March of Dimes was created to deal with polio, and was left without a mission once a vaccine was developed. So with a nationwide infrastructure in place, it decided to change its mission from polio to premature children. Today, if a 501(c)(3) wants to broaden or change its mission it doesn’t need to file a new 1023 and seek a new determination letter. Instead, all it needs to do was notify the IRS on its annual 990. On the state level, it will need to amend its Articles of Formation to reflect the new purposes of the organization.
Use of donated funds is a bit more complicated. If funds already raised are restricted, it will not be able to use those funds for the new charitable purpose. It would be better to raise new donations for the new purpose and segregate them from existing funds.
The bottom line is a charity can change and evolve. It doesn’t have to start over.
Recently, the Alaska Supreme Court in Toni 1 v. Wacker put a nail in the coffin of domestic asset protection trusts as effective creditor protection for out of state donors. After a Montana state court issued a series of judgments against Donald Tangwall and his family, the family members transferred two pieces of property to the “Toni 1 Trust,” a trust allegedly created under Alaska law. A Montana state court and an Alaska bankruptcy court found that the transfers were made to avoid the judgments and were therefore fraudulent. Tangwall, the trustee of the Trust, then filed suit, arguing that Alaska state courts have exclusive jurisdiction over such fraudulent transfer actions under AS 34.40.110(k). The Alaska Supreme Court concluded this statute could not unilaterally deprive other state and federal courts of jurisdiction, therefore it affirmed dismissal of Tangwall’s complaint.
Planners have long wondered if the full faith and credit clause of the US Constitution would prevail over state laws in DAPT states. The answer is “yes” in Alaska. It likely is “yes” anywhere else in the United States.
You can still do a DAPT for estate planning reasons, and they do provide asset protection as a trust in the state of the donor’s residence would. You just can’t avoid a judgement in the donor’s state of residence by fraudulently transferring assets to a DAPT created in another state.
You can still create a foreign trust which isn’t subject to the constrains of the US Constitution, but foreign trusts raise another set of issues.
When in comes to asset protection planning, do it when the skies are clear and have other reasons for doing it.
Proposed regulations were issued in November under Code Section 2010 addressing the possibility of “clawback” when the temporary high exemption amount reverts to pre TCJA levels (adjusted for inflation). The good news is that the proposed regulations state that clawback will not occur if one fully uses his or her exemption amount prior to sunset. The bad news is that the proposed regulations did not address the issue of what happens if you only gift the temporary exemption increase during the period when the temporary high exemption is in effect.
The consensus at Heckerling was that if you only gift the exemption increase you will not have any remaining exemption left after sunset, other than annual increases for inflation. So it is “use it or lose it.”
Here in Texas and other community property states, we can offer you ways to fully utilize the temporary high exemption amount without losing income on gifted assets and obtain some asset protection in the process. The time to act is now, however, since it is very possible that the current political environment could result in a termination of the temporary high exemption amount as early as 2021.
In theory conservation easements are simple- a landowner grants a perpetual easement on a portion of his land for a charitable purpose and gets an income tax deduction for the reduction in value to the land encumbered by the easement. Many wealthy landowners have successfully done conservation easements. However, they have been highly abused over the years with inflated appraisals and syndication of the concept.
Recently, the Tax Court in Pine Mountain Preserve channeled Meatloaf’s famous song, and held that two out of the three conservation easements claimed were bad. The issue here wasn’t inflated appraisals but rather improper reservations of future residential development of sixteen homes on the easement property without specifying where this potential residential development could be done. This meant that the easement was not granted “in perpetuity” as required by Section 170(h)(2)(C) the Internal Revenue Code.
Bottom line is this- if you are going to consider a conservation easement, apply the KISS principle. The statute is straightforward, keep the deal simple and get a highly qualified appraiser that follows best practices.
Proposed regulations on Qualified Opportunity Funds (QOF) were released at the end of October. The regulations are complex, and a complete analysis is beyond the scope of a blog post. However, there are some interesting provisions to note:
- There was some confusion over whether the deferred gain had to be recognized 12/31/2026 if the property is not sold. The answer is “yes.”
- Investment in a QOF can be directly in a Qualified Business Zone Property (QBZP) or indirectly in a corporation or flow through entity. The rules are different for each. Most interestingly, indirect investment cannot be in a so-called “sin business” such as golf course (I didn’t know golf was a sin), massage parlors, hot tubs, sun tanning and gambling, but the sin business prohibition does not apply to direct investment in a QBZP.
- If a QOF sells its interest in a QBZ, it can elect to defer again if the sales proceeds are reinvested in another QOF within 180 days.
- If you own a QOF via a partnership interest (or other flow through entity) and the partnership elects not to defer capital gain, you can elect to defer your distributive share of the capital gain by investing in another QOF within 180 days.
Comments are being submitted on these proposed regs. We will continue to monitor this new investment opportunity.
S corporations are pass through entities, but lack the flexibility of partnerships. When more than 20% of the stock of an S corporation is sold, the issue arises as to how to account for income to the shareholders during the year. The default rule is to wait until the the end of the year, determine income for the year and then allocate it on a per day basis. For example, if shareholder A owns 50% of the S corporation and sells all of his stock on October 1 to shareholder B and the S corporation has $100 of income, shareholder A will be allocated $75 of income. But what if all $100 of income is earned after October 1? Poor shareholder A will be allocated $75 of income, but will have no right to receive any of it since he wasn’t a shareholder when it was earned. This creates a phantom income problem for shareholder A.
What is the solution for shareholder A? Well if all shareholders agree the S corporation can elect to use the cut off method. The cut off method creates two separate tax years-one to the date of sale and one after. The cut off method can be elected anytime before the tax return is filed. However, there will usually be a winner and a loser here. In this case shareholder B would be disadvantaged to agree to the cut off method. Therefore, it is recommended that shareholder A require the cut off method to mandated in the stock purchase agreement.
The common wisdom is to select an LLC for a new business. That wisdom needs to be scrutinized. Sure forming an LLC is easy. Generally, the filing fees are less than a corporation, and the documentation is less complicated.
While the LLC may remain the best choice for an investment, it can create issues for an operating business. With the corporate tax rate now only 21%, the tax advantages of an LLC have diminished. Yes, in early years the LLC is likely to generate losses, which can flow through to the owners but this flow through status can cause headaches down the road. For example, employees in corporations are often given stock options. In an LLC employees might be given “profits interests,” which means they start to participate when the founding owners are paid back. The problem is that the profits interest will have to be valued upon receipt. Intangibles, etc… are hard to value. The LLC may not have the resources to provide a professional appraisal or they may not even be aware of the issue. If the LLC become valuable, the IRS will have to benefit of hindsight in valuing the profits interest and the employees may have no evidence to counter the IRS with. The result could be a huge tax surprise for the employees. In addition, the IRS treats all of the owners as partners, which means they will receive a K-1 from the LLC, which will disclose financial information about the LLC. Also, each owner is responsible for their own tax withholding payments.
Finally, as a general rule, private equity and venture capital prefers to invest in corporations rather than pass-through structures. This is because those entities are typically flow through entities and they don’t want the income or loss of their investments to flow through to their limited partners. This might require their limited partners to pay tax on the income and file a return. Filing a return creates an additional audit risk they would prefer to avoid.
Again, the type of business will have a significant influence on the legal structure. Just keep in mind it isn’t as easy as LLC.
Contained in the TCJA, qualified opportunity zones are a new tax incentivized investment vehicle aimed at encouraging investment in low-income housing. Here are the highlights:
- If a taxpayer has a realized capital gain, taxpayer can invest the gain in a Qualified Opportunity Fund within 180 days and defer the capital gain. A Qualified Opportunity Fund is an investment vehicle that holds at least 90% of its assets in Qualified Opportunity Zone Property.
- A Qualified Opportunity Zone is a low-income community designated as a Qualified Opportunity Zone. Governors of the states nominate properties, and those nominations are submitted to the Department of Treasury for certification.
- An investment in a Qualified Opportunity Zone can be made in a domestic corporation, partnership or a Qualified Opportunity Business Zone Property. Regardless of the type of investment vehicle, it must be a Qualified Opportunity Business Zone Business. A Qualified Opportunity Zone Business is a trade or business that owns or leases substantially all of its tangible property in Qualified Opportunity Business Zone Property. Among other requirements, the business must generate at least 50% of its total gross income from active business conduct, and alas there is a long list of excluded businesses, including golf courses. Qualified Opportunity Business Zone Property must be acquired after December 31, 2017 and can be new or “substantially improved.” To be “substantially improved” the taxpayer must invest in the property an amount that exceeds taxpayers adjusted basis in the property over the 30 month period beginning with acquisition.
The tax benefits of investing in a Qualified Opportunity Fund increase with the holding period. If the investment is held for 5 years, the taxpayer receives a 10% increase in basis. If the taxpayer holds for at least 7 years, taxpayer receives an additional 5% basis increase. All Qualified Opportunity Fund interests held on December 31, 2026 are taxed. If the Fund continues to be held after December 31, 2026 and the total holding period reaches 10 years, the taxpayer receives a basis step up to the fair market value at that time. Accordingly, all appreciation after December 31, 2026 avoids tax.
Regulations on Qualified Opportunity Funds were recently issued, and we are studying them. Let us know if we can assist if you are considering investing in this interesting new investment vehicle.
Many times we shy away from doing the hard things that we need to do to improve. For example, in golf everyone is trying to get more distance. Many try to get there by getting a super light driver or buy the latest get long quick training aid. In reality, you get longer by training the golf muscles hitting golf balls. One of the best drills for both distance and quality of the strike is one arm golf shots. You simply can’t consistently make good contact if you don’t have your arm in sync with the torso. If you can sync your torso and arm swing you will hit better shots.
On August 8, 2018 the Treasury issued proposed regulations under Code Section 199A, a provision that was part of the 2017 tax act that provides a 20% deduction on “qualified business income.” Code Section 199A is a very complex provision, but every business owner needs to be advised as to whether it applies to the business owner and, if so, whether the business owner should structure his business to claim it or whether he or she should structure the business as a C corporation to take advantage of the lowered corporate tax rate of 21%.
Generally, for taxpayers with taxable income under the threshold amounts of $157,500 single and $315,000 married filing joint, organizing as a sole proprietor or pass-through entity will produce more tax savings than operating as a C corporation. This is only a generality, however. A taxpayer needs to sit down with a tax professional and do projections on business income and taxes as a C or as a sole proprietor or pass-through to determine the best course, and it should be noted that differences exist between types of pass-through entities and between pass-through entities and sole proprietors.
These proposed regulations are not law, but can be relied on by the taxpayer. An analysis of the proposed regulations is well beyond the scope of this blog. Some of the questions that arose under Code Section 199A have been addressed, however, such as (i) reclassifying employees as independent contractors so that their income is eligible for qualified business income treatment (doesn’t work), (ii) narrowly defining the catch-all for special services, trades or businesses where the reputation of the employees or owners is a “principal asset” to product endorsements, licensing revenue from use of individual’s image, likeness or trademark, and appearance fees and (iii) a business aggregation rule, allowing taxpayer’s to aggregate related businesses.
Code Section 199A has made choice of entity a complex decision. Let me know if I can help you with that analysis.
About Grady Dickens
I created this blog to comment on items of current interest regarding trusts, estate planning, charitable planning and tax law, and share my knowledge and over thirty years of experience as an attorney practicing in Dallas, Texas.