314 11 TAXES AND BUSINESS DECISIONS Richard P. Mandel It is not possible to fully describe the federal taxation system in the space of one book chapter. It may not even be realistic to attempt to describe federal taxation in a full volume. After all, a purchaser of the Internal Revenue Code (the Code) can expect to carry home at least two volumes consisting of more than 6,000 pages, ranging from Section 1 through Section 9,722, if one includes the estate and gift tax and administrative provisions. And this does not even begin to address the myriad Regulations, Revenue Rulings, Revenue Proce- dures, Technical Advice Memoranda, private letter rulings, court decisions, and other sources of federal tax law that have proliferated over the better part of the twentieth century. Fortunately, most people who enroll in a federal tax course during their progression toward an MBA have no intention of becoming professional tax advisers. An effective tax course, therefore, rather than attempting to impart encyclopedic knowledge of the Code, instead presents taxation as another strategic management tool, available to the manager or entrepreneur in his or her quest to reach business goals in a more efficient and cost-effective manner. After completing such a course, the businessperson should always be conscious that failure to consider tax consequences when structuring a transaction may result in needless tax expense. It is thus the purpose of this chapter to illustrate the necessity of taking taxation into account when structuring most business transactions, and of con- sulting tax professionals early in the process, not just when it is time to file the return. This purpose will be attempted by describing various problems and op- portunities encountered by a fictitious business owner as he progresses from Taxes and Business Decisions 315 early successes, through the acquisition of a related business, to intergenera- tional succession problems. THE BUSINESS We first encounter our sample business when it has been turning a reasonable profit for the past few years under the wise stewardship of its founder and sole stockholder, Morris. The success of his wholesale horticultural supply business (Plant Supply Inc.) has been a source of great satisfaction to Morris, as has the recent entry into the business of his daughter, Lisa. Morris paid Lisa’s business school tuition, hoping to groom her to take over the family business, and his in- vestment seems to be paying off as Lisa has become more and more valuable to her father. Morris (rightly or wrongly) does not feel the same way about his only other offspring, his son, Victor, the violinist, who appears to have no in- terest whatsoever in the business except for its potential to subsidize his at- tempts to break into the concert world. At this time, Morris was about to score another coup: Plant Supply pur- chased a plastics molding business so it could fabricate its own trays, pots, and other planting containers instead of purchasing such items from others. Morris considered himself fortunate to secure the services of Brad (the plant manager of the molding company) because neither he nor Lisa knew very much about the molding business. He was confident that negotiations then underway would bring Brad aboard with a satisfactory compensation package. Thus, Morris could afford to turn his attention to the pleasant problem of distributing the wealth generated by his successful business. UNREASONABLE COMPENSATION Most entrepreneurs long for the day when their most pressing problem is figur- ing out what to do with all the money their business is generating. Yet this very condition was now occupying Morris’s mind. Brad did not present any problems in this context. His compensation package would be dealt with through ongoing negotiations, and, of course, he was not family. But Morris was responsible for supporting his wife and two children. Despite what Morris perceived as the unproductive nature of Victor’s pursuits, Morris was determined to maintain a standard of living for Victor befitting the son of a captain of industry. Of course, Lisa was also entitled to an affluent lifestyle, but surely she was addi- tionally entitled to extra compensation for her long hours at work. The simple and natural reaction to this set of circumstances would be to pay Lisa and Morris a reasonable salary for their work and have the corporation pay the remaining distributable profit (after retaining whatever was necessary for operations) to Morris. Morris could then take care of his wife and Victor as he saw fit. Yet such a natural reaction would ignore serious tax complications. 316 Planning and Forecasting The distribution to Morris beyond his reasonable salary would likely be characterized by the IRS as a dividend to the corporation’s sole stockholder. Since dividends cannot be deducted by the corporation as an expense, both the corporation and Morris would pay tax on these monies (the well-known buga- boo of corporate double taxation). A dollar of profit could easily be reduced to as little as $0.40 of after-tax money in Morris’s pocket (Exhibit 11.1). Knowing this, one might argue that the distribution to Morris should be characterized as a year-end bonus. Since compensation is tax deductible to the corporation, the corporate level of taxation would be removed. Unfortunately, Congress has long since limited the compensation deduction to a “reasonable” amount. The IRS judges the reasonableness of a payment by comparing it to the salaries paid to other employees performing similar services in similar businesses. It also examines whether such amount is paid as regular salary or as a year-end lump sum when profit levels are known. The scooping up by Morris of whatever money was not nailed down at the end of the year would surely come under attack by an IRS auditor. Why not then put Victor on the payroll directly, thus reducing the amount that Morris must take out of the company for his family? Again, such a payment would run afoul of the reasonableness standard. If Morris would come under attack despite his significant efforts for the company, imagine attempting to defend payments made to an “employee” who expends no such efforts. Subchapter S The solution to the unreasonable compensation problem may lie in a relatively well-known tax strategy known as the subchapter S election. A corporation making this election remains a standard business corporation for all purposes other than taxation (retaining its ability to grant limited liability to its stock- holders, for example). The corporation elects to forgo taxation at the corporate level and to be taxed similarly to a partnership. This means that a corporation that has elected subchapter S status will escape any taxation on the corporate level, but its stockholders will be taxed on their pro rata share of the corpora- tion’s profits, regardless of whether these profits are distributed to them. Under this election, Morris’s corporation would pay no corporate tax, but Mor- ris would pay income tax on all the corporation’s profits, even those retained for operations. EXHIBIT 11.1 Double taxation. $1.00 Earned −0.34 Corporate tax at 34% 0.66 Dividend −0.25 Individual tax at 39.1%* 0.41 Remains * Highest federal income tax rate in 2001. Taxes and Business Decisions 317 This election is recommended in a number of circumstances. One exam- ple is the corporation that expects to incur losses, at least in its start-up phase. In the absence of a subchapter S election, such losses would simply collect at the corporate level, awaiting a time in the future when they could be “carried forward” to offset future profits (should there ever be any). If the election is made, the losses would pass through to the stockholders in the current year and might offset other income of these stockholders such as interest, dividends from investments, and salaries. Another such circumstance is when a corporation expects to sell substan- tially all its assets sometime in the future in an acquisition transaction. Since the repeal of the so-called General Utilities doctrine, such a corporation would incur a substantial capital gain tax on the growth in the value of its assets from their acquisition to the time of sale, in addition to the capital gain tax incurred by its stockholders when the proceeds of such sale are distributed to them. The subchapter S election (if made early enough), again eliminates tax at the corporate level, leaving only the tax on the stockholders. The circumstance most relevant to Morris is the corporation with too much profit to distribute as reasonable salary and bonuses. Instead of fighting the battle of reasonableness with the IRS, Morris could elect subchapter S sta- tus, thus rendering the controversy moot. It will not matter that the amount paid to him is too large to be anything but a nondeductible dividend, because it is no longer necessary to be concerned about the corporation’s ability to deduct the expense. Not all corporations are eligible to elect subchapter S status. However, contrary to a common misconception, eligibility has nothing to do with being a “small business.” In simplified form, to qualify for a subchapter S election, the corporation must have 75 or fewer stockholders holding only one class of stock, all of whom must be individuals who are either U.S. citizens or resident aliens. Plant Supply qualifies on all these counts. Alternatively, many companies have accomplished the same tax results, while avoiding the eligibility limitations of subchapter S, by operating as lim- ited liability companies (LLCs). Unfortunately for Morris, however, a few states require LLCs to have more than one owner. Under subchapter S, Morris can pay himself and Lisa a reasonable salary and then take the rest of the money either as salary or dividend without fear of challenge. He can then distribute that additional money between Lisa and Vic- tor, to support their individual lifestyles. Thus, it appears that the effective use of a strategic taxation tool has solved an otherwise costly problem. Gif t Tax Unfortunately, like most tax strategies, the preceding solution may not be cost free. It is always necessary to consider whether the solution of one tax problem may create others, sometimes emanating from taxes other than the income tax. To begin with, Morris needs to be aware that under any strategy he adopts, the gifts of surplus cash he makes to his children may subject him to a federal gift 318 Planning and Forecasting tax. This gift tax supplements the federal estate tax, which imposes a tax on the transfer of assets from one generation to the next. Lifetime gifts to the next generation would, in the absence of a gift tax, frustrate estate tax policy. Fortu- nately, to accommodate the tendency of individuals to make gifts for reasons unrelated to estate planning, the gift tax exempts gifts by a donor of up to $10,000 per year to each of his or her donees. That amount will be adjusted for inflation as years go by. Furthermore it is doubled if the donor’s spouse con- sents to the use of her or his $10,000 allotment to cover the excess. Thus, Mor- ris could distribute up to $20,000 in excess cash each year to each of his two children if his wife consented. In addition, the federal gift tax does not take hold until the combined total of taxable lifetime gifts in excess of the annual exclusion amount exceeds $675,000 in 2001. This amount will increase to $1 million in 2002. Thus, Mor- ris can exceed the annual $20,000 amount by quite a bit before the government will get its share. These rules may suggest an alternate strategy to Morris under which he may transfer some portion of his stock to each of his children and then have the corporation distribute dividends to him and to them directly each year. The gift tax would be implicated to the extent of the value of the stock in the year it is given, but, from then on, no gifts would be necessary. Such a strategy, in fact, describes a fourth circumstance in which the subchapter S election is recommended: when the company wishes to distribute profits to nonemployee stockholders for whom salary or bonus in any amount would be considered excessive. In such a case, like that of Victor, the owner of the company can choose subchapter S status for it, make a gift to the nonemployee of stock, and adopt a policy of distributing annual dividends from profits, thus avoiding any challenge to a corporate deduction based on unreasonable compensation. MAKING THE SUBCHAPTER S ELECTION Before Morris rushes off to make his election, however, he should be aware of a few additional complications. Congress has historically been aware of the po- tential for corporations to avoid corporate-level taxation on profits and capital gains earned prior to the subchapter S election but not realized until after- ward. Thus, for example, if Morris’s corporation has been accounting for its inventory on a last in, first out (LIFO) basis in an inflationary era (such as vir- tually any time during the past 50 years), taxable profits have been depressed by the use of higher cost inventory as the basis for calculation. Earlier lower- cost inventory has been left on the shelf (from an accounting point of view), waiting for later sales. However, if those later sales will now come during a time when the corporation is avoiding tax under subchapter S, those higher tax- able profits will never be taxed at the corporate level. Thus, for the year just preceding the election, the Code requires recalculation of the corporation’s profits on a first in, first out (FIFO) inventory basis to capture the amount Taxes and Business Decisions 319 that was postponed. If Morris has been using the LIFO method, his subchap- ter S election will carry some cost. Similarly, if Morris’s corporation has been reporting to the IRS on a cash accounting basis, it has been recognizing income only when collected, regard- less of when a sale was actually made. The subchapter S election, therefore, af- fords the possibility that many sales made near the end of the final year of corporate taxation will never be taxed at the corporate level, because these re- ceivables will not be collected until after the election is in effect. As a result, the IRS requires all accounts receivable of a cash-basis taxpayer to be taxed as if collected in the last year of corporate taxation, thus adding to the cost of Morris’s subchapter S conversion. Of course, the greatest source of untapped corporate tax potential lies in corporate assets that have appreciated in value while the corporation was sub- ject to corporate tax but are not sold by the corporation until after the sub- chapter S election is in place. In the worst nightmares of the IRS, corporations that are about to sell all their assets in a corporate acquisition first elect sub- chapter S treatment and then immediately sell out, avoiding millions of dollars of tax liability. Fortunately for the IRS, Congress has addressed this problem by impos- ing taxation on the corporate level of all so-called built-in gain realized by a converted S corporation within the first 10 years after its conversion. Built-in gain is the untaxed appreciation that existed at the time of the subchapter S election. It is taxed not only upon a sale of all the corporation’s assets, but any time the corporation disposes of an asset it owned at the time of its election. This makes it advisable to have an appraisal done for all the corporation’s as- sets as of the first day of subchapter S status, so that there is some objective basis for the calculation of built-in gain upon sale somewhere down the line. This appraisal will further deplete Morris’s coffers if he adopts the subchapter S strategy. Despite these complications, however, it is still likely that Morris will find the subchapter S election to be an attractive solution to his family and compensation problems. Pass-Through Entity Consider how a subchapter S corporation might operate were the corporation to experience a period during which it were not so successful. Subchapter S corporations (as well as most LLCs, partnerships, and limited partnerships) are known as pass-through entities because they pass through their tax attributes to their owners. This feature not only operates to pass through profits to the tax returns of the owners (whether or not accompanied by cash) but also results in the pass-through of losses. As discussed earlier, these losses can then be used by the owners to offset income from other sources rather than having the losses frozen on the corporate level, waiting for future profit. The Code, not surprisingly, places limits on the amount of loss which can be passed through to an owner’s tax return. In a subchapter S corporation, the 320 Planning and Forecasting amount of loss is limited by a stockholder’s basis in his investment in the cor- poration. Basis includes the amount invested as equity plus any amount the stockholder has advanced to the corporation as loans. As the corporation oper- ates, the basis is raised by the stockholder’s pro rata share of any profit made by the corporation and lowered by his pro rata share of loss and any distribu- tions received by him. These rules might turn Morris’s traditional financing strategy on its head the next time he sits down with the corporation’s bank loan officer to negotiate an extension of the corporation’s financing. In the past, Morris has always at- tempted to induce the loan officer to lend directly to the corporation. This way Morris hoped to escape personal liability for the loan (although, in the begin- ning he was forced to give the bank a personal guarantee). In addition, the cor- poration could pay back the bank directly, getting a tax deduction for the interest. If the loan were made to Morris, he would have to turn the money over to the corporation and then depend upon the corporation to generate enough profit so it could distribute monies to him to cover his personal debt service. He might try to characterize those distributions to him as repayment of a loan he made to the corporation, but, given the amount he had already ad- vanced to the corporation in its earlier years, the IRS would probably object to the debt to equity ratio and recharacterize the payment as a nondeductible dividend fully taxable to Morris. We have already discussed why Morris would prefer to avoid characterizing the payment as additional compensation: His level of compensation was already at the outer edge of reasonableness. Under the subchapter S election, however, Morris no longer has to be concerned about characterizing cash flow from the corporation to himself in a manner that would be deductible by the corporation. Moreover, if the loan is made to the corporation, it does not increase Morris’s basis in his investment (even if he has given a personal guarantee). This fact limits his ability to pass losses through to his return. Thus, the subchapter S election may result in the unseemly spectacle of Morris begging his banker to lend the corporation’s money directly to him, so that he may in turn advance the money to the corpo- ration and increase his basis. This would not be necessary in an LLC, since most loans advanced to this form of business entity increase the basis of its owners. Passive Losses No discussion of pass-through entities should proceed without at least touching on what may have been the most creative set of changes made to the Code in re- cent times. Prior to 1987, an entire industry had arisen to create and market business enterprises whose main purpose was to generate losses to pass through to their wealthy investor/owners. These losses, it was hoped, would normally be generated by depreciation, amortization, and depletion. These would be mere paper losses, incurred while the business itself was breaking even or possibly generating positive cash flow. They would be followed some years in the future Taxes and Business Decisions 321 by a healthy long-term capital gain. Thus, an investor with high taxable income could be offered short-term pass-through tax losses with a nice long-term gain waiting in the wings. In those days, long-term capital gain was taxed at only 40% of the rate of ordinary income, so the tax was not only deferred but substantially reduced. These businesses were known as tax shelters. The 1986 Act substantially reduced the effectiveness of the tax shelter by classifying taxable income and loss in three major categories: active, portfolio, and passive. Active income consists mainly of wages, salaries, and bonuses; portfolio income is mainly interest and dividends; while passive income and loss consist of distributions from the so-called pass-through entities, such as LLCs, limited partnerships, and subchapter S corporations. In their simplest terms, the passive activity loss rules add to the limits set by the earlier de- scribed basis limitations (and the similar so-called at-risk rules), making it im- possible to use passive losses to offset active or portfolio income. Thus, tax shelter losses can no longer be used to shelter salaries or investment proceeds; they must wait for the taxpayer’s passive activities to generate the anticipated end-of-the-line gains or be used when the taxpayer disposes of a passive activ- ity in a taxable transaction (see Exhibit 11.2). Fortunately for Morris, the passive activity loss rules are unlikely to af- fect his thinking for at least two reasons. First, the Code defines a passive ac- tivity as the conduct of any trade or business “in which the taxpayer does not materially participate.” Material participation is further defined in a series of Code sections and Temporary Regulations (which mock the concept of tax simplification but let Morris off the hook) to include any taxpayer who partic- ipates in the business for more than 500 hours per year. Morris is clearly ma- terially participating in his business despite his status as a stockholder of a subchapter S corporation, and thus the passive loss rules do not apply to him. EXHIBIT 11.2 Passive activity losses. Active Portfolio Passive Material participation Pass-throughs from partnerships, Subchapter S, LLCs, and so on Passive loss Salary, bonus, and so on Interest, dividends, and so on 322 Planning and Forecasting The second reason Morris is not concerned is that he does not anticipate any losses from this business; historically, it is very profitable. Therefore, let us de- part from this detour into unprofitability and consider Morris’s acquisition of the plastics plant. ACQUISITION Morris might well believe that the hard part of accomplishing a successful ac- quisition is locating an appropriate target and integrating it into his existing op- eration. Yet, once again, he would be well advised to pay some attention to the various tax strategies and results available to him when structuring the acquisi- tion transaction. To begin with, Morris has a number of choices available to him in acquir- ing the target business. Simply put, these choices boil down to a choice among acquiring the stock of the owners of the business, merging the target corpora- tion into Plant Supply, or purchasing the assets and liabilities of the target. The choice of method will depend on a number of factors, many of which are not tax related. For example, acquisition by merger will force Plant Supply to ac- quire all the liabilities of the target, even those of which neither it nor the tar- get may be aware. Acquisition of the stock of the target by Plant Supply also results in acquisition of all liabilities but isolates them in a separate corpora- tion, which becomes a subsidiary. (The same result would be achieved by merg- ing the target into a newly formed subsidiary of Plant Supply—the so-called triangular merger.) Acquisition of the assets and liabilities normally results only in exposure to the liabilities Morris chooses to acquire and is thus an at- tractive choice to the acquirer (Exhibit 11.3). Yet tax factors normally play a large part in structuring an acquisition. For example, if the target corporation has a history of losses and thus boasts a tax- loss carryforward, Morris may wish to apply such losses to its future profitable operations. This application would be impossible if he acquired the assets and liabilities of the target for cash since the target corporation would still exist after the transaction, keeping its tax characteristics to itself. Cash mergers are treated as asset acquisitions for tax purposes. However, if the acquirer obtains the stock of the target, the acquirer has taken control of the taxable entity it- self, thus obtaining its tax characteristics for future use. This result inspired a lively traffic in tax-loss carryforwards in years past, where failed corporations were marketed to profitable corporations seeking tax relief. Congress has put a damper on such activity by limiting the use of a tax- loss carryforward in each of the years following an ownership change of more than 50% of a company’s stock. The amount of that limit is the product of the value of the business at acquisition (normally its selling price) times an interest rate linked to the market for federal treasury obligations. This amount of tax- loss carryforward is available each year, until the losses expire (15 to 20 years Taxes and Business Decisions 323 after they were incurred). Since a corporation with significant losses would normally be valued at a relatively low amount, the yearly available loss is likely to be relatively trivial. Acquisition of the corporation’s assets and liabilities for cash or through a cash merger eliminates any use by the acquirer of the target’s tax-loss carryfor- ward, leaving it available for use by the target’s shell. This may be quite useful to the target because, as discussed earlier, if it has not elected subchapter S status for the past 10 years (or for the full term of its existence, if shorter), it is likely to have incurred a significant gain upon the sale of its assets. This gain would be taxable at the corporate level before the remaining portion of the purchase price could be distributed to the target’s shareholders (where it will be taxed again). EXHIBIT 11.3 Acquisition strategies. T Owned by T’s stockholders Owned by T’s stockholders Owned by T’s stockholders Owned by T’s stockholders Owned by T’s stockholders Owned by T’s stockholders Before After A Target Acquirer T T’s assets T T A A T A A T’s assets Merger Acquisition of stock Purchase of assets [...]... return of the interest is a gift and is thus excluded from income The donor receives interest income and has no compensating deduction for the return gift In fact, if the interest amount is large enough, he may have incurred an additional gift tax on the returned interest The amount of income created for the donor, however, is limited to the donee’s investment income except in very large loans In the corporation/stockholder... loans Interest remains deductible, however, in limited amounts on loans secured by a mortgage on either of the taxpayer’s principal or EXHIBIT 11. 4 Taxable interest Employer Employer Employer Interest income Deductible compensation Interest income Nondeductible compensation Interest income Nondeductible gift (gift tax) Nondeductible interest Taxable compensation Nondeductible interest Dividend income... Planning and Forecasting to pay a bonus based upon a certain formula Since these devices are not recognized as capital assets, they are not eligible to be taxed as long-term capital gains when redeemed This difference is quite meaningful since the maximum tax rate on ordinary income in 2001 is 39.1% and on long-term capital gains is 20% Thus, Brad may have good reason to reject phantom stock and SARs and. .. this type of asset is land Unlike buildings, land has an unlimited useful life and is not depreciable This distinction has spawned some very creative theories, including one enterprising individual who purchased a plot of land containing a deep depression that he intended to use as a garbage dump The taxpayer allocated a significant amount of his purchase price to the depression and took depreciation... with the tournament coming to town and the hotels full Morris is in a position to make a killing by renting his home to a golfer or spectator during this time at inf lated rental rates All that rental income would be entirely tax-free Just be sure the tenants don’t stay beyond two weeks LIK E-KIND EXCHANGES Having acquired the desired new business and secured the services of the individual he needed... interest Nontaxable gift Employee Stockholder Donee 330 Planning and Forecasting secondary residence If Brad grants Plant Supply a mortgage on his home to secure the repayment of his no- or low-interest loan, his deemed payment of market interest may become deductible mortgage interest and may thus offset his additional deemed compensation from the imaginary return of this interest Before jumping into... the lender incurs interest income and has no compensating deduction as its deemed return of the interest is characterized as a dividend Thus the IRS gets increased tax from both parties unless the corporation has elected subchapter S (see Exhibit 11. 4) All may not be lost in this situation, however Brad’s additional income tax arises from the fact that there is no deduction allowable for interest paid... his taxable income for that year Despite the fact that he had no income to declare in the year of grant, Brad must elect to include that nullity in his taxable income for that year by filing such an election with the IRS within 30 days of his purchase of the stock In situations in which there is little difference between the value of stock and the amount an employee will pay for it (e.g., in start-up... Although taxes and mortgage interest were deductible as personal expenses (assuming, in the case of mortgage interest, that Morris was deducting such payments only with respect to this and his principal residence and no other home), the previously mentioned limits on the use of itemized deductions made the usefulness of these deductions questionable However, in addition to the inconvenience of renting one’s... effort one puts into the process Thus, in the absence of any relief provision, these losses would be deductible only against other passive income and would not be usable against salary, bonus, or investment income Such a relief provision does exist, however, for rental activities in which the taxpayer is “actively” involved In such a case, the taxpayer may deduct up to $25,000 of losses against active . by classifying taxable income and loss in three major categories: active, portfolio, and passive. Active income consists mainly of wages, salaries, and bonuses; portfolio income is mainly interest and. quite meaningful since the maximum tax rate on ordinary income in 2001 is 39.1% and on long-term capital gains is 20%. Thus, Brad may have good reason to reject phantom stock and SARs and insist. deemed return of the interest is a gift and is thus excluded from income. The donor receives in- terest income and has no compensating deduction for the return gift. In fact, if the interest amount