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Tax Law for the Closely-Held Business

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).

Compensation: Determining What is Reasonable – And Deductible

Posted in Federal Tax Issues

The clash between the form in which a corporate taxpayer casts a payment to a shareholder-employee, and the substance of such a payment, has been played out in the courts for as long as there has been a corporate income tax. The stakes involved can be significant. (See, e.g., A Story of Law Firm Compensation, Part II)

Dividend

To the extent the payment is properly treated as a dividend (assuming the corporation has sufficient earnings and profits), the corporation is not permitted to reduce its taxable income by the amount of the payment. Thus, the corporation pays a corporate-level tax on the amount distributed, up to a maximum federal rate of 35%. [IRC Sec. 11]

As for the recipient shareholder, he or she will report the dividend as investment income, taxable up to a maximum federal rate of 20%. [IRC Sec. 1(h)] The dividend may also be subject to the 3.8% federal surtax on net investment income. [IRC Sec. 1411]

Compensation

To the extent the payment is properly treated as compensation, and is reasonable in amount for the services rendered, the corporation will be allowed to deduct the payment in determining its own taxable income. [IRC Sec. 162] Thus, the corporation will “save” corporate income tax up to an amount equal to 35% of the payment.

However, the corporation will also be obligated to withhold employment taxes in respect of the compensation paid. Both the corporate employer’s share of such taxes, and the employee’s share thereof, are determined at the rate of 7.65% each; the corporation may deduct its share (the amount it pays from its own funds) in determining its taxable income.

The employee-shareholder will report the compensation received as ordinary income, taxable up to a maximum federal rate of 39.6%; greater than the corporate rate at which it would have been taxed if it had not been paid as compensation to the employee-shareholder.

It Was A Very Good Year (or Two)

With this background, let’s turn to a recent Tax Court decision that considered the tax treatment of substantial compensation payments made by a corporation to two of its shareholders. [Johnson v. Commr., T.C. Memo. 2016-95]

Corporation was created in 1974 by Dad and Mom. Shortly after, Sons A and B began working for Corporation. A and B gradually assumed increasing responsibilities and took over Corporation’s daily operations in 1993. Mom and Dad gifted shares of stock to A and B and, by 1996, when Dad retired from the business, A and B had each acquired 24.5% of the shares, with Mom retaining the remaining 51%. The brothers became officers and members of the board of directors, along with Mom.

Corporation’s revenues grew rapidly after A and B assumed control of operations, tripling within three years. The revenues climbed steadily every year thereafter, then increased dramatically during the years at issue (the “Years”).

Corporation was profitable and experienced significant revenue and asset growth during the Years, with gross profit margins before payment of officer bonuses of over 38%.

During the Years, A and B personally guaranteed loans whose proceeds Corporation used to purchase materials and supplies.

Sons A and B together managed all operational aspects of petitioner’s business. Operations were split into two geographical divisions, eastern and western, with each brother managing a division’s operations, including contract bidding and negotiation, project scheduling and management, equipment purchase and modification, personnel management, and customer relations. They each supervised over 100 employees in their respective divisions, and worked 10 to 12 hours a day, five to six days a week. They were at the jobsites daily. They were readily available if problems at a jobsite arose and were known in the local industry for their responsive and hands-on management style.

Corporation earned an excellent reputation with its business partners, and was known for its timely performance and quality product. As a result, Corporation was routinely awarded contracts even where it was not the lowest bidder, and the company needed little marketing beyond its reputation in the industry.

During the Years, Corporation’s board held annual meetings to determine officer compensation, director’s fees, and dividends. Corporation compensated A and B for their services as officer-employees; they also received directors fees.

A bonus pool was calculated on a sliding scale in proportion to Corporation’s annual revenue. At year-end, and upon the advice of Corporation’s accountant, the board paid bonuses out of the bonus pool based on officer performance and the company’s ability to pay.

During the Years, Corporation also had a dividend plan that called for dividend distributions when the Corporation’s retained earnings exceeded $2 million. The board determined the amount of the dividend on the basis of Corporation’s financial position, profitability, and capitalization, based upon the advice of its accountant. Historically, Corporation paid modest dividends to its shareholders.

The Tax Dispute

On its corporate income tax returns for the Years, Corporation claimed deductions for the salaries and bonuses paid to A and B.

The IRS asserted that a portion of the amounts reported as officer compensation could not be deducted because it exceeded reasonable compensation.

The Code permits a taxpayer to deduct, as an ordinary and necessary business expense [IRC Sec. 162], compensation payments that are reasonable in amount and that are, in fact, paid purely for services rendered. The taxpayer has the burden of proving that the amounts paid to its employees were reasonable.

Among the factors that are often considered to determine the reasonableness of compensation, are the following: (1) the employee’s role in the company; (2) a comparison of compensation paid by similar companies for similar services; (3) the character and condition of the company; (4) potential conflicts of interest; and (5) the internal consistency of compensation arrangements. In analyzing the fourth factor, the courts often evaluate the reasonableness of compensation payments from the perspective of a hypothetical independent investor, focusing on whether the investor would receive a reasonable return on equity after payment of the compensation.

The Court’s Analysis
The Tax Court considered each of these factors, observing that no one factor is deemed dispositive.

Role in the Company
This factor focuses on the employee’s importance to the success of the business. Pertinent considerations include the employee’s position, duties performed, and hours worked.

After reviewing their activities, as described above, the Court noted that Sons A and B were integral to Corporation’s success during the Years. While some of Corporation’s growth was due to external factors, Corporation’s reputation for quality and timely performance under A’s and B’s management allowed it to secure contracts even when it was not the lowest bidder.

Moreover, A and B personally guaranteed indebtedness that Corporation incurred to purchase materials and supplies, adding to their role in ensuring its successful operations. This factor weighed in Corporation’s favor.

External comparison
This factor compares the employee’s compensation with that paid by similar companies for similar services.

The IRS conceded that Corporation’s performance so exceeded that of any of the companies identified by the parties’ experts as comparable that compensation comparisons were not meaningful. Corporation contended that its performance so exceeded the industry average that the divergence of its compensation from the average was justified. The Court decided that it lacked reliable benchmarks from which to assess Corporation’s claim and, therefore, concluding instead that this factor was neutral.

Character and Condition of the Company
This factor considers the company’s character and condition, focusing on size as measured by sales, net income, or capital value. The complexities of the business and general economic conditions are also relevant.

As reflected in the Court’s findings, Corporation experienced remarkable revenue, profit margins (before officer compensation), and asset growth during the Years. The IRS conceded Corporation’s “substantial success” during the Years. Thus, this factor weighed in Corporation’s favor.

Conflict of interest
The primary focus of this factor is whether a relationship exists between the company and the employee which may permit the company to disguise nondeductible corporate distributions (dividends) as deductible compensation payments.

A potentially exploitable relationship may exist where the employee is the company’s sole or controlling shareholder, or where a special family relationship indicates that the terms of a compensation arrangement may not be arm’s-length.

According to the Court, because Mom was Corporation’s majority shareholder during the Years at issue and, together with her Sons, owned all of Corporation’s stock, this factor warranted scrutiny.

The Court noted that Corporation paid minor dividends for the Years, notwithstanding gross profit margins (before officer compensation) for each year exceeded 38%.

The Court evaluated the compensation payments from the perspective of a hypothetical independent investor, focusing on the investor’s return on equity. If the company’s earnings on equity after payment of compensation remain at a level that would satisfy an independent investor, there is a strong indication that the employee is providing compensable services and that profits are not being siphoned out of the company disguised as salary.

The parties agreed that Corporation had average pretax returns on equity of 9.6% for the Years. They differed, however, on what an expected return on equity should have been for Corporation. The Court found that Corporation’s return on equity figures were derived from financial information of privately-held companies that were more comparable to Corporation for purposes of a return on equity analysis than those used by the IRS. Thus, they provided the best index of a reasonable return on equity.

The IRS claimed that an independent investor would have demanded a return more commensurate with Corporation’s superior performance. Corporation contended that its return on equity was in line with the industry average and therefore would have satisfied an independent investor.

The Court agreed with Corporation, noting that the IRS had cited no authority for the proposition that the required return on equity for purposes of the independent investor test must significantly exceed the industry average when the subject company has been especially successful. Rather, it is compensation that results in returns on equity of zero or less than zero, the Court noted in passing, that has been found to be unreasonable.

Consequently, the court found that Corporation’s returns on equity for the Years tended to show that the compensation paid to A and B was reasonable. Thus, this factor weighed in Corporation’s favor.

Internal consistency of compensation
This factor focuses on whether the compensation was paid pursuant to a structured, formal, and consistently applied program; bonuses not awarded under such plans are suspect.

Corporation consistently adhered to the officer bonus formula for many years, and the IRS conceded as much. The Court concluded that this factor weighed in Corporation’s favor.

Conclusion
As a whole, the factors supported the conclusion that the compensation Corporation paid to A and B in the Years was reasonable. The brothers were integral to Corporation’s successful performance, and its remarkable growth in revenues, assets, and gross profit margins during those years. The return on equity generated for the Years after payment of officer’s compensation was in line with the return generated by comparable companies; accordingly, an independent investor would have been satisfied with the return.

For these reasons, the Court held that the amounts paid by Corporation as officer compensation were reasonable and, therefore, deductible in determining its taxable income.

Takeaway
The taxpayer in the decision discussed above did many things right; for example, it consistently applied a formula in setting officer bonuses, and it followed a process for determining dividend payments.

Although it ultimately succeeded – on the strength of its economic performance – in defending the amount of compensation paid to its officers, query whether it could have avoided a drawn-out audit and a Tax Court proceeding if it had been aware of the factors generally employed by the courts in determining the reasonableness of compensation. It could then have tied the form of its payments to their substance.

If it had considered those factors in advance, it could have, presumably, contemporaneously gathered the necessary data and memorialized its compensation and dividend decisions, and presented them to the IRS during the examination of its tax returns.

Unfortunately, it has been my experience that most taxpayers are averse to spending a little more today in order to avoid spending what is likely to be much more later. Nonetheless, it remains the role of the tax adviser to encourage clients to do their homework before they act, and to document their actions. You can lead a horse to water, . . .

So, Am I a Partner or an Employee?

Posted in Federal Tax Issues

Partner or Employee?

It has long been the position of the IRS that a bona fide member of a partnership is not an employee of the partnership. Such a partner, who devotes his or her time and energies to the conduct of the trade or business of the partnership, or in providing services to the partnership, is a self-employed individual.

According to the IRS, however, it appears that some taxpayers have been misreading the so-called “entity classification” rules so as to permit the treatment of individual partners, in a partnership that owns a disregarded entity, as employees of the disregarded entity. Under this reading, some partnerships have permitted partners to participate in certain tax-favored employee benefit plans.

In order to address this issue, the IRS recently proposed regulations to clarify that such partners are subject to the same self-employment tax rules as partners in a partnership that does not own a disregarded entity. [TD 9766]

Before reviewing the proposed regulations, it may be helpful to describe the tax treatment of “partner compensation.”

Payments for Services

The rules that govern the tax treatment of transactions between partners and their partnerships are among the most complex rules in the Code. The treatment of a particular transaction will depend, in part, upon the capacity in which the partner is acting and upon the nature of the transaction.

For example, payments made by a partnership to a partner for services rendered in his or capacity as such, are considered as made to a person who is not a partner, if such payments are determined without regard to the income of the partnership. [IRC Sec. 707(c)]

However, such a “guaranteed payment” is considered as made to a non-partner only for certain enumerated purposes.

Specifically, the partner must include the amount of the payment in his or her gross income [IRC Sec. 61; https://www.law.cornell.edu/uscode/text/26/61 ], even if the partnership has a loss for the year in which the payment is made. Moreover, because the payment is made in respect of services rendered, the income is taxed as ordinary income regardless of the character of the income, if any, realized by the partnership.

Similarly, the partnership may deduct the payment [IRC Sec. 162], provided it constitutes an ordinary and necessary trade or business expense , is reasonable for the services rendered, and does not have to be capitalized under the rules relating to capital expenditures. [IRC Sec. 263]

The impact of this rule is limited to these enumerated purposes. For purposes of other provisions of the tax law, guaranteed payments are regarded as a partner’s share of the partnership’s income. Thus, as in the case of a partner’s distributive share of partnership income, the partner must include such payments in gross income for his or her taxable year within or with which ends the partnership taxable year in which the partnership deducted such payments under its method of accounting. [Reg. Sec. 1.707-1(c)]

For purposes of other provisions of the Code, guaranteed payments are regarded as a partner’s distributive share of ordinary income. Thus, a partner who receives guaranteed payments for a period during which he or she is absent from work because of personal injuries or sickness is not entitled to exclude such payments from his gross income. [IRC Sec. 105] Similarly, a partner who receives guaranteed payments is not regarded as an employee of the partnership for the purposes of income or employment tax withholding, deferred compensation plans, etc. [Reg. Sec. 1.707-1(c)] Instead, guaranteed payments received by a partner, from a partnership that is engaged in a trade or business, for services rendered to the partnership are treated as “net earnings from self-employment” and are subject to self-employment tax. [1.1402(a)-1(b)]

The Entity Classification Rules

A business entity (typically, an LLC) that has a single owner, and that is not a corporation, is disregarded as an entity separate from its owner for purposes of the income tax. The single owner is treated, for example, as owning all of the entity’s assets and as receiving all of its income.

However, such a “disregarded entity” is treated as a corporation for purposes of the employment taxes imposed under the Code. Therefore, the disregarded entity, rather than the owner, is considered to be the employer of the entity’s employees for purposes of the employment taxes.

While a disregarded entity is, thus, treated as a corporation for employment tax purposes, this rule does not apply for self-employment tax purposes. Rather, the general rule applies, and the entity will be disregarded as an entity separate from its owner for purposes of the self-employment tax.

The applicable regulation illustrates this rule in the context of a single individual owner (not a partnership) by stating that the owner of an entity that is treated in the same manner as a sole proprietorship is subject to tax on self-employment income. However, the regulation includes an example in which the disregarded entity is subject to employment tax with respect to employees of the disregarded entity, while the individual owner is subject to self-employment tax on the net earnings from self-employment resulting from the disregarded entity’s activities.

Because the regulation does not include a specific example applying the general rule in the context of a partnership, many taxpayers believed – unreasonably, you might say – that an individual partner, in a partnership that owns a disregarded entity, could be treated as an employee of the disregarded entity. Consequently, they decided to pay wages to partners through a disregarded entity, like a wholly-owned LLC, in order to qualify the partners as “employees” for purposes of certain tax-advantaged benefit plans.

The Proposed Regulation

The IRS noted that the regulation did not create a distinction between a disregarded entity owned by an individual (that is, a sole proprietorship) and a disregarded entity owned by a partnership in the application of the self-employment tax rules. Rather, the regulation applies for self-employment tax purposes for any owner of a disregarded entity without carving out an exception regarding a partnership that owns such a disregarded entity.

The regulations proposed by the IRS apply the existing general rule to illustrate that, if a partnership is the owner of a disregarded entity, the partners are subject to the same self-employment tax rules as partners in a partnership that does not own a disregarded entity. In other words, the rule that treats the entity as disregarded for self-employment tax purposes applies to partners in the same way that it applies to a sole proprietor owner. A disregarded entity that is treated as a corporation for purposes of employment taxes is not treated as a corporation for purposes of employing its individual owner, or for purposes of employing an individual that is a partner in a partnership that owns the disregarded entity.

Where Is This Leading?

In order to allow adequate time for partnerships to make necessary payroll and benefit plan adjustments, the proposed regulations, which were also issued as temporary regulations, will apply no earlier than August 1, 2016.

Between now and then, any partnership that has been treating its partners as employees of an LLC wholly-owned by the partnership will have to stop doing so.

A the same time, however, it should be noted that the IRS has indicated that it will consider whether it should allow partnerships to treat partners as employees in certain circumstances; for example, in the case of employees of a partnership who obtain a small ownership interest in the partnership as a compensatory award or incentive.

In connection therewith, the IRS will have to analyze, among other things, the impact on employee benefit plans (including, but not limited to, qualified retirement plans, health and welfare plans, and fringe benefit plans) and on employment taxes if partners were to be treated as employees in certain circumstances.

Stay tuned – the IRS may eventually change its position.

Guaranteeing a Loan to Your IRA? No Way!

Posted in Federal Tax Issues

Having worked with many families in the administration of their loved ones’ estates, I can report anecdotally that over the last decade, tax-deferred retirement assets have constituted an ever-increasing share of individual wealth, even for those estates that fall below the estate tax exemption amount. Such tax-deferred assets come in many different forms; some of the more popular vehicles include the individual retirement account (IRA), the 401(k) account, and the 403(b) account.  As such assets are creatures of highly-technical tax statutes and regulations, dealing with them often requires a greater level of care and attention to detail than the “run of the mill” real estate, corporate, and partnership assets.  This reality is most often acknowledged by (and causes the most consternation to) my colleagues and me when planning for the testamentary disposition of retirement assets, such as ensuring that a trust named as beneficiary of a retirement asset satisfies the complex rules regarding continued income tax deferral. IRA

Although planning for the transfer of a decedent’s IRAs requires careful navigation around many mines, death is not the only time to be aware of the IRA rules. Indeed, many business owners have, over the years, viewed their IRAs as a ready source of funds.  In their haste to access these funds, they often discover, too late, that they have made a terrible mistake.  A recent U.S. Tax Court decision drives home the point that great care and attention is required where a business owner-IRA participant wants to use his or her IRA to fund a business.  The simple lesson to be learned is that participants are not as free to deal with their tax-deferred assets as they are with their other assets.

When reading the decision, the Taxpayers, husband and wife, both under 59 years of age, come across as sympathetic. The husband was a former 30-year employee of a grocery store chain who decided to pursue his dreams and follow his entrepreneurial spirit by investing in a metal fabrication business, a field he had long ago studied in college; the wife was an employee of the same company.  They seemingly did all the right things before taking the plunge into a new business: they consulted with an accountant, a lawyer, and an experienced business broker in order to ensure the deal was structured wisely.

The business broker advised Taxpayers that they could roll over the funds in their respective retirement accounts from the grocery store into new IRAs, cause the IRAs to acquire the initial stock of a newly-formed C corporation, and cause the C corporation to acquire the existing business. More than that, the brokerage company explained that it typically recommended to its clients acquiring companies that they borrow and issue a note to the seller as part of the consideration for the sale so that “the seller would have an interest in helping the buyer.”  In this context, that meant causing Taxpayers’ newly formed C corporation to “borrow” funds from, and issue a note to, the seller of the existing business (an installment sale).

Taxpayers then retained an accountant to advise them about the IRA funding structure. Incidentally, the accountant was referred to Taxpayers by a friend who had recently utilized the same IRA funding structure in his own business acquisition (query whether the friend’s structure was also scrutinized by the IRS).  They also retained legal counsel to establish the C corporation that acquired the target metal fabrication business.  Taxpayers were named as the sole officers and directors of the C corporation.  They then rolled over their retirement accounts at the grocery store, approximately $432,000 in the aggregate, to new, self-directed IRAs custodied at a local financial institution.  Because the IRAs were self-directed, Taxpayers retained all discretionary authority and control concerning the investment of their respective IRA’s assets.

Taxpayers directed the IRAs to purchase shares of the newly-formed C corporation, which, in turn, purchased the existing metal fabrication business. The consideration for the business consisted, in part, of a $200,000 promissory note issued by the C corporation to the seller.  The note was secured by the business’s assets and was personally guaranteed by the Taxpayers, i.e., the IRA participants.

All of the above-described transactions took place during the same tax year. On their personal income tax return filed for said tax year, Taxpayers reported the IRA rollovers, but did not disclose the guaranties of the loan or, as the Tax Court noted, “any other fact that would have put [the IRS] on notice of the nature and the amount of any deemed distribution resulting from the guaranties.”

The IRS nevertheless discovered the transaction and issued a notice of deficiency for approximately $180,000, primarily attributable to an understatement of income in the approximate amount of the IRAs that were rolled over, i.e., about $432,000 in the aggregate. At the Tax Court, the IRS argued that the IRAs ceased to be IRAs when the taxpayers guaranteed the note issued by the C corporation, which was wholly-owned by the IRAs.  The Tax Court agreed.

The Code provides that if an IRA participant engages in any “prohibited transaction” with respect to the IRA, such IRA ceases to be an IRA as of the first day of the taxable year in which such prohibited transaction took place. A “prohibited transaction” includes any “direct or indirect … lending of money or other extension of credit between a plan and a disqualified person….”  The Taxpayers fell within the meaning of “disqualified person.

The Tax Court, citing prior case law, agreed with the IRS’s argument that the Taxpayers’ guaranties constituted indirect extensions of credit to their respective IRAs. Thus, the Taxpayers’ entire IRAs were deemed to have been distributed to them in a taxable transaction.

Again, the simple lesson is that IRA participants are not as free to deal with their tax-deferred assets as they are with their other assets. There are myriad traps for the unwary.  Red flags should certainly be raised whenever either a loan or guaranty is being made, directly or indirectly, in connection with an IRA.  Taxpayers, and their advisors, are well-advised to seek the appropriate counsel to avoid such a terrible outcome as discussed above.

Split-Dollar Life Insurance & Succession Planning

Posted in Federal Tax Issues

The owners of a closely-held business confront several issues upon the death of any one of them:

  • How will the decedent’s shares be valued?
  • How will the decedent’s estate pay the resulting estate tax?
  • To whom will the decedent’s shares be transferred?
  • How will the acquiring party pay for such shares?

In most cases, the owners of the business will limit the universe of persons to whom the decedent’s shares can pass, for example, by entering into a shareholders’ agreement that requires the business or the surviving owners to purchase the shares from the decedent’s estate.

As to the funding for such a purchase, the owners of the business may decide to acquire life insurance upon the lives of the various shareholders, the proceeds from which would serve two purposes: to fund the purchase price for the shares, and to provide the decedent’s estate with liquidity for purposes of paying the estate tax. tornhundreddollarbill-thumb

A recent Tax Court decision considered one family’s use of split-dollar life insurance arrangements to serve these purposes.

Buy-Sell Arrangement

Decedent and her late husband started a business that eventually grew into a total of eleven companies (“Group”). All companies in the Group were brother-sister corporations with identical ownership.

Decedent established a revocable trust (“Trust”) in 1994, appointed herself as trustee, and contributed all of her stock in each company in the Group to the Trust.

Decedent then established three “dynasty” trusts in 2006: one for the benefit of each of her Sons and that Son’s family (each a “Dynasty Trust”).

Also in 2006, the Trust was amended to permit the trustee to “(i) pay premiums on life insurance policies acquired to fund the buy-sell provisions of the * * * [Group’s] business succession plan, and (ii) make loans, enter into split-dollar life insurance agreements or make other arrangements.”

Additionally, the amendment authorized the trustee of Trust to transfer each “receivable” from the split-dollar life insurance arrangement, when paid by each Dynasty Trust, back to the Dynasty Trust that owed the receivable.

In late 2006, the Dynasty Trusts, the Sons and the Trust entered into a shareholders agreement. The agreement provided that upon the death of any Son, his surviving siblings and their respective Dynasty Trusts would purchase the Group stock held by the deceased sibling.

To provide the Dynasty Trusts with the resources to purchase the Group stock held by or on behalf of a deceased Son, each Dynasty Trust purchased two life insurance policies, one on the life of each other brother.

Split-Dollar Life Insurance Arrangements

To fund the purchase of the policies, each Dynasty Trust and the Trust entered into two split-dollar life insurance arrangements in 2006, to set forth the rights of the respective parties with respect to the policies. The Trust contributed almost $10 million to each Dynasty Trust, which then used that money to pay a lump-sum premium on each policy to maintain that policy for the insured Son’s projected life expectancy.

Under the split-dollar arrangements, upon the death of the insured Son, the Trust would receive a portion of the death benefit from the policy insuring the life of the deceased Son equal to the greater of (i) the cash surrender value (“CSV”) of that policy, or (ii) the aggregate premium payments on that policy (each a “receivable”).

Each Dynasty Trust would receive the balance of the death benefit under the policy it owned on the life of the deceased Son, which would be available to fund the purchase of the stock owned by the deceased Son. If a split-dollar arrangement terminated for any reason during the lifetime of an insured Son, the Trust would have the unqualified right to receive the greater of (i) the total amount of the premiums paid or (ii) the CSV of the policy, and the Dynasty Trust would not receive anything from the policy.

Additionally, the Dynasty Trusts executed collateral assignments of the policies to the Trust to secure payment of the amounts they each owed to the Trust. Neither the Dynasty Trusts nor the Trust retained the right to borrow against a policy.

Insurance Policies

The life insurance policies acquired by the Dynasty Trusts were universal life insurance policies, a form of permanent life insurance providing the owner with flexibility in making premium payments. Under the policies, the owner could pay premiums in a lump-sum, over a limited number of years, over an extended number of years, or over the life of the insured. The owner could determine the amount of premiums at the inception of the contract, change the amount of the future premium from time to time, stop paying premiums for any other reason, and resume paying premiums at a later date if desired.

 The IRS’s Challenge

From 2006 to 2009, Decedent reported gifts to the Dynasty Trusts as determined using the so-called “economic benefit” regime. The amount of each gift reported was the cost of the current life insurance protection as determined using tables issued by the IRS.

After Decedent’s death in late 2009, her Estate retained an appraiser to value the receivables owing to the Trust and includible in Decedent’s gross estate as of the date of her death.

The IRS issued two notices of deficiency to the Estate. One sought to increase the value of the receivables payable to the Trust, as reported by the Estate. The other notice asserted that the Estate had failed to report almost $30 million of gifts in 2006 — specifically, the total amount of the policy premiums paid by Trust for the split-dollar insurance policies.

Split-Dollar Life Insurance

In general, split-dollar life insurance arrangements are governed by IRS regulations.  These regulations define a “split-dollar life insurance arrangement” as an arrangement between an owner and a non-owner of a life insurance contract in which: (i) either party to the arrangement pays all or a portion of the premiums on the life insurance contract; and (ii) the party paying for the premiums is entitled to recover all or any portion of those premiums, and such recovery is to be made from the proceeds of the life insurance contract.

The split-dollar arrangements at issue were governed by these regulations. Trust paid the premiums on the policies; it was entitled to recover, at a minimum, all of those premiums paid, and this recovery was to be made from, and was secured by, the proceeds of the policies.

The regulations provide two mutually exclusive regimes for taxing split-dollar life insurance arrangements. The determination of which regime applies to a particular arrangement depends on which party owns the life insurance policy subject to the arrangement. Generally, the person named as the owner in the insurance contract is treated as the owner.

Under this general rule, the Dynasty Trusts would be considered the owners of the policies, and the premium payments by Trust would be treated as loans to the Dynasty Trusts.

Deemed Owner

As an exception to the general rule, the regulations include a special ownership rule that provides that if the only economic benefit provided to the donee under the split-dollar arrangement is current life insurance protection, then the donor will be treated as the owner of the life insurance contract, regardless of who actually owns the policy.

On the other hand, if the donee receives any additional economic benefit, other than current life insurance protection, then the donee will be considered the owner, and the loan regime will apply.

Thus, the key question in the case – which determined which party owned, or was deemed to own, a life insurance policy – was whether the lump-sum payment of premiums made on the policies by the Trust generated any additional economic benefit, other than current life insurance protection, to the Dynasty Trusts.

If there was no additional economic benefit to the Dynasty Trusts, then the Trust would be the deemed owner of the policies, and the split-dollar life insurance arrangements would be governed by the economic benefit regime.

Economic Benefit Regime

For a split-dollar arrangement to be taxed under the economic benefit regime, the owner or deemed owner will be treated as providing an annual benefit to the non-owner in an amount equal to the value of the economic benefits provided under the arrangement, reduced by any consideration the non-owner pays for the benefits. The value of the economic benefits provided to the non-owner for a taxable year under the arrangement is equal to the sum of (i) the cost of current life insurance protection, (ii) the amount of cash value to which the non-owner has current access during the year, and (iii) any other economic benefits that are provided to the non-owner.

To determine whether any additional economic benefit was conferred by the Trust to the Dynasty Trusts, the relevant inquiry was whether the Dynasty Trusts had current access to the cash values of their respective policies under the split-dollar arrangements or whether any other economic benefit was provided.

Current Access?

The regulations provide that the non-owner has current access to any portion of the policy cash value to which the non-owner (i) has a current or future right and (ii) that currently is directly or indirectly accessible by the non-owner, inaccessible to the owner, or inaccessible to the owner’s general creditors.

For the Dynasty Trusts to have current access, they must first have had a current or future right to any portion of the policy cash value. The split-dollar arrangements, however, were structured so that upon the termination of the arrangement during the lifetime of the insured, 100% of the CSV would be paid to the Trust. Additionally, upon the death of the insured, the Dynasty Trusts would be entitled to receive only that portion of the death benefit of the policy in excess of the amount payable to the Trust.

Accordingly, the Dynasty Trusts had no current or future right to any portion of the policy cash value, and thus, no current access under the regulations.

The IRS argued that the Dynasty Trusts had a right to the cash values of the insurance policies by virtue of the terms of the 2006 amendment to the Trust. Under that amendment, the IRS argued, the Trust’s interest in the cash values of the policies would pass to the Dynasty Trusts or directly to the Sons or their heirs upon Decedent’s death.

However, because the Trust was a revocable trust with respect to Decedent, she retained an absolute right to alter the Trust throughout her lifetime. Accordingly, the Dynasty Trusts did not have a legally enforceable right to the cash values of the policies during the lifetime of the Decedent-grantor. Furthermore, the split-dollar arrangements did not require the Trust to distribute the receivables to the Dynasty Trusts. Rather, Decedent retained the right to receipt of the receivables.

The Court also noted that when the regulations state that “[t]he value of the economic benefits provided to a non-owner for a taxable year under the arrangement equals . . . [t]he amount of policy cash value to which the non-owner has current access. . .,” the regulations are referring to the split-dollar arrangement. The 2006 amendment to the Trust was not part of the split-dollar arrangements between the Trust and the Dynasty Trusts.

Under each split-dollar arrangement, the Court stated, upon the death of the insured-Son, the Trust would be entitled to receive a portion of the death benefit of the policies insuring the life of the deceased equal to the greater of (i) the CSV of the applicable policies or (ii) the aggregate premium payments made with respect to the applicable policies. The Trust obtained the receivables as a result of entering into the split-dollar arrangements. Thus, it was appropriate to execute the 2006 amendment to provide for the disposition of these assets. Importantly, the split-dollar arrangements did not address the disposition of the receivables by the Trust and did not require or permit the receivables be distributed to the Dynasty Trusts. Thus, the Dynasty Trusts did not have a right in the cash values of the policies by virtue of the 2006 amendment.

Other Economic Benefit?

The IRS argued that the circumstances of the split-dollar arrangements at issue prohibited the use of the economic benefit regime. Specifically, it compared the arrangements to certain abusive split-dollar life insurance arrangements under which one party holding a right to current life insurance protection uses inappropriately high current term insurance rates, prepayment of premiums, or other techniques to confer policy benefits other than current life insurance protection on another party. The use of such techniques by any party to understate the value of these other policy benefits distorts the income or gift tax consequences of the arrangement, the IRS claimed, and does not conform to, and is not permitted by the regulations.

The Court found that the split-dollar arrangements between the Trust and the Dynasty Trusts bore no resemblance to the transactions described by the IRS. Decedent, who was 94 at the time she set these arrangements into motion, wanted the Group to remain in her family. To that end, she caused the Trust to pay a lump-sum premium, through the Dynasty Trusts, on the life insurance policies held on the lives of her Sons, the proceeds of which would be used to purchase the stock held by each of her Sons upon his death. Unlike the abusive insurance arrangements described by the IRS, the receivables the Trust obtained in exchange for its advances provided the Trust sole access to the CSV of the policies.

Conclusion

Because the Dynasty Trusts received no additional economic benefit beyond that of current life insurance protection, the Court held that the Trust was the deemed owner of the life insurance contracts by way of the special ownership rule under the regulations. Therefore, the economic benefit regime under the regulations applied to the split-dollar arrangements.

It should be noted that the preamble to the split-dollar regulations included an example that was structured identically to the split-dollar arrangements at issue. The preamble distinguished between a donor (or the donor’s estate) who is entitled to receive an amount equal to the greater of the aggregate premiums paid by the donor or the CSV of the contract and a donor (or the donor’s estate) who is entitled to receive the lesser of those two values.

In the former situation, as in the case above, the donor makes a gift to the donee equal to the cost of the current life insurance protection provided.

Thus, the issue remaining to be resolved in this case is the value of the receivable owing to the donor’s estate, which the IRS asserted was significantly understated.

Depending upon the outcome of this valuation, estate planners may, in the appropriate situation, be able to utilize split-dollar arrangements within a family-owned business to provide funds for a buyout and for the payment of the estate tax.

“Bad Boy Guarantees” Redux

Posted in Federal Tax Issues

Partnership Allocations

The allocation of a partnership’s items of income, gain, deduction and loss among its partners must have substantial economic effect if it is to be respected by the IRS. The determination of whether an allocation has substantial economic effect for tax purposes involves a two-part analysis: first, the allocation must have economic effect; and second, the economic effect of the allocation must be substantial.

In order for an allocation to have economic effect, it must be consistent with the underlying economic arrangement of the partners. This means that in the event there is an economic benefit or an economic burden that corresponds to the allocation, the partner to whom the allocation is made must receive such economic benefit or bear such economic burden. Stated differently, tax must follow economics. For example, if a partnership incurs debt to acquire property, and only some of its partners are ultimately responsible for the satisfaction of such debt, the depreciation deductions attributable to the acquisition indebtedness would be allocable only to those partners.

Bad Boy Guarantees

A few weeks ago, we discussed a pronouncement by the IRS regarding a partner’s guarantee of a partnership’s nonrecourse debt. The partner had provided a “bad boy guarantee,” and the ruling considered whether the guarantee would cause the debt to be treated as recourse to the partner. The outcome was important because the deductions attributable to a nonrecourse liability are generally allocated among all the partners in accordance with their interest in the partnership, while those attributable to a recourse liability are allocable only to those partners who bear the economic risk of loss for that liability.

The IRS determined that the circumstances under which the guarantee would be enforced were not “contingencies” and, so, it concluded that the guarantor-partner did bear the risk of loss, notwithstanding certain language in the partnership agreement that could have been construed as imposing an obligation on the other partners to reimburse the guarantor.

This week, the IRS released yet another memorandum regarding a partner’s guarantee of a partnership’s nonrecourse debt. As in the case of the earlier pronouncement, this memorandum addressed the treatment of a partner’s guarantee of a partnership nonrecourse liability when the guarantee was conditioned on certain “nonrecourse carve-out” events (or “bad boy guarantees”). Specifically, the IRS considered whether a partner’s guarantee of a partnership’s nonrecourse obligation, which was conditioned on the occurrence of certain “bad boy” events, would cause the obligation to fail to qualify as a nonrecourse liability of the partnership (i.e., would make it a recourse liability as to the guarantor). This time, however, the IRS reached a different conclusion.

Recourse Liabilities

In general, a partnership liability is a recourse liability to the extent that any partner bears the economic risk of loss for that liability. A partner’s share of a recourse partnership liability equals the portion of that liability, if any, for which the partner bears the economic risk of loss.

A partner bears the economic risk of loss for a partnership liability to the extent that, if the partnership constructively liquidated, the partner would be obligated to make a payment to any person (or a contribution to the partnership) because that liability becomes due and payable, and the partner would not be entitled to reimbursement from another partner.

Upon a constructive liquidation, all of the following events are deemed to occur simultaneously:

(i) all of the partnership’s liabilities become payable in full;

(ii) with the exception of property contributed to secure a partnership liability, all of the partnership’s assets, including cash, have a value of zero;

(iii) the partnership disposes of all of its property in a fully taxable transaction for no consideration (except relief from liabilities for which the creditor’s right to repayment is limited solely to one or more assets of the partnership);

(iv) items of income, gain, loss, or deduction are allocated among the partners; and

(v) the partnership liquidates.

The determination of the extent to which a partner or related person has an obligation to make a payment is based on the facts and circumstances at the time of the determination. All statutory and contractual obligations relating to the partnership liability are taken into account for these purposes, including (i) contractual obligations outside the partnership agreement such as guarantees, indemnifications, reimbursement agreements, and other obligations running directly to creditors or other partners, or to the partnership; (ii) obligations to the partnership that are imposed by the partnership agreement, including the obligation to make a capital contribution and to restore a deficit capital account upon liquidation of the partnership, and (iii) payment obligations (whether in the form of direct remittances to another partner or a contribution to the partnership) imposed by state law.

How Likely Are the Bad Acts?

Sometimes, guarantees of partnership nonrecourse obligations are conditioned upon the occurrence of one or more of the following “nonrecourse carve-out” events:

 

  1. The borrower fails to obtain the lender’s consent before obtaining subordinate financing or transfer of the secured property;
  2. The borrower files a voluntary bankruptcy petition;
  3. Any person in control of the borrower files an involuntary bankruptcy petition against the borrower;
  4. Any person in control of the borrower solicits other creditors of the borrower to file an involuntary bankruptcy petition against the borrower;
  5. The borrower consents to or otherwise acquiesces or joins in an involuntary bankruptcy or insolvency proceeding;
  6. Any person in control of the borrower consents to the appointment of a receiver or custodian of assets; or
  7. The borrower makes an assignment for the benefit of creditors, or admits in writing, or in any legal proceeding, that it is insolvent or unable to pay its debts as they come due.

By including these provisions in a loan agreement, the lender seeks to protect itself from the risk that the borrower, or a guarantor in charge of the borrower, will undertake “bad acts” that will diminish or impair the value of the property securing the loan, that might disrupt the cash flow from the property, or that could delay, complicate or prevent the lender’s repossession of the property in the event of a default.

An important aspect of these nonrecourse carve-outs, the IRS noted, is that the bad acts that they seek to prevent are within the control of the borrower or guarantor—meaning that the borrower, or a guarantor in control of the borrower, can prevent them from occurring. Because it is in the economic self-interest of borrowers and guarantors to avoid committing those bad acts and subjecting themselves to liability, they are unlikely to voluntarily commit such acts.

Moreover, “nonrecourse carve-out” provisions are not intended to allow the lender to require an involuntary action by the borrower or guarantor, or to place borrowers or guarantors in circumstances that would require them to involuntarily commit a “bad act.” Rather, the fundamental business purpose behind such carve-outs, and the intent of the parties to such agreements, is to prevent actions by the borrower or guarantor that could make recovery on the debt, or acquisition of the security underlying the debt upon default, more difficult.

The “nonrecourse carve-out” provisions at issue, the IRS stated, should be interpreted consistently with that purpose and intent in mind. Consequently, because it is not in the economic interest of the borrower or the guarantor to commit the bad acts described in the typical “nonrecourse carve-out” provisions, it is unlikely that the contingency (the bad act) will occur and, so, the contingent payment obligation should be disregarded.

Take-Away

In sum, unless the facts and circumstances indicate otherwise, a typical “nonrecourse carve-out” provision that allows the borrower or the guarantor to avoid committing the enumerated bad act will not cause an otherwise nonrecourse liability to be treated as recourse for purposes of allocating among the partners the deductions and losses attributable to such liability, at least until such time as the contingency actually occurs.

Thus, the guarantee will not cause the obligation to fail to qualify as a nonrecourse liability of the partnership until such time as one of those events actually occurs and causes the guarantor to become personally liable for the partnership debt.

This memorandum represents a retreat from the position that the IRS staked out in its earlier pronouncement on “bad boy guarantees” and their effect on the tax treatment of partnership nonrecourse liabilities. It is also more in line with the IRS’s own regulatory rule that a payment obligation is disregarded if, taking into account all the facts and circumstances, the obligation is subject to contingencies that make it unlikely that the obligations will ever be discharged.

This result should come as a relief to “investor-partners.” Even though IRS chief counsel memoranda cannot be cited as precedent, they do give us a glimpse into the IRS’s thinking on a particular issue. Consequently, such partners should be assured, in determining the economic consequences of their investment, that their allocations of partnership deductions attributable to nonrecourse debt should, generally speaking, be respected by the IRS.