Imagine, if you will, the owner of a closely held business. Although the business has done well, the owner believes they can take it to the proverbial “next level” by dedicating another five years of intense effort and some additional investment, following which they will try to sell the business.

After learning of this “plan” during one of their regular meetings,[i] the owner’s attorney and accountant recommend, among things, that the owner consider the creation of a trust for the benefit of the owner’s family. They explain that the trust could be funded with an interest in the business.

The owner asks . . .

Why A Trust?

Many people are aware that trusts are often used as vehicles through which the owner of a closely held business may pass along to, or for the benefit of, their family – either during the owner’s life[ii] or upon their death[iii] – a beneficial, or economic, interest in the business without actually giving them direct, or legal, ownership in the business.

An owner may have several reasons for employing a trust, rather an outright transfer, to pass along the business, and the value it represents, to their spouse or children. For example, where a child is the issue of the owner from a prior marriage, the owner may want to provide for their current spouse while also ensuring that the child will receive their share of the remainder of the trust upon the death of the second spouse.[iv] Or the owner may be interested in setting aside assets to provide for the well-being of the child while preventing the child’s creditors (present or future)[v] from reaching such assets. Then there are those owners who (at least in their parental roles) are control freaks, and for whom death is not the end insofar as their ability to control their wealth is concerned. Oh well.[vi]

Funding the Trust

Ideally, a trust will be funded with an asset that is reasonably expected to appreciate significantly in value. The owner of a closely held business will typically transfer an equity, often non-voting, interest in the business by either gifting or selling[vii] the interest to the trust.[viii] In general, an owner-grantor will try not to incur a gift tax liability on an inter vivos transfer; rather, they will seek to maximize the use of all or a portion of their remaining exemption amount.[ix]

The trustee will hold the equity interest and, in accordance with the terms of the trust agreement – which reflect the owner-grantor’s directions or preferences – the trustee may distribute the trust’s income, and perhaps its corpus, among the one or more beneficiaries of the trust.[x]

The owner does not retain any interest in or control over the trust. This helps to ensure that the transfer to the trust is “completed” for gift tax purposes,[xi] and prevents the value of the trust from being included in the grantor’s gross estate for purposes of the estate tax. In this way, the business interest that was transferred to the trust,[xii] along with the post-transfer income generated by the interest, as well as its appreciation in value, are excluded from the grantor’s estate.

Income Tax

A lot of planning goes into the transfer of equity in a business to a trust. Unfortunately, there is one important trait of the trust that is often overlooked: its treatment for purposes of the income tax; specifically, the fact that a trust is itself a taxpayer, unless it is a grantor trust.[xiii]

Non-Grantor Trust

This is no small matter when one considers that non-grantor trusts are generally subject to the same graduated federal income tax rates as individuals, except that the highest rates[xiv] apply at a much lower level of taxable income in the case of a trust than for an individual; the rate brackets are much more compressed, with the result that a trust will generally pay more federal income tax than an individual on the same amount of taxable income.[xv] The same holds true for the federal surtax on net investment income.[xvi]

However, a non-grantor trust may not have to pay federal income tax for a taxable year if it distributes its taxable income for such year (with certain modifications)[xvii] to its beneficiaries on a current basis. The trust is allowed to claim a deduction in respect of the distribution for purposes of determining its taxable income for the year.[xviii] In turn, the distribution “carries out” the trust’s income into the hands of the recipient beneficiaries,[xix] thereby shifting the liability for the distributed income to the beneficiaries.[xx]

In this way, the non-grantor trust’s income is taxed only once: to the trust to the extent it does not distribute its income, or to the trust’s beneficiaries to the extent such income is distributed by the trust.[xxi] Income that has already been taxed to the trust in a prior year is not taxed again when it is distributed to the beneficiary.

Grantor Trust

That being said, there is a special set of rules that causes the taxable income and gains of a trust to be taxed, neither to the trust nor to its beneficiaries, but to the grantor of the trust.

Under the “grantor trust” rules,[xxii] the individual grantor – i.e., the business owner, for our purposes – who contributes property (equity in the business) to the trust will be treated as the owner of the trust property, and of the income and gains from such property, if they retain certain rights with respect to the property.[xxiii] Thus, the grantor must include the trust’s income and gains on their individual income tax return, and pay the tax thereon.[xxiv]

This allows the trust to grow without being reduced by tax payments, and it further reduces the grantor’s gross estate by causing the grantor to use their other assets to satisfy the income tax liability.[xxv]

New York Taxation of Trusts

For the most part, N.Y. follows the federal rules as to the income taxation of trusts. In applying these rules, however, along with some uniquely N.Y. modifications thereto, the State divides trusts into resident and non-resident trusts, and then into grantor[xxvi] and non-grantor trusts.

In general, a non-grantor trust will be treated as a N.Y. resident trust if it consists of property:

  • that was transferred by the will of a decedent who, at the time of such decedent’s death, was domiciled in N.Y.;
  • of a person who was domiciled in N.Y. at the time such property was transferred to the trust, if such trust was then irrevocable; or
  • of a person domiciled in N.Y. at the time such trust became irrevocable, if it was revocable when such property was transferred to the trust, but has subsequently become irrevocable.[xxvii]

Note that the residence of the trustee does not affect the status of a trust as resident or nonresident.

A trust that is not a resident trust, as defined by these rules, is treated as a nonresident trust for purposes of the N.Y. income tax.[xxviii]

The N.Y. taxable income of a resident trust is its federal taxable income for the tax year, subject to certain modifications. The resident trust is subject to tax on its N.Y. taxable income at the rates applicable to individual taxpayers.[xxix]

A nonresident trust is subject to N.Y. income tax only as to its N.Y. source income.[xxx] Thus, income and gain attributable to the trust’s ownership of any interest in real or tangible personal property in N.Y. is taxable.[xxxi] The trust’s income also includes the trust’s distributive share of partnership income that is sourced in N.Y., as well as the trust’s pro rata share of S corporation income sourced in N.Y., including income or gain attributable a trade or business carried on in the State.[xxxii]

An “Exempt” Resident Trust?

There is, however, an exemption from N.Y. income tax for a resident trust that is not a grantor trust and that meets the following requirements:

  • the trustee is not domiciled in N.Y.;[xxxiii]
  • the trust has no N.Y. assets;
    • intangible assets, like stock of a corporation, are deemed sitused at the domicile of the nonresident trustee, outside N.Y.;[xxxiv]
    • if the trust has any tangible assets located in N.Y. (e.g., real estate), the trust will remain subject to N.Y. tax; and
  • the trust does not have any N.Y.-source income or gain; this includes, for example, flow-through income from a partnership or S corporation; any N.Y. income will cause the trust to be taxable in N.Y.[xxxv]

A N.Y. resident trust that satisfies these conditions will not be subject to N.Y. income tax.[xxxvi]

If the exempt resident trust were to make a current distribution to a N.Y. beneficiary – whether mandatory or discretionary – an amount up to the trust’s taxable income for that tax year would be included in the beneficiary’s federal adjusted gross income for the year and, thereby, in their N.Y. adjusted gross income for that year.[xxxvii] Thus, the income would be subject to N.Y. income tax in the hands of the beneficiary.

However, if the trust does not make current distributions to its N.Y. beneficiaries, the trust’s income for the tax year will not be subject to N.Y. income tax either in the hands of the trust or of its beneficiaries, though the trust will, of course, be subject to federal income tax with respect to such undistributed income.

The “Throwback” – Sort Of

This raises the following question: what happens when an exempt resident trust distributes to its N.Y. beneficiaries income that the trust accumulated in earlier tax years, on which the trust paid federal income tax, but no N.Y. income tax?

Before January 1, 2014, because such a distribution of prior year income would not have been included in a N.Y. beneficiary’s federal adjusted gross income for the year received, it would not have been subject to N.Y. income tax.

Beginning after 2013, however, a N.Y. resident beneficiary of an exempt resident trust must include in their N.Y. adjusted gross income any income that was accumulated by the trust in a tax year beginning on or after January 1, 2014 and that is distributed to a beneficiary of the trust in a year subsequent to the year in which the trust included the income on its federal tax return (an “accumulation distribution”).[xxxviii]

In order to facilitate the enforcement of this rule, N.Y. requires an exempt resident trust to submit Form IT-205-C, “New York State Resident Trust Nontaxable Certification” every year with its Fiduciary Income Tax Return (on Form IT-205).[xxxix]

When an exempt resident trust makes an accumulation distribution for a tax year to a beneficiary who is a New York State resident, the trust must report the distribution on Form IT-205-J, “New York State Accumulation Distribution for Exempt Resident Trusts,” which is filed with its Form IT-205 for that year.

According to the Form IT-205-J instructions, an accumulation distribution is the excess of the amounts properly paid, credited, or required to be distributed during the tax year of the distribution (other than income required to be distributed currently), over the trust’s DNI for the year reduced by income required to be distributed currently. To have an accumulation distribution, the distribution must exceed the accounting income of the trust.

In general, a resident beneficiary receiving an accumulation distribution from an exempt resident trust must include the accumulation distribution in their N.Y. adjusted gross income for the year of the distribution.[xl]

Significantly, when one works through the federal “throwback” provisions, which are incorporated by reference into the N.Y. rule,[xli] it appears that capital gains that are not distributed during the year[xlii] in which they are recognized by the trust for federal tax purposes may not be subject to the N.Y. accumulation regime when distributed in a later year. That’s because capital gain is generally not included in DNI.[xliii] In other words, capital gain attributable to an earlier tax year may escape N.Y. tax when distributed by an exempt resident trust in a later year to the trust’s N.Y. resident beneficiaries.

The Sale

Returning to our owner, let’s assume they and their family are N.Y. residents, and that the business operates in N.Y. The business is organized as a C corporation,[xliv] and doesn’t own any N.Y. real property.[xlv]

The owner creates and funds a non-grantor trust with non-voting shares of the C corporation’s stock, and nothing else.[xlvi] The trust is a N.Y. resident trust.[xlvii] The trustee, is not a N.Y. resident and, so, the shares of stock are not treated as N.Y. property.

The trust agreement authorizes the trustee to distribute among any or all of the beneficiaries so much of the trust income and/or principal, and at such times, as the trustee determines in their sole discretion.

A few years pass, the value of the business increases, the owner begins to solicit and entertain bids for the sale of the business.[xlviii] A few months into the process, the business is sold – miracle of miracles, a sale of stock.[xlix]

The owner and the trust report the gain from the sale on their respective federal tax returns.[l] The owner also reports the gain on their N.Y. tax return and pays the resulting tax.[li]

The trust is an exempt resident trust. Therefore, it is not subject to N.Y. income tax on the gain from the sale of the stock.

The trustee invests the proceeds, earning dividends and interest. The trust does not make any distributions. It pays federal taxes on such income.

Several years later, in accordance with its terms, the trust terminates and distributes all of its principal and undistributed income to the beneficiaries, all of whom still reside in N.Y.

Although the trust’s previously undistributed income will be subject to N.Y. income tax in the hands of the recipient beneficiaries, the capital gain should not be.[lii]


[i] Would that it were so. Many issues could be addressed before developing into more difficult, more expensive issues.

[ii] An inter vivos transfer, or gift, of an interest in the business or in real property associated with the business.

[iii] A testamentary transfer: a devise in the case of real property, and a bequest of an interest in the business.

[iv] Indeed, this is the premise underlying the estate tax marital deduction afforded the so-called “QTIP” trust. IRC Sec. 2056(b)(7).

[v] The child’s future spouse – as yet unidentified – if often seen as the main culprit.

[vi] N.B.: The owner-grantor should not serve as trustee of the trust if one of their goals is to remove the trust from their gross estate for purposes of the estate tax. For that reason, it would behoove the owner to prepare a shareholders’ agreement, to be entered into with the trustees, which would, among other things, give the owner the right to drag-along the other equity owners in the event the owner decides to dispose of the business.

[vii] The sale will typically be to a so-called “grantor trust,” which is a trust the property of which the grantor is treated as still owning. Because a taxpayer cannot “sell” property to themselves (except, perhaps, in a metaphysical sense), the transfer is not treated as a taxable event. See, e.g., Rev. Rul. 85-13. This principle provides the basis for a transaction that you may have heard about: the sale to an “intentionally defective grantor trust” (the word “defective” is so far off the mark).

[viii] You’ll note that the owner is not, thereby, “retaining” the right to vote the gifted shares – these shares have no right to vote. IRC Sec. 2036. In the case of a corporation, all it takes is a simple recapitalization; an “E” reorganization under Reg. Sec. 368(a)(1)(E).

[ix] IRS Sec. 2010 and Sec. 2505. The fact that the property being transferred represents a non-voting, non-readily tradeable, equity interest in a closely held business, will typically enable the grantor to leverage their exemption amount. Of course, any portion of their exemption amount that remains at the owner’s death may be used to cover a testamentary transfer. In most cases, the IRS will, almost as a matter of course, challenge the valuation of the business. Many taxpayers utilize a formula clause, based on the Tax Court’s decision in Wandry, to address the risk that such a challenge may convert an otherwise non-taxable gift into a taxable transfer. T.C. Memo. 2012-88.

[x] There are so many formulations. For example, the trust agreement may authorize the trustee to distribute so much of the income or principal of the trust, at such times and in such amounts, as the trustee, in the exercise of their sole discretion determines; it may direct that all income be distributed at least currently, and authorize the trustee to distribute any part of the principal that the trustee determines necessary for the health, education, maintenance and support of the beneficiary. In each case, the advisor’s responsibility is to see that the grantor act reasonably in light of the property being transferred, its likely future, the unique traits of each known beneficiary, and the advisor’s own experience – this last is where some aspect of the “social sciences” come into play.

[xi] A very important consideration if the goal is to remove the business interest, and its future appreciation in value (yes, that’s redundant), from the grantor’s estate. Reg. Sec. 25.2511-2.

[xii] Hopefully, without triggering any gift tax liability.

[xiii] IRC Sec. 1(e).

[xiv] 37-percent as to ordinary income, and 20-percent as to qualified dividends and capital gain. IRC Sec. 1(a) and Sec. 1(h).

[xv] In 2019, for example, the top federal rate of 37-percent for ordinary income applies to the taxable income of a married couple filing jointly when their taxable income exceeds $612,350, whereas the same rate applies to a trust when its taxable income exceeds $12,750. In the case of capital gains, the top federal rate of 20% will apply to a married couple filing jointly with taxable income exceeding $488,850; for a trust, the threshold is $12,950.

[xvi] IRC Sec. 1411. Married individuals filing jointly are subject to the tax when their “modified adjusted gross income” exceeds $250,000; trusts when it exceeds $12,500.

[xvii] Its distributable net income, or DNI. IRC Sec. 643.

[xviii] A distribution deduction.

[xix] And preserves its character in the hands of the beneficiaries. See, e.g., IRC Sec. 662(c).

[xx] The deduction by the trust is under IRC Sec. 651 and Sec. 661; the inclusion by the beneficiaries is under IRC Sec. 652 and Sec. 662.

In recognition of the fact that a trust may not be able to determine its DNI for a tax year before the end of such year, the trust is allowed to claim a distribution deduction for the year for distributions made to its beneficiaries during the first 65 days of the immediately succeeding year. IRC Sec. 663(b).

[xxi] This is in contrast to a pass-through business entity, such as a partnership/LLC or an S corporation, the “taxable income” of which flows through and is currently taxed to the partners/members and shareholders, without regard to whether it has been distributed to them. IRC Sec. 702 and Sec. 1366. The partnership and the S corporation are not, themselves, taxable entities (at least in most cases). IRC Sec. 701 and Sec. 1363(a), respectively.

[xxii] IRC Sec. 671 through Sec. 679.

[xxiii] These rights need not be of a kind that would cause the trust property to be included in the grantor’s gross estate. For example, the grantor’s right to reacquire the contributed property from the trust in exchange for property of equivalent value will cause the trust to be treated as a grantor trust without exposing the trust property to inclusion in the grantor’s estate. IRC Sec. 675(4). In addition, the right to borrow from the trust without adequate security will result in grantor trust treatment, without inclusion in the estate (provided there is adequate interest charged). IRC Sec. 675(2).

It is this disconnect between the estate and income tax rules that facilitates some very effective estate tax planning strategies. It is also this disconnect that the Obama administration tried to eliminate year after year, without success. Just look at the administration’s Green Books.

[xxiv] IRC Sec. 671.

[xxv] This assumes the grantor has enough liquidity from other sources with which to pay the income tax liability. The grantor may waive or release their rights under the trust agreement, thereby “converting” the trust to a non-grantor trust.

[xxvi] If the individual who is treated as the grantor-owner of the trust is a N.Y. resident, the income and gains of the trust will be taxed to them accordingly. NY Tax Law Sec. 601(a). Likewise in the case of a nonresident grantor-owner. NY Tax Law 601(e).

[xxvii] NY Tax Law Sec. 605(b)(3).

For purposes of these rules, a trust is revocable if it is subject to a power, exercisable immediately or at any future time, to revest title in the person whose property constitutes such trust, and a trust becomes irrevocable when the possibility that such power may be exercised has been terminated.

[xxviii] NY Tax Law Sec. 605(b)(4).

[xxix] NY Tax Law Sec. 618 and Sec. 601(c).

[xxx] NY Tax Law Sec. 631 and Sec. 633.

[xxxi] NY Tax Law Sec. 631. In general, an interest in real property includes an interest in a partnership/LLC, S corporation, or non-publicly traded C corporation with no more than 100 shareholders, that owns real property located in N.Y, provided the fair market value of such real property represents at least 50-percent of the value of all of the entity’s assets, excluding those assets that the entity has owned for less than two years.

[xxxii] NY Tax Law Sec. 631 and Sec. 632.

[xxxiii] This is often accomplished by appointing a Delaware corporate trustee – there is no Delaware income tax on a trust that accumulates income for beneficiaries who are not residents of Delaware.

[xxxiv] NY Tax Law Sec. 605(b)(3)(D)(ii).

[xxxv] NY Tax Law Sec. 631(b)(1). See also TSB-M-18(1)I.

[xxxvi] NY Tax Law Sec. 605(b)(3)(D)(i).

[xxxvii] IRC Sec. 662; NY Tax Law Sc. 612.

[xxxviii] NY Tax Law Sec. 612(b)(40).

[xxxix] In general, the due date is April 15 of the succeeding year. There is a failure to file penalty.

[xl] NY Tax Law Sec. 612(b)(40). There are exceptions: where the accumulation distribution is attributable to a tax year that the trust was subject to N.Y. tax, or a tax year starting before January 1, 2014; where the accumulation distribution is attributable to a tax year prior to when the beneficiary first became a N.Y. resident, or a tax year before the beneficiary was born or reached age 21; or where the income was already included in the beneficiary’s gross income. See also TSB-M-14(6)S.

[xli] IRC Sec. 667(a), the first sentence, which in turn refers to IRC Sec. 666; these sections refer to IRC Sec. 662(a)(2) and Sec. 661(a)(2).

[xlii] As “other amounts properly paid . . .” See IRC Sec. 661(a)(2) and Sec. 662(a)(2) – both of which are limited by DNI.

[xliii] IRC Sec. 643(a)(3).

[xliv] Otherwise, we have to deal with the flow through of N.Y-source income of a partnership or S corporation.

[xlv] In my world, the real property is held by the owner in an LLC that leases the property to the corporation.

[xlvi] Let’s assume the owner did not incur any gift tax liability on the transfer.

[xlvii] In addition, the trustee is “independent” of the owner within the meaning of the grantor trust rules. See IRC Sec. 674.

[xlviii] Although our assumed facts do not raise the issue, the owner has to be careful about a sale that follows on the heels of a gift. First, the sale may fix the fair market value of the gifted shares notwithstanding what the owner’s appraisal concludes. Second, if negotiations for the sale preceded the gift transfer, the owner may be charged with the gain from the sale under assignment of income principles.

[xlix] Buyers will generally prefer to acquire the target’s assets: they receive a basis step-up and they cherry pick the liabilities to be assumed. I just didn’t want to deal with a liquidating distribution following an asset sale.

[l] Forms 1040 and 1041, respectively. Long term capital gain: 20% tax on the gain, and the 3.8% surtax on net investment income. IRC Sec. 1(h) and Sec. 1411, respectively.

[li] 8.82% personal income tax. The owner does not reside in N.Y. City (which imposes a 3.876% tax on its residents).

[lii] Of course, to the extent the distribution carries out current DNI, the beneficiaries will be taxed thereon by both the IRS and N.Y.

Four media outlets have quoted Tax Law for the Closely Held Business blog author Lou Vlahos on the topic of whether New York resident President Donald Trump will be successful in changing his residency to Florida for tax purposes. In these articles, Lou discusses steps that President Trump must take to effectively establish domicile in a different state, cautioning that the process is more complicated than some might think.

Not So Fast, Mr. Trump! Relocating to a Low-Tax State Is Hard to Do (Wall Street Journal)

All the reasons Trump’s move from New York to Florida for tax purposes could be ‘doomed’ (Market Watch)

Will Trump escape New York taxes with Florida move? (FOX Business)

Tax travails Trump could face in trying to escape New York (Don’t Mess With Taxes)

Personal Use of Business Assets

“But it’s my business. I own it.”

How many times have you heard this response from the owners of a business entity after you’ve advised them that they should not treat the entity as their personal bank account?

Too often, I’d wager.

What’s more, the response is not limited to any particular set of owners; for example, members of the family business, who may be less likely to object to each other’s “transgressions,” especially if perpetrated by mom or dad.[i]

Indeed, the practice of using the resources of the business for non-business purposes – i.e., for personal ends – is pervasive among closely held entities regardless of their level of sophistication or the extent to which the owners are otherwise unrelated to one another.

There are too many examples of such personal use to list here, but expenditures by the business for the following uses are illustrative:[ii] the cost of meals,[iii] mortgages, education expenses, charitable contributions, car rental payments, phones, home utilities, country club dues, children’s allowances,[iv] shopping bills, apartment rent, boats, entertainment, travel costs,[v] weddings and other “social” gatherings.[vi]

The justifications offered by the beneficiary of such expenditures are also wide-ranging, though marketing, public relations, sales, client development and retention lead the pack. In most cases, however, the connection between the expenditure and the purported business purpose is usually pretty tenuous.

A less “offensive” use of business assets, and one that is less obvious to many observers, is the business’s satisfaction of an owner’s business or investment obligations; for example, where the business redeems the stock of a departing owner notwithstanding that another owner was contractually obligated to purchase such stock.[vii]

How Are They Reported?

More interesting is the variety of treatments accorded these expenditures by the preparer of the expending entity’s income tax return.

Some preparers will keep track of these figures throughout the course of the year, then add them to the owner’s salary and deduct them accordingly, without considering whether the aggregate consideration paid to the owner (inclusive of these expenditures) was reasonable for the services actually rendered.

Others seem reluctant to treat them as salary, perhaps recognizing that the total amount paid would not represent reasonable compensation,[viii] with the result that part of the deduction would be disallowed,[ix] though it is more likely because they want to avoid the imposition of employment taxes. Instead, they will add these expenditures to the “other deductions” line of the corporation[x] or partnership[xi] tax return; the explanatory statement attached to the return in respect of these deductions will often bury this cost as a nondescript expenditure among a long list of others, probably in the hope that it will go unnoticed.[xii]

Some preparers will forego the deduction – more likely where the business entity is a pass-through – and report the expenditures as cash distributions made in respect of the owner’s equity in the business entity. Such a distribution will not generate a deduction on the corporation’s or partnership’s tax return. In the case of a C corporation, the distribution will be taxable to the shareholder-beneficiary as a dividend to the extent of the corporation’s earnings and profits, then as a return of capital (stock basis), with any excess being treated as gain from the sale of the stock.[xiii] In the case of an S corporation without E&P, the distribution would not be taxable to the extent of the shareholder’s basis in the stock, with any excess being treated as gain from the sale of the stock.[xiv] Finally, in the case of a partnership, the deemed cash distribution would not be taxable to the extent of the partner’s basis in their partnership interest, with any excess being treated as gain from the sale of such interest.[xv]

Then there are those preparers who will report the amount of the expenditure as a loan from the business entity to the owner – anything to defer the tax liability that may result from a constructive distribution[xvi] – though they rarely memorialize the indebtedness with a promissory note, secure it with collateral, or provide a maturity date, and they almost never impute the interest,[xvii] let alone pay it.[xviii]

In addition to the foregoing indirect payments by the business entity which may be characterized as constructive distributions to an owner, transactions between the owner and the business entity may also result in a deemed distribution. We’ve already mentioned the payment of excessive compensation by the entity to the owner, but what about the payment of an above-market rent for the use of the owner’s (or an affiliate’s) property, or an above-market interest rate for a loan from the owner to the business?  Then, there’s the above-market purchase price for the owner’s sale of property to the entity, or the below-market (“bargain”) sale of property by the entity.[xix]

Of course, an actual expenditure, or other outlay of value, by the business entity is not the only way by which an owner may benefit from the use of the entity’s assets or resources.

Thus, the rent-free use of the entity’s car, plane or apartment should rise to the level of a deemed or constructive transfer of value from the entity to the owner. The nature of that transfer, whether as a payment of compensation or as a distribution in respect of equity,[xx] will depend upon the facts and circumstances.[xxi]

When Will They Ever Learn?[xxii]

Notwithstanding the body of case law and administrative rulings that has developed over the years in this subject area, there are those owners and advisers who have somehow remained ignorant of it, or who have simply chosen to ignore it. This was certainly the case of the taxpayer is a recent decision of the U.S. Tax Court.[xxiii]

The issue before the Court was whether Taxpayer, who failed to file a tax return for the tax year in issue, had constructive dividend income as a result of cash withdrawals, fund transfers to their personal bank account, and payments of personal and meal expenses, all from Corp’s bank account.

Taxpayer was the sole shareholder of Corp. During the year in issue, Taxpayer maintained a business checking account in their name, and another business checking account in the name of Corp.

Corp had gross receipts for the year in issue, the amount of which represented the aggregate amount of deposits into Taxpayer’s personal and Corp’s bank accounts for the year.[xxiv] Corp. did not keep books and records, so there was no way to distinguish between Taxpayer’s personal finances and those of the corporation.

Taxpayer expended Corp funds for their own use. Taxpayer made cash withdrawals from Corp’s bank account for their own use and not for corporate expenses. Corp transferred funds from its corporate account to Taxpayer’s personal bank account for their own use. Taxpayer paid the cost of personal meals by using Corp’s corporate debit card. Corp paid many of Taxpayer’s other personal expenses, including rent, travel, and childcare, among others.

The IRS computed Taxpayer’s income for the year in issue by reference to bank deposits and cash payments, plus personal and other nondeductible expenditures.  On the basis of the results of that analysis, the IRS prepared a substitute return[xxv] for Taxpayer and issued a notice of deficiency[xxvi] which determined, among other things, that Taxpayer had received unreported business income, which resulted in a tax deficiency.

Taxpayer’s Bad Day in Court

Taxpayer’s petition to the Tax Court did not contest the unreported gross income stated in the deficiency notice, but argued that the gross receipts were attributable to Corp rather than to Taxpayer, personally.[xxvii]

The IRS argued that Taxpayer had received constructive dividends from Corp. The IRS posited that during the year in issue, Taxpayer “drew no distinction between” the funds of the business and their personal funds. The IRS identified various categories of expenditures in Corp’s bank statements that the IRS argued were distributions to Taxpayer – cash withdrawals, electronic transfers, personal expenses, and meal expenses – and presented evidence of those expenditures.

To determine the character of the constructive distributions, the IRS calculated Corp’s earnings and profits for the year in issue. These exceeded, the IRS asserted, all of the constructive distributions Taxpayer received from Corp. Thus, according to the IRS, these distributions represented dividends.[xxviii]

The Court observed that Taxpayer relied almost entirely on their uncorroborated testimony and non-contemporaneous documents. Taxpayer failed to explain with any detail, or to substantiate with any contemporaneous documentation or log, the amounts or business character they alleged for the expenditures at issue.[xxix] The Court stated that it need not accept a taxpayer’s self-serving testimony when the taxpayer failed to present corroborating evidence. Accordingly, because Taxpayer had the burden of proof, the Court did not accept most of Taxpayer’s self-serving testimony.

The Court explained that a distribution from a corporation to its shareholders is treated as a dividend, which is included in gross income.[xxx] “A constructive dividend arises,” the Court explained, ‘[w]here a corporation confers an economic benefit on a shareholder without the expectation of repayment, * * * even though neither the corporation nor the shareholder intended a dividend.’”

According to the Court, “[c]orporate expenditures constitute constructive dividends if (1) the expenditures do not give rise to a deduction on behalf of the corporation, and (2) the expenditures create economic gain, benefit, or income to the owner-taxpayer.”

The Court stated that an “expenditure generally does not have independent and substantial importance to the distributing corporation if it is not deductible” as an ordinary and necessary business expense.[xxxi] Conversely, the Court added, “not every corporate expenditure which incidentally confers economic benefit on a shareholder is a constructive dividend. The crucial test of the existence of a constructive dividend is whether the distribution was primarily for the benefit of the shareholder.”

In the case of the amounts withdrawn by Taxpayer from Corp’s accounts, the Court was persuaded that they were not made for Corp’s business expenditures but for Taxpayer’s personal use.

The IRS identified deposits to Taxpayer’s personal account that corresponded with certain withdrawals from Corp’s bank account. Taxpayer admitted that these amounts were deposited into their personal account and conceded that these withdrawals “were personal”, “were not proven to be for business expenses and therefore * * * [were] constructive income for” Taxpayer.

The balance of the cash withdrawals after the amounts Taxpayer deposited into their personal account corresponded closely to the amount Taxpayer claimed was used to pay for business-related expenses. At trial, Taxpayer provided receipts purporting to prove this fact; however, the Court found these receipts very “problematic”, stating that they “indirectly but convincingly underscore[d] the personal character of the withdrawals.”

In fact, the Court expressed its belief that Taxpayer fabricated the receipts.  Rather than substantiating a deductible business purpose for the cash withdrawals, these “manifestly bogus receipts,” the Court continued, “revealed a deceptive intention and showed that the actual purpose of the cash withdrawals was other than the false proffered business purpose.”

Therefore, the Court found that the entire amount withdrawn from Corp’s bank account – both the portion that was deposited into Taxpayer’s personal account and the portion for which the false receipts were produced – created income for Taxpayer, did not give rise to deductions by Corp and, therefore, were a constructive distribution.

Taxpayer conceded at trial that they transferred cash from Corp’s bank account into their personal bank account. Taxpayer made no argument that this electronic transfer served a corporate purpose; and in their post-trial brief, Taxpayer conceded that this payment constituted “constructive dividends.”

At trial, the IRS entered schedules into evidence showing that during the year in issue, Corp paid many of Taxpayer’s personal expenses. Taxpayer admitted that Corp’s bank account was used to pay for all of Taxpayer’s groceries for that year, a gym membership, and various other personal expenses.

Taxpayer conceded the personal character of all of those amounts, except for an amount which was attributable to certain payments by Corp for the monthly rental of Taxpayer’s personal residence. Taxpayer contended that these residential rental payments were business expenses of Corp because Taxpayer used part of the residence for business.

Unfortunately for Taxpayer, the Court was not convinced, finding that Taxpayer had established no business-related use of a home office. Thus, it concluded that Corp’s payments for Taxpayer’s personal residence were personal expenditures.

The Court also found that the IRS had successfully carried its burden of showing that Taxpayer received a personal economic benefit from Corp’s payment of certain of Taxpayer’s travel expenses. Taxpayer, the Court observed, failed to enter a receipt, a log, or any other evidence of their trip into the record. Thus, the lodging expense was not a business expense.

Finally, the IRS was able to establish that Corp paid many of Taxpayer’s meal expenses which, the Court stated, were generally non-deductible personal expenses.

In summary, the Court concluded the IRS had proven that Taxpayer received distributions from Corp that were primarily for Taxpayer’s personal benefit and not for deductible expenses of Corp.

The IRS next contended, and the Court agreed, that Corp had sufficient earnings and profits to characterize the constructive distributions Taxpayer received as dividends.[xxxii]

Let’s Be Careful Out There [xxxiii]

The “transitive law” of mathematics and logic,[xxxiv] as expressed in the title of this post, has no place in governing the relationship between business owners and their business entities. In fact, it can only lead to trouble, as many owners who have applied this basic rule have learned over the years, much to their dismay.

In general, the business entity is treated as a separate taxpayer from its owner. The premise underlying transactions between taxpayers is that they will treat with one another at arm’s length.[xxxv] However, where the parties are related, the IRS and the courts will scrutinize the transaction more closely to ascertain whether its terms depart from the arm’s length standard, and if so, why. As in the case of the Taxpayer, above, the IRS will look at the facts and circumstances of the transaction in order to determine the appropriate tax treatment for any such departure; for example, a constructive distribution.

In light of the foregoing, except where the entity has elected to be disregarded for tax purposes,[xxxvi] the transaction of any activity between the entity and its owners has to be undertaken with care – the arm’s length standard must be considered, and the likely tax consequences have to be accounted for in advance.

However, even where the owner engages in an activity with a disregarded business entity,[xxxvii] they must not be misled into thinking that the “neutral” consequence of that activity for tax purposes will necessarily carry over for all other purposes. For example, if the owner freely moves property in and out of their single member LLC without considering the arm’s length standard and without exchanging adequate consideration therefor with the LLC, they risk opening the doors for the LLC’s creditors to reach the owner’s other assets. Creditors understand the law of transitivity.

Most parents of means know they wield the power of the will, or revocable trust, and their kids know it too. If a child complains, perhaps too vehemently, a phone call, a few taps on a keyboard, and voila, Jack or Jill is out of the will.

[ii] Interestingly, these events have their counterparts in the world of tax-exempt private foundations: acts of self-dealing, which are addressed under IRC Sec. 4941.

[iii] I know restaurant owners who have rarely stepped into a supermarket.

[iv] In the form of compensation to the kids, who don’t even work for the business.

[v] One individual explained to me that they won’t attend a destination wedding unless one of their vendors, customers, or prospects is located nearby. Honest. Hmm.

[vi] Do you remember the scene from Ghostbusters when the accountant, Louis Tully (Rick Moranis), is hosting a party in his apartment?

Hey, this is real smoked salmon from Nova Scotia, Canada, $24.95 a pound. It only cost me $14.12 after tax, though. I’m giving this whole thing as a promotional expense. That’s why I invited clients instead of friends.

[vii] See, e.g., Rev. Rul. 69-608.

[viii] IRC Sec. 162; Reg. Sec. 1.162-7.

[ix] At least in the case of a corporate taxpayer; guaranteed payments made by a partnership to a partner for services rendered by the partner are not subject to a standard of reasonableness in order to be deductible.

[x] IRS Form 1120 or Form 1120S.

[xi] IRS Form 1065.

[xii] This drives me crazy.

[xiii] IRC Sec. 301(c), Sec. 316. The dividend would be taxed at a 20% federal tax rate under IRC Sec. 1(h), and at a 3.8% federal surtax on net investment income under IRC Sec. 1411.

[xiv] IRC Sec. 1368(b).

[xv] IRC Sec. 731(a), Sec. 741, Sec. 751. The partner’s capital account should likewise be adjusted.

Of course, when most people hear about a constructive distribution in the case of a partnership, they think of the deemed distributions of cash to a partner when the partner’s share of partnership liabilities is reduced. IRC Sec. 752.

[xvi] I’m sure you’ve seen this: a shareholder with very substantial amounts owing to a corporation that has plenty of unappropriated retained earnings but that has never declared a dividend.

[xvii] Using the applicable federal rate in accordance with IRC Sec. 7872.

[xviii] In fact, such loans are rarely repaid, or otherwise “eliminated,” before the sale of the business or the death of the debtor-shareholder.

[xix] Each of these scenarios may be viewed as a transfer pricing issue that requires the application of the arm’s length standard under IRC Sec. 482 and the regulations promulgated thereunder.

[xx] What about a deferred payment of the rental amount? How would this be determined in the absence of an agreement? Based on market rates? There’s no denying that value has been provided.

[xxi] How many of you have struggled with the tax treatment of a corporation’s guarantee of a shareholder’s indebtedness to a third party?

[xxii] Apologies to Peter, Paul and Mary, Where Have All the Flowers Gone?

[xxiii] Santos v. Comm’r, T.C. Memo. 2019-148.

[xxiv] Meaning, Corp’s receipts were sometimes deposited into its account, and sometimes into Taxpayer’s account. Talk about intermingling.

[xxv] IRC Sec. 6020(b).

[xxvi] IRC Sec. 6212.

[xxvii] In other words, the deficiency was Corp’s.

[xxviii] IRC Sec. 301(c)(1) and Sec. 316.

[xxix] IRC Sec. 6001 requires that “[e]very person liable for any tax imposed by this title, or for the collection  thereof, shall keep such records, render such statements, make such returns, and comply with such rules and regulations as the Secretary may from time to time prescribe.” Taxpayers are thus required to keep records and maintain them as long as they may become material. Reg. Sec. 1.6001-1(a), (e).

[xxx] IRC Sec. 316. I.e., paid out of the corporation’s earnings and profits.

[xxxi] IRC Sec. 162.

[xxxii] IRC Sec. 301(a), Sec. 301(c)(1), Sec. 316. According to the Court, a dividend is first paid from earnings and profits of the current taxable year, and if the current earnings and profits are insufficient, the dividend is paid from accumulated earnings and profits.

[xxxiii] Sergeant Phil Esterhaus, from Hill Street Blues.

[xxxiv] aRb, bRc, then aRc, where R represents a particular relationship.

[xxxv] For example, the hypothetical willing buyer and willing seller standard that governs most valuations of property, or the transfer pricing rules under IRC Sec. 482.

[xxxvi] Reg. Sec. 301.7701-3.

[xxxvii] For example, a single member LLC that has not elected to be treated as an association for tax purposes.

Mostly Divisions

Over the last several months, many of the projects on which I have been working have involved the division of a corporation or of a partnership. Yes, there have been purchases and sales of businesses along the way. And, yes, there have been restructurings of organizations for various purposes, including to facilitate a sale of a business or the admission of a new investor. However, the divisive transaction seems to be ascendant in that sector of the tax firmament over which I keep watch.[i]

Some of these business divisions were strategic in nature,[ii] but some originated[iii] in disputes between individual owners who are family members, and were once friends and collaborators. Over time, and with changing circumstances, the relationship between the owners begins to fray, and eventually devolves into a cold war, and sometimes outright hostility. As a result, the business suffers.

As many earlier posts have explained,[iv] the feuding owners may be separated on a tax-efficient basis through some variation of the spin-off transaction, in the case of a business organized as a corporation, provided the many requirements therefor are satisfied.[v] There are far fewer criteria to be met in order for the division of a partnership to be effected without materially adverse tax consequences.[vi]

One factor that is often considered in the context of such a spinoff, but which rarely presents much of an issue given the reason for the transaction, is the receipt of adequate value by each owner. Because neither shareholder is in any way inclined, under the circumstances, to leave behind value to which they believe they are entitled, the likelihood of either owner experiencing a windfall or being shortchanged is fairly remote.

That being said, the spin-off does not always result in a dollar-for-dollar exchange;[vii] as a practical business matter, this is not unusual, and is sometimes unavoidable. That is not to say, however, that any “bargain” element rises to the level of a gift, even where the parties are members of a single family.

Ordinary Business Transactions

The IRS has long recognized this economic and business reality. At the same time, however, it has stated that donative intent on the part of the transferor is not an essential element in the application of the gift tax to the transfer.[viii] Rather, the application of the tax is based on the objective facts of the transfer and the circumstances under which it is made, rather than on the subjective motives of the donor. Thus, transfers reached by the gift tax[ix] are not confined to those which, being without a valuable consideration, accord with the common law concept of gifts; instead, the tax also embraces sales, exchanges, and other dispositions of property for a consideration to the extent that the value of the property transferred by the transferor-donor exceeds the value in money or money’s worth of the consideration given therefor.

Does this mean that any bargain element may trigger gift tax? No. The IRS has explained that, in addition to not being applicable to a transfer for full and adequate consideration, the gift tax also does not apply to “ordinary business transactions.”[x] Thus, a sale, exchange, or other transfer of property made “in the ordinary course of business” – i.e., a transaction which is bona fide, at arm’s length, and free from any donative intent – will be considered as made for an adequate and full consideration.[xi]

This last point acknowledges the fact that there are circumstances in which the application of the gift tax would not be appropriate notwithstanding that the parties – even related parties – have not exchanged equal values, whether in terms of property or services, provided the exchange represents an arm’s length, genuine business transaction.

In the case of a divisive transaction, provided that the values received or relinquished are not so disproportionate, relative to the value of each party’s interest in the divided business prior to the division, as to call into question the business purpose for the transaction, it would be inappropriate to find there was a gift from one party to the other. Instead, the party being “shortchanged” may have determined that the resolution of the conflict with the other party, via the division of the corporation, and the resulting benefit of being able to own and operate their own business without interference from the other, constitute adequate consideration.

Stated differently, provided the division is principally motivated by at least one strong business purpose, the likelihood of finding a gift transfer is more remote.

This approach recalls the “device” test, which seeks to prevent the use of a spin-off for the purpose of withdrawing earnings and profits from a corporation.[xii] Any evidence of such a device may be outweighed by the existence of a corporate business purpose. The stronger the evidence of device, the stronger the corporate business purpose required to prevent the determination that the transaction was used principally as a device.

What About Combinations?

Intuitively, there is no reason why the same line of reasoning should not apply to the combination of two business entities. Provided the parties are motivated primarily by a bona fide, non-tax business reason, the fact that one party to the transaction ends up with a slightly disproportionately larger share of the combined entity’s fair market value should not be taken as evidence of a gift from the other party.

However, where the individuals involved are members of the same family, and the values “exchanged” are, let’s say, out of whack – whether intentionally or not – the IRS may rightfully wonder why.

Which brings us to a recent case[xiii] that was before the U.S. Tax Court on remand from the Court of Appeals for the First Circuit.[xiv] Although the First Circuit sent the case back to the Tax Court for reconsideration on the issue of valuation, the underlying facts are worthy of examination.

A “Donative” Merger?

Parents owned Corp A, out of which they operated Business X. Their children (“Kids”) were employed by the corporation.  In order to diversify its operations and provide another source of revenue, Corp A began development of a new technology (“IP”).

The development process proved to be expensive, so Parents decided that Corp A should just focus on Business X. Kids, however, believed they could develop IP and find a market for it.  Parents assented to their continued efforts.

Kids formed a new corporation, Corp B, to which they made a nominal capital contribution in exchange for all of its shares.  At no time, however, did Corp A grant to Corp B the right to produce or sell Corp A’s IP.

As Kids continued to develop IP, Corp A continued to compensate them as employees of Corp A. What’s more, Corp A personnel, using Corp A’s equipment, assisted Kids with implementing their development ideas.  In time, Corp A was manufacturing products based on IP, which Corp B sold and distributed.

Unfortunately, however, Corp A and Corp B never took a consistent approach to the overall allocation of income and expenses between them. Instead, it appeared that profits were disproportionately allocated to Corp B, which the Court (see below) attributed either to the “deliberate benevolence” of Parents, or else to “a non-arm’s length carelessness born of the family relationships.”

The lax approach to the relationship between the two corporations was also reflected in the fact no documentation existed that memorialized any transfer of IP from Corp A to Corp B.  Indeed, the relevant documents affirmatively showed that Corp A owned IP.

Several years into their “relationship,” Corp A and Corp B decided that, on the advice of their accountant (“Accountant”), they would need to merge, with Corp B as the surviving entity, if they wanted to expand their market. Accountant projected that “the majority of the shares (possibly as high as 85%)” in the surviving entity would go to Parents as a result of the merger, in their capacity as the shareholders of Corp A. Accountant valued the merged company as being worth between $70 million and $75 million.

However, the corporations’ attorney (“Attorney”) advised Parents to assume (incorrectly) that Corp B, not Corp A, owned IP. Accountant did not agree with that view, and shared this concern with Attorney; the latter responded: “History does not formulate itself, the historian has to give it form without being discouraged by having to squeeze a few embarrassing facts into the suitcase by force.”[xv] Accountant acquiesced.

The two corporations merged in a tax-deferred merger,[xvi] with Kids receiving 81-percent of the surviving corporation, based upon the incorrect assumption that Corp B – which Kids owned – held IP.

Slightly before the merger, Attorney prepared[xvii] a “confirmatory” bill of sale that reflected an earlier purported transfer of IP from Corp A to Corp B despite the lack of any evidence as to Corp B’s ownership of IP.

Gift by Corporate Merger

The IRS conducted a gift tax examination relating to Parents, and eventually issued a notice of deficiency which determined that Parents made significant gifts to Kids by merging Parents’ company (Corp A) with and into Kids’ company (Corp B), and allowing Kids an 81-percent interest in the merged entity.

Parents petitioned the Tax Court for a redetermination of the resulting gift tax liability. The Tax Court agreed with the IRS.

The Court noted that donative intent on the part of the donor is not an essential element for gift tax purposes.  The application of the gift tax, it said, is based on the objective facts and circumstances of the transfer rather than the subjective motives of the donor.  The Court quoted from IRS regulations: “Where property is transferred for less than an adequate and full consideration …, then the amount by which the value of the property exceeded the value of the consideration shall be deemed a gift.”  Such taxable transfers, the Court said, include exchanges between family members.  Indeed, when a transaction is made between family members, it is “subject to special scrutiny, and the presumption is that a transfer between family members is a gift.”

Parents argued that the transaction should be considered one that was made for “an adequate and full consideration” because it was made in the “ordinary course of business” and was “bona fide, at arm’s length, and free from donative intent.”

The Court disagreed.  It pointed out that if an unrelated buyer had approached either Corp A or Corp B, it would have demanded to see documentation regarding the ownership of IP, and it would have acted accordingly.[xviii]

The instant case, the Court stated, did not involve a hypothetical unrelated party; instead, it involved parents “who were benevolent to their sons,” and it involved “sons who could … proceed without the caution that normally attends arm’s length commercial dealing between unrelated parties.”  The Court observed that, throughout the process of developing IP, Parents gave no thought to which corporation would own it, and they gave no thought to which corporation would pay for its development.

In the end, the Court concluded, based on the IRS’s valuation of the corporations, that there was a gift, the amount of which would be based upon a 60-40 split of value between Corp A and Corp B, respectively.[xix]

The Valuations

During trial, Parents entered into evidence two reports on the issue of valuation: the Accountant’s valuation, on which the post-merger share distribution had been based, and another valuation prepared for trial. These reports valued the combined company at between $70 million and $75 million, and both assumed (incorrectly) that Corp B had owned IP, and that Corp A had been a contractor for Corp B in the development of IP.

The IRS’s appraisal report assumed (correctly) that Corp A had owned IP. It also made adjustments to Parents’ allocation of profit and loss between the two related corporations. Using a discounted cash flow analysis, the report concluded that the total value of the merged entity was $64.5 million (less than the value determined by Parents’ appraisers), that Corp A’s value was $41.9 million (i.e., 65% of the total), and that Corp B’s value was $22.6 million (i.e., 35% of the total). On the basis of this analysis, the IRS argued that the merger of the two corporations, and the disproportionate distribution of shares among their shareholders, resulted in a gift to Kids totaling $29.7 million.

Parents challenged the IRS’s appraisal methodology, alleging that its valuation was flawed for a number of reasons, including its reallocation of profit between the two corporations.

The Court found that: Corp A, rather than Corp B, owned IP; the merger transaction was “notably lacking in arm’s length character”; the merger of the two corporations with the issuance of 81-percent of the stock of the new combined entity to Kids reflected a presumption that Corp B had owned IP; the 81-percent:19-percent allocation of the stock was therefore not in accord with the actual relative values of the two corporations; and the transaction, therefore, resulted in disguised gifts to Kids.

The Court held in favor of the IRS, and never considered the merits of Parents’ arguments concerning the IRS valuation.

Appeal and Remand

Parents appealed to the Court of Appeals, alleging that the Tax Court erred in various respects, including the following: (1) concluding Corp A owned IP; and (2) failing to consider flaws in the IRS valuation.

The Court of Appeals sustained the Tax Court’s findings and conclusions, with one exception: it determined that the IRS valuation had “methodological flaws that made it . . . excessive.”

On remand, Parents argued that the IRS valuation erred by not taking into consideration Attorney’s “confirmatory” bill of sale that attested to a transfer between Corp A and Corp B, which Parents contended was a “cloud on the title”, and that the IRS valuation therefore erred by not discounting the value of Corp A, because a “buyer considering the acquisition of [Corp A] without [Corp B] would have to take into account the risk that [Corp B] might claim rights to the [IP].”

This argument, the Court pointed out, was based on premises that were explicitly contrary to its earlier factual finding that “the . . . ‘confirmatory’ bill of sale confirmed a fiction”, and “[i]f an unrelated party had purchased [Corp B] before the merger and had then sued [Corp A] to confirm its supposed acquisition of [IP], without doubt that suit would fail.”[xx]

Parents also renewed their criticism of the profit reallocation calculation that the IRS performed before valuing the two corporations, arguing that it was unnecessary.

The Court rejected Parents’ position that the profit reallocation was unnecessary because the argument was contrary to the Court’s findings that (i) “[Corp A] received less income than it should have as the manufacturer . . . , while [Corp B] received more than it should have as the mere seller,” and (ii) the allocation of stock in the merger was not done at arm’s length.

The IRS’s profit reallocation adjustment, the Court explained, reflected the correct view that Corp A and Corp B were not dealing with each other at arm’s length, that Corp A was effectively subsidizing Corp B’s operations, and that Corp A, rather than Corp B, owned IP. The Court concluded that this reallocation was necessary to yield an accurate valuation of the two corporations.[xxi]

After correcting for an error in the IRS’s valuation, the Court determined that the proportion of the combined value attributable to Corp A was 51-percent. Because Parents received only 19-percent of that value in stock from the merger, the Court determined that Parents “forfeited in favor of their sons 32% (i.e., 51% minus 19%) of that combined value to which they were entitled.” Therefore, the Court concluded, Parents made disguised gifts totaling 32-percent of the $70 million combined company, or $22.4 million.

Be Alert, Be Prepared

Corporate divisions and combinations involving family-owned businesses are just two of the scenarios in which owners and their advisers must be attuned to possible gift tax consequences. There are others.

For example, the transfer of property by a corporation to a non-shareholder may be a gift to the non-shareholder from the shareholders of the corporation if the non- shareholder has provided neither property nor services, either to the corporation or to its shareholders.[xxii] If the recipient is a shareholder, the transfer may be a gift to them from the other shareholders, but only to the extent it exceeds the recipient-shareholder’s own interest in such amount as a shareholder. Similarly, a transfer of property by an individual to a corporation, other than in exchange for stock, may represent a gift by the individual to the other individual shareholders of the corporation to the extent of their proportionate interests in the corporation.[xxiii]

Likewise, when property is transferred to a corporation by two or more persons in exchange for stock, and the stock received is disproportionate to the transferors’ prior interest in such property, “the entire transaction will be given tax effect in accordance with its true nature,” and the transaction may be treated as if the stock had first been received in proportion, and then some of such stock had been used to make gifts.[xxiv]

For example, Parent and Kid organize a corporation with 100 shares of common stock to which Parent transfers property worth $8,000 in exchange for 20 shares of stock, and Kid transfers property worth $2,000 in exchange for 80 shares of stock. No gain or loss will be recognized on these exchanges.[xxv] However, if it is determined that Parent made a gift to Kid, such gift (of $6,000) will be subject to gift tax.[xxvi]

Whatever the scenario, it is imperative that family members and their commonly-controlled business entities be especially careful when transacting with one another.  They must recognize these transactions will be subject to close scrutiny by the IRS; accordingly, they have to “build their case” contemporaneously with the transactions.  They must treat with each other at arm’s length as much as possible, they must document their business dealings, and they must be able to support the reasonableness of any transactions between them.

If a gift is intended, an appraiser should be consulted, and the “transfer” should be timed and structured so as shift as much of the potential for appreciation in the gifted interest as possible, while minimizing the tax cost and exposure.

[i] “And God said, Let there be a firmament in the midst of the waters, and let it divide the waters from the waters. And God made the firmament, and divided the waters which were under the firmament from the waters which were above the firmament: and it was so.” Genesis 1 (KJV): 6-7. See what I mean? The “firmament” was all about dividing things.

[ii] Seeking to position each business so as to enable it to compete more effectively, or to enable it to issue equity to a key employee.

[iii] Had their genesis, you might say. Hmm.

[iv] For example,


[vi] Reg. Sec. 1.708-1(d).

[vii] Rev. Proc. 2017-52 requires the following representation: “The fair market value of Controlled stock, Controlled securities, or Other Property to be received by each shareholder of Distributing that surrenders Distributing stock will be approximately equal to the fair market value of Distributing stock surrendered by the shareholder in the transaction.” Emph. added.

[viii] Reg. Sec. 25.2511-1(g)(1).

[ix] Chapter 12 of the Code; IRC Sec. 2501 et seq.

[x] Reg. Sec. 25.2511-1(g)(1).

[xi] Reg. Sec. 25.2512-8.

[xii] IRC Sec. 355(a)(1)(B); Reg. Sec. 1.355-2(d).

[xiii] Cavallaro v. Comm’r, T.C. Memo. 2019-144.

[xiv] Cavallaro v. Comm’r, 842 F.3d 16 (1st Cir. 2016).

[xv] Well-written, but WTF.

[xvi] Presumably under IRC Sec. 368(a)(1)(A).

[xvii] “Concoct” was the word used by the Tax Court.

[xviii] Absolutely.

[xix] As opposed to the 20-80 split claimed by Parents and Kids in the merger. Actually, a friendlier position for the taxpayers, from a gift tax perspective, than the one they had originally decided upon.

[xx] The Court of Appeals affirmed this finding, stating that Parents “advanced no argument that would warrant overturning the Tax Court’s finding that [Corp A] owned all of the [IP] at the time of the merger.”

[xxi] Parents argued that the IRS’s reallocation violated the principles of IRC Sec. 482. Section 482 is an income tax provision. It gives the IRS discretion to allocate income and deductions among taxpayers that are owned or controlled by the same interests, for purposes of preventing the evasion of taxes or to clearly reflect income. Broadly speaking, “[t]he purpose of section 482 is to prevent the artificial shifting of the net incomes of controlled taxpayers by placing controlled taxpayers on a parity with uncontrolled, unrelated taxpayers”. Section 482 is expressly applicable when the issue in dispute is the income tax of the subject companies, not the gift tax of their shareholders. This generality does not mean that principles and authorities under section 482 may never be considered in analogous contexts; but neither is section 482 the governing authority every time a gift tax valuation requires allocating profits between two companies.

[xxii] In the latter situation, the corporation’s payment may be treated as a constructive dividend to the relevant shareholder.

[xxiii] Reg. Sec. 25.2511-1(h)(1). For example, where the contributor has no business connection to the corporation in connection with which it may be making the transfer.

[xxiv] Reg. Sec. 1.351-1(b)(1).

[xxv] Under Section 351 of the Code.

[xxvi] Depending upon the relationship between the contributing parties, the disproportionate transfer may represent compensation for services rendered, or repayment of a loan, among other things.

The Break-Up

After a tense period of disagreement and stalemate, the threat of litigation,[i] the ensuing economic and emotional stress, Client and their former fellow-shareholder (“Departing”) – and onetime friend, before their disagreement on the direction of the business turned into much worse – have gone their separate ways. The corporation (“Corp”)[ii] through which they once operated the business together has been divided in two, with Departing taking one part of the business, while Client remained with the other. Each of them will now be free to manage and operate their respective business without interference or objections from the other.[iii]

Thankfully, the break-up was accomplished on a tax-efficient basis; otherwise, the process would have been a lot more expensive considering the very low basis each of them has for their shares of Corp stock. Their attorneys had discussed a buyout, either by way of a cross-purchase[iv] or a redemption,[v] but that would have required third-party financing,[vi] and would have resulted in a large taxable gain to Departing.[vii] Besides, by that point, the two of them could never have agreed on a price for the shares (though Client seems to recall a provision in that draft shareholders’ agreement, that was never executed, which set forth a process for determining the value of the corporation).[viii] Client had also considered a sale by Corp to Departing of those assets needed for that part of the business in which Departing was most interested, and which proved to be the root cause of their disagreement. However, this too would have generated significant taxable gain.[ix]

Then Client met with their tax adviser.[x]

After consulting with the adviser, and pursuant to written agreement, Corp formed a subsidiary corporation (“Sub”) to which it contributed the business assets that Departing wanted;[xi] in exchange for this contribution, Sub issued all of its stock to Corp, and Corp then distributed all of the Sub stock to Departing in exchange for all of Departing’s shares of Corp stock. As a result of this transaction – the tax adviser called it a “divisive reorganization” or a “split-off”[xii] – Client was left as the sole shareholder of Corp while Departing became the sole shareholder of Sub. It’s true that Corp also had to distribute some cash to Departing in order to fully compensate Departing for their shares in Corp, but that was a small price to pay.[xiii]

The tax adviser explained that the foregoing transaction would be treated as a “reorganization”[xiv] and would not be taxable to Client,[xv] to Corp,[xvi] or to Sub, and that Departing would recognize any gain realized on the exchange only to the extent of the “equalizing” cash distribution.[xvii]

The adviser also explained that certain information would have to be filed with the tax returns for the year of the transaction by each corporation and exchanging shareholder involved in the reorganization.[xviii] Client thought, “I’ll let the accountants worry about that.”

Finally, the tax adviser said something about “It ain’t over til the cows sing,” which Client interpreted as a warning that something may still go wrong, that some post-reorganization event may trigger an adverse tax result. At the same time, however, Client knew how the adviser regularly mangles idioms;[xix] still, they wondered what the adviser meant – who wouldn’t, right?

A few months later, Client finds out that Departed (formerly Departing) may be selling C to a competitor and moving to Florida.[xx] Client calls their tax adviser and informs them of this development, to which the adviser replies, “I guess the cows are coming home.” Again, Client doesn’t fully grasp the adviser’s meaning, but recognizes that it can’t be good.

Tax-Free Division

In order to appreciate the import of this last exchange between the tax adviser and Client, it will help to first review the many requirements that have to be satisfied in order for the above-described divisive reorganization of Corp to receive favorable income tax treatment:

  • In general, the distributing parent corporation (Corp or “D”) must distribute to some or all of its shareholders (Departing) all of the stock of a subsidiary corporation (Sub or “C”) that was controlled by D immediately prior to the distribution (the “Distribution”);
  • D and C must each be engaged in the “active conduct of a trade or business” immediately after the Distribution;[xxi]
  • Neither D’s nor C’s active trade or business was acquired in a taxable transaction during the five-year period preceding the Distribution;[xxii]
  • There is a corporate business purpose[xxiii] for the Distribution that cannot be accomplished by another nontaxable alternative which is neither impractical, nor unduly expensive;[xxiv]
  • Immediately following the Distribution, neither D nor C has investment assets the FMV of which is two-thirds or more of the FMV of all of the corporation’s assets;
  • The distributee-shareholders (Departed) did not acquire their D shares by “purchase” during the five-year period ending on the date of the Distribution;[xxv]
  • The transaction must not be used principally as a “device” for the distribution of the earnings and profits of either D or C (the “device” test);
  • D’s pre-Distribution shareholders (Client and Departed) must maintain a sufficient degree of stock ownership in both D and C following the Distribution (the “continuity of interest” test);[xxvi]
  • The Distribution is not made pursuant to a plan by which at least 50-percent of D’s or C’s stock will be acquired by third parties (the “disguised sale” test);[xxvii] and
  • Following the Distribution, D must continue the business it retained, while C must continue the business transferred to it by D.[xxviii]

In general, if these requirements are satisfied, (1) Departed will not recognize gain or loss upon the receipt of the C stock,[xxix] (2) D will not recognize gain or loss upon the funding of C, or upon the distribution of the C stock to Departed, (3) the assets contributed by D to C will have the same basis in C’s hands as they had in D’s immediately before the contribution,[xxx] (4) the aggregate basis of the C stock received by Departed in the Distribution will equal their aggregate basis in the D stock surrendered in the Distribution,[xxxi] and (5) the holding period of the C stock received by Departed will include the holding period of their D stock.[xxxii]

Post-Distribution Acquisition

A glance at the foregoing list[xxxiii] should alert D’s pre-Distribution shareholders – Client and Departed – that the satisfaction of some of these requirements may be dependent upon events that occur (or don’t occur) after the Distribution.

Where the specific post-Distribution event at issue is Departed’s sale of C’s stock – as posited above – the satisfaction of any one of the following tests may be called into question:

  • The device test;
  • The continuity of interest test; and
  • The disguised sale test.

If the IRS were to find that the divisive reorganization failed any one of these tests,[xxxiv] the transaction would not qualify for the favorable tax treatment described above. We’ll consider each of these in turn.

Device Test

The Code denies tax-free treatment where Distribution is used principally as a “device” for the distribution of the earnings and profits of D and/or C.[xxxv] This rule is intended to prevent a shareholder from removing corporate income – that might otherwise have been distributed as a dividend – through post-Distribution sales of C stock which allow a shareholder to recover the basis for their shares.[xxxvi]

 According to the Code, “the mere fact” that stock in either D or C is sold by Departed subsequent to the Distribution, “other than pursuant to an arrangement negotiated or agreed upon prior to the [Distribution] shall not be construed to mean that the transaction was used principally as a . . . device.”[xxxvii]

The determination of whether a divisive reorganization was used principally as a device will be based on all the facts and circumstances. The regulations list both “device factors,” tending to indicate that a transaction is a device,[xxxviii] and “nondevice factors,” tending to indicate that the transaction is not a device.[xxxix] These factors are weighed against each other.

The prearranged sale by Departed of their stock in C would be considered “substantial evidence” of device, whereas a stock sale that was not prearranged would nonetheless be considered “evidence of device.”[xl] Either way, the Distribution and the later sale must somehow be connected in order to rise to the level of a device; this presents a question of fact.

In general, the greater the percentage of C stock sold, and the closer in time to the Distribution that the sale of C occurs, the stronger the evidence of device.[xli]

Significantly, a post-Distribution sale of C may be treated as having been effectuated “pursuant to an arrangement negotiated or agreed upon before the distribution,” even though enforceable rights to buy or sell the C stock did not exist at the time of the spin-off, if the sale was discussed before the Distribution and was “reasonably to be anticipated by both parties.”[xlii]

By reason of certain “non-device” factors in the regulations, however, the post-Distribution sale of C stock may not trigger a device problem, even where the sale occurs soon after the distribution. The presence of these factors tends to negate the existence of a device, though the strength of the nondevice evidence will depend upon all the facts and circumstances, and must be balanced against the evidence of device.

For example, although the “business purpose” requirement exists independently of the device test,[xliii] the regulations recognize a relationship between the device test and the business purpose requirement.[xliv] Specifically, a strong corporate business purpose for the Distribution is generally evidence that the transaction was not used principally as a device for the distribution of earnings and profits, and may outweigh the presence of device factors.[xlv] However, the stronger the evidence of device, the stronger the corporate business purpose that may be required to prevent a determination that the transaction was used as a device.[xlvi]

Continuity of Interest

The sale of the C stock received by Departing in the Distribution may also implicate the continuity of interest requirement.[xlvii]

The regulations[xlviii] state that “Section 355 applies to a separation that effects only a readjustment of continuing interests in the property of [D and C].” This requires that, after the Distribution, “one or more persons who . . . were the owners of” D before the Distribution – i.e., Client and Departed – “own, in the aggregate, an amount of stock establishing a continuity of interest in each of” D and C after the Distribution. However, it is not necessary for the same pre-Distribution shareholders of D to satisfy the continuity requirement for both D and C after the Distribution; rather, the test is satisfied so long as some D shareholders (Client) retain a meaningful continuing interest in D, while others (Departed) do so as to C.[xlix] After all, this is a divisive reorganization.

Of course, “continuity” requires a certain degree of stock ownership. For advance ruling purposes, the IRS considers continuity of interest to exist when one or more persons who were the owners of D before the Distribution own, in the aggregate, 50-percent or more of the stock in each of D and C after the Distribution.[l] Likewise, although the regulations do not establish a minimum required continuity, they also indicate that 50-percent continuity is sufficient.[li]

Viewed as of the date of the Distribution only, this requirement should not present an issue. However, where the stock of C is sold shortly after the Distribution, the IRS and the courts have always looked beyond the time of the Distribution itself.

Specifically, they will examine the period preceding the Distribution to see if Departed had any discussions with potential buyers during that time which might lead to the conclusion that Departed never intended to hold the C stock. They will try to ascertain whether Departed had obligated themselves to sell the stock.

Alternatively, they will consider the period following the Distribution to see if anything unexpected occurred – whether in C’s industry or in the economy generally, for example – that might have created a situation in which the sale of the C stock should not be interpreted as a violation of the continuity of interest test.

Depending on the outcome of this examination of the surrounding circumstances, the reorganization may fail the continuity of interest test on account of the post-Distribution sale of C stock.

The IRS has always treated a post-Distribution sale – like Departed’s sale of the C stock – as a significant factor in determining whether the continuity of interest test was satisfied in the case of a divisive reorganization. Thus, for advance ruling purposes, taxpayers are asked to represent that there is no plan or intention by D’s shareholders to sell, exchange, or otherwise dispose of any of their stock in C after the transaction.[lii]

Applying basic continuity of interest principles[liii] – including variations of the step transaction doctrine[liv] – where a former D shareholder is obligated at the time of the Distribution to sell their C stock to a third party after the Distribution, the continuity test is not satisfied.

By the same token, where there is no such obligation to sell the C stock, one must consider the overall facts and circumstances to discern the former D shareholder’s intent with respect to the C stock. For example, a sale of the stock shortly after the Distribution may indicate to the IRS – which almost always has the benefit of hindsight – that Departed intended to sell the C stock which, the IRS would assert, violated the continuity of interest rule.

In that case, Departed may be faced with the challenge of trying to establish that they did not intend to sell the C stock at the time of the Distribution, but that circumstances changed unexpectedly after the Distribution, such that the shareholder’s original plan or intention with respect to the C stock was no longer viable or sensible.

Even where the former D shareholder had no plan, as of the date of the Distribution, to sell the C stock – meaning that their intention was to hold such stock – the question remains: how long after the Distribution must they hold the C stock to satisfy the continuity of interest test? Unfortunately, there is no clear answer. In the absence of a significant change in circumstances, the longer the better, though two years is generally considered a safe period.

Disguised Sale

The Code denies tax-free treatment to any distribution of C stock that is a component of a divisive reorganization of D if it is part of a plan (or series of related transactions) pursuant to which one or more persons acquire stock in C (or D) that represents a 50-percent or greater interest in C (or D).[lv] In other words, this rule causes D to be taxed on the Distribution.

What’s more, the Code establishes a presumption that such a plan exists if one or more persons acquire 50% or more of the stock of C during the four-year period beginning two years before a spin-off and ending two years after the spin-off,[lvi] “unless it is established that the distribution and acquisition are not pursuant to a plan or series of related transactions.”

Whether a distribution and an acquisition are part of a “plan” is determined based on all the facts and circumstances surrounding the transactions. The regulations set forth a non-exhaustive list of facts and circumstances to be considered in determining whether a distribution and an acquisition are part of a plan. In general, the weight to be given each of the facts and circumstances depends on the particular case. Whether a distribution and an acquisition are part of a plan does not depend on the relative number of facts and circumstances that evidence that a distribution and an acquisition are part of a plan as compared to the relative number of facts and circumstances that evidence that a distribution and an acquisition are not part of a plan.[lvii]

That being said, and before turning to the plan and non-plan factors referenced above, it is important to note that the regulations provide, in the case of an acquisition after a distribution – as in the case of the sale by Departed of the C stock after the Distribution – that the distribution and the acquisition can be part of a plan only if there was an agreement, understanding, arrangement, or substantial negotiations[lviii] regarding the acquisition of C, or a “similar” acquisition,[lix] at some time during the two-year period ending on the date of the distribution. Therefore, in the absence of such an agreement, understanding, arrangement, or substantial negotiations during the two-year period ending with the Distribution, the sale of C after the Distribution should not run afoul of the disguised sale rule.

That being said, in the case of an acquisition after a distribution, the existence of an agreement, understanding, etc., regarding the acquisition or a similar acquisition at some time during the two-year period ending on the date of the distribution tends to show that the distribution and the acquisition were part of a plan. The weight to be accorded this fact will depend on the nature, extent, and timing of the agreement, understanding, etc., though the existence of any of these “at the time of the distribution is given substantial weight.”[lx]

However, it is still possible for the taxpayer to establish, based on all facts and circumstances, that the distribution and the acquisition were not part of a plan; for example, if the distribution was motivated in whole or substantial part by a corporate business purpose other than a business purpose to facilitate the acquisition of C, and would have occurred at approximately the same time and in similar form regardless of whether the acquisition was effected.[lxi]

Of course, the fact that the distribution was motivated by a business purpose to facilitate the subsequent acquisition tends to show that the distribution and acquisition were part of a plan.[lxii]

On the other hand, one also has to consider those factors tending to show that a distribution and an acquisition occurring after the distribution are not part of a plan. For example,

  • There was an identifiable, unexpected change in market or business conditions occurring after the distribution that resulted in the acquisition that was otherwise unexpected at the time of the distribution.
  • The distribution was motivated in whole or substantial part by a corporate business purpose other than a business purpose to facilitate the acquisition.
  • The distribution would have occurred at approximately the same time and in similar form regardless of the acquisition.[lxiii]

In order to provide taxpayers greater certainty as to certain post-distribution sales, the regulations promulgated under the disguised sale rules also set forth the following safe harbors:[lxiv]

  • (a) The Distribution was motivated in whole or substantial part by a corporate business purpose other than to facilitate an acquisition of C; (b) the acquisition of C occurs more than six months after the Distribution; and (c) there was no agreement, understanding, arrangement or substantial negotiations concerning the acquisition or a similar acquisition during the period that begins one year before, and ends six months after, the Distribution.
  • (a) The distribution was not motivated by a business purpose to facilitate the acquisition or a similar acquisition; (b) the acquisition occurs more than six months after the Distribution; and (c) during the period beginning one year before and ending six months after the Distribution, there was no agreement, understanding, arrangement or substantial negotiations concerning the acquisition or a similar acquisition; and (d) no more than 25-percent of the stock of the acquired corporation was acquired during such 18-month period.
  • (a) There was no agreement, understanding, or arrangement concerning the acquisition or a similar acquisition at the time of the Distribution; and (b) there was no agreement, understanding, arrangement or substantial negotiations concerning the acquisition or a similar acquisition within one year after the Distribution.[lxv]

Did The Cows Sing or Come Home?

If, as of the date of the Distribution, at least, the division of Corp otherwise satisfied the criteria for a tax-free divisive reorganization, would the subsequent sale of the C stock by Departed result in a taxable division by causing the transaction to violate any of the device, continuity of interest and disguised sale tests?

Based on the facts provided, above, it is difficult to say. The fact of a sale shortly after the Distribution would be a negative factor, though we have no information regarding the impetus for the sale. Moreover, we do not know whether Departed had any discussions with the prospective acquirer of C prior to the Distribution, the nature thereof, or whether any agreement was reached. We do know that Client’s and Corp’s only purpose for the division was to enable the two shareholders and their respective business interests to go their separate ways, not to facilitate a sale.

Thankfully, the idiom-challenged tax adviser foresaw some of the risks that would be posed by a subsequent sale, and tried to address them as much as possible in the negotiations that preceded the Distribution.

For one thing, the adviser ensured, as the saga between the two shareholders unfolded and during the preparation of reorganization agreements, that the business purpose for the transaction was well documented and substantiated.

The adviser also succeeded in convincing Departing to include in the agreement (i) representations that they had not engaged in any discussions with any person up until then regarding a disposition of C, and had no present plan or intention of selling C, or of causing C to sell its assets,[lxvi] after the Distribution; (ii) a covenant that, for the two-year period following the Distribution, Departing would not transfer any C stock without first notifying Corp and Client, and providing an opinion of counsel, acceptable to Corp and Client, that the proposed sale would not compromise the tax-free divisive reorganization;[lxvii] (iii) a covenant that the parties would report the Distribution consistently with the agreement and would not take any action that may reasonably be expected to jeopardize the tax-free reorganization; and (iv) indemnity provisions in case of a breach of any of the foregoing.

With these provisions in place, the cows may eventually feel like singing. Whether they do so at home or elsewhere is beside the point.

[i] Including, perhaps, a petition for dissolution under NY-BSC Sec. 1104, on the ground that the shareholders were deadlocked.

[ii] Do you recall the name of John Wayne’s character’s canine sidekick in the movie Big Jake? “Dog.”

[iii] A classic “fit and focus” business purpose. See Rev. Proc. 96-30, Appendix A.

[iv] I.e., a purchase and sale of shares of stock between the two shareholders.

[v] In which the corporation would have purchased its stock from the departing shareholder, resulting in a complete termination of the seller’s equity interest in the corporation. IRC Sec. 302(b)(3).

[vi] For example, a bank loan, and its attendant costs (including ongoing interest payments and financial covenants).

[vii] IRC Sec. 1001. Probably a long-term capital gain because the stock represented a capital asset in the hands of the selling shareholder. IRC Sec. 1221. Such gains are taxed at a federal rate of 20-percent. If the issuing corporation is a C corporation, the 3.8-percent surtax on net investment income will also apply. Assuming the seller is a resident of N.Y. City, the maximum State tax rate on personal income (whether ordinary income or capital gain) is 8.82-percent, while the City rate is 3.876-percent.

[viii] I’m not gonna say it. You won’t hear “I told you so,” from me. Nope. No way.

[ix] For the selling-corporation, and perhaps for the departing shareholder if the transfer by the corporation was made, in part, in redemption of the buyer’s shares. Of course, if the corporation were an S corporation, the remaining shareholder would be allocated their share of the corporation’s gain. IRC Sec. 1366.

[x] “A dog who thinks he is a man’s best friend is a dog who obviously has never met a tax lawyer.” – Fran Lebowitz.

[xi] Of course, Corp also “transferred” to Sub, and Sub accepted, the liabilities associated with the assets. For purposes of this discussion, we will not be focusing on the treatment of such liabilities.

[xii] In general, a “spin-off” describes what will usually be a pro rata distribution by a parent corporation of the stock of a subsidiary corporation to the parent corporation’s shareholders, following which the two corporations may be described as brother-sister corporations (because of their overlapping ownership); a split-off describes a distribution in which one of more of the parent’s shareholders exchange all of their parent stock for stock in the distributed subsidiary corporation (though some shareholders may continue to own stock in both corporations); a split-up may be described as the liquidation of the parent corporation, in which it distributes all of the stock of two or more subsidiary corporations to its shareholders in liquidation of their parent stock.

[xiii] So-called “boot.”

[xiv] Described in IRC Sec. 368(a)(1)(D) and Sec. 355. A corporation is generally required to recognize gain on the distribution of property (including stock of a subsidiary) as if the property had been sold for its fair market value. See, e.g., IRC Sec. 311(b). The shareholders generally treat the receipt of the property as a taxable event as well. Section 355 provides an exception to this general rule.

[xv] No sale or exchange of any property.

[xvi] IRC Sec. 361; see also Sec. 355(c).

[xvii] IRC Sec. 355(a) and IRC 356.

[xviii] Reg. Sec. 1.368-3 and Reg. Sec. 1.355-5.

[xix] “Behind the cue ball” and “beating a horse to death” are two of the better-known examples of the adviser’s missteps in the world of idioms.

[xx] Hopefully, Departed consulted their own advisers before doing so.

[xxi] Actively conducted for at least five years prior to the distribution, and that was not acquired by D or C during that period in a transaction in which any gain or loss was recognized. IRC Sec. 355(b).

[xxii] Though the expansion of an existing qualifying business may, generally, be effected through such an acquisition.

[xxiii] Reg. Sec. 1.355-2(b). As distinguished from a shareholder purpose. There are times when these will overlap, especially in the context of a family-owned corporation.

[xxiv] Rev. Proc. 96-30.

[xxv] IRC Sec. 355(d).

[xxvi] Reg. Sec. 1.355-2(c).

[xxvii] IRC Sec. 355(e); Reg. Sec. 1.355-7.

[xxviii] Reg. Sec. 1.368-1(d). The “continuity of business enterprise” test.

[xxix] IRC Sec. 355(a). Except to the extent on any boot received. IRC Sec. 356.

[xxx] IRC Sec. 362.

[xxxi] IRC Sec. 358.

[xxxii] IRC Sec. 1223.

[xxxiii] Or at the underlying regulations in some cases.

[xxxiv] Truth be told, if the sale of C violated one of these three tests, odds are that all three have been violated.

[xxxv] IRC Sec. 355(a)(1)(B); Reg. Sec. 1.355-2(d).

[xxxvi] Reg. Sec. 1.355-2(d)(1). A dividend does not allow for basis recovery. See also IRC Sec. 302 and Sec. 301.

[xxxvii] IRC Sec. 355(a)(1)(B). It follows that an arrangement agreed upon prior to the distribution is not a good fact.

[xxxviii] Reg. Sec. 1.355-2(d)(2).

[xxxix] Reg. Sec. 1.355-2(d)(3).

[xl] Reg. Sec. 1.355-2(d)(2)(iii)(B)-(C).

[xli] Reg. Sec. 1.355-2(d)(2)(iii)(A).

[xlii] Reg. Sec. 1.355-2(d)(2)(iii)(D).

[xliii] Reg. Sec. 1.355-2(b).

[xliv] Reg. Sec. 1.355-2(d)(3)(ii).

[xlv] Reg. Sec. 1.355-2(b)(4).

[xlvi] Thus, strong device factors may overcome a weak business purpose.

[xlvii] As indicated earlier, the continuity of interest requirement is an independent requirement for IRC Sec. 355 qualification.

[xlviii] Reg. Sec. 1.355-2(c)(1).

[xlix] Reg. Sec. 1.355-2(c)(2), Ex. 1.

[l] Rev. Proc. 96-30.

[li] This should be distinguished from the acquisitive reorganization provisions, for which the continuity of interest test is applied differently.

[lii] Rev. Proc. 96-30. For purposes of the fact pattern considered herein, a more accurate representation would be that the former D shareholder (Departed) had no plan or intention to dispose of a number of shares of C stock received in the Distribution that would reduce their ownership of C stock to a number of shares having a value, as of the date of the Distribution, of less than 50-percent of the value of all of the C stock as of the same date.

[liii] Which are still applicable to divisive reorganizations, but which have been somewhat relaxed for acquisitive reorganizations.

[liv] Under this doctrine, a set of pre-arranged transactional steps (some of which may lack economic substance) may be collapsed or stepped together to arrive at the same end-result, though with a less favorable income tax outcome for the taxpayer. The problem from the taxpayer’s perspective is the uncertainty inherent in the application of the doctrine. Those transactions that include steps that are undertaken solely for their tax consequences are clear candidates. Others are more difficult to ascertain.

[lv] IRC Sec. 355(e); Reg. Sec. 1.355-7. The focus herein will be on C. The rationale behind this provision is simple: the reorganization provisions are intended to permit a tax-free division of an existing business arrangement among existing shareholders. In cases in which it is intended that new persons will acquire ownership of a business in connection with the division, the transaction more closely resembles a sale by the corporation of the portion of the business that is acquired by the new persons.

[lvi] IRC Sec. 355(e)(2)(B). The rule also covers the sale of D stock, but for our purposes we are focusing on C.

[lvii] Reg. Sec. 1.355-7(b)(1). In other words, one factor may outweigh other contrary factors.

[lviii] Reg. Sec. 1.355-7(b)(2). Whether an agreement, understanding, or arrangement exists depends on the facts and circumstances. It requires the involvement of persons authorized to act on behalf of C and their authorized counterparts at the acquirer. The parties do not necessarily have to have entered into a binding contract or have reached agreement on all significant economic terms to have an agreement, understanding, or arrangement. However, an agreement, understanding, or arrangement clearly exists if a binding contract to acquire stock exists.

Substantial negotiations in the case of an acquisition generally require discussions of significant economic terms by persons authorized to act on behalf of C with persons who are authorized to act on behalf of the acquirer. See Reg. Sec. 1.355-7(h)(1).

[lix] In general, an actual acquisition is similar to another potential acquisition if the actual acquisition effects a combination of all or a significant portion of the same business operations as the combination that would have been effected by such other potential acquisition. However, in general, an actual acquisition is not similar to another acquisition if the ultimate owners of the business operations with which C is combined in the actual acquisition are substantially different from the ultimate owners of the business operations with which C was to be combined in such other acquisition. Reg. Sec. 1.355-7(h)(12).

[lx] Reg. Sec. 1.355-7(b)(3)(i).

[lxi] Reg. Sec. 1.355-7(b)(2).

[lxii] Reg. Sec. 1.355-7(b)(3)(v).

[lxiii] Reg. Sec. 1.355-7(b)(4).

[lxiv] Reg. Sec. 1.355-7(d). These are the ones applicable to transactions between closely held corporations.

[lxv] There are a lot of nuances in these safe harbors – read them carefully.

[lxvi] Other than in the ordinary course.

[lxvii] Client made the same representations and covenants as to Corp for the benefit of Departing.

General Principles

Many business owners who reside in New York, and whose business is headquartered in the state, pay income taxes not only to New York, but to other jurisdictions as well.

For example, the resident owners of a business may operate through a corporation that has elected to be treated as an S corporation,[i] or through a limited liability company that is treated as a partnership for tax purposes.[ii] This pass-through entity[iii] may be doing business outside New York. Because of the entity’s pass-through nature, the owners themselves may be considered as engaging in business within those jurisdictions.[iv] Thus, the New York owners may be required to file a nonresident income tax return in such a “foreign” jurisdiction in order to report their share of the business’s income that is sourced in that jurisdiction, and to pay the resulting tax liability.[v]

Of course, each resident owner will also file a resident income tax return with New York. These returns will report the owner’s entire income, regardless of source,[vi] and will determine the New York tax thereon.[vii]

The resident return will also report the income taxes paid by the resident owner to other jurisdictions on account of the owner’s deemed “business activities” therein.[viii]

Tax Credits

These “foreign” taxes generally will be credited against the tax owing by the resident owner to New York, in order to ensure that the same items of income are not taxed twice – once by New York and once by the source jurisdiction.[ix]

Specifically, the resident owner will be allowed a credit against the tax otherwise due New York only for that portion of any personal income tax imposed by the other jurisdiction that is “applicable to the income derived from sources within such other taxing jurisdiction.”[x]

Generally speaking, the term “income derived from sources within” another state is construed so as to limit the income for which New York will allow a credit to income that is attributable to real property in the other state, or to a trade or business carried on in the other state.[xi]

Income from intangible property is not treated as “income derived from sources within” another state unless the intangible property is employed in a business carried on in that other state.[xii] Thus, gains from the disposition of intangible personal property – for example, from the sale or exchange of shares of stock – will not constitute income derived from within another state except to the extent that the property is employed in a business carried on in the other state.[xiii]

Consequently, New York’s credit for “foreign” taxes generally does not extend to investment income from intangible personal property that is taxed by other states. For all intents and purposes, such income is without a geographical situs insofar as New York is concerned.

“Dual Residence”

New York’s tax credit rules may seem “limited” in that a large category of taxable income is excluded from their purview.

It should be noted, however, that a state – including New York[xiv] – will generally not impose a tax on a nonresident’s income from intangible personal property except to the extent the property is used in a business in that state. The taxation of such income is left to the individual’s state of residence, which renders moot the question of a credit for taxes paid by that individual on such income to another state.

But what happens when an individual taxpayer is a resident of two states?

Statutory Residence

There are instances in which an individual taxpayer who is not domiciled[xv] in New York will nonetheless be treated as a resident of New York for a particular tax year. Specifically, if the individual maintained a permanent place of abode[xvi] in the state for substantially all of the taxable year[xvii] and spent more than 183 days in the state during such year, they will be taxed a New York resident.[xviii]

In that case, the taxpayer is required to file as a resident of their state of domicile and as a resident of New York.[xix] In most cases, that means they have to report all of their income, from whatever source, to both states, and they have to pay tax on the same income to both states.

Unfortunately for most taxpayers, they are not aware of their classification as a “statutory resident” of New York until they have been audited by the state’s Department of Taxation and Finance, at which point they face not only a tax deficiency,[xx] but also interest and penalties.

And if that isn’t enough of a shock, the newly anointed statutory resident also learns at that time that the credit which New York extends for taxes paid to other states, on income derived from those states, is generally not available for intangible income because that income has no identifiable situs. In other words, such income generally is not deemed to have been derived from the taxpayer’s efforts in any jurisdiction outside of New York, and it cannot be traced to any jurisdiction outside New York. Rather, it is treated as investment income which is subject to tax in New York as the taxpayer’s state of residence.

In the case of a New York statutory resident who is domiciled in another state, these tax rules may cause the individual taxpayer to actually be taxed twice – by New York and by their state of domicile – on the same income from intangible property.

Sounds outrageous, doesn’t it?

The Edelman Case

One taxpayer certainly thought it did.

“Taxpayer” was domiciled in Connecticut in the years 2010 and 2013, but also maintained a home in New York City, where they had worked for thirty years and where, in 2003, they had formed a corporation (“Corp”), with its only office in New York City.

Both before and after they sold Corp to Buyer in 2010, Taxpayer – who commuted from Connecticut – served as an executive in New York City of what prior to the sale was Corp, and thereafter was a division of Buyer. Taxpayer was physically present in New York City for more than 183 days during both 2010 and 2013.

In the transaction with Buyer in 2010, Taxpayer sold their shares of Corp’s outstanding stock, of which they owned 95-percent, generating significant capital gains. In addition, in both 2010 and 2013, Taxpayer had interest and dividend income from investments in securities, in addition to their wage income from either Corp or Buyer.

Taxpayer filed Connecticut Resident Income Tax Returns for 2010 and 2013, and paid Connecticut tax on the income reported.

In their New York income tax returns for 2010 and 2013, Taxpayer claimed to be a “nonresident” of New York, and reported a substantial part of their wage income as “New York source,” because it resulted from Taxpayer’s work in New York City.

However, Taxpayer failed to treat any of their interest, dividends or capital gain income in either year as “New York source” because, as Taxpayer alleged, “it constituted income from intangible property.”[xxi]

New York’s Position

In 2014, the Department of Taxation and Finance commenced an audit of Taxpayer’s 2010 and 2013 New York tax returns, and concluded that Taxpayer was a “statutory resident” of New York State and of New York City during those years. As such, Taxpayer became subject to New York tax on their worldwide income regardless of the source of such income. This included the gain derived from the sale of their Corp stock to Buyer in 2010.

The Department issued a Notice of Deficiency asserting additional New York State and New York City income tax due from Taxpayer in excess of $4 million, plus interest of almost $2 million. Taxpayer had paid these amounts prior to the Notice of Deficiency, under protest, in order to stop the accumulation of interest.[xxii]

The Courts

In 2016, Taxpayer commenced a declaratory judgement action in the Supreme Court of New York,[xxiii] New York County, in which they claimed that New York’s statutory residence scheme – under which taxpayers who were treated as statutory residents were denied credits for taxes actually paid to their state of domicile in respect of intangible income – violated the U.S. Constitution by discriminating against, or unduly burdening, interstate commerce.[xxiv]

Well, it didn’t go too well for Taxpayer.

The Department asked the Supreme Court to dismiss Taxpayer’s action for failure to state a cause of action. The Department contended that Taxpayer’s intangible income was being taxed solely because they were New York residents. It further claimed that Taxpayer’s status as a commuter was not at issue, only their “degree of permanence” in New York. The Department also argued that the double taxation issue had no merit because Taxpayer enjoyed the privileges of protection of two states, and were given tax credits in New York for taxes paid for income “derived from” the other states.

The Court observed that Taxpayer owned an apartment in New York City, worked in New York City, and had a presence in New York for more than 183 days. Thus, Taxpayer was being taxed as a New York statutory resident. Taxpayer described themselves as domiciled in Connecticut and paying taxes in that state, but the intangible income being taxed by New York, the Court noted, was not specifically derived from employment or business conducted outside New York. Therefore, the taxation in New York did not involve income derived from Connecticut.

Accordingly, the Court dismissed Taxpayer’s complaint.[xxv]

Undeterred, Taxpayer appealed the Supreme Court’s decision to the Appellate Division[xxvi] but, in 2018, this Court upheld the lower court’s decision in a one-page opinion.[xxvii]

Perhaps thinking that the third time would be the charm, earlier this year Taxpayer asked New York’s highest court to consider its case. The Court of Appeals, however, denied Taxpayer’s motion for leave to appeal, upon the ground that no substantial constitutional question was directly involved.[xxviii]

Finally, Taxpayer asked the U.S. Supreme Court to review the decisions of the New York courts. Last week, the Taxpayer’s petition for writ of certiorari was denied.[xxix]

So Where Are We?

The refusal by the U.S. Supreme Court (i) to review the New York Court of Appeals’ refusal (ii) to review the Appellate Division’s decision (iii) to uphold the New York Supreme Court’s decision (iv) to dismiss Taxpayer’s action for failure to state a cause of action – take a deep breath – leaves intact New York’s scheme for taxing the intangible income of statutory residents.

That means a business owner who is domiciled in another state – say, in any of the states that are contiguous to New York (Connecticut, Massachusetts, New Jersey, Pennsylvania or Vermont) – and whose business is in New York, who works in New York in excess of 183 days during a taxable year, and who has a permanent place of abode in New York, whether or not such place of abode is located anywhere near the place of business, will be subject to New York income tax with respect to all of their income as if they were a resident of New York.

If the owner disposes of their business during a period of statutory residence – a status of which the owner may not become aware until a couple of years later, and only after an audit by New York – their gain realized from the sale will be subject to New York income tax as though the owner were a New York resident. Thus, the gain would be taxed at the state level at a tax rate of 8.82-percent and, if the owner is also treated as a statutory resident of New York City, an additional tax at a rate of 3.876-percent will be imposed on such gain.

Can it get any better than this? Yep. The “pièce de résistance” is New York’s denial to the statutory resident of any credit for tax paid by the owner on this very same gain to the owner’s state of domicile.

Ah, the bliss of double taxation.

I ask you: is the New York tax on the sale of a non-domiciliary’s New York business worth the apartment in New York City, or the lodge in the Adirondacks, or the beach house in Montauk, or the cabin near the Finger Lakes?[xxx]

Before such an individual disposes of their New York business in a taxable transaction, they need to address the issue of their permanent place of abode.


[i] IRC Sec. 1361 and Sec. 1362.

[ii] IRC Sc. 761; Reg. Sec. 301.7701-3.

[iii] The entity’s income is generally not taxed at the entity-level but, rather, passes through to its owners who report it on their own tax returns. IRC Sec. 701, Sec. 702, Sec. 1363, Sec. 1366.

[iv] There is a comparable rule with respect to non-U.S. persons who are partners of a partnership doing business in the U.S. See IRC Sec. 875.

[v] In some cases, the entity may have to make estimated tax payments to the “foreign” jurisdiction on behalf of its nonresident partners.

[vi] I.e., from all jurisdictions.

[vii] Tax Law Sec. 612(a).

[viii] I.e., through the pass-through entities of which they are a shareholder or a member/partner.

[ix] Assuming that income is subject to tax in New York. Tax Law Sec. 620(a).

[x] 20 NYCRR Sec. 120.1(a)(2).

[xi] 20 NYCRR Sec. 120.4(d). It may also include income related to a business previously carried on in that state, including, for example, payments under a covenant not to compete.

[xii] Tax Law Sec. 631.

[xiii] A business owner’s shares of stock in the corporation through which the owner operates their business do not fall within this category.

[xiv] Tax Law Sec. 631(b)(2).

[xv] “Domicile” refers to an individual’s “permanent” home. An individual can have only one domicile. One’s domicile does not change unless one can demonstrate that they have abandoned such domicile and have established a new domicile elsewhere. NYCRR Sec. 105.20(d).

[xvi] NYCRR Sec. 105.20(a).

[xvii] Generally speaking, at least eleven months.

[xviii] Tax Law Sec. 605(b). So-called “statutory residence.” It “serves the important function of taxing those ‘who, while really and [for] all intents and purposes [are] residents of the state, have maintained a voting residence elsewhere and insist on paying taxes to us as nonresidents.’” Tamagni, 91 N.Y. 2d at 535 (quoting Bill Jacket, L.1922, ch 425).


[xx] For which a federal itemized deduction may not be presently available, courtesy of the Tax Cuts and Jobs Act (P.L. 115-97).

[xxi] Which is not taxable to a nonresident of New York unless the property is used by the nonresident in a New York trade or business.

[xxii] The power of compound interest.

[xxiii] The trial-level court in New York.

[xxiv] The “dormant commerce clause.”

[xxv] Edelman v. New York State Department of Taxation and Finance, 2017 WL 2537050 (N.Y.Sup.) (Trial Order), Supreme Court of New York, New York County.

[xxvi] This court hears appeals from lower courts in New York, including the Supreme Court.

[xxvii] Edelman v. New York State Department of Taxation and Finance, 162 A.D.3d 574, Supreme Court, Appellate Division, First Department, New York.

[xxviii] Edelman v. New York State Department of Taxation and Finance, 32 N.Y.3d 1216, Court of Appeals of New York.

[xxix] Edelman v. New York State Department of Taxation and Finance, 2019 WL 4921468, Supreme Court of the United States.

[xxx] What’s wrong with the Vermont side of Lake Champlain, or the Poconos, or the Berkshires, or the Connecticut shore? What’s wrong with staying in a New York City hotel? I’m just saying.

The Benefit of Knowing

Monday morning quarterbacking – the connotations are anything but positive.

Life is full of instances in which someone, in possession of all the factors that informed – or that should have informed, had they known about them – another’s earlier decision, and with full knowledge of the outcome of such decision,[i] has been critical of the decision-maker, or has proffered what their own choice would have been had they been in the decision-maker’s place.

Notwithstanding the negative reactions that such behavior may elicit, it is a fact that decisions will always be judged by reference to their results[ii] – how can they not? It’s the most obvious manifestation of a decision.

Regardless of its consequences, however, a more thoughtful observer may determine that a decision was sensible under the circumstances, where it was made after careful consideration, and on the basis of the relevant facts, both known and reasonably knowable at the time.

In many cases, it may be small comfort to the decision-maker that some folks have concluded the decision made sense. In other situations, however, the ability to demonstrate that one acted reasonably and thoughtfully may be enough to shield the decision-maker from certain “penalties.”

That being said, it is unlikely that the decision-maker will be able to convince anyone that they acted sensibly, and that the consequences of their decision should be accepted, if they were no more than a passive recipient of data; rather, they must take a proactive role in gathering information, assessing its accuracy, and deducing its implications.

Post-Date Events and Taxes

Naturally, these precepts have found their way into the tax law, where they have assumed many forms.

Penalty Abatement

For example, penalties imposed with respect to various tax-related transgressions occurring in earlier years may be abated if, years later, the taxpayer can show that they had “reasonable cause” for the action taken at the time it was taken.

Generally, the most important factor in determining whether a taxpayer acted with reasonable cause is the extent of the taxpayer’s effort to assess their proper tax liability in the earlier year. Where the taxpayer consulted a professional, all facts and circumstances must be taken into account in determining whether the taxpayer reasonably relied in good faith on the professional’s advice as to the tax treatment of the taxpayer.[iii]


In the case of the sale of a closely held business, the owner of the business and the potential buyer will sometimes disagree as to the fair market value of the business because they have differing expectations[iv] for the future performance of the business, at least over the short term.

That being said, they will often agree on a “base” value – in general, the amount the buyer is willing to pay at closing – and they will then wait for the actual financial results of the business, typically over a one-to-three-year period[v] immediately following the closing, to retroactively determine the “final” sale price. In that case, the seller will treat the subsequent earn-out payment as a deferred payment of purchase price; similarly, the buyer will increase their basis for the business.[vi]

Assignment of Income

More relevant to the ruling that is the subject of today’s post, a donation of shares of stock in a closely held business to a charity will often be followed by a sale of such stock, which raises the question of whether the donating taxpayer has assigned income in these circumstances.[vii]

One relevant question is whether the prospective sale of the donated stock was a mere expectation on the date of the gift, or was it or a virtual certainty? Another relevant question is whether the charity was obligated, or could be compelled by one of the parties to the transaction, to surrender the donated shares to the acquirer?

The existence of an “understanding” among the parties, or the fact that the contribution and sale transactions occurred simultaneously, or according to prearranged steps, may be relevant in answering these questions.

For example, a court will likely find there was been an assignment of income where stock was donated after a tender offer has effectively been completed and it is unlikely that the offer would be rejected.

Charitable Contribution

Another area of the tax law in which subsequent events have played a key role in determining the tax consequences of an earlier event is the charitable contribution of property; specifically, the valuation of such property.

For example, where a donee charity sells property within three years of its receipt as a charitable contribution, the charity must report the subsequent sale on IRS Form 8282; this acts as a check on the amount claimed by the donor as a charitable deduction in respect of such property for the year in which the contribution was made.[viii]

Transfer Tax Valuation Date

Consider also the valuation of a donor’s lifetime gift of property for purposes of determining the federal gift tax liability with respect to such transfer, or the valuation of property that is included in a decedent’s gross estate for purposes of determining the decedent’s federal estate tax liability.

In each case, the value of the property is the price at which such property would change hands between a willing buyer and a willing seller, neither being under any compulsion to buy or to sell, and both having reasonable knowledge of relevant facts.[ix]

In each case, the valuation is keyed to a specified date: the date on which the gift transfer is completed or the date of death, as the case may be.[x] For example, the gift tax regulations provide that “if a gift is made in property, its value at the date of the gift shall be considered the amount of the gift.” These regulations go on to state that “[a]ll relevant facts and elements of value as of the time of the gift shall be considered.”[xi]

The foregoing references to the date of death and to the date of the gift seem to imply that events occurring after the relevant valuation date should not be considered in determining fair market value as of such date; indeed, that is the general rule.

However, the IRS has long acknowledged that “[v]aluation of securities is, in essence, a prophesy as to the future and must be based on facts available at the required date of appraisal.”[xii]

Post-Transfer Date Events

Can one reconcile the statement that post-date-of-transfer events should not be considered in determining the fair market value of property on the transfer date with the statement that the valuation process seeks to “predict” the future performance of the property?

Absolutely, if one accepts the proposition that post-transfer events should be taken into account for valuation purposes if they were reasonably foreseeable as of the valuation date.[xiii]

However, what does it mean that an event was “reasonably foreseeable?”

According to the IRS, “[a] prospective seller would inform a prospective buyer of all favorable facts in an effort to obtain the best possible price, and a prospective buyer would elicit all the negative information in order to obtain the lowest possible price. In the arm’s length negotiation between the two parties, all relevant factors available to either buyer or seller, known to both, provide a basis on which the buyer and seller make a decision to buy or sell and come to an agreement on the price.”[xiv] This would include current information concerning transactions that may occur after the valuation date.

In other words, the “reasonable knowledge of relevant facts” to which the valuation regulations refer should include those “future facts” that were knowable on the valuation date.

A recent IRS pronouncement[xv] considered whether the hypothetical willing buyer and seller of shares in a corporation[xvi] should consider a pending merger when valuing shares of the corporation’s stock for gift tax purposes.

Facts of the Ruling

Donor was a co-founder and chairman of the board of Corporation A. On Date 1, Donor transferred shares to Trust, a newly-formed grantor retained annuity trust.[xvii] Under its terms, the remainder of Trust would pass to Donor’s children upon the expiration of the annuity interest.

Later, on Date 2, Corporation A announced a merger with Corporation B. The merger was the culmination of exclusive negotiations between the two corporations occurring before the Date 1 transfer to Trust.

After the merger was announced, the value of the Corporation A stock increased substantially, though it was less than the agreed-upon merger price.[xviii]

The merger was consummated at some point after Date 1, the date of Donor’s transfer to Trust.

The IRS audited Donor’s gift tax return,[xix] and reviewed the underlying transaction documents from the year preceding the merger, including the correspondence between Corporation A and Corporation B, and the Corporation A board’s meeting minutes.

According to the IRS, the record as compiled supported the position that, as of Date 1, the hypothetical willing buyer of the shares transferred to Trust could have reasonably foreseen the merger of the two corporations and anticipated that the price of Corporation A stock would trade at a premium over what its value would otherwise have been at the valuation date.

Analysis of Valuation Rules

The IRS first reviewed the valuation rules for gift transfers (described above), including the “hypothetical willing buyer and willing seller” standard, where neither party is under any compulsion to buy or sell, and both parties have reasonable knowledge of relevant facts. The CCA stated, where it is established that the value per share of stock – as determined under the normally applicable rules[xx] – does not represent the fair market value of the stock,[xxi] some reasonable modification of the value determined on that basis, or other relevant facts and elements of value, should be considered in determining fair market value.[xxii]

“The value of property for federal transfer tax purposes,” the CCA continued, “is a factual inquiry wherein the trier of fact must weigh all relevant evidence and draw appropriate inferences to arrive at the property’s fair market value.”

The willing buyer and willing seller are hypothetical persons, the CCA stated, rather than specific individuals or entities, and their characteristics are not necessarily the same as those of the donor and the donee. What’s more, “the hypothetical willing buyer and willing seller are presumed to be dedicated to achieving the maximum economic advantage.”

According to the CCA, the principle that the hypothetical willing buyer and seller are presumed to have “reasonable knowledge of relevant facts” affecting the value of the property at issue applies even if the relevant facts at issue were unknown to the actual owner of the property.

Moreover, both parties are presumed to have made a reasonable investigation of the relevant facts. Thus, in addition to facts that are publicly available, reasonable knowledge includes those facts that a reasonable buyer or seller would uncover during the course of negotiations over the purchase price of the property. In addition, a hypothetical willing buyer is presumed to be “reasonably informed” and “prudent,” and to have asked the hypothetical willing seller for information that is not publicly available.

Reasonably Foreseeable Events

Generally, a valuation of property for federal transfer tax purposes is made as of the valuation date without regard to events happening after that date.

Subsequent events may be considered, however, if they are relevant to the question of value. Specifically, a post-valuation date event may be considered if the event was reasonably foreseeable as of the valuation date.

The CCA next reviewed a Court of Appeals decision that addressed the application of the assignment of income doctrine to a charitable contribution of stock in a corporation.[xxiii] The taxpayers owned 18 percent of Target and served as officers and directors of the corporation. Target’s board authorized an investment bank to find a purchaser for Target. Shortly thereafter, Target entered into a merger agreement with Acquirer. Target’s board unanimously approved the merger agreement, and a tender offer was started. The taxpayers then executed a donation-in-kind record with respect to their intention to donate stock to certain charities. One month later, the charities tendered their stock. A couple of days later, the final shares were tendered, and then the merger was completed. The Court concluded that the transfers to charity occurred after the shares in Target “had ripened from an interest in a viable corporation into a fixed right to receive cash” because the merger was “practically certain” to go through. In particular, the Court noted that “as of [the valuation] date, the surrounding circumstances were sufficient to indicate that the tender offer and the merger were practically certain to proceed by the time of their actual deadlines – several days in the future.” Consequently, the assignment of income doctrine applied, and the taxpayers realized gain when the shares were disposed of by the charity.

The IRS observed that the situation under consideration in the CCA shared many factual similarities with the case of donor-taxpayer, above, including a merger agreement that was “practically certain” to go through. While the Court’s opinion dealt exclusively with the assignment of income doctrine, it also relied upon the proposition that the presently-known facts and circumstances surrounding a transaction were relevant to the determination that a merger was likely to go through. The current situation, the IRS stated, presented an analogous issue; that is, whether the fair market value of the stock should take into consideration the likelihood of the merger as of the Date 1 transfer of Corporation A shares to Trust. The Court’s opinion, the CCA asserted, supported the conclusion that the value of stock in Corporation A must take into consideration the pending merger with Corporation B.

Accordingly, the value determined under the applicable regulations did not represent the fair market value of the shares transferred to Trust as of the valuation date; other relevant facts and elements of value had to be considered in determining such fair market value. Under the fair market value standard as articulated in the regulations, the hypothetical willing buyer and willing seller, as of Date 1, would be reasonably informed during the course of negotiations over the purchase and sale of the shares and would have knowledge of all relevant facts, including the pending merger. Indeed, the CCA stated, “to ignore the facts and circumstances of the pending merger would undermine the basic tenets of fair market value and yield a baseless valuation.”

Thus, the IRS concluded that, under the fair market value standard, the hypothetical willing buyer and seller would consider a pending merger of a corporation when valuing the corporation’s stock for gift tax purposes.

Use Your Crystal Ball

So, what does this mean for the owner of a closely held business who may be planning for the sale of their business, but who may also be interested in doing some estate planning?

Planning Basics

In order to maximize the effectiveness of an estate plan that involves the transfer by the owner of their interest in the business, it is important to recognize certain guiding principles: (i) the gift transfer of the interest to a family member, or to a trust for the benefit of a family member, will remove the current value of the interest from the transferor’s gross estate for purposes of the federal estate tax; (ii) the transfer will also remove the income generated by that interest from the gross estate; (iii) if a grantor trust is used as the vehicle for the gift transfer, the transferor’s future gross estate will be reduced by the amount of the tax on such income; and, perhaps most importantly, (iv) the appreciation in the value of the transferred interest will be removed from the transferor’s gross estate.[xxiv]

What Really Happens

Of course, in order to obtain these transfer tax benefits, the business owner has to be willing to give up at least some of their equity in the business sooner rather than later.

Predictably, however, most business owners are reluctant to give up any ownership until they are ready to consider a sale of the business. This is borne out by the number of times I have had owners, who have just executed a letter of intent (“LOI”) for the sale of their business, ask me about transferring some of their interest in the business to a trust for the benefit of their children.[xxv]

Therein lies the issue. Assume that, within a month of executing the LOI, the owner makes a gift of some of their equity – representing a minority interest – to a trust, and say that the sale of the business is consummated a couple of months after that, on substantially the same business terms as set forth in the LOI.

The owner obtains an appraisal report for the minority interest that claims discounts for lack of control and lack of marketability. The report does not mention the LOI or the sale. The owner then files a gift tax return reporting the transfer and the gift tax consequences thereof using the value set forth in the appraisal.

The owner, the trust and the business each file an income tax return reporting the sale of the business; the gain realized is based upon the agreed-upon purchase price.[xxvi]

How is the IRS going to approach the now-former owner’s gift tax return?[xxvii] For one thing, as in the case of the CCA described above, was the sale of the business reasonably foreseeable at the time of the gift? The IRS will consider that the LOI was already executed by the time the gift was made, and it will observe that the business was, in fact, sold shortly thereafter.

With the benefit of hindsight, the IRS can choose from two lines of attack: the reported valuation was too low – no discounts should have been claimed because the sale (and the resulting conversion of the equity interest to cash) was reasonably foreseeable at the time of the gift;[xxviii] or the reported valuation was too low for purposes of the gift tax, and the grantor should be taxed on the gain from the sale.[xxix]

Bottom line: a gifting program with respect to the equity in one’s business is not something to be initiated on the eve of a sale of the business if one hopes to minimize the gift tax impact thereof, and one must take a realistic approach to the valuation of the gifted interest, which should include a consideration of significant upcoming “corporate” events.

[i] And often without due regard to the circumstances or context within which such decision was made.

[ii] I am told that psychologists refer to this as “outcome bias.” No surprise there.

[iii] See, e.g., Reg. Sec. 1.6664-4.

[iv] Based in no small part on their differing perspectives with respect to the business.

[v] Anything longer may be more indicative of the buyer’s efforts on behalf of the business rather than of the going concern that the seller built and then sold to the buyer.

[vi] This is commonly referred to as an “earn-out” and is premised on the attainment by the business of certain agreed-upon financial targets. Installment reporting, under IRC Sec. 453, will be applied to report the gain attributable to the receipt of a post-closing earn-out payment. In addition, the imputed interest rules will apply to convert some of the “deferred” purchase price from capital gain into ordinary interest income. IRC Sec. 1274.


[viii] Donee Information Return (Sale, Exchange or Other Disposition of Donated Property).

[ix] Reg. Sec. 20.2031-1(b); Reg. Sec. 25.2512-1; Rev. Rul. 59-60, 1959-1 C.B. 237.

[x] We’ll ignore the alternate valuation date under IRC Sec. 2032.

[xi] Reg. Sec. 25.2512-1.

[xii] Rev. Rul. 59-60, Sec. 3. That’s because the date-of-death value of a property – such as an equity interest in a business – necessarily reflects the future stability of the property and its prospects for growth. A negative view of its future as of the date of transfer will result in a lower value as of that date, whereas a more positive outlook would result in a greater value.

[xiii] Furthermore, a post-valuation date event, even if unforeseeable as of the valuation date, may be probative of the earlier valuation to the extent that it is relevant to establishing the amount that a hypothetical willing buyer would have paid a hypothetical willing seller for the subject property as of the valuation date.

For example, a sale of stock between other parties shortly after the valuation date. The same concept underlies the purpose of IRS Form 8282 dealing with the subsequent sale of property contributed to a charity.

[xiv] Rev. Rul. 78-367, 1978-2 C.B. 249.

[xv] Chief Counsel Advice Memorandum (“CCA”) 201939002. CCAs are issued by the Office of Chief Counsel to assist IRS personnel in performing their functions by providing legal opinions on certain matters.

[xvi] The corporation in the CCA was publicly traded, but the concepts discussed are just as applicable to the case of a closely held corporation.

[xvii] GRAT. IRC Sec. 2702; Reg. Sec. 25.2702-3.

[xviii] The merger price reflected a premium?

[xix] IRS Form 709.

[xx] For example, based on a multiple of earnings.

[xxi] For example, where, as in this case, there was a merger in the corporation’s future.

[xxii] Reg. Sec. 25.2512-2(e).

[xxiii] Ferguson v. Commissioner, 174 F.3d 997 (9th Cir. 1999), aff’g 108 T.C. 244 (1997).

[xxiv] This strategy is most effective if the donor funds a generation-skipping trust to which they allocate their GST exemption amount. In this way, the value of the gifted interests will not be taxable to the family until they are distributed to the beneficiaries, who then make a taxable transfer thereof.

[xxv] Sadly, a not-so-distant second is the following question: “Can I change my residence to Florida and avoid paying New York tax on the gain?” Shoot me now.

[xxvi] Depending upon the form of the sale, this may include the buyer’s assumption of, or their taking subject to, certain liabilities.

[xxvii] Yes, I am assuming that the return will be examined. One should always assume that a return will be examined, and advise accordingly.

[xxviii] This would result in the owner’s exhausting more of their estate tax exemption amount than they had anticipated; it may even cause the owner to incur a gift tax liability.

[xxix] If the gift was made via a grantor trust, the owner would be taxable on the gain in any event. IRC Sec. 671.

Under One Roof

I sometimes wonder at the number of corporations that own real property.

It is often the case that the property is the corporation’s principal asset, which it leases to one or more commercial tenants, for example. That’s bad enough.[i]

There are other instances, however, in which the corporation is engaged in an active trade or business that operates out of the corporation’s real property.[ii] In most cases, the operating business occupies the entire property – there are no other tenants. What’s more, the corporation is not engaged in the kind of activity that the active management of a property typically entails; in other words, the corporation is dealing with itself for the most part.[iii]

There is a kind of simplicity in this arrangement that often appeals to the owners of a closely held business. There is no need for two business entities – one that owns the operating business and one that owns the real property – no need to file two business tax returns, no need to keep separate books and records, no need to maintain separate bank accounts, no need for a lease between the two entities, etc.

Unfortunately, this minimalist approach may turn into a serious tax problem, one that may go unrecognized until it is too late to address it in any meaningful or economical way – on the “eve” of selling the business.

Asset Sale

As we’ve discussed on many occasions, a prospective buyer of a corporate-owned business would prefer to acquire from the corporate seller only those assets that will be necessary to the buyer’s operation of the business after the deal closes. This is best accomplished by identifying and purchasing only those assets.[iv]

A not insignificant benefit of such a “direct” purchase of assets is the stepped-up cost basis[v] for these assets in the hands of the buyer, which the buyer may then be able to expense, depreciate or amortize[vi] – depending upon the asset – and, thereby, reduce the buyer’s economic cost for the transaction.

Thus, where the buyer has no need for the real property owned by the corporate-seller – for example, where the buyer is consolidating the seller’s business into one of the buyer’s existing locations – the buyer may simply choose not to purchase the property.

Stock Sale

By contrast, the purchase of the stock of the corporation from its shareholders would necessarily include the indirect acquisition of every asset owned by the corporation, including those that the buyer neither needs nor wants.

There are instances, however, in which the buyer has no choice – as a legal or as a practical matter – but to acquire the stock of the target corporation, along with everything that goes with it, including the real property. This may occur, for example, where the corporation’s business includes certain difficult-to-transfer assets,[vii] and the target corporation must be kept in existence.

In recognition of this reality, the Code permits the buyer and the selling shareholders to elect to treat the actual purchase-and-sale of the target corporation’s stock as a deemed purchase-and-sale of its assets for tax purposes – provided certain conditions are satisfied – thereby generating a basis step-up in the underlying assets for the benefit of the buyer.[viii]

Removing/Keeping the “Unwanted” Property

Query, in a situation where the purchase-and-sale transaction must be effected as a sale of stock, how the corporate target may dispose of the unwanted real property before the stock sale is completed?[ix]

Conversely, what if the shareholders of the target corporation want to keep the real property for themselves, in order to lease it to the buyer, or to another party, after the stock sale?[x] How may they remove the property in a tax-efficient manner?

The issue is easily surmounted where the corporate target is selling its assets. In that case, the buyer may simply choose not to purchase, and the target corporation may simply choose not to sell, the real property. Instead, the buyer will often agree to lease the property from the corporate-seller for an arm’s-length rate over some period of time (perhaps with extensions) beginning immediately after the closing; the delivery of an executed lease will often be identified as a condition to closing the deal.

But what if the transaction is structured as a purchase-and-sale by the shareholders of the target corporation’s stock?[xi]

Sell the Property?

One of the more obvious “solutions” is for the target corporation to sell the real property to some unrelated person before the shareholders sell the corporation’s stock to the buyer. The corporation would likely realize a gain from the sale[xii] that would be taxable to the corporation,[xiii] and for which its shareholders will likely be held responsible by the buyer even after the buyer’s acquisition of their shares in the corporation.[xiv]

If the corporation is an S corporation, the gain from the sale of the property (including its character as ordinary or capital) will pass through, and be taxed, to its shareholders.[xv]

Where the corporation is a C corporation, or an S corporation with earnings and profits from taxable years during which it was a C corporation,[xvi] and the shareholders want the net proceeds from the sale of the real property to be distributed to them,[xvii] they may want to consider structuring the purchase-and-sale of their stock to include a partial redemption of their shares by the corporation.[xviii]

Sale or Distribution to Shareholders?

Another option would be for the corporation to sell the real property to those of its shareholders who want it.

In the case of an S corporation, the gain from this sale will pass through, and be taxed, to all of the shareholders based upon their relative stock ownership. However, the gain from this sale may be treated as ordinary income, rather than capital gain, under certain related party sale rules.[xix] Although this result may not matter in the case of a C corporation[xx] (except to the extent it has capital losses, which may only offset capital gains), the effect on the shareholders of an S corporation cannot be underestimated: a federal capital gain tax rate of 20-percent versus an ordinary income tax rate of 37-percent.[xxi]

The corporation may also distribute the real property to its shareholders in respect of their shares in the corporation: as a dividend, or in a partial redemption of their stock that is part of their plan to sell their shares to the buyer. Such a distribution would likewise be treated as a sale of the property by the corporation,[xxii] with the same basic consequences as above, including treatment of the gain as ordinary income.

Although the foregoing options are certainly effective in removing the real property – unwanted by the buyer and/or wanted by the target’s shareholders – from the target corporation prior to the sale by the shareholders of the corporation’s stock, they also probably generate a not-insignificant tax cost.

What other alternatives might be considered?


Some readers may ask whether a “tax-free” spin-off of the real property would be possible.[xxiii] Specifically, why couldn’t the target corporation form a new subsidiary corporation, contribute the real property to the subsidiary in exchange for all of its stock, then distribute this subsidiary stock to the target’s shareholders?

Under the facts as stated, above, where the property is basically owner-occupied, probably not. The corporation would be hard-pressed to demonstrate that its activities with respect to the real property satisfy the five year “active trade or business” requirement.[xxiv]

Even if the active trade or business test were met, the relative proximity (in terms of time) of the spin-off distribution and the sale of the corporation’s stock – for all intents and purposes, on the eve of sale[xxv] – would likely cause the distribution to be taxable.[xxvi]

Disregarded Entities

Where does that leave the buyer, not to mention the target corporation and its shareholders? In the context of a stock sale where the shareholders of the target corporation want to retain ownership of the property, will they have to remove the property by way of a taxable transaction, the price tag for which includes a hefty tax liability?

Or might it be possible to remove the property by restructuring the target corporation in advance of the transaction so as to enable it to take advantage of the rules that govern transactions between a taxpayer and an entity owned by the taxpayer and that is disregarded as separate from the taxpayer for tax purposes.[xxvii]

In general, transactions between a taxpayer and an entity that is disregarded as separate from the taxpayer for tax purposes – including a sale or exchange of property – have no tax consequences for the simple reason that a taxpayer cannot sell property to themselves. That is not to say that, as a matter of contract or of state law, the transaction did not occur – indeed, a sale has occurred and ownership of the subject property has changed; it’s just that the transaction is ignored for tax purposes.[xxviii]

For example, assume corporation “Corp” owns 100-percent of limited liability company “LLC.” LLC is treated as a “disregarded entity” for tax purposes.[xxix] If LLC sells property to Corp pursuant to a contract, in exchange for full and adequate consideration paid in cash, there has been a bona fide sale between the two business entities. If LLC distributes property to Corp in respect of its membership interest, there has, in fact, been a distribution. However, because LLC is disregarded for tax purposes, Corp is treated as owning all of LLCs assets. Thus, as a tax matter, Corp cannot acquire from LLC – whether by way of a purchase-and-sale or by way of a distribution – property that Corp is already deemed to own.

Might this basic rule provide a means by which a target corporation can divest itself of unwanted real property on a tax-efficient basis, while it remains intact as a matter of state law?

Perhaps. The question, of course, is how does a corporation create an entity that is disregarded from it for tax purposes, and to which it may transfer a property (i.e., remove the property from the corporation) without adverse tax consequences, in preparation for the sale of the corporation’s stock?

Enter the F reorganization.

F Reorganization

The Code describes several types of corporate transactions that constitute “tax-free” reorganizations. The purpose of the reorganization provisions of the Code is to except from gain recognition certain specifically described exchanges that are incident to readjustments of corporate structures made in one of the particular ways specified in the Code, and which effect only a readjustment of continuing interest in property under a modified corporate form.[xxx]

One of these transactions is described as “a mere change in identity, form, or place of organization of one corporation, however effected” – a so-called “F” reorganization.[xxxi]

Like other types of corporate reorganizations, an F reorganization generally involves, in form, two corporations, one (a “transferor corporation”) that transfers (or is deemed to transfer) assets to the other (a “resulting corporation”). However, the statute describes an F reorganization as being undertaken with respect to “one corporation.”

An F reorganization is treated for most purposes of the Code as if the resulting corporation were the same entity as the transferor corporation that was in existence before the reorganization; indeed, the resulting corporation retains the transferor’s tax attributes.

Thus, the tax treatment accorded an F reorganization is more consistent with that of a single continuing corporation; for example, the taxable year of the transferor corporation does not close, its tax return includes the operations of the resulting corporation for the post-reorganization portion of the taxable year, and the resulting corporation inherits the tax elections of the transferor corporation.

A transaction that involves an actual or deemed transfer of property by a transferor corporation to a resulting corporation may qualify as an F reorganization – as may a series of related transactions, that together result in a mere change of one corporation – if certain regulatory requirements are satisfied.[xxxii]

According to one of these regulatory requirements, the transferor corporation must completely liquidate for federal income tax purposes as part of the potential F reorganization; however, the corporation is not required to dissolve under applicable state law.

Deemed transfers also include those resulting from the application of step transaction principles. For example, step transaction principles may treat a contribution of all the stock of the transferor corporation to the resulting corporation, followed by a liquidation (or deemed liquidation) of the transferor corporation – which are formally separate steps – as a deemed transfer of the transferor corporation’s property to the resulting corporation, followed by a distribution of stock of the resulting corporation in complete liquidation of the transferor corporation.

In keeping with the basic premise that the F reorganization involves a mere change in form of a single corporation, a qualifying transaction may occur before or within other transactions that effect more than a mere change, even if the resulting corporation has only a transitory existence. Related events that precede or follow the potential F reorganization generally will not cause that potential reorganization to fail to qualify as an F reorganization. Conversely, an F reorganization will not alter the character of other transactions for federal income tax purposes.

As we will see, it is the “deemed liquidation” requirement, the application of step transaction principles, and the fact that the F reorganization may be undertaken as part of a larger transaction without affecting the tax treatment of such transaction that, brought together, may provide a target corporation the means to divest itself of an unwanted asset just prior to the sale of its stock.

Practical Example

The following is but one example of how the foregoing rules and principles may be brought together to achieve the desired result: the removal of an asset from the target corporation on a tax efficient basis and the subsequent sale of the target’s stock.[xxxiii]

Assume Taxpayer owns all of the stock of Y, an S corporation. Y owns Prop plus other assets.

In Year 1, Taxpayer forms New-Corp and contributes all of the Y stock to New-Corp in exchange for all of the New-Corp stock.

New-Corp meets the requirements for qualification as an S corporation, and timely elects to treat Y as a qualified subchapter S subsidiary (QSub), effective immediately following the transaction.

As a result of the QSub election, Y is deemed to have liquidated into New-Corp on a tax-free basis, and its separate existence is then ignored, tax purposes, though it continues to exist as a matter of state law. Because Y is not treated as a separate corporation for tax purposes (but more like a division of New-Corp), and all its assets (including Prop), liabilities, and items of income, deduction, and credit are treated as assets, liabilities, etc. of the S corporation, New-Corp.

This transaction – the transfer of the Y stock to New-Corp, coupled with the QSub election – qualifies as an F reorganization, with New-Corp being treated as the “new form” of Y. Consequently, Y’s (now New-Corp’s) original S election does not terminate, but attaches to New-Corp.

In Year 2, Y distributes Prop to New-Corp. The distribution of Prop from Y to New-Corp is disregarded for tax purposes because New-Corp is already treated as owning it.

In Year 3, New-Corp sells the stock of Y to Buyer.[xxxiv] However, because New-Corp is deemed to own all of Y’s assets (for tax purposes), the sale – a stock sale as a matter of state law – is treated as a sale of an undivided interest in Y’s assets for tax purposes. Buyer acquires these assets with a basis step-up (and the opportunity for cost recovery deductions). Buyer is then treated as having contributed the newly acquired assets to a “new Y” corporation that comes into existence after the stock sale and the termination of its QSub status.


The fact pattern set forth above is but one illustration of how F reorganizations and disregarded entities may be utilized by a selling corporation and its shareholders to achieve some pre-sale “corporate tailoring” – the removal of an asset from a target corporation prior to the sale of its stock – on a tax efficient basis; there are others.

The interplay of these rules, however, can be complicated, and it will be imperative that the parties’ respective tax advisers be fully engaged in the analysis. Moreover, there will be times when the seller, the buyer, and their respective owners will not be able to reconcile their various goals through such corporate tailoring, though they will often need the input of their tax advisers to come to that realization.

At that point, choices will have to be made. Much will depend, as it usually does, upon relative leverage – including the ability to extract a gross-up for the tax liability arising from such tailoring – and upon how badly the parties want to consummate the sale.



[ii] Every now and then, you encounter a situation where the real property owned by the corporation has no connection to the business being conducted by the corporation.

[iii] For example, it is not listing the property for rent, it is not interviewing tenants or dealing with brokers, it is not negotiating leases, it is not attending to tenant complaints, etc.

[iv] A forward merger of corporations under state law that does not qualify as a tax-deferred reorganization under IRC Sec. 368 is treated as a taxable purchase and sale of assets.

[v] IRC Sec. 1012.

[vi] IRC Sec. 168(k), Sec. 167, Sec. 197.

[vii] This would include an asset that, by its terms, is generally not transferable; for example, a contract or a license.

[viii] IRC Sec. 338(h)(10) and Sec. 336(e).

[ix] Of course, the buyer may cause the newly acquired target corporation to sell the real property post-closing.

[x] Not an uncommon situation.

[xi] Including a reverse subsidiary merger, which may be necessary when dealing with a relatively large number of shareholders, or where some minority shareholders are reluctant to go along. In those circumstances, the merger will likely trigger appraisal rights for any dissenting shareholder. That’s when folks wish they had a shareholders’ agreement that included a drag-along provision.

[xii] IRC Sec. 1001.

[xiii] This would include an S corporation that is subject to the built-in gains tax. IRC Sec. 1374.

[xiv] The allocation of economic “risk” as between the seller and the buyer (including for taxes) is a significant part of any purchase-and-sale agreement.

[xv] IRC Sec. 1366. The gain will result in an upward adjustment to the shareholders’ stock basis pursuant to IRC Sec. 1367.

[xvi] Or if it acquired the assets of a C corporation in a tax-deferred exchange (for example, under IRC Sec. 368), so that the C corporation’s earnings and profits became tax attributes of the S corporation pursuant to IRC Sec. 381.

[xvii] After all, they will likely be responsible for any liabilities arising from the sale that are arise post-closing.

[xviii] Zenz v. Quinlivan, 213 F.2d 914 (6th Cir. 1954).

[xix] IRC Sec. 1239.

[xx] The ordinary income and capital gain of a C corporation are taxed at the same flat rate of 21-percent; there is no reduced rate as in the case of individuals.

[xxi] One must also consider the application of the 3.8-percent surtax on net investment income under IRC Sec. 1411.

[xxii] IRC Sec. 311(b).

[xxiii] IRC Sec. 368(a)(1)(D) and Sec. 355.

[xxiv] IRC Sec. 355(b), Sec. 368(a)(1)(D).; Reg. Sec. 1.355-3(b)(2).

[xxv] I’ve really stacked the deck here.

[xxvi] IRC Sec. 355(e). Reg. Sec. 1.355-7.

[xxvii] For example, a single member LLC that has not elected to be treated as an “association” (basically, a corporation) for tax purposes.

[xxviii] The same concept has been applied in the case of transactions between a grantor trust and the grantor. Rev. Rul. 85-13. See also Reg. Sec. 1.368-2(b)(1)(iii), Ex. 2 (Good “A” reorganization where target corp. merges pursuant to state law with and into a disregarded subsidiary entity (maybe an LLC) of the acquiring corp., and the target shareholders receive stock of the acquiring corp. – the target is treated as having merged into the acquiring corp.).

[xxix] Reg. Sec. 301.7701-3.

[xxx] IRC Sec. 368(a). There are a number of statutory and regulatory requirements, not to mention a number of administrative and judicial interpretations, of which the taxpayer contemplating a reorganization must be aware.

[xxxi] IRC Sec. 368(a)(1)(F).

[xxxii] Reg. Sec. 1.368-2(m). Note that the continuity of interest and continuity of business enterprise requirements do not apply to an F reorganization. Reg. Sec. 1.368-1(d) and (e).

In general, other requirements include no change in ownership of the corporation, and the resulting corporation must not have had any assets or conducted any business prior to the reorganization.

[xxxiii] See, e.g., Rev. Rul. 2008-18, and PLR 201115016.

[xxxiv] The sale does not affect the F reorganization. Rev. Rul. 96-29.

Most transactions have their share of hiccups. Some cases are more serious than others.

Generally speaking, they originate with the seller. For example, due diligence turns up some disturbing information about the target company’s legal status, the target’s financials aren’t as rosy as the buyer was led to believe, the target’s owners keep trying to renegotiate the deal, or a rift develops among the target’s owners – these and other surprises are not unusual. Some result in a change in purchase price or a change in payment terms (including escrows and other holdbacks), while others just kill the deal.

Of course, there are also times when the buyer is the source of the setback or hold-up; for example, the buyer’s financing for the transaction may be in question, or the buyer is distracted by another deal.

It is rarely the case, however, that the buyer’s ownership structure, or the composition of its ownership, presents a stumbling block, especially in what appears to be the well-choreographed process of a private equity deal.

Unfortunately, no one is immune from surprises.

Acquisitions by Private Equity

For the owners of many closely held businesses, the final step of a successful career may be the sale of their business.[i] At that point, the investment into which they have dedicated so much time, effort and money is monetized, leaving them with what is hopefully a significant pool of after-tax proceeds with which to enjoy their retirement, diversify their assets, or pursue other goals.

It used to be that the prospective buyer would almost always come from within the same industry[ii] as the business being sold. It was often a competitor, or someone seeking to fill a void in their own business. In other words, the buyers were strategic – they were looking for synergistic acquisitions, ones that would enable them to grow their own business and otherwise provide long-term benefits. Occasionally, the buyer would be a company from a different industry, one that was looking to diversify or add another line of business so as to hedge against a downturn in its primary business.

However, for many years now, the private equity fund (“PEF”) has been a dominant player in the competition for the acquisition of closely held businesses. In general, PEFs are not engaged in any “conventional” business; rather, they are well-funded investment vehicles that are engaged in the acquisition of conventional businesses (or “portfolio companies”).

Almost by definition, a PEF is not necessarily looking to the acquisition as a means of developing or establishing a long-term presence in a particular industry (a “buy and hold” investment strategy). Instead, it is looking for “value”[iii] to add to its portfolio of companies, perhaps even consolidating similar companies in the process in order to grow market share and reduce overall costs. In turn, the PEF hopes to sell its “inventory” of portfolio companies to other buyers not-too-far down the road, and hopefully at a sizable gain[iv] that it may share with its investors.

The PEF is formed as a partnership, which is not a taxable entity,[v] and which also facilitates the admission of new investors.[vi] The PEF will often create a holding company (the “HC”) to which it will transfer the funds contributed to the PEF by its investors. The HC, in turn, may establish and fund its own subsidiary companies through which it will aquire target businesses.

Rollover: PEF’s Perspective

One aspect of a PEF acquisition that tends to distinguish it from a strategic buyer acquisition is the PEF’s strong preference that the owners of a target business “rollover” (or reinvest) some portion of their equity in the target business into the PEF’s “corporate structure” in exchange for an equity interest therein, usually at the level of the HC.

From the perspective of the PEF, such a rollover yields several benefits. For one thing, it aligns the former owners of the target business with the interests of the PEF – their rolled-over investment is subject to the risks of the business, as is that of the PEF’s investors. Thus, the former owners are incentivized – or so the theory goes – to remain with the business, to cooperate fully in the transition of the business and its customers, and to work toward its continued growth and success.[vii]

Rollover: Seller’s Perspective

From the perspective of the target’s owners, however, the rollover may present a troublesome issue.

In many cases, an owner will want to take all of their cash off the table. They may not want to continue risking their capital, especially where the investment is to be controlled by another.

Of course, some owners will be attracted to the potential upside that a rollover investment in a PEF-controlled business may generate. After all, the owner may have the opportunity to benefit not only from the future growth of their former business, but also that of the PEF’s other portfolio companies. In fact, a business owner will generally insist upon being given the opportunity to participate in the growth of these other companies, which is consistent with most PEF’s desire that the target owners invest at the same level of the corporate structure as the PEF itself has – i.e., the HC.

However, the target owners will also insist that their rollover be effected without any adverse tax consequences. The ability of the PEF to satisfy this prerequisite will depend, in no small part, upon the form of the acquisition of the target business.

Acquisition Mechanics

Like most other buyers, the PEF will generally prefer an acquisition of the target’s assets, in a transaction that is taxable to the target, over an acquisition of the equity interests of the target’s owners.[viii] A taxable sale of assets will provide the PEF (specifically, the subsidiary through which the HC indirectly acquires the target’s business) with a cost basis in the acquired assets that may be expensed, depreciated or amortized by the PEF.[ix] The tax deductions so generated will offset the HC’s and, through it, the PEF’s income, thereby allowing the PEF to recover some of its investment in the target’s business and reducing the overall cost of the transaction to the PEF.

The target’s owners, on the other hand, will generally not choose an asset sale because such a sale may result in both the recognition of ordinary income by the target’s owners,[x] as well as an entity-level tax,[xi] thus reducing the net economic benefit to the owners. Rather, they would prefer to sell their equity interest in the target, at least in the case of a corporate target. The gain realized on such a sale will generally be treated as long-term capital gain.[xii] However, such a sale will not generate basis in the target’s assets for the PEF.

Rollover: Mechanics

As indicated above, a PEF will often create a subsidiary – the HC – through which it will acquire a target company. Where the target’s assets are being purchased, the acquisition may be effected through an acquisition vehicle (a corporation or LLC) that will be wholly-owned by the HC.[xiii]

The form of rollover by the target’s owners will depend upon the form of the acquisition. Thus, where the HC is acquiring the equity interests of the target owners, the rollover will come directly from the former owners.[xiv] Where the HC (more likely, its subsidiary) is acquiring the target’s assets, the rollover may come from the target. However, if the PEF insists that it must come from the target’s owners, then the proceeds paid to the target will have to find their way into the hands of its owners to enable them to acquire equity in the HC.[xv]

The chosen forms of acquisition and rollover will generate very different tax results for both the PEF and the target’s owners. Thus, it is imperative that the target’s owners examine the nature of both the PEF’s acquisition vehicle and of the target (e.g., corporation or partnership/LLC), and the nature of the sale (a sale of equity interests in the target or a sale of the target’s assets). They must consider how their equity rollover can be effectuated, and whether this transfer may be done tax-efficiently.

The owners of the target business have to recognize that if the rollover cannot be accomplished on a tax-deferred basis, they may be left with less cash and less liquidity than they would have preferred.[xvi]

In order to facilitate the rollover of the target’s equity, the HC may be formed as a partnership for tax purposes.[xvii] A tax-deferred contribution of property to a partnership in exchange for a partnership interest is generally easier to accomplish than a tax-deferred contribution of property to a corporation in exchange for shares of stock in the corporation. That’s because a tax-deferred contribution to a corporation requires that the contributor be in “control” of the corporation immediately after the exchange;[xviii] there is no such requirement for a contribution to a partnership.[xix]

The partnership structure, however, may present an issue for a non-U.S. investor of the PEF.

Target Partnership
Assume for our purposes that the target to be acquired by the HC is treated as a partnership for tax purposes, and that it is engaged in a U.S. trade or business. Also assume that the HC is treated as a partnership.

All Cash Deal – Fully Taxable

The gain from a sale of assets by the target partnership to a subsidiary corporation of the HC, in exchange for cash only, will flow through the partnership, and will be taxable, to the target’s owners.[xx] The nature of the gain taxed to the owners[xxi] will depend upon the nature of the assets sold.[xxii]

Alternatively, the owners of a target partnership may sell all of their partnership interests to the HC, or to its acquisition subsidiary, for cash.[xxiii] A sale of all of the partnership interests will be treated, for tax purposes from the buyer’s perspective, as a purchase of the target’s assets,[xxiv] thus providing the HC (and, ultimately, its owners) with a recoverable cost basis in such assets.[xxv]

In either case, if the target’s owners (the partners or members) are to acquire an equity interest in the HC, they will have to do so with after-tax dollars.[xxvi]

Rollover of Some Equity

In order for the target partnership to rollover a portion of its equity into the HC on a tax-advantaged basis, the target will have to contribute some of its assets to the HC in exchange for a partnership interest in the HC. In other words, the transaction will have to be effected as a part-sale-for-cash/part-contribution-for-equity by the target.[xxvii] The HC will acquire a depreciable or amortizable basis for the assets acquired for cash,[xxviii] and a carryover basis for those received in exchanged for an interest in the HC.[xxix]

The same result may be achieved where some interests in the target partnership are contributed by its partners to the HC as capital, while the remaining interests are sold to the HC (or its subsidiary) for cash.[xxx] In that case, because the HC is treated as acquiring all of the interests in the target partnership, it will receive a depreciable or amortizable basis for the assets to the extent of the cash paid, whereas it will take the target’s basis in the assets deemed to have been contributed.[xxxi]

Hiccup: PEF with Foreign Owner?

Assume the target’s owners contribute a portion of their partnership interests to the HC (the rollover) in exchange for an interest therein. Also assume that they sell the balance of their interests to a corporate subsidiary of the HC. Finally, assume that the HC immediately drops the rolled-over target partnership interests to this subsidiary.

Does the PEF, which is itself a partnership, have an issue if one of its members is a foreign investor (“FI”)?[xxxii]

It very well may.

The HC will be the owner of a partnership interest in the target, albeit for a very short period. This will cause HC to be treated as engaging in the target partnership’s business during such period, as would PEF.[xxxiii] In turn, this will cause FI to be treated as engaging in such business.[xxxiv] As a result, FI will have U.S.-source effectively connected income to the extent of its allocable share thereof. PEF will be required to pay a withholding tax with respect to FI’s allocable share of PEF’s effectively connected income.[xxxv] As importantly, FI will be required to file a U.S. federal income tax return.[xxxvi]

Can these adverse consequences be avoided where the PEF only realizes the issue during the process of acquiring the U.S. target partnership?

Possible Solution?

One possibility is for the target’s owners to contribute to a newly-formed C corporation (“Corp”), in exchange for all of Corp’s stock, that portion of their target partnership interests that are to be rolled-over to the HC.

Corp’s shareholders would then contribute its stock to the HC in exchange for partnership interests in the HC. Corp’s stock would then be dropped down to the HC’s corporate subsidiary (that purchased the remaining target partnership interests), and liquidated,[xxxvii] causing the target to become a disregarded entity.

The insertion of Corp between the target partnership and the rollover partnership interests of target’s erstwhile owners, and subsequently between the HC and the rolled-over interests in the target, would seem to prevent the HC, PEF and the FI from being engaged in the target’s trade or business.

But what is the impact of this arrangement upon the target’s owners? Will they still obtain tax-deferred treatment for the now indirect exchange of their partnership interests for equity in the HC?

The contribution of the Corp stock to the HC will qualify for tax-deferral as a capital contribution to a partnership.[xxxviii] But what about the contribution of the rollover target partnership interests to Corp?

The contribution of property to a corporation in exchange for stock in the corporation is accorded tax-deferred treatment if the contributor is in control of the corporation immediately after the contribution.[xxxix] Under the principles of the step transaction doctrine, however, where the contributor is obligated before the exchange to dispose of their stock in such a way that they lose control of the corporation, the IRS will ignore the momentary control and treat the exchange as a taxable event to the contributor.

Some have pointed to Rev. Rul. 2003-51 and to PLR 201506008 in support of the proposition that the tax-deferred contribution of property to a corporation in exchange for its stock will not be jeopardized by the pre-ordained transfer of such stock to a partnership as part of another tax-deferred exchange. Unfortunately, this revenue ruling and the PLR are easily distinguished from the scenario described above.

The revenue ruling describes a taxpayer that contributed property to a corporation in exchange for 100-percent of its stock. The taxpayer then contributed this stock to another corporation, to which another person also contributed property, and they both received stock in such second corporation,[xl] with the taxpayer receiving only 40-percent thereof. The IRS recognized that the second contribution in the ruling would normally break control with respect to the first contribution. The IRS disregarded this consequence, however, because the contributing taxpayer could have by-passed the first contribution and gone directly to the second, with the second qualifying as tax-deferred exchange. That this alternative route was available to the contributing taxpayer was key to the IRS’s ruling – the first contribution was not necessary to effect a tax-deferred exchange.[xli] The ruling distinguished earlier IRS rulings – which on similar facts had found a taxable exchange – based on the fact that there was no such alternative exchange available to the contributor in those rulings.

The above PLR is also easily distinguished. It doesn’t even rely on or cite the revenue ruling. Three taxpayers contributed assets to a new corporation in exchange for all of its stock. The same three taxpayers then contributed their stock in the new corporation to a new partnership in exchange for all of its partnership interests. The taxpayers represented that the new corporation would remain in existence and be engaged in a trade or business – it had economic substance. Thus, the new partnership, which was wholly-owned by the three taxpayers, owned all of the new corporation, which was previously owned by the three taxpayers. In other words, the three taxpayers continued to own 100-percent of the corporation, albeit indirectly.[xlii]

Neither the revenue ruling nor the PLR bear any similarity to the issue presented by the situation described above.

What’s more, there is no bona fide, non-tax business reason for the use of Corp. It is being formed for the sole purpose of shielding the FI from tax liability and from having to file tax returns. What’s more, Corp will be liquidated by the HC’s corporate subsidiary shortly after its drop-down to such subsidiary; i.e., its existence is transitory.

In light of the foregoing, the target’s owners may realize nothing but a Pyrrhic victory – a tax-deferred contribution to a partnership (the rollover) that causes the recognition of gain for their preceding contribution to a corporation – if they follow the strategy suggested to accommodate the FIs.

What Is To Be Done?

Answer: The owners of the target partnership should ask that the PEF agree to indemnify them for the amount of the lost tax deferral benefit.

The PEF itself should take measures to ensure that it does not find itself in the same position for future acquisitions. For example, if it cannot ask the FIs to contribute their interest in PEF to a corporate blocker, perhaps it should consider providing an alternative or parallel investment vehicle through which the FIs may acquire an interest in the PEF’s portfolio companies.

What is clear, is that the burden of resolving the issue should not rest with the target company’s owners, with whom the PEF has already agreed to engage in a tax-deferred rollover of a portion of their target equity.

[i] The “end” of a business does not always take the form of a sale to a new owner; indeed, many businesses simply peter out.

[ii] Or at least one related to it.

[iii] Or the potential for value that may be realized with the proper management that the PEF’s team can provide.

[iv] Return on investment.

[v] IRC Sec. 701.

[vi] IRC Sec. 721.

[vii] The rollover also saves the PEF some money: issuing equity is less expensive than paying out funds that the PEF has to borrow, or that it already has and would prefer to use for operations or further investment.

[viii] An exception would be the acquisition of all of the membership interests of an LLC that is treated as a partnership for tax purposes. In that case, the buyer is still treated as having purchased the assets of the target LLC, and as taking a cost basis in such assets. Rev. Rul. 99-6, Situation 2.

[ix] IRC Sec. 168(k), Sec. 167, and Sec. 197.

[x] For example, in the case of a target partnership or S corporation, from the sale of assets subject to depreciation recapture under IRC Sec. 1245.

[xi] In the case of a C corporation, under IRC Sec. 11; in the case of an S corporation subject to built-in gains tax, under IRC Sec. 1374. There is no entity level tax in the case of a partnership. IRC Sec. 701.

[xii] IRC Sec. 1221. But see IRC Sec. 741 in the case of the sale of a partnership interest, and its reference to Sec. 751 (regarding “hot assets”).

Also note the application of the tax on net investment income under IRC Sec. 1411 which, in the case of a target S corporation or partnership, may apply to some of the target’s owners and not others, depending upon their level of participation in the business.

[xiii] In this way, the HC’s other subsidiaries and assets may be protected from the liabilities of the business being acquired.

[xiv] If the target is an S corporation, and the parties make an election under IRC Sec. 338(h)(10) to treat the stock sale as a sale of assets instead, the rollover will not yield any tax deferral benefit. In other words, the election is incompatible with a tax-deferred rollover.

[xv] In the case of a corporate target, this will require a distribution of assets by the corporation to its shareholders. Such a distribution would be treated as a sale of the distributed assets by the corporation. IRC Sec. 311(b) or IRC Sec. 336. The distribution may also be taxable to the shareholders. IRC Sec. 301, Sec. 302, or Sec. 331.

[xvi] That’s because they will have to use some of the cash received to satisfy the tax liability arising from the exchange for equity in the HC.

[xvii] IRC Sec. 761, Reg. Sec. 301.7701-3.

[xviii] IRC Sec. 351 and Sec. 368(c). “Control” is defined as ownership of stock possessing at least 80-percent of the total combined voting power of all classes of stock entitled to vote and at least 80-percent of the total number of shares of all other classes of stock of the corporation.

[xix] IRC Sec. 721.

[xx] IRC Sec. 702(a).

[xxi] As ordinary income or as capital gain.

[xxii] IRC Sec. 702(b).

[xxiii] IRC Sec. 741 and Sec. 751.

[xxiv] Rev. Rul. 99-6, Situation 2, explains that, from the buyer’s perspective, the target LLC will be treated as having distributed its assets to its members, from whom the buyer then acquired the assets.

[xxv] IRC Sec. 1012.

[xxvi] In other words, they will pay tax on the gain recognized from the sale, then use some of the after-tax proceeds to invest in the HC.

[xxvii] Reg. Sec. 1.707-3, and IRC Sec. 721.

Assume S transfers property X to partnership HC in exchange for an interest in the partnership. At the time of the transfer, property X has a fair market value of $4,000,000 and an adjusted tax basis of $1,200,000. Immediately after the transfer, HC transfers $3 million in cash to S. The partnership’s transfer of cash to S is treated as part of a sale of property X to the partnership. Because the amount of cash S receives does not equal the fair market value of the property, S is considered to have sold a portion of property X with a value of $3,000,000 to the partnership in exchange for the cash. Accordingly, S must recognize $2,100,000 of gain ($3 million amount realized less $900,000 adjusted tax basis ($1.2 million multiplied by $3,000,000/$4,000,000)). Assuming S receives no other transfers that are treated as consideration for the sale of the property, S is considered to have contributed to the partnership, in S’s capacity as a partner, and on a tax-deferred basis, $1 million of the fair market value of the property with an adjusted tax basis of $300,000. Reg. Sec. 1.707-3(f), Ex. 1.

[xxviii] IRC Sec. 1012.

[xxix] IRC Sec. 723.

[xxx] The HC would then drop down the contributed interest to its subsidiary, following which the subsidiary will own all of the equity in the target partnership, and the target will become a disregarded entity for tax purposes. Reg. Sec. 301.7701-3.

[xxxi] Where the rollover contribution is to the HC in exchange for equity in the HC, and the sale is to a subsidiary of the HC, an election under IRC Sec. 752 should be made on the target partnership’s final tax return to adjust the basis for the assets in the hands of the acquiring subsidiary. IRC Sec. 743; Reg. Sec. 1.743-1(g).

[xxxii] A non-U.S. person. IRC Sec. 7701(a).

[xxxiii] Reg. Sec. 1.702-1(b).

[xxxiv] IRC Sec. 875. However, query in the case of an FI from a treaty country whether the permanent establishment requirement would be satisfied.

Previously, PEF’s FI did not have this issue because PEF’s activities, and those of the HC, consisted only of trading in stocks or securities for their own account, which is not treated as a trade or business. IRC Sec. 864(b)(2)(A)(ii). The HC’s only activity consisted of holding the stock of its corporate subsidiary (a C corporation), which effectively acted as a blocker with respect to any actual trade or business activities being conducted by the portfolio companies; only when the corporation paid dividends to the HC did the foreign members have U.S. income; moreover, these dividends may have qualified for a reduced U.S. tax rate depending on the jurisdiction of the FI and whether there was a tax treaty with the U.S.; in the absence of a treaty, the dividends would be subject to 30% U.S. tax on the gross amount thereof. Finally, assuming the sale of the FI’s interest in PEF generated only capital gain, it would not be subject to U.S. income at all.

See IRC Sec. 864(c)(8) – enacted as part of the Tax Cuts and Jobs Act – with respect the taxation of the gain from the sale of an interest in a partnership engaged in a U.S. trade or business.

[xxxv] IRC 1446.

[xxxvi] Reg. Sec. 1.6012-1(b), Reg. Sec. 1.6012-2(g).

[xxxvii] Under IRC Sec. 332, on a tax-deferred basis.

[xxxviii] IRC Sec. 721.

[xxxix] IRC Sec. 351.

[xl] As the “control group.”

[xli] Query why the taxpayer acted as they did – was the first contribution made in error?

[xlii] Compare this to the target partnership’s former owners who are receiving only a small interest in the HC.

See also Reg. Sec. 1.368-1(d), which addresses the continuity of business enterprise requirement for a tax-free reorganization (not a Sec. 351 transaction) where the assets acquired by the acquiring corporation are contributed to a partnership. Although not directly on point, it conveys the IRS’s thinking in a situation that, like a Sec. 351 exchange, considers whether the transferor-taxpayer’s relationship to, or form of ownership of, the assets it has transferred has changed to a degree that warrants taxation. Each partner of the partnership is treated as owning (in accordance with their partnership interest) the partnership assets used in a business. The issuing corporation is treated as conducting the business of the partnership if the corporation owns an interest in the partnership that represents a significant interest in the partnership business, or if the corporation has active and substantial management functions as a partner with respect to the partnership business; between 20-percent and 33.3-percent of the partnership is enough if the corporation performs substantial management functions.

More than one-third suffices if the corporation has no management functions in the partnership. See examples 14 and 15 of Reg. Sec. 1.368-1(d) for illustrations of situations that involve the transfer of acquired stock to a partnership.

Moving To Florida?

A few days ago, one of the daily tax services reported that the billionaire investor and businessman, Carl Icahn, was planning to move his home from New York City to Florida, presumably for tax reasons. What’s more, the article continued, Icahn was planning to move his NYC-based business (including employees) to Florida.[i]

The article noted that, over the years, a number of prominent investors and hedge fund managers have relocated to Florida for tax reasons – it cited David Tepper, Paul Tudor Jones and Eddie Lampert as examples – explaining that Florida has no personal income tax, and a corporate tax rate of 5.5-percent, as compared to NY’s corresponding rates of 8.82-percent and 6.5-percent.[ii]

Shortly after reading this article, I came across a recent decision by NY’s Tax Appeals Tribunal regarding the tax status of another hedge fund manager: Nelson Obus (the “Taxpayer”), a co-founder, and the Chief Investment Officer, of NYC-based Wynnefield Capital; specifically, the Tribunal considered whether Taxpayer was a statutory resident of NY during the 2012 and 2013 tax years.[iii]

“It’s no wonder,” I thought to myself after reviewing the Tribunal’s opinion, “that NY is among the lowest-ranked states in terms of ‘tax climate’ – not only will we tax non-resident owners on the profits they realize from operating their business within the State, we’ll also tax them on their non-NY-source income if they decide to spend some of those profits by vacationing in the State.”[iv]

“I Love NY” – Unrequited Love?

The general fact pattern was not at all unusual and, unfortunately, the outcome was not at all unexpected – indeed, it was consistent with many other decisions under similar circumstances – which is why it is instructive for individuals who are not domiciled in NY, but who own and operate a NY-based business, and who are considering the purchase of a “second home” in the State.[v]

It was undisputed that Taxpayer was domiciled in New Jersey during the years at issue – that was his “permanent” home.

It was also undisputed that Taxpayer, who worked primarily out of his NYC office,[vi] was present in NY for over 183 days during each of the years in issue.

The question of Taxpayer’s statutory residence, therefore, turned on whether he maintained a permanent place of abode in NY.

In fact, just prior to the years at issue, Taxpayer had purchased a house in Northville, New York, which is located more than 200 miles from NYC, on a northern extension of Great Sacandaga Lake, in the Adirondack Park.[vii] The house had five bedrooms and three bathrooms, with year-round climate control.

It was undisputed that Taxpayer and his family used this house for vacation purposes[viii] only: Taxpayer enjoyed cross-country skiing in the winter months and attending the Saratoga Race Track in the summer. Taxpayer spent no more than two to three weeks at a time in Northville.

The Issue is Joined

Taxpayer filed NY State nonresident income tax returns, on Form IT-203, for each of the years at issue.[ix] In response to a question on Form IT-203, Taxpayer responded that he did not maintain any living quarters within NY State for either 2012 or 2013.[x]

After an audit conducted by the Department of Taxation, a notice of deficiency was issued to Taxpayer in 2016. The notice asserted additional NY State income tax due in excess of $525,000 (plus interest and penalty) for the two years at issue.[xi]

The additional liability was based upon the Department’s finding that, because Taxpayer maintained a permanent place of abode in the NY, and was present within the State in excess of 183 days, he was liable as a statutory resident for income tax purposes for the years 2012 and 2013.

Taxpayer protested the notice by filing a timely petition with the Division of Tax Appeals.

Unfortunately, Taxpayer didn’t stand a chance of succeeding under the current state of the law relating to NY statutory residence.

Statutory Residence

The NY Tax Law sets forth the definition of a NY State resident individual for income tax purposes. A resident individual means an individual: “(A) who is domiciled in this state, . . . or (B) who is not domiciled in this state but maintains a permanent place of abode in this state and spends in the aggregate more than one hundred eighty-three days of the taxable year in this state, . . .”[xii]

As set forth above, there are two alternative bases upon which an individual taxpayer may be subjected to tax as a resident of NY State, namely (A) the domicile basis, or (B) the statutory residence basis – i.e., the maintenance of a permanent place of abode in the NY, and physical presence in the State on more than 183 days during a given taxable year.

Because Taxpayer was domiciled in New Jersey during the audit years, the issue for the Tribunal was whether Taxpayer was liable for NY personal income tax on the basis of statutory residence. As there was no dispute that Taxpayer was physically present within NY for more than 183 days – after all, he worked in the City, where his business was located – the sole issue in the case involved whether Taxpayer maintained a permanent place of abode in NY during the years at issue.

Permanent Place of Abode

The phrase “permanent place of abode” is interpreted in the Department’s regulations as “a dwelling place of a permanent nature maintained by the taxpayer, whether or not owned by such taxpayer, . . . However, a mere camp or cottage, which is suitable and used only for vacations, is not a permanent place of abode. Furthermore, . . . any construction which does not contain facilities ordinarily found in a dwelling, such as facilities for cooking, bathing, etc., will generally not be deemed a permanent place of abode.”[xiii]

Taxpayer framed his argument as whether his limited use of the Northville house, which he claimed was otherwise rented out during the year, constituted a permanent place of abode. Taxpayer relied on the NY Court of Appeals decision in Gaied [xiv] to emphasize that, because his property was maintained for another’s use, such residence did not qualify as a permanent place of abode for him.

In Gaied, the petitioner owned a multi-family apartment building in Staten Island that contained three rental units. Two of these units were rented out and the third unit was maintained by the petitioner for use by his parents. The petitioner was domiciled in New Jersey; however, he owned an automotive service and repair business on Staten Island[xv] and commuted daily from New Jersey. The Tax Appeals Tribunal concluded that the petitioner was liable as a statutory resident based upon his presence within NYC for over 183 days and his maintenance of a permanent place of abode in Staten Island. The Tribunal based its decision on the fact that the petitioner had access to the permanent place of abode[xvi] although he maintained it for his parents. The Tribunal held that access was enough, and there was no requirement that petitioner actually reside there. The Tribunal was affirmed by the Appellate Division.[xvii]

The Court of Appeals, however, disagreed and reversed. The court held that:

“The Tax Tribunal has interpreted ‘maintains a permanent place of abode’ to mean that a taxpayer need not ‘reside’ in the dwelling, but only maintain it, to qualify as ‘statutory resident’ under Tax Law § 605 [b] [1] [B]. Our review is limited to whether that interpretation comports with the meaning and intent of the statutes involved . . . Notably, nowhere in the statute does it provide anything other than the ‘permanent place of abode’ must relate to the taxpayer. The legislative history of the statute, to prevent tax evasion by New York residents, as well as the regulations, support the view that in order for a taxpayer to have maintained a permanent place of abode in New York, that taxpayer must, himself, have a residential interest in the property.” [Emph. added]

In Taxpayer’s case, the Tribunal rejected his argument that he maintained the residence for a tenant’s use. Primarily, the tenant had their own separate living quarters and, as such, their occupancy did not affect the use of the house by Taxpayer as a vacation home. The decision in Gaied simply did not apply to the facts of this case.

Taxpayer also urged the Tribunal to find that the language in the above-quoted regulation regarding “a mere camp or cottage, which is suitable and used only for vacations,” described his Northville house. Taxpayer asserted that because his use was limited to only vacations, it could not be determined that Taxpayer, in fact, maintained the home for substantially all of the year.

The Tribunal responded by pointing out that Taxpayer was at no point prevented from using the property for substantially all of the year for both 2012 and 2013. The Northville house, it stated, could be (and was) used year-round and, as such, was considered permanent. The fact that Taxpayer chose to use the property exclusively for vacations did not transform its characterization as a permanent place of abode.[xviii]

Therefore, the Tribunal concluded that the Northville house was a permanent place of abode maintained by Taxpayer for his use. Because Taxpayer maintained a permanent place of abode in NY, and was present within the State for more than 183 days during each of the years in question, the Tribunal found that he was properly taxable as a statutory resident of NY for the years 2012 and 2013.[xix]

The fact that the house was located more than 200 miles away from where Taxpayer logged almost all of those 183-plus NY-days was of no consequence to either the Department or the Tribunal. The question, however, is whether it should it have been.

Think About It

Say I lived in Burlington, Vermont, and work in Plattsburgh, New York.[xx] I commute to work almost every day, just 32 miles each way.[xxi] Say my spouse is originally from Long Island, and her family used to spend their summers in Montauk. She misses the ocean beaches, so we purchase a year-round studio apartment in Montauk – almost 400 miles away from Burlington, but within walking distance of the Atlantic – that we use on long weekends, some holidays, and vacations.

Most of my wages are earned in NY and, thus, are subject to NY income tax; I get a credit for the tax paid to NY against the income tax I owe to Vermont as a domiciliary of that State.

Imagine my surprise when NY informs me that I am a statutory resident of the State and, therefore, owe NY tax on all of my income, which includes that part of my wages that I earned outside NY, my investment portfolio income, and my rental income from a condominium in Stowe, Vermont.[xxii]

The Department explains to me that even though I am not domiciled in NY, I am nevertheless subject to income taxation as a resident of the State because I maintain a permanent place of abode in NY – one in which I clearly have some residential interest, notwithstanding that it is almost 400 miles from my job in northern NY – and (b) spend more than 183 days in NY during the year.

Would the result have been any different if I lived in eastern Pennsylvania, worked in western NY, and had a studio apartment on the East End, over 500 miles away? Under the current interpretation of the statute, nope.

You get the picture. What’s wrong with this analysis? Does it make sense?

An Alternative?

The beginnings of an answer may be found in the dissent to the Appellate Division’s decision in Gaied, where the court held for the State. The dissent there explained that the intent of the statutory residence law, as stated in its legislative history, is to tax those individuals who, as a matter of fact, are NY residents.[xxiii]

Before Gaied, the Court in Tamagni[xxiv] considered the constitutionality of two states taxing someone as a resident. The Court there referenced the legislative history of the permanent residence test – signed into law in 1922 – stating that the test was enacted to discourage tax evasion by NY residents.

The Court explained that, at the time the statute was enacted, the Department of Taxation[xxv] noted in its memorandum in support of the legislation that, “[w]e have several cases of multimillionaires[xxvi] who actually maintain homes in New York and spend ten months of every year in those homes . . . but they . . . claim to be nonresidents.”[xxvii] According to the memorandum, the statutory residence test serves the important function of taxing those “who, while really and [for] all intents and purposes [are] residents of the state, have maintained a voting residence elsewhere and insist on paying taxes to us as nonresidents.”

Similarly, the Tax Department’s memorandum in support of the 1954 amendment to the statute, which established the “more than one hundred eighty-three days” requirement, specifically states that the amendment was necessary to deal with “many cases of avoidance and . . . evasion” of income tax by NY residents.[xxviii]

Turning again to Gaied in the Appellate Division, the dissent continued, “[a] permanent place of abode means a dwelling place of a permanent nature maintained by the taxpayer.” Using language that would later be adopted by the Court of Appeals in Gaied, and heavily emphasizing the distinction between “permanently maintaining” and “continuing living arrangements at” a particular dwelling place, the dissent asserted that the inquiry should focus on the person’s own living arrangements in the purported place of abode, and on whether the taxpayer had a personal residential interest in the place.

In reaching its decision, the Court of Appeals in Gaied concluded that there was no rational basis to interpret “maintains a permanent place of abode” to mean that a taxpayer need not “reside” in a given dwelling, but only maintain it, to qualify as a statutory resident. The Court rejected the Department’s and the Appellate Division’s analyses, and made a distinction between having a property interest, as opposed to a residential interest, in a dwelling.

The Court of Appeals explained that the legislative history supported the idea that the law was intended to prevent tax evasion by de facto NY residents. Thus, the permanent place of abode had to actually relate to the taxpayer, and the taxpayer themselves must have a residential interest (as opposed to just a property interest) in the property.

Nowhere, however, did the Court discuss any requirement that there be a nexus between the permanent place of abode in which the taxpayer has a personal residential interest and the location(s) within NY at which the taxpayer spends the requisite number of days that cause them to be treated as a resident. In fact, some courts – including the Tribunal in the Taxpayer’s case, above – have rejected such arguments based upon the Department’s interpretation of the law, which fails to require such a nexus.

For example, in Barker,[xxix] a Connecticut domiciliary who worked in Manhattan every day, as an investment manager, and who owned a vacation home in East Hampton (which they used for less than three weeks in any of the years at issue), was found to be liable for NY income tax on all of their income because they spent over 183 days in NY during the year – working in NYC – and owned a permanent place of abode in NY – approximately 110 miles away from Manhattan. The Tribunal rejected the taxpayer’s argument that the house was not suitable for use by the taxpayer’s family as a permanent home – which it characterized as “subjective” – stating that it was “well settled that a dwelling is a permanent place of abode where, as here, the residence is objectively suitable for year round living and the taxpayer maintains dominion and control over the dwelling. There is no requirement,” the Tribunal added, “that the [taxpayer] actually dwell in the abode, but simply that he maintain it.”

As we just saw, the Court of Appeals in Gaied rejected this last statement, that maintenance of a dwelling alone sufficed for purposes of the statutory residence test. Relying on the legislative history, the Court held that a taxpayer cannot have a permanent place of abode in NY unless “[he], himself, ha[s] a residential interest in the property.” The purpose of the test, the Court explained by reference to the legislative history, was to prevent avoidance by people who really live in NY but attempt to be taxed as nonresidents.

A Call to Action?

What does this mean for cases like the Taxpayer’s? Presumably, it requires that a more subjective inquiry occur before a non-NY domiciliary who spends more than 183 days a year in NY – as a result of operating a business in the State – can be taxed as a resident simply by virtue of having a dwelling somewhere in NY; what’s more, this inquiry must focus on whether the dwelling is actually “utilized as the taxpayer’s residence.”

Does this inquiry necessarily include a consideration of nexus? It should. There is a huge difference between finding a residential interest in a NY-situs property that is located near the NY place of business of someone who is not domiciled in NY,[xxx] as opposed to “looking for” such an interest in a vacation property situated in NY, but many miles from the NY place of business, such that a reasonable person would not entertain a daily commute between the two points.[xxxi]

When applying the statutory residence rule, the Department and the courts should take into account its intended purpose: to tax people who actually live in NY, and to discourage tax evasion by such individuals. The rule was not enacted to tax non-resident commuters who do not live in NY, even if they have some connection to NY real property, like a vacation home.

[i] “Carl Icahn Is Said to Be Heading to Florida for Lower Tax Rates,” Bloomberg’s Daily Tax Report, Dec. 12, 2019. Another article indicated that his employees were being offered a moving allowance to back their bags and head south with him.

Clearly, he has been advised that it will not suffice for him to move from NY while leaving his business behind – the business must come along too if he is to successfully demonstrate that he has abandoned his NY domicile and has established Florida as his new domicile.

[ii] The article could have added that New York City imposes a personal income tax on its residents at a rate of 3.876%; it also imposes a corporate tax at the rate of 8.85%, and a tax on unincorporated businesses of 4%.

The article also could have mentioned that Florida has no estate tax, whereas NY imposes an estate tax of 16%.

[iii] Nelson Obus and Eve Coulson, DTA NO. 827736 (August 22, 2019).

[iv] Yes, some hyperbole, but I’m making a point here.

[v] The opinion’s reasoning applies equally in determining the NYC resident status of a NY State domiciliary – for example, an individual whose permanent home is in Westchester or Nassau County – who owns and operates a business in NYC, and who is considering the purchase of an apartment in the City.

[vi] This is important to note because NYC did not claim he was a resident of the City, though he worked there most of the time.

[vii] A car drive of almost 4 hours; a bus or train ride of almost 5 hours; almost 5 hours by plane and car (flying from Newark to Albany then to Saratoga Springs, then by car to Northville).

[viii] It was obvious that he hasn’t going to commute to his office in NYC from Northville.

[ix] Taxpayer’s share of the profits from his NYC-based business probably included NY-source income.

[x] This drives me crazy. Whether it is done inadvertently or intentionally, I cannot say; its effect is the same: the NY auditor is left with the impression that the taxpayer is looking to avoid having their return selected for a residency exam. Why start behind the eight ball?

[xi] This translates, roughly, into additional taxable income of approximately $6 million in each of the years at issue. This income would, for example, represent wages earned outside of NY, rental income sourced outside NY, and investment income.

[xii] Tax Law Sec. 605(b)(1)(A) and (B).

[xiii] 20 NYCRR 105.20(e)(1).

[xiv] Matter of Gaied v New York State Tax Appeals Trib., 22 NY3d 592 [2014].

[xv] AKA Richmond County, and somehow one of NYC’s five boroughs.

[xvi] It was located in the same neighborhood as his business.

[xvii] Matter of Gaied v New York State Tax Appeals Trib., 101 AD3d 1492 [3d Dept. 2012].

[xviii] The regulation at 20 NYCRR 105.20[e][1], in interpreting the phrase permanent place of abode, provides guidance concerning certain living quarters maintained by a taxpayer that are not permanent in nature, where the property is not suitable for year-round use or does not contain cooking facilities or bathing facilities.

[xix] Finally, Taxpayer argued that the imposition of a resident income tax in his circumstances was unconstitutional because it would lead to multiple taxation of his income. Specifically, Taxpayer asserted that New Jersey would not allow a credit for taxes paid to other states on income – such as investment portfolio income (which represents a significant portion of the income of most money managers) – that had no identifiable situs.

According to the Tribunal – and unfortunately for Taxpayer – the Court of Appeals had already rejected this argument. Matter of Tamagni v Tax Appeals Trib., 91 NY2d 530 [1998], cert. denied, 525 U.S. 931 (1998), wherein the statutory residence statute was upheld as constitutional.

[xx] Ah, Lake Champlain.

[xxi] About the distance from Jericho, NY (a bedroom community) to Manhattan.

[xxii] Which, ironically, I lease mostly to people from NY. Again, this is my story, so I can take as much license as I need to make a point. Besides, I am told that it’s good to dream.

[xxiii] Gaied v. New York State Tax Appeals Tribunal, 957 N.Y.S. 2d 480.

[xxiv] See EN xix.

[xxv] Then known as the Income Tax Bureau.

[xxvi] No one talks about millionaires today. Billionaires are now the fashion.

[xxvii] Bill Jacket, L. 1922, ch. 425.

[xxviii] Memorandum of Dept. of Taxation and Finance, 1954 N.Y. Legis. Ann., at 296.

[xxix] Matter of Barker, DTA No. 822324 (N.Y. Tax App. Trib. 2011).

[xxx] The classic Manhattan pied-a-terre owned by a non-NY domiciliary who works in the City.

[xxxi] The question, of course, is where does one draw the line? There are people who commute to NYC every day from the East End, or from parts of Dutchess and Orange Counties. How far away is too far for this purpose?