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There are two basic types of business combinations – taxable and nontaxable.

Taxable Business Combinations (Asset Purchase):

In a taxable business combination, new tax bases for acquired assets and assumed liabilities are generally determined on the basis of the fair market value. The acquirer “steps up” the acquiree’s historical tax bases in the assets acquired and liabilities assumed to fair market value.  Under the U.S. federal income tax law (IRC Section 338), certain stock purchases can be treated as taxable business combinations if an election to treat the stock purchase as a taxable asset purchase is filed.

Both the seller and purchaser of a group of assets that makes up a trade or business generally must use Form 8594 to report the transaction and both must attach the form to their respective income tax returns.  The taxpayers are not required to file Form 8594 when a group of assets that makes up a trade or business is exchanged for like-kind property in a transaction to which section 1031 applies and when a partnership interest is transferred. For stock purchases treated as asset purchases under Sections 338(g) or 338(h)(10), the purchaser and seller must first file Form 8023, to make the 338 election.  Form 8883 is then filed by both the purchaser and the target to supply information relevant to the election.

There is no legal requirement that the target and acquiring company take consistent positions on their respective tax returns, and therefore each could in principle take a different position favorable to itself.  However, if they do so, the IRS is likely to discover this fact and protect itself by challenging the positions taken by both parties.  To avoid this result, acquisition agreements almost always provide that the parties will attempt to agree on an allocation of price among the assets within a relatively short time after the closing of the transaction. 

Non-Taxable Business Combinations (Stock Purchase):

In a nontaxable business combination, the acquirer assumes the historical tax basis of the acquired assets and assumed liabilities. In this case, the acquirer retains the “historic” or “carryover” tax bases in the acquiree’s assets and liabilities. Generally, stock acquisitions are treated as nontaxable business combinations (unless a Section 338 election is made). Nontaxable business combinations generally result in significantly more temporary differences than do taxable business combinations because of the carryover of the tax bases of the assets acquired and liabilities assumed. To substantiate the relevant tax bases of the acquired assets and assumed liabilities, the acquirer should review the acquired entity’s tax filings and related books and records. This information should be evaluated within the acquisition’s measurement period.

The non-taxable corporate reorganization Internal Revenue Code provisions are concerned with the form, rather than the substance, of the transaction.  Therefore, it is important to document that the correct procedures have been followed.  Regulation Section 1.368-3 sets forth which records are to be kept and which information needs to be filed with tax returns for the year that such a transaction is completed.  Each corporate party to a non-taxable reorganization must file a statement with its tax return for the year in which the reorganization occurred that contains the names and EINs of all parties, the date of the reorganization, the FMV of the assets and stock transferred, and the information concerning any related private letter rulings.  All parties must also maintain permanent records to substantiate the transaction.  While there are no statutory penalties for failure to comply with the reporting requirements, the IRS has argued that failure to comply with the requirements could indicate that a transaction was a sale and not a non-taxable reorganization.

Authored by Robert Cutolo

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One of the major advantages of owning real estate in a partnership is the ability to leverage the real estate and distribute the proceeds of the borrowing to the partners on a tax free basis. 

FOR EXAMPLE: 

Individuals A & B equally own a Limited Liability Company that is treated as a partnership for tax purposes.  The LLC owns real estate with a tax basis of $1 million and a fair market value of $5 million.  The LLC borrows $3 million from a bank on a non-recourse basis, that is, the bank can only look to the property for repayment.  Neither partner is personally obligated to repay the bank.  Immediately after the borrowing, the LLC distributes the $3 million equally to the two partners.

As long as the non-recourse liability is allocated equally to the two partners, the withdrawal of $1.5 million by each partner is a tax free transaction.  This follows Section 752 of the Internal Revenue Code which states that any increase in a partner’s share of the liabilities of a partnership shall be considered a contribution of money by such partner to the partnership.  In effect, the partner’s outside tax basis is deemed to increase by his share of the increase in the partnership’s liabilities.  This increase can provide sufficient tax basis to allow a withdrawal of funds to be considered a tax-free return of basis. Additionally, such an increase in outside tax basis can permit the use of valuable deductions, the benefit of which may have been deferred absent the increase in liabilities and tax basis.     

While an increase in a partner’s share of partnership liabilities increases the partner’s outside basis, a decrease in the partner’s share of partnership liabilities decreases the partner’s outside basis.  Thus, it is important for partner A and B that their share of the partnership’s liabilities does not significantly decrease.  A significant decrease may have the same effect as withdrawing money in excess of tax basis, i.e. resulting in a current taxable gain. 

Thus, a partnership that is contemplating taking in new partners or contributing its property to a larger partnership (for example, a real estate venture fund) must examine how the reallocation of its liabilities will affect the tax liability of its current partners.

A partner who is facing a taxable event due to the reallocation of liabilities may find it beneficial to guarantee a portion of the partnership’s non-recourse liabilities.  A guarantee will convert a portion of the non-recourse liability to a recourse liability.  Partnership recourse liabilities are allocated to that partner who may be ultimately liable for the debt. Thus, by guaranteeing the debt, the partner may be able to maintain a sufficient allocation of partnership liabilities to avoid gain.     

While a guarantee of debt is good for tax purposes, most partners are not willing to take on a possible liability that they did not have previously.  A guarantee may not be a good economic choice.

BOTTOM DOLLAR GUARANTEE

A method of guaranteeing the debt while mitigating the economic risk of satisfying the guarantee is a so-called “bottom dollar guarantee.”  This is a guarantee where the partner agrees to repay partnership debt only if the bank collects less than the guaranteed amount from the partnership. In the example above, if partner A signs a bottom dollar guarantee for $1 million, partner A will only have to satisfy this guarantee if the bank cannot collect at least $1 million of the $3 million debt from the partnership.  Once the bank collects $1 million from the partnership, partner A is relieved of all further liability on the debt.  This is contrary to a normal guarantee, where the guarantor is liable for any and all amounts of the debt left unsatisfied by the partnership up to the stated guarantee amount.

The Internal Revenue Service has been struggling with the issue of whether a bottom dollar guarantee is a real guarantee and should be respected as such for tax purposes.  Recently released proposed regulations under Section 752 make it clear that the IRS will not recognize bottom dollar guarantees as valid guarantees of partnership debt. Under the proposed regulations, a partner only bears the economic risk of loss if the partner is liable for amounts that the partnership does not satisfy. 

The new proposed regulations will not be effective until published in final form.  However, for those partners who have bottom dollar guarantees in place at the time the regulations are finalized, a seven year transition rule is provided. In conclusion, the proposed regulations, if finalized in their current form, will provide that a partner is not able to both mitigate his or her economic risk and increase his or her outside tax basis when he or she guarantees partnership debt.  Accordingly, maintaining a partner’s share of partnership debt will require that the partner take on a real economic burden.  

By Robert E. Demmett, CPA, MS, Partner | rdemmett@withum.com

If you have any questions about this real estate update, please contact your WithumSmith+Brown professional or a member of WS+B’s Real Estate Services Group. 

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While the National Collegiate Athletic Association (NCAA) landscape remains entwined with issues regarding compensation of student-athletes, another element of the debate reached a “foothold”…

U.S. District Court Judge Claudia Wilken (Oakland, CA) recently issued an injunction invalidating NCAA rules that prohibit student-athletes from being compensated for use of their names, images, and likenesses in television broadcasts and video games.

The decision is a win for certain student-athletes in the sense that it would allow football players in the top 10 conferences, and all Division I men’s basketball players, a limited share of the revenue generated by schools from the use of their likenesses. 

However, there are aspects of the injunction that provide factors somewhat beneficial to the NCAA.  Based on witness testimony and current NCAA rules, Judge Wilken determined that the NCAA and schools are allowed to cap the amount of money paid to college athletes while they are in enrolled in school; an eligible athlete must be paid at least $5,000 per year they are academically eligible, but schools do not have to necessarily pay more than that.  Furthermore, the compensation will likely be deferred as schools are permitted to pay the funds to a trust, which would then be held until after an athlete’s eligibility ends or he graduates, whichever occurs sooner. 

Former UCLA basketball player Ed O’Bannon had filed the class-action lawsuit on behalf of himself and other former college athletes against the NCAA, alleging that the NCAA’s prohibition on allowing student-athletes from receiving any compensation other than scholarships and the cost of attendance at schools violated federal antitrust laws.

The NCAA traditionally required student-athletes to sign a form before participating in athletics, which gave the NCAA permission to use player images and likenesses to “promote NCAA championships or other NCAA events, activities or programs.”  Because of this document, student-athletes had been unable to negotiate deals for the use of their likenesses, which the plaintiffs alleged was an unreasonable restraint on trade conspiring to fix the price for the use of athletes’ image and likeness at zero.

The injunction stops short of allowing athletes to receive money for endorsements, nor does it prevent the NCAA from creating rules that prohibit athletes from selling their name, image, and likeness rights individually.  But Judge Wilkin’s ruling is certainly a battle won by the Ed O’Bannon plaintiffs in this continuing “war” with the NCAA over amateurism and legal rights of student-athletes.

An issue with the decision is that was confined “revenue sports” (football players in the top 10 conferences, and all Division I men’s basketball players).  Thus, for the time being it remains up to the NCAA and the individual conferences and schools to determine how, or if at all, “non-revenue athletes” will be compensated for use of their likeness.  “Non-revenue athletes” encompasses the remaining Division I, Division II, and Division III athletes, as well as female student-athletes.  Application of Title IX, which requires equal opportunities and resources for all male and female athletes, is seemingly called into question if only certain athletes are able to be paid for to use of their likeness.

The ruling will not affect any recruit enrolled in college before July 1, 2016.  The NCAA has announced that it will appeal the ruling.

Authored by CJ Stroh

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We have all heard the term milestone payment in the life science field. Generally, milestone payments are made under a collaboration agreement upon the completion of a successful stage of research. These payments are generally deductible for financial accounting purposes. However, these payments are generally capitalized and amortized in the eyes of the Internal Revenue Service.

The Internal Revenue Code generally allows a deduction for all ordinary and necessary expenses paid or incurred during a taxable year on carrying on a trade or business. However, expenditures that create or develop an asset with a useful life beyond the taxable year must be capitalized rather than expensed in the year paid.

The Internal Revenue Service believes that milestone payments relate to the acquisition or creation of intangibles and thus should be capitalized and amortized. They are generally amortizable over the life of the agreement, the remaining life of the patent or 15 years.

Authored by Stephen Talkowsky

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So, you are development stage life science company located in New Jersey and, like the rest of us, in need of cash.  Your accountant tries to sell you a federal research and development tax credit study.  Your response is, “Why?  I don’t have any revenue and thus pay no taxes – get lost!”  While that may be the appropriate response from a federal perspective, that may not be the correct answer from the state of New Jersey’s perspective.

In 1999, New Jersey commenced a program that allows certain development stage companies (emerging technology or biotech companies) to actually sell their unused net operating losses (“NOLS”) and research and development tax credits for cash –  generally to the tune of 90 cents on the dollar.  So, if you have unused New Jersey R&D credits of $100,000, you may be able to sell those credits for $90,000!  The buyer is generally another New Jersey company in need of credits and NOLS.

As with any other program, when dealing with the Federal or State government you need to jump through some hoops and fill out some paperwork.  But, all in all, the process is not that painful.

So, if you are sitting on some unused credits and NOLS or you believe you may have some that you have not yet captured, it is probably worthwhile to taking a look to see if you are sitting on some cash.

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Today’s post comes from Guest Blogger, Daniel Clark.

ANY business that requires their consumers to have internet access to enjoy their services will be affected by the new EU VAT digital services reform.

The new rules have been created with the intention of creating a “level playing field” for all businesses in the digital economy. These are the word of the EU’s Taxation Commissioner Algirdas Semeta who has also stated that the aim of the new EU VAT on digital services is to ensure that the digital economy “plays fair and pays fair.”

In a sense, the powers that be in Brussels, have become increasingly agitated over the influence and power of Silicon Valley multinationals within the EU.

The new rules will close the oft-used loophole of non-EU businesses setting up their European HQ in Luxembourg.  The Grand Duchy has become extremely popular due to its low-tax environment.  For some businesses – such as Amazon – the VAT rate drops as low as 3% for eBooks.  This is referred to as a ‘super-reduced’ rate.

The Silicon Valley giants have been able to do this without breaking any laws.  These new VAT rules are the European Commission’s first steps towards changing the tax culture in the EU.

So, why change VAT first?

VAT has not been as effective as the European Commission would have hoped.  It has been too easy to avoid or not comply with VAT regulations.  The main reason for this is that VAT – which was always intended to be a tax on consumption – was turned on its head and businesses took advantage.  The giants setting up in Luxembourg were doing so to take advantage of the low-tax environment because the rules allowed them to do so.  They charge the low VAT rate based on where they are located.  The key change in the new rules returns VAT to a tax on consumption and from January 2015 onwards VAT on digital services will be charged based on where the consumer is located.

This instantly eliminates any commercial advantage to setting up in a low-tax environment.

This will hurt Luxembourg

Luxembourg has already changed their VAT rates – probably because of the introduction of these new rules.  The finance ministry in Luxembourg has estimated a loss of between €600 million and €1 billion from the EU VAT on digital services reform.  That is 70% of its VAT revenue.

However, there isn’t a lot of sympathy for the Grand Duchy with many arguing that they have for too long taken advantage of the VAT system at the expense of other EU member states.

Meanwhile, EU member states with a large digital service consumer base such as the UK and Germany will benefit from the new rules.  Remember, VAT will now have to be charged based on the location of the consumer.  The rule change only affects B2C sales of digital services.  The UK, for example, has already estimated that it will benefit to the tune of €1.2 billion over four years between 2015 and 2018.

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Way back near the end of May, which feels like a very long time ago, we published a couple of pages of overview on how to classify ownership interests in activities as passive vs. non-passive.  Somewhere in that article I promised to mention how real estate interests can qualify as non-passive activities.

This determination is key in the proper treatment of income and losses both for the purposes of the limitations under the passive activity loss rules and also for the inclusion in the calculation of the new Net Investment Income tax.

For an activity to be considered non-passive, the owner must materially participate in that activity and generally meet one of seven tests enumerated in Reg. Section 1.469-5T, explained previously.  Despite those requirements, rental activities are per se passive, that is, automatically treated as passive regardless of the level of the owner’s participation.  There are a couple of exceptions to that default which we mentioned in the earlier article for self-rental activities, holding a working interest in an oil and gas property, and where a grouping election would be allowed with a non-rental activity in only specific circumstances. However, the most frequently used (and risky) exception to the default treatment of real estate income or loss as passive is when an election is made for a real estate professionals.

Special rules are provided under IRC §469(c)(7) for rental activities commonly referred to as the real estate professional rules.  If the test is met, the rental activity of a real estate professional is treated as non-passive.  Treatment as non-passive is advantageous when a real estate rental activity is generating losses that can be used to offset other income such as interest, dividends and wages.  Conversely, the passive losses would not reduce other passive real estate income for purposes of the net investment income tax.  Planning to make this election should be well thought out in that it may not always be desirable to treat net rental real estate income or loss as non-passive and the election itself may invite increased IRS scrutiny.

Am I a real estate professional?

The real estate professional must satisfy two tests:

  • more than one half of the personal services performed in trades or businesses by the taxpayer during such taxable year are performed in real property trades or businesses in which the taxpayer materially participates, and
  • such taxpayer performs more than 750 hours of services during the taxable year in real property trades or businesses in which the taxpayer materially participates.

At first glance, the test seems relatively easy to satisfy until you realize that for an activity to be counted towards the first and second test, the owner must materially participate in each activity to treat the income or losses as non-passive.  If there are interests in several real estate activities, this may be difficult to satisfy.  To help satisfy the material participation for each activity, a special grouping election can be made under Reg. Section 1.469-9 to treat all interests in rental estate as one activity. Once made, the election is binding for all future years the taxpayer is a qualifying real estate professional and is revocable only if there is a material change in facts and circumstances.  In case you missed the election, one can be filed with an amended return under Rev. Proc. 2011-34.

The rental estate activity is owned by a trust.  Can the trust be a real estate professional?

The Code nor the regulations address how material participation rules can be satisfied for taxpayers who are trust, estate or personal service corporations.  Under IRC §469(c)(7)(B) the requisite amount of service hours must be performed in real property trades or businesses, the performance of which the IRS has previously stated must be by a taxpayer who is a natural person and has the capability for physically performing such services.  In looking to case law for guidance, the U.S, Tax court in a recent decision, held that a trust taxpayer could meet the material participation standards through the performance of its trustees and thus qualify for the real estate professional exception under §469(c)(7). [Frank Aragona Trust, (2014) 142 TC No. 9.] In the case, the taxpayer was a trust that owned rental real estate properties and engaged in other real-estate activities.  The court ultimately rejected the IRS’ argument that a trust is incapable of performing personal services.  Rather, the Tax Court held that the trust is an arrangement whereby trustees have a fiduciary responsibility to manage assets for the benefit of the trust’s beneficiaries and therefore worked performed by an individual as part of their trustee duties are personal services for purposes of satisfying the section 469(c)(7) exception.

The trust was formed by a grantor who, after his death, was succeeded as trustee by his five children and one independent trustee.  All six trustees acted as a management board for the trust and made all major decisions regarding the trust’s property. In addition, a disregarded LLC, wholly owned by the trust, managed the trust’s rental real-estate properties.  The LLC employed several people, some of whom were the trustees.  The court ruled that not only were the activities performed by the individuals in their duties as trustee included as personal services performed in a real-estate trade or business, but also their time spent as employees of the LLC managing the rental real estate properties.

Because the requisite hours in real-property trades were met and the trust materially participated in the real property businesses, the trust met the exception to the per se passive treatment of rental real estate activities and was able to treat the income and losses from the activities as non-passive.

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