Category Archives: Income Tax/Other Tax Topics

A Case Study in Succession Planning: Should the Sons Start a New Business Entity?

Succession planning for a closely-held construction business has many potential pitfalls, including:

  • Reluctance of the founder to relinquish control
  • Absence of family members ready to run the business
  • Squabbles over control of the business
  • Concerns about how to value the business and equalize distributions of the founder’s estate.
  • Income and gift tax liability

Consider the following hypothetical case.

Background

succession-planning

Photo credit: Highways Agency

Dad, the family patriarch, has a wholly-owned corporation (“POP, Inc.”) that has operated a family business for 40 years.  Recently, however, regulatory authorities have been particularly critical of certain aspects of the “old school” way the business is being conducted, asserting regulatory infractions and threatening to close down the business.  Dad, weary of the regulatory hassles, is eager to retire and turn the business over to his sons, while it is still viable.

Dad’s sons, Able and Bright, have not previously worked at POP, but they get along well with one another, have a close relationship with Dad, and are entrepreneurs in their own right.  Able and Bright are ready and willing to take over the family business.

A Question of Goodwill

Under Dad’s direction and as a direct result of Dad’s contacts and developed business practices (an intangible asset sometimes referred to as “goodwill”), POP has been profitable. POP has assets consisting of cash, receivables, and some tangible equipment, but most of what has made POP successful is the foregoing goodwill.

Dad is concerned about the income and gift tax cost that might result from transferring control of POP to Able and Bright and is averse to any succession plan that might involve complex trust arrangements.

In order to avoid these tax complications, Able and Bright are advised to set up their own corporation, GTO, Inc., and begin to operate the same type of business as POP, implementing practices they have learned from Dad.

Regarding income and gift taxes, Able and Bright’s financial advisors note that:

If Dad had transferred POP’s stock to Able and Bright, there would have been gift tax considerations.

  • If POP had distributed appreciated business assets to Dad, which Dad then gave to GTO,

 o   POP would have had to recognize gain as if the property had been sold to Dad,

 o   Dad, upon transferring the assets to Able and Bright via GTO, would have encountered gift tax considerations.

 The End Result

Able and Bright begin to grow the business by nurturing Dad’s contacts and by developing their own contacts. Their business activities are similar to POP’s and they do business with many of POP’s prior customers.  GTO also undertakes other business activities initiated by the entrepreneurial Able and Bright. POP’s business activity decreases.

The question at hand is whether Dad managed to transfer the family business to Able and Bright in a simple manner, sidestepping income and gift taxes?

In a recent real-life case, the Tax Court said yes.

Opinion from the Tax Court

In Bross Trucking Inc. (TC Memo 214-107, 6/5/14), IRS asserted that a father had taken a taxable distribution of “goodwill” from his company, and had then gifted the goodwill to his sons via their new company.  IRS asserted income tax deficiencies against the father’s company and gift tax deficiencies against the father.

The Court clearly sets forth the reasons that the goodwill – including its ability to generate revenues, its customer base, and its developed business operations – had been created by the father and thus constituted his personal goodwill, not the company’s.

The Court noted that a business can only distribute corporate assets; it cannot distribute assets that it does not own.  Goodwill that is personal to the owner is not a corporate asset.  The personal relationships of a shareholder-employee do not comprise a corporate asset when the employee has no specific employment contract that (through the use of a covenant not to compete) in effect transfers the goodwill to the corporation. [Martin Ice Cream v. Commissioner (110 TC 189 (1998)].

The Court concluded that there was no taxable distribution by the father’s company of the father’s personal goodwill, and no taxable gift of the father’s personal goodwill from the father to his sons.

 

For further information about estate and succession planning for your construction company, please contact Richard Lee at 301.231.6268 or Michael Yuen at 301.222.8209.

IRS Releases Draft Forms for ACA Coverage Reporting Requirements

One of the fundamental goals of the Affordable Care Act “ACA” is health coverage for all. With that goal comes new reporting requirements for employers and insurance companies offering health coverage. The IRS recently released drafts of the forms that will be used to report 2015 coverage information in early 2016.

Construction companies with more than 50 full-time equivalent employees will be required to use Form 1095-C  to report whether or not they offered health coverage to their employees. The Form 1095-C that employees receive from their employer will include information on the months the employee was offered coverage and the employee’s share of the lowest cost monthly premium for self-only “minimum value” coverage. The employer will transmit the Form 1095-Cs, via Form 1094-C, to the IRS.

Regardless of their size, contractors that sponsor self-insured health plans and insurers are required to report on the individuals covered by their health plans. Form 1095-B will be provided to all primary insureds to show the months the primary insured and his or her family members had coverage under the plan. The plan sponsor/insurance company will transmit the forms to the IRS via Form 1094-B.

These reporting requirements are designed so that the IRS can monitor several key features of the ACA: compliance with the individual and employer mandates as well as eligibility for the premium tax credits associated with purchasing coverage through an exchange.

While these new requirements are not effective until the end of 2015, employers should begin to make sure systems and procedures will be modified in time to ensure compliance.

Please contact Mark Flanagan of Aronson’s compensation and benefits practice at 301.231.6257 to further discuss the impact of this requirement on your construction business.

 

Navigating Sales Tax Complexities for Construction Companies: An Aronson Q&A

questionQ. How do you file for a refund in Maryland for sales tax paid on purchases for exempt jobs in the District of Columbia?

A. Maryland requires contractors to pay sales tax on all purchases of materials that will be incorporated into real property as part of a construction contract. However, Maryland allows contractors to apply for a refund if the materials will be used for a contract in another jurisdiction where the same purchase would not have been subject to tax (e.g., a contract with a government agency in the District of Columbia). Virginia has a similar rule; however, the contractor can prequalify for an exemption from tax, rather than having to pay the tax upfront and apply for a refund after the fact.

Maryland has a standard refund application that is required when claiming a refund of sales and/or use tax; claimants are required to describe the reason for the claimed refund, including exemptions. Claimants must provide substantiation for the requested refund by attaching the receipts/invoices reflecting the tax paid, the contract to perform the work in the exempt area, and support for the exemption (e.g., sales tax exemption certificate of the customer).

Q. Where can I download the Maryland application for refund?

A. Maryland’s sales and use tax refund application (Form ST205) can be found on the Comptroller’s website.

Q. What are the time limitations on claiming a refund?

A. Every state has rules that limit the time for the filing of a refund claim. Typically, states allow refund claims to be filed for taxes paid within a three to four year period, depending on the state. Maryland, Virginia, and the District of Columbia all have three year limitation periods for the filing of a claim for refund. It’s important to keep in mind that if you have not paid use tax in a state and have never filed a use tax return that it is likely that there will be limitations on the years for which they can issue an assessment. The period of limitation for assessment purposes is only triggered once a return is filed.

Q. Does sales tax apply to repair services in Virginia and Maryland?

A. Most states only impose sales tax on services that are specifically listed as a service subject to tax. Neither Virginia nor Maryland imposes sales tax on repair services performed on real property. For repairs to tangible personal property, Maryland does not impose a tax on the labor. However, if separate charges are made for the materials incorporated in the property being repaired, Maryland requires that sales tax be collected on the charges for the materials. Under these circumstances, purchases of materials transferred to customers in connection with the repair work can be purchased tax-free by presenting the supplier a resale certificate.

Similarly, Virginia does not tax repair services. However, sales tax must be collected for materials and parts used to perform the repair. In order for the labor charges to remain exempt from tax, the contractor needs to separately itemize such charges on the customer’s invoice. If the contractor does not separately state the labor, then Virginia requires sales tax to be collected on the entire charge.

Q. Does sales tax apply to freight/shipping charges?

A. The taxability of freight varies from state to state. A number of states base the taxability of an item on the tax rules of its final destination. In these states, the shipping charge is considered part of the price of the taxable item. Further, many states do not tax shipping charges when the service is provided by a third party (i.e., not the seller of the items being shipping). Contractors are typically considered the consumer of goods purchased for incorporation in their construction projects.

Aronson recently held a webinar on sales and use tax for construction companies, highlighting the above topics and more. To view a recording of the webinar and ask more questions, please click here and fill out the brief registration form for instant access. For a review and analysis of your specific situation, contact your Aronson tax advisor or Michael L. Colavito, Jr. at 301.231.6200 or mcolavito@aronsonllc.com.

One Contractor, Two Bids, Three Different Sets of Sales Tax Rules

spreadsheetState sales tax rules vary significantly for construction contractors doing business in the DC region, and can substantially affect the final cost on a contract. For instance, a Virginia-based contractor bids on two separate construction contracts for a federal government agency. Both of the contracts are for the construction of a building, one contract will be performed in the District of Columbia and the other in Maryland. If all necessary materials and supplies for each contract are purchased in Virginia and subsequently transferred to the job site, a number of potential sales and use tax implications may arise.

First, the contractor should recognize that it may be eligible for exemptions because the customers are both government entities, which are relieved from state sales tax. However, just because a contractor’s customer can make tax-free purchases does not necessarily mean that the contractor can do the same when incorporating the materials into that customer’s real property. The sales tax rules in this area vary significantly from state-to-state.

The potential sales tax exemption for government construction contracts create an exception to the general rule followed in most states (including DC, MD, and VA), which is that a construction contractor is considered the consumer of materials that will be incorporated into real property. Thus, a contractor generally pays sales tax when purchasing those materials.

In our example, the Virginia contractor will temporarily store the materials at its Virginia location but use them at job sites in the District and Maryland. Our fictitious contractor should be aware that Virginia’s regulations allows the purchase of materials tax-free from Virginia if those materials are stored temporarily to be used in an exempt construction project in another state. Thus, the contractor will need to refer to the sales tax rules in DC and Maryland when determining if it can purchase the materials free from Virginia sales tax.

The District allows a contractor to make tax-free purchases of materials that will be incorporated in and become part of the real property of the United States or DC government. Therefore, the contractor can claim the Virginia exemption for the materials temporarily stored in Virginia that will be used in the contract in the District. However, in order to do so, it must make a written request to the Department of Taxation for a certificate of exemption.

Maryland also has an exemption for construction materials purchased for contracts performed for certain tax exempt entities, but the exemption is limited to private charitable, educational, and religious nonprofit organizations. The exemption does not apply to materials purchased for a government construction contract. Therefore, our contractor should factor in Virginia sales tax when bidding on the Maryland contract.

Further, the contractor has a potential use tax liability on the materials that will be used in Maryland. Maryland will not require use tax to be paid if the contractor paid at least a 6% sales tax in the state where the materials were purchased. Differing sales tax rates throughout Virginia locales adds another dimension to this complex issue, so contractors should pay special attention to these details when making its bid.

Contractors face myriad issues when dealing with sales tax. In addition to the example above other challenges may include bonding requirements, rules regarding fabricated materials, and varying treatment of time and materials contracts.

To learn more about the intricacies of sales and use tax laws, please join us on Thursday, July 24th for a complimentary webinar that addresses these important issues in greater detail. To register, click here.

For a review and analysis of your specific situation, contact your Aronson tax advisor or Michael L. Colavito, Jr. at 301.231.6200.

 

Recent Tax Developments that May Impact Construction Contractors

gavel5Staying abreast of tax changes for your construction business can seem like a moving target, but continuous planning can help you minimize liability. In the second quarter of 2014, we saw a number of important tax developments that should be considered when managing your construction business.

No bankruptcy exemption for inherited IRAs.A unanimous Supreme Court held that inherited IRAs do not qualify for a bankruptcy exemption (i.e., they are not protected from creditors in bankruptcy). Under the Bankruptcy Code, a debtor may exempt amounts that are both (1) retirement funds, and (2) exempt from income tax under one of several Internal Revenue Code provisions, including one that provides a tax exemption for IRAs. The Supreme Court held that this exemption does not extend to inherited IRAs because funds held in them are not retirement funds. For this purpose, the term “inherited IRA” doesn’t include amounts inherited by the spouse of the decedent. This decision should be taken into account when selecting IRA beneficiaries. If a potential beneficiary is under financial distress, the IRA owner should consider naming a trust as beneficiary instead. The individual could be named as beneficiary of the trust without jeopardizing the full IRA funds in the event of a personal bankruptcy.

Purchase of underlying property didn’t prevent deduction for lease termination payment. The Court of Appeals for the Sixth Circuit has allowed a party that exercised an option to buy property that it was leasing to deduct a portion of the amount tendered in the transaction as a lease termination payment. In so doing, it rejected the IRS’s argument that the full amount tendered had to be capitalized as part of the purchase price. The dispute centered on an obscure tax law, which states that, where property is acquired subject to a lease, no basis is allocated to the leasehold interest. The IRS said that this provision precluded a deduction, but the Sixth Circuit disagreed. Because the lease terminated when the taxpayer acquired the property, the property was not acquired subject to a lease and the law at issue did not apply to bar the deduction. Years earlier, the Tax Court reached the opposite result in a case with similar facts.

Employer health insurance tactic may backfire. The IRS has warned of costly consequences to an employer that doesn’t establish a health insurance plan for its employees, but reimburses them for premiums they pay for health insurance (either through a qualified health plan in the Marketplace or outside the Marketplace). According to the IRS, these arrangements, called employer payment plans, are considered to be group health plans subject to the market reforms of the Affordable Care Act. These reforms include the prohibition on annual limits for essential health benefits and the requirement to provide certain preventive care without cost sharing. Such arrangements cannot be integrated with individual policies to satisfy the market reforms. Consequently, such an arrangement fails to satisfy the market reforms and may be subject to a $100/day excise tax per applicable employee.

More enforcement of responsible person penalty likely.If an employer fails to properly pay over its payroll taxes, the IRS can seek to collect a trust fund recovery penalty equal to 100% of the unpaid taxes from a person who is responsible for collecting and paying over payroll taxes and who willfully fails to do so. A recent report issued by the Treasury Inspector General for Tax Administration has found the IRS has often not taken adequate and timely action in assessing and collecting the responsible person penalty. The report also makes recommendations for improvements, which the IRS has agreed to implement, making enforcement more likely.

Taxpayer Bill of Rights. In an effort to help taxpayers better understand their rights, the IRS has adopted a “Taxpayer Bill of Rights,” which dictates that previously disparate clauses are now prominently displayed in one place on the IRS’s website, falling into these 10 broad categories:

    • The right to be informed
    • The right to quality service
    • The right to pay no more than the correct amount of tax
    • The right to challenge the IRS’s position and be heard
    • The right to appeal an IRS decision in an independent forum
    • The right to finality
    • The right to privacy
    • The right to confidentiality
    • The right to retain representation
    • The right to a fair and just tax system.

Next year’s inflation adjustments for health savings accounts.The IRS has provided the annual inflation-adjusted contribution, deductible, and out-of-pocket expense limits for 2015 for health savings accounts (HSAs). Eligible individuals may, subject to statutory limits, make deductible contributions to an HSA. Employers as well as other persons (e.g., family members) also may contribute on behalf of an eligible individual. Employer contributions are generally treated as employer-provided coverage for medical expenses under an accident or health plan and are excludable from income. Typically, a person is an “eligible individual” if he is covered under a high deductible health plan (HDHP) and is not covered under any other health plan that is not a high deductible plan, unless the other coverage is permitted insurance (e.g., for worker’s compensation, a specified disease or illness, or providing a fixed payment for hospitalization).

For calendar year 2015, the limitation on deductions is $3,350 (up from $3,300 for 2014) for an individual with self-only coverage. It’s $6,650 (up from $6,550 for 2014) for an individual with family coverage under a HDHP. Each of these amounts is increased by $1,000 if the eligible individual is age 55 or older. For calendar year 2015, a “high deductible health plan” is a health plan with an annual deductible that is not less than $1,300 (up from $1,250 for 2014) for self-only coverage or $2,600 (up from $2,500 for 2014) for family coverage, and with respect to which the annual out-of-pocket expenses (deductibles, co-payments, and other amounts, but not premiums) do not exceed $6,450 (up from $6,350 for 2014) for self-only coverage or $12,900 for family coverage (up from $12,700 for 2014).

For more information about these changes or other tax issues, please contact an Aronson tax advisor at 301.231.6200 or contact us online.

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