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Friday, October 11, 2013 9 a.m.–4:15 p.m.

Oregon State Bar Center Tigard, Oregon

6 General CLE credits

Cosponsored by the Taxation Section

Broadbrush Taxation

Broadbrush Taxation ii

BrOadBruSh TaxaTiOn

SECTiOn PLannErS

Planning Chair: dan Eller, Schwabe Williamson & Wyatt PC, PortlandJeremy Babener, Lane Powell PC, Portlandryan r. nisle, Miller Nash LLP, Portland

Barbara Jo Smith, Heltzel Williams Law Firm, Salem

OrEGOn STaTE Bar TaxaTiOn SECTiOn ExECuTiVE COMMiTTEE

Robert T. Manicke, ChairJeffrey S. Tarr, Chair-Elect

Neil D. Kimmelfield, Past ChairBarbara J. Smith, Treasurer

Dan Eller, SecretaryJonathan Joseph CavanaghBernard A. M. Chamberlain

Patrick J. GreenStephen G. Jamieson

Lee D. KerstenHeather Anne Marie Kmetz

John Anthony MaglianaRyan R. Nisle

Tricia M. Palmer OlsonJames R. Puetz

Jennifer L. Woodhouse

The materials and forms in this manual are published by the Oregon State Bar exclusively for the use of attorneys. Neither the Oregon State Bar nor the contributors make either express or implied warranties in regard to the use of the materials and/or forms. Each attorney must depend on his or her own knowledge of the law and expertise in the use or modification of these materials.

Copyright © 2013

OREGON STATE BAR16037 SW Upper Boones Ferry Road

P.O. Box 231935Tigard, OR 97281-1935

Broadbrush Taxation iii

TaBLE OF COnTEnTS

1. Key developments in Federal Tax . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1–i— Bernard a. M. Chamberlain, Chamberlain Law PC, Portland, Oregon

2. 2013 Oregon Tax update . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2–i— robert T. Manicke, Stoel Rives LLP, Portland, Oregon

3. Tax Considerations for Choice of Business Entity . . . . . . . . . . . . . . . . . . . . . . . . 3–i— Bryon L. Land, Arnold Gallagher PC, Eugene, Oregon

4. Tax Collection . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4–i— Jennifer L. Woodhouse, Schwabe Williamson & Wyatt PC, Portland, Oregon

5. drafting Tax-related Provisions for Business documents . . . . . . . . . . . . . . . . . . . 5–i— david C. Culpepper, Thede Culpepper Moore Munro & Silliman LLP, Portland, Oregon

6. Estate and Gift Tax issues Every Lawyer Should Know . . . . . . . . . . . . . . . . . . . . . 6–i— Barbara Jo Smith, Heltzel Williams Law Firm, Salem, Oregon

7. Tax Planning for real Estate Workouts. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7–i— Jeneé Gifford hilliard, Miller Nash LLP, Portland, Oregon

Broadbrush Taxation iv

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SChEduLE

8:00 registration

9:00 Key developments in Federal Tax

F Recap of recent federal legislationF Regulatory developments and IRS activitiesF Impact of recent court decisionsBernard a. M. Chamberlain, Chamberlain Law PC, Portland

9:45 Oregon Tax update

F Recent legislationF Cases of interestF What’s ahead?robert T. Manicke, Stoel Rives LLP, Portland

10:30 Break

10:45 Choice of Entity

F General characteristics of different business entitiesF How business entities are organized under state lawF Tax aspects of each business entityF Tax considerations in selecting an entityBryon L. Land, Arnold Gallagher PC, Eugene

11:45 Lunch

12:45 Tax Collection

F State and federal enforcement toolsF Taxpayer collection optionsF Procedural considerations and important deadlinesJennifer L. Woodhouse, Schwabe Williamson & Wyatt PC, Portland

1:30 drafting Tax-related Provisions for Business documents

F Allocation provisions for LLC operating agreements and partnership agreementsF S corporation shareholder agreementsF Corporate merger and reorganization agreementsF Deferred compensation arrangements in employment and compensation agreementsdavid C. Culpepper, Thede Culpepper Moore Munro & Silliman LLP, Portland

2:30 Break

2:45 What Every Lawyer Should Know about Estate and Gift Taxes

F Avoiding unintended taxable or reportable giftsF Knowing when clients need advice regarding federal and Oregon estate taxesF Counseling DIY estate planners to avoid costly tax mistakesBarbara Jo Smith, Heltzel Williams Law Firm, Salem

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3:30 Tax Planning for real Estate WorkoutsF Cancellation of debt (COD)F ForeclosuresF Short salesF Loan modificationsJeneé Gifford hilliard, Miller Nash LLP, Portland

4:15 adjourn

SChEduLE (Continued)

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FaCuLTy

Bernard a. M. Chamberlain, Chamberlain Law PC, Portland. Mr. Chamberlain advises clients on tax, business, and estate planning questions that arise for business owners and in the life cycle of a small business. He also advises individuals on U.S. international tax matters. Before founding Chamberlain Law PC, Mr. Chamberlain worked as an associate for KPMG LLP consulting on U.S. international tax matters and as a business associate for a local law firm advising clients on tax, business, and estate planning questions. He is a member of the Oregon State Bar Taxation and Business Law sections. Mr. Chamberlain holds an LL.M. from the University of Washington School of Law Graduate Program in Taxation.

david C. Culpepper, Thede Culpepper Moore Munro & Silliman LLP, Portland. Mr. Culpepper focuses his practice on tax and business law, with an emphasis on partnerships, limited liability companies, S corporations, real estate taxation and like-kind exchange transactions, executive compensation, and corporate acquisitions. He is a member of the American Bar Association Taxation Section Committee on Partnerships and LLCs and a Fellow of the American College of Tax Counsel. He has been active in drafting and lobbying Oregon legislation involving LLCs and partnerships. He has published articles and chapters on stock options, executive compensation, corporate reorganizations, LLCs, and partnership allocations, and he is an editor of Advising Oregon Businesses (Oregon CLE & Supp 2007). Mr. Culpepper is a frequent lecturer on complex issues relating to partnerships, LLCs, like-kind exchange transactions, and executive compensation techniques.

Jeneé Gifford hilliard, Miller Nash LLP, Portland. Ms. Hilliard focuses her practice on real estate and business transactions, including tax issues related to real estate such as 1031 exchanges and cancellation of indebtedness. Ms. Hilliard’s clients include developers, property owners, tenants, financial institutions, and educational institutions.

Bryon L. Land, Arnold Gallagher PC, Eugene. Mr. Land’s practice focuses on estate planning, business and corporate law, and state and federal taxation, with a special emphasis on business sales and acquisitions, executive compensation, entity selection and formation, individual and entity taxation, and estate planning for individuals and business owners. Mr. Land holds an LL.M. in Taxation from the University of Florida.

robert T. Manicke, Stoel Rives LLP, Portland. Mr. Manicke heads the firm’s Benefits, Tax and Private Client group. His practice emphasizes state and local taxation. He regularly represents clients in the Oregon Tax Court and before state revenue authorities regarding income tax and property tax matters. Mr. Manicke chairs the Oregon State Bar Taxation Section and its Laws Committee.

Barbara Jo Smith, Heltzel Williams Law Firm, Salem. Ms. Smith conducts an active estate planning, business, and probate and trust administration practice. She is past president of the Willamette Valley Estate Planning Council and treasurer of the Oregon State Bar Taxation Section. She has taught the Estate and Gift Tax course at Willamette University as an adjunct professor. She has been a speaker at previous Oregon State Bar Broadbrush Taxation seminars and at the Willamette Valley Estate Planning Council on various tax topics, including noncitizen spouse estate planning and community property.

Jennifer L. Woodhouse, Schwabe Williamson & Wyatt PC, Portland. Ms. Woodhouse focuses her practice in the area of tax controversy and estate planning. She is experienced in dealing with a range of tax matters including collection cases, innocent spouse cases, audits, and state and federal tax court cases. She also helps clients respond to lien and levy notices and evaluate and pursue collection options, including requesting currently not collectible status, setting up installment payment plans, and drafting offers in compromise and Oregon settlement offers. Ms. Woodhouse also represents clients through the trust fund recovery penalty interview process. She assists estate planning clients with probate, trust administration, and the preparation of wills, trusts, advance directives, and powers of attorney. Ms. Woodhouse serves on the Oregon State Bar Taxation Section Executive Committee and its Newsletter Committee New Tax Lawyers Committee. She is also active in the ABA.

Broadbrush Taxation viii

Chapter 1

Key developments in Federal TaxBernard a. M. ChaMBerlain

Chamberlain Law PCPortland, Oregon

Contents

I. Business Income and Deductions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1–1A. Olive v. Commissioner, 139 T.C. No. 2 (8/2/12) . . . . . . . . . . . . . . . . . . . . . . . 1–1B. Final “Repair” Regulations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1–1C. Section 179 Small Business Expensing and Bonus Depreciation . . . . . . . . . . . . . 1–2

II. Compensation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1–2A. Substantial Risk of Forfeiture . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1–2B. Sample Language for § 83(b) Election . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1–3C. Indirect Guaranty a Prohibited Transaction. . . . . . . . . . . . . . . . . . . . . . . . . 1–3

III. Personal Income and Deductions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1–3A. IRS Guidance on Windsor . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1–3B. Net Investment Income Tax. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1–4C. Individual Tax Rates . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1–5D. “Pease” Limitation Revived . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1–5E. Personal Exemption Phaseout . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1–6F. Principal Residence COD . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1–6

IV. Corporations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1–6A. IRC § 336(e) Regulations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1–6

V. S Corporations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1–7A. Built-In Gains Tax . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1–7B. Updated Procedures for Relief for Late S Election . . . . . . . . . . . . . . . . . . . . . 1–7C. S Corporation Reasonable Compensation. . . . . . . . . . . . . . . . . . . . . . . . . . 1–7

VI. Partnerships . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1–8A. Withholding on ECI for Foreign Partners . . . . . . . . . . . . . . . . . . . . . . . . . . 1–8

VII. Tax Procedure . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1–8A. Offer in Compromise “Fresh Start” Initiative. . . . . . . . . . . . . . . . . . . . . . . . 1–8B. Updated Guidance on Innocent Spouse Equitable Relief . . . . . . . . . . . . . . . . . 1–9C. Revised IRS Form 2848 Power of Attorney . . . . . . . . . . . . . . . . . . . . . . . . 1–10

VIII. Employment Tax . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1–11

AppendixesA. IRC § 280E . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1–13B. IRS—Answers to Frequently Asked Questions for Individuals of the Same Sex

Who Are Married Under State Law . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1–15C. IRS—Answers to Frequently Asked Questions for Registered Domestic Partners

and Individuals in Civil Unions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1–21D. Excerpts from Rev. Proc. 2013-30, Flowcharts Relating to Late S Elections . . . . . . 1–27E. Rev. Proc. 2013-34, Relating to Innocent Spouse Equitable Relief . . . . . . . . . . . 1–31F. Questions and Answers for the Additional Medicare Tax. . . . . . . . . . . . . . . . 1–37

Chapter 1—Key Developments in Federal Tax

Broadbrush Taxation 1–ii


Broadbrush Taxation 1–1-‐ Broadbrush Taxation – Key Developments in Federal Tax 1

Key Developments in Federal Tax

I. Business Income and Deductions

A. Olive v. Commissioner, 139 T.C. No. 2 (8/2/12). The taxpayer operated a

business consisting of the sale of marijuana for medical purposes under the California

Compassionate Care Act of 1996. On the business premises, the employees of the taxpayer also

provided massages and educated patrons as to the benefits of medical marijuana. The taxpayer

failed to maintain books and records sufficient to allow the Commissioner to verify the

taxpayer’s income and expenditures. The Tax Court upheld the IRS’s determination of gross

receipts and applied the Cohan rule to find the taxpayer’s cost of good sold (COGS) was

approximately 75% of its gross receipts. The Tax Court found that the limited provision of

massages, snacks, and movies did not amount to a separate caregiving business, as existed in

Californians Helping Alleviate Medical Problems, Inc. v. Commissioner, 128 TC 173 (2007).

The Tax Court held that IRC § 280E was triggered by the taxpayer’s trafficking in controlled

substances under federal law and precluded the deduction of any remaining expenses.

Notwithstanding the taxpayer favorable outcome on the COGS issue in this case, some

commentators have suggested that IRC §§ 280E and 263A(a)(2), read together, clearly deny

COGS to a taxpayer subject to IRC § 280E.

B. Final “Repair” Regulations. (TD 9636). The IRS released the final regulations

governing when taxpayers must capitalize and when they can deduct their expenses for

acquiring, maintaining, repairing, and replacing tangible property. The stated goal of the

regulations is to move away from facts and circumstances determinations with bright-line rules

and safe harbors.

The regulations that were finalized are as follows: Materials and supplies (Reg. 1.162-3),

repairs and maintenance (Reg. 1.163-4), capital expenditures (Reg. 1.263(a)-1), amounts paid for

the acquisition or production of tangible property (Reg. 1.263(a)-2), and amounts paid for the

improvement of tangible property (Reg. 1.263(a)-3).

Five changes singled out in the preamble: revised and simplified de-minimis safe harbor

under § 1.263(a)-1(f), extension of the safe harbor for routine maintenance to buildings, an

annual election for buildings that cost $1 million or less to deduct up to $10,000 of maintenance

costs or, if less, two percent of the building’s adjusted basis; a new annual election to capital



repair costs that are capitalized on the taxpayer’s books and records, and the refinement of the

criteria for defining betterments and restorations to tangible property.

The regulations are effective starting January 1, 2014, and can be retroactively applied to

the start of 2012. The IRS has stated it intends to issue final companion regulations under IRC §

168 governing general asset accounts and the disposition of depreciable property by the end of

2013.

C. Section 179 Small Business Expensing and Bonus Depreciation. The 2012

American Taxpayer Relief Act extended IRC § 179 small business expensing and bonus

depreciation. In 2013, the IRC § 179 small business expensing dollar limit is $500,000 with a $2

million investment limit. Fifty-percent bonus depreciation through 2013 was also extended.

II. Compensation

A. Substantial Risk of Forfeiture. Compensation in the form of restricted property

(such as employer stock) is generally not taxable while it is subject to a substantial risk of

forfeiture. Usually this is a service condition, i.e., a promise to forfeit the stock if the employee

fails to complete a specified term of service with the employer, but other types of conditions may

create an substantial risk of forfeiture and allow the recipient of restricted property to delay

taxation.

The Treasury Department has proposed amendments to Reg. § 1.83-3 to clarify the

meaning of “substantial risk of forfeiture.” REG–141075–09, Property Transferred in

Connection With the Performance of Services Under § 83, 77 F.R. 31783 (5/30/12). Under the

proposed amendments, a substantial risk of forfeiture may be established only through a service

condition or a condition related to the purpose of the transfer. When determining whether a

substantial risk of forfeiture exists based on a condition related to the purpose of the transfer,

both the likelihood that the forfeiture event will occur and the likelihood that the forfeiture will

be enforced must be considered. In addition, the proposed amendments clarify that except as

specifically provided in § 83(c)(3) and Reg. § 1.83–3(j) and (k), transfer restrictions do not create

a substantial risk of forfeiture, including transfer restrictions which carry the potential for

forfeiture or disgorgement of some or all of the property, or other penalties, if the restriction is

violated. The proposed amendments would add two additional examples to Reg. § 1.83–3(c)(4)

illustrating that a substantial risk of forfeiture is not created solely as a result of potential liability

under Rule 10b–5 of the Securities Exchange Act of 1934 or a lock-up agreement.



B. Sample Language for § 83(b) Election. Rev. Proc. 2012-29, 2012-28 (IRB 49

(6/27/12). Revenue Procedure provides optional sample language for making an 83(b) election.

C. Indirect Guaranty a Prohibited Transaction. Peek v. Commissioner, 140 TC

No. 12 (5/9/13). Guarantees are an indirect extension of credit between an IRA and a beneficiary

of the IRA and therefore a prohibited transaction that disqualifies the IRA. Two unrelated

taxpayers established self-directed IRAs to purchase a business. They funded the IRAs with

rollovers from other IRAs and 401(k) accounts. To purchase the business the taxpayers formed a

corporation which issued stock to their IRAs in exchange for the cash that they had rolled into

the IRAs. The corporation then purchased business assets from the seller with the cash it

received from the IRAs, proceeds from a bank loan, and the corporation’s promissory note,

which was guaranteed by the taxpayers. The IRAs subsequently sold the stock of the corporation,

and the IRS asserted deficiencies against the taxpayers on the grounds that the IRAs had failed to

defer the gain on the sale because it did not qualify under IRC § 408. The IRS’s argument was

that an account ceases to qualify as an IRA if an individual for whose benefit an individual

retirement account is established engages in any transaction constituting the “direct or indirect ...

lending of money or other extension of credit between a plan and a disqualified person” under

IRC § 4975(c)(1)(B). The taxpayers argued that their guarantee of the corporation’s note was not

an extension of credit to the IRA. The Tax Court disagreed, holding that the extension of credit

to a corporation held by the IRS was exactly the kind of “indirect” extension of credit prohibited

by the obvious meaning of the statute.

III. Personal Income and Deductions

A. IRS Guidance on Windsor. Rev. Rul. 2013-17 (August 29, 2013). The IRS

issued Revenue Ruling 2013-17 in response to the Supreme Court’s holding in United States v.

Windsor, 570 US ___, 133 S.Ct. 2675 (2013), that section 3 of the Defense of Marriage Act is

unconstitutional. Holdings: (1) Gender neutral terms in the Code referring to marriage, namely

terms such as spouse and marriage, refer to an individual married to a person of the same sex

under state law and to a marriage between such individuals of the same sex. The terms “husband

and wife,” “husband,” and “wife” should be interpreted to mean same sex spouses. (2) The Code

recognizes the validity of a same-sex marriage that was valid in the state where it was entered

into, regardless of the married couple’s place of domicile. (3) For federal tax purposes, the term

“marriage” does not include registered domestic partnerships, civil unions, or other similar



formal relationships recognized under state law that are not denominated as marriage under that

state's law, and the terms “spouse,” “husband and wife,” “husband,” and “wife” do not include

individuals who have entered into such a formal relationship. This conclusion applies regardless

of whether individuals who have entered into such relationships are of the opposite sex or the

same sex.

B. Net Investment Income Tax. IRC § 1411, added by the Health Care and

Education Reconciliation Act of 2010, imposes a 3.8 percent tax on the lesser of the net

investment income of an individual, estate, or trust or the excess of the modified adjusted gross

income (MAGI) is over a specific threshold amount. IRC § 1411(a). MAGI is adjusted gross

income adjusted for the foreign earned income exclusion (and related adjustments) under IRC §

911. IRC §1411(d). The threshold amounts are $250,000 for spouses filing jointly, half of that

for spouses filing separately, and $200,000 otherwise. IRC § 1411(b). Net investment income is

investment income less regular income tax deductions allocable to that income. IRC §

1411(c)(1). Net investment income includes (1) gross income from interest, dividends, annuities,

royalties, and rents, other than such income which is derived in the ordinary course of a trade or

business which is a passive activity under IRC § 469 or a trade or business of trading in financial

instruments or commodities under IRC 475(e)(2); (2) other gross income which is derived in the

ordinary course of either of the aforementioned types of trade or business; and (3) net gain

attributable to the disposition of property held in either of the aforementioned types of trade or

business. IRC § 1411(c)(1) and (2). However, in the case of a disposition of an interest in a

partnership or S corporation, that net gain is limited to the amount that would be taken into

account by the taxpayer if all the assets of the partnership or S corporation were sold for market

value immediately before the disposition of the interest. IRC § 1411 (c)(4). Finally, income

from investment of working capital is subject to the tax and distributions from qualified plans

and income subject to self-employment tax are not subject to the tax. IRC § 1411(c)(3) and

(c)(5). The tax is imposed for tax years starting on or after 12/31/12; it is subject to the estimated

tax provisions. IRC § 6654(a).

FAQs on the net investment income tax were released by the IRS on 11/29/12.

(http://www.irs.gov/uac/Newsroom/Net-Investment-Income-Tax-FAQs). The FAQs provide

answers to a number of questions that might come up for individuals, e.g., a gain on the sale of a



person al residence is excluded from net investment income tax to the extent it is excluded under

regular income tax rules (i.e., IRC § 121).

REG-130507-11, Net Investment Income Tax, 77 F.R. 72612 (12/05/12). Prop. Reg. §

1.469-11 is amended and Prop. Regs. §§ 1.1411-0 through 1.1411-10 have been published to

provide guidance under IRC § 1411. Commentators have focused on the failure of the proposed

regulations to provide guidance on the ‘facts and circumstances’ determinations of when

activities, in particular real estate activities, rise to the level of a trade or business.

C. Individual Tax Rates.

¥ The 2012 Taxpayer Relief Act of 2012 makes permanent 10%, 15%, 25%, 28%, 33%,

and 35% tax rates enacted in 2001. This includes the expanded 15% bracket intended

to mitigate the “marriage penalty.” Capital gains and dividend rates are 15%.

¥ The 39.6% rate from pre-2001 law has been restored for taxable incomes in excess of

(1) $450,000 for married couples filing jointly and surviving spouses, (2) $425,000

for head-of-households, (3) $400,000 for single taxpayers, and (4) $225,000 for

married taxpayers filing separately. For tax years after 2013, these highest bracket

threshold amounts are adjusted for inflation with 2012 as the base year. For these

highest brackets, capital gains and dividend rates are 20%.

¥ Alternative Minimum Tax “Patch” was made permanent, and indexed with inflation.

The 2013 AMT exemption amounts were projected to be $80,750 for married filing

jointly, $51,900 for single and head of household, and $40,375 for married filing

separately. The 2012 American Taxpayer Relief Act also provides that all

nonrefundable personal credits are allowed to the full extent of the taxpayer’s regular

tax and AMT liability.

¥ For trusts and estates the brackets are 15%, 25%, 28%, 33% and, for income in excess

of $11,950, 39.6%.

D. “Pease” Limitation Revived. The Pease limitation, named after the member of

Congress who sponsored the original provision, reduces the total amount of a higher-income

taxpayer’s otherwise allowable itemized deductions by three percent of the amount by which the

taxpayer’s adjusted gross income exceeds an applicable threshold. However, the amount of

itemized deductions is not reduced by more than 80 percent. The applicable thresholds for 2013



are $300,000 for married couples, $275,000 for heads of households, $250,000 for unmarried

taxpayers, and $150,000 for married taxpayers filing separately.

E. Personal Exemption Phaseout. The 2012 American Taxpayer Relief Act also

revived the personal exemption phaseout. The applicable income thresholds at which it comes

into effect are higher: $300,000 for married couples, $275,000 for heads of households, $250,000

for unmarried taxpayers, and $150,000 for married taxpayers filing separately.

F. Principal Residence COD. The 2012 Taxpayer Relief Act, § 202, extends the

exclusion from income of discharged principal residence indebtedness to indebtedness

discharged before 1/1/14. See IRC § 108(a)(1)(E).

IV. Corporations

A. IRC § 336(e) Regulations. T.D. 9619, Regulations Enabling Elections for

Certain Transactions Under IRC § 336(e), 78 F.R. 28467 (5/15/13). The IRS published

regulations under IRC § 336(e). IRC § 336(e), enacted as part of the TRA 1986 repealing the

General Utilities doctrine, authorizes regulations allowing a corporation that sells, exchanges, or

distributes stock in another corporation (target) meeting the requirements of IRC § 1504(a)(2)

(i.e., 80% control by vote and value) to elect to treat the disposition as a sale of all of target’s

underlying assets in lieu of treating it as sale, exchange, or distribution of stock, as under IRC §

338(h)(10). The purpose of a IRC § 336(e) election is to prevent creation of a triple layer of

taxation – one at the controlled corporation level, one at the distributing corporation level and,

ultimately, one at the shareholder level. Under the regulations, this is accomplished by recasting

the corporate parent’s sale or disposition of target stock as the deemed sale of assets by target

(old target) to itself (new target), followed by a tax deferred liquidation to the corporate parent of

the deemed proceeds. In the case of a sale of the stock of an S Corporation, the sale of target

stock is recast as the sale by old target of its assets to new target, with the consequences of the

sale passing through to the old shareholders. There are many complexities in the IRC § 336(e)

regulations, not unlike the IRC § 338(h)(10) elections on which they are modeled, however the

new regulations present significant new possibilities for transactions where the buyer is not a

corporation, where there are multiple purchasing shareholders, and where purchasing shareholder

intend to convert the corporation to a flow-through entity following the acquisition.



The new regulations, Reg. §§ 1.336-0 through 1.336-5, provide the requirements and

mechanics for, and consequences of, treating a stock sale, exchange, or distribution as an asset

sale under IRC § 336(e).

V. S Corporations

A. Built-In Gains Tax. 2012 Taxpayer Relief Act, § 326(a)(2), extends the § 1374

five-year holding period for recognized built-in gain in 2012 and 2013. The built-in gains tax is

an exception to the general non-taxability of S corporations. It generally provides that any assets

held by a C corporation that files an S election, that have value in excess of basis at the time of

an S election, will trigger a corporate income tax upon their disposition if that occurs within a ten

year “recognition period.” Section 1374(d)(7)(C) reduces that period to five years for 2012 and

2013.

B. Updated Procedures For Relief For Late S Election. Rev. Proc. 2013-30

(8/14/13). A late S election can cause an S corporation to be liable for corporate tax as if it was

not an S corporation. As it has in the past, the IRS has provided new and simplified methods for

taxpayers to request relief for late S corporation elections, electing small business trust (ESBT)

elections, qualified subchapter S trust (QSST) elections, qualified subchapter S subsidiary

(QSub) elections, and late corporate classification elections that the taxpayer intended to take

effect on the same date that the taxpayer intended that an S corporation election for the entity

should take effect. The revenue procedure extends to 3 years and 75 days the amount of time

after an S election was intended to be effective to request relief for the late S election. If certain

requirements are met, relief may be requested after that time. Reasonable cause, albeit

reasonable cause with a low threshold, is still required.

C. S Corporation Reasonable Compensation. In David E. Watson P.C., 668 F3d

1008 (8th Cir. 2012), the IRS asserted that the wages of an employee shareholder were too low,

and shareholder distributions where therefore to high, consequently reducing employment taxes

related to the employment. The taxpayer in this case was a well-qualified and experienced

accountant working in a reputable and well-established firm, the firm paid him a salary of

$24,000 in each of 2002 and 2003, the firm paid him $203,651 in 2002 and $175,470 in 2003 in

addition to salary, the IRS valuation engineer testified that the value of the taxpayer’s services

provided to the firm was approximately $91,044 in each of 2002 and 2003. This was based on

adjusted salary information taken from a survey conducted by the American Institute of Certified



Public Accountants relevant specifically to the Iowa Society of CPAs, the state where the

taxpayer practiced. The taxpayer argued, among other things, that the intent of the parties was

that his salary would be $24,000. The district court found that the taxpayer’s statements as to the

intent of the parties was not credible and determined that the taxpayer’s wages were $91.044 in

each of 2002 and 2003; the 8th Circuit affirmed the judgment of the district court.

VI. Partnerships

A. Withholding on ECI for Foreign Partners. T.D. 9621, Noncompensentary

Partnership Options, 78 F.R. 7997 (2/5/13). Ann. 2013-30, 2013-21, I.R.B. ___ (4/24/13).

Partnership income effectively connected with a U.S. trade or business allocable to a foreign

partner is subject to withholding at the highest rate specified in § 1 or 11. Fiscal year

partnerships for a year beginning in 2012 must withhold at rates in effect for 2012, but foreign

partners who include partnership income in their 2013 returns are subject to 2013 rates.

VII. Tax Procedure

A. Offer in Compromise “Fresh Start” initiative. IR-2012-53 (5/21/12). In May

of 2012, the IRS announced it had expanded its “Fresh Start” initiative by making available more

flexible terms in its Offer In Compromise (OIC) program for settling back taxes. IRM Revision

9/30/13 included significant changes relating to the OIC Fresh Start initiative:

¥ Revised calculation for future income – The IRS will now look at only one year of future

income for offers paid in five months or less, and two years of future income for offers

paid in six to 24 months, but all offers must be paid within 24 months of acceptance.

IRM 5.8.5.25 (9/30/13).

¥ Allowing repayment of student loans – The IRS will now allow repayment of student

loans, provided payments are being made or nonpayment is due to financial hardship.

IRM 5.8.5.22.4 (9/30/13).

¥ Allowing payment of delinquent state and local taxes – The IRS will now allow payment

of delinquent state or local taxes in most cases based on a percentage basis (i.e.,

percentage of amount of state and local taxes owed of the total taxes owed). IRM

5.8.5.22.4(7). The IRS may also allow a pre-assessment state or local settlement payment

plan. Id.



¥ $1000 reduction in RCP for amounts in individual bank accounts – For the determination

of Reasonable Collection Potential, for the amount of cash in the taxpayers’ bank

account, a reduction is permitted of $1000. IRM 5.8.5.7 (9/30/13). This is in addition to

a reduction for amounts reasonably believed to be necessary to pay monthly allowable

living expenses. Id.

¥ Equity in income producing assets potentially excluded from RCP – As a general rule,

equity in income producing assets will not be added to the RCP of a viable, ongoing

business; unless it is determined the assets are not critical to business operations. IRM

5.8.5.15 (9/30/13).

¥ Reduction of equity in vehicle – An exclusion of $3,450 in net equity (i.e., post 20%

reduction for quick-sale value) is permitted per car owned by the taxpayer and used for

the production of income or the welfare of the taxpayer’s family (two cars for joint

taxpayers and one vehicle for a single taxpayer). IRM 5.8.5.12(3) (9/30/13).

¥ Evaluating dissipated assets – For dissipation of equity in an asset occurring before the

OIC, the timeframe which might require inclusion in the OIC has been reduced to three

years; for dissipation of equity in an asset around the time the taxpayer incurred the

liability, the timeframe has been more explicitly laid out as six months. IRM 5.8.5.16

(9/30/13).

¥ Retired debt – In calculating the taxpayer’s ability to pay (i.e., future disposable income

after allowed expenses), the IRS will allow a expense of $400 per month on a loan on a

vehicle to continue after the loan is repaid. IRM 5.8.5.19(3) (9/30/13).

¥ Addition operating expense allowance for older vehicles – The IRS will generally allow

an additional monthly operating expense of $200 per vehicle (up to two vehicles when a

joint offer is submitted) where the taxpayer has a vehicle that is currently over six years

old or has reported mileage of 75,000 miles or more. IRM 5.8.5.22.3 (9/30/13).

B. Updated Guidance on Innocent Spouse Equitable Relief. Rev. Proc. 2013-34

(9/16/13). The IRS issued updated guidance for a taxpayer seeking equitable relief under the

IRC § 6015(f), relating to innocent spouse relief.

Greater weight and greater analytical import is given to the presence of abuse not

amounting to duress: “The Service recognizes that the issue of abuse can be relevant with respect

to the analysis of other factors and can negate the presence of certain factors. This change is



intended to give greater weight to the presence of abuse when its presence impacts the analysis

of other factors.” Rev. Proc. 2013-34, Section 3.01.

The factors for a claim meeting certain threshold conditions: current marital status,

economic hardship, knowledge or reason to know (viewed in light of abuse or financial control),

legal obligation in a divorce decree, presence of a significant benefit to the requesting spouse,

compliance with tax laws since the years for which relief is requested, and mental or physical

health in the years for which relief is requested. Rev. Proc. 2013-34, Section 4.03. Each factor

contains rules for whether it should weigh in favor, against, or have neutral weight with respect

to granting equitable relief.

Abuse is defined more helpfully than in Rev. Proc. 2003-61 (7/24/2003), the preceding

revenue procedure governing claims for equitable relief: “Abuse comes in many forms and can

include physical, psychological, sexual, or emotional abuse, including efforts to control, isolate,

humiliate, and intimidate the requesting spouse, or to undermine the requesting spouse’s ability

to reason independently and be able to do what is required under the tax laws. * * * [A]buse of

the requesting spouse's child or other family member living in the household may constitute

abuse of the requesting spouse.” Rev. Proc 3013-34, Section 4.02(c)(iv).

The timeframe for requesting relief is generally the ten-year statute of limitations on

collection and, where the claiming spouse provided funds to satisfy the tax debt, the three-year

period of limitations on filing a claim for refund. Rev. Proc. 2013-34. Section 3.02. The

revenue procedure also provides for a streamlined process for cases meeting certain criteria to

receive faster resolution. The revenue procedure is effective immediately.

C. Revised IRS Form 2848 Power of Attorney. The version of IRS Form 2848,

Power of Attorney and Declaration of Representative (Rev. March 2012) requires a some

changes in how the form is used.

¥ For joint returns, the form now requires that a husband and wife each complete and

submit a separate Form 2848 to authorize their representative to deal with a joint tax

return year(s).

¥ A taxpayer must now specifically check a box on the form to authorize the IRS to send

copies of all notices and communications to the representative.

¥ Representatives are not longer permitted to receive refund checks and/or other amounts

payable to the taxpayer.



¥ Unless specifically authorized, a representative now may not execute a request for

disclosure of tax returns or return information to a third party, substitute or add additional

representatives, or sign certain tax returns.

VIII. Employment Tax.

IRC § 1401, as amended by the 2010 Health Care Act, increases the employee portion

of the hospital insurance tax by an additional 0.9 percent on wages in excess of a threshold

amount. The threshold amount is $250,000 of the combined wages of both spouses on a joint

return ($125,000 for a married individual filing a separate return). The threshold is $200,000

for all other individuals. The employer must withhold the additional HI tax, but the employee

is liable for the additional 0.9 percent tax to the extent it is not withheld by the employer.

I.R.C. § 3102(f). Section 1402(b), as amended, imposes an additional tax of 0.9 percent on

self-employment income above the same thresholds. No deduction under IRC § 164(f) is

allowed for the additional SECA tax, and the alternative deduction under IRC § 1402(a)(12)

is determined without regard to the additional SECA tax rate. The additional tax applies to

wages received in taxable years after 12/31/12.

Proposed regulations relating to the Additional Medicare Tax were released. REG-

130074-11, Rules Relating to Additional Medicare Tax, 77 F.R. 72268 (12/5/12).

FAQs to the Additional Medicare tax were released by the IRS on 11/30/12. They

can be found at http://www.irs.gov/Businesses/Small-Businesses-&-Self-

Employed/Questions-and-Answers-for-the-Additional-Medicare-Tax


Broadbrush Taxation 1–12



IRC § SEC. 280E. EXPENDITURES IN CONNECTION WITH THE ILLEGAL SALE OF DRUGS.

No deduction or credit shall be allowed for any amount paid or incurred during the taxable year in carrying on any trade or business if such trade or business (or the activities which comprise such trade or business) consists of trafficking in controlled substances (within the meaning of schedule I and II of the Controlled Substances Act) which is prohibited by Federal law or the law of any State in which such trade or business is conducted.



10/8/13 9:32 PMAnswers to Frequently Asked Questions for Individuals of the Same Sex Who Are Married Under State Law

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Answers to Frequently Asked Questions forIndividuals of the Same Sex Who Are Married Under StateLawThe following questions and answers provide information to individuals of the same sex who arelawfully married (same-sex spouses). These questions and answers reflect the holdings in RevenueRuling 2013-17 in 2013-38 IRB 201.

Q1. When are individuals of the same sex lawfully married for federal tax purposes?

A1. For federal tax purposes, the IRS looks to state or foreign law to determine whether individualsare married. The IRS has a general rule recognizing a marriage of same-sex spouses that wasvalidly entered into in a domestic or foreign jurisdiction whose laws authorize the marriage of twoindividuals of the same sex even if the married couple resides in a domestic or foreign jurisdictionthat does not recognize the validity of same-sex marriages.

Q2. Can same-sex spouses file federal tax returns using a married filing jointly or marriedfiling separately status?

A2. Yes. For tax year 2013 and going forward, same-sex spouses generally must file using a marriedfiling separately or jointly filing status. For tax year 2012 and all prior years, same-sex spouses whofile an original tax return on or after Sept. 16, 2013 (the effective date of Rev. Rul. 2013-17),generally must file using a married filing separately or jointly filing status. For tax year 2012, same-sex spouses who filed their tax return before Sept. 16, 2013, may choose (but are not required) toamend their federal tax returns to file using married filing separately or jointly filing status. For taxyears 2011 and earlier, same-sex spouses who filed their tax returns timely may choose (but are notrequired) to amend their federal tax returns to file using married filing separately or jointly filing statusprovided the period of limitations for amending the return has not expired. A taxpayer generally mayfile a claim for refund for three years from the date the return was filed or two years from the date thetax was paid, whichever is later. For information on filing an amended return, go to Tax Topic 308,Amended Returns, at http://www.irs.gov/taxtopics/tc308.html.

Q3. Can a taxpayer and his or her same-sex spouse file a joint return if they were married in astate that recognizes same-sex marriages but they live in a state that does not recognize theirmarriage?

A3. Yes. For federal tax purposes, the Service has a general rule recognizing a marriage of same-sex individuals that was validly entered into in a domestic or foreign jurisdiction whose lawsauthorize the marriage of two individuals of the same sex even if the married couple resides in adomestic or foreign jurisdiction that does not recognize the validity of same-sex marriages. The rulesfor using a married filing jointly or married filing separately status described in Q&A #2 apply to thesemarried individuals.

Q4. Can a taxpayer’s same-sex spouse be a dependent of the taxpayer?

A4. No. A taxpayer’s spouse cannot be a dependent of the taxpayer.

http://www.irs.gov/pub/irs-drop/rr-13-17.pdf






Q5. Can a same-sex spouse file using head of household filing status?

A5. A taxpayer who is married cannot file using head of household filing status. However, a marriedtaxpayer may be considered unmarried and may use the head-of-household filing status if thetaxpayer lives apart from his or her spouse for the last 6 months of the taxable year and providesmore than half the cost of maintaining a household that is the principal place of abode of thetaxpayer’s dependent child for more than half of the year. See Publication 501 for more details.

Q6. If same-sex spouses (who file using the married filing separately status) have a child,which parent may claim the child as a dependent?

A6. If a child is a qualifying child under section 152(c) of both parents who are spouses (who fileusing the married filing separate status), either parent, but not both, may claim a dependencydeduction for the qualifying child. If both parents claim a dependency deduction for the child on theirincome tax returns, the IRS will treat the child as the qualifying child of the parent with whom thechild resides for the longer period of time during the taxable year. If the child resides with eachparent for the same amount of time during the taxable year, the IRS will treat the child as thequalifying child of the parent with the higher adjusted gross income.

Q7. Can a taxpayer who is married to a person of the same sex claim the standard deductionif the taxpayer’s spouse itemized deductions?

A7. No. If a taxpayer’s spouse itemized his or her deductions, the taxpayer cannot claim thestandard deduction (section 63(c)(6)(A)).

Q8. If a taxpayer adopts the child of his or her same-sex spouse as a second parent or co-parent, may the taxpayer (“adopting parent”) claim the adoption credit for the qualifyingadoption expenses he or she pays or incurs to adopt the child?

A8. No. The adopting parent may not claim an adoption credit. A taxpayer may not claim an adoptioncredit for expenses incurred in adopting the child of the taxpayer’s spouse (section 23).

Q9. Do provisions of the federal tax law such as section 66 (treatment of community income)and section 469(i)(5) ($25,000 offset for passive activity losses for rental real estate activities)apply to same-sex spouses?

A9. Yes. Like other provisions of the federal tax law that apply to married taxpayers, section 66 andsection 469(i)(5) apply to same-sex spouses because same-sex spouses are married for all federaltax purposes.

Q10. If an employer provided health coverage for an employee’s same-sex spouse andincluded the value of that coverage in the employee’s gross income, can the employee file anamended Form 1040 reflecting the employee’s status as a married individual to recoverfederal income tax paid on the value of the health coverage of the employee’s spouse?

A10. Yes, for all years for which the period of limitations for filing a claim for refund isopen. Generally, a taxpayer may file a claim for refund for three years from the date the return wasfiled or two years from the date the tax was paid, whichever is later. If an employer provided healthcoverage for an employee’s same-sex spouse, the employee may claim a refund of income taxespaid on the value of coverage that would have been excluded from income had the employee’sspouse been recognized as the employee’s legal spouse for tax purposes. This claim for a refundgenerally would be made through the filing of an amended Form 1040. For information on filing anamended return, go to Tax Topic 308, Amended Returns, at http://www.irs.gov/taxtopics/tc308.html.





For a discussion regarding refunds of social security and Medicare taxes, see Q&A #12.

Example. Employer sponsors a group health plan covering eligible employees and their dependentsand spouses (including same-sex spouses). Fifty percent of the cost of health coverage elected byemployees is paid by Employer. Employee A was married to same-sex Spouse B at all times during2012. Employee A elected coverage for Spouse B through Employer’s group health plan beginningJan. 1, 2012. The value of the employer-funded portion of Spouse B’s health coverage was $250 permonth.

The amount in Box 1, “Wages, tips, other compensation,” of the 2012 Form W-2 provided byEmployer to Employee A included $3,000 ($250 per month x 12 months) of income reflecting thevalue of employer-funded health coverage provided to Spouse B. Employee A filed Form 1040 forthe 2012 taxable year reflecting the Box 1 amount reported on Form W-2.

Employee A may file an amended Form 1040 for the 2012 taxable year excluding the value ofSpouse B’s employer-funded health coverage ($3,000) from gross income.

Q11. If an employer sponsored a cafeteria plan that allowed employees to pay premiums forhealth coverage on a pre-tax basis, can a participating employee file an amended return torecover income taxes paid on premiums that the employee paid on an after-tax basis for thehealth coverage of the employee’s same-sex spouse?

A11. Yes, for all years for which the period of limitations for filing a claim for refund isopen. Generally, a taxpayer may file a claim for refund for three years from the date the return wasfiled or two years from the date the tax was paid, whichever is later. If an employer sponsored acafeteria plan under which an employee elected to pay for health coverage for the employee on apre-tax basis, and if the employee purchased coverage on an after-tax basis for the employee’ssame-sex spouse under the employer’s health plan, the employee may claim a refund of incometaxes paid on the premiums for the coverage of the employee’s spouse. This claim for a refundgenerally would be made through the filing of an amended Form 1040. For information on filing anamended return, go to Tax Topic 308, Amended Returns, athttp://www.irs.gov/taxtopics/tc308.html. For a discussion regarding refunds of social security andMedicare taxes, see Q&A #12.

Example. Employer sponsors a group health plan as part of a cafeteria plan with a calendar yearplan year. The full cost of spousal and dependent coverage is paid by the employees. In the openenrollment period for the 2012 plan year, Employee C elected to purchase self-only health coveragethrough salary reduction under Employer’s cafeteria plan. On March 1, 2012, Employee C wasmarried to same-sex spouse D. Employee C purchased health coverage for Spouse D throughEmployer’s group health plan beginning March 1, 2012. The premium paid by Employee C forSpouse D’s health coverage was $500 per month.

The amount in Box 1, “Wages, tips, other compensation,” of the 2012 Form W-2 provided byEmployer to Employee C included the $5,000 ($500 per month x 10 months) of premiums paid byEmployee C for Spouse D’s health coverage. Employee C filed Form 1040 for the 2012 taxable yearreflecting the Box 1 amount reported on Form W-2.

Employee C’s salary reduction election is treated as including the value of the same-sex spousalcoverage purchased for Spouse D. Employee C may file an amended Form 1040 for the 2012taxable year excluding the premiums paid for Spouse D’s health coverage ($5,000) from grossincome.

Q12. In the situations described in FAQ #10 and FAQ #11, may the employer claim a refundfor the social security taxes and Medicare taxes paid on the benefits?





A12. Yes. If the period of limitations for filing a claim for refund is open, the employer may claim arefund of, or make an adjustment for, any excess social security taxes and Medicare taxes paid. Therequirements for filing a claim for refund or for making an adjustment for an overpayment of theemployer and employee portions of social security and Medicare taxes can be found in theInstructions for Form 941-X, Adjusted Employer’s Quarterly Federal Tax Return or Claim forRefund. A special administrative procedure for employers to file claims for refunds or makeadjustments for excess social security taxes and Medicare taxes paid on same-sex spouse benefitswill be provided in forthcoming guidance to be issued by the IRS in the near future.

Q13. In the situations described in Q&A #10 and Q&A #11, may the employer claim a refundor make an adjustment of income tax withholding that was withheld from the employee withrespect to the benefits in prior years?

A13. No. Claims for refunds of overwithheld income tax for prior years cannot be made byemployers. The employee may file for any refund of income tax due for prior years on Form 1040X,provided the period of limitations for claiming a refund has not expired. See Q&A #10 and Q&A#11. Employers may make adjustments for income tax withholding that was overwithheld from anemployee in the current year provided the employer has repaid or reimbursed the employee for theoverwithheld income tax before the end of the calendar year.

Q14. If an employer cannot locate a former employee with a same-sex spouse who receivedthe benefits described in Q&A #10 and Q&A #11, may the employer still claim a refund of theemployer portion of the social security and Medicare taxes on the benefits?

A14. Yes, if the employer makes reasonable attempts to locate an employee who received thebenefits described in Q&A #10 and Q&A #11 that were treated as wages but the employer is unableto locate the employee, the employer can claim a refund of the employer portion of Social Securityand Medicare taxes, but not the employee portion. Also, if an employee is notified and given theopportunity to participate in the claim for refund of Social Security and Medicare taxes but declines inwriting, the employer can claim a refund of the employer portion of the taxes, but not the employeeportion. Employers can use the special administrative procedure that will be set forth in forthcomingguidance to file these claims.

Q15. If a sole proprietor employs his or her same-sex spouse in his or her business, can thesole proprietor get a refund of Social Security, Medicare and FUTA taxes on the wages thatthe sole proprietor paid to the same-sex spouse as an employee in the business?

A15. Services performed by an employee in the employ of his or her spouse are excluded from thedefinition of employment for purposes of the Federal Unemployment Tax Act (FUTA). Therefore, forall years for which the period of limitations is open, the sole proprietor can claim a refund of theFUTA tax paid on the compensation that the sole proprietor paid his or her same-sex spouse as anemployee in the business. Services of a spouse are excluded from Social Security and Medicaretaxes only if the services are not in the course of the employer's trade or business, or if it is domesticservice in a private home of the employer.

Q16. What rules apply to qualified retirement plans pursuant to Rev. Rul. 2013-17?

A16. Qualified retirement plans are required to comply with the following rules pursuant to Rev. Rul.2013-17:

1. A qualified retirement plan must treat a same-sex spouse as a spouse for purposes of satisfyingthe federal tax laws relating to qualified retirement plans.

2. For purposes of satisfying the federal tax laws relating to qualified retirement plans, a qualifiedretirement plan must recognize a same-sex marriage that was validly entered into in a jurisdiction





whose laws authorize the marriage, even if the married couple lives in a domestic or foreignjurisdiction that does not recognize the validity of same-sex marriages.

3. A person who is in a registered domestic partnership or civil union is not considered to be aspouse for purposes of applying the federal tax law requirements relating to qualified retirementplans, regardless of whether that person’s partner is of the opposite or same sex.

Q17. What are some examples of the consequences of these rules for qualified retirementplans?

A17. The following are some examples of the consequences of these rules:

1. Plan A, a qualified defined benefit plan, is maintained by Employer X, which operates only in astate that does not recognize same-sex marriages. Nonetheless, Plan A must treat a participantwho is married to a spouse of the same sex under the laws of a different jurisdiction as marriedfor purposes of applying the qualification requirements that relate to spouses.

2. Plan B is a qualified defined contribution plan and provides that the participant’s account must bepaid to the participant’s spouse upon the participant’s death unless the spouse consents to adifferent beneficiary. Plan B does not provide for any annuity forms of distribution. Plan B mustpay this death benefit to the same-sex surviving spouse of any deceased participant. Plan B isnot required to provide this death benefit to a surviving registered domestic partner of adeceased participant. However, Plan B is allowed to make a participant’s registered domesticpartner the default beneficiary who will receive the death benefit unless the participant chooses adifferent beneficiary.

Q18. As of when do the rules of Rev. Rul. 2013-17 apply to qualified retirement plans?

A18. Qualified retirement plans must comply with these rules as of Sept. 16, 2013. Although Rev.Rul. 2013-17 allows taxpayers to file amended returns that relate to prior periods in reliance on therules in Rev. Rul. 2013-17 with respect to many matters, this rule does not extend to matters relatingto qualified retirement plans. The IRS has not yet provided guidance regarding the application ofWindsor and these rules to qualified retirement plans with respect to periods before Sept. 16, 2013.

Q19. Will the IRS issue further guidance on how qualified retirement plans and other tax-favored retirement arrangements must comply with Windsor and Rev. Rul. 2013-17?

A19. The IRS intends to issue further guidance on how qualified retirement plans and other tax-favored retirement arrangements must comply with Windsor and Rev. Rul. 2013-17. It is expectedthat future guidance will address the following, among other issues:

1. Plan amendment requirements (including the timing of any required amendments).2. Any necessary corrections relating to plan operations for periods before future guidance is

issued.

Q20. Can a same-sex married couple elect to treat a jointly owned and operatedunincorporated business as a Qualified Joint Venture?

A20. Yes. Spouses that wholly own and operate an unincorporated business and that meet certainother requirements may avoid Federal partnership tax treatment by electing to be a Qualified JointVenture. For more information on Qualified Joint Ventures, see the tax topic “Husband and WifeBusiness” at http://www.irs.gov/Businesses/Small-Businesses-&-Self-Employed/Husband-and-Wife-Business.

Related Item:





Page Last Reviewed or Updated: 2013-09-19

IR-2013-72, Treasury and IRS Announce That All Legal Same-Sex Marriages Will BeRecognized For Federal Tax Purposes; Ruling Provides Certainty, Benefits and ProtectionsUnder Federal Tax Law for Same-Sex Married Couples

http://www.irs.gov/uac/Newsroom/Treasury-and-IRS-Announce-That-All-Legal-Same-Sex-Marriages-Will-Be-Recognized-For-Federal-Tax-Purposes;-Ruling-Provides-Certainty,-Benefits-and-Protections-Under-Federal-Tax-Law-for-Same-Sex-Married-Couples



10/8/13 9:33 PMAnswers to Frequently Asked Questions for Registered Domestic Partners and Individuals in Civil Unions

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Answers to Frequently Asked Questions forRegistered Domestic Partners and Individuals in CivilUnionsThe following questions and answers provide information to individuals of the same sex and oppositesex who are in registered domestic partnerships, civil unions or other similar formal relationships thatare not marriages under state law. These individuals are not considered as married or spouses forfederal tax purposes. For convenience, these individuals are referred to as “registered domesticpartners” in these questions and answers. Questions and answers 9 through 27 concern registereddomestic partners who reside in community property states and who are subject to their state’scommunity property laws. These questions and answers have been updated since the SupremeCourt issued its decision in United States v. Windsor. As a result of the Court’s decision, theService has ruled that same-sex couples who are married under state law are married for federal taxpurposes. See Revenue Ruling 2013-17 in 2013‑38 IRB 201.

Q1. Can registered domestic partners file federal tax returns using a married filing jointly ormarried filing separately status?

A1. No. Registered domestic partners may not file a federal return using a married filing separatelyor jointly filing status. Registered domestic partners are not married under state law. Therefore,these taxpayers are not married for federal tax purposes.

Q2. Can a taxpayer use the head-of-household filing status if the taxpayer’s only dependentis his or her registered domestic partner?

A2. No. A taxpayer cannot file as head of household if the taxpayer’s only dependent is his or herregistered domestic partner. A taxpayer’s registered domestic partner is not one of the specifiedrelated individuals in section 152(c) or (d) that qualifies the taxpayer to file as head of household,even if the registered domestic partner is the taxpayer’s dependent.

Q3. If registered domestic partners have a child, which parent may claim the child as adependent?

A3. If a child is a qualifying child under section 152(c) of both parents who are registered domesticpartners, either parent, but not both, may claim a dependency deduction for the qualifying child. Ifboth parents claim a dependency deduction for the child on their income tax returns, the IRS willtreat the child as the qualifying child of the parent with whom the child resides for the longer period oftime during the taxable year. If the child resides with each parent for the same amount of time duringthe taxable year, the IRS will treat the child as the qualifying child of the parent with the higheradjusted gross income.

Q4. Can a registered domestic partner itemize deductions if his or her partner claims astandard deduction?

A4. Yes. A registered domestic partner may itemize or claim the standard deduction regardless ofwhether his or her partner itemizes or claims the standard deduction. Although the law prohibits a






taxpayer from itemizing deductions if the taxpayer’s spouse claims the standard deduction (section63(c)(6)(A)), this provision does not apply to registered domestic partners, because registereddomestic partners are not spouses for federal tax purposes.

Q5. If registered domestic partners adopt a child together, can one or both of the registereddomestic partners qualify for the adoption credit?

A5. Yes. Each registered domestic partner may qualify to claim the adoption credit for the amount ofthe qualified adoption expenses paid for the adoption. The partners may not both claim a credit forthe same qualified adoption expenses, and the sum of the credit taken by each registered domesticpartner may not exceed the total amount paid. The adoption credit is limited to $12,970 per child in2013. Thus, if both registered domestic partners paid qualified adoption expenses to adopt the samechild, and the total of those expenses exceeds $12,970, the maximum credit available for theadoption is $12,970. The registered domestic partners may allocate this maximum between them inany way they agree, and the amount of credit claimed by one registered domestic partner canexceed the adoption expenses paid by that person, as long as the total credit claimed by bothregistered domestic partners does not exceed the total amount paid by them. The same rulesgenerally apply in the case of a special needs adoption.

Q6. If a taxpayer adopts the child of his or her registered domestic partner as a second parentor co-parent, may the taxpayer (“adopting parent”) claim the adoption credit for the qualifyingadoption expenses he or she pays to adopt the child?

A6. Yes. The adopting parent may be eligible to claim an adoption credit. A taxpayer may not claiman adoption credit for the expenses of adopting the child of the taxpayer’s spouse (section 23) . However, this limitation does not apply to adoptions by registered domestic partners becauseregistered domestic partners are not spouses for federal tax purposes.

Q7. Do provisions of the federal tax law such as section 66 (treatment of community income)and section 469(i)(5) ($25,000 offset for passive activity losses for rental real estate activities)that apply to married taxpayers apply to registered domestic partners?

A7. No. Like other provisions of the federal tax law that apply only to married taxpayers, section 66and section 469(i)(5) do not apply to registered domestic partners because registered domesticpartners are not married for federal tax purposes.

Q8. Is a registered domestic partner the stepparent of his or her partner’s child?

A8. If a registered domestic partner is the stepparent of his or her partner’s child under state law, theregistered domestic partner is the stepparent of the child for federal income tax purposes.

Publication 555, Community Property, provides general information for taxpayers, includingregistered domestic partners, who reside in community property states. The following questions andanswers provide additional information to registered domestic partners (including same-sex andopposite-sex registered domestic partners) who reside in community property states and are subjectto community property laws.

Q9. How do registered domestic partners determine their gross income?

A9. Registered domestic partners must each report half the combined community income earned bythe partners. In addition to half of the community income, a partner who has income that is notcommunity income must report that separate income.





Q10. Can a registered domestic partner qualify to file his or her tax return using head-of-household filing status?

A10. Generally, to qualify as a head-of-household, a taxpayer must provide more than half the costof maintaining his or her household during the taxable year, and that household must be the principalplace of abode of the taxpayer’s dependent for more than half of the taxable year (section 2(b)). Ifregistered domestic partners pay all of the costs of maintaining the household from communityfunds, each partner is considered to have incurred half the cost and neither can qualify as head ofhousehold. Even if one of the partners pays more than half by contributing separate funds, thatpartner cannot file as head of household if the only dependent is his or her registered domesticpartner. A taxpayer’s registered domestic partner is not one of the specified related individuals insection 152(c) or (d) that qualifies the taxpayer to file as head of household, even if the partner is thetaxpayer’s dependent.

Q11. Can a registered domestic partner be a dependent of his or her partner for purposes ofthe dependency deduction under section 151?

A11. A registered domestic partner can be a dependent of his or her partner if the requirements ofsections 151 and 152 are met. However, it is unlikely that registered domestic partners will satisfythe gross income requirement of section 152(d)(1)(B) and the support requirement of section 152(d)(1)(C). To satisfy the gross income requirement, the gross income of the individual claimed as adependent must be less than the exemption amount ($3,900 for 2013). Because registered domesticpartners each report half the combined community income earned by both partners, it is unlikely thata registered domestic partner will have gross income that is less than the exemption amount.

To satisfy the support requirement, more than half of an individual’s support for the year must beprovided by the person seeking the dependency deduction. If a registered domestic partner’s(Partner A’s) support comes entirely from community funds, that partner is considered to haveprovided half of his or her own support and cannot be claimed as a dependent by another. However,if the other registered domestic partner (Partner B) pays more than half of the support of Partner Aby contributing separate funds, Partner A may be a dependent of Partner B for purposes of section151, provided the other requirements of sections 151 and 152 are satisfied.

Q12. Can a registered domestic partner be a dependent of his or her partner for purposes ofthe exclusion in section 105(b) for reimbursements of expenses for medical care?

A12. A registered domestic partner (Partner A) may be a dependent of his or her partner (Partner B)for purposes of the exclusion in section 105(b) only if the support requirement (discussed inQuestion 11, above) is satisfied. Unlike the requirements for section 152(d) (dependency deductionfor a qualifying relative), section 105(b) does not require that Partner A's gross income be less thanthe exemption amount in order for Partner A to qualify as a dependent.

Q13. How should registered domestic partners report wages, other income items, anddeductions on their federal income tax returns?

A13. Registered domestic partners should report wages, other income items, and deductionsaccording to the instructions to Form 1040, U.S. Individual Income Tax Return, and relatedschedules, and Form 8958, Allocation of Tax Amounts Between Certain Individuals in CommunityProperty States. Form 8958 is used to determine the allocation of tax amounts between registereddomestic partners. Each partner must complete and attach Form 8958 to his or her Form 1040.

Q14. Should registered domestic partners report social security benefits as communityincome for federal tax purposes?





A14. Generally, state law determines whether an item of income constitutes communityincome. Accordingly, if Social Security benefits are community income under state law, then they arealso community income for federal income tax purposes. If Social Security benefits are notcommunity income under state law, then they are not community income for federal income taxpurposes.

Q15. How should registered domestic partners report community income from a business onSchedule C, Profit or Loss From Business?

A15. Half of the income, deductions, and net earnings of a business operated by a registereddomestic partner must be reported by each registered domestic partner on a Schedule C (orSchedule C-EZ). In addition, each registered domestic partner owes self-employment tax on half ofthe net earnings of the business. The self-employment tax rule under section 1402(a)(5) thatoverrides community income treatment and attributes the income, deductions, and net earnings tothe spouse who carries on the trade or business does not apply to registered domestic partners.

Q16. Are registered domestic partners each entitled to half of the credits for income taxwithholding from the combined wages of the registered domestic partners?

A16. Yes. Because each registered domestic partner is taxed on half the combined communityincome earned by the partners, each is entitled to a credit for half of the income tax withheld on thecombined wages.

Q17. Are registered domestic partners each entitled to take credit for half of the totalestimated tax payments paid by the partners?

A17. No. Unlike withholding credits, which are allowed to the person who is taxed on the incomefrom which the tax is withheld, a registered domestic partner can take credit only for the estimatedtax payments that he or she made.

Q18. Are community property laws taken into account in determining earned income forpurposes of the dependent care credit, the refundable portion of the child tax credit, theearned income credit, and the making work pay credit?

A18. No. The federal tax laws governing these credits specifically provide that earned income iscomputed without regard to community property laws in determining the earned income amountsdescribed in section 21(d) (dependent care credit), section 24(d) (the refundable portion of the childtax credit), section 32(a) (earned income credit), and section 36A(d) (making work pay credit).

Q19. Are community property laws taken into account in determining adjusted gross income(or modified adjusted gross income) for purposes of the dependent care credit, the child taxcredit, the earned income credit, and the making work pay credit?

A19. Yes. Community property laws must be taken into account in determining the adjusted grossincome (or modified adjusted gross income) amounts in section 21(a) (dependent care credit),section 24(b) (child tax credit), section 32(a) (earned income credit), and section 36A(b) (makingwork pay credit).

Q20. Are amounts a registered domestic partner receives for education expenses that cannotbe excluded from the partner’s gross income (includible education benefits) considered to becommunity income?

A20. Generally, state law determines whether an item of income constitutes communityincome. Accordingly, whether includible education benefits are community income for federal income





tax purposes depends on whether they are community income under state law. If the includibleeducation benefits are community income under state law, then they are community income forfederal income tax purposes. If not community income under state law, they are not communityincome for federal income tax purposes.

Q21. If only one registered domestic partner is a teacher and pays qualified out-of-pocketeducator expenses from community funds, do the registered domestic partners split theeducator expense deduction?

A21. No. Section 62(a)(2)(D) allows only eligible educators to take a deduction for qualified out-of-pocket educator expenses. If only one registered domestic partner is an eligible educator (theeligible partner), then only the eligible partner may claim a section 62(a)(2)(D) deduction. If theeligible partner uses community funds to pay educator expenses, the eligible partner may determinethe deduction as if he or she made the entire expenditure. In that case, the eligible partner hasreceived a gift from his or her partner equal to one-half of the expenditure.

Q22. If a registered domestic partner incurs indebtedness for his or her qualified educationexpenses or the expenses of a dependent and pays interest on the indebtedness out ofcommunity funds, do the registered domestic partners split the interest deduction?

A22. No. To be a qualified education loan, the indebtedness must be incurred by a taxpayer to paythe qualified education expenses of the taxpayer, the taxpayer’s spouse, or a dependent of thetaxpayer (section 221(d)(1)). Thus, only the partner who incurs debt to pay his or her own educationexpenses or the expenses of a dependent may deduct interest on a qualified education loan (thestudent partner). If the student partner uses community funds to pay the interest on the qualifiededucation loan, the student partner may determine the deduction as if he or she made the entireexpenditure. In that case, the student partner has received a gift from his or her partner equal to one-half of the expenditure.

Q23. If registered domestic partners pay the qualified educational expenses of one of thepartners or a dependent of one of the partners with community funds, do the registereddomestic partners split the section 25A credits (education credits)?

A23. No. Only the partner who pays his or her own education expenses or the expenses of his or herdependent is eligible for an education credit (the student partner). If the student partner usescommunity funds to pay the education expenses, the student partner may determine the credit as ifhe or she made the entire expenditure. In that case, the student partner has received a gift from hisor her partner equal to one-half of the expenditure. Similarly, if the student partner is allowed adeduction under section 222 (deduction for qualified tuition and related expenses), and usescommunity funds to pay the education expenses, the student partner may determine the qualifiedtuition expense deduction as if he or she made the entire expenditure. In that case, the studentpartner has received a gift from his or her partner equal to one-half of the expenditure.

Q24. Are community property laws taken into account in determining compensation forpurposes of the IRA deduction?

A24. No. The federal tax laws governing the IRA deduction (section 219(f)(2)) specifically providethat the maximum IRA deduction (under section 219(b)) is computed separately for each individual,and that these IRA deduction rules are applied without regard to any community property laws. Thus,each individual determines whether he or she is eligible for an IRA deduction by computing his or herindividual compensation (determined without application of community property laws).

Q25. If a registered domestic partner is self-employed and pays health insurance premiumsfor both partners out of community property funds, are both partners allowed a deduction






under section 162(l) (deduction for self-employed health insurance)?

A25. If one of the registered domestic partners is a self-employed individual treated as an employeewithin the meaning of section 401(c)(1)(the employee partner) and the other partner is not (the non-employee partner), the employee partner may be allowed a deduction under section 162(l) for thecost of the employee partner’s health insurance paid out of community funds. If the non-employeepartner is also covered by the health insurance, the portion of the cost attributable to the non-employee partner’s coverage is not deductible by either the employee partner or the non-employeepartner under section 162(l).

Q26. If a registered domestic partner has a dependent and incurs employment-relatedexpenses that are paid out of community funds, how does the registered domestic partnercalculate the dependent care credit? How about the child tax credit?

A26. If a registered domestic partner has a qualifying individual as defined in section 21(b)(1) andincurs employment-related expenses as defined in section 21(b)(2) for the care of the qualifyingindividual that are paid with community funds, the partner (employee partner) may determine thedependent care credit as if he or she made the entire expenditure. In that case, the employeepartner has received a gift from his or her partner equal to one-half of the expenditure. In computingthe dependent care credit, the following rules apply:

The employee partner must reduce the employment-related expenses by any amounts he or sheexcludes from income under section 129 (exclusion for employees for dependent care assistancefurnished pursuant to a program described in section 129(d));The earned income limitation described in section 21(d) is determined without regard tocommunity property laws; andThe adjusted gross income of the employee partner is determined by taking into accountcommunity property laws.

A child tax credit is allowed for each qualifying child of a taxpayer for whom the taxpayer is allowed apersonal exemption deduction. Thus, if a registered domestic partner has one or more dependentswho is a qualifying child, the registered domestic partner may be allowed a child tax credit for eachqualifying child. In determining the amount of the allowable credit, the modified adjusted grossincome of the registered domestic partner with the qualifying child is determined by taking intoaccount community property laws. Community property laws are ignored, however, in determiningthe refundable portion of the child tax credit.

Q27. Does Rev. Proc. 2002-69, 2002-2 C.B. 831, apply to registered domestic partners?

A27. No. Rev. Proc. 2002-69 allows spouses to classify certain entities solely owned by the spousesas community property, as either a disregarded entity or a partnership for federal tax purposes. Rev.Proc. 2002-69 applies only to spouses. Because registered domestic partners are not spouses forfederal tax purposes, Rev. Proc. 2002-69 does not apply to registered domestic partners.

Related Item: Forms and Publications

http://www.irs.gov/pub/irs-drop/rp-02-69.pdf

http://www.irs.gov/Forms-&-Pubs



Did the Requesting Entity intend to be classified as an ESBT or QSST as of the Effective Date? § 4.02(1)

A private letterruling is requiredto obtain relief.

Does the Requesting Entity fail to qualify as an ESBT or QSST as of the Effective Date solely because the Election Under Subchapter S was not timely filed by the Due Date of the Election Under Subchapter S?

§ 4.02(3)

Yes

Have less than 3 years and 75 days passed since the Effective Date of the election? § 4.02(2)

No

Yes

No

Yes

The S corporation and the person or entity are seeking relief for an inadvertent invalid S corporation

election or an inadvertent termination of an S corporation election due to the failure to make the

timely ESBT or QSST election, the failure to file the timely Election Under Subchapter S was inadvertent, and the S corporation and the person or entity seeking relief acted diligently to correct the mistake upon its

discovery? § 4.02(4)

Sections 4 and 6 provide relief for the late election.Follow the procedural requirements in Section 4.03 and

Section 6

Yes

Can the S corporation provide statements from all shareholders during the period between the date the S

corporation election terminated or was to have become effective and the date the completed election was filed that they have reported their income on all

affected returns consistent with the S corporation election for the year the election should have been

made and for all subsequent years? § 6.01(4)

Yes

No

No

No

Relief for Late QSST & ESBT Elections



Did the Requesting Entity intend for the subsidiary corporation to be classified as an QSub as of the

Effective Date? § 4.02(1)


Does the subsidiary corporation fail to qualify as a QSub as of the Effective Date solely because the

Election Under Subchapter S was not timely filed by the Due Date of the Election Under Subchapter S?

§ 4.02(3)

Yes


No

Yes

No

Yes

Does the Requesting Entity have reasonable cause for its failure to timely file the Election Under

Subchapter S and has it acted diligently to correct the mistake upon its discovery? § 4.02(4)

Sections 4 and 7 provide relief for the late election.Follow the procedural requirements in Sections 4.03 and

Section 7.

Yes

Is it the case that (i) the subsidiary corporation satisfies the QSub requirements and (ii) all assets,

liabilities, and items of income, deduction, and credit of the QSub have been treated as assets, liabilities, and items of income, deduction, and credit of the S

corporation on all affected returns consistent with the QSub election for the year the election was intended

to be effective and for all subsequent years? § 7.02

Yes

No

No

No

Relief for Late QSub Elections



Did the Requesting Entity intend to be classified as an S corporation as of the Effective Date? § 4.02(1)


Does the Requesting Entity fail to qualify as an S corporation as of the Effective Date solely because

the Election Under Subchapter S was not timely filed by the Due Date of the Election Under Subchapter S?

§ 4.02(3)

Yes

No

No

Yes

Does the Requesting Entity have reasonable cause for its failure to timely file the Election Under

Subchapter S and has it acted diligently to correct the mistake upon its discovery? § 4.02(4)

Sections 4 and 5 provide relief for the late election.Follow the procedural requirements in Sections 4.03

and Section 5.

Yes

Can the S corporation provide statements from all shareholders during the period

between the date the S corporation election was to have become effective and the date the completed election was filed that they have reported their income on all affected returns consistent with the S corporation election for the year the election should have been made and for all subsequent

years? § 5.02

Yes

No

No

No

Relief for Late S Corporation Elections


Yes

Is it the case that (i) the corporation and all of its shareholders reported their income consistent

with S corporation status for the year the S corporation election should have been made, and for every subsequent taxable year (if any); (ii) at

least 6 months have elapsed since the date on which the corporation filed its tax return for the

first year the corporation intended to be an S corporation; and (iii) neither the corporation nor

any of its shareholders was notified by the Service of any problem regarding the S

corporation status within 6 months of the date on which the Form 1120S for the first year was

timely filed? § 5.04Yes

No

Yes

No

NoNo



Did the Requesting Entity intend to be classified as an S corporation as of the Effective Date? §§ 4.02(1) / 5.03(2)


Did the Requesting Entity fail to qualify as an S corporation as of the Effective Date solely because the Election Under Subchapter S was not timely filed by the Due Date of

the Election Under Subchapter S? §§ 4.02(3) / 5.03(4)

Does the Requesting Entity have reasonable cause for its failure to timely file the Election Under Subchapter S and has it acted diligently to correct the mistake upon its

discovery? § 4.02(4)

Sections 4 and 5 provide relief for the late election.Follow the procedural requirements in Sections 4.03

and 5.

Can the S corporation provide statements from all shareholders during the period between the date the S corporation election was to have become effective and the date the completed election was filed that they have reported their income on all affected

returns consistent with the S corporation election for the year the election should have been made and for all subsequent years? §§ 5.01 / 5.02

Relief for Late S Corporation and Entity Classification Elections for the Same Entity


Is the Requesting Entity an eligible entity as defined in § 301.7701-3(a)? § 5.03(1)

Did the Requesting Entity fail to qualify as a corporation solely because Form 8832 was not timely filed under § 301.7701-3(c)(1)(i), or Form 8832 was not deemed to have been

filed under § 301.7701-3(c)(1)(v)(C)? § 5.03(3)

Yes

Yes

Yes

Yes

Yes

Yes

Yes No

No

No

No

No

No

No

Did the Requesting Entity: (i) timely file all Forms 1120S consistent with its requested classification as an S corporation, or (ii) the due date for the first year’s Form 1120S has

not yet passed? 5.03(5)

No

Yes

Yes

No



10/9/13 2:29 PMQuestions and Answers on the Net Investment Income Tax

Page 1 of 5http://www.irs.gov/uac/Newsroom/Net-Investment-Income-Tax-FAQs

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Questions and Answers on the NetInvestment Income TaxBasics of the Net Investment Income Tax1. What is the Net Investment Income Tax (NIIT)?

The Net Investment Income Tax is imposed by section 1411 of the Internal Revenue Code (IRC).The NIIT applies at a rate of 3.8 percent to certain net investment income of individuals, estates andtrusts that have income above the statutory threshold amounts.

2. When did the Net Investment Income Tax take effect?

The Net Investment Income Tax went into effect on Jan. 1, 2013. The NIIT affects income tax returnsof individuals, estates and trusts for their first tax year beginning on (or after) Jan. 1, 2013. It doesnot affect income tax returns for the 2012 taxable year filed in 2013.

Who Owes the Net Investment Income Tax3. What individuals are subject to the Net Investment Income Tax?

Individuals will owe the tax if they have Net Investment Income and also have modified adjustedgross income over the following thresholds:

Filing Status Threshold AmountMarried filing jointly $250,000Married filing separately $125,000Single $200,000Head of household (with qualifying person) $200,000Qualifying widow(er) with dependent child $250,000

Taxpayers should be aware that these threshold amounts are not indexed for inflation.

If you are an individual that is exempt from Medicare taxes, you still may be subject to the NetInvestment Income Tax if you have Net Investment Income and also have modified adjusted grossincome over the applicable thresholds.

4. What individuals are not subject to the Net Investment Income Tax?

Nonresident Aliens (NRAs) are not subject to the Net Investment Income Tax. If an NRA is marriedto a U.S. citizen or resident and has made, or is planning to make, an election under IRC section6013(g) to be treated as a resident alien for purposes of filing as Married Filing Jointly, the proposedregulations provide these couples special rules and a corresponding IRC section 6013(g) election forthe NIIT.

5. What Estates and Trusts are subject to the Net Investment Income Tax?

Estates and Trusts will be subject to the Net Investment Income Tax if they have undistributed NetInvestment Income and also have adjusted gross income over the dollar amount at which the highest





tax bracket for an estate or trust begins for such taxable year (for tax year 2012, this thresholdamount is $11,650). There are special computational rules for certain unique types of trusts, such aCharitable Remainder Trusts and Electing Small Business Trusts, which can be found in theproposed regulations (see # 19 below).

6. What Trusts are not subject to the Net Investment Income Tax?

The following trusts are not subject to the Net Investment Income Tax:

1. Trusts that are exempt from income taxes imposed by Subtitle A of the Internal Revenue Code(e.g., charitable trusts and qualified retirement plan trusts exempt from tax under IRC section501, and Charitable Remainder Trusts exempt from tax under IRC section 664).

2. A trust in which all of the unexpired interests are devoted to one or more of the purposesdescribed in IRC section 170(c)(2)(B).

3. Trusts that are classified as “grantor trusts” under IRC sections 671-679.4. Trusts that are not classified as “trusts” for federal income tax purposes (e.g., Real Estate

Investment Trusts and Common Trust Funds).

What is Included in Net Investment Income7. What is included in Net Investment Income?

In general, investment income includes, but is not limited to: interest, dividends, capital gains, rentaland royalty income, non-qualified annuities, income from businesses involved in trading of financialinstruments or commodities, and businesses that are passive activities to the taxpayer (within themeaning of IRC section 469). To calculate your Net Investment Income, your investment income isreduced by certain expenses properly allocable to the income (see #12 below).

8. What are some common types of income that are not Net Investment Income?

Wages, unemployment compensation; operating income from a nonpassive business, SocialSecurity Benefits, alimony, tax-exempt interest, self-employment income, Alaska Permanent FundDividends (see Rev. Rul. 90-56, 1990-2 CB 102) and distributions from certain Qualified Plans(those described in sections 401(a), 403(a), 403(b), 408, 408A, or 457(b)).

9. What kinds of gains are included in Net Investment Income?

To the extent that gains are not otherwise offset by capital losses, the following gains are commonexamples of items taken into account in computing Net Investment Income:

1. Gains from the sale of stocks, bonds, and mutual funds.2. Capital gain distributions from mutual funds.3. Gain from the sale of investment real estate (including gain from the sale of a second home that

is not a primary residence).

Gains from the sale of interests in partnerships and S corporations (to the extent you were a passiveowner).

10. Does this tax apply to gain on the sale of a personal residence?

The Net Investment Income Tax will not apply to any amount of gain that is excluded from grossincome for regular income tax purposes. The pre-existing statutory exclusion in IRC section 121exempts the first $250,000 ($500,000 in the case of a married couple) of gain recognized on the saleof a principal residence from gross income for regular income tax purposes and, thus, from the NIIT.





Example 1: A, a single filer, earns $210,000 in wages and sells his principal residence that he hasowned and resided in for the last 10 years for $420,000. A’s cost basis in the home is $200,000. A’srealized gain on the sale is $220,000. Under IRC section 121, A may exclude up to $250,000 of gainon the sale. Because this gain is excluded for regular income tax purposes, it is also excluded forpurposes of determining Net Investment Income. In this example, the Net Investment Income Taxdoes not apply to the gain from the sale of A’s home.

Example 2: B and C, a married couple filing jointly, sell their principal residence that they haveowned and resided in for the last 10 years for $1.3 million. B and C’s cost basis in the home is$700,000. B and C’s realized gain on the sale is $600,000. The recognized gain subject to regularincome taxes is $100,000 ($600,000 realized gain less the $500,000 IRC section 121 exclusion). Band C have $125,000 of other Net Investment Income, which brings B and C’s total Net InvestmentIncome to $225,000. B and C’s modified adjusted gross income is $300,000 and exceeds thethreshold amount of $250,000 by $50,000. B and C are subject to NIIT on the lesser of $225,000(B’s Net Investment Income) or $50,000 (the amount B and C’s modified adjusted gross incomeexceeds the $250,000 married filing jointly threshold). B and C owe Net Investment Income Tax of$1,900 ($50,000 X 3.8%).

Example 3: D, a single filer, earns $45,000 in wages and sells her principal residence that she hasowned and resided in for the last 10 years for $1 million. D’s cost basis in the home is $600,000. D’srealized gain on the sale is $400,000. The recognized gain subject to regular income taxes is$150,000 ($400,000 realized gain less the $250,000 IRC section 121 exclusion), which is also NetInvestment Income. D’s modified adjusted gross income is $195,000. Since D’s modified adjustedgross income is below the threshold amount of $200,000, D does not owe any Net InvestmentIncome Tax.

11. Does Net Investment Income include interest, dividends and capital gains of my childrenthat I report on my Form 1040 using Form 8814?

The amounts of Net Investment Income that are included on your Form 1040 by reason of Form8814 are included in calculating your Net Investment Income. However, the calculation of your NetInvestment Income does not include (a) amounts excluded from your Form 1040 due to thethreshold amounts on Form 8814 and (b) amounts attributable to Alaska Permanent Fund Dividends.

12. What investment expenses are deductible in computing NII?

In order to arrive at Net Investment Income, Gross Investment Income (items described in items 7-11above) is reduced by deductions that are properly allocable to items of Gross Investment Income.Examples of properly allocable deductions include investment interest expense, investment advisoryand brokerage fees, expenses related to rental and royalty income, and state and local income taxesproperly allocable to items included in Net Investment Income.

13. Will I have to pay both the 3.8% Net Investment Income Tax and the additional .9%Medicare tax?

You may be subject to both taxes, but not on the same type of income.

The 0.9% Additional Medicare Tax applies to individuals’ wages, compensation and self-employmentincome over certain thresholds, but it does not apply to income items included in Net InvestmentIncome. See more information on the Additional Medicare Tax.

How the Net Investment Income Tax is Reported and Paid14. If I am subject to the Net Investment Income Tax, how will I report and pay the tax?

http://www.irs.gov/Businesses/Small-Businesses-&-Self-Employed/Questions-and-Answers-for-the-Additional-Medicare-Tax





For individuals, the tax will be reported on, and paid with, the Form 1040. For Estates and Trusts, thetax will be reported on, and paid with, the Form 1041.

15. Is the Net Investment Income Tax subject to the estimated tax provisions?

The Net Investment Income Tax is subject to the estimated tax provisions. Individuals, estates, andtrusts that expect to be subject to the tax in 2013 or thereafter should adjust their income taxwithholding or estimated payments to account for the tax increase in order to avoid underpaymentpenalties.

16. Does the tax have to be withheld from wages?

No, but you may request that additional income tax be withheld from your wages.

17. What form will I use to report the Net Investment Income Tax?

The IRS has released a draft of Form 8960, which been developed for the purpose of reporting theNet Investment Income Tax. Click here to see a draft of Form 8960 or go to www.irs.gov/draftforms.

Examples of the Calculation of the Net Investment Income Tax18. How does a Single taxpayer with income less than the statutory threshold calculate theNet Investment Income Tax?

Taxpayer, a single filer, has wages of $180,000 and $15,000 of dividends and capital gains.Taxpayer’s modified adjusted gross income is $195,000, which is less than the $200,000 statutorythreshold. Taxpayer is not subject to the Net Investment Income Tax.

19. How does a Single taxpayer with income greater than the statutory threshold calculate theNet Investment Income Tax?

Taxpayer, a single filer, has $180,000 of wages. Taxpayer also received $90,000 from a passivepartnership interest, which is considered Net Investment Income. Taxpayer’s modified adjustedgross income is $270,000.

Taxpayer’s modified adjusted gross income exceeds the threshold of $200,000 for single taxpayersby $70,000. Taxpayer’s Net Investment Income is $90,000.

The Net Investment Income Tax is based on the lesser of $70,000 (the amount that Taxpayer’smodified adjusted gross income exceeds the $200,000 threshold) or $90,000 (Taxpayer’s NetInvestment Income). Taxpayer owes NIIT of $2,660 ($70,000 x 3.8%).

Additional Information20. Other than these FAQs, where can I find additional information about the Net InvestmentIncome Tax?

Find it in the full text of the proposed regulations, request for comments, and information on thepublic hearing.

21. The proposed regulations are effective for tax years beginning after Dec. 31, 2013, but theNet Investment Income Tax went into effect on Jan. 1, 2013. May I rely on the regulations forguidance on the Net Investment Income Tax during 2013?

Taxpayers may rely on the proposed regulations for purposes of compliance with section 1411 untilthe effective date of the final regulations. To the extent the proposed regulations provide taxpayers

http://www.irs.gov/pub/irs-dft/f8960--dft.pdf

http://www.irs.gov/draftforms

http://apps.irs.gov/app/scripts/exit.jsp?dest=http://www.gpo.gov/fdsys/pkg/FR-2012-12-05/pdf/2012-29238.pdf





Page Last Reviewed or Updated: 08-Aug-2013

with the ability to make an election, taxpayers may make the election provided that the election ismade in the manner described in the proposed regulation. Any election made in reliance on theproposed regulations will be in effect for the year of the election, and will remain in effect forsubsequent taxable years. However, if final regulations provide for the same or a similar election,taxpayers who opt not to make an election in reliance on the proposed regulations will not beprecluded from making that election pursuant to the final regulations.



10/11/13 1:03 AMQuestions and Answers for the Additional Medicare Tax

Page 1 of 9http://www.irs.gov/Businesses/Small-Businesses-&-Self-Employed/Questions-and-Answers-for-the-Additional-Medicare-Tax

Small Business/Self-Employed

Industries/ProfessionsInternational TaxpayersSelf-EmployedSmall Business/Self-Employed Home

Small Business/Self-Employed Topics

A-Z Index for BusinessForms & PubsStarting a BusinessDeducting ExpensesBusinesses withEmployeesFiling/Paying TaxesPost-Filing IssuesChanging Your Business

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Questions and Answers for the AdditionalMedicare TaxThe following questions and answers provide employers and payroll service providers informationthat will help them as they prepare to implement the Additional Medicare Tax which goes into effectin 2013. The Additional Medicare Tax applies to individuals’ wages, other compensation, and self-employment income over certain thresholds; employers are responsible for withholding the tax onwages and other compensation in certain circumstances. The IRS has prepared these questions andanswers to assist employers and payroll service providers in adapting systems and processes thatmay be impacted.

BASIC FAQs

1. When does Additional Medicare Tax start?Additional Medicare Tax applies to wages and compensation above a threshold amount receivedafter December 31, 2012 and to self-employment income above a threshold amount received intaxable years beginning after December 31, 2012.

2. What is the rate of Additional Medicare Tax?The rate is 0.9 percent.

3. When are individuals liable for Additional Medicare Tax?An individual is liable for Additional Medicare Tax if the individual’s wages, compensation, or self-employment income (together with that of his or her spouse if filing a joint return) exceed thethreshold amount for the individual’s filing status:

Filing Status Threshold Amount

Married filing jointly $250,000

Married filing separately $125,000

Single $200,000

Head of household (with qualifying person) $200,000

Qualifying widow(er) with dependent child $200,000

4. What wages are subject to Additional Medicare Tax?All wages that are currently subject to Medicare Tax are subject to Additional Medicare Tax ifthey are paid in excess of the applicable threshold for an individual’s filing status. For moreinformation on what wages are subject to Medicare Tax, see the chart, Special Rules for VariousTypes of Services and Payments, in section 15 of Publication 15, (Circular E), Employer’s TaxGuide.

5. What Railroad Retirement Tax Act (RRTA) compensation is subject to Additional MedicareTax?All RRTA compensation that is currently subject to Medicare Tax is subject to AdditionalMedicare Tax if it is paid in excess of the applicable threshold for an individual’s filing status. AllFAQs that discuss the application of the Additional Medicare Tax to wages also apply to RRTAcompensation, unless otherwise indicated.

6. Are nonresident aliens and U.S. citizens living abroad subject to Additional Medicare Tax?There are no special rules for nonresident aliens and U.S. citizens living abroad for purposes ofthis provision. Wages, other compensation, and self-employment income that are subject toMedicare tax will also be subject to Additional Medicare Tax if in excess of the applicable





threshold.7. Additional Medicare Tax goes into effect for taxable years beginning after December 31,

2012; however, the proposed regulations (REG-130074-11) are not effective until after thenotice and comment period has ended and final regulations have been published in the FederalRegister. How will this affect Additional Medicare Tax requirements for employers, employees, orself-employed?Additional Medicare Tax applies to wages, compensation, and self-employment income receivedin tax years beginning after December 31, 2012. Taxpayers must comply with the law as of thatdate. With regard to specific matters discussed in the proposed regulations, taxpayers may relyon the proposed regulations for tax periods beginning before the date that the final regulationsare published in the Federal Register. If any requirements change in the final regulations,taxpayers will only be responsible for complying with the new requirements from the effectivedate of the final regulations.

INDIVIDUAL FAQs

8. Will Additional Medicare Tax be withheld from an individual's wages?An employer must withhold Additional Medicare Tax from wages it pays to an individual in excessof $200,000 in a calendar year, without regard to the individual’s filing status or wages paid byanother employer. An individual may owe more than the amount withheld by the employer,depending on the individual’s filing status, wages, compensation, and self-employment income. In that case, the individual should make estimated tax payments and/or request additionalincome tax withholding using Form W-4, Employee's Withholding Allowance Certificate.

9. Will Additional Medicare Tax be withheld from an individual’s compensation subject toRailroad Retirement Tax Act (RRTA) taxes?An employer must withhold Additional Medicare Tax from RRTA compensation it pays to anindividual in excess of $200,000 in a calendar year without regard to the individual’s filing statusor compensation paid by another employer. An individual may owe more than the amountwithheld by the employer, depending on the individual’s filing status, wages, compensation, andself-employment income. In that case, the individual should make estimated tax paymentsand/or request additional income tax withholding using Form W-4, Employee's WithholdingAllowance Certificate.

10. Can I request additional withholding specifically for Additional Medicare Tax?No. However, if you anticipate liability for Additional Medicare Tax, you may request that youremployer withhold an additional amount of income tax withholding on Form W-4. The additionalincome tax withholding will be applied against your taxes shown on your individual income taxreturn (Form 1040), including any Additional Medicare Tax liability.

11. Will I need to make estimated tax payments for Additional Medicare Tax?If you anticipate that you will owe Additional Medicare Tax but will not satisfy the liability throughAdditional Medicare Tax withholding and did not request additional income tax withholding usingForm W-4, you may need to make estimated tax payments. You should consider your estimatedtotal tax liability in light of your wages, other compensation, and self-employment income, and theapplicable threshold for your filing status when determining whether estimated tax payments arenecessary.

12. Does an individual who makes estimated tax payments to pay an expected liability forAdditional Medicare Tax need to identify the payments as specifically for this tax?No. An individual cannot designate any estimated payments specifically for Additional MedicareTax. Any estimated tax payments that an individual makes will apply to any and all tax liabilitieson the individual income tax return (Form 1040), including any Additional Medicare Tax liability.

13. Will individuals calculate Additional Medicare Tax liability on their income tax returns?Yes. Individuals liable for Additional Medicare Tax will calculate Additional Medicare Tax liabilityon their individual income tax returns (Form 1040). Individuals will also report AdditionalMedicare Tax withheld by their employers on their individual tax returns. Any AdditionalMedicare Tax withheld by an employer will be applied against all taxes shown on an individual’sincome tax return, including any Additional Medicare Tax liability.

14. Will an individual owe Additional Medicare Tax on all wages, compensation, and/or self-employment income or just the wages, compensation, and/or self-employment income inexcess of the threshold for the individual’s filing status?

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An individual will owe Additional Medicare Tax on wages, compensation, and/or self-employmentincome (and that of the individual’s spouse if married filing jointly) that exceed the applicablethreshold for the individual’s filing status. For married persons filing jointly the threshold is$250,000, for married persons filing separately the threshold is $125,000, and for all others thethreshold is $200,000.

15. If my employer withholds Additional Medicare Tax from my wages in excess of $200,000,but I won't owe the tax because my spouse and I file a joint return and we won't meet the$250,000 threshold for joint filers, can I ask my employer to stop withholding AdditionalMedicare Tax?No. Your employer must withhold Additional Medicare Tax on wages it pays to you in excess of$200,000 in a calendar year. Your employer cannot honor a request to cease withholdingAdditional Medicare Tax if it is required to withhold it. You will claim credit for any withheldAdditional Medicare Tax against the total tax liability shown on your individual income tax return(Form 1040).

16. What should I do if I have two jobs and neither employer withholds Additional MedicareTax, but the sum of my wages exceeds the threshold at which I will owe the tax?If you anticipate that you will owe Additional Medicare Tax but will not satisfy the liability throughAdditional Medicare Tax withholding (for example, because you will not be paid wages in excessof $200,000 in a calendar year by an employer), you should make estimated tax payments and/orrequest additional income tax withholding using Form W-4. For information on making estimatedtax payments and requesting an additional amount be withheld from each paycheck, seePublication 505, Tax Withholding and Estimated Tax.

17. Are wages that are not paid in cash, such as fringe benefits, subject to AdditionalMedicare Tax?Yes, the value of taxable wages not paid in cash, such as noncash fringe benefits, are subject toAdditional Medicare Tax, if, in combination with other wages, they exceed the individual’sapplicable threshold. Noncash wages are subject to Additional Medicare Tax withholding, if, incombination with other wages paid by the employer, they exceed the $200,000 withholdingthreshold.

18. Are tips subject to Additional Medicare Tax?Yes, tips are subject to Additional Medicare Tax, if, in combination with other wages, they exceedthe individual’s applicable threshold. Tips are subject to Additional Medicare Tax withholding, if,in combination with other wages paid by the employer, they exceed the $200,000 withholdingthreshold.

19. How do individuals calculate Additional Medicare Tax if they have wages subject toFederal Insurance Contributions Act (FICA) tax and self-employment income subject toSelf-Employment Contributions Act (SECA) tax?

Individuals with wages subject to FICA tax and self-employment income subject to SECA taxcalculate their liabilities for Additional Medicare Tax in three steps:

Step 1 Calculate Additional Medicare Tax on any wages in excess of the applicable threshold forthe filing status, without regard to whether any tax was withheld.

Step 2 Reduce the applicable threshold for the filing status by the total amount of Medicarewages received - but not below zero.

Step 3 Calculate Additional Medicare Tax on any self-employment income in excess of thereduced threshold.

Example 1: C, a single filer, has $130,000 in wages and $145,000 in self-employment income.

1. C’s wages are not in excess of the $200,000 threshold for single filers, so C is not liable forAdditional Medicare Tax on these wages.

2. Before calculating the Additional Medicare Tax on self-employment income, the $200,000threshold for single filers is reduced by C’s $130,000 in wages, resulting in a reduced self-employment income threshold of $70,000.

3. C is liable to pay Additional Medicare Tax on $75,000 of self-employment income ($145,000





in self-employment income minus the reduced threshold of $70,000).

Example 2: D and E are married and file jointly. D has $150,000 in wages and E has $175,000 inself-employment income.

1. D’s wages are not in excess of the $250,000 threshold for joint filers, so D and E are not liablefor Additional Medicare Tax on D’s wages.

2. Before calculating the Additional Medicare Tax on E’s self-employment income, the $250,000threshold for joint filers is reduced by D’s $150,000 in wages resulting in a reduced self-employment income threshold of $100,000.

3. D and E are liable to pay Additional Medicare Tax on $75,000 of self-employment income($175,000 in self-employment income minus the reduced threshold of $100,000).

Example 3: F, who is married and files separately, has $175,000 in wages and $50,000 in self-employment income.

1. F is liable to pay Additional Medicare Tax on $50,000 of his wages ($175,000 minus the$125,000 threshold for married persons who file separately).

2. Before calculating the Additional Medicare Tax on self-employment income, the $125,000threshold for married persons who file separately is reduced by F’s $175,000 in wages to $0(reduced, but not below zero).

3. F is liable to pay Additional Medicare Tax on $50,000 of self-employment income ($50,000 inself-employment income minus the reduced threshold of $0).

4. In total, F is liable to pay Additional Medicare Tax on $100,000 ($50,000 of his wages and$50,000 of his self-employment income).

Example 4: G, a head of household filer, has $225,000 in wages and $50,000 in self-employmentincome. G’s employer withheld Additional Medicare Tax on $25,000 ($225,000 minus the$200,000 withholding threshold).

1. G is liable to pay Additional Medicare Tax on $25,000 of her wages ($225,000 minus the$200,000 threshold for head of household filers).

2. Before calculating the Additional Medicare Tax on self-employment income, the $200,000threshold for head of household filers is reduced by G’s $225,000 in wages to $0 (reduced,but not below zero).

3. G is liable to pay Additional Medicare Tax on $50,000 of self-employment income ($50,000 inself-employment income minus the reduced threshold of $0).

4. In total, G is liable to pay Additional Medicare Tax on $75,000 ($25,000 of her wages and$50,000 of her self-employment income).

5. The Additional Medicare Tax withheld by G’s employer will be applied against all taxes shownon her individual income tax return, including any Additional Medicare Tax liability.

20. How do individuals calculate Additional Medicare Tax if they have compensation subjectto Railroad Retirement Tax Act (RRTA) taxes and wages subject to Federal InsuranceContributions Act (FICA) tax? Compensation subject to RRTA taxes and wages subject to FICA tax are not combined todetermine Additional Medicare Tax liability. The threshold applicable to an individual’s filingstatus is applied separately to each of these categories of income.Example: J and K, are married and file jointly. J has $190,000 in wages subject to Medicare taxand K has $150,000 in compensation subject to RRTA taxes. J and K do not combine theirwages and RRTA compensation to determine whether they are in excess of the $250,000threshold for a joint return. J and K are not liable to pay Additional Medicare Tax because J’swages are not in excess of the $250,000 threshold and K’s RRTA compensation is not in excessof the $250,000 threshold.

21. How do individuals calculate Additional Medicare Tax if they have compensation subjectto Railroad Retirement Tax Act (RRTA) taxes and self-employment income subject to Self-Employment Contributions Act (SECA) tax? The threshold applicable to an individual’s filing status is applied separately to RRTAcompensation and self-employment income. In calculating Additional Medicare Tax on self-





employment income, an individual does not reduce the applicable threshold for the taxpayer'sfiling status by the total amount of RRTA compensation.Example: F and G are married and file jointly. F has $160,000 in self-employment income and Ghas $140,000 in compensation subject to RRTA taxes. The $140,000 of RRTA compensationdoes not reduce the threshold at which Additional Medicare Tax applies to self-employmentincome. F and G are not liable to pay Additional Medicare Tax because F's self-employmentincome is not in excess of the $250,000 threshold and G’s RRTA compensation is not in excessof the $250,000 threshold.

22. Will I also owe net investment income tax on my income that is subject to AdditionalMedicare Tax?No. The new tax imposed by section 1411 on an individual’s net investment income is notapplicable to FICA wages, RRTA compensation, or self-employment income. Thus, an individualwill not owe net investment income tax on these categories of income, regardless of thetaxpayer’s filing status. See more information on the Net Investment Income Tax.

23. What form will individuals use to report the Additional Medicare Tax?The IRS has released the draft of Form 8959, which has been developed for the purpose ofreporting the Additional Medicare Tax. Click here to see a draft of Form 8959 or go towww.irs.gov/draftforms.

EMPLOYER and PAYROLL SERVICE PROVIDER FAQs

24. When must an employer withhold Additional Medicare Tax?The statute requires an employer to withhold Additional Medicare Tax on wages it pays to anemployee in excess of $200,000 in a calendar year, beginning January 1, 2013. An employer hasthis withholding obligation even though an employee may not be liable for Additional MedicareTax because, for example, the employee’s wages together with that of his or her spouse do notexceed the $250,000 threshold for joint return filers. Any withheld Additional Medicare Tax will becredited against the total tax liability shown on the individual’s income tax return (Form 1040).

25. Is an employer liable for Additional Medicare Tax even if it does not withhold it from anemployee’s wages? An employer that does not deduct and withhold Additional Medicare Tax as required is liable forthe tax unless the tax that it failed to withhold from the employee’s wages is paid by theemployee. Even if not liable for the tax, an employer that does not meet its withholding, deposit,reporting, and payment responsibilities for Additional Medicare Tax may be subject to allapplicable penalties.

26. Is an employer required to notify an employee when it begins withholding AdditionalMedicare Tax?No. There is no requirement that an employer notify its employee.

27. Is there an “employer match” for Additional Medicare Tax (as there is with the regularMedicare tax)? No. There is no employer match for Additional Medicare Tax.

28. May an employee request additional withholding specifically for Additional Medicare Tax?No. However, an employee who anticipates liability for Additional Medicare Tax may request thathis or her employer withhold an additional amount of income tax withholding on Form W-4. Thisadditional income tax withholding will be applied against all taxes shown on the individual’sincome tax return (Form 1040), including any Additional Medicare Tax liability.

29. If an employee’s annual Medicare wages are expected to be over $200,000, will anemployer withhold Additional Medicare Tax from the beginning of the year or only afterMedicare wages are actually paid in excess of $200,000 year-to-date?An employer is required to begin withholding Additional Medicare Tax in the pay period in which itpays wages in excess of $200,000 to an employee.

30. If a single payment of wages to an employee exceeds the $200,000 withholding threshold,will an employer withhold Additional Medicare Tax on the entire payment?No. Additional Medicare Tax withholding applies only to wages paid to an employee that are inexcess of $200,000 in a calendar year. Withholding rules for this tax are different than the incometax withholding rules for supplemental wages in excess of $1,000,000 as explained in Publication15, section 7.Example: M received $180,000 in wages through November 30, 2013. On December 1, 2013,

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M’s employer paid her a bonus of $50,000. M’s employer is required to withhold AdditionalMedicare Tax on $30,000 of the $50,000 bonus and may not withhold Additional Medicare Taxon the other $20,000. M's employer also must withhold Additional Medicare Tax on any otherwages paid in December 2013.

31. I have two employees who are married to each other. Each earns $150,000, so I know thattheir combined wages will exceed the threshold applicable to married couples that filejointly. Do I need to withhold Additional Medicare tax?No. An employer should not combine wages it pays to two employees to determine whether towithhold Additional Medicare Tax. An employer is required to withhold Additional Medicare Taxonly when it pays wages in excess of $200,000 in a calendar year to an employee.

32. What should an employer do if an employee receives wages that are not paid in cash,such as taxable fringe benefits, from which Additional Medicare Tax cannot be withheld?If an employee receives wages from an employer in excess of $200,000 and the wages includetaxable noncash fringe benefits, the employer calculates wages for purposes of withholdingAdditional Medicare Tax in the same way that it calculates wages for withholding the existingMedicare tax. The employer is required to withhold Additional Medicare Tax on total wages,including taxable noncash fringe benefits, in excess of $200,000. The value of taxable noncashfringe benefits must be included in wages and the employer must withhold the applicableAdditional Medicare Tax and deposit the tax under the rules for employment tax withholding anddeposits that apply to taxable noncash fringe benefits. Additional information on how to withholdtax on taxable noncash fringe benefits is available in Publication 15 (Circular E), section 5, andPublication 15-B, section 4.

33. If an employee receives tips and other wages in excess of $200,000 in the calendar year,how is Additional Medicare Tax paid on the tips?To the extent that tips and other wages exceed $200,000, an employer applies the samewithholding rules for Additional Medicare Tax as it does currently for Medicare tax. An employerwithholds Additional Medicare Tax on the employee’s reported tips from wages it pays to theemployee.

If the employee does not receive enough wages for the employer to withhold all the taxes that theemployee owes, including Additional Medicare Tax, the employee may give the employer moneyto pay the rest of the taxes. If the employee does not give the employer money to pay the taxes,then the employer makes a current period adjustment on Form 941, Employer’s QUARTERLYFederal Tax Return (or the employer’s applicable employment tax return), to reflect anyuncollected employee social security, Medicare, or Additional Medicare Tax on reported tips.However, unlike the uncollected portion of the regular (1.45%) Medicare tax, the uncollectedAdditional Medicare Tax is not reported in box 12 of Form W-2 with code B.

The employee may need to make estimated tax payments to cover any shortage. Moreinformation about this process of giving an employer money for taxes is available in Publication531, Reporting Tip Income.

34. If a former employee receives group-term life insurance coverage in excess of $50,000 andthe cost of the coverage, in combination with other wages, exceeds $200,000, how doesan employer report Additional Medicare Tax on this?The imputed cost of coverage in excess of $50,000 is subject to social security and Medicaretaxes, and to the extent that, in combination with other wages, it exceeds $200,000, it is alsosubject to Additional Medicare Tax withholding. However, when group-term life insurance over$50,000 is provided to an employee (including retirees) after his or her termination, the employeeshare of social security and Medicare taxes and Additional Medicare Tax on that period ofcoverage is paid by the former employee with his or her tax return and is not collected by theemployer. In this case, an employer should report this income as wages on Form 941,Employer’s QUARTERLY Federal Tax Return (or the employer’s applicable employment taxreturn), and make a current period adjustment to reflect any uncollected employee socialsecurity, Medicare, or Additional Medicare Tax on group-term life insurance. However, unlike theuncollected portion of the regular (1.45%) Medicare tax, an employer may not report theuncollected Additional Medicare Tax in box 12 of Form W-2 with code N.

35. For employees who receive third-party sick pay, will wages paid by an employer and bythe third party need to be aggregated to determine whether the $200,000 withholding





threshold has been met?Yes. Wages paid by an employer and by the third party need to be aggregated to determinewhether the $200,000 withholding threshold has been met. The same rules that currently assignresponsibility for sick pay reporting and payment of Medicare tax based on which party is treatedas the employer (that is, the employer, the employer’s agent, or a third party that is not theemployer’s agent) apply also to Additional Medicare Tax. For more information on sick pay, seePublication 15-A, Employer’s Supplemental Tax Guide, and Notice 91-26, 1991-2 C.B. 619.

36. If an employee has amounts deferred under a nonqualified deferred compensation (NQDC)plan, when is the nonqualified deferred compensation taken into account as wages forpurposes of withholding Additional Medicare Tax? An employer calculates wages for purposes of withholding Additional Medicare Tax fromnonqualified deferred compensation (NQDC) in the same way that it calculates wages forwithholding the existing Medicare tax from NQDC. Thus, if an employee has amounts deferredunder a nonqualified deferred compensation plan and the NQDC is taken into account as wagesfor FICA tax purposes under the special timing rule described in §31.3121(v)(2)-1(a)(2) of theEmployment Tax Regulations, the NQDC would likewise be taken into account under the specialtiming rule for purposes of determining an employer’s obligation to withhold Additional MedicareTax. Additional information about the special timing rules for NQDC is in Publication 957,Reporting Back Pay and Special Wage Payments to the Social Security Administration.

37. For a company that goes through a merger or acquisition, will the wages from thepredecessor and successor employers be combined to determine whether the $200,000withholding threshold has been met?When corporate acquisitions meet certain requirements, wages paid by the predecessor aretreated as if paid by the successor for purposes of applying the social security wage base and forapplying the Additional Medicare Tax withholding threshold (that is, $200,000 in a calendar year).For more information on acquisitions under the predecessor-successor rules, see Rev. Proc.2004-53, 2004-2 C.B. 320; Schedule D (Form 941), Report of Discrepancies Caused byAcquisitions, Statutory Mergers, or Consolidations; and the Instructions for Schedule D (Form941).

38. Should an employer combine an employee’s wages for services performed for all of itssubsidiaries if it has an employee who performs services for more than one subsidiary inits company, but the payroll is paid through one of the subsidiaries?An employer is required to withhold Additional Medicare Tax on wages paid to an employee inexcess of $200,000 in a calendar year. When an employee is performing services for multiplesubsidiaries of a company, and each subsidiary is an employer of the employee with regard tothe services the employee performs for that subsidiary, the wages paid by the payor on behalf ofeach subsidiary should be combined only if the payor is a common paymaster. Publication 15-A,section 7 contains more information on common paymasters. The wages are not combined forpurposes of the $200,000 withholding threshold if the payor is not a common paymaster.

39. I am a common paymaster that pays wages to an employee who is concurrently employedby related corporations. Should I combine this employee's wages for purposes ofdetermining whether wages are paid in excess of the $200,000 withholding threshold?Yes. Liability to withhold Additional Medicare Tax with respect to wages disbursed by thecommon paymaster is computed as if there was a single employer, just as it is for application ofthe social security wage base. See section 7 of Publication 15-A for more information oncommon paymasters.

40. If an agent pays wages to an employee on behalf of an employer (under an approved Form2678, Employer Appointment of Agent), then, for purposes of determining whether wagesare paid in excess of the $200,000 withholding threshold, should the agent combine thosewages with wages paid to that same employee

directly by the employer,by the same agent on behalf of a different employer, orby another agent on behalf of the same employer?

No. Wages paid by an agent with an approved Form 2678 on behalf of an employer shouldnot be combined with wages paid to the same employee by any of the above other parties indetermining whether to withhold Additional Medicare Tax.







41. I use an employee leasing company. How should wages be determined for purposes of the$200,000 withholding threshold? An employer is required to withhold Additional Medicare Tax on wages paid to an employee inexcess of $200,000 in a calendar year. Generally, if you provide wages in excess of the$200,000 withholding threshold to the employee leasing company to pay to an employee thatperforms services for you, Additional Medicare Tax should be withheld from the wages in excessof $200,000. Taxpayers should be aware that the employer is ultimately responsible for thedeposit and payment of federal tax liabilities. Even though you forward tax payments to a thirdparty to make the tax deposits, you may be responsible as the employer for the tax liability.

42. Will the IRS be changing Form 941 or any other forms for tax year 2013 to be completed byemployers and payroll service providers?Yes. For example, a line will be added to Form 941 on which employers will report anyindividual’s wages paid during the quarter that is in excess of $200,000 for the year, and onwhich employers will report their withholding liability for Additional Medicare Tax on those wages.The existing line, on which employers report the liability for regular Medicare tax on all wages, willremain unchanged.

However, there will be no change to Form W-2. Additional Medicare Tax withholding on wagessubject to Federal Insurance Contributions Act (FICA) taxes will be reported in combination withwithholding of regular Medicare tax in box 6 (“Medicare tax withheld”).

The IRS plans to release drafts of revised forms, including Forms 941, 943, and the tax returnschemas for the F94X series of returns.

43. When an employer deposits Additional Medicare Tax through the Electronic Federal TaxPayment System (EFTPS), does it need to separate Additional Medicare Tax from regularMedicare tax?No. When providing the deposit detail, regular Medicare tax and Additional Medicare Tax areentered as one combined amount.

44. If an employer underwithholds Additional Medicare Tax (for example, fails to withhold thetax when it pays the employee wages in excess of $200,000 in a calendar year) anddiscovers the error in the same year the wages are paid but after its Form 941 is filed, howcan the employer correct this error?An employer is liable for Additional Medicare Tax required to be withheld, whether or not itdeducts the tax from wages it pays to the employee. If the employer fails to withhold the correctamount of Additional Medicare Tax from wages it pays to an employee and discovers the error inthe same year it pays the wages, the employer may correct the error by making an interest-freeadjustment on the appropriate corrected return (for example, Form 941-X). Once the employerhas discovered the error, the employer should deduct the correct amount of Additional MedicareTax from other wages or other remuneration, if any, it pays to the employee on or before the lastday of the calendar year. However, even if the employer is not able to deduct the correct amountof Additional Medicare Tax from other wages or other remuneration it pays to the employee, theemployer must report and pay the correct amount of Additional Medicare Tax on its return. If theemployer pays Additional Medicare Tax without having deducted it from wages or otherremuneration it pays to the employee, the obligation of the employee to the employer withrespect to the payment is a matter for settlement between the employer and the employee. Formore information on adjustments, see section 13 of Pub 15 or visit the IRS website and enter thekeywords Correcting Employment Taxes.

45. If an employer overwithholds Additional Medicare Tax (for example, withholds the taxbefore it pays the employee wages in excess of $200,000 in a calendar year) and discoversthe error in the same year the wages are paid, how can the employer correct this error?The employer may correct the error by making an interest-free adjustment on the appropriatecorrected return (for example, Form 941-X). The employer must first repay or reimburse theoverwithheld amount to the employee prior to the end of the calendar year in which it paid thewages. If the employer does not repay or reimburse the employee the amount of overcollectedAdditional Medicare Tax before the end of the year in which the wages were paid, the employershould not correct the error via an interest-free adjustment. In this case, the employer shouldreport the amount of withheld Additional Medicare Tax on the employee’s Form W-2 so that theemployee may obtain credit for Additional Medicare Tax withheld on the employee’s individual

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income tax return. For more information on adjustments, see section 13 of Pub 15 or visit the IRSwebsite and enter the keywords Correcting Employment Taxes.

46. If an employer overwithholds Additional Medicare Tax (for example, withholds the taxbefore it pays the employee wages in excess of $200,000 in a calendar year) from anemployee’s wages, should the employer file a claim for refund for the Additional MedicareTax?No. An employer should only claim a refund of overpaid Additional Medicare Tax if it did notdeduct or withhold the overpaid Additional Medicare Tax from the employee’s wages. Theemployer should correct the error by making an interest-free adjustment on the appropriatecorrected return (for example, Form 941-X). For more information on claims for refund, seesection 13 of Pub 15 or visit the IRS website and enter the keywords Correcting EmploymentTaxes.

47. If an employer underwithholds Additional Medicare Tax (for example, fails to withhold thetax when it pays the employee wages in excess of $200,000 in a calendar year) anddiscovers the error in a subsequent year, should the employer correct this error bymaking an interest-free adjustment?No. If an employer underwithholds Additional Medicare Tax and does not discover the error in thesame year wages were paid, the employer should not correct the error by making an interest-freeadjustment. However, to the extent the employer can show that the employee paid AdditionalMedicare Tax, the underwithheld amount will not be collected from the employer. The employerwill remain subject to any applicable penalties.

48. If an employer overwithholds Additional Medicare Tax (for example, withholds the taxbefore it pays the employee wages in excess of $200,000 in a calendar year) and discoversthe error in a subsequent year, should the employer correct this error by making aninterest-free adjustment?No. If an employer withholds more than the correct amount of Additional Medicare Tax fromwages paid to an employee and does not discover the error in the same year the wages werepaid, the employer should not correct the error by making an interest-free adjustment. In thiscase, the employer should report the amount of withheld Additional Medicare Tax on theemployee’s Form W-2 so that the employee may obtain credit for Additional Medicare Taxwithheld. Additional Medicare Tax withholding will be applied against the taxes shown on theemployee’s individual income tax return (Form 1040).

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Chapter 2

2013 Oregon Tax updateroBert t. ManiCke

Stoel Rives LLPPortland, Oregon

Contents

I. New Income Tax Laws . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2–1A. Reconnection to Internal Revenue Code (HB 2492) . . . . . . . . . . . . . . . . . . . . 2–1B. Denial of Deduction for Contributions to Certain Listed Charities (HB 2060) . . . . . 2–1C. Collections and Compliance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2–1D. Business Taxpayers: Withdrawal from Multistate Tax Compact (SB 307) . . . . . . . . 2–2E. Corporate Taxpayers: “Tax Havens” (HB 2460) . . . . . . . . . . . . . . . . . . . . . . 2–2F. Tax Credits (HB 3367) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2–2

II. Recent Income Tax Cases . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2–3A. Oregon’s Reliance on Federal Law. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2–3B. Nonresident Individuals . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2–3C. Oregon’s Jurisdiction to Tax a Business That Sells into Oregon from Outside . . . . . 2–3D. Apportionment. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2–4E. Consolidated Returns . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2–4F. Most Tax Credits Offset the Corporate Minimum Tax . . . . . . . . . . . . . . . . . . . 2–5G. Statute of Limitations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2–5

III. Property Tax . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2–6A. New Laws (2011–2013) Modify Senior Property Tax Deferral Program . . . . . . . . . 2–6B. Property Tax Exemption Update . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2–6

IV. Oregon Tax Court Practice . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2–7A. Filing Fees (HB 4168, 2012 Or Laws Ch 48) . . . . . . . . . . . . . . . . . . . . . . . . . 2–7B. Oregon Tax Court’s Jurisdiction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2–7

V. What’s Ahead? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2–7

Oregon’s 2013 Special Legislative Session Passes Changes to Oregon Tax Law . . . . . . . . . . . . 2–9

Chapter 2—2013 Oregon Tax Update




i. nEW inCOME Tax LaWS

a. reconnection to internal revenue Code (hB 2492)

Generally updates Oregon’s date of connection to federal tax law from December 31, 2011, to January 3, 2013, so as to take into account the federal Affordable Care Act. Applies to certain provisions for which “rolling reconnection” is not applicable.

Reconnection for purposes of the earned income tax credit is achieved separately, through HB 3367.

B. denial of deduction for Contributions to Certain Listed Charities (hB 2060)

Allows the Oregon Attorney General to issue an order disqualifying a charitable organization from receiving contributions that are deductible for purposes of Oregon income tax and corporate excise tax if the Attorney General finds that the charitable organization has failed to expend at least 30% of total annual functional expenses on program services when those expenses are averaged over most recent three fiscal years.

The Attorney General may decline to issue a disqualification order if certain mitigating circumstances exist, including payments made to affiliates that should be counted as program services expenses, or a need to accumulate revenue for purposes disclosed to potential donors.

Specifies organizations exempt from the Act, including private foundations, certain community trusts or foundations, charitable remainder trusts, organizations not required to file a Form 990, organizations receiving less than 50% of annual revenues from contributions or grants identified in accordance with a Form 990 or equivalent, and organizations in existence less than four years.

Imposes mandatory disclosure requirements for charitable organizations subject to a disqualification order. Requires the Attorney General to publish on the Internet and otherwise make available a list of charitable organizations that are subject to disqualification orders.

Denies property tax exemption under ORS 307.130 starting with the tax year following the tax year in which the order goes into effect.

Requires a donor to add back to Oregon taxable income the amount deducted for a contribution to an entity that received a disqualification order, if the contribution was made more than 30 days after the Attorney General published the order on the Internet. A donor can avoid the addback by providing the DOR a contribution receipt on which the organization failed to include the disclosure of the order.

Effective October 7, 2013.

C. Collections and Compliance

1. new Oregon Penalties for Missing, incomplete, or incorrect Forms 1099 and W-2 and Other information returns (hB 2464). Imposes Oregon-only penalties for failure to file an information return with the Department of Revenue or for incomplete or incorrect returns. Includes Forms 1099, W-2, and annual and quarterly withholding returns.

Applies to payments made in tax years beginning on or after January 1, 2013.

2. dOr Garnishments (SB 185). Eliminates the requirement that the Department of Revenue deliver a warrant or a true copy of the warrant with a notice of garnishment. Requires that a notice of garnishment issued by the department bear the name of the individual issuing the notice on behalf of the department, but not be signed by that person. Effective on passage.

3. Tax Compliance by Licensed Professionals (hB 2871). Directs the Department of Revenue, no later than February 1, 2014, to report to the legislature on progress in implementing a 2009 pilot project that requires persons with state-issued business or professional licenses to demonstrate and maintain tax compliance as condition of issuance or renewal of their license. Directs the department



to include in its report plans for development and improvement of the project and recommendations for expansion. Effective October 7, 2013.

Reference: HB 3082, 2009 Or Laws ch 576.

d. Business Taxpayers: Withdrawal from Multistate Tax Compact (SB 307)

Withdraws Oregon from the Multistate Tax Compact by repealing the compact and reenacting it without those articles applicable to income tax and apportionment of business income for corporate tax purposes. Effective and operative October 7, 2013.

References:

F ORS 305.655 (Multistate Tax Compact) Art X (“No withdrawal shall affect any liability already incurred by or chargeable to a party state prior to the time of such withdrawal.”)

F Health Net Inc. v. DOR, Or Tax Ct No. 5127.

F Gillette Co. v. FTB, Cal Supreme Ct No. 206587.

E. Corporate Taxpayers: “Tax havens” (hB 2460)

Requires a corporation that is required to file an Oregon corporation excise tax return to include the income of a unitary corporation that is incorporated in a listed jurisdiction on the taxpayer’s Oregon tax return. The final list is:

Andorra, Anguilla, Antigua and Barbuda, Aruba, the Bahamas, Bahrain, Barbados, Belize, Bermuda, the British Virgin Islands, the Cayman Islands, the Cook Islands, Cyprus, Dominica, Gibraltar, Grenada, Guernsey-Sark-Alderney, the Isle of Man, Jersey, Liberia, Liechtenstein, Luxembourg, Malta, the Marshall Islands, Mauritius, Monaco, Montserrat, Nauru, the Netherlands Antilles, Niue, Samoa, San Marino, Seychelles, St. Kitts and Nevis, St. Lucia, St. Vincent and the Grenadines, the Turks and Caicos Islands, the U.S. Virgin Islands and Vanuatu.

Issues identified by the Laws Committee to the Public Affairs Committee: potential constitutional concerns because Oregon provides no ability to elect worldwide combined reporting, concerns under Foreign Commerce Clause and foreign affairs doctrine, lack of criteria for additions to or deletions from the list, additional compliance burdens.

Directs the Department of Revenue to report to the legislature on or before January 1 of each odd-numbered year on recommended changes to the list.

Directs the Department of Revenue to report to the legislature on the use of out-of-state tax shelters and to make recommendations for addressing noncompliance attributable to out-of-state tax shelters.

Applies to tax years beginning on or after January 1, 2014.

F. Tax Credits (hB 3367)

Extends the earned income tax credit in ORS 315.266 to tax years beginning before January 1, 2020, and reconnects to the Internal Revenue Code pursuant to the general reconnection provision in ORS 315.004(2) (as of January 3, 2013, pursuant to HB 2492).

Extends the following additional tax credits for six years: political contributions (with an income cap of $200,000 for married taxpayers filing jointly and $100,000 for all other returns), cultural trust, pension income, rural EMT, employer scholarships, farmworker housing construction (including references to agricultural workers), and the manufactured home park closure.

Extends the rural medical practice tax credit (with modifications to the eligibility requirements) for two years. Extends the subtraction for manufactured dwelling park capital gains for six years.



Clarifies the double deduction prohibition for the research and development tax credit.

Disallows the biomass tax credit for canola grown in the Willamette Valley.

Clarifies the three-year structure of the University Venture Development Fund tax credit.

Requires a revenue impact statement prepared for a tax expenditure bill to provide estimates for three biennia and include a public policy purpose statement.

Creates a default six-year sunset date for tax expenditures enacted after January 1, 2014.

Sunsets the workers’ compensation tax credit.

Makes a technical correction to the tax credit for livestock killed by wolves.

Increases the annual cap on film and video tax credit from $6 million to $10 million per year (including other reimbursement policy changes).

Restricts the additional senior medical deduction to the expenses of taxpayers who are age eligible for the program (at least age 62).

Restricts the maximum federal tax subtraction for married-filing-separately taxpayers to 50% of the amount allowed for other taxpayers.

Various applicability dates.

ii. rECEnT inCOME Tax CaSES

a. Oregon’s reliance on Federal Law

Oregon and Federal Tax Law Can Treat the Same deduction differently. Oregon tax law generally adopts, and conforms to, federal tax law. However, the Oregon Department of Revenue and the IRS may reach different conclusions with respect to the application of these principles. For example, the Magistrate Division upheld the department’s position that all of a structure was subject to the longer, 39-year, depreciation period applicable to real property, even though the IRS had determined that 80% of the structure qualified for shorter depreciation periods allowed for personal property. Ackley v. Dep’t of Revenue, TC-MD 111083C (Aug. 30, 2012) (slip op).

B. nonresident individuals

Payment to nonresident Employee for accumulated Leave is Sourced using Stock Option rules Similar to on deferred Compensation. Nonresidents of Oregon generally are subject to Oregon income tax on Oregon-source income, with wages generally being sourced to the state in which the nonresident employee performs the services. Accordingly, a nonresident working in Oregon is subject to Oregon tax on the wages earned for working in Oregon. The Oregon Department of Revenue has promulgated a rule for stock options that vest over a period of time in which the nonresident employee works both within and without Oregon. Pursuant to that rule, the portion of the stock option payment treated as Oregon-source income equals a fraction in which the numerator is the number of days worked in Oregon during the vesting period and the denominator is the number of days worked in everywhere during the vesting period. The Regular Division of the Oregon Tax Court has ruled that a similar formula is used with respect to accumulated leave time paid out upon termination of employment. Ballard v. Dep’t of Rev., TC 5136 (Or Tax Reg Div June 20, 2013) (slip op).

C. Oregon’s Jurisdiction to Tax a Business That Sells into Oregon from Outside

Warranty repair Work by independent Contractors Causes an Out-of-State Taxpayer to Lose PL 86-272 Protection. Public Law No. 86-272, 15 USC §§ 381–384 (“PL 86-272”), generally provides that a state may not tax an out-of-state taxpayer if the only in-state activities by or on behalf of the taxpayer are the solicitation of orders for the sale of tangible personal property. In a case of first impression, the Regular Division of the Oregon Tax Court held that warranty repair services performed in Oregon by



independent contractors were on behalf of an out-of-state manufacturer for purposes of PL 86-272. Accordingly, the warranty repair services caused the taxpayer to lose the protection provided by PL 86-272. The court acknowledged that its ruling could mean that an out-of-state taxpayer could become subject to Oregon tax by hiring an Oregon law firm, accounting firm, or advertising agency. See Ann Sacks Tile and Stone, Inc., Canac Kitchens Limited, and Kohler Rental Power, Inc. v. Dep’t of Revenue, TC-RD 4879 (Or Tax Reg Div Nov. 29, 2011) (slip op). The decision is currently on appeal before the Oregon Supreme Court.

d. apportionment

The Sales Factor Excludes Gain from the Sale of Goodwill Because the relevant income-Producing activities Cannot Be readily identified. The Regular Division of the Oregon Tax Court has held that an Oregon corporation properly excluded gain from the sale of goodwill from the numerator and denominator of its Oregon sales factor. The court held that the value of the goodwill arose from the corporation’s various activities over several years, in the several jurisdictions in which it operated. This meant that the applicable income-producing activities creating the goodwill could not be readily identified, triggering an administrative rule that generally excludes from the sales factor gain from the sale of an intangible asset for which the applicable income-producing activities cannot be readily identified. See Tektronix, Inc. v. Dep’t of Revenue, TC-RD 4951 (Or Tax Reg Div June 5, 2012) (slip op) (appeal pending in Oregon Supreme Court).

Business income of a Financial institution or Public utility includes Gain from the Sale of Property That Generates Business income. The Oregon Tax Court has held that business income includes gain from the sale of property that was used in the taxpayer’s trade or business. The Oregon Supreme Court, in affirming the Tax Court’s decisions, limited the scope of the decisions to financial institutions and public utilities. These businesses are subject to allocation and apportionment rules as determined by the Oregon Department of Revenue, rather than Oregon’s adoption of the Uniform Division of Income for Tax Purposes Act (“UDITPA”). The court held that the department’s interpretation of the functional test was reasonable and thus permitted pursuant to the statutory grant of authority related to the allocation and apportionment of the income of a financial institution or public utility. The court declined to rule on whether that interpretation would apply to a taxpayer subject to UDITPA. Crystal Communications, Inc. v. Dep’t of Revenue, 353 Or 300, 297 P3d 1256 (2013); CenturyTel, Inc. v. Dep’t of Revenue, 353 Or 316, 297 P3d 1264 (2013).

E. Consolidated returns

a Corporate Taxpayer’s income does not include dividends Paid by a unitary insurance affiliate That Files a Separate return. The Regular Division of the Oregon Tax Court held that dividends eliminated from federal taxable income pursuant to the federal consolidated return regulations remain eliminated in calculating the Oregon taxable income of a corporate parent, even if the subsidiary files an Oregon return separate from the recipient corporation. If the parent and subsidiary are unitary, and both are subject to Oregon tax, no part of the eliminated dividend is added back to the parent’s income even if the parent and the subsidiary file separately because each uses a different set of apportionment factors. StanCorp Financial Group, Inc. v. Dep’t of Revenue, TC-RD 5039 (Or Tax Reg Div Aug. 2, 2012) (slip op).

a Corporate Taxpayer’s income includes the Separate Federal Taxable income of a unitary insurance affiliate That is not Subject to Oregon Tax. The starting point for calculating Oregon taxable income on an Oregon consolidated return is the federal taxable income reported on the federal consolidated return. This starting point amount includes the separate federal taxable income of unitary affiliates that are not subject to Oregon corporation excise tax (e.g., because the affiliate does not have nexus or because Public Law No. 86-272 prevents Oregon from taxing the affiliate). The Regular Division of the Oregon Tax Court ruled that a corporate taxpayer’s starting point amount



includes the separate federal taxable income of a unitary insurance affiliate that does not have nexus with Oregon even though, if the insurance affiliate were taxable by Oregon, it could not join in the Oregon consolidated return filed by the corporate taxpayer. The Regular Division further determined that no provision of Oregon law removed the separate federal taxable income of a unitary insurance affiliate from the starting point amount. Accordingly, this income was included in the calculation of the taxpayer’s Oregon taxable income. See Costco Wholesale Corp. v. Dep’t of Revenue, TC-RD 4956 (Or Tax Reg Div July 16, 2012) (slip op). The Tax Court previously reached the same conclusion in Dep’t of Revenue v. Penn Independent Corp., 15 OTR 68 (1999).

F. Most Tax Credits Offset the Corporate Minimum Tax

Corporations Can use Credits to Pay the Minimum Corporation Excise Tax. Since 2009, Oregon has imposed a minimum tax on corporations that ranges up to $100,000, measured by gross receipts sourced to Oregon. The Regular Division of the Oregon Tax Court held that a corporate taxpayer may use an acquired business energy tax credit (“BETC”) to pay its minimum tax liability. Although the case concerned the BETC, the Department of Revenue now agrees that the holding applies to a large number of credits, depending on the language of the statute allowing the credit. Con-way Inc. & Affiliates v. Dep’t of Revenue, TC-RD 5003 (Or Tax Reg Div June 6, 2011) (slip op), aff’d ___ Or ___ (2013).

G. Statute of Limitations

The department of revenue May Make Changes to a Closed Tax year to assess Tax in an Open Tax year. It is a well-established principle of federal tax law that the IRS can make adjustments to a closed tax year to calculate a deficiency for an open year. See, e.g., Lewis v. Reynolds, 284 US 281 (1932); Springfield Street Ry. Co. v. United States, 312 F2d 754 (Ct Cl 1963). The applicability of this principle in Oregon was somewhat unclear because of a case in which the Oregon Tax Court applied the doctrine, but that was reversed on other grounds by the Oregon Supreme Court. See Smurfit Newsprint Corp. v. Dept. of Rev., 14 OTR 434 (1998), rev’d on other grounds, 329 Or 591 (2000). The Magistrate Division of the Oregon Tax Court has confirmed that the department may issue an assessment for an open tax year based on changes made to a closed tax year. Pearce v. Dep’t of Revenue, TC-MD 100892C (Or Tax Mag Div Oct. 31, 2011) (slip op) (involving depreciation deduction carryforwards).

a Change or Correction by the Taxing authority of another State with respect to a Corporate Taxpayer does not Extend the Limitations Period if the Other State’s Change has no Effect on Oregon Tax. Certain changes or corrections that result in an assessment of tax or issuance of a refund by the IRS or other state taxing authority extend the limitations period for assessment to two years from the date the department is notified of the change or correction. To trigger the extension, the change or correction by the IRS or other state taxing authority must change Oregon taxable income or tax liability. The Regular Division of the Oregon Tax Court has limited changes or corrections by other state taxing authorities that trigger the extension to changes made with respect to an individual taxpayer that modify the tax credit claimed by the individual for taxes paid to another state. Because corporate taxpayers do not receive a credit for taxes paid to other states, a change or correction by another state taxing authority to the taxable income of a corporation for purposes of that other state’s tax laws does not cause the Oregon statute of limitations extension provision to apply because the change by the other state does not affect Oregon taxable income or tax liability. See Dep’t of Revenue v. Washington Federal, Inc., TC-RD 5010 (Or Tax Reg Div June 29, 2012) (slip op).

irS reduction of a Tentative refund arising from a Carryback is not an “assessment of Tax” for Purposes of a Statute of Limitations Extension Provision. Oregon law generally provides a three-year statute of limitations. There are several exceptions that extend this period, including one that applies when the IRS, or another state taxing authority, makes a change or correction that (1) changes the taxpayer’s Oregon taxable income or tax liability and (2) results in an assessment of tax or issuance of a refund by the IRS or other state taxing authority. In this situation, the department may assess tax



any time within two years of being notified of the change or correction. In the Tektronix case discussed above, the Regular Division of the Oregon Tax Court held that an IRS reduction of a refund owed to the Oregon corporation related to a carryback loss, which required the corporation to return to the IRS a portion of a tentative refund, did not trigger the two-year extension provision. The case involved a net capital loss recognized in a loss year that was carried back to a carryback year. The taxpayer claimed and received a tentative refund from the IRS for the carryback year. When the IRS audited the loss year, however, it reduced the amount of the net capital loss, and the taxpayer had to return a portion of the tentative refund. The Regular Division determined that, because the amount the IRS could receive from the taxpayer with respect to the carryback year was limited to the tentative refund, the IRS’s demand for a return of part of the tentative refund was not an “assessment of tax” for purposes of the statute of limitations extension provision. See Tektronix, Inc. v. Dep’t of Revenue, TC-RD 4951 (Or Tax Reg Div June 5, 2012) (slip op) (appeal pending in Oregon Supreme Court).

iii. PrOPErTy Tax

a. new Laws (2011–2013) Modify Senior Property Tax deferral Program

1. Senior and disabled Property Tax deferral (hB 4039, 2012 Or Laws Ch 13). The 2011 legislature substantially amended the law governing the senior and disabled property tax deferral, which generally allows a qualifying taxpayer to delay paying property taxes, with a lower interest rate than the 16% rate that normally applies. See ORS 311.666 to 311.701. The 2011 changes imposed a wide range of additional requirements for initial and continuing eligibility, including a provision making homes burdened by a reverse mortgage ineligible for the program. HB 4039 generally provides limited and temporary relief from disqualification for certain taxpayers who applied for recertification but were denied because of a reverse mortgage. This provision applies to determinations of eligibility made on or after September 29, 2011. HB 4039 also requires the Department of Revenue, in consultation with the Legislative Revenue Officer, to present a report to the January 2013 interim revenue committees for consideration in the 2013 legislative session. Effective June 4, 2012.

2. Prospective relief re reverse Mortgages; Transferee Liability for deferred amount (hB 2489). Permanently extends the exception for certain homesteads pledged as security for reverse mortgages, thus allowing continued qualification for deferral.

Clarifies that transferee liability for deferred amounts is limited to any positive amount remaining after subtraction of liens prior to Department of Revenue’s liens from the real market value of the homestead. Requires department to issue notice of liability to transferee. Provides process for collection and appeal of deferred amounts to which transferee notice of liability relates. Authorizes Department of Revenue to determine the joint and several liability of multiple transferees. Effective October 7, 2013.

3. reactivation of Certain Previously disqualified homesteads (hB 2510). Provides that the five-year minimum requirement and reverse mortgage prohibition do not apply to homesteads that had been granted deferral for any property tax years beginning before July 1, 2011. Requires the Department of Revenue to provide notice to individuals with inactive deferral accounts that they may be eligible to have their account reactivated for property tax years beginning on or after July 1, 2014. Requires a claim for reactivation to be filed. Caps the number of homesteads reactivated for property tax year beginning July 1, 2014, at 700. Increases the number of homesteads eligible to be reactivated each subsequent year by 5%. Provides that unpaid taxes assessed against homestead during the period when the homestead was temporarily inactivated for deferral are not subject to foreclosure once the homestead is reactivated for deferral. Various operative dates with retroactive effect.

B. Property Tax Exemption update

1. Statutory relief for Late Exemption applications. ORS 307.162 and 307.166 require charities and other organizations to apply for exemption, generally by April 1. However, over the last



several sessions the legislature has increasingly created exceptions to the deadline upon payment of a fee. Most extensions are until December 31. In addition, the legislature has allowed taxes assessed for prior years to be paid over a multi-year period instead of all at once.

2. Exemptions under increasing Scrutiny. County budget constraints have put increasing pressure on assessors and taxpayers to justify and document exemptions.

iV. OrEGOn Tax COurT PraCTiCE

a. Filing Fees (hB 4168, 2012 Or Laws Ch 48)

The 2011 legislature increased a number of filing fees, including the fee to commence an action in either division of the Oregon Tax Court. The fee is now generally $252, effective October 1, 2013, although it can be waived based on economic circumstances. HB 4168 (2012) includes a provision, with which the Tax Court was involved, that clarifies that no second fee applies when a case pending in the Magistrate Division is moved to the Regular Division pursuant to special designation. The new law clarifies that a second fee does generally apply when the plaintiff or petitioner files a complaint in the Regular Division appealing a Magistrate Division decision. Effective March 16, 2012.

B. Oregon Tax Court’s Jurisdiction

Tax Court’s Jurisdiction Concerns Law Being Challenged and not Basis for the Challenge. Subject to review by the Oregon Supreme Court, the Oregon Tax Court generally has exclusive jurisdiction with respect to “all questions of law and fact arising under the tax laws of this state.” ORS 305.410(1). The Magistrate Division of the Oregon Tax Court has determined that this jurisdiction is limited to the tax being challenged (the tax in question must be a state tax), and not the basis for the challenge (the fact that a local tax may violate a state tax provision is immaterial). Accordingly, the Tax Court lacks jurisdiction to determine whether a city tax (the Portland arts tax) violates a constitutional provision barring a poll or head tax. Instead, the Oregon Circuit Court has jurisdiction to hear the matter. See Bogdanski v. City of Portland TC-MD 130075C Or Tax Mag Div June 4, 2013) (slip op).

V. WhaT’S ahEad?

F Reviving the “Grand Bargain” as prerequisite to larger tax reform.

F Appeals process changes?

F Awaiting decision on Comcast affecting central assessment of communications companies.

F Talk of changes to interaction of corporate minimum tax and credits in light of Con-way.



Oregon’s 2013 Special Legislative Session Passes Changes to Oregon Tax Law

Robert Manicke, Eric Kodesch, Chris Heuer and Elisabeth Shellan Sent to Alert subscribers October 3, 2013

The special legislative session called by Governor Kitzhaber adjourned on October 2, 2013, after passing a “grand bargain” primarily implementing cost and benefit reductions to Oregon’s public employees retirement system (PERS), increasing funding of education, and adopting tax changes. The tax portion of the grand bargain (HB 3601) contains several provisions, including reduced Oregon tax rates on nonpassive flow-through income from partnerships (including LLCs taxed as partnerships) and S corporations, a change in the corporation excise and income tax brackets that increases the tax on taxable income between $1 million and $10 million, and the creation of an Oregon interest charge domestic international sales company (IC-DISC) regime. Governor Kitzhaber is expected to sign the five bills making up the grand bargain, including HB 3601.

The tax provisions of the grand bargain include:

• Reduced Oregon Tax Rate on Nonpassive Flow-Through Income from Partnerships and S Corporations. For tax years beginning on or after January 1, 2015, taxpayers subject to the Oregon personal income tax may elect to have nonpassive income attributable to any partnership or S corporation (after reduction for nonpassive losses) taxed at the following rates:

If income is more than But not more than The tax rate is ---- $250,000 7.0% $250,000 $500,000 7.2% $500,000 $1,000,000 7.6% $1,000,000 $2,500,000 8.0% $2,500,000 $5,000,000 9.0% $5,000,000 ---- 9.9%

The term “partnership” includes a limited liability company (LLC) or other entity taxed as a partnership. However, the new reduced rates will not apply to a single-member LLC that is disregarded as an entity separate from its owner. As a result, Schedule K-1 income reported on Schedule E generally will receive more favorable tax treatment than either Form W-2

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wage income or income from a sole proprietorship (including from a single-member LLC) reported on Schedule C.

“Nonpassive income” is as defined in the Internal Revenue Code and does not include wages, interest, dividends or capital gains. In calculating the amount of income not subject to the special rates, taxpayers must use the subtractions, deductions and additions otherwise allowed. On the other hand, in calculating the amount of income subject to the special rates, depreciation adjustments directly related to the partnership or S corporation are the only additions or subtractions allowed.

A taxpayer can elect to use the alternative rates only if: (1) the taxpayer materially participates in the day-to-day operations of the trade or business; (2) the partnership or S corporation employs at least one person who is not an owner, member or limited partner of the partnership or S corporation; and (3) those non-owner employees perform at least 1,200 aggregate hours of work in Oregon by the close of the tax year, taking into account for this purpose only hours worked by an employee in weeks in which the employee works at least 30 hours.

A nonresident may apply the reduced rates only to “income earned in Oregon.” A part-year resident must calculate the tax due using the reduced rates by first applying those rates to the taxpayer's qualifying nonpassive income, and then multiplying that amount by the ratio of the taxpayer’s nonpassive income in Oregon divided by nonpassive income from all sources. A nonresident joining in the filing of a composite return is not eligible for the reduced rates.

The bill directs the Legislative Revenue Officer to calculate projected and actual ratios of revenue loss to total state income. To the extent the actual ratios deviate from the projected ratios by specified thresholds, the special tax rates will be adjusted for tax years beginning after 2018 and again after 2022.

Change in the Oregon Corporation Excise Tax Brackets. For tax years beginning on or after January 1, 2013, the Oregon corporation excise tax brackets have been changed so that the 7.6% top marginal rates apply to taxable income in excess of $1 million, rather than taxable income in excess of $10 million. This change also applies to the Oregon corporation income tax, which adopts by reference the Oregon corporation excise tax brackets and rates.

Creation of an Oregon IC-DISC Regime. Prior to the special session, Oregon did not conform to the federal tax regime applicable to an IC-DISC. Instead, Oregon law treated an IC-DISC in the same manner as any other corporation and disregarded transactions between a taxpayer and an IC-DISC if the two were related. For tax years beginning on or after January 1, 2013, the new law changes this treatment for IC-DISCs formed on or before January 1, 2014 (the date HB 3601 takes effect). For these IC-DISCs:

• The Oregon minimum tax does not apply.

• A 2.5% tax rate applies to commissions received by the IC-DISC, rather than the marginal tax rates that generally apply to corporations.

• A related taxpayer is allowed a deduction for commissions paid to the IC-DISC.

• The federal taxable income of a shareholder subject to the Oregon personal income tax is reduced by the amount of any dividend paid by the IC-DISC.

It appears that some of the new benefits of the Oregon IC-DISC regime (the 2.5% tax rate and the deduction allowed to a taxpayer) may apply only to commission-based IC-DISCs, and not to buy/resell IC-DISCs.

Elimination of Personal Exemption for Higher-Income Taxpayers. Oregon generally provides a personal exemption credit equal to an inflation-adjusted amount (for 2013, $183) multiplied by the number of personal exemptions allowed to the taxpayer. Prior to the special session, the credit was reduced if the taxpayer’s income exceeded a threshold amount. For tax years beginning on or after January 1, 2013, the credit has been eliminated for taxpayers whose federal adjusted gross income exceeds $200,000 (for joint return filers, a surviving spouse or a head of household) or $100,000 (for single filers, including married filing separately).

Senior Medical Expense Deduction Means - Testing and Increased Age Threshold. For tax years beginning on or after January 1, 2013, the reduction in Oregon taxable income allowed to seniors for nondeductible medical expenses is phased out for adjusted gross incomes between $100,000 and $200,000 (for joint return filers, a surviving spouse or a head of household) or $50,000 and $100,000 (for single filers, including married filing separately). The minimum age for eligibility will rise incrementally from 62 for 2013 to 66 starting in 2020.

If you have questions about the new tax bill, please contact one of the following tax attorneys:

Robert Manicke at (503) 294-9664 or [email protected]

Eric Kodesch at (503) 294-9684 or [email protected]

Chris Heuer at (503) 294-9206 or [email protected]

Elisabeth Shellan at (503) 294-9887 or [email protected]

Robert Manicke is a partner at Stoel Rives, where he heads the firm’s Benefits, Tax and Private Client group. His practice emphasizes state and local taxation. He regularly represents clients in the Oregon Tax Court and before state revenue authorities regarding income tax and property tax matters. He is a 1992 graduate of the University of Illinois, College of Law. He chairs the Laws Committee of the OSB Taxation section, and he also is this year’s chair of the Taxation Section as a whole.

IRS Circular 230 notice: The information contained herein was not intended or written to be used, and cannot be used, by you or any other person (i) in promoting, marketing or recommending any transaction, plan or arrangement or (ii) for the purpose of avoiding penalties that may be imposed under federal tax law.

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Chapter 3

Tax Considerations for Choice of Business EntityBryon l. land

Arnold Gallagher PCEugene, Oregon

Contents

Important Notice. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3–1

I. Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3–1

II. Overview of General Forms of Business Entities . . . . . . . . . . . . . . . . . . . . . . . . . . 3–1A. Sole Proprietorship . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3–1B. Partnerships . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3–1C. Corporations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3–2D. Limited Liability Company . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3–3

III. Comparison of Forms of Business Entities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3–3A. Legal Documentation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3–3B. Management and Control . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3–6C. Liability of Owners . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3–6D. Taxation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3–9E. Entity Taxation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3–9

IV. General Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3–22A. General Guidelines in Selecting Form of Entity . . . . . . . . . . . . . . . . . . . . . 3–22B. General Rules of Thumb . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3–23

Choices of Entities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3–27Sole Proprietorship . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3–27General Partnership . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3–27Limited Partnership . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3–28Limited Liability Partnership . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3–28Limited Liability Company . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3–29Corporation (or PC) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3–30

Chapter 3—Tax Considerations for Choice of Business Entity




iMPOrTanT nOTiCE

To comply with IRS regulations, we are required to notify you that this presentation, if it contains advice relating to federal taxes, cannot and is not intended to be used for the purpose of avoiding penalties that may be imposed under federal tax law.

i. inTrOduCTiOn

These materials provide a general overview of the legal issues and considerations involved in selecting, forming, operating, and maintaining the various types of business entities. The materials review the general characteristics of different business entities, compare the basic functions and characteristics of the different entities to provide a general understanding of each entity’s structure and purpose, and analyze common tax considerations that typically weigh into the entity selection process.

ii. OVErViEW OF GEnEraL FOrMS OF BuSinESS EnTiTiES

a. Sole Proprietorship

The sole proprietorship is a business owned and operated by a single person who individually owns the business assets. The business may or may not have employees. The owner or proprietor is entitled to the profits of the business, must bear its losses, and is personally liable on an unlimited basis for its debts and obligations.

B. Partnerships

1. General Partnerships. Oregon general partnerships are governed by the Oregon Revised Partnership Act (the “Act”), which is ORS chapter 68. A general partnership is defined as (a) an association (b) of two or more persons (c) to carry on as co-owners of (d) a business (e) for profit. A partnership may be created by a written (preferred) or oral (not preferred) agreement or may be implied by the conduct or acts of the parties (really not preferred). Provisions of the partnership not covered by agreement of the parties are governed by the Act. Partners generally share in management of the partnership and in its profits and losses. The partners are “jointly” liable for all partnership debts and obligations and are “jointly and severally” liable to third parties for acts or omissions of partners occurring in the ordinary course of partnership business.

Under the “entity” and “aggregate” theories, a general partnership is either a separate legal entity or simply the aggregate of the individual partners. Generally, a partnership is treated as a separate entity that may own assets, operate a business, and sue or be sued. However, for income tax purposes, a partnership is not a taxpayer. Instead, it is a funnel through which its income and deductions are channeled to the partners who individually recognize the partnership’s income, gain, losses, deductions, and credits. The partnership simply files an informational income tax return with the IRS.

Subject to certain exceptions (like disguised sales or mixing bowl transactions, discussed below), there is generally no gain recognized by the partnership or the partners on appreciated assets distributed from the partnership to partners.

2. Limited Partnerships. A limited partnership is governed by ORS chapter 70. A limited partnership is (a) a partnership (b) of two or more persons (c) having one or more general partners and (d) one or more limited partners. As in a general partnership, the general partners in a limited partnership share in the operation and management of the partnership and are jointly liable for all partnership debts and obligations and jointly and severally liable to third parties for acts and omissions of the general partners occurring in the ordinary course of the partnership’s business. A limited partner is generally not liable for the obligations of the limited partnership beyond the limited partners’ agreed-upon partnership contribution. To retain limited liability, the limited partner must not take part in the



control of the partnership business or permit his or her name to be used in the partnership’s name unless the creditors have actual knowledge that he or she is a limited partner.

For income tax purposes, a limited partnership is taxed in generally the same manner as a general partnership.

3. Limited Liability Partnerships. A limited liability partnership (LLP) is a partnership for which the liability of partners is limited in certain aspects. LLPs are governed by the law applicable to general partnerships except to the extent modified by the LLP statutory provisions.

General partnerships that render professional services (e.g., medical services, accounting services, legal services, dental services) and their affiliates may register with the Oregon Secretary of State as LLPs. For income tax purposes, generally speaking, an LLP is taxed in the same manner as a general partnership.

C. Corporations

1. C Corporations. A corporation is a separate legal entity created by law. ORS chapter 60, the Oregon Business Corporation Act (the “Act”), and the corporation’s articles of incorporation written in conformance with the Act and filed with the state, give the corporation its powers and rights. Because it is a separate entity, the corporation can acquire, hold, and convey property. Likewise, a corporation can sue or be sued. Also, unlike a partnership, a C corporation is a separate taxable entity. The corporation computes its profits and losses and pays taxes. Thus, shareholders (the owners) of a C corporation are not taxed on corporate profits and cannot deduct corporate losses on their individual income tax returns. Any corporate profits distributed to the shareholders as dividends are recognized as taxable income by the shareholders and are not deductible to the corporation. However, unlike partnership-taxed entities, appreciated assets distributed from a corporation to shareholders generate a corporate level income tax.

As alluded to above, a corporation is owned by one or more shareholders or stockholders. For the most part, the rights of the shareholders to manage the corporation are limited to the election of the board of directors. The board of directors establishes policies, determines the amount and timing of distributions (that is, dividends) to shareholders, and appoints the corporate officers. The corporate officers are responsible for the day-to-day operation of the corporate business.

A shareholder has limited liability. Unless a shareholder agrees with creditors that the shareholder will be liable for corporate obligations, the shareholder is generally not liable for the corporation’s debts and obligations.

2. S Corporations. An S corporation is a creation of federal and state income tax laws and, except for taxation, is similar to a C corporation. An S corporation is generally not treated as a separate taxable entity but is a conduit that merely files an informational income tax return with the IRS. For income tax purposes, the shareholders are much like partners who individually recognize the corporation’s income, gains, losses, deductions, and credits. However, there are limitations to the number (i.e., 100) and type (i.e., generally, individuals who are U.S. citizens or residents and certain trusts) of shareholders who can own stock in an S corporation. Further, an S corporation cannot have more than one class of stock, which means that profits/losses and cash distributions must be allocated strictly based on the number of shares owned.

3. Professional Corporations. The professional corporation itself, like any other corporation, is a separate legal entity. The Oregon Professional Corporation Act, ORS chapter 58, governs the formation and operation of professional corporations. One of the primary distinctions between a nonprofessional corporation and a professional corporation lies in the limited liability feature. Under Oregon law, a professional who incorporates continues to be liable for his or her own negligence and wrongful acts and for the negligence and wrongful acts of other shareholders in rendering professional services, but



the professional shareholder is not personally liable for other tort claims or contract actions. Thus, limited liability is an advantage of the professional corporation, even though the limited liability has some restrictions.

A professional corporation may be either a C corporation or an S corporation. Historically, however, S corporations have not been used in the professional corporation situation. This is probably due to the fact that S corporations were subject to restrictive retirement plan contribution limitations and that various tax benefits available in a C corporation context that were not available in the S corporation context. Due to changes in the tax laws to eliminate, or reduce to a great degree, these discrepancies, the use of the S corporation in the professional corporation setting is becoming more prevalent.

d. Limited Liability Company

A limited liability company (“LLC”) is a cross between a partnership and a corporation. If the LLC has more than one owner (called a “member”), then the entity and its members are taxed as if the entity were a partnership, unless an election is made for the LLC to be taxed as a corporation. If the LLC has only one member, then the LLC is taxed as if the entity were a sole proprietorship, unless an election is made for the LLC to be taxed as a corporation.

The members may actively participate in the management of the business while retaining limited liability for its obligations. If the members choose not to manage the company’s business, they can elect “managers.” Like a corporation’s board of directors or officers, managers may be members or nonmembers and will direct and control company operations.

iii. COMPariSOn OF FOrMS OF BuSinESS EnTiTiES

a. Legal documentation

1. Sole Proprietorship. A sole proprietorship requires no legal documentation for formation and is required to prepare and file relatively few reports. Federal and state tax returns and reports regarding employees are the main reporting requirements for a sole proprietorship. Since the assets of the business are owned by the sole proprietor, no federal or state tax return is filed for the business. Profits and losses are reported on Form 1040, Schedule C, of the owner’s return. In addition, if the sole proprietorship is operated under an assumed business name, that name must be registered with the Secretary of State and a report filed every other year to assure continuance of the name’s registration.

2. General Partnership. General partnerships are required to file the same reports that sole proprietorships must file relating to their employees. In addition, the partnership must file an informational income tax return, which is in addition to the individual tax returns filed by the partners. Also, the partnership usually is operated under an assumed business name, and that name must be registered with the Secretary of State and renewed every other year.

Although there are no statutory requirements regarding the maintenance of books and records for partnerships, the partnership agreement should require that the partnership maintain adequate records and books of account in accordance with generally accepted accounting principles. Additionally, it is common for the partnership agreement to require that annual financial statements of the partnership be prepared, including a balance sheet, a profit and loss statement, and such supporting statements as the partners from time to time deem relevant. If any special allocations will be made, to be respected, the partnership will need to maintain separate capital accounts for each partner in accordance with Treasury Regulation § 704-1 and comply with the “general economic effect” rules.

If any of the general partners are not actively engaged in the management or operation of the partnership, there may be Securities Act filing obligations.

3. Limited Partnership. A limited partnership requires one additional filing from those required of a general partnership. A certificate of limited partnership must be filed with the Secretary



of State. The certificate includes, among other things, the name of the limited partnership, so that no assumed business name filing is necessary.

As with the general partnership, a limited partnership may have Securities Act filing obligations. Also, though there is no statutory requirement that the partnership maintain books and records, the limited partnership agreement will contain provisions similar to those discussed above in connection with general partnerships concerning the maintenance of records.

4. Limited Liability Partnership. As mentioned, registration under the LLP statute is limited to professional partnerships and their affiliates. The word “professional” includes accountants, attorneys, chiropractors, dentists, landscape architects, naturopaths, nurse practitioners, psychologists, physicians, podiatrists, radiologic technologists, and real estate appraisers. Any eligible general partnership may register as a limited liability partnership. A limited partnership may not register as an LLP.

A partnership may become a limited liability partnership by delivering an application for registration to the office of the Secretary of State for filing on appropriate forms. The LLP registration is perpetual, subject only to cancellation or administrative revocation. An LLP is required under Oregon law to file an annual report with the Oregon Secretary of State. The annual report must be filed each year not later than the anniversary date that the LLP registration was effective. The Secretary of State may commence a proceeding to administratively revoke the registration of an LLP if the LLP does not deliver its annual report or pay the correct fees when due.

5. Corporation. Like sole proprietorships and partnerships, a corporation must maintain reports regarding its employees. In addition, the corporation must make numerous other filings. First, a corporation must file its articles of incorporation and an annual report with the Secretary of State. At the start-up of the corporation, the incorporator or the board of directors must also adopt corporate bylaws to establish the structure of management of the business. Moreover, as mentioned previously, a corporation is required to file its own federal and state income tax returns. In addition, a qualified S corporation must elect S corporation status by filing its election with the appropriate IRS center.

Generally speaking, a corporation must make certain filings and maintain the following books and records.

a. A corporation must file its articles of incorporation and an annual report with the Secretary of State, as well as any amendments to the articles of incorporation.

b. At the start-up of a corporation, the incorporator or the board of directors must adopt corporation bylaws to establish the structured of management of the business.

c. A corporation is required to file its own federal and state income tax returns, although an S corporation files an informational income tax return like a partnership. In addition, a qualified S corporation must elect S corporation status by filing its election with the appropriate IRS center in a timely manner. An S corporation is formed, in most instances, in the same manner as a C corporation, with the exception of the S election.

d. It is necessary for a corporation to maintain corporation and accounting records for the benefit of shareholders and directors. Lending institutions and others who deal with the corporation may require that the corporation certify minutes and resolutions to assure that management has duly delegated the authority necessary to make a particular transaction.

e. Public corporations, or corporations with stocks that otherwise meet the requirement for filing under the state or federal securities laws, must submit registrations and an annual report, as must their officers, directors, and, in some instances, shareholders.



f. Under ORS 60.771, each corporation is required to maintain the following records in written form or in another form capable of conversion into a written form without a reasonable time:

i. Minutes of all meetings of shareholders and board of directors, a record of all actions taken by the shareholders or board of directors without a meeting, and a record of all actions taken by a committee of the board of directors in place of the board of directors on behalf of the corporation.

ii. Appropriate accounting records. These records help protect against the piercing of the corporate veil.

iii. A record of shareholders in a form that permits preparation of a list and the names and addresses of all shareholders in alphabetical order by class of shares, showing the number and class of shares held by each.

iv. A copy of the following records at the corporation’s principal office or registered office:

(A) Articles of restated articles of incorporation and all amendments thereto;

(B) Bylaws or restated bylaws and all amendments thereto;

(C) Resolutions adopted by the corporation’s board of directors creating one or more classes or series of shares and fixing their relative rights, preferences, and limitations, if shares issued pursuant to those resolutions are outstanding;

(D) The minutes of all shareholder meetings and records of all action taken by the shareholders without a meeting for the past three years;

(E) All written communications to shareholders generally within the past three years;

(F) A list of the names and business addresses of current directors and officers; and

(G) The most recent annual report.

6. Limited Liability Company. Like all other business entities, limited liability companies must maintain reports regarding their employees. In addition, the LLC must file articles of organization and an annual report with the Secretary of State. At the start-up of the limited liability company, the organizer, manager, or member(s) must also adopt an operating agreement to provide for the regulation and management of the affairs of the limited liability company. The company must also file an informational federal and state income tax return.

Under ORS 63.771, an LLC is required to keep the following records at its registered office or another office designated in the operating agreement:

a. A list of the name and last-known business, residence, or mailing address of each member and manager;

b. A copy of the articles of organization and all amendments thereto, together with any executed copies of any powers of attorney pursuant to which any amendment has been executed;

c. Copies of the LLC’s federal, state, and local income tax returns and reports, if any, for the three most recent years;

d. Copies of any currently effective written operating agreements and all amendments thereto,

e. Copies of any financial statements of the LLC for the three most recent years;

f. Minutes of any meeting of members or managers;

g. Unless contained in a written operating agreement or other writing, a statement prepared and certified as accurate by a manager or member of the LLC describing the amount of cash and including a description and statement of the agreed value of other property or services contributed



by each member in which each member has agreed to contribute in the future, the times at which or events on the occurrence of which any additional contributions agreed to be made by each member are to be made, and, if agreed upon, the time at which or the events on the occurrence of which the LLC is dissolved and its affairs wound up; and

h. Any written consent resolutions of the members or managers.

In addition, the operating agreement will require that the company keep adequate records and books of account and maintain them in accordance with generally accepted or sound accounting principles. These records commonly consist of annual financial statements, including a balance sheet, a profit and loss statement, and such supporting statements as the members deem relevant. Maintenance of records is necessary to help ensure the limited liability feature of the LLC.

B. Management and Control

1. Sole Proprietorship. Because there is only one owner in a sole proprietorship, the owner has absolute control and management over the business.

2. General Partnership. Each partner is entitled to share equally in the management and business decisions of a partnership regardless of the size of the partner’s specific interest. Further, Oregon law gives equal voting power to each of the partners in order to resolve disputes. So in essence, control and management is shared equally among the partners. However, the partners may agree among themselves to alter the statutory provisions regarding management. For instance, the partners may select a managing partner or committee, or they may allocate voting power based on percentage of ownership. The partnership agreement is controlling. These same rules apply to LLPs.

3. Limited Partnership. General partners in a limited partnership have control of the partnership and essentially make all of the partnership’s business decisions. A limited partner is restricted to inspecting partnership records and obtaining reasonable information about the partnership unless the partnership agreement provides otherwise. A limited partner who participates in the partnership may be deemed a general partner and lose the protection of limited liability.

4. Corporation. In a corporation, control and management are actually separate functions. Day-to-day business decisions (management) of the corporation are made by the officers. The officers are appointed by and are subject to the direction of the board of directors. The board of directors oversees the management of the corporation and establishes corporate policies. The shareholders elect the board of directors, with each shareholder having a vote equal to his or her interest in the corporation; therefore, the shareholders have actual “control” of the corporation.

In many small, closely held corporations, the separation of management and control is simply a matter of form—the same person or few persons are shareholders, directors, and officers of the corporation.

5. Limited Liability Company. The control and management of a limited liability company rests with its members unless the members elect to have the business managed by a manager or managers. Such election, if any, must be set forth in the articles of organization and should be reflected in the operating agreement.

C. Liability of Owners

1. Sole Proprietor. The sole proprietor is personally liable for all obligations arising out of the business and thus places his or her personal assets at the risk of the business.

2. General Partner. Like a sole proprietor, a general partner in either a general or limited partnership is personally liable for the obligations arising out of the business if the partnership assets are not sufficient to satisfy the partnership liabilities. However, unlike a sole proprietor, a general partner is liable for the acts of his or her partner(s) as well as himself or herself and therefore is financially exposed



beyond his/her own acts. In addition, a partner has unlimited personal liability for the obligations of the partnership regardless of his/her percentage interest in the partnership. Therefore, a general partner is exposed to a greater liability than someone who invests in a business as either a limited partner, a member of a limited liability company, or a corporate shareholder.

3. Partner of an LLP. Partners in an LLP who are professionals remain directly liable for their own negligent or wrongful acts or omissions or misconduct in the same manner as shareholders of a professional corporation. This means that the partners are liable for their own professional negligence and are jointly and severally liable for professional services rendered on behalf of the professional practice, up to an annual maximum amount of $300,000 per licensed Oregon professional with an aggregate limited of $2 million for the professional partnership. For LLPs with fewer than seven licensed Oregon partners, the maximum aggregate liability is $300,000 multiplied by the number of licensed Oregon professionals. For liabilities unrelated to the professional practice, such as offices leases and tort claims arising from circumstances unrelated to the professional practice, the partners have limited liability.

4. Limited Partner. A limited partner’s liability is limited to the amount that the limited partner originally contributed to the partnership, unless he or she has expressly agreed to be liable for an additional amount. A limited partner will lose the limited liability if he or she is either a general partner or takes part in the control of the business.

5. nonprofessional Corporate Shareholder. With few exceptions, a shareholder’s liability is limited to the shareholder’s investment in the business. However, and as mentioned previously, particularly with regard to small, closely held corporations, creditors usually require that the shareholders personally guarantee debts of the corporation. In that instance, the shareholder has given up the limitation on his or her liability.

6. Professional Corporate Shareholder. In the rendering of professional services on behalf of a professional corporation, a shareholder of the corporation is personally liable “as if the shareholder were rendering the service or services as an individual, only for negligent or wrongful acts or omissions or misconduct committed by the shareholder, or by a person under the direct supervision and control of the shareholder.” ORS 58.185(3). As with LLPs, liability for professional malpractice is limited to a yearly cap of $300,000 for joint and several liability for all claims made against a single shareholder of a professional corporation during a single year. Also, a $2 million cap exists for joint and several liability for a single claim made against all shareholders during a calendar year. If the number of shareholders multiplied by $300,000 equals an amount that is less than $2 million, the total joint and several liability for a single claim made against all shareholders of the corporation cannot exceed an amount equal to $300,000 multiplied by the number of shareholders. These amounts are subject to adjustment for inflation every six years. The professional corporation shareholders have limited liability for corporate obligations, such as office leases and tort claims, arising from circumstances unrelated to the professional practice.

7. Limited Liability Company Member. Members of a limited liability company are not personally liable for the obligations of the business. As a result, like shareholders of a closely held corporation, members of a closely held LLC are usually required to personally guarantee the obligations of the company by creditors and thereby forfeit the limits on their liability. Managers of an LLC are not exposed to personal liability by reason of serving as a manager. It should be noted that for LLCs providing professional services, member liability for professional malpractice is the same as for partners in an LLP and shareholders of a professional corporation.

8. downstream Liability. Downstream liability refers to a creditor’s ability to attack a person’s ownership interest in a corporation, general partnership, limited partnership, limited liability partnership, or limited liability company in satisfaction of the person’s personal debts/liabilities. For



example, assume that Ann and Bill own a successful corporation. Ann owns 51% of the issued and outstanding stock and Bill owns 49%. Although Ann is a highly successful businesswoman, she has a gambling problem and has personally received loaned money from various creditors, including Charlie. Ann defaults on her loan to Charlie, who sues and in turn obtains a judgment against Ann. Charlie forecloses on the judgment and obtains ownership of Ann’s 51% of the shares. Charlie is not interested in running Ann’s business. He just wants his money and as the majority shareholder decides to sell the business to a competitor at a discount. A creditor’s ability to attack a person’s ownership interest depends on the type of entity and associated protections afforded by law or contract.

a. Corporations. Share ownership in corporations is not protected from creditors by statute (except professional corporations—generally, ownership in professional corporations is limited to licensed professionals). However, shareholders can contractually agree among themselves to limit transfers of ownership (including transfers to creditors) through shareholder agreements generally known as “buy-sell” agreements. As a general matter, these agreements provide that if shares are transferred to a creditor, the remaining shareholders or the corporation have the right to purchase/redeem those shares for the lesser of the fair market value or debt owed. If Ann and Bill had such an agreement, then Bill may be in luck. If not, then Bill will be looking for a new job.

b. Limited Liability Companies. A judgment creditor may obtain a charging interest in the member’s ownership interest in the limited liability company. The creditor obtains the rights of an assignee to the extent charged. An assignee has the right to receive and retain, to the extent assigned (i.e., charged), the distributions, as and when made, and allocations of profits and losses to which the assignor would be entitled. However, an assignee does not have the right to participate in the management of the company unless and until accepted as a member. If not stated in the operating agreement, an assignee will become a member upon a majority vote of the members other than the assignor. If Ann and Bill had been owners in a limited liability company, Charlie would have obtained a charging interest in Ann’s ownership to the extent of the debt owed to Charlie. Once that debt was satisfied (e.g., through distributions), then Charlie’s interest would be discharged and ownership would revert to Ann. During the time Charlie had the charging interest, Ann would retain the right to vote and act on her ownership interest. Oftentimes, the operating agreement will provide that a transfer of a member’s interest to a creditor results in a withdrawal or disassociation of that member’s interest, which forces a buyout by the company or remaining members of the withdrawing or disassociating member’s interest.

c. General Partnerships and Limited Liability Partnerships. A judgment creditor may obtain a charging interest in the transferable interest of a partner in the partnership. The court may order a foreclosure of the interest subject to the charging order at any time. The purchaser at the foreclosure sale has all of the rights of the transferee. At any time prior to the foreclosure sale, the charging order may be redeemed by the judgment debtor, by one or more of the other partners with property (other than partnership property), or by one or more of the other partners using partnership property with the consent of all partners whose interests are not charged. If Ann and Bill were partners in a limited liability partnership, then Charlie would obtain a charging interest in Ann’s partnership interest. Either Ann or Bill could redeem that charging interest before foreclosure. If the interest were foreclosed, Charlie would step into the shoes of Ann entirely. At that point, Charlie could once again force a sale of the partnership. A limited liability partnership offers Ann and Bill more protection than a corporation (without a buy-sell agreement) but not as much protection as a limited liability company.

d. Limited Partnerships. A judgment creditor may obtain a charging interest against the partnership interest of the debtor partner. The judgment creditor has only the rights of an assignee to the extent the interest is charged. An assignee may become a limited partner, if and to the extent that



the assignor gives the assignee that right in accordance with the partnership agreement or all other partners consent.

d. Taxation

1. Types of Tax

a. income Tax. An entity may be subject to federal and state income tax, depending on the type of entity, the state of organization, and where it does business. How and when the income is taxed depends on what type of entity is involved. The income taxation of various entity types is discussed more specifically below in each section designated to that entity.

b. Social Security and unemployment Taxes

i. Social Security Taxes. Social Security taxes are collected on employment wages and are paid by employers, employees, and self-employed individuals. These taxes are paid pursuant to the Federal Insurance Contributions Act (FICA) or the Self-Employment Contributions Act (SECA). The payments made under FICA and SECA fall into two categories.

(A) Old-Age, Survivor, and Disability Insurance (OASDI) funds are used to pay retirement and disability benefits. The rate currently for OASDI is 6.2% for the employer and 6.2% for the employee (12.4% combined and for the self-employed). However, the employment wages subject to the OASDI portion of FICA and SECA obligations is limited to the taxable wage base defined in IRC § 3121. The taxable wage base is an employee’s earnings, less certain very limited deductions, and is capped at $113,700 for 2013.

(B) Hospital Insurance (HI) taxes are used to pay medical expenses for elderly and disabled individuals. The HI rate is 1.45% and not subject to any wage cap. Like its OASDI counterpart, the 1.45% HI tax is paid by both an employer and employee or both halves (totaling 2.9%) are paid by a self-employed individual. Beginning in 2013 an additional 0.9% will be added on earned income exceeding $200,000 for individuals and $250,000 for married couples filing jointly.

ii. unemployment Taxes. Unemployment taxes are paid by employers pursuant to the Federal Unemployment Tax Act (FUTA). FUTA taxes are paid at the rate of 6.2% on the first $7,000 of wages paid to each employee, subject to a credit for state unemployment tax paid up to 5.4%.

E. Entity Taxation

Tax is often the tail that wags the dog when deciding what type of entity to employ or how to structure certain transactions. Each type of entity available for use has its own characteristics. Some are shared and some are unique. This section will discuss the basic elements of several common types of business entities from a taxation perspective.

1. Sole Proprietorship. A sole proprietorship is not a legal entity. It is a business conducted by an individual with no co-owners and as such is not distinguished or recognized as an entity separate from the individual.

Tax Characteristics

F All items of income and deductions are recognized directly by the proprietor on his or her personal tax return.

F Subject to income tax and self-employment tax.

F Tax-free creation.

2. General Partnership. A general partnership is an entity/aggregation of individuals who carry on a business for profit. A general partnership offers no liability protection, and each partner is personally liable for the debts and obligations of the partnership.



Tax Characteristics

F Tax-free creation under section 721(a) for transfers of “property” to a partnership in exchange for partnership interest; but note exception in section 721(b) for transfer of property to “investment company” (which prevents taxpayers from diversifying their investment portfolios tax free); no control requirement for tax-free treatment under section 721(a).

F “Property” is not defined in the Tax Code, but the courts have been guided by the interpretation of the term under section 351, the counterpart of section 721 in the corporate area, which provides that “property” includes cash, inventory, accounts receivable, patents, installment obligations, and other intangibles such as goodwill and industrial know-how; does not include the performance of services for the partnership.

F A partner’s basis in his or her partnership interest is referred to as the “outside basis.” A partnership’s basis in its assets is referred to as the “inside” basis. These terms are used to distinguish between the partner’s and the partnership’s bases. On a contribution of property in exchange for a partnership interest, a partner’s outside basis under section 722 is equal to the sum of the money and the adjusted bases of property contributed to the partnership. Under section 723, the partnership’s inside basis is equal to the basis the contributing partner had in the property.

F Because a partnership is treated as an aggregate of its individual partners for purposes of taxing its income, the Tax Code adopts aggregate principles to determine the impact of partnership liabilities on the partners and their outside bases. Under section 752(a), an increase in a partner’s share of partnership liabilities is considered a contribution of money which increases the partner’s outside basis under section 722. A decrease in a partner’s share of partnership liabilities is considered under section 752(b) to be a distribution of money to the partner which decreases the partner’s outside basis (but not below zero). If a decrease in a partner’s share of partnership liabilities exceeds the partner’s outside basis, the partner must recognize the excess as capital gain from the sale or exchange of a partnership interest under sections 731(a)(1) and 741.

exaMple: X, Y, and Z each contribute $50,000 cash to form the XYZ partnership and agree to share all partnership profits and losses equally. XYZ purchases a piece of investment real estate for $180,000, paying $60,000 cash and giving the seller a $120,000 purchase money note secured by the real estate. No partner is personally liable for the note. The purchase money obligation is a nonrecourse liability of the partnership that will be shared equally by the partners, because they have equal interests in partnership profits. X, Y, and Z will be treated as if they contributed $40,000 each to XYZ under section 752(a) to reflect the increase in their share of partnership liabilities (from $0 to $40,000). As a result, each partner’s outside basis will be $90,000 under section 722.

If property is contributed by a partner to a partnership and the property is subject to a liability, the partnership is considered to have assumed the liability to the extent it does not exceed the fair market value of the property at the time of contribution.

exaMple: Z contributes property with a $1,500 adjusted basis to a general partnership for a 25% interest in the partnership, which results in Z receiving an outside basis of $1,500. The property is subject to a $2,000 nonrecourse liability and has a fair market value of $5,000. The partnership is considered to have assumed the liability and Z’s individual liabilities are considered to have decreased by $2,000, which is a deemed cash distribution under section 752(b). There is no corresponding increase in Z’s share of partnership liabilities, which results in a net change in Z’s individual and partnership liabilities being a decrease of $2,000. In this case, Z’s outside basis will be reduced from $1,500 to zero under section 752(b) and Z will recognize $500 of capital gain ($2,000 liability relief minus $1,500 basis).



F A partner’s outside basis is increased and decreased based on partnership activities. Under section 702, a partner is taxed directly on his distributive share of partnership income or loss. Section 705 adjusts the partner’s outside basis to reflect these results. In general, a partner must increase his outside basis by his distributive share of partnership taxable income and tax-exempt income and decrease it (but not below zero) by partnership distributions, as provided in section 733, and his distributive share of partnership losses and expenditures.

exaMple: Partner X has a $1,000 outside basis in her partnership interest, and her distributive share of partnership income for the year is $4,000. The partnership income passes through to X and is reported on her personal tax return. Under section 705, her outside basis will be increased to $5,000 ($1,000 plus $4,000). If the partnership distributed $3,000 of cash to X at the end of the year, her outside basis would be reduced to $2,000 by the distribution.

F There is no tax imposed on the partnership as an entity, so it is what is known as a pass-through entity for income tax purposes.

F The partnership is required file a Form 1065, as are all types of partnerships, but isn’t itself liable for any income tax.

F The partners will report their appropriate portion of all partnership income and deduction items, which are provided to them on a Schedule K-1, on their individual returns.

F Profits and losses may be allocated among the partners in any way desired, as long as they have “substantial economic effect,” as defined in section 704(b).

G To have “economic effect,” an allocation must be consistent with the underlying economic arrangement of the partners. The Treasury Regulations use a three-part test to determine whether an allocation is consistent with the underlying economic arrangement of the partners. This basic test is backed up by other tests that, if satisfied, can validate an allocation.

G The “basic test” generally provides that an allocation will have economic effect if, throughout the full term of the partnership, the partnership agreement provides for proper maintenance of the partners’ capital accounts, that upon liquidation of the partnership liquidating distributions will be made in accordance with positive capital account balances of the partners, and that a partner will be unconditionally obligated to restore any deficit capital account balance.

G Under the “alternate test” for economic effect, an allocation will be respected if capital accounts are appropriately maintained and liquidating distributions are made in accordance with positive capital account balances, provided that the allocation does not cause or increase a deficit in the partner’s capital account. The partnership agreement must contain a “qualified income offset,” which requires that if a partner has a deficit capital account balance as a result of certain events that partner will be allocated items of income or gain in an amount and manner sufficient to eliminate the deficit as quickly as possible.

G In general, the capital account of each partner is increased by (a) the amount of money contributed by the partner; (b) the fair market value of property contributed by the partner (net of secured liabilities); and (c) allocations to the partner of partnership income or gain (including tax-exempt income); and decreased by (a) the amount of money distributed to the partner; (b) the fair market value of property distributed to the partner (net of secured liabilities); and (c) allocations to the partner of partnership losses. Although these calculations are similar to the rules for determining and adjusting a partner’s outside basis, it should be noted that, with respect to capital account maintenance, contributions and distributions of property are accounted for at fair market value, rather than basis.

exaMple: A and B form a general partnership, with A contributing $30,000 cash and B contributing GreenAcre valued at $30,000 and with a $10,000 basis. Immediately after



the formation of the partnership, A’s outside basis is $30,000 and her capital account is $30,000. B’s capital account is also $30,000, but his outside basis is $10,000.

G In addition to meeting the economic effect requirements, in order to be respected, an allocation must be “substantial,” which requires that there be a reasonable possibility that the allocation will affect substantially the dollar amounts to be received by the partners from the partnership, independent of tax consequences.

F Loss limited to outside basis under section 704(d); this basis includes partnership debt allocated to partner under section 752.

F Generally, the at-risk rules of section 465 and the passive activity rules of section 469 apply at the partner level.

G Under section 465, a partner’s share of partnership losses and deductions is limited to his amount “at risk.” The at-risk limitation is applied on a partner-by-partner basis. Under section 465, generally speaking, a partner is initially considered “at risk” to the extent of cash contributions to the partnership, the adjusted basis of property contributed to the partnership, and amounts borrowed for use in the activity for which the partner is personally liable or has pledged property as security to the extent of the property’s fair market value.

G Under section 469, a taxpayer’s passive activity loss for the year is disallowed. The purpose of section 469 is to prevent taxpayers from using losses from passive activities to offset salary and investment income. The limitation is applied on a partner-by-partner basis, not at the partnership level. The taxpayer’s “passive activity loss” is the amount by which her aggregate losses from all passive activities exceed her aggregate income from such activities.

F Self-employment tax applies to partners, subject to real estate rent and gain on sale exception.

F Pure profits interest issued to partner for services is not presently taxable, unless tradeable, tied to securities or stream of income, or disposed of within two years; capital interest subject to taxation if issued for services; split of authority on tax impact on partnership if capital interest is issued for services, which could result in gain recognition at partnership level (and flow-through to partners).

G A partner may acquire an interest in partnership capital or profits as compensation for services performed or to be performed. A partnership capital interest is one that entitles the partner to a share of the proceeds if the partnership’s assets are sold at fair market value and the proceeds are then distributed in a complete liquidation of the partnership. A partnership profits interest is a partnership interest that is not a capital interest. It could be an interest in the future profits of the partnership, an interest in the appreciation of the value of the partnership, or some other type of interest. The key distinguishing characteristic between a capital interest and a profits interest is whether the partner acquiring such interest would be entitled to a portion of the proceeds that would exist if the partnership liquidated the moment after the partner obtained the interest.

G Historically, a partner has not been taxed upon the receipt of a profits interest in a partnership, and the partnership has not been able to claim any deduction upon the grant of a profits interest. See Revenue Procedure 93-27; Revenue Procedure 2001-43. In Notice 2005-43, the IRS announced plans to propose regulations that add additional complexities and reporting requirements for the issuance of a profits interest in a partnership in exchange for services. To date, the regulations remain proposed and are not in effect.

G If the partner acquires an interest in partnership capital, the receipt of the capital interest is (a) taxable to the partner and (b) deductible to the partnership. In other words, it is as if the partnership paid the partner an amount equal to the fair market value of the partnership interest and the partner



then contributed the amount back to the partnership in exchange for the partnership interest. Also, the partnership may be required to recognize gain inherent in a portion of its assets.

G Under the majority view, a partnership that transfers a capital interest for services is treated as transferring an undivided interest in each of its assets to the service partner in a taxable transaction and must recognize any gain or loss inherent in the transferred portion of each asset. The service partner is then treated as retransferring the assets back to the partnership in a tax-free, section 721 transaction. A few commentators believe that the transfer of a capital interest for services should not be a taxable event to the partnership, noting by analogy that a corporation does not recognize gain when it issues stock as compensation for services.

exaMple: The AB general partnership has $150,000 of assets, consisting solely of land used in AB’s business (which has a $120,000 value and a $60,000 adjusted basis) and $30,000 of cash. In connection with the issuance of a one-third capital interest to C for services, AB will be entitled to a $50,000 deduction, assuming C’s services qualify as ordinary and necessary business expenses. AB will be viewed as having transferred 1/3 of its land ($40,000 fair market value, $20,000 adjusted basis) and cash ($10,000) to C for services and must recognize $20,000 of gain on the land. The 1/3 interest in the land and cash is then deemed to be transferred back to AB by C, who takes a $50,000 outside basis in her partnership interest and has a $50,000 capital account. The land would now have an $80,000 inside basis ($40,000 basis in the 2/3 interest that remained in the partnership plus $40,000 in the 1/3 interest deemed transferred by C). The $20,000 gain and $50,000 deduction should be allocated to partners A and B, because the appreciation in the land took place before C became a partner and A and B paid for C’s services with their partnership capital. The remaining $40,000 of gain in the land should be taxable to A and B when the land is sold since that gain represents the appreciation prior to C’s entry into the partnership.

F Distributions of previously taxed earnings are not taxable; gain is recognized on cash distributed in excess of basis under section 731; generally, no gain or loss is recognized on property distribution (subject to disguised sale, mixing bowl, or section 751 hot asset transactions); debt-shift treated as cash distribution under section 752,

exaMple: A’s outside basis in the partnership is $10,000. If the partnership distributes $4,000 cash to A in a pro rata distribution to all partners, he will not recognize any gain or loss, and his outside basis will be reduced to $6,000. If, instead, the partnership distributed $13,000 cash to A, he would recognize $3,000 of gain from the sale or exchange of his partnership interest, and his outside basis would be reduced to zero. The results would be the same if, under section 752(b), the $13,000 distribution resulted from a $13,000 decrease and A’s share of partnership liabilities.

G Section 751 is designed to prevent shifts of ordinary income and capital gain among the partners through property distributions. Generally, it provides that if a partner receives in a distribution (a) “unrealized receivables” or “substantially appreciated inventory” in exchange for some or all of her interest in other partnership property (including money), or (b) other property (including money) of the partnership in exchange for some or all of her interest in the partnerships section 751 property (that is, unrealized receivables or substantially appreciated inventory), then the distribution is to be treated as a sale or exchange of the section 751 property between the partner and the partnership.

G “Mixing bowl transactions” are generally described as an income-shifting strategy that involves a partner first transferring appreciated property to a partnership and the partnership later either distributing the contributed property to another partner or distributing other property to the contributing partner. The objective is to shift or defer the recognition of the contributing partner’s



precontribution gain by exploiting the nonrecognition rules for contributions to a partnership (section 721) and distributions by a partnership (section 731). Under section 704(c)(1)(B), if property contributed by a partner is distributed to another partner within seven years of its contribution, the contributing partner must recognize the pre-contribution gain inherent in the property at the time of the contribution. Under section 737, a contributing partner must recognize gain if she contributes appreciated property to a partnership and within seven years of the contribution receives property other than money as a distribution from the partnership.

G Section 707(a)(2)(B) is the disguised sale rule that is designed to prevent sales of property between a partner and partnership from being structured as nontaxable contributions and distributions under sections 721 and 731. In general, if there are direct or indirect transfers of money and property between a partner and a partnership and the transfers, when viewed together, are properly characterized as a sale or exchange of property, then the transfers are to be treated as a sale or exchange between the partner and the partnership (or between two partners).

F Distributions need not be pro rata based on ownership percentages; priority distributions, preferred returns, and other disproportionate distributions are allowed.

F Tax year is that of a majority of the partners (usually calendar year).

F Tax-free reorganization is not applicable (only corporations under section 368).

F With respect to the sale of a partnership interest by partner, generally capital gain treatment under section 741, except for “hot assets” under section 751 (A/R, inventory), and buyer acquires partnership interest with a cost basis; ordinary income on certain redemption payments under section 736 (depends on whether partnership is services partnership or asset partnership); possible termination of entity under section 708 if more than 50% interest sold or exchanged within 12-month period; need to address interim/part-year tax allocations; possible step-up of buyer inside basis on section 754 election.

G If section 751 applies to a sale of a partnership interest, it overrides the general rule in section 741 that the gain recognized from the sale or exchange of partnership interest is capital gain. Consequently, section 751 is the starting point in characterizing a partner’s gain or loss from the sale of a partnership interest.

G Section 751 provides that the consideration received by a selling partner in exchange for all or part of his interest in “unrealized receivables” or “inventory items” shall be considered as an amount realized from the sale or exchange of property producing ordinary income rather than capital gain. In applying section 751, the critical questions are:

a. Does the partnership have unrealized receivables or inventory items; and

b. If so, what portion of the selling partner’s gain or loss is attributable to those assets?

F If a partner’s entire interest in the partnership is liquidated (that is, redeemed), section 736 is the starting point for determining the tax consequences of the transaction. Under section 736(b), payments for a partner’s “interest in partnership property” generally are treated as distributions by the partnership and taxed under the normal distribution rules applicable to nonliquidating distributions. In the case of a general partnership interest in a partnership in which capital is not a material income-producing factor, payments for the partner’s share of unrealized receivables and goodwill are generally not treated as payments for partnership property. Under section 736(a), payments not within section 736(b) (that is, payments for unrealized receivables and unstated goodwill for a general partnership interest in a services partnership) are to be considered either (a) a distributive share if the amount of the payment is dependent on partnership income or (b) a guaranteed payment if the amount is determined without reference to partnership income. Under general tax principles, capital is not a material income-producing factor where substantially all of the income comes from the compensation



for services. Accordingly, a partnership of doctors, lawyers, engineers, architects, or accountants is not a business where capital as a material income-producing factor.

F With respect to a sale of assets by the partnership, generally asset-by-asset treatment.

G Capital gain characterization possible on flow-through to partners.

F On death of partner, step-up basis in partnership interest; estate may get benefit of step-basis in partnership assets with special election under section 754.

F Limited Measure 67 tax exposure.

3. Limited Partnership. A limited partnership is a partnership with at least one general partner and one limited partner. The limited partner is only liable for the debts or obligations of the partnership up to the amount it has invested in the partnership, while the general partner has unlimited liability for the debts and obligations of the partnership. To limit the liability exposure of the general partner, it is often formed as a limited liability company or a corporation.

Tax Characteristics

F Tax-free creation under section 721(a); but note exception in section 721(b) for “investment company”; no control requirement.

F Property encumbered by debt that is contributed to LP may generate taxable income under section 752(b).

F Inside and outside basis calculations same as general partnership.

F The LP is a pass-through entity, so items of income and loss flow through to the individual income tax returns of the partners; files Form 1065.

F The partners report their appropriate portion of all partnership income and deduction items, which are provided to them on a Schedule K-1, on their individual returns.

F Profits and losses may be allocated among the partners in any way desired, as long as they have “substantial economic effect,” as defined in section 704(b).

F The profits allocable to the general partner are subject to self-employment tax, while those allocable to the limited partner are not (unless paid as a guaranteed payment, which is a wage equivalent and not truly a return of “profit” to the limited partner; but query whether limited partner should be receiving any such compensation).

F For partnership interest issued for services, for general partner, same as with general partnerships; limited partners should not be receiving compensation in LP in connection with the performance of services for the LP.

F Distributions of cash or property treated in the same manner as distributions in general partnership.

F Tax year is generally that of majority of partners (usually calendar year).

F Tax-free reorganization not available (only corporations under section 368).

F Loss for each partner limited to outside basis; this basis includes partnership debt allocated to partner, same as general partnership.

F Generally, at-risk rules and passive activity rules apply at partner level.

F Sale and redemption of partnership interest treated in same manner as general partnership.

F Sale of assets by partnership treated in same manner as general partnership.

F Death of partner treated in same manner as general partnership.




4. Limited Liability Company. A limited liability company is essentially a hybrid entity that incorporates the flexibility of a partnership for tax purposes and the full liability protection of a corporation. Unlike a general or limited partnership, there is no partner (or “member” in the case of an LLC) that is subject to unlimited liability, but unlike a corporation taxed under subchapter C, there is no second layer of tax imposed on the entity (assuming it elects to be taxed as partnership).

Tax Characteristics

F Generally taxed as a partnership if multiple members (tax-free creation usually available under partnership rules), unless an election is made to be taxed as a corporation (tax-free creation may be available under corporation rules).

F Taxed as a sole proprietorship if single member unless an election is made to be taxed as a corporation.

F There is no tax imposed on the LLC as an entity, provided it is taxed as a partnership, which means that the LLC will be a pass-through entity; the LLC will file a Form 1065 but is itself not liable for any income tax.

F Tax-free creation under section 721(a), subject to section 721(b) “investment company” exception.

F Inside and outside basis calculations same as general partnership.

F Property encumbered by debt that is contributed to the LLC may generate taxable income under section 752(b).

F The members will report their appropriate portion of all LLC income and deduction items, which are provided to them on a Schedule K-1, on their individual returns. Profits and losses may be allocated among the members in any way desired, as long as they have “substantial economic effect,” under section 704(b).

F For a membership interest issued as compensation for service, pure profits interest not presently taxable, unless tradeable, tied to securities or stream of income, or disposed of within two years; capital interest subject to tax to recipient; split of authority on tax impact on LLC; same rules as general partnership.

F Usually, the self-employment tax applies to income allocated to a member like general partnership (note: real estate rent, gain on sale exception), except for purely passive members like limited partners.

F Distributions of cash and property treated in same manner as general partnership.

F The tax year of the LLC is generally that of a majority of the members (usually calendar year).

F A tax-free reorganization is not available.

F Losses allocated to members limited to outside basis; this basis includes LLC debt allocated to member; same as general partnership.

F Generally, at-risk rules and the passive activity rules apply at the member level.

F Sale and redemption of membership interest generally treated in same manner as general partnership.

F On sale of assets, generally asset-by-asset treatment; same as general partnership.

F On death of owner, same treatment as general partnership.




5. C Corporation. A C corporation is a legal entity that is recognized as distinct from its owners. Its shareholders have no liability for the debts or obligations of the corporation and stand to lose only the amount they have invested in the company. A corporation is governed by a shareholder elected board of directors, who in turn appoint officers to run day-to-day operations.

Tax Characteristics

F A C corporation is its own taxpaying entity and files its own tax return (Form 1120) that reflects all items of income and loss.

F Tax-free creation if it meets control test under section 351, which provides no gain is recognized if “property” is transferred to a corporation by one or more persons “solely” in exchange for “stock” in the corporation and “immediately after” the exchange the contributing person or group is “in control” of the corporation (i.e., 80% of all voting stock and 80% of all outstanding stock).

exaMple: In connection with the formation of Newco, X and Y each transfers appreciated property. A receives 50 shares of voting common stock, and B receives 50 shares of nonvoting common stock. Z receives 5 shares of nonvoting preferred stock solely in exchange for services rendered to Newco. Z is not a transferor of property and may not be counted in testing for “control.” Because transferors of property do not own 80% or more of each class of stock, the transaction does not qualify under section 351. Accordingly, X and Y must recognize gain on their property transfers. Z recognizes ordinary income on her receipt of stock for services.

F Transfers to an “investment company” do not qualify for nonrecognition under section 351(e). The purpose of this rule is to prevent unrelated taxpayers from achieving tax-free diversification by transferring appreciated portfolio securities in exchange for stock of a newly formed pooled investment vehicle.

F If property is transferred in a section 351 transaction solely in exchange for stock, the transferor’s basis in the stock received will equal his basis in the transferred property immediately prior to the exchange as specified in section 358(a)(1). The corporation’s basis in the assets transferred in any section 351 transaction is the same as the transferor’s basis as provided in section 362(a).

exaMple: On the formation of ABC Corp., A transfers land with a basis of $10,000 and a value of $60,000 and inventory with a basis of $30,000 and a value of $40,000 in exchange for 100 shares of ABC common stock with a value of $100,000. The transaction qualifies under section 351(a). A’s basis in the ABC stock is $40,000, which is the sum of A’s bases in the land and inventory. ABC Corp. takes a $10,000 basis in the land and a $30,000 basis in the inventory under section 362(a).

F If the sum of the liabilities assumed by the corporation in a section 351 transaction exceeds the aggregate adjusted basis of the properties transferred by a particular transferor, the excess is treated as gain from the sale or exchange of property under section 357(c). This rule is applied separately to each transferor of property.

exaMple: On the formation of ABC Corp., A transfers land with a basis of $30,000, a value of $100,000 and subject to a $55,000 liability, in exchange for ABC Corp. stock with $45,000 value. Under section 357(c), A must recognize $25,000 of gain (the excess of the $55,000 liability over A’s basis in the land). A’s basis in the ABC Corp. stock is $30,000 (basis of land), less $55,000 (debt relief), plus $25,000 (gain recognized), or zero.

F The corporation pays a tax on its income (files Form 1120) and shareholders then pay a tax on any dividends they receive; hence the infamous corporate “double tax.”



G For purposes of subchapter C of the Tax Code, a “distribution” is any kind of payment by a corporation to its shareholders with respect to their stock. A “dividend” is a distribution out of the current or accumulated “earnings and profits” of a corporation. Payments to shareholders that are unrelated to their ownership of stock (such as salary, interest, rent, etc.) are neither distributions nor dividends.

G The term “earnings and profits” is not defined in the Tax Code or the regulations, but section 312 describes the effect of various transactions on earnings and profits. In general, earnings and profits are determined by starting with taxable income and making certain additions, subtractions and adjustments.

G Distributions in excess of current or accumulated “E & P” are a return of capital, which are offset against stock basis.

F To avoid double tax, shareholders who are employees often attempt to pay substantially all corporate profit in salary and bonus—a technique that works as long as the IRS doesn’t successfully argue the compensation was too high, resulting in a portion of the compensation being recharacterized as a dividend.

F Other strategies to transfer funds from a C corporation to its shareholders include excessive rent or other payments to shareholders for assets sold to the corporation. Alternatively, a shareholder may seek to purchase property from the corporation at a bargain, with the dividend being the difference between the amount paid by the shareholder and the actual value of the property.

F If the corporation pays a dividend with appreciated property, the company recognizes income equal to the fair market value of the asset less its basis; the shareholder then recognizes dividend income equal to the fair market value of the asset received; usually, a disastrous tax result.

exaMple: XYZ Corp. distributes Property A ($30,000 value, $10,000 adjusted basis) to its shareholder, A. The corporation recognizes $20,000 gain on the distribution. Additionally, A recognizes $30,000 of dividend income.

F Dividends and distributions need not be pro rata among all shareholders; different classes of stock can be created to provide varying rights and preferences to shareholders (i.e., common stock and preferred stock can have different voting, dividend, and liquidation rights).

F No special capital gain rate for C corporation on asset sale.

F For stock issued as compensation for services, the value of the stock will represent ordinary income to recipient and a tax deduction to the corporation; statutory and nonstatutory stock options available; exercise of option must be analyzed for tax consequences.

G Stock issued for services is not considered as issued in return for property under section 351. A service provider recognizes ordinary income under section 61 on the value of any stock received from the corporation for past, present, or future services. The timing of the income is determined under section 83. If the stock is subject to a substantial risk of forfeiture and is not transferrable, the service provider is taxed on the fair market value of the stock at the time the restrictions lapse less the amount (if any) paid for the stock. The service provider, however, may elect under section 83(b) to be taxed on the fair market value of the stock at the time of transfer less any amount paid. In that event, no additional income is recognized when the restrictions lapse, and no loss (except for any amount paid) is allowed if the stock is forfeited. In either case, the service provider’s basis for the stock is the amount paid plus any amount included in income.

exaMple: On the formation of New Corp in Year 1, A receives 200 shares of stock (valued at $50,000) in exchange for future services. The stock is not transferable and is subject to a substantial risk of forfeiture and will not vest until Year 5. Assume that the stock will



be worth $200,000 in Year 5. Under section 83(a), A has no income in Year 1 and $200,000 of ordinary income in Year 5, and his basis in the stock is $200,000. If A makes a section 83(b) election, he has $50,000 of ordinary income in Year 1, his basis in the stock is $50,000, and he has no additional income when the restrictions lapse in Year 5. If A sells the stock in Year 5 after having made an election under section 83(b), he recognizes $150,000 long-term capital gain. If he forfeits the stock in Year 3, A will not have any loss to deduct.

F Normal employee payroll taxes will apply to compensation paid to employee-shareholders.

F The tax year is the accounting year of the corporation, which may select a fiscal year other than the calendar year.

F Tax-free reorganization is available under section 368.

F Corporate losses subject to general corporate rules; do not pass through to shareholders.

F The at-risk rules and passive activity rules apply at corporate level.

F The sale of stock will result in capital gain treatment to the seller (redemptions may be dividends and need to be carefully analyzed; must be in substance a true redemption); possible election by buyer to treat as asset purchase under § 338 (but usually not workable with C corporation).

F With respect to a sale of assets, gain or loss computed at the corporate level, asset by asset; no special capital gain rate limit at corporate level.

F On the death of a shareholder, no entity asset step-up in basis; only stock step-up in basis.

F Potential Measure 67 tax exposure.

F An advantage of C corporations over other forms of business organization, including S corporations, is that part of the gain on the sale of stock of a C corporation recognized by an individual shareholder can be excluded from taxable gain under section 1202 if the stock qualifies as “small business stock” and has been held for at least five years. Additionally, if a stock has been held for six months, tax on the gain can be postponed under section 1045 by rolling the sales proceeds over tax-free into an investment in qualified small business stock issued by another corporation. Among other requirements, qualified small business stock must be issued by a corporation that has always been a C corporation.

F Another advantage of a C corporation is the availability of tax-favored employee benefits. This is less important than it has been historically because corporate and noncorporate qualified retirement plans are now subject to substantially similar rules and contribution limits, and sole proprietors, partners, LLC members, and 2% shareholders of S corporations can deduct their health insurance premiums. But certain benefits not considered income to the recipient and deductible by the provider are available only to shareholder-employees of C corporations. These include health care reimbursement under uninsured plans, group term life insurance, and child care benefits. Employee benefits can also be offered to shareholder-employees under cafeteria plans that allow the individuals to select the benefits they want.

6. S Corporation. An S corporation is a corporation that is taxed as a pass-through entity. However, it is not taxed as a partnership, which gives rise to several interesting differences between it and an LLC taxed as a partnership.

Tax Characteristics

F Tax-free creation if meet control tests under section 351 (like the C corporations); Section 721 has no application to formation of an S corporation.

F The profit and loss of an S corporation flows through to the shareholders on a pro rata basis. Allocation of profit and loss in any fashion other than pro rata is restricted by the second class of



stock prohibition, which is different than partnership “substantial economic effect” allocations. Voting and nonvoting stock is allowed, but all shares must have identical economic rights. This is different than C corporations (which can have different classes of stock with varying economic rights) and partnerships (which may provide for priority or preferred returns and disproportionate distributions).

F The basis of each shareholder’s stock in an S corporation is first increased by the shareholder’s share of allocated income and decreased, but not below zero, by distributions to the shareholder and then decreased by the shareholder’s allocated losses. If allocated losses exceed the shareholder’s stock basis, they may be applied against and reduce (but not below zero) the shareholder’s basis in any S corporation debt.

exaMple: A is a shareholder in an S corporation who paid $5,000 for her stock and loaned the corporation $1,000 in exchange for a corporate note. During the corporation’s first taxable year (Year 1), C is allocated $6,000 of S corporation income and $1,000 of S corporation loss. At the end of Year 1, her stock basis will be $10,000, calculated as the $5,000 original stock basis plus $6,000 of allocated income less $1,000 of allocated loss. C’s basis in the corporate note remains $1,000.

In Year 2, C’s share of the corporation’s tax items consist of $12,000 of operating loss. C can only deduct $11,000 of the loss (the total of her stock and debt basis in the corporation). The remaining $1,000 of loss will be suspended and carried over to Year 3. C’s basis in her stock and debt will be reduced to zero.

In Year 3, the corporation’s business improves and C’s share of the corporation’s tax items consists of $5,000 of operating income. C will include the $5,000 of income in her personal tax return and will be allowed to deduct the $1,000 loss from the prior year. For basis purposes, the $5,000 increase attributable to the income will be reduced by the $1,000 loss. The remaining $4,000 of basis will be first allocated to the debt to restore it to its original $1,000 basis. At the end of Year 3, C’s stock basis is $3,000, which is the beginning basis of zero, plus the $5,000 income allocation less $1,000 of suspended loss less $1,000 attributable to the restoration of debt basis.

F Losses allocated to shareholders limited to outside basis; this basis does not include corporate debt (which is different than partnership). A shareholder’s share of S corporation losses and deduction is limited to the shareholder’s adjusted basis in the (a) stock of the corporation and (b) indebtedness of the corporation to the shareholder. Losses and deductions disallowed under this rule carry over indefinitely and may be used when the shareholder obtains additional stock or debt basis by, for example, contributing or loaning additional funds to the corporation or buying more stock.

exaMple: C is a shareholder in an S corporation and has a $5,000 basis in her stock. C also loans the corporation $4,000 in exchange for a corporate note. If C’s share of the corporation’s loss for the year is $12,000, she will be limited to a $9,000 deduction (her combined basis in the stock and note) and will have $3,000 of suspended loss that will carry over until she obtains additional basis.

G Most courts agree that an S corporation shareholder does not obtain basis credit for a guaranty of a loan made by a lender directly to the corporation.

F For stock issued as compensation for services, the value of the stock will be taxable to the recipient as income; may use statutory incentive stock options or nonstatutory stock options (similar to a C corporation but not partnership—no profits interest concept).

F On distributions, no tax until prior taxed income used (which is similar to partnership rule); but property distributed is deemed sold and this often creates gain to corporation (outside basis adjustment and pass through); if an appreciated asset is distributed, there will be a tax on the inherent



gain in the asset (as with a C corporation) that will pass through to all the shareholders on a pro rata basis. The value of the distributed asset would then be taxed to the distributee only to the extent it exceeded her basis in the stock.

G Distributions by an S corporation are tax-free to the extent of the shareholder’s adjusted basis in stock of the corporation. If the distribution exceeds the shareholder’s stock basis, the excess is treated as gain from the sale or exchange of the stock, normally capital gain of the stock of the capital asset. Finally, the shareholder’s stock basis is reduced by the amount of any distribution that is not includable in income by reason of the distribution rules.

exaMple: A is a shareholder in an S corporation and has a $5,000 basis in his stock. If the corporation distributes $8,000 of cash to A, he will be permitted to receive $5,000 tax-free and $3,000 will be treated as gain from the sale or exchange of A’s stock. A’s stock basis will be reduced to zero as a result of the distribution.

G With respect to a property distribution, the amount of the distribution will be the fair market value of the property, and the receiving shareholder will take a fair market value basis in the distributed property. The shareholder’s stock basis also will be reduced by the fair market value of the distributed property. At the corporate level, a distribution of appreciated property to a shareholder will require recognition of gain as if the property were sold. The gain will be taxed directly to the shareholders like any other gain recognized by the corporation.

exaMple: Assume Newco, an S corporation, breaks even in business during the year and distributes appreciated land (a capital asset held long-term with a $50,000 fair market value and a $20,000 adjusted basis) to A, one of its two equal shareholders. Also, assume A’s basis in her Newco stock is $70,000 and Newco makes a simultaneous $50,000 cash distribution to B, its other shareholder. Newco will recognize $30,000 of long-term capital gain, $15,000 of which will be taxed to each shareholder. A will receive a $50,000 tax-free distribution, and her stock basis beginning the next year will be calculated as follows:

$70,000 stock basis +15,000 allocated gain –50,000 amount of distribution $35,000 new stock basis

G Distributions for S corporations with a C corporation history are more complicated and require additional analysis.

F The S corporation files a Form 1120S but does not pay any income tax.

F The tax year of the S corporation is generally the calendar year.

F Tax-free reorganization is generally available under section 368.

F The section 465 at-risk rules apply at the shareholder level.

F The section 469 passive activity rules apply at the shareholder level.

F Sale of stock results in capital gain treatment to seller; book-closing issues; possible election by buyer to treat as asset purchase under section 338(h)(10).

F On sale of assets, gain or loss computed at corporate level asset-by-asset; pass through and basis adjustment for shareholders; possible capital gain treatment.

F On death of a shareholder, no entity assets step-up in basis; only stock step-up in basis.

F Generally, employers engaged in an active trade or business must pay a federal self-employment tax of 15.3% on net income in 2013 (12.4% Social Security, 2.9% Medicare). An individual who is self-employed (i.e., the whole or partial owner of an S corporation) is taxed both as an employer



and an employee on all annual income up to $113,700 as of 2013, after which only the portion of the employment tax applicable to Medicare (2.9% total and an additional .9% on wages in excess of $200,000 starting in 2013) applies. Generally speaking, current tax law provides no exception for entities treated as sole proprietorships or partnerships, but it does provide an exception for owners of an entity taxed as an S corporation. So long as the shareholder takes a reasonable salary for the shareholder’s employment with the S corporation, any amount over and above that reasonable salary is distributed to the shareholder without being subject to the withholding tax. Accordingly, the owner/employee of an S corporation can avoid being taxed at 15.3% (in 2013 12.4% Social Security, 2.9% Medicare) of the company’s net profit up to approximately $113,700 and at 2.9% of the company’s net profit thereafter with an additional .9% Medicare tax on wages in excess of $200,000 starting in 2013. This is one advantage of an S corporation that does not exist for entities (such as an LLC) treated as a partnership or sole proprietorship. Incidentally, limited partners in a limited partnership who do not materially participate and do not provide more than 500 hours of service to the limited partnership each year generally do not have to pay the employment tax upon their receipts or tax allocations from the limited partnership.

note: With careful planning, employment-related liabilities can be mitigated in the LLC context. However, due to increased complexities and costs associated with such enhanced planning, it is sometimes not feasible to utilize these alternative approaches.


iV. GEnEraL SuMMary

a. General Guidelines in Selecting Form of Entity

The most critical factors in choosing the proper form of entity include appropriate consideration of the following.

Questions to ask

F What type of assets will be owned by the entity (e.g., real estate, equipment, cash)?

F What type of business will the entity operate (passive, active)?

F Will the owners or the entity borrow funds as part of initial capitalization?

F What will owners contribute to the entity at formation in exchange for ownership interests?

F Who will be the owners {e.g., individuals, entities)? Do they individually have creditor issues?

F Is there potential for the company seeking private equity or capital from public markets?

F Will business be conducted in multiple states? Are there, or will there be, multiple owners?

F Is the business expected to generate profits or losses initially? If losses, for how long?

F How does the business expect to allocate profits and losses among the owners for tax reporting purposes? On a related note, how does the business expect to distribute cash?

F What is the anticipated method of exit from the business?

F Are there employment tax issues for owner-employees?

F Will equity be issued to service providers as compensation?

F What type of employment benefits are anticipated to be offered (e.g. cafeteria plans, medical reimbursement plans)?



B. General rules of Thumb

The choice of entity almost always leads to a one-way street. It is key to keep in mind that it is often possible to move from a partnership-taxed entity to a corporation on a tax-free basis. It is rare to transition from a corporation to a partnership-taxed entity on a tax-free basis. Thus, in case of doubt, it is best to start with a sole proprietorship or partnership-taxed entity rather than a corporation. Here are a few other general rules of thumb.

1. LLCs should generally be given first consideration when forming a business organization. Existing sole proprietorships should consider an LLC (taxed as a disregarded entity). Existing general partnerships should consider converting to an LLC or an LLP, depending on the nature and type of business being conducted.

2. If it is anticipated that there may be owners other than individuals (such as trusts, corporations, LLCs, or other entities), then an S corporation will likely not be a feasible solution. Similarly, if income tax allocations and/or profit or liquidating distributions will not be based strictly on proportionate ownership, then an S corporation will not be available. In either of these situations, either an LLC or a C corporation must be considered. Frequently, profit distributions are to be made to certain investors on a priority basis and/or certain investors are granted priority returns on their investment. These provisions can be addressed in the LLC context (taxed as a partnership) and in the C corporation (with preferred stock), but cannot be provided with an S corporation.

3. There are three common methods of exit: the asset sale, the taxable equity sale, and the tax-deferred reorganization. If the company anticipates an asset sale, an S corporation or LLC is generally best, as there would be substantial tax disadvantages to using a C corporation (i.e., double tax, no capital gain opportunity). With an S corporation or LLC, there is only one level of income tax, the basis of the buyer in purchased assets will be stepped up on the sale, and capital gain characterization is possible for the seller (i.e., goodwill), but consider section 751 characterization for LLC taxed as partnership. With a C corporation, there are two levels of income tax on an asset sale (and no potential for capital gain treatment), and consequently C corporation asset sale transactions are frequently abandoned.

If the company anticipates a taxable equity sale, then either an S corporation (particularly if it has made a section 338(h)(10) election to treat the equity sale as an asset sale) or an LLC may be an option. Once again, there would be only one level of income tax to the selling owners, potential capital gain treatment for the sellers and the basis of the purchasers in their ownership interests (and the inside basis of the selling entity’s assets) may be stepped up upon the sale. However, for an LLC (taxed as a partnership), there may be recharacterization of capital gain to ordinary income under section 751. With a C corporation, part of the gain on the sale of the stock may be excluded from taxable gain under section 1202 if the stock qualifies as small business stock and has been held for at least five years. If the stock has been held for six months, tax on the gain may be postponed by rolling the sales proceeds over tax-free into an investment in qualified small business stock issued by another corporation. The rollover provision, set forth in section 1045, may be elected if the seller invests in new qualified small business stock within 60 days following the sale. Additionally, if a C corporation is used, then there would be one level of tax to the selling shareholders and a basis step-up on the purchased stock, but the basis of the assets inside the corporation would not be stepped up, which is a distinct disadvantage to the buying party and often makes the stock sale of a C corporation not feasible.

If the company anticipates a tax-deferred reorganization or some sort of stock exchange, then the S corporation or C corporation generally is best, as partnership-taxed entities cannot participate on a tax-deferred basis. Generally speaking, for entities where it is expected that there will be a merger or reorganization of some sort with a public company, a C corporation is used, because it is anticipated that there will be private equity or capital from public markets in connection with the organization and operation of the corporation prior to the exit of the founding owners, and the shareholder and stock



limitations of the S corporation usually prove to be prohibitive to the business plan. It may be possible to initially form such an entity as an LLC in an effort to preserve the potential benefits of sections 1202 and 1045 and to allow the owners to personally benefit from start-up losses due to the flow-through nature of the LLC and then convert from the LLC to the C corporation before a reorganization or sale transaction. However, the conversion would need to be “old and cold” to avoid IRS assertions that the LLC entity was, in actuality, the real party to the reorganization transaction and that the tax benefits available to the corporation may not be utilized.

4. If it is anticipated that equity of the entity will be used as compensation for key personnel, then an LLC (taxed as a partnership) should be given strong consideration, because the issuance of a profits interest for services will not be a taxable event to the recipient worker or the issuing LLC.

5. S corporations are often best suited for companies in which owners will be individuals and will be employees. This allows for the reduction in employment tax liability and often results in significant financial benefit to the business owners. It is established law that an employee/S corporation shareholder may receive both salary payments subject to self-employment tax and profit distributions as a shareholder that are not subject to FICA or SECA. The only limit on this structure is that the salary payments must be reasonable, which in this case means “high enough” rather than “too high” as the IRS challenges for C corporations.

6. If it is anticipated that the business will be highly successful and that the owners will likely be withdrawing substantial amounts from the business venture, then an S corporation or an LLC should be considered due to its flow-through tax attributes, which will eliminate any concern of IRS challenges to excessive compensation that may be paid to owner-employees in the C corporation context.

7. If it is anticipated that there will be start-up losses, it may be advisable to form a partnership-taxed entity (i.e., an LLC), perhaps converting to (or electing) S corporation status upon achieving profitability. Particularly if the business will be capitalized in part with funds borrowed by the entity and guaranteed by the owners, use of an LLC taxed as a partnership should be given consideration.

8. If the entity will own appreciated or appreciating assets (such as real estate or equipment that will be depreciated but retain value), an LLC (taxed as a partnership) is the entity to use. Corporate entities will be taxed disadvantageously in these circumstances due to the tax consequences resulting from the distribution of appreciated assets from corporations.

9. If there are concerns about one of the owners individually having creditor issues, an LLC is the preferred entity because of its downstream liability protections.

10. Measures 66 and 67 weigh in favor of sole proprietorship, partnership, or S corporation (that is, pass-through entities) to avoid revenue-based excise tax (C corporations, particularly for professionals, are at risk for Measure 67 tax).

11. If it is anticipated that business may be conducted in multiple states, and if the business may have multiple shareholders, consider potential administrative burdens of filing income tax returns for business and shareholders if there is a pass-through entity. If a business is organized as a partnership or an entity is taxed like a partnership and transacts business in several states, then each of the partners, as well as the partnership, may be required to file tax returns in each state. Separate tax returns for the business and the owners may also be required if the business is organized as an S corporation. If the business is organized as a C corporation, only one tax return is required, and it will be filed by the business.

12. The manner in which the various forms of business entity are taxed in the state or states in which a business expects to transact business may also affect the choice of entity. For example, some



states dot not tax S corporations as pass-through entities, and using an LLC in these states may avoid undesirable double taxation of the income of the business. On the other hand, some states impose entity level taxes on LLCs that are not imposed on S corporations or other forms of business entity. If these taxes are high, another form of business entity may be more attractive.

13. If the venture wishes to provide employment benefits that are only available to a C corporation, such as a cafeteria plan, health care reimbursement under uninsured plans, group term life insurance, or child care benefits, then a C corporation must be used. However, generally speaking, other employment-related benefits, such as retirement plans and health care plans, provide the same tax treatment for C corporations and other types of business entities.

14. Recent Obama tax legislation relating to health care may affect some decisions regarding choice of entity and the type of income generated by business and investment entities. The legislation imposes a new surtax (Medicare contribution tax) of 3.8% on “investment income” of certain taxpayers earned after December 31, 2012, and increases the FICA self-employment tax rate from 2.9% to 3.8% for many taxpayers. In effect, the Medicare surtax may result in a 3.8% tax on dividends C corporations pay to their owners.

These new taxes may encourage many entities to adopt the pass-through tax treatment provided by partnerships, LLCs, and S corporations. Although pass-through entities do not pay the Medicare contribution tax, individuals, trusts, and estates that are direct or indirect owners may be subject to taxation to the shares of income and gain they derive from these entities.

The 3.8% Medicare contribution tax applies to the lesser of a taxpayer’s net investment income or the excess of its modified adjusted gross income (MAGI) over a threshold amount. The threshold amount is $250,000 for joint filers or surviving spouses, $125,000 for a married individual filing separately, and $200,000 in other cases.

The MAGI basically equals a taxpayer’s adjusted gross income (AGI), with some modifications. A taxpayer’s net investment income equals the excess of the sum of its:

a. Gross income from interest, dividends, annuities, royalties, and rents (other than income from the ordinary course of a trade or business not included in b., below);

b. Gross income from a trade or business that is a passive activity (under IRC § 469) with respect to the taxpayer, or a trade or business of trading in financial instruments or commodities (under IRC § 475(3)(2));

c. Net gain from the disposition of property other than property held in a trade or business (other than a trade or business described in b., which includes capital gain transactions);

Over allowable deductions properly allocable to such gross income or net gain.

In effect, the Medicare contribution tax applies to portfolio income and passive income as defined under IRC Section 469.



ChOiCES OF EnTiTiES

Tax Law Entities State Law OptionsSole Proprietorship Sole Proprietorship

LLCPartnership (Subchapter K, §§ 701–761) General Partnership

Limited PartnershipLLCLLP

C Corporation (Subchapter C (§§ 301–385))S Corporation (Subchapter S (§§ 1361–1379))

CorporationProfessional CorporationLLC

Sole Proprietorship

Business Owner (Individual)

Business Assets

Business owner directly owns all business assets and manages and controls business.

General Partnership

Partners

Partnership

General Partners

General Partnership

Partnership Assets

Partners

General Partners

General Partnership

Control/Manage Elect

Control/Manage



Limited Partnership

General Partner Limited Partners

Limited Partnership

Limited Partnership Assets

Not Active in Partnership Business

Control/Manage

Limited Liability Partnership

Partners

LLP

Partners

LLP

LLP Assets

Partners

Managing Partners

LLP


Control/Manage



Limited Liability Company

Members

LLC

Members

LLC

LLC Assets

Members

Member-Managed Manager-Managed

Managers

LLC


Control/Manage



Corporation (or PC)

Shareholders

Corporation

Corporate Assets

Shareholders

Board of Directors

Of�cers

Conduct Day-to-Day Business Activities

(Need President and Secretary—May

Appoint Other Of�cers, e.g., VP, Treasurer)

Elect

Make Major Policy Decisions and

Appoint Of�cers

Chapter 4

Tax CollectionJennifer l. Woodhouse

Schwabe Williamson & Wyatt PCPortland, Oregon

Contents

I. State and Federal Collection Powers. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4–1A. Sources of Levy and Garnishment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4–1B. Liens vs. Levies. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4–2

II. Tax Collection Options . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4–2A. Pay the Debt in Full . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4–2B. Currently Not Collectible (Federal Only) . . . . . . . . . . . . . . . . . . . . . . . . . . 4–2C. Offers (Federal and State) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4–4D. Installment Agreements (Federal and State) . . . . . . . . . . . . . . . . . . . . . . . . 4–7E. Bankruptcy . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4–8F. Do Nothing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4–8

III. Preparing for Collection. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4–9A. File Missing Returns . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4–9B. Stop the Problem That Is Causing the Debt . . . . . . . . . . . . . . . . . . . . . . . . . 4–9C. Track Financial Information and Gather Supporting Documentation . . . . . . . . . 4–10

IV. Evaluate the Validity of the Debt. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4–10A. Automated Substitute for Return (ASFR) . . . . . . . . . . . . . . . . . . . . . . . . . 4–10B. Audit . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4–10

V. Deadlines and Timing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4–11A. Notice of Deficiency . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4–11B. Final Notice of Intent to Levy or File a Lien. . . . . . . . . . . . . . . . . . . . . . . . 4–11C. Refund Deadline . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4–11D. Collection Statute of Limitations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4–12E. Innocent Spouse Claims. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4–12

VI. Additional Resources . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4–12

Chapter 4—Tax Collection




1 – TAX COLLECTION PDX\125549\188716\JLW\12294168.1

I. State and Federal Collection Powers In order to help the taxpayer determine which collection option is best for the taxpayer’s individual situation, the attorney will need a basic understanding of the collection powers of the Internal Revenue Service (IRS) and the Oregon Department of Revenue (DOR).

A. Sources of Levy and Garnishment. Whether the IRS or DOR can levy or garnish depends upon the source of the income. Some of the most common types of income are listed in the table below, along with whether the IRS or the DOR can take that income through enforced collection action.

Source of Income Can IRS take it? Can DOR take it?

Wages Yes—see IRS Pub. 1494 for limits

Yes—25% each pay period

Money in a bank account

Yes—unless it is from a source of income the

IRS could not otherwise levy (e.g.,

unemployment)*

Yes—unless it is from a source of income Oregon could not otherwise garnish

(e.g., unemployment)*

Unemployment benefits No No

Social Security retirement Yes—15% each month No

Social Security disability Yes—15% each month No

Other retirement benefits Yes No

Supplemental Security Income (SSI) No No

Temporary Assistance to Needy Families (TANF) No No

* If funds from an exempt source are mingled with funds from a non-exempt source in a bank account, it can be difficult for the taxpayer to prove to the IRS or DOR that the seized funds were exempt.

Taxpayers with exempt income may want to consider filing an affidavit notifying the taxpayer’s bank of the exempt funds. A form is available online at www.oregonlawhelp.org, “How to Tell a Financial Institution that You Have Deposits Protected from Garnishment.”




B. Liens v. Levies

1. A lien is a legal claim against the taxpayer’s property. The federal lien arises when the taxpayer is assessed.1 This lien is sometimes called the “secret lien” because, initially, only the taxpayer and the IRS are aware of it. If the debt remains unpaid, the IRS may file a notice of federal tax lien which gives public notice to creditors.2 The Oregon tax lien process begins with the issuance of a Distraint Warrant and Writ of Execution, which can be issued if the tax is not paid within 30 days after DOR issues a written notice and demand for payment.3 The distraint warrant is generally issued to the county in which the taxpayer lives and, once recorded, becomes a lien against any property owned or later acquired by the taxpayer.

2. A levy takes property from the taxpayer to pay the debt. Oregon refers to the same process as a garnishment.

II. Tax Collection Options There are at least six collection options for federal tax debts, including requesting currently not collectible status, submitting an offer in compromise, entering into an installment agreement, discharging the tax debts in bankruptcy, paying the debt in full, and doing nothing.

A. Pay the Debt in Full. This option is preferred by both the IRS and the DOR. Taxpayers with the ability to pay their tax debts in full are unlikely to contact an attorney for assistance with the debt.

B. Currently Not Collectible (federal only)

1. Currently not collectible (CNC) is a temporary collection hold the IRS will grant to taxpayers who cannot afford to make payments on their tax debts. It is sometimes referred to as “hardship” status.

2. When a taxpayer’s tax debts are placed into CNC status, most collection activity stops, including levies.

Two collection actions can continue after a taxpayer is placed in CNC. The IRS may still file a notice of federal tax lien and the IRS will continue to offset future tax refunds and apply them to the debts.

1 IRC § 6322. 2 IRC § 6323. 3 ORS 314.430(1).




3. If the IRS has recently levied from a taxpayer who qualifies for CNC status, and, as a result, the taxpayer is unable to pay the taxpayer’s allowable monthly living expenses, it may be possible to get a refund of the most recently levied funds by contacting the Taxpayer Advocate Service. The taxpayer will need to be able to prove through documentation the hardship caused by the IRS collection action.

4. CNC does not eliminate the underlying debt or reduce the penalties and interest. Interest will continue to accrue.

5. CNC does not toll the collection statute expiration date. The ten-year statute of limitations for collection of the federal tax continues to run while a taxpayer is in CNC.

6. CNC does not remove a lien. As mentioned above, the IRS may file a notice of federal tax lien when it places a taxpayer in CNC.

7. CNC can be requested by calling IRS and providing information about the taxpayer’s assets, income, and expenses over the phone. Depending upon how high the debt is and the type of income and expenses, the taxpayer may be asked to fax or mail a written financial statement and supporting documentation to the IRS. The taxpayer’s income will be compared against the taxpayer’s allowable expenses to determine whether the taxpayer has any disposable income. If the taxpayer has liquid assets or disposable income, the taxpayer may not qualify for CNC and will be asked to make payments instead. Once the taxpayer is placed in CNC, the taxpayer will receive an annual notice reminding them of the debt. If the IRS receives information that indicates the taxpayer’s financial situation has improved (e.g., a W-2 showing increased wages) the taxpayer will be asked to provide updated financial information and may be asked to make payments. Taxpayers can make voluntary payments on their tax debts while in CNC.

The IRS cannot refuse to place an eligible taxpayer in CNC just because the taxpayer has unfiled returns.4

4 Vinatieri v. Comm’r, 133 T.C. 16 (2009).




8. There is no Oregon equivalent to CNC

a. In some cases the state will allow a temporary collection hold with proof of the taxpayer’s financial hardship. Oregon does not publish the procedures and guidance its agents use to determine whether such a hold is appropriate.

b. Holds seem to only be provided for taxpayers from whom the DOR could not otherwise collect (e.g., because all the taxpayer’s income and assets are exempt from state garnishment).

c. The holds are generally shorter in duration and carry an obligation to submit updated financial information at some future date (sometime as short as three months).

9. For additional information about CNC, see:

a. IRS Form 433-A: Collection Information Statement for Wage Earners and Self-Employed Individuals

b. IRS Form 433-F: Collection Information Statement

c. www.irs.gov/Individuals/Collection-Financial-Standards

C. Offers (federal and state)

1. Offer in Compromise Overview The federal offer in compromise program allows a taxpayer to settle a tax debt for less than the full amount owed. There are three types of offers: doubt as to collectability, doubt as to liability and effective tax administration.

a. Effective tax administration offers. This type of offer is appropriate where the tax is legally owed and the taxpayer has the ability to pay in full, but there is some other hardship, public policy or equity reason why a lower amount should be accepted to resolve the debt. Offers of this type are rare.

b. Doubt as to liability offers. This type of offer is appropriate where the taxpayer has a legitimate doubt that all or part of the tax is owed. For example, this type of offer may be used in situations where the taxpayer was audited but does not believe the final result was correct either because the taxpayer failed to participate in the audit, the examiner incorrectly applied the law, or the taxpayer




was unable to provide sufficient documentation that later became available.

c. Doubt as to collectability offers can be used to resolve tax debt for less than the amount owed if the taxpayer can demonstrate the amount offered is more than the IRS is likely to otherwise collect. This is the most common type of offer. The remainder of this section deals with doubt as to collectability offers.

2. Doubt as to collectability offers compare the amount offered by the taxpayer against the reasonable collection potential (RCP); i.e., the most the IRS may expect to collect through enforced collection actions. The RCP is determined by reviewing the taxpayer’s earnings history, current income, expenses and assets. If the amount offered is greater than the RCP, the IRS is likely to accept the offer. Once the offer is accepted and the taxpayer has complied with all the terms of the offer (including payment and five years of compliance), the debt is gone.

The IRS will release the notice of federal tax lien after the full amount of the offer is paid.

3. An offer does not settle the debt for “pennies on the dollar.” The amount of an acceptable offer is not calculated as a percentage of the tax debt. The amount a taxpayer is required to pay under this type of offer is based only upon the taxpayer’s ability to pay and the IRS’s evaluation of the reasonable collection potential of the taxpayer.

4. Mechanics

a. In order to submit an offer, the taxpayer is required to provide a written financial statement and supporting documentation of certain items of income and expenses, and assets. These documents are submitted under penalties of perjury. The taxpayer must also submit the application fee (currently $150) and a down payment (20% of their offer amount).5

b. Once the offer is submitted, collection activity (aside from refund offsets) stops until the IRS makes a decision on the offer. It can take months before the IRS makes a decision on the offer. While collection activity is stopped, the collection statute expiration date is also tolled.

5 Low income taxpayers may apply for a waiver of these fees.




c. The taxpayer must have filed all required returns before the IRS will process the offer.

d. If the offer is accepted, the taxpayer must file all required returns and pay all taxes owed on time, and in full, for the next five years or the offer could default. For this reason, taxpayers who are unable to keep current on their tax payments (either through estimated payments or withholding) are not good offer candidates until they are able to set aside sufficient funds to pay their taxes each year.

e. The IRS will offset the taxpayer’s refund for the year in which the offer was accepted. This means that if the offer was accepted in January of 2014, the IRS will keep the taxpayer’s 2013 tax refund (which the taxpayer would otherwise receive in April of 2014) and the taxpayer’s 2014 tax refund (which they would otherwise receive in April of 2015).

If the taxpayer generally receives large refunds that will pay the debt in a year or two, it may not be worth doing an offer.

f. For more information, see:

i. www.irs.gov/Individuals/Offer-in-Compromise-1

ii. IRS Form 656-B: Offer in Compromise Booklet

5. Oregon Settlement Offer Oregon has a program similar to the IRS’s doubt as to collectability offer called the settlement offer program. Differences include:

a. There is no application fee and the down payment is 5% of the offer amount (rather than 20%). No waiver of the down payment is available.

b. If the taxpayer’s offer is accepted, the taxpayer only needs to be in compliance (file and pay on time) for three years, rather than the five required by IRS.

c. DOR does not have published guidance about its procedures for considering offers.




d. DOR offers are generally processed more quickly than federal offers.

e. For more information, see www.oregon.gov/dor/forms/ personal/settlement-offers_101-157.pdf.

6. Taxpayers who need to make state and federal offers may wish to stagger them to avoid having to make payments to both agencies at the same time.

D. Installment Agreements (federal and state)

1. Federal Installment Agreements

a. The IRS offers several options for making installment payments.

b. Payment plans are allowed even if the amount offered will not fully pay the debt before the collection statute expires if the taxpayer demonstrates the taxpayer cannot make a higher payment. The minimum payment plan the IRS will accept is $25 per month.

c. There is a fee of $52-$105 to set up an installment plan with the IRS. Low income taxpayers may qualify for a reduced fee of $43.

d. The amount of tax owed and the amount the taxpayer is able to pay will determine whether the plan can be obtained over the phone or online or whether financial information and documentation will need to be provided.

e. The taxpayer must generally have filed all the taxpayer’s returns, and, if self-employed, must be making estimated tax payments in order to get an installment agreement.

f. Taxpayers who qualify for CNC but want to make payments should be placed in CNC instead of installment agreements. This saves the installment agreement setup fee and avoids collection problems if the taxpayer makes any late payments. Taxpayers in CNC can make voluntary payments at any time.

g. See:

i. www.irs.gov/Payments.




ii. www.irs.gov/Businesses/Small-Businesses-&-Self-Employed/Fresh-Start-Installment-Agreements.

iii. IRS Form 9465-FS: Installment Agreement Request.

2. Oregon Installment Plans

a. Oregon will accept a payment plan that will fully pay the tax in 12 months without a financial statement. Payments of less than that amount can be arranged if a financial statement and supporting documentation are provided.

b. See www.oregon.gov/dor/PERTAX/docs/financial-statement_860-009.pdf.

E. Bankruptcy

1. Some state and federal tax debts may be dischargeable in bankruptcy. The intersection of bankruptcy and tax law is very complicated. For a full analysis of whether bankruptcy is an appropriate way to resolve a tax debt, a bankruptcy attorney with experience discharging taxes should be consulted.

2. Some instances in which bankruptcy may not be a good option include when:

a. The taxes are from the last three tax years.

b. The taxes are from a recent audit.

c. Tax returns were not filed.

d. Tax returns were filed late, within the last two years.

e. The taxpayer has recently received a bankruptcy discharge.

3. Legal Aid and the Oregon State Bar Debtor-Creditor Section operate a bankruptcy clinic for low income taxpayers. For contact info by county, visit www.osbar.org/public/legalinfo/ bankruptcy.html.

F. Do nothing

If the taxpayer does not try to resolve the tax debt, DOR and the IRS will begin trying to find and collect from the taxpayer’s income and assets. Enforced collection action like garnishments and levies can severely impair a taxpayer’s




ability to pay monthly expenses. These types of collection actions can also be difficult and time consuming to stop.

If the taxpayer owes Oregon taxes and has income the state could seize (e.g., wages), the taxpayer should seriously consider setting up an installment plan and prioritizing those payments. Oregon is an aggressive collector. If the taxpayer does nothing to pay the debt the state will try to garnish. Once the state begins garnishing, it will no longer accept an installment agreement and will not stop a garnishment. The best the taxpayer can hope for at that point is a reduction in the garnishment to a lower percentage of the taxpayer’s income. Such reductions are time consuming and difficult to obtain.

III. Preparing for Collection There are many steps a taxpayer can take to improve the taxpayer’s collection position either before or during the taxpayer’s collection case.

A. File missing returns

1. Many of the collection options require the taxpayer to have filed all missing returns. Compliance with return filing requirements is important to the IRS and the DOR, so the taxpayer should try to file all required returns.

2. Some taxpayers may be entitled to refunds they have not yet claimed. The taxpayer may not actually receive the refunds shown on the return, but, if claimed within the limitations period for filing claims for refund,6 the refunds will reduce the debts owed.

3. Free tax preparation is available at sites throughout the state. Visit www.cashoregon.org for a list of sites in your area. Most sites will prepare past year returns and operate only during the tax season (late January through April).

B. Stop the problem that is causing the debt

1. The IRS and DOR hate “stacking” (the continual accrual of tax debt from year to year). If the debt results from the failure of a self-employed taxpayer to make estimated tax payments, take steps to ensure the taxpayer begins making sufficient estimated tax payments to cover the current tax year’s liability. Likewise, W-2 employees should make sure enough tax is withheld from their paycheck to cover their tax debt for their current year tax.

6 IRC § 6511.




If the debt results from taxable withdrawals from a retirement plan, the taxpayer should ask the payor to withhold tax or make estimated tax payments sufficient to cover the current year’s tax liability on the withdrawal.

2. Preventing the tax debt from affecting current and future tax years is a significant step towards helping the taxpayer eventually resolve all of the taxpayer’s tax problems. As the tax debts become older, more options (specifically, bankruptcy and the federal collection statute expiration) become available.

C. Track financial information and gather supporting documentation

1. In order to obtain many of the collection alternatives, the taxpayer will be required to provide detailed financial information and a considerable amount of supporting documentation. Taxpayers who anticipate working with the IRS or the DOR to deal with a tax debt should begin tracking expenses and income and saving documentation.

2. The taxing authorities may give very short deadlines for providing information so it will be very helpful if the taxpayer has already begun tracking and documenting the taxpayer’s expenses before the information is requested.

IV. Evaluate the Validity of the Debt. When handling a tax collection case, it is worth checking to verify that the amount of the underlying debt is correct. Some possible issues which could result in an inflated tax assessment include:

A. Automated Substitute for Return (ASFR). If the taxpayer did not file a return and the IRS believes one was required, the IRS will determine the amount of tax owed based on the information available to it. The assessment is made as if the taxpayer had no itemized deductions, chose Single filing status and had no dependents. Filing a correct original return will reduce the amount owed if the taxpayer has a more favorable filing status (e.g., Married Filing Jointly or Head of Household), dependents, itemized deductions, or is eligible for any tax credits.

B. Audit. Audits (or, as the IRS refers to them, “examinations”) can also result in inflated assessments if the taxpayer does not participate in the audit. If an audit occurred, it is worth evaluating whether the results were correct. If not, there may be ways to reduce the debt through audit reconsideration, filing a doubt as to liability offer in compromise, or by challenging the underlying debt in a collection due process hearing.




It is also possible that the taxpayer will contact an attorney about a tax “debt” before the audit is concluded and the tax has been assessed. If that occurs, the attorney should immediately evaluate the procedural status of the case. If a Notice of Deficiency has not yet been issued, or if the time for responding to that Notice has not yet expired, it is critical that the taxpayer act to preserve the taxpayer’s right to challenge the assessment of the liability in the United States Tax Court. See Notice of Deficiency, below.

V. Deadlines and Timing Options for reducing the debt (e.g., filing a return, requesting audit reconsideration) can be done concurrently with pursuing collection options. Determining the order in which to handle each aspect of the case can depend upon the urgency of the collection problem and whether any procedural rights or remedies require immediate action. At a minimum, the attorney will need to evaluate whether any collection or other deadlines exist before choosing a course of action.

Important Deadlines Include:

A. Notice of Deficiency—90 days to petition tax court. This is likely the taxpayer’s best opportunity to challenge the amount of tax IRS believes is owed. If the Notice of Deficiency has been issued, the taxpayer only has 90 days to file a petition in the United States Tax Court. That deadline is statutory and cannot be extended. If that deadline passes, the taxpayer’s options for challenging the debt are limited significantly.

B. Final Notice of Intent to Levy or File a Lien—30 days to request a Collection Due Process hearing (CDP). A taxpayer only gets one opportunity for a Collection Due Process hearing for each tax year for each notice (one for a levy notice and one for a lien notice). The CDP hearing can be a very useful opportunity for a taxpayer to discuss collection options with an Appeals Officer at the IRS. If the taxpayer misses the 30-day deadline, the taxpayer can request an equivalency hearing within one year of the notice, but has no right to appeal an adverse determination.

C. Refund deadline—the deadline for claiming a refund is three years from the date the return was due or two years from the date of the payment, whichever is later. If the IRS formally denies the refund, the taxpayer has two years from the date of the denial to file a refund suit in Federal District Court. If the IRS does not respond to the claim for refund within six months after the claim is filed, the claim is “deemed” denied and the taxpayer may file a refund suit in Federal District Court at any time.




D. Collection statute of limitations—the collection statute expires 10 years from the date of the assessment for federal taxes.7 Certain actions (e.g., filing an offer in compromise or bankruptcy) can extend the 10-year period. Unfortunately, Oregon has no statute of limitations on collection.

E. Innocent Spouse claims—claims for relief from joint and separate liability under 6015(b) (referred to as “Innocent Spouse Relief”) and 6015(c) (referred to as “Separation of Liability Relief”) must be filed within two years from the first “collection activity.”8 The two-year limit does not apply to equitable relief claims under IRC § 6015(f).

VI. Additional Resources

A. The Taxpayer Advocate Service (TAS) can help taxpayers who are experiencing economic harm or a systemic problem or who are seeking help in resolving tax problems that have not been resolved through normal channels. (503) 415-7003.

B. IRS Collection Line can be reached at (800) 829-7650. IRS’s Practitioner Priority Service can be reached at (866) 860-4259..

C. The Oregon Department of Revenue collection division can be reached at (503) 945-8200.

D. CashOregon coordinates sites throughout the state that prepare tax returns for free. A list of sites is available on the website: www.cashoregon.org.

E. Low Income Taxpayer Clinics provide representation and advice to low income taxpayers who have controversies with the IRS. Some clinics may also help with related state issues.

1. Catholic Charities, El Programa Hispano, Low Income Taxpayer Clinic, (503) 489-6845.

2. Legal Aid Services of Oregon Statewide Tax Clinic, (888) 610-8764.

3. Lewis & Clark Low Income Taxpayer Clinic, (503) 768-6500.

7 IRC § 6502. 8 IRC § 6015(b)(1)(E) and 6015(c)(3)(B).

Chapter 5

drafting Tax-related Provisions for Business documents

david C. Culpepper

Thede Culpepper Moore Munro & Silliman LLPPortland, Oregon

Contents

I. Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5–1

II. Overview of Business Documents Discussed. . . . . . . . . . . . . . . . . . . . . . . . . . . . 5–1A. Allocation Provisions for Partnership Agreements and LLC Operating

Agreements . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5–1B. S Corporations Shareholder Agreement Provision . . . . . . . . . . . . . . . . . . . . . 5–1C. Deferred Compensation Arrangements . . . . . . . . . . . . . . . . . . . . . . . . . . . 5–1D. Areas Where Business Lawyers Should Seek Assistance of Tax Specialists . . . . . . . 5–2

III. Allocation Provisions of Partnership Agreements and LLC Operating Agreements . . . . . . 5–2A. Background – Substantial Economic Effect . . . . . . . . . . . . . . . . . . . . . . . . . 5–2B. Alternative Ways to Structure LLC Allocation Provisions. . . . . . . . . . . . . . . . . 5–4C. Forms of Allocation Provisions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5–7

IV. S Corporation Shareholder Agreements. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5–7A. Tax Distribution Provisions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5–7B. Provisions to Avoid Termination of S Corporation Status . . . . . . . . . . . . . . . . . 5–8

V. Deferred Compensation Arrangements . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5–9A. IRC § 409A Overview . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5–9B. Basic Requirements of IRC § 409A . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5–10C. Take-Away Points for Business Lawyers . . . . . . . . . . . . . . . . . . . . . . . . . 5–12

VI. Specialized Business Transactions That Demand Specialized Tax Advisers. . . . . . . . . . 5–12

AppendixesA. Simple Non–Safe-Harbor Allocation Provisions: Two Members, 50-50 Split . . . . . 5–13B. Safe-Harbor Allocation Provisions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5–15C. Safe-Harbor, Target-Based Allocation Provisions. . . . . . . . . . . . . . . . . . . . . 5–27D. S Corporation Tax Distribution Provision . . . . . . . . . . . . . . . . . . . . . . . . . 5–29E. S Corporation Status Protection Provisions . . . . . . . . . . . . . . . . . . . . . . . . 5–31

Chapter 5—Drafting Tax-Related Provisions for Business Documents




i. inTrOduCTiOn

These materials provide some general guidance in drafting tax-related provisions in a number of common business documents typically prepared by lawyers with a general business law practice who are not tax specialists. The materials discuss the importance of the tax-related issues and provide some suggested form provisions.

ii. OVErViEW OF BuSinESS dOCuMEnTS diSCuSSEd

a. allocation Provisions for Partnership agreements and LLC Operating agreements

The basic principle governing allocations of income, loss, deductions, and distributions for partnerships and LLCs is deceptively simple: allocations for income tax purposes (i.e., determining what share each partner or member is required to report on his or her individual tax return) must closely reflect the actual economic arrangement among the partners or members. In Internal Revenue Code (“Code”) terms, allocations for tax purposes must have “substantial economic effect” or must otherwise reflect the partners’ (or LLC members’) overall economic interests in the partnership or LLC. However, the Treasury Regulations (the “Allocation Regulations”) turn this simple-sounding principle into pages and pages of complex rules.

The discussion below outlines the basic thrust of the Allocation Regulations and discusses three approaches for drafting partnership and LLC agreements that comply with the tax requirements. There is also a brief discussion of drafting an LLC operating agreement for an LLC that has elected to be taxed as an S corporation (rather than as a partnership).

As LLCs are much more common than general and limited partnerships, these materials will focus on allocation provisions of LLC operating agreements. However, the principles discussed below generally apply to partnerships as well.

B. S Corporations Shareholder agreement Provision

Forming an S corporation where there are two or more shareholders is not completed (or should not be treated as completed) by merely preparing articles of incorporation, bylaws, and a Form 2553 election by a small business corporation. Rather, it is important to have a shareholders’ agreement to cover basic buy-sell arrangements. The basic buy-sell arrangements are not particularly tax-sensitive provisions, and buy-sell arrangements for an S corporation are not significantly different from those for a C corporation (with one exception discussed below). However, S corporation shareholders’ agreements should also include two sets of tax-related provisions that are not needed in a C corporation shareholders’ agreement: (1) a provision for mandatory tax distributions, and (2) provisions for protecting the status of the S corporation.

C. deferred Compensation arrangements

Business lawyers typically recognize that qualified pension and profit sharing plans and employee handbooks are areas best reserved for specialized compensation practitioners. However, business lawyers are frequently involved in another area where there are less commonly recognized significant and complex tax requirements. As part of the reaction (many say overreaction) to the Enron fiasco in the early 1990s, Congress enacted Code § 409A to address perceived abuses in deferred compensation arrangements. Most general business lawyers would seek employment and compensation expertise when being asked to prepare a formal deferred compensation plan for a client. However, the rules of Code § 409A apply to many compensation arrangements that are not commonly thought of as deferred compensation plans. The materials provide some general guidance on recognizing arrangements that are subject to § 409A and how to avoid violations of § 409A.



d. areas Where Business Lawyers Should Seek assistance of Tax Specialists

The focus of most of these materials is aimed at giving general business lawyers guidance in drafting tax-related provisions in what are otherwise contracts and business documents that are not specifically intended to be tax arrangements. However, there are a number of situations where a general business lawyer should not proceed without engaging (in the same firm or from a third party) advice of a tax specialist (either attorney or CPA). The materials list some examples of such areas.

iii. aLLOCaTiOn PrOViSiOnS OF ParTnErShiP aGrEEMEnTS and LLC OPEraTinG aGrEEMEnTS

a. Background – Substantial Economic Effect

1. General Principles. As a partnership, an LLC does not itself pay taxes. Rather, the LLC computes income and loss at the LLC level and then allocates that income or loss among the members. Under the Internal Revenue Code, members of an LLC are free to allocate LLC income among the members in any way the members agree, so long as the allocations either (a) can be established to be consistent with the members’ overall economic interests in the LLC, or (b) have “substantial economic effect.” IRC §704(b).

Under the Allocation Regulations, determination of LLC members’ overall economic interests is based on all the facts and circumstances relating to the economic arrangement of the partners, including factors such as the members’ relative shares of contributions, economic profits and losses, distributions of cash flow, and final liquidating distributions. Treas. Reg. § 1.704-1(b)(3). As discussed below, this alternative of using the members’ interests in the LLC provides a useful simpler approach for some LLCs without using all of the safe-harbor provisions of the Allocation Regulations.

The provisions of the Allocation Regulations defining what constitutes substantial economic effect are long and complex. This complexity was probably a reaction to partnership tax shelter abuses of the 1980s. These Allocation Regulations provide a safe harbor for establishing that allocations have substantial economic effect.

The general goal of the safe-harbor Allocation Regulations is to ensure that allocations of income and deductions for income tax purposes reflect actual economic benefits and burdens. These regulations use a strict capital account mechanism to accomplish this goal by requiring that:

a. All items of income, loss, and deduction that are allocated to a member must be reflected in the member’s capital account; and

b. A member’s capital account must control the amount distributable to the member on liquidation of the LLC or on liquidation of the member’s interest in the LLC.

As discussed below, these basic requirements are built into most LLC operating agreement in a section providing for how capital accounts are to be maintained (which usually expressly cross references the Allocation Regulations account maintenance requirements) and a section dealing with final liquidating distributions to members on liquidation of the LLC (requiring the distributions to be in accordance with final adjusted capital accounts).

2. Exception for LLC Members (and Limited Partners). The basic scheme of the Allocation Regulations is modeled on general partnerships. Although multiple-member LLCs (that don’t elect to be treated as corporations) are treated as partnerships for income tax purposes, a significant difference between LLCs and general partnerships requires an exception to the general Allocation Regulations requirements. For general partnerships, a corollary of the capital account mechanism described above (and a third basic requirement of the substantial economic effect safe-harbor test) is that a partner’s final distribution is determined by the partner’s final capital account balance, whether positive or negative. The safe-harbor Allocation Regulations require that a general partner who ends up with a deficit (negative)



final capital account balance must be obligated to make a contribution to the partnership (or to the partnership’s creditors) to restore that deficit (a “Deficit Restoration Obligation”).

LLC members (as well as limited partners in a limited partnership) typically do not have Deficit Restoration Obligations. In recognition of this, the safe-harbor provisions of the Allocation Regulations allow an alternative method of ensuring that allocations to LLC members have “substantial economic effect.” This alternative rule acknowledges that LLC members are not required to restore a deficit capital account but requires affirmative provisions in an LLC operating agreement to ensure that LLC members will never have a deficit capital account balance.

Under these alternative rules, allocations to an LLC member have substantial economic effect only if:

a. All allocations to a member are properly reflected in the member’s capital account;

b. Final distributions to the member are controlled by the positive balance in the member’s final capital account;

c. The LLC operating agreement contains a provision that expressly prohibits allocations of loss or deduction to an LLC member that would create a capital account deficit (except as provided below with respect to nonrecourse debt); and

d. The LLC operating agreement contains a “qualified income offset” provision that expressly requires offsetting allocations of LLC income to an LLC member who receives a distribution of cash or property that creates a capital account deficit.

The two additional mandatory requirements (items c. and d. above) are satisfied by the sections of LLC operating agreements typically captioned something like “Limitations on Allocations of Loss” and “Qualified Income Offset.”

3. additional Exception relating to nonrecourse debt. The rule that losses or deductions cannot be allocated to an LLC member that would cause the member to have a deficit capital account balance is intended to ensure that only losses or deductions that reflect a potentially real economic loss for that member can be allocated to the LLC member. (Once an LLC member’s capital account is reduced to zero, the LLC member’s investment is, at least temporarily, lost and, as the LLC member has no obligation to pay any LLC liabilities, further allocations of loss or deduction would not have an economic impact on the LLC member.)

However, the Allocation Regulations provide a special exception to this rule with respect to deductions attributable to LLC property securing a nonrecourse liability (one for which no member has personal liability). The regulations recognize that such “nonrecourse deductions” (such as depreciation) may not correspond to an economic burden for any LLC member because the risk of economic loss with respect to such property (up to the balance of the indebtedness) rests on the nonrecourse creditor.

Even though no LLC member bears the risk of economic loss attributable to nonrecourse deductions, the allocation regulations nevertheless allow all LLC members to deduct nonrecourse deductions even if such deductions create a deficit capital account balance, but only if the LLC operating agreement includes “minimum gain chargeback” provisions that requires gain from ultimate disposition of the property securing the nonrecourse debt (including potential recognition of gain on foreclosure or abandonment of the property) to be allocated among the LLC members in exactly the same proportions as the nonrecourse deductions were previously allocated to the LLC members. These “minimum gain chargeback” rules are among the most arcane, complex, and theoretical provisions of the Allocation Regulations.

The Allocation Regulations make a distinction between nonrecourse liabilities owed to creditors who are unrelated to any member of an LLC and nonrecourse liabilities owed to an LLC member or an



affiliate of a member (referred to as “member nonrecourse debts”). In turn, the regulations distinguish between “company minimum gain,” which relates to gains from property securing nonrecourse liabilities to unrelated creditors, and “member nonrecourse debt minimum gain,” which relates to gains from property securing member nonrecourse debts.

Most long-form (safe-harbor) allocation provisions expressly provide for allocations of both company minimum gain and member nonrecourse debt minimum gain. These provisions, together with the related special definitions typically included in the long-form allocation provisions, are designed to comply with all the requirements in the Allocation Regulations with respect to allocations of nonrecourse deductions.

B. alternative Ways to Structure LLC allocation Provisions

1. Simple non–Safe harbor allocation Provisions. Recall that IRC § 704(b) provides that allocation provisions in an LLC operating agreement will be respected for income tax purposes if either:

a. The allocations are consistent with the members’ overall economic interests in the LLC; or

b. The allocations have substantial economic effect (i.e., meet the safe-harbor requirements of the Allocation Regulations).

The advantage of the safe-harbor provisions (discussed below) is the certainty that the IRS would be bound by the allocations in the LLC operating agreement. Without the safe harbor, the determination of the members’ overall economic interests in the LLC is subject to evaluation of all of the facts and circumstances surrounding the LLC, its members, and their contractual arrangements.

However, in some circumstances the economic arrangement among the LLC and its members is so straightforward that there is little if any risk that the IRS could disagree with the allocation provisions in the LLC operating agreement. For example, imagine a four-person LLC where each member contributes $10,000 in an investment opportunity and the LLC operating agreement provides that in all circumstances each member will have a 25% interest in all contributions, distributions, and allocations. Such an LLC could provide a simple, non–safe harbor allocation provision that all income, loss, and deductions are to be allocated in equal 25% proportions. There is no risk that the IRS could determine that this simple allocation provision does not match the members’ overall economic interests in the LLC.

In a situation like this where the economic arrangement is straight up (with each member having a share in all distributions and allocations that is proportional to that member’s contributions), a simple non–safe harbor allocation provision is sufficient. In such a simple non–safe harbor LLC operating agreement:

F There is no requirement that liquidating distributions be made in accordance with capital accounts;

F There is no need to incorporate the technical provisions for maintenance of capital accounts or even to refer to capital accounts; and

F A provision that all allocations and all distributions, including liquidating distributions, will be made in proportion to the members’ sharing percentages is sufficient.

It is important to recognize when such a non–safe harbor LLC operating agreement is not sufficient. The following factors indicate that such a simple approach should not be used and a safe-harbor agreement should be used.

a. Any member has a sharing percentage that is higher or lower than his or her proportional capital contribution. This includes the not-uncommon situation where a member receives a share in LLC profits for his or her services.



b. Any member has any preference rights (as to income, current distributions, or liquidation proceeds).

c. Allocation percentages change during the life of the LLC.

d. Any member is entitled to receive a distribution based on the amount of his or her contribution (such as a percentage return on investment) that is not determined based on the LLC’s net income.

Furthermore, a safe-harbor form of agreement should be considered in real property LLCs where property is, or may be, financed using nonrecourse loans. Technically, the Allocation Regulations treat allocations of nonrecourse deductions as having substantial economic effect only when the LLC operating agreement otherwise satisfies the safe-harbor requirements of the Allocation Regulations. However, in a truly straight-up real property LLC (such as one in which a small number of investors make equal or proportional contributions to purchase and lease investment property, a simple non–safe harbor agreement can be sufficient.

2. Traditional Safe-harbor allocations—no nonrecourse Financing. Most long-form safe-harbor forms of LLC operating agreement are designed to meet the requirements of the Allocation Regulations to ensure that the allocations under the agreement have substantial economic effect. The key provisions of such agreements (other than real property LLCs that utilize nonrecourse financing) are as follows.

a. The agreement must satisfy the capital account maintenance requirements of the Allocation Regulations. This means the agreement must either spell out how capital accounts are to be maintained under the LLC (and make sure that such maintenance satisfies the Allocation Regulations) or (more commonly) incorporate by reference the capital account maintenance requirements of the Allocation Regulations. Typically, the maintenance requirements are spelled out in the definition of capital account (which might include the incorporation by reference of the Allocation Regulations).

b. The operating agreement must require that on liquidation of the LLC (or on liquidation of a member’s interest in the LLC), after allocation of all income and loss through and including the liquidation transactions and reflection of all prior contributions, distributions, and allocations in capital accounts, each member is entitled to a liquidating distribution equal to his or her final adjusted capital account balance.

note: This requirement is not the same as a provision that final liquidating distributions be allocated pro rata in proportion to final capital account balances.

c. The operating agreement must expressly prohibit allocations of loss or deduction to any member if or to the extent that such allocation would result in a deficit capital account balance. If any member has a zero capital account while other members have positive capital accounts, this provision requires allocation of deductions and losses to the members with positive capital account balances, even if such allocations are different from their overall sharing percentages. (Typically, agreements include a make-up provision that if such reallocations of loss or deduction are required due to a member’s zero capital account, first items of income or gain are allocated to the members who received the extra allocations of loss or deduction to balance out those allocations.)

d. The operating agreement must expressly provide a “qualified income offset” requiring that whenever any distribution results in a member having a deficit capital account balance, items of LLC income and gain (including gross income or gain if net income is insufficient) must be allocated to the member with the deficit capital account to increase such capital account “as quickly as possible” back to zero (i.e., to restore the deficit balance).

CoMMent: Traditional safe-harbor allocation provisions are sometimes referred to as “layer cake” allocations. The metaphor is that the draftsman builds up the “layers” (i.e.,



the members’ capital accounts) by carefully delineating how income and losses will be allocated among the members so that on liquidation of the LLC the proceeds will be distributed in accordance with final capital accounts. If the layers are correctly built up, the distributions of each member’s capita account balance will correctly mirror the economic deal.

3. Traditional Safe-harbor allocations—with nonrecourse Financing. Real estate LLCs (or other LLCs utilizing nonrecourse financing) need to include in their LLC operating agreements all of the safe-harbor allocation provisions described above in part 2., plus the following:

a. Technical definitions of “Company Minimum Gain,” Member Nonrecourse Debt Minimum Gain,” “Nonrecourse Deductions,” “Nonrecourse Liability,” “Member Nonrecourse Debt,” “Member Nonrecourse Deductions” meeting or incorporating by reference the requirements of § 1.704-2 of the Allocation Regulations;

b. A company minimum gain chargeback provision meeting or incorporating the requirements of the Allocation Regulations; and

c. A member nonrecourse debt minimum gain chargeback provision meeting or incorporating the requirements of the Allocation Regulations.

4. Safe-harbor allocations using Target Capital accounts. The traditional safe-harbor allocation provisions described above satisfy the Allocation Regulations’ substantial economic effect requirements but have a significant drawback. The requirement that liquidating distributions be made in an amount exactly equal to final adjusted capital account balances troubles clients (as well as business lawyers and tax lawyers who are not versed in Subchapter K). Clients frequently object that they want the final distributions to be based on the economic deal, not some bookkeeping account incorporating arcane complex Treasury Regulations. Furthermore, even though allocation provisions can be carefully drafted so that in all foreseeable circumstances liquidating distributions will in fact match the agreed-upon economic deal, such drafting is complex and difficult and often nearly impossible for clients to read.

A common arrangement is to provide for so-called waterfall distributions. The metaphor is a cascade of water flowing into a collection of buckets. The water first goes solely into bucket 1 until it is filled up; then into bucket 2 until it is filled, and so on. Thus an LLC’s deal could be that on liquidation all proceeds first go to one class of LLC members until a pre-specified threshold is met, and then to another class until another threshold is met, and so on. It is possible to draft traditional safe-harbor allocation provisions (i.e., allocate first, then distribute based on resulting capital accounts) to comply with such a waterfall distribution deal, but it is difficult to do so.

An allocation approach that responds to these objections is referred to as target capital account allocations. The basic elements of this approach (figure out how distributions will be made and then allocate to force capital accounts to conform to these distributions) are as follows.

a. First to describe in clear detail the actual economic deal, including the manner in which distributions will be made. The goal is simply to describe the economic deal (including any waterfalls) in a manner that the parties can understand and agree upon.

b. The operating agreement then provides that for each taxable year items of income, gain, and deduction as determined for income tax purposes will be allocated among the members in a manner so as to cause each member’s capital account to have a balance equal to the amount the member would receive in distribution under the distribution section.

For example, the LLC operating agreement could define for each member a “Partially Adjusted Capital Account” and a “Target Capital Account.” For this purpose, a member’s Partially Adjusted Capital Account would be defined for any taxable year as the member’s capital account at the



beginning of the taxable year before allocations of income, gain, loss, and deduction for the year. The member’s Target Capital Account would be defined as the amount the member would receive in a hypothetical liquidation of the LLC as of the end of the taxable year (under the distribution provisions of the operating agreement). The allocation provision of the operating agreement would then require that allocations of income loss and deduction for income tax purposes be allocated to each member an a manner to eliminate the difference between the member’s Target Capital Account and his or her Partially Adjusted Capital Account.

It should be noted that target capital account approach is not a short form or simple allocation non–safe harbor method. All of the requirements and specialized definitions of the traditional safe-harbor allocation provisions need to be incorporated in the operating agreement. The only provision that is deleted from the traditional safe-harbor agreement is the requirement that liquidating allocations be made in accordance with final capital account balances.

C. Forms of allocation Provisions

F Appendix A: Simple Non–Safe Harbor Allocation Provisions.

F Appendix B: Safe-Harbor “Layer Cake” Allocation Provisions.

F Appendix C: Safe-Harbor, Target-Based “Waterfall” Allocation Provisions.

iV. S COrPOraTiOn SharEhOLdEr aGrEEMEnTS

a. Tax distribution Provisions

Because S corporations are pass-through entities for income tax purposes, the corporation generally pays no corporate-level tax and the S corporation’s taxable income and gain is automatically “passed through” to and taxed on each shareholder’s individual tax return. Note that this results in each shareholder recognizing taxable income for each fiscal year in which the corporation has positive taxable income, whether or not the corporation makes distributions. It is the existence of net corporate income, not distributions to the shareholders, that creates taxable shareholder income for the shareholders. (If and when the corporation does make distribution, i.e., declare and pay dividends, the distributions are generally not themselves taxable to the shareholders.)

Many, but probably not all, S corporation shareholders expect that the corporation will make cash distributions to the shareholders for taxable years in which the corporation has positive taxable income. If the corporation does not distribute all of its income, many shareholders desire that the corporation make distributions (i.e., declare and pay cash dividends) at least sufficient to provide the shareholders the cash to pay their taxes attributable to the S corporation income (sometimes referred to as “tax distributions”).

The decision whether to cause an S corporation to make tax distributions can create disagreement among the shareholders of an S corporation.

exaMple: Imagine an AB corporation with two shareholders, Ann (with 60% of the stock) and Beth (with 40% of the stock). Imagine further that Ann has tax losses available to her and would prefer that the corporation reinvest all of its available cash. Beth, on the other hand, is in a fully taxable situation and does not have cash available from other sources to pay her taxes due with respect to her K-1 income from the AB corporation. As Ann has control of the AB corporation, she can cause the corporation to retain all of its cash and not make any tax distributions. In that case, Beth is still required to report her share of AB’s taxable income and pay the resulting tax.

However, it is essential that the S corporation make its tax distributions pro rata, even if they do not exactly match the shareholders’ various tax liabilities. To do otherwise would create two (or more) classes of stock with the result that the corporation would no longer be eligible to be an S corporation.



Because of this conflict of interest (or potential conflict of interest) regarding tax distribution policy, it is a good idea to include a provision in the S corporation shareholder agreement requiring tax distribution or at least clearly describing when tax distributions will be made. This is especially important when the practitioner is representing a minority owner who will not be able to force the corporation to make tax distributions.

At its most simple, a tax distribution provision in an S corporation shareholder agreement would require that the corporation must declare and pay tax distributions at least annually in an amount equal to the taxes that shareholders will be required to pay on their respective shares of S corporation income. However, it is important that the distributions be pro rata based on the shareholders’ respective number of shares. This can result in some shareholders getting distributions greater than their actual taxes payable and others getting less.

exaMple: CD corporation has two shareholders, Charlie (a 70% shareholder) and Dan (a 30% shareholder). Charlie lives in Washington, and Dan lives in Oregon. For 2012, CD had $1,000 of income. Assume Charlie will owe $245 in federal tax on his $700 of K-1 income, and Dan will owe a total of $132 ($105 federal and $27 Oregon) on his $300 of K-1 income. If the CD corporation distributed 35% of its $1,000 net income, Charlie would get $245 and Dan would get $105. If CD distributed 44% of its net income, Charlie would get $308 and Dan would get $132.

Typically, the drafting approach is to pick a percentage that approximates the marginal tax rate of most of the shareholders or an average of the marginal rates of all the shareholders. Appendix D has a sample tax distribution provision that incorporates this approach.

The details of tax distribution provisions can get more complicated when the shareholders have more complex and varying tax positions, especially if there is an overall objective of minimizing tax distributions. For example, the parties may want to negotiate a tax distribution provision that requires tax distributions to be made only if the net taxable income of the corporation for a given year exceeds all losses incurred in prior years. The theory of this approach is that in loss years shareholders get the tax benefit of the losses (either on a current basis or as a tax loss carry-forward) and therefore don’t need the liquidity protection of a tax distribution.

B. Provisions to avoid Termination of S Corporation Status

The status of being taxed as an S corporation is a valuable asset for a corporation. S corporations avoid a corporate level tax in most situations and thus income of the business carried on by the corporation is subject to only one level of tax at the shareholder level.

While it’s easy for an eligible corporation to become an S corporation, it is also all too easy to lose that status. Shareholders of an S corporation can affirmatively elect to terminate the corporation’s status as an S corporation. However, other events can inadvertently terminate S corporation status, principally:

F Having more than one class of stock with differing economic interests;

F Having one or more ineligible shareholders; and

F Having more than the statutory maximum number of shareholders.

As S corporations can now have up to 100 shareholders (and even more when various rules counting certain related shareholders as one shareholder for this purpose), the last of these three disqualifying events is so rare that it is not typically addressed in S corporation shareholder agreements.

The restriction on having a single economic class of stock is typically addressed in the articles of incorporation and bylaws of an S corporation rather than the shareholder agreement. However, even when the articles of incorporation authorize only one class of stock, actual distributions can create



varying economic rights that in effect can be treated as multiple classes of stock. For example, the provisions for tax distributions discussed above must be carefully drafted to ensure that dividends for tax distribution purposes are pro rata based on the number of shares held by each shareholder to avoid creating de facto different classes of stock.

The primary way that an S corporation shareholder agreement can and should protect against inadvertent termination of S corporation status relates to avoiding ineligible shareholders. Shareholders of an S corporation can include only:

F Individuals (who are not nonresident aliens);

F Decedent’s estates;

F Certain types of trusts; and

F Certain types of charitable organizations.

The S corporation can avoid issuing stock to anyone who is not an eligible S corporation shareholder. However, without contractual restrictions, any shareholder could terminate the S corporation status by merely transferred all or even one share of his or her stock to an ineligible person. For this reason, it is important to include in an S corporation shareholder agreement strict restrictions on transfers of stock to prohibit transfers to ineligible persons.

Appendix E sets forth a comprehensive set of provisions for an S corporation shareholder agreement to avoid transfers of stock that would result in termination of the S corporation. The appendix also includes a provision requiring all shareholders to participate in seeking an IRS waiver of any inadvertent termination of the corporation’s S corporation status.

V. dEFErrEd COMPEnSaTiOn arranGEMEnTS

a. irC § 409a Overview

IRC § 409A was enacted in late 2004 as part of the American Jobs Creation Act of 2004. The legislation was generally effective for new plans adopted after, and plans where the benefit was not fully vested before, January 1, 2005. Final Regulations under § 409A were issued in April 2007 and became effective January 1, 2008.

Although IRC § 409A was specifically targeted at nonqualified deferred compensation plans (such as the plans maintained by the Enron corporation that provided the trigger for the enactment of the section), § 409A potentially applies to any plan, agreement, or arrangement (including an arrangement or agreement for a single employee) that provides for the deferral of compensation. The basic requirement is any arrangement that creates a legally binding right to receive compensation in a subsequent taxable year. These restrictions apply to compensation payable to employees, corporate directors, LLC managers, and even many independent contractors (with a narrow exception where the contractor is actively engaged in a trade or business providing services to two or more clients).

An arrangement provides for the deferral of compensation only if the employee has a legally binding right during a taxable year to compensation that, pursuant to the terms of the plan or agreement, is or may be payable to the employee in a later year. For this purpose, there is a legally binding right even if the compensation may be reduced or eliminated under the terms of the plan or agreement or is subject to a “risk of forfeiture.”

exaMples: A right to a bonus in a future year where the amount of the bonus is subject to satisfaction of performance criteria is still a legally binding right. Similarly, a bonus that would be forfeited if the employee quits before the bonus is fully vested is still considered a legally binding right.



By contrast, if the employer has the discretion to unilaterally reduce or eliminate the bonus, there is no legally binding right.

Business lawyers and CPAs should be alert to identify what kinds of arrangements are, or at least are potentially, subject § 409A. These include (but are not limited to):

F Actual deferred compensation plans and agreements;

F Employment agreements and offer letters;

F Severance plans and agreements;

F Compensatory stock option plans and other stock or equity-based compensation arrangements;

F Change in control agreements; and

F Supplemental executive retirement plans (SERPs).

B. Basic requirements of irC § 409a

For all arrangements that are subject to § 409A, there are three sets of basic requirements that must be complied with, both in form (in plan documents) and in actual operation:

F Distribution restrictions;

F Acceleration restrictions; and

F Election restrictions.

1. distribution requirements. Deferred compensation cannot be distributed (paid) any earlier than one of six specified events:

F Separation from service (narrowly defined);

F Disability (narrowly defined);

F Death;

F A payment date or schedule specified as of the date of deferral;

F A change in ownership or effective control of the employer (narrowly defined); or

F An “unforeseeable emergency” (narrowly defined).

Separation from service is defined generally as death, retirement, or termination of employment. However, in order to avoid sham arrangements intended solely to accelerate payment while the employee continues to work at a similar position, the regulations under § 409A are very detailed. In order to assure compliance with the requirements, documents should use the precise definition of separation from service in the regulations.

Although the regulations have a very narrow definition of disability, the definition may not have much practical application because a distribution based on termination of employment will meet the separation from service requirement, whether or not the disability that causes the termination meets the disability definition.

The use of a specified payment date or schedule that is one of the allowable distribution events can best be illustrated by an example.

exaMple: In 2008, employee Ann defers compensation (meeting the election requirements of § 409A) under terms that the entire deferred compensation account will be payable to Ann in 2015 (the date Ann expects her daughter to start college). The deferred amount would be payable in 2015 whether or not the daughter actually started college at that time.



As this 2015 distribution date is specified by Ann at the time the deferral was entered into, it can qualify as an allowable distribution event. Not that stating the event (start of college) rather than a date would not be allowable. The specified date (or schedule) must be objectively determinable and nondiscretionary at the time the amount is deferred.

The requirements for a distribution upon a change of control of the employer are governed by a very detailed definition in the regulations. Documents should use the precise definition of change in control in the regulations.

The § 409A regulations incorporate a strict definition of unforeseeable emergency from IRC § 457 (covering government and tax-exempt employer plans). If an arrangement is to include a potential emergency distribution event, it is important to specifically incorporate the definition from the regulations.

2. acceleration restrictions. With very narrow exceptions, a plan or arrangement that is subject to § 409A may not allow the acceleration of the time or schedule of distributions or payments. This rule prohibits acceleration at the discretion of the employer as well as acceleration requested by the employee. A plan may allow acceleration of payment in the amount the employee has to include any amount in income as a result of the plan failing to meet the § 409A requirements. Also, a plan may allow acceleration upon termination of the plan but only if several very specific requirements are met.

3. Election restrictions. The Regulations impose two types of election restrictions:

F Deferral elections by a participant; and

F Elections as to the time and form of distributions or payments of the deferred compensation.

a. deferral Elections. Note that not all plans or arrangements involve deferral elections. These requirements apply only where the employee can elect to have a portion of the employee’s compensation deferred under a plan or arrangement. In general, deferral elections to defer compensation for services to be performed in a taxable year must be made no later than the close of the preceding taxable year. Note that the focus is on when the services will be performed not when payment is due.

exaMple: For a bonus to be paid in early 2015 (or a later year) based on services to be performed in 2014, this general rule requires a deferral election no later than December 31, 2013.

There are exceptions for initial deferral elections (for a new plan or a participant first becoming eligible to participate in a plan) that allow elections within 30 days of initial eligibility. Deferral elections with respect to “performance-based compensation” can be made at least six months before the end of the performance period, provided the performance period is at least 12 months.

b. Elections Concerning Time and Form of Payment. Again, not all plans give the participant any choice in when and how the deferred compensation is to be paid. However, many plans do have such election provisions. In general, elections as to the time and form of distributions or payments must be made at the time of the initial deferral election. For plans or arrangements with no deferral election, the election of the time and form of payment must be made no later than the time the employee obtains a legally binding right to the benefit. In general, this means such elections must be made at commencement of participation.

Once an election for time and form of payment is made, it can be changed but only within very strict limitations. Elections to accelerate payment are never allowed. An election as to time and form of payment may be amended to further delay or change the form of payment but only if (i) the change will be effective at least 12 months after the date of the change, (ii) the changed payment date must be at least five years later than when it would otherwise be made; and (iii) in the case of payments on a pre-



specified date or schedule, the change cannot be made later than 12 months before the first scheduled payment.

c. Effect of noncompliance. If a plan or arrangement is covered by § 409A and does not comply with the requirements outlined above, the consequences are disastrous for the employee. The deferred compensation must be included in income in the year in which the services were performed or, if later, in the year in which the compensation is first not subject to a substantial risk of forfeiture (even if not yet payable). An additional tax is imposed equal to the interest that would have been imposed during the deferral period if the income was included in income when first deferred. Finally, an additional penalty tax of 20% of the deferred compensation is imposed.

C. Take-away Points for Business Lawyers

1. Evaluate any Compensation arrangement. Evaluation is in steps. First, does the arrangement result in the deferral of income covered by a legally binding right? If so, does § 409A apply, namely, are there any statutory exceptions? If the business lawyer determines that § 409A applies, then he or she must make sure that the plan or arrangement complies with the distribution, acceleration, and election restrictions. If the plan does not comply and cannot be made to comply, then the plan must be terminated. A practitioner should consult with compensation specialists if an existing noncomplying plan needs to be terminated. Even in this situation, there are complex rules and traps.

2. areas Where Specialized Compensation Counsel are needed. Although § 409A issues will come up frequently in everyday business planning transactions, there are areas where a general business lawyer should defer to compensation specialists. This is especially true in the § 409A arena because the potential employee penalties of a noncomplying plan are so disastrous.

a. Actual deferred compensation and supplemental executive retirement plans;

b. Equity-based compensation arrangements such as stock options, stock appreciation rights, restricted stock, and similar arrangements for partnerships and LLCs; and

c. Change-in-control agreements.

Vi. SPECiaLizEd BuSinESS TranSaCTiOnS ThaT dEMand SPECiaLizEd Tax adViSErS

In the discussion above of deferred compensation arrangements, I listed areas where specialized compensation counsel is essential. There are several other business transaction documents that should not be undertaken by general business lawyers without involving specialized tax counsel. These include:

F Mergers of corporations that are intended to qualify as tax-free reorganizations;

F Sales of stock of S corporations that are intended to qualify as asset sales under IRC § 338(h)(10);

F Mergers of LLCs and partnerships;

F Deferred compensation arrangements for executives of tax-exempt organizations; and

F Real estate transactions that are intended to qualify as like-kind exchanges under IRC § 1031.



aPPEndix a—SiMPLE nOn–SaFE-harBOr aLLOCaTiOn PrOViSiOnS: TWO MEMBErS, 50-50 SPLiT

. . . .

2.4 Membership Percentages. Each Member’s percentage interest in the Company (the “Membership Percentage”) is as follows:

Member 1 50% Member 2 50% 100%

3. allocation of Profits and Losses; distributions

3.1 income and Loss determination. The Company’s income or loss for each fiscal year will be determined as of the end of such fiscal year by the Company’s accountants in accordance with federal income tax accounting principles, consistently applied, utilizing that method of accounting employed in the federal income tax informational return filed by the Company for that fiscal year.

3.2 allocations of Profits and Losses. All items of income, gain, loss, deduction, and credit will be allocated among the Members pro rata in proportion to their respective Membership Percentages.

3.3 interim distributions

3.3.1 net Cash Flow. For purposes of this § 3, “Net Cash Flow” means, for any given fiscal period of the Company, the amount by which (a) the gross cash receipts received by the Company during that fiscal period exceed (b) the sum, without duplication, of (i) all cash operating expenses of the Company during that fiscal period, (ii) debt service payments made during that fiscal period on all indebtedness of the Company, (iii) payments made during that fiscal period on account of the maintenance, leasing, repair, replacement, or improvement of property of the Company, and (iv) all amounts allocated during that fiscal period, in the reasonable judgment of the Members, to reserves established to meet the reasonable needs of the business, including working capital and capital improvement requirements and for reserves for unknown or unfixed liabilities or contingencies of the Company.

3.3.2 distributions. Subject to the limitations described in § 3.3.3, distributions of Company’s Net Cash Flow prior to dissolution and winding up of the Company pursuant to § 10 will be made at the discretion of the Members at such times and in such amounts as the Members determine. All distributions will be allocated between the Members pro rata in proportion to their respective Membership Interests.

3.3.3 Limitations on distributions. No distribution will be declared and paid unless, as reasonably determined by the Members: (a) after the distribution is made, the assets of the Company are in excess of all liabilities of the Company, except liabilities to Members on account of their contributions, and (b) the Company is able to pay its debts as they become due in the ordinary course of business.

. . . .

10. dissolution and Winding up of the Company

10.1 dissolution. The Company will be dissolved upon the happening of any of the following events:

(a) The agreement of both Members; or

(b) Otherwise by operation of law.

10.2 Winding up. Upon the dissolution of the Company, the Members will take full account of the Company’s assets and liabilities, and the assets will be liquidated as promptly as is consistent with



obtaining their fair value, and the proceeds, to the extent sufficient to pay the Company’s obligations with respect to such liquidation, will be applied and distributed in the following order:

(a) To payment and discharge of the expenses of liquidation and of all of the Company’s debts and liabilities, including debts and liabilities owed to the Members; and

(b) To the Members in proportion to their respective Membership Percentages.



aPPEndix B—SaFE-harBOr aLLOCaTiOn PrOViSiOnS1

Operating agreement__________, LLC

an Oregon Limited Liability Company

This Operating Agreement made and entered into effective __________ (the “Effective Date”), by and among __________, LLC, an Oregon limited liability company (the “Company”), and the parties identified on Appendix 1.7 to this Agreement (the “Members”).

. . . .

2.2 units of Membership interest. Except as otherwise provided in this Agreement, the interest of each Member in the capital and profits of the Company will be in the form of units of membership interest (“Units”). The Company is authorized to issue up to __________ Units. Initially, there will be __________ Units issued to the Members in exchange for the initial capital contributions described on Appendix 2.1. No certificates will be issued to represent Units.

. . . .

2.4 Membership Percentages. Each Member will have a “Membership Percentage” equal to the ratio, expressed as a percentage rounded to the nearest one-hundredth of a percent, of the number of Units owned by the Member divided by the total number of issued and outstanding Units.

. . . .

3. allocations of Profits and Losses and Provisions for distributions

3.1 definitions. Capitalized terms used in this § 3 have the meanings given in Exhibit 3.1.

3.2 allocation of Profits and Losses. Subject to the special allocations and limitations set forth in § 3.4 and Exhibit 3.4, the Profits and Losses of the Company for each Allocation Period will be allocated among the Members as follows:

3.2.1 Losses. Losses will be allocated among the Members as follows:

(a) Losses will be allocated among the Members pro rata in proportion to their respective Membership Percentages.

(b) The Losses allocated pursuant to § 3.2.1(a) may not exceed the maximum amount of Losses that can be allocated without causing any Member to have an Adjusted Capital Account Deficit at the end of any Allocation Period. In the event some but not all of the Members would have Adjusted Capital Account Deficits as a consequence of an allocation of Losses pursuant to § 3.2.1(a), the limitation set forth in this § 3.2.1(b) will be applied on a Member by Member basis so as to allocate the maximum permissible Losses to each Member under Treasury Regulation § 1.704-1(b)(2)(ii)(d).

(c) All Losses in excess of the limitations set forth in § 3.2.1(b) will be allocated to those Members (if any) that have a positive Capital Account Balance, and allocated among them pro rata in proportion to their respective positive Capital Account balances and thereafter to all the Members in accordance with their interests in the Company as determined by the Manager in his or her reasonable discretion.

3.2.2 Profits. Profits will be allocated among the Members as follows:

(a) First, Profits will be allocated to each Member that previously has been allocated Losses pursuant to § 3.2.1 that have not been fully offset by allocations of Profits pursuant to this § 3.2.2(a) (“Unrecovered Losses”) until the cumulative amount of Profits allocated to each such Member pursuant to this § 3.2.2(a) is equal to the cumulative amount of Losses previously allocated to such Member.

1 Excerpted from 5 Advising Oregon Businesses (Oregon CLE & Supp 2007) Form 6.



Profits allocated pursuant to this § 3.2.2(a) will be allocated among such Members pro rata in proportion to their respective Unrecovered Losses.

(b) Next, all remaining Profits will be allocated to the Members pro rata in proportion to their respective Membership Percentages.

3.3 distribution of net Cash Flow.

3.3.1 General. Except as expressly provided in § 3.3.2, and except for liquidating distributions in accordance § 10, the Net Cash Flow of the Company, if any, will be distributed to the Members at such times and in such amounts as determined by the Manager, with the Approval of the Members. All distributions of Net Cash Flow will be allocated among the Members pro rata in proportion to their respective Membership Percentages.

3.3.2 Tax draws. Except upon Approval of the Members, the Manager will cause the Company to make quarterly distributions (timed to coincide with the due dates for federal income tax estimate payments) in an amount equal to 42% of the Company’s net taxable income or gain for federal income tax purposes (or an estimate of such taxable income or gain as determined by the Manager) for each fiscal year. Such distributions (“Tax Draws”) will be allocated among the Members in the manner (determined or estimated by the Manager) that the Company’s taxable income or gain will be allocated among the Members for such fiscal year. The Manager may adjust the percentage to be distributed as Tax Draws to reflect changes in the maximum marginal tax rates (but in all cases the percentage will be applied uniformly to all Members).

3.4 Special allocations and Limitations. The Members intend that in general all allocations of Profits and Losses will be pro rata as described in § 3.2. However, in order to comply with federal income tax regulations regarding the substantial economic effect of Company allocations, in the special circumstances described in such provisions, all allocations of Company Profits or Losses are subject to the special allocations and limitations described in Appendix 3.4.

3.5 allocations for income Tax (But not Capital account) Purposes.

(a) Contributed Property. In the event a Member contributes property with an initial Gross Asset Value that differs from its adjusted basis for federal income tax purposes (“Adjusted Tax Basis”) at the time of contribution, income, gain, loss, and deductions with respect to the property will, solely for federal income tax purposes, be allocated among the Members in accordance with Code § 704(c)(1)(A) and Treasury Regulation § 1.7041(b)(2)(i)(iv) so as to take account of any variation between the Adjusted Tax Basis of such property to the Company and its Gross Asset Value at the time of contribution.

(b) revalued Property. In the event the Gross Asset Value of any Company asset is adjusted pursuant to the definition of Gross Asset Value (set forth in Appendix 3.1 to this Agreement), subsequent allocations of income, gain, loss, and deduction with respect to such asset will, solely for federal income tax purposes, take account of any variation between the Adjusted Tax Basis of such asset and its Gross Asset Value in the same manner as under Code § 704(c) and the Treasury Regulations under that section.

(c) allocation Methods. Any elections or other decisions relating to allocations pursuant to § 3.5(a) or (b) will be made by the Manager in any manner that reasonably reflects the purpose and intention of this Agreement.

(d) distributions of Contributed Property.

(i) Pursuant to Code § 704(c)(1)(B), if any contributed property is distributed by the Company to any Member other than to the contributing Member within seven years of being contributed, then, except as provided in Code § 704(c)(2), the contributing Member will, solely for federal income tax purposes, be treated as recognizing gain or loss from the sale of such property in an amount equal to the gain or loss



that would have been allocated to such Member under Code § 704(c)(1)(A) if the property had been sold at its fair market value at the time of the distribution.

(ii) In the case of any distribution by the Company to a Member within seven years following any contribution by such Member to the Company of property (other than money), such Member will, solely for federal income tax purposes, be treated as recognizing gain in an amount equal to the lesser of:

(A) The excess (if any) of (x) the fair market value of the property (other than money) received in the distribution over (y) the adjusted basis of such Member’s membership interest immediately before the distribution reduced (but not below zero) by the amount of money received in the distribution; or

(B) The Net Precontribution Gain (as defined in Code § 737(b)) of the Member. The Net Precontribution Gain means the net gain (if any) that would have been recognized by the distributee Member under Code § 704(c)(1)(B) if all property that (x) had been contributed to the Company within seven years of the distribution, and (y) was held by the Company immediately before the distribution, had been distributed by the Company to another Member. If any portion of the property distributed consists of property that had been contributed by the distributee Member to the Company, then such property will not be taken into account under this § 3.5(d)(ii) and will not be taken into account in determining the amount of the Net Precontribution Gain. If the property distributed consists of an interest in an entity, the preceding sentence will not apply to the extent that the value of such interest is attributable to the property contributed to such entity after such interest had been contributed to the Company.

(e) recapture. All recapture of income tax deductions resulting from sale or disposition of Company property will be allocated to the Members to whom the deduction that gave rise to such recapture was allocated under this Agreement to the extent that such Member is allocated any gain from the sale or other disposition of such property.

(f) Effect of Tax allocations. Allocations pursuant to this paragraph 5 are solely for purposes of federal, state, and local income taxes and will not affect, or in any way be taken into account in computing, any Member’s Capital Account or share of Profits, Losses, or distributions pursuant to any provision of this Agreement.

3.6 no right to demand return of Capital. No Member will have any right to any distribution except as expressly provided in this Agreement. No Member will have any drawing account in the Company.

3.7 Transfer of units by Member during Fiscal year. If, after compliance with the requirements of § 8, any Member transfers any Units during any fiscal year of the Company by sale, exchange, transfer, assignment, gift, death, operation of law, or in any other manner, the Profits or Losses of the Company allocable to the transferred Units will be prorated between the transferor and the transferee in accordance with the number of days during the fiscal year each party owned the Units; but the Profits or Losses realized by the Company from an insurance recovery or a condemnation award will be allocated to the owner of the Units on the date of the transaction.

. . . .

7.6 Capital accounts.

7.6.1 General. The Company will maintain a Capital Account for each Member on a cumulative basis in accordance with the following provisions:

(a) Each Member’s Capital Account will be increased by the following items :

(i) The amount of money and the Gross Asset Value (as defined in Appendix 3.1 to this Agreement) of property contributed by the Member to the Company (net of liabilities secured by such contributed property that the Company assumes or is considered to assume or take subject to under Code § 752); and



(ii) The Member’s distributive share of Profits and any items in the nature of income or gain that are specially allocated to the Member pursuant to paragraphs 2, 3, 4, or 5 of Appendix 3.4 to this Agreement.

(b) Each Member’s Capital Account will be decreased by the following items:

(i) The amount of money and the Gross Asset Value of any Company asset (net of liabilities secured by such distributed property that the Member assumes or is considered to assume or take subject to under Code § 752) distributed to the Member pursuant to any provision of this Agreement; and

(ii) the Member’s distributive share of Losses and any items in the nature of expenses or losses that are specially allocated to the Member pursuant to paragraphs 2, 3, 4, or 5 of Appendix 3.4 to this Agreement;

(c) In the event that all or a portion of a Member’s Units in the Company are transferred in accordance with the terms of this Agreement, the transferee will succeed to the Capital Account of the transferor to the extent it relates to the transferred Units.

7.6.2 Compliance with Treasury regulations § 1.704-1(b). The provisions of this § 7.6 and the other provisions of this Agreement (including its appendices) relating to the maintenance of Capital Accounts are intended to comply with Treasury Regulations § 1.704-1(b) and will be interpreted and applied in a manner consistent with such Treasury Regulations. In the event the Manager determines that it is prudent to modify the manner in which the Capital Accounts, or any debits or credits to Capital Accounts (including, without limitation, debits or credits relating to liabilities that are secured by contributed or distributed property or that are assumed by the Company or a Member), are computed in order to comply with such Treasury Regulations, the Manager may make such modification, provided that it is not likely to have a material effect on the amounts distributed to any Member pursuant to § 10 of this Agreement upon the dissolution of the Company. The Manager also may (a) make any adjustments that are necessary or appropriate to maintain equality between the Capital Accounts of the Members and the amount of capital reflected on the Company’s balance sheet, as computed for book purposes, in accordance with Treasury Regulation § 1.704-1(b)(2)(iv)(q), and (b) make any appropriate modifications in the event unanticipated events might otherwise cause this Agreement not to comply with Treasury Regulation § 1.704-1(b).

7.6.3 Effect of OrS 63.185(4). The adjustments to the Members’ Capital Accounts resulting from the definitions of Gross Asset Value and Profits and Losses are intended by the Members to be in lieu of the adjustments described in ORS 63.185(4).

CoMMent: ORS 63.185(4) provides a statutory default rule providing for capital account adjustments in connection with the subsequent admission of a new member to an existing LLC. The purpose of the adjustment is to ensure that unrealized appreciation in the value of the LLC’s assets at the time such new member is admitted will accrue to the members who were in the LLC prior to such admission. The adjustments to capital accounts under this Form pursuant to the provisions in the definitions of Gross Asset Value and Profits and Losses accomplish the same result in a more accurate manner. Accordingly, § 7.6.3 is needed to make sure that these provisions control rather than the “rough justice” provision of ORS 63.185(4).

7.6.4 no deficit restoration Obligation. Except as otherwise expressly required in the Act, no Member will have any liability to restore all or any portion of a deficit balance in such Member’s Capital Account.

. . . .



10. dissolution and Winding up of the Company

10.1 dissolution. The Company will be dissolved upon the happening of any of the following events:

(a) The Approval of the Members; or

(b) Otherwise by operation of law.

10.2 Winding up. Upon the dissolution of the Company, the Manager (or if there is no Manager at such time, a successor Manager or other liquidator appointed by Approval of the Members) will take full account of the Company’s assets and liabilities, and the assets will be liquidated as promptly as is consistent with obtaining their fair value, and the proceeds, to the extent sufficient to pay the Company’s obligations with respect to such liquidation, will be applied and distributed in the following order, after any Profits or Losses realized in connection with the liquidation has been allocated in accordance with § 3 of this Agreement, and the Members’ Capital Accounts have been adjusted to reflect such allocation and all other transactions through the date of such distribution:

(a) To payment and discharge of the expenses of liquidation and of all the Company’s debts and liabilities, including those owed to Members; and

(b) To Members in the amount of their respective adjusted positive Capital Account balances on the date of distribution.

10.3 distribution in-Kind.

10.3.1 General. If practicable, and if consented to by Approval of the Members, in lieu of liquidating all or some of the assets of the Company, the Manager may distribute some or all of the assets of the Company to the Members in-kind and, to facilitate such distribution, may create tenancies-in-common or other concurrent ownership interests in Company properties. The Members mutually agree to waive any and all rights of partition in the event of the creation of any such tenancies-in-common or other concurrent ownership interests. Company assets to be distributed in-kind upon dissolution of Company will be distributed to the Members in accordance with Sections 10.2 and 10.3.2.

10.3.2 deemed Liquidation Profits or Losses. In the event that Company assets are to be distributed in-kind upon liquidation and winding up of the Company, the Manager will adjust, subject to Approval of the Members, the Gross Asset Value of the Company’s assets to be distributed to reflect their fair market value as of the date of distribution, and the Members’ respective Capital Accounts will be adjusted to reflect the manner in which the deemed Profits or Losses that would have been recognized by the Company if such assets were sold for such Gross Asset Values would have been allocated under § 3.2. After such adjustments, all Company assets, including the assets to be distributed in-kind and the proceeds of assets sold in liquidation, will be distributed pursuant to § 10.2 in accordance with the Members’ adjusted Capital Accounts (with reference to the Gross Asset Values assigned to such unsold properties).

10.4 Completion of Winding up. Upon completion of the winding up, liquidation, and distribution of assets as provided in this § 10, the Company will be deemed terminated. The Manager will comply with any filings or other applicable requirements under the Act with respect the winding up of the affairs and dissolution of the Company

. . . .

[Signatures for Company and Members]



Exhibit 3.1definition of Terms for § 3

“adjusted Capital account deficit” means, with respect to any Member, the deficit balance, if any, in such Member’s Capital Account as of the end of any Allocation Period, after giving effect to the following adjustments:

(a) Credit to such Capital Account any amounts that the Member is deemed to be obligated to restore pursuant to the penultimate sentences in Treasury Regulation §§ 1.704-2(g)(1) and 1.704-2(i)(5), and

(b) Debit to such Capital Account any Adjustment Items.

The foregoing definition of Adjusted Capital Account Deficit is intended to comply with the provisions of Treasury Regulation § 1.704-1(b)(2)(ii)(d) and will be interpreted consistently with such regulation.

“adjustment items”—Adjustments, allocations, and distributions described in Treasury Regulation § 1.704-1(b)(2)(ii)(d)(4),(5), and (6).

“allocation Period”—A fiscal year of the Company or other fiscal period for which the Company allocates Profits, Losses, and other items of Company income, gain, loss, or deduction pursuant to § 3 of this Agreement

“Capital account”—The account maintained for each Member pursuant to § 7.6.

“Code” means the Internal Revenue Code of 1986, as amended from time to time.

“Company Minimum Gain”—As of any date, the amount of gain, if any, that would be recognized by the Company for federal income tax purposes, as if it disposed of property in a taxable transaction on that date in full satisfaction of any nonrecourse liability secured by the property, computed in accordance with Treasury Regulation § 1.704-2(d)(1).

“depreciation” means, for each Allocation Period, an amount equal to the depreciation, amortization, or other cost recovery deduction allowable for federal income tax purposes with respect to an asset for such Allocation Period, except that if the Gross Asset Value of an asset differs from its adjusted basis for federal income tax purposes at the beginning of such Allocation Period, Depreciation will be an amount which bears the same ratio to such beginning Gross Asset Value as the federal income tax depreciation, amortization, or other cost recovery deduction for such Allocation Period bears to such beginning adjusted tax basis; provided, however, that if the adjusted basis for federal income tax purposes of an asset at the beginning of such Allocation Period is zero, Depreciation will be determined with reference to such beginning Gross Asset Value using any reasonable method selected by the Manager.

“Gross asset Value” means, with respect to any asset, the asset’s adjusted basis for federal income tax purposes, except as follows:

(a) The initial Gross Asset Value of any asset contributed by a Member to the Company will be the gross fair market value of such asset, as determined by the contributing Member and the Manager, provided that (i) the initial Gross Asset Values of the assets contributed to the Company pursuant to § 2.1 will be as set forth on Appendix 2.1 to this Agreement, and (ii) if the contributing Member is a Manager, the determination of the fair market value of a contributed asset will require Approval of the Members;

(b) The Gross Asset Values of all Company assets will be adjusted to equal their respective gross fair market values, as reasonable determined by the Manager, as of the following times:



(i) the acquisition of an additional interest in the Company by any new or existing Member in exchange for more than a de minimis capital contribution or money or property;

(ii) the grant of an interest in the Company (other than a de minimis interest) as consideration for the provision of services to or for the benefit of the Company by an existing Member (acting in a Member capacity) or by a new Member (acting in a Member capacity or in anticipation of being a Member);

(iii) the distribution by the Company to a Member of more than a de minimis amount of money or property as consideration for all or a portion of a membership interest in the Company; and

(iv) the liquidation of the Company within the meaning of Treasury Regulations § 1.704-1(b)(2)(ii)(g);

provided, however, that adjustments pursuant to clauses (i) through (iii) above will be made only if the Manager reasonably determines that such adjustments are necessary or appropriate to reflect the relative economic interests of the Members in the Company;

CoMMent: Clause (ii) of paragraph (b) of the definition of Gross Asset Value is based on Proposed Regulation §1.704-1(b)(2)(iv)(f)(5)(iii). (REG-139796-02; July 1, 2003; 2003 TNT 127-7; Tax Analysts Document No. 2003-15723) This proposed regulation will not be effective until it is published as a final regulation. The preamble to the proposed regulation also indicated that the IRS is considering a further regulation that “would allow revaluations any time there is more than a de minimis bona fide change in the manner in which partners [or LLC members] agree to share profits or losses.” In the event such a regulation is issued, the definition of Gross Asset Value should be supplemented to incorporate such change.

(c) The Gross Asset Value of any Company asset distributed to any Member will be adjusted to equal the gross fair market value of such asset on the date of distribution (taking into account the requirements of Code § 7701(g) dealing with clarification of the fair market value of property that is subject to nonrecourse indebtedness) as determined by the distributee and the Manager, provided that, if the distributee is a Manager, the determination of the fair market value of the distributed asset will require Approval of the Members; and

(d) The Gross Asset Values of Company assets will be increased (or decreased) to reflect any adjustments to the adjusted basis of such assets pursuant to Code § 734(b) or Code § 743(b), but only to the extent that such adjustments are required to be taken into account in determining Capital Accounts pursuant to Regulation § 1.704-1(b)(2)(iv)(m); provided, however, that Gross Asset Values will not be adjusted pursuant to this paragraph (d) of this definition to the extent the Manager reasonably determines that an adjustment pursuant to paragraph (b) of this definition is necessary or appropriate in connection with a transaction that would otherwise result in an adjustment pursuant to this paragraph (d).

If the Gross Asset Value of an asset has been determined or adjusted pursuant to paragraph (a), (b), or (d) of this definition, such Gross Asset Value will thereafter be adjusted by Depreciation taken into account with respect to such asset for purposes of computing Profits and Losses.

“Member nonrecourse debt” has the same meaning as “partner nonrecourse debt” set forth in Treasury Regulation § 1.704-2(b)(4).

“Member nonrecourse debt Minimum Gain” means an amount, with respect to each Member Nonrecourse Debt, equal to the Company Minimum Gain that would result if such Member Nonrecourse Debt were treated as a Nonrecourse Liability, determined pursuant to Treasury Regulation § 1.704-2(i)(2) and (3).



“Member nonrecourse deductions” has the same meaning as “partner nonrecourse deductions” set forth in Treasury Regulation § 1.704-2(i)(2). The amount of Member Nonrecourse Deductions with respect to a Member Nonrecourse Debt for a Company Allocation Period equals the excess, if any, of (A) the net increase, if any, in the amount of the Company Minimum Gain attributable to such Member Nonrecourse Debt during the Allocation Period over (B) the aggregate amount of any distribution during the Allocation Period to the Member that bears the economic risk of loss for such Member Nonrecourse Debt to the extent the distributions are from proceeds of the Member Nonrecourse Debt and are allocable to an increase in Member Nonrecourse Debt Minimum Gain attributable to the Member Nonrecourse Debt, determined pursuant to Treasury Regulation § 1.704-2(i).

“net Cash Flow”—For any given fiscal period of the Company, the amount by which (1) the gross cash receipts received by the Company during that fiscal period exceed (2) the sum, without duplication, of (a) all cash operating expenses of the Company during that fiscal period, (b) debt service payments made during that fiscal period on all indebtedness of the Company, (c) payments made during that fiscal period on account of the maintenance, leasing, repair, replacement, or improvement of property of the Company, and (d) all amounts allocated during that fiscal period, in the reasonable judgment of the Manager, to reserves established to meet the reasonable needs of the business, including working capital and capital improvement requirements and for reserves for unknown or unfixed liabilities or contingencies of the Company.

“nonrecourse deductions” has the meaning set forth in Treasury Regulation § 1.704-2(c). The amount of Nonrecourse Deduction for a Company Allocation Period equals excess, if any, of the net increase, if any, in the amount of Company Minimum Gain during that Allocation Period over the aggregate amount of any distributions during that Allocation Period of proceeds of a Nonrecourse Liability that are allocable to an increase in Company Minimum Gain, determined pursuant to Treasury Regulation § 1.704-2(c).

“nonrecourse Liability” has the meaning set forth in Treasury Regulation § 1.704-2(b)(3).

“Profits” and “Losses” means, for each Allocation Period, an amount equal to the Company’s taxable income or loss for such Allocation Period, determined in accordance with Code § 703(a) (for this purpose, all items of income, gain, loss, or deduction required to be stated separately pursuant to Code § 703(a)(1) will be included in taxable income or loss), with the following adjustments (without duplication):

(a) Any income of the Company that is exempt from federal income tax and not otherwise taken into account in computing Profits or Losses pursuant to this definition will be added to such taxable income or loss;

(b) Any expenditures of the Company described in Code § 705(a)(2)(B) or treated as Code § 705(a)(2)(B) expenditures pursuant to Treasury Regulations § 1.704-1(b)(2)(iv)(i), and not otherwise taken into account in computing Profits or Losses pursuant to this definition will be subtracted from such taxable income or loss;

(c) In the event the Gross Asset Value of any Company asset is adjusted pursuant to paragraph (b) or (c) of the definition of Gross Asset Value, the amount of such adjustment will be taken into account as gain or loss from the disposition of such asset for purposes of computing Profits or Losses;

(d) Gain or loss resulting from any disposition of any Company asset with respect to which gain or loss is recognized for federal income tax purposes will be computed by reference to the Gross Asset Value of the asset disposed of by the Company, notwithstanding that the adjusted tax basis of such asset differs from its Gross Asset Value;



(e) In lieu of the depreciation, amortization, and other cost recovery deductions taken into account in computing such taxable income or loss, Depreciation will be taken into account for such Allocation Period, computed as provided in the definition of Depreciation;

(f) To the extent an adjustment to the adjusted tax basis of any Company asset pursuant to Code § 734(b) is required, pursuant to Treasury Regulation § 1.704-1(b)(2)(iv)(m)(4), to be taken into account in determining Capital Accounts as a result of a distribution other than in complete liquidation of a Member’s interest in the Company, the amount of such adjustment will be treated as an item of gain (if the adjustment increases the basis of the asset) or loss (if the adjustment decreases the basis of the asset) from the disposition of the asset and will be taken into account for purposes of computing Profits or Losses; and

(g) Notwithstanding any other provision of this definition, any items that are specially allocated pursuant to Appendix 3.4 of this Agreement will not be taken into account in computing Profits or Losses.



Exhibit 3.4Special allocations and Limitations

(1) Company Minimum Gain Chargeback. Except as otherwise provided in Treasury Regulation § 1.704-2(f), notwithstanding any other provision of § 3 of the Agreement or this Exhibit 3.4, if there is a net decrease in Company Minimum Gain during any Company Allocation Period, each Member will be specially allocated items of Company income and gain for the Allocation Period (and, if necessary, subsequent Allocation Periods) in an amount equal to each Member’s share of the net decrease in Company Minimum Gain, determined in accordance with Treasury Regulation § 1.704-2(g)(2). Allocations pursuant to the previous sentence will be made in proportion to the respective amounts required to be allocated to each Member pursuant to such sentence. The items to be so allocated will be determined in accordance with Treasury Regulation §§ 1.704-2(f)(6) and 1.704-2(j)(2). This paragraph (1) of Exhibit 3.4 is intended to comply with, and will be interpreted consistently with, the “minimum gain chargeback” provisions of Treasury Regulation § 1.704-2(f).

(2) Member nonrecourse debt Minimum Gain Chargeback. Except as otherwise provided in Treasury Regulation § 1.704-2(i)(4), notwithstanding any other provision of § 3 of the Agreement or this Exhibit 3.4, if there is a net decrease in Member Nonrecourse Debt Minimum Gain attributable to a Member Nonrecourse Debt during any Allocation Period, each Member who has a share of the Member Nonrecourse Debt Minimum Gain attributable to such Member Nonrecourse Debt, determined in accordance with Treasury Regulation § 1.704-2(i)(5), will be specially allocated items of Company income and gain for such Allocation Period (and, if necessary, subsequent Allocation Periods) in an amount equal to such Member’s share of the net decrease in Member Nonrecourse Debt, determined in accordance with Treasury Regulation § 1.704-2(i)(4). Allocations pursuant to the previous sentence will be made in proportion to the respective amounts required to be allocated to each Member pursuant to such sentence. The items to be so allocated will be determined in accordance with Treasury Regulations § 1.704-2(i)(4) and § 1.704-2(j)(2). This paragraph (2) of Exhibit 3.4 is intended to comply with, and will be interpreted consistently with, the partner nonrecourse debt minimum gain chargeback provisions of Treasury Regulation § 1.704-2(i)(4).

(3) Qualified income Offset. In the event any Member unexpectedly receives an Adjustment Item for any Allocation Period that results in an Adjusted Capital Account Deficit for that Member, items of Company income and gain will be specially allocated to such Member in an amount and manner sufficient to eliminate, to the extent required by the Treasury Regulations, the Adjusted Capital Account Deficit created by such Adjustment Item as quickly as possible, provided that an allocation pursuant to this paragraph 3 of Appendix 3.4 will be made only if and to the extent that the Member would have an Adjusted Capital Account Deficit after all other allocations provided for in § 3 of the Agreement and this Exhibit 3.4 have been tentatively made as if this paragraph 3 were not in the Agreement.. This paragraph (3) of Exhibit 3.4 is intended to comply with, and will be interpreted consistently with, the “qualified income offset” requirements of Treasury Regulation § 1.704-1(b)(2)(ii)(d).

(4) Gross income allocation. In the event any Member has a deficit Capital Account at the end of any Allocation Period that is in excess of the sum of (a) the amount such Member is obligated to restore pursuant to the penultimate sentences of Treasury Regulations §§1.704-2(g)(1) and 1.704-2(i)(5), each such Member will be specially allocated items of Company income and gain in the amount of such excess as quickly as possible, provided that an allocation pursuant to this paragraph 4 of Exhibit 3.4 will be made only if and to the extent that such Member would have a deficit Capital Account in excess of such sum after all other allocations provided for in § 3 of the Agreement and this Exhibit 3.4 have been made as if paragraphs 3 and 4 of this Appendix 3.4 were not in the Agreement.

(5) nonrecourse deductions. Nonrecourse Deductions for any Allocation Period will be specially allocated to the Members in proportion to their respective Membership Percentages.



(6) Member nonrecourse deductions. Any Member Nonrecourse Deductions for any Allocation Period will be specially allocated to the Member or Members who bear the economic risk of loss with respect to the Member Nonrecourse Debt to which such Member Nonrecourse Deductions are attributable in accordance with Treasury Regulation §1.704-2(i)(1).

(7) Section 754 adjustments. To the extent an adjustment to the adjusted tax basis of any Company asset pursuant to Code § 734(b) or § 743(b) is required, pursuant to Treasury Regulations § 1.704-1(b)(2)(iv)(m)(2) or 1.704-1(b)(2)(iv)(m)(4), to be taken into account in determining Capital Accounts as the result of a distribution to a Member in complete liquidation of such Member’s interest in the Company, the amount of such adjustment to Capital Accounts will be treated as an item of gain (if the adjustment increases the basis of the asset) or loss (if the adjustment decreases such basis) and such gain or loss will be specially allocated to the Members in accordance with their interests in the Company in the event Treasury Regulations § 1.704-1(b)(2)(iv)(m)(2) applies, or to the Member to whom such distribution was made in the event Treasury Regulations § 1.704-1(b)(2)(iv)(m)(4) applies.

(8) allocations relating to Taxable issuance of Company units. Any income, gain, loss, or deduction realized as a direct or indirect result of the issuance of Units by the Company to a Member (the “Issuance Items”) will be allocated among the Members so that, to the extent possible, the net amount of such Issuance Items, together with all other allocations under this Agreement to each Member will be equal to the net amount that would have been allocated to each such Member if the Issuance Items had not been realized.

(9) Curative allocations. The allocations set forth in paragraphs 1 through 7 of this Exhibit 3.4 and in § 3.2.1(b) and (c) of the Agreement (the “Regulatory Allocations”) are intended to comply with certain requirements of the Treasury Regulations. It is the intent of the Members that, to the extent possible, all Regulatory Allocations will be offset either with other Regulatory Allocations or with special allocations of other items of Company income, gain, loss, or deduction pursuant to this paragraph 9 of Exhibit 3.4. Therefore, notwithstanding any other provision of § 3 of the Agreement or this Exhibit 3.4 (other than the Regulatory Allocations), the Manager will make such offsetting special allocations of Company income, gain, loss, or deduction in whatever manner the Manager determines appropriate so that, after such offsetting allocations are made, each Member’s Capital Account balance is, to the extent possible, equal to the Capital Account balance such Member would have had if the Regulatory Allocations were not part of the Agreement and all Company items were allocated pursuant to § 3.2 of the Agreement and paragraph 8 of this Exhibit 3.4.



aPPEndix C—SaFE-harBOr, TarGET-BaSEd aLLOCaTiOn PrOViSiOnS

Similar to the form in Appendix B, above, with the following changes and additions.

. . . .

3. Provisions for distributions and allocations of Profits and Losses

3.1 distributions. All Net Cash Flow will be distributed in the following priority:

(a) First, Net Cash Flow will be distributed 100% to the Class A Unitholders, and allocated among them pro rata in proportion to their respective Class A Membership Percentages, until [Describe Economic Event 1];

(b) Next, all remaining Net Cash Flow will be distributed 100% to the Class B Unitholders, and allocated among them pro rata in proportion to their respective Class B Membership Percentages until [Describe Economic Event 2]; and

(c) All remaining Net Cash Flow will be distributed to all the Members pro rata in proportion to their respective Overall Membership Percentages.

3.2 allocations of Profits and Losses. All Profits and Losses for each Allocation Period will be allocated among all the Members in a manner determined by the Manager, after consultation with the Company’s accountants, to eliminate the difference between each Member’s Target Capital Account and the Member’s Partially Adjusted Capital Account as of the end of the Allocation Period.

. . . .

10.2 Winding up. Upon the dissolution of the Company, the Manager (or if there is no Manager at such time, a successor Manager or other liquidator appointed by Approval of the Members) will take full account of the Company’s assets and liabilities, and the assets will be liquidated as promptly as is consistent with obtaining their fair value, and the proceeds, to the extent sufficient to pay the Company’s obligations with respect to such liquidation, will be applied and distributed in the following order:

(a) To payment and discharge of the expenses of liquidation and of all the Company’s debts and liabilities, including debts and liabilities owed to the Members; and

(b) To the Members in the manner and in the order provided in § 3.1 for distributions of Net Cash Flow.

. . . .



Exhibit 3.1definition of Terms for Section 3

Add following definitions to those in Appendix B above.

“Class a units” mean the Class A Units issued for $__________ per Unit.

“Class B units” mean the Class B Units issued for $__________ per Unit.

“Class a unitholders” mean the Members holding Class A Units.

“Class B unitholders” mean the Members holding Class B Units.

“Class a Membership Percentage” means a fraction, expressed as a percentage, for each Member with a numerator equal to the Member’s number of Class A Units and a denominator equal to the total number of issued and outstanding Class A Units.

“Class B Membership Percentage” means a fraction, expressed as a percentage, for each Member with a numerator equal to the Member’s number of Class B Units and a denominator equal to the total number of issued and outstanding Class B Units.

“Overall Membership Percentage” means a fraction, expressed as a percentage, for each Member, with a numerator equal to the total number of Units of any Class held by the Member and a denominator equal to the total number of Units of all Classes issued and outstanding.

“Partially adjusted Capital account” means, for each Allocation Period for each Member, the Member’s Capital Account as of the first day of the Allocation period, before any allocations of Profits or Losses for the Allocation period.

“Target Capital account” means, for each Member for each Allocation Period, the dollar amount that would be distributed to the Member under Sections 10.2 and 3.1 if the Company sold all its assets for an amount of cash equal to their Gross Asset Value as of the last day of the Allocation Period.



aPPEndix d—S COrPOraTiOn Tax diSTriBuTiOn PrOViSiOn

6. distribution of income

6.1 Mandatory distribution. During the period while Corporation remains an S corporation for federal income tax purposes, Corporation will declare and pay dividends for each taxable year in an amount equal to a percentage of Corporation’s taxable income determined by the Board of Directors to represent the highest combined effective federal, state, and local marginal income tax rates imposed on any Shareholder with respect to Corporation’s taxable income. Corporation’s Board of Directors may adjust such percentage amount from time to time to reflect changes in marginal income tax rates. Such dividend for a taxable year will be paid not later than April 1 of the following year.



aPPEndix E—S COrPOraTiOn STaTuS PrOTECTiOn PrOViSiOnS

1. definitions. In addition to the defined terms at the head of this Agreement, the following terms have the meanings set forth below for all purposes of this Agreement.

“approved Counsel” means Corporation’s general legal counsel or other legal counsel specifically approved by Corporation’s Board of Directors.

“Beneficial Shareholder” means, in the case of any Shares held by a trust, the individual who is the grantor of the trust (in the case of any revocable trust) or the individual who is the lifetime income beneficiary of the trust (in the case of any irrevocable trust).

“irC” means the Internal Revenue Code of 1986, as amended from time to time. Reference to a specific section of the IRC includes any successor section.

“nonqualified Person” means any Person who, if such Person became a beneficial owner of Shares, would cause Corporation to lose its S Status. Specifically, a Nonqualified Person includes:

(c) Any Person who, upon a Transfer of Shares to such Person, would cause Corporation to have a total number of shareholders in excess of the number permitted by IRC § 1361(b)(1)(A);

(d) A Nonqualified Trust;

(e) Any other Person who is not an individual, an estate of a deceased individual, an estate of an individual in bankruptcy, or a tax exempt organization described in IRC § 1361(c)(6); or

(f) Any nonresident alien.

“Permitted Family Member” means, for each Shareholder, a Qualified Person who is:

(a) A Shareholder or a lineal descendant of the Shareholder; or

(b) A Qualified Trust of which:

(i) Each lifetime or remainder beneficiary is either a lineal descendant of the Shareholder or another Shareholder; and

(ii) Any trusts for remainder beneficiaries are also Qualified Trusts meeting the requirements of this paragraph (b).

For purposes of this Agreement: (i) lineal descendants include adopted children, and references to other Shareholders include persons who are Shareholders at the time of a proposed Transfer.

“Permitted Transferee” means a Person who is a Qualified Person to whom Shares are Transferred after compliance with all the provisions of this Agreement and who executes a counterpart of this Agreement.

“Person” means any individual, trust, estate, partnership, association, company, or corporation.

“Qualified Person” means any Person who is not a Nonqualified Person.

“Qualified Trust” means a trust that, in the opinion of Approved Counsel, meets the requirements of IRC § 1361(c)(2), including without limitation a qualified subchapter S trust as defined in IRS § 1361(d)(3) and an electing small business trust as defined in IRC § 1361(e).

“Shareholder or Shareholders” mean the persons named above in § _____ and any other Shareholders executing this Agreement and any Permitted Transferee or Permitted Transferees of Shares.

“S Status” means the status of Corporation as an S corporation pursuant to IRC § 1361.

“Transfer” means any sale, assignment, transfer, exchange, conveyance, gift, donation, pledge, mortgage, encumbrance, hypothecation, or other disposition of or grant of a security interest in Shares,



or any interest in Shares, whether voluntary or by operation of law, that would change the legal or beneficial ownership interest of the Shares. A Transfer includes, without limitation, any transaction which creates a form of joint ownership in Shares (whether or not one of the co-owners is the spouse of the transferor) or any transaction that creates or grants an option, warrant, or right to obtain the Shares or an interest in the Shares.

2. restrictions on Transfer

2.1 nonqualified Persons. Corporation may not issue any Shares, and no Shareholder may Transfer any Shares, to a Nonqualified Person.

2.2 Transfers to Other Shareholders or Permitted Family Members. Any Shareholder may, during life or at death, transfer Shares to another Shareholder or to any Permitted Family Member, provided (for Transfers to a Permitted Family Member who is not already a Shareholder) such Permitted Family Member, or his or her legal representative, executes a counterpart of this Agreement in the form attached to this Agreement as __________.

2.3 Transfers to Corporation. Nothing in this Agreement will prohibit or restrict the ability of Corporation and any Shareholder to negotiate a redemption of some or all of the Shareholder’s Shares on such terms as Corporation and the Shareholder mutually agree. Furthermore, nothing in this Agreement will prohibit or apply to purchases or repurchases by Corporation of Shares held by Employee Shareholders under the terms of Stock Purchase Agreements among Corporation, the Senior Shareholders, and an Employee Shareholder.

2.4 Prohibited Transfers Void. Corporation and each Shareholder expressly agree that any purported or attempted issuance or Transfer of Shares to a Nonqualified Person and any other purported or attempted Transfer in violation of this Agreement (a “Prohibited Transfer”) will be null and void and may and should be enjoined.

3. Beneficial Ownership. Any purported Prohibited Transfer of Shares will not affect the beneficial ownership of the Shares. With respect to the Shares subject to the purported Prohibited Transfer, the Shareholder attempting to make the Transfer will, for all purposes, remain a Shareholder of Corporation, retain the right to vote and the right to receive dividends and liquidation proceeds, and be allocated (and required to report) his or her distributive share of Corporation’s income or loss for income tax purposes.

. . . .

4.3 Transfers upon death.

4.3.1 Estate notice. Upon the death of a Shareholder (or the death of the Beneficial Shareholder in the case of a Shareholder that is a trust), the Shareholder’s legal representative must, within 90 days after the date of the Shareholder’s death (or, if later, within 60 days after the appointment of the legal representative for the deceased Shareholder), give written notice (an “Estate Notice”) to Corporation at its principal place of business setting out:

(a) The name and address of the legal representative.

(b) The proposed disposition of the Shares held by the Shareholder at the time of death, including:

(i) The name of each Qualified Person to whom Shares are proposed to be Transferred pursuant to the will or inter vivos trust of the Shareholder and the number of Shares (the “Qualified Estate Shares”) proposed to be Transferred to each such Person; and

(ii) The name of each Nonqualified Person, if any, to whom Shares are proposed to be Transferred pursuant to the will or inter vivos trust of the Shareholder and the number of Shares (the “Nonqualified Estate Shares”) proposed to be Transferred to each such Person.



If a proposed recipient is a Qualified Trust, the Estate Notice must identify the trustee or trustees and the beneficiary and beneficiaries and must be accompanied by an opinion of Approved Counsel that the trust is a Qualified Trust.

4.3.2 Mandatory Purchase. Upon receipt of an Estate Notice specifying that pursuant to the will or trust of the deceased Shareholder (or the death of the Beneficial Shareholder in the case of a Shareholder that is a trust), Shares are proposed to be Transferred to a Nonqualified Person, Corporation will be required to purchase, and the legal representative of the deceased Shareholder will be required to sell, all the Nonqualified Estate Shares for the price and pursuant to the payments terms described in § 4.5. Such purchase by Corporation will not affect any claim Corporation or any Shareholder may have against the estate of the deceased Shareholder for bequeathing Shares to a Nonqualified Person in violation of this Agreement. Corporation may assign its right to purchase the Nonqualified Estate Shares on a pro rata basis (or on any other basis mutually agreed upon by all the other Shareholders) to the other Shareholders.

4.3.3 Estate Option. Upon receipt of an Estate Notice specifying that pursuant to the will or trust of the deceased Shareholder (or the death of the Beneficial Shareholder in the case of a Shareholder that is a trust), Shares are proposed to be Transferred to a Qualified Person other than an existing Shareholder or a Permitted Family Member, Corporation and the remaining Shareholders will have the option (the “Estate Option”), but not the obligation, to purchase all or any portion of the Qualified Estate Shares for the price and subject to the purchase terms described in § 4.5 of this Agreement. Corporation and the remaining Shareholders may divide the purchase of the Qualified Estate Shares among Corporation and the remaining Shareholders as they mutually agree.

4.4 Purchase Option. A Transfer Option described in § _____, an Estate Option described in § 4.3.3, a Divorce Option described in § _____, or an Involuntary Transfer Option described in § _____ (collectively a “Purchase Option”) may be exercised by Corporation and/or the other or remaining Shareholders by giving written notice to the transferor Shareholder (or his or her legal representative) within 90 days (the “Option Period”) after the event or notice giving rise to the Purchase Option (an “Option Event”).

. . . .

4.7 dispositive Provisions regarding Transfers upon death. Each individual Shareholder and each Beneficial Shareholder of Shares held in a Trust that is a Shareholder agrees not to provide by will or by inter vivos trust for the Transfer upon the Shareholder’s death of any Shares to a Nonqualified Person.

. . . .

12. Waiver of Termination of S Status or ineffectiveness of Election. If Corporation’s status as an S corporation is terminated inadvertently, or if Corporation’s S election is found to have been ineffective, and Corporation wishes to obtain a waiver or ruling under IRC § 1362(f), each Shareholder agrees to cooperate and to sign any documents and to make any adjustments required pursuant to IRC § 1362(f)(4) and approved by the Company’s Board. A Shareholder’s obligation to make such adjustments will continue after the Shareholder has ceased to own stock in Corporation and after this Agreement has terminated.

Chapter 6

Estate and Gift Tax issues Every Lawyer Should Know

BarBara Jo sMith

Heltzel Williams Law FirmSalem, Oregon

Contents

I. What Is a Gift? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6–1

II. Federal Gift Tax . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6–1

III. Oregon Gift Tax . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6–2

IV. Select Income Tax Issues . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6–2

V. Assets Includable in a Decedent’s Estate (for Purposes of Estate Tax Calculation) . . . . . . . 6–3

VI. Federal Estate Tax . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6–4

VII. Oregon Estate Tax (Formerly Oregon Inheritance Tax)—Chapter 118 . . . . . . . . . . . . . . 6–5

U.S. Department of the Treasury Press Release—All Legal Same-Sex Marriages Will Be Recognized for Federal Tax Purposes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6–7

Rev. Rul. 2013-21 Table 1—Applicable Federal Rates (AFR) for October 2013 . . . . . . . . . . . . . 6–9

Illustrative Chart . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6–11

Chapter 6—Estate and Gift Tax Issues Every Lawyer Should Know




i. WhaT iS a GiFT?

A. A gift occurs any time an item, money or otherwise, goes from Person A to Person B without adequate consideration and not for services rendered.

B. Paying an adult child’s expenses such as the mortgage, rent, and food is a gift.

C. The “sale” of property to a child for less than fair market value is a gift. If the purchase price is below the fair market value, then it is a part-sale, part-gift.

D. The “loan.” If there is no intention that the borrower will pay back the amount and there is evidence of this intent, then the entire loan amount is a gift. No payments at all can be evidence that there was no intention of repayment.

E. No- or low-interest loans. IRC Section 7872.

F. Adding children as joint owners (not as a beneficiary) on real property in order to avoid probate.

ii. FEdEraL GiFT Tax

A. Lifetime exemption of $5,250,000 for use either during life or at death. This amount is inflation-adjusted. There is no automatic sunset for the law.

B. Any gifts not covered by specific exclusions require that a gift tax return (Form 709) be filed by April 15 of the following year. The penalty for failure to file is a percentage of the tax due. In addition, no statute of limitations will run on the valuation of the gift if no return is filed.

C. Unlimited marital deduction.

1. Gifts to a spouse who is not a U.S. citizen do not qualify for the unlimited marital deduction. There is a $143,000 per year exclusion for gifts to a noncitizen spouse. This exclusion is inflation-adjusted.

2. Defense of Marriage Act (DOMA) and U.S. v. Windsor, 133 S.Ct. 2675 (2013).

3. Transfers to an ex-spouse do not qualify, but IRC § 2516 provides that certain transfers incident to a divorce are for full and adequate consideration.



D. Annual exclusion of $14,000 per year per recipient. IRC § 2503(b)(1).

1. Present interest requirement.

2. Check has to be cashed before death.

E. Tuition and medical exclusion of an unlimited amount.

1. Must be paid directly to the institution.

2. 529 plans, loan payoffs, and reimbursements do not qualify.

3. Room, board, books, and technology do not qualify.

4. Tuition at any level, not just college, qualifies. See IRC § 170(b)(1)(A)(ii).

F. Charitable gifts are unlimited for gift tax purposes.

iii. OrEGOn GiFT Tax

There is no Oregon gift tax.

iV. SELECT inCOME Tax iSSuES

A. The basis of an asset received by gift is the basis of the transferor. The basis of an asset received because of the death of the prior owner is generally the fair market value of the asset on date of death. This new basis at death is generally known as the stepped-up basis.

B. Income in respect of a decedent (IRD) does not get a stepped-up basis. The unrecognized taxable income still has to be recognized by the recipient. Examples are U.S. savings bonds, IRAs and other pretax retirement savings, land sale contracts.

C. An inheritance other than IRD is not taxable income for the recipient. There may be earned income during administration that passes out to the beneficiary, however.



D. The age of the IRA beneficiary will usually determine the maximum number of years over which the account has to be distributed.

1. An individual named as beneficiary will get to use his or her life expectancy to extend withdrawal over his or her entire lifetime. The beneficiary could always take withdrawal more quickly.

2. The estate of the decedent named as beneficiary (or as a default beneficiary) would generally require that the IRA be distributed over no more than five years if the decedent died prior to beginning required minimum distributions. If the decedent died after commencing required minimum distributions, then the decedent’s life expectancy at time of death may be used to determine the slowest timing of distributions.

3. A trust named as beneficiary that does not qualify for special treatment under the tax regulations has the same rules as an estate.

V. aSSETS inCLudaBLE in a dECEdEnT’S ESTaTE (FOr PurPOSES OF ESTaTE Tax CaLCuLaTiOn)

A. Assets passing pursuant to probate.

B. Assets passing pursuant to a revocable living trust.

C. Life insurance on the decedent’s life.

D. Annuities and all retirement accounts (IRA, 401(k), 403(b) . . .). These are at full face value and are not reduced for the income tax owing.

E. Assets over which the decedent held a general power of appointment.

F. Assets the decedent gave away but held a retained interest either legally (life estate) or by implied agreement.

G. Be careful of client ideas to avoid inclusion of property while the client still controls or uses the asset.



Vi. FEdEraL ESTaTE Tax

A. Lifetime exemption of $5,250,000 for use either during life or at death. Any amount used during life for gifts is not available at death. This amount is inflation-adjusted. There is no automatic sunset for the law. The tax rate for amounts over the exemption is 40%.

B. Unlimited marital deduction.

1. Spouse has to receive the assets outright or in a trust that qualifies as a general power of appointment trust or qualified terminable interest property (QTIP) trust.

2. Gifts to a spouse who is not a U.S. citizen do not qualify for the unlimited marital deduction. A trust that qualifies as a qualified domestic trust can be used to obtain the marital deduction. There are also some treaties that provide limited relief.

3. Defense of Marriage Act (DOMA) and U.S. v. Windsor, 133 S.Ct. 2675 (2013).

C. Portability of unused lifetime exemption.

1. The Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010 added the ability for a surviving spouse to use a deceased spouse’s unused lifetime exemption.

2. The trap is that an estate tax return (Form 706) has to be timely filed at the first spouse’s death.

3. If the surviving spouse remarries and the second spouse passes away first, the surviving spouse can no longer use the unused exemption of the first spouse but only qualifies for the unused exemption of the second spouse.

4. Is there a requirement for children of a prior marriage to file a Form 706 estate tax return costing several thousand dollars or more in order to allow the surviving stepparent to receive the unused lifetime exemption when the surviving stepparent received no assets? If the surviving stepparent received an asset and thus is allowed to file, how does he or she obtain information from stepchildren in order to complete the return?

5. You may want to address portability in prenuptial agreements, especially when estates probably will not warrant the cost of filing a Form 706 federal estate tax return.



D. Charitable deductions are unlimited for estate tax purposes.

Vii. OrEGOn ESTaTE Tax (FOrMErLy OrEGOn inhEriTanCE Tax)—ChaPTEr 118

A. $1 million exemption. Because gifts are not taxed in Oregon, the full $1 million will be available at death. The tax rate schedule is as follows:

1 2Tax on amount

in Column 1rate on amount Over Column 1

$1,000,000 $1,500,000 $ 0 10.00%$1,500,000 $2,500,000 $ 50,000 10.25%$2,500,000 $3,500,000 $ 152,500 10.50%$3,500,000 $4,500,000 $ 257,500 11.00%$4,500,000 $5,500,000 $ 367,500 11.50%$5,500,000 $6,500,000 $ 482,500 12.00%$6,500,000 $7,500,000 $ 602,500 13.00%$7,500,000 $8,500,000 $ 732,500 14.00%$8,500,000 $9,500,000 $ 872,500 15.00%$9,500,000 $1,022,500 16.00%

B. There are three states west of the Mississippi River with an estate tax. Washington with a $2 million exemption and Hawaii with a $3 million exemption are the other two states.

C. Generally, what is included in the taxable estate and the allowable deductions are all based on federal estate tax law.

D. Oregon has another way to qualify property for the marital deduction called an Oregon Special Marital Property Election.

E. Oregon has a special Natural Resources Credit (NRC) for agricultural, timber, and commercial fishing property.

F. There is no Oregon equivalent to the federal portability of unused exemption to a surviving spouse.



Press Center

All Legal Same-Sex Marriages Will Be Recognized for Federal Tax Purposes

8/29/2013

Ruling Provides Certainty, Benefits and Protections Under Federal Tax Law for Same-Sex Married Couples

WASHINGTON — The U.S. Department of the Treasury and the Internal Revenue Service (IRS) today ruled that same-sexcouples, legally married in jurisdictions that recognize their marriages, will be treated as married for federal tax purposes. The rulingapplies regardless of whether the couple lives in a jurisdiction that recognizes same-sex marriage or a jurisdiction that does notrecognize same-sex marriage.

The ruling implements federal tax aspects of the June 26th Supreme Court decision invalidating a key provision of the 1996 Defenseof Marriage Act.

“Today’s ruling provides certainty and clear, coherent tax filing guidance for all legally married same-sex couples nationwide. Itprovides access to benefits, responsibilities and protections under federal tax law that all Americans deserve,” said Secretary Jacob J.Lew. “This ruling also assures legally married same-sex couples that they can move freely throughout the country knowing that theirfederal filing status will not change.”

Under the ruling, same sex couples will be treated as married for all federal tax purposes, including income and gift and estate taxes.The ruling applies to all federal tax provisions where marriage is a factor, including filing status, claiming personal and dependencyexemptions, taking the standard deduction, employee benefits, contributing to an IRA, and claiming the earned income tax credit orchild tax credit.

Any same-sex marriage legally entered into in one of the 50 states, the District of Columbia, a U.S. territory, or a foreign countrywill be covered by the ruling. However, the ruling does not apply to registered domestic partnerships, civil unions, or similar formalrelationships recognized under state law.

Legally-married same-sex couples generally must file their 2013 federal income tax return using either the “married filing jointly” or“married filing separately” filing status.

Individuals who were in same-sex marriages may, but are not required to, file original or amended returns choosing to be treated asmarried for federal tax purposes for one or more prior tax years still open under the statute of limitations.

Generally, the statute of limitations for filing a refund claim is three years from the date the return was filed or two years from thedate the tax was paid, whichever is later. As a result, refund claims can still be filed for tax years 2010, 2011, and 2012. Sometaxpayers may have special circumstances (such as signing an agreement with the IRS to keep the statute of limitations open) thatpermit them to file refund claims for tax years 2009 and earlier.

Additionally, employees who purchased same-sex spouse health insurance coverage from their employers on an after-tax basis maytreat the amounts paid for that coverage as pre-tax and excludable from income. How to File a Claim for RefundTaxpayers who wish to file a refund claim for income taxes should use Form 1040X, Amended U.S. Individual Income Tax Return. Taxpayers who wish to file a refund claim for gift or estate taxes should file Form 843, Claim for Refund and Request for Abatement. For information on filing an amended return, go to Tax Topic 308, Amended Returns at http://www.irs.gov/taxtopics/tc308.html or theInstructions to Forms 1040X and 843. Information on where to file your amended returns is available in the instructions to the form. Future GuidanceTreasury and the IRS intend to issue streamlined procedures for employers who wish to file refund claims for payroll taxes paid onpreviously-taxed health insurance and fringe benefits provided to same-sex spouses. Treasury and IRS also intend to issue furtherguidance on cafeteria plans and on how qualified retirement plans and other tax-favored arrangements should treat same-sex spousesfor periods before the effective date of this Revenue Ruling. Other agencies may provide guidance on other federal programs that they administer that are affected by the Code. For Revenue Ruling 2013-17, click here .

http://www.treasury.gov/press-center/press-releases/Pages/jl2153.aspx



For Frequently Asked Questions, click here. For registered domestic partners who live in community property states, click here for Publication 555, Community Property. Treasury and the IRS will begin applying the terms of Revenue Ruling 2013-17 on September 16, 2013, but taxpayers who wish torely on the terms of the Revenue Ruling for earlier periods may choose to do so (as long as the statute of limitations for the earlierperiod has not expired).

###

http://www.treasury.gov/press-center/press-releases/Pages/jl2153.aspx



rEV. ruL. 2013-21 TaBLE 1—aPPLiCaBLE FEdEraL raTES (aFr) FOr OCTOBEr 2013

Period for Compoundingannual Semiannual Quarterly Monthly

Short-term (0–3 years)AFR .32% .32% .32% .32%110% AFR .35% .35% .35% .35%120% AFR .38% .38% .38% .38%130% AFR .42% .42% .42% .42%

Mid-term (3–9 years)AFR 1.93% 1.92% 1.92% 1.91%110% AFR 2.12% 2.11% 2.10% 2.10%120% AFR 2.31% 2.30% 2.29% 2.29%130% AFR 2.52% 2.50% 2.49% 2.49%150% AFR 2.90% 2.88% 2.87% 2.86%175% AFR 3.39% 3.36% 3.35% 3.34%

Long-term (over 9 years)AFR 3.50% 3.47% 3.46% 3.45%110% AFR 3.86% 3.82% 3.80% 3.79%120% AFR 4.20% 4.16% 4.14% 4.12%130% AFR 4.56% 4.51% 4.48% 4.47%



Marital Assets

First Death

Credit Shelter Trust or

By-Pass Trust $750,000

Survivor’s Trust or

Marital Trust $750,000

Second Death

Children Children

iLLuSTraTiVE CharT

Chapter 7

Tax Planning for real Estate WorkoutsJeneé Gifford hilliard

Miller Nash LLPPortland, Oregon

Contents

What’s Worse Than Losing Your Real Estate to Foreclosure, Short Sale, or Deed in Lieu of Foreclosure? Owing Taxes as a Result . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7–1

Borrower’s Tax Implications of Foreclosure . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7–3General Tax Principles. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7–3Recourse Debt . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7–4Nonrecourse Debt . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7–5Tax Attribute Reductions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7–5Tax Planning Opportunities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7–5

Lender’s Tax Implications of Foreclosure . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7–7Gain or Loss on Exchange or Retirement of Debt . . . . . . . . . . . . . . . . . . . . . . . . . 7–7Specific Scenarios . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7–7Bad Debt Deduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7–8Character of Gain or Loss on Foreclosure, Short Sale, or Deed in Lieu . . . . . . . . . . . . . 7–8Tax Reporting by Lenders. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7–8

Presentation Slides . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7–9

Chapter 7—Tax Planning for Real Estate Workouts




GroundBreaking News | miller nash llp | 3

(continued on page 5)

Unfortunately, foreclosures, short sales, and deeds in lieu of foreclosure are much more common these days. Although the practical aspects of foreclosure are readily apparent—the owner of the property no longer owns property and has lost any money that he or she put into the property—it’s often easy to overlook the tax implications of foreclosure (in this article, unless otherwise indicated, we will use the term “foreclosure” to mean foreclo-sures, short sales, and deeds in lieu of foreclosure because for tax purposes, they are all treated essentially the same). The tax results of foreclosure can often catch a borrower by surprise and even seem unfair because the borrower loses his or her property, does not receive any money for it, and then can end up ow-ing a hefty sum to Uncle Sam.

Under tax law, when a borrower is relieved of the obligation to repay a debt, the amount of debt that is forgiven is income to the borrower. For example, if Builder Bob gets a $10,000 loan from Friendly Bank and later Friendly Bank agrees to reduce the amount that Builder Bob has to repay to $7,000, if Builder Bob pays the $7,000 immedi-ately, Builder Bob will recognize $3,000 of income as a result of the forgiveness

of the debt. This outcome is true re-gardless of whether the loan is secured or unsecured. The nature of the income and whether the borrower can avoid or minimize income taxes depend on whether the loan is nonrecourse rather than recourse.

The first step in determining the tax consequences of foreclosure is to determine whether the debt is recourse or nonrecourse. A debt is generally classified as recourse if the lender may

foreclose on the property securing the debt and seek repayment from the borrower for any deficiency. A debt is generally classified as nonrecourse if the lender’s ability to be paid back for the loan is limited to the value of the collateral securing the debt (i.e., the lender does not have recourse against the borrower personally).

If the debt is recourse, the tax consequences must be analyzed in a two-step approach. First, we pretend that the borrower sold the property and determine the borrower’s gain or loss on the “sale.” The “sales price” equals (1) the actual price paid for the property at the foreclosure auction, (2) the actual

price paid for the property in the short sale, or (3) the fair market value of the property at the time the deed in lieu of foreclosure is given to the lender. The gain or loss recognized by the borrower is the difference between the “sales price” of the property and the tax basis of the property. Assuming that a property had debt of $100, a “sales price” of $50, and a tax basis of $45, the borrower would recognize $5 of taxable gain ($50 “sales price” minus

$45 basis). Such gain is taxable unless an exception applies or it is offset by a loss. (Note that the “sales price” could be less than the tax basis of the property, thereby resulting in a loss.) Next, we determine how much debt, if any, was forgiven. If the lender agrees not to pursue the borrower for the remaining $50 due on the loan, the borrower would have $50 of debt forgiven (deter-

mined by subtracting the “sales price” from the loan balance). This debt that is forgiven is subject to income tax, un-less an exception applies, and is called “cancellation of indebtedness income” or “COD income.”

If a borrower anticipates having COD income, an exception to COD income may apply to avoid tax on that income. In general, COD income will not be recognized if the bor-rower is bankrupt or has debts that exceed the value of his or her assets (i.e., insolvent) at the time the debt is forgiven. Additionally, COD income will generally not be recognized if the

What’s Worse Than Losing Your Real Estate to Foreclosure, Short Sale, or Deed in Lieu of Foreclosure? Owing Taxes as a Result

(continued on page 6)

by Jeneé Giffordjeneé[email protected]

The tax results of foreclosure can often catch a borrower by surprise and even seem unfair because the borrower loses his or her property, does not receive any money for it, and then can end up owing a hefty sum to Uncle Sam.



6 | miller nash llp | GroundBreaking News

Owing Taxes Af ter Foreclosure | Continued from page 3

debt that is forgiven is secured by real estate and the debt was incurred by the borrower in connection with its acquisi-tion, construction, reconstruction, or substantial improvement of that real estate and is used in the borrower’s trade or business or as the borrower’s principal residence. The exclusion for principal residences is available only for debt that is forgiven before January 1, 2013, and if the residence was used as a principal residence for at least two years out of the previous five years. If any of the exceptions apply, either (1) a borrower would not recognize COD income, or (2) the amount of COD income would be reduced, as a result of the forgiveness of debt. The COD exceptions, however, apply only to COD income. Since foreclosure may also generate gain, the bor-rower may avoid gain only if a gain exception applies (exceptions to recognition of gain are discussed brief ly below).

If the debt is nonrecourse, the entire outstanding balance of the loan is treated as cash received by the borrower. Using the same facts as above except that the loan is now a nonrecourse loan, the tax result would be that the borrower would recognize a gain of $55 ($100 minus $45) (the fact that the “sales price” was $50 is not rel-evant). Because the lender does not have recourse against the borrower, there is never cancellation of indebtedness income on the sale of property secured by nonrecourse debt, and therefore no COD income exclusion will apply to exclude the income from tax. The borrower may be able to avoid tax on such gain if (1) the principal-residence

exception applies, (2) the foreclosure qualifies as a like-kind exchange or involuntary conversion, or (3) the bor-rower has unused losses that offset the gain.

Although the borrower usually has few options to actually prevent the foreclosure, the borrower may be able to lessen the tax hit as a result of the foreclosure. Many of the planning alternatives available to the borrower are related to timing of the foreclosure or the forgiveness of the debt (the best approach will depend entirely on the facts of the situation, including the

borrower’s tax situation and other financial considerations—there are no “rules of thumb”). For example, in the case of a recourse loan, if the borrower is insolvent today, but anticipates that it will not be insolvent tomorrow, it could try to negotiate with its lender so that the lender agrees to forgive the remaining balance of the loan today if the borrower agrees to give the lender a deed in lieu of foreclosure. In this way, the insolvency exception to recognition of COD income would apply. Similarly, in the case of a nonrecourse loan, the borrower could negotiate with its lender to time the transaction to trigger gain

on the transaction at a time when it had unused capital losses to offset the gain.

Many tax planning techniques are available to a borrower in foreclosure. We recommend that a borrower who is facing such a dire situation talk to his or her tax advisers about steps to eliminate or reduce the foreclosure’s negative tax consequences.


Broadbrush Taxation 7–3- 1 -PDXDOCS:1772958.5

BORROWER'S TAX IMPLICATIONS OF FORECLOSURE1

Jeneé HilliardMiller Nash LLP

General Tax Principles

What is Gross Income? Gross income is all income from whatever source derived, including, but not limited to, income from discharge of indebtedness.2

Can Modification of Loan Documents Create Gross Income? Certain modifications to loan documents can be treated as a realizing event that can result in a gain or loss being realized by the parties.3

What is Discharge of Indebtedness? In general terms, discharge of indebtedness4 is the taxpayer's satisfaction of debt for less than its face value.5 For example, if a taxpayer owes a lender $100, and the lender accepts a payment of $70 in full satisfaction of the debt, the taxpayer was relieved of a $30 obligation and has discharge of indebtedness income equal to $30.

Exceptions to Inclusion of Discharge of Indebtedness as Gross Income. Gross income will not include discharge of indebtedness, if:

o The discharge occurs as part of a bankruptcy;6

o The discharge occurs when the taxpayer is insolvent7 (defined to mean the amount by which the taxpayer's liabilities exceed the fair market value of the taxpayer's assets,)8

except that the amount excluded from gross income may not exceed the amount by which the taxpayer is insolvent;9

o The taxpayer is not a C corporation and the indebtedness that is discharged is qualified real property business indebtedness10 (defined to mean debt: if incurred or assumed on or after January 1, 1993, debt incurred or assumed by the taxpayer in connection with the acquisition, construction, reconstruction, or substantial improvement of real property used in a trade or business; and secured by property);11 or

1 Tax implications of foreclosure and insolvency are complex. This outline is not intended to be an exhaustive discussion of the topic, but an overview of some issues of which to be aware. Additionally, this outline addresses only tax implications to a borrower; lenders also need to be aware of tax implications of foreclosure, including special rules relating to foreclosure of a land sale contract, and debt modifications.2 IRC § 61(12).3 Treas Reg § 1.1001-3.4 Discharge of indebtedness is also called cancellation of debt or COD. 5 Treas Reg § 1.61-12(a).6 IRC § 108(a)(1)(A).7 IRC § 108(a)(1)(B).8 IRC § 108(d)(3).9 IRC § 108(a)(3).10 IRC § 108(a)(1)(D).11 IRC § 108(c)(3).



o The indebtedness that is discharged is discharged before January 1, 2014, and is qualified principal residence indebtedness12 (defined to mean debt incurred to acquire, construct, or substantially improve real property owned by the taxpayer and used as its principal residence for at least two years out of the previous five years, if the debt is secured by such property).13

Certain limitations, rules, and exclusions apply. Additionally, for an entity treated as a partnership for tax purposes (including limited liability companies that are treated as partnerships for tax purposes), the excludability of discharge of indebtedness income is determined at the partner level.14 Similarly, the excludability of discharge of indebtedness income is determined at the owner level for entities that are disregarded for tax purposes.

Gain or Loss on Sale or Other Disposition of Property. When property is sold or otherwise disposed of, the taxpayer realizes gain or loss on the disposition equal to the difference between the amount realized and the adjusted basis of the property.15 The amount realized on the disposition of the property equals the sum of any money received plus the fair market value of other property received,16 this includes the amount of liabilities from which the taxpayer is discharged as a result of the disposition.17

Recourse Debt

What is Recourse Debt? A debt is recourse if the borrower is personally obligated to repay the loan. Typically, upon the default of the borrower, the lender may foreclose on the property securing the recourse debt and may seek repayment from the borrower for the difference in the value of the property and the outstanding balance of the debt.18

What are the Tax Implications of Foreclosure or Voluntary Surrender of Property that Secures Recourse Debt? On the disposition of property that secures recourse debt, amounts that would be treated as discharge of indebtedness will not be treated as the amount realized on the disposition of the property.19 For example, if the taxpayer owned real property with a fair market value of $50 and an adjusted basis of $25, the property secured recourse debt in the amount of $100, and the taxpayer surrendered the property to the lender in satisfaction of the debt, the taxpayer would have $50 of discharge of indebtedness (equal to the amount of debt that was forgiven which is calculated by subtracting the fair market value of the property from the amount of the debt), and the amount realized would be $50 (equal to the amount of the debt that was repaid but excluding the discharge of indebtedness).20 The tax consequences to the taxpayer would be the $50 of discharge of indebtedness income (possibly excluded if a relevant

12 IRC § 108(a)(1)(E) (this exception was originally enacted by The Mortgage Forgiveness Debt Relief Act of 2007, and was revised by the 2008 Emergency Economic Stabilization Act).13 IRC § 108(h).14 IRC § 108(d)(6).15 IRC § 1001.16 IRC § 1001(b).17 Treas Reg § 1.1001-2(a).18 Note that most residential mortgages in Oregon are still considered to be recourse loans for tax purposes even though state law requires a lender to chose between foreclosing on the property securing the recourse debt or obtaining a judgment against the borrower.19 Treas Reg § 1.1001-2(a)(2).20 See also Table 6 on attached handout.



exclusion applies), and $25 of gain (the difference between the adjusted basis in the property and the fair market value of the property relinquished by the borrower). If the property was a capital asset, the gain will be capital (rather than ordinary), except to the extent of depreciation recapture, if any, which will be ordinary income.

Nonrecourse Debt

What is Nonrecourse Debt? A debt is nonrecourse if, upon the default of the borrower, the lender's only remedy is to foreclose on the property securing the debt and the Lender may notseek repayment from the borrower for the difference in the value of the property and the outstanding balance of the debt.

What are the Tax Implications of Disposing of Property that Secures Nonrecourse Debt? When property that secures a nonrecourse debt is disposed of, the entire amount of debt secured by the property is treated as the amount realized on the disposition of the property.21 For example, if the taxpayer owned real property with a fair market value of $50 and an adjusted basis of $25, the property secured nonrecourse debt in the amount of $100, and the lender forecloses on the property, the amount realized by the taxpayer on the disposition would be $100 (the amount of the debt that was satisfied).22 The tax consequences to the taxpayer would be the $25 of gain and none of the discharge of indebtedness exclusions would apply because none of the income is discharge of indebtedness income but rather gain on the disposition of property. If the property was a capital asset, the gain is capital gain (rather than ordinary gain), except to the extent of depreciation recapture, if any, which will be ordinary income.

Tax Attribute Reductions

When discharge of indebtedness is excluded from a taxpayer's gross income pursuant to one of the exceptions identified above, certain tax attributes of the taxpayer must be reduced, dollar for dollar, to the extent of the discharge of indebtedness.23 The tax attributes that must be reduced include any (a) net operating losses for the tax year of the discharge and carryover of such losses from prior tax years, (b) net capital losses for the tax year of the discharge and carryover of such losses from prior tax years, and (c) the tax basis of property owned by the taxpayer.24 Note that the reduction of tax attributes is applied at the end of the year in which the discharge of indebtedness occurs. As discussed below, this presents certain tax planning opportunities.25

Tax Planning Opportunities

Any tax planning opportunities that may exist in a foreclosure or voluntary surrender of collateral will depend on the facts of the situation and should be thoroughly discussed with a tax attorney or accountant. Additionally, it is important to ensure that any steps taken will not result in a recharacterization of the transaction by the IRS under the "step transaction doctrine."

21 See Treas Reg § 1.1001-2(c)(Example 7). See also PLR 9302001 (Aug 31, 1992).22 See also Chart 5 on attached handout.23 IRC § 108(b).24 Id.25 Reg § 1.108-7(b).



Planning Opportunities with Respect to Recourse Debt

o Time the transaction so that the discharge of indebtedness income can be offset by"soaking" up carryover losses of the taxpayer. If the activity is passive, such unused losses may include unused passive activity losses.26

o Time the transaction to occur at a time when the taxpayer is insolvent.o Consider voluntarily surrendering the collateral at the beginning of the next tax year.

This allows the taxpayer to defer the tax attribute reduction until the end of the next tax year and thereby possibly using such tax attributes in the next tax year before they are reduced in connection with the exclusion of discharge of indebtedness income.

o If the taxpayer is a corporation, if the taxpayer's disposition of the property securing the debt generates a loss, the taxpayer can generate a cash refund of income taxes paid in prior tax years by carrying the loss back for up to three preceding tax years.

Planning Opportunities with Respect to Nonrecourse Debt

o Consider converting the debt to a recourse debt so that taxpayer may benefit from the discharge of indebtedness provisions.

o Time the transaction so gain generated from the disposition of the property is offset by"soaking" up unused capital losses of the taxpayer.

o Negotiate with the lender to reduce the outstanding principal balance on the loan to the fair market value of the property (thus generating discharge of indebtedness income on the reduction of the principal balance and shielding the taxpayer from gain on the later disposition of the property).

o If the taxpayer is a corporation, if the taxpayer's disposition of the property securing the debt generates a loss, the taxpayer can generate a cash refund of income taxes paid in prior tax years by carrying the loss back for up to three preceding tax years.

26 See Rev. Rul. 92-92, 1992-2 C.B. 103.



LENDER'S TAX IMPLICATIONS OF FORECLOSURE1

Jeneé HilliardMiller Nash LLP

Gain or Loss on Exchange or Retirement of Debt. When a loan is paid off or discharged, the lender realizes gain or loss on the transaction equal to the difference between the amount realized and the lender's adjusted tax basis in the loan.2 The amount realized on the transaction is the amount of cash the lender receives plus the fair market value of otherproperty the lender receives.3

Specific Scenarios Short Sale or Foreclosure (Third-Party Buyer). In the event the collateral for a loan is sold,

whether in a short sale or a foreclosure sale where a third party purchases the property, the lender will realize an amount equal to the cash it receives at closing. If the debtor is released from its obligations under the loan in connection with the short sale or foreclosure and the proceeds are less than the lender's tax basis in the loan, the lender will recognize a loss on the transaction equal to its basis in the loan minus the amount it receives at closing and take a bad debt deduction of this amount.4 If the debtor is not released from its obligations under the loanand the proceeds are less than the lender's tax basis in the loan, the Lender will not recognize a loss on the transaction but will apply the proceeds of the sale towards the outstanding principal balance due under the loan and may have a bad debt deduction in the future.

Foreclosure (Lender Purchases the Property). In a foreclosure sale where the lender purchases the property by bidding in the note at the sale, the lender realizes an amount equal to the bid price.5 If the debtor is released from its obligations under the loan in connection with the foreclosure and the proceeds are less than the lender's tax basis in the loan, the lender will recognize a loss on the transaction equal to its basis in the loan minus the bid price and can take a bad debt deduction of this amount.6 If the debtor is not released from its obligations under the loan (i.e. the lender obtains a deficiency judgment against the debtor) and the proceeds are less than the lender's tax basis in the loan, the lender will not recognize a loss on the transaction but will apply the proceeds of the sale towards the outstanding principal balance due under the loan and may have a bad debt deduction in the future. When the lender resells the property, the lender's basis in the property is typically the bid price7 and the lender will recognize gain or loss on the sale equal to the difference between the bid price and the amount realized on the subsequent sale of the property. The gain or loss on the sale of the property will be taxed at ordinary rates unless the lender can show it held the property for investment.

Deed in Lieu. If the debtor gives the lender a deed in lieu of foreclosure, the lender realizes an amount equal to the fair market value of the property on the date of the transfer and, assuming

1 Tax implications of foreclosure and insolvency are complex. This outline is not intended to be an exhaustive discussion of the topic, but an overview of some issues of which to be aware. Additionally, this outline addresses only tax implications to a lender; debtors also need to be aware of tax implications of foreclosure.2 IRC § 1001.3 Treas Reg § 1.1001-2(a).4 Treas Reg § 1.166-6.5 Treas Reg § 1.166-6.6 Treas Reg § 1.166-67 Treas Reg § 1.166-6(c).



the remaining balance is cancelled, the lender can take a bad debt deduction for the amount of debt forgiven. The lender will recognize a further gain or loess on the final disposition of the property.

Bad Debt Deduction What is a Bad Debt Deduction? A lender is allowed a deduction for any debt that becomes

worthless or partially worthless within the tax year.8

When is a Bad Debt Deduction Allowed? A debt becomes worthless or partially worthless when the facts and circumstances indicate that legal action to enforce payment of the debt would probably not result in satisfaction of the debt.9 There is no bright line test to determine when a legal action would probably not result in the satisfaction of the debt. However, it is clear that if the statute of limitations on the debt has expired or the debtor has been discharged from its obligations under the debt through bankruptcy, that the debt is worthless. When the lender is a bank,10 the lender can make an election to have its debts treated as bad debts for tax purposes in the same year that the debts are charged-off for regulatory purposes.11

Character of Gain or Loss on Foreclosure, Short Sale, or Deed in LieuAny gain or loss triggered when a bank sells or exchanges a loan will be ordinary and not capital.12

For lenders other than banks, the gain or loss will be capital if the loan was a capital asset in the hands of the lender.13

Tax Reporting by Lenders Foreclosure. A lender must file a Form 1099-A with the IRS following the foreclosure of

property that secures payment obligations under a loan.14 Form 1099-A must be filed with the IRS no later than March 31 (if filed electronically) and a copy must be delivered to the debtorno later than January 31 of the year following the foreclosure.15

Cancellation of Debt. If a financial institution discharges debt of $600 or more, the institutionmust file a Form 1099-C with the IRS.16 Form 1099-C must be filed with the IRS no later than March 31 (if filed electronically) and a copy must be delivered to the debtor no later than January 31 of the year following the cancellation.17 This informational return must be filed whether the cancellation of debt occurs in the context of a foreclosure, deed in lieu of foreclosure, agreement of the parties, or bankruptcy.18

8 IRC § 166.9 Treas Reg § 1.166-2.10 Defined in Internal Revenue Section 581 as an entity that (a) is incorporated and doing business in the United States, (b) has a substantial part of its business comprised of receiving deposits and making loans and discounts, and (c) is subject to supervision by the state or federal authority having supervision over banking institutions.11 Treas Reg § 1.166-2(d)(3).12 See IRC § 582(c).13 IRC § 1221 (accounts and notes acquired in the ordinary course of the lender's business are not capital assets).14 IRC §6050J (this obligation only applies to a person who makes a loan in connection with that person's trade or business—this is different, and broader, than being in the business of loaning money).15 Treas Reg § 1.6050J-1T.16 IRC § 6050P.17 Treas Reg § 1.6050P-1.18 See Treas Reg § 1.6050P-1(b)(2).



Friday, October 04, 2013

1

October 11, 2013 Jeneé Hilliard

Tax Planning for Real Estate Workouts

Real Estate WorkoutsPage 2

Presentation Outline

• Cancellation of Debt (COD)• Tax Consequences of Foreclosures, Short

Sales, and Deeds in Lieu• Tax Consequences of Loan Modifications




2

Cancellation of Debt (COD)

• Gross income includes discharge of indebtedness (IRC 61(a)(12))

• Gain is realized when the taxpayer has an accession to wealth (U.S. v. Kirby Lumber, 284 U.S. 1 (1931))




• COD = obligation satisfied for less than face value (IRC 108(a))

• COD is ordinary income• Exceptions to recognition of COD include:

– Bankruptcy– Insolvency– Qualified real property business indebtedness– Qualified principal residence indebtedness




3



• Acquisition of debt by related party triggers COD (IRC 108(e)(4))

• In seller financing transaction, if debt is later reduced by the seller, the reduction can be treated as a purchase price reduction instead of COD (IRC 108(e)(5))



• Debt-for-equity exchange – Treated as COD if FMV of the interest

exchanged for the debt is less than the amount of the debt

– FMV of interest = amount the lender would receive if borrower’s assets were immediately sold for their FMV and distributed




4


Is Debt Recourse or Nonrecourse?

For COD purposes, debt is characterized as recourse or nonrecourse, based on state law

Recourse = Lender’s rights are not limited to specified collateralNonrecourse = Lender’s rights are limited to specified collateral = Lender may only seek repayment from a subset of borrower’s assets



• Partial debt forgiveness = COD regardless of recourse or nonrecourse nature of loan

• Cannot have COD for total cancellation of nonrecourse debt




5

COD Example

• Borrower owes $100 to lender; secured by real estate worth $75; lender reduces loan to $75

• Result = $25 of COD• Same result if recourse or nonrecourse.

(Rev Rul 91-31)



Foreclosure Mechanics

• Lender forecloses trust deed• Nonjudicial = no deficiency • Judicial = deficiency allowed on

commercial loans, but very limited for residential trust deeds

• Party acquiring property at the foreclosure auction is treated as buyer




6

Foreclosure — Fair Market Value

• FMV is deemed to = auction price• FMV determines partial pay-down of

loan, if remaining debt not cancelled• FMV determines gain, loss and/or COD

if remaining debt cancelled and debt is recourse debt

• FMV is irrelevant if the debt is nonrecourse



Deed in Lieu Mechanics

• Borrower conveys property to lender in lieu of foreclosure

• Remaining debt not automatically cancelled




7


Deed in Lieu — Fair Market Value

• FMV = FMV of property at time of the conveyance

• FMV determines partial pay-down of loan, if remaining debt not cancelled

• FMV determines gain, loss and/or COD if remaining debt cancelled and debt is recourse debt



Short Sale Mechanics

• Borrower sells property to buyer and lender reconveys trust deed

• Remaining debt not automatically cancelled




8


Short Sale — Fair Market Value

• FMV = price buyer pays• FMV determines partial pay-down of

loan, if remaining debt not cancelled• FMV determines gain, loss and/or COD

if remaining debt cancelled and debt is recourse debt



Nonrecourse Debt




9


Nonrecourse Tax Planning

• Taxes not dischargeable in bankruptcy• Use carryover losses or trigger losses to

offset gain• Exception to gain (e.g., personal

residence, 1031)• If a loss results, can the loss be used?• Convert to a recourse loan• Carry losses back to offset prior income


Recourse Debt




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Recourse Tax Planning

• Document FMV in a borrower-friendly manner

• Use carryover losses or trigger losses to offset gain

• Exception to gain (e.g., personal residence, 1031)

• If a loss results, can the loss be used?• Carry losses back to offset prior income• Does a COD exception apply (e.g., bankruptcy,

insolvency)


Foreclosure—Example 1 - Agreed upon FMV

Facts• Lender is foreclosing• Recourse debt of $500• Tax basis of $300• Lender estimates FMV of $150• Borrower believes FMV is $250




11


Foreclosure—Example 1 – Agreed upon FMV

Opportunity• Give deed in lieu if lender will agree that

FMV is $250• $250 of COD income instead of $350• $50 capital loss instead of $150


Foreclosure—Example 2 - Insolvency

Facts• Recourse debt of $500; tax basis of

$300; and FMV of $280• Foreclosure will generate $220 of COD

and $20 loss• Borrower is insolvent by $150, but

expects to be solvent in 2014




12


Foreclosure—Example 2 - Insolvency

Opportunity• Grant deed in lieu if lender will agree to

cancel remaining debt and accept deed in lieu in 2013

• Ensures exclusion of $150 of COD income when borrower is insolvent


Foreclosure—Example 3 (Partnership)

Facts• ABC LLC owns property subject to $90

recourse loan with FMV of $60 and a basis of $80

• ABC LLC is insolvent by $60• Parters of ABC LLC are solvent• Lender forecloses on property and issues

1099-C for $30




13


Foreclosure—Example 3 (Partnership)

Result• $30 of COD ($90 debt - $60 FMV)• $20 capital loss ($80 basis - $60 FMV)• Each member of ABC LLC is allocated

their share of the $30 COD and $20 capital loss

• Insolvency exclusions for COD do not apply


Foreclosure—Example 4 (Qualified Business Real Property)

Facts• Lucky LLC’s loses its real property used

in its trade or business in foreclosure• Property sold for $300• Debt equals $350• Basis of property equals $400




14


Foreclosure—Example 4 (Qualified Business Real Property)

Result• 1099-C issued showing $50 COD• COD flows through to LLC members• Members may elect to exclude the COD

because it was qualified real property indebtedness and decrease basis in their depreciable property

• Loss of $100 flows throughto members


Foreclosure—Example 5 (Purchase Money Debt Reduction)

Facts• Takeback LLC purchases property

($0 cash and $200 seller financing)• LLC defaults on loan• Seller agrees to reduce principal due

under note to $150




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Foreclosure—Example 5 (Purchase Money Debt Reduction)

Result• LLC’s members can agree to treat the

debt reduction as a purchase price adjustment

• Instead of receiving $50 of COD income, the LLC is treated as having a $50 purchase price reduction and corresponding reduction in the basis in the property


Foreclosure—Lender’s Tax Consequences

• Bad debt deduction• Gain if FMV exceeds tax basis in loan• Reporting to IRS on 1099-A or 1099-C• Ongoing consequences of real estate

inventory




16


Foreclosure—1099 Issues

• 1099-A issued by lender in foreclosure or deed in lieu

• 1099-C issued by lender when debt is cancelled (identifiable event)–Uncollectable by law (bankruptcy

discharge, statute of limitations, and nonjudicial foreclosure)

–Agreement to discharge–Decision by creditor to

discontinue pursuing debt collection


Loan Workouts

• Loan workout = taxable exchange of old debt for new debt, if the workout involves:– A modification to the debt instrument; and – The modification is significant

• Compare value of old debt to value ofnew debt to determine if there is COD(Treas Reg §1.1001-3)




17


Loan Workouts

In general, if: • principal due under new note = principal

due under old note; and • interest on the loan exceeds the

Applicable Federal Rate (AFR)The old note should equal the value of the new note


Loan Workouts—Is there a Modification?

What is a modification?• Any alteration of a legal right or

obligation of the issuer or the holder of a debt instrument

• Can be written, oral, or course ofconduct

• “Hair trigger” definition




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Loan Workouts—Is Modification Significant?

• Change in yield more than the greater of (a) ¼% or (b) 5% of the annual yield

• Payments deferred the lesser of more than 5 years or ½ of the original term

• Change in obligor• Change in security


Loan Workouts—Is Modification Significant?

• Facts and circumstances test• Significant modification = legal rights

and obligations are altered such that they are economically significant




19


Loan Workouts—Example 1

Original Loan• $900 current principal amount• 6% interest• 10-year termModified Loan• Interest rate lowered to 5%



Result• Modification is significant (yield

changed more than ¼% and more than 5% of annual yield)

• No tax consequences (face value of new loan equals face value of old loan and interest exceeds AFR)




20



Original Loan• $900 current principal amount• 6% interest• 10-year termModified Loan• Change interest rate to 1%• Current AFR is 3.5%





• COD income equals $262 (new loan OIP is $638, which is present value of $900, for 10 years at AFR)




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Original Loan• $900 current principal amount• 12% interest• 10-year term • Lender sold loan to new lender for $600Modified Loan• Change interest rate to 5%





• Lender has taxable gain (OIP of new loan is $900, but lender’s basis is $600)

• Lender’s gain equals $300• Borrower does not have gain or loss




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Recap

• Loan modifications—don’t let the tax consequences catch you by surprise

• Foreclosures—don’t let the tax consequences catch you by surprise

• There are tax planning opportunities, and it might be worthwhile for your clients to explore these options before signing any deals


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