Let’s say in 2011, your accountant suggested it might be good to elect S Corporation treatment for your business which has been a C corporation for 5 years. You’ve got the hottest bar in town. Its worth $1 Million and you only invested $100,000 which is fully depreciated, but there are good years and bad years and you like the fact that you can deduct losses and avoid double taxation of income by using S. Fast forward to 2015. Porky comes by and wants to buy your name, assets. He’s offering $1.2 Million. You are so excited. Selling these assets would yield a gain at capital gains rates what could be better. Then you talk to your tax lawyer. He says wait. Under Section 1374 of the Internal Revenue Code there is a built in gains tax that looks back 10 years. Thus, if at the time of your S Election in 2011, your business was worth $1 Million, it must recognize that $1 Million at ordinary corporate rates. Thus, instead of the tax being $250,000 on the gain it is $565,000 give or take. A huge difference.
Category Archives: income tax
SPIN OFFS
Suppose you own a corporation MYTABLES, Inc. that manufactures tables. Your company has an opportunity to go into the desk market, but wants to limit its exposure. So, it sets up a subsidiary, DESKO, LTD. MYTABLES, INC., owns all of the stock of DESKO. People love the desks. The Company needs capital to hire more people to make desks. The owners go on the Barracuda Tank and Cube Markan offers to give $1 Million for 18% of the Company, but wants DESKO separated from MYTABLES. So, how do you separate out DESKO from MYTABLES. Under Section 355 of the IRS Code you can do what is known as a spin-off and so long as the DESKO has a different line of business from MYTABLES (they do) and so long as the shareholders of MYTABLES still own 80% of the stock of DESKO, then you can spin off, so long as DESKO and MYTABLES continue in business. There are lots of technical rules under Section 355, but that is the gist of it.
New Tax Act passed
I’ve been waiting on Congress to do its job and finally some legislation has come through. There is something in the new Tax Act for everyone.
First, the highlights:
The tax benefits of the 2001, 2003 Tax Acts were extended for two years. This means that the tax rates for 2010 will hold for two more years including on capital gains. With regard to Alternative Minimum Taxes, the relief is in the Act. So, there will not be a jump in people affected by AMT next year.
With regard to Estate and Gift Taxes two huge changes.
(1) Reunification of Gift and Estate tax exemptions. Since 2001, gift tax exemption was capped at $1 Million. Now it will be the same as the estate tax exemption of $5 Million.
(2) Estate tax unified credit increased to $5 Million for years beginning in 2011. There is also a retroactive election for 2010 relating to step-up in basis. If the estate is under $5 Million, it would appear that the one can elect to step-up the basis of the assets. If its above $5 Million we’ll need to assess your personal situation to decide whether you want to pay estate tax to get a step-up in basis. The rate will stay at the current 35% rate for estates over $5 Million. There is also portability for married couples. This means that if one spouse dies after December 31, 2010 and the other dies later and the first spouse used up $3 Million of his or her credit amount, the second spouse can take up to $7 Million of the first spouse’s unused credit. Given the limited period of this law, it might be wise to look at gifts, although there is a basis trade-off if that occurs. Either way, its a huge change in the law.
These changes are only for two years. So, after December 31, 2012, the exemption amount falls back to $1 Million and estate tax rate to 55%.
With regard to the 2% payroll tax holiday for 2011, it also applies to self-employed individuals.
Energy Efficient Home Credit is extended to through 2011. Energy efficient appliances credit is extended through 2011 as well. Credits for windows, wood stoves, water heaters will continue.
Deductions for school teachers shall be continued through 2011. Sales tax deduction continued through 2012. Tax free distributions to charities from retirement plans extended through 2011.
Lots of continuation of popular business credits, research credit, and other industry specific credits.
The verdict
“It means that on the $50 Million of negative capital account you owe ordinary income taxes at your rate. Since this is 2011, you owe them at 39.5%. That translated into $19.75 Million. You also owe capital gains taxes, that translates into $20 Million dollars. You also owe state taxes that translates into $8 Million. So that’s $48 Million dollars. Subtract out the debt of $50 Million. That leaves untaxed $52 Million to be divided among your family members. The family trust gets the entire $52 Million. That means that you won’t see the money until your momma dies. And then you have to divide what’s left among your siblings.” “Oh, that’s pretty bleak” said Delicious.
The story
“Well”, said Snotnose, “you see, your father had a negative capital account in those real estate partnerships. That means that he took losses greater than what he contributed into the partnership. Further his carry-over losses were lost when he died. Because you did not receive a basis increase at his death due to Section 1022, you recognize ordinary income to the extent of his negative capital account.” “How much is that? asked Delicious. “About $50 Million. The rest is capital gain. But of course there is debt on the property of $50 Million” said the lawyer. “So what does all that mean?” asked Delicious