Posts Tagged ‘season’

I’m not a big fan of bitching about April 15th, because let’s be honest: nobody put a gun to our head and forced us to become accountants. We knew what we were getting into when we sat for that CPA exam; we would be trading long hours and tight deadlines for job security and sex appeal. Lots and lots of sex appeal. So it’s like I tell my three-year old son: if your pain is self-inflicted, don’t come crying about it to me.

/takes swig from whiskey bottle and returns to watching COPS

That’s why I can appreciate this list of 10 awful things about tax day; because it’s written from the perspective of non-accountant. But more importantly, it makes some valid points about the absurdity that is the current state of affairs with the U.S. tax law:

Some highlights include:

1. Paperwork: The U.S. tax code is insane and out of control. It’s tripled in a decade. It now runs to 3.8 million words. To put that in context, William Shakespeare only needed 900,000 words to say everything he had to say. Hamlet. Othello. The history plays. The sonnets. The whole shebang. But the IRS needs four times as many words? Really?

3. How they treat investment income: The tax treatment of investment income is arbitrary and stupid. We treat debt and equity differently for companies and investors. It’s irrational. The rules encourage debt. And we treat long-term capital gains better than short-term ones. That’s absurd. We only buy securities because we think they are undervalued. Why is it better if they rise in price slowly instead of quickly?

7. Taxing overseas Americans: The United States is about the only country in the world that taxes its citizens on all their worldwide income. And, most outrageously, it does this even if they live overseas. Yes, even on money they earn overseas, and on which they are already taxed overseas.

10. Alternative Minimum Tax: What kind of moron thought this up?  Forty years ago Congress — sorry, I gave you the answer — was shocked to discover that the tax code had become so complicated and insane and riddled with loopholes and the like that a few very rich people were able to game the system successfully. They were paying little, if any, tax. The sensible response to this was to treat it as a wake-up call, and simplify the entire system. Congress instead added yet another layer of complexity. They created a second, parallel tax code, the AMT. You have to run your tax calculations under both, and pay whichever bill is higher.

Valid points, all. And a refreshing change from the standard “I’ve been here 77 straight hours” game of one-upmanship CPAs engage in during busy season that invariably devolves into something out of a Monty Python sketch:


Accepting that we’re often our own worst enemies during this time of year — its long been my contention that CPAs have mastered the art of craftily spinning procrastination into martyrdom — that’s not to say we’re not within our rights to ponder if there’s a better way to manage the April workload. And perhaps I’m running the risk of taking food off my table, but I like what David Cay Johnston over at Reuters has to say on the topic. Couldn’t we eliminate 100,000,000 basic “W-2 and standard deduction”‘ tax returns by having the government automate the income tax calculation based on the copies provided to them of the relevant information?

Makes sense to me. Expand the W-4 to include the taxpayer’s filing status and dependent information, and if the taxpayer fails to file an expanded return by April 15th, let the IRS do it for them. Of course, that would likely force companies like H&R Block and Turbo Tax into extinction, but hey; it’s a cruel, cruel world.

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Today is March 15th, which means the last thing we should be writing about is a corporate tax issue. But let’s be honest, many of the more complex corporate returns get extended until September 15th, meaning the corporate filing season is really just starting as opposed to coming to an end.  

As tax-paying entities, C corporations present many issues that are unique when compared to the flow-through regimes of Subchapters K (partnerships) and S (S corporations). When these issues are not properly identified and addressed, the result is often real dollars to clients in the form of a tax deficiency assessed by the IRS.

One of the issues that causes confusion among even the most experienced of advisers is the limitation on net operating losses for certain C corporations that have undergone an ownership shift under the meaning of I.R.C. § 382.

Q: Why is Section 382 important?

A: Because over the next six months, it will simply be reflexive to offset any federal corporate taxable income for 2011 with available net operating loss carryforwards. Should a Section 382 change have occurred under your nose, however, those losses may well be limited in their usefulness.

Q: Why does Section 382 exist? What’s the point?

A: Section 382 exists predominately for two reasons.

1. In the context of an outright sale of corporate stock to new owners, Congress believes the new owners should not be able to “traffic” in NOLs and acquire losses that can be used to offset income previously earned by the buyer.

2. In the context of a change in corporate ownership created by the issuance of stock to new investors, Congress believes that new “controlling” owners should not have unfettered access to losses that were generated by the previous controlling shareholders

Q: OK, makes sense. So when does a corporation have a Section 382 change?

A: A Section 382 ownership change occurs when a loss corporation undergoes an ownership shift in which the stock ownership percentage (by value) of 5-percent shareholders has increased by more than 50 percentage points over such shareholders’ lowest ownership percentages within the testing period.

Q: I recognize all the words you just wrote, but I have no idea what that sentence means. Can we approach this differently?

A: Sure. There are a lot of moving parts in that definition, so breaking it down into its components is essential to developing an understanding of the mechanics of Section 382. Fire away.  

Q: What’s a loss corporation?

A: A loss corporation is any corporation entitled to use a NOL or generating an NOL for the tax year in which an ownership shift occurs. If a corporation is currently not generating a NOL and has no NOL carryforwards, then it can have all the ownership turnover in the world and Section 382 is not an issue.

Q: What is an ownership shift?

A:  Ownership shifts can take the form of sales of stock by existing shareholders, or issuances of new stock from the corporation to new or existing shareholders. Without ownership shifts, a corporation can generate unlimited NOLs without risk of Section 382 applying.

Q: Got it. So I need a corporation with losses and changes in the shareholders’ ownership. What if I have a bunch of shareholders with tiny interests?

A: The transfers of stock your concerned with involve 5-percent shareholders. While this definition can become confusing when evaluating public companies, in general a 5% shareholder is any shareholder that owns — directly or indirectly through attribution — 5% of the stock of the loss corporation. All of the shareholders who own less than 5% in a corporation are aggregated together and treated as one 5% shareholder.[i]

Q: Do I have to test every time a 5% shareholder buys, sells, or is issued additional stock?

A: Yes. However, the transfers of stock involving 5% shareholders must only be evaluated throughout a testing period. The testing period is the shorter of 1) three years, 2) the period of time since the corporation became a loss corporation, or 3) the period of time since a previous Section 382 change occurred.

Q: You lost me there. Can you show me what you mean?

A: Example: X Co. generated NOLs from 2003 through 2011. Thus, X Co. is a loss corporation. X Co. previously underwent a Section 382 change on May 3, 2008. On December 1, 2010, A, who owns 70% of X Co.’s stock, sells his stock to B, who was  not  previously a shareholder.

A is a 5-percent shareholder, and his sale of stock to B constitutes an ownership shift. X Co. must test its cumulative changes during the testing period. The testing period ends on December 1, 2010, and begins on the later of 1) December 1, 2007 (three years prior to the ownership shift); 2) January 1, 2003 (the date X Co. became a loss corporation); or 3) May 3, 2008 (the date of X Co.’s most recent Section 382 change resulting in a limitation). Thus, the testing period is from May 3, 2008-December 1, 2010.

Q: OK, but what exactly am I testing for?

A: To have an ownership change that limits your NOLs, there needs to be a cumulative increase in the ownership interest of 5-percent shareholders of at least 50 percent during the testing period. There are three common misconceptions surrounding this requirement that often result in inaccurate Section 382 computations:

  • The 50-percent increase is based on absolute values. If A’s ownership increases from 20% to 40%, even though his ownership interest has increased by 100% over his previous interest, it is not an absolute 50% increase. If ,however, A’s ownership increases from 20% to 75%, then A’s ownership has increased by 55-percent for purposes of Section 382.
  • The measure of the change is based on value, rather than pure percentage of stock held. This complicates matters greatly, as the value of the corporation must be known at each testing date in order to determine each 5-percent shareholder’s share of the total value. For a publicly traded corporation, value can be determined by merely glancing at the stock ticker. But for all other corporations, particularly those that may have multiple classes of stock outstanding with varying liquidation rights, the determination of the total enterprise value — and each 5-percent shareholder’s piece of that value on the testing date — often presents the biggest hurdle in measuring whether a Section 382 change has occurred.
  • The 50-percent increase is measured by comparing the percentage of value held by a 5-percent shareholder on a testing date to the lowest percentage owned by the shareholder throughout the testing period. Thus, if during a testing period A’s ownership of X Co. goes from 20% to 30%, and then from 30% to 45%, A’s increase for the second change is 25% (45% compared to 20%), rather than 15%. Even worse, the cumulative increases of the 5-percent shareholders are not offset by any decreases in interest by a 5-percent shareholder.

Q: Once I’ve confirmed I have a 50-percent change, what do I do next?

A: Once it has been determined that a Section 382 change has in fact occurred, an annual limitation must be determined on the utilization of the pre-change losses against taxable income. The limitation is generally equal to the long-term tax exempt rate in place during the month of change (issued by the IRS every month) multiplied by the value of the corporation immediately prior to the ownership change. The resulting amount represents the maximum amount of taxable income the corporation may offset in a post-change year with pre-change NOLs.

Example: X Co. underwent a Section 382 change on December 31, 2011. The value of the corporation was $1,000,000 prior to the change, and the long-term tax exempt rate was 5%. Thus, X Co.’s Section 382 limitation is $50,000. If X Co. recognizes $200,000 of taxable income in 2012, it may only use $50,000 of its pre-change NOLs to offset the $200,000 of taxable income.

Q: So I pretty much only need to be worried about big stock sales, right?

A: You weren’t listening, were you? A Section 382 change will not always be the result of an obvious 100% sale of a corporation’s stock; rather, they often are the end result of creeping changes over a period of time, or even situations where no new shareholders acquire interests in the corporation, but rather an existing shareholder greatly increases his ownership.

Example: A, B, C, and D each own 25% of X Co., a loss corporation. On January 10, 2009, A buys 10% of X Co. stock from D. On March 4, 2009, A buys all of B’s stock. Finally, on January 20, 2010, X Co. buys 20% of X Co. stock from C. An ownership change has occurred, because during the testing period ending January 20, 2010, A has increased his ownership in X Co. from 25% to 80%, a 55% increase. A’s increase is not offset by B, C, and D’s decrease in stock ownership.  

Q: I think I understand, thanks to your thoughtful explanation. You clearly deserve a large raise.

A: That’s’ really not a question, but thank you, I appreciate that. Truth be told, simply understanding that Section 382 exists is half the battle. Many tax advisers miss the issue entirely and utilize an NOL regardless of an underlying ownership change, inviting scrutiny from the IRS. While the hard part — the calculation — doesn’t begin until you’ve identified that your corporate client may be subject to Section 382, by simply undertaking the calculation, you’ve helped minimize risk for your clients.  

[i] If a 5-percent owner is an entity (i.e., a corporation, partnership or trust), the loss corporation is required to look through the entity (and through any higher-tier entity) in order to determine which owners of the entity are indirectly 5-percent shareholders of the loss corporation. It is the ownership of these ultimate 5-percent shareholders, including public groups, that is considered when determining whether a greater than 50 percentage point increase has occurred.

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[Ed note: Burgeoning WS+B tax guru Scott Pintabone stops by to provide this weeks tax season lesson. Scott tackles three related code sections that all tax advisers are aware of, but few fully understand. What follows is an excellent primer to keep close to your desk during the remaining six weeks. Now, on to Scott:]

The number 1245 doesn’t just signify retired NFL running back Ricky Williams’ total rushing yards in 2001, three years before he decided to live the American dream and turn down millions of dollars, move to Africa, grow a raging beard and smoke enough marijuana to kill an army of Seth Rogens. It’s also a very important but oft-misunderstood Code section relating to the sale of business property, along with Sections 1231 and 1250. When disposing of an asset, these provisions are vital to determining the character of the gain or loss on the disposition.

Section 1231

So called “Section 1231 assets” are afforded the best of both worlds when disposed of: Section1231(a)(1) provides that a gain is treated as a long-term capital gain[i], while Section 1231(a)(2) provides that a loss is treated as an ordinary loss. Section 1231 assets are assets used in a trade or business, which are subject to depreciation and held for more than one year, or real property used in a trade or business that is held for greater than one year. Seems pretty simple right? Now the confusion…

When a taxpayer sells Section 1231 property for a gain, if within the last five years the taxpayer recognized Section 1231 losses, they may have to treat the gain as ordinary income. It’s a logical result, because since the taxpayer got the benefit of an ordinary loss in the previous year, he should have to “recapture” any previous ordinary losses as ordinary income prior to getting the capital gain treatment normally afforded Section 1231 gains.

To illustrate: if Taxpayer A sells Asset B recognizing an ordinary $30,000 Section 1231 loss in 2009 and then subsequently sells Asset C recognizing a $20,000 Section 1231 gain in 2011, the 2011 gain is characterized as ordinary income to the extent of the non-recaptured Section 1231 loss from 2009, or $20,000. Alternatively, if the 2011 gain were $40,000, the taxpayer would recognize ordinary income of $30,000 (the amount of the ordinary Section 1231 loss from 2009) and $10,000 of long-term capital gain, provided Sections 1245 or 1250 doesn’t apply (see below).

Section 1245

Section 1245 comes into play when you sell Section 1231 property (other than real property, which is covered in Section 1250) for a gain. In the simplest terms, Section 1245 requires that a taxpayer characterize the gain on the sale of 1231 property as ordinary income to the extent of any prior depreciation taken on the property.

For example, Taxpayer A purchases Asset B (equipment used in its trade or business) for $50,000 in 2009. Between 2009 and 2011, the taxpayer depreciated the asset by $20,000. In 2011, the taxpayer sells the asset for $40,000, recognizing a gain of $10,000 ($40,000 sale price less the adjusted basis of $30,000). This gain first must be considered under Section 1231. The taxpayer used the property in their trade or business, it is depreciable and was held for greater than one year therefore meeting the definition of Section 1231 property. Section 1245 trumps Section 1231 to convert any gain attributable to prior depreciation into ordinary income, however; because the gain is entirely a result of $20,000 of depreciation taken in prior years as an ordinary deduction, Section 1245 requires that the entire $10,000 gain be classified as ordinary income.

Alternatively, if the asset were sold for $60,000 resulting in a $30,000 gain, the taxpayer would recognize gain under Section 1245 of $20,000 (amount of prior depreciation taken) and a Section 1231 gain of $10,000 ($30,000 total gain less the Section 1245 gain of $20,000), which would be treated as capital gain.

Section 1250

Section 1250 is very similar to Section 1245 but deals with real property. Section 1250 requires that a gain on the sale of real property be treated as ordinary income to the extent of any accelerated depreciation in excess of straight-line that was previously taken on the property. Because most real property is depreciated under the straight-line method under current law, ordinary income recapture under Section 1250 is rare.

Even when there is no ordinary income recapture, however, Section 1(h) requires that all prior depreciation taken on a Section 1250 asset be taxed at a 25% rate as opposed to the typical 15% long-term capital gain. This is often referred to as “unrecaptured Section 1250 gain.”

To illustrate: A sells Asset X, a building used in A’s trade or business. X was originally purchased for $1,000,000 and was previously depreciated under the straight-line method to the tune of $200,000. A sells the building for $1,300,000, resulting in a $500,000 Section 1231 gain. Section 1250 (like Section 1245) trumps Section 1231, however, and requires any prior accelerated depreciation in excess of straight-line to be recaptured as ordinary income.

Because X was depreciated on a straight-line basis, there is no excess depreciation and thus no ordinary income recapture. To the extent of the prior straight-line depreciation, Section 1(h) requires A to tax the gain on the sale of X at 25%, rather than 15%. Thus, the $500,000 gain resulting from the sale of Asset X is bifurcated: $200,000 of the gain is taxed at 25%, with the remaining $300,000 taxed as Section 1231 gain eligible for a 15% rate.

As you can see, the disposition of business property can be pretty confusing. Hopefully the summary above helps clarify the application of the different code sections when dealing with the sale of property used in a trade or business.

[i] as long as there aren’t any non-recaptured 1231 losses over the 5 years prior)

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CPAs are often their own worst enemies, and I say this not with regards to the long hours that stress our heart, the accompanying fast food that softens our midsections, and the prolonged exposure to fluorescent lighting that over time will leave the male portion of our population unable to get their soldiers to salute. Rather, we often sabotage ourselves and make things more difficult than they need to be by failing to search for an adequate authority when confronted with a problematic issue.

Consider the following alternative fact patterns:

Situation 1. A and B each own 50% of AB LLC. During 2011, AB LLC paid health insurance premiums for 2011 coverage on behalf of both A and B under AB LLC’s health plan.

Situation 2. C and D each own 50% of the stock of CD, Inc. an S corporation. C and D are also employees of CD, Inc. During 2011, CD, Inc. paid health insurance premiums for 2011 coverage on behalf of all of its employees, including C and D.

Question: How do AB, LLC, A and B, CD, Inc. and C and D account for the health insurance premiums paid by the partnership and S corporation, respectively?

In the absence of proper guidance, trying to determine the proper treatment of entity-paid health insurance premiums could easily send a CPA on a wild goose chase, leapfrogging from Section 401 to 106 to 1402 to 162(l) without ever finding a definitive answer. Such wayward wondering is responsible for many of the creative — albeit incorrect — tax return presentations of these items I’ve witnessed over the years.

But with a little digging, you’ll find that the IRS has wrapped these seemingly complicated issues up with a nice neat bow, eliminating any of the confusion that might otherwise exist. Revenue Ruling 91-26 covers the two situations posited above, and reaches the following conclusions:

Situation 1: The payment by AB, LLC of health insurance premiums on behalf of partners A and B are treated as guaranteed payments,[i] deductible by the partnership.[ii] A and B must then report the premiums paid on their behalf as guaranteed payment income on their individual tax returns.[iii] A and B can then deduct the premiums on Page 1 of their Form 1040 as self-employed health insurance.[iv]

Alternatively, Revenue Ruling 91-26 provides that AB, LLC may also treat the health insurance premiums paid on behalf of A and B as distributions. In this case, AB, LLC receives no deduction for the payments, but A and B may still deduct the cost of the premiums on Page 1 of their Form 1040 as self-employed health insurance.

Situation 2: Because Section 1372 provides that for purposes of the fringe benefit rules, any person who owns more than 2% of stock in an S corporation is treated as a partner in a partnership, the Ruling reaches the same conclusion as that found in Situation 1: CD, Inc. is entitled to deduct the cost of the health insurance premiums paid on behalf of C and D as part of the compensation paid to C and D. In turn, C and D, like partner A and B above, are required to include the value of the premiums in their respective wages.[v] C and D may then deduct the premiums paid on their behalf on Page 1 of their Form 1040 as self-employed health insurance.[vi]

As opposed to Situation 1, however, CD, Inc. may nottreat the premiums as distributions to C and D.

[i] I.R.C. § 707(c).
[ii] I.R.C. § 162(a). Note, the partnership level deduction should not be specially allocated to the partners on whose behalf the premiums were paid.
[iii] While I.R.C. § 106 generally excludes from the income of an employee any coverage provided by an employer under a health plan, the premiums paid on behalf of a partner is not excludible, because the benefit is treated as a distributive share of partnership income for purposes of the fringe benefit rules, and a partner is treated as self employed to the extent of his distributive share. Note, the guaranteed payment income should be specially allocated to A and B based on their respective share of premiums paid.
[iv] I.R.C. § 162(l). Subject to limitation.
[v] This is often where things go awry, as tax advisers don’t realize that in the S corporation setting, the health insurance premiums paid by the corporation must be included in a W-2.
[vi] See I.R.C. § 162(l)(5)(A), which provides that a 2% shareholders wages are treated as “earned income” for purposes of I.R.C. § 401(c), which qualifies them for the self-employed health insurance deduction.

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