@156 CHAP ZZ 旼컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴� � CHOICE OF ENTITY: AUTHORS, SOFTWARE DEVELOPERS � � AND OTHERS WHO EARN SIGNIFICANT ROYALTY INCOME � 읕컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴� 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 28% 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, 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 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 or partnership, which would rule out most venture capital com- panies 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"). 旼컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴� 쿍OTTOM LINE RECOMMENDATION: DON'T INCORPORATE IF YOU ARE� 쿌N INDIVIDUAL WRITER, INVENTOR OR SOFTWARE DEVELOPER WHO� 쿥ILL BE RECEIVING ROYALTY INCOME---DOING SO WILL OFTEN BE� 쿌 VICIOUS TAX TRAP. FOR SOFTWARE COMPANIES WITH MULTIPLE� 쿚WNERS WHO FEEL THEY NEED TO INCORPORATE FOR NON-TAX REA-� 쿞ONS, BE AWARE THAT YOU MUST DO CAREFUL PLANNING TO AVOID� 쿟HE PERSONAL HOLDING COMPANY TAX, A TRAP FOR THE UNWARY.� 읕컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴�