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To Gift or Not to Gift? The Time May Have Arrived

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Article written by Lou Vlahos of FarrellFritz Attorneys, used with their written permission.

The Joy – and Tax Benefits – of Gifting

IRS icon behind a green overlayAs we enter the “season of giving” and the end of yet another year, the thoughts of many tax advisers turn to . . . tax planning.(i) In keeping with the spirit of the season, an adviser may suggest that a client with a closely held business consider making a gift of equity in the business to the owner’s family or to a trust for their benefit.(ii)

Of course, annual exclusion gifts(iii) are standard fare and, over the course of several years, may result in the transfer of a not insignificant portion of the equity in a business.

However, the adviser may also recommend that the client consider making larger gifts, thereby utilizing a portion of their “unified” gift-and-estate tax exemption amount during their lifetime. Such a gift, the adviser will explain, may remove from the owner’s gross estate not only the current value of the transferred business interests, but also the future appreciation thereon.(iv)

The client and the adviser may then discuss the “size” of the gift and the valuation of the business interests to be gifted, including the application of discounts for lack of control and lack of marketability. At this point, the adviser may have to curb the client’s enthusiasm somewhat by reminding them that the IRS is still skeptical of certain valuation discounts, and that an adjustment in the valuation of a gifted business interest may result in a gift tax liability.

The key, the adviser will continue, is to remove as much value from the reach of the estate tax as reasonably possible, and without incurring a gift tax liability – by utilizing the client’s remaining exemption amount – while also leaving a portion of such exemption amount as a “cushion” in the event the IRS successfully challenges the client’s valuation.

“Ask and Ye Shall Receive”(v)

Enter the 2017 Tax Cuts and Jobs Act (the “Act”).(vi) Call it an early present for the 2018 gifting season.

One of the key features of the Act was the doubling of the federal estate and gift tax exemption for U.S. decedents dying, and for gifts made by U.S. individuals,(vii) after December 31, 2017, and before January 1, 2026.

This was accomplished by increasing the basic exemption amount (“BEA”) from $5 million to $10 million. Because the exemption amount is indexed for inflation (beginning with 2012), this provision resulted in an exemption amount of $11.18 million for 2018, and this amount will be increased to $11.4 million in 2019.(viii)

Exemption Amount in a Unified System

You will recall that the exemption amount is available with respect to taxable transfers made by an individual taxpayer either during their life (by gift) or at their death – in other words, the gift tax and the estate tax share a common exemption amount.(x)

The gift tax is imposed upon the taxable gifts made by an individual taxpayer during the taxable year (the “current taxable year”). The gift tax for the current taxable year is determined by: (1) computing a “total tentative tax” on the combined amount of all taxable gifts made by the taxpayer for the current and all prior years using the common gift tax and estate tax rate table; (2) computing a tentative tax only on all prior-year gifts; (3) subtracting the tentative tax on prior-year gifts from the tentative tax computed for all years to arrive at the portion of the total tentative tax attributable to current-year gifts; and, finally, (4) subtracting the amount of the taxpayer’s unified credit (derived from the unused exemption amount) not consumed by prior-year gifts.

Thus, taxable gift transfers(xi) that do not exceed a taxpayer’s exemption amount are not subject to gift tax. However, any part of the taxpayer’s exemption amount that is used during their life to offset taxable gifts reduces the amount of exemption that remains available at their death to offset the value of their taxable estate.(xii)

From a mechanical perspective, this “unified” relationship between the two taxes is expressed as follows:

• the deceased taxpayer’s taxable estate is combined with the value of any taxable gifts made by the taxpayer during their life;
• the estate tax rate is then applied to determine a “tentative” estate tax;
• the portion of this tentative estate tax that is attributable to lifetime gifts made by the deceased taxpayer is then subtracted from the tentative estate tax to determine the “gross estate tax” – i.e., the amount of estate tax before considering available credits, the most important of which is the so-called “unified credit”; and
• credits are subtracted to determine the estate tax liability.

This method of computation is designed to ensure that a taxpayer only gets one run up through the rate brackets for all lifetime gifts and transfers at death.(xiii)

What Happens After 2025?(xvi)

However, given the temporary nature of the increased exemption amount provided by the Act, many advisers questioned whether the cumulative nature of the gift and estate tax computations, as described above, would result in inconsistent tax treatment, or even double taxation, of certain transfers.

To its credit,(xv) Congress foresaw some of these issues and directed the IRS to prescribe regulations regarding the computation of the estate tax that would address any differences between the exemption amounts in effect: (i) at the time of a taxpayer’s death and (ii) at the time of any gifts made by the taxpayer.

Pending the issuance of this guidance – and pending the confirmation of what many advisers believed was an expression of Congressional intent not to punish individuals who make gifts using the increased exemption amount – many taxpayers decided not to take immediate advantage of the greatly increased exemption amount, lest they suffer any of the consequences referred to above.

Proposed Regulations

In response to Congress’s directive, however, the IRS proposed regulations last week that should allay the concerns of most taxpayers,(xvi) which in turn should smooth the way to increased gifting and other transfers that involve an initial or partial gift.

In describing the proposed regulations, the IRS identified and analyzed several situations that could have created unintended problems for a taxpayer, though it concluded that the existing methodology for determining the taxpayer’s gift and estate tax liabilities provided adequate protection against such problems:

• Whether a taxpayer’s post-2017 increased exemption amount would be reduced by pre-2018 gifts on which gift tax was paid. If the taxpayer makes additional gifts during the post-2017 increased exemption period, would the gift tax computation apply the increased exemption to the pre-2018 gifts, thus reducing the exemption otherwise available to shelter gifts made during the post-2017 period, effectively allocating credit to a gift on which gift tax in fact was already paid, and denying the taxpayer the full benefit of the increased exemption amount for transfers made during the increased exemption period?

• Whether the increased exemption amount available during the increased exemption period would be reduced by pre-2018 gifts on which gift tax was paid. If the taxpayer died during the increased exemption period, would the estate tax computation apply the increased exemption to the pre-2018 gifts, thus reducing the exemption otherwise available against the estate tax during the increased exemption period and, in effect, allocating credit to a gift on which gift tax was paid?

• Whether the gift tax on a post-2025 transfer would be inflated by the theoretical gift tax on a gift made during the increased exemption period that was sheltered from gift tax when made. Would the gift tax determination on the post-2025 gift treat the gifts made during the increased exemption period as gifts that were not sheltered from gift tax given that the post-2025 gift tax determination is based on the exemption amount then in effect, rather than on the increased exemption amount, thereby increasing the gift on the later transfer and effectively subjecting the earlier gift to tax even though it was exempt from gift tax when made?

With respect to the first two situations described above, the IRS determined that the current methodology by which a taxpayer’s gift and estate tax liabilities are determined ensures that the increased exemption will not be reduced by a prior gift on which gift tax was paid. As to the third situation, the IRS concluded that the current methodology ensures that the tax on the current gift will not be improperly inflated.

New Regulations

However, there was one situation in which the IRS concluded that the methodology for computing the estate tax would, in effect, retroactively eliminate the benefit of the increased exemption that was available for gifts made during the increased exemption period.

Specifically, the IRS considered whether, for estate tax purposes, a gift made by a taxpayer during the increased exemption period, and that was sheltered from gift tax by the increased exemption available during such period, would inflate the taxpayer’s post-2025 estate tax liability.

The IRS determined that this result would follow if the estate tax computation failed to treat such gifts as sheltered from gift tax.

Under the current methodology, the estate tax computation treats the gifts made during the increased exemption period as taxable gifts not sheltered from gift tax by the increased exemption amount, given that the post-2025 estate tax computation is based on the exemption in effect at the decedent’s death rather than the exemption in effect on the date of the gifts.

For example, if a taxpayer made a gift of $11 million in 2018, (when the BEA is $10 million; a taxable gift of $1 million), then dies in 2026 with a taxable estate of $4 million (when the BEA is $5 million), the federal estate tax would be approximately $3,600,000: 40% estate tax on $9 million – specifically, the sum of the $4 million taxable estate plus $5 million of the 2018 gift that was sheltered from gift tax by the increased exemption. This, in effect, would impose estate tax on the portion of the 2018 gift that was sheltered from gift tax by the increased exemption allowable at that time.

Alternatively, what if the taxpayer dies in 2026 with no taxable estate? The taxpayer’s estate tax would be approximately $2 million, which is equal to a 40% tax on $5 million – the amount by which, after taking into account the $1 million portion of the 2018 gift on which gift tax was paid, the 2018 gift exceeded the BEA at death. This, in effect, would impose estate tax on the portion of the 2018 gift that was sheltered from the gift tax by the excess of the 2018 exemption over the 2026 exemption.

The IRS determined that this problem arises from the interplay between the differing exemption amounts that are taken into account in the computation of the estate tax.

Specifically, after first determining the tentative tax on the sum of a decedent’s taxable estate and their adjusted taxable gifts,(xvii)

i. the decedent’s estate must then determine the credit against gift taxes for all prior taxable gifts, using the exemption amount allowable on the dates of the gifts (the credit itself is determined using date of death tax rates);
ii. the gift tax payable is then subtracted from the tentative tax, the result being the net tentative estate tax; and
iii. the estate next determines a credit based on the exemption amount as in effect on the date of the decedent’s death, which is then applied to reduce the net tentative estate tax.

If this credit (based on the exemption amount at the date of death) is less than the credit allowable for the decedent’s taxable gifts (using the date of gift exemption amount), the effect is to increase the estate tax by the difference between the two credit amounts.

In this circumstance, the statutory requirements for computing the estate tax have the effect of imposing an estate tax on gifts made during the increased exemption period that were sheltered from gift tax by the increased exemption amount in effect when the gifts were made.

In order to address this unintended result, the proposed regulations would add a special computation rule in cases where (i) the portion of the credit as of the decedent’s date of death that is based on the exemption is less than (ii) the sum of the credits attributable to the exemption allowable in computing the gift tax payable. In that case, the portion of the credit against the net tentative estate tax that is attributable to the exemption amount would be based upon the greater of those two credit amounts.

Specifically, if the total amount allowable as a credit, to the extent based solely on the BEA, in computing the gift tax payable on the decedent’s post-1976 taxable gifts, exceeds the credit amount based solely on the BEA in effect at the date of death, the credit against the net tentative estate tax would be based on the larger BEA.

For example, if a decedent made cumulative taxable gifts of $9 million, all of which were sheltered from gift tax by a BEA of $10 million applicable on the dates of the gifts,(xviii) and if the decedent died after 2025 when the BEA was $5 million, the credit to be applied in computing the estate tax would be based upon the $9 million of exemption amount that was used to compute the gift tax payable.

Time to Act?

By addressing the unintended results presented in the situation described – a gift made the decedent during the increased exemption period, followed by the death of the decedent after the end of such period – the proposed regulations ensure that the decedent’s estate will not be inappropriately taxed with respect to the gift.

With this “certainty,” an individual business owner who has been thinking about gifting a substantial interest in their business may want to accelerate their gift planning. As an additional incentive, the owner need only look at the results of the mid-term elections, which do not bode well for the future of the increased exemption amount. In other words, it may behoove the owner to treat 2020 (rather than 2025) as the final year for which the increased exemption amount will be available, and to plan accordingly. Those owners who decide to take advantage of the increased exemption amount by making gifts should consider how they may best leverage it.

And as always, tax savings, estate planning, and gifting strategies have to be considered in light of what is best for the business and what the owner is comfortable giving up.

—————————————————————
(i) What? Did you really expect something else? Tax planning is not a seasonal exercise – it is something to be considered every day, similar to many other business decisions.
(ii) Of course, the interest to be gifted should be “disposable” in that the owner can comfortably afford to give up the interest. Even if that is the case, the owner may still want to consider the retention of certain “tax-favored” economic rights with respect to the interest so as to reduce the amount of the gift for tax purposes.
(iii) Usually into an irrevocable trust, and coupled with the granting of “Crummey powers” to the beneficiaries so as to support the gift as one of a “present interest” in property. A donor’s annual exclusion amount is set at $15,000 per donee for 2018 and $15,000 for 2019.
(iv) In other words, a dollar removed today will remove that dollar plus the appreciation on that dollar; a dollar at death shields only that dollar.
The removal of this value from the reach of the estate tax has to be weighed against the loss of the stepped-up basis that the beneficiaries of the decedent’s estate would otherwise enjoy if the gifted business interest were included in the decedent’s gross estate.
(v) Matthew 7:7-8. Actually, many folks asked for the repeal of the estate tax. “You Can’t Always Get What You Want,” The Rolling Stones.
(vi) P.L. 115-97.
(vii) For purposes of the estate tax, this includes a U.S. citizen or domiciliary. The distinction between a U.S. individual and non-resident-non-citizen is significant. In the absence of any estate and gift tax treaty between the U.S and the foreign individual’s country, the foreign individual is not granted any exclusion amount for purposes of determining their U.S. gift tax liability, and only a $60,000 exclusion amount for U.S. estate tax purposes.
(viii) https://www.irs.gov/pub/irs-drop/rp-18-57.pdf
(ix) Only individual transferors are subject to the gift tax. Thus, in the case of a transfer from a business entity that is treated as a gift, one or more of the owners of the business entity will be treated as having made the gift.
(x) They also share a common tax rate table.
(xi) As distinguished, for example, from the annual exclusion gift – set at $15,000 per donee for 2018 and for 2019 – which is not treated as a taxable gift (it is not counted against the exemption amount).
(xii) An election is available under which the federal exemption amount that was not used by a decedent during their life or at their death may be used by the decedent’s surviving spouse (“portability”) during such spouse’s life or death.
(xiii) A similar approach is followed in determining the gift tax, which is imposed on an individual’s transfers by gift during each calendar year.
(xiv) As indicated above, the increased exemption amount is scheduled to sunset after 2025, at which point the lower, pre-TCJA basic exclusion amount is reinstated, as adjusted for inflation through 2025. Of course, a change in Washington after 2020 could accelerate a reduction in the exemption amount.
(xv) I bet you don’t hear that much these days.
(xvi) https://www.federalregister.gov/documents/2018/11/23/2018-25538/estate-and-gift-taxes-difference-in-the-basic-exclusion-amount; the regulations are proposed to be effective on and after the date they are published as final regulations in the Federal Register.
(xvii) Defined as all taxable gifts made after 1976 other than those included in the gross estate.
(xviii) Post-TCJA and before 2026.

Equal Isn’t Always Fair: How to Divide Founders’ Equity

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Guest Article By Kate Heptig, partner, Rivkin Radler LLP

When starting a business, there are numerous decisions that must be made by the owners at the outset. One rises above all others, however, and becomes the proverbial elephant in the room – how to divide the founders’ equity.

The easiest answer, an even split among the founders, isn’t necessarily the best one, even if it sidesteps the founders’ emotions and egos. The primary shortcoming of this approach is that it fails to take into consideration the relative contributions being made by each individual.  Ideally, the value of those contributions relative to the value of the enterprise would be the basis for determining how to apportion the equity. Unfortunately, in the context of a startup, valuation is far from an exact science.

The Value Vacuum

A startup, by its nature, has no history. There are no arm’s-length transactions to use as a means of calculating the business’ value, so assessing or even trying to predict that value is difficult.  In addition, each founder likely brings something unique to the venture. Perhaps one of them had the original idea but has no business experience, while others have executive-level experience in the industry, or startup capital and an extensive business network. What impact will each of those contributions ultimately have on the success of the business? The challenge here is really twofold – the founders aren’t sure what they are giving up to each other in value, nor what the venture will get back from each in return.

Believe it or not, when advising startup founders, the two best pieces of advice I give to help guide them through the process come from Albert Einstein and Wayne Gretzky. You may wonder whether a physicist/Nobel laureate and a hockey legend ever gave business advice, and the truth is, I’m not sure either of them ever did. But, taken together, their quotes encompass the guiding principles that should be used by founders when deciding how to divide their initial equity.

I skate to where the puck is going to be, not to where it has been.” – Wayne Gretzky

Gretzky’s notion of looking forward is an important piece of the puzzle for business founders. In the context of a startup, founders often get caught up arguing about how they got to where they are today – who had the original idea, who was willing to contribute capital, who has relevant business experience from a prior position. While each of these considerations is relevant and may be important, it’s equally important for the group to consider what happens next, when the startup phase is complete and the doors are open for business. Although it’s important to consider what background, experience, education and skills a founder is bringing to the enterprise, it’s also important to look ahead and try to determine each founders’ potential impact and level of commitment to the business. The founders, like Gretzky, literally need to try to stay ahead of the game.

 Not everything that can be counted counts, and not everything that counts can be counted.” – Albert Einstein

Each founder has gotten a seat at the table because he/she is viewed by the others as a critical piece of the team who brings something valuable to the venture’s success. The nature of those specific contributions is vast but can generally be grouped into categories, for example:

  • the original idea
  • funding/capital
  • relevant experience
  • business acumen
  • applicable skills
  • industry know-how
  • network/contacts
  • pre-existing intellectual property
  • time commitment/sacrifice
  • business responsibilities

A simple approach may involve quantifying the contribution in some tangible, material way.  For example, some founders try to translate each of these categories to a dollar figure.  The problem with that approach is that some of these categories don’t lend themselves as easily to being “measured” in this way. Certain things that are easily quantifiable, like capital, may ultimately be less valuable to the success of the business than a more conceptual contribution that is harder to label with a dollar figure, like industry know-how. In other words, what ultimately “counts” may be difficult to measure.

Another mistake founders often make is trying to equate their respective contributions to an equivalent employee salary. Founders should avoid the temptation to simplify things in this way. The value of a founder’s work for a potential employer may only be a fraction of what some of these contributions may ultimately yield for the business, in part because salaries are determined by a variety of factors and may differ greatly among industries. In addition, the nature of business valuation is to take into account certain temporal factors and risk adjustments. Neither of these fundamental components of business valuation would be reflected in a determination based on a snapshot of an individual’s worth to the company, particularly at inception.

Putting it All Together

There is no single, authoritative formula for arriving at the optimal equity split. The best and most tenable result will come from a process guided by principles that each founder believes to be relevant and fair. That isn’t to say that settling on the final split will be easy. However, coming to consensus early on the short- and long-term needs of the business and the founders’ respective contributions will minimize the potential for friction and, ultimately, disengagement.   A thoughtful process has the greatest likelihood of yielding a result that is acceptable to all.

Once the founders are all in agreement as to what it will take to make the company succeed, they should work backwards, looking at the categories of contributions and assigning a relative weight to each. This may be the hardest part of the process, as each founder may look to convince the others that the categories in which he/she will make the greatest contributions are the ones that should be most heavily weighted. The partners must work together to determine the relative importance of each category. Then, they can determine the equity split through a weighted calculation of their respective contributions. Taking this quasi-mathematical approach may serve to eliminate some of the more emotional, subjective arguments that each founder will undoubtedly use to plead his/her case.

The founders should strive to be patient with each other, listening to each other’s concerns and asking questions to help narrow down the areas of potential disagreement. Such a process may feel a bit more cumbersome than simply splitting the equity evenly, but it will be time well-spent if the process meaningfully engages each founder. An equity split derived from shared principles is more likely to be accepted and respected by all.

Other Considerations – Vesting and Dilution

Founders should keep two other important concepts in mind when starting down this road. No matter how the initial equity is divided among the founders, all equity interests should be subject to a vesting schedule. This way, each founder will bear less risk upon an unexpected departure of an individual they deemed critical to the venture. The vesting schedule can be customized however the founders wish, based on any combination of time and/or performance-based conditions, but I always counsel my clients to place some restriction on the ability of a founder to walk away with a significant ownership interest in the startup stage.

Also consider dilution when formulating the initial equity split. Many startups pursue equity financing from outside investors. Successful businesses may also use equity as a compensation tool to attract and retain talented executives. In these cases, the issuance of additional equity will dilute the initial founders’ equity. Founders usually give themselves pre-emptive rights in order to maintain their initial ownership share, but typically that anti-dilution protection requires an actual purchase of additional equity. The founders should create one or more models for a future capitalization table to account for these additional issuances and make an informed decision about splitting the initial equity. If market demand or a new phase of the company’s growth is what triggers the issuance of additional equity shares, a founder who has failed to consider that potential dilution may realize that he/she doesn’t have the opportunity to participate in the appreciation of the company’s value to the extent that was expected.

While there isn’t necessarily a clear-cut formula to divide founders’ equity, the result should be derived from a process that feels right to the group. If they succeed with this initial agenda item, they will likely spend less time looking backward, second-guessing the decision that they collectively made, and more time focusing on moving the business forward and the bright future that potentially lies ahead.

Three Essential Components of Online Marketing Success

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Guest Article By: Hans Reimer, President & CEO, Market Vantage

I remember when I first heard about the Internet in the early ‘90s. Being a natural skeptic, it didn’t sound like anything important to me. My first look, which consisted of a primitive browser displaying an ugly, text-heavy page over a slow and unreliable dial-up modem connection merely reinforced my cynicism.

Several “killer-aps” like the Yahoo Directory and Netscape changed my opinion. Search engines hadn’t been invented yet but Yahoo employed an army of people that curated and classified online content. The Netscape browser made everything a lot more presentable. Being able to sift through vast amounts of information, to find something you were looking for, did sound important, even to a skeptic like me.

Although I had a background in software engineering, that early career evolved into selling technology solutions. I was given a base salary and paid commissions on sales. I did OK, but some of my peers made more money than the CEO. Out of necessity, I became an effective cold caller. After all, the more calls you made, the more leads you generated, and ultimately, the more sales you closed. Cha-ching!

Cold calling, though, seemed terribly inefficient to me. I was pretty good at assessing complex customer needs, explaining how our solution would impact their business, overcoming objections and closing sales. But, most of my time and emotional energy were spent in calling people, getting rejected, picking myself up and making the next call. What would happen, I imagined, if the customers started using the Internet to find the solutions they were looking for instead of sales reps, like me, chasing after customers? I could spend my time doing higher value work and closing more sales.

Think of your organization and your website as the hub of a big wheel. The spokes of the wheel are the paths that your prospects can take to find you. Those spokes are things like search engines, referrals, social media posts, traditional media, advertisements of many types, published articles or PR. In short, anything that brings prospects, a/k/a “traffic,” to your website is part of your online marketing engine. Website traffic is the first essential component of your online marketing strategy. Without traffic, your business is as good as dead.

However, traffic alone won’t make you rich. The second component, conversions, are required for success. Think of your website as a store, and your traffic as the customers that walk in and look around. Doubling your traffic may be exciting, but if everyone that comes in leaves without buying anything, then only difference will be that you have to sweep the floor more often. We call the act of increasing the ratio of buyers to shoppers “conversion rate optimization.”

That’s where the third component, “web analytics,” can help. Part of the beauty of online marketing is that so much of it is measurable. If you’re willing to put in the time and the effort, you can see where your visitors are coming from, which pages they visit, and where they exit from. You can segment your traffic and observe different behaviors depending on the source. For example, you can tell if Google ad clicks convert into sales at a higher rate than Facebook ad clicks. Combine that with your click cost data and you’re suddenly equipped to make some great marketing decisions.

If you’re an online retailer, analytics can tell you which step in the checkout process is most prone to cart abandonment. It may sound a little creepy, but you can essentially follow your customers around your “store,” recording what they are looking at and how they are behaving. Plus, you know something about where they are geographically located and how they got to your site!

At my last corporate job, I had the opportunity to learn online marketing first-hand through experimentation. When I started Market Vantage as an online marketing consultancy in 2002, I recall that many of the people I talked to didn’t understand exactly what I did or how I would make money. Bear in mind that Google’s IPO wasn’t until August, 2004.

Today, I have a small team and can see that virtually every business is engaged in some form of online marketing. Larger organizations have teams of people that are highly skilled in this area. At the other end of the spectrum, business owners try to do the job themselves. Mid-sized organizations sometimes hire a consulting firm like ours to collaborate with their in-house marketing people, where we provide extensive expertise, implementation support and some elbow grease.

Regardless of where your organization fits in the spectrum of online marketing, you can and should always be learning and improving. The technology keeps getting better, but the competition is getting smarter too. Just remember, the Internet is not just a source of customers, it’s also a great resource for learning how to steer your business out ahead of your competition.

Banking – A Changed World

Guest Article By: A.G. Divers, Founder and former president, The Bank of Tampa

(Editor’s note: The Bank of Tampa currently holds over $1.2 billion in deposits and is considered the premier community bank in the Tampa-Clearwater-St. Pete market)

When I was young, the old guys would clench their teeth around their cigars and grumble “the world ain’t what it used to be.”  If I sound that way I apologize in advance.

In the mid 1950’s I attended St. Petersburg Junior College and had no idea what I wanted to do with my life.  I took a course called Money and Banking and heard the professor explain that “the role of a bank is to take the surplus funds of a community and lend them wisely to local businesses to help them achieve their goals – and in the process enhance the economy of the community.”  That stuck with me (as you can tell it did if I remember it sixty years later) and I went home that day and announced that I wanted to become a banker.  I majored in banking at the University of Florida – a specialty that included only 18 students.  I was asked by one of them “Jerry, what are you doing here?  You don’t have a father, grandfather or an uncle who owns a bank!”

After serving in the United States Navy, in 1961 I began my career in Tampa at The Exchange National Bank of Tampa.  That bank was at that time seventh largest in the state with $126 million in deposits.  It was a close second to the largest bank in Tampa, and the two were by far the largest banks along the West Coast of Florida.  There were no out of state banks operating in Florida, no holding companies, no branches and no computers. Most banks were managed by families which had a large stake in their ownership.  And most of the banks in Florida at that time were survivors of the depression, and operated very conservatively.  The staffs of Florida banks considered themselves part of the “bank family” and there was negligible turnover of staff.

Banking was commonly referred to as a profession, and bankers in Tampa were part of the respected elite.

The president of my bank, whose father had preceded him in that role, told me a bank should keep one third of its assets in cash, one third in bonds and one third in loans.  Because our deposits were subject to overnight withdrawal, no loan should have a maturity of over a year, and under no circumstances were we to make a loan secured by real estate.  Not long after I started I worked with the manager of the bond portfolio, and learned that we kept 10% of the portfolio in municipal bonds, laddered over twenty years, and 90 % in treasuries, laddered over five years.  The bank was open Monday through Friday from ten to two.  The staff – including officers – were gone by three thirty.   I remember thinking “this is the life.”

Early on I was in training to become a loan officer.  I thought it a good idea to go see the customer and learn his business first hand.  I was told that was undignified and that “if someone wants a loan they can come in and ask for it.”  As my grandfather, an Indiana farmer, used to say “them was the good days.”

One message from that bank president, which I thought then was timeless, and I still do though there aren’t many like me anymore, described what were the “first two rules of banking.”  The first was “know your customer.”  The reason for this, of course, is to know the customer’s personal values – what the textbooks refer to as character; the customer’s ability; and the customer’s current financial condition and history, in order to properly assess the likelihood of the repayment of the loan.  The second rule was “know your customer’s business and financial goals so that you can help him achieve them.”  Sounds like that professor at junior college.

With all the changes which have taken place in banking, at The Bank of Tampa we have tried to live by those two rules in our relationships with our customers.  That, more than anything else, explains our success.  It explains more than anything else the need for banks like ours across the country.  We only have a small slice of the total banking market, but I read recently that community banks make more than half the loans to small business made in the United States.

Banking regulation has made it next to impossible to use our own judgment in making loans to individuals (we have to offer “products” and use standard criteria to grant them) but we still work closely with and tailor our loans to the specific needs of  our business customers to help them get where they want to go.  Let us hope with no doubt continued change in the future, those rules – and our ability to implement them – won’t change.

Valuations: A Cautionary Tale

By: Joshua Levin-Epstein, Esq.
Levin-Epstein & Associates, P.C.
Email: Joshua@levinepstein.com

A recent decision from a Minnesota federal court in a contested valuation proceeding that rejected both of the experts’ valuation reports of a successful grocery store business shows the danger of the incorporation of client advocacy and bias into a valuation report.

The Minnesota federal court, in Lund v Lund, Decision, Order & Judgment, No. 27-CV-14-20058 [Minn. Dist. Ct. Hennepin Cnty. June 2, 2017], basically concluded that both of the valuation experts were hired guns.  In Lund, the Court explained that:

“Both experts are highly trained and experienced professionals.  Both have testified and provided valuation reports in many trials and contested valuation situations. While the Court finds that [the parties’ respective valuation experts] are unquestionably qualified to testify on the issue of valuation, the obvious, zealous advocacy in which they engaged on behalf of their respective clients compromised their reliability in this instance.”

The Court went onto further criticize both of the valuation experts:

“Looking at their contention at a high level, it is abundantly clear that their valuations are tailored to suit the party who is paying them. This cold fact cuts against both experts’ credibility in equal measure.”

While both experts used an income approach on a discounted cash flow analysis to value the business, their disagreement over every input and assumption contemplated in their discounted cash flow analysis calculation compromised the professional integrity of each report, according to the Court.  The Court concluded that the $100 million difference in the value of the business between the experts’ reports was attributable to client bias.

Valuation experts are often under immense pressure in valuation proceedings to deliver reports in line with client expectations; however, the inclination to satisfy the client cannot compromise professional objectivity.  Ultimately, valuation reports that are perceived by a court as contrived will backfire against the client and the expert because the courts are empowered to undertake an independent judgment in a contested valuation proceeding.  For experts whose professional livelihood depends on credibility, the Minnesota federal courts’ decision should serve as a cautionary tale.

Editor’s Note: At JBV, remaining neutral is a prime objective.

Guidance for North-South Spinoffs

Guest Author Lou Vlahos, Esq, Partner, Farrell Fritz, P.C.

The IRS continues to issue guidance in the much debated area of corporate spinoffs. A recently published ruling examined the federal income tax treatment of the two steps that comprise a so-called “north-south” transaction. In doing so, it provides taxpayers with some welcome certainty.

A “north-south” transaction is one in which a parent corporation (P) contributes property constituting an active trade or business to its wholly-owned first-tier subsidiary corporation (D) for the purpose of enabling D to satisfy the requirements for a “tax-free spinoff” within the meaning of the Code. Then, pursuant to the same overall plan, and for a bona fide business purpose, D immediately distributes the stock of its own wholly-owned corporate subsidiary (C) to P.

The IRS considered whether the contribution and distribution that comprise a north-south transaction should be treated as two separate transactions for federal income tax purposes.

The Transaction

P owns all the stock of D, which owns all the stock of C. The fair market value (“FMV”) of the C stock is $100X. P has been engaged in Business A for more than 5 years, and C has been engaged in Business B for more than 5 years. Business A and Business B each constitutes the “active conduct of a trade or business” within the meaning of the Code’s spinoff rules. D is not engaged in the active conduct of a trade or business directly or through any subsidiary other than C.

On Date 1, P transfers the property and activities constituting Business A, having a fair market value of $25X, to D in exchange for additional shares of D stock. On Date 2, pursuant to a dividend declaration, D transfers all the C stock to P for a valid corporate business purpose. D retains the Business A property and continues the active conduct of Business A after the distribution. The purpose of P‘s transfer of the property and activities of Business A to D is to allow D to satisfy the active trade or business requirement for a “tax-free” spinoff.

The Law

A distribution that is treated, for tax purposes, as a dividend made by a corporation to a shareholder with respect to its stock, is includible in the gross income of the shareholder. The portion of the distribution that is not a dividend – i.e., the amount that exceeds the distributing corporation’s accumulated and current earnings and profits – is applied against and reduces the shareholder’s adjusted basis for the stock. The remaining portion of the distribution, in excess of the adjusted basis of the stock, is treated as gain from the sale or exchange of property by the shareholder.

If a corporation distributes appreciated property (rather than cash) to a shareholder in a distribution that is treated as a dividend, the distributing corporation recognizes gain as if it had sold the property to the shareholder at its FMV.

Spinoff

However, if certain requirements are met, a corporation may distribute all of the stock of a controlled corporation to its shareholders without recognition of gain or income, either to the corporation or to the recipient shareholders. In order for a distribution to qualify for this nonrecognition treatment, the distributing corporation must distribute stock of a corporation that it controls immediately before the distribution. In addition, the distributing corporation and the controlled corporation each must be engaged in the active conduct of a trade or business immediately after the distribution. Finally, the distribution must be made for a bona fide business purpose.

But what if the distributing corporation would be left without an active trade or business after the distribution of its subsidiary to its shareholders? How may it salvage nonrecognition treatment? If the shareholders are, themselves, engaged in the conduct of an active trade or business, can they contribute this business to the distributing corporation immediately prior to the distribution?

Capital Contribution

The Code provides that no gain will be recognized when property is transferred to a corporation by one or more persons solely in exchange for stock in such corporation and, immediately after the exchange, such person or persons are in “control” of the corporation. “Control” is defined as ownership of stock possessing at least 80 percent of the total combined voting power of all classes of stock entitled to vote and at least 80 percent of the total number of shares of all other classes of stock of the corporation. In addition, no gain or income is recognized to a corporation on the receipt of money or other property in exchange for stock of such corporation.

Reorganization

The Code also provides that no gain or loss will be recognized to a corporation on its exchange of property pursuant to a plan of reorganization solely for stock in another corporation a party to the reorganization. Under the Code, a “reorganization” includes a transfer by a corporation of part of its assets to another corporation if, immediately after the transfer, the transferor is in control of the corporation to which the assets are transferred, and the transferor distributes the stock of the controlled corporation in a spinoff transaction.

Continued Investment

The underlying assumption of these exceptions to the general gain recognition rule is that the stock of the controlled corporation is substantially a continuation of the property contributed to such corporation, so that the “old” investment remains unliquidated, and, in the case of a reorganization, that the new enterprise, the new corporate structure, and the new property are substantially continuations of the old one, still unliquidated.

Step Transaction

The federal income tax consequences to P and D, above, will depend on whether the Date 1 and Date 2 transfers are treated as separate transactions. Because they are undertaken pursuant to the same overall plan, a question arises as to whether the two transactions are part of a single reciprocal transfer of property – an exchange.

If the Date 1 and Date 2 transfers are respected as separate transactions for federal income tax purposes, P would be treated as contributing property to Don Date 1 for D stock in an exchange that qualified for nonrecognition treatment, and D would be treated as distributing all the stock of C to P on Date 2 in a distribution that qualified for nonrecognition treatment under the spinoff rules.

If the Date 1 and Date 2 transfers are integrated into a single exchange for federal income tax purposes, P would be treated as transferring its Business A property to D in exchange for a portion (FMV of $25X) of the C stock in a taxable exchange in which gain would be recognized to P on the transfer of its property to D; gain would also be recognized to D upon its transfer of 25 percent of the C stock (FMV of $25X) to P in exchange for the property transferred to it. In addition, the distribution of C stock would not qualify as a tax-free spinoff because D would not have distributed stock constituting control (at least 80 percent) of C. Gain would be recognized to D upon the distribution of the remaining 75 percent of the C stock with respect to P‘s stock in D.

The IRS’s Ruling

According to the IRS, the determination of whether steps of a transaction should be integrated requires a review of the scope and intent underlying each of the implicated provisions of the Code. The tax treatment of a transaction generally follows the taxpayer’s chosen form unless: (1) there is a compelling alternative policy; (2) the effect of all or part of the steps of the transaction is to avoid a particular result intended by otherwise-applicable Code provisions; or (3) the effect of all or part of the steps of the transaction is inconsistent with the underlying intent of the applicable Code provisions.

The IRS noted that the Code’s spinoff rules permit the direct and indirect acquisition of an active trade or business by a corporation, within the 5-year period ending on the date of a distribution, in transactions in which no gain or loss was recognized. The intent of the rule is to prevent the acquisition of a trade or business by the distributing corporation or the controlled corporation from an outside party in a taxable transaction within the 5-year pre­distribution period; this ensures that transfers of assets in transactions eligible for nonrecognition treatment throughout the 5-year period will not adversely impact an otherwise qualifying spinoff.

The transfer of property permitted to be received by D in a nonrecognition transaction has independent significance when undertaken in contemplation of a spinoff distribution by D of stock of a controlled corporation. The transfer, the IRS ruled, is respected as a separate transaction, regardless of whether the purpose of the transfer is to qualify the distribution as a spinoff. Back-to-back nonrecognition transfers, the IRS continued, are generally respected when consistent with the underlying intent of the applicable Code provisions.

P‘s transfer on Date 1 is the type of transaction to which nonrecognition treatment is intended to apply. Analysis of the transaction as a whole does not indicate that P‘s transfer should be properly treated other than in accordance with its form. The IRS observed that each step provides for continued ownership in modified corporate form. Additionally, the steps do not resemble a sale, and none of the interests are liquidated or otherwise redeemed; the transferor retained beneficial ownership in the assets transferred to the first corporation. On these facts, nonrecognition treatment under the above rules is not inconsistent with the Congressional intent of these Code provisions. The effect of the steps is consistent with the policies underlying these nonrecognition provisions.

Accordingly, the IRS held, the Date 1 and Date 2 transfers would be respected as separate transactions for federal income tax purposes, and both would be accorded nonrecognition treatment.  Moreover, the federal income tax consequences would be the same if, instead of acquiring an active trade or business as a contribution to capital from P, D acquired an active trade or business from another subsidiary of P in a cross-chain reorganization (for example, by way of a merger with a sister corporation).

Thus, the transfer by P to its subsidiary, D, of property constituting an active trade or business for the purpose of meeting the spinoff requirements, immediately followed by the distribution by D to P of the stock of its controlled subsidiary, C, is treated as a tax-free contribution of property, followed by a tax-free spinoff of the C stock.

Beyond the Ruling

An IRS revenue ruling is an official interpretation by the IRS of the Code and the regulations promulgated thereunder. It represents the conclusion of the IRS on how the law is applied to a specific set of facts. Thus, it may certainly be relied upon by a taxpayer in a situation similar to the one described in the ruling.

The factual situation from the revenue ruling described above is fairly straightforward. Nevertheless, taxpayers should be pleased with the ruling’s conclusion that the capital contribution and the subsequent spinoff distribution will be respected as two separate nonrecognition transactions even though they represented integral parts of a single plan.

The key to the IRS’s holding is the fact that the two steps did not resemble a sale; rather, the business assets remained in corporate solution under the same beneficial ownership.

Furthermore, the steps did not violate the overall purpose of the spinoff rules, which is to prevent “devices” that are designed to bail out corporate profits; indeed, the active trade or business test is another element of this anti-dividend-device purpose of the rules. One should not lose sight of this purpose when examining the various nonrecognition requirements for a spinoff.