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Investment
in Qualified Small Businesses
There is a
great incentive for individuals to invest in certain small businesses that
operate in corporate form. This inducement allows investors to exclude 50%
of the gain realized form the sale of qualified small business stock
(QSBS). The stock has to be held for at least five years and other
requirements must be met. This rule applies to stock issued by qualifying corporations
after August 10, 1993.
However, the low capital gains rate of 15%
does not apply to the portion of the gain that is included in the taxpyer's
income. Instead, the maximum tax rate remains at 28%. But, because of the
50% exclusion, the investor's total gain from a qualified investment is
subject to a maximum effectifve rate of only 14%. The maximum gain that may
be excluded by an investor on the stock from one issuer cannot exceed the
greater of (1) 10 times the taxpayer's basis in the stock, or (2) $10
million gain from stock in that corporation. Further, stock can qualify
only if issued after August 10, 1993, by a C corporation. In order for its
stock to qualify, the corporation's gross assets cannot exceed $50 million.
The stock of certain corporations can never
qualfiy under these tax provisions. For example, if the principal asset of
the corporation is the skill of one or more of its employees, its stock
will not qualify. Examples of these excluded corporations are those engaged
in providing health, legal, engineering, or accounting services. Also
excluded are corporations involved in banking, investing or farming, or in
the hotel, motel or restaurant industry.
Potential investors in such stock should
factor into their investment decision the possibility that if the
corporation is a new "start-up" business, the chance for capital
loss may be greater than the potential for capital gain. However, even if
this is the case, the possibility that any resultant capital gain could be
taxed at a maximum of 14% may outweigh the risk to investment capital. In
addition, an investor may elect to roll over gain from the sale of small
business stock held for more than 6 months if other small business stock is
purchased during the 60-day period beginning on the date of sale.
Read more...
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Greetings!
I want to thank all of you who have given me such
great feedback on the previous months' tax newsletters. I hope that you
continue to find the newsletters informative and thought-provoking.
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· Worker
Classification
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 The IRS has the
power to reclassify workers that an employer treats as independent
contractors as employees, using in most cases a common-law test under
which it analyzes the employer-employee relationship by looking at 20
factors (including, right to control, right to discharge, furnishing of
tools and supplies). This often arises in the course of employment tax
audits. Alternatively, either an employee or an employer can ask to have
a worker's classification determined. However it occurs, having a worker
who has been treated as an independent contractor reclassified as an
employee can be expensive for an employer. The first step will be to pay
the taxes (plus penalties and interest) that should have been paid under
the income tax and social security and Medicare tax withholding
provisions, and to issue corrected Forms W-2 and 1099 for the years of
reclassification. Furthermore, the employer will also have to reassess
all of its benefit plans to determine the consequences of the
reclassification, and may face possible claims and, perhaps, litigation
from the reclassified employees.
One of
the most serious consequences of worker reclassification is
disqualfiication of an employer's retirement plan. Fortunately, the IRS
generally has not followed up employment tax reclassfications with
attacks on the qualified status of the plans, except in very abusive
situations. However, employers cannot rely on this as a reason to ignore
the effect of the reclassification on plan qualification. Instead,
employers whose workers are reclassified will need to analyze their
plans' provisions and the makeup of their workforce to determine whether
benefits will have to be provided for the "new" employees, and
may have to retroactively correct their plans through one of the IRS'
voluntary correction programs. Employers will have to go through a
similar analysis with respect to their other benefit plans (e.g. group
health insurance, a cafeteria plan, an educational assistance plan,
etc.). The key to this issue is to analyze the common-law factors
relevant to the proper classification of workers and treat such workers
appropriately. The cost of improper classification can be prohibitive.
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· Business Owners
and Mortgage Interest Deductions
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Interest paid on home equity debt is deductible to the
extent that the debt does not exceed $100,000. Home equity debt is any
debt, other than acquisition debt, that is secured by a qualified
residence to the extent of the difference between the fair market value of
the residence and any acquisition debt secured by the residence. However,
taxpayers may elect to treat home quity debt as not secured by a
qualified residence. Such an election may be desirable where interest
secured by a qualified residence may be deductible under other sections
of the Internal Revenue Code. By making the election, the taxpayer may be
able to deduct more interest than would otherwise be allowed. For
example, the election should be considered where a small business owner
borrows money for the business and the bank requires the owner to use his
or her residence as collateral.
A bank
may also require a business loan to be secured by a residence and
additional collateral (e.g. inventory or other business assets). The
question then arises whether interest paid on the debt is qualified
residence interest. If it is not, then the interest is deductible as
business interest. If it is, then the interest is considered qualified
residence interest with the result that interest on additional loans subsequently
received by the taxpayer may not be deductible. In such a situation, it
is important to make the election to treat the first debt as not being
secured by a qualified residence. A literal reading of the Code implies
that additional collateral should not prevent debt from being secured by
a qualified residence where the residence has enough value to stand on
its own as sufficient collateral. Another example of use of the election
is a taxpayer borrowing money from a bank, securing it with his residence,
and then lending the proceeds to an entity he either owns or is a partner
in. By making the election, interest subsequently paid on other non-
business loans secured by the taxpayer's residence can be deducted. This
election strategy should be carefully examined by business owners
utilizing their residence as collateral for debt used in their business.
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· Using Bargain
Sales to Charities
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Bargain sales (i.e. transfers of property that are in part a
sale and in part a gift) allow a taxpayer to make a charitable
contribution and obtain cash at the same time. Bargain sales can be
burdensome where appreciated property is involved because the tax rules
are designed to create neutrality between selling a portion of the
property to an unrelated party at fair market value with the proceeds
being donated to a charity and selling the property directly to the
charity. This generally results in the donor recognizing gain on the
transaction. However, bargain sales may be the only way to make a
charitable contribution in some cases. To gain maximum tax benefit, at
minimum cost, it is important to choose the right property and to
minimize or delay the recognition of the gain.
In a
bargain sale, the taxpayer sells property at less than its full fair
market value to a charitable organization. The taxpayer is entitled to a
charitable deduction for the difference between the fair market value and
the price at which the property is sold. However, if the property is
appreciated, i.e. its fair market value exceeds its tax basis, the
taxpayer must recognize a portion of the gain. Taxpayers can minimize the
amount of the gain recognized by selecting property with a relatively
high tax basis. Accordingly, bargain sales should never be used to
dispose of depreciated property. Furthermore, since losses are not
recognized on bargain sales, property with a basis higher that its value
should not be used in a bargain sale. In such a situation, the taxpayer
is better off selling the property at a loss and donating the proceeds of
the sale to the charity. Taxpayers also should avoid transferring
property subject to debt, as debt assumed by another is treated as
additional amount realized, triggering additional gain. Taxpayers can
delay gain recognition by making a bargain sale to a charity on the
installment method. Other techniques for delaying gain recognition
requires the cooperation of the charity. If the charity is willing, the
taxpayer can delay gain recognition indefinitely by taking back like-kind
property in a tax-free exchange. Alternatively, a taxpayer can delay
recognizing gain by taking back a charitable annuity, so that the gain is
recognized ratably over the period of the annuity. Bargain sales to
charities should be examined, in a proper case, as a valuable tax
planning strategy. There are various ways to accomplish such a
transaction and maximize the tax benefits.
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