“We Could Have Had it All”

ABC has been looking for someone special for a long time. Suitors have come and gone. Some have been better than others. Some were non-starters. Then ABC meets a person that may be “the one.” As it turns out, that person has also been looking for someone.

After getting to know each other a bit, ABC decides that it may be time to open up to one another, with the implicit understanding, of course, that neither of them would ever hurt the other by sharing this information with anybody else.Breakup Fee

In a few months’ time, that special someone indicates that they are interested in a long-term relationship, and ABC promises that it will not entertain “overtures” from others. Then, one day, the moment ABC has been waiting for finally comes. That special someone proposes a permanent relationship with ABC. They select a date to formalize their union and announce it to the world.

ABC couldn’t be happier, or so it thinks. Then someone new appears. ABC never expected to hear from anyone like this person, didn’t think they would ever be interested, but there they are. What’s more, they are offering ABC much more than any other suitor ever did.

Too good to turn down? You bet. The existing engagement has to be called off. But there’s a price to pay. ABC’s now-former suitor spent a lot of money in getting to the point where they agreed to unite with ABC. In the process, the former suitor (who has been burned before) also determined that there was a less-than remote possibility that ABC would walk away if another, “better” suitor came along. “I would never do that to you,” ABC said, and in that spirit, agreed not to hold itself out as being “available,” and also agreed to pay a break-up fee if it ever called off the engagement.

Deal Economics

Every deal, whether from the perspective of the seller or the buyer, is about economics. Few items will impact the economics of a deal more immediately than taxes. The deal involves the receipt and transfer of value, with each party striving to maximize its economic return on the deal. The more taxes that a party to the deal pays as a result of the deal structure, the lower is the party’s economic return. The more slowly that a party recovers its investment in the deal – for example, through tax deductions, such as amortization – the more expensive the deal becomes.

But what happens if the deal does not close? The buyer may have retained accountants, attorneys, financial advisers, and appraisers to assist it in investigating the deal and in putting it together. These professionals are expensive. (Sometimes, you even have to pay them what they are worth.)

Many buyers will seek to protect themselves from a target that may suffer from the jitters, or that may get a better offer, by requiring that the target agree to pay a termination fee. The target will recognize the logic in this, at least from the buyer’s perspective, and will have to take it into account – as an additional cost that it or its new suitor will have to bear – in determining whether to walk away from the deal.

Whether the amount of this fee will fully reimburse the buyer for its expenditures will depend, in no small part, upon how it will be treated for tax purposes.

Termination Fee

The IRS’s Office of Chief Counsel recently issued an advisory opinion in which it discussed how gain or loss would be determined by a buyer corporation (“Taxpayer”) that incurred expenses investigating the acquisition of a target corporation’s stock (“Target”). Taxpayer entered into an agreement (“Contract”) with Target that was designed to lead to Taxpayer’s acquisition of Target’s stock. The Contract also provided that Taxpayer would receive a fee in the event Target terminated the Contract.

The Contract required Taxpayer and Target to pursue a plan of merger to effectuate Taxpayer’s stock acquisition through a merger of a newly-formed, wholly-owned subsidiary of Taxpayer with and into Target, with Target as the surviving entity (a “reverse subsidiary merger” – often used where Target has many shareholders, some of whom may be less than cooperative).

Regarding Target’s obligations under the Contract, the Contract required Target to recommend to its shareholders that they approve the plan of merger subject, however, to the receipt of a superior offer. The Contract provided that Target may terminate the contract upon (i) entering into another agreement based on a superior offer, (ii) a rejection of Taxpayer’s offer by Target’s shareholders, or (iii) a failure to obtain approval of Target’s shareholders by a certain date. The Contract provided that in the event the Contract was terminated due to one of the foregoing, Target would have to pay a termination fee of $X to Taxpayer.

As it turned out, Target received a superior offer from another suitor and entered into an agreement with this other corporation. Target terminated the Contract and paid Taxpayer the $X termination fee. At the time the Contract was terminated, Taxpayer had incurred $Y of costs in the process of investigating and pursuing the transaction that Taxpayer capitalized as costs of facilitating the proposed transaction.

Capitalization Rules

Before discussing the IRS’s opinion, let’s review the applicable capitalization rules.

Amounts that are paid in the process of investigating or otherwise pursuing certain acquisitive transactions – including a taxable acquisition of assets that constitute a trade or business or a taxable acquisition of an ownership interest in a business entity if, immediately after the acquisition, the acquiring taxpayer owns more than 50% of the equity of the business entity – are capitalized as costs of “facilitating” the transaction.

An amount is paid to facilitate an acquisitive transaction if the amount is paid in the process of investigating or otherwise pursuing the transaction. Whether an amount is paid in the process of investigating or pursuing the transaction is determined based on all of the facts and circumstances. In determining whether an amount is paid to facilitate a transaction, the fact that the amount would not have been paid but for the transaction is relevant, but is not determinative. An amount paid to determine the value or price of a transaction is an amount paid in the process of investigating or otherwise pursuing the transaction. Employee compensation, overhead, and other costs are treated as amounts that do not facilitate a transaction.

In general, an amount paid by a taxpayer in the process of investigating or otherwise pursuing a covered transaction facilitates the transaction only if the amount relates to activities performed on or after the earlier of –

(i) The date on which a letter of intent, exclusivity agreement, or similar written communication (other than a confidentiality agreement) is executed by the acquirer and the target; or
(ii) The date on which the material terms of the transaction (as tentatively agreed to by the acquirer and the target) are authorized or approved by the taxpayer’s board of directors, or the date on which the acquirer and the target execute a binding written contract reflecting the terms of the transaction.
Notwithstanding the general rule, an amount paid in the process of investigating or otherwise pursuing a covered transaction facilitates that transaction if the amount is “inherently facilitative”, regardless of whether the amount is paid for activities performed prior to the date determined above. An amount is inherently facilitative if the amount is paid for –
(i) Securing an appraisal or formal written evaluation;
(ii) Structuring the transaction, including obtaining tax advice on the structure;
(iii) Preparing and reviewing the documents that effectuate the transaction;
(iv) Obtaining regulatory approval;
(v) Obtaining shareholder approval; or
(vi) Conveying property between the parties.

In the case of a taxable asset or stock acquisition, an amount required to be capitalized by the acquirer is added to the basis of the acquired assets (in the case of a transaction that is treated as an acquisition of the target’s assets for federal income tax purposes) or the acquired stock (in the case of a transaction that is treated as an acquisition of the target stock for federal income tax purposes).

The IRS’s Opinion: Capital Gain or Loss?

The IRS explained that capital gain or loss is gain or loss that is realized from the sale or exchange of a capital asset.

Gain or loss, it stated, that is attributable to the cancellation, lapse, expiration or other termination of a right or obligation with respect to property which is (or on acquisition would be) a capital asset in the hands of the taxpayer is treated as gain or loss from the sale of a capital asset.

The Code allows as a deduction any uncompensated loss sustained by a taxpayer during the taxable year. The IRS noted, however, that capital losses are subject to certain limitations.

Specifically, in the case of a corporation, losses from sales or exchanges of capital assets are limited to gains from the sale or exchange of such assets. The IRS noted, however, that capital losses in excess of such gains are carried forward.

In the advisory opinion, the IRS determined that Target’s stock would have been a capital asset in Taxpayer’s hands upon acquisition. The Contract provided Taxpayer with a bundle of rights vis-a-vis Target that related to Taxpayer’s proposed acquisition of Target stock. Although the Contract was between Taxpayer and Target, rather than between Taxpayer and Target’s shareholders, a contract between the acquiring corporation and the target corporation, the IRS stated, is a customary part of the process by which the stock of a target corporation may be acquired. The Contract imposed obligations on both parties with respect to Target’s stock. The Contract also provided Taxpayer with rights with respect to Target’s stock.

The IRS determined that the termination fee payable to Taxpayer under the Contract was in the nature of liquidated damages. Thus, any gain or loss realized by Taxpayer on the termination of the Contract, which provided rights and obligations with respect to Target’s stock (a capital asset), would be capital in nature.

Based on the foregoing, the IRS concluded that Taxpayer’s amount realized from the receipt of the termination fee of $X should be reduced by Taxpayer’s capitalized facilitative costs of $Y.

Where the termination fee exceeded these costs, Taxpayer would have realized a gain. Because this gain would have been attributable to the termination of Taxpayer’s right with respect to Target’s stock, property that would have been a capital asset in Taxpayer’s hands, the gain would have been treated as a gain from the sale of a capital asset. Accordingly, Taxpayer would have realized a capital gain.

Where the termination fee was less than Taxpayer’s capitalized facilitative costs, Taxpayer would have realized a loss and, because this loss was attributable to the termination of Taxpayer’s right with respect to Target’s stock, property that would have been a capital asset in Taxpayer’s hands, the loss would be treated as a loss from the sale of a capital asset. Accordingly, Taxpayer would have a capital loss that Taxpayer may deduct, subject to certain limitations on capital losses.


Yes, I sound like a broken record (or CD or phone or notebook or whatever), but it bears repeating.

Every transfer of value in an acquisitive transaction will have economic and tax consequences. In order to ensure the desired economic result (after taxes), a party to the transaction has to consult its tax advisers regarding the tax consequences and the manner in which the transfer should be structured and/or characterized so as to generate the desired result. Armed with this knowledge, the party can then determine whether the appropriate amount of value is being paid or received.

Last week’s post explored the federal income tax consequences to a taxpayer who failed to timely file an election for the classification of his wholly-owned business entity.

Today’s post considers how one taxpayer sought to utilize the IRS’s business entity classification rules to reduce his estate’s exposure for NY estate tax. Individuals who are not domiciled in NY (“nonresidents”), but who operate a NY business, should familiarize themselves with NY’s response to the taxpayer’s proposed plan.

Situs of an LLC Interest
NY had previously ruled in an advisory opinion that a membership interest in a single-member LLC (“SMLLC”) that owned NY real property, and that was disregarded for federal income tax purposes, would be treated as real property – not as an intangible – for NY estate tax purposes.

The opinion also held that when a SMLLC makes an election to be treated as an association (taxable as a corporation) pursuant to the IRS’s “check-the-box” rules, the membership interest in the SMLLC would be treated as intangible property.

It concluded that the election that is in place on the date of the single member’s death is the election that will be used to determine whether the interest in the SMLLC is treated as real property or as intangible property for purposes of NY’s estate tax.

A recent NY advisory opinion addressed Taxpayer’s question whether a membership interest in a SMLLC would be treated as intangible property for NY estate tax purposes where the SMLLC initially elects to be disregarded for income tax purposes but, immediately upon the single member’s death, retroactively elects to be treated as an association taxable as a corporation.

Electing to Change Tax Status – and Situs?
Taxpayer represented that he was currently a NY resident, but that he planned to move to another state. At that time, Taxpayer would transfer his NY real property into a SMLLC, of which he would be the sole member. This SMLLC would not elect to be treated as an association for federal income tax purposes. Thus, it would be treated as a disregarded entity, and Taxpayer would continue to be treated as the owner of the real property.

Taxpayer also represented that he intended to remain the sole owner of the LLC for the remainder of his life, and to continue to have the SMLLC treated as a disregarded entity until his death. This would enable Taxpayer to claim on his personal income tax return the income and deductions associated with the real property.

Upon his death, Taxpayer’s Last Will and Testament would direct his executor to elect that the SMLLC be taxed as an association, and as an S-corporation, for income tax purposes. These elections would have retroactive effect to at least one day prior to the date of Taxpayer’s death.

Before we consider NY’s response to Taxpayer’s proposal, let’s first review the application of NY’s estate tax to nonresident decedents, as well as the IRS’s entity classification rules, the interplay of which is key to NY’s opinion.

The NY Estate Tax
NY imposes an estate tax on the transfer by the estate of a nonresident decedent of real property located in NY.

However, where the real property is held by a corporation or partnership, an interest in such entity has been held to constitute intangible property.

The NY Constitution prohibits the imposition of an estate tax on a nonresident’s intangible property, even if such property is located in NY. For example, securities and other intangible personal property within the state, that are not used in carrying on any business within the state by the owner, are considered to be located at the domicile of the owner for purposes of taxation.

NY’s tax law likewise provides that the NY taxable estate of a nonresident decedent does not include the value of any intangible personal property otherwise includible in the decedent’s gross estate.

The Entity Classification (“check-the-box”) Rules
Pursuant to the IRS’s entity classification rules, an entity that has a single owner, such as a SMLLC, is disregarded as an entity separate from its owner unless it elects to be classified as an association taxable as a corporation.

In other words, where no election is filed, the default classification of the SMLLC is that of a disregarded entity, one that is not deemed to be an entity separate from its owner. The SMLLC will retain this default classification until it makes an election to change its classification.

If the SMLLC is disregarded for tax purposes, its assets and activities are treated in the same manner as those of a sole proprietorship, branch, or division of the owner – the sole member is treated as the direct owner of the LLC’s assets, and is treated as conducting the LLC’s activities himself, for tax purposes.

A SMLLC may elect to be classified as other than its default classification by filing an entity classification election with the IRS. Specifically, a SMLLC may elect to be classified as an association, and thus treated as a corporation for tax purposes, by making such an entity classification election.

Such an election would be effective on the date specified by the entity on the election form, or on the date the form was filed if no such date is specified on the form. The effective date specified on the form cannot be more than 75 days prior to the date on which the election is filed, or more than 12 months after the date on which the election is filed.

NY’s Opinion
“A membership interest in a SMLLC owning New York real property, which is disregarded for income tax purposes, is not treated as ‘intangible property’ for purposes of New York State estate tax purposes. However, where a SMLLC makes an election to be treated as a corporation pursuant to [the ‘check-the-box’ rules], rather than being treated as a disregarded entity, such ownership interest would be considered intangible property for New York State estate tax purposes.”

The opinion noted that there is no provision in NY law applicable to the estate tax that provides for retroactively changing an entity’s classification, in this case to be treated as an association/corporation, after the death of its sole owner. Consequently, any post-mortem, retroactive classification election would be disregarded and not treated as a valid election for NY estate tax purposes.

Based on the above analysis, the advisory opinion stated that where a SMLLC is disregarded for Federal income tax purposes, the assets and activities of the SMLLC are treated as those of the deceased nonresident sole member without regard to any post-mortem election directed by his Last Will and Testament.

Therefore, under the circumstances described above, the interest in the SMLLC owned by Taxpayer would not be treated, for NY estate tax purposes, as an intangible asset. Instead, the NY real property held by the SMLLC would continue to be treated as real property held by the Taxpayer for NY estate tax purposes, even after the retroactive classification election was filed.

The Right Answer
Although an advisory opinion is limited to the facts set forth therein, and is binding on NY only with respect to the person to whom it is issued, it is pretty clear that NY’s position regarding Taxpayer’s proposed gambit stands on fairly solid ground.

The proposal described above is premised on the fact that Taxpayer has no idea of when he will die. He wants to enjoy the flexibility of operating through a SMLLC during his life and, upon his demise, take advantage of the opportunity afforded by the entity classification rules to make a retroactive change to the LLC’s tax status and, thereby, to change the situs of his membership interest in the LLC.

Although there are several statutorily-approved post-mortem planning opportunities (for example, the 6-month alternate valuation rule), the ability to elect to change the situs of a nonresident decedent’s property for NY estate tax purposes is definitely not one of them.

A nonresident business owner who operates in NY through a SMLLC certainly should not rely upon his executor’s making a post-mortem entity classification election to “remove” his tangible assets from the reach of the NY estate tax.

An S-corporation is a viable alternative, though it is more restrictive than a SMLLC, and the S-corporation election would have to be made while the owner was still alive.

Alternatively, the owner could choose to admit a second member to the LLC – perhaps an S-corporation, wholly-owned by him, that would hold a de minimis membership interest. The LLC would be treated as a partnership for tax purposes, thereby affording the owner the desired flexibility and pass-through treatment. The LLC interest would also be treated as an intangible in the hands of the nonresident owner under the NY estate tax.

Fortunately, Taxpayer sought professional guidance, as well as NY’s opinion, before implementing the proposed gambit. It’s a lesson to be remembered.

Whose Tax Liability?

In order to properly assess and collect a tax, the IRS first needs to identify the taxpayer that is responsible for reporting the income, and for collecting and remitting the tax, at issue. This is not always a simple proposition. In the case of a business entity, it may depend, in part, upon the entity’s classification for tax purposes.

Tax LiabilityFor example, a business entity that was incorporated under State law will be treated as a taxable C corporation for tax purposes. The same corporation may file an election with the IRS to be treated as a pass-through small business (“S”) corporation, and it may subsequently elect to revoke its “S” election.

In the case of every other business entity, however, the classification is more “fluid.” In order to provide certainty both to the IRS and to taxpayers, the IRS has issued entity classification regulations. These regulations provide certain “default” classifications that coincide with what most taxpayers would desire for the entity in question. Where the taxpayer wants to elect a classification other than the “preferred” default status, it must affirmatively notify the IRS of its decision.

Thus, an LLC that has only one member is ignored for income tax purposes; it is treated as partnership if it has at least two members; regardless of how many members it has, it may elect to be treated as an association that is taxable as a corporation.

The importance of properly making and filing an election so as to change the classification of a business entity for tax purposes cannot be understated.

An Illustration

Taxpayer was the sole shareholder of Corp., a “C” corporation on behalf of which he consistently filed Form 1120, U.S. Corporation Income Tax Return.

Taxpayer formed LLC at the end of Year 1 and became LLC’s sole member. Immediately after the formation of LLC, Corp. merged with and into LLC, with LLC as the surviving entity, and Corp. ceased to exist. LLC continued to own Corp.’s assets and to operate Corp’s business. Since the merger, LLC filed Forms 1120 using Corp’s employer identification number (“EIN”). However, LLC did not file IRS Form 8832, Entity Classification Election.

Taxpayer filed Forms 940 and 941 on behalf of LLC, but did not make sufficient tax deposits or pay the tax due for its employment tax liabilities for several taxable periods after the merger (but before 2009 – see later).

The IRS issued a Notice of Intent to Levy for these periods and filed a Notice of Federal Tax Lien.

Taxpayer argued that LLC, and not Taxpayer individually, was liable for the employment tax liabilities due from LLC.

The only issue for consideration by the Tax Court was whether Taxpayer, as the sole member of LLC, was personally liable for the payment of the employment tax liabilities of LLC for the taxable periods in question.

Entity Classification

The so-called “check-the-box” regulations allow an “eligible business entity” to elect its classification for federal tax purposes. An eligible business entity is one that is not treated as a corporation, per se, under the regulations.

An eligible entity with a single owner, such as the LLC and Taxpayer in the present case, may elect to be classified as an association – i.e., as a corporation – for tax purposes, or it may choose to be disregarded as an entity separate from its owner.

An eligible entity with a single owner that does not file an election is disregarded as an entity separate from its owner; its default status is that of a disregarded entity.
An election is necessary only when an eligible entity chooses to be classified initially as something other than its default classification, or when an eligible entity chooses to changes its classification.

The tax treatment of a change in the classification of an entity for federal tax purposes by election is determined under all relevant provisions of the Code and general principles of tax law, including the step transaction doctrine.

For example, if an eligible entity that is disregarded as an entity separate from its owner (the default status of a single-member LLC) elects to be classified as an association, the following is deemed to occur: the owner of the eligible entity contributes all of the assets and liabilities of the entity to the association in exchange for stock of the association.

If an eligible entity classified as an association (a business entity that elected to be treated as a corporation for tax purposes) elects to be disregarded as an entity separate from its owner, the following is deemed to occur: the association distributes all of its assets and liabilities to its owner in liquidation of the association.

Form 8832

An entity whose classification is determined under the default classification rules retains that classification until the entity makes an election to change its status by filing IRS Form 8832, Entity Classification Election.

An election will not be accepted unless all of the information required by Form 8832 and its instructions is provided. Further, to avoid penalties, an eligible entity that is required to file a federal tax or information return for the taxable year in which an election is made must attach a copy of Form 8832 to its tax or information return for that year.

Under these rules, LLC was disregarded as a separate entity from Taxpayer, its owner, because it was a single-member LLC that had never filed Form 8832.

Notwithstanding this conclusion, Taxpayer made a number of arguments as to why Form 8832 was not the only method by which an eligible entity could elect to change its classification.

The Taxpayer’s Position

First, Taxpayer argued that the merger of Corp. and LLC was a valid reorganization under Section 368(a)(1)(F) of the Code (an “F reorganization,” or “mere change” in corporate identity or form) and, as a result, LLC should be treated as a corporation for federal tax purposes.

Second, Taxpayer argued that the filing of Forms 1120 for the first year after the merger of Corp. and LLC constituted a valid election for LLC to be taxed as a corporation.

Third, Taxpayer argued that the doctrine of equitable estoppel prevented the IRS from contending that LLC was not a corporation because the IRS had “tacitly acquiesced” to the filings of Forms 1120 for the year of the merger and subsequent years.

The Tax Court’s Response

The Court responded that regardless of whether the merger of Corp. and LLC qualified as a valid F reorganization, LLC never filed Form 8832 electing its classification for federal tax purposes as an association and, thus, was not a corporation but, rather, was disregarded as an entity separate from its owner. (Incidentally, this would have caused the merger to be treated as a taxable liquidation of Corp.)

Next, the Court stated that an eligible entity could not elect its entity classification by filing any particular tax return it wished; it had to do so by filing Form 8832 and following the instructions within the regulations. Thus, LLC could not elect to be treated as an association/corporation merely by filing corporate income tax returns.

Finally, according to the Court, equitable estoppel did not bar the IRS from treating LLC as a disregarded entity. The Court noted that equitable estoppel was to be applied against the IRS with the utmost restraint. The elements of estoppel, it stated, are: “(1) * * * a false representation or wrongful misleading silence; (2) the error must be in a statement of fact and not in an opinion or a statement of law; (3) the person claiming the benefits of estoppel must be ignorant of the true facts; and (4) he must be adversely affected by the acts or statements of the person against whom an estoppel is claimed.” The IRS made no false statement to Taxpayer, and the Court did not agree that the IRS’s failure to reject LLC’s filed Forms 1120 was a wrongful misleading silence. Moreover, Taxpayer knew that LLC had never filed a Form 8832 to elect to be treated as anything other than a disregarded entity.

For the foregoing reasons, the Court rejected Taxpayer’s arguments, and found that LLC was disregarded as an entity separate from Taxpayer.

The Taxes At Issue

The Code requires employers to pay employment taxes imposed on employers and to withhold from employees’ wages certain taxes imposed on employees. Employers are required to withhold from employees’ wages the amounts of federal income tax owed by those employees. The Code also imposes a tax on every employer with respect to individuals in his employ.

For employment taxes related to wages paid before January 1, 2009, a disregarded entity’s activities were treated in the same manner as those of a sole proprietorship, branch, or division of the owner.

Accordingly, the sole member of a limited liability company and the limited liability company itself were treated as a single taxpayer who is personally liable for purposes of the employment tax reporting and wages paid before January 1, 2009. Taxpayer was, therefore, liable for LLC’s unpaid employment tax liabilities arising during the tax periods at issue since they related to wages paid before 2009.

Did the Court Get it Right?

On a strict reading of the regulations, yes, it did.

However, the Court’s decision seems harsh. Taxpayer clearly intended to treat LLC as an association taxable as a corporation for tax purposes. He caused LLC and Corp. to merge as part of a transaction that was reported as a tax-free corporate reorganization, not as a taxable liquidation. He treated LLC as the continuation of Corp. for tax purposes, causing LLC to file income tax returns as a “C” corporation, using Corp.’s EIN, after the merger.

What Taxpayer failed to do was file a Form 8832 to elect to be treated as an association.

Interestingly, an eligible entity, including a single-member LLC, that timely elects to be an S corporation, by filing IRS Form 2553, is treated as having made an election under the regulations to be classified as an association, provided that (as of the effective date of the “S” election) the entity meets all other requirements to qualify as a small business corporation. The deemed election to be classified as an association will apply as of the effective date of the S corporation election and will remain in effect until the entity makes a valid election to be classified as other than an association.

When this provision of the check-the-box regulations was adopted, the IRS explained that requiring eligible entities to file two elections in order to be classified as S corporations – Form 8832 and Form 2553 – creates a burden on those entities and on the IRS. The regulations sought to simplify these paperwork requirements by eliminating the requirement that the entity also elect to be classified as an association by filing Form 8832. Instead, an eligible entity that makes a timely and valid election to be classified as an S corporation by filing Form 2553 will be deemed to have elected to be classified as an association taxable as a corporation.

The regulation also provides that, if the eligible entity’s “S” election is not timely and valid, the default classification rules will apply to the entity unless the IRS provides late S corporation election relief or inadvertent invalid S corporation election relief.

Unless the IRS amends the regulations to expand the relief available thereunder beyond “S” elections, to cover eligible business entities in general, a taxpayer seeking a particular entity classification for tax purposes must file Form 8832. It will not be enough that the taxpayer has otherwise acted consistently with the desired status.

Proposed RegulationsLast week, we considered (i) the context in which the recently proposed regulations under Section 2704 of the Code would eventually be applied, (ii) the principles underlying Section 2704, (iii) the valuation of an interest in a closely-held business, generally, and (iv) the failed legislative efforts to address the issues covered by the proposed regulations. Today, we turn to the proposed rules themselves.

The 2016 Proposed Regulations – In General

The preamble to the proposed regulations could have been lifted verbatim from the 2010 through 2013 Green Books. Indeed, any tax adviser would be hard-pressed to say that he had no idea what was going to be included in the proposed regulations (which is why their prospective effective date is generous).

Main Themes

There are two main themes that permeate the regulations, and they reflect the legislative intent behind Section 2704.

First, if there is a lapse of any voting or liquidation right upon the transfer of an interest in a business entity, and the individual transferor who held such right immediately before the lapse holds control of the entity – with members of his family – both before and after the lapse, such lapse will be treated as a transfer by such individual by gift, or as a transfer which is includible in his gross estate, whichever is applicable.

In other words, because the lapsed right can be restored after the transfer by the transferor and his family, the lapse must have been provided only for valuation purposes, and did not have an independent, non-tax purpose, or so the theory goes.

Second, a restriction that limits the ability of a business entity to liquidate will be disregarded in valuing the transfer of an interest in the business to a member of the transferor’s family if the transferor and members of his family control the entity before the transfer, and the restriction may be removed by them after the transfer.

This echoes the first theme: a restriction that may be toggled on and off by the transferor and his family must not be meaningful, other than for valuation purposes, or so the theory goes.

The elements shared by these themes are (i) the presence of “transferor/family control” of an entity both before and after the transfer of an interest in the entity, and (ii) the ability of the transferor and his family to restore any lapsed rights and to remove any restrictions.

The 2016 Proposed Regulations – Specific Provisions

The following discussion will focus upon what I regard as the principal “entity-planning-related” changes to the current regulations.

Single-Member LLCs

The proposal would clarify that Section 2704 applies to the transfer of an interest in a single-member LLC (and not just to corporations and partnerships, as is literally stated in the statute), even if the LLC is disregarded as an entity separate from its owner for tax purposes.

In other words, an LLC’s classification for other purposes of federal tax law is irrelevant for valuation purposes. A taxpayer’s transfer of a membership interest in his wholly-owned LLC will be treated as a transfer of an interest in a business entity – the LLC – not as a transfer of an interest in its underlying assets; and, thus, the value of such an interest will be determined in accordance with the terms of the LLC’s operating agreement, state law, and – more to the point – the regulations under Section 2704.

This proposed change is aimed at the Tax Court’s decision in Pierre, where the Court determined that valuation discounts may be applied to value the transfer an interest in an LLC that was wholly-owned by the transferor and that she had funded with liquid assets.

Three-Year Rule for “Deathbed (?) Transfers”

The proposal would address so-called “deathbed transfers” (a misnomer) that result in the lapse of a liquidation right.

You will recall the provision in the current regulations under which the transfer of an interest conferring a right is not treated as a lapse of that right if the right is not reduced or eliminated, but simply transferred to another.

For example, the transfer of a minority interest by a controlling shareholder, who thereby ceases to be a controlling shareholder, is not treated as a lapse of voting or liquidation rights as to the controlling shareholder even though it results in the transferor’s loss of control.

This kind of transfer is a staple among estate planners. It enables them to divide the ownership of a business between the taxpayer and his family (e.g., his spouse) without significant economic consequences, while positioning the taxpayer’s interest to be valued as something less than a controlling interest.

The proposed regulations are aimed at exactly this situation. They do not eliminate the exception, but narrow its application to transfers occurring more than three years before the transferor’s death. Thus, if the transferor dies within three years of the transfer, a lapse of a right covered by Section 2704 will be deemed to have occurred upon his death.

For example, in what turns out to be more than three years before his death, D transfers one-half of his X Corp. stock in equal shares to his three children. Section 2704 does not apply to the loss of D’s ability to liquidate X Corp. because the voting rights with respect to the transferred shares are not restricted or eliminated by reason of the transfer, and the transfer occurs more than three years before D’s death. However, had D died within three years of the transfers, the transfers would have been treated as the lapse of D’s liquidation right, occurring at D’s death.

This results in the creation of a phantom asset in the estate on which estate tax will have to be paid. Query how a taxpayer and the executor of his estate may pay for payment of the tax.

According to the proposal, this rule will apply to lapses occurring on or after the date the rules are finalized. Thus, they may cover transfers (and lapses) that have already occurred (before the proposals are finalized) if the transferor dies after the effective date of the regulations and not more than three years after the transfer.

I think it likely that the effective date will be amended to clarify that it covers transfers occurring after the effective date. (This was the approach taken when the subjective “in contemplation of death” provisions of Section 2035 of the Code were replaced by a similar three-year rule.)

The application of this proposed rule is bound to have some unintended consequences; a relatively young, healthy transferor who is hit by the bus while crossing the street is covered as much as a bed-ridden octogenarian who is adjusting his holdings for estate tax valuation purposes. However, the proposed bright-line test is reasonable when one considers its “actuarial underpinnings” and the universe of taxpayers whose estates it is likely to cover.

State Law Restrictions

The proposed regulations would refine the definition of “applicable restriction” by eliminating the comparison to the liquidation limitations of state law.

You will recall the provision in the current regulations that limits the definition of an applicable restriction to one that is more restrictive than the default rules under state law. Under this regulatory exception, a restriction will not be disregarded for valuation purposes if it is not more restrictive than the default rule under the applicable state law.

The proposal would remove this exception. The reasoning for the removal is consistent with the purpose of Section 2704. Any restriction that is not imposed or required by federal or state law is a restriction that the transferor and his family can remove or replace with a less restrictive one. It is an applicable restriction that will be disregarded for valuation purposes.

If an applicable restriction is disregarded, the fair market value of the transferred interest is determined under generally applicable valuation principles as if the restriction did not exist (that is, as if the governing documents and the local law were silent on the question) and, thus, there is deemed to be no such restriction on liquidation of the entity.

The proposal also clarifies that an applicable restriction does not include a restriction that is imposed or required to be imposed by law. A provision of law that applies only in the absence of a contrary provision in the governing documents, or that may be superseded with regard to a particular entity (whether by the shareholders, partners, members and/or managers of the entity or otherwise), is not a restriction that is imposed or required to be imposed by law.

Although I have no argument with this position in the case of a family-owned investment company holding marketable securities (in which liquid assets to pay a withdrawing owner are available or can be readily obtained), its application to a family-owned business or real estate entity seems unreasonable. Most closely-held operating businesses, including those that are family-owned, seek to limit the withdrawal of capital from the entity for bona fide business reasons and, so, restrict the ability of an owner to liquidate his interest in the business.


Taxpayers have attempted to avoid the application of Section 2704 through the transfer of a partnership interest to an assignee, rather than to a partner. Again, relying on the regulatory exception for restrictions that are no more restrictive than those under state law, and the fact that an assignee is allocated partnership income, gain, loss, etc., but does not have the rights or powers of a partner, taxpayers have argued that an assignee’s inability to cause the partnership to liquidate his or her partnership interest is no greater a restriction than that imposed upon assignees under state law. Thus, taxpayers have argued that the conversion to assignee status of the transferred partnership interest is not an applicable restriction.

The proposed regulations provide that a transfer that results in the restriction or elimination of any of the rights or powers associated with the transferred interest (an assignee interest) will be treated as a lapse, within the meaning of Section 2704, the value of which will be taxable.

New Disregarded Restrictions

As indicated in the Obama administration’s Green Books, and pursuant to the authority granted under Section 2704 itself, the IRS has identified a new class of restrictions that are to be disregarded for valuation purposes.

According to the proposal, where an interest in a family-controlled entity is transferred, any restriction on an owner’s right to liquidate his interest (as opposed to liquidating the entity) will be disregarded for valuation purposes if the transferor and/or his family may remove or override the restriction.

Under the proposal, a “disregarded restriction” includes one that:

  • limits the ability of the holder to liquidate the interest, or
  • limits the liquidation proceeds to an amount that is less than a “minimum value”, or
  • defers the payment of the liquidation proceeds for more than six months, or
  • permits the payment of the liquidation proceeds in any manner other than cash or “other property” (generally excluding promissory notes).

For purposes of this rule, the “minimum value” of an interest is defined as the interest’s share of the net value of the entity on the date of liquidation or redemption. It is basically a liquidation value: the interest’s share of the proceeds remaining after the deemed sale of the entity’s assets at fair market value, and the deemed satisfaction of its liabilities.

Again, if we are considering a family investment vehicle holding marketable securities, I have no issue with the proposal. Such an entity can easily generate the liquidity needed, or distribute marketable assets, to redeem or liquidate a member’s interest in a timely manner.

What about a family-owned operating business? The IRS acknowledges the “legitimacy” of such a business. For example, a provision in an agreement that permits the payment of the liquidation proceeds by way of a promissory note will not be disregarded under the proposal if the proceeds are not attributable to passive investment assets, and the note is adequately secured, provides for periodic payments, bears a market rate of interest, and has a present value equal to the minimum value.

Even so, the IRS ignores the fact that close businesses will often require a “haircut” on the redemption price for someone’s interest, in part to dissuade owners from withdrawing, whether to prevent competition or to preserve capital for the business, or for some other valid business purpose.

It should be noted that the proposed regulations include an exception to these otherwise disregarded restrictions. Unfortunately, it requires the inclusion of certain provisions in the partnership or shareholders’ agreement that are rarely found even in a business owned by unrelated persons. Specifically, the exception applies if:

  • each owner has the right to put his interest to the business in exchange for cash and/or other property at least equal to the minimum value; and
  • the full amount of such purchase price must be received within six months after the owner has given notice of his intent to exercise his put right; and
  • such “other property” does not include a note, unless the entity is engaged in an active business and the note satisfies certain requirements.

If a restriction is disregarded, the fair market value of an interest in the entity is determined assuming that the disregarded restriction did not exist. The fair market value is determined under generally accepted valuation principles, including any appropriate discounts or premiums.

Ignoring Certain Unrelated “Owners”

In determining whether the transferor and/or the transferor’s family has the ability to remove a restriction, any interest in the entity held by a person who is not a member of the transferor’s family will be disregarded under the proposal if, at the time of the transfer, the interest:

  • has been held by such person for less than three years; or
  • constitutes less than 10 percent of the equity in the entity; or
  • when combined with the interests of all other persons who are not members of the transferor’s family, constitutes less than 20 percent of the equity in the entity; or
  • any such person, as the owner of an interest, does not have an enforceable right to receive in exchange for such interest, on no more than six months’ prior notice, the “minimum value.”

If an ownership interest is disregarded, the determination of whether the family has the ability to remove the restriction will be made assuming that the remaining interests are the sole interests in the entity.

This provision is aimed at the suspect practice of trying to avoid the application of Section 2704 through the transfer of a nominal business interest to a nonfamily member, such as a charity or an employee, to “ensure” that the family alone does not have the power to remove a restriction.

In the case of a charity, it is likely that this practice has been limited to investment entities that hold marketable securities. A charity would likely not be interested in acquiring an interest in an operating business with its potential for generating unrelated business taxable income and a limited ability to monetize its ownership interests.

What’s Next?

Two bills have been introduced in the House of Representatives this month that seek to void the proposed regulations. Neither of these will get very far.

As mentioned in an earlier post, the IRS has scheduled hearings on the proposed regulations for December 1, 2016. It is expected that many comments will be submitted by the November 2 deadline and, hopefully, considered.

Ignoring the fact that the results of the Presidential and Congressional elections may render the proposed regulations moot, my hope is that the IRS will refocus the proposals so that they are limited to family-owned investment entities, and not operating businesses.

As for investment entities, the regulations should distinguish between those that hold real estate and those that hold marketable securities and cash equivalents. Only the latter are appropriate subjects for the proposed rules.

Assuming the IRS proceeds with the hearings scheduled for December 1, and assuming it accepts some of the changes being suggested by the professional community, the regulations will likely not be finalized until at least early 2017. If the IRS rejects this commentary, the regulations may become effective on December 1.

Stay tuned.

In yesterday’s post, we considered the context in which the recently proposed regulations under Section 2704 of the Code will eventually be applied. Today, we will discuss Section 2704 and the valuation of an interest in a closely-held business. We will also review the failed legislative efforts to address the issues covered by the regulations.

Valuation Principles

Both the courts and the IRS have defined the “fair market value” of property as the price at which the property would change hands between a willing buyer and a willing seller, neither being under any compulsion to buy or sell, and both having reasonable knowledge of relevant facts.

According to the IRS, shares of stock of a closely-held corporation should be valued based upon a consideration of the factors affecting its fair market value, including the size of the block of stock to be valued. Indeed, the IRS has concluded in a public ruling that a minority interest in a closely-held corporation is more difficult to sell than a similar block of publicly-traded stock.

The IRS’s regulations echo this point, providing that the fair market value of shares of stock is to be determined by taking into consideration the degree of control of the business represented by the block of stock to be valued. Thus, a willing buyer may not pay a willing seller a proportionate share of the value of a closely-held business when purchasing a minority interest in the business.

Among other factors to be considered in the valuation of closely-held stock, the IRS has noted, is whether the stock is subject to an agreement restricting its liquidation, sale or transfer. The IRS has observed that it is always necessary to consider the relationship between the parties to the agreement, the relative number of shares held by the taxpayer, and other material facts, to determine whether the agreement represents a bona fide business arrangement or a device to pass the taxpayer’s shares to his family for less than an adequate and full consideration in money or money’s worth.

Section 2704 Is Born

The year is 1990. By that time, many courts had held that, because the fair market value of an interest in a family-held business was determined at the moment of death, the value attributable to a voting or liquidation right that lapsed under the terms of a partnership or shareholders’ agreement upon the death of an owner, could not be taken into account in valuing the interest and, thus, was not subject to estate tax.

As a result, the value for transfer tax purposes of the decedent’s equity interest in the business was determined by the courts to be less than its value either in the hands of the decedent immediately before death (i.e., before the lapse) or in the hands of his family immediately after his death (when the family could restore the “lapsed” right).

Congress moved to prevent this result and to tax the “lost” value attributable to the lapsed right, by providing, in new Section 2704 of the Code, that the lapse of a voting or liquidation right in a family-controlled entity results in a transfer by gift or an inclusion in the gross estate.

Example 1. Parent and Child control a corporation. Parent’s stock has a voting right that lapses on Parent’s death. Parent’s stock is valued for Federal estate tax purposes as if the voting right of the parent’s stock were non-lapsing.

Example 2. Father and Child each own general and limited interests in a partnership. The general partnership interest carries with it the right to liquidate the partnership; the limited partnership interest has no such right. The liquidation right associated with the general partnership interest lapses after ten years. There is a gift at the time of the lapse equal to the excess of (1) the value of Father’s partnership interests determined as if he held the right to liquidate over (2) the value of such interests determined as if he did not hold such right.

However, Congress also stated that this new rule regarding lapsing rights would not affect “minority discounts or other discounts” available under the law. In other words, the IRS’s public ruling and regulations described above, that identified the size of one’s holding in a business as a factor to consider in the valuation of such holding, would continue to apply. In other words, Congress did not seek the elimination of valuation discounts by enacting Section 2704.

In addition to the issue of lapsing rights, Congress also addressed restrictions agreed to among the owners of a family business that effectively limited the ability of the family-owned entity to liquidate. Such a restriction, it said, would be ignored in valuing a transfer among family members if (1) the transferor and family members control the business, and (2) the restriction can be removed by the transferor or members of his family, either alone or collectively.

Example 3. Mother and Son are partners in a two-person partnership. The partnership agreement provides that the partnership cannot be terminated. Mother dies and leaves her partnership interest to Daughter. As the sole partners, Daughter and Son acting together could remove the restriction on partnership termination. The value of Mother’s partnership interest in her estate is determined without regard to the restriction.

Recognizing that other situations may present similar valuation issues or potential abuses, Congress authorized the IRS to identify other restrictions that should be disregarded for valuation purposes; specifically, restrictions that reduced the value of the transferred interest for transfer tax purposes but which did not reduce the value of the interest to the transferee.

The First Set of Regulations

Shortly after its passage, in 1991 the IRS proposed regulations under Section 2704.

The IRS explained that the lapse of a voting or liquidation right was a transfer for estate and gift tax purposes only if the holder of the lapsing right and members of his family controlled the business both before and after the lapse; for example, the holder and his family can, immediately after the lapse, liquidate an interest the holder could have liquidated prior to the lapse.

Conversely, if the holder’s family cannot recover the value lost as a result of the lapse, the lapse is not of the type to which Section 2704 is directed.

The IRS explained that a lapse of a right occurs when the right is reduced or eliminated.

This last factor was important because it provided the basis for the following provision of the existing regulations: the transfer of an interest conferring a right is not treated as a lapse of that right if the right was not reduced or eliminated, but simply transferred to another.

For example, the transfer of a minority interest by a controlling shareholder, who thereby ceases to be a controlling shareholder, is not a lapse of voting or liquidation rights as to the controlling shareholder even though it results in the transferor’s loss of control; the voting right associated with the transferred interest continues to exist.

Consistent with Section 2704, the regulations provided that, in valuing a transfer of an interest in a business to a family member, certain restrictions on the ability to liquidate the business are to be disregarded if (1) the transferor’s family controls the business entity immediately before the transfer, and (2) the transferor and members of his family can remove the restriction immediately after the transfer.

Importantly – and notwithstanding the general theme of “family control” under Section 2704 (and its assumption that a family could add or remove a restriction at will) – when the regulations were finalized in 1992, the IRS provided that a restriction would not be disregarded if it was not more restrictive than the default rule under the applicable state law. The fact that the family could agree to a less restrictive provision was not relevant.

“Family Attribution”

In 1993, the year following the issuance of final regulations under Section 2704, the IRS issued a public ruling in which it held that, if a donor transfers shares in a corporation to each of the donor’s children, the factor of corporate control in the family would not be considered in valuing each transferred interest for purposes of the gift tax.

For estate and gift tax valuation purposes, the IRS stated that it would not assume that all voting power held by family members may be aggregated for purposes of determining whether the transferred shares should be valued as part of a controlling interest.

Consequently, a minority discount would not be disallowed, the IRS stated, solely because a transferred interest when aggregated with interests held by family members, would be part of a controlling interest.

It should be noted that the above ruling made no mention of then-recently enacted Section 2704 and the concept that the taxpayer’s family could, if it controlled the entity immediately after the taxpayer’s transfer of an interest in the entity, either restore the lapsed right or remove the restriction. Indeed, it seems reasonable to conclude that the IRS recognized Congress’s intent that Section 2704 did not affect otherwise available “minority discounts or other discounts.”

The Green Books: 1999 through 2001

The IRS’s 1993 ruling opened the flood-gates to the gifting of interests in family-owned business entities. Many advisers and their clients sought to leverage the opportunity for valuation discounting, not only as to family operating businesses and real estate investments but also with respect to liquid investment assets. They prepared partnership and operating agreements with restrictive provisions that literally did not run afoul of Section 2704 and its regulations, and that supported lower values for the business interests being transferred.

According to the Clinton administration’s budget proposals from 1999 through 2001:

Under current law, taxpayers making gratuitous transfers of fractional interests in entities routinely claim discounts on the valuation of such interests.

The concept of valuation discounts originated in the context of active businesses, where it has long been accepted that a willing buyer would not pay a willing seller a proportionate share of the value of the entire business when purchasing a minority interest in a non-publicly traded business.

Without legislation in this area, tax planners have carried this concept over into the family estate planning area, where a now common planning technique is to contribute marketable securities to a family limited partnership or LLC and to make gifts of minority interests in the entity to other family members. Taxpayers then claim large discounts on the valuation of these gifts.

This disappearing value is illusory because family members are not minority interest holders in any meaningful sense.

The Clinton administration’s proposal sought to eliminate valuation discounts except as they applied to active businesses.

The Green Books: 2010 through 2013

The Clinton administration failed in its efforts. The Obama administration then took a different approach to curbing what it saw as valuation abuses in family gift tax planning.

According to its budget proposals from 2010 through 2013:

Section 2704 was enacted to prevent the reduction of taxes through the use of techniques designed to reduce the value of the transferor’s taxable estate and discount the value of the taxable transfer to the beneficiaries of the transferor when the economic benefit to the beneficiaries is not reduced by these techniques.

Generally, section 2704(b) provides that certain ‘applicable restrictions’ (that would normally justify discounts in the value of the interests transferred) are to be ignored in valuing interests in family-controlled entities if those interests are transferred (either by gift or on death) to or for the benefit of other family members.

Without referring to the regulations under Section 2704, it went on to say:

Judicial decisions and the enactment of new statutes in most states have, in effect, made section 2704(b) inapplicable in many situations, specifically by re-characterizing restrictions such that they no longer fall within the definition of an ‘applicable restriction’.

In addition, the IRS has identified additional arrangements to circumvent the application of section 2704.

This proposal would create an additional category of restrictions (‘disregarded restrictions’) that would be ignored in valuing an interest in a family-controlled entity transferred to a member of the family if, after the transfer, the restriction may be removed by the transferor and/or the transferor’s family.

Specifically, the transferred interest would be valued by substituting for the disregarded restrictions certain assumptions to be specified in regulations.
Disregarded restrictions would include limitations on a holder’s right to liquidate that holder’s interest that are more restrictive than a standard to be identified in regulations.

For purposes of determining whether a restriction may be removed by members of the family after the transfer, certain interests (to be identified in regulations) held by charities or others who are not family members of the transferor would be deemed to be held by the family.

After failing to convert any of these proposals into legislation, the Obama administration ceased including them in its budget proposals from 2014 thru 2017.

However, during this period, the IRS indicated that it was working on proposed regulations under Section 2704 – the regulations that were issued last month.

In next week’s post, we will consider these proposed regulations in some detail.

“The” Proposed Regulations

They were years in the making – proposed regulations that seek to address what the IRS believes are abuses in the valuation of family-owned business and investment entities. Based upon the volume of commentary generated in response to the proposed rules, it is clear that the IRS has struck the proverbial raw nerve. It is difficult to recall the last time there was this much interest in proposed estate tax and gift tax rules. Almost every tax adviser under the sun has issued a client advisory. Many of these have been quite critical of the proposed rules. All have urged clients to act now, before the rules are finalized, or face the prospect of paying millions of dollars in transfer tax later.

By way of comparison, when the original version of these regulations was proposed in 1991, the year after the enactment of the legislation under which the regulations are being issued, the IRS received only one set of comments from the tax bar before finalizing them in 1992.

I think it’s safe to say that the IRS will be inundated with comments, questions and suggestions this time around. I daresay that, by the time the November 2, 2016 deadline for such comments arrives, the IRS may decide that it has to add an additional day of hearings to the single, currently scheduled day of December 1, 2016.

Given the importance of these proposed regulations, the amount of attention that they have garnered, and the calls-to-action from the estate tax planning bar, today’s post – which will be the first of three posts on the proposed regulations – will try to provide some historical and theoretical context for the regulations. In this case, historical perspective is important not only for purposes of understanding the regulations, but also in appreciating the “valuation options” that remain available. Tomorrow’s post will consider Section 2704 of the Code and the valuation of an interest in a closely-held business, generally. The third and final post will appear next week, and will discuss and comment on the technical aspects of the proposals, themselves.

Planning, In General

In order to better appreciate the effect of the proposed regulations, we need to first consider the traditional goal of estate tax and gift tax (“transfer tax”) planning, which has been to remove valuable, preferably appreciating, assets from a taxpayer’s hands.

In the case of interests in a family-owned business, a related goal has been to structure and/or reduce the taxpayer’s holdings in the business in such a way so as to reduce their value for purposes of the estate tax, to thereby reduce any resulting tax liability and, thus, to maximize the amount passing to the taxpayer’s family.

Over the years, many transfer techniques and vehicles have been developed to assist the taxpayer in accomplishing the goal of removing assets from his estate, though some of these vehicles/techniques have, themselves, been under attack by the IRS. In connection with the transfer of business interests, planners have used, among other things, GRATs, sales to grantor trusts, sales in exchange for private annuities, sales in exchange for self-cancelling installment notes, recapitalizations into voting and non-voting interests, and simple gifts.

Each of these techniques, standing alone, enables the taxpayer to save transfer taxes on the transfer of an interest in a family-owned entity to members of his family, even without significant valuation discounting.

However, if the interest being transferred is valued on a favorable – i.e., significantly discounted – basis, the tax-saving impact of the transfer is multiplied. The taxpayer is effectively given a “head start.”

Saving On Taxes – It’s Not Everything

Although tax savings are obviously an important considerations in any gift/estate tax plan, the assets to be transferred must be “disposable” insofar as the transferor is concerned.

No doubt, many of you have fond memories of the final days of 2012, when many believed that the transfer tax exemption amount would revert to its 2001 levels. Many taxpayers rushed to make gifts as we approached the end of that year, lest they lose their ability to make large gifts free of transfer tax. Many acted without sufficient regard for their own personal needs, or their tolerance for loss of control. All that seemed to matter was that if they didn’t act right away, they would “lose” the ability to make transfers free of gift tax.

Following the “permanent” restoration of the $5 million exemption (indexed to $5.45 million for 2016; likely to approach $5.5 million in 2017), many of these same taxpayers sought to recover the gifted properties or to rescind the gifts. Clearly, many acted only for the transfer tax benefit. Not a good move.

A Cautionary Note

As stated above, many advisers are urging taxpayers to act quickly, before the proposed regulations are finalized, or face the prospect of enormous tax bills. To this I respond: remember 2012. In other words, does the gifting being considered make sense from a personal and business perspective? If not, then stop right there.

Next, I say, keep in mind the increased (and indexed) exemption amount, not to mention the portability of the exemption amount between spouses, which may allow a taxpayer to hold onto property until his demise.

Closely connected to this is the basis step-up, to fair market value, for property that a taxpayer owns at his date of death, and the ability afforded by the step-up to avoid or reduce future income taxes, capital gains taxes, and the surtax on net investment income.

Many individuals who have already implemented a gift program should also keep in mind that reduced valuation discounts may actually benefit them. For example, a GRAT that is forced to distribute interests in a closely-held business may have to distribute fewer equity units of the business to satisfy the trust’s annuity obligation if the units are valued at a greater amount than would result with the application of large discounts.

The Top Tier

Of course, in the case of more affluent taxpayers, gift tax planning retains its luster. For these folks, the proposed regulations, if finalized in their present form, may present a significant challenge.

For those very affluent individuals who have deferred their gift tax planning, it may be advisable to act now, before the regulations are finalized. The goal in acting now will be to secure larger valuation discounts, and lower transfer tax values, for the closely-held business interests to be transferred.

Even as to these taxpayers, however, caution should be exercised. They have been forewarned that the IRS does not have a favorable view of the items identified in the proposed regulations. In fact, many taxpayers have already experienced the IRS’s suspicion of these items; for the most part, the proposed regulations do not introduce new concepts – rather, they embody the IRS’s historical audit and litigation positions. Thus, these taxpayers (and their advisers) can expect a serious challenge by the IRS, and should be prepared for it.

Prospects for Change Before Going Final?

Many advisers believe that the IRS has exceeded its authority in issuing these regulations. They believe that the courts will strike down the proposed rules if finalized in their current form. That may be, but I would not bet on it, nor would I plan for it; if the courts speak at all, it will likely be years from now – the IRS and death wait for no one.

Moreover, I disagree with this assessment of the IRS’s authority. The 1990 enabling legislation granted the IRS significant authority to interpret the statute and to issue regulations. That being said, my guess is that the IRS will be responsive to some of the comments from the tax bar, which may include some tweaking of the effective date for one provision of the proposed rules.

As regards all other items covered by the proposed regulations, the clock is in fact running. The good thing is that the proposed regulations will be effective prospectively only. Of course, we don’t know when they will go final – December 1, 2016 (the scheduled hearing date) is a possibility, as is early 2017. Of course, we also have to await the outcome of the presidential election in November.

Tomorrow’s Post

Before we turn to the proposed regulations, tomorrow’s post will briefly describe some of the factors that are typically considered by the IRS in determining the value of an interest in a closely-held business, including the rules under Section 2704 of the Code.

Why Waive A Dividend?

For the most part, the shareholders of closely-held corporations and their counterparts in the public realm are subject to the same set of federal income tax rules. However, there are situations within each of these two realms where unique policy or practical considerations dictate the application of different sets of rules.

One such situation involves the declaration of a dividend by a closely-held corporation, and a shareholder’s waiver of his pro rata share thereof.

For example, assume an individual taxpayer owns 65% of the stock of a corporation, relatives of the taxpayer, including his children, own 25% of the stock, and the remaining 10% is owned by key employees of the corporation who are not related to the taxpayer. Due to the necessity of keeping abreast of competition by procuring new equipment, the immediate and long-term working capital requirements of the corporation are such that payments of dividends in large amounts cannot be made. In fact, no dividends have been paid by the corporation since its formation – not an usual circumstance for a close corporation. However, the minority shareholders, most of whom are relatives of the majority shareholder, feel that they are entitled to a proper return on their investment. In order to address this situation, the taxpayer “waives” his rights to any dividends to be declared by the corporation up to a date certain. This permits the distribution of dividends in substantial amounts to the minority shareholders, ostensibly to preserve their goodwill, without depleting the working capital of the corporation.

Upon examination of the above facts, it is likely that the benefits to be afforded the taxpayer’s relatives (including his children) by the waiver of his right to share in the dividend payments was the primary purpose for the waiver. The alleged business purpose to be served, namely, the payment of a larger dividend to minority stockholders, including some who are key employees, to maintain their goodwill is likely incidental. Since the amounts distributed to the minority stockholders do not impair the capital by any greater amount than if distributed pro rata to all shareholders, the waiver should not be considered necessary to protect the working capital of the corporation. Thus, the taxpayer’s waiver of his right to receive his pro rata share of any dividends declared by the corporation, through effecting payment of such pro rata share to his relatives as well as to his employees, should be considered the realization of income by him to the extent of any dividend payments waived. Moreover, the “excess” dividend received by his relatives and key employees should probably be treated as gifts and as compensation, respectively.

Bona Fide Business Purpose?

This is to be contrasted with a situation in which no family or direct business relationship exists between the majority and minority shareholders, and the arrangement is entered into only for bona fide business reasons. In that case, the IRS is likely to hold that the declaration of a dividend did not result in the receipt of income by a shareholder who had waived his right to share in the dividend. In addition, the “excess” dividend paid to the other shareholders is unlikely to be treated as other than a distribution in respect of their shares in the corporation.

A recent IRS ruling [Private Letter Ruling 201636036] illustrates such a situation. Individuals A and B were the beneficiaries and co-trustees of Trust. Prior to Year 1, Trust was the sole shareholder of SmallCo. In Year 1, SmallCo. entered into a merger agreement with BigCo. whereby SmallCo. became a wholly-owned subsidiary of BigCo. (the “Merger”). As consideration for the Merger, Trust exchanged its stock in SmallCo. for ownership of approximately X% of the post-Merger shares of BigCo. stock. The pre-Merger shareholders of BigCo. owned the remaining post-Merger shares of BigCo.

At the time of the Merger, BigCo. owned Note, a subordinated debt instrument related to a prior business venture. As a result of the degree of uncertainty as to the amount of any payment the holder of Note might eventually receive, BigCo. and SmallCo. were not able to agree on a fair market value for Note while negotiating the Merger. In order to proceed with the Merger, the two corporations agreed that for purposes of determining the Merger consideration owed to Trust, the value of Note would be treated as zero (resulting in Trust’s receiving a larger percentage of stock in BigCo.). The parties further agreed that, in the event that BigCo. disposed of Note within three years of the Merger, the proceeds from the disposition would be distributed to all shareholders of BigCo. other than Trust (or related transferees of Trust), and Trust agreed (on behalf of itself and any related transferees) to waive any and all rights to its pro rata share of such a distribution.

Later in Year 1, Trust transferred a portion of its holdings in BigCo. to Partnership, an LLC established for estate planning purposes and taxed as a partnership for federal income tax purposes. Partnership was owned by trusts formed for the benefit of the children of A and B. Partnership, as a related transferee of Trust, acknowledged and agreed to the terms of the Merger related to any distributions from the disposition of Note.

Before the end of Year 1, but after the Merger, BigCo. disposed of Note in a sale, and decided to distribute the proceeds of such sale as a dividend to its shareholders other than Trust and Partnership (the “non-waiving shareholders”).

Income to the Waiving Shareholder?

Gross income means all income received or realized by a taxpayer, from whatever source derived, including dividends. Of course, this may include amounts actually received by the taxpayer — i.e., reduced to the taxpayer’s possession. It may also include income that is not actually reduced to a taxpayer’s possession but that is constructively received by him. Thus, income that is credited to a taxpayer’s account, set apart for him, or otherwise made available so that he may draw upon it at any time, is treated as having been received by him.

A controlling shareholder will sometimes elect not to retain a dividend where the funds distributed are needed in the business of the distributing corporation. In that case, the “waiving” shareholder may elect to be treated as having received the dividend, being taxed thereon, and then returning the dividend amount to the corporation as a capital contribution (presumably in exchange for more stock) or as a loan to the corporation.

But what happens if a shareholder actually gives up his right to receive a dividend?

Generally, a majority shareholder who agrees to waive dividends (rather than simply not keep them) while other shareholders receive theirs does not realize income if there is no family or direct business relationship between the majority and minority shareholders, and the waiver is executed for valid business reasons.

However, the waiver by a majority shareholder of the right to receive a pro rata share of any dividends paid by a corporation will not be recognized for income tax purposes where such dividends are paid to, and redound primarily to the benefit of, his minority shareholder-relatives as increased dividends. In that case, income is realized by the majority shareholder to the extent of the increased distribution to the related shareholders resulting from the waiver.

Or Not? Ruling Conditions

The IRS identified four conditions that had to be satisfied before it would consider issuing a favorable ruling on a proposed waiver of dividends when the waiving and non-waiving shareholders are individuals: (1) a bona fide business reason must exist for the proposed waiver of dividends; (2) the relatives of the waiving shareholder must not be in a position to receive more than 20 percent of the total dividends distributed to the non-waiving shareholders; (3) the ruling will not be effective if any change in stock ownership (other than death) enables non-waiving relatives to receive more than 20 percent of the dividend; and (4) the ruling will not be effective after the third anniversary of the date of the ruling.

The IRS found there was a bona fide business reason for the proposed waiver of dividends described in the above ruling. The waiver was an express condition of the Merger between BigCo. and SmallCo. that would permit the pre-Merger shareholders of BigCo. to obtain the full value of their holdings, and prevent Trust and Partnership from receiving windfall profits from property they did not own.

Trust and Partnership also represented that relatives of their beneficiaries and members were not in a position (as shareholders of BigCo.) to receive, in the aggregate, more than 20 percent of the total dividends attributable to proceeds from the disposition of Note. Trust and Partnership also agreed that any ruling from the IRS would no longer be applicable if any change in the stock ownership of BigCo. enabled non-waiving relatives of the beneficiaries and members of Trust and Partnership to receive more than 20 percent of total dividends attributable to proceeds from the disposition of Note, unless the change occurs because of death. Furthermore, Trust and Partnership agreed that any ruling issued on the waiver of dividends would not be effective for a period longer than three years from the date of the ruling.

On the basis of the foregoing, the IRS concluded that the waiver by Trust and Partnership (in connection with the Merger) of the dividends resulting from the subsequent sale of Note would not result in gross income to either Trust or Partnership.

Be Aware

When advising a closely-held business and its owners in connection with any transaction, it is imperative that the tax adviser be familiar with the personal and business relationships among the owners. It is also important that the adviser understand the business purpose for the transaction, and that he be comfortable in defending its bona fide nature.

The importance of these factors is highlighted in the ruling described above.

Where these relationships have not been considered, and where the transaction at issue is not motivated primarily by a valid business purpose, the tax consequences to the various parties are likely to be other than what they hoped for and, in fact, reported.

I imagine that neither the client-taxpayer nor the adviser will appreciate being surprised.

The Adviser’s Dilemma

The tax adviser to a closely held business is often “encouraged” by his client to find ways to reduce the client’s federal, state and local tax bills. One obvious way of accomplishing this goal is by claiming a deduction for a business-related expense. NYC UBT

In considering whether such an expense is, in fact, deductible by his client, the adviser must bear in mind two basic principles of tax law: provisions granting a deduction are construed in favor of the taxing authority, and the extent to which a deduction is allowed is a matter of legislative grace to which the taxpayer must prove entitlement.

Sometimes, in his eagerness to save a client money, an adviser may fail to consider an issue thoroughly, including the arguments that a taxing authority may raise against the client’s position. As a result, additional professional fees are incurred in defending the taxpayer’s position, the desired tax benefit is lost, and penalties are often imposed. These consequences were illustrated in a recent decision involving a deduction claimed in calculating a taxpayer’s liability for New York City’s unincorporated business tax (“UBT”).


The UBT is imposed on the unincorporated business taxable income of every unincorporated business carried on within the City. An unincorporated business includes a partnership.

The unincorporated business taxable income of an unincorporated business is defined as the excess of its unincorporated business gross income over its unincorporated business deductions.

The unincorporated business deductions are the items of loss and deductions directly connected with or incurred in the conduct of the business, and which are allowable for federal income tax purposes for the taxable year, subject to certain modifications.

One of those modifications provides that no deduction is allowed to a partnership for amounts paid to a partner for services rendered by the partner. This is to be contrasted with payments by a partnership to partners that represent the value of any services provided to the partnership by the employees of the partner, for which a deduction is allowed.

Partner or Employee Services?

Limited Partnership (“LP”) had no employees – all of its activities were performed by its sole general partner (“GP”), an S corporation. GP’s employees serviced LP’s clients.

GP charged LP an annual management fee (the “Fee”) for the services it provided to or on behalf of LP. The amount of the Fee was based on the expenses the GP incurred to provide its services. The largest component of those expenses was the compensation GP paid to its employees for the services rendered to LP.

GP did not report the Fee as income for the Tax Year on its federal and UBT tax returns. Nor did it deduct the related expenses, including the compensation paid to its employees. Instead, LP reported each of GP’s operating expense items comprising the Fee, including the compensation GP paid to its employees who performed services for LP, as deductions on the corresponding lines of LP’s federal partnership income tax return (IRS Form 1065) and UBT return (Form NYC-204). As a result, all of the expenses GP incurred to operate LP were reported by LP as if LP had incurred them.

Although LP had no employees of its own, on its tax returns LP deducted as salary and wages the portion of the Fee it paid for the services of GP’s employees. GP, however, issued forms W-2 and filed employment tax returns to report the compensation paid to its employees.

At the beginning of the Tax Year, GP underwent a restructuring in which its employee-shareholders redeemed their shares in GP and were given limited partnership interests in LP. On the same date, additional employees of GP were given limited partnership interests in LP. As a result, following the restructuring, many of GP’s employees became limited partners in LP.

On LP’s UBT return for the Tax Year, LP deducted compensation paid to GP’s Employee-Partners.

The ALJ Disagreed . . .

The City audited LP’s UBT return for the Tax Year and disallowed LP’s deductions for salaries paid to the Employee-Partners and for amounts paid to the Employee-Partners’ pension plans.

The City asserted a UBT deficiency against LP, and an ALJ sustained the deficiency, concluding that LP’s payments to the Employee-Partners for their services were not deductible under the UBT rules.

The ALJ concluded that under the statute it was irrelevant that the payments were for services performed in a dual capacity, as employees of GP and as partners of LP, or that the payments were made to GP rather than directly to the Employee-Partners.

LP contended that the amounts it paid to GP for the services of the Employee-Partners were not amounts paid or incurred to a partner for services under the UBT rules because the Employee-Partners were employed by GP and performed the services for their employer (GP), not LP.

LP further contended that its payments fell within an exception to disallowance of the deduction under the UBT rules (the “Exception”). The Exception provides that payments to a partner for services are allowed as a deduction to the extent attributable to the services of the partner’s employees. LP argued that it satisfied the requirements of the Exception because the Employee-Partners were employees of GP. In addition, LP asserted that it was irrelevant to the operation of the Exception that the Employee-Partners are also partners in LP.

The City countered that, as a matter of substance, the payments in question were made to GP for the services of the Employee-Partners (who were partners in LP) and, therefore, were not deductible under the UBT rules.

. . . So Did the Tribunal And . . .

The NYC Tax Appeals Tribunal affirmed the ALJ’s determination, and LP appealed to the Appellate Division, which affirmed the Tribunal in a summary decision.

LP paid a management fee to GP for its services. According to the Tribunal, because the payment was to a partner for services, the UBT rules denied a deduction for the entire amount of the payment.

The Exception carves out an exception to the denial of the deduction where the partner’s services are performed by employees of the partner. The Exception provides:

. . . payments to partners for services do not include amounts paid or incurred by an unincorporated business to a partner of such business which reasonably represent the value of services provided the unincorporated business by the employees of such partner, and which . . . would constitute allowable business deductions . . . . The amounts paid or incurred for such employee services must be actually disbursed by the unincorporated business and included in that partner’s gross income for Federal income tax purposes.

Strike One

LP read the Exception broadly to include compensation paid to any employee of GP, regardless of whether the employee was also a partner in LP. Thus, LP contended that, under the Exception, LP could deduct the portion of its payment to GP representing compensation for the services of the Employee-Partners.

The Tribunal rejected LP’s reading of the Exception. LP’s reading of the Exception, it stated, was incompatible with a clear statutory policy to deny a deduction for payments to a partner for services.

Significantly, the UBT rules provide:

Amounts paid or incurred to an individual partner of the unincorporated business for services provided the unincorporated business by such an individual shall not be allowed as a deduction . . . .. The fact that the individual is providing such services not in his capacity as a partner within provisions of Sec. 707 of the Federal Internal Revenue Code will not change the result. (emph. added)

Under the UBT rules, LP’s payments to an individual partner for services were not deductible. The Employee-Partners were not merely employees of GP but were also individual partners in LP.

According to the Tribunal, the UBT rules made it clear that LP’s payment to GP for the services of the Employee-Partners was not deductible. Similarly, LP’s overly broad interpretation of the Exception, to allow a deduction for the services of a partner’s employees who are also partners, had to be rejected as contrary to the statute.

Strike Two

The Tribunal also rejected LP’s related argument that the portion of the Fee paid to GP representing compensation to the Employee-Partners was deductible because it was paid for services of the Employee-Partners in their capacity as employees, not as partners. The Tribunal pointed out that General Partner did not report the Fee as income on its federal and UBT tax returns. If the payment was not reported as income, it was rational for the UBT rules to deny the deduction, it stated.

Furthermore, because LP reported GP’s employees, including the Employee-Partners, as its own employees on its federal and UBT tax returns, the Exception did not apply. It applies only to payments for the services of a partner’s employees, not employees of the unincorporated business. The form in which LP reported its income and expenses removed it from the scope of the Exception.

Strike Three

LP argued that it did not pay the Employee-Partners for their services. Instead, it paid a Fee to GP which, in turn, compensated its employees for the work performed for GP. Therefore, LP argued the payments were not amounts paid to a partner. The Tribunal responded that this argument ignored the fact that LP paid the Fee directly to GP, who performed the services directly for LP.

In advancing this argument, LP took the position that payments to GP for the services of the Employee-Partners were payments to a third party and not within the scope of UBT Rules, which LP read as applying only to amounts paid directly to a partner. LP argued that the City had no authority to elevate substance over form to disallow third-party payments for partner services.

The Tribunal rejected this argument, holding that the taxing authority was not bound by the form of the payments, and could look to the economic substance of an arrangement to determine its tax consequences:

Tax legislation should be implemented in a manner that gives effect to the economic substance of the transactions . . . and the taxing authority may not be required to acquiesce in the taxpayer’s election of a form for doing business but rather may look to the reality of the tax event and sustain or disregard the effect of the fiction in order to best serve the purposes of the tax statute . . . .

The Tribunal considered the substance of the payments and found that they were not deductible, regardless of whether they were made directly to the Employee-Partners or to GP for their services.

Did You Notice?

LP had one argument that it presented in three slightly different ways. This argument failed at the audit stage, it was rejected by the ALJ, and then by the Tax Appeals Tribunal. Was it any surprise that the Appellate Division dismissed it with a summary decision?

It bears repeating: a deduction is a matter of legislative grace, and the provision granting it will be construed in favor of the taxing authority.

To make matters worse, in the present case, the UBT rules expressly stated that amounts paid to a partner for services were not deductible by the partnership regardless of the capacity in which such services were provided.

As always, it will behoove the tax adviser, and ultimately the closely held business client, to proceed with caution and to be thorough in his approach toward the issue being addressed before recommending a course of action. This includes a consideration of the arguments that will be presented in defense of one’s position in the event it is ever challenged by a taxing authority. No time like the present.

Same Old Story

This probably sounds familiar: You are reviewing an already-filed tax return for a closely held business, and you see that the balance sheet reflects a liability that is identified as “loans from shareholders.” You ask to see the loan agreement or promissory note that memorializes the loan. “There aren’t any,” you are told. You then ask for the board or management resolutions that approved the loan – you are answered with a blank stare. You then ask what the terms of the loan are: interest rate, payment terms, maturity date, collateral? Again, silence – it’s deafening. “Have you at least reported imputed interest income?” you ask. “Was I supposed to?” comes the response.Balance Sheet
“Not again,” you think to yourself, but you inquire anyway, as hope springs eternal: “What did you intend by transferring these funds to the business entity? Were these really intended to be loans, or capital contributions?”

Here it comes – wait on it – “What would be better for me?” asks the business owner.

By now, you know this blog’s mantra: “plan in advance, leave little to chance.”

Every now and then, however, a taxpayer who has not dotted and crossed the proverbial “i’s” and “t’s” catches a break, as illustrated by a recent Tax Court decision.

Funding the Business

Taxpayer was an S corporation, and Shareholder was its sole shareholder and sole corporate officer.

Although it had a “rough start,” Taxpayer’s business quickly grew. On several occasions, Taxpayer was forced to move to larger locations to meet increased demand. In order to fund Taxpayer’s growth, Shareholder began raising money from various sources. In 2006, he established a home equity line of credit. In no time, he had drawn on the entire line and advanced the funds to Taxpayer. Shareholder then established another line of credit by refinancing a home mortgage, the entire amount of which he advanced to Taxpayer. In 2008, he established a general business line of credit and advanced all the funds to Taxpayer. Shareholder also borrowed from his family and advanced all the funds to Taxpayer throughout 2007 and 2008.

Taxpayer reported all of the advances as loans from Shareholder on its general ledgers and on its Forms 1120S, U.S. Income Tax Return for an S Corporation, but there were no promissory notes between Shareholder and Taxpayer, there was no interest charged, and there were no maturity dates imposed.

Times Got Hard

While Taxpayer was initially profitable, there was a decline in business in 2008, with the recession. Because Shareholder was unable to borrow from commercial banks, he financed Taxpayer’s operations from 2009 through 2011 by borrowing additional funds from his family and then advancing the funds to Taxpayer. Shareholder also began charging business expenses to his personal credit cards. Again, there were no promissory notes executed between Shareholder and Taxpayer, but Taxpayer reported the advances on its general ledgers and tax returns as loans from Shareholder.

Taxpayer reported operating losses during the years at issue (2010 and 2011). During the same years, Taxpayer paid significant personal expenses of Shareholder by making payments from its bank account to Shareholder’s creditors. These payments made on behalf of Shareholder were treated on Taxpayer’s general ledgers and tax returns as repayments of Shareholder loans. Taxpayer did not deduct the payments made on behalf of Shareholder as business expenses.

Shareholder worked full-time for Taxpayer, and occasionally employed other individuals to help with Taxpayer’s operations. Taxpayer filed employment tax returns, and paid employment taxes on wages paid to each employee except Shareholder – Taxpayer did not report paying wages to Shareholder during the years at issue.

Wages or Repayments of Debt?

The IRS determined that Shareholder was an employee of Taxpayer for the years at issue, and that Taxpayer’s payment of Shareholder’s personal expenses constituted wages that should have been subject to employment taxes.

Taxpayer petitioned the Tax Court to decide whether Taxpayer’s payment of personal expenses on behalf of Shareholder should be characterized as wages subject to employment taxes.

Employers are required to make periodic deposits of amounts withheld from employees’ wages and amounts corresponding to the employer’s share of FICA and FUTA tax.

“Employee” is defined for FICA and FUTA purposes to include “any officer of a corporation” and “any individual who, under the usual common law rules applicable in determining the employer-employee relationship, has the status of an employee.” An officer of a corporation who performs more than minor services and receives remuneration for such services is a “statutory” employee for employment tax purposes.

Taxpayer did not object to the IRS’s determination that Shareholder was its employee for the years at issue: Shareholder was Taxpayer’s only officer, and he performed substantial services for Taxpayer. Accordingly, Shareholder was an employee of Taxpayer for the years at issue.

The Court’s Analysis

The central issue for the Court was whether Taxpayer’s payments made on behalf of Shareholder should have been characterized as wages subject to employment taxes.

Taxpayer argued that the advances Shareholder made to it were loans and that payments made on behalf of Shareholder represented repayments of those loans.

The IRS argued that the funds advanced to Taxpayer were contributions to capital and that payments made on behalf of Shareholder were wages.

The Court began by explaining that proper characterization of the transfers to Taxpayer as either loans or capital contributions had to be made by reference to all the evidence. Taxpayer had the burden of proving that the transfers were loans.

Courts have established a non-exclusive list of factors to consider when evaluating the nature of transfers of funds to closely held corporations. Such factors include:

(1) the names given to the documents that would be evidence of the purported loans;
(2) the presence or absence of a fixed maturity date;
(3) the likely source of repayment;
(4) the right to enforce payments;
(5) participation in management as a result of the advances;
(6) subordination of the purported loans to the loans of the corporation’s creditors;
(7) the intent of the parties;
(8) identity of interest between creditor and stockholder;
(9) the ability of the corporation to obtain financing from outside sources;
(10) thinness of capital structure in relation to debt;
(11) use to which the funds were put;
(12) the failure of the corporation to repay; and
(13) the risk involved in making the transfers.

According to the Court, these factors serve only as aids in evaluating whether transfers of funds to a closely held corporation should be regarded as capital contributions or as bona fide loans. No single factor is controlling.

The ultimate question is whether there was a genuine intention to create a debt, with a reasonable expectation of repayment, and whether that intention comported with the economic reality of creating a debtor-creditor relationship.

Transfers to closely held corporations by controlling shareholders, the Court stated, are subject to heightened scrutiny, however, and the labels attached to such transfers by the controlling shareholder through bookkeeping entries or testimony have limited significance unless these labels are supported by other objective evidence.

What Was Intended?

In its analysis, the Court focused on: the relative financial status of Taxpayer at the time the advances were made; the financial status of Taxpayer at the time the advances were repaid; the relationship between Shareholder and Taxpayer; the method by which the advances were repaid; the consistency with which the advances were repaid; and the way the advances were accounted for on Taxpayer’s financial statements and tax returns.

The Court reviewed the evidence of Shareholder’s intention to create a debtor-creditor relationship with Taxpayer. Taxpayer reported the advances as loans on its general ledgers and its tax returns. Taxpayer’s balance sheets reported Shareholder’s advances as increases in loans from Shareholder each year. Additionally, Taxpayer consistently reported the expenses it was paying on behalf of the Shareholder as repayments of loans rather than as business expenses. While the Court recognized that transfers by Shareholder as the controlling shareholder (and the corresponding labels attached to such transfers) were subject to heightened scrutiny, it believed Shareholder provided enough objective evidence to overcome the higher standard.

The Court found that this consistent reporting indicated Shareholder and Taxpayer intended to form a debtor-creditor relationship and that Taxpayer conformed to that intention. Taxpayer’s payments on behalf of the Shareholder were consistent regardless of the value of the services Shareholder provided to Taxpayer. Many of the payments Taxpayer made were the Shareholder’s recurring monthly expenses, including his home mortgage and personal vehicle loan payments. The consistency of these payments, both in time and in amount, the Court noted, was characteristic of debt repayments. Finally, and most importantly, the fact that Taxpayer made payments when it was operating at a loss strongly suggested a debtor-creditor relationship existed. “A fundamental difference between a creditor and an equity investor is that the former expects repayment of principal and compensation for the use of money * * * whereas the latter understands that the return of its investment, and any return on that investment, depend on the success of the business.”

Consequently, the Court decided that Shareholder’s advances were intended to be loans because Shareholder was repaid even when the business was operating at a loss and the repayments were, therefore, not dependent on the success of the business.

Expectation of Repayment

The Court turned next to the question of whether Shareholder had a reasonable expectation of repayment.

When Shareholder advanced funds to Taxpayer during 2006 through 2008, the business was well-established and successful. Because Taxpayer was operating profitably and showed signs of growth, the Court believed that Shareholder was reasonable in assuming his loans would be repaid. Accordingly, the Court found that Taxpayer and Shareholder intended the advances to create debt rather than equity, that there was a reasonable expectation at the time the initial advances were made that such advances would be repaid, and that such intention comported with the economic reality of creating a debtor-creditor relationship.

Although the Court recognized that Shareholder’s advances had some of the characteristics of equity – the lack of a promissory note, the lack of a definitive maturity date, and the lack of a repayment schedule – it did not believe those factors outweighed the evidence of intent.

However, the Court could not find that all of the advances were loans. While it believed that Shareholder had a reasonable expectation of repayment for advances made between 2006 and 2008, the Court did not find that a similarly reasonable expectation of repayment existed for later advances. When the recession began in 2008 and Taxpayer’s business dropped off sharply, Shareholder should have known that future advances would not result in consistent repayments. When neither Taxpayer nor Shareholder was able to raise funds from unrelated third parties, Shareholder must have recognized, the Court stated, that the only hope for recovery of the amounts previously advanced to Taxpayer was an infusion of capital subject to substantial risk. After 2008, the only source of capital was from Shareholder’s family and his personal credit cards. No reasonable creditor would have loaned to Taxpayer.

Accordingly, the Court found that advances made through 2008 were bona fide loans but that advances made after 2008 were more in the nature of capital contributions.

Don’t Get Comfortable

Taxpayer and Shareholder fared pretty well in the decision described above, all things considered. No promissory note, no authorization to borrow, no maturity date, no interest, no payments terms, no collateral. In other words, nothing that any reasonable third party lender would have required in making a loan.

Yet the Court was satisfied that a loan was intended based, in part, upon Taxpayer’s financial and tax reporting. More importantly, the facts and circumstances supported a finding that loans were intended for the pre-recession period.

The importance of the circumstances in which funds are transferred to a business cannot be understated. However, the closely held business needs to consider them from the perspective of a third party lender, it needs to document the transfers accordingly, and it needs to act consistently with what was intended.

Passive Losses

The Code provides various rules that may limit the ability of an individual taxpayer, who owns an interest in a closely held business, to deduct losses that are attributable to such business.

Under the passive activity loss (“PAL”) rules, for example, the losses realized by a taxpayer from passive activities that exceed the income realized by the taxpayer from such passive activities are disallowed for the current year, though the taxpayer can carry forward the disallowed passive losses to the next taxable year.

Any passive activity losses that have not been allowed (including current year losses) generally are allowed in full in the tax year the taxpayer disposes of his entire interest in the passive activity in a transaction in which all realized gain or loss is recognized.

Material Participation

Passive activities include business activities in which the taxpayer does not materially participate. A taxpayer materially participates in a business activity for a tax year if he satisfies any of the following tests:

  1. He participated in the activity for more than 500 hours.
  2. His participation was “substantially all” the participation in the activity of all individuals for the tax year, including the participation of individuals who did not own any interest in the activity.
  3. He participated in the activity for more than 100 hours during the tax year, and he participated at least as much as any other individual (including individuals who did not own any interest in the activity) for the year.
  4. The activity was a “significant participation activity,” and he participated in all significant participation activities for more than 500 hours.
  5. He materially participated in the activity for any 5 of the 10 immediately preceding tax years.
  6. The activity was a personal service activity – for example, one which involved the performance of personal services in the field of health – in which he materially participated for any 3 preceding tax years.
  7. Based on all the facts and circumstances, he participated in the activity on a regular, continuous, and substantial basis during the year.

Grouping Activities

A taxpayer can treat one or more business activities as a single activity if those activities form an “appropriate economic unit” for measuring gain or loss under the PAL rules.

Grouping is important for a number of reasons. If a taxpayer groups two activities into one larger activity, he need only show material participation in the one larger activity as a whole to avoid the limitations of the PAL rules. But if the two activities are separate, the taxpayer must show material participation in each one. On the other hand, if the taxpayer groups two activities into one larger activity and he disposes of one of the two, then he has disposed of only part of his entire interest in the activity. But if the two activities are separate and he disposes of one of them, then he has disposed of his entire interest in that activity and may use the passive losses therefrom in full.

Generally, to determine if activities form an appropriate economic unit, the taxpayer must consider all the relevant facts and circumstances. He can use any reasonable method of applying the relevant facts and circumstances in grouping activities. The following Grouping Factors are assigned the greatest weight in determining whether activities form an appropriate economic unit; all of the factors do not have to apply to treat more than one activity as a single activity:

  • The similarities and differences in the types of businesses,
  • The extent of common control,
  • The extent of common ownership,
  • The geographical location, and
  • The interdependencies between or among activities, which may include the extent to which the activities:
    • Buy or sell goods between or among themselves,
    • Involve products or services that are generally provided together
    • Have the same customers
    • Have the same employees, or
    • Use a single set of books and records to account for the activities.

Generally, when a taxpayer groups activities into appropriate economic units, he may not regroup those activities in a later tax year.

However, if the original grouping is clearly inappropriate, or if there is a material change in the facts and circumstances that makes the original grouping clearly inappropriate, the taxpayer must regroup the activities and comply with any disclosure requirements of the IRS.

If any of the activities resulting from the taxpayer’s grouping is not an appropriate economic unit, and one of the primary purposes of his grouping (or failure to regroup) is to avoid the PAL rules, the IRS may regroup the activities.

A recent ruling by the IRS Office of Chief Counsel (“OCC”) considered the IRS’s authority to regroup a physician’s various business interests into a single activity.

IRS: “What’s Up Doc?”

Doctor was an employee/shareholder of X, an S corporation, through Date1, when Doctor left X and became an employee/shareholder of Y, also an S corporation, through Date2.

Doctor also held a small ownership interest in P partnership during Year1 and Year2. In turn, P owned a partnership interest in R, which provided outpatient surgery facilities for qualified licensed physicians. P was established by a group of local City area physicians to acquire an interest in R. These physicians saw a benefit to having a surgical facility in City area which would give patients a lower-cost choice for their surgical needs as opposed to Hospital being the only available surgical facility.

The majority of the equity in R was owned by Q partnership, which had ownership interests in similar facilities throughout the country.

Physicians were not required to be owners of R or be in practice with an owner of R in order to use its facilities. R was used extensively by non-owner physicians or surgeons in City area.

Under applicable local law, physicians were not permitted to refer patients to an entity in which they had a financial interest. Instead, patients had to be given a choice in surgery location. However, patients often chose R over Hospital due to its lower cost.
The income generated from Doctor’s indirect ownership in R (through P) was not tied to the number of surgeries he performed at R’s facility or to the revenue generated by those surgeries. Moreover, even if Doctor did not perform any surgeries at R, he would still receive the same proportionate share of R’s profits allocable to his ownership interest in P.

Prior to the opening of R, the surgeries that could not be performed in Doctor’s office were performed at Hospital. The opening of R did not affect Doctor’s income from his medical practice, but his patients were given a choice as to where to have the surgery performed. Moreover, there were no interdependencies between X, Y, and R. Doctor was compensated for his surgical services to patients through medical charges made by X or Y. The revenue generated by R through facility charges were separate from the charges for medical services rendered by Doctor to his patients.

Challenging the Grouping

On his tax returns, Doctor did not treat X and Y as passive activities. He treated P as a separate activity from X and Y, and reported his income from P as passive income.

Doctor incurred a passive loss on rental condo Z in Year1, which was deducted against the passive income reported from P. In Year2, Doctor incurred another passive loss on condo Z, but again reported passive income from P, allowing him to deduct the entire Z loss in Year2.

The IRS challenged Doctor’s treatment of his interest in P as a separate activity. The IRS asserted that P should have been grouped with Doctor’s interests in X and Y, thereby re-characterizing his income from P as non-passive.

OCC Responds

In reviewing the IRS’s challenge, OCC noted that, generally, one or more business activities may be treated as a single activity if the activities constitute an appropriate economic unit for the measurement of gain or loss for purposes of the PAL rules.

Whether activities constitute an appropriate economic unit and, therefore, may be treated as a single activity depends on all the relevant facts and circumstances. According to OCC, a taxpayer may use any reasonable method of applying the relevant facts and circumstances in grouping activities, but OCC also stated that the Grouping Factors were to be given the greatest weight in determining whether activities constitute an appropriate economic unit.

OCC illustrated the intended application of these rules with the following example:

F, G, and H were doctors who operated separate medical practices. The doctors intended to invest in real estate that would generate passive losses.

In order to circumvent the underlying purposes of the PAL rules, the doctors converted a portion of their practices into a single passive income generator. They formed a partnership to engage in the business of acquiring and operating X-ray equipment. In exchange for equipment contributed to the partnership, the taxpayers received limited partnership interests. The partnership was managed by a general partner selected by the taxpayers; the taxpayers did not materially participate in its operations.

Substantially all of the partnership’s services were provided to the taxpayers or their patients, roughly in proportion to the doctors’ interests in the partnership. Fees for the partnership services were set at a level equal to the amounts that would be charged if the partnership were dealing with the taxpayers at arm’s length and were expected to assure the partnership a profit.

The taxpayers treated the partnership’s services as a separate activity from their medical practices and offset the income generated by the partnership against their passive losses.

For each of the taxpayers, the taxpayer’s own medical practice and the services provided by the partnership constituted an appropriate economic unit, but the services provided by the partnership did not separately constitute an appropriate economic unit. Accordingly, OCC stated, the IRS could require the taxpayers to treat their medical practices and their interests in the partnership as a single activity.

OCC contrasted the above example with the present case. An unrelated entity, Q, was the majority owner of R and controlled the day-to-day management of the surgical facility. Doctor and the other partners of P did not have any control over the day-to-day operations of R, unlike Doctor’s clear control over X or Y. In addition, the services provided by R to patients of P’s partners did not comprise substantially all of R’s patient services, and the services provided by R to the patients of P’s partners were not in proportion to the partners’ interests in P or their indirect interests in R.

Thus, while the above example concluded that the partnership’s activities did not separately constitute an appropriate economic unit, it was not necessarily inappropriate for Doctor to treat P’s activity as a separate economic unit in the present case.

While the business activities of X, Y, and R (held by Doctor through P) were similar in that they were all in the medical industry and involved the provision of medical services to patients, X, Y, and R provided different types of medical services. Certain surgeries could not be performed at X’s or Y’s office, and diagnostic and post-operative care was not provided through P or R. Doctor did not have the same kind of management control over R that Doctor exercised over his own medical practice conducted through X or Y. Doctor had different ownership interests among X, Y, and P. It also appeared that X, Y, and R were in different locations and did not share employees or recordkeeping.

Applying the Group Factors to the facts and circumstances of this case, OCC concluded that there may be more than one reasonable method for grouping Doctor’s activities into appropriate economic units. It also concluded that the facts and circumstances did not support a determination that Doctor’s grouping of the interests in X, Y, and P as separate activities was clearly inappropriate. Thus, the IRS did not have authority to regroup Doctor’s interests in X, Y, and P as a single activity.

Planning for Grouping?

It may be difficult, but not impossible.

The above ruling confirms that taxpayers have some flexibility in determining the grouping of their business activities for purposes of the PAL rules. This flexibility may enable a taxpayer to achieve a desired tax result.

For example, the taxpayer may be able to group certain activities in order to ensure satisfaction of the material participation test, thereby “converting” an otherwise passive activity to non-passive. Alternatively, if he has suspended losses, the taxpayer may decide to treat a particular activity, in which he is not active, as separate from other related non-passive activities in order to generate passive income from the separate activity.

Depending upon the facts and circumstances, a broad grouping may be beneficial to the taxpayer in some cases, while a narrower grouping would be preferred in others.

Unfortunately, it may be difficult to predict whether a taxpayer will realize income or loss from a particular business activity. In addition, a taxpayer may not accurately foresee the level of his participation in an activity.

The best that a taxpayer can do is to speak to his advisers and, based, upon his and their respective experiences, and the economic forecasts for the business, arrive at a strategy that is reasonable under the circumstances and that preserves a measure of flexibility.