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Module 5: Tax Considerations. Part 1: Tax Perks and Traps . Basic Terms. Income : Monies earned. Portfolio, active and passive income. Basis : cost Adjusted basis : cost + adjustments for improvements Gain or Earnings : profits (income – expenses)

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Module 5: Tax Considerations


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module 5 tax considerations

Module 5: Tax Considerations

Part 1: Tax Perks and Traps

basic terms
Basic Terms
  • Income: Monies earned. Portfolio, active and passive income.
  • Basis: cost
  • Adjusted basis: cost + adjustments for improvements
  • Gain or Earnings: profits (income – expenses)
  • Built-in gains: adjustments in the basis that is tied to income fluctuations.
  • Double tax: Tax paid by corporation when earned; tax paid by shareholder when distributed.
  • Pass-thru: Entity does not have any tax liability.
  • Accumulated earning: Earnings retained and not distributed.
  • Capital Gain: Investments held for more than one year
check the box

Check-The-Box

Default provisions apply based upon selection.

Corporate entities are C or S under IRC.

Partnerships and LLCs taxed under Subchapter K (partnership) unless all consent to C status.

Single owner entity is C corp or sole proprietor. One owner LLC disregarded for tax purposes.

Election is locked in for 60 months unless more than 50% change in ownership.

Tax consequences of switching can be costly.

tax variables
Tax Variables
  • Income: Dividend vs. Bonus salary
  • Gain: Ordinary income vs. Capital gains
  • Earnings: Cap on accumulated earnings
  • Losses: Retained vs. Offset
  • Basis: Rolled over vs. Stepped-up
  • Taxation: Double tax vs. Pass-thru
  • Bail-out: Pre-tax vs. After tax dollars
  • Tax on Gain: Recognized vs. Deferred
future sale potential

Future Sale Potential

C Corporation Factors:

Double tax potential

No basis booster for income accumulations

Tax-free reorganization potential

1045 rollover gain potential

15% capital gains rate at shareholder level

1202 exclusion (not a big deal now)

Ordinary loss treatment under 1244 (no big deal)

Copyright 2005 Dwight Drake. All Rights Reserved.

Business Planning: Closely Held Enterprises

www. drake-business-planning.com

c corp double tax hit on asset sale

Assets

C Corp

34% Tax Rate

Buyer

C Corp Double Tax Hit on Asset Sale

Cash

Net Proceeds

Summary tax impact on $1,000 gain

Corporate tax @ 34% $340

Shareholder Tax

15% of $660 99

Total Taxes $439

Percent ($439/1000) 43.9%

Shareholders

15% Tax Rate

Copyright 2005 Dwight Drake. All Rights Reserved.

Business Planning: Closely Held Enterprises

www. drake-business-planning.com

c corp non basis booster

C Corp Non-Basis Booster

Copyright 2005 Dwight Drake. All Rights Reserved.

Business Planning: Closely Held Enterprises

www. drake-business-planning.com

pass thru entity basis booster

Pass-Thru Entity Basis Booster

Copyright 2005 Dwight Drake. All Rights Reserved.

Business Planning: Closely Held Enterprises

www. drake-business-planning.com

sale potential of s corp vs sub k partnership

Sale Potential of S Corp vs. Sub. K (Partnership)

S corp can participate in tax-free reorg.

Less ordinary income traps with S corp

Basis boosting a push

C corp convertibility

- S-corp. possible with nuisance traps

- Partnership and LLC usually prohibitive

Copyright 2005 Dwight Drake. All Rights Reserved.

Business Planning: Closely Held Enterprises

www. drake-business-planning.com

c corp losses

Losses

C Corp Losses

Carry Back

Carry Forward

C Corp

Never Pass Thru

Shareholders

Copyright 2005 Dwight Drake. All Rights Reserved.

Business Planning: Closely Held Enterprises

www. drake-business-planning.com

s corp partnership llc losses

Losses

S Corp, Partnership, LLC Losses

  • Hurdles:
  • Basis limitations (704(d) and 1366(d))
  • At-risk limitations (465)
  • Passive activity limitations (469)

C Corp

Pass Thru

Owners

Copyright 2005 Dwight Drake. All Rights Reserved.

Business Planning: Closely Held Enterprises

www. drake-business-planning.com

material participation under 469

Material Participation Under 469

More than 500 hrs in year

Sole participant in activity

More than 100 hrs and anyone else

More than 100 hrs and more than 500 hrs in significant participation activities

5 of last 10 yrs meet standard

Any previous 3 yrs if personal service

Regular, continuous, substantial based on all facts and circumstances

Copyright 2005 Dwight Drake. All Rights Reserved.

Business Planning: Closely Held Enterprises

www. drake-business-planning.com

nuisance c traps avoid

Nuisance C Traps (Avoid)

Accumulated earnings trap

- Penalty tax on excess income accumulations

- Rate now low 15% (may go back up)

- No tax on accumulations for reasonable business needs

- Minimum credit of $250k ($150k for professional service organizations)

- Nuisance trap that requires awareness and basic planning

Personal holding company trap

- Penalty tax on excess accumulations of investment income, incorporated talent income, and shareholder rental income

- Rate now low 15% (may go back up in 2008 to 39.6%)

- Closely held and 60% requirements for tax to apply

- Remedial action is to bailout income via dividends or compensation

Copyright 2005 Dwight Drake. All Rights Reserved.

Business Planning: Closely Held Enterprises

www. drake-business-planning.com

slide14

TAX DISTINCTIONS BETWEEN DIFFERENT

PARTNERSHIPS, LIMITED LIABILITY COMPANIES AND CORPORATIONS

module 5 tax considerations15

Module 5: Tax Considerations

Part 2: Tax Planning

goals
Goals

Maximize the tax consequences.

1) to transfer only qualifying property;

2) to defer as much gain as possible,

3) to allow the basis to carry over,

4) to tack on the holding period to the taxpayer gets the benefit of the time he or she previously held the period; and

5) to satisfy the control test.

example
Example
  • Linda transfers to XYZ Inc. equipment that has a basis of $100,000 and a fair market value of $200,000 in return for 100 shares of XYZ Inc. common stock.
if section 351 does not apply

C Corp

  • Tax Impacts:
  • Linda recognizes $100k income
  • Linda stock basis equals $200k
  • Linda has new holding period in stock
  • Corp’s basis in equipment $200k
  • Corp has new holding period in equipment
  • Corp has no income recognition per 1032

If Section 351 Does Not Apply?

  • Equipment
  • Basis 100k
  • FMV 200k

Stock

Shareholder

Linda

Copyright 2005 Dwight Drake. All Rights Reserved.

Business Planning: Closely Held Enterprises

www. drake-business-planning.com

slide19

Rule 1: The 351 Rule

No gain or loss is recognized by the transferor on the transfer of property to a corporation in exchange for stock of the corporation if:

1. Property is transferred;

2. Solely in exchange for stock; and

3. Transferor(s) in “control” “immediately after exchange. Two 80% requirements – 80% of all voting stock and 80% of total shares of all classes of stock.

Example: XYZ Inc issues 100 share of its stock to its sole shareholder Linda for equipment worth $200k that has a basis of $100k. Linda recognizes no gain or loss on the exchange.

Copyright 2005 Dwight Drake. All Rights Reserved.

Business Planning: Closely Held Enterprises

www. drake-business-planning.com

if section 351 does apply

Tax Impacts:

  • Linda recognizes no income (Rule 1)
  • Linda stock basis equals $100k (Rule 3)
  • Linda has tacked holding period in stock
  • (Rule 4)
  • Corp’s basis in equipment $100k (Rule 6)
  • Corp has tacked holding period in equipment
  • (Rule 7)
  • Corp has no income recognition per 1032
  • (Rule 5)

C Corp

If Section 351 Does Apply?

  • Equipment
  • Basis 100k
  • FMV 200k

Stock

Shareholder

Linda

Copyright 2005 Dwight Drake. All Rights Reserved.

Business Planning: Closely Held Enterprises

www. drake-business-planning.com

section 351 eligibility traps

Section 351 Eligibility Traps

Trap Solution

Stock for services Keep under 20% or have dual consideration

and meet 10% standard of Rev. Proc. 77-37

Multiple transfers Document part of integrated plan.

at different times

Subsequent stock sale Prohibit; require time lapse; no prearrangement;

gifts generally not a problem.

Accommodation transfers Meet 10% threshold of Rev. Proc. 77-37.

Subsequent corp property Okay if in ordinary business or insure

sales time lapse and no pre-arrangement.

Nonvoting stock 80% control of each class. Only direct ownership counts.

Nonqualified preferred Cf. boot for income recognition purposes.

Investment company risk Contribute same stock or identical interests.

Copyright 2005 Dwight Drake. All Rights Reserved.

Business Planning: Closely Held Enterprises

www. drake-business-planning.com

section 351 with boot

Tax Impacts:

  • Linda recognizes $80k income (Rule 2)
  • Linda stock basis equals $100k (Rule 3)
  • Linda has tacked holding period in stock
  • (Rule 4)
  • Corp’s basis in equipment $180k (Rule 6)
  • Corp has tacked holding period in equipment
  • (Rule 7)
  • Corp has no income recognition per 1032
  • (Rule 5)

C Corp

Section 351 With Boot

  • Equipment
  • Basis 100k
  • FMV 200k

Stock and 80k cash

Shareholder

Linda

Copyright 2005 Dwight Drake. All Rights Reserved.

Business Planning: Closely Held Enterprises

www. drake-business-planning.com

slide23

Rule 2: The 351(b) Boot Rule

If 351 would apply except that corporation issues property in addition to stock (“boot”) to the shareholder, then shareholder recognizes gain on the property transferred to corporation equal to the lesser of:

1. The built-in gain on the property transferred – the excess of FMV over basis

2. The FMV of boot received by the shareholder.

Example: XYZ Inc issues 100 share of its stock and $80k cash to its sole shareholder Linda for equipment worth $200k that has a basis of 100k. Linda recognizes gain equal to boot – $80k. If $120k boot was paid by XYZ Inc in addition to stock, Linda would recognize gain equal to 100k – excess of 200k FMV over 100k basis.

Copyright 2005 Dwight Drake. All Rights Reserved.

Business Planning: Closely Held Enterprises

www. drake-business-planning.com

slide24

Rule 3: The 358 Basis Rule

If 351 applies to an exchange of property for stock in a corporation, the basis of the stock received by the shareholder equals:

1. The basis of the property transferred to the corporation in the hands of the shareholder, plus

2. Any gain recognized by the shareholder (over stock), less

3. The FMV of any boot received.

Example: XYZ Inc issues 100 share of its stock and $80k cash to its sole shareholder Linda for equipment worth 200k that has a basis of $100k. Linda recognizes gain equal to boot – $80k. Linda’s basis in stock is equal to 100k (basis in equipment), plus $80k gain less $80k boot = $100k.

If $120k boot was paid by XYZ Inc in addition to stock, Linda would recognize gain equal to 100k. Basis in stock would equal 100k, plus 100k gain, less 120k boot = 80k basis.

Copyright 2005 Dwight Drake. All Rights Reserved.

Business Planning: Closely Held Enterprises

www. drake-business-planning.com

slide25

Rule 4: The Shareholder Tacking Rule

If 351 applies to an exchange of property for stock in a corporation, the holding period of the property transferred by the shareholder is “tacked on” to the holding period of the stock if the transferred property was a capital asset or a 1231 asset (asset used in trade or business). No inventories or receivables.

Example: XYZ Inc issues 100 share of its stock and $80k cash to its sole shareholder Linda for equipment worth $200k that has a basis of $100k. Linda’s holding period of equipment is “tacked on” in determining holding period of stock.

Copyright 2005 Dwight Drake. All Rights Reserved.

Business Planning: Closely Held Enterprises

www. drake-business-planning.com

slide26

Rule 5: The 1032 Rule

Corporation recognizes no gain or loss on receipt of money or property in exchange for its own stock.

Example: XYZ Inc issues 100 share of its stock and 80k cash to its sole shareholder Linda for equipment worth 200k that has a basis of 100k. XYZ Inc recognizes no gain or loss.

Copyright 2005 Dwight Drake. All Rights Reserved.

Business Planning: Closely Held Enterprises

www. drake-business-planning.com

slide27

Rule 6: The 362 Rule

A corporation’s basis in property acquired in exchange for its stock in a transaction that qualifies under 351 equals the shareholder’s basis in the property’s basis plus any gain recognized by the shareholder.

Example: XYZ Inc issues 100 share of its stock and 80k cash to its sole shareholder Linda for equipment worth 200k that has a basis of 100k. Linda recognizes gain equal to boot – 80k. XYZ Inc.’s basis in equipment is $100k (Linda’s basis in equipment), plus 80k gain recognized by Linda = $180K.

Copyright 2005 Dwight Drake. All Rights Reserved.

Business Planning: Closely Held Enterprises

www. drake-business-planning.com

slide28

Rule 7: The Corp Tacking Rule

If 351 applies to an exchange of property for stock in a corporation, the holding period of the property transferred by the shareholder is “tacked on” in determining the holding period of the property in the hands of the corporation.

Example: XYZ Inc issues 100 share of its stock and $80k cash to its sole shareholder Linda for equipment worth $200k that has a basis of $100k. Linda’s holding period of equipment is “tacked on” in determining XYZ Inc.’s holding period of equipment.

Copyright 2005 Dwight Drake. All Rights Reserved.

Business Planning: Closely Held Enterprises

www. drake-business-planning.com

slide29

Rule 8: The Assumed Liability Rule

General Rule: If corporation assumes liability of shareholder in 351 exchange:

1. Assumption not considered “boot” for gain or loss purposes. 357(a)

2. Assumption does reduce shareholder stock basis by debt amount. 358(d)

Exceptions: Debt treated as “boot” for gain purposes if:

1. Tax avoidance purpose or not bona fide business purpose. Burden on taxpayer to prove by clear preponderance of evidence.

2. Debt exceeds basis of all property transferred to corp – then excess treated as taxable boot.

Copyright 2005 Dwight Drake. All Rights Reserved.

Business Planning: Closely Held Enterprises

www. drake-business-planning.com

section 351 with assume debt

Tax Impacts:

  • Linda recognizes $20k income (Rule 8)
  • Linda stock basis equals 0 (Rule 3)
  • Linda has tacked holding period in stock
  • (Rule 4)
  • Corp’s basis in equipment $120k (Rule 6)
  • Corp has tacked holding period in equipment
  • (Rule 7)
  • Corp has no income recognition per 1032
  • (Rule 5)

C Corp

Section 351 With Assume Debt

Stock and 120k debt assumed

  • Equipment
  • Basis 100k
  • FMV 300k

Shareholder

Linda

Copyright 2005 Dwight Drake. All Rights Reserved.

Business Planning: Closely Held Enterprises

www. drake-business-planning.com

section 351 assumed debt traps

Section 351 Assumed Debt Traps

Trap Solution

Tax avoidance purpose Bad purpose taints all debt. Proof burden on

taxpayer. Recent debts suspect.

Shareholder Liabiltiy Leave no doubt as to parties’ expectations regarding who pays

Nonrecourse debts Specify amount to be paid from outside assets.

Amount should never exceed FMV.

Future accountable debts Not debt for 351 purposes. Identity and exclude.

Both deductible (cash basis APs) and capital

expenditures excluded. Rev. Rule 95-74

Basis pumping Contribute more cash or assets than debt to increase basis. Helps to avoid debt in excess of basis.

Copyright 2005 Dwight Drake. All Rights Reserved.

Business Planning: Closely Held Enterprises

www. drake-business-planning.com

slide32

Partnership Rules Comparison

Corporate Partnership

Rule 1: The 351 Rule 721: No gain or loss to partner and

control requirement. But built-in

gain allocated back to partner on

sale per 704(c)

Rule 2: The 351(b) Boot Rule Boot not trigger income unless

money distributed in excess of

partner’s basis before distribution

Rule 3: The 358 Basis Rule Same per 722 & 733, except

reduction for non-money boot

limited to partnership’s basis

in property and 721(b) gain limited to investment companies

Copyright 2005 Dwight Drake. All Rights Reserved.

Business Planning: Closely Held Enterprises

www. drake-business-planning.com

slide33

Partnership Rules Comparison

Corporate Partnership

Rule 4: Shareholder Tacking Rule Same per 1223 (1)

Rule 5: The 1032 Rule Same per 721 if for property

(not services)

Rule 6: The 362 Rule Same per 723 (Note limiting

reference to 721(b) gain)

Rule 7: The Corp Tacking Rule Same per 1223(2)

Rule 8: The Assumed Liability Rule Similar result - New Game

Copyright 2005 Dwight Drake. All Rights Reserved.

Business Planning: Closely Held Enterprises

www. drake-business-planning.com

slide34

Partnership Liability Game

1. 752 Upside Twist: Increase in partner’s share of partnership’s liabilities

deemed contribution of money to partnership. Basis increase.

2. 752 Downside Twist: Decrease in partner’s share of partnership’s

liabilities deemed money distribution. If money distribution exceeds

basis before distribution, then gain recognized to extent of excess per

731. No negative basis.

3. Recourse liability allocation: Allocated to partners according to how

partners agree to bear ultimate risk for liability.

4. Non-recourse liability: Allocated to partners according to profits

interests with some flexibility. But if property contributed with NR

debt in excess of basis, debt first allocated to contributing partner to

amount of gain allocated to such partner under 704(c) if property

sold for debt.

Copyright 2005 Dwight Drake. All Rights Reserved.

Business Planning: Closely Held Enterprises

www. drake-business-planning.com

slide35

Partnership Capital Interest For Services

Capital Interest: An interest that gives service partner a share of the partnership’s existing capital and future profits. A right to future profits interest only gives share of future profits. Test: If partnership liquidated now, would service partner get anything?

Triple Impact: Capital interest for services

1. Partner has section 61 compensation income equal to FMV of interest,

subject to section 83 game.

2. Partnership gets section 162 deduction in same amount, allocated to

existing partners (not new partner)

3. Existing partners may share gain equal to FMV of interest transferred

over allocable basis of each partner. Deemed sale from existing to new.

Proposed Regs would eliminate deemed sale.

Copyright 2005 Dwight Drake. All Rights Reserved.

Business Planning: Closely Held Enterprises

www. drake-business-planning.com