GetDomains.info

There are significant decisions to make regarding both the structure of your business (mine is an California LLC for legal protection, and for its simplicity), and of how you treat your names — are they inventory? Are they expenses? Are purchases (above and beyond reg fee) capital expenditures? Amortization? Cap gains or ordinary income?

Crap. It’s enough to make you want to quit the business, if the sheer insanity of the seemingly 24-hour a day name hunting is not for any normal person anyway.

Anyway, it’s likely that your general CPA may not know anything about domain name accounting, so to save a few hundred dollars on him searching for information, I’m going to point you to something that after you read it, you can pass along to your accountant to give them at least a basis of understanding from someone who specializes in this.

Monte Cahn, president of registrar Moniker.com, has a radio program (can’t say I’ve heard it yet, but I’m going to start listening). My CPA found the transcript of one show where he interviewed Evan Brody from Brody & Associates. Evan is Moniker’s corporate tax guy.

I can’t tell you that this interview will answer every question for you on the subject. Hell, when it comes to taxes, I don’t know if one can ever get complete answers. Sometimes, it’s so subjective anyway. But there is a lot of good information. It’s at least enough to get you scared into thinking about how to do it right, I hope.

One of the most interesting things I got out of it is this shocking statistic: “when you’re unincorporated on what they call a Schedule C or Sole Proprietorship, the audit ratio which is really something that is a variable that you really don’t take into consideration for tax planning, but just some statistical information, those entities get audited 11 times more than if you were a corporation.”

Now that’s frightening. I’m assuming since I’m neither a Schedule C or Sole Proprietorship, or a corporation, my LLC falls into or close to the corporation audit rate. I think it just signals to the IRS that the filer is simply more willing ($800 a year in California) to take steps to be serious about their taxes. By the way, I can also tell you that I’ve heard that having your taxes done by a CPA greatly reduces the risk of an audit. I guess individuals are more likely to either lie or make mistakes, than would be a CPA.

So, for your reading enjoyment, here is the Monte Kahn Domains and Taxes transcript (see below).

Evan: That’s a very good question. Basically, setting up the entity or operating out of the correct structure is really important as much as coming up with other tax strategies and other ideas. For example, the structure that you create is really going to be the structure that you may live with for the duration of your entity’s operation. And each entity is different treated for tax purposes. For example, most people usually use a flow-through entity. Flow-through entities are entities that are not taxed at the corporate level, they’re taxed at the individual or the entity that’s going to receive that flow-through income or loss. First item on the list is a C corporation. C corporations usually are not the best for anyone to use. They’re taxed both in the corporation, usually there is a state tax sometimes, and then there is a dividend tax on the way out. So, the triple tax usually is not what people run to. Plus, if you were ever going to sell your assets inside of a C corporation – So let’s say you’ve had a couple assets in there that you’ve held more than 12 months, and we’re going to get into some of these topics hopefully later on about what kind of assets can create a capital gain at 15% and what assets can create an ordinary income at 35%. And generally speaking, an asset that is ever sold in a C corporation never gets a capital gain rate of 15%. There is no such thing as capital gains in C corporations for that favorable tax treatment. So, everything is taxed at ordinary income rates; so the one thing you definitely probably don’t want to be is a C corporation. Moving our way into the other realms, the different other entities would be an LLC and a partnership. Generally LLCs are Limited Liability Companies and they avail themselves to pretty good tax positions on that as well. The best benefit of an LLC is the fact that, if you own 100% of it or if you have an entity that owns 100% of an LLC, without making a form 8832 election, that entity is disregarded for tax return purposes. So what happens is, whatever domain names or other property that you have in the 100% owned LLC, it’s disregarded for tax purposes and is deemed to be owned by the individual or the entity that owns that. But, of course, you still get the legal liability protection, so you get the best of both worlds. Now, an LLC with more than one member is actually defaulted to a partnership; so a partnership, whether it be an LLC or actually filing as a limited partnership or general partnership, the connotations associated with that particular entity is that the income derived from those type of operations, what it is basically subject to is a tax called FICA. FICA comprises of both Social Security, which is at 6.2%, and Medicare, which is at 1.45%. The summation of 7.65% is then matched by the employer. Also, the owner and the employee, you pay 15.3%. So if you’re a service entity, which most of the domains do both selling and you know other service-type orientation, which is pretty much everything else in the domain world, is then going to have this tax that is over and above federal income tax. It’s called FICA tax, and that’s at 15.3% up to about $90,000 and any income above that $90,000 mark, which is indexed each year from inflation, is then taxed at another 2.9% for unlimited income, including sales of some of these domain sites.

Monte: Oh, okay. So, basically, the big buzz was that I’ve got to get an LLC. A matter of fact, a couple of people in the chat room were saying yeah I need to form my LLC. That’s really not, may not be the best advice from a corporate structure when you’re a domainer or own domain names, unless it’s wholly owned by another organization, is that correct?

Evan: Well, yeah. There’s one item to that too. It’s so we have LLCs, we have partnerships, we have unincorporated entities, self proprietorships, and now we move ourselves into, and we talked about the C corp., but let’s talk about an S corporation. An S corporation basically is like a flow-through entity. It doesn’t pay tax inside of the entity itself; it pushes that through usually to the individual owner. That entity, an S corporation, is the only entity that can filter FICA taxes. Now, the IRS is somewhat privy to that; and so, what the requirement is, is that you pay yourself a reasonable salary from that operation. Once you pay yourself that reasonable salary, all the income over and above that generally is FICA-free, and that’s a permanent savings of 2.9%, unlike Social Security, that [inaudible] paid into some sort of account for you in the future; Medicare is not a function of what you pay in, the function of what you don’t have in the future, so any amount that you pay in for that, you know, is not really going to benefit you. So you really want to make sure you pay in what you really, truly should pay, and that’s your reasonable salary.

Monte: Right, right. Okay, so, and then are there any other types of creative structures that would work best or is that basically it?

Evan: Usually an S corporation is usually the best structure to filter the service income; and of course, that S corporation could, in turn, own 100% LLCs. So, an S corporation filing one tax return could have underneath it subsidiaries, 5, 6, 100 different LLCs, which give asset protection but then are disregarded, and all are treated as if there’s one asset in the S corp. So there are some ways you can plan with the S corp. to have it own LLCs and other interests as well. But, of course, there are other drawbacks associated with S corporations on the basis, if you’re a company that loses money and maybe is funding that through loans, you may want to look to a partnership or an LLC structure, at least during the period that you’re having losses; because you can receive basis sometimes from the losses that, or at least from the loans, that are from the company itself. S corporations, you do not.

Monte: Okay. Okay. Great. Well that’s very important, cause that’s the foundation and the structure of how one owns domain names. So those people that own domain names personally and have not incorporated themselves, they’re really subject to the extra taxes then?

Evan: Extra taxes plus the IRS released some statistical information that, when you’re unincorporated on what they call a Schedule C or Sole Proprietorship, the audit ratio which is really something that is a variable that you really don’t take into consideration for tax planning, but just some statistical information, those entities get audited 11 times more than if you were a corporation.

Monte: Well, that’s an interesting statistic.

Evan: Yes. That was just released.

Monte: Oh, wow. And where was that released?

Evan: That was one of the informations from one of the [inaudible] centers that go on this statistical information on audits on all different types of entities; and the abuse that the IRS sees most, which they have focused most of their audits on, are people that are unincorporated, because that seems to be the highest exposure area.

Monte: Right. Right. Alright. Well, that’s great to know. Okay. So now let’s move into the domain names themselves. And there are several areas in which we’ve served our customers and also have experienced domain-related events which are related to receiving income. And, there is the basic registration of a domain name, and the renewals of those domain names and how those are treated, and then there’s we go on to how people are monetizing domain names and earning money from those domain names, either through traffic aggregation and monetization or domain name sales and services, and then of course donations and donating domain names to charity and how those are all treated. Let’s go with the first step in terms of just the basic registration process of a domain name and how it should be treated in terms of taxes in the structure that you recommend.

Evan: Well, generally speaking, the registration fees and renewal fees are an annual type of expenditure; and annual expenditures are spent in the year that you incur them, so there usually is not a capitalization requirement for that. Other, I guess, realms from that would be, let’s say that you acquire a domain name. When you acquire a domain name, that’s a little different; because that’s deemed to be an asset to the IRS that has value that exceeds beyond one year. And, generally speaking, we consider those Section 1231 assets, which are kind of a hybrid, which is really the best treatment that you’re going to get out of an asset for the IRS. Meaning that, if it appreciates and you sell it, in general you’ll get capital gains at 15%. If you sell it at a loss, you get an ordinary loss. So, there’s some recapture rules, but generally speaking, those are how you treat those two items.

Monte: Okay. So, the actual annual renewal fees is just an annual fee and it’s treated that way; but if you sold it for a profit, then it’s a capital gains event at 15%.

Evan: Yes.

Monte: And the difference of what you bought it for to what you sold it for, I guess, is equated in that transaction.

Evan: Exactly.

Monte: Okay. Now, moving on to making money on domain names. So let’s say I own domain names, I’m not selling it, but I’m now monetizing my assets. I’m turning all the traffic over to paper click advertising and I’m making money on them, or let’s say somebody is paying me to use my domain name as a lease and so on. How is that treated?

Evan: Well, generally speaking, income is recognized on the basis of accounting that the individual utilizes, whether it be a cash receipts methodology or an accrual methodology. So, what happens is they pick it up first as they have their general method of accounting and it’s cash and they get money, they pick it up that year. If it’s an accrual, they pick it up in the year that it accrues and accruals which is not necessarily always the best way to go, accrual method taxpayers, if they receive cash, sometimes on prepaid services will have to pick that up in income under Section 481 or 461 earlier than they had accrued it.

Monte: Okay. Okay. Great. And, so if you’re earning money from that, either through somebody leasing a property from you or basically you’re receiving money from companies that are having you fill a W-9 out which are paying you a monthly income based off of the use of your domain name. That’s how that’s treated?

Evan: That’s correct. It’s income when earned.

Monte: Okay. Now, how about appraising domain names and establishing an asset value. How can that be used either for or against you in terms of taxes? Let’s say, I have a domain name and I’m going to get it appraised to establish an asset value so that I have a net worth of a certain amount, or even to the point where I’m going to donate that domain name to charity. For example, a couple of years ago, we were responsible for appraising the domain name Holocaust.org; and it went to the Shoah Foundation after Schindler’s List was out as the movie. And my client was able to get over a million dollar tax credit for that domain name. How is that all treated?

Evan: Okay. Evaluations for your current assets really is just something that you would need to present to a bank. It really doesn’t have any tax implications; but, on your question regarding a charitable contribution, you’re right on the numbers with that. Basically speaking is that, if you’re going to donate property, and this is now a general rule, not anything specifically to domain sites at all, but if you’re going to donate property and the property is what they consider to be not inventory. So, you’ve held it, and it’s appreciated, either it’s what they call 1231 assets, meaning that’s an asset that you’ve maintained in your company or, in this case here, when someone just had this domain name and I’m going to make the assumption that they’ve held onto that site for 12 months or more. And if you held onto that for more than 12 months, the rule basically is this, and again let me go back a little bit with that $5,000 mark. The $5,000 mark again is a requirement for any contributions of property that’s not obviously cash or a check; and any time it’s over $5,000, the IRS requires an independent appraisal to be done on that just to qualify that amount to be what it is. And so now, that qualifies the deduction. Now the question is how do you get to that deduction? The fair market value necessarily is not the deduction amount. So, the deduction first goes off of what it’s fair market value is minus what ordinary income that would have been generated on the sale of that, had you sold it to a third party. So, if you’ve held onto it for more than 12 months, and it’s a 1231 asset for your company, then the full fair market value is deductible; and that portion that would be the appreciation escapes tax. Of course, there is what they call the 30% AGI limitation, meaning that that deduction cannot exceed more than 30% of the total income on your personal tax return, nevertheless any amount over that is carried forward to another year. Normal deductions are charitable and organizations under say a 501(c)(3) is at 50%, so it’s not like anything substantial. But, of course, you do have that limitation and, most important, you escape tax on the appreciation.

Monte: How many years can you flow that through. Let’s say it’s something of extreme value. Let’s say it’s over $100,000 and you’ve donated it.

Evan: Sure, charitable contributions that, in our example let’s say had a 30% AGI limitation, when I say someone had $100,000 of income and then they donated an asset for also let’s say $100,000 as well. So, the first year, in year one, you take that $100,000, your total income on your personal return, times that by 30%, that means that $30,000 of the $100,000 is deductible that year; and the remaining $70,000 would be carried with the same limitations applying that year with 5 years being the period that you have to utilize it or you lose it.

Monte: I see. I see. So it can really work to your benefit if you’re looking for a way to decrease the amount of taxes you have to pay if you want to donate a domain name to your church or to a charity, or what have you.

Evan: Yeah. And then there’s all these other special rules now. I’m going through an asset that’s been held by a domain company that was used in their primary trader business. Let’s say on the Web, trafficking, etc. etc. If there was an entity that, instead, held these out for sale, whether it be on an auction or that’s just part of their business of doing that, those are considered inventory. Inventory doesn’t get that great step up to fair market value on the charitable contribution. Instead, what they do is they give you the fair market value as your deduction, but they say okay, whatever ordinary income would have been generated from this, you reduce that contribution. Effectively, it brings you right down to your cost basis. And there are some exceptions to the rule. And if you were a C corp., which again I would never recommend but by some chance you were and you donated this inventory to say to maybe, you know there’s a special rule dealing with elementary schools and secondary schools, you get your cost basis plus ½ of the profits. So, that applies there. Also, if you were donating equipment, may you had old antiquated equipment on your side but maybe it could be used by an elementary school or a secondary school, that one you’d get favorable treatment as well.

Monte: Okay. Great. And now we talked about a scenario if the domain name was owned more than 12 months. What if its under 12 months? What if I’ve only owned the domain name for 6 months?

Evan: Yes. What happens is, any of the gain that would be treated as not being a long-term capital gain, which is then any short-term item is then ordinary income, and then what you do is, you have to reduce the gain, or I should say the donation, by any ordinary income that you would recognize. So, if you had this asset less than 12 months and you paid say $30,000 and you were trying to get a $100,000 fair market value deduction, you would be limited only to $30,000 for short term. Own it for 12 months, it goes to $100,000.

Monte: Okay. So it might be an advantage to hold it instead of donate it early. For sure.

Evan: [Laughing] It would be on that notation, yes.

Monte: So, one other important issue we should cover then is how you, just about domain names and amortization and depreciation and how you treat that year-to-year. So, I have a domain name inventory. How does one go about treating depreciation and amortization of my web site assets?

Evan: Well, the first item you mentioned was inventory in there. The one item that’s associated with inventory that, in general, is not depreciable, unless you were selling airline engines, which is a special case ruling, but certainly background for this one, anything that you’re holding out for sale for customers cannot have any amortization or depreciation associated with it. Only the ones that, let’s say, you purchase a domain site, you purchased it for $150,000 and you were using it to monetize traffic flow, that one you would amortize. Again, we amortize that over 15 years. There are some special rules that if you did fall into, like research and development kind of criteria, that we could maybe move it into let’s say 60 months or 36 months, but that comes with some very substantial research and development connotations with that. So, in general, it’s 15 years.

Monte: Okay. So 15 years?

Evan: Yes.

Monte: And how do you list that on the tax form? Is it listed as normal property?

Evan: Well, it would be a Section 1231 property. Again, this would be one that is not inventory, that you’re using it for monetization of traffic flow. In that situation, it would just be, uh, you can put it under the fixed assets side of the equation, you could put it under the intangibles. [inaudible] We would probably move more to the intangible side of the equation and then we would amortize that again over 15 years.

Monte: Okay. Okay. Alright, so we’ve covered a lot in a short period of time. Is there anything I’m missing here that can help the audience out? What are a couple things that some of the folks can walk away with in terms of stuff they didn’t know before. I mean we already talked about how best to set you up from a corporate structure and a lot of people thought an LLC was the best idea, but really it’s not. It’s more probably an S corp.