The entrepreneur and founder stock that can eliminate tax – but needs advanced planning and an eye on the news from DC

Here in Michigan, the LLC is a popular choice for new businesses.  I’ve seen companies ranging from new STEM startups, to the new venture created by experienced industry veterans, use this flexible, cost efficient entity choice and never look back.  In general, tax-wise, if the LLC is taxed as a partnership, then income and loss passes through the entity directly to its owners and the dreaded C corporation “double taxation” (tax to the corporation on its income, then tax to its shareholders on distributions) is avoided.

The LLC/partnership tax treatment is frequently preferred by founders for tax efficiency during their ownership of the LLC.  However, when interests in a LLC are eventually sold, the selling members may experience taxable gain and tax liability as if they had sold any other asset that grew in value.

Unless those founders held their new venture in Section 1202 Qualified Small Business stock, which offers exclusions of up to 100% of capital gains upon eventual stock sale of IF a number of conditions are met.

First, just as there is no free lunch, there is no easy gain exclusion.  For Internal Revenue Code Section 1202 to apply, the company and founders must have met all of the tests set forth in the Internal Revenue Code (including (i) at least 80% of assets used in an active business (service businesses, hotels and some other types of business excluded), (ii) revenues not exceeding $50 million at the time stock was acquired, and (iii) taxpayer is not a corporation, and held stock for at least 5 years after acquisition) and Congress must continue to extend the capital gain exclusion (currently at 100% for stock acquired through 12/31/2014) – which may occur at the end of 2015 (not convenient for tax planning).

In a world of LLCs (often rightly chosen) there are some serial entrepreneurs who favor Section 1202.  Sure, it’s a balancing act between possible double taxation and gain exclusion on sale, and as we must wait every year for year-end tax extenders and patches from Congress, the availability of Section 1202 for 2015 and later years is uncertain.  However, for some founders and some circumstances, this may be an appropriate option.

Interested in Section 1202, but you’d like to own it through a LP or LLC?  Interested in buying Section 1202 stock, but the corporation has redeemed a significant chunk of its stock recently when other shareholders departed?   Consult a business tax professional ASAP, as Section 1202 offers great benefit along with great statutory detail and disqualifications that must be understood before money changes hands.  In some circumstances, though, it might be worth a look.

2015, Year of the Michigan Offer in Compromise

I’ve been involved in the State Bar of Michigan Taxation Section, in a committee or Council role, for a number of years, and throughout that time we’ve had a few recurring hot topics on the agenda.  One has been and continues to be Michigan tax reform (especially regarding the Tax Tribunal/Court of Claims filing and pre-payment rules), the other has been pursuing an Offer in Compromise process that would mirror the IRS program.

Why is it beneficial to have federal and state Offer in Compromise programs?

The Internal Revenue Service’s federal Offer in Compromise program allows taxpayers who meet certain criteria (one of the most critical is being up to date in filings and payments – if you haven’t filed several past years of Form 1040s, “no soup for you” until you come into compliance) the option of compromising (or settling) outstanding tax, penalty and interest if the taxpayer cannot pay or may legitimately argue that they are not liable for the tax debt, or, at the Service’s discretion, to advance administrative efficiency.  It is not an easy process or one that offers guarantees or bargains, but for qualifying taxpayers who can provide documentation and advance the required payment with application it can provide a fresh start and chance to get past crippling tax debt.

Effective 2015, thanks to nearly 10 years of hard work by former Section Chair Wayne Roberts and others, Michigan finally has a way for taxpayers to compromise (or settle) taxes.  Like the federal program, it is not a “get out of debt free” card – but it is better that the prior situation in Michigan where Treasury was barred from settling tax liability by statute.

Michigan’s OIC program may allow settlement and reduction of taxes in the following situation:

A doubt exists as to the liability based on evidence provided by the taxpayer.
A doubt exists as to the collectability of the tax due based on the taxpayer’s financial condition.
A federal offer-in-compromise has been given for the same tax year(s).

Who does this benefit?  Anyone who has a good argument that they are not liable legally for the tax, anyone who cannot pay without incurring serious financial harm, or anyone who has already compromised federal taxes due to lack of liability or ability to pay.  These beneficiaries can be anyone from owners of defunct businesses (where the business left tax debts) to working families of any economic class facing an extraordinary tax liability that is threatening to pull family finances under.

Michigan’s OIC program won’t be easy, immediate, or a “get out of debt free” card but in the right circumstances it – and the federal OIC program for federal tax debt – may be worth pursuing.  Since we live in a “you get what you pay for” world, in complex situations, taxpayers will most likely do themselves favors by contacting real, live tax attorneys and accountants who can provide individual attention and solutions instead of tax resolution companies that rely on TV advertising and promise enormous discounts for minimal client costs.  When in doubt ask for an estimate of fees and interview a few professionals before you commit.

Dealing with an Out of State Series LLC? Don’t Go Alone.

If you are in Michigan and evaluating an investment, transaction or other dealing with a Series LLC in another state, you may be wondering “what is this thing?”  Which is an excellent question, since the “Series LLC” form is not available under Michigan law, and is unfamiliar to Michigan business people (and many attorneys and accountants too).

I have an answer and a piece of advice – don’t assume the Series LLC is the same as the LLC you already know and love and proceed accordingly.  This little-understood, new and unusual entity form is one to run past an experienced tax and LLC attorney BEFORE you commit assets or funds.

A good botanical or culinary analogy for the Series LLC is a pomegranate.  There is the overall structure of the fruit, a large globe enclosing seeds within external rind, and then there are numerous internal seeds, each separate and contained within its own wall.  Similarly, the Series LLC as permitted in Delaware and 11 other states consists of a LLC (the overall, external structure) that has established one or more series (the separate, internal structures – analogous to internal subsidiaries).   The Series LLC may have one series or 100, with each internal series owning its own assets, bearing its own liabilities, having limited liability against the containing or “parent” LLC and also every other sibling series, and with its own members and managers.

Ideally, under the laws of the state of Series LLC formation, each series or cell has its own operations and limited liability.  But tremendous uncertainty exists in all 50 states on this new, not-widely-used entity form – what about fraudulent conveyances between series?  What are a creditor’s rights when the debtor series is broke but its “siblings” have assets (perhaps by design)?  How will the federal Bankruptcy Act and Article 9 of the UCC (Secured Transactions) address Series LLCs?  Will the IRS continue to treat each series as a separate entity for choice of tax treatment under Proposed Regulations, and how will the Service trust fund and other tax liabilities of only one series (when siblings have assets and perhaps common management) in the future?

At this time, answers are unknown, and the National Conference of Commissioners on Uniform State Laws (NCCUSL, the people who give us Model Acts for LLCs, partnerships and state level commercial codes) is beginning work on a Model Series LLC Act.  One of the NCCUSL’s first questions to address regards what benefit, at all, the Series LLC presents (guesses involve saving incorporation and franchise fees in states that impose franchise fees, and Michigan is not one).  If the drafters of model state laws have to ask why we need Series LLCs at all, and bankruptcy and other federal legal treatment are uncertain – as well as treatment under Michigan law – then proceed with caution and ask for advice before you sign a contract or transmit wealth.


That’s a Human Problem, Not a Legal Problem (But a Trusted Advisor Can Still Help)

Any reader of legal news or recipient of business advertising will see coverage, and ads, touting low cost, DIY legal document sites. “Why pay more to fill out a form?”  Yes, there are forms to be filled out in the world, but there are even more nuanced, personalized, customized situations and solutions where a living and breathing attorney (not outsourced to a data site on another continent) can provide value.  Human issues that can be helped by legal solutions require a human who can respond in the moment, these especially are not best left to a “why pay more?” solution.

I see two general types of issues in my tax and business law practice – the technical legal issue and the human issue.  Both can be addressed, and very likely resolved or improved, by an experienced attorney.

Technical legal issues may or may not be easier, but usually either have a clear answer, or a clear view of where authority ends and business judgment or risk taking is required.  We can find these answers and provide guidance on a facts and circumstances, client by client basis.

  • For example, a shareholder in a S corporation has died intestate – what are the rules for protecting the corporation’s S election?
  • The founder of a LLC wants to restrict voting rights for minority owners who didn’t contribute money or other property – what are the LLC Act rules, and the drafting options, to strike the right balance of rights and powers?
  • The IRS thinks that a deduction is not a legitimate business expense – what are the arguments and precedents to establish that the taxpayer had an ordinary and necessary need for the expense?

Then there are the human issues, which can be much bigger, and much more material to a business’s success or failure.  These require all of the human attorney’s skills and responses to hear, see, process and respond to vulnerable human clients in real time.

  • The new business partners who realize, after forming an entity and contributing property and services, that their values, goals and intentions are misaligned after all and they don’t want to go forward.  A LLC Operating Agreement that has competently covered withdrawal, tie breaking or dissolution, and a patient advisor, can smooth or assist with things here.
  • A manufacturing company desiring to negotiate around onerous purchase order terms and conditions issued by an OEM customer, but then someone at a plant who wasn’t aware of the pending negotiations accepts the onerous T&Cs automatically.  A review of the breadth and reasonability of the T&Cs and acceptance may shed light on solutions and possible strategies for negotiation, termination or limiting work to certain plants or operating entities.
  • Fairness issues and wounded feelings when some members of a LLC contribute property and others critical services.  What does each camp really want?  It isn’t always more ownership percentage or more voting power.  Most answers are possible and can be documented properly.

Don’t be afraid to contact an attorney with a human issue – disappointment, broken promises, mistakes.  There are often legal solutions, improvements or alternatives available that can’t be dispensed automatically from a machine.

That’s not a hobby, that’s my creative career! What about my deductions?

Federal tax law is like an onion, or an opened golf ball, with a hard core and multiple layers building outward.  Which reminds me of the great Roy Blount Jr. poem “Song to Onions” (link here), speaking of unpeeling and unraveling things.

The hard core or kernel of tax law is – “all income is taxable, all expenses nondeductible, unless there is an exemption or exception.”  Typically, most income is taxable, but expenses connected to a trade or business are deductible under IRC Section 162 (the “ordinary and necessary business expense” section) – one of the most valuable provisions of the Code for business people.

However, in the eyes of the Service, a “hobby” is not a “business” for the purposes of Section 162 and Section 183 treats deductibility of hobby expenses and losses much more severely.

What’s a hobby?  Per the IRC, an “activity not entered into for profit,” in classic cases often a successful, wealthy taxpayer’s casual entry into a pursuit that brings pleasure, such as horse breeding, done without the rigor, expertise and organization brought to the taxpayer’s prior wealth-producing line of work.  A “hobby” may fail to earn income in excess of deductions for 3 or more of the immediately prior 5 years.  Facts and circumstances determine hobby versus trade/business characterization, so each case may be taxpayer-specific.

Which brings us to the latest pro-taxpayer, pro-artist USTC case, Susan Crile v Commissioner (opinion here). Susan Crile is an accomplished fine artist and art professor who earns a good wage from her teaching job at Hunter College, and periodic revenue from sales of her fine art work through galleries.  By all accounts Crile treated her fine art career as a true trade or business, pursuing it in a methodical, professional manner, with field-appropriate advisors an a genuine (though long-term) profit motive.  The Service surprisingly sought, and litigated, to treat Crile’s fine art career as a Section 183 “hobby,” and lost at the US Tax Court where Judge Lauber repeatedly smacked down the Service’s arguments and held that Crile was pursuing a trade or business, for a profit motive, and entitled to treatment as a businessperson rather than hobbiest.

The moral of the story?  In a creative career, or a highly speculative one where the payoff, if one comes, will be significant (e.g., oil wildcatting), believed to be and operated as a trade or business, there is hope of prevailing against the Service.  What are best practices in the taxpayer’s creative or speculative field?  Does the taxpayer keep documents and receipts?  Have professional advisors?  Do the necessary but mundane grunt work?  Facts and circumstances can win a case, or lose one, and each case is unique.

Predictive Coding in the US Tax Court – The 21st Century Meets Tax

When business writers and commentators talk about future-focused and innovative industries, they don’t tend to put law on the list.  Maybe on the “slower to change” list (examples of why include wigs in court (outside of the US), lace-up wingtips as office attire (in the US), and the ongoing unresolved discussion of what to do about the billable hour system).  There are people and places looking to bring law into an efficient, tech savvy 21st century (such as the Michigan State University College of Law’s Reinvent Law Laboratory) but law, especially tax law, tends towards traditional processes and structures.

However, in true case of first impression (and 21st Century impression), the United States Tax Court has authorized the use of predictive coding in replying to an IRS request for taxpayers to produce electronically stored information (ESI) contained on backup storage tapes.    USTC Opinion for Dynamo Holdings LP v. Commissioner, 143 T.C. No. 9 (Sept. 17, 2014) is  here.

The Commissioner and taxpayer ran into disagreement over how ESI would be sorted and produced based on the taxpayer’s estimation that it would “take many months and cost at least $450,000 to fulfill [the IRS request] because they would need to review each document on the tapes to identify what is responsive and then withhold privileged or confidential information.”

Predictive coding is a computer-aided search and document review process that allows one or more parties to select search criteria (names, dates, other key words, etc.) from sample representative documents and then search larger data fields for patterns of potential relevance. The taxpayer in Dynamo Holdings believed that use of predictive coding would allow it to respond to the IRS at a cost substantially less than $450,000 and without inadvertent disclosure of confidential information.

The Tax Court, in light of its mandate to construe its Rules “to secure the just, speedy, and inexpensive determination of every case” considered the taxpayer’s request to use predictive coding “to efficiently and economically identify the non-privileged [responsive] information” and permitted it, finding a “potential happy medium” in the use of this new “form of computer-assisted review that allows parties in litigation to avoid the time and costs associated with the traditional, manual review of large volumes of documents.”

While this is one opinion, the USTC’s recognition of the technical and efficiency value of predictive coding is big news in and of itself.  Maybe not to tax law, but to efficient and modern practice of law in a time where clients want faster, cheaper, better service.

What May Qualify as a 501(c)(3) charity? A Medical Marijuana business?

While I generally work with mature companies in traditional fields (services, manufacturing, construction, pharmaceuticals), I occasionally receive phone calls from individuals I’ve not worked with before, referred to me by another professional, with fresh new questions.  A new question came last week – can a medical marijuana business that is legal under relevant state law qualify as a federally exempt charity under IRC Section 501(c)(3)?  I presume that the desire to operate as a nonprofit comes from the desire to avoid IRC Section 280E, which penalizes businesses “trafficking in controlled substances” by denying them deductions and credits.

I did not know the answer off-hand, but had two immediate thoughts – (1) isn’t pot still covered, federally, by the Controlled Substances Act? and (2) I don’t see the IRS getting behind granting the most valuable form of tax exempt status (valuable because (i) the nonprofit is exempt from tax and (ii) donors may take deductions from their taxes) to an activity that is not federally legal.

My hunch was correct – quick research produced several PLRs (IRS Private Letter Rulings) explaining why medical marijuana clinics could not qualify for IRC 501(c)(3) status due to the federal “illegal” status of the drug under the Controlled Substances Act and the public policy implications of permitting “charity” and donation deduction status to a disfavored activity.   My Walsh College colleague Professor Dan Hoops has written on the CSA and marijuana businesses in other contexts (again, the CSA is not “facilitating” the spread and profitability of this business).  Paper here.  A law professor at American University Washington College of Law suggests that IRC 501(c)(4) “social welfare organization” status may be available instead, or at least not barred under public policy grounds. I have not tested this concept. Paper here.

This is not an issue that is practically applicable to most taxpayers or clients, but it is a good example of what I like best about tax law – a novel question, a payoff for those who like deep dives into research, and a public policy angle.  It’s a living subject and an ever-changing body of law with some clear answers and thousands of gray areas.  And while the answer of “If you want to have your farm or clinic receive 501(c)(3) status you have a battle ahead of you that others have lost” may not have been the desired one, it’s better to ask first (or at least ask early).