January 5, 2021 – LOS ANGELES, CA.  Stubbs Alderton & Markiles announced today that it represented client, Venice Pacific Investments, LP, over a two-year period in a $162M transaction for the sale of its properties located at 8771 Washington Boulevard, 8876-8888 Venice Boulevard, 8825 National Boulevard and 8829 and 8833 National Boulevard.

 

SA&M attorneys representing Venice Pacific Investments in the sale transaction included Jonathan Hodes, Michael Shaff, with assistance from Stubbs Alderton & Markiles paralegal Cynthia Otero.

Jonathan Hodes:  Jonathan Hodes specializes in buy side and sell side domestic and international mergers and acquisitions, management buy-outs, leveraged buy-outs, leveraged recaps, mezzanine and senior debt financing transactions, work-outs and secured lending and leasing transactions.

Jonathan’s focus emphasizes M&A activity in the middle market and also includes representation of emerging growth companies from inception through various tiers of venture capital and growth financing often with the goal of an exit through a sale, merger, IPO or other corporate finance transaction. He devotes significant time to private equity deals with an emphasis on add on portfolio acquisitions to existing platforms, and dispositions of portfolio companies.

Michael Shaff:  Michael Shaff 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.

 

The Stubbs Alderton & Markiles' Mergers & Acquisition Group advises clients in connection with a full range of mergers, acquisitions, dispositions, joint ventures and other strategic transactions, both public and private, domestic and international.  For more information about the Mergers & Acquisitions practice at SA&M, please contact M&A Practice Co-Chair Jonathan Hodes at jhodes@stubbsalderton or (818) 444-4508.

Stubbs Alderton & Markiles' attorney Michael Shaff co-authored the “Real Estate Investment Trusts Handbook, 2020-2021 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. The book will also discuss the related tax requirements and SEC rules in order to maximize the profitable opportunities offered by REITs. provide analysis and guidance on the Sarbanes-Oxley Act requirements affecting REITs, reviews the effect of non-GAAP financial rules on REIT FFO reporting. and advises the reader on the latest rulings on Taxable REIT Subsidiaries (TRS.) The handbook also helps ensure total compliance with coverage of federal securities requirements, such as registration, disclosure, and financial statements. It contains income, asset, and distribution tests to help ensure appropriate tax guidance.

For more information and to purchase the Real Estate Investment Trusts Handbook, click here.

About Michael Shaff
Michael Shaff joined the firm in 2011 as Of Counsel. He is the Chair 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.

Michael received his A.B. at Columbia college in 1976, his J.D. from New York University School of Law in 1979 and his LL.M. in taxation from New York University School of Law in 1986. He is admitted to practice law in the states of California, New York, and Massachusetts and is a member of the Orange County Bar Association.

For more information about our Tax & Estate Practice contact Michael Shaff at

 

“Tax Proposal Comparison September 2020” - Michael Shaff, Chair, Tax Practice

With the election approaching, it may be of interest to compare the tax proposals of President Trump and former Vice President Biden.  At this time, neither candidate has tax proposals on his website.  It is also important to note that the proposals will be subject to change once in the hands of Congress and will only resemble the President’s or former Vice President’s proposal if the newly elected President’s party, whichever one it is, controls both houses of Congress.  The proposals, if and when enacted, may take effect prospectively or retroactive to January 1, 2021. 

Discussing tax planning strategies may be prudent at this time, as there will only be a short window between elections and the start of the 2021 tax year 

TRUMP Proposals.  The Administration’s tax proposals were obtained from the Tax Foundation website, https://taxfoundation.org/president-trump-tax-plan-2020/.   A number of the President’s tax policy changes were enacted in 2017. 

  1. Payroll tax cut.  The President has authorized an optional plan to defer the 6.2% employee’s portion of the payroll tax until next year.  The plan is basically a loan and will have to be paid by the employee in the form of higher withholding later.  The President has stated that he would want to have the loans forgiven if he is reelected. 
  2. Opportunity Zones.  At present the Tax Cut and Job Act enacted in 2017 provides for opportunity zones, investment in which can result in the deferral and ultimately no taxation on gains reinvested in an opportunity zone.  Each state can designate economically impacted areas for Treasury to recognize as opportunity zones.  The proposal is to expand the opportunity zone program. 
  3. 100% expensing of capital expenditures.  Instead of capitalizing and depreciating the cost of capital assets, US based pharmaceutical and robotics manufacturers would be able to deduct instead of capitalize capital expenditures.  The proposal reflects the desire to domesticate key industries from abroad. 
  4. 15% capital gains tax rate.  The maximum tax rate on net long term capital gains is now 20% (exclusive of the 3.8% Obamacare tax on net investment income that may apply).  The proposal is to drop the maximum rate to 15%. 
  5. Tariffs.  The Tax Foundation anticipates the continued use of tariffs to foster key US industries. 

 

BIDEN Proposals.  Former Vice President Joe Biden’s tax proposals are also derived from the Tax Foundation website https://taxfoundation.org/reviewing-joe-bidens-tax-vision/ .   

  1. Capital Gains.  The preferential tax rate for net long term capital gains would go to 39.6% for taxpayers with incomes over $1,000,000. 
  2. Top tax bracket.  The top tax bracket would increase from 37% to 39.6% for incomes over $400,000. 
  3. Estate tax.  The value of assets in an estate would be recognized as if all the assets were sold at death.  While the proposal is not specific, it seems reasonable to infer that the rate for the death tax would be up to 39.6%.  The automatic tax free step up in basis to the date of death value would not apply.  Inherited basis would be a function of the gain recognized on death.  It is unclear how the marital deduction would work if it were preserved. 
  4. Section 199A.  The qualified business income deduction designed to narrow the gap between the corporate tax and the individual tax rate would be repealed for those with incomes over $400,000. 
  5. Corporate tax rate.  The corporate tax rate would go from 21% to 28%. 
  6. Itemized deductions.  Individuals with income over $400,000 would lose the benefit of some of their itemized deductions.  The Pease Amendment that was in effect until 2018 limited the deductibility of mortgage interest, state and local taxes and charitable deductions. The former two deductions are already severely limited by the changes enacted in 2017.   
  7. Minimum corporate tax.  15% minimum book income tax for corporations with income over $100,000,000. 
  8. GILTI.  The tax rate on global intangible low taxed income (basically most income that a corporation earns from foreign sources) would double from 10.5% to 21%. 
  9. Social Security Payroll Tax.  At present the social security payroll tax of 12.4% (6.2% on the employer, 6.2% on the employee) phases out on income over $137,700.  The phase out would be eliminated. 
  10. Childcare Tax Credit.  Up to $8,000 tax credit for qualifying child care.

There was no mention of restoring the state and local tax deduction.  In fact, the value of itemized deductions for those with income over $400,000 would be greatly limited.

Californians in the top federal and state brackets could be paying a combined 56.4% income tax rate if the pending proposal to raise the top tax rates by 3.5%, to a top rate of 16.8%, is enacted retroactive to January 1, 2020 as proposed.

About Michael Shaff

Michael Shaff

Michael Shaff joined the firm in 2011 as Of Counsel. He is the Chair 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.

Michael received his A.B. at Columbia college in 1976, his J.D. from New York University School of Law in 1979 and his LL.M. in taxation from New York University School of Law in 1986. He is admitted to practice law in the states of California, New York and Massachusetts and is a member of the Orange County Bar Association.

For more information about our Tax Practice, contact Michael Shaff at .

409A ValuationAs COVID-19 continues to curtail economic activity, private companies granting equity-based incentive awards should consider whether the pandemic’s impact on their business warrants a new independent valuation of their equity securities.

As a reminder, with limited exceptions Section 409A of the Internal Revenue Code and its associated regulations (“Section 409A” and/or the “regulations”) require companies to issue equity-based incentive awards at fair market value (“FMV”) to avoid potentially significant tax penalties resulting from a determination that such awards constitute deferred compensation issued under non-qualified deferred compensation plans.

Determining FMV
Section 409A clarifies that a company may determine FMV for stock that is readily tradable on an established securities market (such as the NYSE or Nasdaq) by any reasonable method using actual transactions in such stock as reported by such market. However, determining FMV is more difficult for privately held companies, including early-stage companies, whose stocks are not freely transferrable and/or cannot be readily liquidated.

The regulations provide that such companies may determine FMV for their stock by the reasonable application of a reasonable valuation method, based on facts and circumstances existing as of the valuation date.  Fortunately, the regulations also provide that the use of certain methods, including a valuation determined by an independent appraisal that meets the requirements of the regulations (a “409A valuation”), are presumed to be reasonable.

Impact of Material Events
Companies can generally rely on a 409A valuation for a period of 12 months after the valuation date.  However, the use of such a valuation may not be reasonable if it fails to reflect information available after the date of the valuation that may materially affect the value of the company.  The issue of a 409A valuation not accounting for a material event is more likely to arise when the material event increases the company’s value, since granting equity-based incentive awards at a price above FMV will not trigger the negative tax consequences associated with the issuance of deferred compensation under a nonqualified deferred compensation plan.  Nevertheless, obtaining a new 409A valuation where a material event negatively impacts a company’s value merits review, at least from the perspective of the additional incremental value that may accrue to service providers who receive equity-based incentive awards.  A lower valuation allows a company to issue options and other equity based compensation at a lower exercise price, meaning a greater potential upside for recipients.

Factors to Consider
While the recent decrease in the value of indices of publicly traded stocks appears to indicate that the COVID-19 pandemic has materially adversely impacted businesses overall, some businesses and sectors have increased in value.  Each company must therefore determine how, and to what extent, the pandemic has impacted its value.  Companies should consider the following in assessing the need for a new 409A valuation:

In addition, companies should consult with their 409A valuation provider, along with their tax, financial and legal advisors, to assist in their analysis.  The cost of a 409A valuation is generally significantly less than the cost of a full appraisal but the potential benefits for incentive award recipients could be meaningful.

For more information or if you have questions about its effects on your business please contact our COVID-19 Task Force at  or one of our attorneys at SA&M.

For a more in-depth discussion regarding the IRS’ rules and Section 409A, please see additional articles written by the Chair of our Firms Tax and Estate Planning Practice, Michael Shaff at .

Additional Resources:

Common Questions about Tax Rules for Pricing Options:
https://www.dailyjournal.com/mcle/449-common-questions-about-tax-rules-for-pricing-options

Taxation Of Deferred Compensation – An Overview of Section 409A.
https://stubbsalderton.com/taxation-of-deferred-compensation-an-overview-of-section-409a/

COVID-19 Client Resource Center
https://stubbsalderton.com/category/insights/covid-19-client-resources/

Authors: Louis Wharton

Michael Shaff

The IRS and the California Franchise Tax Board have issued guidance allowing an extension of time to pay income taxes ​and file returns.

CALIFORNIA:  The California Franchise Tax Board has announced that the filing and payment deadlines of March 15th for entities and April 15th for individuals have been extended until June 15, 2020.  That extension includes tax returns for 2019 and estimated tax payments for 2020.  The FTB will not impose interest on tax payments otherwise due on April 15th that are made on June 15th as to taxes for 2019 and 2020.  The FTB continues to require and collect installment payments for prior years.

FEDERAL:

The IRS will be granting automatic payment and filing extensions both for 2019 income, gift and FATCA taxes and 2020 estimated taxes through July 15, 2020.  The IRS has suspended installment payments for prior years' taxes until July 15, 2020

“If you owe a payment to the IRS, you can defer up to $1 million as an individual and the reason why we’re doing $1 million is that it covers lots of pass-throughs and small businesses, and $10 million to corporations, interest-free and penalty-free for 90 days. All you have to do is file your taxes, you’ll automatically not get charged interest and penalties. Now, of course, any American has the right to extend their taxes, we’re not taking away that right.”  To extend the time to file your individual income tax return, file an extension request with the IRS on Form 4868 by April 15th.  That will get you an extension of time to file your 2019 federal income tax return through October 15, 2020 (but payment would be due by July 15th for individuals and June 15th for entities).

REFUNDS:   If you expect an income tax refund, it makes sense to file timely.

For more information about the California Franchise Tax Board or our Tax & Estate Practice contact Michael Shaff at

The legal professionals at Stubbs Alderton & Markiles, LLP will continue to monitor changes to legislation and publish updates as information becomes available. Please contact one of our attorneys at SA&M if you would like to discuss how these changes might affect your business.

Stubbs Alderton & Markiles client, Growers Cold Storage celebrated a victory recently, when the LA County Assessor determined to reverse the reappraisal of their property. The Los Angeles County Assessor originally had determined that a change of ownership for property tax assessment purposes resulted from a series of mergers and recapitalizations involving commonly owned corporations and reassessed the surviving corporation's real properties.  The assessor's office incorrectly determined that the totality of the transactions resulted in a change of ownership for the former group's real property.  Our [SA&M] protest letter laid out the substance of the series of transactions and showed that the same shareholder controlled the corporation owning the real estate before and after the transactions, qualifying for an exemption from reassessment.  The ownership division of the assessor's office agreed and reversed the reappraisal of the property.

Stubbs Alderton & Markiles' attorneys representing Growers Cold Storage in this matter were Michael Shaff and Scott Galer.

About Michael Shaff
Michael Shaff joined the firm in 2011 as Of Counsel. He is the Chair 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.

Michael received his A.B. at Columbia college in 1976, his J.D. from New York University School of Law in 1979 and his LL.M. in taxation from New York University School of Law in 1986. He is admitted to practice law in the states of California, New York, and Massachusetts and is a member of the Orange County Bar Association.

For more information about our Tax & Estate Practice contact Michael Shaff at

 

 

Stubbs Alderton & Markiles’ attorney Michael Shaff was published in the Daily Journal for his MCLE article entitled “Who Wants (Tax-Free) $10 Million?" Michael discusses special federal income tax rules allowing individuals to exclude the monetary gain on the sale of qualified small business stock.

To find how to get tax-free $10 million and see the full article in the Daily Journal visit here.

tax-free $10 million

Michael Shaff joined the firm in 2011 as Of Counsel. He is the Chair 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.

Michael received his A.B. at Columbia college in 1976, his J.D. from New York University School of Law in 1979 and his LL.M. in taxation from New York University School of Law in 1986. He is admitted to practice law in the states of California, New York and Massachusetts and is a member of the Orange County Bar Association.

 

For more information about our Tax & Estate Practice contact Michael Shaff at

For more articles written by Michael Shaff, visit his bio page for insights and features.

 

os nationalStubbs Alderton & Markiles’ client, OS National, a premier nationwide title insurance agency, announced this week that it has been acquired by Opendoor, which makes instant online offers to buy homes. The purchase allows Opendoor to integrate title, escrow and closings into its online buying and selling experience.

To read the full press release visit here.

Stubbs Alderton & Markiles attorneys representing OS National in this matter were Greg Akselrud, Louis Wharton, Michael Shaff, Madeleine Barenholtz and Brent Armitage.

About OS National
OS National is building the premier nationwide title insurance agency. Founded on a deeply rooted passion to better serve their customers and their evolving needs, they are approaching title insurance differently – with the customer first. Keeping this at the forefront, they are able to define what OS National is, what they stand for, and how they will interact with you. And, it is simple. They are not your typical title company. OS National is redefining title services. Visit https://osnational.com.

For more information about our Internet, Digital Media and Entertainment Practice contact Greg Akselrud at

 

 

Stubbs Alderton & Markiles’ attorney Michael Shaff was published in the Daily Journal for his MCLE article entitled “Questions about Tax Rules for Pricing Options.” Michael discusses special tax rules on the exercise price of options issued to employees and consultants, stock based equity incentives, and "stock rights" issued to employees.

To view a digital copy of the article published in the Daily Journal visit here: Questions about Tax Rules for Pricing Options - Michael Shaff

Michael Shaff joined the firm in 2011 as Of Counsel. He is the Chair 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.

Michael received his A.B. at Columbia college in 1976, his J.D. from New York University School of Law in 1979 and his LL.M. in taxation from New York University School of Law in 1986. He is admitted to practice law in the states of California, New York and Massachusetts and is a member of the Orange County Bar Association.

For more information about our Tax & Estate Practice contact Michael Shaff at

 

In addition to a number of business tax changes, the Tax Cuts and Jobs Act of 2017 (the “Tax Act”) added a number of important changes for individuals as follows.  The changes discussed are not all of the changes for individuals.

  1. The maximum tax bracket has been reduced from 39.6% to 37%. Each bracket has been reduced.
  2. The standard deduction has been increased from $6,500 for an individual and $13,000 filing jointly to $12,000 and $24,000, respectively—meaning you will need $24,000 in itemized deductions in order for itemizing to make sense.
  3. The personal exemption for each taxpayer and dependent has been “suspended” through 2025.
  4. The 3.8% tax on net investment income and the .9% additional Medicare tax on payroll and self-employment income remain intact.
  5. The Obamacare individual mandate was effectively repealed by reducing the applicable rate to zero. There is no compulsion to obtain insurance or to obtain insurance that complies with Obamacare coverage requirements.
  6. Individuals now face a limitation in deducting state and local taxes not incurred in conducting a business or an activity for profit. The non-business state and local tax deduction is now limited to $10,000.
  7. Mortgage interest may only be deducted to the extent that it accrued on $750,000 or less of mortgage loan principal. Interest accrued on debt incurred or contracted to be incurred before December 15, 2017, is not subject to the limitation.  Homeowners will have be very careful before refinancing a mortgage loan. Interest on home equity lines will not be deductible.
  8. The charitable deduction limit has been raised from 50% of adjusted gross income to 60% of adjusted gross income.
  9. There is no longer a charitable deduction for fees paid to a college for athletic event seating rights.
  10. For divorce agreements entered into after 2018, alimony will no longer be deductible by the payor or includible by the recipient.
  11. Miscellaneous itemized deductions, formerly subject to a floor of 2% of adjusted gross income, are now nondeductible.
  12. The exclusion from income for qualified moving expenses is generally repealed except for active duty military personnel.
  13. The child care credit is increased to $2,000 from $1,000, with up to $1,400 per child treated as a refundable credit.
  14. Other than for losses incurred in a federally declared disaster area, the deduction for casualty and theft losses is limited to gains from casualties and thefts. In effect, the deduction is only allowed for casualties in federally declared disaster areas and to shelter insurance recoveries for thefts and casualties.
  15. An individual’s excess business loss is subject to limitations on deductibility.  An excess business loss for the tax year is the excess of aggregate deductions of the taxpayer attributable to the taxpayer's trades and businesses, over the sum of aggregate gross income or gain of the taxpayer plus a threshold amount. The threshold amount for a tax year is $500,000 for married individuals filing jointly and $250,000 for other individuals.  Excess business loss is computed after applying the passive loss rules of Section 469.
  16. Qualified equity grants. A qualified equity grant is stock of a corporation that is not publicly traded if the corporation has adopted a plan to distribute options or restricted stock units to at least 80% of its employees.  A qualified employee may elect to defer income attributable to the value of the stock until the earliest of any of the following:

(1)  The first date the qualified stock becomes transferable, including, solely for this purpose, transferable to the employer.

(2)  The date the employee first becomes an “excluded employee” (i.e., an individual: (a) who is one-percent owner of the corporation at any time during the 10 preceding calendar years; (b) who is, or has been at any prior time, the chief executive officer or chief financial officer of the corporation or an individual acting in either capacity; (c) who is a family member of an individual described in (a) or (b); or (d) who has been one of the four highest compensated officers of the corporation for any of the 10 preceding tax years. [This requirement may well limit the availability of the deferral in many cases.]

(3)  the first date on which any stock of the employer becomes readily tradable on an established securities market;

(4)  the date five years after the first date the employee's right to the stock becomes substantially vested; or

(5)  the date on which the employee revokes his or her election. (Code Sec. 83(i)(1)(B), as amended by Act Sec. 13603(a))

  1. New carried interest rule.  In order to obtain long term capital gain treatment for an interest in a partnership (including an LLC) received for services, the manager must hold the interest for at least three years, not the usual one year.  The new rule applies to partnerships (and LLCs) engaged in acquiring securities, commodities, real estate, cash, options or derivative contracts.
  2. The estate and gift tax unified lifetime exemption for decedents dying in 2018 is increased from $5 million to $11.2 million.  With proper estate planning, a married couple with up to $22.4 million in value in their taxable estates may avoid the federal estate tax. The exemption amount is indexed to increase with inflation. At present, California does not have an estate tax.

 

Michael 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. 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 our Tax & Estate Planning Practice or questions on how the new Tax Law will affect your business contact Michael Shaff at

This blog article provides a very brief summary of the business tax changes in the new federal tax legislation, the Tax Cuts and Jobs Act of 2017, H.R. 1.

An excess business loss for the tax year is the excess of aggregate deductions of the taxpayer attributable to the taxpayer's trades and businesses, over the sum of aggregate gross income or gain of the taxpayer plus a threshold amount. The threshold amount for a tax year is $500,000 for married individuals filing jointly, and $250,000 for other individuals, with both amounts indexed for inflation. (Code Sec. 461(l)(3), as added by Act Sec. 11012)

In the case of a partnership or S corporation, the provision applies at the partner or shareholder level. Each partner's or S corporation shareholder's share of items of income, gain, deduction, or loss of the partnership or S corporation is taken into account in applying the above limitation for the tax year of the partner or S corporation shareholder; and regulatory authority is provided to apply the new provision to any other pass-through entity to the extent necessary, as well as to require any additional reporting as IRS determines is appropriate to carry out the purposes of the provision. (Code Sec. 461(l)(4), as added by Act Sec. 11012(a))

(1)  any contribution in aid of construction or any other contribution as a customer or potential customer, and

(2)  any contribution by any governmental entity or civic group (other than a contribution made by a shareholder as such). (Code Sec. 118, as amended by Act Sec. 13312)

The “combined qualified business income amount” means, for any tax year, an amount equal to: (i) the deductible amount for each qualified trade or business of the taxpayer (defined as 20% of the taxpayer's QBI subject to the W-2 wage limit; see below); plus (ii) 20% of the aggregate amount of qualified real estate investment trust (REIT) dividends and qualified publicly traded partnership income of the taxpayer for the tax year. (Code Sec. 199A(b))

QBI is generally defined as the net amount of “qualified items of income, gain, deduction, and loss” relating to any qualified trade or business of the taxpayer. (Code Sec. 199A(c)(1).) For this purpose, qualified items of income, gain, deduction, and loss are items of income, gain, deduction, and loss to the extent these items are effectively connected with the conduct of a trade or business within the U.S. under Code Sec. 864(c) and included or allowed in determining taxable income for the year. If the net amount of qualified income, gain, deduction, and loss relating to qualified trade or businesses of the taxpayer for any tax year is less than zero, the amount is treated as a loss from a qualified trade or business in the succeeding tax year. (Code Sec. 199A(c)(2)) QBI does not include: certain investment items; reasonable compensation paid to the taxpayer by any qualified trade or business for services rendered with respect to the trade or business; any guaranteed payment to a partner for services to the business under Code Sec. 707(c); or a payment under Code Sec. 707(a) to a partner for services rendered with respect to the trade or business.

The 20% deduction is not allowed in computing adjusted gross income (AGI), but rather is allowed as a deduction reducing taxable income. (Code Sec. 62(a).)

Excluded businesses include:  health (i.e., medical services by physicians, nurses, dentists, and other similar healthcare professionals, but not services not directly related to healthcare, such as the operation of spas and health clubs), law, accounting, actuarial science, performing arts (but not services by persons other than performing artists, such as promoters or broadcasters), consulting, athletics, financial services, brokerage services, including investing and investment management, trading, or dealing in securities, partnership interests, or commodities, and any trade or business where the principal asset of such trade or business is the reputation or skill of one or more of its employees”

Limitations. For pass-through entities, other than sole proprietorships, the deduction cannot exceed the greater of:

(1)  50% of the W-2 wages with respect to the qualified trade or business (“W-2 wage limit”), or

(2)  the sum of 25% of the W-2 wages paid with respect to the qualified trade or business plus 2.5% of the unadjusted basis, immediately after acquisition, of all “qualified property.” Qualified property is tangible, depreciable property held by and available for use in the qualified trade or business at the close of the tax year, and used at any point during the tax year in the production of qualified business income, and the depreciable period for which has not ended before the close of the tax year.

The second limitation, which was newly added to the bill during Conference, apparently allows pass-through businesses to be eligible for the deduction on the basis of owning property that qualifies under the provision (e.g., real estate).

For a partnership or S corporation, each partner or shareholder is treated as having W-2 wages for the tax year in an amount equal to his or her allocable share of the W-2 wages of the entity for the tax year. A partner's or shareholder's allocable share of W-2 wages is determined in the same way as the partner's or shareholder's allocable share of wage expenses. For an S corporation, an allocable share is the shareholder's pro rata share of an item. However, the W-2 wage limit begins phasing out in the case of a taxpayer with taxable income exceeding $315,000 for married individuals filing jointly ($157,500 for other individuals). The application of the W-2 wage limit is phased in for individuals with taxable income exceeding these thresholds, over the next $100,000 of taxable income for married individuals filing jointly ($50,000 for other individuals). (Code Sec. 199A(b)(3)

Thresholds and exclusions. The deduction does not apply to specified service businesses (i.e., trades or businesses described in Code Sec. 1202(e)(3)(A), but excluding engineering and architecture; and trades or businesses that involve the performance of services that consist of investment-type activities). However the service business limitation begins phasing out in the case of a taxpayer whose taxable income exceeds $315,000 for married individuals filing jointly ($157,500 for other individuals), both indexed for inflation after 2018. The benefit of the deduction for service businesses is phased out over the next $100,000 of taxable income for joint filers ($50,000 for other individuals). (Code Sec. 199A(d).) The deduction also does not apply to the trade or business of being an employee.

— A holding period of more than one year in the stock of the foreign corporation is required.

— No exemption for any dividend received by a US shareholder from a CFC is allowed if the dividend is deductible by the foreign corporation when computing its taxes.

Michael Shaff Stubbs AldertonMichael 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 our Tax & Estate Planning Practice contact Michael Shaff at

There are more than $25 trillion dollars in U.S. pension plan assets as of December 31, 2016.[1]  To a company (for purposes of this article the entity seeking pension plan investment is referred to as the “Company”) seeking investment capital, pension plans may be important potential investors.  This blog article identifies two important considerations when seeking pension plan investment:  1.  Will the assets of the Company be considered “plan assets”? and 2. Will an investment in the Company result in an income tax liability for the investing plan?

PLAN ASSETS:    The first hurdle is whether the Company’s assets will be considered “plan assets” and what are the implications if the Company’s assets are regarded as plan asset?  The general rule is in general that a portion of the Company’s assets will be treated as plan assets in percentage that pension plan investment bears to all investment.[2]  As having the Company’s assets treated as plan assets turns the Company’s management into plan fiduciaries, plan asset treatment is to be avoided.  To avoid a portion of its assets being treated as plan assets of the investing plans, the Company must meet one of the exceptions listed in the plan asset regulation.[3]

  1.  Debt. The plan asset regulation applies to equity and equity-participating debt instruments.  Straight debt is not subject to the plan asset regulation.[4]  Convertible debt is only treated as equity on conversion unless the conversion feature is more than an incidental feature of the debt instrument[5].   Relying on the determination that the conversion right in a debt instrument is “incidental” would be risky.
  2. Publicly offered security. The plan asset regulation exempts a class of security that is sold to the public under a registration statement effective under the Securities Act of 1933[6] and that is registered under Section 12(b) or 12(g) of the 1934 Act within 120 days after the end of the fiscal year in which the registration statement was declared effective.[7]  To avoid manipulation of this exception, a publicly offered security must have a minimum investment of $10,000 or less and be held by 100 or more investors independent of the Company.[8]
  3. Operating company. The plan asset regulation exempts equity securities issued by an “operating company”.  The plan asset regulation gives no helpful guidance on what would constitute an “operating company.”[9]  Instead, the plan asset regulation offers two safe harbors, for a venture capital operating company[10] and for a real estate operating company[11].   A venture capital operating company is a company 50% or more of whose assets are securities of companies in which the company obtains and actually exercises management rights.[12]  A real estate operating company is a company 50% or more of whose assets consist of real estate that the company manages and develops.[13]  Real estate that is net leased on a long term basis is not considered “managed” for purposes of qualifying for the real estate operating company safe harbor.[14]  On the other hand, where the Company has the obligation to maintain and operate the real estate and hires a manager on a short term basis, the Company may still be a real estate operating company.[15]
  4. No significant participation. Probably the most relied on exception from the plan asset rules is the no significant participation exception, meaning that at all times pension plans hold less than 25% of the value of any class of equity interest in the Company.[16]  Investment in the Company’s securities by the Company’s sponsor or managers is ignored.  The effect of that computational rule is to make it harder to meet the test for not significant participation.  If the Company raises $1,000,000 in capital, $200,000 from a pension plan and $200,000 from management, the pension plan’s investment will be 25% (200,000/800,000), with the investment by management being excluded from the calculation.  On the other hand, if a manager were to invest through his IRA or 401K, that investment would be included in the aggregate pension plan investment in the Company.[17
  5. Tax implications of plan asset treatment. If the assets of the Company are treated as pension plan assets—because none of the exemptions in the plan assets regulation has been met—the managers of the Company will be deemed fiduciaries[18] of the plan assets under management. Use of the plan assets to benefit the Company’s managers would be susceptible of being treated as a prohibited transaction, with the Company’s managers potentially liable for a 15% penalty excise tax imposed on the investment.[19]  That tax rate jumps to 100% of the amount involved if the transaction is not reversed by the time the IRS issues a notice of deficiency to the fiduciaries with respect to the prohibited transactions.[20]
  6. ERISA Fiduciary implications of plan assets treatment. Section 406 of the Employee Retirement Income Security Act of 1974 (“ERISA”)[21] creates a civil cause of action against plan fiduciaries and in appropriate cases against non-fiduciaries who are “parties in interest.”[22] If a plan suffers an economic loss in a transaction that involved a prohibited transaction, the fiduciaries can expect to be required to personally restore those losses.  With that understanding, no entrepreneur should want pension plan investors without assurance that the entrepreneur will not be a fiduciary to the pension plan investors, meaning management of the Company should be motivated to avoid plan asset treatment.

UNRELATED BUSINESS INCOME.  Another issue for pension plan investors, completely apart from the prohibited transactions discussed above, is the determination of whether an investment in a Company will generate unrelated business income (“UBI”)[23] for the pension plan or exempt organization investor.  As noted above, an operating company is not subject to plan asset treatment, but an operating company may well generate unrelated business income.[24]  Income from a business that an exempt organization or pension plan operates or invests in is treated as UBI.  UBI less allowable deductions results in unrelated business taxable income, upon which the unrelated business income tax is imposed[25].

Income from dividends, interest, royalties, rents and capital gains are excluded from UBI[26].  Rents of personal property and rents based on the income or profits of any person are includible in UBI.[27]   A portion of dividends, interest, royalties, rents and capital gains derived from debt-financed property will be included in UBI.[28]

The allocation of net profits to an investing pension plan by a limited liability company (“LLC”) or other partnership that itself conducts an operating business will be treated as UBI to the investing Plan.[29]  A plan really has three choices when considering an investment, (a) avoid an investment in an active business through a pass-through entity like an LLC, (b) invest in an active business through a pass-through entity and pay the tax on the UBI, or (c) form a wholly-owned C corporation to hold the interest in the operating LLC (generally known as a blocker corporation).  Where a sponsor is promoting an investing in an operating business through a pass-through entity, the sponsor itself may form the blocker corporation through which plans, exempt organizations and foreign taxpayers may invest.

As a general rule, the purchase of an interest in an investment that would otherwise be exempt from UBI, for instance because it generates royalties, dividend, interest or rents, by incurring debt or buying subject to debt will cause a portion of the income to be taxed as UBI.[30]  The determination that an investment constitutes “debt financed property” that will cause a portion[31] of the income from the investment to be UBI can be made at the investing plan level and at the investment level.  For example, if a plan borrows to buy a corporate bond, a portion of the interest from that bond will debt-financed property.  In addition, if a plan invests in an LLC that borrowed to acquire an asset, the debt-financed character of a portion of the income will be passed through to investing plans.

Section 514 provides a limited exception from acquisition indebtedness treatment for mortgage debt secured by real property owned by a “qualified organization”.  The term “qualified organization” includes (a) a charitable educational organization, (b) a pension trust, (c) a corporation formed to hold real estate for a pension plan or charitable educational organization, and (d) a church retirement income account.[32]  If a partnership or LLC will acquire real estate subject to mortgage debt, as is typical, the sponsor may make the investment more attractive to potential pension plan investors by satisfying the requirements for partnerships to avoid debt financed income for investing plans in the LLC’s operating agreement or the limited partnership’s limited partnership agreement.[33]

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. Michael received his A.B. at Columbia College in 1976, his J.D. from New York University School of Law in 1979 and his LL.M. in taxation from New York University School of Law in 1986. He is admitted to practice law in the States of California, New York and Massachusetts and is a member of the Orange County Bar Association.

For more information about our Tax & Estate Planning practice, contact Michael Shaff at 
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[1]   https://www.ici.org/research/stats/retirement/ret_16_q4
[2]   29 C.F.R. §2510-3.101(a)(2)(second sentence); the first sentence of subsection (a)(2) establishes the “general rule” that a pension plan’s assets consist of its investment but not the underlying assets of the entity.  The second sentence relegates that rule to being an exception.
[3]  29 C.F.R. §2510.3-101 will be referred to as the “plan asset regulation” in this article.
[4]  29 C.F. R. §2510-3.101(b)(1).
[5]  29 C.F.R. §2510-3.101(j)(example 1).
[6]  As Regulation D is an exemption from registration pursuant to Section 5 of the Securities Act of 1933, securities offered pursuant to Rule 504 or 506 would not satisfy this part of the plan asset regulation.
[7]  29 C.F.R. §2510-3.101(b)(2).
[8]  29 C.F.R. §2510-3.101(b)(3) and (4).
[9]  29 C.F.R. §2510-3.101(c)(1): “An ‘operating company’ is an entity that is primarily engaged, directly or through a majority owned subsidiary or subsidiaries, in the production or sale of a product or service other than the investment of capital.”
[10]  29 C.F.R. §2510.3-101(d).
[11]  29 C.F.R. §2510.3-101(e).
[12]  29 C.F.R. §2510.3-101(d)(3).|
[13]  29 C.F.R. §2510.3-101(e).
[14]  29 C.F.R. §2510.3-101(j)(example 7).
[15]  29 C.F.R. §2510.3-101(j)(example 8).
[16]  29 C.F.R. §2510.3-101(f).
[17]  29 C.F.R. §2510.3-101(f)(1).
[18]  26 U.S.C. §4975(e)(3).
[19]  26 U.S.C. §4975(a)).
[20]  26 U.S.C. §4975(f)(2).
[21]  29 U.S.C. §1106
[22]  Harris Trust Savings v. Salomon Smith Barney Inc., 530 U.S. 238 (2000).  Salomon Smith Barney acted as broker for a pension plan’s fiduciary, executing trades that constituted self-dealing prohibited transactions.  (Id.)  The Supreme Court found that although not a fiduciary, Salomon Smith Barney was a party in interest and therefore could be sued for the plan’s actual damages, effectively making the defendant the insurer of every transaction that the fiduciaries engaged in.
[23]  Internal Revenue Code (I.R.C.), 26 U.S.C. §511-514.
[24]  I.R.C. §512(a).
[25]  Id.
[26]  I.R.C. §512(b).
[27]  I.R.C. §512(b)(3).
[28]  I.R.C. §511(a)(1).
[29]  I.R.C. §512(c)(1).
[30]  I.R.C. §514(a).
[31]  In short, the ratio that average acquisition indebtedness bears to the average basis of the debt financed property will determine the portion of the income from the debt financed property that will be UBI.  As the amount of debt and the adjusted basis of the debt-financed property change, the portion of the income treated as UBI will change. I.R.C. §514(a).
[32]  I.R.C. §514(c)(9)(C).  The exemption for these organizations may reflect Congress’s determination that pension plans and certain educational institutions often invest in leveraged real estate.
[33]  I.R.C. §514(c)(9)(E).

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. 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 Stubbs AldertonMichael 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
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[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.

There 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).

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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

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.

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Michael Shaff Stubbs AldertonMichael 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

Michael Shaff Stubbs AldertonMichael 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.

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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 Tax & Estate Planning Practice, please contact Michael Shaff at (818) 444-4522 or .

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[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).

This 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.

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Michael 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 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).

A real estate investment trust (a “REIT”) is a corporation or an association otherwise taxable as a domestic corporation intended to own interests in real property or in debt secured by real property.  The principal advantage of a REIT for holding real property is the deduction for dividends paid that enables a REIT to avoid corporate level taxation.

 To qualify as a REIT, a corporation must satisfy a number of, shareholder, income and asset tests, including income tests requiring that at least 75 percent of its gross income must be derived from real estate sources, principally (i) rents from real property, (ii) interest on debt obligations secured by mortgages or deeds of trust on real property, (iii) gains from the sale of real property; and that at least 95 percent of the corporation’s gross income must be derived from interest or dividends as well as real estate income qualifying for the 75 percent of income test.

 As a statutorily favored entity, REITs are often the objects of generous revenue rulings and private letter rulings.  For example, in late 2012, the Internal Revenue Service released several favorable private letter rulings on the issue of REITs holding an interest in a passive foreign investment company (a “PFIC”) or a controlled foreign corporation (a “CFC”), ruling that the Subpart F Income of a CFC (CFCs are foreign corporations at least 50% of whose stock, by vote and value, is owned by US shareholders and are subject to federal income tax on their undistributed “Subpart F Income”) and the foreign personal holding company income of a PFIC in each case recognized by a REIT owning interests in a CFC or a PFIC may be treated as qualifying for the 95 percent of income test under Section 856(c)(2).[1]  A PFIC is a foreign corporation, at least 75% of whose income is “passive income” and at least 50% of whose assets are held for the production of passive income.  For that purpose, “passive income” is generally dividends, interest, royalties, rents, annuities, and gains from the sale of property.  US shareholders are required to include in income their share of certain of the PFIC’s excess distributions.

 In addition to the income tests described above, to qualify as a REIT, at least 75% of the value of the corporation’s assets must consist of real estate assets, cash and cash items and government securities as of the last day of each calendar quarter.  In a recent private letter ruling, the Service held that the value of deferred organizational expenses carried as an asset on a REIT’s balance sheet would be considered zero for purposes of the quarterly asset test.[2]  By so ruling, the IRS enabled the REIT not to have to consider the deferred organizational expenses in comparison to the value of its real estate, government securities and cash and cash items.

 The Service has long treated various fixtures as real estate assets for REIT qualification purposes, going back to 1973 when it held that a building’s “total energy system,” powered by turbines, would qualify as a real estate asset.[3]   More recently, relying in part on that 1973 revenue ruling, the Service agreed to treat an offshore oil drilling platform (exclusive of machinery) as real property.[4]

The Service has also been issuing favorable “infrastructure” rulings for REITs engaged in owning wireless cell towers.  In those rulings, the cell towers are held to qualify as real property and the income attributable to tenants’ payments for power generated by the REIT’s on-site generators is treated as includible in rents from real property.[5]

 The Service also provided a favorable published revenue ruling to the effect that investments in money market funds qualify as “cash items” for purposes of the 75 percent of assets quarterly REIT qualification test.[6]  In reaching its favorable conclusion, the Service looked to the Investment Company Act of 1940.[7]  While the Investment Company Act itself does not define the term “cash item,” the Securities and Exchange Commission issued a no-action letter, upon which the Service relied in issuing its private letter ruling, to the effect that an investment in a money market fund is a cash item under Section 3(a)(1)(C) of the Investment Company Act.[8]

 In addition to the income and asset tests, the REITs dividend distributions must be pro rata within the meaning of Section 562 in order to be deductible.  In Private Letter Ruling 201244012 (Nov. 2, 2012), the Internal Revenue Service issued a favorable ruling on the issue of whether dividends distributed among three different classes of stock of a REIT would be deductible.  In order for a REIT to be able to deduct dividend distributions, a REIT’s distributions must be made pro rata among the shareholders in accordance with the rights and preferences set forth in the REIT’s corporate charter.[9]  REIT “distributions must not prefer any shares of stock of a class over other shares of stock of that same class. The distribution must not prefer one class of stock over another class except to the extent that one class is entitled (without reference to waivers of their rights by stockholders) to that preference.”

In that letter ruling, the subject REIT adopted some of the liquidity features of a mutual fund.  The REIT had issued shares of its common stock (the “Class E Shares”) to accredited investors in a private placement on its formation.  Thereafter, the REIT filed a registration statement to register the sale of two new classes of its stock, Class A and Class M.  The Class A Shares and Class M Shares were to be offered for sale on a daily basis at the net asset value (“NAV”) for shares of such class plus, with respect to Class A Shares, applicable selling commissions and would be repurchased by the REIT at the NAV for such share class. Subject to certain limitations, the REIT intended the share repurchase plan to allow holders of Class A Shares and Class M Shares to request that the REIT repurchase their shares in an amount up to an agreed percentage of the REIT’s NAV after such shares have been outstanding for at least one year.  The Class A Shares would be subject to a selling commission (“Selling Commission”) to the extent not otherwise waived or reduced and paid directly by the shareholder, in addition to the NAV for such shares. No Selling Commission would be charged with respect to the Class M Shares.   Despite the differences among the three classes of stock, the Service held that dividend distributions on all of the classes of stock would be deductible as pro rata according to the terms and preferences stated in that REIT’s charter documents.[10]

The Service continues its long-standing practice of issuing favorable rulings, private as well as published, on REIT qualification issues, including assets constituting real property, and the types of income qualifying for the 75% of income and 95% of income REIT qualification tests.  Because of the Service’s willingness to accept reasonable pro-REIT analyses in issuing private letter rulings, practitioners may feel more comfortable relying on the analysis set forth in private letter rulings when opining on REIT issues, especially in the context of a REIT that is not publicly issued and traded.

Michael 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.

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[1]   Priv. Ltr. Rul. 201246013 (Nov. 16, 2012).

[2]   Priv. Ltr. Rul. 201236006 (Sept. 7, 2012).

[3]   Rev. Rul. 73-425, 1973-2 C.B. 222.

 [4]  Priv. Ltr. Rul. 201250003 (Dec. 14, 2012).

 [5]  Priv. Ltr. Rul. 201301007 (Jan. 4, 2013); see also Priv. Ltr. Rul. 201129007 (Jul. 22, 2011).

 [6]   Rev. Rul. 2012-17, 2012-25 I.R.B. 1018 (June 15, 2012).

 [7]  15 U.S.C. §§80a-1, et. seq.   I.R.C. Section 856(c)(5)(F) so authorizes (“All other terms shall have the same meaning as when used in the Investment Company Act of 1940...”).

 [8]   Op. Off. of Chief Counsel, No. 200010241124 (Oct. 23, 2000), available at http://www.sec.gov/divisions/investment/noaction/2000/willkiefarrgallagher102300.pdf.

 [9]   Treas. Reg. §1.562-1.

 [10]   See Treas. Reg. §1.562-2(a).

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For more information regarding REIT or about the Tax Practice at Stubbs Alderton & Markiles, LLP, please contact Michael Shaff at or (818)444-4522.

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