Recovering Transaction Costs

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

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

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

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

According to the IRS

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

Examples of Facilitative Expenses

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

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

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

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

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

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

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

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

“Simplifying Conventions”

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

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

Election to Capitalize

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

Facilitative Costs

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

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

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

The term “covered transaction” means the following transactions:

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

Inherently Facilitative Costs                    

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

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

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

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

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

(iv) Obtaining regulatory approval of the transaction;

(v) Obtaining shareholder approval of the transaction; or

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

Success-Based Fees

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

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

Capitalized Costs: Basis & Reduction of Gain

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

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

Recap

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

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

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

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

Last week, we reviewed the various U.S. federal income tax consequences that may be visited upon a foreign person who owns and operates U.S. real property (“USRP”). Today we will consider the U.S. federal gift and estate tax consequences of which a foreign individual must be aware when investing in USRP.

Gift Tax

As you probably know, the gift tax is imposed upon the transfer of property by an individual, to or for the benefit of another individual, for less than full and adequate consideration. The typical scenario involves an outright transfer to a family member, or a transfer to an irrevocable trust for the benefit of a family member.

For a U.S. person – meaning a citizen or an alien individual who is domiciled in the U.S. – who makes a gift, the Code currently affords an annual exclusion of $14,000 per donee, plus a combined lifetime/testamentary exemption of $5.49 million, plus an unlimited marital deduction provided the donor’s spouse is a U.S. citizen.  (Note that “domicile” for gift and estate tax purposes is not necessarily the same as “residency” for U.S. income tax purposes; domicile is a more subjective concept: what jurisdiction does the foreign individual consider to be his “permanent home”?)

In the case of a non-U.S. person who is also a non-domiciliary, the Code provides the same $14,000 annual exclusion as above, as well as an annual $149,000 exclusion for gifts to a non-U.S. citizen spouse (not an unlimited marital deduction). There is no other exclusion. The marginal gift tax rate is 40% for taxable gifts over $1 million.

U.S.-Situs Property

In order for the U.S. gift tax to apply to a transfer of property by a non-domiciliary, the property transferred must be located in the U.S. Thus, a gift transfer of USRP is taxable.

Importantly, however, a transfer of intangible property, including shares of stock in a USC, including a U.S. real property holding corporation (USRPHC), is not subject to the gift tax.

As a result, a gift transfer by a foreign individual (“FI”) of shares of USRPHC stock (or of cash to fund a corporation’s acquisition of USRP) to an irrevocable foreign trust for the benefit of the FI’s family is not subject to U.S. gift tax. It is imperative that the foreign donor respect the separate identity of the corporation the stock of which stock is being gifted: the corporation should have its own accounts, act in its own name, hold board meetings, etc. – it may even be advisable that the FI not use the corporation’s USRP without paying a fair market rental rate for such use; otherwise, the IRS may be able to ignore the corporate form and treat the transfer of the stock as a transfer of the underlying USRP.

Similarly, though it is not entirely free from doubt, a transfer of an interest in a partnership that owns USRP should not be subject to gift tax, provided the partnership is not engaged in a U.S. trade or business (USTB).

Estate Tax

We all have to go sometime. It’s the morbid truth. Even wealthy foreigners.

The U.S. estate tax is imposed on the FMV of the U.S. assets of a foreign decedent. This includes the foreigner’s direct interest in USRP.

It also includes the FMV of USRP in a foreign trust if the FI gifted the USRP into the trust and retained an interest in the income from, or in the use of, the trust’s property.

Where the USRP is subject to a nonrecourse debt, the amount of such debt may be applied to reduce the FMV of the property for estate tax purposes. In order to claim a reduction for any recourse debt encumbering the property, the estate of the FI must disclose his/her worldwide assets and claim only a proportionate part of the debt as a deduction, the assumption being that the FI’s worldwide assets are available to satisfy the recourse debt.

The FI’s U.S. gross estate also includes his shares of stock in a U.S. corporation (“USC”), including a USRPHC.

The state of the tax law as to the situs of a partnership interest is not entirely clear, though there is authority for the proposition that U.S. property includes an interest in a partnership that is engaged in a USTB.

The gross estate does not include shares of stock in a foreign corporation (“FC”), however, even if its only asset is USRP, and even if the FC has elected to be treated as a USC for purposes of FIRPTA (see above). Again, it is imperative that the FI have respected the corporate form: it should have its own accounts, act in its own name, etc. (see last week’s post); otherwise, the IRS may be able to ignore the corporate form, treat the FC as a sham, and include the value of the underlying USRP in the FI’s estate.

The FI’s estate does not include an interest in USRP that is held in a foreign trust, provided the FI did not retain (expressly or implicitly) any beneficial interest in, or control over, the trust.

Unlike the estate of a U.S. citizen or domiciliary, the estate of a FI will not have the benefit of the $5.49 million exemption. Rather, there is only a $60,000 exemption amount (though some treaties may provide for a greater amount provided the FI’s estate discloses its worldwide assets). The 40% rate kicks in when the U.S. taxable estate exceeds $1 million in value.

Additionally, there is no unlimited marital deduction unless the FI’s surviving spouse is a U.S. citizen. If the spouse is not a U.S. citizen, a qualified domestic trust (“QDOT”), with a U.S. trustee, will allow an unlimited marital deduction, and the resulting tax deferral benefit, though it is less than ideal for planning purposes. For example, every time principal is distributed to the surviving spouse, the U.S. trustee must report the distribution, and must withhold and transmit the applicable estate tax.

Finally, let’s not forget that any property that is included in the U.S. estate of a FI receives a basis step-up, thereby removing the depreciation in basis during the life of the decedent, and the appreciation in value of the property, from the reach of the U.S. income tax.

Takeaway

Last week’s post explained that the role of the U.S. tax adviser is to educate the foreign client as to basic U.S. tax considerations before the foreigner acquires USRP; to confer with the foreigner’s non-U.S. tax advisers as to the treatment of the investment under foreign tax law; and to see how to accommodate the foreigner’s business, investment, and other goals within a tax-efficient structure.

I can say with some certainty that there is no single structure that satisfies all of a taxpayer’s goals. The many relevant, and oftentimes competing, factors that we have discussed over the last couple of weeks must be identified and weighed, the various options must be formulated and presented to the foreign client, the client must understand the advantages and disadvantages of the options available, and then the best option under the circumstances must be selected.

Catching up? Start with Part I here.

Sale of USRP – FIRPTA

Aside from planning for the taxation of U.S.-sourced rental income, the foreigner must plan for the disposition of the USRP pursuant to a sale.

The taxation of gain realized by a foreigner on the sale of an interest in USRP is governed by FIRPTA (the “Foreign Investment in Real Property Tax Act of 1980”).

Because FIRPTA treats such gain as income that is effectively connected with the conduct of a USTB, the tax rate that is applied to the gain will depend upon whether the foreign seller is an individual or a corporation.

Assuming the property is a capital asset in the hands of a foreign individual (not inventory or otherwise used in a USTB – the sale of either of which would have been taxable as effectively connected income anyway), and has been held by the foreign individual for more than twelve months, the gain from the sale will be taxed as capital gain at a rate of 20%.

If the seller is a FC, the gain will be taxed at the applicable corporate rate, up to 35%.

FIRPTA – Withholding

Upon the foreigner’s sale of USRP, the buyer is required to withhold 15% of the gross purchase price, which amount must be remitted to the IRS. The purchase price includes the amount of any liability assumed or taken subject to. The remaining tax, if any, must be paid by the foreign seller when it files its U.S. income tax return. If the tax withheld exceeds the amount of tax owed as a result of the sale, the foreigner may use the filing of the tax return to claim a refund.

Because the 15% withholding does not necessarily bear any relationship to the amount of tax actually owed – indeed, the sale may have generated a loss – IRS regulations allow a foreign seller to request a certificate from the IRS that directs the buyer to withhold a lesser amount, based upon the information submitted by the foreigner to establish its actual tax liability.

For example, one may apply for a withholding certificate based on a claim that the transfer is entitled to nonrecognition treatment (as in the case of a like-kind exchange for other USRP), or based on a calculation of the foreigner’s maximum tax liability.

There are also other exceptions to FIRPTA withholding, where a USC, the stock of which is sold by a foreigner, certifies that it is not a USRPHC, and has not been one in the last five years.

Withholding as to Corporate Distributions

Note that special withholding rules apply to certain dispositions by corporations.

If a FC distributes USRP to its shareholders, it must withhold tax at a rate equal to 35% of the gain that is recognized by the FC on the distribution. (The distribution of appreciated property by a corporation to its shareholders in respect of their stock is treated as a sale of such property by the corporation.)

In the case of a USRPHC, it must withhold 15% of the amount distributed if the distribution is made in redemption of a foreigner’s shares or in liquidation of the corporation.

U.S. Real Property

The foregoing has assumed that the property being sold by the foreign person is a direct interest in USRP.

FIRPTA, however, covers not only direct interests in USRP, but also certain indirect interests.

Specifically, if the FMV of a USC’s USRP equals or exceeds 50% of the sum of (i) the FMV of all of its real property plus (ii) the FMV of its trade or business assets, then the corporation will be treated as a USRP Holding Corporation (“USRPHC”), and any gain realized on the disposition of any amount of stock in that USRPHC will be subject to tax under FIRPTA (so long as the disposition is treated as a sale or exchange for tax purposes).

What’s more, if a USC was a USRPHC at any time during the five-year period ending with the date of the sale of stock therein by a foreigner, the gain realized will remain subject to FIRPTA even if less than 50% of the value of the corporation is attributable to USRP at the time of the sale.

Fortunately, there is an exception to this five-year rule: under the so-called “cleansing” rule, if the USC disposes of all of its interests in USRP in taxable sales or exchanges, such that the entire gain thereon has been recognized, and the corporation owns no USRP at the time of the stock sale by the foreign person, then the stock sale shall not be taxable under FIRPTA (or at all for that matter).

Election to be treated as a USRPHC 

As you may have gathered, a FC cannot be a USRPHC. Seems straightforward enough, except that there is a special election that allows a FC to elect to be treated as a USRPHC exclusively for purposes of FIRPTA.

Why would a FC make such an election? One reason is to avoid gain recognition upon the transfer of USRP to the FC. Among the requirements that must be satisfied in order for an election to be effective, the FC must satisfy the above “50% of value” test for USRPHCs.

Exceptions to FIRPTA

Not every disposition of USRP by a foreign person is taxable and subject to withholding under FIRPTA.

For example, a foreigner may sell USRP and roll over the net proceeds therefrom as part of a deferred like-kind exchange without incurring a tax liability (provided that the replacement property is also USRP, the subsequent disposition of which would be taxable to the foreign seller).

This principle underlies other exceptions to gain recognition; specifically, if a foreign person exchanges one interest in USRP for another interest in USRP, the gain realized on the exchange may not be taxable if certain regulatory requirements are satisfied.

For example, a foreigner may contribute USRP to a USC (or to a FC that has elected to be treated as a USC under FIRPTA) in exchange for shares of stock in that corporation without incurring a tax liability, provided the foreign person “controls” the USC immediately after the exchange, and provided the transferee USC is a USRPHC after the contribution. (A narrower exception applies for certain transfers by foreigners to a non-electing FC, which is somewhat inconsistent with the above principle.)

Varieties of Dispositions

A sale of USRP is the most common type of disposition that triggers FIRPTA. However, there are many other transactions of which a foreigner needs to be aware.

For example, if a USRPHC redeems some (but not all) of the shares of a foreign shareholder, the redemption may not be subject to FIRPTA, and may instead be treated as a dividend, if the foreigner’s stock ownership is not sufficiently reduced.

If a USRPHC makes a cash dividend distribution to its shareholders in an amount that exceeds its earnings and profits, the distribution may result in taxable gain that will be subject to FIRPTA.

The partnership rules may generate similar results as to both distributions by, and contributions to, partnerships. The disguised sale rules, for example, may convert what appears to be a tax-free contribution of USRP by a foreigner to a partnership in exchange for a partnership interest into a partially taxable sale that is subject to FIRPTA.

What’s Next

Our next post will review the U.S. gift and estate tax consequences of which a foreign investor in USRP must be aware and must consider in structuring the acquisition, operation, and disposition of such property.

Over the last few years, we have received an ever-increasing number of inquiries from “foreigners” who are interested in acquiring U.S. real property (“USRP”).

Some of these foreigners – meaning closely-held business organizations formed outside the U.S., and individuals who are neither U.S. citizens nor U.S. permanent residents – were acquiring USRP to be used in their U.S. business operations (a “U.S. trade or business,” or “USTB”). Others were acquiring USRP for investment purposes, whether for the production of rental income or for appreciation.

Know the Client

Where the foreign client is acquiring USRP for business or investment use, we have to ascertain the client’s goals and, in the case of a client that is a business entity, the personal goals of its owners.

For example, are they looking to generate rental income, will they remit the net income out of the U.S., how important is limited liability protection, what about U.S. tax and other filing requirements?

In all cases, we need to understand whether the foreigner plans to dispose of the USRP in the relatively short-term, or whether the acquisition represents a longer-term investment.

Once we have determined these personal and business/investment goals, preferences, and concerns, we can turn to the related tax considerations.

U.S. Taxes – In General

There are a number of U.S. federal income tax consequences that may arise from a foreigner’s ownership, operation, and disposition of USRP. (There are state and local tax considerations, as well, of which the foreign person must be made aware, including, for example, the N.Y. Real Estate Transfer Tax and the N.Y.C. Real Property Transfer Tax.)

As in the case of any other business or investment transaction, taxes will have a significant impact upon the net economic benefit or cost realized by the foreigner. The more that a taxpayer pays in taxes in respect of the income or gain realized from a property, or the more slowly the taxpayer recovers the taxpayer’s investment in the property, the more expensive the investment becomes.

Where taxes are not considered early on, the acquisition and ownership of a USRP may not be properly structured to minimize taxes and expenses. Thus, it is critical to plan for taxes prior to the acquisition of the USRP. It may be very difficult, and very expensive, to “correct” the structure later, once the property has appreciated in value.

The Adviser’s Goal

The tax adviser’s job is to educate the foreign investor as to these basic U.S. tax considerations – before the USRP is acquired – and, then, to see how to accommodate the foreigner’s business, investment, and other goals within a tax-efficient structure.

I should note that, although we are focusing on a U.S.-tax-efficient structure, it is also imperative that the U.S. adviser confer with the foreigner’s non-U.S. tax advisers. The client’s U.S. and foreign plans must be coordinated, lest one undermine a purpose of the other. Thus, each of the transactions described below should be examined for the its consequences under the law of the foreign person’s home country.

For this reason, and for other reasons that will vary from taxpayer to taxpayer, I can say with some certainty that there is no single structure that satisfies all of a taxpayer’s goals.

U.S. Income Tax 

We begin with a brief summary of the principles that govern the U.S. income taxation of foreign persons as it relates to USRP.

Income Taxes – Source 

In general, the U.S. will tax foreigners only as to their U.S.-sourced real property income.

Rental income from a USRP, dividends paid by a U.S. corporation (“USC”) that owns USRP, an allocable share of income from a partnership that owns USRP, interest from loans made to U.S. persons to acquire or improve USRP, and gains from the sale of URSP are all treated as U.S.-sourced income that will generally be subject to U.S. income tax.

Income Tax – Nature of the Income

Next, we need to determine the nature of the US-sourced income. Specifically, is it “portfolio” investment income, or is it effectively connected to the foreigner’s conduct of a USTB?

Nature of the Income – FDAP

If it is “portfolio” income – i.e., not effectively connected to a USTB of the foreigner – the rental income, the dividend income, and the interest income will be characterized as so-called “fixed and determinable annual and periodic” (“FDAP”) income.

Notably, the gain from the sale of stock of a USC is not treated as FDAP. Indeed, it is generally not taxable by the U.S. at all, provided the stock is a capital asset in the hands of the foreign seller, it is not used in a USTB, and the corporation is not a U.S. real property holding corporation (“USRPHC”).

The U.S. taxes the gross amount of a foreigner’s FDAP income. Thus, in the case of “portfolio” rental income from USRP, no deduction is allowed for property taxes, maintenance, depreciation, etc.

In addition, the tax on such gross income is imposed at a default rate of 30%, though it may be reduced under a U.S. tax treaty if the foreigner is a bona fide resident of the other treaty country. This rate applies regardless of whether the foreigner is an individual or a corporation, and regardless of the assets held by the U.S. payor.

Thus, if a USC, the principal asset of which is USRP, pays a dividend to a foreign shareholder, the dividend will be treated as U.S.-sourced income and will be taxable at a 30% (or lower treaty) rate. If a U.S. borrower pays interest to a foreign lender, the interest will be taxable at a 30% (or lower treaty) rate.

By comparison, if the dividend is paid by a foreign corporation (“FC”), there generally is no U.S.-sourced income because the payor is not a USC; this is the case even if the FC’s only asset is USRP.

That being said, if a FC is treated as being engaged in a USRP trade or business, it may be subject to the so-called “branch profits tax” (“BPT”). This tax, which is basically a “deemed dividend tax,” is imposed at the rate of 30% on the FC’s accumulated net profits that were not reinvested in its USTB. It purports to be a tax on the FC’s undistributed U.S. income. Because it is applied after application of the U.S. corporate income tax, the BPT can result in a total federal corporate tax rate in excess of 54%.

FDAP Withholding

The tax on a foreigner’s FDAP is collected, or withheld, at the source, by the U.S. payor of the income, which then remits the tax to the IRS.

Assuming the withholding fully satisfies the foreigner’s U.S. income tax liability, the foreigner need not file a U.S. income tax return.

That being said, the foreigner may nevertheless choose to file a return so as to start the running of the limitations period for the assessment of any additional U.S. income tax; for example, just in case the IRS later determines that its USRP activities rise to the level of a USTB.

U.S. Trade or Business

Speaking of a USTB, what level of activity is required before the IRS will treat the foreigner’s USRP activity as a trade or business?

If a foreigner is developing property in the U.S., it is safe to say that the foreigner is engaged in a USTB, and that the net taxable income generated therefrom is effectively connected with such business and will be taxable as ordinary income at the graduated rates applicable to U.S. persons, up to a top marginal rate of 39.6% for individuals, and up to 35% for corporations.

It is equally safe to say, as one would imagine, that a triple net lease does not constitute a trade or business. The rental income therefrom is FDAP that is taxable on a gross basis.

In between, there can be a lot of uncertainty.

Thus, the management of a multi-unit building may rise to the level of a trade or business if the foreigner is involved (directly or through agents) in paying expenses, maintaining the property, making repairs, hiring contractors, interviewing tenants, handling tenant complaints, dealing with local government, etc., with some continuity and regularity, and the foreigner does not substantially rely upon a local management company. In the latter situation, the foreigner’s activities may be difficult to distinguish from those of a prudent investor.

Assuming the activity rises to the level of a trade or business, then the foreigner may deduct the expenses associated with the rental activity in determining taxable income. Thus, depreciation, property taxes, interest on a mortgage, contractor fees, insurance, etc., will be deducted from the gross income in determining the foreigner’s U.S. taxable income.

Partnership

Note that if a foreigner is a partner in a partnership that is itself engaged in a USRP trade or business, then the foreigner will be treated as being engaged in a USTB as to the foreigner’s distributive share of the partnership’s income, even if the foreigner is not itself actually so engaged.

USTB Election

Based on the foregoing, one would guess that being taxed on a net basis is usually better, economically speaking, than being taxed at a flat rate on a gross basis, and that is generally the case.

However, as we noted earlier, a foreigner whose USRP income is treated as FDAP is generally not required to file a U.S. income tax return, while a foreigner who is engaged in a USRP trade or business must file such a return. This is often an important consideration for some foreign investors.

Assuming that reporting is not an issue, the Code recognizes that it may be difficult to determine whether a USRP investment rises to the level of a USTB. Thus, a special election is provided.

If this election is filed timely – by the due date, with extensions, for the first year that the election is to apply – the foreigner who has rental income from USRP for the filing year may treat that income as being effectively connected with the conduct of a USTB. Thus, the foreigner will be able to claim the related expenses (including depreciation) as deductions for purposes of calculating its U.S. income tax liability. Once made, this election is irrevocable, and will apply for all subsequent years.

The IRS has taken this election a step further by allowing foreign taxpayers to make a protective election, such that if the IRS were to determine on audit that the rental income should have been taxed on a gross basis (as FDAP), the protective election would be triggered to preserve the tax treatment as a USTB reflected on the filed return.

Stay tuned for Part II, tomorrow.

The Charitably-Inclined Business

Many successful business owners attribute some part of their financial success to their community. The term “community” may have a different meaning from one business owner to another. In some cases, it may refer to the community in which the owner grew up, was educated, learned the values of hard work and sacrifice, and came to appreciate the importance of team effort. In other cases, it may refer to the community in which the business operates, from which it draws its workforce, to which it sells its services or products, and that supports the business in both good times and bad.

For some of these business owners, it is not enough to simply acknowledge this “debt” their community; rather, they feel an obligation to share some of their financial success with the community. Some owners or businesses will make contributions to local charities, religious organizations, schools, hospitals and civic groups. Others will provide scholarships or grants to local residents who otherwise could not afford to cover educational, medical, or other expenses. Still others will solicit the voluntary assistance of their workforce to support a local charitable organization in a fundraising or other public event.

These endeavors are commendable, but they are of an ad hoc nature, which means they are also of limited duration. This is because such activities are not necessarily institutionalized and they are dependent, in no small part, upon the business owner, who acts as the catalyst or motivating force for the charitable activities of the business.

Private Foundations

Recognizing these limitations, some business owners will establish a private foundation – typically, a not-for-profit corporation (separate from the business), that may be named for the owner, the owner’s family, or the business – which they will fund, either personally or through the business, with an initial contribution of cash or property. In later years, the owner may contribute additional amounts to the foundation, often culminating with a significant bequest to the foundation upon the death of the owner. With this funding, the foundation – which will not be financially dependent upon contributions from the general public (thus a “private” foundation, as distinguished from a “public” charity) – will have the wherewithal to conduct its charitable activities.

The foundation may be formed for a single charitable purpose or for a variety of charitable purposes. In most cases, the foundation’s only activity will be to make grants of money to other not-for-profit organizations that are directly and actively engaged in charitable activities (i.e., not grant-making), provided these grants and activities are in furtherance of the foundation’s stated purposes. In some cases, the foundation may, itself, be directly and actively engaged in conducting a charitable activity.

Whatever the nature of the foundation’s activities, the Code prescribes a number of rules with which the business owner must become familiar, and with which the foundation must comply if it hopes to secure and maintain an exemption from federal income tax. The following is a brief description of these rules.

Federal Tax-Exempt Status

Many business owners embark upon the establishment of a private foundation without first educating themselves as to the operation and tax treatment of a not-for-profit organization. Too often, they create the not-for-profit, transfer funds and other property to it, and begin conducting charitable activities. Years later, they learn that, under the Code, a not-for-profit is not per se exempt from federal income tax; indeed, they learn that the organization is fully taxable unless and until it applies to the IRS for recognition of its status as a tax-exempt organization; even then, they learn that the organization may lose its tax-favored status if it fails to file annual tax returns with the IRS.

In addition, because foundations are not dependent upon the public support for their financial survival – and, so, are not to “answerable” to the public – the Code provides a number of restrictions upon the use of foundation funds. These restrictions seek to discourage, and hopefully prevent, certain activities by a foundation that the IRS deems to be contrary to, or inconsistent with, the charitable nature, and tax-exempt status, of a foundation. The IRS enforces these restrictions through the imposition of special excise (i.e., penalty) taxes upon the foundation, the foundation’s managers (e.g., its board of directors), and so-called disqualified persons (“DP”; i.e., persons who are considered to be “insiders” with respect to the foundation).

Federal Tax Compliance Checklist

Securing recognition by the IRS of its tax-exempt status is only the beginning of a private foundation’s life as an organization for which tax considerations, and compliance with various tax rules, will play a significant role.

“It pays to know,” as the saying goes. In that spirit, the following “compliance checklist” should be reviewed by any business owner who has already formed, or who is contemplating the establishment of, a typical grant-making private foundation.

Is the Foundation being operated in furtherance of its charitable purposes? The Foundation must be operated in accordance with the exempt purposes set forth in its certificate of incorporation and described in its tax-exemption application (Form 1023) filed with the IRS. It must be operated to further a public interest, and no part of its net earnings may inure to the benefit of any private individual.  If the Foundation’s activities result in any prohibited private benefit or inurement, its tax-exempt status could be revoked by the IRS.

  • Does the Foundation have a grant-making policy? How does it select the organizations to which it make grants? What criteria are used? Does it accept applications for grants? How is the selection process recorded? How does the Foundation assure itself of a donee’s tax-exemption, its public charity status, and the grant’s furtherance of the Foundation’s charitable purpose, prior to making a distribution?
  • Is the Foundation authorized to make grants to organizations in addition to those that are recognized as tax-exempt charities by the IRS? How do such grants further charitable purposes?
  • Is the Foundation authorized to make grants to foreign charities? If so, how will it establish that the foreign charity would have qualified as a tax-exempt organization if it had been formed in the U.S.? Does it make pre-grant inquiries, including the donee’s financial status and its ability to accomplish the purpose for which the grant is being made? How does the Foundation verify that the grant funds are being used for the intended purpose?
  • Is the Foundation authorized to make grants to other private foundations? Is it prepared to exercise “expenditure responsibility” with respect to such grants? What types of reports does it require from the donee as to the use of the grant monies?
  • Is the Foundation authorized to make grants to individuals and, if so, for what purposes? How will it select individuals for grants? What criteria will it use? If the purposes are for travel or education, will it require periodic reports from the grantee? Does it maintain case histories?
  • Has the Foundation engaged in any political campaign activity? If the Foundation engages in any political activity, its tax-exempt status could be revoked by the IRS.
  • Has the Foundation sought to influence legislation? Has it engaged in any “lobbying” activity and, if so, to what degree? Does it limit itself to “educating” the public, to presenting both sides of an issue?
  • Has the Foundation distributed the prescribed minimum annual amount, equal to five percent of the fair market value of its non-charitable assets, to accomplish charitable purposes? In general, “qualifying distributions” include administrative expenses and grants to independent public charities.
  • Does the Foundation have, and has it complied with, a conflict of interest policy?
  • Does any DP have any business dealings with the Foundation? For example, has the Foundation sold property to, or purchased property from, a DP? Generally speaking, it shouldn’t have such business dealings.
  • Does the Foundation lease property from a DP? It may only do so on a rent-free basis.
  • Has the Foundation leased its property to a DP? It is prohibited from doing so.
  • Has the Foundation borrowed money from a DP? It may only do so on an interest-free basis.
  • Has the Foundation loaned money to a DP? It is prohibited from doing so.
  • Has the Foundation paid compensation to, or has it reimbursed the expenses incurred by, a DP? The Foundation may only pay compensation that is reasonable for the services rendered. How will it determine the reasonableness of the compensation? Has it looked for comparables? How does it memorialize its compensation decisions?
  • Has the Foundation paid the personal expenses, or satisfied the personal obligations, of any DP?
  • Has the Foundation invested in business entities, including any in which a DP owns an interest? A private foundation is not permitted any holdings in a sole proprietorship that is a “business enterprise.” In general, a private foundation is permitted to hold up to twenty percent of the voting stock of a corporation, reduced by the percentage of voting stock actually or constructively owned by DP. (There are some exceptions.)
  • Has the Foundation invested any of its assets in such a manner that the carrying out of its exempt purposes is jeopardized?  An “ordinary business care and prudence” standard applies in determining whether the Foundation has made investments that may jeopardize its exempt purpose.
  • Has the Foundation reported the existence of any of the proscribed situations set forth above? Has it, along with its DP, “corrected” any of these?
  • Has the Foundation paid the annual excise tax on its investment income?
  • Has the Foundation engaged in any business that is unrelated to its exempt purpose? Has it reported this activity and the income therefrom to the IRS on Form 990-T?
  • Has the Foundation made its annual federal tax return (on IRS Form 990‑PF), its tax-exemption application (IRS Form 1023), and its IRS determination letter available for public inspection?
  • Has the Foundation issued a receipt to its donors in respect of any contribution to the Foundation of two hundred fifty dollars ($250) or more? Contemporaneous written acknowledgment of the contribution is required in order for the donor to claim a deduction.

Parting Advice

The above checklist may intimidate many business owners and their families. The operation of a private foundation, however, is no small matter. Because of its tax status, it is effectively a quasi-public organization. A business owner who is used to “doing things his own way” may find these rules too restrictive or onerous.

As was stated earlier, the foregoing is intended as a resource for those already operating a foundation, and for those thinking about starting one. However, it is no substitute for retaining the services of knowledgeable and experienced tax and not-for-profit corporate advisers. Although a sophisticated business owner may be familiar with, or may intuit, some of the rules described above, there are many more that will be foreign to one who is not immersed in the world of tax-exempt not-for-profits. These rules are the price exacted for the favorable tax treatment bestowed upon private foundations and their contributors.

As always, the well-intentioned, charitably-inclined business owner will be well-served, and will successfully accomplish his charitable goals (and avoid unpleasant surprises), if he educates himself and consults with a qualified professional.

NYC Never Sleeps – But It Does Tax

“If I can make it there, I’ll make it anywhere.”  So begins one of the most iconic of musical tributes to New York City. It is sung at every Yankees game. It sums up the feelings of thousands of aspiring artists. As it turns, out, however, it also captures the reaction of many closely-held businesses that choose to make a go of it in The Big Apple.

No, I am not referring to the intensely competitive business environment that is NYC, nor am I referring to the high cost of rent and labor in NYC that reduce the margins of every business and challenge the bottom line of every business owner.

Rather, I am referring to the many different kinds of taxes that NYC imposes on closely-held businesses. No business owner can afford to begin operations in NYC without first educating himself as to the taxes that may be imposed upon his business for the privilege of operating in NYC, and the economic cost that these taxes represent.

What follows is a brief summary of these taxes. Some taxes will be familiar to most readers; others will come as a surprise to some readers. Still other taxes are unique to NYC. In some cases, different taxes are imposed upon the same base amount; in others, the application of the tax will depend upon the “tax residence” of the business owner.

Personal Income Tax (the “PIT”)

An individual who is a resident of NYC is responsible for paying NYC Personal Income Tax (at a maximum rate of 3.876%, inclusive of a special surcharge) on the income he derives from all sources, regardless of where the income is generated, and regardless of the nature of the income; for example, it includes a NYC resident’s operating income generated through a sole proprietorship or partnership, as well as dividends received by the NYC resident from a corporation.

On the other hand, a nonresident individual is not subject to PIT, notwithstanding that his income is generated within NYC; for example, a nonresident who is a member of a partnership that does business in NYC is not subject to PIT as to his share of partnership income attributable to NYC; whereas a NYC resident of that same partnership would be subject to PIT on his share of the partnership’s income.

Resident Status

A business owner who calls NYC home – who is “domiciled” in NYC – is a resident taxpayer. One who owns and operates a business in NYC, but who lives outside NYC, and who does not maintain a so-called “permanent place of abode” in NYC, is not a City resident.

However, if the business owner, or if the business, owns or rents an apartment in NYC that the owner may use personally, the business owner could be treated as a City resident for purposes of the personal income tax by virtue of the number of days (more than 183) he spends working in NYC, even if he uses the apartment only infrequently (and even if the apartment is located in a borough other that the one in which the business is located).

Business Corporation Tax (the “BCT”)

Effective for tax years beginning on or after January 1, 2015, several significant changes were made to NYC’s corporate income tax, including, for example, with respect to the nexus, the primary tax base, combined reporting (based on ownership rather than intercorporate transactions), and the apportionment/sourcing of income to NYC.

Unlike the PIT, which is based on residency, a corporation is subject to the BCT based on whether it is “doing business” (i.e., doing business, employing capital, owning or leasing property, or maintains an office) in NYC, for all or any part of its taxable year.  The BCT is imposed at a maximum rate of 8.85%. A corporation may be considered to be “doing business” in NYC if it is a partner/member in a partnership/LLC that does business in NYC.

A “corporation” for this purpose includes any entity that is formed as a corporation under state law, as well as an entity that elects (under the “check the box” rules) to be taxable as a corporation for federal tax purposes.

A foreign corporation is not treated as doing business (and thus, would not be subject to the BCT by virtue of certain de minimis activities, including, for example, (1) maintaining cash balances with NYC banks; (2) owning shares of stock or securities that are kept in NYC (as in a safe deposit box, safe, or vault); (3) the maintenance of an office in NYC by a director or officer of the corporation who is not employed by the corporation, provided the corporation is not otherwise doing business in NYC; (4) keeping books or records of the corporation in NYC if they are not kept by employees of the corporation and the corporation does not otherwise do business in NYC; (5) or any combination of the foregoing activities.

The tax is generally determined upon the basis of the corporation’s business income, or the portion thereof that is allocated within NYC. The term “business income” means the corporation’s entire net income, minus investment income and other exempt income. The term “entire net income” generally means total net income from all sources that the taxpayer is required to report to the IRS.

An “S corporation” and its “qualified subchapter S subsidiaries” are not subject to the Business Corporation Tax, but remain subject to the pre-2015 provisions of the General Corporation Tax. NYC does not recognize “S-Corporation” elections, and thus, the S corporation itself is subject to the entity-level BCT (unlike for federal and New York State purposes).

Unincorporated Business Tax (the “UBT”)

NYC imposes the UBT on the unincorporated business taxable income of an unincorporated business (e.g., a partnership) that is wholly or partly carried on within NYC at a rate of 4%. If an unincorporated business is carried on both within and without NYC, a portion of its business income must be allocated to NYC. The UBT is an entity-level tax, and thus, unincorporated business taxable income is subject to both the UBT and, in the case of a NYC resident, the PIT (unlike for federal and New York State purposes, which generally do not impose an entity level tax on unincorporated business income).

An “unincorporated business” means any trade or business conducted or engaged in by an individual (a sole proprietorship) or unincorporated entity, including a partnership. If an individual or an unincorporated entity carries on two or more unincorporated businesses in NYC, all such businesses will be treated as one unincorporated business for the purposes of the tax.

An unincorporated entity will be treated as carrying on any trade or business carried on in whole or in part in NYC by any other unincorporated entity in which the first unincorporated entity owns an interest.

An individual or other unincorporated entity, except a dealer, shall not be deemed engaged in an unincorporated business solely by reason of (A) the purchase, holding and sale of property for his or its own account, (B) the acquisition, holding or disposition, other than in the ordinary course of a trade or business, of interests in unincorporated entities that are themselves acting for their own account, or (C) any combination of such activities. The term “property” generally means real and personal property, including, for example, stocks or bonds.

An owner of real property, a lessee or a fiduciary will not be deemed engaged in an unincorporated business solely by reason of holding, leasing or managing real property. In general, if an owner, lessee or fiduciary (other than a dealer) who is holding, leasing or managing real property, is also carrying on an unincorporated business in NYC, whether or not such business is carried on at, or is connected with, such real property, such holding, leasing or managing of real property shall not be deemed an unincorporated business if, and only to the extent that, such real property is held, leased or managed for the purpose of producing rental income from such real property or gain upon the sale or other disposition of such real property.

In general, the term “unincorporated business gross income” means the sum of the items of income and gain of the business includible in gross income for federal income tax purposes (with certain modifications), including income and gain from any property employed in the business, or from the sale or other disposition by an unincorporated entity of an interest in another unincorporated entity if, and to the extent, such income or gain is attributable to a trade or business carried on in NYC by such other unincorporated entity.

The term “unincorporated business deductions” of an unincorporated business generally means the items of loss and deduction directly connected with or incurred in the conduct of the business, which are allowable for federal income tax purposes for the taxable year (with certain modifications).

If an unincorporated business is carried on both within and without NYC, a portion of its business income must be allocated to NYC.

Commercial Rent Tax (the “CRT”)

NYC requires most tenants to pay the CRT based on the tenant’s base rent (generally at an effective rate of 3.9%) where the annual base rent exceeds $250,000. The CRT is imposed only with respect to “taxable premises.”

The term “taxable premises” generally means any premises located south of the center line of 96th Street in Manhattan that are occupied or used for the purpose of carrying on any trade, business, or other commercial activity, including any premises that is used solely for the purpose of renting the same premises in whole or in part to tenants. Physical occupancy of the premises by the tenant is not required – a tenant’s possessory right to the premises makes them taxable.

The term “base rent” means the amount paid, or required to be paid, by a tenant for the use or occupancy of premises for an annual period, whether received in money or otherwise, including all credits and property or services of any kind, and including any payment required to be made by a tenant on behalf of a landlord for real estate taxes, water rents or charges, sewer rents, or any other expenses (including insurance) normally payable by a landlord who owns the realty, other than expenses for the improvement, repair or maintenance of the tenant’s premises, with certain adjustments.

Sales and Use Tax (the ‘SUT”)

In general, the Sales Tax applies to retail sales of tangible personal property made, and to certain services rendered, where such property or services are delivered within NYC. The SUT also applies to tangible personal property or services that are purchased outside NYC and then used within NYC. The SUT is imposed in addition to, and is administered together with, the New York State sales and use tax.

The SUT rate is 4.5%. Every vendor of property and services subject to the SUT is required to collect the SUT from the purchaser of such property or services. In addition to the SUT, taxable “retail sales” are also subject to the NYS sales and use tax of 4% and a Metropolitan Commuter Transportation District surcharge of 0.375%, thereby bringing the total NYC sales and use tax rate to 8.875%.

Real Property Transfer Tax (the “RPTT”)

The RPTT is imposed on the conveyance of real property, including certain economic interests in real property, situated in NYC. The RPTT is imposed in addition to the NY State Real Estate Transfer Tax.

The RPTT, which is payable by the grantor, applies whenever the consideration for the sale or other transfer is more than $25,000. The tax – which is usually paid as part of the closing costs at the sale or transfer of real property – is imposed as follows: in the case of an interest in non-residential real property, if the value is $500,000 or less, the rate is 1.425% of the consideration; if the value is more than $500,000 the rate is 2.625%.  (The New York State Real Estate Transfer Tax applies to transfers in excess of $500, and is imposed at a rate of 0.40% of the consideration.)

A taxable sale includes, among other things, the sale of real property, the grant of a lease of real property (unless the only consideration paid constitutes rent), and the sale of a leasehold interest. The tax is also imposed with respect to the sale or transfer of at least 50% of the ownership in a corporation, partnership, or other entity that owns or leases real property in NYC (and there have been legislative proposals to impose RPTT on all transfers of interests in entities that own or lease real property in NYC, not just those transfers of at least a 50% interest).

Certain transfers are exempted from the tax; among these are the following: a pledging of real property solely as security for a debt; a transfer from an agent or “straw man” to its principal (or vice versa); a transfer that effects a mere change of identity or form of ownership or organization, with no change of the beneficial ownership.

“Hand[s] in the Air for the Big City”? (apologies to Alicia Keys)

No, it’s not a hold-up – more likely a plea for divine intervention – but based upon the above description of some of NYC’s business-related taxes, it certainly may feel that way to a business owner operating in NYC. The number of different taxes for which returns must be filed and taxes paid, and the magnitude of the tax rates, will certainly make some businesses pause before venturing into NYC – even after accounting for the deductibility of some of these taxes for federal income tax purposes, for example – especially when one factors in the other costs involved.

That being said, there may be valid business reasons for a “taxable presence” in NYC, including the panache and visibility of a City address, the proximity to a sophisticated market, and the convenience afforded to certain clients or customers.

These business reasons need to be weighed against the costs of a NYC presence, and that includes City taxes.

Oops

The last few posts have focused upon the “tax-free” contribution of property to a partnership. Today, we’re “doing a 180,” as they say (whoever “they” are), and considering how the acquisition of assets may be structured so as to provide the buyer with a cost, or “stepped-up,” basis in those assets. It sounds simple enough, but there will be times when a buyer (especially a partnership) may inadvertently stumble into a partially tax-free transaction – as where part of the consideration paid consists of equity in the buyer – thereby losing the benefit of a full basis step-up for the assets being acquired.

For example, I recently came across a situation in which the buyer-LLC was treated as a partnership for tax purposes. The buyer offered to acquire most of the target corporation’s assets (with zero basis in the hands of the target) in exchange for cash and a minority membership interest in the LLC (both payable at closing). I learned that the buyer intended to take the target assets with a full step-up in basis, and believed that this structure would accomplish this goal. What a surprise when it learned that the target’s transfer of its assets for cash plus equity would be treated for tax purposes as two transactions: (i) an acquisition of some target assets in exchange for equity in the buyer-LLC, which would be treated as a tax-free exchange, with the buyer taking those assets with zero basis, and (ii) an acquisition of the other target assets for cash, with the buyer taking those assets with a basis step-up.

Buyer’s Druthers

As we have stated on many occasions, the buyer’s preference will almost always be to acquire the assets of the target company, rather than its stock. There are two primary reasons for this preference:

  • First, the buyer does not want to take subject to, or assume, all of the liabilities of the target company (which will necessarily be the case with an acquisition of all of the issued and outstanding shares of the target stock); and

Second, the buyer wants to acquire a step-up in basis for the target assets (equal to the purchase price for the assets) that it may then amortize or depreciate, as the case may be, thereby allowing the buyer to recover its cost for the assets on a current basis, and thus making the transaction economically less expensive for the buyer.

Use of Buyer’s Equity

Of course, the seller will prefer to defer the recognition and taxation of any gain to be realized on the transfer of assets to the buyer.

This deferral may be achieved in one of two ways:

  • the buyer agrees to pay at least part of the purchase price after the tax year in which the sale occurs (an installment obligation, or an “IO”), or
  • the buyer issues equity to the seller.

The former is still part of a taxable transaction for tax purposes, but it defers the seller’s tax liability to the year(s) in which principal payments are made under the installment obligation (though the sale of some assets does not qualify for installment reporting, and the deferred gain may be accelerated under certain circumstances); the latter is generally not a taxable event.

I say “generally” because there are exceptions, depending upon the buyer’s status for tax purposes and upon how the acquisition is structured. For example, if the buyer is a corporation, it may issue shares to the target in exchange for the target’s assets without jeopardizing its acquiring the target assets with a full step-up in basis equal to the fair market value of the equity and other consideration transferred by the buyer, provided these shares represent less than 80% of the total voting power or value of the corporation’s equity (i.e., less than “control”).

Similarly, where both the target and the buyer are corporations, and the target merges with and into the buyer, with the buyer surviving, the buyer may issue shares of its stock, plus other property and/or cash, as merger consideration without jeopardizing its acquiring the target assets with a full step-up in basis, provided the equity represents less than 40% of the total consideration transferred.

On the other hand, if the buyer is an LLC that is either disregarded or treated as a partnership for tax purposes, its issuance of even a minority equity interest in exchange for any assets of the target will result in its taking such assets with the same basis that they had in the hands of the target – not stepped-up to the value of the consideration paid.

Straight Asset Sale

The simplest structure for ensuring the buyer receives a full basis step-up in the acquired assets is for the buyer to transfer cash, an installment obligation or other deferred payments (such as an earn-out), and/or other property to the target company in exchange for its assets. The consideration may also include those target liabilities that the buyer may agree to assume (such as trade payables). A corporate buyer may even transfer its own stock as consideration, provided the amount transferred does not give the seller control of the buyer immediately after the transfer.

The buyer will thereby acquire the assets with a holding period that begins with the acquisition, and with a basis equal to the total consideration paid, including the face amount of any IO issued by the buyer (assuming the IO bears adequate interest).

Acquisition Subsidiary

Although the buyer may acquire the assets directly, it may prefer to shelter its existing assets and business from any liabilities that may arise out of the acquired assets.

For that reason, the buyer may first form a wholly-owned subsidiary corporation or LLC that will be funded by the buyer and that will act as the acquisition vehicle for the target assets. The wholly-owned LLC will generally be disregarded for tax purposes. Where the buyer is an S-corporation, it may elect to treat the new subsidiary corporation as a “qualified subchapter S subsidiary” (or “Q-sub”) that will also be disregarded for tax purposes. Either way, the tax consequences arising from the ownership and operation of the acquired target business will be reflected on the parent company’s tax return.

Sec. 338(h)(10) Election for Stock Purchase

It may be that the assets of the target corporation include assets the direct acquisition of which may be difficult to effectuate through a conventional purchase and sale (e.g., a license). In that case, the buyer may have to purchase the issued and outstanding shares of the target’s stock. How, then, can the buyer obtain a basis step-up for the target’s assets?

In general, provided: (i) the buyer is a corporation, (ii) the buyer acquires at least 80% of such stock, (iii) the target is an S-corporation, or a member of an affiliated or consolidated group of corporations, and (iv) the target’s shareholders consent (including, in the case of an S-corporation target, any non-selling shareholders), then the stock sale will be ignored, and the buyer will be treated, for tax purposes, as having acquired the target’s assets with a basis step-up equal to the amount of consideration paid by the buyer plus the amount of the target’s liabilities.

Section 336(e) Election for Stock Purchase

Where an election under Sec. 338(h)(10) of the Code is not available – for example, because the buyer is not itself a corporation – the buyer may want to consider an election under Sec. 336(e) of the Code.

The results of a Sec. 336(e) election are generally the same as those of a Sec. 338(h)(10) election in that the target, the stock of which was acquired by the buyer, is treated as having sold its assets to the buyer.

This election, however, may only be made by the seller’s shareholders – it is not an election that is made jointly with the buyer. In the case of an S-corporation target, all of its shareholders must enter into a binding agreement to make the election, and a “Sec. 336(e) election statement” must be attached to the S-corporation’s tax return for the year of the sale.

The buyer that finds itself in these circumstances will want to “require” the S-corporation’s shareholders to make the Sec. 336(e) election. Of course, it may have to pay a premium in terms of increased purchase price for the stock being acquired in order to induce them to consent.

Purchase of Membership Interests

If the target is an LLC that is either treated as a partnership or disregarded for tax purposes, the buyer’s acquisition of all of the LLC’s outstanding membership interests will be treated as a purchase of all of the LLC’s assets and the “assumption” of its liabilities. Thus, the buyer will take the assets with a stepped-up basis.

Where the LLC is treated as a partnership, it may be that some of its members do not want to sell their membership interests (and nothing in their operating agreement compels them to do so). In that case, the buyer will not be treated as having acquired the LLC’s assets for tax purposes.

However, if the LLC has already made an election (that remains in effect) under Section 754 of the Code, or if the LLC makes such an election for the taxable year in which the sale of the membership interests occurs, then the buyer will receive a special basis adjustment with respect to the LLC’s underlying assets. This adjustment will be treated as a “new asset” that is being placed in service beginning with the buyer’s acquisition of the membership interests. Moreover, any depreciation or amortization deductions attributable to these “new” assets will be specially allocated to the buyer and not to the holdover members of the LLC. On a later sale of any of these “new” assets, the amount the gain therefrom that is otherwise allocated to the buyer will be reduced by the amount of any remaining (i.e., not-yet-depreciated/amortized) adjustment for that asset.

Forward Merger

It may be that the assets of the target corporation are such that their direct acquisition through a conventional purchase and sale may be difficult to effectuate. In that case, the buyer may want to consider a merger of the target with and into the buyer, with the buyer surviving the merger. Provided the consideration does not include equity in the buyer (or, in the case of a corporate buyer, includes only a relatively small amount of equity), the transaction will be treated for tax purposes as an acquisition of the target’s assets (followed by the liquidation of the target) for which the buyer will receive the desired stepped-up basis.

As in the case of a straight asset sale, the buyer may prefer to keep its existing business assets separate from those being acquired from the target by first creating a wholly-owned subsidiary corporation or LLC that will be funded by the buyer and that will act as the acquisition vehicle for the merger; the target will merge into this subsidiary and, in exchange, the target’s shareholders will receive the taxable merger consideration.

Purchase Subsidiary Equity

In some situations it may be easier to acquire the target business by acquiring the target’s equity from its owners. Of course, this will also result in the buyer’s acquiring all of the target assets and assuming all of the target liabilities (including both assets and liabilities that the buyer does not want to take).

This need not be the buyer’s only choice, however; instead, the target may transfer the desired assets and the assumed liabilities into a newly-formed LLC, while retaining the unwanted assets and liabilities. The buyer may then acquire the target’s entire membership interest in the LLC. For tax purposes, this acquisition will be treated as a purchase of the LLC’s assets, thereby giving the buyer the desired basis step-up.

Where the target assets cannot be easily transferred, the better approach may be to keep the target intact and to remove the unwanted assets. The target owners may contribute their equity in the target to a new holding company in exchange for all of the equity in the holding company. The holding company thereby becomes the sole owner of the target.

Following this step, if the target is an LLC, it will be treated as a disregarded entity for tax purposes. If the target is an S-corporation, the holding company and the target may elect to be treated as an S-corporation and a Q-sub, respectively. If the target is a C-corporation, it may be merged into a newly-formed LLC that is also entirely owned by the holding company (though it should be noted that this merger will be treated as a taxable sale of its assets by the C-corporation target). The “conversion” of the target into a disregarded unity for tax purposes will enable the target to then transfer to its parent holding company those assets and liabilities that the buyer does not want to take. The buyer may then acquire the target equity from the holding company in a transaction that, for tax purposes, will be treated as a purchase of the target assets with a stepped-up basis.

Consider the Options

The foregoing discussion highlights a number of methods by which a buyer may acquire a target’s assets with a step-up in basis. One approach may be better than another, depending upon the facts and circumstances and upon the nature of the target, its business, its assets, and its owners. In some cases, it may be possible to combine methods as part of a “single” acquisition.

What the buyer must realize is that there are choices – it is not limited to only one method by which to acquire a target’s assets with a basis step-up. One of these approaches, or a combination thereof, may not only secure a depreciable/amortizable basis increase for the buyer, it may also accommodate other business goals.

A Continuing Investment

In the last two posts, we saw how a Taxpayer who transfers Property A to a partnership (“Partnership”) in exchange for an equity interest therein will not be required to recognize the gain realized on the transfer. This gain will not be included in Taxpayer’s gross income because Taxpayer is viewed under the Code as continuing his investment in Property A, albeit indirectly, through his interest in Partnership; thus, the theory goes, it would not be appropriate to tax him on the gain realized.

We also saw that, because the Code views Taxpayer’s investment in Partnership as a continuation of his investment in Property A, Taxpayer’s basis for his interest in Partnership will be the same basis that he had in Property A at the time of the contribution. In this way, the gain realized by Taxpayer on his transfer of Property A is preserved and may be recognized on the subsequent sale or liquidation of his Partnership interest.

In what may be characterized as the other side of the same coin (I may have mentioned in some earlier post that I am “idiom-challenged”), we saw that Partnership will take Property A with a basis equal to the basis that Taxpayer had in Property A at the time of its contribution to Partnership. Thus, the gain inherent in Property A at the time it was contributed by Taxpayer (the “pre-contribution gain”) will also be preserved in the hands of Partnership, and such gain will be taxed to Taxpayer on Partnership’s taxable disposition of Property A.

An In-Kind Distribution

Distribution to Taxpayer

Instead of selling Property A, what if Partnership simply distributes Property A to Taxpayer? Taxpayer is thereby restored to his pre-contribution position, even if Property A has appreciated in value after its contribution to Partnership (as, presumably, has Taxpayer’s interest in Partnership). Thus, the distribution is not taxable.

Distribution to Another Partner

What if Partnership, instead, distributes Property A to another partner (“Partner”)? At that point, Taxpayer’s indirect interest in Property A is terminated, and Taxpayer no longer has to be concerned that the gain realized by Partnership on a later sale of Property A (to the extent of its pre-contribution gain) will be specially allocated, and taxed, to him. Rather, Partner will now be taxed on his subsequent sale of Property A; without more, and provided the distribution to Partner is not in liquidation of his interest in Partnership, he will take Property A with the same basis that Partnership had in the property. Thus, Taxpayer’s pre-contribution gain may be shifted to Partner. Would it be appropriate to require Taxpayer to recognize the pre-contribution gain at that time?

Distribution of Another Property to Taxpayer

What if Partnership retains Property A, but distributes other property (“Property B”) to Taxpayer? Taxpayer continues to have an indirect interest in Property A, but he has also acquired a property other than the one that he originally contributed to Partnership. Taxpayer’s basis in Property B will be the same basis that Partnership had in the property. If that basis is greater than Partner’s pre-contribution basis in Property A, Taxpayer may sell Property B and realize less gain than if he had sold Property A. In addition, it follows that Taxpayer’s interest in Property A is somewhat reduced as a result of the distribution of Property B to Taxpayer, while Partner’s interest therein has increased. Would it be appropriate to require Taxpayer to recognize the pre-contribution gain in Property A at that time?

A “Deemed” Exchange

In general, a partner who receives a distribution of property from a partnership will not recognize gain on the distribution, except to the extent that the amount of money distributed exceeds the partner’s adjusted basis for his interest in the partnership immediately before the distribution. Likewise, no gain will be recognized to the partnership on the distribution of property to a partner. In short, an in-kind distribution of property will generally not be taxable to the distributee partner or to any other partner.

There are exceptions to this general nonrecognition rule that encompass the situations described above, and that seek to prevent the shifting of the tax consequences attributable to a property’s pre-contribution gain away the contributing partner, and to another partner.

In order to accomplish this goal, these rules – often referred to as the “mixing bowl” rules – effectively treat a partnership’s in-kind distribution of a property to a partner as the second step of a taxable exchange, the first step being that partner’s, or another partner’s, contribution of another property to the partnership. The partnership is treated as a vehicle through which the exchange is effected.

Distribution to Taxpayer

Under the first exception, if property that was contributed by a partner to a partnership is then distributed by the partnership to another partner within seven years of its contribution, then the contributing partner will be required to recognize gain in an amount equal to the gain that would have been allocated to him if the property had been sold at its fair market value at the time of the distribution (the pre-contribution gain). (Congress decided that a seven-year period was necessary in order to ensure that the contribution to, and distribution from, the partnership were independent of one another, and not steps or parts of planned exchange.)

Thus, in the first scenario described above, if Property A is distributed to Partner within seven years of Taxpayer’s contribution of the property to Partnership, Taxpayer will recognize, and be taxed on, Property A’s pre-contribution gain.

Distribution to Another Partner

Under the second exception, if a partnership distributes property to a partner who, within the preceding seven years, contributed other property to the partnership (which the partnership still owns at the time of the distribution – meaning that its pre-contribution gain has not yet been recognized), then such partner shall be required to recognize the pre-contribution gain of the contributed property.

This is the same gain that would have been recognized by the contributing partner if the property which had been contributed to the partnership by such partner within seven years of the distribution, and is held by such partnership immediately before the distribution, had been distributed by the partnership to another partner (as in the first scenario described above).

Thus, in the second scenario described above, if Property B (which had been contributed to Partnership by Partner) is distributed to Taxpayer within seven years of Taxpayer’s contribution of Property A to Partnership, Taxpayer will recognize, and be taxed on, Property A’s pre-contribution gain.

A “Like-Kind” Exchange?

We stated earlier that the above “anti-gain-shifting” rules effectively treat a partnership’s distribution of a property to a partner as the second step of a taxable exchange, with the first step being that partner’s, or another partner’s, contribution of another property to the partnership.

These rules implicitly assume that the properties that are deemed to have been exchanged are not of like-kind and, so, the exchange is taxable. However, what if the properties are, in fact, of “like-kind”? In other words, what if the like-kind properties had exchanged directly, without first passing them through the partnership? In that case, the exchange may have qualified as a “tax-free” exchange under the like-kind exchange rules.

Following this line of thinking, the mixing bowl rules generally provide that if pre-contribution gain property is distributed to a partner other than the contributing partner, and other property of like-kind to the contributed property is distributed from the partnership to the contributing partner within a specified period of time, then the amount of gain that the contributing partner would otherwise have recognized under the above mixing bowl rules is reduced by the amount of built-in gain in the distributed like-kind property in the hands of the contributing partner immediately after the distribution.

Thus, if Property A and Property B are of like-kind to one another and, within seven years of Taxpayer’s contribution of Property A to Partnership, Partnership distributes Property B to Taxpayer and Property A to Partner, then Taxpayer will not have to recognize the pre-contribution gain in Property A to the extent of the gain inherent in Property B after the distribution; at least some of the pre-contribution gain in Property A is preserved in Taxpayer’s hands.

Advice to the Contributing Partner?

Last week we stated that Taxpayer would be well-advised to negotiate for a prohibition, for a period of time, on Partnership’s sale of any property contributed by Taxpayer.

Based upon this week’s discussion, it may behoove Taxpayer to also negotiate for a period of time (say, seven years) during which Partnership will not distribute Property to another partner, at least not without Taxpayer’s prior consent.

Taxpayer may also want to request that, in the event that Partnership has to distribute its properties (e.g., in liquidation), it will do so in a way that minimizes any adverse tax consequences to Taxpayer under the mixing bowl rules. This may include a provision that requires the “return” of Property A to Taxpayer, if feasible (and provided it makes sense from a business perspective).

Alternatively, Taxpayer may try to negotiate for a provision that would require Partnership to make a cash distribution to Taxpayer in an amount sufficient to enable him to satisfy the tax liability resulting from the application of these rules.

As always, it is important that Taxpayer be aware of, and that he consider the potential economic effect of, the foregoing rules prior to his contributing Property to Partnership in exchange for a partnership interest. Armed with this knowledge, Taxpayer may be able to negotiate a more tax-favorable agreement regarding the disposition of his contributed property by the Partnership.

Contributing Property to A Partnership

When a taxpayer (“Taxpayer”) sells a property (“Property”) with a fair market value (“FMV”) in excess of Taxpayer’s basis in Property in exchange for cash in an arm’s-length transaction, the amount of gain that he realizes on the sale is measured by the difference between the amount of cash received by Taxpayer over his basis for Property.

Because Taxpayer has terminated his investment in Property (by exchanging it for cash), he must include the gain realized in his gross income for the year in which the sale occurred.

If Taxpayer instead contributes Property to a partnership (“Partnership”) in exchange for an “equally” valuable equity interest therein, he will still realize a gain on the exchange, but such gain will not be recognized (i.e., it will not be included in Taxpayer’s gross income) because Taxpayer is viewed under the Code as continuing his investment in Property, albeit indirectly, through his partnership interest; thus, it would not be appropriate to tax him on the gain realized.

Preserving the Gain

As we saw last week, because the Code considers Taxpayer’s investment in Partnership as a continuation of his investment in Property, Taxpayer’s basis for his partnership interest will be the same basis that he had in Property. In this way, the gain realized by Taxpayer on his disposition of Property is preserved and may be recognized on the subsequent sale or liquidation of his Partnership interest.

But what if Taxpayer does not dispose of his Partnership interest in a taxable transaction? What if he leaves it to his heirs with a stepped-up basis at his death? What if Partnership disposes of Property? To whom will the gain from a sale of Property be allocated?

Never fear, the Code and the regulations promulgated thereunder have foreseen this possibility and have accounted for it.

First of all, Partnership will take Property with a basis equal to the basis that Taxpayer had in Property at the time of its contribution to Partnership.

Thus, the gain inherent in Property at the time it is contributed by Taxpayer (the “pre-contribution BIG”) will also be preserved in the hands of Partnership.

You may ask, won’t this gain be allocated among all the partners, including Taxpayer, based upon their relative interests in Partnership? Simply put, no, and that is why it is imperative that any taxpayer who intends to contribute appreciated property to a partnership in exchange for a partnership interest therein should be aware of the tax consequences described below and should plan for them.

The Allocation of Pre-Contribution Built-In Gain

In order to prevent the pro rata allocation of the pre-contribution BIG among the contributing and noncontributing partners, and the resultant “shifting” of income tax consequences, the Code and the Regulations provide a set of rules with respect to the allocation of any pre-contribution BIG. These rules require that a partnership must allocate its income, gain, loss and deduction with respect to contributed property so as to take into account the pre-contribution BIG.

In general, these rules require that when a partnership has income, gain, loss or deduction attributable to a property that has pre-contribution BIG, the partnership must make appropriate allocations among its partners to avoid shifting the tax consequences of the pre-contribution BIG away from the contributing partner. (View it as a variation of the “assignment of income” doctrine.)

Allocating Gain

Thus, if Partnership sells Property and recognizes gain, the pre-contribution BIG on Property will first be allocated to Taxpayer as the contributing partner. Then, any remaining gain will be allocated among all of the partners in accordance with their relative interests in Partnership.

Allocating Depreciation Deductions

If Property is subject to depreciation, the allocation of the deductions attributable to the depreciation for tax purposes must take into account the pre-contribution BIG on Property. Specifically, the rules provide that the tax allocation of depreciation deductions to the noncontributing partners must, to the extent possible, equal the “book allocations” of depreciation deductions to those partners. This allocation rule is often referred to as the “traditional method.”

Partnership’s depreciation deduction for tax purposes will be determined by reference to Partnership’s starting basis in Property – the same basis that Taxpayer (as the contributor) had for Property – while its depreciation deductions for financial accounting (or “book”) purposes will be determined based upon Partnership’s book value for Property. A contributed property’s starting “book value” – the amount at which it is recorded on the partnership’s financial accounting records (its “books”) – is equal to its FMV at the time of its contribution.

Where the contributed property has pre-contribution BIG (as in the case of Property), its beginning book value (the property’s FMV) will exceed its basis for tax purposes. Thus, the effect of the above allocation rule, which “matches” the tax allocation of depreciations deductions to the noncontributing partners with the allocation of such deductions to such partners for book purposes, is to shift more of the partnership’s (Partnership’s) taxable income to the contributing partner (Taxpayer) by allocating more of its tax-deductible depreciation deductions to the noncontributing partners.

In this way, over time, an amount equal to Property’s pre-contribution BIG will have been allocated to the Taxpayer, at which point the special allocation rule will cease to apply.

In order to further ensure the intended result of the above allocation rules – i.e., to prevent the shifting of tax consequences with respect to pre-contribution BIG to the noncontributing partners – the special allocation rules provide yet additional rules that may be applied where, contrary to the above matching rule, a noncontributing partner would otherwise be allocated less tax depreciation than book depreciation with respect to the contributed property. (This will usually be the case when talking about appreciated property.) The effect of these so-called “curative” allocation and “remedial” allocation rules is to make up this difference, and to reduce or eliminate the disparity, between the book and tax items of the noncontributing partners. The rules thereby prevent the shifting of any portion of pre-contribution BIG to the noncontributing partners, thus ensuring that the tax consequences attributable to the pre-contribution BIG are visited upon the contributing partner.

Protecting the Contributing Partner

Although a taxpayer generally may contribute appreciated property to a partnership in exchange for an interest therein without incurring an immediate income tax liability, the application of the pre-contribution BIG allocation rules discussed above has the potential to immediately wipe away this deferral. For example, if Partnership decides to sell Property shortly after its contribution, Taxpayer (as the contributing partner) will not have enjoyed the benefit of tax deferral.

Moreover, Taxpayer may find himself in a situation where he must include the pre-contribution BIG in his gross income for tax purposes, but he has not received any cash with which to pay the tax, and he may not be in a position to compel Partnership to make the necessary cash distribution or to give him a loan.

What is Taxpayer to do?

For one thing, it would have behooved Taxpayer to retain a tax adviser who was familiar with the above allocation rules. Such an adviser would have advised Taxpayer to try to negotiate a period during which Partnership would not sell or otherwise dispose of the Property (except as part of a “tax-free” exchange).

Alternatively, the tax adviser might have counseled Taxpayer try to negotiate a provision that would require Partnership to make a cash distribution to Taxpayer in an amount sufficient to enable him to satisfy the tax liability resulting from the application of these rules.

Insofar as the allocation of depreciation deductions pursuant to these rules is concerned, the tax adviser would likely have suggested that Taxpayer negotiate for the use of the “traditional method” so as to maximize the deferral period for “recognition” of the pre-contribution BIG, failing which he may have suggested the use of the “remedial allocation method” over the “curative allocation method,” as the former generally allows the book-tax difference (the excess of book value over tax basis) described above to be spread out over a longer period of time.

Bottom line: the foregoing options may not be available after Taxpayer has already contributed Property to Partnership. The time to consider these issues, to plan for them, and to negotiate ways to reduce any adverse impact is prior to making the contribution.

“Tax free” – two words that often bring great delight when they are spoken by a tax adviser to the owner of a business, whether he is considering the disposition of a single asset, or of substantially all of the assets, of his business. (It’s the feeling I have when the local McDonald’s offers two-for-one breakfast sandwiches.)

Yes, “tax free” can be a great result for a transfer of property out of one business and into another. However, such a transfer is not really free of tax in the sense of never being taxed; rather, it defers the recognition, and taxation, of the gain inherent in the asset being transferred.

It is important that the business owner recognize the distinction. Allow me to illustrate this concept.

Gain Recognition

When a taxpayer disposes of property, the amount of gain that he realizes is measured by the difference between the amount realized – the amount of cash plus the fair market value (FMV) of the property received by the taxpayer – over his adjusted basis for the property transferred.

Where the property received by the taxpayer is not of a kind that the Code views as a “continuation” of the taxpayer’s investment in the property disposed, the taxpayer must recognize and pay tax on the entire amount realized. This is what occurs, for example, when a taxpayer exchanges a property for other property that is not of like-kind (such as cash).

Continuing the Investment

So, what kind of property must a taxpayer receive in exchange in order to make the disposition of his property “tax free”?

Most business owners are familiar with the “like-kind exchange” transaction, especially one that involves the exchange of one real property for another, where both are held by the taxpayer for use in a trade or business or for investment.

Many owners are also familiar with the contribution of property by a taxpayer to a corporation in exchange for shares of stock in the corporation. In general, if the taxpayer does not receive any cash in the exchange and is “in control” of the corporation immediately after the exchange, the taxpayer’s disposition of the property will not be treated as a taxable event.

A similar rule applies in the case of a contribution of property to a partnership in exchange for a partnership interest. Generally speaking, such a property transfer will not be treated as a taxable event, even if the taxpayer receives a less-than controlling interest in the partnership.

Preserving the Gain

In each of the above examples of “tax free” dispositions, the taxpayer’s adjusted basis for the property or equity interest that he receives will be the same basis that he had in the property transferred.

Similarly, the business entity to which a contribution of property is made, in exchange for an equity interest therein, will take the contributed property with a basis equal to the basis that the contributing taxpayer had in the property at the time of the contribution.

Thus, the gain inherent in the property disposed of by the taxpayer is preserved in the property received by the taxpayer in the exchange, such as the shares of stock issued by a corporation.

Receipt of Cash

The foregoing discussion contemplates a situation in which a taxpayer does not receive any cash in connection with the transfer of his property. Often, however, a taxpayer will want to monetize some of his equity in connection with the transfer of what may otherwise be illiquid property. (It may also be the case that the acquiring entity wants to increase its depreciable/amortizable basis in the property by paying some cash for it, or the existing owners of the entity may not appreciate the dilution of their holdings that an issuance of only equity would cause.)

In that case, because the taxpayer is partially “discontinuing” his investment in the transferred property (by receiving cash), he is required to recognize some taxable gain.

Contribution to Corp/ Like-Kind Exchange

In the case of a like-kind exchange, or in the case of a contribution to a corporation in exchange for stock therein, the taxpayer must recognize an amount equal to the lesser of the amount of cash received or the gain realized in the exchange.

Thus, if the amount of cash received is less than the gain realized on the transfer of the property, the taxpayer will recognize, and be taxed on, a portion of the gain realized, up to the amount of cash received.

Where the amount of cash received is equal to or greater than the gain realized on the transfer of the property, then the entire gain realized must be recognized by, and taxed to, the taxpayer.

The import of this result should not be underestimated, as will be shown below.

Contribution to a Partnership

The analysis is somewhat different in the case of a partnership. The Code’s partnership tax provisions do not have a rule equivalent to the “recognition of gain to the extent of cash received” rule applicable to corporations.

Instead, the contribution of property to a partnership in exchange for a partnership interest plus cash is treated as two transactions: a partial sale/contribution in which property with a FMV equal to the amount of cash paid by the partnership is treated as having been sold (under the so-called “disguised sale” rules), and a contribution of the remaining FMV of the property.

The gain to be recognized by the taxpayer is determined by allocating the taxpayer’s basis in the property between the sale and the contribution transactions, based upon the percentage of the total consideration that is represented by the cash.

Some Examples

Assume that Property has a FMV of $100, and an adjusted basis in the hands of Taxpayer of $40.

If Property were sold in exchange for $100 of cash, Taxpayer would realize and recognize $60 of gain ($100 minus $40).

Same facts, except Taxpayer contributes Property to a corporation in exchange for $100 worth of stock therein in a transaction that satisfies the criteria for “tax free” treatment. Taxpayer realizes $60 of gain ($100 of stock over $40 basis), but because Taxpayer receives only stock of the transferee corporation (no cash), none of the gain is recognized. Taxpayer takes the stock with a basis of $40 (preserving the $60 of unrecognized gain).

Same facts, except Taxpayer receives $70 of stock and $30 of cash. Taxpayer must recognize an amount equal to the lesser of the amount of cash received ($30) or the gain realized ($60). Thus, Taxpayer must recognize $30 of gain. He takes the stock with a basis equal to his basis in Property ($40), less the amount of cash received ($30) plus the amount of gain recognized ($30), or $40. Thus, $30 of the unrecognized gain inherent in Property ($30) is deferred ($70 FMV stock over $40 basis.)

Same facts, except Taxpayer receives $20 of stock and $80 of cash. Taxpayer must recognize an amount equal to the lesser of the amount of cash received ($80) or the gain realized ($60). Thus, Taxpayer must recognize the entire $60 of gain realized. He takes the stock with a basis equal to his basis in Property ($40), less the amount of cash received ($80) plus the amount of gain recognized ($60), or $20 (there is no gain to defer).

Same facts, except Taxpayer contributes Property to Partnership in exchange solely for a partnership interest therein. Taxpayer takes his partnership interest with a basis of $40 (his basis in Property), and Partnership takes Property with a basis of $40.

Same facts, except Taxpayer receives a $70 equity interest in Partnership, plus $30 of cash. Taxpayer is treated as having sold a $30 portion of Property, and as having contributed a $40 portion. The gain to be recognized on the sale and the gain to be deferred on the contribution are determined by allocating Taxpayer’s basis in Property between the sale and contribution transactions. Because the cash represents 30% of the total consideration received, 30% of Taxpayer’s basis is allocated to the sale, or $12 ($40 x 0.30). Thus, Taxpayer recognizes gain of $30 minus $12 = $18. The remaining 70% of the basis, or $28, is allocated to the contribution transaction; thus, Taxpayer takes his partnership interest with a basis of $28 (preserving the $42 of gain not recognized on the transfer of Property).

Is the “Deferral” Worthwhile?

The taxpayer who finds himself in one of the foregoing situations usually transfers a business asset over which he has full control. He may give up this control in order to attain other benefits, including, for example, diversification, the funding and assistance necessary to further grow the business (and to share in the growth as an equity owner, albeit one with a minority stake), and the deferral of tax on any gain that he may realize on the transfer.

The loss of control may present many difficulties for the taxpayer. Some are obvious; others are less so – for example, if he contributes appreciated property to a partnership in exchange for a partnership interest, the partnership is required to allocate its income, deductions, gains, and losses in such a way so as to cause the gain inherent in the property at the time of its contribution to be allocated entirely to the taxpayer. He will be taxed on such gain, but he may not receive a distribution of cash from the partnership to enable him to satisfy his tax liability.

Moreover, the like-kind property or the equity interest that the taxpayer receives in exchange for his property may be just as illiquid, at least initially, as the property he has exchanged for it. There may not be a market for the entity’s equity, and its shareholders’ agreement or operating agreement will likely restrict the transfer of the taxpayer’s interest.

But at least he deferred the tax on the transfer of his property.

But What If?

Query, then, what happens if a taxpayer gives up control of a property in exchange for an illiquid minority interest in the business entity to which he contributed such property, yet does not enjoy any tax deferral?

If the deferral was not a principal reason for the transfer, which otherwise made good business sense, then the taxpayer should be fine with the outcome: although he has suffered an immediate net loss of economic value (in the form of taxes paid), hopefully he has determined that the long-term prospects of exchanging his property for the acquirer’s equity are worth the short-term cost.

If, on the other hand, deferral was an important consideration, then the taxpayer should rethink his deal.

Perhaps he can ask to be grossed up for the tax hit, though this may be too expensive a proposition for the acquiring entity. Or, he may ask for more equity, and less cash, so as to reduce the tax hit, provided he recognizes that there will be more investment risk associated with holding more equity. Of course, the other investors may not want to be diluted further, and they may resist losing the benefit of any depreciation/amortization basis step-up for the property acquired.

The matter will ultimately be determined by the parties’ relative bargaining leverage: how badly does one want to dispose of the property, and how badly does the other want to acquire it?