Many of our clients, most of which are closely-held U.S. businesses, are looking to expand their operations overseas. Some are venturing into foreign markets on their own, while others are joint-venturing with established foreign businesses.

In structuring a joint venture, the parties will often form a foreign business entity that affords a significant degree of limited liability protection, such as a corporation.

As a matter of U.S. Federal tax law, however, it may be advisable that the form of foreign entity not be treated as a corporation per se. Rather, the better choice may be that the foreign entity qualify as a so-called “eligible entity” under U.S. tax law – one that provides limited liability protection to its members but that may elect to be treated as a partnership.

If the foreign eligible entity is treated as a partnership for U.S. tax purposes, a share of the losses that may be generated by the entity in the early stages of its operation may flow through to the U.S. business to be used in determining its taxable income.

The IRS recently considered an interesting version of this scenario.

Joint Venture

In Year 1, US Parent corporation and Foreign Parent corporation formed JV, as a foreign limited liability company, to carry out a joint venture. As a matter of Foreign Law, JV had two equity owners: foreign corporations FC-1 and FC-2, each of which contributed funds to JV. US Parent and Foreign Parent owned the equity of FC-2; Foreign Parent was the sole owner of FC-1.

US Parent also provided funds to JV through its U.S. subsidiary, US Partner, and Foreign Parent did so directly. The amounts provided were treated as loans under Foreign Law. Thus, under Foreign Law, JV was treated as having two owners: FC-1 and FC-2.

Check the Box

US Parent elected to treat JV as a partnership for U.S. Federal tax purposes. US Parent also treated the amounts provided to JV by US Partner and Foreign Parent as equity, rather than debt. As a result, for US tax purposes, JV was treated as having four partners: FC-1, FC-2, US Partner, and Foreign Parent. Thus, the partnership allocation rules became applicable for purposes of determining US Partner’s share of JV’s tax items.

The joint venture agreement for JV did not set forth any of the “economic effect test” provisions regarding capital account maintenance, liquidation in accordance with positive capital accounts, or deficit restoration obligations; nor did it specify the allocation of JV/partnership tax items among the partners.

Additional Funding

Foreign Law required that, in order for an entity to maintain its legal status as a limited liability company, it should have net assets greater than or equal to its charter capital.

If an entity’s net assets were less than its charter capital, then the entity must either (1) decrease its charter capital, or (2) obtain additional contributions from its owners. If the entity’s owners do not take steps to improve its negative net asset position, the Foreign governmental authority may seek the liquidation of the entity. Furthermore, where an entity improves its net asset position by reducing its charter capital, in lieu of obtaining contributions from its owners, Foreign Law allows any creditor to seek the liquidation of the entity.

The JV Agreement required the owners of JV to lend additional funds pro-rata to their respective ownership interests in JV whenever JV lacked sufficient assets to meet these funding requirements.

Guaranteed Payments

According to the JV Agreement, US Partner and Foreign Parent would receive fixed payments related to their contribution amounts. The fixed payments were computed without regard to the income and cash flow of JV.

US Parent characterized these payments by JV to US Partner as guaranteed payments (for U.S. tax purposes) for the use of capital. From Year 2 to Year 5, JV deducted its payments to US Partner as guaranteed payments. JV had cumulative operating losses from Year 2 to Year 6. The guaranteed payments generated much of these losses. The loss deductions were allocated by JV solely to FC-2 and FC-1.

End of the Joint Venture

After several years of disappointing results, Foreign Parent and US Parent reached an agreement for US Parent to sell its indirect interest in JV to Foreign Parent. Because no JV loss deductions had been allocated to US Partner, US Partner’s basis in JV at the time of the sale was not insignificant and, as a result, US Parent reported a loss of on its U.S. return attributable to the sale of US Partner’s interest in JV.

The IRS’s Analysis

After examining the U.S. Parent’s tax return, the IRS field office asked the National Office to consider the proper allocation of JV’s losses. The IRS examiner believed that part of the loss allocated to FC-2 should have been allocated to US Partner, while US Parent argued that FC-2 bore the economic risk of JV’s operating losses.

Allocation Rules

Under the Code, a partner’s distributive share of income, gain, loss deduction, or credit (or item thereof) is determined in accordance with the partner’s interest in the partnership (taking into account all facts and circumstances), if:

  • the partnership agreement does not provide as to the partner’s distributive share of the partnership’s income, gain, loss, deduction, or credit (or item thereof), or
  • the allocation of such items to a partner under the agreement does not have substantial economic effect.

The IRS applies a two-part analysis for determining substantial economic effect:

  • the allocation must have economic effect; and
  • the economic effect of the allocation must be substantial.

An allocation of partnership income, gain, loss, or deduction to a partner will have economic effect if the partnership agreement provides that:

  • the partnership will maintain a capital account for each partner;
  • the partnership will liquidate according to positive capital account balances; and
  • the partners are obligated to restore any deficit balances in their capital accounts following a liquidating distribution.

If an allocation lacks substantial economic effect, the IRS requires that the item be allocated in accordance with the partners’ interest in the partnership.

“Partner’s Interest”

A partner’s “interest in the partnership” signifies the manner in which the partners have agreed to share with that partner the economic benefits or burdens corresponding to the income, gain, loss, deduction, or credit of the partnership. The determination of a partner’s interest in a partnership is made by taking into account all facts and circumstances relating to the economic arrangement of the partners.

The IRS explained that a partner receives income, not a distributive share, from a guaranteed payment for the use of capital, and the partnership receives a corresponding business deduction. The income from the guaranteed payment does not affect the recipient’s basis in its partnership interest or its capital account. The partnership’s deduction for the guaranteed payment reduces the partnership’s income (or increases the partnership’s loss) to be allocated among its partners.

Because they were determined without regard to the income of the JV-partnership, the fixed payments made by JV to US Partner and Foreign Parent from Year 2 to Year 5 were guaranteed payments for the use of capital. The guaranteed payments generated ordinary income for US Partner and Foreign Parent and deductions for JV.

During this period, JV incurred operating losses, primarily as a result of the guaranteed payment deductions. These losses were allocated entirely to FC-2 and FC-1. US Partner and Foreign Parent received no allocation of loss.

The IRS found that the allocation of JV’s operating loss did not have economic effect because JV did not maintain capital accounts, it did not provide for the liquidation of its partners’ interests in accordance with positive capital account balances, nor did it provide a deficit restoration obligation.

Thus, the IRS continued, JV’s operating loss had to be reallocated in accordance with the partners’ interests in the partnership, reflecting the manner in which the partners agreed to share the economic burden corresponding to that loss.

US Parent argued that Foreign Law effectively subjected FC-2 to a deficit restoration obligation because, if JV’s capitalization fell below a certain threshold, the equity holders of JV (FC-1 and FC-2 under Foreign Law; not US Partner and Foreign Parent) would need to contribute additional capital to JV to avoid its liquidation.

The IRS rejected this argument, finding that these additional capital contributions were not required by Foreign Law, as JV’s partners could allow JV to liquidate rather than make these additional contributions. While FC-2 and FC-1 did contribute additional amounts to JV after Year 2, these amounts were minimal compared with the substantial additional amounts contributed to JV by US Partner and Foreign Parent.

As creditors under Foreign Law, US Partner and Foreign Parent had priority over FC-2 and FC-1 if JV was liquidated. However, FC-2 and FC-1 had no obligation to restore any shortfall in payments to US Partner and Foreign Parent upon liquidation. Consequently, JV would not have the assets to repay US Partner and Foreign Parent their positive capital account balances upon liquidation, thus placing the economic burden for the operating loss allocations to FC-2 and FC-1 on US Partner and Foreign Parent. Any capital contributions by FC-2 and FC-1 would be necessary only to keep JV a going concern and avoid liquidation in the event JV became undercapitalized. Whether to keep JV a going concern would be up to US Parent and Foreign Parent, and was not mandated by Foreign Law.

Based on the foregoing, the IRS concluded that the allocation of JV’s loss to FC-2 and FC-1 should be limited to the amount of their positive capital account balances. They bore the burden of the economic loss of their capital contributions on liquidation up to this amount.

In addition, the IRS concluded that US Partner and Foreign Parent bore the economic burden of JV’s losses in excess of those positive capital accounts.

Don’t Forget

U.S. persons are subject to U.S. income tax on their worldwide income. Thus, before selecting the form of foreign entity through which to begin its foreign operations, a U.S. person should consider the options available.

The form of foreign entity ultimately chosen must be optimal from a business perspective, and it should afford the U.S. person limited liability protection.

However, as always, the tax consequences of a business structure may have a significant effect on the net economic benefit of a transaction, including the foreign operations of a U.S. business. Therefore, the U.S. person should consider how the applicable foreign law will affect the foreign entity’s tax status from a U.S. perspective.

The U.S. person should also examine how each option would be treated for U.S. tax purposes – as a corporation, partnership, or disregarded entity, and whether a check-the-box election would be advisable – and how the tax items attributable to the foreign business may impact the U.S. person’s overall tax liability.

The choice of foreign business entity should be approached with an eye toward maximizing the U.S. person’s overall foreign and U.S. tax benefits, including the use of foreign losses and foreign tax credits, and the deferral of foreign income.

The process is far from simple, but it is absolutely necessary.

Relief? Not So Fast

You may recall that the President directed the Treasury Department to identify “significant tax regulations” issued during 2016 that, among other things, add undue complexity to the tax laws. An interim report to the President in June identified the proposed rules on the valuation of family-controlled business entities as “unworkable,” and recommended that they be withdrawn.

Although many taxpayers are pleased to see the demise of the proposed valuation rules, which many had heralded as the end of valuation discounts for estate and gift tax purposes, there remain a number of traps against which taxpayers and their advisers must be vigilant – but of which many are unaware – lest they inadvertently stumble onto a taxable gift.

One such trap involves the maintenance of capital accounts where the family-controlled business entity is treated as a partnership for tax purposes.

Family Partnership

Family members often combine their “disposable” investment assets in a tax-efficient family-held investment vehicle, such as an LLC that is taxable as a partnership. By pooling their resources, they may be able to better diversify their investments and gain access to larger, more sophisticated, investments that may not have been available to any single family member.

Moreover, as younger family members mature and amass their own wealth, they may decide to participate in the family investment vehicle by making a capital contribution in exchange for a partnership interest.

Capital Account Rules

An earlier post reviewed the capital account and allocation rules applicable to partnerships; in particular, the requirement that the tax consequences to each partner arising from the partnership’s operations – specifically, from such partner’s allocable share of the partnership’s items of income, gain, loss, deduction, or credit – must accurately reflect the partners’ economic agreement.

According to these regulations, an allocation set forth in a partnership agreement shall be respected by the IRS if the allocation has substantial economic effect or, if taking into account all of the facts and circumstances, the allocation is in accordance with the partners’ interests in the partnership.

Economic Effect

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 economic burden that corresponds to the allocation, the partner to whom an allocation is made must receive such economic benefit or bear such economic burden. Stated differently, tax must follow economics.

In general, an allocation will have economic effect if the partnership agreement provides for the determination and maintenance of the partners’ capital accounts in accordance with the rules set forth in the regulations and, upon the liquidation of the partnership (or of a partner’s interest in the partnership), liquidating distributions are made in accordance with the positive capital account balances of the partners, as determined after taking into account all capital account adjustments. In other words, a partner’s capital account will generally reflect the partner’s equity in the partnership.

Basically, the capital account rules require that a partner’s capital account be increased by (1) the amount of money contributed by him to the partnership, (2) the fair market value (“FMV”) of property contributed by him to the partnership (net of liabilities that the partnership is considered to assume or take subject to), and (3) allocations to him of partnership income and gain; and is decreased by (4) the amount of money distributed to him by the partnership, and (5) the FMV of property distributed to him by the partnership (net of liabilities that such partner is considered to assume or take subject to), and (6) allocations to him of partnership loss and deduction.

Revaluation of Property

It should be noted that the capital account rules generally do not require that the partners’ capital accounts be adjusted on an ongoing basis to reflect changes in the FMV of the partnership’s assets.

However, the rules do require that the capital accounts be adjusted to reflect a revaluation of partnership property on the partnership’s books upon the happening of certain enumerated events. In general, these adjustments are based upon the FMV of partnership property on the date of the adjustment.

These adjustments reflect the manner in which the unrealized gain inherent in such property (that has not been reflected in the capital accounts previously) would be allocated among the partners if there were a taxable disposition of such property for its FMV on the date of a “revaluation event.”

In general, a revaluation event is one that marks a change in the economic arrangement among the partners. Among these events is the contribution of money or other property (other than a de minimis amount) to the partnership by a new or existing partner as consideration for an interest in the partnership. The adjustments are made among the capital accounts of the existing partners in accordance with their existing economic agreement, just prior to the above-referenced change.

In this way, the capital accounts will reflect the amount to which each existing partner would have been entitled had the partnership been liquidated immediately prior to the admission of the new partner and the change in the partners’ economic agreement.

Grandson:      Hold it, hold it! What is this? Are you tryin’ to trick me?

   Where’s the [estate tax]? Is this a [partnership tax post?]

Grandfather:  Wait, just wait.

Grandson:     Well when does it get good?

– from “The Princess Bride” (mostly)

Book-Tax Difference

When partnership property is revalued under these rules, and the partners’ capital accounts are adjusted accordingly, the gain computed for book purposes with respect to such property will differ from the gain computed for tax purposes for such property; in other words, the book value of the property reflected in the now-adjusted capital accounts will differ from the tax basis of such property (which was not adjusted in connection with the revaluation).

Consequently, the partners’ shares of the corresponding tax items – such as the gain on the sale of the property – are not reflected by further adjustments to the capital accounts, which have already been adjusted as though a sale had occurred.

Rather, these tax items must be shared among the partners in a manner that takes account of the variations between the adjusted tax basis of the property and its book value. Otherwise, the allocation may not be respected by the IRS.

Illustration

Perhaps the best way to convey the import of the foregoing rules is with an example.

Facts

Assume dad Abe and son Ben form an equal partnership to which each contributes $10,000 cash (which is credited to their respective capital account; each has a capital account of $10,000). This $20,000 is invested in securities (the book value and the tax basis of the securities are both $20,000). Assume that the partnership breaks even on an operational basis (no profit, no loss; no change to capital accounts), and that the securities appreciate in value to $50,000.

At that point, grandson Cal joins the partnership, making a $25,000 cash contribution in exchange for a one-third interest (an amount equal to one-third of the FMV of the partnership ($75,000) immediately after his capital contribution). Assume that the cash is held in held in a bank account.

Revaluation; Account for Book-Tax Difference

Upon Cal’s admission to the partnership – a revaluation event – the capital accounts of Abe and Ben are adjusted upward (from $10,000 to $25,000, each: $50,000 FMV of securities minus book value of $20,000 = $30,000 gain, or $15,000 each) to reflect their shares of the unrealized appreciation in the securities that occurred before Cal was admitted to the partnership.

Immediately after Cal’s admission, the securities are sold for $50,000, resulting in taxable gain of $30,000 ($50,000 less tax basis of $20,000), and no book gain (because the capital accounts had already been adjusted to FMV to reflect the appreciation; $50,000 less $50,000 = zero). Because there is no gain for book purposes, the allocation of the taxable gain cannot have economic effect (tax is unable to follow book in that situation).

Unless the partnership agreement provides that the tax gain will be allocated so as to account for the variations between the adjusted tax basis of the securities and their book value – by allocating the $30,000 of tax gain to Abe and Ben ($15,000 each), to whom the economic benefit of the appreciation “accrued” prior to Cal’s admission (tax to follow economics, as reflected in the adjusted capital accounts) – the IRS may not accept the allocation.

No Revaluation, but Special Allocation

Alternatively, assume that the capital accounts of Abe and Ben are not adjusted upon Cal’s admission to reflect the $30,000 of appreciation in the partnership securities that occurred before Cal was admitted.

Rather, the partnership agreement is amended to provide that the first $30,000 of taxable gain upon the sale of the securities is allocated equally between Abe and Ben, and that all other gain (appreciation occurring after Cal’s admission) will be allocated equally among all three partners, including Cal.

These allocations of taxable gain have economic effect; tax will follow book. Moreover, the capital accounts of Abe and Ben will in effect be adjusted upon the sale (by $15,000 each, to $25,000 each) to reflect the appreciation inherent in the securities immediately prior to Cal’s admission.

No Revaluation, no Special Allocation – Gift?

If the capital accounts of Abe and Ben are not adjusted upon Cal’s admission, and the partnership agreement provides for all taxable gain (including the $30,000 attributable to the appreciation in the securities that occurred prior to Cal’s admission to the partnership) to be allocated equally among Abe, Ben and Cal ($10,000 each), the allocation will have economic effect (tax will follow book). In that case, Abe and Ben will each have a capital account of $20,000 (instead of $25,000 as above), while Cal will have a capital account of $35,000 (instead of $25,000 as above).

However, the partners will have to consider whether, and to what extent, a gift may have been made to Cal in that his capital account is allocated one-third of the appreciation ($10,000 of the $30,000) that occurred prior to his admission.

As always, query whether this same result would have followed if Cal had not been related to Abe and Ben. After all, why would someone allow value that accrued on their investment, to inure to the benefit of another?

Let’s Be Careful Out There (from “Hillstreet Blues”)

The foregoing may not be easy to digest, but anyone who purports to provide estate and gift tax advice to the members of a family-owned business or investment vehicle that is formed as a tax partnership must realize that there is nothing simple about the taxation of such an entity.

Whether we are talking about the disguised sale rules, the shifting of liabilities, hot assets, the mixing bowl rules or, as in this post, the capital account revaluation rules, there are many pitfalls. The provisions of a partnership agreement, including the revaluation rule, that are so often described as “boilerplate” are anything but, and the partnership’s advisers must be familiar with their purpose and application.

It is imperative that the partnership agreement be reviewed periodically, especially in connection with the admission or withdrawal of a partner. In this way, the tax and economic consequences of such an event may be anticipated and, if possible, any adverse results may be addressed or avoided.

“When will they ever learn?”

No, I am not channeling Seeger. I am referring to those individuals[i] who continue to acquire real property (“RP”) in, or who contribute RP to, corporations. In just the last couple of months, I have encountered taxpayers who want to remove RP from the closely held corporations in which they are shareholders. Of course, they want to do so on a “tax efficient” basis. Their reasons for removing the property are varied.

In one case, for example, the shareholders want to dispose of the business that also resides in the corporation; they want to do so by selling their shares of stock in the corporation, so as to avoid the two levels of tax that would result from a sale of the corporation’s assets; however, they also want to retain ownership of the RP.

In another, the shareholders want to withdraw some of their equity from the RP in the form of a distribution from the corporation.

In yet another, the two shareholders want to go their separate ways, each of them taking one of the RPs owned by the corporation.

There are others. In each case, the shareholders have come to realize – for the reasons set forth below – that they should not have used a corporation to hold their RP.

In the Beginning

A taxpayer who contributes RP to a corporation in exchange for shares of stock in the corporation will be taxable on the gain realized in such exchange unless the taxpayer – alone, or in conjunction with others are also contributing a not insignificant amount of money or other property to the corporation in exchange for shares – owns at least 80% of the total combined voting power of all classes of stock entitled to vote and at least 80% of the total number of other all other classes of stock of the corporation immediately after the exchange. It may not be possible for a taxpayer to attain this level of control – and the desired tax deferral –when he is seeking to become a shareholder of an established corporation.

This should be contrasted with a contribution of property to a partnership (or to an LLC that is treated as a partnership for tax purposes). In that case, the contributor is not required to attain a specific level of ownership in order to avoid gain recognition on the contribution of the RP to the partnership in exchange for a partnership interest.

However, the contributor must be attuned to the partnership “disguised sale” rules, which may treat the contributor as having sold all or some of the RP to the partnership; for example, where he mortgages the RP to withdraw equity therefrom just prior to contributing the RP (subject to the indebtedness) to the partnership.

The contributor must also be careful of “shifting” liabilities, as where he contributes mortgaged property to a partnership; if the contributor is not personally liable for the indebtedness, it will be “re-allocated” among all the partners, and he will be treated as receiving a distribution of money that may be taxable to him. .

“Day by Day” Operations

Where the RP is held in a C corporation, the corporation, of course, enjoys the benefits and burdens of ownership. If the property is leased to another, the corporation includes the rent in its gross income; it also claims the associated depreciation and other expenses in determining its taxable income. After satisfying its tax liability, the corporation may pay a dividend to its shareholders, which will be taxable to them.

If the shareholders elect to treat the corporation as an S corporation, the corporate-level tax may be avoided, the corporation’s taxable income will be passed through and taxed to its shareholders, the basis for their shares will be adjusted upward to reflect this income, and the distribution of the corporation’s net income should not generate additional tax to the shareholders.

In order to qualify as an S corporation, however, the corporation will be limited as to who may have hold its stock; for example, another corporation, a partnership, and a nonresident alien cannot own shares of stock in an S corporation.

In addition, an S corporation may have only one class of stock, meaning that each outstanding share must have the same rights to current and liquidating distributions as every other share; no preferred interests are permitted.

Thus, an S corporation is severely limited in its capitalization choices.

Finally, if an S corporation was formerly a C corporation, and has accumulated earnings and profits from its C corporation tax years, the S corporation will be subject to a 35% corporate-level excise tax on a portion of its rental income if the gross receipts from such rental activity constitute “passive investment income” and they exceed 25% of the S corporation’s total gross receipts. The corporation will even lose its “S” election if this situation continues for three consecutive tax years, in which case the corporation will generally not be eligible to re-elect “S” status for a period of five years.

In contrast, a partnership is not subject to an entity-level income tax, its profits are taxed directly to its owners and may be withdrawn by them without additional tax (to the extent the money withdrawn does exceeds a partner’s adjusted basis for his partnership interest), the partnership is not limited as to the nature or the number of its owners, and it can provide for any manner of profit allocation among its partners, including preferred and carried (“promote”) interests, provided such allocation has substantial economic effect.

Refinancing

Once a RP has reached a certain level of equity (fair market value over mortgage balance), it is not uncommon for the owner of the RP to access the increased equity – without having to sell the RP – by refinancing the existing indebtedness; the owner borrows more than the amount of the existing indebtedness, replaces that indebtedness, and withdraws the balance. Because the money that the owner has “cashed out” must eventually be repaid, the owner do not have a taxable event.

As we saw a few weeks ago, this approach to withdrawing equity from RP on a tax efficient basis works well when the property is held by a partnership. Unfortunately, the same cannot be said when a corporation owns the property.

Of course, the corporation, itself, can withdraw the increased equity from its RP through a refinancing without tax consequences. However, what happens when the corporation then distributes this cash to its shareholders? In the case of a C corporation, the amount distributed is treated as a dividend to the extent of the corporation’s current and accumulated earnings and profits; the balance is then treated as a tax-free return of capital to the extent of each shareholder’s basis for his shares of stock; any remaining portion of the distribution is taxable to the shareholders as gain from the sale of their stock.

In the case of an S corporation with no C corporation earnings and profits, the amount distributed is first applied against a shareholder’s adjusted basis for his shares, and any excess is treated as gain from the sale of such shares. Unlike the partners of a partnership, the S corporation shareholders do not receive an increased basis in their shares of corporate stock as a result of the refinancing, even if they personally guarantee the corporation’s indebtedness.

Disposition of the Property

There may come a time when the RP is sold. In the case of a C corporation, that means a corporate-level tax followed by a taxable liquidating distribution to its shareholders.

There is also a corporate-level tax where an S corporation that is subject to the built-in gain rules sells its RP within the recognition period (the 5-year period beginning with the first day of the first taxable year for which the corporation was an S corporation).

Where the S corporation was always an S corporation, and did not acquire the RP from a C corporation in a tax-free exchange, there is no corporate-level tax, and the gain from the sale is taxed to its shareholders. The subsequent distribution of the net proceeds from the sale may be taxable to a shareholder to the extent it exceeds his stock basis (as adjusted for his pro rata share of the gain from the sale of the property).

Again, in the case of a partnership, there is no entity-level tax, its partners are taxed on their pro rata share of the gain recognized on the sale (though the partner who contributed the disposed-of RP may receive a special allocation of taxable gain based upon the gain inherent in the RP at the time it was contributed to the partnership), and a partner may recognize additional taxable gain to the extent the amount of cash distributed to the partner exceeds his basis for his partnership interest (as adjusted for his pro rata share of the gain from the sale of the property).

What if the disposition is to take the form of a like kind exchange? In that case, the taxpayer that sells the “relinquished property” must also acquire the “replacement property;” thus, a corporation-seller must acquire the replacement property – there is no opportunity for a single shareholder to participate in such an exchange if most of the shareholders have no interest in doing so.

In the case a partnership, however, the partnership and one or more partners may be able to engage in a so-called “drop and swap” – by making a non-taxable in-kind distribution of a tenancy-in-common interest in the RP to one or more partners – thus enabling either the partnership or the distributee partners to participate in a like kind exchange.

Distribution of the Property

What if the RP is not to be sold? What if it is to be distributed by the entity to one or more of its owners?

In general, a corporation’s distribution of appreciated RP to its shareholders is treated as a sale of the property by the corporation, with the usual corporate tax consequences. In addition, the shareholders will be taxed upon their receipt of the property, either as a dividend or as an exchange, depending on the circumstances.

Where the corporation is an S corporation, and the RP will be depreciable in the hands of the shareholders, the gain realized on the deemed sale of the RP may be treated as ordinary income and taxed to the shareholders as such.

There is an exception where the corporation’s activity with respect to the RP rises to the level of an “active trade or business.” In that case, the actively-conducted RP business, or another active business being conducted by the corporation, may be contributed to a subsidiary corporation, the stock of which may then be distributed to one or more shareholders on a tax-deferred basis. Unfortunately, if the RP is owner-occupied, the corporation will generally not be able to establish the existence of such an active business. Moreover, the corporation will have to be engaged in a second active business.

In general, a distribution of property by a partnership to its partners will not be treated as a taxable disposition; thus, the partnership may be able to distribute a RP to a partner in liquidation of his interest, or it may split up into two or more partnerships with each taking a different property, without adverse tax consequences. There are some exceptions.

For example, if RP is distributed within seven years of its having been contributed to the partnership, its distribution to a partner other than the contributor will be treated as a taxable event as to the contributor-partner. If a contributor- partner receives a distribution of RP within seven years of his in-kind contribution of other property to the partnership, the distribution will be treated as a taxable event as to the contributor-partner.

In addition, the so-called “disguised sale” rules may cause a distribution of RP to be treated as a sale of the property; for example, where the partnership encumbers the RP with a mortgage (a “non-qualified liability”) just before distributing the RP to the partner who assumes or takes subject to the mortgage.

Even where the disguised sale rules do not apply, a distribution of RP may be treated, for tax purposes, as including a cash component where the distributee partner is “relieved” of an amount of partnership debt that is greater than the amount of debt encumbering the RP.

“Choose Wisely You Must” – Yoda

The foregoing represents a simple outline of the tax consequences that must be considered before a taxpayer decides to acquire or place RP in a corporation or in a partnership.

There may be other, non-tax, considerations that also have to be factored into the taxpayer’s thinking, and that may even outweigh the tax benefits.

All-in-all, however, a closely held partnership is a much more tax efficient vehicle than a corporation for holding, operating, and disposing of real property.

Yes, some of the tax rules applicable to partnerships are complicated, but that should not be the decisive factor. Indeed, with proper planning, these rules can negotiated without adverse effects, and may even be turned to one’s advantage.

 

 

[i] This post focuses on U.S. persons. Different considerations may apply to foreign persons. See http://www.taxlawforchb.com/?s=foreign

Some lessons need to be repeated until learned. It’s a basic rule of life. Don’t tug on Superman’s cape; don’t spit into the wind; don’t pull the mask off that old Lone Ranger; and if you are going to make a loan, give it the indicia of a loan and treat it as a loan.

The last of these lessons appears to be an especially difficult one for many owners of closely held businesses, at least based upon the steady flow of Tax Court cases in which the principal issue for decision is whether an owner’s transfer of funds to his business is a loan or a capital contribution.

The resolution of this question can have significant tax and economic consequences, as was illustrated by a recent decision.

Throwing Good after Bad

Corp had an unusual capital structure. It had about 70 common shareholders, including key employees and some of Taxpayer’s family members, but common stock formed a very small portion of its capital structure. Indeed, although Taxpayer was Corp’s driving force, he owned no common stock. Corp’s primary funding came in the form of cash advances from Taxpayer.

Over several years, Taxpayer made 39 separate cash advances to Corp totaling millions of dollars. For each advance, Corp executed a convertible promissory note, bearing market-rate interest that Corp paid when due.

Taxpayer subsequently advanced a few more millions, of which only a small portion was covered by promissory notes, Corp recorded all these advances as loans on its books, and it continued to accrue interest, though no interest was paid on any of this purported indebtedness.

After a few years, the entirety of this purported indebtedness was converted to preferred stock (the “Conversion”), representing 78% of Corp’s capital structure.

Taxpayer then made additional cash advances to Corp which were Corp’s sole source of funding during this period. Taxpayer generally made these advances monthly or semi-monthly in amounts sufficient to cover Corp’s budgeted operating expenses for the ensuing period.

Corp executed no promissory notes for these advances and furnished no collateral. As before, it recorded these advances on its books as loans and accrued interest, but it never paid interest on any of this purported indebtedness. These advances, coupled with Taxpayer’s preferred stock, constituted roughly 92% of Corp’s capital structure.

Corp incurred substantial losses during most years of its existence. This fact, coupled with Corp’s inability to attract other investors or joint venture suitors, caused Taxpayer to question the collectability of his advances. He obtained an independent evaluation of Corp’s financial condition, and was informed that Corp’s condition was precarious: Its revenue was 98% below target, and it had massive NOLs. Without Taxpayer’s continued cash infusions, he was told, the company would have to fold.

Taxpayer discussed with his accountant the possibility of claiming a bad debt loss deduction for some or all of his advances. Taxpayer took the position that all of his advances were debt and that the advances should be written off individually under a “first-in, first-out” approach.

Taxpayer’s attorney prepared a promissory note to consolidate the still-outstanding advances that Taxpayer did not plan to write off. While these documents were being prepared, Taxpayer made additional monthly advances to Corp. Taxpayer and Corp executed a debt restructuring agreement, a consolidated promissory note, and a certificate of debt forgiveness, all of which were backdated to a date after the Conversion.

Corp continued to operate with Taxpayer continuing to advance millions which, again, were not evidenced by promissory notes.

Taxpayer filed his Federal income tax return on which he reported a business bad debt loss reflecting the write-down of his advances to Corp. According to Taxpayer, this loss corresponded to advances he had made after the Conversion. Taxpayer claimed this loss as a deduction against ordinary income.

Business Bad Debt

The IRS disallowed the business bad debt deduction, and issued a notice of deficiency. Taxpayer petitioned the Tax Court.

The Code allows as an ordinary loss deduction for any “bona fide” business debt that became worthless within the taxable year. A business debt is “a debt created or acquired in connection with a trade or business of the taxpayer” or “a debt the loss from the worthlessness of which is incurred in the taxpayer’s trade or business.” To be eligible to deduct a business bad debt, an individual taxpayer must show that he was engaged in a trade or business, and that the debt was proximately related to that trade or business.

A bona fide debt is one that arises from “a debtor-creditor relationship based upon a valid and enforceable obligation to pay a fixed or determinable sum of money.” Whether a purported loan is a bona fide debt for tax purposes is determined from the facts and circumstances of each case, including the purported creditor’s reasonable expectation that the amount will be repaid.

Advances made by an investor to a closely held or controlled corporation may properly be characterized, not as a bona fide loan, but as a capital contribution. In general, advances made to an insolvent debtor are not debts for tax purposes, but are characterized as capital contributions.

The principal issue for decision was whether Taxpayer’s advances to Corp constituted debt or equity.

Bona Fide Debt

Taxpayer asserted that all of his advances to Corp constituted bona fide debt, whereas the IRS contended that Taxpayer made capital investments in his capacity as an investor. In determining whether an advance of funds constitutes bona fide debt, the Court stated, “economic reality provides the touchstone.”

The Court began by noting that, if an outside lender would not have lent funds to the corporation on the same terms as did the insider, an inference arises that the advance was a not a bona fide loan, even if “all the formal indicia of an obligation were meticulously made to appear.”

In general, the focus of the debt-vs.-equity inquiry is whether the taxpayer intended to create a debt with a reasonable expectation of repayment and, if so, whether that intent comports with creating a debtor-creditor relationship. The key to this determination is generally the taxpayer’s actual intent.

The Court identified the following nonexclusive factors to examine in determining whether an advance of funds gives rise to bona fide debt as opposed to an equity investment:

Labels on the Documents

If a corporation issues a debt instrument, such as a promissory note, that labeling supports the debt characterization.

Corp issued promissory notes for some of the cash advances Taxpayer made before the Conversion, those notes were converted to preferred stock and were not before the Court. The amount that was before the Court was advanced after the Conversion, and Corp did not issue a single promissory note to cover any of those advances. Rather, Taxpayer advanced cash on open account.

It was only in connection with the write-down that Corp issued a promissory note to Taxpayer to consolidate the portion of his advances that he chose not to write off, backdated to an earlier time. The Court found that this document was a self-serving document created in connection with Taxpayer’s year-end tax planning.

Fixed Maturity Date

A fixed maturity date is indicative of an obligation to repay, which supports characterizing an advance of funds as debt. Conversely, the absence of a fixed maturity date indicates that repayment depends on the borrower’s success, which in turn supports characterization as equity.

Because Corp issued no promissory notes for any of the advances at issue, there was of necessity no fixed maturity date.

Source of Payments

Where repayments depend on future corporate success, an equity investment may be indicated. And where prospects for repayment are questionable because of persistent corporate losses, an equity investment may be indicated.

Corp had substantial losses, its expenses vastly exceeded its revenue for all relevant years, and no payments of principal or interest had been made on Taxpayer’s still-outstanding advances. Corp was kept afloat only because Taxpayer continued to provide regular cash infusions keyed to Corp’s expected cash needs for the ensuing period. Thus, the most likely source of repayment of Taxpayer’s advances would be further cash infusions from Taxpayer himself.

Taxpayer testified that he hoped to secure ultimate repayment upon sale of Corp to a third party or a third-party investment in Corp. But this, the Court countered, is the hope entertained by the most speculative types of equity investors. Taxpayer was a “classic capital investor hoping to make a profit, not a creditor expecting to be repaid regardless of the company’s success or failure.”

Right to Enforce Payment of Principal and Interest

A definite obligation to repay, backed by the lender’s rights to enforce payment, supports a debt characterization. A lack of security for repayment may support equity characterization.

Although Taxpayer’s advances were shown as loans on Corp’s books, there was no written evidence of indebtedness fixing Corp’s obligation to repay at any particular time. None of Taxpayer’s advances was secured by any collateral. And even if Taxpayer were thought to have a “right to enforce repayment,” that right was nugatory because his continued cash infusions were the only thing keeping Corp afloat. Had he enforced repayment, he would simply have had to make a larger capital infusion the following month.

Participation in Management

Increased management rights, in the form of greater voting rights or a larger share of the company’s equity, support equity characterization.

Although Taxpayer had de facto control, he literally owned no common stock. But through his cash advances and preferred stock he held about 92% of Corp’s capital. Taxpayer contended that none of his advances gave him increased voting rights or a larger equity share. This was literally true, but it meant little because he already had complete control of the company by virtue of his status as its sole funder.

Status Relative to Regular Creditors

If Taxpayer had subordinated his right to repayment to that of other creditors, that would have supported an equity characterization.

However, Taxpayer was the only supplier of cash to Corp, which borrowed no money from banks and had no “regular creditors.” Taxpayer had, in absolute terms, none of the rights that a “regular creditor” would have; there was no promissory note, no maturity date, no collateral, no protective covenant, no personal guaranty, and no payment of interest. No “regular creditor” would have lent funds to a loss-ridden company like Corp on such terms.

Parties’ Intent

The Court examined whether Taxpayer and Corp intended the advance to be debt or equity. The aim is to determine whether the taxpayer intended to create a “definite obligation, repayable in any event.”

Taxpayer’s actions suggested that he intended the advances to be equity. He did not execute promissory notes for any of the advances at issue. He received no interest on his advances and made no effort to collect interest or enforce repayment of principal. Although Corp recorded the advances as loans and accrued interest on them, Taxpayer’s control over the company gave him ultimate discretion to decide whether and how repayment would be made. In fact, he expected to be repaid, as a venture capitalist typically expects to be repaid, upon sale of Corp to a third party or a third-party investment in Corp.

Inadequate Capitalization

A company’s capitalization is relevant to determining the level of risk associated with repayment. Advances to a business may be characterized as equity if the business is so thinly capitalized as to make repayment unlikely.

Taxpayer urged that, after the Conversion, the bulk of Corp’s capital structure consisted of preferred stock. He accordingly insisted that Corp was adequately capitalized at the time he made later advances.

The Court disagreed with Taxpayer’s assessment of the situation, observing that he made dozens of cash advances totaling many millions of dollars, and did not receive promissory notes until he decided to write off a portion of the purported debt.

Moreover, the Court continued, while Corp’s capitalization may have been adequate, that fact was not compelling. Normally, a large “equity cushion” is important to creditors because it affords them protection if the company encounters financial stress: The creditors will not be at risk unless the common and preferred shareholders are first wiped out. But because Taxpayer himself supplied almost 100% of Corp’s “equity cushion,” he would not derive much comfort from the latter prospect.

Identity of Interest between Creditor and Sole Shareholder

Taxpayer was not Corp’s sole shareholder, but he controlled the company and during the relevant period owned between most of Corp’s capital structure. There was thus a considerable identity of interest between Taxpayer in his capacities as owner and alleged lender. Under these circumstances, there was not a “disproportionate ratio between * * * [the] stockholder’s ownership percentage and the corporation’s debt to that stockholder.”

Payment of Interest

If no interest is paid, that fact supports equity characterization. Corp made no interest payments on any of the advances that Taxpayer made after the Conversion.

Ability to Obtain Loans From Outside Lending Institutions

Evidence that the business could not have obtained similar funding from outside sources supports characterization of an insider’s advances as equity. Although lenders in related-party contexts may offer more flexible terms than could be obtained from a bank, the primary inquiry is whether the terms of the purported debt were a “patent distortion of what would normally have been available” to the debtor in an arm’s-length transaction.

The evidence was clear that no third party operating at arm’s length would have lent millions to Corp without insisting (at a minimum) on promissory notes, regular interest payments, collateral to secure the advances, and a personal guaranty from Taxpayer. Especially is that so where the purported debtor was losing millions a year and could not fund its operations without Taxpayer’s monthly cash infusions.

Corp’s financial condition was extremely precarious in every year since its inception. The IRS determined that Corp had an extremely high risk of bankruptcy and that, without Taxpayer’s continued advances, it would surely have ceased operations. Under these circumstances, no third-party lender would have lent to Corp on the terms Taxpayer did.

In addition, Taxpayer continued to advance funds to Corp even after he concluded that its financial condition was dire enough to justify writing off some of his advances. An unrelated lender would not have acted in this manner.

After evaluating these factors as a whole, the Court found that Taxpayer’s advances were equity investments and not debt. Thus, it disallowed the Taxpayer’s business bad debt deduction.

Lesson

The proper characterization of a transfer of funds is more than a metaphysical exercise enjoyed by tax professionals. It has real economic consequences. In the Taxpayer’s case, it meant the loss of a deduction against ordinary income. Whether out of ignorance, laziness, or negligence, many business owners continue to act somewhat cavalierly toward the characterization and tax treatment of fund transfers to their business.

This behavior begs the question: “Why?” Why, indeed, when the owner can dictate the result by following a simple lesson: a promissory note, consistent bookkeeping, accrual and regular payment of interest at the AFR. C’mon guys.

Setting the Stage

Over the last couple of months, I’ve encountered several situations involving the liquidation of a partner’s interest in a partnership. Years before, the partnership had borrowed money from a third party lender in order to fund the acquisition of equipment or other property. During the interim period, preceding the liquidation of his interest, the departing partner had been allocated his share of deductions attributable to the debt-financed properties, which presumably reduced his ordinary income and, thus, his income tax liability.

The departing partner negotiated the purchase price for his interest based upon the liquidation value of his equity in the partnership. Imagine his surprise when he learned (i) that his taxable gain would be calculated by reference not only to the amount of cash actually distributed to him (the amount he negotiated), but would also include his “share” of the partnership’s remaining indebtedness, and (ii) that the amount of cash he would actually receive would just barely cover the resulting tax liability.

A recent decision by the Tax Court illustrated this predicament, and much more.

The End of a Partnership

Prior to Taxpayer’s admission as a partner, Partnership had entered into a lease for office space and had borrowed funds from Lender I for leasehold improvements.

Subsequently, Taxpayer joined Partnership as a general partner. Upon joining Partnership, Taxpayer did not sign a partnership agreement. At some point after Taxpayer joined the Partnership, the Partnership entered into a line of credit loan arrangement with Lender II.

Partnership dissolved in Year One. Upon Partnership’s dissolution, the Partnership began to wind up its affairs by collecting accounts receivable and settling pending lawsuits brought against the Partnership by its lenders and landlord.

In order to create a fund out of which to make partial payments to settle with the aforementioned creditors, Partnership’s former partners signed a settlement agreement pursuant to which Taxpayer agreed to pay a fixed dollar amount, constituting X% of the Partnership settlement fund. The settlement agreement included a provision entitled “Special Tax Allocation,” which provided:

In recognition of the contribution by each of the various Partners to the settlement of the Lawsuits, to each Partners’ allocation of income and loss for the year in which the [settlement] occurs shall be credited the percentage of loss created by the settlement and satisfaction of the Lawsuits equal to the pro-rata contribution by such Partner to the fund created by the terms of this Agreement. It is specifically recognized that this is a special allocation of losses made by the Partners in recognition of the contributions to the settlement of the Lawsuits and in lieu of and in substitution for the allocation of losses pursuant to the respective interests of the Partners in the [Partnership].

In Year Two, Partnership’s former partners entered into settlement agreements with each of its Lenders, pursuant to which Partnership agreed to pay a portion of the outstanding indebtedness to settle its debts, and the Lenders forgave their remaining balance.

Partnership filed Forms 1065, U.S. Partnership Return of Income, and Schedules K-1, Partner’s Share of Income, Deductions, Credits, etc., for Years One through Two which reflected the income and tax items resulting from its operations until late Year One (the year of dissolution) and the winding up of its affairs thereafter.

Taxpayer received a Schedule K-1 from Partnership for Year One, and another for Year Two, and reported his share of Partnership income and other tax items as reflected on the Schedules K-1 on his personal income tax returns.

Taxpayer’s Year Two return reported a nonpassive loss from Partnership, but it did not report any cancellation of indebtedness income from Partnership; nor did it report any capital gains.

Some Basic Partnership Tax Concepts

In general, a partner’s adjusted basis (“investment” for our purposes) in his partnership interest reflects the amount of cash contributed by the partner to, or left in the partnership by, the partner.

Income

A partner must recognize his distributive share of partnership income regardless of whether the partnership makes any distribution to the partner. The amount of income so recognized is reflected as an increase in the partner’s adjusted basis in his partnership interest.

Distributions

A partnership’s distribution of cash to a partner (representing, perhaps, already-taxed income, or capital contributions) reduces the partner’s adjusted basis in his partnership interest. If a cash distribution exceeds the partner’s adjusted basis in his interest, the excess amount is taxable to the partner. Thus, a partner may withdraw cash from a partnership without realizing any income or gain to the extent of his adjusted basis.

Losses

A partner can deduct his distributive share of partnership loss to the extent of his adjusted basis in his partnership interest at the end of the partnership’s tax year in which the loss occurred (one cannot lose more than one has “invested”); in general, his adjusted basis reflects the amount of cash contributed by the partner to, or left in the partnership by, the partner.

Borrowed Funds

When an individual borrows money, he does not realize any income; the loan proceeds do not represent an accretion in value to the individual. However, the individual may use the borrowed funds to pay expenses for which he may claim a deduction, or he may use them to acquire an asset for which he may claim depreciation deductions.

As a pass-through entity, a partnership tries to mirror these tax consequences of borrowing by its partners. Thus, when a partnership borrows money, the indebtedness is “allocated” among the partners, as though they had borrowed the funds and then contributed them to the partnership, thereby increasing each partner’s adjusted basis by his share of the partnership indebtedness. By doing so, the partners may withdraw the borrowed funds from the partnership without recognition of income (reducing their adjusted basis in the process), and may claim deductions for expenses paid with the borrowed funds, or for depreciation deductions with respect to property acquired with the borrowed funds.

Similarly, any increase in a partner’s share of partnership liabilities is treated, for tax purposes, as a contribution of money by the partner to the partnership, thereby increasing the partner’s basis in his partnership interest.

Conversely, any decrease in a partner’s share of partnership liabilities is treated as a distribution of money by the partnership to the partner. If the amount of this decrease exceeds the partner’s adjusted basis in his partnership interest, the partner will recognize gain to the extent of the excess.

IRS Audit

After examining Taxpayer’s returns, the IRS issued a notice of deficiency to Taxpayer, relating to Year Two, in which it: disallowed the Partnership loss deductions claimed; determined that Taxpayer failed to report his distributive share of Partnership’s discharge of indebtedness income; and determined that Taxpayer failed to report capital gain stemming from the deemed distribution of cash in excess of Taxpayer’s basis in his Partnership interest.

Cancellation of Debt

According to the IRS, Partnership’s settlement of its indebtedness to its Lenders, with a partial payment, resulted in cancellation of indebtedness income for the balance; it eliminated the Partnership’s outstanding liabilities.

Reduced Share of Debt

As a result of these transactions, the IRS contended that Taxpayer had to include in income his X% share of Partnership’s discharge of indebtedness income.

The IRS also argued that there had been a deemed distribution of cash to Taxpayer in an amount equal to the canceled Partnership liabilities previously allocated to Taxpayer on his Schedule K-1. According to the IRS, this deemed distribution exceeded Taxpayer’s adjusted basis in his Partnership interest and triggered a capital gain in an amount equal to the excess, which Taxpayer had to include in income.

Insufficient Basis for Deductions

Finally, the IRS contended that because Taxpayer had no remaining basis in his Partnership interest with which to absorb his distributive share of Partnership loss for Year Two, Taxpayer was not entitled to the deduction he claimed, and had to increase his income accordingly.

Tax Court’s Analysis

Taxpayer petitioned the Tax Court to review the IRS’s determinations.

COD Income

The Court explained that gross income generally includes income from the discharge of indebtedness; when realized by a partnership, such income must be recognized by its partners as ordinary income. The recognition of such income provides each partner with an increase in the adjusted basis in his partnership interest.

Under the settlement agreement, each partner, including Taxpayer, agreed that his distributive share of Partnership income and loss for Year Two would be calculated according to the percentage of funds that each had contributed towards the settlement fund. Taxpayer contributed X% of the total; thus, Partnership allocated X% of its discharge of indebtedness income to Taxpayer on his Schedule K-1.

Taxpayer made several arguments in an attempt to avoid the allocation of this income, but the Court found they had no merit, stating that the basic principle that partners must recognize as ordinary income their distributive share of partnership discharge of indebtedness income was well-established, even as to nonrecourse debts for which no partner bears any personal liability.

In sum, Taxpayer had to recognize his X% distributive share of Partnership’s discharge of indebtedness income for Year Two, thereby increasing Taxpayer’s adjusted basis in his Partnership interest to that extent.

Deemed Cash Distribution

The Court next determined that there was a deemed cash distribution to Taxpayer as a result of the elimination of Partnership’s outstanding liabilities during Year Two when it settled with its creditors, which “relieved” Taxpayer of his share of the partnership’s liabilities. Therefore, Taxpayer received a deemed distribution of cash from Partnership in an amount equal to his share of the liabilities.

Because this deemed distribution exceeded Taxpayer’s adjusted basis in his Partnership interest, Taxpayer was required to recognize capital gain in the amount of the excess.

No Basis? No Deduction

Finally, having determined that Taxpayer had no remaining basis in his Partnership interest as of the end of Year Two, the Court concluded that Taxpayer was not entitled to deduct his share of partnership losses for that year.

Lessons?

One often hears about the “phantom income” realized by a departing partner when his partnership has outstanding indebtedness, part of which was allocated to him, and is then deemed distributed to him in liquidation of his interest.

Many partners equate “phantom” with “unfair,” which is itself unfair, and inaccurate. In fact, the deemed cash distribution that is attributable to the departing partner’s share of partnership indebtedness results in gain to the partner only to the extent he previously received a “tax-free” distribution of the loan proceeds or was allocated partnership deductions or losses attributable to the partnership’s use of the borrowed funds. A more accurate description, therefore, may be that the departing partner is forced to recapture the tax benefit previously realized.

Theory and semantics aside, though, can the departing partner reduce or defer any of the adverse tax consequences described above? Maybe.

For example, a partner to whom income is allocated from the cancellation of a partnership’s indebtedness may be able to exclude the income if he – not the partnership – is insolvent at the time of the discharge.

As regards the deemed distribution of cash resulting from a former partner’s share partnership indebtedness, the distribution may be deferred so long as the partner remains a partner for tax purposes (for example, where his interest is being liquidated in installments). The amount of the deemed distribution may also be reduced if the partner receives an in-kind liquidating distribution of encumbered property, thereby resulting in a netting of the “relieved” and “assumed” liabilities, with only the net amount relieved being treated as a cash distribution.

The key, as always, is to analyze and understand the tax, and resulting economic, consequences of a liquidation well in advance of any negotiations. You cannot bargain for something of which you are unaware.

Oops?

Are you a member of a partnership or of a limited liability company that is treated as a partnership for tax purposes (a “partnership”)? Did your partnership file its 2016 tax return late this year? How about K-1s? Were these forms issued late to its partners? Then this post may be for you.

Late last week, the IRS issued guidance providing penalty relief for certain partnerships that did not file the required tax return, on IRS Form 1065 (“U.S. Return of Partnership Income”), or issue Schedule K-1s (“Partner’s Share of Income, Deductions, Credits, etc.”) to its partners, by the new due date for taxable years beginning in 2016.

“New due date?” you say. Yep, this post is for you.

New Due Date

The Surface Transportation and Veterans Health Care Choice Improvement Act of 2015 (the “Act”), amended the Code to change the date by which a partnership must file its annual return. https://www.congress.gov/114/plaws/publ41/PLAW-114publ41.pdf; https://www.law.cornell.edu/uscode/text/26/6072

The due date for filing the annual return of a partnership – or for requesting an extension of time to file such return (using IRS Form 7004, “Application for Automatic Extension of Time To File”) – changed from the fifteenth day of the fourth month following the close of the taxable year (April 15 for calendar-year partnerships) to the fifteenth day of the third month following the close of the taxable year (March 15 for calendar-year partnerships).

A partnership must also issue a Schedule K-1 to each of its partners – reporting such partnership information as the partners may need to complete their own income tax returns, including each partner’s share of the partnership’s income and deductions – by the same due date. Partnerships that receive an extension of time to file Form 1065 receive a concurrent extension of time to furnish their partners with Schedules K-1.

The new due date applies to the returns of partnerships for taxable years beginning after December 31, 2015.

Penalty for Late Filing

It seems that you and your partnership were not alone. Many partnerships filed their 2016 returns (for their first taxable year beginning after December 31, 2015), or requests for an extension of time to file such returns, by the date previously required by the Code (April 15 in the case of a partnership with a taxable year ending December 31); in other words, they were filed late.

Partnerships that fail to timely meet their obligations to file their partnership tax returns by the specified due date (with regard to extensions), or to furnish Schedule K-1s to their partners, will be assessed a monetary penalty, unless such failure is due to reasonable cause (for example, reliance upon the advice of a tax professional whose competence the taxpayer has no reason to doubt).

The penalty is $195 for each month or part of a month (for a maximum of 12 months) the failure to file Form 1065 continues, multiplied by the total number of persons who were partners in the partnership during any part of the partnership’s tax year for which the return is due.

For each failure to furnish Schedule K-1 to a partner when due, a $260 penalty may be imposed for each Schedule K-1 for which a failure occurs.

It should be noted that where a partnership has failed to timely file its Form 1065, it is likely that it has also failed to file additional tax returns that are required to be filed by the same due date as the Form 1065, such as IRS Form 5471, “Information Return of U.S. Persons with Respect to Certain Foreign Corporations;” such additional failures may expose the partnership to the imposition of other penalties.

Relief from Penalties

If not for the Act, these returns and requests for extension of time to file would have been timely under prior law.

Because of that fact, and given the number of late filings, the IRS recently announced that it will provide penalty relief to partnerships that filed certain untimely returns, or untimely requests for extension of time to file those returns, for the first taxable year that began after December 31, 2015, by the fifteenth day of the fourth month following the close of that taxable year. https://www.irs.gov/pub/irs-drop/n-17-47.pdf

The IRS will grant relief from the late filing penalties described above for any return described above for the first taxable year of any partnership that began after December 31, 2015, if the following conditions are satisfied:

  • the partnership filed the Form 1065 or other return required to be filed with the IRS, and furnished Schedules K-1 to the partners, by the date that would have been timely under the Code before its amendment by the Act; or
  • the partnership filed a request for an extension of time to file by the date that would have been timely under the Code before amendment by the Act and files the return with the IRS, and furnishes Schedules K-1 to the partners, by the fifteenth day of the ninth month after the close of the partnership’s taxable year. This relief will be granted automatically for penalties for failure to timely file a partnership return on Form 1065, and any other returns for which the due date is tied to the due date of the Form 1065. In addition, partnerships that qualify for this relief and that have already been assessed penalties can expect to receive a letter within the next several months notifying them that the penalties have been abated.

Do the Right Thing

The Code and the Regulations issued thereunder are full of instances in which a taxpayer may be granted relief for a late filing, a late election, an inadvertently voided election, etc.

It is comforting to know that, in the “appropriate” circumstances, the IRS may provide relief to a “qualifying” taxpayer.

The granting of such relief, however, generally remains within the discretion of the IRS. Moreover, what if the taxpayer’s situation does not satisfy the threshold criteria for consideration by the IRS for relief?

A taxpayer cannot “plan” on the basis of the IRS’s generosity and understanding. Rather, a taxpayer must consult his tax advisers to ensure that he “does the right thing” from a tax perspective, whether in undertaking a business transaction, or in reporting the tax consequences of such a transaction. It is often too late to fix a problem after it has been created, and the IRS is not charged with helping taxpayers get out of problems of their own doing.

Choice of Entity

One of the first decisions – and certainly among the most important – that the owner of a new business must make is the form of legal entity through which the business will be operated. This seemingly simple choice, which is too often made without adequate reflection, can have far-reaching tax and, therefore, economic consequences for the owner.

The well-advised owner will choose a form of entity for his business only after having considered a number of tax-related factors, including the income taxation of the entity itself, the income taxation of the entity’s owners, and the imposition of other taxes that may be determined by reference to the income generated by, or withdrawn from, the entity.

In addition to taxes, the owner will have considered the rights given to her, the protections afforded her (the most important being that of limited exposure for the debts and liabilities of the entity), and the responsibilities imposed upon her, pursuant to the state laws under which a business entity may be formed.

The challenge presented for the owner and her advisers is to identify the relevant tax and non-tax factors, analyze and (to the extent possible) quantify them, weigh them against one another, and then see if the best tax and business options may be reconciled within a single form of legal or business entity.

The foregoing may be interpreted as requiring a business owner, in all instances, to select one form of business entity over another; specifically, the creation of a corporation (taxable as a “C” or as an “S” corporation) over an LLC (taxable as a partnership or as a disregarded entity) as a matter of state law. Fortunately, that is not always the case. In order to understand why this is so, a brief review of the IRS’s entity classification rules is in order.

The Classification Regulations

A business entity that is formed as a “corporation” under a state’s corporate law – for example, under New York’s business corporation law – is classified as a corporation per se for tax purposes.

In general, a business entity that is not thereby classified as a corporation – such as an LLC – can elect its classification for federal tax purposes.

An entity with at least two members can elect to be classified as either a corporation (“association” is the term used by the IRS) or a partnership, and an entity with a single owner can elect to be classified as a corporation or to be disregarded as an entity separate from its owner.

Default Classification

Unless the entity elects otherwise, a domestic entity is classified as a partnership for tax purposes if it has two or more members; or it is disregarded as an entity separate from its owner if it has a single owner. Thus, an LLC with at least two members is treated as a partnership for tax purposes, while an LLC with only one member is disregarded for tax purposes, and its sole member is treated as owning all of the LLC’s assets, liabilities, and items of income, deduction, and credit.

Election to Change Tax Status

If a business entity classified as a partnership elects to be classified as a corporation, the partnership is treated, for tax purposes, as contributing all of its assets and liabilities to the corporation in exchange for stock in the corporation, and immediately thereafter, the partnership liquidates by distributing the stock of the corporation to its partners.

If an entity that is disregarded as an entity separate from its owner elects to be classified as a corporation, the owner of the entity is treated as contributing all of the assets and liabilities of the entity to the corporation in exchange for stock of the corporation.

An election is necessary only when an entity chooses to be classified initially (upon it creation) as other than its default classification, or when an entity chooses to change its classification. An entity whose classification is determined under the default classification retains that classification until the entity makes an election to change that classification.

In order to change its classification, a business entity must file IRS Form 8832, Entity Classification Election. Thus, an entity that is formed as an LLC or as a partnership under state law may file Form 8832 to elect to be treated as a corporation for tax purposes.

Alternatively, an LLC or a partnership that timely elects to be an S corporation (by filing IRS Form 2553) is treated as having made an election to be classified as a corporation, provided that it meets all other requirements to qualify as a small business corporation as of the effective date of the election.

Electing S Corporation Status – Why?

Most tax advisers will recommend that a new business be formed as an LLC that is taxable as a pass-through entity (either a partnership or a disregarded entity). The LLC does not pay entity level tax; its net income is taxed only to its members; in general, it may distribute in-kind property to its members without triggering recognition of gain; it may pass through to its members any deductions or losses attributable to entity-level indebtedness; it can provide for many classes of equity participation; it is not limited in the types of person who may own interests in the LLC; and it provides limited liability protection for its owners.

In light of these positive traits, why would an LLC elect to be treated as an S corporation? Yes, an S corporation, like an LLC, is not subject to entity-level income tax (in most cases), but what about the restrictive criteria for qualifying as an S corporation? An S corporation is defined as a domestic corporation that does not: have more than 100 shareholders, have as a shareholder a person who is not an individual (other than an estate, or certain trusts), have a nonresident alien as a shareholder, and have more than one class of stock.

The answer lies, in no small part, in the application of the self-employment tax.

Self-Employment Tax

The Code imposes a tax on the “self-employment income” of every individual for a taxable year (self-employment tax). In general, self-employment income is defined as “the net earnings from self-employment derived by an individual.”

“Net earnings from self-employment” is defined as the gross income derived by an individual from any trade or business carried on by such individual, less allowable deductions which are attributable to such trade or business, plus his distributive share (whether or not distributed) of income or loss from any trade or business carried on by a partnership of which he is a member . . . .”

Certain items are excluded from self-employment income, including “the distributive share of any item of income . . . of a limited partner.”

That being said, any guaranteed payments made to a limited partner for services actually rendered to or on behalf of the partnership, “to the extent that those payments are established to be in the nature of remuneration for those services . . . ,” are subject to the tax.

In creating the exclusion for limited partners, Congress recognized that certain earnings were basically in the nature of a return on investment. The “limited partner exclusion” was intended to apply to those partners who “merely invest” in, rather than those who actively participate in and perform services for, a partnership in their capacity as partners.

A partnership cannot change the character of a partner’s distributive share for purposes of the self-employment tax simply by making guaranteed payments to the partner for his services. A partnership is not a corporation and the “wage” and “reasonable compensation” rules which are applicable to corporations do not apply to partnerships.

Instead, a partner who is not a “limited partner” within the meaning of the exclusion is subject to self-employment tax on his full distributive share of the partnership’s income, even in cases involving a capital-intensive business.

Thus, individual partners who are not limited partners are subject to self-employment tax on their distributive share of partnership income regardless of their participation in the partnership’s business or the capital-intensive nature of the partnership’s business.

Unfortunately, the Code does not define the term “limited partner,” though the IRS and the courts have, on occasion, interpreted the term as applied to the members of an LLC; specifically, based upon these interpretations, the level of a member’s involvement in the management and operation of the LLC will be determinative of her status as a “limited partner” and, consequently, of her liability for self-employment tax.

S Corporations

The shareholders of an S corporation, on the other hand, are not subject to employment taxes in respect of any return on their investment in the corporation – i.e., on their pro rata share of S corporation income – though they are subject to employment taxes as to any wages paid to them by the corporation.

For that reason, the IRS has sought to compel S corporations to pay their shareholder-employees a reasonable wage for services rendered to the corporation. In that way, the IRS hopes to prevent an S corporation from “converting” what is actually compensation for services into a distribution of investment income that is not subject to employment taxes.

Why Not Incorporate?

If the self-employment tax on an owner’s share of business income can be legitimately avoided by operating through an S corporation – except to the extent it is paid out as reasonable compensation for services rendered by the owner to the corporation – why wouldn’t the owner just form a corporation through which to operate the business?

The answer is rather straightforward: because tax planning, although a very important consideration, is not necessarily the determinative factor in the choice-of-entity decision.

There may be other, non-tax business reasons, including factors under state law, for establishing a business entity other than a corporation.

For example, in the absence of a shareholders’ agreement – which under the circumstances may not be attainable – shares of stock in a corporation will generally be freely transferable, as a matter of state law; on the other hand, the ability of a transferee of an ownership interest in an LLC to become a full member will generally be limited under state law – in most cases, the transferee of a membership interest in an LLC will, in the absence of a contrary provision in the LLC’s operating agreement, become a mere assignee of the economic benefits associated with the membership interest, with none of the rights attendant on full membership in the LLC.

With that in mind – along with other favorable default rules under a state’s LLC law, as opposed to its corporate law – and recognizing the limitations imposed under the Code for qualification as an S corporation, a business owner may decide to form her entity as an LLC in order to take advantage of the “benefits” provided under state law; but she will also elect to treat the LLC as an S corporation for tax purposes so as to avoid entity-level income tax and to limit her exposure to self-employment tax.

In this way, the business owner may be able to reconcile her tax and non-tax business preferences within a single legal entity. The key, of course, will be for both the owner and her tax advisers to remain vigilant in the treatment of the LLC as an S corporation. The pass-through treatment for tax purposes will be easy to remember, but other tax rules applicable to corporations (such as the treatment of in-kind distributions as sales by the corporation), and to S corporations in particular (such as the single class of stock rule), will require greater attention, lest the owner inadvertently cause a taxable event or cause the LLC to lose its “S” status.

Form v. Substance

It is a basic precept of the tax law that the substance of a transaction, rather than its form, should determine its tax consequences when the form of the transaction does not coincide with its economic reality. This substance-over-form argument is a powerful tool in the hands of a taxing authority.

According to another basic precept of the tax law, a taxpayer will generally be bound, for purposes of determining the tax consequences of a transaction, by the form of the transaction that he has used to achieve a particular business goal; the taxpayer may not freely re-characterize a transaction.

That being said, a taxpayer may assert a substance-over-form argument under certain circumstances. In those situations, however, the taxpayer faces a higher than usual burden of proof; indeed, the taxpayer must adduce “strong proof” to establish his entitlement to a position that is at variance with the form of the transaction reported on the taxpayer’s return.

The case discussed below addressed the classic tax issue of form versus substance as the Third Circuit considered a taxpayer’s attempt at re-characterizing a transaction.[1]

The Ingredients

Taxpayer, a U.S. person, was the majority shareholder of a U.S. corporation (“Target”) that owned and operated two Russian LLCs that, in turn, owned and operated most of Russia’s Pizza Huts and KFCs. Another U.S. corporation (“Minority”) held the remaining Target shares.

In order to sell the company, Taxpayer planned to buy out Minority’s Target shares, and then transfer all the Target shares – including those just purchased – to the buyer, a European corporation (“Buyer”) that owned KFCs, Pizza Huts, and other fast-food restaurants throughout Europe.

In May of the year in question, Taxpayer agreed to “purchase”, for his “own account”, Minority’s stake in Target. At closing, Minority was to transfer its Target shares to Taxpayer and then, in the following month, Taxpayer would make a “deferred” payment of the purchase price to Minority.

“You better cut the pizza in four pieces because I’m not hungry enough to eat six.” – Yogi Berra

Taxpayer also entered into a Merger Agreement with Target and Buyer. Under the terms of this Agreement: (1) Taxpayer would ensure, at the closing, that he was the “record” owner of 100% of the Target stock, “free and clear of any restrictions”; (2) Taxpayer would transfer 100% of Target’s shares to Buyer; and (3) Buyer would transfer cash and Buyer stock to Taxpayer as consideration. The transaction was intended to qualify as a partially “tax-free” reorganization within the meaning of the Code.[2] [IRC Sec. 368, 367]

The two transactions went through as planned. In June of the year in question, Minority transferred its Target stock to Taxpayer. On July 2, the Target-Buyer merger closed, and Taxpayer transferred all the Target stock to Buyer. On July 3, Buyer paid Taxpayer over $23 million in cash and transferred over $30 million worth of Buyer stock, a total of nearly $54 million for all Target’s shares. Then on July 5, Taxpayer paid Minority $14 million for its stake in Target.

In two tax filings for the year in question, Taxpayer took two different approaches to the transaction. In his original return, Taxpayer reported tax liability of almost $3.8 million, and paid that amount to the IRS. Taxpayer subsequently amended his return, reported a lower tax liability, and requested a refund.

“Finger Lickin’ Good” – Not for the Taxpayer

The IRS audited Taxpayer, found that the originally-filed return was correct, and denied Taxpayer’s request for a refund. Taxpayer then petitioned the U.S. Tax Court for a redetermination. The Tax Court held for the IRS, and Taxpayer then appealed to the Third Circuit Court of Appeals.

Taxpayer Never Owned It?

Taxpayer challenged the IRS’s determination that he had to pay tax on the $14 million that he received from Buyer and immediately remitted to Minority. The question was whether the form of the transaction made Taxpayer liable for the gain on the Target stock that had been held by Minority.

The Court began by describing the so-called “Danielson rule”:

[W]hile a taxpayer is free to organize his affairs as he chooses, . . . once having done so, he must accept the tax consequences of his choice, whether contemplated or not, and may not enjoy the benefit of some other route he might have chosen to follow but did not.

A taxpayer who falls within the scope of this rule, the Court stated, is generally stuck with the form of his business transaction, and can make an argument that substance should prevail over that form only if a limited class of exceptions applies.

Taxpayer argued that he was never the substantive owner of the Minority block of stock and, therefore, should not be taxed on the $14 million portion of Buyer’s payment that Taxpayer passed to Minority.

However, according to the Court, none of the Danielson exceptions applied – Taxpayer was not defrauded into the transaction, for example – and the contracts signed by the parties explicitly stated that Taxpayer acquired ownership of Minority’s stock: he purchase it for his “own account” prior to selling it to Buyer; and even though the shares were in his hands for only a brief period of time, he was the “record” owner, “free and clear of any restrictions.”

Thus, under Danielson, Taxpayer had to bear the tax liability for owning all the Target shares. He could have hypothetically structured the deal so that he never acquired formal ownership of Minority’s shares, but he did not, and could not benefit from an alternative route now.

“Danielson” Policy Wasn’t Implicated?

Taxpayer argued that the Danielson rule should not apply because its policies were not implicated. According to Taxpayer, the purpose of the Danielson rule was “to prevent a taxpayer from having her cake and eating it too.” Taxpayer claimed that he realized no benefit from serving as Minority’s and Buyer’s go-between.

The Court countered that Taxpayer likely did benefit: by structuring the transaction so that he purchased Minority’s stock for his own account prior to the sale to Buyer, Taxpayer made the overall transaction simpler by ensuring that Buyer would deal with only one party, which likely reduced the deal’s transaction costs and litigation risk, increased the likelihood of the deal actually closing, and perhaps caused Buyer to pay a higher price than it otherwise may have.

In any case, the Court stated, the point of a bright-line rule like Danielson’s requires that judges enforce it without wading into policy analysis, ensuring that the rule’s application will be easy and predictable.

Agency?

Taxpayer claimed that he was nothing more than Minority’s agent in selling Minority’s block of stock, and agents are not liable for the tax burden of their principals.

In responding to this claim, the Court explained that an agency relationship is created through “manifestation by the principal to the agent that the agent may act on his account” and the agent’s “consent” to the undertaking. The problem with this argument, the Court noted, is that the written agreement between Minority and Taxpayer stated in straightforward terms that Taxpayer purchased Minority’s shares for his own account; it did not mention an agency relationship, and none of the terms suggested that Taxpayer ever had an obligation to sell his newly-acquired shares to Buyer or anyone else; Taxpayer could have kept the stock for as long as he wanted, as long as he paid Minority its $14 million. That Taxpayer did encumber himself with an obligation to sell the Minority shares to Buyer arose out of the separate Merger Agreement to which Minority was not a party.

The food in Europe is pretty disappointing. I like fried chicken. But other than that Europe is great.” – Donnie Wahlberg

“Make it Great” – Not for the Taxpayer

The Court concluded that Taxpayer owned 100% of Target’s stock when he transferred Target to Buyer for a total consideration of $54 million, comprised of Buyer stock and cash, and he had to bear the tax burden for the entire payment, even the portion associated with the $14 million he remitted to Minority.

Taxpayer argued that if he must be taxed on the full $54 million from Buyer, he should be permitted to subtract from the gain on his original shares the amount that he “lost” on the sale of the Minority shares.

The Code provides that no gain or loss shall be recognized by a shareholder of a corporation if the shareholder’s stock in the corporation is exchanged, pursuant to a “plan of reorganization,” solely for stock in another corporation that is a party to the reorganization. [IRC Sec. 354]

Thus, a target corporation shareholder who receives only shares of stock in the buyer corporation in exchange for his shares of the target corporation stock, as part of a stock-for-stock merger transaction, does not recognize any of the gain or loss realized in the exchange.

This general rule has an exception for instances when a corporate reorganization involves a transfer of target stock in exchange for both stock of the acquiring corporation and other property or money (“boot”). In those transactions, gain must be recognized by the target shareholder to the extent of the boot received, but any losses realized by the target shareholder still fall within the scope of the general rule – they may not be recognized notwithstanding the receipt of boot by the target’s shareholder. [IRC Sec. 356]

Blocks of Target Stock

The Court explained that, in order to give content to the above recognition / nonrecognition rules, the IRS and the courts historically have analyzed multifaceted transactions according to their “separate units” of stock, so as to prevent a taxpayer from making an end-run around the non-recognition-of-loss rule by tucking his unit’s statutorily unrecognizable loss under the transaction’s broader recognizable gain; thus when an exchange transaction pursuant to a reorganization involves “separate units” of stock, each unit must be analyzed separately.

Taxpayer asked the Court to treat the two blocks of target stock – his block and Minority’s – as one unit, sold in one exchange. By doing so, Taxpayer hoped to subtract the loss realized on the Minority shares from the gain on his original shares (as he could have done if the transaction had not been structured as a partially tax-free reorganization). The Court rejected this request, finding that Taxpayer’s Target stock holdings were composed of two units: Taxpayer acquired one block of Target stock years before acquiring the second block, and he had a vastly different cost basis in the two blocks. Given that the blocks were separate, the Code’s reorganization provisions prohibited recognition of any loss realized by taxpayer in the Minority block.

Plop, Plop, Fizz, Fizz

Fried chicken and pizza aren’t the only things that can give a taxpayer heartburn. Unexpected tax liabilities are just as, if not more, likely to do so. Moreover, tax liabilities cannot be relieved by a simple antacid.

This part of almost every post on this blog must sound like the proverbial broken record. I apologize, but it cannot be said often enough. Before a taxpayer enters into a transaction, he has to be as certain as reasonably possible under the circumstances – risk can never be eliminated – that the transaction will accomplish the taxpayer’s desired business goal. Assuming that is the case, the taxpayer next has to analyze and quantify the tax cost associated with the transaction. This cost has to be added to the other deal costs, and weighed against the expected economic benefits. Depending upon the results of this analysis, the taxpayer may want to reconsider some of the proposed deal terms.

“Eschew obfuscation,” one of my high school physics teachers used to say. I have my own ironic saying: “avoid surprises.” Business owners should consult their tax advisers well before executing a letter of intent for a transaction – the foregoing analysis should not to be deferred until late in the game, because doing so could prove to be an expensive mistake.

_____________________________________________________________________________________________

[1] I have to confess that when I came across this decision, I had already started writing a post on why some LLCs make S-corporation elections. For those of you who know me, as soon as I saw the references to Pizza Hut and KFC, I completely forgot about the LLC.

[2] As we shall see, this reorganization treatment was at the crux of the Taxpayer’s position (see infra).

It is not uncommon for a partner to engage in a business transaction with a partnership of which he is a member. If the partner engages in a transaction with his partnership other than in his capacity as a partner, he will be treated as if he were not a member of the partnership with respect to such transaction. Examples of such transactions include loans of money by the partner to the partnership, the sale of property by the partner to the partnership, the purchase of property by the partner from the partnership, and the rendering of services by the partner to the partnership.

Although not as common, it is sometimes the case that the “partner” with whom the partnership has engaged in a transaction is not a bona fide partner for tax purposes. For example, although a person may be member of a partnership as a matter of local law, the “member” does not have an interest in the capital, profits or losses of the partnership, and has very limited, if any, management rights with respect to the business of the partnership. Indeed, the only reason the person is a member may be to secure some benefit for the partnership under local law, or to satisfy some requirement under local law (as in the case of some foreign jurisdictions that require the presence of a resident in an entity otherwise controlled by a foreign investor).

A recent decision of the Federal Claims Court managed to implicate both of these scenarios.

Bonus Compensation

Taxpayer was a U.S. citizen. She worked for US-Employer, an investment firm based in London, as a senior analyst in its New York office. Taxpayer’s role was to analyze investment opportunities for the US-Employer. She worked for US-Employer on an at-will basis, and received a base salary and a bonus. Taxpayer’s bonus compensation was determined under a formula that was tied to the performance of certain funds.

Although US-Employer’s senior managers who received formulaic bonuses were employees, the company considered those employees to be “partners” in the company, in that they participated in the profitability of the firm according to a specific formula.

However, because US-Employer was a corporation, not a partnership, the participating individuals who received formulaic bonuses, including Taxpayer, were “partners” in name only. Taxpayer’s income from US-Employer, including her bonus, was reported to the IRS on a Form W–2, reflecting her status as an employee of US-Employer.

Welcome Partner?

In January 2008, Taxpayer transferred to US-Employer’s European affiliate, UK-Co., and moved to London. Taxpayer’s job responsibilities and compensation did not change upon transferring to UK-Employer.

Taxpayer became a “member” of UK-Co. in January 2008 by signing a “joinder agreement” and making a capital contribution. By signing the agreement, Taxpayer agreed to “observe and perform the terms and conditions of the [UK-Co.] partnership agreement. The agreement identified US-Employer as the “Corporate Member” of UK-Co., listed certain individuals as members of UK-Co., and identified Taxpayer as a “Further Member.” The agreement did not provide Taxpayer with voting rights in the UK-Co. partnership.

UK-Co. was created under English law. The partnership agreement identified US-Employer and one of the listed individuals as “Designated Members” of UK-Co. and the other listed individual as a “Member.” The agreement designated 82% of the voting rights in UK-Co. to US-Employer and the remaining voting rights to the two listed individuals.

UK-Co. members, other than US-Employer, were required “to devote [their] whole time and attention to [UK-Co.]” and could not engage in other business ventures without the consent of US-Employer. With regard to the allocation of partnership profits and losses, the agreement provided that US-Employer would determine the allocation of UK-Co. profits and losses among the partners at the end of UK-Co.’s fiscal year. UK-Co. never generated its own profits, however, because it “ha[d] no funds to invest. It only ha[d] the money sent over from [US-Employer] to pay its costs and … formulaic bonuses and the staff salaries . . . [UK-Co.] ha[d] no [other] funds.”

Taxpayer did not expect to be asked to make a capital contribution or sign the joinder agreement, but she was told upon arriving in the U.K. that both were required as a condition of her employment at UK-Co. She did not see the partnership agreement before signing the joinder agreement, and she did not receive a copy of it until 2011.

During her time working at UK-Co. Taxpayer remained an at-will employee. She performed the same duties and received the same compensation as she had as an employee at US-Employer. Taxpayer understood that she had to become a member of UK-Co. so that UK-Co. could avoid certain U.K. employment tax obligations.

The Payment

On December 31, 2008, UK-Co. directed that a formula-based bonus (the “Payment”) be made to Taxpayer. US-Employer wired the necessary funds to UK-Co. for the Payment, and UK-Co. in turn directed that money to Taxpayer’s bank. Taxpayer’s bank received the payment in January 2009, and it was credited to Taxpayer’s account.

The formula used to determine the Payment was the same formula used to calculate Taxpayer’s bonus when she was still employed by US-Employer. 

Taxpayer’s 2008 and 2009 Tax Returns

Prior to preparing her 2008 U.S. tax return, Taxpayer requested a tax-reporting statement from UK-Co. for the 2008 tax year, but to no avail. Consequently, Taxpayer reported the salary she received from UK-Co. in 2008 on her original 2008 U.S. tax return, but did not report thereon the Payment that she received in January 2009.

On her 2008 U.K. tax return, Taxpayer reported as her “share of the partnership’s profit or loss” from UK-Co. an amount equal to her salary for those months. Taxpayer paid taxes to the U.K. in 2008, and reported a foreign tax credit on her original 2008 U.S. tax return.

The amount reported on Taxpayer’s 2009 U.K. tax return as her “share of the partnership’s profit or loss” from UK-Co. included the Payment she received in 2009. She had a U.K. tax liability for 2009, and reported a foreign tax credit on her 2009 U.S. tax return.

UK-Co.’s 2008 Tax Return

On its 2008 partnership tax return, UK-Co. included an “Analysis of Partners Capital Accounts” which reflected an entry for “Partner 4” that appeared to include the Payment to Taxpayer. Nonetheless, a Schedule K-1 identifying Taxpayer and setting forth the partnership distributions she received for 2008 was not filed with UK-Co.’s 2008 tax return. The only Schedule K-1 included with the return was for US-Employer.

The IRS Audit

The IRS audited both Taxpayer and UK-Co. for the 2008 tax year.

The IRS requested clarification of Taxpayer’s role at UK-Co. In response, Taxpayer explained that she joined UK-Co. as a limited partner in 2008 and that she spent all of her working time “on duties in relation to the [US-Employer’s] Europe partnership.”

In 2011, Taxpayer received for the first time a 2008 Schedule K-1 from UK-Co. This Schedule K-1 showed that Taxpayer received the Payment in 2008.

Consequently, the IRS treated the Payment as a distribution of Taxpayer’s share of UK-Co.’s profit for 2008; therefore, the IRS asserted that the Payment had to be included by the Taxpayer as ordinary income for her 2008 tax year; i.e., the year with or within which the taxable year of the partnership ended.

In 2012, the IRS issued Taxpayer a Notice of Tax Due showing tax and interest owing.

Refund Claim and Appeal

Taxpayer paid the IRS the tax and interest, but Taxpayer also filed a claim for refund with the IRS.

As her primary ground for relief, Taxpayer alleged that the Payment was made to her in a non-partner capacity, and should be taxed in the year she received it, 2009, rather than in 2008 as reflected on the late-produced Schedule K-1.

The IRS denied Taxpayer’s’ refund claim on the grounds that the Payment was made to her as a partner, rather than as a payment for services rendered by her outside her capacity as a partner.

Taxpayer filed suit in the Court of Federal Claims in 2014, alleging that she was entitled to a refund of the amount paid to the IRS to satisfy the notice of tax due, plus interest. Taxpayer asserted that the Payment was not a partnership distribution but a bonus paid to her in her capacity other than as a partner, and therefore she – as a cash-basis taxpayer – did not need to report the payment until she received it in 2009.

Court’s Analysis

The Court examined Taxpayer’s assertion that the Payment should be taxable in the 2009, when she received the payment, because it was not a partnership distribution. In support of this contention, Taxpayer argued that she was either not a bona fide partner in UK-Co. for U.S. tax purposes, or that, if she was a partner, the Payment was for services performed outside her capacity as a partner. (For purposes of its analysis, the Court assumed, but did not decide, that Taxpayer was a member in UK-Employer in order to analyze the nature of the payment.)

Non-Partner Capacity

The Code provides that, if a partner engages in a transaction with a partnership other than in his capacity as a member of such partnership, the transaction shall generally be considered as occurring between the partnership and one who is not a partner.

If a partner (i) performs services for a partnership, (ii) there is a related direct or indirect allocation and distribution to such partner, and (iii) the performance of such services and the allocation and distribution, when viewed together, are properly characterized as a transaction occurring between the partnership and a partner acting other than in his capacity as a member of the partnership, then (iv) such allocation and distribution shall be treated as a transaction between the partnership and one who is not a partner.

Where partners perform services for a partnership outside their role as a member of the partnership and receive a commensurate payment from the partnership for those services, the payment is not classifiable as a partnership distribution. The payment is, instead, treated as a payment to a non-partner in determining the partnership’s taxable income or loss and the partner’s share thereof.

Not a Partner

The Court determined that the Payment to Taxpayer was appropriately categorized as a payment for services outside her capacity as a partner, and not as a partnership distribution. The Court also noted that the services performed by Taxpayer when she worked at UK-Co. did not change when she transferred from US-Employer in New York to UK-Co. in London and became a member of UK-Co. She continued to analyze investment opportunities for the funds managed by US-Employer. None of these funds were owned by UK-Co. or based in London; rather, Taxpayer’s job duties at UK-Co. continued to center around US-Employer’s business in New York, with UK-Co. acting as a “legal … conduit” for US-Employer and its employees to do business in Europe. Taxpayer only relocated to London to have easier access to European investment opportunities for the funds, and became a “member” of UK-Co. so that UK-Co. could avoid certain U.K. tax obligations.

The fact that she became a partner primarily to obtain tax benefits for the partnership which would not have been available if she had rendered the services to the partnership in a third party capacity was relevant to determining whether the Payment was a partnership distribution.

In her work at UK-Co., Taxpayer did not perform any services on behalf of the partnership itself, but rather the partnership served as a European conduit for Taxpayer to perform the same services she performed as an employee of US-Employer.

Other Factors

Additionally, the circumstances surrounding the issuance and receipt of the Payment indicated that it was not a partnership distribution. Taxpayer’s compensation arrangement, which remained the same when she transferred from US-Employer to UK-Co. was not tied to the success of UK-Co. in any way. Rather, Taxpayer’s formulaic bonus was tied to the yearly performance of the funds that were based at US-Employer in New York; indeed, no funds of any kind were directly tied to or controlled by UK-Co. Taxpayer’s bonus was dependent on the success of the funds, but it was not linked to any profit or risk of UK-Co., which did not generate profits on its own, but rather was merely a conduit for US-Employer to pay its European expenses and personnel. In fact, at the time the Payment was issued, UK-Co. did not have any funds on hand to be subjected to the risks of the partnership. The Payment was entirely under the control, and subject to the risks, of US-Employer, and not UK-Co., thus indicating that the Payment was not a distribution of partnership profits.

The fact that the Payment was disproportionate to Taxpayer’s actual ownership share of the partnership, further supported the conclusion that it was not a partnership distribution, but rather a payment for services performed outside her capacity as a member of UK-Co.

Thus, the Court concluded, the Payment was made to Taxpayer for services performed outside her capacity as a member of the UK-Co. partnership, the payment was taxable to Taxpayer by the U.S. in the year she received it (2009), and she was entitled to a full refund of the tax paid on the Payment for the 2008.

Guidance?

In most cases, it should not be too difficult to determine the capacity in which a partner is dealing with his partnership.

In others, it will be important for the partnership and its partners to clearly establish their intentions at the outset of the transaction though, even then, the IRS will not be bound thereby.

For example, was a transfer of money to the partnership made as a loan or as a capital contribution? The absence of documentation and the presence of inconsistent reporting can only lead to trouble down the road, perhaps because the partnership is in financial straits.

As always, a partner and the partnership will be in a better position to secure the desired tax and economic consequences if (i) they discuss these consequences among themselves and their advisers before engaging in the transaction being contemplated, (ii) they document the transaction accordingly, and, (iii) if necessary, they research and compile the appropriate legal authority to support their position.

Last week, we considered the U.S. taxation of a closely held foreign corporation that owned a minority interest in a partnership that was engaged in business in the U.S. This week, we turn our sights to the U.S. taxation of a domestic corporation that owned foreign corporate subsidiaries.

Policy Underlying the CFC Rules

In general, a U.S. person must include in its gross income its directly-earned income from foreign sources; thus, if a U.S. person operates a business through a branch located overseas, the net business income attributable to that branch is included in the U.S. person’s gross income.

Absent the so-called “Subpart F rules,” the inclusion of this foreign source income may be circumvented when the U.S. person chooses to operate overseas indirectly, through a controlled foreign corporation (“CFC”), rather than through a foreign branch. In that case, the foreign subsidiary corporation is generally treated as a separate taxpayer from its U.S. owner; the foreign-source income earned by the CFC is generally not included in the U.S. owner’s gross income; and the imposition of U.S. income tax on the foreign-source income earned by the CFC is deferred until it is repatriated by the CFC to the U.S.

Anti-deferral

That a U.S. person may defer the inclusion in its gross income of the foreign-source income earned by its controlled foreign corporate subsidiaries does not, in and of itself, violate any U.S. tax policy. However, Congress and the IRS have sought to defeat the deferral benefit in situations where certain “U.S. shareholders” may direct the flow of certain types of income (“Subpart F Income”) to a low-tax jurisdiction; for example, income earned in transactions between related corporations that are located in different countries, one of which is a tax haven. In those situations, the Code and the IRS’s regulations require the current inclusion of the CFC’s un-repatriated Subpart F Income in the U.S. shareholder’s gross income.

Deemed Repatriation

Although the current inclusion of Subpart F Income is a major concern of the Subpart F rules, they also seek to prevent the tax-free repatriation of other foreign income through investments in U.S. property. In general, the foreign-source income earned by a CFC (other than Subpart F Income) is subject to U.S. tax when the income is repatriated as a dividend. If the CFC, instead, invested the foreign-source income in the U.S., by the purchase of U.S.-situs property, or by a loan to the U.S. parent corporation, the foreign income would effectively be repatriated in a manner that would escape current U.S. tax.

In order to address this situation, the Code generally provides that certain “investments” by a CFC in U.S.-situs property will be treated as the repatriation of the CFC’s foreign-source income, as a result of which, the U.S. shareholder must include in its gross income an amount calculated by reference to the amount deemed to have been repatriated by the CFC.

A recent decision by the U.S. Tax Court considered the application of this deemed repatriation rule.

Investment in U.S. Property?

Taxpayer was a domestic “C” corporation and the parent of a group of domestic and foreign subsidiary corporations. The IRS determined that the CFCs had invested substantial amounts of untaxed foreign profits in “U.S. property”. Accordingly, the IRS determined that Taxpayer was required to include in its gross income the amounts that the CFCs had invested. As a result, the IRS asserted income tax deficiencies against the Taxpayer, and the Taxpayer petitioned the Tax Court for relief.

According to the IRS, Taxpayer’s CFCs made investments in U.S. property through the following transactions: (1) they extended loans to a domestic subsidiary, in the form of intercompany cash advances; and (2) one of them guaranteed of a loan that a domestic subsidiary had obtained from Foreign Bank.

Intercompany Loans

Taxpayer was the sole shareholder of US-Sub, a domestic corporation, which in turn was the sole shareholder of four CFCs. Taxpayer and US-Sub were U.S. shareholders of these CFCs because they owned (directly or indirectly) 100% of the total combined voting power of all classes of the CFCs’ stock.

At various times, the CFCs had made loans to US-Sub. Substantial balances on these loans remained outstanding throughout the tax periods at issue.

Guaranty Transaction

US-Sub also borrowed money from Foreign Bank. As a condition of extending credit, Foreign Bank required US-Sub to secure a guaranty for the loan, preferably from a subsidiary located in the same jurisdiction as Foreign Bank. One of Taxpayer’s CFCs (“F-Sub”) supplied the requisite guaranty.

US-Sub was also required to pledge as security for the Foreign Bank loan all the stocks that US-Sub then owned or thereafter acquired, including its equity interest in the CFCs.

The outstanding balance on the Foreign Bank loan remained constant throughout the tax periods at issue, as did F-Sub’s guaranty of the loan.

IRS Audit

Neither Taxpayer nor US-Sub had previously included in income, for any year, any portion of this outstanding loan balance.

Taxpayer filed consolidated Forms 1120, U.S. Corporation Income Tax Return, for the years at issue. The IRS examined Taxpayer’s returns and determined that the CFCs had held substantial investments in U.S. property, which Taxpayer had neglected to include in gross income; specifically, the IRS contended that Taxpayer’s CFCs held two sets of investments in U.S. property that Taxpayer was required to include in gross income: (1) the outstanding loan balances owed by US-Sub to the CFCs; and (2) F-Sub’s guaranty of the Foreign Bank loan to US-Sub. As a result, the IRS issued a notice of deficiency, and Taxpayer petitioned the Tax Court.

Governing Statutory Framework

A CFC is a foreign corporation more than 50% of whose stock (in terms of voting power or value) is owned (directly or constructively) by U.S. shareholders. A U.S. shareholder is a U.S. person who owns (directly or constructively) 10% or more of the total combined voting power of the foreign corporation’s stock.

In general, a U.S. shareholder owning CFC stock on the last day of the CFC’s taxable year must include in gross income the lesser of: (1) the excess of such shareholder’s pro rata share of the amount of U.S. property held by the CFC as of the close of such taxable year, over the amount of CFC profits otherwise included in such shareholder’s gross income; or (2) such shareholder’s pro rata share of the applicable earnings of such CFC.

“U.S. property” includes (among other things) an obligation of a U.S. person, such as a bond, note, or other indebtedness. According to IRS regulations, any obligation of a U.S. person with respect to which a CFC is a pledgor or guarantor is considered U.S. property held by the CFC. A CFC will be considered a guarantor if its assets serve at any time, even though indirectly, as security for the performance of an obligation of a U.S. person.

The amount of the investment with respect to an obligation of a U.S. person is the CFC’s adjusted basis in the obligation. In the case of a pledge or guaranty, the amount includible is based on the unpaid principal amount of the obligation with respect to which the CFC is the pledgor or guarantor. The amount includible is reduced by any previously taxed profits of the CFC, and it cannot exceed the U.S. shareholder’s pro rata share of the CFC’s earnings.

The Court’s Analysis

With respect to the loans made by Taxpayer’s CFCs to US-Sub, the Court found that substantial loan balances remained outstanding during the tax periods at issue. The Taxpayer asserted that some of the loans might have been “discharged,” but was unable to provide specific facts supporting its claim.

Thus, the Court concluded that the intercompany loan balance owed by US-Sub to each CFC constituted U.S. property held by that CFC, and that the Taxpayer was required to include in gross income, subject to the net profits of the CFCs.

CFC as Guarantor and as Pledgor

The Court next turned to US-Sub’s loan from Foreign Bank. This loan had a substantial outstanding balance during the periods at issue, and F-Sub’s guarantee of the loan remained in place throughout these periods. Neither Taxpayer nor US-Sub had previously included in income, for any year, any portion of this outstanding loan balance.

The IRS contended that F-Sub, as a guarantor of the Foreign Bank loan, was considered as holding the obligation of a U.S. person. The IRS accordingly concluded that the unpaid principal balance of that loan was includible in Taxpayer’s gross income.

Although F-Sub’s status as a guarantor would have been sufficient to support inclusion in Taxpayer’s gross income, F-Sub also appeared to have been a pledgor in support of the Foreign Bank loan. A CFC will be regarded as a pledgor if its assets serve directly or indirectly as “security for the performance of an obligation” of a U.S. person.

According to IRS regulations, the pledge by a U.S. shareholder of stock of a CFC will be considered as the indirect pledge of the CFC’s assets if at least two-thirds of the total combined voting power of all classes of CFC stock is pledged, and if the pledge of stock is accompanied by one or more negative covenants or similar restrictions on the shareholder effectively limiting the corporation’s discretion with respect to the disposition of assets and the incurrence of liabilities other than in the ordinary course of business.

Because US-Sub was required to pledge to Foreign Bank its 100% stock ownership interest in the CFCs, including F-Sub, F-Sub was treated as having pledged all of the assets which it then held or thereafter acquired. To the extent that this pledge effectively limited US-Sub’s discretion with respect to the disposition of F-Sub’s assets and the incurrence of liabilities, the Foreign Bank loan contained “negative covenants or similar restrictions,” that rendered F-Sub an indirect pledgor as well as a guarantor.

Financial Condition of CFC?

Taxpayer argued that F-Sub’s guaranty had little or no value, and represented a “meaningless gesture.” According to Taxpayer, S-Sub’s guaranty furnished only a secondary form of collateral that provided no incremental security for Foreign Bank.

The Court failed to see the relevance of this argument. A CFC, it stated, is considered as holding an obligation of a U.S. person if the CFC “is a pledgor or guarantor of such obligation.” That is the end of the inquiry, the Court said; neither the Code nor the regulations issued thereunder inquire into the relative importance that the creditor attaches to the guarantee.

In any event, the Court continued, Taxpayer failed to offer any facts to support its assertion. Foreign Bank demanded a guaranty from a company with assets in Foreign Bank’s location, and F-Sub provided that guarantee. When a bank agrees to make a substantial loan only after securing a guaranty from a local company with local assets, it is logical to assume that the bank regarded that guaranty as valuable security.

Alternatively, Taxpayer asserted that F-Sub’s guaranty was worthless because other liabilities encumbering F-Sub’s assets exceeded the fair market value of those assets at the time F-Sub guaranteed the loan.

The Court, however, observed that Taxpayer did not supply any balance sheets, income statements, or other documentation concerning F-Sub’s financial position or its insolvency. Moreover, F-Sub’s guaranty remained in place continuously, and Taxpayer did not provide any documents suggesting that Foreign Bank ever questioned the value of F-Sub’s collateral or demanded additional security.

In any event, the Court stated, it was not clear that a CFC’s financial condition is even relevant in determining whether its guaranty gives rise to an investment in U.S. property. The Code provides that a CFC shall be considered as holding an obligation of a U.S. person if such CFC is a pledgor or guarantor of such obligation. The regulations provide that any obligation of a U.S. person with respect to which a CFC is a pledgor or guarantor shall be considered U.S. property held by the CFC. They make no reference to the likelihood that the CFC will be called upon, or will be able, to make good on its guarantee. According to the Court, this reflects the common sense proposition that a lender would not ask for, or be satisfied with, a guarantee from a person who lacked the financial capacity to provide the security that the lender desires.

For these reasons, the Court concluded that F-Sub’s guarantee of the Foreign Bank loan gave rise to an investment in U.S. property and, subject to F-Sub’s earnings and profits, Taxpayer was required to include in gross income for the years at issue the outstanding balance of the Foreign Bank loan.

Takeaway

Many closely held U.S. businesses have realized that there are ample opportunities for growth and profits overseas. In pursuing such opportunities, however, a U.S. taxpayer must be mindful of the complex rules that apply in determining the taxation of overseas profits – including the Subpart F rules, discussed above – and the reporting thereof.

With an understanding of these rules, and with the guidance of knowledgeable advisers, a U.S. taxpayer may be able to structure its overseas investments, and the repatriation of its overseas earnings, in a more tax efficient manner.

Where business exigencies are such that a less than ideal tax structure has to be employed, the U.S. taxpayer must at least be able to account for the additional tax cost in analyzing the economic prospects and anticipated returns of its overseas investments and operations.