Tax Prophet FAQ February 4, 1996

Frequently Asked Tax Questions -- February 4, 1996

This column, in slightly different format, originally appeared in The San Francisco Examiner Newspaper, Sunday, February 4, 1996



Note: This exercise is for educational purposes only and is not intended to be legal or tax advice. Your particular facts and circumstances must be considered when applying the U.S. tax law. You should always consult with a competent tax professional with respect to your particular situation.

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  1. Question: Have you heard of a little-known Form 1127, which permits an extension of time to pay federal taxes? [Answer]
  2. Question: I have just formed a Limited Liability Company. Should I have a buy-sell agreement among the members and will the IRS respect the buyout price for estate tax purposes? [Answer]
  3. Question: A father (who is a non-U.S. citizen and a non-resident for U.S. income tax purposes) owns 50% interest in a U.S. corporation owning U.S. real estate. His children (both U.S. residents) own the balance. Father made a loan to the corporation which is subject to a 30% tax (enforced by withholding on the borrower) on the interest paid to him. Because of this, father wants a foreign bank to refinance his loan and he would pledge certain assets for the repayment of the loan. Will such a plan avoid his 30% tax on the interest income? [Answer]

  1. Answer to Question #1: Form 1127 is called an Application for Extension of Time for Payment of Tax. For the Application to be granted, the taxpayer must: (1) show "undue hardship" that prevents the payment of tax; (2) show there are no other source of income from which to pay the tax; (3) show an inability to borrow the funds; (4) provide security for the payment (unless the taxpayer has no assets). Extensions are usually granted for 6 months, but interest accrues on the unpaid tax. Critically, the application must be filed before the tax is due. Form 1127 is often used with in estate taxes when the estate must sell assets to pay its taxes.

    For amounts less than $10,000 (this amount could expand to $25,000 in 1996), explore using an Installment Agreement Request, Form 9465, rather than Form 1127. These usually require equal monthly payments of principal and interest with the total paid in 2 or 3 years, with less paperwork and fewer legal requirements.


  2. Answer to Question #2: An LLC or any closely-held entity (partnership or corporation) should have buy-sell provisions to ensure that the remaining Members (or the company) may acquire a Member's interest, if that Member dies or decides to sell. In many cases, the buy-sell provisions provide a market for the sale of shares. Buy-sell provisions protect the Members by: (1) reducing valuation disputes in the future; (2) providing a method of selecting future Members of the LLC; and (3) providing an estate tax value of a Member's share.

    The IRS will respect buy-sell provisions if they set a fair price for Member's shares. Fairness is measured at the time the agreement is executed. You should use an appraiser to develop a price per share formula for the buy-out, but even if you don't, you need to document the pricing. Note: Although the purchase formula may exclude intangibles or property appreciation, the fairness of the price may be questioned when intangibles (goodwill or trademarks) have great value compared to the book value of other assets.

    A buy-sell agreement will be ignored by the IRS for estate tax valuations of your interest in the company, unless there are valid business reasons for the agreement. These include the desire to have: (1) active participants in the company; (2) experienced or knowledgeable participants in the company; (3) continuity of company management, or (4) retention of control within the Member's family in the company. Once a valid business purpose is established, the IRS must prove the provisions should be disregarded for estate tax purposes. Buy-sell provisions must apply to a Member's interest during life and upon death. The provisions must also be binding on the Member and the Member's estate.

    In addition, there cannot be a clause that "releases" the valuation if it is later challenged by the IRS; otherwise, the purchase price formula will not be respected. For example, if the formula price results in a valuation of $1 million, but the IRS claims the value is $2 million, the sales price must remain at $1 million.

    If 50% or more of the company is owned by "family members" (defined below), then the buy-sell provisions must be comparable to similar arrangements entered into by persons in an arm's length transaction. Factors such as independent legal representation, use of independent appraisers to develop the purchase price formula, evidence of a negotiation process and strict compliance with the terms of the buy-out provisions all indicate that an arm's length transaction has occurred. Comparables for similar businesses may demonstrate general business practices in the industry. In addition, tax regulations state that the agreement must represent a "fair bargain."

    Family members include a Member's spouse, lineal descendants of the Member or the Member's spouse, spouse of a lineal descendant, any ancestor of the Member or Member's spouse, spouse of any ancestor or any individual who is the natural object of the decedent's bounty.


  3. Answer to Question #3: No. Your question concerns tax consequences of a foreign shareholder's loan to a U.S. corporation. Generally, interest on such loans is subject to a 30% tax (unless there is an applicable tax treaty to lower the tax rate). An exception is the "portfolio interest" exclusion which permits interest to be received tax-free. However, the lender must own, directly or indirectly, less than 10% of the borrower corporation. Because parents are considered to own the stock of their children (regardless of their ages -- suprisingly--), a parent cannot own any stock in a corporation if he makes a direct or indirect loan when he and his children together own 10% or more of the stock. In addition, pledging property owned by a shareholder as security for a loan from a foreign bank will be treated as an indirect loan from that shareholder.

    Alternatively, the parent's brother or sister (provided they are neither U.S. residents nor citizens) may qualify under the portfolio interest exception, since there is no attribution of ownership between brothers and sisters. Individually, neither the brother nor the sister may own 10% or more of the corporation for them to remain exempt from the U.S.'s 30% tax on interest paid to a foreign person.

    For U.S. estate tax purposes, it is advantageous for the stock of a U.S. corporation to be owned by a foreign corporation. Also, the U.S. corporation should file annual income tax returns with respect to its real estate holdings. Transfer of any stock to a foreign corporation is considered a taxable event; consequently, the fair market value of the U.S. real estate and its adjusted basis (its tax basis) must be determined to ascertain whether such a transfer will cause any taxable gain.



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