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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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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.

 

IRS audits of businesses have dropped in 2016 to just 0.49% of all business tax returns, the lowest level since 2004. IRS audits of large corporations have also dropped. The IRS audited 6,458 large corporations, which are entities with assets exceeding $10 million. Four years ago, the IRS audited over 10,000.

Tax audits of individual by the IRS declined for the fifth straight year in 2016. The IRS audited just 0.7% of tax returns, which represents 1 in every 143 individual tax returns, down from 1 in 90 back in 2000. In 2016, the IRS audited 5.83% of high-income households, which is defined as returns with income over $1 million, down from 9.55% in 2015, which represents the lowest audit rate for that income group since 2008.

The above drop in audit rates are a result of budgets cuts at the IRS, which has lost 30% of its enforcement staffing since 2010. Expect Republicans to continue cutting the agency’s budget as part of broader spending cuts and the continued lowering of IRS audit rates.

The rules for the collection of New York State sales tax as it relates to computer software are quite complex.  In this article we look to explain how sales tax applies to sales of computer software and related services.

Prewritten computer software is taxable as tangible personal property, whether it is sold as part of a package or as a separate component, regardless of how the software is conveyed to the purchaser. Therefore, prewritten computer software is taxable whether sold:

  • on a disk or other physical medium;
  • by electronic transmission; or
  • by remote access.

Prewritten computer software includes any computer software that is not designed and developed to the specifications of a particular purchaser. This includes software created by combining two or more prewritten programs or portions of prewritten programs.

Custom software is not subject to tax provided it is designed and developed to the specifications of a particular purchaser. If the custom software is sold or otherwise transferred to someone other than the person for whom it was originally designed and developed, it becomes subject to tax.

Prewritten software that is modified or enhanced to the specifications of a particular purchaser is subject to tax. However, if the charge for the custom modification or enhancement is reasonable and separately stated on the invoice, then the charge for the modification or enhancement is not subject to tax.

Computer software services

Many services related to computer software are exempt. Examples of these services include:

  • training
  • consulting
  • instruction
  • troubleshooting
  • installing
  • programming
  • systems analysis
  • repairing
  • maintaining
  • servicing

However, when these otherwise exempt services are provided in conjunction with the sale of prewritten software, the charge for the service is exempt from tax only when the charge for the service is reasonable and separately stated on the invoice or billing statement given to the customer.

Sales of software upgrades

Generally, the sale of a revision or upgrade of prewritten software is subject to tax as the sale of prewritten software. If, however, the software upgrade is designed and developed to the specifications of a particular purchaser, its sale to that specific purchaser is exempt as a sale of custom software.

Remotely accessed software

A sale of computer software includes any transfer of title or possession or both, including a license to use.

When a purchaser remotely accesses software over the Internet, the seller has transferred possession of the software because the purchaser gains constructive possession of the software and the right to use or control the software.

Accordingly, the sale to a purchaser in New York of a license to remotely access software is subject to state and local sales tax. The situs of the sale for purposes of determining the proper local tax rate and jurisdiction is the location from which the purchaser uses or directs the use of the software, not the location of the code embodying the software. Therefore, if a purchaser has employees who use the software located both in and outside of New York State, the seller of the software should collect tax based on the portion of the receipt attributable to the users located in New York.

Software maintenance agreements

Separately stated and reasonable charges for maintaining, servicing, or repairing software are exempt from sales tax. However, if a software maintenance agreement provides for the sale of both taxable elements (such as upgrades to prewritten software) and nontaxable elements, the charge for the entire maintenance agreement is subject to tax unless the charges for the nontaxable elements are:

  • reasonable and separately stated in the maintenance agreement, and
  • billed separately on the invoice or other document of sale given to the purchaser.

Exempt sales for production or research and development

Prewritten computer software used or consumed directly and predominantly in the production of tangible personal property for sale, or directly and predominantly in research and development, is exempt from tax. The purchaser must provide the seller with a properly completed Form ST-121, New York State and Local Sales and Use Tax Exempt Use Certificate. See Tax Bulletins Exempt Use Certificate (TB-ST-235) and Research and Development (TB-ST-773).

Exempt sales to corporations and partnerships

Custom software is exempt from tax when resold or transferred directly or indirectly by the purchaser of the software to either:

  • a corporation that is a member of an affiliated group of corporations that includes the original purchaser of the custom software; or
  • a partnership in which the original purchaser of the custom software and other members of the affiliated group have at least a 50% interest in capital or profits.

However, the exemption does not apply if the sale or transfer of the custom software is part of a plan having as its principal purpose the avoidance or evasion of tax, or if the sale is prewritten software that is available to be sold to customers in the ordinary course of business.

 

As more companies in the manufacturing industry are becoming involved in foreign transactions, particularly exporting, they need to be aware that they can reduce their U. S. tax liability using an Interest-Charge Domestic International Sales Corporation, more commonly known as an IC-DISC.  The IC-DISC is a federal tax export incentive entity structuring available for U. S. companies that export goods and services to foreign countries.  An IC-DISC creates the opportunity to tax a portion of export related to profits at lower tax rates, and to potentially defer export related income to future years. 

The IC-DISC allows certain U. S. exporters to reduce their overall tax liability through a commission mechanism.  The exporter manufacturing company pays a tax deductible commission, based on qualified export sales, to a newly created corporation that makes an IRS election to be an IC-DISC.  By design, IC-DISCs are exempt from federal tax, and therefore do not pay tax on the commission received.  The IC-DISC then distributes the commission income to the shareholder as a qualified dividend subject to tax at reduced capital gains tax rates.

The IC-DISC entity can be created by the shareholders of the exporter manufacturing company as a brother-sister configuration, typically used when the exporter manufacturing company is a regular corporation for tax purposes.  Or, the IC-DISC can be established by the exporter manufacturing company as a parent-subsidiary configuration when the parent exporter manufacturing company is a pass-through type tax entity.

In either case, the benefit received from utilizing an IC-DISC structuring is dependent on the tax structuring and the effective tax rates of the taxpayers involved in the commission transactions.  The IC-DISC is not required to distribute its accumulated earnings, allowing for the dividend income to be deferred into future years. 

Export sales must meet the following requirements in order to qualify for the IC-DISC benefit:

  1.  Export property must be manufactured in the U. S.
  2.  Export property must be sold for direct use outside the U. S.
  3.  Less than 50 percent of the export property’s sale price must be attributable to imported

In addition to export sales of manufactured property, the following transactions may also qualify for IC-DISC treatment:

  1.  Leasing U. S. manufactured property for use outside of the U. S.
  2.  Export sales of property that is extracted, produced, or grown in the U. S., including crops and 
  3.  Engineering and architectural services provided for construction projects located outside the U. S.