Introduction to Qualified Opportunity Funds

The 2017 Tax Cuts and Jobs Act added sections 1400Z-1 and 1400Z-2 to the Internal Revenue Code. The former provides for the designation of certain low-income communities as "qualified opportunity zones," and the later provides certain incentives for investment in such QOZs. IRS Notice 2018-48 provides a full list of population census tracts designated as qualified opportunity zones; investments within these zones can qualify for the new tax incentive.

The tax incentive permits a taxpayer who has realized a capital gain from the sale of property to an unrelated person to invest all or part of the gain amount into a "qualified opportunity fund" within 180 days of the realization event and elect to defer paying tax on the gain amount so invested. The deferral lasts until the earlier of (a) the date that the taxpayer sells the QOF investment or (b) December 31, 2026.

In addition, if the taxpayer holds the QOF investment for at least five years, ten percent of the deferred gain is permanently excluded from taxation, and if the taxpayer holds the QOF investment for at least seven years, a total of fifteen percent of the deferred gain is permanently excluded from taxation. Finally, if the taxpayer holds the QOF investment for at least ten years, all post-acquisition gain on the QOF investment can be permanently excluded from taxation.

A QOF is an entity organized as a corporation or a partnership for the purpose of investing in QOZ property. Such an entity uses IRS Form 8996 to initially certify that it is organized to invest in QOZ property as well as annually report that it meets the investment standards. Generally speaking, a QOF must hold 90% of its assets in QOZ property or pay a penalty. This tax incentive is a new and important opportunity for many taxpayers with capital gains.

See Maule, 597-2nd T.M., Tax Incentives for Economically Distressed Areas; Qualified Opportunity Zones.

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Captive Insurance Companies

Insurance does two things: First, it shifts a risk from an insured to the insurance company. Second, it distributes the risk taken on by the insurance company among a pool of like risks with a predictable number of risks that will materialize. In other words, from the insured’s perspective, insurance shifts risks; and from the insurer’s perspective, insurance distributes risk.

This is the view of insurance from a tax perspective and helps explain why historically, the IRS challenged "captive" insurance companies, or insurance companies owned by the insured. The IRS argued that true risk shifting and distribution could never occur within the same "economic family" and that as such, deductible premiums by the insured were really non-deductible contributions to a reserve fund.

Beginning with the case of Humana v. Commissioner, 88 T.C. 197 (1987), which was discussed at length in the recent case of Rent-A-Center, Inc. v. Commissioner, 142 T.C. No. 1 (2014), the IRS started consistently losing this argument. Eventually, in Rev. Rul. 77-316, the IRS announced that it would no longer rely on its economic family argument. Currently, there are a few safe harbors that taxpayers can rely upon to obtain the expected tax treatment of their captive insurance companies and payments made thereto. However, as Rent-A-Center makes clear, the IRS can still litigate based on facts and circumstances of individual scenarios.

Rev. Rul. 2002–89 and Rev. Rul. 2002-90 stand for the following two safe harbors: If a captive insurance company either (1) receives at least 50% of its income from a non-parent or (2) provides insurance for at least twelve subsidiaries, with no subsidiary accounting for less than 5% or more than 15% of the total risk underwritten, the IRS will normally concede that adequate risk shifting and distribution has occurred and not challenge the captive arrangement. 11 Mertens Law of Fed. Income Tax'n § 44:24.

Firms who market and help clients establish captive insurance companies can help clients pool with third parties in order to meet these requirements. The viability of this strategy assumes that the captive is operated as a bona fide insurance company in every respect.

While captive insurance companies provide clear asset protection benefits, the tax benefits are substantial as well. If the captive qualifies and elects to be taxed as a "small company" under section 831(b) of the Internal Revenue Code, it will be taxed only on taxable investment income, not underwriting income. A captive insurance company can receive up to $1.2 million in annual premiums and still qualify under section 831(b). Effectively, this means that by establishing a captive insurance company, a taxpayer can reduce taxable income by deducting premiums of $1.2 million, while recognizing no taxable income to the captive. Assuming a good claims history, the premiums accumulate tax-deferred and are available to be withdrawn later as dividends or long term capital gains.

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The Research and Development Tax Credit

The research and development tax credit is an extremely valuable benefit to companies engaged in R&D. However, the credit is not just available to those who "wear lab coats and use test tubes [because] the definition of research and development for tax credit purposes is fairly broad."

The R&D credit is generally allowed for wages, supplies, and certain contract research expenses paid or incurred for qualified research. Qualified research means research, the expenses for which qualify as deductible business expenses, and which is undertaken for discovering technological information and developing a new or improved business component or process, and which involves a process of experimentation.

The credit is calculated from a base amount designed to encourage "increasing" research activities. The net benefit can be around 6.5 percent of qualified research expenditures, which reduces a company's taxes dollar-for-dollar, not including potential state tax benefits. For businesses that are in losses and don't pay taxes, unused credits can be carried forward for 20 years.

The credit became even more widely available due to a recent regulation that expands the class of companies that can benefit. Previously, the Alternative Simplified Credit (ALS) could only be taken on original returns, not amended returns from past years. Now, the ALS can be taken on past year amended returns, making it much easier to offset the cost of an R&D tax credit study.

The R&D credit technically expired Dec. 31, 2013, requiring Congress to enact legislation extending the credit. Fortunately, this is what typically happens. "Congress has extended the R&D credit 15 times since its inception in 1981. In 11 of those instances, the extension retroactively restored the credit."

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Gay Marriage Cases Yield Estate Tax Planning Opportunities

Some of the court decisions on the issue of gay marriage are creating estate tax loopholes that could allow wealthy individuals to pass their estate to their heirs tax free. Every state restricts close relatives from marrying. However, the language of some states' statutes technically only prohibits opposite-sex relatives from marrying, but with a definition of "marriage" that only includes male-female unions.

Consider the statute in Massachusetts, which contains the traditional definition of marriage and provides that "No man shall marry his mother, grandmother, daughter, granddaughter, sister, stepmother, grandfather’s wife, grandson’s wife, wife’s mother, wife’s grandmother, wife’s daughter, wife’s granddaughter, brother’s daughter, sister’s daughter, father’s sister or mother’s sister." There are corresponding provisions for women.

In Goodridge v. Department of Public Health, the court acknowledged this language and said in a footnote that "the statutory provisions concerning consanguinity or polygamous marriages shall be construed in a gender neutral manner." However, the statute has not been updated despite ample opportunity for the legislature to do so. Given this, it is at least arguable that, as Phillip Greenspun pointed out, a "grandfather [could] marry his grandson, give his spouse/grandson a tax-free spousal gift of $25 million, and then get a no-fault divorce after a couple of years."

In contrast, the Connecticut legislature did amend the gender-based consanguinity provisions in its marriage statutes. Shortly after the case of Kerrigan v. Commissioner of Public Health was handed down, the legislature passed Public Act No. 09-13. This act replaced the language "No man may marry his mother, grandmother, daughter, granddaughter, sister, aunt, niece, stepmother or stepdaughter, and no woman may marry her father, grandfather, son, grandson, brother, uncle, nephew, stepfather or stepson" with the following: "No person may marry such person's parent, grandparent, child, grandchild, sibling, parent's sibling, sibling's child, stepparent or stepchild."

It is unclear what rationale Connecticut or any state would have in removing the right of same-sex relatives to marry. As has been astutely pointed out, "[T]he biological rationale for the consanguinity rules makes no sense in the context of two women or two men, as there simply can be no progeny produced between them, and hence there is no possibility of in-breeding."

The state of Iowa chose to remain silent on this question; its statute declares as void any marriage between "a man and his father's sister, mother's sister, daughter, sister, son's daughter, daughter's daughter, brother's daughter, or sister's daughter" (and vice versa) in Iowa Code Ann. § 595.19. The court in Varnum v. Brien did not mention 595.19 or consanguinity and the legislature has not updated the statute since. As such, Iowa has seen fit to allow close same-sex relatives to marry; accordingly, an unmarried woman can marry her daughter and pass wealth to her tax free.

With the 10th Circuit currently considering whether to overturn traditional marriage laws in multiple states, it will be interesting to see how or if it approaches the varied consanguinity provisions within its jurisdiction. Oklahoma is poised to become another state with an estate-tax loophole.

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Educational Assistance Programs

Companies who hire students or potential students can offer educational benefits that would be more beneficial to both employer and employee than a standard wage offer would be. This can be accomplished through the fringe benefit known as an Educational Assistance Program.

An Educational Assistance Program allows an employer to provide an employee assistance in paying for tuition, fees, books, and supplies for education. Benefits provided under this program will not be subject to income or employment taxes, and the first $5,250 will be excluded from the employee's income each year.

The requirements are as follows: (1) The program must benefit employees who qualify under rules set up by the employer but that do not favor 5%-or-more owners or employees earning more than $115,000; (2) the program may not provide more than 5% of its benefits during the year for shareholders or owners; (3) the program may not allow employees to choose to receive cash or other benefits that must be included in gross income instead of the educational assistance, (4) the employer must give reasonable notice of the program to eligible employees, and (5) the program must be in writing.

To illustrate how such a program can be better for both an employer and an employee who is indifferent about receiving wages or educational assistance as compensation, assume that an employer is contemplating offering an employee an annual raise of $5,000. Were this raise to come in the form of a salary increase, the employer would need to first deduct 6.2% for social security, 1.45% for medicare, and some amount for income tax withholding, say 5%, for a total of $632.50, leaving the employee with $4,367.50. The employer must pay out, in addition to the $5,000, an additional $382.50 for the employer portion of social security and medicare, for a total of $5,382.50.

In contrast, if the annual raise is in the form of educational assistance, neither the employee nor the employer is subject to any of the above taxes. If the employer offers a raise of $5,250.00, the total payout will be $5,250.00, a savings of $132.50. The employee will have $5,250.00 of his or her educational expenses paid for, a net benefit of $882.50 compared to receiving a salary and paying for tuition with after-tax dollars.

Certainly, an educational assistance program isn't appropriate in all cases, but it can provide savings and incentives to both the employer and employee for whom the situation is right.

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Valuation Discounts

One of the primary objectives of estate planning is to arrange for the transfer of wealth to the next generation at the lowest possible cost. For large estates, the most significant cost is the gift and estate tax. These two tax regimes are essentially a single tax imposed on total lifetime gifts plus the value of property transferred at death. As mentioned in a previous post, gifting during lifetime can be part of an estate planning strategy.

For a gifting example, assume a gift tax rate of 40% and a donor who has previously utilized his or her entire tax exemption and who desires to make a gift of $1,000,000 of a $4,000,000 investment in a publicly-traded company.

After making the gift of the $1,000,000 asset, the donor will pay a $400,000 gift tax. Obviously, a key factor in the calculation of the gift tax is the valuation of the stock that is the subject of the gift. In this case, the valuation is straight-forward because the stock is easy to sell and has a ready market.

However, consider the gift of a small, privately-owned family business. In this case, the value of the asset will reflect the fact that there is not a ready market for the business; it is more difficult to sell. In addition, the value of a minority interest in a private business will reflect a lower value if the owner does not have managerial control.

For planning purposes, both the "lack of control" and "lack of marketability" discounts can be effectuated in not only the small, privately-owned family business context, but also for nearly any other asset. For example, suppose that the owner of the $4,000,000 stock investment first transfers the stock into a limited partnership. Subsequently, if the owner transfers a 25% limited partnership interest to a donee, the value of the gift for gift tax purposes will be less than $1,000,000.

This is because there is not a ready market for a privately-owned partnership interest. Furthermore, instead of owning $1,000,000 worth of publicly traded stock outright, the donee merely owns a 25% limited interest in a private partnership. Since the donee lacks managerial control over that interest, it does not matter that the underlying asset is publicly-traded stock; the lack of control discount would apply in addition to the lack of marketability discount.

If the total valuation discount in this case works out to be 30%, this results in a gift valuation of $700,000 instead of $1,000,000. This results in an accompanying gift tax of $280,000 instead of $400,000, an immediate cash savings of $120,000 simply by utilizing the limited partnership.

Source: Valuation, Jonathan C. Lurie and Edwin G. Schuck, Jr., The American Law Institute - American Bar Association Continuing Legal Education, 2008

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Savings Incentive Match Plan for Employees

A Savings Incentive Match Plan for Employees (SIMPLE Plan) is a written salary-reduction arrangement that allows small businesses that meet certain requirements to make retirement contributions on behalf of eligible employees. A SIMPLE Plan "is ideally suited as a start-up retirement savings plan for small employers not currently sponsoring a retirement plan." A SIMPLE Plan is established by a written agreement and setting up Individual Retirement Accounts for employees.

In order to be eligible to establish and maintain a SIMPLE Plan, a business can not maintain or sponsor another retirement plan and must have 100 or fewer employees who earned $5,000 or more in the prior year. All of the employees in this category are eligible to participate in the plan and the employer may not impose more restrictive eligibility requirements. The employer is required to make either a non-elective contribution of 2% of each eligible employee’s compensation or a match of the employee’s elective salary reduction of up to 3% of the employee’s compensation.

Employees can make salary reduction contributions up to $12,000 in 2013, plus catch-up contributions of $2,500 for individuals 50 or older. Elective deferrals of an employee’s wages are included in Form W-2 wages for social security and Medicare purposes only. Employer contributions to a SIMPLE Plan are excluded from the gross income of the employee and deductible by the employer.

While the contribution limits of a SIMPLE Plan are lower than some other small employer retirement plan options, SIMPLE IRA Plans do not have the start-up and operating costs of other plans, nor is there any filing requirement for the employer. Furthermore, because SIMPLE Plan contributions can reduce salary, they can be used to reduce payroll or self-employment tax when compared to some other retirement plans.

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