Florida Tax Attorney Blog

Often, a divisive D reorganization precedes a Section 355 spin-off for the reason that the corporation must first segregate the assets and liabilities of the business to be spun off in a separate entity before it can spin off the business. Thus, the spin-off is actually comprised of two steps. Step 1: the parent corporation ("P") transfers the assets representing the business to be spun off to a subsidiary corporation ("S") in exchange for consideration including stock of the subsidiary. Step 2: P spins off the business by distributing the S stock received in the exchange to its shareholders so that after the transaction, the P shareholders own stock in two corporations: P and S.

The corporate level exchange that occurs in step 1 is governed by I.R.C. § 361. In this respect, P recognizes no gain or loss if it receives back solely corporate stock or securities. I.R.C. § 361(a). But often, the consideration consists of cash or "boot" in addition to stock or securities of S. One way to avoid gain recognition despite the receipt of boot is for P to distribute the boot received to its shareholders or creditors under I.R.C. § 361(b). With respect to the latter, an interesting question arises in the context of defeasance.

Defeasance

Defeasance is a financial accounting concept whereby a company can eliminate indebtedness from its financial statements without actually paying it off. At the most basic level, the company establishes an independent trust which is funded with high-grade government securities (AAA). Upon maturity, those securities will be sufficient to satisfy the entire amount of the debt. In essence, then, the company is collateralizing its debt with government securities rather than satisfying them. In any event, if properly structured, the company may treat the collateralized indebtedness as satisfied for financial accounting purposes. Such treatment allows the company to remove the liability represented by the collateralized indebtedness from its financial statements (with a corresponding reduction in assets, of course) which, in turn, favorably impacts financial ratios. That's the financial accounting treatment. But financial accounting and tax consequences often vary.

Is Defeasance a Distribution to a Creditor Under I.R.C. § 361(b)?

In the spinoff context, the question ultimately becomes whether use of the cash boot to collateralize a debt as described above constitutes a distribution to a creditor under I.R.C. § 361(b) which purges the transaction of the boot taint and preserves non-recognition treatment. It depends.

More specifically, it depends on the type of defeasance involved. As a matter of law, there are two types of defeasance: (1) legal defeasance; and (2) covenant (aka in substance) defeasance. In the case of a legal defeasance, the creditor no longer has a claim against the debtor corporation once the securities have been deposited into the trust. That is, the debtor corporation is released from liability, and the creditor must look solely to the trust for repayment. In the case of a covenant defeasance, on the other hand, the corporate debtor remains technically liable for the debt. That is, while the debt will be repaid from the trust, privity remains between the debtor corporation and the creditor such that the debtor corporation remains liable on the debt despite the collateralization.

Because a legal defeasance results in extinguishment of the creditor's rights against the debtor corporation, the tax law treats a legal defeasance as if the corporate debtor used the assets which were used to fund the trust as currency to satisfy the debt. By contrast, because a covenant defeasance does not result in extinguishment of the debtor corporation's liability or the creditor's rights against the corporation, the tax law treats a covenant defeasance as not in repayment of the debt.

Conclusion

A legal defeasance is treated as a distribution to a creditor, but a covenant defeasance is not. Thus, P's use of the boot received to effect a legal defeasance is sufficient to purge the transaction of the boot taint and preserve non-recognition treatment. By contrast, P's use of the boot received to effect a covenant defeasance is not sufficient to purge the transaction of the boot taint, and P would be subject to gain recognition despite the defeasance.

St. Thomas University School of Law Young Alumni Association, Farrell & Patel Law Firm, and Neiman Marcus Bal Harbour recently teamed up with Miami Children's Hospital to raise in excess of $25,000 for the hospital! The Fashion Gives Back event featured cocktails, hor d'oeuvres, and the latest collections for men and women from the shops of Tom Ford, Gucci and other popular designers. I'm pictured above (second from the right) with two of my classmates from law school, Lincoln and Joey, and Lincoln's wife, Lori. We all had a great time for a great cause!

A recent article published by Soundings Trade Only Today, a news source for marine industry professionals, touted the success of Florida's $18,000 sales and use tax cap on boats purchased or brought into Florida. According to the article, Florida generated some $13.4 million in direct sales tax revenue from sales of tax-capped boats during 2011.

According to a joint study conducted by the Florida Yacht Brokers Association (FYBA) and the Marine Industries Association of South Florida, the marine sales tax cap, which was enacted in 2010, has impacted the maritime industry in two significant respects. First, the average sale price for post- sales tax cap transactions was about $907,000. This figure represents nearly twice the average pre- sales tax cap. Second, out-of-state closings (presumptively to avoid sales tax) dropped from 21.5 percent to 12.8 percent.

In light of the success of the marine sales tax cap, a spokesman for FYBA stated that "setting a reasonable tax basis for high dollar purchases provides an incentive for more boats to be purchased, provisioned and kept plying the waters of Florida." Of course, this is a basic principle of tax policy in general. Unfortunately, however, this fundamental principle seems to have been forgotten in this new "occupy Wall Street" era of proposed "millionaire's taxes."
Aside from the inherently unresolvable policy issues associated with a millionaire's tax (e.g., class warfare, enhancing the social gap while only minimally closing the economic gap between the rich and the poor), raising taxes leads to decreased spending. While this may be less true with respect to inelastic items such as food, housing, and transportation, it cannot be debated with respect to more elastic luxury items . By contrast, reducing taxes stimulates the economy by boosting spending.

On the surface, one might be unsympathetic to the plight of the white-collar tax payer who is required to reduce his or her discretionary spending on luxury items such as boats, traveling, dining out, etc. But in the end, it all comes back to the middle-class because it is the middle class who will inevitably bear the incidence of a millionaire's tax. It is the middle-class who work in the shipyards where the boats are manufactured and the boat dealerships and brokerage houses where the boats are sold. It is the middle class who work and operate the upscale restaurants in which the wealthy dine. It is the middle class who repair and sell the Bentleys, Mercedes, and Porsches which the wealthy drive. The list goes on and on.

Moral of the Story: Love them or hate them, the spending habits of the wealthy keep many Americans employed. So don't kill the goose that lays the golden egg.

The Florida maritime sales tax cap is compelling evidence of the longstanding and well-established principle that reasonable levels of taxation stimulate economic growth. With that being said, other areas of government - both local and federal - would be well-advised to follow the Florida maritime industry's lead.

Two new questions appear on the corporate tax return (Form 1120) for the 2011 tax year:

(1) Did the corporation make any payments in current year that would require it to file Form(s) 1099?

(2) If "Yes," did the corporation or will the corporation file all required Form(s) 1099?

These questions are found on Schedule K as items 15a and 15b, respectively.

So what's this all about?

In 2010, Congress expanded 1099 reporting requirements and increased penalties for failure to file required 1099s when it enacted The Small Business Jobs Act (PL 111-240) and the Patient Protection and Affordable Care Act (PL 111-148). The specific 1099 reporting expansions which each Act effectuated are not important because both expansions were repealed in 2011 when the Comprehensive 1099 Taxpayer Protection and Repayment of Exchange Subsidy Overpayments Act of 2011 (more commonly known as the "1099 Act") was signed into law.

As a result of the repeal, the 1099 reporting rules remain largely unchanged for the 2011 tax year. Pursuant to I.R.C. § 6041(a), "[a]ll persons engaged in a trade or business and making payment in the course of such trade or business to another person" of $600 or more must report the amount and the name and address of the recipient to the IRS and to the recipient. The Code applies this requirement to payments of "rent, salaries, wages, premiums, annuities, compensations, remunerations, emoluments, or other fixed or determinable gains, profits, and income," and the Treasury regulations add, "commissions, fees, and other forms of compensation for services rendered aggregating $600 or more" as well as interest (including original issue discount), royalties and pensions. Treas. Reg. § 1.6041-1(a)(1)(i).

Note, however, that the 1099 Act did not operate to repeal the increased penalties for failure to file a required 1099. Under the Small Business Jobs Act, the first-tier penalty under I.R.C. § 6721 for failure to timely file an information return was increased from $15 to $30, and the calendar-year maximum was increased from $75,000 to $250,000. The second-tier penalty was increased from $30 to $60, and the calendar-year maximum was increased from $150,000 to $500,000. The third-tier penalty was increased from $50 to $100, and the calendar-year maximum was increased from $250,000 to $1,500,000. For small business filers, the calendar-year maximum increased from $25,000 to $75,000 for the first-tier penalty; from $50,000 to $200,000 for the second-tier penalty; and from $100,000 to $500,000 for the third-tier penalty. The minimum penalty for each failure due to intentional disregard of the reporting requirement was increased from $100 to $250.

The retention of the enhanced penalties, together with Schedule K's explicit inquiry regarding 1099 reporting obligations tends to suggest an intent on the part of the Treasury to crack down on the enforcement of the1099 reporting requirements. Thus, items 15a and 15 b on Schedule K appear to be an unsubtle reminder to businesses of their 1099 reporting obligations.

Key Takeaway: The IRS has indiciated an intent to crack down on enforcement of 1099 reporting requirements. So make sure your business complies with all relevant 1099 reporting requirements for the 2011 tax year.