October, 2014
By Roger Royse

It’s time again to think about year-end tax planning. The bad news is that Congress has yet to act on several tax breaks that expired at the end of 2013. Some of these tax breaks may be retroactively reinstated and extended, but Congress may not decide the fate of these tax breaks until the very end of this year (and, possibly, not until next year). Tax breaks that expired at the end of last year include: 50% bonus first year depreciation for most new machinery, equipment and software; the $500,000 annual expensing limitation; the research tax credit; and the 15-year write-off for qualified leasehold improvement property, qualified restaurant property, and qualified retail improvement property.

Higher-income-earners should be aware of the 3.8% surtax on unearned income and the additional 0.9% Medicare (hospital insurance, or HI) tax that applies to individuals receiving wages with respect to employment in excess of $200,000 ($250,000 for married couples filing jointly and $125,000 for married couples filing separately). Employers must withhold the additional Medicare tax from wages in excess of $200,000 regardless of filing status or other income. Self-employed persons must take it into account in figuring estimated tax.

Businesses should consider the following moves by year end:

  • Businesses should buy machinery and equipment before year end and, under the generally applicable “half-year convention,” thereby secure a half-years’ worth of depreciation deductions for the first ownership year.
  • Make year end expenditures that qualify for the business property expensing option, which is $25,000 for tax years beginning in 2014. An investment-based reduction in the dollar limitation starts to take effect when property placed in service in the tax year exceeds $200,000.
  • Businesses may be able to take advantage of the “de minims safe harbor election” (also known as the book-tax conformity election) to expense the costs of inexpensive assets and materials and supplies, assuming the costs don’t have to be capitalized under the Code Sec. 263A uniform capitalization (UNICAP) rules.
  • A corporation should consider accelerating income from 2015 to 2014 where doing so will prevent the corporation from moving into a higher bracket next year. Conversely, it should consider deferring income until 2015 where doing so will prevent the corporation from moving into a higher bracket this year.
  • A corporation should consider deferring income until next year if doing so will preserve the corporation’s qualification for the small corporation alternative minimum tax (AMT) exemption for 2014.
  • A corporation (other than a “large” corporation) that anticipates a small net operating loss (NOL) for 2014 (and substantial net income in 2015) may find it worthwhile to accelerate just enough of its 2015 income (or to defer just enough of its 2014 deductions) to create a small amount of net income for 2014. This will permit the corporation to base its 2015 estimated tax installments on the relatively small amount of income shown on its 2014 return, rather than having to pay estimated taxes based on 100% of its much larger 2015 taxable income.
  • If a business qualifies for the domestic production activities deduction for its 2014 tax year, it should consider whether the 50%-of-W-2 wages limitation on that deduction applies. If so, the business should consider ways to increase 2014 W-2 income, e.g., by bonuses to owner-shareholders whose compensation is allocable to domestic production gross receipts.
  • To reduce 2014 taxable income, consider deferring a debt-cancellation event until 2015.
  • To reduce 2014 taxable income, consider disposing of a passive activity in 2014 if doing so will allow the deduction of suspended passive activity losses.
  • A taxpayer who owns an interest in a partnership or S corporation should consider increasing their outside basis in the entity in order to deduct a loss from it.

October, 2014
By Roger Royse

In 2012 the President signed the JOBS Act, which introduced the concept of letting the wisdom of the crowd instead of the regulator determine the sale of securities. The crowdfunding movement (as expressed in the JOBS Act) is the result of the perfect storm of technology, legislation and market acceptance of the idea of leveraged fundraising models. There are now several new ways to raise money, and selecting the right approach, and avoiding the wrong one, is an important consideration for every startup entrepreneur.

What do the new developments mean for a startup seeking capital? The past few years have opened up two main avenues for raising money:  (1) donation-based or rewards-based crowdfunding (think Kickstarter or Indiegogo as examples); and (2) equity crowdfunding.  Equity crowdfunding can be broken down into public and private equity crowdfunding.

Donation-Based Crowdfunding – Money for Nothing

Despite the debate about equity crowdfunding, the crowdfunding scene is still dominated by donation-based (or rewards-based) crowdfunding, which has exploded in the last five years.  Businesses can now seek donations on websites like Kickstarter and Indiegogo and, while not typical, there are success stories of businesses raising million dollar sums within just a few weeks.

Donation based crowdfunding is best suited to young businesses that are still testing their model. Websites like Kickstarter and Indiegogo provide businesses a platform upon which to raise money for whatever purpose they see fit (within reason) without having to give away any ownership interest in the business.  In return for the donations, the business usually offers rewards linked to the product for which they are seeking funds.  The rewards could be anything from a thank you email for a $1 donation to a personal meeting with the business owner for a donation in the thousands of dollars.  Many donors donate at a level where the reward is the actual product or service for which funds are being raised. When used in this way, donation-based crowdfunding looks a lot like collecting pre-payments for goods and services.

Donation-based crowdfunding typically covers a broader array of businesses than equity crowdfunding.  It is not uncommon to see artists such as musicians, authors, and designers using donation-based crowdfunding to raise money to fund their latest project.

One of the key benefits of the donation model is the lack of securities regulation.  That said, those raising money should make sure they follow through on their commitments.  Earlier this year, the Washington attorney-general initiated a lawsuit against an individual for an alleged failure to deliver packs of playing cards to donors after collecting money through Kickstarter.  As accusations of fraud become more common, we can expect to see more states take an interest in protecting those who “donate” through these websites.

Equity Crowdfunding

Raising money through the issuance of equity has been highly regulated since the introduction of the Securities Act in 1933.  The JOBS Act was supposed to cut down on the regulations impeding start-ups from accessing capital, however the slow reaction from the SEC means that the future is still uncertain.  The most significant regulatory changes in equity crowdfunding are happening under Title III of the JOBS Act and Rule 506 of the Securities Regulations.

  • Title III of the JOBS Act

Title III equity crowdfunding will allow companies to raise up to $1 million from the public through a broker-dealer or registered funding portal.  The issuer will be required to make disclosures to the SEC at least 21 days prior to the first sale and audited financial statements will be required for issuances above $500,000.  Neither the issuer, nor the broker-dealer/funding portal, will be able to solicit investments and there will be caps on how much individual investors can invest in a given year.

The JOBS Act instructed the SEC to draft regulations legalizing this form of equity crowdfunding by the end of 2012.  The SEC finally released proposed regulations in October 2013 and the comment period expired on February 4, 2014.  Nine months later the final regulations are still nowhere to be seen; however, based on the statute and the proposed regulations, Title III is unlikely to be very useful for the typical startup.

For starters, the transaction costs will be relatively high after you add up fees for brokers, accountants and auditors, attorneys, and insurance due to the requirements for (in some cases) audited financial statements, a business plan, registered broker-dealers and a heightened standard of liability for anyone who touches one of these offerings. In addition, many companies may be put off by the prospect of numerous small and unsophisticated shareholders. In conclusion, don’t hold your breath for anything that represents true deregulation of equity crowdfunding.

  • Funding Portals Under Rule 506

While Title III received much of the attention following the enactment of the JOBS Act, most of the action to date has occurred under Rule 506, which provides two main forms of exemption.  Broadly, under Rule 506(b) an issuer can issue securities to up to 35 non-accredited investors, but cannot use general solicitation in doing so.  Conversely, under Rule 506(c) an issuer may conduct general solicitation, but it cannot issue securities to any non-accredited investors.

Private Placements. In 2013, the SEC released two no-action letters that implied that issuers could use funding portals for Rule 506(b) issuances so long as access to the portal is restricted to accredited investors.  Numerous “internet VCs” sprung up in the wake of these rulings (and, in fact, before the rulings). Now, there is healthy competition for deal flow by investor groups that form “one off” funds comprised of relatively large groups of accredited investors to invest through highly automated internet-based funds. This has been more of a technology development than a legal one, since the internet has simply streamlined an existing investment process and allowed it to be leveraged more efficiently. As a practical matter, this development freed up billions of dollars of new angel capital that may not have otherwise found its way into the startup world.

Publicly Solicited Issuances. While Title III is hopeful, and 506(b) private placements are dominant, the future belongs to 506(c) publicly solicited transactions. Under 506(c), a company can advertise and publicly solicit the sale of its securities, provided that all eventual investors are verified as “accredited” with appropriate evidence such as tax returns, financial statements, or a letter from the investor’s lawyer or accountant. There are other requirements, such as increased Form D reporting, but all in all, the ability to advertise the sale of securities has huge potential. Many sites have been successfully marketing the sale of securities under this exemption and we can expect many more to figure it out going forward.

Conclusions and Thoughts

So what is a startup to make of this confusing array of options? Here are some general guidelines:

If your company is newly formed, unestablished and you have not yet gotten “traction” (i.e. revenues or customer validation), consider donation-based or rewards-based crowdfunding. Equity investment will be a hard sell without any sales metrics and pre-sales or donations may be your best bet to raise money and prove the concept.

If the startup has traction, a 506(b) offering has a lower hassle factor as a regulatory matter whether you seek funding on a private portal or the old fashioned way (with people with whom you have a pre-existing relationship). If the startup not only has good fundamentals (team, traction, technology) but is also in an affinity business (one that is cool, easy to understand, or otherwise hot), 506(c) publicly solicited fundraising may allow you to access (potentially) billions of dollars of new capital and may be worth doing. In any case, strategy is important, as your company will want to take its best shot and target its most likely vehicle for raising money.

We live in the age of “big data.”  While many of us may have heard the term “big data” used, lawyers and business managers may not fully understand the impact big data may have on our respective clients and companies.  Big data is a collection of data sets so large and complex that it becomes difficult to process using on-hand database management tools or data processing applications.  Complicated data-mining techniques parse information in the data-sphere to offer companies and organizations new ways to identify untapped markets and create efficiencies.  The McKinsey Global Institute identified monetary benefits big data could produce.  Retailers could increase operating margins by more than 60 percent.  The health care system could drive efficiencies valued at over $300 billion each year.  Users of services enabled by personal-location data could capture $600 billion in consumer surplus.  With all of its potential, big data also poses risks to both the companies seeking to unlock its potential and individuals whose information is constantly being collected, combined, mined, analyzed and acted upon.

The main legal issue related to big data involves privacy.  Information may be reconstituted using other public information to identify the consumer personally and a consumer’s right to access and verify accuracy of the information without a contract leaves the consumer with no legal recourse requiring the broker to provide access.  Users of reconstituted data could be violating consumers’ right to personal privacy.  One solution the industry has developed to mitigate risks is de-identification or anonymization.  Key information is stripped away to prevent miners from identifying the persons individually related to specific data sets.  The issue is that unless done correctly, the data could be reconstituted, effectively re-identifying the individual exposing an organization to existing data breach notification laws and lead to litigation or regulatory scrutiny.  The analysis and combination of anonymized data sets with data sets containing identified individuals is largely unpredictable and could result in serious legal trouble.

 

Employers take a risk when they classify someone performing services for them as an independent contractor instead of an employee. Because employers owe contractors far fewer obligations than employees, employers risk each of the following if a court determines that a misclassification occurred:

– Unpaid overtime.
– Unpaid taxes.
– Un-provided benefits.
– A discrimination claim, or claims under other laws that protect employees but not contractors (i.e., the FMLA).

In determining whether a worker is an employee or an independent contractor, the IRS compares the degree of control exerted by the company to the degree of independence retained by the individual. Generally, the IRS examines this relationship in three ways:

  1. Behavioral: Does the company control or have the right to control what the worker does and how the worker does his or her job?
  2. Financial: Are the business aspects of the worker’s job controlled by the payer? (these include things like how the worker is paid, whether expenses are reimbursed, who provides tools/supplies, etc.)
  3. Type of Relationship: Are there written contracts or employee type benefits (i.e. pension plan, insurance, vacation pay, etc.)? Will the relationship continue and is the work performed a key aspect of the business?

If you are considering classifying someone performing services for you as an independent contractor, your answers to these three questions will determine whether that individual is a bona fide contractor, or instead, is an employee. When in doubt, err on the side of caution. The government applies these tests aggressively to find employee-status whenever it can. You should too, and the risks are too high to make a mistake.

Hire a Contractor or an Employee?

Independent contractors and employees are not the same, and it’s important to understand the difference. Knowing this distinction will help you determine what your first hiring move will be and affect how you withhold a variety of taxes and avoid costly legal consequences.

What’s the Difference?

An Independent Contractor:

  • Operates under a business name
  • Has his/her own employees
  • Maintains a separate business checking account
  • Advertises his/her business’ services
  • Invoices for work completed
  • Has more than one client
  • Has own tools and sets own hours
  • Keeps business records

An Employee:

  • Performs duties dictated or controlled by others
  • Is given training for work to be done
  • Works for only one employer

Many small businesses rely on independent contractors for their staffing needs. There are many benefits to using contractors over hiring employees:

  • Savings in labor costs
  • Reduced liability
  • Flexibility in hiring and firing

Why Does It Matter?

Misclassification of an individual as an independent contractor may have a number of costly legal consequences.  If your independent contractor is discovered to meet the legal definition of an employee, you may be required to:

  • Reimburse them for wages you should’ve paid them under the Fair Labor Standards Act, including overtime and minimum wage
  • Pay back taxes and penalties for federal and state income taxes, Social Security, Medicare and unemployment
  • Pay any misclassified injured employees workers’ compensation benefits
  • Provide employee benefits, including health insurance, retirement, etc.

Tax Requirements

Visit the IRS Independent Contractor or Employee Guide to learn about the tax implications of either scenario, download and fill out a form to have the IRS officially determine your workers’ status, and find other related resources. NOTE: For tax consequences for limited liability entities in California see: http://www.edd.ca.gov/pdf_pub_ctr/de231llc.pdf

Employment Information

There is no single test for determining if an individual is an independent contractor or an employee under the Fair Labor Standards Act. However, the following guidelines should be taken into account:

  1. The extent to which the services rendered are an integral part of the principal’s business
  2. The permanency of the relationship
  3. The amount of the alleged contractor’s investment in facilities and equipment
  4. The nature and degree of control by the principal
  5. The alleged contractor’s opportunities for profit and loss
  6. The amount of initiative, judgment, or foresight in open market competition with others that is required for the success of the claimed independent contractor
  7. The degree of independent business organization and operation

Whether a person is an independent contractor or an employee generally depends on the amount of control exercised by the employer over the work being done. Read Equal Employment Opportunity Laws – Who’s Covered? for more information on how to determine whether a person is an independent contractor or an employee, and which are covered under federal laws.  If there is a serious concern as to whether you should classify an individual as an employee or independent contractor you may use Form SS-8 to ask the IRS to give their opinion.

CALIFORNIA LAW

The IRS, Department of Labor and many state agencies are taking aim at businesses using independent contractors. Why? Paying an independent contractor means no wage withholding, no employment taxes, no unemployment insurance, no workers’ compensation, and no liability for pensions and fringe benefits. Even the red tape of nondiscrimination rules go out the window.

When you look at the advantages of using independent contractors and at the amorphous question of who qualifies, it is clear why some businesses push the envelope. With tax revenues everywhere suffering, enforcement takes a front seat.  Besides enforcing existing laws, new laws have been implemented to further punish wrong-doers.

California passed legislation to increase the stakes:

  • California’s Labor and Workforce Development Agency can fine you for “willfully misclassifying” an employee from $5,000 to $15,000 per violation.
  • The penalty goes up to $25,000 per violation if you commit a “pattern and practice” of “willfully misclassifying” workers.
  • There’s joint and several liability for consultants (but excluding practicing lawyers) who advise employers on such independent contractor engagements.
  • It’s unlawful to charge misclassified independent contractors any fee or take deductions from the compensation paid to them.  Companies cannot deduct fees for goods, materials, space rental, services, government licenses, repairs, etc. provided to contractors who are reclassified.

These penalties are in addition to existing penalties for misclassifying contractors. California’s Labor Commissioner can enforce the law, but Private Attorney General Act lawsuits also seem allowed.  Also, if a business has willfully misclassified an independent contractor, a prominent public notice must be posted for one year on a website or worksite reciting the misclassification.

What’s Willful Misclassification?

It can be hard to tell whether someone is an independent contractor or an employee.  So how do you know you won’t be labeled “willful” if it turns out you misclassified someone?  ”Willful misclassification” means avoiding employee status for an individual “by voluntarily and knowingly misclassifying that individual as an independent contractor.”  Does a good faith dispute over the individual’s classification mean you can’t be “willful?”  It’s not clear.

WHO IS AN EMPLOYER?

Under Section 675 of the California Unemployment Insurance Code (CUIC), a business becomes an employer when it employs one or more employees and pays wages in excess of $100 during any calendar quarter. Wages are compensation for personal services performed, including, but not limited to, cash payments, commissions, bonuses, and the reasonable cash value of nonmonetary payments for services, such as meals and lodging.  Once a business becomes an employer, a registration form from the DE 1 series must be completed and submitted within 15 days to the Employment Development Department (EDD). Employers are responsible for reporting wages paid to their employees and paying Unemployment Insurance (UI) and Employment Training Tax (ETT) on those wages, as well as withholding and remitting State Disability Insurance (SDI) and Personal Income Tax (PIT) due on wages paid.

WHO IS AN EMPLOYEE?

An “employee” includes all of the following:

  • Any officer of a corporation.
  • Any worker who is an employee under the usual common law rules.
  • Any worker whose services are specifically covered by law.

An employee may perform services on a less than full-time or permanent basis. The law does not exclude services from employment that are commonly referred to as day labor, part-time help, casual labor, temporary help, probationary, or outside labor.

Who Is a Common Law Employee?

Whether an individual is an employee for the purpose of Section 621(b) of the CUIC will be determined by the usual common law rules applicable in determining an employer/employee relationship. To determine whether one performs services for another as an employee, the most important factor is the right of the principal to control the manner and means of accomplishing a desired result. The right to control, whether or not exercised, is the most important factor in determining the relationship. The right to discharge a worker at will and without cause is strong evidence of the right to control. Other factors to take into consideration are:

  1. Whether or not the one performing the services is engaged in a separately established occupation or business.
  2. The kind of occupation, with reference to whether, in the locality, the work is usually done under the direction of a principal without supervision.
  3. The skill required in performing the services and accomplishing the desired result.
  4. Whether the principal or the person providing the services supplies the instrumentalities, tools, and the place of work for the person doing the work.
  5. The length of time for which the services are performed to determine whether the performance is an isolated event or continuous in nature.
  6. The method of payment, whether by the time, a piece rate, or by the job.
  7. Whether or not the work is part of the regular business of the principal, or whether the work is not within the regular business of the principal.
  8. Whether or not the parties believe they are creating the relationship of employer and employee.
  9. The extent of actual control exercised by the principal over the manner and means of performing the services.
  10. Whether the principal is or is not engaged in a business enterprise or whether the services being performed are for the benefit or convenience of the principal as an individual.

Another consideration relative to employment is whether or not the worker can make business decisions that would enable him or her to earn a profit or incur a financial loss.  Investment of the worker’s time is not sufficient to show a risk of loss.  The numbered factors above are evidence of the right to control. These factors are described more fully in Section 4304-1 of Title 22, California Code of Regulations.

A determination of whether an individual is an employee will depend upon a grouping of factors that are significant in relationship to the service being performed, rather than depending on a single controlling factor.  The courts and the California Unemployment Insurance Appeals Board have held that the existence of a written contract is not, by itself, a determining factor. The actual practices of the parties in a relationship are more important than the wording of a contract in determining whether a worker is an employee or independent contractor.

Not all workers are employees as they may be volunteers or independent contractors. Employers oftentimes improperly classify their employees as independent contractors so that they, the employer, do not have to pay payroll taxes, the minimum wage or overtime, comply with other wage and hour law requirements such as providing meal periods and rest breaks, or reimburse their workers for business expenses incurred in performing their jobs. Additionally, employers do not have to cover independent contractors under workers’ compensation insurance, and are not liable for payments under unemployment insurance, disability insurance, or social security.

The state agencies most involved with the determination of independent contractor status are the Employment Development Department (EDD), which is concerned with employment-related taxes, and the Division of Labor Standards Enforcement (DLSE), which is concerned with whether the wage, hour and workers’ compensation insurance laws apply. There are other agencies, such as the Franchise Tax Board (FTB), Division of Workers’ Compensation (DWC), and the Contractors State Licensing Board (CSLB), that also have regulations or requirements concerning independent contractors. Since different laws may be involved in a particular situation such as a termination of employment, it is possible that the same individual may be considered an employee for purposes of one law and an independent contractor under another law. Because the potential liabilities and penalties are significant if an individual is treated as an independent contractor and later found to be an employee, each working relationship should be thoroughly researched and analyzed before it is established.

What is a trademark?

A trademark is a distinctive sign which identifies certain goods or services as those produced or provided by a specific person or enterprise. Its origin dates back to ancient times, when craftsmen reproduced their signatures, or “marks” on their artistic or utilitarian products. Over the years these marks evolved into today’s system of trademark registration and protection. The system helps consumers identify and purchase a product or service because its nature and quality, indicated by its unique trademark, meets their needs.

What does a trademark do?

A trademark provides protection to the owner of the mark by ensuring the exclusive right to use it to identify goods or services, or to authorize another to use it in return for payment. The period of protection varies, but a trademark can be renewed indefinitely beyond the time limit on payment of additional fees. Trademark protection is enforced by the courts, which in most systems have the authority to block trademark infringement.  They promote initiative and enterprise worldwide by rewarding the owners of trademarks with recognition and financial profit. Trademark protection also hinders the efforts of unfair competitors, such as counterfeiters, to use similar distinctive signs to market inferior or different products or services.

What kinds of trademarks can be registered?

The possibilities are almost limitless. Trademarks may be one or a combination of words, letters, and numerals. They may consist of drawings, symbols, three- dimensional signs such as the shape and packaging of goods, audible signs such as music or vocal sounds, fragrances, or colors used as distinguishing features.

How does one secure trademark rights?

Trademark rights arise from actual use of a name, logo or symbol in the marketplace. However, rights important to the protection and enforcement of the trademark can be obtained only through registration. The first step to register a trademark is to clear the mark for use. This process normally entails ensuring that the mark is not already being used by someone else in connection with similar goods and/or services. If the mark is already being used, another mark may have to be selected or features added to the proposed mark to help distinguish it from other uses. If the mark is not being used, one simply registers by applying to the Patent and Trademark Office.

How long does a Trademark last?

In the United States, Trademark rights are perpetual in nature as long as the owner renews the rights of the trademarks by filing certain declarations of continued use at specific time periods and pays the associated USPTO filing fees.

Four Reasons Why Trademarks Are Important to Your Business

The purchasing decisions of consumers are constantly influenced by trademarks. As a business person or corporate executive, it is important to have a solid understanding of why trademarks are so important to effective commerce.

1. Trademarks make it easy for consumers to find you

  • Trademarks help you distinguish your products and services from those of competitors and help identify you as the source.
  • Trademarks indicate a consistent level of quality of your products and services.
  • Awareness of your brand and the goodwill embodied in your trademark can often take decades to establish.
  • Aggregate cost of advertising, promotion, marketing, and sales efforts can easily reach into tens of millions or even billions of dollars, depending on the product/service.
  • Differentiating your product/service from competitors is increasingly difficult to achieve, especially over a protracted period.
  • Trademarks are the most efficient commercial communication tool ever devised to:

– “cut through the clutter”;
– capture the consumer’s attention; and
– make your products/services stand out.

2. Trademarks help prevent marketplace confusion

  • Trademarks protect the consuming public by preventing confusion as to the source of goods or services.
  • If the product made under a brand turns out to be defective, consumers have accurate information about the source of a product and can return it to the manufacturer or supplier for a refund.
  • Trademarks give consumers the ability to protect themselves by relying upon known brands of products or services.
  • Trademarks provide consumer convenience by allowing consumers to identify (by word, logo, slogan, package design, or other indicators of origin) which product or service they would like to purchase or to avoid purchasing.
  • Trademarks provide consumer convenience by allowing consumers to base their purchasing decisions on what they have heard, read, or experienced themselves.
  • Trademarks motivate companies to provide a consistent level of quality, helping the consumer to decide whether to purchase a desirable product or service again or to avoid an undesirable one.

3. Trademarks are a very economically efficient communication tool

  • Trademarks dramatically reduce the costs of decision-making by allowing consumers to rapidly select the desired product or service from among competitive offerings.
  • Trademarks can wrap up in a single brand or logo intellectual and emotional attributes and messages about your:

– Company;
– Reputation;
– Products and services; and
– Consumers’ lifestyles, aspirations, and desires.

  • Trademarks can work effectively across borders, cultures, and languages.
  • Famous marks can be recognized as brands even when the native population speaks a different language and reads a different alphabet (i.e., the McDonalds “arches” logo, the NIKE “swoosh” logo).

4. Trademarks are your most enduring assets

  • Trademarks are one of the few assets that can provide you with a long-term competitive advantage.
  • Trademarks are usually the only business asset you have that can appreciate over time.
  • Trademarks are leverageable – they provide value beyond your core business, and can pave the way for expansion (or acquisition, if desired) of your business.

January, 2011
By Roger Royse

U.S. tax rates and filing obligations associated with owning and selling U.S. real estate can vary widely depending on the structure and jurisdiction of the owners of such U.S. real estate. When considering an investment in U.S. real estate, a foreign person should consider the opportunities and risks inherent to the ownership structures summarized below.

A. Direct Ownership by Foreign Individual

In the simplest structure, a foreign individual would simply own his or her U.S. real estate, in such person’s individual capacity.

As a result of their ownership of U.S. real estate, foreign individuals may receive rental or similar payments over the course of each taxable year. If a foreign individual is not engaged in a U.S. trade or business, and does not otherwise file U.S. tax returns, he or she will likely pay taxes (through withholding, at 30% rates) on the gross income paid to such individual. Alternatively, a foreign individual could elect to file tax returns in the U.S., as though such individual were engaged in a U.S. trade or business, and pay taxes on the net income associated with the real estate (i.e. utilize applicable tax deductions) at the graduated tax rates applicable to U.S. persons.

The favorable capital gains tax rate (currently 15%) may apply on the net income received in a foreign individual’s sale of his or her U.S. real estate, assuming the holding period is satisfied and the income is not otherwise subject to depreciation recapture. Special rules under the Foreign Investment in Real Property Tax Act (FIRPTA) apply when U.S. real estate (or an interest in U.S. real estate) is transferred by a foreign individual or corporation. Under the FIRPTA rules, a 10% gross withholding tax will ordinarily apply to the sale proceeds, but a foreign individual will be eligible to claim a refund on his or her U.S. tax return in the event the 10% withheld exceeds the actual tax due.

U.S. estate tax laws will also likely require taxation on the value of a foreign individual’s U.S. real estate in the event such individual dies while owning U.S. real estate.

B. Ownership by Foreign Individual through U.S. LLC

In a slightly more advantageous, but perhaps more expensive, structure, a foreign individual can own his or her U.S. real estate through a U.S. Limited Liability Company (LLC).

The main benefit of owning through a U.S. LLC is the “limited liability” that such ownership structure offers. If a legal liability arises with respect to U.S. real estate owned by an LLC, in nearly all cases, the liability will not extend to an owner of the LLC (i.e. the foreign individual). Shielding personal assets of a foreign individual can be critical depending on the type of U.S. real estate owned and the extent of such foreign individual’s assets.

The income tax rates and rules applicable to individuals, discussed above (including the FIRPTA rules), will in most cases apply to a foreign individual holding ownership through a U.S. LLC. Absent an election to be taxed as a corporation, if a U.S. LLC has just one owner it is disregarded for U.S. tax purposes, and if it has multiple owners it is taxed as a partnership. The compliance burden and expense can become noteworthy because a U.S. LLC may have a tax withholding and filing obligation on top of the filing obligation of a foreign owner of that LLC. In addition, California charges LLCs an annual fee based on gross receipts.

It is commonly believed that U.S. estate tax laws will require taxation on a foreign individual’s ownership of interests in U.S. LLCs, as such interests are considered “US situs property.” Whether similar rules would require U.S. estate taxation of interests of a foreign LLC owning U.S. real estate is debatable. Some practitioners believe that using a foreign LLC can allow a foreign individual to harness the benefit of the preferential rate on capital gains and also avoid death taxes on the basis that the foreign LLC interests are foreign situs intangible property not subject to U.S. estate tax.

It should also be noted that U.S. LLCs are often treated as corporations by foreign taxing authorities, and the mismatch in classification can create a mismatch in income taxation between the U.S. and the foreign country in any given year.

C. Ownership by Foreign Individual through Foreign Corporation

In a structure that has obvious advantages and disadvantages, a foreign individual can own his or her U.S. real estate through a Foreign Corporation (FC).

The three major benefits of ownership through an FC are as follows: (i) a foreign individual will have limited liability as discussed above, (ii) the U.S. tax filing obligations fall on an FC and not on its owners (i.e. no individual tax returns filed by a foreign individual), and (iii) the U.S. estate tax laws will not treat an interest in a foreign corporation as U.S. situs property and a foreign individual should avoid U.S. estate tax with respect to his or her U.S. real estate.

A significant disadvantage of ownership through an FC is that an FC is not entitled to the benefit of favorable capital gains tax rates on disposition of U.S. real estate (discussed above). Instead such a disposition would be taxed at corporate tax rates (approx. 35%) under the FIRPTA rules (which can become increasingly complex when foreign entities are added to the equation). In addition, unless exempted by treaty, the repatriated income of a FC is subject to a US branch profits tax.

D. Ownership by Foreign Individual through Foreign Corporation and U.S. LLC or Corporation

For reasons discussed below, a foreign individual may choose to own his or her U.S. real estate in a double entity structure.

When investing in an existing or newly created U.S. real estate fund, a foreign individual may be advised that the U.S. real estate will be owned by a U.S. LLC. Without any ability to change the U.S. structure, a foreign individual may want to acquire his or her interest in the U.S. LLC through an FC. Here the foreign individual trades the beneficial capital gains rates to both (i) avoid filing individual tax returns in the U.S. and (ii) eliminate the risk of U.S. estate tax. A foreign individual in this double entity structure will also have double the limited liability protection. Two entities will increase costs, but otherwise, the description above for investment through a foreign corporation should apply to this double entity structure.

Aside from the U.S. tax implications discussed in each of the structures above, the foreign individual should consider the taxes of his or her home country that may be applicable to his or her ownership and sale of U.S. real estate, as well as the effect of treaties. For example, some countries may tax LLCs as corporations under foreign law, which may have significant implications in structures that rely on treaty exemptions from withholding tax.