Original Issue Discount and Debt Instruments

What is original issue discount?  Original issue discount (OID) is a form of interest that you may not realize you have earned, received or need to report.  The article below has been prepared by a tax attorney to provide information regarding (OID), but please consult directly with your tax advisors regarding your specific facts and circumstances.

Generally, you should (or will) report OID as income as it accrues over the term of any debt instruments even if you do not received any payment(s) of the actual interest from the party paying the debt and/or interest.  A debt instrument could be a promissory note, bond, debenture or any other evidence of indebtedness based upon the facts and circumstances.  You may typically see a debt instrument have OID when the debt instrument was issued for less than the stated redemption price.  A debt instrument that pays no interest before the instrument matures would likely be considered issued at a discount.  The following are examples of discounted debt instruments.

 

  • Municipal Bonds (interest may not be taxable)
  • Notes between individuals or private parties
  • United States Treasury Bonds
  • Stripped Bonds
  • Certificates of Deposit (CODs)

An example may help illustrate the discount and interest amount.  If a bank issues a bond with a maturity price of $1,000 for $900, the original issue discount is $100, and the discount would be included in income as it accrues over the term of the bond.  Please note, if the discount is less than one-quarter of an interest percentage (.0025) the discount may be considered de minimis discount and treated as zero.

 

All of the above being said, many people will ask if there are any exceptions to reporting OID income. The OID may not apply to the debt instruments below, but please always check current law and regulations with your tax attorney or tax advisors.

 

  • United Savings Bond
  • Tax Exempt Obligations
  • Debt instruments with a fixed maturity date less than one-year from the date of issuance (short-term debt instruments)
  • Obligations issued by an individual prior to March 2, 1984
  • A loan between individuals if the loan and any other prior loans between the same individuals is less than $10,000 (USD), the individual lending the money is not in the business or regularly lending money; and, a primary purpose of the loan is not to avoid federal income tax.

Is a 1099 issued?  If the total of the OID is $10 or greater, the party issuing the debt instrument should issue a 1099-OID.

You can speak with a tax attorney or business attorney with questions related to interest and OID by contacting The McGuire Law Firm.   Call 720-833-7705 to discuss your matters with a tax attorney.

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What is my Cost Basis?

What is my cost basis in certain property and why do I care?  Many people and businesses are not fully aware of their basis in property, do not properly track the basis and may be unaware as to the importance of their basis in property.  The article below has been prepared by a tax attorney to provide information regarding basis.  Please remember, this is not legal advice and it is recommended you consult directly with your tax attorney regarding your specific issues and questions.

You could look at your cost basis as your initial threshold for gain or loss when an asset or property is sold.  Although, not discussed in this article, under certain circumstances you may not be able to recognize a loss, and you may not have recognize gain.  Further, your basis may be adjusted because of certain issues.  Regardless, to calculate basis, you would start with your cost basis.  Generally, the basis of your property is the cost.  You would likely determine cost by the amount of cash paid, debt obligations (loan or promissory note) and other property transferred.  However, it is very important to remember that your cost basis may also include:

  • Freight/shipping
  • Installation and testing
  • Sales Tax
  • Legal and accounting fees
  • Excise Taxes
  • Recording Fees
  • Real estate taxes

For example, say you decide to purchase a piece of equipment for $100,000.  The shipping fee was $2,500 and you paid an attorney $1,000 to draft the bill of sale and related purchase documents.  Your cost basis would thus be $103,500.  Thus, if you sold the equipment immediately thereafter, your threshold for any gain would be $103,500.  If you held the equipment for business use, and depreciated the equipment, this depreciation would lower the cost basis and you would track the adjusted basis of the property.

 

Often when a business is purchased, you purchase all assets and the assets differ.  Thus, how do you report or track the cost basis in the purchase of a business?  When you purchase business assets, you can report the amount paid for each class of assets on Form 8594.  The IRS allocates purchase price in an asset sale between seven classes of assets, which are outlined on the Form 8594 and defined in the instructions and elsewhere.  The business selling the assets would report the sale of the assets on Form 4797 (Sales of Business Property).  Generally, the seller and buyer involved in the asset purchase will agree to the allocation of the purchase price and Form 8594 will be agreed upon and completed prior to closing, perhaps even as an exhibit to the asset purchase agreement.

 

If you have questions relating to your basis in property and tax treatment through the sale or purchase of property, you may want to speak with a tax attorney and/or business attorney.  You can contact The McGuire Law Firm at 720-833-7705 with any questions.

Denver Tax Lawyer

Operating Agreement Invalidating S Corporation Election

Limited Liability Companies (LLC) are a very popular entity choice and structure for new businesses and closely held entities.  An LLC can be formed quickly and has a lot of flexibility regarding members, operations and taxation structure.  It is not rare for an LLC to eventually consider and perhaps decide to be taxed as an S corporation.  Although, an LLC converting to a Subchapter S corporation has benefits, such as potentially reducing self-employment taxes, these benefits may be mistakenly lost if the Subchapter S corporation status is invalidated.  A means by which to invalidate the S corporation status, which is many business owners may not consider is the LLC operating agreement.  Abiding by the LLC operating agreement may cause the entity to operate in a manner than invalidates the S corporation election.  The article below has been prepared by a tax attorney and business attorney to further discuss the risk of losing S corporation status by abiding by an operating agreement.  Please remember this article is for information purposes only, and is not intended to be legal or tax advice.

To properly evaluate how an S corporation could lose or invalidate the S corporation election, it is important to remember how a business qualifies and the requirements for an S corporation.  The qualify as an S corporation, the corporation must:

 

  • Have only allowable shareholders (no partnership, corporate or non-resident alien shareholders)
  • Have only 100 shareholders or less
  • Have only one class of stock
  • Be a domestic corporation
  • Not be an ineligible corporation (insurance companies and other disallowed companies)

Our focus will be on the one class of stock requirement.  The one class of stock requirement requires that all shareholders receive distributions and liquidation preferences pro-rata per their stock ownership.  An S corporation can have a different class of stock for voting rights, but the economic benefits and distributions to the shareholders must follow the ownership percentage, which is directly related to the number of shares each shareholder owns.  Many LLC operating agreements will contain clauses and language that actually require unequal or disproportionate distributions to the LLC members.  Thus, if the distributions are in accordance with the operating agreement, the issuance of disproportionate distributions could lead to the IRS claiming the corporation has multiple classes of stock, and therefore, the S corporation election is invalid.  Treasury Regulation Section 301.7701-(3)(c)(1)(v)(c) states that the S corporation election is valid only if ALL requirements are met.  Thus, an LLC electing be to be taxed as an S corporation should consider removal of certain clauses within the operating agreement relating to substantial economic effect, IRC Section 704 and any other clause that could create disproportionate distributions.  If the S corporation election was lost, the owners may be subject to additional self-employment tax, or the business, if taxed as a C corporation would be subject to tax at the corporate level, and the shareholder level, thus double taxation.

If you have questions related to your choice of entity, taxation matters and internal business documents, it is recommended you speak with a tax attorney and/or business attorney to review the documents, taxation matters and intended tax treatment.

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The Cohan Rule

Individuals or business who have been audited by the Internal Revenue Service may be familiar with the Cohan rule.  The Cohan rule is based upon a court case that may allow a taxpayer an allowance for certain business deductions even if the taxpayer is unable to verify or substantiate certain expenses.  This article has been prepared by a tax attorney at the The McGuire Law Firm to provide additional information related to the Cohan Rule and IRS tax audits.  It is recommended you use this article for informational purposes only and discuss your facts and circumstances specifically with your tax attorney and other advisors.

The Internal Revenue Code requires that a taxpayer maintain certain records for the IRS to allow an expense or deductions.  When a taxpayer is being audited by the IRS, generally the taxpayer must show a receipt, invoice, cancelled check or like item for the IRS to allow the expense that is under audit.  If the taxpayer is unable to provide the necessary documentation, the IRS may disallow the expense or item.  Under the Cohn rule, the IRS or a court may allow a taxpayer reasonable amount of the deductions.  The key issue is, what is reasonable?

The Cohan rule was established through a Court of Appeals case in the Second Circuit in 1930.  Although, the court stated the taxpayer did not have adequate substantiation to verify expenses, the court held the board (IRS) should make an approximation.  In short, the court felt that it was reasonable for the taxpayer to have some reasonable business expenses, and should not be disallowed all deductions due to lack of records.  Thus, under the Cohan rule, a taxpayer can make an argument for an expense deduction to be allowed without proper documentation.

It is important to remember that the Cohan rule does not apply to all expenses.  For example, the Cohan rule does not apply to items whereby Internal Revenue Code Section 274(d) applies.  IRC 274(d) applies to travel expenses, entertainment expenses, gifts and other listed property, and taxpayer must comply with very strict verification rules for the IRS to allow a deduction.

One question that is often asked is, who has the burden of proof in a tax audit?  Generally, the taxpayer will have the burden of proof that they are entitled to the deduction and the additional tax proposed by the IRS is incorrect.  However, under Internal Revenue Code Section 7491(a), the burden of proof can switch to the IRS when the taxpayer produces credible evidence relating to factual issues, complies with requirements and verifies deductions, cooperates with reasonable requests by the IRS relating information, documents, interviews, meetings and maintains records under the Internal Revenue Code.

If you are being audited by the IRS, you may consider representation by a tax attorney.  You can speak with a tax attorney by contacting The McGuire Law Firm.

Deductible or a Capital Expense?

Is an amount paid by a business an expense that is currently deductible, or is it a capital expenditure that should be depreciated,, amortized or depleted?  This issue is one of the most common issues in a tax audit with the Internal Revenue Service, as well as one of the most litigated issues in United States Tax Court.  The article below has been prepared by a tax attorney to provide additional information related to this common issue.  Please remember that this article is for informational purposes, and you should consult directly with your tax attorney and advisors related to your specific issues.

A currently deductible expense is an ordinary and necessary expense that is paid or incurred by the business during the taxable year in the ordinary course of operating the trade or business.  Please reference Internal Revenue Code Section 162.  In comparison, a capital expenditure would be the cost to acquire, improve or restore an asset that is expected to last more than one year.  These capital expenditures are not allowed a deduction, but rather are subject to amortization, depreciation or depletion over the useful life of the property. See Internal Revenue Code Section 263.

That being said, how does one determine whether an expenditure is an expense to be deducted or a capital expenditure?  The answer is, it is a question of fact.  The Courts have applied the principles of deductibility versus capitalization on a case by case basis, and the facts and circumstances of each case will likely determine the outcome.

An example may help illustrate the difference between an expense that would be deductible versus one that would be capitalized.  If a business owner bought certain office supplies such as pens and paper, they would be deductible.  If the same business owner, purchased a building to operate the business, the building would be capitalized.  Let’s look at a different example that might not be as obvious.  Assume a business owns and rents property.  In one property a hole was placed in the wall when a tenant moved.  In another property, the owner decided to replace the walls with new drywall and paint.  It is likely the fixing of the hole in the wall would be deductible as a repair or maintenance, whereas the cost to replace the walls would be capitalized by the business.

One further issue to consider beyond the matters discussed above is that the Internal Revenue Code requires books and records to be maintained to verify and substantiate the expense whether it be a deduction or capital expense.  If the item or amount of the expense cannot be verified and substantiated by the taxpayer, the IRS may disallow the deduction or the capital expense.

If you have questions related to a deduction or capital expense, you can speak with a tax attorney by contacting The McGuire Law Firm.   The McGuire Law Firm offers a free consultation with a tax attorney to discuss your questions and issues.

Denver Tax Attorney

Compliance Requirements to Establish an Agreement With IRS

In order to be eligible to resolve an outstanding federal tax liability on a voluntary basis (i.e. installment agreement or offer in compromise), as opposed to having it forcefully resolved through collection action such as levies, garnishments, and the seizure of assets, the IRS has two basic requirements.  The first requirement is that you are in filing compliance.  This means that all outstanding tax returns that are required to be filed have been filed.  Most people do not have a difficult time understanding this requirement once it is determined whether or not there are delinquent returns that need to be filed.

The second requirement is that the taxpayer is current with all required federal tax deposits and/or quarterly estimated deposits.  There are several different possible deposits that may need to be made to be considered current by the IRS.

One type of deposit is the Estimated Deposit Requirements for Individual Income Taxes. 
 The deposit requirements for individuals tend to be simpler than that of a business, because there is only one deposit that may be required. If a federal tax liability has been assessed against you personally, and you are seeking a voluntary resolution such as a payment plan or an offer in compromise, it is a prerequisite that any required quarterly estimated payments be made.

In order to determine if you are required to make a quarterly estimated payment, the first and best step is to review your prior year’s federal income tax return, Form 1040.  If the return was filed with a tax liability of over $1,000 (after subtracting federal tax withholding and credits), and you expect the federal withholding and credits to be less than the smaller of 90% of the tax to be shown on your 2015 federal tax return, or 100% of the tax shown on your 2014 federal tax return (only applies if your 2014 tax return covered 12 months – otherwise refer to 90% rule above only), then you are required to make quarterly estimated payments toward your next income tax return as it is presumed that the next income tax return will be similar to the current one.

There are two ways of determining the amount of each quarterly estimated payment that needs to be made.  The simpler way is to just divide the tax liability of the last and most recently filed return by four.  For example, if you filed your 2014 1040 income tax return with a tax liability of $5,000, you are required to make four quarterly estimated payments of $1,250 toward your 2015 1040 income tax return.  If you anticipate your next return to be substantially different than your present return, another means of determining the amount of each quarterly estimated payment is to complete an IRS estimated tax worksheet.  This can be found at on the IRS website.  The worksheet is a series of calculations and estimates that will determine the amount of the quarterly estimated payments in an attempt to eliminate any future liability on the next filed return.

If you are an individual whose income is derived from a W2 wage, one fairly simple method of eliminating the need for a quarterly estimated payment is to increase the income taxes being withheld from your wage

 

The required quarterly estimated payments are due on April 15th, June 15th, September 15th, and January 15th. However, you do not have to make the payment due on January 15th, if you file your tax return by February 1st and pay the entire balance due with your return.

 The second type of deposit is IRS Deposit Requirements for Businesses. 
 Similar to an individual, a business may also have to make quarterly estimated payments toward its future income tax return. The same criteria for individual estimated payments apply to a business.  However, in addition to being current with quarterly estimated payments for income tax, the business also has to be current with its required federal 941 employment tax deposits and possibly with its 940 unemployment tax deposits.  The 941 employment tax deposits are due either on a quarterly, monthly, or semi-weekly deposit schedule depending on the amount of wages that are issued each quarter.

Additionally, the business may be required to make quarterly deposits toward its future 940 unemployment tax return.  The amount is determined by looking at the current quarter’s tax liability.  If the 940-unemployment tax is $500 or less during that quarter, you can carry it over to the next quarter and not make a deposit.  You can continue to carry the tax liability over to the next quarter until the cumulative tax is more than $500. At that point, a tax deposit is required for the current quarter.  The deposit is due by the last day of the month after the end of the quarter.  If your tax for the next quarter is $500 or less, you are not required to deposit your tax again until the cumulative amount is more than $500.  If the cumulative tax liability never exceeds $500 then it is acceptable to pay the liability with the return at the end of January of the following year when you file the return.

The IRS requires deposit and payment compliance to obtain voluntary resolution for one important and primary purpose.  The IRS wants to ensure that a liability is not incurred on a future return.  It is a critical requirement for any voluntary resolution of a back tax liability to not accrue any additional tax liability.  The IRS does not want to grant voluntary resolution such as a payment plan to resolve a back tax liability if the payment plan is likely to default in the near future when you file your next return with a liability. Thus, the IRS has established these requirements in an attempt to ensure that a future liability does not occur, thereby allowing the taxpayer to adhere to the terms of their approved resolution plan.

The above article has been prepared by Greg Johnson.  Mr. Johnson is a tax attorney and of counsel at The McGuire Law Firm.  Greg has represented many individual and business taxpayers before the IRS regarding many different issues.

Identifying Tax Related Identity Theft

Identity theft has become a very common crime and can impact individuals in many ways.  Apart from an identity thief stealing your identity and obtaining credit cards or bank account information, an identity thief may use your personal information and steal your identity for tax purposes and tax related theft.  Although, the Internal Revenue Service and state taxing authorities work hard to prevent identity theft, you can assist your assist by being aware of common signs of tax related identity theft.  The article below has been prepared by a tax attorney to provide information and what you may consider as warnings or red flags that your identity has been compromised, and the thief using your identity for a tax related purpose.

  • When you go to file your tax return electronically, the return is rejected. The message may state that a return with a duplicate social security number or tax identification number has already been filed.  This may mean that someone has used your social security number to file a tax return.  You may want to check the social security number you used, but if the social security number you are using is correct, your identity may have stolen.  The Internal Revenue Service has an identity theft affidavit (Form 14039) that can be filed with the IRS.  Please see the instructions for Form 14039, and any related form.
  • The Internal Revenue Service may forward you a letter requesting that you verify whether you have filed a return with your name and social security number. When the IRS receives a suspicious return, the IRS may hold the return and mail a letter to the taxpayer to verify certain information.  If you did not file the return, it is likely someone is attempting to steal your identify for a tax related purpose.
  • If you receive a W-2 or a 1099 (or other items) reported to you for income you did not receive or from third parties you did not work for, or perform services for, someone may have compromised your identity and reported income under your social security number.
  • You receive a check from the United States Department of Treasury as a refund that you did not claim. If the refund is incorrect, you likely do not want to deposit the check, and should contact the IRS or a tax attorney.
  • You receive a wage and income transcript, account transcript, tax return transcript or other tax return transcript from the Internal Revenue Service that you did not request. A identity theft may be attempting to test or receive information via transcript.

The Internal Revenue Service has information available regarding identity theft, including Publication 4524.  The article above has been prepared for informational purposes by John McGuire, a tax attorney at The McGuire Law Firm.  Please consult with your tax attorney, tax advisor or other parties regarding our specific questions.

Tax Identity Theft by Denver Tax Attorney

How is a Profits Interest in an LLC Taxed?

If I am given a profits interest in a partnership or limited liability company, how am I taxed?  It is relatively common for an LLC (for purposes of this article, a partnership and LLC may be considered the same type of business) to give an interest to a service provider.  The taxation of the interest is different depending upon the type of interest as a capital interest can be different than a profits interest.  The article below discusses a profits interest.  A profit’s interest is a type of equity in the applicable business, and is designed to give the individual a predetermined share of future growth in the value of the business.  A profits interest can be differentiated from a grant of stock within a corporation because the profits interest would not entitle the holder of the profits interest to share in the businesses current value.  Rather the profits interest provides for a share of future profits and appreciation within the business, as opposed to an interest or share in the company’s current value.  This position, is what dictates the tax treatment of a profits interest when provided to the holder of the interest.

 

Initially, courts appeared to have mixed feelings regarding the taxation of a profits interest.  In 1974, a federal court of appeals held that the receipt of the profits interest should be considered taxable income when the interest had a readily determinable market value.  However, later another federal court made a determination that would appear to suggest the service provider receiving a profits interest and acting as a partner within the company could receive the interest without the interest being taxed upon receipt.

 

Revenue Procedure 93-27 was issued by the Internal Revenue Service in 1993 to provide guidance regarding the taxation and treatment of a profit’s interest in a partnership.  The Internal Revenue Service used a hypothetical liquidation test in the Revenue Procedure 93-27 analysis.  Under the hypothetical liquidation analysis, a liquidation would not give the profits interest holder a share of the partnership assets if the partnership liquidated all assets and distributed cash to the partners.  In terms of the timing of the liquidation, the liquidation is deemed to occur at the time of the partner receives the profits interest, and thus there would have been no real increase in the value of the business from the time of receipt to the time of the deemed liquidation.  This analysis entitles the holder of the profits interest only to a share of future profits and appreciation in the business, rather than an immediate interest in the partnership’s current value.  Thus, when a partner receives a profits interest for services, or for the benefit of the partnership in a partner capacity, or even in anticipation of being a partner, the IRS will likely not treat the receipt of the interest as a taxable event.  It is important to note that the IRS may not treat the receipt of a partnership interest as a non-taxable event if in fact the profits interest would bring about a substantially certain and predictable amount of income to the recipient.

 

The article above has been prepared by John McGuire of the McGuire Law Firm.  As a tax attorney and business attorney, John’s practice focuses primarily on taxation issues and business transactions.

Denver Tax Attorney

Denver Tax Attorney

Is Your Business a Hobby?

Is your business considered a hobby by the Internal Revenue Service?  One of the key questions or issues is whether or not your business is an activity engaged in for profit.  While you may feel your business is established and engaged in for a profit, the IRS may feel otherwise, and the Internal Revenue Code can impact your deductions.  This article has been prepared by a tax attorney to provide additional information regarding this issue.  Please consult with your tax advisors or tax attorney regarding any questions you have.

The pertinent section relating to activities engaged in for profit is section 183, which is often referred to as the “Hobby Loss Rule.”  IRC Section 183 limits deductions that a business may anticipate they can claim when the business is not engaged for a profit.  As a business owner you can deduct ordinary and business expenses when conducting your business activity.  However, if your business activity is deemed to not be engaged in for the production of income (a profit), you may not be able to deduct some or all of the expenses.

The IRS will consider certain facts and circumstances when determining whether your activity or business is a hobby, or an activity engaged in for profit. Some of these issues are stated below.

 

  • Do you depend upon the income? Do you rely upon the activity or business to provide income that supports you?
  • What amount of effort and time do you put into the activity, and does the amount of time and effort show you intended to make a profit?
  • What is your knowledge base in regards to the activity and does such knowledge provide you with the ability to make a profit?
  • Have you been successful in making a profit with the applicable activity or a like activity in the past?
  • Has the activity made a profit in some of the taxable periods?
  • What actions or methods have you implemented to improve profit or allow the activity to be profitable?
  • If the activity has sustained losses, are the losses explained by circumstances beyond the taxpayer’s control?
  • If the activity has sustained losses, are the losses due to reasonable or anticipated start up expenses?

 

If an activity makes a profit in at least three of the last five years, then the IRS should validate the business as an activity engaged in for profit.  If the activity is deemed a hobby (not for profit), the losses from the activity cannot be used to offset other income.  In short, the activity cannot produce a loss.  Thus, the allowable deductions and expenses for the activity cannot exceed the gross income (gross receipts) of the activity.

If you have questions related to your business income, deductions and related matters, speak with a tax attorney at The McGuire Law Firm.  Free consultation with a tax attorney in Denver or Golden Colorado.

IRS Lien Release With Offer in Compromise Acceptance

A Notice of Federal Tax Lien can provide a number of problems for a taxpayer.  Recently, the IRS has been releasing the Notice of Federal Tax Lien when a taxpayer successfully has an offer in compromise accepted by the IRS and pays the offer amount.  This is a wonderful benefit to the taxpayer as the IRS did not always release the tax lien upon payment of the settlement amount, but rather would wait for the five-year compliance period after the offer has been accepted.

The video below has been prepared by a tax attorney at The McGuire Law Firm to provide additional information regarding this issue.  If you have any type of tax issues with the Internal Revenue Service, contact The McGuire Law Firm to speak with a tax attorney.