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In this edition:
In a recent case, the Tax Court supported the IRS's disallowance of a charitable contribution deduction for a bargain sale of fill to a city government.
Boone Operations Co. owned and operated a landfill in Tucson, Ariz., which was adjacent to a landfill operated by the city. The municipal landfill encountered a number of environmental problems. In 1996, Boone agreed to help Tucson close its landfill. A dispute between the parties ensued, and Tucson eventually filed criminal and civil charges against Boone.
In 2003, Boone and Tucson entered into a settlement to resolve their disagreements and lawsuits. One aspect of this settlement agreement involved Tucson agreeing to pay Boone $6 per cubic yard for fill. Boone claimed charitable contribution deductions for the fill for 2003 and 2004 as a bargain sale contribution. To qualify for a charitable contribution deduction of $250 or more, taxpayers must receive from a qualified organization contemporaneous written acknowledgment showing the description of the gift and a good-faith estimate of the value of any goods or services provided by the organization to the donee.
The IRS argued that Boone was not entitled to a charitable contribution deduction because it received significant cash and noncash consideration in exchange for the fill, and it failed to prove that the value of the fill exceeded the value of the consideration that Boone received. In addition, the IRS argued that Boone failed to obtain a contemporaneous written acknowledgment and to provide a qualified appraisal.
Boone argued that the fair market value of the donated fill exceeded $6 per cubic yard. The company provided valuation reports by an appraiser to support this contention. Boone argued that it intended to make a charitable contribution to Tucson at the time of the sale and so had the requisite charitable intent. It further argued that it complied with all substantiation requirements, including the contemporaneous written acknowledgment requirement and the qualified appraisal requirement.
The court found that Boone could not use the settlement agreement with Tucson to meet the contemporaneous written acknowledgment requirement. While the settlement agreement indicated that Tucson provided goods and services in exchange for Boone's contribution of fill, the agreement lacked a good-faith estimate of the value of those goods and services. Further, although the agreement indicated the amount of cash Tucson agreed to pay for the fill, it didn't value the other benefits Boone received.
The court found that Boone failed to prove that the fair market value of the fill Boone contributed exceeded the value of the consideration Boone received from Tucson (Boone Operations Co., LLC, et. al. v. Commissioner, TC Memo 2013-101, April 11, 2013). The court's analysis of the appraisal by Boone's appraiser supported a conclusion that the actual fair market value of Boone's fill ranged from $4.72 to $7.87 per cubic yard. However, the court found that it could not conclude, on the basis of the evidence, that the value of the fill transferred exceeded the amount Boone received, including cash plus other benefits.
The other benefits that Boone received included resolution of zoning disputes, dismissal of civil and criminal complaints, and other items. Boone's appraiser did not value these additional benefits and failed to provide any evidence that would allow the court to estimate the value of these additional benefits.
Now that most people have completed their 2012 tax filings, it's time to think about tax planning for 2013.
One tried-and-true planning tip is to contribute to your individual retirement account (IRA) early in the year. That way, you start earning tax-favored investment returns as soon as possible. For 2013, the maximum amount that you may contribute to your IRAs is $5,500, or $6,500 if you will be over age 50 by the end of the year. The limit applies to your total contributions to all IRAs, traditional and Roth.
Many people prefer to contribute to traditional IRAs if they can claim an income tax deduction for the contribution. Those who are not eligible for the deduction because, for example, they are covered by an employer-sponsored plan prefer to contribute to a Roth IRA. Some choose to forgo the immediate deduction and contribute to a Roth IRA because the retirement distributions from the Roth IRA will be entirely tax-free.
Some people who would like to contribute to a Roth IRA are barred by income limitations. For 2013, the following income limits apply to Roth IRA contributions:
- For married couples filing jointly, the allowable contribution begins to phase out at $178,000 of adjusted gross income (AGI), and no deduction is available if AGI equals $188,000 or more.
- For singles, the phase-out range is $112,000 to $127,000 of AGI.
- For a married individual filing a separate return who is covered by a retirement plan at work, the phase-out range is $0 to $10,000 of AGI.
One recommendation to those who wish to contribute to a Roth IRA, but their income is too high, is to contribute to a traditional IRA followed by a conversion of the traditional IRA to a Roth IRA. Some years ago, Congress removed the income limits on Roth conversions.
While this strategy can work fine in many circumstances, it should be undertaken only with the counsel of a tax adviser. One reason to proceed with caution is that the IRS does not allow converters to specify which dollars are being converted. Therefore, it is impossible for those who have funds in any non-Roth IRA accounts to contribute to a traditional IRA and then "convert that account" to a Roth IRA. Conversions must be performed on a pro rata basis, not on specific dollars or accounts. For example, assume you have $44,500 of untaxed money in traditional IRAs. During 2013, you contribute $5,500 to a traditional IRA and then convert that account to a Roth IRA. The conversion will result in $4,895 of taxable income.
The calculation looks at the $50,000 in total non-Roth IRA money as if it were one account. Since 89 percent of that balance (i.e., $44,500 out of $50,000) is untaxed, you will owe taxes on 89 percent of the conversion amount (i.e., $4,895).
An IRS private letter ruling waived the rollover requirement for a woman who had withdrawn funds from her individual retirement account but failed to roll them over within the required 60 days because her medical condition had impaired her ability to manage her financial affairs.
A distribution from a traditional IRA may be subject to income tax plus a 10 percent penalty in the case of a premature withdrawal that does not meet a statutory exception. However, no immediate tax or penalty is applied if a taxpayer rolls over a distribution from a traditional IRA to another IRA or other eligible retirement plan within 60 days of having received the distribution.
In general, to accomplish a tax-free rollover, a taxpayer must again contribute the distribution from the traditional IRA to a traditional IRA no later than 60 days after the date that the individual received the withdrawal from the IRA.
The IRS may waive the 60-day rule, called a hardship waiver, if not waiving the rule would be against equity or good conscience. The waiver may be granted to individuals under conditions such as casualty, disaster or any other event beyond their reasonable control.
In deciding whether to grant a hardship waiver, the IRS considers several factors, including the time elapsed since the distribution; errors committed by a financial institution; and the inability to complete the rollover due to death, disability, hospitalization, incarceration, restrictions imposed by a foreign country or postal error.
The facts as shown in the private letter ruling () are as follows:
- On Dec. 22, 2011, a woman withdrew funds from her IRA.
- In January 2012, she contacted a financial institution requesting information about how to roll over the distribution, and she received email instructions on Jan. 8, 2012.
- She did not roll over the funds until March 16, 2012, more than 60 days after she received the withdrawal.
During the 60-day period, the woman was under the care of a doctor for several conditions that severely impaired her mental abilities, including her ability to manage her financial affairs. A doctor examined her during the 60-day period and prescribed medications to treat several medical conditions.
A statement from the doctor said the woman's medical condition had worsened, resulting in poor judgment, faulty memory, poor concentration and impaired decision-making abilities. In fact, she was granted a Social Security disability award during the rollover period.
The IRS determined that the information and documentation provided supported the woman's assertion that her ongoing medical condition caused her to fail to roll over the funds in a timely manner. Because her medical condition impaired her ability to manage her financial affairs, the IRS granted the hardship waiver.
A private letter ruling applies only to the specific taxpayer addressed in the ruling. Individuals encountering similar situations may find it advisable to request their own private letter rulings.
As both a certified public accountant and a certified fraud examiner, I have clients ask me all the time about the difference between a fraud or forensic examination and a regular external audit. My initial answer is that you may need one (external audit) depending on financing requirements, and the other will be necessary when fraudulent activity is detected (fraud or forensic examination).
One of the major differences I deal with continuously is that external audits are planned in advance and usually during the same time period each year. The client’s staff assists in preparing the information, schedules and account balance reconciliations needed to determine the validity of the account balances.
Fraud examinations are spontaneous in a majority of cases, usually coming, of course, at the most inappropriate time in a fraud examiner’s schedule. I can’t detail the number of weekends, nights and holidays that I’ve had interrupted with the words, “I think we have someone stealing from the company.”
Time is critical when fraud occurs. Unless you are actually engaged in performing a forensic audit, looking for waste or internal control weaknesses in the client’s systems, there is no time to plan out a fraud examination in detail beforehand. In most cases, covert activities must be used by the fraud examiner to negate detection by the perpetrator before evidence is destroyed.
In an external audit, the auditor begins with a risk assessment of the client’s system to determine where the risk is in such areas as cash, inventory, accounts payable, etc. The auditor uses this risk assessment to focus the external audit.
In a fraud examination, that focus or direction has usually been determined for me by the client. The clients have, in most cases, performed an evaluation of the situation themselves after detecting fraud.
In a substantial number of cases, the client has determined who has committed the fraud as well as where the fraud has occurred. I establish a hypothesis about the fraud and/or the individual who committed it. Next, through interviews and review of specific documentation, I go about substantiating the hypothesis by identifying the different ways the fraudster might be taking advantage of weaknesses in the internal control system.
In an external audit, you still conduct interviews and review specific documentation, and you may even depend on analytical review procedures. But you are substantiating a specific account balance that is included in the aggregate determination of the financial statements’ reasonableness and fairness overall.
Another way a fraud examination differs from an external audit is in the way the work results report is used. An external audit report is usually prepared for a specific individual, financial institution or group of individuals, such as shareholders. The external audit report is a narrative attesting to the financial results and disclosures of a company. In very rare occasions, the audit report may be used in a civil proceeding.
However, a report resulting from a fraud investigation is almost always used as the basis for stating evidence in a civil or criminal proceeding. I start every investigation with the mindset that the findings documented in my report will be used in a court proceeding to substantiate the hypothesis developed to help determine the guilt or innocence of the perpetrator.
Keep in mind that a fraud examination report does not provide a conclusion as to whether an individual or group actually committed the fraud. It attests to the methods used to commit the fraud and states only the evidence obtained. A certified fraud examiner is prohibited from concluding directly about a perpetrator but funnels the reader to arrive at a common-sense result based on the evidence presented. Thus, we have the similarity between an audit report and a fraud examination report – the apprehension of conclusions.
An audit report doesn’t state the “absolute correctness” of the financial representation of a company. Similarly, a fraud examination report doesn’t determine a conclusion as to the guilt or innocence of the perpetrator. Of the two reports, the fraud examination report is the more definitive.
An external audit is not designed to search for fraudulent activity in the accounting records. If fraud is detected, the auditors have a responsibility to report it to management. An assessment is then made about the impact on the fair presentation of those financial statements. Materiality of the total fraud or the transactions is used to determine the steps taken and additional procedures needed to attest to the fairness of the financial statements.
A fraud examination’s sole purpose is to detect the expected or alleged fraud and report on the evidence uncovered and the methods used to perpetrate the fraud. Materiality on the size of transactions rarely guides your steps taken in a fraud examination.
Keep in mind that if fraud is discovered during an external or internal audit, it will usually necessitate a fraud examination. However, the reverse is not true – the performance of a fraud examination will not necessitate the performance of an external audit.
Although there are many differences between an external audit and a fraud examination, there are some similarities. These include the following:
- Both engagements require an engagement letter.
- A certified public accountant and a certified fraud examiner each must abide by a Code of Ethics.
- Both engagements arrive at their end results through the use of interviews, analytical review procedures and review of supporting documentation.
- Both engagements enlist the use of a blend of accounting, auditing and financial detective techniques to arrive at their end results.
- Both engagements enlist the use of reports that state, in narrative format, the procedures performed, evidence examined and results of the accountant’s testing or findings.
- Both reports are used by outside third parties – an audit report usually to fulfill financing requirements and the fraud report to use during prosecution, to recover stolen funds or to fulfill the requirements of an insurance company for collection on fraud policies.
Both engagements could recommend additional or new preventative internal controls or ways procedures can be strengthened as a by-product of the engagements.
As the saying goes, if you’re not getting better, someone else is. This rings particularly true in the current economy, with continuing fierce competition for each customer dollar. Internal audits, when implemented effectively, provide the valuable information businesses need to continually “get better.” Strategic planning and constant application characterize a strong internal audit. And it’s carried out with an unwavering goal to improve the organization.
This standard may seem rigorous. But anything less misses the intrinsic value that a well-built internal audit function provides.
Planning comes first. Diving into procedures without a plan is a sure way to waste time and resources. Strategic planning involves thoughtful discussion about organizational risks and input from the board, management and operating personnel. As an organization identifies risks, it can develop an audit plan that directly addresses and mitigates these risks.
Audit procedures will often be simple, but they must be customized. For example, if the board is concerned about related-party transactions, an auditor may review recent contracts to ensure they are “arm’s-length” agreements, free of pressure from either party.
Once an organization decides upon an audit plan, it must systematically apply the plan. An effective internal auditor will be consistent, objective and responsive to all members of the organization. Procedures should be performed while keeping in mind that the final goal is to make the organization better. A successful internal auditor will connect with people, work to prevent tension and keep everyone working toward this goal.
If the process is strategically planned and systematically applied, adding value to the organization will come naturally. Over time, best practices will be seeded and nurtured, and poor processes will be weeded out.Many clients ask about the relationship between an internal and an external audit. This is a valid question, and sometimes the line between these functions appears to blur.
It’s important to remember that they are distinct processes that may or may not overlap. AU-C Section 610, The Auditor’s Consideration of the Internal Audit Function in an Audit of Financial Statements, provides specific guidance on the extent to which an external auditor may use and rely upon the work of an internal auditor.
Having an internal auditor perform work for the external auditor has several advantages for an organization:
- The external auditor will have intimate knowledge of emerging accounting practices and can pass this information along to the internal auditor.
- The external auditor may be able to expand procedures or reduce the man-hours involved in an engagement.
While utilization in this manner requires prior coordination, when successfully accomplished, there are positive effects for all parties.
As with any aspect of business, the internal audit function faces some common pitfalls. The most common of these is a scope that is too narrow. An internal audit function is not optimal if it only ensures compliance, only reviews a specific transaction class or is solely dedicated to working with the external auditor.
While each of these items may be important at one time or another, when taken on individually, they miss the underlying value of a cohesive internal audit function. When effectively executed, the internal audit function allows an organization to strive for constant improvement in all areas.
Internal audits can and should address a diverse cross-section of issues in which nothing is off-limits. Common focus areas include quality control, compliance risks and procurement procedures. Hiring practices, independence, ethics and information technology are also good areas to consider.
When determining where to focus internal audit resources, it’s wise to step back and take an overall look at your organization. A holistic approach will ensure both efficient use of resources and tangible results.
With the increasing complexity of addressing accounting and reporting matters to comply with accounting principles generally accepted in the United States (U.S. GAAP), many financial statement preparers often look for less complicated, less time-consuming and less costly alternatives for their financial reporting needs.
When acceptable from the perspective of financial statement users, one widely used alternative is to prepare financial statements using an “other comprehensive basis of accounting” (OCBOA). Since tax basis and cash basis – including modifications to the cash basis – financial statements are the most widely used OCBOA statements; the remaining guidance focuses on significant issues associated with preparing and reporting on financial statements using those bases.
Some practical reminders
In addressing the preparation and reporting of OCBOA financial statements over the years, the following are some of the issues that need to be understood:
- OCBOA statements can be audited, reviewed or compiled.
- They are simpler and more cost-effective to prepare.
- Disclosures in OCBOA statements need to either parallel disclosures in U.S. GAAP-based statements or communicate the substance of disclosures that would have been included in the U.S. GAAP-based statements.
- OCBOA statements should include a policy note describing the other comprehensive basis of accounting and clearly delineating the primary substantive differences between the OCBOA and U.S. GAAP. There is no difference in disclosure requirements between audited financial statements and those that are reviewed or compiled.
- In modifying cash-based statements, preparers need to exercise care not to go so far with the modifications as to have the statements essentially prepared on a U.S. GAAP basis with departures from that basis of accounting.
- OCBOA financial statement titles need to be modified to clearly indicate the basis of accounting used in the statements.
- A statement of cash flows is not required in OCBOA financial statements.
Answers to frequently asked questions
Following are some of the issues in which questions have risen to the forefront in the recent past:
Q. Do fair value measurement and disclosure requirements in U.S. GAAP need to be incorporated into OCBOA statements?
A. No. Financial statements pre¬pared on a tax basis incorporate measurements into the statements paralleling measurements included in the tax returns. Cash basis statements include measurements based on cash receipts and disbursements.
Q. Do the uncertain tax positions measurement and disclosure require¬ments in U.S. GAAP need to be incorporated into OCBOA statements?
A. To some extent. Financial statements prepared on a tax or cash basis certainly do not incorporate the uncertain tax position recognition and measurement guidance that would be used in preparing statements using U.S. GAAP. With that said, given that uncertainties need to be disclosed in OCBOA statements in a manner similar to how they are disclosed in statements prepared using U.S. GAAP, any interest and penalties associated with income taxes do need to be disclosed. In addition, open tax years need to be disclosed in all financial statements without regard to the basis of accounting used in preparing the statements.
Q. Do the consolidation of variable interest entities requirements in U.S. GAAP need to be incorporated into OCBOA statements?
A. No. Financial statements prepared on a tax basis incorporate the consolidation of affiliated entities based on the provisions of income tax laws and regulations. And, there is no need to address the consolidation of variable interest entities in cash basis statements. Essentially, some of the more challenging requirements associated with reporting entities needing to consolidate variable interest entities do not need to be considered when financial statements are prepared using an OCBOA.
Q. Do the disclosure requirements associated with management evaluating subsequent events in U.S. GAAP need to be incorporated into OCBOA statements?
A. Yes. Disclosure requirements associated with subse¬quent events are the same without regard to whether financial statements are prepared using U.S. GAAP or either the income tax basis or the cash basis of accounting, including modifications to the cash basis of accounting. Essentially, from a disclosure perspective, there is no difference in how subsequent events issues should be addressed.
Q. When compiled financial statements exist from which management elects to omit substantially all disclosures, should the date through which management evaluates subsequent events be in the practitioner compilation reports?
A. No. This is another issue in which the basis of accounting is irrelevant. When practitioners compile financial statements from which management elects to omit substantially all disclosures, practitioners are precluded from including the date through which management evaluates subsequent events in their compilation reports. If they include the date, practitioners would introduce information into the financial statements that is not included in the financial statements themselves.
What are capital gains? They typically are profits made from the sale of property that is a capital asset. For individuals, gains from the sale of capital assets –such as stocks, bonds, real estate or collectibles – are generally taxed more favorably than those gains from the sale of an ordinary asset. However, short-term capital gains – resulting from sales of properties held for a year or less – are taxed at a higher rate. Consequently, it is important to consider the holding period when you are planning to reduce your tax on capital gains.
Capital gains are generally defined as the excess of the sales price of the investment over its “basis,” the purchase price, plus associated purchase costs. Basis is determined by how the investment was acquired. For instance, if you:
- Purchased the investment, then the basis is what it cost you.
- Received the investment as a gift, then the basis is the cost of the investment paid by the one you received it from, unless the investment was worth less than the original price when it was given to you.
- Inherited the investment, the basis is the value of the investment on the date that the person you inherited it from died.
- The best way to minimize your tax from capital gains is to do some tax planning. Here are two general strategies, but it is always best to consult your tax adviser:
- Hold investments for over a year before selling them.
- Consider selling investments with capital losses to offset capital gains.
When do you pay capital gains taxes?
Capital gains are not taxed until the assets have been sold. So, no matter how much your property may have appreciated capital gains tax is not imposed until the gains have been “realized” from a sale or exchange. The IRS cannot tax unrealized capital gains. The capital gains tax is imposed, generally, from the actual collection of these gains.
How do capital gains for dealers differ?
If your business is dealing in land or stocks, for instance, these assets are not considered capital gains property. They are ordinary income tax property. There have been many tax cases dealing with whether someone’s activity is that of a business or of an investor to qualify the profits as eligible for capital gains treatment.
How is dealer vs. investor status determined?This dealer versus investor status is not just a choice. It really depends on what you were doing with the assets and, sometimes, what your intent was. Investors are generally those who have limited transactions for their own purposes, whereas dealers regularly buy and sell assets to customers in the ordinary course of business. You can see how this is not a “bright line” test.
It is interesting to note that, since the economy has declined, some taxpayers are now arguing that they are in the business of dealing in property and are not investors. Why? It’s because the property values have declined and capital losses are generally much less tax-attractive than ordinary losses. After offsetting any capital gains, capital losses can only be deducted against ordinary income up to $3,000 per year (with a carryover of the excess to future years). Ordinary losses, on the other hand, can offset ordinary income without limitation.
What are capital gains tax rates today?
Favorable capital gains rates have been around for many years, and there have been many variations. The intended purpose of better rates on capital gains is to stimulate investment and fund entrepreneurial activity. However, for some “higher income” taxpayers, capital gains rates have increased this year due to the American Taxpayer Relief Act of 2012.
So, how favorable are capital gains? Gains from the sale of capital assets held for longer than a year, “long-term capital gains,” are still taxed at a maximum rate of 15 percent for many taxpayers. However, for tax years beginning after 2012, a new 20 percent tax rate will apply to dividends and long-term capital gains for married taxpayers with taxable incomes exceeding $450,000 ($400,000 for single taxpayers) to the extent these gains and/or dividends exceed these thresholds. For taxpayers between the 25 percent and 39.6 percent brackets, capital gains and dividends will continue to be taxed at 15 percent, while the lower bracket individuals will still enjoy a zero percent tax rate.
That same income, if not for long-term capital gains rates, could be taxed as high as 39.6 percent. Also effective in 2013 are the new Medicare taxes. One of these additional taxes is called the unearned income Medicare contribution tax and was enacted as part of the healthcare reform laws. This additional tax of 3.8 percent can apply to capital gains.
Sales of collectibles such as antiques, stamps, gems, coins, etc., are taxed at a different capital gains rate. Generally, these capital gains are taxed at a maximum rate of 28 percent if they are long-term gains or at the ordinary income tax rate if they are short-term gains.
For some who still may be lucky in the housing market, some profits from the sale of your home may be taxed at capital gains rates. When you sell your primary residence, you can take $250,000 tax-free if you are single and $500,000 if you are married. Profits above these caps are taxed as capital gains.
A note on what may seem like capital gains but, unfortunately, are not: Profits from the sale of investments held in a traditional IRA or a 401(k) plan, even if these assets are otherwise capital assets, are taxed as ordinary income when distributions are made. This is true because of the rules regarding retirement plan contributions and distributions.
Many taxpayers who realized substantial gains in their retirement plans had expected to pay favorable capital gains rates and were very disappointed to find this advantage was not available.
A new unearned income Medicare contribution tax, with an effective date of Jan. 1, 2013, was enacted as part of the healthcare act. That date has come and gone, and the tax is now applicable. The new Medicare tax applies to net investment income of individuals whose modified adjusted gross income exceeds certain threshold amounts. The threshold amounts are $250,000 for married filing jointly, $125,000 for married filing separately and $200,000 for single taxpayers.
The tax also applies to undistributed net investment income of estates and trusts when adjusted gross income exceeds the highest estate and trust tax bracket.
Trade or business income
In the case of a trade or business, the Joint Committee on Taxation’s Technical Explanation of the provision says that the tax applies to business income if the trade or business:
- Is a passive activity, with respect to the taxpayer, or
- Consists of trading financial instruments or commodities
But the tax does not apply to other trades or businesses conducted by a sole proprietor, partnership or S corporation.(Refer to Joint Committee on Taxation’s Technical Explanation of the Revenue Provisions of the “Reconciliation Act of 2010,” as amended, in combination with the “Patient Protection and Affordable Care Act,” March 21, 2010.)
Sale of business assets
Upon disposition of a business, only net gain or loss attributable to property held by the entity that is not property attributable to an active trade or business is subject to the tax. However, income, gain or loss on working capital is not treated as derived from a trade or business, so it’s taxable. The tax applies to net investment income, including net gain (to the extent taken into account in computing taxable income), from the disposition of property other than property held in a trade or business. When a disposition of an active equity interest in a partnership or S corporation is made, rather than a disposition of the underlying assets, an exception also applies.
Sale of equity interests
An interest in a partnership or S corporation in most cases is not property held in a trade or business, according to the preamble to proposed regulations issued in November 2012. Therefore, gain or loss from the sale of a partnership interest or S corporation stock will be subject to the tax. This generally is not the case when partners or S corporation shareholders materially participate in the business. So, dispositions of those interests should be closely reviewed for exemption from the tax.
Sale of partnership or LLC equity interests
A sale of equity interests in a partnership or limited liability company (LLC) is treated as a direct sale of partnership or LLC assets. Therefore, a net gain on the sale of partnership interests or LLC member interests by a partner or member who materially participates in the business is exempt from the tax. This result differs from the sale of interests in an S corporation, in which there is a strong distinction between stock and asset transactions.
Sale of S corporation stock
Absent further guidance, the sale of S corporation stock, even by a shareholder who materially participates in the business, would appear to be subject to the tax. Fortunately, the law itself provides an exception. The Internal Revenue Code addresses gain in the case of a disposition of an interest in a partnership or S corporation. For purposes of the tax, gain is considered only to the extent of the net gain the seller would take into account if all property of the partnership or S Corporation were sold for fair market value immediately before the disposition of the equity interest.
Deemed asset sale election
The exception for a disposition of an active equity interest in an S corporation is inapplicable to the deemed asset sale and liquidation transactions that result from an election. The exception is unnecessary, since the exception for the sale of active business assets would apply directly.
The IRS requires information to verify a taxpayer’s eligibility for the exception for certain active interests in partnerships and S corporations. This information will be used to determine whether the amount of tax has been reported and calculated correctly. The IRS specifically requests comments concerning whether the proposed collection of information is necessary for the proper performance of the IRS’s functions, including whether the information will have practical utility.
Payments for services, Noncompete covenants and personal goodwill
In the context of selling a business, Form 8594, Asset Acquisition Statement Under Section 1060, asks – even for a stock sale – whether ancillary agreements were negotiated with the sellers in addition to the related stock or asset sale agreement. Employment or consulting agreements may attract the new 0.9 percent Medicare tax. But they should not be subject to the 3.8 percent unearned income Medicare contribution tax because payments would not constitute net investment income. Noncompete payments should not be subject to either of the new taxes since they are neither self-employment income nor net investment income. The sale of personal goodwill creates a capital gain that may be subject to the active trade or business exceptions to the 3.8 percent tax.
If the sale of an S corporation would have avoided the tax under the active trade or business exception, a question comes to mind: Would that gain also be excluded from the new tax with a tax-free merger of the S corporation into a C corporation and reduce the ultimate net investment income on a taxable sale of the stock received in the merger? Nothing in the statute, Technical Explanation or proposed regulations addresses that issue.
An additional 3.8 percent tax on top of a 20 percent capital gains tax amounts to a 19 percent surtax. While it is appropriate to minimize the tax when possible, the Joint Committee on Taxation warned in March 2010 that the IRS will closely review transactions that manipulate a taxpayer’s net investment income to reduce or eliminate the amount of tax imposed. Professional tax advice is strongly advised in applying the provisions of the unearned income Medicare contribution tax.
The prospective sale of the company might seem to be the obvious reason for getting a business valuation, but there are many other reasons as well. Other reasons a business valuation is needed include:
- Estate, gift and trust planning – To determine estate taxes, a value must be placed on all assets, which include the business.
- Buy/sell agreements – A buy/sell agreement is an understanding between shareholders of a closely held business that specifies the terms and prices of a buyout when one or more shareholders want to sell.
- Mergers or acquisitions – If the merger is through the exchange of stock, both companies must be valued to establish a fair exchange.
- Divorce settlements – Typically, a business must be valued during divorce proceedings. The business is usually given to one spouse while the other receives assets of equal value.
- Litigation – In addition to divorce, there are other types of litigation that require a business valuation, such as eminent domain proceedings and insurance claims for lost business.
- Employee stock ownership plans (ESOPs) – An ESOP is a retirement plan in which company stock is donated instead of cash. The value of the stock must be determined annually to establish the employer’s deduction for the contribution.
- Initial public offerings – When a company goes public, the corporation’s stock must be valued to set the initial offering price.
Because of its in-depth analysis of all factors affecting your company’s performance, a business valuation is an excellent starting point for developing a strategic plan for your company’s future. A valuation will point out areas of weakness and strength, as well as possible opportunities for future growth.
Many businesses use valuations on a regular basis to objectively measure their company’s performance.