By Ryan Bartholomee, CPA
With the battle for talent in Texas due in large part to the thriving oil and gas industry and supporting industries, employers have to be creative in how they attract, retain and motivate experienced talent. Some employers may consider providing ownership opportunities in an affiliated entity to key employees in exchange for services contributed. In the case of an LLC taxed as a partnership, a profits interest could be provided in which the employees could share in the future profits and appreciation in value of the LLC going forward after the interest was granted (if fully vested). In general, receiving a profits interest is not a taxable event (see Rev. Proc. 93-27, clarified by Rev. Proc. 2001-43 for additional information regarding exceptions). Making an IRC section 83(b) election (discussed further below) after receiving a profits interest may still be recommended despite these safe harbor rules so as to protect against the violation that would occur from disposing of the profits interest within two years of receipt.
In contrast to a profits interest, a capital interest entitles the member to receive the proportionate share of the net proceeds of a complete liquidation of the LLC as of the grant date (if fully vested). If a capital interest is earned by the employee and a vesting period is applied, then an IRC section 83(b) election might be worth considering. This election has to be made within 30 days of receiving the capital interest even though the vesting has not yet occurred. It allows the member of the LLC to pay tax on the full fair market value of the membership interest as if it was entirely vested at this time. This is beneficial if the LLC’s assets (such as undeveloped leasehold costs) have a significantly lower value at that time than they are expected to have in the future after assets are developed.
For example, if a membership interest (a capital interest in this case) of 1 percent was granted with a five-year vesting period to an employee, the employee could make a section 83(b) election within 30 days. Let’s say the capital interest had a value of $100,000 (with assets made up largely of leasehold costs associated with undeveloped leases) after discounts for lack of marketability and lack of control. The employee would need to pay ordinary income taxes on the $100,000. If, after five years, the 1 percent capital interest was worth $500,000, then the employee would have paid taxes on $100,000 in order to eventually receive an asset worth $500,000. There are obviously significant assumptions and risks to consider when evaluating this election. Remember that time is of the essence in making an 83(b) election. The 30 days passes quickly. Consistent communication with your clients and knowledge of their plans early on could help these members make wise tax-planning decisions. This could ultimately prevent the LLC in this example from having to distribute too much cash to its members for tax purposes during a phase when capital for asset development is critical.
For definitions and a comparison of capital interests versus profits interests, please see the following link on the IRS website: http://www.irs.gov/publications/p541/ar02.html.
By Miguel Reyna, CPA
Normally, we all treat stock distributions as taxable in the year received. However, my firm recently met with a client in a situation where the taxation of the stock distribution was deferred to the next year. This is a technical example that is not seen every day, but it is an interesting example that CPAs may find handy.
The taxpayer received a 2012 Schedule K-1 from an LLC taxed as a partnership. This Schedule K-1 reported $1 on lines 6a ordinary dividends and 6b qualified dividends. Line 19A distributions indicated $1 in cash distributions. Line 19C distributions indicated $223,395 in other property distributions.
The partner footnotes included:
"A distribution of the above number of shares of ABC company stock distributed to you in liquidation of your interest in XYZ, LLC. Please see the accompanying letter for additional information on determining your tax basis and holding period in the aforementioned shares.”
The accompanying letter states:
"It appears that the member owned only Class B Units in XYZ, LLC and as such, the member should have zero tax basis in these units as these units represent profits interests issued for services for which IRC Sec. 83(b) elections were made at issuance. As such, it would appear that the member should receive zero tax basis in the distributed shares of ABC.
Under IRC Sec. 735, the member's holding period for the distributed shares of ABC is deemed to begin on Jan. 18, 2007, which is the same date that XYZ, LLC's holding period began. This date should be used as your acquisition date for the distributed shares of ABC for purposes of determining your holding period irrespective of the date(s) you were issued units in XYZ, LLC.”
Generally, under IRC section 731 (c), a marketable security like the described stock distribution on the taxpayer's Schedule K-1 is taxed in that year. A significant exception to section 731(c) is the exception for "investment partnerships." Section 731(c) does not apply to the distribution of marketable securities by an investment partnership to an "eligible partner." A partnership qualifies as an investment partnership if it has never engaged in a trade or business and substantially all of its assets have always consisted of certain specified assets, including money, stock, bonds, notes, plus some other very specific assets.
XYZ, LLC is deemed to be a qualifying investment partnership and has met the exception to IRC section 731(c). This allows the taxpayer receiving the distribution of shares to not pay taxes when received in 2012, but in the year when they are sold. The taxpayer was then able to wait until the share’s fair market value increased in 2013 before selling the shares at a higher profit than if the shares were sold in 2012.
This sale qualifies for long-term capital gain treatment.
In the U.S., bitcoin has become a regulatory hot potato, attracting the attention of a number of federal agencies trying to figure out their particular level of responsibility. The accounting profession needs to watch how the regulatory activity develops going forward. See article from Today’s CPA. TSCPA’s Federal Tax Policy Committee is considering drafting comments to IRS Notice 2014-21 on the treatment of virtual currency. Today's CPA article
The Texas Society of CPAs asked our members of the House of Representatives to sign a bipartisan letter by Congressmen Brad Schneider (D-IL), Blaine Luetkemeyer (R-MO), Mike Quigley (D-IL), and Richard Hudson (R-NC) opposing the cash accounting changes originally proposed in Chairman Dave Camp’s Tax Reform Act of 2014. The letter is addressed to the House leadership and urges that they preserve the cash method for partnerships, pass-through entities, personal service companies, farmers and ranchers. TSCPA’s federal key persons also contacted their legislators to encourage support for this important issue.
by Tom Ochsenschlager, CPA, J.D.
In Schaeffler v. United States, Case No. 1:13-cv-04864 (S.D.N.Y. May 28, 2014), the U.S. District Court for the Southern District of New York took a narrow view of the taxpayer’s right to assert privilege regarding an opinion letter it had received from its accountants. The court found that the memorandum did not satisfy the requirements of the attorney-client privilege generally available for communications from a federally authorized tax practitioner because, under the facts of the case, the “opinion” had been shared with a financial institution that had an economic but not a “legal” interest in the transaction.
The court also found the “opinion” was not privileged under the work product doctrine because there was no specific reference to litigation in the memorandum. In effect, the court took the position that the memorandum would be privileged only if it had been in response to current or anticipated litigation.
Although the court has delayed the IRS’s access to the opinion pending Schaeffler’s appeal to the Second Circuit, in the meantime we should be certain that opinion letters are not shared with anyone outside the client regardless of their economic interest in the transaction and that the opinion letter is drafted with language referring to the possibility that the IRS may litigate the issue.
by Tom Ochsenschlager, CPA, J.D.
The Tax Court, in a reviewed decision, found that the hours of work performed by trustees who were also full-time employees counted in determining whether the trust was materially active in the trade or business under the passive loss rules (Frank Aragona Trust v. Commissioner, 142 T.C. No. 9). Accordingly, the losses generated by the trust were passed through to the beneficiaries of the trust and not suspended under the passive loss rules. Perhaps of equal importance is the fact that, had the trust been profitable, the income passed through to the beneficiaries would not have been subject to the net investment income tax in the event their adjusted gross income had exceeded the threshold for that implementation.
While this case is important, it does leave some questions unanswered. The IRS in arguing the case had only challenged whether a trust could be materially active in the business as a real estate professional. It did not challenge whether the trustees, in their capacity as employees, had met the 50 percent of personal services performed and the 750 hours of services thresholds. It appears in the facts of the case that only three of the six trustees were full-time employees. The other three were not active in the business. (One of the trustees was disabled, another was a practicing attorney and a third was a financial institution.) Had the IRS challenged the level of activity of the trust as a composite of all the trustees, the case conceivably could have come out differently. Accordingly, where the trust includes a trustee that is not materially active, discretion is advised in taking a tax return position.
By William R. Stromsem, CPA, JD
The IRS has published final regulations related to practice before the IRS, amending Circular 230. The final amended Circular 230 will be available in a few weeks.
In general, the IRS has not made many changes from its proposed regulations and specifically declined to make an important change recommended by the Texas Society of CPAs’ Federal Tax Policy Committee. New section 10.37 regarding covered written opinions changes the burden of proof for whether assumptions used in the opinion are reasonable. In the past, former section 10.37(a) prohibited a practitioner from basing advice on unreasonable factual or legal assumptions. This placed the burden of proof on the IRS to prove that the assumptions were unreasonable. New section 10.37 requires that practitioners base opinions on reasonable facts and legal assumptions, shifting the burden of proof to the practitioner, with the IRS only having to assert that the assumptions were unreasonable. The TSCPA committee raised this issue in comments on the proposed regulations, but the IRS specifically rejected its comment saying that it did not believe this was a substantive change, and that the amendment, “is part of the larger effort undertaken in these regulations to affirmatively state the requirements and standards for practitioners rather than merely specifying prohibited conduct. Treasury and the IRS also disagree that a reasonableness standard is too burdensome.” Note that although the IRS believes the standard is not too burdensome, it nevertheless shifted the burden.
Other changes include:
Today, the Texas Society of CPAs asked Senator John Cornyn and Reps. Sheila Jackson Lee (D-18) and Pete Sessions (R-32) to cosponsor H.R. 1129/S. 1645, the Mobile Workforce State Income Tax Simplification Act. Both Jackson Lee and Sessions cosponsored the House bill that passed by voice vote last year, but stalled in the Senate. The Mobile Workforce bill would establish a uniform national standard governing the withholding of state income taxes for non-resident employees. It would not apply to professional athletes, professional entertainers, and certain public figures.
With final Circular 230 regulations out now, the IRS officially eliminated the previous section 10.35 on covered opinions that caused a ubiquitous disclaimer at the end of so many emails, newsletters, and other communications. Preparers can still include some sort of email notice for liability purposes, but the IRS clearly wants everyone to remove the boilerplate language that falsely asserts a tax advice disclosure pursuant to Circular 230 (or U.S. Treasury or the IRS). Karen Hawkins, director of the IRS Office of Professional Responsibility, told practitioners at a tax conference, “I'm here to tell you to get that jurat, that disclaimer, off your e-mails. It's no longer necessary.” Hawkins clarified during a recent webcast that if you are giving tax advice, it’s not a bad idea to use a disclaimer based on fact. However, continued inclusion of a standard disclaimer would be considered a misstatement. (The IRS reassigned section 10.35 provision to cover competence.)