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NEWS

NEWS

 
 
 

Section 1202 of the Internal Revenue Code allows non-corporate taxpayers to exclude from federal income tax 100% of the gain on the sale of certain qualified small business stock (QSBS), limited to the greater of $10 million or 10 times the adjusted basis of the investment. Unlike in prior years, this creates possible opportunities for non-corporate taxpayers who dispose of QSBS in a taxable transaction to potentially exclude the entire gain for federal tax purposes.

The Creating Small Business Jobs Act of 2010 was developed to encourage individual taxpayers to make additional equity investments in startup corporations during the remainder of calendar year 2010. The 2010 Jobs Act included an amendment that for the first time provided for a complete US federal income tax exemption (with no application of the alternative minimum tax) for specific gains recognized by non-corporate investors on the sale of QSBS held for more than five years ? but only if the stock was purchased at original issue in the limited window after September 27, 2010, and before January 1, 2011.

Although initially intended as a tax incentive for stock issued during a limited period, the 0 percent rate for gains on QSBS became so popular that Congress began expanding it. In fact, Congress repeatedly extended the applicable window for issuance of the 0 percent-eligible QSBS in successive one-to-two-year tranches. And recently, on December 15, 2015, President Barack Obama signed into law the Protecting Americans From Tax Hikes Act of 2015, making the 0 percent rate for specific gains from sales of QSBS a permanent tax benefit.


Thus, assuming all applicable requirements are met, the 0 percent federal income tax rate could now apply to gains from sales of QSBS acquired at any time after September 27, 2010.

However, several requirements must be satisfied before those benefits can be realized, and even if those requirements are met, there are important limitations on the amount of gain that can qualify for the 0 percent rate. These requirements and limitations are further discussed below.

GENERAL REQUIREMENTS

The general requirements for qualifying for the 0 percent federal tax rate on gains from the sale of QSBS include the following:

(i) Original issue.

The taxpayer recognizing the gain must not be a corporation and must have acquired the stock at original issue from a US domestic C corporation.

(ii) Five-year holding period.

The taxpayer must have held the stock for more than five years.

(iii) After September 27, 2010.

The taxpayer must have acquired the stock at original issue after September 27, 2010, in exchange for cash, property other than cash or stock, or services.

(iv) After September 27, 2010.

The aggregate gross assets of the corporation that issued the stock cannot have exceeded $50 million at any time before (and including the time immediately after) the issuance of the stock to the taxpayer. Importantly, the amount of a corporations assets at any given time is generally measured by the corporations adjusted tax basis in those assets, except when any property is contributed to the corporation. In that case, the property must be taken into account for this purpose based on its fair market value (FMV) at the time of the contribution.

(v) Active Business Test.

During substantially all of the taxpayer is holding period of the stock, at least 80 percent of the issuing corporation is assets must be used by the corporation in the active conduct of one or more qualified trades or businesses. This includes assets used in furtherance of a prospective active business, i.e., startup activities, research and experimentation, and in-house research. It also includes working capital, investments expected to finance research and experimentation or increased working capital within two years, and computer software rights that produce active business royalties. After the corporation has existed for two years, however, no more than half of its assets can be working capital or investments held for future research or working capital.

Although many types of trade or business should qualify for this purpose, the following are specifically excluded: any trade or business involving the performance of services in the fields of health, law, engineering, architecture, accounting, actuarial science, performing arts, consulting, athletics, financial services, and brokerage services. Also specifically excluded is any trade or business for which the principal asset is the reputation or skill of any of its employees.

(vi) No significant redemptions.

The issuer of the stock must not have engaged in specific levels of buybacks (redemptions) of its own stock during specified periods before or after the date of issuance of the stock to the taxpayer.

LIMITATIONS

A non-corporate taxpayer who recognizes gain from the sale of stock meeting the above requirements can thus generally qualify for a 0 percent federal income tax rate. The amount of gain eligible for this 0 percent rate is subject to a cap, however. Section 1202(b)(1) states that the aggregate amount of gain for any taxpayer regarding an investment in any single issuer that may qualify for these benefits is generally limited to the greater of (a) $10 million, or (b) 10 times the taxpayer is adjusted tax basis in the stock. For a taxpayer who invests cash in the QSBS, basis would generally be equal to the cash purchase price. There is a special rule, however, for when a taxpayer instead purchases the QSBS for in-kind property (that is, other than cash). In those cases, the taxpayer is basis in the QSBS, solely for purposes of these Section 1202 rules, is deemed to be an amount not less than the FMV of the property transferred for that QSBS (often referred to as the basis-is-not-less-than-value rule). The general purpose of the basis-is-not-less-than-value rule is to ensure that inherent built-in gain for any property contributed to a corporation in exchange for QSBS does not qualify for the Section 1202 benefits. Only the gains from the sale of QSBS that are attributable to appreciation in value of the QSBS occurring after the date of issuance are potentially eligible for the 1202 benefits.

Additionally, although this potential planning opportunity may lead to significant federal tax savings, many states, including California, do not follow federal income tax treatment of QSBS under Sec. 1202.

ROLLOVER OF GAIN

A taxpayer other than a corporation (i.e., individuals, partnerships, S corporations, estates and trusts) may elect to roll over capital gain from the sale of QSBS held for more than six months if QSBS is purchased by the taxpayer during the 60-day period beginning on the date of sale. Accordingly, gain is recognized only to the extent that the amount realized on the sale exceeds the cost of the replacement QSBS purchased during the 60-day period, as reduced by the portion of such cost, if any, previously taken into account. To the extent that capital gain is not recognized, that amount will be applied to reduce the basis of the replacement small business stock. The basis adjustment is applied to the replacement stock in the order the replacement stock is acquired.

TREATMENT FOR PASS-THROUGH ENTITIES

Gain on qualified stock held by a partnership, S corporation, RIC, or common trust fund is excludable if the entity held it for more than five years and if the partner, shareholder, or participant to whom the gain passes through held an interest in the entity when the entity acquired the stock and at all times thereafter. The partner, shareholder, or participant cannot exclude the gain to the extent that his or her share in the entity is gain is greater than what it was when the entity acquired the qualified stock, however.

 
 
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What is Your Entrepreneurial Personality Type: Mountain Climber, Freedom Fighter, or Master Craftsman?

We know that entrepreneurs are a different creed from the typical person.  But why do some entrepreneurs run their businesses totally different from other entrepreneurs even if that company is in the exact same industry and location?  How can two leaders convey the same message with very different results?

John Warrillow, author of “Built to Sell: Turn Your Business into One You Can Sell,” suggests it’s the way they’re wired. He recorded his research and findings on the psychographics of business owners in his body of work named, “The Value Builder System.” Warrillow described business owners from his research by categorizing them into three distinct psychographic profiles that define their motivation:

  • Mountain Climbers: Focused on revenue, goals associated with a threshold, and aspirations all around top line growth, bar none.
  • Freedom Fighters: Focused on being independent: when to work, who to work with and what to wear. They prefer creating and overseeing their own ideal culture.
  • Mastery/Craftsman: Love to achieve mastery of the craft they have chosen. For example, they like to be known as the best photographer in the market, best plumber or entertainment artist. They are the most risk averse of the three types.

To begin understanding the type of business owner you are, Warrillow suggested simply looking for key traits in social and other settings. For example, check your business card title. Titles often give clues to primary motivations and the way a business owner perceives their roles. A “mountain climber” will call him or herself the founder, CEO or chairman, even if they only have a handful of people in their firm. The “freedom fighter” will often classify him or herself as the owner or president, while the craftsman may describe their profession or trade as a title.

Another quick check is to probe pain points. A mountain climber has a hard time identifying employees who live up to expectations since they project their own high expectations for themselves onto others. Warrillow offered Jeff Bezos as an example. Employees at Amazon have historically lasted only 18 months on average. Why? The turnover trend at Amazon trickles down from the very top and out through managers to the entire employee base, according to Warrillow. A freedom fighter would differ in that he or she may tend to cultivate more so-called dead wood since keeping a nonproductive employee is more acceptable in an environment where top-line revenue goals and threshold aspirations are not as important as having an independent or ideal company that may include family members. Mastery/craftspeople are the most risk averse and don’t tend to take on many employees.

“Mountain climbers will often have several businesses at once, or a portfolio of companies listed in their history since achievement defines who they are,” states Warrillow. “A freedom fighter is one who is more prone to run the same company for many years. Craftspeople may have a pattern of being in and out of the economy in synch with the employment rate.”

I believe that it’s important for entrepreneurs to know their personality types for several reasons including developing mastery in breaking through resistance or barriers that they themselves may have created.  Let’s take the case of entrepreneurs raising equity for their companies.  Mountain climbers will have to share equity to fund growth and will tend to create a complex capital structure.  Warrillow noted, “Freedom fighters want independence, and will generally avoid sharing equity at all costs since sharing equity is nearly the opposite of how they are wired.”

To know your company and where it is going, it is best for the entrepreneur to know himself or herself. The success of his company depends on it.


Home Office Deductions for Owners of LLCs and S Corporations.

Self-employed individuals whose businesses are set up as sole proprietorships routinely use the home-office deduction for expenses related to the business use of their homes. The deduction is available to those who use a portion of their homes regularly and exclusively for conducting business and for whom the home is their principal place of business.  Taking the home office deduction is fairly simple when you’re a self-employed individual and file Schedule C. In those instances, you simply indicate on IRS Form 8829 the percentage of your home that is used for work and the costs to maintain your space, and that amount will go on your Schedule C as a deduction.

However, there are additional tests that those who use a home office in their role as an employee, and technically, when a business is set up as an S corporation rather than a sole proprietorship or partnership, the business owner will have an employment relationship with the corporation. The additional tests include a requirement that the business use of the property be for the convenience of the employer and that the employee must not rent any part of the home to the employer.

For shareholders of an S corporation or members of a partnership or multi-member LLC, while the calculation of the dollar amount is pretty much the same as the sole proprietorship, how it is treated on the shareholders’ or members’ personal tax returns differs. If you are a member of a partnership or multi-member LLC, then you deduct the expenses as unreimbursed partnership expenses on Schedule E of your personal tax return, below the line that you report your activity from the partnership or LLC.

S corporation shareholder-employees may deduct office-in-the-home expenses as miscellaneous itemized deductions on Schedule A of their personal tax returns. But these deductions are of little or no value because of the 2% income floor imposed on miscellaneous itemized deductions, and the add back of such deductions in computing alternative minimum taxable income. For many taxpayers, that makes the home-office deduction essentially useless.

Rather than claiming an office-in-the-home deduction as a miscellaneous itemized deduction, an S corporation shareholder-employee could have the corporation reimburse the expenses properly allocable to the business use of the home.  Reimbursement of business expenses is provided for under Internal Revenue Code Section 132.  Pursuant to regulations applicable to Section 132, out-of-pocket business expenses should be documented and reimbursed on a current, monthly basis. To accomplish this, we recommend that shareholders of the S corporation submit an expense report as part of what is called an “accountable plan”. Take these steps to follow this path:

  • Draft an accountable plan agreement for your company. It will outline what expenses are eligible for reimbursement, how they will be paid, etc.
  • Calculate the percentage of your home that is used exclusively for business purposes.  Divide the square footage used for business by the total square footage of the home and multiply by 100.
  • Calculate the total amount of eligible reimbursable expenses using IRS Form 8829.  Multiply each amount by the percentage of business use calculated in the step above and enters the results on the expense form that you use for your accountable plan.
  • Prepare expense reports as the employee and turn them in to your company on a regular basis.  Attach receipts or other documentation to the form to substantiate them.
  • Cut the check from the business account and deposit it into your personal account.  Attach a copy of the check to the form as documentation that these were paid.
  • Enter the amount of the payment into your S corporation’s records as a reimbursement for employee expenses. Post each expense claimed to the appropriate expense account so that these expenses may be deducted from the corporation’s income on its tax return.

You have now created a tax-deductible business expense for the S corporation, and you don’t have to report the reimbursement as income.

There is one catch to this treatment: the deduction that the business can take is limited to the net income that the business generates. Therefore, if you have a loss for a given year, then you won’t be able to claim the deduction. What you can do is carry it forward to a future year. If you earn a profit in the future, you will be able to claim it then.

By documenting reimbursements from a corporate bank account to your personal account, you will be able to establish records to support your position to the IRS.  That will make it easier for you to get the tax benefit of your home-office expenses without potentially triggering red flags.


New York Grant Incentives That Were Recently Renewed for Three Years.

New York City offers some of the best, most effective economic incentive programs in the nation. These programs afford public and private companies, not-for-profit organizations and communities the opportunity to growth.

Below is a list of New York City incentive programs that were recently renewed for three years:

PROGRAM

DESCRIPTION

EXPIRATION DATE

Relocation Employment Assistance Program (REAP)

A 12 year annual business income tax credit of up to $3,000 for each qualified job for companies relocating to eligible areas of NYC. The credit is refundable in cash for the first four years and can offset NYC income taxes for the remaining eight years.

JUNE 30, 2020

Lower Manhattan Energy Program (LMEP)f

A 12 year program provides NYC property owners and commercial tenants that relocate to new or improved space in eligible buildings a reduction of approximately 15% in electricity costs.

JUNE 30, 2020

Energy Cost Savings Program (ECSP)

A 12 year program for NYC companies that reduces electricity and gas costs by approximately 15%  for eligible businesses that relocate, make improvements, or lease space in qualified buildings.

JUNE 30, 2020

Commercial
Revitalization Program (CRP)

Provides up to $2.50 per square foot (PSF) in rent credits for up to 5 years for tenants in qualified buildings located in lower Manhattan.

MARCH 31, 2021

Commercial
Expansion Program (CEP)

Provides up to $2.50 PSF in rent credits for up to 5 years (10 years if manufacturing) for tenants in qualified buildings north of 96th Street in Manhattan or outside of Manhattan.

MARCH 31, 2021

Lower Manhattan Sales Tax Exemption

Exemption from 8.875% sales tax on build-out (capital) costs for commercial tenants south of Murray St. Full exemption on capital costs; furniture, fixtures, & equipment for tenants in WTC, WFC and BPC areas.

DECEMBER 1, 2021


Using the Research & Development Credit to Offset Payroll Taxes

New businesses or start-up companies may be eligible to apply the research and development (R&D)tax credit against their payroll tax for up to five years. The R&D credit was permanently extended as part of the Protecting Americans from Tax Hikes (PATH) Act of 2015. It includes some enhancements starting in 2016, including offsets to alternative minimum tax and payroll tax for eligible businesses.

The credit is still based on credit-eligible R&D expenses, but offsets apply to only those costs incurred beginning in 2016. The new payroll tax offset allows companies to receive a benefit for their research activities regardless of whether they are profitable. The new payroll tax offset is available only to companies that have:

  • Less than $5 million in gross receipts in 2016 and for each subsequent year the credit is elected.  A company isn’t eligible if it generated gross receipts prior to 2012.
  • Qualifying research activities and expenditures.

The maximum benefit an eligible company is allowed to claim against payroll taxes each year under the new law is $250,000.

Qualifying Activities

Regardless of industry, if a company’s activities meet the following requirements, known as the four-part test, then they could potentially be eligible for this credit:

  • Technical uncertainty. The activity is performed to eliminate technical uncertainty about the development or improvement of a product or process, which includes computer software, techniques, formulas, and inventions. 
  • Process of experimentation. The activities include some process of experimentation undertaken to eliminate or resolve a technical uncertainty. This process involves an evaluation of alternative solutions or approaches and is performed through modeling, simulation, systematic trial and error, or other methods. 
  • Technological in nature. The process of experimentation relies on the hard sciences, such as engineering, physics, chemistry, biology, or computer science. 
  • Qualified purpose. The purpose of the activity must be to create a new or improved product or process (computer software included) that results in increased performance, function, reliability, or quality.

Additional thresholds may apply if a company develops software for internal use. Also, activities must be performed in the United States and can’t be funded by another party.

Eligible Research and Development Costs

Eligible R&D costs include these categories:

  • Wages. W-2 taxable wages for employees offering direct support and first-level supervision of research.
  • Supplies. Supplies used in research, including so-called extraordinary utilities but not capital items or general administrative supplies.
  • Contract research. Certain subcontractor expenses (provided the subcontractor’s tasks would qualify if they were instead being performed by an employee). These can include labor, services, or research, but payment can’t be contingent on results. In addition, the taxpayer must retain substantial rights in the results, whether exclusive or shared.
  • Rental or lease costs of computers. This could include payments made to cloud service providers (CSPs) for the cost of renting server space, as longs as payments are related to hosting software under development versus payments for hosting a stable software release.

Social Security Tax

Companies are required to pay Social Security tax of 6.2 percent on up to $118,500 of each employee’s salary in 2016. A company that employs 50 employees with an average salary of $75,000 per person would pay approximately $232,500 in Social Security payroll taxes in 2016. The credit can only be applied to the employer’s Social Security portion of payroll taxes. As such, a company would need to have more than $4 million in annual payroll subject to social security tax and $2.5 million in eligible R&D costs to offset the maximum $250,000 in payroll taxes each year under the new law.

Most employers are required to deposit their payroll taxes to the federal government on a monthly or semiweekly basis and also file a quarterly payroll tax return (Form 941). The credit will be applied against the Social Security tax on the quarterly return, not when it’s deposited monthly or semiweekly. It’s important to note, however, that the IRS is still formulating a plan for how the process will be formally implemented.

The payroll tax offset may be available to new businesses and start-up companies for up to five years. Any unused R&D credits that aren’t elected to offset payroll taxes may be carried forward for up to 20 years and used when the business becomes profitable.

IRS Risks to Claiming the R&D Credit

Once a company starts to use these credits, they see a much higher level of scrutiny from the IRS. In fact, R&D credits are often a high priority for the agency every year and it’s assembled project teams by industry with technical specialists that assist in reviewing R&D credit claims. Even at the small business level, it’s common for IRS technical specialists to be involved in R&D credit examinations.  In general, larger credits may receive more scrutiny from the IRS and, therefore, require a higher degree of review and documentation.

Although many companies in the technology industry are likely engaged in activities that would otherwise be eligible for R&D credits, the rules surrounding the credit are complex and ever-changing. New legislation, regulations, court cases, and IRS guidelines have drastically shifted the landscape of R&D tax law over the past few years and will continue to do so in the future.

Considering these complexities and potential financial penalties, companies should have their activities analyzed by a CPA, attorney, or enrolled agent familiar with the intricacies of tax law and accounting rules that govern the R&D credits as well as the IRS examination and appeals process. To deter companies from claiming credits without the proper level of review and documentation, the IRS has the ability to impose penalties in excess of 20 percent of the credit amounts claimed. For example, if a taxpayer claims a $250,000 R&D credit and the credit is then audited by the IRS, it’s possible that the agency could deny the entire credit and fine the company with accuracy-related penalties in excess of $50,000.