Nevada Tax Considerations For Businesses
By Richard T. Cunningham and Matthew R. Policastro

Forming a business entity for the client is only the beginning. Clients also need to be advised of the five major licenses and taxes that apply to businesses: the business license, the sales and use tax, the modified business tax, the property tax, and the transfer tax. This article provides an overview of these licenses and taxes.

State business license
Most businesses (including sole proprietors) must acquire a state business license, for an annual fee of $200. New legislation has simplified the process: the business license is now obtained from the Secretary of State’s office when the initial list of officers, members, managers, and directors is filed.

Before any privilege or local business licenses are issued by a state or local government, the new business must show proof of having a business license, or a certificate of compliance stating either that (i) they have the business license or (ii) they are one of the following businesses that are exempt:

• Corporations formed under NRS Chapter 82 (nonprofit corporations);
• Corporations formed under NRS Chapter 84 (owning church or religious society property);
• A nonprofit religious, charitable, fraternal, or other organization that qualifies as a federal tax-exempt organization;
• A person who operates a business from his home and whose net earnings from that business are not more than 66 2/3 percent of the average annual wage of the preceding calendar year ($26,600 for 2009).
• A business whose primary purpose is to create or produce motion pictures.

 

Sales and use tax
Sales tax is imposed on all retailers for the privilege of engaging in the sale of tangible personal property in the state of Nevada. The current combined maximum rate is 8.1 percent. Retailers are required to report and remit sales and use tax collections on a monthly basis, except that quarterly reports and payments are permitted for accounts with taxable sales of less than $10,000 per month (and annual reports for sales less than $1,500 for the prior four reporting periods). Every retailer that sells tangible property for storage, use, or other consumption in Nevada must register with the Department of Taxation for a sales and use tax permit, which should be done at time of applying for the business license.

Use tax is assessed on tangible personal property purchased outside of Nevada and stored, used, or consumed within Nevada. Thus, even a business that does not intend to sell any personal property and will only store, use, or consume its own tangible personal property in Nevada, should still register with the Department of Taxation for a sales and use tax permit.

Because the sales tax and use tax are complimentary, a single transaction will only be subject to one, but not both, taxes. Use tax applies to mail order and other out-of-state purchases of tangible personal property on which Nevada sales tax has not been paid. Yes, if you did not pay a sales tax, then you owe a use tax for all of those out-of-state purchases.

Modified business tax
All businesses that have employees in Nevada must pay the modified business tax, based on gross wages paid (including reportable tips), after health care deductions.

If the gross wages do not exceed $62,500 for the calendar quarter, the amount of tax is 0.5 percent of the wages. If the amount of all wages exceeds $62,500, the tax is $312.50 plus 1.17 percent of the amount in excess of $62,500. For example, if the sum of all wages for a quarter is $120,000, the amount of tax is $312.50 plus $672.75 (0.0117 x $57,500) for a total tax due of $985.25.

Financial institutions, nonprofit organizations, Indian tribes, political subdivisions, and any business that does not supply a product or service, are not subject to the tax.

Property tax
Property taxes in Nevada are imposed on all real and personal property located within the state, unless exempted. Generally, the maximum rate of property tax is a total of $3.64 for each $100 of assessed valuation. Property taxes are comprised of various types of taxes within each tax district in Nevada, and can vary within a single county based on the location of the property assessed.

Real property is assessed at 35 percent of its taxable value. Taxable value is the full cash value of the land, unless the land is improved, in which case value is instead based on its actual use. For improvements, value is replacement cost less depreciation at 1.5 percent per year up to 50 years.

Personal property is assessed at 35 percent of its original cost less depreciation. The definition of personal property includes most items that intuitively appear to constitute personal property (with the exception of vehicles).

An annual eight percent cap applies to tax increases on property that is not a taxpayer’s primary residence, including land, commercial buildings, and business personal property, unless there has been a change in use to the property. Real property taxes exceeding $100 and personal property taxes exceeding $10,000 may be paid on a quarterly basis.

Numerous real and personal property tax exemptions apply to governmental, religious, educational, and charitable organizations.

Transfer tax
A transfer tax is imposed on each deed conveying real property with a market value of more than $100. The tax is collected at the time of recording the deed, which must be presented with a declaration of value form for calculation of the tax. The basis for the tax is the actual selling price or the estimated fair market value of the property.

The transfer tax rate in a county whose population is 400,000 or more (e.g. Clark County) is $2.55 for each $500 of value or fraction thereof, and $1.95 for each $500 of value or fraction thereof in a county whose population is less than 400,000. The buyer and seller in the transaction are jointly and severally liable for the payment of the transfer tax.

The primary business exemptions are:

• Transfers to an affiliate or subsidiary with iden-
  tical common ownership with the transferor;
• Transactions where real property is used to se- cure a debt;
• Transfers in bankruptcy;
• Transfers between joint tenants or tenants in common without consideration.

But, hey, there’s still no Nevada Income Tax! (Well, at least as of the date of this publication).

Richard T. Cunningham is a tax and trusts and estates attorney at the Las Vegas and Reno office of Lionel Sawyer & Collins.

Matthew R. Policastro is a tax and trusts and estates attorney at the Las Vegas office of Lionel Sawyer & Collins.

Cancellation of Indebtedness Income and the Related Bad Debt Deduction
By Michael Kearney and Andrew J. Glendon

The past two years have been tough for businesses and real estate investors in Nevada (as well as the rest of the country), and unfortunately 2010 is not looking much better. Significant federal income tax issues arise out of cancellation of indebtedness, which is treated as income to borrowers and may give rise to a deduction by lenders for bad debts. This article describes some of the general income tax ramifications applicable to borrowers and non-bank lenders in connection with commercial transactions involving underwater loans.

Cancellation of indebtedness income
Reduction or cancellation of debt is generally income to the borrower for income tax purposes (COD Income). Foreclosures and deed-in-lieu of foreclosure transactions can also result in COD Income. In addition, care must be taken with any modification of a debt instrument that does not involve a foreclosure or deed in lieu. Regulations under Internal Revenue Code (I.R.C.) section 1001 contain a series of rules governing the substantial modification of debt instruments that may give rise to a deemed exchange of old debt for new debt. Examples of substantial modification of debt instruments include changes in yield, changes in payments schedules resulting in deferral of payments, and substitution of the obligor or security for the debt. COD Income in a debt-for-debt exchange is the difference between the issue price of the old obligation less the issue price of the new obligation.

Under special rules contained in I.R.C. section 108, borrowers who are insolvent (i.e., when liabilities exceed the fair market value of assets), in bankruptcy, and non-corporate debtors whose debt is "qualified real property indebtedness," may be able to minimize the recognition of COD Income by reducing tax loss or tax credit carryovers and the basis of assets. In 2009, Congress amended these rules to allow taxpayers to defer COD Income for a period of up to five years in connection with certain "reacquisitions" of indebtedness incurred in a trade or business by a debtor-taxpayer or a related person. A separate exception to non recognition of COD Income relates to "qualified real property indebtedness" (QRPBI) and is available to certain taxpayers regardless of whether the insolvency or bankruptcy exclusions apply. For this purpose QRPBI is: (1) indebtedness incurred or assumed by the taxpayer in connection with real property used in a trade or business and that is secured by the real property, (2) that is qualified acquisition indebtedness, and (3) for which the taxpayer elects to treat as QRPBI. Mere rental property that is not part of a true trade or business does not qualify for QRPBI treatment, and land held for resale (such as houses built by a homebuilder) is treated as property held for sale as inventory and not real property qualify for the QRPBI exception.

The general rule for basis reductions under I.R.C. section 1017 applicable to insolvent or bankrupt taxpayers provides that a taxpayer must reduce the adjusted basis of property held on the first day of the tax year (but not below zero) in a specified order, to the extent of the excluded COD Income. The foregoing rules are subject to complex modifications in the case of QRPBI.

If a debtor or a party related to the debtor reacquires its own debt and COD Income arises, the debtor may be able to defer the receipt of the COD Income over a period of up to five years pursuant to the I.R.C. section 108(i) election. Note that the complete cancellation of a debt is considered to be a reacquisition, and has particular applicability to related party debts. For COD Income arising from reacquisitions occurring in 2009, the five year deferral period commences in 2014. If a debtor makes a reacquisition in 2010, then the deferral period is a four year period commencing in 2015. Deferral is elective, and an analysis should be undertaken to determine whether the insolvency or QRPBI exclusions may also apply. In the case of a partnership or LLC taxed as partnership, the election to defer COD Income under the insolvency or QRPBI exclusions is made at the partner/member level while the I.R.C. section 108(i) election is made at the partnership level. Note that gain deferred pursuant to the I.R.C. section 108(i) election will be accelerated if the applicable debt entity is liquidated, ceases to do business, or there is a sale or exchange of substantially all of the entity’s assets.

As demonstrated, a transaction that could be a necessity to a borrower from a business perspective (e.g., modifying debt by reducing the amount owing) could have significant COD Income and other tax ramifications which need to be considered and analyzed by such borrower prior to engaging in such a transaction.

Bad debt rules – An overview
Pursuant to I.R.C. section 166, a taxpayer may claim an ordinary deduction where a business debt is either wholly or partially worthless. However, the loss arising from the complete worthlessness of a non-business bad debt of a taxpayer (other than a corporation) is allowed as a short-term capital loss. No loss is allowed with respect to a partially worthless non-business debt. In the absence of capital gain income to offset the short-term capital loss arising from the complete worthlessness of a non-business bad debt, non-business bad debt characterization is generally less favorable to a taxpayer since only $3,000 per year of such losses may be used to offset ordinary income in the year of the write off and in future years.

Loans between related parties present additional tax issues. A partner or limited liability company member can deduct a debt owed by the related partnership/LLC as a business bad debt only if the taxpayer proves that the dominant motivation for the debt is business related and that the taxpayer is not a mere investor. Generally, a creditor is not considered to be engaged in a trade or business in connection with a loan made to a related partnership that holds only rental real estate. Loans to related entities will be considered to be business bad debts if the related entities are essentially in the same business as the taxpayer-creditor, or if the related entity somehow enhances or aids the trade or business of the taxpayer and the business related aspect is the dominant motive for the loan.

Related party debt invites further enhanced scrutiny in determining whether a bad debt deduction should be permitted. The taxpayer creditor must show that the debt is true debt for tax purposes and not "disguised equity" under a fact intensive analysis. Where a shareholder gratuitously forgives a debt owed by the corporation, the transaction may be treated as a contribution to capital with no worthlessness debt deduction available. The theory behind the contribution to capital analysis is that cancellation of the related debt permits the corporation to obtain additional financing. This theory assumes that the debtor corporation will continue in existence. Where the debt is truly worthless, so that forgiveness of the debt does not enhance the value of the taxpayer’s stock, the taxpayer will not be denied a bad debt deduction based on a characterization of the transaction as a contribution to capital.

The IRS may apply a similar analysis to partnership/LLC related debt. Apart from the contribution to capital analysis, where a partner/LLC Member is permitted to take a worthless debt deduction in connection with the cancellation of partnership debt, the results are complicated by the interplay of the partnership tax rules that "allocate" debt to partners/members pursuant to I.R.C. section 752. First, the partner/LLC creditor takes a deduction under I.R.C. section 166 for the debt that is charged off, or, if property is transferred to the partner/LLC creditor in connection with the write-off, the partner/LLC Member may have a loss from the exchange of the debt instrument under I.R.C. Section 1271 that is potentially a capital loss. Second, the partnership has COD Income or sale gain depending on the nature of the debt (recourse or nonrecourse) and whether property is transferred to the partner in connection with the discharge. Third, there is a deemed distribution of cash under I.R.C section 752(b) attributable to the reduction in the debt of the partnership/LLC as a whole.

A taxpayer has the burden of showing that a debt has become worthless. In order to satisfy this burden, the taxpayer must prove that the debt had some value at the beginning of the taxable year and that it became worthless during the year. The value of the collateral securing the debt and the financial condition of the debtor are two of the more important factors to be considered in determining worthlessness. According to the regulations under I.R.C. section 166, where the surrounding circumstances indicate that a debt is worthless and uncollectible and that legal action to enforce payment in all probability will not result in the satisfaction of an execution on a judgment, a taxpayer should be entitled to a deduction under section 166. Bankruptcy generally is an indication that at least part of the unsecured and unpreferred debt is worthless. Generally, the simple act of canceling a debt will not establish a creditor’s right to a bad debt deduction. While a taxpayer need not necessarily institute a suit for collection to show worthlessness, a taxpayer may not simply fail to enforce a debt and then claim a bad debt deduction under I.R.C. section 166. Where other parties in addition to the primary obligor are liable for the debt (such as general partners or guarantors), the creditor must look beyond the primary obligor for satisfaction of the debt before it may take a bad debt reduction.

As shown, the rules for determining deductibility of a debt, are as equally complex as the COD Income rules. Deductibility depends on the characterization of a debt as business vs. non-business and a taxpayer must also be able to establish when such debt became worthless. Not to mention the added complexity involved in related party loans.

Michael Kearney is a shareholder with law firm of Santoro, Driggs, Walch, Kearney, Holley & Thompson. Mr. Kearney is a graduate of the University of Nevada and received his law degree from the University of Santa Clara. Mr. Kearney also holds a Master of Laws (LL.M.) in taxation from New York University. Mr. Kearney’s practice centers on mergers and acquisitions with emphasis on federal tax issues. Mr. Kearney is a frequent lecturer to business and professional groups on federal tax law issues.

Andrew J. Glendon is a shareholder with the law firm of Santoro, Driggs, Walch, Kearney, Holley & Thompson. Mr. Glendon is a graduate of the University of California at Davis and received his law degree (With Distinction) from McGeorge School of Law (University of the Pacific). Mr. Glendon also holds a Master of Laws (LL.M.) in taxation from New York University. Mr. Glendon’s practice centers on commercial real estate and business transactions with emphasis on federal tax issues.