The Foreign Account Tax Compliance Act (FATCA), signed into law in 2010, requires, in some circumstances, additional withholding obligations on payments made from the United States to non-compliant foreign financial institutions, and this senate bill may close the loop by covering the reverse, i.e. payments into the United States from non-compliant foreign financial institutions.

The final senate vote on the bill is expected to occur on March 13

Generally, FATCA imposes an obligation on banks and other financial institutions to report personal information of any of their accountholders that are United States persons. FATCA’s implementation is scheduled for 2014 and remains the subject of great controversy, however, the agreements between governments referenced above could be implemented much sooner. These inter-government agreements present an imminent threat of exposure for U.S. persons with undisclosed foreign bank accounts.

As previously discussed in our blog from January 12, 2012, earlier this year the IRS announced a third initiative to allow U.S. taxpayers with unreported income relating to undisclosed foreign bank or financial accounts to make a voluntary disclosure to get current with their taxes and information filing obligations. US taxpayers with unreported offshore income (especially in the countries mentioned above) should consult the Royse Law Firm or another tax professional to discuss the new voluntary disclosure initiative in detail.

For more information, contact your tax professional or go to the IRS website at: http://www.irs.gov/instructions/i8937/ar01.html

Like its predecessors, the 2012 OVDI offers a simplified penalty structure compared to that present under applicable law and protection for taxpayers concerned with criminal sanctions. 2012 OVDI participants must also look back eight years and file all original and amended tax returns to include unreported offshore income and make payment for back-taxes, interest, accuracy-related and/or delinquency penalties.  Unlike its predecessors, the 2012 OVDI is not set to expire on a specified date, but the IRS warns that the terms of the program could change or the program could end at any time. In addition, the standard penalty for participants has increased to 27.5% (2011 OVDI was 25%) of the sum of (i) the participant’s highest aggregate balance of foreign financial accounts and (ii) the value of other includable foreign assets.

US taxpayers with unreported offshore income should consult a tax professional to discuss the new program in detail. More information can also be found on the IRS website:http://www.irs.gov/newsroom/article/0,,id=252162,00.html?portlet=108

Generally, Section 108(e)(8) provides that when a partnership transfers a capital or profits interest to a creditor in satisfaction of the partnership’s indebtedness, the partnership will be treated as having satisfied the indebtedness with cash of a value equal to the fair market value of the partnership interest transferred to such creditor. COD income exists if the value of the partnership interest transferred is less than the indebtedness cancelled. COD income realized on such a transfer, if any, is allocated to the partners of the partnership based on their distributive shares immediately before such cancellation. The Guidance clarifies that the value of partnership interest transferred is equal to the liquidation value of such interest so long as – (1) all parties involved in the exchange (i.e. the creditor, debtor, partnership etc) consistently treat the value as being the liquidation value; (2) the partnership uses a consistent valuation methodology in all debt for equity exchange that are part of the same transaction; (3) the debt for equity exchange is made at arm’s length (can be satisfied even if the parties are related); and (4) following the debt for equity exchange, neither the partnership nor any related person purchases the partnership interest as a part of a plan that existed as of the time of the debt for equity exchange in a transaction that’s principal purpose is the avoidance of COD income.

The Guidance also address the application of Internal Revenue Code Section 721 relating to a creditor’s contribution of a recourse or nonrecourse indebtedness to a partnership in exchange for a capital or profits interest.  Generally, the nonrecognition rule of Section 721 applies in a debt for equity exchange and the creditor will not recognize a loss or bad debt deduction in such an exchange. The creditor’s basis in the partnership interest received is increased by the adjusted basis of the indebtedness. Ordinary income items, such as rent, royalties and interest cannot, however, be cancelled in a nonrecognition transaction under Section 721, unless such obligations arose before the beginning of the creditor’s holding period for the indebtedness.

Finally, the Guidance address how to allocate income arising from a partnership’s discharge of indebtedness as a minimum gain chargeback. The Guidance provides that COD income arising in the discharge of a partnership or partner nonrecourse indebtedness is treated as a first-tier item for minimum gain chargeback purposes.

The Guidance and new regulations will contain a few examples to demonstration application of these rules.

The 100% gain exclusion described above is, however, limited to the greater of (i) $10 million or (ii) 10 times such taxpayer’s basis in the QSBS. $10 million is a pretty high cap, but certain LLC’s may be able to do even better.

In the event the QSBS stock is acquired in an exchange (i.e. not for cash), the Section 1202 rules determine a taxpayer’s basis in its QSBS stock to be equal to the fair market value of property transferred. So, while a start-up company may have been created as an LLC, with very little cash being contributed by its investors, if that LLC start-up has increased in value, the investors may consider converting the LLC to a corporation. Assuming that the stock the investors receive in the LLC conversion will be QSBS, the investors will be eligible for the 100% gain exclusion on a later disposition of that QSBS. Assuming that the LLC, at the time of its conversion, had a value at least $1 million, the cap on the gain exclusion will be increased (since the cap is equal to 10 times that value). So, if the LLC had a $5 million value at the time of its conversion, the gain that could be excluded on its sale is capped at $50 million; much higher than $10 million cap that might otherwise apply. In summary, by organizing as an LLC initially and creating value in that LLC prior to corporate conversion, an investor can increase his potential for QSBS gain exclusion.

While the gain exclusion described above benefits QSBS investors in a stock sale exit transaction, the LLC form may still be better in the event of an asset sale exit transaction. Many other differences exist between LLC’s and corporations, so all factors should be thoroughly considered before an LLC is converted to a corporation to take advantage of the QSBS benefits described above.

Generally in an installment sale, a seller recovers a ratable portion of his or her basis as each installment payment is received. For example, assume the seller has a basis of $4,000 and sells for $10,000, payable $5,000 in year 1 and $5,000 in year 2. Under the installment sale rules, the seller would recognize $3,000 of income ($5,000 – $4,000/2) with his or her receipt of each $5,000 payment.

Now assume the same facts for a Section 338(h)(10) transaction. According to IRS Treasury Regulations (see Reg. 1.338(h)(10)-1(e), Example 10), there is a tax difference because the Section 338(h)(10) transaction adds an intermediate step; the deemed liquidation of the target company. The target company is deemed to have sold its assets for $5,000 plus an installment note of $5,000. Here the target still recognizes $3,000 of income on its receipt of the first $5,000 cash, which taxable income flows through to the shareholder, increasing the shareholder’s basis to $7,000 ($4,000 + $3,000). Now comes the unexpected part.  In the deemed liquidation, the target is deemed to distribute the $5,000 cash and the $5,000 installment note to the shareholder, and the shareholder’s basis is allocated between each distributed asset in proportion to their relative values. On the deemed distribution, the shareholder has another $1,500 of income ($5,000 – $7,000/2) and takes the installment note of $5,000 with a $3,500 basis. The shareholder in this example has $4,500 of taxable income in year 1 ($3,000 as a flow-through from the target + $1,500 on the deemed distribution), and will recognize just $1,500 of taxable income in year 2 ($5,000 – $3,500 basis).  As you can see, in comparison to the example in the paragraph above, $1,500 of income is moved from year 2 to year 1.

While it is just a timing difference, accelerating income is not the goal of a noble tax professional. In addition, many states (CA included) do not permit carrybacks of net operating losses, so realizing additional income in the first year creates even more risk that the taxpayer will incur a loss in the second year that cannot be recovered. Because of the potential federal tax adjustments, the tax effect is much worse than just state taxes.

The FTB is actively auditing this transaction and aggressively applying the method found in IRS Treasury Regulations. For unwary or poorly advised taxpayers who have not planned into a 338(h)(10) with installment notes, the result can be both unexpected and devastating. Small changes in the structure of this transaction may avoid the adverse result described above. For example, if there is all installment note and no cash at the moment of close, theoretically,  the acceleration would be avoided. Sellers of S corporations should seek specialized tax advice on this issue.