Kaiser corp tax update - 2012

Minnesota State Bar Association

2012 Tax Institute

Hot Topics In Corporate Taxation

December 5, 2012

By: Kevin Kaiser

Agenda • Report of Organizational Action Affecting Basis of

Securities - IRS Form 8937

• Abandonment Loss and Worthless Assets

• Liquidation – Reincorporation (upstream C Reorgs)

• Purchase Price Allocations

• Reasonable compensation

• Earnings and Profits and Year-end dividends

Report of Organizational Actions IRS Form 8937

• In 2008, Congress enhanced the information reporting on Form 1099 to include tax basis information

• Congress also added Section 6045B requiring any issuer of a specified security to file an information return to describe any organizational action that affects the basis of the security

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Report of Organizational Actions IRS Form 8937

• Form 8937 – Report of Organizational Actions Affecting Basis of Securities

– Designed to allow corporations to comply with Section 6045B corporation action reporting requirements

– Issued January 6, 2012

– Form must be filed when a corporate action affects basis

• Stock distribution

• Stock split

• Merger

• Acquisition

– Form must be filed by the earlier of (1) the 45th day following the organizational action; or (2) January 15th of the year following the calendar year of the organizational action

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Abandonment Loss and Worthless Assets

• Section 165 permits taxable losses for assets, including securities, that become worthless or abandoned during the current year

• Asset must have no current value and potential future value

• Loss must be claimed in the year the asset became worthless

– Taxpayer must show that asset was not entirely worthless in the preceding year

• Claiming of the loss must be accompanied by an “identifiable event”

• CCA 201207009 – Taxpayer may claim an abandonment loss with actually disposing of the asset if it is held solely for salvage value (reference to PLR 7920002 – permitting abandonment loss)

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Upstream C Reorganization PLR 201127004

P

S

LLC1

Other Members

1. S converts from corp to LLC – treated as C Reorg

2. S assigns LLC1 interest to P

3. S converts from LLC to corp – treated as a section 351 exchange

Steps

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Upstream C Reorganization

PLR 201127004 • P, a publicly-traded state X corporation, is the common parent of an affiliated group of corporations

filing a consolidated U.S. federal income tax return. P owns all of the outstanding common and preferred stock of S. The preferred stock is nonvoting preferred. Through its direct and indirect subsidiaries, S conducts Business A Operations and Business B Operations. All of S's Business A Ops are conducted by LLC1, which is classified as a partnership.

• To achieve state income tax savings and to "enhance management focus within S," P has proposed the following transactions:

• S will convert to a single-member LLC (Sub LLC) that would be disregarded (Conversion)

• Sub LLC would assign and transfer the LLC1 interest to P

• P would assign and transfer the LLC1 interest to new LLC classified as a disregarded entity (LLC2) in exchange for all membership interests in LLC2.

• Sub LLC would distribute the intercompany debt to P

• Sub LLC would convert to a corporation (New S) , (the Reincorporation)

• The deemed transfers will qualify as a reorganization under section 368(a)(1)(C). The Conversion will not be disqualified or recharacterized by reason of the reincorporation. Section 368(a)(2)(C) and Treas. Reg. Sec. 1.368-2(k).

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• Parent and subsidiary affiliated group (consolidated or nonconsolidated)

• Move appreciated asset from subsidiary ("Sub") to parent (P)

1. Sub should be a "checkable entity" i.e., limited liability company classified

as a corporation

2. Check-the-box to liquidate Sub

3. Transfer or assign appreciated asset to P (while Sub is DRE)

4. Check-the-box to reincorporate Sub

• See also 201232033 and 200952032 (similar rulings)

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• Tax developments that support the tax treatment of the upstream C

reorganization

– Regulation 1.368-2(k) transaction first to qualify for recognition should be respected (issued in 2007) – no recharacterization

When the elements of the C reorganization are satisfied, the tax analysis should stop, then begin to evaluate next transaction (in the example, a valid section 351 capital contribution)

– Section 368(a)(2)(C) transfer of assets to controlled corporation is OK (no remote continuity or asset alienation problem)

– Repeal of Bausch & Lomb doctrine - pre-existing ownership of target (Sub) stock will not prevent tax-free reorganization treatment

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Asset Purchases

Purchase Price Allocation

• Section 1060 prescribes allocation rules for asset acquisition that constitute an applicable asset acquisition

• Allocation reported on IRS Form 8594 – seven asset classes "I - VII”

• Section 1060 applies the so-called residual allocation method

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Asset Purchases

Purchase Price Allocation

• Purchase Price Allocation Cannot Be Changed – Post Acquisition

• Peco Foods Inc. v. Comm., T.C. Memo 2012-18 (1/17/12)

– Taxpayer cannot change Section 1060 purchase price allocation describe in asset purchase agreement (“APA”)

– IRS and Tax Court rejected taxpayer’s attempt to reclassify assets based on post-acquisition cost-segregation project

– APA was clear and there was no mistake or unknown facts

– Taxpayer bound by the agreement

– Court applied the rule of Danielson to bar a unilateral change

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Asset Purchases

Purchase Price Allocation – Cost Segregation studies, cont.

• AmeriSouth XXXII, Ltd. v. Comm., T.C. Memo 2012-67 (3/12/12)

– Cost segregation study successfully challenged by the IRS

– Court focused on the purpose of the building in order to determine the classification of the assets used in the building

– Court stated that the focus of the analysis should take into account the context in which the assets are used - the buildings in question in AmeriSouth were apartment buildings

– Court concluded that although certain assets “could be moved”, in the residential apartment context, assets such as shelves, mirrors and other fixtures were intended to be “permanent”

Reasonable Compensation

• C corporations

– IRS challenges excess compensation

• S corporations

– IRS challenges insufficient compensation

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• Reasonable Compensation Factors

– Multi-factor Test

• Qualifications and training of employees

• Nature and scope of employees duties

• Size and complexity of business operation

• Compensation rates for competitors

– Hypothetical Independent Investor Test

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• Hypothetical Independent Investor Test

– Would an independent investor pay the employee the compensation at issue, and how the employees services affect the investor's return

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Recent cases

• Menard v. Commr., 560 F3d 620 (CA-7, 2009)

– Taxpayer victory in C corporation compensation case

• Mulcahy, Pauritsch, Salvador v. Commr., 680 F.3d 867 (CA-7, 2012)

– Government victory in S corporation compensation case

• David Watson PC v. U.S., 668 F.3d 1008 (CA-8, 2012)

– Government victory in S corporation compensation case

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• C corporation Excess Compensation

Corporation losses the compensation deduction

Recharacterized as corporate distribution

Dividend to the extent of earnings and profits (E&P)

Note – Adequate disclosure for penalty protection

Complete Form 1120, Schedule E (Rev. Proc. 2012-15)

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Earnings and Profits and Year-end Dividends

I. Present overview of federal tax rules governing the tax treatment of earnings and profits (“E&P”) and Dividend Distributions

II. Describe the E&P Computation process

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Overview of E&P Concepts

• Tax planning for distributions has always started with a few basic facts of life:

– Corporate shareholders generally prefer dividends, because of the dividends received deduction, presently embodied in Section 243

– Noncorporate shareholders generally prefer capital gain treatment (or return of capital)

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• The principal Code provisions governing pro rata distributions are contained in:

– Section 301 Distributions of Property

– Section 311 Taxability of Corporation on Distribution

– Section 312 Effects on Earnings and Profits

– Section 316 Dividend Defined

• In addition, with respect to corporate distributees, Sections 243, 246 and 1059, which contain the principal rules dealing with the dividends received deduction, are of particular importance.

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• Earnings and profits ("E&P") are taxed at the corporate level when earned, and again when the corporation distributes them to the owners of the company, the shareholders.

• E&P forms the foundation of the double tax system and applies to non-corporate shareholders and, to a limited extent (depending on ownership), to corporate shareholders.

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Earnings and Profits

• Dividend distribution to extent of “earnings and profits”

• Current E&P

• Accumulated E&P

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Consolidated E&P

• Treat consolidated group as a single entity by reflecting the E&P of lower-tier members in E&P of higher-tier members

• Consolidate the group’s E&P in the common parent

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Consolidated E&P

• Parent’s E&P are adjusted for Sub’s E&P

• Unused losses reduce E&P currently

• Intercompany transactions affect E&P when taken into account

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Deconsolidation

• Sub’s E&P eliminated immediately before it becomes a nonmember to the extent taken into account by any member

• Exceptions

– Acquisition of group

– Certain corporate separations and reorganizations

• This is an important consideration when acquiring companies or selling a subsidiary

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E&P Calculation • START - Taxable income

• Plus additions

– Tax exempt income, excess LIFO, DRD excess accumulated depreciation, etc.

• Depreciation Adjustment

• Less subtractions

– E.g., federal income tax, penalties, 50% meals and entertainment, §267 deductions, etc.

• Less Distributions to the extent of E&P

• FINISH = E&P

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E&P Determination (process) • Taxable income reconciliation

– Each year since inception

Reconcile originally filed return to final taxable income (audit adjustments, amendments, etc.)

• Transaction Analysis - analyze E&P effects of every corporate transaction

• E&P Adjustments - analyze E&P adjustments for each year

• E&P Depreciation - apply E&P depreciation rules (usually separate project)

• Final E&P Determination

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Example of a Summary of Estimated Consolidated Earnings & Profits

December 31, 2004 to December 31, 2011

Year

Beginning

of Year

E&P

Total Adjusted

Consolidated

Taxable

Income

Adjusted

Federal

Income Tax

Merger

and

Liquidation

Adjustments

Tax Exempt

& N/D Expense

Adjustments Distributions

End of

Year

E&P

12/31/04 0 10,000 (3,000) (150) (1,300) 5,550

12/31/05 5,550 7,500 (2,250) (100) (1,400) 9,300

12/31/06 9,300 2,500 (750) 100 (80) (1,560) 9,510

12/31/07 9,510 (100) 0 (75) (100) 0 9,235

12/31/08 9,235 3,000 (1,000) (200) (1,200) 9,835

12/31/09 9,835 4,000 (1,200) 120 (150) (1,750) 10,855

12/31/10 10,855 5,000 (1,500) (100) (1,500) 12,755

12/31/11 12,755 7,500 (2,250) (300) (1,555) 16,150

Totals 0 39,400 (11,950) 145 (1,180) (10,265) 16,150

Subtotal Accumulated E&P Before E&P Depreciation 16,150

Estimated Section 312(k) E&P Depreciation (cumulative) 500

Estimated Accumulated E&P (with depreciation adjustment) 16,650

Thank You

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Contact Information Kevin W. Kaiser Lindquist & Vennum PLLP 4200 IDS Center 80 South Seventh Street Minneapolis, MN 55402 Phone: (612) 371-2467 E-mail: [email protected]

ANY TAX ADVICE CONTAINED IN THIS COMMUNICATION IS NOT INTENDED OR WRITTEN TO BE USED, AND CANNOT BE USED 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 general in nature and based on authorities that are subject to change. Applicability to specific situations is to be determined through consultation with your tax advisor.

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Kaiser corp tax update - 2012