Using private-letter rulings to determine the tax consequences of a proposed business transaction.
Want to know -- in advance -- how the IRS would respond to that somewhat aggressive tax strategy you've been contemplating? Instead of fantasizing about finding a crystal ball, consider using a system that is relied upon regularly by large corporations with sophisticated tax advisers: the so-called private-letter ruling. "Put simply, this is a written determination from the IRS regarding the tax consequences of a proposed transaction," explains Joseph Newberg, a tax partner at the Boston law firm of Sullivan & Worcester.
Private-letter rulings are, in Newberg's words, "the equivalent of an insurance policy. So long as you have accurately and completely described your potential transaction to the IRS, the agency will commit itself to the way it plans to assess your taxes." That removes the guesswork that often accompanies aggressive tax strategies.
For growing businesses, there are three typical scenarios in which a private-letter ruling might make sense. The first would involve restructuring or selling a business (especially in cases in which adverse tax treatment by the IRS could make or break the profitability of the deal). The second scenario: complex or ambiguous transactions with multiple possible IRS interpretations, such as spinning off part of a business to resolve a family dispute, provided the IRS agrees in advance to the most favorable tax treatment. The third case would be the correction of mistakes. If you can explain why you missed an important tax deadline or you can prove that you took bad advice from a financial adviser, a ruling from the IRS may limit your costs.
You can request private-letter rulings that relate to either corporate or personal tax strategies, but they're not cheap. The IRS charges $3,000 to issue a ruling. (There's a discounted rate -- $500 -- for companies or taxpayers with a total income below $150,000.) Add to that your lawyer's fee, which might start at about $1,500 for a fairly straightforward transaction and rise to $10,000 or more on a complex, state-of-the-art proposal. Rulings can take three to six months. But the time and expense are well worth it, says Newberg, "if you're planning a transaction in which the downside tax risk is so huge that you wouldn't even get involved if you knew the IRS would side against you."
There's a lower-cost alternative, though: read other companies' rulings instead. (Since they can be a little dry, you may want to ask your tax lawyer to summarize the ones that relate to entrepreneurial companies in your industry.) The advantage? "They give you clues to the IRS's thinking about state-of-the-art transactions, and they may suggest tax strategies," says Newberg. One caveat: if you rely on another company's ruling, there are no guarantees that the IRS will treat your business the same way. But if you get audited, you'll have a reasonable line of defense.