New York State Bar Association Continuing Legal Education Fall Accounting

New York State Bar Association Continuing Legal Education Fall 2008 Accounting and Other Differences Among Business Entities ◊ Business and Family Entities: What the Divorce Lawyer Must Know Presented By: John R. Johnson, CPA/ABV/CFF, CBA, DABFA Managing Partner BST Valuation & Litigation Advisors, LLC www.BSTco.com 1 1 Organizational Structures Corporations Partnerships Sole Proprietorships 2 2 Corporations S-Corporations C-Corporations Professional Service Corporations 3 3 S-Corporations Pass-through entity – Federal income taxes not paid at the entity level – Shareholders declare pro-rata earnings on personal returns and – Pay taxes at personal rates NYS imposes minimum franchise tax Restrictions 4 4 S-Corporations Restrictions – Number of shareholders – Shareholder eligibility – Only 1 class of stock 5 5 S-Corporations Tax-impacting Income Stream – IRS says “no” • Gross v. Commissioner • Estate of Heck v. Commissioner – Valuation professionals says “yes” • Must consider fair market value standard • A company is not worth significantly more simply because it elects Subchapter S status – Compromise is evolving 6 6 C-Corporations Federal, State and Local income taxes paid at the entity level Graduated tax rates based on income for majority of C-corporations Personal Service Corporations (PCs) subject to flat tax rate 7 7 2007 Corporate Federal Tax Rates Taxable Income Over: $0 50,000 75,000 100,000 335,000 10,000,000 15,000,000 18,333,333 But Not Over: $ 50,000 75,000 100,000 335,000 10,000,000 15,000,000 18,333,333 Tax Rate 15% 25% 34% 39% 34% 35% 38% 35% • Personal service corporations are subject to a flat Federal tax rate of 35%, regardless of their income. • Plus applicable State and Local taxes. 8 8 Corporations Built-in gains (“BIG”) tax – If FMV of an asset exceeds its tax basis – S-corporation shareholder pay one tax on the sale • !0 Yr. Holding Period following elections – C-corporation shareholders taxed twice -- at corporate level & at shareholder level 9 9 Corporations Built-in gains (“BIG”) tax – court decisions – Estate of Dunn, 301 F.3d 330 (5th Cir. 2002) – General Utilities v. Helvering, 296 U.S. 200 (1935) – Learner v. Commissioner, TC Memo 1983-122 (1983) – Eisenberg v. Commissions of Internal Revenue, 155 F.3d 50, 54 (2nd Cir. 1998) – Ward v. Commissioner, 87 T.C. 78 (1986) – Wechsler v. Wechsler, NYS Supreme Court 10 st Dept (NYLJ Pg 18 10/27/08) 10 Appellate Div. 1 What Wechsler Says and What it Doesn’t What it Doesn’t say: –That assets should always be fully tax impacted at the relevant valuation date 11 11 What Wechsler Says and What it Doesn’t What it Does say: – “This appeal, however, does not require us to reach a conclusion about which of the two approaches is preferable with respect to the issue of embedded taxes” – “…we find on that as and between the competing methodologies advanced by the parties at trial, under all of the factual circumstances of this case, the Supreme Court should have adopted the one accepted by the Fifth Circuit in Dunn” 12 12 What Wechsler Says and What it Doesn’t What it Does say: – “uncertainty concerning future events should not bar attempts to assign value to an asset” – In many jurisdictions, capital gains taxes are not considered in matrimonial cases “unless a sale is imminent” (citing Shannon Pratt) – However “This is not to suggest that the Court of Appeals thereby has ruled that judges in matrimonial actions never may conclude that a future event is too fraught with uncertainties to be grappled with and taken into account”. 13 13 In Summary The decision to tax impact should be based on the facts and circumstances of each case respecting the discretion of the trier of fact in the determination of whether taxes are appropriate or too speculative given the probability and timing of the taxes and the sale of the asset or need to sell to effectuate E.D. The decision of the Appellate Court was limited to the record and the testimony of the trial experts at trial. The Court could not explore other options. Read the dissent 14 14 Corporations Discounts for Lack of Control/Marketability – DLOC same for S-corporations & C-corporations – DLOM same, except: • Unfavorable economics of paying tax on nondistributed income considered for S-corporations • Lower discount depending on treatment of BIG tax 15 15 Partnerships General Partnership Limited Partnership Family Limited Partnership Limited Liability Company 16 16 Partnerships Advantages over Corporation – Owners are not employees (receive K-1 not W-2) – Year-end bonuses can be after December 31 – Profit sharing and capital percentages can change – Multiple classes of ownership allowed (unlike S-corporation 17 17 Partnerships Taxes – No income taxes at entity level (except LLCs can elect to be taxed as a corporation) – Pass-through entity • Federal income taxes not paid at the entity level • Shareholders declare pro-rata earnings on personal returns and • Pay taxes at personal rates 18 18 Partnerships Tax-impacting for valuation purposes – IRS says “no” • Gross v. Commissioner • Estate of Heck v. Commissioner – Valuation professionals says “yes” • A partnership or LLC should not be worth 35%-40% more than a C-corporation • Earnings base should match capitalization rate or income multiplier 19 19 Partnerships Built-in gains (“BIG”) tax – Can avoid potential double tax liability – 754 election provides step-up basis thereby decreasing the recognizable gain 20 20 Partnerships Discounts for Lack of Control/Marketability – Similar to S-corporations – High discounts can be created by nuanced and restrictive limited partnership agreements 21 21 Sole Proprietorships & DBAs Owners are not employees (do not receive W-2) Can be single member LLCs Income/expenses reported on Schedule C of owner’s personal income tax return 22 22 Sole Proprietorships & DBAs Taxed at owner’s personal tax rate Self-employment tax on earnings over $400 Net income not reduced by owner’s retirement plan contributions or health insurance premiums 23 23 2007 Single Federal Tax Rates Over $0 7,825 31,850 77,100 160,850 349,700 But Not Over: $ 7,825 31,850 77,100 160,850 349,700 Tax Payment $0 782.50 4,386.25 15,698.75 39,148.75 % on Excess 10% 15% 25% 28% 33% 35% Of the Amount Over $0 7,825 31,850 77,100 160,850 349,700 24 24 - 101,469.25 Sole Proprietorships & DBAs Discounts for Lack of Control – Not applicable since owner has 100% control Discounts for Lack of Marketability (2 schools of thought) – Small discount to account for transaction costs & time on the market – Discount mitigated since owner has control and is enjoying the cash flow during the holding period 25 25 following decision to sell How to Read a Tax Return in Establishing True Economic Income &/or Business Value 26 26 Form 1120S U.S. Income Tax Return for an S-Corporation 27 27 28 28 Turn to Page 192 of the Materials 29 29 1-A 1 2 1-A 1 3 30 30 4 5 31 31 6 7 23 8 9 18 24 10 11 12 13 & 25 30 32 32 Absolute Guarantee That The Tax Return is True and Error Free “Under penalties of perjury, I declare that I have examined this return, including accompanying schedules and statements, and to the best of my knowledge and belief, it is true, correct, and complete. Declaration of preparer (other than taxpayer) is based on all information of which preparer has any knowledge.” 33 33 14 15 15 34 34 35 35 16 16 36 36 17 37 37 Accounting Methods Cash – Revenue recognized when received; expenses when paid, regardless of when earned or incurred (easy to manipulate income). – Unrealized assets and liabilities not recorded on books. 38 38 Accounting Methods Accrual – Revenue recognized when earned; expenses when incurred, regardless of when received or paid (less opportunity to manipulate). – Assets and liabilities recorded when acquired or incurred. 39 39 Accounting Methods Other – Some combination or modification of cash or accrual methods. 40 40 18 18 19 41 41 20 20 42 42 43 43 44 44 22 23 16 22 23 16 24 24 10 10 24 24 27 27 45 45 20 26 25 46 46 26 26 26 47 47 28 10 26 29 48 48 Form 1065 U.S. Return of Partnership Income 49 49 50 50 17 3 51 51 4 5 52 52 7 6 8 23 9 10 11 12 13 & 25 30 15 15 53 53 54 54 16 16 55 55 32 56 56 57 57 20 20 6 20 20 10 58 58 59 59 21 60 60 22 23 16 22 23 16 10 10 24 21 24 21 61 61 20 26 25 21 26 21 62 62 63 63 28 26 11 12 29 64 64 THANK YOU FOR YOUR ATTENTION !! 65 65