On April 17, 2019, Treasury issued its second installment of proposed regulations relating to Qualified Opportunity Zones (“QOZs”). The regulations are 169 pages in length, and (as suspected) are fairly complex. Nevertheless, Treasury addresses a significant number of important QOZ issues.
We will dive into the proposed regulations in some detail in subsequent blog posts. In this post, however, we provide a high-level overview of some of the more significant provisions in the proposed regulations.
The NYU 77th Institute on Federal Taxation (IFT) is taking place in New York City on October 21-26, 2018, and in San Diego on November 11-16, 2018. This year, I will be presenting my latest White Paper, Subchapter S After The Tax Cuts And Jobs Act – The Good, The Bad And The Ugly. My presentation will include a discussion about the direct changes made by the TCJA to Subchapter S as well as the impact on Subchapter S by other provisions of the TCJA, including creation of a single corporate tax rate under Section 11, creation of the Section 199A deduction, elimination of personal property exchanges under Section 1031, and elimination of the corporate alternative minimum tax. I will also discuss the ongoing benefits of Subchapter S and new traps that exist for the unwary.
The IFT is one of the country's leading tax conferences, geared specifically for CPAs and attorneys who regularly are involved in federal tax matters. The speakers on our panel, Taxation of Closely Held Businesses, include some of the most preeminent tax attorneys in the United States, including Jerry August, Terry Cuff, Wells Hall, Stephen Looney, Ronald Levitt, Stephen Kuntz, Mark Peltz, and Bobby Philpott. I am proud to be a part of IFT.
This will be my eighth year as an IFT presenter, and I am again speaking as part of the Closely Held Business panel on October 25 (NYC) and November 15 (San Diego). As in previous years, the IFT will cover a wide range of fascinating topics, including tax controversy, executive compensation and employee benefits, international taxation, corporate taxation, real estate taxation, partnership taxation, taxation of closely-held businesses, trusts and estates, and ethics. The IFT is especially important this year given the recent passage of the TCJA and the many new tax provisions that were added to the Code, including Section 199A.
I hope you will join us this year for what will be a terrific tax institute. Looking forward to seeing you in either New York or San Diego!
View the complete agenda and register at the NYU 77th IFT website.
As we have been discussing these past several weeks, the Tax Cuts and Jobs Act (“TCJA”) drastically changed the Federal income tax landscape. The TCJA also triggered a sea of change in the income tax laws of states like Oregon that partially base their own income tax regimes on the Federal tax regime. When the Federal tax laws change, some changes are automatically adopted by the states, while other changes may require local legislative action. In either case, state legislatures must decide which parts of the Federal law to adopt (in whole or part) and which parts to reject, all while keeping an eye on their fiscal purse.
C Corporations with Oregon annual revenues greater than $25 million may face a new minimum tax obligation – 2.5 percent of the excess – if Measure 97 passes. If a business falls within this category, there may be ways to mitigate its impact. The time to start planning, however, is now.
Oregon taxes corporations under an excise tax regime. The Oregon corporate excise tax regime was adopted in 1929. The original legislation included what is commonly called a “minimum tax” provision. In accordance with this provision, corporations subject to the Oregon excise tax are required to pay the greater of the tax computed under the regular corporate excise tax provision or the tax computed under the “minimum tax” provision. Accordingly, the “minimum tax” is an “alternative” tax; it is not an “additional” tax as many commentators have recently asserted.
Originally, the Oregon corporate “minimum tax” was a fixed amount – $25. As a result of the lobbying efforts of Oregon businesses, the “minimum tax” was eventually reduced to $10, where it remained for almost 80 years.
In 2010, Oregon voters dramatically changed the corporate “minimum tax” landscape with the passage of Measure 67. The corporate “minimum tax” (beginning with the 2009 tax year), is no longer a fixed amount. Rather, it is now based on Oregon sales (gross revenues). The “minimum tax” is now:
|Oregon Sales||Minimum Tax|
|$500,000 to $1 million||$500|
|$1 million to $2 million||$1,000|
|$2 million to $3 million||$1,500|
|$3 million to $5 million||$2,000|
|$5 million to $7 million||$4,000|
|$7 million to $10 million||$7,500|
|$10 million to $25 million||$15,000|
|$25 million to $50 million||$30,000|
|$50 million to $75 million||$50,000|
|$75 million to $100 million||$75,000|
|$100 million or more||$100,000|
S corporations are exempt from the alternative graduated tax system. Instead, they are still subject to a fixed amount “minimum tax,” which is currently $150.
As an example, under the current corporate “minimum tax” provision, a corporation with Oregon gross sales of $150 million, but which, after allowable deductions, has a net operating loss of $25,000, would be subject to a minimum tax of $100,000. Many corporations operating in Oregon, which traditionally have small profit margins (i.e., high gross sales, but low net income), found themselves (after Measure 67 was passed) with large tax bills and little or no money to pay the taxes. Three possible solutions for these businesses exist:
- Make an S corporation election (if eligible);
- Change the entity to a LLC taxed as a partnership (if the tax cost of conversion is palatable); or
- Move all business operations and sales outside of Oregon to a more tax-friendly jurisdiction.
Several corporations in this predicament have adopted one of these solutions.
Initiative Petition 28/ Measure 97
Measure 97 will be presented to Oregon voters this November. If it receives voter approval, it will amend the “minimum tax” in two major ways:
- The “minimum tax” will remain the same for corporations with Oregon sales of $25 million or less. For corporations with Oregon sales above $25 million, however, the “minimum tax” (rather than being fixed) will be $30,001, PLUS 2.5 percent of the excess over $25 million.
- The petition specifically provides that “legally formed and registered benefit companies” as defined in ORS 60.750 will not be subject to the higher “minimum tax.” Rather, they will continue to be subject to the pre-Measure 97 “minimum tax” regime (as discussed above). Caveat: The exception, as drafted, appears to only apply to Oregon benefit companies; it does not extend to foreign benefit companies authorized to do business in Oregon.
Measure 97 expressly provides that all increased tax revenues attributable to the new law will be used to fund education, healthcare and senior citizen programs. As a result, many commentators believe the initiative has great voter appeal and will likely be approved by voters. If Measure 97 is passed, it is slated to raise over $6 billion in additional tax revenue per biennium.
As reported in my November 2013 blog post, for tax years beginning in 2015 or later, under ORS 316.043, applicable non-passive income attributable to certain partnerships and S corporations may be taxed using reduced tax rates. The reduced tax rates are as follows:
- 7 percent for taxable income of $250,000 or less;
- 7.2 percent for taxable income greater than $250,000 but less than or equal to $500,000;
- 7.6 percent for taxable income greater than $500,000 but less than or equal to $1,000,000;
- 8 percent for taxable income greater than $1,000,000 but less than or equal to $2,500,000;
- 9 percent for taxable income greater than $2,500,000 but less than or equal to $5,000,000; and
- 9.9 percent for taxable income greater than $5,000,000.
In accordance with ORS 316.037, the Oregon income tax rates that would otherwise apply to individual taxpayers are 9 percent on taxable income over $5,000 (up to $125,000), and 9.9 percent on taxable income over $125,000. At first blush, the reduced tax rates offered under ORS 316.043 look desirable. An understanding of the statute, however, is needed before jumping in head first.
- Election. To qualify for this reduced rate structure, which is subject to adjustment as provided by ORS 316.044, taxpayers must make an election on their original return by checking Box 22c and completing and attaching Oregon Department of Revenue Schedule OR-PTE, OR-PTE-PY or OR-PTE-NR. The election cannot be made on an amended return. Does the original return have to be timely filed? The statute is silent. Caution is advised!
- Material Participation. The reduced rate structure is only available to taxpayers who materially participate in day-to-day operations of a partnership or an S corporation that constitutes a trade or business.
- Non-Passive Income Only. The reduced rate structure only applies to “non-passive” income that flows through to the taxpayer from the partnership or S corporation.
- One or More Non-Owner Employees. The S corporation or partnership must employ at least one non-owner and an aggregate of at least 1,200 hours of work must be performed in Oregon during the taxable year by the non-owner employee(s). For the purpose of computing the number of hours worked in Oregon during the taxable year, only hours during weeks in which the non-owner worker(s) performed 30 hours or more of services may be counted.
- Irrevocable. Per the statute, once made, the election is irrevocable—it cannot be amended or revoked. Does this mean that once an election is made, the taxpayer is required to use the reduced rate structure for all future tax years, or does it simply mean that the taxpayer cannot revoke the election for the particular tax year the election is made? Logic dictates that the election is made for each tax year, so the later should be true. The statute, however, does not provide a clear answer to this question. Caution is advised! The Oregon Department of Revenue has not yet written administrative rules to accompany ORS 316.043. I suspect, it will address this question in any rules it drafts.
- No Disregarded Entities. The owner of a disregarded entity (e.g., a single-member limited liability company or a sole proprietorship) is not eligible for the reduced tax rates.
- Limited Deductions. For purposes of computing the taxpayer’s income, which is subject to the regular income tax rates, the taxpayer is allowed to use all subtractions, deductions or additions otherwise allowable under the Oregon tax laws set forth in ORS Chapter 316. For purposes of computing the non-passive income to which the reduced tax rates apply, however, the taxpayer is only allowed to take into consideration depreciation deductions or adjustments directly related to the partnership or S corporation. Consequently, before making the election to use the reduced tax rates, an analysis of the impact of the limited use of subtractions, deductions and additions against the non-passive income needs to be undertaken.
- Composite Returns. A taxpayer who uses the reduced income tax rates may not join in the filing of a composite return under ORS 314.778.
Until the Oregon Department of Revenue drafts administrative rules to accompany ORS 316.043, the questions discussed above will remain unanswered. Consequently, caution is advised. Careful review and consideration is required before tax practitioners jump into an election under this alternative tax rate regime. Unfortunately, traps exist for the unwary.
The Extender’s Bill impacts Subchapter S in at least two respects. It amends IRC Section 1374(d)(7) and IRC Section 1367(a)(2). Both of these amendments are temporary. Unless extended, they only live until the end of this year. Yes, they only apply to tax years beginning in 2014.
I. IRC Section 1374(d)(7).
In the last five (5) years, we have seen at least three temporary amendments to the built in gains tax recognition period.
- The first amendment is found in Section 1251 of the American Recovery and Reinvestment Tax Act of 2009. This provision shortened the ten (10) year recognition period for tax years 2009 and 2010 to seven (7) years.
- The second amendment is found in Section 2014 of the Small Business Jobs Act of 2010. This provision extended the built in gains tax relief to 2011 and further shortened the recognition period to five (5) years. For tax year 2012, it appeared we would be back to the old ten (10) year recognition period.
- With the passage of the Taxpayer Relief Act of 2012, however, a third amendment to Code Section 1374 was given life. As a result, the five (5) year recognition period was extended to the end of last year.
Unfortunately, it looked like we were back to the ten (10) year built in gains tax recognition period. Lawmakers saved the day one more time, at least temporarily, when both the Senate and the House passed the 2014 Tax Increase Prevention Act on December 16, 2014. President Obama signed the bill into law on December 19, 2014. So, for your clients that dispose of built in gains assets this year, they are subject to a five (5) year built in gains tax recognition rule. For dispositions of built in gains tax property next year, unless Congress acts for a fifth time, we are subject to the old ten (10) year recognition period rule.
II. IRC Section 1367(a)(2).
Section 1367(a)(2) was added to the Code in 2006. It was set to sunset at the end of 2011. Section 325 of the 2012 Taxpayer Relief Act, effective January 1, 2013, however, extended the life of Code Section 1367(a)(2) to the end of 2013. It appeared IRC Section 1367(a)(2) was no longer in existence for 2014. The 2014 Tax Increase Prevention Act gave this provision one more year of life.
So, at least for 2014, shareholders of a S Corporation get to reduce their stock basis by the adjusted basis of property contributed by the S Corporation to a charity, even though the full fair market value of the property passes through to the shareholder as a charitable contribution deduction on their IRS Form K-1.
If any of your S Corporation clients made charitable contributions this year, they may be able to take advantage of this law. Unless extended again, Section 1367(a)(2) will no longer be law on January 1, 2015.
Year end is almost here. For your S Corporation clients, it is worth looking to determine if either of these provisions, amended by the 2014 Tax Increase Prevention Act, apply. Time is running out!
I was recently interviewed by Ama Sarfo, a reporter for Law360 (a national legal publication of LexisNexis). I discussed some of the audit risks Subchapter S corporations and their shareholders face these days. Below is an excerpt of the Article.
Audit Risk: It's estimated that the U.S. has a $450 billion gap between taxes that are owed to the government and taxes that are actually paid on time. This staggering number, despite significant budgetary constraints, has put taxpayer compliance back in the forefront for the IRS. In the 1990s, the Service was forced to move its focus from the audit function to information and technology as its systems were terribly out of date. Taxpayers need to be on their game because the IRS is back in the audit business, and noncompliance penalties are stronger than they've ever been before.
Compensation Documentation: Subchapter S corporation exams often lead to a review of shareholder compensation. The focus is generally on whether the compensation is unreasonably low — an amorphous label that lacks a uniform standard within the courts and instead depends on questions of facts and circumstances. I advise S corporation clients, among other things, to annually document their compensation decisions and their rationale for establishing shareholder employee compensation. This would include developing a compensation methodology based on qualifications, nature of work and information about what other like companies pay similar employees. It's an art.
Loss Deductions: Shareholder basis calculations used for the purpose of absorbing losses passed through from the corporation are often reviewed in S corporation examinations. S corporations aren't required to track and report shareholder basis on IRS Form K-1 issued to shareholders each year. According to IRS studies, in a large number of cases, errors are made in this computation (it is usually user error). So, the IRS is closely scrutinizing this issue in its audits. Don’t be surprised if, in the future, S corporations are required to track and report basis calculations on IRS Form K-1, just like partnerships are required to track and report capital account changes.
The law governing S corporations is ever changing. As tax practitioners, we need to keep abreast of these developments. I try to report important developments in this area of tax law on the blog.
If you would like to read the complete Article, it is available at www.Law360.com.
Barnes v. Commissioner, 712 F.3d 581 (D.C. Cir. 2013) aff’g T.C.M. 2012-80 (2012) is illustrative of the point that understanding the basis adjustment rules is vital.
If this case was made into a movie, the name of the movie would tell the entire story – S corporation shareholders are not allowed to just make up the basis adjustment rules! Also, as I have repeatedly stated, poor records lead to disastrous results. The DC Circuit affirmed the US Tax Court in April of 2013 to finally put an end to the case.
Marc and Anne Barnes, husband and wife, are entrepreneurs. They were engaged in several businesses, including restaurants, nightclubs and entertainment promotion. These businesses were operated through a sole proprietorship and several entities they owned 100% of, including two S corporations and a C corporation.
The tax returns at issue were the 2003 returns. One of the Barnes’ S corporations was Whitney Restaurants, Inc. which operated a Washington DC restaurant and nightclub called Republic Gardens (Whitney has since sold Republic Gardens). Upon audit of the Barnes’ 2003 tax return, the Service pulled in the 1120S of Whitney Restaurants.
In addition to some smaller items, the Service disallowed a $123,006 loss stemming from Whitney on the ground the Barnes’ had insufficient basis to take the losses. In addition, the Service assessed an IRC Section 6662 accuracy related penalty and an IRC Section 6651 late filing penalty.
The Barnes’ contested the assessment, including the penalties, and filed a petition in the US Tax Court. Prior to the court’s ruling, however, they conceded liability for the late filing penalty. The return was eight months late. So, the Court was left to decide whether the assessment of taxes and the accuracy related penalty were appropriate.
The facts are a little convoluted. In 1995, the Barnes’ had a $22,282 loss from Whitney, suspended due to lack of basis. On their 1996 joint return, they reported the $22,282 loss even though their 1996 K-1 showed an additional $136,229 loss for the tax year. In 1997, they contributed $278,000 in capital to Whitney, enabling them to finally take the suspended losses from 1995 and 1996, which totaled $158,511, but in fact they only deducted the current 1997 loss of $52,594 on the 1997 return. USER ERROR!
To follow the story, we must fast forward to 2003. The taxpayers awake from the sleep they were in and with the help of a new accountant, they determine they should have deducted the losses on the 1997 return. Guess what; that year is closed. Ouch!
Sounds bad; but, the Barnes’ find a way to relieve some of the pain. They claim, since they did not use the basis for the losses from 1995 and 1996, they can take a deduction for the losses resulting from the current year on the current return – tax year 2003 -- using the unused basis from 1997. They make three arguments in favor of this position:
First, they argue IRC Section 1367(a)(2)(B) only requires you to reduce basis for losses you actually report on your return. So, since they did not take the losses on the 1997 return, there should be no reduction in basis. WRONG!
IRC Section 1367(a)(2)(B) requires an S corporation shareholder to reduce stock basis by any losses that a shareholder should have taken into account under IRC Section 1366(a)(1)(A), even if the shareholder did not actually claim the benefit of the pass-through of the losses on his/her return.
Next, the Barnes’ argued the tax benefit rule allowed them to claim a deduction in 2003 for the loss they should have deducted in 1997. WRONG AGAIN!
The tax benefit rule generally only applies when taxpayers recover amounts they deducted in a prior year. When that situation arises, the taxpayer may exclude the recovered income to the extent the prior deduction did not give rise to a tax benefit. The tax benefit was inapplicable in the Barnes case.
Last, the Barnes argued that their failure to properly deduct the losses in 1997 caused them to compute an incorrect amount of losses that could be used to offset income in 2003. I do not understand the argument. It makes no sense. Guess what, the Tax Court did not understand it either. The Barnes’ lose the battle!
The Barnes’ do not go down for the count. Instead, they turn on their CPA and claim they relied upon professional advice. So, no penalties for accuracy or negligence are appropriate. Unfortunately, the court concluded they did not provide evidence to show they acted in good faith in relying upon professional advice. In fact, the evidence showed the accounting firm’s advice was limited by the Barnes’ inadequate accounting records and erroneous basis information from prior years in which it did not represent the taxpayers.
The result is simple: The Barnes’ were stuck with the tax and penalty assessment and a boat load of interest as the case muddled through the IRS and the court system for over nine years.
There are two pearls of wisdom to take away from the case:
- You reduce stock basis by the losses allowable under IRC Section 1366 even if you fail to report the losses on your return; and
- If a taxpayer does not provide you with adequate records, they will not likely prevail in a dispute over negligence or accuracy related penalties.
CPAs and other tax advisors need to be careful. You want to resist the temptation to represent or continue to represent clients that do not maintain adequate records.
S corporations and their shareholders must keep track of stock and debt basis. Failure to do so can lead to disastrous results. Nathel v. Commissioner, 105 AFTR 2d 2010-2699 (2d Cir 2010), illustrates this point.
In Nathel, the government and the taxpayer stipulated to the facts. Two brothers and a friend formed three separate S corporations to operate food distribution businesses in New York, Florida and California. All three shareholders made initial capital contributions to the corporations. The brothers also made loans to two of the corporations.
In late 2000, before the reorganization, the brothers made loans to the corporations totaling around $1.3 million. In 2001, they made capital contributions totaling approximately $1.4 million. Also, in 2001, they received loan repayments combined in excess of $1.6 million.
Immediately before the repayment of the loans, the brothers had zero basis in their stock and only nominal basis in the loans. Ouch! To avoid the ordinary income tax hit on the delta between the $1.6 million in loan repayments and their nominal loan basis, the brothers, with the likely help of their handy dandy tax advisor, asserted the $1.4 million in capital contributions was really tax-exempt income to the corporation, excludable under IRC Section 118(a), but which, under IRC Section 1367(b)(2)(B), increased their loan basis. Therefore, the ordinary income tax hit on the loan repayments was nominal.
The Nathel brothers were correct about one point - - under IRC Sections 1366 and 1367, if the corporation had income, including tax-exempt income, such would restore debt basis to the extent of their share of that income. The Service pointed out to the Nathel brothers, however, that they were wrong about the most important point: capital contributions, in accordance with IRC Section 118, are not income to the recipient corporation. So, since the corporation had no income, there was no loan basis restoration. The additional capital contributions did, however, increase their stock basis, which may be of help to the Nathel brothers down the road. Additional stock basis, however, was of no help to the Nathel brothers as it did not reduce the tax burden resulting from the loan repayment.
- The taxpayers lose the debate;
- The IRS issues a 90-day letter; and
- The Nathel brothers are off to Tax Court.
The Nathel brothers, of course, lose again! Rather than stay down for the count, they proceed forward to the Second Circuit Court of Appeals, where they lose a third time.
There are two morals to this story:
- Capital contributions are not income to the recipient corporation for purposes of IRC Sections 1366 and 1367; and
- Shareholders of S corporations need to keep track of stock and debt basis to avoid the unpleasant tax news the Nathel brothers received in this case.
In a recent GAO report that looked at tax years 2006 through 2008, the government found that losses deducted by S corporation shareholders that exceeded basis limitations totaled around $10,000,000, or amounted to about $21,600 per shareholder/taxpayer. The GAO concluded that this non-compliance is the consequence of the actions of the shareholder, not the corporation. In other words, it is the shareholders’, not the corporation’s, duty to track and compute stock basis. Don’t be surprised, however, if Congress does not amend the law, requiring S corporations to compute each shareholder’s basis and include it on the IRS Form K-1 each year. Partnerships already have this duty in that they have to report the partner’s beginning and ending capital account balances on the IRS Form K?1 each year.
S corporations and their shareholders must track both stock and debt basis. It is that simple.
Please join me for the NYU 73RD Institute on Federal Taxation. This year’s Institute will be held in San Diego at the Hotel Del Coronado November 16 – 21, and in New York City at the Grand Hyatt New York October 19 – 24. Please see the attached brochure. The coverage of tax topics is both timely and broad. This year’s presentations will cover topics in the areas of: executive compensation and employee benefits; partnerships and LLCs; corporate tax; closely held businesses; and trusts and estates. What is so terrific about the Institute, in addition to a wonderful faculty and the interesting current presentation topics, you can choose the presentations you want to attend. In other words, you can pick and choose the topics that relate to your tax practice.
This is my second time speaking at the Institute. My topic this year is: "Developments In The World Of S Corporations." I plan to deliver a White Paper that will provide attendees with an historic overview of Subchapter S and a look through a crystal ball at the future of Subchapter S, including a review of the recent cases, rulings and legislative proposals impacting Subchapter S.
I hope to see you in either San Diego or New York.
Larry J. Brant
Larry J. Brant is a Shareholder in Foster Garvey, a law firm based out of the Pacific Northwest, with offices in Seattle, Washington; Portland, Oregon; Washington, D.C.; New York, New York, Spokane, Washington; and Beijing, China. Mr. Brant practices in the Portland office. His practice focuses on tax, tax controversy and transactions. Mr. Brant is a past Chair of the Oregon State Bar Taxation Section. He was the long-term Chair of the Oregon Tax Institute, and is currently a member of the Board of Directors of the Portland Tax Forum. Mr. Brant has served as an adjunct professor, teaching corporate taxation, at Northwestern School of Law, Lewis and Clark College. He is an Expert Contributor to Thomson Reuters Checkpoint Catalyst. Mr. Brant is a Fellow in the American College of Tax Counsel. He publishes articles on numerous income tax issues, including Taxation of S Corporations, Reasonable Compensation, Circular 230, Worker Classification, IRC § 1031 Exchanges, Choice of Entity, Entity Tax Classification, and State and Local Taxation. Mr. Brant is a frequent lecturer at local, regional and national tax and business conferences for CPAs and attorneys. He was the 2015 Recipient of the Oregon State Bar Tax Section Award of Merit.
Upcoming Speaking Engagements
- "The Road Between Subchapter C and Subchapter S – It May Be a Well-Traveled Two-Way Thoroughfare, but It Isn’t Free of Potholes and Obstacles," New York University 78th Institute on Federal TaxationSan Francisco, CA, 11.14.19
- "The Oregon Corporate Activity Tax," Oregon Society of Certified Public Accountants (OSCPA) 2020 OSCPA State & Local Tax ConferencePortland, OR, 1.6.20
- "The Road Between Subchapter C and Subchapter S – It May Be A Well-Traveled Two-Way Thoroughfare, But It Isn’t Free of Potholes and Obstacles," The J. Nelson Young Tax InstituteChapel Hill, NC, 4.23.2020-4.24.2020