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Understanding the Connelly Est. v. IRS Case

In Connelly Est. v. IRS, the Supreme Court unanimously upheld the Eighth Circuit’s decision, affirming that Crown’s (the business) contractual obligation to redeem shares of a deceased shareholder did not diminish the value of those shares for estate tax purposes. The Court made it clear that while redemption obligations can affect a corporation’s value, they do not universally reduce it. This distinction is critical for structuring buy-sell agreements.  In other words, life insurance proceeds paid to corporation increased the value of the corporation and thus its shares in the hands of the decedent. Moreover, the corporation’s obligation to redeem the shares was not considered a corporate “liability” that would reduce the value of the shares in this instance.

Key Takeaways from the Decision

1. Life Insurance Proceeds as Corporate Assets: The Court confirmed that life insurance proceeds payable to a corporation are considered corporate assets, increasing the corporation’s fair market value. This ruling highlights the necessity for businesses to carefully consider how life insurance policies are owned and utilized within buy-sell agreements.
2. Redemption Obligations: The Supreme Court clarified that not all redemption obligations reduce a corporation’s net value. However, specific redemption obligations might decrease a corporation’s value if they require liquidation of operating assets. This nuanced view necessitates precise drafting and clear understanding of the implications of such obligations.

Best Practices for Structuring Buy-Sell Agreements

To align with the insights from Connelly Est. v. IRS, here are key guidelines for structuring effective buy-sell agreements:

1. Clear Definition of Terms: Ensure that all terms, including redemption obligations and the valuation process, are clearly defined. Ambiguities can lead to disputes and unintended tax consequences.
2. Consideration of Life Insurance Proceeds: Evaluate the impact of life insurance proceeds on corporate valuation. If the policy is intended to fund a buy-sell agreement, decide whether these insurance policies should be treated as corporate assets or instead owned by the shareholders.
3. Use of Cross-Purchase Agreements: A cross-purchase agreement, where shareholders agree to buy each other’s shares, can mitigate the risk of increasing share value due to corporate-held life insurance. However, this approach requires shareholders to maintain their policies and can introduce its own set of challenges, such as funding premium payments and making sure that the premium payments are made.
4. Incorporating Valuation Discounts: Apply appropriate valuation discounts for lack of control and marketability in the agreement. These discounts can significantly affect the valuation of shares and the resulting tax obligations.
5. Regular Appraisals: Conduct regular appraisals to ensure the valuation methods outlined in the buy-sell agreement are followed accurately. This practice helps maintain up-to-date valuations and supports compliance with tax regulations.
6. Legal and Tax Compliance: Work closely with legal and tax advisors to ensure the agreement complies with current laws and reflects the latest judicial interpretations. Regular reviews and updates to the agreement are essential to adapt to evolving legal landscapes.

The Connelly Est. v. IRS decision underscores the importance of meticulously structured buy-sell agreements in business transition matters.  By incorporating clear definitions, considering the impact of life insurance proceeds, utilizing cross-purchase agreements where appropriate, applying valuation discounts, conducting regular appraisals, and ensuring legal and tax compliance, businesses can navigate the complexities highlighted by this landmark ruling.

In the evolving field of corporate governance and tax compliance, are your buy-sell agreements crafted to withstand legal scrutiny and optimize valuation outcomes?  The business attorneys at Dawda have years of experience working with business owners and companies to help structure the right agreement and approach for different types of businesses.  Please be assured that there is no “one size fits all”.  We can work with you and your other professional advisors to draft or update your “buy-sell” agreements.

The post Structuring Effective Buy-Sell Agreements following the Connelly Est. v. IRS Decision appeared first on Dawda PLC.

Article submitted by Gary Remer, Dawda Member

The U.S. Department of Labor, the Internal Revenue Service and the Pension Benefit Guaranty Corporation announced changes to the audit requirements of the 2023 Form 5500 Annual Return/Report of Employee Benefit Plan.  To understand a significant aspect of this, we start with the basic rule that a 401(k) plan must be audited when it has more than 100 “eligible participants” on the first day of the plan year, with an exception under the “80-120” Participant Rule (discussed later).  This basic rule has not changed, but the methodology for counting eligible participants is now more favorable to the sponsor of the 401(k) plan trying to avoid the expense of an audit.

Under the old rule, the number of participants was based upon those eligible to elect to have contributions made under a 401(k) plan, even if they elected not to participate and do not have an account balance in the plan.  This meant that there could be a 401(k) plan where 10 office employees elected to participate, and 200 shop works elected not to participate but an audit would still be required.

The new rule changes who is deemed an eligible participant under a 401(k) plan. Instead of using all those eligible to participate, the 401(k) plan filers will look at the number of participants/beneficiaries with account balances as of the beginning of the plan year when determining if they are eligible for small plan reporting options with no audit required.

The U.S. Department of Labor regulations include a special “80-to-120 participant rule,” which states that if the number of participants at the beginning of the year is between 80 and 120, and a Form 5500 was filed for the prior plan year, the plan may file a 5500 in the same category (small or large plan) as the year before. A plan that files a small filer 5500 for the plan year is not subject to the required large plan audit until it exceeds the 120-participant threshold at the beginning of a plan year.

That analysis estimates that there would be a reduction of 19,442 large plan filings for defined contribution pension plans.  Each plan would save an estimated $7,500 (or more) on audit expenses.

For more information, contact Gary Remer, gremer@dmms.com

The post New Rules May Eliminate Your 401(K) Audit appeared first on Dawda PLC.

Accountants and attorneys aren’t the only people who use tax transcripts. There are a variety of non-tax purposes for transcripts, such as: verifying income for home mortgages; obtaining car loans; and applying for financial aid. But, if you’ve ever found yourself using the IRS’ fax transfer service to obtain one of these transcripts, you should make yourself aware of the newest step implemented to protect your data from cybercriminals.

While fax communication seems archaic to most, faxes are used by the IRS to send copies of tax transcripts until recently. On June 4, 2019, the IRS reported that it would no longer offer its tax transcript faxing service beginning June 28, 2019. The IRS also announced its plans to amend the Form 4506 series to end third-party mailing of tax returns and transcripts in July. This change does not prevent individual taxpayers from having copies of their returns or transcripts mailed to their address of record.

This change comes as the IRS continues to face attacks by cybercriminals. In 2017 hackers victimized 16.7 million U.S. taxpayers, cheating them out of $16.8 billion. Cybercriminals have been able to obtain your tax transcripts and use them to file fraudulent returns, closely mirroring legitimate returns. These fraudulent documents are extremely difficult for the IRS to detect.

In 2018, cybercriminals used a malware, known as Emotet, to send emails masqueraded as IRS communication. The scam email carried an attachment labeled “Tax Account Transcript” or the subject line used some variation of the phrase “tax transcript.” When opened, the emails contained malicious software that spread throughout entire networks, taking months to successfully remove from the host. Emotet Malware has been labeled as one of the costliest and most destructive malwares. Thus, the IRS hopes by no longer sending transcripts to third parties that the appeal of these masquerading emails is reduced.

Copies of returns and transcripts are still available despite IRS changes. Individual taxpayers may:

• Use IRS.gov or IRS2Go app to access transcripts online for download or print;
• Use IRS.gov or IRS2Go app to get transcripts by mail; or
• Call 800-908-9946 for an automated get transcript by mail feature.

Third parties who use Form 4506, or any of its versions, may use the IRS Income Verification Express Service to order transcripts.

In any event, you should ensure that you plan ahead. Online and phone orders can take 10 days from the time the request is received, while transcripts ordered by mail can take 30 days. Despite the slight delay, ending the transcript fax service is clearly a step in the right direction toward protecting your personal data.

The post IRS Changes Access to Transcripts to Fend Off Cybercriminals appeared first on Dawda PLC.

If you haven’t heard about the Opportunity Zone tax incentive yet, you will soon. The “Opportunity Zone” Program was created in the Tax Cuts and Jobs Act of 2017 with the creation of two new Tax Code Sections 1400Z-1 and 1400Z-2. The purpose of the Opportunity Zone Program is to encourage the investment of private capital into certain designated economically depressed areas throughout the United States that were designated as “Qualified Opportunity Zones” by each state.

The mechanism for investing in a Qualified Opportunity Zone is through a “Qualified Opportunity Fund.” As of the date this article is written, the IRS has not yet issued any regulations related to Qualified Opportunity Zones or Qualified Opportunity Funds and there are many unanswered questions. Regulations are anticipated soon. Notwithstanding that, investor groups and speculators are establishing the framework for creating Qualified Opportunity Funds (“QOF”) so that they will be primed to invest in businesses and properties located in Qualified Opportunity Zones (“QOZ”).

WHAT IS THE TAX BENEFIT TO INVESTING IN OPPORTUNITY FUNDS AND OPPORTUNITY ZONES?

This new tax incentive allows the seller of appreciated property to roll his gain into a Qualified Opportunity Fund and to obtain a temporary deferral of taxation depending upon the holding period of the investment. As currently written, IRC Section 1400Z-2 generally triggers taxable gain at the end of 2026 even if the investor has not sold the Qualified Opportunity Fund shares by then. The amount of gain that the investor would recognize in 2026 is 100% of the deferred gain if the investor has held the QOF investment less than five (5) years; is 90% of the deferred gain if the investor has held the QOF investment more than five (5) years, but less than seven (7) years; and is 85% of the deferred gain if the investor has held the QOF investment longer than seven (7) years. Section 1400Z-2 does exclude post-investment increases in value if an investor holds the QOF investment for at least ten (10) years, but note that 2026 is less than ten (10) years from now, so even if an QOF investment is held for ten (10) years, in most cases there will be some tax paid before then.

Mechanically, the way this works is when someone invests in a QOF, they take a basis of zero in the QOF but their basis increases by 10% of the deferred gain after five (5) years and an additional 5% of the deferred gain after seven (7) years.

It is believed that an investor who rolls over gain into a QOF investment and holds the investment for at least ten (10) years will receive a step-up in the basis of the QOF investment to its fair market value on the date the investor disposes of its investment. This step-up in basis potentially eliminates any gain which occurs after the investor acquires the investment. The net result is for QOF property held for more than ten (10) years, the investor has no post-investment appreciation but will still pay tax on 85% percent of the gain initially deferred by 2026.

It is believed that the gain exclusion and basis step-up apply only to investments in QOFs purchased with reinvested gain. Therefore, a person who desires to shift funds from a regular cash account into a QOZ Program will not obtain any tax benefit. Moreover, an investor that rolls in an asset with a basis, will find that only the gain deferred, but not the entire investment, will benefit from the ten (10) year holding period. Thus, the post-acquisition gain could still be partially taxable to the extent the taxpayer rolled basis into the QOF. The investor may also have other taxes to pay such as depreciation recapture.

It appears that the use of Qualified Opportunity Funds to invest in Qualified Opportunity Zones will create some tax benefit for some investors with deferred gain. However, there are plenty of complications related to basis and also other requirements related to the definition of a Qualified Opportunity Zone investment. One such limitation is that a QOF must make invest at least 90% of its assets into “qualified opportunity zone property.” Thus, Investments must be made into real estate or a trade or business operating in the Qualified Opportunity Zone. Notwithstanding that, certain types of businesses such as golf courses, country clubs, massage parlors, hot tub facilities, sun tan facilities, gambling facilities or liquor stores are not qualifying businesses and are not qualifying investments and a QOF cannot invest in those types of businesses.

If you want to know more about the pros and cons of QOZ and QOFs, please contact Jeffrey D. Moss at jmoss@dawdamann.com or your Dawda attorney.

The post Learning about the New Opportunity Zone Tax Incentive appeared first on Dawda PLC.

Following up on an earlier blog post, US Supreme Court To Hear Digital Sales Tax Case, in a 5-4 decision on Thursday, June 21, the US Supreme Court ruled in favor of South Dakota in the case South Dakota v. Wayfair when it overturned the “physical presence rule,” a precedent previously established by the Court in Quill Corp. v. North Dakota and in Bellas Hess v. Dep’t of Rev. of Ill. and one which has been followed for the past half century.

Unsurprisingly, Justice Kennedy wrote for the majority, after he urged the legal system three years earlier to find a case that would allow the Court to reexamine Quill. In his opinion, he wrote in the age of the Internet, a physical presence is no longer necessary for a business to have a “substantial nexus” with a state, as required by Control Auto.

The dissent conceded that Bellas Hess was wrong when decided but it emphasized the fact that e-commerce has since grown exponentially “against the backdrop of established rules, including the physical presence rule,” and thus overturning such precedent could disrupt the future development of the e-commerce industry. The majority, however,  rejected this view, however, by arguing that, while e-commerce used to be an attractive option due to price, it is now the desired alternative because of its convenience. As such, the Court’s ruling should not have a major impact in this sense.

The real question is: Who will this help, who will it hurt, and who will perhaps not be affected at all by the Court’s decision?

Who It Will Help

• States

Nearly all states that collect a sales tax are expected to follow in South Dakota’s footsteps, creating similar models that will allow them to increase their sales and use tax revenue. The states that are expected to see the biggest percentage increase in revenue, with a maximum revenue increase of around 3 percent, include Louisiana, Tennessee, South Dakota, Oklahoma, and Alabama (according to a Barclays research note).

• Traditional Brick-and-Mortar Retailers

Big-box retailers like Walmart, Target, and Best Buy have been welcoming such a change for some time. They believe this change will do away with the competitive edge that has long been given to retailers that primarily transact business over the Internet. At the close of business on Thursday, Walmart gained 1.1 percent, while Best Buy advanced as much as 2.5 percent in the stock market.

• Congress

Congress finally has the opportunity to correct past inaction. After not moving forward with legislation on the issue for years, due in part to the political backlash that would likely ensue by initiating new taxes on businesses, the ruling may actually spur Congress to finally take action by enacting federal compliance standards.

Who It Will Hurt

• Small to Medium-Sized Online Retailers

Small to medium-sized online retailers, especially those with large third-party seller markets, like eBay and Etsy, are the businesses most likely to suffer from such a change. Both eBay and Etsy finished down in the stock market on Thursday. A spokeswoman for eBay was quoted by the Wall Street Journal, stating that “[n]ow is the time for Congress to provide clear tax rules with a strong small business exemption.”

• Online Consumers

Online consumers will be hurt to an extent with a foreseeable increase in prices for online sales purchases. However, many large e-retailers have already been collecting sales tax. Thus, the noticeable impact will not be as great as some may think.

Who Will Remain Unaffected

• Startups

South Dakota’s model only applies to sellers that deliver more than $100,000 of goods or services to the state or engage in more than 200 or more separate transactions in the state. If states follow South Dakota’s model, as expected, startup companies are unlikely to be affected by the new ruling until they have reached one of these thresholds.

• States That Do Not Collect Sales Tax

For obvious reasons, states that do not currently collect sales tax are unlikely to be affected by the Court’s decision.

The post US Supreme Court Digital Sales Tax Case—The Decision appeared first on Dawda PLC.

April 15^th is traditionally “Tax Day” in the U.S.  However, April 15^th falls on a Sunday this year, and April 16^th is “Emancipation Day,” a holiday recognized in Washington D.C. to mark the anniversary of the signing of the Compensated Emancipation Act. Therefore, Tax Day this year is Tuesday, April 17^th, which gives procrastinators some breathing room.

If you don’t use an accountant, tax attorney or other tax preparer, and you haven’t started preparing your taxes for 2017, the best place to start is by using the information in your 2016 federal and state returns as a starting point.  This will give you a great idea of what information for 2017 that you may need to obtain, as well as point out items you may have neglected in the mad rush to beat the tax deadline.

Nowadays, it seems like the Internet is both a blessing and a curse. With that being said, one benefit to taxpayers is that most information needed for preparing tax returns, such as W-2s and various 1099 forms (i.e., bank interest, student loan interest statements, mortgage interest statements, etc.) are typically available online. Just make sure you haven’t misplaced your username or password!

If you itemize your deductions, make sure you have detailed backup of certain items, such as charitable contributions and business expenses.  Although the chances of being audited seem to decrease every year, the easiest way to raise red flags is by being aggressive with certain deductions. In general, keep copies of your tax returns and all supporting information for three years after filing them.

If you find yourself owing money, and you have a traditional IRA or a Health Savings Account, you have until April 17^th to make a contribution that will count towards the 2017 tax year and will lower your taxable income. Even if you don’t have a tax liability, it’s not a bad idea to take advantage of contributing towards these types of tax-advantaged accounts.

If you find yourself owing money for 2017, look at what might have triggered that tax liability and, if necessary, make adjustments for 2018.  More importantly, if you find yourself getting a tax refund, you shouldn’t celebrate or brag to your family and friends. A tax refund just means that you gave an interest-free loan to the government for 2017. That’s not something to brag about!  Most people would rather have that money in their pocket throughout the year. There are many ways to do this, such as keeping an eye on your tax withholding from your paycheck, or if you pay estimated taxes throughout the year, adjusting quarterly tax payments throughout the year if it appears you are or could be overpaid.

The post Still Haven’t Prepared Your Taxes? Here Are Some Last Minute Tips. appeared first on Dawda PLC.

On April 17, 2018, the United States Supreme Court will hear oral arguments in South Dakota v. Wayfair. The Court will reconsider the long-standing rule established in Quill Corp. v. North Dakota in 1992 stating a business or vendor must have a “physical presence” in a state in order for the state to require it to collect or remit sales tax on its sales. Specifically, the Court in Quill held that a state could not impose taxes on a mail order house because the vendor lacked a “substantial nexus” with the state, which is an element required by the Commerce Clause. The precedent set forth in Quill has since been applied to online retailers who regularly sell to customers throughout the country.

Undeniably, much has changed since Quill was decided in 1992. The scope of today’s Internet use for online shopping purposes had not even been conceptualized a few decades ago. Due to significant advancements in technological development, and our movement toward a more globalized economy, Internet sales have continued to skyrocket. States claim that this has caused them as a whole to miss out on collecting critical tax revenue from the multi-trillion-dollar Internet sales industry. The Government Accountability Office estimates that states suffered a loss in revenue of over $13.4 billion in 2017 alone. Online retailers, however, argue that they do not and should not have a duty to collect or remit sales tax from customers who live in states where the retailer does not have a physical presence.

Two of the current sitting Supreme Court justices have expressed their own criticism of Quill in recent years. In 2015, Justice Kennedy himself urged the legal system in Direct Marketing Ass’n v. Brohl to “find an appropriate case for this Court to reexamine Quill.” Upon Direct Marketing being remanded to the Circuit Court, Justice Gorsuch, who was then sitting on the 10^th Circuit, wrote about Quill at great length. He expressed that Quill has given mail order and Internet retailers “a competitive advantage over their brick-and-mortar competitors” and that the Quill case essentially remains on the books solely out of respect for stare decisis (a judicial concept giving deference to prior rulings) established in an even earlier case, Nat’l Bellas Hess v. Dep’t of Rev. of Ill. However, Justice Gorsuch also noted that the ability of the states to impose notice and reporting burdens on Internet retailers is comparable to the sales and use tax obligations imposed on their brick-and-mortar competitors.

Arguments against overturning Quill are that it would create a burden on large-scale and small-scale online retailers, and limit their ability to freely engage in commerce in the several states. It would also weaken the Commerce Clause in the US Constitution. Furthermore, those in opposition believe that it is Congress, rather than the courts, that should be addressing this issue.

Arguments in favor of overturning Quill are that it would have a positive effect on small brick-and-mortar retailers, who have been struggling in recent years to compete with Internet giants such as Wayfair, Overstock, and Newegg [the three Respondents in the upcoming case]. If Quill is overturned, proponents believe the result would be to strengthen the position of state governments, allowing for a significant increase in state tax revenue that could be allocated to improve resources such as education, healthcare, and infrastructure.  In fact, several states have been successful in collecting back sales tax revenue from online travel companies.

In conclusion, most people would not realize that the taxation of online sites was actually an important US Constitutional question.  It is not clear how the US Supreme Court will decide on this issue, but it is an important precedent related to state taxation rights and the decision will impact everyone who shops online.

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The IRS announced that the popular offshore voluntary disclosure program (OVDP) used by taxpayers to divulge previously unreported foreign assets with reduced penalties will be ending effective September 28, 2018.

Under the terms of the OVDP, which was originally initiated in 2009, and reinstated and modified in various forms in 2011, 2012 and 2014, taxpayers could avoid criminal charges and pay reduced civil penalties if they willingly disclosed foreign assets that were previously unreported and amended returns to pay back taxes. Per IRS statistics, since 2009, more than 56,000 taxpayers have used the program, resulting in more than $11 billion in taxes being collected.  The IRS will close these types of programs to motivate participation and may later open similar programs with higher penalties. There is no guarantee that the program will be reopened.

Foreign Income is Taxable and Many Foreign Assets Reportable

Closure of the OVDP program doesn’t mean taxpayers will stop paying taxes on foreign assets, however. The U.S. government mandates that all international income must be reported on an income tax return. The IRS will continue to provide education to taxpayers who may unknowingly fail to disclose foreign assets, and it will rely on whistleblower leads, civil examination and criminal prosecution to discourage flagrant offshore tax avoidance and noncompliance. The IRS will also rely upon the mandates of FATCA to require foreign banks to report offshore accounts held by US persons.

Additional Options for Undisclosed Foreign Income

For individuals who have not reported foreign income, investments or other monetary assets on their U.S. taxes, the September 28 deadline gives you only a few more months to become compliant with reduced penalties and no-inquiry into motive. Beyond that deadline, the penalties will be higher. Outside of OVDP, the IRS offers other programs for taxpayers who may not have been aware of their filing obligations to utilize. One such program is the Streamlined Filing Compliance Procedure, but, like the OVDP, the IRS may end this program at some point in the future as well.

Other options include:

• IRS-Criminal Investigation Voluntary Disclosure Program;
• Delinquent FBAR submission procedures; and
• Delinquent international information return submission procedures.

These programs and procedures have eligibility rules and possible inquiry into “reasonable cause” claimed by the taxpayer.

When to Consult an Expert

There are a variety of reasons why an individual or organization may fail to claim foreign financial assets. Regardless of the reason, it’s important to work closely with legal professionals who understand the nuances of navigating these difficult situations and can advise you of the best course of action based on your unique circumstances.

Even if you’re not sure if your foreign financial assets are taxable or if you qualify for the OVDP or a similar program, it’s important to consult a legal expert who is well-versed in these matters so you can avoid criminal charges or large financial penalties. Time is running out to utilize OVDP.

If you have questions about your assets or options or would like to discuss this matter further, contact me directly at (248) 642-1485 or by email at jmoss@dawdamann.com.

The post The Offshore Voluntary Disclosure Program is Scheduled to End Soon appeared first on Dawda PLC.

Section 1031 tax-deferred exchanges have become common with taxpayers who intend to reinvest the proceeds from the sale of an investment property into another investment property to defer capital gains tax. When purchasing a replacement real property as part of a 1031 exchange, the purchaser must be wary of receiving cash credits at closing for property that is not like-kind to the relinquished property. These cash credits will result in what is referred to as “boot” and are taxable to the extent of gain realized on the 1031 exchange. Since the point of a 1031 exchange is to defer capital gains tax, any 1031 exchange “boot” serves to defeat the purpose of the exchange.

To avoid cash boot, a real estate purchaser should request the seller to pay the following closing costs to the purchaser outside of closing rather than on the settlement statement:

• Rent credit
• Security deposit credit
• Utility expenses
• Repair costs
• Property liability insurance costs
• Lender’s title policy insurance premium
• Earnest money deposit credit (if buyer placed deposit in escrow out-of-pocket)
• Property tax prorations

The following customary closing costs are considered by the IRS to be incident to the transaction and will not contribute to cash boot. They can therefore appear on the settlement statement:

• Survey costs
• Environmental costs
• Escrow fees
• Owner’s title insurance policy premium
• Broker fees
• 1031 intermediary fees
• Transfer taxes
• Recording fees
• Legal fees

A taxpayer should also keep in mind it is possible to receive “mortgage boot” if the amount of mortgage debt is reduced by exchanging properties, which will cause the taxpayer to pay tax on the difference between the two mortgage balances, and “personal property boot” if the taxpayer receives anything of value that is not considered like-kind property, including vehicles, art, furniture and other personal property.

Carefully reviewing the settlement statement prior to closing to identify items that may lead to “boot” will ensure a taxpayer is able to defer all capital gains tax in a 1031 exchange transaction.

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