D2 -- Reis, Churchill & Delger


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D2 -- Reis, Churchill & Delger

  1. 1. Bank and Capital Markets Tax Institute – S CorporationsMark Reis, Partner – Moss Adams LLPRandy Churchill, Sr. Manager – Moss Adams LLPColleen Delger – AmericanWest Bank 1
  2. 2. The material appearing in this presentation is for informational purposesonly and is not legal or accounting advice. Communication of thisinformation is not intended to create, and receipt does not constitute, alegal relationship, including, but not limited to, an accountant-clientrelationship. Although these materials may have been prepared byprofessionals, they should not be used as a substitute for professionalservices. If legal, accounting, or other professional advice is required, theservices of a professional should be sought. 2
  3. 3. AGENDA• S Corporation Overview• Bank Specific/IRS Audit Issues• Planning• Current Issues 3
  4. 4. S CORPORATION OVERVIEW• Introduction & Background• Built-In Gains• Material Participation• Passive Activities• Distributions 4
  5. 5. INTRODUCTIONIncome Shifting: A Snapshot of RatesType of Federal Tax 2011/12 2013 %a) Income • Ordinary 35% 39.6% 13.4% • Dividends 15% 43.4% 189.3% • Capital Gains 15% 23.8% 58.7%b) State: look at marginal rates; the main point is that income shifting will likely become more attractivec) Don’t forget: “Non-material participation” planning for 2013 and beyond for pass-through entities 5
  6. 6. INTRODUCTIONLooking back, looking forward:Transfer Tax Provisions – Federal Only (States Vary) Estate Tax Gift Tax GST Tax2010 Rates 0% or 35% $1 million 0%2010 Exemptions Unlimited or $5 $1 million $5 million million2011-2012 Rates 35% 35% 35%2011-2012 Exemptions $5 million $5 million $5 million2013+ Rates & 55% and $1 55% and $1 55% and $1+Exemptions (scheduled) million million million 6
  7. 7. SOME HISTORICAL BACKGROUND• Prior to 1981: for those of us who were alive, would you still be alive if you advised an S Corp to a profitable C owner?• Common practices for C’s: “All Assets In”• Between 1981 and 1985: educating the client and the profession on double tax on income• 1986: Tax law change turned thinking upside down for corporations…how? 7
  8. 8. HISTORY 101…CONTINUED• The big three in C Corps: o Double tax on income: federal & state o Double tax on gains (no capital gain rate benefit) o Single tax (ordinary and capital gain) rates for individuals  corporate rates—WOW!• 1986 scramble year: why? Repeal of “General Utilities;” BIG and 10-year rule• Why were people so slow to act? 8
  9. 9. HISTORY 101…CONTINUEDThe top 5 reasons:5. “General Utilities” will be back4. We have too many other things to do3. Corporate and individual rates will return to historical levels and we will be right back where we started2. We will never sell assets and liquidate anyway; besides, we can always sell stock1. Give up a fiscal year? No way! 9
  10. 10. HOW TIMES CHANGE…Today’s reality:1. Corporate/individual ordinary rates are roughly the same but the 20% capital gain break is way too big to ignore2. Due to §197 and legal liability, most corporate transactions are asset sales or “elected” asset sales3. Many closely-held corporations have sold & liquidated, and this trend will likely continue via sale or restructuring to different entity forms 10
  11. 11. A “SIMPLE” EXAMPLE OF THEDIFFERENCE—ASSET SALECapital Gain Asset Sale—Federal Only; Zero StockBasis (2012 rates): Description C Corp S Corp* Sales price $10,000,000 $10,000,000 Basis (2,000,000) (2,000,000) Gain $8,000,000 $8,000,000 Double tax $3,880,000 n/a Single tax $1,500,000 Variance $2,380,000 *since inception or for more than 10 years 11
  12. 12. CHOICE OF ENTITY IS MOST CRUCIALWHEN PLANNING FOR WHAT?1. Asset Protection – for the business and its owners2. Ease of business transition, whether “inside” or “outside” 12
  13. 13. TRANSITION IS INEVITABLE• Retirement of primary shareholder(s)• Industry competition-forced consolidation• Mergers & acquisitions• Death or disability of an owner• Company in financial difficulty• Change in family circumstances (if family-controlled) 13
  14. 14. CURRENT TAX STRUCTURES-Corps:• Corporation still files a tax return but does not pay Federal income tax (with exceptions)• May pay incremental state tax (franchise, income, minimum, etc.)• Only reasonable stockholder/employee wages are subject to payroll tax• Can pay stockholder dividends, which stockholders can use to pay principal and interest on stock acquisition note• Corporation’s taxable income reported to stockholders on Schedule K-1 to be reported on his/her own personal income tax return 14
  15. 15. CURRENT TAX STRUCTURES-Corp stockholders:• Pay Federal income tax of up to 35% and state taxes up to 11% on proportionate share of corporate taxable income• Post S-Corp earnings distributed to stockholders are not taxable• Pass-through income less distributions increases basis in corporate stock• Neither K-1 income nor dividends are subject to employee Medicare tax• Stockholder interest payments are deductible against K-1 and salary income, not limited to investment income 15
  16. 16. BENEFITS OF S CORP STATUS• Eliminate double taxation on income and gains• Capital gain availability on flow through gains• Losses, deductions and credits flow through to stockholders• Greater payroll tax certainty• Deduction for interest expense paid by stockholders to acquire stock• Potential for future tax-free distributions• Ease of future ownership transfers• Flexibility for future expansion and acquisition 16
  17. 17. S CORP TAX & BUSINESS RISKS• Built-in gains tax• Passive investment income tax• Loss of S-election status• Deferred income taxes not being recorded• Inadequate stock or debt basis• Alignment of buy/sell agreement, life insurance and estate planning• No step-up in basis in corporate assets 17
  18. 18. S CORP CONCERNSFuture income tax rates: combined individualFederal and state rates may be higher than combinedcorporate rate— Does not take into account deduction for stockholder interest payments as business interest vs. investment interest Does not take into account capital gain rates available to individuals and not corporations Does not take into account “income shifting” over multiple taxpayers in certain tax years 18
  19. 19. S CORP CONCERNS• State income tax filing requirement: individual vs. composite• Restrictions on stock ownership• Alternative Minimum Tax: stockholders could be subject• Regulatory limitations tax distributions 19
  20. 20. BUILT-IN GAINS• Net Unrealized Built-in Gain o Valuation o Measurement Period• Small Business Jobs Act2010 and ARRA o Reduced Recognition Period not applicable for 2012 20
  21. 21. MATERIAL PARTICIPATION TESTS• Material Participation in a trade or business activity tests: o You participated in the activity for more than 500 hours o Your participation was substantially all the participation in the activity of all individuals o You participated in the activity for more than 100 hours during the tax year and you participated at least as much as any other individual o The activity is a significant participation activity and you participated in all significant participation activities for more than 500 hours o Your materially participated in the activity for any 5 of 10 immediately preceding tax years o The activity is a personal service activity in which you participated in for any 3 preceding tax years o Based on all the facts and circumstances, you participated in the activity on a regular, continuous and substantial basis during the year 21
  22. 22. GROUPING ACTIVITIES• One or more trade or business activities or rental activities may be grouped as a single activity. o Benefits include meeting material participation requirements o Detriments include disposing of substantially all of one trade or business when attempting to deduct suspended losses 22
  23. 23. S CORPORATION DISTRIBUTION RULES• If S Corporation has Accumulate E&P o AAA = Tax-free o PTI = Tax-free o C Corporation Accumulated E&P = Taxed as Dividends o OAA = Cannot make non-dividend distriutions o Balance – Tax-free return of Capital or o Balance – Capital Gain 23
  24. 24. S CORPORATION DISTRIBUTIONS• AAA is reduced by distributions, as well as losses and deductions recognized during the year• Lack of sufficient AAA can limit tax-free distributions from AAA and may cause future distributions to be taxed as dividends from C Corporation AE&P• S Corporations may elect to treat its distributions of the year as being made first out of C Corporation AE&P• The election is made on an annual basis and applies to all distributions made during the year 24
  25. 25. S CORPORATION DISTRIBUTIONPLANNING• The S Corporation can make an irrevocable election to distribute part of its C Corporation AE&P without having to actually distribute cash (deemed dividend)• Deemed dividend is considered distributed and immediately contributed to the S Corporation• Deemed dividend cannot exceed the amount of the C Corporation AE&P at year end• Considerations include shareholder loss carryovers, current year losses, deductions and tax rate changes. 25
  26. 26. BANK SPECIFIC & IRS AUDIT ISSUES o Personal Holding Company Rules o Bad Debts o Non-Accrual Interest o TEFRA Disallowance 26
  27. 27. PERSONAL HOLDING COMPANY• Personal Holding Company o IRC SEC 542(c)(6) o Notice 97-5 27
  28. 28. BANK SPECIFIC/IRS AUDIT ISSUES• Bad Debts o IRC 585 Reserve Automatic Change o Specific Charge-Off o Conformity Election 28
  29. 29. NON-ACCRUAL INTEREST• Tier II Issue – Non-Performing Loans Directive #1Directive Overview:The timing of when a regulated bank can stop accruing interest onnon-performing loans for tax purposes involves a difficult and timeconsuming loan-by-loan analysis, which was previously the subject ofa Coordinated Issue Paper. Factually, interest should only stopaccruing on non-performing loans for tax purposes when, at the timethe interest becomes due, that interest is determined to beuncollectible or the underlying loan is determined to be worthless. 29
  30. 30. NON-ACCRUAL INTEREST CONT.Directive Provides the Following:Rev. Rul. 2007-32 requires that an accrual method bank with a “reasonableexpectancy” of receiving future payments on a loan must include accruedinterest (determined under Treas. Reg. Sec. 1.446-2(a)(2)) in gross incomefor the taxable year in which the right to receive the interest becomes fixed,notwithstanding bank regulatory rules that prevent accrual of the interestfor regulatory purposes (i.e. loan placed in non-accrual status for regulatorypurposes). This ruling also states that when an income item is properlyaccrued and subsequently becomes uncollectible, a taxpayer’s remedy is byway of a bad debt deduction under section 166, rather than throughelimination (i.e. reversal) of the accrual. Furthermore, this tax rule isapplicable even when the item of income is accrued and becomesuncollectible during the same taxable year. Spring City Foundry Co. v.Commissioner, 292 U.S. 182 (1934). 30
  31. 31. TEFRA INTEREST EXPENSEDISALLOWANCE• IRS will not apply Sec. 291 to a QSUB bank or S- Corp bank unless the bank (or any predecessor) was a C-Corp bank in the three immediately preceding taxable years. 31
  32. 32. TAX PLANNING• Individual Rate Change• Shareholder Considerations 32
  33. 33. INDIVIDUAL RATES – FEDERAL ONLYIncome Type 2012 Tax Rates Post-2012 Tax RatesOrdinary 35.0% 39.6%Dividends 15.0% 43.4%1Capital Gains 15.0% 23.8%11 Includes 3.8% Medicare tax on net investment income 33
  34. 34. MEDICARE TAX• Beginning in 2013, a 3.8% surtax is levied on the lesser of net investment income or income in excess of a defined threshold amount• The threshold amount is $250,000 for a joint returns, $125,000 for married filing separately, and $200,000 for all others• The 3.8% surtax is levied on estates and trusts on the lesser of undistributed net investment income or income in excess of the highest estate or trust tax bracket 34
  35. 35. TRANSFER TAX PROVISIONS – FEDERALONLY (STATES VARY)Looking back, looking forward: Estate Tax Gift Tax GST Tax2010 Rates 0% or 35% $1 million 0%2010 Exemptions Unlimited or $5 $1 million $5 million million2012 Rates 35% 35% 35%2012 Exemptions $5.12 million $5.12 million $5.12 million2013+ Rates & 55% and $1 55% and $1 55% and $1+Exemptions (scheduled) million million million 35
  36. 36. THE PLANNING OPPORTUNITYToday’s economy for valuations (estate, gift, BIG)• What’s happened to: o Real estate values? “Blue sky/intangibles”? o Transactions “slowing” down? o The credit markets—a “little” tighter now?• “Bad” economies always create more opportunities o State & local taxes o International taxes o Income, payroll, transfer taxes 36
  37. 37. ALIGNING COMMON STRATEGIES• Don’t kill the “golden goose”• How to incorporate familiar strategies that make business planning sense• Look at the big picture of applying the strategy o How does our business plan affect our estate plan if we implement this technique? Do we have the appropriate entity structure to cash flow the technique? o Have we adequately considered the parent personal financial planning and security needs before we implement an estate plan to reduce taxes? o If we are transferring ownership or control, does the future ownership and control put the business at risk? o If we are transferring control to the next generation, are they prepared to manage? o Has a sale been considered? 37
  38. 38. GIFTING AND TRUST SHAREHOLDERS• The rules for trust shareholders are complicated• Disqualified shareholders may cause an inadvertent termination of S election• There are special relief provisions to correct this problem• S elections and trust agreements are a focus area in due diligence 38
  39. 39. CURRENT TAX ISSUES• Information Reporting• Tangible Property Regulations• BASEL III Proposals 39
  40. 40. IRC §6045B REPORTING REQUIREMENTS• Requires issuers of stock and securities to report actions undertaken by the issuer that affect a holder’s per-share basis in such securities• Reporting is made to the owners of the applicable securities and to the IRS• Any organizational action that impacts the basis of the securities must be reported, including (but not limited to): o Mergers and tax-free reorganizations o Stock dividends o Stock splits o Non-dividend distributions• The reporting must include identification of the affected securities and a detailed description of the impact the organizational action has on the basis of the securities. 40
  41. 41. IRC §6045B REPORTING REQUIREMENTS• Separate reporting is required o Reporting to each holder of record by January 15th of the year following the calendar year in which the organizational action was executed; and o Reporting to the IRS within 45 days following the organizational action or, if earlier, January 15th of the year following the calendar year in which the organizational action was executed• S Corporation rule• Website reporting• Penalties for non-compliance - $100 for each IRS return and each shareholder statement (K-1), subject to separate $1.5 million-per-year maximum 41
  42. 42. TANGIBLE PROPERTY REGULATIONS - A BIT OF HISTORY… Dec Mar 2004 2006 2008 2011 2012 TBD IRS Issues IRS Issues IRS IRS Issues IRS Issues Rev. IRS Issues ANRPM to Proposed Withdraws Temporary Procs. 2012- Final Announce Regulations Initial Regulations, 19 and 2012- RegulationsTPR Project Proposed Withdrawing 20 and Issues under TPR (Shortly Regulations Prior Field Directive After – Reissues Proposed to Agents Intangible Proposed RegulationsRegulations RegulationsWere Issued) Temporary Regulations are Generally Effective for Tax Years Beginning after 2011 42
  43. 43. SCOPE OF NEW TEMPORARYREGULATIONS Acquisition of tangible propertyMaterial & supply De minimis rule Capitalized acquisition costs Improvement of tangible property Unit of property Repair vs. improvement Routine maintenance Disposition of tangible property Structural components General asset accounts 43
  44. 44. WHAT ARE MATERIALS AND SUPPLIES?Tangible property used or consumed in the taxpayer’s business that is not inventory and that is:1) A component acquired to maintain, repair, or improve a unit of tangible property that is not acquired as part of any single unit of property;2) Fuel, lubricants, water, and similar items that are reasonably expected to be consumed within 12 months after use begins;3) A unit of property that has an economic life of 12 months or less after use begins; or o Useful life on AFS or from facts and circumstances4) A unit of property that has an acquisition cost of $100 or less. 44
  45. 45. DE MINIMIS RULE: OVERVIEW• Taxpayers may expense costs under the de minimis rule if: 1. Taxpayer has an applicable financial statement (AFS), 2. At beginning of year, taxpayer has written accounting policy for expensing property costing less than a certain amount, 3. Taxpayer treats the amounts paid as an expense in its AFS during the year in accordance with written policy, AND 4. Total amount paid and not capitalized under the de minimis rule is less than or equal to the greater of: A. .1% of the taxpayer’s gross receipts for the year on its federal return; OR B. 2% of the taxpayer’s total depreciation and amortization for the taxable year on its AFS. 45
  46. 46. DE MINIMIS RULE• Shared cap o A taxpayer can use the de minimis rule for amounts paid for: – Materials and supplies (if elected) – Acquisitions of tangible property – Improvements to tangible property• Cliff effect o Can elect to capitalize certain items to fall below cap• Consolidated groups o Cap applied at entity level o AFS and written policy ok at consolidated level 46
  47. 47. ACQUISITION OF TANGIBLE PROPERTY: OVERVIEW• General rule: Taxpayer must capitalize amounts paid to acquire or produce a unit of real or personal property.• Costs required to be capitalized: 1) Invoice price 2) Facilitative transaction costs – Amts paid to pursue or investigate transaction – 11 “inherently facilitative” costs 3) Work performed prior to placing property in service 4) Defending or perfecting title to real or personal property• Real property exception: “whether and which” test• Employee comp and overhead deductible 47
  48. 48. UNIT OF PROPERTY FOR IMPROVEMENT STANDARDS: BUILDINGSBuilding structure Building systems• Consists of the building 1. HVAC system and its structural 2. Plumbing system components other than 3. Electrical system building systems. 4. All escalators• This includes: walls, floors, 5. All elevators partitions, ceilings, 6. Fire protection and alarm systems windows, doors, etc. 7. Security systems 8. Gas distribution systems 9. Other structural components identified in guidance 48
  49. 49. DISPOSITIONS OF MACRS PROPERTY• A disposition is a transfer of ownership or permanent withdrawal of an asset from a trade or business o Same definition for SAA/MAA and GAA• Includes: o Sale or exchange o Retirement o Physical abandonment o Destruction o Retirement of a structural component of a building 49
  50. 50. WHY ELECT GAA?• Interplay with Restoration Tests 1-3 o Loss recognized/basis adjusted = Restoration = Capitalized 1. GAA Default: No loss, repair may possibly be deducted 2. QD Election: Recognize loss, capitalize improvement• SAA/MAA: Disposition of structural component requires gain/loss recognition o What if you fail to recognize?  Potential permanent effect (“allowed vs. allowable”) o Allocation of basis? Reasonable method. 50
  51. 51. METHOD CHANGES• 19 automatic changes based on temporary regulations o Rev. Proc. 2012-19 applies to §§162, 263(a) changes o Rev. Proc. 2012-20 applies to §§167, 168 changes• Effective for tax years beginning on or after January 1, 2012• All scope limitations waived for first two years• Mix of §481(a) and “modified §481(a)”• 3115s can/should be combined• Many necessitate proper capitalization for UNICAP• Retroactive GAA election ONLY available for 1st 2 years 51
  52. 52. BASEL III• The proposed Basel III capital rules have a number of dividend restrictions. The new capital rules contain dividend restrictions if the organization is not in full compliance with the requirement to maintain the required capital conservation buffer: a requirement for banking organizations to maintain common equity Tier 1 capital equal of 2.5% of total risk-weighted assets in addition to the minimum risk-based capital requirements.• If a banking organization does not maintain the full capital conservation buffer, it becomes subject to restrictions on the payment of dividends and on payments of discretionary bonuses to executive officers. These restrictions increase as the organization’s capital conservation buffer decreases, and if the organization does not maintain a capital conservation buffer of at least 1.25% of risk-weighted assets, it will be able to pay dividends of no more than 20% of its eligible retained income in dividends, subject to receiving a waiver of these restrictions from its regulators. Eligible retained income is defined as the organization’s net income for the previous four quarters, net of dividends and discretionary bonus payments to executive officers during that period. 52
  53. 53. QUESTIONS 53