September 27, 2012 – 3.8 Reasons to Consider Making Passive Real Estate Active On or Before January 1, 2013 and Clash of the Reorganizations

Providing updates and comments on Florida estate planning and creditor protection developments and insight for lawyers, CPAs, and other planning professionals

1. 3.8 REASONS TO CONSIDER MAKING PASSIVE REAL ESTATE ACTIVE ON OR BEFORE JANUARY 1, 2013.

2. CLASH OF THE REORGANIZATIONS: HOW YOU CAN USE A NEW PARENT F REORGANIZATION TO RELEASE TRAPPED ASSETS

Each week we will provide a fresh update as well as analysis and ideas associated therewith.  Please send us your ideas for future topics!

We thank attorney Erica Good Pless of The Pless Law Firm, P.A. for her assistance with preparing today’s report.

Erica Pless
The Pless Law Firm, P.A.
146 2nd Street North, Suite 310
St. Petersburg, FL 33701
727-362-4730

IN THE NEWS

On Tuesday, the Forbes Real Estate blog mentioned our new book, The Annihilation of Wealth 2013:

Click here to read the blog post.

3.8 REASONS TO CONSIDER MAKING PASSIVE REAL ESTATE ACTIVE ON OR BEFORE JANUARY 1, 2013

Grandpa—what was it like before the Medicare tax (or when it was only 3.8%)?

Real estate investors are beginning to brace for the impending “Taxmageddon” on December 31, 2012. Already facing the elimination of the George W. Bush era tax cuts on capital gains, Taxmageddon will see the introduction of a 3.8% Medicare tax on income from interest, dividends, annuities, royalties, and rents not derived in the ordinary course of trade or business. The new 3.8% Medicare tax will apply to individuals with a modified adjusted gross income (MAGI) above $200,000 and to married couples filing jointly with a combined MAGI above $250,000. While the Medicare tax is only expected to affect about 3% of U.S. households, nearly all high-earning taxpayers will be subject to the 3.8% tax on some income and investments.  Click here to see Real Estate Scenarios and Examples from the National Association of Realtors.

For real estate investors, the tax will affect gross income from one of the two passive activities as defined by Internal Revenue Code Section 469: (1) Trade or business activities in which the taxpayer did not materially participate during the year; and (2) Rental activities, even if participated in by the taxpayer, unless the taxpayer is a “real estate professional.”

The Tricks

 Trick #1: Material participation in an investing activity removes the activity from the passive activity category. Therefore, some real estate investors may be able to avoid the upcoming 3.8% Medicare tax by ensuring that they “materially participate” in the trade or business activity enough to remove the activity from classification as a passive activity. Some real estate investors may already be close to meeting one of the IRS material participation tests. With a few extra hours and some planning, an investor may be able to ensure that their investment qualifies as a non-passive activity.

An investor can establish material participation by meeting any one of the following seven tests:

1. You participated in the activity for more than 500 hours during the tax year.

2.  Your participation was substantially all the participation in the activity of all individuals for the tax year, including the participation of individuals who did not own any interest in the activity.

3. You participated in the activity for more than 100 hours during the tax year, and you participated at least as much as any other individual (including individuals who did not own any interest in the activity) for the year.

4. The activity is a significant participation activity, and you participated in all significant participation activities for more than 500 hours. A significant participation activity is any trade or business activity in which you participated for more than 100 hours during the year and in which you did not materially participate under any of the material participation tests, other than this test.

5.  You materially participated in the activity for any 5 (whether or not consecutive) of the 10 immediately preceding tax years.

6.  The activity is a personal service activity in which you materially participated for any 3 (whether or not consecutive) preceding tax years. An activity is a personal service activity if it involves the performance of personal services in the fields of health (including veterinary services), law, engineering, architecture, accounting, actuarial science, performing arts, consulting, or any other trade or business in which capital is not a material income-producing factor.

7.  Based on all the facts and circumstances, you participated in the activity on a regular, continuous, and substantial basis during the year. You did not materially participate in the activity under this test if you participated in the activity for 100 hours or less during the year. Further, your participation in managing the activity does not count under this test if any person other than you received compensation for managing the activity or any individual spent more hours managing the activity than you did (regardless of compensation) during the tax year.

 Trick #2: Generally all rental activities are considered passive activities, even if you materially participated in them. But real estate investors focused in rental real estate activities can also get around the 3.8% Medicare tax by qualifying as a “real estate professional.”

To qualify as a real estate professional, an individual must meet tworequirements: (1) more than half of the personal services you performed in all trades or business during the tax year were performed in real property trades or businesses in which you materially participated; and (2) you performed more than 750 hours of services during the tax year in real property trades or businesses in which you materially participated.

Activities that qualify as a real property trade or business include developing or redeveloping; constructing or reconstructing; acquiring; converting; renting or leasing; operating or managing; or brokering real property. Separate interests are evaluated separately for the above tests, unless the taxpayer chooses to treat all rental real estate activities as one. For more on both of these tricks,click here to read IRS Publication 925: Passive Activity and At-Risk Rules.

The Traps

 Trap #1: Failing to keep proof of material participation

If the IRS audits a tax return and questions whether a taxpayer materially participated in a real estate activity, the taxpayer will be required to submit substantiation of material participation. The IRS states that a taxpayer can use any reasonable method to prove participation in an activity for the year. It is best practice to keep an appointment book, calendar or similar document with the date, time, and brief description of the services you performed throughout the tax year.

Although the IRS does not require contemporaneous written reports or logs, they will scrutinize a document that is drafted specifically for an IRS audit. Courts also tend to agree with the IRS on this issue and have consistently denied taxpayers the benefit of the real estate professional classification when they fail to submit reliable records.  See D’Avanzo v. U.S., 67 Fed. Cl. 39 (2005), aff’d, 215 Fed. Appx. 319 (Fed. Cir. 2007); Bosque v. Comm’r., T.C. Memo 2011-79 (Apr. 4, 2011).

 Trap #2: Failing to meet both tests to qualify as a real estate professional

Many clients believe that in order to qualify as a real estate professional for tax purposes, they simply have to work 750 hours during the year in the real estate business. Unfortunately, that is not the case. To qualify as a real estate professional, a taxpayer must work 750 hours during the tax year in the real estate business and must perform more than half of the personal services in all trades or businesses during the tax year in real property trades or businesses in which he or she materially participates. So what exactly does this mean?

Here is an example. John Smith owns several rental properties and materially participates with respect to these properties. Last year, he spent a total of 800 hours actively managing the properties. He also works for an engineering firm, where he worked a total of 1,000 hours last year. Although John meets the 750 hours requirement, he does not qualify as a real estate professional because he did not spend more than one-half of his personal services time in the real property business. In order to satisfy this test, he would have had to spend more than 1,000 hours materially participating in the real property business. See Anyika v. Comm’r., T.C. Memo 2011-69 (2011).

This test makes it very difficult for someone who holds a full time job in addition to the real estate activities to be considered a real estate professional for tax purposes. Therefore, proper planning is essential.

CLASH OF THE REORGANIZATIONS: HOW YOU CAN USE A NEW PARENT F REORGANIZATION TO RELEASE TRAPPED ASSETS

One role of the estate planner is to evaluate corporate structures for estate planning, asset protection, and liability insulation purposes. Until recently, valuable assets had been considered “trapped” within a corporation due to potential adverse federal tax consequences upon distribution of the assets from the corporation.  The IRS now recognizes that Section 368(a)(1)(F) of the Internal Revenue Code permits what the Authors call a “New Parent F Reorganization.”

A New Parent F Reorganization can segregate separate assets of a business, which can insulate potential liability associated with certain assets from other assets that perform a separate function of the business.  A New Parent F Reorganization leaves the historical operating entity to continue its business while any potential business risks are allocated only to the applicable assets, which can insulate potentially risky operations of the business from valuable assets that are not performing risky functions.

Before New Parent F Reorganizations became a realistic, tax-favored alternative, estate planners would have to explain to their clients that the transfer of an appreciated asset out of an S Corporation or a C Corporation would trigger income tax as if the asset was sold.  The difference between the fair market value of the asset transferred and the tax basis of that asset would be treated as taxable income, with taxable amounts determined by an operating entity’s corporate structure (i.e. the double taxation of a C Corporation, or the flow-through taxation of an S Corporation).

Some companies were able to use “D Reorganizations” to divide assets without incurring tax liability.  However, D Reorganizations are not as taxpayer friendly as New Parent F Organizations because of the requirement that all companies that are parties to the Reorganization were active trades or businesses for at least five years prior to reorganization in order to prevent tax liability for the transfer of assets.

Many practitioners may be concerned about whether a reorganization will be properly classified under Code 368(a)(1)(F) as opposed to either a “Type A,” “Type C,” “Type D,” or “Type G” reorganization.

Pursuant to Revenue Ruling 57-276 (1957-1 C.B. 126), a Type F reorganization that also meets the requirements of a Type A, C, or D reorganization will be treated as a Type F reorganization. In bankruptcy, however, a Type G reorganization will be considered to have occurred in lieu of a Type F reorganization pursuant to Internal Revenue Code Section 368(a)(3)(C). A Type G reorganization is similar to a Type D reorganization, except that a Type G reorganization occurs in a Bankruptcy or similar type case.

A New F Parent Reorganization is ideal for a medical practice reorganization because the historical operating entity does not need to apply for a new tax identification number or change its name or identity, even though it is now a subsidiary of the new parent company.  Changing identification numbers, identity, and the resulting registration and payment delay factors have traditionally been the death knell of strategies to “migrate” a medical practice to a new entity.  Medical law aspects must, however, be reviewed before medical practice entity segregation.  Anti-referral laws will often prevent a physician from referring patients to entities other than the “group medical practice” of that physician.  The Authors believe that referrals among companies owned by a common parent company can qualify under the Stark rules where the “group medical practice” exception would apply.

The Tricks

 Trick #1: Taking Each Step in the Proper Order

To ensure that a New Parent F Reorganization goes off without a hitch, the following steps should be taken in order:

1. A new parent corporation is established with the exact same shareholders as the  historical entity. Because F Reorganizations do not trigger the “continuity of business  ownership” requirement like most tax-free corporate reorganizations, ownership can be  transferred in whole or in part to family members after the new parent entity has been  established.

2.  If the historical operating entity was an S Corporation, the new parent entity makes an S  election by filing a Form 2553, which can be effective no sooner than when the entity is  established, and no later than 75 days before the appropriate filing of the Form 2553.   Where the new parent entity is a limited liability company and files an S election, the  Treasury Regulations no longer require the filing of a Form 8832 to allow the entity to be  characterized as a corporation for federal tax purposes.  It is important to make sure that the corporate structure does not disqualify the company from making an S election by  having “two classes of stock,” “an ineligible shareholder,” or otherwise violates the  requirements for a valid S Corporation election under Subchapter S of Chapter 1 of the  Internal Revenue Code.

3. The ownership of the historical operating entity is transferred via a completeequity  transfer to the new entity.  The shareholders must also maintain ownership of the  historical operating entity through a plan of reorganization that satisfies the following  requirements:

a. It must provide for a business purpose for the reorganization, which can be to  protect capital assets from liabilities of the business, and to provide for separate  accountability and segregated management thereof.

b. It is not a device to avoid income taxes, which is satisfied due to the fact that no  income taxes are saved by this technique.

As a result of this, the historical owner or assignees thereof hold 100% of the new parent company, which owns 100% of the historical operating entity.

4. If the historical operating entity was an S Corporation, the new parent company files a  Form 8869 with the Internal Revenue Service to elect to have the historical entity treated  as a QSUB for federal income tax purposes. As a result of this election, the QSUB is  deemed to have been liquidated into the new parent S corporation.  All of the assets,  liabilities, income, credits, and deductions of the QSUB will go directly onto the income  tax return of the new parent S corporation.

The QSUB will not need to file a separate  federal income tax return or a Form 966 regarding corporate dissolutions or liquidations.  The QSUB can nevertheless use its historical taxpayer identification number and identity  when dealing with third parties pursuant to Treasury Regulation Section 301.6109-1(i)(1).

5. Once the above have been completed, which may be before IRS confirmation of receipt  of the applicable elections (which can presently take several months based upon the  Authors’ experience), the tax-free transfer of assets may occur from the historical  operating entity to the new parent company or to subsidiary disregarded LLCs, other  QSUBs, or consolidated return subsidiaries of C corporations.

For federal income tax  purposes, this is treated as a continuation of the underlying entities by the new parent  corporation. Under state law, implications of such transfers may vary.

6. Appropriate changes to insurances, loan arrangements, and operational formalities are  instituted at the time of the reorganization.

 Trick #2: Maintaining Separation between Companies after a New Parent F  Reorganization

The law has been remarkably supportive of the ability of affiliated companies and parent/subsidiary companies to be insulated from one another’s obligations and liabilities. In one often cited New York appellate case, an operation, which consisted of an individual shareholder who had a dispatcher company and multiple companies with two cabs in each company, was found to be sheltered from liability caused by cab driver negligence.  Walkovszky v. Carlton, 223 N.E.2d 6 (N.Y. 1966). A Florida Supreme Court case has followed the common law in finding that in order to “pierce the corporate veil,” there has to be an active defraudment of the plaintiff, or it must be found that the defendant company and the affiliated company or companies would be identified as being partners, joint venturers, or agents of one another.  Dania Jai’alai Palace, Inc. vs. Sykes, 450 So. 2d. 1114 (Fla. 1984).

In order to maintain separation of corporations, the Authors offer the following suggestions with respect to segregating liability:

1. The companies should be treated separately, particularly as to revenue deposits.

2. The companies should not comingle their money.

3. The companies should not comingle their books or bookkeeping.

4. No company should hold itself out, directly or impliedly, as being an agent or openly affiliated with another company.  It is best to expressly set this out in writing on any documents, particularly as to documents that might otherwise be interpreted to imply a “brother-sister” relationship.

 The Traps

 Trap #1: Fraudulent Transfers

A New Parent F Reorganization can be set aside by as a “fraudulent transfer” after a judgment by a creditor against the historical operating entity. A transfer is fraudulent if at the time of the transfer, the remaining assets of the debtor are insufficient to satisfy reasonably expected claims, or if as a result of the transfer, the assets of the historical operating entity are insufficient to satisfy reasonably expected claims. Liability may even extend to the directors of a corporation.

In order to avoid this trap, it is important to document at the time of the transfers that the assets and income stream remaining in the historical operating entity are sufficient to satisfy any reasonably expected creditor issues that may exist at the time of the transfers and that any transfer of assets out of the historical operating company does not render the entity “insolvent.”  This can be accomplished through the preparation of a balance sheet with a fair market value analysis and an analysis of possible liability exposure. Do not forget that goodwill of the entity may have a value that can be taken into consideration in such an analysis.

Trap #2:  Confusing New Parent F Reorganizations with Type D Divisive  Reorganizations

Many tax lawyers are under the impression that transferring assets that have debt exceeding the tax basis of the assets in a “tax-free reorganization” will trigger gain as if the assets were sold for the amount of debt involved.  But Internal Revenue Code Section  357(c), as amended in 2004 by the American Jobs Creation Act, Section 898, only applies to a Type D divisive reorganization for reorganizations that occur on or after October 22, 2004.  Internal Revenue Code Section 357 does not apply to Type F reorganizations.

When a transaction can be characterized as a Type D reorganization and a Type F reorganization, the transaction will be characterize as a Type F reorganization and Code Section 357(c) will not apply to the transaction.  SeeRev. Rul. 79-289, 1979-2 C.B. 145; Rev. Rul. 87-27, 1987-1 C.B. 134.

Out of an abundance of caution, the Authors would like to point out Treasury Regulation 1.1361-4(a)(2)(ii) Example 3, which seems to provide that a New Parent Reorganization would be considered a D reorganization. Under the Treasury Regulation example, individual A, pursuant to a plan, contributes all of the outstanding stock of Y to his wholly owned S corporation, X, and immediately causes X to make a QSUB election for Y.  The example concludes that the transaction is a Type D reorganization, and that Code Section 357(c) applied to the transaction if the sum of the amount of the liabilities of Y treated as assumed by X exceeds the total of the adjusted basis of the property Y.  The Authors assume that the transaction would not have qualified as a Type F reorganization because the transfer of Y’s assets to X would not result in a mere change in form or identity for Y.  However, it is unclear why Code Section 357(c) would apply to the transaction.

As stated above, Section 898 of the American Jobs Creation Act amended Code Section 357(c) so that it only applies to Type D divisive reorganizations. A Type D divisive reorganization must comply with the corporate division requirements of Code Section 355.  Code Section 357(c) does not apply to Type D acquisitive reorganizations.  Type D acquisitive reorganizations must satisfy Code Section 354.  The transaction described by Treasury Regulation 1.1361-4(a)(2)(ii) Example 3 appears to be an acquisitive Type D reorganization.  See PLR 200430025.  As such, Code Section 357(c) should not apply to the transaction.

The Thursday Report now includes this month, last month, and the preceding month’s applicable federal rates. For a sale, you are permitted to use the lowest of the 3 rates.  Click here to view the rates.

NEWS AND UPCOMING EVENTS

THURSDAY, SEPTEMBER 27, 2012, 4:00 p.m. – 4:50 p.m. 
Please join us for The 4-4-4 Show, a monthly Clearwater Bar Association continuing education webinar series that qualifies for 1 hour of continuing education credit and is moderated by Alan S. Gassman, Esq.  This month’s topic is “Florida LLC and Limited Partnership Law and Strategies Update” with well known expert Tom Wells, Esquire of Coral Gables, Florida.  To register please visit: www.clearwaterbar.org

MONDAY, OCTOBER 1, 2012 12:30 p.m. – 1:00 p.m. 
Please join us for Lunch Talk, a free monthly webinar from the Clearwater Bar Association and moderated by Alan S. Gassman, Esq.  Each month we feature topics of interest to attorneys and legal staff.  This month’s topic is “Learn About Features of The Florida Bar’s Law Office Management Assistance Service (LOMAS).  A Wealth of Information Awaits You by Accessing the Benefits You Have Coming to You Through The Florida Bar” with guest speaker Judith D. Equels, Director, The Florida Bar’s Law Office Management Assistance Service (LOMAS).  To register please visit www.clearwaterbar.org

FREE CONTINUING EDUCATION CREDIT

TUESDAY, OCTOBER 2, 2012 5:00 p.m.
Alan Gassman and nationally known author and business coach Dan Sullivan will be presenting a free webinar beginning at 5:00 p.m. on Tuesday, October 2, 2012 on “Why 20% of the Doctors Make 80% of the Money (and Enjoy What They Are Doing!).”  This 1-hour program qualifies for continuing education credit for Florida lawyers and CPAs, and will include live discussions with successful physicians who will share what they have done in their practices to enhance income and their enjoyment of practicing medicine.  Complimentary replays and audio downloads will also be available.  To register for this event please email agassman@gassmanpa.com

WEDNESDAY, OCTOBER 17, 2012 12:30 p.m. – 2:00 p.m.
Professor Jerry Hesch, Alan Gassman, Esq. and Christopher Denicolo, Esq. will be speaking on a Bloomberg BNA webinar entitled Interesting Interest. To register please contact Janine Ruggiero via email atagassman@gassmanpa.com.

 THURSDAY, OCTOBER 18, 2012
Alan S. Gassman, Esq. will speak at the The Tampa Bay Research Institute, Inc. 2nd Annual Estate Planning Seminar, in partnership with the Pinellas Community Foundation.  Alan Gassman’s topic is Trust Planning for 2013 and Beyond – How to Keep Wealth in the Family.  The seminar will take place at TBRI, 10900 Roosevelt Boulevard in St. Petersburg, Florida.  Additional Topics and presenters include, Panel Discussion on Conflict of Interest Issues for Estate Planning Professionals.  The moderator for the panel discussion is Sandra F. Diamond, J.D., and the panel consists of Angela Adams and Jeffrey Goethe; and Charitable Estate Planning in a Changing Tax Environment by Christopher Pegg, J.D., LL.M., Taxation. For more information please contact Tom Taggart atttaggart@tampabayresearch.org.

Christopher Denicolo, J.D., LL.M. is a partner at the Clearwater, Florida law firm of Gassman, Crotty & Denicolo, P.A., where he practices in the areas of estate tax and trust planning, taxation, physician representation, and corporate and business law.  He has co-authored several handbooks that have been featured in Bloomberg BNA Tax & Accounting, Steve Leimberg’s Estate Planning and Asset Protection Planning Newsletters and the Florida Bar Journal.  is also the author of the Federal Income Taxation of the Business Entity Chapter of the Florida Bar’s Florida Small Business Practice, Seventh Edition Mr. Denicolo received his B.A. and B.S. degrees from Florida State University, his J.D. from Stetson University College of Law and his LL.M. (Estate Planning) from the University of Miami.

Kenneth J. Crotty, J.D., LL.M., is a partner at the Clearwater, Florida law firm of Gassman, Crotty & Denicolo, P.A., where he practices in the areas of estate tax and trust planning, taxation, physician representation, and corporate and business law. Mr. Crotty has co-authored several handbooks that have been published in BNA Tax & Accounting, Estate Planning, Steve Leimberg’s Estate Planning and Asset Protection Planning Newsletters, Estate Planning magazine, and Practial Tax Strategies.  Mr. Crotty is also the author of the Limited Liability Company Chapter of the Florida Bar’s Florida Small Business Practice, Seventh Edition. He, Alan Gassman and Christopher Denicolo are the co-authors of the BNA book Estate Tax Planning in 2011 & 2012. His email address is ken@gassmanpa.com.

Thank you to our law clerks who assisted us in preparing this report:

Kacie Hohnadell is a third-year law student at Stetson University College of Law and is considering pursuing an LL.M. in taxation upon graduation. Kacie is also the Executive Editor of Stetson Law Review and is actively involved in Stetson’s chapter of the Student Animal Legal Defense Fund. In 2010, she received her B.A. from the University of Central Florida in Advertising and Public Relations with a minor in Marketing, and moved to St. Petersburg shortly after graduation to pursue her Juris Doctor. Her email address is Kacie@gassmanpa.com.

Alexandra Fugate earned her B.A. in English from the University of Florida in 2008, and J.D. from Stetson University College of Law in 2012. She has been a Guardian ad Litem for the past two years, a judicial intern for the Twelfth Circuit in Bradenton, and is currently seeking admission to the Florida Bar. She wants to pursue a career in Business, Employment, and Property law.

Eric Moody is a third-year law student, scheduled to graduate in December 2012, at Stetson University College of Law and is considering pursuing an LLM in estate planning upon graduation. Eric is also an Articles and Symposia Editor for Stetson Law Review. In 2009, Eric received a B.S. in Business Management from the University of South Florida. Eric’s email address is Eric@gassmanpa.com.