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Tax Law for the Closely-Held Business

Real Estate Transfer Tax: Form, Substance, Or Confusion?

Posted in State Tax Issues

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.

Recapitalizing for Control & Tax-Free Spin-Offs

Posted in Federal Tax Issues

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.

Proposed Changes to Transaction-Related 409A Compliance

Posted in Federal Tax Issues

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.

Heads I Win, Tails You Lose?

Posted in Federal Tax Issues

“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.

Pigs Get Fat, Hogs Get Slaughtered

Posted in Federal Tax Issues

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.

What Is It Worth? It Depends

Posted in Federal Tax Issues

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.

Exclusion of COD Income for the Developer – or Not?

Posted in Federal Tax Issues

COD & QRPBI
The discharge of indebtedness generally gives rise to gross income to the debtor-taxpayer. The law, however, provides several exceptions to this general rule. Among these exceptions are rules providing that income from the discharge of indebtedness of the taxpayer is excluded from income if the discharge occurs in a Title 11 case, or if the discharge occurs when the taxpayer is insolvent. The amount excluded from income is applied to reduce various tax attributes of the taxpayer (in other words, there is a price to pay for the benefit).

During the economic downturn of the early 1990s – ah, it seems like yesterday – the value of real property declined in some cases to such a degree that a property could no longer support the debt with which it was encumbered. Many believed that where an individual had discharge of indebtedness that resulted from a decline in value of the business real property securing that indebtedness, it was appropriate to provide for deferral, rather than current income inclusion, of the resulting income.

Congress responded by providing an election to taxpayers (other than C corporations) to exclude from gross income certain income from the discharge of qualified real property business indebtedness (“QRPBI”). The amount so excluded could not exceed the basis of certain depreciable property of the taxpayer and was treated as a reduction in the basis of that property. [See “Impact of the Revenue Reconciliation Act of 1993 on Real Estate,” Special Legislative Alert, by James H. Kenworthy and Louis Vlahos, Matthew Bender, 1994]

Recently, the IRS addressed the issue of whether real property that a taxpayer develops and holds primarily for sale to customers in the ordinary course of the taxpayer-developer’s business constitutes “real property used in a trade or business” for purposes of this exclusion rule. [Rev. Rul. 2016-15]

The Developer Stumbles
C is engaged in the business of developing and holding real property for sale. C obtains the $10 million loan from a bank to construct a residential community and subdivides the residential community into lots; it holds the lots primarily for sale. C secures the loan with the residential community real property.

Before the loan’s maturity date, C reduces the principal of the loan to $8 million. On the loan’s maturity date, C is unable to repay the full $8 million of principal that C owes to the bank because C has only $5.5 million in cash. The FMV of the property is $5 million and C’s adjusted basis for the property is $9.4 million.

After negotiations, the bank agrees to cancel the loan on the property in exchange for $5.25 million in cash. At the time of the loan cancellation, C is neither under the jurisdiction of a bankruptcy court nor insolvent.

For the taxable year in which the bank cancels the loan, C elects to exclude the $2.75 million ($8 million minus $5.25 million) of cancellation of debt (“COD”) income arising from the cancellation of the loan.

Cancellation of QRPBI
The Code provides that a taxpayer that is not a C corporation may exclude COD income from gross income if the cancelled debt is QRPBI.

QRPBI is defined as indebtedness which (A) is incurred or assumed by the taxpayer in connection with real property used in a trade or business, (B) is secured by such real property, (C) is qualified acquisition indebtedness, and (D) with respect to which the taxpayer makes an election to exclude from gross income.

“Qualified acquisition indebtedness” is defined as indebtedness incurred or assumed by the taxpayer to acquire, construct, reconstruct, or substantially improve the real property.

If a taxpayer excludes COD income under the exception for QRPBI, the taxpayer must reduce its basis in depreciable real property by the same amount. In some circumstances, a taxpayer may elect – as the developer tried in the ruling – to treat real property that is held by the taxpayer primarily for sale to customers in the ordinary course of its trade or business as depreciable property for purposes the basis reduction rule, even though such property is not usually treated as depreciable property.

In general, the amount of COD income that a taxpayer may exclude is limited to the excess of the outstanding principal amount of the QRPBI immediately before the cancellation over the FMV of the real property securing the debt. Further, the amount of COD income that a taxpayer may exclude may not exceed the aggregate adjusted bases of depreciable real property held by the taxpayer immediately before the cancellation.

Under a special ordering rule, a taxpayer must reduce the adjusted basis of the “qualifying real property” to the extent of the discharged QRPBI before reducing the adjusted bases of other depreciable real property. For this purpose, “qualifying real property” means the real property with respect to which the indebtedness is QRPBI.

IRS Clarifies the Rules
In effect, these rules allow a qualifying taxpayer to elect to defer the recognition of COD income resulting from the cancellation of QRPBI by excluding the COD income and making a corresponding basis reduction in the taxpayer’s property.

This is consistent with the Congressional intent to provide for deferral of the COD income that does not extend beyond the period that the taxpayer owns the property.

However, the Code provides that debt secured by property held by a taxpayer primarily for sale to customers in the ordinary course of its trade or business (“inventory real property”) is outside the scope of the QRPBI exclusion rules.

A taxpayer that excludes COD income under these rules must make an offsetting basis reduction in depreciable real property. Inventory real property is not depreciable property. The IRS explained that, although the COD exclusion rules generally permit a taxpayer to elect to treat inventory real property as depreciable property, they preclude a taxpayer from making this election in the case of QRPBI.

According to the IRS, the “COD income deferral period” generally should correspond to the period that the taxpayer holds the property securing the cancelled debt. A taxpayer must first reduce basis in the property securing the cancelled debt, and then in other depreciable real property.

If debt associated with inventory real property were treated as QRPBI, the IRS stated, then a taxpayer would be unable to reduce the basis of the property securing the debt, much less reduce the basis of that property prior to reducing the bases of other depreciable real property used in the taxpayer’s trade or business. This result would be inconsistent with the Congressional intent.

Moreover, the inability to reduce the basis of the inventory real property securing the debt would create deferrals of COD income that could extend well beyond the period the taxpayer holds the inventory real property because the taxpayer would need to reduce the basis of depreciable real property unrelated to the indebtedness and, typically, a taxpayer holds depreciable business property substantially longer than it holds inventory real property.

Accordingly, debt incurred in connection with, and secured by, inventory real property cannot be treated as QRPBI.

Time to Pay Up?
The IRS concluded that because C holds the residential community lots primarily for sale to customers in C’s business, C is not allowed to depreciate the lots. Accordingly, the debt C incurred to construct the residential community may not be treated as QRPBI, and C may not elect to exclude from its gross income the $2.75 million of COD income.

Does this necessarily mean that C will be taxed upon the COD income? Probably, unless C qualifies under one of the other exclusions. For example, if C is an individual (a sole proprietorship) or an S corporation, and is insolvent, it may be able exclude the COD income to the extent of such insolvency. If C is a partnership, its members may be able to exclude the COD income if they (as opposed to the partnership) are insolvent.

Alternatively, if C retains ownership of some of the residential community property, it may qualify, in part, for the QRPBI exclusion; for example, if it continues to own and operate any of the common areas of the development, such as a health club, restaurant, etc., or if it holds on to some of the residential units as rentals.

Of course, no one goes into a development project with the expectation that there will be a downturn in the market. That being said, it may be prudent to hedge one’s bets by structuring one’s investment in as tax-advantageous a way as possible, provided, as always, that it makes sense from a business perspective.

Like-Kind Exchanges, The “Productive Use in a Trade or Business” Requirement, and Related Party Transactions

Posted in Federal Tax Issues

Come Fly With Me
What is a like-kind exchange? Many would respond that it is a transaction by which a company exchanges one real property that it has used in its trade business for another property that will also be used by the company in its trade or business.

Generally speaking, this response would be correct. However, it would also be incorrect in limiting its description to real properties. In fact, many items of tangible personal property, including, for example, vehicles and equipment, may be “swapped” – for other vehicles or equipment, as the case may be – as part of a like-kind exchange, provided the requirements therefor, as set forth in the Code and regulations issued thereunder, are satisfied.

The IRS office of chief counsel recently issued an advisory that reviewed a like-kind exchange in which a company exchanged one aircraft for another. Specifically, the IRS considered whether the company held the relinquished aircraft and the replacement aircraft “for productive use in a trade or business” within the meaning of the like-kind exchange rules. The aircraft, which were leased by the company to a related entity that was partially owned by the same individuals who owned the company, were the company’s only operating assets and did not generate an economic profit for the company. [CCA 201601011]

1031 Basics
The gain realized from the conversion of property into cash, or from the exchange of property for other property differing materially in kind from the relinquished property, is treated as taxable gain because the exchanging taxpayer has changed the fundamental nature of the taxpayer’s property interest and of the taxpayer’s relationship to such property.

By contrast, the Code provides an exception from the general rule requiring the recognition of gain upon the exchange of property if property held for productive use in a trade or business is exchanged solely for property of a like-kind to be held for productive use in a trade or business.

Whether the property is held for productive use in a trade or business is a question of fact. The manner in which the relinquished property is held at the time of the exchange controls, not the manner in which it was held when acquired. Similarly, replacement property is held for productive use in a trade or business if it is so held at the time of its acquisition.

“Boss! The Plane!”
Partnership P (“P”) owned multiple aircraft which were leased to Partnership O (“O”). O was the primary business entity of the “O group” of entities, which included P and other entities. O’s business activities involved air travel, particularly by its executives. For both business and legal reasons, the aircraft were owned by P, an entity separate from the main business entity, O, and were leased to O. The aircraft were the only operating assets of P, but P also owned interests in other entities in the O group of entities.

The aircraft were principally used by two of O’s senior executives: A and B. A and B used the aircraft variously for business purposes and for personal purposes. Thus, the aircraft served a business purpose for O both in terms of business travel and as an employment perk for its senior executives. To the extent A and B used the plane for personal purposes, they included the required amount in gross income as compensation. A and B, who owned interests in O, also owned 50 percent each of P.

The Exchange
In Year 1, P exchanged the relinquished aircraft for replacement aircraft. Both the relinquished and replacement aircraft were leased to O. The lease payments for the relinquished aircraft approximated the fair market rental value of the aircraft, whereas the lease payments for the replacement aircraft were below market. Nevertheless, in both cases, the lease payments were designed to cover the aircraft’s carrying costs, and were not designed to generate meaningful economic profit.

The IRS initially asserted that P did not hold either the relinquished or replacement aircraft for productive use in a trade or business. In determining whether the planes were “held for productive use in a trade or business” (as required by the Code), the IRS contended that the two entities (P and O) should be examined solely on an entity by entity basis, not as a single business unit, and that the profit motive of one entity (O) should not be attributed to the other entity (P), even though the two entities were closely related.

The IRS concluded that P did not hold the aircraft for “productive use” in a trade or business, stating that P’s intercompany activity with O did not demonstrate a profit motive.

The IRS Reconsiders
The office of chief counsel acknowledged that the rent P charged O for the use of the relinquished property and the replacement property was insufficient for P to make an economic profit on the aircraft rental to O.

It also observed, however, that many businesses hold and use property in a way that, if the use of the property were viewed as a separate activity, does not and could not generate profit. Nevertheless, the property itself is held for productive use in that business.

The Business Structure
The IRS pointed out that businesses, for any number of good business reasons, choose to hold property (like aircraft) in a separate entity.

In the present case, O, which operated a legitimate business enterprise, required private aircraft to be available to its senior executives, both for business travel and as an employment perk. However, for business and legal reasons, the aircraft were owned not by O but by P, a related entity.

The chief counsel’s office noted that if O owned the aircraft, or was the sole owner of P, it is unlikely the IRS would have raised the issue of whether the aircraft were held for productive use in a trade or business.

It went on to state that if the IRS were to disallow like-kind exchange treatment based merely on the entity structure presented, many businesses would be forced to structure their transactions in inefficient and potentially risky ways, from a business perspective, to achieve such treatment.

Thus, the entity structure in the present case could not be used as grounds for determining that the aircraft failed to qualify as property held for productive use in a trade or business.

Chief counsel stated that O operated a legitimate business enterprise and required private aircraft to be available to its senior executives. For business and legal reasons, O structured its affairs so that the aircraft were owned through P, and leased to O for an amount not intended to generate a profit for P. On these facts, the IRS determined that the aircraft were held for productive use in a trade or business for purposes of the like-kind exchange rules.

Thus, P’s lack of intent to make an economic profit on the aircraft rental did not establish that the aircraft failed the “productive use in a trade or business” standard of the like-kind exchange rules.

The “Personal” Use
In addition, the chief counsel noted that A’s and B’s use of the property for personal purposes was not relevant in determining whether P held the aircraft for productive use in a trade or business.

More accurately, the opinion should have stated that because such “personal use” was treated as compensation paid by the business to A and B, it constituted a business use from P’s and O’s perspectives.

Observations
We often tell clients that the “tax tail should not wag the business dog” (or something like that – those of you who know me well also know that no idiom, or variation thereon, is safe from being mangled in my hands).

The advisory opinion described herein recognized that there are circumstances in which it may be prudent for a single business to structure its holdings or operations in a certain way for bona fide business, non-tax-motivated reasons. Provided the requirements for like-kind exchange treatment are otherwise satisfied, the taxpayer-business should not be punished for having structured its operations, property holdings, and intercompany transactions in a way that is advantageous from a business or legal perspective, notwithstanding the fact that such transactions, when viewed in isolation, may not generate a profit.

That being said, it is worth observing that certain facts raised by the IRS in the advisory do present legitimate tax concerns: P charged O below-market rent for the replacement aircraft; A and B, rather than O (or all of O’s partners), owned P.

Query, should the IRS be able to apportion or allocate the income and deductions between O and P in a way that “clearly reflects” arm’s-length dealing?

If the facts were developed further, would we find that the O group family of entities and their owners frequently failed to act at arm’s-length with respect to one another? In that case, might this result in a tax treatment different from the treatment claimed by P and O, or A and B?

Would the facts support a finding that P was not a valid partnership, but a sham entity? If P were a sham entity, then A and B, and not P, would be the owners of the aircraft. In that case, the IRS’s analysis and conclusion may have been different. Indeed, the advisory’s acknowledgement that the structure chosen by the taxpayers was based on bona fide business grounds may not have been forthcoming. After all, if the principals ignored the separateness of their own business entities, then so might a potential creditor or claimant.

As always, the best way for related parties to avoid surprises that may arise from their business dealings with one another, is to treat with one another on as close to an arm’s-length basis as possible. But, as Zorba the Greek said, “On a dead man’s door, you can knock forever.”

Owning Real Property: TIC or Partnership – Why Care?

Posted in Federal Tax Issues

What is It?
It is a frequently recurring issue for those who advise the owners of rental real property, but one that is rarely raised by the owners themselves: does the ownership arrangement constitute a partnership for income tax purposes?

The question appears to be fairly straightforward – just ask any client. “We haven’t executed a partnership agreement, “ they may say, or “we haven’t filed a certificate of limited partnership, or articles of organization.” Therefore, there is no partnership.

Alternatively, they may respond that they have been filing partnership tax returns for years, on which they have been reporting the rental income and associated expenses of the “partnership.” Thus, there is a partnership.

Too often, the taxpayer-owners discover the likely consequences of their actions late in the game, when it may be difficult to redress any problems.

Why Does It Matter?
Taxpayers may be bound by the form of their agreed-upon ownership arrangement, if such form benefits the IRS.

On the other hand, the IRS is free to consider the facts and circumstances surrounding the ownership and operation of the real property for purposes of determining whether the ownership arrangement should be re-characterized as a partnership for tax purposes.

The availability of such facts and circumstances necessarily implies a history of dealings among the owners with respect to the property, on the basis of which the existence of a partnership may be determined. When this happens, it will usually be the case that the owners did not “intend” to form a tax partnership, and failed to consult with a tax adviser before engaging in such dealings.

As a result, taxpayers who believed they owned a TIC interest, the proceeds from the sale of which could be used to acquire replacement property as part of a like-kind exchange, instead find that what they owned was a partnership interest the sale of which does not qualify for like kind exchange treatment.

Fortunately, for the well-advised client, his or her adviser will be familiar with the factors on which the IRS has historically relied in establishing the existence of a partnership. Of course, this knowledge will only benefit the client if he or she consults the adviser before getting into trouble.

A recent IRS ruling describes a complex business arrangement that must have concerned the taxpayer and its advisers enough to lead them to seek the “opinion” of the IRS. [PLR 201622008]

Specifically, the taxpayer requested a ruling that undivided fractional interests in a property were not interests in a partnership for purposes of qualifying the undivided fractional interests as eligible relinquished property under the like kind exchange rules.

The Facts
Taxpayer was a business entity that owned 100% of the fee title to Property. Taxpayer operated Property as a commercial rental property.

Taxpayer triple net leased Property to an unrelated third party (“Co-Owner”). Taxpayer represented that the lease for the Property was a bona fide lease for tax purposes and that the rent due under the lease reflected the fair market value (“FMV”) for the use of Property. Further, Taxpayer represented that the rent under the lease was not determined, in whole or in part, based on the income or profits derived by any person from Property.

Contemporaneously with the triple net lease, Taxpayer and Co-Owner entered into an Option Agreement under which Taxpayer had an option to sell any or all of its interest in Property to Co-Owner at any time before the fifth anniversary of the effective date of the Option Agreement (the “Put”). If Taxpayer exercised the Put with respect to a part of its interest in Property, it could exercise the Put again with respect to another part of its interest in Property and continue to do so until all interests in Property were transferred or the Put expired.

Under the Option Agreement, Co-Owner had an option to acquire the entire remaining interest then held by Taxpayer beginning on the seventh anniversary of the effective date of the Option Agreement, and ending X days later (the “Call”).

The purchase price for the exercise of the Put or the Call would be based on the FMV of Property at the time of the execution of the Option Agreement, increased at each anniversary date of such execution by Y% of the then-current exercise price, as increased by any prior Y% increases. Taxpayer represented that Y% was a reasonable appreciation factor for Property.

Within six months of executing the triple net lease and the Option Agreement, Taxpayer could exercise its right under the Put to sell a Z% tenancy-in-common (“TIC”) interest in the Property to Co-Owner. Taxpayer represented that neither co-owner would provide financing to the other to acquire a TIC interest in the Property.

When Taxpayer sold the Z% TIC interest to Co-Owner, Taxpayer and Co-Owner would either (i) refinance the existing indebtedness encumbering the Property by borrowing from an unrelated lender and creating a blanket lien on the Property, or (ii) cause the debt agreement to be amended to provide that the lien was a blanket lien and that the cost would be shared proportionately. Each co-owner would share the indebtedness on Property in proportion to that co-owner’s interest in Property.

Property would be owned by the Taxpayer and Co-Owner pursuant to a TIC agreement (the “Co-Ownership Agreement”) that would run with the land. Taxpayer represented that Taxpayer and Co-Owner would not file a partnership or corporate tax return, conduct business under a common name, execute an agreement identifying the co-owners as members of a business entity, or otherwise hold themselves out as members of a business entity. The Co-Ownership Agreement would be consistent with these representations.

Under the Co-Ownership Agreement: any sale or lease of all or a portion of Property, any negotiation or renegotiation of indebtedness secured by a blanket lien, and the hiring of a manager, required the unanimous approval of the co-owners; all actions not otherwise required to be taken by unanimous consent would require the vote of co-owners holding more than 50 percent of the undivided interests in Property; there would be no buy-sell agreement; there would be no waiver of partition rights among co-owners unless required by the lender; a co-owner would be free to partition its interest in Property unless prohibited by the lender; a co-owner would be able to create a lien upon its own interest without the agreement or approval of any person, subject to the terms of the Co-Ownership Agreement, provided it did not create a lien on any other co-owner’s interest; in the event Property was sold or refinanced, each co-owner would receive its percentage interest in the net proceeds from the sale or refinancing of Property; upon the sale of Property, the co-owners would have to satisfy any blanket lien encumbering Property in proportion to their respective interests in Property; the Taxpayer and the Co-Owner would share in all revenues generated by Property and have an obligation to pay all costs associated with Property in proportion to their respective interests in Property; if either co-owner advanced funds necessary to pay expenses associated with Property, the other co-owner would have to repay such advance within 30 days of the date the expense, obligation, or liability was paid; to secure such an advance repayment obligation, each co-owner would grant each other co-owner a lien against such granting co-owner’s interest in Property and the rents and income therefrom and the leases thereof.

Taxpayer represented that the co-owners could, but were not required to, enter into a management agreement with Manager. The Co-Ownership Agreement would provide that the term of any management agreement entered into by the co-owners would be for one year, and would be automatically renewed for one-year periods unless either the Manager or any co-owner otherwise gave timely written notice to the other parties prior to the then-current expiration date.

Any such management agreement would: authorize the Manager to maintain a common bank account for the collection and deposit of rents and to offset expenses associated with Property against any revenues before disbursing each co-owner’s share of net revenues; provide that the Manager disburse the co-owner’s share of net revenues from Property within three months from the date of receipt of those revenues (subject to holding back reserves for anticipated expenses of Property, with each co-owner’s share of such reserves being proportionate to that co-owner’s interest in Property); authorize the Manager to prepare statements for the co-owners showing their shares of revenue and costs from Property; authorize the Manager to obtain or modify insurance on Property, and to negotiate modifications of the terms of any lease or any indebtedness encumbering Property, subject to the approval of the co-owners; provide that the fees paid by the co-ownership to the Manager would not depend in whole or in part on the income or profits derived from Property, and would not exceed the FMV of the Manager’s services.

Taxpayer represented that the activities of the Manager in managing Property would not result in non-customary services with respect to Property, taking into account the activities of the co-owners’ agents and any person related to the co-owners with respect to Property.

Taxpayer represented that the Co-Owner would acquire its interest in Property through the use of its own capital or through funds from an unrelated lender. Taxpayer also represented that, when the Put or Call was exercised, the Co-Owner would be required to pay the full purchase price of the interest in cash.

A Separate Entity?
Whether an organization is an entity separate from its owners for federal tax purposes is a matter of federal tax law and does not depend on whether the organization is recognized as an entity under local law.

A joint venture or other contractual arrangement may create a separate entity for federal tax purposes if the participants carry on a trade, business, financial operation, or venture, and divide the profits therefrom, but the mere co-ownership of property that is maintained, kept in repair, and rented or leased does not constitute a separate entity for federal tax purposes.

The term “partnership” includes any joint venture or other unincorporated organization through or by means of which any business, financial operation, or venture is carried on, and which is not, within the meaning of the Code, a corporation, trust or estate.

The IRS has enumerated certain conditions under which it would consider ruling that an undivided fractional interest in rental real property is not an interest in a business entity for federal tax purposes. The conditions relate to, among other things, TIC ownership of the property, number of co-owners, no treatment of the co-ownership as an entity, co-ownership agreements, voting by co-owners, restrictions on alienation, sharing of proceeds and liabilities upon sale of the property, proportionate sharing of profits and losses, proportionate sharing of debt, options, no business activities by the co-owners, management agreements, leasing agreements, and loan agreements.

TIC or Partnership?
The IRS determined that the Co-Ownership Agreement and Management Agreement would satisfy all of the conditions set forth above.

Regarding the condition that a co-owner may not acquire a put option to sell the co-owner’s undivided interest to another co-owner, the IRS distinguished the facts in the ruling, stating that the Put would not cause the fractional interests in Property to constitute interests in a business entity. The Taxpayer’s Put was not an option to sell an existing undivided interest that was previously acquired by the Taxpayer. Rather, the put option was an option to sell property held by the Taxpayer prior to entering into the proposed transaction.

Regarding the exercise price, and the requirement that the exercise price be the FMV at the time of exercise, the IRS found that the Y% appreciation factor adequately approximated the FMV of Property.

Regarding business activities, the IRS stated that the co-owners’ activities must be limited to those customarily performed in connection with the maintenance and repair of rental real property. Activities will be treated as “customary activities” for this purpose if the activities would not prevent the amount received from qualifying only as rent, as opposed to compensation (in part) for services. In determining the co-owners’ activities, all activities of the co-owners, their agents, and any persons related to the co-owners with respect to the property are taken into account, whether or not those activities are performed by the co-owners in their capacities as co-owners.

The Taxpayer represented that the co-owners’ activities with respect to Property, conducted directly or through the Manager, would be limited to customary activities.

Based on the foregoing, the IRS concluded that, if Taxpayer sold a TIC interest in Property to Co-Owner, an undivided fractional interest in Property would not constitute an interest in a business entity for purposes of qualifying the undivided fractional interests as eligible relinquished property under the like-kind exchange rules.

Before You Act
Of course, there may be good business reasons for using an LLC; for example, a lender may require the use of a single business entity to hold the real property, or the business relationship among the owners may be such that the terms of a mere TIC agreement will not suffice.

However, it bears repeating: the mere co-ownership of real property that is maintained, kept in repair, and rented does not constitute a partnership for tax purposes. Too often, such an arrangement is formed as an LLC and is thereby treated as a partnership for tax purposes, subject to the rules and limitations applicable to such business entities.

Under certain conditions, however, an unincorporated organization may be excluded from the application of all or a part of the partnership rules. Such an organization must be availed of for investment purposes only and not for the active conduct of a business. The members of such organization must be able to compute their income without the necessity of computing partnership taxable income.

Where the participants in the joint purchase, retention, sale, or exchange of investment property: own the property as co-owners; reserve the right separately to take or dispose of their shares of any property acquired or retained; and do not actively conduct business or irrevocably authorize some person acting in a representative capacity to purchase, sell, or exchange such investment property, then such group may elect to be excluded from the application of the partnership tax rules.

Any such unincorporated organization that wishes to be excluded from these rules must elect not later than the time prescribed (including extensions thereof) for filing the partnership return for the first taxable year for which exclusion from the partnership rules is desired.

A Taxpayer to New York: “Just when I thought I was out… [You Try to] pull me back in”

Posted in State Tax Issues

One Day . . .
It is the dream of so many New York business owners: build a successful business, get your kids involved in the business, transition the operation, management and – eventually – the ownership of the business to the kids, move to Florida (or another warm, tax-friendly venue), successfully fend off New York’s inevitable challenge to your claimed change of domicile, stay involved in the business, pay no New York income tax on any income derived from the business, and pass away – yes, that is a morbid thing to say, but “death and taxes” – happy in the knowledge that your estate will not be subject to New York’s estate tax. Not much to ask for, right?

Earlier posts have described the factors that New York considers in determining an individual’s domicile or residence. See, e.g., “New York Business, the Federal Tax Return, and New York Domicile.”

Escape from NY . . .
The resolution of a taxpayer’s resident status vis-à-vis New York is of paramount importance to the taxpayer.

A New York State resident taxpayer is responsible for reporting and paying New York State personal income tax on income from all sources regardless of where the income is generated, or the nature of the income.

A nonresident taxpayer, however, is given the opportunity to allocate income, reporting to New York State only that income actually generated in New York. In addition, the nonresident need only report to New York income from intangibles which are attributable to a business, trade or profession carried on in the State.

Thus, significant benefits may be derived from filing as a nonresident.

. . . Not Entirely
Because a taxpayer’s New York source income will remain subject to New York’s tax jurisdiction even where the taxpayer has successfully established his or her status as a non-resident, it behooves the taxpayer to become familiar with New York’s sourcing rules. A nonresident taxpayer’s New York income will include the taxpayer’s income from:
• real or tangible personal property located in New York State, (including certain gains from the sale or exchange of an interest in an entity that owns real property in New York;
• services performed in New York;
• a business, trade, profession, or occupation carried on in New York;
• his or her distributive share of New York partnership income or gain;
• his or her share of New York estate or trust income or gain;
• any income he or she received related to a business, trade, profession, or occupation previously carried on in New York State, including but not limited to covenants not to compete and termination agreements; and
• a New York S corporation in which he or she is a shareholder.
Some of these source rules are more easily applied than others. In those cases where the facts are disputed, the taxpayer can count on New York to assert the requisite nexus.

In a recent decision, an Administrative Law Judge (“ALJ”) rejected New York’s somewhat creative attempt to tax a Florida resident’s consulting fees. [Carmelo and Marianna Giuffre, DTA NO. 826168)

Unfortunately, the ruling is light on facts and, so, leaves several questions unanswered.

Father Knows Best?
The Taxpayer resided and was domiciled in Florida during the year at issue. He was employed by Consulting LLC (Consulting). Consulting was a Florida limited liability company with its principal place of business located in Florida. Taxpayer was its sole member.

Prior to his employment by Consulting, Taxpayer was the president Family Corp., located in New York City. Family Corp. was a family-owned company that operated Business in New York and New Jersey. During the year at issue, Taxpayer’s sons and nephew owned and operated Business.

Consulting provided “management consulting” services for Business. Taxpayer rendered these services as an employee of Consulting, from its offices in Florida.

By agreement between Consulting and Family Corp., Consulting agreed to perform consulting work for Family Corp. The agreement explicitly provided that the consulting services “shall be provided via telephone or electronically” and that it is not anticipated that the consulting services would require any Consulting employee to travel to New York City or any of Business’s other locations.

Under the agreement, Consulting acted in an advisory role, and neither it nor Taxpayer was involved in the day-to-day management or decision-making process of Family Corp. The consulting services were performed, and the business of Consulting was conducted, from its Florida office. Taxpayer was paid an annual salary for his services by Consulting.

Taxpayer visited New York during the year at issue. The primary purpose of his visits were personal in nature. He visited family members who resided in the New York metropolitan area. Although he also visited the Business locations owned by Family Corp., these visits also were personal in nature. Taxpayer did not maintain a desk or office in any of the locations. He was not involved in any daily operations of Business during the year at issue.

New York’s Unsuccessful Play
New York asserted that Taxpayer had New York source income for the year at issue, based upon an allocation formula that used the number of Business locations in New York, divided by the total number of Business locations, to arrive at an allocation of 10/17, or approximately 59%. The State then multiplied that percentage by the amount of Taxpayer’s salary from Consulting for that year to arrive at a net allocation of almost $800,000 as New York income.

The only issue before the ALJ was whether Taxpayer had income that was derived from, or connected to, New York sources; in other words, whether Taxpayer had rendered consulting services in New York during the year at issue. According to the ALJ, he did not.

The ALJ explained that New York imposes personal income tax on the income of nonresident individuals to the extent that their income is derived from or connected to New York sources (Tax Law Sec. 601[e][1] http://codes.findlaw.com/ny/tax-law/tax-sect-601.html ). A nonresident individual’s New York source income includes the net amount of items of income, gain, loss and deduction entering into the individual’s federal adjusted gross income derived from or connected with New York sources, including income attributable to a business, trade, profession or occupation carried on in New York (Tax Law Sec. 631[a][1]; [b][1][B]).

The ALJ also observed that, under New York’s tax regulations, a business, trade, profession or occupation is carried on in New York by a nonresident when:
“such nonresident occupies, has, maintains or operates desk space, an office, a shop, a store, a warehouse, a factory, an agency or other place where such nonresident’s affairs are systematically and regularly carried on, notwithstanding the occasional consummation of isolated transactions without New York. (This definition is not exclusive.) Business is carried on within New York if activities within New York in connection with the business are conducted in New York with a fair measure of permanency and continuity” (20 NYCRR 132.4[a][2]).

The ALJ found that Taxpayer was employed by Consulting, the offices of which were located in Florida. There was no evidence that Taxpayer or Consulting maintained any office or place of business within New York.

In fact, as noted above, the consulting agreement specifically stated that the services provided by Taxpayer would be rendered via telephone or electronically. The agreement did not mention any work space located in New York nor did it contemplate Taxpayer providing any services within New York.

The State relied on case law that involved nonresident individuals who were employed by a New York employer, yet for convenience worked both within and without the State. According to this precedent, a nonresident who performs services in New York, or has an office in New York, is allowed to avoid New York tax liability for services performed outside the State only if they are performed of necessity in the service of the employer. Where the out-of-State services are performed for the employee’s convenience, they generate New York tax liability.

The ALJ rejected the State’s reasoning, finding this case law distinguishable from the Taxpayer’s situation. Taxpayer was a nonresident who worked for a Florida company, not a New York employer. Moreover, Taxpayer did not render services in New York and he did not have an office in New York. As such, the “convenience of the employer” analogy was inapplicable to the Taxpayer.

Any Takeaways?
Although the ALJ’s opinion does not state that Taxpayer was previously a New York resident, it is safe to assume that he was domiciled in New York before moving to Florida.

However, query over what period of time, and how (gifts, sales, GRATs, etc.), Taxpayer transitioned the management of Business, and transferred the ownership of Family Corp., to his sons? This would have been an important consideration in establishing that Taxpayer was no longer domiciled in New York.

According to the opinion, Taxpayer was not involved in the day-to-day management or decision-making process of Family Corp., and his “management consulting” services were to be rendered “via telephone or electronically.” The ALJ based its opinion on these “facts.”

That being said, Family Corp. nevertheless must have determined that Taxpayer’s ongoing services were important to its continued well-being. After all, New York sought to tax $800,000 (or 59%) of Taxpayer’s salary from Consulting for just one tax year. What, then, was the nature of the advice given? (I should tell you, Business operated car dealerships.)

Query also why the ALJ does not seem to have asked whether the fee payable to Consulting (and thereby to Taxpayer) represented reasonable compensation for the services rendered? What if the fee was excessive? To what would the excess amount be attributed? A form of continuing equity participation in Business? Additional, deferred, purchase price for Taxpayer’s equity in Family Corp.? Payment for Taxpayer’s promise not to compete against Family Corp.? Deferred compensation for services rendered by Taxpayer to Family Corp. when he was still a New York resident?

I don’t believe that I would be going out on a limb to suggest that at least one of these elements was at play. In any case, each of these re-characterizations would have generated New York income.

Or was the Family Corp.’s payment made simply to accede to Taxpayer’s demand for some cash flow from “his” business (not an uncommon occurrence) and to thereby remain in Taxpayer’s good graces? After all, a “last” will and testament (or revocable trust) may be changed at any time before the testator’s (or grantor’s) death. (Back to death again.)

As always, it is best for related parties to treat with one another on an arm’s-length basis. Taxpayer undoubtedly gave up ownership and control of Family Corp. and Business in order to support his claim that he had abandoned his New York domicile, and to achieve certain income and estate tax savings.

Yet Taxpayer appears to have required significant cash flow from Business – he could not afford to part with all the economic benefits associated with Family Corp. Granted, that reality is difficult to reconcile with the ends desired (e.g., no New York tax), but “you can’t always get what you want,” but with a little planning, . . . (you know how it goes).