21 Sep [Transcript] Tax Law Issues for New Economy
Tax Issues for the New Economy.
Good morning, this is Roger Royse, Founder of the Royse Law Firm, a corporate business and tax firm with offices in Menlo Park, San Francisco, and Los Angeles, and today, we are continuing our series on the new gig sharing, peer-to-peer, and innovation economy with a session today on tax issues. We are a tax law firm, so this is an issue that looms large with us in all of the structure that we do, so we’re going to take a full hour to go over the tax issues. But you’ll see even though we have an hour; we’re really just hitting the high points.
I want to remind people that this is part of a series on the gig economy. Our last program in the series will be on October 19, where we’re going to discuss employment law issues in the new economy. Also, as part of our webinar series on October 11, Jonathan Baer will be here to discuss his new book, “Decoding Silicon Valley.” I hope you can join us for that. And then on November 21st, we have a program on disaster response, and what you should do in the event of a natural disaster.
If you’re tweeting today, use #royseuniversity, Royse with an “S,” Royse University. You can tweet us @royseuniversity on Twitter. The program is being recorded. It will be posted on Royse University webinar site, royseuniversity.com. You’ll also find it on the Royse Law Firm YouTube channel. The audio will be available for download as a podcast in the iTunes store, and you’ll find the slides on SlideShare. And if you’d like a copy of the slides, just email me, and I’ll provide those to you.
So I am going to start with a few issues, and then follow up with two of the tax associates in our firm. You all know me. I am the founder of the firm. I work with a variety of businesses. I’ve been doing this for 30 years in multiple markets throughout the world. And these days, what we do is primarily technology startups and the investment funds that invest in them, both domestic and international.
Mark Mullin is a tax attorney here at Royse Law Firm. He structures complex multi-jurisdictional tax-efficient transactions. He’s done work with transfer pricing, tax-exempts, golden parachute payments, M and A transactions, and international. He also works with intellectual property, including the taxation patent transactions.
Fiona Xu is a tax attorney here. She works with corporate transactions, M and A transactions, reorganizations, a variety of tax and individual tax matters. She is not only a member of the California Bar, but she also has passed the National Judicial Examination for the People’s Republic of China.
So I will start, and we’re going to cover a handful of topics today, and the first one that I want to start that I would like … The slides are different. I’m going to start with some structuring issues because as tax lawyers, the very first thing we like to think about is the structure, and I want to break this down into domestic versus international.
So one of the interesting things that have come out of this new economy is we’ve seen the rise of a new kind of business, a platform. We’ve all heard that, right? The largest hotel business, Airbnb doesn’t own any property. The largest tax business, Uber, and Lyft, they don’t own any cars, and there are a million examples like that. These are companies that are just purely platforms, and that creates some really interesting tax dynamics right at the start. We have to, first of all, define what the relationship is. What are the parties doing? Airbnb, for example, they’re not a hotel operator. They simply have the platform, right? Uber simply has a platform, and that’s significant because it has a lot to do with who is earning the income, and what kind of income it is.
So for example, I can think of three ways we could characterize. Here is a typical transaction. Customer contracts with the platform. Platform contracts with the service provider, maybe it’s a maid for example, or a chef, or something like that. The service provider provides the service to the customer.
There are three different ways we could look at that as a tax matter. Number one, the platform is recognizing all of the income and then making a deductible expense payment to the service provider. Secondly, the platform is merely a collection agent, who is collecting income from the customer on behalf of the service provider and keeping a piece of it. The third, it’s simply a commission agent, and it’s just collecting a commission on the transaction between the customer and service provider.
The way we characterize it is significant for lots of reasons because it will determine how much gross income is recognized by the platform. It also is significant for reporting purposes that we’re going to talk about later. I’m going to add one more component to this slide to make it even more complex because one of the things we’ve seen come up in recent years is social impact companies adding a charitable or social good component to the transaction, where a little piece of the income here ends up in the hands of a charity, and that can add an additional level of complexity. It’s exponential. Just imagine that the platform collects money from the customer, pays the service provider, but also pays a piece of it to a charity or sets it aside for a charitable purpose. Well, who gets the charitable deduction, and the way we characterize this transaction is going to have a significant role in making that determination. Does the customer get it? Does the platform get it? Does the service provider get it? So these are issues that we work into the documents, as lawyers, we draft the documents and set up these relationships and also ensure that they have the appropriate or the desired tax consequences.
This gets more complex in the international context. For the last 20 years, we’ve been talking about the idea of mobile income and how we could move that around the world and put that in different places, now more so than ever because these platforms, they can be sitting anywhere. Those servers could be anywhere. And in fact, the markets are everywhere. These days, the smallest startup company will be going international almost immediately.
So here is a very typical structure, the US parent company, we divide it into its domestic and its foreign components, and I think it’s now pretty much established that cost-sharing is the way to divide up IP. In the early days, we did transfers and license backs and things like that. These days, we’re almost always doing cost-sharing. What cost-sharing is, it’s where we take some IP, and we say, look, you, US IP Company, you own all the US rights to this IP that we’re about to develop and so of which has developed, and you, Foreign IP Holding Company, you own all the non-US rights, so maybe all non-North American rights, and we will just split the cost of developing the IP, split the deductions, but also split the income from it. That way, we don’t need a transfer and license back and have to worry about royalty withholding issues. We don’t have to worry about transfer pricing issues, is the license fee correct? We’re just sharing the cost and sharing the income, and we’re sharing the cost based on the relative benefit of the IP.
Now, I would add one more thing to this structure to make it look a little more typical. Imagine if you will that there’s another orange company on the floor inside of … We’ll call it foreign holding company above the two foreign companies because we want to do what we call to check the box planning because if we check the box, we treat the foreign companies, the foreign operating company as a pass-through and the foreign IP holding company as a pass-through. And that way, when foreign IP holding company, which holds the IP, licenses to the foreign operating company, which it’s going to have to do so the operating company can run the operating business, it gets a license fee back. We check the box. We can ignore that transaction and treat those two companies as effectively the same, and why would we want to do that? It’s so we don’t have any of this bad passive income in the foreign company. Instead, we just have one foreign company for US tax purposes that have active income. And I say bad passive income because it’s bad because it will be taxed back to the US parent, even though it sits over in a foreign country. Active income, on the other hand, is probably set up … Will not be taxed back to the US parent until it’s actually repatriated, so we get a deferral.
This is the game we all play, and we’ve been doing it since the ’60s, and it is still a viable strategy. The check the box planning is relatively more recent but very important in this to keep the foreign income offshore. I will tell you that if you’ve been reading the papers, you see that this structure is under attack by almost every politician that’s ever run for office. Donald Trump’s tax plan would end deferral altogether, so it doesn’t matter how we characterize it or who earns it. If a US company owns the foreign company, the US company pays tax on it. The Clinton Tax Plan will take a little bit different approach and presumably follow up on the Obama tax proposals, would tax a portion of the IP-related income back to the United States, and the proposals in Congress right now would go a completely different approach and adopt a completely territorial approach. That’s way beyond the scope of what we’re going to talk about here. We’ll probably do another webinar on that topic down the road. But for now, just understand that a little bit of international tax structuring is appropriate and typical in the new economy.
Moving on. Probably the biggest issue that we have with new businesses is this worker classification issue, and we’ve always had a problem. There’s always been a tax issue as to how to classify a worker. Are they an employee? Are they an independent contractor? That’s always been an issue, but it is really an issue now, and we have an entire hour devoted to this issue, employment law issues, coming up on October 19. But for now, I’m going to focus just on the federal tax issue.
So employee versus independent contractor, why do we care? So, employees, they all pay tax. They all pay income tax. The biggest difference, of course, is who has to collect it. So for example, although the employee doesn’t pay self-employment tax, they will have FICA/FUTA tax that has to be collected by the employer, and I can tell you that this is an issue that can wipe out a company pretty easily. Taxes, penalties, and interest and underwithholding can be massive, and I will tell you why. The way it comes up is that if somebody is properly classified as an employee or improperly classified as an independent contractor, who should be an employee, that means that the employer hasn’t collected the taxes that they should have. And if the employee didn’t pay those taxes that should have been withheld, the IRS can go directly against the employer. The employer has what we call primary liability on this.
In fact, savvy employees will sometimes go to the tax authorities first in order to force that issue and to get the IRS to go after the employer because how many employers are going to sue the employee for the taxes they should’ve withheld? Good luck with that case. So this is a big, big problem for an employer. And once penalties start adding up, the underpayment and non-filing penalties start to accrue. Like I say, I have seen companies get wiped out by this issue. We’re going to talk more about that on October 19. I’ll give you some real-life examples of how bad this can be, so it’s really important to get this right.
How do we get it right? So, unfortunately, this is very highly factual. It’s very subjective, and frankly to be cynical about it, it’s somewhat result-oriented depending on who is making the determination, but the basic definition is that an employee is subject to the direction and control of the employer. So the question is what does it take to be subject to somebody’s direction and control? Does the employee have the right to direct and control the result of the work, or is it what work will be done and how it will be done? So for example, by hiring you to give me a deliverable and I don’t really care how you get to it, I just want the deliverable, or are you punching a clock, come to my office, sitting there from 8:00 to 5:00 and I’m leaning over your shoulder and telling you how to code?
We have several factors. There is the control that I just mentioned, the behavioral control, whose facilities, supervision, training, the financial control, the right to direct and control the business. Generally, we say that if what you’re doing for the company is its core business, you are more likely an employee. So for example, if I hire a plumber, if I’m in the plumbing business and that plumber is doing plumbing services for my customers, that plumber is more likely my employee than if I’m a law firm that just happens to need a plumber, that sort of analysis. And if it is a relationship, permanent, temporary, this is really important. Does the employee contractor have other clients or customers, or people that they work for? These are really the bigger factors that you see in this sort of analysis.
Now, this is really interesting. We have a way now because this is such a difficult question usually that you can actually go to the IRS, file a form SS-8 and ask for a determination from the service if we’re still not sure. This is relatively new. And the IRS, what they will do is they will take that SS-8, and if you’re the employer, they’ll go back to the employee, of course, and get their view of this to make sure that the information is consistent. But based on this SS-8, you may be able to get the service to actually give you that determination.
They’re going to want to know how the worker attained the job. They’re going to want a description of the work. They’re going to want your explanation as to why you think he’s an employee or a contractor. They’re going to want you to attach any agreements that you have. So the written documents are important. They’re not determinative, but they’re important here, and they’ll ask you specific questions about all three of these categories. Behavioral, work assignments, training, instruction, the routine. The financial control, who are taking the risk of loss here? Who’s providing supplies and materials, leased equipment, reimbursing expenses, and also questions relating to the relationship between the worker and the firm, such as the benefits, are there penalties for termination? Is there a non-compete? Is he in a union? Things like that. So either the worker or the employer can file this SS-8 and get a determination from the IRS, and when the IRS gets the request, they’ll start their research, and they may ask for additional information or not. But at the end of the process, which could take a long time, it could take up to six months, you’ll either get a determination letter from the service, and you’re home free, or you just get an informational letter because it’s way too factual, which is advisory. It’s nonbinding on the IRS, but it can give you some comfort as to the result. Interesting process.
Okay, one last thing before I move on here, the R&D credit. If you’re in the Silicon Valley, you know how important the R&D credit is to everybody. Just in the recent “Tax Extenders” Bill, we got some relief because it used to be that the R&D credit was of very little use to our investors here because of AMT, alternative minimum tax, and it now can be used to offset both the regular tax and the AMT, the alternative minimum tax. It’s not quite good enough that we’re going to see R&D partnerships come back into vogue any time soon, but we’re working on that.
The part that’s really interesting is this payroll tax credit. Senator Pat Roberts from Kansas has been pushing this for a long time. He was here in our office a couple years ago. He stopped and visited with us and talked to us about this particular proposal, which Kansas actually, you might not know this, has a lot of biotech, medical companies, and this is something that was really important to medical startups because they don’t have income for a long time but they have lots of payrolls. So now, a qualified business can claim a certain amount of its research credit as a payroll tax credit. My clients are startup companies. They don’t have any income. They don’t pay any tax. They don’t care about credits before they do payroll, and they do have payroll taxes. So really interesting developing for startup companies, and of course, the IRS has not yet issued guidance on this proposal but has been asked to do so.
Congressman Boustany from Louisiana and Congressman Neal, one is a Republican, one is a Democrat, they got together and came up with an “Innovation Box” proposal. I had an opportunity to talk with Congressman Boustany a couple months ago about this proposal, and he tells me he believes it could work along with the R&D credit in conjunction. An “Innovation Box” is completely different than the R&D. The R&D credit basically provides a tax benefit for the costs incurred in innovation, in R&D. The “Innovation Box” goes at it from the other end and says, look, we’re just going to tax a lower rate the income from the innovation, so both of these are designed to encourage innovation. They get at it a little bit differently. The pro of that, of course, is that we have a real benefit here for true innovation. The devil is in the details. This could be really complicated. Other countries all over the world have implemented patent boxes or innovation boxes. It’s on the agenda for the US. It could happen here.
Now with that, I’m going to turn the clicker over to Fiona Xu, who is going to talk a little bit about deduction and loss issues that occur in the innovation economy. Go ahead, Fiona.
Okay. Thank you, Roger. This is Fiona. I am going to talk about deductions and losses in your sharing economy. So there is the relevant code section. The general is under Section 162 that you can take the deduction if you have ordinary and necessary expenses incurred in connection with a trade or business. On the other hand, living and family expenses are generally not deductible under Section 262, and when a deduction is allowed, there are several limitations may be applicable.
The first one is Section 183, which applies when you’re engaging a hobby, not a business, for tax purpose. And Section 280A disallows certain expenses in connection with the business use of the home. In Section 469 and 465 puts further limitations on deductions of losses in a passive activity.
So for people who are engaged in the sharing business, the first question to ask is, do you have a business? Because many times a business is started as a hobby, and it’s often hard to tell when the hobby converts into a real business, but for tax purpose, the distinction is critical because as we just said, losses incurred from a business is fully deductible and is deductible against other income. Well, if it is just as a hobby, it can never generate a loss for you, so the expenses incurred are only deductible to the extent of income generated from the hobby. And another difference is business expenses are above the law deduction, where deductions in connection with a hobby need to be itemized and subject to the general limitation itemized deduction, which is 2% of your adjusted gross income in your given tax per year.
So how to decide whether you have a hobby or a business? The question is a subjective one. Does the taxpayer engage in the activity for profit? The regulations under Section 183 provide nine factors, which includes things like whether you carry on the activity in a business-like manner, and how much time and effort you have put into the activity and whether you have other income already. But the decision is made a case by case, and the question eventually relies on the taxpayer’s own intentions. So you can imagine that in practice, there can be a lot of issues for the tax to apply. As a reaction, the regulation under Section 183 made an assumption that if a taxpayer makes a profit from any activity during at least three years of the last five years, you are deemed to have a business.
So specifically about the home rental deduction, in the 1970s, there were outgrowth litigations under Section 183 in connection with vacation homes. So as a reaction, the Congress in 1976, enacted Section 280A to specifically disallow certain expenses in connection with the business use of one’s home. This slide is a roadmap to get you through how Section 280A and Section 469 applies in your home rental business.
There are two situations that may trigger 280A. One is by using part of your home as a home office. The other is by renting or sharing your home with others. Since our topic today is the new economy, I will focus on the second, the home rental activities. But I want to note here that taking a home office deduction is widely perceived as a red flag for the IRS audit and the rule put a heavy burden on taxpayers to establish that expenses are really deductible.
So, people who rent out your home online like Airbnb, all rental income must be reported unless an exemption applies. If you rent out your residence for less than 15 days, it is a totally nontaxable event. So you do not have to report income no matter how big the amount is, and you don’t take deductions for expenses related to the rental. If you do report income and you want to claim deductions, you should be aware of Section 280A, the gross income limitation.
Under the rule, the gross income limitation was triggered by the personal use of a dwelling unit as a residence. I don’t have time to focus on the definitions, but I want to point out the three keywords here, the dwelling unit, personal use, and as a residence have specific meanings for tax purpose, and it is broader than the ordinary English meaning. For example, personal use not only includes the time used by you and your family member, but it also includes use by others under home swap arrangement. And also, if you’re charged for less than the fee of rental, the rental period may count it as personal use. So if that’s a concern, a taxpayer should pay close attention to the definitions and do not just assume it does not apply to you.
What exactly is the gross income limitation? In general, like a hobby, expenses deductions cannot be used to create a net loss of a home rental activity. The way Section 280A applies is it groups the qualified deduction into four tiers, and you must take the deduction in the order prescribed.
So what you do is you allocate expenses pro rata between business use and personal use of your home. Only the expenses related to business use is qualified deductions, and then you group the qualified deductions into the four tiers. Firstly, apply tier one deductions against your income and then tier two, tier three, and tier four in sequence until the deduction reduces your income from the home rental activity to zero. Any disallowed deduction can be carried over to the next succeeding tax year if assume that you continue to allocate and substantiate actual expenses next year.
So the slide gives some examples for each tier’s deductions. As one can tell, this rule is complicated, and it poses a heavy burden on an individual taxpayer to group his expenses and apply the deductions tier by tier. So under Revenue Procedure 2013-13, the IRS provides a safe harbor election for individual taxpayers. The taxpayer can make the election each year, and under the safe harbor rule, you just multiply the allowable square footage by the prescribed rate. The allowable square footage is the portion of the home used for business purpose but cannot exceed 300 square feet, and currently, the rate is $5 US Dollars per square foot and is subject to update from time to time.
If a taxpayer makes the safe harbor election, the gross income limitation applies in a slightly different way. It is beyond the scope of the presentation, but just remember that the safe harbor amount is still subject to the limitation of income from the rental income and any disallowed deduction under the safe harbor is lost forever. It cannot be carried over to the next tax year. So if you have carried over deductions from last year and you make the safe harbor election for the current year, the carried over amount is lost. You cannot apply it to your safe harbor amount this year.
Okay, that’s enough for Section 280A. I just want to note that Section 469 may also apply to a home rental activity because rentals generally are considered as a passive activity, and if Section 469 applies, losses incurred by a passive activity is only deductible to the extent of passive income.
The law makes it clear that in Section 280A, the gross income limitation applies. Section 469 does not apply. But say if you do not have personal use of the home or the personal use does meet the residence test, then Section 280A limitation does not apply but you may still subject to the Section 269 passive limitation.
There is a $25,000 special allowance if a taxpayer actively participated in a rental-related business, and the modified adjusted gross income for the tax per year is less than $100,000. To qualify for the active participant, there is no specific home our requirement. But if the average period of the customer is seven days or less or is 30 days or less and you provide significant personal services, the special allowance does not apply to you, and the idea is that the special allowance is only for a rental business. And if the rental is below certain period and you provide significant services, the rental is only incidental to the personal service, so you’re not really conducting a rental activity. An obvious example of extraordinary personal service is the use of a hospital boarding facilities. The use of the house is incidental to the services provided by the doctors and nurses. The regulations under 469 also provide other rules and examples for the special allowance.
Last but not least, recordkeeping is credential in claiming deductions. Under Section 274(d), no deduction is allowed unless the taxpayer substantiates by adequate records or by sufficient evidence. It is not a focus of our webinar today, so I won’t go through the details, but it is important to note that the IRS and the tax court make a big deal of contemporaneous records. There was a case that the taxpayer wrote down notes each day for the expenses, but they lost the receipts, so the IRS disallowed the deduction. They went to court, and the tax court ruled for the taxpayer, relied on the contemporaneous records, even though there was no other evidence.
So of course, the result of each case was based on the specific facts and situations, but the takeaway here is the best practice is to keep contemporaneous records and keep other relevant approved documents, like receipts. Also, use apps to helps you. Be reasonable to claim a deduction, and be ready to tell a story.
In the time left, I want to talk about the choice of entity. For most of the small business owners, the recommended business entity is the S corporation or a limited liability company. The main reason is that compared to C corporation, S corporation and limited liability companies don’t have company-level tax and the incorporation and administration is relatively simple. It gives the owner more flexibilities in managing the company. Also, it’s not very difficult to incorporate an S corporation, or an LLC if you structure it and plan in advance.
For the purpose of this presentation, I want to highlight two points for choice of entity. One is qualified small business stock, and the other is self-employment tax. Section 1202 of the Jobs Act provides beneficial tax treatment to stocks issued by a qualified small business. Potentially, you can exclude 100% federal tax on the first 10 million capital gain on the qualified small business stock. To qualify, the stock must be issued by a domestic C corporation, and the company may not have more than 50 million in assets as of the date that the stock was issued and immediately after, which means that including the value of the stock issued. The stock must be acquired at its original issue. You must hold the stock for more than five years before distribution, and the company must also meet the active business test.
I should also note that the 100% exclusion of federal tax is only available for stocks after September 27, 2010. For qualified stocks purchased before the date, you may qualify for 50% or 75% exclusion. And because the tax benefits of qualified small business stock are only available to C corporations, some people suggest that C corporations should be a better choice for small business owners and startup companies. At Royse Law Firm, we think it depends on the facts and circumstances of each company. There are pros and cons for each form, but in most cases, we think S corporation would still be a better choice for small business.
The reason for saying that is, first of all, the beneficial tax treatments and the qualified small business stock is subject to a cap. It is 10 million or 10 times on the stockholder’s basis, and also you can only enjoy the tax benefit in a qualified stock sale. While if you have an S corporation, you can choose between a stock sale or asset sale. That itself gives more flexibility to the equity holder, and the buyer is usually willing to pay more in an asset sale because they can get the benefit of stepped-up basis and more depreciation in the assets. And as we just mentioned, in general, S corporation only has one level of taxes in operation, while C corporations usually have two levels of taxes.
Another reason we think S corporation could be a better choice is that by using the S corporation, individual owners will also provide services to the corporation can manage to get around the self-employment tax, at least on the part of the income. As Roger mentioned in the worker’s classification, if you are self-employed, compensation income is subject to a payroll tax substantially similar to the social security and Medicare tax that applies to employees. But remember, you only pay self-employment tax on earned income.
So if you organize your business as the S corporation, you can classify some of your income as wage and some as a distribution. Only the wage portion of your income is subject to the self-employment tax, and you will pay ordinary income tax on the distribution portion. Depending on how you divide your income, it is possible that you could save a substantial amount on self-employment taxes. But of course, the allocation of income must be reasonable. Generally, you cannot pay a minimum wage to yourself, and at the same time have large distribution as the shareholder, and a similar scheme may be taken against the limited partners in a partnership as well.
I won’t go through the details because the situation for a limited partner is less straightforward than the S corporation shareholder. The net investment income tax generally applies to a limited partner because their share of the distributed income is usually considered to be from a passive activity, and the net investment income tax is imposed to equalize the 3.8% Medicare taxes on compensation income and unearned income. But potentially, you can see both the self-employment tax and the net investment income tax, and the opportunity lies on the disparity between the definition of a limited partner for self-employment tax purpose, and the definition of a passive activity for net investment income tax purpose. I will say this is a gray area. Not everyone agrees with the interpretation, and the New York State Bar Association submitted a letter to the IRS back in 2012, requesting guidance on the net investment income tax.
This chart summarized my presentation, and I will pass the speaker to Mark.
Thanks, Fiona. So this is Mark Mullin, I’ll be finishing out the presentation with three topics. First, we go over the reporting requirements in the new economy, and then discussing the special tax issues of cannabusiness recent changes in law and then I will be quickly going through state and local tax issues with the time I have left.
So to begin, when I’m talking about reporting issues for the new economy, it’s not immediately an exciting topic for most people. This is an expansion of the 1099 concept with which most of you are familiar. The old news, which you might be all probably familiar with is the 1099-MISC. Basically, if you’re paying someone for services, occasionally royalties or goods, you will often need to issue them a 1099-MISC. There are actually three different provisions that are relevant to the new economy that would require you to file the Form 1099-MISC. They’re not hugely different. There is a priority rule. For instance, 6050N beats out 6041 if both of them seem to apply. But really, at the end of the day, when you’re still filing the Form 1099-MISC, no matter which section you follow, and so it’s not going to be very … As long as you’re filing it, it doesn’t matter which statute got you to do it, but it does matter that you file it. If you do not file your Form 1099-MISCs that you’re required to, you will be penalized. It’s not a lot perform, but it adds up. You can have over $1 million in penalties and fees if you completely blow your 1099-MISCs to a bunch of different potential recipients.
So I have in this chart a three-person situation, where a 1099-MISC would need to be issued. I also mention a W-2, but we’re going to disregard that for this presentation.
Typically, a 1099-MISC is more of a two-person transaction in most situations. Person A receives something of value from Person B, and issues that person a 1099-MISC. In what seems to be a three-person transaction, there may be a 1099-MISC involved. Here we have something that’s like a platform economy, a platform market.
A customer has a contract with the company to get some sort of service. The company contracts out to a provider to provide that service or whatever value to the customer. Here the company pays the money to the company and the money to the provider. This would be a 1099-MISC. Really, the provider is providing the services to the company and to help the company fulfill its contract.
1099-MISCs get actually pretty complex when there’s a lot of intermediaries involved, there can be multiple, and not quite duplicative requirements, but we’ll leave that out for this.
Now, here is the newer news. Instead of the 1099-MISC, there is the 1099-K. Congress passed this specifically to deal with advances in eCommerce and platform markets. When this applies, you are not supposed to file a Form 1099-MISC. You are to file a Form 1099-K instead, and vice versa. Again, this is important because if you’re filing the wrong form, that’s going to get you into a penalty position, so you better know when you should do which.
So when do you have to file a Form 1099-K? Well, if there are payment and settlement of a reportable transaction and that payment is made by a payment settlement entity, then that payment settlement entity owes the special reporting via the 1099-K. So each of those terms, of course, this being tax law, needs to be unpacked and has semi-complicated meaning. Payment settlements of a reportable transaction, that part is not so complicated. Basically, that’s the payment settlement deputy saying, hey, we should transfer funds to that guy to settle the transaction.
The reportable payment transaction, there are two kinds. There are payment card transactions, like credit cards. Those are not really our concern in this presentation, but interestingly, they’re under the same reporting regime with some tweaks. What we’re concerned about is the third-party network transaction, which I’m going to go into on the next page, and it’s very relevant to platform markets.
The payment settlement entity involved with a third-party network is called a third-party settlement organization. Now, an interesting somewhat very generous aspect of this statute is that third-party settlement organizations don’t need to do a 1099-K for a payee unless that payee gets over $20,000 in gross over more than 200 transactions. Different companies, different platform companies will often just file it anyway just to give everyone the same treatment rather than determining which ones are under the exception. In more complicated structures, there may be intermediaries that take over the 1099-K reporting responsibility, or in some cases, will actually have to file a duplicate 1099-K if there’s an aggregate payee situation. Or not by duplicate, but related.
So as I promised in the last slide, I would tell you what a third-party network is, and I am a man of my word, so I will do that now. This is a third-party network and one way of looking at it. The basic requirements of the third-party payment network are as follows. There must be a third-party settlement organization, a central organization, which has accounts with providers who are unrelated to the TPSO who provide goods or services, and to agree to settle transaction for pursuant to the terms of the arrangement with the TPSO.
The next requirement is that there must be a standard or mechanism for settling the transactions to the provider. There must be a guarantee that the providers will be paid for good or services, and this cannot be the mere issuance of payment cards. It’s clear that this does apply to many platform markets, and you can include these terms that make it a third-party network in terms of using themselves. The IRS has ruled consistently with that in a nonbinding, non-presidential ruling. Another thing to note is that there really isn’t a focus on the relationship to the customer of the central organization in the definition of a third-party network, and there is no focus on what else the third-party settlement organization is doing in addition to the third-party network transaction.
Now, one of the things I’ve put up here is that there is a direct contract between the customer and provider, and that’s not formally a part of the definition of a third-party network model. So why is it up there? Well, the IRS has looked to this a lot in its private rulings on this issue to determine whether there is a third-party network. For instance, in a situation where a central organization contracts with a customer and provider, the customer’s contract said, hey, they’re going to pay us for this stuff, and we’re going to pass them onto the provider who provides you this stuff. The IRS said because that is not a direct contract between the customer and provider, this is not really a third-party network, so this is not going to be subject to 1099-K reporting.
So what is a direct contract? Well, it does seem to be important that providers set their own prices. The IRS cited that very favorably as showing that there is a direct contractual relationship. But otherwise, we’ve seen the facts in the cases, but we don’t exactly know what it takes.
Now, to step back and pontificate for a brief moment, I think that this is actually one of the better legal analyses of what a platform market is. A lot of areas, we’re stuck with issues. We’re trying to apply outdated legal analysis to what’s essentially a pretty new idea, and you get to see that what a third-party or a platform market really is, is a place for trading contracts in a sense, sort of similar to a derivatives market. Like in a derivatives market, these contracts are standardized, so they’re fungible. That one was transaction cost, so if someone wants a specific derivative, they just buy a pre-made contract from another person. That’s more or less what’s going on here. The platform market limits the kind of contracts that can be done over the platform. The only thing is that service contracts can’t really be made fully fungible, they just can’t. Your driver might not be that near you, so Uber can’t just give you a contract with a guy in New York. It means to give you a little more than that. And so what it does is it uses technology to settle the rest of those transaction costs that can’t be settled by making the contracts fungible.
So it is very key to look at the contracting that’s going on here as that’s what really differentiates and defines to my mind, a platform market. Businesses, of course, and firms in an employment relationship are also trying to minimize transaction costs, but they’re doing it through making a hierarchy, through making cooperating, and this is a very different process. There is no real breakthrough in what I’m saying. I think that this is a good start for those of us who are concerned that the law is falling way behind the market. This is sort of a good start. A little bit is encouraging to see the law doing something that seems a little bit innovative and accurate to the actual market.
So from here, I’m going to move onto cannabusiness taxation under Section 280E. This is an interesting provision. These guys have a unique struggle thanks to Section 280E. So back in the ’80s, Congress added Section 280E to the code because they didn’t really like drug traffickers taking business deductions. This actually is a case, Edmondson, where a drug dealer got in trouble and was like, well, at least I shouldn’t pay so much in taxes because I was putting money into this business. I’m a good business owner, and the tax clerk was like, yeah, that’s technically tax law, you get all those deductions.
So 280E comes along and says for a trade or business that consists of trafficking in controlled substances, illegal under federal or state law, they can’t get deductions or credits. So this, of course, immediately brings a planning opportunity to mind. Maybe we can split off parts of the business as a non-trafficking business. I’ll let you a little bit more about how that turns out later.
Now, the most important limitation to Section 280E is not in the text that I just had in the previous slide. It’s in the Constitution. Congress is limited by the 16th Amendment. According to the 16th Amendment, it gives them the power to tax income without direct apportionment, so that’s all it gives them. They can’t tax a broader tax base than income.
So to preclude the Constitutional challenge according to the legislative history and according to case law which has agreed with the legislative history, 280E does not block reductions in gross income from the cost of goods sold. That is when you make an inventory, when you’re producing it, some of the cost you spend on that inventory is capitalized into that inventory, and you get a return of capital when you finally sell that inventory. This is the bare minimum. This is the biggest tax base that Congress has under the 16th Amendment. Net income that involves deductions and credits, those are legislative grace. Congress doesn’t have to give those to you.
So the way that cannabusinesses have handled this is that they’ve tried to maximize their cost of goods sold. They’re the only industry ever that’s wanted to capitalized costs, so good for them. Then, the way that they’ve done this is taking relatively aggressive positions of capitalization, every cost is capitalizable or that’s what they’d want. And then, they can even have some transfer pricing planning between related parties to sort of get the highest arm’s length price applicable for certain costs that are capitalize-able.
So how have these different planning opportunities gone? The business splitting has only had really two cases on it, and it’s worked once, and it’s failed miserably in another. A business is an activity entered into with the dominant hope of and intent on achieving a profit. But then, the issue here is what are separate businesses? If you’re doing two businesses, what makes them not really just one interrelated business?
The view that CHAMP took is that it’s a question of fact that depends on the degree of economic interrelationship between the two undertakings. So in CHAMP, the taxpayer had a cannabis dispensary and also had a caregiving facility with its own fees. The court agreed that these were truly separate businesses. They had separate books and records, which they found important, and the cannabis dispensary went away, the caregiving facility would stand on its own.
Now, Olive v. Commissioner did not have this. There, the taxpayer had a dispensary, and it had a lounge next door which didn’t sell anything, didn’t make any money, and it was just a place to hang out effectively and use their products. The court understandably said that this really wasn’t a separate business. It’s entirely dependent on the first one, and so in a lot of ways, the two are not very helpful. It would’ve been really hard to understand why the lounge existed other than to induce people to buy cannabis and buy more and hang out. So who knows how far this planning will go?
As for capitalization, cannabis businesses, what they would do even when they didn’t have to is they would apply Section 263A to increase the cost of goods sold. This provision came out in the ’80s to standardize the cost of goods sold, and largely to make it, so taxpayers had to capitalize more costs. And the legislative history, Congress also seemed to suggest that 263A made capitalization more accurate.
So the IRS released chief counsel advice, this is nonbinding advice that more or less gives a legal opinion of theirs on a specific tax matter. Their opinion is that cannabis businesses cannot use 263A whatsoever. According to them, 263A only added the use of cost of goods sold as a timing measure. Congress did not intend to change the Constitutional definition of cost of goods sold or gross income under Section 263A. So they tax the rather unusual conclusion that only the capitalization methods in place at the time of Section 280 was passed are okay to use for cannabis businesses, which is unusual. I don’t know anywhere else in the tax law where you have to literally go find an old set of regulations and old set of the code and apply it unless you’re applying the law to a tax thing that occurred in the past.
This is a widely critiqued CCA, it’ll be interesting to see how far this goes. There is sort of circularity. 280E needs to know the cost of goods sold to tell you what can’t be deducted. 263A(a)(2) basically says costs that aren’t deductible don’t become deductible because they’re capitalized under 263A. So it seems to imply you need to know what’s not deductible before you can apply 263A, which is circular, and a lot of people’s arguments essential come down to Congress can’t say what income is whatever it wants. There has to be some external limit, and cannabis businesses say that limit happens to give them a lot of capitalization.
Now, I think that a lot of these arguments are sort of missing out on an even better planning opportunity, which is diagrammed on this slide. Section 280E only prevents deductions and credits, but it doesn’t limit your allocation of income from a partnership. So the easiest way to explain what I’m talking about here is just to go through these two transactions.
Say in transaction one; there is a cannabis business A. It takes in $100 of gross income. It then spends $50 on expenses to B. I guess B was providing services, and these are deductions that are not going to be capitalized. So what happens in transaction number one to A? Well, without 280E, transaction number one would be A would have $50 of taxable income, that’s 100 minutes 50. With 280E, A has $100 of taxable income because it does not get the deduction, so it’s 100 minutes nothing. So that’s obviously, that really demonstrates just how bad 280E’s effect can be that you can have double your income, your actual net income thanks to the application of the section.
Transaction number two shows what I think is a good way to plan around it. There, $100 of gross income comes into a tax partnership. The tax partnership itself is the cannabis business, and it splits up the income 50/50 to A and B. So without 280E, A gets $50, and with 280E, A still gets $50, except 280E can’t make it add back in the money that went through B. There’s just no statutory authority for that. So mostly, if that becomes a planning opportunity, I’m hoping to set up some of those. We’ll see if state law becomes more accommodating although maybe it works now.
The last thing. I’m going to do a real quick run-through on state and local taxation since we’re essentially out of time, so here we go. The first thing I want to point out is that California has an entity-level tax on LLCs and S corporations. The S corporation tax is technically larger in terms of tax rate but its own net income. So if you’re not producing a lot of net income because you have a lot of expenses, the S corporation tax may still be more affordable than the LLC tax because the LLC tax will apply on gross receipts. So that’s just the total amount of money in, period, without looking to any cost, whatsoever. This sort of ignores also the state filing fees and combined reporting, and other complications, but this is a good start.
The California property tax. This is something that you’re going to have to be concerned with if you’re buying stuff to participate in the new economy. This is not particularly special to the new economy. Really, the major planning opportunity in any of these situations is not to accidentally trigger revaluation. The way real property works in California is that the tax base is 2% of the original cost of your real property per year, or it’s not 2%, excuse me. There’s a 2% increase per year at most, so the tax base is limited, but it will be revalued. The original cost will be updated if there’s a transfer considered to happen or a construction.
The next thing I’d like to point out right quick is for multi-state planning. A state will only have jurisdiction to tax you under the Constitution if you have nexus. Now, nexus, it seems to mean different things to income tax and sales tax. Sales tax seems to require you to have a physical presence, but the states are challenging this, and income tax seems to trigger if you just have enough of an economic connection. It’s more complicated than that, but that should be a generally good understanding of your exposures. It is interesting that having your server in a state may be enough to have a physical presence there. States are taking different positions on that.
The last thing I’ll close with on sales and use tax is that sales and use tax doesn’t tax everything. Traditionally, it’s only taxed the sale of goods, not services, and we have a lot of stuff in the new economy that falls into a weird gray area. What is cloud computing? Is it really a service? Is it a license? Are we kind of transferring software? Information services, some state will even tax differently. So figuring out what cloud computing is and then characterizing your contract in a way to give you the best sales tax result is something that you should consider if you’re in a cloud computing business. It’s also interesting because you’ll see that it has some distorted effects. Uber is a service, and Zipcar is leasing of goods. In principle, there is something very similar to them, but they’re going to be treated totally different on their sales and use tax.
The last thing to keep in mind is if you have an innovative product, say you sell a product that collects data, and part of the sales price also goes towards the fact that it sends data to the cloud, which you analyze and you send back to the customer, what have you sold to the customer? Have you sold the services and the cloud? Have you sold the product? Really, you sold both, but how does the sales and use tax handle that, and different states disagree. Some will say you have to determine essentially the dominant aspect transaction, and some will do this differently. Other states say you’ve got to allocate purchase price, or we’re going to just tax it as much as possible, which that’s a state kind of thing to do.
And that’s it for the presentation on my end. Thank you very much for your time.
Okay, thank you, Mark. Thank you, Fiona. That’s a lot. We hit the high points of a tremendous number of topics, all of these new issues that are coming up, and maybe old issues applied to a new economy.
Again, if you’re tweeting, use #royseuniversity. You can tweet to us @royseuniversity. You’ll find this webinar recorded on Royse University website under webinars, also on the Royse Law YouTube channel, and available to download as a podcast in the iTunes store, and the slides will be available on SlideShare.
And with that, again, I’d like to thank you, Mark and Fiona. I’d like to thank you, folks, for tuning in today, and we will now conclude the webinar.Disclaimer: This blog and website are public sources of general information concerning our firm and its lawyers, as well as the information presented. They are intended, but not promised or guaranteed, to be correct, complete, and up-to-date as of the date posted. This blog and website are not intended to be, and are not, sources of legal opinion or advice. The materials, information, and communications on this blog and website do not apply to any particular person, entity, or situation, and do not apply to you or to your specific situation. You will need to consult with an attorney and/or other appropriate professional about your specific situation. Thank you.