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C corporations, like flying, were once a choice of last resort. The aversion of most taxpayers to doing business as a C corporation was attributable to the possibility of suffering a fate worse than death: DOUBLE TAXATION.

Double taxation is the hallmark of the subchapter C regime. Unique in the tax world, C corporations are first taxed on their income at the entity level. Then, when the business owner withdraws the income, the owner is taxed on the income a second time as a dividend. Under current law, the top rate on corporate income is 35%; meanwhile, the top rate on dividend income is 23.8%. As you might imagine, this can lead to painful consequences when doing business as a C corporation.

Continue reading on Forbes.com.

 

Authored by Tony Nitti, Withum Partner and writer for Forbes.com.

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Sometimes in life, when faced with a given situation, we say things simply as a matter of reflex. For example:

“What an adorable baby!”

“You have a lovely home here.”

“You’re a great gal, I’ll call you sometime. Now can you help me find my pants?”

Things are no different in the tax world. As advisors, we keep an army of axioms always at the ready to be used in response to client queries. Take, for example, the client who contemplates the type of entity that should be used to hold a piece of real estate. For most tax practitioners, this would elicit the following Pavolovian reaction:

“You should NEVER put real estate inside a corporation.”

And while there are very few NEVERS in the tax world, this one is pretty darn accurate. But do you really understand why you should never put real estate into a corporation? It’s because, as the ensuing discussion will reflect, while real estate can go into a corporation tax-free, it can never come out tax free. In today’s Tax Geek Tuesday, let’s peel back the layers of the statute and find out why.

Case study:  A, an individual, owns a building with a basis of $400,000 and a fair market value of $1,000,000. B, another individual, owns business assets worth $1,000,000. A and B would like to form a business that will use both the business assets owned by B and the building owned by A.  The entity will be owned 50/50 by A and B. Should the entity be a C corporation,  S corporation, or partnership?

Transfers to Controlled Corporations, In General

Under the general tax principles of Section 1001, the transfer of appreciated property triggers gain for the difference between the amount realized on the transfer less the adjusted tax basis of the property. Thus, barring a statutory exception, if A were to transfer the building to a corporation in exchange for the corporation’s stock, A would recognize $600,000 of gain ($1,000,000 fair market value less A’s $400,000 tax basis).

Section 351 is one such exception to the general rule of gain recognition, however, as it allows you to contribute appreciated property to a corporation in exchange for the corporation’s stock without recognizing gain provided you “control” the corporation immediately after the transfer.

For these purposes, “control” is defined as 80% of the vote and value of the corporation, with a couple of important distinctions. First, you don’t have to acquire 80% of the corporation; you simply must own 80% immediately after. A taxpayer who already owns say, 85% of a corporation may continue to transfer appreciated property to the corporation, and the gain will be deferred under Section 351.

In addition, Section 351 allows for a group of transferors. If you contribute appreciated property to a corporation in exchange for, say 20% of the corporation’s stock, but simultaneous to the transfer, another two individuals transfer cash or property to the corporation in exchange for an additional 65% of the stock, all three transfers are covered by Section 351 because on a combined basis, the transferor group controls the corporation immediately after the transfer.

Section 357(c)

Problems arise when the property contributed to a corporation is subject to a liability. Under Section 357(c), if you transfer property to a corporation that is subject to a liability and the corporation assumes that liability as part of the transfer, the transfer triggers gain to the extent the liability exceeds the tax basis of the property.

This provision is particularly problematic when the subject property is real estate, where mortgages are the norm. If, for example, A’s property were subject to a $700,000 mortgage, the transfer of the property to a corporation in exchange for corporate stock would generate $300,000 ($700,000 debt relief less $400,000 tax basis) of gain to A, even if the transfer were otherwise tax-free under Section 351.

Basis and Holding Period

When Section 351 applies to a transfer of property to a corporation, the gain is not excluded, it is merely deferred. This is accomplished through two statutory provisions that provide basis rules that ensure that any gain inherent in the building will be recognized if either you dispose of the corporation’s stock or the corporation disposes of the building.

Under Section 358, you must take a basis in the stock received equal to the basis in the property you transferred to the corporation. This is often referred to as a “substituted basis,” because the basis in the property received is determined in reference to the basis in the property relinquished.

In turn, Section 362 provides that the corporation must take a basis in the building equal to your basis in the building. This is often referred to as a “carryover basis,” because the corporation’s basis in the property remains unchanged from that which you held in the property.

Going back to our case study, if A and B simultaneously transfer property to a corporation in exchange for 50% of the corporation’s stock, Section 351 applies to the transfer. Despite the fact that A’s building has a fair market value of $1,000,000 and a tax basis of $400,000, no gain is recognized. 

Under Section 358, A takes a basis of $400,000 in the corporate stock received. Because the total value of the corporation’s assets is $2,000,000, A’s 50% stock ownership is presumably worth $1,000,000. If A sells the stock for its value of $1,000,000, A will recognize $600,000 of gain, the amount that was deferred when A transferred the building to the corporation.

Under Section 362, the corporation takes a basis in the building of $400,000. If the corporation sells the building for its value of $1,000,000, the corporation will recognize the $600,000 of gain deferred on the contribution.

Distributions and Liquidations of C Corporations, In General

The big problem with placing real estate in a corporation does not present itself until it’s time to get the property out, whether as a sale or distribution.

Sale

As mentioned above, if the corporation sells the building, courtesy of the basis mechanics of Section 362, the sale will generate $600,000 of gain. This gain will be taxed at the corporate level at a maximum federal rate of 35%, resulting in $210,000 of corporate-level tax.

The tax inefficiency is only exacerbated if A would like to get his hands on the remaining $790,000 ($1,000,000 less $210,000 tax liability) of purchase price.  If the corporation liquidates and distributes the net cash to A, A would be required by Section 331 to recognize capital gain for the difference between the amount distributed and A’s basis in the stock. A would recognize $390,000 of gain ($790,000 distribution less $400,000 stock basis) upon the liquidation, and assuming the stock were held longer than one year, would pay tax on the liquidation at a maximum rate of 23.8%, resulting in an individual tax bill of $93,000.

Thus, by selling the property in a C corporation and withdrawing the after-tax cash, A will incur a total tax liability in excess of $300,000.

Current Distribution

Alternatively, A may simply have second thoughts about dropping the building into a corporation, and wish to unwind the transaction. If the corporation transfers the building to A in a non-liquidating distribution, Section 311(b) governs the taxability of the transfer. Under this provision, when a corporation distributes appreciated property to a shareholder, the corporation recognizes gain as if it had sold the property for its fair market value. Thus, the distribution would trigger $600,000 of gain to the corporation — just as it did with a sale — which would be taxed at a maximum federal rate of 35%.

And just as seen with a sale, A isn’t through paying tax yet. Under Section 301, A must treat the fair market value of the distributed property as dividend income (to the extent of any corporate E&P, which will include the $600,000 of gain) where it will be taxed at a maximum rate of 23.8%.

Liquidating Distribution

Things are equally painful if the corporation distributes the property to A in a liquidating distribution. Under Section 336, when a corporation transfers appreciated property in a liquidating distribution, the corporation recognizes gain as if the property were sold for its fair market value. Thus, the corporation would once again recognize gain of $600,000, just as it did in the sale and current distribution examples, and once again pay corporate level tax of $210,000.

Under Section 331, A is treated as having received payment for his corporate stock equal to the fair market value of the distributed property ($1,000,000) less the corporate tax liability assumed by A in the liquidation ($210,000). A receives $790,000 of payment in exchange for his stock with a $400,000 basis, resulting in long-term capital gain of $390,000 that is taxed at a maximum of 23.8%. As you may have noticed, these are the exact same tax consequences that would arise if the corporation had simply sold the building for cash and distributed the after-tax proceeds.

Summary

In summary, while A can get his building into the corporation without triggering the $600,000 of appreciation, he cannot get it out of the corporation — by sale or distribution — without incurring a tax liability of approximately $300,000. For this reason, a C corporation is not the ideal entity choice for A and his building.

Application to S Corporations

Section 351 applies equally to C and S corporations. Unfortunately, Sections 311(b) and 336 also apply equally to an S corporation. This means that if the S corporation distributes the property to A in either a non-liquidating or liquidating distribution, the S corporation will be treated as if it sold the property for its fair market value of $1,000,000, triggering $600,000 of corporate level gain.

Of course, S corporations – at least S corporations that are not subject to the built-in-gains tax (future Tax Geek Tuesday idea!) – do not generally pay tax at the corporate level. Instead, the $600,000 of gain will flow through to A who will pay tax on the income at the individual level, and the gain will increase his basis from $400,000 to $1,000,000 under Section 1367(a)(1). As a result, the distribution will not be taxed a second time at the shareholder level. If the distribution were of the non-liquidating variety, A would simply reduce his $1,000,000 stock basis by the $1,000,000 value of the building. If the property were distributed in a liquidating distribution, under Section 331 A would be treated as having received property worth $1,000,000 in exchange for stock with a basis of $1,000,000, resulting in no further gain or loss. .

Even with the favorable single-level taxation afforded S corporations, however, because of Section 331 A cannot take the property out of the corporation without incurring a tax bill of nearly $150,000 ($600,000 flow-through gain * 23.8% rate on LTCG or 25% rate on unrecaptured Section 1250 gain).

Application to Partnerships

So, what is it that makes partnerships such an attractive entity choice for holding real estate? For starters, just like corporations, appreciated property can be contributed to a partnership in exchange for a partnership interest without the recognition of gain. This is accomplished by virtue of Section 721, which works just like Section 351, only without as many restrictive rules.

For example, while Section 351 requires the transferor or a group of transferors to own more than 80% of the corporation immediately after the transfer in order to obtain tax-free treatment, Section 721 carries no such ownership requirement. Instead, an individual can transfer appreciated property to a partnership in exchange for as little as a 1% interest without triggering any gain.

Like Section 351, Section 721 is a deferral provision rather than an exclusion provision. Moreover, there are basis rules in Section 722 and 723 that mirror those previously discussed in Sections 358 and 362. Under these rules, when a partner transfers property to a partnership in exchange for an interest in the partnership, the partner takes a substituted basis in the partnership interest equal to his basis in the property contributed, and the partnership takes a carryover basis in the contributed property equal to the partner’s basis in the property.

Applying Section 721, 722 and 723 to our case study, A recognizes no gain on the transfer of property with a basis of $400,000 and a fair market value of $1,000,000 in exchange for a 50% interest in the partnership. A takes a basis of $400,000 in the partnership interest received, and the partnership takes a $400,000 basis in the real estate.

Liability Relief

It is much less likely that transferring mortgaged property to a partnership will create gain, because there is no parallel to Section 357(c) in subchapter K. Instead, a transferor of mortgaged property to a partnership must apply the principles of Sections 731 and 752 to determine if gain is recognized on the transfer, and as shown below, gain can be avoided in the partnership context where it would be required in subchapter C.

Section 752 provides that a partner increases his basis in the partnership interest for his share of the partnership liabilities. Conversely, if a partner’s share of the partnership’s liability decreases, the reduction is treated as a distribution of cash to the partner. Why do we care?

Because Section 731 provides that a partner will only recognize gain on a distribution if the cash (or liability relief) distributed exceeds the partner’s basis in the partnership interest.

Combiningg these rules with the partner basis rules of Section 722, it becomes much less likely that a partner contributing leveraged property to a partnership will recognize gain.

To illustrate, assume the property A contributes to the partnership has a basis of $400,000, a fair market value of $1,700,000, and is subject to a $700,000 mortgage. If the property were transferred to a corporation, Section 357(c) would apply and A would be required to recognize $300,000 of gain on the transfer for the excess of the liability over the tax basis of the property.

The partnership rules yield a different result. Under Section 722, A takes an initial basis in the partnership interest of $400,000. Then, under Section 752, A increases his basis to reflect his 50% share of the $700,000 liability that now belongs to the partnership, or $350,000, raising A’s basis to $750,000. Finally, because A has been personally relieved of 100% of the liability upon transferring it to the partnership, this debt relief is treated as a distribution of cash to A by Section 752. Under Section 731, A must reduce his outside basis by the deemed distribution of $700,000. As a result, A’s final outside basis is $50,000 ($750,000 – $700,000).

Because the deemed distribution of $700,000 did not exceed A’s basis immediately before the distribution, no gain is recognized by A on the transfer.

Distributions and Liquidations of Partnerships, In General

While appreciated property can go into a corporation free from tax, as shown above, it can’t come out without the corporation being required to recognize gain as if the property were sold for its fair market value. Partnership law, however, provides deferral rules governing both the contribution of property to a partnership as well as the distribution of appreciated property from a partnership.

Sections 731 and 732 combine to provide that when a partnership distributes property to a partner in a current distribution, generally no gain or loss is recognized by either the partnership or the partner. Instead, the partner simply takes a basis in the distributed property equal to the lesser of:

  • The partnership’s basis in the distributed property, or
  • The partner’s outside basis in his partnership interest.

This nonrecognition treatment is extended to liquidating distributions as well. If a partnership transfers property to a partner in liquidation of the partnership, no gain is recognized by either the partnership or the partner; rather, the partner simply takes a basis in the property equal to the partner’s remaining basis in the partnership interest, after reduction for any cash received or debt relief.

And this is why partnerships are the vehicle of choice for holding real estate. Put a building in a C corporation, and it’s not getting out – either by sale or distribution – without triggering two levels of tax. Contribute the property to an S corporation instead, and the property can’t come out without triggering corporate-level gain. But place appreciated real estate into a partnership, and you receive the gift of flexibility; you can always undo your previous decision and distribute the building without recognizing gain at either the partnership or individual level.

Assume A and B transfer their respective properties to a partnership, and the value of the building increases from $1,000,000 to $2,000,000 while the tax basis of the building decreases from $400,000 to $300,000. Assume further that A’s basis in his partnership interest has also decreased from $400,000 to $250,000.

If the partnership distributes the building to A, neither A nor the partnership will recognize any gain on the distribution, despite the fact that the building’s fair market value of $2,000,000 greatly exceeds its tax basis of $300,000. Upon the distribution, A will take a basis in the building equal to the lesser of:

  • The partnership’s basis in the building of $300,000, or
  • A’s basis in his partnership interest of $250,000.

Thus, A reduces his basis in the partnership from $250,000 to zero and takes a $250,000 basis in the building.

If instead, the partnership liquidates and distributes the building to A in liquidation of his 50% interest, neither the partnership nor A will recognize gain. Instead, A will simply take a basis in the distributed building equal to A’s basis in the partnership interest, or $250,000.

Of course, these favorable distribution rules also operate on deferral principles; should A turn around and sell the property, the pre-distribution appreciation inherent in the building will be triggered by virtue or A’s modified carryover basis in the building. This still represents a tremendous advantage over the corporate regime, which forces the hand of the shareholder upon distribution by requiring the corporation to recognize all appreciation at the time of distribution. And that, above all other reasons, is why partnerships have become the entity of choice for holding real estate.

Got an idea for a future Tax Geek Tuesday? Send it along to anitti@withum.com or on twitter @nittigrittytax

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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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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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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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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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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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