rroyselaw.com Blog

Corporate Reporting of Transactions Affecting Basis

Administrator — Tue, 24 Jan 2012 05:59:15 +0000

Under Section 6045B of the Internal Revenue Code of 1986, as amended (the “Code”) many corporations are required to file a new return (Form 8937) with the IRS in connection with non-dividend distributions and other corporate actions affecting stock basis. More specifically, starting in 2011, the issuer of “specified securities” shall file a return with the Department of the Treasury within 45 days of any “organizational action which affects the basis of such specified security of the issuer.” “Specified securities” include both (1) shares of stock in an entity organized as, or treated for federal tax purposes as, a corporation, and (2) other interests treated as stock. The reporting requirement applies to both United States and foreign corporations, and a reporting corporation may instead of sending the Form 8937 to the IRS and each shareholder, choose to satisfy its obligation by publicly posting such completed Form 8937 on its website for 10 years.

For more information, contact your tax professional or go to the IRS website at: http://www.irs.gov/instructions/i8937/ar01.html

Third Offshore Voluntary Disclosure Program Announced by IRS

Administrator — Thu, 12 Jan 2012 06:04:04 +0000

In 2009 and 2011 the Internal Revenue Service (IRS) created two temporary initiatives to allow U.S. taxpayers with unreported income relating to undisclosed foreign bank or financial accounts to make a voluntary disclosure to get current with their taxes and information filing obligations. On Monday, January 9, 2012, the IRS announced a third initiative with terms largely similar to that of the 2011 Offshore Voluntary Disclosure Initiative (OVDI).

Like its predecessors, the 2012 OVDI offers a simplified penalty structure compared to that present under applicable law and protection for taxpayers concerned with criminal sanctions. 2012 OVDI participants must also look back eight years and file all original and amended tax returns to include unreported offshore income and make payment for back-taxes, interest, accuracy-related and/or delinquency penalties. Unlike its predecessors, the 2012 OVDI is not set to expire on a specified date, but the IRS warns that the terms of the program could change or the program could end at any time. In addition, the standard penalty for participants has increased to 27.5% (2011 OVDI was 25%) of the sum of (i) the participant’s highest aggregate balance of foreign financial accounts and (ii) the value of other includable foreign assets.

US taxpayers with unreported offshore income should consult a tax professional to discuss the new program in detail. More information can also be found on the IRS website:http://www.irs.gov/newsroom/article/0,,id=252162,00.html?portlet=108

IRS Releases Final Rules Applying Section 108(e)(8) COD Income to Partners and Partnerships

Administrator — Fri, 16 Dec 2011 04:36:34 +0000

On Nov. 15, 2011 the Internal Revenue Service (IRS) released guidance on the application of the Section 108(e)(8) to cancellation of indebtedness (COD) income of partners and partnerships (the “Guidance”). See T.D. 9557. The new rules are effective Nov. 17, 2011.

Generally, Section 108(e)(8) provides that when a partnership transfers a capital or profits interest to a creditor in satisfaction of the partnership’s indebtedness, the partnership will be treated as having satisfied the indebtedness with cash of a value equal to the fair market value of the partnership interest transferred to such creditor. COD income exists if the value of the partnership interest transferred is less than the indebtedness cancelled. COD income realized on such a transfer, if any, is allocated to the partners of the partnership based on their distributive shares immediately before such cancellation. The Guidance clarifies that the value of partnership interest transferred is equal to the liquidation value of such interest so long as – (1) all parties involved in the exchange (i.e. the creditor, debtor, partnership etc) consistently treat the value as being the liquidation value; (2) the partnership uses a consistent valuation methodology in all debt for equity exchange that are part of the same transaction; (3) the debt for equity exchange is made at arm’s length (can be satisfied even if the parties are related); and (4) following the debt for equity exchange, neither the partnership nor any related person purchases the partnership interest as a part of a plan that existed as of the time of the debt for equity exchange in a transaction that’s principal purpose is the avoidance of COD income.

The Guidance also address the application of Internal Revenue Code Section 721 relating to a creditor’s contribution of a recourse or nonrecourse indebtedness to a partnership in exchange for a capital or profits interest. Generally, the nonrecognition rule of Section 721 applies in a debt for equity exchange and the creditor will not recognize a loss or bad debt deduction in such an exchange. The creditor’s basis in the partnership interest received is increased by the adjusted basis of the indebtedness. Ordinary income items, such as rent, royalties and interest cannot, however, be cancelled in a nonrecognition transaction under Section 721, unless such obligations arose before the beginning of the creditor’s holding period for the indebtedness.

Finally, the Guidance address how to allocate income arising from a partnership’s discharge of indebtedness as a minimum gain chargeback. The Guidance provides that COD income arising in the discharge of a partnership or partner nonrecourse indebtedness is treated as a first-tier item for minimum gain chargeback purposes.

The Guidance and new regulations will contain a few examples to demonstration application of these rules.

Valuable QSBS Opportunity for Investors and LLC’s to End on December 31, 2011

Administrator — Mon, 05 Dec 2011 05:36:25 +0000

In our blog post from December 2010, we discussed the potential for investors to acquire certain qualified small business stock (“QSBS”) and be eligible to exclude 100% of the gain realized on a subsequent sale of that QSBS, if held for at least five years. That 100% gain exclusion for QSBS was enacted by Congress as a part of the Small Business Jobs Act of 2010 (“SBJA 2010”) and then extended as a part of the Tax Extension Act of Dec. 17, 2010. Potential investors have a limited window to take advantage because this special exclusion only applies to QSBS acquired before January 1, 2012.

The 100% gain exclusion described above is, however, limited to the greater of (i) $10 million or (ii) 10 times such taxpayer’s basis in the QSBS. $10 million is a pretty high cap, but certain LLC’s may be able to do even better.

In the event the QSBS stock is acquired in an exchange (i.e. not for cash), the Section 1202 rules determine a taxpayer’s basis in its QSBS stock to be equal to the fair market value of property transferred. So, while a start-up company may have been created as an LLC, with very little cash being contributed by its investors, if that LLC start-up has increased in value, the investors may consider converting the LLC to a corporation. Assuming that the stock the investors receive in the LLC conversion will be QSBS, the investors will be eligible for the 100% gain exclusion on a later disposition of that QSBS. Assuming that the LLC, at the time of its conversion, had a value at least $1 million, the cap on the gain exclusion will be increased (since the cap is equal to 10 times that value). So, if the LLC had a $5 million value at the time of its conversion, the gain that could be excluded on its sale is capped at $50 million; much higher than $10 million cap that might otherwise apply. In summary, by organizing as an LLC initially and creating value in that LLC prior to corporate conversion, an investor can increase his potential for QSBS gain exclusion.

While the gain exclusion described above benefits QSBS investors in a stock sale exit transaction, the LLC form may still be better in the event of an asset sale exit transaction. Many other differences exist between LLC’s and corporations, so all factors should be thoroughly considered before an LLC is converted to a corporation to take advantage of the QSBS benefits described above.

Franchise Tax Board Audits Sale of S Corp in 338(h)(10) Transaction

Administrator — Mon, 07 Nov 2011 17:32:30 +0000

Shareholders of Subchapter S Corporations frequently sell their stock and are inspired, either by their own tax professionals or the tax professionals of the buyer, to make a Section 338(h)(10) Election to treat such sale of stock as a sale of assets for tax purposes. The expectation is that the buyer can obtain a valuable step-up in the basis of the assets purchased with little difference in the cost or tax position of the selling shareholder. However, when the consideration is paid to the selling shareholder on an installment basis (i.e. over the course of more than 1 tax year), the installment sale rules intersect with the Section 338(h)(10) rules in a manner that both (i) is frequently not anticipated by those same tax professionals and (ii) can create a significant difference in the timing of the taxes paid by the selling shareholder. The Franchise Tax Board (FTB) is now exploiting a huge tax trap that poorly advised taxpayers regularly fall into.

Generally in an installment sale, a seller recovers a ratable portion of his or her basis as each installment payment is received. For example, assume the seller has a basis of $4,000 and sells for $10,000, payable $5,000 in year 1 and $5,000 in year 2. Under the installment sale rules, the seller would recognize $3,000 of income ($5,000 – $4,000/2) with his or her receipt of each $5,000 payment.

Now assume the same facts for a Section 338(h)(10) transaction. According to IRS Treasury Regulations (see Reg. 1.338(h)(10)-1(e), Example 10), there is a tax difference because the Section 338(h)(10) transaction adds an intermediate step; the deemed liquidation of the target company. The target company is deemed to have sold its assets for $5,000 plus an installment note of $5,000. Here the target still recognizes $3,000 of income on its receipt of the first $5,000 cash, which taxable income flows through to the shareholder, increasing the shareholder’s basis to $7,000 ($4,000 + $3,000). Now comes the unexpected part. In the deemed liquidation, the target is deemed to distribute the $5,000 cash and the $5,000 installment note to the shareholder, and the shareholder’s basis is allocated between each distributed asset in proportion to their relative values. On the deemed distribution, the shareholder has another $1,500 of income ($5,000 – $7,000/2) and takes the installment note of $5,000 with a $3,500 basis. The shareholder in this example has $4,500 of taxable income in year 1 ($3,000 as a flow-through from the target + $1,500 on the deemed distribution), and will recognize just $1,500 of taxable income in year 2 ($5,000 – $3,500 basis). As you can see, in comparison to the example in the paragraph above, $1,500 of income is moved from year 2 to year 1.

While it is just a timing difference, accelerating income is not the goal of a noble tax professional. In addition, many states (CA included) do not permit carrybacks of net operating losses, so realizing additional income in the first year creates even more risk that the taxpayer will incur a loss in the second year that cannot be recovered. Because of the potential federal tax adjustments, the tax effect is much worse than just state taxes.

The FTB is actively auditing this transaction and aggressively applying the method found in IRS Treasury Regulations. For unwary or poorly advised taxpayers who have not planned into a 338(h)(10) with installment notes, the result can be both unexpected and devastating. Small changes in the structure of this transaction may avoid the adverse result described above. For example, if there is all installment note and no cash at the moment of close, theoretically, the acceleration would be avoided. Sellers of S corporations should seek specialized tax advice on this issue.

California Voluntary Compliance Initiative 2

Administrator — Fri, 09 Sep 2011 16:50:15 +0000

The Franchise Tax Board of California has announced the Voluntary Compliance Initiative 2 (VCI 2) as an opportunity for taxpayers with underreported California tax liabilities relating to either (i) abusive tax avoidance transactions (ATATs) or (ii) offshore financial arrangements (OFAs), to amend their tax returns for 2010 and prior years and obtain a waiver of most penalties. If you are concerned that you may have underreported your California tax liabilities, please continue reading for more information regarding the VCI 2.

As mentioned above, VCI 2 only relates to taxpayers with underreported California tax liabilities relating to either ATATs or OFAs.

An ATAT includes: (i) any tax shelter as defined under Internal Revenue Code (IRC) Section 6662(d)(2)(C); (ii) any reportable transaction as defined under IRC Section 6707A(c)(1) that is not adequately disclosed in accordance with IRC Section 6664(d)(2)(A); (iii) any listed transaction as defined under IRC Section 6707A(c)(2), (iv) any transaction resulting in a gross misstatement within the meaning of IRC Section 6404(g)(2)(D), or (v) any transaction to which the noneconomic substance transaction (NEST) penalty applies under Revenue and Taxation Code (RTC) section 19774.

An OFA includes: “any transaction designed to avoid or evade California income or franchise tax through the use of: (a) offshore payment cards, including credit, debit, or charge cards issued by banks in foreign jurisdictions, or (b) foreign banks, financial institutions, corporations, partnerships, trusts, or other entities.”

If you believe you may have underreported California tax liabilities relating to either an ATAT or an OFA, you should consider participation in VCI 2. To participate in VCI 2, you will be required to (i) complete a Participation Agreement with the Franchise Tax Board on or before October 31, 2011; (ii) attach the Participation Agreement to your amended tax return to report all income from all sources, without regard to the ATAT and including all income from the OFA; and (iii) pay all tax and interest by October 31, 2011.

The Franchise Tax Board provides that participants in VCI 2 can avoid the following penalties through participation as described above: (i) Noneconomic Substance Transaction Understatement Penalty; (ii) Accuracy Related Penalty; (iii) Interest Based Penalty; and (iv) Fraud Penalty.

Additional information regarding VCI 2 can be found on the Franchise Tax Board website at: http://www.ftb.ca.gov/voluntary_compliance_initiative_2/

Amnesty Deadline Nears

Administrator — Tue, 23 Aug 2011 23:31:46 +0000

On August 31, the IRS Offshore Voluntary Disclosure Initiative is closing. The Initiative allows U.S. taxpayers with unreported income relating to undisclosed foreign bank or financial accounts to make a voluntary disclosure to get current with their taxes and information filing obligations for the past 8 years. When the program closes later this month, U.S. taxpayers can continue to make voluntary disclosures, but a disclosure made after the deadline will not be eligible for the simplified penalty structure set forth in the Initiative. A U.S. taxpayer desiring to participate in the Initiative should act quickly to gain preliminary acceptance prior to the August 31 deadline, a process that could take between 2 and 3 weeks.

CA Court of Appeals Rules Licensed Software Exempt from CA Sales and Use Tax

Administrator — Wed, 15 Jun 2011 06:33:11 +0000

For many years retailers and businesses have been paying California state sales and use taxes on transfers of prewritten software. California tax authorities have claimed that taxes were payable on such transfers, but in the recent case of Nortel Networks Inc. v. State Board of Equalization, the CA Court of Appeals ruled that a license for prewritten software is not subject to state sales and use tax. The ruling applied to a license subject to a patent or copyright entered into pursuant to a technology transfer agreement (TTA).

CA taxpayers who have paid sales and use tax on TTA transactions in the past or who have current TTA arrangements in place should review the tax payments they have made to determine whether the taxes were properly due and payable. There is an refund opportunity for taxpayers that discover taxes were improperly paid. Refund claims must be made before the statute deadline for the applicable tax year (generally within 3 years of the return due date); don’t let your refund opportunity lapse!

How the New City of San Francisco Stock Option Tax Legislation Affects You

Administrator — Thu, 09 Jun 2011 16:18:44 +0000

On Friday, June 3, 2011, Mayor Ed Lee addressed San Francisco’s current policy on taxing gains on stock options by signing into legislation an ordinance granting a partial tax exclusion on stock options for private companies in San Francisco. San Francisco is the only jurisdiction in the state to impose a payroll tax on stock options. The rate is currently 1.5% of the spread on exercise. Under the new tax break, the tax for public companies is capped at $750,000 or what the company’s 2010 tax was, whichever is greater. By capping taxes paid on the stock options, the legislation addresses what would be a sizable spike in startups’ tax bills upon going public.

The exclusion is set to expire after six years, in December 2017, but the chief sponsor of the bill, Supervisor Ross Mirkarimi, viewed it as an interim step in overhauling the payroll tax system, which is blamed for stifling job growth by taxing companies for hiring new workers.[1] Mirkarimi hinted at future changes to come, and Mayor Lee stated that the six-year moratorium would allow the city to figure out a more permanent solution to the payroll tax challenge to place on next year’s ballot.[2]

The city further formed a technology advisory council that represents around thirty different companies and advises the city on issues with technology companies.[3] While the ordinance will probably benefit less than a dozen companies[4], Zynga committed to keeping its home base in San Francisco, signing a long-term lease for a 270,000 square foot office in the southern part of Mission Bay.[5] Although these tax breaks benefit powerhouses such as Twitter, Yelp, and Zynga, a review of companies that have gone public found that they paid between $39,000 to $685,000 in taxes on stock-based compensation, all less than the new $750,000 threshold.[6]

[1] Coté, Mayor Ed Lee to Sign Stock Option Exemption Today.

[2] Adam Lashinsky, Mayor Edwin Lee on San Fran’s Pension Problem and Keeping Twitter in Town, June 3, 2011, available at http://finance.fortune.cnn.com/2011/06/03/mayor-edwin-lee-on-san-frans-pension-problem-and-keeping-twitter-in-town/.

[3] Lashinsky, Mayor Edwin Lee on San Fran’s Pension Problem and Keeping Twitter in Town.

[4] Joshua Sabatini, San Francisco Supervisors Approve 6-Year Break on Stock-Option Taxes, May 17, 2011, available at http://www.sfexaminer.com/local/2011/05/san-francisco-supervisors-approve-6-year-break-stock-option-taxes.

[5] Lashinsky, Mayor Edwin Lee on San Fran’s Pension Problem and Keeping Twitter in Town.

[6] Kopytoff, San Francisco Tech Companies Get a Tax Break.

2011 OVDI Program Q&A’s Updated by IRS; FBAR Deadline Reminder

Administrator — Sun, 05 Jun 2011 04:36:01 +0000

On June 2, the IRS updated the Q&A’s describing the 2011 Offshore Voluntary Disclosure Initiative. The initiative is discussed in more detail in our March 3rd blog post, but generally it is a program that allows taxpayers with undisclosed foreign income or assets to come into compliance for a penalty that is below that which would apply outside the program (in most cases).

The updated Q&A’s (1) provide for a 90-day extension period for taxpayers wishing to comply that are unable to make the August 31 deadline, so long as the taxpayer makes a good faith attempt to comply and can explain which items are missing and why; (2) compare in detailed explanations, the penalties that would potentially apply to taxpayers participating in the initiative versus with those penalties that would potentially apply to taxpayers that “opt-out” of the initiative; and (3) provide an additional reduced penalty for foreign residents with very little U.S. source income so long as such foreign residents have been reporting and paying tax in their jurisdiction of residence.

Remember 2010 FBAR (Form TD F 90-22.1) filings are due June 30th, and the deadline to participate in the 2011 OVDI is August 31.