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Our Perspectives

Personal goodwill & Martin Ice Cream Co. v. Commissioner

11/10/2020

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The concept of goodwill and the use of goodwill as an intangible asset in mergers, acquisitions, and asset sales has existed for decades, and its use by businesses has generated a non-insignificant amount of legal scholarship and corporate doctrine. However, prior to 1998, the only form of goodwill recognized by courts was the already well-known corporate goodwill. On March 17, 1998, that changed when the Tax Court delivered its opinion on Martin Ice Cream Co. v. Commissioner, a case dealing with a the valuation of assets and a claim by the IRS that the petitioner, Martin Ice Cream Company, had underreported the amount of taxes owed following an asset sale of the company’s assets to Haagen-Dazs Co., Inc.

Martin Ice Cream Company was a father-son business operated out of Bloomfield, New Jersey, that distributed ice cream to the many supermarkets and grocery stores in the area. (See Martin Ice Cream Co. v. Commissioner, 110 T.C. 189, 191-92 (1998)). The father, Arnold Strassberg, had begun a small side-business of selling wholesale ice cream products to grocers in the Newark area after the end of World War II, and by the 1960’s Arnold had developed personal and professional relationships with many of the large supermarket chains that catered to the area. In 1971, Arnold and his son Martin entered into a venture together following a falling-out between Arnold and his main supplier which they named Martin Ice Cream (MIC), and in 1974 the founder of the newly-formed Haagen-Dazs sought out MIC in a bid to use Arnold’s extensive experience in the distribution industry to turn Haagen-Dazs into a well-known brand. In 1988, following several offers by Haagen-Dazs to purchase MIC and disagreements between Arnold and Martin regarding the direction of the company, MIC agreed to spin-off the assets of MIC, including its supermarket distribution rights, in a sale to Haagen-Dazs; in addition to the assets of MIC, Haagen-Dazs also purchased exclusive rights to the expertise, consulting skills, and industry knowledge of Arnold so as to prevent Arnold from competing against them and to express gratification for Arnold’s role in making Haagen-Dazs a national brand. The final bill of sale contained an itemized list of all assets purchased from MIC, the price for each asset, and included a clause including in the sale ". . . and other business records as requested by Buyer, and the goodwill associated therewith."

Following the conclusion of the sale, MIC was required to pay taxes on the gain from assets sold to Haagen-Dazs, and when calculating the amount owed to the IRS the company did not include the amount that was paid to Arnold for the goodwill exchanged during the transaction; the IRS disputed this calculation and levied tax and a penalty on MIC for the full value of the sale amount, which included the exchange of goodwill between Arnold and Haagen-Dazs. However, the tax court disagreed with the IRS determination of tax and found for the first time that the goodwill exchanged between Arnold and Haagen-Dazs had never been owned by MIC, and characterized the goodwill as “personal” rather than “corporate.” 

In ruling that the goodwill that had been exchanged between Arnold and Haagen-Dazs was personal rather than corporate, the court effectively created a new type of asset, but was now required to differentiate between corporate goodwill and personal goodwill. In order to differentiate between the two types of goodwill, the court highlighted a number of factors that set personal goodwill apart from corporate goodwill. First, personal goodwill is based on the relationships created by individuals through the course of their work in a field and generally consists of personal connections to other individuals, industry experience, and industry reputation. Personal goodwill can be created prior to, during, or after working in a particular field, and can also extend into other fields. Second, personal goodwill is differentiated from corporate goodwill in the way that it is transferred; while corporate goodwill can be transferred through a typical asset transfer, a holder of personal goodwill must sign some form of a covenant not to compete. These restrictive covenants can take the form of a traditional covenant not to compete or even employment agreements, but must clearly transfer the intangible assets of the individual to either their employer or any potential buyer. Absent any such agreement, the personal goodwill of an individual remains the property of the individual, and can be used or disposed of however that individual sees fit.
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In addition to creating a new form of goodwill, the decision in Martin Ice Cream generated a larger body of law centered around personal goodwill. Numerous cases have been decided in the years following that expanded on the tax court’s Martin ruling, such as Norwalk v. Commissioner (
Norwalk v. Commissioner, 76 T.C.M. 208 (1998)) and Lopez v. Lopez. (In re: Marriage of Lopez, 113 Cal. Rptr. 58 (38 Cal. App. 3d 1044 (1974)). Personal goodwill has also developed as an interesting tax advantaged tool that corporations will use in asset sales and mergers to avoid the issue of double taxation resulting from the deal. Corporations and corporate leaders contemplating mergers or acquisitions should familiarize themselves with this useful and interesting asset due to the many benefits it provides, and the experienced attorneys and professionals at B.J. Kang Law, P.C. are available to assist and counsel you through all aspects of a transaction.
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Denial of Business Expense Deduction for Executive’s Acquired Shares Affirmed by Fourth Circuit

1/11/2017

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For most of us, the days following the New Year were filled with introspection, one or two remaining holiday/New Year’s parties, and plenty of hunkering down as a cold front swept through the country.  The start of 2017 for QinetiQ U.S. Holdings, Inc. & Subsidiaries (“QinetiQ” or “Acquiring Co.”), a technology-based solutions and products company that offers support services to defense, security, and related markets, was, unfortunately, not so mundane.  QinetiQ was recently forced to deal with a January 6, 2017, Fourth Circuit decision affirming the Service’s denial of QinetiQ’s Internal Revenue Code (the “Code”) § 83(h) deduction, for stock issued to its officers (the “DTRI Stock”), as well as the $117,777,501 in additional taxable income that must be recognized (a natural consequence of the Fourth Circuit’s decision).

Section 83(a) of the Code generally treats [stock] transferred "in connection with the performance of services" as "gross income of the person who performed such services."  The person who receives such stock, in exchange for their services, generally recognizes the receipt of the stock as income in the year the stock is transferred.  Employer is then entitled to a deduction, in the amount that is recognized as income by the recipient, in the same year that recipient employee captures the receipt of stock as income.  This general rule, however, is greatly modified when the stock received by employee, in connection with employee’s services to employer, is subject to a substantial risk of forfeiture.  In such an instance, employee is allowed to delay the recognition of income until the year in which the substantial risks of forfeiture lapse.  Employer’s deduction under § 83(h), accordingly, must also be delayed until the substantial risks of forfeiture lapse.  This delay allows employer’s ordinary and necessary business expense deduction, under §§ 83(h) and 162, to occur in a year (potentially much) later than the year in which the stock was “transferred” and for an amount (potentially much) greater than the FMV at the time of the initial “transfer.”

In 2008, QinetiQ entered into negotiations to acquire Dominion Technology Resources, Inc. (“DTRI”) vis-a-vi a stock acquisition (“M&A Plan”).  As part of the M&A Plan, QinetiQ agreed to purchase all outstanding DTRI stock for $123,000,000 (the outstanding DTRI Stock was primarily owned by two DTRI executives).  Initially, pursuant to the M&A Plan, the two major DTRI shareholders executed consent agreements waiving DTRI's rights with regards to DTRI Stock transfer restrictions (“Consent Agreements”).  Such restrictions were put in place as part of the initial 2002 transfer of stock to the two executives.  The M&A Plan was eventually finalized and QinetiQ proceeded to deduct from its 2008 taxable income, pursuant to Code §§ 83(h) and 162, the fair market value of the DTRI Stock that was initially “transferred” to the two DTRI executives in 2002.  

QinetiQ’s rationale to make an ordinary and necessary business expense deduction for the DTRI Stock, in taxable year 2008, was based on its belief that there was a substantial risk of forfeiture attached to the executives’ DTRI Stock, from 2002 through 2008, but that such risk of forfeiture, after execution of the Consent Agreements, had lapsed.

The Service, however, concluded that the DTRI Stock was never subject to an actual substantial risk of forfeiture.  The Service determined that the DTRI Stock should have been previously included in the executives’ 2002 taxable income and, thus, tax year 2002 was when DTRI would have been allowed a deduction pursuant to § 83(h). The Fourth Circuit proceeded to examine the facts and circumstances surrounding the 2002 DTRI Stock transfer and ultimately upheld the denial of the deduction.  The Fourth Circuit found that the record showed: (i) that under the DTRI Stock transfer agreements, DTRI would have been required to pay the executives the fair market value of the stock if the stock was forfeited for almost any reason (such is not indicative of an actual substantial risk of forfeiture); and (ii) the sole event dictating actual forfeiture of DTRI Stock, for less than fair market value, would unlikely have been enforced by DTRI since the executives’ had majority control of DTRI and had a strong working relationship with one another.

We all remember the good old days of the fast-track IPOs (which would allow founders to continue to grow their companies and build their legacy within such company). An IPO, naturally, is much more attractive than exit through merger and acquisition. However, sometimes we must face reality. Startups will likely, eight-out-of-ten times, remain unprofitable private ventures, be acquired through an acquirer, or pivot and merge into a new business that is a far more profitable venture.  For these reasons, in order to have the most attractive opportunity possible when contemplating and planning an exit through merger and acquisition, entrepreneurs have to start paying more attention to § 83 of the Code and the necessary requirements that must be followed in order to take full advantage of Code § 83.


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Intro to Stock Options

12/30/2015

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Oftentimes a business desires to compensate key employees with equity. There are several tools to accomplish this, including restricted stock, restricted stock units, stock appreciation rights, and employee stock purchase plans. Each of these plans is designed to compensate an employee through some special consideration regarding the terms or price of a company’s stock. But the stock option is by far the most common of these tools.

If you are granted a stock option, what you have is a right to buy a certain amount of shares at a fixed price for a set number of years. The price is fixed at the grant. For example X Inc. may give you the option to buy up to 1000 shares of X Inc. stock at $10/share, with the options having a term of 6 years (the option may be held for 6 years before expiring). The exercise of options is usually restricted through a vesting schedule, companies will usually either set time-based vesting schedules or have the options vest once some goal or metric is met (often times a combination of both of these is used). For example, your options may be subject to a four (4) year vesting period, but could be set to fully vest earlier if you sell $1 million worth of X’s product.

Because an option is a right to buy, you do not have to pay the purchase price when the option vests, only when you exercise it. For instance, if all 1000 of your options vest in Year 1 at a $10/share price, you do not have to pay anything yet. In Year 2, the price of X’s stock goes down from $10/share to $8. In this case you would not want to exercise your options because you would be paying $10/share and receiving only $8/share in value, taking a loss of $2/share. If in Year 5 the stock goes up to $25 a share, you may choose to exercise your options and pay $10 for each option you chooses to exercise. This payment can be made in different ways: in cash, by liquidating some of the options, etc... The spread on this exercise, the difference between the exercise price of the option ($10) and the fair market value of the stock at the time of exercise ($25), would be $15 (as oppose to a negative $2 spread if you exercised in Year 2).

The tax consequences of exercising the option depend on the type of stock option plan A is a part of.

Types of Stock Options

There are two types of Options: nonqualified stock options (NSOs), sometimes also referred to as nonstatutory stock options, and incentive stock options (ISOs).

An NSO is any stock option which is not an ISO. When you exercise an NSO the spread is taxable as ordinary income even if the shares have not been sold, but any subsequent gain or loss is treated as capital gain or loss when the shares are sold. If the spread on your exercise of an NSO is $1,000,000, for example, that could mean up to $350,000 in tax liability without your actually having gotten any cash from the NSO. On the upside, a corresponding amount is deductible by the company issuing the NSO. NSOs are also more flexible in that there is no required holding period (although the company may impose one).

An ISO gives you the benefit of having all gain, including the spread, treated as capital gain, and deferring tax on options until the shares are actually sold. Although an ISO seems like a no-brainer, on the down side the company does not get to take a tax deduction, there may also be Alternative Minimum Tax (AMT) repercussions upon the exercise of ISOs, and it may be difficult to qualify for ISO treatment. In order for an option to qualify as an ISO, several conditions must be met:

  1. You must hold the stock for at least two years after the grant of an option and one year after exercise
  2. Only $100,000 of stock options may become exercisable in a calendar year, as measured by the fair market value of the option on the grant date.
  3. The exercise price must be at least the fair market value of the company’s stock on the date of the grant. (See IRC 409A)
  4. ISOs may only be issued to employees
  5. The option must be granted pursuant to a written plan approved by shareholders. The plan must specify the option pool size and the class of employees eligible to receive options. Options must be granted within ten (10) years of the board of director’s adopting the plan.
  6. Options must be exercised within ten (10) years of the grant date.
  7. If an employee owns more than 10% of the voting power of all outstanding stock of the Company at the time of the grant, the exercise price must be at least 110% of the fair market value of the stock on the grant date and must have a five (5) year or shorter term.

It is important to carefully structure stock options and stock option plans in a manner that maximizes your net benefit, taking into account their effects on both the grantor (the company) and the recipients (the employees/executives). Oftentimes this means lowering your tax bill using an ISO while making sure not to run into the AMT, but sometimes the deductibility and flexibility of an NSO is the best decision for your business.
    

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Are you planning to buy a business in Maryland?

10/2/2015

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Unbeknownst to most buyers and sellers of businesses in Maryland (as well as New York and a handful of other states), MD law requires the buyer and seller of all or a substantial amount of a business's assets, when the asset sale is “not in the ordinary course of the transferor’s business,” to: (1) comply with a list of notice requirements (not the subject of this article); and (2) pay a 6% sales and use tax on the price of tangible personal property that is sold as part of a sale of a business.

The Bulk Sales tax applies to a business’s tangible personal property, such as furniture and fixtures, business records and customer lists, computer software, and non-capitalized goods and supplies. The Bulk Sales tax does not apply to a business’s real or intangible assets, most importantly intellectual property, goodwill, cash, or accounts receivable, and it does not apply to a business’s inventory as such inventory will be subject to Maryland sales and use tax when it is eventually sold to the business’s customers.

Consequently, this 6% sales and use tax can, unfortunately, be quite costly and often comes as a surprise to the buyers and sellers of a business. Buyers of business tax when a business sale is structured as an asset sale, as opposed to a sale of a business’s stock or eqsses, rightfully so, generally favor structuring the purchase and sale of a business as an asset sale. These buyers receive a stepped-up tax basis in the assets they purchase, avoid hidden liabilities and legal exposure that attach with simply purchasing an existing business’s equity, and are able to amortize goodwill. However, as we see time-and-time again, these same buyers (and sellers) frequently overlook the sales and use tax implications that specifically result from structuring the transaction as an asset sale.

Simply having knowledge of the existence of this additional 6uity, can be quite beneficial for both parties. With such knowledge and foresight of the impending Bulk Sales tax, the buyer and seller can avoid penalties and interest that arise from not paying the tax, can arrange and negotiate how to allocate the sales tax into the purchase price of the business assets, and can ultimately determine if it would be more beneficial to structure the purchase and sale of a business in a different manner.

For questions regarding the Bulk Sales Tax, please contact us at (703)-595-2836 or admin@bjkanglaw.com

MD Comm. Law § 6-102(1).
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TOO GOOD TO BE TRUE?: 100% EXCLUSION ON QUALIFIED SMALL BUSINESS STOCK (QSBS)

6/19/2015

 
On December 19th, 2014, President Barack Obama signed into law the 2014 Tax Increase Prevention Act (“TIPA 2014”). §1202 of the Internal Revenue Code previously allowed a 100% capital gain exclusion for Qualified Small Business Stock (“QSBS”) purchased in parts of 2010 up until December 31st, 2013. TIPA 2014 subsequently extended §1202’s 100% exclusion  for QSBS to such stock purchased on, or before December 31st, 2014. There is no indication yet of whether the exclusion will be extended yet again, but Congress has seen fit to extend it three times so far.

What does this mean practically speaking? Founders, along with others with original issue stock, can get a possible 0% effective tax rate on gains from the sale of all or part of their business, as long as the acquisition and sale of the business was, and is structured properly. Do not feel too let down, however, if your stock does not fall into the 100% exclusion period, you may still be eligible for a 50%, 60%, or 75% exclusion under §1202.

Qualified Small Business

Qualified Small Businesses are generally the only entities who can issue QSBS. A Qualified Small Business is (1) a domestic C corporation (but not a Disc, RIC, REIC, REMIC, Cooperative, or various other corporations); (2) whose aggregate gross assets before issuance, and up until immediately after issuance, do not exceed $50,000,000; (3) which agrees to submit any reports as required by the IRS (no reports are currently required); and (4) which is engaged in an active business during substantially all of a taxpayer’s holding period of the QSBS.

The active business requirement is met if 80% or more of the corporation’s assets are used by the corporation in actively conducting certain qualified trade or business. A business or trade is generally qualified for the purposes of §1202 if it does not involve: (1) the provision of one of several services (i.e. law, accounting, or engineering), or (2) doing business in any one of several industries (i.e. farming, banking, and oil and gas).

Qualified Small Business Stock

Stock is considered QSBS if it is original issue stock (not previously owned) in a qualified trade or business, received in exchange for money or property (other than stock), or as compensation for services to the corporation (other than services as an underwriter of the stock).

Finally, for the exclusion to qualify as to your gain the stock being sold must have been held for more than five years.

California’s QSBS

California has its own similar 50% exclusion at the state level, set out in  Revenue & Taxation Code §18152.5. The main difference is the requirement that the corporation have at least 80% of its payroll be attributable to employment in California at the time the stock is issued. Unfortunately §18152.5 does not apply to sales made after January 1, 2013. However, if you sold your stock before 2013 but are still taking installment payments for that sale, you may be eligible for the 50% exclusion.

For advice on whether your business may be a Qualified Small Business, or if you have Qualified Small Business Stock, it is recommended that you contact a professional who is qualified to render such counsel.


Nonprofit Income from a Convention or Conference: UBIT or not?

7/19/2013

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Technology has changed how we communicate in our business and personal lives. Even if you have not met a single friend for a month or two, you can still have thousands of FaceBook friends.

You did not meet a person during the day? Not an issue. You know what is going on with other people by following their Twitter accounts.

Overbooked professionals or businesses on a budget will routinely look for  alternatives to meetings in person in the realm of technology, such as Skype or similar teleconferencing ideas.  These new technologies seem to makes our social and business lives richer at a cheaper cost Then, why do many nonprofits still spend a significant amount of resources to periodically organize large conferences, conventions, or trade shows?

I believe it is because nonprofit people understand the importance of fun and the value of play in building a community. At least, all the people I have met in the nonprofit industries have understood the importance of the entertaining features of their services to members and supporters. As Johan Huizinga, a Dutch historian, once put it in his book Homo Ludens, the play aspect is a necessary condition to produce a culture.

Whether a nonprofit’s mission is to protect animal rights or to amplify an occupational group’s voice in society, your organization won’t be successful with dry or boring program activities. Constrained professionalism will not generate the “culture or vibe” to attract members or supporters. Our tax code reflects this same reality.

According to the IRS, convention and trade show activities, when carried on by a qualifying organization in connection with a qualified activity, will not be treated as unrelated trade or business.[1]

In order for a convention activity to be considered qualified, the  organization must sponsor the activity for the “promotion and stimulation” of interest in products and services that are either common in the industry or related to the exempt activities of the organization.[2]

[1] Treas. Reg. §1.513-3.

[2] Internal Revenue Code §513 (d)(3)(B).
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Calculating Nonprofit Income from Membership Journals

7/19/2013

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Last week, we spoke a little about how to factor in an income from periodicals for your nonprofit.

The first issue is to find how much you need to allocate the membership income to journal income. The sales price of the subscription without membership was $60.00. However, the discount that members received for not receiving the journal was $50.00. If you were once a math person, the answer that you came up with will be one of the following three.

(1)   $60.00 x (600 Members with subscription + 300 Subscription only) = $54,000.

(2)   ($50.00  x 600 Members with Subscription) + ($60 x 300 Subscription only) = $48,000

(3)   (40% x $100 x 600 Members with subscription) + ($60 x 300 Subscription only) = $42,000

These three answers are all correct in a sense. However, we are dealing with this issue in the context of Form 990, which is governed by specific code and rules.[1] To get a correct answer, you should be a good reader of the legal rules too.

The rule can be summarized like so:

  1. When 20% or more of the total circulation consist of sales to nonmembers, the nonmember price is used to calculate the journal income.

  2. If the first condition is not applicable and 20% or more members pay reduced due by electing not to receive the journals, the reduction in dues for a member is used to calculate the journal income.

  3. If neither of these two conditions is applicable, the membership receipt is multiplied by the ratio of periodical cost vs. Sum of periodical cost and other exempt activities cost.

Based on this rule, our example Associations’ journal income should be (1) $54,000.

The subscription sale was only 300 out of 900, so it was more than 20% of total subscription sale. Therefore, the first condition was applied, and the subscription price is assumed to be at $60 for all 900 subscription sales.

You should be wary though, as you might get confused with the second condition. More than 40% of members of the Association here have elected not to receive the journal.  The second condition, therefore, seems to be satisfied too, right? Or since the first and second conditions are both met, should we not just use the third method or any choice among the three?

Let me get back to the correct reading of the rule. The second rule clearly says that it is applicable “only when” the first condition is not satisfied. [2] Therefore, when the first condition is met, the second and third rules are not applicable. Therefore, we don’t even have to look into the second and third condition.

If you’ve made it this far, I salute your patience. You are one of few who are not allergic to the complication of legal math. Trust me. Many people are allergic to math. If that’s not the case, they are likely allergic to the laws. If neither is the case, they certainly hate complicated issues.

[1] 26 CFR 1.512(a)-1(f)(4)(i) to (iii).

[2] See 26 CFR 1.512(a)-1(f)(4)(ii) that the rule reads quite complicated. (Subscription price to nonmembers: If paragraph (f)(4)(i) of this section does not apply and if the membership dues from 20 percent or more of the members of an exempt organization are less than those received from the other members because the former members do not receive the periodical, the amount of the reduction in membership dues for a member not receiving the periodical shall determine the price of the periodical for purposes of allocating membership receipts to the periodical).

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Membership Organizations with Journals

7/19/2013

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A question for a membership organization with journals: How much is your journal subscription income when a subscription is offered as a part of the membership benefit?

When you sell a subscription of periodicals separately from  membership, the price is usually set higher than the one that includes membership. The reasoning for this is that generally we give more benefits to members or to attract more people to become members. The question is how do we calculate the journal income with these two different price tags for Form 990 and 990-T.

To give you more detailed view of this situation, let me set up an imaginary membership association,  called National Caffeinators Association.

Membership and Benefits: The membership is offered to coffee shop owners at $100.00 per year, and its membership benefits include a one-year subscription of quarterly journal, Coffees R Us.  The quarterly journal gives you the newest information about roasting, brewing, and serving coffee.

Price Structure and Sale: If a member opted not to receive journals, the member pays $50.00 instead of $100. The journal subscription for sale is separate from the membership at the organization’s website, Amazon.com, and many bookstores at $60.00. The Association had 1,000 members in 2011 and 400 of these members elected not to receive the journals. The Association sold 300 subscriptions separately from the membership in 2011.

Journal Publication Cost: The publication cost of the quarterly journal is about 40% of the association’s cost including publication cost and other exempt activities cost.


Can you calculate the 2011 income from the sale of journal subscription?

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    ​B.J. Kang JD, CPA
    Josh Portman JD, LL.M
    Habeeb Syed JD
    Nora Ji Li LL.M
    Nathaniel S. Johnson

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