Federal Income Tax Update

Keith, a white man with brown hair, wears wire-rimmed glasses, a white shirt and black jacket.By Keith A. Wood

This is the first of three installments of this article. 

I. Audit Statistics: What Are Your Chances of Being Audited?

The 2021 Internal Revenue Service Data Book contains audit statistics for 2011 through 2019. Below are audit statistics for 2019 returns:

A. Audit Rates for Individual Income Tax Returns. During FY 2021, only 0.2% of individual income tax returns filed in 2019 were audited (about the same as for 2018 returns).

Total individual returns audited:    0.2%

(1) With no positive income             8%
(2) $100,000 to $500,000                 1%
(3) $500,000 to $1 Million                3%
(4) $1 Million to $5 Million               6%
(5) $5 Million to $10 Million            1%
(6) $10 Million or More                    2%

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Transferee Liability Under Section 6901

John, a white man with brown hair and blue eyes, wears a blue jacket, white shirt, and blue tie. By John G. Hodnette

In general, operating a business through an entity can provide limited liability in the event the entity is insolvent or goes out of business. Limited liability applies even to business taxes owed by an entity such as a C corporation. Some taxpayers have attempted to take advantage of that by causing a corporation to transfer to its shareholders assets that should be used to pay taxes. Such shareholders liquidate the corporation and ignore IRS attempts to collect. Absent Section 6901, the IRS might have no ability to collect the corporate taxes from the owners of the corporation.  However, Section 6901 imposes transferee liability on the owners of the business who received such assets. Read more

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Taxation of Noncompete Agreements

John, a white man with brown hair and blue eyes, wears a blue jacket, white shirt, and blue tie. By John G. Hodnette

Purchasers of a successful business have the reasonable concern that the prior owners will use their expertise to open a new business across the street that immediately competes with the one they just purchased. Noncompete agreements are key to ensuring that does not happen. How is the consideration paid for the noncompetition agreement treated under the tax law for both the seller and the purchaser?

A seller may expect, particularly in a stock sale, the cash allocated to a noncompetition covenant will be taxed as long-term capital gain, like the proceeds from the sale of stock. However, payments received for a noncompetition agreement are actually taxed as ordinary income. Therefore, the seller will want to allocate as little as possible to the noncompete and instead maximize the allocation to the stock (in the case of a stock sale) or to goodwill (in the case of an asset sale). In both cases, that allocation will generally result in long-term capital gain, which is taxed at lower rates than ordinary income. Read more

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You Cannot be Both an Employee and a Partner of a Partnership

John, a white man with brown hair and blue eyes, wears a blue jacket, white shirt, and blue tie. By John G. Hodnette

A person who is both an employee and a partner in a partnership is not treated as an employee for tax purposes. Rev. Rul. 69-184 states “bona fide members of a partnership are not employees of the partnership [for employment tax purposes because a partner is] a self-employed individual.” An employee will generally be treated as a partner if he or she (a) receives a profits interest, (b) receives a vested capital interest, or (c) makes a Section 83(b) election. Read more

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Wells Hall Becomes Chair of the ABA Section of Taxation

By Herman Spence III

Our colleague Wells Hall is now the chair of the ABA Tax Section. Congratulations Wells! Wells is an attorney with Nelson Mullins and a long-time mainstay of the North Carolina Bar Tax Section.

Recently Wells publicly defended appropriate funding of the IRS. We appreciate Wells’ principled position, notwithstanding the temptation to demonize the IRS.

Herman Spence III is an attorney with Robinson Bradshaw in Charlotte.

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What is an IC-DISC?

John, a white man with brown hair and blue eyes, wears a blue jacket, white shirt, and blue tie. By John G. Hodnette

An interest charge domestic international sales corporation (“IC-DISC”) is a special tax exempted domestic corporation that qualifies under Sections 991 through 994. The IC-DISC incentivizes (from a federal income tax perspective) exporting U.S. manufactured property. An IC-DISC is not the operating exporter but rather is a separate entity that receives a tax-free commission from the operating entity in an amount limited by the Code. This tax-free commission can produce valuable tax savings and deferral of income for qualifying exporters. Read more

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The Basics of F Reorganizations

John Hodnette is a man with brown hair and blue eyes. He is pictured wearing a dark blue jacket, white shirt, and pale blue and pink plaid tie. He is smiling and standing against a grey background.By John G. Hodnette

Among the tax-free reorganizations authorized by Section 368 is the F reorganization. Section 368(a)(1)(F) defines this type of reorganization as “a mere change in identity, form, or place of organization of one corporation, however effected.” This section prevents tax liability upon certain common changes in a business, including changes in a corporate name, reincorporation of a business in a new state, and changes of the form of the business for state law purposes that do not change the tax treatment of the business. F reorganizations are also valuable in certain complex transactions as a way to reposition companies as part of a merger or acquisition. Although the statute refers to one corporation, the legislative history explains more than one entity may be involved in the transaction so long as only one operating company is involved.

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Remembering Bob Mendenhall

By Wells Hall

Bob Mendenhall is a man with a grey beard and dark eyes. He is pictured smiling and wearing a white shirt, a black jacket and a red tie with a white pattern.

Bob Mendenhall

Bob Mendenhall, former Chair of the North Carolina Bar Association Tax Section, passed away on July 14, 2022, at the Charlotte Rehab Center, one day before his 68th birthday. His obituary is available here.

When I spoke to Bob shortly before his death, he told me about his surgery to remove a blood clot after a head injury resulting from a fall in late May. He knew that his recovery would take some time, but he looked forward to resuming his law practice at Holland & Knight in Charlotte. He shared with me his daughter Lauren’s summer plans prior to her junior year at Elon. He was so proud of her. Read more

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What is an Investment Partnership?

John Hodnette is a man with brown hair and blue eyes. He is pictured wearing a dark blue jacket, white shirt, and pale blue and pink plaid tie. He is smiling and standing against a grey background.By John G. Hodnette

As discussed in my January 12, 2022, blog post, Section 731(c) generally treats marketable securities as money in determining gain or loss on a distribution to a partner. Section 731(c)(3)(A)(iii) provides an exception in the case of marketable securities held by an investment partnership that are distributed to an eligible partner. But what is an investment partnership, and what is an eligible partner?

An investment partnership is defined by Section 731(c)(3)(C)(i) to mean “any partnership which has never been engaged in a trade or business and substantially all of the assets (by value) of which have always consisted of (i) money, (ii) stock in a corporation, (iii) notes, bonds, debentures, or other evidences of indebtedness, (iv) interest rate, currency, or equity notional principal contracts, (v) foreign currencies, (vi) interest in or derivative financial instruments (including options, forward or future contracts, short positions, and similar financial instruments) in any asset described in any other subclause of this clause or in any commodity traded on or subject to the rules of a board of trade or commodity exchange, (vii) other assets specified in regulations prescribed by the Secretary, or (viii) any combination of the foregoing.”
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Quid Pro Quo: Charity Disclosure Requirements

John Hodnette is a man with brown hair and blue eyes. He is pictured wearing a dark blue jacket, white shirt, and pale blue and pink plaid tie. He is smiling and standing against a grey background.By John G. Hodnette

Section 6115 imposes a disclosure requirement on charitable organizations that receive quid pro quo contributions in excess of $75. A quid pro quo contribution is a payment made partly as a contribution to the charity and partly in consideration for goods and services provided to the payor by the charitable organization. The disclosure by the charity to the payor must include (i) a statement informing the donor the amount of the contribution deductible for federal income tax purposes is limited to the excess of the amount of any money and the value of any other property contributed by the donor over the value of the goods or services provided by the donee organization, and (ii) a good-faith estimate of the value of the goods or services provided by the donee organization.

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