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1 TaxUpdate April/May 2011 Berwyn Boston Detroit Harrisburg New York Orange County Philadelphia Pittsburgh Princeton Washington, D.C. Wilmington Follow Us on Twitter Speakers Corner On May 23, Steven D. Bortnick will present Private Equity Investments Through Partnerships and LLCs to the London Business School Private Equity Club in London, England. Joan C. Arnold, Timothy C. Atkins, Jonathan A. Clark and Raymond A. Miller will participate in the 2011 Association of Bioscience Financial Officers (ABFO) National Conference: The New Normal - Today s Formula for Success? Pepper Hamilton is a sponsor of the conference being held May 31 - June 2 in Seattle, Washington. On June 1, Mr. Atkins and Mr. Miller will moderate a panel titled, Deal Killers: Primer for CFOs. Ms. Arnold will moderate a panel titled, Tax Planning and Transfer Pricing: Strategies for Today s Complex Regulatory Environments. On June 2, Mr. Clark will moderate a panel titled, Executive Compensation: Best Practices, Compliance & Latest from Ratford. The material in this publication was created as of the date set forth above and is based on laws, court decisions, administrative rulings and congressional materials that existed at that time, and should not be construed as legal advice or legal opinions on specific facts. The information in this publication is not intended to create, and the transmission and receipt of it does not constitute, a lawyer-client relationship. Internal Revenue Service rules require that we advise you that the tax advice, if any, contained in this publication was not intended or written to be used by you, and cannot be used by you, for the purposes of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction or matter addressed herein. Please send address corrections to phinfo@pepperlaw.com Pepper Hamilton LLP. All Rights Reserved. Significant Changes to FBAR Filing For Employees of Public Companies Applicable to 2010 Filings Joan C. Arnold By June 30, 2011, every U.S. person who owns or has signatory authority over a foreign financial account must report those accounts to the IRS on form TD , (the FBAR form) if the value of the accounts totaled more than $10,000 at any time during calendar year Through new regulations issued earlier this year, significant changes have been made to the rules that define who is required to file, with the most significant changes impacting individuals who have signature authority over accounts owned by their employers. The new rules are applicable for the 2010 year and for any prior years for which reporting was deferred for accounts in which an individual had signing authority but no financial interest. For prior years, if a U.S. citizen or resident had signing authority over a foreign financial account owned by her employer, or a subsidiary of the employer, and the employer met certain size or trading requirements, the individual was excused from filing the FBAR form so long as the employer provided her with a certification that it had complied with its own FBAR requirements for the accounts it owns. That certification process has now been radically changed, and the employee may have significantly increased reporting obligations. The definition of a foreign financial account can be found in Pepper Hamilton s April 22, 2011 Tax Alert, Preparing to File Report of Foreign Financial Accounts by June 30, 2011, at pepperlaw.com/publications_update.aspx?articlekey=2088. An employee has signing authority over an account if she (or she in conjunction with others if more than one signature is required) can This publication may contain attorney advertising. in this issue... 1 Significant Changes to FBAR Filing for Employees of Public Companies Applicable to 2010 Filings 2 Self-Employment Taxes and Renkemeyer 4 New Safe Harbor for Success-Based Fees Holds Potential Benefits for Taxpayers 8 Pepper Hamilton s Tax Practice Group

2 control the funds in the account through direct communications with the account holder. The baseline rule is that an employee with such power over a foreign financial account must file the FBAR with respect to all such accounts if in the aggregate the value is more than $10,000 at any point in the year. There are limited employment-related exemptions remaining for 2010: An employee of a company (whether U.S. or foreign) the stock (or ADR) of which is listed on a U.S. national securities exchange is exempted from reporting the foreign financial accounts of that company (not any of its subsidiaries). An employee of a U.S. subsidiary of a U.S. corporation the stock of which is listed on a U.S. national securities exchange is exempted from reporting the foreign financial accounts of that subsidiary if the subsidiary has filed a consolidated FBAR filing, including the U.S. subsidiary. It does not exempt the employee from filing FBAR forms with respect to the foreign financial accounts of the parent corporation or any other subsidiary of the parent corporation. An employee of a U.S. subsidiary of a foreign parent described in point 1 above cannot rely on this exemption. These results were known to the drafters of the regulations and they made a conscious decision to adopt them as-is. They have been adopted in the instructions for the FBAR form as of March Pepper Perspective Companies have some interesting collateral concerns if they decide to prepare the returns for their employee. Because they are returns of the employee and not of the company, if the company prepares them, the company may become a tax preparer for purposes of Circular 230, which means it becomes subject to the potential oversight of the Office of Professional Responsibility. If the company pays to have the returns prepared, there is an issue of whether that is compensation to the employee. The change in the regulations may produce a significantly increased compliance burden on the employees, and, as discussed above, trying to fix it for the employees raises collateral questions that can be of concern. Self-Employment Taxes and Renkemeyer La u r a D. Wa r re n w a r re n l@p e p p e r l a w.c o m Michelle Moersfelder moersfelderm@pepperlaw.com The Tax Court recently published Renkemeyer, 1 a case noteworthy for its relatively usual facts and its interpretation of what constitutes a limited partner entitled to the exception to the selfemployment tax provided under Section 1402(a)(13). Summary of Re n k e m e y e r Renkemeyer involves the audit of a tax law firm formed as a limited liability partnership (LLP). In 2004, the LLP was comprised of three attorneys and an S corporation owned by an employee stock option plan (ESOP), the sole beneficiaries of which were the three attorneys. In 2004 the LLP specially allocated percent of its income (99 percent of which was income from legal services) to the S corporation. Because the S corporation was solely owned by the ESOP, it paid no income or self-employment tax with respect to its distributive shares from the LLP. The LLP did not report any of its income as net earnings from selfemployment. In 2005, the partnership recapitalized to provide for a general managing partner interest (a GP interest) and an investing partner interest (an LP interest). The three individual partners each had a 1 percent GP interest and a 32 percent LP interest (the S corporation was no longer a partner). Allocations were generally limited to a partner s collections and no self-employment tax was paid on allocations to the LP interests. With respect to the 2004 tax year, the court upheld the Internal Revenue Service s disallowance of the special allocation to the S corporation because, among other things, the LLP did not produce an LLP agreement that evidenced the special allocation. The court also affirmed the Service s position that the redetermined distributive shares of the three individual partners should be subject to the self-employment tax. With respect to the 2005 tax year, both the Service and court accepted the allocations, largely due to production of an amended LLP agreement supporting the allocations. However, the court rules that the entire distributive share (from both types of interests) to each partner was subject to self-employment tax. 2

3 TaxUpdate Overview of Self-Employment Tax Code Section 1401(a) imposes a 13.3 percent, previously 15.3 percent, tax on an individual s self-employment income. The selfemployment tax is the equivalent of the combined contributions of the employee and employer under the FICA tax and is levied to collect a self-employed person s payment of Social Security and Medicare taxes. Section 1402(a) defines the term selfemployment income to include an individual s distributive share of income or loss described in Section 702(a)(8) from any trade or business carried on by a partnership of which he is a member. Section 1402 also provides a number of exceptions to the general definition, including an exception for the distributive share of a limited partner. There is no definition of a limited partner in the Code or regulations. The Service issued proposed regulations in 1997 which, among other things, allow for a bifurcation of limited and general partner interests held by the same individual. The proposed regulations also provide that a service partner in a service partnership is never considered a limited partner. After the proposed regulations were issued, Congress imposed a one-year moratorium on finalizing the regulations. They have yet to be finalized. As a result, what constitutes a limited partner entitled to the exception to self-employment tax is unknown. The Court s Analysis of Self-Employment Tax The court ruled that the partners distributive shares were subject to the self-employment tax because the law firm s fees were part of the partners Section 702(a)(8) distributive share and the partners did not constitute limited partners. Therefore, the exception to self-employment tax for limited partners did not apply. In determining that the partners did not constitute limited partners, the court looked to statutory construction principles and considered the plain meaning of the phrase, the history of the regulatory interpretation of the exception, and the legislative history of the exception. The court interpreted the legislative history to provide that limited partners of a limited partnership are akin to passive investors in that they lack management powers and their distributive shares arise as a return on invested capital and constitute investment-type earnings. 2 In contrast, the three law partners of the LLP enjoyed limited liability protection, had management powers and performed services that generated the LLP s income. 3 Accordingly, the court concluded that the investment partners of the LLP were not the same as limited partners. In large part because no final regulations have been issued, positions taken with respect to whether a member of a passthrough entity is a limited partner vary considerably. Analysis of Decision The Tax Court s decision in Renkemeyer can be interpreted to provide that only passive investors may qualify as limited partners and that members of entities treated as partnerships for federal income tax purposes (pass-through entities) are subject to an all-or-nothing approach. Under this approach, the performance of services for an entity will subject the service-providing partner s entire distributive share to the self-employment tax, regardless of whether such partner has invested capital in the entity or not. However, a different view of Renkemeyer is that the outcome should be limited to the facts of the case. The court s opinion did not provide insight into many issues surrounding the question of what constitutes a limited partner for purposes of the exception to self-employment tax. The court did not address (i) the statutory carve-out for guaranteed payments to limited partners and how this should impact the analysis, and (ii) whether an investment of capital is a determining factor or cause for bifurcation of a member s interest. The court did not explain whether its interpretation of the term limited partner is applicable for all pass-through entities. Also, the court did not actually define the term limited partner. Beyond Re n k e m e y e r In large part because no final regulations have been issued, positions taken with respect to whether a member of a pass-through entity is a limited partner vary considerably. For example, many service-providing members of pass-through entities take an approach akin to the approach mandated by the Subchapter S rules, which require S corporations to pay reasonable compensation to their service-providing shareholders. However, some members take a position similar to the partners in Renkemeyer, in which 3

4 they look only to the literal language of the exception in Section 1402(a)(13) to take the position that income earned with respect to a limited interest in a pass-through entity is not subject to the self-employment tax. Alternatively, many members of serviceproviding pass-through entities follow the approach taken in the 1997 proposed regulations: that their entire distributive share is subject to the self-employment tax. Pepper Perspective Service-providing members of pass-through entities that are taking the position that no portion of their distributive share is subject to the self-employment tax should take notice of Renkemeyer, as it may provide the Service additional arguments for imposing the tax. In particular, managers of investment funds who pay little or no self-employment tax due to creative structuring should be aware of this case and the Tax Court s interpretation of a limited partner as a capital-contributing passive investor. However, it is likely that the determination of a limited partner for self-employment tax purposes is a legislative issue and one that will not be settled in the court system. En d n o t e s 1 Renkemeyer, Campbell, and Weaver, LLP, et al. v. Commissioner, 136 T.C. No. 7 (2011). 2 Renkemeyer, 136 T.C. No. 7 at 7 (citing 1 Bromberg & Ribstein, Partnership sec. 101(b)(3) ( Supp.); Revised Unif. Ltd. Pship. Act (1976), sec. 303(a), 6B U.L.A. 180 (2008); and 3 Bromberg & Ribstein, supra sec (a) (1988)). 3 Id. New Safe Harbor for Success- Based Fees Holds Potential Benefits for Taxpayers Ellen McEl r o y m c e l r o y e p p e r l a w.c o m Anthony Balden baldena@pepperlaw.com In early April, the Internal Revenue Service released Rev. Proc , 1 providing a safe-harbor election for success-based fee allocations under Section 263(a) and its Regulations. This election provides the benefit of a fairly high-percentage deduction for success-based fees while also allowing taxpayers and the Service to avoid disputes regarding the type and extent of documentation required to support a deduction for services associated with a success-based fee. If a taxpayer pays or incurs a success-based fee while investigating or otherwise pursuing a covered transaction (e.g., stock acquisitions, business asset acquisitions, or acquisitive tax-fee reorganizations) and makes the election provided in Rev. Proc , the revenue procedure indicates that the Service will not challenge and a taxpayer may treat 70 percent of the successbased fee as an amount that does not facilitate the transaction that is, as a deductible expense. The remaining portion must be capitalized as an amount that facilitates the transaction. The election may be made for success-based fees paid or incurred in taxable years ending on or after April 8, Success-based fees are defined broadly in Treas. Reg (a)- 5(f ) as amounts contingent on the successful closing of a transaction. Consequently, this new guidance suggests that a significant portion of success fees may be deducted without being subject to the arduous documentation requirements. To make the election, the taxpayer must attach a statement to its return electing the safe harbor, identifying the covered transaction to which the election applies, and stating the success-based fee amounts that are deducted and capitalized. Importantly, the election applies only to the transaction identified in the statement, and all success-based fees paid or incurred in that transaction are treated under the safe harbor. The safe-harbor election is irrevocable once made. While the safe harbor allows significant deductions of successbased fees, taxpayers should nonetheless analyze each transaction and associated success fees to confirm eligibility for the 4

5 TaxUpdate Taxpayers must continue to consider the deductibility rules and analyze their success-based fees to weigh the benefits of the safe harbor. safe harbor. For this analysis, familiarity with the case law and Regulations regarding fee allocations can help taxpayers both evaluate the documentation burden for a deductibility position and determine whether the safe harbor is beneficial or underestimates its success-based fee deductions. Ba c k g r o u n d Proper cost allocations are grounded in the origin of the claim doctrine. Under this doctrine, the origin and character of the claim with respect to which an expense was incurred, rather than its potential consequences upon the fortunes of the taxpayer, is the controlling basic test of whether the expense is deductible or not. 2 In Woodward v. Commissioner, 3 the Supreme Court applied the origin of the claim doctrine to corporate transaction costs, finding that the nature of the transaction governs whether an item is a deductible expense or a capital expenditure. Following the Woodward Court s rationale, the Seventh Circuit in A.E. Staley Manufacturing Co. v. Commissioner 4 applied an origin of the claim approach and permitted the taxpayer to allocate a lumpsum investment-banking fee between deductible and capital categories. In Wells Fargo & Co. v. Commissioner, 5 the Eighth Circuit similarly followed the Supreme Court s precedent and allowed a taxpayer to deduct salaries and other indirect merger expenses. In addition, the Eighth Circuit held that the legal expenses incurred before the final merger decision date were deductible, and the remaining portion of the legal expenses after the decision date were required to be capitalized. The Wells Fargo Court relied upon Rev. Rul to analyze the taxpayer s costs. Rev. Rul includes three examples involving acquisitive transactions and describes services provided by various firms. Although technically limited to Section 195 and start-up expenditures, Rev. Rul s conclusions that investigatory costs are amortizable as start-up expenditures is premised on the deductibility of such costs in the context of the operation of an existing business. Situation 1 of Rev. Rul provides that costs attributable to conducting industry research in several industries and review of research involving several businesses within a single industry, including the review of publicly available financial information, constitute investigatory costs. Moreover, appraisal and in-depth review of books and records to ascertain a fair acquisition price are also considered investigatory activities. In Situation 2, the taxpayer commenced the search for a trade or business to acquire and hired an investment banker to research three potential targets, which the Service also found to be investigatory to the extent that the services preceded the taxpayer s final whether and which decisions. In Situation 3, the taxpayer hired accountants and attorneys to perform preliminary due diligence, including financial projection analysis and industry analysis in conjunction with a potential acquisition. The Service found that costs incurred prior to the final decision related to preliminary due diligence are investigatory costs. Against this background, the Section 263(a) Regulations incorporated the concepts developed in Wells Fargo and its predecessor cases. These Regulations provide that costs incurred while investigating a covered transaction are facilitative and capitalized if the amount relates to activities performed on or after the decision to acquire. 7 The Regulations list a number of inherently facilitative services that must be capitalized regardless of when they are performed, but for investigatory and other non-inherently facilitative costs incurred to pursue a covered transaction, the costs incurred prior to the decision to acquire are not facilitative and may be deducted. For success-based fees in particular, Treas. Reg (a)-5(f ) presumes that payments contingent upon a successful closing facilitate the transaction, and these fees generally are capitalized. However, the taxpayer may rebut this presumption by maintaining sufficient documentation establishing an allocation to non-facilitative activities. Under these Regulations, the documentation must be completed on or before the due date of the taxpayer s timely filed, original federal income tax return (including extensions) for the taxable year during which the transaction costs were paid. 5

6 The Regulations provide that supporting records to establish sufficient documentation include: time records, itemized invoices, or other records that identify the activities performed by the service provider, the amount of the fee allocable to each of the various activities, the date of services (when relevant), and the name, business address, and telephone number of the service provider. 8 Other guidance in a private letter ruling specifies that all evidence should be considered, including: service provider invoices; service provider attestation regarding the scope and timing of services; service provider engagement letters; board of director minutes; corporate and service provider meeting minutes and calendar entries; documents developed by the providers and presented to the board of directors; general ledger entries; financial statements; management agreement; flow of funds memo; wire transfer and other bank records; transaction documents; and Company s internal accounting information. 9 Pepper Perspective Given the extensive documentation typically required and the totality-of-the-circumstances approach, taxpayers sought clarification regarding the types of records necessary to support their deductions and to avoid burdensome recordkeeping requirements. For its part, the Service regularly challenges the adequacy of substantiation in examinations, sometimes disallowing an allocation because the documentation is not sufficient in the Service s subjective view. In other cases, the Service has viewed documentation and allocation letters prepared after a transaction as self-serving and not as contemporaneous support of a particular service. Rev. Proc notes that numerous disagreements have arisen regarding the type and extent of documentation required, and the safe-harbor election is designed to minimize these disputes. Nevertheless, taxpayers must continue to consider the deductibility rules generally and analyze their success-based fees to weigh the benefits of the safe harbor with the potential understatement of deductible costs. In some circumstances, the safe harbor will be less advantageous than an actual allocation. It is not uncommon for the non-facilitative percentage of a success-based fee to be above 90 percent. For example, when an investment banking firm has a long-standing relationship with a company or when deal identification is protracted, the non-facilitative portion of a fee may be well beyond the safe-harbor amount. For this reason, it will be prudent to determine the actual allocation so that the safe harbor can be fully evaluated. Additionally, although the revenue procedure indicates that the election is irrevocable, it is nonetheless advisable to gather documentation to substantiate a deduction so that a taxpayer is prepared for an examination. As the regulations note, unless this documentation is gathered prior to the due date of a return, success-based fees are presumed non-deductible. It would be unfortunate to be selected for Exam and have the Service determine that the taxpayer was ineligible for the safe harbor if no documentation had been gathered in advance of return filing, in this circumstance, the success-based fee would be presumed non-deductible. Further, this guidance places increased emphasis on the determination of whether a transaction is a covered transaction. In a multi-phased transaction, a portion of the transaction may be characterized as covered whereas other aspects of the transaction may not meet the definition of a covered transaction. For this reason, it may be important to seek confirmation regarding whether the safe-harbor election is available if any part of the transaction is considered a covered transaction. A related question is whether a success-based fee should be apportioned between investigatory services and other services. For example, if an investment banker is receiving a single success-based fee, which is attributable to both services associated with investigating a transaction and with the financing of the transaction, the revenue procedure is unclear regarding whether the fee should be split between the services and whether the safe harbor is limited to services associated with investigating a transaction. Another consideration involves the recovery of the facilitative portion of the success-based fee. For example, if the successbased fee is attributable to a range of services, for which amortization would be available for a portion of the fee, e.g., the success-based fee is attributable to investigating, financing, and structuring the transaction. It is not clear how the facilitative portion of the fee should be treated and whether it would be recoverable in full or in part. The revenue procedure was designed as a simplifying measure and as such, an argument can be made that the 30 percent could be amortized or recovered depending on the scope of services rendered. Recently, a Service representative indicated that these capitalized costs could be amortized in accordance with financing authority. This result may create ambiguity with the requirement in the regulations that an amount paid to facilitate a borrowing does not facilitate another transaction. See Treas. Reg (a)-5(c)(1). As noted, the election is available for success-based fees paid or incurred in taxable years ending on or after April 8, For this reason, it is important to fully consider the effective date 6

7 TaxUpdate provisions as applicable to both calendar-year and fiscal-year taxpayers. There are certain circumstances in which the safe-harbor election may be available for transactions that occurred prior to the April 8 effective date. For example, an acquiring taxpayer with a fiscal year may be eligible for the safe harbor even though the transaction occurred prior to December 31, It is important to note that the election is not a method of accounting and thus, the election is not available outside the effective date provisions. This revenue procedure is welcome guidance and will provide significant benefit to many companies. However, because of the numerous unanswered questions, companies should carefully review their transaction to correctly elect the safe harbor and to protect themselves against future challenge at Exam. En d n o t e s I.R.B. (Apr. 8, 2011). 2 United States v. Gilmore, 372 U.S. 39, 49 (1963) U.S. 572 (1970) F.3d 482, 491 (7th Cir. 1997) (finding that it is the nature of the services performed by the investment bankers that determines the proper tax treatment of the costs of those services ) F.3d 874 (8th Cir. 2000) C.B Treas. Reg (a) (5)(e)(1). 8 Treas. Reg (a) 5(f ). 9 Priv. Ltr. Rul ( Jan. 4, 2010), but see, Tech. Adv. Mem , ( Jan. 15, 2010) (stating that Treas. Reg (a)-5(f ) should not be read as automatically precluding the deductibility of non-facilitative costs simply because the taxpayer is unable to provide time records or itemized invoices). RSS on Subscribe to the latest Pepper articles via RSS feeds. Visit today and click on the RSS button on the publications page to subscribe to our latest articles in your news reader. 7

8 Pepper Hamilton s Tax Practice Group Federal and International Tax Issues Annette M. Ahlers ahlersa@pepperlaw.com Timothy B. Anderson andersontb@pepperlaw.com Joan C. Arnold arnoldj@pepperlaw.com Anthony J. Balden baldena@pepperlaw.com James W. Barson barsonj@pepperlaw.com Steven D. Bortnick bortnicks@pepperlaw.com Gordon R. Downing downingg@pepperlaw.com W. Roderick Gagné gagner@pepperlaw.com Howard S. Goldberg goldbergh@pepperlaw.com Timothy J. Leska leskat@pepperlaw.com Ellen McElroy mcelroye@pepperlaw.com Michelle Moersfelder moersfelderm@pepperlaw.com Paul D. Pellegrini pellegrinip@pepperlaw.com Lisa B. Petkun petkunl@pepperlaw.com Todd B. Reinstein reinsteint@pepperlaw.com Joan M. Roll rollj@pepperlaw.com Laura D. Warren warrenl@pepperlaw.com State and Local Tax Issues Philip E. Cook, Jr cookp@pepperlaw.com Lance S. Jacobs jacobsls@pepperlaw.com Employee Benefits Issues Jonathan A. Clark clarkja@pepperlaw.com David M. Kaplan kapland@pepperlaw.com Andrew J. Rudolph rudolpha@pepperlaw.com 8