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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.

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.

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.

The Philadelphia 76ers will construct an $82 million dollar state-of-the-art practice facility and team headquarters in Camden, NJ, aimed to be completed by 2016.  Pursuant to New Jersey’s New Jobs Investment Tax Credit,” the State has awarded tax credits to the 76ers over a 10-year period (not to exceed $82 million,) which should allow the team to recoup the FULL cost of building the complex.

The deal guarantees an $8.2 million tax credit annually that the Sixers can use or sell, so long as the team (1) employs 250 people in Camden, and (2) stays in the city for 15 years.  If the team employee total at the facility drops below 250 in any year, the tax credits would be reduced to $5 million per year.

This specific New Jersey tax credit entitles corporate entities to a credit against the portion of their corporation business tax liability that is attributable to certain qualified investments in buildings, building components, equipment and capitalized start-up costs, in any new or expanded business facility in New Jersey, which results in the creation of a specified number of new jobs in the state.

The credit is determined by multiplying the amount of a corporation’s “qualified investment” by its “new jobs factor.” “Qualified investment” is determined based on the expected depreciation life of the property for federal income tax purposes, as depicted below:

  • property with a 3-year life—35% of cost;
  • property with a 5-year life—70% of cost; and
  • property with a life of seven or more years—100% of cost.

The “new jobs factor” is based on the number of jobs created in New Jersey which are directly attributable to the entity’s investment in the new or expanded business facility.

While the Sixers are required to provide 250 jobs to maintain the tax breaks, 200 of these positions are already filled by team administrators, players, and staff. Thus, only 50 new jobs will actually be created.

The 76ers are the only NBA franchise without its own practice facility, and the team has been using the Philadelphia College of Osteopathic Medicine for such purposes since 1999. The team will continue to play its home games at the Wells Fargo Center in Philadelphia.

The team’s individual players currently pay Philadelphia wage taxes on days they have home games, and pay other city wage taxes when the team is on the road. The players will eventually have to pay a New Jersey wage tax for the time they spend practicing in New Jersey.

Authored by CJ Stroh

One of the most common questions I get from clients relates to the structure of their potential real estate deals.  While almost everyone has heard the age old adage “Never put real estate in a C corporation,” many people seem to see LLCs and S corporations as equally acceptable pass-through alternatives for holding real estate.   In reality, this couldn’t be farther from the truth.  The following will outline five reasons why an LLC is preferable to an S corporation for holding real estate in the current environment.

  1. Number of shareholders – An S corporation is limited to only 100 shareholders.  Under Sec. 1361, members of a family (as defined within the Code) are considered one shareholder for purposes of this 100 shareholder test.   Conversely, there is no limit on the number of allowable members of an LLC.  While this wouldn’t seem like a major limitation for a majority of property owners, if a taxpayer were interested in syndicating interests in the pass through entity in an effort to raise capital this 100 shareholder cap could significantly limit their ability to do so.
  2. Type of shareholders – In addition to limiting the number of shareholders to 100, the Internal Revenue Code also limits the types of entities that can be shareholders of an S corporation.  For starters, nonresident aliens are not permitted to own stock in an S corporation and certain types of trusts are excluded as shareholders as well.  Neither C corporations nor partnerships and other entities taxed as partnerships under the default entity classification rules (multi-member LLCs) may not own shares in an S corporation.  With an LLC, any type of entity, domestic or foreign, is a permitted member.
  3. Only one class of stock – Many investors demand priority returns on their invested capital, as well as a priority return of their invested capital. In an S corporation, it is not possible to offer these benefits to investors.  S corporations are only permitted to issue one class of stock. While the rules will permit an S corporation to issue voting and nonvoting stock, it is not possible to provide distribution or liquidation preference to certain shareholders at the expense of others.  In an LLC, the allocations of cash are much more flexible and allow for these priority returns so long as the allocations meet the overall requirement of substantial economic effect.
  4. Basis concerns – Many real estate investments offer losses in early years as a result of the benefits of accelerated depreciation deductions.  These noncash deductions shield cash flow from taxation during the early years of the investment and generate losses that are allocable to the shareholders or members.  The investors are only permitted to deduct those losses to the extent that they have basis in the pass through entity.  I will avoid for now a long detour into the rules of both partnership and S corporation basis, but there is one major difference that is worth highlighting. Shareholders in an S corporation are only deemed to have basis in the pass through entity to the extent of any money invested into the entity and any loans made directly from the shareholder to the pass through entity. In an LLC, members are deemed to have basis for both their contributions into the entity and their ratable share of all liabilities of the entity. This allows members in an LLC to deduct losses in excess of their individual investment to the extent that they are allocable a portion of the liabilities of the entity.
  5. Basis adjustments – The last way in which the two past through types differ is in the allowable adjustment to basis under IRC Sec. 754.  This section of the Internal Revenue Code allows a partnership to adjust the basis of partnership property when there are taxable sales or exchanges of interests or redemptions of a partnership interest.  There is no similar adjustment available to shareholders of an S corporation.  This adjustment helps to keep a members’ outside basis in his or her partnership interest in line with the partnerships’ basis in the underlying partnership property. Since this opportunity does not exist for an S corporation, an S corporation shareholder can end up with a substantial variance in his or her basis in the S corporation stock, which could generate undesirable income tax consequences.

These five issues should be considered heavily when making a choice of entity.  In most cases, one or more of these factors will make the choice of entity obvious. In more cases than not, an LLC will be preferred entity type for real estate investment. With an LLC, there is no cap on the number of shareholder and no limitation on the types of shareholders.  In addition, a referred return on capital and a priority return of capital can be provided to investors without the fear of running afoul of the IRC rules.  If none of the other issues outlined makes the decision, the optional basis adjustment under Sec. 754 alone can be substantial enough to point to an LLC as the preferred entity type.  The Sec. 754 adjustment can provide significant tax advantages to an investor and should be given a good amount of weight in the choice of entity decision.

Authored by Brian Lovett

If you are like the most of us – you have heard the term “Captive Insurance Company,” but have no idea what it means or how it works.  Most companies I deal with think they are “too small” to create a captive.  Well, not too fast – many middle market companies have reaped the benefits of creating a captive.  Discussed below, is a high-level summary of some of the benefits your business can obtain.

The use of captives is one of the best-defined strategies for closely-held and middle market companies.  They can provide a wide array of benefits for clients including lower insurance costs, improved risk management, diversified profits and tax planning opportunities.

Captives have generated much attention due to recent legislation allowing their formation in many states.  In addition, captives have been the subject of favorable rulings from regulatory agencies such as the Internal Revenue Service.

A captive is a legally bona fide insurance company.  It insures the risks of operating companies with which it shares common ownership.

Capture

Following are some of the benefits of implementing a captive insurance company:

  • Improved Insurance Program- The ability to customize a program to the operating company’s needs can result in (i) reduced costs; (ii) better claims management; (iii) stabilization of insurance rates; and (iv) the purchase of insurance at “wholesale” rates.
  • Enhance Tax Planning Opportunities

o    Income Tax. The operating company receives a deduction for bona fide insurance premium paid.  The captive receives this premium as income, but does not pay tax on it under the Code, provided those premiums are less than $1.2 million annually per captive.  The net result is that the captive converts taxable income to non-taxable income, less associated expenses and claims.

o    Estate and Gift Tax. The captive is not subject to estate or gift tax when properly structured.  Consequently, the value can pass to heirs without those taxes.

  • Improve Financials- The captive has appreciable expense and tax management benefits.  Provided the structure is compliant with any bank covenants, the overall financial solvency of Client should be improved.

Steve Talkowsky

 

One of the questions asked most often from clients is whether they can currently deduct improvements to their property or must they capitalize and deduct ratably over many years.

In September, 2013, the IRS provided guidance when they issued the New Tangible Property Regulations (T.D. 9636). The regulations are applicable to tax years beginning on or after January 1, 2014.

Under the regulations dealing with improvements, an expenditure must be capitalized if it meets any of the “BAR” tests. That is, the expenditure results in a betterment to the unit of property, adapts the unit of property to a new or different use, or results in a restoration of the unit of property.

Betterment – an expenditure results in a betterment if it ameliorates a condition or defect that existed before the acquisition of the property or arose during the production of the property; is for a material addition to the property; or increases the property’s productivity, efficiency, strength, etc.  For an example of an amelioration of a pre-existing condition assume in Year 1, “A” purchases a store located on a parcel of land that contains underground gasoline storage tanks left by prior occupants.  The tanks had leaked prior to “A’s” purchase, causing soil contamination.  “A” is not aware of the contamination at the time of purchase.  In Year 2, “A” discovers the contamination and incurs costs to remediate the soil.  The remediation costs are for a betterment to the land because “A” incurred the costs to ameliorate a material condition or defect that existed prior to “A’s” acquisition of the land.

Adapts - An expenditure results in an adaptation to a new or different use if it adapts the unit of property to a use inconsistent with the taxpayer’s intended ordinary use at the time the taxpayer originally placed the property into service.  For an example of an adaptation to a new or different use, assume “A” is a manufacturer and owns a manufacturing building that it has used for manufacturing since Year 1, when “A” placed it in service.  In Year 30, “A” pays an amount to convert its manufacturing building into a showroom for its business.  To convert the facility, “A” removes and replaces various structural components to provide a better layout for the showroom and its offices.  The amount paid to convert the manufacturing building into a showroom adapts the building structure to a new or different use because the conversion to a showroom is not consistent with “A’s” ordinary use of the building structure at the time it was placed in service.  Therefore, “A” must capitalize the amount paid to convert the building into a showroom as an improvement to the building.

-  Restoration - An expenditure results in a restoration of an asset if the expenditure (1) restores basis that has been taken into account (e.g., as a loss or in computing gain or loss); (2) returns the unit of property to working order from a state of nonfunctional disrepair; (3) results in a rebuilding of the unit of property to a like-new condition after the end of the property’s alternative depreciation system class life; or (4) replaces a major component or substantial structural part of the unit of property.  For an example of a restoration, assume “A” owns a manufacturing building containing various types of manufacturing equipment.  “A” does a cost segregation study of the manufacturing building and properly determines that a walk-in freezer in the manufacturing building is section 1245 property as defined in section 1245(a)(3).  Several components of the walk-in freezer cease to function, and “A” decides to replace them.  “A” abandons the old freezer components and properly recognizes a loss from the abandonment of the components.  “A” replaces the abandoned freezer components with new components and incurs costs to acquire and install the new components.  “A” must capitalize the amounts paid to acquire and install the new freezer components because “A” replaced components for which it had properly deducted a loss.

Please note that the expenditure is tested against all the BAR tests.  As such, if an expenditure does not constitute a betterment, the taxpayer may still have to capitalize it as an adaptation to a new use or as a restoration.  Expenditures on existing assets that do not meet the BAR tests are generally deductible repairs.

 

David Poillucci/Darren Thomas

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