NW Tax Wire Tax Breaks for Oregon Partnerships, LLCs, and S - - PDF document

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2 More Flexibility for Reverse Exchanges 3 Is Oregon Charitable to Charities? Recent Developments From the Oregon Tax Court 4 Export Tax Incentive: The DISC Touches Down in Oregon

(continued on page 5)

Tax Breaks for Oregon Partnerships, LLCs, and S Corporations

In a special legislative session that adjourned on October 2, 2013, the Oregon legislature passed House Bill 3601, which provides for reduced personal income tax rates on non- passive, flow-through income from S corporations, partnerships, and lim- ited liability companies that are taxed as partnerships. This is income ordi- narily listed on Schedule E of the indi- vidual’s federal form 1040. Beginning January 1, 2015, individual taxpayers subject to Oregon personal income tax will be taxed at preferential rates of 7 to 9 percent (versus the top marginal rate of 9.9 percent) on the first $5 mil- lion of nonpassive income each year, depending on the level of income. To be eligible, a taxpayer must materially participate in the entity and there must be at least one nonowner employee. To determine what income is eligible for reduced rates, the statute refers to Internal Revenue Code Section 469, which is used to establish federal income tax limitations on passive-activ- ity losses and credits. If flow-through income or losses are subject to the limitations of Section 469, then that income or loss is not eligible to be in- cluded in the calculation of the reduced

• rates. Note that regardless of whether

income from a particular activity is subject to the Internal Revenue Code Section 469 passive-loss rules, there is an additional, potentially different Oregon requirement that the taxpayer “materially participat[e] in the day-to- day operations of the trade or business.” It is not clear from the statute how the Oregon “material participation” requirement differs, if at all, from the federal “active participation” test under Section 469. Eligibility for the reduced rates also requires that the entity employ at least one person who is not an owner, member, or limited partner of the partnership or S corporation, and that at least 1,200 hours of work in Oregon be performed during the tax year by the employee(s). Only hours worked in a week in which a worker works at least 30 hours may be counted toward that requirement. The statute appears to require employed personnel (versus independent contractors). The reduced rates will be automati- cally applied each year, but taxpayers can choose to elect out (to have regular rates apply), if that is more advanta-

• geous. The election can be made in any

year, is irrevocable, and is made on the taxpayer’s original Oregon income tax

• form. Once made, the election to accept

the reduced rates or apply regular rates will apply to all eligible income for that tax year. The reduced rates are applied

• n the net amount of all eligible non-

passive income, after applying eligible nonpassive losses. The reduced rates apply to nonresidents’ income earned in Oregon, and to part-year residents’ Oregon income, by first applying the reduced rates to all nonpassive income, and then multiplying by the ratio of the taxpayer’s nonpassive Oregon income to all nonpassive income. The decision whether to elect

• ut will require careful analysis of

a taxpayer’s situation each tax year. Why would a taxpayer not elect to take advantage of the lower rates? It appears that if the election is made, itemized de- ductions such as mortgage interest and

by William S. Manne

bill.manne@millernash.com 503.205.2584

2 | miller nash llp | NW Tax Wire

(continued on page 5)

More Flexibility for Reverse Exchanges

When the real estate market is hot, it can be a great time to sell real prop-

• erty. And because people don’t want to

pay tax unless they have to, it can be attractive to complete a 1031 exchange with the proceeds from the sale. But a hot real estate market can be a difficult time to buy real estate, and if a taxpayer sells real estate, it doesn’t necessarily mean that acceptable replacement prop- erty can be found within the timelines required by Section 1031. Private Letter Ruling 201416006, issued earlier this year, provides a little additional flex- ibility for taxpayers with multiple real estate holdings who complete a reverse 1031 exchange. Reverse exchanges are typically accomplished by complying with the “parking” rules in Revenue Procedure 2000-37. In a typical reverse exchange, a taxpayer will enter into a qualified exchange accommodation agreement (referred to as a “QEAA”) with an exchange accommodation titleholder (referred to as an “EAT”; this role is typically played by a single-member limited liability company formed by the 1031 accommodator). This approach can be used to ensure that the taxpayer isn’t under any time pressure to find and purchase replacement property, but replaces that risk with the fact that the exchange will fail if the taxpayer cannot find someone to buy his or her relin- quished property within the 180-day

• period. This structure also requires that

the taxpayer have the cash and financ- ing available to acquire the replacement property before the relinquished prop- erty is sold; for many taxpayers, this is a difficult hurdle to overcome. A typical reverse exchange can be illustrated as follows. Our taxpayer, Leonard, finds an apartment complex that he’d like to buy as investment property, and he also wants to sell his current investment duplex without paying tax. Leonard can sign a QEAA and have an EAT buy the apartment complex for him, and then Leonard can list his duplex for sale. If the duplex sells within 180 days after the apartment complex is purchased, he can complete the exchange and have the apartment complex serve as replacement prop- erty for his duplex. But if Leonard has multiple duplexes, owns them through various partnerships, and is willing to sell any of the duplexes as part of a 1031 exchange, it increases Leonard’s chances of completing a 1031 exchange if he can use whichever duplex sells first as the relinquished property in an exchange with the apartment complex. Private Letter Ruling 201416006 has

• pened the door to allow more flexibility

in designating relinquished property in reverse exchanges. The facts of Private Letter Ruling 201416006 can be illustrated as follows. Leonard owns three duplexes and also

• wns 51 percent of the Howard Leonard

Partnership and 51 percent of the Shel- don Leonard Partnership. Each of the partnerships also owns three duplexes. Leonard finds the apartment complex and wants it to serve as replacement property for whichever of the nine duplexes sells first. Leonard has an EAT acquire the apartment complex as potential replacement property. He then enters into three QEAAs with the EAT. One QEAA is with Leonard personally,

• ne QEAA is with the Howard Leonard

Partnership, and the final QEAA is with the Sheldon Leonard Partnership. When the EAT acquires the apartment complex, it is not clear whether Leonard, the Howard Leonard Partnership, or the Sheldon Leonard Partnership will complete the exchange and acquire the apartment complex as replacement

• property. So each QEAA acknowledges

that there are QEAAs outstanding with two other parties, and each QEAA provides that any of the three parties can give notice to the EAT of the intent to acquire the apartment complex, and upon doing so, the other two parties will have no right to acquire the apartment

• complex. Leonard signs 45-day designa-

tions for all three taxpayers, and each designation lists the three duplexes

• wned by that taxpayer as the relin-

quished property. This results in nine duplexes’ being designated as potential relinquished properties to pair with the apartment complex. The IRS ruled that each of the three QEAAs was a separate QEAA meeting the requirements of Revenue Procedure 2000-37 and that each taxpayer was allowed to complete a separate 45-day designation. This struc- ture provides flexibility for a taxpayer with multiple potential relinquished properties held in various forms of

• wnership by increasing the number of

potential relinquished properties that can be designated for a single replace- ment property. There are, of course, a few limita- tions with this ruling. First, private letter rulings provide tax advisors with guidance about how the Internal Revenue Service might view an issue, but they can be relied on only by the taxpayer who requested the ruling and cannot be used or cited as precedent. Second, the taxpayer who requested the ruling asserted that each taxpayer had a bona fide intent to acquire the replacement property under the terms

• f the QEAA. In its ruling, the IRS

specifically stated that it was relying

• n this representation in making its
• ruling. Ultimately only one taxpayer can

by Jeneé Hilliard

jenee.hilliard@millernash.com 503.205.2505

miller nash llp | NW Tax Wire | 3

Is Oregon Charitable to Charities? Recent Developments From the Oregon Tax Court

All persons and organizations in Oregon are subject to a tax on personal and real property unless they can prove that a specific exemption applies. All too frequently, organizational leaders believe their nonprofit organization will be exempt from such state prop- erty taxes if the organization quali- fies for federal tax exemption under Section 501(c)(3) of the Internal Rev- enue Code. Yet a nonprofit organiza- tion’s federal tax exemption does not automatically equate to tax-exempt sta- tus for Oregon property-tax purposes. Instead, for a federally tax-exempt orga- nization to be tax-exempt in Oregon, it must file an application with the county assessor and prove that it falls within the ambit of the property-tax exemption for charitable institutions contained in ORS 307.130. The statute grants a property-tax exemption for all property “actually and exclusively occupied or used in the liter- ary, benevolent, charitable or scientific work carried on by” a charitable institu-

• tion. To qualify, the institution must

first prove that it is “charitable,” as Or- egon courts have interpreted that term. Once the institution has proved that it is charitable, it must further prove that its property is actually and exclusively used for its charitable purpose. Charitable Institution. Although many 501(c)(3) organiza- tions believe they will qualify as chari- table institutions, that is not always the case. To be a charity in Oregon, an organization must have primarily charitable purposes, perform its work in furtherance of its charitable purpose, and involve an element of giving. The element of giving is often successfully challenged as the key element lacking for many institutions in Oregon. Case law has established a range

• f giving, expressed as a percentage
• f total revenue, which has or has not

been sufficient to justify exemption from property tax. For instance, the Supreme Court of Oregon has found that overall giving of less than 4 percent

• f a charitable organization’s income

was insufficient to support a finding that the organization was engaged in charitable giving under the property- tax exemption.1 Using this benchmark, the Oregon Tax Court has found the element of giving lacking in cases in which giving constituted 7 percent of total revenues, in which 10 percent of the taxpayer’s patients received reduced rates, and even in which up to 30 percent

• f patients received reduced rates.2 With

this background, it was no surprise that giving less than half of 1 percent of the total revenue of a university bookstore was a clearly insufficient level of chari- table giving.3 In contrast, total cash and service giving of 58 percent, 65 percent, and 83 percent of total revenue has been found to be an acceptable level of giving for a charitable institution.4 Until recently, it was unclear wheth- er the level of satisfactory giving was measured across an entire organization,

• r whether each specific property had to

qualify for tax exemption individually. In August 2014, the Magistrate Divi- sion of the Oregon Tax Court addressed this issue in Serenity Lane, Inc. v. Mult- nomah Cnty. Assessor.5 Serenity Lane is an Oregon nonprofit corporation that is exempt from federal income tax under Section 501(c)(3) of the Internal Revenue

• Code. Serenity Lane provides residen-

tial and outpatient addiction-treatment services at various locations throughout the state. Certain of the organization’s services, such as residential treatment and detoxification programs, are avail- able only at its Eugene location. Yet certain less-expensive outpatient and “recovery support” services are offered at all locations. At one such location, the level of charitable care from outpatient and recovery-support services was as low as 2.8 percent of the organization’s

• verall revenues.

The Tax Court clarified that once an institution qualifies as a chari- table institution for the purposes of the property-tax exemption of ORS 307.130, the institution does not need to prove sufficient levels of charitable giving at each separate property. Rather, each property must substantially contribute to the accomplishment of the institu- tion’s charitable purposes. Thus, the satellite facility qualified for the property-tax exemption notwithstand- ing its relatively low 2.8 percent level of charitable giving. Actual and Exclusive Use. Qualifying as a charitable institu- tion is only half the battle for property- tax exemption. Once qualified, the charity has to prove that its property is actually and exclusively used for chari- table purposes. While this has tradition-

(continued on page 5) by Ryan R. Nisle

ryan.nisle@millernash.com 503.205.2521

by David J. Brandon

david.brandon@millernash.com 503.205.2372

1 YMCA v. Dept. of Rev., 308 Or 644, 653-54, 784 P2d 1086 (1989). 2 Serenity Lane, Inc. v. Lane Cnty. Assessor, No. TC-MD 101243C (Or TC Mar. 7, 2012); Hazelden Found. v. Yamhill Cnty. Assessor, No. TC 5030 (Or TC Aug. 30, 2013) (disallowing exemption for taxpayer that reduced fees for 25 to 30 percent of patients and donated 7 percent of total revenues). 3 Portland State Univ. Bookstore v. Multnomah Cnty. Assessor, No. TC MD 060824C (Or TC Jan. 29, 2009). 4 We Care Oregon v. Wash. Cnty. Assessor, No. TC-MD 091226B (Or TC Nov. 18, 2010); Or. State Univ. Found. v. Benton Cnty. Assessor, No. TC-MD 080847B (Or TC Oct. 5, 2010). 5 No. TC-MD 111141N (Aug. 8, 2014).

NW Tax Wire | miller nash llp | 4 In 2013, a little-known tax incentive was given some prominence when the Oregon legislature passed its “grand bargain.” The tax incentive, an export- focused corporation known as a “do- mestic international sales corporation” (or “DISC”), is a creation of federal law. DISCs are not subject to federal income tax, but before 2013 had received no special treatment under Oregon law. In 2013, the Oregon legislature de- cided that DISCs formed on or before January 1, 2014, could receive benefited status under Oregon law. From 2013

• n, these DISCS would be exempt from

Oregon’s minimum tax, and subject to

• nly a 2.5 percent tax on commissions

received. DISCs have been around since the 1970s and are intended to incentivize export of U.S. products.1 DISCs come in two flavors: (1) commission DISCs, which act as commission agents for U.S. exporters, and (2) buy/sell DISCs, which act as distributors, buying and selling products for export on their own

• account. Commission DISCs are most

common, and the focus of this article. Oregon’s 2013 legislative changes ap- pear to have been drafted with commis- sion DISCs in mind. A DISC is typically set up as a sub- sidiary or brother-sister corporation to the exporting company. For example, the exporter may own the DISC, or the same shareholder(s) may own both the DISC and the exporter. But no particu- lar structure is required, so exporters have significant flexibility in determin- ing who will benefit from the DISC. The exporter and DISC enter into a commission agreement, under which the exporter pays the DISC a commis- sion related to export sales. The DISC rules set out different methods for calculating a DISC’s commission. In addition to using the transfer pricing rules under Section 482 of the Internal Revenue Code, a DISC’s commission may be calculated as up to 4 percent of qualified export receipts or 50 percent

• f combined taxable income of the sup-

plier and DISC. The commission is deductible to the exporter for federal tax purposes (as well as Oregon purposes, so long as the DISC was formed before January 1, 2014), and the DISC is not taxed on the commission income under the federal rules (and is taxed only 2.5 percent in Oregon). When the DISC pays a divi- dend to its shareholders, the dividend is taxed at the capital gains rate (plus the 3.8 percent unearned income Medicare tax, if applicable). Tax savings can be significant. Because the DISC rules relax the IRS’s normal focus on substance over form, a DISC is not required to have employees or an office, or even to par- ticipate in the export sales for which the DISC is paid a commission. Thus, a DISC may be completely transparent to a U.S. exporter’s customers. So what is a DISC? A DISC is a corporation with one class of stock that files an election with the IRS to be treated as a DISC. The DISC must maintain separate books and records. And the DISC must satisfy the “quali- fied export receipts” and “qualified export assets” tests each year. To satisfy the “qualified export re- ceipts” test, 95 percent of a DISC’s gross receipts for a tax year must be receipts from sales of “export property” by the DISC or its principal.2 Very generally speaking, “export property” refers to U.S.-origin finished goods destined for export outside the United States.

Export Tax Incentive: The DISC Touches Down in Oregon

1 Since the mid-1980s, DISCs have been referred to as “interest charge DISCs” (or “IC-DISCs”) because of a change in legislation to address indefinite deferral of income by applying an interest charge to undistributed income of a DISC. 2 Receipts from certain services, including engineering and architectural services for construction projects outside the United States, may also constitute qualified export receipts.

by Merril A. Keane

merril.keane@millernash.com 503.205.2556

(continued on page 6)

IC-DISC Summary Income without DISC Sales Price $1,000

• Expense (COGS, SG&A)

$900 Total Income $100 Tax without DISC (× 35%) $35 DISC Commission 50% combined taxable income: 50% × $100 = $50 4% gross receipts: 4% × $1,000 = $40 DISC Commission (greater of) = $50 Tax Savings Income $100

• DISC Commission

$50 Total Income with DISC $50 Tax with DISC (× 35%) $17.50 Tax on DISC Commission (× 15%) $7.50 Total tax savings with DISC = $10

5 | miller nash llp | NW Tax Wire Tax Breaks for Oregon Partnerships, LLCs, and S Corporations | Continued from page 1 ally been a fact-specific inquiry unique to each taxpayer, in August 2014, the Magistrate Division of the Oregon Tax Court decided a case that helps define the outer limit of “actual and exclusive use” of property within the meaning of the charitable-institution exemption.6 Habitat for Humanity of the Mid-Willamette Valley is a nonprofit corporation qualified for tax exemption under Section 501(c)(3) of the Internal Revenue Code. Habitat for Humanity also qualifies as a charitable institution for purposes of the Oregon charitable- institution property-tax exemption. Yet for Habitat for Humanity’s property to be tax-exempt under the statute, the property must have been used actually and exclusively for Habitat for Human- ity’s charitable purposes. The organiza- tion delivers affordable housing options for low-income families by providing volunteer-based home construction, below-market pricing, no-interest financing, and repair services. Part of this mission involves the practice of ac- quiring vacant real property for future use as building sites. The property at issue, the taxpayer argued, was exempt from property taxation because acquir- ing and holding property for use as building sites was part of the charitable purpose of the organization. Despite precedent from the Magistrate Division in the taxpayer’s favor,7 the Magistrate Division disagreed with Habitat for Humanity, thereby subjecting its prop- erty to taxation. In doing so, the court

• pted to strictly adhere to the rule that

real property may qualify for exemption under ORS 307.130 only if a building is currently under construction on the property.8 As a result, the Magistrate Division effectively eliminated the pos- sibility that acquisition of land could be considered a component of an organiza- tion’s charitable purpose. These cases add to the growing number of cases interpreting Oregon’s strict property-tax exemption for chari- table institutions. While the require- ments for exemption are stringent, the Tax Court’s decision in Serenity Lane ensures that properly qualified charitable institutions may extend

• perations to satellite facilities without

fear of losing the exemption. On the

• ther hand, the Habitat for Humanity

decision creates a judicial limitation

• n organizations’ flexibility in organiz-

ing projects and could have a very real effect on the future cost of providing low-income housing. Is Oregon Charitable to Charities? Recent Developments From the Oregon Tax Court | Continued from page 3

6 Habitat for Humanity of the Mid-Willamette Valley v. Marion Cnty. Assessor, No. TC-MD 130518C (Or TC Aug. 8, 2014). 7 Habitat for Humanity Mt. Angel Area, Inc. v. Marion Cnty Assessor, No. 020065E, 2003 WL 25846519 (Or TC Jan. 30, 2003). 8 The Tax Court derived this rule from Willamette Univ. v. Tax Com., 245 Or 342, 422 P2d 260 (1966), and Eman. Luth. Char. Bd. v. Dept. of Rev., 263 Or 287, 502 P2d 251 (1972).

taxes could be deducted only from other income that is not subject to the special tax rate. Thus, the loss of the tax benefit from the itemized deduction, especially for taxpayers whose income is primar- ily from their nonpassive business, might be greater than the benefit of the lower rates. Obviously, the value of the reduction in Oregon income tax will be offset by the resulting increase in federal income tax (because the federal deduction for state income taxes will be reduced). The amount of that increase in federal income tax will depend on a number of other factors, including (but not necessarily limited to) whether the taxpayer is subject to the federal alternative minimum tax scheme and the taxpayer’s marginal federal income tax rate. Furthermore, the reduction in the taxpayer’s Oregon income tax could limit the taxpayer’s ability to utilize the full amount of available tax credits or itemized deductions (especially if the nonpassive income is eliminated from the calculation of Oregon taxable in- come on form 40). We expect to gain a better understanding of how the statute will apply to individual situations as the Oregon Department of Revenue sets

• ut appropriate rules and forms over

the next year. For now, taxpayers should plan to consult with their tax advisors to de- termine whether certain partnerships, S corporations, or limited liability com- panies in which they have a direct or indirect ownership interest and materi- ally participate should be restructured to take advantage of the reduced rates. It may be advantageous for a regular corporation to elect S corporation sta- tus, or for an unincorporated business to organize as an S corporation, lim- ited liability company, or partnership. Although we have a year to plan, the analysis is potentially complicated for

• many. The potential payoff, however,

can be substantial: an annual reduction in Oregon individual income taxes that can exceed $75,000. More Flexibility for Reverse Exchanges | Continued from page 2 acquire the replacement property, so it seems difficult for all three taxpayers to prove that they had a bona fide intent to acquire the property; this could be an area in which the IRS could challenge this type of arrangement. Nonetheless, this structure is interesting and worth considering in connection with reverse exchanges.

NW Tax Wire™ is published by Miller Nash LLP. This newsletter should not be construed as legal opinion on any specific facts

• r circumstances. The articles are intended for general informational purposes only, and you are urged to consult a lawyer con-

cerning your own situation and any specific legal questions you may have. To be added to any of our newsletter or event mail- ing lists or to submit feedback, questions, address changes, and article ideas, contact Client Services at 503.205.2608 or at clientservices@millernash.com.

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Export property can have no more than 50 percent of its fair market value at- tributable to articles imported into the United States. Agricultural products grown in the United States are more

• bviously U.S.-origin goods, but other

items such as software and manufac- tured products may also qualify as ex- port property. Even recycled items can qualify as export property—for example, the IRS has held that previ-

• usly manufactured machine compo-

nents acquired from foreign businesses and restored in the United States were export property when the components were acquired for less than 10 percent of their restored fair market value. To satisfy the “qualified export Export Tax Incentive: The DISC Touches Down in Oregon | Continued from page 4 assets” test, the adjusted basis of the DISC’s “qualified export assets” must be at least 95 percent of the adjusted basis of all of the DISC’s assets at the close of its tax year. The DISC regula- tions list a number of different items that constitute qualified export assets, including export property, certain business assets, trade receivables, pro- ducer’s loans, and Ex-Im Bank obliga-

• tions. Commission DISCs commonly

rely on trade receivables to satisfy the “qualified export assets” test—accounts receivable arising out of sales of export property in which a DISC is the prin- cipal agent. Trade receivables must be paid within specific time frames set forth in the IRS regulations in order to be “qualified export assets.” The DISC rules are complicated, and assistance from an experienced tax advisor is highly recommended. But the benefits may be substantial. The federal benefits alone may be worth pursuing, even for a company that did not establish a DISC by January 1, 2014, and cannot benefit from Oregon’s re- cent changes. Additionally, other states have adopted the federal approach or

• ther preferred treatment of DISCs, so

for exporters with operations outside Oregon, it may make sense to establish a DISC in another state.