Pro “C” Corporation Bias?

Although closely-held businesses have generally welcomed the TCJA’s[i] amendments to the Code relating to the taxation of business income, many are also frustrated by the complexity of some of these changes. Among the provisions that have drawn the most criticism on this count are the changes to the taxation of business income arising from the foreign (“outbound”) activities of U.S. persons.

Because more and more closely-held U.S. businesses, including many S corporations, have been establishing operations overseas – whether through branches or corporate subsidiaries[ii] – the impact of these changes cannot be underestimated.

Moreover, their effect may be more keenly felt by closely-held U.S. businesses that are treated as pass-through entities[iii]; in other words, there appears to be a bias in the TCJA in favor of C corporations.

Overview: Deferred Recognition of Foreign Income – Pre-TCJA

In general, the U.S. has taxed U.S. persons on their worldwide income, although there has been some deferral of the taxation of the foreign-sourced income[iv] earned by the foreign corporate (“FC”) subsidiaries of U.S. businesses.[v]

The Code defines a “U.S. person” to include U.S. citizens and residents.[vi] A corporation or partnership is treated as a U.S. person if it is organized or created under the laws of the U.S. or of any State.[vii]

In general, income earned directly by a U.S. person from the conduct of a foreign business – for example, through the operation of a branch in a foreign jurisdiction – is taxed on a current basis.[viii]

Historically, however, active foreign business income earned indirectly by a U.S. person, through a FC subsidiary, generally has not been subject to U.S. tax until the income is distributed as a dividend to the U.S. person – unless an anti-deferral rule applies.

The CFC Regime

The main U.S. anti-tax-deferral regime, which addresses the taxation of income earned by controlled foreign corporations (“CFC”), may cause some U.S. persons who own shares of stock of a CFC to be taxed currently on certain categories of income earned by the CFC, regardless of whether the income has been distributed to them as a dividend.[ix]

CFC

A CFC is defined as any FC if U.S. persons own (directly, indirectly, or constructively[x]) more than 50-percent of the corporation’s stock (measured by vote or value), taking into account only those U.S. persons who own at least 10-percent of the FC’s stock (measured by vote or value; each a “United States shareholder” or “USS”).[xi]

Subpart F Income

Under the CFC rules, the U.S. generally taxes the USS of a CFC on their pro rata shares of the CFC’s “subpart F income,” without regard to whether the income is distributed to the shareholders. In effect, the U.S. treats the USS of a CFC as having received a current distribution of the CFC’s subpart F income.

In the case of most USS, subpart F income generally includes “foreign base company income,” which consists of “foreign personal holding company income” (such as dividends, interest, rents, and royalties), and certain categories of income from business operations that involve transactions with “related persons,” including “foreign base company sales income” and “foreign base company services income.”[xii]

One exception to the definition of subpart F income permits continued U.S.-tax-deferral for income received by a CFC in certain transactions with a related corporation organized and operating in the same foreign country in which the CFC is organized (the “same country exception”). Another exception is available for any item of income received by a CFC if the taxpayer establishes that the income was subject to an effective foreign income tax rate greater than 90-percent of the maximum U.S. corporate income tax rate (the “high-tax exception”).[xiii]

Actual Distributions

A USS may exclude from its income actual distributions of earnings and profits (“E&P”) from the CFC that were previously included in the USS’s income under the CFC regime.[xiv] Ordering rules provide that distributions from a CFC are treated as coming first out of E&P of the CFC that were previously taxed under the CFC regime, then out of other E&P.[xv]

Foreign Tax Credit

Subject to certain limitations, U.S. persons are allowed to claim a credit for foreign income taxes they pay. A foreign tax credit (“FTC”) generally is available to offset, in whole or in part, the U.S. income tax owed on foreign-source income included in the U.S. person’s income; this includes foreign taxes paid by an S corporation on any of its foreign income that flows through to its shareholders.

A domestic corporation is allowed a “deemed-paid” credit for foreign income taxes paid by the CFC that the domestic corporation is deemed to have paid when the related income is included in the domestic corporation’s income under the anti-deferral rules.[xvi]

Unfortunately for S corporations, they are treated as partnerships – not corporations – for purposes of the FTC and the CFC rules; thus, they cannot pass-through any such deemed-paid credit to their shareholders.

However, any tax that is withheld by the CFC with respect to a dividend distributed to an S corporation will flow through to the S corporation’s individual shareholders.

TCJA Changes

The TCJA made some significant changes to the taxation of USS that own stock in CFCs.

Transition Rule: Mandatory Inclusion

In order to provide a clean slate for the application of these new rules, the TCJA provides a special transition rule that requires all USS of a “specified foreign corporation” (“SFC”) to include in income their pro rata shares of the SFC’s “accumulated post-1986 deferred foreign income” (“post-1986-DFI”) that was not previously taxed to them.[xvii] A SFC means (1) a CFC or (2) any FC in which a domestic corporation is a USS.[xviii]

The mechanism for the mandatory inclusion of these pre-effective-date foreign earnings is the CFC regime. The TCJA provides that the subpart F income of a SFC is increased for the last taxable year of the SFC that begins before January 1, 2018.

This transition rule applies to all USS of a SFC, including individuals.

Consistent with the general operation of the CFC regime, each USS of a SFC must include in income its pro rata share of the SFC’s subpart F income attributable to the corporation’s post-1986-DFI.

Reduced Tax Rate

Fortunately, the TCJA allows a portion of that pro rata share of deferred foreign income to be deducted. The amount deductible varies, depending upon whether the deferred foreign income is held by the SFC in the form of liquid or illiquid assets. To the extent the income is not so deductible – i.e., is included in the income of the USS – the USS may claim a portion of the foreign tax credit attributable thereto.

The total deduction from the amount included under the transition rule is the amount necessary to result in a 15.5-percent tax rate on post-1986-DFI held by the SFC in the form of cash or cash equivalents,[xix] and an 8-percent tax rate on all other earnings.

The calculation of the deduction is based on the highest rate of tax applicable to domestic corporations in the taxable year of inclusion, even if the USS is an individual.

However, an individual USS – including the shareholder of an S corporation – will be taxed on the amount included in their income at the higher federal tax rate applicable to individuals.[xx]

That being said, an individual USS, including one who is a shareholder of an S corporation, generally may elect application of the corporate tax rates for the year of inclusion.[xxi]

Deferred Payment of Tax

A USS may elect to pay the net tax liability resulting from the mandatory inclusion of post-1986-DFI in eight unequal installments.[xxii] The timely payment of an installment does not incur interest.[xxiii]

The provision also includes an acceleration rule. If (1) there is a failure to pay timely any required installment, (2) there is a liquidation or sale of substantially all of the USS’s assets, (3) the USS ceases business, or (4) another similar circumstance arises, the unpaid portion of all remaining installments will become due immediately.

Special Deferral for S corporation Shareholders

A special rule permits deferral of the above transitional tax liability for shareholders of a USS that is an S corporation.

The S corporation is required to report on its income tax return the amount includible in gross income by reason of this provision, as well as the amount of deduction that would be allowable, and to provide a copy of such information to its shareholders.

Any shareholder of the S corporation may elect to defer their portion of the tax liability until the shareholder’s taxable year in which a “triggering event” occurs.[xxiv]

Three types of events may trigger an end to deferral of this tax liability. The first is a change in the status of the corporation as an S corporation. The second category includes liquidation, sale of substantially all corporate assets, termination of the company or end of business, or similar event, including reorganization in bankruptcy. The third type of triggering event is a transfer of shares of stock in the S corporation by the electing taxpayer, whether by sale, death or otherwise, unless the transferee of the stock agrees to be liable for tax liability in the same manner as the transferor.[xxv]

If a shareholder of an S corporation has elected deferral under this special rule, and a triggering event occurs, then the S corporation and the electing shareholder will be jointly and severally liable for any tax liability (and related interest or penalties).[xxvi]

After a triggering event occurs, an electing shareholder may elect to pay the tax liability in eight installments, subject to rules similar to those generally applicable absent deferral. Whether a shareholder may elect to pay in installments depends upon the type of event that triggered the end of deferral. If the triggering event is a liquidation, sale of substantially all corporate assets, termination of the company or end of business, or similar event, the installment payment election is not available. Instead, the entire tax liability is due upon notice and demand.[xxvii]

The New CFC Regime

With the mandatory “repatriation” of the post-1986-DFI of SFC, the TCJA implemented a new “participation exemption” regime for the taxation of USS of “specified 10-percent-owned FCs,”[xxviii] effective for taxable years of FCs beginning after December 31, 2017.

Dividends Received Deduction

Specifically, it allows an exemption for certain foreign income by means of a 100-percent deduction for the foreign-source portion of dividends[xxix] received from a specified-10%-owned FC by a domestic corporation that is a USS of such FC.[xxx]

The term “dividends received” is intended to be interpreted broadly; for example, if a domestic corporation indirectly owns stock of a FC through a partnership, and the domestic corporation would qualify for the DRD with respect to dividends from the FC if the domestic corporation owned such stock directly, the domestic corporation would be allowed a DRD with respect to its distributive share of the partnership’s dividend from the FC.[xxxi]

This DRD is available only to regular domestic C corporations that are USS, including those that own stock of a FC through a partnership; it is not available to C corporations that own less than 10% of the FC. The DRD is available only for the foreign-source portion of dividends received by a qualifying domestic corporation from a speficied-10-percent-owned FC.

No foreign tax credit or deduction is allowed to a USS for any foreign taxes paid or accrued by the FC (including withholding taxes) with respect to any portion of a dividend distribution that qualifies for the DRD.[xxxii]

Significantly, the DRD is not available to individuals; nor is it available to S corporations or their shareholders. Considering that an S corporation is not entitled to the deemed-paid credit for foreign income taxes paid by its foreign subsidiary, the income of the foreign subsidiary may be taxed twice: once by the foreign country and, when distributed, by the U.S.[xxxiii]

Holding Period

A domestic corporation is not permitted a DRD in respect of any dividend on any share of stock of a specified-10-percent-owned FC unless it satisfies a minimum holding period.

Specifically, the FC’s stock must have been held by the domestic corporation for at least 365 days during the 731-day period beginning on the date that is 365 days before the date on which the share becomes ex-dividend with respect to the dividend. For this purpose, the holding period requirement is treated as met only if the specified-10-percent-owned FC qualifies as such at all times during the period, and the taxpayer is a USS with respect to such FC at all times during the period.

GILTI

Having captured and taxed the post-1986-DFI of SFC (through 2017), and having introduced the DRD, the TCJA also introduced a new class of income – “global intangible low-taxed income” (“GILTI”) – that must be included in income by a USS of a CFC, and which further erodes a taxpayer’s ability to defer the U.S. taxation of foreign income.

Amount Included

This provision requires the current inclusion[xxxiv] in income by a USS of (i) their share of all of a CFC’s non-subpart F income (other than income that is effectively connected with a U.S. trade or business and income that is excluded from foreign base company income by reason of the high-tax exception),[xxxv] (ii) less an amount equal to the USS’s share of 10-percent of the adjusted basis of the CFC’s tangible property used in its trade or business and of a type with respect to which a depreciation deduction is generally allowable (the difference being GILTI).[xxxvi]

In the case of a CFC engaged in a service business or other business with few fixed assets, the GILTI inclusion rule may result in the U.S taxation of the CFC’s non-subpart F business income without the benefit of any deferral.

This income inclusion rule applies to both individual and corporate USS.

In the case of an individual, the maximum federal tax rate on GILTI is 37-percent.[xxxvii] This is the rate that will apply, for example, to a U.S. citizen who directly owns at least 10-percent of the stock of a CFC, or to one who indirectly owns such CFC stock through an S corporation.

C Corporations

More forgiving rules apply in the case of a USS that is a C corporation. For taxable years beginning after December 31, 2017, and before January 1, 2026, a regular domestic C corporation is generally allowed a deduction of an amount equal to 50-percent of its GILTI; thus, the federal corporate tax rate for GILTI is actually 10.5% (the 21% flat rate multiplied by 50%).[xxxviii]

In addition, for any amount of GILTI included in the gross income of a domestic C corporation, the corporation is allowed a deemed-paid credit equal to 80-percent of the foreign taxes paid or accrued by the CFC with respect to such GILTI.

Based on the interaction of the 50-percent deduction and the 80-percent foreign tax credit, the U.S. tax rate on GILTI that is included in the income of a regular C corporation will be zero where the foreign tax rate on such income is 13.125%.[xxxix]

S Corporations

Because an S corporation’s taxable income is computed in the same manner as an individual, and because an S corporation is treated as a partnership for purposes of the CFC rules, neither the 50-percent GILTI deduction nor the 80-percent deemed-paid credit apply to S corporations or their shareholders. Thus, individuals are treated more harshly by the GILTI inclusion rules than are C corporations.

What is an S Corp. to Do?

So what is an S corporation with a FC subsidiary to do when confronted with the foregoing challenges and the TCJA’s pro-C corporation bias?

C Corporation?

One option is for the S corporation to contribute its FC shares to a domestic C corporation, or the S corporation itself could convert into a C corporation (its shareholders may revoke its election, or the corporation may cease to qualify as a small business corporation by providing for a second class of stock or by admitting a non-qualifying shareholder).

However, C corporation status has its own significant issues (like double taxation), and should not be undertaken lightly, especially if the sale of the business is reasonably foreseeable.

Branch?

Another option is for the S corporation to effectively liquidate its foreign subsidiary and to operate in the foreign jurisdiction through a branch, or through an entity for which a “check-the-box election” may be made to disregard the entity for tax purposes.

This would avoid the CFC and GITLI rules entirely, and it would allow the shareholders of the S corporation to claim a credit for foreign taxes paid by the branch.

Of course, operating through a branch would also prevent any deferral of U.S. taxation of the foreign income, and may subject the U.S. person to a branch profits tax in the foreign jurisdiction.[xl]

It should be noted, however, that the liquidation or reorganization of a CFC into a branch will generally be a taxable event, with the result that the accumulated foreign earnings and profits of the CFC will be included in the income of the USS as a “deemed dividend.”

That being said, the rules for determining such accumulated earnings and profits generally exclude amounts previously included in the gross income of the USS under the CFC rules. To the extent any amount is not so excluded, the S corporation shareholder of the CFC will not be able to utilize the DRD to reduce its tax liability.[xli]

Section 962 Election?

Yet another option to consider – which pre-dates the TCJA, but which seems to have been under-utilized – is a special election that is available to an individual who is a USS, either directly or through an S corporation.

This election, which is made on annual basis, results in the individual being treated as a C corporation for purposes of determining the income tax on their share of GILTI and subpart F income; thus, the electing individual shareholder would be taxed at the corporate tax rate.[xlii]

The election also causes the individual to be treated as a C corporation for purposes of claiming the FTC attributable to this income; thus, they would be allowed the 80-percent deemed-paid credit.

Of course, like most elections, this one comes at a price. The E&P of a FC that are attributable to amounts which were included in the income of a USS under the GILTI or CFC rules, and with respect to which an election was made, shall be included in gross income, when such E&P are actually distributed to the USS, to the extent that the E&P so distributed exceed the amount of tax paid on the amounts to which such election applied.[xliii]

No Easy Way Out[xliv]

We find ourselves in a new regime for the U.S. taxation of foreign income, and there is still a lot of guidance to be issued.

In the meantime, an S corporation with a foreign subsidiary would be well-served to model out the consequences of the various options described above, taking into account its unique circumstances – including the possibility of a sale – before making any changes to the structure of its foreign operations.


[i] “TCJA”. Public Law No. 115-97.

[ii] These may be wholly-owned, or they may be partially-owned; the latter often represent a joint venture with a foreign business.

[iii] The “20% of qualified business income deduction” for pass-through entities does not apply to foreign-source income.

[iv] The Code provides sourcing rules for most categories of business income. It should be noted that, in certain cases, a foreign person that is engaged in a U.S. trade or business may have limited categories of foreign-source income that are considered to be effectively connected such U.S. trade or business.

[v] Special rules apply where the foreign subsidiary engages in business transactions with its U.S. parent or with another affiliated company. A basic U.S. tax principle applicable in dividing profits from transactions between related taxpayers is that the amount of profit allocated to each related taxpayer must be measured by reference to the amount of profit that a similarly situated taxpayer would realize in similar transactions with unrelated parties. The “transfer pricing rules” of section 482 seek to ensure that taxpayers do not shift income properly attributable to the U.S. to a related foreign company through pricing that does not reflect an arm’s-length result.

[vi] Noncitizens who are lawfully admitted as permanent residents of the U.S. (“green card holders”) are treated as residents for tax purposes. In addition, noncitizens who meet a “substantial presence test” (based upon the number of days spent in the U.S.) are also, generally speaking, taxable as U.S. residents.

[vii] It should be noted that an unincorporated entity, such as a partnership or limited liability company, may elect its classification for Federal tax purposes – as a disregarded entity, a partnership or an association – under the “check-the-box” regulations. See Treas. Reg. 301.7701-3.

[viii] The same goes for income that is treated as having been earned directly, as through a partnership. IRC Sec. 702(b).

[ix] The other main anti-deferral regime covers Passive Foreign Investment Companies (“PFIC”). There is some overlap between the CFC and PFIC regimes; the former trumps the latter.

[x] The TCJA amended the applicable ownership attribution rules so that certain stock of a FC owned by a foreign person is attributed to a related U.S. person for purposes of determining whether the related U.S. person is a USS of the FC and, therefore, whether the FC is a CFC. The pro rata share of a CFC’s subpart F income that a USS is required to include in gross income, however, continues to be determined based on direct or indirect ownership of the CFC, without application of the new downward attribution rule. In making this amendment, the TCJA intended to render ineffective certain transactions that were used to as a means of avoiding the CFC regime. One such transaction involved effectuating “de-control” of a foreign subsidiary, by taking advantage of the prior attribution rule that effectively turned off the constructive stock ownership rules when to do otherwise would result in a U.S. person being treated as owning stock owned by a foreign person.

[xi] The TCJA expanded the definition of USS under subpart F to include any U.S. person who owns 10 percent or more of the total value of shares of all classes of stock of a FC. Prior law looked only to voting power. The TCJA also eliminated the requirement that a FC must be controlled for an uninterrupted period of 30 days before subpart F inclusions apply.

[xii] The 10-percent U.S. shareholders of a CFC also are required to include currently in income for U.S. tax purposes their pro rata shares of the CFC’s untaxed earnings invested in certain items of U.S. property. This U.S. property generally includes tangible property located in the U.S. stock of a U.S. corporation, an obligation of a U.S. person, and certain intangible assets, such as patents and copyrights, acquired or developed by the CFC for use in the U.S. The inclusion rule for investment of earnings in U.S. property is intended to prevent taxpayers from avoiding U.S. tax on dividend repatriations by repatriating CFC earnings through non-dividend payments, such as loans to U.S. persons.

[xiii] Before the TCJA reduced the tax rate on C corporations to a flat 21 percent, that meant more than 90 percent of 35 percent, or 31.5 percent. The reduced corporate tax rate should make it easier for a CFC to satisfy this exception; 90% of 21% is 18.9%.

[xiv] This concept, as well as the basis-adjustment concept immediately below, should be familiar to anyone dealing with partnerships and S corporations.

[xv] In order to ensure that this previously-taxed foreign income is not taxed a second time upon distribution, a USS of a CFC generally receives a basis increase with respect to its stock in the CFC equal to the amount of the CFC’s earnings that are included in the USS’s income under the CFC regime. Conversely, a 10-percent U.S. shareholder of a CFC generally reduces its basis in the CFC’s stock in an amount equal to any distributions that the 10-percent U.S. shareholder receives from the CFC that are excluded from its income as previously taxed under subpart F.

[xvi] The deemed-paid credit is limited to the amount of foreign income taxes properly attributable to the subpart F inclusion. The foreign tax credit generally is limited to a taxpayer’s U.S. tax liability on its foreign-source taxable income. This limit is intended to ensure that the credit serves its purpose of mitigating double taxation of foreign-source income without offsetting U.S. tax on U.S.-source income.

[xvii] Basically, foreign earnings that were not previously taxed, that are not effectively connected to the conduct of a U.S. trade or business, and that are not subpart F income.

[xviii] Such entities must determine their post-1986 deferred foreign income based on the greater of the aggregate

post-1986 accumulated foreign earnings and profits as of November 2, 2017 or December 31,

[xix] The cash position of an entity consists of all cash, net accounts receivables, and the fair market value of similarly liquid assets, specifically including personal property that is actively traded on an established financial market, government securities, certificates of deposit, commercial paper, and short-term obligations.

[xx] It should be noted that the increase in income that is not taxed by reason of the deduction is treated as income that is exempt from tax for purposes of determining (i.e., increasing) a shareholder’s stock basis in an S corporation, but not as income exempt from tax for purposes of determining the accumulated adjustments account (“AAA”) of an S corporation (thus increasing the risk of a dividend from an S corporation with E&P from a C corporation).

[xxi] IRC Sec. 962. However, there are other consequences that stem from such an election that must be considered,

[xxii] The net tax liability that may be paid in installments is the excess of the USS’s net income tax for the taxable year in which the pre-effective-date undistributed CFC earnings are included in income over the taxpayer’s net income tax for that year determined without regard to the inclusion. https://www.taxlawforchb.com/?s=foreign

[xxiii] If a deficiency is determined that is attributable to an understatement of the net tax liability due under this provision, the deficiency is payable with underpayment interest for the period beginning on the date on which the net tax liability would have been due, without regard to an election to pay in installments, and ending with the payment of the deficiency.

[xxiv] The election to defer the tax is due not later than the due date for the return of the S corporation for its last taxable year that begins before January 1, 2018.

[xxv] Partial transfers trigger the end of deferral only with respect to the portion of tax properly allocable to the portion of stock sold.

[xxvi] Query how the shareholders’ agreement for an S corporation should be amended to address this possibility.

[xxvii] If an election to defer payment of the tax liability is in effect for a shareholder, that shareholder must report the amount of the deferred tax liability on each income tax return due during the period that the election is in effect. Failure to include that information with each income tax return will result in a penalty equal to five-percent of the amount that should have been reported.

[xxviii] In general, a “specified 10-percent owned foreign corporation” is any FC (other than a PFIC) with respect to which any domestic corporation is a USS.

[xxix] A distribution of previously-taxed income does not constitute a dividend, even if it reduced earnings and profits.

[xxx] The “dividends received deduction” (“DRD”).

[xxxi] In the case of the sale or exchange by a domestic corporation of stock in a FC held for one year or more, any amount received by the domestic corporation which is treated as a dividend for purposes of Code section 1248, is treated as a dividend for purposes of applying the provision. Thus, the DRD will be available to such a deemed dividend. Sec. 1248 is intended to prevent the conversion of subpart F income into capital gain.

[xxxii] In addition, the DRD is not available for any dividend received from a FC if the dividend is a “hybrid dividend.” A hybrid dividend is an amount received from a FC for which a DRD would otherwise be allowed and for which the specified-10-percent-owned FC received a deduction (or other tax benefit) with respect to any income taxes imposed by any foreign country.

[xxxiii] Of course, we also have to consider any withholding tax that the foreign country may impose of the foreign corporation’s dividend distribution to its S corporation shareholder. This tax will be creditable by the shareholders of the S corporation.

[xxxiv] For purposes of the GILTI inclusion, a person is treated as a U.S. shareholder of a CFC for any taxable year only if such person “owns” stock in the corporation on the last day, in such year, on which the corporation is a CFC. A corporation is generally treated as a CFC for any taxable year if the corporation is a CFC at any time during the taxable year.

[xxxv] Thus, subpart F income, effectively connected income, and income that is subject to foreign tax at a rate greater than 18.9% is not GILTI. For example, the corporate tax rate is 19% in the U.K., 24% in Italy, 25% in Spain 25%, 18% in Luxembourg, and 25% in the Netherlands.

[xxxvi] “Qualified business asset investment (“QBAI”). The CFC’s intangible property is not included in QBAI.

The 10% represents an arbitrary rate of return on the “unreturned capital” (i.e., tangible property) of the CFC, represented by its adjusted basis, for which continued deferral is permitted. Anything in excess thereof must be included in the gross income of the USS on a current basis.

[xxxvii] The maximum individual tax rate applicable to ordinary income.

[xxxviii] For taxable years beginning after December 31, 2025, the deduction is lowered to 37.5-percent.

It should be noted that it is intended that the “50-percent of GILTI deduction” be treated as exempting the deducted income from tax. Thus, for example, the deduction for GILTI could give rise to an increase in a domestic corporate partner’s basis in a domestic partnership that holds stock in a CFC.

[xxxix] 13.125% multiplied by 80% equals 10.5 percent.

[xl] Of course, an income tax treaty between the U.S. and the foreign jurisdiction may affect this result.

[xli] The applicable regulations have yet to be amended to reflect the changes made by the TCJA.

[xlii] However, the shareholder will not be allowed the 50-percent GILTI deduction. This deduction is not part of the CFC or FTC rules.

[xliii] In other words, the regular double taxation rules for C corporations will apply; the corporation is treated as having distributed its after-tax E&P.

[xliv] Remember “Rocky IV”?

“You Mess with the Bull . . .”

An often-explored theme of this blog is the frequency with which similarly situated business taxpayers, facing the same set of economic circumstances, and presented with the same set of choices, will knowingly repeat the “mistakes” made by countless taxpayers before them.[i] They will choose a course of action that violates the spirit, if not the letter, of the tax law.

Rational behavior? Does the answer depend upon the taxpayer’s appetite for risk-taking? Being an entrepreneur necessarily involves some exposure to risk. However, there is a difference between the calculated risk that an intelligent business owner takes, on the one hand, and the risk that comes with tweaking the nose of the IRS, on the other.

“ . . . You get the Horns”

For example, many business owners (and former owners) have regretted certain choices regarding their withholding tax obligations.

Employment Taxes

In order to assist the IRS in the collection of those taxes that are imposed on an employee’s wages, employers generally must withhold from their employees’ wages the federal income, social security, and Medicare taxes owing by such employees on account of such wages. These taxes are called “trust fund” taxes because employers actually hold the employee’s money in trust until making a federal tax deposit of the amounts withheld.

Trust Fund Penalty

The amounts withheld must be paid over to the IRS (“deposited”) in accordance with the applicable deposit schedule. To encourage the prompt payment by employers of the withheld income and employment taxes, the Code provides for the so-called trust fund recovery penalty (“TFRP”) under which a person who is responsible for withholding, accounting for, or depositing or paying these taxes, and who willfully fails to do so, can be held personally liable for a penalty equal to the full amount of the unpaid trust fund tax, plus interest.

Thus, if an employer fails to collect the appropriate amount of tax (for example, as result of having misclassified employees as independent contractors) or collects the tax but fails to remit it, and the unpaid trust fund taxes cannot be immediately collected from the business, the TFRP map be applied to the responsible persons.

It should be noted that the employer’s business does not need to have ceased operating in order for the TFRP to be assessed. Indeed, it may be that, in some cases, a business has survived only because the withheld taxes have not been remitted to the IRS but have, instead, been used to pay other expenses of the business.

In many other cases, however, the imposition of the TFRP plus interest has led to the demise of the business. Although this result may seem harsh, it is probably the correct outcome from an economic perspective. A business that cannot survive on its own should not be able to divert withheld tax amounts toward its own private use.[ii]

A Recent Example

Taxpayer formed LLC with his deceased business partner, Dead Guy[iii]. Each was a fifty-percent owner of LLC, and they were the company’s only officers. LLC’s operating agreement gave them joint managerial control of the company and prohibited either one from engaging in major financial transactions without the other’s approval. Taxpayer’s title was “managing member.” He oversaw LLC’s office operations, and Dead Guy oversaw LLC’s field operations.

Both Taxpayer and Dead Guy had signing authority on LLC’s bank accounts. Taxpayer frequently signed checks, including payroll checks, during the years at issue. LLC had a stamp of Taxpayer’s signature, and Taxpayer regularly directed the employee who handled payroll to issue checks with his signature to employees and creditors. Taxpayer admitted that he decided which bills to pay if there were insufficient funds to pay them all. LLC also had an outside accountant, CPA, who prepared LLC’s corporate income and employment tax returns. Once CPA prepared the returns, he reviewed them with Taxpayer and Dead Guy before filing.

During the years at issue, LLC did not fully pay its federal payroll taxes. Taxpayer was aware that employers are required to withhold income and social security taxes from their employees’ wages. He also became aware at some point during this time period that LLC owed taxes.

Taxpayer said that he first learned that the payroll taxes were not being paid when an IRS agent came to LLC’s office. Taxpayer then tried to work with the IRS to pay the delinquent taxes. CPA corroborated that Taxpayer was kept apprised of LLC’s ongoing tax struggles.

Following an administrative investigation, the IRS determined that both Taxpayer and Dead Guy were “responsible persons” who had willfully failed to pay over the trust fund taxes. It assessed trust fund recovery penalties against both of them.

Trust fund taxes are amounts withheld for income and social security tax and remitted to the IRS.

Procedural History

During the pendency of their case before the District Court, Dead Guy, well, died, and was dismissed as a defendant.[iv] The case proceeded against Taxpayer, and the IRS sought a judgment against Taxpayer for the unpaid balance of the amounts assessed against him. The parties filed cross-motions for summary judgment on the issues of: (i) whether Taxpayer was a person responsible for paying over the trust fund portion of LLC’s payroll taxes; and (ii) whether Taxpayer willfully failed to pay over those taxes.

The Courts Speak

The District Court concluded that Taxpayer was a responsible person because he was a fifty-percent owner, one of only two officers, he had check-signing authority, and he exercised his power to pay LLC’s bills and sign paychecks. The Court further determined that Taxpayer learned during the years at issue that the taxes were not being paid, and that he received regular updates on communications with the IRS regarding the delinquencies. The Court concluded that he was willful because he paid other creditors after having actual knowledge that the payroll taxes were not being paid, and because he acted with reckless disregard for whether the taxes were being paid.

In opposition to the IRS’s motion for summary judgment, Taxpayer claimed – contrary to his deposition testimony! – that he had not been aware of the delinquencies. The District Court disregarded this declaration because “conclusory, self-serving affidavits are insufficient to withstand a motion for summary judgment.”

The District Court granted the IRS’s motion, and Taxpayer appealed the decision to the Court of Appeals for the Third Circuit.

The Code provides that any person required to pay over trust fund taxes who “willfully fails to collect such tax, or truthfully account for and pay over such tax, or willfully attempts in any manner to evade or defeat any such tax or the payment thereof” will be liable for the amount of tax evaded. The two conditions for liability are (1) that the individual must be a “responsible person,” and (2) their failure to pay the tax must be “willful.”

On appeal, Taxpayer argued that the District Court should not have granted the IRS’s motion for summary judgment because his case presented genuine disputes of material fact regarding both conditions. The Court disagreed.

Responsible Person?

First, Taxpayer contended that he was not a “responsible person” under the Code. “Responsible person,” while not appearing in the statute itself, is a term of art for the person who has the duty or power to perform or direct the collecting, accounting for, or paying over trust fund taxes. The Court pointed out that “[r]esponsibility is a matter of status, duty or authority, not knowledge.” And “[w]hile a responsible person must have significant control over the corporation’s finances,” the Court continued, “exclusive control is not necessary.” Additionally, there can be more than one responsible person for a particular employer. The Code imposes joint and several liability on each responsible person. A person who has paid the penalty may seek contribution from other liable persons.

To determine whether an individual is a responsible person, the Court stated, the following factors are typically considered:

(1) the corporate bylaws, (2) ability to sign checks on the company’s bank account, (3) signature on the employer’s federal quarterly and other tax returns, (4) payment of other creditors in lieu of the United States, (5) identity of officers, directors, and principal stockholders in the firm, (6) identity of individuals in charge of hiring and discharging employees, and (7) identity of individuals in charge of the firm’s financial affairs.

Based on the foregoing, the Court did not see any error in the District Court’s conclusion that Taxpayer was a responsible person. The undisputed evidence established that he was a fifty-percent owner of LLC and one of only two officers, his approval was required for company decisions and many significant financial transactions, he had check-signing authority, and had exercised his power to pay the company’s bills and sign paychecks.

On appeal, Taxpayer protested that he was not responsible for LLC’s payroll or tax contributions. He claimed these responsibilities were entirely Dead Guy’s. But the District Court properly determined that the division of labor between the two partners was irrelevant, because there can be more than one responsible person, and Taxpayer possessed and exercised the authority that qualified one as statutorily “responsible” to pay over taxes. Moreover, Taxpayer’s contentions that he was somehow not responsible because he managed LLC’s business while Dead Guy directly supervised employees only solidified the District Court’s conclusion. Faced with this evidence, the Court found that Taxpayer was a responsible person.

Willful Failure?

Taxpayer next argued that his failure to pay over the taxes was not willful.

According to the Court, willfulness is “a voluntary, conscious and intentional decision to prefer other creditors over the Government.” It may also be established, the Court stated, if the responsible person acts with “reckless disregard” of a known or obvious risk that withheld taxes may not be remitted to the government. “Reckless disregard includes failure to investigate or correct mismanagement after being notified that withholding taxes have not been paid.” Willfulness need not be in bad faith, nor does it require actual knowledge of the tax delinquency.

The Court concluded that Taxpayer’s behavior was willful because he permitted LLC to pay other creditors after he knew that the taxes were in arrears. The record demonstrated that he had actual knowledge the taxes were due and, despite this knowledge, LLC paid substantial sums to Taxpayer and Dead Guy throughout the delinquency.

Moreover, to the extent that Taxpayer claimed he was unaware the taxes were not being paid, the Court countered that he was in a position to know for certain that they were not. Under the circumstances, Taxpayer’s inaction amounted to a reckless disregard qualifying as willfulness.

The More Things Change . . .

Indebtedness that isn’t “real,” unreasonable compensation, constructive dividends, below-market transactions with related parties, questionable losses[v], weakly-supported valuations, misclassified service providers – these are but some of the more common instances in which taxpayers flout the tax laws and invite the imposition of penalties.

They are also among the most easily avoidable situations because they fail to comport with economic reality and, as such, are readily identifiable by both the taxpayer and the IRS. Moreover, they typically do not involve especially convoluted fact patterns or complex issues in areas of the law where the outcome may be debatable and where a taxpayer may have a reasonable basis for its position.

For these reasons, among others, a well-advised – i.e., well-informed – taxpayer should never place itself in a position where it will have to concede such an “error” in the course of an audit. Such a taxpayer loses credibility with an examiner, which may taint other, more defensible positions on its tax return. Why jeopardize oneself by repeating the mistakes for which countless decisions have upheld the imposition of penalties? Such an action does not stem from a calculated risk – it’s just reckless.


[i] No, I am not turning this into a social science paper or a discussion on rational choice theory. However, I am channeling that great Sicilian, Vizzini: “You fell victim to one of the classic blunders – the most famous of which is ‘never get involved in a land war in Asia’ – but only slightly less well-known is this: ‘Never go in against a Sicilian when death is on the line’! Ha ha ha ha ha ha ha!” From The Princess Bride.

[ii] As one IRS agent put it to me many years ago, a taxpayer should go out of business before it fails to satisfy its tax obligations.

[iii] All references to “Dead Guy” relate to the period prior to his passing. On information and belief, Dead Guy was alive when LLC was formed, and ceased to be active in LLC’s business only after his death.

[iv] A tax lien arises at the time an assessment of tax is made and continues until the tax is satisfied or becomes unenforceable by reason of lapse of time. Thus, when a trust fund penalty is assessed, a tax lien attaches to all of the responsible person’s property. The lien remains attached and is not invalidated by a transfer of the property upon the death of the responsible person.

[v] For example, where a taxpayer makes deductible cash expenditures year after year in excess of their cash revenue, thereby generating a loss – even without regard to depreciation/amortization or elections to expense certain items – yet remaining in business.

It is said that repetition is the mother of all learning. It is also said that insanity is repeating the same mistake and expecting a different result. It is my hope that the result of the former will overwhelm the source of the latter before it is too late.

However, based upon the seemingly continuous flow of decisions from the Tax Court rejecting taxpayers’ characterization of their outlays of funds as indebtedness, it may be a forlorn hope.

What follows is a summary of one especially ill-advised or misguided taxpayer.

Debts and Distributions

Taxpayer was the sole shareholder of S-Corp.[i] The corporation operated a mortgage broker business. It acted as an intermediary between borrowers and lenders; it did not hold any loans itself. https://www.ustaxcourt.gov/USTCInOP/OpinionViewer.aspx?ID=11650

Bad Debts?

In Tax Year, S-Corp. to make a series of advances to Borrower. The advances were made by checks, credit card payments, and wire transfers. Each advance was recorded on S-Corp.’s general ledger as a loan receivable from Borrower.

Borrower did not execute any notes for the advances received during Tax Year. The advances were unsecured, and neither S-Corp. nor Taxpayer made a public filing to record a debt in connection with the advances. Taxpayer did not know the business activities that Borrower conducted.

An adjusting entry in S-Corp.’s general ledger for December 31 of Tax Year reflected that Taxpayer instructed that the loan receivable for the Tax Year advances be written off.

On its return for Tax Year, S-Corp. claimed a large deduction for bad debts; the debt deduction was attributable to a write off for advances made to Borrower.

S-Corp.’s trial balance for the following tax year reflected that it made another loan to Borrower in that year. Taxpayer claimed not to know the purpose for that advance.

“Bad” Distributions?

As S-Corp.’s president and sole shareholder, Taxpayer authorized distributions to himself during the two years in issue. In Tax Year, Taxpayer received total distributions in excess of $1.6 million. In the following year, he received distributions in excess of $2 million.

For the years in issue, S-Corp. reported ordinary business losses, based in part on the bad debt deduction claimed for the advances made to Borrower. Taxpayer claimed S-Corp.’s losses on the Schedules E, Supplemental Income and Loss, Part II, Income or Loss from Partnerships and S Corporations, attached to his Forms 1040, U.S. Individual Income Tax Return. He engaged the same CPA firm to prepare S-Corp.’s returns and his individual returns for the years in issue.

For the years in issue, S-Corp. reported on its returns the distributions to Taxpayer. It issued Schedules K-1, Shareholder’s Share of Income, Deductions, etc., for Taxpayer that reflected the distributions and reported them as “[i]tems affecting shareholder basis”.

Taxpayer did not report any of the distributions that he received from S-Corp. for the years in issue on his individual returns.

The IRS Disagrees

The IRS examined Taxpayer’s income tax returns for the years in issue, and then issued a notice of deficiency in which it: (i) disallowed the full amount of S-Corp.’s claimed bad debt deduction for Tax Year – this adjustment flowed through to Taxpayer and was reflected as an increase to the income reported on his Schedule E; and (ii) determined that Taxpayer had unreported long-term capital gains for the years in issue.

Taxpayer petitioned the U.S. Tax Court.

Bad Debt Deduction

The Code allows a deduction for a taxable year for any debt that becomes wholly worthless within the taxable year. To deduct a business bad debt, the taxpayer must establish the existence of a valid debtor-creditor relationship, that the debt was created or acquired in connection with a trade or business, the amount of the debt, the worthlessness of the debt, and the year that the debt became worthless.

The IRS contended, and the Court agreed, that Taxpayer failed to establish any of these elements as they relate to the advances made by S-Corp. to Borrower during Tax Year.

A bad debt is deductible only for the year in which it becomes worthless. The Court explained that the subjective opinion of the taxpayer that the debt is uncollectible, without more, is not sufficient evidence that the debt is worthless.

The Court observed that Taxpayer failed to present any evidence that the alleged debt was objectively worthless in Tax Year. He testified only as to his subjective belief. Taxpayer did not identify any events during Tax Year which showed that the alleged debt was uncollectible. He testified that Borrower told him early in the following year that he could not repay the Tax Year advances, but he offered no reasoning as to why in that case the alleged debt should be treated as being worthless at the end of Tax Year.

Even accepting Taxpayer’s uncorroborated testimony, Borrower’s statement early in the following year was not enough to establish that the alleged debt to S-Corp. was objectively worthless at the end of Tax Year. Taxpayer did not describe any actions taken to try to collect the alleged debt, and he testified that he did not know whether Borrower was actually insolvent in the following year. Moreover, there was no reasonable explanation for advancing more funds to Borrower the next year if the prior advances were deemed totally unrecoverable.

Bona Fide Debt?

Taxpayer also failed to establish that the advances constituted a bona fide debt – “a valid and enforceable obligation to pay a fixed or determinable sum of money” – and that the parties intended to create a bona fide debtor-creditor relationship. Generally a debtor-creditor relationship exists if the debtor genuinely intends to repay the loan and the creditor genuinely intends to enforce repayment.

Factors indicative of a bona fide debt include: (1) whether the purported debt is evidenced by a note or other instrument; (2) whether any security was requested;

(3) whether interest was charged; (4) whether the parties established a fixed schedule for repayment; (5) whether there was a demand for repayment; (6) whether any repayments were actually made; and (7) whether the parties’ records and conduct reflected the transaction as a loan.

Borrower did not execute any notes, and Taxpayer did not request any collateral or other security for the advances. Taxpayer did not provide any documents reflecting the terms for the purported loan.

Apart from the way that the advances were recorded in S-Corp.’s general ledger, the parties’ conduct did not reflect that the advances were intended as a bona fide loan. S-Corp. made a series of unsecured advances to Borrower, and as the balance of the advances rapidly increased S-Corp. did not receive any offsetting payments or obtain any guaranties of repayment. Taxpayer did not claim that he and Borrower agreed to a schedule for repaying the advances or that he ever demanded repayment. Rather, he contended that he determined that the advances were uncollectible as of the end of Tax Year, only 10 days after the last advance had been made and without making any efforts to collect the amounts allegedly owed. He testified that by early the next year, he believed Borrower would not be able repay the advances, but he continued to direct S-Corp. to advance him more funds.

Taxpayer contended that he had a “good-faith expectation” that Borrower would repay him. He testified about his prior business dealings with Borrower, but the objective evidence and the preponderance of all evidence suggested that Taxpayer had no genuine intention of requiring Borrower to repay the advances. The real purpose of the advances remained unexplained.

The Court was not persuaded that a bona fide debt was created. It held that Taxpayer had failed to establish whether and when the advances became worthless or that the advances should even be considered a bona fide debt for tax purposes. Accordingly, the Court sustained the IRS’s determination to disallow the bad debt deduction in full.

Distributions from S-Corp.

The IRS contended that Taxpayer failed to report capital gains from the distributions that he received from S-Corp., during the years in issue. According to the IRS, the distributions were in excess of Taxpayer’s adjusted basis in S-Corp’s stock.

Under the Code, a shareholder of an S corporation takes into account their pro rata share of the corporation’s items of income, loss, deduction, or credit for the corporation’s taxable year ending with or in the shareholder’s taxable year. The Code also provides that a shareholder’s basis in their stock of the S corporation is increased by items of income passed through to the shareholder, and decreased by passed through items of loss and deduction. A shareholder’s stock basis is also decreased by distributions received from the S corporation that are not includible in the shareholder’s income. A distribution is not included in the gross income of a shareholder to the extent that it does not exceed the shareholder’s adjusted basis for the stock. The portion of a distribution that exceeds this adjusted basis is treated as gain from the sale or exchange of property.

Taxpayer contended that he did not take distributions in excess of basis. He claimed that he was personally liable to S-Corp. for the distributions that he received during the years in issue because he received them in violation of State law. Under State law, Taxpayer claimed, a shareholder who knowingly receives any distribution that exceeds the amount of the corporation’s retained earnings immediately prior to the distribution is liable to the corporation for the amount so received. For each of the years in issue, S-Corp.’s tax return reflected that it had negative retained earnings.

At this point, one might have expected Taxpayer to characterize the erstwhile “distributions” as loans from the corporation; after all, if his description of the result under State law was accurate, the funds had to be returned. However, Taxpayer instead contended that his liability to S-Corp. under State law “increased his debt basis in the corporation.” How this would have been relevant in determining the proper tax treatment of the distributions made to Taxpayer is anyone’s guess.

The Court stated that Taxpayer had misinterpreted the Code in arguing that his purported obligation to repay the distributions created debt basis. The Court then pointed out that even if Taxpayer established that he had basis in some bona fide indebtedness of S-Corp., it would not affect the taxability of the distributions that he received. The Court pointed out that the Code’s S-corporation-distribution provisions do not identify distributions that decrease a shareholder’s stock basis as an item to be applied to a shareholder’s debt basis after the stock basis has been reduced to zero.

The Court agreed with the IRS that the distributions had to be reported as income and treated as capital gain to the extent that they exceeded Taxpayer’s basis in S-Corp.’s stock. Taxpayer did not dispute the IRS’s calculations of his stock basis for the years in issue. Thus, the Court sustained the determination that Taxpayer had unreported capital gain for the years in issue.

Another One Bites the Dust

Taxpayer did not fare well, but he received his “just deserts.” He totally failed to establish that the advances to Borrower were real debts. The disallowance of the bad debt deduction claimed by Taxpayer resulted in an increase of his “flow-through” S corporation income and, thereby, an increase in his basis for his S-Corp. stock.

The interplay of the disallowed bad debt deduction for Tax Year, and the tax treatment of the distribution made to Taxpayer that year, affords us an opportunity to consider the order in which stock basis is increased or decreased under the Code, and the importance thereof.

The taxability of a distribution and the deductibility of a loss are both dependent on stock basis; for this reason, there is an ordering rule in computing stock basis. Under this rule – which favors tax-free distributions over currently deductible losses – stock basis is adjusted annually, as of the last day of the S corporation’s tax year, in the following order:

  1. Increased for income items;
  2. Decreased for distributions;
  3. Decreased for non-deductible, non-capital expenses; and
  4. Decreased for items of loss and deduction.

When determining the taxability of a distribution, the shareholder looks solely to their stock basis; debt basis is not considered, as Taxpayer learned.

Thus, there was a “silver lining” in the denial of Taxpayer’s loss deduction in that his stock basis was increased, thereby sheltering some of the distribution from S-Corp. – small comfort, though, because he recognized more ordinary income in exchange for less capital gain. Oh well.

 

[i] The corporation was always treated as an S corporation for tax purposes, and had no earnings and profits accumulated from the operations of any C corporation tax years.

Metamorphosis      [i]

By now, most readers have heard about the benefits and pitfalls of “checking the box” or of failing to do so. Of course, I am referring to the election afforded certain unincorporated business entities to change their status for tax purposes. Thus, for example, an LLC with one or more members – which is otherwise treated as a disregarded entity or as a partnership – may elect to be treated as an association taxable as a corporation; an association that has one member may elect to be treated as an entity that is disregarded for tax purposes, while an association with at least two members may elect to be treated as a partnership.

Each of these elections triggers certain income tax consequences of which its owners have to be aware prior to making the election; for instance, an association that elects to be treated as a disregarded entity or as a partnership is treated as having undergone a liquidation, which may be taxable to the entity and to its owner(s).

Although incorporated entities are not eligible to check the box, they may nevertheless desire to change their tax status – i.e., the legal form through which they conduct business[ii]; for example, they may, instead, want to operate as a partnership; conversely, a partnership may desire to “incorporate.” The conversion of a corporation into a partnership constitutes a taxable liquidation, while the incorporation of a partnership may generally be accomplished on a tax-deferred basis.

Stemming Abuse

But what if a business wanted to preserve its flexibility to change its tax status by switching from one form of legal entity to another, depending upon the circumstances?

The IRS foresaw that the ability to change the tax status of a business whenever it suited the owners to do so may lead to abuse. Thus, the check-the-box rules provide that an eligible entity may not elect, as a matter of right, to change its status more than once within any five-year period; similarly, a corporation that loses or revokes its “S” corporation status may not, without the permission of the IRS, elect to again be treated as an S corporation for five years.

“Swapping” Bodies[iii]

A recent Tax Court decision involved a limited liability partnership (“LLP”) that actually shifted its business (“Business”) into a professional corporation (“PC”) – it did not check the box – then, about five years later, shifted it back to LLP. In making these shifts, the owners of these business entities – who remained the same – kept both entities in existence notwithstanding the transfers of Business between them.

Interestingly, the dispute before the Court did not involve the income tax consequences arising from the “conversion” but, rather, the overpayment of employment taxes by LLP and the underpayment of such taxes by PC.

In Year One, four individuals engaged in Business through LLP. In Year Two, they operated through LLP for only two weeks, at which point they commenced operations through newly-formed PC (a C-corporation).

Although LLP ceased conducting ongoing operations, it was maintained for the purpose of collecting revenues, satisfying liabilities, and distributing profits related to LLP’s work.

PC conducted Business from that point forward through the end of Year Two. LLP paid wages to its employees for the first quarter of Year Two (“Quarter”), but the employment tax deposits it made for that period exceeded the wages paid.

The employees who were paid wages by LLP for the first two weeks of Quarter received the balance of their wages during Quarter from PC. Although PC’s general ledger recorded the employment tax deposits made, its payroll services provider that made the employment tax deposits, erroneously submitted them under LLP’s EIN.

The IRS credited LLP’s account for the employment tax deposits made by LLP; it also recorded that LLP timely filed a Form 941, Employer’s Quarterly Federal Tax Return. However, the IRS’s account for PC recorded no employment tax deposits or filings for Quarter.

The IRS’s account transcripts for LLP’s three remaining quarters for Year Two indicated that LLP had neither filed Forms 941 nor reported any employment tax liabilities for those quarters, while PC’s account transcripts for the same quarters indicated that PC had timely filed Forms 941 and made employment tax deposits for each quarter.

In Year Five, Business was again moved to LLP, while PC was kept alive in order to collect receivables, satisfy payables, and distribute profits relating to PC’s work. Hmm.

Tax Deficiency?

In Year Seven, the IRS notified PC that there was no record of PC’s having filed a Form 941 for Quarter. PC used its general ledger to prepare the Form 941, which reported the correct amount of employment tax due, and claimed a credit for employment tax deposits made, on the basis of entries in PC’s general ledger for wages paid and employment tax deposits made. The IRS assessed the employment taxes reported as due but did not credit PC with the employment tax deposits claimed.

PC thereafter sought to correct the Form 941 filed by LLP, claiming adjustments for LLP’s overpayment of employment taxes for Quarter based on the wages actually paid and the amounts actually owing thereon. PC also requested that a credit be applied to its employment tax liability for Quarter.

The IRS informed PC that a credit for LLP’s claimed overpayment could not be applied as requested because the period of limitations for claiming a refund had expired.

PC contended that the Quarter’s employment tax liability the IRS sought to collect had been previously paid by LLP, a related entity, which entitled PC to a credit, refund, setoff or equitable recoupment for the asserted liability.

PC explained that, through the error of its payroll service provider, PC’s employment tax deposits during Quarter had been remitted under the EIN of LLP, an entity through which the business had previously conducted its operations. PC further contended that PC should be credited with the Quarter’s deposits that had been erroneously submitted under LLP’s EIN through equitable recoupment.

In addition, PC tried to explain why both LLP and PC had been maintained as active entities during Year Two and thereafter, with each entity being used at various times to conduct the bulk of Business’s operations.

The IRS concluded that (i) PC had failed to sufficiently explain the continued active status of LLP, and (ii) because PC and LLP were both active entities, it would not be appropriate to allow PC to offset any of its employment tax liability with deposits LLP had made.

Equitable Recoupment

PC petitioned the Tax Court for review of the IRS’s determination. The issue for decision was whether PC was entitled to offset its unpaid employment tax liability for Quarter with the employment tax that LLP overpaid for Quarter.

“Long story short,” as they say, the Tax Court found that PC was entitled to offset the employment tax liability that the IRS sought to collect from it with the overpayment of employment tax made by LLP for the same period, the refund of which was time-barred. Without this offset, the Court stated, the IRS would have twice collected the employment taxes for Quarter arising from the payment of wages to the employees of Business: once from the deposits made under LLP’s EIN for Quarter, and a second time from the proposed levy on PC’s property.

The Court explained that the judicially-created doctrine of equitable recoupment applied to PC’s situation.[iv] In coming to that conclusion, the Court considered the documentary evidence submitted by PC regarding the organizational history of Business, including its alternating use of LLP and PC as its principal operating entity, with the other entity maintained for the purpose of collecting revenues and paying liabilities arising from past work. This alternating use, the Court observed, was substantiated with copies of each entity’s income tax returns for several years, demonstrating that the bulk of Business’s income was received through only one of the two entities in any given year.

According to the Court, when each entity’s general ledger for Quarter was compared to the IRS’s corresponding account transcripts, they conclusively established PC’s equitable recoupment claim. Specifically, the general ledgers demonstrated that PC was the source of the employment tax payments for Quarter that created LLP’s overpayment, and PC paid the wages that gave rise to the employment tax liability that was paid under LLP’s EIN.

Shape-Shifting, At Will?

The Court’s decision was all well and good for PC’s and LLP’s owners.

But what about the shifting of Business from LLP to PC, and then back to LLP? Specifically, what about the income tax consequences resulting from the “incorporation” of LLP and the “liquidation” of PC? The Court made no mention of these whatsoever, which begs several question.

Did the LLP liabilities assumed or taken subject to by PC exceed the adjusted bases of the assets “contributed” by LLP to PC? Did the fair market value of PC’s assets exceed their adjusted bases, or the owners’ adjusted bases for their shares of PC stock? The decision does not indicate whether LLP, PC, or their owners reported any gain on the transfer of “Business” between PC and LLP.

Indeed, was there any transfer of assets at all, other than a transfer of employees? Is that why the-then existing receivables and payables remained with LLP in Year Two and with PC in Year Five?

Did LLP’s/PC’s tangible personal properties remain in one entity, and were these leased or subleased to the other entity when Business was shifted to that entity? Was the real property they occupied leased or subleased between them? Was a market or below-market rate charged for the use or assignment? Or were these properties sold or exchanged for consideration?

What about projects that were ongoing at the time of the shift – how were these handled? What about the goodwill associated with Business – how was it transferred? Or did the goodwill reside with the individual owners of LLP and PC (so-called “personal goodwill”), and not with the entities?

Of course, these issues were not before the Court, but the “identity of interest” among PC, LLP, and their owners underpinned the Court’s decision. It is clear from the decision that LLP and PC operated a single Business, that their owners were identical, that the entities used the same name (but for the “PC” versus “LLP” designation), and that they employed the same individuals.[v]

What, then, was the impetus for the owners of LLP and PC to shift the operation of Business between the two entities? It wasn’t the nature of a particular project – for example, the complexity of the project, or the degree of liability exposure – after all, only one entity was active at any one time; the owners did not assign some projects to LLP and others to PC. Was there another business reason at work? Or was the shifting based upon some undisclosed tax considerations?

Whatever the reasons for LLP’s and PC’s actions, the owners of a closely held business should not think, based upon the underlying facts of the above decision, that they may freely, and without adverse tax consequences, shift the operation of a single business between two commonly-controlled entities simply by “turning off” one entity and “turning on” the other. The use of “successor” entities to a single business without a significant change in beneficial ownership of the business is an invitation to trouble with the IRS.

Indeed, even the allocation of projects among two or more commonly-controlled entities engaged in a single business may generate adverse tax results.

The owners should first consider why they would allocate projects – is it only for tax savings, or is there a bona fide business reason? For example, as mentioned above, does one entity engage in one aspect of a business, such as design, while another handles another aspect, such as construction? Or does one entity handle higher-end work, and markets or brands itself accordingly, while the other takes care of “lesser” jobs? Does one entity assume riskier projects and is insured therefor, while the other gets the plain-vanilla assignments?

Assuming there is a bona fide business reason for the allocation of work among the controlled entities, the owners will still have to consider how to allocate the resources of the business among these entities, and for what consideration; for example, if the equipment necessary for the completion of a project resides in an entity other than the one engaged in the project, how will the equipment be made available and at what price; what about employees and overhead, such as office space?

In every case, the owners of the related entities need to consider the business reason for the allocation of work to one entity as opposed to another; then they have to consider the tax consequences thereof and how to deal with them.


[i] Fear not, we’re talking tax, not Kafka.

[ii] By contrast, some entities may seek to change their legal form (for example, switching from a corporation to an LLC as a matter of state law), while maintaining their tax status. Thus, the merger a corporation into an LLC that has elected to be taxed as a corporation may qualify as an F-reorganization; the entity remains a corporation for tax purposes, but it is now governed by the state rules applicable to limited liability companies rather than those applicable to corporations.

[iii] Fear not, we’re talking tax, not “The Exorcist.”

[iv] The doctrine operates as a defense that may be asserted by a taxpayer to raise a time-barred refund claim as an offset to reduce the amount owed on the IRS’s timely claim of a deficiency, thereby preventing an inequitable windfall to the IRS. In general, a taxpayer claiming the benefit of an equitable recoupment defense must establish the following elements: (1) the overpayment for which recoupment is sought by way of offset is barred by an expired period of limitations; (2) the time-barred overpayment arose out of the same transaction, item, or taxable event as the deficiency before the Court; (3) the transaction, item, or taxable event was inconsistently subjected to two taxes; and (4) if the transaction, item, or taxable event involves two or more taxpayers, there is sufficient identity of interest between the taxpayers subject to the two taxes that the taxpayers should be treated as one.

[v] Courts may, in certain circumstances, permit a taxpayer to recoup an erroneously paid tax that the taxpayer did not pay himself. But the payor of the tax and the recipient of the recoupment must have a sufficient identity of interest such that they should be treated as a single taxpayer in equity.

Though LLP and PC were separate legal entities with distinct EINs during Quarter, each was owned by the same individuals during that period. Consequently, the burden of double taxation would be borne by the same individuals. Therefore, PC demonstrated sufficient identity of interest with LLP to allow PC to recoup the employment tax for Quarter that LLP overpaid.

 

 

“Leaving” the Business

There is a common theme that runs through the history of most closely held businesses. It begins with a motivated, diligent, and independent individual who is not afraid to take charge and to make things happen. Add a bit of luck to the mix, plus the support and guidance of family, friends and mentors, and the business may grow and thrive. The years pass and, at some point, the owner may decide that they are ready to begin the next stage of their life.

In many cases, that next stage is retirement – the owner sells their business and rides off into the sunset.

For some owners, however, the next stage looks more like a form of quasi-retirement, where they step back from the day-to-day management and operation of their business – turning this function over to a family member or a trusted employee – and become a passive investor. This “conversion” may be accompanied by a transfer of some equity in the business to the owner’s anointed successor.

Alternatively, it may mean selling all or part of the business and starting another. The new business may be a variant on the old one, though on a smaller scale; it may be something entirely new; or it may be one that does not require as much hands-on involvement.

For many business owners who reside in New York, this quasi-retirement is often coupled with a change in residence, usually to a warmer, less expensive, and less taxing environment, like Florida.

A quasi-retired business owner who decides to make such a move has to recognize that, at some point, they may be required to convince the New York State Department of Taxation and Finance that they have established Florida as their new domicile.

Domicile

Under New York’s Tax Law, an individual’s “domicile” is defined as the place the individual intends to be their permanent home. It is a subjective inquiry because it goes to one’s state of mind.

Once an individual’s New York domicile has been established, it continues until they abandon it and move to a new location with the bona fide intention of making their permanent home there.

Whether or not an individual’s domicile has been replaced by another depends on an evaluation of their circumstances.  According to the State, certain “primary” factors must be considered in determining the individual’s intent as to domicile – these factors are viewed as objective manifestations of such intent.

Each primary factor must be analyzed to determine if it points toward proving a New York or other domicile.  In conducting this analysis, an individual’s New York ties must be explored in relationship to the individual’s connection to the new domicile claimed.  Each factor is weighed separately, and then collectively.

The primary factors are as follows: (i) the individual’s use and maintenance of a New York residence, (ii) their active business involvement, (iii) where they spend time during the year, (iv) the location of items which they hold near and dear, and (v) the location of family connections.

The evidence required to support a change of domicile must be “clear and convincing.”  Thus, a taxpayer who has been historically domiciled in New York, and who is claiming to have changed their domicile, must be able to support their intention with unequivocal acts.

This is where the nature of the business owner’s continuing connection to their New York business – when weighed against their connection to any business activity in which they are already engaged in Florida, or which they decide to undertake after moving to Florida – may put them at a disadvantage in proving the abandonment of their New York home, as was demonstrated in the decision described below.

Audit of Nonresident Return

Like many others, Taxpayer immigrated to New York and established a successful business. Taxpayer started his business with a single retail location in New York. He later opened additional locations, both in New York and in Florida. Building upon the success of, and parallel to, his retail business, Taxpayer also developed extensive real estate holdings by investing in New York and Florida rental real estate.

Taxpayer and his spouse jointly filed New York State and City resident income tax returns up until the tax years under audit (the “Audit Years”). For both those years, Taxpayer filed a New York nonresident income tax return, claiming the filing status of married but filing separately, and identifying his Florida address as his home.

The Department of Taxation and Finance examined Taxpayer’s nonresident income tax returns for the Audit Years – which included a large gain from the sale of real property in Florida – and concluded that he had failed to present clear and convincing evidence that he had abandoned his New York domicile and acquired a new Florida domicile.

The Department issued a notice of deficiency assessing additional personal income taxes, as well as penalties, against Taxpayer, which he challenged. However, an Administrative Law Judge (“ALJ”) sustained the deficiency. Taxpayer appealed the ALJ’s decision to the Tax Appeals Tribunal, which affirmed the ALJ’s determination. Following this setback, Taxpayer filed a so-called “article 78 proceeding” to appeal the Tribunal’s decision.

Taxpayer’s Business Connections

The Appellate Division, Third Department (to which Tax Appeals Tribunal decisions are appealed), began by stating that, for income tax purposes, an individual is a resident of New York when that individual is domiciled in this State. A person’s domicile, the Court continued, “is the place which an individual intends to be such individual’s permanent home.” Once a domicile is established, it “continues until the individual in question moves to a new location with the bona fide intention of making such individual’s fixed and permanent home there.”

As the individual seeking to establish a change in domicile, it was Taxpayer’s burden, the Court noted, to prove his change of domicile by clear and convincing evidence.

The Court observed that Taxpayer did not contend that his domicile changed from New York to Florida as of a date certain. Rather, Taxpayer maintained that his contacts in Florida dated back over 25 years, to when he opened his first retail location in the State and purchased a condominium there. Taxpayer contended that, slowly over the course of time, his business interests grew and he began spending an increasingly significant amount of time at his Florida residence such that, by the Audit Years, he had effectively abandoned his New York domicile and established a new domicile in Florida.

The Court acknowledged that Taxpayer had submitted evidence demonstrating his significant business ties to Florida, including his ownership and operation of four retail locations and nine rental properties, and the fact that he helped manage another business located in one of his Florida buildings. Taxpayer had also submitted evidence that he had moved many personal items to his Florida residence, and that he had spent the majority of the Audit Years in Florida.

The Court pointed out, however, that there was similarly no dispute that Taxpayer also continued to maintain substantial and significant business and personal contacts in New York.

Significantly, Taxpayer continued to maintain his New York business and, in fact, was working on expanding it. He also maintained a warehouse affiliated with his New York business and another that he rented to third parties.

In addition, Taxpayer acknowledged that the administration and bookkeeping functions for all of his New York and Florida businesses were centralized and maintained in New York. All tax filings for the Florida businesses listed Taxpayer’s New York City office address, and his New York City bookkeeper processed all receipts from the Florida businesses and rental properties.

The Court observed that, over the years, Taxpayer had established a regular pattern of travel, generally consisting of his spending long weekends in Florida, during which he visited his Florida business and investment locations, while spending the rest of the week working in New York.

Moreover, Taxpayer managed and controlled all administrative, operational, and financial aspects of his New York and Florida business and real estate investment interests from his New York City office, and he continued to be the sole owner of the entities that held these interests.

The Audit Years were no exception: all administrative and financial functions for all of Taxpayer’s businesses and real estate investments continued to be handled in New York, Taxpayer spent almost half the year in New York, he derived significant income from his New York businesses and investments, and he continued to be actively engaged in the management and control thereof.

Such active business ties to New York, the Court maintained, typically indicate a failure to abandon a New York domicile.

On the record before it, including Taxpayer’s New York business and real estate investment interests, the presence of his spouse in New York, and his continued ownership and use of his long-time New York City condominium, the Court sustained the Tax Appeal Tribunal’s determination that, as of the Audit Years, Taxpayer had not shown a change in his lifestyle that would support his claimed change of domicile to Florida and the abandonment of New York as his domicile.[I]

Is It All or Nothing?

A business owner’s continued employment or active participation in their New York business, or their substantial investment and management of their New York business, after they have acquired a new residence elsewhere, will be a primary factor in determining their domicile.

If the owner continues to be actively involved in their New York business by managing or actively participating in such business without establishing comparable or greater business connections to the location they claim to be their new home, then their New York business activity will support their continued status as a New York domiciliary.

Does this mean that a business owner who has moved out-of-state cannot remain connected to their New York business if they hope to abandon New York as their domicile?

Not necessarily. It depends upon the extent and nature of the owner’s control and supervision over the New York business.

On the one hand, an owner’s active participation in the day-to-day operation or management of a New York business points to continued New York domicile, even if the business is being run from an out-of-state location.

On the other hand, an owner’s conversion of his interest in a New York business from an active to a passive investment is not supportive of continued domicile; for example, where the owner has resigned his position as an officer and employee of the business, has reduced his compensation accordingly, and has actually – not simply formalistically – turned management over to others.

The conversion of the owner’s interest to that of a “mere” investment does not require that the owner disregard the business entirely. In fact, it is reasonable to expect that the owner would take some interest in the business they have built and which now supplies a stream of income to them in retirement. This continuing interest does not compel a conclusion that the owner remains actively involved in the business.

Thus, the owner’s occasional office visit or phone call to the business should not constitute evidence of active involvement where they are limited in amount of duration.

If the owner has also undertaken other activities in their new home on which to focus their attention and efforts, the change of their relationship to the New York business is consistent with the so-called “change in lifestyle” that supports a conclusion that one domicile has been replaced with another.

Of course, it may be difficult for some owners to step away from their business and to pass control to someone else – did I mention something about an owner’s independence and determination? It’s the same issue they confront when considering gift and estate planning strategies, or in approaching succession planning. Interestingly, the proper planning for any one of these purposes will necessarily assist the owner in successfully removing themselves from New York.


[i] It should be noted that on both of Taxpayer’s nonresident income tax returns, the “No” box was checked in response to the question, “Did you or your spouse maintain living quarters in NYS [for that given year],” despite the fact that Taxpayer continued to own and maintain the condominium in New York City in which his spouse resided, and in which he stayed when he was in New York. The Court sustained the assessment of a negligence penalty against Taxpayer based on this “misrepresentation.” Despite the fact that Taxpayer claimed these misrepresentations were the product of a mistake by his accountant, the Court found no error in the Tribunal’s reliance upon these misrepresentations in upholding the negligence penalty.

I encounter the “‘No’ box” situation with too much frequency. First and foremost, a tax return must be accurate and truthful. The taxpayer is charged with reviewing the return to confirm the information contained therein – whether one owns or rents an apartment in the City is an easy one. Why give the auditor a lay-up, not to mention a bad impression?

 

“Personal liability?!” the client screams. “For sales tax? How is that possible?” The look on their face is at once incredulous and accusatory. “Didn’t you say that the LLC would protect me and my assets from the liabilities of the business so long as we respected ‘corporate’ formalities, and treated the LLC as a separate entity? I’m not even involved in its day-to-day operation and management – I’m just a ‘big-picture’ guy, a passive investor.”

The client’s confusion is understandable. Most investors do not realize that a member of an LLC may be held personally liable by N.Y. State for any sales tax required to be collected and remitted by the LLC, even when the “LLC veil” has not been pierced, and even when the member does not participate in the LLC’s business.

The rationale for this per se personal liability lies in the “trust fund” nature of the sales tax.

The Sales Tax

In general, the sales tax is a transaction tax, with the liability for the tax arising at the time of the transaction. It is also a “consumer tax” in that the person required to collect the tax – the seller – must collect it from the buyer when collecting the sales price for the transaction to which the tax applies.

The seller collects the tax as a trustee for, and on account of, the State. The tax is imposed on the purchase of a taxable good or service, but it is collected from the buyer by the seller, and then held by the seller in trust for the State, until the seller remits the tax to the State.

Responsible Persons

The State’s Tax Law imposes personal responsibility for the collection and remittance of the sales tax on an LLC’s so-called “responsible persons,” which may include certain employees or managers, as well as the members, of the LLC.  More than one person may be treated as a responsible person.

A responsible person is jointly and severally liable for all of the sales tax owed, along with the LLC and any of the LLC’s other responsible persons.  This means that the responsible person’s personal assets could be taken by the State to satisfy the entire sales tax liability of the business. Members of an LLC can be held personally responsible even though they are otherwise protected from the business liabilities of the LLC.

Personal liability attaches whether or not the tax imposed was collected.  In other words, it is not limited to tax that has been collected but has not been remitted.  Thus, it will also apply where a business might have had a sales tax collection obligation, but was unaware of it.

Along the same lines, the personal liability applies even where the individual’s failure to take responsibility for collecting and/or remitting the sales tax was not willful.

In addition, the penalties and interest on the corporation’s unpaid sales tax pass through to the responsible person.

Administrative Relief

In general, the Tax Law provides that every member of an LLC is a “person required to collect” any sales tax for which the LLC is responsible; thus, a member is per se liable for the LLC’s unpaid sales tax, plus interest and penalties, without regard to their role or degree of involvement in the LLC’s business. 

Beginning in 2011, however, the State’s Department of Taxation and Finance provided some relief from the per se personal liability for certain LLC members.

Specifically, a qualifying member would not be personally liable for any penalties relating to the LLC’s unpaid sales taxes, and their liability for such taxes would be limited to their pro rata share thereof.

In order to qualify for this relief, a member of an LLC had to document that their ownership interest in, and distributive share of the profits and losses of, the LLC were each less than 50%. They also had to demonstrate that they were not “under a duty to act” on behalf of the LLC – for example, because of their management position – in complying with the sales tax.

In addition, the member had to agree to such terms and conditions as the State may require in exchange for such relief, including cooperation with the State by providing information regarding the identities of other potentially responsible persons—particularly those persons involved in the day-to-day affairs of the business.

It is important to note that any member of an LLC that held a 50% or more ownership interest in the LLC, or that was entitled to a distributive share of 50% or more of the profits and losses of the LLC, was not eligible for this relief.

2018-2019 Fiscal Year Budget

A variation on this administratively-provided relief was recently codified by the State as part of its 2018-2019 Fiscal Year Budget.

Under the new law, a member of an LLC continues to be treated as a “person required to collect” sales tax. Thus, membership by itself remains a sufficient reason for imposing personal liability on a member for the LLC’s unpaid sales tax.

Application for Relief

However, the new law also provides that the State may grant a member relief from such personal liability if the member applies for relief, and demonstrates that (i) their percentage ownership interest, and their percentage distributive share of profits and losses, of the LLC are each less than 50%, and (ii) they were not under a duty to act for the LLC in complying with the sales tax.

If the State approves a member’s application for relief, the member’s liability will be limited to that percentage of the LLC’s sales tax liability that reflects the member’s ownership interest or distributive share, whichever percentage is higher, plus any interest accrued thereon; the member will not be liable for any penalty owed by the LLC.

Practical Impact?

It is unlikely that more LLC members will find relief under the 2018-2019 Budget provision than under the administrative relief program it replaced.

Members with an LLC ownership interest or distributive share of at least 50% will continue to be out of luck in avoiding personal liability, notwithstanding the level of their “disengagement” from the business of the LLC – there will continue to be an effective presumption that such a member could have acted to ensure compliance with the sales tax law.

This “presumption” was illustrated in a recent ALJ decision. Taxpayer and his partner each owned 50% on an LLC. According to Taxpayer, his partner was the general manager of the business and oversaw all the daily activities of the business, including, among other things, hiring, firing and supervising employees, and purchasing supplies. Taxpayer testified that his health prevented him from being actively involved in the business.

At some point, LLC began having issues paying its bills, and its vendors began pursuing collection from LLC, Taxpayer and his partner.

The State performed a sales tax audit of LLC, which resulted in the assertion of a sales tax deficiency, which LLC agreed to satisfy pursuant to a payment plan. Unfortunately, LLC failed to make any of the scheduled payments, and the State issued a notice and demand for payment of tax due.

The auditor determined that Taxpayer was a responsible person for LLC and, consequently, the State issued a notice of determination to Taxpayer assessing the sales and use taxes due from LLC.

Taxpayer agreed that LLC owed owes sales taxes, and did not challenge the underlying audit amount. However, he asserted that he was not a responsible person during the audit periods. Taxpayer asserted that he could not take an active role in managing LLC because of his health. He further asserted that the other 50% owner was the general manager of the business and the responsible person during the audit periods.

Taxpayer might as well have been speaking to the wall.

ALJ’s Opinion

The ALJ explained that, under the Tax Law, “every person required to collect the sales tax shall be personally liable for the tax imposed, collected or required to be collected.”

The Tax Law, the ALJ continued, defines “person required to collect” sales tax to include: “any employee or manager of [an LLC] . . . who as such . . . employee or manager is under a duty to act for such . . . [LLC] . . . in complying with [the sales tax law]; and any member of a . . . limited liability company.”

The ALJ emphasized that the law “clearly states that any member of [an LLC] is a ‘person required to collect’ [the sales tax]” and, furthermore, that a member of an LLC “shall be personally liable for the [sales] tax imposed, collected or required to be collected.”

The ALJ also pointed out that the Tax Law contains no factors to qualify or limit the liability imposed upon members of an LLC. “[Taxpayer] was a member of [an LLC] and . . . , such members are subject to per se liability for the taxes due from the [LLC]. . . . Since [the Tax Law] imposes strict liability upon members of . . . [an LLC], all that is required to be shown by the [State] for liability to obtain is the person’s status as a member.”

Because Taxpayer was a 50% member of LLC during the audit periods, the ALJ concluded that he was per se personally liable for the sales taxes due; moreover, he was not eligible for the administrative relief afforded under the 2011 program described above.

“Minority” Member?

Ah, the fate of a 50% member.

But what about a “less-than-50%,” or minority, member who was unable to secure any voice in the management of the business from the other member(s) of the LLC (for example, executive employment or a position on its board)? Such a member may be able to demonstrate that they were not “under a duty to act” in connection with sales tax matters and, so, they should be able to avoid personal liability for the LLC’s unpaid sales taxes.

That may provide some comfort to a minority member, who may not be in a position to compel or influence decision-making, and thereby enjoy the economic benefits of membership, including the distribution of profits, or the sale of the business, and who, for the same reasons, was unable to extract any contractual indemnity obligation from the controlling member of the LLC.

As in so many instances involving the application of the tax laws, there seems to be a direct relationship here between the ability to control one’s investment in a business, on the one hand, and one’s exposure for the tax liability of the business, on the other. Decisions, decisions.

Will They Ever Learn?

The following probably sounds familiar. You’re meeting with a new client who is being audited by the IRS. The client brings you their federal and state individual income tax returns and the income tax returns for their business entity.

You look at the client’s reported wages and dividends; you look at their Sch. E for information on their S corp. or partnership income; you notice on Part I that they own the real property on which the business operates (thankfully, through a wholly-owned LLC). You check the client’s home address and the property taxes on their home(s) as shown on their Sch. A (pre-2018, of course, at least for now). You see that the question on their N.Y. State return, whether they maintain living quarters in N.Y.C., has been answered in the negative.

Then you turn to their business returns. You review the reported wages or guaranteed payments paid to the client, at the dividends or other distributions paid to the client; you check the balance sheet for loans to or from the client, and at the line for interest received or paid (which you double check with the Sch. B on the client’s individual return – nothing); you look at the statement attached to the return that purports to describe the line on the return for “other deductions” and see that it states simply “other expenses;” you look at the explanatory statements for the lines on the balance sheet for “other assets” and “other liabilities,” and see something like “transactions with affiliate;” you check the depreciation schedules and notice the Range Rover.

Then you turn to the client. You’ve already “googled” them (you hate surprises) – thankfully, nothing exciting. “Thanks for the returns, but I’d also appreciate your books and other records, so I can check them against one another.” You take a deep breath, then ask the question, the answer to which you sometimes dread: “Is there anything I should know regarding the operation of the business that may not be evident from these returns?” “What do you mean?” or “Like what?” are the usual responses.

“Like pulling teeth,” you think to yourself. “For instance,” you say, “how do you determine your salary? Are family members employed? How do you determine the rental? Tell me about these ‘affiliates’ and these transactions. Do you have written agreements and leases? What about promissory notes for the loans on this balance sheet? Do you pay the business for the use of its apartment in the City?” You’re trying to develop a picture, and you’re finding that there is some cause for concern. You didn’t put them in this position, but you resolve that, once this audit is concluded, you will try to put them on the right course going forward.

Unfortunately, there’s always someone who doesn’t appreciate what you’re trying to do for them. Or it may be that they are so set in their ways that a voluntary change in their mode of operation is remote, at best. I imagine the taxpayer in a recent case, described below, as one such person.

Bad to the Bone?

Taxpayer was the sole shareholder of Corp, a C-corporation. On its tax returns, which were signed by Taxpayer as president of Corp, the corporation reported that it had loans from shareholders on its returns for years up to and including Year One, but it did not report the existence of any loans from shareholders after Year One, and no loans from shareholders were shown on Corp’s books and records. Corp did not file any federal tax returns after Year Four, notwithstanding that it had positive earnings and profits.

Corp paid net wages to Taxpayer in years before, and in the first few months of, Year Six. Taxpayer reported wages from Corp on his tax returns through Year Five.

Corp ceased operating in Year Six. Some of the checks issued to Taxpayer from Corp bore the preprinted phrase “Payroll Check” and taxes were withheld from these, while others were not so identified and taxes were not withheld from these.

During Years Six and Seven, Taxpayer endorsed several checks payable to Corp and deposited them into his personal account.

In Year Six, Taxpayer opened a checking account at Bank in the name of Newco. Taxpayer was the only individual with signature authority over the account, and during that year Taxpayer wrote three checks payable to himself from Newco.

Also in Year Six, Taxpayer deposited checks into Newco’s account which represented payment by Corp’s customers for services rendered by Corp.

Taxpayer’s Returns

Taxpayer filed Forms 1040 for Years Six, Seven and Eight. Taxpayer did not provide the C.P.A. who prepared the Year Six return with any verification of the reported amounts of income. The C.P.A. required Taxpayer to sign a letter acknowledging that Taxpayer had provided the C.P.A. with no verification of those amounts; that Corp had gone out of business during Year Six; and that its stock had become worthless in Year Six.

On Schedule D, Capital Gains and Losses, of the Year Six Form 1040, Taxpayer reported a long-term capital loss calculated by reference to Taxpayer’s claimed loan to Corp. Taxpayer carried over the unused portion of the long-term capital loss to the Years Seven and Eight Forms 1040.

The IRS issued a notice of deficiency to Taxpayer for Years Six, Seven and Eight, and Taxpayer timely petitioned the Tax Court.

Tax Court: Loan Repayments, Salary, or Dividends?

The Court began by noting that Taxpayer did not deny that he received payments from Corp in Year Six in the amounts the IRS determined. But Taxpayer contended that these amounts were the nontaxable repayment of loans that he had made to Corp. However, the only evidence in the record of any loans to Corp was Taxpayer’s testimony.

Taxpayer testified that the “payroll checks” he received in Year Six were actually loan repayments because Corp’s supply of general checks was exhausted. The Court disagreed, pointing out that the record showed that some general checks were written after these payments were made using payroll checks.

Taxpayer contended that he made several loans to Corp. However, he claimed a long-term capital loss resulting from only one of them on his Year Six return. Corp reported outstanding “loans from shareholders” on earlier returns, but none after Year One. The Court stated that it did not understand why Taxpayer would have claimed a loss resulting from only one loan if, in fact, he had lent far more than that, or why Corp did not report such outstanding, as it had done in the past, if the loans were genuine.

The IRS interviewed Taxpayer regarding whether he had received wages that were not reported on his return. Taxpayer told the IRS that the only loans he made to Corp were made in the early 1990s. The IRS also interviewed Taxpayer’s bookkeeper and reviewed Corp’s books and records with the bookkeeper. The IRS did not find any record of loans from Taxpayer to Corp after Year One. Moreover, Taxpayer testified that it would not make sense to draft a promissory note to himself when taking money out of his account and depositing it into Corp’s account, because it would be “basically out of one pocket and putting it into another.” Based on the forgoing, the Court concluded that Corp did not have outstanding loans to Taxpayer during the years at issue and that its payments to Taxpayer were salary.

The Court next considered certain other amounts received by Taxpayer from Corp in Years Six and Seven, which the IRS characterized as dividends. Taxpayer did not dispute receiving the payments, but contended that they were loan repayments rather than constructive dividends as claimed by the IRS.

The Court explained that a dividend is “any distribution of property made by a corporation to its shareholders” from its earnings and profits. Funds distributed by a corporation over which the taxpayer/shareholder has dominion and control, the Court explained, are taxed as dividends to the recipient to the extent of the earnings and profits of the corporation. A constructive dividend arises, the Court continued, where a corporation confers an economic benefit on a shareholder without the expectation of repayment, even though neither the corporation nor the shareholder intended a “formal” dividend.

In Year Six, Taxpayer opened a bank account in the name of Newco. The account was controlled solely by Taxpayer. According to the Court, the record revealed no purpose for Newco other than to serve as a conduit to transfer money from Corp to Taxpayer.

About halfway through Year Six, Corp made its final wage payment to Taxpayer. Shortly before that, Taxpayer deposited the first in a series of checks made payable to Corp by Corp’s customers into his own bank account. A while later, Taxpayer deposited checks payable to Corp into Newco’s account. Then Taxpayer wrote checks to himself from the Newco account. The sum of these checks was characterized by the IRS as constructive dividends to Taxpayer. The checks payable to Corp that Taxpayer deposited into his own account and the checks payable to Corp that Taxpayer deposited into Newco’s account represented an economic benefit to Taxpayer, and constituted constructive dividends for Year Six, and the checks written to Corp which Taxpayer cashed or deposited into his account in Year Seven were constructive dividends to Taxpayer for Year Seven.

In determining the amount of the dividends received by Taxpayer, the Court observed that Corp had earnings and profits at the end of Year Four, the last year for which it filed an income tax return. The Court also noted that there was no evidence in the record to show any change to Corp’s earnings and profits before Year Six. Thus, the Court concluded that the distributions were fully taxable.

Finally, the Court considered the long-term capital loss that Taxpayer reported on his Year Six return. His claim for entitlement to that deduction was based on his claim that Corp owed him money.

The C.P.A. who prepared Taxpayer’s Year Six tax return was unable to verify the existence of the claimed loans and asked Taxpayer to sign a statement that the return was based entirely on amounts provided by Taxpayer and his representation of the amounts of outstanding loans.

The Court found that there was no credible evidence that Taxpayer made loans to Corp after Year One, or that there was any outstanding debt from Corp to Taxpayer in Year Six, when Taxpayer reported the loss. Therefore, the Court concluded that Taxpayer was not entitled to the loss claimed for Year Six, or to the capital loss carryforward deductions claimed for the two succeeding years.

Know Your Client

I mentioned something about “googling” the client earlier. It wasn’t a joke. What does the “public record” tell you about the client and their character? We have all encountered clients or potential clients – fortunately, relatively few – who will “shop around” for an answer until they get the right one; i.e., the most favorable, though not necessarily the correct one.

Or we have seen clients like the Taxpayer, who will put anything in writing so as to induce their tax return preparer to sign a return that presents information that cannot be verified and is probably suspect.

At times, the prospect of landing a client, or the pressure to retain one, may feel irresistible. That’s when you need to check that the antennae are functioning properly.

Consider your professional duties and obligations; in particular, given the story of the Taxpayer, the duty to exercise due diligence in preparing and filing tax returns and other documents/submissions with the IRS, and in determining the correctness of representations made to the IRS.

In general, you may rely in “good faith,” and without verification, on information furnished by your client, but you cannot ignore other information that has been furnished to you, or which is actually known by you. You must make reasonable inquiries if any information furnished to you appears to be incorrect, incomplete, or inconsistent with other facts or assumptions.

Related to the duty of due diligence is the directive that you not sign a tax return, or advise a client to take a position on a return, that you know or should know contains a position for which there is no reasonable basis, or that lacks substantial authority, or which is a willful attempt to understate tax liability, or which constitutes a reckless or intentional disregard of rules or regulations.

By following these basic rules, you protect yourself and our system of self-assessment.

Estates and Beneficiaries

I recently encountered a situation in which the so-called “basis consistency” rule was implicated. This rule requires consistency between the estate tax value of a decedent’s property – its fair market value (“FMV”) as reported on the decedent’s estate tax return – that passes to a beneficiary, and the basis claimed by a beneficiary for such property; in general, this means that the “stepped-up” basis of the property in the hands of the beneficiary can be no greater than the FMV of the property reported by the estate to the IRS. The rule is aimed at preventing the government from being whipsawed between a lower valuation of a property for purposes of determining the estate tax attributable to the property, and a higher valuation for purposes of determining the beneficiary’s basis for the property and their income tax consequences on its subsequent disposition.

Prior to the enactment of this rule in 2015, the FMV of a property at the date of the decedent’s death was deemed to be its value as appraised for estate tax purposes: the price at which the property would change hands between a willing buyer and a willing seller, neither being under any compulsion to buy or to sell and both having reasonable knowledge of relevant facts.

However, the value of the property as reported on the decedent’s estate tax return provided only a rebuttable presumption of the property’s basis in the hands of the beneficiary. Thus, unless the beneficiary was estopped by their previous actions or statements with regard to the estate tax valuation, they could rebut the use of the estate’s valuation as their basis in the property by clear and convincing evidence.

What About Corporations and Shareholders?

While considering the application of this rule, I tried to recall whether a similar consistency rule applied between a corporation and its shareholders in the context of an in-kind distribution by the corporation, whether as a current distribution (a dividend or dividend-equivalent), as part of a redemption of stock that is treated as a sale or exchange for tax purposes, or as a liquidating distribution.

In-Kind Distributions, Generally

Under the Code, if a corporation distributes property (other than its own obligation) to a shareholder in respect of their stock in the corporation, and the FMV of the property exceeds its adjusted basis in the hands of the corporation, then gain must be recognized by the corporation in an amount equal to such excess, as if the corporation had sold the property.

Repeal of “General Utilities”

Prior to the enactment of this recognition rule, a corporation was permitted to distribute appreciated property to its individual shareholders without recognizing gain, but the shareholders’ basis for the property would nevertheless be stepped up without any corporate-level tax having been paid.

In repealing this rule, Congress explained that under a double-tax system for corporations, the distributing corporation generally should be taxed on any appreciation in value of property distributed to its shareholders; for example, had the corporation sold the property and distributed the proceeds, it would have been taxed on the gain from the sale.

According to Congress, the result should not be different if the corporation distributed the property to its shareholders and the shareholders then sold it.

Amount Distributed?

At the same time, the courts have rejected the suggestion by many corporate taxpayers – in an attempt to reduce the corporate-level gain – that this corporate-gain-recognition rule requires that the FMV of the property distributed by the corporation must be the same as the FMV of the property received by the shareholders. The courts have noted that the FMV of an entire interest in a property is greater than the sum of its fractional parts (for example, the FMV of a real property distributed by a corporation vs the aggregate value of the various tenancy-in-common interests in the property received by its distributee-shareholders).

Similarly, the rules that address the tax treatment of a shareholder’s receipt of property distributed from a corporation in respect of its stock, including the rule that determines the basis of such property in the hands of the shareholder, refer to the FMV of the property received by the shareholder, not the FMV of the property distributed by the corporation.

Who Decides FMV?

Of course, this begs the question: who determines the FMV of the distributed property?

Is it the corporation? After all, the corporation has to report on its income tax return any gain recognized on the distribution. It must also report on such return the value of any property distributed. The corporation must also issue a Form 1099 to the shareholder.

In the case of an S corporation, the corporation has to determine its gain on the distribution, which it must then allocate among its shareholders; this allocation, as well as the amount distributed to each shareholder, is reflected on the Sch. K-1 issued to each shareholder.

Alternatively, should each shareholder be free to determine the FMV of the property distributed to them? For example, may (or must) a shareholder who already owns an interest in the larger asset of which the distributed property is a part (as where the shareholder and the distributing corporation were co-owners before the distribution) assign a greater value to their distribution if it causes them to become the majority owner of the asset?

Provided the corporation’s determination of FMV is reasonable, it should control; otherwise, each shareholder would be free to determine the FMV of the property received by the shareholder which may result in different values for similarly situated persons and which, in turn, may lead to abuses.

Why an In-Kind Distribution?

Now, you may be wondering, how can this scenario ever occur? Why would a corporation distribute appreciated property to its shareholders and thereby intentionally trigger corporate-level tax and gain? Even if the corporation were in liquidation mode, wouldn’t it sell its properties for cash, rather than distribute them to its shareholders?

Two possible situations come immediately to mind: in the first, the corporation has sufficient net operating loss carryovers to offset a significant part of the corporate-level gain, which allows the corporation to remove the property from corporate solution with one level of tax; in the second, the corporation was going to sell the property anyway, but its shareholders plan to share the proceeds other than in accordance with their stock ownership – by distributing the property to its shareholders, the corporation enables each shareholder to sell its share of the property for the desired consideration.

The following hypothetical illustrates some of the issues that may be encountered under the second situation.

“But I Want More”

S corporation has several shareholders. As an S corporation, it has only one class of stock issued and outstanding. Its governing provisions (including its certificate of incorporation, by-laws, shareholder agreements, and state law) do not contradict the identical rights enjoyed by each share of stock to current and liquidating distributions.

The corporation proposes to make a pro rata, in-kind distribution of non-depreciable property to its shareholders.[1] The FMV of the property, as reasonably determined by the corporation, exceeds the corporation’s adjusted basis for the property. The property constitutes a capital asset in the hands of the corporation, and the corporation has held the property for more than one year.

For tax purposes, the corporation is treated as having sold the property to its shareholders. Under the S corporation rules, the corporation’s long term capital gain from the deemed sale is allocated among, and recognized by, the shareholders in accordance with their stock ownership. The S corporation will issue a Sch. K-1 to each shareholder that reflects the amount of gain allocated to the shareholder and the FMV of the property distributed to the shareholder.[2]

Each shareholder will take the property distributed to them with a starting basis equal to the FMV of such property, and each shareholder will begin a new holding period for such property.

Shortly after receiving their in-kind distribution, the shareholders sell their respective interests in the property to an unrelated buyer. With one exception, each shareholder receives an amount equal to the FMV of their interest in the property as reported to them by the S corporation. Because this amount is also equal to their basis for their respective interests in the property, these shareholders do not realize any gain on the sale to the buyer.

However, one shareholder receives consideration in excess of the FMV of the distribution reported to the shareholder on the Sch. K-1 issued to them by the S corporation.[3]

If the story ended here, this shareholder would recognize short term capital gain (taxable at the rates applicable to ordinary income) equal to the excess of the consideration received for their interest in the property over their basis for such property.[4]

What If?

But what if this shareholder took the position that, based on the amount paid by the buyer, the FMV of the property interest distributed to them was actually greater than the distribution amount reported by the S corporation on the shareholder’s Sch. K-1?

And what if, consistent with this position, the shareholder reported a greater amount of capital gain on their tax return than the amount reported by the corporation on the shareholder’s Sch. K-1 as their share of the gain from the deemed sale of the property?

Finally, what if the shareholder claimed a basis in the distributed property equal to this greater value on which they have been taxed? In that case, the shareholder will not realize any gain on the sale of their interest in the property to the buyer.

By taking a position that differs from the S corporation’s as to the value of the property distributed, will the shareholder have succeeded in converting what would have been short term capital gain into long term capital gain?

Parting Thoughts

As I contemplated this question, I identified a number of issues, with which I will leave you:

  • Should the “extra” consideration received by the one shareholder be treated as having been paid pro rata to all the shareholders, following which they paid over the extra consideration to that shareholder in a separate transaction? If so, how should that payment be treated? Would its tax treatment depend upon the facts and circumstances? For example, should it be treated as a bonus (i.e., compensation)?
  • May the IRS treat the excess payment received by the one shareholder as an additional payment or distribution from the corporation?
  • Depending upon the facts and circumstances, including any agreement among the shareholders, might the arrangement that leads to the one shareholder’s receipt of the extra consideration be interpreted as a second class of stock that would end the corporation’s “S” status?
  • May the one shareholder avoid accuracy-related or fraud penalties by disclosing to the IRS its position as to the FMV of the property distributed? In the case of an S corporation, is the shareholder required to disclose this position as an inconsistent position?
  • What if the sale of the property by the shareholders does not occur for several years? What if the statute of limitations on assessment of any deficiency for the year of the distribution has expired? Would the common law duty of consistency require that the one shareholder be barred from claiming that their basis for the property is greater than the amount of the distribution reported by the S corporation?

In light of the forgoing issues – not to mention several others not set forth above – and in the interest of facilitating the administration and fair application of the tax law, should Congress act to prohibit the shareholders of a corporation – as in the case of the beneficiaries of a decedent’s estate – from claiming a different FMV and basis for the property distributed to them by a corporation, regardless of whether such distribution takes the form of a dividend, a redemption of stock, or a liquidation of the corporation?


[1] If the property were depreciable in the hands of the shareholders, the related party sale rules may apply to treat the gain as ordinary.

[2] Assume that the corporation determines the amount of the distribution made to a shareholder by simply applying the shareholder’s percentage ownership of the corporation to the FMV of the property as a whole – it does not discount the fractional interest received by each shareholder.

[3] Perhaps the one shareholder negotiated a better deal?

[4] Query whether the gain is capital in light of the fact that the shareholders never intended to hold the property except for a brief period prior to its sale.

New York’s legislature has been in the news lately after having “rotated an avian creature through more than 90 degrees”[1] at Congress in response to the limitations passed under the Tax Cuts and Jobs Act on the deduction of state and local taxes. The provisions recently enacted by the State that have received the most attention are also the ones that are likely to have the least impact: the voluntary payroll tax (which business owners don’t care for) and the statewide charitable funds (which the IRS doesn’t care for and has stated it will challenge).

NY-Source Income

In the meantime, the Department of Taxation (the “Dept.”) has just issued some helpful guidance that will be of far greater interest to certain closely-held businesses that count nonresidents among their owners.

Specifically, the Dept. issued a memorandum that discusses the expansion of the definition of New York (“NY”) source income for nonresident individuals – effective for taxable years beginning on or after January 1, 2017 – to include the gain or loss from the sale of ownership interests in certain entities that own shares in cooperative housing corporations located in NY.

Before discussing the memorandum, let’s review its background.

Some History

In general, nonresidents are subject to NY personal income tax on their NY source income.

NY source income is defined as the sum of income, gain, loss, and deduction derived from or connected with NY sources. For example, where a nonresident sells real property or tangible personal property located in NY, the gain from the sale is taxable in NY.

In general, under NY tax law (the “Tax Law”), income derived from intangible personal property, including interest and gains from the disposition of such property, constitute income derived from NY sources only to the extent that the property is employed in a business, trade, profession, or occupation carried on in NY.

From 1992 until 2009, this analysis also applied to the gain from the disposition of interests in entities that owned NY real property. Thus, generally speaking, a nonresident who owned an interest in a close corporation, for example, that owned NY real property, could sell such interest without realizing NY source income and incurring NY income tax.[2]

2009 Amendment

However, in 2009, the Taw Law was amended to provide that items of gain derived from or connected with NY sources included items attributable to the ownership of any interest in real property located in NY.

For purposes of this rule, the term “real property located in” NY was defined to include an interest in a partnership, LLC, S corporation, or non-publicly traded C corporation with one hundred or fewer shareholders, that owns real property located in NY and has a fair market value (“FMV”) that equals or exceeds 50% of all the assets of the entity on the date of the sale or exchange of the taxpayer’s interest in the entity.

In accordance with an “anti-stuffing” rule, only those assets that the entity owned for at least two years before the date of the sale or exchange of the taxpayer’s interest in the entity are used in determining the FMV of all the assets of the entity on such date.

The gain or loss derived from NY sources from a nonresident’s sale or exchange of an interest in an entity that is subject to this rule is the total gain or loss for federal income tax purposes from that sale or exchange multiplied by a fraction, the numerator of which is the FMV of the real property located in NY on the date of the sale or exchange and the denominator of which is the FMV of all the assets of the entity on such date.

2017 Amendment – Coops

Then, in 2017, the definition of “real property located in NY” was expanded once again, this time to add an interest in a partnership, LLC, S corporation, or non-publicly traded C corporation with one hundred or fewer shareholders that owns shares of stock in a cooperative housing corporation where the cooperative units relating to the shares are located in NY, provided that the sum of the FMV of the entity’s real property located in NY, plus the FMV of its cooperative shares, and related cooperative units, equals or exceeds fifty percent of all the assets of the entity on the date of the sale or exchange of the nonresident taxpayer’s interest in the entity.

This is no small change when one considers (a) the number of nonresidents with interests in entities that own real estate, including cooperatives, in NY, and (b) estimates that between 70% and 75% of Manhattan’s residential inventory consists of cooperatives.  It was also a change that was bound to occur in light of the fact that the IRS concluded long ago that stock in a NY cooperative apartment constitutes real property for many tax purposes, including the like kind exchange rules, and that NY itself has long taxed (since 2004) the gain recognized by nonresidents on their sale of cooperative apartments.

The Memorandum

The Dept.’s memorandum restates the amended Tax Law, as outlined above, and then explains that a nonresident must include all or part of the gain or loss from the sale or exchange of an interest in any of the above entities in the nonresident’s NY source income if the entity owns:

  • real property located in NY, and/or
  • shares of stock in a NY cooperative,

and the FMV of all its real property in NY and shares of stock in NY cooperatives equals or exceeds 50% of the FMV of the assets the entity has owned for at least two years on the date of the sale or exchange.

Less than Two Years

According to the memorandum, if all the entity’s assets have been owned for less than two years, then the 50% condition is met.

Fraction of Gain Included

The portion of the gain or loss the nonresident must include in NY source income is the total gain or loss reported on their federal return from that sale or exchange multiplied by the following fraction (determined as of the date of the sale or exchange): (a) the FMV of the entity’s real property in NY and the shares of stock in NY cooperatives, over (b) the FMV of all the assets that the entity owns.

Part-year Resident

A part-year resident individual – one who is not a statutory resident and who successfully changed domicile during the tax year – is subject to this inclusion rule if they have a sale or exchange of an interest in an entity and the gain or loss on the sale or exchange occurs in the nonresident portion of the tax year.

Tiered Entities

If a nonresident sells or exchanges an interest in an entity that is part of a tiered structure of entities, the change in the “NY source inclusion rule” applies to the sale or exchange if any entity in the tiered structure owns real property in NY or shares of stock in NY cooperatives.

If a partnership in a tiered structure of entities sells or exchanges its interest in an entity in the tiered structure, the partnership must determine whether it has any NY source income relating to the sale or exchange for personal income tax as if it were a nonresident individual.

Looking Ahead

In any investment transaction, a price must be established for the amount of the investor’s equity contribution in the investment entity. Similarly, in any sale by the investor of their interest in the entity – whether to a third party buyer or back to the entity itself – the price at which the interest is to be sold must be established.

Each of these situations will entail negotiations between the investor and the investment entity, and between the investor/seller and the buyer. In each case, it will behoove the investor/seller to understand and account for the tax costs of the investment and of the ultimate sale in advance of any discussions. This will enable the investor/seller to settle on the appropriate sales price: one that will yield, as closely as possible, the desired after-tax economic result.

In the case of a nonresident taxpayer with an interest in an entity that owns at least some NY real property and/or shares of stock in a NY cooperative, the taxpayer will need to determine whether the entity meets the 50% threshold described above. In some cases, depending upon the entity’s business or investment purpose, not to mention the authority or leverage possessed by the nonresident, it may be possible to periodically adjust the entity’s investment holdings – being mindful of the two-year “anti-stuffing rule” – so as to fall short of the threshold. Of course, any such adjustments must make sense from a business or investment perspective.

Where the nonresident has little control over the entity, it may be possible to “time” the sale of his or her interest, taking advantage of a drop in real estate values or of an increase in the value of other assets held by the entity (for example, securities). However, this option may be impractical in cases where, for example, a shareholders or operating agreement restricts the sale of interests in the entity.

The important point is for the nonresident to recognize at the inception of their investment in an entity that there may be an issue on a subsequent disposition of the investment, to try to account for the ultimate tax cost when pricing the acquisition of the investment and/or its later sale, and to try to secure the periodic valuation of the entity’s underlying assets so as to facilitate any decision as to a disposition, and to support one’s reporting position in the event of a sale.


[1] One of my high school teachers would sometimes respond with “tauric defecation” to a student’s excuse for not having completed an assignment. Bronx Science, after all.

[2] I’ve seen too much of this. Real property should rarely be held in a corporation by a U.S. person.

I had a call a couple of weeks ago from the owner of a business. His brother, who owned half of the business, owed some money to someone in connection with a venture that was unrelated to the business. The brother didn’t have the wherewithal to satisfy the debt and, to make matters worse, the person to whom the money was owed was a long-time customer of the business. The customer qua creditor had proposed and, under the circumstances, the brothers had agreed, that the business would satisfy the debt by significantly discounting its services to the customer over a period of time. The brothers wanted to know how they should paper this arrangement and that the resulting tax consequences would be.

We talked about bona fide loans, constructive distributions, disguised compensation, and indirect gifts. “What?” the one brother asked incredulously, “how can all that be implicated by this simple arrangement?” After I explained, he thanked me. “We’ll get back to you,” he said.

Last week, I came across this Tax Court decision.

A Bad Deal

Taxpayer and Spouse owned Corp 1, an S corporation. Taxpayer also owned Corp 2, a C corporation.

Things were going well for a while. Then Taxpayer bid and won a contract for a project overseas. Taxpayer formed LLC to engage in this project, and was its sole member. Unfortunately, the project required a bank guaranty. Taxpayer was unable to obtain such a guaranty, but he was able to obtain a line of credit, which required cash collateralization that he was only able to provide by causing each of his business entities to take out a series of small loans from other lenders.

The project did not go well, and was eventually shut down, leaving LLC with a lot of outstanding liabilities and not much money with which to pay them.

“Intercompany Transfers”

In order to avoid a default on the loans, Taxpayer tapped the assets of the other companies that he controlled. However, because Corp 1, Corp 2, and LLC were “related” to one another, he “didn’t see the merit” in creating any formal notes or other documentation when he began moving money among them.

Taxpayer caused Corp 2 to pay some of Corp 1’s and LLC’s debts. On its ledgers, Corp 2 listed these amounts as being owed to it, but on its tax returns, Corp 2 claimed them as costs of goods sold (COGS); because Corp 2 was profitable, there was enough income to make these claimed COGS valuable. That same year, Corp 2 issued Taxpayer a W-2 that was subsequently amended to reflect a much smaller amount.

In the following year, Corp 2 paid Taxpayer a large sum, which he used to pay a portion of LLC’s debts. Corp 2’s ledgers characterized these payments as “distributions”. Corp 2 also directly paid a significant portion of Corp 1’s and LLC’s expenses, which its ledger simply described as “[Affiliate] Payments.”

That same year, Corp 2 elected to be treated as an S corporation and filed its tax return accordingly, reporting substantial gross receipts and ordinary business income, which flowed through to Taxpayer. At the same time, Taxpayer and Spouse claimed a large flow-through loss from Corp 1 – a loss that was principally derived from Corp 1’s claimed deduction for “Loss on LLC Expenses Paid” and its claimed deduction for “Loss on LLC Bad Debt.” Taxpayer’s W-2 from Corp 2, however, reported a relatively small amount in wages.

The IRS Disagrees

The IRS issued notices of deficiency to: (i) Corp 2 for income taxes for the first year at issue (its last year as a C corporation), (ii) Taxpayer for income taxes for both years at issue, and (iii) Corp 2 for employment taxes for the second year at issue in respect of the amounts it “distributed” to Taxpayer and the amounts it used to pay Corp 1’s and LLC’s expenses. Taxpayer petitioned the Tax Court.

The Court considered whether:

  • Corp 2’s payment to creditors of Corp 1 and LLC were a loan between Corp 2 and those companies, or a capital contribution that was also a constructive dividend to Taxpayer;
  • Corp 1 was entitled to a bad-debt deduction for payments it made to LLC’s creditors prior to the years at issue, or for the payments Corp 2 made; and
  • Corp 2’s payments to Taxpayer and to creditors of Corp 1 and LLC should be taxed as wages to Taxpayer and, thus, also subject to employment taxes.

Loans or Constructive Dividends?

Corp 2 claimed a COGS adjustment for expenses of Corp 1 and LLC that it had paid. However, it changed its position before the Court, arguing that the payment was a loan.

The IRS countered that the payment was only “disguised” as a loan; it was not a bona fide debt. Rather, it was really a contribution of capital by Corp 2 to each of Corp 1 and LLC. According to the IRS, this made the payment a constructive dividend to Taxpayer, for which Corp 2 could not claim a deduction, thereby increasing its income.

A bona fide debt, the Court explained, “arises from a debtor-creditor relationship based upon a valid and enforceable obligation to pay a fixed or determinable sum of money.”

Whether a transfer creates a bona fide debt or, instead, makes an equity investment is a question of fact. To answer this question, the Court stated, one must ascertain whether there was “a genuine intention to create a debt, with a reasonable expectation of repayment, and did that intention comport with the economic reality of creating a debtor-creditor relationship?”

According to the Court, there are a number of factors to consider in the “debt vs equity” analysis, including the following:

  • names given to the certificates evidencing the indebtedness
  • presence or absence of a fixed maturity date
  • source of payments
  • right to enforce payments
  • participation in management as a result of the advances
  • status of the advances in relation to regular corporate creditors
  • intent of the parties
  • identity of interest between creditor and stockholder
  • “thinness” of capital structure in relation to debt
  • ability to obtain credit from outside sources
  • use to which the advances were put
  • failure of the debtor to repay
  • risk involved in making the advances.

Corp 2’s book entries showed a write-off for payments made to Corp 1 described as “Due from Related Parties” which made it seem as though Corp 2 intended the payments to be loans. But Corp 2 deducted the payments as “purchases,” thus belying the label used on its books. And when Corp 2 made the payments, it didn’t execute a note, set an interest rate, ask for security, or set a maturity date.

The lack of these basic indicia of debt and Corp 2’s inconsistent labeling weighed in favor of finding that Corp 2 intended the payments to be capital contributions, not loans.

The fact that Corp 1 and LLC were broke when Corp 2 made the payments also undermined Taxpayer’s position that the payments were loans. Taxpayer testified that LLC “had no funds” or “wasn’t capitalized,” and its only contract (for which it hadn’t been paid) had been canceled. Corp 1’s situation was similar; it had virtually no book of business, its liabilities exceeded its assets, and it was losing money.

So, Corp 2’s payments went to entities that were undercapitalized, had no earnings, and could not have obtained loans from outside lenders – all factors suggesting that the payments were capital contributions.

The Court observed that Taxpayer treated legally separate entities as one big wallet. “Taking money from one corporation and routing it to another will almost always trigger bad tax consequences unless done thoughtfully.” The Court stated that “Taxpayer did not approach LLC’s problems with any indication that he thought through these consequences or sought the advice of someone who could help him do so.”

The Court found that Corp 2’s payments were not loans to LLC and Corp 1, but were capital contributions; the entities didn’t intend to form a debtor-creditor relationship.

Constructive Dividend

The Court then considered whether Corp 2’s payments were constructive dividends to Taxpayer. A constructive dividend, the Court explained, occurs when “a corporation confers an economic benefit on a shareholder without the expectation of repayment.”

A transfer between related corporations, the Court continued, can be a constructive dividend to common shareholders even if those shareholders don’t personally receive the funds. That type of transfer is a constructive dividend if the common shareholder has direct or indirect control over the transferred property, and the transfer wasn’t made for a legitimate business purpose but, instead, primarily benefited the shareholder.

Taxpayer had complete control over the transferred funds – he was the sole shareholder of Corp 2, the sole member of LLC, and he owned 49% of Corp 1. Moreover, there was no discernible business reason for Corp 2 to make the transfers because there was no hope of repayment or contemplation of interest. The transfer was bad for Corp 2, but it was good for Taxpayer because it reduced his other entities’ liabilities.

Corp 2’s payment of LLC’s and Corp 1’s expenses, therefore, was a constructive dividend to Taxpayer.

Bad-Debt Deduction

On their tax return, Taxpayer and Spouse claimed a large flow-through loss derived from a bad-debt deduction that Corp 1 took for earlier payments it made on behalf of LLC, and a deduction that it took for “Loss on LLC Expenses Paid.” The IRS denied all of these deductions, increasing the Taxpayer’s flow-through income from Corp 1.

Before there can be a bad-debt deduction, there had to be a bona fide debt. Even when there was such a debt, the Court continued, a bad-debt deduction was available only for the year that the debt became worthless.

The Court recognized that “transactions between closely held corporations and their shareholders are often conducted in an informal manner.” However, given the significant amount of the purported debt, the Court noted that the absence of the standard indicia of debt – formal loan documentation, set maturity date, and interest payments – weighed against a finding of debt.

The only documents Taxpayer produced about the purported loans were its books.

The amount that Corp 2 paid and that Corp 1 deducted that same year as “Loss on LLC’s Expenses Paid” appeared as entries on those books. But, the Court stated, it is not enough to look at the label a corporation sticks on a transaction; one has to look for proof of its substance, which the Court found was lacking.

Based upon the “debt vs equity” factors described above, the absence of any formal signs that a debt existed, and the underlying economics of the situation, the Court found that Taxpayer was “once again just using one of his companies’ funds to pay another of the companies’ debts.” Therefore, Corp 1’s advances to LLC did not create bona fide debt for which a bad debt deduction could be claimed.

Compensation

Taxpayer argued that the payments he received from Corp 2, and that he immediately used to pay other corporate debts, was either a distribution or a loan. He also claimed that Corp 2’s payments to Corp 1’s and LLC creditors were loans.

The IRS contended that these payments were wages to Taxpayer, and argued that Corp 2 “just called them something else” to avoid employment taxes.

The Court pointed out that these payments lacked formal loan documentation, had no set interest rate or maturity date, were made to companies with no capital, and could be repaid only if the companies generated earnings. For those reasons, the payments couldn’t have been loans.

But were the payments wages, as the IRS insisted?

Wages are payments for services performed. Whether payments to an employee-shareholder are wages paid for services performed or something else – such as dividends – is a question of fact. Again, the Court emphasized that all the evidence had to be considered; one had to look to the substance of the situation, not the name the parties gave a payment.

According to the Court, a significant part of this analysis was determining what “reasonable compensation” for the employee’s services would be. Among the factors to consider in making this determination were the following:

  • employee’s qualifications
  • nature, extent and scope of the employee’s work
  • size and complexities of the business
  • comparison of salaries paid with the gross income and the net income
  • prevailing general economic conditions
  • comparison of salaries with distributions to stockholders
  • prevailing rates of compensation for comparable positions in comparable concerns
  • salary policy of the employer as to all employees
  • in the case of small corporations with a limited number of officers, the amount of compensation paid to the particular employee in previous years.

The IRS estimated the salary for the CEO of a company comparable to Corp 2, and pointed out that while Taxpayer’s W-2 fell short of this salary, the amount paid to Taxpayer came fairly close to the IRS’s estimate when combined with the contested payments. There was no reason, the Court stated, “for us to think that the IRS’s estimate was unreasonable given Taxpayer’s decades” of business experience and the fact that he singlehandedly ran three companies, one of which was very profitable.

Be Aware

The overlapping, but not necessarily identical, ownership of closely held business entities, especially those that are controlled by the members of a single family, can breed all sorts of tax issues for the entities and for their owners.

Intercompany transactions, whether in the ordinary course of business or otherwise, have to be examined to ensure that they are being undertaken for valid business reasons. That is not to say that there cannot be other motivating factors, but it is imperative that the parties treat with one another as closely as possible on an arm’s-length basis.

To paraphrase the Court, above, related companies and their owners may avoid the sometimes surprising and bad tax consequences of dealing with one another – including the IRS’s re-characterization of their transactions – if they act thoughtfully, think through the tax consequences, and seek the advice of someone who can help them.