By Jeffrey P. Hart, Esq.
A tax ruling was just released in Massachusetts
that accepts an innovative tax strategy that can eliminate the 10.5%
financial institution excise tax now imposed on many mortgage
companies. A few years ago, tax legislation was passed which broadened
the category of entities falling within the definition of a
"financial institution." Many mortgage companies fell under this new
definition. Unfortunately, this created a double tax for mortgage
companies that had elected to be taxed as "S Corporations" for federal
and state income tax purposes. (S corporations, a common form of
organization for closely-held businesses, pay no corporate tax but
instead pass their taxable income through to the shareholders to be
recognized by them on their personal income tax returns.) Beginning in
1999, financial institutions that had elected to be S Corporations
became subject to the 10.5% excise tax at the company level and the
company's shareholders were also subject to the 5.85% income tax on
all of the company's income. A double-tax trap had been created.
Clever accountants reacted to this trap by advising the owners of S
corporation-financial institutions to take large year-end bonuses to
reduce or eliminate taxable income at the corporate level. This helped
with the double tax problem by reducing the company's taxable income,
but the bonuses were themselves subject to a 2.9% social
security/medicare payroll tax. Calculating the proper bonus also
required the company's accountant to accurately estimate the company's
projected profit before December 31st. If the accountant's estimates
were off, the company still had to pay the 10.5% tax on the shortfall.
The year-end bonus was also subject to the risk of it being
classified as "unreasonable compensation" and disallowed as a tax
deduction by the IRS. Finally, the large bonuses that reduced or
eliminated the taxable income also reduced or eliminated the company's
year end profit reported on its financial statements, possibly raising
concerns with the company's bank or with state regulators.
The new planning technique can eliminate virtually all
of these headaches. No excise tax. No Medicare tax. No scrambling at
year end to zero out the company's taxable income. No reporting of
reduced or zero profits on the year-end financial statements.
The steps required to meet the conditions of the
ruling involve the organization of a new parent company entity as a
Massachusetts Business Trust ("New Trust"), an entity not commonly
used to transact business in Massachusetts. New Trust would elect to
be treated as an S corporation for Federal income tax purposes. After
creating New Trust, the shareholders of the financial institution would
then transfer their corporate stock into New Trust in exchange for
shares of stock representing the beneficial interest of New Trust.
Subsequently, New Trust would make an election to treat the financial
institution as a "qualified subchapter S subsidiary." Assuming a valid
business purpose for the plan, the federal tax law will recognize
this transaction as a tax-free reorganization. For corporate law
purposes, the mortgage company continues to operate just as before. The
company's employees and customers won't even notice the change. New
Trust, now the parent company of the financial institution, would be
required to file a number of federal forms with the IRS to create the
proper tax reporting structure. Under some very complicated federal
tax rules, the results of this plan should be as follows:
1. The financial institution's taxable income will be treated as earned directly by New Trust; and
2. Neither New Trust nor the financial institution
will be subject to the excise tax imposed on financial institutions or
be required to file a financial institution excise tax return.
It is important to realize that a private letter
ruling issued by the Massachusetts DOR can be officially relied on
only by the specific taxpayer who requested the ruling. However, a
letter ruling does reflect the DOR's current thinking and such rulings
are often used as guidance by other taxpayers. There is one final
benefit: since the technique, if properly executed, is considered a
reorganization for federal tax purposes, the benefits will be
retroactive to the beginning of the tax year, allowing the entire
year's profit to qualify for the tax savings. Though the strategy is
complicated, financial institutions can take comfort in the fact the
Massachusetts DOR just last week issued the ruling accepting the plan.
Jeffrey P. Hart is a senior member of the Boston law
firm of Tarlow, Breed, Hart & Rodgers, P.C. Mr. Hart requested the
DOR letter ruling referenced in the article. Note: This article is
for informational purposes only and does not constitute legal advice.
The application of specific laws and legal principles will vary
according to individual circumstances. Any information contained in
this article should not be acted upon without seeking professional
counsel from an experienced attorney.