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S Corporation At-Risk Rules

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Do you own interest in an S-Corporation (“S-Corp”)? If so, the IRS at-risk rules may apply to you and may limit the loss deductions you will be allowed to take. The IRS at-risk rules may also apply to partnerships, LLCs and closely-held C corporations (subject to certain exceptions), so they may be important to learn if you hold an interest in such entities.

This article will explain the basics of the at-risk rules in the context of S-Corps. It is not intended to provide tax or legal advice. S-Corp taxation can be a very complex area, so you may wish to seek the advice of a competent, experienced attorney. Sherayzen Law Office, Ltd. can assist you in all of your tax and legal needs.

A Taxpayer’s At-Risk Amount

In an S-Corp, the deductibility of a distributed loss may be determined by three separate limitations: (1) The shareholder’s adjusted basis of an interest, or the shareholder’s stock plus any loans made by the shareholder to the entity, (2) the at-risk rules, and (3) the passive activity rules. As noted, this article will cover the at-risk rules (the other limitations will be covered in future articles).

Under the Internal Revenue Code Section 465, a taxpayer is considered to be at-risk for an activity with respect to amounts including, “(A) the amount of money and the adjusted basis of other property contributed by the taxpayer to the activity, and (B) amounts borrowed with respect to such activity” to the extent that the taxpayer is, “(A) is personally liable for the repayment of such amounts, or (B) has pledged property, other than property used in such activity, as security for such borrowed amount [to the extent of the net fair market value of the taxpayer’s interest in such property].”

According to the IRS, any of the following activities for a trade or business that produce income will subject a taxpayer to the at-risk rules: “Holding, producing, or distributing motion picture films or video tapes. 2. Farming. 3. Leasing section 1245 property, including personal property and certain other tangible property that is depreciable or amortizable… 4. Exploring for, or exploiting, oil and gas. 5. Exploring for, or exploiting, geothermal deposits [for wells started after September 1978]. 6. Any other activity not included in (1) through (5) that is carried on as a trade or business or for the production of income.” Taxpayers will not be considered at-risk for amounts of nonrecourse financing that protects against losses, guarantees, and other related arrangements.

In general, the at-risk rules do not apply to the holding of real property placed in service before 1987 or to the holding of an interest in a pass-through entity acquired before 1987 that holds real property placed in service prior to 1987. Mineral property holdings, however, are not included in this exception.

Separate Activities or One Activity?

In most S-Corps, the business will be engaged in many different types of transactions and activities. Thus, it will often be necessary to determine whether the loss limitation at-risk rules apply to each activity, determined separately. Every shareholder in an S-Corp should receive a schedule stating their profit or loss share of each separate activity.

However, activities that constitute a trade or business must be aggregated into one activity if a shareholder actively participates in the management of the trade or business, or 65% or more of the losses in a partnership or S-Corp are allocable to individuals who actively participate in the management of the trade or business. Additionally, certain leased items, among others, may be treated as one activity.

Contact Sherayzen Law Office for Help With S-Corporation Tax Issues

If you have any tax questions regarding your S-Corp, contact the experienced tax law firm of Sherayzen Law Office.

Pursuant to IRS Circular 230, any advice rendered in this communication on U.S. tax issues (i) is not intended or written to be used, and it cannot be used, for the purpose of avoiding penalties imposed by the U.S. Internal Revenue Service, and (ii) may not be used or referred to in promoting, marketing or recommending a partnership or other entity, investment plan or arrangement.

Deductible Expenses for a Newly-Formed Partnership

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Are you planning on starting a partnership for business purposes? Usually, partnerships will incur various costs while forming a partnership. Some of these costs may be deductible or amortizable, others will not. This article will examine the deductibility of the most common costs in the formation of a partnership.

Partnerships often involve complex legal and tax issues, so it may be advisable to obtain legal counsel when forming a partnership. Sherayzen Law Office, Ltd. can assist you in all of your tax and legal needs.

Syndication Costs

Often, the formation of a partnership will involve various costs associated with marketing and selling partnership interests to prospective partners. These fees are termed “syndication” costs. Unfortunately for taxpayers, such costs are neither deductible nor amortizable under Internal Revenue Code Section 709. This will be the case regardless of whether the costs were incurred or actually paid.

Organizational Expenses

Unlike syndication costs, however, certain organization costs connected with forming a partnership may be deductible or amortizable. Under IRC Section 709, organizational costs include expenses that are: “(1) are incident to the creation of the partnership; (2) are chargeable to a capital account; and (3) would be amortized over the life of the partnership if they were incurred for a partnership having a fixed life.” Organizational costs may include certain legal and accounting fees associated with the formation of a partnership.

In general, a partnership may be allowed a $5,000 initial deduction for the organizational costs it incurs in its first year of business. However, if organization costs amount to more than $50,000, the $5,000 deduction will be reduced by any amount that exceeds the $50,000 threshold. Organization costs that are not deductible because of the threshold may be amortizable over a period of not less than 180 months, beginning with the month that the partnership begins operating its business. Note, special rules that are not covered in this article apply to partnerships formed before October 22, 2004.

It is important to also note that not all initial costs a partnership may incur or pay will be treated as organizational costs. Besides syndication costs (covered above), costs associated with acquiring and transferring assets to the new partnership, admitting or removing partners after the initial formation of a partnership, and various other costs may not be treated as organizational costs under these rules.

Startup Costs

Startup Costs are amounts that are paid or incurred after a business is formed, but before business operations actually start. In general, startup costs include pre-operation costs associated with employee training, advertising, promotion and market surveys, and related expenses. Costs associated with investigating the purchase of a partnership interest of a partnership may also be treated as startup costs by partners, provided certain rules are met.

A partnership may deduct $5,000 of startup costs in its initial year of operations. Startup costs that exceed $50,000 will reduce this amount, similar to operating expenses (explained above). A partnership may elect to amortize startup costs that have been reduced by the $50,000 limit over a period of 180 months, beginning with the month the partnership commences its operations. If a business is acquired, the period of amortization will begin the month after the business is purchased.

Contact Sherayzen Law Office for Partnership Organization and Tax Planning

If you are thinking about starting a partnership or your existing partnership is need of a sound tax plan, contact Sherayzen Law Office. Our experienced business and tax law firm will thoroughly analyze your current situation and create a customized plan to move your business toward achieving your business and tax goals.

Underpayment and Overpayment Interest Rates for the Second Quarter of 2013

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On March 1, 2013, the IRS announced that the underpayment and overpayment interest rates will remain the same for the calendar quarter beginning April 1, 2013. The rates will be:

  • three (3) percent for overpayments [two (2) percent in the case of a corporation];
  • three (3) percent for underpayments;
  • five (5) percent for large corporate underpayments; and
  • one-half (0.5) percent for the portion of a corporate overpayment exceeding $10,000.

Under the Internal Revenue Code, the rate of interest is determined on a quarterly basis. For taxpayers other than corporations, the overpayment and underpayment rate is the federal short-term rate plus 3 percentage points.

Generally, in the case of a corporation, the underpayment rate is the federal short-term rate plus 3 percentage points and the overpayment rate is the federal short-term rate plus 2 percentage points. The rate for large corporate underpayments is the federal short-term rate plus 5 percentage points. The rate on the portion of a corporate overpayment of tax exceeding $10,000 for a taxable period is the federal short-term rate plus one-half (0.5) of a percentage point.

The rate for large corporate underpayments is the federal short-term rate plus 5 percentage points. The rate on the portion of a corporate overpayment of tax exceeding $10,000 for a taxable period is the federal short-term rate plus one-half (0.5) of a percentage point.

Interest factors for daily compound interest for annual rates of 0.5 percent are published in Appendix A of Revenue Ruling 2011-32. Interest factors for daily compound interest for annual rates of 2 percent, 3 percent and 5 percent are published in Tables 7, 9, 11, and 15 of Rev. Proc. 95-17, 1995-1 C.B. 561, 563, 565, and 569.

Revenue Ruling 2013-6, announcing the rates of interest, is attached and will appear in Internal Revenue Bulletin 2013-13, dated March 25, 2013.

Types of Assets Covered by OVDP Offshore Penalty

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Before one enters into the 2012 Offshore Voluntary Disclosure Program (“OVDP”), it is highly important to understand what kind of assets are covered by the OVDP Offshore Penalty. In this essay, I intend to broadly outline some of the major types of assets covered by the OVDP Offshore Penalty.

From the outset, it is important to emphasize that this article does not set forth the exclusive list of assets; rather, only some of the types of assets are covered. Also, this article does not represent a legal advice; rather, it is meant only for educational purposes. I strongly recommend retaining an international tax attorney before entering into the OVDP; only your attorney experienced in voluntary disclosures can assess what type of assets are covered by the OVDP Offshore Penalty.

OVDP Offshore Penalty is Broader Than the FBAR Penalty

It comes as a surprise to many of my clients that the OVDP Offshore Penalty is not equivalent to the FBAR penalties in terms of the types of assets covered. The Offshore Penalty is much broader than the FBAR penalty.

The general rule is that the offshore penalty is intended to apply to all of the taxpayer’s offshore holdings that are related in any way to tax non-compliance, regardless of the form of the taxpayer’s ownership or the character of the asset.

This is an extremely broad definition; in fact, it is so broad that it practically incorporates the assumption of willfulness and fraud on the part of the taxpayer who enters the OVDP. This is why it is important for your attorney to advise you on the possibility of other of your foreign assets to be covered in the calculation of the Offshore Penalty.

While there are many types of assets that fall under the general rule above, I would like to concentrate on the fivemajor types of assets that the OVDP Offshore Penalty covers: (1) FBAR assets not otherwise excluded; (2) real estate; (3) art and collectibles; (4) intangible assets; and (5) interest(s) in a U.S. or foreign business.

FBAR Assets Covered by Offshore Penalty

The Offshore Penalty covers all of the financial accounts listed on the FBAR, including bank accounts, securities accounts, precious metals custodial accounts and other assets that should be reported on the FBAR. Unless any of these assets are otherwise excluded under the OVDP rules, they will be used in calculation of your Offshore Penalty.

Real Estate Covered by Offshore Penalty

This type of asset constitutes a major deviation from the FBAR penalties. Under the OVDP rules, the real estate assets related to tax non-compliance are included in the calculation of the Offshore Penalty. It is important to understand that if the real estate was acquired with funds that were subject to U.S. tax but on which no such tax was paid, the offshore penalty would apply regardless of whether the real estate produced any income. Obviously, the rental real estate is also likely to be included in the calculation of the Offshore Penalty if this real estate produced income that should have been disclosed on U.S. tax return and on which U.S. taxes were not paid.

Artwork and Other Similar Assets Covered by Offshore Penalty

The same principal applies to artwork and other similar assets. As long as the artwork was related to income tax non-compliance or was acquired with funds that were subject to U.S. tax but on which no such tax was paid (so-called “tainted funds”), the offshore penalty is likely to be applied to these assets.

Intangible Assets

Intangible Assets constitute another major deviation from the FBAR penalties. The Offshore Penalty is likely to apply where intangible assets, like patents and trademarks, were acquired by tainted funds and/or are related to income tax non-compliance.

Interest in a U.S. or Foreign Business

It is important to remember that the Offshore Penalty applies in lieu of the FBAR penalty as well as other penalties that would be applicable to information returns such as Forms 5471, 8865, 8858, 926 and so on. This is why the Offshore Penalty also applies to ownership of foreign businesses.

What is unique to the OVDP is the application of the Offshore Penalty to the ownership of U.S. businesses acquired with tainted funds. The only justification for such a broad coverage of the Offshore Penalty is that it most likely comes from the aforementioned assumption that the non-compliant taxpayer engaged in fraudulent behavior.

In another article, I will explore how the Offshore Penalty applies to ownership of business interests including possible exceptions to the general rule. For the purposes of this essay, it is important to understand that the Offshore Penalty may be applied to such ownership interests.

Other Assets Maybe Covered Under the General Rule

It is important to emphasize that other assets may be included in the calculation of the Offshore Penalty pursuant to the general rule above (i.e. offshore penalty is intended to apply to all of the taxpayer’s offshore holdings that are related in any way to tax non-compliance, regardless of the form of the taxpayer’s ownership or the character of the asset). It will be up to your attorney to assess which of your assets are subject to the Offshore Penalty.

Broad Coverage of Offshore Penalty Complicates the Entrance of Non-Compliant Taxpayers into the OVDP

Such a broad application of the Offshore Penalty greatly complicates the decision to enter into the OVDP. In some situations (particularly, where the IRS cannot establish willfulness), the taxpayer may be better off taking his chances under the existing FBAR penalty structure and face the individual information return penalties rather than subject themselves to a 27.5% penalty on the highest value of all of his assets (the so-called Modified Voluntary Disclosure or Noisy Disclosure).

Again, this is the decision that can only be taken only after your attorney examines your particular situation and makes the recommendation of not entering into the OVDP.

Contact Sherayzen Law Office for Help With Your Voluntary Disclosure of Offshore Assets

Sherayzen Law Office can help you with the disclosure of any of your foreign assets. Our international tax firm is highly experienced in conducting offshore voluntary disclosures. We will thoroughly analyze your case, assess your current FBAR liability as well as the liablity that you would face under the OVDP, determine the available disclosure options and implement the disclosure strategy (including preparation of all legal and tax documents as well as IRS representation).

Contact Sherayzen Law Office NOW to schedule your consultation!