Entrepreneur Rollover Stock Purchase Plans

Financing a business start-up can be a challenge. Most traditional lenders require that a business be operational for at least a year before they will provide small business loans. Moreover, venture capitalists are quick to reject most start-up proposals and if the venture capitalist is willing to fund the start-up they typically demand a significant ownership stake in the business. This has caused many entrepreneurs to look for alternative means for financing business start-ups. The entrepreneur rollover stock purchase (ERSOP) plan is one such financing alternative.

The idea behind the ERSOP is to use the entrepreneur’s 401(k), IRA, or other qualified plans to fund the start-up. The ERSOP process looks something like this: establish a legal entity; get a taxpayer identification number and checking account for the entity; set up a trust and get a taxpayer identification number and a checking account for the trust; (hopefully) get a determination letter from the IRS specifying that the trust qualifies as an everyday employee stock option purchase plan (ESOP); roll the entrepreneur’s retirement accounts over to the trust checking account and then to the entity checking account; the entity transfers entity stock into the trust. At that point the money is in the business checking account and the business stock is in the ESOP.

Most transactions such as this are disseminated via financial planners or via the large accounting firms; however, it appears that very few of those advisors are actively recommending the ERSOP. Instead the ERSOP seems to be being pushed by the professionals who help facilitate the transfer of franchise businesses. There are a number of businesses on the internet that claim to specalize in handling these types of transactions (see, e.g., http://www.ERSOP.com).

The main problem with the ERSOP is that it involves pulling money out of retirement accounts to fund speculative business ventures. This is a particularly risky undertaking given today’s diminishing government safety net and increasing government regulation.

Other problems involve violating the self-dealing rules required for ESOPs, volunteering for additional accounting and compliance requirements and costs, limiting future business structuring by creating a near permanent stock ownership arrangement, possibly limiting the entrepreneurs’ rights if the business goes under or if the entrepreneur wants to sell the business in the future, and placing the business in a vulnerable position with respect to future changes in the law.

While these drawbacks will probably preclude the use of an ERSOP in most cases, this does not mean that the ERSOP would never be appropriate. A client who is going to start a business using other risky financing methods (such as taking on credit card debt), who is fully advised of the consequences and requirements, and who is fully willing to comply with the requirements and willing to take the risk might be a viable candidate for the ERSOP. The ERSOP may be particularly attractive for clients who have significant wealth that is held outside of their retirement accounts, but it is currently illiquid.

A tight money supply and tougher underwriting mandates from Congress will probably help fuel the popularity of ERSOPs and other alternative financing arrangements in the near future. However, long-term, ERSOPs will probably be legislated out of existence or will continue to be passed up for simpler financing alternatives.

November 26th, 2005 | No Comments »

Basic Estate Administration and Taxes: Elections & Timing

This post is written to remind non-tax attorneys who administer estates of a few basic tax issues that must be considered in administering estates. From a tax perspective, estate administration is all about making elections and timing distributions, income and expenses.

The first group of elections involves selecting tax years. IRC § 441 defines a taxpayers “taxable year” as the taxpayer’s annual accounting period that may be a calendar year or a fiscal year. IRC § 441(e) defines a “fiscal year” as any period of 12 months ending other than in the month of December. IRC § 441(d) defines a “calendar year” as a tax year as ending in December. The second election that the estate attorney must consider is whether to elect a “short period.” With some exceptions, IRC §§ 443 and 7701(a)(1),(14) provides that a “short period” is a period of less than 12 months. These elections essentially allow the estate attorney to terminate the tax year when it will result in the least amount of tax.

The second group of elections involves timing the receipt of income and flow through and allocation of tax attributes. Most states have adopted some version of the Uniform Principal and Income Act, which allows the fiduciary to elect to elect to allocate capital gains to principal. Similarly, Treas. Reg. § 1.643(a)-3(b)(1) permits the fiduciary to treat certain capital gain receipts as income for trust accounting purposes, IRC § 663(b)(2) permits the fiduciary to elect to treat certain distributions as having been made during the prior year, IRC § 645 permits the fiduciary to treat a revocable trust as part of the estate, IRC § 642(g) permits the fiduciary to elect to deduct administrative expenses, and IRC § 643(g) permits the fiduciary to treat estimated tax payers as made by beneficiaries.

There are a number of other decisions that fiduciaries must make that are not elections per say, but are in essence elections. For example, fiduciaries are often able to time distributions, to make distributions under residuary clauses versus specific distribution clauses in wills, to make in-kind distributions in lieu of specific distributions, and to allocate deductions and expenses to certain beneficiaries or property.

This combination of elections presents fiduciaries administering estates with a number of planning opportunities. For example, the fiduciary may elect a short fiscal year for the first tax year and then have the estate terminate and deductions or other tax attributes flow through to the heirs’ tax returns in the second tax year. This is possible because IRC § 642(h) specifically provides that certain carryovers and excess deductions pass through to the beneficiaries if they arise in the year that the estate is terminated. This can be particularly useful where the estate is entitled to significant depreciation or depletion deductions, which would otherwise be lost because the estate had deductions in excess of income. Similarly, in other cases these flexible election rules may permit the fiduciary to time distributions so that the heirs receive distributions and expenses in years where the heirs have other offsetting tax attributes or income.

Of course, tax minimization is often not the main consideration in administering an estate. However, the rules sufficiently flexible and present the fiduciary with a number of tax minimization opportunities. Fiduciaries administering estates should not inadvertently pass up these tax minimization opportunities.

November 19th, 2005 | No Comments »

Sometimes It is Best Not to NIMCRUT

The best laid tax plans often go awry as tax laws and life circumstances change. In other cases tax plans go awry because they were improperly conceived. I have been encountering a number of NIMCRUTs that should not have been undertaken.

The NIMCRUT, otherwise known as the net income with makeup charitable remainder unitrust, is a charitable trust that requires the less of a fixed percentage of the income (minimum 5%) or the actual earnings be distributed to the donor or other non-charitable beneficiary annually. Upon the demise of the donor or non-charitable beneficiary or the expiration of a set period (not to exceed 20 years), the trust assets are distributed outright to the named charity. Taxpayers typically establish NIMCRUTs in order to provide a current income tax deduction, to convert appreciated assets to income-producing assets, and to fulfill charitable inclinations.

NIMCRUTs often hold a variety of assets. The idea is typically to invest in growth assets during the donor’s accumulation years and then sell the assets and/or invest in income assets during the donor’s retirement years or when the donor wants to receive income. This allows the trust to have little or no income during the donor’s accumulation years, resulting in little or no trust distributions during those years. When the donor begins receiving income they are able to receive the amount stated in the trust plus an additional amount to make up for the under performing years. This can allow prolonged tax-free build up, current income tax deductions and a steady stream of income when the donor desires. This timing is most often achieved by investing in zero coupon bonds, partnerships or LLCs, or even variable annuity contracts. The partnership, LLC, and variable annuity contract options allow the trustee to turn the investment income on and off at will, which allows the trustee to most effectively make distributions when most appropriate for the donor.

Remember that most NIMCRUTs are established with appreciated property, which when sold by the trust does not result in capital gain for income tax purposes. Thus, the gain is typically appreciation that occurred before the trust was established. The Regulations prohibit such gain from being allocated to trust income, regardless of whether the state allows the trustee to allocate the gain from trust principal to trust income. Consequently, even though it is simplistic, I encounter NIMCRUTs where there is almost no trust income or items that can be allocated to income and the term of the trust is set sufficiently short so that it is impossible to time the distributions in a way that benefits the donor, as would otherwise be the case.

If that is not bad enough I have encountered NIMCRUTs that invest in variable annuities, which result in ordinary income when they are paid out. In these instances the donor is giving up the option to pay a lower capital gains tax currently in exchange for tax deferral and a higher ordinary tax at a later time. This can be particularly problematic for older clients or for trusts with shorter maturities. This is even more problematic in that all of the annuity income in such situations is fully taxable, rather than it being partially taxable and partially a return of basis as when individuals own and receive annuity income. Again, while simplistic, I have encountered a number of clients is this situation.

The combination of a NIMCRUT and a variable annuity or partnership can be a powerful planning tool; however, advisors must run the numbers before making such a recommendation.

November 13th, 2005 | No Comments »

Will the Gay and Lesbian Marital Rights Debate Come to the Tax Policy Arena?

It appears that the States have effectively shut down recent attempts by gays and lesbians to achieve full marital equality. However, this does not appear to be the end of this issue and it leaves me wondering if gay and lesbian rights advocates might try their case in the tax policy arena. This raises questions as to what this type of case would involve and what the implications would be if the case were successful.

Most likely the case would involve gay or lesbian partners filing a single tax return as married filing jointly or partners filing separate tax returns with the married filing separate status. Undoubtedly the IRS would reject the returns as filed, noting that gay and lesbian partners do not qualify as married under the state law. The gay or lesbian partners could then challenge the IRS position, likely by making an equal protection argument. The IRS would counter by arguing that Congresses has the Constitutional power to lay and collect taxes and that Congress has deferred to the state’s definition of marriage for tax purposes. So the ultimate question would be whether in this case the Congressional power to lay and collect taxes would trump an equal protection argument. Given Congressional deferral to state law to define marriage, it seems like an equal protection argument would triumph. So the question is then whether in this situation gay and lesbian partners could make a successful equal protection argument.

Essentially the gay or lesbian taxpayer would be arguing that Internal Revenue Code Section 6013 and other Code sections and administrative regulations and rulings and state laws treat gay and lesbian partners different than non-homosexual spouses even though the two groups are similarly situated. Moreover, the gay or lesbian partner would be arguing that state law definitions of marriage should not shape our federal tax law. There is some precedent for this type of argument in our tax law. For example, it has long been held that state law determines the nature of property rights, but federal law determines how that property is taxed. For a more specific example, state law grants individuals property rights for trusts that are created under state law, yet federal tax law (IRC Sections 671 through 677) determines which taxpayer actually owns the property for federal income, gift, and estate tax purposes. So state law may say that a specific person owns the property in the trust, but federal tax law may say that someone else may in fact own it for purposes of federal tax law. Applying this reasoning, the gay and lesbian partner would in essence be arguing that state law definitions of marriage can define marriage, but federal law should determine how married and unmarried taxpayers are taxed under our federal income, gift and estate tax laws.

Who knows if the Court would buy into this argument. However, it should be noted that the Court has struck down legislation where the Court found that the legislation was motivated by “animus” or “hostility” towards politically unpopular groups. For example, in Romer v. Evans, the Court struck down a Colorado constitutional amendment that would have prevented the state or any of its cities from giving certain protections to gays or lesbians. Essentially the Court held that the amendment had no legitimate government interest and the government interest being served and the means chosen by the government were not rationally related to the interest that the government asserted. This is the least restrictive analysis that the Court employs, so even if the Court applied this analysis to the case there would be a good chance that the gay or lesbian partner’s argument would be successful.

If this argument were successful then Congress would be in the position of having to simply allow gay and lesbian partners to enjoy married filing jointly status or amend the Internal Revenue Code. The big picture implication would be that gay and lesbian couples could combine their items of gain and loss and they would qualify for the more favorable tax rates and other tax benefits. Similarly such a change would have sweeping implications for all of the tax provisions that favor married couples, including health, retirement, insurance, and other provisions.

The administrative problem for the IRS would be the increased number of persons who the IRS would essentially have to treat as married under common law. Common law marriage, which is allowed in a number of states, affords taxpayers who can qualify as such with a number of tax planning opportunities (and a number of tax pitfalls). For example, a taxpayer who survives the demise of an unmarried partner that lives in one of these states is often able minimize or avoid the federal estate tax by arguing that he or she was in fact common law married (and therefore, qualifies for the unlimited marital deduction). Similarly, the IRS would have to address innocent spouse claims made by unmarried gay and lesbian partners and the IRS would have to deal with cases where unmarried gay and lesbian partners dispute who is entitled to the head of household exemption and other deductions and credits.

Such a challenge is not improbable and if successful it would force a number of tax code changes. This type of federal recognition of gay and lesbian rights would invariably further gay and lesbian rights and eventually it could even lead to full gay and lesbian marital equality.

October 23rd, 2005 | No Comments »

Can the IRS be Friendlier and More Efficient at the Same Time?

The Treasury has been working on stepping up its exam and collections efforts. As a result the IRS appears to be moving back its pre-Revenue Restructuring Act (RRA) of 1998 posture, which was enacted as a result of numerous IRS abuses. Yet, the IRS is still bound by the RRA. Are we asking too much of the IRS to be more efficient and friendlier at the same time? Is that possible? If so, how?

The short answers are that we are not asking too much and it is possible. Now, for the most part, IRS personnel are friendly. However, all that means is that they are a little more polite and they may even smile when they make false statements (citing notes of conversations that did not occur), make intentionally deceptive statements (purporting to state the law by reading a document aloud while intentionally skipping over the part that is helpful for clients, implying that the part that was read was all there was – even though the listener had copy of the exact same document in front of them), and flat out stating that they will not consider a taxpayers case (even though the internal revenue code, treasury regulations, and the internal revenue manual require that they do so).

I often encounter honest and fair IRS personnel that carry out their duties with the utmost integrity. But I have also encountered an increasing number of abusive IRS employees as of late. The increasing frequency of these encounters is probably a result of the Bush administration giving the IRS the go-ahead to ramp up its exam and collection efforts, an action which probably stirred up anti-taxpayer sentiment in the IRS that was previously dormant.

Regardless of the cause, I have been getting the impression that taxpayers’ are becoming more and more frustrated by the IRS. In fact, anti-IRS sentiment seems to have been increasing so much as of late that many taxpayers have begun talking about taking alternative actions against IRS personnel, such as bringing various types of civil suits against IRS personnel and even taking steps to harm IRS personnel financially. For example there seems to be an increasing number of taxpayers who are filing frivolous liens and financing statements against IRS personnel. We saw this recently in US v. Stouder II, which involved a taxpayer who filed financing statements against two IRS employees in the amount of $300 million, in an effort to harm the IRS employees’ personal credit rating. The federal court declared the financing statements void; however, the IRS employees credit rating was probably harmed. The taxpayer probably achieved his aim.

I feel caught in the middle. Of course I would never counsel a taxpayer to file a frivolous or fraudulent document or case, nor would any other tax attorney that I know. It is wrong. Taxpayers who file such cases should be subject to sanctions. However, taxpayers should have some more effective means of redressing grievances against abusive IRS personnel. We already have laws on the books that deal with these types of acts, yet this cat-and-mouse game continues. This game harms the IRS’s image, it hinders the collections of tax revenues, and it is a wasteful use of limited resources.

If there is to be some improvement it must start with the IRS. The IRS must admit that there is a problem. IRS personnel at the highest and lowest levels must begin to discover and weed out abusive employees. Moreover, the IRS must begin to recruit and retain fair and honest employees. Of course this would probably entail paying higher wages and seeking higher qualified employees. These steps should be taken before the IRS increases its collections activities; otherwise we will see more and more IRS abuses and taxpayers pursuing alternative remedies – a tit for tat scenario similar to the one that prompted Congress to enact the friendlier-IRS RRA. In the end, honest taxpayers are the ones that are harmed by this game. Why should honest taxpayers be subject to an increasing frequency of IRS abuses (which may very well be a response to previous abusive actions by other taxpayers)? At this point it is not likely that the IRS is going to change voluntarily, so Congress should preemptively act to halt this wasteful game.

October 16th, 2005 | No Comments »

The Bankruptcy Abuse Prevention and Consumer Protection Act

For the most part the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 comes into full force on October 17, 2005. The Act contains a number of tax-related provisions, almost all of which are contradictory and unworkable. I will refrain from describing some of the more ridiculous non-tax provisions, instead focusing on some of the tax-related Congressional blunders contained in the Act.

First, the Bankruptcy Code now requires all debtors file either tax returns or tax transcripts shortly after seeking the protection of bankruptcy and to make those returns or transcripts available to the US Trustee and, upon request, to the creditors (the tax returns are then a matter of public record). The provision is mandatory. No exceptions are permitted. The penalty is dismissal of the bankruptcy case. That appears to make sense, unless you consider that not all taxpayers are required to file tax returns (in which case there would be no tax returns or tax transcripts).

For example, taxpayers are not required to file tax returns if their taxable income is less than the standard deduction plus the allowable exemption. Similarly, individuals and businesses located in certain territories and possessions, such as the Virgin Islands, are not required to file federal tax returns. So it now appears that those businesses and persons are now not entitled to seek the protection of our bankruptcy laws. Of course the provision is unconstitutional. Because of this Congressional blunder some unfortunate taxpayers will have to pay the costs of litigation to have a court make this ruling.

If that is not bad enough, it now takes the IRS over a month to provide taxpayers with copies of their tax returns or with tax transcripts. Yet, Congress required that the taxpayer present these documents in less than 30 days after commencing the bankruptcy case. How are taxpayers to do this, especially since more taxpayers are now going to be requesting tax returns and transcripts from the IRS? The answer is that Congress has created an opportunity for tax businesses to provide these transcripts sooner by their signing up to receive them electronically (i.e., yet another artificial and unnecessary government-created industry that reduces the efficiency of our markets). The result is that taxpayers will have to pay this fee instead of paying their creditors. Moreover, this rule begs the question as to what will happen in the cases where the IRS has lost the tax returns, there are no tax records entered in the IRS records sufficient to produce a tax transcript, but the IRS IMF file indicates that returns were filed? This scenario occurs quite often. For now, it appears that taxpayers in this situation will not be entitled to seek the relief of bankruptcy, so the IRS can conveniently lose records and prevent taxpayers from qualifying for bankruptcy relief.

Second, Congress failed to close several large bankruptcy-tax loopholes. For example, Congress failed to shutdown the ability of taxpayers to take out loans (which are dischargeable in bankruptcy) to pay off tax liabilities (that are not dischargeable in bankruptcy), with the intent of using the loan proceeds to pay off the tax liability. Taxpayers do this to minimize the amount of debt that they will owe after they emerge from bankruptcy. Congress did provide that a “debt relief agency” (FYI most bankruptcy attorneys will now be considered “debt relief agencies” when they are working with lower income taxpayers) can not now advise taxpayers about this option. Again, this provision is clearly unconstitutional (also, a bankruptcy attorney is subject to disbarment and/or malpractice if they do not fully advise their client). Even then, Congress did not prevent non-debt relief agencies (such as bankruptcy attorneys, who are individuals who help higher income taxpayers) from advising clients as to this loophole. So attorneys working with higher income taxpayers are still free to make this recommendation to higher income taxpayers (this even undermines the infamous means test that Congress devised to prevent higher income taxpayers from qualifying for bankruptcy relief). Moreover, attorneys and “debt relief agencies” are under a duty to provide taxpayers with copies of the law and in this instance handing the taxpayer a copy of the law would clearly tip off the client that they would benefit from taking the action that is proscribed in the rule. In essence the legislation points out the loophole to taxpayers. So Congress has done for debt relief agencies what the agencies could not do for themselves.

Third, Congress requires all taxpayers undergo and pay for budgeting and counseling in order to qualify for bankruptcy relief. The idea is that this will present the potential-bankrupt business or individual with an opportunity to hear non-bankruptcy options for dealing with debt. This is of little to no value in cases where the primary debt is a dischargeable tax liability, yet it is still mandatory. How is setting a budget going to help the taxpayer pay for an unpaid tax debt? Even if the counseling points out ways to avoid bankruptcy, why would the taxpayer want to pursue those options if the tax debt is fully dischargeable? This will create a new stream of income for credit counseling agencies, at the expense of the legitimate creditors.

Fourth, Congress changed the priority rules with respect to tax liabilities. In essence, the Bankruptcy Code provides that all of the taxpayers assets are to be added up and then applied to debts according to a priority list provided in the Bankruptcy Code. IRS tax liabilities are next to last on that list, which makes them payable before general unsecured creditors. This priority allows the IRS to collect most of all tax liabilities that are not otherwise dischargeable. Tax liabilities are not dischargeable if they are due to taxes for more recent tax years. Congress changed the Bankruptcy Code to extend this time period in accordance with any time period in which the IRS was not lawfully able to collect the tax debt, such as times during which a collection due process hearing request is pending or the case is before the Appeals Office pending placement on the Tax Court docket. So in essence this new provision now allows the IRS to delay processing such requests in order to make tax debts priority claims, rather than non-priority general unsecured claims (is it likely that the IRS would be accused of not acting timely?). The bottom line is that now the IRS should be able to, in bad-faith or by way of negligence, delay and make their claims superior to all other non-priority claims, taking money from the taxpayer at the expense of legitimate non-government creditors.

Fifth, Congress has prohibited debt relief agencies (i.e., bankruptcy attorneys who work with lower income taxpayers) from hiring a tax attorney to advise taxpayers on their tax obligations. The idea appears to be that attorneys should not be able to dissipate the bankruptcy assets unnecessarily by hiring other attorneys to work for the taxpayer (this is contradictory to Congresses requiring taxpayers dissipate assets to pay for unnecessary credit counseling and tax transcript fees). This rule fails to recognize that there are situations where hiring an attorney would increase the assets available to creditors, such as where the taxpayer needs to know whether they are required to pay tax on certain transactions. Thus, bankruptcy attorneys are no longer able to advise taxpayers to bring in a tax attorney when there is a tax issue that the bankruptcy attorney cannot answer, regardless of whether it is necessary and warranted. This rule can be really detrimental to taxpayers given that tax returns now must be filed (including some prior year tax returns) in order to qualify for bankruptcy relief. So the taxpayer will now have to tax positions on tax returns and taxable transactions without counsel and then they will be subject to non-dischargeable penalties and interest if they are incorrect.

These are just a few of the tax-related blunders created by the new Act. The non-tax issues are undoubtedly even more glaring and ridiculous. Almost every commentator that I have spoken with (including several judges) has stated that many of the provisions of the Act are clearly unconstitutional. The ensuing litigation is going to last for many years and will be very costly. Instead of focusing our efforts on making the country more productive and efficient, we are collectively going to spend a great deal of our national energies on correcting these Congressional blunders. Should we reduce our national GDP projections to account for this?

Even the most conservative of our citizens would disagree with most of the provisions in the new Act, if they were aware of the scope of the new law and how the new law will play out. Does this signal the failure of our democratic system - a system where the electorate does not listen to or care for the concerns of the citizenry? That post will follow….

October 8th, 2005 | No Comments »

Trust as the IRA Beneficiary

I continue to hear a number of financial planners, accountants and even attorneys say, “Don’t name a trust as the beneficiary of an IRA. ” The rationale is that naming individuals as the IRA beneficiary is preferable because the individual can take the IRA distributions over the course of the beneficiaries lifetime; whereas, a trust named as a beneficiary would require the beneficiary to take a lump sum distribution within five years of the IRA holders death. That was once true; however, the Treasury Regulations have since been amended, as evidenced by private letter ruling 2005-37-7044.

This ruling describes a “required minimum distribution conduit trust ” (RMD trust). RMD trust rules are somewhat involved, but essentially RMD trusts allow IRA proceeds to be held in trust for individual beneficiaries and the IRA funds can be maintained in trust for and paid out over the course of the beneficiaries lifetime. In general, these trusts involve two issues: (1) whose life expectancy IRA distributions are based on and (2) how the life expectancy is calculated when there are multiple beneficiaries.

The Treasury Regulations provide that the life expectancy of IRA distributions is based upon the beneficiary’s life expectancy. If there are multiple trust beneficiaries then the life expectancy is that of the oldest beneficiary. This can be disadvantageous for younger beneficiaries when there are also older trust beneficiaries (such as where a trust names the grandchildren and parents as beneficiaries). The Regulations and letter ruling address this inequity by providing that if the IRA proceeds are allocated to separate trusts with separate trust beneficiaries, the life expectancy for each individual beneficiary will be the life expectancy used for purposes of making distributions.

Skipping over the rest of the specifics, you might be wondering when these trusts might be useful or when they should be used. The short answer is that these trusts are useful when a significant portion of ones estate consists of an IRA (or IRAs), there are multiple beneficiaries who could benefit from stretching out IRA distributions for a long period of time, the beneficiaries will be likely to have taxable estates that are large enough to incur an estate tax liability, and/or one or more of the beneficiaries might have future creditor problems. In the later case, the trust can contain provisions granting the trustee the power to make distributions and a spendthrift provision. The net result is that IRAs can be stretched out for the maximum period allowed, income taxes are deferred for that period allowing maximum growth, the beneficiary does not increase their estate tax liability, and the IRA proceeds can continue to be a creditor-proof stream of income for beneficiaries.

RMD trusts are powerful estate planning tools. RDM trusts can solve a number of issues given the right circumstances. The bottom line: More advisers should be recommending RMD trusts, as opposed to saying that “trusts should not be named as IRA beneficiaries.”

October 1st, 2005 | No Comments »