by Mat Sorensen | Feb 4, 2013 | Uncategorized
The JOBS Act of 2012 amended the rules for private placement offerings (aka “PPMs”) to allow people to advertise and solicit their offerings to prospective investors. Under prior law, a PPM could not be marketed or solicited to people whom the offeror did not have an existing relationship with. Hence, the use of the word “private” offering in the current labeling of these types of investments.
This new type of offering that will allow advertising and general solicitation will be known as a Rule 506 (c) Offering. Under this new law, the person raising money could create a website soliciting the funds, or they could hold seminars or meetings with potential investors and could solicit the investment of funds from those in attendance. This is a significant change to the current rules that clearly prohibit such activities.
Under the new Rule 506 (c) Offering there is one hitch: the person raising funds may only accept funds from accredited investors. An accredited investor is someone who has $200K in annual income ($300K if married) or $1M in net worth (excluding equity in home). The accredited investor status must be documented by the investor or certified by a third party such as an accountant or financial planner. This verification rule is a new requirement for Rule 506 (c) Offerings.
The SEC has proposed regulations on the new rule and it should be implemented in the next month or two. A new Rule 506 (c) Offering requires the same documents and SEC filings as the current PPMs. These documents include a Regulation D filing to the SEC, an offering memorandum, accredited investor questionnaires, and numerous other company documents.
All other prior offering rules are still available under law including those rules that allow an issuer to raise money from up to 35 unaccredited investors per offering but that offering must remain private and the new advertising rules would not apply. So, moving forward, those seeking to raise large amounts of money under Regulation D approved offerings have two options. First, raise money under the current rule and you can accept up to 35 unaccredited investors but are restricted from advertising. Or, second, only accept money from accredited investors but be allowed to advertise the offering. You don’t get both options in one (advertising and unaccredited investors) but at least you now have another option in being allowed to advertise and solicit under the new rules.
by Mat Sorensen | Dec 18, 2012 | Uncategorized
One of the most common tax minimization strategies used by operational small business owners is known as the salary/dividend or salary/net income split. This strategy can only be properly executed in an s-corporation where a business owner can pay themselves a portion of income in salary and a portion of income in dividend or net profit. The ultimate goal is to pay as little salary as possible (and therefore as much net income as possible) so as to minimize the amount of self employment taxes that are due.
This strategy cannot be utilized in a c-corporation nor can it be utilized in an LLC or sole proprietorship. It is only possible in an s-corporation as similar income running through a sole proprietorship or an LLC is entirely subject to self employment tax as income cannot be split between salary and net income in an LLC or sole proprietorship. Also, keep in mind that such a strategy is not utilized in passive business structures such as real estate businesses as rental income, interest income, and other passive income is exempt from self employment tax and therefore it is not necessary to implement the income splitting technique of the s-corporation.
In short, the strategy is implemented by “splitting” the income that is payable to the s-corporation owner into two categories: salary and net income (aka dividend). The reason this splitting of income is advantageous is that net income received by the s-corporation owner is not subject to the 15.3% self employment tax that is otherwise due and payable on salary. For every $10,000 of income an s-corporation owner can classify as net income as opposed to salary the business owner will save $1,530. Keep in mind that after about $100,000 of salary the savings of pushing additional income to net income is reduced as the self employment tax rate drops to 2.9%. It is still certainly worth implementing at higher income but the savings are then made at the 2.9% rate.
Watson v. Commissioner
When this strategy was first utilized many years ago, some taxpayers decided to just pay all of their income out as net income and elected to take no salary or wages and therefore pay no self employment tax. This was quickly challenged by the IRS and Revenue Ruling 59-221 was issued which stated that a business owner who renders services to their business must take “reasonable compensation” for the services rendered. Over the years, the Courts have ruled on many cases of what is reasonable compensation but in 2012 the Courts made a significant ruling where they adjusted a business owners allocation between salary and net income in a case known as Watson v. Commissioner, 668 F.3d 1008 (8th Cir, 2012).
In Watson, the owner/employee Watson was a CPA and took $24,000 of salary a year and about $190,000 of annual net income. The IRS challenged the allocation of $24,000 of salary as being unreasonably too low. Watson lost in the District Court and appealed to the 8th Circuit Court of Appeals who re-characterized Watson’s income to $93,000 of salary and about $120,000 of net income. The case is an important one for properly understanding the factors that should be considered in all businesses when determining how much income a business owner can claim as net income instead of salary. Here are some of those factors.
Factors Determining Net Income
- Professional services businesses should take a larger portion of salary to net income than those in non-professional services: If the business is a professional services business (e.g. physician, dentist, lawyer, consultant, real estate broker, contractor, etc.) the IRS will more carefully scrutinize the services provided by business owners because the business provides a personal service.
- Full-time working business owners should take a larger portion of salary to net income than part-time working business owners: If the business owner is involved full time in the business, more salary will be required. If the business owner’s involvement is part time or if they are involved in other businesses, a much lower salary can be justified.
- Don’t take a salary that is below the salary paid to lower level employees in the business: In the Watson case the Court determined that a salary for Watson of $24,000 was not reasonable as new accountants salaries at his office were more than this.
- Take a salary that is around the industry average for a person of similar experience in your industry: In the Watson case the Court scrutinized the experience and training of Watson and determined that a salary of $24,000 was not reasonable as accountants with similar experience and training in the industry were paid at least $70,000.
In summary, the salary/net income split is a legitimate tax planning technique for business owners but it is not one in which a business owner making over $200,000 a year can justify taking about 10% of income as salary (as was the case in Watson). The Court disallowed the 10% salary level but did allow him to take about 43% of his income as salary (and almost 60% as net income). This still resulted in some excellent tax savings.
As a general rule, we recommend that business owners take at least 1/3 of their income as salary and pay self employment tax on those amounts. Many other factors should be considered, such as those outlined above, and every business has a unique situation. The good news is that taking a large portion of income from a business as net income as opposed to salary is alive and valid and there are plenty of taxes to be saved each year by using this strategy. A business owner just can’t get too aggressive and take salary levels that are grossly below what people with similar experience in the industry are paid.
by Mat Sorensen | Nov 20, 2012 | Uncategorized
By: Mathew Sorensen, Partner KKOS Lawyers
The 2012 estate and gift tax exemption is $5,120,000. This means that the first $5,120,000 of an individual’s estate may be inherited (at death) or gifted (during life) in 2012 before any estate or gift tax is due. This exemption amount will be reduced to $1,000,000 in 2013 unless the Congress and President act on a compromise plan to fix the current reduction in the exemption. As a result of the significant reduction in the exemption, many individuals are contemplating a transfer of assets by gifts to their children/heirs now as a way to reduce their estate and to utilize the large exemption amounts while they can.
If you are an individual with a large estate (over $2M) you should consider whether to gift certain assets to family members while the exemption remains high. There are certain items to consider when analyzing your estate and determining whether to make a gift now as a result of estate and gift tax laws.
GIFT PROPERTY WITH HIGH TAX BASIS
First, when you gift during your lifetime the tax basis in the asset transfers to the person who receives the gift. In other words, if you have a property you bought for $100,000 that is now worth $300,000, the person receiving the gift would receive your $100,000 tax basis such that when they sell the property they pay capital gains taxes on anything above $100,000. When someone inherits property upon death, however, they receive tax basis in the property at the fair market value of the property at the date of death. So, if the basis to the owner was $100,000 but the fair market value was $300,000 at their death the heir would get the property at a $300,000 tax basis and when they sell the property they would only pay taxes on any gain above $300,000 (as opposed to $100,000 with a gift during the lifetime of the donor). As a result of the tax basis rule difference between receiving property at death or by gift during life, we recommend clients retain highly appreciated assets that may be subject to capital gains and instead pass those on following their death. Contrastingly, assets with high tax basis where there would be no large capital gains are excellent assets to gift since there is no tax benefit to retain until death.
UTILIZE THE EXEMPTION OF ONLY ONE SPOUSE
A second planning item to consider for married couples is using the gift tax exemption of only one spouse when gifting. Under current tax law, each spouse has their own separate exemption and you can utilize one spouse’s gift tax exemption (or a portion) now during their lifetime while leaving the other spouse’s exemption totally un-used and available to the other spouse. Special planning and tax reporting needs to be taken into account in this situation but the benefit of having one spouse use up a large part of their exemption and to take advantage of a very large gift tax exemption – while we know one is there – is a significant benefit and we leave the other spouses exemption totally un-used and available for future years (whatever those limits may be).
ASSETS THAT ARE GOOD CANDIDATES TO TRANSFER BY GIFT & FLLCs/FLPs
The last item to consider is what types of assets may be transferred by gift now. There are a few assets that are very good assets to transfer by gift now. First, if there are any large loans to family members that may be forgiven as part of your estate you may want to consider forgiving those loans now as a way to lock in the large gift tax exemption.
High basis stocks or investment properties are also excellent assets to consider gifting now while the exemption is relatively large. Since these assets don’t have a high tax basis there is not an incentive to keep them and to let them transfer upon death.
Lastly, clients with very large estates who are making significant transfers may want to consider forming a Family Limited Liability Company (“FLLC”) or Family Limited Partnership (“FLP”) which own the assets and gifting portions of those company’s interests to their family members. These companies are used by many families to hold real estate, family businesses, or stock and are used to transfer value to family members over time in a tax advantageous way. Because of certain IRS rules regarding ownership in a family company the actual value of these ownership interests may be reduced and thereby a larger portion of value may be transferred in a FLLC or FLP during the lifetime of the owners than can be done in transferring the property or stock directly to heirs. The outcome of this is you can squeeze more value and gifting into the tax exemption with zero taxes in a FLLC or FLP than you can in transferring the asset outright.
Careful planning and tax reporting needs to be done when making large gifts and we can help develop a plan for your family and estate. In most situations, a gift tax return claiming the exemption (IRS Form 709) needs to be filed with the IRS (and in some states with state gift tax laws) and estate planning documents may need to be modified or amended.
by Mat Sorensen | Nov 6, 2012 | Uncategorized
When analyzing asset protection for self directed IRAs we must consider two types of potential threats. First, we must analyze how a creditor can collect against an IRA when the creditor has a judgment or claim against the IRA owner personally. Secondly, and most importantly for self directed IRA owners, we must analyze how a creditor can collect against an IRA or its owner when the IRAs investment incurs a claim or judgment.
There has been much written on the protections to retirement plans that prevents a creditor of the IRA owner from collecting against the IRA to satisfy their judgment. Various federal and state laws provide this protection which prohibits a creditor of an IRA owner from collecting or seizing the assets of an IRA or other retirement plan. For example, if an individual personally defaults on a loan in his or her personal name and then gets a judgment against them the creditor may collect against the individual’s personal bank accounts, non retirement plan investment accounts, wages, and other non-exempt assets but is prohibited from collecting against the IRA or other retirement plans of the individual. Even in the case of bankruptcy a retirement plan is considered an exempt asset from the reaches of the creditors being wiped out. U.S. Bankruptcy Code, 11 U.S.C. §522. Because of these asset protection benefits retirement plans are excellent places to hold assets outside the reach or creditors.
The second asset protection issue and the focus of this article is to consider how an is IRA protected from claims arising from the IRA’s investments and activities? This issue is one that is particularly important to self directed IRA accounts since some self directed IRA investments are made into assets that can create liability to the IRA and the protections preventing a creditor of the IRA owner against the IRA assets does not apply to liabilities arising from the IRAs investments. In other words, if the IRA has a liability the IRA is subject to the claims of creditors. For example, if a self directed IRA owns a rental property and the tenant in that property slips and falls the tenant can sue the self directed IRA who owned and leased the property to the tenant. Consequently, the IRAs assets are subject to the collection of the creditor including the property the IRA owned and leased to the tenant as well as the other assets of the IRA. But what about the IRA owner and their personal assets, are their personal assets also at risk?
Let’s analyze this issue further and look at whether a creditor/plaintiff against the IRA can also sue the IRA owner personally if the IRA’s assets are not sufficient to satisfy the judgment against the IRA. IRC § 408 states that an IRA is a trust created when an individual establishes an IRA by signing IRS form 5305 (this form is completed, with some variations, with every IRA) with a bank or qualified custodian. Courts have analyzed what an IRA is under law and have stated that they are a trust or special deposit of the individual for the benefit of the IRA owner. First Nat’l Bank v. Estate of Thomas Philip, 436 N.E. 2d 15 (1992). In other words, the IRA is not a separate entity or trust which would be exempt from creditor protection of its underlying owner. Since the IRA is a trust that is revocable and terminated at the discretion of the IRA owner, each investment in fact is truly controlled by the IRA owner as he or she could terminate the IRA at any time and take ownership in their personal name. As a result, the IRA is akin to a revocable living trust used for estate planning which trust is commonly understood by lawyers and courts to provide no asset protection and prevention of creditors from pursuing the trust creator and owner from liabilities and judgments that arise in the trust. Following this same rationale, a self directed IRA would likely be subjected to a similar downfall in the event of a large liability which is not satisfied by the assets of the IRA. As a consequence, the personal assets of the IRA owner may be at risk.
As a result of the asset protection liabilities for self directed IRAs, we recommend that self directed IRA owners consider an IRA/LLC for the asset protection reasons that many individuals use LLC’s in their personal investment and business activities. Simply put, an LLC prevents the creditor of the LLC from being able to pursue the owner of the LLC (in this case the IRA). An IRA/LLC is an LLC owned typically 100% by the IRA and the LLC would operate and take ownership of the investments and the liabilities similar to an LLC used by an individual. For example, instead of the IRA taking ownership of a rental property directly and leasing it to a tenant the IRA/LLC would instead take title to the property and would lease the property to the tenant. When the IRA/LLC owns and leases the property any claims or liabilities that arise are contained in the LLC and as a result of the LLC laws a creditor is prevented from going after the LLC owner (in this case the IRA, or the IRA owner).
There are certain types of self directed IRA investments that benefit greatly from the asset protection offered by an IRA/LLC. Rental real estate owned by an IRA achieves significant asset protection benefits from an IRA/LLC since rental real estate can create liabilities to their owner. Other self directed IRA investments such as promissory note loans, precious metals, or land investments do not have the same asset protection issues and potential to create liability for the IRA and as a result an IRA/LLC isn’t as beneficial from an asset protection perspective for these types of investments.
by Mat Sorensen | Oct 9, 2012 | Uncategorized
Many investors are aware of the opportunities that are available with self directed IRAs. This article highlights the strategies being used by self directed IRA investors and addresses some important issues and some recent cases regarding the IRA/LLC strategy.
As most of our readers are aware, a self directed IRA can be used to execute “alternative” investments such as real estate, precious metals, private lending, or non-publicly traded stock, and the investment returns receive the same tax favored IRA investment treatment we are all familiar with when investing our retirement accounts into stocks or mutual funds (e.g. tax deferred growth with traditional IRAs and tax free growth with Roth IRAs). One of the commonly used strategies by self directed IRA investors is commonly referred to as an IRA/LLC (aka checkbook control LLC). The idea of the IRA/LLC is that the self directed IRA invests its funds into a newly created LLC and in return receives 100% (unless there are partners or more than one IRA) of the membership of the newly created IRA/LLC. The IRA/LLC typically establishes an LLC bank account to hold the IRAs cash investment and this account is managed by the IRA owner or an advisor/professional third party. The IRA/LLC then executes the transactions on behalf of the IRA and holds legal title or ownership to the IRA/LLC assets on behalf of its IRA owner. In many instances, the IRA owner serves as the Manager of the IRA/LLC and performs administrative and investment oversight functions on behalf of the LLC such as signing contracts on investments, managing the IRA/LLC checking account, and receiving income and paying expenses on behalf of the IRA/LLC and its investments. There are lots of rules, such as the prohibited transaction rules, that an IRA owner needs to be aware of before investing their retirement account with an IRA/LLC and we routinely advise clients on these laws and issues. For example, the IRA and the IRA/LLC cannot make a transaction with someone who is prohibited to the IRA such as the IRA owner itself or his spouse, children or parents. See IRC § 4975. This would prohibit the IRA from purchasing a rental property from the IRA owner’s father.
The original case where the IRA/LLC concept was permitted by the U.S. Tax Court is known as Swanson v. Commissioner, 106 T.C. 76 (1996). In this case an IRA owner established a corporation that was 100% owned by his IRA and which the IRA owner subsequently managed. The IRS challenged the investment into the corporation as a prohibited transaction and the Tax Court ruled that the investment was not prohibited. For many years, this was one of the few cases addressing the IRA/LLC investment structure whereby an IRA is the owner of 100% of a newly created company. However, in 2011 and 2012 there were two additional cases whereby the IRA/LLC structure has been analyzed by the Tax Court and the structure was again recognized as a valid investment option for an IRA that does not constitute a prohibited transaction.
The 2011 case was Hellwig v. Commisioner, 2011-58 (U.S. Tax Court 2011). This case involved the creation of four 100% owned corporations by Roth IRAs. The IRS challenged the 100% corporations which were managed by the respective Roth IRA owners. In the Court’s ruling the Court referenced the prior ruling in Swanson and stated that a retirement plan may purchase 100% of a newly formed company because the company is not a disqualified person upon formation. Also, the Court further held that actions of the Roth IRA owner who was managing the Roth IRA owned corporation was not prohibited.
The 2012 case was Repetto, et al v. Commissioner, T.C. , Memo 2012-168 (U.S. Tax Court 2012). This case involved a husband and wife who owned a construction company. The husband and wife both created corporations owned 98% by their Roth IRAs and 2% by a partner. The Roth IRA owned corporations then performed services for the construction company owned by the Repettos. The Court ruled against the taxpayer in this case because the Roth IRA owned corporations were performing services to the Repetto’s own company when there was no legitimate business purpose for such services and the resulting transfer and payment for services. While the taxpayer lost the case, the Court’s ruling was very helpful in analyzing the IRA/LLC structure as the Court stated in its ruling, “ The [IRS] agrees that generally an entity in which substantially all of the interest is owned or acquired by a Roth IRA may be recognized as a legitimate business entity for Federal tax purposes. However, …the resulting payments [from the Repetto construction company to the Roth IRA owned corporations] were nothing more than a mechanism for transferring value to the Roth IRAs [since there was no legitimate business purpose for the services and payments].”
In summary, the IRA/LLC strategy has been recognized as a legitimate investment structure for an IRA in three cases before the U.S. Tax Court. The strategy does not, however, allow the IRA investor to avoid the prohibited transaction rules or allow the IRA owner to unfairly shift income or assets from themselves personally to their IRA. While we’d never recommend a client use an IRA/LLC for these purposes it is important to understand that the IRA/LLC strategy is a valid and well recognized investment structure for your IRA and that your IRA is still subject to the prohibited transaction and income shifting rules.
For more information and a consultation regarding your particular situation, please call the KKOS law office at 435-586-9366.
by Mat Sorensen | Sep 28, 2012 | Uncategorized
When it comes to transferring property, such as our rental properties into LLCs and our personal residence into a Trust, it can be confusing understanding the differences between a Quit Claim Deed, Warranty Deed and other terms that may be thrown out.
Some states use the term “Grant Deed”, California being one of the most preeminent. The reality is that a Grant Deed can be used as a Quitclaim Deed OR a Warranty Deed. It essentially depends on the verbiage used inside the terms of the Deed itself. Bottom line- Make sure that you look at the language used in the deed itself. Don’t think that because you have a Grant Deed you have all of the benefits of a Warranty Deed. Here is a brief description of each type of Deed:
Quitclaim Deed
A quitclaim deed transfers whatever ownership interest a person has in a property. It makes no guarantees about the extent of the person’s interest. Quitclaim deeds are also frequently used when there is a “cloud” on title — that is, when a search reveals that a previous owner or some other individual, like the heir of a previous owner, may have some claim to the property. The transferor can sign a quitclaim deed to transfer any remaining interest.
Warranty Deed
A warranty deed transfers ownership and explicitly promises the buyer that the transferor has good title to the property, meaning it is free of liens or claims of ownership. Also, whatever the ‘title’ of the deed is you may use, check the verbiage in the deed itself to understand what warranties you may be making, if any. The transferor guarantees that he or she will compensate the buyer if that turns out to be wrong. The warranty deed may make other promises as well, to address particular problems with the transaction.
Our Recommendation
Always double check the ‘local’ state and county laws regarding the type of deed to use when transferring property and what the different types of deeds actually provide. HOWEVER, we generally recommend the Warranty Deed when transferring property to yourself, your trust, or your own company; because we want to make sure that the Title Policy and all of its benefits transfer to the Grantee of your deed.
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