Withdrawal of Proposed Regulations

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

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

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

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

The Reorganization Rules, In Brief

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

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

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

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

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

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

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

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

The Proposed Regulations

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

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

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

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

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

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

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

Withdrawn, But Not Useless

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

 

Maximize Capital Gain

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

Property Used in Trade or Business

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

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

Capital Asset

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

Contracts as Capital Asset?

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

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

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

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

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

Congress Provides Some Certainty

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

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

Sale of a Franchise

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

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

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

Tax Return and Audit

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

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

Tax Court

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

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

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

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

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

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

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

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

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

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

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

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

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

Guidance?

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

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

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

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

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

“Disposing” of a Partnership Interest

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

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

Liquidation

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

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

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

Abandonment

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

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

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

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

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

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

PE Acquisition & Partnership Agreement

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

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

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

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

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

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

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

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

PE Flips the Business

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

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

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

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

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

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

Taxpayers’ Position(s)

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

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

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

Tax Court’s Response

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Accordingly, the Court sustained the IRS’s determination.

With Sincerest Apologies to Dante

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

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

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

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

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

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

 

 

Potential for Abuse

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

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

Deferring the Deduction

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

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

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

S-Corp.’s Payroll Expenses

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

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

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

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

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

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

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

The IRS Audit

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

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

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

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

Taxpayers petitioned the U.S. Tax Court.

Tax Accounting

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

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

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

The Tax Court’s Analysis

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

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

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

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

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

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

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

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

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

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

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

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

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

Words of Advice?

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

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

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

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

“Add-Backs”

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

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

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

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

“Father Knows Best” (?)

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

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

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

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

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

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

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

Disallowed Deductions

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

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

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

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

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

“Reasonable” Compensation

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

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

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

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

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

The Court’s Analysis

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

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

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

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

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

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

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

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

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

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

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

Apologies to Dad? Nope

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

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

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

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

Introduction

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

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

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

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

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

Application to LLC Members

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

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

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

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

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

The IRS challenged the Taxpayers’ treatment of this excess.

Self-Employment Tax

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

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

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

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

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

A “Historical” Digression

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

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

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

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

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

The Court’s Opinion

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

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

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

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

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

Lessons & Planning

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

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

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

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

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

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

The Contribution

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

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

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

The Liabilities

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

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

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

Company represented that:

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

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

The Disguised Sale Rules

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

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

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

Facts & Circumstances

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

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

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

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

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

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

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

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

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

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

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

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

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

Presumptions

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

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

Assumed Liabilities

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

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

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

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

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

The IRS Rules

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

Lessons?

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

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

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

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

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

Close Corporations and Compensatory Grants of Equity

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

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

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

Substantial Risk of Forfeiture

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

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

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

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

Likelihood of Enforcement

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

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

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

The “Earnout” (?)

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

Capital Contribution

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

Restricted Stock

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

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

Allocation of S Corp. Income

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

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

The ESOP

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

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

The Issue

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

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

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

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

The Taxpayers timely petitioned the Tax Court.

The Court’s Analysis

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

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

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

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

“Enforceable” Restriction?

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

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

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

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

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

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

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

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

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

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

What Does It Mean?

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

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

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

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

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

The Transaction

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

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

The Law

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

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

Spinoff

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

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

Capital Contribution

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

Reorganization

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

Continued Investment

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

Step Transaction

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

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

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

The IRS’s Ruling

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

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

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

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

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

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

Beyond the Ruling

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

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

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

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