The Advisor Summer 2011


Important Deadline Is Getting Closer
For Qualified Small Business Stock

Gains from selling qualified small business stock (QSBS) issued between now and year end are eligible for a zero (0) percent federal income tax rate. Shares must be held for over five years to take advantage of this unbelievably good deal. However, not all shares qualify.

Whether you are considering obtaining funding for your own business or acting as an investor for someone else’s operation, here's what you should know about QSBS and the 0 percent tax rate.

 

Qualified Small Business Stock Basics

QSBS is stock in a C corporation that meets the definition of a qualified small business corporation (QSBC). In general, QSBCs are the same as garden-variety C corporations for all tax and legal purposes. The only exception is that QSBS gains are eligible for favorable federal income tax treatment.

The most important thing to understand right now is that gains from selling QSBS issued between now and the end of 2011 are potentially eligible for a 100 percent federal income tax gain exclusion break, which equates to a 0 percent federal income tax rate.

On the other hand, for QSBS issued after this year, the gain exclusion percentage will revert to the standard 50 percent unless Congress changes the law to provide something better.

 

Gain Exclusion Depends on Issuance Date

The current super-generous 100 percent gain exclusion break is only available for QSBC shares issued between September 28, 2010, and December 31, 2011. Therefore, a share issuance deadline of December 31 of this year applies if you want to line yourself up to benefit from the 100 percent gain exclusion.

The standard 50 percent gain exclusion deal is available for QSBS issued before February 18, 2009, or after December 31, 2011. Therefore, qualified stock issued after this year will be eligible for the standard 50 percent gain exclusion unless Congress takes action.

An enhanced 75 percent gain exclusion is available for QSBS that were issued between February 18, 2009, and September 27, 2010.

Key Point: These gain exclusion breaks are not available for QSBS owned by C corporations. However, shares held by individuals, S corporations, and partnerships are eligible.

Five-Year Holding Period Requirement

In order to take advantage of the gain exclusion deal, you must hold QSBS for over five years. Therefore, the 100 percent gain exclusion break will only be available for sales that occur after September 28, 2015, at the earliest. For QSBC shares that have not yet been issued, the 100 percent gain exclusion will only be available for sales that occur sometime in 2016 at the earliest.

 

Excludable Gain Limits and Tax Rates

Congress placed limits on the amount of QSBS gain that is eligible for the gain exclusion break. In any tax year, a taxpayer's eligible gain (the amount of gain that qualifies for the applicable gain exclusion percentage of 100, 75, or 50 percent) is limited to the greater of:

1. 10 times the taxpayer's aggregate adjusted basis in the QSBS that is sold; or

2. $10 million reduced by the amount of eligible gain already taken into account by the taxpayer in prior tax years for sales of QSBS issued by the same corporation ($5 million if you use married filing separate status). In effect, the $10 million (or $5 million) restriction is a lifetime limitation.

The amount of eligible gain that you cannot exclude (either 25 or 50 percent of the total eligible gain) is subject to 28 percent maximum federal income tax rate. That translates into an effective maximum rate on eligible gains of either: 0 percent if the 100 percent gain exclusion applies; or 7 percent if the 75 percent exclusion applies; or 14 percent if the 50 percent exclusion applies.

Any gain in excess of the eligible gain amount is taxed as a garden-variety stock sale gain. Therefore, a 15 percent maximum federal rate applies to excess gains that are recognized through 2012. For 2013 and beyond, the maximum rate on excess gains is scheduled to increase to 18 percent.

 

Another QSBS Break: Tax-Free Rollover

In addition to the QSBS gain exclusion explained in this article, there's also a tax-free gain rollover break. Under it, the amount of QSBS gain you must recognize for federal income tax purposes is limited to the excess of the QSBS sales proceeds over the amount you reinvest to acquire other QSBS during a 60-day period, beginning on the date of the original sale. The rolled-over gain reduces the basis of the new QSBS (the "replacement shares"). However, you must hold QSBS for more than six months to qualify for the gain rollover deal.

If the replacement shares still meet the definition of QSBS when you sell them, you'll be eligible for the applicable gain exclusion break, as long as you've held the shares for more than five years. You must count the holding period of your original QSBS (the shares you sold in the rollover transaction), plus your holding period of the replacement shares.

Key Point: In essence, the rollover deal allows you to sell your original QSBS without owing any federal income tax and without losing eligibility for the gain exclusion break when you eventually sell the replacement shares.

 

What Counts as QSBS?

To be eligible for the QSBS gain exclusion break, shares must meet a number of requirements set forth in Section 1202 of the Internal Revenue Code. These requirements include:

  • The shares must be acquired after August 10, 1993, and they generally must be acquired upon original issuance or by gift or inheritance.
  • The issuing corporation must be a qualified small business corporation (QSBC) at the stock issuance date and during substantially all the time you hold the shares.

  • A QSBC must be a domestic C corporation. It cannot be an S corporation, foreign corporation, domestic international sales corporation (DISC), former DISC, regulated investment company (RIC), real estate investment trust (REIT), real estate mortgage investment conduit (REMIC), a cooperative, a Section 936 corporation, or a corporation with a subsidiary that is a Section 936 corporation.

  • To be a QSBC, the corporation must actively conduct a qualified business. Qualified businesses do not include rendering services in health; law; engineering; architecture; accounting; actuarial science; performing arts; consulting; athletics; financial services; brokerage services; other businesses where the principal asset is the reputation or skill of employees; banking, insurance, leasing, financing, investing, or similar activities; farming; production or extraction of oil, natural gas, or other minerals for which percentage depletion deductions are allowed; or the operation of a hotel, motel, restaurant, or similar business.

  • To be a QSBC, a corporation's gross assets cannot exceed $50 million: (1) At all times on or after August 10, 1993 and before the stock is issued and (2) Immediately after the stock is issued. If after the stock is issued the corporation grows and exceeds the $50 million threshold, it will not lose its QSBC status for that reason.

Key Point: Before concluding that you are investing in a QSBC, consult with your tax adviser. We have summarized the most important QSBC eligibility rules here, but there are many more.

 

AMT Preferences on Excluded Gains

For alternative minimum tax (AMT) purposes, 7 percent of the excluded gain from a pre-2013 QSBS sale counts as income. For post-2012 excluded gains, the AMT preference is scheduled to increase to 28 percent unless Congress takes action. For taxpayers who are subject to the AMT, these preferences can reduce, or even almost eliminate, the expected tax savings from selling QSBS.

Now for the good news: There is no AMT preference for QSBS gains that qualify for the 100 percent exclusion. Therefore, the advertised 100 percent gain exclusion break is actually for real. There is neither regular federal income tax nor AMT hits. There is a real 0 percent maximum federal income tax rate on eligible gains from QSBS that are issued between September 28, 2010, and December 31, 2011, and held for more than five years.

 

Summary: Time Is of the Essence

When a start-up business is incorporated and can meet the definition of a QSBC, the conventional wisdom that it is always best to operate as a pass-through entity (S corporation, partnership, or LLC) may be incorrect, due to the tax breaks offered to QSBS owners.

To sum up:

  • The American Recovery and Reinvestment Act of 2009 increased, from 50 percent to 75 percent, the amount of gain that could be excluded on qualified small business stock. The Small Business Jobs Act of 2010 went further, completely eliminating the tax on gain of qualified stock issued after the date of enactment through the end of 2010. Later that year, the Tax Relief, Unemployment Insurance Reauthorization and Job Creation Act extended this tax break through the end of 2011.

  • For the QSBS gain exclusion deal to be available, you must hold the stock for over five years. The super-generous 100 percent gain exclusion deal will not be available for shares issued after December 31, 2011, unless Congress grants an extension. So time may be of the essence if you want to cash in on the 100 percent gain exclusion deal.

  • For the tax-free gain rollover break to be available, you must hold the stock for over six months.

  • There may be state taxes due on gains.

  • For questions in your situation, consult with your tax adviser.

 

 

IRS Delays Government
Contractor Withholding

The IRS has again delayed the implementation of mandatory 3 percent withholding on payments to government contractors. It is now postponed to apply to payments beginning on January 1, 2013. (The previous implementation dates were January 1, 2012, and January 1, 2011.)


Reason for the delay: The Treasury Department and the IRS received numerous comments expressing concerns about the administrative burdens of compliance and the revenue effect on those subject to withholding.

The withholding requirement was part of the Tax Increase Prevention and Reconciliation Act of 2005. It requires federal, state, and local government entities to withhold income tax when making payments to those providing property or services.

The new final regulations also include:

  • A withholding threshold for payments of $10,000 or more. The Treasury Department noted that the people commenting requested that the threshold amount be raised. "This $10,000 threshold level strikes a reasonable balance between alleviating administrative burdens and preserving the legislative intent that the withholding requirement apply broadly," the regulations state.

  • Exclusion from the withholding requirement for payments from one government entity to another government entity.

Why was the provision implemented? According to reports by the General Accounting Office (GAO), "thousands of federal contractors had substantial amounts of unpaid federal taxes."

The GAO states: "This practice is inconsistent with the fundamental concept that those doing business with the federal government should be required to pay their federal taxes."

For more information, consult with your tax adviser.

 

 

Appeals Court Case
Limits SOX Whistleblowers

In a recent case that surprised many legal pundits, the Ninth Circuit Court of Appeals ruled that the "whistleblower" provisions of the Sarbanes-Oxley Act (commonly called SOX) do not protect employees who leak information to the news media. The ruling, which represents a significant victory for Seattle-based airplane manufacturer, Boeing, has drawn the wrath of vocal whistleblower advocates.

In effect, the Ninth Circuit said in the case that a whistleblower under SOX can't go directly to the press. The ruling, which upheld a lower court decision, was rendered by a unanimous three-judge panel.

Background: Enacted in 2002, the Sarbanes-Oxley Act includes standards for corporate accountability and imposes penalties on wrongdoers. The law changed how corporate boards and executives interact with each other and with corporate auditors. Significantly, corporate officers such as CEOs and CFOs are now held accountable for the accuracy of financial statements. In addition, SOX establishes new financial reporting responsibilities as well as requiring compliance with internal controls designed to ensure the validity of the financial records.

However, SOX is also noteworthy for its whistleblower provisions. Not only does the law prohibit retaliation against whistleblowers, it also encourages and reinforces the actual act of whistle blowing. Public companies must set up internal procedures to receive, review, and solicit employee reports concerning fraudulent actions and ethical violations. Enforcement includes administrative, civil, and criminal means that may result in both corporate and individual liability.

However, the new Ninth Circuit case places a restriction on the whistle blowing mechanism.

Key facts of the case: The two plaintiffs, Nicholas Tides and Matthew Neumann, were employed by Boeing. They worked as auditors involved in the testing of the company's information technology controls as mandated by SOX. On several occasions, Tides and Neumann said that they complained about what they perceived as auditing deficiencies. They also alleged, according to court documents, there was "a generally hostile work environment" and pressure from management to rate Boeing's internal controls as "effective."

In 2007, tensions were running high at Boeing amidst talk that an external auditor might declare a material weakness within the internal controls. Tides and Neumann "repeatedly complained" to management about the practice of giving contractors managerial authority over Boeing employees, as well as the involvement of the contractors in both the design and audit of Boeing's internal controls. "They also expressed concerns about the integrity of data stored in the software system Boeing used to record its IT SOX audit results," according to court documents.

Eventually, a newspaper ran an investigative report about the problems in Boeing's computer systems’ security. After the article was published, Tides and Neumann admitted they had spoken to the newspaper's reporter. A few months later, both were fired for violating a company policy prohibiting employees from releasing information to the media without obtaining approval from the communications department.

The pair of employees was discovered after an investigation by Boeing that included the monitoring of both of their work computers and e-mail accounts.

The plaintiffs filed SOX whistleblower complaints with the Occupation Safety and Health Administration. They argued that giving the information to the media was simply one method of providing it to the government, which is protected under SOX. But the Ninth Circuit rejected this broad interpretation of the SOX whistleblower provisions.

The court stated: "Boeing was within its rights ... to terminate the plaintiffs for violating company policy prohibiting unauthorized disclosures of Boeing information to the media."

The court's logic: If Congress wanted to protect reports to reporters, the Ninth Circuit noted, "it could have listed the media as one of the entities to which protected reports may be made." Or it could have included language to protect "any disclosure," as it does with the Whistleblower Protection Act governing federal workers. The court further commented that Congress "took neither course, opting instead to limit protected activity to employees who raise certain concerns of fraud or securities violations with those authorized or required to act on the information."

Under SOX, the individuals and entities that an employee can disclose information to are:

1. A federal agency or law enforcement agency.

2. A member or committee of Congress.

3. A supervisor at the employer organization.

The Ninth Circuit also shot down the other arguments of the plaintiffs. Tides and Neumann claimed that the media disclosures were merely a reason for Boeing to fire them for other activities (for example, complaining to their supervisors), which were protected under SOX. Alternatively, Tides and Neumann argued that the media leaks were privileged by the National Labor Relations Act.

These arguments were also dismissed by the Court. (Tides, et al v. The Boeing Company, D.C. No. v. 2:08-cv-01601-JCC, 5/3/11).

The decision leads to a more narrow interpretation of the SOX whistleblower provisions that both employers and employees should heed.

 

 

IRS Releases Guidance
Regarding First-Year Bonus Depreciation

The IRS has issued some much needed guidance on how the new business depreciation tax breaks work and the options available to taxpayers. (IRS Revenue Procedure 2011-26)

The Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act included a favorable provision that allows 100 percent first-year bonus depreciation for qualified new assets. The new IRS guidance includes rules clarifying the deduction, as well as rules about a retroactive extension of 50 percent bonus depreciation for part of last year.

Here is a quick summary of the key points in IRS Revenue Procedure 2011-26.

What Is Qualified Property?

To be eligible for 100 percent bonus depreciation, an asset must meet all three of the following requirements:

1. It must be qualified property, which includes personal property with an MACRS depreciation period of 20 years or less, certain leasehold improvement property, and certain water utility property. Software that is not required to be amortized over 15 years also qualifies.

2. It must be acquired between September 9, 2010, and December 31, 2011. However, the acquisition and placed-in-service deadlines are extended to December 31, 2012, for certain assets with longer production periods, such as transportation equipment and aircraft. (Under the extended deadline deal, only the portion of an asset's basis that is allocable to costs that are incurred by December 31, 2012 is eligible for 100 percent bonus depreciation.)

3. The original use of the property must begin by no later than December 31, 2011, or by December 31, 2012, for certain property with longer production periods. In other words, the property must be new rather than used when it is placed in service.

Self-Constructed Property Components

The acquisition date for property a business constructs for use in its own operations (which we will call self-constructed property) is deemed to be the date when the taxpayer begins construction.

What if a business began construction of an item of self-constructed property before September 9, 2010? The item would have qualified for 100 percent bonus depreciation except for the fact that its acquisition date preceded September 9, 2010. The business can elect to claim 100 percent bonus depreciation for components of the self-constructed property. To qualify for the election, the components must be:

  • Acquired or self-constructed after September 8, 2010; and
  • Placed in service by December 31, 2011 (December 31, 2012, for certain components with longer production periods).

Restaurant and Retail Improvement Property

Qualified leasehold improvement property is eligible for 100 percent bonus depreciation if the acquisition and placed-in-service date rules are met.

The new IRS guidance clarifies that qualified restaurant property and qualified retail improvement property are eligible for 100 percent bonus depreciation if they also meet the definition of qualified leasehold improvement property, and the acquisition and placed-in-service date rules are met.

Vehicles Subject to Luxury Auto Depreciation Limits

Claiming 100 percent bonus depreciation for a new passenger auto, light truck, or light van that is subject to the luxury auto depreciation limits will increase the maximum first-year depreciation allowance by an even $8,000.

For new autos placed in service in 2010, the maximum first-year depreciation allowance is increased to $11,060. The same $11,060 maximum first-year allowance applies to new autos placed in service in 2011.

For new light trucks and light vans placed in service in 2010, the maximum first-year depreciation allowance is increased to $11,160. For 2011, the maximum first-year allowance is increased to $11,260.

After claiming 100 percent bonus deprecation in Year 1, a technical glitch in the way the maximum depreciation allowances are calculated for later years causes the allowances for those years to be zero. Since this is not what Congress intended, the new IRS guidance provides a fix in the form of a safe-harbor depreciation calculation method that taxpayers can use for Years 2 to 6. After the fix, the maximum depreciation allowances will be the "standard" amounts shown in the following tables.

 

New Autos

Placed in Service in 2010 and 2011

Year 1

$11,060

Year 2

$4,900

Year 3

$2,950

Year 4

$1,175

Year 5

$1,175

Year 6 and beyond

$1,175 until fully depreciated

New Light Trucks and Vans

Placed in service in 2010

Year 1

$11,160

Year 2

$5,100

Year 3

$3,050

Year 4

$1,875

Year 5

$1,875

Year 6 and beyond

$1,875 until fully depreciated

 

New Light Trucks and Vans

Placed in Service 2011

Year 1

$11,260

Year 2

$5,100

Year 3

$3,150

Year 4

$1,875

Year 5

$1,875

Year 6 and beyond

$1,875 until fully depreciated

For relatively inexpensive vehicles, the maximum depreciation allowances for Year 2 and beyond, under the fix, can turn out to be lower than the "standard" amounts shown above. For more expensive vehicles, the maximum allowances for Year 2 and beyond turn out to be the "standard" amounts shown above.

Taxpayers Can Step Down to 50 Percent Bonus Depreciation

For qualified property placed in service in tax years that include September 9, 2010, Revenue Procedure 2011-26 says taxpayers can elect 50 percent bonus depreciation instead of 100 percent. This bonus depreciation "step-down election" can be made for any class of property placed in service during the tax year that includes September 9, 2010.

Key Point: The IRS previously stated bonus depreciation step-down elections were not allowed.

Taxpayers Can Also Elect to Forego Bonus Depreciation

Taxpayers can also elect to entirely give up 50 and 100 percent bonus depreciation for a particular class of qualified property that is placed in service during the tax year. Making this election could be advisable if your business has an expiring net operating loss, an expiring capital loss carryover, or you believe that higher tax rates will be paid in future years.

Rules to Implement the Retroactive Extension of 50 Percent Bonus Depreciation

In addition to establishing the new 100 percent bonus depreciation break, the Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act also retroactively restored the 50 percent bonus depreciation break for qualified property placed in service between January 1, 2010 and September 8, 2010. Because the law did not become effective until December of 2010, many taxpayers already filed returns that did not take advantage of 50 percent bonus depreciation. Revenue Procedure 2011-26 supplies guidance for taxpayers in this situation.


The guidance only applies to already-filed returns for:

  • 12-month tax years that began in 2009 and ended in 2010; and
  • Short tax years that ended in 2010.

Retroactively claiming the deduction. If your already-filed return for the applicable year did not claim 50 percent bonus depreciation for qualified assets, it can be retroactively claimed by filing an amended return before the return for the subsequent tax year is filed. Alternatively, the taxpayer can file a request for a change in accounting method (on Form 3115) to retroactively claim 50 percent bonus depreciation.

Revoking an earlier election to forego the deduction. If a taxpayer's already-filed return for the applicable year included an election to forego 50 percent bonus depreciation for one or more classes of property, the taxpayer can revoke the election and thereby retroactively claim the deduction for one or more of the property classes by filing an amended return. The amended return must be filed by the later of June 17, 2011, or the day before the return for the subsequent tax year is filed.

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