Software of the Month Club 1996 May/Software of the Month Club 1996 May.iso/mac/ISO9660/ZIPFILES/SBA962.ZIP/F116.SBE

Text File | 1996-02-15 | 9.1 KB | 187 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 "intel-
lectual property" (such as copyrights or patents) will find
to their serious dismay that the tax law provides some maj-
or DISincentives to incorporating those business activities.
@IF177xx](Take careful note, since this could be particularly appli-
@IF177xx]cable 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 have in-
@IF172xx]dicated is in the data processing business, but you're like-
@IF172xx]ly to be affected only if significant amounts of gross income
@IF172xx]from 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 pos-
@IF120xx]sible concern to you for now, and should not 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, which is pre-
@IF117xx]cisely the type of legal entity that is likely to encounter
@IF117xx]the most serious income tax problems, if it has significant
@IF117xx]royalty income from ownership of patents, copyrights, or oth-
@IF117xx]er similar intangible property rights.
@IF117xx]

 (i)   PERSONAL HOLDING COMPANY STATUS.  An almost univer-
       sal 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 cor-
       poration 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 re-
       sult 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 individ-
       uals from sheltering personal service income and
       income from passive sources (such as oil and gas
       royalties or investment income) by using corpor-
       ations to avoid the much higher individual tax
       rates that once existed.  Despite the fact that
       corporate tax rates are now higher than individ-
       ual rates, and that the PHC provisions were not
       targeted at actively conducted businesses, the
       Congress has not bothered to repeal this obso-
       lete 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 cor-
       porations are not subject to the PHC tax.  How-
       ever, 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, rath-
       er than sell, their software, but several require-
       ments 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 de-
               ductions must be at least 25% of ordin-
               ary gross income for the year (or, al-
               ternatively, this test can be based on
               an average for the last 5 years); and

           .   Dividends must be paid by the corpora-
               tion, 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 strate-
       gies 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 share-
       holders own over 50%; by disincorporating (which
       can result in substantial income tax upon liqui-
       dation); by paying out most PHC income as divi-
       dends; 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, there-
       fore, avoid putting their royalty income in a C cor-
       poration, 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 cor-
       poration, 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 corpor-
       ation 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 royal-
ties 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 your-
self 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 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.│
   └─────────────────────────────────────────────────────────┘