One of the most frequently asked questions tax professionals receive is “Are injury settlement payments are taxable?” According to Code Sec. 104(a)(2), payments received as compensation for a personal physical injury or physical sickness are not taxable. The key term here is physical. Payments for emotional distress or other reasons that do not stem from a physical injury are taxable income. Likewise, a portion of punitive damages awarded are taxable income even if they are related to the physical injury. This is ultimately because the purpose of a punitive damage award is to punish the defendant rather than to compensate from the physical injury. A recent tax memo, TC Memo 2017-129, highlighted this code when the court ruled against the taxpayer. In this particular case, the Tax Court concluded that the payments the taxpayer received during a discrimination claim settlement were taxable.
The taxpayer suffered a physical injury not related to his employment. He was unable to fully return to his job because of his disability, and asked his employer for reasonable accommodation. However, the employer refused and terminated the taxpayer. The taxpayer brought a discrimination lawsuit alleging that the employer failed to make a reasonable accommodation to allow the taxpayer to work a different, more sedentary position. Eventually, the taxpayer and employer reached a settlement and the settlement payment was included in the taxpayer’s W-2.
After receiving his settlement, the taxpayer argued with the IRS that the settlement payment should be excluded from his income because of his physical injury. The Court noted that the settlement award was not a result of the taxpayer’s physical injury, but his alleged discrimination. As with any agreement, properly wording the settlement award description is critical to help ensure the desired tax outcome. Your tax advisor should review aspects of the agreement that determine the tax treatment of the settlement, prior to the agreement being signed.
If you have questions on this matter or would like to discuss your particular tax situation, please contact Aronson’s Tax Controversy Practice Partner, Larry Rubin, at 301.222.8212 or email@example.com.
Establishing an individual retirement account (IRA) is a great way to prepare for the future. Although divorces are rarely foreseeable, separating couples should be aware that dividing an IRA may result in it being subject to income taxes, penalties, or both, if not structured properly. Evidenced in TC Memo 2017-125, the Tax Court has concluded that an IRA split between a divorcing husband and wife is subject to an early distribution penalty.
In this particular case, the couple worked out their own divorce terms without an attorney. Prior to obtaining a court order showing how the martial property will be divided, the husband withdrew his IRA and gave half of it to his wife as part of their settlement. During the transaction, the husband deposited all of the IRA proceeds into their joint bank account and gave the wife her share. Subsequently, the settlement agreement was filed with the court without mention of their self-prepared agreement because the IRA had already been divided.
Unless the withdrawal meets one of a few exemptions, all IRA funds withdrawn before the age of 59½ are taxable and subject to a 10% early distribution penalty. One of these exemptions is a distribution incident to divorce, if structured properly.
IRC 72(t)(2)(C) states that this penalty does not apply to an IRA distribution that is made to an alternate payee pursuant to a qualified domestic relations order. For this code section, the order is defined as a court order to, among other elements, divide marital property rights paid in accordance with the state’s domestic relations law. An alternate payee includes a spouse or former spouse who has the right under an aforementioned order to receive the property.
In this particular instance, the IRA distribution was not made to the spouse and was not made pursuant to a court order. Because of the form of the transaction, the Tax Court determined that this distribution was subject to the 10% penalty.
Tax law is unforgiving and fraught with complexity. These surprises could have easily been avoided if the taxpayers sought out qualified advisors to assist them. If you have questions on this matter or would like to discuss your particular tax situation, please contact Aronson’s Tax Controversy Practice Partner, Larry Rubin, at 301.222.8212 or firstname.lastname@example.org.
Despite being at odds with the “physical presence” test established by the U.S. Supreme Court in Quill Corporation v. North Dakota, states are continuing to enact legislation requiring certain “remote sellers” to collect sales tax on in-state sales. The newest states to join the “kill Quill” movement are Maine and Ohio, who both enacted legislation in June. This type of legislation is being used as a push for the U.S. Supreme Court to reconsider the physical presence rule, which has been in effect since 1992.
Similar to rules adopted in other states over the past two years, the new legislation in Maine and Ohio requires out-of-state sellers who meet a certain sales threshold to register with the state and begin collecting sales tax, despite the sellers having no in-state presence. Ohio’s law H.B. 49 was signed by the governor on June 30, 2017 and sets the annual sales threshold at $500,000. The law will officially go into effect on January 1, 2018. Maine’s new law requires sellers with more than $100,000 of prior year in-state sales to register for sales tax collection beginning on October 1, 2017. Regardless of the value of in-state sales, Maine’s law will also require remote sellers to collect the state’s sales tax if they had at least 200 separate taxable sales delivered to Maine in the prior year.
Maine’s law, similar to legislation enacted in South Dakota last year, provides for a fast-track judicial review. This means that the state can bring a declaratory judgement action against a taxpayer prior to the issuance of an assessment or audit. All appeals will go straight to the state supreme court. In South Dakota, a trial court ruled in favor of the remote sellers during a fast-track judicial review because they lacked physical presence in the state, a requirement established under Quill. In March, the state filed an appeal of the trial court’s decision with the state supreme court.
In addition to Maine, Ohio, and South Dakota, similar “remote seller” sales tax collection rules have already been established in Alabama, Massachusetts, Tennessee, Vermont, and Wyoming. Massachusetts recently revoked their administrative directive in favor of more formally adopted regulations. With a growing number of states implementing remote seller provisions, and South Dakota already set to address the constitutionality issue in its highest court, it seems prudent for the U.S. Supreme Court to step in and end what is an uncertain environment for retailer’s torn between complying with these rules or hanging their hat on Quill. With Justice Kennedy already stating in his concurring opinion in Direct Marketing Association v. Brohl that “the legal system should find an appropriate case for th[e] Court to reexamine Quill,” it seems like only a matter of time before the “kill Quill” movement achieves its goal of having the physical presence test reevaluated.
If you have any questions regarding your sales tax collection obligations, please contact your Aronson tax advisor or Michael L. Colavito, Jr. at 301.231.6200.
In the context of an S Corporation selling target, one of the most effective and popular tax planning techniques currently available to a buyer party seeking asset sale tax treatment optimization involves the combination of a pre-sale of F reorganization in conjunction with application of the one-day note concept into the final deal arrangement. To achieve the optimum tax results, the tax planning technique calls for the implementation of the following sequence of steps:
Step 1: Adopt a plan of reorganization and conduct a pre-sale F reorganization. This will change the current tax structuring of the S Corporation selling target to a disregarded entity status. The former S corporation selling target will now be wholly owned by the newly created S Corporation Holding Company. For more information on the benefits of consummating an F reorganization, please read the blogs, “Handling Deferred Revenue When Selling Your Business,” “M&A Tax Shop Talk – F reorganization,” and “Accrual Basis Is King When Selling Your Business.“
Step 2: Before entering the asset sales transaction, execute a plan of liquidation to be consummated by the selling shareholders within 12 months after closing. The distribution of the one-day note obligation, discussed in step 3, and the earn-out and escrow hold back components, if applicable, will not be taxable to the beneficial selling shareholders until the underlying funds are constructively received post-closing. Hence, the selling shareholders under the installment sale provision rules will step into the shoes of the liquidating S Corporation Holding Company.
Step 3: Negotiate and incorporate the one day note application concept into the final transaction arrangement. For more information of the benefits of using the one-day note application concept, please read “M&A Shop Talk: Tax Planning Using One-Day Note Concept Application.”
It is important to keep in mind that, for income tax reporting purposes, the selling shareholders do not physically need to dissolve the newly created S Corporation Holding Company, created in step 2, in order to achieve liquidation status. Additionally, the one-day note application use will never prevent the immediate taxability at closing of any built-in gains attributable to hot asset items. This includes all unrecognized cash basis deferral items, all pre-sale instalment sale deferred net profit, all advance payment received and deferred under the accrual, deferral method, and all unrecognized net profit from long-term contracts being deferred under the completed contract method.
If you are interested in scheduling an initial consultation on how to effectively structure the sale of your business, please contact Jorge Rodriguez, Aronson’s Tax Partner specializing in M&A specialized services for middle market businesses, at 301.222.8220 or email him at email@example.com.
In June, Michael L. Colavito, Jr. and Grant Patterson hosted an informative webinar, “Virginia Businesses: STOP Overpaying Local BPOL Tax,” where they guided taxpayers in determining if they are paying too much in Virginia local business license tax, also known as BPOL tax. As a follow up to this webinar, Michael and Grant have prepared answers to the questions asked by the webinar attendees. To watch the complete webinar, please visit Aronson’s website.
Would government contractors who provide engineering services, logistics, or training be taxed under the contractor or retailer BPOL classification?
A government contractor that provides engineering, logistics, and training services would not be classified as a contractor for BOPL purposes. It is also unlikely that the taxpayer would be taxed as a retailer.
“Contractors” are defined for BPOL purposes under state law Va. Code Ann. § 58.1-3714(D) and are limited to construction contractors. “Retailers” or “retail” sales are not specifically defined under state law for BPOL purposes. Typically, local ordinances have their own definition. For example, Fairfax County defines a “retail merchant” as a person who sells goods, wares, or merchandise at retail only and not for resale. A business primarily providing services would not be classified as a retailer.
Most government contractors are likely to be classified as providing a “business service” or “specialized occupation.” Keep in mind that the correct classification will vary by locality. When separate service types are provided with respect to a taxpayers contracts rise to the level of being separate business activities, then separate licenses may be required for each business. For example, a service provider may have a substantial number of contracts related to procurement services and a number of contracts providing engineering services. In this case, the taxpayer may have to obtain a license under the “professional services” classification for the engineering services, and another license under the “business services” classification for the procurement services.
Are virtual manufacturing businesses exempt from BPOL?
Virginia does not define the term “manufacturer” for purposes of the BPOL exemption. The Supreme Court of Virginia has developed a test involving three essential elements in determining whether a manufacturing activity is being undertaken. These elements are:
In Virginia Public Document Ruling No. 99-239, 08/23/1999, the Department of Taxation states that “for BPOL purposes, a manufacturer is one engaged in a processing activity whereby the original materials are transformed into a product that is substantially different in character from the original materials. These three elements are all equally important; if any one of these elements is missing, a business cannot fairly be said to be engaged in manufacturing.”
If a business is designing a product, subcontracting out the building and processing activities, but is still the seller of the product being produced, the manufacturing exemption may still apply. The BPOL guidelines issued by the Department of Taxation, that addresses the scope of the manufacturing exemption, concluded that the “manufacturing process consists of work subcontracted out but under the taxpayer’s control at all times, work in the taxpayer’s shop, and work by the taxpayer’s employees at the customer’s location.”
Still, additional facts regarding the activity would be needed to reach a more definite conclusion.
Are rental receipts and other revenue, not normally business income sources, subject to the BPOL tax?
Per Virginia § 58.1-3703(C)(19), gross receipts from the sale and rental of real estate and buildings are taxable by the locality in which they are located, provided the locality is authorized to tax such businesses. Gross receipts from the rental of real estate are generally exempt from tax, unless the localities tax on the activity is “grandfathered” in because they imposed such a tax on January 1, 1974.
Ultimately, this activity would likely be considered a separate business activity for which an additional license would be needed.
Is revenue from employees who work onsite at government facilities located in DC and MD subject to the BPOL tax? What if the employees report to managers in the Virginia locality?
Government contractors that derive revenue from employees working at government facilities in other jurisdictions, such as DC and MD, should not report their revenue to the VA locality even if the activity is managed from there. These receipts would not be reported to the VA locality based on one of two filing positions.
First, the receipts derived from the employees’ activities in MD and DC would be sitused to those locations because it is considered a “definite place of business” outside of the VA locality. If the employees are working at the facility for at least 30 consecutive days, it would then be correct to situs those receipts. All services performed at the DC and MD locations would only be sitused to the VA locality if the locations where the services are performed are not “definite places of business.”
Second, even if the services are not performed from definite places of business in DC and MD, the out-of-state deduction would still apply. It is assumed that the government contractor is filing income and franchise tax returns in DC and MD. Although the receipts would initially sitused to VA, where the services are being managed and controlled from, the out-of-state deduction can be utilized to reduce these “otherwise” taxable receipts.
Does the deduction for the resale of hardware and software to the government apply if the resale is not performed in the Virginia locality?
This particular deduction is from “otherwise taxable receipts.” If the applicable receipts are sitused to the VA locality under the applied situsing rules, then the deduction would be available. However, depending on the facts, these receipts may not be sitused to the applicable locality to begin with. Review a recording of the webinar for a complete understanding on the process that is generally applicable to most taxpayers.
In this particular case, no deduction would be needed. For businesses that are reselling hardware and software to the government, it’s possible that the deduction can be performed first and the remaining receipts are sitused accordingly.
My company has no office, but we rent a building in Fairfax County with servers and other hardware to do cloud hosting, software development, and consulting services provided by remote employees. What is best way to situs receipts?
Typically, service revenue derived from remote employees should be sitused to the location from where they are managed and controlled. Their residence would only be considered a “definite place of business,” and the receipts can be sitused if the business has absolutely no other office location. This typically occurs only with sole proprietors. Services performed by remote employees should not be sitused to the building being rented in the County because the employee services are not managed and controlled there.
In terms of renting a building to maintain servers and other hardware, it would be difficult to argue that the building is not a “definite place of business,” for BPOL purposes. It is extremely likely that no services are being performed from that location. Therefore, no receipts would be sitused to the location for BPOL.
If you have any additional question about Virginia BPOL, please contact your Aronson tax advisor or Michael L. Colavito, Jr. at 301-231-6200 or firstname.lastname@example.org.