Issue: April, 2005
Author: Thomas N. Long
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A Few Tax Principles Every General Practitioner Should Know
If you are a general practitioner, this issue of the Wyoming Lawyer with its emphasis on taxation and finance may strike you as irrelevant to your practice. If you already understand the many unhappy tax consequences that can surprise clients as a result of steps taken in a civil or criminal matter, perhaps you need not read any further. If you think at least one of the handful of points mentioned below might be news to you, and you would prefer to learn by reading about it rather than learn the hard way, read on.
Having a debt forgiven can create a new debt (to the IRS). The discharge of a debt is considered the receipt of taxable income. There is a bankruptcy exception under Internal Revenue Code § 108 that says that a discharge resulting from a Title 11 case, a discharge when the taxpayer is “insolvent,” a discharge of either “qualified farm indebtedness” or “qualified real property business indebtedness” does not cause taxable income.
A criminal plea may lead to a tax bill as well as hard time. If your client stole money or otherwise had a gain from an illegal transaction, such as embezzlement, fraud, extortion, drug sales, etc., the “earnings” from the illegal activity are taxable as ordinary income. Section 61 taxes “all income from whatever source derived.”
Loans usually need to bear interest. The IRS mandates that certain interest rates be used for certain purposes under various sections of the tax code. Section 7872 provides that certain loans must bear a minimum rate of interest. Section 1274 establishes rates for installment sale obligations, and § 7872 utilizes the same rates for loans (although it does not allow the three month look back that is available for installment sales). If a loan or sale provides for an inadequate rate of interest, interest income will be imputed to the seller or lender. The rules differ depending on whether a loan is a demand loan or a term loan. A demand loan is required to have a rate at least equal to the applicable federal rate (AFR) of interest, and the interest rate is going to need to adjust each month if the AFR is increasing.
Life insurance benefits can be taxable. Usually the death benefits under an insurance policy are income tax free. However, if an insurance policy is transferred when it has policy loans that exceed the total amount of premiums paid, or if ownership of it is transferred to someone other than the insured or a partner or partnership of the insured or a corporation in which the insured is a shareholder, the death benefit may become taxable.
Be aware of litigation settlements that are based on taxable rather than non-taxable claims. Damages paid on account of physical personal injuries or sickness are tax-free, but damages for injuries to reputation or other “non-physical” injuries, including punitive damages, are taxable. Damages for emotional distress are non-taxable only if they can be shown to flow from physical injury or sickness. Settlement of actions involving multiple claims for relief should focus on the tort claims rather than the contract claims. Settlement documents sometimes include the preparation of an amended complaint, though the intent of the payor is more important than the intent of the payee, and thus an expression of intent in the settlement agreement is perhaps the most important step that can be taken.
Avoiding probate may cost more than it saves. Some attorneys encourage clients to make gifts or put a deed in the desk drawer or create a joint tenancy ownership interest in order to avoid probate. Arrangements that involve an inter vivos gift will not allow the asset to get a step-up in basis to the date of death value. Certain kinds of joint tenancies involve an inter vivos gift of half of the property, and certain other kinds of joint tenancies do not, even though in both cases there may be a right of survivorship.
The way a business is sold may have a significant tax impact. Businesses that are owned by a corporation could be sold in any of five classic ways, two of which are a straight sale by the shareholder(s) of 100% of the corporation’s stock, or sale of 100% of the assets by the corporation, and three of which involve merger arrangements. A sale of the corporate stock will trigger a single maximum 15% tax and the sale of corporate assets could trigger two taxes (maximum tax rates of 39% and 15% respectively).
Purchase price allocations can make a big difference. In sales of business assets by either corporate or non-corporate sellers, allocation of the sales price to various classes of assets can create significant differences in the tax results. The purchase price allocated to personal property may result in depreciation recapture ordinary income, allocation to real property likely will not result in depreciation recapture, and there are special rules depending upon whether property was in service prior to 1997, whether accelerated depreciation was taken, etc. A buyer can write off the cost of assets over 5, 15, or 39 years, or other time periods, depending on the nature of the asset. Allocations of price set forth in a purchase agreement will be honored by the IRS, at least to the extent the buyer and seller have somewhat adverse interests.
Your client who wants a corporation may not really want a corporation. Corporations have a double tax problem unless they make an “S” election, and liquidating a corporation is treated as a deemed sale of the assets at fair market value by the corporation. Operating businesses might be appropriate “C” corporations, but capital-intensive businesses, especially those with real estate, may belong in a different type of entity.
Don’t assume an LLC is better than a corporation. An “S” corporation provides an artificial form of pass-through taxation that is intended to mimic true partnership taxation but which has approximately 20 income tax differences. For the most part, a pure partnership taxation regime is better. However, members of a member-managed LLC or members who are managers in a manager-managed LLC will face a payroll tax under § 1402(a) because they will be viewed to be the equivalent of general partners (1997 proposed regulations say so).
Don’t assume the establishment of a corporation or a partnership/LLC will be non-taxable. Transfers of property to a partnership or to a corporation could be taxable as deemed sales. Transfers of appreciated or debt-encumbered property to a business entity could trigger a tax. If the transfer is to a corporation, under § 351 the transferors must have 80% control following the transfer in order to avoid having the transfer be treated as if it were a sale. If the transfer of assets is to a partnership or LLC, gain might be recognized to the extent the contributing partner is deemed to be relieved of an indebtedness which exceeds the contributing partner’s basis under § 751. If excess marketable securities are transferred to a partnership/LLC, certain anti-diversification rules will trigger adverse tax consequences unless the partnership/LLC can qualify as an “investment partnership.”
Transferring assets out of a corporation or partnership/LLC may be taxable. Property transferred from a corporation is presumed to be a dividend unless it is a liquidating distribution (also taxable). Transfers of assets out of a partnership are normally tax-free, unless the partner is receiving “money” in excess of the partner’s basis in his partnership interest. For purposes of determining if a withdrawal from a partnership/LLC is taxable, “money” is defined to include relief from indebtedness and to include marketable securities.
Some property divisions may be taxed as alimony. Under current law, divisions or transfers of property between ex-spouses incident to a divorced or separation are not sales and the basis of the assets carries over to the recipient. Payments of alimony are taxable income to the recipient and deductible by the payor. In order for a payment to be treated as alimony, it must (1) be a cash payment, (2) it must be received by, or on behalf of, a spouse or former spouse under a divorce or separation instrument, (3) the divorce or separation instrument must not designate the payment as a payment that is not includible in the payee's gross income under §71 and not deductible by the payor under §215, (4) the payor and payee must not be members of the same household when the payment is made, and (5) there must be no liability to make any payment for any period after the death of the payee. Therefore, beware of opposing counsel’s suggestion that the periodic cash “property division” payments terminate at the death of your client simply because the parties both have the same set of heirs.
There are many other situations where a little bit of tax knowledge might avoid some unwanted questions from a client later (“Why didn’t you warn me about . . .”). As with virtually all other elements of the practice of law, tax issues usually don’t present themselves because a client asks the right questions; rather, the lawyer needs to be able to diagnose the situation and provide the right answers.
Thomas N. Long is a 1972 graduate of the University of Wyoming and received his J.D. from Harvard Law School in 1976. He is the senior partner of a five-lawyer firm in Cheyenne, and is a fellow of the American College of Tax Counsel and the American College of Trust and Estate Counsel.
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