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.
Showing posts with label earnings and profits. Show all posts
Showing posts with label earnings and profits. Show all posts
Friday, November 12, 2010
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.
Wednesday, September 15, 2010
Time to Purge C Corporations
Generally in this blog addresses specific developments - a tax court decision or a private letter ruling for example - issued in the last few months. I'm celebrating entity extended due date (one of the four major holy days in the tax nerd religion) by pointing out a major planning opportunity. It requires action before December 31 and if applicable may require significant study, so the time to start looking at it is right now.
Are you involved in anyway with a C corporation with significant appreciated assets ? A youngster might wonder how such a thing came to be. Well have you ever noticed that when you see a copy of the Code it says Internal Revenue Code of 1986 ? Did you ever wonder what it was like before that ? Under the Internal Revenue Code of 1954 that is. Individual rates were much much higher. The maximum individual rate was 70% (and that was down from higher levels). There was a special maximum rate on earned income of 50%. The first 50,000 of corporate income was taxed at significantly lower rates. Prior to the Tax Reform Act of 1969 it was possible to have multiple corporations with common ownership take advantage of this feature. (That is getting before my time.)
The neat thing that you could do back then was sell the assets of the corporation in a complete liquidation without recognizing gain at the corporate level. The proceeds were then distributed to the shareholders who had capital gains treatment. Eliminating this feature, sometime referred to as the General Utilities doctrine, was one of the biggest changes in TRA 1986, which is really saying something. To prevent people getting around the gain recognition by a last minute S election, the S corporation built in gain tax was created. If in 1985 you had a C corporation the thing to do was to look at it closely and see if there was a reason to not make an S election. Over the years I've encountered a few instances of C corps that really should have converted in 1985. I suspect there are probably a few still kicking around. As a matter of fact, I just read about one in the case of Estate of Marie J. Jensen, et al. v. Commissioner, TC Memo 2010-182. The decedent had owned stock in a corporation that owned real estate, a moribund summer camp. In valuing the stock interest the estate was allowed to deduct the capital gains tax that the corporation would have to pay if the real estate were sold. Now I wouldn't want to deprive the Jensen estate of its discount, but there is a strategy that an entity like that might consider.
The built-in gains tax (Section 1374) only applies to the appreciated value of the real estate at the time of the S election. (I know you don't think that there is any such thing as appreciated real estate anymore, but you have to remember we might be talking about something a corporation purchased in 1957.) So any future appreciation will not be subject to double taxation. More significantly the built-in gains tax only applies for ten years. (Well maybe I should not have used the word "only" there.) So imagine you have inherited Oldco, Inc, a C corporation, which owns land worth $10,000,000. Your basis in the stock is $5,000,000. The corporations basis in the land is $500,000.
If you can take a long view an S election can solve the double tax problem. You have to be able to wait out the ten years, though. An installment sale will not do the trick. A like-kind exchange will. I have written here and there about the perils of like-kind exchanges, but there is no question that they can be a fantastic wealth building device. The owners of Oldco, Inc would have to do a really bad job in selecting a target property to make them wish they had just paid the taxes. A likely strategy would be property that is triple net leased to a credit tenant. You always wanted to own a Walgreen's right ? So now Oldco, Inc without incurring any tax is flowing through $800,000 of rental income to its shareholders subject to a single tax. The built in gains tax taint has transferred from the raw land to the Walgreen's, but it will go away in 10 years and nothing prevents you doing another like kind exchange. Everything would be great except that now you have an S corporation with excess passive income(Section 1375). So your $800,000 is subject to double taxation. And you are not going to be able to wait out the ten years, because if you have excess passive income for three years running your S election is revoked. The two sections 1374 and 1375 sit their like Scylla and Charybdis waiting to devour you (I leave it to one with better classical training to decide which section is Scylla and which Charybdis).
There are at least two approaches to solve the problem. One is to make sure that Oldco Inc has active business income at least three times as great as its passive income. I could go on at length about this strategy. It could work, but it has the danger of creating a tail wagging the dog type of problem. I will note, though, that rental income which is passive for purposes of the passive activity loss rules might be considered active for purposes of the S corporation tax on excess passive income. Conceivably you might solve the problem by swapping your triple net Walgreen's for a strip mall, but there is another solution. Section 1375 applies to S corporations that have excess passive income and accumulated earnings and profits. If Oldco, prior to making its S election, distributes its accumulated earnings and profits it will be not be subject to the tax on excess passive income.
Why is this timely ? Under current law dividends are taxed at 15%. So Oldco's purging of its accumulated earnings and profits may be much less expensive if it is accomplished in 2010. Assuming Oldco is really on the old side determining what the amount of its earnings and profits is may turn out to be a non-trivial question. As Biker and Eustice note :
To compute a corporation's earnings and profits is often no simple task, especially if the corporation has gone through a series of reorganizations or other adjustments. It may be necessary to decide how a transaction occurring many years ago should have been treated under a long-interred statute because of its effect on accumulated earnings and profits; and, because there is no statute of limitations governing the effect of prior transactions on accumulated earnings and profits, it is advisable to retain corporate records permanently.
There may be a host of other problems to solve including, most likely, stubborn inertia.
Are you involved in anyway with a C corporation with significant appreciated assets ? A youngster might wonder how such a thing came to be. Well have you ever noticed that when you see a copy of the Code it says Internal Revenue Code of 1986 ? Did you ever wonder what it was like before that ? Under the Internal Revenue Code of 1954 that is. Individual rates were much much higher. The maximum individual rate was 70% (and that was down from higher levels). There was a special maximum rate on earned income of 50%. The first 50,000 of corporate income was taxed at significantly lower rates. Prior to the Tax Reform Act of 1969 it was possible to have multiple corporations with common ownership take advantage of this feature. (That is getting before my time.)
The neat thing that you could do back then was sell the assets of the corporation in a complete liquidation without recognizing gain at the corporate level. The proceeds were then distributed to the shareholders who had capital gains treatment. Eliminating this feature, sometime referred to as the General Utilities doctrine, was one of the biggest changes in TRA 1986, which is really saying something. To prevent people getting around the gain recognition by a last minute S election, the S corporation built in gain tax was created. If in 1985 you had a C corporation the thing to do was to look at it closely and see if there was a reason to not make an S election. Over the years I've encountered a few instances of C corps that really should have converted in 1985. I suspect there are probably a few still kicking around. As a matter of fact, I just read about one in the case of Estate of Marie J. Jensen, et al. v. Commissioner, TC Memo 2010-182. The decedent had owned stock in a corporation that owned real estate, a moribund summer camp. In valuing the stock interest the estate was allowed to deduct the capital gains tax that the corporation would have to pay if the real estate were sold. Now I wouldn't want to deprive the Jensen estate of its discount, but there is a strategy that an entity like that might consider.
The built-in gains tax (Section 1374) only applies to the appreciated value of the real estate at the time of the S election. (I know you don't think that there is any such thing as appreciated real estate anymore, but you have to remember we might be talking about something a corporation purchased in 1957.) So any future appreciation will not be subject to double taxation. More significantly the built-in gains tax only applies for ten years. (Well maybe I should not have used the word "only" there.) So imagine you have inherited Oldco, Inc, a C corporation, which owns land worth $10,000,000. Your basis in the stock is $5,000,000. The corporations basis in the land is $500,000.
If you can take a long view an S election can solve the double tax problem. You have to be able to wait out the ten years, though. An installment sale will not do the trick. A like-kind exchange will. I have written here and there about the perils of like-kind exchanges, but there is no question that they can be a fantastic wealth building device. The owners of Oldco, Inc would have to do a really bad job in selecting a target property to make them wish they had just paid the taxes. A likely strategy would be property that is triple net leased to a credit tenant. You always wanted to own a Walgreen's right ? So now Oldco, Inc without incurring any tax is flowing through $800,000 of rental income to its shareholders subject to a single tax. The built in gains tax taint has transferred from the raw land to the Walgreen's, but it will go away in 10 years and nothing prevents you doing another like kind exchange. Everything would be great except that now you have an S corporation with excess passive income(Section 1375). So your $800,000 is subject to double taxation. And you are not going to be able to wait out the ten years, because if you have excess passive income for three years running your S election is revoked. The two sections 1374 and 1375 sit their like Scylla and Charybdis waiting to devour you (I leave it to one with better classical training to decide which section is Scylla and which Charybdis).
There are at least two approaches to solve the problem. One is to make sure that Oldco Inc has active business income at least three times as great as its passive income. I could go on at length about this strategy. It could work, but it has the danger of creating a tail wagging the dog type of problem. I will note, though, that rental income which is passive for purposes of the passive activity loss rules might be considered active for purposes of the S corporation tax on excess passive income. Conceivably you might solve the problem by swapping your triple net Walgreen's for a strip mall, but there is another solution. Section 1375 applies to S corporations that have excess passive income and accumulated earnings and profits. If Oldco, prior to making its S election, distributes its accumulated earnings and profits it will be not be subject to the tax on excess passive income.
Why is this timely ? Under current law dividends are taxed at 15%. So Oldco's purging of its accumulated earnings and profits may be much less expensive if it is accomplished in 2010. Assuming Oldco is really on the old side determining what the amount of its earnings and profits is may turn out to be a non-trivial question. As Biker and Eustice note :
To compute a corporation's earnings and profits is often no simple task, especially if the corporation has gone through a series of reorganizations or other adjustments. It may be necessary to decide how a transaction occurring many years ago should have been treated under a long-interred statute because of its effect on accumulated earnings and profits; and, because there is no statute of limitations governing the effect of prior transactions on accumulated earnings and profits, it is advisable to retain corporate records permanently.
There may be a host of other problems to solve including, most likely, stubborn inertia.
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