Leveraged partnerships have been one of the few remaining techniques to dispose of unwanted businesses. A recent Tax Court decision has raised questions about the continued viability of this technique. Even more disturbing is the court’s view of the role of opinions in corporate business transactions.

The tax law often looks to the economic substance of a transaction—rather than its form—to determine its proper tax treatment. Thus, if a taxpayer transfers appreciated property to a partnership and receives back cash from the partnership, the law treats the transaction as a “disguised sale.” The regulations provide an exception to this result, however, where the cash is a distribution of partnership debt; in that case, the partner would recognize gain only to the extent that the amount distributed exceeds the partner’s basis in its partnership interest.

Taxpayers have used this exception to defer (but not eliminate) gain. For example, A and B form a partnership, with A contributing appreciated assets and B contributing a small amount of cash. The partnership then borrows money from a bank and A guarantees the debt in some way. A’s guaranty causes the basis in A;s partnership interest to increase by the amount of the debt guarantee. The partnership then distributes the borrowed cash to A some or all of which is tax free. A would generally recognize the deferred gain no later than when A exits the partnership. Clearly, the difficulty in these cases is to effectively allocate the debt to A’s tax basis while minimizing the impact on A’s balance sheet.

In Canal Corp. v. Commissioner, 135 T.C. No. 9 (Aug. 5, 2010), the taxpayer, Chesapeake Corporation (“C”), used a leveraged partnership structure to transfer control of its tissue paper subsidiary, WISCO, to Georgia-Pacific (“G-P”). The partnership borrowed $755 million from Bank of America and distributed the proceeds to C. G-P guaranteed the debt, but WISCO agreed to indemnify G-P for any principal payment G-P might have to make under its guaranty. C believed that the indemnity was sufficient to allocate the debt to C, thereby making the cash distribution tax free.

The Tax Court disagreed, relying on an anti-abuse rule that disregards a partner’s obligation to make a payment if the facts and circumstances (1) indicate that a principal purpose of the arrangement is to eliminate the partner’s risk of loss or to create a façade of the partner’s bearing the economic risk of loss, or (2) evidence a plan to circumvent or avoid the obligation. The court disregarded the indemnity because (1) G-P did not require the indemnity; (2) WISCO, not C, was the indemnitor; (3) WISCO was not required to maintain sufficient net worth to pay the indemnity; (4) the indemnity covered only the loan’s principal, not interest; and (5) G-P was required to proceed first against the partnership’s assets before demanding indemnification. These factors convinced the court that the indemnity was designed to avoid WISCO’s payment of the obligation.

While increasing the risk of leveraged partnerships significantly, this decision may be viewed more as a result of poor planning and structuring than a categorical rejection of the technique. A more disturbing element of the case, however, is the Tax Court’s imposition of a penalty even though C had obtained a “should” opinion on the transaction from PricewaterhouseCoopers (“PwC”).

The court concluded that C’s reliance on the opinion was unreasonable for several reasons:

• The opinion entered into evidence by C was a “draft”, not a final opinion;
• The draft opinion was “littered with typographical error, disorganized and incomplete”;
• C paid PwC a flat fee for the opinion so PwC was paid the same amount regardless of how much time was spent on it;
• The opinion was “riddled with questionable conclusions and unreasonable assumptions”; and
• PwC issued a “should” opinion even though no authority on point existed.

Most disturbingly, the court believed that C did not act with good faith in relying on PwC’s opinion because PwC had an “inherent conflict of interest” as C’s auditor and as the advisor that structured the transaction “without the normal give-an-take in negotiating terms with an outside party.”

Does this case mean that a taxpayer should never rely on an opinion prepared by an advisor that planned the transaction? Such a conclusion may be going too far, given the unusual facts surrounding PwC’s opinion in this case. Nevertheless, after Canal Corp., prudence might dictate that taxpayers should ensure that they receive opinions from disinterested objective advisers whenever possible.

This document was not intended or written to be used, and it cannot be used, for the purpose of avoiding U.S. federal, state, or local tax penalties.

Written by: Jessica Dorsett, CPA

In our accounting classes, we learn about fixed assets.  Problem is the book examples were way too theoretical and simple.  It’s important to start out simple when learning, I get it, I was there and you have to start out slow.  However, in real life, it’s NEVER cut and dry.  Here are a few items to think about when you think you might have a fixed asset to record.

The text book says to look for these major characteristics of a fixed asset:

• “Used in operations” and not for resale (basically, not inventory)
• Long-term in nature and usually depreciated
• Possess physical substance

Easy enough, but then there are other factors to consider:

• What is the company’s capitalization policy?  Meaning, at what dollar limit do you record an asset rather than expense it?  A common limit for small businesses is $1,000.  Therefore, if you buy a desk for $500, you will expense it because it doesn’t meet the capitalization threshold, even though everything about it says “fixed asset”.
  • What if I bought two desks at the same time for a total of $1,000? It depends on your policy.  While it needs to be reasonable, you have some flexibility when creating your capitalization policy.  However, make it as clear as possible so that your bookkeeper doesn’t have to second guess every purchase.
• Did you buy the asset or lease the asset? If you paid cash, no worries.  If you took out a loan, still no worries (see warning in next point).  If you are leasing the asset, then you have to look a little closer.  You must determine if you entered into an operating lease or a capital lease.  If you entered into a capital lease, you treat it as if you purchased the asset like you would with a loan.  If it’s an operating lease, then you don’t record the asset.
• I took out a loan to buy an asset. When you buy an asset with a loan, you only record the asset for the purchase price (which may be the principal amount of the loan if you didn’t have a cash down payment or trade in).  You do not include future interest payments.  Interest payments are period costs and are expensed when paid. The only time you include interest with the cost of an asset is if you are constructing the asset yourself with loan money (see next point).
• I’m making my own asset, rather than buying it already made.  You need to include the cost of labor and materials – that is a given.  In some circumstances, you might include overhead.  If you took out a construction loan, then you have to include some interest costs.  BE CAREFUL with the interest costs, this can be a difficult calculation.

Then you have the tax consequences.  When you capitalize the asset, the cash goes out, but you don’t get the immediate tax deduction for the purchase.  The exception is with the Section 179 expense which allows you fully depreciate (or in a sense, expense) an asset in the year of purchase if certain requirements are met.

If you work in two different states, you will file a tax return in both the states. One state is your Home Tax State with the other state being where you were/are a  part year resident. Or as I get a lot of  here in Kansas City, You live in one state and work in another. In some cases, you may have even more states.   

 Last year I had a client (new) that lived in one state and worked in five states.   

•  (Interestingly enough that particular client had one W-2 and the employer withheld for all five states – Self-filers, would you know how to work that out?)

In the state that is not your tax home, you are part year resident or a non-resident; you report income you earned while in that state, to that state. If you have received only one W-2 from your employer, then use simple arithmetic based on number of days spent in the state to figure out the income that you should report to that state.   

•  (Of course, that in itself brings up a really interesting taxing issue. You paid your home state taxes that should have gone to the other.)

•  Colorado - 4.63% 
• Illinois – 3% 
• Indiana – 3.4% 
• Massachusetts – 5.3% 
• Michigan – 4.35% 
• Pennsylvania - 3.07% 
• Utah – 5%. 

(The above rates may have changed) 

  Moving After Retirement 

 If you are getting retirement benefits and you move/d from a state with no income tax to a state with income tax, then you must pay state income tax even on your retirement benefits.

 Non-resident Aliens and Exempt Individuals  

 States define tax residence differently than the IRS does at the federal level. At the state level, there are generally three types of people:   

• Residents,
• Part-year residents and
• Non-residents

The determination of residence tends to be based on the time of year an individual moved into or out of a state, or if they lived there all year. It is entirely possible that a non-resident alien is considered a resident for tax purposes at the state level several years before they are considered a resident for federal tax purposes.    

Some states honor the federal tax treaty benefits. States the do not honor federal treaty benefits are Alabama, Arkansas, California, Connecticut, Hawaii, Kansas, Kentucky, Mississippi, New Jersey, North Dakota and Pennsylvania.  

 It has been my experiences that if a taxpayer has a tax year where they need to file in more than one state, it is best if you visit with a tax professional to be sure you have all the information you need to file all the returns correctly. Of course, I recommend that any tax payer filing their own return visit with a tax professional to talk over their situation. Your situation might not have changed but the rules almost assuredly have.

There are three major financial statements – the profit & loss, the balance sheet, and the statement of cash flow.  The balance sheet is what drives the cash flow of the business. 

The balance sheet is an important financial-analysis and reporting tool that outlines the assets, liabilities and equity of the company at the end of the accounting period. If the balance sheet is not correct, then the cash flow forecast is most likely inaccurate and worthless. 

Unfortunately the balance sheet is what is usually the most neglected and least understood.

In an effort to help get the balance sheet forecasting correct, here are some common mistakes that entrepreneurs, CEOs, business owners, and even business financial consultants regularly make:

The most common mistake made is not having a balance sheet.  The balance sheet represents the most complex transactions of the company and may be left out because the company lacks the expertise of a CFO (Chief Financial Officer) or a firm with CFO services to assemble this critical part of the three major financial statements needed.

The major operating assets include accounts receivable, inventory, pre-paid items, and much more.  The major operating liabilities include accounts payable, taxes payable, and other accrued expenses.  When sales go up, accounts receivables go up, and cash goes down.  However, does your information show that?  If sales go up, can we expect our inventory level to stay the same?  Most likely it will need to increase.  The increments of these changes are dependent upon the relationship between the days sales outstanding and your inventory turnover. 

As sales increase, your accounts payable usually increase as well.  The timing of your payments against your accounts payable is a major outflow in the cash flow puzzle that is called working capital.  We need to define the relationship that payables have with your operating activities and implement this relationship in your balance sheet. 

There are several other operating assets and liabilities that dramatically influence cash flow.  I’ll avoid all of the details of each, but it is fair to say that without properly forecasting them, your cash flow forecast will never be accurate.

Are we bringing in any more equity investments during the period?  What is your dividend policy for shareholders?  Is some or all of the active shareholders compensation coming through equity?  All of these items can have a significant impact on cash flow, although none of them show up on the P&L. 

In addition to equity transactions, the structure of all of the company’s debts and obligations need to be correctly reflected. This is done on the balance sheet.  An interest only line of credit will keep the same balance until more is withdrawn or some is paid back based on the cash flow of your business.  Term loans need to show the correct amount of principal being reduced every month. 

Obviously these items can seriously change your cash flow, and they need to be included in the financial model so you can correctly forecast your cash flow.

Above are a few common mistakes, certainly not all-inclusive (you’ll notice I did not address capital expenditures at all), but should help create a positive foundation to build the balance sheet. 

L & R Tax Preparation offers CFO services. We have helped our clients get a handle on their companies, make the best strategic decisions possible, raise necessary capital, and perhaps most importantly, track their progress so they can correct problem areas and make more valid assumptions in the future.

You must file a tax return if your income is above a certain level. The amount varies depending on filing status, age and the type of income you receive.

Check the Individuals section of IRS.gov or consult the instructions for Form 1040, 1040A, or 1040EZ for specific details that may affect your need to file a tax return with the IRS this year.

Even if you don’t have to file, here are eight reasons why you may want to file:

1. Federal Income Tax Withheld If you are not required to file, you should file to get money back if Federal Income Tax was withheld from your pay, you made estimated tax payments, or had a prior year overpayment applied to this year’s tax.
2. Making Work Pay Credit You may be able to take this credit if you have earned income from work. The maximum credit for a married couple filing a joint return is $800 and $400 for other taxpayers.
3. Government Retiree Credit You may be eligible for this credit if you received a government pension or annuity payment in 2009. However, the amount of this credit reduces any making work pay credit you receive.
4. Earned Income Tax Credit You may qualify for EITC if you worked, but did not earn a lot of money. EITC is a refundable tax credit; which means you could qualify for a tax refund.
5. Additional Child Tax Credit This credit may be available to you if you have at least one qualifying child and you did not get the full amount of the Child Tax Credit.
6. Refundable American Opportunity Credit This education tax credit is available for 2009 and 2010. The maximum credit per student is $2,500 and the first four years of postsecondary education qualify.
7. First-Time Homebuyer Credit The credit is a maximum of $8,000 or $4,000 if your filing status is married filing separately. The credit applies to homes bought anytime in 2009 and on or before April 30, 2010. However, you have until on or before June 30, 2010, if you entered into a written binding contract before May 1, 2010. If you bought a home after November 6, 2009, you may be able to qualify and claim the credit even if you already owned a home. In this case, the maximum credit for long-time residents is $6,500, or $3,250 if your filing status is married filing separately.
8. Health Coverage Tax Credit Certain individuals, who are receiving Trade Adjustment Assistance, Reemployment Trade Adjustment Assistance, or pension benefit payments from the Pension Benefit Guaranty Corporation, may be eligible for a Health Coverage Tax Credit worth 80 percent of monthly health insurance premiums when you file your 2009 tax return.

For more information about filing requirements and your eligibility to receive tax credits, visit IRS.gov.

Links:

• Forms and Publications
• Earned Income Tax Credit
• First-Time Homebuyer Credit Information Center
• Health Coverage Tax Credit
• 1040 Central

The Schedule is deceptively simple. For the current tax year and past tax years, Parts I and II respectively ask for the following information for each uncertain tax position:

For example, the question “Are severance payments subject to FICA taxes?” ought to have a simple “Yes” or “No” answer. Unfortunately, as two recent court decisions illustrate, the answer is unclear. But, as is often the case, this very uncertainty can provide the possibility of saving money for taxpayers.

The Tax Code imposes a tax on “wages” to fund both Social Security and Medicare. (Both employers and employees are subject to the tax.) It has long been clear that certain “supplemental unemployment benefits” (“SUB”) payments are not “wages” for FICA purposes. To qualify as a SUB, the payment must (1) follow the involuntary separation of the employee; (2) supplement state unemployment benefits; (3) not be made in a lump sum; (4) be based on the employee’s seniority and not on the rendering of any services; and (5) provide that no employee has any interest in the fund paying the benefits until the employee is eligible to receive benefits. The IRS takes the position that payments that do not meet these requirements—including most severance payments—are wages and thus subject to FICA taxation.

In February, 2010, however, a U.S. District Court in United States v. Quality Stores held that severance payments that were not SUBs were nevertheless not wages for FICA tax purposes. The payments in that case were made to employees under the company’s severance plans; the severance resulted directly from a reduction in force or discontinuing a line of business, were not connected to the receipt of state unemployment compensation, were not based on providing any employment service, and some of the payments were made in a lump sum. The court concluded that the payments were not subject to FICA taxes.

The decision in Quality Stores is directly contrary to a 2008 decision of the U.S. Court of Appeals for the Federal Circuit in CSX Corporation v. United States. In that case, the court held that severance payments not qualified as SUBs were wages and thus subject to FICA taxes.

The government views CSX as controlling and has filed an appeal in Quality Stores. Nevertheless, some taxpayers have filed refund claims to ensure that they retain their right to a refund should the Quality Stores decision ultimately be upheld. While the IRS is currently disallowing these claims, taxpayers who have made severance payments during taxable years open under the applicable statute of limitations should seriously consider filing refund claims to protect their (and their consenting employees’) rights.

This document was not intended or written to be used, and it cannot be used, for the purpose of avoiding U.S. federal, state, or local tax penalties.

The American Jobs and Close Tax Loopholes Act of 2010 (aka Tax Extenders Bill) passed the House on May 28, 2010 quickly. In fact, so quickly that there wasn’t a lot of time for the lobbying groups to rally protests.

The bill extended unemployment compensation, various tax deductions and credits, changed the way interest charge was taxed and made all S Corporation income subject to self-employment tax.

There has been a lot of news about the extenders and the interest charge, but not as much about the S Corporations. The biggest problem is that this is a regressive tax. If you have an S Corporation and make over the Social Security limit, you’ll only pay an extra 2.9% tax. If you make under, though, like many small business owners do, you’ll pay an extra 15.3% tax. To further add insult to injury, big S Corporations with more than 3 shareholders were exempted. So, it’s just the smaller S Corporation owners who would get hammered with this tax.

The Bill hasn’t gone so smoothly through the Senate, though. In fact, the Bill failed to pass Wednesday, June 16, 2010. The Senate Finance Committee has come back with a welcome change for S Corporations.

There are two significant changes out of the Senate Finance Committee:

(1) Non-active income does not become subject to self-employment tax just because it’s held in an S Corporation.

This language change was critical. It was crazy to think that suddenly rental income would be considered active income because of the entity you used, for example.

(2) An S Corporation is exempt if more than 21% of the professional activity income comes from someone other than the shareholders (provided there are only 3 or less shareholders).

The big biz S Corporations still have their out, but now S Corporations have one too. If they have employees or outside contractors who provide more than 21% of the income, then they are exempted as well.

The ones still stuck in all of this will be professionals who work by themselves or with just an assistant, who doesn’t actually bring in income.

And, of course, the bill flies in the face of the promises to only tax the rich. This is a bill that is specifically targetted at the non-rich, who may see their taxes going up by 80% or more next year if it passes the Senate and the House approves the changes.

The IRS has been making changes to the Electronic Filing Mandate that originated in H.R. 3548 as  predicted when it first came out.

At this point in time they are saying for this next tax season they “anticipate” asking requiring preparers who do 100 or more returns to file electronically and then lower that threshold to 10 for the next filing season.  They are doing this because they expect low volume preparers may need more time to get signed up and familiar with the process.  They will also be looking at a waiver process so if there is an extreme hardship for a tax preparing firm they may obtain extra time to get into compliance.  They are also stating that taxpayers may need some convincing so if a tax client wishes to opt out there may be a way to do so. 

As you can tell there is a lot of “supposes” and “may be’s” in this statement……the IRS isn’t completely finished with what they are planning for this next tax season.  As I hear more, I’ll make sure to update everyone.I see this as one of many upcoming changes designed to eliminate competition from those large Fast food chain preparer shops.

Stay clear of those who have limited training (all of up to six weeks for one), choosing a qualified preparer is more important than find the cheapest one.

Written by: Jessica Dorsett, CPA

Congress passed the HIRE Act into law March 2010.  This is a credit of 6.2% of the qualifying social security wages (essentially the employer’s portion of the tax) for the remainder of 2010 on qualifying new employees.  If a payroll company prepares your payroll, please check with them to make sure you have all the information they need.

If you prepare payroll in house, be careful, there are some changes to the quarterly form 940 as well as the payroll deposits.

Here are the criteria for qualifying new employees:

1. The employee must be hired after February 3, 2010, and prior to January 1, 2011;
2. The employee has been out of work for at least 60 days prior to being hired (and did not work more than 40 hours during those 60 days);
3. The employee cannot be related to the employer;
4. The employee is not hired to replace another employee unless the former employee quit or was let go for cause (basically you can’t fire everyone just to hire new people to take advantage of the credit)

If you retain the employee for at least 52 weeks, you may also be eligible for up to $1,000 as a general business tax credit.

It’s worth noting that the employee does not have to be a full time employee.  Part time employees and seasonal employees qualify.  If you hire for the summer busy season or you are a farmer who hires for the harvest, those employees may qualify if they meet the four criteria listed above.

As always, see a professional if you have any questions.