The City Never Sleeps – But It Does Tax

“If I can make it there, I’ll make it anywhere.”  So begins one of the most iconic of musical tributes to New York City. It is sung at every Yankees game. It sums up the feelings of thousands of aspiring artists. As it turns, out, however, it also captures the reaction of many closely-held businesses that choose to make a go of it in The Big Apple.

No, I am not referring to the intensely competitive business environment that is NYC, nor am I referring to the high cost of rent and labor in the City that reduce the margins of every business and challenge the bottom line of every business owner.

Rather, I am referring to the many different kinds of taxes that the City imposes on closely-held businesses. No business owner can afford to begin operations in the City without first educating himself as to the taxes that may be imposed upon his business for the privilege of operating in the City, and the economic cost that these taxes represent.

What follows is a brief summary of these taxes. Most readers will be familiar with some of them; others will come as a surprise to some readers. Still other taxes are unique to NYC. In some cases, different taxes are imposed upon the same base amount; in others, the application of the tax will depend upon the “tax residence” of the business owner.

Personal Income Tax

An individual who is a resident of NYC is responsible for paying NYC Personal Income Tax (at a maximum rate of 3.876%, inclusive of a special surcharge) on the income he derives from all sources, regardless of where the income is generated, and regardless of the nature of the income; for example, it includes operating income generated through a sole proprietorship or partnership, and dividends paid by a corporation.

A nonresident individual, however, is not subject to the City’s Personal Income Tax, notwithstanding that his income is from within the City; for example, a nonresident who is a member of a partnership that does business in the City is not subject to the tax as to his share of partnership income attributable to the City, while the share of a similarly situated resident is taxable.

Resident Status

A business owner who calls the City home – who is “domiciled” in the City – is a resident taxpayer. One who owns and operates a business in the City, but who lives outside the City, and who does not maintain a so-called “permanent place of abode” in the City, is not a City resident.

However, if the business owner, or if the business, owns or rents an apartment in the City that the owner may use personally, he may be treated as a City resident for purposes of the personal income tax by virtue of the number of days (more than 183) he spends working in the City, even if he uses the apartment only infrequently (and even if the apartment is located in a borough other that the one in which the business is located).

Business Corporation Tax

Effective for tax years beginning on or after January 1, 2015, several significant changes were made to NYC’s corporate income tax, including, for example, with respect to the nexus, the primary tax base, combined reporting (based on ownership rather than intercorporate transactions), and the apportionment/sourcing of income to the City.

A corporation that does business, employs capital, owns or leases property, or maintains an office (i.e., is “doing business”) in the City, for all or any part of its taxable year, must pay the Business Corporation Tax (at a maximum rate of 8.85%). A corporation may be considered to do business in the City if it is a partner/member in a partnership/LLC that does business in the City.

The term “corporation” includes any entity that is taxable as a corporation for federal tax purposes, by election (under “check the box” rules), or otherwise.

A foreign corporation is not subject to the Business Corporation Tax by virtue of certain de minimis activities, including, for example, (1) maintaining cash balances with NYC banks; (2) owning shares of stock or securities that are kept in the City (as in a safe deposit box, safe, or vault); (3) the maintenance of an office in the City by a director or officer of the corporation who is not employed by the corporation, provided the corporation is not otherwise doing business in the City; (4) keeping books or records of the corporation in the City if they are not kept by employees of the corporation and the corporation does not otherwise do business in the City; (5) or any combination of the foregoing activities.

The tax is generally determined upon the basis of the corporation’s business income, or the portion thereof that is allocated within the City. The term “business income” means the corporation’s entire net income, minus investment income and other exempt income. The term “entire net income” generally means total net income from all sources that the taxpayer is required to report to the IRS.

An “S corporation” and its “qualified subchapter S subsidiaries” are not subject to the Business Corporation Tax, but remain subject to the pre-2015 provisions of the General Corporation Tax. The City does not recognize “S-Corporation” elections.

Unincorporated Business Tax

The City imposes an unincorporated business tax (“UBT”) on the unincorporated business taxable income of an unincorporated business (at a rate of 4%) that is wholly or partly carried on within the City. The tax is imposed in addition to any other taxes that may be imposed on such income (for example, the personal income tax).

An “unincorporated business” means any trade or business conducted or engaged in by an individual (a sole proprietorship) or unincorporated entity, including a partnership. If an individual or an unincorporated entity carries on two or more unincorporated businesses in the City, all such businesses will be treated as one unincorporated business for the purposes of the tax.

An unincorporated entity will be treated as carrying on any trade or business carried on in whole or in part in the City by any other unincorporated entity in which the first unincorporated entity owns an interest.

An individual or other unincorporated entity, except a dealer, shall not be deemed engaged in an unincorporated business solely by reason of (A) the purchase, holding and sale of property for his or its own account, (B) the acquisition, holding or disposition, other than in the ordinary course of a trade or business, of interests in unincorporated entities that are themselves acting for their own account, or (C) any combination of such activities. The term “property” generally means real and personal property, including, for example, stocks or bonds.

An owner of real property, a lessee or a fiduciary will not be deemed engaged in an unincorporated business solely by reason of holding, leasing or managing real property. In general, if an owner, lessee or fiduciary (other than a dealer) who is holding, leasing or managing real property, is also carrying on an unincorporated business in the City, whether or not such business is carried on at, or is connected with, such real property, such holding, leasing or managing of real property shall not be deemed an unincorporated business if, and only to the extent that, such real property is held, leased or managed for the purpose of producing rental income from such real property or gain upon the sale or other disposition of such real property.

In general, the term “unincorporated business gross income” means the sum of the items of income and gain of the business includible in gross income for federal income tax purposes (with certain modifications), including income and gain from any property employed in the business, or from the sale or other disposition by an unincorporated entity of an interest in another unincorporated entity if, and to the extent, such income or gain is attributable to a trade or business carried on in the City by such other unincorporated entity.

The term “unincorporated business deductions” of an unincorporated business generally means the items of loss and deduction directly connected with or incurred in the conduct of the business, which are allowable for federal income tax purposes for the taxable year (with certain modifications).

If an unincorporated business is carried on both within and without the City, a portion of its business income must be allocated to the City.

Commercial Rent Tax

The City requires every tenant to pay a tax on the tenant’s base rent (at a 6% rate) where the annual base rent exceeds $250,000. The tax is imposed only with respect to taxable premises that are located south of the center line of 96th Street in Manhattan.

The term “taxable premises” generally means any premises in the City that is occupied or used for the purpose of carrying on any trade, business, or other commercial activity, including any premises that is used solely for the purpose of renting the same premises in whole or in part to tenants. Physical occupancy of the premises by the tenant is not required – a tenant’s possessory right to the premises makes them taxable.

The term “base rent” means the amount paid, or required to be paid, by a tenant for the use or occupancy of premises for an annual period, whether received in money or otherwise, including all credits and property or services of any kind, and including any payment required to be made by a tenant on behalf of a landlord for real estate taxes, water rents or charges, sewer rents, or any other expenses (including insurance) normally payable by a landlord who owns the realty, other than expenses for the improvement, repair or maintenance of the tenant’s premises, with certain adjustments.

Sales and Use Tax

In general, the Sales Tax applies to retail sales of tangible personal property made, and to certain services rendered within, the City, and the Use Tax applies if to tangible personal property or services that are purchased outside the City and then used within the City. The tax is imposed in addition to the NY State sales and use tax, and is administered together with the State tax.

The City’s Sales and Use Tax rate is 4.5%, and the vendor is required to collect the tax from the purchaser of the property or service; in addition, a Metropolitan Commuter Transportation District surcharge of 0.375% is imposed on the taxable sale or use, thereby bringing the total City tax rate to 8.875% (inclusive of the State’s 4% tax).

Real Property Transfer Tax

The City imposes a Real Property Transfer Tax (“RPTT”) on the conveyance of real property, including certain economic interests in real property, situated in NYC. The RPTT is imposed in addition to the NY State Real Estate Transfer Tax.

The RPTT, which is payable by the grantor, applies whenever the consideration for the sale or other transfer is more than $25,000. The tax – which is usually paid as part of the closing costs at the sale or transfer of real property – is imposed as follows: in the case of an interest in non-residential real property, if the value is $500,000 or less, the rate is 1.425% of the consideration; if the value is more than $500,000 the rate is 2.625%.  (The State transfer tax applies to transfers in excess of $500, and is imposed at a rate of 0.40% of the consideration.)

A taxable sale includes, among other things, the sale of real property, the grant of a lease of real property (unless the only consideration paid constitutes rent), and the sale of a leasehold interest. The tax is also imposed with respect to the sale or transfer of at least 50% of the ownership in a corporation, partnership, or other entity that owns or leases real property in the City.

Certain transfers are exempted from the tax; among these are the following: a pledging of real property solely as security for a debt; a transfer from an agent or “straw man” to its principal (or vice versa); a transfer that effects a mere change of identity or form of ownership or organization, with no change of the beneficial ownership.

“Hand[s] in the Air for the Big City”? (apologies to Alicia Keys)

No, it’s not a hold-up – more likely a plea for divine intervention – but based upon the above description of some of NYC’s business-related taxes, it certainly may feel that way to a business owner operating in the City. The number of different taxes for which returns must be filed and taxes paid, and the magnitude of the tax rates, will certainly make some businesses pause before venturing into the City – even after accounting for the deductibility of some of these taxes for federal income tax purposes, for example – especially when one factors in the other costs involved.

That being said, there may be valid business reasons for a “taxable presence” in NYC, including the panache and visibility of a City address, the proximity to a sophisticated market, and the convenience afforded to certain clients or customers.

These business reasons need to be weighed against the costs of a NYC presence, and that includes City taxes.

Oops

The last few posts have focused upon the “tax-free” contribution of property to a partnership. Today, we’re “doing a 180,” as they say (whoever “they” are), and considering how the acquisition of assets may be structured so as to provide the buyer with a cost, or “stepped-up,” basis in those assets. It sounds simple enough, but there will be times when a buyer (especially a partnership) may inadvertently stumble into a partially tax-free transaction – as where part of the consideration paid consists of equity in the buyer – thereby losing the benefit of a full basis step-up for the assets being acquired.

For example, I recently came across a situation in which the buyer-LLC was treated as a partnership for tax purposes. The buyer offered to acquire most of the target corporation’s assets (with zero basis in the hands of the target) in exchange for cash and a minority membership interest in the LLC (both payable at closing). I learned that the buyer intended to take the target assets with a full step-up in basis, and believed that this structure would accomplish this goal. What a surprise when it learned that the target’s transfer of its assets for cash plus equity would be treated for tax purposes as two transactions: (i) an acquisition of some target assets in exchange for equity in the buyer-LLC, which would be treated as a tax-free exchange, with the buyer taking those assets with zero basis, and (ii) an acquisition of the other target assets for cash, with the buyer taking those assets with a basis step-up.

Buyer’s Druthers

As we have stated on many occasions, the buyer’s preference will almost always be to acquire the assets of the target company, rather than its stock. There are two primary reasons for this preference:

  • First, the buyer does not want to take subject to, or assume, all of the liabilities of the target company (which will necessarily be the case with an acquisition of all of the issued and outstanding shares of the target stock); and

Second, the buyer wants to acquire a step-up in basis for the target assets (equal to the purchase price for the assets) that it may then amortize or depreciate, as the case may be, thereby allowing the buyer to recover its cost for the assets on a current basis, and thus making the transaction economically less expensive for the buyer.

Use of Buyer’s Equity

Of course, the seller will prefer to defer the recognition and taxation of any gain to be realized on the transfer of assets to the buyer.

This deferral may be achieved in one of two ways:

  • the buyer agrees to pay at least part of the purchase price after the tax year in which the sale occurs (an installment obligation, or an “IO”), or
  • the buyer issues equity to the seller.

The former is still part of a taxable transaction for tax purposes, but it defers the seller’s tax liability to the year(s) in which principal payments are made under the installment obligation (though the sale of some assets does not qualify for installment reporting, and the deferred gain may be accelerated under certain circumstances); the latter is generally not a taxable event.

I say “generally” because there are exceptions, depending upon the buyer’s status for tax purposes and upon how the acquisition is structured. For example, if the buyer is a corporation, it may issue shares to the target in exchange for the target’s assets without jeopardizing its acquiring the target assets with a full step-up in basis equal to the fair market value of the equity and other consideration transferred by the buyer, provided these shares represent less than 80% of the total voting power or value of the corporation’s equity (i.e., less than “control”).

Similarly, where both the target and the buyer are corporations, and the target merges with and into the buyer, with the buyer surviving, the buyer may issue shares of its stock, plus other property and/or cash, as merger consideration without jeopardizing its acquiring the target assets with a full step-up in basis, provided the equity represents less than 40% of the total consideration transferred.

On the other hand, if the buyer is an LLC that is either disregarded or treated as a partnership for tax purposes, its issuance of even a minority equity interest in exchange for any assets of the target will result in its taking such assets with the same basis that they had in the hands of the target – not stepped-up to the value of the consideration paid.

Straight Asset Sale

The simplest structure for ensuring the buyer receives a full basis step-up in the acquired assets is for the buyer to transfer cash, an installment obligation or other deferred payments (such as an earn-out), and/or other property to the target company in exchange for its assets. The consideration may also include those target liabilities that the buyer may agree to assume (such as trade payables). A corporate buyer may even transfer its own stock as consideration, provided the amount transferred does not give the seller control of the buyer immediately after the transfer.

The buyer will thereby acquire the assets with a holding period that begins with the acquisition, and with a basis equal to the total consideration paid, including the face amount of any IO issued by the buyer (assuming the IO bears adequate interest).

Acquisition Subsidiary

Although the buyer may acquire the assets directly, it may prefer to shelter its existing assets and business from any liabilities that may arise out of the acquired assets.

For that reason, the buyer may first form a wholly-owned subsidiary corporation or LLC that will be funded by the buyer and that will act as the acquisition vehicle for the target assets. The wholly-owned LLC will generally be disregarded for tax purposes. Where the buyer is an S-corporation, it may elect to treat the new subsidiary corporation as a “qualified subchapter S subsidiary” (or “Q-sub”) that will also be disregarded for tax purposes. Either way, the tax consequences arising from the ownership and operation of the acquired target business will be reflected on the parent company’s tax return.

Sec. 338(h)(10) Election for Stock Purchase

It may be that the assets of the target corporation include assets the direct acquisition of which may be difficult to effectuate through a conventional purchase and sale (e.g., a license). In that case, the buyer may have to purchase the issued and outstanding shares of the target’s stock. How, then, can the buyer obtain a basis step-up for the target’s assets?

In general, provided: (i) the buyer is a corporation, (ii) the buyer acquires at least 80% of such stock, (iii) the target is an S-corporation, or a member of an affiliated or consolidated group of corporations, and (iv) the target’s shareholders consent (including, in the case of an S-corporation target, any non-selling shareholders), then the stock sale will be ignored, and the buyer will be treated, for tax purposes, as having acquired the target’s assets with a basis step-up equal to the amount of consideration paid by the buyer plus the amount of the target’s liabilities.

Section 336(e) Election for Stock Purchase

Where an election under Sec. 338(h)(10) of the Code is not available – for example, because the buyer is not itself a corporation – the buyer may want to consider an election under Sec. 336(e) of the Code.

The results of a Sec. 336(e) election are generally the same as those of a Sec. 338(h)(10) election in that the target, the stock of which was acquired by the buyer, is treated as having sold its assets to the buyer.

This election, however, may only be made by the seller’s shareholders – it is not an election that is made jointly with the buyer. In the case of an S-corporation target, all of its shareholders must enter into a binding agreement to make the election, and a “Sec. 336(e) election statement” must be attached to the S-corporation’s tax return for the year of the sale.

The buyer that finds itself in these circumstances will want to “require” the S-corporation’s shareholders to make the Sec. 336(e) election. Of course, it may have to pay a premium in terms of increased purchase price for the stock being acquired in order to induce them to consent.

Purchase of Membership Interests

If the target is an LLC that is either treated as a partnership or disregarded for tax purposes, the buyer’s acquisition of all of the LLC’s outstanding membership interests will be treated as a purchase of all of the LLC’s assets and the “assumption” of its liabilities. Thus, the buyer will take the assets with a stepped-up basis.

Where the LLC is treated as a partnership, it may be that some of its members do not want to sell their membership interests (and nothing in their operating agreement compels them to do so). In that case, the buyer will not be treated as having acquired the LLC’s assets for tax purposes.

However, if the LLC has already made an election (that remains in effect) under Section 754 of the Code, or if the LLC makes such an election for the taxable year in which the sale of the membership interests occurs, then the buyer will receive a special basis adjustment with respect to the LLC’s underlying assets. This adjustment will be treated as a “new asset” that is being placed in service beginning with the buyer’s acquisition of the membership interests. Moreover, any depreciation or amortization deductions attributable to these “new” assets will be specially allocated to the buyer and not to the holdover members of the LLC. On a later sale of any of these “new” assets, the amount the gain therefrom that is otherwise allocated to the buyer will be reduced by the amount of any remaining (i.e., not-yet-depreciated/amortized) adjustment for that asset.

Forward Merger

It may be that the assets of the target corporation are such that their direct acquisition through a conventional purchase and sale may be difficult to effectuate. In that case, the buyer may want to consider a merger of the target with and into the buyer, with the buyer surviving the merger. Provided the consideration does not include equity in the buyer (or, in the case of a corporate buyer, includes only a relatively small amount of equity), the transaction will be treated for tax purposes as an acquisition of the target’s assets (followed by the liquidation of the target) for which the buyer will receive the desired stepped-up basis.

As in the case of a straight asset sale, the buyer may prefer to keep its existing business assets separate from those being acquired from the target by first creating a wholly-owned subsidiary corporation or LLC that will be funded by the buyer and that will act as the acquisition vehicle for the merger; the target will merge into this subsidiary and, in exchange, the target’s shareholders will receive the taxable merger consideration.

Purchase Subsidiary Equity

In some situations it may be easier to acquire the target business by acquiring the target’s equity from its owners. Of course, this will also result in the buyer’s acquiring all of the target assets and assuming all of the target liabilities (including both assets and liabilities that the buyer does not want to take).

This need not be the buyer’s only choice, however; instead, the target may transfer the desired assets and the assumed liabilities into a newly-formed LLC, while retaining the unwanted assets and liabilities. The buyer may then acquire the target’s entire membership interest in the LLC. For tax purposes, this acquisition will be treated as a purchase of the LLC’s assets, thereby giving the buyer the desired basis step-up.

Where the target assets cannot be easily transferred, the better approach may be to keep the target intact and to remove the unwanted assets. The target owners may contribute their equity in the target to a new holding company in exchange for all of the equity in the holding company. The holding company thereby becomes the sole owner of the target.

Following this step, if the target is an LLC, it will be treated as a disregarded entity for tax purposes. If the target is an S-corporation, the holding company and the target may elect to be treated as an S-corporation and a Q-sub, respectively. If the target is a C-corporation, it may be merged into a newly-formed LLC that is also entirely owned by the holding company (though it should be noted that this merger will be treated as a taxable sale of its assets by the C-corporation target). The “conversion” of the target into a disregarded unity for tax purposes will enable the target to then transfer to its parent holding company those assets and liabilities that the buyer does not want to take. The buyer may then acquire the target equity from the holding company in a transaction that, for tax purposes, will be treated as a purchase of the target assets with a stepped-up basis.

Consider the Options

The foregoing discussion highlights a number of methods by which a buyer may acquire a target’s assets with a step-up in basis. One approach may be better than another, depending upon the facts and circumstances and upon the nature of the target, its business, its assets, and its owners. In some cases, it may be possible to combine methods as part of a “single” acquisition.

What the buyer must realize is that there are choices – it is not limited to only one method by which to acquire a target’s assets with a basis step-up. One of these approaches, or a combination thereof, may not only secure a depreciable/amortizable basis increase for the buyer, it may also accommodate other business goals.

A Continuing Investment

In the last two posts, we saw how a Taxpayer who transfers Property A to a partnership (“Partnership”) in exchange for an equity interest therein will not be required to recognize the gain realized on the transfer. This gain will not be included in Taxpayer’s gross income because Taxpayer is viewed under the Code as continuing his investment in Property A, albeit indirectly, through his interest in Partnership; thus, the theory goes, it would not be appropriate to tax him on the gain realized.

We also saw that, because the Code views Taxpayer’s investment in Partnership as a continuation of his investment in Property A, Taxpayer’s basis for his interest in Partnership will be the same basis that he had in Property A at the time of the contribution. In this way, the gain realized by Taxpayer on his transfer of Property A is preserved and may be recognized on the subsequent sale or liquidation of his Partnership interest.

In what may be characterized as the other side of the same coin (I may have mentioned in some earlier post that I am “idiom-challenged”), we saw that Partnership will take Property A with a basis equal to the basis that Taxpayer had in Property A at the time of its contribution to Partnership. Thus, the gain inherent in Property A at the time it was contributed by Taxpayer (the “pre-contribution gain”) will also be preserved in the hands of Partnership, and such gain will be taxed to Taxpayer on Partnership’s taxable disposition of Property A.

An In-Kind Distribution

Distribution to Taxpayer

Instead of selling Property A, what if Partnership simply distributes Property A to Taxpayer? Taxpayer is thereby restored to his pre-contribution position, even if Property A has appreciated in value after its contribution to Partnership (as, presumably, has Taxpayer’s interest in Partnership). Thus, the distribution is not taxable.

Distribution to Another Partner

What if Partnership, instead, distributes Property A to another partner (“Partner”)? At that point, Taxpayer’s indirect interest in Property A is terminated, and Taxpayer no longer has to be concerned that the gain realized by Partnership on a later sale of Property A (to the extent of its pre-contribution gain) will be specially allocated, and taxed, to him. Rather, Partner will now be taxed on his subsequent sale of Property A; without more, and provided the distribution to Partner is not in liquidation of his interest in Partnership, he will take Property A with the same basis that Partnership had in the property. Thus, Taxpayer’s pre-contribution gain may be shifted to Partner. Would it be appropriate to require Taxpayer to recognize the pre-contribution gain at that time?

Distribution of Another Property to Taxpayer

What if Partnership retains Property A, but distributes other property (“Property B”) to Taxpayer? Taxpayer continues to have an indirect interest in Property A, but he has also acquired a property other than the one that he originally contributed to Partnership. Taxpayer’s basis in Property B will be the same basis that Partnership had in the property. If that basis is greater than Partner’s pre-contribution basis in Property A, Taxpayer may sell Property B and realize less gain than if he had sold Property A. In addition, it follows that Taxpayer’s interest in Property A is somewhat reduced as a result of the distribution of Property B to Taxpayer, while Partner’s interest therein has increased. Would it be appropriate to require Taxpayer to recognize the pre-contribution gain in Property A at that time?

A “Deemed” Exchange

In general, a partner who receives a distribution of property from a partnership will not recognize gain on the distribution, except to the extent that the amount of money distributed exceeds the partner’s adjusted basis for his interest in the partnership immediately before the distribution. Likewise, no gain will be recognized to the partnership on the distribution of property to a partner. In short, an in-kind distribution of property will generally not be taxable to the distributee partner or to any other partner.

There are exceptions to this general nonrecognition rule that encompass the situations described above, and that seek to prevent the shifting of the tax consequences attributable to a property’s pre-contribution gain away the contributing partner, and to another partner.

In order to accomplish this goal, these rules – often referred to as the “mixing bowl” rules – effectively treat a partnership’s in-kind distribution of a property to a partner as the second step of a taxable exchange, the first step being that partner’s, or another partner’s, contribution of another property to the partnership. The partnership is treated as a vehicle through which the exchange is effected.

Distribution to Taxpayer

Under the first exception, if property that was contributed by a partner to a partnership is then distributed by the partnership to another partner within seven years of its contribution, then the contributing partner will be required to recognize gain in an amount equal to the gain that would have been allocated to him if the property had been sold at its fair market value at the time of the distribution (the pre-contribution gain). (Congress decided that a seven-year period was necessary in order to ensure that the contribution to, and distribution from, the partnership were independent of one another, and not steps or parts of planned exchange.)

Thus, in the first scenario described above, if Property A is distributed to Partner within seven years of Taxpayer’s contribution of the property to Partnership, Taxpayer will recognize, and be taxed on, Property A’s pre-contribution gain.

Distribution to Another Partner

Under the second exception, if a partnership distributes property to a partner who, within the preceding seven years, contributed other property to the partnership (which the partnership still owns at the time of the distribution – meaning that its pre-contribution gain has not yet been recognized), then such partner shall be required to recognize the pre-contribution gain of the contributed property.

This is the same gain that would have been recognized by the contributing partner if the property which had been contributed to the partnership by such partner within seven years of the distribution, and is held by such partnership immediately before the distribution, had been distributed by the partnership to another partner (as in the first scenario described above).

Thus, in the second scenario described above, if Property B (which had been contributed to Partnership by Partner) is distributed to Taxpayer within seven years of Taxpayer’s contribution of Property A to Partnership, Taxpayer will recognize, and be taxed on, Property A’s pre-contribution gain.

A “Like-Kind” Exchange?

We stated earlier that the above “anti-gain-shifting” rules effectively treat a partnership’s distribution of a property to a partner as the second step of a taxable exchange, with the first step being that partner’s, or another partner’s, contribution of another property to the partnership.

These rules implicitly assume that the properties that are deemed to have been exchanged are not of like-kind and, so, the exchange is taxable. However, what if the properties are, in fact, of “like-kind”? In other words, what if the like-kind properties had exchanged directly, without first passing them through the partnership? In that case, the exchange may have qualified as a “tax-free” exchange under the like-kind exchange rules.

Following this line of thinking, the mixing bowl rules generally provide that if pre-contribution gain property is distributed to a partner other than the contributing partner, and other property of like-kind to the contributed property is distributed from the partnership to the contributing partner within a specified period of time, then the amount of gain that the contributing partner would otherwise have recognized under the above mixing bowl rules is reduced by the amount of built-in gain in the distributed like-kind property in the hands of the contributing partner immediately after the distribution.

Thus, if Property A and Property B are of like-kind to one another and, within seven years of Taxpayer’s contribution of Property A to Partnership, Partnership distributes Property B to Taxpayer and Property A to Partner, then Taxpayer will not have to recognize the pre-contribution gain in Property A to the extent of the gain inherent in Property B after the distribution; at least some of the pre-contribution gain in Property A is preserved in Taxpayer’s hands.

Advice to the Contributing Partner?

Last week we stated that Taxpayer would be well-advised to negotiate for a prohibition, for a period of time, on Partnership’s sale of any property contributed by Taxpayer.

Based upon this week’s discussion, it may behoove Taxpayer to also negotiate for a period of time (say, seven years) during which Partnership will not distribute Property to another partner, at least not without Taxpayer’s prior consent.

Taxpayer may also want to request that, in the event that Partnership has to distribute its properties (e.g., in liquidation), it will do so in a way that minimizes any adverse tax consequences to Taxpayer under the mixing bowl rules. This may include a provision that requires the “return” of Property A to Taxpayer, if feasible (and provided it makes sense from a business perspective).

Alternatively, Taxpayer may try to negotiate for a provision that would require Partnership to make a cash distribution to Taxpayer in an amount sufficient to enable him to satisfy the tax liability resulting from the application of these rules.

As always, it is important that Taxpayer be aware of, and that he consider the potential economic effect of, the foregoing rules prior to his contributing Property to Partnership in exchange for a partnership interest. Armed with this knowledge, Taxpayer may be able to negotiate a more tax-favorable agreement regarding the disposition of his contributed property by the Partnership.

Contributing Property to A Partnership

When a taxpayer (“Taxpayer”) sells a property (“Property”) with a fair market value (“FMV”) in excess of Taxpayer’s basis in Property in exchange for cash in an arm’s-length transaction, the amount of gain that he realizes on the sale is measured by the difference between the amount of cash received by Taxpayer over his basis for Property.

Because Taxpayer has terminated his investment in Property (by exchanging it for cash), he must include the gain realized in his gross income for the year in which the sale occurred.

If Taxpayer instead contributes Property to a partnership (“Partnership”) in exchange for an “equally” valuable equity interest therein, he will still realize a gain on the exchange, but such gain will not be recognized (i.e., it will not be included in Taxpayer’s gross income) because Taxpayer is viewed under the Code as continuing his investment in Property, albeit indirectly, through his partnership interest; thus, it would not be appropriate to tax him on the gain realized.

Preserving the Gain

As we saw last week, because the Code considers Taxpayer’s investment in Partnership as a continuation of his investment in Property, Taxpayer’s basis for his partnership interest will be the same basis that he had in Property. In this way, the gain realized by Taxpayer on his disposition of Property is preserved and may be recognized on the subsequent sale or liquidation of his Partnership interest.

But what if Taxpayer does not dispose of his Partnership interest in a taxable transaction? What if he leaves it to his heirs with a stepped-up basis at his death? What if Partnership disposes of Property? To whom will the gain from a sale of Property be allocated?

Never fear, the Code and the regulations promulgated thereunder have foreseen this possibility and have accounted for it.

First of all, Partnership will take Property with a basis equal to the basis that Taxpayer had in Property at the time of its contribution to Partnership.

Thus, the gain inherent in Property at the time it is contributed by Taxpayer (the “pre-contribution BIG”) will also be preserved in the hands of Partnership.

You may ask, won’t this gain be allocated among all the partners, including Taxpayer, based upon their relative interests in Partnership? Simply put, no, and that is why it is imperative that any taxpayer who intends to contribute appreciated property to a partnership in exchange for a partnership interest therein should be aware of the tax consequences described below and should plan for them.

The Allocation of Pre-Contribution Built-In Gain

In order to prevent the pro rata allocation of the pre-contribution BIG among the contributing and noncontributing partners, and the resultant “shifting” of income tax consequences, the Code and the Regulations provide a set of rules with respect to the allocation of any pre-contribution BIG. These rules require that a partnership must allocate its income, gain, loss and deduction with respect to contributed property so as to take into account the pre-contribution BIG.

In general, these rules require that when a partnership has income, gain, loss or deduction attributable to a property that has pre-contribution BIG, the partnership must make appropriate allocations among its partners to avoid shifting the tax consequences of the pre-contribution BIG away from the contributing partner. (View it as a variation of the “assignment of income” doctrine.)

Allocating Gain

Thus, if Partnership sells Property and recognizes gain, the pre-contribution BIG on Property will first be allocated to Taxpayer as the contributing partner. Then, any remaining gain will be allocated among all of the partners in accordance with their relative interests in Partnership.

Allocating Depreciation Deductions

If Property is subject to depreciation, the allocation of the deductions attributable to the depreciation for tax purposes must take into account the pre-contribution BIG on Property. Specifically, the rules provide that the tax allocation of depreciation deductions to the noncontributing partners must, to the extent possible, equal the “book allocations” of depreciation deductions to those partners. This allocation rule is often referred to as the “traditional method.”

Partnership’s depreciation deduction for tax purposes will be determined by reference to Partnership’s starting basis in Property – the same basis that Taxpayer (as the contributor) had for Property – while its depreciation deductions for financial accounting (or “book”) purposes will be determined based upon Partnership’s book value for Property. A contributed property’s starting “book value” – the amount at which it is recorded on the partnership’s financial accounting records (its “books”) – is equal to its FMV at the time of its contribution.

Where the contributed property has pre-contribution BIG (as in the case of Property), its beginning book value (the property’s FMV) will exceed its basis for tax purposes. Thus, the effect of the above allocation rule, which “matches” the tax allocation of depreciations deductions to the noncontributing partners with the allocation of such deductions to such partners for book purposes, is to shift more of the partnership’s (Partnership’s) taxable income to the contributing partner (Taxpayer) by allocating more of its tax-deductible depreciation deductions to the noncontributing partners.

In this way, over time, an amount equal to Property’s pre-contribution BIG will have been allocated to the Taxpayer, at which point the special allocation rule will cease to apply.

In order to further ensure the intended result of the above allocation rules – i.e., to prevent the shifting of tax consequences with respect to pre-contribution BIG to the noncontributing partners – the special allocation rules provide yet additional rules that may be applied where, contrary to the above matching rule, a noncontributing partner would otherwise be allocated less tax depreciation than book depreciation with respect to the contributed property. (This will usually be the case when talking about appreciated property.) The effect of these so-called “curative” allocation and “remedial” allocation rules is to make up this difference, and to reduce or eliminate the disparity, between the book and tax items of the noncontributing partners. The rules thereby prevent the shifting of any portion of pre-contribution BIG to the noncontributing partners, thus ensuring that the tax consequences attributable to the pre-contribution BIG are visited upon the contributing partner.

Protecting the Contributing Partner

Although a taxpayer generally may contribute appreciated property to a partnership in exchange for an interest therein without incurring an immediate income tax liability, the application of the pre-contribution BIG allocation rules discussed above has the potential to immediately wipe away this deferral. For example, if Partnership decides to sell Property shortly after its contribution, Taxpayer (as the contributing partner) will not have enjoyed the benefit of tax deferral.

Moreover, Taxpayer may find himself in a situation where he must include the pre-contribution BIG in his gross income for tax purposes, but he has not received any cash with which to pay the tax, and he may not be in a position to compel Partnership to make the necessary cash distribution or to give him a loan.

What is Taxpayer to do?

For one thing, it would have behooved Taxpayer to retain a tax adviser who was familiar with the above allocation rules. Such an adviser would have advised Taxpayer to try to negotiate a period during which Partnership would not sell or otherwise dispose of the Property (except as part of a “tax-free” exchange).

Alternatively, the tax adviser might have counseled Taxpayer try to negotiate a provision that would require Partnership to make a cash distribution to Taxpayer in an amount sufficient to enable him to satisfy the tax liability resulting from the application of these rules.

Insofar as the allocation of depreciation deductions pursuant to these rules is concerned, the tax adviser would likely have suggested that Taxpayer negotiate for the use of the “traditional method” so as to maximize the deferral period for “recognition” of the pre-contribution BIG, failing which he may have suggested the use of the “remedial allocation method” over the “curative allocation method,” as the former generally allows the book-tax difference (the excess of book value over tax basis) described above to be spread out over a longer period of time.

Bottom line: the foregoing options may not be available after Taxpayer has already contributed Property to Partnership. The time to consider these issues, to plan for them, and to negotiate ways to reduce any adverse impact is prior to making the contribution.

“Tax free” – two words that often bring great delight when they are spoken by a tax adviser to the owner of a business, whether he is considering the disposition of a single asset, or of substantially all of the assets, of his business. (It’s the feeling I have when the local McDonald’s offers two-for-one breakfast sandwiches.)

Yes, “tax free” can be a great result for a transfer of property out of one business and into another. However, such a transfer is not really free of tax in the sense of never being taxed; rather, it defers the recognition, and taxation, of the gain inherent in the asset being transferred.

It is important that the business owner recognize the distinction. Allow me to illustrate this concept.

Gain Recognition

When a taxpayer disposes of property, the amount of gain that he realizes is measured by the difference between the amount realized – the amount of cash plus the fair market value (FMV) of the property received by the taxpayer – over his adjusted basis for the property transferred.

Where the property received by the taxpayer is not of a kind that the Code views as a “continuation” of the taxpayer’s investment in the property disposed, the taxpayer must recognize and pay tax on the entire amount realized. This is what occurs, for example, when a taxpayer exchanges a property for other property that is not of like-kind (such as cash).

Continuing the Investment

So, what kind of property must a taxpayer receive in exchange in order to make the disposition of his property “tax free”?

Most business owners are familiar with the “like-kind exchange” transaction, especially one that involves the exchange of one real property for another, where both are held by the taxpayer for use in a trade or business or for investment.

Many owners are also familiar with the contribution of property by a taxpayer to a corporation in exchange for shares of stock in the corporation. In general, if the taxpayer does not receive any cash in the exchange and is “in control” of the corporation immediately after the exchange, the taxpayer’s disposition of the property will not be treated as a taxable event.

A similar rule applies in the case of a contribution of property to a partnership in exchange for a partnership interest. Generally speaking, such a property transfer will not be treated as a taxable event, even if the taxpayer receives a less-than controlling interest in the partnership.

Preserving the Gain

In each of the above examples of “tax free” dispositions, the taxpayer’s adjusted basis for the property or equity interest that he receives will be the same basis that he had in the property transferred.

Similarly, the business entity to which a contribution of property is made, in exchange for an equity interest therein, will take the contributed property with a basis equal to the basis that the contributing taxpayer had in the property at the time of the contribution.

Thus, the gain inherent in the property disposed of by the taxpayer is preserved in the property received by the taxpayer in the exchange, such as the shares of stock issued by a corporation.

Receipt of Cash

The foregoing discussion contemplates a situation in which a taxpayer does not receive any cash in connection with the transfer of his property. Often, however, a taxpayer will want to monetize some of his equity in connection with the transfer of what may otherwise be illiquid property. (It may also be the case that the acquiring entity wants to increase its depreciable/amortizable basis in the property by paying some cash for it, or the existing owners of the entity may not appreciate the dilution of their holdings that an issuance of only equity would cause.)

In that case, because the taxpayer is partially “discontinuing” his investment in the transferred property (by receiving cash), he is required to recognize some taxable gain.

Contribution to Corp/ Like-Kind Exchange

In the case of a like-kind exchange, or in the case of a contribution to a corporation in exchange for stock therein, the taxpayer must recognize an amount equal to the lesser of the amount of cash received or the gain realized in the exchange.

Thus, if the amount of cash received is less than the gain realized on the transfer of the property, the taxpayer will recognize, and be taxed on, a portion of the gain realized, up to the amount of cash received.

Where the amount of cash received is equal to or greater than the gain realized on the transfer of the property, then the entire gain realized must be recognized by, and taxed to, the taxpayer.

The import of this result should not be underestimated, as will be shown below.

Contribution to a Partnership

The analysis is somewhat different in the case of a partnership. The Code’s partnership tax provisions do not have a rule equivalent to the “recognition of gain to the extent of cash received” rule applicable to corporations.

Instead, the contribution of property to a partnership in exchange for a partnership interest plus cash is treated as two transactions: a partial sale/contribution in which property with a FMV equal to the amount of cash paid by the partnership is treated as having been sold (under the so-called “disguised sale” rules), and a contribution of the remaining FMV of the property.

The gain to be recognized by the taxpayer is determined by allocating the taxpayer’s basis in the property between the sale and the contribution transactions, based upon the percentage of the total consideration that is represented by the cash.

Some Examples

Assume that Property has a FMV of $100, and an adjusted basis in the hands of Taxpayer of $40.

If Property were sold in exchange for $100 of cash, Taxpayer would realize and recognize $60 of gain ($100 minus $40).

Same facts, except Taxpayer contributes Property to a corporation in exchange for $100 worth of stock therein in a transaction that satisfies the criteria for “tax free” treatment. Taxpayer realizes $60 of gain ($100 of stock over $40 basis), but because Taxpayer receives only stock of the transferee corporation (no cash), none of the gain is recognized. Taxpayer takes the stock with a basis of $40 (preserving the $60 of unrecognized gain).

Same facts, except Taxpayer receives $70 of stock and $30 of cash. Taxpayer must recognize an amount equal to the lesser of the amount of cash received ($30) or the gain realized ($60). Thus, Taxpayer must recognize $30 of gain. He takes the stock with a basis equal to his basis in Property ($40), less the amount of cash received ($30) plus the amount of gain recognized ($30), or $40. Thus, $30 of the unrecognized gain inherent in Property ($30) is deferred ($70 FMV stock over $40 basis.)

Same facts, except Taxpayer receives $20 of stock and $80 of cash. Taxpayer must recognize an amount equal to the lesser of the amount of cash received ($80) or the gain realized ($60). Thus, Taxpayer must recognize the entire $60 of gain realized. He takes the stock with a basis equal to his basis in Property ($40), less the amount of cash received ($80) plus the amount of gain recognized ($60), or $20 (there is no gain to defer).

Same facts, except Taxpayer contributes Property to Partnership in exchange solely for a partnership interest therein. Taxpayer takes his partnership interest with a basis of $40 (his basis in Property), and Partnership takes Property with a basis of $40.

Same facts, except Taxpayer receives a $70 equity interest in Partnership, plus $30 of cash. Taxpayer is treated as having sold a $30 portion of Property, and as having contributed a $40 portion. The gain to be recognized on the sale and the gain to be deferred on the contribution are determined by allocating Taxpayer’s basis in Property between the sale and contribution transactions. Because the cash represents 30% of the total consideration received, 30% of Taxpayer’s basis is allocated to the sale, or $12 ($40 x 0.30). Thus, Taxpayer recognizes gain of $30 minus $12 = $18. The remaining 70% of the basis, or $28, is allocated to the contribution transaction; thus, Taxpayer takes his partnership interest with a basis of $28 (preserving the $42 of gain not recognized on the transfer of Property).

Is the “Deferral” Worthwhile?

The taxpayer who finds himself in one of the foregoing situations usually transfers a business asset over which he has full control. He may give up this control in order to attain other benefits, including, for example, diversification, the funding and assistance necessary to further grow the business (and to share in the growth as an equity owner, albeit one with a minority stake), and the deferral of tax on any gain that he may realize on the transfer.

The loss of control may present many difficulties for the taxpayer. Some are obvious; others are less so – for example, if he contributes appreciated property to a partnership in exchange for a partnership interest, the partnership is required to allocate its income, deductions, gains, and losses in such a way so as to cause the gain inherent in the property at the time of its contribution to be allocated entirely to the taxpayer. He will be taxed on such gain, but he may not receive a distribution of cash from the partnership to enable him to satisfy his tax liability.

Moreover, the like-kind property or the equity interest that the taxpayer receives in exchange for his property may be just as illiquid, at least initially, as the property he has exchanged for it. There may not be a market for the entity’s equity, and its shareholders’ agreement or operating agreement will likely restrict the transfer of the taxpayer’s interest.

But at least he deferred the tax on the transfer of his property.

But What If?

Query, then, what happens if a taxpayer gives up control of a property in exchange for an illiquid minority interest in the business entity to which he contributed such property, yet does not enjoy any tax deferral?

If the deferral was not a principal reason for the transfer, which otherwise made good business sense, then the taxpayer should be fine with the outcome: although he has suffered an immediate net loss of economic value (in the form of taxes paid), hopefully he has determined that the long-term prospects of exchanging his property for the acquirer’s equity are worth the short-term cost.

If, on the other hand, deferral was an important consideration, then the taxpayer should rethink his deal.

Perhaps he can ask to be grossed up for the tax hit, though this may be too expensive a proposition for the acquiring entity. Or, he may ask for more equity, and less cash, so as to reduce the tax hit, provided he recognizes that there will be more investment risk associated with holding more equity. Of course, the other investors may not want to be diluted further, and they may resist losing the benefit of any depreciation/amortization basis step-up for the property acquired.

The matter will ultimately be determined by the parties’ relative bargaining leverage: how badly does one want to dispose of the property, and how badly does the other want to acquire it?

Last month, Governor Cuomo presented his budget proposal for NY State’s 2017- 2018 fiscal year. Included in the proposal were a number of tax provisions that should be of interest to closely-held businesses and their owners.

S-Corporation Conformity with IRS Return

Under current NY law, a federal S-corporation that is subject to tax in NY (e.g., the corporation is doing business or owns property in NY) can “elect” to be taxed as an S-corporation or as a C-corporation for NY purposes. If a federal S-corporation is taxed as a NY S-corporation, the corporation is responsible only for the fixed dollar minimum tax, and the corporation’s income is passed through, and taxed, to its shareholders. Conversely, if a federal S-corporation is taxed as a NY C-corporation, it computes and pays tax on its apportioned entire net income or capital base.

Further, if a federal S-corporation has elected to treat its wholly-owned corporate subsidiary as a “qualified subchapter S subsidiary” (QSSS) for federal purposes, the QSSS is ignored as a separate taxable entity, and the assets, liabilities, income and deductions of the QSSS are included on the parent’s return. However, for NY purposes, the tax treatment of the QSSS is not required to be conformed to the federal treatment and the QSSS under certain circumstances can be a stand-alone C-corporation taxpayer.

While the Tax Law was amended a few years back to mandate that a federal S-corporation be treated as a NY S-corporation in any tax year in which its investment income exceeded 50% of its federal gross income, this mandate did not cover the entire universe of federal S-corporations that have elected to be taxed as NY C-corporations.

According to the budget proposal, the failure to mandate consistent treatment at the State level has resulted in a tax avoidance opportunity, as well as confusion and tax filing errors, for S-corporation shareholders.

For example, a federal S-corporation generally may choose to pay tax as a NY C-corporation when paying tax at the entity level reduces the corporation’s tax liability. It also may choose to pay corporate income tax in order to shield its nonresident shareholders from having a NY tax liability.

Under the budget proposal, NY’s tax law would be amended to require a federal S-corporation that is subject to tax in NY, or that has a QSSS subject to tax in NY, to be treated as an S-corporation for NY tax purposes.

According to the proposal, requiring conformity to the federal S-corporation status would simplify the corporation’s and its shareholders’ NY tax filings, and eliminate potential tax avoidance schemes. It would also result in NY-source income for nonresident shareholders.

Real Estate Transfer Tax on the Transfer of a Business Interest

Under current law, the transfer of a “controlling interest” in an entity that owns NY real property is subject to the real estate transfer tax (“RETT”), with the taxable consideration being determined by reference to the relative fair market value (FMV) of the entity’s NY real property. The RETT applies even where the FMV of the NY real property is not a significant part of the entity’s total FMV.

However, members of a closely-held business entity that owns real property are not subject to the RETT when they sell a minority (non-controlling) interest in the entity, even where the primary asset held by the entity is an interest in NY real property.

The budget proposal would amend the definition of “conveyance” to include the transfer of an interest in a partnership, LLC, S-corporation, or non-publicly traded C-corporation with fewer than 100 shareholders that owns an interest in NY real property with a FMV that equals or exceeds 50% of the FMV of all the assets of the entity on the date of the transfer of the interest in the entity. Only those assets that the entity owned for at least two years before the date of the transfer of the taxpayer’s interest in the entity would be used in determining the FMV of all the assets of the entity on the date of the transfer.

The consideration for such a conveyance would be calculated by multiplying (i) the FMV of the NY real property that is owned by the entity; and (ii) the percentage of the entity that is being conveyed.

As an aside, the proposal would effectively align the treatment of these conveyances, for purposes of RETT, with the personal income tax rules for determining the NY-source income of a nonresident individual when that individual sells an interest in an entity that owns NY real property.

Non-Resident Asset Sale “Loophole”

There are instances in which the purchase of a partnership interest may be treated, for federal tax purposes, as a purchase of the partnership’s underlying assets. In those situations, the consideration paid for the partnership interest must be allocated among the partnership’s underlying assets (which are deemed to have been acquired). As a result of this tax treatment, the buyer of the interest may receive a basis step-up with respect to his share of the partnership’s underlying assets. This step-up may afford the buyer additional depreciation deductions against his share of partnership income, and also may reduce the gain allocated to the buyer upon the partnership’s sale of the assets to which the basis step-up is allocated.

The selling partner, however, may nevertheless be treated as having sold his partnership interest, and not the underlying assets. Thus, a NY resident partner who sells his partnership interest will be subject to tax on the gain realized. On the other hand, the sale of an intangible – such a partnership interest – by a nonresident partner is not a taxable transaction, notwithstanding that the buyer may achieve a basis step-up in the partnership’s assets. As a result, non-residents are afforded an opportunity to avoid NY taxation on transactions that, in effect, involve the purchase of NY-source assets.

The budget proposal seeks to close this loophole by treating the transaction as a sale of the partnership’s underlying NY-based tangible assets for both the buyer and seller, so that the gains realized from the sale of an interest in the partnership by nonresident partners would be subject to NY tax as NY-source income.

Extend the Personal Income Tax Top Bracket

Currently, the top personal income tax bracket in NY, along with its associated tax rate of 8.82%, is scheduled to expire for taxable years beginning after 2017. Without legislative action, the top marginal tax rate will decline to 6.85%.

The budget proposal would extend the top tax bracket and the associated 8.82% personal income tax rate for taxable years 2018, 2019 and 2020.

Sales Tax Related Entity “Loopholes”

With certain exceptions, existing NY tax law allows a purchaser to buy tangible personal property or services that are intended for resale without paying sales tax. According to the budget proposal, however, certain related business entities have exploited this exemption by purchasing expensive property “for resale” and then leasing the property to a member or owner of the entity using long-term leases or lease payments that are a small fraction of the FMV of the property.

The budget proposal would amend the sales tax definition of “retail sale”, which currently contains the exception for resale, to include any transfer of tangible personal property to certain entities when the property would be resold to a related person or entities, including: (1) sales to single-member LLCs or subsidiaries that are disregarded for federal income tax purposes, for resale to a member or owner; and (2) sales to a partnership for resale to one or more partners. This change is intended to remove the incentive to use or create such entities to avoid sales tax.

In addition, current law allows a person or entity that is not a resident of NY to bring property or services into the State for use therein without incurring use tax. However, this construct has led to situations where a resident person or entity creates a new, non-NY entity, such as a single-member LLC, to purchase expensive property out-of-state and then bring the property into NY to avoid the use tax.

The budget proposal would provide that the use tax exemption does not apply when a person (other than an individual) brings property or services into NY unless that person has been doing business outside of NY for at least six months prior to the date the property is brought into the State. This amendment would still allow ongoing businesses to move into NY without incurring use tax on property or services brought into the State.

Looking Ahead

And you thought that tax relief was just around the corner. Silly rabbit.

While most eyes are focused on Washington, D.C. and the promised, but yet to be disclosed, “tax reduction and/or reform” legislation, states like NY are busy reviewing and amending their own tax laws and regulations to ensure the collection of much-needed revenues. Thus, in the case of NY, it may be that closely-held businesses and their owners will be faced with increased tax liabilities. We’ll know soon enough – the deadline for approving NY’s budget is April 1, 2017.

Speaking of Washington, the States themselves are undoubtedly waiting to see what comes out of the new administration and Congress and how it will impact them and their finances.

As always, until legislation is passed, it is imperative that taxpayers keep abreast of tax-related legislative developments that may impact their business and wallets. Increased tax liabilities will reduce the yield realized from one’s business efforts and investments; thus, it will be advisable for taxpayers to formulate a plan for addressing these developments and any resulting taxes.

It will be equally important that any business plans considered by a taxpayer be flexible enough to respond to, and accommodate, a changing tax environment, provided that doing so does not compromise business decisions.

Stay tuned.

Looking Overseas

We have heard a lot about large, publicly-traded U.S. corporations that have parked trillions of dollars overseas to avoid the payment of U.S. income tax. We have heard how the tax system must be seriously broken to have so incentivized so many of these corporations to “relocate” overseas.

What is usually overlooked or omitted in these reports is the number of smaller, closely-held U.S. corporations and partnerships that have established operations overseas in pursuit of legitimate business goals, including the opening of new markets, among others.

Equally absent from these reports is any mention of the number of U.S. citizens living outside the U.S. who own companies that are engaged in business overseas.

Quite often, these closely-held companies are unaware of their U.S. income tax reporting obligations as regards their foreign operations and income. The owner of one of these companies will naturally be focused on the business opportunities, and challenges, presented by establishing an overseas presence and, unless the company’s tax advisers are well-versed in so-called “outbound” transactions, the company may unwittingly fail to satisfy its filing obligations.

This may result in the imposition of steep penalties on the business, as one taxpayer recently discovered to its detriment.

A Taxpayer Can Get Burned

Taxpayer was a U.S. citizen residing in Country. During the years in issue, he operated a business in Country through a foreign corporation (“FC”). At some point during this period, he sold the majority of his stock to a non-U.S. resident of Country. The issue for decision was whether Taxpayer was liable for the penalties assessed against him for his failure to declare, on IRS Form 5471, his ownership interest in FC.

Taxpayer timely filed his Forms 1040, U.S. Individual Income Tax Return, for the years in issue but did not attach IRS Forms 5471 to any of his returns.  Although Taxpayer hired a tax preparation firm in Country to prepare his U.S. tax returns during the years in issue, he did not inform this firm until years later that he held an interest in FC.

Thereafter, the IRS began an examination of Taxpayer’s ownership of FC. Taxpayer then submitted delinquent Forms 5471 regarding his interest in FC, after his tax counsel advised him of his obligation to do so. The Forms 5471 submitted were incomplete.

The IRS assessed penalties for Taxpayer’s failure to timely file completed Forms 5471 declaring his ownership interest in FC.

The Tax Court explained that the Code imposes information reporting requirements on any U.S. person who controls a foreign corporation. A person controls a foreign corporation (a “controlled foreign corporation,” or “CFC”), the Court stated, if he owns (directly or constructively):

  • Stock that that represents more than 50% of the total combined voting power of all classes of voting stock of the corporation, or
  • More than 50% of the total value of shares of all classes of stock of the corporation.

Under the Code, a U.S. person must furnish, with respect to any foreign corporation which that person controls, such information as the IRS may prescribe. Form 5471 is used to satisfy these reporting requirements, and it must be filed with the U.S. person’s timely-filed Federal income tax return. Moreover, a U.S. person who disposes of sufficient stock in a CFC to reduce his interest to less than the above stock ownership threshold is required to provide certain information with respect to the foreign corporation.

Additionally, information reporting requirements are also imposed on any U.S. person treated as a “U.S. shareholder” of a corporation that was a CFC for an uninterrupted period of 30 days during its annual accounting period and who owned stock in the CFC on the last day of the CFC’s annual accounting period. A U.S. shareholder, with respect to any foreign corporation, is a U.S. person who owns, or is considered as owning, 10% or more of the total combined voting power of all classes of stock entitled to vote of the foreign corporation.

To avoid a penalty, a taxpayer must make an affirmative showing that the failure to furnish the appropriate information with his return was due to reasonable cause.

To establish reasonable cause through reliance on a tax adviser’s advice, the taxpayer must prove: (i) the adviser was a competent professional with sufficient expertise, (ii) the taxpayer provided necessary and accurate information to the adviser, and (iii) the taxpayer relied in good faith on the adviser’s judgment.

The Taxpayer could not satisfy these requirements. Thus, the Court found that he failed to show reasonable cause for his failure to file Forms 5471, and the imposition of the penalties was sustained.

But Wait, There’s More

The penalties imposed upon the taxpayer in the decision described above are bad enough, but there are other issues of which such a taxpayer needs to be aware.

Indeed, Congress recognizes that the IRS may not be able to “timely” identify all U.S. persons who conduct business overseas and fail to report their foreign activities and income.

Thus, another consequence of failing to file the requisite returns may be the additional tax for the year in which the event(s) to be reported occurred – meaning that the IRS can impose a tax upon a delinquent taxpayer whenever the IRS discovers the existence of the foreign business activities or transactions.

In other words, these reporting obligations cannot be ignored; they must be taken seriously.

However, these failures, and the resulting consequences, can be avoided relatively easily if the company’s tax adviser or tax compliance officer is familiar with the IRS’s many reporting requirements for U.S. businesses that operate overseas, and understands the underlying purpose for the required filings.

Common Filing Obligations

The following summarizes some of the more common reporting requirements imposed upon a U.S business that operates or holds assets overseas, as well its U.S. owners.

A basic principle of U.S. tax law is that U.S. persons – which includes, for example, U.S. citizens and resident individuals, domestic corporations, and domestic trusts – must file an annual tax return with the IRS to report their worldwide income, regardless of the source or the type of income. This income is taxable in the U.S., notwithstanding that it may also have been taxed by the foreign country in which it was sourced or generated. Of course, the U.S. person may be able to claim a tax credit for any foreign taxes withheld and/or paid on such income in the foreign country; such credit may offset any U.S. income tax that would otherwise be imposed on such income.

If a U.S. person transfers property to a foreign corporation or partnership in what purports to be a tax-free exchange, the U.S. person may have to report the transfer on IRS Form 926.  This filing provides a means by which the IRS confirms the taxable or tax-free nature of the transfer of property by a U.S. person to a foreign jurisdiction, and perhaps beyond the reach of the IRS.

If a U.S. person owns an interest in a foreign corporation, the U.S. person may have to file IRS Form 5471 (as we saw above). The rules for CFCs may require the inclusion of CFC income (so-called “Subpart F” income) in the gross income of a U.S. person even where such income has not been distributed to the U.S. person (i.e., repatriated). In general, this reporting is aimed at situations in which the U.S. person, the CFC, and/or certain other related persons, engage in intercompany transactions of a nature that tends to shift the resulting tax liability to a lower tax jurisdiction.

If a U.S. person owns or acquires an interest in a foreign partnership, IRS Form 8865 may have to be filed.  This form is similar to Form 5471 and to the partnership tax return on Form 1065.  It is intended to assist the IRS in monitoring the overseas business and investment activities of U.S. taxpayers through foreign flow-through entities, the income from which must be reported on the U.S. person’s tax return in the same way that a U.S. person’s distributive share of a domestic partnership’s taxable income must be reported.

If a U.S. person owns an interest in a passive foreign investment company (a “PFIC”; e.g., a foreign mutual fund), and receives certain distributions from the PFIC, or recognizes gain on the disposition of PFIC stock, the U.S. person may have to file IRS Form 8621 and pay a tax, along with a special interest charge that is intended to offset the tax deferral benefit that the U.S. person enjoyed as to the distributed funds and the recognized gain.  The purpose of these rules is to help ensure that U.S. investors in such foreign investment vehicles are taxed on an equal footing with similar investments in domestic investment vehicles.

If a U.S. person has an interest in certain foreign accounts or other foreign financial assets, including accounts in foreign financial institutions and interests in a foreign corporation or partnership, those assets may have to be reported on Form 8938.  This filing is intended to assist the IRS in cracking down on unreported investment income from overseas.

The U.S. person may also have to file FinCEN Form 114 (the well-known “FBAR”) to report accounts held in foreign financial institutions.  The FBAR reporting requirement is aimed at establishing a U.S. taxpayer’s connection to such an account for the purpose of ensuring that the funds deposited therein, as well as the investment income earned thereon, were properly reported and taxed.

Don’t Be Overwhelmed

Granted, this is a daunting litany of reporting obligations, and it may appear overwhelming – “overkill,” some taxpayers may say. From the perspective of the IRS, however, they are necessary if the tax statutes in effect today are to be enforced and their underlying goals accomplished.

The best way to avoid any issues and surprises is, first and foremost, to find a tax adviser who is familiar with the rules and can explain them. The next step is to establish internal procedures to ensure that the necessary information will be collected in a usable form. Finally, the taxpayer must prepare and timely file the proper returns.

Yes, it may be a chore today, but it certainly beats the alternative down the road. Just witness those “poor” taxpayers who failed to timely file their FBARs and are now walking through the OVDP gauntlet.

Limited Liability

In general, the creditors of a corporation cannot recover the corporation’s debts from its shareholders—the shareholders enjoy the benefit of limited liability protection as a matter of state law. Among the corporate liabilities from which shareholders are usually shielded is the Federal income tax imposed on a corporation’s taxable income.

There are a number of exceptions to this general rule, however – some of which are better known than others – including the ones described below.

Piercing the Veil

A creditor, including the IRS, may be able to “pierce the corporate veil” or “sham” the corporation, in appropriate circumstances, as where the corporation does not have a bona fide business purpose, or where its shareholders do not respect it as a separate entity, or where their withdrawal of funds from the corporation renders it insolvent.

Transferee Liability

In the right circumstances, the IRS may pursue a corporation’s shareholders as transferees of a corporation’s assets in order to satisfy a corporate tax liability. While the Code does not create the substantive tax liability as to a transferee-shareholder of a transferor-corporation’s property – which is determined as a matter of state law – it does provide the IRS with a remedy for collecting from the transferee-shareholder, the transferor-corporation’s existing tax liability.

Responsible Person

In certain circumstances, the Code imposes a duty on a taxpayer to withhold and remit income taxes from certain payments made by the taxpayer. These withheld funds are often referred to as “trust fund taxes” because the Code characterizes them as a special fund that is held in trust for the IRS. When these taxes are not collected or are not remitted by the taxpayer, the IRS is generally authorized to “collect the tax” from any “responsible person” who was required to collect, truthfully account for, or pay over any tax withheld but failed to do so. In the case of a corporate taxpayer, this may include an officer or employee of the corporation who, as such, is under a duty to collect, account for, or pay over the withheld tax.

Federal Priority Statute

One of the most powerful tools available to the IRS for the collection of income tax is not found in the Code and, in fact, is sometimes overlooked by tax advisers.

According to the Federal Priority Statute, a person (for example, a corporation) that (i) is indebted to the U.S. government, (ii) is not in bankruptcy, (iii) is insolvent, and (iv) does not have enough property to pay all of its debts, must satisfy its indebtedness to the U.S. government before satisfying any other debts that do not have priority over the government’s claim; the U.S. has the right to be paid first, and all other creditors are subordinate.

If that person, instead, pays any part of a debt owing to a non-priority creditor at a time when the debtor was insolvent, before paying a claim of the Federal government, that creditor is necessarily favored at the expense of the government. In the case of such a preferential transfer, the Federal Priority Statute authorizes the government to hold that person’s “representative” liable for the unpaid claims of the government up to the amount of the payment made to the non-priority creditor.

For purposes of the statute, the term “claim” or “debt” means any amount of funds that has been determined by the Federal government to be owed to the U.S. by any individual or entity. This includes taxes, as well as any interest and penalties imposed with respect to such taxes.

Representatives of the Taxpayer

If it is determined that a violation of the Federal Priority Statute has occurred – there has been a preferential transfer – a court must decide whether anyone other than the taxpayer should incur liability for that violation. As the courts have noted, the purpose of the statute “is to make those into whose hands control and possession of the debtor’s assets are placed, responsible for seeing that the Government’s priority is paid.”

In the case of a corporation, the courts have interpreted the reach of the Federal Priority Statute as extending to those individuals who, responsible for the conduct of a corporation’s affairs, allow the corporation to make payments that defeat the government’s tax claims. Thus, a director, an officer or a shareholder of the corporation, who was in control of the corporation’s affairs, who was (or should have been) aware of the outstanding claims against the corporation, and who either (i) directed or controlled the wrongful payments, or (ii) knew of such payments and failed to prevent them, may be held personally liable for the corporation’s taxes.

The exact nature of the duties and control exercised by an individual, and his status as a “representative” of the debtor, is a matter of proof, and must be determined by examining all the relevant facts and circumstances. The individual may be found to be a “representative” of a corporation and thus liable, to the extent of the payment, for unpaid claims of the government, where such individual is the sole officer, director and/or shareholder of the corporation. An individual may also be treated as a corporation’s representative where he oversees the corporation’s finances, and executes most of its checks.

Notice of Tax Claim

Once it is determined that an individual is a representative of a corporation within the meaning of the Federal Priority Statute, it must still be established that the individual knew about or was put on notice of the government’s outstanding tax claim before liability for such claim may imposed upon him. In general, the officers and directors of a corporation are deemed to be in control of its affairs, and the courts have often assumed that, being responsive to their duties, these individuals were aware of all the outstanding claims against the corporation.

Based on the foregoing, the lack of knowledge may be asserted as a defense against the application of the statute. However, the courts have found the requisite notice of a claim where the representative lacks actual notice of the liability, but possesses notice of such facts as would lead a reasonable person to inquire as to the existence of any unpaid claims.

Advice?

The foregoing highlights the fact that the privilege of stock ownership in a close corporation may also entail a number of burdens.

In the case of a closely held corporation that is struggling, its directors, officers and shareholders have to be diligent in monitoring its financial vital signs, and they need to be as objective as possible in ascertaining its prospects.

Many times, they will forego the payment of certain taxes, using these funds, instead, to satisfy the corporation’s business creditors in the hope of keeping the business alive until it can “turn the financial corner,” and then pay off its tax liabilities.

Too often, however, the corporation will fail, notwithstanding the efforts of its “insiders,” at which point its shareholders may be left holding the proverbial “bag” for the corporation’s taxes.

What, then, is a shareholder to do?

The IRS’s response would be to shut down the business, liquidate its assets, and satisfy the unpaid taxes. This course of action may be difficult for a shareholder to accept, but it will often be the best choice.

Roll-Over: Tax Issue

Picking up on yesterday’s discussion, how can a PEF reconcile its preference to acquire a depreciable or amortizable basis for its target’s assets while, at the same time, affording the target’s owners the opportunity to roll-over a portion of their equity in the target into the PEF HC on a tax-favored basis? The answer is hardly simple, and it will depend upon a number factors.

inspecting taxesThe following discussion will consider some of these factors in the context of various scenarios. In each case, it is assumed that the acquisition will be structured to give the PEF a depreciable or amortizable basis for the acquired assets; that the target or its owners, as the case may be, will acquire an equity interest in the PEF’s HC (the roll-over that will allow them to participate in the growth of the PEF’s other portfolio companies); and that such equity interest shall not exceed 50% of the HC’s equity (thus ensuring capital gain treatment where otherwise available).

Target “C” Corporation
Where the target is a “C” corporation, the sale of its assets will be taxable to the corporation, and the corporation’s distribution of the after-tax proceeds to its shareholders will generate a second layer of tax (albeit as capital gain) to the shareholders (a combined tax rate of almost 50% at present). The shareholders may then invest some portion of their after-tax proceeds in the PEF HC in exchange for an equity interest therein.

In this case, the only way for the target’s owners to enjoy a tax-free, but indirect, roll-over of a portion of their equity into the PEF is by having the target contribute some of its assets to the PEF’s HC in exchange for an equity interest therein, while selling the balance of the assets for cash.

In general, provided the PEF’s HC will be treated as a tax partnership, the contribution of assets to the HC in exchange for a partnership interest therein will not be taxable to the target corporation. (An exception to this nonrecognition rule would apply if the HC assumes liabilities of the target’s business, or takes assets subject to such liabilities, and the contributing corporation’s allocable share of the HC’s liabilities after the contribution is less than the amount of the liabilities assumed or taken subject to) another exception to nonrecognition may apply where the liabilities were incurred in anticipation of the transaction.

However, if the PEF’s HC is a corporation, the target corporation’s contribution of assets to the HC’s capital in exchange for shares of stock therein will be treated as a taxable disposition of its assets unless the target corporation is treated as part of a so-called “control group.” This would be a group of persons (including the PEF) that, acting “in concert,” contributed assets to the HC in exchange for stock in the HC, and that was in “control” of the HC immediately afterwards.

Of course, not all of the target shareholders may want to participate in the roll-over to the PEF’s HC. In that case, the target corporation may have to redeem those shareholders, thus limiting the amount of cash that may be reinvested.

Moreover, some PEFs may insist that only individual shareholders, rather than the target corporation, hold equity in the HC. In that case, a contribution by the target corporation may not be permitted, or may have to be followed by a liquidating distribution to its shareholders. Such an in-kind distribution would be treated as taxable sale by the corporation, thus defeating the sought-after tax deferral benefit.

Target “S” Corporation
If the target corporation is an “S” corporation, it may sell its assets to the PEF HC without incurring a corporate-level income tax (provided the target is not subject to the built-in gains tax). Of course, the gain realized on the sale of the target’s assets will flow through and be taxable to its shareholders. Depending upon the nature of the assets sold, the gain may be taxed as ordinary income or as capital gain.

As in the case of a C corporation, the S corporation may distribute the net proceeds from the sale of its assets to its shareholders, who may then invest a portion of their after-tax proceeds in the PEF’s HC.

Alternatively, if the sale of the S corporation’s business is effected through an acquisition of at least 80% of its stock for cash, coupled with an election to treat the stock sale as a sale of assets for tax purposes, the target shareholders may contribute their remaining shares to the PEF’s HC as a capital contribution. Unfortunately, this capital contribution will not generate any tax deferral benefit for the shareholders because they will still have to recognize all of the gain inherent in the target’s assets by virtue of the deemed asset sale election.

If the only way in which the shareholders of the S corporation target may roll over a portion of their investment on a tax-free basis is for the S corporation itself to make a capital contribution to the HC, then regardless of whether the HC is a corporation or a LLC, then they will have to consider the same issues as described above for a C corporation.

Target Partnership
A sale of assets by a target partnership to a PEF HC in exchange for cash will be taxable to the target’s owners. As in the case of an S corporation, the nature of the gain taxed to the owners will depend upon the nature of the assets sold.

Alternatively, the owners of a target partnership may sell all of their partnership interests to the PEF, or to its acquisition subsidiary. A sale of 100% of the partnership interests will be treated, for tax purposes, as sale of the target’s assets, thus providing the PEF with a depreciable or amortizable basis in such assets.

In either case, if the target’s owners (the partners or members) are to acquire an equity interest in the PEF or subsidiary, they will have to do so with after-tax dollars.

In order to roll-over a portion of its equity into the HC on a tax-advantaged basis, the target partnership will have to contribute some of its assets to the HC, or the target owners will have to contribute some of their partnership interests to the HC. In other words, the transaction will have to be effected as a part-sale-for-cash/part-contribution-for-equity by either the target or its owners. The PEF will acquire a depreciable or amortizable basis for the assets acquired for cash. The same result may be achieved where interests in the target partnership are sold to the HC for cash while the remaining interests are contributed to the HC as capital. In that case, because the HC is treated as acquiring all of the interests in the target partnership, it will receive a depreciable or amortizable basis for the assets to the extent of the cash paid (though a protective election may also be made on the target partnership’s final tax return to adjust the basis for the assets in the hands of the HC).

If the PEF’s HC is a corporation, however, then the target partnership and its owners face the same issues with respect to their capital contributions to the HC as were described earlier in the case of a corporate target – they will need to be treated as part of a “control group.”

Before the LOI

The foregoing discussion should provide potential parties to a PEF acquisition transaction with some insight into their respective structural and tax preferences. It should also give them an understanding of the tax and economic consequences they will have to consider in negotiating such a transaction.

Armed with this information, they may consider how best to structure the target or the acquisition vehicle so as to minimize any negative tax consequences that may arise out of a roll-over (for example, making an “S” corporation election as early as possible for a potential target corporation, or substantiating the existence and value of personal goodwill).

Where a structural solution is not feasible, the parties should consider a “gross-up” to the purchase price for the depreciable or amortizable assets to be acquired, so as to leave the target’s owners in the same after-tax position in which they would have been had their roll-over been completed on a tax-free basis.

As always, it will behoove the parties to be aware of these considerations and to plan for them well before executing a letter of intent, let alone a purchase and sale agreement. Such preparation will facilitate negotiations and completion of the sale and acquisition of the business.

For many business owners, the final step of a successful career may be the sale of their business. At that point, the investment into which the owners have dedicated so much time, effort and money is liquidated, leaving them with what is hopefully a significant pool of funds with which to enjoy their retirement, diversify their assets, or pursue other goals.private equity

It used to be that the prospective buyer would almost always come from within the same industry (or one related to it) as the business being sold. It was often a competitor, or someone seeking to fill a void in their own business. In other words, the buyers were strategic and were looking for synergistic acquisitions – ones that would enable them to grow their own business and provide long-term benefits.

Over the last several years, however, a new type of buyer has emerged: the private equity fund (“PEF”). In general, PEFs are not engaged in any “conventional” business. Rather, they are well-funded investment vehicles that are engaged in the acquisition of conventional businesses (“portfolio companies”). A PEF will often create a holding company (“HC”) that, in turn, will use subsidiary companies to acquire target businesses. Almost by definition, a PEF is not necessarily looking to develop long-term synergistic relationships from an acquisition. Instead, it is looking to add to its portfolio of companies that it, in turn, hopes to sell to another buyer in the not-too-distant future, hopefully at a gain for the PEF’s investors.

Roll-Over: PEF’s Perspective

One facet of a PEF acquisition that tends to distinguish it from a strategic buyer acquisition is the PEF’s strong preference that the owners of a target business “roll over” (or reinvest) some portion of their equity investment in the target business into the PEF’s “corporate structure” in exchange for a minority interest therein. From the perspective of the PEF, such a roll-over yields several benefits. For one thing, it aligns the former owners of the target business with the interests of the PEF – their rolled-over investment is at risk similar to that of the PEF’s investors. Thus, the former owners are incentivized (the theory goes) to remain with the business, to cooperate fully in the transition of the business and its customers, and to work toward its continued growth and success. The roll-over also saves the PEF some money: issuing equity is less expensive than paying out funds that the PEF already has or that it has to borrow.

Roll-Over: Seller’s Perspective

From the perspective of the target’s owner, however, the roll-over may present a troublesome issue.

In many cases, an owner will want to take all of his cash off the table. He may not want to continue risking his capital, especially where the investment is to be controlled by another.

Of course, some owners will be attracted to the potential upside that a roll-over investment in a PEF may generate. After all, the owner may have the opportunity to benefit not only from the future growth of his former business (to which similar businesses may have been added by the PEF), but also that of the PEF’s other portfolio companies. In fact, a business owner may even insist upon being given the opportunity to participate in the growth of these other companies (which is generally consistent with most PEF’s desire that the owners invest at the same level of the corporate structure as the PEF has).

However, the owner may also insist that the roll-over be effected without any adverse tax consequences. The ability of the PEF to satisfy this request will depend, in no small part, upon the form of the acquisition of the target business.

Acquisition Mechanics

Like most other buyers, the PEF will prefer an acquisition of the target’s assets, in a transaction that is taxable to the target, over an acquisition of the equity interests of the target’s owners. A taxable sale of assets will provide the PEF (specifically, its HC) with a depreciable or amortizable basis in the acquired assets that may be written off by the PEF over the useful lives of the assets. The tax deductions so generated will offset the PEF’s income, thereby allowing the PEF to recover some of its investment in the target’s business and reducing the overall cost of the transaction to the PEF.

The target’s owners, on the other hand, will generally not prefer an asset sale because such a sale may result in both the recognition of ordinary income by the target’s owners as well as an entity-level tax, thus reducing the net economic benefit to the owners. Rather, they would choose to sell their equity interest in the target, at least in the case of a corporate target. The gain realized on such a sale will generally be treated as long-term capital gain. However, such a sale will not generate a depreciable or amortizable basis for the PEF.

Roll-Over: Mechanics

In general, a PEF will create a subsidiary corporation or LLC as the HC through which it will acquire a target. This HC will, at least initially, be wholly-owned by the PEF. Where the assets of a target are being purchased, each target acquisition may be completed through an acquisition vehicle (another corporation or LLC) that will be wholly-owned by the HC. In this way, the assets of one business may be protected from the liabilities of another.

The form of roll-over by the target’s owners will depend upon the form of the acquisition. Thus, where the HC is acquiring the equity interests of the target owners, the roll-over will come directly from the former owners. Where the HC is acquiring the target’s assets, the roll-over may, at least in theory, come from the target. However, if the PEF insists that it must come from the target’s owners, then the proceeds paid to the target will have to find their way into the hands of its owners to enable them to acquire equity in the HC.

The chosen forms of acquisition and roll-over will generate very different tax and economic results for both the PEF and the target’s owners. Thus, it is imperative that the target’s owners examine the nature of both the PEF’s acquisition vehicle and of the target (e.g., corporation or partnership/LLC), and the nature of the sale (a sale of equity interests in the target or a sale of the target’s assets). They must consider how their equity roll-over can be effectuated, and whether this transfer may be done tax-efficiently.

The owners of the target business have to recognize that if the roll-over cannot be accomplished on a tax-free (or, more accurately, tax-deferred) basis, they may be left with less liquidity than they would have preferred.

Check back tomorrow for a discussion of the specific effects of a roll-over depending on the types of entity involved and the approach taken in various scenarios.