You Don’t Know What You Don’t Know

My parents are in the middle of winding down their farm operation in Northern Iowa. The idea was simple: sell the land; retire and walk off into the sunset. But as they began the process, so too came layers of complication. The deal involved land that had been in the family for decades, the estate of my grandmother, multiple siblings (nine total, to be exact), and complex tax treatment. It was to say the least – complicated.  

At some point in the process, they realized they needed help—not because they lacked capability, but because there’s no clear-cut blueprint for navigating situations like this. You can only go so far on your own before the complexity outpaces what you can manage without professional help.

Tariffs and Trade Wars, and Taxes, Oh My!

Man your battle stations--it’s time for a trade war! If you’ve been following the news, it’s likely you have been bombarded with near constant updates about escalatory tariffs and the looming threat of trade wars as the new administration has been following up on its promise to impose tariffs of 10-60% of all U.S. imports. Within the first few weeks, we have seen the posturing with Mexico, Canada, and China. The Trump administration has now ordered 25% tariffs on aluminum and steel. But what are tariffs and how do they result in a trade war? And how might trade wars impact consumers, entrepreneurs and the economy?

The Minnesota Angel Tax Credit Program – good news for startups; good investment in Minnesota.

The Minnesota startup community received good news to begin 2023 as Gov. Tim Walz proposed $20 million in funding for the Angel Tax Credit Program in his biannual budget.

The Minnesota Angel Tax Credit Program, started in 2010, provides a refundable 25% tax credit to investors and angel investment funds that make equity investments in emerging—primarily high-tech—Minnesota businesses. The tax credit, worth up to $125,000 per individual or $250,000 for taxpayers filing jointly, incentivizes a rather low risk investment in capital-needy businesses, fueling their growth, and, in turn, creating more jobs, tax revenue, and vibrant Minnesota communities.

MN DEED Now Accepting Applicants for Minnesota Angel Tax Credit Program

Summer is in full swing and as you prepare to head to the cabin for the fourth of July, now is a good time to review exciting news for Minnesota entrepreneurs! After a several year hiatus, as of July 1, 2019, the Minnesota Department of Employment and Economic Development (DEED) once again accepts applications from businesses, investors, and funds to participate in the Minnesota Angel Tax Credit program. If you are an avid follower of this blog (and you should be), you probably are already aware of the historical popularity of the Minnesota Angel Tax Credit and some of its limitations. If you are not a frequent reader or are new to the entrepreneurial scene in Minnesota, below are some highlights of the 2019 Angel Tax Credit program.

• Minnesota’s Angel Tax Credit provides a 25% credit to investors, or investment funds, that make equity investments in early stage companies (with a particular focus on high technology, new technology, or new proprietary products, processes, or services in select fields). 
• The maximum credit is $125,000 per person, per year ($250,000 if filing jointly) and the credit is both refundable and available to residents of other states and foreign countries. 
• For 2019, the Minnesota legislature allocated $10 million of tax credits for eligible investments. Until September 30, 2019, $5 million of that $10 million is reserved for businesses owned by women or minorities, or for businesses located outside of the seven county metro area. Beginning on September 30, 2019, any portion of that $5 million that has not been allocated will be made available for all other eligible investments.
• If you are planning to use the Minnesota Angel Tax Credit for an investment in 2019, you should plan on becoming qualified as soon as possible. Many companies are submitting applications now, and some have even delayed financings that would have been otherwise completed at this point in the year.

As a reminder, the process requires that the company be certified as a qualified business and that the investor also be certified as a qualified angel. Both of these steps require filings with DEED. Once the company and investor are both certified, they must jointly submit a credit allocation application. 

Tax Reform to the Rescue?

Over the last several years, entrepreneurs have learned that 409A is not just a different version of a household cleaning product but, rather, an important IRS regulation relating to deferred compensation. If you thought deferred compensation was a narrow and obvious category of compensatory arrangements, 409A helped convinced you otherwise because of its impact on simple things like granting nonqualified stock options.

If you were hoping that tax reform would simplify the issue of deferred compensation for businesses, the bill introduced by the House Ways and Means Committee on Nov. 2, 2017 may fall under the category of “be careful what you wish for.” Effective Jan. 1, 2018, the House bill would repeal Section 409A of the Internal Revenue Code, the often onerous section governing most forms of deferred compensation. Sounds like good news, right? 

Entity Selection: LLCs and S-Corporations

A common question facing entrepreneurs is whether to organize their business as a limited liability company (“LLC”) or S-corporation (“S-corp”).  While there is no one-size-fits-all answer, in this post, I highlight some of the features of LLCs and S-corps, setting forth some factors that may influence your decision.

Both LLCs and S-corps are limited liability vehicles, meaning they protect an individual owner’s assets from creditors of the business.  

• Both LLCs and S-corps are taxed as pass-through entities for federal income tax purposes, meaning there is no tax imposed on the entity, but that income and losses of the business are passed through to the owners.  That being said, some states do impose taxes on S-corps.

Non-qualified Stock Options or Restricted Stock Awards?

Recently, an early-stage, high-growth client (a Delaware S corp.) called to ask whether, and when, to begin awarding stock options, in this case the non-qualified variety (NSOs), instead of using restricted stock grants to key contributors. Many growing companies struggle with this same issue, and the recipient and company may have differing views. Although there are five common types of individual equity compensation awards (stock options, restricted stock, stock appreciation rights, phantom stock, and employee stock purchase plans), this post focuses on NSOs and restricted stock.

A NSO grants someone the right to purchase a predetermined number of shares at a predetermined exercise price (for tax reasons, at least the fair market value on the date of grant). Typically, a NSO vests over time, after achievement of performance milestones, or a combination of the two. When exercised, the individual recognizes ordinary income equal to the excess of (i) the fair market value of the stock received over (ii) the exercise price.

For example, assume a NSO to purchase up to 100 shares at an exercise price of $10 per share. The NSO vests at the rate of 25% per year for four years and has a 10-year term. At the conclusion of the four-year vesting period, the recipient exercises 50 options. If the fair market value of a share was $20 at such time, the optionee has ordinary income equal to the difference between the $20 fair market value and the $10 exercise price, or $10 per share ($500 total). Therefore, a NSO operates as a tax-deferral mechanism by delaying the recognition of income until the option is exercised. The company receives an equivalent deduction. Of course, NSOs are highly dependent on a company’s performance because if the fair market value of the stock falls below the exercise price, the option is essentially worthless.    

A restricted stock award is a grant of shares which are subject to as risk of forfeiture until certain restrictions, like the passage of time or achievement of performance milestones, are met. For example, an employee may be granted 360 shares of restricted stock that “vest” over a period of 36 months at the rate of 10 shares per month, provided the employee continues to be employed. If the employee ceases to be employed, the restricted stock agreement often will give the company the right to repurchase any “vested” shares, with the right to any “unvested” shares automatically terminating.

The tax consequences to someone receiving restricted stock depend upon whether a Section 83(b) election was filed with the IRS. When a 83(b) election is timely filed (it must be filed within 30 days of the issuance) the recipient reports as ordinary income, the excess of (i) the stock’s fair market value at the time of the award over (ii) the amount, if any, paid for the stock. The recipient then has no tax consequences as the risk of forfeiture lapses. Alternatively, if no 83(b) election is filed, the recipient is taxed as the risk of forfeiture lapses, in an amount equal to the excess of (i) the value of the stock at the time of vesting over (ii) the amount paid for the stock, if any. This is also taxed as ordinary income and the company receives a compensation-related deduction at the same time and in the same amount. 

The type of equity compensation award granted is likely to be based on the goals and objectives of both the company and the recipient.  For example, when a company’s stock has very little value, the recipient is likely to prefer restricted stock; however, as the value of the stock rises, the recipient may prefer NSOs because of the potential immediate tax (with an 83(b) election) on grant. On the other hand, if the company performs poorly, the stock’s value may fall below the NSO’s exercise price, rendering the NSO worthless. Restricted stock awards may be more complicated for the company because the recipient becomes a shareholder on the award date, even though some of the shares remain subject to forfeiture.  Therefore, unless clearly defined in the agreement granting the restricted stock, issues may arise as to the voting, dividend, and other shareholder rights the recipient has with respect to the unvested shares.

This is a high-level summary of two types of equity compensation awards that might be useful to entrepreneurs. Of course, it is important to discuss equity compensation with your legal counsel and other tax advisors in order to develop and implement a plan that achieves the desired objectives.

How to Answer the Top Five Legal Questions You Will Get from Family Members at Holiday Gatherings

1. Should Mom and Dad give us the house as a gift now so that they don’t have to “give it to the government” later?

This is a common question that involves technical medical assistance rules. Generally, the best way to answer this question is “no,” and, “You should talk to a lawyer who specializes in this area.” These rules are very complex and often misunderstood.

If you give a home to another person as a gift, that person will receive the home with a tax basis that is the same as your tax basis. In some cases, this can be a very low basis and the built-in capital gains very high. In addition, as the owners are no longer the primary residents, the recipient of the gift will no longer get any kind of exemption on paying some of that capital gain when the house sells. In contrast, if your parents die owning the house, the house will get a fresh tax basis. And if they sell the house while they still own it, they are exempt from paying much of the capital gains.

Further, transactions within a certain period of time are ignored. Your parents could end up without a house, and still be excluded from some government assistance.

Finally, if you and your siblings receive their house as a gift, YOU NOW OWN A HOME WITH YOUR SIBLINGS. And their spouses, really. Who gets along well enough with their siblings to start going into real estate investing? Overall, this is rarely a good idea. 

2. When our daughter, Susie, gets married next year, should we give the couple a down payment on a house?

Again, this is very generous; you have a great family. On the other hand, it can be difficult to navigate the marital property rules, and you could be sharing family assets in a way you don’t intend.

Sometimes a simple traceable gift like cash can be harmless, but if a gift is actually—for example—an interest in an operating business, or a job for a new son-in-law, such a gift should only be made with a prenuptial agreement attached. Especially if someone is going to own a growing business that he or she (or his or her new spouse) will be working at, consult a lawyer about the safest way to make that gift. Any family with operating family businesses or family wealth should discuss the possibility of an agreement or an estate plan that ensures you are protecting the family’s assets and preparing the young couple to be good stewards of that wealth.

3. When grandma died four years ago, she had a will, so we didn’t need to go through probate, right?

Probate is a court-supervised process that transfers property after someone’s death. Even if you have a will, probate is necessary to properly transfer property to the beneficiaries after someone dies. The beneficiaries are either determined by the terms of the will or by state law, but probate is a necessity either way. The only way to avoid probate is to transfer all of your property through beneficiary designations or through a living trust. If any asset is still in the decedent’s name and does not have a designated beneficiary, the only way to transfer it is through probate. Also, if it has been four years, you have to go through a slightly more complex court proceeding instead of the typically simple probate process.

Some people also ask why they need a will if they don’t have millions of dollars. A will does not avoid probate, but it does allow you to select the people who will be in charge of your estate and the people who will benefit from the assets you do have. Your will allows you to select specific assets or dollar amounts and give them to specific people. If you don’t have a will, state intestacy law will direct where your stuff will go. This is based on your living descendants and whether you have a spouse. If you have children, your children will have some interest in your assets, even if you are married. Intestacy tries to mirror what most people may want, but it is rarely applied in the same way that you would choose.

It does matter that you have a will.

4. Speaking of grandma, I can just use her power of attorney to close her bank account, right?  Is having a power of attorney the same as being her executor?

A power of attorney is a document that authorizes someone to make financial decisions and transactions on your behalf, while you are alive. This document is no longer valid once someone has died.

Often, people think they can continue to close accounts or write checks for bills after someone has passed away because they were the power of attorney when that person was living. The executor—or personal representative, as it is called in Minnesota—is the person in charge of collecting assets, paying debts, and distributing a person’s assets after their death. That person has to be appointed by the court through probate, and that can take some time. There is often a gap in time where there is no one legally able to conduct financial transactions on behalf of the person who has died.

5. If I get in an accident, I don’t want to be a vegetable, so you can just pull the plug—right?

Making medical decisions for someone is a very serious matter. Often medical staff will consult with family when important decisions are to be made, but they are starting with the presumption that they should save your life at all costs.

If you have situations where you would prefer that you not be kept alive, you have to put that direction in a legal document, or you have to be sure that you have immediate family that will convey that wish without wavering, and without disagreement among them. A health care directive, or power of attorney for medical purposes, is the best document to outline these wishes and to designate someone to carry them out.

This is also the case if you wish to donate organs or be cremated instead of buried, things like that.  Further, “pulling the plug” could mean that you want to be taken off life support after certain conditions are met or that you do not want to be kept alive by way of a feeding tube, or it may refer to an order not to resuscitate you if that is necessary. A health care directive can cover the first two examples, but does not cover an order not to resuscitate, and that must be done in a separate and specific document.

Details on Amendments to the Minnesota Angel Tax Credit

Regular readers of entreVIEW are no doubt aware that the Minnesota Angel Tax Credit, a frequent topic of interest here, ran out of funds a few weeks ago. The $12.2 million available for issuance had been used up by early March, as predicted in a prior post.  

You’re probably aware that Governor Dayton just signed a tax relief bill passed by the legislature last week. I’d like to think that the reason for bipartisan action on tax relief so early in the session is because of all the contacts made by entreVIEW readers who were encouraged by my prior post to contact their legislators to support the Angel Tax Credit. (I’m sure it didn’t have anything to do with political wrangling in an election year.)

The good news, as you may know if you’ve been reading the Business Journal, is that, buried in the tax relief measure’s 50-plus pages, an additional $3 million of Angel Tax Credit funding was allocated for this year. According to the article, the Minnesota Department of Economic Development will begin accepting applications for this year’s additional funds on March 31st, and expects to have all funds allocated by May 11th.  Obviously, this won’t fully satisfy the demand for this year, but it may help those who just missed the funding cutoff earlier this year. 

Also, the legislation extends the angel tax credit program through 2016, with $15 million in credits available for each of 2015 and 2016. If the past is any guide, this amount is likely to be far less than the demand (as $15 million in total credits will probably be allocated this year by mid-May), but it is better than nothing and is evidence that the legislature is beginning to view the angel tax credit as an important factor for Minnesota start-ups trying to raise capital.

There were other changes made to the Angel Tax Credit in the new law, a few of them notable:

• Of the $15 million allocation in 2015 and 2016, $7,500,000 will be reserved (until October 1 of each year) for allocation to qualified greater Minnesota, minority, or women-owned businesses.

• An investor who is an officer or principal of the qualified business or who owns or controls 20% or more of the voting power or shares of such business will no longer be eligible for credit on investments made in that business.

• The three-year holding period for investments won’t apply to a qualified investor who dies before the end of the three-year period.

Fortunately I haven’t had any clients or contacts who would have benefitted from the third bullet above, but I do know several who would have been impacted by the first two bullets.

I’m glad to see the program survive because it has helped facilitate the raising of angel capital. We’ll have to wait and see how these other modifications affect the program over the next couple of years.

Given past activity, more posts on the Angel Tax Credit this year are inevitable. We can only hope the weather will warm up before we’ve got something more to write…. 

Using a Charitable Trust to Offset Capital Gains

We are approaching the extended income tax deadline for 2012 and it reminded me (as if anyone could forget) that 2013 carries significantly higher income tax rates for a lot of folks. We have the Medicare surcharge, and most of rates increased as well at a state and federal level. Between now and the end of the year, many people, including cash strapped entrepreneurs, will begin to assess their income tax situation for 2013—WARNING, you won’t like it. One of the things that are (happily) back this year is capital gains.

I wanted to use this post to introduce an interesting way to offset capital gains—a trust for charities and other beneficiaries called a charitable lead annuity trust, “CLAT”—yes, we estate planners have an acronym for just about everything… A CLAT is an irrevocable trust that pays an annual amount to charity for a period, usually a term of years. At the end of this term, all assets remaining in the trust are given to one or more non-charitable beneficiaries. Any appreciation on the trust assets in excess of the specified amount given to charity each year will pass to the remainder beneficiaries free of tax.

There are two types of CLATs, a “Grantor CLAT” and (what else) a “Nongrantor CLAT.” With a Grantor CLAT, the grantor will receive an immediate income tax deduction for the present value of the charity’s interest when the trust is funded, but the trust’s income will be treated as the grantor’s income for income tax purposes. This is where the offset of capital gains comes in, a large charitable deduction.  In contrast, with a Nongrantor CLAT, the grantor will not receive an income tax deduction upon creation, but will also not pay any income tax on the trust’s income. 

When a CLAT is created, the present value of the remainder interest for the noncharitable beneficiaries (e.g., a sibling, child, niece or nephew) will be a taxable gift. This portion is calculated using the term of the trust and the current IRS §7520 rate.  The §7520 rate was at a historic low of 1.2% for June, but was up to 2.0% for August. We have the option to use any of the last three months’ rates.  A low rate means that the present value of the remainder interest will be extremely low—resulting in a low value taxable gift, even though the eventual benefit to your sibling or niece or nephew may be significantly higher. Essentially, any growth of the trust assets in excess of the projected rate of 1.2% will pass to your child, sibling, or niece or nephew tax free.   

Below you will find an illustration of how you could use that spare $1 million you’ve got lying around (from your last successful venture) to create a CLAT that would benefit of one or more charities for a term of years and then benefit your beneficiaries when the trust terminates. In preparing these calculations, I used the IRS rate for June (1.2%); I also assumed that the trust would pay out 5% each year and would be for a term of 15 years.  

Charitable Lead Annuity Trust: 

Initial Contribution:          $1,000,000
Term of the Trust:          15 Years
Initial Annual Payout to Charity (5%):            $50,000
Present Value of Interest for Family:          $317,355
Present Value of Charitable Interest:          $682,645
Immediate Charitable Deduction:  $682,645 (If a Grantor CLAT)
Taxable Gift to Sibling, Niece, or Nephew:  $318,871
Expected Value on Termination (7% Growth):$1,502,580
Benefit to each of Child: $751,290 (assumes 50/50 division between 2 children)

Although you would have an initial taxable gift of $318,871 (which reduces your lifetime exemption of $5,250,000), you would eventually transfer $1,502,580 without any tax.  If you share in this gift with a spouse, it will impact each of your lifetime exemptions by half as much. Using the above example, you would receive an immediate income tax deduction of $682,645!  Amazing option to benefit your favorite charities and beneficiaries while offsetting some gains this year. 

I often recommend this to clients with high earning years, or when selling a substantial block of stock or a business. It is just another tool in the estate planning toolbox that not many people know about.

Lessons from Tony Soprano’s Estate Plan

James Gandolfini, a/k/a Tony Soprano, died unexpectedly at the age of 51.  Not that we should all take money management lessons from a TV mobster, nor should we take guidance on estate planning from him, but the death of a high profile actor at such a young age provides an opportunity to review the good and the bad decisions his estate plan made.

First, here is a copy of his will.  Mistake #1:  If you are a famous person, you should (or your lawyer should insist) that you keep your estate plan PRIVATE.  Any will that has to be probated is public.  Most of the time no one will care, but if you are Tony Soprano, someone will care.  In fact, I am nowhere near the first person to write about this.  If his estate plan had been private, no one could write about it.  His estate plan would have been private if he had used a revocable living trust to hold his assets.  Trusts are not public documents.  Even if they become an issue for dispute in court, often the document itself is a non-public filing.  Now we all know he is giving his assistant $200,000.  

The second reason James Gandolfini’s estate plan is notable is because it appears to be very tax inefficient.  Newspapers and magazines have been making a huge deal about this calling his estate plan a horrible mistake, a tax disaster.  His plan gives about 80% of his estate, including a property in Italy, to taxable beneficiaries (not a spouse or charity).  This triggers estate tax on all but $5,000,000 at a rate of 40% or more.  The New York Daily News estimates that this amounts to about $30,000,000 in tax on his approximately $70,000,000 estate.

Again, the media labels this a horrible mistake, a disaster.  Is it possible that James only provided 20% to his wife (thereby making that 20% not taxable) because they agreed to do that in a premarital agreement, he had another trust for her benefit, or he used the 2012 gifting craziness to give her a number of assets already?  Or, maybe, he WANTED to give the rest of it to his kids and relatives, and didn't care about the taxes.  Novel idea?  It is true, however, that most people care about the taxes.  A few relatively simple estate planning techniques may accomplish the same goals but save significant taxes.  I certainly hope he was informed of the consequences of the design of his plan.

The third lesson from this estate plan is how (not) to structure gifts to your children.  His will provides for his children significantly, and early.  Many children, even children of celebrities, are not ready to manage a pile of money at 21.  I can appreciate his desire to keep things simple, but providing more money to your young daughter than you do your wife—seems like a bad idea?

The final lesson is in the disposition of his Italian property.  James gave his children the property in Italy.  Italy and many foreign countries have limitations on who can own property there, and who may be taxed as a beneficiary of that property (inheritance tax).  It is also possible that a significant capital gains tax occurs when the property is transferred to certain individuals.  Our system is an estate tax borne by the deceased’s estate, not by the beneficiaries receiving the property (unless the document requires that).  As a result, it can be possible that the estate would pay estate taxes in the U.S. for the property, and the recipient could pay further taxes to the country the property is located in.  Many countries in Europe, like Italy, have a treaty with the U.S.to make sure there are less situations of double tax, but it is important to take careful consideration with properties abroad.

Minnesotax?

A couple of weeks ago, the Minnesota Legislature passed new tax legislation that, among other things, added a brand new Minnesota gift tax and expanded the applicability of the Minnesota estate tax. A summary of the entire new tax bill is here, but I wanted to highlight a few things that probably matter most to the entreVIEW audience:

Increased Income Tax Rates. In case you haven’t heard, the top rate for couples making more than $250,000 net income, or $150,000 for individuals, has increased from 7.85% to 9.85%. Since it applies retroactively to all of 2013, you can’t avoid paying that rate on the gazillions you’ve already earned this year…

Minnesota Gift Tax. Minnesota is only the second state in the entire country to implement a separate gift tax. This tax will apply to gifts made after June 30, 2013. Taxable gifts are those gifts to non-spouses over the annual exclusion amount as prescribed by the federal definition (generally), which is currently $14,000 per person. Each resident has an additional $1,000,000 lifetime exemption to use over and above the annual exclusion gifts. Gifts over the $1,000,000 exemption will be taxed at a flat 10% rate.  This is in addition to the 40% federal tax on gifts over a $5,250,000 lifetime exemption. As a result, if residents have made gifts over the $5,250,000 federal exemption, any further gifts will now be taxed at a combined 50% rate. Since, of course, the federal system and the Minnesota system differ, there are gifts that Minnesota residents make that will incur Minnesota gift tax but not federal gift tax. This new Minnesota gift tax also applies to residents of any state making gifts of Minnesota real estate or tangible property.

Estate Tax on Pass-Through Entities Owning Real and Tangible Property in Minnesota. Prior to this change in the tax law, non-Minnesota residents did not pay estate tax on assets that were held in business entities like LLCs or partnerships--even if those entities owned real estate. If the deceased was not a resident of Minnesota, it was not considered Minnesota located property. The new tax law looks through those entities to tax any real estate or tangible property (equipment, crops, etc.) held in a pass-through entity. Pass-through entities are LLCs, partnerships, some trusts and S-corporations. This change is effective for any decedents dying after December 31, 2012. This doesn’t change the application of the estate tax for Minnesota residents. Individuals owning any pass-through entity that owns any real estate or tangible property in Minnesota will now owe some estate tax to Minnesota.

MN Angel Tax Credits Run Out for 2013

In recent posts, my colleagues, here and here, and I have provided updates on the status of the Minnesota Angel Tax Credit.  As of early-May, according to the Minnesota Department of Economic Development’s (DEED) website, all $12.7 million of the tax credits available for issuance in 2013 had been exhausted.

There was some hope that the Minnesota legislature would allocate additional credits for 2013 in this session’s tax bill.  Indeed, there was at least one proposal to increase the tax credits available for issuance this year.  However, the tax bill that the legislature approved at the end of the session on May 20th, and which the governor signed, did not include an increase for tax credits this year.

The legislature did approve an allocation of $12 million for calendar year 2014.  Given the pace at which tax credits have been allocated the past two years, I think we can assume that the $12 million of tax credits available for 2014 will be exhausted by the time the snow melts next spring in Minnesota. (Jeff Nelson, the angel tax credit program’s coordinator, speculates that they will run out of credits by April.)  So, if you are planning to raise capital next year, and hope your investors will be able to take advantage of the tax credit, you will need to get in line early.  DEED will begin accepting applications for the 2014 angel tax credit in November this year.

…the “Talk”…

Recently, I just about drove my truck off the road after hearing my daughter’s pre-adolescent voice, all the way from the back seat, direct “the question” to me. The question was, you know, the question that many parents dread because you have to talk about. It’s awkward, frustrating and frankly, it’s a coming of age that reminds you that your kids are no longer innocent and are getting older.

Many of you reading this can remember where you were when you had “the talk” with your parents. Some kids figure it out on their own; other more responsible parents (innocent of this charge) take the issue head-on by sitting down and talking with their kids. I’ve heard that some parents use charts and some even go to a class (with their kids!). I haven’t checked, but I’m pretty sure there must now be “an app for that”—parenting made easy, courtesy of Steve Jobs. 

After collecting myself, we pulled into a parking lot and the talk ensued—quick, succinct and to the point. I didn’t have much time and I was going to do a brief overview with the full talk to occur later that evening with her mother who really has some strong feelings about the topic. “Do your friends talk about it?” I quickly asked, and sensing the concern in my voice, she politely said “no.” Thank goodness, I thought to myself, but she went on. “I heard you and mom talking about it last night” (uh-oh) “and mom was talking about it with the neighbor on the phone too.” (WITW!) “I think I heard her talking about it out loud after watching the news, too.” I was slack-jawed. 

As you can imagine, this parent was overcome by youthful awareness and the pressing questions surrounding taxes.

Since that fateful ride in the truck and the parking lot crash course in taxation, I have been strafed with questions about why adults pay taxes, who made taxes, how are they collected, what are they used for, do we ever get them back…and the list goes on and on and on. Curiosity has also spread through the family. We have what is referred to in the world of geese as a gaggle of children. They are inquisitive and the conversation migrates quickly (and at times resembles honking), is painfully direct, and typically not restrained by common sense. Although my wife and I are affectionately referred to as “tax hawks,” I struggle to explain all the nuances of the how’s and why’s of taxes, especially the rates. 

About the time of the initial “talk”, my state was in the throes of a tax bill that would not only raise taxes, but would introduce new taxes on professional services (since that time, the professional services tax has been stricken from the proposal). I was explaining what that meant as a lesson since one of the children is learning percentages in math class. We did the math and it was interesting to hear the banter back and forth between siblings.

The part my children thought was really fun to listen to was my explanation of personal income and tax rates. You can image the stunned look on my daughter’s face when she said, “Uh dad, you mean some people pay half of their income in taxes?” (Take that percentage of a weekly allowance in exchange for basic “services” provided in the house and watch the reaction.) “Yes,” I said, “but it’s different for you because you wouldn’t have to pay tax because you fall below the state and federal limit.” Without flinching, her response was classic. “But when I get older and I get a good job, will I pay half?” I gave my typical (non-classic) response—“Its depends.” 

Recently there have discussions about revenue increases in a proposed California state budget. This is combined with a recent case which challenged the 50% exclusion on QSBS corporations, meaning that they pay only half the regular California tax rate on the gain (about 4.5 percent instead of 9 percent). This would be a crippling retroactive tax for business generators (read “job creators”) that are a vital piece of California’s economy. What’s even more troubling is that many entrepreneurs go for years foregoing market income (and in some cases, any income at all) and will have a massive tax event upon exit (think liquidation event, sale, merger, IPO, etc.) I have no idea what the current status of this situation is as it will likely be subject to litigation for some time as well. Even if you think that you have your tax structure in order, that isn’t necessarily the case. (Anything that has the word “retroactive” in it has to be looked at with some suspicion.)

It’s never too late to have “the talk.” As a matter of fact, if you haven’t had a review on your existing and future tax outlook, there is no better time. Many changes are on the horizon for you and your business regardless whether you are an entrepreneur in a pre-revenue company or an existing company that is facing new government mandates for health insurance. Or you could be thinking about selling your company in the near or distant future. Guess what? Planning now, even if a sale is not in the forefront of your mind, may be the best thing that you ever did for yourself, your company, your employees, your shareholders, your stakeholders—and maybe even that youth in the backseat of your truck who asks, “Dad, I have another question….”

New Minnesota Income Tax Developments—Is Everyone and Anyone Going to be Considered a Minnesota Resident?

There is a new proposal from Governor Dayton that would change the landscape of how many people view their residency status. This is not official; I repeat—THIS IS NOT OFFICIAL. I don’t want everyone to panic and start driving south, but it is possible and we should discuss it. 

The new proposal would make every person that spends 60 days (whole or partial) in Minnesota, and has a residence that is suitable for year-round use, whether owned or rented, a Minnesota resident and subject to Minnesota income tax. Currently, there are a number of factors that determine residency, the major one being the requirement that you spend at least 183 days in Minnesota. There is a major difference between spending 183 days in Minnesota and a mere 60 days (123 days, if my elementary school math skills are still working). The traditional “snowbirds” spend the summer here, and then migrate South for the rest of the year. A change to 60 days would mean less than half the “nice” months in Minnesota (not to be confused with “Minnesota Nice“).

What does this mean? Other than the expected outcry from those who love their lake homes and treasure the summer months they spend here, but also love the no income tax environments of Florida, Texas, Arizona, and others, this means major changes to our local economy. Well, at least in my opinion—I guess if you assume that everyone who currently does so will continue to spend more than 60 days in the state and pay additional taxes, then it may not be such a big deal.

Take one example: country clubs.  Not that I think we need protective legislation for country clubs, but it serves as an easy example. The way country clubs collect membership dues to pay for the upkeep of the buildings and golf courses are broken up between food and beverage minimums, and monthly dues relating to peak season expenses. Peak season is usually April through October. Dues typically increase up to ten times during this period, and this is also the time members use their food and beverage minimums because they are using the facilities. Also, I would guess that the demographics of country club members are made up of quite a few snowbirds. If this new residency requirement goes through, a typical snowbird can only spend 60 days on Minnesota soil, and it won’t necessarily all be during peak golf season. I think country clubs may have a hard time keeping members, let alone getting them to pay for 5 or more months of peak golf season that they aren’t using.

Use the country club example and expand that to restaurants that cater to the summer months, rental summer homes, lake homes in general, and the local economies of the cities that our lake homes are located near (Brainerd, Duluth, Alexandria, and others). If it is going to require that snowbirds sell their lake homes, apartments, or other seasonal homes, the real estate market will be flooded and diminish values.

I don’t mean to be advocating a particular political position. I simply want to point out the major change that could be around the corner and get people, may even the state legislators who will need to take up this issue, thinking about it. After all, we are nearly 60 days in to 2013 now…

Fiscal Cliff Doom and Gloom Averted (?)

Happy 2013 everyone!  I hope your New Year’s festivities were safe and enjoyable, and that you were able to spend a few moments thinking of something other than the imminent doom that might have been our fate after we headed over the “fiscal cliff.” I don’t know about you, but news coverage of the “fiscal cliff” negotiations, or lack of negotiations, and the ruin we were all about to experience, left me wishing that Santa had brought me a fallout shelter for Christmas.

No need for hysterics though, as apparently our government averted the total disaster that would have been the fiscal cliff crash by agreeing to a compromise earlier this week.  President Obama signed the compromise legislation into law—the American Taxpayer Relief Act of 2012—on January 2nd, which obviously was after midnight on December 31st.  I was under the mistaken impression that after midnight on the 31st we were headed off the cliff and there was no turning back.  I was wrong.  Our economy is more like  the coyote in the Looney Tunes cartoons, in that we were able to run off the cliff, but then stop and remain suspended in midair, turn around, and run back to safe land.

In the days ahead, there will be plenty written about how the Taxpayer Relief Act impacts Americans in general and, of interest to readers of this blog, small businesses and entrepreneurs in particular.  I haven’t had a chance to go through the legislation in any detail, but did notice one provision that might be of interest to entrepreneurs and owners of small businesses.  The Taxpayer Relief Act shortens the time period to five years during which the Built in Gains Tax, or BIG Tax, will be applicable for years 2012 and 2013.

As many of you probably already know, the BIG Tax applies to S corporations that were formerly C corporations.  At the time the former C Corporation elects S corporation status, the corporation must calculate the amount of unrecognized appreciation in its assets (measured by fair market value less tax basis).  The asset most likely to experience significant appreciation is good will.  If the S corporation subsequently sells its assets within a certain period of time after the S election is made, the BIG Tax will be applied against the previously unrecognized appreciation on the assets that existed prior to making the S election.

Prior to the Taxpayer Relief Act, the BIG Tax applied to a ten-year period, so that any asset sale made within 10 years after the conversion from a C corporation to an S corporation would potentially be subject to an additional BIG Tax.  The Taxpayer Relief Act changed that waiting period to 5 years for years 2012 and 2013.  So any asset sales consummated by S corporations during 2012 and 2013 should not be subject to BIG Tax so long as the corporation made its “S” election more than 5 years ago. 

The retroactive change for 2012 won’t help you with planning any of last year’s transactions (at least for those of you who don’t have a time machine), but the change for 2013 may be useful for S corporations planning to sell this year.  Knowing that the change would have been applied to 2012 could have been helpful for at least one transaction I worked on that didn’t close at the end of last year, although it may be helpful in facilitating a closing in 2013.

Get In Line for 2013 Minnesota Angel Tax Credits

Among all of the other holiday tasks and resolutions likely still on your to-do list, if you are an entrepreneur looking to raise capital in 2013 and hope to take advantage of the Minnesota Angel Tax Credit, you should think about starting the process now. The state’s annual allotment of credits, which gives qualifying investors up to a 25% tax credit on eligible investments in Minnesota start-up businesses, has seen a trend of depletion earlier and earlier in each year of its existence. The first full year’s allotment of $16 million in 2011 was fully subscribed for by November of that year. 2012’s allotment of $12 million was exhausted by the end of July, in part due to a last-minute rush on the credits precipitated by articles reporting on the scarcity of credits. So, if word on the street is any indicator, the additional $12 million allotment for 2013 will be gone even earlier this year.

The credits have proven to be deserving of their status as a “hot commodity.” Between July of 2010 (when the program started) and the end of 2011, the credits helped generate $92 million in investments in Minnesota companies, and that number reached $140 million after the 2012 allotment. Over 100 companies were issued the credits in 2012 (a few of which, we are proud to say, are Gray Plant Mooty clients.) The program is currently only set to last through 2014, with the same amount of funding in its final year as in 2012 and 2013. 

So what should you do to make sure you get your share of the tax credits this year? Minnesota’s Department of Employment and Economic Development (DEED) is already accepting applications for business certification, which solidifies a business’s qualification to receive applicable investors in the coming year. Investors may also currently submit their certification applications to obtain qualified investor status. These forms and other directions can be found on the DEED website. You will still have to wait until 2013 to officially begin a joint filing between the business and the investors of the specific credit allocation application (and, of course, the making of the actual investment). With businesses and investors already poised to file for allocations and transfer money, I can only imagine that the DEED office is gearing up for a busy start to the new year next week!

A Post by Karen Wenzel, Guest Blogger

2012 Gifting—When is a gift actually complete?

Many clients are doing year-end gifting this year. We have an unusually large gift tax exemption and thus the additional ability to gift without tax implications, and we are facing unknown tax laws going forward.  You may or may not be gifting assets, or receiving assets by gift, but I thought this might be a good opportunity (albeit boring—unless you are receiving a large gift this year) to discuss what it means to actually complete the gift by the end of 2012.

• Cash and checks—a gift of cash or checks is complete when the transfer of funds is complete or when the check is cashed.

• Real estate—a deed (warranty deed or quitclaim deed) is necessary to transfer the property. The gift is complete when the deed is delivered to the recipient or recorded in the appropriate county.

• Stock in a company—a decision to make the gift, or even a letter, is not sufficient.  There must be an Assignment Separate from Certificate with the stock certificate, or an endorsed stock certificate, to complete the gift of stock. The gift is complete when the assignment or endorsed certificate is delivered to the recipient or an agent of the recipient, but not if it is merely delivered to the agent of the person making the gift.  The agent of the recipient could be a transfer agent, but often either (1) there is no such thing for a closely held company, or (2) that transfer agent is considered an agent of the person gifting and not the recipient.  The other way to determine if the gift is complete is if the transfer is recorded in the company records.  Be sure to check buy-sell agreements or other documents for transfer restrictions.  If a transfer is done in violation of any such restrictions, it could be considered void even if it is otherwise complete.

• LLC’s/Partnerships—as is the case with the transfer of corporate stock, an assignment with an acceptance from the recipient will complete the transfer of interests in an LLC or partnership.  The gift is complete when control is transferred to the recipient. Again, consult the transfer restrictions or requirements applicable to new members in the company’s documents to be sure you comply with those requirements as well.

In addition to completing the steps outlined above, it is important after the fact to treat the asset that has been given as a gift as having been transferred.  For real estate, it is important to treat property as if the new owners have complete control.  Change the insurance, execute a lease to use the property, change the property tax information.  With stock or interests in LLC’s and partnerships, the company records should reflect the change, distributions should go to the new owners, any guaranties should be negotiated, new members should be added to the buy-sell or other corporate documents, and K-1’s should be prepared for the new owners.  Also, report these gifts on a gift tax return.  If you are gifting in 2012, or really any year, be sure to meet the reporting requirements with the IRS and have your attorney or accountant prepare a gift tax return in April of 2013.

Sequestration Looming (Part II)

In a prior post, I wrote about the pending impact of sequestration on the defense industry. Since then, sequestration has drawn increased attention, including some confusing references during the third presidential debate. The potentially devastating effect of sequestration is now becoming apparent.
 
As I mentioned in my earlier post, October 1 was the deadline for the 90-day notice some states require under circumstances covered by the federal Worker Adjustment Retraining Notification Act (“WARN”) Act.  The WARN Act requires companies with more than 100 employees to give 60 days’ advance notice of mass layoffs or plant closures. Many defense contractors, however, have ended up backing off from issuing such notices because of uncertainty as to what the sequestration bill passed earlier this year actually requires. 

Following passage of this bill, the White House issued a memo directing contractors to follow the guidance of the Labor Department, which, in a July letter, said the WARN Act does not require contractors facing sequestration to send layoff notices to their workers. And the Office of Management and Budget stated in September that the government would pay for related legal costs incurred by companies that follow the Labor Department’s advice.

Based on this, many of the largest federal contractors have concluded that they will not send out WARN Act notices “unless they get more details about how sequestration—the dramatic cuts that will take effect in January if lawmakers don’t agree on an alternative long-term budget plan—would affect them.”   

The net result? No one seems to be sure, but one thing is clear. If Congress does not act, sequestration, as currently contemplated, will take effect as soon as 2013 rolls around, and the WARN Act notice requirement will also kick in for many companies based on known and immediate cuts that will result in layoffs. What is also likely is that companies subject to these requirements that have followed Labor Department guidance but nonetheless find themselves to be noncompliant with WARN Act requirements will be looking to the government (read: taxpayers) to cover their costs of noncompliance.

Where does this leave the second tier of government contractors—vendors and service providers? Even further in the dark and possibly facing sudden project cancellations (and the ripple effect of that is potentially huge). Stay tuned.

Are the NFL Rules (and Those Who Enforce Them) Getting as Unpredictable as the Tax Code?

Coming off the heels of Monday night’s interesting finish  to the Packers-Seahawks game, I have started to wonder if the NFL rules have become so complicated, and the turnover of officials so frequent, that tracking the outcome of a football game is starting to get as difficult as tracking the changes to the tax laws. We are looking, once again, at potentially significant changes to our tax laws after 2012, what with an upcoming election that could change those who shape and enforce those tax laws.

I have spent the last two years discussing pending changes to the tax laws with clients and with my colleagues. We talk about what provisions are going to sunset, what provisions we are supposed to pretend never existed, what rates might fluctuate, what techniques still work, etc.  We try to guess at what might change next. I have in-depth discussions about proposed bills in committees and obscure Senate races as we try to picture what the tax rules may look like next year. I have clients waiting to sell their entire businesses until “after the election” just to see who will be creating and enforcing those tax rules next year.

Are we destined to have a 2013 that resembles the NFL games from this weekend? Will we be able to tell how many time-outs a team gets, or what a simultaneous catch really looks like?  Are the rules so complicated that we can’t add replacement enforcers without serious implications to the outcomes of the game?

I still have no idea what the tax laws will look like next year.  I also have no idea how the election will shake out.  But I do know that, like football, there will always be taxes and there will always be rules.   I might just have to learn the difference between a force-out and the new overtime rules, to accept the inconsistencies and unknowns of new officials, and try to continue to guide clients on the probable outcomes of the game.