What Was Intended?

Over the last thirty years, I have reviewed the income tax returns of many closely held corporations and partnerships. Quite often, on Schedule L (the balance sheet), I will see an entry for “other assets” or “other liabilities,” which are described on the attached explanatory statement as loans to or from affiliates, as the case may be. I then ask a series of questions: did the board of directors or managers of the entities approve the loan; how was the loan documented; is there a note with repayment terms; is the debt secured; does the loan provide for interest; has interest or principal been paid; has there ever been a default and, if so, has the lender taken action to collect on the loan?

Bona Fide DebtThe proper characterization of a transfer of funds to a business entity from a related entity may determine a number of tax consequences arising from the transfer, including, for example, the following: the imputation of interest income to the lender; the ability of the lender to claim a bad debt deduction; the payment of a constructive dividend to the lender’s owner where the “loan” is really a capital contribution.

If a transfer of funds to a closely held business is intended to be treated as a loan, there are a number of factors that are indicative of bona fide debt of which both the purported lender and the borrower should be aware: evidence of indebtedness (such as a promissory note); adequate security for the indebtedness; a repayment schedule, a fixed repayment date, or a provision for demanding repayment; business records (including tax returns) reflecting the transaction as a loan; actual payments in accordance with the terms of the loan; adequate interest charges; and enforcement of the loan terms.

The big question is whether there was “a genuine intention to create a debt, with a reasonable expectation of repayment, and did that intention comport with the economic reality of creating a debtor-creditor relationship?” A transaction will come under special scrutiny where the borrowing entity is related to the lender. In that case, especially, can it be shown that there was a realistic expectation of repayment? Would a third party lender have made the loan on similar terms?

A recent Tax Court opinion considered these questions at some length.

An “Investment Company”?

Taxpayer was the sole owner of Corp, an S corporation that advanced funds to start-up companies and to established companies that had an opportunity for a new product or line of business. Inexplicably, Taxpayer rarely reviewed formal written projections. obtained any third-party audits, or requested any financial statements for the companies that Corp invested in. As a matter of course, Corp did not finance any company if that company had other means to borrow, such as traditional banking. Taxpayer acknowledged that Corp provided “high-risk capital” and that it was engaged in “an investment business.”

In “return” for the money that Corp advanced, Taxpayer would acquire an equity interest in the borrower-company. Taxpayer would also acquire financial control over of the company by becoming a director, a bank account signatory, and the CFO.

According to Taxpayer, repayment of amounts advanced by Corp to a company to fund a start-up or other new “project” were not anticipated until the project had been “completed.”

Corp invested in three Companies that were relevant to the tax year at issue. Corp advanced significant amounts to each Company, some of which were advanced after the year at issue. In each case, Taxpayer acquired a significant equity interest in the Company; he was appointed a director, the CFO, the bookkeeper, and the paymaster of the Company; and he was made a signatory of its accounts. Taxpayer never received a salary from the Companies, and he stipulated that his goal for his investment in the Companies was to profit from his ownership interest.

Although Corp’s records included journal entries labeling some of its advances to the Companies as “loans,” neither Taxpayer nor Corp executed any notes, agreements, or other documents evidencing any loans to the Companies.

The IRS Steps In

On its tax return, on Form 1120S, for the tax year at issue, Corp deducted approximately $10 million as bad debt that was attributed to the advances made to the Companies. According to Taxpayer, he believed the possibility that the Companies would become profitable was remote. The bad debt deduction resulted in Corp’s reporting a net loss for the year; this loss flowed through to the Taxpayer’s personal income tax return.

The IRS examined Corp’s tax return for the tax year at issue and concluded that the bad debt deduction was erroneous. The IRS issued a notice of deficiency that disallowed Corp’s bad debt deduction, attributed the resulting income to the Taxpayer, and determined the resulting deficiency in tax.

The Tax Court asked Taxpayer to offer into evidence financial information regarding the Companies to show that they could not pay the debts to Corp. Taxpayer was unable to do so. Taxpayer did not provide any evidence that Corp ever held any of the Companies in default, and he admitted that Corp neither demanded repayment of these advances from the Companies, nor did it take legal action against them. There was no documentary evidence that Corp wrote off any portion of the alleged debts of the Companies on its books for the tax year at issue. Indeed, after the year at issue, the Companies were still operating and in good standing.

Taxpayer asserted that because he was an insider wearing several hats, no formal demands were necessary. He also claimed that Corp did not take legal action against the Companies because of his status as a shareholder of the Companies.

Bona Fide Debt

A taxpayer is entitled to a deduction in a tax year for any bona fide debt that becomes worthless within the tax year.

To be able to deduct the reported bad debt for the tax year at issue, Taxpayer had to show: (1) that the advances made to the Companies were debt (not equity); (2) that the debt became worthless in the year at issue; and (3) that the debt was incurred not as an investment, but in connection with a trade or business (i.e., the business of promoting, organizing, and financing or selling corporations). (If a taxpayer makes advances as an investor, and not in the course of a trade or business, then its loans may yield nonbusiness bad debt, which may be deducted as such only when they become worthless, and then only as short-term capital losses.)

According to the Court, a bona fide debt arises from “a debtor-creditor relationship based on a valid and enforceable obligation to pay a fixed or determinable sum of money.” By definition, a capital contribution is not a debt. The question before the Court was whether Taxpayer proved that Corp’s advances to the Companies were loans or, instead, were equity investments.

The Code authorizes the IRS to prescribe regulations setting forth factors to be taken into account in resolving the issue of whether an interest in a corporation is debt or equity, and it provides five factors that “the regulations may include”, the first of which is “a written unconditional promise to pay on demand or on a specified date a sum certain in money in return for an adequate consideration in money or money’s worth, and to pay a fixed rate of interest.” The other factors are: whether there is subordination to or preference over any indebtedness of the corporation; the ratio of debt to equity of the corporation; whether there is convertibility into the stock of the corporation; and the relationship between holdings of stock in the corporation and holdings of the interest in question.

Many courts have expanded upon these factors, and have relied upon the following criteria by which to judge the true nature of an investment which is in form a debt:
(1) the intent of the parties; (2) the identity between creditors and shareholders; (3) the extent of participation in management by the holder of the instrument; (4) the ability of the corporation to obtain funds from outside sources; (5) the “thinness” of the capital structure in relation to debt; (6) the risk involved; (7) the formal indicia of the arrangement; (8) the relative position of the obligees as to other creditors regarding the payment of interest and principal; (9) the voting power of the holder of the instrument; (10) the provision of a fixed rate of interest; (11) a contingency on the obligation to repay; (12) the source of the interest payments; (13) the presence or absence of a fixed maturity date; (14) a provision for redemption by the corporation; (15) a provision for redemption at the option of the holder; and (16) the timing of the advance with reference to the organization of the corporation.

However, the courts have also cautioned that, in such an analysis, no single criterion or group of criteria is conclusive. Moreover, the enumerated factors should be used only as aids in analyzing the economic reality of the transaction; that is, whether there is actually a contribution to capital or a true loan for income tax purposes.

The Court’s Analysis

The Court grouped the above factors into three categories: (1) the intent of the parties; (2) the form of the instrument; and (3) the objective economic reality of the transaction as it relates to the risks taken by investors.

Form
The Court noted that, unlike most “debt vs. equity” controversies, which involve investments in the form of a debt, Corp’s investment in the Companies had little or no form. There was no loan agreement providing for repayment of Corp’s advances; there was no written agreement of any sort.

According to the Court, the absence of an unconditional right to demand payment was practically conclusive that an advance was an equity investment rather than a loan for which an advancing taxpayer might be entitled to claim a deduction for a bad debt loss.

The salient fact of this case, the Court continued, was the lack of written evidence demonstrating that there was a valid and enforceable obligation to repay on the part of any of the Companies at issue that received advances from Corp. There was no written evidence of an enforceable obligation between Corp and any of the Companies, much less a provision for a fixed maturity date or a fixed rate of interest.

The Court observed that Taxpayer was not a financially unsophisticated person unaccustomed to having written agreements, yet the loans allegedly made by Corp were undocumented. Taxpayer’s uncorroborated oral testimony was insufficient to satisfy his burden in an equity-versus-debt determination. The absence of any type of formality typically associated with loans supported the conclusion that the advances were contributions to capital.

Intent
Taxpayer testified that the intent of both sides was that this was a loan and that there would be no profit-sharing, that interest would be paid and only interest would be paid, and that principal and only principal would be repaid. There was, Taxpayer said, an understanding between the parties that the borrower would post the advances as borrowed money and the lender would post them as money loaned out; and consistent with that, Taxpayer offered Corp’s journal entries that labeled some advances as loans.

In the absence of direct evidence of intent, the Court stated, the nature of the transaction may be inferred from its objective characteristics. In this case, the Court continued, no loans were documented. Such objective characteristics may include the presence of “debt instruments, collateral, interest provisions, repayment schedules or deadlines, book entries recording loan balances or interest payments, actual repayments, and any other attributes indicative of an enforceable obligation to repay the sums advanced.”

Economic Reality
The Court then turned to the economic reality of the advances. “A court may ascertain the true nature of an asserted loan transaction by measuring the transaction against the ‘economic reality of the marketplace’ to determine whether a third-party lender would extend credit under similar circumstances.”

If an outside lender would not have loaned funds to a corporation on the same terms as did an insider, an inference arises that the advance is not a bona fide loan; in other words, would an unrelated outside party have advanced funds under like circumstances?

Taxpayer stated that the Companies he chose to finance were start-up ventures that could not obtain financing from unrelated banks. As a matter of Corp policy, if a start-up company had other sources or means to borrow, Corp would not advance money to it. The Court concluded that the Companies were objectively risky debtors, and an unrelated prospective lender would probably have concluded that they would likely be unable to repay any proposed loan.

When Taxpayer decided to write off the advance to the Companies, it was because he believed the possibility they would be profitable was remote. And yet Corp continued to provide financing to the Companies after the tax year for which the bad debt deduction was claimed. No prudent lender would have continued to advance money to any of the Companies under such circumstances. The amounts advanced to the Companies were, as a matter of economic reality, placed at the risk of the businesses and more closely resembled venture capital than loans.

Also at odds with a conclusion that this was a genuine loan transaction was Taxpayer’s failure to obtain third-party audits, financial statements, or credit reports for the Companies that Corp had chosen to invest in.

The Court believed that no reasonable third-party lender would have extended money to these Companies when none of the objective attributes which denote a bona fide loan were present, including a written promise of repayment, a repayment schedule, and security for the loan.

The transfers simply did not give rise to a reasonable expectation or enforceable obligation of repayment. For these reasons, the Court found that the relationship between Taxpayer and Corp on the one hand and the three Companies on the other was not that of creditor and debtor, and the Court concluded that Corp’s advances of funds were in substance equity, and that the IRS properly disallowed the deduction.

The Lesson

The factors discussed by the Court, above, provide helpful guidance for structuring a loan between related companies. If these factors are considered, and the parties to the loan transaction document it on a contemporaneous basis, they will have objectively determinable proof of their intent, as reflected in the form and economic reality of the transaction. Of course, they will also have to act consistently with what the transaction purports to be – they will have to act as any unrelated party would under the circumstances.
There are many other situations in which the proper characterization of a transfer of funds between related entities can have significant income tax consequences. The bottom line in each case can be stated simply: decide early on what is intended, then act accordingly

Double Taxation

A business entity that is treated as a “flow-through” for income tax purposes enjoys the benefit of a single level of tax – the entity itself is typically not subject to tax on its net income; rather, that income “flows through” to the entity’s owners, who then report it on their own income tax returns. This flow-through treatment occurs whether or not the entity has made a distribution to its owners. For that reason, partnership/LLC agreements and “S” corporation shareholder agreements often provide for so-called “tax distributions,” meaning that the entity will distribute, on an annual or quarterly basis, enough cash to enable its owners to satisfy their income tax liabilities attributable to their share of the entity’s income that is flowed-through to them.

By contrast, the income of a so-called “C” corporation is taxed twice: once to the corporation, and then to its shareholders to the extent the corporation distributes any part of its after-tax income to the shareholders in the form of a dividend. The “double tax” occurs because a corporation is not permitted to deduct such a distribution in determining its taxable income.

Historically, the tax laws have been concerned that corporations and their controlling shareholders would be reluctant to distribute their “excess” profit – meaning the profits remaining after the corporation has satisfied the reasonable needs of its business including, for example, the establishment of capital or other reserves. A corporation may decide to accumulate such profits, or it may decide to pay its shareholder-employees an amount of compensation that is unreasonable for the services rendered by such shareholders, but which the corporation will nonetheless claim as a reasonable and deductible expense.

The IRS views both of these strategies as tax avoidance schemes. As regards the accumulation of corporate profits beyond the reasonable needs of the corporation, the Code provides for a corporate-level “accumulated earnings tax” (“AET”). A recent Chief Counsel Advisory considered one corporate taxpayer’s attempt to avoid the AET solely on the basis that it lacked liquidity from which to pay dividends to its shareholders.

An Investment Company

Corp. was treated as a “C” corporation for income tax purposes. Shareholder was its sole owner, director and officer. Shareholder contributed to Corp. his entire interest in several limited partnerships and in LLCs that were treated as partnerships for income tax purposes (the “partnerships”).

Partnership served as the manager for all of the entities contributed to Corp. Partnership itself was managed by a board that included Corp. Each member of the board was a “Director” with power to vote on Partnership matters. In addition, Shareholder joined Partnership as a partner and became an officer thereof. In that capacity, Shareholder was responsible for overseeing part of Partnership’s operations, for which he received a salary during the years at issue.

Each of the partnership/operating agreements (the “partnership agreements”) contained a provision allowing the partnerships to make distributions to their partners/members (the “partners”) sufficient to pay the respective partner’s income tax liability, but the remainder of the respective partner’s distributive share of the partnership income was retained in the partnership.

Accordingly, Corp. reported its distributive share of each partnership’s income, but only received distributions sufficient to pay its tax liability.

All of the income and essentially all of the expenses reported by Corp. were flow-through items from the various partnerships. This flow-through income consisted of dividends, interest, capital gain, Form 4797 gain (for example, from oil, gas and other mineral properties), and certain other income.

Since its inception and during the tax years at issue, Corp. conducted no business activity other than holding and maintaining the various partnership interests contributed to it by Shareholder. Corp. had no employees and paid no wages or expenses, other than a minimal amount for accounting and other fees. Additionally, Corp. neither declared any dividends nor did it otherwise make any distributions to Shareholder. Furthermore, it appeared – based on its balance sheets – that Corp. had made loans or advances to Shareholder.

Corp. reported retained earnings for the tax years at issue. It also reported a federal income tax liability for those years.

The AET

Distribution of Corp.’s earnings and profits for the years at issue would have resulted in additional tax to Shareholder.

According to the IRS, no valid business purpose seemed to exist for Shareholder’s incorporation of Corp. According to Corp., Shareholder contributed his partnership interests to Corp. in order to avoid potential taxation by various state, local, and foreign tax jurisdictions. Corp. did not otherwise provide any information to show a business reason for the accumulation of its retained earnings, and a review of its board of director minutes for the years at issue did not contain or provide any plans or information relating to the reasons for the accumulation.

The IRS explained that the Code imposes a tax on the accumulated taxable income of every corporation formed or availed of for the purpose of avoiding the income tax with respect to its shareholders by permitting its earnings and profits (“E&P”) to accumulate instead of being distributed. The avoidance of tax, the IRS noted, need only be one purpose for the accumulation; it need not be the only or primary purpose.

For purposes of this rule, the fact that the E&P of a corporation are permitted to accumulate beyond the reasonable needs of the business is determinative of the purpose to avoid the income tax with respect to shareholders, unless the corporation proves to the contrary by a preponderance of the evidence.

Although the term “earnings and profits” is not statutorily defined, it is generally described in rulings as referring to the excess of the net amount of assets of a corporation over the capital contributions of its shareholders. (See Sch. L of IRS Form 1120.) E&P is an economic concept that is generally based on taxable income, with certain adjustments set forth in the Code. The IRS pointed out that there are no adjustments relating to a corporate partner’s distributive share of a partnership’s income.

The IRS’s Analysis

The IRS has the burden of proving that all or any part of a corporate taxpayer’s E&P has been permitted to accumulate beyond the reasonable needs of the corporation’s business. Of course, the corporate taxpayer has an opportunity to establish that all or part of the alleged unreasonable accumulation of E&P was reasonable for the needs of its business.

Some reasons that the IRS has found are acceptable for accumulating E&P include: debt retirement, business expansion and plant replacement, acquisition of another business by purchase of stock or assets, working capital, investments or loans to suppliers or customers necessary to maintain the corporation’s business, and reasonably anticipated product liability losses.

Some grounds that the IRS has determined do not justify the accumulation of E&P include: loans to shareholders and expenditures for their personal benefit, loans to others which have no reasonable connection to the business, loans to a related corporation, investments that are not related to the business, and any accumulations (self-insurance) to provide for unrealistic hazards.

If a corporation is a mere holding or investment company, that fact is treated as prima facie evidence, the IRS stated, of the purpose to avoid income tax with respect to the corporation’s shareholders. A “holding company” for this purpose is a corporation having practically no activities except holding property and collecting the income therefrom or investing therein. If the activities further include, or consist substantially of, buying and selling stocks, securities, real estate, or other investment property so that the income is derived not only from the investment yield but also from profits based upon market fluctuations (appreciation), the corporation is considered an investment company.

Corp. had no activity other than holding and maintaining the various partnership interests contributed to it by Shareholder. Furthermore, none of the partnerships in which it owned an interest, controlling or otherwise, appeared to perform any activity other than investment activity. Accordingly, Corp. was a mere holding or investment company, it did not engage in any active business activity. Thus, there was prima facie evidence that Corp. was formed to avoid tax.

Corp. argued that it was not liable for the AET because it did not have control over distributions from the partnerships in which it invested. That is to say, because Corp.’s taxable income was derived solely from partnerships from which Corp. could not control distributions, Corp. did not have liquid capital from which to distribute earnings to Shareholder and, therefore, should not be subject to the AET.

Corp. suggested that an “accumulated surplus” must be represented by cash (liquidity) that is available for distribution. However, the Code computes the AET based on accumulated taxable income and, at least with respect to a mere holding company for which the reasonable needs of a business are not relevant, it is not concerned with the liquid assets of the corporation. The starting point for defining “accumulated taxable income,” the IRS continued, is “taxable income,” and none of the adjustments to taxable income address the undistributed income of partnerships.

“Consent Dividend”

In any case, Corp. could have availed itself, the IRS said, of the consent dividend procedures provided by the Code, which would have allowed Corp. and Shareholder to avoid the AET regardless of any lack of liquidity.

According to the IRS, the consent dividend election manifested a Congressional intent to provide corporations the same treatment as if they made distributions even when they lacked the liquidity to actually do so. In pertinent part, the consent dividend procedures provide that if a shareholder agrees to treat as a dividend the amount specified in a consent filed with the corporation’s tax return, the amount so specified shall constitute a consent dividend that is considered (1) as distributed in money by the corporation to the shareholder on the last day of the corporation’s taxable year, and (2) as contributed to the capital of the corporation by the shareholder on the same day.

Because consent dividends could have been used, the IRS stated, Corp.’s distributive share of partnership income should be taken into account in determining whether the AET should be imposed. Importantly, the availability of the consent dividend option does not depend or rely upon a controlling shareholder’s control of the partnership that retained all of its earnings.

Thus, Corp. remained subject to the AET in spite of its lack of liquidity and its lack of control over the partnerships in which it invested.

Lesson?

Although the foregoing discussion relates to a corporate tax issue, the key actors in the IRS’s decision were the partnerships in which Corp. was a partner.

The avoidance of double taxation that is afforded by a partnership is an important consideration in selecting the appropriate entity for a taxpayer’s business or investment activities. The partnership structure also affords the partners great flexibility in that there are no limitations upon who may invest in a partnership, and the partnership is flexible enough to accommodate many kinds of economic arrangements among its members.

That being said, the flow-through treatment can also present significant issues and surprises for the partners.

The AET issue discussed above is one such issue. Another is the tax imposed on S corporations that have E&P from years in which they were C corporations and that are invested in partnerships that generate substantial passive investment income. This could result in the imposition of a special tax on the S corporation and, eventually, in the loss of its S corporation status.

Another example may be found in the case of a flow-through entity that is invested in a partnership. The creditors of the flow-through entity may impose limitations upon its ability to make distributions to its owners, notwithstanding that the income of the partnership of which it is a member continues to be taxed to those owners.

Yet another instance where investment in a partnership may result in some “hardship” is in the case of a foreign partner. Its investment in the partnership may cause the foreign partner to be treated as engaged in a U.S. trade or business, and may also (where a treaty applies) constitute a “permanent establishment.” Add to that the withholding obligation imposed upon the partnership as to the foreigner’s distributive share of partnership income, and you may have one unhappy partner.

The bottom line, as always: these issues need to be identified in advance of the investment, they need to be examined and, if possible, the taxpayer and the partnership need to plan for them.

Back to Basics

This is not a silly question. In fact, it is often one of the most difficult issues confronted by a tax adviser, and it arises from one of the most basic of tax principles; specifically, that income is taxable to the person who earns it. The difficulty in addressing the issue derives from the many varieties of situations in which it is presented.

For example, taxpayers have often tried to transfer their earned income or built-in gain to others (including family members, partnerships, and charities) so as to avoid or reduce the liability for the tax attributable thereto. In some instances, the Code provides rules that seek to prevent the shifting of one’s tax liability. (See, e.g., the rules regarding a taxpayer’s contribution of appreciated property to a partnership, which effectively prevent a taxpayer from shifting the tax inherent in the “built-in gain” to the other partners – a topic that will be covered in a later post.)Taxpayer In other situations, the courts have had to parse through sometimes convoluted fact patterns to determine who actually earned the income at issue, or whether a taxpayer’s transfer of “property” succeeded in also transferring any income that had accrued with respect to such property, or whether any property has been transferred at all (as opposed to a transfer of earned income), or whether the purported transferor even owned the property being transferred (see our previous discussion on personal vs. corporate goodwill).

It only seems appropriate, as we begin a new tax year (at least for those persons who use the calendar year as their tax year – tax humor), that we discuss this basic principle. Fortunately, the Tax Court recently provided us with a fairly simple scenario to illustrate the application of this principle. The issue for decision was whether Taxpayer or his S corporation had to report the income earned for the years in issue.

There Once Was A Taxpayer . . .

Taxpayer was a financial consultant. He provided advice and services to his employer’s clients. Wanting to have his own clients and accounts on which to
work, Taxpayer struck out on his own.

Shortly thereafter, Taxpayer entered into an agreement with Firm. The agreement stated that Taxpayer’s relationship with Firm was that of an independent contractor. Taxpayer signed the agreement in his personal capacity.

A few weeks later, after consulting with his attorney and his accountant, Taxpayer created Corp., and caused it to elect S corporation status. Taxpayer was the sole shareholder of Corp. He then entered into an employment agreement with Corp. The agreement stated that Taxpayer’s term of employment with Corp. began with the date of its incorporation.

Under this employment agreement, Taxpayer was paid an annual salary to “perform duties in the capacity of financial advisor.” Those duties consisted of: (1) acting in the best interests of Corp.’s clients in managing their investment portfolios; (2) expanding Corp.’s client base and the “overall presence” of Corp.; and (3) representing Corp. “diligently and responsibly at all times.” The agreement did not include a provision requiring Taxpayer to remit any commissions or fees from Firm or any other third party to Corp. Taxpayer signed the agreement twice–once as Corp.’s president and once in his personal capacity. Outside of the employment agreement, Corp. did not enter into any other contracts during the years in issue.

Two years later, Taxpayer entered into a contract with Financial Group. The contract was between Taxpayer and Financial Group – there was no mention of Corp. in the contract. The contract stated that there was no employer-employee relationship between Taxpayer and Financial Group. Taxpayer signed the contract in his personal capacity.

There were no amendments to either the Firm agreement or the Financial Group contract requiring those entities to begin paying Corp. instead of Taxpayer, or to recognize Corp. in any capacity.

The Tax Returns

For the years in issue, both Firm and Financial Group issued Forms 1099 to Taxpayer in his individual capacity for the years in issue. In general, Form 1099-MISC, Miscellaneous Income, is the form used to report nonemployee compensation.

For the same years, Corp. reported ordinary business income on its Form 1120S, U.S. Income Tax Return for an S Corporation. The amount of Corp.’s gross receipts was calculated from the Forms 1099 that Firm and Financial Group issued to Taxpayer for those years.

Generally, an S corporation is not subject to income taxes, though it is required to file an annual information return. The corporation’s income, losses, deductions, and credits are passed through to the shareholders based upon their pro rata stock ownership. These passthrough items are taken into account in determining a shareholder’s income tax liability, but not for purposes of the employment tax. The Schedule K-1s issued to Taxpayer for the years in issue reported Corp.’s ordinary business income.

Taxpayer reported taxable wage income from Corp. on his Form 1040, U.S. Individual Income Tax Return. He also attached a Schedule E to his Form 1040, reporting the S corporation income that passed through to him from Corp. No amount was reported as income from self-employment, notwithstanding the 1099s that were issued to Taxpayer.

The IRS issued Taxpayer a notice of deficiency for the years in issue in which it determined that the gross receipts that Corp. reported on its Forms 1120S should, instead, have been reported by Taxpayer as self-employment income on Schedule C of his Forms 1040 for the years in issue. Taxpayer challenged the IRS’s determination in Tax Court.

Corporation or Shareholder as Taxpayer?

As stated above, it has long been a first principle of income taxation that income must be taxed to the person who earned it. While this principle is easily applied, relatively speaking, between two individuals by simply asking who performed the services or sold the goods, the question of who earned the income is not as easily answered when a corporation is involved. In part, this is because another basic principle of income taxation provides that a corporation is generally treated as a separate taxable entity.

Because it may be difficult to apply a simplistic “who earned the income” test
when the choices are a corporation and its service-provider employee, the
question has evolved to one of “who controls the earning of the income.” In order for a corporation – as opposed to its service-provider employee – to be the controller of the income, two elements must be found: (1) the individual providing the services must be an employee of the corporation whom the corporation can direct and control in a meaningful sense; and (2) there must exist between the corporation and the person using the services a contract or similar “evidence” recognizing the corporation’s controlling position.

The Court began by examining the second element.

Indicia of Control

When Taxpayer individually entered into the agreement with Firm, there was no mention of Corp. because it was not even incorporated until a few weeks later. It did not exist as a separate entity. Additionally, Taxpayer did not enter into an agreement that purportedly created an employer-employee relationship with Corp. until after Corp. was created. Therefore, there could be no indicium that Firm was aware that Corp. controlled Taxpayer as its employee.

There was also no mention of Corp. in the contract that Taxpayer signed with Financial Group. In contrast to the agreement with Firm, Taxpayer enter into this contract after the creation of Corp., but he still signed the contract in his individual capacity. The contract expressly stated that there was no employer-employee relationship between Financial Group and Taxpayer. There was no mention of Corp. in the contract and no evidence in the record that Financial Group was aware of whether Corp. had any degree of meaningful control over Taxpayer.

Taxpayer did not dispute that Firm and Financial Group never contracted
directly with Corp. In fact, Taxpayer testified that Corp. could have signed the contract with Financial Group, but he chose to sign the contract in his individual capacity because, he claimed, this would afford him the flexibility to sell other products in the future. He also argued that it was impossible for those entities to contract with Corp. because Corp. was not registered to sell securities under the securities laws and regulations. In other words, Taxpayer implied that he had acted on behalf of Corp. in entering into these arrangements in order to circumvent these rules.

The Court responded by pointing out that the securities rules did not prohibit a business entity, such as Corp., from registering. The fact that Corp. was not registered, the Court stated, did not allow Taxpayer to assign the income he earned in his personal capacity to Corp.

The Court continued by noting there was no reason for Firm to believe that Corp. had any meaningful control over Taxpayer as Corp. had not been incorporated, and no purported employer-employee relationship between Corp. and Taxpayer existed, at the time he signed the agreement with Firm. Moreover, there was no evidence of any amendments to the Firm agreement after Corp. was incorporated. Although Corp. had been incorporated before Taxpayer entered into the contract with Financial Group, Corp. was not mentioned in the contract, and Taxpayer offered no evidence that Financial Group had any other indicium that Corp. had any meaningful control over him.

Based on the foregoing, the Court found that Taxpayer had failed to meet the second element of the control test outlined above; i.e., that there must exist between the corporation and the person using the services a contract or similar “evidence” recognizing the corporation’s controlling position. Therefore, Taxpayer individually, not Corp., should have reported the income earned under the agreement with Firm and the contract with Financial Group for the years in issue. Consequently, Taxpayer owed self-employment tax with respect to such income.

Another Basic Principle

It is clear that Taxpayer sought to avoid the self-employment tax on the ordinary business income generated under the agreements above.

Other taxpayers have sought to use S corporations for the same avoidance purpose. Recognizing that a shareholder’s pro rata share of an S corporation’s ordinary business income is not subject to employment tax, shareholder-employees have caused their corporate-employer to pay them a below-market (often unreasonably low) salary for their services provided to or on behalf of the corporation. Although this salary is subject to employment taxes, the remaining corporate profit is not. Unfortunately for them, the IRS has caught on to this gambit and has taken steps to address it.

Which brings us to another basic tax principle, and recurring message of this blog: a taxpayer and his advisers have to examine a proposed structure or arrangement with a critical eye – they cannot ignore that which they do not want to see. Before embarking upon any course of action, they need to objectively consider: How will the IRS and a court view the arrangement? What legal authority supports the taxpayer’s position? Will parts of the arrangement be disregarded as having no bona fide business purpose? Will the taxpayer be able to substantiate the stated business reason for the structure? Will the form of the arrangement be respected, or will the IRS recharacterize it (for example, by ignoring certain steps or constructing “missing” steps)? These and other questions will need to be considered if the taxpayer hopes to convince the IRS as to the identity of the proper taxpayer and the desired tax consequences.

According to statistical data released by the IRS earlier this year, the examination rate for partnership tax returns has been increasing significantly over the last couple of years; of course, this includes returns filed by LLCs that are treated as partnerships for Federal income tax purposes. This should come as no surprise given the significant growth in LLC business structures.

However, as the number of partnerships (LLCs) has increased, so has their complexity, such that the IRS has found it increasingly difficult to audit partnerships and to collect any resulting income tax deficiencies. As we previously noted, it was in response to these difficulties that Congress enacted, as part of the Bipartisan Budget Act of 2015, a number of new tax compliance provisions targeted specifically at partnerships.

In light of the IRS’s increased attention on partnerships, next year’s blog posts will include a number of articles that will cover many of the basic principles of partnership taxation.

We end this year with a factually simple partnership case that is nonetheless a head-scratcher, as least insofar as the taxpayer’s behavior is concerned.

The Not-So-Great Recession

Taxpayer was a member of Partnership. Taxpayer alleged that, in the wake of the 2008 recession, other partners at Partnership could not cover their share of the firm’s expenses and that, as a result, the firm had gone into “significant negative capital.” For some reason, Taxpayer felt that it was his fiduciary obligation under New York partnership law to cover other partners’ shares of partnership expenses.

Although New York’s partnership statute prescribes certain fiduciary obligations that partners owe each other, it is not clear why Taxpayer believed that he was obligated to pay other partners’ shares of Partnership expenses. In any event, whether he had an obligation under State law to reinvest some of his income in Partnership was not relevant to the amount of Partnership’s income properly attributable to him for Federal income tax purposes.

Taxpayer claimed that his positive “capital account bore no relationship to the financial condition of the partnership, and what little money was available to” Taxpayer was used to absorb expenses that normally would have been expenses of the firm.

“Don’t Do It”

Because the available money had allegedly not been paid out to Taxpayer, but had been used to pay firm expenses, Taxpayer felt it should not be treated as income to him. But according to Taxpayer,

Man holding head in hands shutterstock_220688068When I sought the advice of the firm’s accountants and tax preparers, I was in essence told that the tax law was unfair and unjust under these circumstances, and my options were to dissolve the firm, take all the capital in the firm to pay my taxes and move on, and let my partners fend for themselves, and the employees go on unemployment. When I discussed [m]y obligations under New York State Partnership Law to act as a fiduciary to my partners, I was told to be prepared to face the consequence of that decision as I am now, that the [IRS] would likely be deaf to the financial realities of the firm and not respect the state law fiduciary partnership duties.

That is, the tax professionals told Taxpayer that the law “unfairly” required him to report the income, but he decided not to follow their advice.

The Return and Its Aftermath

Taxpayer prepared and filed his own Form 1040, “U.S. Individual Income Tax Return”, for 2011. On the attached Schedule E, “Supplemental income and loss”, (“Nonpassive income from Schedule K-1”), Taxpayer reported that his income from Partnership (i.e., revenue over expenses) was much less than the actual amount of $461,386.

In 2013, the IRS issued a notice of deficiency to Taxpayer relating to his 2011 tax year. The IRS determined that Taxpayer had failed to properly report his share of Partnership income. The IRS also determined an accuracy-related penalty.

In 2014, Taxpayer timely petitioned the Tax Court, contending that: (1) New York partnership law imposed a fiduciary duty upon him that prevented him from withdrawing his capital account and thereby causing Partnership to fail; and (2) the expenditure of Partnership funds to pay partnership expenses left the firm with no money to pay Taxpayer his share of income and, thus, left him with no money to pay his Federal income tax liability.

The IRS filed a motion for summary judgment.

As to his underlying Federal tax liability, Taxpayer’s response to the IRS’s motion essentially advanced the same two arguments that were in his petition – i.e., he received no actual income in 2011, and he was, therefore, unable to pay his income tax.

As to the accuracy-related penalty, Taxpayer argued that it would be inappropriate to impose the penalty in light of his good-faith payment of Partnership expenses.

The Tax Court

The issue for decision was whether Taxpayer failed to report taxable income from Partnership for taxable year 2011; in other words, whether Taxpayer’s otherwise taxable income from Partnership was reduced by his alleged obligation to make expenditures on behalf of Partnership.

The Code provides: “A partnership * * * shall not be subject to the income tax imposed by this chapter. Persons carrying on business as partners shall be liable for income tax only in their separate or individual capacities.” In determining his individual income tax, each partner must separately include his distributive share of the entity’s taxable income or loss. [Sec. 701, 702]

Even assuming Taxpayer’s factual assertions, Partnership’s income was taxable to Taxpayer as a partner to the extent of his distributive share. This was so whether Taxpayer received distributions or not; “[f]or it is axiomatic,” the Court stated, “that each partner must pay taxes on his distributive share of the partnership’s income without regard to whether that amount is actually distributed to him.”

Taxpayer did not provide evidence to challenge the IRS’s determinations for 2011. He did not dispute that Partnership had income (revenue greater than expenses) in 2011 nor the amount of his share thereof. Rather, Taxpayer simply asserted that the firm did not distribute to him his share of the 2011 income (a fact that would not affect the attribution of that income to him) and that the firm used its available money to pay firm expenses (a fact that could generate partnership deductions, reducing the firm’s income, and Taxpayer’s share of it).

If Taxpayer did in effect plow his share of the 2011 income back into the firm (because he thought that State law required him to do so), then that amount presumably constituted a contribution to the firm’s capital, and would increase his own capital account at the firm, but such a capital contribution was not deductible.

As a partner in Partnership, Taxpayer was obliged to report his share of the firm’s income, whether or not it was distributed to him, and whether or not that money was thereafter used to pay firm expenses.

But I Can’t Pay

Taxpayer did not advance an argument based on partnership taxation principles. Rather, his argument was that he could not reasonably be expected to pay tax on money that was never paid to him.

The Court replied that a taxpayer’s assertion that he has no money to pay an income tax liability might be relevant in a “collection due process” case.” But where the issue was the unreported amount of the liability, the Court stated, Taxpayer’s argument “missed the mark.”

According to the Court, a taxpayer’s ability to pay the tax he owes has no bearing on the amount of his tax liability. Taxpayer may in the future raise issues of collectability at a collection due process hearing before the IRS. However, in a deficiency case, Taxpayer’s argument about his inability to pay was not relevant to the ultimate issue – the amount of Taxpayer’s tax liability.

The Court therefore upheld the IRS’s determinations regarding the taxability of Taxpayer’s distributive share of Partnership’s income.

Allocation Basics

Query why Partnership and its members did not amend their partnership agreement to specially allocate to Taxpayer the deductions attributable to his payment of Partnership’s expenses. Indeed, such an amendment could have ben adopted as late as the date prescribed for filing Partnership’s 2011 tax return (not including any extension) on Form 1065.

Whatever the reason, it is clear that Taxpayer and his fellow partners were ignorant of, or chose to ignore, some basic principles of partnership taxation:

  • Each partner of a business organization that is treated as a partnership for tax purposes is required to take into account separately in his income tax return his distributive share, whether or not distributed, of each class or item of partnership income, gain, loss, deduction, or credit.
  • The character in the hands of a partner of any item of income, gain, loss, deduction, or credit is determined as if such item were realized directly from the source from which realized by the partnership or incurred in the same manner as incurred by the partnership.
  • In general, the taxable income of a partnership is computed in the same manner as the taxable income of an individual; there are certain statutorily- and regulatory-prescribed exceptions.
  • A partner’s distributive share of any item or class of items of income, gain, loss, deduction, or credit of the partnership shall be determined by the partnership agreement, provided such allocation has “substantial economic effect”; otherwise, the partner’s distributive share shall be determined in accordance with such partner’s interest in the partnership (taking into account all facts and circumstances).

We will revisit these and other partnership concepts throughout 2017.

Happy New Year.

With apologies to St. Mark 8:36. “For what does it profit a man to gain the whole world and forfeit his soul?”

Do you mean to tell me, Katie Scarlett, . . . that land doesn’t mean anything to you? Why, land is the only thing in the world worth workin’ for, worth fightin’ for, worth dyin’ for, because it’s the only thing that lasts. – Gerald O’Hara, from “Gone With The Wind”

Many of our clients are heavily invested in real property. In some cases, this investment may be a single property in a prime location; in others, the client (and maybe his family) is in the business of owning and operating a portfolio of properties of differing qualities and values. It is often the case that the real property constitutes the greater part of the client’s wealth.

As the client gets older, he may seek to withdraw from, or to reduce his involvement in, the management of the real property. He may seek to diversify his portfolio, or to acquire one or more other properties, so as to provide greater investment stability or to ensure a steadier stream of revenue in retirement.

He may seek to “re-task” his property to take advantage of changing circumstances in the neighborhood in which it is located, perhaps as part of a joint venture with a third party developer and property manager. (This is happening in many parts of Queens and Brooklyn.)

It many cases, the client may be able to leverage his existing real property and withdraw some of the equity therefrom in order to finance the acquisition of one or more new properties.

In other cases, however, the client would prefer not to leverage the existing property and, so, has to sell that property, and then use the net proceeds therefrom to purchase other property.

Taxable Sale

A sale of investment real property is usually not desirable where it will generate a not insignificant tax bill. After all, the improvements on the property may have been held for many years, and have been almost fully depreciated, thus resulting in a very low adjusted basis for the property against which the gain on the sale of the property will be determined. Although most of the gain realized on the sale will likely be taxed as capital gain (a 20% federal tax rate) and as “unrecaptured depreciation” (a 25% federal rate), there may also be some ordinary income (a 39.6% federal rate, at least for now) if the client has depreciated various components of the property on an accelerated basis.

For that reason, when a client wants or has to dispose of a real property, he would prefer to do so on a tax-free or, more accurately, tax-deferred basis.

Like Kind Exchange

The Code provides an exception from the general rule requiring the recognition of gain upon the sale or exchange of property. Specifically, no gain will be recognized if real property held by the taxpayer for productive use in a trade or business or for investment is exchanged solely for property of a like kind to be held by the taxpayer for productive use in a trade or business or for investment.

In most cases, a taxpayer disposing of real property will not be able to swap his property with another taxpayer (a “simultaneous exchange”); for example, Taxpayer A transfers Prop A to Taxpayer B in exchange for Taxpayer’s Prop B. In recognition of this reality, Congress and the IRS have provided special rules for non-simultaneous exchanges. Unfortunately, because of very strict statutory requirements, these rules are often not as helpful as most taxpayers would like.

A non-simultaneous exchange, where the relinquished property is transferred before the replacement property is acquired, generally may qualify for nonrecognition of gain if the taxpayer identifies the replacement property or properties within 45 days of the transfer of the relinquished property, and then receives such replacement property within 180 days of the transfer. The taxpayer may only purchase one or more of the identified properties in order to complete a like kind exchange; an “unidentified” property does not qualify.

In addition, as a general rule, the taxpayer may only identify up to three replacement properties. Under an alternative rule, however, the taxpayer may identify any number of like kind replacement properties, provided their aggregate fair market value does not exceed two times the fair market value of the relinquished property.

Because the identification and acquisition periods cannot be extended, a taxpayer may find it very difficult to complete a like kind exchange. After all, 45 days is not a very long period of time within which to investigate, and identify, replacement properties. Even where replacement properties are timely identified, it may be difficult to acquire those properties within the prescribed 180-day replacement period. The taxpayer’s diligence of the properties may uncover structural or environmental issues with the properties, or the owner may decide, for whatever reason, not to sell to the Taxpayer.

In addition, because of the limits on the number of replacement properties that may be identified, and the time constraints for their acquisition, a taxpayer may find it difficult to diversify his real property holdings through a like kind exchange.

UPREIT

REITs, or real estate investment trusts, may be publicly-traded corporations the assets of which consist of a diversified portfolio of real properties and related assets. They are comparable to mutual funds, and are required to pay out at least 90 percent of their income to their unitholders (shareholders).

Unfortunately for a taxpayer who owns real property, he may not contribute his property to an existing REIT in exchange for an equity interest therein on a tax-free basis.

That being said, many REITs are structured as UPREITs, or “umbrella partnership REITs.” Under this structure, the REIT has formed a partnership that it controls. The partnership owns the REIT’s real properties. An owner of real property who wants to dispose of such property on a tax-free basis may contribute his property to the UPREIT partnership in exchange for a partnership interest that is convertible into shares of stock (units) in the REIT partner.

In general, the owner’s contribution of his real property to the partnership in exchange for a partnership interest is not a taxable transaction. A subsequent conversion of the partnership interest into REIT stock, on the other hand, would be a taxable exchange, though the taxpayer can plan for this tax consequence and may time it to his advantage.

There are other potential tax consequences, however, that need to be considered.

For example, if the real property being contributed to the UPREIT partnership is encumbered by debt, any reduction in the contributing taxpayer’s share of that debt will be treated as a cash distribution to the taxpayer. If the amount of this reduction exceeds the taxpayer’s basis in his partnership interest, he will recognize income to the extent of the excess. Similarly, if the debt was placed on the property within two years of the contribution to the partnership, the so-called “disguised rules” may cause the contribution to be treated as a partial sale of the property.

In addition, the taxpayer will have to consider certain rules that are intended to ensure that the taxpayer will be taxed on the gain inherent in (or “built-into”) his property at the time it is contributed to the partnership. Under these rules, if the partnership were to sell the contributed property, the gain realized would first be allocated, and taxed, to the taxpayer to the extent of the built-in gain. For that reason, the taxpayer will want to negotiate a period of time during which the partnership will not be permitted to sell the contributed property; otherwise, the taxpayer may never realize any tax deferral benefit. Alternatively, the taxpayer will want to be indemnified by the partnership for the resulting tax liability.

Joint Venture

The taxpayer may decide that his real property can be converted to a different, more profitable use. For example, commercial properties in good or up-and-coming locations may be turned into residential rental buildings or condominiums.

Because the taxpayer may not have the expertise or the financial wherewithal to do this on his own, he may decide to co-venture with a real estate professional to undertake the development project.

The joint venture would be structured as a partnership (usually in the form of an LLC) and, so, the contribution of the real property to the LLC will raise many of the issues described above regarding UPREITs. However, there may also be other factors at play. For example, although the owner will be contributing his real property to the venture in exchange for a membership interest therein, he may also want to take some equity off the table. In that case, the partnership (using funds contributed by the other partner) may distribute some cash to the taxpayer.

This cash distribution may cause the contribution of the property to be treated as a partial sale of the property. In that case, the taxpayer will have taxable gain, unless the distribution falls within one of several enumerated exceptions (including the reimbursement of certain pre-formation capital expenditures), or the taxpayer uses the proceeds to acquire replacement property as part of a like kind exchange. In general, the gain recognized will be treated as capital gain. However, such gain may be treated as ordinary income under the related party rules, depending upon the size of the taxpayer’s interest in the partnership.

Wrap-Up

Real estate cannot be lost or stolen, nor can it be carried away. Purchased with common sense, paid for in full, and managed with reasonable care, it is about the safest investment in the world. – Franklin D. Roosevelt

The foregoing was just a brief description of some of the ways in which a taxpayer may handle the disposition of his real property in a tax-advantaged manner. Of course, a taxpayer’s particular facts may make it difficult to effectuate a disposition through one of more of these tax-deferral vehicles. For example, the taxpayer may not be the sole owner of the subject property. Once co-owners are introduced into the equation, it may be that all bets are off, depending upon their relationship and their relative priorities, and depending upon the terms of their partnership, operating, or shareholder agreement, if any.

Speaking of shareholders, if the real property is held in a corporation – every tax adviser’s nightmare – the above deferral techniques will have to be employed at the corporate level, but the resulting economic consequences will also have to be considered from the perspective of the shareholders.

As always, it will behoove the real property owner to plan for his exit from the investment well in advance, and to structure his holdings in a way that will best facilitate such exit.

A couple of weeks ago, we considered a situation in which an unscrupulous partner (perhaps in cahoots with an IRS agent) tried to stick one of their partners with the federal employment taxes owed by their failing business. This week, we encounter a somewhat similar situation involving the imposition of personal liability on an innocent employee for a corporation’s N.Y. sales taxes.

Personal Liability for Sales Tax?

Many taxpayers fail to appreciate that, under certain circumstances, a shareholder, officer, director or employee of a corporation may be held personally liable for the sales tax collected or required to be collected by the entity.

In general, the sales tax is a transaction tax, with the liability for the tax arising at the time of the transaction. The person required to collect the tax – the seller – must collect it from the buyer when collecting the sales price for the transaction to which the tax applies.

The seller collects the tax for and on account of the State, then holds it in trust for the State until the seller remits the tax to the State.

In the case where the seller is a corporation, N.Y. State imposes personal responsibility for payment of the sales tax on certain shareholders, officers, directors, or employees (“responsible persons”) of the corporation.  More than one person may be treated as a responsible person.

A responsible person is jointly and severally liable for the tax owed, along with the corporation and any other responsible persons.  This means that the responsible person’s personal assets may be taken by the State to satisfy the sales tax liability of the corporation (the corporate “shield” is ignored).

Personal liability attaches whether or not the tax imposed was collected by the corporation – it is not limited to tax that has been collected but has not been remitted. The personal liability applies even where the individual’s failure to take responsibility for collecting and/or remitting the sales tax was not willful.

Moreover, the personal liability of a responsible person for sales tax is separate and distinct from that of the business – it extends beyond the corporation.   For example, a corporate bankruptcy does not affect the responsible person’s liability for the tax because the latter involves a separate claim than the one that is asserted against the corporation.

The Responsible Person

Every officer or employee of a corporation who is under a duty to act for the corporation in complying with any requirement of the N.Y. sales tax law is a responsible person required to collect, truthfully account for, and pay over the sales tax.

Holding a corporate office or being a shareholder does not, in and of itself, warrant the imposition of personal liability. Only those who were “under a duty to act” on behalf of the corporation may be assessed the tax, with the main inquiry being whether the individual in question had sufficient authority and control over the affairs of the corporation.

Whether such officer or employee is a responsible person is to be determined in every case on the basis of particular facts involved. Generally, a person who is authorized to sign a corporation’s tax returns, or who is responsible for maintaining the corporate books, or who is responsible for the corporation’s management is under a duty to act. However, it is actual, rather than titular, control that counts.

Fact or Fiction?

A recent decision considered whether an individual who was both an officer and a shareholder of a corporation may be held responsible for the corporation’s sales tax liability where he was precluded from taking action with regard to the financial and management activities of the corporation, and whether the significance of his officer and shareholder status may be offset by the circumstances relating to control of the corporation.

Taxpayer was an employee of Corp X during the audit period. During the same period, he was the president and sole shareholder of  Corp Y, a separate purchasing company that was effectively operated by Corp X.

During the audit period, Taxpayer signed several sales tax returns as president of Corp Y and was listed as the sole shareholder of Corp Y on its N.Y. “S” corporation tax return.

Corp Y filed the sales tax returns but did not remit the tax due.

N.Y. issued to Corp Y notices and demands for payment of the tax due. The corporation was also assessed penalties and interest.

N.Y. also issued notices to Taxpayer, arguing that the facts in evidence justified holding him liable for the sales taxes due from Corp Y: he was an officer and shareholder who signed checks and corporate documents for Corp Y.

In response, Taxpayer argued that he was “young and naïve” when Corp Y was “put in his name.” He was not aware of what his boss, Mr. X, had done. (It should be noted that, by the time of the audit, Mr. X had died.) He did not contribute any capital to the business. He was being used without knowing or understanding what was being done in his name. The sales and taxes generated were as a result of his recently deceased boss’s efforts.

In short, Taxpayer claimed that he was not a person responsible for the collection and payment of sales tax on behalf of Corp Y.

The matter was then presented to an administrative law judge, where the question to be resolved was whether Taxpayer had or could have had sufficient authority and control over the affairs of Corp Y to be considered a responsible officer or employee.

Here Comes the Judge

N.Y. imposes upon any person required to collect sales tax personal liability for the tax imposed, collected or required to be collected. A person required to collect tax is defined to include, among others, corporate officers and employees who are under a duty to act for such corporation in complying with the requirements of the sales tax law.

According to the Court, the determination of whether an individual is a person under a duty to act for a business is based upon a close examination of the particular facts of the case. Among the factors to be considered were the following: whether Taxpayer was authorized to sign corporate tax returns; was responsible for managing or maintaining the corporate books; was permitted to generally manage the corporation; was an officer, director, or shareholder; was authorized to write checks on behalf of the corporation; had knowledge of and control over the financial affairs of the corporation; was authorized to hire and fire employees; and had an economic interest in the corporation.

The Court determined that Taxpayer was not an individual who had or could have had sufficient authority and control over the affairs of the corporation to be considered a responsible officer or employee for Corp Y.

There was no dispute that Taxpayer signed checks, tax returns and corporate documents for Corp Y, or that he was the sole shareholder, as listed on the Corp Y S corporation tax return. However, he never received a salary or any remuneration or distribution from Corp Y. The real question, the Court stated, was whether Taxpayer, as a young man with no business background or education, had any meaningful control of the affairs of the corporation.

Taxpayer credibly testified that he was under the direction and control of Mr. X in all his dealings with Corp Y. He was directed to sign checks and other corporate and tax documents at Mr. X’s direction. All the business operations of Corp Y were handled by Mr. X’s personal assistant and bookkeeper. These facts were buttressed by the testimony of others who worked at Corp X at the same time, who credibly testified that Taxpayer was hired by Corp X to conduct mundane and routine tasks, and that Mr. X controlled both Corp X and Corp Y and made all decisions for both. He did not delegate duties to his employees. Everything was done on his direction.

On the basis of the foregoing, the Court found that Taxpayer was not in a position to have any kind of meaningful control over the business, and it determined that he was not responsible for the sales tax due on behalf of Corp Y.

Know Your “Partners”

Now, you may be thinking, “why two posts in three weeks on the dire tax consequences that may befall someone who goes into business with an unscrupulous partner?”

The answer is simple: to stress the importance of a business person’s knowing his partner – his finances, experience, reputation, personality, etc. – before going into business with him.

Even after conducting a due diligence review, it will behoove the business person to memorialize the relationship with the new partner in a written agreement, such as a shareholders’ agreement, that covers, among other things, the allocation of duties between them, decision-making procedures, distributions, buyouts, etc. Yes, it will cost more upfront, but it will help to avoid more expensive surprises down the road, especially if the business is not going well.

Captives: In Theory

Assume that a business pays commercial market insurance premiums to commercial insurers to insure against various losses. These premiums are deductible in determining the business’s taxable income. As in the case of most P&C insurance, the premiums are “lost” every year as the coverage expires.

A business will sometimes “self-insure” by setting aside funds to cover its exposure to a particular loss. The setting aside of these funds, however, is not deductible by the business for tax purposes.
The Code, on the other hand, affords a “smaller” business the opportunity to establish its own “captive” insurance company. In order to facilitate the creation and operation of such a caprice, the Code provides for the deductibility of reasonable premiums paid to such a company by the business, and allows the captive may receive up to $1.2 million of annual premium payments ($2.2 million for taxable years beginning after December 31, 2016) from the business free of income tax.

In order to be respected, the captive must operate as a bona fide insurance company. It must insure bona fide risks. It must not be a risk that is certain of occurring; there must be an element of “fortuity” in order to be insurable.

In addition, there must be “risk-shifting” and “risk distribution.” Risk shifting is the actual transfer of the risk from the business to the captive. Risk distribution is the exposure of the captive to third-party risk (as in the case of traditional insurance).

The IRS Issues A Warning – And Then Another

Too often, however, taxpayers use captives for personal, nonbusiness planning. Indeed, many promoters tout the captive arrangement as a retirement, compensation, or estate planning device.
Last year, the IRS released its list of “dirty dozen” tax scams. Among the abusive tax structures highlighted was a variation on the so-called “micro-captive” insurance company, described above. The IRS characterized the scam version as an arrangement with “poorly drafted ‘insurance’ binders and policies to cover ordinary business risks or esoteric, implausible risks for exorbitant ‘premiums.’ ” According to the IRS, promoters in such scams received large fees for managing the captive insurance company while assisting unsophisticated taxpayers “to continue the charade.”

Last month, the IRS went a step further and announced (in the “Notice”) that certain micro-captive insurance transactions would be treated as “transactions of interest” – in other words, transactions of a type that have a potential for tax avoidance or evasion. This IRS Notice alerted persons involved in such transactions to certain responsibilities and penalties that may arise from their involvement with these transactions.

A “transaction of interest” is one in which a taxpayer attempts to reduce the aggregate taxable income of the taxpayer and/or related persons using contracts that the parties treat as insurance contracts and a related company that the parties treat as a captive insurance company. The entity that the parties treat as an insured entity under the contracts claims deductions for premiums paid for insurance coverage. The related company that the parties treat as a “micro-captive” insurance company elects to be taxed only on its investment income and, therefore, excludes the “premium” payments received under the contracts from its taxable income. The manner in which many of these contracts are interpreted, administered, and applied, the IRS indicated, is inconsistent with arm’s length transactions and sound business practices.

Overview of Transactions of Interest

In a typical micro-captive transaction, Taxpayer owns an entity (“Insured”) that conducts a trade or business. Taxpayer and/or persons related to Taxpayer also own another entity (“Captive”).

Captive enters into a contract (“Contract”) with Insured. Captive and Insured treat the Contract as an insurance contract for federal income tax purposes. Captive provides insurance coverage for Insured.

Captive enters into a pooling agreement under which a portion of the risks covered under the Contract are treated as pooled with risks of other entities and Captive assumes risks from other entities.

Insured makes payments to Captive under the Contract, treats the payments as insurance premiums that Insured deducts as ordinary and necessary business expenses. Captive treats the payments received from Insured under the Contract as premiums for insurance coverage. The micro-captive transaction is structured so that Captive has no more than $1.2 million in net premiums written for each taxable year ($2.2 million for taxable years beginning after December 31, 2016) in which the transaction is in effect. Captive elects under the Code to be taxed only on taxable investment income and to exclude the premiums from taxable income.

A promoter (“Promoter”) typically markets the micro-captive transaction structure to the Taxpayer. Promoter typically provides continuing services to Captive, including:

(1) providing the forms used for the Contract;
(2) management of Captive; and
(3) administrative, accounting, or legal services, including the filing of tax forms.

The coverage provided by Captive under the Contract has one or more of the following characteristics:

(1) the coverage involves an implausible risk;
(2) the coverage does not match a business need or risk of Insured;
(3) the description of the scope of the coverage in the Contract is vague, ambiguous, or illusory; or
(4) the coverage duplicates coverage provided to Insured by an unrelated, commercial insurance company, and the policy with the commercial insurer often has a smaller premium.

The payments made by Insured to Captive under the Contract have one or more of the following characteristics:

(1) the amounts of Insured’s payments under the Contract are designed to
provide Insured with a business deduction of a particular amount;
(2) the payments are determined without an underwriting or actuarial analysis that conforms to insurance industry standards;
(3) the payments are not made consistently with the schedule in the Contract;
(4) the payments are agreed to by Insured and Captive without comparing the amounts of the payments to payments that would be made under alternative insurance arrangements providing the same or similar coverage; or
(5) the payments significantly exceed the premium prevailing for coverage offered by unrelated, commercial insurance companies for risks with similar loss profiles.

Captive, Insured, or both do one or more of the following:

(1) Captive fails to comply with some or all of the laws or regulations applicable to insurance companies in the jurisdiction in which Captive is formed, the jurisdiction(s) in which Captive is subject to regulation;
(2) Captive does not issue policies or binders in a timely manner consistent with industry standards;
(3) Captive does not have defined claims administration procedures that are consistent with insurance industry standards; or
(4) Insured does not file claims for each loss event covered by the Contract.

Captive’s capital has one or more of the following characteristics:

(1) Captive does not have capital adequate to assume the risks that the Contract transfers from Insured;
(2) Captive invests its capital in illiquid or speculative assets usually not held by insurance companies; or
(3) Captive loans or otherwise transfers its capital to Insured.

Claimed Tax Treatment and Benefits

Insured and Captive treat the Contract as an insurance contract for federal income tax purposes. Insured claims a deduction for the premiums paid. Captive excludes the premium income from its taxable income and is taxed only on its investment income.

Captive uses the premium income for purposes other than administering and paying claims under the Contract, generally benefitting Insured or a party related to Insured. For instance, Captive may use premium income to provide a loan to Insured.

However, if the transaction does not constitute insurance, Insured is not entitled to deduct the amount of that payment as an insurance premium. In addition, if Captive does not provide insurance, Captive does not qualify as an insurance company and Captive’s election to be taxed only on its investment income is invalid.

According to the Notice, the IRS recognizes that related parties may use captive insurance companies for risk management purposes that do not involve tax avoidance, but it also believes that there are cases in which the use of such arrangements to claim the tax benefits of treating the Contract as an insurance contract is improper.

However, according to the IRS, it lacks sufficient information to identify which micro-captive arrangements should be identified as tax avoidance transactions, and it also lacks sufficient information to define the characteristics that distinguish the tax avoidance transactions from other micro-captive transactions.

Therefore, the IRS Notice identified certain transactions as transactions of interest that would trigger certain reporting requirements under the Code.

Transactions To Be Reported

The following transaction is identified as a transaction of interest under the Notice:

(a) Taxpayer owns an interest in an entity (“Insured”) conducting a trade or business;
(b) An entity owned by Taxpayer, Insured, (“Captive”) enters into a contract (the “Contract”) with Insured that Captive and Insured treat as insurance;
(c) Captive elects under the Code to be taxed only on taxable investment income;
(d) Taxpayer, Insured, or one or more persons “related” to Taxpayer or Insured own at least 20 percent of the voting power or value of the outstanding stock of Captive; and
(e) One or both of the following apply:

(1) the amount of the liabilities incurred by Captive for insured losses and claim administration expenses during the Computation Period is less than 70 percent of the following:
(A) premiums earned by Captive during the Computation Period, less
(B) policyholder dividends paid by Captive during the Computation Period; or
(2) Captive has at any time during the Computation Period made available as financing or otherwise conveyed or agreed to make available or convey to Taxpayer, Insured, or a person related to Taxpayer or Insured (collectively, the “Recipient”) in a transaction that did not result in taxable income or gain to Recipient, any portion of the payments under the Contract, such as through a guarantee, a loan, or other transfer of Captive’s capital.

The Computation Period is (a) the most recent five taxable years of Captive, or (b) if Captive has been in existence for less than five taxable years, the entire period of Captive’s existence.

Any transaction that is substantially similar to the above-described transactions is identified as a “transactions of interest,” and any person entering into such a transaction on or after November 2, 1016 must report the transaction to the IRS. The required disclosure, on Form 8886, Reportable Transaction Disclosure Statement, must identify and describe the transaction in sufficient detail for the IRS to be able to understand the tax structure of the transaction and the identity of all parties involved in the transaction. For example, the Captive must disclose:

(1) whether it has, at any time during the Computation Period, made available as financing or otherwise conveyed or agreed to make available or convey any portion of the payments under the Contract to Taxpayer, Insured, or a person related to either of them, through a separate transaction, such as a guarantee, a loan, or other transfer;
(2) A description of all the type(s) of coverage provided by Captive;
(3) A description of how the amounts treated as premiums for coverage provided by Captive were determined, including the name and contact information of any actuary or underwriter who assisted in these determinations;
(4) A description of any claims paid by Captive, and of the amount of, and reason for, any reserves reported by Captive on the annual statement; and
(5) A description of the assets held by Captive; that is, the use Captive has made of its premium and investment income, including but not limited to, securities, loans, real estate, or partnerships or other joint ventures, and an identification of the related parties involved in any transactions with respect to those assets.

Persons required to disclose these transactions who fail to do so may be subject to severe penalties under the Code.

Next Steps

According to the Notice, once the IRS has gathered enough information regarding potentially abusive arrangements, it may remove a transaction from the “transactions of interest” category or it may designate a transaction as a listed transaction.

In the interim, the IRS may challenge a position, taken as part of a transaction that is substantially similar to the transactions of interest described in the Notice, under other provisions of the Code or judicial doctrines such as sham transaction, substance over form, or economic substance.

What is a taxpayer to do during this interim period? It depends. If the taxpayer already has a micro-captive arrangement in place, the taxpayer needs to determine whether it falls within the “transactions of interests” category described in the Notice. If it does, then the taxpayer has to very careful and very thorough in disclosing the requested information. If a taxpayer has not yet created a captive, but is considering one for bona fide business reasons, I would nevertheless advise patience. Although tax avoidance or the improper use of the insurance arrangement may be the farthest thing from the taxpayer’s mind, it would behoove the taxpayer to wait for whatever guidance the IRS eventually issues based on the information that will be gathered pursuant to the Notice.

“It Wasn’t My Fault”

When a business is successful and there are profits to share, the owners of the business get along well enough. As revenues fall off, however, while costs often remain steady or even increase, the owners will sometimes choose to “defer” the payment of so-called “trust fund” taxes in order to satisfy business expenses instead, in the hope of keeping the business afloat until it can turn the proverbial corner.

Of course, that corner turns into a spiral, the business fails, and the IRS seeks to collect the unpaid trust fund taxes from those persons in the business who were responsible for collecting and remitting the taxes. There may be several individuals to whom the IRS will look for payment, and it is not unusual to find erstwhile partners blaming one another and pointing fingers so as to deflect responsibility onto anyone but themselves. It is amazing what some people will do to avoid responsibility for the taxes owed by their business.

The U.S. Tax Court recently considered what can only be described as an especially egregious case of finger-pointing by former partners, coupled with what can most generously be described as incompetence by the IRS, that resulted in the IRS’s exoneration of those persons who were actually responsible for the unpaid taxes, and that almost ended with the assessment of those taxes against a truly innocent party.

Let’s Go Into Business

Partner and Taxpayer’s spouse (“Spouse”) formed Corp. to purchase and operate the Business. Partner and Spouse agreed they would be equal owners of Corp. but, because Spouse worked full-time at another job and had little time to participate in the Business, Partner would be the president of Corp. and would oversee its operations – indeed, Partner was the only person listed in Corp.’s articles of incorporation as an officer and director – while Spouse would be a passive investor. For family and medical reasons, Taxpayer was unable to devote much effort to the Business.

Shortly after Partner and Spouse began engaging in preliminary business matters, Partner was unexpectedly called out of state, and most of the pre-opening responsibilities fell upon Spouse. Because of his busy schedule, Spouse asked Taxpayer to carry out some of those responsibilities.

Upon his return, Partner and Spouse conducted interviews and hired new employees. Taxpayer was not involved in the interviewing and hiring process.

Spouse, Partner, and the new employees then underwent training related to the Business. Taxpayer did not attend the training.

During this pre-opening training phase, Partner contacted Taxpayer and asked her to retain the services of a payroll company so the new employees could be paid. Taxpayer engaged the services of a payroll company (“Pay-Co”) that, in addition to preparing employee paychecks and determining payroll tax liability, would debit the Business’s bank account; directly deposit Federal payroll taxes; and electronically file Forms 941.

Partner also directed Taxpayer to open a corporate bank account on behalf of Corp. She opened an account at Bank, and was identified as someone having signatory authority on the account.

Day-to-Day Operations

After the Business opened, it was run primarily by Partner and a key employee (“Employee”). Partner carried out his role as president of the corporation, and was heavily involved in the initial hiring and structuring of the Business. Partner indicated that he “drove all aspects of building business from the ground up, . . ., hired, trained, and supervised staff . . ., while managing . . . costs.”

Partner oversaw the day-to-day operations of the Business and, when he was not physically present, was in constant contact with Employee, with whom he discussed daily business dealings. Partner also monitored the Business’s bank balances and determined when it was appropriate for the Business to borrow money.

Employee was the general manager of the Business and was responsible for carrying out the day-to-day business operations. He managed the employees, paid creditors, and oversaw purchases from vendors. He was responsible for hiring, training, and firing personnel, purchasing, inventory, sales strategies and yield management, reviewing financial statements, product mix, budgeting, forecasting revenues and expenses, and management of individual department managers/supervisors. Employee was also Pay-Co’s main contact, and maintained control over the payroll process.

Taxpayer did not have a significant role at the Business. While she was directed to establish the Business’ bank account and to contract with Pay-Co during the pre-opening phase of the business, she became decidedly less involved once the Business was operational. Taxpayer’s main responsibilities were delivering checks, relaying electronic bank account balances to Employee, and delivering the Business’s mail that was sent to her private mailbox. Taxpayer occasionally transferred funds to and from the corporate bank account at the direction of Partner or Spouse. She also issued checks at the direction of Partner or Spouse for some of the Business’s recurring monthly expenses. During the periods at issue Taxpayer signed roughly 4% of the non-payroll checks.

Taxpayer made no operational decisions. Indeed, she did not have the proper education, training, or experience to hold a management position at the Business.

Payroll

Employee maintained control over the payroll process. He was responsible for compiling the payroll information and transmitting this information directly to Pay-Co every week. Because of the quick turnaround between providing the weekly payroll information to Pay-Co and payday at the Business, it was necessary for Pay-Co to hand-deliver the payroll checks by courier.

Because the Business had no business location at the time Pay-Co was first contracted, the payroll checks were initially delivered to Spouse’s and Taxpayer’s home address. Later, once the Business formally opened, Pay-Co began delivering the payroll checks directly to the business location. However, because employees were rarely onsite to receive the payroll checks at the time of delivery, the parties reverted to having the checks delivered to Spouse’s and Taxpayer’s residence.

Upon delivery of the payroll checks, Taxpayer was directed by Partner to sign the checks and deliver them to the business premises. It was usually necessary for Taxpayer to sign the checks because Employee was usually off on payday, and there was no one else onsite available to sign the checks. Taxpayer was not responsible for and did not review statements included in the Pay-Co package. Taxpayer signed about 81% of the payroll checks.

The Business Fails

Within a year of opening, the Business was losing money.

As a result of several bounced checks, vendors began to lose faith in the Business’s ability to pay its bills, and many demanded cash on delivery or certified checks.

Employee began to pay creditors by first using cash received from daily operations. When the Business’s cash balance was exhausted, he would resort to using standard checks or certified checks. The owners limited the number of checks available to Employee at any one time, in an effort to rein in his spending.

Eventually, the account at Bank was frozen. At that point, Partner directed Taxpayer to open a new bank account, with Second Bank. Before opening the account, a bank employee instructed Taxpayer to indicate she held some form of corporate office on the commercial signature card and on a form titled “Bank Resolution by Corporation”. Taxpayer handwrote “sec” next to her signature on the signature card, and she signed the Resolution as Corp.’s secretary even though she was never actually secretary for Corp.

Shortly thereafter, Pay-Co tried to withdraw $X for taxes from the account at Second Bank. The electronic withdrawals were rejected.

Pay-Co then scaled back its services to Corp., limiting them to producing payroll checks and reference copies of Forms 941. The payroll checks continued to be debited from the Second Bank account. However, Pay-Co did not debit the payroll tax portion from the account, make payroll deposits on the Business’s behalf, or file Forms 941. Taxpayer was unaware these services had been canceled.

The IRS Comes A-Knocking

Corp. finally stopped operating the Business and, within a couple of months, the IRS visited the office of Corp.’s CPA.

CPA informed Spouse and Taxpayer that a representative of the IRS had visited his office investigating unpaid payroll taxes. This was the first time Spouse and Taxpayer had knowledge that Federal payroll deposits had not been made for various quarters and that Forms 941 remained unfiled.

The IRS originally investigated Corp., but expanded its investigation to include Partner, Employee, and Taxpayer. After conducting its investigation, the IRS recommended assessing the Trust Fund Recovery Penalty (“TFRP”) against Partner, Employee, and Taxpayer.

The IRS eventually assessed the TFRP against Taxpayer as a “responsible person.” However, both Partner and Employee somehow successfully contested the IRS’s efforts to assess the penalty against them.

Taxpayer challenged the IRS’s determination, which was sustained by an IRS Appeals officer. Taxpayer then filed a petition with the Tax Court.

Trust Fund Recovery Penalties

Employers have a duty to withhold income and employment taxes from their employees’ wages. These withheld funds are often referred to as “trust fund taxes” because the Code characterizes such withholdings as “a special fund [held] in trust for the United States.” Employees generally are allowed a credit against their tax liability for the amount of taxes withheld from their wages, regardless of whether the employer actually remits the funds to the IRS. Therefore, when net wages are paid to an employee and the employer does not pay over the withheld funds, the IRS has no recourse against the employees for their payments and may collect only from the employer.

The Code provides a collection tool allowing the IRS to impose penalties on certain persons who fail to withhold and/or pay over trust fund taxes. The penalty is equal to the total amount of the tax that was withheld but not paid over, and is imposed on any “person” required to collect, truthfully account for, or pay over any tax withheld who willfully fails to do so.

The term “person” is often taken to mean a “responsible person” and includes an officer or employee of a corporation who, as such, is under a duty to collect, account for, or pay over the withheld tax. Therefore, liability for a TFRP is imposed only on (1) a responsible person who (2) willfully fails to collect, account for, or pay over the withheld tax.

Responsible Person?

The Court addressed whether Taxpayer was a responsible person. A “responsible person,” it explained, is any person required to collect, account for, or pay over withheld taxes. Whether someone is a responsible person is a “matter of status, duty and authority, not knowledge.” Indicia of responsibility include “the holding of corporate office, control over financial affairs, the authority to disburse corporate funds, stock ownership, and the ability to hire and fire employees.”

The IRS argued that Taxpayer possessed all the recognized indicia of responsibility and was, therefore, a responsible person. The IRS further asserted that Taxpayer exercised substantial financial control over Corp., and that at all times Taxpayer was a de facto officer of the corporation because she opened two corporate bank accounts, had signatory authority on both accounts, and signed checks on behalf of the corporation.

Taxpayer argued that she lacked decision-making authority and did not exercise significant control over corporate affairs. She further asserted that despite her signatory authority, she was not a responsible person because she had a limited role in the Business’s payroll process and merely signed payroll checks for the convenience of the corporation.

Taxpayer claimed that Partner and Employee were responsible for running the corporation day-to-day, and that her duties were ministerial.

The Court’s Analysis

The Court agreed with Taxpayer and found that the preponderance of the evidence showed that her role was ministerial and that she lacked decision-making authority. Accordingly, the Court held that Taxpayer was not a responsible person.

Responsibility, the Court stated, is a matter of status, duty, and authority. “In considering the individual’s status, duty, and authority, the test is one of substance.” In other words, the focus of the inquiry does not involve a mechanical application of any particular list of factors. The inquiry must focus on actual authority to control, not on trivial duties.

The Court determined that Taxpayer lacked the authority to control the financial affairs of the Business, including the disbursement of Corp.’s funds. Notwithstanding Taxpayer’s signatory authority and her spousal relationship to one of Corp.’s owners, the substance of her position was largely ministerial and she lacked actual authority.

According to the Court, the “credible” testimony and the documentary evidence introduced at trial demonstrated that Partner and Employee exercised control over the financial affairs of Corp., and that Taxpayer served only support functions. The Court commented that the testimony of Partner and Employee regarding Taxpayer was not credible.

The Court Reprimands the IRS

Interestingly, the Court noted that it was, in fact, puzzled that Partner, the president of the corporation and a hands-on owner, and Employee, the day-to-day manager, successfully “evaded” – the Court’s word – any personal liability for TFRP.

The Court observed that the IRS went to great lengths to characterize Taxpayer as a savvy business person whose actions and prior work experience made her a de facto director and officer. On the basis of the record, the Court could not make such a finding.

It was clear, the Court stated, that Taxpayer was not an officer, director, owner, or employee of Corp. at any time. With the exception of a few weeks during the preopening phase, Taxpayer had no involvement in the day-to-day affairs of the corporation. She usually visited the corporation only once a week (on payday), for less than an hour each time. The record also showed that there were times that she did not visit the business for periods of several months.

The IRS had determined that Taxpayer was a responsible person during the pre-opening phase (1) because of her alleged status as secretary of the corporation, and (2) because she signed checks.

However, the Court determined that the IRS did not conduct a thorough investigation.

Additionally, Taxpayer had no authority to hire and fire employees of the corporation. She had no responsibility to oversee or ensure the payment of payroll taxes on its behalf. She was not its bookkeeper or accountant. She did not reconcile the bank statements.

Even though she wrote and signed roughly 4% of the non-payroll checks to pay some of the corporation’s recurring operating expenses, such as rent, she was merely doing so at the direction of others and for the convenience of the corporation.

Moreover, even though Taxpayer signed most of the payroll checks prepared by Pay-Co, the duty was ministerial and done only for the convenience of the corporation. She had no duty to, and did not, oversee the employees, collect payroll information, compile payroll information, or remit the payroll information to Pay-Co on behalf of Corp.

Accordingly, because Taxpayer did not hold corporate office, did not control financial affairs, had no ownership interest, had no authority to hire and fire employees, and otherwise had little or no decision-making power beyond some ministerial duties, the Court found that she was not a responsible person.

Beware of Fair-Weather Partners

How could the IRS have absolved Partner and Employee while continuing to pursue Taxpayer in the above case? Might securing the testimony of the absolved parties have had anything to do with the IRS’s actions? Perhaps. Might their legal representatives have been more competent than Taxpayer’s? Maybe. In any case, the Court was right to be puzzled.

How can a taxpayer in a closely held business protect himself from a similar scenario? Unfortunately, there is no completely fail-safe way to do so – a resourceful “bad guy” will likely find a way or two to circumvent, at least in part, the obstacles to his evasion scheme.

A good place to start would be at the beginning. The passive investor should educate himself – what kind of activity will expose him to liability as a responsible person. During the initial phase of a business, it would behoove the passive investor to insist that each participant’s role within the business be described and documented.

A well-drafted shareholders’ agreement and by-laws would go a long way, as would accurate and timely recorded directors’ and shareholders’ minutes.

Finally, the investor should consider memorializing any activity undertaken on behalf of the business, including its nature and extent, and who requested his participation and under what circumstances.

It is not a perfect strategy, and may be resisted by others, but that in itself should be a wake-up call.

Exchanges, In General

A taxpayer must recognize the gain realized by the taxpayer from the conversion of a property into cash, or from the exchange of the property for other property differing materially in kind.

Under an exception to this general recognition rule, gain is not required to be recognized if property that is held by the taxpayer for productive use in a trade or business, or for investment, is exchanged by the taxpayer solely for property of a like-kind to be held either for productive use in a trade or business or for investment.

However, even an otherwise qualifying like kind exchange may be adversely impacted where the parties to the transaction are “related” to one another. Such a result is most likely to occur within a group of closely held business entities, as was illustrated in a recent decision of the U.S. Tax Court.

A Related Company Exchange?

Commercial Real Estate LeaseTaxpayer was a consolidated group of corporations consisting of Parent and its wholly-owned subsidiary (“Sub”). During the years at issue, Taxpayer’s operations consisted of leasing commercial real estate throughout the country.

Parent also owned 70% of the common shares of Affiliate, another corporation that owned real estate. Each company had a separate board of directors and a different president. However, Mr. Big served as president of Parent and as CEO of Sub during all relevant years.

Parent had made substantial loans to Affiliate. Decisions concerning the loans were made by a committee of Parent’s board established for that purpose. The committee’s role was to assess Affiliate’s financial condition and to determine how much would be lent. The committee was composed of Mr. Big and two other individuals.

Sub received a letter of intent from an unrelated third party offering to purchase the Relinquished Property. The letter outlined the anticipated terms for a purchase agreement covering the Relinquished Property. It reserved to Sub the right to effect an exchange of the property under Section 1031 of the Code (a “like-kind exchange”) and obligated the third party purchaser to cooperate toward that end. Sub’s representative signed the letter of intent and, thereafter, Parent and Sub began a search for suitable replacement property with the aid of real estate brokers.

Sub engaged Qualified Intermediary (“QI”) to serve as an intermediary through which the Relinquished Property could be exchanged, and entered into an exchange agreement with QI setting forth the terms under which QI would serve as an intermediary. Sub thereupon assigned its rights under the letter of intent to QI and subsequently transferred the Relinquished Property to QI. QI sold the Relinquished Property to the third party.

In order to meet the requirements of a “tax-free” like-kind exchange, Sub had to identify replacement property within 45 days after the sale of the Relinquished Property. As of the sale date of the Relinquished Property, neither Parent nor Sub had considered acquiring a replacement property from Affiliate or any other related party. The brokers presented numerous properties owned by unrelated parties to the Parent and Sub as potential replacement properties, and Sub attempted, unsuccessfully, to negotiate the purchase of some of these properties for that purpose. However, just before the identification period expired, in an attempt to preserve the like-kind exchange, Sub identified three potential replacement properties, all belonging to Affiliate.

QI timely purchased one of these real properties owned by Affiliate (the “Replacement Property”) and transferred it to Sub as replacement property for the Relinquished Property.

Like-Kind Exchanges

Taxpayer timely filed a consolidated Form 1120, U.S. Corporation Income Tax Return, on which Taxpayer reported a realized gain from the sale of the Relinquished Property but deferred recognition of the gain pursuant to Section 1031. Taxpayer also reported an unrelated net operating loss (“NOL”).

Affiliate recognized gain on its tax return from the sale of the Replacement Property, which would have increased its regular income tax liability by a significant amount. However, Affiliate had sufficient NOLs to fully offset its regular tax liability relating to the sale.

The IRS determined that the gain realized by Taxpayer on the sale of the Relinquished Property did not qualify for Section 1031 deferred recognition.

Section 1031 of the Code allows nonrecognition of gain on the exchange of property held for productive use in a trade or business, or for investment, when the property is exchanged for property of a like-kind.

As a nonrecognition provision, Section 1031 merely defers recognition of the gain inherent in the property sold – it does not eliminate it. This deferred gain is preserved for recognition by Taxpayer upon a later taxable disposition of the like-kind property acquired. This is accomplished by requiring that the basis of the property acquired in the Section 1031 exchange (the replacement property) be the same as the basis of the property exchanged (the relinquished property).

Deferred Exchanges

In most cases, a taxpayer disposing of property will not be able to find a buyer who owns like-kind property that the buyer is willing to exchange, and that the taxpayer wants to acquire (a “simultaneous exchange”). In recognition of this reality, Congress and the IRS provided special rules for non-simultaneous exchanges. Unfortunately, because of very strict statutory requirements, these rules are often not as helpful as most taxpayers would like.

A non-simultaneous exchange, where the relinquished property is transferred before the replacement property is acquired, generally may qualify for nonrecognition of gain if the taxpayer identifies the replacement property, and then receives it, within 45 days and 180 days, respectively, of the transfer of the relinquished property. These identification and acquisition periods cannot be extended.

A taxpayer may use a qualified intermediary to facilitate such a deferred exchange – wherein the intermediary acquires the relinquished property from the taxpayer, sells it, and uses the proceeds to acquire replacement property that it transfers to the taxpayer – without the intermediary’s being treated as the taxpayer’s agent or the taxpayer’s being treated as in constructive receipt of the sales proceeds from the relinquished property.

In the case of a transfer of relinquished property involving a qualified intermediary, the taxpayer’s transfer of relinquished property to a qualified intermediary and the subsequent receipt of like-kind replacement property from the qualified intermediary is treated as an exchange with the qualified intermediary.

The Related Party Rules

In order to prevent certain perceived abuses, Congress enacted a special rule to limit nonrecognition treatment in the case of like-kind exchanges between certain related persons. This rule generally provides that if a taxpayer and a “related person” exchange like-kind property and, within two years, either one of them disposes of the property received in the exchange (i.e., “cashes out” the investment), the nonrecognition provisions will not apply, and the gain realized must be recognized as of the date of the disposition.

The anti-abuse rule applies to direct simultaneous exchanges between related persons, and to any exchange which is part of a transaction or series of transactions “structured to avoid the purposes of” the rule. Therefore, it may disallow nonrecognition treatment of deferred exchanges that only indirectly involve related persons because of the interposition of a qualified intermediary.

However, under an exception to the disallowance-upon-disposition rule, any disposition of the relinquished or replacement property within two years of the exchange is disregarded if the taxpayer establishes to the satisfaction of the IRS “that neither the exchange nor such disposition had as one of its principal purposes the avoidance of Federal income tax.”

The Tax Court’s Analysis

The parties stipulated that Parent, Sub, and Affiliate were “related persons” within the meaning of the rule.

The IRS did not dispute that Sub’s exchange of the Relinquished Property for the Replacement Property met the requirements for a like-kind exchange. Furthermore, because Sub used QI, a qualified intermediary, to facilitate its sale of the Relinquished Property and acquisition of the Replacement Property, the IRS did not contend that the exchange ran afoul of the specific requirements for like-kind exchange treatment.

However, the IRS contended that Sub’s exchange was disqualified from nonrecognition treatment pursuant to the related party rule because QI had sold the relinquished property to Affiliate for cash as part of the exchange transaction (an “indirect” transfer between related parties).

The Court noted that, in earlier cases in which had considered taxpayers who had received replacement property from related persons in deferred exchanges involving qualified intermediaries, followed by the related persons’ sales of the relinquished property, it had concluded that the transactions were the economic equivalent of direct exchanges of property between the taxpayer and the related person, followed by the related person’s sale of the relinquished property and retention of the cash proceeds. Thus, the investment in the relinquished property had been cashed out, contrary to the purpose of the related party rule.

The transaction at issue, the Court stated, was no different: The investment in the Relinquished Property was cashed out with a related person’s (Affiliate’s) retaining the cash proceeds. The interposition of a qualified intermediary could not obscure that result.

Taxpayer, however, argued that the exchange of the Relinquished and Replacement Properties was not structured to avoid the purposes of the related person rule because Sub had no “prearranged plan” to conduct a deferred exchange with Affiliate. Taxpayer argued that, initially, Sub diligently sought a replacement property held by an unrelated party, and only turned to the Replacement Property when the deadline to complete a deferred exchange was imminent.

The Court rejected this argument, stating that the presence or absence of a prearranged plan to use property from a related person to complete a like-kind exchange was not dispositive of a violation of the rule.

Instead, the inquiry into whether a transaction had been structured to avoid the rule should focus, the Court said, on the actual tax consequences of the transaction to the taxpayer and the related party, considered in the aggregate, as compared to the hypothetical tax consequences of a direct sale of the relinquished property by the taxpayer. According to the Court, those actual consequences form the basis for an inference concerning whether a transaction was structured in violation of the rule.

The Court in compared the hypothetical tax that would have been paid if a taxpayer had sold the relinquished property directly to a third party with the actual tax paid as a result of the taxpayer’s transfer of the relinquished property to the related person in a like-kind exchange followed by the related person’s sale of the relinquished property. For this purpose the actual tax paid comprised the tax liability of both the taxpayer and the related person in the aggregate.

Where the aggregate tax liability of the taxpayer and the related person arising from their like-kind exchange and sale transaction is significantly less than the hypothetical tax that would have arisen from the taxpayer’s direct sale of the relinquished property, it may be inferred that the taxpayer structured the transaction with a tax-avoidance purpose.

The Court’s Conclusion

Taxpayer would have had to recognize a significant gain had Sub directly sold the Relinquished Property to an unrelated third party. Although Taxpayer’s NOLs would have offset a portion of this gain, it would have paid additional tax as a result of the direct sale.

However, because the transaction was structured as a like-kind exchange, only Affiliate was required to recognize gain – and that gain was almost entirely offset by its NOLs.

The substantial economic benefits to Taxpayer and Affiliate as a result of structuring the transaction as a deferred exchange were thus clear: Parent and Sub were able to cash out of the investment in the Relinquished Property almost tax-free. The Court thus inferred that Sub had structured the transaction with a tax-avoidance purpose.

Taxpayer argued that the transaction nonetheless lacked a tax-avoidance purpose because it did not involve the exchange of low-basis property for high basis property. Although it was true that Affiliate recognized more gain on the disposition of the Replacement Property than Sub realized on the disposition of the Relinquished Property, Affiliate was able to offset the gain recognized with NOLs, resulting in net tax savings to Taxpayer and Affiliate as an economic unit. The Court stated that net tax savings achieved through use of the related party’s NOLs may demonstrate the presence of a tax-avoidance purpose notwithstanding a lack of basis shifting.

In sum, by employing a deferred Section 1031 exchange transaction to dispose of the Relinquished Property, Taxpayer and Affiliate, viewed in the aggregate, effectively “cashed out” of the investment, virtually tax free – in stark contrast to the substantial tax liability Taxpayer would have incurred as a result of a direct sale.

Moreover, Taxpayer failed to demonstrate that avoidance of Federal income tax was not one of the principal purposes of Sub’s exchange with Affiliate and the disposition of the Relinquished Property.

The Court, therefore, concluded that the transaction was structured to avoid the purposes of the related person rule. The transaction was structured in contravention of Congress’s desire that nonrecognition treatment only apply to transactions “where a taxpayer can be viewed as merely continuing his investment.” Consequently, Taxpayer was not entitled to defer recognition of the gain realized on the exchange of the Relinquished Property under the like-kind exchange rules.

Keep In Mind

The foregoing illustrates only one of the pitfalls of which a seller of property must be aware when dealing with a related party buyer.  There are many others. Any sale or exchange that may involve a related party should be examined closely to account for potential tax consequences. Once the tax and the business issues have been identified, and the resulting economic consequences have been considered, the taxpayer can plan accordingly.

Business Owners & Employment Taxes

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

The wages paid to individuals who are non-owner-employees of a business are 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, so as to prevent its “conversion” into a distribution of investment income that is not subject to employment taxes.

In the case of a partnership, its “limited partners” are generally not subject to employment taxes in respect of their distributive share of the partnership’s income, while the shares of its “general partners” are subject to such taxes, regardless of whether or not they receive a distribution from the partnership.

The IRS recently considered whether a portion of an individual partner’s distributive share of partnership income could properly be treated as a return on his investment in the partnership and, thus, not subject to employment taxes.

Background

Taxpayer owned several franchise restaurants and contributed them to LLC, a limited liability company treated as a partnership for tax purposes.

During the years at issue, LLC’s gross receipts and net ordinary business income were almost entirely attributable to food sales.

Taxpayer owned the majority of LLC. The remaining interests in LLC were owned by Taxpayer’s spouse and an irrevocable trust. LLC’s operating agreement provided for only one class of ownership. Neither Taxpayer’s spouse nor the trust were involved with LLC’s business operations.

Taxpayer’s franchise agreements required him to personally work full-time on, and to devote his best efforts to, the operation of the restaurants. LLC’s operating agreement provided that Taxpayer was LLC’s Operating Manager, President, and CEO, and required him to conduct its day-to-day business affairs. In particular, Taxpayer had authority to manage LLC, make all decisions, and do anything reasonably necessary in light of its business and objectives.

Taxpayer directed the operations of LLC, held regular meetings and discussions with his management team and staff, made strategic, investment management and planning decisions, and was involved in the franchisor’s regional board and in its strategic planning.

LLC employed a number of individuals, many of whom had some level of management or supervisory responsibility. Pursuant to his authority under LLC’s Operating Agreement, Taxpayer appointed an executive management team consisting of financial and operations executive employees who did not have an ownership interest in LLC, but were given the responsibility of managing certain of LLC’s day-to-day business affairs, including making certain key management decisions.

Taxpayer had ultimate responsibility for hiring, firing, and overseeing all LLC’s employees, including members of the executive management team.

During the years at issue, LLC made “guaranteed payments” to Taxpayer for his services rendered to LLC.

Taxpayer as Limited Partner?

LLC treated Taxpayer as a limited partner for purposes of the employment tax rules, and included only the guaranteed payments in Taxpayer’s net earnings from self-employment, not his full distributive share of LLC’s net income.

LLC’s position was that Taxpayer’s income from LLC should be bifurcated for employment tax purposes between his (1) income attributable to capital invested or the efforts of others, which was not subject to employment tax, and (2) compensation for services rendered to LLC, which was subject to employment tax.

LLC asserted that, as a retail operation, it required capital investment for buildings, equipment, working capital and employees. LLC noted that Taxpayer and LLC made significant capital outlays to acquire and maintain the restaurants, and argued that LLC derived its income from the preparation and sale of food products by its employees, not the personal services of Taxpayer.

LLC asserted that Taxpayer had a reasonable expectation for a return on his investment beyond his compensation from LLC. It argued that Taxpayer’s guaranteed payments represented “reasonable compensation” for his services, and that his earnings beyond his guaranteed payments were earnings which were basically of an investment nature.

Therefore, LLC concluded that Taxpayer was a limited partner for employment tax purposes with respect to his distributive share of LLC’s net income.

Self-Employment Tax – In General

The Code imposes self-employment taxes on the self-employment income of every individual. The term “self-employment income” means the net earnings from self-employment derived by an individual during any taxable year.

In general, the term “net earnings from self-employment” means the net income derived by an individual from any trade or business carried on by such individual, plus his distributive share (whether or not distributed) of net income from any trade or business carried on by a partnership of which he is a member, with certain enumerated exclusions.

Among these exclusions, the Code provides that there shall be excluded any gain from the sale or exchange of property if such property is neither (i) stock-in-trade or other property of a kind which would properly be includible in inventory, nor (ii) property held primarily for sale to customers in the ordinary course of the trade or business. Thus, the exclusion does not apply to gains from the sale of stock in trade, inventory, or property held primarily for sale to customers in the ordinary course of a trade or business.

Partnerships & Self-Employment Tax

The Code also provides another exclusion:

there shall be excluded 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 . . . the partnership to the extent that those payments are established to be in the nature of remuneration for those services.

Unfortunately, the Code does not define “limited partner,” and the exclusion was enacted before LLCs became widely used.

Prior to the enactment of the exclusion, the Code provided that each 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 of an investment nature. However, the exclusion was not extended to guaranteed payments, such as salary, received for services actually performed by the limited partner to or for the partnership.

Thus, individual partners who are not limited partners are subject to self-employment tax on their distributive share of partnership income regardless of their participation in the partnership’s business or the capital-intensive nature of the partnership’s business.

The Once-Proposed Regulations

In 1997, the IRS issued proposed regulations defining “limited partner” for these purposes. They 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 immediately imposed a temporary moratorium on finalizing the proposed regulations, which expired in 1998; however, the 1997 proposed regulations were never finalized.

Subsequently, however, some Courts had the opportunity to shed light on the issue in the context of cases in which taxpayers attempted to distinguish between a partner’s wages and his share of partnership income. The Courts explained that a limited partnership has two fundamental classes of partners, general and limited. General partners typically have management power and unlimited personal liability. Limited partners lack management powers but enjoy immunity from liability for debts of the partnership. Indeed, a limited partner could lose his limited liability protection were he to engage in the business operations of the partnership. Consequently, the interest of a limited partner in a limited partnership is akin to that of a passive investor.

According to these Courts, the intent of the “limited partner exclusion” was to ensure that individuals who merely invested in a partnership and who were not actively participating in the partnership’s business operations would not receive credits toward Social Security coverage. In addition, the Courts noted that the legislative history of the “limited partner exclusion” did not support the conclusion that Congress contemplated excluding partners who performed services for a partnership in their capacity as partners (i.e., acting in the manner of self-employed persons) from liability for self-employment taxes. In addition, the Courts stated that “members of a partnership are not employees of the partnership” for purposes of self-employment taxes. Instead, a partner who participates in the partnership business is “a self-employed individual.” Thus, such a partner should treat all of his partnership income as self-employment income, rather than characterizing some of it as wages.

The IRS’s Analysis . . .

The IRS stated that, in general, a partner must include his distributive share of partnership income in calculating his net earnings from self-employment.

While the Code excludes from self-employment tax the gain on the disposition of certain property, the exclusion does not apply to a restaurant or retail operation’s sales of food or inventory. Thus, the IRS noted, the Code contemplates that a capital-intensive business such as a retail operation with stock in trade or inventory may generate income subject to self-employment tax. Because LLC earned its income from food sales in the ordinary course of its trade or business, the exclusion in the Code does not apply to LLC’s income.

Therefore, unless Taxpayer was a limited partner, he was subject to self-employment tax on his share of LLC’s income, notwithstanding the capital investments made, the capital-intensive nature of the business, or the fact that LLC had many employees.

Surprisingly, LLC did, in fact, take the position that Taxpayer was a limited partner for purposes of the “limited partner exclusion”.

The IRS disagreed. Relying upon the legislative history of the “limited partner exclusion,” the IRS explained that it was intended to apply to those who “merely invested ” rather than those who “actively participated” and “performed services for a partnership in their capacity as partners (i.e., acting in the manner of self-employed persons).”

The IRS further explained that “the interest of a limited partner in a limited partnership is generally akin to that of a passive investor,” and stated that limited partners are those who “lack management powers but enjoy immunity from liability for debts of the partnership.”

. . . And Conclusion

Taxpayer had sole authority over LLC, and was the majority owner, with ultimate authority over every employee and each aspect of LLC’s business. Even though LLC had many employees, including several executive level employees, Taxpayer was the only partner of LLC involved with the business and was not a mere investor, but rather actively participated in the partnership’s operations and performed extensive executive and operational management services for LLC in his capacity as a partner (i.e., acting in the manner of a self-employed person). Thus, the income Taxpayer earned through LLC was not income of a mere passive investor that Congress sought to exclude from self-employment tax.

LLC conceded that “service partners in a service partnership acting in the manner of self-employed persons” were not limited partners. However, LLC argued that a different analysis should apply to partners who: (1) derived their income from the sale of products, (2) made substantial capital investments, and (3) delegated significant management responsibilities to executive-level employees. LLC asserted that in these cases the IRS should apply “substance over form” principles to exclude from self-employment tax a reasonable return on the capital invested.

LLC interpreted the legislative history to mean that the “limited partner exclusion” applied to exclude a partner’s reasonable return on his capital investment in a capital-intensive partnership, regardless of the extent of the partner’s involvement with the partnership’s business.

Essentially, LLC argued that the self-employment tax rules for capital-intensive businesses carried on by partnerships were identical to the employment tax rules for corporate shareholder-employees: only reasonable compensation should be subject to employment tax.

Under this analysis, LLC argued that (1) LLC’s guaranteed payments to Taxpayer were reasonable compensation for his services, and (2) Taxpayer’s distributive share represented a reasonable return on capital investments in LLC’s business, and, therefore, Taxpayer was not subject to self-employment tax on his distributive share.

The IRS rejected these arguments, pointing out that they “inappropriately conflate the separate statutory self-employment tax rules for partners and the statutory employment tax rules for corporate shareholder employees.” The Code, it said, provides an exclusion for limited partners, not for a reasonable return on capital, and it does not indicate that a partner’s status as a limited partner depends on the presence of a guaranteed payment or the capital-intensive nature of the partnership’s business.

Lessons?

A partnership cannot change the character of a partner’s distributive share for tax purposes simply by making guaranteed payments to the partner for his services. A partnership is not a corporation and the “wage” and “reasonable compensation” rules which are applicable to corporations do not apply to partnerships.

The “limited partner exclusion” 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.

Instead, 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 business.

However, it should be noted that there remain other transactions involving payments from a partnership to a partner that do not generate self-employment income, including interest on loans from the partner to the partnership, and rental payments for the partnership’s use of the partner’s property. Not only are such payments excluded from the partner’s self-employment income, they also reduce the partnership’s net operating income, the partner’s distributive share of which is subject to self-employment tax.