“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?

Last month, Governor Cuomo presented his budget proposal for NY State’s 2017- 2018 fiscal year. Included in the proposal were a number of tax provisions that should be of interest to closely-held businesses and their owners.

S-Corporation Conformity with IRS Return

Under current NY law, a federal S-corporation that is subject to tax in NY (e.g., the corporation is doing business or owns property in NY) can “elect” to be taxed as an S-corporation or as a C-corporation for NY purposes. If a federal S-corporation is taxed as a NY S-corporation, the corporation is responsible only for the fixed dollar minimum tax, and the corporation’s income is passed through, and taxed, to its shareholders. Conversely, if a federal S-corporation is taxed as a NY C-corporation, it computes and pays tax on its apportioned entire net income or capital base.

Further, if a federal S-corporation has elected to treat its wholly-owned corporate subsidiary as a “qualified subchapter S subsidiary” (QSSS) for federal purposes, the QSSS is ignored as a separate taxable entity, and the assets, liabilities, income and deductions of the QSSS are included on the parent’s return. However, for NY purposes, the tax treatment of the QSSS is not required to be conformed to the federal treatment and the QSSS under certain circumstances can be a stand-alone C-corporation taxpayer.

While the Tax Law was amended a few years back to mandate that a federal S-corporation be treated as a NY S-corporation in any tax year in which its investment income exceeded 50% of its federal gross income, this mandate did not cover the entire universe of federal S-corporations that have elected to be taxed as NY C-corporations.

According to the budget proposal, the failure to mandate consistent treatment at the State level has resulted in a tax avoidance opportunity, as well as confusion and tax filing errors, for S-corporation shareholders.

For example, a federal S-corporation generally may choose to pay tax as a NY C-corporation when paying tax at the entity level reduces the corporation’s tax liability. It also may choose to pay corporate income tax in order to shield its nonresident shareholders from having a NY tax liability.

Under the budget proposal, NY’s tax law would be amended to require a federal S-corporation that is subject to tax in NY, or that has a QSSS subject to tax in NY, to be treated as an S-corporation for NY tax purposes.

According to the proposal, requiring conformity to the federal S-corporation status would simplify the corporation’s and its shareholders’ NY tax filings, and eliminate potential tax avoidance schemes. It would also result in NY-source income for nonresident shareholders.

Real Estate Transfer Tax on the Transfer of a Business Interest

Under current law, the transfer of a “controlling interest” in an entity that owns NY real property is subject to the real estate transfer tax (“RETT”), with the taxable consideration being determined by reference to the relative fair market value (FMV) of the entity’s NY real property. The RETT applies even where the FMV of the NY real property is not a significant part of the entity’s total FMV.

However, members of a closely-held business entity that owns real property are not subject to the RETT when they sell a minority (non-controlling) interest in the entity, even where the primary asset held by the entity is an interest in NY real property.

The budget proposal would amend the definition of “conveyance” to include the transfer of an interest in a partnership, LLC, S-corporation, or non-publicly traded C-corporation with fewer than 100 shareholders that owns an interest in NY real property with a FMV that equals or exceeds 50% of the FMV of all the assets of the entity on the date of the transfer of the interest in the entity. Only those assets that the entity owned for at least two years before the date of the transfer of the taxpayer’s interest in the entity would be used in determining the FMV of all the assets of the entity on the date of the transfer.

The consideration for such a conveyance would be calculated by multiplying (i) the FMV of the NY real property that is owned by the entity; and (ii) the percentage of the entity that is being conveyed.

As an aside, the proposal would effectively align the treatment of these conveyances, for purposes of RETT, with the personal income tax rules for determining the NY-source income of a nonresident individual when that individual sells an interest in an entity that owns NY real property.

Non-Resident Asset Sale “Loophole”

There are instances in which the purchase of a partnership interest may be treated, for federal tax purposes, as a purchase of the partnership’s underlying assets. In those situations, the consideration paid for the partnership interest must be allocated among the partnership’s underlying assets (which are deemed to have been acquired). As a result of this tax treatment, the buyer of the interest may receive a basis step-up with respect to his share of the partnership’s underlying assets. This step-up may afford the buyer additional depreciation deductions against his share of partnership income, and also may reduce the gain allocated to the buyer upon the partnership’s sale of the assets to which the basis step-up is allocated.

The selling partner, however, may nevertheless be treated as having sold his partnership interest, and not the underlying assets. Thus, a NY resident partner who sells his partnership interest will be subject to tax on the gain realized. On the other hand, the sale of an intangible – such a partnership interest – by a nonresident partner is not a taxable transaction, notwithstanding that the buyer may achieve a basis step-up in the partnership’s assets. As a result, non-residents are afforded an opportunity to avoid NY taxation on transactions that, in effect, involve the purchase of NY-source assets.

The budget proposal seeks to close this loophole by treating the transaction as a sale of the partnership’s underlying NY-based tangible assets for both the buyer and seller, so that the gains realized from the sale of an interest in the partnership by nonresident partners would be subject to NY tax as NY-source income.

Extend the Personal Income Tax Top Bracket

Currently, the top personal income tax bracket in NY, along with its associated tax rate of 8.82%, is scheduled to expire for taxable years beginning after 2017. Without legislative action, the top marginal tax rate will decline to 6.85%.

The budget proposal would extend the top tax bracket and the associated 8.82% personal income tax rate for taxable years 2018, 2019 and 2020.

Sales Tax Related Entity “Loopholes”

With certain exceptions, existing NY tax law allows a purchaser to buy tangible personal property or services that are intended for resale without paying sales tax. According to the budget proposal, however, certain related business entities have exploited this exemption by purchasing expensive property “for resale” and then leasing the property to a member or owner of the entity using long-term leases or lease payments that are a small fraction of the FMV of the property.

The budget proposal would amend the sales tax definition of “retail sale”, which currently contains the exception for resale, to include any transfer of tangible personal property to certain entities when the property would be resold to a related person or entities, including: (1) sales to single-member LLCs or subsidiaries that are disregarded for federal income tax purposes, for resale to a member or owner; and (2) sales to a partnership for resale to one or more partners. This change is intended to remove the incentive to use or create such entities to avoid sales tax.

In addition, current law allows a person or entity that is not a resident of NY to bring property or services into the State for use therein without incurring use tax. However, this construct has led to situations where a resident person or entity creates a new, non-NY entity, such as a single-member LLC, to purchase expensive property out-of-state and then bring the property into NY to avoid the use tax.

The budget proposal would provide that the use tax exemption does not apply when a person (other than an individual) brings property or services into NY unless that person has been doing business outside of NY for at least six months prior to the date the property is brought into the State. This amendment would still allow ongoing businesses to move into NY without incurring use tax on property or services brought into the State.

Looking Ahead

And you thought that tax relief was just around the corner. Silly rabbit.

While most eyes are focused on Washington, D.C. and the promised, but yet to be disclosed, “tax reduction and/or reform” legislation, states like NY are busy reviewing and amending their own tax laws and regulations to ensure the collection of much-needed revenues. Thus, in the case of NY, it may be that closely-held businesses and their owners will be faced with increased tax liabilities. We’ll know soon enough – the deadline for approving NY’s budget is April 1, 2017.

Speaking of Washington, the States themselves are undoubtedly waiting to see what comes out of the new administration and Congress and how it will impact them and their finances.

As always, until legislation is passed, it is imperative that taxpayers keep abreast of tax-related legislative developments that may impact their business and wallets. Increased tax liabilities will reduce the yield realized from one’s business efforts and investments; thus, it will be advisable for taxpayers to formulate a plan for addressing these developments and any resulting taxes.

It will be equally important that any business plans considered by a taxpayer be flexible enough to respond to, and accommodate, a changing tax environment, provided that doing so does not compromise business decisions.

Stay tuned.

Looking Overseas

We have heard a lot about large, publicly-traded U.S. corporations that have parked trillions of dollars overseas to avoid the payment of U.S. income tax. We have heard how the tax system must be seriously broken to have so incentivized so many of these corporations to “relocate” overseas.

What is usually overlooked or omitted in these reports is the number of smaller, closely-held U.S. corporations and partnerships that have established operations overseas in pursuit of legitimate business goals, including the opening of new markets, among others.

Equally absent from these reports is any mention of the number of U.S. citizens living outside the U.S. who own companies that are engaged in business overseas.

Quite often, these closely-held companies are unaware of their U.S. income tax reporting obligations as regards their foreign operations and income. The owner of one of these companies will naturally be focused on the business opportunities, and challenges, presented by establishing an overseas presence and, unless the company’s tax advisers are well-versed in so-called “outbound” transactions, the company may unwittingly fail to satisfy its filing obligations.

This may result in the imposition of steep penalties on the business, as one taxpayer recently discovered to its detriment.

A Taxpayer Can Get Burned

Taxpayer was a U.S. citizen residing in Country. During the years in issue, he operated a business in Country through a foreign corporation (“FC”). At some point during this period, he sold the majority of his stock to a non-U.S. resident of Country. The issue for decision was whether Taxpayer was liable for the penalties assessed against him for his failure to declare, on IRS Form 5471, his ownership interest in FC.

Taxpayer timely filed his Forms 1040, U.S. Individual Income Tax Return, for the years in issue but did not attach IRS Forms 5471 to any of his returns.  Although Taxpayer hired a tax preparation firm in Country to prepare his U.S. tax returns during the years in issue, he did not inform this firm until years later that he held an interest in FC.

Thereafter, the IRS began an examination of Taxpayer’s ownership of FC. Taxpayer then submitted delinquent Forms 5471 regarding his interest in FC, after his tax counsel advised him of his obligation to do so. The Forms 5471 submitted were incomplete.

The IRS assessed penalties for Taxpayer’s failure to timely file completed Forms 5471 declaring his ownership interest in FC.

The Tax Court explained that the Code imposes information reporting requirements on any U.S. person who controls a foreign corporation. A person controls a foreign corporation (a “controlled foreign corporation,” or “CFC”), the Court stated, if he owns (directly or constructively):

  • Stock that that represents more than 50% of the total combined voting power of all classes of voting stock of the corporation, or
  • More than 50% of the total value of shares of all classes of stock of the corporation.

Under the Code, a U.S. person must furnish, with respect to any foreign corporation which that person controls, such information as the IRS may prescribe. Form 5471 is used to satisfy these reporting requirements, and it must be filed with the U.S. person’s timely-filed Federal income tax return. Moreover, a U.S. person who disposes of sufficient stock in a CFC to reduce his interest to less than the above stock ownership threshold is required to provide certain information with respect to the foreign corporation.

Additionally, information reporting requirements are also imposed on any U.S. person treated as a “U.S. shareholder” of a corporation that was a CFC for an uninterrupted period of 30 days during its annual accounting period and who owned stock in the CFC on the last day of the CFC’s annual accounting period. A U.S. shareholder, with respect to any foreign corporation, is a U.S. person who owns, or is considered as owning, 10% or more of the total combined voting power of all classes of stock entitled to vote of the foreign corporation.

To avoid a penalty, a taxpayer must make an affirmative showing that the failure to furnish the appropriate information with his return was due to reasonable cause.

To establish reasonable cause through reliance on a tax adviser’s advice, the taxpayer must prove: (i) the adviser was a competent professional with sufficient expertise, (ii) the taxpayer provided necessary and accurate information to the adviser, and (iii) the taxpayer relied in good faith on the adviser’s judgment.

The Taxpayer could not satisfy these requirements. Thus, the Court found that he failed to show reasonable cause for his failure to file Forms 5471, and the imposition of the penalties was sustained.

But Wait, There’s More

The penalties imposed upon the taxpayer in the decision described above are bad enough, but there are other issues of which such a taxpayer needs to be aware.

Indeed, Congress recognizes that the IRS may not be able to “timely” identify all U.S. persons who conduct business overseas and fail to report their foreign activities and income.

Thus, another consequence of failing to file the requisite returns may be the additional tax for the year in which the event(s) to be reported occurred – meaning that the IRS can impose a tax upon a delinquent taxpayer whenever the IRS discovers the existence of the foreign business activities or transactions.

In other words, these reporting obligations cannot be ignored; they must be taken seriously.

However, these failures, and the resulting consequences, can be avoided relatively easily if the company’s tax adviser or tax compliance officer is familiar with the IRS’s many reporting requirements for U.S. businesses that operate overseas, and understands the underlying purpose for the required filings.

Common Filing Obligations

The following summarizes some of the more common reporting requirements imposed upon a U.S business that operates or holds assets overseas, as well its U.S. owners.

A basic principle of U.S. tax law is that U.S. persons – which includes, for example, U.S. citizens and resident individuals, domestic corporations, and domestic trusts – must file an annual tax return with the IRS to report their worldwide income, regardless of the source or the type of income. This income is taxable in the U.S., notwithstanding that it may also have been taxed by the foreign country in which it was sourced or generated. Of course, the U.S. person may be able to claim a tax credit for any foreign taxes withheld and/or paid on such income in the foreign country; such credit may offset any U.S. income tax that would otherwise be imposed on such income.

If a U.S. person transfers property to a foreign corporation or partnership in what purports to be a tax-free exchange, the U.S. person may have to report the transfer on IRS Form 926.  This filing provides a means by which the IRS confirms the taxable or tax-free nature of the transfer of property by a U.S. person to a foreign jurisdiction, and perhaps beyond the reach of the IRS.

If a U.S. person owns an interest in a foreign corporation, the U.S. person may have to file IRS Form 5471 (as we saw above). The rules for CFCs may require the inclusion of CFC income (so-called “Subpart F” income) in the gross income of a U.S. person even where such income has not been distributed to the U.S. person (i.e., repatriated). In general, this reporting is aimed at situations in which the U.S. person, the CFC, and/or certain other related persons, engage in intercompany transactions of a nature that tends to shift the resulting tax liability to a lower tax jurisdiction.

If a U.S. person owns or acquires an interest in a foreign partnership, IRS Form 8865 may have to be filed.  This form is similar to Form 5471 and to the partnership tax return on Form 1065.  It is intended to assist the IRS in monitoring the overseas business and investment activities of U.S. taxpayers through foreign flow-through entities, the income from which must be reported on the U.S. person’s tax return in the same way that a U.S. person’s distributive share of a domestic partnership’s taxable income must be reported.

If a U.S. person owns an interest in a passive foreign investment company (a “PFIC”; e.g., a foreign mutual fund), and receives certain distributions from the PFIC, or recognizes gain on the disposition of PFIC stock, the U.S. person may have to file IRS Form 8621 and pay a tax, along with a special interest charge that is intended to offset the tax deferral benefit that the U.S. person enjoyed as to the distributed funds and the recognized gain.  The purpose of these rules is to help ensure that U.S. investors in such foreign investment vehicles are taxed on an equal footing with similar investments in domestic investment vehicles.

If a U.S. person has an interest in certain foreign accounts or other foreign financial assets, including accounts in foreign financial institutions and interests in a foreign corporation or partnership, those assets may have to be reported on Form 8938.  This filing is intended to assist the IRS in cracking down on unreported investment income from overseas.

The U.S. person may also have to file FinCEN Form 114 (the well-known “FBAR”) to report accounts held in foreign financial institutions.  The FBAR reporting requirement is aimed at establishing a U.S. taxpayer’s connection to such an account for the purpose of ensuring that the funds deposited therein, as well as the investment income earned thereon, were properly reported and taxed.

Don’t Be Overwhelmed

Granted, this is a daunting litany of reporting obligations, and it may appear overwhelming – “overkill,” some taxpayers may say. From the perspective of the IRS, however, they are necessary if the tax statutes in effect today are to be enforced and their underlying goals accomplished.

The best way to avoid any issues and surprises is, first and foremost, to find a tax adviser who is familiar with the rules and can explain them. The next step is to establish internal procedures to ensure that the necessary information will be collected in a usable form. Finally, the taxpayer must prepare and timely file the proper returns.

Yes, it may be a chore today, but it certainly beats the alternative down the road. Just witness those “poor” taxpayers who failed to timely file their FBARs and are now walking through the OVDP gauntlet.

Limited Liability

In general, the creditors of a corporation cannot recover the corporation’s debts from its shareholders—the shareholders enjoy the benefit of limited liability protection as a matter of state law. Among the corporate liabilities from which shareholders are usually shielded is the Federal income tax imposed on a corporation’s taxable income.

There are a number of exceptions to this general rule, however – some of which are better known than others – including the ones described below.

Piercing the Veil

A creditor, including the IRS, may be able to “pierce the corporate veil” or “sham” the corporation, in appropriate circumstances, as where the corporation does not have a bona fide business purpose, or where its shareholders do not respect it as a separate entity, or where their withdrawal of funds from the corporation renders it insolvent.

Transferee Liability

In the right circumstances, the IRS may pursue a corporation’s shareholders as transferees of a corporation’s assets in order to satisfy a corporate tax liability. While the Code does not create the substantive tax liability as to a transferee-shareholder of a transferor-corporation’s property – which is determined as a matter of state law – it does provide the IRS with a remedy for collecting from the transferee-shareholder, the transferor-corporation’s existing tax liability.

Responsible Person

In certain circumstances, the Code imposes a duty on a taxpayer to withhold and remit income taxes from certain payments made by the taxpayer. These withheld funds are often referred to as “trust fund taxes” because the Code characterizes them as a special fund that is held in trust for the IRS. When these taxes are not collected or are not remitted by the taxpayer, the IRS is generally authorized to “collect the tax” from any “responsible person” who was required to collect, truthfully account for, or pay over any tax withheld but failed to do so. In the case of a corporate taxpayer, this may include an officer or employee of the corporation who, as such, is under a duty to collect, account for, or pay over the withheld tax.

Federal Priority Statute

One of the most powerful tools available to the IRS for the collection of income tax is not found in the Code and, in fact, is sometimes overlooked by tax advisers.

According to the Federal Priority Statute, a person (for example, a corporation) that (i) is indebted to the U.S. government, (ii) is not in bankruptcy, (iii) is insolvent, and (iv) does not have enough property to pay all of its debts, must satisfy its indebtedness to the U.S. government before satisfying any other debts that do not have priority over the government’s claim; the U.S. has the right to be paid first, and all other creditors are subordinate.

If that person, instead, pays any part of a debt owing to a non-priority creditor at a time when the debtor was insolvent, before paying a claim of the Federal government, that creditor is necessarily favored at the expense of the government. In the case of such a preferential transfer, the Federal Priority Statute authorizes the government to hold that person’s “representative” liable for the unpaid claims of the government up to the amount of the payment made to the non-priority creditor.

For purposes of the statute, the term “claim” or “debt” means any amount of funds that has been determined by the Federal government to be owed to the U.S. by any individual or entity. This includes taxes, as well as any interest and penalties imposed with respect to such taxes.

Representatives of the Taxpayer

If it is determined that a violation of the Federal Priority Statute has occurred – there has been a preferential transfer – a court must decide whether anyone other than the taxpayer should incur liability for that violation. As the courts have noted, the purpose of the statute “is to make those into whose hands control and possession of the debtor’s assets are placed, responsible for seeing that the Government’s priority is paid.”

In the case of a corporation, the courts have interpreted the reach of the Federal Priority Statute as extending to those individuals who, responsible for the conduct of a corporation’s affairs, allow the corporation to make payments that defeat the government’s tax claims. Thus, a director, an officer or a shareholder of the corporation, who was in control of the corporation’s affairs, who was (or should have been) aware of the outstanding claims against the corporation, and who either (i) directed or controlled the wrongful payments, or (ii) knew of such payments and failed to prevent them, may be held personally liable for the corporation’s taxes.

The exact nature of the duties and control exercised by an individual, and his status as a “representative” of the debtor, is a matter of proof, and must be determined by examining all the relevant facts and circumstances. The individual may be found to be a “representative” of a corporation and thus liable, to the extent of the payment, for unpaid claims of the government, where such individual is the sole officer, director and/or shareholder of the corporation. An individual may also be treated as a corporation’s representative where he oversees the corporation’s finances, and executes most of its checks.

Notice of Tax Claim

Once it is determined that an individual is a representative of a corporation within the meaning of the Federal Priority Statute, it must still be established that the individual knew about or was put on notice of the government’s outstanding tax claim before liability for such claim may imposed upon him. In general, the officers and directors of a corporation are deemed to be in control of its affairs, and the courts have often assumed that, being responsive to their duties, these individuals were aware of all the outstanding claims against the corporation.

Based on the foregoing, the lack of knowledge may be asserted as a defense against the application of the statute. However, the courts have found the requisite notice of a claim where the representative lacks actual notice of the liability, but possesses notice of such facts as would lead a reasonable person to inquire as to the existence of any unpaid claims.

Advice?

The foregoing highlights the fact that the privilege of stock ownership in a close corporation may also entail a number of burdens.

In the case of a closely held corporation that is struggling, its directors, officers and shareholders have to be diligent in monitoring its financial vital signs, and they need to be as objective as possible in ascertaining its prospects.

Many times, they will forego the payment of certain taxes, using these funds, instead, to satisfy the corporation’s business creditors in the hope of keeping the business alive until it can “turn the financial corner,” and then pay off its tax liabilities.

Too often, however, the corporation will fail, notwithstanding the efforts of its “insiders,” at which point its shareholders may be left holding the proverbial “bag” for the corporation’s taxes.

What, then, is a shareholder to do?

The IRS’s response would be to shut down the business, liquidate its assets, and satisfy the unpaid taxes. This course of action may be difficult for a shareholder to accept, but it will often be the best choice.

Roll-Over: Tax Issue

Picking up on yesterday’s discussion, how can a PEF reconcile its preference to acquire a depreciable or amortizable basis for its target’s assets while, at the same time, affording the target’s owners the opportunity to roll-over a portion of their equity in the target into the PEF HC on a tax-favored basis? The answer is hardly simple, and it will depend upon a number factors.

inspecting taxesThe following discussion will consider some of these factors in the context of various scenarios. In each case, it is assumed that the acquisition will be structured to give the PEF a depreciable or amortizable basis for the acquired assets; that the target or its owners, as the case may be, will acquire an equity interest in the PEF’s HC (the roll-over that will allow them to participate in the growth of the PEF’s other portfolio companies); and that such equity interest shall not exceed 50% of the HC’s equity (thus ensuring capital gain treatment where otherwise available).

Target “C” Corporation
Where the target is a “C” corporation, the sale of its assets will be taxable to the corporation, and the corporation’s distribution of the after-tax proceeds to its shareholders will generate a second layer of tax (albeit as capital gain) to the shareholders (a combined tax rate of almost 50% at present). The shareholders may then invest some portion of their after-tax proceeds in the PEF HC in exchange for an equity interest therein.

In this case, the only way for the target’s owners to enjoy a tax-free, but indirect, roll-over of a portion of their equity into the PEF is by having the target contribute some of its assets to the PEF’s HC in exchange for an equity interest therein, while selling the balance of the assets for cash.

In general, provided the PEF’s HC will be treated as a tax partnership, the contribution of assets to the HC in exchange for a partnership interest therein will not be taxable to the target corporation. (An exception to this nonrecognition rule would apply if the HC assumes liabilities of the target’s business, or takes assets subject to such liabilities, and the contributing corporation’s allocable share of the HC’s liabilities after the contribution is less than the amount of the liabilities assumed or taken subject to) another exception to nonrecognition may apply where the liabilities were incurred in anticipation of the transaction.

However, if the PEF’s HC is a corporation, the target corporation’s contribution of assets to the HC’s capital in exchange for shares of stock therein will be treated as a taxable disposition of its assets unless the target corporation is treated as part of a so-called “control group.” This would be a group of persons (including the PEF) that, acting “in concert,” contributed assets to the HC in exchange for stock in the HC, and that was in “control” of the HC immediately afterwards.

Of course, not all of the target shareholders may want to participate in the roll-over to the PEF’s HC. In that case, the target corporation may have to redeem those shareholders, thus limiting the amount of cash that may be reinvested.

Moreover, some PEFs may insist that only individual shareholders, rather than the target corporation, hold equity in the HC. In that case, a contribution by the target corporation may not be permitted, or may have to be followed by a liquidating distribution to its shareholders. Such an in-kind distribution would be treated as taxable sale by the corporation, thus defeating the sought-after tax deferral benefit.

Target “S” Corporation
If the target corporation is an “S” corporation, it may sell its assets to the PEF HC without incurring a corporate-level income tax (provided the target is not subject to the built-in gains tax). Of course, the gain realized on the sale of the target’s assets will flow through and be taxable to its shareholders. Depending upon the nature of the assets sold, the gain may be taxed as ordinary income or as capital gain.

As in the case of a C corporation, the S corporation may distribute the net proceeds from the sale of its assets to its shareholders, who may then invest a portion of their after-tax proceeds in the PEF’s HC.

Alternatively, if the sale of the S corporation’s business is effected through an acquisition of at least 80% of its stock for cash, coupled with an election to treat the stock sale as a sale of assets for tax purposes, the target shareholders may contribute their remaining shares to the PEF’s HC as a capital contribution. Unfortunately, this capital contribution will not generate any tax deferral benefit for the shareholders because they will still have to recognize all of the gain inherent in the target’s assets by virtue of the deemed asset sale election.

If the only way in which the shareholders of the S corporation target may roll over a portion of their investment on a tax-free basis is for the S corporation itself to make a capital contribution to the HC, then regardless of whether the HC is a corporation or a LLC, then they will have to consider the same issues as described above for a C corporation.

Target Partnership
A sale of assets by a target partnership to a PEF HC in exchange for cash will be taxable to the target’s owners. As in the case of an S corporation, the nature of the gain taxed to the owners will depend upon the nature of the assets sold.

Alternatively, the owners of a target partnership may sell all of their partnership interests to the PEF, or to its acquisition subsidiary. A sale of 100% of the partnership interests will be treated, for tax purposes, as sale of the target’s assets, thus providing the PEF with a depreciable or amortizable basis in such assets.

In either case, if the target’s owners (the partners or members) are to acquire an equity interest in the PEF or subsidiary, they will have to do so with after-tax dollars.

In order to roll-over a portion of its equity into the HC on a tax-advantaged basis, the target partnership will have to contribute some of its assets to the HC, or the target owners will have to contribute some of their partnership interests to the HC. In other words, the transaction will have to be effected as a part-sale-for-cash/part-contribution-for-equity by either the target or its owners. The PEF will acquire a depreciable or amortizable basis for the assets acquired for cash. The same result may be achieved where interests in the target partnership are sold to the HC for cash while the remaining interests are contributed to the HC as capital. In that case, because the HC is treated as acquiring all of the interests in the target partnership, it will receive a depreciable or amortizable basis for the assets to the extent of the cash paid (though a protective election may also be made on the target partnership’s final tax return to adjust the basis for the assets in the hands of the HC).

If the PEF’s HC is a corporation, however, then the target partnership and its owners face the same issues with respect to their capital contributions to the HC as were described earlier in the case of a corporate target – they will need to be treated as part of a “control group.”

Before the LOI

The foregoing discussion should provide potential parties to a PEF acquisition transaction with some insight into their respective structural and tax preferences. It should also give them an understanding of the tax and economic consequences they will have to consider in negotiating such a transaction.

Armed with this information, they may consider how best to structure the target or the acquisition vehicle so as to minimize any negative tax consequences that may arise out of a roll-over (for example, making an “S” corporation election as early as possible for a potential target corporation, or substantiating the existence and value of personal goodwill).

Where a structural solution is not feasible, the parties should consider a “gross-up” to the purchase price for the depreciable or amortizable assets to be acquired, so as to leave the target’s owners in the same after-tax position in which they would have been had their roll-over been completed on a tax-free basis.

As always, it will behoove the parties to be aware of these considerations and to plan for them well before executing a letter of intent, let alone a purchase and sale agreement. Such preparation will facilitate negotiations and completion of the sale and acquisition of the business.

For many business owners, the final step of a successful career may be the sale of their business. At that point, the investment into which the owners have dedicated so much time, effort and money is liquidated, leaving them with what is hopefully a significant pool of funds with which to enjoy their retirement, diversify their assets, or pursue other goals.private equity

It used to be that the prospective buyer would almost always come from within the same industry (or one related to it) as the business being sold. It was often a competitor, or someone seeking to fill a void in their own business. In other words, the buyers were strategic and were looking for synergistic acquisitions – ones that would enable them to grow their own business and provide long-term benefits.

Over the last several years, however, a new type of buyer has emerged: the private equity fund (“PEF”). In general, PEFs are not engaged in any “conventional” business. Rather, they are well-funded investment vehicles that are engaged in the acquisition of conventional businesses (“portfolio companies”). A PEF will often create a holding company (“HC”) that, in turn, will use subsidiary companies to acquire target businesses. Almost by definition, a PEF is not necessarily looking to develop long-term synergistic relationships from an acquisition. Instead, it is looking to add to its portfolio of companies that it, in turn, hopes to sell to another buyer in the not-too-distant future, hopefully at a gain for the PEF’s investors.

Roll-Over: PEF’s Perspective

One facet of a PEF acquisition that tends to distinguish it from a strategic buyer acquisition is the PEF’s strong preference that the owners of a target business “roll over” (or reinvest) some portion of their equity investment in the target business into the PEF’s “corporate structure” in exchange for a minority interest therein. From the perspective of the PEF, such a roll-over yields several benefits. For one thing, it aligns the former owners of the target business with the interests of the PEF – their rolled-over investment is at risk similar to that of the PEF’s investors. Thus, the former owners are incentivized (the theory goes) to remain with the business, to cooperate fully in the transition of the business and its customers, and to work toward its continued growth and success. The roll-over also saves the PEF some money: issuing equity is less expensive than paying out funds that the PEF already has or that it has to borrow.

Roll-Over: Seller’s Perspective

From the perspective of the target’s owner, however, the roll-over may present a troublesome issue.

In many cases, an owner will want to take all of his cash off the table. He may not want to continue risking his capital, especially where the investment is to be controlled by another.

Of course, some owners will be attracted to the potential upside that a roll-over investment in a PEF may generate. After all, the owner may have the opportunity to benefit not only from the future growth of his former business (to which similar businesses may have been added by the PEF), but also that of the PEF’s other portfolio companies. In fact, a business owner may even insist upon being given the opportunity to participate in the growth of these other companies (which is generally consistent with most PEF’s desire that the owners invest at the same level of the corporate structure as the PEF has).

However, the owner may also insist that the roll-over be effected without any adverse tax consequences. The ability of the PEF to satisfy this request will depend, in no small part, upon the form of the acquisition of the target business.

Acquisition Mechanics

Like most other buyers, the PEF will prefer an acquisition of the target’s assets, in a transaction that is taxable to the target, over an acquisition of the equity interests of the target’s owners. A taxable sale of assets will provide the PEF (specifically, its HC) with a depreciable or amortizable basis in the acquired assets that may be written off by the PEF over the useful lives of the assets. The tax deductions so generated will offset the PEF’s income, thereby allowing the PEF to recover some of its investment in the target’s business and reducing the overall cost of the transaction to the PEF.

The target’s owners, on the other hand, will generally not prefer an asset sale because such a sale may result in both the recognition of ordinary income by the target’s owners as well as an entity-level tax, thus reducing the net economic benefit to the owners. Rather, they would choose to sell their equity interest in the target, at least in the case of a corporate target. The gain realized on such a sale will generally be treated as long-term capital gain. However, such a sale will not generate a depreciable or amortizable basis for the PEF.

Roll-Over: Mechanics

In general, a PEF will create a subsidiary corporation or LLC as the HC through which it will acquire a target. This HC will, at least initially, be wholly-owned by the PEF. Where the assets of a target are being purchased, each target acquisition may be completed through an acquisition vehicle (another corporation or LLC) that will be wholly-owned by the HC. In this way, the assets of one business may be protected from the liabilities of another.

The form of roll-over by the target’s owners will depend upon the form of the acquisition. Thus, where the HC is acquiring the equity interests of the target owners, the roll-over will come directly from the former owners. Where the HC is acquiring the target’s assets, the roll-over may, at least in theory, come from the target. However, if the PEF insists that it must come from the target’s owners, then the proceeds paid to the target will have to find their way into the hands of its owners to enable them to acquire equity in the HC.

The chosen forms of acquisition and roll-over will generate very different tax and economic results for both the PEF and the target’s owners. Thus, it is imperative that the target’s owners examine the nature of both the PEF’s acquisition vehicle and of the target (e.g., corporation or partnership/LLC), and the nature of the sale (a sale of equity interests in the target or a sale of the target’s assets). They must consider how their equity roll-over can be effectuated, and whether this transfer may be done tax-efficiently.

The owners of the target business have to recognize that if the roll-over cannot be accomplished on a tax-free (or, more accurately, tax-deferred) basis, they may be left with less liquidity than they would have preferred.

Check back tomorrow for a discussion of the specific effects of a roll-over depending on the types of entity involved and the approach taken in various scenarios.

What Was Intended?

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

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

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

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

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

An “Investment Company”?

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

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

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

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

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

The IRS Steps In

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

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

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

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

Bona Fide Debt

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

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

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

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

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

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

The Court’s Analysis

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

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

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

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

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

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

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

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

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

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

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

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

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

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

The Lesson

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

Double Taxation

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

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

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

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

An Investment Company

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

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

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

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

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

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

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

The AET

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

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

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

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

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

The IRS’s Analysis

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

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

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

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

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

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

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

“Consent Dividend”

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

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

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

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

Lesson?

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

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

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

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

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

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

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

Back to Basics

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

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

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

There Once Was A Taxpayer . . .

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

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

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

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

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

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

The Tax Returns

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

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

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

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

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

Corporation or Shareholder as Taxpayer?

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

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

The Court began by examining the second element.

Indicia of Control

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

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

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

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

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

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

Another Basic Principle

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

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

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

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

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

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

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

The Not-So-Great Recession

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

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

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

“Don’t Do It”

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

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

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

The Return and Its Aftermath

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

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

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

The IRS filed a motion for summary judgment.

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

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

The Tax Court

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

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

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

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

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

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

But I Can’t Pay

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

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

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

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

Allocation Basics

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

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

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

We will revisit these and other partnership concepts throughout 2017.

Happy New Year.

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