GOTCHA Transactions in the Formation, Structure, and Conveyance of Business Interests

Transcription

1 GOTCHA Transactions in the Formation, Structure, and Conveyance of Business Interests By: Steven B. Gorin Thompson Coburn, LLP St. Louis, Missouri Daniel H. McCarthy The Blum Firm, P.C. Fort Worth, Texas William I. Sanderson McGuire Woods, LLP Richmond, Virginia American Bar Association Section of Real Property, Trust & Estate Law Section of Tax Law Joint Fall Meeting October 21, 2011

2 Deed and Recordation Taxes: Beware! Case of Mr. Magnate Mr. Hedgefund ( H.F ) Magnate lives in Greenwich, Connecticut, and manages a New York City based private equity fund. H.F. and his wife own a townhouse in Georgetown, Washington D.C. Because of the increasing activity in Washington, H.F. wants to transfer the townhouse to a new LLC and rent the townhouse to his fund when his team travels to Washington to negotiate with the Federal Reserve. Also, his children have found it a convenient place to party when they want to hit the scene on the Potomac, and H.F. is worried about liability. H.F. and his wife form a New York limited liability company and transfer their 100% undivided interest to the new LLC. 2

3 Deed and Recordation Taxes: Beware! In many states, the transfer of real property to an entity where there is commonality of ownership is exempt from transfer and recordation tax. Because of tightening budgets, many states (and the District of Columbia) are tightening the exemptions and any transfer may be subject to transfer and recordation tax. 3

4 Deed and Recordation Taxes: Beware! Back to Mr. Magnate Because H.F. s townhouse is located in the District of Columbia, he will owe deed transfer and recordation tax when the property is transferred from H.F. and his wife to the entity. D.C. imposes a Deed Transfer Tax (1.45%) and a Deed Transfer Tax (1.45%) a combined 2.9% on the consideration or fair market value of the property transferred. The recordation costs of transferring a townhouse valued at $1,500, to an entity will be $43, If H.F. and his wife owned the same townhouse in Old Town Alexandria, Virginia, the recordation costs of transferring the same townhouse to an entity would be less than $50. 4

5 Deed and Recordation Taxes: Beware! Before transferring property, a smart practitioner will review all the potential exemptions from deed transfer and recordation tax and promptly alert the client if no exemptions are available. But is it free from further deed and recordation tax? Once the real property is owned by the entity, future transfers will be free of deed tax. Some savvy states are catching on and may tax transfers of entity interests that otherwise escape deed taxes. Stay tuned for more. 5

6 Qualified to do Business? What s Mr. Magnate to do? Now that H.F. has transferred the real property to the new New York LLC, should the LLC qualify to do business in the District of Columbia? Some states say that a foreign entity that does nothing more than own real property in the jurisdiction need not qualify to do business in the state where the real property is located. Others require some form of registration. 6

7 Qualified to do Business? Important Considerations Access to Courts? Insurance? Banking? Fines/fees/penalties? 7

8 S Corporation with Depreciable Real Estate Death of Shareholder S corporation stock receives step up in basis at death, but not inside basis of assets. If depreciable real estate is sold by S corporation after death of a shareholder, the gain will flow through to the estate and further increase the basis in the stock. In order to offset the gain in the year of the sale, advisors may recommend liquidating the S corporation by distributing the remaining property to the shareholders. The liquidation should produce a loss because the value of the assets received should be less than the outside basis in the stock. pp

9 S Corporation with Depreciable Real Estate Code Section 1239 characterizes gain on the sale or exchange of depreciable property between related parties as ordinary income. Consider Code Section 355 split up prior to death. pp ;

10 S Corporation with C Corporation E&P After Sale Code Section 1362(d)(3) provides that S corporation election terminates when passive investment income exceeds 25% of gross receipts for 3 consecutive years and S corporation has accumulated earnings and profits. Investments in partnerships can provide solution. Rev. Rul ; Gross receipts (rather than net income) of nonpassive income from partnerships in which the S corporation is a partner can be considered in the calculation. Investing in oil and gas partnerships frequently helps generate sufficient nonpassive gross receipts. pp

11 Accredited Investor Rules: What Counts? H.F. and his new fund: Hedgefund Magnate has opened a new fund. Investors must be accredited investors under the 33 Act (The Securities Act of 1933). The following potential investors have asked H.F. to get in on the ground floor: Potential Investor: H.F. s daughter a recent graduate of Wharton and on the board of the fund. Rule: A director, executive officer, or general partner of the company selling the securities. 11

12 Accredited Investor Rules: What Counts? H.F. and his new fund: Hedgefund Magnate has opened a new fund. Investors must be accredited investors under the 33 Act (The Securities Act of 1933). The following potential investors have asked H.F. to get in on the ground floor: Potential Investor: H.F. s long time accountant. She has asked to invest through a family investment company. The accountant is the majority owner and her three children own less than 10%. The net assets of the family investment company exceed $2,500,000. Rule: A business in which all the equity owners are accredited investors. 12

13 Accredited Investor Rules: What Counts? H.F. and his new fund: Hedgefund Magnate has opened a new fund. Investors must be accredited investors under the 33 Act (The Securities Act of 1933). The following potential investors have asked H.F. to get in on the ground floor: Potential Investor: H.F. s dentist. Rule: A natural person who has individual net worth, or joint net worth with the person s spouse, that exceeds $1 million at the time of the purchase. Rule: A natural person with income exceeding $200,000 in each of the two most recent years or joint income with a spouse exceeding $300,000 for those years and a reasonable expectation of the same income level in the current year. 13

14 Accredited Investor Rules: What Counts? H.F. and his new fund: Hedgefund Magnate has opened a new fund. Investors must be accredited investors under the 33 Act (The Securities Act of 1933). The following potential investors have asked H.F. to get in on the ground floor: Potential Investor: H.F. s college roommate. He has asked to invest through a family trust established after his parent s death. The roommate and the roommate s siblings are all beneficiaries, and the trust will ultimately terminate when each beneficiary has reached age 55. The trust has $7,500,000 in marketable securities. Rule: A trust with assets in excess of $5 million, not formed to acquire the securities offered, whose purchases a sophisticated person makes. 14

15 S Corporation Ownership Transfers Allocation of Income in Year of Transfer of S Corporation Stock If transfer less than entire interest, must use pro rata method. Code Section 1377(a)(1). If transfer entire interest, default rule is pro rata method, unless election is made by the corporation and all shareholders to use special rule under Code Section 1377(a)(2) to close books as of date of transfer. Special election not available for change from grantor to non grantor trust status. Analyze potential advantage of closing of books prior to transfer of interest. pp

16 S Corporation Ownership Transfers Tax Dividend After Stock Transfer A shareholder may transfer S corporation stock and expect to receive a dividend sufficient to pay the income tax liability associated attributable to his or her ownership of the S corporation stock. Many state statutes require a dividend to be declared one to two months prior to payment of the dividend. The transferring shareholder may not be a shareholder of record as of the date of payment of the dividend. Adjust the purchase price of the stock to allow for an increase based upon the transferor s allocable share of taxable income. Distributions from an S corporation in excess of basis will result in capital gain to the extent they exceed basis. p

17 S Corporation Ownership Transfers QSST with second marriage QSST qualifications: One current beneficiary who is a US citizen. Mandatory distribution of income. Any principal distributions must be made to current beneficiary. Income interest terminates upon death of beneficiary or termination of trust. Marital Trusts satisfy the QSST requirements. pp

18 S Corporation Ownership Transfers QSST with second marriage Estate of deceased spouse who is beneficiary of a QSST will receive K 1, but trust agreement determines when distributions of income are to be made to beneficiary. Beneficiaries of estate are not likely same as remainder beneficiaries of QSST. Require trustee to reimburse estate of deceased spouse for income tax liability generated by S corporation. Rev. Rul : post mortem distribution may be made to beneficiary s estate (if allowed under state law) or to successor beneficiary. pp

19 Termination of Grantor Trust Status S Corporation Stock held by IDGT ESBT Gain on sale of S corporation stock includable in S corporation portion of ESBT income. Code Section 641(c)(2)(C)(ii). Interest on acquisition indebtedness can be used to offset S corporation income. Code Section 641(c)(2)(C)(ii). p

20 Termination of Grantor Trust Status S Corporation Stock held by IDGT QSST Gain on sale of S corporation stock allocated to non S corporation portion of trust and not directly to beneficiary. Treas. Reg. Sec (j)(8). Code and Regulations are silent as to allocation of interest on acquisition indebtedness and likely treatment is that interest is allocated to non S corporation portion of trust. pp

21 Termination of Grantor Trust Status Income Tax Effects of Deemed Sale Intervivos Termination. Relief of indebtedness may trigger gain. Termination at Death. Uncertainty as to whether death triggers sale in event note is outstanding. Impact on Partnerships. Does trust step into shoes of grantor for purposes of Codes Section 704(c), 737, and 731? 21

22 Exploding GRAT with S Corporation Stock Grantor of a GRAT is responsible for the income tax liability generated by assets held in the GRAT. A GRAT which performs extraordinarily well may create an income tax liability which the grantor may have difficulty satisfying. pp

23 Exploding GRAT with S Corporation Stock Include income tax reimbursement provision in the GRAT requiring trustee to make income tax payments to the extent income tax liability generated by S corporation stock held by GRAT exceeds annuity payments. Code Section 2036 inclusion already present with GRAT. Rev. Rul pp

24 Life Insurance Issues Split Dollar Exit Strategy Important to have one. Section 101(j) Contains exception to general rule that life insurance proceeds generally received income tax free. Applies to life insurance owned by an employer on the life of an employee. Will not apply if consent of certain individuals (directors or highlycompensated employees) is obtained prior to issuance of policy. pp

25 Section 754 Issues Mandatory Election Code Section 754 election is mandatory if, upon the death of a partner or the transfer of a partnership interest, the partnership has a built in loss in excess of $250,000. Mandatory election provisions were intended to prevent loss duplication. Code Section 267 may prevent partner disposing partnership interest to recognize loss, and transferee partner will not be able to utilize loss because of basis step down. Consider having partnership sell loss assets prior to transfer of interest and reinvest proceeds without triggering Code Section 1091 wash sale rules. pp

26 Section 754 Issues Service Partnership Code Section 736 governs treatment of payments to retiring or deceased partner. Code Section 736(a) payments are either treated as guaranteed payments (if fixed in amount) or as a distributive share of partnership income. Code Section 736(b) payments are treated as distributions by the partnership in exchange for partnership property. Payments for unrealized receivables cannot be treated as Code Section 736(b) distributions. The partnership agreement must specifically state that a payment is being made in exchange for goodwill under Code Section 736(b) or the payment will be reclassified as a Code Section 736(a) distribution, unless Code Section 754 election is in place, in which case it will be a Code Section 736(b) distribution. pp

27 Section 754 Issues Service Partnership Estate of deceased partner will receive step up in basis of partnership interest to date of death value. A Code Section 754 election will likely produce upward basis adjustment under Code Section 743(b) with a large component likely attributable to goodwill. Payment by partnership attributable goodwill will then be a Code Section 736(b) payment not deductible by the partnership. Consider not making Code Section 754 election. pp

28 Section 754 Issues Suspended Losses at Death Upon death, suspended passive losses may be deducted on final income tax return to the extent they exceed basis increase in partnership interest resulting from Code Section 469(g)(2). Any excess losses are lost and are added to basis. Same issue occurs when estate or trust terminates. Consider early funding of trust with partnership interest when administering the estate. pp

29 QTIP and Buy Sell Agreement Risk of loss of marital deduction if stock passes to a QTIP and is subject to fixed price buy sell agreement. Code Section 2056(b)(5) requires no one have power to appoint other than surviving spouse. Code Section 2056(b)(7) requires that surviving spouse be sole beneficiary. pp

30 QTIP and Buy Sell Agreement Options Separate QTIP to hold stock. Revise terms of buy sell agreement. Intervivos disposition of stock. pp

31 Self Employment Tax: The Basics Self Employment Tax: Net earnings from self employment 15.3% on the first $106,800. Medicare Tax: 2.9% Health Care and Education Reconciliation Act of 2010: Effective January 1, 2013 Increase Medicare Tax to 3.8% Investment income, including the distributive share of the operating income of a partnership, LLC or S corporation, will be subject to 3.8%. pp

32 Self Employment Tax: How Not to Get Slaughtered David E. Watson, P.C. v. United States David Watson 100% Thomas Larson 100% Jeff Bartling 100% Dale Eastman 100% DEW, P.C. TEL, P.C. JTB, P.C. DAE, P.C. S Corp S Corp S Corp S Corp 25% 25% 25% 25% Larson, Watson, Bartling & Eastman p

33 Self Employment Tax: How Not to Get Slaughtered David E. Watson, P.C. v. United States Determination of salary vs. dividends turns on remuneration for services performed. David E. Watson: Salary * $24,000 $24,000 Gross Billings $197,682 $200,380 Profit Distributions $203,651 $175,470 * The median starting salary for graduates from the Drake University accounting program, where Watson taught, was $40,000. The lowest reported offer to a graduate was $26,000. p

34 Self Employment Tax: Too Good to be True Tony L. Robucci, et al. v. Commissioner Tony L. Robucci 100% T.L. Robucci & Associates, P.C. 5% S Corp Tony L. Robucci 95% Tony L. Robucci 100% Westphere Management Corp. S Corp Robucci, LLC 34

35 Self Employment Tax: Too Good to Be True Tony L. Robucci, et al. v. Commissioner Formalities matter in the structuring of professional corporations and practices. Accuracy related penalties may apply: 20% of the portion of any underpayment attributable to negligence or intentional disregard of the rules or regulations or any substantial understatement (IRC Section 6662). 35

36 Gift of Voting Stock in Trust Code Section 2036(b) risk if gift voting stock to trust. Rev. Rul Recapitalize with voting and non voting stock and gift non voting stock. Rev. Rul Consider limiting the non voting stock to no more than 95%. Use Code Section 1036 to exchange non voting for voting stock income tax free if existing trust holds voting stock. pp