How to lower federal tax on business stock sales

With an increased capital gain tax rate of 20 percent for tax years 2013 and after, small-business owners should be aware of a provision that eliminates one-half or more of capital gains recognized on the sale of their C corporation stock.

Enacted in the early ’90s, Internal Revenue Code Section 1202 excludes 50 percent of the corporate stock gain, provided that the stock has been held for more than five years before the sale. This provision applies to original issue stock issued to noncorporate stockholders after August 10, 1993.

The total assets of the issuing corporation must not exceed $50 million on the date of issue and sale.

For stock issued after Feb 17, 2009, and before Sept. 28, 2010, the exclusion is 75 percent of qualified small-business gain. The exclusion is 100 percent for stock issued after Sept. 27, 2010, and before Jan. 1, 2014.

Corporation stock issued in an empowerment zone after Dec. 21, 2000, has an exclusion rate of 60 percent for empowerment zone stock sold before Jan. 1, 2019. Empowerment zones are certain geographic areas with enhanced tax benefits that terminated after Dec. 31, 2013.

How does this provision affect an existing business?

Does your company need capital?

Instead of lending the corpo­ration money, the business owner may issue new stock. If the stock is issued more than five years before the business is sold, one-half of the gain from this newly issued stock is tax-free.

If the company grants stock options to employees, it should consider funding the executed stock option with new small-business corporation stock. Not only does the employee receive an equity position, but if the company performs favorably in the future, the employee’s sale of stock is 50 percent or more tax-free.

A company may convert its debt to stock and give the newly issued stock to the former debt holder. If the debt holder sells the small-business stock more than five years later, the gain is only 50 percent taxable.

Small-business stock converted to preferred stock is treated as qualified small-business stock. Some employers may pay bonuses with original issue stock, which saves the company�s cash and potentially reduces the capital gains tax that the employee may pay when the company is sold.

Some wealthy employees may choose to make charitable contributions with their fully tax­able stock and keep qualified small-business stock to sell if the company is seeking a future buyer.

The gain exclusion also reduces the net investment income tax of 3.8 percent on excluded gains. Net investment income is gross income from interest, dividends, annuities, royalties, rents and substitute interest and dividend payments, but not to the extent this income is derived from a trade or business. Net gains are net investment income if recognized as attributable to property disposition, but not to the extent the property is held by a trade or business.

The net investment income tax applies to:

  • Single taxpayers if their adjusted gross income is over $200,000
  • Married taxpayers if their adjusted gross income is over $250,000
  • Married taxpayers filing separately if their adjusted gross income is over $125,000

The tax is computed by taking 3.8 percent of the lesser of:

  • Taxpayer net investment income for the tax year, or
  • Adjusted gross income in excess of the threshold amounts of $200,000 (single taxpayer), $250,000 (married taxpayer) or $125,000 (married filing separately).

One CPA client’s 2013 business stock sale saved over $485,000 in income and net investment taxes. This savings resulted because, during the past decade, the client’s corporation issued original stock to its employees after they had executed their stock options.

Can a sale of stock result in zero tax on qualified business stock gain? Yes, paying no tax is achievable.

A noncorporate stockholder is allowed under IRC Section 1045 to exclude capital gain from the sale of qualified business stock if it has been held more than six months – and if similar small-business stock is acquired within a 60-day period beginning on the date of the stock sale. Gain is recognized only to the extent that equal dollars are not reinvested in qualified small-business stock within 60 days of the previous stock sale.

In future years, noncorporate stockholders may exclude 50 percent, 60 percent, 75 percent or 100 percent of the gains realized from the sale of their corporate business. This opportunity should enable families to keep more of their career’s wealth invested for future retirement or new investments.

Passive Activity: Trust can be a “real estate professional”

In a highly anticipated decision that could save substantial taxes for trusts that manage real estate investments, the Tax Court recently ruled in favor of a Michigan real estate developer’s estate that an estate can be treated as a “real estate professional.”

The Tax Court ruled in favor of the taxpayer – the Frank Aragona Trust – that a trust that owned real estate properties and engaged in other real estate activities qualified for the exception to the passive activity loss rules for real estate professionals.

A passive activity is any activity conducted by a trade or business in which a person does not materially participate. Material participation is a key issue with real estate investors, more so today with the new Medicare tax, which imposes a 3.8 percent tax on net investment income.

In general, any rental activity is considered a passive activity, even if the person materially participates in the activity. However, there are exceptions.

For example, the rule for rental activities does not apply to a qualifying real estate professional if:

  • More than half of the personal services the real estate professional performs during the year are performed in real property trades or businesses in which the professional materially participates; and
  • The real estate professional performs more than 750 hours of services during that tax year in real property trades or businesses in which the professional materially participates.

In this case, the Frank Aragona Trust owns rental real estate properties and is involved in other real estate business activities, such as holding and developing real estate. Frank Aragona created the trust in 1979, with him as trustee and his five children as beneficiaries.

Frank Aragona died in 1981. He was succeeded as trustee by six trustees – one independent trustee and Aragona’s five children, one of whom acted as executive trustee.

Three of the children also worked full time for, and received wages from, Holiday Enterprises, LLC, which is wholly owned by the trust and a disregarded entity for federal income tax purposes. Holiday managed most of the trust’s rental real estate properties and had a number of other employees in addition to the three children.

The trust conducted some of its rental real estate activities directly, some through wholly owned entities and the rest through entities in which it owned majority interests. It conducted its real estate holding and real estate development operations through entities in which it owned majority or minority interests.

The issue presented in the case was whether the Frank Aragona trust can qualify as a real estate professional. The IRS asserted that it cannot because “personal services” means work performed by an individual in connection with a trade or business. As support, the IRS cited certain legislative history stating that the exception applies to individuals and closely held C corporations.

The Tax Court concluded that, if the trustees are individuals and they work in a trade or business as part of their trustee duties, their work can be considered “work performed by an individual in connection with a trade or business.” Accordingly, it concluded that a trust is capable of performing personal services and therefore can be considered a real estate professional.

The court then determined that the trust materially participated in its real estate operations and thus qualifies for the exception. The court concluded that the activities of the trustees, including their activities performed as employees of Holiday, should be considered in determining whether the trust materially participated (Frank Aragona Trust v. Commissioner, 142 TC No. 9, March 27, 2014).

The determination of whether a particular trade or business is subject to the 3.8 percent surtax on investment income is based in part on whether the trade or business is considered a passive activity. The holding in this case could potentially result in fewer trusts being liable for the surtax.

Home builders get big win in Tax Court case

Home builders won a significant victory in a recent Tax Court case, allowing them to defer income recognition until the entire development is complete, not on a house-by-house basis under the completed contract method of accounting.

The U.S. Tax Court concluded in the case of California-based Shea Homes (Shea Homes, Inc. v. Commissioner, 142 TC No. 3, Feb. 12, 2014) that Shea did not have to recognize income under the completed contract method until the year the development has been completed.

Developers are warned to take caution because the case was based on specific facts that may not be present in all situations.

The amenities of the development were a crucial aspect of the developer’s sales effort, the attainment of governmental approval of the development and the buyers’ purchase decision. Accordingly, the amenities were an essential element of the home purchase and sale contract.

Shea Homes and its related entities developed large planned residential communities ranging in size from 100 homes to more than 1,000. They sold more than 114 developments across three states: California, Arizona and Colorado.

Shea contended that final completion and acceptance under the completed contract method of accounting did not occur until the last road was paved and the final performance bond required by state and municipal law was released.

The IRS contended that the subject matter of Shea’s contracts consisted only of the houses and the lots upon which the houses were built. Under its interpretation, the contract for each home met the final completion and acceptance test upon the close of escrow for the sale of each home.

The IRS also contended that contracts entered into and closed within the same tax year were not long-term contracts eligible for the completed contract method of accounting.

The Tax Court called the IRS analysis “simplistic and short sighted; it does not acknowledge the complex relationships created by the purchase and sales agreement, especially obligations that continue long after the first home is built.”

The court determined that Shea was permitted to use the completed contract method of accounting and that the subject matter of the contracts consisted of the home and the larger development, including amenities and other common improvements.

The court reasoned that the primary subject matter of the contracts included the house, the lot, improvements to the lot and common improvements to the development.

New safe harbor for structuring historic tax credit partnerships

Are you an investor or a developer with questions about historic tax credits?

You should be aware that the IRS issued new safe-harbor rules in Revenue Procedure 2014-12 on Dec. 30, 2013, in direct response to the holding in Historic Boardwalk Hall, LLC v. Commissioner 694 F.3rd 425 (3rd Cir 2012).

In the Historic Boardwalk Hall case, the 3rd U.S. Circuit Court of Appeals denied the taxpayer the right to claim historic tax credits on the basis that it was not a true partner in the partnership through which historic tax credits pass. The court found that the investor partner lacked both a meaningful downside risk and a meaningful upside potential.

The IRS, reacting to the impact of the case on the historic tax credit industry, issued Rev. Proc. 2014-12 to provide a safe harbor to give investors and developers comfort in structuring historic tax credit partnerships. The safe-harbor rules apply equally to project-level partnerships and master-lease partnerships, in which the developer has elected to pass the historic tax credits through to a master tenant.

Rev. Proc. 2014-12 is effective for allocations of historic tax credits made on or after Dec. 30, 2013 – that is, with a placed-in-service date of on or after Dec. 30, 2013.

The four key partnership structural provisions required to take advantage of the safe harbor are as follows:

1. Partnership Interests: The minimum requirements are a developer interest of 1 percent and an investor interest of 5 percent. Most deals are structured with 1 percent/99 percent interests, which may “flip” at the end of the five-year compliance period to as low as 5 percent of the investor’s initial 99 percent interest, or to 4.95 percent.

2. Guarantees: The developer may guarantee the investor against recapture of historic tax credits for direct acts or omissions to act that cause the partnership to fail to qualify for historic tax credit. However, a guarantee against recapture based on an IRS challenge of the transaction structure of the partnership is impermissible.

A developer may provide completion, operating deficit, financial covenant breach (but not minimum net worth covenant) and/or environmental guarantees, as long as these guarantees are unfunded. However, cash reserves are allowed as long as they total no more than reasonably projected 12-month operating expenses.

3. Exit Structure: At the end of the five-year compliance period, the developer may not have a call option (an option to buy at a specified price from the investor). Rather, the investor may have a put option, as long as the sales price is less than the fair market value of the investor’s partnership interest at the time of exercise.

4. Bona Fide Investment: This factor has four separate terms:

  • Equity timing: An investor must contribute at least 20 percent of its total expected equity prior to the placed-in-service date, and at least 75 percent of the investor’s equity must be fixed prior to the placed-in-service date. Note that typical equity adjusters based on milestones are allowed but cannot adjust the investor”s commitment by more than 25 percent.
  • Bona fide investment: The investor�s interest must be a bona fide equity investment with a reasonable anticipated value that is commensurate with the investor�s overall percentage interest in the partnership, separate from tax attributes (deductions, credits, allowances) allocated by the partnership to the investor, and that is not substantially fixed in amount.
  • Commensurate value: To have a commensurate value requires that the investor receive the cash and other economic benefits – other than historic tax credits – on a basis equal to its percentage interest. This requirement continues to allow an investor’s interest in the partnership to be determined principally by the amount of anticipated historic tax credits to be allocated.
  • Value impacts: An investor’s interest may not be depressed through the use of developer fees, disproportionate distributions, lease or other business terms that are not reasonable (and a sublease with a term not shorter than the master lease is deemed unreasonable) relative to arm’s-length development transactions not using historic tax credits. This is really the key requirement in Rev. Proc. 2014-12.

    While preferred returns, developer, management and/or incentive fees are allowed, they must be comparable to non-historic-tax-credit development partnerships. This may likely require third-party verification from accountants or appraisers as a condition to a tax opinion from legal counsel.

Rev. Proc. 2014-12 establishes a number of safe-harbor requirements that differ significantly in material ways from customary terms in most historic tax credit transactions closed over the years. These requirements play out most significantly in the value impact requirements, requiring negotiation of business terms (fees, preferred returns and lease arrangements) that previously were fairly well settled.

Because counsel will likely require independent verification of the reasonableness of such business terms as a condition to providing a tax opinion, you should seek the advice of your CPA, who may enlist the expertise of an appraiser, in connection with historic tax credit transactions.

What final repair regulations say about materials and supplies

It is no secret that business owners generally – with some exceptions – prefer to deduct as much as possible up front rather than capitalize and then depreciate over time.

For this reason, it has become increasingly important for business owners to be aware of the tax laws associated with materials and supplies. These laws can be found among various other equally important topics in the seemingly endless final repair regulations, released Sept. 19, 2013, which become effective Jan. 1, 2014.

Proposed regulations were issued in August 2006, followed by temporary regulations in December 2011, with which your business may or may not be in compliance. Unfortunately, determining deductible materials and supplies isn’t as simple as choosing an arbitrary dollar threshold to expense smaller items used in your business operations.

Materials and supplies defined

The following information attempts to outline the basics of what constitutes materials and supplies as well as the various tax treatments of those expenses.

The basic definition of materials and supplies is tangible property used or consumed in your business operations that is not inventory and that meets one or more of five possibilities:

  • It was acquired to maintain, repair or improve a unit of property owned, leased or serviced by the taxpayer and was not acquired as any single unit of property.
  • It consists of fuel, lubricants, water and other similar items that are reasonably expected to be consumed within 12 months or less.
  • It is considered a unit of property with an economic useful life of 12 months or less, beginning when the unit is first used in the business operations.
  • It is a unit of property with an acquisition or production cost of $200 or less.
  • It is specifically identified in the Federal Register or Internal Revenue Bulletin.

Taxpayers that were previously in compliance with the temporary regulations may notice that they were given a slight break with the increase in the previous $100-or-less limitation to $200. During the discussion phase, some consideration was given to increasing the limit to $500, which the IRS felt was too high. But keep an eye on this threshold in the future because the IRS still has the power to amend the amount.

Treatment of material and supply types

A distinction between various types of materials and supplies dictates their particular treatments. These types are:

  • Nonincidental materials and supplies
  • Incidental materials and supplies
  • Rotable spare parts
  • Temporary spare parts
  • Emergency spare parts

Both nonincidental and incidental materials and supplies are those that are kept on hand for the maintenance, repair or improvement of a unit of property.

However, a record of consumption is kept of nonincidental materials and supplies, and a deduction is allowed in the first year that the material or supply is used or consumed. Incidental materials and supplies differ in that there is no record of consumption, and the deduction is allowed only in the year when the business pays for the materials or supplies.

Rotable and temporary spare parts are generally deductible in the year they are disposed of, unless an optional accounting method (described below) is elected allowing for a deduction upon initial installation.

A rotable spare part is a part that is acquired for a unit of property, is removable and can be repaired or improved before being reinstalled on either the same unit of property or a different unit or stored for later use. A temporary spare part is a part that can be installed on a temporary basis until a new or repaired part becomes available, at which point the temporary part may be stored for future installation.

Emergency spare parts are also deductible in the year they are disposed of, as are rotable and temporary spare parts. However, the optional accounting method is not available to them.

In short, an emergency spare part would be considered either rotable or temporary, except that it is normally very specific to a particular unit of property. It isn’t interchangeable, tends to be very expensive and difficult to obtain, and isn’t repaired or reused.

Optional accounting method

As mentioned above, the optional method of accounting allows for immediate expensing when installed. However, this method imposes additional tracking and administrative responsibilities that a taxpayer may or may not be willing to perform.

Basically, upon each removal from the unit of property on which the part had been installed, the taxpayer must recognize the part’s fair value in gross income and subsequently include this amount, as well as any removal costs, in the basis of the part. Any amounts paid to maintain, repair or improve the part must be included in the basis but not deducted currently. When the part is reinstalled on a different unit of property, the basis is deducted along with any reinstallation costs.

Capitalizing election

Sometimes deducting everything at once is not the best option. When this is the case, there is the option to capitalize rotable, temporary and emergency spare parts. This election may lessen the business’s administrative burden by aligning the company’s book capitalization policy with its tax policy, effectively eliminating book to tax differences.

To capitalize the allowable supplies and materials, the taxpayer must elect on its tax return for each item to be capitalized in the year the item is placed in service. This election may not be revoked unless the taxpayer files a request for a private letter ruling. Regulations dictate that the Commissioner of Internal Revenue will grant this letter ruling if it is deemed that the taxpayer acted reasonably and in good faith and if the revocation will not prejudice the government’s interests.

Keep in mind that a letter ruling’s authority is specific to individual items. In addition, a letter ruling is usually quite expensive to obtain. Do not try to revoke this election by filing an application for a change in accounting method or filing an amended return.

Safe harbor

There are many more intricacies of the finalized repair regulations. In fact, the materials and supplies topic is really only one component with which other components within the repair regulations may become intertwined.

For example, there is a safe harbor, found in the section of regulations dealing with capital expenditures, that allows for items that would otherwise require capitalization to be treated essentially as material or supplies and expensed up front. It’s allowed provided that the item’s cost on a per invoice basis is at or below either $5,000, with audited financials, or $500, without audited financial statements.

As demonstrated, it can’t be stressed enough how numerous and complicated the rules get. This is why consulting with your tax professional is highly recommended.

Although materials and supplies may seem immaterial by themselves, cumulatively, they can have a huge effect on taxable income – either positive or negative – depending on how they are managed.

Foreign reporting doesn’t have to be a dirty word … if you learn the rules

Offshore reporting is filled with sinkholes that can entrap the unwary taxpayer. With some of the largest civil penalties found anywhere, it’s an area where even the smallest mistake can be costly.

The Report of Foreign Bank and Financial Accounts, or FBAR, is one of the most common offshore reporting forms (Form TD F 90-22.1). But it’s often overlooked.

Schedule B of the U.S. Individual Income Tax Return, Form 1040, requires taxpayers to disclose whether they own or have signatory authority in foreign accounts. If the answer is “yes,” a taxpayer may be required to file an FBAR.

Many taxpayers incorrectly fail to check the appropriate box on Schedule B. That’s critical because the IRS views a box that is checked “no” as an affirmative or “willful” misstatement.

A willful misstatement can subject a taxpayer to enhanced civil penalties. Those penalties can include prison, a $500,000 fine and civil penalties of 50 percent of the highest account balance for each year the taxpayer did not report the account properly.

It’s important for taxpayers to tell their accountants whether they have offshore accounts. Often a CPA will have an affirmative representation in the engagement letter stating that a client doesn’t have any interests in foreign accounts.

Many taxpayers think that the offshore reporting requirements affect only foreign bank accounts. But FBAR may also require the following to be reported:

  • Foreign brokerage accounts
  • Custodial precious metal accounts
  • Foreign hedge funds
  • Real estate investments
  • Life insurance policies with some type of annuity or savings component

If taxpayers have ownership or signature authority in a foreign investment or account, they should share answers to the following questions with their CPA:

  • When was the account opened?
  • What is the approximate value of the account?
  • What is the source of funds?
  • What is the account used for?
  • Does the account generate income?
  • Is the account related to any business activity?
  • Is anyone else related to the account?

Answers to these questions will determine whether a taxpayer has an FBAR reporting requirement.

The instructions give the following guidance: “A United States person that has a financial interest in or signature authority over foreign financial accounts must file an FBAR if the aggregate value of the foreign financial accounts exceeds $10,000 at any time during the calendar year.”

That may be a good starting point. But a few important clarifications may affect a CPA’s final decision.

First, some taxpayers have the false impression that, as long as no individual account exceeds the threshold of $10,000, they aren’t required to file an FBAR report for any of their accounts. This is a common error.

Actually, the aggregate of the accounts is determinative. If two accounts hold $8,000 each, both accounts must be reported.

Another big hurdle in FBAR reporting is the definition of “U.S. person.” It is not uncommon for taxpayers to be dual nationals, foreign-born naturalized citizens, ex-pats living overseas and resident aliens (green card holders).

Are green card holders who never lived here residents? What if they moved here late in the calendar year? If taxpayers are unsure of how the answers apply to them, they should consult with an immigration attorney or ask their CPA to review the residency tests.

A taxpayer’s CPA should carefully note the definition of “resident alien” and the Substantial Presence Test. First- and last-year residency may complicate things but can be important for tax purposes.

Another issue is whether a taxpayer has a financial interest or signature authority over a foreign account. Estate planning maneuvers and cultural norms can play havoc. The Tax Code often says that interests are reportable even though taxpayers do not consider the accounts to be “theirs.”

Common reporting scenarios include elderly parents who add their children to accounts to help with money management and children who open accounts “back home” to provide for elderly parents or siblings who have not emigrated. As a general rule, a taxpayer should report the account if the taxpayer’s name is on it.

Indirect interest through more than 50 percent ownership of an entity is another area of complication. Many countries do not allow foreigners to own land directly, so Americans wishing to own property must set up LLCs or trusts to buy property. Then they own 100 percent of that LLC.

Other similar situations are comparable to condominium ownership or timeshares but through a foreign entity. Depending on the ownership and entity, this type of ownership may be reportable.

The definition of “foreign financial account” is not as black and white as one might think. For the average taxpayer, only checking, savings, investment and retirement accounts come to mind. As noted above, the definition encompasses many other financial instruments, such as:

  • Certificates of deposit
  • Foreign stock and securities
  • Hedge funds
  • Mutual funds
  • Commodities and precious metals accounts
  • Indirect interests in foreign financial assets through an entity if ownership exceeds 50 percent
  • Life insurance and annuities with cash value 

With so many financial products and derivatives invented every year, it’s important to remember that the definition of “account” is quite broad.

The definition of “foreign financial institution” is also important. An account at the local UBS branch is not a foreign financial account. However, an account at the London branch of the Bank of America is.

For people who hold gold bullion or silver bars, the definitions of these accounts are also important. Reporting may be required, depending on what type of institution holds the metal and whether the taxpayer can purchase and sell through that account.

The purpose of this information isn’t to frighten people away from having offshore accounts. The number of taxpayers who do is growing. They need to know when to seek outside help and be aware of the potential pitfalls. Addressing these issues with their CPAs is wise.

Simply hoping that they won’t need to disclose offshore accounts or even to understand what the IRS considers reportable is a recipe for disaster for taxpayers.

How the new 3.8 percent tax may apply to selling a business

A new unearned income Medicare contribution tax, with an effective date of Jan. 1, 2013, was enacted as part of the healthcare act. That date has come and gone, and the tax is now applicable.

The new Medicare tax applies to net investment income of individuals whose modified adjusted gross income exceeds certain threshold amounts. The threshold amounts are $250,000 for married filing jointly, $125,000 for married filing separately and $200,000 for single taxpayers.

The tax also applies to undistributed net investment income of estates and trusts when adjusted gross income exceeds the highest estate and trust tax bracket.

Trade or business income

In the case of a trade or business, the Joint Committee on Taxation’s Technical Explanation of the provision says that the tax applies to business income if the trade or business:

  • Is a passive activity, with respect to the taxpayer, or
  • Consists of trading financial instruments or commodities

But the tax does not apply to other trades or businesses conducted by a sole proprietor, partnership or S corporation.

(Refer to Joint Committee on Taxation’s Technical Explanation of the Revenue Provisions of the “Reconciliation Act of 2010,” as amended, in combination with the “Patient Protection and Affordable Care Act,” March 21, 2010.)

Sale of business assets

Upon disposition of a business, only net gain or loss attributable to property held by the entity that is not property attributable to an active trade or business is subject to the tax. However, income, gain or loss on working capital is not treated as derived from a trade or business, so it’s taxable.

The tax applies to net investment income, including net gain (to the extent taken into account in computing taxable income), from the disposition of property other than property held in a trade or business. When a disposition of an active equity interest in a partnership or S corporation is made, rather than a disposition of the underlying assets, an exception also applies.

Sale of equity interests

An interest in a partnership or S corporation in most cases is not property held in a trade or business, according to the preamble to proposed regulations issued in November 2012. Therefore, gain or loss from the sale of a partnership interest or S corporation stock will be subject to the tax.

This generally is not the case when partners or S corporation shareholders materially participate in the business. So, dispositions of those interests should be closely reviewed for exemption from the tax.

Sale of partnership or LLC equity interests

A sale of equity interests in a partnership or limited liability company (LLC) is treated as a direct sale of partnership or LLC assets. Therefore, a net gain on the sale of partnership interests or LLC member interests by a partner or member who materially participates in the business is exempt from the tax. This result differs from the sale of interests in an S corporation, in which there is a strong distinction between stock and asset transactions.

Sale of S corporation stock

Absent further guidance, the sale of S corporation stock, even by a shareholder who materially participates in the business, would appear to be subject to the tax. Fortunately, the law itself provides an exception.

The Internal Revenue Code addresses gain in the case of a disposition of an interest in a partnership or S corporation. For purposes of the tax, gain is considered only to the extent of the net gain the seller would take into account if all property of the partnership or S corporation were sold for fair market value immediately before the disposition of the equity interest.

Deemed asset sale election

The exception for a disposition of an active equity interest in an S corporation is inapplicable to the deemed asset sale and liquidation transactions that result from an election. The exception is unnecessary, since the exception for the sale of active business assets would apply directly.

Information reporting

The IRS requires information to verify a taxpayer’s eligibility for the exception for certain active interests in partnerships and S corporations. This information will be used to determine whether the amount of tax has been reported and calculated correctly.

The IRS specifically requests comments concerning whether the proposed collection of information is necessary for the proper performance of the IRS’s functions, including whether the information will have practical utility.

Payments for services, noncompete covenants and personal goodwill

In the context of selling a business, Form 8594, Asset Acquisition Statement Under Section 1060, asks – even for a stock sale – whether ancillary agreements were negotiated with the sellers in addition to the related stock or asset sale agreement.

Employment or consulting agreements may attract the new 0.9 percent Medicare tax. But they should not be subject to the 3.8 percent unearned income Medicare contribution tax because payments would not constitute net investment income. Noncompete payments should not be subject to either of the new taxes since they are neither self-employment income nor net investment income.

The sale of personal goodwill creates a capital gain that may be subject to the active trade or business exceptions to the 3.8 percent tax.

Deferred gain

If the sale of an S corporation would have avoided the tax under the active trade or business exception, a question comes to mind: Would that gain also be excluded from the new tax with a tax-free merger of the S corporation into a C corporation and reduce the ultimate net investment income on a taxable sale of the stock received in the merger? Nothing in the statute, Technical Explanation or proposed regulations addresses that issue.

Tax impact

An additional 3.8 percent tax on top of a 20 percent capital gains tax amounts to a 19 percent surtax.

While it is appropriate to minimize the tax when possible, the Joint Committee on Taxation warned in March 2010 that the IRS will closely review transactions that manipulate a taxpayer’s net investment income to reduce or eliminate the amount of tax imposed.

Professional tax advice is strongly advised in applying the provisions of the unearned income Medicare contribution tax.