The IRS continues to issue guidance in the much debated area of corporate spinoffs. A recently published ruling examined the federal income tax treatment of the two steps that comprise a so-called “north-south” transaction.” In doing so, it provides taxpayers with some welcome certainty.

A “north-south” transaction is one in which a parent corporation (P) contributes property constituting an active trade or business to its wholly-owned first-tier subsidiary corporation (D) for the purpose of enabling D to satisfy the requirements for a “tax-free spinoff” within the meaning of the Code. Then, pursuant to the same overall plan, and for a bona fide business purpose, D immediately distributes the stock of its own wholly-owned corporate subsidiary (C) to P.

The IRS considered whether the contribution and distribution that comprise a north-south transaction should be treated as two separate transactions for federal income tax purposes.

The Transaction

P owns all the stock of D, which owns all the stock of C. The fair market value (“FMV”) of the C stock is $100X. P has been engaged in Business A for more than 5 years, and C has been engaged in Business B for more than 5 years. Business A and Business B each constitutes the “active conduct of a trade or business” within the meaning of the Code’s spinoff rules. D is not engaged in the active conduct of a trade or business directly or through any subsidiary other than C.

On Date 1, P transfers the property and activities constituting Business A, having a fair market value of $25X, to D in exchange for additional shares of D stock. On Date 2, pursuant to a dividend declaration, D transfers all the C stock to P for a valid corporate business purpose. D retains the Business A property and continues the active conduct of Business A after the distribution. The purpose of P’s transfer of the property and activities of Business A to D is to allow D to satisfy the active trade or business requirement for a “tax-free” spinoff.

The Law

A distribution that is treated, for tax purposes, as a dividend made by a corporation to a shareholder with respect to its stock, is includible in the gross income of the shareholder. The portion of the distribution that is not a dividend – i.e., the amount that exceeds the distributing corporation’s accumulated and current earnings and profits – is applied against and reduces the shareholder’s adjusted basis for the stock. The remaining portion of the distribution, in excess of the adjusted basis of the stock, is treated as gain from the sale or exchange of property by the shareholder.

If a corporation distributes appreciated property (rather than cash) to a shareholder in a distribution that is treated as a dividend, the distributing corporation recognizes gain as if it had sold the property to the shareholder at its FMV.

Spinoff

However, if certain requirements are met, a corporation may distribute all of the stock of a controlled corporation to its shareholders without recognition of gain or income, either to the corporation or to the recipient shareholders. In order for a distribution to qualify for this nonrecognition treatment, the distributing corporation must distribute stock of a corporation that it controls immediately before the distribution. In addition, the distributing corporation and the controlled corporation each must be engaged in the active conduct of a trade or business immediately after the distribution. Finally, the distribution must be made for a bona fide business purpose.

But what if the distributing corporation would be left without an active trade or business after the distribution of its subsidiary to its shareholders? How may it salvage nonrecogntion treatment? If the shareholders are, themselves, engaged in the conduct of an active trade or business, can they contribute this business to the distributing corporation immediately prior to the distribution?

Capital Contribution

The Code provides that no gain will be recognized when property is transferred to a corporation by one or more persons solely in exchange for stock in such corporation and, immediately after the exchange, such person or persons are in “control” of the corporation. “Control” is defined as ownership of stock possessing at least 80 percent of the total combined voting power of all classes of stock entitled to vote and at least 80 percent of the total number of shares of all other classes of stock of the corporation. In addition, no gain or income is recognized to a corporation on the receipt of money or other property in exchange for stock of such corporation.

Reorganization

The Code also provides that no gain or loss will be recognized to a corporation on its exchange of property pursuant to a plan of reorganization solely for stock in another corporation a party to the reorganization. Under the Code, a “reorganization” includes a transfer by a corporation of part of its assets to another corporation if, immediately after the transfer, the transferor is in control of the corporation to which the assets are transferred, and the transferor distributes the stock of the controlled corporation in a spinoff transaction.

Continued Investment

The underlying assumption of these exceptions to the general gain recognition rule is that the stock of the controlled corporation is substantially a continuation of the property contributed to such corporation, so that the “old” investment remains unliquidated, and, in the case of a reorganization, that the new enterprise, the new corporate structure, and the new property are substantially continuations of the old one, still unliquidated.

Step Transaction

The federal income tax consequences to P and D, above, will depend on whether the Date 1 and Date 2 transfers are treated as separate transactions. Because they are undertaken pursuant to the same overall plan, a question arises as to whether the two transactions are part of a single reciprocal transfer of property—an exchange.

If the Date 1 and Date 2 transfers are respected as separate transactions for federal income tax purposes, P would be treated as contributing property to D on Date 1 for D stock in an exchange that qualified for nonrecognition treatment, and D would be treated as distributing all the stock of C to P on Date 2 in a distribution that qualified for nonrecognition treatment under the spinoff rules.

If the Date 1 and Date 2 transfers are integrated into a single exchange for federal income tax purposes, P would be treated as transferring its Business A property to D in exchange for a portion (FMV of $25X) of the C stock in a taxable exchange in which gain would be recognized to P on the transfer of its property to D; gain would also be recognized to D upon its transfer of 25 percent of the C stock (FMV of $25X) to P in exchange for the property transferred to it. In addition, the distribution of C stock would not qualify as a tax-free spinoff because D would not have distributed stock constituting control (at least 80 percent) of C. Gain would be recognized to D upon the distribution of the remaining 75 percent of the C stock with respect to P’s stock in D.

The IRS’s Ruling

According to the IRS, the determination of whether steps of a transaction should be integrated requires a review of the scope and intent underlying each of the implicated provisions of the Code. The tax treatment of a transaction generally follows the taxpayer’s chosen form unless: (1) there is a compelling alternative policy; (2) the effect of all or part of the steps of the transaction is to avoid a particular result intended by otherwise-applicable Code provisions; or (3) the effect of all or part of the steps of the transaction is inconsistent with the underlying intent of the applicable Code provisions.

The IRS noted that the Code’s spinoff rules permit the direct and indirect acquisition of an active trade or business by a corporation, within the 5-year period ending on the date of a distribution, in transactions in which no gain or loss was recognized. The intent of the rule is to prevent the acquisition of a trade or business by the distributing corporation or the controlled corporation from an outside party in a taxable transaction within the 5-year pre-distribution period; this ensures that transfers of assets in transactions eligible for nonrecognition treatment throughout the 5-year period will not adversely impact an otherwise qualifying spinoff.

The transfer of property permitted to be received by D in a nonrecognition transaction has independent significance when undertaken in contemplation of a spinoff distribution by D of stock of a controlled corporation. The transfer, the IRS ruled, is respected as a separate transaction, regardless of whether the purpose of the transfer is to qualify the distribution as a spinoff. Back-to-back nonrecognition transfers, the IRS continued, are generally respected when consistent with the underlying intent of the applicable Code provisions.

P’s transfer on Date 1 is the type of transaction to which nonrecognition treatment is intended to apply. Analysis of the transaction as a whole does not indicate that P’s transfer should be properly treated other than in accordance with its form. The IRS observed that each step provides for continued ownership in modified corporate form. Additionally, the steps do not resemble a sale, and none of the interests are liquidated or otherwise redeemed; the transferor retained beneficial ownership in the assets transferred to the first corporation. On these facts, nonrecognition treatment under the above rules is not inconsistent with the Congressional intent of these Code provisions. The effect of the steps is consistent with the policies underlying these nonrecognition provisions.

Accordingly, the IRS held, the Date 1 and Date 2 transfers would be respected as separate transactions for federal income tax purposes, and both would be accorded nonrecognition treatment. Moreover, the federal income tax consequences would be the same if, instead of acquiring an active trade or business as a contribution to capital from P, D acquired an active trade or business from another subsidiary of P in a cross-chain reorganization (for example, by way of a merger with a sister corporation).

Thus, the transfer by P to its subsidiary, D, of property constituting an active trade or business for the purpose of meeting the spinoff requirements, immediately followed by the distribution by D to P of the stock of its controlled subsidiary, C, is treated as a tax-free contribution of property, followed by a tax-free spinoff of the C stock.

Beyond the Ruling

An IRS revenue ruling is an official interpretation by the IRS of the Code and the regulations promulgated thereunder. It represents the conclusion of the IRS on how the law is applied to a specific set of facts. Thus, it may certainly be relied upon by a taxpayer in a situation similar to the one described in the ruling.

The factual situation from the revenue ruling described above is fairly straightforward. Nevertheless, taxpayers should be pleased with the ruling’s conclusion that the capital contribution and the subsequent spinoff distribution will be respected as two separate nonrecognition transactions even though they represented integral parts of a single plan.

The key to the IRS’s holding is the fact that the two steps did not resemble a sale; rather, the business assets remained in corporate solution under the same beneficial ownership.

Furthermore, the steps did not violate the overall purpose of the spinoff rules, which is to prevent “devices” that are designed to bail out corporate profits; indeed, the active trade or business test is another element of this anti-dividend-device purpose of the rules. One should not lose sight of this purpose when examining the various nonrecognition requirements for a spinoff.

Missed Part I?  Check it out here!

“Related Party” Transactions
Transfer Pricing

Valuations figure prominently in determining the proper tax treatment of transactions – such as sales, loans, leases, and performance of services – between related taxpayers, including, for example, commonly-controlled business entities.

The IRS is authorized to allocate items of income or deduction, or any other items affecting taxable income, so as to ensure that the related parties properly reflect their income attributable to such transactions – in other words, that the transactions reflect an arm’s-length result.

The IRS thus requires that a taxpayer use the method that, under the facts and circumstances, provides the most reliable measure of an arm’s-length result. In determining the best method, data based on the results of transactions between unrelated parties provides the most objective basis for determining whether the results of a transaction are arm’s-length.

Constructive Transfers

Where a corporation or partnership sells or leases property to one of its owners in exchange for an amount of consideration that is less than the relevant FMV, the entity may be treated as having made a distribution to the transferee. Depending upon the facts and circumstances, this constructive distribution may be taxable to the transferee.

Where the transferee has provided services to the business entity, the bargain element of the transaction may be treated as a compensation to the transferee.

Where a corporation distributes property to its shareholders, either as a dividend or as a liquidating distribution, the corporation will be treated as having sold such property. Thus, if the FMV of the property exceeds the corporation’s adjusted basis in the property, the corporation will realize a taxable gain.

Where a taxpayer contributes property to a corporation or partnership and the value of the equity issued to the taxpayer in exchange for the contribution is less than the FMV of the property contributed, the IRS may characterize the difference according to its “true” nature; for example, has the contributor made a gift to the other owners, a payment for services, or the repayment of a debt?

Capital Contributions of Property

How many of you have responded to the question on the federal partnership tax return: did the partner contribute property with a built-in gain?

How about the question on the federal S-corporation tax return: if the corporation was a C-corporation before it elected to be an S-corporation, or the corporation acquired an asset from a C-corporation in a tax-free exchange, does it have any built-in gain?

How many of you have obtained appraisals in connection with such a contribution to the partnership or in connection with an “S” election?

It is imperative that you obtain an appraisal in these situations, in order to minimize the allocation issues for the contributing partner and the exposure to corporate-level tax.

Second Class of Stock

Speaking of S-corporations, the regulations provide that buy-sell agreements among shareholders, agreements restricting the transferability of stock, and redemption agreements are disregarded in determining whether a corporation’s outstanding shares of stock confer identical distribution and liquidation rights unless (1) a principal purpose of the agreement is to circumvent the one class of stock requirement, and (2) the agreement establishes a purchase price that, at the time the agreement is entered into, is significantly in excess of or below the FMV of the stock.

Because the first requirement is subjective and, so, often presents an issue, most taxpayers choose to rely upon the second, relating to purchase price.

Agreements that provide for the purchase or redemption S-corporation of stock at book value or at a price between fair market value and book value are not considered to establish a price that is significantly in excess of or below the FMV of the stock. A good faith determination of fair market value will be respected unless it can be shown that the value was substantially in error and the determination of the value was not performed with reasonable diligence.

It should be noted that although an agreement may be disregarded in determining whether shares of stock confer identical distribution and liquidation rights, payments pursuant to the agreement may have income or transfer tax consequences.

Sale of Business

Whether the client is the sole owner of a business or one of several, it behooves the owner(s) to make sure they are getting the right price for their business.

This will be especially important where there are minority shareholders who may object to the sale negotiated by the majority owner – whether on principle, or because of the price, or because they will not be continuing in any employment or other capacity with the buyer.

Allocation of Purchase Price

There are several circumstances, attendant to the sale of a business or of an interest in a business, where the amount paid for the acquisition of the property must either be allocated among the assets purchased or attributed to the underlying assets of the business an interest in which is being acquired.

This allocation/attribution has both income and state transfer tax consequences.

Among these situations are the following:

  • Purchase/sale of the assets of a business (ordinary income v. capital gain; sales tax).
  • Purchase/sale of the stock of a corporation coupled with an election to treat the transaction as a sale of its underlying assets (ordinary income v. capital gain).
  • Purchase/sale of an interest in a partnership that holds “hot assets” (ordinary income v. capital gain).
  • Purchase/sale of stock/partnership interest in an entity that owns NY real property (NY State and NYC transfer tax).
  • Election to adjust a transferee partner’s share of inside basis for a partnership asset (future depreciation/amortization/gain).

Tax-Free Reorganizations

In order for a “reorganization” to qualify for tax-free treatment, it must meet certain statutory and regulatory requirements, including a requirement under proposed regulations that there be a surrender of net value (really an extension of the continuity of interest principle), determined by reference to the assets and liabilities of the target, and a receipt of net value, determined by reference to the assets and liabilities of the issuing corporation.

In other words, the FMV of the property transferred by the target must exceed the amount of the target liabilities assumed by the acquiring corporation in connection with the exchange. Similarly, the FMV of the assets of the issuing corporation must exceed the amount of its liabilities after the exchange.

Loss Company

No business owner wants his business to generate losses, but it happens. For some start-up businesses, the losses eventually give way to profits. In other cases, losses may be realized as a result of a downturn in the economy or the departure of a significant client.

Whatever the reason, another business or investor may see something in the struggling corporation that is worth saving or acquiring. When this person acquires stock in the corporation, or acquires the assets of the corporation in a tax-free reorganization, the target or acquiring corporation, as the case may be, could be limited in its ability to utilize the target’s NOLs.

Specifically, if there is a greater than 50% change in the beneficial ownership of the target, the target’s or acquirer’s ability to utilize the losses will be limited as follows: the amount of such losses that may be claimed by the target or acquirer in any tax year will be capped at an amount equal to the product of the FMV of the target and the long-term tax-exempt rate issued by the IRS.

Penalties

Aggressive valuations can result in the imposition of significant so-called “accuracy-related penalties.”

For example, if a gift or estate tax deficiency is based upon a substantial understatement of value for a property, the IRS may impose a 20% penalty upon that portion of the deficiency that is attributable to such understatement.

There is a similar result in the case of an income tax deficiency that is based upon a substantial valuation misstatement, including an overvaluation of a property or of a property’s adjusted basis.

This penalty may also apply where the price for any property, for the use of any property, or for a service, in connection with a transaction between certain related persons is either too high or too low compared to the correct price.

Where the misstatement of value is especially egregious, the penalty may be increased to 40%.

Et cetera

There are many other situations in which a closely-held business, its owners, and their advisers will have to consider retaining the services of a qualified appraiser in order to give themselves a reasonable chance of defending the desired tax consequences of a transaction. After all, the IRS’s determination of a tax deficiency (whether derived from a re-valuation of property or otherwise) is presumed to be correct, and the taxpayer has the burden of proving that the IRS’s determination is invalid.

When last I checked, business appraisers – like investment bankers, business consultants, accountants, lawyers, and other service providers to the business community – do not work for free. Based upon the foregoing discussion, these other advisers may be seriously compromised in doing their jobs without the services of a reputable and qualified appraiser.

Thus, the old English maxim, “be careful not to be penny-wise and pound-foolish.”

 

One word: “taxes.” There are so many transactions in which the tax consequences visited upon a closely-held business and its owners, and, therefore the true economic cost of the transaction, will depend upon the valuation of the business, its property, or its equity.

The following discussion highlights some of the more commonly-encountered situations in which such valuations may be critical, and with which advisers to closely-held businesses should be familiar.

Transfers in Connection with Estate and Gift Tax Planning

Estate and gift taxes are imposed upon the taxable amount of property transferred by a taxpayer upon his death or during his life, respectively. The determination of the taxable amount, begins with the fair market value (“FMV”) of the transferred property.

Thus, the first step in formulating any estate or gift plan is determining the FMV of the assets that the client plans to transfer. This FMV will tell us whether the client will likely be subject to the estate tax and, in the event he will be, whether a gifting program can lessen that expected tax hit.

If a gifting plan is to be implemented, a valuation of the property to be gifted should be undertaken in advance, to ensure that the economic consequences of the planned transfers are understood.

For example, how much of the client’s exemption amount will be consumed by his transfer of shares of stock in a corporation or membership interests in an LLC, and how much gift tax will be owed in respect of those transfers? If the goal is to avoid using the client’s exemption amount – as in the case of a sale to a grantor trust – is the consideration paid by the trust sufficient so as to avoid a gift?

Paying the Estate Tax

Assuming the client will have a taxable estate, the valuation of the assets to be included in his gross estate for tax purposes may assist in planning for the satisfaction of the resulting estate tax liability.

Once there is an estimate for this tax liability, the client can implement a plan to provide the requisite liquidity, such as by acquiring life insurance. Over time, if the value of the business is determined to have changed, the amount of insurance coverage may be adjusted accordingly.

Additionally, if the client owns an active business, the valuation of his interest therein may help with planning to ensure that the client retains a sufficiently large interest in the business so that, upon his demise, his estate may utilize the five-year installment payments option provided under the Code.

Finally, with the relevant valuation data, the client may be able to arrange for financing to be obtained from his business or investment entities in order to satisfy the estate tax liability.

Buy-Sell Agreements

Closely related to death (but certainly not limited to that situation), the dispositive provisions of a buy-sell agreement among shareholders or partners are very dependent upon an accurate valuation. For example, how will the buy-sell agreement affect the FMV of the equity at issue for tax purposes? Will the IRS be free to disregard the stated value, thereby placing the taxpayer in a position where the purchase price paid for his shares or partnership interests is not sufficient to cover his estate tax liability?

Statute of Limitations

If a gift of an interest in a closely-held business entity is not adequately disclosed on a gift tax return, the limitations period within which the IRS may assess additional gift tax will not begin to run. “Adequate disclosure” generally requires submission of the appraisal for the transferred property.

Income Tax Considerations of a Transfer

Adjusted Basis

The valuation of a decedent’s assets is critical not only to determine the estate tax ability, but also because it determines the tax basis for the decedent’s properties in the hands of his estate’s beneficiaries.

This basis will enable the beneficiaries to claim depreciation or amortization deductions for any qualifying property, and will also reduce their gain on a subsequent sale of the property.

Compensation

If property is transferred by a service recipient (“SR”) to a service provider (“SP”) in consideration of the latter’s services, the SP must include the FMV of such property in his gross income unless the SR’s rights to the property are subject to substantial risk of forfeiture.

Where the SP’s rights to the property are subject to risk of forfeiture, the SP may, nevertheless, elect to include the FMV of such property in his gross income for the year in which the property was received so as to prevent the subsequent appreciation in such property from being treated and taxed as compensation upon the lapse of the risk of forfeiture.

By the same token, the SR will have to withhold employment taxes based upon the FMV of such property where the SP is an employee of the SR.

Non-Qualified Deferred Compensation

The determination of FMV also figures prominently in various forms of non-qualified deferred compensation.

Where the SR grants the SP an option to acquire shares of stock or other equity interest in the SR, the strike price at which the option is exercisable may not be less than the FMV of the equity interest on the date the option was granted.

In the case of stock appreciation rights (“SAR”), when the SP has satisfied the conditions precedent to his being able to exercise the SAR, he becomes entitled to an amount equal to the difference between the FMV of the underlying shares on the date the SARs were granted and their FMV on the date of exercise.

Another similar situation is the case of a phantom stock plan, under which a SP will be entitled to receive an amount equal to the FMV of the underlying stock upon the achievement of certain benchmark events, such as the sale of the business.

In each of these situations, the failure to set a strike price or to establish a starting point at FMV may result in the deferral of compensation that, if not structured properly, could expose the SP to immediate income taxation with respect to the amount of the deferral (e.g., the spread in the case of an in-the-money option); it may also expose the SP to a 20% excise tax.

Reasonable Compensation

Speaking of compensation, a taxpayer-SR may deduct as an ordinary and necessary business expense a reasonable allowance for compensation paid to a SP for personal services actually rendered.

Although some may not view the determination of compensation for services as falling within the ambit of an appraiser’s job, that is only because they fail to recognize that the process of determining the FMV for services – i.e., reasonable compensation – involves the consideration of the amount that would be paid for like services by like enterprises under like circumstances (to use the language of real property appraisers, “comparables”).

Cancellation of Indebtedness 

In general, when a creditor cancels a debt owing to the creditor, the amount of this cancelled debt is treated as income to the borrower. However, there are exceptions to this general rule, some of which are dependent upon the valuation of the borrower’s property.

For example, gross income does not include any amount that would otherwise be includible by reason of the discharge of the taxpayer’s indebtedness if the discharge occurs when the taxpayer is insolvent. In that case, the amount excluded from gross income cannot exceed the amount by which the taxpayer is insolvent. In order to determine insolvency, the taxpayer must be able to establish the total FMV of all of his assets.

Under another exception, where a corporation transfers its stock, or a partnership transfers a capital or a profits interest, to a creditor in satisfaction of indebtedness, the borrower-entity is treated as having satisfied the indebtedness with an amount of money equal to the FMV of the transferred stock or partnership interest.

Stay tuned for Part II, tomorrow.

An Unreasonable Burden?

One of the reasons often given in support of the elimination of the estate tax is the economic burden it imposes upon the closely-held business; specifically, the requirement that the 40% federal estate tax be satisfied within nine months of the death of the business owner. The imposition of a state “death tax,” such as New York’s 16% tax, only exacerbates the problem.

Under these circumstances, or so the argument goes, a decedent’s estate would be forced to sell the business in what proponents of estate tax repeal describe as a “forced sale,” thus depriving the decedent’s family of an opportunity to continue the business, and resulting in the loss of the value created by the decedent over a lifetime of hard work.

Truth be told, where the decedent’s business represents the most valuable, and perhaps most illiquid, asset in the decedent’s estate, how else is the estate to raise the funds needed to pay the estate tax in such a short period of time?

Plan Ahead

Thankfully, many business owners begin to address this issue while they are still alive. Because the first step in calculating the estate tax is determining the value of the gross estate, a business owner who is able (for example, under the terms of a shareholders’ or operating agreement) and willing can make gifts of interests in the business to family members or to trusts for their benefit, thereby removing the appreciation in the value of those interests from his gross estate.

Although the reduction of one’s gross estate goes a long way in managing the estate tax burden, it has its limits – planning for deductions is necessary, especially for transfers to a spouse who may or may not be involved in the business, but who will require the revenue from the business. However, depending upon the value of the business, this approach will only defer the payment of the tax.

Insurance

In recognition of the foregoing limits, business owners will often acquire insurance on their lives, hopefully in an irrevocable life insurance trust. These funds may be used to purchase the decedent’s business interest, and the terms of the trust would then provide for the disposition of the interest.

In other situations, the business itself, or the decedent’s fellow partners or shareholders, may acquire life insurance on the decedent; pursuant to the terms of a shareholders’, partnership, or other buyout agreement, the owner/beneficiary of the policy would use the insurance proceeds to acquire the decedent’s business interest from his estate.

Where life insurance is not acquired, or the insurance acquired is insufficient, or where the insured is, for whatever reason, not insurable, the decedent’s estate may nevertheless have other options available to it.

Installment Payments

Under one statutory provision, which was enacted for the express purpose of helping to preserve closely-held businesses, the estate of a deceased owner may elect to pay the estate tax attributable to the value of the decedent’s interest in the closely-held business over a period of ten years. Furthermore, these payments are due beginning five years after the estate tax return is filed (with only interest payable until the fifth year). In this way, the profits from the business itself may assist the estate is satisfying the tax liability.

In order to qualify for this benefit, the value of the decedent’s interest in the closely-held business must exceed 35% of the decedent’s adjusted gross estate (which may restrain a lifetime gifting program), and the decedent must have owned at least a 20% interest in the business.  In addition, the business entity must be carrying on an active trade or business (as opposed to a passive or portfolio investment-type activity).

However, the estate is not in the clear just yet; for example, if any portion of the interest in the closely-held business is sold, or if money is withdrawn from the business, and the aggregate value of such transactions equals or exceeds 50% of the value of the business, then the extension of time for payment of the estate tax ceases to apply, and the IRS may demand payment of the unpaid portion of the estate tax.

The logic behind this acceleration rule is fairly obvious.  If the interest is sold, and the estate thereby becomes liquid, then the justification for installment payments – to preserve the interest in the closely-held business – no longer exists.

“Graegin Loans”

In other circumstances – for example, where the estate does not qualify for installment reporting, or where it prefers to pay the tax upfront – the estate may be able to borrow the necessary funds from the decedent’s business (which may have to borrow the funds from an institutional lender). Provided this borrowing represents a bona fide indebtedness between the business and the estate, and provided the interest to be paid by the estate in respect of the loan can be ascertained with reasonable certainty (for example, the loan terms provide that it may not be prepaid as to principal or interest), the estate will be able to deduct the total amount of interest payable under the loan – for purposes of determining the estate tax liability – as an administration expense incurred to prevent the financial loss that may otherwise occur as a result of a forced sale of the business in order to pay the estate tax.

Is the Loan “Necessary”?

A recent decision by the Court of Appeals for the Eleventh Circuit considered the interest deduction claimed by Decedent’s estate in connection with a loan from a controlled LLC.

At his death, Decedent owned 46.9% of Company’s voting stock and 51.5% of its nonvoting stock. His children owned most of the remaining stock, either directly or through trusts, while other family members and trusts held the remaining shares.

The Decedent’s Revocable Trust held a 50.50% interest in LLC on the date of his death, 46.94% of which was a voting interest and 51.59% of which was a nonvoting interest. The Revocable Trust comprised the majority of the assets of Decedent’s Estate, with the Trust’s interest in LLC being its primary asset. LLC was flush with liquid assets at the time of Decedent’s death.

The Loan

The Estate’s remaining liquid assets, however, were insufficient to pay its tax liability. The fiduciaries of the Estate declined to direct a distribution of the Revocable Trust’s interest in LLC to pay the estate tax liability, believing that immediate payment would hinder LLC’s plans to invest in operating businesses.

As a result, the trustees instead obtained a large loan from LLC in exchange for a promissory note bearing a market interest rate, though no payment was due for 18 years, at which point principal and interest were scheduled to be repaid in 14 annual installments. Prepayments were not permitted under the terms of the loan, and the projected interest payments were determined with reasonable certainty.

Because the Revocable Trust’s primary asset was its interest in LLC, it anticipated that the loan would be repaid with distributions from LLC, which had significant liquid assets at the time of the loan.

IRS Challenges the Estate Tax Return

When the Estate filed its estate tax return, it claimed a large deduction, as an administrative expense, for the interest payable on the loan.

The IRS determined a significant estate tax deficiency, in large part due to its determination that the interest payments were not properly deductible.

The U.S. Tax Court agreed, holding that Estate was not allowed to deduct the projected interest expense on the loan from LLC to the Revocable Trust. In reaching this holding, the Tax Court concluded that the loan was not necessary to the administration of the estate because, at the time the loan was made, LLC had substantial liquid assets and the Revocable Trust had a sufficient voting interest in LLC to force a pro rata distribution by the LLC in the amount of the debt. The Tax Court also rejected the Estate’s argument that the loan was preferable because a distribution would have depleted the LLC of cash that could have been used to purchase additional businesses; the Court noted that the loan also depleted the LLC of cash.

Additionally, the Tax Court observed that the loan would ultimately be repaid using the Revocable Trust’s distributions from LLC, such that it merely delayed the use of such distributions to pay the Estate’s tax liability. Further, it stated that the loan repayments were due many years after Decedent’s death, which hindered the proper settlement of the Estate.

The Estate appealed this decision to the Eleventh Circuit.

Administration Expense?

An estate is permitted to deduct expenses that are actually and necessarily incurred in the administration of a decedent’s estate. Expenditures that are not essential to the proper settlement of the estate, but that are incurred for the individual benefit of the decedent’s heirs, may not be taken as deductions. Expenses incurred to prevent financial loss to an estate resulting from forced sales of its assets to pay estate taxes are deductible administration expenses. Conversely, interest payments are not a deductible expense if the estate would have been able to pay the debt using the liquid assets of one of its entities, but instead elected to obtain a loan that will eventually be repaid using those same liquid assets.

The Court began by noting that an estate’s interest payments on a loan may be a necessary expense where the estate would have otherwise been forced to sell its assets at a loss to pay the estate’s debts. The Court described the case of an estate that held a substantial number of shares of voting stock of a closely-held corporation, but lacked sufficient liquidity to pay its tax liability; as a result, the estate obtained a loan from a third party rather than selling its voting stock. The interest payment in that case was necessarily incurred and properly deducted as an administrative expense, the court stated, because the estate consisted of largely illiquid assets and, had it not obtained the loan, it would have been forced to sell its assets on unfavorable terms to pay the taxes.

The Court observed, however, that an interest deduction is properly denied if the estate can pay its tax liability using the liquid assets of an entity, but elects instead to obtain a loan from the entity and then repays the loan using those same liquid assets.

The court then determined that the “loan structure, in effect, constituted an indirect use of [the decedent’s] stock to pay the debts . . . and accomplished nothing more than a direct use of that stock for the same purpose would have accomplished, except for the substantial estate tax savings.” It observed that those cases that permitted the interest deduction involved loans that were necessary to avoid the sale of illiquid assets, and did not involve the sale of the lender’s stock or assets to pay the borrower. Finally, because the petitioner was a majority partner in the limited partnership, “he was on the both sides of the transaction, in effect paying interest to himself,” resulting in the payments having no effect on his net worth aside from the tax savings.

Interest payments are not necessary expenses, the Court stated, where: (1) the entity from which the estate obtained the loan has sufficient liquid assets that the estate can use to pay the tax liability in the first instance; and (2) the estate lacked other assets such that it would be required to eventually resort to those liquid assets to repay the loan.

The Estate’s Liquidity

If the Estate had been forced to sell its interest in LLC, it would have been required to do so at a loss. Tax Court decisions are clear that interest payments on loans constitute a necessary expense if the estate’s only other option is a forced sale of assets at a loss. Therefore, if the Estate’s only option had been to redeem the Revocable Trust’s interest in the LLC, then the loan would have been necessary and the interest payments on the loan would be a necessary expense. However, because the Revocable Trust had voting control over LLC, and because LLC had substantial liquid assets, the Revocable Trust could have ordered a pro rata distribution to obtain these funds and pay its tax liability.

According to the Court, a loan is not unnecessary merely because the estate had access to a related entity’s liquid assets and could have used those assets to pay its tax liability. Instead, a loan is unnecessary if the estate lacks any other assets with which to repay the loan, and inevitably will be required to use those same assets to repay it. Stated differently, where the estate merely delays using the assets to repay the loan rather than immediately using the assets to pay the tax liability, the loan is an “indirect use” of the assets and is not necessary.

The loan in the present case was an “indirect use” of funds and was not necessary. Aside from the Revocable Trust and the Trust’s interest in LLC, the Estate lacked sufficient funds to repay the loan. The Estate’s Loan repayment schedule was designed to enable the Trust to repay the loan out of its distributions from LLC. Accordingly, the Revocable Trust’s distributions from LLC would be used to satisfy the Estate’s tax obligations regardless of whether the Estate paid its tax liability immediately or obtained a loan and then repaid the tax liability gradually. Further, LLC would be paying disbursements to the Revocable Trust only to have those payments returned in the form of principal and interest payments on the loan. The same entity is on both sides of the transaction, resulting in LLC “in effect paying interest to” itself.

Thus, the loan had no net economic benefit aside from the tax deduction. This further demonstrated that the loan was not necessary.

Decisions, Decisions

It will behoove the future fiduciaries and beneficiaries of a taxpayer’s estate – not to mention the taxpayer himself – to consider how the estate tax on the taxpayer’s estate will be paid. As is the case with gift and estate planning, there is likely no single “silver bullet” solution; rather, different strategies may be combined to produce a payment plan that will be optimal for the decedent’s estate given the nature of his business and other assets, and the cash flow they generate.

If a loan is to be considered, then in addition to the substantive issues described above, the interested parties will have to weigh the economic benefit of preserving the estate’s assets against the economic cost of taking and servicing a loan.

In General

It is a basic principle of federal tax law that a taxpayer cannot, for purposes of determining the taxpayer’s taxable income, claim a loss with respect to an investment in excess of the taxpayer’s unrecovered economic cost for such investment. If the taxpayer invested $X to acquire a non-depreciable asset – for example, a capital contribution in exchange for shares of stock in a C corporation, or a loan to a corporation in exchange for an interest-bearing note – the amount of loss realized by the taxpayer upon the disposition or worthlessness of the asset will be based upon the amount invested by the taxpayer in acquiring the asset. Where the asset is depreciable by the taxpayer, the loss realized is determined by reference to the taxpayer’s cost basis, reduced by the depreciation deductions claimed by the taxpayer (which represent a recovery of the taxpayer’s cost), i.e., the taxpayer’s adjusted basis.

Application to S-Corps

In the case of an S corporation, a shareholder’s ability to utilize his pro rata share of any deductions or losses realized by the S corporation is limited in accordance with this principle; specifically, for any taxable year, the aggregate amount of losses and deductions that may be taken into account by a shareholder cannot exceed the sum of the adjusted basis of the shareholder’s stock in the S corporation, and the shareholder’s adjusted basis for any bona fide loans made by the shareholder to the S corporation.

Stock Basis

Because an S corporation is treated as a pass-through for tax purposes, its income is generally not subject to corporate-level tax; rather, it is taxed to its shareholders (whether or not it is distributed to them).

In order to preserve this single level of tax, a shareholder’s initial basis for his shares of S corporation stock – which may be the amount he paid to acquire the shares from another shareholder or the adjusted basis of any property he contributed to the corporation in a tax-free exchange for such shares – is adjusted upward by the amount of income that is allocated and taxed to the shareholder; in this way, the already-taxed income may later be distributed to the shareholder without causing him to realize a gain (as where the amount distributed exceeds the stock basis).

By the same token, where already-taxed income has not been distributed to the shareholder, it remains subject to the risks of the business, and the shareholder is effectively treated as having made an “economic outlay” which may be lost in the operation of the business; this is reflected in his stock basis.

Debt Basis

In general, a shareholder’s basis for a cash loan from the shareholder to the corporation is equal to the face amount of the loan.

If the corporation’s indebtedness to the shareholder arose out of a transfer of property by the shareholder to the corporation – basically, a sale of the property in exchange for the corporation’s obligation to pay the purchase price some time in the future – the basis is equal to the face amount of the obligation less the amount of the deferred gain.

As the corporate indebtedness is satisfied, and the amount at economic risk is reduced, the shareholder’s basis in the debt is reduced.

“Necessity” as the Mother of Invention?

Because of this basis-limitation rule, S corporation shareholders, over the years, have proffered many arguments to support their ability to claim their share of S corporation losses – i.e., to increase their stock or debt basis – without having made an economic outlay. A recent decision by the U.S. Tax Court illustrates one such argument.

The Personal Guarantee

The sole issue in this case was whether Taxpayer had a sufficient basis in S-Corp., on account of his obligation with respect to S-Corp’s debt to a third party, to permit Taxpayer to deduct $X, which represented a portion of his distributive share of the corporation’s flow-through losses, on his personal income tax return.

Taxpayer was the sole shareholder of S-Corp. S-Corp. borrowed $Y from Bank, and Taxpayer personally guaranteed the loan. S-Corp. was later liquidated. At the time of liquidation, S-Corp. still owed Bank $X. S-Corp. filed its Form 1120S, U.S. Income Tax Return for an S corporation, on which it reported an ordinary business loss of $X. Taxpayer had no stock or debt basis in S-Corp. when it was liquidated.

According to the record before the Court, after S-Corp. was liquidated, the operations of the business somehow continued under its former name, S-Corp.’s loan with Bank was somehow renewed, and S-Corp. remained the named borrower of the renewed loan. Taxpayer signed the renewal note as president of S-Corp. and was the guarantor of the loan.

Also according to the record, Taxpayer made all loan payments following the liquidation of S-Corp., but the record did not indicate whether he made the payments from his personal funds or merely signed checks drawn on the account of S-Corp.

The IRS examined Taxpayer’s tax return and disallowed the $X loss deduction related to S-Corp., explaining that, because Taxpayer’s share of S-Corp.’s loss was limited to the extent of his adjusted basis for his stock, the amount of loss in excess of such basis was disallowed and was not was not currently deductible.

The Court’s Analysis

The Court began by explaining that an S corporation shareholder may take into account his or her pro rata share of the corporation’s losses, deductions, or credits. It then explained how the Code limits the aggregate amount of losses and deductions the shareholder may take into account to the sum of (A) the adjusted basis of the shareholder’s stock in the S corporation, and (B) the shareholder’s adjusted basis in any indebtedness of the S corporation

Taxpayer conceded that he had no stock or debt basis in S-Corp. at the time of its liquidation. However, he contended that upon the liquidation, he assumed the balance due on the note as guarantor and, because he was the sole remaining obligor, this assumption was effectively a contribution to capital, allowing him to deduct the amount of S-Corp.’s losses. Further, he asserted that, following S-Corp.’s liquidation, the Bank expected him, as guarantor, to repay the loan and that the Bank’s expectation was sufficient to generate basis for Taxpayer in S-Corp.

The Court rejected Taxpayer’s arguments. Merely guaranteeing an S corporation’s debt, it stated, was not sufficient to generate basis. The Court pointed out that, on many prior occasions, it had held that no form of indirect borrowing, be it by guaranty, surety or otherwise, gives rise to indebtedness from an S corporation to its shareholders until and unless the shareholders pay part or all of the obligation. “Prior to that crucial act, ‘liability’ may exist, but not debt to the shareholders.” The Court also stated that a shareholder may obtain an increase in basis in an S corporation only if there was an economic outlay on the part of the shareholder that leaves the shareholder “poorer in a material sense.” In other words, the shareholder must make an actual “investment” in the corporation.

The Court recognized, however, that a shareholder who has guaranteed a loan to an S corporation may increase his or her basis where, in substance, the shareholder has borrowed funds and subsequently advanced them to the corporation. Although, as a general rule, an economic outlay is required before a shareholder in an S corporation may increase his or her basis, this rule does not require a shareholder, in all cases, to “absolve a corporation’s debt before [he or she] may recognize an increased basis as a guarantor of a loan to a corporation.” Observing that “where the nature of a taxpayer’s interest in a corporation is in issue, courts may look beyond the form of the interest and investigate the substance of the transaction.” The Court indicated that a shareholder’s guaranty of a loan to an S corporation “may be treated for tax purposes as an equity investment in the corporation where the lender looks to the shareholder as the primary obligor.”

This determination, the Court stated, was an “inquiry focused on highly complex issues of fact and that similar inquiries must be carefully evaluated on their own facts.” (For example, the testimony of a loan officer stating that the lender-bank looked primarily to the taxpayer, and not the corporation, for repayment of the loan, as well as evidence that the S corporation was thinly capitalized.)

The Court then turned to the facts in the case to determine whether Taxpayer had established that the Bank looked to Taxpayer for repayment and Taxpayer had made economic outlays in making those payments.

The Court found that Taxpayer presented no evidence to support a finding that the Bank looked primarily to him, as opposed to S-Corp., for repayment of the loan, especially given the fact that, even after the corporate liquidation, S-Corp. remained an ongoing business enterprise.

It acknowledged that, according to the stipulation of facts, “[t]he [Taxpayer] continues to make payments on the loan”, but there was no indication, it pointed out, that the loan payments were made from Taxpayer’s personal funds rather than S-Corp.’s funds with Taxpayer signing payment checks as president. Moreover, under the terms of the renewal note, the renewed loan was to S-Corp. and Taxpayer’s obligation was that of a guarantor, not the maker of the loan.

The Court next considered Taxpayer’s assertion that the renewal of the loan to S-Corp. did not affect his position that he became the primary obligor of the loan upon S-Corp.’s liquidation. Taxpayer posited that he assumed the debt at the time of S-Corp.’s liquidation and that “his status as the sole remaining obligor”, for tax purposes, caused the repayments of the loan to be treated as contributions to the capital of S-Corp. The IRS disagreed, arguing that “upon the corporation’s liquidation, the debt remained undisturbed: the corporation did not default on the debt, the terms of the debt were not altered, and payments on the debt continued.”

The Court determined that there was insufficient evidence in the record to support a finding that the loan was made to Taxpayer personally, as opposed to S-Corp., and that Taxpayer, as the borrower, advanced the loan proceeds to S-Corp. Because Taxpayer failed to establish that the Bank looked primarily to Taxpayer to satisfy the debt obligation or that Taxpayer made an economic outlay with respect to the loan, Taxpayer failed to prove he had a basis in S-Corp. sufficient for him to deduct the reported business losses.

Advice to S Corporation Shareholders

What is an S corporation shareholder to do when corporate losses have been allocated to him, but he has no basis in his shares, and he either has no outstanding loan to the corporation or at least not one in which he has any basis? What happens to these excess losses, and how can they be utilized?

The excess losses allocated to a shareholder for a tax year cannot be used by the shareholder to offset ordinary income reported on the shareholder’s tax return for that year. That being said, the shareholder must realize that the excess losses are not lost (sorry for the pun) – they are merely suspended until such time as the shareholder has sufficient basis in his stock, or in a loan made by him to the corporation, to allow the losses to flow through to him. (Even then, however, the losses have to pass muster under the “at risk” and “passive loss” rules before the shareholder can realize their full benefit.)

So, how can a shareholder facilitate or expedite the use of his suspended losses? There are some options to consider:

  • Make a capital contribution to the corporation (using the shareholder’s own funds, or using funds borrowed from a third party; paying off a corporate debt)
  • Forego distributions by the corporation in profitable years (loan the distributed funds back to the corporation)
  • Accelerate the recognition of income by the corporation
  • Defer the deduction of corporate expenses
  • Make a loan to the corporation (using the shareholder’s own funds, or using funds borrowed from a third party; substituting the shareholder’s note for the corporation’s)

Each of these options presents its own risks and issues. For example, what if the shareholder does not receive additional stock in the corporation in exchange for his capital contribution? Has he made a gift to the other shareholders? He has certainly put more of his money at risk.

Of course, the shareholder can wait until the corporation sells its business. The gain from the sale may generate sufficient basis so as to allow the use of the suspended losses for the year of the sale (though the shareholder will thereby likely realize more gain on a subsequent liquidation of his shares).

However, if the disposition of the business is effected through a sale of stock by the shareholders (without an election to treat it as an asset sale), the suspended losses will disappear. They will also be lost if all of the shares are gifted to another (other than the shareholder’s spouse or to a grantor trust) prior to any sale. The suspended losses will also be lost if the shareholder dies before having used the losses – the step-up in basis for the stock that occurs at death does not benefit the deceased shareholder.

Thus, it may behoove the shareholder to find a way to “consume” the suspended losses before it is too late, provided as always, of course, that the means chosen makes sense from a business perspective.

Recovering Transaction Costs

It is a basic tax principle that the more a seller pays in taxes on the sale of its business, the lower will be the economic benefit realized on the sale; similarly, the more slowly that a buyer recovers the costs it incurs in acquiring a business, the lower will be the return on its investment.

In most cases, these “truths” are only considered in the context of allocating the consideration paid and received for the purchase and sale of a business among the assets comprising the business. An allocation of consideration to the goodwill of the business, for example, will generate capital gain for the seller, and will be recoverable by the buyer over a 15-year amortization period; an allocation to the tangible personal property used in the business may generate significant ordinary income for the seller (in the form of depreciation recapture), though it will be depreciable by the buyer over a relatively shorter period.

There is another element in every transaction, however, that needs to be considered in determining the tax consequences of the purchase and sale, but that is often overlooked until after the transaction has been completed and the parties are preparing the tax returns on which the tax consequences of the transaction are to be reported.

I am referring to the tax treatment of the various costs that are incurred by the buyer and the seller in investigating the acquisition or disposition of a business, in conducting the associated due diligence, in preparing the necessary purchase and sale agreements and related documents and, then, in completing the transaction. Where these costs may be deducted, they generate an immediate tax benefit for the party that incurred them by offsetting the party’s operating income, thereby reducing the economic cost of the transaction. Where the costs must be capitalized (i.e., added to the basis of the acquired property), they may reduce the amount of capital gain realized by the seller on the sale, whereas, in the case of the buyer, they may be recovered over the applicable recovery periods for the assets acquired (up to 39 years, in the case of nonresidential real property), thereby making the deal more expensive.

According to the IRS

Under regulations promulgated by the IRS, a purchaser must generally capitalize any amounts incurred to “facilitate” the acquisition of a business from a target company or the acquisition of ownership interests from the target’s owners; a similar rule applies as to costs incurred by the target or its owners to facilitate the sale.

Examples of Facilitative Expenses

An amount is paid to “facilitate” a purchase and sale transaction if it is incurred in the process of investigating or otherwise pursuing the transaction. Whether an amount is incurred “in the process of investigating or pursuing the transaction” is determined based on all of the facts and circumstances.

The fact that an expense would not have been incurred but for the transaction is relevant, but it is not determinative of whether it was incurred to facilitate a transaction.

On the other hand, an amount incurred to determine the value of a transaction is treated as an amount incurred in the process of investigating or otherwise pursuing the transaction.

However, an amount paid to another party in exchange for property is not treated as an amount incurred to facilitate the exchange. For example, the purchase price paid to a target in exchange for its assets is not an amount paid to facilitate the acquisition. Similarly, the amount paid by an acquirer to the target’s owners in exchange for their ownership interests is not an amount incurred to facilitate the acquisition of the ownership interests. (Of course, the amount paid by a taxpayer to another party to acquire the assets of a business or an ownership interest in the business must be capitalized; specifically, it must be added to the taxpayer’s cost basis for the business assets or the ownership interest, as the case may be.)

An amount incurred by a taxpayer to facilitate acquisition financing does not facilitate the acquisition for which the borrowing is incurred.

An amount paid by a target to facilitate a sale of its assets does not facilitate another transaction (other than the sale); for example, where a target corporation, in preparation for a merger with an acquiring corporation, sells assets that are not desired by the acquiring corporation, amounts incurred by the target to facilitate the sale of the unwanted assets are not required to be capitalized as amounts incurred to facilitate the merger.

An amount incurred to integrate the business operations of the taxpayer with the business operations of another does not facilitate an acquisition transaction, regardless of when the integration activities occur.

However, an amount paid to terminate an agreement to enter into an acquisition transaction will constitute an amount paid to facilitate a second acquisition transaction only if the transactions are mutually exclusive.

“Simplifying Conventions”

In order to simplify the determination of whether certain “routine” costs are incurred to facilitate a transaction, the IRS’s regulations provide that employee compensation and overhead costs are treated as amounts that do not facilitate an acquisition transaction and, thus do not need to be capitalized; instead, they may be deducted against the taxpayer’s operating income in the year they are incurred.

The term “employee compensation” means compensation (including salary, bonuses and commissions) paid to an employee of the taxpayer. For this purpose, a guaranteed payment to a partner in a partnership is treated as employee compensation, as is the annual compensation paid to a director of a corporation. However, an amount paid to the director for attendance at a special meeting of the board of directors is not treated as employee compensation. An amount paid to a person that is not an employee of the taxpayer (including the employer of the individual who performs the services) is generally treated as employee compensation only if the amount is paid for administrative support services.

Election to Capitalize

A taxpayer may elect to treat otherwise deductible employee compensation or overhead costs paid in the process of investigating or otherwise pursuing an acquisition as amounts that facilitate the transaction and, thus, must be capitalized. For example, a taxpayer may elect to treat overhead costs, but not employee compensation, as amounts that facilitate the transaction.

Facilitative Costs

In general, an amount incurred by the taxpayer in the process of investigating or otherwise pursuing a “covered transaction” (other than employee compensation and overhead costs) facilitates the transaction only if the amount relates to activities performed on or after the earlier of:

The date on which a letter of intent, exclusivity agreement, or similar written communication is executed by the acquirer and the target (an “LOI”); or

  • The date on which the material terms of the transaction (as tentatively agreed to by the acquirer and the target) are authorized or approved by the taxpayer’s board of directors or, in the case of a taxpayer that is not a corporation, the date on which the material terms of the transaction (as tentatively agreed to by the acquirer and the target) are authorized or approved by the appropriate governing officials of the taxpayer.

The term “covered transaction” means the following transactions:

  • A taxable acquisition by the taxpayer of a target’s assets that constitute a trade or business; and
  • A taxable acquisition of a significant ownership interest in a business entity (whether the taxpayer is the acquirer in the acquisition or the target of the acquisition).

Inherently Facilitative Costs                    

This “pre- vs. post-LOI timing rule” provides a helpful bright-line approach to the treatment of many deal expenses. However, the rule does not apply in the case of amounts incurred in the process of investigating or otherwise pursuing an acquisition transaction if they are “inherently facilitative.” Such amounts must be capitalized by the taxpayer regardless of whether they are incurred for activities performed prior to, or after, the execution of an LOI.

An amount is inherently facilitative if the amount is incurred for:

(i) Securing an appraisal, formal written evaluation, or fairness opinion related to the transaction;

(ii) Structuring the transaction, including negotiating the structure of the transaction and obtaining tax advice on the structure of the transaction;

(iii) Preparing and reviewing the documents that effectuate the transaction (for example, a purchase agreement);

(iv) Obtaining regulatory approval of the transaction;

(v) Obtaining shareholder approval of the transaction; or

(vi) Conveying property between the parties to the transaction (for example, transfer taxes).

Success-Based Fees

An amount incurred by a taxpayer with respect to a service provider that is contingent on the successful closing of an acquisition transaction is presumed to be an amount incurred to facilitate the transaction and, thus, must be capitalized, though a taxpayer may rebut the presumption by maintaining sufficient documentation to establish that a portion of the fee is allocable to activities that do not facilitate the transaction.

In lieu of maintaining this documentation, however, the IRS has provided taxpayers a simplified method for allocating between facilitative and non-facilitative activities any success-based fee paid in a covered transaction. Under this safe harbor for allocating a success-based fee, an electing taxpayer may treat 70 percent of the success-based fee as an amount that does not facilitate the transaction; this amount would be currently deductible by the taxpayer. The remaining portion of the fee would be capitalized as an amount that facilitates the transaction.

Capitalized Costs: Basis & Reduction of Gain

In the case of an acquisition that is not treated as a tax-free reorganization, any amount that is required to be capitalized by the acquirer under the preceding rules is added to the basis of the acquired assets (in the case of a transaction that is treated as an acquisition of the assets of the target for tax purposes) or to the basis of the acquired stock (in the case of a transaction that is treated as an acquisition of the stock of the target for tax purposes).

Any amount required to be capitalized by the target is treated as a reduction of the target’s amount realized on the disposition of its assets.

Recap

It is important for taxpayers that are contemplating the acquisition or disposition of a business that they not overlook the tax benefits that may be realized from the expenses they incur in connection with such acquisition or disposition.

For that reason, a brief summary of the principles set forth above is in order:

  • Any non-facilitative fees may be deducted by the taxpayer regardless of when incurred in the acquisition process.
  • Employee compensation and overhead costs may be treated as deductible, non-facilitative costs.
  • Any facilitative costs that are incurred prior to the execution of an LOI may also be deducted, provided they are not inherently facilitative.
  • Inherently facilitative fees must be capitalized regardless of when incurred in the acquisition process.
  • Success-based fees may be treated as partially facilitative and partially not facilitative.

Armed with this knowledge, an acquiring or selling taxpayer will be in a better position to gauge the true costs of certain expenditures, and should therefore be in a better position to negotiate the true economics of a deal.

Last week, we reviewed the various U.S. federal income tax consequences that may be visited upon a foreign person who owns and operates U.S. real property (“USRP”). Today we will consider the U.S. federal gift and estate tax consequences of which a foreign individual must be aware when investing in USRP.

Gift Tax

As you probably know, the gift tax is imposed upon the transfer of property by an individual, to or for the benefit of another individual, for less than full and adequate consideration. The typical scenario involves an outright transfer to a family member, or a transfer to an irrevocable trust for the benefit of a family member.

For a U.S. person – meaning a citizen or an alien individual who is domiciled in the U.S. – who makes a gift, the Code currently affords an annual exclusion of $14,000 per donee, plus a combined lifetime/testamentary exemption of $5.49 million, plus an unlimited marital deduction provided the donor’s spouse is a U.S. citizen.  (Note that “domicile” for gift and estate tax purposes is not necessarily the same as “residency” for U.S. income tax purposes; domicile is a more subjective concept: what jurisdiction does the foreign individual consider to be his “permanent home”?)

In the case of a non-U.S. person who is also a non-domiciliary, the Code provides the same $14,000 annual exclusion as above, as well as an annual $149,000 exclusion for gifts to a non-U.S. citizen spouse (not an unlimited marital deduction). There is no other exclusion. The marginal gift tax rate is 40% for taxable gifts over $1 million.

U.S.-Situs Property

In order for the U.S. gift tax to apply to a transfer of property by a non-domiciliary, the property transferred must be located in the U.S. Thus, a gift transfer of USRP is taxable.

Importantly, however, a transfer of intangible property, including shares of stock in a USC, including a U.S. real property holding corporation (USRPHC), is not subject to the gift tax.

As a result, a gift transfer by a foreign individual (“FI”) of shares of USRPHC stock (or of cash to fund a corporation’s acquisition of USRP) to an irrevocable foreign trust for the benefit of the FI’s family is not subject to U.S. gift tax. It is imperative that the foreign donor respect the separate identity of the corporation the stock of which stock is being gifted: the corporation should have its own accounts, act in its own name, hold board meetings, etc. – it may even be advisable that the FI not use the corporation’s USRP without paying a fair market rental rate for such use; otherwise, the IRS may be able to ignore the corporate form and treat the transfer of the stock as a transfer of the underlying USRP.

Similarly, though it is not entirely free from doubt, a transfer of an interest in a partnership that owns USRP should not be subject to gift tax, provided the partnership is not engaged in a U.S. trade or business (USTB).

Estate Tax

We all have to go sometime. It’s the morbid truth. Even wealthy foreigners.

The U.S. estate tax is imposed on the FMV of the U.S. assets of a foreign decedent. This includes the foreigner’s direct interest in USRP.

It also includes the FMV of USRP in a foreign trust if the FI gifted the USRP into the trust and retained an interest in the income from, or in the use of, the trust’s property.

Where the USRP is subject to a nonrecourse debt, the amount of such debt may be applied to reduce the FMV of the property for estate tax purposes. In order to claim a reduction for any recourse debt encumbering the property, the estate of the FI must disclose his/her worldwide assets and claim only a proportionate part of the debt as a deduction, the assumption being that the FI’s worldwide assets are available to satisfy the recourse debt.

The FI’s U.S. gross estate also includes his shares of stock in a U.S. corporation (“USC”), including a USRPHC.

The state of the tax law as to the situs of a partnership interest is not entirely clear, though there is authority for the proposition that U.S. property includes an interest in a partnership that is engaged in a USTB.

The gross estate does not include shares of stock in a foreign corporation (“FC”), however, even if its only asset is USRP, and even if the FC has elected to be treated as a USC for purposes of FIRPTA (see above). Again, it is imperative that the FI have respected the corporate form: it should have its own accounts, act in its own name, etc. (see last week’s post); otherwise, the IRS may be able to ignore the corporate form, treat the FC as a sham, and include the value of the underlying USRP in the FI’s estate.

The FI’s estate does not include an interest in USRP that is held in a foreign trust, provided the FI did not retain (expressly or implicitly) any beneficial interest in, or control over, the trust.

Unlike the estate of a U.S. citizen or domiciliary, the estate of a FI will not have the benefit of the $5.49 million exemption. Rather, there is only a $60,000 exemption amount (though some treaties may provide for a greater amount provided the FI’s estate discloses its worldwide assets). The 40% rate kicks in when the U.S. taxable estate exceeds $1 million in value.

Additionally, there is no unlimited marital deduction unless the FI’s surviving spouse is a U.S. citizen. If the spouse is not a U.S. citizen, a qualified domestic trust (“QDOT”), with a U.S. trustee, will allow an unlimited marital deduction, and the resulting tax deferral benefit, though it is less than ideal for planning purposes. For example, every time principal is distributed to the surviving spouse, the U.S. trustee must report the distribution, and must withhold and transmit the applicable estate tax.

Finally, let’s not forget that any property that is included in the U.S. estate of a FI receives a basis step-up, thereby removing the depreciation in basis during the life of the decedent, and the appreciation in value of the property, from the reach of the U.S. income tax.

Takeaway

Last week’s post explained that the role of the U.S. tax adviser is to educate the foreign client as to basic U.S. tax considerations before the foreigner acquires USRP; to confer with the foreigner’s non-U.S. tax advisers as to the treatment of the investment under foreign tax law; and to see how to accommodate the foreigner’s business, investment, and other goals within a tax-efficient structure.

I can say with some certainty that there is no single structure that satisfies all of a taxpayer’s goals. The many relevant, and oftentimes competing, factors that we have discussed over the last couple of weeks must be identified and weighed, the various options must be formulated and presented to the foreign client, the client must understand the advantages and disadvantages of the options available, and then the best option under the circumstances must be selected.

Catching up? Start with Part I here.

Sale of USRP – FIRPTA

Aside from planning for the taxation of U.S.-sourced rental income, the foreigner must plan for the disposition of the USRP pursuant to a sale.

The taxation of gain realized by a foreigner on the sale of an interest in USRP is governed by FIRPTA (the “Foreign Investment in Real Property Tax Act of 1980”).

Because FIRPTA treats such gain as income that is effectively connected with the conduct of a USTB, the tax rate that is applied to the gain will depend upon whether the foreign seller is an individual or a corporation.

Assuming the property is a capital asset in the hands of a foreign individual (not inventory or otherwise used in a USTB – the sale of either of which would have been taxable as effectively connected income anyway), and has been held by the foreign individual for more than twelve months, the gain from the sale will be taxed as capital gain at a rate of 20%.

If the seller is a FC, the gain will be taxed at the applicable corporate rate, up to 35%.

FIRPTA – Withholding

Upon the foreigner’s sale of USRP, the buyer is required to withhold 15% of the gross purchase price, which amount must be remitted to the IRS. The purchase price includes the amount of any liability assumed or taken subject to. The remaining tax, if any, must be paid by the foreign seller when it files its U.S. income tax return. If the tax withheld exceeds the amount of tax owed as a result of the sale, the foreigner may use the filing of the tax return to claim a refund.

Because the 15% withholding does not necessarily bear any relationship to the amount of tax actually owed – indeed, the sale may have generated a loss – IRS regulations allow a foreign seller to request a certificate from the IRS that directs the buyer to withhold a lesser amount, based upon the information submitted by the foreigner to establish its actual tax liability.

For example, one may apply for a withholding certificate based on a claim that the transfer is entitled to nonrecognition treatment (as in the case of a like-kind exchange for other USRP), or based on a calculation of the foreigner’s maximum tax liability.

There are also other exceptions to FIRPTA withholding, where a USC, the stock of which is sold by a foreigner, certifies that it is not a USRPHC, and has not been one in the last five years.

Withholding as to Corporate Distributions

Note that special withholding rules apply to certain dispositions by corporations.

If a FC distributes USRP to its shareholders, it must withhold tax at a rate equal to 35% of the gain that is recognized by the FC on the distribution. (The distribution of appreciated property by a corporation to its shareholders in respect of their stock is treated as a sale of such property by the corporation.)

In the case of a USRPHC, it must withhold 15% of the amount distributed if the distribution is made in redemption of a foreigner’s shares or in liquidation of the corporation.

U.S. Real Property

The foregoing has assumed that the property being sold by the foreign person is a direct interest in USRP.

FIRPTA, however, covers not only direct interests in USRP, but also certain indirect interests.

Specifically, if the FMV of a USC’s USRP equals or exceeds 50% of the sum of (i) the FMV of all of its real property plus (ii) the FMV of its trade or business assets, then the corporation will be treated as a USRP Holding Corporation (“USRPHC”), and any gain realized on the disposition of any amount of stock in that USRPHC will be subject to tax under FIRPTA (so long as the disposition is treated as a sale or exchange for tax purposes).

What’s more, if a USC was a USRPHC at any time during the five-year period ending with the date of the sale of stock therein by a foreigner, the gain realized will remain subject to FIRPTA even if less than 50% of the value of the corporation is attributable to USRP at the time of the sale.

Fortunately, there is an exception to this five-year rule: under the so-called “cleansing” rule, if the USC disposes of all of its interests in USRP in taxable sales or exchanges, such that the entire gain thereon has been recognized, and the corporation owns no USRP at the time of the stock sale by the foreign person, then the stock sale shall not be taxable under FIRPTA (or at all for that matter).

Election to be treated as a USRPHC 

As you may have gathered, a FC cannot be a USRPHC. Seems straightforward enough, except that there is a special election that allows a FC to elect to be treated as a USRPHC exclusively for purposes of FIRPTA.

Why would a FC make such an election? One reason is to avoid gain recognition upon the transfer of USRP to the FC. Among the requirements that must be satisfied in order for an election to be effective, the FC must satisfy the above “50% of value” test for USRPHCs.

Exceptions to FIRPTA

Not every disposition of USRP by a foreign person is taxable and subject to withholding under FIRPTA.

For example, a foreigner may sell USRP and roll over the net proceeds therefrom as part of a deferred like-kind exchange without incurring a tax liability (provided that the replacement property is also USRP, the subsequent disposition of which would be taxable to the foreign seller).

This principle underlies other exceptions to gain recognition; specifically, if a foreign person exchanges one interest in USRP for another interest in USRP, the gain realized on the exchange may not be taxable if certain regulatory requirements are satisfied.

For example, a foreigner may contribute USRP to a USC (or to a FC that has elected to be treated as a USC under FIRPTA) in exchange for shares of stock in that corporation without incurring a tax liability, provided the foreign person “controls” the USC immediately after the exchange, and provided the transferee USC is a USRPHC after the contribution. (A narrower exception applies for certain transfers by foreigners to a non-electing FC, which is somewhat inconsistent with the above principle.)

Varieties of Dispositions

A sale of USRP is the most common type of disposition that triggers FIRPTA. However, there are many other transactions of which a foreigner needs to be aware.

For example, if a USRPHC redeems some (but not all) of the shares of a foreign shareholder, the redemption may not be subject to FIRPTA, and may instead be treated as a dividend, if the foreigner’s stock ownership is not sufficiently reduced.

If a USRPHC makes a cash dividend distribution to its shareholders in an amount that exceeds its earnings and profits, the distribution may result in taxable gain that will be subject to FIRPTA.

The partnership rules may generate similar results as to both distributions by, and contributions to, partnerships. The disguised sale rules, for example, may convert what appears to be a tax-free contribution of USRP by a foreigner to a partnership in exchange for a partnership interest into a partially taxable sale that is subject to FIRPTA.

What’s Next

Our next post will review the U.S. gift and estate tax consequences of which a foreign investor in USRP must be aware and must consider in structuring the acquisition, operation, and disposition of such property.

Over the last few years, we have received an ever-increasing number of inquiries from “foreigners” who are interested in acquiring U.S. real property (“USRP”).

Some of these foreigners – meaning closely-held business organizations formed outside the U.S., and individuals who are neither U.S. citizens nor U.S. permanent residents – were acquiring USRP to be used in their U.S. business operations (a “U.S. trade or business,” or “USTB”). Others were acquiring USRP for investment purposes, whether for the production of rental income or for appreciation.

Know the Client

Where the foreign client is acquiring USRP for business or investment use, we have to ascertain the client’s goals and, in the case of a client that is a business entity, the personal goals of its owners.

For example, are they looking to generate rental income, will they remit the net income out of the U.S., how important is limited liability protection, what about U.S. tax and other filing requirements?

In all cases, we need to understand whether the foreigner plans to dispose of the USRP in the relatively short-term, or whether the acquisition represents a longer-term investment.

Once we have determined these personal and business/investment goals, preferences, and concerns, we can turn to the related tax considerations.

U.S. Taxes – In General

There are a number of U.S. federal income tax consequences that may arise from a foreigner’s ownership, operation, and disposition of USRP. (There are state and local tax considerations, as well, of which the foreign person must be made aware, including, for example, the N.Y. Real Estate Transfer Tax and the N.Y.C. Real Property Transfer Tax.)

As in the case of any other business or investment transaction, taxes will have a significant impact upon the net economic benefit or cost realized by the foreigner. The more that a taxpayer pays in taxes in respect of the income or gain realized from a property, or the more slowly the taxpayer recovers the taxpayer’s investment in the property, the more expensive the investment becomes.

Where taxes are not considered early on, the acquisition and ownership of a USRP may not be properly structured to minimize taxes and expenses. Thus, it is critical to plan for taxes prior to the acquisition of the USRP. It may be very difficult, and very expensive, to “correct” the structure later, once the property has appreciated in value.

The Adviser’s Goal

The tax adviser’s job is to educate the foreign investor as to these basic U.S. tax considerations – before the USRP is acquired – and, then, to see how to accommodate the foreigner’s business, investment, and other goals within a tax-efficient structure.

I should note that, although we are focusing on a U.S.-tax-efficient structure, it is also imperative that the U.S. adviser confer with the foreigner’s non-U.S. tax advisers. The client’s U.S. and foreign plans must be coordinated, lest one undermine a purpose of the other. Thus, each of the transactions described below should be examined for the its consequences under the law of the foreign person’s home country.

For this reason, and for other reasons that will vary from taxpayer to taxpayer, I can say with some certainty that there is no single structure that satisfies all of a taxpayer’s goals.

U.S. Income Tax 

We begin with a brief summary of the principles that govern the U.S. income taxation of foreign persons as it relates to USRP.

Income Taxes – Source 

In general, the U.S. will tax foreigners only as to their U.S.-sourced real property income.

Rental income from a USRP, dividends paid by a U.S. corporation (“USC”) that owns USRP, an allocable share of income from a partnership that owns USRP, interest from loans made to U.S. persons to acquire or improve USRP, and gains from the sale of URSP are all treated as U.S.-sourced income that will generally be subject to U.S. income tax.

Income Tax – Nature of the Income

Next, we need to determine the nature of the US-sourced income. Specifically, is it “portfolio” investment income, or is it effectively connected to the foreigner’s conduct of a USTB?

Nature of the Income – FDAP

If it is “portfolio” income – i.e., not effectively connected to a USTB of the foreigner – the rental income, the dividend income, and the interest income will be characterized as so-called “fixed and determinable annual and periodic” (“FDAP”) income.

Notably, the gain from the sale of stock of a USC is not treated as FDAP. Indeed, it is generally not taxable by the U.S. at all, provided the stock is a capital asset in the hands of the foreign seller, it is not used in a USTB, and the corporation is not a U.S. real property holding corporation (“USRPHC”).

The U.S. taxes the gross amount of a foreigner’s FDAP income. Thus, in the case of “portfolio” rental income from USRP, no deduction is allowed for property taxes, maintenance, depreciation, etc.

In addition, the tax on such gross income is imposed at a default rate of 30%, though it may be reduced under a U.S. tax treaty if the foreigner is a bona fide resident of the other treaty country. This rate applies regardless of whether the foreigner is an individual or a corporation, and regardless of the assets held by the U.S. payor.

Thus, if a USC, the principal asset of which is USRP, pays a dividend to a foreign shareholder, the dividend will be treated as U.S.-sourced income and will be taxable at a 30% (or lower treaty) rate. If a U.S. borrower pays interest to a foreign lender, the interest will be taxable at a 30% (or lower treaty) rate.

By comparison, if the dividend is paid by a foreign corporation (“FC”), there generally is no U.S.-sourced income because the payor is not a USC; this is the case even if the FC’s only asset is USRP.

That being said, if a FC is treated as being engaged in a USRP trade or business, it may be subject to the so-called “branch profits tax” (“BPT”). This tax, which is basically a “deemed dividend tax,” is imposed at the rate of 30% on the FC’s accumulated net profits that were not reinvested in its USTB. It purports to be a tax on the FC’s undistributed U.S. income. Because it is applied after application of the U.S. corporate income tax, the BPT can result in a total federal corporate tax rate in excess of 54%.

FDAP Withholding

The tax on a foreigner’s FDAP is collected, or withheld, at the source, by the U.S. payor of the income, which then remits the tax to the IRS.

Assuming the withholding fully satisfies the foreigner’s U.S. income tax liability, the foreigner need not file a U.S. income tax return.

That being said, the foreigner may nevertheless choose to file a return so as to start the running of the limitations period for the assessment of any additional U.S. income tax; for example, just in case the IRS later determines that its USRP activities rise to the level of a USTB.

U.S. Trade or Business

Speaking of a USTB, what level of activity is required before the IRS will treat the foreigner’s USRP activity as a trade or business?

If a foreigner is developing property in the U.S., it is safe to say that the foreigner is engaged in a USTB, and that the net taxable income generated therefrom is effectively connected with such business and will be taxable as ordinary income at the graduated rates applicable to U.S. persons, up to a top marginal rate of 39.6% for individuals, and up to 35% for corporations.

It is equally safe to say, as one would imagine, that a triple net lease does not constitute a trade or business. The rental income therefrom is FDAP that is taxable on a gross basis.

In between, there can be a lot of uncertainty.

Thus, the management of a multi-unit building may rise to the level of a trade or business if the foreigner is involved (directly or through agents) in paying expenses, maintaining the property, making repairs, hiring contractors, interviewing tenants, handling tenant complaints, dealing with local government, etc., with some continuity and regularity, and the foreigner does not substantially rely upon a local management company. In the latter situation, the foreigner’s activities may be difficult to distinguish from those of a prudent investor.

Assuming the activity rises to the level of a trade or business, then the foreigner may deduct the expenses associated with the rental activity in determining taxable income. Thus, depreciation, property taxes, interest on a mortgage, contractor fees, insurance, etc., will be deducted from the gross income in determining the foreigner’s U.S. taxable income.

Partnership

Note that if a foreigner is a partner in a partnership that is itself engaged in a USRP trade or business, then the foreigner will be treated as being engaged in a USTB as to the foreigner’s distributive share of the partnership’s income, even if the foreigner is not itself actually so engaged.

USTB Election

Based on the foregoing, one would guess that being taxed on a net basis is usually better, economically speaking, than being taxed at a flat rate on a gross basis, and that is generally the case.

However, as we noted earlier, a foreigner whose USRP income is treated as FDAP is generally not required to file a U.S. income tax return, while a foreigner who is engaged in a USRP trade or business must file such a return. This is often an important consideration for some foreign investors.

Assuming that reporting is not an issue, the Code recognizes that it may be difficult to determine whether a USRP investment rises to the level of a USTB. Thus, a special election is provided.

If this election is filed timely – by the due date, with extensions, for the first year that the election is to apply – the foreigner who has rental income from USRP for the filing year may treat that income as being effectively connected with the conduct of a USTB. Thus, the foreigner will be able to claim the related expenses (including depreciation) as deductions for purposes of calculating its U.S. income tax liability. Once made, this election is irrevocable, and will apply for all subsequent years.

The IRS has taken this election a step further by allowing foreign taxpayers to make a protective election, such that if the IRS were to determine on audit that the rental income should have been taxed on a gross basis (as FDAP), the protective election would be triggered to preserve the tax treatment as a USTB reflected on the filed return.

Stay tuned for Part II, tomorrow.

The Charitably-Inclined Business

Many successful business owners attribute some part of their financial success to their community. The term “community” may have a different meaning from one business owner to another. In some cases, it may refer to the community in which the owner grew up, was educated, learned the values of hard work and sacrifice, and came to appreciate the importance of team effort. In other cases, it may refer to the community in which the business operates, from which it draws its workforce, to which it sells its services or products, and that supports the business in both good times and bad.

For some of these business owners, it is not enough to simply acknowledge this “debt” their community; rather, they feel an obligation to share some of their financial success with the community. Some owners or businesses will make contributions to local charities, religious organizations, schools, hospitals and civic groups. Others will provide scholarships or grants to local residents who otherwise could not afford to cover educational, medical, or other expenses. Still others will solicit the voluntary assistance of their workforce to support a local charitable organization in a fundraising or other public event.

These endeavors are commendable, but they are of an ad hoc nature, which means they are also of limited duration. This is because such activities are not necessarily institutionalized and they are dependent, in no small part, upon the business owner, who acts as the catalyst or motivating force for the charitable activities of the business.

Private Foundations

Recognizing these limitations, some business owners will establish a private foundation – typically, a not-for-profit corporation (separate from the business), that may be named for the owner, the owner’s family, or the business – which they will fund, either personally or through the business, with an initial contribution of cash or property. In later years, the owner may contribute additional amounts to the foundation, often culminating with a significant bequest to the foundation upon the death of the owner. With this funding, the foundation – which will not be financially dependent upon contributions from the general public (thus a “private” foundation, as distinguished from a “public” charity) – will have the wherewithal to conduct its charitable activities.

The foundation may be formed for a single charitable purpose or for a variety of charitable purposes. In most cases, the foundation’s only activity will be to make grants of money to other not-for-profit organizations that are directly and actively engaged in charitable activities (i.e., not grant-making), provided these grants and activities are in furtherance of the foundation’s stated purposes. In some cases, the foundation may, itself, be directly and actively engaged in conducting a charitable activity.

Whatever the nature of the foundation’s activities, the Code prescribes a number of rules with which the business owner must become familiar, and with which the foundation must comply if it hopes to secure and maintain an exemption from federal income tax. The following is a brief description of these rules.

Federal Tax-Exempt Status

Many business owners embark upon the establishment of a private foundation without first educating themselves as to the operation and tax treatment of a not-for-profit organization. Too often, they create the not-for-profit, transfer funds and other property to it, and begin conducting charitable activities. Years later, they learn that, under the Code, a not-for-profit is not per se exempt from federal income tax; indeed, they learn that the organization is fully taxable unless and until it applies to the IRS for recognition of its status as a tax-exempt organization; even then, they learn that the organization may lose its tax-favored status if it fails to file annual tax returns with the IRS.

In addition, because foundations are not dependent upon the public support for their financial survival – and, so, are not to “answerable” to the public – the Code provides a number of restrictions upon the use of foundation funds. These restrictions seek to discourage, and hopefully prevent, certain activities by a foundation that the IRS deems to be contrary to, or inconsistent with, the charitable nature, and tax-exempt status, of a foundation. The IRS enforces these restrictions through the imposition of special excise (i.e., penalty) taxes upon the foundation, the foundation’s managers (e.g., its board of directors), and so-called disqualified persons (“DP”; i.e., persons who are considered to be “insiders” with respect to the foundation).

Federal Tax Compliance Checklist

Securing recognition by the IRS of its tax-exempt status is only the beginning of a private foundation’s life as an organization for which tax considerations, and compliance with various tax rules, will play a significant role.

“It pays to know,” as the saying goes. In that spirit, the following “compliance checklist” should be reviewed by any business owner who has already formed, or who is contemplating the establishment of, a typical grant-making private foundation.

Is the Foundation being operated in furtherance of its charitable purposes? The Foundation must be operated in accordance with the exempt purposes set forth in its certificate of incorporation and described in its tax-exemption application (Form 1023) filed with the IRS. It must be operated to further a public interest, and no part of its net earnings may inure to the benefit of any private individual.  If the Foundation’s activities result in any prohibited private benefit or inurement, its tax-exempt status could be revoked by the IRS.

  • Does the Foundation have a grant-making policy? How does it select the organizations to which it make grants? What criteria are used? Does it accept applications for grants? How is the selection process recorded? How does the Foundation assure itself of a donee’s tax-exemption, its public charity status, and the grant’s furtherance of the Foundation’s charitable purpose, prior to making a distribution?
  • Is the Foundation authorized to make grants to organizations in addition to those that are recognized as tax-exempt charities by the IRS? How do such grants further charitable purposes?
  • Is the Foundation authorized to make grants to foreign charities? If so, how will it establish that the foreign charity would have qualified as a tax-exempt organization if it had been formed in the U.S.? Does it make pre-grant inquiries, including the donee’s financial status and its ability to accomplish the purpose for which the grant is being made? How does the Foundation verify that the grant funds are being used for the intended purpose?
  • Is the Foundation authorized to make grants to other private foundations? Is it prepared to exercise “expenditure responsibility” with respect to such grants? What types of reports does it require from the donee as to the use of the grant monies?
  • Is the Foundation authorized to make grants to individuals and, if so, for what purposes? How will it select individuals for grants? What criteria will it use? If the purposes are for travel or education, will it require periodic reports from the grantee? Does it maintain case histories?
  • Has the Foundation engaged in any political campaign activity? If the Foundation engages in any political activity, its tax-exempt status could be revoked by the IRS.
  • Has the Foundation sought to influence legislation? Has it engaged in any “lobbying” activity and, if so, to what degree? Does it limit itself to “educating” the public, to presenting both sides of an issue?
  • Has the Foundation distributed the prescribed minimum annual amount, equal to five percent of the fair market value of its non-charitable assets, to accomplish charitable purposes? In general, “qualifying distributions” include administrative expenses and grants to independent public charities.
  • Does the Foundation have, and has it complied with, a conflict of interest policy?
  • Does any DP have any business dealings with the Foundation? For example, has the Foundation sold property to, or purchased property from, a DP? Generally speaking, it shouldn’t have such business dealings.
  • Does the Foundation lease property from a DP? It may only do so on a rent-free basis.
  • Has the Foundation leased its property to a DP? It is prohibited from doing so.
  • Has the Foundation borrowed money from a DP? It may only do so on an interest-free basis.
  • Has the Foundation loaned money to a DP? It is prohibited from doing so.
  • Has the Foundation paid compensation to, or has it reimbursed the expenses incurred by, a DP? The Foundation may only pay compensation that is reasonable for the services rendered. How will it determine the reasonableness of the compensation? Has it looked for comparables? How does it memorialize its compensation decisions?
  • Has the Foundation paid the personal expenses, or satisfied the personal obligations, of any DP?
  • Has the Foundation invested in business entities, including any in which a DP owns an interest? A private foundation is not permitted any holdings in a sole proprietorship that is a “business enterprise.” In general, a private foundation is permitted to hold up to twenty percent of the voting stock of a corporation, reduced by the percentage of voting stock actually or constructively owned by DP. (There are some exceptions.)
  • Has the Foundation invested any of its assets in such a manner that the carrying out of its exempt purposes is jeopardized?  An “ordinary business care and prudence” standard applies in determining whether the Foundation has made investments that may jeopardize its exempt purpose.
  • Has the Foundation reported the existence of any of the proscribed situations set forth above? Has it, along with its DP, “corrected” any of these?
  • Has the Foundation paid the annual excise tax on its investment income?
  • Has the Foundation engaged in any business that is unrelated to its exempt purpose? Has it reported this activity and the income therefrom to the IRS on Form 990-T?
  • Has the Foundation made its annual federal tax return (on IRS Form 990‑PF), its tax-exemption application (IRS Form 1023), and its IRS determination letter available for public inspection?
  • Has the Foundation issued a receipt to its donors in respect of any contribution to the Foundation of two hundred fifty dollars ($250) or more? Contemporaneous written acknowledgment of the contribution is required in order for the donor to claim a deduction.

Parting Advice

The above checklist may intimidate many business owners and their families. The operation of a private foundation, however, is no small matter. Because of its tax status, it is effectively a quasi-public organization. A business owner who is used to “doing things his own way” may find these rules too restrictive or onerous.

As was stated earlier, the foregoing is intended as a resource for those already operating a foundation, and for those thinking about starting one. However, it is no substitute for retaining the services of knowledgeable and experienced tax and not-for-profit corporate advisers. Although a sophisticated business owner may be familiar with, or may intuit, some of the rules described above, there are many more that will be foreign to one who is not immersed in the world of tax-exempt not-for-profits. These rules are the price exacted for the favorable tax treatment bestowed upon private foundations and their contributors.

As always, the well-intentioned, charitably-inclined business owner will be well-served, and will successfully accomplish his charitable goals (and avoid unpleasant surprises), if he educates himself and consults with a qualified professional.