Copyright 2005 Dwight Drake. All Rights Reserved. Business Planning: Closely Held Enterprises www. drake-business-planning.com LIFO Inventory Trap – LIFO inventory reserve recaptured over four years 2.C Corp E & P Trap – Post-conversion distributions in excess of S corp accumulated adjustment account will trigger taxable dividends to shareholders to extend of C corp E & P 3.The Passive Income Trap of The BIG Tax Trap of 1374 Potential Conversion Tax Traps

Copyright 2005 Dwight Drake. All Rights Reserved. Business Planning: Closely Held Enterprises www. drake-business-planning.com 5-14 Royalties Dividends Interest Annuities Note: Looks more like portfolio income. But for 1375 purposes, called “passive income” DO NOT CONFUSE WITH 469 PASSIVE INCOME S Passive Income – Not Like the Other Passive

Copyright 2005 Dwight Drake. All Rights Reserved. Business Planning: Closely Held Enterprises www. drake-business-planning.com 5-15 Passive Income S Penalties Penalty One: S Corp has accumulated earnings and profits for three years and passive S receipts more than 25% total receipts. S election terminated. 1362(d)(3) Penalty Two: S Corp has accumulated earnings and profits and passive S receipts more than 25% total receipts. Entity level tax equal to 35% of “excess net passive income.” How to calculate: - First, “net passive income” = passive income less passive expenses - Second, ratio with numerator equal passive income over 25% of gross receipts and denominator equal to total passive income - Third, multiple “net passive income” by ratio to arrive at “excess passive income” - Limit – excess passive income can’t exceed corp’s taxable income

Copyright 2005 Dwight Drake. All Rights Reserved. Business Planning: Closely Held Enterprises www. drake-business-planning.com Be aware – keep an eye on receipts 2.Bail accumulated C Corp E & P at 15% rate with 1368(e)(3) election 3.Distribute or sell investments that trigger passive S to get below 25% 4.Increase active receipts relative to passive – do more business or stick additional operation or active business in S Stay Clear of Passive S Penalties

Copyright 2005 Dwight Drake. All Rights Reserved. Business Planning: Closely Held Enterprises www. drake-business-planning.com 5-17 C to S: The “BIG” Tax Trap Huge exception to “no entity tax” rule Applies only when C corp has converted to S corp Purpose is to limit ability to convert and then sell and strip income with no double tax hit “BIG” stands for “Built-in-Gain” May also have built-in loss Major factor in converting from C to S corp. Although BIG tax can be rough, nothing compared to going from C Corp to partnership or LLC

Copyright 2005 Dwight Drake. All Rights Reserved. Business Planning: Closely Held Enterprises www. drake-business-planning.com 5-18 How “BIG” Trap Works Determine built-in gain or loss at time of conversion for all assets. This is gap between FMV and basis. Requires appraisals If asset sold during 10 years after conversion (“recognition period”), any gain or loss recognized up to “Built-in” amount taxed at corporate level Tax rate is highest corporate rate – 35% Income still taxed at shareholder level, but BIG tax treated as loss. 1366(f)(2) BIG income may not exceed corp income for year if taxed as C corp. Carry forward any excess

Copyright 2005 Dwight Drake. All Rights Reserved. Business Planning: Closely Held Enterprises www. drake-business-planning.com 5-19 How “BIG” Trap Works BIG income from any sale may not exceed total BIG income at conversion less BIG income previously recognized. Carry-over BIG income potential in non-recognition transactions (i.e. 1031, 1034), tax-free corporate reorgs. Installment sales during 10 year period that defers income beyond ten year window doesn’t help. Recognition period extended. Recognized BIG losses during 10 year window can offset recognized BIG income.

Copyright 2005 Dwight Drake. All Rights Reserved. Business Planning: Closely Held Enterprises www. drake-business-planning.com 5-20 Convert early, carefully document assets at conversion Pre-conversion – hang onto losers, but watch out for “loss stuffing” Collect zero basis receivables before conversion. May require factoring Accrue bonuses and similar expenses prior to conversion – counts in reducing total built-in amount at conversion Match BIGs and BILs during 10 year recognition period to extent possible Use non-recognition transaction (1031, 1033) to get through non-recognition period Work goodwill/going concern valuation Strategies to Mitigate BIG Tax

Copyright 2005 Dwight Drake. All Rights Reserved. Business Planning: Closely Held Enterprises www. drake-business-planning.com 7-8 Acquisition Reorg Requirements Control within meaning of 368(c) – Dual 80% test. Continuity of interest – varies. Measured by nature of consideration and boot. Transfers before and after not a factor. Continuity of business enterprise. Carry-on sellers business or assets. Transfer to sub or partnership allowed Business purpose.

Copyright 2005 Dwight Drake. All Rights Reserved. Business Planning: Closely Held Enterprises www. drake-business-planning.com 7-9 Acquisition Reorg Options Statutory Merger – A Reorg - Merger under state law - 50% to 60% boot allowed Stock Swap – B Reorg - No boot allowed Assets for Stock – C Reorg - Boot allowed for liabilities assumed and other boot (at 20% max) - Substantially all assets (90% net FMV) - Buyer’s stock distributed in liquidation as part of reorg. Forward Triangular Merger - Substantially all assets – same as C - Boot of A Reorg – 50% to 60% works Reverse Triangular Merger - Same as forward but boot limited to 20%

Problem 7-A Circle Inc. Copyright 2005 Dwight Drake. All Rights Reserved. Business Planning: Closely Held Enterprises www. drake-business-planning.com 7-10 Olson Inc. Buyer Doug Basis 300k (d) Forward Triangular Merger Circle Inc. Seller Sue Basis 7 Mill Tax Impacts: No recognized gain or loss for any party Doug and Sue stock basis carryover to new stock New Sub gets assets carryover basis Taxable boot allowed up to 50% to 60% Buyer Stock New Sub. S New Sub Survives 100% Stock Token Assets Buyer Stock

Problem 7-A Circle Inc. Copyright 2005 Dwight Drake. All Rights Reserved. Business Planning: Closely Held Enterprises www. drake-business-planning.com 7-11 Olson Inc. Buyer Doug Basis 300k (e) Reverse Triangular Merger Circle Inc. Seller Sue Basis 7 Mill Tax Impacts: No recognized gain for any party Doug and Sue stock basis carryover to new stock New Sub gets assets carryover basis Taxable boot can’t exceed 20% Buyer Stock New Sub. S Seller Survives 100% Stock Token Assets Buyer Stock