Once upon a time, a large fiscal cliff was

Transcription

1 September October 2012 Anti-Deferral and Anti-Tax Avoi dance By Peter A. Glicklich and Abraham Leitner Tax Planning to Mitigate the Fiscal Cliff Including Retrospective Elections INTERNATIONAL TAX JOURNAL Peter A. Glicklich is a Partner in the New York office of Davies Ward Phillips & Vineberg LLP. Abraham Leitner is a Partner in the New York office of Davies Ward Phillips & Vineberg LLP. Once upon a time, a large fiscal cliff was constructed by clever Congresspersons in Washington D.C. It was viewed as a means to an end during a budget clash and a virtually certain hammer to get the parties to the table to work out a more reasonable compromise on taxing and spending budgets starting on January 1, On that date, unless the law is changed, automatic budget cuts come into effect and the Bush-era tax cuts come to an abrupt end, with the following impacts: Tax rates on the ordinary investment income of individuals, trusts and estates (collectively Individuals ) will increase from a maximum of 35 percent to 43.4 percent. 1 Tax rates on Individual long-term capital gain will increase from 15 percent to 23.8 percent. Tax rates on Individual qualified dividends from domestic and certain foreign corporations will increase from 15 percent to 43.4 percent. Gift and estate tax rates will rise from 35 percent to 50 percent, and the lifetime exclusion will drop from $5 million to a measly $1 million. It is widely accepted that the abrupt impact of this combination of spending cuts and tax increases will have a dramatic effect on the U.S. economy and could well tip the United States into a recession (as recently predicted by the Congressional Budget Office). Yet, the end of the year is approaching and many in Washington are distracted by upcoming elections, and it is far from clear that the fiscal cliff can be avoided. 5

2 Anti-Deferral and Anti-Tax Avoidance If it were certain that the Bush-era tax cuts were going to expire without being extended, then it would be an easy decision for taxpayers to accelerate income that would otherwise be earned next year (or even in later years) to capture the significantly lower rates in effect this year. Given the uncertainty of that outcome, however, taxpayers may be reluctant to accelerate their tax liability. Ideally, taxpayers should seek techniques that will enable them to defer the decision on whether to accelerate gain into 2012 until the uncertainty of whether the Bush-era tax cuts will be extended is resolved. That is, the ideal transaction is one which permits a taxpayer to elect in 2013 either to have retroactively recognized income in 2012 (if the rates increase next year) or to recognize the income in 2013 (if they don t). This column considers methods and transactions useful in potentially accelerating income or gain into 2012 or deferring deductions into later years for federal income tax purposes, since of course the deferral of a deduction will result in a similar acceleration of taxable income. Some of those techniques require transactions or structures being put into place by December 31, 2012, and some allow decisions as to whether to trigger gain in 2012 to be made in 2013 or even beyond. This column may thus be useful for taxpayers and their advisors, because Congress may not act until early 2013 to defer or extend arrival of the fiscal cliff; or may act to defer the cliff only for a subset of taxpayers (such as those with lower incomes). 2 Mitigation of the Fiscal Cliff with a Host of Techniques Most of the methods described below are no secret they will be familiar to most of us though some of the mechanics may be less well known. Some transactions will occur in the ordinary course of business before December 31, 2012; other transactions will be accelerated to close by December 31, 2012; still other transactions will be structured in order to allow elections to be filed (up to 75 days after December 31, 2012) to cause transactions to be deemed to occur on or before December 31, Ideally, taxpayers should seek techniques that will enable them to defer the decision on whether to accelerate gain into 2012 until the uncertainty of whether the Bush-era tax cuts will be extended is resolved. Some techniques commonly used to accelerate income or defer deductions will require action to be taken in A second set of techniques requires a transaction to be closed in 2012, with a later ( retrospective ) election to treat the transaction as triggering gain-recognition in A third set of techniques may not require a transaction or documentation until sometime in A final set of techniques requires only that an election be included in a return for 2012, which would be filed some time in 2013 (with or without extensions). It also may go without saying but we ll say it anyway: Accelerating income or gain (and deferring deductions or triggering of losses) is not usually considered a tax-reduction technique, but when rates are scheduled to increase, sometimes dramatically, it s time to put income acceleration in that category. In other words, these days, like many things, the normal tax-orthodoxy seems to be resting on its head. In the case of ordinary investment income and long-term capital gains, accelerating the tax into 2012 results in reducing the federal tax rate by 8.4 to 8.8 percentage points, which may well justify the acceleration. In the case of qualifying dividends, the case for acceleration is even more compelling, with a potential reduction of 28.4 percentage points. It should also go without saying that this column is not meant to provide specific advice but rather to encourage taxpayers to consult with their advisors about whether and how to take advantage of any of the ideas set forth below. Acceleration of Income/ Deferral of Deduction or Loss with Action in 2012 Consider the following: Pledge or Disposition of an Installment Obligation from a Prior Transaction. See Code Sec. 453B, providing that the gain from the original sale that was deferred under the installment method is triggered in full upon a pledge or disposition of the installment obligation. Modification of an install CCH. All Rights Reserved

3 September October 2012 ment obligation may also accelerate remaining gain, but the rules for modification require more substantial changes to trigger a deemed disposition than modification of other debt. 3 In addition, modification would generally require participation of the issuer of the obligation. Sale and Repurchase Transactions. Taxpayers can actually sell and repurchase select positions in order to fine tune the amount of gain that is triggered (only losses are subject to suspension under the wash-sale rules of Code Sec. 1091). Unfortunately, Congress has not enacted a broad rule to permit a mark-to-market election for some publicly traded positions with built-in gains (and whose price could be readily determined) without the need to engage in actual sale and repurchase transactions, but a couple of exceptions are noted below. Taxpayers might have done better, at lower cost, with a selective election if it were available, if for no other reason than they could at least wait to decide until filing their application for extension of their 2012 income tax return. Pledge of PFIC Stock. Code Sec. 1298(b)(6) provides that if a taxpayer uses any stock in a passive foreign investment company as security for a loan, the taxpayer is treated as having disposed of the stock. Code Sec. 83(b) Election. Upon a service provider s receipt of restricted stock or other property, such as in an employment setting, the service provider can make the Code Sec. 83(b) election to include the property in income. However, this election must be made within 30 days of receipt of the restricted stock or other property. Issuer of Distressed Debt. An issuer of debt can acquire the debt at a discount, or have a related party do so, triggering cancellation of indebtedness income under Code Sec. 108(e)(4). Of course, it would be better to defer triggering the COD income if the taxpayer expects to be able to exclude it in the future on the grounds that the taxpayer may become insolvent. Using Wash Sale As a Weapon. Loss on the sale of stock or securities might be suspended where the sale occurs within 30 days before or after the purchase of substantially identical stock or securities, increasing the taxpayer s net capital gain in For example, if the taxpayer sells shares at a loss during the month of December, 2012, the taxpayer can defer the loss to 2013 by purchasing identical shares in January within 30 days of the prior sale, and then immediately reselling the newly purchased shares to avoid the risk of significant further price depreciation. Transaction in 2012 with Retrospective Election Possibilities Consider the following: Installment Sales. Code Sec. 453 provides the most straightforward way of triggering gain in 2012 through merely filing an election out of installment method reporting 4 (with a properly extended tax return for 2012) as late as October 15, 2013 in a sale transaction that closes at some time in To avoid late payment penalties of up to one percent per month, 90 percent of the tax that may ultimately be due must be paid with the extension request. 5 Certain gain does not qualify for installment sale reporting, however, including gain from the sale of publicly traded property, gains of a dealer or from a sale of inventory property, issuance of notes to shareholders where the gain is reported under Code Sec. 301(c)(3), 6 and recapture income. Other transactions may be treated as resulting in an installment sale, such as a deferred like-kind exchange where proceeds of sale are deposited with a qualified intermediary and the exchange ultimately is not consummated in the next year either because the timely replacement property acquisition fails or there is a failure to identify qualified replacement property in a timely fashion. In such a case, the taxpayer can elect under Code Sec. 453(d) to report the gain in the year of the sale. Use of Check-the-Box Structures and Elections Since a check-the-box election to treat an eligible entity can be made effective up to 75 days after the effective date, it should be possible to decide as late as March 16, 2013, whether to file such an election to trigger gain in 2012 in an appropriate case. 7 There is a limit on entities that are eligible to check the box; this practically will limit common transactions to those involving partnerships or LLCs, or a foreign entity that is not on the per-se list of corporations. 8 To INTERNATIONAL TAX JOURNAL 7

4 Anti-Deferral and Anti-Tax Avoidance provide for maximum flexibility it may be necessary to restructure existing entities (e.g., as LLCs) before December 31, Note that an initial election can be made for a newly created eligible entity without triggering the rule that normally limits a second limit the check-the-box elections to once every 60 months 9 ; and reliance can be placed on the default rule for domestic eligible entities (treating them as passthroughs absent an affirmative election to treat them as corporations). Our attempt here is not to cover the universe of opportunities to use check the box structures in retrospectively electing to create a deemed exchange, but the following is illustrative: Incorporation with Boot. Where a wholly owned LLC has issued a note or other obligation prior to December 31, 2012, the LLC can elect to be treated as a corporation, resulting in a deemed contribution of the LLC s assets by the owner of the LLC in exchange for stock and debt of a newly formed corporation. The note would be treated as taxable boot in a transaction that otherwise would qualify for nonrecognition of gain under Code Sec Code Sec. 357(c) can also be used as a sword, taking into account its requirement that gain be recognized to the extent that third-party debt exceeds the aggregate basis of assets transferred to a controlled corporation under Code Sec Incorporation of a REIT with Boot. Where the property in question is real estate, the election to retroactively trigger gain on the contribution in exchange for stock and boot can be delayed for much longer. A REIT election causes a deemed election, effective retrospectively during the same period, to treat an entity that otherwise would not be a C corporation as a C corporation as well. 10 The REIT election is made by filing a return for the calendar year, which return can be extended. Thus, for property contributed to an LLC at the end of 2012, the decision of whether to accelerate the gain to 2012 could be deferred until October 15, The shares of a REIT must be held by at least 100 shareholders for most of the second tax year, and the REIT cannot be closely held during the second half of its tax year. However, the suggested strategy would be effective even if the REIT election were to terminate on January 1, 2013 (at the beginning of its second year), at which point consideration might be given to liquidating the REIT (perhaps through a check-the-box election to treat it as a partnership) or making a subchapter S election. Incorporation of an Installment Obligation. An installment obligation can be contributed to a wholly owned LLC at the end of 2012 and then an election can be made in 2013 to treat the LLC as a corporation. The election would result in a deemed disposition of the installment obligation, which would be taxable under Code Sec. 453B. Liquidation of an S Corporation. An S corporation that is formed as an LLC under local law can be liquidated by a retrospective check the box election filed within the first 75 days of 2013, which can be made effective on or before January 1, (A check-the-box election would also be effective to liquidate a C corporation, but in that case, any corporate-level gain would not benefit from the acceleration of tax into 2012, since corporate tax rates are not scheduled to increase.) Liquidation of a Foreign Corporation. As noted above, the largest increase resulting from the expiration of the Bush tax cuts would be in the case of qualifying dividends, including from a qualifying foreign corporation. Thus, it would be especially attractive to be able to repatriate any accumulated earnings and profits of a foreign corporation that is a qualifying foreign corporation under Code Sec. 1(h)(11) before the end of One simple way to do this would be to liquidate the corporation and trigger a deemed dividend under Reg (b) Where such a liquidation can be accomplished through the filing of a check-the-box election for the corporation, it would be possible to defer the decision on whether to trigger the liquidation in 2012 until Transaction or Documentation in 2013 Consider the following: Amendment to a Partnership Agreement to accelerate income or defer losses to Individual partners. Such amendments can be made by April 15, 2013, effective for However, Rev. Rul asserts that the determination of whether an allocation added to the partnership agreement has substantial economic effect under Code Sec. 704(b) must be made by testing the CCH. All Rights Reserved

5 September October 2012 effect of the allocation as of the date it is added to the agreement rather than as of the date the allocation is effective. 14 Using Wash Sale As a Weapon. As noted above, loss on the sale of stock or securities might be suspended where the sale occurs within 30 days before or after the purchase of substantially identical stock or securities. Thus, a repurchase of shares early in 2013 can trigger a deferral of a loss from a sale of substantially identical shares completed in Triggering GRAs. A taxpayer that disposed of stock in a transaction completed prior to 2013 and that entered into a gain recognition agreement under Reg can trigger the gain in 2013 or later and (absent an election made in the GRA) would be taxed at the rates in effect for the year of the original transaction. Mere Filing of an Election in 2013 The elections noted below typically assume a transaction occurred in 2012 in the ordinary course of business without the intention of accelerating any event into 2012: Mark-to-Market Elections. Taxpayers do have an opportunity to make mark-to-market elections for a small group of assets, and they should consider whether to do so for Those assets include publicly traded shares in foreign corporations that are passive foreign investment companies (PFICs). Unfortunately, the gain is treated as ordinary income (and an interest charge applies if the position has been held since before 2012). Similar purging elections are available for a small class of interests in other, nontraded PFICs, with a similar resulting tax effect. 15 A broader election is available for publicly traded positions held by commodities and securities traders under Code Sec. 475(f). That election, however, has to be made during the year for which it is sought to be effective. 16 Avoiding Accelerated Depreciation. Taxpayers can avoid electing 100-percent Code Sec. 168(k) bonus depreciation in 2012, for example. Of course, this may result in more than one year s deferral, so taxpayers should tread carefully before deciding to forgo such deductions. Electing to Capitalize Certain Expenses. Many expenses can be amortized at the election of the taxpayer or capitalized, e.g., Code Sec. 709 organizational expenses. Again, these elections generally affect multiple years, so in most cases it will make more sense to make the amortization election. Retirement Contributions. First quarter retirement plan contributions made in 2013 might be taken as a deduction for 2013 instead of However, this may deny an employee one year s worth of pension contributions if the employee would otherwise have made contributions for both years. Change in Accounting Method. Although Reg (e)(3)(i) ordinarily requires an application for permission to change a taxpayer s accounting method to be filed during the affected year, Rev. Proc permits a filing to be made with the return for the affected year in the case of many elections listed in an appendix to that Revenue Procedure The new rates listed in this and the next two bullet points include a new 3.8-percent tax on investment income which was added as a part of the healthcare reform legislation enacted in As tempting as it might be, this article does not consider gift and estate planning devices, but many of our trust and estates colleagues were quite busy during 2012 doing transfers to capture the $5 million exclusion. 3 Compare the rules of Reg with the authorities under Code Sec. 453B. Note that the Preamble to T.D states that the rules of Reg do not govern for purposes of determining whether there has been a disposition of an installment note under Code Sec. 453B. ENDNOTES 4 See Code Sec. 453(d). 5 Regardless of whether the taxpayer pays the tax due with the extension, the taxpayer is required to estimate the amount of tax that will be due in order for the extension to be valid. See Instructions for Form See R. Cox, 78 TC 1021, Dec. 39,103 (1982). 7 Reg (c)(1)(iii). 8 See Reg Reg (c)(iv). 10 Reg (c)(v)(B). 11 The deemed liquidation resulting from a check-the-box election is treated as occurring as of the close of the day before the effective date of the election. Thus, an election effective on January 1, 2013, would trigger a deemed liquidation on December 31, In the case of a 10-percent voting U.S. shareholder of a controlled foreign corporation, the deemed dividend would be automatic. Other shareholders can elect dividend treatment or the default capital gain treatment. Notice , CB 724, provides that deemed dividends under Reg (b) (2)(e)(2) are treated as dividends for purposes of Code Sec. 1(h)(11). 13 See Code Sec. 761(c) CB Purging elections are available in three situations. Code Sec. 1291(d)(2) and Reg provide for a purging election for a PFIC that becomes a QEF. Code Sec. 1298(b)(1) provides for similar purging elections for a shareholder of a PFIC that ceases to be a PFIC, either because it no INTERNATIONAL TAX JOURNAL 9

6 Anti-Deferral and Anti-Tax Avoidance longer meets the income and asset tests or because the PFIC becomes a CFC with respect to which the shareholder is a U.S. shareholder under Code Sec. 951(b). See Regs and All three elections permit the shareholder to elect ENDNOTES deemed dividend treatment in lieu of markto-market treatment if the PFIC is also a CFC (regardless of whether the shareholder is a Code Sec. 951(b) U.S. shareholder). 16 Notice 99-17, CB 503 requires that the Code Sec. 475(f) election be filed by the due date of the return for the year prior to the effective year of the election. 17 Rev. Proc , IRB , 330, Section 6.02(2). This article is reprinted with the publisher s permission from the INTERNATIONAL TAX JOURNAL, a bimonthly journal published by CCH, a Wolters Kluwer business. Copying or distribution without the publisher s permission is prohibited. To subscribe to the Journal of INTERNATIONAL TAX JOURNAL or other CCH Journals please call or visit All views expressed in the articles and columns are those of the author and not necessarily those of CCH CCH. All Rights Reserved