LLCS AND S CORPORATIONS. An Update on Pending Legislation. William C. Staley ATTORNEY (818)

Transcription

1 LLCS AND S CORPORATIONS An Update n Pending Legislatin William C. Staley ATTORNEY (818) Hllywd/Beverly Hills Chapter CALIFORNIA SOCIETY OF CPAS West Ls Angeles June 18, dc :1156 William C. Staley

2 LLCS AND S CORPORATIONS An Update n Pending Legislatin TABLE OF CONTENTS 1. American Jbs and Clsing Tax Lphles Act f 2010 (H.R. 4213) Small Business Tax Bill (H.R. 5486) Disqualified S Crpratins (H.R. 4213) Carried Interests (H.R. 4213) Sectin 83 and Partnership Interests (whether r nt carried H.R. 4213) Synthetic ( disqualified ) interests in entities (H.R. 4213) Thinking abut ignring these new rules? Cpyright 2010 All rights reserved William C. Staley, Attrney 6303 Owensmuth Avenue, 10 th Flr Wdland Hills, CA (818) This utline shuld be viewed nly as a summary f the law and nt as a substitute fr legal r tax cnsultatin in a particular case. Yur cmments wuld be appreciated and are invited dc : William C. Staley

3 LLCS AND S CORPORATIONS An Update n Pending Legislatin William C. Staley Attrney (818) June 18, 2010 Nte: This utline discusses prpsed legislatin that is nt law tday and may never becme law. These bills culd change substantially if they are enacted, and culd change substantially during the legislative prcess even if they are nt enacted. Unlike mst enacted laws, the legislative histry f these bills is still being made, and there is n definitive interpretatin f them by the IRS r any agency r curt. Be extra careful abut relying n the discussin in this utline fr any purpse. 1. American Jbs and Clsing Tax Lphles Act f 2010 (H.R. 4213) 1.1. Status: Passed in Huse. In Senate Finance Cmmittee. Cntrversial. Prspects uncertain. On Senate flr. Amendment prpsed by Senatr Baucus (Chair f the Senate Finance Cmmittee) failed n Senatr Baucus prpsed a substitute amendment n Failed a clture vte by fur vtes n Senatr Baucus cnfident that he can get the vtes needed t pass sme versin f the bill dc :1156 William C. Staley

4 update: An amended versin failed anther clture vte n The bill appears t be dead. Hwever, the revenue raising prvisins might be inserted in ther bills Tax cuts and extenders: Extends fr ne year (there are many thers): R&D credit 15-year recvery perid fr leasehld imprvements 5-year recvery perid fr farm equipment Allws S crp sharehlder t take entire share f crprate-level charitable cntributin, even if the sharehlder des nt have sufficient basis in his shares t absrb the deductin. Allws film and televisin prducers t expense the first $15 millin f prductin csts incurred in the United States ($20 millin if the csts are incurred in ecnmically depressed areas) Tax increases: Carried interest. The bill wuld recharacterize certain capital gain f investment fund managers (their carried interest ) in an investment fund as rdinary incme. 1 T the extent that carried interest reflects a return n invested capital, the bill wuld cntinue t tax carried interest at capital gain tax rates. 1 Sectins 411 and 412 f the Bill amending IRC Sectins 83(b) and (c) and adding a new Sectin IRC dc : William C. Staley

5 T the extent that carried interest des nt reflect a return n invested capital, the bill wuld treat 75% f that carried interest as rdinary incme (50% fr taxable years beginning befre January 1, 2013). Effective fr taxable years ending n r after Expected t raise $18.7 billin ver 10 years. 2 Scial Security Taxes fr Prfessinal Firms 3 Fr a disqualified S crpratin, all f the flwthrugh incme under IRC Sectin 1366 is treated as incme frm self-emplyment -- t certain sharehlders. Whse flw-thrugh incme? Each sharehlder wh prvides substantial services (nt necessarily prfessinal) with respect t the prfessinal services business. AND Each f his family members wh d nt prvide substantial services t the prfessinal services business. Dividends cntinue t be excluded frm selfemplyment incme. 4 Applies t An S crpratin that is engaged in a prfessinal service business AND the business is 2 JCT estimate. Daily Tax Reprt (BNA) , 98 DTR G-8. 3 Sectin 413 f the Bill amending IRC Sectin 1402 and Sectin 211 f the Scial Security Act. 4 I.R.C. 1402(a)(2) dc : William C. Staley

6 principally based n the reputatin and skill f 3 r fewer individuals, r An S crpratin that is a partner in a prfessinal service business. Remves the self-emplyment tax exclusin fr limited partners if they prvide substantial services with respect t a prfessinal services business in which the limited partnership engages. (Nt limited t limited partners that are S crpratins.) Definitin f prfessinal service business brader that fr cash methd business (listed in IRC Sectin 448) and includes lbbying, athletics, investment advice r management and brkerage services. 5 Als includes services in the fields f health, law, engineering, architecture accunting, actuarial science, perfrming arts and cnsulting, all allwed the cash methd. Nt as brad as persnal service crpratin, thugh, s dn t cnfuse the tw. 6 Expected t raise $11.2 billin ver 10 years. 7 Effective date: Tax years beginning after It s als brader than the definitin f a prfessinal service crpratin in Treas. Reg (m)-1(c) ( certified r ther public accuntants, actuaries, architects, attrneys, chirpdists, chirpractrs, medical dctrs, dentists, prfessinal engineers, ptmetrists, stepaths, pdiatrists, psychlgists, and veterinarians ). 6 A persnal service crpratin has as its principal activity the perfrmance f services and substantially all f thse services are perfrmed by emplyee-wners. I.R.C. 269A(b)(1). The IRS can reallcate incme between an PSC and its emplyeewner just as it can between related businesses under IRC Sectin 482. I.R.C. 269A(a). 7 JCT estimate. Daily Tax Reprt (BNA) , 98 DTR G dc : William C. Staley

7 1.4. Other prvisins Extends an SBA lan prgram 2. Small Business Tax Bill (H.R. 5486) 2.1. Status: Intrduced Prpsed t be tacked n t the Small Business Lending Bill (H.R. 5297) during the Huse flr debate. Passed by Huse Tax cuts (temprary): 100% exclusin fr capital gains n the sale f small business stck Must be held fr 5 years Acquired between and First-year deductin limit fr start-up expenses wuld be increased frm $5,000 t $20,000 fr 2010 and Tax shelter and listed transactin penalties wuld be made prprtinate t the tax benefit received Tax increases (permanent): GRATS wuld be required t last fr at least 10 years. Limits cellulse bi-fuel credit fr paper manufacturers dc : William C. Staley

8 3. Disqualified S Crpratins (H.R. 4213) 3.1. Has nthing t d with eligibility t be an S crpratin r the S crpratin electin The S crp is a partner in partnership, AND: The partnership is engaged in a prfessinal service business, AND Substantially all f the S crp s activities are perfrmed in cnnectin with the partnership. Example: An incrprated partner in a law r accunting firm OR The S crp is itself engaged in a prfessinal service business AND AS PASSED BY THE HOUSE: The principal asset f the business is the reputatin and skill f three r fewer emplyees. Nte: The emplyees need nt be sharehlders. It is nt The reputatin and skill f three r fewer sharehlders. Why nt fur r mre emplyees? Presumably because it becmes mre likely that capital and nt services generate mre f the prfit as the size increases? SENATOR BAUCUS (CHAIRMAN OF SENATE FINANCE COM- MITTEE) PROPOSAL OF : If 80% r mre f the grss incme f such business is attributable t service f 3 r fewer sharehlders f such crpratin. 8 8 day. S. Amendment 4369, as ppsed t S. Amendment 4301 that failed earlier in the dc : William C. Staley

9 Changes the task frm identifying the principal asset t tracing the surce f the grss incme. Changes the fcus frm emplyees t sharehlders. Mre administrable? Hw des an accuntant knw what grss incme is attributable t the services f a particular sharehlder? Easy if hurly rates are used? If nt? Even fr the billable hur, is the grss incme attributable t the rainmaker wh plays glf with the client r the wrker bee wh bills the hurs? Is this nt what every prfessinal firm struggles with endlessly fr cmpensatin purpses? 4. Carried Interests (H.R. 4213) 4.1. Wuld add a new IRC Sectin Hw des it wrk? It turns ff the rule f IRC Sectin 702 that makes the flwthrugh incme t a partner retain its character. All f the flw-thrugh incme r lss is treated as rdinary incme r lss. Even if the partnership invests in the stck f cmpanies, enhances the businesses f the cmpanies and sells the stck recgnizing lng-term capital gain. It des nt allw lsses frm ne partnership t be used t ffset incme frm ther partnerships r activities. (But it appears t allw an infinite carryfrward f lss realized after enactment.) Lsses d nt reduce the basis f the partnership interest until the lss is used t ffset partnership incme. 9 9 As passed by the Huse, the bill includes this rule: In the case f any dispsitin f an investment services partnership interest, the amunt f net lss which therwise wuld have (but fr [the rule abut basis]) applied t reduce the basis f such interest shall be disregarded fr purpses f this sectin [710] fr all succeeding partnership taxable years. I dn t understand it, but Senatr Baucus prpsed t eliminate it dc : William C. Staley

10 Flw-thrugh dividend incme is taxes as rdinary incme, nt at the lng-term capital gain rate. The rdinary incme is treated as self-emplyment incme fr purpses f Sectin 1402(a). Gain n the dispsitin f the partnership interest is subject t special rules: 10 It s all rdinary incme, and It cannt be tax-free, n matter what. It is always taxed when it is realized. Realizatin = recgnitin. Lss n the dispsitin f the partnership interest can be capital lss. It is rdinary lss t the extent that the flw-thrugh incme after enactment was nt ffset by flwthrugh lsses. If the partnership distributes appreciated prperty (like stck) t the partner, the partner recgnizes the gain and gets a fair market value basis in the prperty. The partner can use any basis increase that resulted frm a Sectin 754 electin in measuring the gain t be recgnized. If the distributin was a deemed distributin and cntributin back as a result f a Sectin 708(b) technical terminatin f the partnership, the gain is nt recgnized. (..cntinued) 10 Mdified by Senatr Baucus s 6-16 amendment dc : William C. Staley

11 An investment services partnership interest is treated as a ht asset like inventry r unrealized receivables. S if a partnership interest is sld and sme f the gain is attributable t an investment services partnership interest held by the partnership, that gain will nt be capital gain Applies t an investment services partnership interest The fcus is n the rle f the partner, nt n the activities f the partnership. This rule is nt limited t investment partnerships, fr example. Fcus is n the expectatin at the time the interest was acquired, nt what the partner actually did. (Administrable?) At that time, was it expected that the partner wuld prvide specific services with respect t [certain] assets held (directly r indirectly) by the partnership. S the issue is the extent t which the partner was expected t prvide specific services invlving certain partnership assets. What quantity f services is required? A substantial quantity. Over what perid f time? Nt stated. A year? N. As lng as the partner held the interest? Maybe. As lng as the partnership held the asset? Maybe. As lng as the partnership held that type f asset? Maybe. What partnership assets are we talking abut? Securities, Real estate held fr rental r investment, Interests in partnerships, Cmmdities, r Optins r derivative cntracts with respect t any f thse dc : William C. Staley

12 What services by the partner invlving the partnership assets? Advising as t the advisability f investing in, purchasing, r selling any specified asset. Managing, acquiring, r dispsing f any specified asset. Arranging financing with respect t acquiring specified assets. Any activity in supprt f thse services (which captures the ffice staff f the private equity cmpany r venture capital firm, if they get partnership interests). Wuld the prmter f a typical real estate prject acquire an investment services partnership interest? Yes. It s abut acquiring, financing and dispsing f real estate held fr rental r investment and the prmter prvides all r mst f the services. Wuld the prmter f a typical restaurant prject acquire an investment services partnership interest? N. The prmter wuld nt be managing real estate r financial assets The qualified capital interest is the part f the partner s partnership interest that has already been taxed. The dracnian rules (fr bth flw-thught items and gain n dispsitin f the interest) d nt apply t that part f the partnership interest. It s like a mini capital accunt (r it culd be the entire capital accunt). Cmpnents f the qualified capital interest : Mney the partner cntributed t the partnership, But nt if the mney was laned t the partner by anther investment services partner dc : William C. Staley

13 Same if the ther investment services partner guaranteed a lan t the acquiring partner r if a relative r affiliate f the ther investment services partner made the lan r guarantee. The fair market value f prperty that the partner cntributed t the partnership, Treasury is directed t prvide fr prper adjustments if the partner s basis in the prperty befre the cntributin is less than its value. Amunts included by the partner in incme under Sectin 83 when the partner acquired the interest, and The excess f the flw-thrugh incme and gain n the qualified capital interest ver the flw-thrugh deductin and lst n the qualified capital interest. Distributins and lsses with respect the qualified capital interest reduce that interest. T avid the dracnian rules, the allcatins n the qualified capital interest must be made in the same way as allcatins t ther partners with nn-trivial interests wh are nt related t the partner and are nt investment services partners. It s OK if the ther partners get a higher preferred return than the investment service partner with the qualified capital interest. If a partnership interest that is nt an investment services partnership interest becmes such an interest, the value f the partnership interest f the investment services partner immediately befre the change becmes a qualified capital interest. Fr tiered partnerships, the flw-thrugh n a qualified dc : William C. Staley

14 capital interest frm a lwer-tier partnership retains its character as flw-thrugh frm a qualified capital interest Any ther exceptins? The dracnian treatment f flw-thrugh incme and lss des nt apply if the partnership is publicly traded and neither the partner nr any f his family members ever prvides any f thse services that he expected t prvide that made the partnership interest an investment services partnership interest in the first place. If the partnership is nt publicly traded and the partner never prvides any f thse services, the partner is stuck with the dracnian rules. The partner can cntribute the investment services partnership interest t anther partnership and have the nnrecgnitin rule f Sectin 721 apply if the partner agrees that (presumably all) f the new partnership interest will be an investment services partnership interest Effective date (if enacted as passed by the Huse) Generally, t tax years ending after Fiscal years including OK t apply t entire year r t apply nly fr incme earned after Applies nly t dispsitins f partnership interests after Phase in (the applicable percentage ) Applies nly t 75% f the incme, lss, gain and dividend incme f an investment services partnership interest until , then it applies t 50% dc : William C. Staley

15 Baucus prpsed amendment: 50% applies nly t interests held fr mre than five years 11 Nte the implicit plitical threat: We can ratchet this up at any time. 5. Sectin 83 and Partnership Interests (whether r nt carried H.R. 4213) 5.1. A Sectin 83 amendment is prpsed fr receipt f a partnership interest by a persn r entity wh prvides services t r fr the benefit f the partnership A methd fr valuing a partnership interest is established fr Sectin 83 purpses. The valuatin date is the date n which the interest is transferred t the service prvider. Pretend: That the partnership sells all f its assets at their fair market value n the valuatin date, pays all f its debts, and distributes the remaining assets t its partners in liquidatin (presumably, accrding t the partnership r perating agreement). What wuld the service prvider receive in that distributin? That s the value f his carried interest Sectin 83 purpses. Nte: A transfer is a term f art under Sectin 83. The recipient generally must acquire all f the upside and dwnside f wnership. Acquiring the interest with a nnrecurse nte, limiting the dwnside r capping the upside can prevent (r, ften wrse, defer) a transfer f the interest t the service prvider fr Sectin 83 purpses. 11 Frm Senatr Baucus s summary f the amendment: This amendment prvides that the lwer recharacterizatin percentage als applies t the gain r lss attributable t the underlying assets held fr 5 r mre years when a partnership interest is sld as well as t gain attributable t sectin 197 intangibles f a partnership whse principal activity is prviding specific investment management services with respect t the assets f the partnership when the partnership interest has been held fr 5 r mre years dc : William C. Staley

16 5.3. A deemed Sectin 83(b) electin is made. The recipient f the interest can unmake the deemed electin if the recipient wants t defer the incme hit and risk a bigger rdinary incme hit in a later year when the interest vests. 6. Synthetic ( disqualified ) interests in entities (H.R. 4213) New rule: Incme r gain n synthetic interests in any entity will be rdinary incme if the persn perfrms investment services fr the entity and the persn hlds a synthetic interest that changes its value r payut based n the incme r gain n the managed assets, whether r nt the gain is realized. The already taxed prtin wuld be excluded frm this rule by regs that shuld tract the rules fr qualified capital interests held by investment services partners Disqualified interests are defined by what they are nt: Nt straight debt, Nt a partnership interest, Nt stck in an S crpratin. Nt stck in a taxable crpratin - a U.S. C crp r a freign crp that is taxed in the U.S. r is subject t a cmprehensive freign incme tax (nt a tax haven?), and 6.3. What are disqualified interests : Interests ther than the nt this interests, Cnvertible r cntingent debt f the entity, 12 Wuld be subsectin (e) f new IRC Sectin 710, but is nt limited t partnerships r investment services partnership interests dc : William C. Staley

17 Optins t acquire synthetic interests, and Derivative instruments entered int with such entity r any investr in such entity Effective n December 31, 2010 (if enacted as passed by the Huse). 7. Thinking abut ignring these new rules? 7.1. There s a 40% penalty fr underpayments in avidance f new Sectin 710 (by amendments t Sectin 6662 in H.R. 4213). [End f utline.] dc : William C. Staley