Midwest Business Law Journal

Liquidation of an S Corporation upon a Shareholder’s Death Can Minimize Gain from the Sale of Corporate Assets

By Daniel J. Waters on Posted in Estate and Business Succession Planning, Tax

Generally speaking, Section 1014(a) of the Internal Revenue Code provides that any appreciated property held by a decedent at the time of his or her death receives a tax free “step-up” in basis.  Specifically, the basis in an asset owned by a decedent at the time of his death becomes the fair market value of the property on the date of death.  By way of comparison, if a decedent owns a farm that he originally purchased for $50,000, his basis in the farm during his lifetime is equal to its cost – $50,000.  A sale of the farm for $500,000 during the decedent’s lifetime would trigger a substantial taxable gain.  However, if the farm is not sold and it appreciates to $500,000 at the time of the owner’s death, the basis in that farm immediately steps up to $500,000 by reason of the owner’s death.  A subsequent sale of that farm for $500,000 would therefore not trigger gain to the decedent’s estate or heirs.

The issue becomes somewhat more complicated when the decedent owned stock in a closely-held Subchapter “S” corporation rather than a tangible, readily marketable asset.  This is especially the case when the decedent owned a majority interest in an asset-intensive S corporation (e.g., a farm).  In that case, the stock owned by the decedent at the time of his death enjoyed the benefit of the step-up in basis provided for under Section 1014.  However, the basis in the corporation’s underlying assets is unaffected by the shareholder’s death.  Consequently, any sale of appreciated assets owned by the corporation would trigger gain to the corporation which would pass through to the shareholders – including the estate.

Initially, it would appear that the decedent’s estate must sell the decedent’s stock in order to take advantage of the Section 1014 step-up in basis.  However, notwithstanding the gain realized upon the sale of the corporation’s assets, the estate may be able to greatly reduce or eliminate any tax from the sale of the corporation’s assets if the sale is coupled with a liquidation of the corporation in the same tax year.  In other words, although the shareholder’s death does not automatically result in an adjustment to the basis of the assets of the S corporation, a complete liquidation of the S corporation will result in an adjustment to the basis of the corporation’s assets by reason of the step up in basis in the shareholder’s stock.

The effect of the complete liquidation is generally summarized as follows:  The liquidation is considered a deemed sale of the corporation’s assets, which results in capital gain to the corporation passing through to the estate/shareholder.  That gain would increase the estate’s basis in the decedent’s stock over and above the fair market value of the stock at the date of death.  The liquidating distribution of corporate assets is considered payment in exchange for the shareholders’ stock.  Consequently, the liquidating distribution of corporate assets would produce a capital loss which offsets the estate’s pro rata capital gain from the liquidation (deemed sale).  The net result of the liquidation, at least with respect to the estate, is a wash.  The estate’s basis in the assets distributed to it in complete liquidation is the assets’ fair market value.  Thus, the estate will ultimately hold assets with a stepped-up basis, notwithstanding the fact that the decedent owned stock rather than underlying assets at the time of his death.

The liquidation technique summarized above is especially beneficial when the assets of the underlying corporation must be sold to generate cash proceeds to pay estate expenses (e.g., estate tax) or to provide for cash distributions to beneficiaries.  However, the surviving shareholders receive somewhat different tax consequences upon liquidation in view of the fact that their stock did not enjoy the benefit of the step-up in basis under Section 1014.  Thus, even if the shareholders are on board with liquidating the corporation’s assets, it will be important for all shareholders to consider the tax effect that the plan of liquidation will have on them personally.

IRS Lien Withdrawal Is Better Than Lien Release

By Matthew J. Bock on Posted in Tax

If you owe back taxes to the federal government the IRS has broad power to collect the past due taxes, including its use of the federal tax lien, which gives the IRS a legal claim to your property for the amount of the tax debt and the lien can be enforced for the amount of the tax debt.  The lien will be released within 30 days from the time you have paid all of your tax, interest and penalties.  A release means your assets are no longer subject to levy and sale by the IRS.

But a release does not necessarily remove from your records the fact that a lien had been filed by the IRS.  In order to clear your record, you need a lien withdrawal!  A lien withdrawal is accomplished by filing IRS Form 12277.  If you qualify for a lien withdrawal and file form 12277, the IRS will send to you IRS Form 10916(c), known as Withdrawal of Filed Notice of Federal Tax Lien.

You may even be able to get a lien withdrawal before your back taxes are completely paid under certain circumstances:

  • Your total amount due to the IRS doesn’t exceed $25,000.00
  • You have an installment agreement with the IRS
  • Payments to the IRS are made via monthly debits from your bank account
  • At least three consecutive debits have been made from your bank account

The biggest benefit of a tax lien withdrawal is how it affects your credit.  A federal tax lien can remain on your credit reports for as long as it takes you to pay off the IRS plus another seven years!  This is true even if the lien is released.  However, all three of the major credit reporting agencies, Equifax, TransUnion and Experian, will remove your tax lien from your credit report once you have provided them with a copy of the withdrawal form (Form 10916(c)) and they have confirmed the withdrawal.

Tax settlements with the IRS, such as an offer in compromise, will achieve a lien release, but you likely will not be granted a lien withdrawal.  Obviously the lien withdrawal process is a carrott used by the IRS to encourage taxpayers to pay their debts in full.

 

BANKRUPTCY BUZZ WORDS AND BASICS – CHAPTER 11

By Frank M. Schepers on Posted in Banking, Finance and Creditors Rights

Many non-lawyers (and some lawyers) become confused when bankruptcy jargon is tossed around. Here are a few basics:

• A case filed under Chapter 11 of the U. S. Bankruptcy Code is a reorganization, and begins with the filing of a Petition with the bankruptcy court serving the area where the Debtor is located. This is also called the Order for Relief.

• Within about 10 days of the filing of the Chapter 11 bankruptcy petition, the clerk of the bankruptcy court will send out a notice to all entities listed as creditors in the case, providing information and deadlines, including the date, time, and place for the First Meeting of Creditors conducted by the U.S. Trustee’s Office, notifying creditors of the existence of the automatic stay, and sometimes establishing a deadline for filing a proof of claim.

• On the filing of the bankruptcy petition an automatic stay goes into effect which mandates that all collection activities by creditors, including pursuit of judgments, foreclosures, repossessions of property, collection of unpaid taxes, demand letters, etc., are stayed or prohibited.

• The Debtor automatically assumes a new identity as the debtor-in-possession. Rarely is a trustee appointed in a Chapter 11 case; the debtor-in-possession performs many of the functions and has many of the duties that a trustee performs in cases under other chapters.

• One of the first things that often happens in a Chapter 11 bankruptcy is that the Debtor and its bank or lender enter into a cash collateral agreement providing for the post-bankruptcy financing of the Debtor’s ongoing operations and permitting the Debtor to use the proceeds of the lender’s collateral to operate.

• In larger Chapter 11 cases, creditors committees often play a major role. The committee is appointed by the U. S. Trustee’s Office and ordinarily consists of unsecured creditors who hold the largest unsecured claims (no collateral) against the Debtor. The committee consults with the Debtor on administration of the case, investigates its conduct, and often participates in formulating a plan of reorganization.

• There is a provision in the Bankruptcy Code defining a Small Business Debtor whose total liquidated secured and unsecured debt is less than a specific amount (currently $2,343,300).

• The ultimate goal of any Chapter 11 bankruptcy is the confirmation of a plan of reorganization. The plan is usually preceded by the filing of a disclosure statement describing the Debtor’s plan and giving some of the background related to why the bankruptcy case was filed.

It is important that creditors with claims, especially substantial ones, immediately consult their attorney upon learning of a bankruptcy filing by a customer or other entity against which they may hold a claim.

Content of E-Mails As Protected From IRS

By Robert J. Murray on Posted in Tax

The IRS may not obtain the content of e-mails from an internet service provider (“ISP”) unless it obtains a warrant to do so.

Chief Council for the IRS recently issued an Advisory Opinion (CCA 201141017) that because of recent Court rulings in the Sixth and Ninth Circuits, the IRS’ efforts to obtain the content of e-mails via the issuance of an Administrative Summons by a Revenue Officer (collection agent) would not be enforced. The facts recited in the Advisory Opinion dealt with the issuance of an Administrative Summons in an attempt to obtain the content of e-mails from an ISP in an effort to ascertain collection sources. The ISP refused to honor the Administrative Summons because of the provisions of the Stored Communications Act (18 U.S.C. §§ 2701 – 2711) and the Fourth Amendment.

Chief Council’s office relied upon an opinion from the Sixth Circuit which was premised upon the Court’s determination that the government’s actions constituted an unreasonable search in violation of the Fourth Amendment. The Sixth Circuit reasoned that an unreasonable search occurs when the government infringes on “an expectation of privacy that society is prepared to consider reasonable”.

Internet Sales Tax and Politics

By Matthew J. Bock on Posted in Corporate and Business, Tax

How many times have you compared the shipping costs of buying an item online to the sales tax of buying the same item at a local shop?  Internet sales have largely escaped sales tax for years, which has provoked plenty of complaints from local retailers and state governments.  The battle lines are now being drawn in several states.   In New York, Amazon.com and Overstock.com’s legal challenge to the constitutionality of New York’s sales tax law is on appeal.

On June 28, 2011, California enacted the Amazon Tax.  In light of constitutional barriers, which limit state governments’ power to tax out of state retailers, Amazon vowed to seek repeal of the new California tax on constitutional grounds and mobilized its political arsenal by also taking the issue to California voters with a ballot initiative.  California countered with a tax truce with Amazon by repealing the Amazon Tax and enacting AB 155, which represents a compromise to give Amazon and other Internet retailers a reprieve from any obligation to collect California sales or use tax until September 15, 2012.

What makes California’s battle with Amazon more interesting is the rising movement of the federal government to enact legislation which would permit states to tax online sales, legislation that Amazon.com, Inc. publicly supports.  Does this mean the end to tax-free Internet sales by the end of 2012?  Only time will tell.

POAs become null and void at death!

By Lauriel Nelson and Matthew J. Bock on Posted in Estate and Business Succession Planning

I recently assisted a title company with the sale of a deceased person’s home, and, on all of the closing paperwork, the personal representative of the estate had signed as the decedent’s power of attorney agent.  The title worker commented about how often she sees this misconception and jokingly said there should be a TV public service announcement with the following message emblazoned in bold letters across the screen: POAs become null and void at death!

Like the title worker, this is not my first experience encountering folks who misunderstand this concept.  Essentially, POAs are only valid while the person for whom the agent is acting is still living, and a PR cannot be qualified until the death of the person who nominates them.  So, let’s get back to the basics and identify the differences between these two important roles.

  • Power of Attorney (POA) agent:  A POA agent is a person whom you appoint to conduct your personal, legal, financial and health care affairs on your behalf in the event of your physical or mental incapacitation.  The term “incapacitation” is a loose term because there are many different types of POAs that can be written for various different situations, and it doesn’t necessarily mean a medical incapacitation.  For example, a large majority of our military personnel appoint POAs while they are deployed overseas.  The most common types of POAs are financial POAs and health care POAs, but you can sign a limited POA, too, which can appoint an agent for only one purpose (such as selling a house).  A POA can be a relative, doctor, financial advisor or even a financial institution, and there can be more than one agent representing you (or, co-agents).  To read more about POAs, this article by Cameron Huddleston at Kiplinger’s offers additional insight into what you should beware of before executing a POA.

 

  • Personal Representative (PR):  A PR is a person who is nominated in your Last Will and Testament to handle and oversee all matters pertaining to the administration of your estate.  A PR will gather all your property and distribute it according to the terms of your Will.  They will, among other things, receive any creditor claims against your estate, file an inventory of your property with the court, pay taxes on behalf of the estate and sell your assets as needed.  A PR’s role is effective upon approval or appointment by the court in which probate proceedings have been initiated.  Upon the conclusion of the estate administration and probate, the court will close the case, and the PR’s duties and powers terminate one year after the closure.

Unfortunately for our friends at the title company, all of the closing paperwork needed to be re-signed correctly.  Not only was this an inconvenience for all parties involved, but technically, this paperwork was invalid because an unauthorized individual executed it - a potential legal and financial snafu that you can avoid by understanding the differences between these very important fiduciary roles.  While executing a POA can be delicate business, it is a tremendous safeguard to ensuring your continued personal, financial and legal welfare.

 

Nebraska Tax Credits for Investors

By Robert J. Murray on Posted in Tax

The Nebraska Legislature enacted LB 389 in the 2011 session which is known as the
“Angel Investment Tax Credit Act”. The purpose of that legislation is to provide refundable state income tax credits to qualified investors and qualified funds that invest capital in qualified start-up companies. The purpose of LB 389 is to encourage investment in areas of Nebraska that have an unemployment rate which exceeds the statewide average, has per capita income below the statewide average per capita income, or experienced a population decrease between the two most recent federal decennial censuses.

The Act authorizes investment in the high technology field which includes a fairly wide range of businesses and industries, including aerospace, agricultural processing, energy efficiency and conservation, food technology, information technology, telecommunications, medical device products, pharmaceuticals and similar areas.

An investor must make a qualified investment of at least $25,000 in a given calendar year and such an investment can give rise to a tax credit of as much as 40% of the original investment.

For taxable years deemed to begin on or after January 1, 2011, a qualified investor is eligible for a refundable tax credit equal to 25% of its qualified investment and as much as 40% of the investment if the qualified small business is located in a distressed area.

There are a number of technical requirements, including a certification process or a determination by the Director of Economic Development regarding qualification for a determination of status as a qualified small business within the provisions of LB 389.

Shareholders In A Closely Held Business May Have Extra Job Protection

By Daniel J. Waters on Posted in Corporate and Business

The abrupt firing of a minority shareholder from positions of employment and management can be viewed as an improper “squeeze out” technique.  That is particularly the case where the minority shareholder has invested significant personal resources in the corporation with the understanding that he would provide important management services to the corporation on a regular basis for an extended period of time.  The threshold issue in a claim for shareholder oppression based on termination of employment is whether the minority shareholder had a reasonable expectation of continued employment.

Courts have adopted a handful of factors to be considered when evaluating a shareholder’s reasonable expectation of continued employment .  Those factors include:

(1)       Whether the shareholder made a capital investment in the company.

(2)       Whether continued employment could be considered part of the shareholder’s investment.

(3)       Whether the shareholder’s salary can be considered a de facto dividend.

(4)       Whether continued employment was a significant reason for making the initial investment.

By way of example, one court recently considered a shareholder-employee’s expectation of continued employment based upon the fact that the shareholder-employee was:

  • The company’s co-founder;
  • An officer;
  • A director; and
  • A key guarantor of the company’s debt.

In that instance, the court found that the termination of shareholder-employee’s employment was oppressive.   Importantly, the court found that the termination was not based upon the shareholder-employee’s ability or capacity to perform services for the corporation; rather, it was motivated by a personal dispute with another shareholder.  The court noted that termination of the shareholder-employee’s employment not only eliminated his salary but also his ability to manage and watch over his investment in the company that he helped to found.  In addition, the loss of employment meant losing the practical ability to see that the funds loaned to the corporation were used for their intended purpose so that his personal guarantee did not trigger liability for a company that he had no ability to control.  In essence, unreasonably terminating his day-to-day employment with the business, which effectively terminated his ability to have a meaningful voice in the management of the business and to protect his investment in the business, gave rise to a claim for shareholder oppression.

Innocent Spouse Relief Expanded by IRS

By Robert J. Murray on Posted in Tax

I.R.C. § 6015(f) provides relief for an innocent spouse in certain circumstances if it is clear that one spouse does not know of the under-reporting or under-payment of tax attributable to his or her spouse. On July 25, 2010, the IRS published Notice 2011-70 expanding the period of time within which individuals who qualify for innocent spouse relief from what otherwise appears to be joint and several liability, may request equitable relief.  In the typical case where married individuals file joint  returns, each spouse is jointly and severally liable for the tax that is due for the taxable year for which the joint return is filed.

The IRS had previously established a two year deadline for requesting equitable relief under § 6015(f).  In recent years there have been a number of challenges to that two year timeline.  IRS Notice 2011-70 sets forth the Commissioner’s agreement that a request for equitable relief will no longer be required to be submitted within two years of the IRS’ first collection activity against the requesting spouse.  Notice 2011-70 will be followed by more formal action to remove the two year deadline from an existing Treasury Regulation, but the effective date for Notice 2011-70 is July 25, 2011.

Under the rules announced in Notice 2011-70, the abandonment of the two year time
requirement is effective for pending requests without the need to file a new Form 8857 requesting innocent spouse relief so long as the applicable period of limitations under § 6502 (the 10 year collection statute) or § 6511 (the statute of limitations with respect to credits or refunds) was open when the request for equitable relief was filed with the IRS.

For requests that were previously denied solely for untimeliness but were not litigated, those individuals may reapply by filing a new Form 8857.  In those circumstances, the IRS will treat the original Form 8857 as a timely filed request for relief.

Notice 2011-70 is clearly good news for those individuals who qualify for innocent spouse relief.  The Treasury Regulation setting forth a two year timeline was apparently implemented as an arbitrary limitation solely for administrative convenience.  However, the IRS had previously relied on that two year timeline to reject otherwise meritorious claims for innocent spouse relief even though  the merits of the claim clearly called for appropriate relief.