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.

 

They’re Not Making Any More of It
Many of our clients own significant interests in real property, both on Long Island and in New York City. Some of these clients are more active investors than others. They may engage in like-kind exchanges in order to diversify their holdings. They may enter into relatively complex joint ventures with other investors. They may spin-off parts of their portfolios in order to obtain better financing, or to address management or ownership issues.

In every case, they are keen on reducing any tax liability that may otherwise be incurred as a result of the particular transaction. After all, they want to maximize the economic return on their investment. The more that they pay in taxes as a result of a particular investment or transaction structure, the lower their economic return will be.

A Recent Development
A recent decision by N.Y.’s Division of Tax Appeals may be of particular interest to real estate investors and their advisers. In this case, an Administrative Law Judge (the “Court”) considered whether the real estate transfer tax (“RETT”) was properly asserted in the transactions described below.

The Transactions
Taxpayer and Partner acquired real property (the “Property”) in N.Y.C. as tenants-in-common (“TIC”). Upon acquisition, Taxpayer held an undivided 45% TIC fee interest in the Property and Partner held an undivided 55% TIC fee interest in the Property. RETT was paid in connection with the acquisition of the Property.

Approximately three-and-one-half years later, Taxpayer and Partner formed Owner LLC.

On Date 1, one week after the creation of the LLC, Taxpayer and Partner contributed their respective 45% and 55% TIC interests in the Property to Owner LLC, in exchange for which Taxpayer received a 45% membership interest in Owner LLC, and Partner received a 55% membership interest.

Immediately thereafter, and on the same day, Taxpayer sold its 45% membership interest in Owner LLC to Partner in exchange for approximately $111 million.

Taxpayer and Partner filed a New York State Combined Real Estate Transfer Tax Return (Form TP-584) reporting the contribution of Taxpayer’s fee interest to Owner LLC, and the sale to Partner of Taxpayer’s membership interest in Owner LLC. Both transfers were reported as tax-exempt transactions: (i) the contribution of Taxpayer’s fee interest to Owner LLC as a conveyance that consisted of a mere change of identity or form of ownership or organization; (ii) the sale of Taxpayer’s 45% membership interest to Partner as the transfer of a less-than-controlling interest.

The Parties’ Positions
New York (the “State”) audited Taxpayer in connection with these real estate transactions. Based on its findings, the State asserted that Taxpayer was liable for RETT, plus interest and penalties.

Taxpayer filed a Request for Conciliation Conference with the Bureau of Conciliation and Mediation Services (“BCMS”), but BCMS issued a conciliation order that upheld the tax assessment.

Taxpayer then filed a petition with the Division of Tax Appeals, where it contended that the State erred in asserting a tax deficiency because Taxpayer’s and Partner’s contributions of their respective interests in the Property to Owner LLC on Date 1 were each exempt from RETT as a “mere change in form.”

Taxpayer also contended that its “subsequent” sale of its 45% membership interest in Owner LLC to Partner, also on Date 1, was not subject to RETT because it did not constitute a transfer of a controlling interest in an entity that owned real property.

The State contended that, with the transfer of Taxpayer’s 45% interest in Owner LLC to Partner, Partner obtained a 100% controlling economic interest in the Property, which resulted in a 55% nontaxable mere change in ownership and a 45% taxable change in beneficial ownership.

The Decision
The Court explained that RETT was “imposed on each conveyance of real property or interest therein.” All conveyances were presumed subject to the tax, it stated, until the contrary was proven, and the burden of proving the contrary was on the taxpayer responsible for the tax.

The term “conveyance,” it continued, is defined as “the transfer or transfers of any interest in real property by any method, including but not limited to sale, exchange, . . . or transfer or acquisition of a controlling interest in any entity with an interest in real property.” The term “controlling interest,” in turn, is defined, in the case of a partnership, as “fifty percent or more of the capital, profits or beneficial interest in such partnership . . .”

However, even where a transfer constitutes a “conveyance,” RETT does not apply to the extent that the conveyance effectuates “a mere change of identity or form of ownership or organization,” without a change in beneficial ownership.

The State conceded that Taxpayer’s and Partner’s contributions of their respective TIC interests in the Property to Owner LLC in exchange for membership interests in Owner LLC, standing alone, were exempt from the RETT as mere changes in form of ownership.

The State argued, however, that because of the subsequent sale of Taxpayer’s 45% membership interest to Partner, the combined transactions became subject to RETT. According to the State, “[i]t is [Taxpayer’s] sale of its 45% interest in Owner LLC to [Partner] in aggregation with [their] conveyances of their interests in the [Property] to Owner LLC, and the RETT implications of aggregating those transactions, that are at issue in this case.”

The State attempted to “aggregate” what the Court stated were “three nontaxable transactions,” namely (1) the transaction between Partner and Owner LLC, which effectuated a mere change in form of ownership, (2) the transaction between Taxpayer and Owner LLC, which also effectuated a mere change, and (3) Taxpayer’s transfer of its 45% membership interest in Owner LLC to Partner, in order to impose RETT on the transfer of this 45% interest.

The Court rejected this attempt, pointing out that the third transaction did not meet the definition of a transfer of a “controlling interest” because Taxpayer did not sell more than 50% of Owner LLC. As such, that transaction, by definition, could not be considered a transfer or acquisition of a controlling interest in an entity with an interest in real property.

The State nevertheless contended that adding the transfer of Taxpayer’s 45% interest in Owner LLC with Partner’s 55% interest in Owner LLC resulted in Partner’s “acquisition” of a controlling interest in Owner LLC. In support of its position, the State pointed to the RETT regulations, which provide:

“Where there is a transfer or acquisition of an interest in an entity that has an
interest in real property, . . . , and subsequently there is a transfer or acquisition of an additional interest or interests in the same entity, the transfers or acquisitions will be added together to determine if a transfer or acquisition of a controlling interest has occurred. Where there is a transfer or acquisition or a controlling interest in an entity . . . , and [RETT] is paid on that transfer or acquisition and there is a subsequent transfer or acquisition of an additional interest in the same entity, it is considered that a second transfer or acquisition of a controlling interest has occurred which is subject to [RETT].”

While the Court acknowledged that the regulation provides for adding together multiple transfers or acquisitions of interests in an LLC with an interest in real property to determine if a transfer or acquisition of a controlling interest has occurred, it also noted, contrary to the State’s argument, that the regulation does not authorize or provide for adding such a transfer or acquisition together with a nontaxable “mere change in form of ownership” conveyance in order to achieve a taxable transaction.

The regulation provides that aggregation applies to multiple transfers or acquisitions of interests in an entity with an interest in real properly that occur within a three-year period. The “fallacy of the State’s argument for aggregation,” the Court continued, was that the initial transaction between Partner and Owner LLC, wherein Partner exchanged its 55% TIC interest in the Property for a 55% interest in Owner LLC was not a “transfer or acquisition of an interest in an entity with an interest in real property.” Rather, it was a mere change in the form of ownership of the Property. Since the transaction between Partner and Owner LLC was not a transfer or acquisition of an interest in an entity, that transaction could not be aggregated with Taxpayer’s subsequent transfer of a non-controlling interest.

The Court then noted that, under the above regulation, where there is a transfer or acquisition of a controlling interest in an entity with an interest in real property, “and [RETT] is paid on that transfer or acquisition,” followed by a subsequent transfer or acquisition of an additional interest in the same entity within three years, “it is considered that a second transfer or acquisition of a controlling interest has occurred which is subject to [RETT].” Because the initial transfer between Partner and Owner LLC was not a transfer or acquisition of a controlling interest, but merely a change in form of ownership, no RETT was required to be paid. The State’s argument that the subsequent transfer of Taxpayer’s 45% interest to Partner was considered a second transfer or acquisition of a controlling interest that was subject to the RETT ignored the language of the regulation requiring that RETT was paid on the initial transaction for aggregation to apply.

Thus, the Court concluded that Taxpayer did not owe any RETT as a result of the above transactions.

Did the Court Get It Right? Did the State?
There is no doubt that if Taxpayer had sold its 45% TIC fee interest (not a partnership interest) to Partner, the sale would have been subject to RETT, and Partner would have become the sole owner of the Property.

However, nowhere in its opinion does the Court describe the nature of the TIC arrangement between Taxpayer and Partner for income tax purposes. Did it represent a mere co-ownership of property that was maintained, kept in repair, and leased, and did not constitute a separate entity for federal tax purposes?

Or did the TIC owners treat their arrangement as that of a partnership, for which they filed partnership income tax returns and received K-1s? If they had, then the Court would likely have reached the same conclusion as above, without regard to the contribution of the Property to Owner LLC – rather, it would have based its decision solely on Taxpayer’s not having transferred a controlling interest in a partnership.

But in that case, neither the Court nor Taxpayer would have had to rely upon the “mere change” exemption. For example, see N.Y.’s Limited Liability Company law, which provides, in the case of the conversion of a partnership into an LLC, that all the real property of the converting partnership remains vested in the converting LLC – in other words, there is no “conveyance.”

Enter Owner LLC. Why was it needed? In form, it represented a partnership: a non-corporate business entity with two members.

But can we say that this “partnership” had any substance? It was funded by Taxpayer and Partner on Date 1 (after having been formed only one week earlier), and Taxpayer also sold its newly acquired membership interest in LLC to Partner on Date 1 – presumably pursuant to an earlier binding agreement – following which Partner owned 100% of Owner LLC and the Property.

Although it appears that the parties utilized Owner LLC for the sole purpose of characterizing Taxpayer’s sale of its LLC interest to Partner as a transfer of a non-controlling interest, the State does not appear to have argued that the substance of the above transactions should have determined their RETT consequences.

The State will likely appeal this decision – indeed, it should. Until it does, and unless the Appellate Division agrees with it, taxpayers may have been given a simple way to circumvent the otherwise taxable transfer of a TIC interest.

Underlying the corporate reorganization provisions of the Code is the principle that it would be inappropriate to tax a transaction as a result of which the participating taxpayers – the corporations and their shareholders – have not sufficiently changed the nature of their investment in the corporation’s assets or business, provided the transaction is motivated by a substantial non-tax business purpose.

Corporate Separations
One of these reorganization provisions allows a corporation (Distributing) to distribute to some or all of its shareholders the shares of stock of a subsidiary corporation (Sub) on a tax-free basis. In general, such a distribution (a “Corporate Division”) may be made pro rata among Distributing’s shareholders (a “spin-off”), it may be made in exchange for all of the Distributing stock held by certain of its shareholders (a “split-off”), or it may be made in complete liquidation of Distributing (a “split-up”), where the stock of at least two subsidiary corporations is distributed.

There are many bona fide business reasons for a Corporate Division. The distribution of Sub may, for example: enable competing groups of shareholders to go their separate ways; shelter one line of business from liabilities that may arise from the operation of another line; permit the issuance of equity to a key employee in one line of business; facilitate borrowing; or resolve problems with customers or suppliers who compete with a line of business.

“Control”
In order to secure favorable tax treatment for a Corporate Division, the transaction must satisfy a number of requirements, among which is the requirement that Distributing must distribute stock of a corporation that it controls immediately before the distribution.

For this purpose, “control” is defined as ownership of stock possessing at least 80 percent of the total combined voting power of all classes of Sub stock entitled to vote and at least 80 percent of the total number of shares of each other class of Sub stock.

Given this “control” requirement, what is Distributing to do where it has determined that there are bona fide business reasons for separating from Sub, and that such a separation would satisfy the other requirements for tax-free treatment (including the requirement that both Distributing and Sub be engaged in an “active trade or business”), but where Distributing owns less than 80% of the voting power and/or number of Sub’s issued and outstanding shares?

Recapitalizations
The IRS has allowed certain recapitalizations of Sub that result in Distributing’s securing the necessary level of control. Some of these recapitalizations, which may themselves be effectuated on a tax-free basis, are illustrated by the following examples:

  • Corp M owned all of the voting common stock and 12% of the non-voting preferred stock of Corp N. Disputes arose among the M shareholders, and it was decided that M would distribute its N stock to one group of M shareholders in exchange for all their M stock. To qualify N as a “controlled” corporation, N issued shares of voting common stock to its preferred shareholders, other than M, in exchange for all their non-voting preferred shares in a recapitalization. After the recapitalization, M owned 93 percent of the outstanding N voting common stock and all of the outstanding N nonvoting preferred stock. M then distributed all of its common and preferred N stock to the departing shareholders in exchange for all their M stock.
  • A owned all the stock of Corp X, which owned 70 shares of the stock of corporation Y. A also owned the remaining 30 shares of Y stock. A contributed 10 shares of his Y stock to X, and, immediately thereafter, X distributed all of its 80 shares of Y stock to A. The IRS determined that X, the distributing corporation, did not have control of Y immediately before the distribution except in a transitory and illusory sense.
  • Corp X owned 70%, and A and B owned the remaining 30%, of the single outstanding class of stock of Corp Y. In exchange for the surrender of all the Y stock, Y issued Class A voting stock to A and B and Class B voting stock to X. The Class A stock issued to A and B represented 20% (a “low-vote” class), and the Class B stock issued to X represented 80% (a “hi-vote” class) of the total combined voting power of all classes of Y voting stock. Following the recapitalization, X distributed all of the Class B stock to its shareholders. The IRS determined that, immediately prior to the distribution, X had control of Y. The transaction was distinguished from the immediately preceding example because the recapitalization resulted in a permanent realignment of voting control of Corp Y.

Relaxed Standard?
Over the last several years, the IRS has recognized situations where the recapitalization that secured the necessary level of control had to be undone due to unforeseen but valid business circumstances. Consequently, it has relaxed its historical requirement that the recapitalization result in a “permanent realignment” of Sub’s capital structure in order for Distributing’s “control” to be respected.

Indeed, the IRS has stated that it will not automatically apply the step transaction doctrine to determine whether Sub was a controlled corporation immediately before a distribution solely because of any post-distribution acquisition or restructuring of Sub.

However, in otherwise applying the step transaction doctrine, the IRS has also stated that it will continue to consider all the facts and circumstances, including whether there was a “legally binding obligation” to undo the recapitalization after the distribution, and thereby render the recapitalization a sham.

In other words, even though the control requirement may be satisfied by an acquisition of control that occurs immediately before a distribution, an acquisition of control by Distributing will not be respected if it is transitory or illusory, as where the unwinding of the recapitalization was a foregone conclusion. The acquisition of control must have substance under general federal tax principles. Thus, the IRS may apply the step transaction doctrine to determine if, taking into account all facts and circumstances (including post-distribution events), a pre-distribution acquisition of control has substance such that Distributing has control of Sub immediately prior to a distribution of the Sub stock.

Revenue Procedure 2016-40
In recognition of the fact that determining whether an acquisition of control has substance for federal tax purposes can be difficult and fact-intensive, and that taxpayers may not be able to determine with sufficient certainty whether such an acquisition may proceed as a step toward an otherwise qualifying transaction, the IRS recently issued guidance that identifies certain “safe harbor” transactions in which the IRS will not assert that an acquisition of control lacks substance. [Rev. Proc. 2016-40]

These safe harbors apply to transactions in which–
(1) Distributing owns Sub stock not constituting control of Sub;
(2) Sub issues shares of one or more classes of stock to Distributing and/or to other shareholders of Sub, as a result of which Distributing owns Sub stock possessing at least 80% of the total combined voting power of all classes of Sub stock entitled to vote and at least 80 percent of the total number of shares of all other classes of stock of Sub;
(3) Distributing distributes its Sub stock in a transaction that otherwise qualifies as a tax-free Corporate Division; and
(4) Sub subsequently engages in a transaction that substantially restores (a) Sub’s shareholders to the relative interests they would have held in Sub had the issuance not occurred; and /or (b) the relative voting rights and value of the Sub classes of stock that were present prior to the issuance.

The IRS will not assert that such a transaction lacks substance, and that therefore Distributing lacked control of Sub immediately before the distribution, if the transaction is also described in one of the following safe harbors:

  • No action is taken (including the adoption of any plan), at any time prior to 24 months after the distribution, by Sub’s board of directors, Sub’s management, or any of Sub’s controlling shareholders, that would (if implemented) result in an unwind of the recapitalization.
  • Sub engages in a transaction with one or more persons (for example, a merger) that results in an unwind, regardless of whether the transaction takes place more or less than 24 months after the distribution, provided that–
    (1) There is no agreement, understanding, arrangement, or substantial negotiations or discussions concerning the transaction or a similar transaction, relating to similar acquisitions, at any time during the 24-month period ending on the date of the distribution; and
    (2) No more than 20% of the interest in the other party, in vote or value, is owned by the same persons that own more than 20% of the stock of Sub.

Looking Ahead
These safe harbors apply solely to determine whether Distributing’s acquisition of control of Sub has sufficient substance for purposes of effecting a tax-free Corporate Division. The certainty they provide is a welcome development.

However, if a transaction is not described in one of the safe harbors, the determination of whether an acquisition of control has substance, and will therefore be respected for purposes of a Corporate Division, will continue to be made under general federal tax principles without regard to the safe harbors. In that case, Distributing and its shareholders should proceed with caution – they should consult their tax advisers – especially given the adverse tax consequences that may be visited upon them if Distributing’s control of Sub is determined to have been illusory.

Deferred Compensation
It is not uncommon for a closely-held business to provide an economic incentive to its key employees. The incentive may take the form of compensation the payment of which is deferred until the compensation is “earned,” which may be upon the occurrence of some specified business-related event, such as the sale of the business. In other situations, a key employee may be granted an equity (or equity-flavored) interest in the business, or the right to purchase such an interest, in order that the employee may “participate” in the ultimate sale of the business.

In each of these scenarios, the employer and the employee must pay close attention to the rules and principles that govern the income tax treatment of deferred compensation arrangements. Only by doing so can the employee avoid being taxed on the value of the deferred compensation before it is paid to the employee.

Thus, the arrangement must satisfy certain statutory and regulatory requirements under IRC Sec. 409A, some of which were recently clarified by the IRS.

Section 409A, In Brief
Under Sec. 409A, all amounts deferred under a compensation plan for the benefit of an employee are currently includible in the employee’s gross income to the extent they are not subject to a “substantial risk of forfeiture,” unless certain requirements are satisfied relating to the timing of the distribution of the deferred compensation.

A substantial risk of forfeiture exists when the employee’s rights to the compensation are conditioned upon the performance of substantial services or the occurrence of a condition related to a purpose of the compensation, such as separation from service on the sale of the business.

If a plan fails to comply or to be operated in accordance with the rules under Sec. 409A “at any time during a taxable year,” and there is compensation deferred under the plan that is not subject to a substantial risk of forfeiture (i.e., the employee is vested in the compensation), the amount of such compensation is includible in the employee’s gross income for the taxable year.

If the plan is not compliant, but the deferred amount is subject to a substantial risk of forfeiture at all times during the taxable year (i.e., it is not vested), the compensation is not immediately includible in income under Sec. 409A.

The Regulations – Revisited
In 2007, the IRS issued long-awaited final regulations under Sec. 409A. These final regulations defined certain terms used in Sec. 409A , set forth the requirements for the time and form of payments under nonqualified deferred compensation plans, and addressed certain other issues under Sec. 409A.

More recently, the IRS proposed certain clarifications and modifications to the regulations in order to help taxpayers comply with the requirements of Sec. 409A.

Among other things, these proposed regulations address certain issues that are often encountered in connection with change-in-control events and stock options.

“Haircut” On Repurchase of Stock
The regulations provide that certain stock options and stock appreciation rights (“SARs”; together with options, so-called “stock rights”) granted with respect to service recipient stock do not provide for the deferral of compensation because their exercise price is equal to the fair market value (“FMV”) of the underlying stock at the time of grant.

The term “service recipient stock” is defined as common stock of a corporation that, as of the date of grant, is an eligible issuer of service recipient stock. For this purpose, service recipient stock does not include any stock that is subject to a mandatory repurchase obligation (other than a right of first refusal), or a permanent put or call right, at less than the FMV of the stock.

However, employers may want to deter key employees, to whom employer stock has been granted, from engaging in behavior that could be detrimental to the employer. Toward that end, employers may reduce the amount that the employee receives under a stock rights arrangement if the employee is dismissed for cause, or violates a noncompetition or nondisclosure agreement.

Because this type of reduction is generally prohibited under the above definition of “service recipient stock,” many employers worry that claw-backs might violate Sec. 409A.

The proposed regulations address this issue by providing that a stock right will not violate Sec. 409A where it is subject to repurchase at less than FMV upon an employee’s involuntary separation from service for cause, or upon the employee’s violation of a covenant-not-to-compete. It is unclear whether the occurrence of another condition that is within the control of the employee would also be covered.

Separation from Service
The regulations permit the seller and an unrelated buyer in an asset purchase transaction to specify whether a person who is an employee of the seller immediately before the transaction is treated as separating from service if the employee provides services to the buyer after, and as a result of, the transaction.

The rule is based on the recognition that, while employees may formally terminate employment with the seller and immediately recommence employment with the buyer in an asset transaction, the employees often experience no change in the type or level of services they provide.

Questions have arisen whether this rule may be used with respect to a transaction that is treated as a deemed asset sale under Sec. 338.

In a deemed asset sale under Sec. 338, however, employees do not experience a termination of employment. Accordingly, it would be inconsistent with Sec. 409A to permit the parties to a deemed asset sale to treat employees as having separated from service upon the occurrence of the transaction.

Thus, the proposed regulations provide that a stock purchase transaction that is treated as a deemed asset sale under Sec. 338 is not a sale or other disposition of assets for purposes of this “separation” rule under Sec. 409A . the same guidance should apply to deemed asset sales under IRC Sec. 336(e).

Changes in Status from Employee to Independent Contractor
The regulations provide that an employee separates from service with an employer if the employee has a termination of employment with the employer. A termination of employment generally occurs if the facts and circumstances indicate that the employer and employee reasonably anticipate that no further services would be performed after a certain date (for example, the sale of a division of the employer’s business), or that the level of bona fide services the employee would perform after that date (whether as an employee or as an independent contractor) would permanently decrease to no more than 20 percent of the average level of services performed over the immediately preceding 36-month period.

The regulations further provide that “[i]f a service provider . . . ceases providing services as an employee and begins providing services as an independent contractor, the service provider will not be considered to have a separation from service until the service provider has ceased providing services in both capacities.”

The quoted sentence could be read to provide that an employee who becomes an independent contractor for the same service recipient, and whose anticipated level of services upon becoming an independent contractor are 20 percent or less than the average level of services performed during the preceding 36-month period, would not have a separation from service because a complete termination of the contractual relationship with the service recipient has not occurred and, therefore, there is no separation from service as an independent contractor.

Such a reading, however, is inconsistent with the rule that an employee separates from service if the employer and employee reasonably anticipate that the level of services to be performed after a certain date (in whatever capacity) would permanently decrease to no more than 20 percent of the average level of services performed over the preceding 36-month period.

To avoid potential confusion, the proposed regulations delete the quoted sentence from the regulations.

Certain Transaction-Based Compensation
The regulations provide special rules for payments of transaction-based compensation.

There are payments related to certain types of “changes in control” that (1) occur because an employer purchases its stock held by an employee, or because the employer or a third party purchases a stock right held by an employee, or (2) are calculated by reference to the value of employer stock.

Under the regulations, such transaction-based compensation may be treated as paid at a designated date or pursuant to a payment schedule that complies with the requirements of Sec. 409A if it is paid on the same schedule and under the same terms and conditions as apply to payments to shareholders, generally, with respect to stock of the employer pursuant to the change in control, and it is paid not later than five years after the change in control event.

It is unclear, however, whether this payment schedule could be applied to stock options or SARs that are otherwise exempt from Sec. 409A.

The proposed regulations clarify that the special payment rules for transaction-based compensation apply to a stock rights that did not otherwise provide for deferred compensation before the purchase of the stock right. Accordingly, the purchase of such a stock right in a manner consistent with these rules will not result in the stock right being treated as having provided for the deferral of compensation prior to the transaction.

Prohibition on Acceleration of Payments
Under the regulations, a plan may provide for the acceleration of a payment made pursuant to the termination and liquidation of a plan under certain circumstances. For example, a plan may provide for the acceleration of a payment if the plan is terminated and liquidated within 12 months of a taxable corporate liquidation (such as may follow a sale of assets).

The regulations also provide that a payment may be accelerated pursuant to a change in control event, or in other circumstances, provided certain requirements are satisfied. To terminate a plan under these provisions, the regulations provide that the employer must terminate and liquidate all plans sponsored by the employer that would be aggregated with the terminated plan under the “plan aggregation rules” if the same employee had deferrals of compensation under all such plans.

The plan aggregation rules identify different types of nonqualified deferred compensation plans. All plans of the same type in which the same employee participates are treated as a single plan.

The proposed regulations clarify that the acceleration of a payment pursuant to the above rule is permitted only if the employer terminates and liquidates all plans of the same category that the employer sponsors, and not merely all plans of the same category in which a particular employee actually participates.

The proposed regulations also clarify that under this rule, for a period of three years following the termination and liquidation of a plan, the employer cannot adopt a new plan of the same category as the terminated and liquidated plan, regardless of which employees participate in the plan.

What’s Next?
These amendments to the regulations are proposed to be effective on or after the date on which they are published as final regulations. Taxpayers may, however, rely on the proposed regulations – to take advantage of the clarification and flexibility they provide – before they are published as final regulations, and the IRS will not assert positions that are contrary to the positions set forth in the proposed regulations.

That being said, it is worth noting that certain provisions of the proposed amendments are not intended as substantive changes to the current requirements under Sec. 409A. thus, certain positions may not properly be taken under the existing regulations; for example, that a stock purchase treated as a deemed asset sale under Sec. 338 is a sale or other disposition of assets for purposes of determining when an employee separates from service as a result of an asset purchase transaction; or that the exception to the prohibition on acceleration of a payment upon a termination and liquidation of a plan applies if the employer terminates and liquidates only the plans of the same category in which a particular employee participates, rather than all plans of the same category that the employer sponsors.

“You Made Your Bed, Now . . .”

It is a basic precept of the tax law that, for purposes of determining the tax consequences of a transaction, a taxpayer will generally be bound by the form of the transaction that the taxpayer has used to achieve a particular business goal.

The taxing authorities, however, are not bound by the taxpayer’s chosen form; rather, they are free to ignore the form of the transaction, and may disregard or collapse transaction steps that have no business purpose, in order to determine the substance of the transaction and the resulting tax consequences thereof.

Similarly, a taxpayer is generally not free to characterize a transaction in one way for a particular tax year, and to re-characterize it for another tax year, in such a way that the taxpayer is unjustly enriched and the taxing authorities are whipsawed.

Although many taxpayers will never admit it, fairness and the prevention of unjust enrichment – either to the taxpayer or the government – are recurring themes in the administration of the tax laws, as was illustrated by a recent Tax Court decision.

Cash Basis Accounting?

Shareholders owned Corp, a cash basis taxpayer that was organized as an S corporation.

During each of the years at issue, Corp determined the gross receipts reported on its tax return using the deposits made into its bank accounts during such year.

Thus, Corp deposited into its bank account, in January 2009, checks that were received in 2008, totaling $1.63 million. Corp deposited in January 2010 checks that were received in 2009, totaling $1.89 million. Corp deposited in January 2011 checks that were received in 2010, totaling $2.27 million. Corp deposited in January 2012 checks that were received in 2011, totaling $1.56 million.

Corp timely filed its tax returns for the 2009, 2010, and 2011 tax years, on which it reported gross receipts of $7.22 million, $7.93 million, and $8.72 million, respectively.

The reported gross receipts for any year at issue did not include those checks that were received in such year but deposited in January of the following year. Rather, each year’s reported gross receipts included the checks that were deposited in January of the year at issue but received in the prior year.

Shareholders filed timely individual income tax returns that reported their proportionate shares of income from Corp.

That’s Not How It Works

In 2013, the IRS timely issued notices of deficiency to Shareholders for their 2009, 2010, and 2011 tax years. (The period of limitations for 2008 was already closed.) In the notices, the IRS determined that Corp had improperly computed its gross receipts by excluding the checks that were received during the last quarter of each tax year at issue. Shareholders petitioned the Tax Court (“TC”).

However, the issue for consideration by the TC was whether Shareholders were bound under the doctrine of the “duty of consistency” to recognize the $1.63 million in gross receipts that Corp received in 2008 as income for tax year 2009, the year in which it was deposited and actually reported.

In calculating the adjustment to Corp’s gross receipts for each tax year at issue, except 2009, the IRS: (i) included the checks that were received in the year at issue but deposited by Corp in January of the following year and (ii) excluded the checks that were deposited in January of the tax year at issue, but received in the prior year.

To illustrate: the IRS adjusted the 2010 gross receipts by excluding the checks that had been received in 2009 but deposited in January 2010 and by including the checks that had been received in 2010 but deposited in January 2011.

Taxpayer’s Position

For 2009, however, the IRS did not make the second adjustment; in other words, it did not exclude the checks that had been received in the prior year, 2008, but deposited in January 2009.

Shareholders did not dispute that Corp incorrectly computed its gross receipts for 2009 by using bank account deposits.

However, Shareholders contended that gross receipts of $1.63 million should be excluded from their 2009 income – notwithstanding their having reported them in 2009 – because they were actually received in 2008, and that the IRS did not have the authority to make adjustments for Shareholders’ 2008 tax year.

Shareholders further contended, and the IRS did not dispute, that the period of limitations for tax year 2008 was closed, and that the TC did not have jurisdiction to make adjustments for their 2008 tax year.

On the basis of these arguments, Shareholders believed that the $1.63 million of receipts should not be taxed at all.

The IRS contended that under the duty of consistency, Shareholders should be required to include on their 2009 returns the 2008 income, as they originally reported it.

Basic Rules

The Code requires that taxable income be computed on the basis of the taxpayer’s taxable year. The Code defines a “taxable year” as a taxpayer’s annual accounting period in the case of a calendar year or a fiscal year. A taxpayer’s “annual accounting period” is the annual period on the basis of which the taxpayer regularly computes his income in maintaining his accounting books.

For purposes of calculating taxable income, the Code provides that all items of income received in a taxable year must be reported as income for that taxable year unless the method of accounting requires that the item be accounted for in a different tax period.

Thus, income properly includible for one tax year is not deemed income for some other tax year, even if it was not reported for the proper year.

Because Corp was a cash method taxpayer, all of the checks received in 2008 should have been included in Corp’s gross receipts for tax year 2008.

Duty of Consistency

The duty of consistency, or quasi-estoppel, is an equitable doctrine which prevents a taxpayer from benefiting in a later year from an error or omission in an earlier year which cannot be corrected because the limitations period for the earlier year has expired.

According to the TC, the duty of consistency not only reflects basic fairness, but also shows “a proper regard for the administration of justice and the dignity of the law.”

The TC stated that “[t]he law should not be such a[n] idiot that it cannot prevent a taxpayer from changing the historical facts from year to year in order to escape a fair share of the burdens of maintaining our government. Our tax system depends upon self-assessment and honesty, rather than upon hiding of the pea or forgetful tergiversation.”

The TC explained that for the duty of consistency to apply, the following requirements must be satisfied: (i) a representation or report by the taxpayer, (ii) reliance by the IRS, and (iii) an attempt by the taxpayer, after the statute of limitations has run, to change the previous representation or to re-characterize the situation in such a way as to harm the IRS.

If all those elements are present, the IRS may act as if the previous representation, on which it relied, continues to be true, even if it is not. The taxpayer is estopped to assert the contrary.

The duty of consistency is an affirmative defense. Therefore, the party asserting the duty of consistency bears the burden of proving that it applies. In the present case, that burden rested on the IRS.

Does it Apply?

In applying the first element of the duty of consistency, it had to be shown that Shareholders made a representation or report.

Shareholders consistently reported income on the basis of Corp’s bank deposits. The IRS asked that the TC hold them to this consistent reporting as to 2009.

The TC found that Shareholders made a clear representation on the 2009 tax return for Corp when they represented that Corp had received the $1.63 million of gross receipts in 2009 (rather than in 2008, when it was actually received). Thus, this element of the duty of consistency was met.

The second element of the duty of consistency requires a showing of reliance by the IRS on the taxpayer’s representation. According to the TC, “[c]ase law establishes that the necessary acquiescence exists where a taxpayer’s return is accepted as filed; examination of the return is not required.” The TC further stated that “[t]he [IRS] may rely on a presumption of correctness of a return or report that is given to the [IRS] under penalties of perjury.”

Shareholders claimed that the IRS did not reasonably rely on their representation because the IRS knew that the notices of deficiency did not accurately reflect Shareholders’ income from 2009.

The TC disagreed, stating that the IRS had already relied upon Shareholders’ representations by accepting the 2008 tax returns and allowing the period of limitations to expire. This element of the duty of consistency was met.

The third element of the duty of consistency requires an attempt by the taxpayer, after the statutory period of limitations has expired, to change the previous representation or to re-characterize the situation in such a way as to harm the
IRS.

Shareholders admitted that reporting the 2008 payments for 2008, rather than for 2009, would be inconsistent with their previous reporting. The period of limitations had expired on the 2008 tax year, and allowing Shareholders to re-characterize their income as belonging in 2008 would harm the IRS; it would allow Shareholders to avoid tax on $1.63 million.

Thus, the IRS established that all of the elements for the duty of consistency had been met.

The TC concluded that the duty of consistency required that the $1.63 million in gross receipts that Corp received in 2008, but reported for 2009, be recognized by Shareholders as income for tax year 2009.

Take-Away

It doesn’t take a degree in tax to figure out that the Shareholders’ position in the case discussed above was untenable. Even on just a visceral level, their gambit feels wrong.

They knew that they were not reporting their income in accordance with Corp’s chosen method of accounting. Rather than reporting items of income in the year in which they were received, Corp effectively “stuck the checks in a drawer” until the following tax year.

When it was found out, Corp tried to turn the IRS’s own argument against it in order to avoid the taxation of income altogether.

A taxpayer and its advisers should always assume that the taxpayer’s tax return, and any transactions reported therein, are going to be examined. That mindset should force them to consider the bona fide nature of such a transaction, and to assess the strength of the return positions to be relied upon. This exercise should be conducted before the transaction is even undertaken, and well before the return is filed.

Once an examination has begun, the taxpayer stands to lose credibility in the eyes of the IRS if the taxpayer has taken indefensible or irrational positions on its return. This may adversely affect the taxpayer’s ability to sustain other, reasonable positions, and it will certainly invite the imposition of penalties that cannot be abated.

Nothing Ventured…?
Ask any tax practitioner, “Have you ever advised a client not to do something, only to discover later that they did it anyway?” Or, have you ever reminded a client of the old adage, “if something sounds too good to be true, it probably isn’t?” The likely responses would be “Oh yeah.”

How is that these clients, who are intelligent and successful people, when confronted with a large tax bill, are often willing to throw caution to the wind?

In part, it may be attributable to the fact that they are also risk-takers – after all, they did not grow successful businesses without taking some chances.

On the other hand, there is a difference between taking a calculated risk and a foolish gamble, especially where taxes are involved, as one group of taxpayers recently learned.

Large Tax Bill? No Worries
Brothers each owned 50% of Corp, which was taxable as a C corporation. Corp operated as a construction contractor. Corp entered into a construction contract for which it borrowed money (the “Project Loan”). Brothers guaranteed the loan.

A contract dispute arose, the contract was terminated, and Corp filed a claim for equitable adjustment. The claim was denied, and Corp appealed (the “Appeal”).

Corp won the Appeal and received a $40.8 million litigation award which represented contract damages and interest, all of which Corp received during its FYE March 31, 2003 (the “FY”).

Following receipt of the litigation award, Corp made estimated tax payments to State, and to the IRS.

In anticipation of Corp’s receipt of the litigation award, Brothers asked Big-4 CPA to find out what tax liability Corp and Brothers would incur, and whether there were any strategies that could help them shelter some of the income.

Brothers were eventually introduced to Buyer, a company which represented itself as specializing in “structuring transactions to solve specific corporate tax problems.”

Buyer was interested in purchasing Corp’s stock, but Brothers informed Buyer that they wanted to keep Corp’s land, its interest in Condo LLC, and Corp’s machinery and equipment – basically, Corp’s operating assets.

Buyer sent Brothers a letter of intent (the “LOI”) to purchase their Corp stock (the “Transaction”). At the time that Brothers received the LOI, Corp’s assets consisted of: (i) land, improvements, machinery, and equipment; (ii) an interest in Condo LLC; (iii) $34.5 million in cash; (iv) projected future litigation proceeds; and (vi) prepaid taxes. Corp’s liabilities consisted of: (i) the Project Loan; and (ii) income taxes due on the litigation award from the Appeal.

The LOI reflected that the purchase price for the Corp stock was to be calculated based upon the discounted value for Corp’s prepaid taxes, plus 100% of Corp’s cash at closing, plus a premium (based upon a percentage of Corp’s tax liability) over Corp’s net asset value. The letter reflected that a portion of the purchase price would consist of a promissory note “secured by tax refunds” that would be generated by losses to be realized by Corp after the closing.

The purchase price for the Corp stock was calculated at $24.2 million, an amount greater than Corp’s net asset value.

Buyer proposed to use Corp’s own cash to pay the purchase price for the Corp stock.

The Advisers Speak
Brothers engaged Big-4 and Law Firm to advise them in connection with the LOI.

Law Firm was concerned that Corp could be pulled into bankruptcy if Buyer used Corp’s cash to pay the purchase price to Brothers. Law Firm told Brothers that “there is the possibility that the proposed stock sale can be attacked as a fraudulent transaction.”

Law Firm also considered the risk of transferee liability and communicated to Brothers that if Buyer took steps to render Corp unable to pay its tax liability at the time of the redemption and the stock sale, “there could be a basis for the IRS to seek to impose transferee liability on the selling shareholders” with respect to the stock sale.

After conducting an analysis of the stock sale proposed by the LOI, Big-4 became concerned about Buyer’s plan to offset Corp’s income with its losses because it was similar to a “listed transaction.”

Big-4 spoke with Brothers about its concerns regarding the proposed stock sale, and the chances that the Transaction could be challenged by the IRS. It told them that the proposed stock sale was similar to a “listed transaction,” and tried to discourage Brothers from entering into the proposed stock sale.

Big-4 informed Brothers that it could not assist them in their negotiations with Buyer. Corp did not remain a client of Big-4, although Brothers did remain clients.

Did You Say Something?
Brothers decided to sell its Corp stock in the Transaction under the negotiated terms despite being advised of the risks of the Transaction by Law Firm and Big-4.

The redemption and stock sale were effected as integrated transactions. Under the redemption agreement, Corp redeemed 18% of its capital stock from Brothers in exchange for Corp’s noncash tangible assets, consisting of equipment, machinery, land, and Corp’s interest in Condo LLC. At the direction of Brothers, Corp conveyed these noncash tangible assets to LLC, which had been formed by Brothers to hold them.

Once these noncash assets were held by LLC, Corp’s only assets were $26.3 million of cash, and its estimated tax payments.

At Buyer’s direction, Corp deposited this cash with Bank (which had funded many of Buyer’s other acquisitions). Buyer borrowed funds from Bank, from which it paid to Brothers the purchase price for their remaining Corp stock. This loan was then repaid using the cash in Corp’s account at Bank.

Post-closing Activities
When Corp filed its corporate income tax return for FY, Corp claimed a bad debt deduction of almost $40 million to offset its taxable income from the litigation award on the Appeal. The loss deduction claimed by Corp was based upon Treasury bills that had purportedly been contributed to Corp by one of Buyer’s shareholders, who claimed that it had a very large tax basis in the Treasury bills.

Corp’s return reflected a refund due of $3.8 million.

Eventually, Corp was administratively dissolved pursuant to State law.

Brothers filed their respective tax returns. They reported the redemption and sale of their Corp stock and, on Big-4’s advice that the Transaction was similar to a listed transaction, Brothers included protective disclosures of the Transaction.

Notice of Deficiency to Corp
The IRS disallowed Corp’s claimed bad debt deduction because Corp could not support or substantiate its basis in the purported bad debt. The IRS issued a notice of deficiency to Corp and also determined a gross valuation misstatement penalty and, alternatively, a substantial understatement penalty.

When Corp did not petition the Tax Court (“TC”), the IRS assessed income tax of $15.5 million, accuracy-related penalties of $6.2 million, and interest of $9.6 million against Corp.

Collection of Corp’s liability was assigned to a field revenue officer, who conducted database searches for Corp’s assets, filed notices of Federal tax liens on Corp’s assets, and issued levies to banks where Corp maintained accounts.

Notices of Transferee Liability to Petitioners
After determining that Corp had no assets from which it could collect, the IRS sent a notice of liability to Brothers in which it was determined that they were liable as transferees for $14 million of Corp’s tax liability, plus interest.

The IRS also sent a notice of liability to LLC, in which it determined that LLC was liable as a transferee, and as a transferee of a transferee, for $6.8 million of the tax liability of Corp, plus interest.

Brothers and LLC petitioned the TC in response to the notices.

Transferee Liability Under the Code
The Code authorizes the assessment of transferee liability in the same manner and subject to the same provisions and limitations as in the case of the tax with respect to which the transferee liability was incurred.

It does not create or define a substantive liability but merely provides the IRS a remedy for enforcing and collecting from the transferee of property the transferor’s existing liability. Once the transferor’s own tax liability is established, the IRS may assess that liability against a transferee only if two requirements are met.

First, the transferee must be subject to liability under applicable State law. Second, under principles of federal tax law, that person must be a “transferee” within the meaning of the Code.

The IRS had the burden of proving that Brothers were liable as transferees. Brothers had the burden of proving that Corp was not liable for the tax and penalty.

Transferee Status/Liability Under State Law
Because the Transaction took place in State, the TC applied State law to determine whether Brothers and LLC were liable as transferees for the unpaid tax of Corp.

The IRS’s arguments were predicated on the assumption that the series of transfers among Corp and Buyer should be collapsed and treated as if Corp had sold its assets and then made liquidating distributions to Brothers. If the transfers were collapsed, then Corp would have transferred substantially all of its assets to Brothers and received less than reasonably equivalent value.

The TC reviewed the requirements for establishing transferee liability under State law. State law established that a transfer is fraudulent with respect to a creditor where: (1) the creditor’s claim arose before the transfer; (2) the transferor did not receive “a reasonably equivalent value in exchange for the transfer”; and (3) the transferor was insolvent at the time of the transfer or became insolvent as a result of the transfer.

“Long story short,” as they say, the TC found that Brothers and LLC were liable as transferees under State law. Corp received the litigation award that generated the federal tax liability prior to the transfer of Corp’s assets to Brothers. Before the Transaction closed, Brothers were warned of the risks of transferee liability and that the stock sale was similar to a listed transaction and was advised not to engage in the stock sale. They knew that the litigation award would be considered income to Corp and be subject to corporate income tax. This knowledge motivated them to enter into a transaction to mitigate this tax liability. Brothers received approximately $9 million in consideration in excess of the value of their Corp stock. Thus, Corp did not receive reasonably equivalent value in exchange for the proceeds from the sale of its assets.

Federal Transferee Liability
Under the Code, the term “transferee” includes a distributee, and shareholder of a dissolved corporation. Having found Brothers liable under State law, TC then determined that they were liable under Federal law.

The Transaction had no economic effects other than the creation of a loss for Corp. Brothers recognized the income tax liability from the litigation awards and entered into a series of transfers solely to evade their tax liability. For this reason and the reasons discussed above, the TC disregarded the form of the Transaction and found that Brothers and LLC were transferees within the meaning of the Code.

As the Transaction was collapsed and treated as a de facto liquidation to Brothers, the TC concluded that Corp was liable for the unpaid tax for its FY.

Accordingly, TC concluded that (1) Brothers and LLC were liable under State law for the full amount of Corp’s tax deficiency and penalty and (2) the IRS could collect this liability from them as “transferees” under the Code.

“I Told You So”
No client wants to hear that, especially after they’ve been hit with a large tax bill. (Gloat in private if you must.) At that point, the tax adviser is charged with damage control, though it may be too late for that, as in the case above.

How, then, does an adviser protect a client from itself? Ideally, the adviser will be consulted before the client begins discussions with the buyer or other interested party. (Too often, this is not the case.) Once a proposal is in play, a thorough analysis, including the presentation of calculations, risks, and alternatives, coupled with a frank discussion, are imperative. In the face of a recalcitrant client, the adviser may have to inform the client that it is withdrawing entirely from the deal, as Big-4 did above, though even that measure failed to convince the client of the very serious risks being assumed.

You can lead a horse to water, but you can’t shoot it.

Appraisal
Is it an art or a science? Is it equal parts of art and science? Is one part weighted more than the other? Do the answers to these questions depend upon the purpose for which the appraisal is being sought? Do they depend upon who is asking the question?

Yes, no, maybe, sometimes.

Not very helpful, right? Yet, the results of an appraisal can have far-reaching economic consequences, especially where the object being valued is a decedent’s interest in a closely held business. For example, the appraisal can affect the taxable income from the operation of the business, or the gain realized on a subsequent sale of the business.

The valuation method and the factors considered can vary greatly depending upon, among other things, the nature of the business interest (a partnership interest or shares of stock in a corporation), the tax status of the business (C or S corporation, partnership or disregarded entity), the nature of the business (service- or capital-intensive), the nature of its assets (depreciable or amortizable), the identity of the other owners (family or unrelated persons), the life-stage of the business (in growth mode, or looking for a liquidity event).

It is often said that “where you stand depends upon where you sit.” This truth is often encountered upon the demise of an owner of a close business, as was reflected in a recent Tax Court (“TC”) decision. [Est. of Giustina v. Commr., T.C. Memo 2016-114]

The Partnership
Decedent owned a 41% limited-partner (“LP”) interest in Partnership, which owned timberland, and earned profits from growing trees, cutting them down, and selling the logs.

The Decedent’s estate and the IRS agreed that if Partnership sold off its timberlands, it would have received almost $143 million. If one included the value of its non-timberland assets, Partnership would have received over $150 million on a sale of its assets.

Through corporate structures, Partnership had two general partners (“GPs”): LG and JG. It had eight LPs, including Decedent.

The LPs were members of the same family (or trusts for the benefit of members of the family). The partnership agreement provided that an LP interest could be transferred only to another LP (or to a trust for the benefit of an LP), unless the transfer was approved by the GPs. A dissolution provision in the partnership agreement provided that if two-thirds of the LPs agreed (as measured by percentage interest), then Partnership would be dissolved, its assets sold, and the proceeds distributed to the partners.

The Decedent’s estate and the IRS disagreed over the value of the Decedent’s 41% LP interest. In particular, they assigned different weights to the probability that Partnership would sell its business or continue its operation.

Tax Court: Round One
The IRS’s expert gave greater weight to the sale value of Partnership’s assets than did the estate’s expert, and arrived at a fair market value (“FMV”) of $33.5 MM for the 41% LP interest. The TC declined to adopt the findings of either expert.

The TC took the view that the partnership asset values were relevant to the value of the 41% LP interest only to the extent of the probability that Partnership would sell its assets. The TC determined that there was only a 25% chance that Partnership would sell its assets after Decedent’s LP interest was transferred to a hypothetical third party. It reasoned that there was a 25% chance that the hypothetical buyer of the 41% LP interest could convince two-thirds of the partners to either: (1) vote to dissolve Partnership, resulting in the sale of Partnership’s assets and distribution of the proceeds to the partners, or (2) replace the two GPs (who had the authority to sell the assets and make distributions) to achieve the same result. The TC, therefore, gave a 25% weight to the value of the partnership assets rather than the greater weight used by the IRS’s expert.

The TC took the view that the cash-flows were relevant to the value of the 41% LP interest only to the extent of the probability that Partnership would continue its operations. It determined there was a 75% chance that Partnership would continue its operations.

In order to incorporate the cash-flows from continued operations into its valuation, the TC had to determine the present value of the cash-flows. It did this by adjusting the present value calculations of the estate’s expert. It also made certain assumptions about the annual increase in cash-flows and the rate for discounting the cash-flows to present value. This rate was the sum of: a risk-free rate of return equal to the rate of return on Treasury bonds, a risk premium for timber industry companies, a risk premium for small companies, and a risk premium for the unique risk of Partnership.

The TC accepted all of these components of the estate expert’s discount rate with the exception of the risk premium for the “unique risk” of Partnership’s timber business (as opposed to so-called “market risk”), which the TC reduced by 50%.

The TC explained that risk is not preferred by investors – they require a premium to bear it. However, some of the risk associated with an asset can be eliminated, the TC noted, through diversification if the owner of the asset also owns other assets, if the risks of the other assets are not associated with the asset in question, and if the other assets are great enough in value.

In evaluating a potential buyer’s ability to diversify the risks associated with Partnership, the TC assumed that the buyer could be an entity owned by multiple owners who could have diversified the unique risk associated with the 41% LP interest because the entity’s owners could hold other assets outside the entity.

Alternatively, the entity could diversify the risks of holding the 41% LP interest by holding other substantial assets that were unaffected by the Partnership-specific risk.

On the basis of its assumption that an entity with multiple owners could be the hypothetical buyer of the 41% limited-partner interest, the TC believed that a hypothetical buyer would not require a premium for all the Partnership-specific risk associated with owning the LP interest.

The TC concluded that the FMV of the 41% LP interest was $27.5 MM.

Court of Appeals
The estate appealed the TC’s decision, and the Ninth Circuit (the “Circuit”) held that the TC had erred by finding that there was a 25% chance that Partnership would sell its business and dissolve.

The Circuit held that a buyer who intended to dissolve Partnership would not be allowed to become an LP by the GPs, who favored the continued operation of Partnership. The Circuit also found it implausible that the buyer would seek the removal of the GPs who had just granted the buyer admission to Partnership.

Finally, the Circuit found it implausible that enough of the other partners would go along with a plan to dissolve Partnership.

Consequently, the Circuit directed the TC, on remand, to “recalculate the value of the Estate based on the partnership’s value as a going concern.”

The Circuit also held that the TC erred “by failing to adequately explain its basis for cutting in half the Estate’s expert’s proffered company-specific risk premium.”

The Standard
The FMV of an item of property includible in a decedent’s gross estate is its FMV at the time of the decedent’s death. The FMV is 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 to sell, and both having reasonable knowledge of relevant facts.

In the case of shares of stock of a closely held corporation, the FMV is determined by taking into consideration the company’s net worth, prospective earning power and dividend-paying capacity. Other relevant factors to be considered include the good will of the business; the economic outlook in the particular industry; the company’s position in the industry and its management; the degree of control of the business represented by the block of stock to be valued; and the values of securities of corporations engaged in the same or similar lines of business which are listed on a stock exchange.

The weight to be accorded such comparisons, or any other evidentiary factors considered in the determination of a value, depends upon the facts of each case. In addition to the relevant factors described above, consideration must also be given to non-operating assets, to the extent such non-operating assets have not been taken into account in the determination of net worth, prospective earning power and dividend-earning capacity.

Tax Court: Round Two
In response to the Circuit’s direction , the TC based its adjusted valuation of the 41% LP interest entirely on Partnership’s value as a “going concern.” In the TC’s view, the going-concern value was the present value of the cash-flows Partnership would receive if it were to continue its operations.

However, the Circuit opinion, in discussing the possibility that a hypothetical buyer could force the sale of Partnership’s assets, held that the hypothetical buyer must be a buyer to whom a transfer of an LP interest was permitted under the partnership agreement. By the same token, in evaluating the hypothetical buyer’s ability to diversify risk, the TC considered only a buyer whose ownership of an LP interest was permitted by the partnership agreement.

Under the partnership agreement, an LP interest could be transferred only to another LP (or a trust for the benefit of another LP) or a person receiving the approval of the two GPs. Other than Decedent, there were seven LPs. All seven were individuals and trusts. The record did not support the notion that any of the LPs had enough assets to diversify the risks of owning an additional 41% LP interest. The LPs appeared to be family members (or trusts for the benefit of family members) who probably had most of their wealth tied up in the family business in the form of their partner interests in Partnership.

Under the partnership agreement, an LP interest could be transferred to a person other than an LP (or a trust for the benefit of an LP) only if that person was approved by the two GPs. The two GPs were LG and JG (through corporate structures). For 25 years, they had run Partnership as an operating business. The record suggested that these two partners would refuse to permit someone who was not interested in having Partnership continue its business to become an LP. Thus, the TC determined that they would not permit a multiple-owner investment entity to become an LP.

Such an entity would seek to increase the returns on its investments. If such an entity owned the 41% LP interest, it would attempt to have Partnership discontinue its operations and dissolve. More generally, the TC found that no buyer that LG and JG would permit to become an LP would be able to diversify the Partnership-specific risk.

As a result of these findings, the TC determined that a hypothetical buyer of the 41% LP interest would be unable to diversify the unique risks associated with Partnership. Without diversification, the buyer would demand the full risk premium assigned to the interest by the estate’s expert.

Thus, after eliminating any weight attributed to the value of Partnership’s assets, and applying the Partnership-specific risk premium, the TC valued the LP interest at $13.95 million.

Take-away
In applying the hypothetical willing buyer-willing seller standard, the courts have routinely stated that one must not speculate about who might buy a decedent’s stock, how a buyer might desire to work themselves into a major role in the company, what combinations they might form with the decedent’s family members, and whether the buyer would be able to buy more shares from members of the decedent’s family. According to the courts, speculation about what imaginary buyers might do should be ignored because, by engaging in such speculation, one departs from the willing buyer-willing seller test.

On the other hand, courts have recognized that it is appropriate, in applying the hypothetical willing buyer-willing seller test, to consider who owns the remaining shares in the company. In general, and without more (such as litigation among the members of the family), courts have concluded that it is unlikely that a member of the taxpayer’s family would join with an outsider to control the actions of the company, noting that family members have a distinct advantage in forming coalitions, especially where they have a history of dealing with one another.

As was demonstrated by the decision discussed above, the recognition of a family connection among the surviving owners goes not only to the size of the discount that may be applied in valuing a decedent’s minority interest in a business entity, but also to the methodology that that must be applied in determining the value of the business as a whole.