“Add-Backs”

In the course of valuing a target business, a potential buyer will want to develop an accurate picture of the target’s earnings and cash flow. In doing so, the buyer will try to normalize those earnings by “adding back” various target expenses that the buyer is unlikely to incur in the ordinary course of operating the business after its acquisition. These may include certain one-time costs (for example, an “ordinary and necessary” litigation expense), but the most common add-backs involve payments made to or for the benefit of persons who are somehow related to the owners of the business. Among these related party payments, the compensation paid to family members is by far the most frequently recurring add-back.

“Why is that?” you may ask. Because family-owned and operated businesses are notorious for often paying unreasonable amounts of compensation to family members. These payments may exceed the fair market value of the services actually rendered by the family member – “reasonable compensation,” or the amount that would be paid for like services by like enterprises under like circumstances – or even may be made to a family member who does not actually work in the business. In the case of a family member who is employed by, and provides a valuable service to, the business – a service for which the buyer will have to pay after the acquisition – the add-back will be limited to the amount, if any, by which the payment exceeds reasonable compensation.

There are many reasons why family-owned businesses pay unreasonable compensation: to support a child or grandchild, to enable a family member to participate in retirement and health plans, to make “gifts” to them as part of the owner’s estate planning, and, of course, to zero-out the employer-payor’s taxable income.

Whatever the motivation, the payment violates one of the precepts often advanced by this blog: in a business setting, treat related parties on an arm’s-length basis as much as possible.

“Father Knows Best” (?)

A recent decision of the U.S. Tax Court described one taxpayer who ignored this precept at great cost.

Taxpayer was a C corporation engaged in a wholesale business. Its president and founder (“Dad”), along with his four sons (not My Three Sons; the “Boys”), were its only full-time employees and officers. Each of them performed various and overlapping tasks for the Taxpayer, including tasks that might have been performed by lower level employees. The Boys performed no supervisory functions.

Just before the tax years at issue (the “Period”), Dad owned 98% of Taxpayer’s stock; the other 2% was owned by an unrelated person. Dad then transferred all of his shares of nonvoting common stock to the Boys, after which Dad owned only shares of voting common stock.

Dad was familiar with the marginal income tax rates applicable to him and to his sons. Dad alone determined the compensation payable to the Boys; he did not consult his accountant or anyone else in determining compensation. The only apparent factors considered in determining annual compensation were reduction of Taxpayer’s reported taxable income, equal treatment of each son, and share ownership.

On its corporate income tax returns for the Period, Taxpayer deducted the compensation paid to the Boys.

During those same years, the Taxpayer paid only one insignificant dividend.

Interestingly, during one of the years at issue, Dad considered selling Taxpayer to an unrelated person. They entered into a nondisclosure agreement, and Dad provided the potential buyer with salary figures for the shareholders (his own and the Boys’), adjusted to a market rate that was significantly below what was actually being paid.

Disallowed Deductions

The IRS audited Taxpayer’s returns for the Period, and issued a notice of deficiency in which it disallowed Taxpayer’s deduction for much of the compensation paid to the Boys, claiming that it was unreasonable.

In general, a taxpayer must show that the determinations contained in a notice of deficiency are erroneous, and it specifically bears the burden of proof regarding deductions.

The Tax Court found that Taxpayer’s evidence with respect to the reasonableness of the compensation, as presented by its expert, was not credible.

In fact, the Court was quite critical of the Taxpayer’s “expert.” In most cases, it stated, there is no dispute about the qualifications of the experts. “The problem,” the Court continued, “is created by their willingness to use their résumés and their skills to advocate the position of the party who employs them without regard to objective and relevant facts, which is contrary to their professional obligations.”

The Court concluded that Taxpayer’s expert disregarded objective and relevant facts and did not reach an independent judgment.

“Reasonable” Compensation

The Code allows as a deduction all the ordinary and necessary expenses paid or incurred by a taxpayer during the taxable year in carrying on any trade or business, including a reasonable allowance for salaries or other compensation for personal services actually rendered. A taxpayer is entitled to a deduction for compensation if the payments were reasonable in amount “under all the circumstances,” and were in fact payments purely for services.

Whether the compensation paid by a corporation to a shareholder-employee is reasonable depends on the particular facts and circumstances.

In making this factual determination, courts have considered various factors in assessing the reasonableness of compensation, including:

  • employee qualifications;
  • the nature, extent, and scope of the employee’s work;
  • the size and complexity of the business;
  • prevailing general economic conditions;
  • the employee’s compensation as a percentage of gross and net income;
  • the shareholder-employees’ compensation compared with distributions to shareholders;
  • the shareholder-employees’ compensation compared with that paid to non-shareholder-employees;
  • prevailing rates of compensation for comparable positions in comparable businesses; and
  • comparison of compensation paid to a particular shareholder-employee in previous years where the corporation has a limited number of officers.

No single factor is dispositive. However, special scrutiny is given in situations where a corporation is controlled by the employees to whom the compensation is paid, because there is usually a lack of arm’s-length bargaining.

The Court’s Analysis

The Court noted that while “the actual payment would ordinarily be a good expression of market value in a competitive economy, it does not decisively answer the question” of reasonableness “where the employee controls the company and can benefit by re-labeling as compensation what would otherwise accrue to him as dividends.”

According to the Court, Taxpayer acknowledged as much in the materials prepared in connection with the possible sale, in which the shareholder salaries were recast to a much lower “market rate.”

As in many family enterprises, the Boys were involved early on in the business and did whatever was needed to keep the business going. Compensation in closely-held businesses is subject to close scrutiny because of the family relationships, and it is determined by objective criteria and by comparisons with compensation in other businesses where compensation is determined by negotiation and arm’s-length dealing.

In their testimony, the Boys denied knowledge of principles basic to the performance of their respective functions on behalf of Taxpayer. Moreover, none of them had any special experience or educational background. Each of them testified that they had overlapping duties, but those duties included menial tasks as well as managerial ones because there were no other employees.

Dad testified that he intended to treat the Boys equally, that he alone determined their compensation, and that he was aware of their marginal tax rates, obviously intending to minimize Taxpayer’s, and the family’s overall, tax liability.

The amounts and equivalency of the Boys’ compensation – allegedly to avoid competition among them – the proportionality to their stock interests, the manner in which Dad alone dictated the amounts, the reduction of reported taxable income to minimal amounts, and the admissions in the sale materials relating to their compensation “all justified skepticism,” the Court stated, toward Taxpayer’s “assertions that the amounts claimed on the returns were reasonable.”

The Court was especially critical of Taxpayer’s compensation expert. The expert did not consider any of the foregoing factors. He disregarded sources and criteria that he used in other cases, and that would have resulted in lower indicated reasonable compensation amounts. He used only one source of data although, in his writings and lectures, he had urged others to use various sources. Although he testified that he was an expert in “normalizing owner compensation,” which is “adjusting the numbers to what they think a buyer might experience,” he did not attempt to do so in this case. In attempting to justify the compensation paid to the Boys in the absence of material reported earnings, he assumed that Taxpayer increased in value from year to year.

The expert placed Taxpayer’s officers in the 90th percentile of persons in allegedly comparable positions, which their own testimony showed that they were not. He determined aggregate compensation of the top five senior executives in companies included in his single database while acknowledging that the titles assigned and duties performed by Taxpayer’s officers were not typical of persons holding senior executive offices. He understood that the compensation was set solely by Dad and was not the result of negotiation or arm’s-length dealing, but he ignored that factor. He relied completely on the representations of Dad and the Boys and did not consult any third parties.

Although his report discussed officer retention as a reason for high compensation, he did not consider the likelihood – as confirmed by the Boys’ testimony – that any of them would ever leave Taxpayer’s employ, even if he were paid less.

The approach throughout the appraiser’s report indicated that it was result-oriented – to validate and confirm that the amounts reported on Taxpayer’s returns were reasonable – rather than an independent and objective analysis. The Court found that, overall, neither the expert’s analysis nor his opinion was reliable.

Because Taxpayer’s expert’s opinion disregarded the objective evidence and made unreasonable assumptions, the Court held that Taxpayer failed to satisfy its burden of proving the reasonableness of the amounts paid to the Boys in excess of those allowed in the notice of deficiency.

Apologies to Dad? Nope

Yesterday was Father’s Day, yet here I am, one day later, writing about a Dad who tried to do right by his Boys, but was punished with an increased tax bill. Unfortunately, he deserved it. The compensation paid to the Boys appeared solely related to their shareholdings, to Dad’s desire to transfer his wealth to them equally, and to his desire to reduce the Taxpayer’s corporate income tax liability.

This is what happens when you violate the precept recited above: in a business setting, treat related parties on as close to an arm’s-length basis as possible; stated differently, “you mess with the bull, you get the horns.”

This simple rule accomplishes a number of goals. It supports the separateness of the corporate entity and the protection it affords from personal liability. It rewards those who actually render services, and may incentivize others to follow suit. It may cause those who are not productive to leave the business. It may reduce the potential for intra-family squabbling based on accusations of favoritism. And let’s not forget that it helps to avoid surprises from the IRS.

Where estate and gift planning is a consideration, there are other means of shifting value to one’s beneficiaries. Combined with the appropriate shareholders’ agreement, these transfers may be effectuated without adversely affecting the business.

Introduction

In general, self-employed individuals are subject to employment taxes on their net earnings.

The wages paid to individuals who are non-owner-employees of a business are also subject to employment taxes, regardless of how the business is organized.

The shareholders of a corporation are not subject to employment taxes in respect of any return on their investment in the corporation, though they are subject to employment taxes as to any wages paid to them by the corporation.

In the case of an S corporation, the IRS has sought to compel the corporation to pay its shareholder-employees a reasonable wage for services rendered to the corporation, and thus to prevent it from “converting” into a distribution of investment income that is not subject to employment taxes.

Finally, in the case of a partnership, a “limited partner” is generally not subject to employment taxes in respect of his distributive share of the partnership’s income, while the shares of a “general partner” are subject to such taxes, regardless of whether or not the general partner receives a distribution from the partnership.

Application to LLC Members

The U.S. Tax Court recently considered whether the members of an LLC may be treated as limited partners for purposes of applying the self-employment tax to their distributive share of the LLC’s net income.

Specifically, the issue for decision was whether the three member-managers of the LLC (the “Taxpayers”) were entitled to claim the exclusion from self-employment income for limited partners for a portion of their LLC distributions.

The Taxpayers were attorneys who initially practiced law through a general partnership before reorganizing their firm as a member-managed professional limited liability company (the “PLLC”). The PLLC never had a written operating agreement, and it filed federal income tax returns as a partnership.

For the years at issue, the Taxpayers’/members’ compensation agreement required guaranteed payments (i.e., payments to a partner for services, determined without regard to the income of the partnership) to each member that were commensurate with local area legal salaries. Any net profits of the PLLC in excess of the amounts paid out as guaranteed payments were distributed among the members in accordance with the Taxpayers’ agreement.

The Taxpayers reported all of their guaranteed payments from the PLLC as self-employment income subject to self-employment tax. However, they did not remit self-employment tax on the excess of their distributive shares over the guaranteed payments they received, on the grounds that such distributive shares were attributable to the efforts of the PLLC’s other employees (in other words, they represented a return on investment).

The IRS challenged the Taxpayers’ treatment of this excess.

Self-Employment Tax

The Code imposes a tax on the “self-employment income” of every individual for a taxable year (self-employment tax). In general, self-employment income is defined as “the net earnings from self-employment derived by an individual.”

“Net earnings from self-employment” is defined as the gross income derived by an individual from any trade or business carried on by such individual, less allowable deductions which are attributable to such trade or business, plus his distributive share (whether or not distributed) of income or loss from any trade or business carried on by a partnership of which he is a member . . . .”

Certain items are excluded from self-employment income, including “the distributive share of any item of income . . . of a limited partner, as such, other than guaranteed payments to that partner for services actually rendered to or on behalf of the partnership to the extent that those payments are established to be in the nature of remuneration for those services . . . .”

The Taxpayers contended that the above exclusion applied to their distributive shares in excess of the guaranteed payments. The IRS, however, argued that the members were not “limited partners” for purposes of this exclusion and, therefore, the distributive shares constituted self-employment income.

The Tax Court reviewed the history of the exclusion, explaining that it was enacted well before LLCs became widely used. The Court noted that no statutory or regulatory authority defines “limited partner” for purposes of the exclusion.

A “Historical” Digression

Prior to the enactment of the exclusion, the Code provided that a partner’s share of partnership income was includable in his net earnings from self-employment for tax purposes, regardless of the nature of his membership in the partnership.

In creating the exclusion for limited partners, Congress recognized that certain earnings were basically in the nature of a return on investment. Thus, the exclusion was not extended to guaranteed payments received for services actually rendered by the limited partner to the partnership.

In 1997, in response to the proliferation of LLCs, the IRS issued proposed regulations defining “limited partner” for self-employment tax purposes. These generally provided that an individual would be treated as a limited partner unless the individual: (1) had personal liability for the debts of or claims against the partnership by reason of being a partner; (2) had authority to contract on behalf of the partnership; or (3) participated in the partnership’s trade or business for more than 500 hours.

In response to criticism from the business community, Congress imposed a temporary moratorium on finalizing the proposed regulations, which has long since expired, yet the proposed regulations have neither been finalized nor withdrawn.

A number of courts, however, have addressed the attempts by taxpayers to distinguish between a partner’s wages and his share of partnership income. The courts have generally explained that a limited partnership has two fundamental classes of partners: general partners, who typically have management power and unlimited personal liability; and limited partners, who lack management powers but enjoy immunity from liability for debts of the partnership. A limited partner, these courts have pointed out, could lose his limited liability protection were he to engage in the business operations of the partnership. Consequently, the courts have observed that the interest of a limited partner is akin to that of a passive investor.

The Court’s Opinion

The Tax Court followed this line of this reasoning in its analysis of the Taxpayers’ position. The meaning of “limited partner,” it stated, was not confined to the limited partnership context. Therefore, the issue was whether a Taxpayer/member of the member-managed PLLC was functionally equivalent to a limited partner in a limited partnership.

In a limited partnership, the Court highlighted, a limited partner does not become liable as a general partner unless, in addition to the exercise of his rights and powers as a limited partner (e.g., the right to vote on the dissolution of the partnership or the sale of substantially all of its assets), he takes part in the control of the business.

In this case, the management power over the business of the PLLC was vested in each of the Taxpayer-members. The Taxpayers testified that each of them participated equally in all decisions and had substantially identical relationships with the PLLC, including the same rights and responsibilities: for example, they all participated in collectively making decisions regarding their distributive shares, borrowing money, hiring, firing, and rate of pay for employees, they each supervised associate attorneys, and they each signed checks for the PLLC.

There was no PLLC operating agreement or other evidence to suggest otherwise, nor was there any evidence to show that any member’s management power was limited in any way. Indeed, they had previously operated as a general partnership, and there was no evidence that organizing as a PLLC was accompanied by any change in the way they managed the business.

On the basis of the foregoing, the Court held that the respective membership interests held by the Taxpayers could not have been limited partnership interests, and the Taxpayers were not limited partners. Accordingly, the Taxpayers could not exclude any part of their distributive shares of PLLC net income from self-employment income.

Lessons & Planning

The Tax Court’s decision demonstrates that a business organization that is treated as a partnership for tax purposes cannot change the character of a partner/member’s distributive share for purposes of the self-employment tax simply by making guaranteed payments to the partner for his services. A partnership is not a corporation, and the “wage” and “reasonable compensation” rules that are applicable to corporations do not apply to partnerships.

The “limited partner exclusion” provided by the Code was intended to apply to those partners who “merely invest” rather than those who actively participate in and perform services for a partnership in their capacity as partners.

Therefore, a partner who is not a “limited partner” within the meaning of the exclusion is subject to self-employment tax on his full distributive share of the partnership’s income, even in cases involving a capital-intensive (as opposed to a service-intensive) business.

If a member of an LLC truly intends to be a passive investor, his status as such should be memorialized in an operating agreement, it should be reflected in his actions, and the LLC and other members should treat him accordingly.

As always, the taxpayers must be able to support their position, and the first steps in doing so are to adopt a form of operation (and, if relevant, organization) that conforms with the intended result, to contemporaneously memorialize that intention, including the “action plan” for attaining it, and to act consistently with the foregoing.

Many of  our posts  this year have considered some of the unique issues that are presented by a partner’s contribution of property to a partnership, including the application of the “disguised sale” rules. Today, we will review one aspect of a recent IRS ruling involving a partnership’s assumption of liabilities in connection with a partner’s contribution of substantially all of its assets and liabilities to the partnership. ‎

The Contribution

Company was a joint venture between two corporations that were engaged in Business. In addition to operating assets, Company held all of the general partner interests, and various classes of limited partner interests, in Partnership, a state law limited partnership. Partnership owned all of the membership interests in an LLC (“DRE”), which was disregarded as an entity separate from Partnership for federal income tax purposes.

Company planned to transfer cash and all of its material operating assets to Partnership (through DRE) in exchange for additional limited partner units in Partnership (the “Transfer”).

In connection with the Transfer, Partnership (through DRE) would assume certain liabilities of Company (the “Liabilities”).

The Liabilities

All of the Liabilities were incurred more than two years before the proposed Transfer: Some were originally incurred to make distributions in connection with Company’s formation and were subsequently refinanced, and the remainder were used to acquire assets, make improvements, pay expenses, and otherwise operate Company’s business, including to refinance other liabilities incurred for the same purposes.

Company had also regularly distributed cash to its members in proportion to their ownership interests. Those cash distributions were less than Company’s earnings.

The Liabilities (and the liabilities that they refinanced) were an integral part of Company’s existing and historical capital structure.

Company represented that:

  1. none of the Liabilities was in default;
  2. the Liabilities were not incurred in anticipation of the Transfer to Partnership;
  3. the Transfer to Partnership was not being considered at the time the Liabilities were incurred; and
  4. Company would have incurred the Liabilities without regard to the Transfer to Partnership.

(Company also made other representations concerning the application of another provision of the Code – not addressed in this post – that allocates among the partners any deductions and losses attributable to partnership indebtedness.)

The Disguised Sale Rules

The Code provides that, if (i) there is a transfer of property by a partner to a partnership, (ii) there is a related transfer of money by the partnership to such partner, and (iii) these transfers, when viewed together, are properly characterized as a sale or exchange of the property, such transfers shall be treated as a transaction between a partnership and one of its partners acting other than in its capacity as member of the partnership.

Thus, where these criteria are satisfied, the transfer of money by the partnership is not treated as a distribution to a partner in respect of his partnership interest; rather, it is treated as payment for the property transferred by the partner.

This “disguised sale” is considered to take place on the date that, under general principles of tax law, the partnership is considered the owner of the property. If the transfer of money from the partnership to the partner occurs after the transfer of property to the partnership, the partner and the partnership are treated as if, on the date of the sale, the partnership transferred to the partner an obligation to transfer money to the partner.

Facts & Circumstances

The regulations promulgated under the disguised sale rules provide that a transfer of property by a partner to a partnership and a transfer of money (including the assumption of or the taking subject to a liability) by the partnership to the partner constitute a sale of property, in whole or in part, by the partner to the partnership only if, based on all the facts and circumstances, (i) the transfer of money would not have been made but for the transfer of property; and (ii) in cases in which the transfers are not made simultaneously, the subsequent transfer is not dependent on the entrepreneurial risks of partnership operations.

The determination of whether a transfer of property by a partner to the partnership and a transfer of money by the partnership to the partner constitute a sale, in whole or in part, is made based on all the facts and circumstances in each case. The weight to be given each of the facts and circumstances will depend on the particular case.

Among the facts and circumstances that may tend to prove the existence of a sale are the following:

(i) That the timing and amount of a subsequent transfer are determinable with reasonable certainty at the time of an earlier transfer;

(ii) That the transferor has a legally enforceable right to the subsequent transfer;

(iii) That the partner’s right to receive the transfer of money is secured in any manner, taking into account the period during which it is secured;

(iv) That any person has made, or is legally obligated to make, contributions to the partnership in order to permit the partnership to make the transfer of money;

(v) That any person has loaned or has agreed to loan the partnership the money required to enable the partnership to make the transfer, taking into account whether any such lending obligation is subject to contingencies related to the results of partnership operations;

(vi) That a partnership has incurred or is obligated to incur debt to acquire the money necessary to permit it to make the transfer, taking into account the likelihood that the partnership will be able to incur that debt (considering such factors as whether any person has agreed to guarantee or otherwise assume personal liability for that debt);

(vii) That the partnership holds money beyond the reasonable needs of the business, that is expected to be available to make the transfer;

(viii) That partnership distributions, allocation or control of partnership operations is designed to effect an exchange of the burdens and benefits of ownership of property;

(ix) That the transfer of money by the partnership to the partner is disproportionately large in relationship to the partner’s general and continuing interest in partnership profits; and

(x) That the partner has no obligation to return or repay the money to the partnership, or has such an obligation but it is likely to become due at such a distant point in the future that the present value of that obligation is small in relation to the amount of money transferred by the partnership to the partner.

Presumptions

In order to afford partners and their partnerships some “certainty,” the regulations provide that if, within a two-year period, a partner transfers property to a partnership and the partnership transfers money to the partner (without regard to the order of the transfers), the transfers are presumed to be a sale of the property to the partnership unless the facts and circumstances clearly establish that the transfers do not constitute a sale.

Conversely, if a transfer of money to a partner by a partnership and the transfer of property to the partnership by that partner are more than two years apart, the transfers are presumed not to be a sale of the property to the partnership unless the facts and circumstances clearly establish that the transfers constitute a sale.

Assumed Liabilities

The regulations further provide that if a partnership assumes or takes property subject to a “qualified liability” of a partner, and the transfer of the property by the partner to the partnership is not otherwise treated as part of a sale, the partnership’s assumption of or taking subject to the qualified liability is not treated as part of a sale.

In general, a liability is a “qualified liability” of the partner to the extent: (i) The liability (A) was incurred by the partner more than two years prior to the date the partner transfers the property to the partnership and the liability has encumbered the transferred property throughout that two-year period; or (B) was not incurred in anticipation of the transfer of the property to a partnership, but was incurred by the partner within the two-year period prior to the date the partner transfers the property to the partnership and that has encumbered the transferred property since it was incurred; or (C) is allocable to capital expenditures with respect to the property; or (D) was incurred in the ordinary course of the trade or business in which property transferred to the partnership was used or held, but only if all the material assets related to that trade or business are transferred; and (ii) If the liability is a recourse liability, the amount of the liability does not exceed the fair market value of the transferred property at the time of the transfer.

If a transfer of property by a partner to a partnership is not otherwise treated as part of a sale (for example, the partnership does not also pay money to the partner in connection with the transfer), the partnership’s assumption of or taking subject to a qualified liability in connection with the transfer of property is treated as a distribution by the partnership.

By contrast, if the partnership assumes or takes property subject to a liability of the partner other than a qualified liability, the partnership is treated as transferring consideration to the partner to the extent that the amount of the liability exceeds the partner’s share of that liability immediately after the partnership assumes or takes subject to the liability.

If, within a two-year period, a partner incurs a liability (other than a liability allocable to a capital expenditure or incurred in the ordinary course of business), and transfers property to a partnership and, in connection with the transfer, the partnership assumes or takes the property subject to the liability, the liability is presumed to be incurred in anticipation of the transfer, unless the facts and circumstances establish otherwise.

The IRS Rules

After applying the foregoing rules to the Company’s facts and representations, the IRS concluded that the Liabilities assumed by Partnership (through DRE) in connection with Company’s Transfer to Partnership would constitute qualified liabilities of Company and, as such, would not be treated as consideration paid as part of a sale.

Lessons?

The ruling presented a fairly simple set of facts. Other situations are not as straightforward.

For example, what if the partner wanted to withdraw some equity – cash – from the property (e.g., real estate) being contributed to the partnership? The regulations provide that if a partner transfers property to a partnership, and the partnership incurs a liability, and all or a portion of the proceeds of that liability are traceable to a transfer of money from the partnership to the partner made shortly after incurring the liability, the transfer of money to the partner is taken into account as part of a sale to the extent that the amount of money transferred exceeds that partner’s allocable share of the partnership liability.

Alternatively, what if the partner incurs the liability, and withdraws equity from the property, more than two years prior to transferring the encumbered property to the partnership? What if the partnership then refinances the liability?

The regulations provide that a liability incurred within two years of a transfer of property will be presumed to be incurred in anticipation of the transfer (unless the liability was allocable to a capital expenditure or incurred in the ordinary course of business) and, thus, part of a sale – the regulations do not provide a favorable presumption for a liability incurred more than two years prior to the transfer, though such a liability may constitute a qualified liability.

However, always be mindful that, in the appropriate situation, a facts and circumstances analysis may still be applied by the IRS and, in the absence of a bona fide business reason for the indebtedness, it may be possible for the IRS to successfully characterize a portion of the refinancing as consideration for a sale.

Close Corporations and Compensatory Grants of Equity

It should come as no surprise to readers of this blog that I am not enamored with the notion of issuing equity to employees of a closely-held business. It’s not that these individuals should not be rewarded for their efforts and contributions to the growth, success and stability of the business. Far from it. It’s just that the employer-corporation and the existing shareholders need to fully appreciate the consequences of granting equity, including the fact that state law bestows many rights upon the minority shareholder and imposes many duties upon the majority; moreover, there are other, less compromising, vehicles by which a key employee may be rewarded.

But what if the key employee is already a shareholder of the employee-corporation? Indeed, what if he is a co-founder of the corporation’s business? Does it even make sense that the corporation would make a compensatory grant of stock to such an individual? The answer, of course, depends upon the facts and circumstances.

A recent decision from the U.S. Tax Court described a complex set of transactions involving the grant of stock to the two founders (the “Taxpayers”) of the employer-corporation’s business. The transactions gave rise to several issues, some of which were resolved in favor of the Taxpayers. Unfortunately for the Taxpayers, these proved to be pyrrhic victories, as the IRS ultimately prevailed.

Substantial Risk of Forfeiture

The issue on which we will focus – and on which the Court held for the Taxpayers – was whether the stock issued to the Taxpayers was subject to a substantial risk of forfeiture at the time of issuance.

In general, when stock in the employer-corporation is granted to an employee in consideration of the employee’s services, the employee must include in his gross income the fair market value of such stock.

However, if the stock is subject to substantial risk of forfeiture, the employee does not have to include the stock’s FMV in gross income until the risk of forfeiture lapses (“restricted stock”). Thus, the employee is allowed to defer recognition of income until his rights in the stock become “substantially vested.”

Stock is subject to a substantial risk of forfeiture if the employee’s rights to the stock are conditioned upon the future performance of substantial services by the employee or upon the occurrence of a condition related to the purpose of the transfer; for example, the employee is required to provide a stated number of years of continuous service beginning on the date of grant, or the employee’s division must attain a specified degree of productivity within a stated period of time beginning on such date. Where the employee fails to satisfy the conditions related to the grant, he will be required to return the stock to the employer, usually for no consideration.

Likelihood of Enforcement

An employee will not be required to include the FMV of the stock in his gross income if the possibility of forfeiture is substantial. However, stock is not transferred subject to a substantial risk of forfeiture if at the time of transfer the facts and circumstances demonstrate that the forfeiture condition is unlikely to be enforced.

In determining whether the possibility of forfeiture is substantial in the case of stock transferred to an employee of a corporation who owns a significant amount of the total combined voting power or value of all classes of stock of the employer corporation, there will be taken into account (i) the employee’s relationship to other stockholders and the extent of their control, potential control, and possible loss of control of the corporation, (ii) the position of the employee in the corporation and the extent to which he is subordinate to other employees, (iii) the employee’s relationship to the officers and directors of the corporation, (iv) the person or persons who must approve the employee’s discharge, and (v) past actions of the employer in enforcing the restrictions.

For example, if an employee would be considered as having received rights in property subject to a substantial risk of forfeiture, but for the fact that the employee owns 20 percent of the single class of stock in the employer-corporation, and if the remaining 80 percent of the stock is owned by unrelated individuals so that the possibility of the corporation enforcing a restriction on such rights is substantial, then such rights are subject to a substantial risk of forfeiture. On the other hand, if 4 percent of the voting power of all the stock of a corporation is owned by the president of such corporation and the remaining stock is so widely held that the president, in effect, controls the corporation, then the possibility of the corporation enforcing a restriction on rights in property transferred to the president is not substantial, and such rights are not subject to a substantial risk of forfeiture.

The “Earnout” (?)

In the case considered by the Tax Court, the Taxpayers worked together for many years in the Business. Before Year One, they were the original shareholders and members of a group of related corporations and LLCs (the “Entities”).

Capital Contribution

Toward the end of Year One, the Taxpayers organized, and elected S-corporation status for, a holding company (“Holding Corp.”) to which they contributed their ownership interests in the Entities in exchange for all of the shares of Holding Corp.’s common stock.

Restricted Stock

As part of this exchange, each Taxpayer executed a “Restricted Stock Agreement” (“RSA”) and an “Employment Agreement” with Holding Corp. A principal purpose of these agreements was to require the Taxpayers to perform future services for Holding Corp. in order to acquire full rights in their stock. Read together, these agreements specified a five-year “earnout” period and provided that either Taxpayer would forfeit 50% of the value of his shares if he voluntarily terminated his employment with Holding Corp. before Year Six. Removing or waiving this restriction required consent of the holders of 100% of the shares entitled to vote.

The Taxpayers were the sole directors of Holding Corp. throughout the tax years at issue. Taxpayer A was the company’s president and was responsible for its “front-end” operations. Taxpayer B was its senior executive vice president and was responsible for its “back-end” operations.

Allocation of S Corp. Income

Because the Taxpayers received their Holding Corp. shares in a “tax-free” exchange, they were relieved of any obligation to recognize gain upon receipt of the shares or upon transfer of the ownership interests in the Entities to Holding Corp.

The chief relevance of determining whether the shares were “substantially vested” upon receipt was that this determination controlled whether the Taxpayers’ shares were treated as outstanding stock of the S-corporation for purposes of allocating Holding Corp.’s income to the Taxpayers.

The ESOP

Late in Year One, with the avowed goal of encouraging long-term job retention, the Taxpayers caused Holding Corp. to form an ESOP for its employees, including the Taxpayers.

The company funded the ESOP with a loan, which was used to purchase shares of Holding Corp.’s common stock. Thus, as of the end of Year One, each Taxpayer owned 47.5% of Holding Corp.’s common stock and the ESOP owned the remaining 5%.

The Issue

The Taxpayers discharged their obligations under the RSA and the employment agreements through the end of Year Five and, in Year Six, the restrictions on their stock lapsed accordingly.

The Taxpayers did not report any income from Holding Corp. on their federal income tax returns for Year One, taking the position that their stock was subject to a “substantial risk of forfeiture” and relying on the rule that, for purposes of subchapter S, “stock that is issued in connection with the performance of services * * * and that is substantially nonvested * * * is not treated as outstanding stock of the corporation, and the holder of that stock is not treated as a shareholder solely by reason of holding the stock.”

Under this reasoning, because the shares owned by the Taxpayers were not deemed to be outstanding, Holding Corp. allocated 100% of its income, losses, deductions, and other tax items to the ESOP.

The IRS determined that the Taxpayers’ stock in Holding Corp. was “substantially vested” upon receipt in Year One; that their stock was thereafter “outstanding”; and that they were accordingly required to report their pro rata shares of the company’s income for each year.

The Taxpayers timely petitioned the Tax Court.

The Court’s Analysis

The Court began by stating that a taxpayer’s rights to stock are subject to substantial risk of forfeiture if his rights to full enjoyment of the stock are conditioned upon his future performance of substantial services. The risk of forfeiture analysis, it continued, required the Court to determine whether the property interests transferred by the employer were “capable of being lost.”

The Taxpayers contended that their stock in Holding Corp. was subject to a substantial risk of forfeiture when they received it in Year One and remained subject to a substantial risk of forfeiture until Year Six, when the five-year earnout restriction lapsed.

The IRS contended that the Taxpayers’ stock was substantially vested when they received it in Year One; that their stock was thus “outstanding” for subchapter S purposes throughout the tax years at issue; and that the Taxpayers consequently were required to report their pro rata shares of the company’s income on their tax returns for those years.

After observing that, in prior cases, it had held that an earnout restriction created a “substantial risk or forfeiture,” provided there was a sufficient likelihood that the restriction would actually be enforced, the Court turned to the question of whether the restriction at issue was likely to be enforced.

“Enforceable” Restriction?

Each Taxpayer owned 47.5% of Holding Corp.’s voting common stock, with the ESOP owning the remaining 5%. The Court explained that in situations where nominally restricted property was transferred to an employee “who owns a significant amount of the total combined voting power or value of all classes of stock of the employer corporation,” one must consider several factors in determining whether the possibility of forfeiture was substantial.

The Court emphasized the importance, not just of percentage stock ownership, but of de facto power to control. Under such circumstances, “the possibility of the corporation enforcing a restriction on rights in property transferred to [an employee] is not substantial, and such rights are not subject to a substantial risk of forfeiture.”

The Court stated that if either Taxpayer had quit his job before the end of the five-year earnout period, Holding Corp. would likely have enforced the restriction requiring that he forfeit 50% of the value of his shares.

While both Taxpayers had experience in the Business, the Court reasoned, their skill sets were quite distinct; Taxpayer A performed the front-end work, while Taxpayer B had back-end and back-office responsibilities. According to the Court, the Taxpayers recognized that the success of the Business depended on their both remaining with the company. To incentivize this, they executed reciprocal agreements whereby each would lose 50% of the value of his stock if he left the company within five years. The Taxpayers thus “tied each other to the mast,” the Court said, for a five-year period.

Moreover, removal or waiver of this forfeiture provision required the consent of the holders of 100% of the company’s shares. As a holder of a 47.5% interest facing the holder of another 47.5% interest, neither Taxpayer had power to control the company. Neither Taxpayer could act unilaterally to remove the forfeiture restriction affecting his stock.

If either Taxpayer threatened to leave during the five-year earnout period, the other had a strong incentive, the Court observed, to insist that the forfeiture restriction be enforced as written. First, given the complementary nature of their responsibilities and skill sets, it was in each Taxpayer’s economic interest to have the other remain with the company. Second, if the departing Taxpayer forfeited 50% of the value of his stock, the value of the remaining Taxpayer’s stock (and that of the ESOP) would be increased accordingly. There was no family or other relationship between the Taxpayers, the Court continued, that would have caused either of them to act against his economic interest.

Conceivably, the Court stated, both Taxpayers might have decided independently that they wished to retire early instead of serving out their promised five-year terms. But despite their status as the sole directors of the company, they would have needed the consent of the ESOP to remove the forfeiture provisions. The ESOP, however, would have had a strong economic incentive to refuse such consent. If the Taxpayers left the company, the company might well have folded, and the ESOP beneficiaries would then have lost their jobs.

The IRS nevertheless urged that the Taxpayers could control the ESOP because they served as two of its initial three trustees and the third trustee was subordinate to them. In response, the Court pointed out that the IRS ignored the fiduciary duties that all three owed the ESOP. As trustees, the Taxpayers were personally liable for any breaches of their fiduciary duty.

In sum, the Court concluded that the Taxpayers’ stock was subject to a substantial risk of forfeiture when issued to them in Year One and remained subject to that risk until the restrictions lapsed in January of Year Six. Neither Taxpayer held a controlling position in Holding. If either failed to perform his duties or left the company before the earnout restriction ended, the other would have had every incentive to insist on enforcement of the forfeiture provision according to its terms. The ESOP had even stronger economic incentives to do this.

Because “the possibility of forfeiture * * * [was] substantial,” the Court ruled that the stock held by the Taxpayers did not become “substantially vested” until they completed their promised service through the end of the five-year earnout period.

What Does It Mean?

Granted, the situation presented in the decision described above was somewhat unusual. Moreover, that the Court did not regard as significant the fact that the stock at issue was granted to the Taxpayers in exchange for their capital contributions to Holding Corp. is somewhat surprising, especially in the case of an S-corporation where the issuance of “restricted” stock to certain shareholders would seem to raise the possibility of shifting income or losses among shareholders in violation of the principles underlying the “second-class-of-stock” rule.

Nevertheless, the Court’s opinion should provide some comfort to an employer-corporation that wants to grant restricted stock to individuals who are already shareholders. Provided the stock is issued for a bona fide business reason that is related to the risk of forfeiture, the employer-corporation, the employee-shareholder, and the other shareholders of the corporation should be able to structure the grant so as to ensure that the likelihood of enforcement of a forfeiture condition is substantial, and to thereby avoid the immediate taxation of the stock issued.

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

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

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

The Transaction

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

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

The Law

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

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

Spinoff

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

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

Capital Contribution

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

Reorganization

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

Continued Investment

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

Step Transaction

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

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

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

The IRS’s Ruling

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

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

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

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

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

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

Beyond the Ruling

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

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

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

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

Missed Part I?  Check it out here!

“Related Party” Transactions
Transfer Pricing

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

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

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

Constructive Transfers

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

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

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

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

Capital Contributions of Property

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

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

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

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

Second Class of Stock

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

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

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

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

Sale of Business

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

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

Allocation of Purchase Price

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

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

Among these situations are the following:

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

Tax-Free Reorganizations

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

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

Loss Company

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

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

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

Penalties

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

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

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

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

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

Et cetera

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

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

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

 

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

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

Transfers in Connection with Estate and Gift Tax Planning

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

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

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

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

Paying the Estate Tax

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

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

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

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

Buy-Sell Agreements

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

Statute of Limitations

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

Income Tax Considerations of a Transfer

Adjusted Basis

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

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

Compensation

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

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

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

Non-Qualified Deferred Compensation

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

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

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

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

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

Reasonable Compensation

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

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

Cancellation of Indebtedness 

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

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

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

Stay tuned for Part II, tomorrow.

An Unreasonable Burden?

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

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

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

Plan Ahead

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

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

Insurance

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

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

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

Installment Payments

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

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

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

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

“Graegin Loans”

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

Is the Loan “Necessary”?

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

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

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

The Loan

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

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

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

IRS Challenges the Estate Tax Return

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

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

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

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

The Estate appealed this decision to the Eleventh Circuit.

Administration Expense?

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

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

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

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

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

The Estate’s Liquidity

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

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

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

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

Decisions, Decisions

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

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

In General

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

Application to S-Corps

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

Stock Basis

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

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

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

Debt Basis

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

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

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

“Necessity” as the Mother of Invention?

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

The Personal Guarantee

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

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

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

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

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

The Court’s Analysis

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

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

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

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

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

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

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

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

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

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

Advice to S Corporation Shareholders

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

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

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

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

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

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

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

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

Recovering Transaction Costs

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

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

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

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

According to the IRS

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

Examples of Facilitative Expenses

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

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

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

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

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

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

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

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

“Simplifying Conventions”

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

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

Election to Capitalize

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

Facilitative Costs

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

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

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

The term “covered transaction” means the following transactions:

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

Inherently Facilitative Costs                    

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

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

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

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

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

(iv) Obtaining regulatory approval of the transaction;

(v) Obtaining shareholder approval of the transaction; or

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

Success-Based Fees

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

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

Capitalized Costs: Basis & Reduction of Gain

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

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

Recap

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

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

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

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