Accounting Methods & Periods

Installment Sales: Allocation of Installment Payments

In certain circumstances the installment sale method permits a sale of property without the seller being required to report the gain until the actual receipt of payment. The rules governing installment sales are well defined, and the gain deferral achieved through installment sale treatment enables the seller, in certain circumstances, to spread gain over the period of installment payments based on the proportion that the gross profit on the sale bears to the contract price. Agreements between buyer and seller to specifically allocate installment payments can maximize tax deferral.

To be eligible for installment sale treatment, at least one payment must be received after the close of the tax year in which the sale occurs (Sec. 453(b)(1)); however, not all transactions involving deferred payments qualify for installment sale treatment. There are a number of ineligible transactions, including transactions where:

In addition, Sec. 453 does not permit deferral of depreciation recapture when Sec. 1245 recapture applies to assets sold on installment (Sec. 453(i)).

When a taxpayer sells or exchanges several items of property for an aggregate price that includes installment payments, an allocation of purchase price as well as a specific allocation of particular installment payments is often advantageous. When a taxpayer sells assets comprising a business at a gain and all payments are not received in the year of sale, unless the taxpayer elects otherwise, the gain is required to be reported based on the installment method of accounting. However, tax deferrals in situations in which a number of assets are sold for an aggregate price can be limited when the assets include a variety of tax characteristics—i.e., inventory, items sold at a loss, and other items ineligible for installment sale treatment. An agreement between the parties specifically allocating installment payments to particular assets can maximize tax deferral.

To maximize the installment sale tax deferral, buyer and seller should negotiate an agreement on the allocation of particular installment payments to particular assets. Rev. Rul. 68-13 states that

the sale of a business must be “comminuted into its fragments” where either the selling price or the down payment, or both of them, is separately stated with respect to different assets or types of assets in the agreement of sale. . . . [S]eparate computations must be made to the extent necessary with respect to each asset. . . .

The allocation of early payments to inventory, assets sold at a loss, and other items for which installment reporting is unavailable will maximize the seller’s gain deferral.

Failure to draft installment sale agreements detailing the allocation of installment payments among assets limits the tax deferral achieved from the installment method of accounting. As illustrated by the exhibits, in the event a sales agreement does not specify the allocation of installment payments among the assets, the installment payments must be allocated among the assets on the basis of their relative fair market values (FMVs), often limiting tax deferral.

A specific allocation of installment payments is also beneficial when sale agreements include a substantial initial-year cash payment followed by installment payments in subsequent years. Similar to the analysis above, agreements to allocate the initial payment to assets ineligible for installment method reporting can maximize tax deferral.

Applicability to Sec. 338(h)(10) Installment Payment Allocations

It is unclear whether agreements to allocate installment payments to specific assets under Rev. Rul. 68-13 may be used to defer gain in Sec. 338(h)(10) transactions. When a valid Sec. 338(h)(10) election is made, a parent company’s sale of a subsidiary, or the sale of an S corporation, is treated as a sale of the acquired corporation’s assets. In a Sec. 338(h)(10) transaction, when a payment to purchase stock is received after the tax year, a seller is eligible to use the installment method to report gain. Regs. Sec. 1.338(h)(10)-1(d)(8) outlines the installment sale treatment for Sec. 338(h)(10) transactions; however, the regulations provide no guidance on the applicability of Rev. Rul. 68-13 to deemed-asset sales.

In 2001, Treasury issued final regulations under Secs. 338 and 1060 (T.D. 8940). In the preamble to the proposed regulations issued with respect to these final regulations (REG-107069-97), Treasury stated that the principal purpose for the new regulations was to make the treatment of deemed-asset sales under Sec. 338 substantially the same as actual asset sales under Sec. 1060. Therefore, it would seemingly be incongruous to allow specific allocation of installment payments in a Sec. 1060 asset sale and to deny such an allocation in a Sec. 338(h)(10) transaction. The application of Rev. Rul. 68-13 to Sec. 338(h)(10) transactions furthers the regulatory scheme to report gain on Sec. 338(h)(10) and Sec. 1060 transactions in substantially the same manner.

Conclusion

As shown above, where installment sale reporting is available for asset sales, allocation of installment payments to specific assets can maximize tax deferral. Based on the statutory and regulatory framework, it is not unreasonable to conclude that the advantageous tax deferral received through the specific allocation of Sec. 453 installment payments in actual asset sales outlined in Rev. Rul. 68-13 is applicable to Sec. 338(h)(10) deemed-asset sales.

From Jon R. Klunk, CPA, Oak Brook, IL

Tax Court Denies an Impermissible Accounting Method Change

Taxpayers often want to change either their overall method of accounting (e.g., cash versus accrual) or their method of accounting for a specific item (e.g., inventory). There are varied reasons a taxpayer may request a change. However, as demonstrated by the Tax Court decision discussed below, it is critical that a taxpayer follow all the required procedures to ensure the IRS will grant approval for the change.

What Is an Accounting Method?

An accounting method is the consistent application of a rule to determine when a taxpayer recognizes items of income or deduction. Sec. 446(a) provides that “[t]axable income shall be computed under the method of accounting on the basis of which the taxpayer regularly computes his income in keeping his books.” If the taxpayer’s method of accounting does not clearly reflect income, Sec. 446(b) states that the computation of taxable income shall be made under a method that, in the IRS’s opinion, clearly reflects income.

Regs. Sec. 1.446-1(e)(2)(ii)(a) provides that “[a] change in the method of accounting includes a change in the overall plan of accounting for gross income or deductions or a change in the treatment of any material item used in such overall plan.” A change in method of accounting is distinguished from an adoption of a method, a correction of a mistake, or a change in underlying facts or business policy.

Taxpayers may apply with the IRS to change a method of accounting via Form 3115, Application for Change in Accounting Method. Sec. 446(e) generally requires consent of the Service before a taxpayer may change a method of accounting. The IRS has broad discretion to approve or disapprove a change. Permission is not granted unless the taxpayer and the Service agree to certain conditions. The IRS may also force the taxpayer to change its method of accounting when that method does not clearly reflect taxable income.

The Capital One Case

In Capital One Financial Corp., 130 T.C. No. 11 (2008), the Tax Court denied a retroactive change in treatment of credit card late-fee income, stating that the purported change in accounting method was a change in the treatment of a material item and that Capital One did not follow proper procedures for securing the change in accounting method.

On August 5, 1997, Congress enacted the Taxpayer Relief Act of 1997, P.L. 105-34, which added Sec. 1272(a)(6)(C)(iii). This section requires taxpayers to treat credit card receivables as creating or increasing original issue discount (OID) on the pool of credit card loans to which the receivables relate. The IRS subsequently issued Rev. Proc. 98-60, which explained how taxpayers could secure automatic consent to change their method of accounting for pools of credit card receivables.

From 1995 through 1999, Capital One recognized late-fee income at the time the fee was charged to the cardholder for both financial accounting purposes and federal income tax purposes (i.e., current-inclusion method). On its 1998 tax return, Capital One filed a Form 3115 to change its method of accounting for interest and OID to apply the provisions of Regs. Sec. 1272(a)(6)(C)(iii). The Form 3115 stated that Capital One “requests permission under Section 12.02 of Rev. Proc. 98-60 to change its method of accounting for interest and original issue discount that are subject to the provisions of Section 1004 of the Tax Relief Act of 1997.” Capital One continued to treat late-fee income under the current-inclusion method on its 1998 and 1999 tax returns. However, on its 2000 tax return, Capital One began treating the late-fee income as increasing OID.

The IRS issued a notice of deficiency to Capital One for 1997, 1998, and 1999. Subsequent to filing its 2000 tax return, Capital One filed a petition with the Tax Court challenging the notices of deficiency. In a later amended petition, Capital One claimed that it was entitled to treat the late-fee income as increasing OID on its pool of credit card loans, thus reducing taxable income for 1998 and 1999. The IRS disagreed with this treatment of the late-fee income for 1998 and 1999, arguing that Capital One had not properly requested (and accordingly had not received) consent to change its method of accounting for late fees for 1998 and 1999. Therefore, Sec. 446(e) prohibited a retroactive change in the treatment of the late-fee income for those years from the current-inclusion method to a method conforming to the provisions of Sec. 1272(a)(6)(C)(iii).

Tax Court Position

The Tax Court held in favor of the IRS, stating that Capital One did not comply with the procedures in Rev. Proc. 98-60 for requesting consent to change a method of accounting for pools of credit card receivables. The Form 3115 filed by Capital One did not mention late-fee income. On its 1998 and 1999 tax returns, Capital One treated income from overlimit fees, cash advance fees, and interchange fees as increasing OID on its pool of credit card loans under Sec. 1272(a)(6)(C)(iii). It did not afford similar treatment to the late-fee income, instead recognizing late-fee income under the current-inclusion method.

The Form 3115 filed by Capital One gave no indication that the late-fee income would be treated as OID. In fact, the Tax Court indicated that the language used in the Form 3115 was “ambiguous and vague.” The ambiguity in the description of the items to be changed was only clarified by the treatment of the late-fee income on the 1998 and 1999 tax returns. The court held that by failing to mention late-fee income on the Form 3115, and similarly failing to account for late-fee income as OID on the 1998 and 1999 tax returns, Capital One did not seek proper consent for the change.

Capital One argued in the alternative that even if it did not meet the requirements of Rev. Proc. 98-60, it was still entitled to change its treatment of late-fee income because it was not changing the treatment of a “material item.” Capital One contended that late-fee income was a component of interest, including OID, and was not itself a separate “item.” Consequently, Capital One could make changes to these components of interest without first receiving the Service’s consent. The Tax Court disagreed, stating that late-fee income is a separate and distinct item of income. Capital One earned more in late-fee income than any other type of fee, and late fees were earned for reasons independent of the reasons other types of income are earned, such as finance charges, overlimit fees, interchange fees, and cash advance fees.

Conclusion

As demonstrated by the Capital One case, a taxpayer filing Form 3115 to initiate a change in accounting method must be certain to follow all procedures required to effect such a change and be clear and specific as to the items to which the change in accounting method will apply. In addition, the requested change must be reflected in the tax return for the year of change.

From Ann Seelmeyer, CPA, Louisville, KY, and Kevin Powers, CPA, Oak Brook, IL

Corporations & Shareholders

IRS Clarifies Application of the Step-Transaction Doctrine

On May 8, 2008, the IRS issued Rev. Rul. 2008-25 to clarify the application of the step-transaction doctrine to situations in which an acquiring corporation (P) acquires a target corporation (T) by means of a reverse subsidiary merger followed immediately by a liquidation of T. This ruling addresses a particular fact pattern not considered in prior IRS guidance. In keeping with previously established standards for applying the step-transaction doctrine to postacquisition liquidations of T, the Service concluded that if the application of the step-transaction doctrine failed to result in a tax-free reorganization under Sec. 368(a), then the transaction would be viewed as a qualified stock purchase of T followed by a tax-free liquidation of T under Sec. 332.

Background

Sec. 338 offers acquiring corporation P a unique election to treat a qualified purchase (i.e., a taxable purchase of at least 80% of the vote and value) of the stock of target corporation T as if P had purchased T’s assets rather than T’s stock. The ramifications of this election are significant in that the deemed asset purchase gives P a stepped-up basis in the acquired T assets and amortizable Sec. 197 intangibles.

However, this benefit may come at a significant cost. Under Sec. 338(g), the election is made exclusively by P and results in a corporate-level taxable gain to the newly acquired T from the deemed sale of its assets. However, since P is now T’s owner, P (or the P group) will bear the tax burden on this gain. As a result, an election under Sec. 338(g) is uncommon except where T has tax attributes (such as a net operating loss or tax credit carryforwards) that can be used to offset this taxable gain.

Sec. 338(h)(10) offers P a similar election, but only if T is a subsidiary in an affiliated group of corporations or an S corporation. If made, the Sec. 338(h)(10) election treats a qualified stock purchase as a taxable asset purchase to P and a taxable asset sale to T.

Thus, if T is a corporate subsidiary of a selling affiliated group, there may be little if any additional taxable gain to the selling group from the deemed asset sale if the selling parent’s basis in T stock is proximate in value to the tax basis of T’s assets. For this reason, Sec. 338(h)(10) elections are more common than the Sec. 338(g) elections described above. Unlike the Sec. 338(g) election, both P and T must consent to a Sec. 338(h)(10) election.

Historically, the IRS has wrestled with the application of the step-transaction doctrine in a situation in which P acquires the outstanding T stock in a qualified stock purchase and then immediately liquidates T. Before the issuance of Sec. 338, this series of transactions would be automatically stepped together under the Kimbell-Diamond doctrine and treated as if P had purchased T’s assets in a taxable asset acquisition, with T recognizing a taxable gain on the sale of its assets and P receiving a stepped-up basis in these assets (see Kimbell-Diamond Milling Co., 14 T.C. 74 (1950), aff’d, 187 F.2d 718 (5th Cir. 1951)). However, upon the enactment of Sec. 338, Congress explicitly stated that the election under Sec. 338 was to be the exclusive avenue for deemed asset sale treatment, and the Service would no longer seek to step these transactions together in the manner described above.

Rev. Rul. 90-95

Additional complications surrounding the immediate liquidation of a subsidiary following a qualified stock purchase arose within the context of reverse subsidiary mergers. In a reverse subsidiary merger, P creates a transitory subsidiary, P1, and causes P1 to merge with and into T, with T surviving the transaction. Given that P1’s existence is purely transitory and its only purpose is to facilitate the acquisition structure, P1 is ignored for tax purposes and the transaction is viewed as a direct acquisition of T’s stock by P. If the consideration paid to T’s shareholders consists of cash, other property, or an amount of P stock that is not sufficient to meet the continuity of interest requirements for a tax-free reorganization, then the transaction will constitute a qualified stock purchase of T, assuming P acquires at least 80% of T’s stock in the transaction.

Rev. Rul. 90-95 was issued to clarify this treatment within the context of two reverse subsidiary merger examples. Both examples involve P acquiring all of T’s stock by means of a reverse subsidiary merger with cash being the only consideration paid to T’s shareholders. In one example, T’s existence continues after the acquisition, and in the other example T is immediately liquidated into P. The ruling holds that both situations constitute a qualified stock purchase of T under which a Sec. 338 election could be made to treat the acquisition as a taxable purchase of T’s assets. The ruling further clarifies that, when T is immediately liquidated after its acquisition by P, the transaction will be treated as a qualified stock purchase followed by a Sec. 332 liquidation of T.

Therefore, unless a Sec. 338 election is made with respect to the stock acquisition, no gain will be recognized by T in the transaction, and P will receive a carryover basis in T’s assets upon its liquidation into P. In reaching this conclusion, the IRS reinforced the mandate that a Sec. 338 election, and not the step-transaction doctrine, is the exclusive avenue for a deemed asset sale where a qualified stock purchase is involved.

Rev. Rul. 2001-46

There is extensive precedent for the application of the step-transaction doctrine to integrate the related steps of an overall acquisition plan so that the end result can be tested for qualification as a tax-free reorganization under Sec. 368(a). One of the primary rulings in this area is Rev. Rul. 67-274. This ruling involved a situation in which P acquired all the outstanding T stock solely in exchange for P stock and then immediately liquidated T into P. The ruling concludes that the step-transaction doctrine must be applied to the immediate postacquisition liquidation of T, and the resulting integrated transaction must be viewed as an acquisition of T’s assets in exchange for P stock (which qualified as a tax-free reorganization under Sec. 368(a)(1)(C)).

While Rev. Rul. 90-95 addressed the nonapplication of the step-transaction doctrine within the context of a taxable reverse subsidiary merger, questions surrounding the application of this doctrine continued for reverse subsidiary mergers that would qualify as tax-free reorganizations under Sec. 368(a) if the step-transaction doctrine was applied. If a tax-free reorganization results from the integrated transaction, the nonrecognition provisions of Sec. 361 are mandatory and would generally preclude P from making a Sec. 338 election. In 2001, the Service issued Rev. Rul. 2001-46 to address this situation.

Rev. Rul. 2001-46 illustrates the application of the step-transaction doctrine through two examples. In both examples, P acquires T’s stock using a reverse subsidiary merger and T is then immediately liquidated into P via a merger of T into P (a key point that is later distinguished in Rev. Rul. 2008-25). In the first example, the consideration paid by P to the T shareholders consists of 70% P stock and 30% cash; in the second example, the consideration consists entirely of P stock.

In the first example, P’s acquisition of T via a reverse subsidiary merger would not qualify independently as a tax-free reorganization because the 70% stock consideration falls short of the 80% requirement for this particular structure under Sec. 368(a)(2)(E). Thus, viewed independently, this transaction would constitute a qualified stock purchase and would give P the opportunity to make a Sec. 338 election.

However, the ruling concludes that, because the step transaction must be applied within the context of testing a series of interrelated transactions for qualification as a tax-free reorganization, the transaction must be viewed as a direct merger of T into P. As a result, the transaction qualifies as a tax-free reorganization under Sec. 368(a)(1)(A) because, when viewed in this light, the 70% stock consideration is more than sufficient to meet the continuity of interest requirements for a standard A reorganization. This same conclusion is reached in the second example.

The application of the step-transaction doctrine to achieve tax-free reorganization status for these transactions would seemingly preclude P’s making a Sec. 338 election for either transaction. However, the IRS left open the possibility of allowing taxpayers to make a Sec. 338(h)(10) election if P’s acquisition of T’s stock, when viewed independently of the postacquisition merger of T, would constitute a qualified stock purchase.

Based upon the examples provided in Rev. Rul. 2001-46, this would give P the opportunity to make a Sec. 338(h)(10) election under the first example because P’s initial acquisition of T’s stock would not qualify as a tax-free reorganization. However, the election would not be available in the second example because the initial acquisition would constitute a tax-free reorganization under Sec. 368(a)(2)(E).  

In 2003, the Service issued Regs. Sec. 1.338(h)(10)-1(c)(2), formally acknowledging P’s ability to make a Sec. 338(h)(10) election under these circumstances. A Sec. 338(g) election is not permitted under these circumstances.

Rev. Rul. 2008-25

Rev. Rul. 2008-25 was issued on May 8, 2008, to provide further clarification of the application of the step-transaction doctrine to P’s acquisition of T’s stock followed by an immediate liquidation of T into P. However, the fact pattern provided in this ruling differs from that presented in Rev. Rul. 2001-46 in that P’s postacquisition liquidation of T does not qualify as a merger under state law. This nuance affects the application of the step-transaction doctrine because it disqualifies the integrated transaction from qualifying as a tax-free reorganization under Sec. 368(a)(1)(A).

The fact pattern presented in the ruling involves P acquiring all of T’s stock via a reverse subsidiary merger. The consideration delivered to T’s shareholders consists of 90% P stock and 10% cash. Immediately following P’s acquisition of T, P causes T to liquidate into P in a transaction that does not constitute a merger under applicable state law. While P’s acquisition of the T stock, viewed independently, would qualify as a tax-free reorganization under Sec. 368(a)(2)(E), the immediate liquidation of T into P must also be considered as part of the overall transaction for the purposes of testing the integrated transaction for qualification as a tax-free reorganization.

According to the revenue ruling, P’s acquisition of all T’s assets and liabilities does not qualify for any of the possible tax-free reorganization structures presented in Sec. 368(a). The integrated transaction cannot qualify as a type A reorganization because P did not acquire T’s assets and liabilities in a transaction qualifying as a merger under applicable state law, and the immediate liquidation of T causes the transaction to fail to meet the “substantially all” requirements of Sec. 368(a)(2)(E). The transaction cannot qualify as a B or C reorganization due to the assumption of T’s liabilities and the use of cash consideration. It also cannot qualify as a D reorganization because the control requirements for such a reorganization are not satisfied.

Conclusion

The ruling concludes that because the particular fact pattern presented does not result in a tax-free reorganization under the step-transaction doctrine, the transaction must constitute a qualified stock purchase of T followed by a tax-free liquidation of T under Sec. 332. Absent this conclusion, the application of the step-transaction doctrine would result in a deemed purchase of T’s assets. This would be in direct violation of the mandate set forth by Congress and reinforced in Rev. Rul. 90-95 that a Sec. 338 election, and not the step-transaction doctrine, is to be the exclusive avenue for achieving a deemed asset sale. Thus, a Sec. 338 election would be available to P with respect to P’s acquisition of T’s stock under the circumstances presented in the ruling.

From David A. Thornton, CPA, Columbus, OH

Credits Against Tax

Alternative Simplified Method for Claiming the Research Credit

On June 17, 2008, the IRS issued final and temporary regulations (T.D. 9401, Temp. Regs. Secs. 1.41-6T(j), 1.41-8T(b)(5), and 1.41-9T(d)) relating to the alternative simplified credit (ASC) method of computing the research and experimentation credit under Sec. 41(c)(5). The ASC was enacted in December 2006 as a part of the Tax Relief and Health Care Act of 2006, P.L. 109-432. Before the addition of the ASC, Sec. 41 allowed the taxpayer to choose between two other calculation methodologies: the regular credit calculation and the alternative incremental credit calculation (AIRC). (Note: Sec. 41 is not permanent and is currently expired. Congress must act or the credit provisions will not apply to expenses incurred after December 31, 2007.)

The regular credit calculation methodology is complicated and involves a computation of a “base amount,” which requires historical qualified research expenses (QREs) and gross receipts (many times going back as far as 24 years) as well as an average of the gross receipts for the last four years. The AIRC calculation methodology is somewhat simpler in that no historical QREs are necessary to compute the base amount, but there is still a gross receipts component to the calculation. The ASC simplified the calculation of the credit by limiting the base period computation solely to the use of average QREs incurred over the prior three-year period with no inclusion of gross receipts in any portion of the calculation. In addition, the ASC includes a special provision that allows taxpayers to take the credit even if they do not have QREs in all three of the preceding tax years.

Calculation

The ASC is calculated by multiplying the total amount of current-year QREs that exceed 50% of the average of the three prior tax years by 12% (see Exhibit 1). For taxpayers that did not have QREs in any of the three prior tax years, the credit is calculated using 6% of current-year QREs. Also, if any of the three prior tax years are short years, the total QREs for the short tax year must be annualized before being included in the calculation.

For a controlled group of corporations, the credit is computed for each single entity using the method that provides the greatest credit at the single-entity level. The credit is then computed at the group level to determine the method that produces the greatest group credit. Each single entity is allocated a portion of the total group credit based on a percentage of the individual credit to the total of all individual credits computed at the single entity level regardless of what method was used to compute each credit. For example, group ABC has the greatest combined credit using the ASC (see Exhibit 2). At the single-entity level, the greatest credit for A is created using the regular method, the greatest credit for B is created using the AIRC, and the greatest credit for C is created using the ASC. The total group credit is then allocated to each entity based on the regular credit for A, the AIRC credit for B, and the ASC credit for C. Temp. Regs. Sec. 1.41-6T(e), Example (3), demonstrates the computation of the group credit and the allocation of the credit among the companies included in the controlled group (see Exhibit 3).

Election and Reporting

To make a valid election of either the ASC or AIRC calculation methodology, a Form 6765, Credit for Increasing Research Activities, must be filed with the taxpayer’s timely filed return (including extensions). However, the regular credit calculation methodology may be claimed on Form 6765 on either a timely filed return (including extensions) or an amended return for which the statute of limitation has not run. The election to use the regular, AIRC, or ASC method is made by filing the form using the method chosen. For the AIRC or the ASC, once chosen, the taxpayer must use the calculation methodology each year until the taxpayer revokes this election. The taxpayer may revoke a prior election for the ASC or the AIRC by filing the subsequent year’s form using a different method. However, once either the ASC or the AIRC is elected for the current tax year, the taxpayer cannot change the election on an amended return.

For controlled groups, the election is made on the return of the designated member. Under Regs. Sec. 1.41-8(b)(4)(ii), the designated member is defined as the “member of the group that is allocated the greatest amount of the group credit” under Regs. Sec. 1.41-6(c). All members of the controlled group must follow this election and file Form 6765 using the same method.

Practical Application of the ASC

The addition of the ASC methodology has allowed many taxpayers to begin claiming the research credit for the first time or to increase the amount of credit claimed. There are several types of taxpayers who find the ASC methodology beneficial.  Many taxpayers, especially small to midsize companies in manufacturing industries, were limited in their ability to claim the credit due to a lack of the historical records necessary to document their base amount or a lack of research activity in the time periods that define their base period (for many from 1984 to 1988).  For other taxpayers with an established base amount and in high-growth industries such as pharmaceuticals and software, the inclusion of gross receipts as a part of the base amount calculation severely limited the amount of credit received because their QREs did not increase as fast as their gross receipts.

Another example of taxpayers that benefit from the ASC methodology are those in industries such as banking and insurance, with historically very low levels of QREs relative to gross receipts. Many of these types of taxpayers never before considered the research credit because the available calculation methodologies all included a base amount with a gross receipts component.  For all these taxpayers, the ASC methodology provides a simplified way to calculate the research credit using recent QREs without any gross receipts component in the base amount calculation.

Future Changes?

On September 25, 2008, the IRS is scheduled to hold a public hearing on these temporary regulations. As indicated in its hearing notice, the following issues will be discussed:

From Erin E. Cool, CPA, Oak Brook, IL, Kristin N. Hanson, CPA, Oak Brook, IL, and Marie L. Powell, CPA, Indianapolis, IN

Employee Benefits & Pensions

IRS Increases Scrutiny of Performance-Based Plans Under Sec. 162(m)

Sec. 162(m) governs the deductibility of certain excessive employee compensation. In recent months the IRS has issued Rev. Rul. 2008-13 and Rev. Rul. 2008-32, providing for additional clarification related to certain components of the performance-based compensation rules contained within Sec. 162(m)(4)(C) and Regs. Sec. 1.162-27(e). Corporations not paying careful attention to the application of these recent rulings can be subject to unexpected negative results.

What Is Sec. 162(m)?

Sec. 162(m) disallows a tax deduction to corporations for compensation paid to any “covered employee” in excess of $1 million for the tax year. This section applies only to publicly held corporations registered under Section 12 of the Securities Exchange Act of 1934. As interpreted by Notice 2007-49, issued in June 2007, a covered employee under Sec. 162(m)(3) refers to a publicly held corporation’s chief executive officer, or an individual acting in that capacity, and the three other highest-paid officers whose compensation must be reported to shareholders under SEC regulations, but not including the chief financial officer (unless the CFO was also acting as the CEO or the CFO held another position that was among the top three highest-paid officers other than the CEO).

Commissions based on income generated from individual performance and other performance-based compensation are excepted from the $1 million limitation. Specifically, performance-based compensation is excluded for purposes of Sec. 162(m) if:

Rev. Rul. 2008-13

Rev. Rul. 2008-13, issued on February 21, 2008, affirms the IRS’s position in Letter Ruling 200804004 that compensation will not qualify as performance based under Sec. 162(m) if all or part of the compensation can be paid to a covered employee upon his or her involuntary termination by the corporation without cause, voluntary termination for good reason, or voluntary retirement, even if the performance-based goals and other terms of the plan are satisfied and the covered employee continues employment with the corporation.

This ruling runs contrary to Letter Rulings 199949014 and 200613012. Letter Ruling 199949014 concluded that compensation paid under a performance-based stock award plan qualifies as performance based compensation under Sec. 162(m) even though the plan provided for accelerated vesting upon the covered employee’s termination without cause or for good reason. Similarly, Letter Ruling 200613012 provided that compensation paid under a performance-based plan qualified under Sec. 162(m) even though the plan provided for accelerated payment upon a covered employee’s retirement.

Letter Rulings 199949014 and 200613012 expanded on the exceptions included in Regs. Sec. 1.162-27(e)(2)(v), which provides that compensation does not fail to qualify as performance-based compensation simply because the plan or agreement allows for compensation to be paid upon death, disability, or a change in ownership or control of the company. It also provides that compensation would not qualify as performance based if the plan or agreement indicated that the covered employee would receive full or partial payment regardless of whether the performance goal was met.

In contrast to these prior letter rulings, Rev. Rul. 2008-13 applies a more literal reading of Sec. 162(m) and Regs. Sec. 1.162-27. As such, plans or agreements providing for payment of compensation for conditions (i.e., termination without cause, voluntary termination for good reason, and voluntary retirement) other than death, disability, or a change in control of the company will disqualify all compensation paid under that particular plan or agreement as performance based under Sec. 162(m)(4)(C). Thus, such compensation will be subject to the $1 million deduction limitation, even though the event that would accelerate the payment may not actually occur and the performance goals established under the plan are otherwise met.

Realizing that many corporations drafted compensation arrangements, plans, and employment contracts using prior IRS guidance, Rev. Rul. 2008-13 is applied prospectively. For compensation that otherwise qualifies as performance based under Sec. 162(m)(4)(C) and Regs. Sec. 1.162-27(e), payments under the plan will be excluded as performance-based compensation if either: (1) the performance period begins on or before January 1, 2009, or (2) the compensation is paid pursuant to the terms of a plan or agreement as in effect, not including renewals or extensions, on February 21, 2008.

Rev. Rul. 2008-32

Rev. Rul. 2008-32, issued on July 7, 2008, provides additional guidance in determining whether an individual qualifies as an outside director for purposes of Sec. 162(m)(4)(C)(i). The ruling concludes that an individual does not qualify as an outside director of a corporation if the individual has served as the corporation’s interim CEO in regular and continued service with the full authority vested in that office.

Sec. 162(m)(4)(C)(i) provides one of the qualifications that must be satisfied in order for compensation to be qualified as performance based. It states that performance goals must be determined by a compensation committee of the corporation’s board of directors that is composed solely of two or more outside directors. Regs. Sec. 1.162-27(e)(3)(i) provides that an outside director of a publicly held corporation:

1. Must not be a current employee;

2. Must not be a former employee who receives compensation for prior services during the tax year;

3. Has not been an officer; and

4. Does not receive compensation, directly or indirectly, in any capacity other than as a director.

Regs. Sec. 1.162-27(e)(3)(vii) further states that an officer is an administrative executive who is or was in regular and continued service; it does not include an individual employed for a single and special transaction or an individual with the title of officer but not the authority of an officer.

The circumstances of each case must be assessed individually, but generally a director who has served as interim CEO will not qualify as an outside director for purposes of Sec. 162(m)(4)(C)(i). As such, any plan or agreement approved by the board of directors, while a former interim CEO sits on the board, cannot qualify as a performance-based compensation plan, and any payments under the plan will be subject to the $1 million deduction limitation under Sec. 162(m).

Conclusion

Recent IRS positions have further complicated the rules under Sec. 162(m). Publicly held corporations need to be aware of these developments to avoid unexpected negative results. Current compensation arrangements, plans, and employment contracts, including renewal and extension provisions, should be reviewed to ensure the included language provides for the most advantageous tax treatment. Corporations also should make sure that directors on the compensation committee are in fact considered outside directors for purposes of Sec. 162(m).

From James Slivanya, CPA, Columbus, OH, and Kevin Powers, CPA, Oak Brook, IL

Ten Things to Know About the Roth 401(k)

Since the introduction of the Roth IRA in 1997, it has become a popular retirement vehicle. However, the contribution limits for the Roth IRA have been relatively low and, due to participant income limitations, not everyone has been able take advantage of the Roth designation. The Economic Growth and Tax Relief Reconciliation Act of 2001, P.L. 107-16 (EGTRRA), added Sec. 402A, which provides for designating Roth contributions. Effective January 1, 2006, many individuals previously excluded can now take advantage of the tax-free growth of Roth contributions by means of the Roth 401(k). The Roth 401(k) is not a new plan but a feature for designating deferrals as Roth contributions.

Amendments to the regulations under Secs. 401(k) and (m) provide guidance on designating Roth contributions under Sec. 402A. Initially, Sec. 402A was to sunset on December 31, 2010, but the Pension Protection Act of 2006, P.L. 109-280, made the changes under EGTRRA permanent. This item explains ten things taxpayers should be aware of when considering a Roth 401(k). (For an in-depth discussion of the Roth 401(k) rules, see Beausejour and Lynch, “An Analysis of the New Roth 401(k)/403(b) Plans,” 39 The Tax Adviser 515 (August 2008).)

1. Applicable Plans

The Roth 401(k) is a feature that can be added to a new or existing company-sponsored defined-contribution pension plan, including (1) a plan qualified under Sec. 401(a), which includes a traditional 401(k) and a safe-harbor 401(k); and (2) a 403(b) tax-sheltered annuity arrangement (Sec. 402A(e)(1)). The Roth feature is not allowed in a SARSEP or a SIMPLE IRA plan because they are not applicable retirement plans under Sec. 402A(e)(1). Employees elect to designate a portion or all of their elective contributions as Roth contributions (Sec. 402A(b)(1)).

2. Rules for Roth

Contributions are included in gross income at the time the employee would have received the contribution amounts in cash if the employee had not made the cash or deferred election. Earnings on the account accumulate tax free and, if the distribution is qualified, the distribution is tax free. Therefore, as long as all distributions from an account are qualified distributions, the earnings on the Roth 401(k) funds are never taxed (per Sec. 402A(d)(1)).

3. Qualified and Early Distributions

A qualified distribution is one that occurs at least five years after the year of the participant’s first designated Roth contribution (counting such first year as part of the five) and is made on or after the participant reaches age 59½, because of the participant’s disability, or on or after the participant’s death (Sec. 402A(d)(2)). Sec. 402A does not provide a specific ordering rule regarding unqualified distributions from designated Roth accounts, so Sec. 72 applies to determine the character of distributions from such accounts (Regs. Sec. 1.402A-1, Q&A-3).

4. Funds Designated Irrevocably

Roth contributions are designated irrevocably, so once the designation is made, there is no reversing it (Regs. Sec. 1.401(k)-1(f)(1)(i)). However, the employee must have an opportunity to make or change future elections at least once during a plan year (Regs. Sec. 1.401(k)-1(e)(2)(ii)).

5. Plan Must Also Offer Pretax Elective Contributions

A plan cannot allow for only Roth contributions; it must also allow for the traditional, pretax elective deferrals (Regs. Sec. 1.401(k)-1(f)). This means that many forms used in the plan’s administration will need to be modified to accommodate both features.

6. Contribution Elections

An individual may make both traditional pretax and Roth designated contributions in a plan year. In 2008, an individual has an aggregate elective contribution limit of $15,500 for all designated Roth contributions and traditional pretax contributions, with an additional $5,000 if the participant is age 50 or over (Notice 2006-98). The maximum employee and employer annual contribution is the lesser of $46,000 or 100% of compensation. Under Sec. 402A(c)(2), if, for example, an individual chooses to designate $12,000 as Roth contributions, he or she may designate the remaining $3,500 (or $8,500, if over age 50) as traditional pretax contributions. Any additional contributions over the $15,500 (or $20,500) limit up to $46,000 will be treated as after-tax contributions (included in income), and the earnings will be tax deferred.

7. Matching Contributions Are Not Roth

Employers may match Roth contributions, but these contributions may not be added to the Roth account (Regs. Sec. 1.401(k)-1(f)(2)). Rather, the employer match will be with pretax moneys and must be kept in a separate account. Whereas the employee Roth contributions may be withdrawn tax free, the employer-matched moneys, like any pre-tax contribution to a 401(k) account, will be treated as ordinary income at withdrawal.

8. Separate Accounting Required

Because the 401(k) plan will allow for pretax contributions that are includible in income when distributed (traditional and employer matched contributions) and contributions made with after-tax income that will be distributed tax free (Roth contributions), there must be separate accounts and separate recordkeeping for the different types of contributions (Sec. 402A(b)(2)). This was further clarified to apply to the treatment of separate accounts regarding automatic rollover rules for mandatory distributions (Sec. 402A(d)(4)). In addition, gains, losses, and other charges must be separately allocated on a reasonable and consistent basis to the designated Roth account.

9. Only Roth-to-Roth Rollovers

Whereas a traditional IRA may be converted to a Roth IRA, there is no provision for converting a pretax elective contribution account under a 401(k) to a designated Roth account. A direct rollover of a distribution from a Roth 401(k) may only be made to another Roth elective deferral account, such as another Roth 401(k) or a Roth IRA (Sec. 402A(c)(3)(A)). Regs. Sec. 1.408A-10, Q&A-2, clarified that a rollover from a Roth 401(k) to a Roth IRA may take place even if the individual is not eligible to make regular or conversion contributions to a Roth IRA due to income limitations.

10. Set Up by Year End

The Roth designation is a feature of a new or existing 401(k) plan. The plan does not have to be modified before accepting Roth designated moneys; however, the plan does need to be amended by the end of the plan year (December 31 for calendar year plans) for contributions made that year to be considered Roth designated. For example, funds may be designated Roth on July 1, 2008, even if the Roth feature has not been designated to the plan, as long as the plan is amended by December 31, 2008 (Notice 2005-95).

Conclusion

The most appropriate participants for the Roth designations are those that would like to contribute to a Roth IRA for tax-free growth but are unable to do so because of income limitations or those that would like to contribute more than they are currently allowed. In general, younger individuals saving for retirement and those who expect their tax bracket to increase would benefit greatly from making Roth designations. But the benefit will be realized only if the designation is used, and 401(k) participants and employers will certainly not adopt the designation if they are not familiar with it.

From Kristy Hasseltine, MBA, Nashville, TN

Gross Income

Corporate Cancellation of Debt Relief

The recent economic downturn coupled with the tightening of the credit market has forced many financially distressed corporations to renegotiate the terms of their maturing debt obligations. As little as 12 months ago, these companies would have been able to refinance their maturing debt with slightly higher credit terms or simply would have received  an extension on their original agreement.

Unfortunately, today’s creditors are facing the harsh reality that they must demand payment from debtors under the original terms outlined in the credit agreement or face the possibility of receiving none of the principal and interest due at the date of maturity. Many subordinated debt holders have been eager to offer substantial settlements in lieu of extending credit terms or refinancing for fear that the current economic downturn is here to stay. In addition to allowing the creditor to retrieve some of its original investment, this cancellation of debt can be a substantial windfall to a debtor company on the verge of financial collapse.

The Code’s general rule considers cancellation of debt (COD) income under Sec. 61(a)(12). However, Sec. 108 provides some relief to the financially distressed beneficiaries of these debt cancellation offers. The relief provided under Sec. 108 depends on the debtor’s financial viability and the terms of the COD settlement.

Discharge of Indebtedness by Insolvent Taxpayer

Sec. 108(a) excludes from gross income COD income if the discharge occurs in a Title 11 (bankruptcy) case (Sec. 108(a)(1)(A)) or when the taxpayer is insolvent (Sec. 108(a)(1)(B)). It should be noted that under Sec. 108(a)(3), the amount of the exclusion under the insolvency exception of Sec. 108(a)(1)(B) will be limited to the excess of the debtor company’s fair market value (FMV) of its liabilities over the FMV of its total assets.

It should also be noted that determining the company’s FMV may be a difficult task. Many credit deals are renegotiated at the brink of financial collapse, and substantiating corporate FMV will likely require the assistance of third-party valuation experts. The use of these experts may require a significant amount of time and financial resources, neither of which the company may have.

In either insolvency or bankruptcy, the amount of COD income excluded will result in a reduction of the company’s tax attributes by the exclusion amount. Once the excluded COD has been determined, the amount excluded shall be applied to reduce the tax attributes of the company in the following order (Sec. 108(b)):

1. Net operating losses (NOLs);

2. General business credits;

3. Minimum tax credits;

4. Capital loss carryovers;

5. Basis of property;

6. Passive activity loss and credit carryovers; and

7. Foreign tax credit carryovers.

Under Regs. Sec. 1.108-7(b), the above tax attributes subject to reduction are taken into account by the taxpayer for the tax year of the discharge before such attributes are reduced. Furthermore, Regs. Sec. 1.108-7(a)(2) states that if the excluded COD income exceeds the sum of the taxpayer’s tax attributes, the excess is permanently excluded from the taxpayer’s gross income. In most cases, the loss of these tax attributes will be a much more attractive option for the debtor company because most financially distressed companies will never fully utilize their accumulated tax attributes.

Instead of reducing tax attributes in the order described in the preceding list, the company may elect to first reduce the tax basis of depreciable assets (Sec. 108(b)(5)). Excluded debt discharge income in excess of the tax basis of depreciable assets is then used to reduce other attributes according to the normal ordering procedure.

Indebtedness Contributed as Capital

Another exception to the general rule that COD be treated as gross income under Sec. 61(a)(12) involves any debt discharge that qualifies as a capital contribution by a shareholder. If a principal shareholder’s cancellation of debt owed to the shareholder by the corporation was forgiven in order to improve the corporation’s financial position, the debtor corporation is treated by Sec. 108(e)(6) as having satisfied the debt with cash equal to the shareholder’s adjusted basis in the debt. The shareholders/creditors involved in this transaction would receive additional basis in their stock of the distressed company.

Indebtedness Satisfied by Corporate Stock

A final exception to the recognition of COD income is defined under Sec. 108(e)(8). This provision states that a creditor that receives stock in the debtor corporation in exchange for the cancellation of the outstanding debt will be deemed to have satisfied the indebtedness with an amount of money equal to the FMV of the stock received. In the event the FMV of the company’s stock is less than the outstanding debt forgiven, the company will recognize COD income on the excess of the principal forgiven and FMV of the stock received.

Cancellation of Debt Involving Title 11 or Insolvency of S Corporations

The special relief provisions of Sec. 108 noted above also apply to S corporations. It should first be noted that insolvency must be determined at the corporate level (Sec. 108(d)(7)). Nontaxable income from the cancellation of indebtedness of an S corporation that is excluded from the S corporation’s income because the corporation is bankrupt or insolvent is not a passthrough item and does not increase the basis of any shareholder’s stock (Sec. 108(d)(7)(A)). However, this rule does not apply to taxable COD income. As with any other type of taxable income, taxable COD income passes through to the shareholders and increases their stock basis.

S corporations that obtain relief under Sec. 108(a)(1)(A) or (B) must also reduce their tax attributes as outlined under Sec. 108(b) with the following notations:

1. For S corporations, any corporate loss or deduction disallowed at the shareholder level, during the year of discharge, will be treated as an NOL (Sec. 108(d)(7)(B)). Prior C corporation NOLs will not be reduced because no C corporation NOL can be carried forward into an S corporation tax year (Sec. 1371(b)(1));

2. Any unused general business credits generated in the year of discharge or carried forward from a prior C corporation tax year;

3. Minimum tax credits from prior C corporation tax years;

4. Capital loss carryovers from prior C corporation tax years;

5. Basis of property;

6. Passive activity losses; and

7. Foreign tax credits.

Conclusion

As noted above, the recent economic downturn coupled with the tightening of the credit markets has forced many corporate taxpayers to consider settlements with their creditors or possibly file for Title 11 bankruptcy protection. Until the credit markets soften and the economy begins trending positive again, many corporate taxpayers will use the relief afforded in Sec. 108. The mechanics and intricacies of this Code section should be explored by corporate taxpayers considering any form of negotiated debt settlement. By properly structuring the settlement or financial reorganization, the taxpayer will be able to maximize the COD relief provisions of Sec. 108.

From Eric R. Elliott, CPA/ABV, MBA, Knoxville, TN

Partners & Partnerships

IRS Flexes Its Muscles Under the Partnership Anti-Abuse Rules

Prior to 1997, taxpayers had to navigate a complex set of rules to determine whether their association was one that would be taxed as a corporation or one that would be taxed as a partnership. In many situations the entity of choice was the limited partnership. High-priced counsel would issue opinion letters stating that the entity would be taxed as a partnership. A key element of counsel’s opinion was that the general partner was in substance a partner. Advanced ruling requests from the IRS required a showing that the general partner had at least a 1% interest in profits and losses.

Starting in 1997, the Service simplified the process by permitting unincorporated businesses to elect to be taxed under either subchapter K or subchapter C. Since the adoption of the check-the-box regulations, taxpayers have enjoyed certainty with respect to entity classification for federal income tax. However, these regulations do not provide the same level of certainty in the determination of who is a partner for income tax purposes. Recent activity by the IRS indicates that this is still a real issue and will require taxpayers to analyze whether each member of a partnership or LLC will be treated as a partner for tax purposes.

Determining Who Is a Partner

Chief Counsel Advice (CCA) 200704030 was issued in October 2006 and offers some insight into the approach that the IRS will take to determine who is a partner. The basic transaction described in the CCA was relatively straightforward. The promoters purchased transferable state income tax credits and sold them to investors for a profit. Had the transaction been structured as a straight sale of the credits, the promoters would have recognized ordinary income on the transaction, and the investors would have incurred an itemized deduction that would give them little or no benefit due to the alternative minimum tax.

Rather than an outright sale of the credits, the transaction was structured as a partnership, which improved the transaction’s tax result for both parties. The investors in the partnership received a 1% capital account. The investors were allocated all of the credits, but no profits and no cashflow. The promoters received a 99% capital account, all profits and losses and any cashflow generated by the partnership. Because credits allocated to partners have no effect on capital accounts, the capital accounts of the parties remained unchanged after the allocation of the credits to the investors.

The promoters had the option to purchase the investors’ interests after one year, and this option was generally exercised. After the allocation of credits to the individual investors there was little or no value to the investors’ partnership interests, so the sale price to the promoters was presumably a nominal amount. The result of the transactions was that the investors got the benefit of the credits and realized a capital loss that could offset capital gains while the promoters realized a capital gain upon the eventual liquidation of the partnership.

The Service analyzed the transaction under several theories, including the partnership anti-abuse rules of Regs. Sec. 1.701-2, which were issued in 1994. The general anti-abuse rule could potentially apply to all partnership transactions. Because of its potential broad scope, IRS agents are required to seek National Office approval before applying the rule (Announcement 94-87). These regulations give the IRS broad powers in the case of partnerships and/or partnership transactions that fail any of the following three tests that the regulations hold are critical to the application of subchapter K:

Should the purported partnership arrangement fail any of these three tests, the IRS has a broad array of remedies available to achieve a result that is consistent with the intent of subchapter K. The remedies available include: (1) the ability to disregard the partnership; (2) the ability to treat a purported partner as a nonpartner; (3) the ability to adjust the partnership’s or a partner’s method of accounting; (4) the ability to modify the partnership allocations; and/or (5) the ability to otherwise adjust or modify the claimed tax treatment. These options provide the IRS with a trump card to overturn arrangements it finds abusive, as evidenced in the CCA.

In the CCA, the IRS examined the allocation of the credits and, using the substance-over-form doctrine, concluded that the use of the partnership to effectively sell the credits was an abuse of subchapter K. The IRS asserted that the investors were not partners in the partnership and therefore were not entitled to a capital loss on the transaction. The promoters of the partnership also did not fare well. Using its powers under the anti-abuse regulations, the Service went on to recharacterize the transfer of the credits under the disguised sale rules of Sec. 707, resulting in ordinary income to the promoters. This same conclusion was reached in a similar tax credit partnership transaction in CCA 200704028.

IRS Intentions

In recent years, the IRS has decided to flex its muscles and use this powerful weapon to attack tax shelters and other transactions that it perceives to be abusive. Recent IRS comments indicate that it has given field offices blanket authority to assert the anti-abuse regulations in a number of situations. The partnership credit transaction described above is one of those transactions for which the IRS has granted blanket approval for the use of the anti-abuse regulations. Whether the use of the anti-abuse regulations will have long-term success will ultimately be determined by the courts.

The lesson learned is that business purpose matters. Partners must come together to share both profits and losses, and each one needs to have a meaningful economic stake in the venture. The CCA provides fair warning that the IRS will use the anti-abuse rule to attack not only listed transactions but also those transactions that on their face appear to be in compliance with the other rules of subchapter K.

The anti-abuse regulations offer a framework for analyzing transactions that technically comply with the law but whose tax results appear to be too good to be true. Practitioners should refer to them when structuring their transactions. The advent of the check-the-box regulations clouded the issue of just who should be considered a partner because members do not always fit neatly into the state law definition of a partner. The CCA made it clear that one important element was the participation in profits. Therefore, to survive an attack under the anti-abuse regulations as to whether someone is a partner or an allocation should be respected, taxpayers would be wise to review the requirements for partnership classification before making an election under the check-the-box regulations.

From Bruce J. Belman, CPA, and Howard M. Wagner, CPA, Louisville, KY

Procedure & Administration

Disclosure Under the Preparer Penalty Prop. Regs.

On June 16, 2008, the IRS issued proposed regulations (REG-129243-07) on tax return preparer penalty standards that it hopes to have finalized by the end of the year. The proposed regulations amend existing regulations to take into account the provisions in the Small Business and Work Opportunity Tax Act of 2007, P.L. 110-28 (SBWOTA). A result of increased IRS scrutiny of the number of fraudulent tax returns and tax return preparers engaged in abusive practices, these regulations are relevant to tax return preparers who know or reasonably should know of unreasonable tax return positions.

The proposed regulations address IRS areas of concern to (1) provide for a broader definition of income tax preparer; (2) amend standards of conduct that must be met to avoid tax return preparer penalties; and (3) provide for higher penalty amounts for return positions that result in an understatement of tax. The IRS would like to finalize these regulations by the end of 2008 so that final regulations will apply to returns prepared beginning in 2009. (For an in-depth discussion of the proposed regulations, see Tillinger, “An Analysis of the New Preparer Penalty Proposed Regulations,” on p. 576.)

Standards of Conduct

The proposed regulations amend the standards of conduct that must be met to avoid imposition of the tax return preparer penalties for disclosed and undisclosed tax return positions. The standards as discussed below differ depending on whether a return position is disclosed or undisclosed within the tax return.

For a disclosed return position, the tax return preparer may avoid a penalty for understatement of tax if there is a reasonable basis for the disclosed position. For an undisclosed return position, the tax return preparer may avoid penalty only if the preparer has a reasonable belief that the position would more likely than not (MLTN) be sustained on its merits, which translates into a more than 50% chance of being sustained.

The MLTN standard imposed on the tax return preparer for an undisclosed return position is stricter than the standard imposed on the taxpayer (substantial authority). There is the potential for a conflict of interest for the tax return preparer who wishes to advise a client on a return position but does not want to be subject to penalties for a return position that the client ultimately decides to report on the return. However, under the proposed regulations, a tax return preparer can file a return without disclosure (although the preparer does not reasonably believe that a position would more likely than not be sustained on its merits) and avoid imposition of preparer penalties if the tax return preparer adequately discloses information to the taxpayer.

Adequate Disclosure

SBWOTA and the proposed regulations alike do not state that a tax return preparer must disclose all known issues to the IRS. Instead, the IRS has dealt with the taxpayer versus tax return preparer standards by defining how a tax return preparer can meet the adequate disclosure standard without filing Form 8275, Disclosure Statement, with the IRS. For undisclosed positions, the proposed regulations close the gap between the lower taxpayer standards and the higher tax return preparer standards by providing for adequate disclosure of known issues by the tax return preparer to the taxpayer. For undisclosed positions that have a reasonable basis but do not meet the MLTN standard, the tax return preparer must disclose the issue to the taxpayer.

The proposed regulations indicate that a tax return preparer is not required to inform the IRS about an issue that the taxpayer does not wish to disclose when a position does not meet the MLTN standard. Instead, the tax return preparer must adequately disclose the position to the taxpayer (Prop. Regs. Sec. 1.6694-2(c)(3)(i)). The allowable methods of disclosure differ for signing and nonsigning return preparers.

Signing return preparers: For signing tax return preparers, the IRS provides five methods to disclose such position to a taxpayer:

Nonsigning return preparers: For nonsigning tax return preparers, the IRS provides three disclosure methods:

Under each scenario, in order to establish that the disclosure was adequate and the obligation satisfied, the tax return preparer must document contemporaneously in his or her files that the information and advice required by the proposed regulations were provided. The disclosure to the taxpayer cannot be a boilerplate disclosure and must be specific to the facts and circumstances surrounding the taxpayer.

Conclusion

SBWOTA is the framework for revisions and the foundation for the standards of conduct related to tax return preparer penalties. The proposed regulations offer what the IRS believes is necessary to deter misconduct by tax return preparers and aid the IRS in detecting returns that were inaccurately prepared. Although the tax return preparers are not required to disclose to the IRS questionable return positions, they must be careful to follow the provisions discussed above to avoid tax return preparer penalties.

From Karen E. Galvin, CPA, Oak Brook, IL

Special Industries

Letter Ruling Reaffirms Favorable Treatment for Sale of Charter

Disposing of a valuable corporate charter is not as simple as a straight sale of the asset and can have unintended tax consequences if not properly structured. Corporations in certain regulated industries such as insurance or banking may have to jump through some regulatory hoops in transferring a charter. The requirements for such a transfer vary by state, but government agencies usually do not permit the charter to be transferred as a stand-alone asset. Therefore, the seller of a charter needs to go through certain steps and follow the requisite legal format to comply with the government agency requirements in order to properly effect the transfer.

The IRS has previously provided guidance on how a charter sale may be treated as a reorganization if certain conditions are met. The approved structures depend on the laws of the state and whether the state permits the sale of a single bank charter, but they have generally followed the structure in Rev. Proc. 89-50, with some acceptable deviations to comply with government agency requirements.

In May 2008, the Service issued Letter Ruling 200822022, which discusses the combination of bank subsidiaries’ operations and a subsequent sale of a bank charter. The letter ruling recasts the events leading up to the sale of the bank charter into transaction steps constituting a tax-free reorganization and discusses the tax implications of each step of the reorganization.

Letter Ruling 200822022

Letter Ruling 200822022 provides guidance on a specific factual situation for the sale of a bank charter when state law will not permit a bank charter to be sold by itself. The key issues addressed were: (1) the steps of the reorganization needed to complete the sale of the charter; (2) the representations made by parties to the reorganization; and (3) the tax implications for the reorganization.

In the ruling, Acquirer and Target, both State A chartered banks and subsidiaries of Parent, a bank holding company, desired to combine their operations. Parent also wanted to sell Target’s State A bank charter to Third-Party Holding Company, a State B corporation and bank holding company unrelated to Parent, which owns all the stock of Third-Party Bank. Government Agency would not permit a State A bank charter to be transferred by itself. Rather, it would approve the proposed sale of the bank charter only if a certain transaction form was utilized.

The form required by Government Agency to effect the transaction is as follows:

The steps required above by Government Agency to effect the transaction are in accordance with the form approved in Rev. Proc. 89-50.

Recast as D Reorg.

When applying this particular factual situation and the representations outlined in the ruling, the Service recast the steps of the transaction as follows:

1.The acquisition by Acquirer of all Target’s assets (including the bank charter and the minimum capital) solely in exchange for constructive Acquirer common stock and the assumption by Acquirer of Target’s liabilities;

2.The distribution to Parent by Target of the Acquirer stock in exchange for all of Parent’s Target stock in complete liquidation of Target;

3.The distribution to Parent by Acquirer of the bank charter and minimum capital of Target in redemption of a portion of Parent’s Acquirer stock constructively received in (2) above;

4.The contribution by Parent of the bank charter and the minimum capital of Target received in (3) above to the capital of New Target (the Deemed Contribution) in exchange for the issuance of New Target stock to Parent; and

5.The sale of all New Target’s stock to Third-Party Holding Company (the Deemed Sale) for $X plus the minimum capital.

The IRS ruled, among other things, that the recast steps (1) and (2) above would constitute a tax-free reorganization within the meaning of Sec. 368(a)(1)(D) and that Acquirer would recognize gain or loss under Sec. 311(b) or Regs. Sec. 1.1502-13(f)(2)(iii) from the recast step (3) above. Such gain or loss would be taken into account under the timing rules of Regs. Sec. 1.1502-13 upon the deemed sale of New Target in the recast step (5) above. The favorable conclusions in the ruling are consistent with other letter rulings as well as Rev. Proc. 89-50.

Rev. Proc. 89-50 and Earlier Letter Rulings

In Rev. Proc. 89-50, the IRS addressed situations in which the target did not dissolve under state law so that the value of its corporate charter could be realized. Rev. Proc. 89-50 established certain conditions under which the Service will normally rule that the distribution requirement applicable to reorganizations under Secs. 368(a)(1)(C) and 368(a)(1)(D) has been met. Under Rev. Proc. 89-50, as long as the additional representations for retention of corporate charters in Secs. 368(a)(1)(C) and 368(a)(1)(D) reorganizations were made, the IRS agreed to recast the transaction to qualify as a C or D reorganization. However, the Service has allowed similar but varied transaction structures to qualify for tax-free reorganization treatment.

For example, in Letter Ruling 200645006, in step 1 of the proposed transaction, the minimal capital and the charter of Target were contributed to a newly formed company, which was subsequently merged into an unrelated bank. The Parent of Target received cash for the value of the Target bank charter and any required minimum capital as well as the book value of the assets of Target. Subsequently, Parent transferred the cash to Acquiring, its bank subsidiary. Acquiring retained the cash for the charter and minimal capital and used the cash for the book value of the assets to acquire the assets previously held by Target from the unrelated bank.

While the transaction described in Letter Ruling 200645006 differed slightly in structure to comply with government agency requirements, the tax implications are similar to those outlined in Letter Ruling 200822022. The same holds true for Letter Ruling 200128051, in which the transaction structure again varied to comply with government agency requirements, and the IRS ruled favorably that the transaction would be recast and treated as a D reorganization.

Conclusion

The transaction described in Letter Ruling 200822022 is another structure the IRS has permitted for a bank to consummate a charter sale while complying with certain state law requirements and still receive favorable tax-free reorganization treatment. The ruling exemplifies the Service’s willingness to allow a corporation to dispose of a valuable corporate charter without incurring unfavorable tax consequences for complying with government agency structuring requirements.

From Melissa A. Reinbold, CPA, Oak Brook, IL, and Jennifer M. Sanders, CPA, Louisville, KY

Transactions Between Private Equity Fund–Owned Portfolio Corporations: An Update

In today’s private equity environment, two common transactions between fund-owned portfolio corporations present challenging tax considerations: (1) asset sales between fund-owned portfolio corporations and (2) the acquisition by a fund-owned portfolio corporation of another portfolio corporation’s debt. (These were reviewed in Keller, “Transactions Between Private-Equity-Fund-Owned Portfolio Corporations,” Tax Clinic, 37 The Tax Adviser 518 (September 2006); the current item contains excerpts from that 2006 item.)

In September 2007, there was an interesting Pension Benefit Guaranty Corporation (PBGC) Appeals Board decision that, aside from its obvious potential ERISA implications, might alter the federal income tax consequences of the second item and, for that matter, any other private equity transactions where concluding whether the fund itself conducts a “trade or business” is critical to some income tax result.

The following example was discussed in the September 2006 Tax Clinic:

X Corp. and Y Corp. are both C corporation portfolio investments wholly owned by F, a private equity fund. F is a large, diversely held limited partnership (i.e., five or fewer persons own more than 50%) engaged primarily in long-term investing that generates a preponderance of income from long-term capital gains and dividends. F’s general partner manages its assets full time. Although the investment purpose of any particular underlying portfolio corporation might vary, F is a typical leveraged buyout fund, primarily dedicated to the capital appreciation of its underlying investments. X and Y each operate a separate trade or business, with separate and distinct management. They have no commonalities other than being owned by F. Y has acquired certain debt of X from an unrelated third-party creditor at a substantial discount. If X settled its debt for a discount, cancellation of debt (COD) income would result (assume none of the Sec. 108(a)(1) exclusions apply). However, because Y acquired the debt, and assuming X services the debt’s full face amount, does X recognize the discount as COD income, or does Y recognize it as gain (over the appropriate timing)?

According to Sec. 108(e)(4)(A), the acquisition of debt by a person bearing a relationship to the debtor, as specified in Secs. 267(b) or 707(b)(1), from a person who does not bear such a relationship to the debtor is treated as the acquisition of such debt by the debtor. In addition, Sec. 108(e)(4)(C) provides that two entities, treated as a single employer under Sec. 414(b) or (c), are treated as bearing a relationship to each other as described in Sec. 267(b). Thus, Y’s acquisition of X’s debt will result in COD income to X, if X and Y are “related” under Sec. 108(e)(4). But are they related?

The September 2006 Tax Clinic discussion concluded that X and Y were not related taxpayers under Sec. 267 and that Sec. 707(b)(1) did not apply to them. It also concluded that X and Y were not members of a controlled group under Sec. 414(b). Thus, they were clearly not related under Secs. 267, 707, or 414(b). However, the relationship of X and Y under Sec. 414(c) is less clear. A recent PBGC Appeals Board decision adds context to the analysis as a result of its specificity to a private equity fund and its underlying portfolio corporations (PBGC Appeals Board Decision, “[Company ‘A’] Pension Plan” (9/26/07), www.pbgc.gov/apbletters/Decision--(Liability within a group of companies) 2007-09-26.pdf).

Trades or Businesses Under Common Control

According to Sec. 414(c), all employees of trades or businesses (whether or not incorporated) that are under common control are treated as employed by a single employer. Regs. Sec. 1.414(c)-2(a) defines two or more trades or businesses under common control to include a brother-sister group of trades or businesses under common control, a combined group of trades or businesses under common control, and a parent-subsidiary group of trades or businesses under common control. The first two of these three definitions can be dealt with easily.

Brother-sister group: Under Regs. Sec. 1.414(c)-2(c)(1), a brother-sister group of trades or businesses under common control refers to two organizations conducting trades or businesses, if the same five or fewer persons who are individuals, estates, or trusts own a controlling interest in each organization and, when such person’s ownership of each organization is identical, such person is in effective control of each organization. Under the Regs. Sec. 1.414(c)-2(c)(2)(iii) definition of effective control, if the brother-sister group is owned by a partnership, such five or fewer persons must own more than 50% of that partnership. Thus, X and Y are not members of a brother-sister controlled group because the five-or-fewer/50% test is not met.

Combined group: Regs. Sec. 1.414(c)-2(d) provides that a “combined group of trades or businesses under common control” means any group of three or more organizations, if (1) each such organization is a member of either a parent-subsidiary group of trades or businesses under common control or a brother-sister group of trades or businesses under common control, and (2) at least one such organization is the common parent organization of a parent-subsidiary group of trades or businesses under common control and is also a member of a brother-sister group of trades or businesses under common control. F, X, and Y are not a combined group because although F is the common parent of X and Y, it is not also a member of a brother-sister group.

Parent-subsidiary group: According to Regs. Sec. 1.414(c)-2(b), a parent-subsidiary group of trades or businesses refers to one or more chains of organizations conducting trades or businesses connected through ownership of a controlling interest (80%) with a common parent organization, if a controlling interest in each organization (except the parent) is owned by one or more of the other organizations, and the parent owns a controlling interest in at least one of the other organizations.

The regulations do not explicitly state whether the parent in a parent-subsidiary group must itself conduct a trade or business. However, the regulation’s examples strongly imply that this is necessary. Moreover, the relevant distinction between a parent-subsidiary group and a brother-sister group would appear to be meaningless without a requirement that the parent in a parent-subsidiary group itself be engaged in a trade or business. Regs. Sec. 1.414(c)-2(e), Example (1)(a), offers the following facts:

ABC partnership owns stock possessing 80% of the total combined voting power of all classes of stock entitled to vote of S corporation. ABC partnership is the common parent of a parent-subsidiary group of trades or businesses under common control consisting of the ABC partnership and the S corporation.

This example does not specify that ABC partnership conducts a trade or business. However, this is implied in the conclusion that ABC is the common parent of a parent-subsidiary group of trades or businesses under common control. The very reference to trades or businesses (in the plural) makes this apparent. In addition, Regs. Sec. 1.414(c)-2 is titled, “Two or more trades or businesses under common control.”

Regs. Sec. 1.414(c)-2(e), Example (3), has the following facts:

ABC partnership is treated as the owner of stock possessing 100% of the voting power and classes of stock of X and Y corporations. Thus, ABC is the common parent of the parent-subsidiary group of trades or businesses under common control consisting of ABC partnership, X corporation, and Y corporation.

Although this might at first appear similar to the facts in Regs. Sec. 1.414(c)-2(e), Example (1)(a) (above), Example (3) does not specify that ABC partnership conducts a trade or business. Instead, it is again implied, via the conclusion that ABC is the common parent of this parent-subsidiary group of two chains of organizations conducting trades or businesses under common control. The ABC–X chain is one chain of organizations conducting trades or businesses; the ABC–Y chain is the other. Thus, because there are two chains of organizations conducting trades or businesses connected through ownership of a controlling interest with a common parent (ABC), there is a parent-subsidiary group consisting of ABC, X, and Y. Inasmuch as Regs. Sec. 1.414(c)-2(b) literally requires a chain of organizations conducting trades or businesses, for such a chain to exist, the parent and the subsidiary must each conduct a trade or business.

Distinction: There also is a distinction between the parent-subsidiary group provisions under Regs. Sec. 1.414(c)-2(b) and the brother-sister group provisions under Regs. Sec. 1.414(c)-2(c). A brother-sister group exists if organizations conducting trades or businesses are under the common control of the same five or fewer persons. If the brother-sister group is owned by a partnership, such persons must own more than 50% of that partnership. However, the brother-sister regulations do not require the group to be connected by a parent in a chain of organizations conducting trades or businesses.

In other words, the parent’s trade or business is irrelevant in the brother-sister regulations; it is only relevant that the brother-sister organizations conduct trades or businesses. Thus, if the brother-sister group is owned by a partnership, it is irrelevant whether the partnership conducts a trade or business in determining whether a brother-sister group ultimately exists below the partnership.

In contrast, a parent-subsidiary group exists if there are one or more chains of organizations conducting trades or businesses connected through a common parent. Absent the reference to “one or more chains of organizations conducting trades or businesses,” the brother-sister regulations would have little (if any) distinction from the parent-subsidiary regulations when, for example, multiple subsidiaries exist under a partnership parent (i.e., in  Regs. Sec. 1.414(c)-2(e), Example (3)). Because a law presumably cannot be read to be meaningless, it is apparent that the distinction under the parent-subsidiary regulations is the requirement that the parent itself conduct a trade or business.

Further, a leading treatise cites Regs. Sec. 1.414(c)-2(b)(1) to describe a parent-subsidiary group under Sec. 414(c). According to Bittker and Lokken, Federal Taxation of Income, Estates and Gifts ¶61.11.2 (WG&L 2004), a parent-subsidiary group is

[o]ne or more chains of organizations, each of which carries on a trade or business, one of which is a common parent organization, and a controlling interest in each of which (other than the parent) is owned by the common parent or another member of the group. [Emphasis added.]

Accordingly, in the example from the 2006 Clinic item, unless F is deemed to be engaged in a trade or business, F, X, and Y would not be a parent-subsidiary group as defined in Sec. 414(c). The comment “unless F is deemed to be engaged in a trade or business” is, of course, an important one and is where the September 26, 2007, PBGC Appeals Board decision comes in.

The good news is that in its decision the PBGC Appeals Board clearly agrees that F must be in a trade or business—a conclusion that, until this decision, was never specifically addressed, in either a federal income tax or a benefit plan context. The bad news is that the PBGC Appeals Board decided that F was in fact engaged in a trade or business, and it did so in a stream of thought process specifically and squarely applicable to the typical fund-owned portfolio corporation setting so common in today’s private equity environment.

Defining “Trade or Business”

There is no statutory or regulatory definition of the phrase “trade or business,” although the term appears in literally hundreds of Code provisions. Thus, the definition has fallen to the courts. In Groetzinger, 480 U.S. 23 (1987), the Supreme Court identified two main requirements for an activity to constitute a trade or business when claiming business deductions under Sec. 162: The activity must be conducted (1) for profit (rather than for recreation) and (2) with continuity and regularity.

Almost all of the cases cited in Groet-zinger have dealt with the definition of a trade or business, as used in Sec. 162 and its predecessors. Not only is the term as used in Sec. 414(c) not defined in the Code or regulations, but the definition appears to have never been considered by the courts in a tax case or by the IRS in its rulings. However, the term as used in the Multiemployer Pension Plan Amendments Act of 1980, P.L. 96-364 (MPPAA), has been frequently interpreted and applied by the courts. The September 2006 item cited a number of MPPAA cases in which the vast majority, in finding that a separate entity that merely engages in limited economic activity is a trade or business, involved entities with some economic nexus with the principal business.

Further, many courts in MPPAA cases have accepted the Supreme Court’s analysis in Groetzinger in distinguishing trades or businesses from investments. However, the courts in the MPPAA cases had not yet (and still have not yet) specifically addressed whether a private securities partnership, such as F, constitutes a trade or business. The September 2006 Tax Clinic discussion concluded that, based on case law (particularly Groetzinger and its progeny) and considering F’s activities and sources of income, it is unlikely that F would be classified as being in a trade or business under Sec. 414(c). The common thread of these cases is that for a taxpayer to be a trader rather than an investor, its securities activities must be almost daily, not sporadic, and its income must be from short-term trading-type income, rather than from long-term capital gains, dividends, and interest (i.e., investment-type income).

Now fast forward to today and consider the September 26, 2007, PBGC Appeals Board decision. Although not a judicial decision and, of course, not decided in a federal income tax context (so one might immediately decide it is not determinative for federal income tax purposes), the PBGC decision appears to be the most dedicated analysis of this issue specific to the private equity environment to date.

PBGC Appeals Decision

The company that is the subject of the Appeals Board decision (the subject company) is a management company of a private equity fund. It made the appeal as a result of the PBGC’s determination that the fund, and certain other companies owned by the fund, were members of a controlled group and were jointly and severally liable to the PBGC for the unfunded benefit liabilities of one of the company’s plans. The appeal was made with respect to two issues: (1) the fund’s liability for the unfunded benefit liabilities of the plan and (2) the other companies’ joint and several liability for the same.

With respect to the first item, the PBGC Appeals Board denied the appeal and sustained the PBGC’s determination that the fund was under common control with the sponsor of the plan and that the fund and the sponsor were jointly and severally liable to the PBGC for the liability imposed. With respect to the second item, the PBGC Appeals Board granted the appeal. Of particular interest in the appeal is the Appeals Board’s analysis of whether the fund is conducting a trade or business.

The fund at issue was a limited partnership established under Delaware law by its general partner and numerous independent institutional investors as limited partners. The fund’s governing documents delegated full control over the fund’s business affairs to its general partner, which has a 1% capital interest and a 20% carried interest in all profits realized by the fund. Further, the fund’s governing documents described the fund’s purpose of organization to include creating and realizing long-term capital gains including, without limitation, the general buying, selling, holding, and otherwise investing in securities of every kind and nature, entering into, making, and performing all contracts and other undertakings with respect to such investments, and managing and supervising such investments, etc. All of the background facts presented in the appeal for the fund at issue are typical among numerous funds in today’s private equity environment.

The Subject Company’s Arguments

The subject company asserted various grounds in its appeal for changing the PBGC’s determination. The primary ground was that the fund was not conducting a trade or business and therefore could not be part of the controlled group at issue. The subject company argued that the fund was not conducting a trade or business either because the fund’s general partner did not have responsibility for managing the fund or because the fund was engaged in passive investment activities and its activities did not qualify as trade or business under the Groetzinger test.  The subject company did not dispute the PBGC’s determination that a parent-subsidiary relationship exists between the fund and the plan sponsor.

In analyzing whether or not the fund was engaged in a trade or business, the Appeals Board concluded that it is appropriate to consider the duties and responsibilities delegated to and assumed by the general partner of the fund. The Appeals Board further took into account that in Delaware, as a matter of law, an agency relationship exists between the fund and its general partner whereby each partner is an agent of the partnership for the purpose of its business, purposes, or activities.

In the appeal, the subject company contended that because it was responsible for the day-to-day management of the fund, the general partner was not. However, the Appeals Board countered by citing the terms of the fund’s partnership agreement, which provided that the appointment of a management agent (i.e., the subject company) “shall not in any way relieve the general partner of its responsibilities and authority vested pursuant to the fund’s governing documents or relieve the general partner of any fiduciary duties to the fund and its partners.”

According to the Appeals Board, based on the partnership agreement and the management agreement with the subject company, the fund’s general partner had hired the subject company as the fund’s management agent to assist in managing the fund’s investments but did not relinquish all management responsibilities. The Appeals Board found that while the management and partnership agreements proved that the subject company was hired to assist the fund by providing investment and management services, they did not prove that such activities were conducted only by the subject company.

Therefore, the Appeals Board concluded that the general partner participated in the fund’s investment activities and also received compensation in the form of its 20% carried interest in exchange for its services. As the fund’s agent, all of the general partner’s acts within the scope of its agency were attributable to the fund.

The Appeals Board also applied the Groetzinger trade or business test to the fund in making its decision. As noted above, a taxpayer is engaged in a trade or business under this test if it engages in an activity primarily with a profit motive and if the activity is carried out with continuity and regularity. Based on the fund’s tax returns and language in the partnership agreement, the Appeals Board concluded that the fund met the profit motive requirement described in Groetzinger. The Appeals Board further analyzed the size of the fund’s portfolio, the profits generated by its investments, and the fees that it had paid to the subject company in concluding that the general partner’s management of the fund’s investments was conducted with regularity. It thus determined that the fund, through the activities of its agent (the general partner), met the second prong of the Groetzinger test.

The subject company also asserted in its appeal that the fund is not engaged in a trade or business because “investment activities do not constitute a trade or business.” The subject company described the fund as “a passive investment vehicle that has no employees, no involvement in the day-to-day operations of its portfolio investments, and no income other than passive investment income such as dividends, interest, and capital gains.” Essentially, the argument was that the fund is a passive investor, predicated on the suggestion that “in the income tax context, it is universally accepted that passive investment activities do not constitute a trade or business.” The subject company cited several cases to this effect, most notably Higgins, 312 U.S. 212 (1941); Whipple, 373 U.S. 193 (1963); and Zink, 929 F.2d 1015 (5th Cir. 1991).

The Appeals Board considered all these cases and ultimately concluded that the “passive” investment activities described in all three, as well as other cases the subject company had cited, were distinguishable from the much more active involvement of the fund (through its general partner) with respect to its investments. The Appeals Board further concluded that the fund’s delegation of many of its management functions to other entities did not establish that the fund was merely a “passive investor.” Accordingly, the Appeals Board, having claimed to have fully analyzed the holdings in all the court cases the subject company cited in its appeal, ultimately decided that the fund was in a trade or business for purposes of controlled group liability under ERISA.

Conclusion

The September 2006 Tax Clinic item concluded that, with respect to the COD income matter, X and Y appear unrelated under Sec. 414(c). Thus, Y’s acquisition of X’s debt appears not to result in COD income to X under Sec. 108(e)(4). Instead, Y should recognize the discount as gain over the appropriate timing as the debt is serviced. The September 26, 2007, PBGC Appeals decision certainly gives cause to reconsider this conclusion. And of course this might be only one example of numerous instances in which the relatedness of two portfolio corporations under the same fund might be important to some federal income tax analysis.

As mentioned above, because this is a nonjudicial decision in an ERISA setting, it is not itself determinative in the context of federal income taxation. However, a discussion in the Appeals decision should cause concern about dismissing the decision too quickly. In the appeal, the subject company suggested that the PBGC lacks authority to interpret 29 U.S.C. Section 1301(a)(14)(B) (ERISA Section 4001(a)(14)(B)) related to controlled group determinations because Congress granted such interpretive authority to Treasury. In its decision, the PBGC Appeals Board disagreed and suggested that the only restriction ERISA imposes on the PBGC’s authority to interpret 29 U.S.C. Section 1301(a)(14)(B) is that its regulations must be “consistent and coextensive” with the applicable regulations issued under Sec. 414.

Further, the subject company asserted that the PBGC lacked authority to adjudicate this case under ERISA in any fashion contrary to the judicial definition of “trade or business” in the federal income tax context, stating that this definition excludes investment activities. The Appeals Board disagreed, stating that, as several courts have noted, interpretations under the Internal Revenue Code are not determinative of whether an entity is in a trade or business under ERISA. The Appeals Board further suggested that, in this case, the PBGC’s determination does not involve an interpretation of “trade or business” that differs from the judicial definition in the tax context. The Appeals Board believed that the PBGC’s determination was consistent with the trade or business test articulated in Groetzinger and with judicial decisions that have applied the Groetzinger test in determining liability under ERISA.

From Brian E. Keller, CPA, Oak Brook, IL

State & Local Taxes

The Michigan Business Tax: New Developments

Since being enacted in July 2007, the Michigan Business Tax (MBT) has undergone constant legislative changes and administrative clarifications in the form of revenue administrative bulletins (RABs) and frequently asked questions (FAQs) issued by the Michigan Department of Treasury (see Treasury’s website at www.michigan.gov/taxes under the Michigan Business Tax section for the latest RABs and FAQs). Following are summaries and excerpts from some of the more significant changes (for more details of the MBT as it was originally enacted, see Wright, “The Michigan Business Tax: Overview and Issues to Consider,” 38 The Tax Adviser 750 (December 2007)). These changes include nexus defined for MBT purposes, unitary taxation under the MBT, small business provisions, the MBT surcharge, and an MBT credits update.

Note: Numerous additional changes are being proposed to the MBT as this item goes to press. A significant change that could affect many businesses is a proposal to modify the definition of gross receipts, which would permit a deduction from the modified gross receipts tax base for, among other things, bad debts and taxes collected on behalf of the state (see proposed S.B. 1038).

Nexus Defined for MBT Purposes

In its RAB 2007-6, issued on December 28, 2007, the department complied with its statutory mandate under Mich. Comp. Laws §§208.1200(1) and (2) to define “actively solicits” for nexus standard purposes. A business taxpayer will have nexus under the MBT

[i]f the taxpayer has a physical presence in this state for a period of more than 1 day during the tax year or if the taxpayer actively solicits sales in this state and has gross receipts of $350,000.00 or more sourced to this state.

In the RAB the department defines “actively solicits” to mean

purposeful solicitation of persons within this state. Solicitation means: (1) speech or conduct that explicitly or implicitly invites an order; and (2) activities that neither explicitly nor implicitly invite an order, but are entirely ancillary to requests for an order.

In the RAB the department further explains that

solicitation is purposeful when it is directed at or intended to reach persons within Michigan or the Michigan market. Active solicitation includes, but is not limited to, solicitation through: (1) the use of mail, telephone, and e-mail; (2) advertising, including print, radio, internet, television, and other media; and (3) maintenance of an internet site over or through which sales transactions occur with persons within Michigan. Examples of active solicitation provided by the department include sending mail order catalogs; sending credit applications; maintaining an internet site offering online shopping, services, or subscriptions; and soliciting through media advertising, including internet advertisements.

Probably the most controversial position taken by the department relates to its attempt to subject internet retailers to the modified gross receipts portion of the MBT. For this portion of the MBT the department claims that no physical presence in Michigan is required and that, as explained in Example 1 from their RAB, merely having $350,000 in Michigan gross receipts and having a website whereby Michigan residents can place orders is sufficient to create nexus for MBT purposes.

A retailer located outside Michigan maintains an internet site over and through which customers may browse products and place orders. The internet site is generally available to all persons throughout the country. Through maintenance of the interactive site, the retailer intends to reach all persons and markets, including persons within Michigan and the Michigan market. The retailer is actively soliciting sales in Michigan.

Another controversial position that the department has now taken in a new draft RAB on nexus is how physical presence in Michigan for a period of more than one day during the tax year will be applied. For nexus to exist, there should be a connection between the taxpayer’s in-state activities and the taxpayer’s attempt to establish or maintain a market in Michigan. This nuance was recognized in RAB 1998-1, which provided departmental guidance on the SBT nexus standard, whereby certain activities could be carried on in Michigan without those activities alone creating nexus. They included such things as meeting with in-state suppliers of goods or services; in-state meeting with government representatives in their official capacity; attending occasional meetings (e.g., board meetings, retreats, seminars and conferences sponsored by others, etc.); holding recruiting or hiring events; renting to or from an in-state entity customer list; and/or attending and/or participating at a trade show at which no orders for goods are taken and no sales are made.

As there is no statutory exemption for these activities, even though they are not taking place in Michigan to establish or maintain a Michigan market, the department has now taken a hard line in its new draft RAB on nexus by saying that more than one day of any of these activities, alone or in combination, will create nexus. Now that the department has taken this position, many out-of-state businesses may think twice about using Michigan suppliers, holding meetings or attending conventions in Michigan, or recruiting Michigan citizens for jobs in other states.

Finally, the department’s MBT nexus RAB states that “active solicitation, coupled with $350,000 in Michigan gross receipts, constitutes nexus under the MBT and satisfies the Due Process and Commerce Clauses of the U.S. Constitution.”

While the department is entitled to its opinion as to the constitutionality of these nexus standards, it will be left to the courts to decide whether or not some of these extremely aggressive nexus standards do in fact satisfy both the due process and commerce clauses of the U.S. Constitution.

Unitary Taxation Under the MBT

The Michigan Department of Treasury’s FAQ U33 “What Is a Unitary Business Group?” provides an explanation of the department’s most recent interpretation of the control and relationship tests that must both be met to be considered a unitary business for MBT purposes. For unitary tax purposes the nexus standard is the same as for separate entities. However, because Michigan treats a unitary group as a single taxpayer, thereby ignoring each individual member’s separate legal existence, if one member of the unitary group has nexus in Michigan, all members of the unitary group are considered to have nexus in Michigan (the Finnigan standard; see Appeal of Finnigan Corp., 88-SBE-022, on reh’g (SBE 1/24/90)) and the group is required to file a combined return under Mich. Comp. Laws §208.1511. Further, for purposes of the $350,000 in Michigan gross receipts portion of the active solicitation nexus test, the gross receipts of all members of the group are aggregated. So, for example, if each of the four members of a unitary group has $100,000 in Michigan gross receipts, then the group’s $400,000 in Michigan gross receipts would exceed the $350,000 threshold and the group would have nexus in Michigan and would have to file an MBT return.

According to various department FAQs, the designated member of a unitary business group must register with the department for the MBT. “Designated member” means a member of a unitary business group that has nexus with Michigan under Mich. Comp. Laws §208.1200 and that will file the combined return required under Mich. Comp. Laws §208.1511 for the unitary business group. Only the designated member must register, and the MBT return will be filed under its FEIN. If the member that owns or controls the other members of the unitary business group has nexus with Michigan, then that controlling member must be the designated member. Otherwise, the designated member can be any member of the unitary business group with nexus. The unitary group must use the tax year of the designated member, so, for any entities that have a different tax year, the combined return of the unitary business group must include each tax year of each member whose tax year ends with or within the tax year of the designated member.

Small Business Provisions

The MBT has a credit similar to the small business credit that was available under the single business tax (SBT), but the language was expanded to include members of limited liability companies (Mich. Comp. Laws §208.1417). The credit is also being referred to as an alternative calculation for small businesses. The alternative calculation is adjusted business income multiplied by a reduced tax rate of 1.8% (Mich. Comp. Laws §208.1417(4)).

To be eligible for the reduced tax rate, taxpayers will need to meet the following qualifications: (1) business income minus loss adjustment may not exceed $1.3 million (Mich. Comp. Laws §208.1417(1)); and (2) gross receipts may not exceed $20 million (Mich. Comp. Laws §208.1417(1)) with a phaseout of credit between $19 million and $20 million (Mich. Comp. Laws §208.1417(5)). For individuals, partnerships, limited liability companies (LLCs), or S corporations, the distributive share of an individual, one partner, one member of the LLC, or any one shareholder of the S corporation may not exceed $180,000 of the adjusted business income minus the loss adjustment of the individual, the partnership, the LLC, or the S corporation (Mich. Comp. Laws §208.1417(1)(a)).

For C corporations (Mich. Comp. Laws §208.1417(1)(b)), compensation and directors’ fees of a shareholder or officer may not exceed $180,000, and the sum of the following amounts may not exceed $180,000: compensation and directors’ fees of a shareholder and the product of the percentage of outstanding ownership or of outstanding stock by that shareholder multiplied by the difference between the sum of business income and, to the extent deducted in determining federal taxable income, a carryback or carryover of a net operating loss of capital loss, minus the loss adjustment (add back percentage of net operating loss).

The alternative calculation is applied as if it were a credit. The credit is subject to a phaseout percentage based on the distributive share and/or compensation between $160,000 and $180,000 (Mich. Comp. Laws §208.1417(1)(c)). 

Adjusted business income is defined as federal taxable income derived from business activity, plus compensation and directors’ fees of active shareholders and/or of officers of a corporation; carryback or carryover of a net operating loss (to the extent deducted in determining federal taxable income); and capital loss (to the extent deducted in determining federal taxable income) (Mich. Comp. Laws §208.1417(9)(b)).

The business income limitation will be adjusted annually utilizing the Detroit consumer price index (Mich. Comp. Laws §208.1417(1)). The qualification amounts have been greatly increased over the prior amounts under the SBT, providing additional planning opportunities and increasing the number of taxpayers who may qualify.

MBT Surcharge

Michigan previously passed legislation imposing a use tax on a number of services with an effective date of December 1, 2007. This legislation met with opposition, and the legislature was urged to find an alternative method of meeting deficiencies in the state budget. Public Act (PA) 145, effective December 1, 2007, repealed the services tax and instituted an MBT surcharge to replace the revenue loss from the repealed service tax. The annual surcharge is calculated after allocation and apportionment but before calculation of any credits that are available to the taxpayer. In general, taxpayers doing business in Michigan will have a surcharge of 21.99% imposed on their tax liability before credits. The surcharge is capped at $6 million per taxpayer (Mich. Comp. Laws §208.1281).

Financial institutions are also subject to a 27.7% surcharge for tax years ending during 2008 and a 23.4% surcharge for tax years ending after December 31, 2008, with no cap (Mich. Comp. Laws §208.1281(1)(b)). The surcharge does not apply to financial institutions authorized to execute only trust powers. Insurance companies are also excluded from the surcharge (Mich. Comp. Laws §208.1281(4)).

The surcharge is scheduled to expire on January 1, 2017, if the Michigan personal income growth exceeds zero percent in any one of the three calendar years immediately preceding the 2017 calendar year. “Michigan personal income” means personal income for the state, as defined by the Bureau of Economic Analysis of the U.S. Department of Commerce or its successor (Mich. Comp. Laws §208.1281(2)).

MBT Credits

Although the primary purpose of PA 145 was to institute a surcharge to replace the revenue from the repealed service tax, PA 145 also made a number of additional changes to the MBT. Some of those changes include changes to the compensation credit, the investment tax credit, and the research and development credit. PA 145 also adopted several new MBT credits. The following is a list of some of the changes adopted when the use tax on services was repealed.

Compensation credits: The compensation credit is allowed for compensation paid to employees in Michigan. The credit was reduced to .296% for the 2008 tax year from the originally enacted rate of .37%. For the 2009 tax year and thereafter, the rate returns to .37% (Mich. Comp. Laws §208.1403(2)). The compensation credit generally includes payment to employees in Michigan for all wages, salaries, fees, bonuses, commissions, and other payments made in the tax year on behalf of or for the benefit of employees, officers, or directors of the taxpayers, and any earnings that are net earnings from self-employment as defined under Sec. 1402. Other payments made on behalf of or for the benefit of employees may include 401(k) matches, pretax benefit payments, pensions, and any items included on Form W-2 that are specifically exempted or excepted from federal income tax withholding.

The department indicated in MBT FAQ C28 that

compensation is “in this state” if (a) the individual’s service is performed entirely within Michigan, or (b) the individual’s service is performed both within Michigan and outside Michigan, but the service performed outside Michigan is incidental to the individual’s service within Michigan.

This answer implies that taxpayers with employees who perform their services in several states will need to document the services that are being performed in each state in order to substantiate the compensation credit claimed.

Investment credits: The investment credit is allowed for the cost of new capital assets located in Michigan less any recapture. The credit was reduced to 2.32% for the 2008 tax year from the originally enacted rate of 2.9%. For the 2009 tax year and thereafter, the rate returns to 2.9% (Mich. Comp. Laws §208.1403(3)).

Credit limitations: For the 2008 tax year, the combined compensation credit and the investment tax credit may not exceed 50% of a taxpayer’s MBT liability before the surcharge. For the 2009 tax year and thereafter, these combined credits cannot exceed 52% of a taxpayer’s MBT liability before the surcharge. As originally enacted, the combined total of these two credits could not exceed 65% of the taxpayer’s MBT liability (Mich. Comp. Laws §208.1403(1)).

Research and development (R&D) credit: The R&D credit is allowed for research and development expenses incurred in Michigan during the tax year. The credit was reduced to 1.52% for the 2008 tax year from the originally enacted rate of 1.9%. For the 2009 tax year and thereafter, the rate returns to 1.9% (Mich. Comp. Laws §208.1405).

Credit limitations: The R&D credit, combined with the compensation and investment credits, is limited to 65% of the MBT liability before the surcharge is applied (Mich. Comp. Laws §208.1405). The originally enacted percentage was 75%.

Refundable personal property tax credit: PA 145 added taxes levied on certain public utilities to the definition of property eligible for the refundable personal property tax credit. A 35% credit is allowed for payments made for Michigan industrial personal property taxes. A 23% credit is allowed for payments made for Michigan personal property taxes paid by a telephone company in 2008, and a 13.5% credit is allowed for payments made for Michigan personal property taxes paid by a telephone company in subsequent years. A 10% credit is allowed for payments made for Michigan personal property taxes paid on natural gas pipelines.

Taxpayers must file the Michigan personal property tax statements by the due date of February 20 of each year to be eligible to receive the credit, and the payment must have been made for taxes assessed after December 31, 2007. The only way to receive a refund for the industrial personal property tax credit is to file an MBT return. As such, taxpayers who do not meet the MBT filing threshold or otherwise do not have an MBT filing obligation, but have made payments for qualifying Michigan personal property taxes, should consider filing an MBT return in order to claim the refund (Mich. Comp. Laws §208.1413 (et seq.)).

Other credits: There are a plethora of other MBT credits, and the legislature is enacting new ones all the time. For a listing of the credits, see the Michigan Department of Treasury website and Mich. Comp. Laws §§1409–1453.

Terminated SBT credits: SBT credits that are no longer available under the MBT include the unincorporated business credit, Michigan Economic Development Authority business activity credit, transferred jobs credit, minority venture capital company credit, high-technology activity credit, created jobs credit, donated automobile credit, apprenticeship credit, pharmaceutical research credit, and enterprise zone credit. All these credits may be carried forward to the 2008 and 2009 tax years to the extent that the credit could be used under the SBT. After 2009, unused credit carryforwards are extinguished.

From B. D. Copping, CPA, MST, Amanda Miscisin, CPA, and Lisa Pohl, J.D., Grand Rapids, MI

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© 2008 AICPA