Software of the Month Club 1997 March/Software of the Month Club 1997 March.iso/pc/dos/lg/sba/f116.sbe

Text File | 1996-09-08 | 9.0 KB | 185 lines

@156 CHAP ZZ

       ┌─────────────────────────────────────────────────┐
       │ CHOICE OF ENTITY:  AUTHORS, SOFTWARE DEVELOPERS │
       │  AND OTHERS WHO EARN SIGNIFICANT ROYALTY INCOME │
       └─────────────────────────────────────────────────┘

Authors, computer software developers and other persons
earning significant royalties from the licensing of their
"intellectual property" (such as copyrights or patents) will
find to their serious dismay that the tax law provides some
major DISincentives to incorporating those business activities.
@IF177xx](Take careful note, since this could be very much applicable
@IF177xx]to your business:   You have indicated that much of the
@IF177xx]income of @NAME is from royalties.)
@IF177xx]
@IF156xx]This is important for you to understand, since your company,
@IF156xx]@NAME, is in the software business.
@IF156xx]
@IF172xx]This could be of importance to your firm, which you indicated
@IF172xx]is in the data processing business, but you are likely to be
@IF172xx]affected only if significant amounts of gross income from
@IF172xx]royalties are earned by @NAME.
@IF172xx]
@IF120xx]However, your business is not incorporated right now; thus,
@IF120xx]neither of the 2 major tax problems discussed below is a
@IF120xx]possible concern to you for now and shouldn't be, so long as
@IF120xx]@NAME remains a @ENTITY.
@IF120xx]
@IF118xx]However, your business is not a C corporation right now, so
@IF118xx]only one of the two major tax problems discussed below is a
@IF118xx]possible concern to you, and this should be true as long as
@IF118xx]@NAME remains an S corporation.
@IF118xx]
@IF118xx](S corporations don't have to worry about "personal holding
@IF118xx]company" tax status.)
@IF118xx]
@IF117xx]Your company is organized as a "C" corporation, precisely
@IF117xx]the type of legal entity that is likely to encounter the
@IF117xx]most serious income tax problems, if it has significant
@IF117xx]royalty income from ownership of patents, copyrights, or
@IF117xx]other similar intangible property rights.
@IF117xx]

 (i)   PERSONAL HOLDING COMPANY STATUS.  An almost universal
       problem for such incorporated businesses is that
       if they generate the bulk of their revenues in the
       form of royalties they will often find it difficult
       to avoid being categorized by the IRS as "personal
       holding companies" and thus their corporation will
       become potentially subject to a 39.6% penalty tax on
       any undistributed "personal holding company income"
       it earns each year.  Paying out dividends to avoid
       the penalty tax will still result in double taxation,
       since the shareholder will pay tax on the dividends,
       usually at a 31%, 36%, or even a 39.6% tax rate.

       The PHC (personal holding company) rules in the tax
       law were originally intended to keep individuals
       from sheltering personal service income and income
       from passive sources (such as oil and gas royalties
       or investment income) by using corporations to avoid
       the much higher individual tax rates that once
       existed.  Despite the fact that corporate tax rates
       are now higher than individual rates, and that the
       PHC provisions were not targeted at actively
       conducted businesses, Congress has not bothered to
       repeal this obsolete and grotesquely complex section
       of the tax code.

       Thus, many actively conducted businesses, such
       as software development companies, are potential
       victims of this archaic law if they operate as C
       corporations, if more than 60% of their "adjusted
       ordinary gross income" is PHC income (such as
       royalties) and if over 50% of the stock of the
       company is owned by five or fewer shareholders.
       Larger, widely-held corporations do not need to
       be concerned about PHC status.

       (With S corporations now able to have up to 75
       shareholders, S corporation elections may make
       more sense than ever for such companies, where
       they need to operate in corporate form.  S
       corporations are not subject to the PHC tax.
       However, note that S status is not available if
       there is more than one class of stock--other
       than common with different voting rights--or if
       any shareholder is a corporation, partnership,
       or limited liability company, which would rule
       out most venture capital companies as investors.)

       The Tax Reform Act of 1986 provided some limited
       relief for software companies that license, rather
       than sell, their software, but several requirements
       must be met:

           .   The corporation earning the royalties
               (or a predecessor) must have developed
               or manufactured the software from which
               it receives royalties in connection
               with its trade or business;

           .   Such royalties must be at least 50% of
               the company's "ordinary gross income"
               for the taxable year;

           .   Certain types of business expense deductions
               must be at least 25% of ordinary gross
               income for the year (or, alternatively, this
               test can be based on an average for the last
               5 years); and

           .   Dividends must be paid by the corporation,
               to the extent that other types of PHC
               income exceed 10% of ordinary gross income
               for the year.

       Not all software companies will be able to meet all
       of these requirements.  Therefore, various strategies
       may need to be pursued, such as diluting the
       percentage of PHC income (below the 60% threshold)
       by generating significant active income from sales
       of software, services and other means; by diluting
       control of the company's stock so that no five
       shareholders own over 50%; by disincorporating
       (which can result in substantial income tax upon
       liquidation); by paying out most PHC income as
       dividends; or by electing to become an S corporation,
       where this is feasible.

       Creative professionals such as individual authors
       who receive book royalties will find the PHC rules
       even more difficult to cope with, and should,
       therefore, avoid putting their royalty income in a
       C corporation, if the royalties will be a major
       source of income for the corporation.

 (ii)  TAX ON VALUE OF ROYALTY RIGHTS IN LIQUIDATION.  An
       author of books or software or holder of valuable
       patents who wishes to place the rights to income
       from such intellectual property in a corporation
       and avoid the personal holding company tax may be
       able to elect S corporation status and escape that
       particular trap.  However, if future law changes or
       other factors cause you to want to remove such
       rights from the corporation, you will find that
       you may incur a substantial tax on liquidating the
       corporation, based on the value of those rights (plus
       any other assets) you receive upon liquidation.
       For example, if your corporation receives $100,000
       a year in royalties from books you have written,
       the IRS may value that right at several hundred
       thousand dollars, on which you will pay tax NOW if
       you liquidate the corporation, even if you receive
       no cash from this "exchange" with which to pay the
       tax. Obviously, this would be a major tax disaster,
       perhaps resulting in a six-figure tax liability,
       just for putting the royalty contract in a
       corporation and taking it back out again!

In most cases, this writer is of the opinion that you will
be better off receiving any software, book or patent royalties
as a sole proprietor, rather than incorporating. Since such
income will ordinarily be "earned" income, you will have to
pay self-employment tax on it, but you may also set up Keogh
pension or profit sharing plans (or both) for yourself to
shelter a healthy percentage of any such royalties from
income tax.  For example, with a simple pair of Keogh plans,
a profit sharing plan and a money purchase pension plan, you
can set aside, with a current tax deduction, up to 20% of
your pre-tax earned income (or potentially even more with a
more complex "defined benefit plan").

   ┌─────────────────────────────────────────────────────────┐
   │BOTTOM LINE RECOMMENDATION:  DON'T INCORPORATE IF YOU ARE│
   │AN INDIVIDUAL WRITER,  INVENTOR OR SOFTWARE DEVELOPER WHO│
   │WILL BE RECEIVING ROYALTY INCOME---DOING SO WILL OFTEN BE│
   │A VICIOUS TAX TRAP.  FOR SOFTWARE COMPANIES WITH MULTIPLE│
   │OWNERS WHO FEEL THEY SHOULD INCORPORATE,  FOR SOME NONTAX│
   │REASON, REALIZE THAT YOU MUST CAREFULLY PLAN TO AVOID THE│
   │PERSONAL HOLDING COMPANY TAX, A TRAP FOR THE UNWARY.     │
   └─────────────────────────────────────────────────────────┘