law school outline: tax issues of high tech companies
Tax Issues of High Tech Companies
- Course materials
- Establishing the Business
- Corporation (Subchapter C)
- Allows for stock to be used as compensation or in lieu of cash, but if in exchange for intangible property, see �351 (deferred gain or loss treatment).
- Preferable form to attract financing
- �1202 QSBS provisions (below)
- Stock may meet definition of �1244 stock entitling individuals to treat up to $50k of loss ($100k if joint return) as ordinary, rather than capital.
- PHC: Closely held company with R&D funds invested prior to use and prior to significant sales may meet definition of personal holding company (PHC) and be subject to PHC tax. This occurs, basically, when the company is holding too much cash and not paying it out as dividends.
- No flow through of losses and credits to owners which will likely be unusuable to corporation in its early years. Losses may be larger for high tech company relative to other companies.
- If target of takeover or acquisition, resulting gain subject to double taxation. Loss and credit carry forward limitations of �382 and �383 would apply.
- Subchapter S corporation, Limited liability company (LLC), Partnership (subchapter K), Sole proprietorship
- No PHC liability.
- Partnership or sole proprietorship less costly to form, preserving more cash for R&D.
- No �1202 QSBS gain exclusion.
- Ordinary loss rule of �1244 only available to individual shareholders of C or S corporation.
- Losses and credits (i.e. �41 R&D credit) pass through to owners for immediate tax benefit, but are limited to the tax attributable to the portion of the owner�s taxable income allocable to his interest in the trade or business (�41(g)).
- Passive activity rule of �469
- Partners and S-corp shareholders can deduct R&E expenditures and use credits only if they have sufficient passive activity income, or are a material participant in the activity generating the deductions and credits (this usually excludes limited partners). Unusable deductions and credits will carry forward.
- Owners must also be concerned about the at-risk limitations of �465 and basis limitation of �704(d) and �1366(d).
- Distribution to owners is pro rated to the percentage of shares owned.
- Intangible property may be services, causes tax effect only to partner contributing such property/services. Others contributing property will still get the tax-deferred benefits of �721.
- If taken over or acquired, gain subject only to single layer of tax. Loss and credit carryforward limits of �382 and �383 would not apply, as losses and credits are passed through to owners.
- Can�t really use S corp. stock in lieu of cash because of limit on number of shareholders and requirement to only have one type of stock; can�t use stock in a partnership to compensate employees.
- Owners of passthrough entity may not be entitled to �174 benefits.
- S corporation shareholders cannot increase basis by their share of entity debt.
- Can�t use an LLC for a business that requires a license, certification or registration.
- Can convert to C-corp once income is produced.
Place of business considerations
Tax incentives, including research, training, enterprise zone, sales, manufacturing, capital gains. Physical location of any part of the business may result in sales and use tax collection obligations and income tax liabilities. Strategic location could minimize these taxes. Employee location preferences and availability. Nexus issues for taxable presence
- Minimum allowable contact determined by P.L. 86-272.
- Barnes & Noble.com and Borders.com are separate corporate entities from the brick and mortor stores. Amazon.com specifically did not locate in CA because of the large customer base which would have been subject to taxation.
- Web presence is insufficient.
Method chosen must clearly reflect income.
- Presence or magnitude of accounts receivable may require accrual method to clearly reflect income.
- Required if company has merchandise that is an income-producing factor.
- Is taxpayer�s inventory merchandise? If not, it�s either supplies or depreciable property.
- Inventory must be considered in determining taxable income when the production, purchase, or sale of merchandise is an income producing factor.
- Merchandise: Items held for sale. Price charged to customers reflects cost of items transferred and plays a central role in the business (income producing factor), versus where inventories and inventory fluctuations would be de minimis and have virtually no effect on reflection of income.
- Service business: Business where supplies, not inventory, are transferred to customer along with services. Revenue stream constituting services income may be preferable to inventory sales because accrual method can be adopted and payments deferred under Ruling 71-21. But: Roofing contractor�s inventory of shingles has been held to be inventory.
- Certain costs must be treated as inventory, rather than period costs (�263A): Real or tangible personal property produced by taxpayer and property acquired for resale.
- Exception: Costs of producing intangible property.
- IP is considered tangible property, unless provided incident to services. Include software distributed by internet? Arguably not.
- Required if company is a C corporation or partnership with C corporation partner, with over $5M of average gross receipts for prior 3 year tas period.
Cash method Errors, which by definition would affect total lifetime income, can be fixed with an amended tax return, within 3 years from error (no need to go back beyond because it�s of 3 yr statute of limitation). Incorrect accounting method does not affect total lifetime income; only when it is reported.Research & Development/Experimentation Credit
- Federal Credit for Increasing Research Activities (�41)
- Added in 1981 as a temporary (not perminant) tax credit to encourage an increase in qualified domestic R&D. Supposedly McDonalds claimed a credit for Chicken McNuggets, so Congress limited to technological and experimental R&D in 1986. In 1998, IRS issued proposed regs which were quite vague (unauditable) in defining what research was qualified, so in Dec. 1999 Congress tried to narrow the definition.
- Difficult for business to most effectively use the credit for long-term research planning when credit expires every few years and renewal is uncertain.
Sum of 20% of qualified expenses over the base amount, plus 20% of qualified basic research payments paid to other organizations for research (see �41(e)). Credits cannot be used to reduce tax liability below tentative minimum tax, computed for AMT purposes. Excess credits can be carried back 3 yrs or forward 15 yrs. Maxumum possible research credit as a percentage of qualified research expenses is usually around 6.5%. Postponement of credit (�502 of ___) � purpose was to comply with certain revenue targets.
- Credit earned 7/1/99-9/30/00 can�t be claimed until 10/1/00
- Credit earned 10/1/00 � 9/30/01 can�t be claimed until 10/1/01
- As soon as credit can be claimed, taxpayer can file amended return and application for expedited refund.
Tip: Set up special ledgers and tracking devises to keep track of expenses, especially wages, by project. Document job titles and projects very thoroughly. Example:
Current year R&E = $150
Less base (10%x$1000) = -$100 [for start up = 3% for first 5 years, phased to normal formula over 2nd 5 years]
Incremental R&E = $50
Tax credit (20%) = $10Qualified expenses
Current year R&E = $150
Less base (10%x$1000) = -$100 [for start up = 3% for first 5 years, phased to normal formula over 2nd 5 years]
Incremental R&E = $50
Tax credit (20%) = $10Qualified expenses
In-house research expenses Incurred in carrying on a trade or business of the taxpayer at the time the expense is incurred.
- For a start-up, purpose of in-house research expenses must be for a future trade or business (start-up cannot get credit for contract research expenses).
Which the taxpayer retains a right to in the research (i.e. not if taxpayer performs research on behalf of another person and doesn�t retain any interest in the research), and which taxpayer bears the risk of loss. Includes wages for qualified services (if at least 80% of employee�s wages qualify, they all do), including direct supervision or support of research activities, so long as the person is directly involved in research, directly supporting the research, or directly supervising (first line manager) the research.
- Payments for wages need not be in cash � can include property, such as stock options. But 401(k) matching contributions do not count (�3401(a)).
- Wage = Spread of stock options (purchase price-FMV) upon exercise, even if at time of exercise the employee isn�t working on the research project.
- Example: Wages for technical writer who is writing docs after research is completed does not qualify, but does qualify if doing research. Examine what employee actually does.
Payment for use of computers Supplies (tangible property) used for qualified research with useful life of 1 year or less (>1yr should be depreciated), and which are totally consumed in the research activity. Example: Costs to build prototypes. 65% of cash payments for qualified research performed on your behalf (75% if paid to nonprofit qualified research consortium).Qualified research
Each business component is evaluated separately, and if the component fails, look at the next lowest level of the component (i.e. if the toaster fails, look at the heating elements). Must qualify for �174 treatment. Discovery Test
- Research undertaken for the purpose of discovering information which is technological in nature.
- Go beyond the current state of common knowledge of skilled professionals in the field � innovation.
- Research must rely on principles of physics, biology, engineering or computer science.
- Application of discovered information must be intended to be useful in the development of new or improved business component of taxpayer..
- New or improved function, performance, reliability or quality which is to be sold, leased or licensed, or used by taxpayer in his trade or business.
- Need not be successful.
Process of experimentation used during substantially all (80%) of the research.
- Related to:
- New or improved function;
- Performance; or
- Reliability, quality (but not related to style, taste, cosmetic or seasonal design)
- Evaluation of more than one alternative to achieve a result where the means of achieving the result are uncertain at the outset.
- Research related to style, taste or cosmetics.
- Research after commercial production.
- Adaptation of existing business components of yourself or another.
- Duplication of existing business components of yourself or another (i.e. reverse engineering and developing generic drugs).
- Surveys or studies related to efficiency, management, market research, routine data collection, quality control.
- Computer software developed or acquired for taxpayer�s internal use, except:
- For use in qualified research activities; or
- Software which will be marketed to customers (either as software or bundled with hardware); or
- Software which is highly innovative (economically significant reduced cost or faster speed), involves significant economic risk, and not commercially available for use by taxpayer.
- Payroll, administrative functions, personnel management, accounting, banking, etc. is nonqualified.
- Query: What about web site software?
- Foreign research (Puerto Rico ok)
- Social sciences
- Research funded by grant, contract, or by anyone else, such as the government (but see qualified organizations under �41(e)). Qualifies for credit only if:
- Payment contingent upon success of research (taxpayer bears risk of failure); and
- Taxpayer retains substantial rights in results of the research.
- BUT NOTE: members of a controlled group of corporations (parent/subsidy) are treated as a single taxpayer, and does not create a funded research situation.
Average annual gross receipts of taxpayer for 4 years prior to credit year, multiplied by the fixed base percentage [percentage which the aggregate research expenses for 1984 through 1988 is of the aggregate gross receipts for those years, capped at 16 %].
- If company didn�t have both gross receipts and research expenses until after 12/31/93, or fewer than 3 tax years between 12/31/93 and 1/1/89, then use 3% as the fixed base percentage.
Base amount cannot be less than 50% of the qualified expenses for the credit year.Alternative Minimum Credit
Taxpayer can elect to take a credit equal to:
- 2.65% of the R&E between 1-1.5% of average gross receipts of past 4 years
- 3.2% of that between 1.5-2%
- 3.75% of that which exceeds 2%
Election is irrevolcable without consent of service. AMC is usually only beneficial if company fails to qualify for basic credit due to rapid increase in gross receipts that throws off their formula.Audit notes
- Keep written description of each account and cost center
- Written job descriptions and evaluations.
- R&T �17052.12 and �23609 � perminant provisions.
- Both individuals and corporations can take advantage of a research credit, at 11% (12% after 1/1/99). Only applies to research performed in CA, and gross receipts only includes sales delivered or shipped to purchaser in CA.
- 75% of payments made to certain nonprofit research consortia.
- Unused credit can be carried over until exhausted, but not carried back to prior years.
Profiting from R&D
- Individual transferring patent may be able to obtain capital gain treatment under �1235 if the transfer is of all substantial rights and held by seller for more than one year.
- Need to determine type of income: Sale of goods, license, services, other, so that one can determine tax treatment and consequences.
- State nexus issues for income and sales/use tax. Need to review rules in any state in which taxpayer has customers, licenses, employees or property.
- Collapsible corporation rules of �341 may apply.
- Law not clear as to whether technology may qualify as a �1221 or �1231 asset.
Accounting for R&D
- GAAP FAS #2: R&D
- GAAP FAS #86: Software developed for external use
- Principle of conservatism requires that for accounting purposes R&D costs must be expensed (keep off balance sheet and don�t overstate income or assets), until "technological feasibility" has been met, at which point costs should be capitalized. When product is marketed, the capitalization is amortized and deducted over the life of the product.
Capitalization vs. Expense
- Itemized list
Business expansion: Capitalize Entertainment: �162 deduction (50%) Goodwill: �197 capitalize Improvements which are perminant: �263 capitalize Intangibles: �197 capitalize Loan origination fees: Capitalize Meals: �162 deduction (50%) New buildings: Capitalize (> 1 yr life) Property restoration: �263 capitalize Quality improvement: Capitalize per TAM 9544001 Rental of property: �162 deduction Repairs which are non-incidental: Capitalize (> 1 yr) Research and experimentation expenses: �174 deduction or capitalization (choice) Salary: �162 deduction Software: �167(f) capitalize and depreciate over 36 mos (but see below if developed versus purchased) Start-up expenses: �195 capitalize Takeover costs: Capitalize (>1 yr life) Take-over costs: Indopco capitalization Traveling: �162 deduction Web page development: Capitalize as software development costsDeduction of trade or business expenses (�162)
All ordinary and necessary expenses in carrying on (not starting up - �195) any trade or business can be deducted from income.
- Ordinary: Expense which benefits the current period, as opposed to a capital expenditure or creation of new product (�174)
- Necessary: Important to business; customarily incurred.
- Traveling, so long as not lavish or extravagant (max. 1 year away from home)
- Meals & entertainment: 50%
- Rental of property
- Charitable contributions and gifts
- Illegal bribes and kickbacks
- Certain lobbying and political expenditures (possibly part of the dues to industry associations)
- Prohibited: Deductions for costs to influence legislation.
- Any attempt to influence legislation through a lobbying communication
- All activities engaged in for ht epurpose of making or supporting a lobbying communication, even if not yet made.
- Lobbying communication is not one which is compelled by subpoena, nor one urging Congress to take action without referring to specific legislative proposal.
- Determine amount by ratio of lobbying labor hours over total labor hours, and add that amount to payments to TP�s for lobbying costs. Excludes de minimum time (<5% of person�s total hours). Other methods: gross-up (labor costs times 175%), or per �263A.
- Fines and penalties
- Certain foreign advertising expenses
- Expenditures for benefits beyond the present tax year that is more than incidental must be capitalized (and because it�s hard to determine useful life, the expenses usually stay capitalized on the books until the asset terminates). (Indoptco case).
- Takeover costs
- New buildings or perminant improvements made to increase value of land (�263).
- Restoring property (�263)
- Quality improvement initiatives (TAM 9544001) (but maybe the expense would occur as R&D?)
- Take-over costs (Endoptco)
- Non-incidental repairs which increase value of property, change use, or extend life.
- Loan origination fees
- Business expansion
- Web page development
- OK to deduct: Advertising (92-80), training costs (96-62), business development (i.e. rebates), severence pay (94-77), incidental repairs, K cancellation when no new contract entered into.
Capitalization and depreciation of expenses (�167)
- Compared to other countries, US depreciation isn�t very competitive
- When too slow, companies pay more taxes in early years on income generated by the assets. If too fast, it won�t match the deduction to the period when income is generated.
- Accellerated depreciation will increase after-tax cash flow.
- Expenditures to develop or create an asset with useful life of more than 1 year (must be capitalized)
- Property used in trade or business or used for production of income can be depreciated.
- Amount depreciated: Adjusted basis / Useful life
- Software: 36 month depreciation (�167(f)).
- If capitalized, it�s amortized and depreciated over useful life, but if useful life can�t be determined, then when asset is disposed of it�s deducted.
Deduction or capitalization of R&E expenditures (�174)
Purpose: This statute is a workaround for expenses which would be disallowed under �162 because the business is not yet "carrying on" or because the expenses are not "ordinary." Method
- 174(a) requires R&E costs to be expensed as incurred, rather than capitalized.
- Usually best option for companies who are producing income, because they can use the deduction, but startups may not have any income to deduct against.
- Results in zero tax basis in R&E.
- If expensing would create NOL, evaluate if NOL will have any adverse consequences, and if so, elect (b) or �59(e). May trigger built-in deduction limitations or net unrealized built-in gain and loss rules of �382(h).
- Capitalization of R&E (�59(e))
- Individual, including a corporation, receiving �174(a) expenses (i.e. pass through from a partnership) who doesn�t materially participate in the R&E and who is subject to AMT can elect to amortize all or part of the R&E over a 10 year period.
- Unless AMT applies or other federal or state tax benefits would apply for 10 year amortization, the length of the amortization would not normally be favorable.
- Election by the return filing date, applies only for expenditures that tax year.
174(b) allows taxpayer to elect to capitalize R&E and then amortize over 60 months or more starting when you first realize benefits (income-producing use).
- The expense must be chargeable to a capital account, but not depreciable under �167 (once R&E results in development of depreciable property, deductions for unrecovered expenditures have to be determined under �167).
- Completed software has a determinable life of 36 months (�167(f)), and therefore cannot be amortized under �174(b).
- May help reduce a net operating loss (important for start-ups) which some states do not permit to be carried over.
- Election to use (b) must be made by due date of first tax return, including extensions, in which �174 expenditures were incurred. Election of amortization time period greater than 60 months must also be made at this time.
If neither (a) nor (b) are used, the expenses are charged to a capital account.
- Taxpayer can amortize capitalized R&E expenditures only if it can show a determinable useful life for the asset.
- Taxpayer can write-off (expense) capitalized costs under �165 if project abandoned.
- If taxpayer failed to select either (a) or (b) methods and therefore wound up using default method, taxpayer should request permission to change to (a) or (b). Taxpayer can change to (a) by filing amended return before subsequent year�s return is filed. Change to (b) requires permission of service.
Change of methods requires consent of Commissioner, but selection in first year where R&E expenditures are incurred does not.
- Taxpayer should consider costs of future changes of methods.
- To use different methods for different projects:
- Choose (a) as your default method, and file a formal request to use (b) for certain projects. See Rev Rul. 68-144.
- If you use (b) for your initial research project, and down the road you want to use (a), you have to get permission because (a) can only be adopted without consent in the first year in which R&E expenditures exist.
- In the first year, taxpayer could attach a statement electing (b) for first project, and (a) in future or other projects, and the IRS has in the past allowed that.
- Some changes can now be done using Form 3115 attached to return under Revenue Procedure 98-60 (99-49) (previous procedure was to request a private ruling for $4k).
Limit on �41 research credit (�280C)
- 174(a) deduction is reduced by �41 credit.
- 174(b) capitalization is reduced by the amount that the �41 credit exceeds the amount allowable as a deduction for R&E.
- Alternatively, taxpayer can irrevocably elect to reduce �41 credit by the amount of the credit times the tax rate.
Expenditures incurred in connection with taxpayer�s trade or business which represent research and development costs in the experimental or laboratory sense to eliminate taxpayer�s uncertainty as to taxpayer�s development or improvement of a product. Includes all costs incident to development or improvement of a product: Rent, wages, fringe benefits, attorney fees for developing patent, overhead, travel expenses, etc. Excludes:
- Quality control testing
- Efficiency surveys
- Management studies
- Consumer studies
- Advertising or promotions
- Acquisition of another�s patent, model, production or process
- Research re: literary, historical or similar projects.
- Manufacturing expenses
- Land or depreciable assets, such as a computer (174(c)); although depreciation or depletion costs are ok once placed in service and business has begun.
- Software depreciable over 36 month period under �167(f).
- Objectively unreasonable expenses
TP paid to do research
- Must be made upon taxpayer�s order and at his financial risk, and not just buying an asset (completed software).
- When Partnership is formed fund the R&D work of the Corporation, P cannot take a �174 deduction because they have not materially engaged in the required trade or business, unless P realistically intends to and is capable of enter into its own business with the fruits of the research. P must have the technical expertise, the right to purchase the research, and C must not intend to prevent P from doing so.
- Entity incurring the R&E expenditures must actually manage and control the use or marketing of the results of the research.
- Under �469 Passive Activity Loss Rule, passive activity loss can only offset [passive activity income?]. Purpose was to eliminate a common tax shelter in the 70�s and 80�s.
GAAP FAS 2: Principle of conservatism requires that for accounting purposes R&D costs must be expensed, until technological feasabiliy has been met (FAS 86), at which point costs should be capitalized. When product is marketed, the capitalization is deducted over the life of the product. California: R&T Code �24365 incorporates �174 by reference. Whichever method is used under �174 is also applicable to the taxpayer for state tax purposes, unless taxpayer requests permission from Franchise Tax Board to use a different method.Capitalization of start-up expenses (�195)
No deduction allowed for start-up expenses: Must be capitalized. Includes expenses:
- Investigating creation or acquisition of business
- Creating an active trade or business
- Any activity engaged in for profit and production of income prior to when active business begins, in anticipation of activity becoming an active business.
- Excludes �174 R&E expenditures
Expenses can either remain capitalized for the life of the business, or taxpayer can elect at first tax return to amortize expenses over 60 month period beginning with month the active trade or business begins.
- Business begins when taxpayer acquires it, or when activities have advanced to the extent necessary to establish nature of business operations (such as acquisition and use of operating assets); ready to receive revenue.
Acquisition costs get capitalized under �263. Existing business entering new line of business
- Differentiate �195 capitalization of new line of business expenses vs. �162 deduction of expenses incurred in expanding of a business. Factors:
- Whether pursuit or activity was one for which original business was established
- Whether new activity was within compass of taxpayer�s existing trade or business
- Activities related such that average business in the field would likely involve both activities
- Substantial amounts of new skill or expertise required for new business
- Change in nature of activities
Depreciation of goodwill and intangibles (�197)
Applies when a company purchases another trade or business.
- Acquisition of trade or business is presumed when a trademark or patent is acquired, with the exception of trademarks acquired in software, film, sound, recording, video tape, book, or when value is nominal or taxpayer irrevocably disposes of it immediately after acquisition.
15 year straight line amortization can be elected by taxpayer beginning in the month acquired (no earlier than 7/25/91) if the following criteria is met:
- Asset held by taxpayer in connection with conduct of trade or business, or activity engaged in for production of income.
- Disposing of an intangible asset acquired with other intangible assets cannot result in a loss. The amount of the disallowed loss is added to the adjusted bases of the retained intangibles. This discourages shifting of prices to assets which will be disposed of sooner than other assets.
- Transaction costs identifiable to a specific asset are added to that asset, otherwise, added to residual category (V or VII?).
- Value of intangible assets is determined using �1060: Tangible assets are determined in classes I through V, and intangibles go into VI (�197 assets except GW and GCV) and VII (goodwill and going concern value).
- I. Cash
- II. Actively traded personal property under �1092 (government securities, stock, foreign currency)
- III. Accounts receivable
- VI. Inventory
- V. All other except I-VI and VI, VII.
- VI. �197 intangibles except goodwill and going concern value
- VII. Goodwill and going concern value
- Asset not created by taxpayer, unless:
- Asset is a license, permit or other right granted by government
- Asset is covenant not to compete
- Asset is a franchise, trademark, trade name
- Asset created in connection with transaction that involves acquisition of trade or business.
- Asset is not a "separately acquired" (not in connection with a trade or business)�
- Interest in film, sound recording, video tape, book or similar property
- Government right/K to receive tangible property or services
- Interest in patent or copyright
- K or government right of less than 15 years
- Computer software
- Mortgage servicing right
Specific qualifying assets
Goodwill or going concern value Workforce Business books, records, systems, information base, customer lists Patent, copyright, formula, process, design, pattern, know-how, format, other similar Customer-based intangible Supplier-based intangible License, permit, other governmental right Covenant not to compete. Amount paid pursuant to covenant shall be treated as an amount chargeable to capital account.
- Was the restricted party likely to compete? Examine age, health of party. Parties may be trying to shift income using a covenant, even though there is no real threat of one party competing.
- Buyer of covenant can allocate the entire covenant amount over the 15 year period � not year-by-year.
Franchise, trademark, trade name (automatically constitutes acquisition of trade or business, except where the value is nominal, is disposed of immediately after acquisition, or when included in software, film, sound, video, book or similar property). Trademark or trade name qualifies even if created by taxpayer. Computer software which is custom made and was acquired along with assets constituting a trade or business.
- Custom software purchased alone: 36 month life.
- Off-the-shelf software: 36 month life.
- Readily obtainable by people who would be expected to use the software;
- Nonexclusive license; and
- Not been substantially modified (cost of modification vs. cost of nonmodified software)
- Computer software is defined in Reg. �1.197-2(c)(4)(iv), and includes the media and incidental and ancillary rights necessary to transfer title.
Contract for use of a �197 intangible, i.e. K to license another company�s technology. That cost would be amortized over 15 years.
- Royalty payments for use of a �197 intangible do not have to be treated under �197 due to the difficulty of calculating the amortization. They are deducted in the year in which they are incurred.
- But if the payments are for "all substantial rights" of the intangible,
Exceptions (if it has a determinable useful life > 1yr, depreciate under �167, if < 1yr, expense)
- Financial interests in a corporation, partnership, trust or estate
- Off-the-shelf computer software
- Interest under existing lease of tangible property
- Interest under existing indebtedness
- Sports franchise
- Purchases subject to anti-churning rules: X buy�s A�s business, A rebuys business several years later after goodwill has increased. If A owned business originally between 7/25/91 and 8/10/93, the goodwill is not �197.
Capital asset (�1221)
Property held by taxpayer Not including
- Depreciable property
- Real property
- Copyright or literary, musical or artistic composition if created by or for taxpayer.
- Accounts receivable.
Purchase: �197 intangible as a trademark protection expense per �1.1972(f)(3)(ii)? Other �197 category? Most likely it is capitalized as an asset with more than one year. Sale
- If held for longer than 1 year, it�s a capital asset, and therefore gain (cost minus price received) subject to 20% tax, versus 34% ordinary income rate. Arguably a domain name could be similar to a copyrightable asset, which would preclude it being a capital asset under 1.1221-1(c)(1).
- Unless seller is a dealer in the course of their trade or business (i.e. someone who deals in domain names), in which case it would be ordinary income.
Stock as cash
- Good for R&D and start-ups because it preserves cash.
- Bad due to loss of control, and opportunity cost of releasing stock at less than IPO price.
- For customers
- Company can deduct difference between market value and exercise price, and is treated as income to customer.
- However, documentation must exist that proves the customer was given the stock in exchange for goods purchased or services rendered, and that the customer did not intend to retain the stock.
- For employees in lieu of salary: FMV on date of distribution is deductible as a business expense per 162(a). No gain or loss under �1032.
- Stock option: Allows holder to buy a specified number of shares of stock at a specified (exercise) price during a specified time period.
- Current stock holders usually aren�t thrilled about stock options being granted because of the loss of the opportunity cost (stock could have been sold on the market for FMV, versus given away for free).
- Grant price: Price of stock on date option is given (granted) to employee. Usually the market price.
- Exercise price: Price employee pays to acquire the stock.
- Spread to cover: Sell just enough shares to pay for the purchase.
- Non-qualified Stock Options (NSO)
- Net gain at time of exercise is treated as ordinary income to employee.
- Employer deducts difference between market/grant price and exercise price (�net� or �spread� price) at time of exercise (and can be used for research credit purposes, if qualified).
- Incentive Stock Options (ISO)
- IRC �423
- Amount of shares is limited by statute.
- When option is exercised (stock bought), difference between market/grant price and exercise price is income for AMT purposes.
- If employee retains stock for 2 years from grant date and 1 year from exercise date, no compensation element and entire gain is a capital gain; no employer deduction.
- Otherwise, ordinary income ("disqualifying disposition") which must be included on employee�s W-2. Employer can deduct the amount of income (and can be used for research credit purposes, if qualified).
- Employee limited to selling $100k worth of stock each year (?).
- Nontaxable event to employee, no wage deduction for company
- Nontaxable event to employee, no wage deduction for company
- Employee taxable event on gain; withholding required on difference between FMV and grant price (gain); company has wage deduction for gain.
- Nontaxable event unless AMT applies; no wage deduction for company
- Sale before 1yr of exercise and 2yrs from grant
- Short-term taxable gain for employee on gain beyond what was already reported; no tax withholding; no additional wage deduction for company
- Ordinary income for employee on gain; no withholding; company has wage deduction equal to gain.
- Sale after 1yr from exercise, 2yrs from grant
- Cap gain to employee on amount of gain beyond what was already reported. No tax withholding and no company wage deduction.
- Cap gain to employee on gain (28% for 12-18 mos, 20% after 18 mos from date of exercise); no withholding and no wage deduction for employer.
- Employee Stock Purchase Plans (ESPP) (�423)
- Excess of FMV over option price = wages.
- If offered, all employees meeting the definition of employee (versus independent Ker) gets the ESPP�s (which was the trigger for the Microsoft independent K�er case)
- Company stock is typically purchased at 15% discount. After holding for two year�s, profit is a capital gain and not ordinary income.
- Helps companies raise capital and gives employees ownership stake.
�1202 QSBS (Qualified Small Business Stock) provisions
- Allows non-corporate taxpayers to exclude from gross income 50% of any gain from the sale or exchange of QSBS.
- Stock held over 5 years.
- Acquired from corporation after 8/10/93.
- C corporation.
- Acquired at original issue
- Issued for money, property, or compensation
- QSBS: Aggregate gross assets of corporation don't exceed $50M between 8/10/93 and the date of issue of stock, and immediately after issuance (i.e. no IPO). Keep limit down by expensing R&E under �174(a) rather than capitalizing it.
- Corporation must be an "active business"
- At least 80% of the assets must have been used in active conduct of a qualified trade or business, during the taxpayer�s holding period.
- Waived if company is a Specialized Small Business Investment Company.
- Fails if over 10% of assets are stock in other non-subsidiary corporations, or real property not used in active conduct of qualified trade or business.
- Qualified trade or business: Manufacturing, sales, research operation, start-up activities, R&E, assets which are reasonably required working capital needs, and assets held for investment reasonably expected to be used within 2 years to finance R&E in qualified trade or business (50% max of assets after corporation is in existence for 2 years). Not services (law, health, accounting), banking, insurance, finance, farming, extraction, hotels, restaurants.
- Limited to the greater of ("Bill Gates Exception"):
- $10M ($5M for single filer) minus aggregate amount of eligible �1202 gain taken in prior years for stock in this corporation; or
- 10 times the aggregate adjusted bases of QSBS issued by corporation and disposed of by taxpayer during the tax year.
- 42% of the excluded gain must be indluded in AMT as tax preference (28% for holdings beginning after 12/31/00).
- For shareholders subjected to AMT, 29% of gain excluded.
- Note: The AMT makes this provision not all that attractive, because cap gains tax is only 20%, and with the AMT factored in, there isn�t much difference between the QSBS and just paying the cap gains (plus with cap gains, you have the use your money).
- Rules are very detailed and stock can change character.
- Rollover under �1045: If QSBS has been owned for 6+ months and use proceeds to purchase other QSBS w/in 60 days, defer recognition of gain from sale of first stock.
- CA version of 1202
- Non-corporate shareholder of C-corp.
- At least 80% of payroll in CA
- At least 80% value of assets used in active conduct of one or more qualified trades or businesses
- File FTB 3565 and Form 100, annually.
- Benefits: Loss from sale is treated as ordinary loss, up to $50k ($100k for joint filers).
- Main requirements
- Stock issued to individual or partnership
- Domestic small business corporation at time stock was issued
- During 5 most recent tax years ending before loss is sustained, corporation must have derived over 50% of total gross receipts from non-passive sources.
Contribution of property for stock
- Transfer of property for stock does not result in gain or loss (�351 for corporations, �721 for partnerships).
- Important when A gives company property with $50k cost basis, and receives stock worth $350k, which results in $300k gain. A would like for �351 to eliminate the gain.
- Those who contribute the property must then collectively have 80% or more control over corporation (n/a for partnership).
- Tangible property, such as facilities, supplies, and cash
- Intangible property, such as patents and other knowledge subject to legal protection against unauthorized disclosure and use (includes trade secrets). But if developed solely for the corporation, may be viewed as services, which are not allowed. Warning: Presence of significant intangible assets plus debt may raise issue of thin capitalization.
- All of the rights must be transferred.
- Value of property must be at least 10% of the value of the stock.
- IRS will give advance rulings re: what constitutes property.
- Accumulated earnings tax: High costs of R&D require accumulating earnings (accumulated earnings tax), and requires that these companies conserve their cash and pay their highly-skilled workforce in stock options, which requires using the corporate business form rather than partnerships. Corporation must have "specific, definite, and feasible plan" for accumulation (shouldn�t be a problem for high tech start-ups) and follow the guidelines of �531-573, reg �1.5371(b)(1).
- �541 imposes 39.6% tax on undistributed [passive?] income of a Personal Holding Company (bad). May occur during R&D phase of a start-up, when a lot of cash is retained and expenses capitalized.
- Purpose is to encourage dividends to be paid, but causes problems with start-ups who don�t want to pay dividends.
- Royalties are included in passive income, but there is an exception for active business software royalties, which are treated as sale of goods for this purpose.
- Definition of PHC
- C corporation;
- 60% of adjusted ordinary gross income is passive, i.e. from dividends, interest, certain (software) royalties, and certain rents; and
- 50% of the value of the outstanding stock is directly or indirectly owned by or for no more than 5 people.
- Company announces new product, forecast of increasing sales or profits, or other statement encouraging investors to buy company�s stock.
- Company then announces that product will be late to market or sales or profits will be below the previous forecast.
- Shareholders file lawsuit against officers, directors and key company employees alledging securities fraud under �10b and Rule 10b-5 and insider trading violations under �20A of the SEA of 1934. Fraud, deceit and negligent misrepresentation violations also often alleged under state law.
- Company may be forced to settle by directors� and officers� (D&O) insurance policy which generally won�t indemnify a finding of liability against officer or director found to be engaged in fraud under �10 of SEA of 1934.
Factors determining temporary vs. employee: There are 20 common law factors, described in Rev. Ruling 87-41 [p.94 in course materials]. Temporary contractor
- Independent, hired by company: Charge high rates for projects, maintain own retirement and benefits plans. Microsoft case will decrease use of these workers.
- Third party agency: Definitely contractors. No company benefits. Eliminates most if not all of the problems, because worker is employee of the temp agency.
Employee: Entitled to company benefits Misclassification as temp workers can result in penalty under �3509, and having to pay social security taxes, federal and state income tax withholding and unemployment taxes. Microsoft case: Workers hired as independent contractors were later reclassified by IRS as employees, and the workers sued Microsoft for benefits they would have received as employees, including stock options, which is the major bone of contention due to the increase in stock price. Class action suite with over 10,000 plaintiffs. Appeals court found in favor of workers. Supreme Court denied cert in 2000, and MS will now have to settle with the class.International Trade
- Sale of product, services or stock to a subsidiary or parent corporation must be done at arm�s length, otherwise IRS suspects that the company is trying to move assets out of the jurisdiction.
- Breach of trade agreement: �301 of Trade Act of 1974 authorizes retaliation against foreign country in breach of US trade agreement or engaged in unjustifiable and unreasonable conduct burdening or restricting US commerce. File complaint with US trade representative (USTR).
- Case must be sent to WTO for dispute resolution.
- Includes as unreasonable a lack of IP protections.
- Dumping: Exporter sells in a foreign market at a price below what he charges at home, or sells below cost. Prohibited in most countries, including US. Anti-dumping duties increase exporter�s selling price to home market price or cost of production. Complain to International Trade Commission and US Department of Commerce (implements duties). Dumpers are often monopolies in their home country.
- Generalized System of Preferences (GSP) allows developing countries to ship products to US duty free.
- Duty suspensions allows products to enter EU duty free if means of production do not exist in EU.
- Drawback: Refund of duty for goods imported and subsequently re-exported.
- Free trade zones (FTZ): Usually near international ports. Products can be brought into FTZ duty free, undergo manufacturing, and then shipped out of the country.
- Export control
- Individual validated licenses
- Bulk licensing
- Foreign availability exception
- Deemed export: US companies have to get export license if nationals from certain countries (China, Iran, Russia) have access to controlled technology.
- A1: Each member must grant MFN status to all other member countries. Only a few countries are excluded: Afghanistan, Cambodia, Cuba, Laos, Montenegro, N. Korea, Serbia, Vietnam. About 100 countries have status more favorable than MFN, i.e. under NAFTA, GSP, and free trade areas.
- A4: Dumping and unfair subsidies not allowed
- A12: Restrict entry of imports in certain circumstances
- A19: Restrict imports if serious injury to domestic producers
- A24(5): Allows for free trade areas, such as EU.
- Foreign monopolies: Exon-Florio Act prohibits foreign acquisitions that would create a monopoly and threaten national security.
- Foreign Corrupt Practices Act: Prohibits company and employee payments to foreign government. Exception when made for purpose of routine government action, i.e. to speed up review of customs documents, or when payment is illegal in the US as an illegal bribe but legal in foreign country.
Treatment of costs to defend - �197, �167, �162, �263. Partnership issues with joint ventures. Individual transferring patent may be able to obtain capital gain treatment under �1235. Overview: Limited monopoly right to better ensure economic return for investment, and to stimulate innovation to society�s general benefit. Copyright
- Protects: Works of original authorship fixed in any tangible medium of expression, now known or later developed, from which they can be perceived, reproduced or otherwise communicated, either directly or with the aid of a machine or device. Does not protect ideas � only expression of those ideas.
- Duration: Life of author plus 50 years. If for hire, shorter of 75 years from first publication or 100 years from creation.
- Owner is the creator or the one who financed the creation, and can be changed by writing.
- Employee does not own � - employer does. But independent contractor owns � for his work, and therefore employer should use K terms to transfer � to employer.
- Noninfringing activities
- Fair use, determined by purpose and character of use, nature of copyrighted work, amount and substantiality of work, impact on commercial market.
- Certain parodies
- First sale
- Process: Registration and notice not required, but recommended, and necessary to get statutory damages and not just actual damages. Registration is simple and inexpensive, but copy of work must be deposited.
- Protects: New and useful process, machine, manufacture, or composition or matter or any new and useful imrovement thereof; utility; novelty; nonobviousness; application approved by PTO.
- Software can be patented if it creates a "new machine". Microsoft has a patent on Cascading Style Sheets.
- Exceptions: Abstract ideas, laws of nature, mathematical formulas, until reduced to practical application (useful, concrete and tangible result).
- Utility patents: 20 years from date of filing (although many want this changed to 20 years from date of grant).
- Design patents: 14 years from dat eof grant
- Biotech patents: Possible 1-5 year extension beyond 20 year date of filing period when patent application is subjected to long regulatory delays by the US Patent Office
- Only true inventor can apply for patent, but can sell or transfer ownership. Courts say "shop rights" allow employer to use invention patented by employees without subject for infringement.
- But employee can patent and hold right to invention developed entirely on his or her own time without using employer�s equipment, supplies, facilities, or trade secret information, and which does not relate at the time of conception to employer�s business or result from any work performed by employee for employer (�2870).
- Process: Application with "claims" must be filed, prior art search.
Trademarks: 10 years from registration and indefinite life if continually renewed. Trade Secrets: Information, including formula, pattern, compilation, program, device, method, technique, or process that:
- Derives independent economic value, actual or potential, from not being generally known to the public or other persons who can obtain economic value from its disclosure or use; and
- Is subject of substantial and reasonable efforts to maintain its secrecy.
- Tariff Act of 1930: Section 337 can prevent infringing goods from entering the US market
- "Special 301" of the US Trade Act of 1974 as expanded by Omnibus Trade and Competitiveness Act of 1988 identifies foreign country policies and enforcement mechanisms that allow IP piracy or infringement. Requires WTO dispute settlement proceedings to address the problem though trade sanctions.
Semiconductor Chip Protection Act of 1984: 10 year monopoly period for mask works from date of registration or commercial exploitation, whichever comes first, but reverse engineering is ok.Antitrust
- Two separate products
- Agreement where purchase of one is conditioned on purchase of another.
- Seller possesses sufficient economic power to restrain competition in tied product market
- Not insubstantial impact on interstate commerce
- Example: Microsoft tying internet browser to market-dominant Windows OS.
- Specific intent to monopolice market
- Predatory or anticompetitive acts
- Dangerous probability of success
- Price fixing and pricing below cost: Prevents competitive underbidding
- Joint ventures
- May result in accusations of controlling production or engaging in price fixing or allocating markets, customers or products, even monopolizing an industry.
- National Cooperative Research Act of 1984 permits R&D ventures among competitors and pro-competitive ventures.
- National Cooperative Production Amendments of 1993 permit production joint ventures among competitors.
- Antitrust legislation: Sherman Act of 1890, Clayton Act of 1914
- Enforcement: DOJ, FTC.
- Methods of transfer
- Purchase of disk
- Transfer via network
- Direct use off of creator�s server
- Unlimited actual life
Tangible personal property can be taxed, but intangible cannot be unless legislature explicitly taxes.
- CA considers the property on which the software is recorded (disks, CD�s) to be taxable tangible property.
Choice of transfer modes and business models may impact taxes, i.e. if seller distributes electronically via net versus hosting on their server versus selling in store.
- Electronic transfer where buyer obtains no tangible personal property is not taxed in CA, but is in some states.
- Maintenance or update contracts sold with software: Revenue should be reported when received, except (Rev. Proc. 71-21 tries to reconcile tax accounting with accrual accounting):
- Contingent services: Report income as earned, not received.
- Prepaid services to be provided by the end of the next tax year can be deferred until the services are actually provided, so long as the services are provided by the end of the next tax year. (Rev. Proc. 71-21)
- Only applies where the services are paid for separately (or itemized separately) from the purchase of the accompanying goods (i.e. a separate service K).
- Only applies to goods sold where goods could be sold without the service K � i.e. it is not mandatory.
- If service income is reported earlier for book purposes, then it has to be reported at the same time for tax purposes.
- Prepaid goods (i.e. updates to off-the-shelf software): Report prepaid revenue when services performed, but no later than end of 2nd year following entering K, or when reported for book purposes if earlier. The original software itself can�t be considered deferrable (thus deferring the revenue) � only the update K. (TAM 9231002, reg 1.451-1).
- If sold with off-shelf software and not optional, treated as part of taxable sale by CA. If optional, but only updates are covered, then taxable. Consulting fees separate from update charges are not taxable.
Sale/License/Lease: Revenue Characterization
- Capital gain will result if capital asset was sold.
- Income reported upon sale.
- Sourcing is at residence of seller.
License characteristics (usual method)
- Royalty treated as ordinary income.
- Income is usually reported by accrual basis ratably over license period.
- Sourcing is where property is used.
- Licensee is not the owner of the copy, so the rights ordinarily conferred to an owner of a copyrighted item do not transfer (i.e. reverse engineering through fair use doctrine). Licensee can only do with the software what the license agreement allows.
- Royalty income can be adverse for personal holding company status and passive investment income of S corporation.
- Why it�s bad: For non-S closely-held corporation, a certain amount of PHC income can result in additional tax at 39.6% rate on the undistributed PHC income. Certain amounts of passive investment income earned by S-corp may result in termination of S status.
- PHC income: Arguably, since 1992 ruling says software is sold and not licensed for tax purposes, this is irrelevant. Regardless, Congress has specifically excluded "active business computer software royalties" from definition of PHC income. Qualifies if:
- Royalties received in connection with licensing of software
- Corporation is actively engaged in business of developing, manufacturing or producing software
- Royalties constitute 50% or more of corp�s ordinary gross income for the tax year.
- Total deductions under 162, 174 and 195 allocable to software business is 25% or more of its ordinary gross income for the year, or the average of such deductions for a 5-year tax period ending with the tax year is 25% or more of the average ordinary gross income for the period.
- Dividends equal or exceed the excess of the PHC income over 10% of the ordinary gross income.
- S-Corp: �1362 excludes active business software royalties, as defined above, from passive investment income.
- �469: Royalties will not be considered passive activity income if taxpayer meets material participation requirements.
Examine substance of the transaction to determine proper label 1992 ruling says software license for off-the-shelf software should be treated as a sale of goods. Factors:
- Customer obtained perpetual use for one payment
- Paid price that approximated what it would cost to buy the product outright
- Obtained copyrightable article and not the underlying copyright.
Factors in determining transfer method (sale/license):
- Whether legal title passes
- How parties treat transaction
- Whether equity was acquired in the property
- K create present obligation on seller to execute and deliver deed and present obligation on purchaser to make payments
- Whether right of possession is vested in purchaser
- Which party pays property taxes
- Which party bears risk of loss or damage to property
- Which party receives the profits from operation and sale of property
Case law: License K may be treated as sale for tax purposes even if title remains with grantor. Sale occurs upon transfer of benefits and burdens of ownershp, not on technical requirements for passage of title. Sale will result when there is a transfer of all substantial rights of value in the property transferred. No sale occurs if transferor retains substantial proprietary rights in property transferred. International law (�861): Allows characterization as (if multiple characterizations, treat as separate transactions):
- Sale, if:
- All substantial rights in the � have been transferred: Buyer can make copies to distribute to public, prepare derivative programs based upon purchased program, make a public performance of the program, or publicly display the program.
- Minimal or no know-how or services transferred, and none of the above rights transferred, but benefits and burdens of ownership have been transferred.
- License, if:
- Not all of the substantial rights to the � have been transferred: Buyer can make copies to distribute to public, prepare derivative programs based upon purchased program, make a public performance of the program, or publicly display the program.
- Insufficient rights and benefits and burdens of ownership have been transferred, and minimal or no services and know-how have been transferred.
- Provision of services for development or modification of program
- Provision of know-how
- Provision of information relating to programming techniques, furnished under conditions preventing unauthorized disclosure, and which is considered property subject to trade secret protection.
Purchase/Development: Deduct or capitalize
Purchase of software can be amortized over 36 months once placed in service, unless it meets �197 criteria for 15 year life (�167(f)). Custom software (not generally available, exclusive license, or substantially modified) acquired with assets constituting trade or business has 15 year life (�197) (otherwise 36 mos). Software bundled with hardware is treated in whatever way the hardware is treated. Cost of "developing software" can use the same accounting method of �174 (i.e. deducted), although that doesn�t mean that the costs can necessarily be expensed or amortized per �174. (Rev. Rul. 69-21).
- Some confusion exists about what procedure applies when taxpayer wants to change its accounting method for existing software development project (see �446, �481, Ruling 71-248).
Problems with taxation
- 30,000 separate taxing jurisdictions in the US, 6,000 sales tax jurisdictions.
- Taxation of eCommerce is a bigger problem to cities than states, because cities get most of their revenue through sales tax. State gets most of its through income tax. State encourages growth of businesses, but cities must provide infrastructure without financial support.
- Difficult for local governments to replace eroding sales tax with other revenues, because of supermajority requirements.
- Cost of compliance
- Based on geographic borders, which the internet is not. Tangibles are also less important than they were before, and intangibles are a larger part of our GDP now.
Current statistics on commerce
- Personal purchases are very small: 20% of e-commerce. 80% is B2B, which generally is compliant with paying sales tax. The sales tax lost by personal purchases is less than 1/10 of 1% (per recent E&Y study). 63% of B2C sales were non-taxable (airline tickets, entertainment, etc).
- eCommerce represents less than 1% of all retail sales.
Internet Tax Freedom Act (ITFA)
- 3-year moratorium on most state and local taxes imposed on e-commerce: 10/1/98 � 10/1/01.
- Does not prohibit sales tax � just prohibits multiple taxation and taxing internet access. Quill prevents states from taxing remote vendors � not ITFA.
- Formed a 19 member Advisory Commission on Electronic Commerce.
- Exception: Taxes which were imposed prior to ITFA are grandfathered. About 10 states tax internet access this way.
- There are fewer middle-people in e-commerce, and the middle-people who do exist are different (i.e. b2b auction sites).
Trends to watch for
- Overstatement of revenue: FASB proposes that gross revenue would exclude revenue earned where the taxpayer had no assumption of revenue risk and credit risk, and ownership of title was very brief. Example: Priceline.com presently includes in their gross revenue figure the cost of the airline ticket, even though Priceline has title to the ticket only very briefly. Compare with Macy's who actually takes title for longer period of time. Net revenue and net income will be the same either way.
- Bartering of advertising transactions: Receiving advertising revenue offset by advertising expense: Gross revenue gets inflated.
- ISP/PC rebates: Buy a PC, get $400 rebate for ISP subscription. ISP's view $400 as a marketing expense, SEC views it as a price reduction which would reduce both net and gross revenue.
- SEC wants to treat search engines and other web site tools as internal use s/w.
Foreign Tax Credit
- Income is taxable in both foreign country and in US. FTC prevents double taxation by allowing US tax liability to be reduced by foreign tax liability. But FTC cannot exceed what the US tax liability would have been.
- Carry back 2 years, carry forward 5 years to use up excess credit.
- Formula: (Foreign source taxable income / Worldwide taxable income) x U.S. tax liability before FTC = Maximum amount of creditable foreign taxes.
- Maximize FSTI, minimize foreign expense; minimize WTI (which is FSTI + US income, therefore minimize US income and maximize US expense).
- Earning dividends, interest and royalties from foreign rather than US sources.
- Allocate appropriate amount of R&E to foreign subsidiaries.
- Keep foreign tax to a minimum by locating in low-tax jurisdictions.
Foreign Sales Corporation (FSC "fisk")
- Reduces federal income tax rate on qualifying export transactions from 35% to under 30%. Increases bottom line and earnings per share, because the rate reduction is a permanent accounting difference under FASB rules.
- FSC does business as a commission agent or on a buy-sale basis.
- Must be incorporated outside the US (Guam and US Virgin Islands are popular), and have some overseas corporate substance.
- Formula: 15% of profits exemption, or 1.19% of sales exemption, whichever is best for taxpayer (see p. 129 in Jernigan for calculations).
Controlled Foreign Corporation
- US parent company owns more than 50% of the stock in a foreign company.
- Subpart F income: Income of foreign subsidiary is taxed in the US, even if subsidiary hasn�t paid a dividend. Includes many types of passive income (dividends and interest), and certain types of operating income from sales or services.
- Formula: U.S. shareholding % x income
- Exemption: Subsidiary which can prove that it is a manufacturer.
- Must correctly allocate US profit, foreign subsidiary profit, duty payments, foreign tax credits, and avoid fines and penalties. If sales price doesn�t reflect cost of sales and duty value, there may be a problem and fines could result.
- Best method is arms length transfer pricing (pricing as if it was between unrelated companies) under �482.
Possessions Tax Credit (�936)
- US incorporated company certain amount of earning income from active manufacturing operations in Puerto Rico, Guam, US Virgin Islands and W. Samoa qualify for tax credit which eliminates US tax.
- Must pay US minimum wage, and pays no duties on shipments to US.
- Works well when the possession offers a tax exemption period or reduced tax rate.
- Allows company to sell more in foreign country before being found to be engaged in a taxable business.
- Taxes are generally at lower rates, and disputes easier to administer because treaty provisions ensure that the US and treaty country don�t doubly tax the same income.
Capital gains: Individual cap. gains are taxed at 20%, versus 39.6% highest tax bracket for ordinary income. Corporate cap. gains are taxed at 35%, same as ordinary income. AMT
- Purpose: Curb reporting of losses and not paying income tax, yet reporting earnings on financial statements. This resulted from tax shelters, tax-exempt investments, and lower capital gains rates.
- Rate is 20% for companies, up to 28% for individuals.
- Net operating losses & foreign tax credits: Only 90% are allowable. Remaining 10% must be carried forward.
- ISO�s: Difference between FMV at exercise over option price (gain) is AMT item.
- Exemptions: Corporate $40k, individual ranges from $22.5k to $45k depending on filing status. Phased out to zero as income reaches certain levels.
Based on 1% of land and building costs, valuation increased each year by lesser of 2% or inflation rate. Average is 1.1%. CA does issue abatements of up to 10 years for new plants and equipment, but rare because of low state property tax (why should $2M chip manufacturing plant pay more than $200M WalMart?). Other option is to put a cap on the assessed value. Personal property on the premises (equipment, furniture, etc.) is included in the valuation, and it is important to allocate the property to the correct categories because of varying depreciation schedules. Intangible property (such as rights or licenses) is not taxed (i.e. future revenue stream is disregarded). A8 of state constitution governs.CA sales & use tax
Tax applies to purchase of tangible personal property within the state. Use tax applies when you bring an item into the state.
- State rate of 6%, city and county rates increase that amount by about 1.5%
- If purchaser doesn�t pay state sales tax on a purchase, they are required to pay use tax. If purchaser is taxed in another state, they pay CA use tax only on the difference between rates (no double taxation). Corporations generally do pay use tax, consumers rarely do.
- No sales tax on goods purchased for inventory (resale).
- Partial exemption for purchase of manufacturing equipment (or credit)
- Very few services are taxed (sales tax originated in depression era as a revenue generator for the government � and tangible property was more prevalent than services), but there is no technical reason why services can�t be taxed.
Many of the arguments in favor of internet taxation were debated in 1965 re: the lack of mail-order taxes. Same arguments made re: disadvantage to brick and morter retailers. Nexus: Economic or physical connection between vendor and state.
- Test (Complete Auto Transit)
- Tax is applied to an activity with substantial nexus with taxing state;
- Fairly apportioned;
- Does not discriminate against interstate commerce; and
- Fairly related to services provided by the state
- Due Process clause requires fairness
- Has TP availed himself of the state (and state�s benefits)?
- Physical presence; or
- Purposefully avail himself economically: Examine quality and quantity of contacts.
- Commerce clause requires that the tax not impede interstate commerce, i.e. multiple taxation (but Congress has power over interstate commerce and therefore could pass a law allowing states to tax remote vendors)
- Physical presence (Quill); or
- Purposefully directed business towards state�s residents
The presence must be "substantial" � but some courts use a pretty minimal level. Physical presence can be via agency, so long as the activities are significantly associated with TP�s economic activity in the state. Therefore, query if ISPs may give physical presence to customer. Also query if an associates program, such as Amazon Associates, creates presence (court has held that having teachers sell books for a company does create nexus). Severing one part of the business from another will sever the nexus of the two businesses. Example: Amazon spun its physical warehouses off from its on-line store, so that the on line store doesn�t have a nexus in the states of the warehouses. Entities will be treated separately so long as they area dealing at arm�s length and treated as distinct entities. Uses holding companies. California excludes web sites and computer servers from determining if nexus exists.Personal Jurisdiction: Where the only presence is a web site, personal jurisdiction only if D purposefully and actively directed his activity to forum state. Degree of interactivity, commercial nature, and nature and quality of commercial activity are factors. Passive website generally insufficient to give jurisdiction, although domain name squatter cases have held that CA long-arm statute can haul people into CA court. (Panavision). Deliverate and repeated contact with the state gives PJ. Person gambling in a no-gambling jurisdiction is liable � the location of the server is not controlling. Activity as a presence (i.e. airlines, telephone service):
- Service must originate or terminate in the state; and
- The service is charged to a service address within the state or billed or paid within the state.
- Historically no apportionment needed amongst the states affected by the service because transaction is a discrete event in the place of sale.
Tangible vs. intangible issues
- Tangible property is a factor for apportionment, but intangible property is not.
- Tangible property (tangible inventory, sale of assets) is subject to sales tax, but intangible property (electronic transfer of know-how, sale of stock) is not.
- Sale of manuscript to publisher is not taxable (what is being sold isn�t the tangible manuscript but the intangible rights), but sale of book at Barnes & Noble is taxable (sale of tangible book).
- Sale of software is subject to sales tax, but licensing of software use on-line is not.
- Services are not taxable, but goods are. True object test seeks to determine what the true object was that was transferred: Good, or service. Where there is a combination of goods and services, look to see which is most predominant. Example: Funeral home selling casket is providing both goods and services. The casket has to be taxed, though, because it is a substantial part of the sale.
Computer software and services (CA 1502)
- Sales tax applies to:
- Creation, modification or altering of consumer-furnished storage medium, including recording onto it
- Sale of storage medium containing custom s/w, but no tax for cost of developing the information contained on the medium
- Leases of personal property
- Conversion of data from one form to another, but not where data is being processed and storage medium is merely incidental to the service
- Data entry, but not address labels
- Canned s/w on storage media, regardless of who furnishes the media. Entire cost of s/w is taxed, including license fees, but no tax on the OEM copy used by manufacturers to install on computers being sold.
- Modificiations to custom software taxed as part of the cost of prewritten software, unless separately stated, in which case it�s nontaxable.
- Sales tax doesn�t apply to:
- Processing of information or data, but sales tax applies to personal property sold to customer (disks containing data)
- Computer time share
- Training services (but materials are taxed if charged separately)
- S/W transferred by phone, when purchaser doesn�t obtain possession of tangible personal property.
- S/W installed by seller on customer�s computer, except if part of sale of CPU
- S/W used to make additional copies
- Sale of OEM software to retailer when retailer resells the software (that transaction, however, is taxed).
- Custom S/W (> 50% changed form prewritten program), even if with transfer of tangible personal property.
- Manuals with custom software.
Neutrality: A tax should not differentiate between how a certain product is purchased.Corporate income tax
State: 8.84% is the highest. Income is apportioned to each state in proportion to company�s business presence in the state (per public law 86-272), and then the state income tax is applied to the apportioned income. California uses a four-factor formula to determine apportionment: Sales counts twice, plus property and wages each once. Other states use other formulas. Formula: Add percentages of sales (doubled), property and wages which takes place in CA, and divide by 4. Multiply pre-tax profits by the result, and then multiply that result by the tax rate.Reform
- Impact on state and local government: Flat tax would eliminate tax deductibility advantage of muni bonds (which have low interest rates), making it more difficult for cities to raise funds at low interest rates
- Double taxation: National sales tax plus state sales tax.
- Affect on real estate values by eliminating mortgage deduction
- Errors on tax return: Fix by filing claim for refund or amended return.