Content by Jim Duffy

Generally, the tax consequences to a debtor of debt cancellation depend in large part upon whether the debt is recourse or non-recourse debt. Non-recourse debt is debt where the lender has no recourse against the borrower, but its remedy for nonpayment is limited to property that has been pledged or mortgaged to secure the debt. By contrast, a lender making a recourse loan may have a security interest in property of the debtor, but will also have the ability to seek repayment from the debtor to the extent that the property securing the loan is not adequate for full repayment.

The tax consequences of cancellation of debt are generally as follows. For recourse debt if the lender forecloses (or the debtor gives a deed in lieu of foreclosure), the debtor (i) will have capital gain to the extent that the value of the property transferred to the lender exceeds the debtor’s tax basis in that property and (ii) will have ordinary income (“COD income”) to the extent that the amount of the canceled debt exceeds the value of the property transferred. By contrast, with respect to non-recourse debt, upon the transfer of the collateral to the lender, the debtor will have capital gain equal to the excess of the amount of debt forgiven over the lender’s tax basis in the property. The debtor does not have any COD income in that case even if the value of the collateral is less than the outstanding debt.

Whether a creditor’s security interest in collateral is perfected on either a recourse loan or a non-recourse loan does not affect the foregoing tax treatment of loan cancellation. The significance of perfection of a security interest is that it determines the priority of that security interest vis the other creditors. It does not affect the tax consequences of foreclosure or cancellation.

Bottom Line: If a lender forecloses on an unperfected security interest in collateral, the tax consequences will be the same as foreclosing on a perfected security interest.

Ebenezer Scrooge: Let us deal with the eviction notices for tomorrow, Mr. Cratchit.
Kermit the Frog: Uh, tomorrow’s Christmas, sir.
Ebenezer Scrooge: Very well. You may gift wrap them.” – A Muppet Christmas Carol

In a prior installment of Did You Know, I described the benefits of Section 1202 stock. That section of the Internal Revenue Code allows taxpayers to exclude gain on the sale of qualifying stock from their taxable income in an amount equal to the greater of $10 million or 10 times their tax basis in the stock sold. A strategy known as “stacking“ may allow you to multiply the benefits of the $10 million gain exclusion.

Stacking refers to the practice of making a gift of Section 1202 stock either directly or through a non-grantor trust. Since the $10 million exclusion limitation is a per taxpayer limitation, by transferring a portion of the stock to another person, that recipient can effectively stack his or her $10 million exclusion on the exclusion of the transferor. So for example, if an individual holding Section 1202 stock worth $20 million made a gift of half of that stock to a relative, that relative could exclude up to $10 million of gain from income on the sale of that stock. This is in addition to the $10 million of gain that could be excluded by the original owner on the stock that they retained.

Obviously, such a gift could have significant estate and gift tax consequences that need to be taken into account. Ideally, the stock would be gifted at a time when the value was much lower. Navigating the income and estate tax consequences of stacking needs to be carefully considered.

Bottom Line: Gifts of Section 1202 stock may enable a shareholder to multiply the benefits of the $10 million exclusion of gain on the sale of Section 1202 stock

“Criticism is the best sign you’re onto something.” – Michael Loppt

Content by Jim Duffy

As you may be aware, when a corporation files an election to be taxed as an S corporation, all of the shareholders must consent to that election. If you live in a community property state, your spouse may be an owner in the corporation, even if he or she does not actually own any stock by name. The income tax regulations provide that when a stock of corporation is owned by a husband and wife as community property, both persons must consent to the election.

Arizona, California, Idaho, Louisiana, Nevada, New Mexico, Puerto Rico, Texas, Washington, and Wisconsin are community property states. In those states, property acquired by a spouse during marriage or with marital assets is treated as owned by both spouses. In that situation, your spouse must consent to the election in order for it to be valid. As one might expect, this could be an easy thing to miss.

Fortunately, the Treasury has provided a process to obtain automatic relief for failures to obtain spousal consent in these circumstances. In order to obtain this relief, the corporation must file a statement with the service center where it files its income tax return to the effect that it is seeking relief for late filing of the shareholder consent and stating that the community property spouses have reported all items of income, gain and loss consistent with the S corporation election.

Bottom Line: If you live in a community property state, remember to have your spouse consent to the S election even if he or she is not a shareholder in name. If you forget, however, there is an easy fix.

“If I had asked people what they wanted, they would have said faster horses.”- Henry Ford

Content by Dave Bartoletti, Jim Duffy and Nathan Hagerman

As you may be aware, the Supreme Court decision in South Dakota v. Wayfair in 2018 substantially expanded the ability of states to require out-of-state sellers to collect and remit sales tax on sales into that state. Many companies that make sales into multiple states have found it challenging to maintain compliance with the sales tax requirements for all of the states into which they make sales. These liabilities have taken on substantially increased significance in the negotiation of M&A transactions.

Potential noncompliance with obligations to collect sales tax are commonly discovered in the due diligence process in an acquisition transaction. A seller, believing that it has complied with its sales tax obligations, may be prepared to represent to the buyer that it had collected and paid all required sales tax. When potential noncompliance is uncovered in due diligence, the failure to collect and remit sales tax and file sales tax returns becomes a “known issue” and generally will not be covered by representations and warranties (“R&W”) insurance.

Often times a buyer will wish to pursue a voluntary disclosure action with a state where exposure is identified in order to settle any potential legacy sales tax liabilities and avoid worsening exposure. Predictably, buyers will expect the seller to indemnify it for any such pre-transaction tax liabilities. In addition, buyers may demand that an amount equal to the projected tax liabilities be withheld from the purchase price and placed in escrow pending resolution. Such buyer proposed escrow amounts will invariably represent a worst-case scenario and be extremely unpalatable to the seller.

While a known tax issue will likely not be covered by R&W insurance, a seller may be able to acquire tax insurance against that known tax issue when the tax liability is uncertain (and thereby avoid having to escrow or holdback sales proceeds to cover potential tax exposure). For example, tax insurance may bridge the negotiation gap between the parties in a situation where the buyer views a transaction as taxable for sales tax purposes while the seller maintains the transaction is exempt from sales tax. If the seller can reasonably support its argument with support from its third-party tax advisors, the tax position may be ripe for tax insurance coverage. The cost of this insurance varies based on perceived risk of liability, but typically equals a single-digit fraction of the potential liability.

Bottom Line: Be aware that R&W insurance is unlikely to cover a known issue for unpaid sales taxes uncovered during M&A due diligence; however, where the parties have identified an issue but disagree as to the proper tax treatment of that issue, tax insurance may provide an avenue for sellers seeking to limit escrows or holdbacks.

“The early bird might get the worm, but the second mouse gets the cheese.” – Steven Wright

You can if it’s qualified small business stock (a.k.a. “1202 stock“) that you have held for at least six months. Section 1202 stock is stock in a qualified small business corporation (“QSBC”) that is acquired at original issuance. A QSBC is a C corporation that conducts a “qualified business” (e.g., no legal or medical services businesses, no finance, etc.), the gross assets of which are $50 million or less. For stock acquired after September 27, 2010, that is held for 5 years, the gain from the sale is excluded from a non-corporate owner’s taxable income up to the greater of $10 million or 10 times their tax basis in the stock. With the reduction in corporate income tax rates in 2017, conducting business through a C corporation that qualifies as a qualified small business has gained popularity. But what if you have not held the stock for five years and you have an opportunity to sell?

If you have held the stock for at least 6 months, then under Section 1045 you can defer the gain on the sale if you “rollover” (i.e., reinvest) the sale proceeds into other 1202 stock. You could invest in a start-up QSBC, an existing QSBC or multiple QSBCs and you do not need to reinvest all the sale proceeds to qualify for the tax-free roll over. Stockholders can include the period of time that they held the stock they sell in their holding period of the new 1202 stock for purposes of determining whether they meet the 5-year holding period. There is no limit to the number of times that you can rollover the gain. This deferral for reinvesting in 1202 stock is effective even if you do not ultimately hold the stock for 5 years and end up selling in a taxable sale. Any election to rollover gain under Section 1045 should be reflected on the taxpayer’s IRS Form 8949 for the tax year in which the rollover is made.

The tricky part is that the reinvestment must be made within 60 days. That can be a particularly challenging timeline. Unfortunately, you cannot get around this with an installment sale because the 60 days runs from the date of sale not the receipt of payment. Executing an exchange on this short timeline will require some advanced planning.

Bottom Line: Even if you have not held your qualified small business stock for 5 years, you have an opportunity to defer the gain on sale by reinvesting it in another qualified small business.

“You must pay taxes. But there’s no law that says you gotta leave a tip.” Morgan Stanley

The sale of a C corporation business that is structured as an asset sale is subject to two levels of tax. There is a tax on the corporation (21% federal) and a tax on the shareholders when the sales proceeds are distributed (20% federal). By comparison, on a sale of stock, a shareholder is only subject to a tax of 20% (federal).

In some cases (admittedly not common), the goodwill of a business may be more appropriately treated as owned by a shareholder rather than the corporation itself which is known as personal goodwill. For instance, if the portion of the asset purchase price attributable to goodwill is $2 million but $1 million is personal goodwill of a shareholder and purchased directly from her, she would save $210,000 of federal income tax.

Generally speaking, personal goodwill exists when the success of the business of a corporation is attributable in substantial part to the reputation or the relationships of one or more persons (e.g., an owner/employee) and the owner has not effectively transferred the goodwill to the company by entering into a noncompete or employment agreement that prevents them from using their reputation or relationships to compete with the company. While the IRS has acknowledged the principle of personal goodwill, it will closely scrutinize it if audited so careful planning is advisable.

The shareholder should be prepared to demonstrate, that the success of the company is in fact dependent on his or her reputation or relationships. It is advisable to obtain a third-party determination of the value of the personal goodwill at or prior to the sale. The documentation for the acquisition should clearly reflect that consideration is being paid to the shareholder for their personal goodwill and the seller should enter a consulting or employment agreement with the buyer.

Bottom Line: When the facts are right, the sale of personal goodwill may be an opportunity to save a substantial amount of tax in a C corporation asset sale.

“The only difference between death and taxes is that death doesn’t get worse every time Congress meets.” – Will Rogers

Content by Ivan H. Golden (Chicago)

Many businesses operate as S corporations because of the tax benefits they offer – namely, the ability to avoid corporate tax on the business’ earnings.

Unlike C corporations, S corporations do not pay income tax; instead, profits (and losses) are passed through to owners, who pay tax on the corporation’s earnings on their individual income tax returns. The ability to lawfully avoid corporate income tax often results in a lower overall tax burden for business owners.

But S corporation benefits come with a set of rigid rules: S corporations cannot have more than 100 shareholders; cannot have as a shareholder a person other than an individual (and certain estates and trusts); cannot have a foreign shareholder; and cannot have more than one class of stock. It was this last requirement that was at issue in Maggard v. Commissioner, a recent Tax Court case.

The facts in Maggard were outrageous: the taxpayer, James Maggard, sold a 60% interest in his S corporation to two individuals, who promptly looted the company by making large, unauthorized distributions to themselves. Over a three-year period, Maggard estimated the two new shareholders distributed more than $1 million to themselves, while Maggard – still a 40% shareholder – received nothing. The new shareholders also froze Maggard out of corporate meetings and information, including even the basic information he needed to prepare his income tax returns.

Beginning in 2014, Maggard reported no income or losses from his interest in the corporation. The IRS determined, however, that he had income from the corporation despite receiving no distributions. When the dispute reached the Tax Court, Maggard argued the other shareholders’ unequal distributions amounted to a second class of stock that terminated the corporation’s S election.

The Tax Court disagreed. While expressing sympathy for Maggard, the Court observed that whether an S corporation has more than one class of stock is determined by the corporation’s governing documents, such as its charter, articles of incorporation, bylaws, and the like. According to the Tax Court, the fact an S corporation actually makes unequal distributions does not necessarily create a second class of stock.

Bottom Line: Although the Tax Court’s decision was unfortunate for Maggard, who was forced to pay income tax on money he never received, the Court’s decision was, in many respects, a taxpayer-friendly result because it confirmed that an S corporation that makes unequal distributions, whether accidentally or on purpose, will not lose its subchapter S status, so long as the corporation’s governing documents do not create a second class of stock.

“Next to being shot at and missed, nothing is really quite as satisfying as an income tax refund.” – F.J. Raymond

Content by Dimitrios Lalos (Minneapolis) and Nathan Hagerman (Indianapolis)

Effective July 1st, Minnesota instituted new Retail Delivery Fee obligations for sellers of product delivered into Minnesota to raise revenue for infrastructure and road improvements. Sellers with $1 million or more in retail sales must collect and remit to the Minnesota Department of Revenue, or pay themselves, a new Retail Delivery Fee of fifty cents per transaction that equals or exceeds $100 (before application of sales and use taxes) of taxable products delivered to Minnesota customers.

Taxable items include tangible personal property sales subject to Minnesota sales tax, including clothing, but excluding certain listed exempt items.  Exempt items include drugs; medical devices, accessories, and supplies; food, food ingredients, or prepared food; and specific baby care products. Exempt transactions include sales by sellers with retail sales totaling less than $1 million, sales to purchasers exempt for general Minnesota sales and use tax purposes; deliveries in qualifying motor vehicles with a permit issued by the Minnesota Commissioner of Transportation.

The Retail Delivery Fee is imposed once per transaction no matter how many shipments necessary to deliver the items or of the number of items bought. It does not apply to customer pickups at the retailer’s place of business – including curbside deliveries. Special considerations may apply to items delivered into Minnesota via drop shipment and items sold by construction contractors.

Retailers electing to charge the Retail Delivery Fee to customers must separately state the charge as a separate line item on the receipt labeled “Road Improvement and Food Delivery Fee.” Retailers that do not charge the Retail Delivery Fee to customers must report and remit the fee themselves. The Retail Delivery Fee is reported on seller’s Minnesota periodic sales tax returns. 

Bottom Line: Retailers selling products to Minnesota customers should analyze their Minnesota sales transactions for new Retail Delivery Fee obligations.

“When things are going sweetly and peacefully, please pause a moment, and then say out loud, ‘If this isn’t nice, what is?’”— Kurt Vonnegut

When a company sees its stock value drop, this can result in employees holding options that are “underwater“ or “out of the money“. This can significantly undermine the intended incentive effect desired by the employer in issuing the option.  For these reasons, employers might consider whether to reduce the exercise price on outstanding awards to equal the current market value of the stock, a.k.a. option repricing.

While there are various business impacts of repricing that will need to be considered, the good news is that repricing will not trigger a taxable event for either the employer or the employee.  Option repricing can be implemented in several ways, including amending the existing option, canceling outstanding options and issuing new options, or exchanging new options for old options.  Repricing regardless of the form of the transaction is treated as a grant of a new option for tax purposes.

There are a few potential issues employers will want to keep in mind. The first is to ensure that the new exercise price is not less than the fair market value of the stock as of the effective date of the repriced option so that the option remains exempt from Section 409A.  Second, since repricing is treated as a new option grant, the repricing will start a new holding period for incentive stock options (ISO’s).  Employers also should be mindful of whether the repricing could result in the aggregate ISOs that are exercisable for the first time in any year will exceed the $100,000 limitation.

Bottom Line: Re-pricing options can be a non-taxable way to reinvigorate the incentive of underwater compensatory options.

Money isn’t the most important thing in life, but it’s reasonably close to oxygen on the “gotta have it” scale. ~Zig Ziglar

Oftentimes when a partnership plans to sell real estate, some partners want to cash out while other want to roll over into other real estate tax-free.  The challenge is that if the partnership receives cash in part to pay to the partners cashing out, then all the partners would be taxed on their percentage of that cash. 

As discussed in a prior “Did You Know,” one way to do address this is through a “drop and swap.”  Another alternative is to use a partnership installment note (“PIN”) transaction.  In a PIN transaction, the partnership sells its property to a buyer in exchange for cash (which a qualified intermediary will use to buy replacement property) and an installment note in the amount necessary to cash out the departing partners. The note could provide for payment of most of the note shortly after the sale and a small payment shortly after the end of the year.  The partnership then transfers the note to the departing partners in complete redemption of their partnership interests.

As long as at least one payment under the note is due after the end of the tax year, the gain on the note will be taxed only when the payments are received.  As a result, neither receipt nor distribution of the note by the partnership triggers tax to the partnership or the partner. The partner is taxed when he or she receives the payments from the buyer.  (Note this strategy can result in a portion of the departing partner’s gain being taxed at a 25% rate rather than 20% rate.)

Bottom Line: When some partners want to cash out while others want to defer tax, a PIN transaction may be the answer.  It may be a particularly effective solution when distribution of an interest in the property would violate loan covenants.

Intaxication: Euphoria at getting a refund from the IRS, which lasts until you realize it was your money to start with. ~From a Washington Post word contest