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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

(Continuation from previous blog post…)

Despite the previously discussed requirements, rental activities are per se passive, that is, automatically treated as passive regardless of the level of the owner’s participation.  An exception to this default treatment is for real estate professionals, which will be discussed in my next blog post – Stay Tuned!

Would I make a grouping election?  The passive versus nonpassive status is largely non elective and is generally determined by actual participation of the owner in the activity. A voluntary reduction or increase in time spent in certain activities by owners can serve to change the classification of an activity to or from a passive activity. Another way of voluntarily changing the classification is to make a make grouping election to treat a passive and nonpassive entity as one combined entity for purposes of meeting the material participation rules.  This grouping election under Reg. Section 1.469-4 is for grouping one or more trade or business activities or rental activities as one single activity for purposes of meeting a material participation test. The grouped activities must constitute an appropriate economic unit.  Factors that support this definition include:

  • Similarities and differences in types of trades or businesses;
  • The extent of common control;
  • The extent of common ownership;
  • Geographical location; and
  • Interdependencies between or among the activities

So, for example, if you wished to group two activities, one in which an owner materially participates and the other in which he does not, the grouped single activity will be treated as a material participation activity, or nonpassive, to the owner.  However, there is an important limitation on grouping rental activities with other trade or business activities. A rental activity may not be grouped with a trade or business activity unless the activities being grouped together constitute an appropriate economic unit and

-The rental activity is insubstantial in relation to the trade or business activity;

-The trade or business activity is insubstantial in relation to the rental activity; or

-Each owner of the trade or business activity has the same proportionate ownership interest in the rental activity.

A grouping election under Reg. Section 1.469-4 must be reported on the tax return and the grouping cannot be changed in subsequent years unless the original grouping was inappropriate or a material change in facts and circumstances makes the grouping inappropriate. However, because the new net investment tax applies to activities which are passive, the regulations allow a “fresh start” for making a new grouping election starting in 2014, but a change to an existing grouping election can also be made in 2013 if the client is subject to the net investment tax in 2013.

Does the Net Investment Income Tax apply to a self-rental activity?

The self-rental rules were discussed frequently this tax prep season and given a fresh look because of their applicability to the new net investment income tax. If property is rented for use in a trade or business activity in which the taxpayer materially participates, the net income from the rental activity is considered a “self-rental” and that income is recharacterized as nonpassive. If the rental activity generates a net loss for the tax year, the income is not recharacterized and remains passive. Thus, the treatment can change from year to year. The treatment of the income or loss as nonpassive or passive retains the same character for net investment income tax purposes.

These questions will continue to be asked and examined for next filing season as we continue to get comfortable with the net investment tax.  Although the rules are not new, they have definitely been brought to light due to the new tax and the necessity to determine an activity’s classification as passive or nonpassive.  Of course, the above explanations are fairly general explanations for some very complicated tax areas that need to be read through thoroughly when dealing with these issues.

As I recover from the latest busy season, I took time to reflect on what was the most common question I was asked.  Not surprisingly, it dealt with the material participation standards under Section 469 and the interplay with the net investment income tax under Section 1411

Although material participation rules are hardly new, they were given added importance with the introduction of the new net investment tax this filing season.  This new tax forced many of us to reexamine with our clients, their participation throughout the year in business entities in which they own an interest.  To complete the new Form 8960 we needed to go through the exercise of putting various ownership interests into separate buckets of nonpassive activities and passive activities, that is, activities in which the taxpayer materially participates or does not materially participate. This lead to further discussion on issues that we have always had to deal with such as passive loss limitations, grouping elections, self-rental rules and the real estate professional exception. Various common questions arose and are discussed in general below:

Is this activity passive or nonpassive?  Usually this question arose in the context of whether or not the activity was subject to the new net investment tax.  But, the answer tends to be more important for the reason for which the rule was first enacted: to limit the allowance of passive losses to the amount of passive income for the year.  A passive activity is defined in IRC 469(c) as the conduct of a trade or business in which the taxpayer does not materially participate.  A nonpassive activity is one that is not passive, and, therefore, one in which the taxpayer materially participates.  So, meeting the requirements for material participation is key to this determination.  Material participation is briefly defined in IRC Section 469(h) as involvement in the operations of an activity on a basis which is regular, continuous and substantial.  The Temporary Regulations under Reg. 1.469-5T enumerate seven tests, any one of which can be met to satisfy material participation in an activity:

1) The individual participates in the activity for more than 500 hours during such year.

(2)The individual’s participation in the activity for the taxable year constitutes substantially all of the participation in such activity of all individuals (including individuals who are not owners of interests in the activity) for such year;

(3)The individual participates in the activity for more than 100 hours during the taxable year, and such individual’s participation in the activity for the taxable year is not less than the participation in the activity of any other individual (including individuals who are not owners of interests in the activity) for such year;

(4)The activity is a significant participation activity (within the meaning of paragraph (c) of this section) for the taxable year, and the individual’s aggregate participation in all significant participation activities during such year exceeds 500 hours;

(5)The individual materially participated in the activity (determined without regard to this paragraph (a)(5)) for any five taxable years (whether or not consecutive) during the ten taxable years that immediately precede the taxable year;

(6)The activity is a personal service activity (within the meaning of paragraph (d) of this section), and the individual materially participated in the activity for any three taxable years (whether or not consecutive) preceding the taxable year; or

(7)Based on all of the facts and circumstances (taking into account the rules in paragraph (b) of this section), the individual participates in the activity on a regular, continuous, and substantial basis during such year.

Stay tuned for more in part 2 next week…

Withum Smith + Brown’s (“WS+B”) client base is very diverse.  During my 10+ year career I have worked with clients from multi-national consolidated groups to start-up entities. No matter how big or small the company, I often am asked: “Is my current entity choice optimal from a tax perspective?”

To help our clients better understand their choices, WS+B created a chart that highlights the differences amongst the three most common entities (C-Corporation, S-Corporation and LLC).

Aside from the tax considerations, when choosing an entity, thought should be given to the current goals, long term goals and legal issues of the company.

(Click to enlarge)

Capture

Authored by Steve Talkowsky

A new chapter was added to the ongoing dispute as to whether student athletes should be compensated for (i) the part they play in helping their respective schools generate millions of dollars in revenue from ticket sales and the use of their individual player likenesses, and (ii) the predominant amount of time that is spent as an athlete as opposed to a student.  It is a deeper issue than simply framing it as “pay for play”, but that discussion is one for another day …

What is important for our purposes is that the National Labor Relations Board (“NLRB” or the “Board”) recently ruled Northwestern University’s scholarship football players (differentiated from walk-on players) are “employees” under the National Labor Relations Act (the “Act”), and as such, have the right to unionize for collective bargaining purposes.

The Board’s ruling will be appealed, so the practical application of this unionization right and the resulting sub-issues from the decision will be delayed as of this writing.  However, there are theoretical tax matters that will play a part in the debate, and that could emerge if student-athletes are in-fact deemed “employees”.  Furthermore, the reasoning that the NLRB used to reach its conclusion that student-athletes are “employees” may also be the basis for which student-athletes would be taxed.

Without going into extensive detail, the NLRB determined that the Northwestern football players receive the substantial economic benefit of a scholarship in exchange for performing football-related services, under what amounts to be a contract-for-hire.  Additionally, the Board made note of the extensive amount of control that the football coaching staff and University have over the players, and that if team rules are broken, scholarships can be revoked:

  • NCAA rules prohibit players from receiving additional compensation or otherwise profit from their athletic ability and/or reputation, so scholarship players are dependent on their scholarships to pay for basic necessitates, including food and shelter;
  • Players devote 40-60 hours per week for football, depending on whether it is in-season versus the off-season, despite the NCAA’s prescribed limitation of 20 hours per week once the academic  year begins;
  • Coaches control living arrangements, outside employment, the ability to drive personal vehicles, travel arrangements off-campus, social media, use of alcohol or drugs, and gambling;
  • Players also are sometimes unable to take courses in certain academic quarters because they conflict with scheduled team practices.

At this point it is not entirely clear what student-athletes would be taxed on because if the decision is ultimately affirmed, there could be conflicting definitions and concepts in the tax code with respect to “gross income”, “compensation for services” and “qualified scholarships.”

For income tax purposes, “gross income” means all income from whatever source it is derived, and this includes compensation for services.  Until now student-athletes have not been considered employees, which is essentially why their scholarship (or parts of) have not previously been taxed.  But the NLRB went to great lengths to detail how the Northwestern football players currently receive compensation for playing football (the reason it saw fit to classify them as employees).  On that same basis, the IRS would likely take the position that the granted scholarships are compensation for services, and are thus taxable income to the student-athletes.  Whether the current statutory language would have to be amended or exclusions would have to be created to properly allow for this taxation is a secondary issue.

Yet there are other benefits the Northwestern football players have cited which they feel would outweigh the negative impact of taxes they might incur.  If the decision is upheld, players might be able to qualify for workers’ compensation benefits as a result of injuries suffered on the field.  Moreover, instead of coaches having unilateral control over the schedules and rules players must abide by at the risk of losing scholarships, the union the players could form would bargain with the university over “working conditions”.  This would be similar to the way in which the NFL and MLB players’ unions bargain for benefits of their respective players.

However, rights that are bargained for by this theoretical union could lead to further questions for the university.  For example, if players successfully bargained for health benefits, Title IX (which demands equal treatment of male and female athletes) might require equivalent benefits to all of the other athletic programs on campus.  Conversely, bargained-for benefits such as safer football helmets or equipment would not necessitate comparable action on the part of the school.

The NLRB ruling in the Northwestern case is restricted to private universities, meaning efforts by student-athletes of state schools would be governed by each state’s laws on unions of public employees.  However, this decision is an initial step in what will be a lengthy process that ultimately could re-shape the National Collegiate Athletics Association (“NCAA”) … and tax issues will most certainly have a substantial impact along the way.

CJ Stroh, Esq.

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