Below you will find two hypothetical business transactions that your “clients” will be entering into. Help your clients structure the business transaction they desire in the most tax efficient manner possible. Describe the most likely tax treatment of the proposed transaction and support with substantive law. Make suggestions about how the transaction may be restructured to get better tax results without deviating too much from the proposed business structure. You are expected to take an aggressive pro-taxpayer position. Justify your position.
Please, give some ideas supporting by Regulations
Case
Pete, Andre, John and Jimmy are shareholders in ATP, Inc., a New York-based corporation. There are hundreds of shareholders, but each of Pete, Andre, John and Jimmy own 15% of ATP. ATP has been around since 1930s, and made an S election last March, retroactive to January 1, 2015. ATP is a cash basis taxpayer.
I don’t believe that ATP, Inc. will be approved to be a Subchapter s corporation. The number of shareholders that an S corporation can have is 100 or less, and ATP, Inc. has “hundreds of shareholders”. IRC 1361 (b)(1)(A) limits S corporations to entities “which does not have more than 100 shareholders”. If the four primary shareholders wish S corporation treatment for their endorsement income, they can form their own S corporation and contract with ATP, Inc. to assist with services for a management or similar fee. One could have considered establishing the new entity as a qualified subchapter S subsidiary (QSub), but the number of owners disqualifies even this entity option (eligible under Section 1361(b)(3)(A)).
ATP makes money from personal appearances by Pete, Andre, John and Jimmy and from sponsorship deals. ATP bills for personal appearances following the event. The sponsors sign long-term contracts and then pay ATP over a period of several months to a few years.
Andre signed up a new sponsor shortly before Christmas. He had the contract with the sponsor dated January 2, 2016 and instructed the sponsor to make the first payment in early 2016. The contract called for payments over five years and could be cancelled with a one-year notice, for a partial refund.
The sponsor, eager to get started on its new promotional campaign wired all the money due under the contract to ATP on December 30, at 4pm. ATP was closed between Christmas and New Year’s, and the incoming wire was not discovered until January 2.
ATP, Inc. is a cash basis taxpayer as outlined above. As such, the payment, rendered on a business day, Wednesday, December 30, 2015, might be cash basis income. We don’t know if accrual basis reporting is required (As a C corporation, ATP, Inc. might be required to use accrual basis reporting if their average annual gross receipts are $5,000,000 or more (IRC 448 (c) (1)). It does not qualify as an exception as a personal service corporation (§ 1.448-1T (e)). The amount of endorsement income is not disclosed, but it is likely that the total for the four largest shareholders exceeds $5,000,000 average gross revenues. That is a good thing.
If ATP, Inc. must use the accrual basis, then none of the deposited income is income as of December 30, 2015. The contract terms specify payment begin in 2016, that partial payments will be accepted over time, and that partial refunds will be available. Adhering to the C status will allow ATP, Inc. to defer any tax on the prepayment of Andre’s sponsorship income.
ATP will be merging with WATP, Inc., also a New York S corporation with WATP surviving the merger. ATP shareholders will be receiving stock in WATP as their only consideration. ATP has numerous assets, including cash, licensing deals, endorsement deals, valuable sports memorabilia and two stadiums with a few courts. One stadium is used by ATP for its own events. The other stadium is leased out on a triple-net basis, but ATP manages and cleans the common areas, provides security, parking and janitorial services.
WATP is not interested in owning and operating a stadium, and it wants ATP to shed its stadiums prior to the merger. Pete, Andre, John and Jimmy (the individuals) would like to keep at least one of the stadiums and own it personally. The other shareholders of ATP do not care whether they keep or lose the stadiums. Both stadiums have been fully depreciated.
John and Jimmy do not want to be affiliated with WATP. They would like WATP to cash them out on the merger, which WATP has agreed to do. They are willing to accept cash, property or both.
The planned merger won’t work, as ATP, Inc. is a C corp because it is disqualified from becoming an S, due to the number of shareholders exceeding 100. This fails §1361 (b)(1)(A). That means that the merger into WATP, Inc., with each shareholder of ATP, Inc. getting shares only, will also exceed 100 shareholders, and as such, WATP, Inc. will soil its S election. The merger would force a conversion of the surviving WATP, Inc. to C status, with unknown consequences. It is possible this is a preferred status, but a number of issues, such as compensation of the main players as ordinary wage income, should be considered to avoid the need for dividends, which would create a second layer of tax.
The distribution of the stadium to the four shareholders in exchange for their stock, or as a part of their exchange, will get the following tax treatment under IRC 301 (c), assuming ATP, Inc. is correctly considered a C corporation:
Dividend to the extent of earnings and profits, then
Return of basis, then
Any remainder shall be capital gain (to the extent of fair market value).
That does mean a step up in basis for the asset, so there would be depreciation benefits available at ordinary income rates against future operations incomes.
The shareholders might want to consider taking out debt before the transfer, because if that debt is assumed by the shareholders the debt would reduce the value of their distribution ((IRC 301 (b)(2)). The cash generated could be used to buy out the two owners who do not want to participate in WATP, Inc.
John and Jimmy could accept the other stadium as part of their compensation, with a taxable capital gain, and step up in basis, for the operating stadium. There may be an operating issue, as ATP, Inc. will not offer its services after the merger/liquidation, and WATP, Inc. does not want to, either. There is an opportunity for a reduction in value for the stadium due to the loss of an existing operator to run events as lessor/manager.
Jimmy has started a new business manufacturing wooden tennis rackets and he has been wildly successful. He has $10 million of sales in the US, and $25 million of sales outside the US. He would like to explore setting up an IC-DISC.
Jimmy will be able to establish an s corporation, if he chooses, and an IC-DISC for the foreign sales. There is value to Jimmy, as the qualified dividend payable from the IC-
DISC is taxable to him at a maximum of 20%. This creates a tax benefit, as the commission paid and deducted by the domestic S corp will create a tax savings of up to (39.6% less the 20% tax on dividends equals)19.6% on the commission. It can be more, if the dividend is not paid. There is an interest charge (the IC in IC-DISC) on unpaid dividends, but current interest rates are so low that the deferral might be very tempting.
The commission expense is available as either: 4% of qualified export receipts, or 50% of its export profits. We don’t know about profits, other than he is “wildly successful”, but a 4% commission on $25 million is $1,000,000. The tax savings could be $196,000 to much more annually, depending on the use of the deferral.
There are rules regarding separate corporate structure, books, tax filings via 1120-IC-DISC, mix of qualified export sales, and certain disclosures of boycott transactions.
WATP is currently in talks with Roger and Rafa to sell them a 9% stake in WATP. Roger lives in Switzerland and Rafa in Spain. Each of them travels to the U.S. about ten times a year, staying at a swanky hotel. Roger has kids, who live and go to school in Switzerland and is happily married. He does not attend any social events when in the U.S. Rafa is unattached and has made lots of friends in the U.S. who he spends lots of time with.
Roger and Rafa just signed up a large sponsor of their own and they want to make sure that the income from this sponsor will not be taxable in the U.S.
WATP, Inc. will not be able to retain S status if they sell shares in WATP, Inc. to non resident aliens. Roger and Rafa each live elsewhere, and visit the US. Their resident status will be determined by either the green card test (“permanent resident status”) or the substantial presence test as promulgated by 301.7701(b)-1.
We do not know if green card status has been granted to either (301.7701(b)-1(b) governs).
You will be considered a United States resident for tax purposes if you meet the substantial presence test (301.7701(b)-1(c) governs) for the calendar year. “An alien individual is a resident alien if the individual meets the substantial presence test. An individual satisfies this test if he or she has been present in the United States on at least 183 days during a three year period that includes the current year. For purposes of this test, each day of presence in the current year is counted as a full day. Each day of presence in the first preceding year is counted as one-third of a day and each day of presence in the second preceding year is counted as one-sixth of a day. For purposes of this paragraph, any fractional days resulting from the above calculations will not be rounded to the nearest whole number.”
There is an exception for professional athletes (301.7701(b)-3(c) governs).
In order for Roger and Rafa to be eligible members of WATP Inc., an S corporation, they have to not be non-resident alien shareholders. There is a treatment of such persons as nonresident alien if they meet conditions for a closer connection to a foreign country (301.7701(b)-2(d) governs).Such issues as where each person has a social connection to the US could be determinative for resident alien status. Roger, with family in Switzerland, and limited social connections, would escape resident alien status. Rafa, due to his US social connections, might not.
That means Roger is likely a nonresident alien, unable to participate in WATP, Inc. ownership unless management wishes to convert from S corporation status to C. Rafa may qualify as a resident alien.
There may be exclusions for one or both due to application of US tax treaties with Switzerland and Spain.
Next, both Roger and Rafa want to escape US taxation on sponsorship income. To do so, neither can be considered a resident alien, as that status requires them to report their worldwide income as subject to US taxation (subject to treaty relief and foreign tax credits). Since neither wants to report this new income in the US, they must ensure they are excepted from the resident alien rules.
Roger appears to not be effectively connected to the US, as his visits are infrequent, and he does not have family or social ties to the US. Rafa has US friends, but otherwise does not have a familial base outside the US that we know of. He should again look to 301.7701(b)-2 - Closer connection exception for guidance.
301.7701(b)-2 (d) governs here. If Rafa can establish his closer connection to another country, the US will not consider him a resident alien subject to tax in this country for sponsorship income, only for his prize winnings earned in the US.