Form v. Substance

It is a basic precept of the tax law that the substance of a transaction, rather than its form, should determine its tax consequences when the form of the transaction does not coincide with its economic reality. This substance-over-form argument is a powerful tool in the hands of a taxing authority.

According to another basic precept of the tax law, a taxpayer will generally be bound, for purposes of determining the tax consequences of a transaction, by the form of the transaction that he has used to achieve a particular business goal; the taxpayer may not freely re-characterize a transaction.

That being said, a taxpayer may assert a substance-over-form argument under certain circumstances. In those situations, however, the taxpayer faces a higher than usual burden of proof; indeed, the taxpayer must adduce “strong proof” to establish his entitlement to a position that is at variance with the form of the transaction reported on the taxpayer’s return.

The case discussed below addressed the classic tax issue of form versus substance as the Third Circuit considered a taxpayer’s attempt at re-characterizing a transaction.[1]

The Ingredients

Taxpayer, a U.S. person, was the majority shareholder of a U.S. corporation (“Target”) that owned and operated two Russian LLCs that, in turn, owned and operated most of Russia’s Pizza Huts and KFCs. Another U.S. corporation (“Minority”) held the remaining Target shares.

In order to sell the company, Taxpayer planned to buy out Minority’s Target shares, and then transfer all the Target shares – including those just purchased – to the buyer, a European corporation (“Buyer”) that owned KFCs, Pizza Huts, and other fast-food restaurants throughout Europe.

In May of the year in question, Taxpayer agreed to “purchase”, for his “own account”, Minority’s stake in Target. At closing, Minority was to transfer its Target shares to Taxpayer and then, in the following month, Taxpayer would make a “deferred” payment of the purchase price to Minority.

“You better cut the pizza in four pieces because I’m not hungry enough to eat six.” – Yogi Berra

Taxpayer also entered into a Merger Agreement with Target and Buyer. Under the terms of this Agreement: (1) Taxpayer would ensure, at the closing, that he was the “record” owner of 100% of the Target stock, “free and clear of any restrictions”; (2) Taxpayer would transfer 100% of Target’s shares to Buyer; and (3) Buyer would transfer cash and Buyer stock to Taxpayer as consideration. The transaction was intended to qualify as a partially “tax-free” reorganization within the meaning of the Code.[2] [IRC Sec. 368, 367]

The two transactions went through as planned. In June of the year in question, Minority transferred its Target stock to Taxpayer. On July 2, the Target-Buyer merger closed, and Taxpayer transferred all the Target stock to Buyer. On July 3, Buyer paid Taxpayer over $23 million in cash and transferred over $30 million worth of Buyer stock, a total of nearly $54 million for all Target’s shares. Then on July 5, Taxpayer paid Minority $14 million for its stake in Target.

In two tax filings for the year in question, Taxpayer took two different approaches to the transaction. In his original return, Taxpayer reported tax liability of almost $3.8 million, and paid that amount to the IRS. Taxpayer subsequently amended his return, reported a lower tax liability, and requested a refund.

“Finger Lickin’ Good” – Not for the Taxpayer

The IRS audited Taxpayer, found that the originally-filed return was correct, and denied Taxpayer’s request for a refund. Taxpayer then petitioned the U.S. Tax Court for a redetermination. The Tax Court held for the IRS, and Taxpayer then appealed to the Third Circuit Court of Appeals.

Taxpayer Never Owned It?

Taxpayer challenged the IRS’s determination that he had to pay tax on the $14 million that he received from Buyer and immediately remitted to Minority. The question was whether the form of the transaction made Taxpayer liable for the gain on the Target stock that had been held by Minority.

The Court began by describing the so-called “Danielson rule”:

[W]hile a taxpayer is free to organize his affairs as he chooses, . . . once having done so, he must accept the tax consequences of his choice, whether contemplated or not, and may not enjoy the benefit of some other route he might have chosen to follow but did not.

A taxpayer who falls within the scope of this rule, the Court stated, is generally stuck with the form of his business transaction, and can make an argument that substance should prevail over that form only if a limited class of exceptions applies.

Taxpayer argued that he was never the substantive owner of the Minority block of stock and, therefore, should not be taxed on the $14 million portion of Buyer’s payment that Taxpayer passed to Minority.

However, according to the Court, none of the Danielson exceptions applied – Taxpayer was not defrauded into the transaction, for example – and the contracts signed by the parties explicitly stated that Taxpayer acquired ownership of Minority’s stock: he purchase it for his “own account” prior to selling it to Buyer; and even though the shares were in his hands for only a brief period of time, he was the “record” owner, “free and clear of any restrictions.”

Thus, under Danielson, Taxpayer had to bear the tax liability for owning all the Target shares. He could have hypothetically structured the deal so that he never acquired formal ownership of Minority’s shares, but he did not, and could not benefit from an alternative route now.

“Danielson” Policy Wasn’t Implicated?

Taxpayer argued that the Danielson rule should not apply because its policies were not implicated. According to Taxpayer, the purpose of the Danielson rule was “to prevent a taxpayer from having her cake and eating it too.” Taxpayer claimed that he realized no benefit from serving as Minority’s and Buyer’s go-between.

The Court countered that Taxpayer likely did benefit: by structuring the transaction so that he purchased Minority’s stock for his own account prior to the sale to Buyer, Taxpayer made the overall transaction simpler by ensuring that Buyer would deal with only one party, which likely reduced the deal’s transaction costs and litigation risk, increased the likelihood of the deal actually closing, and perhaps caused Buyer to pay a higher price than it otherwise may have.

In any case, the Court stated, the point of a bright-line rule like Danielson’s requires that judges enforce it without wading into policy analysis, ensuring that the rule’s application will be easy and predictable.

Agency?

Taxpayer claimed that he was nothing more than Minority’s agent in selling Minority’s block of stock, and agents are not liable for the tax burden of their principals.

In responding to this claim, the Court explained that an agency relationship is created through “manifestation by the principal to the agent that the agent may act on his account” and the agent’s “consent” to the undertaking. The problem with this argument, the Court noted, is that the written agreement between Minority and Taxpayer stated in straightforward terms that Taxpayer purchased Minority’s shares for his own account; it did not mention an agency relationship, and none of the terms suggested that Taxpayer ever had an obligation to sell his newly-acquired shares to Buyer or anyone else; Taxpayer could have kept the stock for as long as he wanted, as long as he paid Minority its $14 million. That Taxpayer did encumber himself with an obligation to sell the Minority shares to Buyer arose out of the separate Merger Agreement to which Minority was not a party.

The food in Europe is pretty disappointing. I like fried chicken. But other than that Europe is great.” – Donnie Wahlberg

“Make it Great” – Not for the Taxpayer

The Court concluded that Taxpayer owned 100% of Target’s stock when he transferred Target to Buyer for a total consideration of $54 million, comprised of Buyer stock and cash, and he had to bear the tax burden for the entire payment, even the portion associated with the $14 million he remitted to Minority.

Taxpayer argued that if he must be taxed on the full $54 million from Buyer, he should be permitted to subtract from the gain on his original shares the amount that he “lost” on the sale of the Minority shares.

The Code provides that no gain or loss shall be recognized by a shareholder of a corporation if the shareholder’s stock in the corporation is exchanged, pursuant to a “plan of reorganization,” solely for stock in another corporation that is a party to the reorganization. [IRC Sec. 354]

Thus, a target corporation shareholder who receives only shares of stock in the buyer corporation in exchange for his shares of the target corporation stock, as part of a stock-for-stock merger transaction, does not recognize any of the gain or loss realized in the exchange.

This general rule has an exception for instances when a corporate reorganization involves a transfer of target stock in exchange for both stock of the acquiring corporation and other property or money (“boot”). In those transactions, gain must be recognized by the target shareholder to the extent of the boot received, but any losses realized by the target shareholder still fall within the scope of the general rule – they may not be recognized notwithstanding the receipt of boot by the target’s shareholder. [IRC Sec. 356]

Blocks of Target Stock

The Court explained that, in order to give content to the above recognition / nonrecognition rules, the IRS and the courts historically have analyzed multifaceted transactions according to their “separate units” of stock, so as to prevent a taxpayer from making an end-run around the non-recognition-of-loss rule by tucking his unit’s statutorily unrecognizable loss under the transaction’s broader recognizable gain; thus when an exchange transaction pursuant to a reorganization involves “separate units” of stock, each unit must be analyzed separately.

Taxpayer asked the Court to treat the two blocks of target stock – his block and Minority’s – as one unit, sold in one exchange. By doing so, Taxpayer hoped to subtract the loss realized on the Minority shares from the gain on his original shares (as he could have done if the transaction had not been structured as a partially tax-free reorganization). The Court rejected this request, finding that Taxpayer’s Target stock holdings were composed of two units: Taxpayer acquired one block of Target stock years before acquiring the second block, and he had a vastly different cost basis in the two blocks. Given that the blocks were separate, the Code’s reorganization provisions prohibited recognition of any loss realized by taxpayer in the Minority block.

Plop, Plop, Fizz, Fizz

Fried chicken and pizza aren’t the only things that can give a taxpayer heartburn. Unexpected tax liabilities are just as, if not more, likely to do so. Moreover, tax liabilities cannot be relieved by a simple antacid.

This part of almost every post on this blog must sound like the proverbial broken record. I apologize, but it cannot be said often enough. Before a taxpayer enters into a transaction, he has to be as certain as reasonably possible under the circumstances – risk can never be eliminated – that the transaction will accomplish the taxpayer’s desired business goal. Assuming that is the case, the taxpayer next has to analyze and quantify the tax cost associated with the transaction. This cost has to be added to the other deal costs, and weighed against the expected economic benefits. Depending upon the results of this analysis, the taxpayer may want to reconsider some of the proposed deal terms.

“Eschew obfuscation,” one of my high school physics teachers used to say. I have my own ironic saying: “avoid surprises.” Business owners should consult their tax advisers well before executing a letter of intent for a transaction – the foregoing analysis should not to be deferred until late in the game, because doing so could prove to be an expensive mistake.

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[1] I have to confess that when I came across this decision, I had already started writing a post on why some LLCs make S-corporation elections. For those of you who know me, as soon as I saw the references to Pizza Hut and KFC, I completely forgot about the LLC.

[2] As we shall see, this reorganization treatment was at the crux of the Taxpayer’s position (see infra).

It is not uncommon for a partner to engage in a business transaction with a partnership of which he is a member. If the partner engages in a transaction with his partnership other than in his capacity as a partner, he will be treated as if he were not a member of the partnership with respect to such transaction. Examples of such transactions include loans of money by the partner to the partnership, the sale of property by the partner to the partnership, the purchase of property by the partner from the partnership, and the rendering of services by the partner to the partnership.

Although not as common, it is sometimes the case that the “partner” with whom the partnership has engaged in a transaction is not a bona fide partner for tax purposes. For example, although a person may be member of a partnership as a matter of local law, the “member” does not have an interest in the capital, profits or losses of the partnership, and has very limited, if any, management rights with respect to the business of the partnership. Indeed, the only reason the person is a member may be to secure some benefit for the partnership under local law, or to satisfy some requirement under local law (as in the case of some foreign jurisdictions that require the presence of a resident in an entity otherwise controlled by a foreign investor).

A recent decision of the Federal Claims Court managed to implicate both of these scenarios.

Bonus Compensation

Taxpayer was a U.S. citizen. She worked for US-Employer, an investment firm based in London, as a senior analyst in its New York office. Taxpayer’s role was to analyze investment opportunities for the US-Employer. She worked for US-Employer on an at-will basis, and received a base salary and a bonus. Taxpayer’s bonus compensation was determined under a formula that was tied to the performance of certain funds.

Although US-Employer’s senior managers who received formulaic bonuses were employees, the company considered those employees to be “partners” in the company, in that they participated in the profitability of the firm according to a specific formula.

However, because US-Employer was a corporation, not a partnership, the participating individuals who received formulaic bonuses, including Taxpayer, were “partners” in name only. Taxpayer’s income from US-Employer, including her bonus, was reported to the IRS on a Form W–2, reflecting her status as an employee of US-Employer.

Welcome Partner?

In January 2008, Taxpayer transferred to US-Employer’s European affiliate, UK-Co., and moved to London. Taxpayer’s job responsibilities and compensation did not change upon transferring to UK-Employer.

Taxpayer became a “member” of UK-Co. in January 2008 by signing a “joinder agreement” and making a capital contribution. By signing the agreement, Taxpayer agreed to “observe and perform the terms and conditions of the [UK-Co.] partnership agreement. The agreement identified US-Employer as the “Corporate Member” of UK-Co., listed certain individuals as members of UK-Co., and identified Taxpayer as a “Further Member.” The agreement did not provide Taxpayer with voting rights in the UK-Co. partnership.

UK-Co. was created under English law. The partnership agreement identified US-Employer and one of the listed individuals as “Designated Members” of UK-Co. and the other listed individual as a “Member.” The agreement designated 82% of the voting rights in UK-Co. to US-Employer and the remaining voting rights to the two listed individuals.

UK-Co. members, other than US-Employer, were required “to devote [their] whole time and attention to [UK-Co.]” and could not engage in other business ventures without the consent of US-Employer. With regard to the allocation of partnership profits and losses, the agreement provided that US-Employer would determine the allocation of UK-Co. profits and losses among the partners at the end of UK-Co.’s fiscal year. UK-Co. never generated its own profits, however, because it “ha[d] no funds to invest. It only ha[d] the money sent over from [US-Employer] to pay its costs and … formulaic bonuses and the staff salaries . . . [UK-Co.] ha[d] no [other] funds.”

Taxpayer did not expect to be asked to make a capital contribution or sign the joinder agreement, but she was told upon arriving in the U.K. that both were required as a condition of her employment at UK-Co. She did not see the partnership agreement before signing the joinder agreement, and she did not receive a copy of it until 2011.

During her time working at UK-Co. Taxpayer remained an at-will employee. She performed the same duties and received the same compensation as she had as an employee at US-Employer. Taxpayer understood that she had to become a member of UK-Co. so that UK-Co. could avoid certain U.K. employment tax obligations.

The Payment

On December 31, 2008, UK-Co. directed that a formula-based bonus (the “Payment”) be made to Taxpayer. US-Employer wired the necessary funds to UK-Co. for the Payment, and UK-Co. in turn directed that money to Taxpayer’s bank. Taxpayer’s bank received the payment in January 2009, and it was credited to Taxpayer’s account.

The formula used to determine the Payment was the same formula used to calculate Taxpayer’s bonus when she was still employed by US-Employer. 

Taxpayer’s 2008 and 2009 Tax Returns

Prior to preparing her 2008 U.S. tax return, Taxpayer requested a tax-reporting statement from UK-Co. for the 2008 tax year, but to no avail. Consequently, Taxpayer reported the salary she received from UK-Co. in 2008 on her original 2008 U.S. tax return, but did not report thereon the Payment that she received in January 2009.

On her 2008 U.K. tax return, Taxpayer reported as her “share of the partnership’s profit or loss” from UK-Co. an amount equal to her salary for those months. Taxpayer paid taxes to the U.K. in 2008, and reported a foreign tax credit on her original 2008 U.S. tax return.

The amount reported on Taxpayer’s 2009 U.K. tax return as her “share of the partnership’s profit or loss” from UK-Co. included the Payment she received in 2009. She had a U.K. tax liability for 2009, and reported a foreign tax credit on her 2009 U.S. tax return.

UK-Co.’s 2008 Tax Return

On its 2008 partnership tax return, UK-Co. included an “Analysis of Partners Capital Accounts” which reflected an entry for “Partner 4” that appeared to include the Payment to Taxpayer. Nonetheless, a Schedule K-1 identifying Taxpayer and setting forth the partnership distributions she received for 2008 was not filed with UK-Co.’s 2008 tax return. The only Schedule K-1 included with the return was for US-Employer.

The IRS Audit

The IRS audited both Taxpayer and UK-Co. for the 2008 tax year.

The IRS requested clarification of Taxpayer’s role at UK-Co. In response, Taxpayer explained that she joined UK-Co. as a limited partner in 2008 and that she spent all of her working time “on duties in relation to the [US-Employer’s] Europe partnership.”

In 2011, Taxpayer received for the first time a 2008 Schedule K-1 from UK-Co. This Schedule K-1 showed that Taxpayer received the Payment in 2008.

Consequently, the IRS treated the Payment as a distribution of Taxpayer’s share of UK-Co.’s profit for 2008; therefore, the IRS asserted that the Payment had to be included by the Taxpayer as ordinary income for her 2008 tax year; i.e., the year with or within which the taxable year of the partnership ended.

In 2012, the IRS issued Taxpayer a Notice of Tax Due showing tax and interest owing.

Refund Claim and Appeal

Taxpayer paid the IRS the tax and interest, but Taxpayer also filed a claim for refund with the IRS.

As her primary ground for relief, Taxpayer alleged that the Payment was made to her in a non-partner capacity, and should be taxed in the year she received it, 2009, rather than in 2008 as reflected on the late-produced Schedule K-1.

The IRS denied Taxpayer’s’ refund claim on the grounds that the Payment was made to her as a partner, rather than as a payment for services rendered by her outside her capacity as a partner.

Taxpayer filed suit in the Court of Federal Claims in 2014, alleging that she was entitled to a refund of the amount paid to the IRS to satisfy the notice of tax due, plus interest. Taxpayer asserted that the Payment was not a partnership distribution but a bonus paid to her in her capacity other than as a partner, and therefore she – as a cash-basis taxpayer – did not need to report the payment until she received it in 2009.

Court’s Analysis

The Court examined Taxpayer’s assertion that the Payment should be taxable in the 2009, when she received the payment, because it was not a partnership distribution. In support of this contention, Taxpayer argued that she was either not a bona fide partner in UK-Co. for U.S. tax purposes, or that, if she was a partner, the Payment was for services performed outside her capacity as a partner. (For purposes of its analysis, the Court assumed, but did not decide, that Taxpayer was a member in UK-Employer in order to analyze the nature of the payment.)

Non-Partner Capacity

The Code provides that, if a partner engages in a transaction with a partnership other than in his capacity as a member of such partnership, the transaction shall generally be considered as occurring between the partnership and one who is not a partner.

If a partner (i) performs services for a partnership, (ii) there is a related direct or indirect allocation and distribution to such partner, and (iii) the performance of such services and the allocation and distribution, when viewed together, are properly characterized as a transaction occurring between the partnership and a partner acting other than in his capacity as a member of the partnership, then (iv) such allocation and distribution shall be treated as a transaction between the partnership and one who is not a partner.

Where partners perform services for a partnership outside their role as a member of the partnership and receive a commensurate payment from the partnership for those services, the payment is not classifiable as a partnership distribution. The payment is, instead, treated as a payment to a non-partner in determining the partnership’s taxable income or loss and the partner’s share thereof.

Not a Partner

The Court determined that the Payment to Taxpayer was appropriately categorized as a payment for services outside her capacity as a partner, and not as a partnership distribution. The Court also noted that the services performed by Taxpayer when she worked at UK-Co. did not change when she transferred from US-Employer in New York to UK-Co. in London and became a member of UK-Co. She continued to analyze investment opportunities for the funds managed by US-Employer. None of these funds were owned by UK-Co. or based in London; rather, Taxpayer’s job duties at UK-Co. continued to center around US-Employer’s business in New York, with UK-Co. acting as a “legal … conduit” for US-Employer and its employees to do business in Europe. Taxpayer only relocated to London to have easier access to European investment opportunities for the funds, and became a “member” of UK-Co. so that UK-Co. could avoid certain U.K. tax obligations.

The fact that she became a partner primarily to obtain tax benefits for the partnership which would not have been available if she had rendered the services to the partnership in a third party capacity was relevant to determining whether the Payment was a partnership distribution.

In her work at UK-Co., Taxpayer did not perform any services on behalf of the partnership itself, but rather the partnership served as a European conduit for Taxpayer to perform the same services she performed as an employee of US-Employer.

Other Factors

Additionally, the circumstances surrounding the issuance and receipt of the Payment indicated that it was not a partnership distribution. Taxpayer’s compensation arrangement, which remained the same when she transferred from US-Employer to UK-Co. was not tied to the success of UK-Co. in any way. Rather, Taxpayer’s formulaic bonus was tied to the yearly performance of the funds that were based at US-Employer in New York; indeed, no funds of any kind were directly tied to or controlled by UK-Co. Taxpayer’s bonus was dependent on the success of the funds, but it was not linked to any profit or risk of UK-Co., which did not generate profits on its own, but rather was merely a conduit for US-Employer to pay its European expenses and personnel. In fact, at the time the Payment was issued, UK-Co. did not have any funds on hand to be subjected to the risks of the partnership. The Payment was entirely under the control, and subject to the risks, of US-Employer, and not UK-Co., thus indicating that the Payment was not a distribution of partnership profits.

The fact that the Payment was disproportionate to Taxpayer’s actual ownership share of the partnership, further supported the conclusion that it was not a partnership distribution, but rather a payment for services performed outside her capacity as a member of UK-Co.

Thus, the Court concluded, the Payment was made to Taxpayer for services performed outside her capacity as a member of the UK-Co. partnership, the payment was taxable to Taxpayer by the U.S. in the year she received it (2009), and she was entitled to a full refund of the tax paid on the Payment for the 2008.

Guidance?

In most cases, it should not be too difficult to determine the capacity in which a partner is dealing with his partnership.

In others, it will be important for the partnership and its partners to clearly establish their intentions at the outset of the transaction though, even then, the IRS will not be bound thereby.

For example, was a transfer of money to the partnership made as a loan or as a capital contribution? The absence of documentation and the presence of inconsistent reporting can only lead to trouble down the road, perhaps because the partnership is in financial straits.

As always, a partner and the partnership will be in a better position to secure the desired tax and economic consequences if (i) they discuss these consequences among themselves and their advisers before engaging in the transaction being contemplated, (ii) they document the transaction accordingly, and, (iii) if necessary, they research and compile the appropriate legal authority to support their position.

Last week, we considered the U.S. taxation of a closely held foreign corporation that owned a minority interest in a partnership that was engaged in business in the U.S. This week, we turn our sights to the U.S. taxation of a domestic corporation that owned foreign corporate subsidiaries.

Policy Underlying the CFC Rules

In general, a U.S. person must include in its gross income its directly-earned income from foreign sources; thus, if a U.S. person operates a business through a branch located overseas, the net business income attributable to that branch is included in the U.S. person’s gross income.

Absent the so-called “Subpart F rules,” the inclusion of this foreign source income may be circumvented when the U.S. person chooses to operate overseas indirectly, through a controlled foreign corporation (“CFC”), rather than through a foreign branch. In that case, the foreign subsidiary corporation is generally treated as a separate taxpayer from its U.S. owner; the foreign-source income earned by the CFC is generally not included in the U.S. owner’s gross income; and the imposition of U.S. income tax on the foreign-source income earned by the CFC is deferred until it is repatriated by the CFC to the U.S.

Anti-deferral

That a U.S. person may defer the inclusion in its gross income of the foreign-source income earned by its controlled foreign corporate subsidiaries does not, in and of itself, violate any U.S. tax policy. However, Congress and the IRS have sought to defeat the deferral benefit in situations where certain “U.S. shareholders” may direct the flow of certain types of income (“Subpart F Income”) to a low-tax jurisdiction; for example, income earned in transactions between related corporations that are located in different countries, one of which is a tax haven. In those situations, the Code and the IRS’s regulations require the current inclusion of the CFC’s un-repatriated Subpart F Income in the U.S. shareholder’s gross income.

Deemed Repatriation

Although the current inclusion of Subpart F Income is a major concern of the Subpart F rules, they also seek to prevent the tax-free repatriation of other foreign income through investments in U.S. property. In general, the foreign-source income earned by a CFC (other than Subpart F Income) is subject to U.S. tax when the income is repatriated as a dividend. If the CFC, instead, invested the foreign-source income in the U.S., by the purchase of U.S.-situs property, or by a loan to the U.S. parent corporation, the foreign income would effectively be repatriated in a manner that would escape current U.S. tax.

In order to address this situation, the Code generally provides that certain “investments” by a CFC in U.S.-situs property will be treated as the repatriation of the CFC’s foreign-source income, as a result of which, the U.S. shareholder must include in its gross income an amount calculated by reference to the amount deemed to have been repatriated by the CFC.

A recent decision by the U.S. Tax Court considered the application of this deemed repatriation rule.

Investment in U.S. Property?

Taxpayer was a domestic “C” corporation and the parent of a group of domestic and foreign subsidiary corporations. The IRS determined that the CFCs had invested substantial amounts of untaxed foreign profits in “U.S. property”. Accordingly, the IRS determined that Taxpayer was required to include in its gross income the amounts that the CFCs had invested. As a result, the IRS asserted income tax deficiencies against the Taxpayer, and the Taxpayer petitioned the Tax Court for relief.

According to the IRS, Taxpayer’s CFCs made investments in U.S. property through the following transactions: (1) they extended loans to a domestic subsidiary, in the form of intercompany cash advances; and (2) one of them guaranteed of a loan that a domestic subsidiary had obtained from Foreign Bank.

Intercompany Loans

Taxpayer was the sole shareholder of US-Sub, a domestic corporation, which in turn was the sole shareholder of four CFCs. Taxpayer and US-Sub were U.S. shareholders of these CFCs because they owned (directly or indirectly) 100% of the total combined voting power of all classes of the CFCs’ stock.

At various times, the CFCs had made loans to US-Sub. Substantial balances on these loans remained outstanding throughout the tax periods at issue.

Guaranty Transaction

US-Sub also borrowed money from Foreign Bank. As a condition of extending credit, Foreign Bank required US-Sub to secure a guaranty for the loan, preferably from a subsidiary located in the same jurisdiction as Foreign Bank. One of Taxpayer’s CFCs (“F-Sub”) supplied the requisite guaranty.

US-Sub was also required to pledge as security for the Foreign Bank loan all the stocks that US-Sub then owned or thereafter acquired, including its equity interest in the CFCs.

The outstanding balance on the Foreign Bank loan remained constant throughout the tax periods at issue, as did F-Sub’s guaranty of the loan.

IRS Audit

Neither Taxpayer nor US-Sub had previously included in income, for any year, any portion of this outstanding loan balance.

Taxpayer filed consolidated Forms 1120, U.S. Corporation Income Tax Return, for the years at issue. The IRS examined Taxpayer’s returns and determined that the CFCs had held substantial investments in U.S. property, which Taxpayer had neglected to include in gross income; specifically, the IRS contended that Taxpayer’s CFCs held two sets of investments in U.S. property that Taxpayer was required to include in gross income: (1) the outstanding loan balances owed by US-Sub to the CFCs; and (2) F-Sub’s guaranty of the Foreign Bank loan to US-Sub. As a result, the IRS issued a notice of deficiency, and Taxpayer petitioned the Tax Court.

Governing Statutory Framework

A CFC is a foreign corporation more than 50% of whose stock (in terms of voting power or value) is owned (directly or constructively) by U.S. shareholders. A U.S. shareholder is a U.S. person who owns (directly or constructively) 10% or more of the total combined voting power of the foreign corporation’s stock.

In general, a U.S. shareholder owning CFC stock on the last day of the CFC’s taxable year must include in gross income the lesser of: (1) the excess of such shareholder’s pro rata share of the amount of U.S. property held by the CFC as of the close of such taxable year, over the amount of CFC profits otherwise included in such shareholder’s gross income; or (2) such shareholder’s pro rata share of the applicable earnings of such CFC.

“U.S. property” includes (among other things) an obligation of a U.S. person, such as a bond, note, or other indebtedness. According to IRS regulations, any obligation of a U.S. person with respect to which a CFC is a pledgor or guarantor is considered U.S. property held by the CFC. A CFC will be considered a guarantor if its assets serve at any time, even though indirectly, as security for the performance of an obligation of a U.S. person.

The amount of the investment with respect to an obligation of a U.S. person is the CFC’s adjusted basis in the obligation. In the case of a pledge or guaranty, the amount includible is based on the unpaid principal amount of the obligation with respect to which the CFC is the pledgor or guarantor. The amount includible is reduced by any previously taxed profits of the CFC, and it cannot exceed the U.S. shareholder’s pro rata share of the CFC’s earnings.

The Court’s Analysis

With respect to the loans made by Taxpayer’s CFCs to US-Sub, the Court found that substantial loan balances remained outstanding during the tax periods at issue. The Taxpayer asserted that some of the loans might have been “discharged,” but was unable to provide specific facts supporting its claim.

Thus, the Court concluded that the intercompany loan balance owed by US-Sub to each CFC constituted U.S. property held by that CFC, and that the Taxpayer was required to include in gross income, subject to the net profits of the CFCs.

CFC as Guarantor and as Pledgor

The Court next turned to US-Sub’s loan from Foreign Bank. This loan had a substantial outstanding balance during the periods at issue, and F-Sub’s guarantee of the loan remained in place throughout these periods. Neither Taxpayer nor US-Sub had previously included in income, for any year, any portion of this outstanding loan balance.

The IRS contended that F-Sub, as a guarantor of the Foreign Bank loan, was considered as holding the obligation of a U.S. person. The IRS accordingly concluded that the unpaid principal balance of that loan was includible in Taxpayer’s gross income.

Although F-Sub’s status as a guarantor would have been sufficient to support inclusion in Taxpayer’s gross income, F-Sub also appeared to have been a pledgor in support of the Foreign Bank loan. A CFC will be regarded as a pledgor if its assets serve directly or indirectly as “security for the performance of an obligation” of a U.S. person.

According to IRS regulations, the pledge by a U.S. shareholder of stock of a CFC will be considered as the indirect pledge of the CFC’s assets if at least two-thirds of the total combined voting power of all classes of CFC stock is pledged, and if the pledge of stock is accompanied by one or more negative covenants or similar restrictions on the shareholder effectively limiting the corporation’s discretion with respect to the disposition of assets and the incurrence of liabilities other than in the ordinary course of business.

Because US-Sub was required to pledge to Foreign Bank its 100% stock ownership interest in the CFCs, including F-Sub, F-Sub was treated as having pledged all of the assets which it then held or thereafter acquired. To the extent that this pledge effectively limited US-Sub’s discretion with respect to the disposition of F-Sub’s assets and the incurrence of liabilities, the Foreign Bank loan contained “negative covenants or similar restrictions,” that rendered F-Sub an indirect pledgor as well as a guarantor.

Financial Condition of CFC?

Taxpayer argued that F-Sub’s guaranty had little or no value, and represented a “meaningless gesture.” According to Taxpayer, S-Sub’s guaranty furnished only a secondary form of collateral that provided no incremental security for Foreign Bank.

The Court failed to see the relevance of this argument. A CFC, it stated, is considered as holding an obligation of a U.S. person if the CFC “is a pledgor or guarantor of such obligation.” That is the end of the inquiry, the Court said; neither the Code nor the regulations issued thereunder inquire into the relative importance that the creditor attaches to the guarantee.

In any event, the Court continued, Taxpayer failed to offer any facts to support its assertion. Foreign Bank demanded a guaranty from a company with assets in Foreign Bank’s location, and F-Sub provided that guarantee. When a bank agrees to make a substantial loan only after securing a guaranty from a local company with local assets, it is logical to assume that the bank regarded that guaranty as valuable security.

Alternatively, Taxpayer asserted that F-Sub’s guaranty was worthless because other liabilities encumbering F-Sub’s assets exceeded the fair market value of those assets at the time F-Sub guaranteed the loan.

The Court, however, observed that Taxpayer did not supply any balance sheets, income statements, or other documentation concerning F-Sub’s financial position or its insolvency. Moreover, F-Sub’s guaranty remained in place continuously, and Taxpayer did not provide any documents suggesting that Foreign Bank ever questioned the value of F-Sub’s collateral or demanded additional security.

In any event, the Court stated, it was not clear that a CFC’s financial condition is even relevant in determining whether its guaranty gives rise to an investment in U.S. property. The Code provides that a CFC shall be considered as holding an obligation of a U.S. person if such CFC is a pledgor or guarantor of such obligation. The regulations provide that any obligation of a U.S. person with respect to which a CFC is a pledgor or guarantor shall be considered U.S. property held by the CFC. They make no reference to the likelihood that the CFC will be called upon, or will be able, to make good on its guarantee. According to the Court, this reflects the common sense proposition that a lender would not ask for, or be satisfied with, a guarantee from a person who lacked the financial capacity to provide the security that the lender desires.

For these reasons, the Court concluded that F-Sub’s guarantee of the Foreign Bank loan gave rise to an investment in U.S. property and, subject to F-Sub’s earnings and profits, Taxpayer was required to include in gross income for the years at issue the outstanding balance of the Foreign Bank loan.

Takeaway

Many closely held U.S. businesses have realized that there are ample opportunities for growth and profits overseas. In pursuing such opportunities, however, a U.S. taxpayer must be mindful of the complex rules that apply in determining the taxation of overseas profits – including the Subpart F rules, discussed above – and the reporting thereof.

With an understanding of these rules, and with the guidance of knowledgeable advisers, a U.S. taxpayer may be able to structure its overseas investments, and the repatriation of its overseas earnings, in a more tax efficient manner.

Where business exigencies are such that a less than ideal tax structure has to be employed, the U.S. taxpayer must at least be able to account for the additional tax cost in analyzing the economic prospects and anticipated returns of its overseas investments and operations.

Coming to America

Whether they are acquiring an interest in U.S. real property or in a U.S. operating company, foreigners seek to structure their U.S. investments in a tax-efficient manner, so as to reduce their U.S. income tax liability with respect to both the current profits generated by the investment and the gain realized on the disposition of the investment, thereby increasing the return on their investment.

A recent decision by the U.S. Tax Court may mark a significant development in the taxation of the gain realized by a foreigner on the sale of its interest in a U.S. partnership.

Investment in Partnership

Taxpayer was a privately-owned foreign corporation that owned a minority membership interest in LLC, a U.S. limited liability company that was treated as a partnership for U.S. income tax purposes. Taxpayer had no office, employees, or business operation in the U.S.

Redemption

In 2008, LLC agreed to redeem Taxpayer’s membership interest; as a matter of state law, the redemption was to be effective as of December 31, 2008. LLC made two payments to Taxpayer – the first in 2008 and the second in 2009. Taxpayer realized gain on the redemption of its interest.

Tax returns

With its 2008 Form 1065, “U.S. Return of Partnership Income,” LLC included a Schedule K-1 for Taxpayer that reported Taxpayer’s share of LLC’s income, gain, loss, and deductions for 2008. Consistent with that Schedule K-1, Taxpayer filed a Form 1120-F, “U.S. Income Tax Return of a Foreign Corporation,” for 2008, on which it reported its distributive share of LLC’s income, gain, loss, and deductions. However, LLC did not report on that 2008 return any of the gain it had realized that year on the redemption of its interest in LLC.

With its 2009 Form 1065, LLC included a Schedule K-1 for Taxpayer that – consistent with the agreement between Taxpayer and LLC that the redemption of Taxpayer’s entire membership interest was effective as of December 31, 2008 – did not allocate to Taxpayer any income, gain, loss, or deductions for 2009. As in 2008, Taxpayer took the position that the gain realized was not subject to U.S. tax; thus, Taxpayer did not file a U.S. tax return for 2009.

IRS Audit

The IRS audited Taxpayer’s 2008 and 2009 tax years, and determined that Taxpayer should have recognized U.S.-source capital gain for those years from the redemption of its interest in LLC. This determination was based upon the IRS’s conclusion that, as a result of Taxpayer’s membership interest in LLC, its capital gain was effectively connected with a U.S. trade or business (“USTB”).

Taxpayer petitioned the U.S. Tax Court, where the issue for decision was whether the gain from the redemption of Taxpayer’s interest in LLC was U.S.-source income that was effectively connected with a USTB and, therefore, subject to U.S. taxation.

U.S. Taxation of Foreigners

Before reviewing the Court’s opinion, a brief description of how the U.S. taxes foreigners may be in order.

The income of a foreign corporation may be subject to U.S. income tax if: (1) the income is received from sources within the U.S. (“U.S.-source income”), and it is one of several kinds of income enumerated by the Code (including, for example, dividends, interest, and other “fixed or determinable annual or periodic” (“FDAP”) income); or (2) the income is “effectively connected with the conduct of” a trade or business conducted by the foreign corporation within the U.S. (“effectively connected income”).

In general, the gross amount of a foreigner’s FDAP income is subject to U.S. income tax (and withholding) at a flat 30% rate; no deductions are allowed in determining the tax base to which this rate is applied.

With some exceptions, the Code does not explicitly address the taxation of the capital gain realized by a foreigner on the sale of an equity interest in a U.S. business entity; rather, it is by virtue of addressing these exceptions that the general rule – that capital gain is not subject to U.S. tax – arises. Thus, the gain realized by a foreigner from the sale of a capital asset that is sourced in the U.S. is not subject to U.S. tax unless the asset is related to the foreigner’s USTB or the asset is “an interest in U.S. real property,” the sale of which is treated as effectively connected with a USTB.

In contrast to FDAP income, the foreigner is allowed to deduct the expenses incurred in generating its effectively connected income, and that net income is taxed at graduated rates.

Whether a foreigner is engaged in a USTB depends upon the nature and extent of the foreigner’s activities within the U.S. Generally speaking, the foreigner’s U.S. business activities must be “regular, substantial and continuous” in order for the foreigner to be treated as engaged in a USTB. In determining whether a foreigner’s U.S. activities rise to the level of a trade or business, all of the facts and circumstances need to be considered, including whether the foreigner has an office or other place of business in the U.S.

However, a special rule applies in the case of a foreigner that is a partner in a partnership that is, itself, engaged in a USTB; specifically, the foreigner shall be treated as being engaged in a USTB if the partnership of which such foreigner is a member is so engaged.

In that case, provided it is effectively connected with the conduct of a USTB, the foreigner partner must include its distributive share of the partnership’s taxable income in determining its own U.S. income tax liability.

Generally speaking, all income, gain, or loss from sources within the U.S., other than FDAP income, is treated as effectively connected with the conduct of a USTB.

Points of Agreement

Taxpayer conceded that it was engaged in a USTB by virtue of its membership interest in LLC. In fact, Taxpayer reported on Form 1120-F, and paid U.S. income tax on, its distributive share of LLC’s operating income for every tax year that it was a member of LLC, including the year in which its membership interest was redeemed.

In addition, both Taxpayer and the IRS agreed that no part of the redemption payments made to Taxpayer should be treated as a distributive share of partnership income.

The IRS also agreed with the Taxpayer that the payment made by LLC in redemption of Taxpayer’s membership interest should be treated as having been made in exchange for Taxpayer’s interest in LLC’s property. As such, the Taxpayer would recognize gain as a result of the redemption only to the extent that the amount of money distributed exceeded Taxpayer’s adjusted basis for its interest in LLC immediately before the distribution. This gain would be considered as gain from the sale or exchange of the Taxpayer’s membership interest.

Major Disagreement

In general, the gain realized on the sale of a partnership interest is treated as gain from the sale or exchange of “a capital asset.” According to Taxpayer, because the gain realized on the redemption of its membership interest was equivalent to the sale of a capital asset that was not used by Taxpayer in a USTB, it could not be subject to U.S. tax.

The IRS, however, viewed the issue differently. According to the IRS, Taxpayer’s gain did not arise from the sale of a single, indivisible asset – Taxpayer’s interest in LLC – but rather from the sale of Taxpayer’s interest in the assets that made up LLC’s business, in which Taxpayer was treated as having been engaged.

Aggregate vs. Entity

The IRS argued that the Court should employ the so-called “aggregate theory,” under which a partner’s sale of a partnership interest would be treated as the sale by the partner of its separate interest in each asset owned by the partnership.

The Court, however, rejected the IRS’s argument. It noted that the Code generally applies the “entity theory” to sales and liquidating distributions of partnership interests – it treats the sale of a partnership interest as the sale of “a capital asset” – i.e., one asset (a partnership interest) – rather than as the sale of an interest in the multiple underlying assets of the partnership.

The Court then pointed out that the Code explicitly carves out certain exceptions to this general rule that, when applicable, require that one look through the partnership to the underlying assets and deem the sale of the partnership interest as the sale of separate interests in each asset owned by the partnership; for example, where the partnership holds “hot assets,” or where it holds substantial interests in U.S. real property, in which case an aggregate approach is employed in determining the tax consequences of a sale.

Accordingly, the Court determined that Taxpayer’s gain from the redemption of its membership interest was gain from the sale or exchange of an indivisible capital asset: Taxpayer’s interest in LLC.

Effectively Connected?

The Court then considered whether the gain realized on the redemption was taxable in the U.S., which depended upon whether that gain was effectively connected with the conduct of a USTB — specifically, whether that gain was effectively connected with the trade or business of LLC, which trade or business was attributed to Taxpayer by virtue of its being a member of LLC.

The IRS argued that the gain was “effectively connected,” pointing to one of its own published rulings, in which it held that the gain realized by a foreigner upon the disposition of a U.S. partnership interest should be analyzed asset by asset, and that, to the extent the assets of the partnership would give rise to effectively connected income if sold by the entity, the departing partner’s pro rata share of such gain should be treated as effectively connected income.

The Court, however, did not find the ruling persuasive, and declined to follow it. Instead, the Court undertook its own analysis of the issue.

It considered whether the gain from the sale of the membership interest was U.S.-source. Unfortunately, the Code does not specifically address the source of a foreigner’s income from the sale or liquidation of its interest in a partnership.

However, under a default rule for sourcing gain realized on the sale of personal property (such as a partnership interest), gain from the sale of personal property by a foreigner is generally sourced outside the U.S. In accordance with this rule, the gain from Taxpayer’s sale of its LLC interest would be sourced outside the U.S.

The IRS countered, however, that this gain fell under an exception to the default rule: the “U.S. office rule.” Under this exception, if a foreigner maintains a fixed place of business in the U.S., any income from the sale of personal property attributable to such “fixed place of business” is treated as U.S.-source.

Taxpayer’s gain would be taxable under this exception, the Court stated, if it was attributable to LLC’s office, which the Court assumed – solely for purposes of its analysis – would be deemed to have been Taxpayer’s U.S. office.

In order for gain from a sale to be “attributable to” a U.S. office or fixed place of business, the U.S. office must have been a “material factor in the production” of the gain, and the U.S. office must have “regularly” carried on – i.e., “in the ordinary course of business” – activities of the type from which such gain was derived.

The IRS contended: that the redemption of Taxpayer’s interest in LLC was equivalent to LLC’s selling its underlying assets and distributing to each member its pro rata share of the proceeds; that LLC’s office was material to the deemed sale of Taxpayer’s portion of LLC’s assets; and that LLC’s office was material to the increased value of LLC’s underlying assets that Taxpayer realized in the redemption.

The Court responded that the actual “sale” that occurred here was Taxpayer’s redemption of its partnership interest, not a sale of LLC’s underlying assets. In order for LLC’s U.S. office to be a “material factor,” that office must have been material to the redemption transaction and to the gain realized.

The Court noted that Taxpayer’s redemption gain was not realized from LLC’s trade or business, that is, from activities at the partnership level; rather, Taxpayer realized gain at the partner-member level from the distinct sale of its membership interest. Increasing the value of LLC’s business as a going concern, it explained, is a distinct function from being a material factor in the realization of income in a specific transaction. Moreover, the redemption of Taxpayer’s interest was a one-time, extraordinary event, and was not undertaken in the ordinary course of LLC’s business – LLC was not in the business of buying and selling membership interests.

Therefore, Taxpayer’s gain from the redemption of its interest in LLC was not realized in the ordinary course of the trade or business carried on through LLC’s U.S. office, it was not attributable to a U.S. fixed place of business and, therefore, it was not U.S.-source.

Consequently, the gain was not taxable as effectively connected income.

It Isn’t Over ‘til the Weight-Challenged Person Sings

The Tax Court’s decision represents a victory for foreigners who invest in U.S. businesses through a pass-through entity such as a partnership or limited liability company – how significant a victory remains to be seen.

First, the IRS has ninety days after the Court’s decision is entered in which to file an appeal to a U.S. Court of Appeals. Query whether that Court would be more deferential to the IRS’s published ruling, describe above.

Second – don’t laugh – Congress may act to overturn the Tax Court’s decision by legislation. “Why?” you may ask. Foreigners who rely upon the decision will not report the gain from the sale of a partnership interest. If the partnership has in effect an election under section 754 of the Code, the partnership’s basis in its assets will be increased as a result of the sale (as opposed to the liquidation/redemption) of the foreigner’s partnership interest. This will prevent that underlying gain from being taxed to any partner in the future.

Third, the decision did not address how it would apply to “hot assets” — for example, depreciation recapture. As noted above, the Code normally looks through the sale of a partnership interest to determine whether any of the underlying assets are hot assets. Where the foreign partner has enjoyed the benefit of depreciation deductions from the operation of the partnership’s USTB – thereby reducing the foreigner’s effectively connected income – shouldn’t that benefit be captured upon the later sale of the foreigner’s partnership interest?

Finally, there is a practical issue: how many foreigners will invest through a pass-through entity rather than through a U.S. corporation? Although a corporate subsidiary will be taxable, its dividend distributions to the foreign parent will be treated as FDAP and may be subject to a reduced rate of U.S. tax under a treaty. The foreigner’s gain on the liquidation of the subsidiary will not be subject to U.S. tax. Moreover, the foreigner will not have to file U.S. returns.

Stay tuned. In the meantime, if a foreigner has paid U.S. tax in connection with the redemption of a partnership interest – on the basis of the IRS ruling rejected by the Tax Court – it may be a good idea to file a protective refund claim.

Withdrawal of Proposed Regulations

Earlier this year, the President directed the Secretary of the Treasury to review all “significant tax regulations” issued on or after January 1, 2016, and to take steps to alleviate the burden of regulations that meet certain criteria.

Although not falling within the literal reach of this directive, but perhaps in keeping with its spirit, the IRS recently withdrew proposed regulations (issued in 2005) that would have required an exchange or distribution of “net value” among the parties to certain corporate reorganizations in order for the reorganizations to qualify for non-recognition (“tax-free”) treatment under the Code.

Before taxpayers breathe a sigh of relief over the withdrawal of these proposed regulations, they need to understand the IRS’s long-held position – which it sought to formalize in the proposed regulations – that a corporation has to be solvent in order for its shareholders to benefit from favorable tax treatment under the reorganization provisions of the Code.

In particular, taxpayers should note that, in announcing the withdrawal, the IRS explained that “current law” is sufficient to ensure that tax-free treatment is accorded only to those corporate reorganizations that effectuate a “readjustment” of shareholders’ continuing proprietary interests in a corporate-held business, and that it cited various authorities that generally limit reorganization treatment to solvent corporations.

The Reorganization Rules, In Brief

In general, upon a taxpayer’s exchange of property, gain must be recognized and taxed if the new property differs materially in kind from the old property, and the amount realized in the exchange exceeds the taxpayer’s adjusted basis in the property exchanged.

In the context of a corporate reorganization, there are generally two types of exchanges: (1) the exchange in which one corporation exchanges property for stock in a second corporation; and (2) the exchange in which stock in the first corporation is exchanged by its shareholders for stock in the second corporation.

The purpose of the tax-free reorganization provisions of the Code is to except these types of exchanges from the general gain recognition rule where they (i) are incident to a plan to reorganize a corporate structure in one of the particular ways specified in the Code, (ii) are undertaken for bona fide business or corporate purposes, and (iii) effect only a readjustment of the shareholders’ continuing interest in the corporation’s property under a modified corporate form.

In order to effect only a readjustment of the shareholders’ continuing interest in the corporation’s property, and to thereby secure tax-free treatment under the Code, a reorganization must satisfy a “continuity of business enterprise” requirement and a “continuity of interest” requirement.

In general, under the continuity of business enterprise test, the acquiring corporation must either continue the target corporation’s historic business or use a significant portion of the target’s historic business assets in a business.

The continuity of interest test requires that a substantial part of the value of the proprietary interests in the target corporation be preserved in the reorganization. A proprietary interest in the target corporation is preserved if it is exchanged for a proprietary interest in the acquiring corporation.

All facts and circumstances must be considered in determining whether, in substance, a proprietary interest in the target corporation is preserved. Thus, for example, a proprietary interest in the target corporation is not preserved to the extent that creditors of the target corporation that own a proprietary interest in the corporation – for example, because the target corporation’s liabilities exceed the fair market value of its assets immediately prior to the potential reorganization – receive money for their claims prior to the potential reorganization.

The policy underlying these rules is to ensure that tax-free reorganization treatment is limited to those reorganizations and exchanges that effectuate a readjustment of the shareholders’ continuing interests in property under a modified corporate form, and to prevent transactions that resemble sales from qualifying for non-recognition treatment.

The Proposed Regulations

In general, the Code provides that no gain shall be recognized if a shareholder’s stock in a target corporation is exchanged, pursuant to a plan of reorganization, “solely for stock” in the acquiring corporation. It also provides that no gain shall be recognized to the target corporation if it exchanges property, pursuant to a plan of reorganization, “solely for stock” in the acquiring corporation.

The IRS has consistently stated that the language “solely for stock” requires that there be an exchange of net value among the parties to the reorganization, meaning that both the target corporation and the acquiring corporation must be solvent.

According to the IRS, transactions that fail this requirement – that is, transfers of property that are in effect made in exchange for the assumption of liabilities or in satisfaction of liabilities, as in the case of an insolvent corporation – resemble sales and should not receive non-recognition treatment.

The proposed regulations sought to formalize this position by providing that an exchange of net value was requisite to a tax-free corporate reorganization. According to the proposed regulations, an exchange of net value requires that there be both a surrender of net value and a receipt of net value.

Whether there is a surrender of net value is determined by reference to the assets and liabilities of the target corporation. Whether there is a receipt of net value is determined by reference to the assets and liabilities of the acquiring corporation. The purpose of the “exchange of net value” requirement, the proposed regulations stated, is to prevent transactions that resemble sales (including transfers of assets in satisfaction of liabilities) from qualifying for non-recognition treatment.

Thus, in the case of an asset transfer, the fair market value of the property transferred by the target corporation to the acquiring corporation must exceed the sum of the amount of liabilities of the target corporation that are assumed by the acquiring corporation in connection with the exchange and the amount of any money and the fair market value of any other property (other than stock in the acquiring corporation) received by the target corporation in connection with the exchange. Similarly, the fair market value of the assets of the acquiring corporation must exceed the amount of its liabilities immediately after the exchange.

In the case of a stock transfer, the fair market value of the assets of the target corporation must exceed the sum of the amount of the liabilities of the target corporation immediately prior to the exchange and the amount of any money and the fair market value of any other property (other than stock of the acquiring corporation) received by the shareholders of the target corporation in connection with the exchange. The fair market value of the assets of the acquiring corporation must exceed the amount of its liabilities immediately after the exchange.

Withdrawn, But Not Useless

It is doubtful that the withdrawal of the proposed “net value” regulations signals any change in the IRS’s position. Indeed, almost all of the case law addressing the application of the continuity of interest rule to the reorganization of an insolvent corporation is consistent with the proposed regulations.

A taxpayer would be ill-advised to draw any conclusion to the contrary. After all, the IRS did not announce a change in the representations that must be made by a taxpayer in submitting a request to the IRS for a ruling with respect to a proposed reorganization. For example, a taxpayer must still represent that the fair market value of the assets of the target corporation transferred to the acquiring corporation pursuant to the plan of reorganization is at least equal to the sum of the target liabilities assumed by the acquiring corporation, plus the amount of liabilities, if any, to which the transferred assets are subject; in other words, there must be a transfer of net value.

Rather, taxpayers would be well-served to view the withdrawn proposed rules as a useful summary of the IRS’s thinking on “net value” issues, and as a guide for assessing the qualification of a proposed corporate restructuring or acquisition as a tax-free reorganization within the meaning of the Code.

A Borrower and a Lender Be
Everyone recognizes the importance of debt financing to a business. The business needs liquidity to purchase or improve assets, or to pay expenses. It borrows the necessary funds from an institutional lender that requires their repayment a fixed date or according to a fixed schedule. In order to compensate the lender for the use of the funds, the business promises to pay interest; depending upon various factors, the lender may insist that the loan be secured by some form of collateral.

For years now, many businesses have, themselves, become lenders – as opposed to borrowers – in order to acquire and retain talented employees. Specifically, employers have made a variety of different loans to employees; for example, some are traditional loans calling for a market rate of interest with periodic repayments, others provide for below-market rates of interest, some are made to assist the employee in moving to the employer’s community, and others are made to assist the employee in acquiring life insurance for the benefit of his family (as in the case of split-dollar insurance).

A “Real” Loan?
Although the employer-lender and the employee-borrower are usually not related to one another, the terms of the loan are often closely scrutinized by the IRS to ensure that the income tax treatment of the arrangement, as reported on the parties’ tax returns, is consistent with its economic reality.

In general, the parties intend that the amounts transferred to the employee-borrower represent a true loan, with a genuine and realistic expectation of repayment. In that case, the employee’s receipt of the funds is not treated as an income-realization event because there has been no accretion in value to the employee. If the employer subsequently forgives any of the amounts owing, then those amounts would be taxable to the employee as compensation at that time.

Or Not?
In many cases, unfortunately, the employer and the employee fail to structure their arrangement in a way that achieves the intended result. The “loan” may not be evidenced by a promissory note, it may have not a maturity date, interest may not be paid, events of default may be ignored, etc. Consequently, the IRS will find that the so-called “loan” was, in fact, compensation that should have been taxed to the employee upon receipt.

In a recent decision of the U.S. Tax Court, however, it was the employee, rather than the IRS, who argued that the arrangement was compensation, and not a loan.

Taxpayer Joins a Practice
In 2009, Taxpayer agreed to join LLC’s medical practice as an independent contractor. In connection therewith, LLC agreed to advance $XYZ to Taxpayer as a guarantee of compensation (the “Guaranty Amount”). This loan was evidenced by a promissory note and was advanced to Taxpayer in installments over a period of six months (the “Guaranty Period”). The Guarantee Amount was limited to an amount of salary which the parties agreed represented no more than fair market value for Taxpayer’s services. Taxpayer was obligated to repay to LLC the $XYZ that LLC loaned to him.

Taxpayer and LLC also entered into a so-called “compensation guarantee with forgiveness agreement,” into which the note was incorporated by reference. Together, Taxpayer’s agreements with LLC (the “Agreement”) provided that Taxpayer was to work for LLC on a full-time basis for at least thirty-six months (the “Commitment Period”), and that LLC was to report any compensation paid Taxpayer on IRS Form 1099-MISC, regardless of whether Taxpayer received the compensation in the form of cash, or as a “forgiveness of amounts owed” by Taxpayer to LLC.

Among other things, Taxpayer agreed to actively engage in the full-time practice of medicine in the geographic area served by LLC (the “Community”), to bill all patients and third-party payors promptly for all services rendered, and to use his best efforts to collect all patient accounts.

At the end of the Guarantee Period, the sum of all payments made by LLC to Taxpayer during such period, and not otherwise repaid (the “Loan Repayment Amount”), would become payable by Taxpayer in accordance with the note executed by Taxpayer. Interest on the Loan Repayment Amount (based on the prime rate reported in the WSJ) would begin to accrue at the end of the Guarantee Period. However, in an effort to encourage prompt payment, interest would be forgiven on any principal amounts repaid within six months of the end of the Guarantee Period. Amounts so forgiven, if any, were to be reported on IRS Form 1099.

Notwithstanding the foregoing, and to encourage Taxpayer to remain in the Community beyond the six month Guarantee Period, LLC agreed to forgive one-thirtieth of Taxpayer’s Loan Repayment Amount (corresponding to one-thirtieth of the remaining thirty month period of the thirty-six month Commitment Period) for each calendar month after the end of the Guarantee Period that Taxpayer remained in the full-time private practice of medicine in the Community, and maintained medical staff privileges at LLC. Any amounts forgiven would be reported on IRS Form 1099.

Thus, although Taxpayer had an unconditional obligation to repay the $XYZ that LLC had transferred to him, that obligation was subject to a condition subsequent. Amounts outstanding under the note were subject to forgiveness, but would become due and payable if Taxpayer failed at any time during the Commitment Period to fulfill his obligations under the Agreement regarding his full-time practice in the Community. In the event that Taxpayer defaulted on his obligations, LLC could accelerate repayment of any outstanding debt, plus interest, owed by Taxpayer. Taxpayer could prepay all or any part of the note at any time. As security for the payment of principal and interest on the note, Taxpayer granted LLC a security interest in, and irrevocably assigned to LLC, all accounts receivable of Taxpayer’s private practice of medicine, whether now existing or hereafter arising. Taxpayer also agreed to permit LLC to make regular audits of Taxpayer’s accounts receivable balances, and further agreed that LLC could perfect its security interest in Taxpayer’s accounts receivable.

Reporting the Advance
Taxpayer did not include in his 2009 gross income the $XYZ advanced to him by LLC during that year.

During 2009, LLC paid Taxpayer total nonemployee compensation of $ABC and reported that compensation on the Form 1099-MISC that it issued to him for that year. LLC did not include the $XYZ loan on the Form 1099-MISC or in another information return that it issued to Taxpayer for the 2009 tax year.

During 2010, LLC paid Taxpayer total nonemployee compensation of $DEF and reported that compensation on the Form 1099-MISC that it issued to him for that year.

In early 2011, Taxpayer terminated his employment with LLC. During 2011, LLC did not pay Taxpayer any nonemployee compensation, and did not issue any Form 1099-MISC to Taxpayer for that year.

Pursuant to the Agreement, during 2012 Taxpayer made payments to LLC totaling $MNO in repayment of the remaining balance of the $XYZ that LLC had loaned to him in 2009. LLC did not issue any Form 1099 to Taxpayer for 2012.

Taxpayer filed Schedule C, Profit or Loss From Business, with his tax return for the 2012 tax year, on which he claimed his repayment of $MNO as “Other expenses.”

Taxpayer: “Not a Loan”
The IRS examined Taxpayer’s 2012 tax return and disallowed the repayment expense of $MNO claimed by Taxpayer on his Schedule C because the repayment of a loan, the IRS explained, was not a deductible expense. Taxpayer disputed the IRS’s position, and argued that the $XYZ transferred to him in 2009 did not constitute a loan. (Although it is not discussed in the opinion, query whether the assessment limitations period for 2009 had expired by the time Taxpayer filed his 2012 return.)

In considering whether Taxpayer was entitled to the claimed repayment expense, the Tax Court had to determine whether the $XYZ that LLC transferred to Taxpayer during 2009 pursuant to the Agreement constituted a loan. If the Court found that it constituted a loan, Taxpayer would not be entitled to the repayment expense claimed in 2012.

What is a Loan?
The determination of whether a transfer of funds constitutes a loan is a question of fact. In order for a transfer of funds to constitute a loan, at the time the funds are transferred there must be an unconditional obligation (i.e., an obligation that is not subject to a condition precedent) on the part of the transferee to repay, and an unconditional intention on the part of the transferor to secure repayment of, the funds.

Whether a transfer of funds constitutes a loan may be inferred from factors surrounding the transfer, including the existence of a debt instrument, the existence of a written loan agreement, the provision of collateral securing the purported loan, the accrual of interest on the purported loan, the solvency of the purported borrower at the time of the purported loan, the treatment of the transferred funds as a loan by the purported lender and the purported borrower, a demand for repayment of the transferred funds, and the repayment of the transferred funds.

The Court’s Analysis
According to the Court, various factors surrounding LLC’s transfer of $XYZ to Taxpayer during 2009 indicated that the transfer of those funds constituted a loan, including the following: Taxpayer executed a promissory note in which he agreed to repay to LLC all amounts that LLC transferred to him; there was a loan agreement with respect to LLC’s transfer to Taxpayer of the $XYZ; Taxpayer agreed to pay interest on the $XYZ that he received from LLC at the rate specified in the note; Taxpayer agreed to secure the repayment of the $XYZ loan and the interest thereon by granting LLC a security interest in all accounts receivable of his private practice of medicine; Taxpayer had the ability to repay the $XYZ that LLC transferred to him; and Taxpayer and LLC treated the $XYZ that LLC transferred to Taxpayer as a loan in that LLC did not include the $XYZ loan in Form 1099-MISC or in any other information return that it issued to Taxpayer for the 2009 tax year, and Taxpayer did not include the $XYZ in gross income for that year.

In the face of these factors, which indicated that the $XYZ transferred to Taxpayer in 2009 by LLC constituted a loan, Taxpayer nonetheless took the position that the transfer should be considered an advance payment by LLC of Taxpayer’s salary, not a loan.

In support of his position, Taxpayer contended that there was no unconditional obligation imposed on him to repay the $XYZ. According to Taxpayer, any repayments would only become due if he materially breached the Agreement. In other words, Taxpayer’s obligation to repay the $XYZ that LLC transferred to him was subject to a condition precedent and, consequently, his obligation to repay that amount to LLC was not unconditional.

According to Taxpayer, it was only when he terminated his employment with LLC that any unearned portion of the $XYZ advanced to him became due to LLC.

The Court rejected Taxpayer’s argument, pointing out that it ignored the provisions of the Agreement regarding the $XYZ transfer and was inconsistent with the facts.

The Court found that pursuant to the agreement with respect to the $XYZ transfer to Taxpayer, Taxpayer had an unconditional obligation to repay to LLC the $XYZ that it transferred to him. That obligation of Taxpayer was subject to a condition subsequent. That is to say, if Taxpayer worked in LLC’s medical practice for at least six months, LLC agreed to forgive and cancel one- thirtieth of Taxpayer’s Loan Repayment Amount for each calendar month after the end of the Guarantee Period that Taxpayer remained with LLC.

Because Taxpayer failed to establish that the $XYZ transferred to him during 2009 was not a loan, he was not be entitled to claim the 2012 Schedule C repayment expenses of $MNO.

Employee Forgivable Loans
Employer advances to employees represent an important tool in attracting and retaining qualified individuals. In order to be effective, the amounts advanced have to represent a bona fide loan to the employee, and the recognition by the employee of any portion thereof as income has to be deferred until such time as such amount is forgiven by the employer.

In order to attain this result, and to avoid the immediate taxation upon receipt of the advance as compensation, it is imperative that the arrangement be structured, documented, and implemented as an arm’s-length loan, and that any forgiveness thereof be tied to the employer’s continued service with the employer.

By way of analogy, and as additional guidance, the employer’s adviser review the rules applicable to the transfer of restricted property. Under these rules, the employee to whom an employer transfers property is not “vested” in, and taxed on the value of, such property until the property is no longer subject to “substantial risk of forfeiture;” i.e., the employee has satisfied certain employment-related requirements (for example, a specified number of years of service). As in the case of a forgivable loan, the employee who fails to satisfy these requirements will have to forfeit (repay) the property to the employer.

As always, it will behoove the parties to a forgivable loan arrangement to consult their tax advisers in advance, to familiarize themselves with the tax consequences, and to ensure their consistent treatment of the amounts advanced.

 

Maximize Capital Gain

In the sale of a business, it is the goal of every business owner and his tax adviser to minimize the amount of gain recognized and, to the extent gain is recognized, to maximize the amount that is treated as capital gain.

Property Used in Trade or Business

The gain realized on the sale or exchange of property used in a taxpayer’s trade or business is treated as capital gain. In general, the Code defines “property used in a trade or business” to include amortizable or depreciable property (subject to the so-called “recapture” rules), as well as real property, that has been used in a trade or business and has been held for more than one year.

If a property is not so described, the gain realized on its sale will generally be treated as ordinary income. Indeed, certain properties that are used in a business are explicitly excluded from capital gain treatment, including inventory and property held by the taxpayer primarily for sale to customers in the ordinary course of his trade or business (“inventory”).

Capital Asset

Capital gain treatment may also result from the sale of a “capital asset.” This is generally defined to include property held by the taxpayer, whether or not it is connected with his trade or business, but not including “inventory,” “property used in a trade or business,” or accounts or notes receivable acquired in the ordinary course of a trade or business for services rendered or from the sale of “inventory.”

Contracts as Capital Asset?

Over the years, questions have arisen concerning the proper tax treatment of the gain realized by a business on the sale of certain contracts to which it is a party.

The courts have stated that not everything that can be called “property” under local law, and that is outside the statutory exclusions described above, qualifies as a capital asset; rather, according to the courts, the term “capital asset” should be construed narrowly in accordance with the purpose of Congress to afford capital gain treatment only in situations typically involving the realization of appreciation in value accrued over a substantial period of time.

Beyond these general, cautionary principles, it appears that the courts have not been able to clearly or consistently delineate between contracts that are capital assets and those that represent a right to income.

Thus, the courts have stated, at various times and in various contexts, that:

  • a capital asset requires something more than an opportunity, afforded by a contract, to obtain periodic receipts of income;
  • a taxpayer does not bring himself within capital gain treatment merely by showing that a contract constitutes “property,” that he held the contract for more than one year, and that the contract does not fall within any of the exclusions from the definition of capital asset;
  • the consideration received for the transfer of a contract right to receive income for the performance of personal services is taxable as ordinary income;
  • a lump-sum payment that is essentially a substitute for what would otherwise be received at a future time as ordinary income is consideration for the right to receive future income, not for an increase in the value of the income-producing property;
  • simply because the property transferred will produce ordinary income, and such income is a major factor in determining the value of the property, does not necessarily mean that the amount received in exchange for the property is essentially a lump-sum substitute for ordinary income;
  • contract rights may be a capital asset where they provide the possessor significant long-term benefits;
  • it is important to distinguish between proceeds from the present sale of the future right to earn income (capital gain) and the present sale of the future right to earned income (ordinary income).

Congress Provides Some Certainty

In many cases, taxpayers will have to consider the inconsistently applied criteria that have been developed by the courts in determining how the sale of a contract will be treated for tax purposes.

Thankfully, Congress has occasionally stepped in to clarify, at least somewhat, the tax treatment of the disposition of certain contract rights.

Sale of a Franchise

Taxpayer was formed in 1997 to bid on a request for proposal from County to take care of its waste/recycling needs. Taxpayer won a package of contracts that gave it the exclusive right to collect and dispose of County’s waste. The collection contracts started running in the summer of 1998 and ran through 2007, but could be extended by mutual agreement.

In 2002, a consultant for the waste industry asked Taxpayer if it would be willing to sell its business. It was, and that summer Taxpayer signed an agreement with the consultant, who put together a package that estimated potential sale prices. Things moved quickly and, by that fall, Taxpayer had signed a letter of intent to negotiate with the highest bidder.

In the fall of 2003, Taxpayer sold its assets, including its contracts with County, in an all-cash deal for $X million; there were no contingent payments. Taxpayer did not keep any interest in the contracts. The asset-purchase agreement allocated the purchase price among a covenant not to compete, tangible assets, buildings, land, intangibles, going concern value and goodwill.

Tax Return and Audit

On the Form 8594, Asset Acquisition Statement under Section 1060, filed with its 2003 tax return, Taxpayer reported the values of the assets sold the same way the parties allocated them in the asset-purchase agreement. The bulk of the purchase price was allocated to what Taxpayer reported as intangible assets (including the contracts) and going concern value/goodwill, to be taxed at as capital gain.

The IRS audited Taxpayer’s returns, and proposed an adjustment by re- characterizing as ordinary income the gain realized from the sale of Taxpayer’s contractual rights to provide waste-collection services to County. Taxpayer disagreed with the IRS, and filed a timely petition with the U.S. Tax Court.

Tax Court

Specifically, Taxpayer claimed that the contracts were franchises, and that their sale was covered by a statutory rule that taxed their sale at capital gain rates.

The IRS disagreed, stating that the Code provision relied upon by the Taxpayer did not apply, and urging the Court to apply the “substitute-for-ordinary-income” doctrine instead.

The Court began its discussion by analyzing the provision at issue. According to that provision, the sale of a franchise may not be treated as a sale or exchange of a capital asset if the transferor retains any significant power, right, or continuing interest in the franchise transferred.

The first question to be addressed, the Court stated, was whether the contracts sold were “franchises” within the meaning of that provision. A “franchise” for the purposes of that provision, it continued, includes an agreement that gives one of the parties to the agreement the right to distribute, sell, or provide goods, services, or facilities, within a specified area. The Court found that Taxpayer’s contracts were agreements to provide services within the County. Thus, they satisfied these requirements and came under the provision.

However, holding that the contracts were “franchises,” the Court noted, did not end the matter. The Court also had to determine whether Taxpayer kept any “significant power, right, or continuing interest” in the franchises; if it did, then its income from the sales would be ordinary (as if it had arisen under a license).

The Court found that Taxpayer did not retain any interest in the franchises/contracts, and that it did not receive any contingent payments; in fact, it received a single lump-sum payment.

Because the contracts qualified as franchises, and the Taxpayer neither kept any interests in the franchises nor received any contingent payments, the Court concluded that the sale transaction was not ineligible for capital gain treatment.

Taxpayer argued that this determination alone – not being ineligible for capital gain treatment – automatically entitled it to capital-gain treatment.

The Court pointed out, however, that the provision sets forth what does not get capital gain treatment; it does not specifically state that the sale of a franchise with respect to which the seller did not retain an interest automatically receives capital gain treatment.

According to the IRS, this meant that the provision was inapplicable by its own terms, covering only sales in which an interest in the franchise was retained by the seller. Thus, the IRS argued, the transactions were taxable as ordinary income.

The Court disagreed with the IRS. The provision, it stated, refers to capital accounts; specifically, any amount paid or incurred on account of a sale of a franchise, that is not deductible as an ordinary and necessary business expense by the acquiring-payor because it is not contingent upon the productivity or use of the franchise, is treated as an amount chargeable to capital account.

According to the Court, this implied that the sale of a franchise leads to capital gain treatment so long as the seller does not retain any significant interest in the franchise and the franchise was a capital asset.

Because Taxpayer kept no significant interest in the contracts sold, it was entitled to capital gain treatment on the gain realized from the sales.

Guidance?

I wish there was something beyond general principles on which to confidently rely in determining the tax treatment of the gain realized on the sale of a contract.

Some situations will obviously warrant capital gain treatment while others will obviously warrant ordinary income treatment. In between, there can be considerable uncertainty.

That being said, if the seller does not retain any interest in the contract (query how an earn-out will affect this), if the contract provides significant long-term benefits, if the contract involved a capital investment by the seller, and if the contract has some potential to appreciate in value over time, then the chance of capital gain treatment on the sale of the contract will be improved.

Of course, this analysis only goes to the nature of the gain. It does not necessarily influence the “structure”/terms of the contract, nor should it. The contract is a business arrangement, negotiated and entered into between two parties, each of which expects to profit from it currently, in the ordinary course of its trade or business, and not necessarily upon the disposition of the contract. Indeed, many contracts are not assignable, or are assignable only with the consent of the other party, in which case new contracts may just as likely be “re”-negotiated by the buyer.

It will nevertheless behoove the seller to understand and quantify the tax/economic cost of the sale of a contract, and to account for it in negotiating the price for the sale of the business. After all, it’s how much the seller keeps after taxes that matters.

“Disposing” of a Partnership Interest

If the amount realized by a taxpayer upon the sale of a partnership interest to a third party is insufficient to restore to the taxpayer his adjusted basis for the interest – i.e., his unrecovered investment in the partnership – a loss is sustained to the extent of the difference between such adjusted basis and the amount realized.

In general, this loss will be treated as a capital loss.

Liquidation

A loss may be recognized by a partner upon the liquidation of his interest in a partnership only where no property other than money is distributed to the partner. Loss is recognized to the extent the partner’s adjusted basis for the partnership interest exceeds the amount of money distributed to the partner.

The liquidating distribution may consist of actual and deemed distributions of money by the partnership; for example, a decrease in a partner’s share of the liabilities of a partnership is considered a distribution of money by the partnership to the partner.

Any loss recognized by a partner upon the liquidation of his partnership interest is considered a loss from the sale of the interest. Thus, it is generally treated as a loss from the sale of a capital asset.

Abandonment

What if a taxpayer “abandons” his partnership interest instead of selling it or having it liquidated? How will the loss realized by the taxpayer on the abandonment – equal to the taxpayer’s adjusted basis – be treated for tax purposes?

A loss that results from the abandonment, as opposed to the sale, of a partnership interest is treated as an ordinary loss, even if the abandoned partnership interest is a capital asset.

In other words, the difference between an ordinary loss and a capital loss on the disposition of a partnership interest may depend upon whether the loss results from the abandonment of the partnership interest, or from the liquidation or sale of the interest.

It may be difficult, however, to avoid sale treatment and capital loss (as opposed to ordinary loss) in the case of an “abandoned” partnership interest. That is because the “successful” abandonment of an interest requires that no consideration be received by the departing partner. In other words, if any consideration is received, even as a deemed distribution pursuant to the liability-shifting rules, the transaction will be treated as a sale, and the realized loss will be treated as a capital loss.

Thus, a loss from the abandonment of a partnership interest will be ordinary only if there is neither an actual nor a deemed distribution to the partner; even a de minimis deemed distribution will make the entire loss a capital loss.

This stringent requirement can make it very difficult for a taxpayer to secure ordinary loss treatment on what the taxpayer believes to have been the abandonment of his partnership interest. One group of uninformed taxpayers realized this issue only after having filed their tax returns.

PE Acquisition & Partnership Agreement

Taxpayers founded, owned and managed Business. By 2003, it had grown into 40 locations – most of which were owned by Taxpayers – was doing $200 million in annual sales, employed hundreds, and was attracting the interest of potential buyers.

A private equity firm (“PE”) offered to purchase Business for roughly $93 million. The offer respected Taxpayers’ ownership of the real estate locations by providing that Business would remain Taxpayers’ paying tenant, and also allowed Taxpayers to manage the day-to-day operations of Business.

Taxpayers and PE formed Partnership, the exclusive purpose of which was to own Business. At the same time, Taxpayers and PE executed a purchase agreement whereby Taxpayers sold to PE an 80.5% interest in the newly formed Partnership for $93 million. Of that amount, Taxpayers reinvested approximately $8 million into Partnership in exchange for a 19.5% interest.

Taxpayers and PE entered into a partnership agreement reflecting PE’s purchase and status as the majority owner of Partnership. The agreement recognized both PE and Taxpayers as Partnership’s general partners.

The agreement also established two classes of partnership interests: preferred and common. PE’s entire 80.5% interest comprised preferred interests. Taxpayers owned common interests, amounting to 19.5% of the total Partnership interests.

Among other rights, the agreement entitled the preferred partners to guaranteed annual payments (payable until the earliest of a partnership liquidation, the conversion of preferred interests to common interests, an “exit/reorganization” transaction, or December 2008), and a retirement obligation payment. Furthermore, should Partnership enter an exit/reorganization transaction, the preferred partners were entitled to consideration determined by a formula based upon the amount such preferred partners would be entitled to receive if Partnership were liquidated (a hypothetical liquidation).

The agreement also provided the priority order for the distribution of Partnership liquidation proceeds. After the satisfaction of any Partnership liabilities, any remaining proceeds had to be used to satisfy any accrued but unpaid guaranteed and other preferred payments. Next, the agreement entitled the preferred partners to proceeds in amounts equal to their “initial capital accounts,” followed by distribution of proceeds to the common partners in amounts equal to their initial capital accounts. Only once these priority categories were satisfied would the common and preferred partners share any remaining liquidation proceeds.

PE’s initial capital account was $85.5 million, and Taxpayers’ initial capital account was $7,945,000.

PE Flips the Business

In 2006, PE began looking to sell its investment in Partnership. PE engaged an investment banker to develop a market for Partnership and vet prospective purchasers. When the market development period ended, two names surfaced as potential purchasers: P-1 and P-2.

Taxpayers had several concerns regarding P-2 as a suitor, including the fact that P-2 would probably consolidate locations. Taxpayers still retained ownership of the locations leased to Business, which provided the family with an annual income stream of $4.4 million.

A sale to P-1, however, did not present Taxpayers with the same concerns. P-1 was a private equity firm, and was attractive to Taxpayers for the same reasons PE had previously won them over: autonomy in operating Business and a continued stream of rental income.

Taxpayers voiced their opposition to a sale of the Business to P-2. They implored PE to sell to P-1 even though P-1’s bid was roughly $35 million less than P-2’s bid of $120 million.

PE sold to P-1 in 2007. The purchase agreement executed with P-1 provided a nominal purchase price of $85 million, to be adjusted upon closing, based upon closing costs and upon Partnership’s working capital and indebtedness.

At the closing, P-1 paid $87 million for the Business. Approximately $43.8 million of that amount came in the form of P-1’s payment of Partnership’s debts to Bank (this is important). Exclusive of sales expenses, P-1 paid the final $34.6 million in proceeds directly to PE, in cash by wire transfer. The common partners – including Taxpayers – received none of these final cash proceeds.

Taxpayers’ Position(s)

Because they had received no cash proceeds, Taxpayers reported the transaction on their 2007 federal income tax returns as an abandonment of their partnership interests that generated an ordinary loss. Interestingly, Taxpayers did not consult their tax adviser until after the closing of the transaction.

The IRS examined Taxpayers’ returns and challenged the character of the losses claimed by Taxpayers on the disposal of their Partnership interests, as well as the decision to treat the transaction as an abandonment of such interests.

In contradiction of their original return position as to the abandonment of their interests in Partnership – and probably in belated recognition of the weakness of such position – Taxpayers argued that the form of the P-1 sale, as originally documented and reported, failed to comport with its economic reality, which could only be ascertained by looking through the sale and examining the transaction as a series of component steps that included an undocumented oral agreement with PE pursuant to which Taxpayers had agreed to surrender to PE any sale proceeds due them from the sale in order to incentivize PE’s sale to P-1. Taxpayers claimed this was done with the aim of preserving their stream of rental income. They also argued that these transactions resulted in their realization of actual proceeds from the Partnership sale, and their payments of those proceeds to PE gave rise to an amortizable intangible.

Tax Court’s Response

According to the Court, when the form of a transaction does not coincide with the economic reality, the substance of the transaction rather than its form should determine the tax consequences. A taxpayer may assert substance-over-form arguments, the Court stated, but in such situations the taxpayer faces a higher than usual burden of proof. In fact, the Court continued, taxpayers must adduce “strong proof” to establish their entitlement to a new position that is at variance with a position reported in their original returns.

The Court rejected Taxpayers’ theory because it relied on the presumption that the terms of their agreement with PE gave them rights to a pro rata share of the sale proceeds. This theory, the Court stated, ignored the unambiguous terms of the partnership agreement between Taxpayers and PE.

When the parties closed the sale (which was clearly an “exit/reorganization” transaction), P-1 paid $43.8 million to Bank, extinguishing Partnership’s only debt. Assuming arguendo that Partnership owed PE no accrued but unpaid preferred payments or allocations that might have otherwise increased the total amount due PE, then PE was entitled to recover to the greatest extent possible its initial capital account of $85.5 million from the proceeds of the hypothetical Partnership liquidation.

Taxpayers’ argument, the Court stated, “begins with a conclusion: They were entitled to a pro rata share of the cash proceeds from the [P-1] sale. It ends there, too.” Taxpayers’ “conclusory presumption,” the Court continued, “runs contrary to the unambiguous wording of the agreement.” The agreement did not provide for a pro rata split; it provided PE a priority payment for its interests in the event of a transaction similar to the one at issue.

According to the Court, it was clear that these were negotiated contract provisions, meant to narrow the preferred partner’s exposure to risk. In the event the marketable value of PE’s Partnership interest slipped below its initial capital account value, these provisions operated to recover PE’s investment to the greatest extent possible, even if that recovery came at the expense of the common partners, such as Taxpayers.

Taxpayers failed to establish they were entitled to any cash proceeds from the P-1 sale. It followed, then, that Taxpayers could not offer to surrender such proceeds to incentivize PE’s sale to P-1. Accordingly, Taxpayers’ theory of an amortizable expense failed.

The Court then turned to Taxpayers’ original return position, characterizing the transaction as an ordinary abandonment loss.

Again, the Court began by noting that the IRS’s determinations are presumed correct, and that taxpayers generally bear the burden of proving entitlement to the deductions they claim.

To qualify for an abandonment loss, the Court explained, a taxpayer must demonstrate that: (1) the transaction did not constitute a sale or exchange, and (2) he abandoned the asset, intentionally and affirmatively, by overt act.

As explained earlier, when a partner is relieved of his share of partnership liabilities, the partner is deemed to receive a distribution of cash. The Code requires that liquidating distributions to partners be treated as payments arising from the sale of a partnership interest.

Thus, ordinary abandonment losses may arise only in a narrow circumstance where the partner: (1) was not personally liable for the partnership’s recourse debts, or (2) was limited in liability and otherwise not exposed to any economic risk of loss for the partnership’s nonrecourse liabilities.

The IRS determined that Taxpayers’ disposal of their Partnership interests did not fall within these narrow exceptions. Accordingly, the IRS re-characterized Taxpayers’ losses from ordinary abandonment losses to capital losses on the sale of the interests.

The Court agreed with the IRS, finding that Taxpayers had not met their burden of proof. They presented no documentary or testimonial evidence to establish their eligibility for an abandonment loss deduction. They failed to prove their individual shares of any Partnership liabilities, capital restoration obligations, or lack thereof, in the light of documentary evidence suggesting otherwise.

Thus, P-1’s satisfaction of Partnership’s indebtedness to Bank generated the deemed distribution to Taxpayers that doomed their chance of establishing an abandonment for tax purposes. Indeed, this fact may have accounted for the alternative theory proffered by Taxpayers (contrary to their tax return) in an attempt to salvage some amortization-based tax-saving deductions going forward.

Accordingly, the Court sustained the IRS’s determination.

With Sincerest Apologies to Dante

“Through me you pass into capital loss, or even capital gain.  Abandon all hope of ordinary loss, ye who enter here.”

 During its discussion, the Court conceded that a partnership interest, which represents an intangible “investment asset,” may be abandoned for tax purposes, though only in the absence of any shifting allocation of, or relief from, partnership or individual liability.

The apparently late realization by Taxpayers, that the satisfaction of the Bank debt generated a deemed distribution of money that cut the legs out from under their abandonment theory, forced Taxpayers to not only abandon (pun intended) their tax return position, but to argue against it, and in the process to construct a series of fictional steps that were not in any way supportable.

Although a taxpayer’s disavowal of its reported position increases the burden of proof that already rests upon the taxpayer – which is bad enough – it probably also undermines the taxpayer’s credibility.

As always, taxpayers owe it to themselves to consult their tax advisers throughout the process that comprises the sale of a business or of an interest in a business. By doing so, they may be able to structure the transaction in a tax-efficient manner and to document it accordingly. Even if they fail to influence the structure, they may be able to extract some economic concession as compensation for any tax-inefficiencies imposed upon them.

Query: Taxpayers were probably aware that the sale to P-1 would not result in their receiving a cash distribution under their partnership agreement with PE; concededly, the continuance of their rental income was important to them; but how much did the availability of a large ordinary loss figure into Taxpayers’ decision to back P-1’s offer over that of P-2, which was $35 million richer?

 

 

Potential for Abuse

Many years ago, Congress decided that taxpayers who were “related” to one another should be required to use the same accounting method with respect to transactions between them in order to prevent the allowance of a deduction to one party (using the accrual method of accounting) without the corresponding inclusion in income by the other party (using the cash method).

The failure to use the same accounting method with respect to one transaction, it was believed, involved unwarranted tax benefits, especially where payments were delayed for a long time.

Deferring the Deduction

In order to address this concern, Congress decided that accrual basis taxpayers must shift to the cash method of accounting with respect to the deduction of amounts owed to a related cash-basis taxpayer, thereby deferring the deduction until the amount owing is paid.

Thus, an accrual-basis taxpayer is allowed to deduct amounts owed to a related cash-basis taxpayer only when payment is received, and the corresponding income is recognized, by the related cash-basis party.

This rule applies to all deductible expenses the timing of which depends upon the taxpayer’s method of accounting.

S-Corp.’s Payroll Expenses

The Tax Court recently considered a case involving unusual circumstances that required it to interpret the application of this “deduction deferral” rule.

The question presented was whether this rule applied to defer certain deductions accrued by Corp., which was an S-corporation of which Taxpayers were the original shareholders.

Corp. used the accrual method of accounting for federal income tax purposes.

During the years at issue, Corp. accrued expenses for wages, vacation pay, and related payroll items (collectively, “accrued payroll expenses”) on behalf of its employees.

Approximately 95% of these amounts were attributable to employees who participated in the employee stock ownership plan (“ESOP”) that Corp. maintained during these years. During each year, some or all of Corp.’s stock was owned by related ESOP trust.

Some of these accrued payroll expenses were not expected to be paid, and were not in fact paid, until the year following the year in which Corp. made the accruals.

On its returns for the years at issue, Corp. claimed deductions for (among other things) the accrued but unpaid payroll expenses described above. Taxpayers, on their individual returns, and in accordance with the S-corporation flow-through rules, claimed flow-through deductions equal to their pro rata share of these accrued but unpaid expenses.

The IRS Audit

The IRS examined Corp.’s tax returns, and disallowed the deductions claimed for the accrued but unpaid expenses to the extent they were attributable to employees who participated in the ESOP.

The IRS contended that the ESOP trust was a “trust” within the meaning of the constructive ownership rules that are applicable in determining whether the parties to a transaction are “related” to one another, with the consequence that the trust beneficiaries – specifically, those Corp. employees who were ESOP participants – were deemed to have owned their proportionate shares of the Corp. stock held by the ESOP trust.

If Corp.’s employees, all of whom were cash basis taxpayers, were the beneficiaries of a “trust” that owned Corp. stock, they would be deemed “related” to Corp. for purposes of the “deduction deferral” rule which would require that Corp.’s deductions for accrued but unpaid payroll expenses be deferred until the year the expenses were paid by Corp. and were includible in the employees’ gross income.

The IRS then performed a follow-on examination of Taxpayers’ individual tax returns and, of course, disallowed the flow-through deductions attributable to the disallowed expenses that had been accrued by Corp.

Taxpayers petitioned the U.S. Tax Court.

Tax Accounting

Generally, an accrual basis taxpayer may deduct ordinary and necessary business expenses in the year when “all events” have occurred that establish the fact of the liability, the amount of the liability is set, and “economic performance” has occurred with respect to the liability.

A cash basis taxpayer generally reports income in the year it is actually received, and deducts expenses in the year they are actually paid.

When such expenses are owed by an accrual basis taxpayer to a related cash basis taxpayer, however, the “related party deduction deferral” rule provides that the payor may deduct the expenses only for the taxable year for which the amounts are includible in the payee’s gross income; in other words, the payor must use cash basis accounting as to those expenses.

The Tax Court’s Analysis

The Court began by noting that deductions are a matter of legislative grace, and the burden is on the taxpayer to prove entitlement to claimed deductions.

The parties agreed that the accrued payroll expenses were ordinary and necessary to the company’s business and that the requirements for the proper accrual of the expenses had been met.

The sole issue, therefore, was whether Corp. and the ESOP participants were related persons for purposes of the “deduction deferral” rule.

The Court considered and dismissed several arguments made by Corp. and Taxpayers, including one in which they asserted that the IRS’s position violated generally accepted accounting principles (“GAAP”) by denying a current deduction for properly accrued payroll costs. The Court replied that “[a]s has often been noted, . . . , tax accounting differs in many respects from GAAP financial accounting. Especially is that so where (as here) a Code provision explicitly requires a treatment that differs from GAAP.” Corp., the Court stated, had no greater claim than any other accrual basis taxpayer to exemption from the operation of the “deduction deferral” rule.

This rule, the Court pointed out, was designed “to prevent the use of the differing methods of reporting income and deductions for Federal income tax purposes in order to obtain artificial deductions for interest and business expenses.” It is remedial, the Court continued, requiring related persons to “use the same accounting method with respect to transactions between themselves in order to prevent the allowance of a deduction without the corresponding inclusion in income.”

Among the “relationships” that bring the rule into play is that of an S corporation and “any person who owns (directly or indirectly) any of the stock of such corporation.” Thus, S corporations and their shareholders are deemed to be “related persons” for purposes of the rule regardless of how much or how little stock each shareholder individually owns.

In determining whether a person owns shares of stock of a corporation, certain constructive ownership rules are applied, according to which stock owned, directly or indirectly, by or for a trust, shall be considered as being owned proportionately by or for its beneficiaries.

Thus, if the ESOP participants constructively owned Corp. stock in their capacities as beneficiaries of the ESOP trust, then Corp. and the participant-employees would be treated as “related persons” for purposes of the “deduction deferral” rule, no matter how small their percentage ownership.

With that, the Court turned to the question of whether the Corp. stock owned by the ESOP was owned by a “trust” of which the ESOP participants were “beneficiaries.”

The Court stated that it would ordinarily give the words Congress used their ordinary meaning, “unless doing so would produce absurd or futile results.” If a statute was clear on its face, the Court explained, then “unequivocal evidence of legislative intent would be required” before construing the statute in a manner that overrode the plain meaning of the words used therein.

After a lengthy analysis – in which the Court examined the ESOP documents, including the terms of the associated ESOP trust, and the regulations governing qualified deferred compensation plans (such as ESOPs), among other things – the Court concluded that the entity holding the Corp. stock for the benefit of the ESOP participants was a “trust” in the ordinary sense of that word. The arrangement involved a settlor (Corp.) that established a trust for the benefit of specified beneficiaries (the ESOP participants), contributed property to the trust (Corp. stock and cash), and designated a trustee to hold the property for the beneficiaries and act in their best interest.

Because the ESOP trust was a “trust” within the meaning of the constructive ownership rules, the Corp. stock held by the trust was deemed to be owned by the trust’s beneficiaries: the Corp. employees who participated in the ESOP. As a result the ESOP participants and Corp. were deemed “related persons” for purposes of the “deduction deferral” rule.

Accordingly, Corp.’s deductions for the accrued but unpaid payroll expenses had to be deferred to the year in which such expenses were actually paid by Corp. and were includible in the gross income of the ESOP participants.

Words of Advice?

The IRS and the courts have a long history of closely scrutinizing transactions between related parties. In most cases, the tax authorities are trying to determine whether a transaction was structured in such a way as to achieve a better tax (and, thus, economic) result than if the parties had dealt with one another on an arm’s-length basis.

Often, the related taxpayers can successfully defend the IRS’s attempts to re-characterize payments made between them by identifying the business reason for, and nature of, the payment, by contemporaneously documenting the flow of funds between them, and by endeavoring as much as possible to approach the transaction as if they were unrelated parties.

However, as was illustrated by the decision discussed above, there are other, statutorily-identified situations involving related party transactions, the sometimes-surprising tax consequences of which cannot be avoided if the transaction falls within the literal “criteria” of the statutory provision. In addition to the “deduction deferral” rule, another example of such a situation are the rules applicable to related party sales that characterize the gain recognized on such sales as ordinary income.

The only way to avoid stumbling onto these rules, and the resulting – and unexpected – tax consequences, is to be aware of them, which usually requires seeking the advice of a knowledgeable adviser. The transaction at issue may still be undertaken if it makes business sense to do so, but at least the related taxpayers will know how to report the tax consequences and to account for them, if possible, within the economics of the transaction.

“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.