Like it or not, taxes — income, sales, property, excise, and import duties — often play an out-sized role in business decision making. This short Tax Primer highlights some of the most important issues that business decision makers should bear in mind as they are going about the business of doing business.
Pretty much everyone knows that record-keeping is essential. But beyond routine record-keeping and tax return preparation (which challenge many), significant business transactions should always be evaluated in advance by a competent tax advisor. Too frequently, otherwise smart business owners or managers rush to close a deal and then, after signing, call an advisor for post-transaction tax triage. Unfortunately, once the deal is done it is usually too late to cure the tax carnage.
The tax system is dangerous, in part, because much of it is not common sense. It features federal, state and sometimes foreign tax statutes, treaties, regulations and court decisions — in addition to other slightly less authoritative rulings and pronouncements — that occupy thousands of pages and not infrequently seem inconsistent with each other. Because of the system’s complexity, it usually takes years to “make” an effective tax advisor.
Some of the highest risk transactions, from a tax standpoint, are those in which business entities are formed or ownership interests in them are transferred from one party to another. Normal humans, unacquainted with the intricacies of the tax law, are frequently surprised by the traps that lurk seemingly everywhere.
Often, a prospective client will call saying something like
Sandra has just agreed to accept membership in our LLC in exchange for her help in [fill in the blank with almost any high-value service]. If I e-mail the agreement to you, would you please look it over and do what you can to make it so it doesn’t hurt us tax wise? And, oh, by the way, my brother-in-law, Sam, did exactly the same deal a couple of years ago. His accountant found a way so the Sam and his partners didn’t have to pay any taxes. Can you do the same thing for us?
Most people are unaware of the extreme fact-sensitivity of tax outcomes. By this, I mean that very slight differences in facts between Sam’s deal and that of the prospective client can trigger huge differences in tax results. Only an experienced advisor is likely to detect and account for the factual differences in evaluating how the law applies in the two situations.
Here’s a typical scenario, in the form of a hypothetical:
A, B and C (individuals) are the only members in a Fla LLC, L2. Their aggregate basis in L2 is approx. $350K.
Currently, L2’s balance sheet is upside down, with net debt owed to outsiders totaling $600K, all personally guaranteed by A, B, and C.
A, B, C and D (where D is a Georgia S-corp) currently own L1 in equal 25% shares. In an effort to recapitalize L1, A, B, C, and D have offered 40% of L1, in exchange for $1.5 million cash, to the following:
E (an individual U.S. citizen), F and G (both Russian non-resident alien individuals)
As part of the transaction, A, B, and C will convey their entire interests in L2 to L1. After the transaction, ownership percentages in L1 would be as follows:
Of the $1.5 million cash contributed, $600K will be used to pay off the current L2 debt. L1 and L2 have filed 1065s to date.
Can this deal be done without generating a current-year tax liability for A, B, and C?
Looking at this scenario, most people’s eyes glaze over and they say, “damned if I know!” In fact, in my experience, most owners and managers of emerging closely-held businesses don’t recognize a tax issue at all. They’re too impatient to care about such details. They’re so anxious to get dollars in the door from those Russians, they just want to get it signed and move on.
Some will also assume, incorrectly, that if the IRS later comes calling, they can plead ignorance of the law. In a few cases, ignorance of complicated aspects of the tax law has saved people from prison, but it never prevents the IRS from collecting taxes and penalties. Deliberate ignorance is not a wise tax strategy, nor is the so-called “audit lottery,” in which taxpayers sometimes violate the tax law (either knowingly or in deliberate ignorance) based on their assessment of the probability that the violation won’t be discovered by the IRS. These kinds of tax tactics only lead to trouble.
The reality in the scenario, hidden in the “rough,” is a deal-killing tax booby-trap that only an expert can defuse and only in advance. The solution is about as counter-intuitive as one can imagine and, as you might have guessed, is beyond the scope of this Primer. While the facts in the scenario are relatively complex, it is not safe to assume that seemingly simple facts do not hide similar traps. Facts are often not as simple as they first appear. Hazardous complexity may lie below the surface.
In summary, interpreting and applying the tax law to an important business transaction is not for the uninitiated. Unless you just don’t care about the tax outcome or you are absolutely certain that you know what you’re doing, it is best to make a modest investment in up-front tax advice.