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

The 2016 Proposed Regulations – In General

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

Main Themes

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

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

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

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

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

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

The 2016 Proposed Regulations – Specific Provisions

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

Single-Member LLCs

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

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

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

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

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

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

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

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

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

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

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

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

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

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

State Law Restrictions

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

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

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

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

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

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

Assignees

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

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

New Disregarded Restrictions

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

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

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

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

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

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

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

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

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

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

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

Ignoring Certain Unrelated “Owners”

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

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

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

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

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

What’s Next?

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

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

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

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

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

Stay tuned.

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

Valuation Principles

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

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

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

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

Section 2704 Is Born

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

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

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

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

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

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

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

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

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

The First Set of Regulations

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

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

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

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

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

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

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

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

“Family Attribution”

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

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

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

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

The Green Books: 1999 through 2001

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

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

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

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

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

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

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

The Green Books: 2010 through 2013

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

According to its budget proposals from 2010 through 2013:

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

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

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

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

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

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

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

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

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

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

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

“The” Proposed Regulations

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

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

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

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

Planning, In General

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

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

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

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

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

Saving On Taxes – It’s Not Everything

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

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

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

A Cautionary Note

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

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

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

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

The Top Tier

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

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

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

Prospects for Change Before Going Final?

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

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

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

Tomorrow’s Post

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

Why Waive A Dividend?

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

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

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

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

Bona Fide Business Purpose?

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

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

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

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

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

Income to the Waiving Shareholder?

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

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

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

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

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

Or Not? Ruling Conditions

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

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

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

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

Be Aware

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

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

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

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

The Adviser’s Dilemma

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

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

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

The UBT

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

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

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

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

Partner or Employee Services?

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

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

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

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

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

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

The ALJ Disagreed . . .

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

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

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

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

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

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

. . . So Did the Tribunal And . . .

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

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

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

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

Strike One

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

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

Significantly, the UBT rules provide:

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

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

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

Strike Two

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

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

Strike Three

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

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

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

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

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

Did You Notice?

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

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

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

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

Same Old Story

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

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

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

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

Funding the Business

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

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

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

Times Got Hard

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

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

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

Wages or Repayments of Debt?

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

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

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

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

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

The Court’s Analysis

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

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

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

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

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

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

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

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

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

What Was Intended?

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

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

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

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

Expectation of Repayment

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

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

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

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

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

Don’t Get Comfortable

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

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

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

Passive Losses

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

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

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

Material Participation

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

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

Grouping Activities

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

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

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

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

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

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

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

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

IRS: “What’s Up Doc?”

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

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

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

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

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

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

Challenging the Grouping

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

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

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

OCC Responds

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

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

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

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

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

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

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

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

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

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

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

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

Planning for Grouping?

It may be difficult, but not impossible.

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

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

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

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

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

The Responsible Person

Many taxpayers fail to appreciate that a member of a partnership or LLC may be held personally liable for the sales tax collected or required to be collected by the entity.

New York State Tax Law (the “Tax Law”) imposes personal responsibility for payment of sales tax on certain owners, officers, directors, employees, managers, partners, or members (“responsible persons”).

A responsible person is jointly and severally liable for the tax owed, along with the business entity and any of the business’s other responsible persons. This means that the responsible person’s personal assets could be taken by the State to satisfy the sales tax liability of the business. An owner can be held personally responsible even though the business is an LLC.

Personal liability attaches whether or not the tax imposed was collected. In other words, it is not limited to tax that has been collected but has not been remitted. Thus, it will also apply where a business might have had a sales tax collection obligation, but was unaware of it. Along the same lines, the personal liability applies even where the individual’s failure to take responsibility for collecting and/or remitting the sales tax was not willful. In addition, the penalties and interest on the entity’s unpaid sales tax passes through to the responsible person.

Partnerships/LLCs

Under the Tax Law, every person who is a member of a partnership is a person required to collect tax. A strict reading of this provision concludes that any member of a partnership or of an LLC is per se liable for unpaid sales tax, plus interest and penalties, and this was, in fact, the State’s position for years. One can imagine the surprise of a minority partner upon learning that he was being held responsible for taxes far in excess of his investment in the business.

However, in 2011 New York provided partial relief to the per se personal liability for certain limited partners and LLC members. Under this policy, set forth in a Technical Memorandum, certain limited partners and LLC members who would be considered responsible persons under the Tax Law may be eligible for relief from personal liability for the entity’s failure to remit taxes. Specifically, a qualifying partner or member will not be personally liable for any penalties due from the business entity relating to its unpaid sales taxes, and the member’s liability for sales tax will be limited to his pro rata share of the tax.

An LLC member who can document that his ownership interest and distributive share of the profits and losses of the LLC is less than 50% may qualify for relief, if he can also demonstrate that he was not “under a duty to act” on behalf of the LLC in complying with the Tax Law.

Another One Bites the Dust

A recent ALJ decision considered whether an individual taxpayer (“Taxpayer”) was personally liable for the sales taxes due from an LLC of which he was a member.

NW LLC purchased Hotel in early 2005. Taxpayer executed the purchase agreement on behalf of NW LLC as a member of the LLC. NSP LLC was created by NW LLC to operate Hotel.

NSP LLC entered into a management agreement with Manager. Taxpayer signed the agreement on behalf of NSP LLC. Under the agreement, Manager had the right to hire, fire and supervise Hotel employees. NSP LLC was accorded the right to review Hotel’s books and records.

Taxpayer executed and filed a sales tax registration form, and an application for a liquor license, on behalf of NSP LLC, in his capacity as a manager of the business. Taxpayer subsequently signed sales tax returns on behalf of NSP LLC.

In 2007, NSP LLC refinanced its loan with Lender, and Taxpayer executed the document on behalf of NSP LLC. Among other things, the loan agreement provided Lender with a first priority security interest in all monies deposited into NSP LLC’s bank accounts. The agreement with Manager was also collaterally assigned to Lender as security for the loan.

NSP LLC fell into arrears in property taxes for the years 2007 and 2008. It also fell behind in its sales tax obligations for three quarters of 2008.

In 2008, NSP LLC was declared to be in default of the mortgage because it had failed to remain current in satisfying its sales and real property tax obligations. Lender advised NSP LLC that the failure to pay the taxes was an event of default.

As a result of this default, Lender stopped releasing funds to NSP LLC from the lockbox to the operating account and, together with Manager, assumed complete control over the operations and operating revenue of Hotel. Manager determined who would be paid and that decision was conveyed to NSP LLC and Lender. The people who collected, counted and delivered the money to the bank were all Manager employees. Lender would release money into a bank account that only Manager had access to and then Manager would write the checks. NSP LLC reminded Lender of its obligation to pay sales taxes, but Lender chose not to release the funds.

In 2009, the Supreme Court appointed a receiver for the revenues of NSP LLC. The receiver was ordered to pay only current taxes and not the taxes due from the time of Hotel’s seizure by Lender.

The State then assessed the sales taxes owing by NSP LLC against Taxpayer as a responsible person.

Taxpayer argued that he should not be held liable for the failure to collect and remit sales tax since he was precluded from being involved in Hotel once Lender seized control of Hotel in 2008. Taxpayer maintained that he could not be derivatively liable as a minority owner in NSP LLC because NSP LLC itself was not liable since it was “cut out of the financial decisions of the Hotel once [Lender] seized the Hotel.” He also stated that the sales tax arrearage did not arise until after Lender took over Hotel.

The State responded that, during the period in issue, Taxpayer was a member of NSP LLC and was, therefore, subject to per se liability for the taxes due from the LLC; that Taxpayer participated in the management of the business; and that Taxpayer had the burden of showing that he was not a responsible person.

The ALJ’s Opinion

The ALJ stated that, under the Tax Law, “every person required to collect [sales tax] shall be personally liable for the tax imposed, collected or required to be collected…”

The Tax Law defines a “person required to collect [sales tax]” to include:

“any employee of a partnership, any employee or manager of a limited liability company, . . . who as such . . . employee or manager is under a duty to act for such . . . partnership, limited liability company . . . in complying with any requirement of [the sales tax]; and any member of a partnership or limited liability company.”

The ALJ indicated that the foregoing language has generally been interpreted to impose strict liability upon members of an LLC for the failure to collect and remit sales tax.

Accordingly, as a member of NSP LLC, Taxpayer was personally liable for the sales taxes due from NSP LLC.

The ALJ considered Taxpayer’s contention that the foregoing analysis did not apply to him because Lender had seized Hotel and, as a result, neither NSP LLC nor its members could be held liable for the sales taxes due from Hotel. It contrasted Taxpayer’s position with the State’s contention that Hotel was not seized but, rather, that NSP LLC voluntarily yielded control to Lender.

In general, according to the ALJ, where a taxpayer’s lack of control over the financial affairs of a business entity arises from a choice not to exercise that authority, liability for sales taxes is imposed. However, where a person is precluded from acting on behalf of the business through no fault of his own, the obligations of a responsible person have not been imposed.

The ALJ acknowledged Taxpayer’s position that Taxpayer lacked control over the financial affairs of Hotel once Lender had taken over. It then considered Taxpayer’s position that NSP LLC did not willfully fail to pay and, therefore, could not be liable for the unpaid taxes. However, the question presented was whether this situation arose because of decisions made by Taxpayer.

Prior to the assumption of control by Lender, Taxpayer was clearly involved in the management and financial affairs of NSP LLC. For example, Taxpayer signed the management agreement that gave Manager the authority to manage Hotel. Significantly, NSP LLC retained the right to review Hotel’s books and records. http://www.taxlawforchb.com/2014/12/responsible-persons-sales-tax-issues-part-ii/

The ALJ determined that NSP LLC voluntarily entered into an arrangement that ultimately led to its inability to pay sales tax. There was an act that permitted Lender to exercise rights that directly resulted in the nonpayment of taxes. The inability to act was Taxpayer’s own creation and was foreseeable in the event of financial difficulties.

Accordingly, the arrangement with Lender amounted to a dereliction of Taxpayer’s duty under the Tax Law, as a responsible person, to properly safeguard the interests of the State with regard to sales taxes. Since the inability of NSP LLC to determine the disposition of funds after Lender assumed control was a situation of NSP LLC’s own making, it could not be relied upon, the ALJ said, to absolve NSP LLC of liability. It followed that Taxpayer’s argument, that he could not be held responsible since NSP LLC could not collect and remit sales tax, was without merit.

Finally, the ALJ explained that the policy set forth in the Technical Memorandum, to alleviate some of the harsh consequences of being found to be a responsible officer pursuant to the Tax Law, did not apply to Taxpayer. Specifically, the memorandum provided:

“In the case of a partnership or LLC, [the Tax Law] provides that each partner or member is a responsible person regardless of whether the partner or member is under a duty to act on behalf of the partnership or company. This means that these persons can be held responsible for 100% of the sales and use tax liability of a business. The department recognizes that this provision can result in harsh consequences for certain partners and members who have no involvement in or control of the business’s affairs.”

On its face, the ALJ stated, the policy did not apply to a member of an LLC who had substantial involvement in the financial affairs and management of the business. Here, Taxpayer exercised substantial authority over the business and financial affairs of NSP LLC until there was an event of default, which led to Lender’s utilization of the lockbox.

Lessons?

Was the ALJ’s decision unexpected? No. It certainly highlights the very difficult choice that confronts the responsible person in a struggling business: either pay the sales tax and give up the business, or continue to operate and risk personal liability.

Economic difficulties do not excuse an individual from his responsibility to collect and remit sales tax on behalf of a business entity. The Courts have often stated that individuals may not continue to operate a business “at the expense of ensuring that sales tax was paid.”

The ALJ noted that Taxpayer voluntarily entered into the arrangement on behalf of the LLC and thereby created the scenario which led to LLC’s inability to pay sales tax. In other words, Taxpayer, on behalf of the LLC, gave Lender the authority to determine which liabilities would be paid. Such a grant of authority was in direct contravention of Taxpayer’s duty as a trustee to “properly safeguard the interests of the State with regard to such taxes.” He voluntarily acceded to the terms of the agreement, notwithstanding his knowledge that, under the arrangement, sales taxes were not being paid.

A New Audit Regime

Late last year, we discussed how the IRS has found it increasingly difficult to audit partnerships as they have grown in number, size, and complexity, and to collect any resulting income tax deficiencies, especially in the cases of large partnerships and tiered partnerships.

We noted that, in response to these difficulties, Congress enacted, as party of the Bipartisan Budget Act of 2015 (“BBA”), a number of new tax compliance provisions. A key feature of the BBA is that it imposes liability for any audit adjustments with respect to an earlier partnership tax year on the partnership, rather than on those persons who were partners during the audited tax year.

Specifically, the IRS will examine the partnership’s items of income, gain, loss, deduction, and credit, and the partners’ distributive shares, for a particular year of the partnership (the “reviewed year”). Any adjustments (including interest and penalties) will be taken into account by, and will be collected from, the partnership – not from those who were partners during the reviewed year – in the year that the audit or any judicial review is completed (the “adjustment year”).

Electing Out

Under the BBA, a partnership with 100 or fewer partners is permitted to elect out of the new rules, in which case the partnership and partners will be audited under the general rules applicable to individual taxpayers. In that case, the reviewed year partners will take into account the adjustments made by the IRS, and pay any tax due as a result of those adjustments.

In order to qualify for this “small partnership” election, each partner of the partnership must be an individual, a C corporation, an S corporation, or the estate of a deceased partner.

It is likely that most qualifying partnerships will elect to be treated as small partnerships.

Electing In?

The new partnership audit regime enacted by the BBA will generally apply to returns filed for partnership taxable years beginning after December 31, 2017. The IRS is expected to issue additional guidance relating to the changes prior to January 1, 2018. This should afford partnerships the time to adjust to the new audit regime, and especially to the new default rules that apply to every partnership unless the partnership elects out.

That being said, a partnership may elect to apply these changes early, to any of its returns filed for partnership taxable years beginning after November 2, 2015 (the date of the enactment of the BBA) and before January 1, 2018.

Although it is unlikely that many partnerships will choose to be covered by the new audit regime before it becomes effective, there may be circumstances in which such an election may be considered.

For example, a partnership may choose to make this election to be eligible before 2018 to pay tax at the partnership level, to obviate the need to furnish amended Schedules K–1 to correct a partnership-level error, or to obviate the need for partners receiving amended Schedules K–1 to file amended income tax returns.

However, in light of the absence of any guidance regarding the operation of the new audit rules, it will be difficult for a partnership to determine whether such an election would, in fact, be beneficial.

Moreover, some partners may be concerned that the filing of such an election may be construed by the IRS as a signal that the partnership expects to be audited, that it may have something to “hide.”

Temporary Regulations

The IRS recently adopted a temporary regulation (the “TR”) to provide the time, form, and manner for a partnership to make an election to have the new partnership audit regime apply early – to any of its partnership returns filed for a partnership taxable year beginning after November 2, 2015 and before January 1, 2018. A partnership that elects to apply the new partnership audit regime to a partnership return filed for an eligible taxable year may not elect out of the new rules under the small partnership exception with respect to that return.

The TR further provides that an election , once made, may only be revoked with consent of the IRS. In addition, partnerships may not request an extension of time for making the election.

Significantly, in order to allay the concerns described above, the TR provides that an election to have the new partnership audit regime apply must be made when the IRS first notifies the partnership in writing that a partnership return for an eligible taxable year has been selected for examination (a “notice of selection for examination”). In other words, the partnership can wait to make the election until it is notified that it is going to be audited.

A partnership that is so notified, and that wishes to make an election, must do so within 30 days of the date of the notice of selection for examination.

The election must include a statement that the partnership is electing to have the partnership audit regime enacted by the BBA apply to the partnership return identified in the IRS notice of selection for examination. The statement must be provided to the individual identified in the notice of selection for examination as the IRS contact for the examination.

Among other things, the statement must include representations that the partnership is not insolvent and does not reasonably anticipate becoming insolvent, the partnership is not currently and does not reasonably anticipate becoming subject to a bankruptcy petition under Title 11, and the partnership has sufficient assets, and reasonably anticipates having sufficient assets, to pay the potential underpayment that may be determined during the partnership examination.

In no case may an election under the TR be made earlier than January 1, 2018.

Looking Ahead

The examination rate among partnerships, including LLCs, has increased in recent years, and partnership audits are certain to increase at an even greater rate after the BBA’s changes become effective on January 1, 2018.

In the interim, it will behoove partnerships and their advisers to stay abreast of any guidance that the IRS issues regarding the application and implementation of the changes in the partnership audit rules.

No, I am not referring to some fleeting summer romance. After all, “. . . summer friends will melt away like summer snows.” (George R.R. Martin, A Feast for Crows).

Rather, I am referring to the abundant guidance that the IRS has issued or proposed this summer regarding the requirements that must be satisfied in order for a corporate break-up to receive favorable tax treatment. (See example).

Among the concerns addressed by the IRS are those relating to distributions involving relatively small active businesses or substantial amounts of investment assets. These transactions may (i) present evidence of a prohibited “device,” (ii) may lack an adequate business purpose, or (iii) may fail to distribute a qualifying active business. (See October 13, 2015 blog post).

Statutory Requirements

Generally, if a corporation distributes property with respect to its stock to a shareholder, the amount of the distribution is equal to the fair market value (“FMV”) of the property. This amount is treated first as the receipt by the shareholder of a dividend to the extent of the corporation’s earnings and profits (“E&P”), then as the recovery of the shareholder’s basis in the stock, and finally as gain from the sale or exchange of the stock.

The corporation recognizes gain to the extent the FMV of the property distributed exceeds the corporation’s adjusted basis in the property.

However, the Code provides that, under certain circumstances, a corporation (Distributing) may distribute stock in a corporation that it controls (Controlled) to its shareholders without causing either Distributing or its shareholders to recognize gain on the distribution.

Numerous requirements must be satisfied in order for a distribution to be tax-free to Distributing and its shareholders.

For example, the transaction must not be used principally as a device for the distribution of the E&P of Distributing or Controlled, and Distributing and Controlled must each be engaged, immediately after the distribution, in the active conduct of a trade or business.

A qualifying business is one that has been actively conducted throughout the five-year period ending on the date of the distribution and that was not acquired within this period in a transaction in which gain or loss was recognized.

Distributions of Controlled stock generally take three different forms: (1) a pro rata distribution to Distributing’s shareholders (a spin-off), (2) a distribution in redemption of Distributing stock (a split-off), or (3) a liquidating distribution by Distributing which may be pro rata or non-pro rata (a split-up).

A Device?

In determining whether a transaction was used principally as a device for the distribution of the E&P of Distributing or of Controlled, consideration is given to all of the facts and circumstances of the transaction and, in particular, to the nature, kind and amount of the assets of both corporations immediately after the transaction, and to the ratio for each corporation of the value of assets not used in a qualifying business to the value of its qualifying business.

Thus, the fact that at the time of the transaction substantially all of the assets of each of the corporations involved are used in a qualifying business is considered evidence that the transaction was not used principally as a device, and a difference in the asset ratios for Distributing and Controlled is ordinarily not evidence of device if the distribution is not pro rata among the shareholders of Distributing, and such difference is attributable to a need to equalize the value of the stock distributed and the value of the stock exchanged by the distributees.

In addition, certain distributions are ordinarily not considered a device, including a distribution that, with respect to each distributee, would be a redemption of stock to which sale-or-exchange treatment applies, and distributions in which the corporations have no E&P.

The existence of assets that are not used in a qualifying five-year business is evidence of device. Such assets include liquid investment assets that are not related to the reasonable needs of the qualifying business.

The current regulations, however, are not specific as to the quality or quantity of assets relevant in the “nature and use of assets” device factor or the appropriate weighing of the device and non-device factors.

Active Business

The IRS previously noted there is no requirement that a specific percentage of a corporation’s assets be devoted to a qualifying business, provided its active business assets represent a “substantial portion” of the value of the corporation immediately after the distribution. Thus, the fact that Distributing’s or Controlled’s qualifying business is small in relation to all the total assets of Distributing or Controlled raises an issue as to whether a relatively small active business satisfies the active business requirement.

Proposed Regulations

The IRS recently proposed regulations to address concerns over distributions involving relatively small active businesses, but substantial amounts of investment assets, because these may present evidence of device, or may lack an adequate business purpose or a qualifying active business.

Specifically, the proposed regulations provide guidance regarding the device prohibition, and they also provide a minimum threshold for the assets of one or more active businesses of Distributing and of Controlled.

Device Regulations

The potential for device generally exists either if Distributing or Controlled owns a large percentage of “investment” assets not used in business operations compared to total assets, or if Distributing’s and Controlled’s percentages of these assets differs substantially.

Instead of focusing on investment assets, the proposed regulations compare a corporation’s assets used in an active business (“Business Assets”) to those not so used (“Nonbusiness Assets”).  Business Assets are the gross assets used in an active business – without regard to whether they satisfy the five-year-active-business requirement – including reasonable amounts of cash and cash equivalents held for working capital and assets required to be held to provide for exigencies related to a business or for regulatory purposes with respect to a business.

In addition, under the proposed regulations, if the ratio of  a corporation’s Nonbusiness Assets to its total assets (“Nonbusiness Asset Percentage”) is at least 20 percent, the ownership of the Nonbusiness Assets is evidence of device. Additionally, a difference in this ratio between Distributing and Controlled ordinarily would not be evidence of device if such difference is less than 10 percentage points or, in the case of a non-pro rata distribution, if the difference is attributable to a need to equalize the value of the Controlled stock and securities distributed and the consideration exchanged therefor by the distributees. Such circumstances would ordinarily be treated as not constituting evidence of device.

Corporate Business Purpose

The presence of a strong, bona fide business purpose is a non-device factor.

Under the proposed revision, a corporate business purpose that relates to a separation of Nonbusiness Assets from one or more Businesses, or from Business Assets, would not be evidence of non-device, unless the business purpose involves an exigency that requires an investment or other use of the Nonbusiness Assets in a Business. Absent such an exigency, such a separation would be viewed as evidence of a device.

Per Se Device Test

The IRS also proposes to add a per se device test. If designated percentages of Distributing’s and/or Controlled’s total assets are Nonbusiness Assets, the transaction would be considered a device, notwithstanding the presence of any other non-device factors. However, this per se device rule would not apply if the distribution is one in which the corporate distributee would be entitled to a dividends received deduction or if the distribution would qualify as a sale or exchange if it were a redemption.

The per se device test has two prongs, both of which must be met for the distribution to be treated as a per se device.

The first prong is met if Distributing or Controlled has a Nonbusiness Asset Percentage of 66 2/3 percent or more.

The second prong of the test compares the Nonbusiness Asset Percentage of Distributing with that of Controlled. This prong of the per se device test provides for three “bands” in making this comparison. Each of these bands represents a case in which the Nonbusiness Asset Percentages of Distributing and Controlled are significantly different. For example, in the first band, if one corporation’s Nonbusiness Asset Percentage is 66 2/3 percent or more, but less than 80 percent, the distribution would fall within the band if the other corporation’s Nonbusiness Asset Percentage is less than 30 percent.

If both prongs of this test are met, that is, if the Nonbusiness Asset Percentage for either Distributing or Controlled is 66 2/3 percent or more and the Nonbusiness Asset Percentages of Distributing and Controlled fall within one of the three bands, the distribution would be a per se device.

Minimum Size for Active Business

The Code does not literally provide a minimum absolute or relative size requirement for an active business to qualify. Nevertheless, the IRS has determined that the Code requires that distributions have substance, and that a distribution involving only a relatively de minimis active business should not receive favorable tax treatment because such a distribution is not a separation of businesses.

To ensure that these requirements are satisfied, the IRS proposes to add a new regulation to require that the percentage determined by dividing the FMV of each of Distributing’s and Controlled’s corporation’s five-year-active Business Assets by the FMV of its total assets must be at least five percent. These five-year-active-Business Assets would include reasonable amounts of cash and cash equivalents held for working capital and assets required to be held to provide for exigencies related to a five-year-active Business or for regulatory purposes with respect to such a business.

Timing of Asset Identification, Characterization, and Valuation

For purposes of the above rules, the assets held by Distributing and by Controlled immediately after the distribution must be identified, and their character and FMV must be determined.

The FMV of assets would be determined, at the election of the parties on a consistent basis, either (a) immediately before the distribution, (b) on any date within the 60-day period before the distribution, or (c) on the date of an agreement with respect to the distribution that was binding on Distributing on such date and at all times thereafter. The parties would be required to make consistent determinations between themselves, and use the same date, for purposes of applying the device rules and the five-percent minimum Five-Year-Active-Business Asset Percentage requirement.

Conclusion

Generally speaking, the proposed regulations should be welcomed by taxpayers. Although some may disagree with the thresholds established, and with the resulting increased reliance on valuations, the IRS is correct in its approach: the favorable tax treatment afforded by the Code for certain corporate separations is intended to apply only to genuine separations of businesses and business assets. The congressional purpose for adopting the active business requirement was to separate businesses, not to separate inactive assets from a business. Accordingly, when a corporation that owns only nonbusiness assets and a relatively de minimis active business is separated from a corporation with another active business, the substance of the transaction is not a qualifying separation of businesses.