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Tax Court: S Corporation Shareholder Must Reduce Basis For Loss He Failed To Take

Posted in Uncategorized, tagged , , , , , , , on March 22, 2012 | 1 Comment »

Who’s up for a little S Corporation 101?

Well, I’m doing it anyway. S corporations generally don’t pay tax. Instead, the corporation’s taxable income or loss is divvied up and allocated to its shareholders, who report the income on their Form 1040.[i]

S corporation shareholders are required to maintain their “basis” in their S corporation stock. This is done primarily for three reasons: to determine gain or loss on the sale of the stock, to determine the taxability of S corporation distributions[ii], and lastly, to determine the maximum amount of S corporation loss allowable on the shareholder’s individual income tax return. It is this final reason we concern ourselves with today.

Unlike a C corporation, a shareholder’s stock basis in an S corporation is not static. Because of the “flow through” nature of S corporations, a shareholder’s basis must constantly be adjusted to prevent the corporation’s income from being taxed twice.[iii]

In general, a shareholder’s basis in his S corporation stock is increased for:

  • Capital contributions
  • Items of income (including tax exempt income)

And decreased for:

  • Distributions
  • Items of loss and deduction (including non-deductible expenses like M&E)[iv]

For any tax year, a shareholder’s allocable share of the S corporation’s loss can only be deducted to the extent of the shareholder’s basis in his stock, after accounting for the increases listed above.[v] To the extent a loss is limited under this rule, it is “suspended” and carried forward, where it is treated as a new loss in the succeeding year and is again subject to the basis limitation rule.

Today, the Tax Court tackled a seemingly simple, yet interesting issue. What if a shareholder neglects to deduct a loss they are entitled to. Must they reduce their stock basis for the loss, even though they received no tax benefit from the loss?

Let’s apply some round numbers to make it easier to follow. In 1995, A set up S Co. with a $50,000 capital contribution. During 1995 and 1996, A was allocated $200,000 of loss from S Co. which reduced his basis to $0 as of the end of 1996. Because the loss exceeded A’s positive basis of $50,000, A only received the benefit of $50,000 of loss during those two years, with the remaining $150,000 of loss suspended as of December 31, 1996.

In 1997, A contributed $250,000 to S Co. S Co. allocated a $50,000 loss to A in  1997, which he deducted on his Form 1040. A, however, failed to deduct the prior year suspended loss of $150,000, despite the fact that his capital contribution gave him ample basis to do so. As a result, A did not decrease his basis for the suspended loss, leaving him with $200,000 of stock basis as of December 31, 1997.

Fast forward five years. From 1998-2003, A continued to reflect this “extra” $150,000 in his basis, which stood at $300,000 on January 1, 2003. In 2003, S Co. allocated a $275,000 loss to A, which he deducted in full on his return.

The IRS disallowed $125,000 of the loss, arguing that A’s stock basis was required to be reduced by $150,000 of additional losses in 1998 — even though A did not deduct the loss on his return, as he was entitled to. Because under this calculation, A would have only $150,000 of stock basis on January 1, 2003 ($300,000 according to A less $150,000 downward adjustment from 1998), S Co.’s 2003 loss of $275,000 was limited to A’s stock basis of $150,000.

In defense of his stock basis calculation, A argued that I.R.C. § 1367 requires basis reduction only for losses that the S corporation shareholder reports on his or her tax return and claims as a deduction when calculating tax liability.

The Tax Court disagreed and sided with the IRS, holding that a shareholder is required to reduce his basis in S corporation stock for his allocable share of the S corporation’s loss, even if the shareholder did not deduct the loss on his Form 1040. From the court:

The class of losses described in section 1366(a)(1)(A)[S corporation losses] is not limited to losses that were actually claimed as a deduction by the shareholder on the shareholder’s tax return. Therefore, the basis reduction rule in section 1367(a)(2)(B) is not limited, as the Barneses contend, to losses that were actually claimed as a deduction on a return.

As a result, A was denied $150,000 of loss on his 2003 tax return. Of course, A would have been entitled to amend his 1996 return to take the $150,000 loss he was entitled to during that year, if it weren’t closed by statute. Ouch.

[i] S corporation shareholders are generally required to be individuals, but see I.R.C. § 1361 for the rules regarding certain qualifying trusts.

[ii] See I.R.C. § 1368 and our previous post here

[iii] To illustrate, assume Mr. A contributed $100 to S Co. in exchange for all of its stock. S Co then earns $20 in year 1, which is not taxed at the S corporation level, but rather flows through to Mr. A and is taxed on his Form 1040. Presumably, the value of S Co. is now $120. If Mr. A sells the stock for $120, were he not required to adjust his basis in the S Co. stock, he would recognize $20 on the sale ($120 sales price – $100 basis). By increasing Mr. A’s stock basis by the $20 of income recognized by S Co., Mr. A recognizes no gain on the sale of the S Co. stock ($120 sales price – $120 basis). Thus, the $20 earned by S Co. is only taxed once.

[iv] I.R.C. § 1367

[v] The regulations at Treas. Reg. §1.1367-1(f) also require distributions to reduce stock basis before losses.

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Eighth Circuit Upholds Iowa District Court’s Decision in Watson; Provides Road Map to Reasonable Compensation

Posted in Uncategorized, tagged , , , , , , , on February 21, 2012 | 3 Comments »

In December 2010, an Iowa district court decided Watson, a reasonable compensation case involving an S corporation shareholder-employee. For a primer on why reasonable compensation is a frequently litigated issue with regards to closely held S corporations, click here.

Watson, in many respects, was a precedent-setting case in the S corporation reasonable compensation arena, as it shed much-needed light on the methodology the IRS and the courts will employ to determine reasonable compensation, providing an analytical approach tax advisers could follow when guiding their clients.

Today, the Eighth Circuit affirmed the district court’s decision in Watson, holding that an S corporation shareholder-employee (Watson) who paid himself only $24,000 in salary during 2002 and 2003 while withdrawing over $375,000 in distributions was not reasonably compensated for his services. The court further upheld the district court’s determination of an annual reasonable compensation amount of $93,000, requiring Watson to recharacterize $69,000 of distributions in each year as salary. As a result, the corporation and Watson were held liable for over $23,000 in payroll taxes, penalties, and interest.

Facts in Watson:  

David Watson — like many of the subjects of reasonable compensation scrutiny — was a CPA.[1] He was also the sole shareholder and employee of an S corporation, which in turn was a 25% shareholder in a very successful accounting firm. Watson’s share of the revenue generated by the accounting firm was allocated to his S corporation, which would then pay Watson a salary and distributions. Any amounts not paid out in salary by the corporation were reported by Watson as his share of the S corporation’s income on his personal tax return, where it was not subject to payroll tax.[i]

In 2002 and 2003, Watson set his compensation from his wholly owned corporation at a mere $24,000 per year, an amount that was less than what first-year employees at his firm were earning.  In comparison, Watson received distributions of $203,651 and $175,470, respectively, in those years.

The IRS challenged Watson’s compensation as being unreasonably low; arguing that by foregoing salary in favor of distributions, Watson and the S corporation were avoiding payroll tax responsibilities.

Significance of Watson

In nearly all of the S corporation reasonable compensation cases that preceded Watson, the shareholder-employee failed to take any salary but withdrew distributions, leaving the IRS and the courts the simple task of reclassifying  the distributions as compensation for services.  

Because Watson actually reported compensation of $24,000 in each of the years in question, however, the Iowa District Court and the Eighth Circuit was faced with an issue of first impression: quantifying just what constituted “reasonable compensation” for Watson’s services. The resulting analysis provided the first court-approved roadmap for tax advisers to use in setting appropriate salary amounts for their S corporation shareholder-employee clients.

IRS Approach, District Court Decision

In setting Watson’s salary, the IRS engaged the services of a general engineer, who testified that based on the health of the accounting firm and the compensation of Watson’s peers in the industry, his compensation was unreasonably low.

To quantify the appropriate salary, the engineer utilized MAP surveys conducted by the AICPA, which indicated that the average non-owner director of a CPA firm the size of Watson’s would be paid $70,000. The engineer then grossed up this salary by 33% to account for Watson’s stake as a shareholder,[ii] resulting in “reasonable” compensation of $93,000 for each of 2002 and 2003.

The District Court agreed, citing Watson’s experience, expertise, and time devoted to his role as one of the primary earners at a well-established firm.

Eighth Circuit Decision

Today, the Eighth Circuit affirmed the holding of the district court. In reaching its decision, the court concluded that the characterization of funds distributed by an S corporation to its shareholder-employees turns on the analysis of whether the payments were made as compensation for services, not on the intent of the S corporation in making the payments. [iii]

The Eighth Circuit did briefly address Watson’s argument that his reasonable compensation should be capped at the revenue he personally generated for the CPA firm, less his allocable expenses. While the court admitted that evidence of shareholder billings may be probative on the issue of compensation, the Eight Circuit ultimately refrained from adjusting the previous calculation of Watson’s reasonable compensation performed by the IRS.  

What Can We Learn?

For tax advisers, the Eighth Circuit’s decision should reinforce the lessons taken home from the original Watson decision. The IRS is taking a formal, quantitative approach towards determining reasonable compensation, so to adequately advise our clients, we must be prepared to do the same thing.

At a minimum, in setting the compensation of our S corporation shareholder-employee clients, we must consider the following (note, all of these considerations are discussed in much greater detail in this PDF: Tax Adviser – S Corporation Shareholder-Employee Reasonable Compensation):

1. Nature of the S Corporation’s Business. It is no coincidence that the majority of reasonable compensation cases involve a professional services corporation, such as law, accounting, and consulting firms. It is the view of the IRS that in these businesses, profits are generated primarily by the personal efforts of the employees, and as a result, a significant portion of the profits should be paid out in compensation rather than distributions.

2. Employee Qualifications, Training and Experience, Duties and Responsibilities, and Time and Effort Devoted to Business. A full understanding of the nature, extent, and scope of the shareholder-employee’s services is essential in determining reasonable compensation. The greater the experience, responsibilities and effort of the shareholder-employee, the larger the salary that will be required.

3. Compensation Compared to That of Non-shareholder Employees or Amounts Paid in Prior Years.  Here, common sense rules the day. In Watson, a CPA with significant experience and expertise was  paid a smaller salary than recent college graduates. Clearly, this is not advisable.

4. What Comparable Businesses Pay for Similar Services. Tax advisors should review basic benchmarking tools such as monster.com, salary.com, Robert Half, and Bureau of Labor Statistics wage data to determine the relative reasonableness of the shareholder-employee’s compensation when compared to industry norms.

5. Compensation as a Percentage of Corporate Sales or Profits. Tax advisors should utilize industry specific publications such as the MAP to determine the overall profitability of the corporation and the shareholder-employee’s compensation as a percentage of sales or profits. Whenever possible, comparisons should be made to similarly sized companies within the same geographic region. If the resulting ratios indicate that the S corporation is more profitable than its peers but paying less salary to the shareholder-employee, tax advisors should determine if there are any differentiating factors that would justify this lower salary, such as the shareholder’s reduced role or the corporation’s need to retain capital for expansion. If these factors are not present, an increase in compensation to the industry and geographic norm provided for in the publications is likely necessary.

6. Compensation Compared With Distributions. While large distributions coupled with a small salary may increase the likelihood of IRS scrutiny, there is no requirement that all profits be paid out as compensation. Though the District court in Watson recharacterized significant distributions as salary, it permitted Watson to withdraw significant distributions in both 2002 and 2003. Perhaps the court was content to recharacterize just enough distributions to ensure that Watson’s compensation exceeded the Social Security wage base in place for the years at issue.[iv] In doing so, the payroll tax savings on Watson’s remaining distributions amounted only to the 2.9% Medicare tax.

[1] See Joseph M. Grey.
[i] See Rev. Rul. 59-221.

[ii] The MAP revealed that in general, shareholders billed at a rate 33% higher than non-owner directors.

[iii] Watson tried to argue that it was the intent of the S corporation to pay him only $24,000 for his services, with the remaining cash to be distributed based on the CPA firm’s success, a fact both courts found highly implausible given Watson’s experience and expertise.

[iv] $84,900 in 2002 and $87,000 in 2003.

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The Subtle Differences Between Fraud and Tax Fraud

Posted in Uncategorized, tagged , , , , , , , , , , , , on February 14, 2012 | Leave a Comment »

Certain things, while having the look, sound, and even feel of illegality, are actually within the confines of the law, like cock-fighting, marrying a step-sister, or killing a hobo for sport. Wait…what? OK, scratch that last one. But you get the idea. The law is complicated and convoluted, and what separates the guilty from the accused is often times attributable to puzzling semantics.

Consider this recent Tax Court case, in which an air conditioning technician, despite conducting a pattern of behavior that any reasonable person would coin corporate fraud, successfully avoided over $260,000 in penalties courtesy of the specific nuances of the tax law.  

Paul Avenell (Avenell) owned 96% of a corporation (Tacon). Tacon was sued, lost, and as a consequence, owed significant sums to a former subcontractor. Believing the verdict to be unjust, Avenell filed for bankruptcy and began to divert funds away from the corporation so they couldn’t be accessed by his creditor. As checks came in, he would exchange them for cashier’s checks, which were used to pay both corporate and personal expenses. As a result, the income was never recorded inside Tacon. The IRS assessed tax deficiencies, as well as substantial fraud penalties.

Despite his subversive behavior, the court found that Avenell had not committed tax fraud, because his concealment of income was done with the intent of avoiding judgment collection, rather than with the specific purpose of evading income tax.

Respondent infers that petitioner intended to evade taxes by exchanging general contractor’s checks for cashier’s checks and using those funds for personal purposes, including making a personal loan and opening a Cayman Islands bank account. Respondent further infers fraudulent intent from petitioner’s purchases of real estate in others’ names. Piling inference upon inference, however, does not qualify as clear and convincing evidence.  His inferences fall short of the required proof of fraud by clear and convincing evidence. We cannot conclude that petitioner’s delusive behavior was part of a deliberate scheme of fraudulent tax evasion. Petitioner credibly testified that he refused to deposit funds into Tacon’s account to avoid the judgment collection. The timing of petitioner’s delusive behavior involving cashier’s checks, the Cayman Islands bank account, real property purchases and the personal loan is consistent with that of Grant Metal’s judgment. We do not condone petitioner’s efforts to avoid judgment collection. We also do not find, however, that his actions were done with the intent to evade tax.

Because the underlying tax deficiencies were assessed more than three years from the date the tax returns were filed, the failure of the IRS to prove fraud — which would have extended the statute of limitations indefinitely — permitted Avenell to avoid the assessed tax in addition to the dismissed fraud penalties.

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Tax Aspects of the Facebook IPO (Alternate Title: Mark Zuckerberg Could Buy Most of Europe With His 2012 Tax Bill)

Posted in Uncategorized, tagged , , , , , , , on February 4, 2012 | 20 Comments »

On Wednesday, Facebook filed S-1 documents in advance of its initial public offering,  in which the web giant seeks to raise a cool $5 billion. And while the bulk of the 300 pages serve primarily to sicken readers with the realization that hundreds of 20-somethings will become overnight millionaires simply for designing a place for people to share baby pictures and take joy in how much weight their exes have gained, there are some interesting tax tidbits to be gleaned from the filing:

  • Despite recognizing $1.7 billion in pre-tax book income in 2011, Facebook anticipates that it will generate a net operating loss (NOL) in 2012. How is that possible? Through its employees’ exercise of nonqualified stock options, that’s how.

 After the IPO, hundreds of millions of shares of NQ options previously granted to employees are expected to be exercised. As a reminder, these forms of compensation are generally not taxable under I.R.C. § 83 until exercise, provided that the stock is freely transferable and not subject to a substantial risk of forfeiture at that time. If these requirements are met, upon exercise the employee must recognize income equal to the excess of the FMV of the stock over the exercise price, with the employer getting a corresponding deduction.

 Assuming Facebook stock reaches a price of $40 per share on the open market, the corporate deduction related to the exercise of employee options will be in the billions; large enough not only to enough to wipe out the comany’s 2012 taxable income, but also –according to the prospectus — to generate an NOL that will be carried back to generate $500 million in tax refunds.

  • Because the income recognized by employees upon the exercise of NQ options is taxed as compensation, Facebook is anticipating using a good portion of the $5 billion in proceeds raised from the IPO to pay its required tax withholding obligations.
  • In addition to its public offering, the prospectus indicates that CEO and Founder Mark Zuckerberg will also sell a significant amount of his common stock to the public. Why would he do it? To pay a tax bill.

In the most startling information contained in the S-1 comes the news that Zuckerberg will be exercising options to purchase 120 million shares of Facebook stock after the IPO. These shares have an exercise price of 6 cents per share, so if the stock price reaches $40 per share as anticipated, Zuckerberg stands to make $4.8 billion in compensation upon exercise. That’s right…billion. The tax bill on that $4.8 billion — between federal and California — could reach nearly $2.0 billion, so Zuckerberg will have to sell additional shares to generate some cash. Needless to say, collecting state income tax of this magnitude from Zuckerberg and other Facebook employees could provide a temporary reprieve to the long-struggling California economy.  

  • This could be Zuckerberg’s last tax bill for a while, however. The prospectus indicates that while he was paid $500,000 in 2011 for his work as CEO (he also received a $220,000 bonus and $783,000 related to his personal use of the company jet), Zuckerberg’s base salary beginning in 2012 will be reduced to one dollar. Facebook also announced in its filing that it has no intention to pay dividends on its stock anytime soon. Take these two items in tandem, and Zuckerberg’s adjusted gross income could be extremely small in the coming years. Then throw in the fact that Zuckerberg has long stated his desire to donate much of his fortune to charity, and he may well end up generating a net operating loss in 2013 and beyond.
  • It appears from the financial data contained within the prospectus that Facebook was generating federal NOLs until 2007 or 2008. In 2009, there was a decrease to the valuation allowance reserved against Facebook’s deferred tax assets (DTA) of $76 million. In all likelihood, the bulk of this DTA related to a large NOL carryforward that the company determined in 2009 would be fully utilized in the future against taxable income, so a valuation allowance was no longer necessary.
  • Interestingly, based on the large current tax provisions booked in 2010 and 2011, one could reasonably conclude that Facebook fully utilized its NOLs in 2009 or 2010. However, the tax footnote also indicates that Facebook has $7 million of federal NOL remaining as of 12.31.2011. How could the company, with $2.8 billion of pre-tax book income 2009 and 2010 not fully utilize its NOL carryforward? One possibility is that the pre-2009 NOLs were subject to limitation under I.R.C. § 382, and thus could not be utilized in full to offset taxable income.

In brief, Section 382 applies an annual limit to the amount of pre-change NOL carryforward that may be utilized after a corporation undergoes an “ownership shift” — essentially a more than 50% change in its stock ownership over a three-year period in terms of value. Perhaps during its start-up phase the need to raise capital from outside sources caused Facebook to undergo such a shift, which limited the amount of its pre-2009 NOL available to offset its 2010 and 2011 taxable income. This could explain why the company would have large current tax provisions in both 2010 and 2011 but yet still have an NOL carryforward as of 12.31.2011.

  • Assuming that I’m wrong, however, and Facebook’s $7 million NOL carry is not currently subject to I.R.C. § 382, it shouldn’t be even after the IPO. While the IPO may well trigger an ownership change, the I.R.C. § 382 limit is computed by multiplying the long-term tax-exempt rate in place on the shift date by the value of the company  immediately prior to the ownership change. As Facebook’s value is into the billions, any I.R.C. § 382 limitation would be well in excess of the $7 million remaining NOL.

Some interesting non-tax notes:

  • Fact: There are $2.7 billion likes and comments posted on Facebook every day. Also Fact: 97% of them serve no purpose other than to make the world a dumber place.  
  • Facebook made business acquisitions totaling $68 million in 2011, which was deemed “not material to the consolidated financial statements.”
  • Facebook generates 12% of its revenue from users who purchase virtual tools for use in certain online games. If you’re one of these people, your loneliness saddens me.
  • Facebook gave Mark Zuckerberg’s father $2 million shares of stock for helping keep the company afloat during its infancy. At a total potential value of $80 million, that really makes the $200 beach cruiser I gave my old man on his birthday look like crap. Sorry Dad.
  • Apparently, Facebook is not allowed in China or Iran. Then who is the Mahmoud Ahmadinejad that keeps “liking” all of my old lifeguarding pictures?

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Tax Season Lesson #2: Do You Owe the IRS for Your Use of the Installment Method?

Posted in Uncategorized, tagged , , on February 1, 2012 | 1 Comment »

For Lesson #1 on how to compute the maximum mortgage interest deduction when total mortgage debt exceeds the statutory limits, click here.

Installment sale reporting is generally a pretty cool thing. I.R.C. § 453 permits a taxpayer who sells an asset in exchange for payments to be made over a period of years to recognize the corresponding gain as the payments are received, rather than all at once in the year of sale. But it comes with a cost; one that’s often misunderstood or just flat-out missed by tax practitioners, creating needless risk of IRS scrutiny.

But before we get into that, first, a primer on installment sales:

Assume I sell a share of stock for $10,000,000 when my basis in the stock is $2,000,000, for a total long-term capital gain of $8,000,000. The proceeds are to be paid to me in five annual installments of $2,000,000 each, with the first payment made upon closing.  

Absent the installment sale rules — or if I were to “elect out” of the installment sale rules — I would recognize the full $8,000,000 of gain in the year of sale. Under I.R.C. § 453, however, I am permitted to defer much of the gain, and recognize it as each payment is received based on the portion of each payment that represents my gross profit from the sale, which in the case of my stock sale is 80%:  

Amount realized on stock sale $10,000,000 a
Basis in stock sold ($2,000,000) b
Gross Profit $8,000,000 c
Gross Profit % 80% c/a

As each $2,000,000 payment is received, 80% of the payment is treated as capital gain, with 20% treated as tax-free return of capital.

 

Capital Gain (80%)

Basis Recovery (20%)
Year 1: $2,000,000

$1,600,000

$400,000
Year 2: $2,000,000

$1,600,000

$400,000
Year 3: $2,000,000

$1,600,000

$400,000
Year 4: $2,000,000

$1,600,000

$400,000
Year 5: $2,000,000

$1,600,000

$400,000
TOTALS

$8,000,000

$2,000,000

 Unfortunately, many taxpayers are so blinded by the opportunity for deferral that they fail to recognize the cost of the installment method. This cost is in the form of an interest charge required to be paid to the IRS when the gain deferred on an installment sale exceeds certain thresholds as defined in I.R.C. § 453A.

It’s helpful to look at I.R.C. § 453A this way: Throughout the Code, when the statute throws taxpayers a bone, it often asks for a little something in return.[i]  In this instance, in exchange for the ability to defer a large amount of gain under the installment sale provisions, I.R.C. § 453A  requires taxpayers to pay interest on the deferred gain . For those of you under the age of 30, just think of it as the steep cover charge that gains you access to a kick-ass club.

It works like this. The interest charge is required only when:

  • The sales price of a particular installment sale exceeds $150,000; and
  • The combined installment receivables at the end of the year of all the installment sales made during the year exceed $5,000,000.  

If both requirements are met for an installment sale for a given year, the interest due to the IRS is computed as follows:

  1. The taxpayer must determine the “applicable percentage” of the deferred gain outstanding at the end of the year. This percentage is equal to a) the excess of the installment receivables as of the end of the year over $5,000,000 b) divided by the amount of installment receivables at the end of the year.[ii]
  2. The taxpayer then must determine the total “deferred gain” at the end of the year; defined as the unrecognized gain under the installment method multiplied by the applicable tax rate for the year.
  3. Multiply the applicable percentage in #1 by the deferred gain in #2.
  4. Multiply the interest rate in effect under I.R.C. § 6621[iii] by the amount determined in #3.

Applying I.R.C. § 453A to my installment sale facts, we first determine whether I’m required to pay interest on my sale:

  • Does my sales price of $10,000,000 exceed $150,000? Sure does.
  • Do the installment notes receivable as of the end of the year of sale from all installment sales made during the year exceed $5,000,000? At the end of the year of sale, I still have $8,000,000 of receivable outstanding. So yes again.

I meet both tests, and am thus required to pay the IRS interest on a percentage of my deferred gain. Now I go about applying my formulas:

  1. Applicable Percentage = ($8,000,000-$5,000,000) / $8,000,000 = 37.5%
  2. Deferred Gain = $6,400,000 ($8,000,000 total gain less $1,600,000 recognized in the year of sale) * 15% (long-term capital gain tax rate) = $960,000 (think of this as the tax the IRS is not collecting in Year 1 thanks to my use of the installment sale provisions)
  3. 37.5% * $960,000 = $360,000
  4. Assuming the interest rate for the last month of my year of sale was 5%, the interest due is $360,000 * 5% = $18,000.

So in summary, for my right to defer $6,400,000 of gain beyond the year of sale, I’m required  to pay the IRS $18,000 in Year 1, with subsequent computations to take place in every year that an installment receivable related to my sale is outstanding at the end of the year.[iv]

Still a small price to pay for a significant tax deferral, but the real downside is not in the cost, but in the failure to recognize the issue and report it appropriately, thus inviting unwanted attention from the IRS.

[i] Consider the exclusion for cancellation of indebtedness income under I.R.C. § 108. Several of these exclusions require the taxpayer to reduce certain tax attributes like NOLs for the amount of the excluded COD. In essence, the IRS is saying, “Don’t pay us now, pay us later.”

[ii] This computation is done only for the year of sale and only on those installment sales made during the year that meet both requirements. For example, if a particular installment sale has a sales price less than $150,000, or if  it was made in the prior year when it failed to meet both requirements, it is not included in the computation of those sales made during the current year on which interest is required. Once this percentage is determined in the year of sale, it stays constant throughout the life of the all the installment obligations that were created during that year.

[iii] As of the last month of the tax year.

[iv] In my facts, I would do additional computations at the end of years 2, 3, and 4.

Also note, for partnerships and S corporations, the $5 million threshold is applied, and the interest charge is computed, at the partner or shareholder level rather than at the entity level.

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Tax Court: Ignorance is Bliss

Posted in Uncategorized, tagged , , , , , , , , , , , , , , , , on December 29, 2011 | 1 Comment »

“Plausible deniability” is a term often used in political and military circles to describe the protective chain of command enlisted to insure that when a powerful public figure’s underlings undertake unsavory acts on his behalf, all information regarding the acts is purposely withheld from the public figure. This way, should the shady dealings of the lower-rung lackeys be revealed and potentially implicate the public figure, he can credibly and honestly deny any knowledge of the act.

Stated more simply, in certain situations, ignorance can be your ally.

From a tax perspective, never has this been more evident than on Tuesday, when the Tax Court settled two nearly identical cases; counter-intuitively ruling in favor of a taxpayer who practiced willful ignorance and against a taxpayer who, for lack of a better term, “knew what they were getting themselves into.”  
Let me explain:

Assume you own 100% of the stock of a C corporation that owned only one asset, with a fair market value (FMV) of $1,000,000 and a tax basis of $0. Assume further that you need to unload the business, and because you have a high basis in your stock and wish to take advantage of the favorable tax rate currently imposed on capital gains, you find a stock sale desirable.

Of course, it takes two to tango macarena Zumba, and a buyer would certainly prefer an asset purchase so as to avoid paying $1,000,000 and being stuck with the historical $0 basis in the acquired asset.

Because you’re desperate enough, you eventually give in and sell the asset. As a result, for a moment in time the C corporation will possess the following:

Cash:                                       $1,000,000;

Contingent Tax Liability ($400,000)[1]

Net Value                               $600,000

At this point, the only thing left to do is pay the tax and liquidate the corporation, leaving you with $600,000.[2]

But what if there were another alternative? What if after your asset sale, a buyer proposed to purchase your stock for $750,000 and assume your federal and state tax liability? Sweet deal, right? You walk away with $750,000 (as opposed to $600,000), and you’re off the hook for the corporate tax liability.[3]

As the seller, before finalizing the transaction, would you stop and ask the completley reasonable question, “What’s in it for the buyer? Why would someone pay $750,000 for stock worth $600,000 and pay my $400,000 tax bill?”

Believe it or not, the decision to ask that question may well determine whether you will be on the hook for your corporation’s tax liability when the buyer fails to pay it, which coincidentally, is exactly what’s “in it for the buyer.” Consider the following:

The buyer purchases your corporation, the only asset of which is cash of $1,000,000, for only $750,000. The buyer’s only “downside” is that they must assume the $400,000 of federal and state tax liabilities, but the buyer knows full well prior to entering into the transaction that the liabilities will never be paid. Instead,  the buyer will use the $1,000,000 in cash to pay off the $750,000 borrowed from a third party to purchase the stock, liquidate the remaining $250,000 for themselves, and attempt to shield the tax liability with net operating losses generated from other activities which typically involve tax shelters. In the event the IRS disallows the net operating losses and assesses a deficiency to the buyer, the buyer simply throws up his hands, knowing the corporations are insolvent and unable to pay the tax, and allows the IRS to pursue the seller — you — for the deficiency under the transferee liability laws.

And when that happens, based on the lessons imparted by the Tax Court on Tuesday the less you know, the better.

In Frank Sawyer Trust of May 1992, the taxpayer (the Trust) sold all of the assets in several C corporations to unrelated buyers, then sold the stock of the corporations to Midcoast Credit Corp, who paid a “premium” over the net value of the corporations and assumed the tax liabilities. As illustrated above, the liabilities were never paid, and the IRS pursued the Trust for the deficiency.

The Tax Court held for the taxpayer, noting that the Trust never asked, and thus had no actual or constructive knowledge, as to Midcoast’s plans for the acquired stock:

Faced with a substantial estate tax liability, the trust chose to maximize the cash proceeds from the sales by selling the stock of the corporations rather than liquidating them. Had the trust known of [Midcoast’s] illegitimate scheme to fraudulently offset the tax liabilities of the corporations, then we would be inclined to disregard the form of the stock sales in favor of respondent’s contention. However, there are legitimate tax planning strategies to defer or avoid paying taxes, so it was not unreasonable for the trust to believe that [Midcoast] had alegitimate method of doing so.

To the contrary, on nearly identical facts, the Tax Court ruled in favor of the IRS in Ray Feldman, holding the selling shareholders liable for the corporate tax liability assumed by Midcoast as part of the stock purchase. At the risk of oversimplifying things, the only notable difference between the two cases was that the taxpayer in Feldman was aware that Midcoast had no intention to pay the liabilities, and yet still willingly sold its stock to Midcoast in hopes of taking advantage of a transaction that would yield tax advantages over a straight liquidation:

The credible evidence before us establishes that petitioners’ interest in the MidCoast transaction relied almost entirely on the assumption and calculation that the Woodside Ranch tax liability would remain unpaid; the impetus for taking the cumbersome route of a nominal stock sale was the mutual understanding between petitioners and MidCoast that each party would pocket and retain a portion of the unpaid taxes. MidCoast offered a “no-cost” liquidation as a solution to the tax “dilemma” in which petitioners found themselves. In spite of representations to the contrary in some of the transaction documents, the record is replete with notice to petitioners that MidCoast never intended to pay Woodside Ranch’s Federal income tax liability.

As a result, the Tax Court disregarded the stock sale and treated the transaction as a liquidation of the corporations, holding the former shareholders liable for over $1,000,000 of additional tax liability. Quite a steep price for asking the right questions of a potential buyer.

Note, I am not questioning the court’s decision to hold the shareholders in Feldman liable for the unpaid taxes; to the contrary, I simply believe the shareholders in Frank Sawyer should not benefit from their unwillingness to ask questions and perform the due diligence that any reasonable seller would undertake.

Frank Sawyer Trust of May 1992, T.C. Memo 2011-298 (12.27.11)

Ray Feldman v. Commissioner, T.C. Memo 2011-297 (12.27.11)

[1] (assuming a 40% combined federal and state tax rate);

[2] Ignoring the potential tax implications of the liquidation under Section 331

[3] Note, since a taxable liquidation of a corporation is treated as a sale of the stock for the liquidation proceeds, the stock sale to an unrelated party would not generate any material additional tax liability. For example, the stock sale would result in the seller recognizing $750,000 of amount realized for their stock, while a liquidation would result in the seller recognizing only $600,000, a $150,000 difference that assuming a 40% tax rate, resulting in additional tax of $60,000, leaving the seller with $90,000 of additional after-tax cash.

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Have You Considered Converting to a “C” Corporation Today?

Posted in Uncategorized, tagged , , , , , , , , on December 12, 2011 | 3 Comments »

Subchapter “C” corporations are like pit bulls or prostate exams; while they carry quite the stigma, they’re not nearly as bad as they’re made out to be.

Long thought of as “the entity choice of last resort” — due to the corporate level tax and resulting potential for double taxation (shameless plug!)  upon distribution or liquidation — in reality C corporations offer certain opportunities that S corporations and partnerships simply can’t match.

For example, only C corporation stock meets the definition of “qualified small business stock” under the meaning of Section 1202. And through the end of 2011 — barring an extension of the law — noncorporate taxpayers who invest in such “qualified business stock” can sell the stock after five years and exclude the entire gain from taxable income and AMT (subject to limitations, discussed below.)

Section 1202, In General

Prior to 2010, if a noncorporate taxpayer sold “qualified small business stock” that had been issued after August 10, 1993 and held for more than five years, 50% of the gain was excluded under Section 1202.  The remaining 50% of the gain was subject to tax at 28%, however, meaning the tax rate on the total gain was 14%. This offered only a 1% benefit over the long-term capital gain rate of 15%, and coupled with the fact that 7% of the gain was also treated as an AMT preference item, made Section 1202 a rather useless provision.

Two recent law changes have reincarnated Section 1202, however, providing special rules for “qualified small business stock” acquired after September 27, 2010, and before January 1, 2012. For such stock, 100 percent of the gain is excluded under Section 1202(a) and no portion of the exclusion  is treated as a tax preference item for purposes of the alternative minimum tax. This presents a unique opportunity for noncorporate taxpayers to invest in Section 1202 stock for the next two weeks and enjoy the benefit of tax-free gain on a subsequent sale of the stock five years down the road.

Requirements for Section 1202 Stock

Qualified small business stock is stock that meets the following requirements:

1. It is issued by a corporation that at the date of issuance is a domestic C corporation with cash and other assets totaling $50 million or less, based on adjusted basis, at all times from August 10, 1993 to immediately after the stock is issued.

2. The shareholder acquires it in an original issue in exchange for money or other property or as compensation [certain tax-free transfers and exchanges can also qualify- see IRC Sec. 1202(f) and (h)].

3. It is issued by a C corporation that meets an active business requirement—at least 80% of the value of the corporation’s assets are used in a qualified trade or business[1] during substantially all of the taxpayer’s holding period for such stock and the corporation is an eligible corporation.

Converting a partnership into a C corporation to take advantage of the Section 1202 rules:

With the 100% exclusion set to expire at the end of the month, Section 1202 should clearly be given consideration by any new business forming over the next two weeks. Of course, the potential impact of Section 1202 should not drive the choice of entity decision, but it must be factored into any analysis.

Less obvious, however, is the opportunity that exists to convert  an existing partnership into a C corporation with qualifying Section 1202 stock by year end. Provided the conversion is structured in the correct manner — and provided the C corporation stock meets the requirements discussed above to qualify as Section 1202 stock — any former noncorporate partners of the converted partnership will be entitled to sell the stock after holding it for five years free from income tax (subject to limitations, discussed below.)

Revenue Ruling 84-111 provides three options for a partnership-to-corporation conversion:

1. “Assets Over:” the partnership contributes its assets and liabilities to the new corporation in exchange for stock in the corporation qualifying under Section 351, followed by a liquidation of the partnership in which the stock of the corporation is distributed to the partners in a nontaxable Section 731 transaction.

2. “Assets Up:” the partnership first liquidates, followed by a transfer by the partners of the assets of the partnership to the new corporation in a nontaxable Section 351 transaction (subject to Section 357(c)).

3. “Interests Over:” The partners transfer their partnership interests to the corporation in a nontaxable Section 351 transaction. The corporation can then “liquidate” the single-member LLC or leave it as is.

In order to insure that the stock received in a partnership conversion will qualify as Section 1202 stock, care must be given to which of the three options are chosen under Rev. Rul. 84-111. Option 1, which happens to be the default option, results in the partnership, rather than the partners being the original owner of the corporation stock, thus failing to satisfy the “original isseu” requirement for Section 1202 stock. For the partners to be treated as having received the stock directly from the corporation, Option 2 (Assets Up) or Option 3 (Interests Over) must be used to incorporate the partnership.

Computational Limitations

Importantly, Section 1202(b)(1) limits the exclusion to the greater of (1) $10 million ($5 million for married taxpayers filing separately), minus any amount excluded with respect to that corporation’s stock in prior years, or (2) ten times the aggregate basis of stock of the qualified corporation sold during the year.

The following example illustrates the operation of Section 1202:

 Assume that an investor paid $4 million for 800,000 shares in a qualified small business and six years later sold the stock for $25 million, realizing a gain of $21 million. The ceiling on excluded gain is $40 million (the greater of $10 million or ten times the $4 million basis). Accordingly, the entire gain is excluded.

If the taxpayer’s basis for the stock were only $200,000, however, the gain would be $24.8 million. Ten times the taxpayer’s basis is $2 million, which is less than $10 million. Thus, the exclusion is limited to $10 million, and $14.8 million of the gain must be included in taxable income. Note, this gain is not taxed at 28%, but rather the 15% long term rate.

Cautions:

  • Note, however, that while the exclusion exists for stock issued in 2011, because of the five year holding period requirement, the holder of stock won’t actually enjoy the benefits of the zero percent tax rate on a sale of the stock until 2016 at the earliest.
  • On a stock sale, the buyer is likely to negotiate a lower purchase price than on an asset sale.

[1] A qualified trade or business excludes: 1. any trade or business involving the performance of services in the fields of health, law, engineering, architecture, accounting, etc.; 2. banking, insurance, financing, leasing, investing, or similar business; 3. farming (including the business of raising or harvesting trees); 4. the production or extraction of products subject to percentage depletion; and 5. a hotel, motel, restaurant, or similar business.

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