Cream of the Crop 1/Cream of the Crop 1.iso/BUSINESS/SBA62.ARJ/FSBA.EXE/F116.SBE

Text File | 1992-04-30 | 8KB | 134 lines

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

Authors, computer software developers and other persons earning sig-
nificant royalties from the licensing of "intellectual property" (such
as copyrights or patents) will find to their dismay that the tax law
provides some major DISincentives to incorporating those business
activities.

 (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 28% 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, often at the
       same 28% rate (or perhaps even 31% or slightly more).

       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 35 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 corpor-
       ation or partnership, 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, 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 5 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 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 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 NEED TO INCORPORATE FOR NON-TAX REA-│
      │SONS, BE AWARE THAT YOU MUST DO CAREFUL PLANNING TO AVOID│
      │THE PERSONAL HOLDING COMPANY TAX,  A TRAP FOR THE UNWARY.│
      └─────────────────────────────────────────────────────────┘