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Distributions of Stock and Stock Options

Many corporations may provide or distribute stock or stock rights to employees. When a corporation distributes it’s own stock, this would be referred to as a stock dividend and when a corporation grants stock rights, these are typically referred to as stock options. When individuals receive stock dividends and stock options, they generally will ask or inquire as to whether or not these dividends or stock options are taxable. Generally, the answer is no, stock dividends and stock options are not taxable, and thus not reported on an income tax return. However, under certain circumstances, the stock dividends or stock options can be taxable. These circumstances are discussed below, and please remember to always consult directly with your tax advisors regarding your specific circumstances.

A distribution of stock dividends and stock rights or stock options are taxable if any of the following apply:

1) The corporation distributes cash or other property to certain shareholders of the corporation and provides other shareholders with an increase in their percentage of interest in the assets and earnings and profits of the corporation.
2) The distribution can be converted by the shareholder into preferred shares.
3) Any shareholder has the ability to choose cash or other property be received as opposed to the stock or stock rights.
4) The distribution is a distribution of preferred stock. It should be noted, however, that such a distribution would not be taxable if it is solely an increase in a conversion ratio of convertible preferred stock, which has been made solely due to a stock dividend, stock splitting or similar action that would result in reducing the overall conversion rate.
5) The distribution allows for preferred stock to be issued to some common stock shareholders and common stock of the corporation to be issued to other shareholders.

When a taxpayer does receive a taxable stock dividend or stock rights, the taxpayer would include the fair market value at the time of the distribution in their income. It is also important for shareholders to be aware of constructive distributions. A shareholder may have to treat certain transactions that increase their proportionate share or interest in the earnings and profits or assets of the corporation as if stock or stock options were distributed if the result is the same as items 1, 2, 4 or 5 above. This treatment would apply to a change in a shareholder’s conversion ratio or redemption price, a difference between the stock’s redemption price and issue price, a redemption that is not treated as the sale or exchange of the applicable stock and other transactions whereby the similar effect is realized on the shareholder’s interest in the corporation. An example of a taxable distribution would be the receipt of preferred stock that holds a redemption price higher than the price the stock was issued for. This difference is considered the redemption premium, and generally the redemption premium would be considered a constructive distribution and taxable.

The above article has been prepared by John McGuire of the McGuire Law Firm for informational purposes and should not be considered tax or legal advice. John is a tax attorney and business attorney in Denver, Colorado and Golden, Colorado serving clients in Colorado and nationwide on certain tax matters.
Denver Tax Lawyer

Gain, Loss & Realization Events in Property Transactions

When must I realize gain?  For the most part, it is easy to recognize when gain or loss has been realized, but at other times it may be hard to ascertain.  The article below has been prepared by a tax attorney to discuss gain or loss on certain property transaction and certain realization events.  Please remember this article is for informational purposes and specific facts and circumstances should be discussed specifically with your tax attorney and other tax advisors.

When an asset is sold, disposed of or transferred it may go without saying that a realization event has occurred.  Gain on the sale or disposition of the asset will be the amount received (realized) in excess of the adjusted basis of the property.  Loss, on the other hand would be the amount the adjusted basis exceeded the amount realized.  It is important to remember that not all transactions would require one to recognize the gain or loss in their income at the time of the transaction.  The word recognize in the previous sentence would mean to include the gain or loss in your current income.  A requirement to include gain or loss in your income is the occurrence of some realization event.  Once a realization event has occurred, then you must ascertain and determine the proper tax treatment of the transaction such as:

 

  • The adjusted basis in the property that was sold, transferred or disposed of;
  • The amount realized from the transaction as a whole;
  • Was gain or loss recognized from the transaction;
  • The character of the gain. For example, was the gain short term capital gain or long term capital gain.  Or perhaps, is the gain subject to recapture rules.
  • If there was a loss, is the loss allowed in whole or in part.

In regards to a realization event, generally speaking, a transaction with property will be considered a realization event if the taxpayer’s relationship, or control of the property is terminated, or the interest is significantly or materially reduced.  The lack of any transaction would tend to show a lack of a realization event.  Further, it should be noted that the mere increase or decrease in the fair market value of property does not, by its self, create a realization event.  For example, you may purchase Microsoft stock.  As the stock increase, you do not recognize gain, but rather, when you sell the stock, if the sale price of the stock is in excess of your adjusted basis, gain would likely be realized, and need to be recognized by reporting the gain on your income tax return.  Furthermore, transferring or disposing of property through a gift is generally not a realization event.  While the gift may have many tax implications, the gift alone may not be enough for a realization event whereby income or loss would be recognized on an income tax return.

There are multiple issues to consider relating to realizing gain and loss, and recognizing gain and loss.  Further, there are many situations whereby a loss may be disallowed in whole or part, or the loss can only be recognized in certain amounts or over certain times.

This article has been prepared by John McGuire at The McGuire Law Firm.  John is a tax attorney and business attorney working with individuals and businesses before the IRS and assisting clients with other tax and business matters.  John can be reached at 720-833-7705.

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.

Tax Attorney

Denver Tax Attorney

 

 

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.

Denver Tax Attorney Denver Tax Lawyer IRS Tax Attorney

 

Denver Business Attorney

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

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.