Private Letter Ruling 201050002
There must have been a time when it was a good idea to have real estate in a C corporation. It was well before my time, though and that is starting to be a while ago. My career commenced in the waning days of the Internal Revenue Code of 1954. Even then, before they had assassinated that indomitable old soldier General Utilities, it was not a good idea. It still happens though and they are still around here and there. One way to deal with the problem is an S election. Then you just have to wait ten years, although maybe it will be seven or five, if you are lucky.
The only problem is that an S corporation cannot have "passive income" greater than 25% of its gross receipts if it has accumulated earnings and profits. If it does it is subject to an entity level tax and if the condition continues for three years it is bounced out of S status. One solution to the problem, which I discussed in an earlier post is to purge earnings and profits. Then there is the more risky, but also more entertaining, "DUH" approach outlined in PLR 201042010. Purging earnings and profits can be expensive though, PLR 201050002 points to another possibility.
Included in "passive income" for purposes of the S corporation excise (Section 1375) is rent. Rent is also considered a per se passive activity under the passive activity loss rules of Section 469. Interest and dividends on the other hand are explicitly passive income under 1375 and explicitly not passive income under 469. I could explain why this "makes sense", but I prefer, in this case, to stick with my "It is what it is. Deal with it." philosophy.
It turns out however that there is rent and there is rent. I have little doubt that the operation outlined in this PLR would be a rental activity for 469 purposes, but it is not considered passive income under Section 1375. Here are the facts :
Company was incorporated under the laws of State on Date 1, and elected under § 1362(a) to be an S corporation effective Date 2. Company owns, leases, and manages commercial rental real estate. In addition, Company owns an interest in Entities all of whom own, rent, and operate commercial office and industrial buildings and apartment and multi-family residential buildings. Company is actively involved in the management of each of the Entities. None of the Entities have hired employees or other management companies to handle the day-to-day business of operating the properties owned by them.
With respect to the wholly-owned properties, Company is actively involved in performing all of the leasing and administrative functions for maintaining the properties, including repair and maintenance services. Company has A employees and multiple independent contractors involved in the day-to-day activities associated with its commercial real estate.
With respect to each of the properties owned by the Entities, Company performs varying services. For example, Company may be responsible for management, financing, tenant negotiations, cash flow decision making, remodeling decisions, lease approval and negotiations, major development approval, mortgage and sale negotiations, advertising, repairs and maintenance, capital improvements, services for snowplowing, lawn care, trash removal, overseeing construction, and bookkeeping.
For the tax year ending in Year, Company collected approximately $B in gross rents and paid or incurred approximately $C in relevant operating expenses (other than depreciation).
The ruling goes on to explain the relevant regulation.
Section 1.1362-2(c)(5)(ii)(B)(2) provides that “rents” does not include rents derived in the active trade or business of renting property. Rents received by a corporation are derived in the active trade or business of renting property only if, based on all the facts and circumstances, the corporation provides significant services or incurs substantial costs in the rental business. Generally, significant services are not rendered and substantial costs are not incurred in connection with net leases. Whether significant services are performed or substantial costs are incurred in the rental business is determined based upon all the facts and circumstances including, but not limited to, the number of persons employed to provide the services and the types and amounts of costs and expenses incurred (other than depreciation).
The problem with applying this strategy is that there is no bright line test. If it fits your facts you may really have no alternative to getting a ruling if you want peace of mind.
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Showing posts with label S corporations. Show all posts
Showing posts with label S corporations. Show all posts
Friday, January 28, 2011
Monday, November 29, 2010
Another Round of Miscellany
Original source documents appear in RIA and beg to be shared with my vast readership, Repeatedly they are pulled up and labored on. Time passes and more interesting matters easily transform themselves into full length posts as the promising material slowly begins to wither. Finally it comes to the time to fish or get off the pot. (Pardon my love of deliberately mangling common expressions.) Here are some brief summaries of the posts that go to oblivion unless one of my readers demand that they get the full treatment :
FOUNDATION FOR HUMAN UNDERSTANDING v. U.S., Cite as 106 AFTR 2d 2010-5862, 08/16/2010
This was shaping into a maudlin reminiscence of my father who used to go though this sequence with his hands that started with "This is the church" and ended with "Look inside and see all the people" as he turned his hands over and wiggled his fingers. The point being that the Foundation For Human Understanding failed to qualify as a church, because it didn't have a regular group getting together to worship as a body. It gets into the 14 factors that make a church a church for income tax purposes. It's a little troubling that Jesus and the Apostles would probably have had a hard time passing the test.
UNITED ENERGY CORPORATION v. COMM., Cite as 106 AFTR 2d 2010-6056, 08/27/2010
I was going to title this "The Trouble with S Corps". Probably the biggest deficiency to the S corp form compared to that of partnerships (which includes most LLC's) is that the liabilities of the S corp are not allocated to the shareholders even if they have guaranteed them.
S corps.—income and losses—basis— loans—guarantees—economic outlay—S corp. indebtedness to shareholders. Tax Court decision that shareholders in S corp. and other entities weren't entitled for passthrough loss deduction purposes to increase their bases in S corp. by amount of any of its debt, other than by amount of shareholder ledger debts, was affirmed, based on Court's reasoning that other debt, comprising bank loans or loans with related entities, wasn't “indebtedness of S corp. to shareholders” within meaning of Code Sec. 1366(d)(1)(B) because shareholders made no actual economic outlay in respect to same.
Consolidated returns—interco. transactions and obligations—deemed satisfaction—transfers to controlled corps.—basis—gain—discharge of indebtedness—S corp. indebtedness. Tax Court supplemental decision that new corp. realized taxable gain as result of deemed satisfaction of affiliated S corp.'s shareholder ledger debts, when those debts were contributed to corp. in Code Sec. 351 transaction, was affirmed, based on Court's reasoning regarding operative reg regime/former Reg. §1.1502-13(g)(4) and finding that corp. acquired ledger debts with built-in gain.
MAES v. U.S., Cite as 106 AFTR 2d 2010-6752, 10/13/2010
In this case taxpayer tried to argue that amounts she had reported as alimony were actually disguised child support or alternatively a property settlement. The first argument was based on the fact that amount ran until the year that children turned 20. The agreement did not explicitly reference the children and other evidence argued for alimony. The second argument was based on the fact that agreement did not explicitly state that payments terminated in the event of her death. The requirement was, however, fulfilled because of state law provision which terminates support obligations on death. This case reinforces the point that it is important to have good tax advice in the structuring of alimony.
These two are tax nerd tests. If they seem at all interesting, you are a tax nerd. I sometimes get the impression that in the Chief Counsel's office they spend half their time being confused about TEFRA.
CCA 201034021
A partnership cannot have an affected item in itself. Each partnership year is a separate cause of action whose partnership items are not computationally affected by adjustments to other partnership years. Thus, an amortization for one year will not keep the statute open for other partnership years as “affected items“.
CCA 201033037
That's up to Exam. But its probably unnecessary since we would have to conduct a TEFRA partnership proceeding for any year in which they took excessive deductions to determine the amount, character and allocation of partnership debt, and whether it was guaranteed by each respective partner in that year. These determinations would then be binding for purposes of generating any affected item notices of deficiency limiting loss to basis or at risk for that particular year.
Well that leaves me with enough material to finish out the year. I should be confident that more good stuff will be coming, but you never know.
FOUNDATION FOR HUMAN UNDERSTANDING v. U.S., Cite as 106 AFTR 2d 2010-5862, 08/16/2010
This was shaping into a maudlin reminiscence of my father who used to go though this sequence with his hands that started with "This is the church" and ended with "Look inside and see all the people" as he turned his hands over and wiggled his fingers. The point being that the Foundation For Human Understanding failed to qualify as a church, because it didn't have a regular group getting together to worship as a body. It gets into the 14 factors that make a church a church for income tax purposes. It's a little troubling that Jesus and the Apostles would probably have had a hard time passing the test.
UNITED ENERGY CORPORATION v. COMM., Cite as 106 AFTR 2d 2010-6056, 08/27/2010
I was going to title this "The Trouble with S Corps". Probably the biggest deficiency to the S corp form compared to that of partnerships (which includes most LLC's) is that the liabilities of the S corp are not allocated to the shareholders even if they have guaranteed them.
S corps.—income and losses—basis— loans—guarantees—economic outlay—S corp. indebtedness to shareholders. Tax Court decision that shareholders in S corp. and other entities weren't entitled for passthrough loss deduction purposes to increase their bases in S corp. by amount of any of its debt, other than by amount of shareholder ledger debts, was affirmed, based on Court's reasoning that other debt, comprising bank loans or loans with related entities, wasn't “indebtedness of S corp. to shareholders” within meaning of Code Sec. 1366(d)(1)(B) because shareholders made no actual economic outlay in respect to same.
Consolidated returns—interco. transactions and obligations—deemed satisfaction—transfers to controlled corps.—basis—gain—discharge of indebtedness—S corp. indebtedness. Tax Court supplemental decision that new corp. realized taxable gain as result of deemed satisfaction of affiliated S corp.'s shareholder ledger debts, when those debts were contributed to corp. in Code Sec. 351 transaction, was affirmed, based on Court's reasoning regarding operative reg regime/former Reg. §1.1502-13(g)(4) and finding that corp. acquired ledger debts with built-in gain.
MAES v. U.S., Cite as 106 AFTR 2d 2010-6752, 10/13/2010
In this case taxpayer tried to argue that amounts she had reported as alimony were actually disguised child support or alternatively a property settlement. The first argument was based on the fact that amount ran until the year that children turned 20. The agreement did not explicitly reference the children and other evidence argued for alimony. The second argument was based on the fact that agreement did not explicitly state that payments terminated in the event of her death. The requirement was, however, fulfilled because of state law provision which terminates support obligations on death. This case reinforces the point that it is important to have good tax advice in the structuring of alimony.
These two are tax nerd tests. If they seem at all interesting, you are a tax nerd. I sometimes get the impression that in the Chief Counsel's office they spend half their time being confused about TEFRA.
CCA 201034021
A partnership cannot have an affected item in itself. Each partnership year is a separate cause of action whose partnership items are not computationally affected by adjustments to other partnership years. Thus, an amortization for one year will not keep the statute open for other partnership years as “affected items“.
CCA 201033037
That's up to Exam. But its probably unnecessary since we would have to conduct a TEFRA partnership proceeding for any year in which they took excessive deductions to determine the amount, character and allocation of partnership debt, and whether it was guaranteed by each respective partner in that year. These determinations would then be binding for purposes of generating any affected item notices of deficiency limiting loss to basis or at risk for that particular year.
Well that leaves me with enough material to finish out the year. I should be confident that more good stuff will be coming, but you never know.
Friday, November 12, 2010
Time To Purge The Draft Posts
In case you have ever wondered what the secret is to having a tax blog with conceivably scores of readers, who rarely click on ads, here is how I do it. Whenever I get a chance I scan all the primary source federal tax stuff I have that is available to me through RIA. Federal court decisions, private letter rulings, revenue procedures, chief counsel advice, program manager technical assistance, etc. etc. If something looks promising, I copy it into a draft post. I then work on which ever one the spirit moves me to whenever I get a chance. I've committed to publishing posts on Monday, Wednesday and Friday and have kept up pretty well. The draft posts accumulate at a faster rate than three per week. There are ones that I find kind of interesting, but just don't seem to be able to expand on to have something worth saying.
So in order to keep my draft posts from being cluttered with material that is going stale, I'm going to do a bit of a purge. However, when I first looked at these things, I thought there was something worth sharing, so I at least want to mention them. Once I have done that I will delete them which will make me feel more pressure when I am scanning new stuff, because I am always worried about running out. You can rescue any of these embryonic posts from oblivion by posting a comment.
Martha A. Olson v. Commissioner, TC Summary Opinion 2010-96 is a classic tax court summary opinion, the reality TV of the system. The taxpayers were trying to deduct expenses from a business that they had run several years before. They explained why they hadn't reported the business (a pay day loan operation) in the years it actually operated as follows:
Petitioner did not believe that she needed to report anything from the Checkrite business on the 1996 and 1997 returns because, in her view, she reinvested all the income back into the business; i.e., as customers would make payments against their outstanding liabilities, petitioner would collect the payments and then make additional loans to new or existing customers.
I thought that was kind of amusing and was going to title the post "Consider Taking Accounting 101"
Estate of Marie J. Jensen, et al. v. Commissioner, TC Memo 2010-182 is a valuation case. In valuing a C corporation that owned a moribund summer camp, there was a substantial discount allowed for the potential corporate income taxes on a sale of the property. I gave it a brief mention in my post on purging earnings and profits, since I believe their income tax problem might have been somewhat more manageable than they either thought or at least let on. I haven't felt inspired to give it a full treatment though.
PLR 201016053 is an example of something that is incredibly interesting if you are a total tax geek and rather difficult to make meaningful for a normal human being. Here is the headnote:
:
Self-created customer relationships are severable and distinct asset from acquired customer relationships such that any gain with respect to sale of self-created customer relationships won't be subject to Code Sec. 1245; recapture as result of amortization deductions claimed with respect to acquired customer relationships
I swear if they ever have a machine to test for tax geekiness where they attach and insert all sorts of devices that monitor your reactions and then flash things on the screen that will be one of the things they use. If you just had a WOW - That's really interesting, you are a total tax geek (Maybe some sort of highly specialized business broker just to be open to other possibilities. ). If you just had a WTF (That stands for What The ?) you are a normal human being.
Gordon Kaufman, et ux. v. Commissioner, 134 T.C. No. 9 was about a charitable contribution of a facade easement. The IRS was granted summary judgement on the issue of a deduction for the easement because the property was mortgaged, but it was not granted summary judgement on the issue of the cash contribution that the taxpayers made as part of the deal or their reliance on their accountant to be relieved of penalties. Who knows ? Maybe this case will be back on those two issues.
Gregory J. Bahas, et ux. v. Commissioner, TC Summary Opinion 2010-115 is about the real estate professional exception to the passive activity loss rules. I gave it a brief mention in one of my other posts on that topic. The interesting thing is that I think there is a mistake in it:
Mrs. Bahas misconstrues section 469. Because petitioners did not elect to aggregate their real estate rental activities, pursuant to section 469(c)(7)(A) petitioners must treat each of these interests in the rental real estate as if it were a separate activity. See sec. 469(c)(7)(A)(ii). Thus, Mrs. Bahas is required to establish that she worked for more than 750 hours each year with respect to each of the three rental properties. But, petitioners presented no documents or other evidence with respect to the number of hours Mrs. Bahas worked managing the three rental properties in question. Indeed, the parties stipulated that “petitioners spent less than 750 hours managing the rental properties” in question.
Absent the election, I don't think you need 750 hours in each of the properties. I think you would just have to materially participate in each of the properties. At any rate, I'm beginning to wonder if the actual real estate professionals are beginning to regret that they lobbied for this relief given the number of amateurs that it ends up attracting. Regardless I've probably said enough about Bahas.
Well I guess those five are enough for this post. I still have a decent backlog. If nothing interesting comes out between now and January, I'll be out of material. Not very likely.
So in order to keep my draft posts from being cluttered with material that is going stale, I'm going to do a bit of a purge. However, when I first looked at these things, I thought there was something worth sharing, so I at least want to mention them. Once I have done that I will delete them which will make me feel more pressure when I am scanning new stuff, because I am always worried about running out. You can rescue any of these embryonic posts from oblivion by posting a comment.
Martha A. Olson v. Commissioner, TC Summary Opinion 2010-96 is a classic tax court summary opinion, the reality TV of the system. The taxpayers were trying to deduct expenses from a business that they had run several years before. They explained why they hadn't reported the business (a pay day loan operation) in the years it actually operated as follows:
Petitioner did not believe that she needed to report anything from the Checkrite business on the 1996 and 1997 returns because, in her view, she reinvested all the income back into the business; i.e., as customers would make payments against their outstanding liabilities, petitioner would collect the payments and then make additional loans to new or existing customers.
I thought that was kind of amusing and was going to title the post "Consider Taking Accounting 101"
Estate of Marie J. Jensen, et al. v. Commissioner, TC Memo 2010-182 is a valuation case. In valuing a C corporation that owned a moribund summer camp, there was a substantial discount allowed for the potential corporate income taxes on a sale of the property. I gave it a brief mention in my post on purging earnings and profits, since I believe their income tax problem might have been somewhat more manageable than they either thought or at least let on. I haven't felt inspired to give it a full treatment though.
PLR 201016053 is an example of something that is incredibly interesting if you are a total tax geek and rather difficult to make meaningful for a normal human being. Here is the headnote:
:
Self-created customer relationships are severable and distinct asset from acquired customer relationships such that any gain with respect to sale of self-created customer relationships won't be subject to Code Sec. 1245; recapture as result of amortization deductions claimed with respect to acquired customer relationships
I swear if they ever have a machine to test for tax geekiness where they attach and insert all sorts of devices that monitor your reactions and then flash things on the screen that will be one of the things they use. If you just had a WOW - That's really interesting, you are a total tax geek (Maybe some sort of highly specialized business broker just to be open to other possibilities. ). If you just had a WTF (That stands for What The ?) you are a normal human being.
Gordon Kaufman, et ux. v. Commissioner, 134 T.C. No. 9 was about a charitable contribution of a facade easement. The IRS was granted summary judgement on the issue of a deduction for the easement because the property was mortgaged, but it was not granted summary judgement on the issue of the cash contribution that the taxpayers made as part of the deal or their reliance on their accountant to be relieved of penalties. Who knows ? Maybe this case will be back on those two issues.
Gregory J. Bahas, et ux. v. Commissioner, TC Summary Opinion 2010-115 is about the real estate professional exception to the passive activity loss rules. I gave it a brief mention in one of my other posts on that topic. The interesting thing is that I think there is a mistake in it:
Mrs. Bahas misconstrues section 469. Because petitioners did not elect to aggregate their real estate rental activities, pursuant to section 469(c)(7)(A) petitioners must treat each of these interests in the rental real estate as if it were a separate activity. See sec. 469(c)(7)(A)(ii). Thus, Mrs. Bahas is required to establish that she worked for more than 750 hours each year with respect to each of the three rental properties. But, petitioners presented no documents or other evidence with respect to the number of hours Mrs. Bahas worked managing the three rental properties in question. Indeed, the parties stipulated that “petitioners spent less than 750 hours managing the rental properties” in question.
Absent the election, I don't think you need 750 hours in each of the properties. I think you would just have to materially participate in each of the properties. At any rate, I'm beginning to wonder if the actual real estate professionals are beginning to regret that they lobbied for this relief given the number of amateurs that it ends up attracting. Regardless I've probably said enough about Bahas.
Well I guess those five are enough for this post. I still have a decent backlog. If nothing interesting comes out between now and January, I'll be out of material. Not very likely.
Friday, November 5, 2010
Inadvertent Termination
Private Letter Ruling 201042010, 10/22/2010
Years ago The Practical Accountant ran a series of cartoons. There would be two guys sitting on a park bench. One appeared to be a distinguished looking business man and the other was, well to use language that is consistent with the artwork, a bum. The latter is always the speaker. Probably the funniest comment, which most people will get was "Read the notes to the financial statements." The really funny one has the less elegantly dressed gentleman saying "There I was sitting on top of the world, when in a thoughtless moment I inadvertently terminated my S election." Well since then, the world has become a more forgiving place at least as it relates to S elections.
Not having to deal with the possibility of an inadvertent termination is one of the several reasons to prefer an LLC, taxed as a partnership, to the S corporation form. I recently mentioned that those remaining C corporations with appreciated property might want to consider purging earnings and profits. This is because an S corporation that has passive income constituting more than 25% of its gross income and accumulated earnings and profits is subject to a penalty tax and if the condition continues for three years, its S status is terminated.
The other advantage an LLC has is the possibility of dividing profits and losses in just about any way you want, as long as the allocations have substantial economic effect. Ironically, this ends up often making the S corporation look better to some, because its single class of stock rule, makes it simpler. You can have an LLC with a single membership class if you want to. Complexity is optional.
So now we get to PLR 201042010. The Company, as it is called in the PLR, has only one class of stock. All shares have the same rights to distributions. They have a very special form of preferred stock though. The shareholder who controlled the checkbook preferred to make distributions to himself or herself. There is a special method that it is used to determine distributions in situations like that. It is the WIFL method (Whatever I Feel Like). I'm actually speculating here. The ruling just said that distributions were disproportionate.
The Company also had accumulated earnings and profits and excess passive income for three years running. Other than that Mrs. Lincoln, how did you enjoy the play?
Much to my surprise, the IRS has ruled this to be an inadvertent termination. I suppose if you drove blind folded that any crashes you had would be inadvertent too, but I don't recommend it. The shareholders have to amend their individual returns to pick up a deemed dividend for the amount of the earnings and profits. Also they have agreed that on receipt of the ruling they will make payments to bring distributions to shareholders into proportion with ownership. Why the stiffed shareholders are waiting till then is beyond me, but that's the deal.
So if you made your S election without purging and are having lots of passive income, its no big deal. You can clean it up. It is still the wiser course to purge first. Their will be interest on those amended returns and it costs money to get these rulings.
Years ago The Practical Accountant ran a series of cartoons. There would be two guys sitting on a park bench. One appeared to be a distinguished looking business man and the other was, well to use language that is consistent with the artwork, a bum. The latter is always the speaker. Probably the funniest comment, which most people will get was "Read the notes to the financial statements." The really funny one has the less elegantly dressed gentleman saying "There I was sitting on top of the world, when in a thoughtless moment I inadvertently terminated my S election." Well since then, the world has become a more forgiving place at least as it relates to S elections.
Not having to deal with the possibility of an inadvertent termination is one of the several reasons to prefer an LLC, taxed as a partnership, to the S corporation form. I recently mentioned that those remaining C corporations with appreciated property might want to consider purging earnings and profits. This is because an S corporation that has passive income constituting more than 25% of its gross income and accumulated earnings and profits is subject to a penalty tax and if the condition continues for three years, its S status is terminated.
The other advantage an LLC has is the possibility of dividing profits and losses in just about any way you want, as long as the allocations have substantial economic effect. Ironically, this ends up often making the S corporation look better to some, because its single class of stock rule, makes it simpler. You can have an LLC with a single membership class if you want to. Complexity is optional.
So now we get to PLR 201042010. The Company, as it is called in the PLR, has only one class of stock. All shares have the same rights to distributions. They have a very special form of preferred stock though. The shareholder who controlled the checkbook preferred to make distributions to himself or herself. There is a special method that it is used to determine distributions in situations like that. It is the WIFL method (Whatever I Feel Like). I'm actually speculating here. The ruling just said that distributions were disproportionate.
The Company also had accumulated earnings and profits and excess passive income for three years running. Other than that Mrs. Lincoln, how did you enjoy the play?
Much to my surprise, the IRS has ruled this to be an inadvertent termination. I suppose if you drove blind folded that any crashes you had would be inadvertent too, but I don't recommend it. The shareholders have to amend their individual returns to pick up a deemed dividend for the amount of the earnings and profits. Also they have agreed that on receipt of the ruling they will make payments to bring distributions to shareholders into proportion with ownership. Why the stiffed shareholders are waiting till then is beyond me, but that's the deal.
So if you made your S election without purging and are having lots of passive income, its no big deal. You can clean it up. It is still the wiser course to purge first. Their will be interest on those amended returns and it costs money to get these rulings.
Monday, November 1, 2010
Time to Face the Music
Ramesh J. Bosamia, et ux. v. Commissioner, TC Memo 2010-218
The tax law tolerates some significant asymmetrical results. For example if you make a charitable contribution of appreciated property, you get to deduct the fair market value of the property without recognizing income from the appreciation (If your basis is greater than the fair market value it would be smarter to sell the property and give the cash.) Deductions for depletion computed on the percentage method can exceed the basis of the depletable property. That's why having a gold mine is like having a gold mine.
Nonetheless, there are many situations where you ignore the big balance sheet in the sky at your peril. What Ramesh and Pragati Bosamia did was actually on the egregious side. They owned two S corporations - India Music (IM) and Houston-Rakhee Imports (HRI). IM sold sheet music to the public. It purchased the sheet music from HRI. IM was on the accrual basis of accounting. From 1998 to 2003 it recorded over $800,000 in cost of sales for sheet music that it purchased from HRI.
HRI did not do a very good job of collecting its receivables. During the six year period it collected exactly nothing from IM. It should come as no surprise that HRI was on the cash basis of accounting. The IRS finally caught up with this when they audited 2004. They disallowed any cost of sales for 2004 under Section 267 which limits accruals to related parties who are not themselves on the accrual basis.
The statute of limitations was closed on years prior to 2004. So the service took the position that the accruals had constituted an impermissible accounting method. This required a cumulative adjustment for all the accruals hitting the couple with just shy of $300,000 in tax and $60,000 in penalties for the 2004 year.
The Tax Court upheld the IRS determination.
.
The tax law tolerates some significant asymmetrical results. For example if you make a charitable contribution of appreciated property, you get to deduct the fair market value of the property without recognizing income from the appreciation (If your basis is greater than the fair market value it would be smarter to sell the property and give the cash.) Deductions for depletion computed on the percentage method can exceed the basis of the depletable property. That's why having a gold mine is like having a gold mine.
Nonetheless, there are many situations where you ignore the big balance sheet in the sky at your peril. What Ramesh and Pragati Bosamia did was actually on the egregious side. They owned two S corporations - India Music (IM) and Houston-Rakhee Imports (HRI). IM sold sheet music to the public. It purchased the sheet music from HRI. IM was on the accrual basis of accounting. From 1998 to 2003 it recorded over $800,000 in cost of sales for sheet music that it purchased from HRI.
HRI did not do a very good job of collecting its receivables. During the six year period it collected exactly nothing from IM. It should come as no surprise that HRI was on the cash basis of accounting. The IRS finally caught up with this when they audited 2004. They disallowed any cost of sales for 2004 under Section 267 which limits accruals to related parties who are not themselves on the accrual basis.
The statute of limitations was closed on years prior to 2004. So the service took the position that the accruals had constituted an impermissible accounting method. This required a cumulative adjustment for all the accruals hitting the couple with just shy of $300,000 in tax and $60,000 in penalties for the 2004 year.
The Tax Court upheld the IRS determination.
.
Thursday, September 23, 2010
Short Note on Purging Earnings and Profits
I recently wrote on a strategy for old C corporations with appreciated properties. The idea is to make an S election and wait out the built-in gains period. Among the provisions of the Jobs Act which just passed the House and is now awaiting signature is a shortening of the period to five years. This is a lot less than 10, but it is still greater than 3. So a corporation that cannot rely on having active income will still want to purge its earnings and profits before the favorable rate on dividends goes away. The shortening of the recognition period makes this strategy much more viable.
I need to thank Jeff for pointing out that the shortening of recognition period is not a permanent provision. Someone electing in 2011 still faces a 10 year period. The period was shortened to seven years for sales in 2009 and 2010. We can't count on the shorter period sticking for someone who elects in 2011.
I need to thank Jeff for pointing out that the shortening of recognition period is not a permanent provision. Someone electing in 2011 still faces a 10 year period. The period was shortened to seven years for sales in 2009 and 2010. We can't count on the shorter period sticking for someone who elects in 2011.
Monday, August 23, 2010
LLC or S Corporation - Six of One A Dozen of the Other
PLR 20107019
I've known some people who mangle common expressions without realizing it. "He wants everything handed to him on a silver spoon." "She'll just have to fish or get off the pot." I don't think I do it myself very often. If I mangle a common expression, its on purpose. So I am well aware that the expression is "Six of one - half a dozen of the other". I owe the modification to a friend of mine, who I will gladly credit, if he should claim priority. (I checked with my friend Alan Jacobs. He doesn't remember coining the phrase, but he grants it was characteristic.) He thought "Six of one - half a dozen of the other" was a stupid expression like the oxymoronic "same difference". By using the even stupider "Six of one - a dozen of the other", he made you pay attention.
In general, a corporation is a tax paying entity. Individuals who realize income from corporations either as dividends or from gains on selling interests in corporations are taxed on that income. Profit from an activity can thus be taxed twice before it goes to the ultimate beneficiary of the profit. Used to be if you didn't like that you could just do business as an individual and have unlimited liability or in a partnership where at least one person had unlimited liability. That was a long time ago, though.
Skipping over much history there are two ways in which you can have an entity that provides a liability shield without being subject to double taxation, as some loosely term it. One is to for a corporation make an S election, which requires the consent of all the shareholders. The other is to form a Limited Liability Company (LLC). You can elect to have your LLC treated as a corporation, but absent that election the LLC will be treated as a partnership, if it has more than one owner, or it will be disregarded, for income tax purposes, if it has a single owner.
There, are, however, many difference between the taxation of S Corporations and LLC's, which are treated as partnerships. Generally speaking the partnership form is much more flexible than that of the S Corporation. There is a perception that partnerships are much more complicated than S Corporations. This is mainly due to people taking advantage of the flexibility of the partnership form to do more complicated things. An example of a significant difference is that partners (read LLC members) have basis in their share of the partnership's liabilities, where as S Corporation shareholders do not even if they have personally guaranteed them. So if you had a shopping mall owned by an S corporation that refinanced and used the proceeds to make a distribution, the shareholders might have to recognize gain on the distribution. It is unlikely that LLC members would. These differences will be a persistent theme in this blog as various developments illustrate them.
PLR 20107019 was issued on April 30, 2010 making it still reasonably fresh. It concerns one of the things that make S Corporations appear simpler than entities treated as partnerships. That is the single class of stock rule. An S Corporation can have more than one class of stock. There might be for, example, be voting and non-voting stock. The stock must, however, have identical rights with respect to current and liquidating distributions. Entities taxed as partnership can split the pie up any way that they want. The complexity comes in from the regulations that require that allocations of taxable income reasonably relate to the economic deal. The single class of stock rule makes S corporations a bad choice for deals in which money investors are to get their original investment and a preferred return.
The thing that is scary about S Corporations is that if you screw up badly enough you no longer have a flow through entity. Screw up a non-corporate entity and you are talking more about moving the income or losses around among the different parties, not creating a whole new layer of taxation. The PLR comes out of that type of concern. I had originally considered titling the article "Possible Triumph of Common Sense".
The shareholders of S corporations and partners in partnerships (which includes most LLC members) are taxed on the entity's income regardless of whether it is distributed. Other than in very closely held situations, this creates a business problem. A non-controlling owner has to be concerned that they won't have the cash to pay the taxes that the entity creates for them. This is typically dealt with by having an agreement by the entity to make tax distributions. Generally the distribution is some sort of formula. Certainly in the case of an S corporation it could not be the exact amount of each shareholders federal and state tax, since this amount is unlikely to work out exactly on a per share basis. For example, if you distributed more to a shareholder who happened to live in California, you would probably be violating the single class of stock rule.
PLR 20107019 has a unique wrinkle though. Its tax distribution plan is based on making distributions in proportion to ownership at the time that the taxable income is generated rather than based on ownership when the distribution is declared.
If X's taxable income is increased or its creditable foreign taxes are decreased after X's original return for a particular taxable year is filed, the Stockholder's Agreement allows X to make a distribution to its shareholders, in accordance with their respective interests in X's taxable income or loss for that period, with respect to the deficiency resulting from such increase or decrease within a reasonable time after the amount of the increase or decrease becomes final (the Discretionary Payment Provision). The Discretionary Payment Provision is intended to allow X to assist its shareholders in paying their additional tax liability resulting from adjustments to X's originally filed tax returns.
So imagine that in 2009 X had shown no taxable income and then you sold your stock in early 2010. Sometime in 2012 X settles an audit and you get a corrected K-1 for $20,000. X will then declare a special distribution some of which will go to you even though you have not been a shareholder for over two years.
The IRS ruled that this special plan did not violate the single class of stock rule. Advisers to substantial S Corporations may want to take a look at this ruling as might owners of minority interests in S Corporations.
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