I once heard it said that death keeps no calendar.[i] That may be, but it can sure unsettle a partnership’s advisers when the decedent is one of the partners and their estate chooses to use a fiscal year[ii] for its taxable year. Let’s see why.

Partnership Income

As we know, a partnership[iii] is not, itself, a taxable entity,[iv] and the partnership’s owners – i.e., the partners – are liable for income tax only in their separate capacities.

We also know that, in determining their income tax liability, each partner is required to take into account separately on their tax return their distributive share, whether or not distributed to them, of each class or item of partnership income, gain, loss, deduction or credit (“Tax Items”), including the taxable income or loss of the partnership,[v] as computed under the partnership’s method of accounting.[vi]

What’s more, the character of any partnership item included in a partner’s distributive share is determined as if the item were realized directly from the source from which it was realized by the partnership, or incurred in the same manner as incurred by the partnership.[vii]

In computing their taxable income for a taxable year, a partner must look to the taxable year of the partnership that ends within or with the taxable year of the partner.[viii]

Thus, in the case of a partnership comprised entirely of individuals – who are “required” to use the calendar year as their taxable year – the items of partnership income, gain, loss, deduction and credit for the partnership’s taxable year that ends on December 31, in the case of a partnership that uses the calendar year, will be taken into account by the partners for their taxable year ending December 31.

If that same partnership had chosen to use a fiscal year instead, one that ends before the partners’ own calendar taxable year,[ix] the Tax Items for the partnership’s taxable year would be taken into account by the partners for their first taxable year ending after such fiscal year.

For example, assume A is an individual partner in partnership P, and that P’s taxable year is the calendar year. For A’s taxable year ending December 31, 2020, A will compute their taxable income by taking into account A’s share of P’s Tax Items for P’s taxable year that ends December 31, 2020.

However, if P used a fiscal taxable year ending, say, on April 30, A would compute their taxable income for A’s taxable year ending December 31, 2020 by including P’s Tax Items for P’s taxable year that began on May 1, 2019 and ended on April 30, 2020; i.e., the taxable year of the partnership that ends within or with the taxable year of the partner. Thus, a portion of A’s distributive share of P’s taxable income that was “earned” in 2019[x] will be reported on A’s income tax return for 2020, and the tax liability therefor will not be due until April 15, 2021[xi] – the recognition of such income is deferred – although A may have to make estimated tax payments on a current basis in order to avoid any penalty attributable to the inclusion of A’s distributive share in their 2020 tax year.

A partner must also include in taxable income for a taxable year any guaranteed payments for services rendered by the partner to the partnership, or for the partnership’s use of the partner’s capital, that are deductible by the partnership under its method of accounting in the partnership taxable year ending within or with the partner’s taxable year.[xii]

Required Taxable Year

Which brings us to the taxable year of a partnership, which figures so importantly in the determination of a partner’s own tax liability.

Under the Code, (i) unless a partnership establishes, to the satisfaction of the IRS, a business purpose for a particular fiscal year desired by the partnership,[xiii] or (ii) unless the partnership elects to use a fiscal year that provides a deferral period of not more than three months,[xiv] the partnership’s taxable year has to be determined by reference to the taxable year of its partners.

Specifically, a partnership must use as its taxable year the so-called “majority interest taxable year.” In general, this is the taxable year, if any, which on the first day of the partnership’s taxable year[xv] constitutes the taxable year of one or more partners having an aggregate interest in partnership profits and capital of more than 50-percent.[xvi]

If partners owning a majority of the partnership profits and capital do not have the same taxable year, the partnership must adopt the same taxable year as all of its “principal partners.” A principal partner is a partner having an interest of 5-percent or more in partnership profits or capital.[xvii]

If the partnership has no majority interest taxable year, and no principal partners’ taxable year, its taxable year will be the one that produces the least aggregate deferral of income to the partners.[xviii]

Change in Required Taxable Year

Because the relationship of a partnership’s taxable year to the taxable years of its partners is integral to determining when the partners will have to include their distributive shares of the partnership’s Tax Items on their separate returns, a change in the partnership’s taxable year may affect the timing of a partner’s recognition of such Tax Items.

The Code does not mandate that a partnership retain its originally determined “required” taxable year. In fact, it contemplates that a partnership will have to change its taxable year upon a change of its majority interest taxable year.

Such a change, which is deemed to have been approved by the IRS,[xix] may occur as a result of the admission of a new partner, the complete or partial liquidation of a partner’s interest, or upon a transfer of interests among the existing partners. As we will see shortly, it appears that it may also occur following the death of a partner.

In the event of a change in the ownership of a partnership, as a result of which its “majority interest” taxable year also changes, the partnership will not be permitted to retain its current taxable year[xx] without obtaining the approval of the IRS.[xxi]

Moreover, in order to prevent partners from indirectly causing the required taxable year of their partnership to change, presumably for the purpose of gaining some tax advantage, the Code provides that a partner may not voluntarily change their own taxable year without securing the approval of the IRS.[xxii]

What about a change that the partner did not, could not foresee? For example, their own death.

Death of a Partner[xxiii]

A lot happens upon the death of an individual partner, including, for example, the following:

  • The partnership’s taxable year will close only as to the deceased partner, for purposes of determining the decedent’s distributive share of partnership Tax Items for the portion of the partnership taxable year ending with the date of death;[xxiv]
  • The decedent’s estate (or other successor, such as a living/revocable trust, depending upon how the deceased partner held their partnership interest; the “Estate”), will take such interest with an adjusted basis equal to the fair market value of such interest at the date of the partner’s death, increased by the Estate’s share of partnership liabilities on that date, and reduced to the extent such value is attributable to items constituting income in respect of a decedent;[xxv]
  • If the partnership has in effect, or if it timely makes, an election under Sec. 754 of the Code, the Estate will receive a special basis adjustment to its share of the partnership’s basis for its assets, derived from the Estate’s basis for its partnership interest at the date of the deceased partner’s death.[xxvi]

But what about the taxable year of the partnership? Does the partner’s death have any effect thereon?

The Estate as a Partner

A deceased partner’s Estate is a new and separate taxpayer that springs into existence, and begins its first taxable year, upon the death of the partner.[xxvii]

If the deceased partner’s successor is an irrevocable trust,[xxviii] it generally must use the calendar year as its taxable year.[xxix]

However, if the partnership interest is held by the decedent’s estate,[xxx] the estate may choose any annual accounting period as its taxable year,[xxxi] and there’s the rub.[xxxii]

What if the estate’s choice of taxable year results in a change of the partnership’s taxable year? This would be the case, for example, where the decedent had a greater than 50-percent interest in partnership profits and capital. The estate’s selection of a fiscal year would produce a new “majority interest” taxable year – a new required year.

What if the estate did not hold any interest in the partnership, and said interest was held, instead, by the decedent’s formerly revocable trust? As indicated earlier, a trust must use the calendar year as its taxable year; thus, with nothing more, the partner’s death would have no impact upon the partnership’s taxable year.

But what if the executor of the estate and the trustee of the trust elect to treat and tax the trust as though it were part of the estate for purposes of the income tax?[xxxiii] In that case, the trust would not be treated as a separate trust for the taxable years of the estate ending after the decedent’s date of death and before the “applicable date.”[xxxiv] Rather, as part of the estate, the trust would take the estate’s taxable year for its own. Consequently, the partnership in which the trust holds an interest may be subject to a change in its majority interest taxable year.

Change of Taxable Year

This situation raises an interesting issue: how will the partnership know that the Estate’s selection of a fiscal year may have resulted in a change of the partnership’s required taxable year? Why would the partners care?

There are a number of concerns.

For one thing, the change may affect the timing of when the partnership’s Tax Items are to be accounted for by the partners in determining their taxable income.

In addition, a short period return (of less than twelve months) will have to be filed, beginning with the day following the close of the old taxable year and ending with the day preceding the first day of the new taxable year.[xxxv] The partnership does not annualize its taxable income for purposes of preparing this short period return; rather, the return for the short period is made as if that period were a taxable year.[xxxvi]

A number of elections must be made on a timely filed tax return.[xxxvii] What if a partnership is unaware of the change to its required taxable year? In that case, it will likely fail to file the necessary short period return, along with any elections that must be made with such return.[xxxviii] It will also fail to have included with the return, or to have separately filed, any other forms that are due at the same time as the partnership’s tax return. This failure may very well result in the imposition of penalties.

“Not Again”

Let’s assume the partnership figures out that the fiscal tax year chosen by a deceased partner’s Estate will require a change in the partnership’s own tax year. Let’s also assume that the partnership acts accordingly.

The Estate remains a partner of the fiscal year partnership, at least for tax purposes,[xxxix] until the administration of the Estate is completed. At that point, the Estate will distribute the decedent’s partnership interest as directed by the latter’s will or trust.[xl]

Because the beneficiaries of a decedent’s Estate will almost certainly be individuals who use the calendar year as their taxable year, the partnership may experience another “new” majority interest taxable year, but will it again have to change its own required taxable year?

In general, the answer is yes. However, because the partnership was required to change to a new majority interest taxable year when the Estate selected its fiscal year, then no further change in the partnership’s taxable year will be required for either of the two years following the year of the change;[xli] meaning, if the Estate’s distribution of the partnership interests occurs beyond this “safe” period, the partnership may be required to again change its taxable year, based upon the taxable years of the beneficiaries.

Avoid Surprises

Can a partnership and its partners develop a plan, or a framework, for anticipating and dealing with the issues posed above?

Of course they can.

Well, they can at least try.

For example, the partnership agreement may require that the partners make their estate plans known to the partnership’s management team.[xlii] It may also require that all proposed transfers of a partnership interest be reported to the partnership, whether or not such transfers are “permitted transfers” under the terms of the agreement.

The partnership agreement may also require that the Estate keep the partnership’s management team informed of the Estate’s plans for selecting a taxable year. Query whether it would be appropriate to require that the partnership’s consent be obtained before such a taxable year is chosen, or that the Estate demonstrate that the proposed taxable year will not require a change of the partnership’s own taxable year?

Finally, it may behoove everyone concerned, even without regard to the issue of the taxable year, if the partnership were simply required to redeem the Estate’s interest.[xliii]


[i] Yes, I realize this is supposed to be a festive time of year. Go tell that to any transactional attorney working through Thanksgiving, Christmas and New Year’s Eve. Or to the estate planners who are formulating plans and preparing documents for those who suddenly feel vulnerable just days before the year-end (or just hours before their ski trip – we weren’t meant to go downhill like that – or their trip to Europe). Bah, Humbug, indeed.

[ii] Generally speaking, a twelve month period ending on the last day of any month, other than on December 31. IRC Sec. 441. A taxpayer’s taxable year is often referred to as their annual accounting period.

[iii] IRC Sec. 761; Reg. Sec. 301.7701-3.

[iv] IRC Sec. 701.

[v] IRC Sec. 702(a). See Sch. K-1, Part III, Line 1. This is exclusive of items requiring separate computations – these are partnership items which, if separately taken into account by any partner, would result in an income tax liability for that partner different from that which would result if that partner did not take the item into account separately. Take a look at all those codes on page 2 of the K-1. Oy.

[vi] See IRC Sec. 448 for limitations on the use of the cash method of accounting, as amended by P.L. 115-97.

[vii] IRC Sec. 702(b).

[viii] IRC Sec. 706(a).

[ix] This would be the case where the partners were able to establish to the IRS that there was a valid business purpose for using a fiscal year. See below.

[x] At least for the period from May 1, 2019 through December 31, 2019.

[xi] The due date for A’s income tax return for the tax year ending December 31, 2020.

[xii] IRC Sec. 707(c); Reg. Sec. 1.706-1(a)(1). Thus, a partner may have to include in their gross income for a year the amount of a guaranteed payment that has properly been accrued by the partnership in that year but which will not be received by the partner until the next year.

[xiii] IRC Sec. 706(b)(1)(C). The deferral of income to partners does not qualify as a business purpose.

[xiv] IRC Sec. 444. Where the partnership’s “required’ taxable year ends December 31, the partnership may elect a taxable year ending September 30 to obtain a three-month deferral. This limited deferral comes at a price. Under IRC Sec. 7519, the partnership must pay the IRS an amount that approximates the amount of tax thereby deferred.

[xv] The “testing date.” IRC Sec. 706(b)(4)(A)(ii).

[xvi] IRC Sec. 706(b)(1)(B)(i) and Sec. 706(b)(4).

[xvii] IRC Sec. 706(b)(1)(B)(ii) and Sec. 706(b)(3).

[xviii] Reg. Sec. 1.706-1(b)(3).

[xix] Rev. Proc. 2006-46. See also IRS Form 1128, Application to Adopt, Change or Retain a Tax Year, Part II, Section B.

[xx] Corresponding to its previously required taxable year.

[xxi] Under IRC Sec. 442. Reg. Sec. 1.706-1(b)(9).

[xxii] Reg. Sec. 1.706-1(b)(8)(ii).

[xxiii] OK, you want something more in keeping with the spirit of the season rather than focused on the death of partner, here’s something that accomplishes both:

SCROOGE:  Who are you?

MARLEY:  In life I was your partner, Jacob Marley.

SCROOGE:  Can you . . . sit down?

MARLEY:  Yes.

SCROOGE:  Then do it.

MARLEY: You don’t believe in me.

SCROOGE:  I don’t.

MARLEY:  Why do you doubt your senses?

SCROOGE: Because . . . any little thing affects them . . .

You may be an undigested bit of beef, a blot of mustard, a crumb of

cheese, a fragment of an underdone potato. There’s more of gravy than of grave

about you, whatever you are! Humbug, I tell you! Humbug!

A Christmas Carol, Charles Dickens.

Of course, although the business continued to be operated under the name of “Scrooge & Marley,” after the latter’s death, it was, in fact, a sole proprietorship.

[xxiv] IRC Sec. 706(c)(2)(A). The partnership’s taxable year does not close as a result of the death of a partner. Reg. Sec. 1.706-1(c)(1).

[xxv] Reg. Sec. 1.742-1. See also IRC Sec. 1014, Sec. 752, Sec. 753, and Sec. 691.

[xxvi] IRC Sec. 754, Sec. 743. The adjustment only occurs with respect to the transferee partner (the Estate).

[xxvii] IRC Sec. 1(e), Sec. 641 et seq.

[xxviii] The formerly revocable or living trust that became irrevocable upon the grantor-partner’s death.

[xxix] IRC Sec. 644. There is an exception to this rule for “qualified revocable trusts” under IRC Sec. 645.

[xxx] As distinguished from the “Estate” as defined herein.

[xxxi] There is no rule comparable to IRC Sec. 644 that applies to estates. As a new taxpayer, the estate must determine when its taxable year will end. In general, the estate chooses its taxable year when it files its first income tax return (IRS Form 1041). The estate’s first taxable year may be any period of twelve months or less that ends on the last day of a month.

[xxxii] From Hamlet’s soliloquy on suicide: “To die, to sleep, to sleep perchance to dream: Ay, there’s the rub. For in the sleep of death, what dreams may come.”

[xxxiii] IRC Sec. 645. The trust must be a qualified revocable trust. Sec. 645(b)(1).

[xxxiv] IRC Sec. 645(b)(2) defines the applicable date as follows: if no estate tax return (IRS Form 706) is required to be field, it is the date which is two years after the date of death; if such a return is required to be field, it is the date which is six months after the date of the final determination of estate tax liability.

[xxxv] For example, assume a partnership’s required taxable year ends December 31. One of the partners dies on October 10, 2020. The partner’s death does not, by itself, change or close the partnership’s taxable year. The deceased partner’s estate chooses a fiscal year that ends on September 30; thus, its first tax year will run from October 11 2020 through September 30, 2021. Assume that the estate’s selection of a fiscal year causes a change in the partnership’s required majority interest taxable year from one ending December 31 to one ending on September 30. The partnership will have to file a short period return for the period beginning January 1, 2021 and ending September 30, 2021.

[xxxvi] Reg. Sec. 1.706-1(b)(8); IRC Sec. 443; Reg. Sec. 1.443-1. Basically, a closing of the books.

[xxxvii] Which may also include extensions of the time prescribed for filing.

[xxxviii] Depending upon the election, the automatic relief provision under Reg. Sec. 301.9100-2 may not be available.

[xxxix] Its status as a matter of state law may be that of a mere economic interest holder. It also may be that the Estate has only those partner-related rights that are necessary for settling the decedent’s estate or administering their property. See, e.g., NY’s LLCL, Sec. 608.

[xl] Don’t forget that the distribution may carry out the estate’s DNI. IRC Sec. 662.

[xli] IRC Sec. 706(b)(1)(4)(B).

[xlii] This is not unusual in the case of S corporations and their shareholders, where it is imperative that the corporation’s shares not be transferred to persons who are not qualified to own such shares. See IRC Sec. 1361(b), (c), (d) and (e).

[xliii] IRC Sec. 736. Fa-la-la-la-la, la-la, la, la.

As we approach the end of 2019, I am reminded that this was supposed to have been the year in which New York’s estate tax exclusion amount was to have become the same as the federal estate tax exclusion amount.[i] As things turned out, it didn’t come close, but that wasn’t Albany’s fault, not by a long shot – at least not this time. The Feds were to blame, and how could anyone reasonably have foreseen the 2017 tax legislation?

Looking back on the year, however, it is not difficult to identify a couple of New York’s uniquely home-grown contributions to its reputation as a place that many business owners would like to avoid, or from which they would like to escape.

Before we examine these local products, we should give the Feds their due.

Recent Federal Activity

As you probably recall, among the changes made by the 2017 Tax Cuts and Jobs Act,[ii] the one that immediately caught the attention of “more mature” business owners was the doubling of the federal estate and gift tax exclusion amount for decedents dying, and for gifts made,[iii] after December 31, 2017 and before January 1, 2026.[iv]

This increase was accomplished by doubling the “basic exclusion amount” from $5 million to $10 million for 2018, before taking into account the prescribed inflation adjustments;[v] once indexed for inflation, this generated an exclusion amount of $11.2 million per U.S. individual in 2018 and $11.4 million in 2019. As a result of recently announced inflation adjustments, the exclusion for 2020 will be increased to $11.58 million.[vi]

Thus, in 2020 – only a few weeks from now – a married U.S. couple that has not made any taxable gifts in prior years may pass along to the “objects of their bounty” property with a total fair market value of $23.16 million, by way of either lifetime or testamentary transfers, without incurring gift or estate tax, as the case may be.[vii]

What’s more, because a surviving U.S. spouse may utilize a predeceasing spouse’s unused federal exclusion amount to make tax-free gifts or testamentary transfers (“portability”), a married couple should be able to fully utilize their combined federal exclusion.[viii]

However, given the temporary nature of the increased exclusion amount provided by the Act – it reverts to pre-2018 levels, adjusted for inflation, for lifetime or testamentary transfers made after December 31, 2025 – many advisers questioned whether the cumulative, or unitary, nature of the gift and estate tax computations,[ix] coupled with the differences between the exclusion amounts in effect (i) at the time of a taxpayer’s death and (ii) at the time of any lifetime gifts made by the taxpayer, would result in inconsistent tax treatment of gifts made after 2017 and testamentary transfers made after 2025.[x]

Fortunately, the IRS proposed regulations to address these concerns just over one year ago[xi] and, last week, these regulations (with some modifications) were issued in final form.[xii]

With the publication of these final regulations, an individual business owner should be confident that their estate will not be inappropriately taxed by reason of their having made lifetime gifts that take advantage of the increased federal exclusion amount before its scheduled expiration date of December 31, 2025.

As an additional incentive to making such gifts, the owner need only consider the estate and wealth tax proposals being discussed by so many of the Democratic presidential hopefuls for 2020.[xiii]

But what about a business owner who is domiciled in New York?

Don’t Forget New York

New York eliminated its gift tax for transfers made after December 31, 1999.

What’s more, before the passage of the Act, New York was in the process of “catching up” to the federal estate tax exclusion amount.

Specifically, the New York estate tax exclusion amount, which was $1.0 million through March 31, 2014, was steadily increased to approximately $2.06 million for the 12-month period ending March 31, 2015, then to $3.125 million for the next 12-month period, ending March 31, 2016, and then to approximately $4.188 million for the period ending March 31, 2017; from April 1, 2017 to December 31, 2018, the New York exclusion amount was set at $5.25 million.[xiv]

As of January 1, 2019, the New York estate tax exclusion amount was poised to become the same as the basic federal exclusion amount of $5.0 million,[xv] adjusted annually for inflation.

Thus, if a New York decedent had died during the April 1, 2017-to-December 31, 2017 period, the New York exclusion amount was $5.25 million, while the federal exclusion was $5.49 million.

As a result of the Act, however, the federal exclusion amount[xvi] diverges greatly from the New York amount after 2017.  In the case of a New York decedent dying during 2018, the New York exclusion amount remained $5.25 million, but the federal amount was increased to $11.2 million.

For testamentary transfers made during 2019, the New York exclusion amount is $5.74 million per individual,[xvii] while the federal amount has been $11.4 million.

Finally, for a decedent passing during 2020, the New York exclusion amount is scheduled to be $5.85 million,[xviii] whereas the federal exclusion will be $11.58 million.

The New York Traps

Based on the foregoing, it appears that a New York business owner would be well-advised to start making gifts of their equity in the business so as to reduce their New York taxable estate.[xix]

This appears to be a conceptually sound approach. After all, there is no New York gift tax, and the increased federal exclusion amount may shelter a significant portion of such gifts from federal gift tax liability.[xx]

However, there are two factors, or traps, that conspire against the effectiveness of this strategy.

The first operates to deny more affluent New York business owners the benefit of New York’s increased exclusion amount. It does so by phasing out the exclusion amount when a decedent’s taxable estate exceeds the exclusion amount. What’s more, the phase-out occurs over a very narrow band of value, so that the benefit of the exclusion amount is eliminated entirely when the taxable estate is greater than 105-percent of the exclusion amount. At that point, the owner’s entire taxable estate becomes taxable, not just the part that exceeds the exclusion amount.[xxi]

This is what has been described as New York’s “estate tax cliff.” When the cliff applies, the decedent’s taxable estate is taxed according to New York’s graduated estate tax rates, beginning at 3.06-percent for the first $500,000, and then continuing upward, with the excess over $10.1 million being taxed at 16-percent.[xxii]

The second trap is intended to prevent a taxpayer, like the owner of a closely held business, from circumventing the New York estate tax by making gifts that reduce the taxable estate below the exclusion amount. Not only does this provision ensure the application of the New York tax to the estates of many resident decedents, it also increases the likelihood that New York’s “cliff” rule will apply to these estates, thereby generating a greater tax liability.

Summary of Recent N.Y. Estate Tax Legislation

Since the passage of the Act, New York has made it abundantly clear that it will neither match the federal estate tax exclusion amount, nor adopt the federal rule on portability between spouses.[xxiii]

However, that does not mean New York has been inactive on the estate tax front – on the contrary.[xxiv]

In April of 2019,[xxv] New York retroactively reinstated a provision[xxvi] by which a resident decedent’s New York gross estate will be increased by the amount of any taxable gift[xxvii] made by the decedent during the three-year period ending on the decedent’s date of death,[xxviii] provided the property transferred is not otherwise included in the decedent’s federal gross estate,[xxix] and provided the decedent dies before January 1, 2026.[xxx]

In other words, the requirement to add back taxable gifts has been extended to apply to estates of decedents dying on or after January 16, 2019 and before January 1, 2026.

That being said, the following gift transfers are not subject to the reinstated “claw-back” or inclusion rule:

  • Gifts made when the decedent was not a resident of New York;
  • Gifts made before April 1, 2014;
  • Gifts made between January 1, 2019 and January 15, 2019;
  • Gifts of real property or tangible personal property having an actual situs outside New York at the time the gift was made.[xxxi]

Planning Under the Mismatched Rules

As we approach the year 2020, tax advisors who represent business owners domiciled in New York should take stock of the basic federal and New York estate tax rules within which they will be operating:

  • Federal Rules
    • The combined gift and estate tax exclusion amount will be $11.58 million per individual;[xxxii]
      • This increased basic exclusion amount will remain through 2025;
    • The top federal estate (and gift) tax rate of 40-percent will apply to that portion of a taxable estate (or gift) in excess of $1.0 million;
    • A surviving spouse may utilize the unused exclusion amount of their predeceased spouse;
  • New York Rules
    • The estate tax exclusion amount will be $5.74 million per individual;
      • New York has no gift tax;
    • New York will include in the estate of a New York decedent dying before 2026 the sum of any taxable gifts made by the decedent during the three-year period ending with their date of death;
    • The benefit of the exclusion amount is completely lost for a New York taxable estate that exceeds 105-percent of the exclusion amount;
    • The top New York estate tax rate of 16-percent will apply to that portion of a taxable estate in excess of $10.1 million;
    • There is no portability of the unused exclusion amount from the estate of a deceased spouse to the surviving spouse – if a predeceasing spouse fails to utilize their entire exclusion amount, it will be lost.

Gifts

In light of the fact that New York’s estate tax exclusion amount will be much lower than the federal exclusion amount, at least for the foreseeable future, a business owner who is domiciled in New York, and who is serious about reducing their total estate tax liability and maximizing the amount of wealth that will pass to their family, cannot simply plan for the federal estate tax and ignore New York.[xxxiii]

Depending upon who owns the business, both the owner and their spouse may consider making gifts, or splitting gifts,[xxxiv] of equity in the business in order to reduce both their federal and New York gross estates.

The owner may also want to consider making a gift of stock to their spouse in an amount sufficient to allow the spouse to fully utilize their New York exclusion amount.[xxxv]

Of course, the owner will have to survive for three years following a taxable gift if they hope to avoid New York’s claw-back rule and the inclusion of the gifted property in their New York estate. Because one never knows when Thanatos[xxxvi] will come for us, the owner may want to formulate and implement a gift plan sooner rather than later.

If the owner is concerned about giving away too much, this plan may include the use of SLATs[xxxvii] for the benefit of the owner’s spouse and/or children. This may assure the owner of continued access to the gifted property, “vicariously” through their spouse.[xxxviii]

“Sales”

In addition to outright gifts, this plan may also include transactions that are treated as sales – rather than as taxable gifts – for purposes of the gift tax. Thus, the owner’s sale of an equity interest in their business to a grantor trust[xxxix] in exchange for a promissory note may freeze the value of the property sold at the principal amount of the note, while shifting the appreciation in the property to the trust and away from the grantor-owner, which may keep the owner’s estate below the 105-percent threshold amount.

If there is any concern about a gift resulting from what may, in hindsight, turn out to be a bargain sale, a “Wandry”-like adjustment clause may be used to eliminate the risk of an inadvertent gift.[xl] A transfer to a GRAT may serve the same purpose.[xli]

Revisit Wills and Revocable/Living Trusts

Although gifts and other lifetime transfers are effective vehicles for planning for one’s estate – as well as for addressing the differences between the New York and federal estate tax rules – there are some individuals who find it extremely difficult to part with their property or to otherwise compromise their control, especially over their business.[xlii]

Those business owners, and their advisers, cannot lose sight of the fact that estate planning does not have to end with their demise. This is certainly true when planning for the use of the New York exclusion amount. For example, someone’s will may provide for the funding of a trust with an amount equal to the federal exclusion amount. Because the federal exclusion amount is so much greater than the New York exclusion, this provision may expose this individual’s estate to New York estate tax.[xliii]

It may be advisable to revise the terms of this testamentary trust so that it qualifies for the marital deduction as a QTIP trust;[xliv] in this way, a partial QTIP election may be made for the portion of the trust that exceeds the New York exclusion amount. Alternatively, perhaps the will should be drafted so as to allow the surviving spouse to timely disclaim[xlv] property that would thereby fund a testamentary trust up to the New York exclusion amount.

Escape from NY[xlvi]

In extreme cases, a New York business owner may try to abandon their New York domicile and establish a new domicile in a state that does not impose an estate tax.[xlvii]

However, changing a taxpayer’s domicile is easier said than done, especially where the New York business has not yet been sold and, more difficult still, where the owner remains active in its management.

Do Something

In light of the foregoing, it will behoove the business owner who is domiciled in New York to meet with their advisers for the purpose of considering how their estate plan – including their will and/or revocable trust, and any gift or other transfers that may become a part of such plan[xlviii] – may impact their New York estate tax situation.

 


[i] OK, some of you might view the year-end differently. I can’t account for your lapses, like “I thought the Knicks would be more competitive by this point in the year,” or “Only two and one-half months before pitchers and catchers.” Seriously? Then there are those of you who enjoy the excesses of holiday shopping, and who actually look forward to New Year’s Eve. And you believe that I need help? C’mon.

[ii] P.L. 115-97; the “Act”.

[iii] Don’t forget the GST tax.

[iv] IRC Sec. 2010(c)(3).

[v] Beginning with 2012.

[vi] Rev. Proc. 2019-44.

[vii] In general, if such gifts had been made, but not in excess of the individual’s exclusion amount at the time of the gifts, the individual’s ability to make additional gifts without incurring gift tax liability would be determined by subtracting from the new exclusion amount the fair market value of those earlier taxable gifts based upon the fair market value of the properties transferred at the time of such gifts. The same principle applies – taking into account lifetime gifts – in determining how much value a decedent may pass without incurring estate tax. (You die only once.)

[viii] IRC Sec. 2010(c)(2) and (4).

[ix] Taxable gift transfers that do not exceed a taxpayer’s exclusion amount are not subject to gift tax. However, any part of the taxpayer’s exclusion amount that is used during their life to offset taxable gifts reduces the exclusion amount that remains available at their death to offset the value of their taxable estate.

[x] https://www.taxlawforchb.com/2018/12/to-gift-or-not-to-gift-the-time-may-have-arrived/

[xi] https://www.federalregister.gov/documents/2018/11/23/2018-25538/estate-and-gift-taxes-difference-in-the-basic-exclusion-amount

[xii] T.D. 9884. The regulations apply to gifts made after 2017 and to decedents dying after 2025.

[xiii] Query whether the 2020 election results will accelerate the sunset of the increased exclusion amount into 2021, rather than as scheduled, in 2026?

[xiv] See TSB-M-14(6)M.

[xv] See P.L. 111-312, Sec. 302, and P.L. 112-240, Sec. 101.

[xvi] Effective for gifts and deaths after December 31, 2017.

[xvii] $11.48 million per couple, assuming both individuals utilize their respective exclusion amounts.

[xviii] $11.70 million per couple.

[xix] A gift of property removes the property, the income generated by the property, and the appreciation in the value of the property.

[xx] Especially if one considers the valuation of an equity interest that represents a minority stake in a closely held business.

[xxi] Contrary to the federal rule, which taxes only the excess.

[xxii] Only the states of Washington and Nebraska have a higher top marginal rate, while several others match New York at 16%. https://taxfoundation.org/state-estate-tax-state-inheritance-tax-2019/

[xxiii] Stated differently, although New York is not into portability, it definitely enjoys decoupling, at least when it comes to the federal rules.

[xxiv] See TSB-M-19(1)E.

[xxv] New York Fiscal Year 2020 Budget.

[xxvi] This provision was introduced in 2014, and had expired at the end of 2018. The reinstatement begins for gifts made on or after January 16, 2019.

[xxvii] Within the meaning of IRC Sec. 2503, even if “sheltered” by the federal exclusion amount.

[xxviii] This is derived from the old federal rule under which transfers made “in anticipation of death” were brought back into a decedent’s gross estate. Today, the three-year inclusion rules under IRC Sec. 2035 operate very differently.

[xxix] For example, by virtue of a retained interest in the gifted property under IRC Sec. 2036.

[xxx] Thus, New York’s three-year “claw-back” applies for the period of the increased federal basic exclusion amount.

[xxxi] Part F of Chapter 59 of the Laws of 2019; Tax Law § 954(a)(3).

[xxxii] Of course, 2020 is also a presidential election year. Much may depend upon the outcome, including the size of the federal exclusion.

[xxxiii] We are assuming, for our purposes, that the business will represent the most valuable asset of the estate, and will constitute most of the estate.

[xxxiv] IRC Sec. 2513. Splitting gifts allows one spouse to actually make the gift transfer, while charging one-half of the amount of the transfer against the consenting spouse’s exclusion amount.

[xxxv] Credit shelter planning for the predeceasing spouse is alive and well in New York.

As always, consider a shareholders’ agreement and recapitalizing into voting and nonvoting equity interests.

[xxxvi] The ancient Hellenic god of non-violent death. Best not to contemplate the other.

[xxxvii] Spousal limited (or lifetime) access trusts.

[xxxviii] Rather than through a “retained” interest that would cause the transferred property to be included in the transferor’s gross estate. Careful of reciprocal trusts.

[xxxix] https://www.taxlawforchb.com/2016/03/estate-planning-sales-to-grantor-trusts-not-dead-yet/ .

[xl] https://www.taxlawforchb.com/2014/02/wandrying-about-defined-value-clauses/ .

[xli] IRC Sec. 2702; Reg. Sec. 25.2702-3.

[xlii] Of course, there is no substitute for succession planning within the business. In any situation involving at least two owners, a buy-sell agreement should also be seriously considered.

[xliii] By funding it with an amount in excess of the New York exclusion.

[xliv] IRC Sec. 2056(b)(7).

[xlv] IRC Sec. 2518.

[xlvi] Do you remember this movie from the early ‘80s, with Kurt Russell, Adrienne Barbeau, Lee Van Cleef, and Donald Pleasance?

[xlvii] There are plenty of choices: https://taxfoundation.org/state-estate-tax-state-inheritance-tax-2019/ .

[xlviii] In other words, their plan for disposing of their assets among their family and perhaps others.

“Charitable Behavior”

Our society is fortunate that so many business owners are charitably inclined.

In many cases, their charitable activities are motivated purely by a desire to help others, whether the object of their assistance is a favorite social welfare agency, museum, school or university, religious institution, hospital, scientific research organization, or you name it.[i]

In others, this charitable bent is often accompanied by a desire for some public acknowledgement of the owner’s charitable activities, or perhaps recognition of the contributions made by their business to the communities in which it operates.[ii]

Reward the Good, Punish the “Not so Good”

As a general rule, the tax laws seek to encourage and facilitate the transfer of wealth from private persons – like a business and its owners – to charitable entities.[iii] Because the assets so transferred become dedicated to the public purposes served by these charities, the use and disposition of the assets become subject to regulation by the government. Thus, the Code includes a number of provisions that seek to encourage what is perceived to be “good” behavior, and to discourage what is perceived to be “unacceptable” behavior. The Code punishes such behavior.[iv]

Although it hardly rises to the level of what may commonly be viewed as “bad” behavior, the conduct of unrelated business[v] activities by a charity – whether directly, or indirectly through a pass-through entity like a partnership or LLC – is scrutinized by the IRS,[vi] and the profits therefrom are subject to tax in the hands of the charity at the flat 21-percent rate applicable to taxable C corporations.[vii]

Investment income fares better than unrelated business income because it represents the return on a “passive” activity. Such income – which includes, for example, dividends, interest, rent, and the gain from the sale of the property that produces such income – is generally not taxable unless the charity incurred debt in order to acquire the income-producing property, thereby diverting assets away from its charitable mission.[viii]

In the case of a private foundation, however, even investment income generated by property that was not the object of acquisition indebtedness is subject to a two-percent federal tax.[ix]

Real Property

Among the assets that are often transferred to a charity are interests in real property, including those that generate rental income.

Such property may be a good choice for a contribution to a private foundation organized by the business or by its owners. The property will likely have appreciated in value over time; at the same time, its basis will have been reduced by depreciation[x] – something that other investment assets can’t do. The result is a large built-in gain inherent in the property.[xi]

In order to avoid the recognition of this gain, and to fund the operation of the private foundation, a business or its owners may contribute the property to the foundation.[xii]

In any event, the subsequent sale of the property by the foundation – a not unlikely event because most foundations don’t want to be in the business of managing real property – would generally not be subject to income tax.[xiii]

Gift Acceptance Vehicle

In some cases, the charity will accept a contribution of a direct interest in such real property, following which the charity may drop the property into a wholly-owned LLC or corporation in order to shield its charitable assets from any liabilities that may arise with respect to the property. In others, the charity may insist that the owner first contribute the property to such an entity before the charity will accept the donation.[xiv]

More recently, charities have formed subsidiary LLCs – that are treated as disregarded entities for tax purposes[xv] – for the sole purpose of accepting a gift of real property.[xvi]

Like any other “business,”[xvii] a charity that is thinking of acquiring real property, whether by acceptance of a donation or by purchase, is also thinking about how it may shield its other assets – especially those that are directly used in its charitable mission – from any liabilities that may arise out of the charity’s ownership (however brief) of the real property.

NY and NYC Transfer Taxes

The favorable disposition toward charities that is found in the federal tax rules is often lacking under many provisions of state and local tax law for which there are no federal counterparts; in particular, I am thinking about New York State’s (“NY”) real estate transfer tax, which imposes a tax – payable by the transferor in the first instance – on certain conveyances of real property or of an interest therein.[xviii]

Any private donor of NY real property, and any charitable recipient of such property, has to be mindful of the cost of the NY real estate transfer tax that will be incurred on the charity’s subsequent sale of the property. They have to be even more careful of not incurring NYC’s real property transfer tax.[xix]

Direct Transfers by Charities

The transfer by a charity of an interest in NY real property[xx] is not identified under NY’s Tax Law as one of the transfers that is exempted from the tax; such a transfer, therefore, is subject to the NY transfer tax.[xxi]

The NYC Administrative Code,[xxii] however, provides that the sale by a charity of an interest in real property located in NYC is not subject to the RPTT.

Thus, the sale by a charity of an interest in NYC real property will be subject to NY transfer tax but will not be subject to the RPTT.

Indirect Transfers?

But what about an indirect sale of an interest in NYC real property? For example, what if the charity was a member of a partnership that owned, operated, and eventually sold NYC real property?

Partnerships

In general, a member of a partnership (including an LLC treated as a partnership for tax purposes) is allocated its distributive share of the partnership’s items of income, gain, deduction, loss, and credit for purposes of determining the member’s income tax liability.[xxiii]

What’s more, under general tax principles, the activities of a partnership are often considered to be the activities of the partners.[xxiv] In other words, a member of a partnership is treated as being engaged in the activities in which the partnership is engaged.

Similarly, the character of any item of partnership gain that is allocated to a member of the partnership is determined as if it were realized directly from the source from which realized by the partnership.[xxv] For example, if a partnership were to sell a real property that it had operated as a rental property, the gain from the sale would be treated as Section 1231 capital gain in the hands of its members, including a charity.[xxvi]

Such gain is generally excluded from the unrelated business income of a charity that is a member of the selling partnership.[xxvii] The fact that the property was actually sold by the partnership of which the charity was an owner does not change the nature of the gain in the hands of the charity (as to its distributive share). The charity is treated as having sold that portion of the property itself for purposes of determining the tax treatment for the charity’s share of the gain.[xxviii]

How do these concepts apply to the RPTT? Specifically, will a charity have to bear a portion of the economic cost of the RPTT imposed upon a partnership with respect to its sale of NYC real property? Or will the charity’s distributive share of the gross proceeds from the partnership’s sale of such property be exempted from the imposition of the RPTT?

According to a recent decision of the NYC Tax Appeals Tribunal (the “Tribunal”), the charity-partner will be treated the same as any other partner for these purposes.[xxix]

The Charity

Charity was formed in 1996, and in 1997 it was recognized[xxx] by the IRS as a tax-exempt organization described in Sec. 501(c)(3) of the Code, and as a grant-making private foundation.[xxxi]

According to Charity’s 2016 federal tax return,[xxxii] the Charity acquired a one-third interest in a partnership[xxxiii] (“Partnership”) from a related business corporation.[xxxiv] It appears that this interest in Partnership constituted Charity’s principal asset.

Sale and Refund Claim

In 2017, Partnership sold a real property that it owned in NYC for over $83 million.[xxxv] Partnership reported the sale on the appropriate transfer tax returns, and paid almost $2.2 million of combined NY and NYC transfer taxes, as determined on those returns.[xxxvi]

Charity filed a claim for refund with NYC in which it asserted that one-third of the RPTT paid by Partnership – corresponding to its one-third interest in Partnership – should be returned to Charity because Charity was exempted from payment of the RPTT.[xxxvii]

After the refund claim was disallowed, Charity requested a conciliation conference, but the conferee sustained the disallowance of the claim for refund. Charity then petitioned the Tribunal to contest the conferee’s decision.

The Petition

NYC moved to dismiss Charity’s petition, arguing that the petition failed to state a cause for relief because the entity which sold the real property and paid the RPTT – Partnership –was not tax-exempt and, accordingly, there was no exemption from the tax and no basis for a refund claim.

According to NYC, Charity did not pay the tax and, therefore, could not claim a refund.

In addition, NYC argued that no exemption from RPTT was available where the transfer was by an entity which was not tax-exempt, regardless of whether any of its owners were tax-exempt.

That being said, NYC conceded that no RPTT would have been due if Charity, rather than Partnership, had sold the real property.

Charity argued that the RPTT exemption for transfers by tax-exempt entities should be treated like the exemption for a “mere change in form,” and recognized to the extent that a seller was owned by a tax-exempt entity. In other words, one should look through a partnership to the beneficial owner of the property to determine the application of the exemption.

Charity also argued that the transaction could have been structured so that the exemption would apply.[xxxviii]

The Tribunal

The Tribunal began by noting that Charity did not have standing to assert a claim for refund of the tax paid by Partnership. Accordingly, as a procedural matter, Charity’s petition had to be dismissed.

Notwithstanding the foregoing conclusion, the Tribunal then turned to the substantive issue presented: the exemption claimed by Charity.

The Tribunal explained that the NYCAC imposes the RPTT on the transfer by deed of real property located within NYC.[xxxix]

The RPTT is also imposed, the Tribunal continued, on “each instrument or transaction . . . whereby any economic interest in real property is transferred . . .”[xl] The tax on transfers of an economic interest applies only where there is no transfer by deed. An “economic interest in real property” is defined as “the ownership of an interest or interests in a partnership, association or other unincorporated entity which owns real property.”[xli]

The Tribunal then stated that the taxpayer has the burden of proving entitlement to an exemption: “Exemption . . . provisions are to be construed in favor of the taxing authority, and . . . a taxpayer must prove entitlement.”

With that, the Tribunal turned to the two exemptions claimed by Charity. The first exempts charitable organizations from payment of the RPTT; the second exempts transactions to the extent that the beneficial ownership of the grantor and the grantee is the same.

According to the Tribunal, the first exemption[xlii] provides that the RPTT shall not apply to:

“[a] deed, instrument or transaction conveying or transferring real property or an economic interest therein by . . . any corporation . . . organized or operated exclusively for religious, charitable, or educational purposes, or for the prevention of cruelty to children or animals, and no part of the net earnings of which inures to the benefit of any private shareholder or individual and no substantial part of the activities of which is carrying on propaganda, or otherwise attempting to influence legislation . . .”

The parties agreed that Charity satisfied this definition, and that had Charity itself conveyed the property, the sale would have been exempt from RPTT.

Charity relied, by analogy, on the provisions of the second exemption,[xliii] which provides an exemption for a deed, instrument or transaction conveying or transferring real property or an economic interest therein that “effects a mere change of identity or form of ownership or organization to the extent the beneficial ownership of such real property or economic interest therein remains the same.”

Charity posited that the exemption for transfers by tax-exempt entities should be applied by considering the ownership of the entity selling the real property. Therefore, since Charity owned one-third of the partnership making the sale, the RPTT owing on the sale should be reduced to that extent.

The Tribunal considered Charity’s argument, and found that the exemption was “not susceptible to the interpretation urged by” Charity. It stated that, when construing a statute, courts are to discern and give effect to the legislature’s intent. Moreover, it continued, an exemption must be narrowly construed.

The Tribunal found there was nothing in the statute to suggest that the exemption applied to entities which were not themselves tax-exempt (like the Partnership), to the extent that they were owned by tax-exempt entities (like Charity).

Moreover, the mere change in form provision Charity relied upon states that it applies “to the extent the beneficial ownership” of the real property or economic interest remains the same. The Tribunal found that the exemption for tax-exempt entities does not contain language indicating that the exemption applies to the extent that a tax-exempt entity owns an interest in the seller. Instead, the exemption requires that the seller be a tax-exempt entity.

Because the Partnership was not a tax-exempt entity, the exemption from RPTT was not available.

Charity’s argument that it transferred an economic interest in Property was also rejected. The RPTT is imposed, the Tribunal stated, on a transfer of an economic interest only where the transfer is not evidenced by a deed subject to the RPTT. Because the transfer at issue was by deed, no economic interest in the Property was transferred for purposes of the RPTT.

On the basis of the foregoing, the Tribunal dismissed Charity’s petition and sustained the disallowance of the refund claim.

What’s Next?

It remains to be seen whether Charity will appeal the Tribunal’s decision. I hope it does.

Leaving that possibility aside, and accepting the Tribunal’s reasoning for the moment, are there other circumstances under which the Tribunal might reach a different decision notwithstanding that a charity is not the actual seller?

What if the will of a decedent had directed the executor of the decedent’s estate to sell certain real property and to distribute the net proceeds therefrom to a charity within, say, two years of the decedent’s date of death, failing which the property itself would be distributed to the charity?

Does the foregoing fact pattern support a conclusion that the interest in real property had, in fact, “passed” to the charity upon the decedent’s death, and that the executor of the decedent’s estate was acting merely as the charity’s agent in the sale?[xliv]

Stay tuned.


[i] We will refer to these as “charities;” basically, an organization described in IRC Sec. 501(c)(3).

[ii] Should it matter what motivates the donor if the effect or impact of their “generosity” on the charity and its mission is the same? Call it “charitable realpolitik.” It is the basis for “naming opportunities” ranging from entire buildings, to rooms within those buildings, to seats in a theatre, to bricks outside a school.

[iii] The tax laws operate to reduce the economic cost of transferring assets to a charity. That being said, the tax benefit enjoyed by a donor for a contribution to a public charity will be greater, under current rules, than for an identical contribution by the same donor to a private foundation.

[iv] It does so by imposing a tax upon the charity and, in appropriate circumstances, upon the charity’s officers and directors, as well as other “disqualified” persons. For example, see IRC Sec. 4941 (self-dealing with respect to a private foundation) and IRC Sec. 4958 (excess benefits provided by a public charity to certain “insiders”).

Also keep in mind the role of the States Attorneys General – the People’s lawyers – in the realm of charitable organizations. Because the public is the ultimate beneficiary of a charity’s activities, the charity has to realize that it is ultimately subject to the supervision of the Attorney General of the State in which it is organized or operates.

[v] Unrelated to the performance of the function or purpose that constitutes the basis for the entity’s tax exemption. IRC Sec. 513.

[vi] To ensure they remain an insubstantial part of a charity’s activities.

[vii] IRC Sec. 511 et seq.; IRC Sec. 11.

[viii] IRC Sec. 512(b) and Sec. 514.

[ix] IRC Sec. 4940. The rate may be reduced to 1% in certain circumstances.

[x] IRC Sec. 167 and Sec. 1016.

[xi] That would be realized upon its sale. IRC Sec. 1001.

[xii] Unfortunately, the charitable income tax deduction generated by an inter vivos contribution would be limited to the donor’s adjusted basis for the property. IRC Sec. 170(e). Unless the foundation was an operating foundation.

Of course, if the property had “passed” from a recently deceased taxpayer to the donor-taxpayer, the basis would have been stepped-up to fair market value. IRC Sec. 1014 and Sec. 1015.

[xiii] IRC Sec. 512(b)(5). Of course, the assignment of income doctrine has to be considered lest the whole plan be for naught. https://www.taxlawforchb.com/2018/10/assignment-of-income-and-charitable-contributions-of-closely-held-stock/

[xiv] Although a corporation may be formed under a state’s not-for-profit or non-stock corporation law – and operate as a title-holding company or as a supporting organization, for tax purposes – most LLC statutes, including NY’s, contemplate only for-profit business purposes. Of course, an LLC’s articles of organization may limit its “business” activities to those of its related charitable member.

[xv] Reg. Sec. 301.7701-3.

[xvi] See IRS Notice 2012-52.

[xvii] Let’s face it, in many endeavors, the lines between a pure business and a pure charity have blurred.

[xviii] NY Tax Law Sec. 1402.

[xix] “RPTT”.

[xx] Whether it is a direct interest, or a controlling interest in an entity that owns NY real property.

[xxi] Similarly, the sale of such real property to a charity is also subject to the tax.

[xxii] “NYCAC”.

[xxiii] IRC Sec. 702.

[xxiv] See, e.g., Rev. Rul. 98-15, IRC Sec. 512(c), Sec. 875.

[xxv] IRC Sec. 702.

[xxvi] IRC Sec. 1231. See also IRC Sec. 1221.

[xxvii] IRC Sec. 512(c) and Sec. 512(b)(5).

[xxviii] IRC Sec. 702(a)(3) and Sec. 702(b).

[xxix] In re Jacob & Anita Penzer Found., Inc., N.Y.C. Tax App. Trib. A.L.J. Div., No. TAT (H) 18-18 (RP), 7/31/19.

[xxx] IRC Sec. 508.

[xxxi] Under Sec. 509(a) of the Code.

[xxxii] IRS Form 990-PF. See Guidestar.org. It’s amazing how much information is available on a tax return.

[xxxiii] Probably one of many owned and managed by the investment firm, Ascot Properties Co. Query who the other partners were?

[xxxiv] Penco Fabrics Inc., a closely held business. The contribution was made in two parts: in September and in November of 2016. It appears that the family of the Charity’s founders controlled Penco.

[xxxv] The sale was in February of 2017. It is likely, when Penco contributed its interest in Partnership to Charity (in September and November of 2016), that Partnership and the buyer were already in discussions for the sale of the property.

Charity reported over $25 million as its share of the gain from Partnership’s sale of the property.

It is unclear if this was Partnership’s only real estate asset, or if Partnership liquidated after the transaction.

[xxxvi] For 2017, the NYS real estate transfer tax rate was 0.40%, and the NYC real property transfer tax rate was 2.625%; a total of 3.03%.

[xxxvii] NYCAC Sec. 11-2106.b(2).

[xxxviii] For example, by having Charity sell its interest in Partnership to the buyer, by having Partnership redeem Charity’s interest prior to the sale of the property, or by distributing the property to the partners as tenants-in-common and letting them sell the property.

Query how reasonable this statement was in light of the timing of the contribution of the Partnership interest to Charity and the subsequent sale by the Partnership?

Query also how much control or influence Charity would have had over the structure of the sale?

[xxxix] NYCAC Sec. 11-2102.a

[xl] NYCAC Sec. 11.2102.b.

[xli] NYCAC Sec. 11-2101.6.

[xlii] NYCAC Sec. 11-2106.b(2)

[xliii] NYCAC Sec. 11-2106.b(8).

[xliv] Matter of Petition of E/O Eugene Schwartz, 1995 WL 376858.

“Charitable Behavior”

Our society is fortunate that so many business owners are charitably inclined.

In many cases, their charitable activities are motivated purely by a desire to help others, whether the object of their assistance is a favorite social welfare agency, museum, school or university, religious institution, hospital, scientific research organization, or you name it.[i]

In others, this charitable bent is often accompanied by a desire for some public acknowledgement of the owner’s charitable activities, or perhaps recognition of the contributions made by their business to the communities in which it operates.[ii]

Reward the Good, Punish the “Not so Good”

As a general rule, the tax laws seek to encourage and facilitate the transfer of wealth from private persons – like a business and its owners – to charitable entities.[iii] Because the assets so transferred become dedicated to the public purposes served by these charities, the use and disposition of the assets become subject to regulation by the government. Thus, the Code includes a number of provisions that seek to encourage what is perceived to be “good” behavior, and to discourage what is perceived to be “unacceptable” behavior. The Code punishes such behavior.[iv]

Although it hardly rises to the level of what may commonly be viewed as “bad” behavior, the conduct of unrelated business[v] activities by a charity – whether directly, or indirectly through a pass-through entity like a partnership or LLC – is scrutinized by the IRS,[vi] and the profits therefrom are subject to tax in the hands of the charity at the flat 21-percent rate applicable to taxable C corporations.[vii]

Investment income fares better than unrelated business income because it represents the return on a “passive” activity. Such income – which includes, for example, dividends, interest, rent, and the gain from the sale of the property that produces such income – is generally not taxable unless the charity incurred debt in order to acquire the income-producing property, thereby diverting assets away from its charitable mission.[viii]

In the case of a private foundation, however, even investment income generated by property that was not the object of acquisition indebtedness is subject to a two-percent federal tax.[ix]

Real Property

Among the assets that are often transferred to a charity are interests in real property, including those that generate rental income.

Such property may be a good choice for a contribution to a private foundation organized by the business or by its owners. The property will likely have appreciated in value over time; at the same time, its basis will have been reduced by depreciation[x] – something that other investment assets can’t do. The result is a large built-in gain inherent in the property.[xi]

In order to avoid the recognition of this gain, and to fund the operation of the private foundation, a business or its owners may contribute the property to the foundation.[xii]

In any event, the subsequent sale of the property by the foundation – a not unlikely event because most foundations don’t want to be in the business of managing real property – would generally not be subject to income tax.[xiii]

Gift Acceptance Vehicle

In some cases, the charity will accept a contribution of a direct interest in such real property, following which the charity may drop the property into a wholly-owned LLC or corporation in order to shield its charitable assets from any liabilities that may arise with respect to the property. In others, the charity may insist that the owner first contribute the property to such an entity before the charity will accept the donation.[xiv]

More recently, charities have formed subsidiary LLCs – that are treated as disregarded entities for tax purposes[xv] – for the sole purpose of accepting a gift of real property.[xvi]

Like any other “business,”[xvii] a charity that is thinking of acquiring real property, whether by acceptance of a donation or by purchase, is also thinking about how it may shield its other assets – especially those that are directly used in its charitable mission – from any liabilities that may arise out of the charity’s ownership (however brief) of the real property.

NY and NYC Transfer Taxes

The favorable disposition toward charities that is found in the federal tax rules is often lacking under many provisions of state and local tax law for which there are no federal counterparts; in particular, I am thinking about New York State’s (“NY”) real estate transfer tax, which imposes a tax – payable by the transferor in the first instance – on certain conveyances of real property or of an interest therein.[xviii]

Any private donor of NY real property, and any charitable recipient of such property, has to be mindful of the cost of the NY real estate transfer tax that will be incurred on the charity’s subsequent sale of the property. They have to be even more careful of not incurring NYC’s real property transfer tax.[xix]

Direct Transfers by Charities

The transfer by a charity of an interest in NY real property[xx] is not identified under NY’s Tax Law as one of the transfers that is exempted from the tax; such a transfer, therefore, is subject to the NY transfer tax.[xxi]

The NYC Administrative Code,[xxii] however, provides that the sale by a charity of an interest in real property located in NYC is not subject to the RPTT.

Thus, the sale by a charity of an interest in NYC real property will be subject to NY transfer tax but will not be subject to the RPTT.

Indirect Transfers?

But what about an indirect sale of an interest in NYC real property? For example, what if the charity was a member of a partnership that owned, operated, and eventually sold NYC real property?

Partnerships

In general, a member of a partnership (including an LLC treated as a partnership for tax purposes) is allocated its distributive share of the partnership’s items of income, gain,  deduction, loss, and credit for purposes of determining the member’s income tax liability.[xxiii]

What’s more, under general tax principles, the activities of a partnership are often considered to be the activities of the partners.[xxiv] In other words, a member of a partnership is treated as being engaged in the activities in which the partnership is engaged.

Similarly, the character of any item of partnership gain that is allocated to a member of the partnership is determined as if it were realized directly from the source from which realized by the partnership.[xxv] For example, if a partnership were to sell a real property that it had operated as a rental property, the gain from the sale would be treated as Section 1231 capital gain in the hands of its members, including a charity.[xxvi]

Such gain is generally excluded from the unrelated business income of a charity that is a member of the selling partnership.[xxvii] The fact that the property was actually sold by the partnership of which the charity was an owner does not change the nature of the gain in the hands of the charity (as to its distributive share). The charity is treated as having sold that portion of the property itself for purposes of determining the tax treatment for the charity’s share of the gain.[xxviii]

How do these concepts apply to the RPTT? Specifically, will a charity have to bear a portion of the economic cost of the RPTT imposed upon a partnership with respect to its sale of NYC real property? Or will the charity’s distributive share of the gross proceeds from the partnership’s sale of such property be exempted from the imposition of the RPTT?

According to a recent decision of the NYC Tax Appeals Tribunal (the “Tribunal”), the charity-partner will be treated the same as any other partner for these purposes.[xxix]

The Charity

Charity was formed in 1996, and in 1997 it was recognized[xxx] by the IRS as a tax-exempt organization described in Sec. 501(c)(3) of the Code, and as a grant-making private foundation.[xxxi]

According to Charity’s 2016 federal tax return,[xxxii] the Charity acquired a one-third interest in a partnership[xxxiii] (“Partnership”) from a related business corporation.[xxxiv] It appears that this interest in Partnership constituted Charity’s principal asset.

Sale and Refund Claim

In 2017, Partnership sold a real property that it owned in NYC for over $83 million.[xxxv] Partnership reported the sale on the appropriate transfer tax returns, and paid almost $2.2 million of combined NY and NYC transfer taxes, as determined on those returns.[xxxvi]

Charity filed a claim for refund with NYC in which it asserted that one-third of the RPTT paid by Partnership – corresponding to its one-third interest in Partnership – should be returned to Charity because Charity was exempted from payment of the RPTT.[xxxvii]

After the refund claim was disallowed, Charity requested a conciliation conference, but the conferee sustained the disallowance of the claim for refund. Charity then petitioned the Tribunal to contest the conferee’s decision.

The Petition

NYC moved to dismiss Charity’s petition, arguing that the petition failed to state a cause for relief because the entity which sold the real property and paid the RPTT – Partnership –was not tax-exempt and, accordingly, there was no exemption from the tax and no basis for a refund claim.

According to NYC, Charity did not pay the tax and, therefore, could not claim a refund.

In addition, NYC argued that no exemption from RPTT was available where the transfer was by an entity which was not tax-exempt, regardless of whether any of its owners were tax-exempt.

That being said, NYC conceded that no RPTT would have been due if Charity, rather than Partnership, had sold the real property.

Charity argued that the RPTT exemption for transfers by tax-exempt entities should be treated like the exemption for a “mere change in form,” and recognized to the extent that a seller was owned by a tax-exempt entity. In other words, one should look through a partnership to the beneficial owner of the property to determine the application of the exemption.

Charity also argued that the transaction could have been structured so that the exemption would apply.[xxxviii]

The Tribunal

The Tribunal began by noting that Charity did not have standing to assert a claim for refund of the tax paid by Partnership. Accordingly, as a procedural matter, Charity’s petition had to be dismissed.

Notwithstanding the foregoing conclusion, the Tribunal then turned to the substantive issue presented: the exemption claimed by Charity.

The Tribunal explained that the NYCAC imposes the RPTT on the transfer by deed of real property located within NYC.[xxxix]

The RPTT is also imposed, the Tribunal continued, on “each instrument or transaction . . . whereby any economic interest in real property is transferred . . .”[xl] The tax on transfers of an economic interest applies only where there is no transfer by deed. An “economic interest in real property” is defined as “the ownership of an interest or interests in a partnership, association or other unincorporated entity which owns real property.”[xli]

The Tribunal then stated that the taxpayer has the burden of proving entitlement to an exemption: “Exemption . . . provisions are to be construed in favor of the taxing authority, and . . . a taxpayer must prove entitlement.”

With that, the Tribunal turned to the two exemptions claimed by Charity. The first exempts charitable organizations from payment of the RPTT; the second exempts transactions to the extent that the beneficial ownership of the grantor and the grantee is the same.

According to the Tribunal, the first exemption[xlii] provides that the RPTT shall not apply to:

“[a] deed, instrument or transaction conveying or transferring real property or an economic interest therein by . . . any corporation . . . organized or operated exclusively for religious, charitable, or educational purposes, or for the prevention of cruelty to children or animals, and no part of the net earnings of which inures to the benefit of any private shareholder or individual and no substantial part of the activities of which is carrying on propaganda, or otherwise attempting to influence legislation . . .”

The parties agreed that Charity satisfied this definition, and that had Charity itself conveyed the property, the sale would have been exempt from RPTT.

Charity relied, by analogy, on the provisions of the second exemption,[xliii] which provides an exemption for a deed, instrument or transaction conveying or transferring real property or an economic interest therein that “effects a mere change of identity or form of ownership or organization to the extent the beneficial ownership of such real property or economic interest therein remains the same.”

Charity posited that the exemption for transfers by tax-exempt entities should be applied by considering the ownership of the entity selling the real property. Therefore, since Charity owned one-third of the partnership making the sale, the RPTT owing on the sale should be reduced to that extent.

The Tribunal considered Charity’s argument, and found that the exemption was “not susceptible to the interpretation urged by” Charity. It stated that, when construing a statute, courts are to discern and give effect to the legislature’s intent. Moreover, it continued, an exemption must be narrowly construed.

The Tribunal found there was nothing in the statute to suggest that the exemption applied to entities which were not themselves tax-exempt (like the Partnership), to the extent that they were owned by tax-exempt entities (like Charity).

Moreover, the mere change in form provision Charity relied upon states that it applies “to the extent the beneficial ownership” of the real property or economic interest remains the same. The Tribunal found that the exemption for tax-exempt entities does not contain language indicating that the exemption applies to the extent that a tax-exempt entity owns an interest in the seller. Instead, the exemption requires that the seller be a tax-exempt entity.

Because the Partnership was not a tax-exempt entity, the exemption from RPTT was not available.

Charity’s argument that it transferred an economic interest in Property was also rejected. The RPTT is imposed, the Tribunal stated, on a transfer of an economic interest only where the transfer is not evidenced by a deed subject to the RPTT. Because the transfer at issue was by deed, no economic interest in the Property was transferred for purposes of the RPTT.

On the basis of the foregoing, the Tribunal dismissed Charity’s petition and sustained the disallowance of the refund claim.

What’s Next?

It remains to be seen whether Charity will appeal the Tribunal’s decision. I hope it does.

Leaving that possibility aside, and accepting the Tribunal’s reasoning for the moment, are there other circumstances under which the Tribunal might reach a different decision notwithstanding that a charity is not the actual seller?

What if the will of a decedent had directed the executor of the decedent’s estate to sell certain real property and to distribute the net proceeds therefrom to a charity within, say, two years of the decedent’s date of death, failing which the property itself would be distributed to the charity?

Does the foregoing fact pattern support a conclusion that the interest in real property had, in fact, “passed” to the charity upon the decedent’s death, and that the executor of the decedent’s estate was acting merely as the charity’s agent in the sale?[xliv]

Stay tuned.

[i] We will refer to these as “charities;” basically, an organization described in IRC Sec. 501(c)(3).

[ii] Should it matter what motivates the donor if the effect or impact of their “generosity” on the charity and its mission is the same? Call it “charitable realpolitik.” It is the basis for “naming opportunities” ranging from entire buildings, to rooms within those buildings, to seats in a theatre, to bricks outside a school.

[iii] The tax laws operate to reduce the economic cost of transferring assets to a charity. That being said, the tax benefit enjoyed by a donor for a contribution to a public charity will be greater, under current rules, than for an identical contribution by the same donor to a private foundation.

[iv] It does so by imposing a tax upon the charity and, in appropriate circumstances, upon the charity’s officers and directors, as well as other “disqualified” persons. For example, see IRC Sec. 4941 (self-dealing with respect to a private foundation) and IRC Sec. 4958 (excess benefits provided by a public charity to certain “insiders”).

Also keep in mind the role of the States Attorneys General – the People’s lawyers – in the realm of charitable organizations. Because the public is the ultimate beneficiary of a charity’s activities, the charity has to realize that it is ultimately subject to the supervision of the Attorney General of the State in which it is organized or operates.

[v] Unrelated to the performance of the function or purpose that constitutes the basis for the entity’s tax exemption. IRC Sec. 513.

[vi] To ensure they remain an insubstantial part of a charity’s activities.

[vii] IRC Sec. 511 et seq.; IRC Sec. 11.

[viii] IRC Sec. 512(b) and Sec. 514.

[ix] IRC Sec. 4940. The rate may be reduced to 1% in certain circumstances.

[x] IRC Sec. 167 and Sec. 1016.

[xi] That would be realized upon its sale. IRC Sec. 1001.

[xii] Unfortunately, the charitable income tax deduction generated by an inter vivos contribution would be limited to the donor’s adjusted basis for the property. IRC Sec. 170(e). Unless the foundation was an operating foundation.

Of course, if the property had “passed” from a recently deceased taxpayer to the donor-taxpayer, the basis would have been stepped-up to fair market value. IRC Sec. 1014 and Sec. 1015.

[xiii] IRC Sec. 512(b)(5). Of course, the assignment of income doctrine has to be considered lest the whole plan be for naught. https://www.taxlawforchb.com/2018/10/assignment-of-income-and-charitable-contributions-of-closely-held-stock/

[xiv] Although a corporation may be formed under a state’s not-for-profit or non-stock corporation law – and operate as a title-holding company or as a supporting organization, for tax purposes – most LLC statutes, including NY’s, contemplate only for-profit business purposes. Of course, an LLC’s articles of organization may limit its “business” activities to those of its related charitable member.

[xv] Reg. Sec. 301.7701-3.

[xvi] See IRS Notice 2012-52.

[xvii] Let’s face it, in many endeavors, the lines between a pure business and a pure charity have blurred.

[xviii] NY Tax Law Sec. 1402.

[xix] “RPTT”.

[xx] Whether it is a direct interest, or a controlling interest in an entity that owns NY real property.

[xxi] Similarly, the sale of such real property to a charity is also subject to the tax.

[xxii] “NYCAC”.

[xxiii] IRC Sec. 702.

[xxiv] See, e.g., Rev. Rul. 98-15, IRC Sec. 512(c), Sec. 875.

[xxv] IRC Sec. 702.

[xxvi] IRC Sec. 1231. See also IRC Sec. 1221.

[xxvii] IRC Sec. 512(c) and Sec. 512(b)(5).

[xxviii] IRC Sec. 702(a)(3) and Sec. 702(b).

[xxix] In re Jacob & Anita Penzer Found., Inc., N.Y.C. Tax App. Trib. A.L.J. Div., No. TAT (H) 18-18 (RP), 7/31/19.

[xxx] IRC Sec. 508.

[xxxi] Under Sec. 509(a) of the Code.

[xxxii] IRS Form 990-PF. See Guidestar.org. It’s amazing how much information is available on a tax return.

[xxxiii] Probably one of many owned and managed by the investment firm, Ascot Properties Co. Query who the other partners were?

[xxxiv] Penco Fabrics Inc., a closely held business. The contribution was made in two parts: in September and in November of 2016. It appears that the family of the Charity’s founders controlled Penco.

[xxxv] The sale was in February of 2017. It is likely, when Penco contributed its interest in Partnership to Charity (in September and November of 2016), that Partnership and the buyer were already in discussions for the sale of the property.

Charity reported over $25 million as its share of the gain from Partnership’s sale of the property.

It is unclear if this was Partnership’s only real estate asset, or if Partnership liquidated after the transaction.

[xxxvi] For 2017, the NYS real estate transfer tax rate was 0.40%, and the NYC real property transfer tax rate was 2.625%; a total of 3.03%.

[xxxvii] NYCAC Sec. 11-2106.b(2).

[xxxviii] For example, by having Charity sell its interest in Partnership to the buyer, by having Partnership redeem Charity’s interest prior to the sale of the property, or by distributing the property to the partners as tenants-in-common and letting them sell the property.

Query how reasonable this statement was in light of the timing of the contribution of the Partnership interest to Charity and the subsequent sale by the Partnership?

Query also how much control or influence Charity would have had over the structure of the sale?

[xxxix] NYCAC Sec. 11-2102.a

[xl] NYCAC Sec. 11.2102.b.

[xli] NYCAC Sec. 11-2101.6.

[xlii] NYCAC Sec. 11-2106.b(2)

[xliii] NYCAC Sec. 11-2106.b(8).

[xliv] Matter of Petition of E/O Eugene Schwartz, 1995 WL 376858.

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. https://www.taxlawforchb.com/2014/07/s-corp-trusts-the-3-8-surtax-on-nii-part-iv/

[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.


[i]
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, https://www.taxlawforchb.com/2018/12/business-purpose-and-dividing-the-family-corporation-think-before-you-let-it-rip/

[v] https://www.taxlawforchb.com/2019/10/tax-free-spin-off-that-may-depend-on-post-spin-off-events/

[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. https://www.taxlawforchb.com/2019/07/escape-from-new-york-it-will-cost-you/

[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.