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.
Golf break: A more sophisticated way to work the ball. I give credit to instructor John Erickson for teaching me this.
The legal role of the probate lawyer is to admit the decedent’s will to probate, advise the newly appointed executor on their responsibilities and duties, help the executor inventory all of the assets of the decedent’s estate, settle debts and distribute the assets to the beneficiaries named in the will. Of course, numerous legal issues may arise, which complicate this basis process, but that is the essential role of the probate lawyer in the conventional sense.
But there really is more. In many cases, particularly an unexpected death, the probate lawyer must deal with a client who is emotionally devastated. The client may be depressed, panicked or angry or some combination of all of the above, and the lawyer must understand this and know how to respond. The probate process is necessary, but the client may not want to deal with it. The lawyer must be compassionate, responsive and diligent. For example, the client may be more comfortable meeting at home rather than the office. Things have to be done, but how they are done can make all the difference.
Many times I have the family of the second spouse contact me regarding probate of his or her estate. As I discuss the matter I learn that the first spouse died years earlier, and, since everything passed to the second spouse, no probate was done for the first spouse.
While this isn’t an insurmountable problem, it does complicate the probate process. If the first spouse died more than four years ago, the first spouse’s will cannot be probated. An affidavit of heirship can be filed in the real property records, but it must be on file five years to be determinative of title. In cases where five years have not passed, an heirship proceeding must be commenced for the first spouse. This increases the cost of probate considerably.
Accordingly, probate the first spouse’s will. It may be that all you need to do is a muniment of title to pass title to the second spouse, and no administration is necessary. Regardless, spending the time and money at the death of the first spouse to get it right will save considerable time and money later at the second spouse’s death.
It is golf season again, and I am getting out to the range a bit with my “old stuff.” I know…why are you hitting that? The new clubs are so much easier to hit. Sure I enjoy playing the new stuff, but I always go back to the old stuff. The new gear seems to minimize the “m” in E=mc2. The old stuff was heavier and put the weight right at the sweetspot. That is where the saying “hitting it between the screws” came from. The old stuff trained you to be precise, and rewarded you for it. The new stuff enlarges the effective sweetspot, and hollows out the club. It allows for okay, and reduces the reward for precision.
So go up into your dad’s garage and pull out his old powerbilt and enjoy! Lots can be learned from the past.
One of the changes made by the new tax act was to increase the standard deduction to $12,000 or $24,000 for a married couple filing jointly. The upshot of that will be that many people will claim the standard deduction rather than itemize. If they make any charitable contributions but total itemized deductions are still less than the standard deductions, those deductions will no longer be deductible.
There is a way to still achieve the charitable deduction, however, if the taxpayer can bunch his or her charitable contributions into a single year. For example, if the taxpayer makes charitable contributions of $6,000 per year and has the financial ability to make a contribution of $24,000 in one year, the taxpayer’s contribution of $24,000 will exceed the standard deduction of $12,000 and it will benefit the taxpayer to itemize.
If the charity or charities would benefit more by receiving the $6,000 per year rather than $24,000 in one year, the taxpayer can establish a donor advised fund. The donor advised fund is a mutual fund in which you make tax deductible charitable contributions to the fund and establish an account. The contributed funds remain in the account until the taxpayer decides to direct them to charity. So in this case the taxpayer would contribute $24,000 to the fund in year one, and could direct the fund to distribute $6,000 per year to his or her preferred charity or charities.
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.