Advanced Underwriting Consultants

Question of the Day – August 8

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Here’s the question of the day.

Question: Does a business owner’s spouse need to sign the business buy-sell agreement?

Answer: Given a choice, most attorneys would have the owners’ spouses consent to a buy-sell agreement for the business.

Each state has its own rules about whether a spousal consent is required to enforce a buy-sell agreement against that spouse.  Here’s an example of the Texas case of Mandell v. Mandell, 2010 WL 1006406, (2d Dist. TX 2010).

Susan and Lance Mandell, both doctors, were married in 1989.  While married, Lance became an employee and minority owner of a medical practice (the “practice”) organized as a corporation.  Lance held 22,000 shares.

Lance entered into a shareholders agreement with the practice that included buy-sell provisions.  The terms of the agreement dictated how shares could be transferred voluntarily in the event of withdrawal or retirement.  The agreement also included language requiring an involuntary transfer of shares in the event of the divorce of an owner.

The agreement provided that if a shareholder divorced from his spouse, the divorcing shareholder had the obligation to buy out his ex-spouse’s interest in the practice at 50 cents a share.  If the divorcing shareholder failed to perform the buyout, the right and obligation to purchase the shares would shift to the practice.

The 50 cent a share valuation was consistent for all the triggering events described in the buy-sell agreement.

Susan sued the practice and her ex-husband, arguing that the $11,000 value for Lance’s interest in the practice was unfairly low.  Her main argument was that since she did not sign the shareholders agreement, she was not bound by its terms valuing the stock in the event of a divorce.  Susan and her valuation experts believed the fair value of Lance’s interest in the practice to be about $1 million.

The court held that the buy-sell valuation was binding on Susan, even though she did not sign the agreement.  In so finding, the court noted that the agreement and buyout price would also be binding on Lance; that Lance would never be entitled to sell his shares himself for anything other than 50 cents a share.

Since the shares were only worth $11,000 to Lance, the court reasoned that it would be unfair to assign them a higher value for Susan’s benefit.

The result in the Mandell case can be contrasted with Barton v. Barton, 639 SE 2d 481 (Ga. 2007).  In Barton, the husband owned half the stock in a closely held corporation.  He entered into a buy-sell agreement with the other owner of the company.  The buy-sell agreement provided that in the event of divorce of either owner, the non-divorcing shareholder would have the right to purchase the divorcing owner’s stock.

As was the case in Mandell, the wife did not consent to the agreement.

In its Barton decision, the Georgia Supreme Court ruled that the agreement did not bind the wife to the valuation in the buy-sell agreement.  The court reasoned that because the wife did not consent to the buy-sell agreement, she could not be bound by the valuation in it.  Thus, the original divorce court’s decision to use an arbitrator’s 50% higher value in dividing the marital assets was upheld.

The Barton decision reminds us that where possible, the spouses of parties to a buy-sell agreement should formally consent to the agreement’s terms.

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Interview with H.A. Beasley – Part Three

AUC:This is part three of an interview with H. A. Beasley, founder and director of H.A. Beasley & Company, PC, an accounting firm in Murfreesboro, Tennessee and ICS Law Group, PC.

Click on the following links to read: Part 1 and Part 2

Question: Let’s shift focus back to the IRS for a second. Is there something that a taxpayer can do to minimize the chances of an IRS audit?

H.A. Beasley: Our clients and friends seem to think that filing after April 15th increases the chance that they will be audited. If you file proper extensions, I’m completely convinced that it does not increase your chance of an audit. In fact, there are those out there that are publishing tax advice that say that the contrary is true, that when you file an extension you might actually reduce the chance of an IRS audit.

We believe we can help clients minimize the risk of an audit first of all by choosing the best form of business entity depending on the type of business.  There tends to be market differences in the way the IRS choose to audit for different kinds of businesses.

So whether a person operates as a sole proprietor, on one hand, or perhaps they incorporate or form an LLC on the other hand, can tend to reduce the chance of an audit.

They need to properly file all of the required information returns such as IRS Forms 1099 and W-2.  And they need to have someone that knows review their tax files to make sure they don’t look wrong. Sometimes just the way the information was put on the forms can raise a flag.

Question: What can a CPA firm like yours do to help business owners make sure their taxes are right?

HA: One of the first things we find beneficial is to make sure that all of the local, state and federal taxes requirements are being acknowledged and acted on.   Certain special forms may be required for those in the trucking business, for example, and the forms might be different for a food, service or retail business.

Another way we work with small business owners is that we arrange to have at least one other tax meeting in a year—not at tax time–to help the taxpayer.

During the tax preparation process in the spring, we also try to meet with each client, if they want to, and do our first shot at the tax plan for the year while we are doing last years return. We’ll identify, for example, whether estimated taxes need to be paid or will there be a more effective way to deal with tax liability.

After that first plan is put in place in the spring, or when we do the taxes, sometime before Christmas, probably around Thanksgiving, we’ll have the second meeting. Without a good spring meeting and follow-up late fall meeting, it’s very easy to pay too much tax unnecessarily just by not making the best decisions by the end of the tax year.

Because the clients have some choices with regard to how business cash flow and taxes are managed, some of our larger clients may meet with us three, four times or more a year. But for the vast majority, for hundreds of our clients, the twice a year cycle works out pretty well. There may be an occasional phone call when they are making a business decision that has a potential of tax consequences, just a quick call to determine the best way to handle that business transaction.

Stay tuned for next Thursday as we share Part Three of the interview with H.A. Beasley.

Question of the Day – May 22

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Here’s the question of the day.

Question: Can my client use her IRA in some tax-free way to fund her start-up business?

Answer: Maybe, but probably not directly, due to the rules prohibiting self-dealing.

The most obvious way to try to use IRA money to fund a start-up is by using a self-directed IRA.  The IRA would hypothetically buy ownership interests in the taxpayer’s business.

However, the prohibited transaction rules and rules against self-dealing mean that property cannot be purchased from the IRA owner or family member, and once purchased, cannot be used to benefit the IRA owner or family member.  The investment must be a strictly arms-length transaction not involving the IRA owner or family member.  Having the IRA buy shares in a company where the taxpayer is another owner—or even a key employee—would likely violate those rules.

The consequences of engaging in a prohibited transaction are catastrophic—involving prohibitive excise taxes and causing disqualification of the IRA.

Some experts have advocated setting up a qualified plan, such as a profit sharing plan, in the start-up business.  The owner of the business can roll over the IRA money into the qualified plan, and the plan can buy stock in the employer company.  The transaction would effectively provide capital for the new company to use, arguably without an income tax result to the taxpayer.

The IRS has never completely approved the rollover and purchase company stock strategy, although it has affirmed that some of the steps work.  We strongly urge any would-be entrepreneur to seek independent advice before starting such a strategy.

Have a question for the professionals at AUC?  Feel welcome to submit it by email.  We may post your question and the answer as the question of the day.

Question of the Day – April 2

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The professionals at Advanced Underwriting Consultants (AUC) answer the tax questions posed by producers.  Here’s the question of the day.

Question: My client is one of the two owners of a closely held business.  The business owners are interested in drafting a buy-sell agreement on their own.  Would you recommend that they use an outfit like legalzoom.com?

Answer: No.

Do-it-yourself legal software and online services can work for people when they have the very simplest of legal needs.  However, any fact or circumstance that is not generic may cause the legal document to be invalid, or—worse—lead to a result that is unintended.

Here’s a link to attorney Gweyn Thomas’s blog about how using a do-it-yourself online estate planning document service ended up depriving a widow of a substantial portion of her inheritance.

Legalzoom.com has been sued by dissatisfied customers over the failure of the website to provide needed legal guidance, and for the failure of their documents to pass legal muster.  Here’s an excerpt from one client’s civil complaint, filed after she had problems with a LEGALZOOM living trust:

LEGALZOOM’s business is premised on a false sense of security that people do not need to hire a traditional attorney because LEGALZOOM can assure through development of its materials by top attorneys, its customer service reps, and its peace-of-mind review that all work done will be legally binding and reliable.  These statements are misleading and untrue, and intentionally made by defendants…to induce Plaintiffs to rely on the stated quality…of (LEGALZOOM’s) work.

A buy-sell agreement is a moderately complex legal document, and it’s drafting should be left to a competent local attorney.

Have a question for the professionals at AUC?  Feel welcome to submit it by email.  We may post your question and the answer as the question of the day.

Question of the Day – February 15

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The professionals at Advanced Underwriting Consultants (AUC) answer the tax and technical questions posed by producers.  Here’s the question of the day.

Question: Are governmental pension plans subject to ERISA?

Answer: No, most governmental plans are exempt from the requirements of ERISA.  See 29 USC Sec. 1003(b).  The types of government entities exempt from ERISA are spelled out at 29 USC Sec. 1002(32).

The issues involved in determining whether a government entity is exempt from the requirements of ERISA were discussed in the case of Koval, which is reproduced at this link:

http://caselaw.findlaw.com/us-3rd-circuit/1476142/

Have a question for the professionals at AUC?  Feel welcome to submit it by email.  We may post your question and the answer as the question of the day.

Question of the Day – January 31

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The professionals at Advanced Underwriting Consultants (AUC) answer the tax and technical questions posed by producers.  Here’s the question of the day.

Question: Can the owner of a C corporation realize any tax advantages by running the premium for a qualified long term care policy through her business?

Answer: Yes.  Qualified long term care contracts are generally treated as health insurance for the purpose of the rules.

C corporation employers have the greatest number of potential advantages for implementing LTCi plans for their employees.

1. The premium is deductible by the corporation. LTCi premiums payable by a company are deductible as ordinary and necessary business expenses under Code Section 162.

2. There is no practical limit to the amount of premium that can be paid by the employer’s for an employee’s policy. The amount of premium that a business contributes to LTCi on behalf of an employee is virtually unlimited—subject only to the idea that the employee’s overall compensation package is reasonable.

3. The company can pick the employees to be covered by the plan. Health plans provided by an employer through insurance coverage do not need to follow the nondiscrimination rules of Section 105(h) of the Code.  Code Sections 105 and 106 make reference to health plans sponsored by an employer.  Treasury Regulations Section 1.105-5 provides

a plan may cover one or more employees, and there may be different plans for different employees or classes of employees.  An accident or health plan may be insured or noninsured, and it is not necessary that the plan be in writing or that the employee’s rights to benefits under the plan be enforceable.

4. The premium paid by the corporation is not included in the employee’s taxable income. Code Section 106 says that the premiums paid by an employer to a health plan are not included in the employee’s taxable income.

5. The benefits paid to the insured are tax free. Section 105(b), however, provides that an employee does not have to include in taxable income most payments received for medical care, as defined in Code Section 213(d).  Section 213(d) says benefits paid under a tax-qualified LTCi contract are payments for medical care.

6. Spouse and dependent family members of participating employees may also be included under the plan. Section 105(b) of the Code allows employers to include spouses and income-tax dependents of participating employees within the scope of a health plan.  Since LTCi plans are health plans for the purpose of Section 105(b), that means that the spouse or income-tax dependents of a participating employee can also be included in the LTCi plan so long as the employer permits.

Have a question for the professionals at AUC?  Feel welcome to submit it by email.  We may post your question and the answer as the question of the day.

Question of the Day – January 20

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The professionals at Advanced Underwriting Consultants (AUC) answer the tax and technical questions posed by producers.  Here’s the question of the day.

Question: My client is the 100% owner of a business, and has implemented a Simplified Employee Pension (SEP).  The client has determined that he contributed too much to his own SEP IRA for 2011.  What are the penalties for doing so, and how can he fix the situation?

Answer: Here is a link to an IRS website with information about SEP IRA contributions:  http://www.irs.gov/retirement/article/0,,id=111419,00/#contributions

Here is the specific question and answer regarding withdrawal of over-contributions to a SEP IRA contained on the website:

What are the consequences to employees if excess contributions are made?

If contributions are made in an amount that is more than is allowed, there are tax implications for the employer and the employees. Excess contributions are included in employees’ gross income. If an employee withdraws the excess contribution, and earnings on such amount, before the due date for filing his/her return, including extensions, the employee will avoid a 6% excise tax imposed on excess SEP contributions in an IRA. Excess contributions left in the employee’s SEP-IRA after that time may result in adverse tax consequences to the employer and the employee. If the employer contributes more than it may deduct, it may be subject to a 10% excise tax.

For the business owner in this case, he may withdraw the excess SEP contributions from his IRA, including any earnings on the excess contributions, by the due date for his 2011 return, including extensions.  That will allow the employee to avoid the 6% excess contribution excise tax.

The returned contributions will be taxed as extra compensation the employee/owner.

Have a question for the professionals at AUC?  Feel welcome to submit it by email.  We may post your question and the answer as the question of the day.

Question of the Day – December 22

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Here’s the question of the day.

Question:  My business owner client is implementing a defined benefit plan.  In conjunction with the plan administrator, they’ve decided to buy a nonqualified annuity as a pension investment.  Will the annuity’s inside build-up be subject to the non-natural person tax rules?

Answer:   Possibly yes, but it shouldn’t matter. 

The inside buildup of the annuity is taxable on an annual basis if the annuity is owned by a non-natural owner, such as a corporation.

Here’s what Section 72 of the Tax Code says about annuity ownership by a non-natural owner:

    (u) Treatment of annuity contracts not held by natural persons

(1)   In general

            If any annuity contract is held by a person who is not a

            natural person –

                        (A) such contract shall not be treated as an annuity contract

                        for purposes of this subtitle (other than subchapter L), and

                        (B) the income on the contract for any taxable year of the

                        policyholder shall be treated as ordinary income received or

                        accrued by the owner during such taxable year.

              For purposes of this paragraph, holding by a trust or other

              entity as an agent for a natural person shall not be taken into

              account.

A pension trust might be considered an agent for a natural person—the plan participant—under that analysis.  The IRS hasn’t said for sure.  However, because a pension trust is a non-taxable entity, even if the annuity growth is taxable, the pension trust won’t pay tax.

The pension participant pays tax on amounts received from the pension plan—no matter what the source.  That’s when the IRS has its day or reckoning.

Have a question for the professionals at AUC?  Feel welcome to submit it by email.  We may post your question and the answer as the question of the day. 

Question of the Day – December 7

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The professionals at Advanced Underwriting Consultants (AUC) answer the tax questions posed by producers.  Here’s the question of the day.

Question: Is there a maximum amount a business can spend on an executive bonus plan?

Answer: Yes, if the business wants to deduct the bonus as a business expense.  The statutory source for the executive bonus plan idea is Revenue Code Section 162, which reads as follows:

Sec. 162. Trade or business expenses
    (a) In general
      There shall be allowed as a deduction all the ordinary and
    necessary expenses paid or incurred during the taxable year in
    carrying on any trade or business, including -
        (1) a reasonable allowance for salaries or other compensation
      for personal services actually rendered;

The IRS has consistently ruled that the compensation package as a whole for the participating executive must be reasonable based on the executive’s actual duties for the company.  How does the IRS decide whether a compensation package is reasonable?  It looks to what employees at similar companies get in compensation for comparable jobs.

Is it possible to predict with 100% certainty in advance whether the IRS will view a compensation package—including a bonus element—as reasonable?  No.  However, based on case law, the IRS generally takes a common sense approach to the issue.  For example, if a company pays $500,000 a year to a part-time janitor, it seems likely that the compensation will be considered excessive, and at least some of the deduction for compensation would be disallowed.

Have a question for the professionals at AUC?  Feel welcome to submit it by email.  We may post your question and the answer as the question of the day.

Question of the Day – November 29

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The professionals at Advanced Underwriting Consultants (AUC) answer the tax questions posed by producers.  Here’s the question of the day.

Question: I have two clients who own an S corporation.  They want to change their buy-sell agreement from redemption to cross-purchase, and need to switch ownership and beneficiaries of their life policies at the same time.  What tax issues do they need to be concerned about?

Answer: Since the transfer of the policies is related to business, the transaction will be treated as a sale and purchase.  There are three potential tax issues:

  • The transfer will be treated as a surrender of the policies by the business for income tax purposes,
  • The transfer to the non-insured shareholder will be treated as compensation or a dividend for tax purposes, and
  • The transaction may violate the transfer for value rules.

The business will be treated as surrendering the life policy at the time it makes the transfer.  Any cash value in excess of the company’s basis will be taxed as gain.

When the company transfers the policy to the owner, the policy’s value is either taxable compensation (if the owner is an employee) or taxed as an owner’s distribution.  If the business is a corporation, an owner’s distribution is generally a dividend.

The third issue—the transfer for value problem—is the biggest potential downside for the transaction.

Internal Revenue Code Section 101 (a) (1) says that life insurance death proceeds are usually income tax free.  Code Section 101 (a) (2) creates the so-called transfer for value rule.  The rule says the death benefit of a life policy will be income taxable to the extent it exceeds basis if the contract is transferred for valuable consideration—for example, money or loan forgiveness.

The transfer for value rule itself has exceptions.  If the transfer of a life policy is made to one of the following, the transfer for value rule does not apply.

  • The insured
  • A partner of the insured
  • A partnership including the insured
  • A corporation of which the insured is an officer or shareholder

The problem of the transfer for value rule comes up often in the context of buy-sell planning.  For example, say that Dusty and Lucky are the owners of Western Enterprises, Inc., a C corporation.  Say also that they have a buy-sell agreement in place structured as a redemption arrangement.  To fund the death-time buyout of the deceased owner’s shares, the company owns and is beneficiary of insurance on the lives of Dusty and Lucky.

After talking to their tax advisors, Dusty and Lucky decide to change their buy-sell arrangement from redemption to cross-purchase.  They also decide to transfer each of the existing corporate-owned insurance policies to the non-insured shareholder.

A transfer to a co-shareholder of the insured is not an exception to the transfer for value rule.  That change in policy ownership would cause the death benefit of the policy to be income taxable.

Have a question for the professionals at AUC?  Feel welcome to submit it by email.  We may post your question and the answer as the question of the day.