Let’s say in 2011, your accountant suggested it might be good to elect S Corporation treatment for your business which has been a C corporation for 5 years. You’ve got the hottest bar in town. Its worth $1 Million and you only invested $100,000 which is fully depreciated, but there are good years and bad years and you like the fact that you can deduct losses and avoid double taxation of income by using S. Fast forward to 2015. Porky comes by and wants to buy your name, assets. He’s offering $1.2 Million. You are so excited. Selling these assets would yield a gain at capital gains rates what could be better. Then you talk to your tax lawyer. He says wait. Under Section 1374 of the Internal Revenue Code there is a built in gains tax that looks back 10 years. Thus, if at the time of your S Election in 2011, your business was worth $1 Million, it must recognize that $1 Million at ordinary corporate rates. Thus, instead of the tax being $250,000 on the gain it is $565,000 give or take. A huge difference.
Suppose you own a corporation MYTABLES, Inc. that manufactures tables. Your company has an opportunity to go into the desk market, but wants to limit its exposure. So, it sets up a subsidiary, DESKO, LTD. MYTABLES, INC., owns all of the stock of DESKO. People love the desks. The Company needs capital to hire more people to make desks. The owners go on the Barracuda Tank and Cube Markan offers to give $1 Million for 18% of the Company, but wants DESKO separated from MYTABLES. So, how do you separate out DESKO from MYTABLES. Under Section 355 of the IRS Code you can do what is known as a spin-off and so long as the DESKO has a different line of business from MYTABLES (they do) and so long as the shareholders of MYTABLES still own 80% of the stock of DESKO, then you can spin off, so long as DESKO and MYTABLES continue in business. There are lots of technical rules under Section 355, but that is the gist of it.
Suppose you are a computer software consulting business with offices in Arlington, Virginia and Prince Georges County, Maryland. You have employees who move back and forth between the offices consulting with clients and making calls on clients. Both Maryland and Virginia have income taxes. How do you allocate the income for purposes of the Arlington County, Virginia Business Professional Occupational License Tax. The Supreme Court adopted a three part test to use to determine how you allocate that burden In Nielsen Company v. Arlington County last month.
First, you must allocate the tax based upon payroll percentages in each jurisdiction. Then you are permitted a deduction for income subject to income taxes in another state. It is this deduction that the Court is concerned with.
The Court went on to say:
“That is, “attributable” does not mandate or prohibit any particular
methodology to determine which receipts captured in the pool of
taxable gross receipts are subject to deduction.”
The means that your company can allocate sales receipts in any acceptable manner.
There is a safe harbor under Section 58.1-3732(B)(2) which the Court rules is to be interpreted in the following manner:
“The Tax Commissioner held that the following analysis
determines whether the Code § 58.1-3732(B)(2) deduction may be
taken by a taxpayer, and, if so, how to determine what receipts
are backed out from the pool of taxable gross receipts:
1. Ascertain whether any employees at the Virginia
definite place of business participated in interstate
transactions by, for example, shipping goods to
customers in other states, participating with
employees in other offices in transactions, etc. If
there has been no participation in interstate
transactions, then there is no deduction. If there
has been participation, then;
2. Ascertain whether any of the interstate
participation can be tied to specific receipts. If
so, then those receipts are deducted; however, if
payroll apportionment had to be used to assign
receipts to the definite place of business, then it is
very unlikely that any of those apportioned receipts
can be specifically linked to interstate
transactions. If not, or if only some of the
participation can be tied to specific receipts, then;
3. The payroll factor used for the Virginia definite
place of business would be applied to the gross
receipts assigned to definite places of business in
states in which the taxpayer filed an income tax
return. Note that payroll apportionment would
probably be needed to assign receipts to definite
places of business in other states.”
So, if for example the employees in the Virginia office don’t deal with any interstate business there is not additional deduction. If however, the Virginia employees handled Maryland sales, then you can trace the specific receipt. If that doesn’t work, then you can allocate those according to payroll percentages for the second deduction.
Remember the business can still allocate receipts according to any reasonable formula for allocating receipts, there is just no safe harbor if challenged as unreasonable.
When you gift investment or business property to someone and that person sells that property they owe tax on the gain. The basis in the property for gain purposes is what the basis was in the hands of the donor (the person making the gift). So, if the donor had a basis of $100 and the donee (recipient of the gift) sold the property for $110, there would be a $10 gain.
What is the basis for someone who receives a gift and sells it for a loss. In that circumstance the basis is the LOWER of the basis in the hands of the donor or fair market value at the time of the gift. So let’s say that Fred holds a mortgage note on Blackacre from Mona for $100,000. The mortgage is under-water and there is no way that Mona will ever be able to repay the loan. Fred gifts the note to his son, Bam. Bam immediately forecloses and the property sells for $50,000. Does Bam get a capital loss of $50,000 or a capital loss of zero. That goes to what was the market value of the note on the date of the gift. It would appear that it would no more than $50,000. However, if Bam could have gotten an appraiser or another lender to state that the fair market value of the note was an amount larger than $50,000, then Bam could perhaps take the loss equal to the appraised amount. This is found in Reg. 1015-1 of the IRS regulations.
Let’s say Sid hit it big with your new product, Spacebook and he went from a middle aged computer geek to a billionaire overnight and lives in California. His aging parents are not in great health. His basis in his dot.com stock is about $10,000. His unrealized gain on that stock is $2,999,990,000. He wants to know how to reduce taxes and liquidate some of his stock in the next ten years. Perhaps he should gift $10,000,000 worth of stock to his parents. When the last parent dies, the stock is stepped up to the date of death value. Thus, the $10,000,000 in stock would now have zero capital gains. But Sid is nervous that his parents might not hold onto the stock. So, he said can I create a trust for them. The answer is yes. There are a number of trust vehicles that will work, so long as the last living parent has when is known as a general power of appointment to appoint the assets to his or her estate or creditors. There are trusts known as intentionally defective grantor trusts in which Sid gets taxed on the income while giving his parents the use of that income. The net result to Sid is tax savings of $3,300,000. You can buy a lot of other things for $3,300,000 and he is able to give his parents an income from that stock for the rest of their lives.