IT’S TIME FOR PPP 2
Posted on January 8th, 2021At the end of 2020, Congress passed, and President Trump signed, a new law that provides for additional relief related to the coronavirus (COVID-19) pandemic. This law, the Consolidated Appropriations Act, 2021 (CAA, 2021), includes a second draw of Paycheck Protection Program (PPP) loans (PPP Second Draw Loans). It also allows businesses to deduct ordinary and necessary expenses paid from the proceeds of PPP loans.
BACKGROUND. In March 2020, the Coronavirus Aid, Relief and Economic Security (CARES) Act was enacted. The CARES Act authorizes the Small Business Administration (SBA) to make loans to qualified businesses under certain circumstances. The provision established the PPP, which provided up to 24 weeks of cash-flow assistance through 100% federally guaranteed loans to eligible recipients to maintain payroll during the COVID-19 pandemic and to cover certain other expenses. The Paycheck Protection Program Flexibility (PPPF) Act made substantial changes to the PPP, including decreasing the percentage that loan proceeds must be used on payroll costs from 75% to 60%, thereby increasing the percentage that may be used for nonpayroll costs such as rent, mortgage interest and utilities from 25% to 40%. Additionally, the PPPF Act permits borrowers to defer payments of principal, interest, and fees to 10 months after the last day of the covered period (the earlier of 24 weeks or December 31, 2020). The application period closed on August 8, 2020. The SBA began approving PPP forgiveness applications and remitting forgiveness payments to PPP lenders on October 2, 2020.
PAYCHECK PROTECTION PROGRAM SECOND ROUND DRAWS. The CAA, 2021 permits certain smaller businesses who received a PPP loan and experienced a 25% reduction in gross receipts to take a PPP Second Draw Loan of up to $2 million.
Eligible entities. Prior PPP borrowers must meet the following conditions to be eligible for the PPP Second Draw Loans:
• Employ no more than 300 employees per physical location;
• Have used or will use the full amount of their first PPP loan; and
• Demonstrate at least a 25% reduction in gross receipts in the first, second, or third quarter of 2020 relative to the same 2019 quarter. Applications submitted on or after Jan. 1, 2021 are eligible to utilize the gross receipts from the fourth quarter of 2020.
Eligible entities include for-profit businesses, certain non-profit organizations, housing cooperatives, veterans’ organizations, tribal businesses, self-employed individuals, sole proprietors, independent contractors, and small agricultural co-operatives.
Loan terms. Borrowers may receive a PPP Second Draw Loan of up to 2.5 times the average monthly payroll costs in the one year prior to the loan or the calendar year. However, borrowers in the hospitality or food services industries (NAICS code 72) may receive PPP Second Draw Loans of up to 3.5 times average monthly payroll costs. Only a single PPP Second Draw Loan is permitted to an eligible entity.
Gross receipts and simplified certification of revenue test. PPP Second Draw Loans of no more than $150,000 may submit a certification, on or before the date the loan forgiveness application is submitted, attesting that the eligible entity meets the applicable revenue loss requirement. Non-profits and veterans’ organizations may use gross receipts to calculate their revenue loss standard.
Loan forgiveness. Like the first PPP loan, the PPP Second Draw Loan may be forgiven for payroll costs of up to 60% (with some exceptions) and nonpayroll costs such as such as rent, mortgage interest and utilities of 40%. Forgiveness of the loans is not included in income as cancellation of indebtedness income.
Application of exemption based on employee availability. The CAA, 2021 extends current safe harbors on restoring full-time employees and salaries and wages. Specifically, it applies the rule of reducing loan forgiveness for the borrower reducing the number of employees retained and reducing employees’ salaries in excess of 25%.
DEDUCTIBILITY OF EXPENSES PAID BY PPP LOANS. The CARES Act was silent on whether expenses paid with the proceeds of PPP loans could be deducted. IRS took the position that these expenses were nondeductible. The CAA, 2021 provides that expenses paid both from the proceeds of loans under the original PPP and PPP Second Draw Loans are deductible.
Please contact our office with any further questions you might have on PPP loan forgiveness.
FILING AN INCORRECT 1099 CAN BE COSTLY
Posted on November 4th, 2020I am frequently asked by a client what are the penalties for failing to file a Form 1099 to report money paid to an independent contractor.
Late Forms or Uncorrected Errors
The IRS imposes penalties for failure to file information returns with the IRS on a timely basis (as well as the failure to furnish returns to payees on a timely basis). In addition, the IRS may also assess penalties if a filer fails to include all of the information required to be shown on a return or reports incorrect information.
• If you correctly file within 30 days of deadline: $50 per form ($556,500,000 max)
• If you correctly after 30 days and by August 1: $110 per form ($1,669,500 max)
• If you correctly file after August 1: $270 per form ($3,339,000 max)
The above penalties are for large businesses with more than $5 million in gross receipts for the past three years. The IRS reduces max fines for each tier by $194,500, $556,500 and $1,113,000, respectively for filers that are small businesses with $5 million or less in gross receipts for the past three years.
Missing Forms Due to Intentional Disregard
The penalty has been increased to the greater of $550 per form or 10% of the amount required to be reported on the return if a filer neglects to send forms altogether when the filer knew it should have (what the IRS classifies as “Intentional Disregard”). This penalty has no maximum!
Not Filing Over 250 Forms Electronically
Businesses that are required to file over 250 1099s of the same type (250 1099-MISC forms, for example), must file electronically or face fines of $250 per form.
Exceptions to the Penalty
Concerned about facing a penalty? Don’t give up hope: you may fall into an exception if you faced mitigating circumstances and act fast to solve the issue. Here’s the IRS list of acceptable exceptions:
1. The penalty will not apply to any failure that you can show was due to reasonable cause and not to willful neglect. In general, you must be able to show that your failure was due to an event beyond your control or due to significant mitigating factors. You must also be able to show that you acted in a responsible manner and took steps to avoid the failure.
2. An inconsequential error or omission is not considered a failure to include correct information. An inconsequential error or omission does not prevent or hinder the IRS from processing the return, from correlating the information required to be shown on the return with the information shown on the payee’s tax return, or from otherwise putting the return to its intended use. Errors and omissions that are never inconsequential are those related to (a) an ID number, (b) a payee’s surname, and (c) any money amount.
3. De minimis rule for corrections. Even though you cannot show reasonable cause, the penalty for failure to file correct information returns will not apply to a certain number of returns if you:
a. Filed those information returns timely,
b. Either failed to include all the information required on a return or included incorrect information, and
c. Filed corrections by August 1.
If you meet all the conditions in (a), (b), and (c) above, the penalty for filing incorrect returns will not apply to the greater of 10 information returns or 1/2 of 1% of the total number of information returns you are required to file for the calendar year.
Missing or Incorrect ID numbers
If required 1099-MISC (or the new 1099-NEC) forms are missing TINs (SSN or EIN) or have incorrect TINs, then the IRS can impose fines of up to $270 per form depending on when the corrected return is filed. That fine can be reduced to $50 if a correction is filed within 30 days of the deadlineIn addition, the penalty may be waived by showing the failure(s) was due to reasonable cause and not to willful neglect.
What constitutes reasonable cause?
According to IRS guidance:
Filers must establish that they acted in a responsible manner both before and after the failure occurred, and that:
• There were significant mitigating factors (for example, an established history of filing information returns with correct TINs)
• The failure was due to events beyond the filer’s control (for example, a payee did not provide a correct name/TIN in response to a request for the corrected information). Acting in a responsible manner includes making an initial solicitation (request) for the payee’s name and TIN and, if required, an annual solicitation. Upon receipt of this information, it must be used on any future information returns filed.
What Should You Do?
1. Make sure that you file all of your 1099’s when they’re due – January 31st.
2. If you hire an employee or an independent contractor, get a W-4 for an employee or a W-9 for an independent contractor completed before you make a payment.
IRS RULES ON MEALS & ENTERTAINMENT
Posted on October 26th, 2020The IRS and Treasury have finalized regulations implementing amendments made by the Tax Cuts and Jobs Act (TCJA) to business-related meals and entertainment deductions. The TCJA largely eliminated the deduction for entertainment expenses paid or incurred after 2017, but left intact certain exceptions. Notable changes were made to food and beverage expenses as well; however, the final regulations confirm that 50% deductions for business meals generally remain.
Entertainment
Business-related entertainment expenses were previously allowed a 50% deduction. The TCJA changed this by generally disallowing deductions related to entertainment, amusement, or recreation, even when business related. The regulations , however, provides an important reminder that exceptions were not changed by the TCJA and remain available to allow deductions for certain business-related entertainment expenses.
The nine exceptions to entertainment disallowance are as follows:
• (1.) On site food and beverages for employees, including expenses for related facilities.
• (2.) Expenses treated as compensation.
• (3.) Reimbursed expenses under an accountable plan.
• (4.) Expenses for recreational, social, or similar activities primarily for the benefit of employees.
• (5.) Expenses directly related to business meetings of employees, stockholders, agents, or directors.
• (6.) Expenses related to attending business league or chamber meetings.
• (7.) Items made available to the general public.
• (8.) Entertainment sold to customers.
• (9.) Expenses includable in the income of persons who are not employees of the taxpayer.
If these items are related to otherwise deductible business meals, they may be 100% deductible, depending on whether they meet a further exception discussed next.
Meals
A deduction for business-related food and beverage expense is limited to 50% of the expenditure. Taxpayers may deduct 50% of business food and beverages if—
• the expense is not lavish or extravagant under the circumstances,
• the taxpayer, or an employee of the taxpayer, is present,
• the food or beverage is provided to the taxpayer or a business associate, which includes clients and employees, and
• food and beverages are purchased separately or separately stated on a receipt if provided during an entertainment activity.
That the following exceptions allow for a full deduction of business-related food and beverages:
• (1.) Expenses treated as compensation.
• (2.) Reimbursed food or beverage expenses.
• (3.) Expenses for recreational, social, or similar activities primarily for the benefit of employees.
• (4.) Items made available to the general public.
• (5.) Goods or services sold to customers.
• (6.) Expenses includable in the income of persons who are not employees of the taxpayer.
Breakroom Snacks
Coffee, donuts, and various snacks provided in office breakrooms used to be 100% deductible, but they got trimmed down too and are now considered to be 50% deductible meals. Despite the fun that may be had in the breakroom, it “is not a recreational, social, or similar activity primarily for the benefit of the employees”. Therefore, the exception for social gatherings won’t apply just because employees may incidentally socialize where free food and drinks are available.
Employee Social Gatherings
Occasional social gatherings, such as holiday parties, annual picnics, or summer outings for the benefit of employees, remain fully deductible.
Business Meals
Otherwise deductible business meals remain 50% deductible. This includes taking a client or co-worker to lunch if business is discussed, as well as meals when travelling for work.
It’s important to note that meals determined to be inherently personal are nondeductible. For example, a physician’s regular lunches with co-workers were found to be nondeductible personal expenses. In its decision, the Tax Court noted that occasional lunch meetings with other physicians to discuss current treatment techniques may be deductible as a business expense, but expenses for meals eaten three or four times a week, year-round, are nondeductible personal expenses.
Entertaining Clients and Customers
While taking a client or customer to a concert or ballgame may now be nondeductible, otherwise deductible business meals during an entertainment event are still 50% deductible so long as receipts separately itemize their costs. If the costs are not separately stated, no allocation can be made and the entire expense becomes nondeductible entertainment. The regulations also warn that inflating meals to deduct an entertainment component is not allowed. Amounts charged for food or beverages on a bill, invoice, or receipt must reflect the venue’s usual selling costs for those items as if they were purchased separately from the entertainment component
Conclusion
Before the TCJA, distinguishing between meals and entertainment was generally unnecessary or limited to separating out fully deductible expenses, but it’s imperative now to take it a step further. A best practice to maximize tax deductions and minimize headaches is to revise the chart of accounts to capture each type of meal or entertainment expense that may have different tax treatments on the front end, rather than having to sift through combined costs and recall the events after the fact.
Taking a Bite of Poor Steven’s Profit.
Posted on August 7th, 2020Steven, a dentist by trade, and Georgann were in the process of getting a divorce. His wholly owned S corporation held a 70% interest in Dental Care Alliance, LLC. The S Corporation and its 70% interest in the LLC were both marital assets subject to Equitable Distribution. The parties agreed that the value of the LLC was $30 million and so, by extension, the S Corporation’s share of its value was $21 million. As part of the divorce settlement with Georgann, Steven agreed to pay her $10.5 million for her 50% share of the value of the LLC interest by making upfront cash payments, executing a promissory note, and paying her share of the couple’s liabilities. Three years later, Steven’s S corporation sold its interest in the LLC for approximately $93.8 million (at this point, I have lost all sympathy for Steven). In computing his tax on the gain from the sale of the LLC, Steven decided that payments to his ex-wife and his divorce attorney increased his S corporation’s basis in the LLC. His theory was that the payments, which were necessary to clear title over the LLC membership interest, were capitalizable amounts paid to acquire or produce property. The Tax Court disagreed, finding that (1) the S corporation did not incur any expenses to clear title to its own interest and (2) the ex-wife’s claim to marital assets did not cloud the taxpayer’s title. Therefore, the S corporation underreported its gain from the sale due to an inflated basis. Steven’s eventual liability to the IRS was $804,000 which seems like a paltry sum given the fact that the value increased by $63 million none of which he had to share with Georgann.
I GOT A PPP LOAN. NOW WHAT DO I DO?
Posted on April 26th, 2020How much of my loan will be forgiven?
You will owe money when your loan is due if you use the loan amount for anything other than payroll costs, mortgage interest, rent, and utilities payments over the 8 weeks after getting the loan. Due to likely high subscription, it is anticipated that not more than 25% of the forgiven amount may be for non-payroll costs.
You will also owe money if you do not maintain your staff and payroll.
- Number of Staff: Your loan forgiveness will be reduced if you decrease your full-time employee headcount.
- Level of Payroll: Your loan forgiveness will also be reduced if you decrease salaries and wages by more than 25% for any employee that made less than $100,000 annualized in 2019.
- Re-Hiring: You have until June 30, 2020 to restore your full-time employment and salary levels for any changes made between February 15, 2020 and April 26, 2020.
How can I request loan forgiveness?
You can submit a request to the lender that is servicing the loan. The request will include documents that verify the number of full-time equivalent employees and pay rates, as well as the payments on eligible mortgage, lease, and utility obligations. You must certify that the documents are true and that you used the forgiveness amount to keep employees and make eligible mortgage interest, rent, and utility payments. The lender must make a decision on the forgiveness within 60 days.
What should you do?
- Ideally, you can keep the PPP funds in a separate account to be used to pay your employees, health insurance, employee benefit plan match and any other allowable expenses. You should keep records that will support the payments including retaining copies of paychecks, checks for other payroll costs and checks for other allowable expenses.
- Since the loan has to be spent on allowable costs in the eight-week period beginning on the date that you received the funds, start keeping records immediately upon the receipt of the loan.
- Payroll in excess of $100,000 annually is not counted towards forgiveness so make sure that if you have employees earning more than the cap, you only consider the allowable amount.
Do I need help?
Presumably your lender will contact you prior to the end of the eight-week period and will provide you with their form to confirm your use of the funds. If not, be prepared to provide the support for the use of the funds.
What if I don’t qualify for forgiveness?
If you don’t qualify for 100% forgiveness, you will be required to pay the shortfall back to the bank over a two-year period along with interest at 1%. There is a six-month period where not payments are due.
Feel free to call us if you need any assistance.
COVID 19 FAQ’S
Posted on April 10th, 2020COVID-19 FAQs
Will I receive cash from the government? If so, when?
Single individuals with 2019 (2018, if your 2019 return hasn’t been filed yet) Adjusted Gross Income (AGI) up to $75,000 ($112,500 if you file as “head of household”) will generally receive a $1,200 rebate from the IRS. Joint filers with AGI up to $150,000 will receive a rebate of $2,400. An additional $500 rebate is available for each qualifying child under age 17. If your income is too high, the rebate will be reduced by $5 for each $100 your AGI exceeds the threshold. So, for a typical family of four, the amount is completely phased out once AGI exceeds $218,000.
The IRS has indicated that funds could be direct deposited into bank accounts (based on account information provided on your 2018 or 2019 return) toward the end of April. If the government doesn’t have your account information, you can provide it via a web-based portal currently being developed by the IRS.
Will I have to pay the money back?
No.
What if I don’t need (or want) the money?
Consider donating it to charity. If you itemize deductions, recent legislation increases the limit on deductions for cash contributions made to public charities in 2020 from 60% to 100% of AGI. If you don’t itemize, a new above-the-line deduction of up to $300 is available for cash contributions made to public charities in 2020.
Another option is to contribute the rebate funds to a traditional or Roth IRA. For 2019, you now have until 7/15/20 to make that contribution. If you have any questions on how to do that, please let us know.
I’m struggling financially due to COVID-19. Should I withdraw funds from my retirement account?
This should be your last resort. If you can cut back on expenses, strike deals with creditors, and/or take out personal loans, you might be better off in the long run. Withdrawing retirement funds now means you will miss out on future market recovery.
However, if you have no other option, up to $100,000 in retirement distributions can be made tax-free if (1) you (or your spouse or dependent) have been diagnosed with COVID-19 or (2) you have experienced adverse financial consequences as a result of the virus. The catch is you must return the funds to a retirement account within three years for the distribution to be tax-free. Some retirement plans also offer the option to take a loan from your account balance. We can work with you to see if this option is best for you.
My business is struggling. Is there a way to increase cash flow?
Yes. Due to recent legislation, businesses can now carry back losses to the prior five tax years. Also, the rules surrounding deductibility of business interest expense and qualified improvement property costs have been relaxed. This may provide an opportunity for us to amend your prior-year returns to secure a refund. This will be particularly beneficial if you were previously in a higher tax bracket. We will review your past returns and identify any refund opportunities.
I’ve been hearing a lot about small business loans. Do I qualify for one?
Potentially. Under the Paycheck Protection Program (PPP), eligible small businesses can receive 100% federally guaranteed loans that may be forgiven if payroll is maintained during the COVID-19 crisis (or restored afterward). Amounts that aren’t forgiven will be subject to a maximum 10-year term with an interest rate not to exceed 4%. (According to interim final rules by the SBA, the maturity date is two years, and the interest rate is 1%.) Payments under the loan may be deferred for at least six months, but no longer than one year. Loans can be up to 2½ times your average monthly payroll costs, up to a maximum of
$10 million.
You may qualify for a PPP loan if you are (1) a business with fewer than 500 employees; (2) a business that otherwise meets the SBA’s size standard; or (3) an individual who operates as a sole proprietor or an independent contractor, or who is self-employed and regularly carries on any trade or business.
Another option is an Economic Injury Disaster Loan (EIDL), which provides small businesses with working capital loans of up to $2 million to help overcome the temporary loss of revenue. The interest rate for an EIDL is 3.75%, and the maximum term is 30 years. Thanks to new legislation, small businesses can apply for an advance up to $10,000, which doesn’t have to be repaid.
There are other factors to consider before applying for a small business loan. Please let us know if you’re interested in pursuing this option, and we will walk you through the process.
Do I really have to provide family and sick leave to employees?
Yes, if you have fewer than 500 employees. Recent legislation requires you to provide (1) paid sick leave and (2) expanded family and medical leave to employees from 4/1/20 through 12/31/20 when they’re unable to work (or telework) due to a qualifying reason. Here’s what’s required under the new law:
| Qualifying Reason | Paid Leave Entitlement | Maximum Pay |
| Employee is subject to a federal, state, or local quarantine or isolation order related to COVID-19. | Up to two weeks of sick leave, paid at 100% of the regular rate of pay (or applicable minimum wage, if higher). | $511 per day; $5,110 total. |
| Employee has been advised by a health care provider to self-quarantine due to COVID-19. | Up to two weeks of sick leave, paid at 100% of the regular rate of pay (or applicable minimum wage, if higher). | $511 per day; $5,110 total. |
| Employee is experiencing COVID-19 symptoms and is seeking a medical diagnosis. | Up to two weeks of sick leave, paid at 100% of the regular rate of pay (or applicable minimum wage, if higher). | $511 per day; $5,110 total. |
| Employee is caring for an individual who (1) is subject to a quarantine or isolation order or (2) has been advised by a health care provider to self-quarantine. | Up to two weeks of sick leave, paid at ⅔ of the regular rate of pay (or ⅔ of the applicable minimum wage, if higher). | $200 per day; $2,000 total. |
| Employee is caring for a child whose school or place of care is closed (or child care provider is unavailable) due to coronavirus-related reasons. | Up to 12 weeks of paid sick leave and expanded family and medical leave, paid at ⅔ of the regular rate of pay (or ⅔ of the applicable minimum wage, if higher). | $200 per day; $12,000 total. |
| Employee is experiencing any other substantially similar condition specified by the U.S. Department of Health and Human Services. | Up to two weeks of sick leave, paid at ⅔ of the regular rate of pay (or ⅔ of the applicable minimum wage, if higher). | $200 per day; $2,000 total. |
What if I don’t have enough money to pay family and sick leave?
Eligible employers can take a refundable payroll tax credit equal to the required paid leave. If you’re low on cash, retain and access the funds you would otherwise pay to the IRS in payroll taxes. If those funds aren’t sufficient to cover the cost of paid leave, we can help you get an expedited advance from the IRS.
Are there other things I can do to help my employees?
Yes. Since the COVID-19 pandemic was declared an emergency by President Trump, you can make qualified disaster relief payments to your employees. These payments are tax-free to employees, while generating a tax deduction for you. Amounts must be for reasonable and necessary personal, family, living, or funeral expenses incurred as a result of the coronavirus. These could include childcare expenses resulting from school closures and costs incurred to enable an employee to work from home. However, qualified sick leave wages and qualified family leave wages aren’t considered qualified disaster relief payments.
I need to cut my labor costs. Should I furlough employees or lay them off?
If you don’t want to lay off employees, but don’t have the funds to pay them, a furlough can be a good option. A furlough is a mandatory or voluntary suspension from work without pay for a particular period of time (usually less than six months). In most states, furloughed workers are still considered employees and therefore don’t receive a “final” paycheck. Also, furloughs generally don’t trigger mass layoff notifications under the federal WARN Act. Finally, furloughed employees are generally eligible for unemployment benefits. Laws vary by state, so make sure you check with legal counsel before making a decision.
Will COVID-19 affect my financial statements?
Most likely. Other than potential revenue loss, you will need to account for the effect of recent legislation on any deferred tax assets and liabilities, as well as current taxes payable. Also, COVID-19 may trigger an impairment test for long-lived assets (or asset groups). If you have depreciable assets that become idle due to the pandemic, you will still need to reflect depreciation for those assets in your books (unless a method change is made).
I don’t think I can fulfill a contractual obligation due to COVID-19. Do I have any options?
Possibly. You will need to see if your contract has a force majeure clause. Force majeure (sometimes known as an “act of God”) comes into play when an unexpected event prevents you from fulfilling a contractual obligation. If valid, force majeure will excuse you from the contract.
Historically, parties have relied on force majeure in cases of natural disasters. Many would argue that the COVID-19 pandemic is akin to a natural disaster. Since this issue can get complicated, you will need to consult with legal counsel to see if force majeure can relieve you from a contractual obligation.
Should I be concerned about cybersecurity?
Yes. Cybercriminals
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are using the COVID-19 pandemic to take advantage of taxpayers. They claim you’ll get your stimulus check faster (or get a larger check) if you share personal information or pay a processing fee. Cybercriminals also promise coronavirus-related grants or loans from the government in exchange for personal information. Don’t fall for these—they are scams. If you think you’ve been a victim of a COVID-19 scam, immediately contact law enforcement.
We know that’s a lot of information, and other questions are bound to arise. Just know that we are here to help in any way possible. If you have any questions, or would like to discuss any of these issues in more detail, please don’t hesitate to reach out.
You Can’t Always Get What You Want
Posted on November 27th, 2019
But if you try sometimes you just might get want you need. The federal income tax deduction for alimony required by divorce decrees executed after 2018 was permanently eliminated by the new tax law. However, recipients of alimony don’t have to include payments in gross income. This development is an expensive game-changer for higher-income individuals who are required to pay alimony. The old alimony game of tax arbitrage in history but there are other tax rules to take into consideration.
Take Advantage of Tax-free Asset Transfers between Divorcing Individuals
General Rule. The Internal Revenue Codes provides that property transfers between divorcing spouses are treated as tax-free gifts, with the recipient taking over the transferor’s tax cost and holding period. When the receiving spouse subsequently sells the property, he or she recognizes taxable income or loss as if he or she had owned the property from the outset. There is no gain or loss even if cash is paid or if liabilities that burden the property exceed its cost.
The IRS believes that most ordinary income assets can be transferred tax-free under the Section 1041(a) rule. If so, the spouse who winds up with the asset must recognize the income when the asset is sold, converted to cash, or exercised in the case of stock options. The IRS issued a ruling dealing with vested nonqualified employer stock options and nonqualified deferred compensation rights affirming this.
Transfers Incident to Divorce. A transfer is incident to a divorce and therefore eligible for tax-free treatment in the following circumstances.
One-year Rule Is Satisfied. The transfer occurs within one year after the date on which the marriage ceases.
Cessation of Marriage Rule Is Satisfied. The transfer must be related to the divorce. Any transfer pursuant to a divorce or separation instrument within six years after the divorce is presumed to be related to the divorce. Note that unlike transfers made within one year after the divorce becomes final, transfers made during years two through six after the divorce is final must be made pursuant to a divorce or separation instrument to qualify for Section 1041(a) treatment.
Rebuttable Presumption Rule Is Satisfied. Any transfer that is made more than six years after the divorce is presumed to be unrelated to the divorce and therefore ineligible for tax-free treatment.
Transfer Employer Stock Options to Offset Loss of Alimony Deductions
An individual transfer vested employer stock options with their built-in tax liabilities as a way to offset the loss of alimony deductions. The IRS addressed the federal income tax issues of such transactions in Revenue Rulings
Federal Income Tax Consequences of Divorce-related Option Transfers. According to the fact pattern in the IRS ruling, Spouse A owned vested Non-qualified Stock Options (NQSOs) that he had received as compensation from his employer. Because the NQSOs were not publicly traded, Spouse A was not taxed upon receiving them.
Pursuant to a divorce property settlement, Spouse A (the employee spouse) transferred some of his NQSOs to Spouse B (the non-employee spouse). Several years later, Spouse B exercised the NQSOs. At that time, the value of the stock was in excess of the option exercise price.
Tax-free Transfer Rule Applies. The IRS concluded that the transfer of NQSOs from Spouse A to Spouse B fell under the Section 1041(a) tax-free transfer rule. So, the transfer had no immediate federal income tax consequences for either spouse. Next, the IRS concluded that Spouse B had to recognize ordinary income upon exercising the NQSOs, pursuant to. The income was ordinary because Spouse B was treated as if she herself had received the NQSOs as employee compensation.
Thus, the IRS held that when tax-free treatment applies, it requires the non-employee spouse to “step into the shoes” of the employee spouse..
The IRS takes pointed out two situations when these don’t apply: (1) when NQSOs that are unvested or subject to substantial contingencies are transferred between spouses in connection with a divorce and (2) when NQSOs are transferred between spouses other than in connection with a divorce.
When NQSOs are transferred tax-free from the employee spouse to the non-employee spouse, the transfer itself does not trigger FICA or FUTA taxes.
However, when the options are subsequently exercised by the non-employee spouse, FICA taxes are triggered to the same extent as if the employee spouse held the options and exercised them. Therefore, the FICA and Medicare tax may be payable.
The employee’s share of FICA tax must be withheld from the amount received by the non-employee spouse. This is consistent with the fact that the non-employee spouse is the one who reaps the economic benefit and also the one who owes the related federal income tax. Federal Income Tax also must be withheld from the amount received by the non-employee spouse.
Conclusion
In the right circumstances, divorcing clients can make asset transfers to their soon-to-be ex-spouses that partially or wholly offset the loss of alimony deductions. Various types of assets can come into play here, but tax-smart asset transfers must be planned before the divorce papers are finalized. In a related release, we will explain how divorce-related redemptions of closely held stock can be used to the same end.
NO INFORMATION? NO PROBLEM
Posted on November 20th, 2019Sometimes there is the perfect storm for a business appraiser where the information need to give an opinion of value is not available. This Fifth District Court of Appeals case posed a daunting valuation challenge for the parties’ experts because the business was formed and operated abroad, the valuation date was years in the past, and the sale of the company took place a decade before the divorce trial. Regardless of the absence of financial information, the husband’s expert used a methodology that resulted in a valuation acceptable by the trial court and by the DCA.
The parties were married in Ohio in 1966. After 13 years of marriage, they divorced. But, in the early 1980s, they resumed living together again this time in Kansas which resulted in common law marriage status. In 1992, the parties separated again. The wife returned to Ohio, and the husband moved overseas.
In 1995, the wife filed for legal separation in Ohio, which an Ohio court ultimately granted. In 2004, the wife filed for divorce. In 2008, an Ohio trial court entered final judgment. The trial court’s divorce decree and property distribution order were affirmed on appeal.
Then, in 2009, the wife asked a Brevard County Circuit Court to determine and distribute marital assets and award her spousal support. The Circuit Court decided January 1995 was the valuation date for the purpose of equitable distribution—1995 being the year the wife filed for separation in Ohio. Both parties appealed the trial court’s rulings.
For business valuation purposes, the crux of the dispute was valuing a company in which the husband obtained an ownership in 1991. The company operated in the Middle East. It was sold in 2006 for nearly $2.4 million. Given the fact that the company was operated in a foreign country and financial information at or around the valuation date was not available, the experts were faced with a difficult assignment.
The husband’s expert used a coverture fraction method, which used as the numerator the number of months during which the asset was marital in nature (42 months) and as the denominator the total length of ownership (180 months). The coverture fraction was 23.3%, which the valuator applied to the 2006 sales price ($2.4 million). Using this methodology, the husband’s expert found the marital value of the asset as of 1995 was almost $556,000, which resulted in almost $245,000 for the wife after deducting her share of the taxes paid by the husband. The wife’s expert, on the other hand, used an income approach even though both experts testified to the difficulty of producing an “interim value” where no “normal” financial records were available.
The trial court adopted the approach of the husband’s expert, saying it was reasonable under the circumstances. The wife appealed this finding, arguing the trial court should have adopted her expert’s valuation.
The Fifth DCA rejected the wife’s argument, noting her expert “was a CPA with no business valuation credentials” who used an income approach “despite having essentially no financial documents reflecting the cash flow, liabilities, assets, and so forth of the company.” The DCA said the trial court found the husband’s expert was an experienced business valuator who “offered a reasonable approach” to valuing the company “despite having little financial data beyond the ultimate price for which Former Husband sold his interest.”
I HOPE HE PAID HIS MALPRACTICE PREMIUM
Posted on November 20th, 2018Imagine you have hired an established expert to assist you in your divorce only to have his testimony excluded because it didn’t meet professional standards, nor did it meet the statutory requirements. This happened in a case involving the divorce of a couple that I will call Judy and Steve.
In 2003, Steve started a business that was very successful. He was able to sell the business eight years later for $37 million. Steve and Judy were married in 2009, more than six years after he opened his new venture. Based on Florida law, the business was clearly a separate asset of Steve’s and not marital.
The issue during the divorce proceedings was whether the Judy had a right to a portion of the appreciation in value the company that occurred during the marriage. This analysis has two parts. For one, the Court has to make a determination that there was an appreciation (or “enhancement”) in value. Assuming the Court finds there was an increase in value, it must determine the reasons for the appreciation in order to determine whether any portion of the enhanced value is marital property. Under Florida law, if a nonmarital asset increases in value during the marriage, only the part of the appreciation that is the result of either party’s efforts qualifies as marital property. Basically, once the owner spouse shows the asset was separate property, the nonowner spouse must show there was an enhancement in value and it is marital property. If he or she succeeds, the other party has to show that some or all of the enhanced value is not part of the marital property.
The valuation expert that Judy hired to calculate the marital enhancement used a method that was recognized as a valuation method. He compared revenue and earnings on two dates neither of which were valuation dates to arrive at a value of goodwill. Based on this computation, he projected an increase in book value between the date of marriage and the valuation date to me $8.9 million which would have been a home run for Judy for a two-year marriage.
Steve’s lawyer asked the Court to exclude the expert’s testimony since his opinion was not based on the increase in the fair market value of Steve’s company. The Court agreed that the marital component should be based on the valuation of the company and that the expert’s opinion was not a valuation. Accordingly, the Court ruled that the expert’s testimony should be excluded. Judy appealed the ruling. Steve hired an expert to review the work that Judy’s expert had done. Steve’s expert was one of the authors of the AICPA valuation standards. He testified that Judy’s expert did not comply with valuation standards. Interestingly, Judy’s expert did not have a workpaper file to support his opinion and he did not request information that could be used in a valuation. In the end, he had no way to support his testimony. Since Judy could not prove that there was an increase in value during the marriage, none of the value of Steve’s company was marital.
The are lessons to be learned. First, Judy’s lawyer should have reviewed the law with the expert to ensure that the expert’s opinion complied with Florida law. Second, Judy’s expert should have expressed an opinion based on his failure to follow professional standards.
If You Want to Spend $3MM in Fees, Call Me!
Posted on June 18th, 2018Sometimes tax litigation is so interesting to me that I am forced to read the entire case (yes that makes me a tax nerd). Such is the case of Lucas v. Commissioner. Sky Lucas and his partners formed an investment advisory firm in 2004 that became unbelievably successful until the market crash of 2008. Due to the crash, Sky and his partners had to liquidate the fund and, sad to say Sky was left with the meager sum of $48 million. Sky and his wife Margaret were in the middle of a divorce and she laid claim to half of the distributions. The trial in the divorce was held in Clearwater, Florida. Margaret’s lawyers were only able to convince the court that approximately $5 million of the distribution was marital. Her final equitable distribution included the house in Belleair Bluffs and $7 million in cash. Sky incurred several million dollars in legal fees during his divorce proceedings. He deducted $1.3 million of the fees for 2010 and $1.6 million for 2011. Legal fees incurred during divorce may be deductible if the spouse is interfering in the taxpayer’s business or the issue relates to taxable alimony income. The significant issue in the divorce was the valuation and allocation of distributions from the taxpayer’s investment advisory business. The taxpayer argued that the fees were deductible an ordinary and necessary business expense incurred to defend a claim for profits earned in his business, or under as a nonbusiness profit-seeking expense. The Court determined that the taxpayer was not engaged in any business activity during the divorce proceedings, and the claim only arose due to the marriage relationship. Therefore, the Tax Court held that the litigation fees incurred were not business expenses nor were they related to the pursuit of alimony, but were nondeductible personal expenses. Note: the Internal Revenue Code was amended by the Tax Cut and Jobs Act of 2017. One of the provisions eliminates the miscellaneous itemized deductions so legal fees pursuant to a divorce are now likely not deductible