Category: Tax

Proposition 13 Overhaul Qualifies for November Ballot

California Secretary of State Alex Padilla announced on Friday, May 29, 2020, that the revised initiative entitled “The California Schools and Local Communities Act of 2020” officially qualified for the November ballot. If passed, the initiative would establish a “split roll” where retail, office, commercial, and industrial real property would be taxed based on their market value, while residential property would continue to be assessed based on its purchase price.

THE CURRENT TAX REGIME: PROPOSITION 13

The current property tax regime under Proposition 13 generally provides that real property is taxed at one percent of its fair market value, which usually is the property’s purchase price. Unless there is a change in ownership of the property such as a sale, this “base value” can only increase by an inflationary rate that cannot exceed two percent per year. When property changes ownership, it is reassessed and the property’s base value is reset to its then current fair market value. Under Proposition 13, a property’s base value can be lower than its current fair market value, which in turn can reduce the amount of property tax that might otherwise be owed.

THE SPLIT ROLL

The ballot initiative creates a “split roll” if voters approve it in November. Under the split roll, commercial and industrial property with a fair market value of more than $3 million would be reassessed at its current fair market value at least every three years. The current tax regime under the Proposition 13 rules described above would continue to apply to all residential property, including both single-family and multi-unit structures and the land on which those structures are constructed or placed. The current rules also would remain in place for real property used for commercial agricultural production.

The process of administering this new tax regime will be determined by the California legislature, which will include, among other things, a process for reassessment appeals. The taxpayer will have the burden of proving that the property was not properly valued. The legislature also will determine a process by which to allocate mixed-use property between its commercial and residential uses for purposes of implementing the split roll.

The new regime will not apply to commercial or industrial property with a fair market value of $3 million or less unless any of the direct or indirect owners of such real property also own interests in other commercial and/or industrial real property. In that case, the new regime will apply if all such real property has an aggregate fair market value in excess of $3 million.

TANGIBLE PERSONAL PROPERTY TAX RELIEF

If passed, the ballot initiative would exempt small businesses from property tax on all of its tangible personal property. A small business is a business that: (1) has fewer than 50 annual full time employees, (2) is independently owned and operated such that the ownership interests, management and operation are not subject to control, restriction, modification, or limitation by an outside source, individual or another business, and (3) owns real property located in California.

For all other taxpayers, an amount up to $500,000 of combined tangible personal property and fixtures (other than aircraft and vessels) will be exempt from taxation.

WHEN WOULD THE SPLIT ROLL TAKE EFFECT?

The split roll would become operative beginning January 1, 2022, and the tangible personal property tax relief would become operative on January 1, 2024.

Despite the split roll becoming operative on January 1, 2022, the reassessment of undervalued commercial and industrial property will be implemented through a phase-in over two or more years. An owner of commercial or industrial property would only be obligated to pay taxes based on the new assessed value beginning with the lien date for the fiscal year when the assessor has completed the reassessment. In addition, if 50% or more of the square footage of a commercial or industrial property is occupied by a small business, such property will not be subject to the new regime at least until the 2025-26 fiscal year.

© 2010-2020 Allen Matkins Leck Gamble Mallory & Natsis LLP

For more on real estate taxation, see the National Law Review Tax law section.

COVID-19: IRS Extends Production Tax Credit/Investment Tax Credit Safe Harbors

On May 27, 2020, the IRS issued Notice 2020-41, which responds to industry-wide supply chain disruptions due to the COVID-19 pandemic by giving renewable energy developers additional time to complete their projects. Most importantly, the Notice extends two safe harbors applicable to the renewable energy production tax credit (PTC) and investment tax credit (ITC).

First, the “Continuity Safe Harbor” is extended from four years to five years for projects that began construction in 2016 or 2017. Developers that put the project in service by the end of the fifth calendar year after the year construction began will be deemed to meet the continuous construction requirement.

Second, relief is provided for developers that intend to meet the beginning construction requirement by incurring 5% of project costs, i.e., by making payments for services or property they reasonably expected to receive within 3½ months (a/k/a the 3½ Month Rule). Developers that pay for services or property on or after September 16, 2019 and actually receive the services or property by October 15, 2020, will be deemed to satisfy the 3½ Month Rule.

This relief is available to developers of wind, solar, biomass, geothermal, landfill gas, trash, hydropower, fuel cells, microturbines, and combined heat and power systems.

©2020 Pierce Atwood LLP. All rights reserved.

For more on IRS Safe Harbors, see the National Law Review Tax Law section.

What to Do Now With Your CARES Act PPP Loan

A Warning

Those who have obtained Paycheck Protection Program (PPP) loans (or have applied or been approved for such loans but not yet received the loan proceeds) have been warned by the U.S. federal government to make sure that they, in fact, qualify for the loans. Secretary Mnuchin exonerated lenders who processed the loans and warned that it is the borrowers themselves who sign the application and make the relevant certifications who face potential criminal action for false certifications. Borrowers have now been given a grace period until May 7, 2020, to repay loans they may have obtained “based on a misunderstanding or misapplication of the required certification standard.” This short — now less than one-week — period gives PPP loan borrowers very little time to act and is aggravated by the ambiguity of applicable regulatory and other guidance as discussed below.

Thinking About What to Do

Borrowers are, and should be, asking, “what do we do about our PPP loan?” They are doing so in a unique moment. Indeed, a former member of a Congressional oversight board following the last financial crisis opined in the Wall Street Journal: “[B]orrower beware! Businesses with flexibility should seriously consider to what extent accepting the terms of federal loans or other support may be a Faustian bargain. The ultimate cost may dramatically outweigh the temporary gain.” Understanding the issues that inform the answer to this question, unfortunately, involves some detailed analysis as discussed below.

Broad Loan Availability Initially Heralded and Broad CARES Act Approach

The signing into law of the Coronavirus Aid, Relief, and Economic Security Act (CARES Act)on March 27, 2020, was heralded as a critical response to the COVID-19 economic crisis. The PPP loan program was enacted to make $349 billion of loan funds broadly available to qualifying businesses so that those businesses could keep their employees employed. In fact, following enactment, the federal government repeatedly encouraged businesses to apply for (and lenders to quickly process) PPP loans. Even as late as April 15, 2020, Secretary Mnuchin announced that “[w]e want every eligible small business to participate and get the resources they need.” In order to broaden its reach, the CARES Act affirmatively took action to cut back eligibility restrictions in the existing Small Business Administration (SBA) loan program through which PPP loans are administered, including:

  • suspending the requirement that borrowers must not be able to obtain credit elsewhere;
  • repealing the requirement that liquid owners contribute capital alongside an SBA loan;
  • creating a presumption that loan applicants were adversely impacted by COVID-19; and
  • reducing the breadth of the complex affiliation rules.

The SBA itself even published guidance allowing borrowers to restructure their governance arrangements to qualify for a loan.

A Continuing Changing Landscape; Making a Decision to Keep a PPP Loan

Since the passage of the CARES Act, the landscape has continued to evolve — sometimes daily — with ongoing guidance from the SBA and Treasury, whether in the form of Interim Final Rules (immediately effective upon publication in the Federal Register without first soliciting public comment due to the emergency nature of the situation), FAQ guidance from the SBA with new questions and answers added frequently over the past month, or mere public statements by public officials. Through the end of April — just a month into the CARES Act — seven formal Interim Final Rules for the CARES Act have been issued and 12 updates to the SBA’s FAQs on the PPP have been published. It has been difficult to find clear guidance and sure footing, even before the most recent government warnings.

A Sudden Shift in Approach

On April 23, 2020, after significant press reporting and commentary on those participating in the PPP loans, the SBA and Treasury Secretary abruptly shifted course with the publication of a new FAQ (Question 31) stating that the certification each borrower makes in its application that “[c]urrent economic uncertainty makes this loan request necessary to support the ongoing operations of the Applicant” must be made “in good faith, taking into account their current business activity and their ability to access other sources of liquidity sufficient to support their ongoing operations in a manner that is not significantly detrimental to the business” (emphasis supplied). As to specific examples where certification might raise questions or get a closer look, an April 23 FAQ highlighted large public companies and an April 24 Interim Final Rule highlighted Private Equity (PE) portfolio companies. On April 28, Secretary Mnuchin made public comments promising audits of all loan amounts over $2 million, and then — also on April 28 — the SBA updated its FAQs twice to highlight this new certification interpretation as also applicable to private companies and to formalize the $2 million audit threshold requirement. In other words, virtually all borrowers must be cognizant of the certification that they made in their loan application.

What Does the Certification Mean?

Unfortunately, there is no real guidance as to what this certification means. However, one thing is certain — this certification and the question of access to “other sources of liquidity” will be judged in retrospect. It is anyone’s guess how long the “look back” risk will exist. Our experience is that these kinds of after-the-fact examinations have a long life. In this respect, a borrower may legitimately ask how it knows if it has access to liquidity — must a public company try to test the capital markets; must a PE fund owner consider drawing down on undrawn commitments or fund level credit agreements to fund a highly distressed portfolio company; will VC-backed companies be judged poorly in this context if their investors have large amounts of so-called “dry powder” to invest; and will private business owners have to evaluate their own wealth, liquidity positions, and borrowing capacity? These are all questions that have no ready answer through current SBA rules or guidance. The fact that the CARES Act “suspended” the normal requirement that a borrower be unable to obtain credit elsewhere and repealed the requirement of liquid owners to contribute capital has simply not been reconciled with the SBA’s new scrutiny on available liquidity, as the Treasury and SBA have leaned hard into the statutory certification requirement that any loan request must be “necessary.” Borrowers and applicants would be excused from asking what it means for the SBA to require liquidity that is not “significantly detrimental to the business.” Does that mean “significantly detrimental” to the current business owners (whether public company stockholders, PE or VC fund investors, or the owners of private businesses themselves) in terms of dilution or the like, or does this important phrase instead mean just what it says — such alternative available liquidity is not “significantly detrimental to the business” itself (e.g., financing that the business cannot make “work“ for any real period of time and which damages the business as a going concern)? Again, the SBA and Treasury have provided no clear answers.

The Other Key Certification Issue:

As borrowers evaluate their options to return loans before the expiration of the safe harbor on May 7, 2020, they must also focus on compliance with the SBA “affiliation” rules. The affiliation rules are complex and directly impact the question of who may apply for a PPP loan. This is because the way in which the CARES Act defines eligible borrowers largely turns on the number of employees involved, and an applicant must generally (under applicable regulatory guidance and rules, but subject to certain waivers set forth in the CARES Act itself) apply the SBA’s affiliation rules to aggregate its own number of employees with that of all of its affiliates. Thus, the application of the SBA’s affiliation rules is critically important to an applicant’s ability to make another certification in each PPP loan application: that “the Applicant is eligible to receive a loan under the rules in effect at the time this application is submitted that have been issued by the Small Business Administration (SBA) implementing the Paycheck Protection Program ….” So, in addition to the question of necessity for the PPP loan and alternate sources of liquidity, borrowers must ensure that they have considered the application of the affiliation rules (unless otherwise waived) in deciding whether to keep SBA loans.

Who Is an Affiliate Under the CARES Act?

According to the SBA, affiliate status for purposes of determining the number of employees of a business concern for PPP loans works as follows:

  • “Concerns and entities are affiliates of each other when one controls or has the power to control the other, or a third party or parties controls or has the power to control both”;
  • “It does not matter whether control is exercised, so long as the power to control exists. Affiliation under any of the circumstances described [in 13 C.F.R. § 121.301(f)] is sufficient to establish affiliation” for applicants for the PPP; and
  • There are four general bases of affiliation that the SBA will consider when determining the size of an applicant: (1) affiliation based on ownership; (2) affiliation arising under stock options, convertible securities, and agreements to merge; (3) affiliation based on management; and (4) affiliation based on identity of interest.

As noted, these affiliation rules are both subtle and complex. Interestingly, even Congress did not seem to get the affiliation rules quite right in the CARES Act. In this regard, there are two SBA-related affiliation rules — rules set forth in 13 C.F.R. § 121.103 (Section 103) and rules set forth in 13 C.F.R. § 121.301 (Section 301). When Congress exempted certain business concerns from the affiliation rules for the PPP, it did so under the Section 103 rules. Yet, according to the SBA April 3 Interim Final Rule, it is, in fact, the Section 301 rules that govern affiliation for the PPP loan program (though the SBA explained that it would, consistent with the Congressional Section 103 waiver, also make that waiver applicable for Section 301).

Uncertainty in Application

As questions have arisen under these affiliation tests, borrowers who relied on them in submitting their application would be well advised to “double check” their analysis with appropriate counsel given the heightened scrutiny that will most certainly be applied in retrospective audits of PPP loan recipients. And, it is not just the application of the four bases of control that have given rise to questions of how the affiliation rules work, but the actual language of the CARES Act itself. In this regard, while the CARES Act clearly waives affiliation rules for “any business concern with not more than 500 employees that, as of the date on which the loan is disbursed, is assigned a North American Industry Classification System [(NAICS)] code beginning with 72,” the CARES Act itself has a separate and more expansive provision for NAICS code 72 companies allowing for more than 500 aggregate employees and which provides: “During the covered period, any business concern that employs not more than 500 employees per physical location of the business concern and that is assigned a North American Industry Classification System code beginning with 72 at the time of disbursal shall be eligible to receive a covered loan.” This seems to be clear and self-executing language. Indeed, both applicable House and Senate publicly available explanations of the CARES Act suggest as much, explaining that a qualifying borrower is “Any business concern that employs not more than 500 employees per physical location of the business concern and that is assigned a North American Industry Classification System code beginning with 72, for which the affiliation rules are waived” (emphasis supplied). But, nowhere has the SBA specifically addressed the question of how these two specific NAICS code 72 provisions of the CARES Act are to be applied in conjunction with one another. Even the SBA FAQs seem to intentionally avoid addressing this issue head-on, leaving borrowers at risk for after-the-fact second-guessing.

The Criminal Issue

Secretary Mnuchin referenced criminal liability for a reason. During the past two decades, for every major crisis this country has witnessed, from the Financial Crisis to Hurricane Katrina, high levels of fraud were identified and addressed post-crisis. From the experience gained in prior disasters, the Department of Justice and other enforcers are well aware that fraud may occur under the CARES Act as well. They almost certainly realize that a strong way to prevent such fraud is to take an early, aggressive stance against misconduct. We would predict that U.S. law enforcement will seek to make extreme examples of the individuals who exploited COVID-19-related government assistance improperly and precluded the assistance from helping those actually in need.

The underlying criminal issues relating to PPP loans are relatively straightforward. The loan application itself makes clear that applicants are required to state they qualify, and advises that there are criminal penalties for knowingly making false certifications. Each applicant, by signing the loan application, makes the following statements:
I further certify that the information provided in this application and the information provided in all supporting documents and forms is true and accurate in all material respects. I understand that knowingly making a false statement to obtain a guaranteed loan from SBA is punishable under the law, including under 18 USC 1001 and 3571 by imprisonment of not more than five years and/or a fine of up to $250,000; under 15 USC 645 by imprisonment of not more than two years and/or a fine of not more than $5,000; and, if submitted to a federally insured institution, under 18 USC 1014 by imprisonment of not more than thirty years and/or a fine of not more than $1,000,000.

This certification is essentially the same certification generally applicable to forms and information required by a bank or the government that involve applications for loans, grants or other financial assistance. The certification provides that if you knowingly mislead or lie on the application, you have committed a felony. However, the one completing such an application should endeavor in good faith to provide correct information. This means not simply guessing or blindly answering to expedite processing of the loan application or superficially making the certifications in question. In short, if you mislead in order to receive a PPP loan or lie to receive forgiveness, there is a material risk that the government will believe a felony has been committed.

As stated above, because of the intense pressure to protect the integrity of the PPP loan program and to deter widespread fraud, government enforcers may well use additional criminal statutes to prevent fraud on the United States and the banks. PPP-related prosecutions may involve the usual bank fraud, wire fraud and other common financial fraud statutes. These specific laws all have the common requisite element of deceit. Further, the government will clearly feel free to use whatever remedies possible to recover ill-gotten PPP money and assess related fines to make the U.S. taxpayers whole through various civil enforcement remedies. To avoid such criminal consequences, borrowers need to exercise their best efforts to provide the government with accurate information. There is no criminal liability for mistakes or inadvertent omissions, but when actions are judged retrospectively, trying to prove a lack of intent is not a situation any borrower would want to face. Of course, possible criminal prosecution is not the only redress or negative consequence that wrongful borrowers may face. There are, for example, civil penalties and actions that can be pursued by regulatory or government authorities, qui tam actions, and possible stockholder or equity holders claims against boards or managers, not to mention the potential negative press.

In Sum – This Much is Clear – Double Check, Document and Be Careful Either Way

It would not be surprising or unreasonable for business owners to ask how they are supposed to act with any comfort as to PPP loans given all the uncertainty noted above, with the Treasury Secretary highlighting criminal penalties in relation to improper applications, and with a new “safe harbor” loan “give back” period running only until May 7. It also would not be surprising to see those borrowers who can find a way to make it without the PPP loan decide to return PPP loan proceeds (or not accept funds that have been approved but not yet been received) — even when they have been truly harmed by the COVID-19 pandemic, even when they have always intended to use the loan to keep employees paid exactly as intended by the CARES Act, and even when they believe they qualify for the PPP loan. What is clear from all of the above is that not much is truly clear with respect to the eligibility criteria and certification requirements for PPP loans. What also seems clear — including from the most recent SBA rules issued April 30 stating that the maximum loan amount for a related corporate group will be limited to $20 million — is that loans (even big loans) for qualifying firms are legitimate.

Some Practical Points

Finally, those borrowers who ultimately elect to keep their loans should strongly consider working with counsel to create a contemporaneous, written record to support their certifications or their current decisions to keep those loans based on the certifications that were made at the time of the loan application. There are two key inquiries. First, the borrower should review compliance with the affiliation rules to support the eligibility certification. Second, the borrower should review support for its “necessity” certification, considering (for example) the following questions:

  • What were the specific facts and circumstances showing that the applicant bore financial hardship and faced material economic uncertainty?
  • Did the applicant consider its ability to access capital, including conducting discussions with those who were in a position to provide capital such as the applicant’s current lender(s) and equity holders?
  • Did the applicant prepare a forecast projecting its liquidity position and effect on the operations of not obtaining a PPP loan and that would demonstrate that the loan was necessary to support the ongoing operations of the borrower? Alternatively, did the borrower conduct any other financial review in connection with such certification?

Best practices would then have the foregoing crisply documented and reviewed and approved by the borrower’s board or other governing body. The written record should demonstrate that a bona fide, good-faith effort was undertaken to support the certifications truthfully. If this exercise cannot produce a defensible written record, then the prudent decision may be to return the loan proceeds, ideally before elapse of the grace period for doing so.

Authored by: Trevor J. Chaplick, Peter H. Lieberman & Nathan J. Muyskens  of Greenberg Traurig, LLP

 

©2020 Greenberg Traurig, LLP. All rights reserved.

New Revenue Ruling 2020-8 Helps Taxpayers Seek COVID-19 Tax Refund Claims

Recently, in Revenue Ruling 2020-8, the Internal Revenue Service (IRS) announced that it was suspending Revenue Ruling 71-533, which had addressed the interaction of two Internal Revenue Code (IRC) provisions regarding limitations periods on refund claims, pending reconsideration of the holding of the earlier Revenue Ruling.

Under IRC section 6511(d)(2)(A), a taxpayer generally must make a refund claim relating to an overpayment attributable to a net operating loss (NOL) carryback no later than three years after the taxable year in which the NOL was generated. Under IRC section 6511(d)(3)(A), a taxpayer generally must make a refund claim relating to an overpayment attributable to a foreign tax credit carryback no later than ten years after the taxable year in which the foreign taxes were paid.

Revenue Ruling 71-533 had addressed a situation that implicated both of these provisions. Specifically, the taxpayer at issue in the ruling had incurred a NOL in 1969, which it carried back to 1966. After application of the NOL, the taxpayer had excess foreign tax credits available for 1966, which it then carried back to 1964. The ruling held that the ten-year limitations period in IRC section 6511(d)(3)(A) applied to claims for refund with respect to the 1964 overpayment.

In Revenue Ruling 2020-8, the IRS noted that, even though the fact pattern in Revenue Ruling 71-533 involved both a NOL carryback and a foreign tax credit carryback, the ruling did not consider whether IRC section 6511(d)(2)(A) should apply in lieu of IRC section 6511(d)(3)(A). Therefore, the IRS stated that it was suspending Revenue Ruling 71-533 pending reconsideration of its ruling. However, the IRS also stated that this suspension would not be applied adversely to refund claims properly filed within the IRC section 6511(d)(3)(A) limitations period in accordance with Revenue Ruling 71-533 during the period in which the ruling’s holding is being reconsidered.

Practice Point: Revenue Ruling 2020-8 is particularly important to taxpayers seeking refunds under the special COVID-19 rules. We discussed those refunds here. The IRS is trying to do everything it can to facilitate getting relief to taxpayers.

© 2020 McDermott Will & Emery

For more on IRS COVID-19 Guidance, see the National Law Review Tax Law section.

Stimulus, IRS Extended Deadline and Gifting Opportunities

Coronavirus Aid, Relief, and Economic Security Act (CARES Act)

  • President Trump signed the CARES Act on March 27, 2020, a $2 trillion stimulus package providing $560 billion of relief for individuals, including:
    • Cash Payments: $1,200 per individual ($2,400 for couples); plus $500 per qualifying child1
    • Retirement Funds: Early withdrawal penalties waived for distributions of up to $100,000, if withdrawal is for coronavirus related purposes
    • 401(k) Loans: Loan limit increased from $50,000 to $100,000
    • Required Minimum Distributions: Suspended in 2020 for IRA/401(k) plans, including inherited IRAs
    • Charitable Deduction: Up to $300 charitable deduction for 2020 taxpayers who utilize the standard deduction

Extension of filing and payment deadlines

  • The federal and Wisconsin income tax return filing and payment deadline for the 2019 tax year was automatically extended to July 15, 2020
  • The federal gift tax return filing and payment deadline for the 2019 tax year was automatically extended to July 15, 2020

Gifting opportunities

  • Low valuations, low interest rates, and the anticipated reduction in the federal estate/gift tax exemption from $11.58 million to approximately $6.5 million on January 1, 2026 have created many planning opportunities, including:
    • Gifts and/or sales to existing or newly established Trusts to take advantage of low valuations and use the $11.58 million exemption while it is still available;
    • Amending intra-family loans to take advantage of low interest rates; and
    • Creation of charitable lead trusts, grantor retained annuity trusts, and other estate planning techniques that benefit from low interest rates are particularly attractive right now.

Now may also be a good time for clients to review their existing estate plans to make certain that their plans are up to date and consistent with their wishes.

1Amounts are phased down for individuals making more than $75,000 ($150,000 for couples) and phased out for individuals making more than $99,000 ($198,000 for couples)

Copyright © 2020 Godfrey & Kahn S.C.

Important Guidance for IRS Tax Filers

Due to the situation created by the coronavirus, we’ve been fielding questions from clients, co-workers and accountants about potential changes in the tax filing and tax payment deadlines, as well as other IRS administrative issues such as examinations, collection actions and payment plans.

Because the president declared a national emergency, the IRS has broad powers under statute to extend certain deadlines. The IRS also has broad administrative authority. As of the date and time of this email, there has been no official guidance issued on extending the April 15 deadline for the filing of income tax returns. However, statements made on March 17, 2020 by Secretary of Treasury Mnuchin suggest that the government will allow a 90-day deferral of tax payments to the IRS.

Under this program, individuals can defer up to $1 million of tax payments, and corporations can defer up to $10 million, with no penalties and interest for 90 days. This program does appear to require the filing of a tax return first in order to obtain the deferral. Many questions on this program remain, and Varnum’s tax team will provide updates as they evolve.

Out of an abundance of caution, individuals may want to file an extension (Form 4868) prior to the filing deadline. This is NOT an extension in time to pay. As such, the first quarter tax estimates are due April 15 as is any shortfall in the expected 2019 tax liability. Please note, with respect to the payment deferral program, the secretary has not clarified whether the extension form or the estimated tax payment voucher falls under the definition of “return” for the payment deferral program. Finally, there are some safe harbors for estimated tax payments that may apply. Check the IRS website or talk to a tax advisor.

Tax preparers should check with the IRS employee assigned to any matter for the case status, including document requests, etc. If your client is honoring an IRS levy on an employee at this time, those obligations are still in force unless notified otherwise by the IRS. Some deadlines such as filing a Tax Court Petition for relief are statutory in nature and still valid.

© 2020 Varnum LLP

More on tax laws or the coronavirus outbreak on the National Law Review.

529 Plans: Estate Planning Magic

The most common way to reduce state and federal estate taxes is to make lifetime gifts to irrevocable trusts. However, in order for an irrevocable trust to escape estate taxation at the grantor’s death, the grantor may not retain the power to “designate the persons who shall possess or enjoy the property or the income therefrom.” (IRC § 2036(a)(2).) In other words, the grantor cannot change the beneficiaries of the trust.

This poses a problem. What if circumstances change? What if a grantor creates a trust for a child, but the child no longer needs the funds? What if the grantor ends up needing the funds themselves? A grantor can build flexibility into irrevocable trusts by granting powers of appointment to the beneficiaries or by appointing a trust protector, but these powers may not be held by the grantor. Thus, reluctance to give up control keeps many clients from making gifts to irrevocable trusts.

The general rule that a grantor must relinquish all control over gifted assets has been seared into the mind of every estate planning professional fearful of accidentally causing estate tax inclusion. But there is one exception: the humble 529 Plan.

Section 529 of the Code contains a shocking statement:

“No amount shall be includible in the gross estate of any individual for purpose of [the estate tax] by reason of an interest in a qualified tuition program.” (IRC § 529(c)(4)(A))

There are, of course, exceptions. 529 plans are (likely) includible in the estate of the beneficiary upon the beneficiary’s death. Also, if the grantor has made the election to “front load” five years of annual exclusion gifts to the 529 Plan (discussed further below) and dies before the five years expires, a portion of the gifted amount will be includible in the grantor’s estate.

Still, 529 Plans offer unparalleled flexibility in estate tax planning. A grantor can remain the “owner” of a 529 Plan and retain the power to change the beneficiary to a qualifying family member (which includes grandchildren, nieces and nephews, and others), while still removing the assets in the 529 Plan from his or her estate. This is in contrast with an irrevocable trust, in which the grantor cannot act as trustee and cannot retain the power to change the beneficiaries.

The other “magic” of 529 Plans is the ability to “front load” annual exclusion gifts. The annual exclusion from gift tax allows a grantor to transfer up to $15,000 per year, per person. But, if a grantor makes the proper election on a gift tax return, he or she can make five years of annual exclusion gifts in a single year and use no transfer tax exemption. If the grantor is married and elects “gift‑splitting,” the couple can transfer $150,000 to a 529 Plan in a single year and use no estate and gift tax exemption.

529 Plans are, of course, designed for education, and are not complete substitutes for irrevocable trusts. The “earnings portion” of non-qualified distributions (i.e., distributions not used for “qualified higher educational expenses”) from a 529 Plan are subject to ordinary income tax at the beneficiary’s tax rate plus a 10% penalty, and for this reason, care should be taken not to “overfund” a 529 Plan. However, 529 Plans can nevertheless serve as effective wealth transfer vehicles because of their income tax benefits and the high probability that a grantor will wish to make significant contributions to the education of at least some members of his or her family. Combined with their unparalleled estate tax features, this makes 529 Plans “estate planning magic.”

© 2020 Much Shelist, P.C.

For more Estate Planning, see the Estates & Trusts section of the National Law Review.

Delaware Franchise Taxes Are Around the Corner

If you are a Delaware corporation, you likely received a notice from the Secretary of State of Delaware informing you that your company’s Annual Report and franchise tax payment are due by March 1, 2020. These notices are sent to the corporation’s registered agent. You are still required to file an Annual Report and pay the franchise tax even if your corporation never engaged in business or generated revenue. Delaware requires these to be submitted online.

There are two ways to calculate your Delaware franchise taxes (the Authorized Shares Method and the Assumed Par Value Capital Method). Delaware defaults to calculating its franchise taxes owed by using the Authorized Shares Method, which almost always results in a higher tax liability for startups with limited assets. However, by using the Assumed Par Capital Value Method, startups are often able to significantly lower their franchise tax burden.

For example, a typical early-stage startup corporation with: (i) 10 million authorized shares of stock; (ii) 9 million issued shares of stock; (iii) a par value of $0.0001; and (iv) gross assets of $100,000, would result in the following franchise tax obligations under the different methods:

  • $85,165 under the Authorized Shares Method

  • $400 under the Assumed Par Value Capital Method

    If you are incorporated in Delaware, but conducting business in another state, you must be qualified to do business in that state – meaning, you might be subject to that state’s franchise tax (if any) as well. For example, a Delaware corporation doing business in Texas must still register for a foreign qualification to conduct business in Texas ($750 filing fee), submit a Texas annual Franchise Tax Report (due by May 15 of each year), and pay the associated tax.

Texas franchise taxes are based on an entity’s margin (unless filing under an EZ computation),

and are calculated based on one of the following ways:

  • total revenue times 70 percent;

  • total revenue minus cost of goods sold (COGS);

  • total revenue minus compensation; or

  • total revenue minus $1 million (effective Jan. 1, 2014).

© 2020 Winstead PC.

For more on franchise taxation, see the National Law Review Tax Law section.

Why is Section 962 Back in the Spotlight? [Podcast]

In this podcast, international tax and estate planning attorneys Megan Ferris and Paul J. D’Alessandro, Jr. provide an overview of how individuals and corporations are taxed under the GILTI regime and discuss why section 962 has come back into the spotlight in a post-2017 Tax Act world.

Transcript:

PAUL D’ ALESSANDRO

Good morning, everybody, and welcome to our first Bilzin Sumberg Tax Talk podcast. My name is Paul D’Alessandro, and I’m a tax associate here with our international private client group. I focus my practice on inbound planning and estate planning for international high net worth individuals. I’m here today with my colleague, Megan Ferris.  How are you doing this morning, Megan?

MEGAN FERRIS

Hi, Paul. My name is Megan Ferris. I am an international tax associate with Bilzin Sumberg in Miami, Florida. I focus primarily on inbound and outbound tax structuring for businesses, typically closely held businesses. Our hope with this podcast is to bring you current issues related to various tax, trust, and estate matters.

PAUL D’ ALESSANDRO

Thanks, Megan, and I think we have a great topic for you this morning. Our first topic to kick off our podcast series. And we’re going to be talking about Section 962 and why it’s come back into the spotlight as of late. So, I think we’re going to hop right into it. And, Megan, I think a good way to start would be, can you give us a quick overview of the way individuals and corporations are taxed under the new GILTI regime in a post-2017 Tax Act world?

MEGAN FERRIS

Sure. Generally speaking, and especially when it comes to CFCs, the Tax Cuts and Jobs Acts of 2017, or the Tax Reform Act, treats U.S. corporations much more favorably than U.S. individual shareholders. First, at a high level, individuals are taxed in the U.S. on their ordinary income at graduated rates up to 37%, plus an extra 3.8% net investment income tax on their passive income. Corporations, on the other hand, are taxed at a flat 21% rate on their net taxable income.  Next, the Tax Reform Act introduced a handful of new across border taxes and anti-deferral measures.  One of these is Section 951A which, is called Global Intangible Low Tax Income, or GILTI, as you referred to it, which basically applies to the active operating-income of the CFC.  Now pre-tax reform, this income would not be taxed to the CFC’s U.S. shareholders until it was distributed, but today that income is taxed annually at the shareholder’s ordinary income rate.  Congress, however, went a step further by introducing Section 250, which gives U.S. corporations, and only U.S. corporations, a 50% deduction on their GILTI income and that essentially results in a 10.5% tax rate.  But wait, there’s more. U.S. corporations can also take a foreign tax credit for up to 80% of the foreign taxes paid by the CFC. So essentially, if the CFC paid at least a 13.2% tax rate, or specifically a 13.125% tax rate in its local country, then a U.S. corporate shareholder can use foreign tax credits to offset its entire U.S. income tax liability for that underlying GILTI income.  And that’s great for corporations.  An individual shareholder, on the other hand, has no Section 250 deduction and no foreign tax credit for taxes paid by the CFC.  The individual pays up to 37% U.S. tax on GILTI, end of story.  So, as you can see, the disparity between individual and corporation taxation can be quite dramatic.  And I guess that brings us back to the theme of today’s podcast, which is how some individual tax payers might use Section 962 to avail themselves of these benefits that are available only to domestic corporations.

PAUL D’ ALESSANDRO

Thanks, Megan. So that was a great overview I think of the general operating rules for the taxation of offshore income in a post-2017 Tax Act world. So as Megan alluded to, and our next question here in our podcast is, what is a 962 election, and how might an individual consider using the 962 election?

MEGAN FERRIS

Right.  So, in short, Section 962 allows individual U.S. shareholders of CFCs to elect to be taxed as domestic corporations. The election is available to direct and indirect shareholders of CFCs, so if an individual owned their interest through a partnership or certain trusts, they would still be able to make the election.  So now I’ll get into the mechanics of the election, but first I think it would help to give some historical context. Section 962 first became effective beginning in the tax year 1963 along with the rest of subpart F. Back then, the top individual tax rate in the U.S. was 91%, and the top corporate rate was 52%. So if you think we have it bad today, just be thankful we’re not in the 1960s.  Anyhow, with the introduction of subpart F and the new concept of taxing the U.S. individual shareholder on a CFCs income that the shareholder didn’t actually receive, Congress decided to give taxpayers a break and the means of reducing that current tax burden to the lower corporate tax rate of then only 52%. In addition, taxpayers were permitted to claim deemed paid tax credits under Section 960 for foreign taxes that were paid by that CFC. Now the legislative history under Section 962 tells us that, and I quote, “The purpose of Section 962 is to avoid what might otherwise be a hardship in taxing a U.S. individual at high bracket rates with respect to earnings in a foreign corporation which he does not receive. Section 962 gives such individuals assurance that their tax burdens with respect to these undistributed foreign earnings will be no heavier than they would have been had they invested in an American corporation doing business abroad.”  So, as far as tax policy goes, that’s a breath of fresh air for the taxpayers. Okay, now the mechanics.  This is how a U.S. individual is taxed under a Section 962 election. First, the individual is taxed on amounts that are included in gross income under Section 951a and now Section 951A, which is GILTI, at a corporate tax rate, which are currently 21%. Second, the individual is entitled to a deemed paid foreign tax credit under Section 960 with respect to the subpart F or GILTI inclusion as if the individual were a domestic corporation. Third, when an actual distribution of earnings is made from amounts that were already included in the U.S. shareholder’s gross income under Sections 951a and Section 951A, and just a reminder Section 951a is subpart F income, 951A is GILTI, those earnings are included in gross income again, but only to the extent that they exceed the amount of U.S. income tax paid at the time of the Section 962 election.  So, if an individual initially used foreign tax credits to offset his or her entire U.S. tax liability related to GILTI income in the year that the income was reported, then when the income is actually distributed, it will be includable again as dividend income. If the underlying CFC is in a treaty jurisdiction, then that individual will benefit from qualified dividend rates, which are currently 20% plus a 3.8% tax on passive income, that brings us to a total U.S. effective tax rate of 23.8%.

PAUL D’ ALESSANDRO

Interesting, Megan. So it seems like there’s definitely some benefits to be gained potentially under Section 962, but how does an individual taxpayer make a Section 962 election?

MEGAN FERRIS

An individual would typically file a Section 962 election with his or her timely filed tax return for the year to which the election relates, although in certain circumstances, case law would permit a retroactive election. The election is made on an annual basis, meaning each year you have the option to make the election or not, and you also have the opportunity to miss it, so be careful about that. Once made, the election applies to all Section 951a and 951A, included to the U.S. shareholder for all CFCs for that year.

PAUL D’ ALESSANDRO

So that’s an interesting point there you made at the end and something our readers — our listener’s rather, might want to pick up on.  The election applies to all CFCs that are owned by the individual.  So keep that in mind when you’re analyzing Section 962 and whether it makes sense to make the election based on your facts and circumstances.  So I think we kind of gave an overview here of Section 962 and why it matters now.  But what we’re going to do now is drill really down into the pros and cons of 962, what are the benefits to be gained, and what are some of the drawbacks as well by making the selection. So, Megan, do you want to start by taking us through the benefits of the 962 election?

MEGAN FERRIS

Sure. If the circumstances are right for the taxpayer, then the benefits should certainly outweigh any drawbacks for making this election. For example, the subpart F inclusions and the GILTI inclusions, and those are under Section 951a, and Section 951A are subject to tax at the lower corporate tax rate, which is now 21%.  There is a 50% deduction available for the GILTI inclusions. With a Section 962 election, an individual can take a credit for up to 80% of the foreign taxes paid by the CFC to offset the tax paid on the subpart F and the GILTI.  But keep in mind that the individual would still be subject to tax on any Section 78 gross-up based on foreign taxes.  With the Section 962 election, there is no corporate restructuring required that would otherwise take time and money to implement.  There’s no impact on the other shareholders of the CFC, whether there’s domestic shareholders or foreign shareholders.  And finally, there’s no double tax on the future sale of the CFC. Now on the downside, when those previously taxed earnings are distributed, they are taxed again to the extent that the distribution exceeds the tax paid on the initial inclusion.  Now, if the CFC is not in a treaty country, then under Smith v. Commissioner, ordinary tax rates would apply because the dividends are treated as coming from the CFC and not from the deemed U.S. corporation.  And lastly, on the downside, any basis increase in CFC stock as a result of the subpart f or GILTI inclusion is limited to the amount of tax paid on the inclusion.  So, I’ll give an example.  We recently did some tax planning for a client, an individual U.S. tax resident who owned an S corporation that, in turn, owned a Mexican CFC.  The CFC operates hotels throughout Mexico and pays a 30% income tax in Mexico on its net income.  From the U.S. federal tax perspective, that CFC’s operating income is all GILTI income to our client.  And so under his existing structure, the GILTI would flow up to him, and he would be subject to 37% tax on that income without any offset for the Mexican taxes paid.  We recommended making a Section 962 election, which he did.  Now, under his current structure, the client is treated, for U.S. federal income tax purposes, as if the GILTI is earned by a domestic corporation.  U.S. tax is fully offset with the foreign tax credits for the next to get income taxes paid.  And when CFC eventually distributes the income, the client is taxed on their distribution.  However, because the U.S. and Mexico have an income tax treaty in effect, the clients benefit from qualified dividend rates, which total 23.8%.  So in effect, we helped our client reduce his effective U.S. federal income tax rate with respect to GILTI from 37% to 23.8%.

PAUL D’ ALESSANDRO

So there you have it; 962 potentially can result in a lower effective tax rate for an individual, you get the benefit of the lower corporate tax rate, the 50% GILTI deduction, the 80% indirect foreign tax credit.  On the downside, you have to watch out for actual distributions because there’s less PTI than there would have been otherwise.  So a little bit of balancing based on the facts and circumstances to see if 962 is going to make sense in your case. I think we’re going to wrap up now.  Megan, you alluded to it earlier, but, you know, why has Section 962 come back into the spotlight this past year or two, and really when might a person consider making a 962 election?

MEGAN FERRIS

That’s a great question, Paul.  Now, in the decade since Section 962 was passed, it was rarely used planning tool unless the CFC was located at a high tax treaty country, like Mexico or France.  But fast forward to February 1, 2018, when tax reform became effective, now everything has changed because the corporate tax rates dropped from 35% to 21%.  And the effective tax rate on GILTI emerged at 10.5% for U.S. corporations.  Now finally, it’s an attractive option because even when you account for the 23.8% shareholder level dividend tax, the effective tax rate is still lower with a Section 962 election than if the CFC shares were treated as owned directly by the individual.  As far as U.S. tax planning goes, the Section 962 election can be an incredibly useful and cost-saving tool for the taxpayer who fits the profile that I alluded to, and that would be a U.S. shareholder of a CFC that generates GILTI or subpart F income where CFC has foreign taxes paid in this local country where the CFC is located in a treaty jurisdiction.  Now these individual U.S. shareholders can take advantage of the lower corporate tax rate, they can take advantage of the 50% deduction for GILTI income, and they can obtain a foreign tax credit for foreign taxes paid by the CFC, all without any restructuring required.  On the other hand, if the CFC is not organized in a treaty jurisdiction, then the election may not result in a net benefit to the taxpayer.  Now, in this case, it might make more sense to forego the Section 962 election in lieu of interposing an actual UFC corporation which would feature the same mechanical benefits of the Section 962 election, but it would also open the door to taking advantage of the dividends received deduction on distributions from the CFC.  Alternatively, the taxpayer might consider setting up a flow-through structure, and that would also permit the use of foreign tax credits to offset the GILTI inclusions, although the GILTI inclusions would generally be subject to the higher individual tax rate.

PAUL D’ ALESSANDRO

So those are some great points you made, Megan, and I’ll just piggyback off a few of them before we wrap up here. Section 962, I think you’re going to want to look at whether your CFC is in a treaty jurisdiction versus a non-treaty jurisdiction, as Megan said.  The 962 election is more beneficial when you’re in a treaty jurisdiction because you can take advantage of the lower qualified dividend income rates of 23.8%.  Like anything else in tax planning, I think you have to do a little bit of modeling when you’re looking at 962, and by that I mean you have to see if you’re in a situation where your client is going to be looking to pull dividends out of his CFC on a regular to semi-regular basis, or whether the income realization event is really going to be had upon exit when an individual is going to sell shares in a CFC. In that case, 962 is going to provide some benefit there simply by providing deferral in the years where you’re not taking distributions.  And I think a final point worth noting, and Megan touched on this; there’s been a lot of talk about simply having an individual drop their CFC shares into a parent USC corporation to achieve a lot of these results that we’ve been talking about.  That sounds great in theory, but it cannot always be done tax-free in the foreign country where the CFC is located.  Many times, contributing those shares to a U.S. corporation is a taxable event in that foreign country, and it could even result in that foreign country’s own CFC laws now applying to the U.S. parent corporation.  So 962, in that case, could also serve a tremendous benefit by avoiding all those foreign taxes and local taxes that would otherwise be triggered by dropping shares into an actual U.S. parent C corporation.  And with that, I think we’ve concluded our first podcast.  I hope you all enjoyed it and found it useful.  We‘re going to be looking to bring everybody more timely tax topics and hopefully more useful planning tips over the next few months and in the next year.  Megan, is there anything you want to say before we sign off?

MEGAN FERRIS

Thanks, Paul. I think you made some great points just to wrap up there.  And again, yeah, I hope everybody enjoyed this. I hope they can take some of these points and integrate them into their practices, and I hope you continue to tune in and listen to us as we bring you more current tax topics that might apply to your own practice.

PAUL D’ ALESSANDRO

Okay.  Very good. And with that, we’re signing off. Happy holidays and a happy new year to everyone, and we’ll see you next time.

 

© 2020 Bilzin Sumberg Baena Price & Axelrod LLP

More tax guidance on the National Law Review Tax Law page.

IRS Penalties Assessed Against Your Client May Not Be Valid

Internal Revenue Code section 6751(b) provides that no penalty shall be assessed under the Code unless the initial determination of such assessment is personally approved (in writing) by the immediate supervisor of the individual making such determination, or such higher level official as the Secretary of the Treasury may designate.  This section defines penalty as any addition to tax or any additional amount.  The requirement for prior written approval does not apply to penalties for failure to file a return or pay tax, or to penalties that are automatically calculated through electronic means, but does apply to negligence and substantial understatement penalties, as well as the “responsible party” penalty for failure to withhold or remit payroll taxes.

In Graev v. Commissioner, 140 T.C. 377 (2013), the IRS imposed accuracy related penalties on a taxpayer.  The taxpayer argued that the penalties were invalid because no supervisor’s approval was obtained.  The Tax Court ruled in favor of the IRS, stating that the taxpayer’s challenge was premature because the IRS could comply with approval requirement any time before the Tax Court issued a final determination.  The Graev case was appealable to the Second Circuit Court of Appeals.

In Chai v. Commissioner, 851 F. 3d (2nd Cir. 2017), the Second Circuit Court of Appeals held that Code Section 6751(b) requires the IRS to obtain written approval of an initial penalty determination no later than the date that the IRS issues a notice of deficiency or files an answer asserting the penalty.  In light of the Second Circuit decision in Chai, the Tax Court issued a supplemental opinion in Graev v. Commissioner, 149 T.C. 485 (2018)  and reversed its prior holding regarding Code Section 6751(b).  In the supplemental opinion the Tax Court held that under Code Section 6751(b), the IRS must obtain  written supervisory approval of an initial penalty determination no later than the date that the IRS issues a notice of deficiency or files an answer and that the Government bears the burden of showing that it has complied with Code Section 6751(b).

It is likely that the IRS is now aware of this requirement and will seek the required supervisory approval.  However,  taxpayers should challenge any penalty covered by Code Section 6751(b) and require the IRS to provide proof that the required written supervisory approval was timely obtained.

© 2020 Mitchell Silberberg & Knupp LLP

For more on IRS Code guidance, see theNational Law Review Tax Law section.