Tag: Tax

Why Tax Reform Will Not Happen Soon

Posted on by Liam Mennitt

Corporations have been stockpiling cash awaiting promised tax reform. Enterprises have delayed capital investment, hiring, and cash allocation in anticipation of promised tax features such as lower rates. In February of 2017, the Secretary of the Treasury promised comprehensive tax reform before the August recess.

Because tax reform along the lines or scale articulated by some in government to date seems unlikely, I encourage businesses to consider deploying their capital more profitably than holding it in reserve.

I reviewed the circumstances generally present in the environments of each of the last eight significant tax reform acts. I found three factors present in the majority of them and offer here my view of why their presence then, and their absence now, bodes poorly for sweeping tax reform.

  1. Lobbyists need to be kept at a distance or soundly aligned with the reform goals. Thus far, Congress has led with its chin by pushing such things as the Border Adjustment Tax and lower corporate tax rates. Now, K Street is already fully immersed in the process, either for or against. Neither required element of “Fair” or “Simple” is any longer possible.
  2. A government more or less evenly divided, as it was in 1986, is essential so that no one party has to suffer the fallout from substantial tax reform. Division is considered not just by party within the legislative branch, but also as between the Houses of Congress and the president. See the chart below for an illustration of how this has shaped up in years when tax reform has passed. Also, recall that within 20 years after TRA 1986, over 15,000 changes to the tax law, most incrementally rolling back the changes, had already been made.
  3. Revenue neutrality is a necessarily stated goal of tax reform. In 1986, Representatives took turns at the podium declaring their support for a bill that neither raised nor lowered government revenues. With a current budget deficit of about $440 billion, a tax gap of about $410 billion, and the largest income polarization in history, it’s going to be a tough sell to offer revenue neutrality. Without it, there can be no meaningful tax reform.

Given that none of the factors that have been historically required to accomplish sweeping tax reform are now present, I suspect we will not see it this year or in 2018.

This memo is intended only as an illustration of general principles. It is not intended as legal or tax advice. The reader is cautioned to discuss his or her specific circumstances with a qualified practitioner before taking any action.

Tax Changes for Employees Donating Leave time to Harvey Victims

Posted on by Liam Mennitt

In Notice 2017-48, released on September 5, 2017, the IRS announced that employees who donate vacation, sick, or personal leave in exchange for employer contributions to charitable organizations providing relief to victims of Hurricane/Tropical Storm Harvey will not be taxed on the value of that times as income. Also, employers may deduct the amounts so donated as business expenses.

This Notice is important because it represents a suspension of the normal constructive receipt rules of taxation. Ordinarily, when an employee earns income and has the right to receive such income, he or she is subject to tax on it, even if the employee instructs the employer to give the money, instead, to some other person. The IRS has provided such suspension of the rules before, such as in the cases of Hurricane Sandy (Notice 2012-69) and Hurricane Matthew (Notice 2016-69).

The IRS has now advised it will not assert the constructive receipt doctrine over such leave donations and associated payments so long as the payments are:

  1. Paid to Code Section 170(c) charitable organizations. These are, generally, the organizations often referred to under Section 501(c)(3) of the Code;
  2. For the relief of Hurricane Harvey victims; and
  3. Paid to such organizations before January 1, 2019.

Employees who participate in a leave sharing program, sometimes called a leave “bank,” where the foregone leave is excluded from compensation for tax purposes, will not be able to claim a charitable deduction for contribution of value from such a bank.

As for employers, the IRS states in the Notice that it will allow them to treat donations from leave sharing programs as business expense under Section 162 of the Code rather than as charitable contributions under Section 170. This will allow employers donating value from leave banks to deduct that value without being subject to the several limitations on charitable contributions under Section 170.

The record keeping and reporting rules are also amended in this circumstance. Amounts representing leave sharing donations need not be included in Box 1 (wages, tips, other compensation), Box 3 (Social Security wages, as applicable), or Box 5 (Medicare wages and tips) of Form W-2.

In short, these amounts will be free from income and payroll tax withholding.

This Notice provides relief for both itemizing and non-itemizing taxpayers. A non-itemizing taxpayer who donates $2,000 worth of leave time would be able to take a deduction for $2,000. The same taxpayer would not receive the same tax benefit if he or she had taken the leave and contributed $2,000 in cash to the charity. As well, the reduction in AGI through application of the Notice provisions can make it possible for a participating employee to access a greater tax benefit among the various deductions and credits which decrease as AGI goes up. For example, a participant might be able to take a larger deduction for a contribution to a traditional IRA. On the other hand, participation in donation of leave time could yield a lower retirement plan contribution, if the employer’s plan defines wages to include the donated level and character of donated leave.

 

This memo is intended only as an illustration of general principles and is not legal or tax advice. The reader is cautioned to discuss his or her specific circumstances with a qualified professional before taking any action. In some jurisdictions, this memo may be attorney advertising.

Initial Coin Offerings and the Securities Environment

Posted on by Liam Mennitt

A new financial instrument is arising in the capital markets and it provides both benefits and challenges to the equity environment. Variously denominated as initial coin offerings, crowdsales, token launches, and crowdfunding, this mechanism, rather than offering equity in a start-up venture, offers discounts on cryptocurrencies before they become available on the several exchanges.

Such offerings are made into a fraught landscape where they risk being interpreted as securities offerings that are subject to regulation, oversight, and enforcement by the Securities Exchange Commission. While the innovative characteristics of digital currency ought be encouraged, the SEC may, for reasons I explore in this note, be inclined to bring this device within their purview.

ICOs generally hold their offerings to be outside the conventional definition of securities and, so, outside the legal framework applicable to securities. Nevertheless, there is an expressed sense in the marketplace that government regulation of cryptocurrency will be necessary for the mechanism to be fully utilized.

This paper will review briefly two reasons that U.S. law will likely conclude that cryptocurrency is a security subject to the American regulatory scheme, First, I argue that the offerings made via ICOs are in effect, if not name, securities subject to the associated law. Second, I present my view that the Securities Exchange Commission is likely to find it to be in the public interest to conclude that digital currencies should be characterized as securities.

  1.     The Offering of Digital Currencies by Companies Seeking to Raise Capital Fits the Legal

Construct of a Security

The law defining securities, for purposes of federal regulation, has evolved in considerable nuance and complexity. The Securities Act of 1933 rather quaintly defines a “security” as

any note, stock, treasury stock, security future, security-based swap, bond, debenture, evidence of indebtedness, certificate of interest or participation in any profit-sharing agreement, collateral-trust certificate, preorganization certificate or subscription, transferable share, investment contract, voting-trust certificate, certificate of deposit for a security, fractional undivided interest in oil, gas, or other mineral rights, any put, call, straddle, option, or privilege on any security, certificate of deposit, or group or index of securities (including any interest therein or based on the value thereof), or any put, call, straddle, option, or privilege entered into on a national securities exchange relating to foreign currency, or, in general, any interest or instrument commonly known as a “security,” or any certificate of interest or participation in, temporary or interim certificate for, receipt for, guarantee of, or warrant or right to subscribe to or purchase, any of the foregoing.

The Securities Exchange Act of 1934 uses a somewhat similar definition.

Section 5 of the Securities Act makes it unlawful to offer or sell any security unless a registration statements is in effect for that security or there is an exemption from registration available. That section also requires the use of a statutorily prescribed prospectus document.

Finance is, in the practice, much more intricate than the plain language of the statutes appears to acknowledge, and, so, the courts have articulated considerable law particular to a wide range of circumstances encountered in application an in an evolving industry. Controlling these interpretations is the Supreme Court case SEC v. W.J. Howey Co. That case articulated both the priority of substance over form in evaluating whether a device is a security, as well as a test consisting of four distinct elements:

The first Howey test looks for an investment of money into some enterprise. Court cases has since broadened that notion to include any form of consideration;

Such an investment must be made into a common enterprise. Court rulings have articulated both “horizontal commonality” and “vertical commonality.”

Horizontal commonality describes the pooling of value from several investors who share in the profits and risks. Most circuits that have considered the issue of what is a common enterprise find it satisfied where a movant shows horizontal commonality, that is the pooling of investors’ funds as a result of which the individual investors share all the risks and benefits of the business enterprise] These circuits focus on whether the scheme involves a “pooling” of assets. For the common enterprise test to be satisfied, horizontal commonality requires that an investor’s assets be joined with another investor’s assets into a joint venture where each investor shares the risk of profit and loss according to their individual investment.

Vertical commonality is split into “Narrow” verticality and “Broad” verticality.

  1. The narrow vertical view is held by the Ninth Circuit. The narrow vertical approach finds a common enterprise if there is a correlation between the fortunes of an investor and a promoter. Under narrow vertical commonality a common enterprise is a venture in which the fortunes of the investor are connected with and dependent upon the efforts and success of those seeking the investment. It is not necessary that the funds of investors are pooled; what must be shown is that the fortunes of the investors are linked with those of the promoters, thereby establishing the requisite element of vertical commonality. Thus, a common enterprise exists if a direct correlation has been established between success or failure of the promoter’s efforts and success or failure of the investment. Under this view, the test is satisfied if the promoter and the investor are both exposed to risk and the profits and losses of investor and promoter are correlated.
  2.   The broad verticality test finds a common enterprise if the success of an investor depends on a promoter’s expertise. “Broad vertical commonality … only requires a movant to show that the investors are dependent upon the expertise or efforts of the investment promoter for their returns.” The Fifth Circuit and the Eleventh Circuit (because of the Eleventh Circuit’s adoption of pre-split Fifth Circuit opinions) both follow this view. These courts focus on the expertise of the promoter in the industry of the alleged security. If the investor relies on the promoter’s expertise, then the transaction or scheme represents a common enterprise and satisfies the second prong of the Howey test.

The third prong of the Howey test requires an expectation of profits. Profits can be in the form of a cash return on the principal investment, capital appreciation, dividends, interest, or other earnings. For purposes of the Howey test, “profits” mean return to the investor, and not to the success of the enterprise. For example, a Ponzi scheme has no possibility of real prosperity, but certainly involves a security. This test looks to the motivation of the investor.

The fourth test in Howey calls for the expectation of profits to be derived solely from the efforts of the promoter or some third party. The efforts of the promoter or third party must have a clear role in the success or failure of the enterprise.

We can examine just what it is that ICOs are offering by reviewing their descriptive so-called “White Papers” which offer the promoters’ outlines of the business model and goals of the enterprises. I have reviewed dozens of such white papers and find these elements in common among them:

-A description of the rapid growth presently occurring in the market space the enterprise proposes to enter

-A description of the unique value proposition the enterprise claims to possess (generally using rhetoric focused on results, rather than specific methods and always couched in highly technical language

-Many falsely claim their descriptive language or process is trademarked or otherwise lawfully protected from cooption

-In return for the solicited investment, the promotions offer early or discounted access to some form of digital currency, sometimes the promoter’s own brand of such digital currency

-A vague growth model is postulated, based on such things as “activity” within the proposed business ecosystem, transaction fees derived from cyptocurrency trades, or growth of other users’ participation in the system itself

-Investment in the offering is virtually always through some existing digital currency or, in some cases, precious metals, such as gold

I found no ICO White Paper that did not articulate, or at least imply, satisfaction of all four of the Howey tests for a security. Most satisfied both the horizontal and both vertical tests for a common enterprise. Often, the efforts by promoters to avoid using language they might have considered admissions of Howey criteria worked to render the rhetoric of those white papers cumbersome and incomplete.

In short, the promoters of ICOs conspicuously promote their own skills, insight, and claims to exclusive intellectual property as the value drivers of the enterprise upon which their respective enterprises will generate returns to investors, whose pooled investments are sought to capitalize the business. While nearly all of the white papers I reviewed were cautious to avoid references to specific return values or rates investors might expect, without exception, they all make repeated mentions of “profits” or some synonym thereof By either direct evidence, or by implication, then, these ICO white papers describe “securities” that meet the Howey tests.

  1.     The Digital Currency Market Space Exhibits Characteristics Which May Make it a Good

Subject of Regulation

The statutory authority to regulate these offerings aside, the SEC has an imperative to examine them in detail. Indeed, the SEC has, on more than one occasion, suggested that digital offerings are securities.

At least two other U.S. supervisory entities have articulated their views that digital currencies are subject, to varying extents, regulatory oversight.

The Commodities Futures Trading Commission has designated bitcoin as a commodity, subjecting it to the CFTC’s trading rules. As well, the IRS has characterized cryptocurrency as “property” and not “currency,” thereby disqualifying it for treatment with exchange gain or loss under Reg. §1.988-2.

The argument that the marketplace will serve to govern itself in this sector is somewhat belied by the fact that the marketplace in Bitcoin does not operate with an even hand.

As shown in Figure 1, the volatility of the conversion price of the pairs of Bitcoin/U.S. Dollar and Bitcoin/China Yuan has been growing at a faster rate for the Yuan than for the Dollar, especially since April of 2017. This has created a structural opportunity for arbitrage and can leave investors subject to unregulated speculation in cryptocurrency. Given that bitcoin and similar devices trade anonymously, the opportunity to generate large profits, outside the purview of the tax authorities, could, no doubt, attract any number of participants with obscure intent to the marketplace.

The attraction of a market so apparently open to manipulation by substantial participants may also be worth consideration.

CT’s New Limited Liability Act: New & Existing Operating Agreements Should be Reviewed for Compliance

Posted on by Liam Mennitt

Connecticut’s new Liability Company Act takes effect on July 1, 2017. It introduces numerous changes to Connecticut law and imposes several new requirements on LLCs and their members and managers. Of immediate importance to many LLCs are the several changes that the new law requires to existing operating agreements. This note will review some of those required changes.

While the new law was written to limit the impact it has on existing LLCs, it does require attention to every new and existing operating agreement so members and managers can be sure their agreements comply with the law and avail them of the opportunities within it.

At the outset, the new law changes the name of the initial LLC filing document from “Articles of Organization” to “Certificate of Organization.” The Act retroactively deems “Articles” filed under the old law to be a “Certificate” under the new law.

The new law also creates at least four statutory impositions which, if not suitably addressed by the operating agreement, control the LLC by new statutory requirements. Existing LLCs should immediately review their operating agreements (or the lack thereof) with an eye toward the effect of the new law.

One example of such impositions addresses admission of new members. Under the prior law, if the operating agreement was silent on the issue, the vote of a majority in interest was required to admit a new member. Under the new law, the default vote required is unanimity. If members want to retain the majority-in-interest vote for admission of new members, they must be sure the operating agreement affirmatively reflects this intent.

In a similar way, the old law required a two-thirds majority of votes in interest to amend the operating agreement. The new law now requires unanimous approval if the operating agreement is silent.

The new act describes in some detail the duty of care and level of loyalty required of members and managers. It also provides four areas in which the operating agreement may depart from these prescribed standards, so long as the departures are not “manifestly unreasonable.” The operating agreement may:

  • Alter or eliminate certain portions of the duty of loyalty
  • Identify specific behaviors that do not violate the duty of loyalty
  • Alter, but not eliminate, the duty of care
  • Alter, or eliminate, any other fiduciary duty

C.G.S. §34-243d(d)(3).

The notion of “manifestly unreasonable” will be refined by the courts over time. Pending that, it is imperative that LLCs preferring a less strict standard of loyalty or care for their members or managers, review and revise their operating agreements to so reflect.

It is also important to observe that the new law does not automatically recognize “sweat equity” as a valid metric for distributions. Rather, unless the operating agreement provides otherwise, the law now requires that distributions be based on their respective capital contributions rather than their percentage ownership. C.G.S. §34-255c(a). It is worth noting that federal partnership tax law has also changed to attribute losses differently under the new regulations under Section 707 of the Code.

C.G.S. §34-243d(d)(1)(B) allows for the operating agreement to provide for a more liberal definition of illiquidity than is provided by the default provision of §34-255d(a), which prohibits a LLC from making a distribution if any of the following tests for illiquidity are met: (1) The company would not be able to pay its debts as they become due in the ordinary course of the company’s activities and affairs; or (2) the company’s total assets would be less than the sum of its total liabilities plus the amount that would be needed, if the company were to be dissolved and wound up at the time of the distribution, to satisfy the preferential rights upon dissolution and winding-up of members and transferees whose preferential rights are superior to those of persons receiving the distribution.

If the members want to use the more liberal provision of § 34-243d(d)(1)(B), they may include in the operating agreement a provision that a lawful distribution requires only that the company’s total assets not be less than the sum of its total liabilities.

While the new law provides LLCs considerable discretion in formulating their operating agreements, it provides fourteen circumstances in which LLCs either may not override the statutes or limits their ability to do so.

C.G.S. §34-243d(c) now provides:

(c) An operating agreement may not:

(1) Vary the law applicable under section 34-243c;

(2) vary a limited liability company’s capacity under subsection (a) of section 34-243h, to sue and be sued in its own name;

(3) vary any requirement, procedure or other provision of sections 34-243 to 34-283d, inclusive, pertaining to: (A) Registered agents; or (B) the Secretary of the State, including provisions pertaining to records authorized or required to be delivered to the Secretary of the State for filing under sections 34-243 to 34-283d, inclusive;

(4) vary the provisions of section 34-247c [giving the Superior Court jurisdiction to compel signing, filing, or filing of unsigned records with the Secretary of the State]

(5) alter or eliminate the duty of loyalty or the duty of care, except as provided in subsection (d) of this section;

(6) eliminate the implied contractual obligation of good faith and fair dealing under subsection (d) of section 34-255h, except that the operating agreement may prescribe the standards, if not manifestly unreasonable, by which the performance of the obligation is to be measured;

(7) relieve or exonerate a person from liability for conduct involving bad faith, willful or intentional misconduct, or knowing violation of law;

(8) unreasonably restrict the duties and rights under section 34-255i [generally governing rights of members and managers, and rights for former members to information], except that the operating agreement may impose reasonable restrictions on the availability and use of information obtained under said section and may define appropriate remedies, including liquidated damages, for a breach of any reasonable restriction on use;

(9) vary the causes of dissolution specified in subdivisions (4) and (5) of subsection (a) of section 34-267 [which address the jurisdiction of the Superior Court to dissolve the LLC on application by a member for any of four reasons: i) The conduct of all or substantially all of the company’s activities and affairs is unlawful; ii) it is not reasonably practicable to carry on the company’s activities and affairs; iii) the managers have acted, are acting or will act in a manner that is illegal or fraudulent; or iv) the managers have acted or are acting in a manner that is oppressive and was, is, or will be directly harmful to the applicant]

(10) vary the requirement to wind up the company’s activities and affairs as specified in subsections (a) and (e) of section 34-267a  [articulating general and specific circumstances of the wind up of  certain LLCs] and subdivision (1) of subsection (b) of section 34-267a [describing duties of filing and debt payment for wound-up LLCs]

(11) unreasonably restrict the right of a member to maintain an action under sections 34-271 to 34-271e, inclusive;

(12) vary the provisions of section 34-271d [generally describing the duties and powers of a special litigation committee], except that the operating agreement may provide that the company may not have a special litigation committee;

(13) vary the required contents of a plan of merger under subsection (b) of section 34-279h or, a plan of interest exchange under section 34-279m; or

(14) except as provided in section 34-243e [assent to Operating Agreement] and subsection (b) of section 34-243f, [obligations of LLC and members to transferees] restrict the rights under sections 34-243 to 34-283d [addressing a broad range of rights and duties of LLCs, members, and managers], inclusive, of a person other than a member or manager.

Under the new act, an LLC operating agreement may not relieve a person from liability for conduct involving bad faith, intentional or willful misconduct, or a knowing violation of the law. C.G.S. §34-243d(c)(7). I note especially this change in law here because many existing operating agreements exempt members or managers from liability exempting from such exoneration only in cases of “fraud, gross negligence, or willful misconduct.” LLC members should review their operating agreements and reconcile their intended relief with the new statutory requirements, insofar as possible.

The new statute also addresses the rights of members to access and inspect LLC records.  In practice, we have seen access to records as a point of friction, often within LLCs experiencing dissent among members. The law now provides that an operating agreement may not impose unreasonable restrictions on access to information. It may, however, impose reasonable restrictions on the availability of use of the information. For example, the LLC may require the accessing member to execute and deliver a non-disclosure agreement. The operating agreement may also define particular remedies for breaches of reasonable restriction on the use of the information. C.G.S. §34-243d(c)(8).

While the new act explicitly articulates that “[i]t is the policy of the act to give maximum effect to the principles of freedom of contract and to enforceability of LLC agreements,” the limitations and restrictions it establishes demand careful attention to both existing and new operating agreements.

LLCs that have never had an operating agreement are not required by the new law to adopt one, but LLCs without a compliant agreement will now be subject to the default provisions of the law, whose effect may not be intended or desired by the members or managers.

This note is intended only to illustrate general principles and is not legal or tax advice. The reader should discuss his or her specific circumstances with a qualified practitioner before taking any action.

Dan M. Smolnik Presents at Annual Meeting of the Connecticut Bar Association

Posted on by Liam Mennitt

Pastore & Dailey is proud to announce that Dan M. Smolnik, Special Counsel at Pastore & Dailey, has been asked to present his views on recent developments in Tax Law at the June 12, 2017 Annual Meeting of the Connecticut Bar Association. Mr. Smolnik will be addressing two new developments:

  1. The new rules on self-employment tax affecting tiered partnerships; and
  2. The new rules regarding disguised sales and how these rules now affect a much broader array of transactions than before.

In particular, he expects the new disguised sales rules will affect virtually all partnerships going forward. Mr. Smolnik has practiced in the areas of tax, business transactions, and tax-exempt organizations for almost 30 years and has helped numerous organizations thrive while meeting their responsibilities and opportunities with tax and business law. He has extensive experience representing insurance companies, banks, and international corporations in tax, regulations and organizational law issues.

More information: Two New Tax Rules That Affects Partnerships, LLCs and Other Pass-through Entities (pdf) by Dan M. Smolnik

IRS Seeks Leave from Court to Serve Sweeping Summons on Bitcoin Exchange

Posted on by Liam Mennitt

In an ex parte Application for Leave to Serve John Doe Summonses dated November 17, 2016, the Internal Revenue Service requested of the United States District Court for the Northern District of California the authority to obtain the records of Coinbase, Inc. a bitcoin exchange located in San Francisco.

By its own terms, the request is speculative, relying on an undefined “likelihood” that the resulting summons will yield information identifying persons who have not properly filed or paid taxes due the United States. The only defined term upon which the request is based is IRS Notice 2014-21, which described the Services views on virtual currencies and offered the position that bitcoin (and similar devices) are not “currency” but, rather, are property under 26 U.S.C. §1221. Although the Notice reached this conclusion without analysis or authority, it is probably correct, at least for the moment. Only because bitcoins neither circulate nor are they customarily used and accepted as money in the country in which they are issued, they do not meet the definition of currency in the Bank Secrecy Act. 31 CFR 1010.100(m). Presumably, Treasury adopts this definition for tax purposes.

The request has alarmed the cryptocurrency community because it comes in the wake of absolutely nothing. No criminal case, claims of interviews with only three taxpayers who said they has used virtual currencies as a means of evading taxes, and not even a named suspect in the summons request. The report of the Treasury Inspector General for Tax Administration dated September 21, 2016 observes three critical issues:

  1. The IRS has no strategy concerning virtual currency;
  2. The Criminal Investigation unit of the IRS has undertaken no effort to inquire in matters concerning the improper reporting of bitcoin; and
  3. Notice 2014-21, so far the IRS’s only formal articulation of its position regarding bitcoin, characterizes bitcoin as property, not as currency, although the device is commonly accepted as currency by over 100 major organizations including Subway, Microsoft, Reddit, and Expedia. Many users of bitcoin are likely unaware of the Notice or uncertain of its arcane meaning.

Thus, for the IRS to use as its opening salvo into the matter of virtual currency what is described by its target as a “sweeping fishing expedition” gives every participant in a cutting edge technology pause to consider if the IRS should be able to leverage that enterprise to make up ground in its own investigative dilemmas. In short, should Coinbase become an involuntary source of data for the government absent more evidence supporting a wholesale compromise of the privacy of their customers’ information?

Preserving Loan Treatment of S Corporation Payments from Shareholders

Posted on by Liam Mennitt

The sense of control and informality of operations experienced by shareholders of S corporations is a robust bridge for entrepreneurs, providing them an accessible connection between their personal and work lives, without the constraints of a board of directors, awkward motions and resolutions, and the pesky documentation requirements attorneys seem to impose on entrepreneurs in some other forms of business.

Among the most prevalent and cherished characteristics of S corporations is the perception  by their owners that the income tax transparency of the S corporation translates into the interchangeability of the corporation with the shareholders for all tax purposes.

On August 24, 2016, the Tax Court filed a Memorandum decision providing a good review of the standards for characterization of transfers between shareholders and close corporations as either loans or capital contributions. Tax attorneys see, all too often, shareholders, partners and other principals receive large and unexpected tax bills, with penalties and interest added, resulting from incomplete or inaccurate application of the rules associated with capital contributions and loans to businesses they control. Virtually without exception, the taxpayer is caught by surprise.

In Scott Singer Installations, Inc., T.C. Memo 2016-161 (August 24, 2016), the sole shareholder and sole officer of an S corporation loaned over $1 million to his corporation over about a 5 year period. During the same period, the company paid the shareholder’s personal expenses by paying his creditors directly.

All of the cash advances by the shareholder were reported as shareholder loans on the corporation’s books of account and on the Form 1120S. There were, however, no promissory notes executed and no interest charged.  (A discussion of the correct way to calculate and document interest charges under the tax rules is beyond the scope of this article.)

The IRS audited the books and records of the corporation and concluded that the payment by the corporation of its shareholder’s expenses was taxable income to the shareholder, and, further, subject to employment withholding taxes. The IRS further concluded the advances made by the shareholder were contributions to capital. While such treatment would have the effect, among other things, of increasing the shareholder’s basis in the corporation, it would also generally render the repayments of the advances as return of capital, rather than debt repayment, and the interest portion would not be recognized for tax purposes.

With regard to the advances, the Tax Court weighed the factors associated in law to determine of there was a genuine intention to create a debt, with a reasonable expectation of repayment, and whether that intention was consistent with the economic reality of creating a debtor-creditor relationship. The court found the fact that the corporation consistently carried the advances as outstanding loans on its ledger. It further found that the consistency of the corporation’s payments expense payments for its shareholder, even when the corporation was losing money, supported the conclusion that such payments were debt service and not ordinary income.

The Tax Court’s discussion calls to mind the nonexclusive 13 part test typically used in evaluating the nature of transfers to closely held corporations:

  1. The names given to the documents that would be evidence of the purported loans;
  2. The presence or absence of a fixed maturity date;
  3. The likely source of repayment;
  4. The right to enforce payments;
  5. Participation in management as a result of the advances;
  6. Subordination of the purported loans to the loans of the corporation’s creditors;
  7. The intent of the parties;
  8. The capitalization of the corporation;
  9. The ability of the corporation to obtain financing from outside sources;
  10. Thinness of capital structure in relation to debt;
  11. Use to which the funds were put;
  12. The failure of the corporation to repay; and
  13. The risk involved in making the transfers. (Calumet Indus., Inc., (1990) 95 TC 25795 TC 257)

These tests are, of course, factual, and weighted differently in each case. Hence, it is incumbent on shareholders of S corporations to assure, through clear, written and contemporaneous documentation, consistently prepared and maintained, that the elements of the creditor-debtor relationship are demonstrated in cases where the shareholder is lending money to the corporation.

This article is not intended as legal or tax advice and is a discussion of general principles only. The reader should consult with a qualified professional concerning his or her specific circumstances before taking any action.

Dan Smolnik has Been Elected Director of Governmental Affairs for the League of Women Voters in Connecticut

Posted on by Liam Mennitt

Dan Smolnik has been elected Director of Governmental Affairs for the League of Women Voters in Connecticut. He will be handling issues associated with legislation,  governmental relationships with the State’s Constitutional officers, and official policy positions and testimony. Congratulations to Dan on this fine accomplishment.

 

New Tax Disclosure Requirements for Federal Contractors

Posted on by Liam Mennitt

You are receiving this notice because you are a client or friend of our practice who has a business or other professional interest in doing business with the United States Department of Defense, the General Services Administration or NASA.

On Friday, December 4, 2015, the federal government released an interim rule, effective February 26, 2016, prohibiting the Federal Government from entering into a contract with any corporation having a federal tax liability or a felony conviction under any federal law. The contracting agency is enabled by the interim rule to make exception if two requirement are met:

  1. The agency has considered suspension or debarment of the corporation; and
  2. The agency has made a determination that suspension or debarment of the corporation is not necessary to protect the interests of the government.

The rule requires that all offerors responding to federal solicitations make a representation as to whether the offeror is a corporation with a delinquent tax liability or felony conviction under federal law.

When an offeror indicates it is both a corporation and owes federal taxes or has a felony conviction, then the contracting officer is required to both request additional information from the offeror and notify the agency official responsible for initiating debarment or suspension action. At that point, the CO is disabled from awarding the contract to the offeror unless and until the agency had considered suspension or debarment and decided against it.

A federal tax delinquency is treated elsewhere in the FARs  as greater than $3500 and meeting both of the following conditions:

(i) The tax liability is finally determined. The liability is finally determined if it has been assessed. A liability is not finally determined if there is a pending administrative or judicial challenge. In the case of a judicial challenge to the liability, the liability is not finally determined until all judicial appeal rights have been exhausted.

(ii) The taxpayer is delinquent in making payment. A taxpayer is delinquent if the taxpayer has failed to pay the tax liability when full payment was due and required. A taxpayer is not delinquent in cases where enforced collection action is precluded.

See, FAR 52.209-5.

The new rule also includes a certification requirement for agencies entering into certain contracts worth over $5 million. Generally speaking, if a contract falls under the rule, the agency must receive certain tax certifications.

This rule is the distillation of the issues underlying the inquiries of Congress concerning federal contractors who do not pay their taxes.

If you are facing a federal contracting issue, review these new federal tax compliance requirements and consider the suspension or debarment exposures associated with the associated new disclosure requirements.

This note is intended as a general summary of legal principles and is not intended as legal or tax advice. You should discuss your specific circumstances with a qualified professional before taking an action.

Smolnik Appointed New Chair of Subcommittee by CT General Assembly

Posted on by Liam Mennitt

Dan Smolnik, Of Counsel with Pastore & Dailey LLC, has just been appointed by the Connecticut General Assembly to the Commission on Connecticut’s Leadership in Corporation & Business Law.  He will be chairing the subcommittee on tax law and policy.