Category Archives: Michael Shaff

The New Partnership Audit Rules

For over 30 years, partnerships have been subject to unified audit rules that permit the IRS to examine a partnership’s (including an LLC’s) tax return and make adjustments at the partnership level that affect all the partnership’s members. [1]  To comply with the existing rules, LLC operating agreements generally provide for the appointment of a tax matters partner and grant that tax matters partner the right to interface with the IRS, the obligation to comply with the requirement to notify the members of the LLC of the commencement of the IRS audit and the terms of any settlement or other disposition.

Effective January 1, 2018, all new and existing partnerships will be subject to new partnership audit rules.  The representative of the partnership will be known as the partner representative, dropping the familiar term “tax matters partner”.  The applicable statute of limitations on auditing the partnership and making adjustments that will affect all the partners will be determined at the partnership level and will be determined, or extended, at the entity level.[2]  The partnership representative may unilaterally extend the statute of limitations with the IRS on behalf of the partnership.[3]  A partnership with 100 or fewer partners that in general are US individuals or C corporations may elect out of the unified partnership audit rules.[4]  That is a significant increase in the size of a partnership eligible to elect out from the 10 or fewer individual partner limit on electing out of the unified partnership audit rules under pre-2018 law[5].  A partnership with pass-through entities as constituent partners may still qualify to elect out of the new rules if the pass-through entity partner discloses the identities of its members so that the master partnership can determine and certify that it has 100 or fewer direct and indirect partners who are US individuals (or their estates) or C corporations or foreign entities that would be treated as C corporations if they were US entities.[6]

All of the partners will be bound by the terms of any settlement, final audit report or court decision affecting the partnership.[7]  In a departure from the prior approach, the income tax deficiency will be computed at the partnership level and assessed against the partnership computed applying the highest individual and corporate tax rate for each partner[8].  This is in contrast to the current rule under which the determination of an adjustment is made at the partnership level but the partners are liable for computing the effect of the adjustment on their own returns.[9]  The partnership may opt out of liability for the partners’ taxes with the result that the tax burden will be passed through to the partners and computed at the partner level.[10]  The election to opt out of the unified partnership audit rules must be made when the partnership return is filed in most cases.[11]

The partner representative of the partnership will have the standard 90 days in which to file a petition for the US Tax Court to review the IRS’s proposed action.[12]  The partner representative, unlike a tax matters partner, does not have to be a partner or LLC member.[13]  That new rule may add some flexibility for the sponsor of a syndicated program.  Unlike the current rules, there will not be an opportunity for partners to file a petition for a redetermination of a final partnership administrative adjustment.[14]  Inconsistent treatment by a partner or member requires notification by the partner reporting inconsistent treatment, similar to current law.[15]  The new law has special rules on the timing of the assessment that permit the assessment and collection of a partnership adjustment in the year in which the adjustment becomes and non-contestable.[16]  It will be up to the partnership, if at all, to cause the economic cost of the collection of the adjustment to fall on the partners in the partnership for the year audited rather than for the year assessed and collected. By contrast, under existing law, a final partnership administrative adjustment, whenever assessed, affects the returns of the partners for the year or years audited, not the year collected—the collection occurs at the partner level based on the pass-through of the adjustment on the partnership’s tax return for the year audited.

For example, if the IRS audits a partnership’s return for 2015 and the examination is completed in 2018, any adjustment would be reflected in the tax liability of the partners for 2015.  Under the new law, when the partnership adjustment is final, the IRS will collect the deficiency from the partnership.  An audit of the partnership’s 2018 return might be completed in 2021 and collected at that time, but in the interim between 2018 and 2021 several placements might have added partners who were not investors in 2018 but who would have their share of available cash reduced in 2021.

As a practical matter, LLC operating agreements should reflect these new rules, appoint a partnership representative, describe the partnership representative’s authority to hire professionals, interact with the IRS, inform the partners of any developments and determine whether to elect out of the unified audit rules if there are fewer than 100 direct or indirect partners, and determine what events the partnership representative should be required to inform the partners pursuant to the terms of the operating agreement.  Existing LLC operating agreements for LLCs with more than 100 members, with pass-through entity members that cannot or will not reveal their constituent members’ identities or with foreign members should be analyzed to determine if the operating agreement authorizes the manager to conform the authority of the tax matters partner to these new rules when they become effective.

Michael Shaff joined Stubbs Alderton & Markiles, LLP in 2011 as Of Counsel. He is chairperson of the Tax Practice Group. Michael specializes in all aspects of federal income taxation. Mr. Shaff has served as a trial attorney with the office of the Chief Counsel of the Internal Revenue Service for three years. Mr. Shaff is certified by the Board of Legal Specialization of the State Bar of California as a specialist in tax law. Mr. Shaff is a past chair of the Tax Section of the Orange County Bar Association.  He is co-author of the “Real Estate Investment Trusts Handbook” published annually by West Group.

For more information about the Tax Practice Group, contact Chair, Michael E. Shaff at mshaff@stubbsalderton.com
_____________________________________________________

[1]   Internal Revenue Code (IRC) §6221 et seq. all as in effect after December 31, 2017.
[2]  IRC §6232(d)(2).
[3]   IRC §6232(d)(2).
[4]   IRC §6221(b)(1).
[5]   Old Section 6231.
[6]   IRC §6221(b)(2).
[7]   IRC §6223.
[8]   IRC §6221(a).  The statute authorizes regulations for adjusting the tax rate to be used when the highest rate is not appropriate.
[9]   IRC §6225(b).
[10]   IRC §6225(a).
[11]   IRC §6227(c).
[12]   IRC §6235.
[13]   IRC §6223(a) (“Each partnership shall designate*** a partner (or other person) …”)
[14]   IRC §6223(b).
[15]   IRC §6222(c).
[16]   IRC §6232.

 

FacebookTwitterGoogle+LinkedInEmail

INCENTIVE COMPENSATION IDEAS

Incentive Compensaton PlanThere are a number of types of instruments that an employer can issue key employees and independent contractors (employees and independent contractors are referred to collectively as “service providers” to signify that the benefit discussed applies to independent contractors as well as employees) to give the service providers a piece of the upside in the enterprise.  This article will a summary of most of the popular ones, their standard terms and their tax treatment for the employer and employee or contractor.

What can be issued depends in large part on the type of entity that the employer is.  There are some instruments like options that both a corporation and a limited liability company (LLC) may issue and some that only one or other may issue.

CORPORATIONS

Corporations may issue incentive instruments that are geared to the value of their stock, like options and stock appreciation rights.  An option is the right to purchase a share of the employer’s stock at an agreed price.  The exercise price should not be less than the stock value as of the date of issuance of the option.  Failure to do so will result in income inclusion to the recipient service provider under Section 409A of the Internal Revenue Code (the “Code”). That income would be able to be included in the year of receipt and annually as the spread between stock value and exercise price increases.  (Treasury Regulation §1.409A-1(b)(5).)  The need to value the stock of closely held employers to maintain compliance with Section 409A has created a demand for “409A appraisals” within the valuation industry.  Treasury Regulation §1.409A-(b)(5)(iv)(B)(2)(iii) affords a safe harbor for an employer that bases its valuation on a good faith written valuation report.

There are two kinds of options that a corporation may issue, incentive stock options (“ISOs”) and non-qualified options (“NQOs”).   The benefits of ISOs are (a) the exercise of an ISO does not result in ordinary compensation income for the option holder and (b) income, in the form of capital gain, is not recognized until the stock is disposed of.  (Code Section 422(a).)  If the optionee holds the stock for at least two years from the date of issuance of the ISO and at least one year from date of exercise of the ISO, the gain on the sale of the stock would be long term capital gain.

To be an ISO the option must have been issued to an employee (not an independent contractor or outside director) of an employer corporation; the option must have been issued pursuant to a plan approved by the corporation’s shareholders within 12 months of the adoption of the plan by the corporation’s board;  the option may not have more than a 10 year term from the date of issuance; the option may not be transferable and may not be issued to a 10% or more shareholder (the option must have an exercise price of more than 110% of the stock’s value on the date of issuance if the option is issued to a 10% or more shareholder).  (Code Section 422(b).)

Exercise of an NQO results in income for the service provider in the difference between the value of the stock and the exercise price on the date of exercise.  That benefit is tempered by the inclusion of the difference between stock value and exercise price of an ISO in alternative minimum taxable income, potentially implicating the alternative minimum tax for the option holder.

A stock appreciation right (SAR) is the right of a service provider to receive a cash bonus in the amount of the stock value on the date of exercise over the stock value on the date of issuance.  Exercise of the SAR may be limited to certain events or may exercisable at any time by the service provider, both employee and independent contractor.  To avoid the reach of Section 409A, the SAR must be based on appreciation over the value of the stock on the date of issuance of  the SAR.

Phantom stock rights and restricted stock units (RSUs) are the right to receive a cash bonus equal the value of the employer’s stock.  (“A RSU provides a right to receive an amount of compensation based on the value of stock that is payable in cash, stock, or other property.”  (Treas. Dec. 9716 (Apr. 1, 2015).)  Because Section 409A applies to the right to receive a cash bonus, payments with respect to phantom stock rights and RSUs effectively have to be limited as follows:

(1) the service provider’s “separation from service”, subject to a six-month delay requirement for separation from service of a “specified employee” (generally an officer or highly compensated employee of a public company);

(2)  the date the service provider becomes “disabled”;

(3)  the service provider’s death;

(4)  a specified time or fixed schedule specified under the plan at the date of the deferral of the compensation;

(5)  a change in the ownership or effective control of the corporation, or in the ownership of a substantial portion of the corporation’s assets; or

(6)  the occurrence of an “unforeseeable emergency.”

Grants of equity or any property (options are excluded from the term property for this purpose) to a service provider result in compensation income upon the earlier of issuance of the property or the lapse of any restrictions on the grant.  (Code Section 83(a) and Treasury Regulation §1.83-3(a)(2).)  The recipient service provider has the ability to include the value of the unvested equity grant in income as of the date of receipt.  (Code Section 83(b).)  In a start up, the election is almost always made to include the value of the equity grant in income as of the date of issuance, despite the risk that the vesting requirements might never vest, but with any gain on the sale of the equity eligible for long term capital gain treatment if the holding period of one year is met.

 

LIMITED LIABILITIES COMPANIES

Limited liability companies (LLCs) as well as limited partnerships and general partnerships may offer all of the incentive compensation instruments that a corporation can except for ISOs.  But, LLCs may offer profits interests which are probably the best incentive compensation instruments available.

A profits interest is an interest in an LLC that by definition would yield the recipient no share of the proceeds if the LLC’s assets were sold at fair market value and then the proceeds were distributed in a complete liquidation of the LLC. This determination generally is made at the time of receipt of the LLC interest.  (Revenue Procedure 93-27, 1993-2 C.B. 343.)  The profits interest treatment is only open to interests granted for services to the LLC.  The concept of a profits interest as not being includible in the recipient’s income on receipt is beneficial as the benefit is not dependent on the valuation of the interest granted, but on the assets of the LLC.

When a profits interest is granted, the LLC values its assets and sets that value as the “base value” or the “threshold amount.”  Once the LLC has made cumulative distributions equal to the base value/threshold amount, the profits interest participates along with the other holders of the class of LLC interest granted.  If the LLC sells an asset and recognizes long term capital gain, the profits interest holder recognizes long term capital gain as well.

Unlike an ISO in the corporate context, there is no income on grant of the profits interest (either for regular tax or alternative minimum tax purposes).

____________________________________________

Michael Shaff joined the firm in 2011 as Of Counsel. He is chairperson of the Tax Practice Group. Michael specializes in all aspects of federal income taxation. Mr. Shaff has served as a trial attorney with the office of the Chief Counsel of the Internal Revenue Service for three years. Mr. Shaff is certified by the Board of Legal Specialization of the State Bar of California as a specialist in tax law. Mr. Shaff is a past chair of the Tax Section of the Orange County Bar Association. He is co-author of the “Real Estate Investment Trusts Handbook” published annually by West Group.

For more information about the Incentive Compensation Plans and the Tax & Estate Planning Practice at Stubbs Alderton & Markiles, LLP, contact Michael Shaff at mshaff@stubbsalderton.com

FacebookTwitterGoogle+LinkedInEmail

Highlights of the PATH Act and How It Benefits Startup Companies – By: Michael Shaff

PATH-Act-carnegie-invest.jpgCongress passed and the President signed a tax act in December. Here are some highlights that may benefit startup companies.

R&D Changes

  1. R&D Credit made permanent. The research and development (“R&D”) credit of 20% of qualified research expenditures had expired for costs incurred after December 31, 2014. The new tax act (known as the Protecting Americans from Tax Hikes or the PATH Act) retroactively extends the credit for costs incurred after December 31, 2014. If your company filed a tax return for a fiscal year or a short year ending during 2015 and your company had qualifying R&D costs, consider filing an amended return to claim the credit on the qualifying expenses.
  1. R&D Credit applicable against AMT. An eligible small business (one with average annual gross receipts over the most recent three year period of not more than $50 million) may claim the R&D Credit against the alternative minimum tax (“AMT”). AMT is imposed when the alternative minimum tax [imposed at 20% for corporations and for individuals and other non-corporate taxpayers at 26% (for AMT net income not more than $175,000) or 28% (for AMT net income over $175,000) but computed without many deductions and credits], exceeds the regular tax. The regular tax is imposed at up to 39.6% for individuals and other non-corporate taxpayers and 35% for corporations.
  1. R&D Credit applicable against payroll tax. A qualified small business—meaning an entity having less than $5 million in gross receipts and which did not have taxable receipts in any year more than five years previous (meaning a startup that recently started to have sales income)—may claim some or all of the R&D Credit against the employer portion of FICA withholding. The amount of the R&D credit that may applied to reduce the business’s employment tax liability is limited to $250,000 per year. There are several further limitations on the use of the R&D credit against employment taxes, one of which applies to limit the use of the R&D credit against the entity’s employment tax liability, to the lowest of (a) the amount of the R&D credit elected for use against the employment tax liability, (b) the amount of the R&D credit for the year, or (c) the amount of the R&D credit that would otherwise go unused for the year.

Small Business Changes

  1. 1374 tax on built in gain for S corporations only applies for 5 years now. When a C corporation elects S corporation status or when an S corporation acquires assets of a C corporation in a tax-free transaction, it must determine its subchapter C built in gain—the excess of (i) the value of the assets of the C corporation at the time that the corporation’s subchapter S election becomes effective or the time that the acquisition of the assets of the C corporation by the S corporation is effective over (ii) the tax basis of those assets. If the S corporation sells those assets within five years of the date of the subchapter S election or the date of acquisition of those assets, the S corporation is taxable at the corporate level on the subchapter C built in gain. That five year period was reduced from ten years. A C corporation now only has to wait five years after the effective date of its subchapter S election before it becomes a completely pass-through entity.
  1. Section 1202 100% exclusion now permanent. Section 1202 allows a complete exclusion from tax on gain from the sale of stock of a qualified small business corporation. This may be a very attractive provision for startup companies that engage in a qualified business, in general any business other than personal services, real estate, farming or hotel management. Any C corporation engaged in a qualified business with aggregate gross assets having a value of $50 million or less may be a qualified small business. If an investor (other than a C corporation investor) holds the qualified small business stock for five years, any gain on the sale is permanently excluded from federal income taxation. This had been the treatment since 2010. This provision was annually extended. The PATH act made the 100% exclusion permanent. Incidentally, if qualified small business stock is disposed of after being held for six months but less than five years, the gain may be deferred if the amount realized (not just the gain) is rolled into new qualified small business stock within 60 days of the first sale. That latter rule was unaffected by the PATH act.

Section 179 Expensing Changes

  1. Section 179 allows a business to deduct up to $500,000 in qualified capital expenditures that otherwise would have to be capitalized and depreciated over the useful life of the assets purchased. The PATH act provides that the $500,000 expensing limitation will now be indexed for inflation. The ability to expense the cost of capital assets is reduced for each dollar over $2 million that capital expenditures represent, so at $2.5 million in capital expenditures, the deduction is reduced to zero.
  1. Section 179 allows for expensing of the cost of computer software that might otherwise have to be depreciated or amortized. The computer software would have to satisfy the other requirements of Section 179 for expensing capital expenditures.
  1. The right to revoke the 179 election without IRS consent has been made permanent by the PATH act.
  1. The PATH act made permanent the right to expense up to $500,000 (commencing in 2016) of the cost of qualified real property, which is defined as qualified restaurant property or qualified retail improvement property that was (1) of a character subject to the allowance for depreciation, (2) acquired for use in the active conduct of a trade or business and (2) not excluded under any of the rules that exclude other types of property from being “section 179 property.” The cap on the cost of qualified real property that could be expensed was $250,000 for 2015.

Section 181

Section 181 of the Internal Revenue Code allows expensing of up to $15 million ($20 million for expenses incurred in certain designated distress and low income communities) in film and TV production costs as long as 75% of the compensation costs for actors, directors, production personnel and producers were for services performed in the U.S. Section 181 was supposed to sunset for production costs incurred after 2015, but the PATH act extended the eligibility for the Section 181 deduction for production costs.

______________________

Michael_Shaff_crop

Michael Shaff joined the firm in 2011 as Of Counsel. He is chairperson of the Tax Practice Group. Michael specializes in all aspects of federal income taxation. Mr. Shaff has served as a trial attorney with the office of the Chief Counsel of the Internal Revenue Service for three years. Mr. Shaff is certified by the Board of Legal Specialization of the State Bar of California as a specialist in tax law. Mr. Shaff is a past chair of the Tax Section of the Orange County Bar Association. He is co-author of the “Real Estate Investment Trusts Handbook” published annually by West Group.

For more information about the PATH Act and the Tax & Estate Planning Practice at Stubbs Alderton & Markiles, LLP, contact Michael Shaff at mshaff@stubbsalderton.com

FacebookTwitterGoogle+LinkedInEmail

Why Your Exit Strategy Matters

Michael_ShaffMichael Shaff joined the firm in 2011 as Of Counsel. He is the chairperson of the Tax Practice Group.  Michael specializes in all aspects of federal income taxation. He has served as a trial attorney with the office of the Chief Counsel of the Internal Revenue Service for three years. Mr. Shaff is certified by the Board of Legal Specialization of the State Bar of California as a specialist in tax law. Mr. Shaff is a past chairof the Tax Section of the Orange County Bar Association. He is co-author of the “Real Estate Investment Trusts Handbook” published annually by West Group.

_______________________________________________________________

Exit strategy, the plan for monetizing or disposing of a business, may seem remote and speculative when organizing a new business.  But it is important to know what exit strategies are available and how those strategies are likely to be taxed depending on the form of entity through which the start up does business.

  1. Sole Proprietorship. If a single entrepreneur does nothing more, he will be doing business as a sole proprietorship.  This is true even when the entrepreneur has adopted a trade name through which he does business, often referred to as a “D/B/A”.   The advantages for doing business as a sole proprietorship include not having to pay taxes and file tax returns for a separate entity and being able to include the results of the sole proprietorship on the entrepreneur’s own tax return.  The only exit strategy, if nothing more is done to transfer the entrepreneur’s business to an entity, would be the sale of the business’s assets.  If the business has inventory and accounts receivable the amount of the purchase price allocated to the inventory and receivables would be ordinary income for the selling entrepreneur.  The purchase price allocated to the intellectual property, going concern value and goodwill would be taxed as long term capital gain for the selling entrepreneur—provided the entrepreneur has conducted the business being sold for at least a year.  The obvious down side to operating as a sole proprietorship is the principal’s personal liability for all of the debts and liabilities of the business.
  1. General Partnership. If two or more participants conduct a business together and they do not form an entity, the result is generally going to be a general partnership.  For example, Charlie agrees to back Delta’s start up business.  Delta does most of the work and agrees that when the business starts to make money, it will repay Charlie’s investment then split the business’s profits on an agreed percentage.  Charlie and Delta may not even realize it, but they have formed a general partnership.  Each partner is responsible personally for the debts and obligations of the general partnership[1].  While it is at least theoretically possible that a buyer would purchase Charlie and Delta’s general partnership interests, the realistic exit strategy, without their doing more, is the sale of the assets of the business.  As in the sole proprietorship, the purchase price of a business sold must be allocated among the business’s various assets.  Both buyer and the sellers are expected to agree on the allocation of the purchase price among those assets[2].
  1. Limited Partnership. A limited partnership is an entity that the participants must affirmatively elect to adopt[3].   Like a sole proprietorship and a general partnership, a limited partnership is a pass-through entity—it does not pay income tax but instead passes its income or losses through to its partners in accordance with the terms of its limited partnership agreement and the terms of federal income tax law.  The general partners of a limited partnership are subject to personal liability for the debts of the limited partnership as would the partners of a general partnership[4].  The limited partners are afforded limited liability.  Like the sole proprietorship and the general partnership, the likely exit strategy is the sale of the business’s assets.  Also, like the sole proprietorship and the general partnership, a limited partnership (or a limited liability company) may contribute its assets or its partners may contribute their limited partnership interests to a corporation generally on a tax-free basis. [5]
  1. Limited Liability Company. A limited liability company (LLC) also is taxed as a partnership, meaning that the deductions from starting up and operating the business may be passed through to the investors who funded them.  A limited liability company affords limited liability to all of its members (except for those who signed personal guaranties of loans, leases or other obligations of the limited liability company).  LLCs and limited partnerships have the flexibility to issue a variety of classes of equity, including series of preferred having convertibility features, put rights in sum, having as wide a variety of terms as an investor and the principals of the business may negotiate.  LLCs and limited partnerships also have the ability to issue profits interests.  Profits interests are a way to give service providers (both employees and consultants) a stake in the appreciation of the company with no tax due on grant, no exercise price and capital gains to the extent realized on exit.  A profits interest is defined as a partnership interest that would yield no distribution if the partnership’s assets were sold at their fair market value immediately after the grant of the partnership interest[6].  Any type of investor may invest in an LLC without adversely affecting the LLC’s status[7]  If a potential buyer of the business buys some or all of the LLC interests, the sellers at least in part must allocate a portion of the sales price to inventory and unrealized receivables taxable as ordinary income. As previously noted, an LLC may convert to a corporation on a tax-free basis (in most cases) if possible buyers would be likely to prefer to use stock as the acquisition consideration. [8]
  1. Summary of Partnership Entities. The general partnership, limited partnership and limited liability company are generally treated as partnerships for tax purposes, meaning that they pass through the taxable income or loss to their equity owners.  The tax benefits of net losses passed through to the partners are subject to (a) the partner having sufficient basis in the partner’s  interest in the partnership (or LLC), (b) the partner being “at risk” for his or her share of the entity’s liabilities and (c) the partner being actively involved in the partnership’s business in order to claim net deductions[9].  In many cases, conducting the business through an LLC is sufficient—it provides (i) a single level of tax, (ii) limited liability and (iii) the ability to grant key employees and consultants incentive compensation without incurring tax for the recipient or the partnership.
  1. Corporations. Corporations are taxed under a completely different set of rules from those affecting partnerships.  Corporations are eligible for tax-free acquisitions when properly structured as (a) a statutory merger, (b) an exchange of stock of the target corporation for voting stock of the acquiring corporation or (c) the acquisition of substantially all of the assets of the target corporation for voting stock of the acquiring corporation[10]  Being able to receive the acquiring corporation’s stock tax-free in an acquisition if the acquiring corporation’s payment in its own stock were taxable, is a very helpful feature, especially when a lockup agreement is in place or the acquiring corporation itself is not publicly traded or is thinly traded—if the acquiring corporation’s payment in its own stock were taxable, the target corporation’s shareholders would be taxed on the value of the acquiring corporation’s stock but would have no way to raise the funds to pay the tax.  When sold, corporate stock yields capital gain or loss unless the seller is a securities dealer[11]  Conversion of a partnership or LLC to a corporation is easy and generally can be accomplished tax free[12].  There are two relevant types of corporations from a tax standpoint, C corporations and S corporations.
  1. C Corporations. C corporations are separate legal and tax entities from their shareholders.  C corporations pay tax at the corporate level and do not pass through any taxable income or loss.  Shareholders are only taxed to the extent that the C corporation pays a dividend distributions out of current or accumulated net earnings.  With certain exceptions[13], the dividends of a C corporation are not taxable when received by a tax-exempt entity and are subject to reduced US income tax withholding when paid to a foreign investor from a country with an income tax treaty with the US[14].  The insulation of shareholders, especially foreign investors and retirement plans, from the tax liability of the C corporation and the C corporation’s ease in being able to issue various classes of preferred stock make C corporations most attractive for important types of investors.  As previously discussed, sales of corporate shares almost always give rise to capital gain or loss and the selling shareholder does not have to allocate the sales price between an ordinary and capital portion.   Corporations are eligible for the tax-free reorganizations described generally in paragraph 6 above.  However, if a C corporation sells its assets to the acquiring corporation, the tax cost can be quite high:  35% federal corporate income tax and 9.84% California state corporate income tax with the net amount subject to tax when distributed to individual shareholders at up to 23.8% at the federal level and up to 13.3% in California.  A shareholder in a C corporation that sells its assets may only net about 40% of the total sales proceeds.
  1. S Corporations. S corporations are in many ways a hybrid cross of C corporations and LLCs.  Net income and net loss of an S corporation is passed through to the shareholders, so in that sense S corporations resemble LLCs as pass-through entities.  S corporations, like any other corporation, offer limited liability for all shareholders.  But S corporations may have only one class of stock[15]   The inability to issue preferred stock or convertible debt is a significant disincentive on the use of an S corporation—the issuance of such a class of securities would result in the automatic conversion of the S corporation to a C corporation.  The hardest restriction on the use of an S corporation is the exclusion of all non-US individuals as eligible shareholders[16] and the limitation of no more than 100 US resident individual shareholders.   As a corporation, an S corporation is eligible for use of the corporate reorganization rules.  Like C corporation stock, the stock of an S corporation generates capital gain or loss when sold.

For more information about exit strategies and their tax ramifications, please contact Michael Shaff at (818) 444-4522 or mshaff@stubbsalderton.com.

________________________________________

[1]   Cal. Corp. Code §16306(a).

[2]   Internal Revenue Code (“IRC”) §1060(b).

[3]   Cal. Corp. Code §15902.01(a).

[4]   Cal. Corp. Code §15904.04(a).

[5]   IRC §351.

[6]    Rev. Proc. 93-27, 1993-2 C.B. 343.

[7]   Some entities like pension plans and IRAs may have to pay tax on the net income allocated to them from an LLC or other partnership that is engaged in an active business.  (IRC §512.)  LLCs and other partnership entities present similar issues for foreign investors.

[8]   IRC §751(a).

[9]   Generally, suspended losses may be claimed as the partnership generates net income or when it is ultimately disposed of.

[10]   IRC §368(a)(1).

[11]   E.g., Biefeldt v. Commissioner (7th Cir. 1998) 231 F.3d 1035.

[12]   IRC §351. Care must be taken to convert to corporate form before undertaking acquisition negotiations.

[13]   Voluntary employee benefit associations, supplemental unemployment compensations plans, social clubs and other exempt organizations that have borrowed to purchase the shares.  (IRC §512(a)(3).)

[14]   See, e.g., United States—Peoples Republic of China Income Tax Treaty (1984), Article 9, Section 2, reducing the withholding on dividends paid by a corporation from one country to a resident of the other from the general 30% withholding rate to 10%.

[15]   Differences in, or even a complete absence of, voting rights are permitted.  (IRC §§1361(b)(1)(D) and (c)(4).)

[16]   IRC §1361(a).

FacebookTwitterGoogle+LinkedInEmail

Taxation of Intellectual Property – By: Michael Shaff

 

IP TaxThis summary can only hit some of the more prominent aspects of the taxation of the development, purchase and sale of intellectual property.

 1.          What is intellectual property for purposes of this analysis?

            a.     Copyrights, literary, musical or artistic compositions or similar property are expressly identified under the Internal Revenue Code for special “non-favorable” treatment on sale by the creator.[1]   Video games, books, movies, television shows all fall into this category of asset in the hands of the developer.[2]

            b.    Another class of intellectual property, including trade secrets, formulas, know how and other methods, techniques or processes that are the subject of reasonable efforts to maintain secrecy fall within the general class of intangible assets that may be treated as a capital asset on sale but are subject to special rules on the useful life over which to amortize the cost of the intangible asset, as discussed below.[3]

 2.        How is the developer or owner of intellectual property treated?

         a.        In general, self-created copyrights, literary, musical or artistic compositions are not eligible for capital gain treatment on sale.[4]  As an example, the Tax Court has held that the concept for a television show was not eligible for capital gain treatment.[5]

              b.       Purchased intellectual property is generally eligible to be treated as a capital asset on sale unless the owner holds the intellectual primarily for sale to customers in the ordinary course of business, as in the case of a software or game developer selling individual, non-custom programs.  The sale of the copyright and the code to the program would not be treated as capital gain in the hands of the developer but could yield capital gain if the copyright and the software had been purchased.

             c.     The exclusion from capital asset treatment does not necessarily apply to a self-created invention that can be patented[6].  The treatment on disposition of such assets may depend on whether the cost of development was capitalized and amortized or whether the development costs were expensed and deducted in the course of development as well as whether the asset is held for sale to customers (not a capital asset) or is used in the taxpayer’s business (in which case it may be eligible for capital gain/ordinary loss treatment).

           d.     A transaction in which the developer is compensated has to be analyzed to distinguish a license arrangement from a sale.[7]  An agreement cast in the form of an exclusive license may be treated as a sale for tax purposes even if title remains with the grantor.  The key question is whether the transferor retained any rights which, in the aggregate, have substantial value.[8]

 3.      How is the purchaser of intellectual property treated?

             a.     The purchaser of the intellectual property may capitalize and amortize the cost of developing the intellectual property if the intellectual property is to be used in the creator’s business.[9]  Computer software is automatically accorded three year straight line amortization if the developer or purchaser opts to amortize the cost of the software.[10]  If the development of the software qualifies as research and development in the laboratory or experimental sense, the costs are deductible currently.[11]

           b.     The purchaser of the intangible assets used in the purchaser’s trade or business (other than computer software as provided above) is permitted to amortize the cost of purchase allocated to most forms of intellectual property over 15 years on a straight line basis.[12]   Section 197 assets include goodwill, going concern value, workforce in place, operating systems, information bases, customer based intangibles, vendor based intangibles, licenses, trade marks, trade names, and franchises.[13]

          c.     The purchaser of the stock of a company that owns intellectual property is subject to the treatment to which the company is already subject unless the purchaser and seller of the stock elect to treat the stock sale as an asset sale[14].

 4.     Sales and Use Tax.  Of the states that impose sales and use tax, most impose the tax on the sale of tangible personal property.  In California, the sale of a custom written computer program is not subject to sales tax.[15]  In the case of the sale of a prewritten program to customers, the sales tax is imposed if the software is sold on compact discs or on other media stored in tangible form.[16]  Software that the buyer downloads from a website and that is not otherwise delivered on tangible media is not a sale of tangible personal property subject to the California sales tax.[17]

 5.     Conclusion.  The tax treatment of intellectual property is determined by the nature of the intellectual property and how the taxpayer obtained the intellectual property.  The cost of developing self-created intellectual property may be eligible for immediate expensing or may have to be capitalized and carried on the taxpayer’s books, not eligible for either deduction or amortization depending on its purpose, the nature of the assets’ development and the assets’ useful life.  The cost of purchasing intangible assets used in a business is amortized on a straight line over 15 years except for acquired computer software, which is written off over three years.  The cost of other purchased intangible assets may be eligible for amortization using the income forecast method.  The sale of intellectual property generally results in capital gain or loss unless the property is a self-created copyright or an asset held primarily for sale in the taxpayer’s business.

 ___________________________________________

Michael ShaffMichael Shaff joined Stubbs Alderton & Markiles, LLP in 2011 as Of Counsel. He is chair person of the Tax Practice Group.  Michael specializes in all aspects of federal income taxation. Mr. Shaff has served as a trial attorney with the office of the Chief Counsel of the Internal Revenue Service for three years. Mr. Shaff is certified by the Board of Legal Specialization of the State Bar of California as a specialist in tax law. Mr. Shaff is the past chair of the Tax Section of the Orange County Bar Association.  He is co-author of the “Real Estate Investment Trusts Handbook” published by West Group. Michael’s practice includes all aspects of federal and state taxation, including mergers and acquisitions, executive compensation, corporate, limited liability company and partnership taxation, tax controversies and real estate investment trusts.

For more information regarding Intellectual Property Taxation, please contact Michael Shaff at mshaff@stubbsalderton.com or (818)444-4522.


[1]     Internal Revenue Code (“IRC”) §1221(a)(3) (This category of intellectual property is denied capital asset treatment on sale if created by the taxpayer’s personal efforts.).

[2]     See Rev. Proc. 2000-50, 2000-2 C.B. 601.

[3]     See, e.g., Graham v. United States (N.D. Tex. 1979) 43 AFTR 2d 79-1013, 79-1 USTC ¶9274 (dealing with the formula for Liquid Paper).

[4]    IRC §1221(a)(3).

[5]     See, e.g., Kennedy v. Commissioner T.C.M. 1965-228, 24 (CCH) 1155 (1965).

[6]     IRC §1235 (individual inventor or individual purchaser from the inventor will be able to treat the patent as a capital asset if held for more than a year.)

[7]     See, e.g., Weimer v. Commissioner TC Memo 1987-390, 54 (CCH) TCM 83 (1987).

[8]     E.I. DuPont de Nemours & Co. v. United States (3d Cir. 1970) 432 F2d 1052, 26 AFTR 2d 70-5636, 70-2 USTC ¶9645 (sale of right to use patents to manufacture nylon while retaining the right to manufacture Dacron with the same patents held a sale of substantially all of the value of the patent sold).

[9]     IRC §167(g) (allowing the income forecast method of amortization for many types of intellectual property other than computer software).

[10]    IRC §167(f).

[11]    Treas. Reg. §1.174-2(a).

[12]    IRC §197(a).

[13]    IRC §197(d)(1).

[14]    IRC §338(h)(10).

[15]    Cal. Rev. & Tax. Code §6010.9; Nortel Networks, Inc. v. State Board of Equalization (Cal. App. 2011) 119 Cal. Rptr.3d 905.

[16]    Sales and Use Tax Annotation 120.0531 (Apr. 10, 1997).

[17]    Sales and Use Tax Annotation 120.0518 (March 11, 1994).

FacebookTwitterGoogle+LinkedInEmail

Post-2012 Tax Considerations

Michael Shaff, Of Counsel with Stubbs Alderton & Markiles, LLP discusses the Bush tax cuts and the post-2012 scheduled changes. Michael specializes in all aspects of federal and state taxation, including mergers and acquisitions, executive compensation, corporate, limited liability company and partnership taxation, tax controversies and real estate investment trusts.

 

The Bush tax cuts. The Bush tax cuts primarily enacted by the 2001 and 2003 Tax Acts under President George W. Bush were extended through 2012 as part of the Tax Act of 2010.  The Bush tax cuts currently set to expire at the end of 2012 include:

  • reduced individual tax rates (10%, 15%, 25%, 28%, 33% and 35%);
  • reduced long-term capital gain rates (maximum 15%);
  • reduced qualified dividends rate (15%);
  • no phase-out for personal exemptions;
  • no phase-out for itemized deductions;
  • expanded tax credits, including the earned income tax credit (EITC), child tax credit, adoption credit, and dependent care tax credit;
  • modified education tax incentives (including Coverdell education saving accounts, the student loan interest deduction, favorable tax treatment of certain scholarships and fellowships, and an exclusion for employer-provided educational assistance).

The Bush tax cuts also gradually reduced the estate tax over 2002 to 2009, leading to its repeal in 2010. The 2010 Tax Act reinstated the estate tax for after 2010 and enacted a $5 million exemption (adjusted for inflation in 2012), a top estate tax rate of 35%, and a step-up in basis through 2012. The 2010 Tax Act also introduced the new “portability” feature allowing a deceased spouse’s unused exemption to be shifted to the surviving spouse.

Post-2012 scheduled changes. If the above provisions are allowed to expire, for tax years beginning after Dec. 31, 2012:

  • individual income tax rates will rise to 15%, 28%, 31%, 36% and 39.6% (for taxable income over $250,000, adjusted for inflation);
  • long-term capital gains will be taxed at a maximum rate of 20%;
  • dividends will be taxed as ordinary income;
  • the limit on personal exemptions will be restored such that, for higher-income taxpayers, the total amount of exemptions that can be claimed will be reduced by 2% for each $2,500 by which the taxpayer’s adjusted gross income (AGI) exceeds a certain inflation-adjusted threshold;
  • the limit on itemized deductions will be restored such that, for higher-income taxpayers, the total amount of itemized deductions will be reduced by 3% of the amount by which the taxpayer’s AGI exceeds a certain inflation-adjusted threshold; and,
  • the education incentives will disappear altogether or be significantly cut back.

Additionally, after 2012, the estate tax exemption is scheduled to fall to $1 million and the top rate will revert to 55%.

AMT. For 2012, absent another patch, the AMT exemption amounts are $45,000 for married individuals and $33,750 for unmarried individuals, and most nonrefundable credits won’t be allowed against the AMT. A Congressional Research Service report estimates that, unless Congress acts, 30 million plus taxpayers, or roughly one-fifth of all taxpayers, could be hit by the AMT in 2012.

Payroll tax cut. The Federal Insurance Contributions Act (FICA) imposes two taxes on employers, employees, and self-employed workers—one for Old Age, Survivors and Disability Insurance (OASDI; commonly known as the Social Security tax), and the other for Hospital Insurance (HI; commonly known as the Medicare tax).

To help stimulate the economy by increasing workers’ take-home pay, the 2010 Tax Relief Act reduced by two percentage points the employee OASDI tax rate under the FICA (from 6.2% to 4.2%) and the OASDI tax rate under the SECA tax for the self-employed (from 12.4% to 10.4%) on the first $106,800 of wages. The temporary reduction was originally scheduled to expire at the end of 2011.

Current law. The 2-point reduction was ultimately extended through 2012.  For the first $110,100 of remuneration received during 2012, the 4.2% and 10.4% rates apply.  Absent Congressional action, the OASDI rates will revert to normal levels after 2012.

Obamacare investment tax.   A Medicare contribution tax will be imposed after 2012 on the net investment income—generally interest, dividends, annuities, royalties, rents, and capital gains—of individuals meeting an income threshold. The tax will be 3.8% of the lesser of (a) net investment income or (b) the excess of modified adjusted gross income over $250,000 for joint return filers and surviving spouses, $125,000 for separate return filers, and $200,000 for other taxpayers.  This special tax on investment income will only apply to taxpayers with adjusted gross income in excess of $250,000, taxpayers who also face the reinstated 39.6% top federal income tax bracket.

California Changes.  California voters approved Proposition 30 and Proposition 39.  Proposition 30 increases personal income tax rates for high-income earners by creating three new tax brackets. These brackets are effective for taxable years beginning on or after January 1, 2012, and before January 1, 2019.

Taxpayers, except heads of households and married filing jointly taxpayers, are subject to personal income tax:

  • at a rate of 10.3% for the portion of taxable income over $250,000, but not over $300,000;
  • at a rate of 11.3% for the portion of taxable income over $300,000, but not over $500,000; and,
  • at a rate of 12.3% for the portion of taxable income over $500,000.

The above thresholds for married filing jointly taxpayers are double those for single taxpayers.

Proposition 39 requires the use of single-factor apportionment for most businesses for taxable years beginning on or after January 1, 2013. An apportioning trade or business must apportion business income to California by multiplying the business income by the sales factor, unless the taxpayer is primarily engaged in agriculture, mining or drilling or banking businesses.  The property and payroll factors will now only apply to those industries.  The new rule is intended to have the effect of taxing a higher percentage of the net income of out-of-state businesses.

A lot can still happen on the federal side.  Congress may reach an agreement to extend some of the Bush tax cuts before the end of the year or even in the new year as part of an overall budget reconciliation.  In addition, an AMT “patch” is somewhat more likely to occur.

Should you have further questions or concerns about the post-2012 tax cuts or our Tax & Estate Planning Practice, please contact Michael Shaff at mshaff@stubbsalderton.com or (818) 444-4522.

FacebookTwitterGoogle+LinkedInEmail

Taxation of Deferred Compensation – An Overview of Section 409A

Michael Shaff, Of Counsel with Stubbs Alderton & Markiles, LLP discusses the ins and outs of Section 409A, which regulates taxation of nonqualified compensation plans. Michael specializes in all aspects of federal and state taxation, including mergers and acquisitions, executive compensation, corporate, limited liability company and partnership taxation, tax controversies and real estate investment trusts.

________________________________________________

 1.   General Rule.    Section 409A calls for the annual taxation of a nonqualified deferred compensation plan that violates the provision of Section 409A. (IRC §409A(a)(1)(A).)  Amounts deferred and subject to inclusion under Section 409A(a)(1)(A) are also subject to a penalty tax of 20% of the amount included (the additional 20% tax) in income.  (IRC §409A(a)(1)(B); Prop. Reg. §1.409A-4.)  As a general rule, for purposes of Section 409A, a deferred compensation plan is any written or oral, vested, legally binding right to receive compensation in a later year. (Treas. Reg. §1.409A-1(b)(1).)

 2.   When is deferred compensation not subject to tax under Section 409A?  If the deferred income would not be included in income when paid, such as a right to receive a payment under a cafeteria plan, it is not subject to Section 409A.  (Treas. Reg. §1.409A-1(b)(1).)  Vested rights in a qualified defined benefit retirement plan (such as pension and profit-sharing plans, IRAs and government retirement plans) are outside the ambit of Section 409A.

In addition, as long as the deferred compensation is subject to a substantial risk of forfeiture, it is exempt from Section 409A.   That rule can exempt from the scope of Section 409A income that is subject to vesting.

 Also exempt from the inclusion rules of Section 409A are short term deferrals that meet either of (a) deferrals of up to 30 days in the case of the employer’s normal pay periods or (b) deferrals of up to 2 ½ months after the end of the taxable year.

 Options, stock appreciation rights and other equity based deferred compensation are subject to additional tests for exemption from Section 409A.  Nonqualified stock options do not result in current taxation under Section 409A if the exercise price may never be less than the fair market value of the stock on the date of option grant, the number of shares for which the option is exercisable is fixed at grant, the transfer or exercise of the option is subject to taxation under Section 83 and Regulation 1.83-7, and the option does not provide a feature for the deferral of income beyond the date of exercise or transfer or the date that the stock received on exercise become substantially vested under Regulation 1.83-3.

Stock appreciation rights must set the base for sharing in the appreciation in the value of the stock at the current fair market value on the date of issuance of the rights.

Section 409A effectively put an end to phantom stock and dividend equivalent rights as an effective form of deferred or incentive compensation.  Section 409A would tax the annual appreciation on phantom stock and unpaid accruing dividend equivalent rights.  (Treas. Reg. 1.409A-1(b)(5)(i)(D) and (E).)

Statutory options, even those issued under a Section 423 plan that are issued with an exercise price at less than the fair market value of the stock on the date of grant, do not create deferred compensation for purposes of Section 409A.  (Treas. Reg. §1.409A-1(b)(5)(ii).)  Stock options that qualify for incentive stock option treatment by definition are issued with an exercise price no higher than the stock value on the date of issuance of the option.

Publicly traded stock is easily valued based on one of several methods, the last sale before the option is granted, the closing price, the arithmetic mean of the high and low trading price or other method described in the plan, including a thirty day averaging method. (Treas. Reg. §1.409A-1(b)(5)(iv)(A).)

If the stock is not traded on an established securities exchange, the stock’s fair market value may be based on a reasonable valuation method, which may be based on “the value of tangible and intangible assets of the corporation, the present value of anticipated future cash-flows of the corporation, the market value of stock or equity interests in similar corporations and other entities engaged in trades or businesses substantially similar to those engaged in by the corporation the stock of which is to be valued, the value of which can be readily determined through nondiscretionary, objective means (such as through trading prices on an established securities market or an amount paid in an arm’s length private transaction), recent arm’s length transactions involving the sale or transfer of such stock or equity interests, and other relevant factors such as control premiums or discounts for lack of marketability and whether the valuation method is used for other purposes that have a material economic effect on the service recipient, its stockholders, or its creditors.” (Treas. Reg. §1.409A-1(b)(5)(iv)(B)(1).)

There is a presumption of reasonableness, which the Service may try to rebut with a showing that the method or application was grossly unreasonable (Treas. Reg. §1.409A-1(b)(5)(iv)(B)(2).), if the value of the stock on grant is based on an independent appraisal meeting the test for an independent appraiser for valuing employer securities to be purchased by an ESOP.

A value reached by agreement of the parties will not qualify for the presumption of reasonableness.   Section 409A has its own set of option modification rules very similar to the ISO modification rules of Section 424(h).   An option or other stock right deemed modified is treated as a newly issued right and must satisfy the requirements of Section 409A, including the requirement that the exercise price must not be less than the value of the underlying stock on the date of grant.

 3.   Substantial Risk of Forfeiture.  Compensation subject to a substantial risk of forfeiture is not treated as deferred compensation under Section 409A.  Under the Section 409A regulations, compensation is subject to a substantial risk of forfeiture if entitlement to the amount is conditioned on the performance of substantial future services by any person or the occurrence of a condition related to a purpose of the compensation, and the possibility of forfeiture is substantial. (Treas. Reg. §1.409A-1(d)(1).)  The concept of “substantial risk of forfeiture” is borrowed from Section 83, but the definition is not identical.  Not any substantial contingency will suffice; the only acceptable condition must be the performance of future service under the Section 409A regulation.  A covenant not to compete would probably not qualify as a substantial risk of forfeiture for purposes of Section 409A as it requires the forbearance from services, not the performance of services.

 4.   Performance based compensation is not treated as deferred compensation subject  to Section 409A.  The term “performance-based compensation” means compensation the amount of which, or entitlement to which, depends on the satisfaction of pre-established organizational or individual performance criteria that relate to a performance period of at least 12 consecutive months. Performance criteria are pre-established if established in writing no later than 90 days after the service period begins, provided that the outcome is substantially uncertain when the criteria are established. However, performance-based compensation doesn’t include any amount or portion of any amount that will be paid regardless of performance or based upon a performance level that is substantially certain to be met when the criteria are established.  (Treas. Reg. §1.409A-1(e)(1).)

 5.   Deferral Election.  A service provider may elect to defer compensation without creating deferred compensation under Section 409A if the deferral election is made before the beginning of the year in which the services are performed.  (Treas. Reg. §1.409A-2(a)(3).)  In the first year that the service provider is eligible to elect to defer compensation, an effective deferral election may be made within the first thirty (30) days that the service provider is eligible to defer compensation.  (Treas. Reg. §1.409A-2(a)(7).)

 6.   Corrections.  There is an opportunity for correcting a “plan” subject to Section 409A by December 31, 2012 (IRS Notice 2010-6, 2010-3 IRB 275) for a plan provision that is eligible for correction under any other section of that Notice.

 _______________________________________

Should you have further questions or concerns about deferred compensation or our Tax & Estate Planning Practice Group, please contact Michael Shaff at mshaff@stubbsalderton.com or (818) 444-4522.

FacebookTwitterGoogle+LinkedInEmail

SAM Attorney Michael Shaff to be Featured Speaker at the OCBA Tax Law Secition Meeting

SAM attorney Michael Shaff will be the featured speaker at the May 10, 2012 Orange County Bar Association’s Tax Law Section Meeting in Newport Beach, CA.  Michael will be speaking on “Taxation of Deferred Compensation: An Overview of Section 409A and Common Issues.”  For more information or to register, click here.

FacebookTwitterGoogle+LinkedInEmail

SAM Attorney Michael Shaff Co-Authors “Real Estate Investment Trusts Handbook”, 2011-2012 ed.

SAM attorney Michael Shaff, co-authored the “Real Estate Investment Trusts Handbook, 2011-2012 ed.” This handbook will guide your Real Estate Investment Trusts (REIT) clients safely through the pitfalls of federal tax requirements, SEC rules, and state Blue Sky provisions.  It makes you aware of the related tax requirements and SEC rules in order to maximize the profitable opportunities offered by REITs, and provides analysis and guidance on Sarbanes-Oxley Act requirements affecting REITs, discusses the effect of non-GAAP financial rules on REIT FFO reporting, and advises you on the latest rulings on Taxable REIT Subsidiaries (TRS).
For more information and to purchase the Real Estate Investment Trusts Handbook, click here.

 

FacebookTwitterGoogle+LinkedInEmail