Duvall & Associates, Inc.
BUSINESS ADVISOR NEWSLETTER
 

Always remember: Everything's taxable

- by Alan Duvall 

Published in Dayton Daily News July 16, 2006 

“Money for nothin’ – and your chicks are free.”  Or so the song by Dire Straits goes.  But can you truly get somethin’ for nothin’? 

Not according to the IRS if the somethin’ came from a business.   

You can receive tax-free gifts from another individual, but anything given by a company is eventually taxed.  And this “anything taxable rule” can whiplash individuals in truly unexpected circumstances. 

Take two aspiring entrepreneurs accumulating respective assets to form a new corporate venture.  Owner A has $100,000 cash to throw in the pot – Owner B only talent to offer for a half interest.    

Typical scenario until tax time rolls around.  Owner B has received a 50 percent ownership interest for the performance of services – a situation the IRS reconfigures into a two-step hypothetical.  First, Owner B is treated as having rendered services for value.  Second, Owner B is considered to use the mythical service money to pay for corporate stock. 

Result?  Owner B must pay taxes equal to the calculated fair market value of the 50 percent stock acquired at time the business is initiated.  Assuming the business is worth at least the $100,000 cash originally invested – Owner B must pay taxes on $50,000 ordinary income.  Some consolation is retrieved from the fact the business receives an offsetting $50,000 business deduction for services paid. 

The dilemma – Owner B had no personal financial resources and hoped to earn half ownership in a new business – but now has to find cash to pay taxes for receipt of a purely intangible asset.   

Solution with risk – If the earned ownership is conditioned upon the rendering of future services – income is not taxed until the contingency is removed.  For example, if Owner B had to work at least two years in order to earn half ownership, service taxes would be due on the value of the stock when the two-year requirement is met.  Timing of income recognition is delayed two years with risk the earning condition will never be fulfilled. 

Solution corollary – Despite the contingency, Owner B could elect to pay taxes on the value of the 50 percent stock when the option is initially granted.  This alternative could be advisable if Owner B believes the stock value will appreciate in the future.  Current income would be locked in at Day One value and future appreciation would be taxed at capital gains rates only when the earned stock is sold. 

Complicated, but such is anticipated when the government enacts rules to tax intangible stuff of the business world. 

Alan Duvall is a certified public accountant in Dayton.  Contact him at Alan@Duvallcpa.com.