Gimme 5: What Every Lawyer Should Know about Tax Law
By Douglas W. Schwartz, a partner with Kopple & Klinger, LLP in Los Angeles, where he practices in the areas of income, sales and property tax planning and audits; estate planning; and general business law. The views expressed are his own. He can be reached at firstname.lastname@example.org.
Because tax laws are complex and always changing, all tax lawyers have stories about some transaction where they missed—and, one hopes, caught in time—a critical issue. Most stories fall into five “deadly sins” of tax practice:
Sin #1: Forgetting the alternative minimum tax.
The federal alternative minimum tax has gotten much press lately as a 1970s relic to catch “rich” people but that is now tormenting more and more middle-class taxpayers. The AMT imposes rates different from the “regular” tax rates, taxes items not subject to regular income tax (for example, the economic benefit of buying appreciated employer stock at a discount when so-called “incentive” stock option holders exercise their option), and denies credits, exemptions, and deductions that are available for regular tax (for example, investment and employee expenses, state income taxes, and home equity line interest). A tax advisor should always check the AMT rules before telling a client that a transaction will not be taxed or that a coveted deduction or credit is available because what the regular tax giveth, the AMT often taketh away.
Sin #2: Forgetting California taxes.
California imposes two taxes—sales/use and property—without federal counterparts. Therefore, when tax advisors structure a real estate or other transaction to avoid federal income tax, they also must check whether the transaction results in California sales tax or in a Proposition 13 reassessment because of an “ownership change.” Generally, sales tax may apply in a sale or other transaction involving tangible personal property but not real estate, and a Proposition 13 reassessment may occur in a sale or other transaction involving real estate but not tangible personal property.
California’s taxes on net personal and corporate income also may depart from the federal income tax treatment. For example, California has no reduced rates for long-term capital gain or dividends, and its AMT rules differ from the federal AMT—see Sin #1. Even where California conforms to the federal Internal Revenue Code, the state may not conform to changes in the code occurring after the last date that Sacramento adopted conformity legislation, meaning that the federal changes are not yet part of California law. Therefore, the tax advisor should always check California conformity to the federal treatment.
Sin #3: Not determining whether an S corporation was once a C corporation.
Having a corporation elect S status confers certain tax benefits: The corporation does not pay federal income tax (instead, income and deductions are passed through to the shareholders to be included and taxed on their individual returns), and long-term capital gain of the corporation is generally taxed to the shareholders at the favorable 15 percent federal rate. If a corporation is not an S corporation—that is, it is a so-called C corporation—it must pay tax on its net income; the shareholders are taxed again when the corporation pays out its net income to them as dividends; and the corporation does not get a favorable long-term capital gains rate. However, if an S corporation was once a C corporation (as opposed to having elected S status from the day it was formed), these benefits can be sharply reduced. For example, if an S corporation sells assets within 10 years after it converted from C to S status, some of that gain may be subject to corporate tax under the so-called “built-in gain” rules. The tax advisor must therefore be sure of the S corporation’s history before telling a client that there is no corporate-level tax on the asset sale—and also advise the client that California, unlike federal law, does impose a corporate-level tax—see Sin #2—albeit at a 1.5 percent rate and not the full C corporation 8.84 percent rate.
Sin #4: Forgetting gain recapture or recharacterization rules.
Though federal law generally taxes long-term capital gains of an individual at a maximum rate of 15 percent (as opposed to the graduated rates of up to 35 percent on compensation, interest and other “ordinary” income), some gains (for example, from collectibles or from real property that has been depreciated) are taxed at higher rates but below the ordinary income tax rates; other gains (for example, from tangible personal property than has been depreciated) are taxed at full ordinary rates to “recapture” the prior tax benefits from the depreciation deductions; and some gains are denied favorable capital gains rates entirely if they arise from a sale or other transfer of depreciable property to a “related” taxpayer. The tax advisor should always run the gamut of these rules before advising a client that the favorable 15 percent rate will apply—and remember to tell the client that there is no favorable California capital gains rate—see Sin #2—or C corporation capital gains rate—see Sin #3.
Sin #5: Not distinguishing business terms from tax lingo for the client.
Tax laws use their own terminology, which often differs from terminology for business or other purposes, and it is therefore critical that the tax advisor understand exactly what the client is talking about before rendering tax advice—or, when rendering such advice, be precise as to the terms used. For example, if a client wants to merge two wholly owned companies, the tax advisor must specify what kind of “companies” are involved (and also review possible California sales tax or Proposition 13 consequences—see Sin #2). The client generally can merge one corporation into another without taxable gain in a so-called D reorganization (though the advisor must still do due diligence because even a D reorganization can result in tax depending on the balance sheets of the two corporations); generally merge one limited liability company into another without taxable gain (because 100 percent-owned LLCs are generally “disregarded” as separate entities for tax purposes); and generally merge an LLC into a corporation without taxable gain. However, if the client merges a corporation into an LLC, income tax laws generally would treat that as a fully taxable liquidation of the corporation even though California corporate law allows “inter-species” mergers between LLCs and corporations.