Broadbrush Taxation: Tax Law for the Nonspecialist · 2019-10-11 · Miller Nash Graham & Dunn LLP, Portland. Mr. Brandon is a member of the firm’s tax practice team. He focuses

Cosponsored by the Taxation Section

Friday, October 16, 2015 8:30 a.m.–4:15 p.m.

6.25 General CLE credits and .5 Ethics credit

Broadbrush Taxation: Tax Law for the Nonspecialist

Broadbrush Taxation: Tax Law for the Nonspecialist ii

BROADBRUSH TAXATION: TAX LAW FOR THE NONSPECIALIST

SECTION PLANNERS

Jeremy Babener, Lane Powell PC, PortlandDan Eller, Schwabe Williamson & Wyatt, Portland

Ryan Nisle, Miller Nash Graham & Dunn LLP, Portland

OREGON STATE BAR TAXATION SECTION EXECUTIVE COMMITTEE

Dan Eller, ChairBarbara J. Smith, Chair-Elect

Jeffrey S. Tarr, Past ChairRyan R. Nisle, Treasurer

Jennifer L. Woodhouse, SecretaryKent AndersonJeremy Babener

Jonathan Joseph CavanaghMatthew J. ErdmanCynthia M. Fraser

Christopher K. HeuerLee D. Kersten

Heather Anne Marie KmetzTricia M. Palmer OlsonScott M. Schiefelbein

Hertsel Shadian

The materials and forms in this manual are published by the Oregon State Bar exclusively for the use of attorneys. Neither the Oregon State Bar nor the contributors make either express or implied warranties in regard to the use of the materials and/or forms. Each attorney must depend on his or her own knowledge of the law and expertise in the use or modification of these materials.

Copyright © 2015

OREGON STATE BAR16037 SW Upper Boones Ferry Road

P.O. Box 231935Tigard, OR 97281-1935

Broadbrush Taxation: Tax Law for the Nonspecialist iii

TABLE OF CONTENTS

Schedule . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . v

Faculty . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . vii

1. 2015 Oregon Tax Update . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1–i — Robert Manicke, Stoel Rives LLP, Portland, Oregon

2. Tax Issues for the Tax Exempt (or “I Didn’t Know That”) . . . . . . . . . . . . . . . . . . . . 2–i— William Manne, Miller Nash Graham & Dunn LLP, Portland, Oregon

3. Tax Considerations for Choice of Business Entity . . . . . . . . . . . . . . . . . . . . . . . . 3–i— Berit Everhart, Arnold Gallagher PC, Eugene, Oregon

4. Out of the Frying Pan, Into the Fire: Tax Issues of Closing Up Shop . . . . . . . . . . . . . 4–i— Gwendolyn Griffith, Tonkon Torp LLP, Portland, Oregon

5. Navigating Through Tax Collection . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5–i— Jessica McConnell, Greene & Markley PC, Portland, Oregon— Donald Grim, Greene & Markley PC, Portland, Oregon

6. Tax Issues at Settlement—Presentation Slides . . . . . . . . . . . . . . . . . . . . . . . . . . 6–i— Jeremy Babener, Lane Powell PC, Portland, Oregon

7. Crossing the Columbia: An Introduction to Navigating State Taxes in the Pacific Northwest . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7–i— David Brandon, Miller Nash Graham & Dunn LLP, Portland, Oregon

8. Common Tax Ethics Traps . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8–i— Dan Eller, Schwabe Williamson & Wyatt, Portland, Oregon

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Broadbrush Taxation: Tax Law for the Nonspecialist v

SCHEDULE

7:30 Registration

8:30 Oregon Tax Update

F Recent legislation and rulemakingF Cases of interestF What’s ahead?Robert Manicke, Stoel Rives LLP, Portland

9:30 Tax Issues for the Tax Exempt (or “I Didn’t Know That”)

F Tax-exempt, nonprofit, and charitable corporations—what’s the difference?F Tax and reporting concernsF Special rulesWilliam Manne, Miller Nash Graham & Dunn LLP, Portland

10:15 Break

10:30 Choice of Business Entity

F General characteristics of different business entitiesF How business entities are organized under state lawF Tax aspects of each entityF Tax considerations when selecting an entityBerit Everhart, Arnold Gallagher PC, Eugene

11:45 Lunch

12:30 Out of the Frying Pan, Into the Fire: Tax Issues of Closing Up Shop

F Why the previous choice of entity (really!) mattersF Why “who the client is” (really!) mattersF Unexpected income and useless deductionsF Trips, traps, and easily overlooked itemsGwendolyn Griffith, Tonkon Torp LLP, Portland

1:30 Navigating Through Tax Collection

F Procedural requirements before collectionF Tax liens, levies, and appealsF Resolution optionsJessica McConnell, Greene & Markley PC, Portland

2:15 Break

2:30 Tax Issues at Settlement

F When to consider tax issues in connection with a claimF How settlement proceeds from personal injury and business claims are taxedF Deducting or capitalizing legal feesF Benefits of a structured settlementJeremy Babener, Lane Powell PC, Portland

Broadbrush Taxation: Tax Law for the Nonspecialist vi

3:15 Crossing the Columbia: An Introduction to Navigating State Taxes in the Pacific NorthwestF Tax residencyF NexusF Income sourcing and apportionmentDavid Brandon, Miller Nash Graham & Dunn LLP, Portland

3:45 Common Tax Ethics TrapsF Client identification in payroll tax mattersF Partnership versus partner representationF Ethical tax advice standardsDan Eller, Schwabe Williamson & Wyatt, Portland

4:15 Adjourn

SCHEDULE (Continued)

Broadbrush Taxation: Tax Law for the Nonspecialist vii

FACULTY

Jeremy Babener, Lane Powell PC, Portland. Mr. Babener serves as General Counsel to two affiliated clients of Lane Powell: Multistream Capital and Yellowbrick, Inc. Together, the two companies manage an investment fund that acquires and markets structured settlement income streams. He also serves as Special Tax Counsel at Lane Powell, working on Lane Powell client matters on an as-needed basis. Prior to his work at Lane Powell, he served as a Tax Policy Fellow in the U.S. Treasury Department’s Office of Tax Policy, focusing on partnership tax issues. He is a member of the Oregon State Bar Taxation Section Executive Committee, chair of the Society of Settlement Planners Legal Committee, and a member of the Portland Tax Forum board. Mr. Babener is a nationally recognized expert on the use of structured settlements and the taxation of damages and regularly speaks and writes on these issues.

David Brandon, Miller Nash Graham & Dunn LLP, Portland. Mr. Brandon is a member of the firm’s tax practice team. He focuses on tax and business law, with emphasis on partnership and corporate tax, state and local tax, and emerging businesses. He is a member of the American Bar Association, the Oregon State Bar Taxation Section Laws Committee and New Tax Lawyers Committee, and the Washington State Bar Association Tax Section and Business Law Section. Mr. Brandon holds an LL.M. in Taxation from the University of Washington School of Law.

Dan Eller, Schwabe Williamson & Wyatt, Portland. Mr. Eller focuses on tax and business law, advising clients on both transactional and controversy matters. He is chair of the Oregon State Bar Taxation Section and has been honored by the Section’s New Tax Lawyer Committee as its Mentor of the Year.

Berit Everhart, Arnold Gallagher PC, Eugene. Ms. Everhart’s practice focuses on business and corporate law, with an emphasis on federal and state taxation. Her practice includes business sales and acquisitions, entity selection and formation, individual and entity taxation, and estate planning for individuals and business owners. Before joining Arnold Gallagher PC, Ms. Everhart was a member of the tax group at an international law firm in New York City, where she devoted a significant portion of her time to tax issues related to private investment funds, bank finance transactions, and corporate acquisitions and divestitures. Ms. Everhart holds an LL.M in taxation from New York University School of Law.

Gwendolyn Griffith, Tonkon Torp LLP, Portland. Ms. Griffith’s tax practice includes advice to individuals, businesses, nonprofit entities, and local governments on federal and state tax issues. She is also the Executive Director of the Oregon Facilities Authority, an Oregon state agency that is housed at Tonkon Torp that helps Oregon nonprofits access low-cost financing for the acquisition of facilities and equipment through the issuance of revenue bonds. She is a member of the American Society of Certified Public Accountants The Tax Advisor Advisory Board and the Portland Tax Forum Board of Directors. Ms. Griffith taught tax law at Willamette University College of Law for many years. She is coauthor of Family Wealth Transition Planning, published by Bloomberg in 2008 and available through Wiley Publications. She is also the author of two leading treatises for law and taxation students published by Aspen Publishers. Ms. Griffith is admitted to practice law in Oregon and California.

Robert Manicke, Stoel Rives LLP, Portland. Mr. Manicke heads the firm’s Benefits, Tax and Private Client group. His practice emphasizes state and local taxation, as well as employment tax issues. He is a member of the American College of Tax Counsel, chair of the Oregon State Bar Tax Section Laws Committee, and a member of the ABA Tax Section State Tax Committee and Employment Tax Committee. Mr. Manicke is a regular speaker and author on taxation, legislation, and employment law topics. He is admitted to practice in Oregon, California, Idaho, and Washington.

Broadbrush Taxation: Tax Law for the Nonspecialist viii

William Manne, Miller Nash Graham & Dunn LLP, Portland. Mr. Manne’s practice focuses on tax, business, and corporate law, with an emphasis on tax-exempt and charitable organizations, health care, emerging businesses, and business owner exit planning. He leads the firm’s charitable and nonprofit organizations, estate and trust, and business owner exit planning practice teams and is an Oregon certified public accountant (inactive). He is a member of the Multnomah Bar Association, American Institute of CPAs, and Oregon Society of CPAs. Mr. Manne is admitted to practice in Oregon and Washington.

Jessica McConnell, Greene & Markley PC, Portland. Ms. McConnell concentrates her practice in federal, state, and local tax controversies, including tax audits, offers in compromise and tax collection matters. She also handles a variety of bankruptcy cases, a majority of which involve tax dischargeability issues. Ms. McConnell is an active member of the Oregon State Bar Debtor-Creditor, Taxation, and Business Law sections. She has authored several articles and often lectures on tax controversy and bankruptcy matters.

FACULTY (Continued)

Chapter 1

2015 Oregon Tax Update1

RobeRt Manicke

Stoel Rives LLPPortland, Oregon

1 © Stoel Rives LLP.

Contents

I. New Income Tax Laws . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1–1A. Reconnection (SB 63 2015) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1–1B. Same-Sex Marriage (HB 2478 2015) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1–1C. Business Taxpayer Changes in 2013 Special Session “Grand Bargain” (HB 3601

2013) and 2014 Cleanup (SB 1534 2014) . . . . . . . . . . . . . . . . . . . . . . . . . . . 1–1D. Tax Havens (SB 61 2015). . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1–3E. No Automatic Nexus Caused by Presence Due to Disaster Relief (HB 2566 2015) . . . . 1–4F. Personal Income Taxpayer Changes in 2013 Special Session “Grand Bargain”

(HB 3601 2013) and 2014 Cleanup (SB 1534 2014) . . . . . . . . . . . . . . . . . . . . . 1–4G. Residence of Active-Duty Military Personnel (HB 2171, §§ 50–54 2015) . . . . . . . . . 1–5H. Tax Credits . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1–5

II. Corporate Minimum Tax: No Credits Allowed (Con-way Repeal) . . . . . . . . . . . . . . . . 1–6

III. Oregon Tax Court: Hardship Exception from Pay-to-Play Rule; Payment of Tax After Special Designation (HB 2334) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1–6

IV. Tax Reform . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1–7

V. Tax Compliance and Collections . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1–7A. Public Contract Bidder’s Attestation of Compliance with State Tax Laws (SB

675 2015) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1–7B. Suspension of Collections from Low-Income Individuals (HB 2089 2015) . . . . . . . 1–7

VI. 2016 Ballot Measures . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1–8A. Personal Income Tax Rate Increases After 2016. . . . . . . . . . . . . . . . . . . . . . . 1–8B. Corporate Minimum Tax Becomes 2.5% Gross Receipts Tax on Oregon Sales of

$25 Million or More After 2016: “A Better Oregon” I, II, V–VII . . . . . . . . . . . . . . 1–8

VII. Recent Income Tax Cases . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1–8A. The Department Must Pay Post-Judgment Interest If It Does Not Pay a Tax

Court Judgment That It Unsuccessfully Appeals to the Oregon Supreme Court . . . . 1–8B. Apportionment Cases . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1–9

VIII. Employment Tax Cases . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1–12A. Penalty for Failure to File Employee Withholding Tax Applies Even If Employee

Timely Paid All Oregon Tax. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1–12B. Worker Classification: Some Control Over an Independent Contractor Is

Permissible . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1–12C. Independent Contractor Status Does Not Require the Independent Contractor

to Actually Hire Others to Assist with the Service . . . . . . . . . . . . . . . . . . . . 1–13

IX. New Property Tax Laws (All from 2015 Legislative Session) . . . . . . . . . . . . . . . . . . 1–13A. Central Assessment Changes: Comcast, Intangibles, Data Centers, Fiber Projects

(SB 611) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1–13

Chapter 1—2015 Oregon Tax Update

Broadbrush Taxation: Tax Law for the Nonspecialist 1–ii

B. New: Withholding of Property Tax upon Conveyance to Public Body (HB 2127) . . 1–14C. New: “Business” Personal Property Tax Lien Disclosure (SB 161) . . . . . . . . . . . 1–14D. Industrial Property Classification and Appeals—to Tax Court, Not BOPTA (HB

2482) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1–15E. Limitation on Partial Appeals of Unit of Property (HB 2483) . . . . . . . . . . . . . . 1–15F. No More Extensions for Personal Property Tax Returns; New Deadline (HB 2484) . 1–16G. Property Tax Refunds (HB 2485) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1–16H. Destroyed or Damaged Property: Longer Filing Deadline (HB 3001) . . . . . . . . . 1–16I. Property Tax Exemptions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1–16

X. Recent Property Tax Cases . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1–17A. Valuation Issues . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1–17B. Repeal of Exemption for Property Owned by Another State Was Not

Unconstitutional . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1–18C. Procedural Issues . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1–19D. Property Taxes Used to Fund Urban Renewal Are Categorized as for Government

Operations Other Than the Public School System . . . . . . . . . . . . . . . . . . . . 1–20

XI. Estate Tax: Natural Resource Credit (SB 864) . . . . . . . . . . . . . . . . . . . . . . . . . . . 1–20

Contents (continued)


Broadbrush Taxation: Tax Law for the Nonspecialist 1–1

I. New Income Tax Laws

A. Reconnection (SB 63 2015) BROADBRUSH!

Oregon’s “rolling reconnect” provisions generally mean that Oregon income tax law automatically incorporates the Internal Revenue Code provisions relating to the definition of “taxable income” to the extent Congress makes changes. However, the legislature (with input from the OSCPA) typically passes a reconnection bill each session to update the numerous other references to the Internal Revenue Code that are not related to the definition of “taxable income.” SB 63 updates references to the Internal Revenue Code and to other provisions in federal tax law from December 31, 2013 to December 31, 2014. Examples include the definition of shareholders in S corporations who may represent their companies in proceedings before the tax court magistrate or the Department of Revenue; the definition of organizations that may qualify for consideration for a charitable tax checkoff; and statutes governing the Oregon College Savings Plan, IDAs, and unemployment insurance.

B. Same-Sex Marriage (HB 2478 2015) BROADBRUSH!

This law changes numerous references to “husband and wife” to “spouses in a marriage” and makes other similar changes to reflect recent federal court decisions legalizing same-sex marriage.

C. Business Taxpayer Changes in 2013 Special Session “Grand Bargain” (HB 3601 2013) and 2014 Cleanup (SB 1534 2014)

The tax portion of the 2013 “grand bargain” (generally, tax changes in exchange for cuts to public employee retirement benefits) contains several provisions:

1. “Small Business Tax Relief”: Reduced Oregon Tax Rate on Nonpassive Flow-Through Income from Partnerships and S Corporations. BROADBRUSH!

For tax years beginning on or after January 1, 2015, personal income taxpayers may elect to have nonpassive income attributable to any partnership or S corporation (after reduction for nonpassive losses) taxed at the following rates:

If income is more than But not more than The tax rate is ---- $250,000 7.0%

$250,000 $500,000 7.2% $500,000 $1,000,000 7.6%

$1,000,000 $2,500,000 8.0% $2,500,000 $5,000,000 9.0% $5,000,000 ---- 9.9%



The term “partnership” includes a limited liability company (LLC) or other entity taxed as a partnership. However, the new reduced rates will not apply to a single-member LLC that is disregarded as an entity separate from its owner. As a result, Schedule K-1 income reported on Schedule E generally will receive more favorable tax treatment than either Form W-2 wage income or income from a sole proprietorship (including from a single-member LLC) reported on Schedule C. “Nonpassive income” is as defined in the Internal Revenue Code and does not include wages, interest, dividends or capital gains. In calculating the amount of income not subject to the special rates, taxpayers must use the subtractions, deductions and additions otherwise allowed. On the other hand, in calculating the amount of income subject to the special rates, depreciation adjustments directly related to the partnership or S corporation are the only additions or subtractions allowed. A taxpayer can elect to use the alternative rates only if: (1) the taxpayer materially participates in the trade or business; (2) the partnership or S corporation employs at least one person who is not an owner, member or limited partner of the partnership or S corporation; and (3) those non-owner employees perform at least 1,200 aggregate hours of work in Oregon by the close of the tax year, taking into account for this purpose only hours worked by an employee in weeks in which the employee works at least 30 hours.

The 2014 cleanup bill defines “material participation” by express reference to IRC § 469 in lieu of the 2013 language, which required that the taxpayer materially participate in the “day-to-day operations” of the business (a phrase not used in IRC § 469).

A nonresident may apply the reduced rates only to “income earned in Oregon” (an undefined term). A part-year resident must calculate the tax due using the reduced rates by first applying those rates to the taxpayer’s qualifying nonpassive income, and then multiplying that amount by the ratio of the taxpayer’s nonpassive income in Oregon divided by nonpassive income from all sources. A nonresident joining in the filing of a composite return is not eligible for the reduced rates.

One of the many (18?) amendments proposed to the 2014 cleanup bill would have used the phrase “income from Oregon sources” rather than the undefined phrase “income earned in Oregon.” However, the amendment would have inserted “income from Oregon sources” into a different portion of the law, arguably conferring the benefit of the rate reductions only to the extent the business operates in Oregon. This amendment failed in the last days of the session.

The bill directs the Legislative Revenue Officer to calculate projected and actual ratios of revenue loss to total state income. To the extent the actual ratios deviate from the projected ratios by specified thresholds, the special tax rates will be adjusted for tax years beginning after 2018 and again after 2022.



2. Change in the Oregon Corporation Excise Tax Brackets. BROADBRUSH!

For tax years beginning on or after January 1, 2013, the Oregon corporation excise tax brackets have been changed so that the 7.6% top marginal rates apply to taxable income in excess of $1 million, rather than taxable income in excess of $10 million. This change also applies to the Oregon corporation income tax, which adopts by reference the Oregon corporation excise tax brackets and rates. (HB 3601 also trimmed the portion of tax above the pre-Measure 67 rate of 6.6% that is deposited into the Rainy Day Fund.)

3. Creation of an Oregon IC-DISC Regime.

Prior to the 2013 special session, Oregon did not conform to the federal tax regime applicable to an IC-DISC. Instead, Oregon law treated an IC-DISC in the same manner as any other corporation and disregarded transactions between a taxpayer and an IC-DISC if the two were related. For tax years beginning on or after January 1, 2013, the new law changes this treatment for IC-DISCs formed on or before January 1, 2014 (the date HB 3601 takes effect). For these IC-DISCs:

• The Oregon minimum tax does not apply. • A 2.5% tax rate applies to commissions received by the IC-DISC, rather than the

marginal tax rates that generally apply to corporations. • A related taxpayer is allowed a deduction for commissions paid to the IC-DISC. • The federal taxable income of a shareholder subject to the Oregon personal income tax is

reduced by the amount of any dividend paid by the IC-DISC.

The 2014 cleanup bill states expressly that the IC-DISC must have been formed on or before January 1, 2014 in order for both the deduction to be available and the 2.5% rate to apply. The original language from the 2013 law arguably allowed the 2.5% rate even if the IC-DISC was formed after January 1, 2014.

Note that the 2014 cleanup bill requires that the 2.5% tax be “imposed on the commission” in order for the deduction to apply. D. Tax Havens (SB 61 2015) BROADBRUSH!

A 2013 law—passed without opposing votes—created a list of countries (generally referred to as tax havens). The 2013 law requires an Oregon corporate taxpayer filing a consolidated return to add to its taxable income the taxable income or loss of a unitary corporation that is formed under the law of a listed (tax haven) jurisdiction. The 2013 law also requires the apportionment factors of the tax haven corporation to be taken into account on the Oregon corporate return.

SB 61 modifies the list of jurisdictions, replacing a reference to the former Netherlands Antilles—which ceased to exist in 2010—with the names of former constituent islands Bonaire, Curaçao, Saba, Sint Eustatius, and Sint Maarten; adding Trinidad and Tobago and Guatemala; and deleting Monaco. After much discussion, the Netherlands and Switzerland, among others, remained off the list.



The new law also deletes the requirement to take the apportionment factors of the tax haven company into account. The law adds a provision stating that nothing precludes a taxpayer or the Department from asserting that a modified apportionment method is necessary to equitably apportion the taxpayer’s income, pursuant to ORS 314.667.

These changes apply to tax years beginning on or after January 1, 2016.

The 2013 law requires the Department to biennially recommend additions or deletions to the list. SB 61 creates criteria for the Department to use in developing its recommendations. SB 61 also adds a requirement that the Legislative Revenue Office report by March 15, 2017 on the cost-effectiveness of the tax haven law and other policies governing the treatment of offshore corporations.

E. No Automatic Nexus Caused by Presence Due to Disaster Relief (HB 2566 2015)

HB 2566 provides that disaster- or emergency-related work conducted by an out-of-state business may not be used as the sole basis for determining that the company is doing business in Oregon and therefore subject to Oregon’s income taxes. Similarly, nonresident employees who do not normally work in Oregon but perform disaster- or emergency-related work in Oregon are not subject to personal income tax or wage withholding on their compensation for that work. The new law requires a business requesting the services of an out-of-state business to report that fact to the Department of Administrative Services within 30 days after the business enters Oregon. Applies to disaster response periods beginning on or after October 5, 2015.

F. Personal Income Taxpayer Changes in 2013 Special Session “Grand Bargain” (HB 3601 2013) and 2014 Cleanup (SB 1534 2014)

1. Elimination of Personal Exemption Credit for Higher-Income Taxpayers. BROADBRUSH!

Oregon generally provides a personal exemption credit equal to an inflation-adjusted amount (for 2013, $183) multiplied by the number of personal exemptions allowed to the taxpayer. Prior to the special session, the credit was reduced if the taxpayer’s income exceeded a threshold amount. For tax years beginning on or after January 1, 2013, the credit has been eliminated for taxpayers whose federal adjusted gross income exceeds $200,000 (for joint return filers, a surviving spouse or a head of household) or $100,000 (for single filers, including married filing separately).

2. Senior Medical Expense Deduction Means-Testing and Increased Age Threshold. BROADBRUSH!

For tax years beginning on or after January 1, 2013, the reduction in Oregon taxable income allowed to seniors for nondeductible medical expenses is phased out for adjusted gross incomes between $100,000 and $200,000 (for joint return filers, a surviving spouse or a head of household) or $50,000 and $100,000 (for single filers, including married filing separately). The minimum age for eligibility will rise incrementally from 62 for 2013 to 66 starting in 2020.



The 2014 cleanup bill corrects errors in the description of the income brackets for purposes of the phase-outs.

G. Residence of Active-Duty Military Personnel (HB 2171, §§ 50-54 2015)

Section 50 of HB 2171 amends the definition of an Oregon resident to exclude active-duty military personnel whose residence is outside Oregon as reflected in the records of the Defense Finance and Accounting Service. Applies to tax years beginning on or after January 1, 2012.

H. Tax Credits

1. Earned Income Credit (HB 3601 2013) BROADBRUSH!

As part of the “grand bargain,” HB 3601 (2013) increased the amount of the Oregon earned income tax credit from 6% of the federal credit to 8% of the federal credit, effective for tax years starting on or after January 1, 2014.

2. Credits Changed or Extended by “Omnibus” Bill (HB 2701 2015)

a. Long-Term Care Insurance Credit Repealed (§§ 39-40) BROADBRUSH!

This credit is repealed for tax years beginning on or after January 1, 2015.

b. Working Family Child and Dependent Care Credit “Merged” (§§ 2-5) BROADBRUSH!

The legislature did not modify the dependent care credit allowed by ORS 316.204, or the working family credit allowed by ORS 316.262, and thus allowed these credits to sunset after December 31, 2015 and January 1, 2016, respectively. In their place, however, the legislature adopted a new provision to be codified in chapter 315, referred to in the legislative history as the “working family child and dependent care” credit. The new credit ranges up to $12,000 for one individual or $24,000 for two or more individuals and is an income-based credit for employment-related dependent care expenditures. Press reports describe the new credit as a “merger” that kept the substance of both prior credits alive. Applies to tax years beginning on or after January 1, 2016 and before January 1, 2022.

c. Individual Development Accounts (“IDAs”) (§§ 6-11)

The legislature removed the $75,000 annual cap on credit for contributions to a fiduciary organization for distribution to an IDA and replaced the cap with a flat 70 percent credit for all such contributions. The allowable purposes for establishing an IDA are expanded to include, for example, rental of a primary residence, purchase of a vehicle, payment of certain medical expenses, and certain rollovers to the Oregon College Savings Fund. The sunset is extended to allow the credit to be claimed for contributions made on or before December 31, 2021. A $7.5 million ceiling applies to the total amount of credit allowed to all taxpayers in any one year.



d. Means-Testing for Credits for Child with a Disability (§§ 14-17) BROADBRUSH!

Sections 14-17 modify the credits allowed pursuant to ORS 316.099 and 316.758 by means-testing both credits (no credit if adjusted gross income exceeds $100,000) and limiting the additional personal exemption credit to the amount of the taxpayer’s personal exemption credit for the year. As modified, the credits are extended to tax years beginning on or after January 1, 2022.

e. Rural Medical Care Provider Credit Reduced (§§ 18-19)

Sections 18-19 modify ORS 315.613, reducing the maximum amount of the credit for providers near major population centers and extending the credit to tax years beginning before January 1, 2018.

f. Contributions to Office of Child Care Capped (§§ 20-25)

Sections 20-25 cap the credit pursuant to ORS 315.213 at the lesser of 50 percent of the amount contributed or the taxpayer’s tax liability for the year, eliminate the roles of tax credit marketers, eliminate nonprofit community agencies as potential donees, and extend the credit to tax years beginning before January 1, 2022.

g. Residential Energy Tax Credit (§§ 26-37)

Sections 26-40 amend the statutes governing the residential energy tax credit, including ORS 316.116, modifying the cap and increasing the incentive for certain solar thermal projects. The sunset date (generally tax years beginning before January 1, 2018) is unchanged. II. Corporate Minimum Tax: No Credits Allowed (Con-way repeal) BROADBRUSH!

The 2009 legislature substantially increased the annual minimum tax imposed on C corporations, from a flat $10 to a tiered tax based on annual gross receipts attributable to Oregon. In 2013, the Oregon Supreme Court decided that the legislature intended corporations to be able to apply state tax credits against the minimum tax. See Con-way Inc. & Affiliates v. Department of Revenue, 353 Or 616 (2013). HB 2171, §§ 43-45, amends ORS 317.090 to prohibit the reduction of the annual minimum tax by any tax credit. The amendment applies for tax years beginning on or after January 1, 2015 through 2020.

The new law does not create any exception for tax credits that the taxpayer first became entitled to use before 2015 and that are being claimed over more than one year or carried forward.

III. Oregon Tax Court: Hardship Exception from Pay-to-Play Rule; Payment of Tax After Special Designation (HB 2334) BROADBRUSH!

Existing law (ORS 305.419(3)) allows a taxpayer to seek hardship relief from the requirement to pay all assessed tax, interest, and penalty in order to pursue an appeal in the Oregon Tax Court Regular Division. Pre-amendment law required a taxpayer seeking relief to file an affidavit



“with the complaint.” Taxpayer Leslie Scott filed his affidavit after the complaint, and the Regular Division dismissed his appeal. Scott v. Department of Revenue, 21 OTR 313 (2013). HB 2334, sponsored by the Oregon State Bar and developed in consultation with Judge Breithaupt, allows the taxpayer to file an affidavit alleging undue hardship within 30 days after receiving notice of a lack of this affidavit from the court.

The law also allows payment of taxes, penalties, and interest found to be deficient to be made within 30 days after an order to specially designate a complaint to the Regular Division of the Tax Court from the Magistrate Division. If a dispute exists about whether a tax is imposed on or measured by net income (recent examples include the wage withholding tax and the corporate minimum tax), the tax, penalties, and interest must be paid within 30 days after a decision or order finding that the matter involves a deficiency of taxes imposed on or measured by net income.

Applies to complaints filed on or after October 5, 2015.

IV. Tax Reform BROADBRUSH!

HB 2171 (2015) requires the Legislative Revenue Officer to coordinate with the Department of Revenue to analyze options for restructuring Oregon’s state and local revenue system, including income, property, and consumption taxation, as well as commercial activity and value-added taxation. The agencies are to analyze the effects of the options on the state’s economy, state and local revenues, distribution of the state and local tax burden, and stability of the system. A progress report must be presented to the interim revenue committees by December 1, 2015.

V. Tax Compliance and Collections

A. Public Contract Bidder’s Attestation of Compliance with State Tax Laws (SB 675 2015)

Existing law requires contractors bidding on certain public contracts to represent that they have complied with Oregon state and local income and payroll tax laws. SB 675 modifies existing law, among other things, by replacing the requirement of a notarized affidavit with the requirement of an attestation acceptable to the contracting agency. Operative September 21, 2015.

B. Suspension of Collections from Low-Income Individuals (HB 2089 2015) BROADBRUSH!

Prior law, ORS 305.155, allowed the Department to cancel certain unpaid tax amounts that the Department determined to be uncollectible. HB 2089 retains that grant of authority but adds a requirement that the Department offer to suspend collection against an individual if the individual’s income is no more than 200 percent of federal poverty guidelines and the individual has less than $5,000 in assets, and the sole source of the individual’s income is exempt from garnishment. During suspension, interest continues to apply, and the Department may file a lien against the individual’s property. The individual may make voluntary payments without jeopardizing the suspension. The Department may resume collection if the individual incurs



additional unpaid tax, or if the Department determines that the individual’s income has risen or the individual otherwise ceases to satisfy the eligibility requirements. Applies to debt outstanding as of January 1, 2016.

VI. 2016 Ballot Measures BROADBRUSH!

A. Personal Income Tax Rate Increases after 2016

“A Better Oregon” III:

10.8% on >$125,000 to ≤$250,000

11% on > $250,000

“A Better Oregon” IV:

11.5% on >$125,000 to ≤$250,000

13.5% on > $250,000

15.5% on > $500,000

B. Corporate Minimum Tax Becomes 2.5% Gross Receipts Tax on Oregon sales of $25 million or more after 2016: “A Better Oregon” I, II, V-VII (variations in how revenue is dedicated, whether a state follow-up audit is required)

VII. Recent Income Tax Cases

A. The Department Must Pay Post-Judgment Interest If It Does Not Pay a Tax Court Judgment that it Unsuccessfully Appeals to the Oregon Supreme Court. BROADBRUSH!

The Regular Division of the Tax Court has held that the Department must pay enhanced interest that applies when a taxpayer or the Department fails to pay a judgment amount within 60 days of the judgment. The Department asserted that its appeal of the judgment at issue to the Oregon Supreme Court reset the 60-day period. In rejecting this argument, the court relied on the language of the judgment, which unambiguously required that the second tier of interest would apply. The court did not resolve the statutory interpretation disagreement between the parties. The court also held that the payment previously made by the Department, which was calculated using only the regular interest rate, was first applied to interest and then to principal. Accordingly, regular and post-judgment interest continued to apply to the shortfall. Tektronix, Inc. v. Dep’t of Rev., TC-RD 4951 (control); 5216 (Or Tax Reg Div Dec. 23, 2014).



B. Apportionment Cases BROADBRUSH!

1. The Sales Factor Excludes Gain from the Sale of Goodwill.

In 2012 the Regular Division of the Oregon Tax Court held that an Oregon corporation properly excluded gain from the sale of goodwill from the numerator and denominator of its Oregon sales factor because the applicable income-producing activities creating the goodwill could not be readily identified. The Oregon Supreme Court affirmed the resulting judgment, but on the more narrow ground that the sale of goodwill was not the taxpayer’s primary trade or business (the position asserted by the Department of Revenue). That is, the proceeds were not includible in the sales factor in the first place, so that a throw-out rule that applies when the income-producing activities cannot be readily identified had no relevance. Having decided the matter on the substantive sales factor issue, the Oregon Supreme Court did not address the Oregon Tax Court’s decision that the period of limitations had expired. Tektronix, Inc. v. Dep’t of Rev., 354 Or 531, 316 P3d 276 (2013).

2. The Sale of Electricity Is the Sale of Tangible Personal Property for Apportionment Purposes.

Under Oregon’s single-factor apportionment formula, business income is apportioned to Oregon based on the ratio of the taxpayer’s Oregon sales to the taxpayer’s total sales. Different rules apply in determining whether a sale is an Oregon sale, depending on whether the receipts arise from the sale of tangible personal property or from sales other than tangible personal property. In 2012, the Regular Division of the Oregon Tax Court held that, for apportionment purposes, the sale of electricity is a sale other than a sale of tangible personal property. The Oregon Supreme Court has reversed, holding that electricity is tangible personal property for apportionment purposes. The court remanded the case to the Regular Division to determine whether the electricity was delivered or shipped to a purchaser in Oregon. The court also affirmed the Regular Division’s decision about natural gas at issue in the case – that the delivery of natural gas to a pipeline connection point in Oregon for transfer to a different pipeline for delivery outside of Oregon was not an Oregon sale. The court agreed that the connection point was a location at which tangible personal property was transferred from one common carrier to another on its way to the ultimate point of delivery. In fact, the court suggested that a similar analysis could apply to the electricity on remand. Powerex Corp. v. Dep’t of Rev., No. S060859, 2015 WL 1371031 (Or Mar. 26, 2015).

3. The Three Elements of Unity Are Required for Years Before 2007.

For tax years starting on or after January 1, 1986 and ending before January 1, 2007, Oregon law provided that affiliates were engaged in a single trade or business if three elements were presents: (1) centralized management, (2) centralized administrative services or functions, and (3) functional integration. The Regular Division of the Oregon Tax Court has ruled that “and” as used in the statute is conjunctive, so that the presence of all three elements are needed. Dep’t of Rev. v. Rent-A-Center, Inc., TC-RD 5524 (Or Tax Reg Div Jan. 26, 2015). Effective for tax years beginning on or after January 1, 2007, the Oregon legislature amended the law to replace “and” with “or.” Accordingly, the holding in Rent-A-Center may have no impact on 2007 and later years.



4. Business Income from Cable Television Is Apportioned Using the Special Rules for an Interstate Broadcaster.

The Magistrate Division of the Oregon Tax Court has ruled that cable television involves interstate broadcasting so that the sales factor for cable operations is determined using the interstate broadcaster formula (based on audience), rather than Oregon’s UDITPA formula (based on income producing activity). The primary issue in dispute was whether cable television involved the transmission of a “one-way electronic signal,” which is part of the ORS 314.680(1) definition of “broadcasting.” The Department asserted that the term should be broadly construed, with any transmission from one person (e.g., a cable company) to another (e.g., the customer) being a one-way electronic signal, regardless of whether there is a transmission back to the cable company. The taxpayer, on the other hand, asserted that the ability of customers to communicate back to the cable company (e.g., the widespread use of on-demand services) meant that cable television involves a two-way electronic signal. The court rejected both assertions and instead focused on the word “signal.” The court held that the ORS 314.680(1) definition concerned whether the electronic signal (i.e., the sound, image, or other intelligible communication) moved in only one direction or involved movement back and forth. The court ruled that television is inherently one-way. The fact that a customer may communicate with the cable company about the one-way electronic signal the customer wishes to receive does not change this, just as a call to a radio station to request a song does not make radio a two-way signal. Comcast Corp. v. Dep’t of Rev., TC-MD 140214C (Or Tax Mag Div Dec. 10, 2014).

5. Cost of Performance Decision.

In 2011 the Regular Division of the Oregon Tax Court that held that (1) income producing activities for telephone services are analyzed with respect to each call, rather than treating all calls as a single income producing activity, and (2) for purposes of determining the numerator of the Oregon sales factor, the relevant costs of performance are limited to the direct costs only incurred because of the revenue producing activity (an “incremental cost” test). The Oregon Supreme Court has affirmed the Tax Court’s judgment. In reaching this decision, the Oregon Supreme Court agreed with the Oregon Tax Court that each telephone call was a separate income producing activity. The Oregon Supreme Court went on to rule that, having not identified the correct income producing activity, the taxpayer failed to satisfy its burden of proof. That is, the cost of the performance study provided by the taxpayer identified the costs of performance based on the taxpayer’s network-level assertion about the income producing activity. The study did not identify the costs of performance where each call was an income producing activity. AT&T Corp. v. Dep’t of Rev., 357 Or 691, __P3d __ (2015). The Oregon Supreme Court’s decision leaves unresolved the question of whether the Oregon Tax Court’s “incremental cost” test for costs of performance is correct.

6. Multistate Tax Compact Case: Taxpayers Cannot Elect to Use Equally Weighted, Three-Factor Apportionment.

In 2013 the legislature withdrew Oregon from the Multistate Tax Compact and reenacted the Compact without the election to use equal-weighted, three-factor apportionment based on property, payroll, and sales. A multistate business taxpayer filed suit in the Oregon Tax Court concerning whether the taxpayer, for years before the 2013 legislative change, could use the



Compact election or whether ORS 314.606--which generally provides that when an Oregon statute conflicts with the Multistate Tax Compact the Oregon statute prevails--prevented use of the election. The Regular Division of the Oregon Tax Court has ruled that ORS 314.606 prevails and that the election is not available. Health Net, Inc. and Subsidiaries v. Dep’t of Rev., TC-RD 5127, 2015 Or Tax LEXIS 117 (Or Tax Reg Div Sept. 9, 2015).

7. Gain from the Sale of Stock Used as Collateral for a Note Is Business Income.

Oregon generally follows UDITPA and divides income between (1) apportionable “business income” and allocable “nonbusiness income.” Income is business income if it satisfies either the “transactional test” (generally, income arising from the regular transactions engaged in by the taxpayer) or the “functional test” (generally, income arising from an asset that serves an operational purpose for the taxpayer’s trade or business). The Regular Division of the Oregon Tax Court has held that gain from the sale of stock representing a minority interest in another corporation is business income pursuant to the transactional test if the taxpayer collateralizes the stock or uses the stock to secure a loan in which the proceeds from the collateralization transaction or loan are used in the taxpayer’s general business operations. Fisher Broadcasting Company & Subsidiaries v. Dep’t of Rev., TC-RD 5167, 2015 WL 1933194 (Or Tax Reg Div Apr. 29, 2015).

8. Oregon Tax Benefits for REITs Under Prior Law Are Respected.

For tax years beginning before January 1, 2010, Oregon law conformed to the federal provision that prevented a real estate investment trust (“REIT”) from joining in a consolidated return. Thus, for example, Oregon loans and interest earned on Oregon loans were not includable in the apportionment factor reported on an Oregon return filed by an owner of the REIT. In 2009, the Oregon legislature changed this so that a REIT includable as a member of a federal affiliated group without regard to the REIT carve-out in section 1504(b)(6) of the Internal Revenue Code must be included in a consolidated Oregon corporation excise tax return. In addition, for tax years beginning before January 1, 2006, Oregon tax law, unlike federal tax law, did not contain a provision preventing a corporate REIT shareholder from claiming a dividends received deduction for REIT dividends. In 2005, the Oregon legislature created this limitation. The Magistrate Division of the Oregon Tax Court has ruled that the Oregon tax benefits resulting from the apportionment factor issue and the dividends received deduction are allowed for the years before the applicable laws were changed. In reaching this decision, the Magistrate Division held that (1) a REIT election, like an S election or check-the-box election, does not require a business purpose, (2) the REIT was the owner of the loans for tax purposes, and (3) dividends paid by a REIT are dividends for tax purposes. M & T Bank Corp. and Subsidiaries v. Department of Revenue, TC-MD 120816N, 2015 WL 4572500 (Or Tax Mag Div July 29, 2015) (the court’s substantive analysis of the issues can be found in an interim order issued on July 11, 2014 that is available from the court by request).



9. Location from Which an Independent Contractor Provides Services for a Taxpayer Does Not Determine the Location of the Income Producing Activities.

For apportionment purposes, sales of property other than tangible personal property are sourced to the state in which the applicable income producing activities occur or, if the income producing activities occur in more than one state, to the state in which the plurality of the activities occur. For tax years beginning on or after January 1, 2008, income producing activities include activities undertaken by an independent contractor on the taxpayer’s behalf. Thus, activities undertaken by an independent contractor outside Oregon on behalf of a taxpayer could cause the receipts from the sale to be sourced outside Oregon. However, the Magistrate Division of the Oregon Tax Court has held that if the independent contractor performs services for the taxpayer, rather than on behalf of the taxpayer, the location at which the services are performed has no impact on apportionment. Instead, the location of the taxpayer’s oversight activities determines how to apportion the income. Accordingly, the location of the income producing activity related to independent payment acquirers performing services outside of Oregon for an Oregon taxpayer that oversees the process from Oregon is Oregon. Vesta Corporation v. Department of Revenue, TC-MD 130546D, 2015 WL 3826349 (Or Tax Mag Div June 19, 2015).

VIII. Employment Tax Cases

A. Penalty for Failure to File Employee Withholding Tax Applies Even if Employee Timely Paid All Oregon Tax. BROADBRUSH!

When paying wages to Oregon employees an employer must withhold Oregon income tax and file a quarterly tax report with the Department of Revenue. Although an employer that fails to withhold Oregon income tax can be liable for the tax owed by the employee, the employer is relieved of liability if it can demonstrate that the employee paid the tax. The Magistrate Division of the Oregon Tax Court has held that even if an employer demonstrates that the employee paid the tax, the penalties for failing to withhold tax and file a quarterly return still apply. Softtech, LLC v. Dep’t of Rev., TC-MD 130082C, 2014 Ore Tax LEXIS 29 (Or Tax Mag Div Feb. 24, 2014).

B. Worker Classification: Some Control over an Independent Contractor Is Permissible. BROADBRUSH!

In a pair of related cases, the Oregon Court of Appeals reversed and remanded decisions of an administrative law judge that service providers were employees. In each case, the court found that the administrative law judge misconstrued the statutory requirement that, to be an independent contractor, a service provider must be free from the direction and control of the service recipient. The court noted that the statute does not require that the service provider be free from all direction and control, so that a service provider may retain independent contractor status despite some control by the principal (e.g., right to control the work location). Further, the court distinguished between control over (1) the manner of means by which a job is done, which can result in the service provider being an employee, and (2) the desired result, which is more indicative of an independent contractor relationship. See Portland Columbia Symphony v. Employment Dep’t, 258 Or App 411 (2013) (musicians were not employees despite symphony’s



control over rehearsal schedule, musical arrangement, and type of instrument musicians play); In Transit, Inc. v. Employment Dep’t, 258 Or App 461 (2013) (businesses used by taxpayer to find customers for its freight brokerage services were not employees).

C. Independent Contractor Status Does Not Require the Independent Contractor to Actually Hire Others to Assist with the Service. BROADBRUSH!

A factor in determining whether a service provider is an employee or an independent contractor is that the service provider “is customarily engaged in an independently established business.” ORS 670.600(2)(b). For this purpose, under Oregon’s unique statutory test, the service provider must satisfy three of the five factors listed in ORS 670.600(3), one of which is that the service provider “has the authority to hire other persons to provide or to assist in providing the services and has the authority to fire those persons.” ORS 670.600(3)(e). The Oregon Court of Appeals held that the right to hire/fire prong is satisfied based on the independent contractor’s authority to hire/fire another person, even though the customary practice is not to hire or fire another person. See Portland Columbia Symphony v. Employment Dep’t, 258 Or App 411 (2013).

IX. New Property Tax Laws (all from 2015 Legislative Session)

A. Central Assessment Changes: Comcast, Intangibles, Data Centers, Fiber Projects (SB 611) BROADBRUSH!

The property of a taxpayer that provides data transmission services is subject to central assessment. In 2011 the Regular Division of the Oregon Tax Court held that the defined term “data transmission services” requires the transmission of another person’s content, not that of the taxpayer’s. Accordingly, the Oregon Tax Court held that property used to provide cable television was not subject to central assessment, but property used to provide internet service was subject to central assessment.

In 2014, the Oregon Supreme Court rejected the Oregon Tax Court’s definition, and instead defines data transmission services as “the service of transmitting coded electronic information between computer and computer-like devices.” Pursuant to this definition, property used to provide cable television services and property used to provide internet service is each subject to central assessment. Comcast Corp. v. Dept. of Rev., 356 Or 282 (2014).

The 2015 legislature adopted SB 611, which addresses various issues stemming from the fact that “centrally assessed” businesses (historically, regulated utilities, but also unregulated companies in businesses such as “communication” and “electricity”) are subject to property tax on their intangible property, which can include their entire brand value as allocated to Oregon by a formula. The new law reflects multi-year negotiations among historically centrally assessed businesses and newer entrants such as Facebook, Google, and Apple that were concerned about becoming centrally assessed pursuant to the definition of “communication” in ORS 308.505(3). See Comcast v. Department of Revenue, 356 Or 252 (2014), rev’g, 20 OTR 319 (2011). Among other issues, the construction of high-cost data centers could cause large amounts of overall company value to be assigned to Oregon, based on the existing formula, which is based primarily (75 percent) on the value of real property and tangible personal property.



The new law includes a generally applicable cap on the value of intangible property assessable by Oregon: 130 percent of a company’s historical or original cost of real property and tangible personal property. If this exemption applies, other exemptions do not.

The new law also allows specific full or partial exemptions from property tax for communication franchises, certain communication satellites, and certain residential high-speed communication services (see also HB 2485).

Finally, the law expands a 2012 provision that prohibited central assessment of a company whose Oregon property was limited to certain data center operations. The new law increases and expands the scope of non-data center property that may be held without causing central assessment and lists certain kinds of property that specifically must be locally assessed.

The new provisions generally apply to tax years beginning July 1, 2016. B. New: Withholding of Property Tax upon Conveyance to Public Body (HB

2127) BROADBRUSH!

Case law in Oregon generally precludes collection of delinquent property tax from a government body. E.g., Chizek v. Port of Newport, 252 Or 570 (1969). HB 2127 addresses an aspect of this issue by requiring a person seeking to record an instrument of conveyance to first pay all “charges against the real property,” including tax and interest, if the transferee is exempt from tax as a federal or state government body. An “authorized agent” providing closing and settlement services is allowed to withhold and pay the tax (actual or estimated) from the proceeds. Applies to conveyances that become final, and to instruments presented for recording, on or after October 5, 2015.

C. New: “Business” Personal Property Tax Lien Disclosure (SB 161) BROADBRUSH!

Existing law creates a lien for property tax attributable to personal property and also makes the tax a debt of the owner. See ORS 311.405, 311.455. SB 161 requires the seller of personal property to provide the purchaser with a “disclosure notice” that includes (1) whether property taxes that were assessed against the property are outstanding; (2) whether there are any liens against the property; (3) if known, whether any counties other than the county where the property is located at the time of the transfer have assessed tax against the property; (4) if known, the name and address of any other person who has owned or possessed the property; and (5) that the bona fide purchaser provisions of the new law apply to the transaction.

SB 161 provides that a bona fide purchaser is not liable for assessed taxes if purchased in good faith, for value, at arms-length, and without notice of delinquent taxes. The criteria for meeting the “without notice” standard include checking a new state registry of delinquent tax liens that SB 161 establishes as part of the Uniform Commercial Code filing system.

SB 161 allows a county tax collector to accept a compromise payment on property from a bona fide purchaser, in an amount to be determined based on the facts and circumstances. The amount not forgiven remains a personal debt of the prior owner and a lien against the prior owner’s other



property of the same class. If the total outstanding amount of the tax is paid after receipt of the compromise payment, the compromise payment will be refunded, without interest.

Despite the defined term “business personal property” used throughout the law, the law applies to “tangible personal property” and to certain machinery and equipment treated as personal property. There is no requirement that the property be used in a trade or business.

The new law becomes operative January 1, 2016.

D. Industrial Property Classification and Appeals—to Tax Court, Not BOPTA (HB 2482) BROADBRUSH!

HB 2482 makes nomenclature and procedural changes to the statutes governing appraisal of industrial property, responsibility for which is divided between county assessors and the Department of Revenue. The nomenclature changes eliminate the terms “principal” and “secondary” industrial property, which were based solely on the value of the property. The new term “state-appraised” industrial property refers to any industrial property with improvements having a real market value of more than $1 million on the prior year’s roll, unless the state has delegated appraisal responsibility to the county, in which case the property is “county-appraised” industrial property.

All appeals of the assessed value of state-appraised industrial property must be brought in the Oregon Tax Court. See HB 2482, § 2 (amending ORS 305.403). All appeals of the assessed value of county-appraised industrial property must be brought in the county board of property tax appeals. ORS 309.100(1); HB 2482, § 13 (amending ORS 311.208, relating to omitted property). The deadline in either case remains December 31. These changes apply to the property tax year beginning July 1, 2015, i.e., to appeals that must be filed on or before December 31, 2015.

The new law allows a county to request permission to appraise any industrial property, regardless of value, but requires the county to pay the entire cost of such an appraisal and to continue to appraise the property for five consecutive years. The cost of all state appraisals is required to be reimbursed from the County Assessment Function Funding Assistance Account.

HB 2482 was a Department-sponsored bill, and it passed without amendment.

E. Limitation on Partial Appeals of Unit of Property (HB 2483) BROADBRUSH!

Existing ORS 305.287 allows another party to a valuation dispute to expand the scope of the appeal to include components of property not raised in the appeal. Typically, this rule affects taxpayers who appeal a single component, such as the improvements only, by allowing the county to put the value of the land at issue as well. HB 2483 extends this rule to allow the non-appealing party to put property in other tax accounts at issue, if the property in all accounts make up a single unit of property as defined in ORS 310.160(1) (all contiguous property under common ownership within a single code area in a county, if used and appraised for a single, integrated purpose). Effective October 5, 2015. HB 2483 was a Department-sponsored bill, passed with one minor amendment.



F. No More Extensions for Personal Property Tax Returns; New Deadline (HB 2484) BROADBRUSH!

HB 2484 extends the deadline for filing a personal property tax return from March 1 to March 15. The new law also eliminates the extension that previously was allowed until April 15. The Department sponsored the bill and testified that the practice of granting extensions did not improve the quality of filed returns, and variations in standards among counties and between counties and the Department led to taxpayer confusion. Applies to property tax years beginning on or after July 1, 2016.

G. Property Tax Refunds (HB 2485)

HB 2485 amends ORS 311.806, specifying that a refund made for a roll correction generally will be issued to the owner of record at the time of the refund, while a roll correction refund resulting from an appeal will be made to the person in whose name the appeal was filed. Effective October 5, 2015.

H. Destroyed or Damaged Property: Longer Filing Deadline (HB 3001)

Allows a taxpayer to file an application for determination of the value of property destroyed or damaged between January 1 and July 1 to be filed on or before December 31, instead of within 60 days after the event, upon payment of a late fee. This allows time for the county to generate the tax bill for the year, providing more information to the taxpayer about whether an application is needed. Applies to property tax years beginning on or after July 1, 2014. BROADBRUSH!

I. Property Tax Exemptions

1. “Gain Share” Amendment to Strategic Investment Program Property Tax Exemption (SB 129) BROADBRUSH!

SB 129 modifies the portion of income tax revenue attributable to new or retained jobs associated with Strategic Investment Program projects that is distributed to counties where the projects are located. The new law caps a county’s annual share at $16 million and requires a county receiving funds to distribute portions to other local taxing districts. The “Gain Share” program is extended from 2019 to 2029. Effective July 21, 2015.

2. History or Science Museums (HB 2171, §§ 46-49) BROADBRUSH!

Sections 46-49 of HB 2171 temporarily provide exemption specifically for certain history or science museums, including food service facilities, museum shops if 90 percent of the inventory is museum-related, and certain parking, theater, vacant, display, storage, meeting, and educational space. Space used for commercial enterprises, hotels, chapels, and water parks is not covered by the exemption. Applies to property tax years July 1, 2015 through June 30, 2019.



3. Land Held for Development as Low-Income Housing (HB 2690)

HB 2690 provides a new exemption from property tax for land acquired and held by a nonprofit corporation for the purpose of building on the land residences to be sold to individuals with income not greater than 80 percent of area median income as adjusted for family size. As discussed in committee hearings, the purpose of the exemption is to prevent taxation of the land during the pre-construction development period, which can be lengthy. The new law requires the nonprofit corporation, within 10 years immediately preceding filing of claim for exemption, to have sold at least one residence to individuals with income not greater than 80 percent of area median income as adjusted for family size. The exemption ends at time of title transfer. Absent a title transfer, the exemption ends after seven consecutive years, subject to an option for a three-year extension. Applies to property tax years beginning on or after July 1, 2015.

X. Recent Property Tax Cases

A. Valuation Issues. BROADBRUSH!

1. No Longer Used Portions of a Manufacturing Campus Add No Value to the Campus.

The Regular Division of the Oregon Tax Court has ruled that in determining the real market value of a campus of buildings used by a manufacturer, unused buildings and spaces can be treated as adding no value. In reaching this determination, the court agreed with the property owner that the costs of maintaining the excess space and converting it to leasable property would exceed the potential rent that could be earned. Accordingly, this excess portion added no value to the parts of the campus used by the property owner for manufacturing. Hewlett-Packard Co. v. Benton Cnty. Assessor, 21 OTR 186 (2013), aff’d 357 Or 598 (2015).

2. Purchase Price with Bank May Reflect the Real Market Value of Property.

In previous updates we discussed a trend in property tax cases in which the Oregon Tax Court would not use the purchase price from a recent acquisition from a bank as the real market value of the property for property tax purposes. The court generally held that the bank was acting under a compulsion to sell, so that the purchase price did reflect an arm’s-length price. In a break with this trend, the Magistrate Division used the purchase price negotiated with a bank as the real market value of the property. Glorietta Bay, LLC. v. Lincoln County Assessor, TC-MD 140072C (Or Tax Mag Div Jan. 16, 2014). Importantly, the bank did not immediately sell the property upon foreclosure. Instead, the bank acquired the property at auction and then managed the property for almost two years. When this did not work, the bank sold the property. Further, the property owner submitted a detailed appraisal, including comparable sales, generally necessary for a property valuation dispute.



3. County and Taxpayer Appraisers Must Make Property Adjustments When Determining the Real Market Value of Property.

The Regular Division of the Oregon Tax Court held that a taxpayer’s appraisal for real property was more accurate. As part of the decision, the Regular Division found that there was no basis for the county appraiser’s decision to increase the value of the subject property, a grocery distribution center, for inclement weather costs. In addition, the court found that the calculation of replacement cost must take into account general changes in the industry that render some of the current space as excess or unneeded space. WinCo Foods, LLC v. Marion County Assessor and Department of Revenue, TC-RD 5222, 2015 Or Tax LEXIS 108 (Or Tax Reg Div Aug. 12, 2015).

B. Repeal of Exemption for Property Owned by Another State Was Not Unconstitutional. BROADBRUSH!

In 2004, the Regular Division of the Oregon Tax Court held that property owned or used by non-Oregon municipalities and public utility districts did not qualify for the ORS 307.090 property tax exemption because that exemption was limited to Oregon public or municipal corporations. See Public Utility District No. 1 of Snohomish Cnty. v. Dep’t of Rev., 17 OTR 290 (2004). In 2005, the Oregon legislature amended ORS 317.090 to exempt non-Oregon municipal corporations. In 2009, however, the legislature repealed the 2005 expansion. The Regular Division has held that the 2009 law does not discriminate against out-of-state persons in a manner that violates the United States Constitution. The court relied on an exception to the doctrine generally disallowing more favorable treatment of in-state interests for traditional government functions performed by the state, or a political subdivision of the state. The court determined that, because the provision of electricity to citizens is a traditional government function, the exception applied.

In a 2011 decision related to the case, the Regular Division also held that the bill repealing the exemption did not violate the Origination Clause of the Oregon Constitution (which requires that bills raising revenue originate in the House). For purposes of analysis, the Regular Division assumed that the repeal of the exemption raised revenue. Although the bill originated in the Senate, the version passed by the Senate and sent to the House was “gutted and stuffed” with the repeal provisions, passed by the House, and returned to the Senate. The Regular Division held that this satisfied the Origination Clause.

On appeal, the Oregon Supreme Court affirmed the Tax Court but did not reach the issue of where the bill originated. Instead, the court ruled that because the elimination of an exemption does not possess the essential features of a bill levying a tax, the law did not raise revenue and thus could not be subject to the Origination Clause. See City of Seattle v. Dep’t of Rev., 21 OTR 269 (Or Tax Reg Div 2013), aff’d 357 Or 718 (2015).



C. Procedural Issues. BROADBRUSH!

1. Notice of Valuation Change Invalidated for Failing to Satisfy Procedural Requirements.

Generally, an assessor can correct an error or omission in a tax roll for the five prior years. In order to correct an error or omission, the assessor must provide the officer in charge of the roll with a written direction stating “the type of error and the statutory authority for the correction.” ORS 311.205(2)(a). The Magistrate Division of the Oregon Tax Court invalidated a Notice of Valuation Change for failing to satisfy either of these requirements. The court ruled that a written direction listing “Error of Any Kind” lacked the specificity required by the statute. In addition, although the assessor acknowledged that the written direction did not state the statutory authority for the correction, the assessor asserted that a subsequent email containing the statutory authority issued after making the valuation increase cured this defect. The Magistrate Division held that a written direction satisfying the statutory requirements must precede the correction action and cannot be provided after the action has been taken. Niemeyer v. Jackson Cnty. Assessor, TC-MD 120853D (Control), 130256D (Or Tax Mag Div July 9, 2013) (slip op).

2. Procedural Defects Make Notice Voidable, Not Void; Appeal Is Still Required.

A procedural defect in a notice by the county generally invalidates an asserted increase in the assessed value of property. The Regular Division of the Oregon Tax Court, however, has ruled that a procedurally defective notice makes the purported increase voidable, rather than void ab initio. Accordingly, the property owner still must timely appeal the notice to prevent the notice from having an impact. Nicolynn Properties, LLC v. Dep’t of Rev., 21 OTR 320 (2013); Clifford Parsons v. Clackamas Cnty. Assessor, 21 OTR 331 (2013).

3. Property Tax Relief Available Even Though the Property Owner Did Not Timely Contest Value.

Generally, if a property owner disagrees with the assessed value of property, the property owner must first file an appeal with the Board of Property Tax Appeals for the county. However, the Department of Revenue has supervisory authority to change the assessment roll if the assessor and the taxpayer “agree to facts indicating likely error” on the roll. OAR 150-306.115(4)(b)(A). The Regular Division of the Oregon Tax Court found that an appraiser agreeing to a significant reduction in the 2009 real market value of an apartment complex because of flaws related to the 1996 construction and design of the complex was sufficient to indicate that there likely was an error with respect to the 2008 value of the complex. Accordingly, the court held that the Department abused its discretion in refusing to exercise its supervisory authority with respect to 2008. Oakmont LLC v. Clackamas County Assessor, TC-RD 5178, 2014 Ore Tax LEXIS 67 (Or Tax Reg Div Apr. 29, 2014).

4. 90-Day Period to File Complaint Starts with Actual Knowledge.

The Regular Division of the Tax Court has ruled that a taxpayer who was away from his home and arranged for mail to be picked up did not have actual knowledge of a property tax exemption



disqualification until the taxpayer returned and read the mail. Accordingly, the 90-day window for filing a complaint in the Magistrate Division of the Oregon Tax Court did not start until after the taxpayer returned home. The taxpayer’s complaint was not untimely. Clackamas County Assessor v. Crew, TC-RD 5175, 2014 Ore Tax LEXIS 34 (Or Tax Reg Div Feb. 25, 2014).

D. Property Taxes Used to Fund Urban Renewal Are Categorized as for Government Operations Other Than the Public School System.

Oregon’s property tax limitation system divides property taxes into three categories: (1) property tax revenues used to fund the public school system, (2) property tax revenues used to fund government operations other than the public school system, and (3) property tax revenues used to fund voter-approved bond measures. Pursuant to Measure 5, enshrined in the Oregon Constitution, the amount of property taxes used to fund the public school system cannot exceed 0.5 percent of the real market value of the applicable property, and property taxes used to fund other government operations cannot exceed 1 percent of the real market value (there is no cap on property taxes to fund voter-approved bond measures). A case argued in part by the authors concerned whether property taxes to fund urban renewal on and around a public school campus are categorized as for the public school system or other government operations where the public school would (1) receive the property tax revenues but (2) use those revenues to fund specific aspects of development projects (e.g., creation of ground-floor retail space in a building otherwise used as a classroom). The parties stipulated that the school’s use of the property tax revenues would achieve urban renewal. The Regular Division of the Oregon Tax Court held that, because the building or facility would be used for both a general government purpose (i.e., to alleviate blight) and a public school purpose, Measure 5 required categorizing all of the related property taxes as used to fund government operations other than the public school system. McGuire v. City of Portland, TC-RD 5226, 2015 Or Tax LEXIS 75 (Or Tax Reg Div June 16, 2015).

XI. Estate Tax: Natural Resource Credit (SB 864)

Excerpt from floor letter submitted by the Oregon Farm Bureau on April 15, 2015:

“In order to utilize the credit, the Oregon natural resource property must comprise at least 50 percent of the total estate value. While out-of-state natural resource properties are

counted in the total estate, they are not counted towards the credit because they are not located in Oregon. Disqualification from the credit has devastated some families, and we do not believe this was the intent of the natural resources credit. These assets represent

lifetime investments of a family business that may be forced into selling off assets to pay estate taxes without this credit.

“SB 864 is a fix to this issue; it modifies definition of natural resource property to mean property in the state. The bill provides that determination of eligibility for credit is based on ratio of in-state property to in-state portion of gross estate.”





Chapter 2

Tax Issues for the Tax Exempt (or “I Didn’t Know That”)

WilliaM Manne

Miller Nash Graham & Dunn LLPPortland, Oregon

Contents

I. Entity Definitions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2–1

II. Formation, Qualification, and Operation of 501(c)(3) Organizations. . . . . . . . . . . . . . . 2–1

III. Federal, Oregon, and Local Tax and Reporting. . . . . . . . . . . . . . . . . . . . . . . . . . . 2–3

IV. Use of LLCs in Nonprofit Practice . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2–4

V. Practice Traps. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2–4

Agencies to Contact for Assistance. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2–7

IRS Good Governance Policies for 501(c)(3) Organizations . . . . . . . . . . . . . . . . . . . . . . . . 2–9

“Potholes to Avoid in Road-Tripping with 501(c)(3) Organizations” . . . . . . . . . . . . . . . . . 2–13

Small Nonprofit Consultation Checklist. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2–25

Chapter 2—Tax Issues for the Tax Exempt (or “I Didn’t Know That”)




I. ENTITY DEFINITIONS

A. "Nonprofit corporations" are corporations formed under ORS Chapter 65. Nonprofit corporations have no shareholders. They may or may not have "Members." (See ORS 65.001(26) for the definition of a "Member.") They may or may not be tax exempt or a charity.

B. "Hybrid entities" are mutated business entities. They include low-profit limited liability companies ("L3C"s), benefit corporations (aka "B" corporations), and flexible purpose corporations. Oregon allows business corporations, LLCs, or professional corporations to be classified and operated as a "benefit company" (see 2013 HB 2296, effective January 1, 2014).

C. "Tax exempt" entities are not subject to federal (or, generally, to State of Oregon) income tax, because they are "exempt" from taxation. Note that this status has little or no bearing on whether such entities might be subject to local taxes or fees (such as City of Portland Business License Fee or the Multnomah County Business Income Tax), property tax, sales and use taxes (in other states), payroll taxes and withholdings, etc. (See III, below.)

D. "Charities" are generally organizations (corporations or trusts) that have obtained Internal Revenue Code section 501(c)(3) status by submitting an IRS form 1023 (or 1023EZ) and receiving a favorable "determination letter." Charities are automatically assumed to be "private foundations," but may qualify for status as a "public charity." (See IRC section 509.) Group exemptions may be granted in appropriate situations. (See IRS Revenue Procedure 80-27.) (IRS form 1024 is a generally an optional application for recognition of exemption of a variety of other exempt entities.)

1. "Religious organizations" are not required to submit a form 1023 or receive a determination letter, although they may do so.

2. "State and political subdivisions" are generally entitled to exemption (see IRC section 115).

3. Deduction of charitable donations is generally controlled by IRC section 170.

II. FORMATION, QUALIFICATION, AND OPERATION OF 501(C)(3) ORGANIZATIONS

A. IRC section 501(c)(3) provides that:

1. Entities must be, "organized and operated exclusively for religious, charitable, scientific, testing for public safety, literary, or educational purposes, or to foster national or international amateur sports competition * * *, or for the prevention of cruelty to children or animals * * *" (Italics added);

2. "[N]o part of the net earnings * * * inures to the benefit of any private shareholder or individual * * *"; and,



3. "[N]o substantial part of the activities of which is carrying on propaganda, or otherwise attempting, to influence legislation [with an exception for IRC section 501(h), as described below], and which does not participate in, or intervene in * * * any political campaign on behalf of (or in opposition to) any candidate for public office." (Italics added. See also, Treasury Regulation section 1.501(c)(3)-1, for additional information.)

4. IRC section 501(h) provides an election, made annually on IRS form 990, to allow expenditures by public charities to influence legislation, provided they meet certain criteria.

5. Treasury Regulation section 1.501(c)(3)-1(b)(4) states that, "an organization is not organized exclusively for one or more exempt purposes unless its assets are dedicated to an exempt purpose. An organization's assets will be considered dedicated to an exempt purpose, for example, if, upon dissolution, such assets would, by reason of a provision in the organization's articles or by operation of law, be distributed for one or more exempt purposes, or to the Federal government, or to a State or local government, for a public purpose, or would be distributed by a court to another organization to be used in such manner as in the judgment of the court will best accomplish the general purposes for which the dissolved organization was organized."

B. Some (selected) Oregon statutory requirements for nonprofit corporations:

1. Corporations organized as public benefit, nonprofit corporations, trusts who hold assets in Oregon for charitable beneficiaries, and corporations organized in other states as nonprofit corporations which solicit, hold assets, or do business in Oregon must register with the Charitable Activities Section of the Oregon Department of Justice. (See http://doj.state.or.us/charigroup/pages/index.aspx and ORS 128.610 et. seq., the "Charitable Trust and Corporation Act.")

2. ORS 65.047 requires the articles of incorporation of an Oregon nonprofit corporation specify whether it is a public benefit, mutual benefit, or religious corporation and whether it has "Members." (See Section I.A, above, for reference to definition of a "Member.")

3. ORS 65.307 requires at least three directors if the corporation is a public benefit corporation.

4. Written consent rules and electronic or telephonic meeting rules applicable to nonprofit corporation member or board of director meetings may vary from those for Oregon for-profit (Chapter 60) entities. (Compare similar provisions in ORS chapters 60 and 65.)

5. See ORS 65.354 re authority and composition of board committees. Board committees comprised of non-board of director members may not take formal action, but may make recommendations to the board for formal action.

6. Participation as a member of the board of directors is personal and may not be delegated.



7. ORS 65.311(2) provides for a self-perpetuating board of directors, when there are no Members. ORS 65.251 provides additional ways to elect directors. Consider rotating three-year terms for directors, especially in volunteer organizations.

8. ORS 65.364 contains significant restrictions on making loans to, guaranteeing an obligation of, or modifying a preexisting loan or guarantee to or for the benefit of a director or officer of an Oregon nonprofit corporation.

C. IRC section 170 and Treasury Regulation section 1.170A-13 contain recordkeeping and return requirements for income tax deduction of charitable contributions. Essentially, no deduction is allowed for all or any part of any contribution of $250 or more unless the taxpayer substantiates the contribution with a contemporaneous written acknowledgement from the donee organization. (1.170(A)-13(f)(1).) The details of the "written acknowledgement" are spelled out at 1.170(A)-13(f)(2).

D. ORS 128.001 et. seq. contains the Oregon "Charitable Solicitations Act." See also, ORS 646.605 et. seq., the "Unfair Trade Practices Act."

E. Although there are no statutory requirement that nonprofits or tax exempt entities have a conflict of interest policy, it is a best practice. ORS 65.361 contains rules for board of director conflicts of interest. Note that in Oregon there is no requirement a board member recuse themselves from discussion or not vote on the matter.

F. IRC section 4958 imposes excise taxes on certain "disqualified persons" of 501(c)(3) and 501(c)(4) organizations who receive an "excess benefit," and on the organization's managers who approve the excess benefit transaction. Excess benefit transactions include compensation matters and can be created "automatically" by failure to document a benefit or inadvertently, by (for example) providing for non-fixed payments. (See Treasury Regulations section 53.4958-(c)(3) and (a)(3)(vi).

III. FEDERAL, OREGON, AND LOCAL TAX AND REPORTING

A. Tax exempt entities are generally required to file an IRS form 990 (there are several versions, including 990EZ, 990N, 990PF, and 990-T), annually, by the 15th day of the fifth month following fiscal year-end. Form 990 has boxes to check "yes" if an exempt organization has changed its governance documents or operations during the tax year.

B. Oregon form CT12 is required annually, by the 15th day of the fourth month following fiscal year-end, for organizations registered (see Section II.B.1, above) with the Charitable Activities Section of the Oregon Department of Justice.

C. Oregon Property tax exemption.

1. Does not follow federal income tax exemption. No blanket exemption for "literary" or "scientific" activities unless coupled with a charitable objective. (See ORS 307.130 et. seq.)



2. Requires the property be "* * * actually and exclusively occupied or used in the literary, benevolent, charitable or scientific work carried on * * *."

3. Includes ownership or lease, provided lease meets certain requirements. (See ORS 307.112.)

a. Lease must expressly provide that the rent payable by the institution, organization or public body has been established to reflect the savings below market rent resulting from exemption from taxation.

b. Beware time restrictions on application. Generally, the claim for exemption must be filed on or before April 1 preceding the property tax year (July 1 – June 30) for which the exemption is claimed, with certain exceptions, including late filing fee pursuant to ORS 307.162.

4. ORS 307.022 provides that limited liability companies owned by nonprofit corporations can qualify for property tax exemption, overcoming limitation in original statutory scheme that references only "nonprofit corporations."

IV. USE OF LLCS IN NONPROFIT PRACTICE

A. Although IRS will recognize an LLC as a 501(c)(3) entity, see ORS 63.074(1) that limits Oregon LLC purposes to, "* * * any lawful business or purposes which a partnership, corporation or professional corporation * * * may conduct or promote." Note that ORS 63.001(5) defines the term "Corporation" to mean a corporation for profit, incorporated under ORS chapter 60 (not a nonprofit corporation, incorporated under ORS chapter 65).

B. IRS Notice 2012-52 clarified that charitable donations made to the wholly owned and controlled limited liability company of a single qualified U.S. charity under IRC section 170(c)(2) will qualify for the charitable income tax deduction.

C. Advisers frequently recommend formation of wholly owned LLC entities for charities to hold donated real estate or other assets. Real estate is a particularly attractive asset to hold in a separate LLC, since that structure can limit liabilities, including environmental liabilities, from impacting other assets owned by the charity. With the IRS Notice referenced in B above, and the property tax exemption referenced in Section III.C.4 above, this structure becomes easier to accomplish, because contributions of real property (or other assets) can be made directly to a charity-owned LLC without compromising the donor's charitable deduction.

V. PRACTICE TRAPS

A. Whom do you represent? Does the person (group) you are working with have apparent or actual authority to engage you and to engage in the transaction you have been asked to handle? Consider a written engagement letter. If incorporating a new entity, consider an organizational resolution specifically referencing your engagement and authority to engage you.



B. Recommend against serving on the board of directors (or as an officer) and providing legal advice.

1. Especially if your firm is providing legal advice and you are serving on the board or as an officer (but worthwhile even if your firm is not), consider written correspondence confirming that (a) you are not acting as a lawyer or providing legal services or advice, (b) your board service is personal/individual, and, (c) no attorney/client privilege attaches to your communications.

2. Before agreeing to serve on a board or as an officer, consider the potential for conflict of fiduciary duties you would owe as a member of a legal practice serving the client and in your volunteer capacity. The PLF (and some malpractice carriers) will not provide professional errors and omission coverage unless you are acting as an attorney.





Contact the Following Agencies for AssistanceCharitable Activities Section Oregon Department of Justice 1515 SW 5th Avenue, Suite 410 Portland, Oregon 97201-5451 Phone: (971)673-1880 TTY: (800)735-2900 Fax: (971)673-1882 Email: [email protected] Website: http://www.doj.state.or.us

IssuesQuestions about annual reports for charitable organizations-Forms CT-12, CT-12F, and CT-12S Registration of charitable organizations and trusts Merging nonprofit organizations Dissolving nonprofit organizations Reporting illegal activity by nonprofit organizations Serving as a board member of a nonprofit organization Information about charitable organizations and copies of annual reportsQuestions about raffles and other charitable gaming

FormsRF-C, Registration Form for Charitable Organizations RF-T, Registration Form for Trusts CT-12, Annual Report Form for Oregon Charities CT-12F, Annual Report Form for Foreign Charities CT-12S, Annual Report Form for Split-Interest Trusts Closing Form

PublicationsOregon Wise Giving Guide A Guide to Non-Profit Board Service in Oregon

Oregon Revised Statutes Chapter #65, Nonprofit Corporations Chapter #128, Trusts; Charitable Activities Chapter #130, Uniform Trust Code Chapter #464, Charitable Gaming Chapter #646, Trade Practices & Antitrust Regulations

Oregon Administrative Rules Chapter #137-010-0005 et seq.

Internal Revenue Service Phone: (877)829-5500 Website: http://www.irs.gov

IssuesObtaining federal tax identification number or federal tax-exempt status Completing federal tax forms

Forms990, Return of Organization Exempt From Income Tax 990-EZ, Short Form - Return of Organization Exempt From Income Tax Schedule A, for Form 990 and 990-EZ 990-PF, Return of Private Foundation 990-T, Exempt Organization Business Income Tax Return 1023, Application for Recognition of Exemption Under §501(c)(3) 1024, Application for Recognition of Exemption Under §501(a) 1041, U.S. Income Tax Return for Estates and Trusts 1041-A, U.S. Information Return - Trust Accumulation of Charitable Amounts1128, Application to Adopt, Change, or Retain a Tax Year 4720, Return of Certain Excise Taxes on Charities and Other Persons 5227, Split-Interest Trust Return 5768, Election/Revocation of Election by an Eligible Section 501(c)(3) Organization to Make Expenditures to Influence Legislation 8822, Change of Address 8868, Application for Extension of Time to File an Exempt Organization Return

PublicationsPub. 526, Charitable Contributions Pub. 538, Accounting Periods and MethodsPub. 557, Tax-Exempt Status for Your Organization Pub. 583, Starting a Business and Keeping Records Pub. 598, Tax on Unrelated Business Income of Exempt Organizations Pub. 3079, Gaming Publication for Tax-Exempt Organizations

Veterans’ Services

If you are or know a veteran and would like more information about benefits, please see DOJ Veterans Resources available through the Department of Justice’s website at: http://www.doj.state.or.us

Secretary of StateCorporation Division

Public Service Building 255 Capitol Street NE, Suite 151 Salem, OR 97310-1327 Phone: (503)986-2200 Fax: (503)378-4381 Website:http://sos.oregon.gov/business/Pages/default.aspx

IssuesForming a new corporation Merging nonprofit corporations Dissolving nonprofit corporations Amending articles of incorporation Obtaining copies of filed articles of incorporation and amendments

FormsArticles of Incorporation Assumed Business Name Registration Articles of Amendment Restated Articles Articles of Dissolution Revocation of Dissolution

PublicationsOregon Business Guide

Oregon Department of Revenue

Revenue Building 955 Center St. NE Salem, OR 97301 Phone: (503)378-4988 and (800)356-4222 TTY: (800) 886-7204 Website: http://www.oregon.gov/DOR

IssuesState taxation and filing requirements

Forms20, Oregon Corporation Excise Tax Return 41, Oregon Fiduciary Income Tax Return

State of Oregon Website: http://www.oregon.gov

From Form CT-12S for Split-Interest Trusts, Charitable Activities Section, Oregon Department of Justice, for Accounting Periods Beginning in 2014, http://www.doj.state.or.us/charigroup/pdf/2014_web_ct-12s.pdf.

http://www.doj.state.or.us/charigroup/pdf/2014_web_ct-12s.pdf

http://www.doj.state.or.us/charigroup/pdf/2014_web_ct-12s.pdf





Good Governance Practices for 501(c)(3) Organizations

The Internal Revenue Service believes that governing boards should be composed of persons who are informed and active in overseeing a charity’s operations and finances. If a governing board tolerates a climate of secrecy or neglect, charitable assets are more likely to be used to advance an impermissible private interest. Successful governing boards include individuals not only knowledgeable and passionate about the organization’s programs, but also those with expertise in critical areas involving accounting, finance, compensation, and ethics.

Organizations with very small or very large governing boards may be problematic:Small boards generally do not represent a public interest and large boards may be less attentive to oversight duties. If an organization’s governing board is very large, it may want to establish an executive committee with delegated responsibilities or establish advisory committees.

The Internal Revenue Service suggests that organizations review and consider the following to help ensure that directors understand their roles and responsibilities and actively promote good governance practices. While adopting a particular practice is not a requirement for exemption, we believe that an organization that adopts some or all of these practices is more likely to be successful in pursuing its exempt purposes and earning public support.

Mission Statement

Code of Ethics

Due Diligence

Duty of Loyalty

Transparency

Fundraising Policy

Financial Audits

Compensation Practices

Document Retention Policy



1. Mission Statement

A clearly articulated mission statement that is adopted by an organization’s board of directors will explain and popularize the charity’s purpose and serve as a guide to the organization’s work. A well-written mission statement shows why the charity exists, what it hopes to accomplish, and what activities it will undertake, where, and for whom.

2. Code of Ethics and Whistleblower Policies

The public expects a charity to abide by ethical standards that promote the public good. The board of directors bears the ultimate responsibility for setting ethical standards and ensuring they permeate the organization and inform its practices. To that end, the board should consider adopting and regularly evaluating a code of ethics that describes behavior it wants to encourage and behavior it wants to discourage. The code of ethics should be a principal means of communicating to all personnel a strong culture of legal compliance and ethical integrity.

The board of directors should adopt an effective policy for handling employee complaints and establish procedures for employees to report in confidence suspected financial impropriety or misuse of the charity’s resources. Such policies are sometimes referred to as whistleblower policies.

3. Due Diligence

The directors of a charity must exercise due diligence consistent with a duty of care that requires a director to act:

• In good faith;

• With the care an ordinarily prudent person in a like position would exercise under similar circumstances;

• In a manner the director reasonably believes to be in the charity’s best interests.

Directors should see to it that policies and procedures are in place to help them meet their duty of care. Such policies and procedures should ensure that each director:

• Is familiar with the charity’s activities and knows whether those activities promote the charity’s mission and achieve its goals;

• Is fully informed about the charity’s financial status; and

• Has full and accurate information to make informed decisions.

4. Duty of Loyalty

The directors of a charity owe it a duty of loyalty. The duty of loyalty requires a director to act in the interest of the charity rather than in the personal interest of the director or



some other person or organization. In particular, the duty of loyalty requires a director to avoid conflicts of interest that are detrimental to the charity. To that end, the board of directors should adopt and regularly evaluate an effective conflict of interest policy that:

• Requires directors and staff to act solely in the interests of the charity without regard for personal interests;

• Includes written procedures for determining whether a relationship, financial interest, or business affiliation results in a conflict of interest; and

• Prescribes a certain course of action in the event a conflict of interest is identified.

Directors and staff should be required to disclose annually in writing any known financial interest that the individual, or a member of the individual’s family, has in any business entity that transacts business with the charity. Instructions to Form 1023 contain a sample conflict of interest policy.

5. Transparency

By making full and accurate information about its mission, activities, and finances publicly available, a charity demonstrates transparency. The board of directors should adopt and monitor procedures to ensure that the charity’s Form 990, annual reports, and financial statements are complete and accurate, are posted on the organization’s public website, and are made available to the public upon request.

6. Fundraising Policy

Charitable fundraising is an important source of financial support for many charities.Success at fundraising requires care and honesty. The board of directors should adopt and monitor policies to ensure that fundraising solicitations meet federal and state law requirements and solicitation materials are accurate, truthful, and candid. Charities should keep their fundraising costs reasonable. In selecting paid fundraisers, a charity should use those that are registered with the state and that can provide good references. Performance of professional fundraisers should be continuously monitored.

7. Financial Audits

Directors must be good stewards of a charity’s financial resources. A charity should operate in accordance with an annual budget approved by the board of directors. The board should ensure that financial resources are used to further charitable purpose by regularly receiving and reading up-to-date financial statements including Form 990, auditor’s letters, and finance and audit committee reports.

If the charity has substantial assets or annual revenue, its board of directors should ensure that an independent auditor conduct an annual audit. The board can establish an independent audit committee to select and oversee the independent auditor. The auditing firm should be changed periodically (e.g., every five years) to ensure a fresh look at the financial statements.



For a charity with lesser assets or annual revenue, the board should ensure that an independent certified public accountant conduct an annual audit.

Substitute practices for very small organizations would include volunteers who would review financial information and practices. Trading volunteers between similarly situated organizations who would perform these tasks would also help maintain financial integrity without being too costly.

8. Compensation Practices

A successful charity pays no more than reasonable compensation for services rendered. Charities should generally not compensate persons for service on the board of directors except to reimburse direct expenses of such service. Director compensation should be allowed only when determined appropriate by a committee composed of persons who are not compensated by the charity and have no financial interest in the determination.

Charities may pay reasonable compensation for services provided by officers and staff.In determining reasonable compensation, a charity may wish to rely on the rebuttablepresumption test of section 4958 of the Internal Revenue Code and Treasury Regulation section 53.4958-6.

9. Document Retention Policy

An effective charity will adopt a written policy establishing standards for document integrity, retention, and destruction. The document retention policy should include guidelines for handling electronic files. The policy should cover backup procedures, archiving of documents, and regular check-ups of the reliability of the system. For more information see IRS Publication 4221, Compliance Guide for 501(c)(3) Tax-Exempt Organizations, available on the IRS website.



The Practical Tax Lawyer | 33

Eve Rose Borenstein

ALL LAWYERS need to be careful when providing counsel to “c3” organizations (this article will refer to those with 501(c)(3) exemption as “charities” or “chari-table organizations”). It is common for smaller charities to expect that an attorney working with them will be knowledgeable about every aspect of tax law (and even all state nonprot and charitable trust laws) to which the organization is subject. Today’s climate increasingly re-quires that charities demonstrate obedience to the laws that apply to them. Indeed, adherence to both tax-exemption mandates and good-to-best practices in board governance are being demanded not only by a more robust IRS, but also by state regulators and the public. Practitioners need to “do no harm” in working with charities. Being aware of red ags that may indicate noncompliance and/or evi-dence that additional counsel may be necessary is key in helping the charitable sector “do good.” The aspiration (and need) that lawyers will provide as-sistance to the 501(c)(3) sector (again, commonly referred to as “charitable” organizations) is expressed in the ABA’s Model Rules of Professional Conduct. The Model Rules’ section on public service states the following:RULE 6.1 VOLUNTARY PRO BONO PUBLICO SERVICE

Every lawyer has a professional responsibility to provide legal services to those

unable to pay. A lawyer should aspire to render at least (50) hours of pro bono

publico legal services per year. In fullling this responsibility, the lawyer should:

(a) provide a substantial majority of the (50) hours of legal services without fee

or expectation of fee to:

(1) persons of limited means or

(2) charitable, religious, civic, community, governmental and educational organi-

zations in matters that are designed primarily to address the needs of persons of

limited means; and

Eve Rose Borenstein is a principal in the Minneapolis law firm of Borenstein and McVeigh Law Office LLC (BAM Law). This article is adapted from “Exempt Organizations and Common Tax Traps and Potholes,” by the author, published at the ABA Section of Taxation’s 2006 May Meeting. © 2006 by the American Bar Association. Reprinted with permission.

Potholes To Avoid In Road-Tripping With 501(c)(3) Organizations



34 | The Practical Tax Lawyer Winter 2007

(b) provide any additional services through:

(1) delivery of legal services at no fee or substantially reduced

fee to individuals, groups or organizations seeking to secure or protect

civil rights, civil liberties or public rights, or charitable, religious, civic,

community, governmental and educational organizations in matters in

furtherance of their organizational purposes, where the payment of stan-

dard legal fees would signicantly deplete the organization’s economic

resources or would be otherwise inappropriate;

(2) delivery of legal services at a substantially reduced fee to

persons of limited means; or

(3) participation in activities for improving the law, the legal

system or the legal profession.

In addition, a lawyer should voluntarily contribute nancial

support to organizations that provide legal services to persons

of limited means.

Model Rules of Professional Conduct (2004 Edi-tion). Available at: www.abanet.org/cpr/mrpc/mrpc/rule_6_1.html (emphasis added). The ABA Section of Taxation’s Pro Bono Com-mittee aims to encourage and assist lawyers to pro-vide effective and laudable pro bono service. Its char-itable organizations subcommittee, in conjunction with the Section’s Exempt Organizations Commit-tee, works to support lawyers who provide services without fee to 501(c)(3) organizations “in matters that are designed primarily to address the needs of persons of limited means” or who provide reduced fee (or free) services to 501(c)(3) organizations whose resources are not sufcient to pay for same, thereby performing a public service within the mandates of Rule 6.1(a)(2) or 6.1(b)(1), respectively. Charitable, religious, and educational organiza-tions often seek and qualify for exemption under Internal Revenue Code (“Code”) section 501(c)(3). (All section references are to the Code unless other-wise noted.) Civic and community groups, as well as organizations that work to secure or protect civil rights, civil liberties, or public rights, if they limit their operations appropriately, may also qualify. So when you do your pro bono service in helping these organizations, what are the potholes you need to avoid?

POTHOLE #1: FAILING TO NOTE THAT PUBLIC BENEFIT (OR OTHER) ACTIVI-TIES THAT ARE OUTSIDE OF 501(c)(3)’S NARROW DEFINITIONS ARE BEING CONDUCTED • Section 501(c)(3) requires that organizations exempt under that section be both organized and operated exclusively for one or more of eight “exempt purposes”:• Religious;• Charitable;• Scientic;• Testing for public safety (This one category,

however, is not eligible to receive income tax-deductible contributions; same is omitted from section 170(c)(2), providing for such deductibil-ity);

• Literary;• Educational;• Fostering national or international amateur

sports competition (but only if no part of its activities involve the provision of athletic facili-ties or equipment) (but section 501(j) effectively removes the effect of this parenthetical); or

• Preventing cruelty to children or animals. The regulations provide some broad guidance on three of those specic exempt purposes (charitable, educational, and scientic). For example, they pro-vide a list of charitable purposes that are considered benecial to the public interest:• Relief of the poor, the distressed, or the under-

privileged;• Advancement of religion;• Advancement of education or science;• Erection or maintenance of public buildings,

monuments, or works;• Lessening the burdens of government;• Lessening of neighborhood tensions;• Elimination of prejudice and discrimination;• Defense of human and civil rights secured by

law; and• Combating community deterioration and juve-

nile delinquency.

http://www.abanet.org/cpr/mrpc/mrpc/rule_6_1.html

http://www.abanet.org/cpr/mrpc/mrpc/rule_6_1.html



Road-Tripping With 501(c)(3) Organizations | 35

The regulations also explicate that educational purposes include both the instruction of individu-als to improve their abilities and the instruction of the public on subjects useful to the individual and benecial to the community. Such general denitions do little to guide orga-nizations. In every case, individual operations are judged on a “facts and circumstances” basis. Thus, one issue that arises for 501(c)(3) organizations is that certain activities that are of benet to the community may not actually t within the specic exempt purposes embraced by the Code section. In the most general terms, for an organization to be 501(c)(3)-qualied, its efforts must either serve a charitable class (e.g., the ill, the poor, those suffer-ing discriminatory actions) and/or be conducted to accomplish an overarching 501(c)(3) purpose (e.g., defending civil rights secured by law—one of the activities that ts within “charitable” as noted above; or conducting religious ceremonies—an ac-tivity comporting with a religious purpose; or operating a school—an educational purpose). The fact that certain activities improve the society because they are civic in nature, or can be cast as “social welfare” activities, does NOT mean those activities comprise 501(c)(3) purposes.

Red Flags/Common Problems• Services provided are to small subset of public

(e.g., eight people being served by dog obedi-ence school);

• Efforts perceived as educational go only to those who are already educated in that arena (e.g., the organization exists to sponsor house meetings addressing “how to get the city coun-cil to pay more attention to the neighborhood council’s opinion”);

• Social activities are often conducted, but not allparticipants are from a charitable class;

• Fundraising activities independent of othercharities are what the organization exists toconduct;

• Economic development activities are conduct-ed in a neighborhood or region that is not eco-nomically blighted.

POTHOLE #2: EFFECTIVE GOVERNANCE(AS BRAKE AGAINST TRANSACTIONSTHAT MIGHT UNDULY BENEFIT INSID-ERS) IS NOT EVIDENCED • The governors(board of directors, trustees, ofcers, and those towhom they delegate authority) of charities are le-gally entrusted with the responsibility of ensuringthat two key precepts of 501(c)(3) qualication are

“operationalized” —no privateinurement to insiders nor opera-tions for private, rather than pub-lic, purposes. The last two years have seena marked increase in regulatoryand “court of public opinion” at-tention to scandals and errors inthe charitable sector. Headlines

(and Congressional hearings) have chiey focusedon situations in which excessive compensation toinsiders and/or “asleep at the switch” boards havebeen evidenced. Appropriate capacity of boards tomeet their responsibilities (which under state stat-ute and common law are understood to compriseduties of care, loyalty, and obedience) needs to bedemonstrated by all charities. Failure to manageagainst insider benet can expose board membersof “public charities” to personal tax consequenc-es under the “intermediate sanctions” excise taxscheme found in Code section 4958. (This articleassumes that the charities being advised are pub-lic charities, rather than private foundations. Thedividing line between these two subsets of the c3universe is noted at Pothole #5.)

The last two years have seen a marked increase in regulatory and “court of public opinion” attention to scandals and errors in the charitable sector.




IRS Publication 1828, Tax Guide for Churches and Religious Organizations (9/03) (hereinafter, “Pub. 1828, Tax Guide”) at page 5 provides an excellent narration of the mandates against both private in-urement (including the application of “intermedi-ate sanctions” to “excess benet transactions”) and operation for private rather than public purposes:Inurement and Private Benet

Inurement to Insiders

[A]ll exempt organizations under IRC section 501(c)(3) are

prohibited from engaging in activities that result in inure-

ment of the…organization’s income or assets to insiders….

Insiders could include the…board members, ofcers, and in

certain circumstances, employees. Examples of prohibited

inurement include the payment of dividends, the payment

of unreasonable compensation to insiders, and transferring

property to insiders for less than fair market value. The pro-

hibition against inurement to insiders is absolute; therefore,

any amount of inurement is, potentially, grounds for loss of

tax-exempt status. In addition, the insider involved may be

subject to excise tax. See the following section on Excess ben-

et transactions. Note that prohibited inurement does not in-

clude reasonable payments for services rendered, payments

that further tax-exempt purposes, or payments made for the

fair market value of real or personal property.

Excess benet transactions. In cases where an IRC section 501(c)(3)

organization provides an excess economic benet to an in-

sider, both the organization and the insider have engaged in

an excess benet transaction. The IRS may impose an excise

tax on any insider who improperly benets from an excess

benet transaction, as well as on organization managers who

participate in such a transaction knowing that it is improper.

An insider who benets from an excess benet transaction is

also required to return the excess benets to the organization.

Detailed rules on excess benet transactions are contained in

the Code of Federal Regulations, Title 26, sections 53.4958-0

through 53.4958-8.

Private Benet

An IRC section 501(c)(3) organization’s activities must be di-

rected exclusively toward charitable, educational, religious, or

other exempt purposes. Such an organization’s activities may

not serve the private interests of any individual or organiza-

tion. Rather, beneciaries of an organization’s activities must

be recognized objects of charity (such as the poor or the dis-

tressed) or the community at large (for example, through the

conduct of religious services or the promotion of religion).

Private benet is different from inurement to insiders. Pri-

vate benet may occur even if the persons beneted are not

insiders. Also, private benet must be substantial in order to

jeopardize tax-exempt status.

The IRS website links to many helpful articles on intermediate sanctions. See those listed under the “More information” header at: http://www.irs.gov/charities/charitable/article/0,,id=123298,00.html.

Red Flags• Boards not meeting or meeting infrequently

(e.g., only annually);• Minutes of Board meetings evidence few ac-

tions by Board;• Board or ofcers/key employees populated with

those who have family or business relationships to each other;

• Signicant transaction(s) contemplated or con-summated without employment of basic con-ict of interest policies/procedures;

• Organization is employing contractors, of-cers, or employees who have family or business relationships with members of board or ofcers without appropriate safeguards or reviews;

• No or poor evidence that ofcers’/key employ-ees’ compensation or terms of signicant trans-actions are subject of Board review.

POTHOLE #3: ORGANIZATION FAILS TO APPRECIATE THE “NO SUBSTANTIAL LOBBYING LIMIT” OR THE SO-CALLED ELECTIONEERING PROSCRIPTION • Charities need take care to properly understand (and then follow) each of the two disparate rules

http://www.irs.gov/charities/charitable/article/0,,id=123298,00.html

http://www.irs.gov/charities/charitable/article/0,,id=123298,00.html




that apply to their work on public policy and with public-policy makers. The genesis of these rules is the language of section 501(c)(3) which sets out the following activity limits: “no substantial part of the activities...is the carrying on of propaganda, or oth-erwise attempting to inuence legislation (except as otherwise provided in subsection (h)), and which [the organization] does not participate in, or inter-vene in (including the publishing or distributing of statements), any political campaign on behalf of (or in opposition to) any candidate for public ofce.”

Lobbying Limits Although 501(c)(3) organizations are entitled to inuence public policy to promote outcomes fur-thering their mission by engaging in a wide vari-ety of “lobbying” activities (501(c)(3) organizations classied as private foundations have that entitle-ment further limited, but that is not the topic here!), tax law does limit the mag-nitude of a charity’s activi-ties that may be directed to the passage of legislation. In essence, these limits are expressed by two alterna-tive tests.

The “[No] Substantial Part” Test Pub. 1828, Tax Guide at page 5 rst sets out the rule imposing the overall lobbying limit, and then at page 6 provides the relevant measurement pa-rameters:Substantial Lobbying Activity

In general, no organization, including a church, may quali-

fy for IRC section 501(c)(3) status if a substantial part of its

activities is attempting to inuence legislation (commonly

known as lobbying). An IRC section 501(c)(3) organization

may engage in some lobbying, but too much lobbying activity

risks loss of tax-exempt status.

Legislation includes action by Congress, any state legislature,

any local council, or similar governing body, with respect to

acts, bills, resolutions, or similar items (such as legislative con-

rmation of appointive ofces), or by the public in a referen-

dum, ballot initiative, constitutional amendment, or similar

procedure. It does not include actions by executive, judicial,

or administrative bodies.

Measuring Lobbying Activity

Substantial Part Test. Whether [an] organization’s attempts to

inuence legislation constitute a substantial part of its overall

activities is determined on the basis of all the pertinent facts

and circumstances in each case. The IRS considers a variety

of factors, including the time devoted (by both compensated

and volunteer workers) and the expenditures devoted by the

organization to the activity, when determining whether the

lobbying activity is substantial.

The Code Section 501(h) Expenditure Test Given the imprecision and subjective nature of the preceding test, Congress was moved in 1976 to establish clearer limits (and denitions) by which a charity may measure its permitted maximum

amount of propaganda/attempts to inuence leg-islation. Under section 501(h), which may be elected by certain charities, there is a ‘bright line’ limit that is established in relationship to an organization’s total

expenditures each year. From a reporting and com-pliance perspective, it is often advantageous for eli-gible charities to make the “501(h) election.” Pub. 1828, Tax Guide, at page 6 addresses the measure-ment parameters used under this test:Expenditure Test. Although churches are not eligible, [others

including] religious organizations may elect the expenditure

test under IRC section 501(h) as an alternative method for

measuring lobbying activity. Under the expenditure test, the

extent of an organization’s lobbying activity will not jeopar-

dize its tax-exempt status, provided its expenditures, related

to such activity, do not normally exceed an amount specied

in IRC section 4911. This limit is generally based upon the

size of the organization and may not exceed $1,000,000.

Consequences Of Excessive Lobbying Activity. Under the expendi-

From a reporting and compliance perspective, it is often advantageous for eligible charities to make the “501(h) election.”




ture test, a[n] . . . organization that engages in excessive lob-

bying activity over a four-year period may lose its tax-exempt

status, making all of its income for that period subject to tax.

Should the organization exceed its lobbying expenditure dol-

lar limit in a particular year, it must pay an excise tax equal to

25 percent of the excess.

Electioneering Proscription Pub. 1828, Tax Guide, at page 7 sets out the rule here:Under the Internal Revenue Code, all IRC section 501(c)(3)

organizations . . . are absolutely prohibited from directly or

indirectly participating in, or intervening in, any political

campaign on behalf of (or in opposition to) any candidate

for elective public ofce. Contributions to political campaign

funds or public statements of position (verbal or written)

made by or on behalf of the organization in favor of or in

opposition to any candidate for public ofce clearly violate

the prohibition against political campaign activity. Violation

of this prohibition may result in denial or revocation of tax-

exempt status and the imposition of certain excise tax.

The text there goes on to note that “certain activities or expenditures may not be prohibited, depending on the facts and circumstances. For ex-ample, certain voter education activities (including the presentation of public forums and the publi-cation of voter education guides) conducted in a non-partisan manner do not constitute prohibited political campaign activity.” This notion of requisite “non-partisan”-ship engenders much confusion, particularly because the boundary line for impermissible activity that favors a candidate or group of candidates for 501(c)(3)s is not the same line that 501(c)(4)-exempt organizations face. As an example of this dichotomy, 501(c)(4) or-ganizations not only may compile legislative score-cards but may disseminate them to their member-ship during election cycles as well. They may also tell their members which candidates have pledged to back the organization’s legislative proposals. Such activities are impermissible for a 501(c)(3) organiza-tion. In fact, a 501(c)(4) organization’s only tax law

limit is that its election advocacy activities may not be its primary ones. (However, the Federal Election Campaign Act does generally prohibit corporations from engaging in “express advocacy” with respect to federal candidates. “Express advocacy” not only includes contributing to a candidate, but also com-prises the making of communications that are un-mistakably electoral, such as “vote fair trade” while including a list of names of candidates who are in favor of the organization’s fair trade proposals.) A recap of the IRS’s position and enuncia-tion of the 501(c)(3) rules in this arena has recent-ly been released. See Fact Sheet 2006-17 (2/06), Election Year Activities and the Prohibition on Political Campaign Intervention for Section 501(c)(3) Organiza-tions, available at: www.irs.gov/newsroom/article/0,,id=154712,00.html.

State Law “PAC” Rules Given the electioneering proscription set out in federal tax law, charities are right to perceive themselves as not being allowed to have political action funds or committees (“PACs”) that work with candidates. However, charities may be subject to individual states’ campaign nance/sunshine statutes and regulation when the charity acts to in-uence the electorate on the passage of legislation by the public (e.g., in initiatives or referenda). In dening who must so report, many jurisdictions use language employing “PAC” terminology. In such instances, what the states are describing is activity that is permissible to charities because it is lobbying. Charities need take note of these rules, particularly because they may expose an organization’s entire base of contributors to disclosure if a separate fund is not employed.

POTHOLE #4: FAILING TO HONOR RE-PORTING MANDATES TRIGGERED BY FUNDRAISING OR OTHER NON-EX-EMPT PURPOSE ACTIVITIES • Although Pothole #1 emphasized that a charity’s operations

http://www.irs.gov/newsroom/article/ 0,,id=154712,00.html

http://www.irs.gov/newsroom/article/ 0,,id=154712,00.html




need further the narrow set of exempt purposes set out in section 501(c)(3), it is actually not the case that the statute’s language (“operated exclusively for exempt purposes”) is absolute. Indeed, the Reg-ulations provide that a charity may qualify if it is operated primarily for exempt purposes; they state that an “insubstantial part” of a charity’s activities may be devoted to nonexempt purposes. Lawyers will nd a plethora of “unrelated” ac-tivities conducted in the charitable sector. Many of these are fund-raising activities (which do little to threaten exemption, be-cause it is clear that they are undertaken to generate contributions so that the or-ganization may continue to conduct its primary exempt purposes). Others may have been undertaken by the organization for income production overall. Three compliance/exposure issues are raised when such activities are conducted by the 501(c)(3) organization:• Application Of Income Tax: To the extent that any

activities are “regularly” carried on, constitute a trade or business, and do not t an exception to what comprises an “unrelated trade or busi-ness” in section 513, the gross revenues so gen-erated will be subject to section 511’s level-the-playing-eld-with-the-commercial-sector tax (this tax is referred to as the Unrelated Business Income Tax).

• Appropriate Representation Of What Is (And Is Not) A Tax-Deductible Contribution: Fund-raising activi-ties come with federal tax requirements (and often state regulation) designed to ensure that the public is not misled as to what comprises a gift payment that is deductible as a charitable contribution.

• Transparency In Presenting Revenues And Expenses: Accounting for funds raised at special events and through sales of goods needs be transpar-ent and accurate. The reporting of “net” pro-ceeds after expenses are withheld by agents of the organization or third parties involved in the income-production creates distortions that the IRS does not countenance. Full transparency of such arrangements is also often mandated by state statutes, particular with respect to the

use of “professional fund-raisers”. Practitioners should be mindful that 501(c)(3) organizations have to meet the following reporting re-quirements that such ac-tivities implicate:

Charitable Contributions—Substantiation And Disclosure Organizations that are tax exempt must meet certain requirements for documenting charitable contributions. The federal tax law imposes two general disclosure rules: (1) a donor must obtain a written acknowledgment from a charity for any single contribution of $250 or more before the donor can claim a charitable contribution on the donor’s (per-sonal or corporate) federal income tax return; and (2) a charitable organization must provide a written disclosure to a donor who makes a payment in ex-cess of $75 partly as a contribution and partly for goods and services provided by the organization. IRS Publication 1771, Charitable Contributions—Sub-stantiation and Disclosure Requirements (7/05) provides information on both of these requirements. Contributions earmarked for lobbying or spe-cically designated for an individual (and not oth-erwise within the control of the recipient organiza-tion) are not deductible contributions.

Contributions earmarked for lobbying or specifically designated for an individual (and not otherwise within the control of the recipient organization) are not deductible contributions.




Property donation/auction programs (e.g., car donation programs) and analogous programs whereby property is donated to or for the benet of the charity and then sold, so that it is the net of the sale after associated costs that is retained by the charity, raise additional issues:• Congress has acted to deter potential abuses in

this area, enacting specic rules in the Ameri-can Jobs Creation Act of 2004 that limit the amount of charitable donations attributable to donations of vehicles. The IRS’s website has a page on those rules: www.irs.gov/charities/article/0,,id=139579,00.html.

• Regardless of the type of property donated/sold, charities must take care to properly report the donation as a contribution (at line 1 of the Form 990/990-EZ) and separately report the amount garnered from the sale of that proper-ty, along with the cost of such sale, on the spe-cial event/activity line(s) of those Forms (line 9, Form 990). Costs of solicitations of the prop-erty or for those to attend events are considered fundraising expenses, not costs of the sale.

State Regulation Of Charitable Solicitation, Registration Requirements For Entities Holding Charitable Assets, Registration/Filing/Bonding Of Professional Fundraisers More than 35 states require organizations that solicit charitable contributions or hold assets subject to charitable trust regulation to register and, then as necessary, report. In addition, states typically regu-late “professional fundraisers” and require their registration, which may implicate ancillary (for the organization) reporting requirements. See the web-site of the National Association of State Charity Ofcials for more information on each state: www.nasconet.org/agencies/document_view.

Appropriate Reporting Of Income (And Expenditures) On Unrelated Business Income Tax Return (Form 990-T) An exempt organization must le Form 990-T if it has $1,000 or more of gross receipts from an unrelated trade or business. For more informa-tion on the application of the unrelated business income tax, see IRS Publication 598, Tax on Unre-lated Business Income for Exempt Organizations (3/05).

Exempt organizations that le Form 990 are required to specically note whether or not revenues from non-contribution activities are either “exempt function,”

excepted from the application of the unrelated business income tax, or are subject to that tax (at Part VII).

POTHOLE #5—CONFUSION OVER THE “PUBLIC SUPPORT TEST” • Every exempt charitable organization is classied as either a public charity or a private foundation. Generally, organizations that are classied as public charities are those that:• Are churches, hospitals, qualied medical re-

search organizations afliated with hospitals, schools, colleges, and universities;

• Have an active program of fundraising and receive contributions from many sources, in-cluding the general public, governmental agen-cies, corporations, private foundations, or other public charities;

• Receive income from the conduct of activities in furtherance of the organization’s exempt purposes; or

• Actively function in a supporting relationship to one or more existing public charities.

Private foundations, in contrast, typically have a single major source of funding (usually gifts from one family or corporation rather than funding from many sources) and most have as their primary ac-tivity the making of grants to other charitable orga-

For some organizations, the primary distinction between a classification as a public charity or a private foundation is the organization’s source of financial support.

http://www.irs.gov/charities/ article/0,,id=139579,00.html

http://www.irs.gov/charities/ article/0,,id=139579,00.html

http://www. nasconet.org/agencies/document_view

http://www. nasconet.org/agencies/document_view




nizations and to individuals, rather than the direct operation of charitable programs. (The preceding is taken verbatim from the IRS’s two resources, Life Cycle of a Public Charity and Life Cycle of a Private Foundation. See IRS’ website charities page—www.irs.gov/charities; “Life Cycle” link is available at the left side of the charities page.) IRS Publication 4220, Applying for 501(c)(3) Tax-Exempt Status (9/03) explains:For some organizations, the primary distinction between a

classication as a public charity or a private foundation is the

organization’s source of nancial support. Generally, a public

charity has a broad base of support while a private founda-

tion has very limited sources of support. This classication is

important because different tax rules apply to the operations

of each. Deductibility of contributions to a private founda-

tion is more limited than deductibility of contributions to a

public charity. See Publication 526, Charitable Contributions, for

more information on deductibility of contributions. In addi-

tion, private foundations are subject to excise taxes that are

not imposed on public charities.

. . . .

If the organization requests public charity classication based

on receiving support from the public, it must continue to seek

signicant and diversied public support in later years. A new

organization that cannot show that it has received enough

public support may request an advance ruling of its status. At

the end of its advance ruling period, usually ve years, it must

le a schedule showing its sources of support. If the schedule

indicates sufcient public support, the organization receives a

denitive ruling of its public charity status. If the organiza-

tion does not meet the public support requirements in the

future, it could be reclassied as a private foundation. Unless

the organization is committed to raising funds from the pub-

lic, it may be more appropriate to consider alternate statuto-

rily-based public charity classications.

Advance Rulings As the above description notes, charities that are not automatically classied as public charities (such as schools or hospitals) but that expect to have ap-propriately diverse contribution or program service revenues are accorded an “advance ruling” cover-ing their rst ve tax years. Their initial 501(c)(3) determination letter is not time-expiring. Rather, the “advance ruling” limits the period in which contributors may view the entity as a public charity, rather than a private foundation. In the “advance ruling period,” as well as every year thereafter, organiza-tions that are public charities under one of the two statutory “public support tests” have their revenue streams evaluated for capture of appropriate di-verse support. The “test” looks back over prior con-secutive years (the rst ve tax years are covered for those holding an “advance ruling”; thereafter, it is the four prior years that are tested in each reporting year). Inadvertent failure of the public support test will jeopardize an organization’s ability to capture donative income and expose the organization (and its managers) to excise tax on a series of activities that may be undertaken by public charities without such consequence.

http://www. irs.gov/charities

http://www. irs.gov/charities




PRACTICE CHECKLIST FOR

Potholes To Avoid In Road-Tripping With 501(c)(3) Organizations

Charitable, religious, and educational organizations often seek and qualify for exemption under Internal Revenue Code (“Code”) section 501(c)(3). Civic and community groups, as well as organizations that work to secure or protect civil rights, civil liberties, or public rights, if they limit their operations appropriately, may also qualify. So when you do your pro bono service in helping these organizations, what are the potholes you need to avoid?• Activities outside 501(c)(3)’s narrow denitions are being conducted.__ Services provided are to small subset of public (e.g., eight people being served by dog obedience school);__ Efforts perceived as educational go only to those who are already educated in that arena (e.g., the orga-nization exists to sponsor house meetings addressing “how to get the city council to pay more attention to the neighborhood council’s opinion”);__ Social activities are often conducted, but not all participants are from charitable class;__ Fundraising activities independent of other charities are what the organization exists to conduct;__ Economic development activities are conducted in a neighborhood or region that is not economically blighted.• Ineffective governance.__ Boards not meeting or meeting infrequently (e.g., only annually);__ Minutes of Board meetings evidence few actions by Board;__ Board or ofcers/key employees populated with those who have family or business relationships to each other;__ Signicant transaction(s) contemplated or consummated without employment of basic conict of inter-est policies-procedures;__ Organization is employing contractors, ofcers, or employees who have family or business relationships with members of board or ofcers without appropriate safeguards or review;__ No or poor evidence that ofcers’/key employees’ compensation or terms of signicant transactions are subject of board review.• Organization fails to appreciate the “no substantial lobbying” limit.• Organization confused about electioneering proscription and/or denition of “non-partisan” with

respect to election cycle activities.• Failing to honor the multitude of reporting mandates triggered by fundraising or other non-exempt

purpose activities.• Confusion over the public support test.

To purchase the online version of this article, go to www.ali-aba.org and click on “online”.



Addendum to preceding article, regarding the “public support test” and “five year

advance ruling periods” . . .

In September of 2008, Treasury Department Regulations revised the two public support tests (the first found in Code Sections 509(a)(1) & 170(b)(1)(A)(vi); the second in Code Section 509(a)(2)) in order to have the testing period reach a total of five years (the preceding four back years ALONG WITH the most-recent completed tax year). These regulatory changes also ended the “five year advance ruling period”.

New 501(c)(3) organizations who represent that they will be seeking diverse funders (likely to meet the “contributions” test set out in Code Sections 509(a)(1) & 170(b)(1)(A)(vi)) or will likely capture diverse revenue streams (measuring not only contributions received but also exempt function income per the test set out in Code Section 509(a)(2)) are now granted public charity classification for the entirety of their first five tax years [indeed, any organization who had a five year advance ruling period that was to expire on or after 6/9/08 now is covered by the new Regulations!] Testing of such organization’s revenue streams is first performed on tax years 2-6 (upon the Form 990 reporting on the organization’s sixth tax year), and thereafter continues in all ensuing years. A predicate for these changes was the streamlining and updating of reporting under these tests that occurs on the Redesigned (for tax years begun in 2008) Form 990 . . . .

For more information on these topics, please consult the author’s websites:

www.BAMlawoffice.comwww.taxexemptlaw.org

Reprinted with permission of author. Article downloaded from http://bamlaw.ehclients.com/images/uploads/Practical_Tax_Laywer_Potholes_with_Addendum.pdf.

http://bamlaw.ehclients.com/images/uploads/Practical_Tax_Laywer_Potholes_with_Addendum.pdf

http://bamlaw.ehclients.com/images/uploads/Practical_Tax_Laywer_Potholes_with_Addendum.pdf





SMALL NONPROFIT CONSULTATION CHECKLIST American Bar Association Tax Section Exempt Organizations Committee Meeting,

January 24, 2014

Note: This checklist is designed for small public charities organized as nonprofit corporations. Charitable trusts, private foundations and supporting organizations should not rely on this checklist.

Governing Documents

Articles of Incorporation Were the articles of incorporation and all amendments filed with the proper state agency? Is the purpose clause consistent with the organization’s current (and planned) activities,

mission, and tax-status? Is the dissolution clause appropriate? If the articles state the organization has members, is it clear whether they have voting

rights? Are there any outdated provisions? (e.g., is the life of the corporation limited?)

Bylaws Do the bylaws accurately describe the organization’s current structure and operations? If the bylaws have a separate purpose clause, is it consistent with the purpose clause in

the articles of incorporation? Does the organization operate with the minimum required number of directors? Does the organization have all of the officers required by its bylaws? Does the organization maintain a list of the names, addresses and terms of office of all

officers and directors? Does the organization provide appropriate notice of board and committee meetings or

obtain waivers? Do the bylaws provide for a voting membership? If so, is the organization properly

tracking who is entitled to vote? Is the organization noticing and holding member meetings?

Are the bylaws consistent with current state law? Are there any unusual or outdated provisions? (e.g., are Roberts Rules incorporated by

reference?)

Policies and Procedures Does the organization have a conflict of interest policy? Does the policy cover officers,

directors, key employees, highly compensated employees, and those with substantial influence? Does it require disclosure of conflicts, recusal by interested persons, and decision by disinterested decision makers? Is it followed?



Does the organization have any contracts, agreements or other transactions with organization founders, officers, directors, key employees, substantial donors, their businesses or family members and/or anyone else in a position to influence the organization? If so, are the transactions with the organization: approved by the disinterested members of the board or an independent committee; based on appropriate comparability data; and concurrently documented in writing by the board or committee?

Does the board of directors annually review the performance of the organization’s chief executive?

Does the organization have a whistleblower policy? Is it followed? Does the organization have a document retention and destruction policy? Is it followed? Does the organization have a gift acceptance policy? Is it followed? Does the organization have a travel and expense reimbursement policy? Is it followed? What other types of policies and procedures does the organization have in place? Are the individuals to whom the organization’s policies and procedures are applicable

informed about such policies and procedures and have easy access to them? Is there a board orientation process? Are board members trained regarding their fiduciary duties, oversight responsibilities,

and the key laws that govern charities? Board Meetings and Minutes

Does the organization maintain a minute book? If so, do the minutes properly record attendance, key actions, votes and abstentions? If

not, how are board actions memorialized? Is a schedule of board (or member) meetings mandated and if so, are meetings noticed

and held in accordance with the bylaws? Is selection of directors and election of officers reflected in the minutes (and conducted as

set-forth in the bylaws)? Do the minutes reflect any conflict of interest transactions, and if so, are they properly

managed?

State Compliance

Annual Reports and Filings with the State

Is the organization in good standing with its state of domicile? Is the organization “doing business” in other states? If so, should it register to do business

as a foreign corporation? Should it obtain recognition of state tax-exemption in these other states?

If the state requires articles of incorporation to be published, have the articles and all amendments been published?

Are annual reports up to date?



Is the organization required to file periodically with the Secretary of State and/or Attorney General (e.g., annual registration in state of domicile, registration as foreign organization in other states, annual reports as charitably-soliciting organization)? If so, are all such filings up to date?

Statutory Agent Is the statutory agent listed with the state still at the address on file? If the statutory agent is a private individual, can the organization still rely on that person

to accept service of process and mail for the organization?

Tax Issues Tax-Exemption Issues

Does the organization understand its determination letter and its public charity status? Are the same confirmed by IRS website’s “select check function” (polling what had been Publication 78)?

If the determination letter is an advance ruling and the advance ruling date expired before June 9, 2008, has the organization filed Form 8734 with the IRS?

Is there a state exemption letter (if required)? Does the organization understand and comply with the prohibition against participating in

political campaigns for or against candidates for public office? Does the organization understand and comply with the requirement that all lobbying

activities must be an insubstantial part of the organization’s overall activities? Has the organization considered filing Form 5768 to make the 501(h) election, which provides for relatively generous lobbying expenditure limits without violating the prohibition against substantial lobbying?

If the organization receives revenues from regularly conducted business activities that are not related to its exempt purpose, does it correctly account, report and pay taxes on those funds; if not, has it qualified those activities as excepted from the unrelated business income tax?

Has the organization made any significant changes to its mission, programs, or primary sources of support that have not been reported to the IRS via Form 990/990-EZ?

Have changes to the governing documents been reported to the IRS via Form 990/990-EZ?

Tax Returns If the organization is required to file some form of Form 990, is the organization timely

filing annual notice, Form 990-N (or filing the Form 990-EZ or Form 990 annually)? If not, check IRS website’s “select check function” access of Publication 78 to determine whether the organization is still recognized as a tax-exempt entity.



Is the organization properly reporting its public charity status (i.e., the basis by which it self-asserts current qualification, which need not be that “ruled upon” via exemption determination letter or later requalification)?

Is the organization passing the public support test (if applicable)? Does the organization make its completed Application for Recognition of Tax-Exemption

Form 1023 available for public inspection (if filed after July 1987)? Does the organization make each filed Form 990, 990 EZ, 990-N and 990-T available for

public inspection for the required three year period of time? Is the organization properly reporting its lobbying, if any? If the organization pays directors or officers, is compensation properly reported, and did

the independent members of the board properly approve it? Does the organization timely file any state tax and/or information return required under

applicable state law?

Fundraising

Does the organization fulfill its state registration requirements? If the organization solicits donations in other states, is it complying with registration

requirements in those states? Does the organization appropriately acknowledge gifts of $250 or more in writing? If the organization provides goods or services of more than a nominal value to a donor

who makes a contribution in excess of $75, does it provide a good faith estimate of the fair market value such goods or services?

If the organization receives non-cash gifts, does it appropriately follow the IRS requirements for substantiation of such gifts?

If the organization participates in charitable sales promotions, is it and its partners complying with commercial co-venture laws in the states where the sales promotion is offered?

If the organization participates in raffles are the raffles compliant with state law?

Employees, Independent Contractors, and Volunteers

If the organization has workers, does it appropriately distinguish among employees, independent contractors, interns and volunteers?

Does the organization distinguish between exempt and non-exempt employees? (e.g., those employees that are exempt from federal and state wage and hour laws)

Does the organization verify all employees are eligible to work in the United States by requiring all employees to complete a Form I-9?



If the organization has employees, has it considered adopting an employee handbook describing employee hours, dress code, benefits, paid holidays, vacation policies, grievance procedures, review procedures, and other employment practices? If so, does the organization follow it?

Does the organization timely withhold and remit payroll taxes for its employees? Does the organization provide a From W-2 for employees and a Form 1099 for any

independent contractors paid more than $600 in a calendar year? Does the organization comply with state workers compensation and unemployment laws? If the organization has volunteers, does the organization have a volunteer handbook with

policies and procedures? If the organization works with vulnerable populations, does it perform background

checks on employees, independent contractors, and/or volunteers?

Intellectual Property

Has the organization taken reasonable steps to ensure that none of its intellectual property (including names, logos, web content, other written materials, and videos) infringes on the rights of another party?

Has the organization registered or otherwise obtained protection for any of its unique logos, or written materials or been appropriately advised that such protection is not necessary?

Does the organization allow third parties to use its logos, trademarks, and copyrighted materials? If so, has it considered entering into license agreements with third parties to use such materials?

Does the organization record video or take photos at its events? Does it obtain photo releases from subjects appearing in film or digital media?

Does the organization use the logos, trademarks and/or copyrighted materials of others? If so, does it obtain licenses or permission to use such materials?

Insurance and Risk Management

Does the organization have directors and officers insurance? Does the organization have general liability insurance? Does the organization have other necessary insurance? Does the organization require program participants to sign appropriate waivers and

releases? Has the organization developed and implemented, or considered developing and

implementing, appropriate risk management policies to protect the organization, its



directors and officers, employees, volunteers, agents, program participants, beneficiaries and visitors?





Chapter 3

Tax Considerations for Choice of Business EntitybeRit eveRhaRt

Arnold Gallagher PCEugene, Oregon

Contents

I. Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3–1

II. Overview of General Forms of Business Entities . . . . . . . . . . . . . . . . . . . . . . . . . . 3–1A. Sole Proprietorship . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3–1B. Partnerships . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3–1C. Corporations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3–2D. Limited Liability Company . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3–3

III. Comparison of Forms of Business Entities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3–4A. Legal Documentation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3–4B. Management and Control . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3–7C. Liability of Owners . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3–8D. Taxation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3–11E. Entity Taxation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3–12

IV. General Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3–29A. General Guidelines in Selecting Form of Entity . . . . . . . . . . . . . . . . . . . . . 3–29

Choices of Entities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3–35Chart—Sole Proprietorship . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3–36Chart—General Partnership . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3–37Chart—Limited Partnership . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3–38Chart—Limited Liability Partnership . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3–39Chart—Limited Liability Company . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3–40Chart—Corporation (or PC) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3–41

Presentation Slides . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3–43

Chapter 3—Tax Considerations for Choice of Business Entity




I. INTRODUCTION. These materials provide a general overview of the legal issues and considerations involved in selecting, forming, operating and maintaining the various types of business entities. The materials review the general characteristics of different business entities, compare the basic functions and characteristics of the different entities to provide a general understanding of each entity’s structure and purpose, and analyze common tax considerations that typically weigh into the entity selection process. II. OVERVIEW OF GENERAL FORMS OF BUSINESS ENTITIES. A. Sole Proprietorship. The sole proprietorship is a business owned and operated by a single person who individually owns the business assets. The business may or may not have employees. The owner or proprietor is entitled to the profits of the business, must bear its losses and is personally liable on an unlimited basis for its debts and obligations. B. Partnerships. 1. General Partnerships. Oregon general partnerships are governed by the Oregon Revised Partnership Act (the “Act”), which is ORS chapter 68. A general partnership is defined as (i) an association (ii) of two or more persons (iii) to carry on as co-owners (iv) a business (v) for profit. A partnership may be created by a written (preferred) or oral (not preferred) agreement, or may be implied by the conduct or acts of the parties (really not preferred). Provisions of the partnership not covered by agreement of the parties are governed by the Act. Partners generally share in management of the partnership and in its profits and losses. The partners are “jointly” liable for all partnership debts and obligations and are “jointly and severally” liable to third parties for acts or omissions of partners occurring in the ordinary course of partnership business. Under the “entity” and “aggregate” theories, a general partnership is either a separate legal entity or simply the aggregate of the individual partners. Generally, a partnership is treated as a separate entity which may own assets, operate a business and sue or be sued. However, for income tax purposes, a partnership is not a taxpayer. Instead, it is a funnel through which its income and deductions are channeled to the partners who individually recognize the partnership’s income, gain, losses, deductions and credits. The partnership simply files an informational income tax return with the IRS. Subject to certain exceptions (like disguised sales or mixing bowl transactions, discussed below), there is generally no gain recognized by the partnership or the partners on appreciated assets distributed from the partnership to partners. 2. Limited Partnerships. A limited partnership is governed by ORS chapter 70. A limited partnership is (i) a partnership (ii) of two or more persons (iii) having one or more general partners and (iv) one or more limited partners. As in a general partnership, the general partners in a limited partnership share in the operation and management of the partnership and



are jointly liable for all partnership debts and obligations and jointly and severally liable to third parties for acts and omissions of the general partners occurring in the ordinary course of the partnership’s business. A limited partner is generally not liable for the obligations of the limited partnership beyond the limited partners’ agreed upon partnership contribution. To retain limited liability, the limited partner must not take part in the control of the partnership business nor permit his or her name to be used in the partnership’s name unless the creditors have actual knowledge that he or she is a limited partner. For income tax purposes, a limited partnership is taxed in generally the same manner as a general partnership. 3. Limited Liability Partnerships. A limited liability partnership (LLP) is a partnership for which the liability of partners is limited in certain aspects. LLPs are governed by the law applicable to general partnerships except to the extent modified by the LLP statutory provisions. General partnerships that render professional services (e.g., medical services, accounting services, legal services, dental services) and their affiliates may register with the Oregon Secretary of State as LLPs. For income tax purposes, generally speaking, an LLP is taxed in the same manner as a general partnership.

C. Corporations.

1. C Corporations. A corporation is a separate legal entity created by law. ORS chapter 60, the Oregon Business Corporation Act (the “Act”), and the corporation’s articles of incorporation written in conformance with the Act and filed with the state, give the corporation its powers and rights. Because it is a separate entity, the corporation can acquire, hold and convey property. Likewise, a corporation can sue or be sued. Also, unlike a partnership, a C corporation is a separate taxable entity. The corporation computes its profits and losses and pays taxes. Thus, shareholders (the owners) of a C corporation are not taxed on corporate profits and cannot deduct corporate losses on their individual income tax returns. Any corporate profits distributed to the shareholders as dividends are recognized as taxable income by the shareholders and are not deductible to the corporation. However, unlike partnership-taxed entities, appreciated assets distributed from a corporation to shareholders generate a corporate level income tax.

A corporation is owned by one or more shareholders or stockholders. For the most part, the rights of the shareholders to manage the corporation are limited to the election of the board of directors. The board of directors establishes policies, determines the amount and timing of distributions (that is, dividends) to shareholders and appoints the corporate officers. The corporate officers are responsible for the day-to-day operation of the corporate business.

A shareholder has limited liability. Unless a shareholder agrees with creditors that the shareholder will be liable for corporate obligations, the shareholder is generally not liable for the corporation's debts and obligations.



2. S Corporations. An S corporation is a creation of federal and state income tax laws and, except for taxation, is similar to a C corporation. An S corporation is generally not treated as a separate taxable entity, but is a conduit which merely files an informational income tax return with the IRS. For income tax purposes, the shareholders are much like partners who individually recognize the corporation’s income, gains, losses, deductions and credits. However, there are limitations to the number (i.e., 100) and type (i.e., generally, individuals who are U.S. citizens or residents and certain trusts) of shareholders who can own stock in an S corporation. Further, an S corporation cannot have more than one class of stock, which means that profits/losses and cash distributions must be allocated strictly based on the number of shares owned.

3. Professional Corporations. The professional corporation itself, like any

other corporation, is a separate legal entity. The Oregon Professional Corporation Act, ORS chapter 58, governs the formation and operation of professional corporations. One of the primary distinctions between a non-professional corporation and a professional corporation lies in the limited liability feature. Under Oregon law, a professional who incorporates continues to be liable for his or her own negligence and wrongful acts and for the negligence and wrongful acts of other shareholders in rendering professional services, but the professional shareholder is not personally liable for other tort claims or contract actions. Thus, limited liability is an advantage of the professional corporation, even though the limited liability has some restrictions.

A professional corporation may be either a C corporation or an S corporation.

Historically, however, S corporations have not been used in the professional corporation situation. This is probably due to the fact that S corporations were subject to restrictive retirement plan contribution limitations and that various tax benefits available in a C corporation context that were not available in the S corporation context. Due to changes in the tax laws to eliminate, or reduce to a great degree, these discrepancies, the use of the S corporation in the professional corporation setting is becoming more prevalent.

D. Limited Liability Company. A limited liability company (“LLC”) is a cross

between a partnership and a corporation. If the LLC has more than one owner (called a “member”), then the entity and its members are taxed as if the entity were a partnership, unless an election is made for the LLC to be taxed as a corporation. If the LLC has only one member, then the LLC is taxed as if the entity were a sole proprietorship, unless an election is made for the LLC to be taxed as a corporation.

The members may actively participate in the management of the business while retaining

limited liability for its obligations. If the members choose not to manage the company’s business, they can elect “managers.” Like a corporation’s board of directors or officers, managers may be members or nonmembers and will direct and control company operations.



III. COMPARISON OF FORMS OF BUSINESS ENTITIES.

A. Legal Documentation.

1. Sole Proprietorship. A sole proprietorship requires no legal documentation for formation and is required to prepare and file relatively few reports. Federal and state tax returns and reports regarding employees are the main reporting requirements for a sole proprietorship. Since the assets of the business are owned by the sole proprietor, no federal or state tax return is filed for the business. Profits and losses are reported Form 1040, Schedule C of the owner’s return. In addition, if the sole proprietorship is operated under an assumed business name, that name must be registered with the Secretary of State and a report filed every other year to assure continuance of the name's registration.

2. General Partnership. General partnerships are required to file the same reports that sole proprietorships must file relating to their employees. In addition, the partnership must file an informational income tax return, which is in addition to the individual tax returns filed by the partners. Also, the partnership usually is operated under an assumed business name, and that name must be registered with the Secretary of State and renewed every other year.

Although there are no statutory requirements regarding the maintenance of books

and records for partnerships, the partnership agreement should require that the partnership maintain adequate records and books of account in accordance with generally accepted accounting principles. Additionally, it is common for the partnership agreement to require that annual financial statements of the partnership be prepared, including a balance sheet, a profit and loss statement, and such supporting statements as the partners from time to time deem relevant. If any special allocations will be made, to be respected, the partnership will need to maintain separate capital accounts for each partner in accordance with Treasury Regulation § 1.704-1 and comply with the “general economic effect” rules.

If any of the general partners are not actively engaged in the management or

operation of the partnership, there may be Securities Act filing obligations. 3. Limited Partnership. A limited partnership requires one additional filing

from those required of a general partnership. A certificate of limited partnership must be filed with the Secretary of State. The certificate includes, among other things, the name of the limited partnership, so that no assumed business name filing is necessary. As with the general partnership, a limited partnership may have Securities Act filing obligations. Also, though there is no statutory requirement that the partnership maintain books and records, the limited partnership agreement will contain provisions similar to those discussed above in connection with general partnerships concerning the maintenance of records. 4. Limited Liability Partnership. As mentioned, registration under the LLP statute is limited to professional partnerships and their affiliates. The word “professional” includes accountants, attorneys, chiropractors, dentists, landscape architects, naturopaths, nurse



practitioners, psychologists, physicians, podiatrists, radiologic technologists and real estate appraisers. Any eligible general partnership may register as a limited liability partnership. A limited partnership may not register as an LLP. A partnership may become a limited liability partnership by delivering an application for registration to the office of the Secretary of State for filing on appropriate forms. The LLP registration is perpetual, subject only to cancellation or administrative revocation. An LLP is required under Oregon law to file an annual report with the Oregon Secretary of State. The annual report must be filed each year not later than the anniversary date that the LLP registration was effective. The Secretary of State may commence a proceeding to administratively revoke the registration of an LLP if the LLP does not deliver its annual report or pay the correct fees when due.

5. Corporation. Like sole proprietorships and partnerships, a corporation must maintain reports regarding its employees. In addition, the corporation must make numerous other filings. First, a corporation must file its articles of incorporation and an annual report with the Secretary of State. At the start-up of the corporation, the incorporator or the board of directors must also adopt corporate bylaws to establish the structure of management of the business. Moreover, as mentioned previously, a corporation is required to file its own federal and state income tax returns. In addition, a qualified S corporation must elect S corporation status by filing its election with the appropriate IRS center.

Generally speaking, a corporation must make certain filings and maintain the following books and records:

a. A corporation must file its articles of incorporation and an annual report

with the Secretary of State, as well as any amendments to the articles of incorporation. b. At the start-up of a corporation, the incorporator or the board of directors

must adopt corporation bylaws to establish the structured of management of the business. c. A corporation is required to file its own federal and state income tax

returns, although an S corporation files an informational income tax return like a partnership. In addition, a qualified S corporation must elect S corporation status by filing its election with the appropriate IRS center in a timely manner. An S corporation is formed, in most instances, in the same manner as a C corporation, with the exception of the S election.

d. It is necessary for a corporation to maintain corporation and accounting

records for the benefit of shareholders and directors. Lending institutions and others who deal with the corporation may require that the corporation certify minutes and resolutions to assure that management has duly delegated the authority necessary to make a particular transaction.

e. Public corporations, or corporations with stocks that otherwise meet the

requirement for filing under the state or federal securities laws, must submit registrations and an annual report, as must their officers, directors and, in some instances, shareholders.



f. Under ORS 60.771, each corporation is required to maintain the following records in written form or in another form capable of conversion into a written form without a reasonable time:

i. Minutes of all meetings of shareholders and board of directors, a

record of all actions taken by the shareholders or board of directors without a meeting and a record of all actions taken by a committee of the board of directors in place of the board of directors on behalf of the corporation.

ii. Appropriate accounting records. These records help protect

against the piercing of the corporate veil. iii. A record of shareholders in a form that permits preparation of a list

and the names and addresses of all shareholders in alphabetical order by class of shares, showing the number and class of shares held by each.

iv. A copy of the following records at the corporation’s principal

office or registered office: (A) Articles of restated articles of incorporation and all amendments

thereto; (B) Bylaws or restated bylaws and all amendments thereto; (C) Resolutions adopted by the corporation’s board of directors

creating one or more classes or series of shares and fixing their relative rights, preferences and limitations, if shares issued pursuant to those resolutions are outstanding;

(D) The minutes of all shareholder meetings and records of all action

taken by the shareholders without a meeting for the past three years; (E) All written communications to shareholders generally within the

past three years; (F) A list of the names and business addresses of current directors and

officers; and (G) The most recent annual report.

6. Limited Liability Company. Like all other business entities, limited liability companies must maintain reports regarding their employees. In addition, the LLC must file articles of organization and an annual report with the Secretary of State. At the start-up of the limited liability company, the organizer, manager or member(s) must also adopt an operating agreement to provide for the regulation and management of the affairs of the limited liability company. The company must also file an informational federal and state income tax return.



Under ORS 63.771, an LLC is required to keep the following records at its registered office or another office designated in the operating agreement: a. A list of the name and last-known business, residence or mailing address of each member and manager; b. A copy of the articles of organization and all amendments thereto, together with any executed copies of any powers of attorney pursuant to which any amendment has been executed; c. Copies of the LLC’s federal, state and local income tax returns and reports, if any, for the three most recent years; d. Copies of any currently effective written operating agreements and all amendments thereto; e. Copies of any financial statements of the LLC for the three most recent years; f. Minutes of any meeting of members or managers; g. Unless contained in a written operating agreement or other writing, a statement prepared and certified as accurate by a manager or member of the LLC describing the amount of cash and including a description and statement of the agreed value of other property or services contributed by each member in which each member has agreed to contribute in the future, the times at which or events on the occurrence of which any additional contributions agreed to be made by each member are to be made and, if agreed upon the time at which or the events on the occurrence of which the LLC is dissolved and its affairs wound up; and h. Any written consent resolutions of the members or managers. In addition, the operating agreement will require that the company keep adequate records and books of account and maintain them in accordance with generally accepted or sound accounting principles. These records commonly consist of annual financial statements, including a balance sheet, a profit and loss statement, and such supporting statements as the members deem relevant. Maintenance of records is necessary to help ensure the limited liability feature of the LLC.

B. Management and Control.

1. Sole Proprietorship. Because there is only one owner in a sole

proprietorship, the owner has absolute control and management over the business.

2. General Partnership. Each partner is entitled to share equally in the management and business decisions of a partnership regardless of the size of the partner's



specific interest. Further, Oregon law gives equal voting power to each of the partners in order to resolve disputes. So in essence, control and management is shared equally among the partners. However, the partners may agree among themselves to alter the statutory provisions regarding management. For instance, the partners may select a managing partner or committee, or may allocate voting power based on percentage of ownership. The partnership agreement is controlling. These same rules apply to LLPs.

3. Limited Partnership. General partners in a limited partnership have control of the partnership, and essentially make all of the partnership's business decisions. A limited partner is restricted to inspecting partnership records and obtaining reasonable information about the partnership unless the partnership agreement provides otherwise. A limited partner who participates in the partnership may be deemed a general partner and lose the protection of limited liability.

4. Corporation. In a corporation, control and management are actually separate functions. Day-to-day business decisions (management) of the corporation are made by the officers. The officers are appointed by and are subject to the direction of the board of directors. The board of directors oversees the management of the corporation and establishes corporate policies. The shareholders elect the board of directors, with each shareholder having a vote equal to his or her interest in the corporation; therefore, the shareholders have actual "control" of the corporation.

In many small, closely-held corporations, the separation of management and control is simply a matter of form: the same person or group of people serve as shareholders, directors and officers of the corporation.

5. Limited Liability Company. The control and management of a limited

liability company rests with its members unless the members elect to have the business managed by a manager or managers. Such election, if any, must be set forth in the articles of organization and should be reflected in the operating agreement.

C. Liability of Owners.

1. Sole Proprietor. The sole proprietor is personally liable for all obligations

arising out of the business, and thus places his or her personal assets at the risk of the business.

2. General Partner. Like a sole proprietor, a general partner in either a general or limited partnership is personally liable for the obligations arising out of the business if the partnership assets are not sufficient to satisfy the partnership liabilities. However, unlike a sole proprietor, a general partner is liable for the acts of his or her partner(s) as well as himself or herself, and therefore is financially exposed beyond his/her own acts. In addition, a partner has unlimited personal liability for the obligations of the partnership regardless of his/her percentage interest in the partnership. Therefore, a general partner is exposed to a greater liability than someone who invests in a business as either a limited partner, a member of a limited liability company, or as a corporate shareholder.



3. Partner of an LLP. Partners in an LLP who are professionals remain directly liable for their own negligent or wrongful acts or omissions or misconduct in the same manner as shareholders of a professional corporation. This means that the partners are liable for their own professional negligence and are jointly and severally liable for professional services rendered on behalf of the professional practice, up to an annual maximum amount of $300,000.00 per licensed Oregon professional with an aggregate limited of $2,000,000.00 for the professional partnership. For LLPs with fewer than seven licensed Oregon partners, the maximum aggregate liability is $300,000.00 multiplied by the number of licensed Oregon professionals. For liabilities unrelated to the professional practice, such as offices leases and tort claims arising from circumstances unrelated to the professional practice, the partners have limited liability.

4. Limited Partner. A limited partner’s liability is limited to the amount that the limited partner originally contributed to the partnership, unless he or she has expressly agreed to be liable for an additional amount. A limited partner will lose the limited liability if he or she is either a general partner or takes part in the control of the business.

5. Non-professional Corporate Shareholder. With few exceptions, a

shareholder’s liability is limited to the shareholder’s investment in the business. However, and as mentioned previously, particularly with regard to small, closely-held corporations, creditors usually require that the shareholders personally guarantee debts of the corporation. In that instance, the shareholder has given up the limitation on his or her liability.

6. Professional Corporate Shareholder. In the rendering of professional

services on behalf of a professional corporation, a shareholder of the corporation is personally liable “as if the shareholder were rendering the service or services as an individual, only for negligent or wrongful acts or omissions or misconduct committed by the shareholder, or by a person under the direct supervision and control of the shareholder.” ORS 58.185(3). As with LLPs, liability for professional malpractice is limited to a yearly cap of $300,000.00 for joint and several liability for all claims made against a single shareholder of a professional corporation during a single year. Also, a $2,000,000.00 cap exists for joint and several liability for a single claim made against all shareholders during a calendar year. If the number of shareholders multiplied by $300,000.00 equals an amount that is less than $2,000,000.00, the total joint and several liability for a single claim made against all shareholders of the corporation cannot exceed an amount equal to $300,000.00 multiplied by the number of shareholders. These amounts are subject to adjustment for inflation every six years. The professional corporation shareholders have limited liability for corporate obligations, such as office leases and tort claims, arising from circumstances unrelated to the professional practice.

7. Limited Liability Company Member. Members of a limited liability company are not personally liable for the obligations of the business. As a result, like shareholders of a closely held corporation, members of a closely held LLC are usually required to personally guarantee the obligations of the company by creditors and thereby forfeit the limits on his or her liability. Managers of an LLC are not exposed to personal liability by reason of serving as a manager. It should be noted that for LLCs providing professional services, member



liability for professional malpractice is the same as for partners in an LLP and shareholders of a professional corporation.

8. Down-Stream Liability. Down-stream liability refers to a creditor’s ability

to attack a person’s ownership interest in a corporation, general partnership, limited partnership, limited liability partnership or limited liability company in satisfaction of the person’s personal debts/liabilities. For example, assume that Ann and Bill own a successful corporation. Ann owns 51% of the issued and outstanding stock and Bill owns 49%. Although Ann is a highly successful business woman, she has a gambling problem and has personally received loaned money from various creditors, including Charlie. Ann defaults on her loan to Charlie, who sues and in turn obtains a judgment against Ann. Charlie forecloses on the judgment and obtains ownership of Ann’s 51% of the shares. Charlie is not interested in running Ann’s business. He just wants his money and as the majority shareholder decides to sell the business to a competitor at a discount. A creditor’s ability to attack a person’s ownership interest depends on the type of entity and associated protections afforded by law or contract.

a. Corporations. Share ownership in corporations is not protected

from creditors by statute (except professional corporations - generally, ownership in professional corporations is limited to licensed professionals.). However, shareholders can contractually agree among themselves to limit transfers of ownership (including transfers to creditors) through shareholder agreements generally known as “buy-sell” agreements. As a general matter, these agreements provide that if shares are transferred to a creditor, the remaining shareholders or the corporation has the right to purchase/redeem those shares for the lesser of the fair market value or debt owed. If Ann and Bill had such an agreement, then Bill may be in luck. If not, then Bill will be looking for a new job.

b. Limited Liability Companies. A judgment creditor may obtain a

charging interest in the member’s ownership interest in the limited liability company. The creditor obtains the rights of an assignee to the extent charged. An assignee has the right to receive and retain, to the extent assigned (i.e., charged), the distributions, as and when made, and allocations of profits and losses to which the assignor would be entitled. However, an assignee does not have the right to participate in the management of the company unless and until accepted as a member. If not stated in the operating agreement, an assignee will become a member upon a majority vote of the members other than the assignor. If Ann and Bill had been owners in a limited liability company, Charlie would have obtained a charging interest in Ann’s ownership to the extent of the debt owed to Charlie. Once that debt was satisfied (e.g., through distributions), then Charlie’s interest would be discharged and ownership would revert to Ann. During the time Charlie had the charging interest, Ann would retain the right to vote and act on her ownership interest. Oftentimes, the operating agreement will provide that a transfer of a member’s interest to a creditor results in a withdrawal or disassociation of that members interest, which forces a buyout by the Company or remaining members of the withdrawing or disassociating member’s interest.

c. General Partnerships and Limited Liability Partnerships. A

judgment creditor may obtain a charging interest in the transferable interest of a partner in the



partnership. The court may order a foreclosure of the interest subject to the charging order at any time. The purchaser at the foreclosure sale has all of the rights of the transferee. At any time prior to the foreclosure sale, the charging order may be redeemed by the judgment debtor, by one or more of the other partners with property (other than partnership property) or by one or more of the other partners using partnership property with the consent of all partners whose interests are not charged. If Ann and Bill were partners in a limited liability partnership, then Charlie would obtain a charging interest in Ann’s partnership interest. Either Ann or Bill could redeem that charging interest before foreclosure. If the interest were foreclosed, Charlie would step into the shoes of Ann entirely. At that point, Charlie could once again force a sale of the partnership. A limited liability partnership offers Ann and Bill more protection than a corporation (without a buy-sell agreement) but not as much protection as a limited liability company.

d. Limited Partnerships. A judgment creditor may obtain a charging

interest against the partnership interest of the debtor partner. The judgment creditor has only the rights of an assignee to the extent the interest is charged. An assignee may become a limited partner, if and to the extent that the assignor gives the assignee that right in accordance with the partnership agreement or all other partners consent.

D. Taxation.

1. Types of Tax. a. Income Tax. An entity may be subject to federal and state income tax, depending on the type of entity, the state of organization and where it does business. How and when the income is taxed depends on what type of entity is involved. The income taxation of various entity types is discussed more specifically below in each section designated to that entity. b. Social Security and Unemployment Taxes. i. Social Security Taxes. Social Security taxes are collected on employment wages and are paid by employers, employees and self-employed individuals. These taxes are paid pursuant to the Federal Insurance Contributions Act (FICA) or the Self-Employment Contributions Act (SECA). The payments made under FICA and SECA fall into two categories.

(A) Old-Age, Survivor and Disability Insurance (OASDI) funds are used to pay retirement and disability benefits. The rate currently for OASDI is 6.2% for the employer and 6.2% for the employee (12.4% combined and for the self-employed). However, the employment wages subject to the OASDI portion of FICA and SECA obligations is limited to the taxable wage base defined in section 3121. The taxable wage base is an employee’s earnings, less certain very limited deductions, and is capped at $118,500 for 2015.

(B) Hospital Insurance (HI) taxes are used to pay medical expenses for

elderly and disabled individuals. The HI rate is 1.45% and not subject to any



wage cap. Like its OASDI counterpart, the 1.45% HI tax is paid by both an employer and employee or both halves (totaling 2.9%) are paid by a self-employed individual. An additional 0.9% tax is added on earned income exceeding $200,000 for individuals and $250,000 for married couples filing jointly.

ii. Unemployment Taxes. Unemployment taxes are paid by employers pursuant to the Federal Unemployment Tax Act (FUTA). FUTA taxes are paid at the rate of 6.2% on the first $7,000 of wages paid to each employee, subject to a credit for state unemployment tax paid up to 5.4%.

E. Entity Taxation.

Tax is often the tail that wags the dog when deciding what type of entity to employ or how to structure certain transactions. Each type of entity available for use has its own characteristics. Some are shared and some are unique. This section will discuss the basic elements of several common types of business entities from a taxation perspective.

1. Sole Proprietorship. A sole proprietorship is not a legal entity. It is a business conducted by an individual with no co-owners and as such is not distinguished or recognized as an entity separate from the individual.

TAX CHARACTERISTICS:

• All items of income and deductions are recognized directly by the proprietor on his or her personal tax return.

• Subject to income tax and self-employment tax.

• Tax-free creation.

2. General Partnership. A general partnership is an entity/aggregation of individuals who carry on a business for profit. A general partnership offers no liability protection and each partner is personally liable for the debts and obligations of the partnership.


• Tax-free creation under section 721(a) for transfers of “property” to a partnership in exchange for partnership interest; but note exception in section 721(b) for transfer of property to “investment company” (which prevents taxpayers from diversifying their investment portfolios tax free); no control requirement for tax-free treatment under section 721(a).

• “Property” is not defined in the tax code, but the courts have been guided by the interpretation of the term under section 351, the counterpart of section 721 in the



corporate area, which provides that “property” includes cash, inventory, accounts receivable, patents, installment obligations and other intangibles such as goodwill and industrial know-how; does not include the performance of services for the partnership.

• A partner’s basis in her partnership interest is referred to as the “outside basis.” A partnership’s basis in its assets is referred to as the “inside” basis. These terms are used to distinguish between the partner’s and the partnership’s bases. On a contribution of property in exchange for a partnership interest, a partner’s outside basis under section 722 is equal to the sum of the money and the adjusted bases of property contributed to the partnership. Under section 723, the partnership’s inside basis is equal to the basis the contributing partner had in the property.

• Because a partnership is treated as an aggregate of its individual partners for purposes of taxing its income, the tax code adopts aggregate principles to determine the impact of partnership liabilities on the partners and their outside bases. Under section 752(a), an increase in a partner’s share of partnership liabilities is considered a contribution of money which increases the partner’s outside basis under section 722. A decrease in a partner’s share of partnership liabilities is considered under section 752(b) to be a distribution of money to the partner which decreases the partner’s outside basis (but not below zero). If a decrease in a partner’s share of partnership liabilities exceeds the partner’s outside basis, the partner must recognize the excess as capital gain from the sale or exchange of a partnership interest under sections 731(a)(1) and 741.

Example: X, Y and Z each contribute $50,000 cash to form the XYZ partnership and agree to share all partnership profits and losses equally. XYZ purchases a piece of investment real estate for $180,000, paying $60,000 cash and giving the seller a $120,000 purchase money note secured by the real estate. No partner is personally liable for the note. The purchase money obligation is a nonrecourse liability of the partnership which will be shared equally by the partners, because they have equal interests in partnership profits. X, Y and Z will be treated as if they contributed $40,000 each to XYZ under section 752(a) to reflect the increase in their share of partnership liabilities (from 0 to $40,000). As a result, each partner’s outside basis will be $90,000 under section 722.

• If property is contributed by a partner to a partnership and the property is subject to a liability, the partnership is considered to have assumed the liability to the extent it does not exceed the fair market value of the property at the time of contribution.

Example: Z contributes property with a $1,500 adjusted basis to a general partnership for a 25% interest in the partnership, which results in Z receiving an outside basis of $1,500. The property is subject to a $2,000 nonrecourse liability and has a fair market value of $5,000. The partnership is considered to have assumed the liability and Z’s individual liabilities are considered to have decreased by $2,000, which is a deemed cash distribution under section 752(b). There is no corresponding increase in Z’s share of partnership liabilities, which results in a net change in Z’s individual and partnership liabilities being a decrease of $2,000. In this



case, Z’s outside basis will be reduced from $1,500 to zero under section 752(b) and Z will recognize $500 of capital gain ($2,000 liability relief - $1,500 basis).

• A partner’s outside basis is increased and decreased based on partnership activities. Under section 702, a partner is taxed directly on his distributive share of partnership income or loss. Section 705 adjusts the partner’s outside basis to reflect these results. In general, a partner must increase his outside basis by his distributive share of partnership taxable income and tax-exempt income and decrease it (but not below zero) by partnership distributions, as provided in section 733, and his distributive share of partnership losses and expenditures.

Example: Partner X has a $1,000 outside basis in her partnership interest and her distributive share of partnership income for the year is $4,000. The partnership income passes through to X and is reported on her personal tax return. Under section 705, her outside basis will be increased to $5,000 ($1,000 plus $4,000). If the partnership distributed $3,000 of cash to X at the end of the year, her outside basis would be reduced to $2,000 by the distribution.

• There is no tax imposed on the partnership as an entity, so it is what is known as a pass-through entity for income tax purposes.

• The partnership is required file an IRS Form 1065, as are all types of partnerships, but isn’t itself liable for any income tax.

• The partners will report their appropriate portion of all partnership income and deduction items, which are provided to them on a Schedule K-1, on their individual returns.

• Profits and losses may be allocated among the partners in any way desired, as long as they have “substantial economic effect,” as defined in section 704(b).

• To have “economic effect,” an allocation must be consistent with the underlying economic arrangement of the partners. The treasury regulations use a three-part test to determine whether an allocation is consistent with the underlying economic arrangement of the partners. This basic test is backed up by other tests which, if satisfied, can validate an allocation.

• The “basic test” generally provides that an allocation will have economic effect if, throughout the full term of the partnership, the partnership agreement provides for proper maintenance of the partners’ capital accounts, that upon liquidation of the partnership liquidating distributions will be made in accordance with positive capital account balances of the partners and that a partner will be unconditionally obligated to restore any deficit capital account balance.

• Under the “alternate test” for economic effect, an allocation will be respected if capital accounts are appropriately maintained and liquidating distributions are made in accordance with positive capital account balances, provided that the allocation does not cause or increase a deficit in the partner’s capital account. The partnership agreement



must contain a “qualified income offset,” which requires that if a partner has a deficit capital account balance as a result of certain events that partner will be allocated items of income or gain in an amount and manner sufficient to eliminate the deficit as quickly as possible.

• In general, the capital account of each partner is increased by (i) the amount of money contributed by the partner; (ii) the fair market value of property contributed by the partner (net of secured liabilities); and (iii) allocations to the partner of partnership income or gain (including tax-exempt income); and decreased by (i) the amount of money distributed to the partner; (ii) the fair market value of property distributed to the partner (net of secured liabilities); and (iii) allocations to the partner of partnership losses. Although these calculations are similar to the rules for determining and adjusting a partner’s outside basis, it should be noted that, with respect to capital account maintenance, contributions and distributions of property are accounted for at fair market value, rather than basis.

Example: A and B form a general partnership, with A contributing $30,000 cash and B contributing GreenAcre valued at $30,000 and with a $10,000 basis. Immediately after the formation of the partnership, A’s outside basis is $30,000 and her capital account is $30,000. B’s capital account is also $30,000, but his outside basis is $10,000.

• In addition to meeting the economic effect requirements, in order to be respected, an allocation must be “substantial,” which requires that there be a reasonable possibility that the allocation will affect substantially the dollar amounts to be received by the partners from the partnership, independent of tax consequences.

• Loss limited to outside basis under section 704(d); this basis includes partnership debt allocated to partner under section 752.

• Generally, the at-risk rules of section 465 and the passive activity rules of section 469 apply at the partner level.

• Under section 465, a partner’s share of partnership losses and deductions is limited to his amount “at risk.” The at-risk limitation is applied on a partner-by-partner basis. Under section 465, generally speaking, a partner is initially considered “at risk” to the extent of cash contributions to the partnership, the adjusted basis of property contributed to the partnership, and amounts borrowed for use in the activity for which the partner is personally liable or has pledged property as security to the extent of the property’s fair market value.

• Under section 469, a taxpayer’s passive activity loss for the year is disallowed. The purpose of section 469 is to prevent taxpayers from using losses from passive activities to offset salary and investment income. The limitation is applied on a partner-by-partner basis, not at the partnership level. The taxpayer’s “passive activity loss” is the amount by which her aggregate losses from all passive activities exceed her aggregate income from such activities.



• Self-employment tax applies to partners, subject to real estate rent and gain on sale exception.

• Pure profits interest issued to partner for services is not presently taxable, unless tradeable, tied to securities or stream of income or disposed of within 2 years; capital interest subject to taxation if issued for services; split of authority on tax impact on partnership if capital interest is issued for services, which could result in gain recognition at partnership level (and flow-through to partners).

• A partner may acquire an interest in partnership capital or profits as compensation for services performed or to be performed. A partnership capital interest is one that entitles the partner to a share of the proceeds if the partnership’s assets are sold at fair market value and the proceeds are then distributed in a complete liquidation of the partnership. A partnership profits interest is a partnership interest that is not a capital interest. It could be an interest in the future profits of the partnership, an interest in the appreciation of the value of the partnership, or some other type of interest. The key distinguishing characteristic between a capital interest and a profits interest is whether the partner acquiring such interest would be entitled to a portion of the proceeds that would exist if the partnership liquidated the moment after the partner obtained the interest.

• Historically, a partner has not been taxed upon the receipt of a profits interest in a partnership, and the partnership has not been able to claim any deduction upon the grant of a profits interest. See Revenue Procedure 93-27; Revenue Procedure 2001-43. In Notice 2005-43, the IRS announced plans to propose regulations that add additional complexities and reporting requirements for the issuance of a profits interest in a partnership in exchange for services. To date, the regulations remain proposed and are not in effect.

• If the partner acquires an interest in partnership capital, the receipt of the capital interest is (i) taxable to the partner and (ii) deductible to the partnership. In other words, it is as if the partnership paid the partner an amount equal to the fair market value of the partnership interest, and the partner then contributed the amount back to the partnership in exchange for the partnership interest. Also, the partnership may be required to recognize gain inherent in a portion of its assets.

• Under the majority view, a partnership that transfers a capital interest for services is treated as transferring an undivided interest in each of its assets to the service partner in a taxable transaction and must recognize any gain or loss inherent in the transferred portion of each asset. The service partner is then treated as re-transferring the assets back to the partnership in a tax-free, section 721 transaction. A few commentators believe that the transfer of a capital interest for services should not be a taxable event to the partnership, noting by analogy that a corporation does not recognize gain when it issues stock as compensation for services.



Example: The AB general partnership has $150,000 of assets, consisting solely of land used in AB’s business (which has a $120,000 value and a $60,000 adjusted basis) and $30,000 of cash. In connection with the issuance of a one-third capital interest to C for services, AB will be entitled to a $50,000 deduction, assuming C’s services qualify as ordinary and necessary business expenses. AB will be viewed as having transferred 1/3 of its land ($40,000 fair market value, $20,000 adjusted basis) and cash ($10,000) to C for services and must recognize $20,000 of gain on the land. The 1/3 interest in the land and cash is then deemed to be transferred back to AB by C, who takes a $50,000 outside basis in her partnership interest and has a $50,000 capital account. The land would now have an $80,000 inside basis ($40,000 basis in the 2/3 interest which remained in the partnership plus $40,000 in the 1/3 interest deemed transferred by C). The $20,000 gain and $50,000 deduction should be allocated to partners A and B, because the appreciation in the land took place before C became a partner and A and B paid for C’s services with their partnership capital. The remaining $40,000 of gain in the land should be taxable to A and B when the land is sold since that gain represents the appreciation prior to C’s entry into the partnership.

• Distributions of previously taxed earnings are not taxable. Gain is recognized on cash distributed in excess of basis under section 731. Generally, no gain or loss is recognized on property distribution (subject to disguised sale, mixing bowl or section 751 hot asset transactions). Debt-shift treated as cash distribution under section 752,

Example: A’s outside basis in the partnership is $10,000. If the partnership distributes $4,000 cash to A in a pro rata distribution to all partners, he will not recognize any gain or loss and his outside basis will be reduced to $6,000. If, instead, the partnership distributed $13,000 cash to A, he would recognize $3,000 of gain from the sale or exchange of his partnership interest and his outside basis would be reduced to zero. The results would be the same if, under section 752(b), the $13,000 distribution resulted from a $13,000 decrease and A’s share of partnership liabilities.

• Section 751 is designed to prevent shifts of ordinary income and capital gain among the partners through property distributions. Generally, it provides that if a partner receives in a distribution (1) “unrealized receivables” or “substantially appreciated inventory” in exchange for some or all of her interest in other partnership property (including money), or (2) other property (including money) of the partnership in exchange for some or all of her interest in the partnerships section 751 property (that is, unrealized receivables or substantially appreciated inventory), then the distribution is to be treated as a sale or exchange of the section 751 property between the partner and the partnership.

• “Mixing bowl transactions” are generally described as an income-shifting strategy that involves a partner first transferring appreciated property to a partnership and the partnership later either distributing the contributed property to another partner or distributing other property to the contributing partner. The objective is to shift or defer the recognition of the contributing partner’s precontribution gain by exploiting the non-recognition rules for contributions to a partnership (section 721) and distributions by a partnership (section 731). Under section 704(c)(1)(B), if property contributed by a



partner is distributed to another partner within seven years of its contribution, the contributing partner must recognize the pre-contribution gain inherent in the property at the time of the contribution. Under section 737, a contributing partner must recognize gain if she contributes appreciated property to a partnership and within seven years of the contribution receives property other than money as a distribution from the partnership.

• Section 707(a)(2)(B) is the disguised sale rule that is designed to prevent sales of property between a partner and partnership from being structured as nontaxable contributions and distributions under section 721 and 731. In general, if there are direct or indirect transfers of money and property between a partner and a partnership and the transfers, when viewed together, are properly characterized as a sale or exchange of property, then the transfers are to be treated as a sale or exchange between the partner and the partnership (or between two partners).

• Distributions need not be pro rata based on ownership percentages; priority distributions, preferred returns and other disproportionate distributions are allowed.

• Tax year is that of a majority of the partners (usually calendar year).

• Tax-free reorganization is not applicable (only corporations under section 368).

• With respect to the sale of a partnership interest by partner, generally capital gain treatment under section 741, except for “hot assets” under section 751 (A/R, inventory), and buyer acquires partnership interest with a cost basis; ordinary income on certain redemption payments under section 736 (depends on whether partnership is services partnership or asset partnership); possible termination of entity under section 708 if more than 50% interest sold or exchanged within 12-month period; need to address interim/part-year tax allocations; possible step-up of buyer inside basis on section 754 election.

• If section 751 applies to a sale of a partnership interest, it overrides the general rule in section 741 that the gain recognized from the sale or exchange of partnership interest is capital gain. Consequently, section 751 is the starting point in characterizing a partner’s gain or loss from the sale of a partnership interest.

• Section 751 provides that the consideration received by a selling partner in exchange for all or part of his interest in “unrealized receivables” or “inventory items,” shall be considered as an amount realized from the sale or exchange of property producing ordinary income rather than capital gain. In applying section 751, the critical questions are:

- Does the partnership have unrealized receivables or inventory items; and

- If so, what portion of the selling partner’s gain or loss is attributable to those assets?



• If a partner’s entire interest in the partnership is liquidated (that is, redeemed), section 736 is the starting point for determining the tax consequences of the transaction. Under section 736(b), payments for a partner’s “interest in partnership property” generally are treated as distributions by the partnership and taxed under the normal distribution rules applicable to nonliquidating distributions. In the case of a general partnership interest in a partnership in which capital is not a material income-producing factor, payments for the partner’s share of unrealized receivables and goodwill are generally not treated as payments for partnership property. Under section 736(a), payments not within section 736(b) (that is, payments for unrealized receivables and unstated goodwill for a general partnership interest in a services partnership) are to be considered either (i) a distributive share if the amount of the payment is dependent on partnership income or (ii) a guaranteed payment if the amount is determined without reference to partnership income. Under general tax principles, capital is not a material income-producing factor where substantially all of the income comes from the compensation for services. Accordingly, a partnership of doctors, lawyers, engineers, architects or accountants is not a business where capital as a material income-producing factor.

• With respect to a sale of assets by the partnership, generally asset-by-asset treatment.

- Capital gain characterization possible on flow-through to partners.

- On death of partner, step-up basis in partnership interest; estate may get benefit of step-basis in partnership assets with special election under section 754.

• Limited Measure 67 tax exposure.

3. Limited Partnership.

A limited partnership is a partnership with at least one general partner and one limited partner. The limited partner is only liable for the debts or obligations of the partnership up to the amount it has invested in the partnership, while the general partner has unlimited liability for the debts and obligations of the partnership. To limit the liability exposure of the general partner, it is often formed as a limited liability company or a corporation.


• Tax-free creation under section 721(a); however, note exception in section 721(b) for “investment company.” No control requirement.

• Property encumbered by debt that is contributed to LP may generate taxable income under section 752(b).

• Inside and outside basis calculations same as general partnership.



• The LP is a pass-through entity so items of income and loss flow through to the individual income tax returns of the partners. Files IRS Form 1065.

• The partners report their appropriate portion of all partnership income and deduction items, which are provided to them on a Schedule K-1, on their individual returns.

• Profits and losses may be allocated among the partners in any way desired, as long as they have “substantial economic effect,” as defined in section 704(b).

• The profits allocable to the general partner are subject to self-employment tax, while those allocable to the limited partner are not (unless paid as a guaranteed payment, which is a wage equivalent and not truly a return of “profit” to the limited partner; but query whether limited partner should be receiving any such compensation).

• For partnership interest issued for services, for general partner, same as with general partnerships; limited partners should not be receiving compensation in LP in connection with the performance of services for the LP.

• Distributions of cash or property treated in the same manner as distributions in general partnership.

• Tax year is generally that of majority of partners (usually calendar year).

• Tax-free reorganization not available (only corporations under section 368).

• Loss for each partner limited to outside basis; this basis includes partnership debt allocated to partner, same as general partnership.

• Generally, at-risk rules and passive activity rules apply at partner level.

• Sale and redemption of partnership interest treated in same manner as general partnership.

• Sale of assets by partnership treated in same manner as general partnership.

• Death of partner treated in same manner as general partnership.




4. Limited Liability Company.

A limited liability company is essentially a hybrid entity that incorporates the flexibility of a partnership for tax purposes and the full liability protection of a corporation. Unlike a general or limited partnership, there is no partner (or “member” in the case of an LLC) that is subject to unlimited liability, but unlike a corporation taxed under subchapter C, there is no second layer of tax imposed on the entity (assuming it elects to be taxed as partnership).

• Generally taxed as a partnership if multiple members (tax-free creation usually available under partnership rules), unless an election is made to be taxed as a corporation (tax-free creation may be available under corporation rules).

• Taxed as a sole proprietorship if single member unless an election is made to be taxed as a corporation.

• There is no tax imposed on the LLC as an entity, provided it is taxed as a partnership, which means that the LLC will be a pass-through entity; the LLC will file a Form 1065, but is itself not liable for any income tax.

• Tax-free creation under section 721(a), subject to section 721(b) “investment company” exception.

• Inside and outside basis calculations same as general partnership.

• Property encumbered by debt that is contributed to the LLC may generate taxable income under section 752(b).

• The members will report their appropriate portion of all LLC income and deduction items, which are provided to them on a Schedule K-1, on their individual returns. Profits and losses may be allocated among the members in any way desired, as long as they have “substantial economic effect,” under section 704(b).

• For a membership interest issued as compensation for service, pure profits interest not presently taxable, unless tradeable, tied to securities or stream of income or disposed of within two years; capital interest subject to tax to recipient; split of authority on tax impact on LLC; same rules as general partnership.

• Usually, the self-employment tax applies to income allocated to a member like general partnership (note: real estate rent, gain on sale exception), except for purely passive members like limited partners.

• Distributions of cash and property treated in same manner as general partnership.

• The tax year of the LLC is generally that of a majority of the members (usually calendar year).



• A tax-free reorganization is not available.

• Losses allocated to members limited to outside basis. This basis includes LLC debt allocated to member (same as general partnership).

• Generally, at-risk rules and the passive activity rules apply at the member level.

• Sale and redemption of membership interest generally treated in same manner as general partnership.

• On sale of assets, generally asset-by-asset treatment; same as general partnership.

• On death of owner, same treatment as general partnership.


5. C-Corporation.

A C-corporation is a legal entity that is recognized as distinct from its owners. Its shareholders have no liability for the debts or obligations of the corporation and stand to lose only the amount they have invested in the company. A corporation is governed by a shareholder elected board of directors, who in turn appoint officers to run day-to-day operations.


• A C-corporation is its own taxpaying entity and files its own tax return (Form 1120) that reflects all items of income and loss.

• Tax-free creation if meet control test under section 351, which provides no gain is recognized if “property” is transferred to a corporation by one or more persons “solely” in exchange for “stock” in the corporation and “immediately after” the exchange the contributing person or group is “in control” of the corporation (i.e., 80% of all voting stock and 80% of all outstanding stock).

Example: In connection with the formation of Newco, X and Y each transfers appreciated property. A receives 50 shares of voting common stock and B receives 50 shares of nonvoting common stock. Z receives 5 shares of nonvoting preferred stock solely in exchange for services rendered to Newco. Z is not a transferor of property and may not be counted in testing for “control.” Because transferors of property do not own 80% or more of each class of stock, the transaction does not qualify under section 351. Accordingly, X and Y must recognize gain on their property transfers. Z recognizes ordinary income on her receipt of stock for services.

• Transfers to an “investment company” do not qualify for non-recognition under section 351(e). The purpose of this rule is to prevent unrelated taxpayers from achieving tax-free



diversification by transferring appreciated portfolio securities in exchange for stock of a newly formed pooled investment vehicle.

• If property is transferred in a section 351 transaction solely in exchange for stock, the transferor’s basis in the stock received will equal his basis in the transferred property immediately prior to the exchange as specified in section 358(a)(1). The corporation’s basis in the assets transferred in any section 351 transaction is the same as the transferor’s basis as provided in section 362(a).

Example: On the formation of ABC Corp., A transfers land with a basis of $10,000 and a value of $60,000 and inventory with a basis of $30,000 and a value of $40,000 in exchange for 100 shares of ABC common stock with a value of $100,000. The transaction qualifies under section 351(a). A’s basis in the ABC stock is $40,000, which is the sum of A’s bases in the land and inventory. ABC Corp. takes a $10,000 basis in the land and a $30,000 basis in the inventory under section 362(a).

• If the sum of the liabilities assumed by the corporation in a section 351 transaction exceeds the aggregate adjusted basis of the properties transferred by a particular transferor, the excess is treated as gain from the sale or exchange of property under section 357(c). This rule is applied separately to each transferor of property.

Example: On the formation of ABC Corp., A transfers land with a basis of $30,000, a value of $100,000 and subject to a $55,000 liability, in exchange for ABC Corp. stock with $45,000 value. Under section 357(c), A must recognize $25,000 of gain (the excess of the $55,000 liability over A’s basis in the land). A’s basis in the ABC Corp. stock is: $30,000 (basis of land), less $55,000 (debt relief), plus $25,000 (gain recognized), or zero.

• The corporation pays a tax on its income (files Form 1120) and shareholders then pay a tax on any dividends they receive, hence the infamous corporate “double tax.”

• For purposes of subchapter C of the tax code, a “distribution” is any kind of payment by a corporation to its shareholders with respect to their stock. A “dividend” is a distribution out of the current or accumulated “earnings and profits” of a corporation. Payments to shareholders that are unrelated to their ownership of stock (such as salary, interest, rent, etc.) are neither distributions nor dividends.

• The term “earnings and profits” is not defined in the tax code or the regulations, but section 312 describes the effect of various transactions on earnings and profits. In general, earnings and profits are determined by starting with taxable income and making certain additions, subtractions and adjustments.

• Distributions in excess of current or accumulated E&P are a return of capital, which are offset against stock basis.



• To avoid double tax, shareholders who are employees often attempt to pay substantially all corporate profit in salary and bonus (a technique that works as long as the IRS does not successfully argue the compensation was too high, resulting in a portion of the compensation being recharacterized as a dividend).

• Other strategies to transfer funds from a C corporation to its shareholders include excessive rent or other payments to shareholders for assets sold to the corporation. Alternatively, a shareholder may seek to purchase property from the corporation at a bargain, with the dividend being the difference between the amount paid by the shareholder and the actual value of the property.

• If the corporation pays a dividend with appreciated property, the company recognizes income equal to the fair market value of the asset less its basis. The shareholder then recognizes dividend income equal to the fair market value of the asset received (usually, a disastrous tax result).

Example: XYZ Corp. distributes Property A ($30,000 value, $10,000 adjusted basis) to its shareholder, A. The corporation recognizes $20,000 gain on the distribution. Additionally, A recognizes $30,000 of dividend income.

• Dividends and distributions need not be pro rata among all shareholders: different classes of stock can be created to provide varying rights and preferences to shareholders (i.e., common stock and preferred stock can have different voting, dividend and liquidation rights).

• No special capital gain rate for C corporation on asset sale.

• For stock issued as compensation for services, the value of the stock will represent ordinary income to recipient and a tax deduction to the corporation; statutory and non-statutory stock options available; exercise of option must be analyzed for tax consequences.

• Stock issued for services is not considered as issued in return for property under section 351. A service provider recognizes ordinary income under section 61 on the value of any stock received from the corporation for past, present or future services. The timing of the income is determined under section 83. If the stock is subject to a substantial risk of forfeiture and is not transferrable, the service provider is taxed on the fair market value of the stock at the time the restrictions lapse less the amount (if any) paid for the stock. The service provider, however, may elect under section 83(b) to be taxed on the fair market value of the stock at the time of transfer less any amount paid. In that event, no additional income is recognized when the restrictions lapse, and no loss (except for any amount paid) is allowed if the stock is forfeited. In either case, the service provider’s basis for the stock is the amount paid plus any amount included in income.

Example: On the formation of New Corp in Year No. 1, A receives 200 shares of stock (valued at $50,000) in exchange for future services. The stock is not transferable and is subject



to a substantial risk of forfeiture and will not vest until Year No. 5. Assume that the stock will be worth $200,000 in Year No. 5. Under section 83(a), A has no income in Year 1 and $200,000 of ordinary income in Year 5, and his basis in the stock is $200,000. If A makes a section 83(b) election, he has $50,000 of ordinary income in Year 1, his basis in the stock is $50,000, and he has no additional income when the restrictions lapse in Year 5. If A sells the stock in Year 5 after having made an election under section 83(b), he recognizes $150,000 long-term capital gain. If he forfeits the stock in Year 3, A will not have any loss to deduct.

• Normal employee payroll taxes will apply to compensation paid to employee-shareholders.

• The tax year is the accounting year of the corporation, which may select a fiscal year other than the calendar year.

• Tax-free reorganization is available under section 368.

• Corporate losses subject to general corporate rules; do not pass through to shareholders.

• The at-risk rules and passive activity rules apply at corporate level.

• The sale of stock will result in capital gain treatment to the seller (redemptions may be dividends and need to be carefully analyzed; must be in substance a true redemption); possible election by buyer to treat as asset purchase under §338 (but usually not workable with C corporation).

• With respect to a sale of assets, gain or loss computed at the corporate level, asset by asset; no special capital gain rate limit at corporate level.

• On the death of a shareholder, no entity asset step-up in basis. Only stock step-up in basis.

• Potential Measure 67 tax exposure.

• An advantage of C corporations over other forms of business organization, including S corporations, is that part of the gain on the sale of stock of a C corporation recognized by an individual shareholder can be excluded from taxable gain under section 1202 if the stock qualifies as “small business stock” and has been held for at least five years. Additionally, if a stock has been held for six months, tax on the gain can be postponed under section 1045 by rolling the sales proceeds over tax-free into an investment in qualified small business stock issued by another corporation. Among other requirements, qualified small business stock must be issued by a corporation that has always been a C corporation.

• Another advantage of a C corporation is the availability of tax-favored employee benefits. This is less important than it has been historically because corporate and noncorporate qualified retirement plans are now subject to substantially similar rules and



contribution limits and sole proprietors, partners, LLC members and 2% shareholders of S corporations can deduct their health insurance premiums. But certain benefits not considered income to the recipient and deductible by the provider are available only to shareholder-employees of C corporations. These include health care reimbursement under uninsured plans, group term life insurance and child care benefits. Employee benefits can also be offered to shareholder-employees under cafeteria plans that allow the individuals to select the benefits they want.

6. S-Corporation.

An S-corporation is a corporation that is taxed as a pass-through entity. However, it is not taxed as a partnership, which gives rise to several interesting differences between it and an LLC taxed as a partnership. For instance:


• Tax-free creation if meet control tests under section 351 (like the C-corporations); Section 721 has no application to formation of an S corporation.

• The profit and loss of an S-corporation flows through to the shareholders on a pro-rata basis. Allocation of profit and loss in any fashion other than pro-rata is restricted by the second class of stock prohibition, which is different than partnership “substantial economic effect” allocations. Voting and nonvoting stock is allowed, but all shares must have identical economic rights. This is different than C-corporations (which can have different classes of stock with varying economic rights) and partnerships (which may provide for priority or preferred returns and disproportionate distributions).

• The basis of each shareholder’s stock in an S corporation is first increased by the shareholder’s share of allocated income and decreased, but not below zero, by distributions to the shareholder and then decreased by the shareholder’s allocated losses. If allocated losses exceed the shareholder’s stock basis, they may be applied against and reduce (but not below zero) the shareholder’s basis in any S corporation debt.

Example: A is a shareholder in an S corporation who paid $5,000 for her stock and loaned the corporation $1,000 in exchange for a corporate note. During the corporation’s first taxable year (year 1), C is allocated $6,000 of S corporation income and $1,000 of S corporation loss. At the end of year 1, her stock basis will be $10,000, calculated as the $5,000 original stock basis plus $6,000 of allocated income less $1,000 of allocated loss. C’s basis in the corporate note remains $1,000.

In Year 2, C’s share of the corporation’s tax items consist of $12,000 of operating loss. C can only deduct $11,000 of the loss (the total of her stock and debt basis in the corporation). The remaining $1,000 of loss will be suspended and carried over to Year 3. C’s basis in her stock and debt will be reduced to zero.



In Year 3, the corporation’s business improves and C’s share of the corporation’s tax items consists of $5,000 of operating income. C will include the $5,000 of income in her personal tax return and will be allowed to deduct the $1,000 loss from the prior year. For basis purposes, the $5,000 increase attributable to the income will be reduced by the $1,000 loss. The remaining $4,000 of basis will be first allocated to the debt to restore it to its original $1,000 basis. At the end of Year 3, C’s stock basis is $3,000, which is the beginning basis of zero, plus the $5,000 income allocation less $1,000 of suspended loss less $1,000 attributable to the restoration of debt basis.

• Losses allocated to shareholders limited to outside basis; this basis does not include corporate debt (which is different than partnership). A shareholder’s share of S corporation losses and deduction is limited to the shareholder’s adjusted basis in the (1) stock of the corporation, and (2) indebtedness of the corporation to the shareholder. Losses and deductions disallowed under this rule carry over indefinitely and may be used when the shareholder obtains additional stock or debt basis by, for example, contributing or loaning additional funds to the corporation or buying more stock.

Example: C is a shareholder in an S corporation and has a $5,000 basis in her stock. C also loans the corporation $4,000 in exchange for a corporate note. If C’s share of the corporation’s loss for the year is $12,000, she will be limited to a $9,000 deduction (her combined basis in the stock and note) and will have $3,000 of suspended loss which will carry over until she obtains additional basis.

• Most courts agree that an S corporation shareholder does not obtain basis credit for a guaranty of a loan made by a lender directly to the corporation.

• For stock issued as compensation for services, the value of the stock will be taxable to the recipient as income; may use statutory incentive stock options or non-statutory stock options (similar to a C corporation but not partnership – no profits interest concept).

• On distributions, no tax until prior taxed income used (which is similar to partnership rule); but property distributed is deemed sold and this often creates gain to corporation (outside basis adjustment and pass through); if an appreciated asset is distributed, there will be a tax on the inherent gain in the asset (as with a C-corp) that will pass through to all the shareholders on a pro rata basis. The value of the distributed asset would then be taxed to the distributee only to the extent it exceeded her basis in the stock.

• Distributions by an S corporation are tax free to the extent of the shareholder’s adjusted basis in stock of the corporation. If the distribution exceeds the shareholder’s stock basis, the excess is treated as gain from the sale or exchange of the stock, normally capital gain of the stock of the capital asset. Finally, the shareholder’s stock basis is reduced by the amount of any distribution which is not includable in income by reason of the distribution rules.



Example: A is a shareholder in an S corporation and has a $5,000 basis in his stock. If the corporation distributes $8,000 of cash to A, he will be permitted to receive $5,000 tax-free and $3,000 will be treated as gain from the sale or exchange of A’s stock. A’s stock basis will be reduced to zero as a result of the distribution.

• With respect to a property distribution, the amount of the distribution will be the fair market value of the property and the receiving shareholder will take a fair market value basis in the distributed property. The shareholder’s stock basis also will be reduced by the fair market value of the distributed property. At the corporate level, a distribution of appreciated property to a shareholder will require recognition of gain as if the property were sold. The gain will be taxed directly to the shareholders like any other gain recognized by the corporation.

Example: Assume Newco, an S corporation, breaks even in business during the year, and distributes appreciated land (a capital asset held long-term with a $50,000 fair market value and a $20,000 adjusted basis) to A, one of its two equal shareholders. Also, assume A’s basis in her Newco stock is $70,000 and Newco makes a simultaneous $50,000 cash distribution to B, its other shareholder. Newco will recognize $30,000 of long term capital gain, $15,000 of which will be taxed to each shareholder. A will receive a $50,000 tax-free distribution, and her stock basis beginning the next year will be calculated as follows:

$70,000 stock basis

+ 15,000 allocated gain

- 50,000 amount of distribution

$35,000 New stock basis

• Distributions for S corporations with a C corporation history are more complicated and require additional analysis.

• The S corporation files a form 1120S but does not pay any income tax.

• The tax year of the S corporation is generally the calendar year.

• Tax-free reorganization is generally available under section 368.

• The section 465 at-risk rules apply at the shareholder level.

• The section 469 passive activity rules apply at the shareholder level.

• Sale of stock results in capital gain treatment to seller; book-closing issues; possible election by buyer to treat as asset purchase under section 338(h)(10).



• On sale of assets, gain or loss computed at corporate level asset-by-asset; pass through and basis adjustment for shareholders; possible capital gain treatment.

• On death of a shareholder, no entity assets step-up in basis; only stock step-up in basis.

• Generally, employers engaged in an active trade or business must pay a federal self-employment tax of 15.3% on net income in 2015 (12.4% social security, 2.9% Medicare). An individual who is self-employed (i.e., the whole or partial owner of an S corporation) is taxed both as an employer and an employee on all annual income up to $118,500 as of 2015, after which only the portion of the employment tax applicable to Medicare (2.9% total and an additional .9% on wages in excess of $200,000) applies. Generally speaking, current tax law provides no exception for entities treated as sole proprietorships or partnerships, but it does provide an exception for owners of an entity taxed as an S corporation. So long as the shareholder takes a reasonable salary for the shareholder’s employment with the S corporation, any amount over and above that reasonable salary is distributed to the shareholder without being subject to the withholding tax. Accordingly, the owner/employee of an S corporation can avoid being taxed at 15.3% (in 2015 12.4% social security, 2.9% Medicare) of the company’s net profit up to approximately $118,500 and at 2.9% of the company’s net profit thereafter with an additional .9% Medicare tax on wages in excess of $200,000. This is one advantage of an S corporation that does not exist for entities (such as an LLC) treated as a partnership or sole proprietorship. Incidentally, limited partners in a limited partnership who do not materially participate and do not provide more than 500 hours of service to the limited partnership each year generally do not have to pay the employment tax upon their receipts or tax allocations from the limited partnership.

Note: With careful planning, employment-related liabilities can be mitigated in the LLC context. However, due to increased complexities and costs associated with such enhanced planning, it is sometimes not feasible to utilize these alternative approaches.


IV. GENERAL SUMMARY A. General Guidelines in Selecting Form of Entity. The most critical factors in choosing the proper form of entity include appropriate consideration of the following:

1. Questions to Ask.

• What type of assets will be owned by the entity (e.g., real estate, equipment, cash)? • What type of business will the entity operate (passive, active)? • Will the owners or the entity borrow funds as part of initial capitalization? • What will owners contribute to the entity at formation in exchange for ownership

interests?



• Who will be the owners (e.g., individuals, entities)? Do they individually have creditor issues?

• Is there potential for the company seeking private equity or capital from public markets? • Will business be conducted in multiple states? Are there, or will there be, multiple

owners? • Is the business expected to generate profits or losses initially? If losses, for how long? • How does the business expect to allocate profits and losses among the owners for tax

reporting purposes? On a related note, how does the business expect to distribute cash? • What is the anticipated method of exit from the business? • Are there employment tax issues for owner-employees? • Will equity be issued to service providers as compensation? • What type of employment benefits are anticipated to be offered (e.g., cafeteria plans,

medical reimbursement plans)?

2. General Rules of Thumb. The choice of entity almost always leads to a one-way street. It is key to keep in mind that it is often possible to move from a partnership-taxed entity to a corporation on a tax-free basis. It is rare to transition from a corporation to a partnership-taxed entity on a tax-free basis. Thus, in case of doubt, it is best to start with a sole proprietorship or partnership-taxed entity rather than a corporation. A few other general rules of thumb:

1. LLCs should generally be given first consideration when forming a business organization. Existing sole proprietorships should consider an LLC (taxed as a disregarded entity). Existing general partnerships should consider converting to an LLC or an LLP, depending on the nature and type of business being conducted.

2. If it is anticipated that there may be owners other than individuals (such as trusts,

corporations, LLCs or other entities), then an S corporation will likely not be a feasible solution. Similarly, if income tax allocations and/or profit or liquidating distributions will not be based strictly on proportionate ownership, then an S corporation will not be available. In either of these situations, either an LLC or a C corporation must be considered. Frequently, profit distributions are to be made to certain investors on a priority basis and/or certain investors are granted priority returns on their investment. These provisions can be addressed in the LLC context (taxed as a partnership) and in the C corporation (with preferred stock), but cannot be provided with an S corporation.

3. There are three common methods of exit: the asset sale, the taxable equity sale, and the

tax-deferred reorganization. If the company anticipates an asset sale, an S corporation or LLC is generally best, as there would be substantial tax disadvantages to using a C corporation (i.e., double tax, no capital gain opportunity). With an S corporation or LLC, there is only one level of income tax, the basis of the buyer in purchased assets will be stepped-up on the sale and capital gain characterization is possible for the seller (i.e., goodwill), but consider section 751 characterization for LLC taxed as partnership. With a C corporation, there are two levels of income tax on an asset sale (and no potential for



capital gain treatment) and consequently C corporation asset sale transactions are frequently abandoned. If the company anticipates a taxable equity sale, then either an S corporation (particularly if it has made a section 338(h)(10) election to treat the equity sale as an asset sale) or an LLC may be an option. Once again, there would be only one level of income tax to the selling owners, potential capital gain treatment for the sellers and the basis of the purchasers in their ownership interests (and the inside basis of the selling entity’s assets) may be stepped-up upon the sale. However, for an LLC (taxed as a partnership), there may be re-characterization of capital gain to ordinary income under section 751. With a C corporation, part of the gain on the sale of the stock may be excluded from taxable gain under section 1202 if the stock qualifies as small business stock and has been held for at least five years. If the stock has been held for 6 months, tax on the gain may be postponed by rolling the sales proceeds over tax free into an investment in qualified small business stock issued by another corporation. The rollover provision, set forth in section 1045, may be elected if the seller invests in new qualified small business stock within 60 days following the sale. Additionally, if a C corporation is used, then there would be one level of tax to the selling shareholders and a basis step-up on the purchased stock, but the basis of the assets inside the corporation would not be stepped up, which is a distinct disadvantage to the buying party and often makes the stock sale of a C corporation not feasible. If the company anticipates a tax-deferred reorganization or some sort of stock exchange, then the S corporation or C corporation generally is best, as partnership-taxed entities cannot participate on a tax-deferred basis. Generally speaking, for entities where it is expected that there will be a merger or reorganization of some sort with a public company, a C corporation is used, because it is anticipated that there will be private equity or capital from public markets in connection with the organization and operation of the corporation prior to the exit of the founding owners and the shareholder and stock limitations of the S corporation usually prove to be prohibitive to the business plan. It may be possible to initially form such an entity as an LLC in an effort to preserve the potential benefits of sections 1202 and 1045 and to allow the owners to personally benefit from start-up losses due to the flow-through nature of the LLC, and then convert from the LLC to the C corporation before a reorganization or sale transaction. However, the conversion would need to be “old and cold” to avoid IRS assertions that the LLC entity was, in actuality, the real party to the reorganization transaction and that the tax benefits available to the corporation may not be utilized.

4. If it is anticipated that equity of the entity will be used as compensation for key

personnel, then an LLC (taxed as a partnership) should be given strong consideration, because the issuance of a profits interest for services will not be a taxable event to the recipient worker or the issuing LLC.

5. S corporations are often best suited for companies in which owners will be individuals and will be employees. This allows for the reduction in employment tax liability and



often results in significant financial benefit to the business owners. It is established law that an employee / S-corp shareholder may receive both salary payments subject to self-employment tax and profit distributions as a shareholder that are not subject to FICA or SECA. The only limit on this structure is that the salary payments must be reasonable, which in this case means “high enough” rather than “too high” as the IRS challenges for C-corporations.

6. If it is anticipated that the business will be highly successful and that the owners will likely be withdrawing substantial amounts from the business venture, then an S corporation or an LLC should be considered due to its flow-through tax attributes, which will eliminate any concern of IRS challenges to excessive compensation that may be paid to owner-employees in the C-corporation context.

7. If it is anticipated that there will be start-up losses, it may be advisable to form a partnership-taxed entity (i.e., an LLC), perhaps converting to (or electing) S corporation status upon achieving profitability. Particularly if the business will be capitalized in part with funds borrowed by the entity and guaranteed by the owners, use of an LLC taxed as a partnership should be given consideration.

8. If the entity will own appreciated or appreciating assets (such as real estate or equipment

that will be depreciated but retain value), an LLC (taxed as a partnership) is the entity to use. Corporate entities will be taxed disadvantageously in these circumstances due to the tax consequences resulting from the distribution of appreciated assets from corporations.

9. If there are concerns about one of the owners individually having creditor issues, an LLC

is the preferred entity because of its downstream liability protections. 10. Measures 66 and 67 weigh in favor of sole proprietorship, partnership or S corporation

(that is, pass-through entities) to avoid revenue-based excise tax (C-corporations, particularly for professionals, are at risk for Measure 67 tax).

11. If it is anticipated that business may be conducted in multiple states, and if the business

may have multiple shareholders, consider potential administrative burdens of filing income tax returns for business and shareholders if there is a pass-through entity. If a business is organized as a partnership or an entity is taxed like a partnership and transacts business in several states, then each of the partners, as well as the partnership, may be required to file tax returns in each state. Separate tax returns for the business and the owners may also be required if the business is organized as an S corporation. If the business is organized as a C corporation, only one tax return is required, and it will be filed by the business.

12. The manner in which the various forms of business entity are taxed in the state or states

in which a business expects to transact business may also affect the choice of entity. For example, some states dot not tax S corporations as pass-through entities, and using an LLC in these states may avoid undesirable double taxation of the income of the business.



On the other hand, some states impose entity level taxes on LLCs that are not imposed on S corporations or other forms of business entity. If these taxes are high, another form of business entity may be more attractive.

13. If the venture wishes to provide employment benefits that are only available to a C

corporation, such as a cafeteria plan, health care reimbursement under uninsured plans, group term life insurance or child care benefits, then a C corporation must be used. However, generally speaking, other employment-related benefits, such as retirement plans and health care plans, provide the same tax treatment for C corporations and other types of business entities.





Choices of Entities

Tax Law Entities State Law Options Disregarded Entity Sole Proprietorship LLC Partnership General Partnership (Subchapter K, sections 701-761) Limited Partnership LLC LLP “C” Corporation Corporation (Subchapter C, sections 301-385) Professional Corporation LLC “S” Corporation Corporation (Subchapter S, sections 1361-1379) Professional Corporation LLC



Sole Proprietorship

Business Owner (individual)

Business Owner directly owns all business assets and manages and controls business.

Business Assets



GENERAL PARTNERSHIP

General Partnership

Partners

General Partnership

General Partners

Partners

Partnership Assets

General Partners

Partnership

Control/manage

Control/manage

elect



Limited Partnership

General Partner

Limited Partners

Limited Partnership

Limited Partnership Assets

Not active in partnership business

control/manage partnership



Limited Liability Partnership

LLP

Partners

LLP

Managing Partner(s)

Partners

LLP Assets

Partners

LLP

Control/manage

Control/manage

elect



Limited Liability Company

Member-Managed Manager-Managed

LLC

Members

LLC

Managers

Members

LLC Assets

Members

LLC

Control/manage

Control/manage

elect



Corporation (or PC)

Corporation

Officers

Board of Directors

Shareholders

Corporate Assets

Shareholders

Major policy decisions &

appoint officers

elect

Conduct day to day business activities (Need president &

secretary – may appoint other officers e.g., VP, Treasurer)





10/2/2015

1

TAX CONSIDERATIONS FOR CHOICE OF BUSINESS ENTITY

Berit L. Everhart October 16, 2015

ARNOLD GALLAGHER P.C.800 Willamette Street, Suite 800

Eugene, OR 97401Telephone: (541) 484-0188Facsimile: (541) 484-0536

[email protected] 1

Tax Classifications• Disregarded Entity

• Partnership • Subchapter K, sections 701-761

• C Corporation • Subchapter C, sections 301-385

• S Corporation • Subchapter S, sections 1361-1379

2



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2

Legal Entity Options Tax Classification State Legal Entity Options

Disregarded Entity Sole Proprietorship LLC

Partnership General Partnership Limited Partnership Limited Liability Partnership LLC

C Corporation Corporation Professional Corporation LLC

S Corporation Corporation Professional Corporation LLC 3

Disregarded Entity– Overview • Business owned by a single owner.

• No separate entity recognized for tax purposes (i.e., disregarded entity).

• No entity level tax.

• No federal or state tax form filed for the business (e.g., individual owner reports profits/losses on individual IRS Form 1040, Schedule C).

• Business assets (and liabilities) owned by the owner for tax purposes.

• Unlimited personal liability for business debts/liabilities.

• Generally, default tax status for single member LLC. • Exception: certain non-U.S. entities, which must make an affirmation election

to be treated as a disregarded entity for tax purposes. 4



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3

Disregarded Entity– Structure Overview

5

LLC

A

Partnership – Overview • Business owned by at least two owners.

• Separate entity recognized for tax purposes. However, generally no entity level tax (i.e., flow-through or pass-through entity). • Exceptions: applicable state/local taxes (e.g., Washington’s Business &

Occupation Tax).

• Informational income tax return (e.g., IRS Form 1065). Each owner will receive a Schedule K-1 with his/her/its allocable share of profits and losses.

• Business assets (and liabilities) owned by the entity for tax purposes.

• Generally, limited personal liability for business debts/liabilities.• Exception for owners who are general partners.

• Generally, default tax status for multi-member LLC. • Exception: certain non-U.S. entities, which must make an affirmation election to

be to be treated as a partnership for tax purposes. 6



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4

Partnership – Structure Overview

7

A

LLC

B

A

GP or LP

B

C Corporation – Overview • Business owned by single or multiple owners.

• Separate entity recognized for tax purposes.

• Entity level tax. Owners pay tax as distributions are received from the entity.

• Entity files its own income tax return (i.e., IRS Form 1120).


• Limited personal liability for business debts/liabilities.

• Default tax status for entities incorporated under state law. LLC may make an election (IRS Form 8832) to be treated as a corporation for tax purposes. • Exception: certain non-U.S. entities, which default to corporate tax status.

8



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5

Corporation – Structure Overview

9

Corporation

A

LLC*

A

*Has made an election to be taxed as a corporation.

Corporation

LLC*

A B

A B

S Corporation – Overview • Business owned by no more than 100 qualified S shareholder(s).

• U.S. corporate entity or LLC.

• Separate entity recognized for tax purposes. However, generally no entity level tax (i.e., flow-through or pass-through entity). • Exceptions: built-in gains tax; excessive net passive income tax, applicable

state/local taxes.

• Entity files its own tax return (i.e., IRS Form 1120S). Each owner will receive a Schedule K-1 with his/her/its allocable share of profits and losses.


• Limited personal liability for business debts/liabilities.

• S Election required (IRS Form 2553).

• One class of stock. 10



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6

S Corporation – Structure Overview

11

A

A

*Has made an election to be taxed as an S corporation.

A B

A B

Corporation* Corporation*

LLC* LLC*

Choice of Entity – Questions to Ask • How many owners and who will be the owners (e.g., individuals,

entities)?

• What will owners contribute to the entity at formation in exchange for ownership interests?

• What type of assets will be owned by the entity (e.g., real estate, equipment, cash)?

• What type of business will the entity operate (passive, active) and where will the business be operated?

• Will the owners or the entity borrow funds as part of initial capitalization? 12



10/2/2015

7

Choice of Entity – Questions to Ask (cont’d)• Is the business expected to generate profits or losses initially?

• How does the business expect to allocate profits and losses among the owners for tax reporting purposes? On a related note, how does the business expect to distribute cash?

• Is there potential for the company seeking private equity or capital from public markets?

• What is the anticipated method of exit from the business?

• Are there employment tax issues for owner-employees?

• Will equity be issued to service providers as compensation? 13

Choice of Entity – General Rules of Thumb• LLC provides the most flexibility from a tax perspective.

• Easier to move from pass-through to corporate tax status on a tax-free basis.

• Single level of tax often preferred.

14



10/2/2015

8

Choice of Entity – General Rules of Thumb for Entities Taxed as Partnerships • Often preferred because of the single level of tax.

• Flexibility in allocating profits/losses.

• Owners can take advantage of business losses.

• Ability of owners to leverage entity level debt to take advantage of business losses.

• Preferred when the entity will hold appreciated assets.

• Exit strategy• Sale of assets• Sale of equity

15

Choice of Entity – General Rules of Thumb for Entities Taxed as C Corporations • Double level of taxation.

• Tax status will shield owners from filing tax returns in multiple jurisdictions when business is conducted in multiple states/taxing jurisdictions.

• Certain employment benefits may be available to only C corporations.

• Exit strategy• Tax deferred reorganization

16



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9

Choice of Entity – General Rules of Thumb for S Corporations • Ownership: If entity owners are anticipated, a S corporation will

likely not be feasible.

• Owner/Employees: If the owners are individuals who will also be employees of the business, S corporations may provide an opportunity to reduce employment tax liability.

• Many of the same benefits available to an entity taxed as a partnership with the following exceptions: • No flexibility in allocating profits/losses. • Single class of stock requirement. • No ability to leverage entity level debt to take advantage of losses.

• Exit strategy• Sale of assets• Sale of equity 17



Chapter 4

Out of the Frying Pan, Into the Fire: Tax Issues of Closing Up Shop

GWendolyn GRiffith

Tonkon Torp LLPPortland, Oregon

Contents

I. Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4–1A. Change Happens. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4–1B. The Basic Transaction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4–1C. The Tax Questions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4–1

II. Tax Issues that Potentially Apply Regardless of Form . . . . . . . . . . . . . . . . . . . . . . . 4–3A. Who Is Responsible for the Process? What Is Their Authority?. . . . . . . . . . . . . . 4–3B. Valuation of Assets and Estimate of Tax Liability . . . . . . . . . . . . . . . . . . . . . 4–3C. Sell Some Assets; Keep the Rest for the Owners. . . . . . . . . . . . . . . . . . . . . . . 4–4D. Dealing with Debt . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4–5E. Timing Is Everything . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4–6

III. Sole Proprietorships and Disregarded Entities . . . . . . . . . . . . . . . . . . . . . . . . . . . 4–6A. No Separate Business Entity for Tax Purposes . . . . . . . . . . . . . . . . . . . . . . . 4–6B. Disregarded Entities Are Not Disregarded for All Purposes . . . . . . . . . . . . . . . 4–6

IV. Dissolution and Liquidation of Entities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4–7A. “Dissolution” vs. “Liquidation” . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4–7B. Corporations—Complete Liquidation. . . . . . . . . . . . . . . . . . . . . . . . . . . . 4–7C. Liquidation of LLCs and Other Entities Taxed as Partnerships. . . . . . . . . . . . . 4–10

V. Transferee Liability for Taxes/Protective Strategies . . . . . . . . . . . . . . . . . . . . . . . 4–12A. You Don’t Have to Be a “Transferee” to Have Liability for Certain Taxes . . . . . . . 4–12B. Transferee Liability . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4–12C. Keeping the Entity Alive . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4–12D. Liquidating Trust. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4–13

Chapter 4—Out of the Frying Pan, Into the Fire: Tax Issues of Closing Up Shop




I. Introduction A. Change Happens. So far, no business has lasted forever. This outline focuses on the tax issues involved in closing down a business, technically the “dissolution” and “liquidation” of businesses. B. The Basic Transaction

1. Assumed Transaction Assume a transaction in which the business sells some of its assets, and distributes the proceeds of sale and the rest of the assets to its owners. Then the business terminates. The owners’ desires: “to be done with it” and maximize the value they receive from the business. This outline will address only sole proprietorships, LLCs (regarded and disregarded) and corporations (S and C) because those are the most widely used vehicles. Other, more exotic, entities—such as cooperatives or business trusts—will not be addressed. In addition, to simplify matters, I will assume individual owners of entities, not other entities as owners, and will assume closely held businesses. This outline will not address (a) IRC § 338 stock/deemed asset sales; (b) bankruptcy or near-bankruptcy scenarios; or (c) stealing away into the night.

2. Sources of Law. All of the transactions discussed are structured in accordance with state law. State law provides for certain steps to be taken, and provides the default rules for the rights and obligations of the parties in these transactions. In most cases, it is also necessary to consult the entity’s governance documents (e.g. an operating agreement or shareholder agreement). State law and governance documents inform but do not dictate the tax consequences of these transactions. C. The Tax Questions.

1. The Tax Lawyer's Approach Tax lawyers focus on a series of tax questions whenever a transaction like this is contemplated. If these questions are asked (and answered) in the right way, we can minimize the likelihood of big “tax surprises” later. See Figure 1-1.



Figure 1-1

What transaction

has occurred?

What are the tax consequences to

the owners?

What are the tax consequences to

the entity?

Income, gain, loss, or deduction?

If so, when will the item be recognized?

Character?

Any effect on basis of the property?

Any correlative effects?

2. What Transaction Has Occurred? As with most problems in law, the obvious is a magnet for erroneous assumptions. For example, dissolution of what? Asking the clients about the form of business organization is a good idea, but don’t stop there. If they say “we report on Schedule C,” do they mean they own a sole proprietorship or disregarded entity? If they say “single member LLC,” did anyone ever make a corporation/ S corporation election for that entity? When people are closing up shop, they simply do not remember the discussions they had when they were getting started. They may not have looked at their organizational documents for years.

a. Ask for: the latest tax returns. b. Whatever the client says: compare against the most recently filed

tax return; and c. Whatever the tax returns say, ask yourself: is this accurate?

3. What are The Tax Consequences to the Entity? Will the entity:

a. Recognize income? b. If so, when (in which taxable year)? c. What is the character of that income—ordinary income or capital

gain (and does it matter?) d. Be entitled to claim a deduction? e. If so, when (in which taxable year)? f. If so, is this a deduction available against ordinary income, or only

against certain types of income, such as passive income or capital gain? g. Is there any effect on the basis of property held by the entity?



h. Any correlative effects to be considered? i) LLCs and similar entities taxed as partnerships: effects on

capital accounts? ii) C corporations: effects on earnings and profits? iii) S corporations: effects on pass-through of income?

4. What are the tax consequences to the owners? Will they:

a. Recognize income? b. If so, when (in which taxable year)? c. What is the character of that income—ordinary income, capital

gain or other "investment income" (and does it matter?) d. Be entitled to claim a deduction? e. If so, when (in which taxable year)? f. If so, is this a deduction available against ordinary income, or only

against certain types of income, such as passive income or capital gain? g. Is there any effect on the basis of property received by the owners? h. Any correlative effects to be considered?

II. Tax Issues that Potentially Apply Regardless of Form

A. Who is responsible for the process? What is their authority? Tax law does not designate an official person to make the tax choices and take tax actions in the liquidation process. These devolve onto the sole proprietor or the officers of a corporation, or in an LLC, either the manager or all or certain members. A few LLC operating agreements designate a “winding up member,” which is a useful concept. In the corporate context, it is rare indeed for the descriptions of the officers’ duties in the bylaws to include this responsibility. Because the choices made in the liquidation process can have disparate impacts on the business and various owners, the lawyer assisting a business in closing up shop should have a clear engagement letter that specifies the client, and also addresses the authority, communications and conflicts issues that can arise in this setting, particularly when owners’ interests may not be perfectly aligned. If insurance coverage is to continue (e.g., product liability or malpractice coverage), then confer with the insurance company early in the process. At a minimum, if the company is dissolved (a) will coverage continue, and if so what are the preconditions to continuance (keeping entities alive?) (b) what and whom will it cover (transferees); and (c) who will have the authority to act with respect to insurance issues? B. Valuation of Assets and Estimate of Tax Liability. A good first step in closing up shop is to get a valuation (formal or informal) of the assets of the business and an accountant’s estimate of tax liability if assets were sold for fair market value.



C. Sell Some Assets; Keep the Rest for the Owners.

1. Gain/Loss on Sale of Assets. The sale of assets will generate taxable gain or loss, measured by the difference between the amount realized on the sale and the adjusted basis of the asset.

a. Ask for: depreciation schedules. b. See IRC § 1060: In the sale of assets, the buyer and seller should

agree on the allocation of the purchase price among the classes of assets.

2. Character of Gain or Loss. The character of the gain or loss on sale will depend on the nature of the assets. Many business assets are IRC §1231 assets, which are depreciable assets used in a trade or business. These are subject to IRC §179 recapture and §1245 depreciation recapture.

a. Recapture: When a depreciable asset is sold for an amount greater

than its adjusted basis, the gain is ordinary income to the extent of the recapture amount. i) Section 179 recapture: The gain is ordinary to the extent of

previously claimed § 179 deductions, less the amount to which the taxpayer would have been entitled under MACRS.

ii) Depreciation Recapture: The gain is ordinary to the extent of the previously claimed depreciation under MACRS.

iii) This also applies to installment sales, in which the entire amount of recapture must be reported in the year of sale, even if no cash is received.

b. IRC § 1231 gain or loss: Taken all together, if gains from §1231

assets exceed losses, the gain will be capital in nature; if losses exceed gains, the loss will be ordinary in nature.

c. Installment Notes: If the buyer of the assets has given a note to the seller, the gain will be reported over the period of time that the payments are received. It will be necessary to calculate the reportable amount on a yearly basis. IRC § 453.

3. “Leftover” Assets.

a. Conversion to personal use: When an asset is converted to personal use from business use, i.e., its business use or use in the production of income falls to below 50%, the § 179 recapture rules apply. Treas. Reg. § 1.179-1(e). In that case the taxpayer must include in ordinary income the difference between the fair market value and the adjusted basis of the property, up to the amount of (a) § 179 deduction taken, reduced by (b) the amount of depreciation to which the taxpayer would have been entitled, had the taxpayer not claimed the benefits of § 179. Tip: When closing up shop, use those leftover assets in the production of income activities (such as rentals) instead of



converting them to personal use. The depreciation recapture rules do not apply to the conversion of business assets to personal use. Rev. Rul. 68-487, 1968-2 C.B. 165.

b. Retirement plans: Very few buyers, if any, wish to acquire the retirement plan of a selling business. The closing business will have to terminate the plan, and, for defined contribution plans, the assets will generally be rolled into IRAs for the participants. Planning for this process should begin well in advance of actual liquidation. Often, an owner of the business will be the trustee of the plan, with fiduciary obligations that are independent of the owner’s role in the rest of the liquidation process. Tip: Get an expert’s advice well in advance of terminating any retirement plan.

c. Installment note: A “disposition” of an installment note will trigger the unrecognized gain. When an installment note is received in exchange for sale of the business assets, consider carefully whether its subsequent distribution to owners will trigger a taxable “disposition.” See discussion below.

d. Books and records: It is critical to retain books and records of the closing business in an accessible form for a period of time after liquidation, even if the business assets have been sold. D. Dealing with Debt

1. Debt? What debt? Not all debt is represented by the usual paper, nor does it appear on the public record. One important debt to consider: are the business and its owners current on tax obligations of all kind—employment taxes; property taxes; income taxes; estimated taxes? See Transferee Liability, Section V, infra. Ask for: list of creditors and amounts owed; copies of notes or other evidences of indebtedness.

2. Paying Off Debt. Paying debt requires cash and the payment of the principal on debt does not generate a deduction. In the ordinary course of business, the business is amortizing debt over time, and also generating deductions, thereby managing taxable income. When the business closes, the debt becomes due in full, and that payment is not deductible. Plus, a business in wind-down mode will have less revenue and probably will not have all the ordinary and necessary business expenses that it had when it was going full steam. This creates the situation in which taxable income can spike, increasing the tax burden, just when cash flow is faltering.

3. Cancellation of Indebtedness ("COD) Income. When a lender agrees to take less than it is entitled to in satisfaction of the debt, the debtor has COD income, which is taxed as ordinary income to the debtor unless one of the exceptions to COD income applies. The major useful exception is the insolvency exception, which excludes the COD income to the extent of the debtor’s insolvency. Insolvency is measured as the difference between the fair market value of the debtor’s assets and the face amount of the debtor’s obligations. The debtor must reduce its basis in its remaining assets, if any, by the amount of the COD excluded from the debtor’s income. See IRC § 108.



4. Property Subject to Debt. If property is distributed to an owner subject to debt, in general the amount distributed to the owner is the net value of the property (fair market value less face amount of the debt). In LLCs and other entities taxed as partnerships, this kind of distribution can result in a deemed distribution to other owners. E. Timing is Everything.

1. Timing of Gain or Loss. A liquidation event will likely generate gain or loss to the owners of a business. The impact of this on their larger tax situation must be considered. Gain recognition can affect the tax bracket of the owners and the investment income tax. Capital losses are useful only against capital gains, and a limited amount of ordinary income, so timing capital losses to coincide with the recognition of capital gains is helpful. If the liquidation will trigger current or suspended passive losses, the client may wish to consider accelerating the recognition of other income for maximum use of these losses.]

2. Triggering Passive Losses. The termination of an entity which has generated passive losses for all or some of its owners potentially triggers the recognition of suspended passive losses under IRC § 469(g). Specifically, any current or suspended passive losses from the activity and any loss realized on the disposition of the activity are treated as losses from a nonpassive activity to the extent they exceed the taxpayer's net income or gain from all passive activities for the year. Passive credits are not triggered by a disposition.

III. Sole Proprietorships and Disregarded Entities

A. No Separate Business Entity for Tax Purposes. When there is no separate entity for any purpose (sole proprietorship), the tax issues are simpler, as there is no “distribution” from an entity to its owners and no question as to liability for various taxes—the sole proprietor is liable.

1. But consider: death of a sole proprietor?

2. But consider: divorce of a married sole proprietor? B. Disregarded entities are not disregarded for all purposes.

1. Employment tax issues

2. FBAR reporting

3. Tri-Met and similar taxes?

4. Property taxes?



IV. Dissolution and Liquidation of Entities A. “Dissolution” vs. “Liquidation”

1. "Dissolution". Dissolution is a state law concept applicable to entities. Dissolution does not terminate the corporate existence or effect a transfer of assets to the shareholders. ORS 60.637(2)(a). A corporation in dissolution cannot carry on business, but must limit itself to certain enumerated activities, including payment of claims and distribution of assets to shareholders. Similar provisions apply to LLCs. See ORS 63.637.

2. Federal Law on Corporate Existence. The status of an entity as dissolved for state law purposes is relevant, but not determinative of the status of an entity. The core test of corporate existence for purposes of Federal income taxation is always a matter of Federal law. See Ochs v. United States, 158 Ct. Cl. 115, 119, 10 AFTR 2d 5206, 305 F.2d 844, 847 (1962).

3. "Liquidation.” State statutes generally do not refer to “liquidation,” which is a tax concept referring to the process of an entity distributing its assets to owners in termination of the business activities of the entity. Treas. Reg. § 1.332-2(c) states that "[A] status of liquidation exists when the corporation ceases to be a going concern and its activities are merely for the purpose of winding up its affairs, paying its debts, and distributing any remaining balance to its stockholders."

a. Dissolution for state law purposes does not necessarily result in liquidation for tax purposes. See PLR 200806006 (02-08-2008)(unaware of administrative dissolution, corporation operated over a period of years; no liquidation for tax purposes).

b. Moreover, the tax status of liquidation can occur without a formal state law dissolution. Rev. Rul. 54-518, 1954-2 C.B. 142.

4. When? Generally, the year in which gain is realized by a shareholder (the year in which a liquidation distribution is received) is that year when the assets of the corporation are received by the stockholder. When the transferees of the corporate assets have complete control over the corporation, the date of distribution will be the date such transferees manifest their intention to presently take the property as their own. See Gensinger v. Commissioner, 208 F.2d 576, 44 AFTR 868 (9th Cir. 1953). This is a factual issue. Ochs v. United States, supra. B. Corporations—Complete Liquidation

1. Oregon Law. ORS 60.624 and 60.237 provide the rules of the road for a

corporation making the decision to dissolve. Either all the shareholders must vote to dissolve, or the directors must present the decision to the shareholders and a majority of the shareholders must consent. The corporation must file articles of dissolution with the State (ORS 60.631), and once it does so, it must: (a) collect its assets; (b) dispose of its



properties that will not be distributed in kind to its shareholders; (c) discharge or make provision for discharging its liabilities; (d) distribute its remaining property among its shareholders according to their interests; and (e) do every other act necessary to wind up and liquidate its business and affairs. However, dissolution does not by itself transfer title to any asset. The corporation typically adopts a Plan of Liquidation delineating the why, what, how and when of liquidation.

2. Effects to Corporation. The corporation will typically sell its assets, pay off its debts, and distribute the net assets in liquidation to its shareholders.

a. Gain or loss on sale: The sale of assets will generate gain or loss at the corporate level. In a C corporation, the corporation itself pays tax on that gain. In the S corporation context, the gain passes through to the shareholders, increasing their basis in their shares. The character of the gain is determined at the corporate level. A C corporation does not enjoy a preferential rate for long term capital gains, but capital gain passes through to S corporation shareholders, who do enjoy the preferential rate.

b. Gain or loss on distribution of assets: If a corporation distributes cash, it does not recognize gain or loss. But if it distributes property that has a fair market value greater than its adjusted basis, the corporation (whether S or C) recognizes that gain. IRC §336(a). No loss is recognized if basis exceeds fair market value.

i) Depreciation recapture is triggered on this deemed sale.

ii) When a C corporation distributes an installment obligation in a complete liquidation to an individual, the transaction triggers gain recognition under IRC § 336 (and the distribution is treated as a disposition generating recognition). This can cause liquidity problems and obviates the advantages of the installment sale approach. Tip: For C corporations, you must keep the corporation in existence for the duration of the note, or the gain will be accelerated.

iii) For S Corporations only, if installment treatment is

allowed to shareholders because of IRC § 453(h)(see below), the distributing S corporation will not recognize a gain or loss on this note distribution. See IRC § 453B(h).

c. Cancellation of indebtedness income: If the corporate debtor has

COD income and is a C or S corporation, the determination of whether an exclusion is available under IRC §108(a) is made at the corporation level, not at the shareholder level.

3. Effect to Shareholders. The corporation distributes cash and property to shareholders in complete liquidation of their interests in the corporation. The shareholders recognize gain or loss equal to the difference between what they receive and



their adjusted basis in the stock. That gain or loss is typically capital gain or loss because the stock is a capital asset in their hands. The shareholders take property distributed to them with a fair market value basis (except for installment notes).

a. What is being paid out? When the shareholders have only an interest as shareholders, it is easy to determine that the amounts paid out are for their interest in stock. However, when shareholders have other relationships to the corporation (employee, consultant, lessor, or creditor), the IRS takes the position that anything that comes out of the corporation is first to pay for any debts owed by the corporation to the shareholder in these other capacities. If anything is left over, it is for payment for stock. See, e.g., Dwyer v. United States, 622 F.2d 460 (9th cir. 1980); Braddock Land Co. v. Commissioner, 75 T.C. 324 (1980); O.D. Bratton v. Commissioner, 31 T.C. 891 (1959). See Brod, “Liquidations Involving Shareholder-Creditors—Tax Traps for the Unwary,” 7 J. Corp. Tax’n 352 (1981).

b. Series of liquidating distributions: If distributions are received over a period of time for a single block of stock, the shareholder may recover his or her entire basis before reporting gain. See Rev. Rul. 85-48, 1985-1 C.B. 126; Rev. Rul. 68-348, 1968-2 C.B. 141. This is more favorable, for gain, than installment method reporting. However, loss recognition is also deferred until the last payment. Schmidt v. Commissioner, 55 T.C. 335 (1970). The IRS has been known to argue that distributions are dividends instead of liquidating distributions, which has very different tax effects in the C corporation context.

c. Installment obligations: Under certain circumstances, when a corporation distributes installment obligations in a complete liquidation to an individual, a shareholder (who does not elect out of the installment method) treats the payments under the obligation, rather than the obligation itself, as consideration received in exchange for his stock in the corporation. The shareholder then takes into account the income from the payments under the obligation using the installment method. This treatment applies to installment obligations received by a shareholder (in exchange for the shareholder's stock) in an IRC § 331 complete liquidation, but only if (i) the installment obligations are acquired with respect to a sale or exchange of property by the corporation during the 12-month period beginning on the date a plan of complete liquidation is adopted; and (ii) the liquidation is completed within that 12-month period. IRC § 453(h)(1)(A).

4. Special Issues for S Corporations

a. Because S corporation shareholders can receive distributions tax-free up to the amount of their basis, there is more flexibility of timing of distributions.

b. S corporations that were once C corporations have special issues to consider:



i) Built-in gains tax: If the S corporation elected S status within the previous 10 years, it is subject to the built in gain tax of IRC § 1374, which may result in a corporate-level tax on the distribution of appreciated assets.

ii) Passive income tax: if the former C corporation has

earnings and profits, and will have more than 25% passive income for three years, it must worry about the passive income tax of IRC § 1375 and the possibility of losing its S status under IRC § 1362(d)(3).

iii) AAA dividends—a liquidation may obviate dividend

treatment for distributions that would otherwise be treated as taxable dividends to shareholder. See A. Hebble & J.S. Horvitz, “Tax Planning When an S Corporation Liquidates,” J. S Corporation Tax’n, Summer 1992.

5. Forms:

a. A corporation must file an information return Form 966 within 30

days after it adopts a resolution or plan for dissolution or for liquidation. If a corporation files a return, and the resolution or plan is thereafter amended, the corporation must file an additional Form 966 within 30 days after amendment. The returns must be filed regardless of recognized gain or loss of the shareholders on liquidation. IRC § 6043(a); Treas. Reg. §1.6043-1(a).

b. The corporation must also file a separate Form 1099-DIV for each shareholder to whom it makes a liquidation distribution of $600 or more during a calendar year. These forms are filed on or before Feb. 28 of the following year, except if the return is filed electronically. If Form 1099-DIV is filed electronically, it is not due to the IRS until Mar. 31. Treas. Reg. § 1.6043-2(a). C. Liquidation of LLCs and Other Entities Taxed as Partnerships.

1. Dissolution—Oregon law. An LLC dissolves under ORS 63.621 by reference to dissolution events in the Articles or Operating Agreement or by vote of the members. Articles of Dissolution are filed with the Secretary of State, and thereafter, the LLC can only proceed to dispose of its assets and distribute net assets to those entitled to distributions in accordance with the operating agreement. ORS 63.631, 63.637.

2. Sell Some Assets; Distribute the Rest to the Members.

a. Gain and loss on sale of assets: “Book income and loss” and “tax income and loss” must be allocated as specified in the operating agreement and in accordance with tax law, and capital accounts must be adjusted accordingly (for those



LLCs and partnerships that maintain capital accounts). This may require complicated accounting.

b. Distributions must be made as provided in the operating agreement. Most operating agreements assume that only cash will be available at the termination of the business, but that is rare in small business practice. These operating agreements usually leave it to the manager or members to decide which assets to distribute to which member, which can cause some angst. Tip: Negotiating tenancy in common agreements prior to distribution may be advisable.

c. Distribution of installment obligations: no gain or loss is recognized on disposition, except as required by IRC §§ 736 and 751. Treas. Reg. § 1.453-9(c)(2). See PLR 8032119 (05/19/1980).

3. Entity Level Implications. The entity does not generally recognize gain or

loss on the distribution of assets in liquidation.

a. Disproportionate distributions of assets: If the entity distributes, disproportionately among the partners/members, “hot” assets, this can trigger gain at the entity level, which is then passed through to partners/members. IRC § 751. "Hot" assets are substantially appreciated inventory; certain accounts receivable, and certain other assets. Tip: if “hot” assets are to be distributed, get expert help.

b. COD income: If COD income is generated, whether the IRC §

108(a) exclusions apply at the partner/member level, thus depending on each member’s situation, i.e., whether a member is insolvent. The LLC passes through the COD income and then each member makes the determinations of inclusion/exclusion. The basis adjustments, as applicable, apply at the member level, not at the LLC level. This can result in some members have COD income and others having no COD income. Tip: It is tempting to enact a special allocation in such cases, but resist this temptation and this allocation would likely not have substantial economic effect.

c. Debt: When the LLC has debt, and that debt is paid off prior to distributions being made, that payoff is treated as a deemed distribution to the members, in proportion to their “shares” of the debt. IRC § 752(b). This reduces the members’ basis in their membership interest, and if the deemed distribution exceeds a member’s basis, this will trigger gain without cash. This deemed distribution is taken into consideration before consideration of the liquidating distributions. If property is distributed to one partner/ member subject to a debt, the other partner/members are likely treated as having received a distribution (being relieved of their share of debt), and the receiving partner is treated as having contributed an amount to the entity. This can cause unwelcome surprises.

4. Member-Level Implications. A distributee member recognizes gain only to the extent that money distributed to him or her exceeds his or her basis in the LLC, after all allocations, distributions, and other adjustments are made. A distributee member



takes an exchanged basis in the property received, which means that the member’s unrecovered basis in the LLC interest is assigned to the property received. IRC §732(b). If the property received is inventory, its ordinary income nature will be preserved in the member’s hands for five years. IRC § 735.

5. LLC’s Taxable Year. The LLC will have a short taxable year ending with its final date of distribution.

6. Forms. Final Form 1065 (federal) and 65 (state).

V. Transferee Liability for Taxes/Protective Strategies

A. You Don’t Have to Be a “Transferee” to Have Liability for Certain Taxes Of principal concern is the personal liability for trust fund taxes, which involves a 100% penalty for responsible persons when a business fails to pay these taxes. B. Transferee Liability

1. A transferee may be liable for the transferor's federal tax debt either by statute (IRC § 6901) or in equity (where the transfer was made with actual intent to hinder, delay or defraud IRS or, even if there is no proof of actual intent, where the transfer was made for inadequate consideration by a transferor with inadequate assets). The regulations’ definition of a “transferee” specifically includes shareholders of a dissolved corporation. Treas. Reg. § 301.6901-1(b). Generally, this will not be a problem for income tax of pass-through entities, but S corporations can have an entity-level income tax.

2. State and local law also imposes transferee liability in certain circumstances for state or local taxes, including not only income taxes but also property taxes and other taxes.

C. Keeping the Entity Alive

1. When there is more than one owner, and especially when those owners’

interests are not fully aligned, it may be advisable to delay liquidation (if not dissolution) until it is clear that all tax matters have been resolved. Of course, it is never 100% clear that all tax matters have been put to rest—waiting for six years is usually out of the question. But it is possible to have some degree of certainty as to tax matters, and waiting to make liquidating distributions until that time can avoid future problems.

2. If there is substantial uncertainty, it is possible to create claw-backs and indemnities, but these require enforcement, which is a costly post-liquidation problem and also requires that someone retain authority to enforce these mechanisms.



3. Postponing liquidation does not necessarily obviate the state law procedures for giving an entity a decent burial, thus starting the time period for claims. See ORS 60.641 and 60.444 for corporations; ORS 63.641 and 63.644 for LLCs. But keeping assets in the entity is not advisable when there are contingent claims “out there.” D. Liquidating Trust. When there are multiple owners, ongoing obligations and potential post-liquidation payments, a liquidating trust is an option. These are treated as trusts, not associations taxable as corporations, if the purpose is only to handle liquidation procedures, not carry on business. Treas. Reg. § 301.7701-4(d). Liquidating trusts give the authority to the trustees to handle all claims and make distributions.



Chapter 5

Navigating Through Tax CollectionJessica Mcconnell

Greene & Markley PCPortland, Oregon

donald GRiM

Greene & Markley PCPortland, Oregon

Contents

I. Overview . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5–1A. Assessment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5–1B. Joint and Several Liability. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5–1

II. Collection . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5–2A. Collection Notices and Collection Due Process Appeals . . . . . . . . . . . . . . . . . 5–2B. The IRS’s Collection Power—Garnishments and Levies . . . . . . . . . . . . . . . . . 5–3C. Statute of Limitations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5–3D. Federal and State Tax Liens . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5–3

III. Tax Resolution Options . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5–4A. Do Nothing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5–5B. Installment Plans. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5–5C. Offers in Compromise . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5–5D. Bankruptcy . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5–6E. Uncollectable Status . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5–7F. Relief from Joint and Several Income Tax Liability. . . . . . . . . . . . . . . . . . . . . 5–7

Chapter 5—Navigating Through Tax Collection




I. Overview. The Internal Revenue Service (“IRS”) and the Oregon Department of Revenue’s (“ODR”) tax assessment, collection and resolution procedures typically run parallel to one another. Unless otherwise stated in the Oregon Revised Statutes, Oregon’s taxation laws incorporate and mirror those in the Internal Revenue Code. While these materials will primarily focus on the IRS, the information is generally applicable to the ODR as well. A. Assessment.

A tax assessment is the acknowledgment and recordation of a tax liability in the IRS’ records. Each tax period results in a separate assessment. Assessment is the last step in the determination of a tax liability and a prerequisite to forced collection. The most common assessment is self-assessment by filing an original or amended return showing the tax liability. If the taxpayer fails to file a tax return, the IRS may “file” a substituted return for the taxpayer using the income information received from third parties. The IRS provides the taxpayer with notice and an opportunity to respond prior to “filing” its own substituted return. The tax liability shown on a substituted return is greatly inflated because the IRS enters only the taxpayer’s income but does not account for deductions. The taxpayer may file an “amended return” to correct and reduce the tax due under the substituted return. The IRS may also assess a tax at the conclusion of an audit or after a civil penalty or third party liability investigation. In most cases the IRS must provide the taxpayer with notice of the proposed assessment and an opportunity to appeal prior to making a formal assessment. The IRS’ statute of limitation on assessment is typically three years. The statute of limitation begins to run on the due date of the tax return or the filing date, whichever is later. If the IRS discovers a substantial understatement of gross income, the statute of limitations extends to six years. An understatement of 25 percent or more of total income is considered substantial. There is no statute of limitations on assessment for unfiled or fraudulent returns. B. Joint and Several Liability. If spouses file a joint tax return, the IRS holds each spouse jointly and severally liable for the full tax shown on the return, and for any amount arising from a subsequent audit. Married couples filing joint returns are not the only taxpayers subject to joint and several liability. The IRS may assess multiple parties with the same tax in a host of different circumstances. Most commonly, the IRS will assess officers of a business with civil penalties if the business fails to pay certain taxes such as withholding tax. Officers of the business, certain employees and the business itself may be jointly and severally liable on the same tax. The IRS may collect the entire tax from any one of the parties or it may collect different portions from different parties based on



their ability to pay, but it may only collect the total tax once. The IRS has no interest in equalizing the debt among those liable. II. Collection. A. Collection Notices and Collection Due Process Appeals. If the tax is not promptly paid after assessment, the IRS may begin forced collection actions. This begins with the mailing of collection notices. There is a separate collection notice sent for every tax period. The IRS is required to issue a series of five or six collection notices following assessment; each becomes progressively more threatening until, finally, the taxpayer receives either a “Final Notice of Intent to Levy and Your Right to a Hearing” or “Notice of Federal Tax Lien Filing and Your Right to a Hearing.” The “hearing” referred to is the taxpayer’s collection due process appeal (“CDP Appeal”). The taxpayer is given the opportunity to formally appeal forced collections efforts or a lien filing within 30 days from the date of the notice. Except in special circumstances, the IRS must refrain from forced collections, such as seizures of property, until the taxpayer’s CDP appeal rights expire. If the taxpayer fails to timely file a CDP Appeal, the taxpayer becomes exposed to liens, levies and garnishments. The IRS’ required notice process can take anywhere from four to eight months. A taxpayer may only file a CDP Appeal once for each tax period. This means that the taxpayer will need to decide which appeal may be more important given their individual circumstances, appealing the filing of a tax lien or appealing forced collections. The official request form is Form 12153. The CDP Appeal can be critical to the taxpayer’s resolution strategy. We almost always recommend that a taxpayer file a CDP Appeal on a final notice of intent to levy. Filing an appeal gives the taxpayer more time to figure out the best plan of resolution. Collection actions are stayed until a final determination in the CDP Appeal has been made. It is not uncommon for a CDP Appeal to last four to ten months. The CDP Appeal provides the taxpayer with the opportunity to propose and negotiate alternatives to forced collections like an installment plan, offer in compromise or uncollectible status. The taxpayer may also address spousal defenses or in some cases, contest the amount of the tax. It is also a great opportunity for the taxpayer to work with someone new if the taxpayer or the taxpayer’s representative is struggling to resolve the tax matter with the assigned revenue officer. Once an appeals officer has been assigned to the taxpayer’s case, the taxpayer will be given the opportunity to request an in-person hearing with a local appeals office. We strongly recommend that the taxpayer respond to this letter and request a transfer to the Portland Office of Appeals. The Portland Appeals Office is small and much easier to work with than the larger service centers. The ODR also has a series of collection notices that get progressively more threatening. The ODR does not, however, have the same collection appeal procedures or required collection holds. It is important to respond to the ODR’s collection notices as soon as possible.



It is extremely important that the taxpayer actually receive the tax notices. Notice is proper if the taxing authority sends the notice to the last known address provided by the taxpayer. Unfortunately, the last known address is often the address listed on the taxpayer’s last filed return. This may be out of date for those that have not filed tax returns or for those that have moved. The taxpayer must notify the IRS in writing by using IRS Form 8822 or by writing a letter that includes the taxpayer’s full name, old and new address, social security number and signature. For joint filers, each spouse must sign. B. The IRS’ Collection Power - Garnishments and Levies. Once collection starts, there are few limits on the IRS’ power to collect. It may levy on bank accounts, accounts receivable or any funds due and owing to the taxpayer. It may garnish a taxpayer’s wages without the 25 percent gross wage limitation of other creditors. The IRS has its own exemption calculations and they are far less than reasonable. For example, a single or married filing separate individual with no dependents may exempt a mere $858 from garnishment per month. A head of household with two children may exempt only $1,771 per month. The IRS may also levy a taxpayer’s retirement account and garnish social security payments. The IRS will typically only garnish 15 percent of a taxpayer’s social security payments unless the taxpayer has additional income and is not cooperating with the IRS. It can also summons bank records and information from third parties, without commencing a lawsuit! In contrast, the ODR behaves more like an ordinary creditor. It is subject to a 25 percent limitation on a taxpayer’s wages and does not take priority over other creditors with garnishments already in place. Neither can the ODR seize retirement accounts. In addition, once the ODR commences garnishment, it admittedly refuses to release the garnishment until the tax is paid in full. In contrast, the IRS will release a garnishment once the taxpayer enters into a formal installment agreement or other plan of resolution. C. Statute of Limitations. The IRS has ten years to collect a tax once assessed. Several actions will toll the collection statute. These include filing a bankruptcy, filing a CDP appeal, submitting an offer in compromise and filing for innocent spouse relief. It is common for the statute to be tolled while each action is pending plus an amount of additional time to allow the IRS the opportunity to place the taxpayer’s file back in collections. The ODR has no statute of limitations on its tax collection period. D. Federal and State Tax Liens. A statutory lien arises as a matter of law when the tax is assessed and goes unpaid. The federal tax lien attaches to all of the taxpayer’s property and rights to property that belong to the taxpayer existing then or later acquired. The ODR’s tax lien is more limited. It is afforded the



same rights as an ordinary judgment lien against real property and is subject to Oregon property exemptions. The federal tax lien suffers no such limitations. The IRS files a Notice of Federal Lien with the Oregon Secretary of State to perfect its interest against personal property and in a county’s recording office to perfect its interest against real property located in that county. A tax lien must be filed before it is entitled to priority over security interest holders, purchasers, mechanics liens and judgment lien creditors. However, priority of filed and competing federal and state tax liens is determined by the date of assessment of the tax and not by filing date. The IRS lien need not be filed to be valid against most other interests arising after assessment. A few liens enjoy priority over federal tax liens regardless of when the lien came into existence, including attorney liens and property taxes. A federal tax lien is valid for ten years. Several circumstances extend this period, including the filing of a bankruptcy. In addition, the IRS may commence suit and reduce its liability to judgment. Reducing the liability to judgment gives the IRS the same collection rights as other judgment creditors including the ability to renew the judgment for an additional ten years. In practice, the IRS rarely reduces a lien to judgment. In certain circumstances, the IRS may subordinate its lien to other creditors. A taxpayer requests subordination by completing and submitting IRS Form 14134. Tax liens may be released, withdrawn, or discharged. Each is a different process and has different results. A federal tax lien is released when the debt is paid in full, when a taxpayer has satisfied the monetary obligations of an accepted offer in compromise, or when the collection statute has run. The lien and release will continue to be public record and stays on the taxpayer’s credit report for at least seven years. The IRS may withdraw a notice of lien filing from public record if it made a procedural error, the taxpayer has entered into an installment agreement and certain conditions are met, or if the lien was filed during a bankruptcy proceeding. It may also withdraw its lien if doing so will help the taxpayer pay the tax or if it is in the taxpayer’s and the IRS’ best interest. The IRS will withdraw its lien if the taxpayer can show the filing of a tax lien will result in his or her inability to earn income and pay the tax. If the withdrawal is granted, the original filing and the withdrawal will not be public record and will not show on a credit report. The IRS may also discharge a tax lien. A lien discharge removes the lien from specific property. A taxpayer or a party of interest may apply for a partial or complete lien discharge using IRS Form 14135. The IRS will generally grant a discharge if the IRS receives an amount not less than the value of its interest in the property or if its interest in the property has no value. III. Tax Resolution Options. When a taxpayer owes more in tax than he or she can afford to pay, there are only four options. Each is discussed briefly in turn.



A. Do Nothing. A few taxpayers can look the IRS in the eye, not blink, and get away with doing absolutely nothing to address an unpaid tax. However, these few folks are not necessarily to be envied. They are truly poor and otherwise collection proof. Taxpayers are collection proof as to the IRS only if they have no equity in assets and no income. This is not an enviable position - but at least they needn't worry about tax collection. This is especially so when one considers that the IRS is not deterred by ordinary bars to collection that frustrate most creditors. For example, the IRS is not prohibited from levying Social Security payments or seizing retirement accounts. For taxpayers with regular income or equity in assets, doing nothing comes with grave consequences. Choosing to ignore the IRS will subject the taxpayer to forced collections including levies, wage garnishments and tax liens. B. Installment Plans. The IRS attempts to direct most taxpayers who can't pay their tax bill into installment plans. These are formal agreements between the taxpayer and the IRS under which the taxpayer makes regular monthly payments and the IRS foregoes other collection activities so long as the taxpayer makes each payment on time and stays in current tax compliance. Current tax compliance requires that all subsequent tax returns are filed on time. It also requires that all subsequent tax liabilities, including required estimated deposits, are paid in full when due. A taxpayer must also have filed all required returns before the IRS will agree to an installment plan. Individual taxpayers with a total liability, including penalties and interest, of $50,000 or less may apply for an installment agreement online. This is referred to as a streamlined installment agreement and a financial statement is not required. Taxpayers not qualifying for a streamlined installment agreement may apply for an agreement by submitting a financial statement (433-F or 433-A for individuals) along with a Form 9465 installment agreement request. It is also possible to contact the IRS by telephone and negotiate an installment plan. Be prepared, however, to fax the required documents. Installment plans run until the tax liability is paid in full or until the collections period expires. The IRS can collect a tax for ten years from the date of assessment but certain activities can toll the collections period thereby lengthening the time period. In addition, a tax liability can be reduced to judgment which extends the collections period for an additional ten year. C. Offers in Compromise. As some radio and late night television commercials loudly proclaim, it is possible to settle tax debts for pennies on the dollar. This process, referred to by the IRS as an "offer in compromise," is a good alternative to those taxpayers that qualify.



When a taxpayer's reasonable collection potential is less than their full tax liability, the IRS may agree to a lesser payment. In doing so, the IRS considers a taxpayer's income, reasonable expenses (as determined by the IRS), and equity in assets. In essence there are two components, equity and income, which combine to make up the minimum amount the IRS will settle for. The initial calculations are made on IRS Form 433-A(OIC). First, the IRS determines the value which it can recover if the taxpayer's property were seized and sold. The fair market value of most property is reduced by 20 percent to allow for the cost of seizure and sale. Allowances may be made for payment of income tax incurred on the sale of capital assets or investment and retirement accounts. Second, the IRS calculates a taxpayer's disposable or net monthly income but the expenses used are generally the national standards, not the taxpayer's actual expenses (unless the taxpayer's expenses are less than national standards). Net monthly income is multiplied by 12 or 24 months depending on the type of offer submitted to arrive at the income side of the equation. The offer itself is submitted on IRS Form 656. This form takes the minimum offer calculated on Form 433-A(OIC) and applies it to a proposal for what are confusingly termed a "lump sum payment" plan of five or fewer payments in less than one year or a "periodic payment" plan which may be more than five payments made in less than two years. The taxpayer must be in current tax compliance before an offer is accepted for review. Once accepted, the IRS places the taxpayer in a collection hold until the offer is returned, rejected, or accepted. If the offer is returned, the taxpayer is placed back into collections after 30 days. If the offer is rejected, the same 30 day collection hold applies, however, within that time the rejection may be appealed. An accepted offer places the IRS and the taxpayer into a five year contract. If the taxpayer makes the agreed payments the unpaid tax liability will be discharged - but only if the taxpayer meets the remaining terms of the contract. One of the most important requirements is that the taxpayer stays in tax compliance for the five year term. So long as the taxpayer does not default, at the end of the term the unpaid liability is discharged. As an added bonus, any recorded tax liens should be released within a short time after an offer is accepted. D. Bankruptcy. Income tax liabilities may be dischargeable in bankruptcy unless an exception to discharge applies - and there are many exceptions. Exceptions to discharge include the following: (a) A tax for which a fraudulent return was filed; (b) A tax for which a return was required but never filed; (c) A tax which the taxpayer willfully attempted to evade or defeat;



(d) A tax for which a return was due, including extensions, within three years of the bankruptcy petition date; (e) A tax for which the return was filed late and less than two years prior to filing the bankruptcy case; (f) A Tax assessed within the 240 day period before the petition date; and (g) An unassessed but assessable tax. Withholding tax liabilities such as sales tax and employment taxes are non-dischargeable. Certain excise taxes are also non-dischargeable in bankruptcy. E. Uncollectable Status. The IRS sometimes agrees to place certain taxpayers in uncollectable status, referred to as "currently not collectible" or "CNC." To qualify, taxpayers must have little in the way of assets that the IRS could or would seize, and earn income at or below the amount required to meet their necessary living expenses (as determined by the IRS). These folks may avoid or defer collections by completing and providing to the IRS a simplified financial statement referred to as a Form 433-F. If the 433-F shows that the taxpayers cannot currently pay any portion of their tax liability while meeting their necessary living expenses, the IRS will generally place them in a collections hold referred to as "currently not collectable" or CNC. This status can last up to two years at which time the IRS will require the taxpayers submit new financials. F. Relief From Joint and Several Income Tax Liability. Married couples who file a joint income tax return are jointly and severally liable for any tax due on the return. This is true even if only one spouse earned most or all of the income and remains so even after a divorce - regardless of any language in the judgment of dissolution. Under certain conditions, however, a spouse or former spouse may be relieved of a joint and several tax liability. Four separate types of relief are possible: (1) innocent spouse relief; (2) separation of liability relief; (3) equitable relief; and (4) injured spouse allocation. The first three types of relief are explained by IRS Publication 971 and may be applied for on IRS Form 8857. Injured spouse allocation is applied for on IRS Form 8379 and explained to some extent in the instructions. 1. Innocent Spouse Relief. The IRS may release one spouse from a tax liability created primarily by the other spouse under certain circumstances. If innocent spouse relief is granted, the qualifying spouse is relieved of all tax, interest, and penalties associated with the other spouse for the tax years at issue. Although the IRS has discretion to grant this relief, it is often reluctant to do so. Regardless, there are four conditions, each of which must be met to qualify for innocent spouse relief, as follows: (1) The spouses must have filed a joint return; (2) The return must have shown an understated tax due to an "erroneous item" of the spouse or former spouse of the



taxpayer applying for relief. Erroneous items can be unreported income or a deduction, credit, or basis that the IRS disallows; (3) The taxpayer must prove that, when she signed the joint return, she "did not know and had no reason to know" of the existence or amount of the understated tax; (4) Taking into account all of the facts and circumstances, it would be unfair to hold the taxpayer liable for the understated tax. The IRS considers all of the facts and circumstances in determining whether it is unfair to hold a taxpayer liable for an understated tax. Items considered include: (a) whether the taxpayer received a significant benefit from the understated tax; (b) whether the spouse or former spouse deserted the taxpayer applying for relief; and (c) whether the taxpayers are divorced or separated. 2. Separation Liability Relief. If separation of liability relief is granted, the understated tax is allocated between spouses based on the amount each would be liable for separately. This type of relief is predicated on actual "knowledge" of the erroneous item and does not include a "reason to know" element. This can be important to gaining relief as the IRS nearly always believes that anyone signing a tax return has a "reason to know" everything stated on the return. Although the "actual knowledge" element is less onerous, additional conditions are added. First, the spouse applying for relief must be divorced, legally separated, or not a member of the same household as the non-requesting spouse for any time during the prior 12 month period. Second, relief will not be granted if the taxpayers fraudulently transferred assets in an attempt to avoid paying the tax or a debt owed to a third party. Fortunately, transfers made according to a divorce decree and transfers not intended to avoid the tax payment do not violate these conditions. 3. Equitable Relief. Taxpayers not qualifying for innocent spouse relief or separation of liability relief may nonetheless qualify for "equitable relief" from a joint and several liability. Equitable relief is not often granted and can be considered something of a last resort. First, the taxpayer applying for relief must meet initial threshold requirements: (1) Not eligible for innocent spouse or separation of liability relief; (2) Filed a joint return; (3) Timely filed for relief;

(4) Did not transfer assets as part of a fraudulent scheme or with the primary purpose of avoiding payment of the tax; (5) Did not knowingly file a fraudulent joint tax return; and (6) The tax liability is attributable to the taxpayer's spouse or former spouse. If these initial threshold requirements are met, the IRS then considers a non-exclusive list of factors to determine whether relief should be granted, including the following: (1) Marital status for the preceding 12 months; (2) Will the taxpayer suffer economic hardship if relief is not



granted? (3) Taxpayers knowledge of erroneous item; (4) Did the taxpayer reasonably believe when signing a properly reported but unpaid tax that the other spouse would pay the liability within a reasonable time? (5) Did the taxpayer have reason to know? If granted, equitable relief will provide the same relief as innocent spouse relief. 4. Injured Spouse Allocation. In addition to relief from joint and several liability relating to a jointly filed tax return, there is an additional form of relief when a refund from a jointly filed income tax return is kept by the IRS to pay or offset a past tax liability of only one spouse. Under "injured spouse allocation" a taxpayer can request the portion of the refund allocable to his or her income and tax attributes be returned rather than be retained by the IRS. There are two requirements. First, the tax liability must belong to only one of the spouses. Second, the non-liable spouse is entitled to only that portion of the refund which is properly allocable to his or her income and tax attributes. Injured spouse allocation relief is explained and may be applied for on IRS Form 8379.



Chapter 6

Tax Issues at Settlement—Presentation SlidesJeReMy babeneR

Lane Powell PCPortland, Oregon

Chapter 6—Tax Issues at Settlement—Presentation Slides




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©2012 Lane Powell PC

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Tax Issues at Settlement

Broadbrush Taxation, Oregon State Bar

October 2015Jeremy Babener

[email protected](503) 778-2140


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Notice

Any tax advice in this presentation is not intended or written to be used, and cannot be used, by a client or any other person or entity for the purpose of (i) avoiding penalties that may be imposed on any taxpayer or (ii) promoting, marketing or recommending to another party any matters addressed herein.

The information contained herein is of a general nature and based on authorities that are subject to change. Applicability of the information to specific situations, including suggested strategies, should be determined through consultation with your tax advisor.



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Presentation Outline

1. Business and Investment Damages2. Taxation of PI Lawsuit Proceeds3. Settlement Agreements 4. Deductibility of Legal Expenses5. Structured Settlements6. Qualified Settlement Funds


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Business and Investment Damages• Determining the Character of Damages

• Look to the origin and nature of the claim. United States v. Gilmore, 372 U.S. 39 (1963).

• Treat damages as a substitute for lost items. TAM 200427023.

• Example: Buyer of Asset Sues Seller for Fraud• Damage claims may have multiple “origins”

• Inflated acquisition price• Lost profits

• Character of damages is based on the facts



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Taxation of PI Lawsuit ProceedsGeneral Rules for Physical Injuries and Sickness• Damages received on account of personal physical injuries and physical sickness

are nontaxable.• Damages attributable to deducted medical expenses are taxable.

General Rules for Emotional Distress• Damages for emotional distress not attributable to physical injuries are taxable.• The term “emotional distress” includes physical symptoms of emotional distress

(e.g. headaches and stomach disorders).• Damages paid for medical care attributable to emotional distress are nontaxable.

Other Lawsuit Proceeds• Punitive damages are taxable.• Pre-judgment and post-judgment interest is taxable.


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Settlement Agreements

• Where payments include taxable and nontaxable portions, courts have required plaintiffs to prove (1) the payor’s intent and (2) the size of the nontaxable portion.

• Specific Settlement Agreement vs. General Release• Benefits of specificity• An allocation is respected if…

1. The parties had adverse interests with respect to the allocated item, and2. The allocation reflects the intent of the payor.



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Deductibility of Legal Expenses

Amount of Recovery Used to Pay Legal Expenses• Generally included in income. Comm’r v. Banks, 543 U.S. 426 (2005).• Sometimes excluded from income.

o Limitations on Banks’ scope.o Class action cases.

Deductions Available• Business expenses. § 162.• Expenses to produce income. § 212 (miscellaneous).

• § 212 deductions disallowed under the AMT. § 56(b)(1)(A)(i).• Civil rights and employment cases. § 62(a)(20).


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Structured SettlementsIRC § 104(a)(2) Language• Excludes damages “whether as lump sums or as periodic payments.”

Investing Settlement Payments• Once the payment is received, growth is taxable.

Tax-Free Investment Income by Structuring• A portion of each payment includes investment income.• Payments are not recognized until received.• Benefits available only if no E.B. or C.R.

Use of Qualified Assignment Companies• Assignment company. § 130.• Injured party.

D Assignment Co.

Life Ins. Co.

P

Liability



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Qualified Settlement FundsSolving Different Problems• Time needed to identify payments and liabilities (e.g., medicare).• Time to apportion settlement proceeds among multiple claimants.• Work around defendant’s structured settlement demands.

Treatment of Payment to Qualified Settlement Fund (QSF)• Deduction for payor. § 468B.• Structured settlement opportunity is preserved if plaintiff does not

have economic benefit or constructive receipt.


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Questions?

Jeremy [email protected](503) 778-2140



Chapter 7

Crossing the Columbia: An Introduction to Navigating State Taxes in the Pacific Northwest1

david bRandon

Miller Nash Graham & Dunn LLPPortland, Oregon

1 These materials are for discussion and education purposes only and do not purport to cover the entire scope of issues relevant to state and local tax. The scope of these materials is further limited to the tax regimes of Oregon and Washington.

Contents

Types of State Taxes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7–11. Oregon . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7–12. Washington . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7–1

Taxation of Individuals . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7–21. Tax Residency . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7–2

Taxation of Multistate Businesses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7–51. Constitutional Underpinnings of Multistate Taxation . . . . . . . . . . . . . . . . . . . 7–52. Nexus . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7–63. Income Sourcing and Apportionment . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7–7

Chapter 7—Crossing the Columbia: An Introduction to Navigating State Taxes in the Pacific Northwest




TYPES OF STATE TAXES

1. Oregon:

a. No sales or use tax

b. Personal income tax (ORS 316): Tax against the income of an individual.

c. Corporate income tax (ORS 318): Tax against the Oregon-sourced income of a corporation that does not do business in Oregon.

d. Corporate excise tax (ORS 317): Tax against the income of a corporation doing business in Oregon.

e. Property tax (ORS 306-308A): Tax against the assessed value of real property and improvements thereon.

f. Personal property tax (ORS 306-308): Tax against the value of personal property used by businesses.

g. Estate tax (ORS 118): Tax against the value of the estate of a deceased person.

h. Miscellaneous taxes (ORS 319-324)

i. TriMet payroll / self-employment tax (TriMet Code chapters 13-14): Tax against the quarterly wages paid by employers or against income of self-employed persons located in the Tri County Metropolitan Transit District.

j. Lane county transit tax: The equivalent of the TriMet payroll/self-employment tax against taxpayers located in Lane county.

k. Real estate excise tax (Washington County only) (Washington County Code Section 3.04): Tax against the sale price of real property.

2. Washington:

a. No income tax

b. Retail sales tax (RCW 82.08): Tax against the sale price of tangible personal property.

c. Use tax (RCW 82.12): Tax against the value of tangible personal property purchased outside of Washington but used in the state.

d. Business and occupation tax (RCW 82.04): Tax against gross receipts of businesses doing business in Washington.

e. Real estate excise tax (RCW 82.45): Tax against the sale price of real property.

f. Property tax (RCW 84): Tax against the assessed value of real property and improvements thereon.

g. Estate tax (RCW 83): Tax against the value of the estate of a deceased person.

h. Miscellaneous taxes (see RCW 82)



TAXATION OF INDIVIDUALS

1. Tax Residency

a. General rule:

A state can tax the entire income of its residents, regardless of where that resident earns the income. Alternatively, a state can only tax the income of a nonresident to the extent the income is connected ("sourced") to that state.

Washington does not impose an income tax. Therefore, Washington residents are subject to income tax only to the extent that they derive income from Oregon, Idaho, or Montana (or any other state that imposes an income tax) and are taxed as nonresidents of that state.

b. Oregon:

General rule: Anyone domiciled in Oregon, or anyone spending more than 200 days in Oregon, is a resident.

For Oregon income tax purposes, a resident is someone who fits into one of two categories: (1) someone who is "domiciled" in the state of Oregon or (2) someone who is not domiciled in Oregon, but spends more than 200 days at a permanent place of abode in the state, unless she proves that she was in the state for a temporary or transitory purpose. ORS 316.027. A person is domiciled in the place that she considers to be her permanent home and to which she intends to return after an extended absence. OAR 150-316.027(1). A permanent place of abode is the place established by the taxpayer as her dwelling over a period long enough to "create a well-settled physical connection" with the location. Id. The person doesn't need to own the dwelling for it to become a permanent place of abode: rental properties qualify. OAR 150-316.027(1)(1)(b)(A).

There are certain categories of persons who are statutorily exempted from residency status. The first such category includes persons domiciled in the state, but who have no permanent place of abode in Oregon, have a permanent place of abode outside of the state, and spend less than 30 days per year in Oregon. ORS 316.027(1)(a)(A). United States citizens living abroad for greater than 330 days in a tax year and their spouses are likewise exempt from establishing Oregon residency for income tax purposes. ORS 316.027(1)(b).

A person can only have one domicile at a time. OAR 150-316.027(1). Once a person has established a domicile in Oregon, the person can only change their domicile to another state by showing (1) intent to abandon her Oregon domicile, (2) intent to establish a new domicile elsewhere, and (3) physical presence in the new domicile. OAR 150-316.027(1)(a); see also Davis v. Dept. of Rev., 13 OTR 260, 264 (1995).

These three elements are established by the facts and circumstances of each case. In determining whether each element has been satisfied, the Oregon Tax Court has reviewed a number of factors, including:

i. Physical presence in Oregon; ii. Close family members living in Oregon;

iii. Ownership of a residence or real property in Oregon; iv. Ownership of personal property located in Oregon; v. Bank and investment accounts with Oregon financial institutions;

vi. Possession of an Oregon driver's license;



vii. Vehicles licensed in Oregon; viii. Voter registration in Oregon;

ix. Professional and business affiliations in Oregon (e.g., doctors, dentists, stock brokers, accountants, etc., in Oregon);

x. Participation in social organizations in Oregon (e.g., membership in the Oregon State Bar, Oregon Society of Certified Public Accountants, health clubs, churches, and other community organizations);

xi. Mailing address for bills, tax returns, and personal mail; and xii. Charitable donations to organizations located in Oregon.

c. Washington General rule: Anyone undertaking certain enumerated activities in Washington is

deemed a resident.

Because Washington has no income tax there is no statutory income tax residency standard. Curiously, although there are statutory exemptions for nonresident persons under the sales, use, and watercraft excise-tax regimes, there is no statutory standard for establishing residency for the purposes of these taxes either. The Revised Code of Washington does, however, provide residency definitions in the context of motor vehicle registration and qualification for in-state tuition at state universities. See RCW 46.16A.140; RCW 28B.15.011-013. Each of these definitions provides a relatively high hurdle to establishing oneself as a resident of Washington. Yet, the Washington Department of Revenue ("WDOR") does not apply these standards to any of Washington's tax regimes.

Rather, WDOR publishes guidance on its website stating that, for tax purposes, WDOR presumes a taxpayer is a Washington resident if the taxpayer engages in any of certain enumerated activities, including:

i. Maintaining a personal residence in Washington; ii. Living in a nonpermanent home in Washington, if the person doesn't have

a permanent home in another state; iii. Registering to vote in Washington; iv. Receiving public assistance from Washington; v. Having a state professional or business license in Washington;

vi. Attending school and paying tuition as a Washington resident; vii. Using a Washington address for federal or state taxes;

viii. Having a Washington driver's license; or ix. Claiming Washington residency for eligibility for licensure or public

office.

A taxpayer may rebut the presumption of residency by providing facts showing "that they do not intend to reside in this state on either a temporary or permanent basis."1 WDOR will not consider a person's relationship to another state or the location of the person's established domicile as evidence of that person's intent (or lack thereof) to reside in Washington. The statutory, regulatory, or judicial basis for this presumption is unclear. In fact, there is no authority for such a presumption beyond WDOR's bald assertion of its existence.

1 http://dor.wa.gov/content/contactus/con_residdef.aspx



Although "residence" is undefined in Washington's tax statutes, the Washington Supreme Court held that the term "residence" should be interpreted with respect to the purpose of the statute implementing the term. McGrath v. Stevenson, 194 Wash 160, 162 (Wash. 1938). Subsequently, the Washington Supreme Court repeatedly stated that the term "residence" means "domicile" in the context of state taxation. In re Lassin's Estate, 33 Wash 2d 163, 165-166 (Wash 1949) (construing "residence" and "domicile" for estate tax purposes); In re Mullins, 26 Wash 2d 419, 443-44 (Wash 1946) ("Statutory 'residence' is equivalent to domicile. Especially is this true with regard to the subject[] of … taxation"). A person cannot have more than one domicile at one time, and establishment of domicile requires both physical residence and the intent to remain. In re Lassin's Estate, 33 Wash 2d 163; see also In re Marriage of Strohmaier, 34 Wn App 14 (1983).

There is no controlling case law or statutory authority that compels the conclusion that a taxpayer's residence differs from the taxpayer's domicile for Washington tax purposes. And, indeed, the Washington Board of Tax Appeals traditionally has found that domicile and residence are "invariably intertwined." Everman v. Department of Revenue, Washington Board of Tax Appeals Docket No. 44854, *8 (1995). To the extent that the Washington Supreme Court has so held and the Washington Board of Tax Appeals has so applied the rule prior to 1996, Washington's residency standard should closely mirror that of Oregon and follow the rule that only persons domiciled in Washington are residents of Washington, while those domiciled elsewhere are nonresidents.

However, in 1996 the Supreme Court of Washington decided Sheldon v. Fettig, 129 Wash 2d 601 (Wash 1996) (en banc). In Sheldon, the Court held that a party may serve a defendant by means of substitute service of process at the defendant's "usual place of abode," and that service at any of several abodes will effectuate service if the abode "is a center of domestic activity where it would be most likely that [the] defendant would promptly receive notice if the summons were left there." Sheldon, at 612.

In reliance on Sheldon, the Board of Tax Appeals began separating the concepts of domicile and residence such that a taxpayer could, for the first time, have multiple states of residence for tax purposes. In so doing, the Board of Tax Appeals applied the Sheldon "center of domestic activity" test as the primary method of determining the taxpayer's residency status. See Andreasen v. Department of Revenue, Washington Board of Tax Appeals Docket No. 47810 (1996). The center of domestic activity test implies that a resident "maintains a place of abode where one habitually returns to eat, sleep, and be contacted by relatives, friends, and society at large." Andreasen, at 6. The center of domestic activity is established by objective indicators of residency, including the existence of "personal effects, family property, telephone connections, [and] mail service," on such a scale that fairness mandates imposition of tax as a means of recompensing the state for the services rendered to the taxpayer. Id.

Inexplicably, the Washington Board of Tax Appeals construed the Sheldon holding as replacing the minimum due-process-clause requirements in the realm of state taxation with the due-process standard for establishing personal jurisdiction in a court of law. The standards are inherently different because each standard targets a different level of contacts with the jurisdiction necessary to support different state actions with respect to the individual. For example, a party physically present in a state for even a split second is subject to the jurisdiction of that state for the purpose of service of process, and could be served with notice of a lawsuit within the requirements of the due-process clause as it relates to adequacy of such notice. See



e.g., Grace v. MacArthur, 170 F Supp 442 (E.D. Ark 1959) (state had jurisdiction over a person served in an aircraft in the airspace above the state). Indeed, the concept of residency encompassed in RCW 4.28.080, the statute governing service of process interpreted by the Sheldon court, is nothing more than a requirement that the person served is not stopping by or visiting the location, but has enough connection with the location that there is some assurance that the defendant will actually receive notice of the summons served upon that person by substituted service. See, e.g. Salts v. Estes, 133 Wash2d 160 (Wash 1997) (en banc); Wichert v. Cardwell, 117 Wash2d 148 (Wash 1991) (en banc).

No case law or legal theory compels the conclusion that residence for the purpose of service of process satisfies the due-process standard for imposing tax. Clearly the state must show a higher degree of connection than that sufficient to give notice of a lawsuit under the service of process statute in order to levy a tax that only applies to residents of the state. To the extent the Board of Tax Appeals applied the center of domestic activity test in reliance on Sheldon, the Board's decisions have been wrongly decided and have no precedential value. See Seattle Filmworks, Inc. v. State Dep't of Revenue, 106 Wash. App. 448, 459 (Wash 2001); see also Valley Fruit v. State, Dep't of Revenue, 92 Wash. App. 413, 419 (Wash. 1998) (finding that although both parties cited to a Board of Tax Appeals decision, "the Board's decision is not binding on this court in any event.").

Therefore, because the Supreme Court of the State of Washington has held that a taxpayer's residence does not differ from the taxpayer's domicile and because there is no controlling precedent compelling any different conclusion in the context of sales, use, or watercraft excise tax, the correct standard by which residency should be judged is (1) physical presence in Washington and (2) the intent to remain in the state, as manifested by the taxpayer's actions with respect to Washington and the taxpayer's established domicile in his home state. Unfortunately, however, this is an unsettled question and is not likely to be resolved in the near future.

TAXATION OF MULTISTATE BUSINESSES

1. Constitutional Underpinnings of Multistate Taxation

A state's ability to levy a tax is limited by the United States and state constitutions.

a. Commerce Clause: The commerce clause of the United States constitution reserves to the Congress exclusive right to regulate interstate commerce. Nonetheless, United States Supreme Court jurisprudence dictates that a state may levy a tax upon interstate commerce without encroaching upon the United States' Congress commerce-clause powers if:

i. The activity taxed is sufficiently connected to the state to justify a tax;

ii. The tax is fairly related to the benefits conferred upon the taxpayer;

iii. The tax does not discriminate against interstate commerce; and

iv. The tax is fairly apportioned between the states.

Complete Auto Transit, Inc. v. Brady, 430 US 274, 94 S Ct 1076 (1977).

b. Due Process: The due-process clause of the fourteenth amendment to United States constitution prohibits a state from depriving any person of life, liberty, or property without the due process of law. The due-process clause "requires some definite link, some minimum



connection, between a state and the person, property or transaction it seeks to tax, and that the income attributed to the State for tax purposes must be rationally related to 'values connected with the taxing State.'" Quill Corp. v. North Dakota, 504 US 298, 307, 112 S Ct 1904 (1992) (internal citations omitted).

i. The United States Supreme Court held in Quill that if a corporation purposefully directs its activities at an economic market in the taxing jurisdiction, the "minimum connection" requirement of the due-process clause is satisfied, even if the corporation is not physically present in that jurisdiction. See Quill, at 308. The Court also noted, however, that due to the inherent difference in the ambit of the commerce clause (concerning the right to regulate interstate commerce) and of the due-process clause (concerning fundamental government fairness), a state may satisfy the "minimum connection" required by the due-process clause and yet fail to satisfy the "sufficient connection" required by the commerce clause. Quill, at 313.

ii. The requirement that the income being taxed bear a rational relation to "values connected with the taxing State" is analogous to the commerce-clause requirement that the tax be fairly apportioned; however, the United States Supreme Court has likened this component of due-process jurisprudence to "slicing a shadow," Container Corp. v. Franchise Tax Board, 463 US 159, 192 (1983), meaning that the apportionment considerations under the due-process clause are largely eyewash and do little in the way of providing any real guidance.

2. Nexus

As mentioned in the discussion of the Complete Auto Transit case above, the commerce clause of the United States constitution requires a state to have sufficient connection to the taxpayer's activities to justify the tax. Likewise, the due-process clause, as interpreted by the Supreme Court in the Quill case, requires some minimum connection to the taxing jurisdiction. This level of connection between the taxpayer and the taxing jurisdiction is commonly referred to as "nexus."

a. Terminology:

Agency (or Affiliate) Nexus: The theory that nexus with a taxing jurisdiction can be established through a taxpayer's agents or affiliates. For example, a state taxing a parent company based on the subsidiary's activities in the state.

Economic Nexus: The theory that nexus with a taxing jurisdiction can be established by merely making sales to the residents of the state.

b. Public Law 86-272: Statutory exemption from taxable nexus for taxpayers whose only activities in a state are soliciting sales. This only applies to income-tax nexus. Therefore, taxpayers who are physically present in a state to solicit sales will still be subject to sales tax but not income tax. Conversely, taxpayers who do more than solicit sales will be subject to income tax, even if the taxpayer has no permanent physical establishment in the state.

c. Oregon Corporate Excise and Corporate Income Taxes: There is no statutory definition for the term "nexus" in the Oregon Revised Statutes. Rather, the statutory threshold for taxability in Oregon income-tax law is tied to the concept of "doing business" as defined in ORS 317.010(4). This broad definition includes the conduct of any "transaction" in Oregon.



The regulations, however, clarify that Oregon imposes its income tax to the fullest extent permitted by the United States and Oregon constitutions and public law 86-272. OAR 150-317.010. To that end, the regulations provide that "substantial nexus exists where a taxpayer regularly takes advantage of Oregon's economy to produce income for the taxpayer and may be established through the significant economic presence of a taxpayer in the state." OAR 150-317.010(2).

d. Washington Sales, Use, and Business and Occupation Tax: As of September 1, 2015, Washington applies an economic nexus standard to out-of-state retailers and wholesalers for business- and occupation-tax purposes. By statute, the state dictates that a taxpayer has nexus with Washington if certain operational thresholds are met. Therefore, in 2015, a taxpayer has nexus with the state if the taxpayer earns more than $267,000 of gross income in Washington, has more than $53,000 of its payroll or property in Washington, or more than one quarter of its total property, payroll, or income is attributable to Washington. RCW 82.04.067.

Retailers are additionally subject to an affiliate nexus standard for sales, use, and business and occupation taxes. This standard, also effective as of September 1, 2015, provides that retailers have substantial nexus with Washington if they have entered an agreement with a Washington resident, whereupon the retailer pays a commission to the resident for customer referrals, and the revenue associated with Washington exceeds $10,000.

Quill adopted a bright-line physical-presence test to establish nexus for sales or use taxes. Quill, at 317. Therefore, any taxpayer physically present in Washington is subject to sales or use tax, while any taxpayer not physically present in the state would generally expect to not be subject to Washington's sales- or use-tax regimes. Washington's affiliate nexus rule refines the physical-presence requirement adopted by the United States Supreme Court in Quill for the imposition of sales or use taxes. 6138-S.SL. In recognition of its departure from the accepted interpretation of the commerce-clause jurisprudence, section 201 of the sessional law recites the physical presence requirements established by Quill and explains the legislature's intent to interpret the physical presence nexus standard in a manner more befitting the era of e-commerce. The nexus standard adopted by the Washington legislature is not entirely different from the so-called "click-through" nexus standards adopted in New York, Colorado, and elsewhere in response to the widespread practice of out-of-state retailers not collecting and remitting sales tax in jurisdictions in which the retailer has no physical presence. Under the new Washington statute, an out-of-state retailer is subject to the Washington sales tax regime (that is, the retailer must collect and remit sales tax to the state) if the retailer is party to an agreement with a Washington resident for referral of customers and such referrals results in greater than $10,000 of sales to Washington customers. 6138-S.SL, Section 202.

3. Income Sourcing and Apportionment

A taxpayer's business income is apportioned between the states based on a formula complying with the requirement adopted in the Complete Auto case that the taxpayer's income be "fairly apportioned" between the states. Although the United States Supreme Court has approved a variety of different formulae, it has not imposed a single apportionment regime on the states. Therefore, each state is free to choose its own method of apportioning income, even if such formula differs from neighboring states and subjects the taxpayer to taxation on greater than 100 percent of the taxpayer's income.



a. Oregon i. Apportionment Formula

Business income of nonresident taxpayers is apportioned to Oregon by multiplying the taxpayer's income by the ratio of the taxpayer's Oregon-sourced sales revenue to total sales revenue. ORS 314.650. For example, an equipment manufacturer in Nebraska has $5 million in sales during the tax year. Of that $5 million, $100,000 is sourced to Oregon. The manufacturer would report and pay Oregon taxes on $5 million of income, multiplied by two percent (100,000/5,000,000), or $100, 000.

ii. Sourcing Methodology

Sourcing is the process of determining which sales are attributed to Oregon, and which are attributable to other jurisdictions when calculating the apportionment ratio to be applied against a nonresident taxpayer's income. As applied to the example in subsection (i) above, $100,000 of sales were attributed to Oregon using sourcing rules.

Revenue from the sale of tangible personal property is sourced to Oregon if the property is delivered to a customer in Oregon or shipped from an Oregon location to a customer located outside of the state. ORS 314.665(2). Revenue from the sale of other types of property is sourced to Oregon if the activity giving rise to the sales income occurred in Oregon. ORS 314.665(4). In the event that the revenue-producing activities occurred in multiple states, where a taxpayer conducts business in Portland and Vancouver for example, revenues will be sourced to Oregon if the preponderance of the revenue-producing activity occurred in Oregon. Id. The proportion of activity performed in each state is determined by the cost to the taxpayer of performing such activity. Id. Thus, if our hypothetical taxpayer has $200,000 of expenses associated with its business in Portland, and $199,000 of expenses associated with its business in Vancouver the taxpayer's activities would be deemed to be sourced in Oregon.

b. Washington i. Apportionment Formula

Washington's business and occupation tax regime is a gross receipts tax, rather than an income tax. Yet, even under the business and occupation tax scheme certain income is apportioned to Washington. RCW 82.04.460. For example, an entity whose income-producing activities consist of earning royalties will report the income from royalties as the gross receipts subject to the business and occupations tax. See RCW 82.04.2907. RCW 82.04.460(4)(a) provides a complete list of income that is apportionable under the Washington tax scheme. Much like Oregon, Washington uses an apportionment formula based on sales or receipts. RCW 82.04.460(2)(a).

ii. Sourcing Methodology

Receipts are sourced, or "attributed" in Washington parlance, to Washington based on a series of steps listed in WAC 458-20-19402 and WAC 458-20-19403. Generally, this requires that receipts from sales be sourced to Washington if a customer "received the benefit of the taxpayer's service" in Washington. WAC 458-20-19402(301)(a). Royalty income, in contrast, is sourced based on where the customer uses the intangible property giving rise to royalty payments. WAC 458-20-19403(201)(a). The location of use is not always straightforward. For



example, if intangible property is used by the customer to market the customer's own goods to a second tier of customers, the intangible property is "used" in the location of the second-tier customer. WAC 458-20-19403(202)(a). Thus, in some instances, a taxpayer must request sales information from its customers to accurately source its royalty income.



Chapter 8

Common Tax Ethics Traps1

dan elleR

Schwabe Williamson & WyattPortland, Oregon

1 This outline is provided for discussion purposes only. This is not legal advice.

Contents

I. Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8–1

II. ORPC 1.13 Organization as Client . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8–1A. The Rule . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8–1B. Payroll Tax Example . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8–1C. Cancelation of Indebtedness (“COD”) Income Example . . . . . . . . . . . . . . . . . 8–1

III. ORPC 1.7 Conflict of Interest: Current Clients . . . . . . . . . . . . . . . . . . . . . . . . . . . 8–2A. The Rule. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8–2B. Innocent/Injured Individual Example . . . . . . . . . . . . . . . . . . . . . . . . . . . 8–2C. Estate Planning for Couples . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8–3

IV. ORPC 4.3 Dealing with Unrepresented Parties . . . . . . . . . . . . . . . . . . . . . . . . . . . 8–3A. The Rule. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8–3B. General Example . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8–3

V. ORPC 4.1 Truthfulness in Statements to Others . . . . . . . . . . . . . . . . . . . . . . . . . . 8–3A. The Rule. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8–3B. Financial Statement Example . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8–4C. New Bank Account Example . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8–4D. Power of Attorney Example . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8–4

VI. Conclusion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8–4

Chapter 8—Common Tax Ethics Traps




I. Introduction

These materials are intended to provide an overview of the types of common ethical issues that arise in tax representations. Although no exploration of “common” traps is ever complete, it is my hope that should you be presented with any of the situations below, you will have a working knowledge of the types of ethical issues that you might face. The substantive tax discussions are a bonus!

II. ORPC 1.13 Organization as Client

A. The Rule. ORPC 1.13 provides in pertinent part as follows:

(a) A lawyer employed or retained by an organization represents the organization acting through its duly authorized constituents.

(b) If a lawyer for an organization knows that an officer, employee or other person associated with the organization is engaged in action, intends to act or refuses to act in a matter related to the representation that is a violation of a legal obligation to the organization, or a violation of law which reasonably might be imputed to the organization, and that is likely to result in substantial injury to the organization, then the lawyer shall proceed as is reasonably necessary in the best interest of the organization. Unless the lawyer reasonably believes that it is not necessary in the best interest of the organization to do so, the lawyer shall refer the matter to higher authority in the organization, including, if warranted by the circumstances, referral to the highest authority that can act on behalf of the organization as determined by applicable law.

B. Payroll Tax Example. A common situation in which the “organization as client” rule arises is in payroll tax deficiency cases. In these cases, the organization is alleged to have failed to remit payroll taxes to a taxing authority. With respect to federal cases, certain “responsible persons” may be assessed a trust fund recovery penalty (“TFRP”) under 26 U.S.C. § 6672. The TFRP is usually approximately one-half of the amount due. When a responsible person liable for a TFRP pays any or all of the assessed TFRP, the organization’s payroll tax liability is reduced dollar-for-dollar. The key here is that individuals usually show up in your office in need of assistance. You need to decide very early on whether you represent the organization or one (and not more than one) of the putative responsible persons. It is in the best interests of the organization to have many responsible persons because any amounts those persons remit to the IRS will reduce the organization’s liability. Similarly, each responsible person will want the organization and as many other responsible persons to exist and pay the tax amounts.

C. Cancelation of Indebtedness (“COD”) Income Example. An example that combines ORPC 1.13 and one or more of the rules that follow is the evaluation of COD income in the context of entities. In the case of corporate entities, including S corporations (26 U.S.C. § 108(d)(7)(A)), Section 108 exceptions to the COD income rules are applied at the entity level. Thus, if the only two shareholders of a corporation come to you asking for COD advice for the



corporation, the identification of the client is not of critical importance (however, you should identify the client – the corporation or one (or maybe more than one) of the shareholders – as soon as possible to avoid other ethics traps. In the case of a partnership, however, 26 U.S.C. § 108(d)(6) provides that certain rules of Section 108 are applied at the partner level. Thus, if two partners present themselves with a “partnership COD income” issue, you need to determine who is your client as soon as possible because, for example, one partner may want the partnership to cancel a debt because that partner is insolvent. If any of the other partners is solvent and no other exclusion applies, you may have a conflict among the partners (which leads us to the next rule to consider).

III. ORPC 1.7 Conflict of Interest: Current Clients

A. The Rule. ORPC 1.7 provides as follows:

(a) Except as provided in paragraph (b), a lawyer shall not represent a client if the representation involves a current conflict of interest. A current conflict of interest exists if: (1) the representation of one client will be directly adverse to another client; (2) there is a significant risk that the representation of one or more clients will be materially limited by the lawyer's responsibilities to another client, a former client or a third person or by a personal interest of the lawyer; or (3) the lawyer is related to another lawyer, as parent, child, sibling, spouse or domestic partner, in a matter adverse to a person whom the lawyer knows is represented by the other lawyer in the same matter. (b) Notwithstanding the existence of a current conflict of interest under paragraph (a), a lawyer may represent a client if: (1) the lawyer reasonably believes that the lawyer will be able to provide competent and diligent representation to each affected client; (2) the representation is not prohibited by law; (3) the representation does not obligate the lawyer to contend for something on behalf of one client that the lawyer has a duty to oppose on behalf of another client; and (4) each affected client gives informed consent, confirmed in writing.

B. Innocent/Injured Individual Example. When individuals file joint returns and

do not timely pay-in-full, those individuals are jointly and severally liable for the entire amount. That is true even if only one of the individuals “contributed” to the tax debt. Under 26 U.S.C. § 6015, individuals can be relieved of joint-and-several liability if any one of the test of that statute are satisfied. Thus, it is possible for one individual not to be liable at all, while the other individual is wholly liable. As you might expect, therefore, this is something you want to be looking for when joint filers present themselves in your office seeking assistance with respect to a joint tax liability. Although these situations often present themselves when joint representation is not possible – such as in divorces – it is not always obvious. You should give consideration to seeking separate counsel for each individual in all joint filing cases in which a Section 6015 defense might be available.



C. Estate Planning for Couples. A common representation for any professional is estate planning for a couple. An issue that can arise deals with varying interests that one member of the couple wants to keep secret from the other. For example, if “Husband” calls you separately and tells you that he has a girlfriend on the side and wants to provide for her in his estate plan, and “Wife” wants everything to go to Husband because “of course” that is what Husband will do for Wife, you have a conflict between the clients. To build on top of the Rules potentially at-issue here, you might then consider whether ORPC 1.6 (Confidentiality of Information) prohibits you from disclosing Husband’s request to Wife. In the end, you may be required to withdraw, which could send a message to Wife that something is amiss. Consideration should be given to disclosing this concern up-front.

IV. ORPC 4.3 Dealing with Unrepresented Parties

A. The Rule. ORPC 4.3 provides:

In dealing on behalf of a client or the lawyer’s own interests with a person who is not represented by counsel, a lawyer shall not state or imply that the lawyer is disinterested. When the lawyer knows or reasonably should know that the unrepresented person misunderstands the lawyer’s role in the matter, the lawyer shall make reasonable efforts to correct the misunderstanding. The lawyer shall not give legal advice to an unrepresented person, other than the advice to secure counsel, if the lawyer knows or reasonably should know that the interests of such a person are or have a reasonable possibility of being in conflict with the interests of the client or the lawyer’s own interests.

B. General Example. As a general reminder, in any case in which you have an unrepresented party, you need to avoid giving legal advice to that party. Take the innocent/injured individual example above. If you represent the innocent/injured individual, that individual may ask you to “help out” the other individual because they are still in a relationship and what benefits the other individual should benefit your client. Tread lightly here. Even if the advice is given to your client, it could cause other problems if that advice is telegraphed to the other individual.

V. ORPC 4.1 Truthfulness in Statements to Others

A. The Rule. ORPC 4.1 provides:

In the course of representing a client a lawyer shall not knowingly: (a) make a false statement of material fact or law to a third person; or (b) fail to disclose a material fact when disclosure is necessary to avoid assisting an illegal or fraudulent act by a client, unless disclosure is prohibited by Rule 1.6.



B. Financial Statement Example. Tax collection clients often owe substantial sums that cannot be repaid without seeking a collection alternative from the taxing authority. In the case of a federal tax obligation, collection alternatives include offers in compromise and installment arrangements. In both of those cases, your client will be required to submit a financial statement to the IRS. Although those statements include a “penalties of perjury” admonition immediately above the signature block, taxpayers often ignore that admonition and seek to cut corners in preparing the financial statement in order to “shield” assets from potential collection. You cannot permit your client to knowingly omit information from the financial statement. You should counsel your client (see ORPC 2.1) to include everything, even if doing so might increase the collection exposure or render an option unavailable to the taxpayer.

C. New Bank Account Example. A more difficult situation involves a taxpayer’s desire to open a new bank account when that taxpayer is a debtor to a taxing authority (or any other creditor, for that matter). It is appropriate to advise the client that it is lawful to open a bank account, so long as that account is in the taxpayer’s name and SSN, if required, and all other banking law formalities are followed. That is straightforward. But what if the taxpayer filed a financial statement and is asked for an update? Then, you should advise the client to include the new account. Worse yet, what if the client tells you this is being done in order to avoid a pending levy or garnishment action? The answer now is less clear.

D. Power of Attorney Example. If you represent one partner in a general partnership and that general partnership is under a federal audit, the IRS will require the general partnership to provide a Form 2848 Power of Attorney (“POA”) in order for you to meet with the IRS on behalf of the general partnership. Assuming your client has the authority to issue the POA to you on behalf of the general partnership (or other entity, as the case may be), you should consider Part I, Question 6 on Form 2848. That Question asks whether you want any existing POA to be revoked (the default option) or retained (in which case you are required to submit a copy of that or those other POA(s)). What if your client is in a dispute with the other partners of the general partnership? It might be in your client’s best interest to cause any other POA(s) to be revoked. So long as you are not violating any duties to the other partners, filing a POA that revokes other POAs probably will not cause any problems. If, however, the IRS asks if your client has the only POA or has the authority to revoke other POAs, you should be candid in responding. Similarly, if you have “leap-frogging” POAs, you should check with the IRS from time-to-time to make sure your POA has not been revoked by another partner.

VI. Conclusion

This outline presents a few of the myriad of tax ethics traps that can present themselves. As a general word of advice, be on the lookout. When facts change, go back and reconsider your ethical obligations. If you have questions, seek guidance.



