New York & New Jersey Business Lawyer Blog

Articles Posted in Tax Issues

345829246_a7434a76dc_z.jpgElecting “subchapter S” status has many benefits for a corporation and its shareholders, although it is subject to certain limitations on the number and type of shareholders. If a corporation’s S status is revoked, it may be able to make the election again at a later date, but that raises the question of whether tax benefits available to shareholders during the original subchapter S election are still available. The Office of Chief Counsel for the Internal Revenue Service (IRS) recently issued a memorandum on this question with regard to corporate earnings for which shareholders paid income tax, but that they did not receive as dividends. IRS regulations assign a special account for these funds and allow shareholders to withdraw them tax-free in later tax years. The account does not, however, survive the revocation of subchapter S status, meaning that shareholders lose tax-free access to those funds.

Shareholders of S corporations pay taxes on corporate income, similar to partnership taxation. They are responsible for paying income tax on their pro rata share of corporate income even if they do not receive dividends during that tax year. The IRS allows S corporation shareholders to withdraw dividends for previous tax years without incurring additional tax liability, since that money was already taxed. IRS regulations define an “accumulated adjustments account” (AAA) as containing the amount of corporate earnings taxed to shareholders but not yet paid out to them. 26 U.S.C. §§ 1366(a)(1), 1368(e)(1); 26 C.F.R. § 1.1368-2. The account is not apportioned among the shareholders.

The question presented to the IRS was whether an S corporation’s AAA survived “beyond the post-termination transition period into a subsequent S period.” In Memorandum No. 201446021 (PDF file) (“IRS Memo”), issued on November 14, 2014, the IRS concluded that the AAA does not survive this transition.
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Analyzing_Financial_Data_(5099605109).jpgFund transfers between business subsidiaries could be considered interest-generating loans under New Jersey tax law, according to a series of court cases culminating in a decision by the New Jersey Supreme Court. The shipping company United Parcel Service (UPS) appealed the assessment of late fees and penalties against five of its subsidiaries by the New Jersey Division of Taxation (NJDOT). The New Jersey Tax Court affirmed the NJDOT’s findings regarding imputation of interest income, but it held that the late fees and penalties were in error. UPS v. Dir., Div. of Taxation (“UPS I“), 25 N.J. Tax 1 (2009). The Superior Court, Appellate Division and the Supreme Court of New Jersey affirmed the Tax Court’s ruling. UPS v. Dir., Div. of Taxation (“UPS II“), 61 A.3d 160 (N.J. App. Div. 2013); UPS v. Dir., Div. of Taxation (“UPS III“), No. A-16/17, Sep. Term 2013 072421, opinion (N.J., Dec. 4, 2014).

The plaintiffs belonged to two groups of UPS subsidiaries: a group consisting of “internal service companies” that support other subsidiaries, and a group of companies “that transported packages and documents.” UPS I, 25 N.J. Tax at 11. The UPS parent company maintained a “cash management system” for its subsidiaries that involved transferring all cash received by the subsidiaries into a bank account maintained by the parent company on a daily basis. Id. at 14-15.

The NJDOT treated these transfers as loans from the subsidiaries to the parent company and imputed interest income to the subsidiaries that was not reported. It assessed late payment penalties and five-percent amnesty penalties, N.J. Rev. Stat. §§ 54:53-17, 54:53-18, against the subsidiaries. UPS appealed these actions.
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Dr_Martens,_black,_old.jpgNew York and New Jersey laws provide a wide range of options regarding the organization and structure of businesses, with recognition that the needs of a small, one- or two-person operation are likely to be substantially different from those of a much larger business. Businesses with no formalized legal structure are known as sole proprietorships if they have only one owner, and general partnerships if they have two or more. An informal business structure works for many business owners, but the business entities defined by state law have certain benefits that everyone should consider. Converting a business from a sole proprietorship to a limited liability company (LLC) can be an effective way for a business owner to protect both the business and themselves.

Sole Proprietorship vs. LLC

Operating a business as a sole proprietorship may offer some advantages:

– Simplicity: There is no need to file any specific paperwork with the state to maintain the business, aside from an assumed business name, also known as a “DBA.”

– Only one tax return: A sole proprietorship, unlike a corporation, does not file its own tax return. The business owner includes business income and expenses in a schedule attached to his or her personal return.

These possible advantages, however, come with some distinct disadvantages:

– The owner of a sole proprietorship is personally liable for any and all business debts.

– Similarly, business assets are susceptible to claims against the owner as an individual.

– A sole proprietor must keep meticulous records distinguishing personal and business assets, debts, and expenses.
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295128_6656.jpgA business may decide to sell all or a substantial amount of its business assets to another individual or company for a variety of reasons. These types of transactions are known as “bulk sales” if they are not part of ordinary business activities. Both New York and New Jersey require businesses that collect sales tax to disclose a planned bulk sale to state tax authorities. This disclosure is the purchaser’s obligation, since the purpose is to allow the state to determine the seller’s tax liability. If the purchaser does not make the required disclosures, it could become liable for the seller’s outstanding tax debt to the state. The disclosure process is not terribly complicated, but it appears to be one that many businesses forget in the course of purchasing another business’ assets.

What Is a “Bulk Sale”?

Any sale of business assets that is not part of the normal course of business could qualify as a bulk sale under state law. A bulk sale may occur if a company is going out of business, upgrading its equipment, or making significant changes in its business activities. Bulk sales may also occur in mergers or acquisitions, or if a business is converting from a sole proprietorship to a corporation or other business entity.

“Business assets” include any assets used in the course of business, including:
– Personal property, such as computers, office furniture, and inventory;
– Intellectual property, including patents, trademarks, and trade secrets;
– Certain types of real property; and – Intangible assets, like business goodwill.
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BurgerKingFood.jpg“Corporate inversion,” the process by which a corporation merges with a foreign corporation and relocates its headquarters to the foreign company’s home country, has received a considerable amount of attention in recent months. It is often expressly intended to reduce a corporation’s tax burden by moving the company to a country with lower corporate taxes, while still maintaining physical operations in the U.S. The White House and others have criticized the practice, and corporations are lobbying against laws that would restrict it. The Internal Revenue Code (IRC) already contains “anti-inversion” provisions, and a recent notice from the Department of the Treasury (DOT) states that new Internal Revenue Service (IRS) regulations will enhance the scrutiny of foreign mergers.

Section 7874 of the IRC, 26 U.S.C. § 7874, seeks to regulate corporate inversions. It applies to any U.S. corporation that transfers its headquarters and other assets overseas through a merger with a foreign corporation after March 4, 2003. The merged foreign corporation is subject to the same tax treatment as a domestic corporation if 80 percent of its stock is held by the U.S. company’s former shareholders, and it does not have “substantial business activities” in its home country. Id. at §§ 7874(a)(2), (b). If the merged foreign corporation has 60 percent of its shareholders in common with its domestic predecessor, the IRS designates it as a “surrogate foreign corporation” and applies U.S. tax rates to the amount of its inversion gain. Id. at §§ 7874(a)(1)-(2).

Several U.S. corporations have announced inversion plans in 2014. While some of them decided not to follow through after public opinion turned against them, other deals are still in the works. The U.S. pharmaceutical company Pfizer abandoned a bid to acquire the British company AstraZeneca, and the pharmacy chain Walgreens decided not to reorganize in Switzerland after merging with that country’s Alliance Boots. The fast-food chain Burger King, however, is reportedly still in the process of acquiring Tim Hortons and reorganizing in Canada.
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US_Corporateation_Income_Tax_Return_2011_form_1120.jpgThe minority shareholder of an S corporation appealed a ruling of the Internal Revenue Service (IRS), which held him liable for tax on his pro rata share of the corporation’s income, to the U.S. Tax Court. He argued that he was not the “beneficial owner” of the shares and therefore should not be liable for the tax because he had been shut out of management and received no distributions from the corporation. Kumar v. Commissioner of Internal Revenue, T.C. Memo 2013-184 (2013). The Tax Court rejected his argument, finding that the liability of an S corporation shareholder for federal income tax on the corporation’s earnings is not dependent on factors like management authority or actual receipt of distributions or other income. This should serve as a reminder for all S corporations to maintain shareholder agreements that provide for distribution of income in minimum amounts sufficient to cover taxes.

A subchapter S corporation avoids the “double taxation” found in corporations covered by subchapter C of the Internal Revenue Code, in which the corporation first pays tax on its income, and the shareholders then pay tax on dividends they receive. S corporations do not pay federal income tax. 26 U.S.C. § 1363(a). Instead, income and losses “pass through” directly to the shareholders, who pay taxes on income and deduct losses in proportion to their number of shares on their personal tax returns.

The petitioner in Kumar owned 40 percent of Port St. Lucie Ventures, Inc. (PSLV), a Florida medical practice organized as an S corporation. A dispute arose between him and his business partners in 2004. Around the same time, the majority shareholder of PSLV allegedly shut the petitioner out of the management of the company. The petitioner did not receive any wages or distributions from PSLV for 2005 or any subsequent year. He did, however, receive a Schedule K-1 from the corporation for the 2005 tax year, which reported his share of the corporation’s taxable income as $215,920 and his share of interest income as $2,344.
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1QPS.pngLawmakers often use state and federal tax laws to encourage certain types of business activity, or to discourage activities in lieu of banning them. Tax breaks often serve as incentives to investors and entrepreneurs to focus on a particular industry or market. Bills pending in the U.S. Congress and the New Jersey Legislature propose various tax incentives for businesses, including technology investments, infrastructure development, and hurricane relief. Supporters of these bills hope to promote job creation by spurring business activity. Critics contend, however, that similar New Jersey incentives have not had the desired impact on job creation in the past. New Jersey and New York businesses should be aware of pending legislation in order to take advantage of any tax breaks or tax incentives that might benefit them.

On April 9, 2013, a Democratic lawmaker from Maryland introduced H.R. 1415, the Innovative Technologies Investment Incentive Act of 2013 (ITIIA), in the U.S. House of Representatives. The bill would allow a tax credit for qualified investments in “high technology and biotechnology business concerns,” H.R. 1415 § 2 (113th Cong.), equal to twenty-five percent of the investment amount. This would be a direct credit against the amount of tax owed by the investor, as opposed to a deduction from the investor’s total taxable income. The total amount of the credit would be subject to a nationwide limit of $500 million per year, and the Small Business Administration (SBA) would be responsible for allocating credits among qualified investors. To qualify for the credit, the investment must be a stock purchase or other capital investment in a high-tech or biotechnology business with less than five hundred employees. Investors must hold onto their investments for at least three years. The purpose of the bill is to encourage investment in technology and biotechnology companies, which in turn will hopefully promote innovation and job creation.
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file0001476330609.jpgJust as new businesses start every day, some businesses must cease activities, wind up their affairs, and dissolve. This can occur for any number of reasons, including bankruptcy or the decision of the owners to stop doing business. Any New Jersey business that must wind up and dissolve must follow procedures established by state law, which include notification of creditors, payment of debts, and disposition of other assets.

Reasons for Winding Up a New Jersey Business

Businesses may wind up voluntarily or involuntarily. An involuntary dissolution usually results from bankruptcy or a court order in some other legal matter. A court-appointed trustee may handle the dissolution of a business in a Chapter 7 or Chapter 11 bankruptcy case, but in other situations, the management of a business must handle the winding up process itself. Court-ordered dissolutions in non-bankruptcy cases are rare, but might occur in a dispute between partners in a joint venture or some other single- or limited-purpose business entity.

Shareholder or partnership agreements may include provisions for mandatory dissolution if certain events occur. Voluntary dissolution usually results from a decision by the business’ owners, made according to the procedures established in a shareholder agreement, partnership agreement, or other management agreement.
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800px-New_York_Harbor.jpgThe New Jersey Legislature passed sweeping reforms of the laws governing limited liability companies (LLC) in September 2012. The changes to the Limited Liability Company Act will take effect in March 2013, affecting newly-formed companies immediately. LLCs already in existence will continue to be governed by current LLC law until March 2014, when the new law becomes applicable to all LLCs in the state. The new law represents a major departure from current law, which is based on Delaware’s LLC laws. The Revised Uniform Limited Liability Company Act (RULLCA) forms the basis for the new law.

The new law began in the Assembly as AB 1542, where the RULLCA was introduced in January 2012. The Assembly passed it on May 24, 2012 by a vote of 77 to 1. The Senate passed a counterpart, SB 742, on June 21, 38 to 0. The Governor signed it into law as P.L. 2012 on September 19.

The RULLCA is the work of the National Conference of Commissioners on Uniform State Laws, commonly known as the Uniform Law Commission (ULC). The ULC prepares model statutes for a variety of purposes and proposes them to state legislatures in an effort to develop a standardized set of laws. It first developed the RULLCA in 1996, when LLCs were still a relatively new idea, and modified it in 2006. The New Jersey law is largely based on the 2006 version.
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1277560_99475835.jpgA New Jersey organization representing more than one thousand small business owners rallied outside the Statehouse in Trenton recently to advocate for a state health insurance exchange (HIX). The Legislature passed a bill that would have created a New Jersey HIX in early 2012. Governor Chris Christie vetoed the bill in May, citing the pending decision from the U.S. Supreme Court regarding the constitutionality of the Affordable Care Act (ACA), commonly known as “Obamacare.” Governor Christie stated that, until the Supreme Court ruled on the ACA, the New Jersey law’s constitutionality was similarly up in the air. Since the Supreme Court upheld most of the ACA in June, many small business leaders want him to approve a HIX for the state.

The ACA requires states to create HIXs in order to assist people in obtaining health insurance coverage for the themselves or their families. States have until November 16, 2012 to enact their own state-run HIXs. After that date, the federal government will operate the HIX for the state. So far, eleven state legislatures have created HIXs, and three governors have created them by executive order.

Consumers and small businesses can use HIXs to compare and contrast private health insurance plans, and to learn about tax credits and other benefits. The federal government has made grants available to the states to facilitate the establishment of HIXs. According to the U.S. Department of Health and Human Services (HHS), New Jersey has received two grants: a $1 million “State Planning Grant” in 2010 and a $7.6 million “Level One Grant” in 2011. State HIXs are expected to go online, sometimes literally, in 2014, when many of the provisions of the ACA take effect.
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