The Tax Law

In theory, the primary purpose of the income tax, as a body of law, is to raise from the governed the resources that the government requires in order to perform its most basic functions.[i] However, as society has evolved and its needs have changed, and as “the economy” has become more complex, the government has added to the purposes, and expanded the uses, of the income tax law.

Instead of acting only as a revenue generator, the tax law has been adapted to encourage certain behavior among the governed, or segments thereof, that the government has determined will have a beneficial effect upon society as a whole.

The most obvious manifestation of the tax law as a vehicle for behavior modification is found in the tax treatment of various business and investment-related activities. Specifically, by providing favorable tax treatment[ii] to a business and its owners “in exchange” for their making certain investments or engaging in certain activities, the government hopes to create a level of economic prosperity that will benefit not only the business, its owners and employees, but also the persons with which the business transacts, including its customers and its vendors.[iii]

Among the most recent examples of the use of the tax law as an economic incentive is the creation of qualified opportunity zones and the gain deferral and gain “forgiveness” that a taxpayer may enjoy by investing in a qualified opportunity fund.[iv]

Of course, some of these incentives, though well-intentioned, fail to deliver on their promise, in some cases because the provisions under which they are offered are too complicated, in other cases because the drafters miscalculated the causal connection between the proffered incentive and the hoped-for consequences, and in still other cases because other provisions of the tax law negated or outweighed the incentive.

Within this last class of tax incentives – that have failed to attain their potential, in no small part because of other provisions of the tax law – is the exclusion from gross income of the gain from a non-corporate taxpayer’s disposition of certain “small business stock.”[v]

Capital Gain, Section 1202, & C Corps: Parallel Histories

In general, the gain from the sale or exchange of shares of stock in a corporation that have been held for more than one year is treated as long-term capital gain.[vi]

Capital Gain Rate

The net capital gain of a non-corporate taxpayer for a taxable year – i.e., their net long-term capital gain less their net short-term capital loss for the taxable year – has, for many years, been subject to a reduced federal income tax rate, as compared to the rate applicable to ordinary income.[vii]

Indeed, from 1993 into 1998, the capital gain rate was capped at 28-percent; from 1998 into 2003, it was capped at 20-percent; from 2003 through 2012, it was capped at 15-percent; and from 2013 through today, it is capped at 20-percent.[viii]

Section 1202

In 1993,[ix] Congress determined that it could encourage the flow of investment capital to new ventures and small businesses – many of which, Congress believed, had difficulty attracting equity financing – if it provided additional “relief” for non-corporate investors who risked their funds in such businesses.

Under the relief provision enacted by Congress, as Section 1202 of the Code, a non-corporate taxpayer was generally permitted to exclude 50-percent of the gain from their sale or exchange of “qualified small business stock,” subject to certain limitations. The remaining 50-percent of their gain from the sale of such stock was taxable at the applicable capital gain rate. Thus, the aggregate capital gain tax rate applicable to an individual’s sale of qualified small business stock was capped at 14-percent.[x]

However, a portion of the excluded gain was treated as a preference item for purposes of the alternative minimum tax.

In 2009, the portion of the gain excluded from gross income was increased from 50-percent to 75-percent;[xi] in other words, with the then-maximum capital gain rate of 15-percent, a taxpayer who sold qualifying stock at a gain would have been subject to a maximum effective federal rate of 3.75-percent.[xii]

In 2010, the exclusion was increased to 100-percent – which is where it remains today – and the minimum tax preference was eliminated.[xiii]

C Corporation

In order to be eligible for this benefit, the stock, and the corporation from which it was issued, had to satisfy a number of criteria – which will be described below – including the requirement that the stock must have been issued by a “qualified small business,” which was (and continues to be) defined as a C corporation.

Between a Rock and a Hard Place

The decision by a start-up business and its owners to operate through a C corporation, so as to position themselves to take advantage of the exclusion of gain from the sale of stock in a qualified small business corporation, was no small matter when the relief provision was enacted.

In 1993, when Section 1202 was enacted, the maximum federal corporate income tax rate was set at 34-percent; dividends paid to individual shareholders from a C corporation were subject to the same 39.6-percent federal income tax rate applicable to ordinary income. From 1994 through 2017, the corporate tax rate was capped at 35-percent; until 2003, dividends paid to individuals continued to be taxed at the higher rates applicable to ordinary income, though, after 2002, the federal tax rate on such dividends was reduced and tied to the federal long-term capital gain rate.

Unfortunately, beginning with 2013, the dividends paid by a C corporation to a higher-income individual shareholder became subject to the 3.8-percent surtax on net investment income, regardless of the individual’s level of participation in the corporation’s business.[xiv]

It is likely that the combination of (i) a high federal corporate tax rate, (ii) the taxation (initially at ordinary income rates) of any dividends distributed by the corporation to its shareholders – the so-called “double taxation” of C corporation profits – and (iii) the many threshold requirements that had to be satisfied (see below), conspired to prevent Section 1202 from fulfilling its mission.

Thus, the capital gain relief provision was relegated to the shadows, where it remained dormant until . . . . [xv]

Tax Cuts and Jobs Act[xvi]

Effective for taxable years of C corporations beginning after December 31, 2017, the Act reduced the federal corporate tax rate from a maximum of 35-percent to a flat 21-percent.

In addition, the Act eliminated the alternative minimum tax for C corporations.

What’s more, the Act did not change the favorable federal tax rate applicable to long-term capital gain, nor did it cease to conform the rate for dividends to the capital gain rate.

In light of the foregoing, it may be that the gain exclusion rule of Section 1202 will finally have the opportunity to play its intended role.

Although there are still many other factors that may cause the owners of a closely held business to decide against the use of a C corporation, the significant reduction in the corporate tax rate should warrant an examination of the criteria for application of Section 1202.

Qualifying Under Section 1202

This provision generally permits a non-corporate taxpayer who holds “qualified small business stock” for more than five years[xvii] to exclude the gain realized by the taxpayer from their sale or exchange of such stock (“eligible gain”).[xviii]

The excluded gain will not be subject to either the income tax or the surtax on net investment income; nor will the excluded gain be added back as a preference item for purposes of determining the taxpayer’s alternative minimum taxable income.[xix]

Limits on Exclusion

That being said, the amount of gain from the disposition of stock of a qualified corporation that is eligible for this exclusion is actually limited: it cannot exceed the greater of

  1. $10 million,[xx] reduced by the aggregate amount of eligible gain excluded from gross income by the taxpayer in prior taxable years and attributable to the disposition of stock issued by such corporation, or
  2. 10 times the aggregate adjusted bases of qualified small business stock issued by such corporation and disposed of by the taxpayer during the taxable year (with basis being determined by valuing any contributed property at fair market value at the date of contribution).[xxi]

This limitation notwithstanding, where the provision applies, a taxpayer may exclude a significant amount of gain from their gross income. Moreover, any amount of gain in excess of the limitation would still qualify for the favorable capital gain rate, though it will be subject to the surtax.

Qualified Small Business Stock

In order for a taxpayer’s gains from the disposition of their shares in a corporation to qualify for the exclusion, the shares in the corporation had to have been acquired after December 31, 1992.[xxii]

What’s more, with limited exceptions, the shares must have been acquired directly from the corporation – an original issuance, not a cross-purchase – in exchange for money or other property (not including stock), or as compensation for services provided to the corporation.[xxiii]

If property (other than money or stock) is transferred to a corporation in exchange for its stock,[xxiv] the basis of the stock received is treated as not less than the fair market value of the property exchanged. Thus, only gains that accrue after the transfer are eligible for the exclusion.[xxv]

Qualified Corporation

The corporation must be a qualified small business as of the date of issuance of the stock to the taxpayer and during substantially all of the period that the taxpayer holds the stock.[xxvi]

In general, a “qualified small business” is a domestic C corporation[xxvii] that satisfies an “active business” requirement,[xxviii] and that does not own: (i) real property the value of which exceeds 10-percent of the value of its total assets, unless the real property is used in the active conduct of a qualified trade or business,[xxix] or (ii) portfolio stock or securities (i.e., not from subsidiaries[xxx]) the value of which exceeds 10-percent of its total assets in excess of liabilities.

Active Business

At least 80-percent (by value) of the corporation’s assets (including intangible assets) must be used by the corporation in the active conduct of one or more qualified trades or businesses.[xxxi]

If in connection with any future trade or business, a corporation uses assets in certain start-up activities, research and experimental activities, or in-house research activities, the corporation is treated as using such assets in the active conduct of a qualified trade or business.[xxxii]

Assets that are held to meet reasonable working capital needs[xxxiii] of the corporation, or that are held for investment and are reasonably expected to be used within two years to finance future research and experimentation, are treated as used in the active conduct of a trade or business.[xxxiv]

Qualified Trade or Business

A “qualified trade or business” is any trade or business, other than those involving the performance of services in the fields of health, law, engineering, architecture, accounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage services, or any other trade or business where the principal asset of the trade or business is the reputation or skill of one or more of its employees.[xxxv]

The term also excludes any banking, insurance, leasing, financing, investing, or similar business, any farming business, any business involving the production or extraction of products of a character for which depletion is allowable, or any business of operating a hotel, motel, restaurant or similar business.

Gross Assets

As of the date of issuance of the taxpayer’s stock, the excess of (i) the corporation’s gross assets (i.e., the sum of the cash and the aggregate adjusted bases of other property[xxxvi] held by the corporation), without subtracting the corporation’s short-term indebtedness, over (ii) the aggregate amount of indebtedness of the corporation that does not have an original maturity date of more than one year, cannot exceed $50 million.[xxxvii] For this purpose, amounts received in the issuance of stock are taken into account.

If a corporation satisfies the gross assets test as of the date of issuance, but subsequently exceeds the $50 million threshold, stock that otherwise constitutes qualified small business stock would not lose that characterization solely as a result of that subsequent event, but the corporation can never again issue stock that would qualify for the exclusion.[xxxviii]

Subsidiaries

In the case of a corporation that owns at least 50-percent of the vote or value of a subsidiary, the parent corporation is deemed to own its ratable share of the subsidiary’s assets – based on the percentage of outstanding stock owned (by value) – and to be liable for its ratable share of the subsidiary’s indebtedness, for purposes of the qualified corporation, active business, and gross assets tests.[xxxix]

Pass-Through Entities as Shareholders

Gain from the disposition of qualified small business stock by a partnership or S corporation that is taken into account by a partner or shareholder of the pass-through entity is eligible for the exclusion, provided that (i) all eligibility requirements with respect to qualified small business stock are met, (ii) the stock was held by the entity for more than five years, and (iii) the partner or shareholder held their interest in the pass-through entity on the date the entity acquired its stock and at all times thereafter and before the disposition of the stock.[xl]

In addition, a partner or shareholder of a pass-through entity cannot exclude gain received from the entity to the extent that the partner’s or shareholder’s share of the entity’s gain exceeds the partner’s or shareholder’s interest in the entity at the time the entity acquired the sock.

Sale or Exchange of Stock

The exclusion rule of Section 1202 applies to the taxpayer’s sale or exchange of stock in a qualified small business.

Obviously, this covers a sale by the shareholders of all of the issued and outstanding shares of the corporation, subject to the limitations described above.

It should also cover the liquidation of a C corporation and its stock following the sale of its assets to a third party.[xli] In that case, the double taxation that normally accompanies the sale of assets by a C corporation may be substantially reduced.

The Future?

Assuming a non-corporate shareholder can satisfy the foregoing criteria, they will be permitted to exclude a substantial part of the gain from their sale of stock in a qualifying C corporation.

When individual entrepreneurs and investors start to understand the potential benefit of this exclusion, and as they become acclimated to the new C corporation income tax regime, with its greatly reduced tax rate and the elimination of the alternative minimum tax, they may decide that their new business venture should be formed as a C corporation, assuming it is a qualified trade or business for purposes of Section 1202.

In making this determination, however, these non-corporate taxpayers will have to consider a number of factors, among which are the following: Is the five-year minimum holding period acceptable? Will the corporation be reinvesting its profits, without regular dividend distributions?[xlii] Is it reasonable to expect that the corporation will appreciate significantly in value?

If each of these questions can be answered in the affirmative, then the taxpayer-shareholders should strongly consider whether they can structure and capitalize their business as a C corporation, and whether the corporation’s business can satisfy the requirements described above, in order that the taxpayers may take advantage of the gain exclusion rule.


[i] Stated differently, the income tax is the means by which each member of the public contributes their pre-determined share of the costs to be incurred by the government they have chosen to serve them.

[ii] I.e., a reduced tax liability.

[iii] For example, bonus depreciation under IRC Sec. 168(k).

[iv] IRC Sec. 1400Z-1 and 1400Z-2, added by P.L. 115-97 in 2017.

[v]IRC Sec. 1202.

[vi] IRC Sec. 1222.

[vii] IRC Sec. 1(h).

[viii] Beginning with 2013, a capital gain may also be subject to the 3.8-percent surtax on net investment income. IRC Sec. 1411.

[ix] P.L. 103-66; the Omnibus Budget Reconciliation Act of 1993.

[x] 50-percent of the gain taxed at 28-percent, and 50-percent taxed at 0-percent.

[xi] P.L. 111-5; the American Recovery and Reinvestment Act.

[xii] 25-percent of the gain multiplied by 15-percent.

[xiii] P.L. 111-240; the Small Business Jobs Act of 2010.

[xiv] IRC Sec. 1411.

[xv] It was rediscovered by Smeagol, who lost it to a Hobbit, who then became a star of literature and cinema.

[xvi] P.L. 115-97; the “Act.”

[xvii] This holding period begins with the day the taxpayer acquired the stock. If the taxpayer contributed property other than cash to the corporation in exchange for stock, the taxpayer’s holding period for the property is disregarded for purposes of the 5-year holding requirement.

[xviii] IRC Sec. 1202(a).

[xix] IRC Sec. 1202(a)(4).

[xx] In the case of a married individual filing a separate return, $5 million is substituted for $10 million.

[xxi] Note that the first of these limits operates on a cumulative basis, beginning with the taxpayer’s acquisition of the stock and ending with the taxable year at issue; the second operates on an annual basis, and depends upon how much stock was disposed of during the taxable year at issue.

[xxii] Seems like yesterday. In 1993, I prepared an “Alert” for Matthew Bender (the publisher) that summarized many of the changes enacted by the Omnibus Budget Reconciliation Act of 1993.

[xxiii] IRC Sec. 1202(c).

In the case of certain transfers, including, for example, a transfer by gift or at death, the transferee is treated as having acquired the stock in the same manner as the transferor, and as having held the stock during any continuous period immediately preceding the transfer during which it was held by the transferor.

Two more special rules should be noted: (i) stock acquired by the taxpayer is not treated as qualified small business stock if, at any time during the 4-year period beginning on the date 2 years before the issuance of such stock, the issuing corporation purchased any of its stock from the taxpayer or from a person “related” to the taxpayer; and (ii) stock issued by a corporation is not treated as qualified business stock if, during the 2-year period beginning on the date 1 year before the issuance of such stock, the corporation made 1 or more purchases of its stock with an aggregate value (as of the time of the respective purchases) exceeding 5-percent of the aggregate value of all of its stock as of the beginning of such 2-year period. IRC Sec. 1202(c)(3).

[xxiv] It is assumed for our purposes that any in-kind contribution to a corporation in exchange for stock qualifies under IRC Sec. 351; in other words, the contributor, or the contributing “group” of which they are a part, will be in control of the corporation immediately after the exchange; otherwise, the contribution itself would be a taxable event.

[xxv] IRC Sec. 1202(i)(1)(B). Compare this to Sec. 351 and Sec. 358, which provide that stock received in a Sec. 351 exchange has the same basis as that of the property exchanged.

[xxvi] IRC Sec. 1202(c)(2)(A).

[xxvii] Because the corporation must be a C corporation at the issuance of its stock, an S corporation issuer can never qualify for the benefits under Section 1202 by converting to a C corporation.

[xxviii] IRC Sec.1202(e)(4).

[xxix] IRC Sec. 1202(e)(7). The ownership of, dealing in, or renting of real property is not treated as the active conduct of a qualified trade or business for purposes of this rule.

[xxx] A corporation is considered a subsidiary if the parent owns more than 50-percent of the combined voting power of all classes of stock entitled to vote, or more than 50-percent in value of all outstanding stock, of such corporation.

[xxxi] IRC Sec. 1202(e)(1).

[xxxii] IRC Sec. 1202(e)(2).

[xxxiii] IRC Sec. 1202(e)(6). Sounds familiar? See the proposed regulations for under IRC Sec. 1.1400Z-2 and the definition of a qualified opportunity zone business.

The term “working capital” has not been defined for this purpose.

[xxxiv] For periods after the corporation has been in existence for at least 2 years, no more than 50-percent of the corporation’s assets may qualify as used in the active conduct of a qualified trade or business by reason of this rule. In other words, the corporation may have to be careful about raising “too much” capital.

[xxxv] IRC Sec. 1202(e)(6). Déjà vu, for the most part? See the exclusion of a “specified service trade or business” under IRC Sec. 199A’s qualified business income deduction rule.

[xxxvi] For purposes of this rule, the adjusted basis of property contributed to the corporation is determined as if the basis of the property immediately after the contribution were equal to its fair market value. IRC Sec. 1202(i).

This should be compared to the general rule under IRC Sec. 351 and Sec. 362, under which the corporation takes the contributed property with the same adjusted basis that it had in the hands of the contributing shareholder.

Property created or purchased by the corporation is not subject to this rule.

Both the corporation and the contributing taxpayer will have to be very careful to determine the fair market value of any in-kind contribution of property to the corporation lest they cause the corporation to exceed the $50 million threshold, and thereby disqualify the contributing taxpayer and any future contributors from taking advantage of Sec. 1202’s gain exclusion rule.

[xxxvii] IRC Sec. 1202(d). What’s more, the gross assets of the corporation must not have exceeded $50 million at any time after the 1993 legislation and before the issuance.

[xxxviii] Query what effect this would have on raising additional capital.

[xxxix] IRC Sec. 1202(e)(5). The subsidiary stock itself is disregarded.

[xl] IRC Sec. 1202(g).

[xli] IRC Sec. 331 treats the amount received by a shareholder in a distribution in complete liquidation of the corporation as full payment in exchange for the stock.

[xlii] In other words, will the corporation’s earnings be subject to one or two levels of tax?

Don’t Take It Lightly

Regardless of who or what they are, taxpayers have to be careful of saying things like, “I guarantee it” or “it’s guaranteed.”

First of all, they’re not Joe Namath guaranteeing a Jets victory over the Colts in Super Bowl III, where the worst thing that could have happened had Broadway Joe not delivered on his promise would have been a brief delay in the AFL/AFC’s first Super Bowl title.[i] Nor are they George Zimmer guaranteeing that you’re going to look good in a Men’s Wearhouse suit, where the worst thing that could have happened was that you . . . well . . . you didn’t look too good.

The foregoing results pale in significance to the sometimes surprising tax consequences that may accompany a taxpayer’s guarantee of a business entity’s liability.

What Are They?

Before we consider some of the more common instances of guarantees and their tax effects, it would be helpful if we first defined the term “guarantee,” at least for purposes of this discussion.

Generally speaking, the object of one person’s guarantee is another person’s obligation to perform an act – usually the repayment of an amount borrowed from a lender; stated differently, a guarantor will agree to satisfy an obligor’s indebtedness to a lender in the event the obligor itself fails to do so. The lender is typically viewed as the beneficiary of the guarantee because it provides the lender with a degree of protection from the adverse consequences of the obligor’s default under the loan.

That being said, one may just as easily characterize the obligor as the beneficiary of the guarantee because the lender may not otherwise be willing to make a loan to the obligor without the presence of the guarantee, or would be willing to do so only under less favorable terms (from the perspective of the borrower).

Tax Considerations

When considering the tax consequences of a guarantee, the focus is usually on the relationship between the guarantor and the obligor (the “beneficiary” for tax purposes); more often than not, these parties are a closely held business and its owners.

For example, the owners of a business will often be asked by a lender to personally guarantee a loan or a line of credit to their business.[ii] Alternatively, one company may be asked to guarantee the loan obligations of another company;[iii] the latter may be a parent, a subsidiary, or a sister company with respect to the guarantor.

It should be obvious that the guarantor provides an immediate economic benefit to the obligor by guaranteeing the obligor’s indebtedness to the lender; by doing so, the guarantor allows its own economic strength and creditworthiness to support the obligor.

It should also be obvious that the guarantor suffers an economic detriment because by guaranteeing the obligor’s indebtedness the guarantor has agreed to assume responsibility for the indebtedness in the event the obligor is unable to satisfy the indebtedness itself.[iv]

Which brings us to the tax question: how is this economic benefit measured, was any consideration provided by the obligor in exchange for this benefit, and what tax consequences are realized by the obligor as a result of the transaction?[v]

A Guarantee Fee?

The value of the economic benefit inuring to an obligor, and the “value” of the detriment suffered by the guarantor, as a result of a guarantee are not necessarily the same as the consideration (or fee) that may have been paid by the obligor in exchange for the guarantee; by analogy, think in terms of insurance coverage and insurance premiums – one would never guarantee an indebtedness unless the obligor was reasonably capable of satisfying the indebtedness.

With that in mind, how do a closely held business and those related to it even determine what an appropriate guarantee fee is?

If the guarantor is the controlling owner of the obligor-business, should a fee be imputed between them,[vi] such that the guarantor is deemed to have received an item of taxable income, and the obligor is deemed to have received a capital contribution of the same amount?

In the absence of any consideration for the guarantee, has there been a capital contribution by the guarantor-owner to the obligor-business? Has there been a distribution of earnings from the guarantor-subsidiary business entity to the obligor-parent business entity? If there has been, then how much? The amount of the foregone fee?

Herein lies the issue, and perhaps the source of much confusion among taxpayers. This state of affairs may best be illustrated by exploring a few not uncommon scenarios.

CFCs,[vii] U.S. Properties & Guarantees

Normally, a CFC’s non-Subpart F income – and, after 2017, its non-GILTI – is not taxable to its U.S. shareholder or shareholders unless and until the income is distributed to them.[viii] In the face of this principle, taxpayers once attempted to avoid U.S. income tax by taking loans from unrelated financial institutions and having their CFCs guarantee the loans.

Guarantee as Distribution

Then Congress amended the Code to require the inclusion in the U.S. shareholder’s income of any increase in investment in U.S. properties made by a CFC it controls. Such an investment of earnings by a CFC in U.S. properties, Congress determined, was tantamount to the repatriation of such earnings. Therefore, “U.S. property” was defined as including, among other things, an obligation of a U.S. person arising from a loan by the CFC to the U.S. person.

The Code and regulations then went further by providing that a CFC would be considered as holding an obligation of a U.S. person if the CFC was a guarantor of the obligation, where the loan was made by a third party.[ix]

They also provided that the amount of the obligation treated as held by the CFC, as a result of its guarantee, was the unpaid principal amount of the obligation; in other words, the IRS treated the CFC-guarantor as if it had made the entire loan directly, thereby acquiring a U.S. property interest – i.e., as if it had made a distribution to its U.S. shareholders of an amount equal to the principal amount of the loan – though the amount included in the gross income of the CFC’s U.S. shareholder was capped at the CFC’s earnings.[x]

S Corporation Shareholder Guarantees

The foregoing demonstrates that, in the case of a CFC, the corporation’s guarantee of its U.S. shareholder’s indebtedness bestowed a significant economic benefit upon the U.S. shareholders – one that may characterized, for tax purposes, as a distribution that accelerated the recognition by the U.S. shareholder of the CFC’s previously undistributed income.

However, where the taxpayer is a shareholder of an S corporation, the issue surrounding the shareholder’s guarantee of the corporation’s indebtedness is not one of income inclusion, or the acceleration of income recognition; rather, it is usually a question of whether the shareholder should be entitled to deduct their allocable share of S corporation loss up to the amount of indebtedness guaranteed by the shareholder.

Loss Limitation Rule

The Code provides that a shareholder may deduct their share of an S corporation’s losses only to the extent that such share does not exceed the sum of “the adjusted basis of the shareholder’s stock in the S corporation,” and “the shareholder’s adjusted basis of any indebtedness of the S corporation to the shareholder.”[xi] In other words, the shareholder cannot deduct more than the sum of the following: (i) what they have contributed to the corporation as a capital contribution,[xii] (ii) their share of corporate income and gain that has not been distributed to them by the corporation, and (iii) the amount they have loaned to the corporation. [xiii]

Any disallowed deduction – i.e., the amount by which a shareholder’s share of the corporation’s losses exceeds the shareholder’s aggregate stock and debt basis – is treated as incurred by the corporation in the succeeding taxable year with respect to the shareholder whose deductions are limited. Once the shareholder increases their basis in the S corporation, any deductions previously suspended become available to the extent of the basis increase.

Economic Outlay

The Code does not provide a means by which a shareholder may acquire basis in an S corporation’s indebtedness other than by making a direct loan to the corporation. Likewise, the courts have generally required an “actual economic outlay” by the shareholder to, or on behalf of, the corporation before determining whether the shareholder has made a bona fide loan that gives rise to an actual investment in the corporation.

A taxpayer makes an economic outlay sufficient to acquire basis in an S corporation’s indebtedness when the taxpayer incurs a ‘cost’ on a loan. The taxpayer bears the burden of establishing this basis.

It does not suffice, however, for the shareholder to have made an economic outlay. The term “basis of any indebtedness of the S corporation to the shareholder” means that there must be a bona fide indebtedness of the S corporation that runs directly to the shareholder.[xiv]

Whether a corporation’s indebtedness is “bona fide indebtedness” to a shareholder is determined under general Federal tax principles and depends upon all of the facts and circumstances.

Guarantees

Moreover, a shareholder does not obtain basis for an indebtedness of the S corporation to a third party merely by guaranteeing such indebtedness.

According to most courts and the IRS, it is when a shareholder makes a payment on bona fide indebtedness of the S corporation, for which the shareholder has acted as guarantor, that the shareholder creates a direct indebtedness between themselves and the corporation – the shareholder-guarantor steps into the shoes of the original creditor vis-à-vis the corporation to the extent of such payment – and the shareholder acquires basis for that indebtedness to the extent of that payment.[xv]

That being said, some shareholders have argued, unsuccessfully, against the form of the loan transaction; specifically, these taxpayers have claimed that the lender was, in fact, looking to them for repayment of the loan, and not to the corporation. Under this theory, the shareholders would be treated as having received the loan, and then as having made a capital contribution to the corporation. Unfortunately for them, the courts have not accepted their theory; rather, the courts have bound them to the form of their transaction – a loan to the corporation that is guaranteed by the shareholders; the fact that the corporation, and not the shareholders, made the loan payments did not help their position.

However, the fact remains that a shareholder’s guarantee of their S corporation’s indebtedness to a third party bestows a valuable benefit upon the corporation – that enables the corporation to borrow from an unrelated lender – and exposes the shareholder to a contingent liability for which the corporation likely paid no consideration.

Yet neither the IRS nor the courts have shown any willingness to accept the argument that the value of this guarantee – whether it is the amount of the guarantor’s actual or imputed fee, the value of the benefit, or the value of the detriment, however determined – should be treated as a capital contribution by the shareholder to the corporation.

Of course, a possible corollary to this position – and perhaps the reason that the argument has not found any traction – is that income should be imputed to the shareholder in exchange for their guarantee of the corporation’s indebtedness.

A more likely reason, however, is probably the difficulty in determining the value of the benefit.[xvi]

Partner Guarantees and Partnership Recourse Debt

As in the case of a shareholder of an S corporation, a partner’s distributive share of partnership loss is allowed only to the extent of the partner’s adjusted basis in their partnership interest at the end of the partnership year in which the loss occurred.[xvii]

In contrast to a shareholder’s guarantee of an S corporation’s indebtedness, however, a partner’s guarantee of a partnership’s indebtedness may increase the partner’s adjusted basis for their partnership interest,[xviii] and thereby allow the partner to claim a greater portion of their share of partnership loss.

Specifically, any increase in a partner’s share of partnership liabilities, or any increase in a partner’s individual liabilities by reason of the partner’s assumption of partnership liabilities,[xix] is treated as a contribution of money by that partner to the partnership and increases the partner’s basis in their partnership interest.

Economic Risk of Loss

A partner’s share of a partnership’s liability depends upon whether the liability is a recourse or a nonrecourse liability.

A partnership liability is a recourse liability to the extent that any partner bears the economic risk of loss for that liability. A partner’s share of a recourse liability equals the portion of that liability for which the partner bears the economic risk of loss. In other words, each partner’s share of a recourse liability is proportionate to the partner’s economic risk of loss with respect to such liability.[xx]

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

Partner Guarantee

If a partner guarantees a partnership’s liability to an unrelated lender, it would appear that the partner bears the economic risk of loss with respect to that liability – the partner is obligated to pay the lender if the partnership defaults – and, consequently, should be treated as having made a capital contribution to the partnership, which would increase the basis of the partner’s partnership interest.[xxii] The fact that the partner is never actually called upon to fulfill their guarantee is irrelevant – there does not need to be an actual economic outlay[xxiii] – it suffices that they bear the economic risk of loss.

That being said, the partner’s guarantee may be disregarded if, taking into account all the facts and circumstances, the partner’s obligation under the guarantee is subject to contingencies that make it unlikely that it will ever be discharged. In that case, the guarantee would be ignored until the event occurs that triggers the payment obligation.[xxiv]

According to the IRS, a guarantee may also be disregarded where it was not required in order to induce the lender to make the loan to the partnership, or where the terms of the loan were no different than they would have been without the guarantee.[xxv]

Take-Away

The point of the foregoing discussion was to remind the reader of a few common business situations in which one person’s guarantee of another’s indebtedness may have significant income tax consequences; based upon the volume of litigation and regulatory activity in this area, it appears that these consequences are not yet fully appreciated by many taxpayers, who are either unaware of the issue or who try to circumvent it.[xxvi]

This post does not seek to explain or justify the different tax treatment of a guarantee in one business scenario versus another; for example, a shareholder’s guarantee of an S corporation’s indebtedness versus a partner’s guarantee of a partnership’s indebtedness.

Nevertheless, I hope that the following themes were conveyed: (i) in order for a guarantee to be respected, it must serve a bona fide economic purpose – it cannot be undertaken only to generate a beneficial tax result (for example, additional basis); otherwise, the guarantee will not be given tax effect until the occurrence of the contingency to which the guarantee is directed; and (ii) the IRS’s treatment of a guarantee will depend in no small part upon the direction of the guarantee – for example, upstream, as in the case of the CFC described above, or downstream, as in the case of partner and a partnership – and the fiscal policy sought to be enforced.

Therefore, before agreeing to guarantee the indebtedness of a related person or business entity, a taxpayer should consult their tax adviser, lest any hoped-for tax consequences turn out to be unattainable, or lest the taxpayer incur an unintended tax liability.


[i] 1969. The Jets, the Mets and the Knicks won championships. The Rangers made it to the playoffs, losing to the Bruins (my then hero, goalie Eddie Giacomin, had a great regular season).

[ii] These guarantees may be joint and several, or they may be capped at a certain amount per owner. Sometimes, a lender will require that the owners secure their guarantee (perhaps by agreeing to maintain some minimum amount on deposit at the lending institution).

[iii] There are many permutations.

[iv] A contingent liability.

[v] OK, actually three questions. Have you ever known a tax person who stops at one question?

[vi] See IRC Sec. 482. The purpose of IRC section 482 is to ensure taxpayers clearly reflect income attributable to controlled transactions and to prevent avoidance of taxes regarding such transactions. It places a controlled taxpayer on a tax parity with an uncontrolled taxpayer by determining true taxable income. Transactions between one controlled taxpayer and another will be subject to special scrutiny to ascertain whether common control is being used to reduce, avoid, or escape taxes. In determining the true taxable income of a controlled taxpayer, the IRS’s authority extends to any case in which either by inadvertence or design the taxable income of a controlled taxpayer is other than it would have been had the taxpayer been dealing at arm’s length with an uncontrolled taxpayer.

[vii] A controlled foreign corporation (“CFC”) is defined as “any foreign corporation if more than 50-percent of (1) the total combined voting power of all classes of stock of such corporation entitled to vote, or (2) the total value of the stock of such corporation is owned by U.S. shareholders on any day during the taxable year of such foreign corporation.” IRC Sec. 957.

[viii] In the Tax Cuts and Jobs Act world, this would include its “high tax” income, as well as the amount representing the “reasonable” 10-percent return on the investment in tangible personal property. IRC Sec. 954(b), Sec. 951A(b).

[ix] IRC Sec. 956(d); Reg. Sec. 1.956-2(c)(1).

[x] IRC Sec. 951, Sec. 956. For a recent decision involving this issue, see the Third Circuit’s opinion in SIH Partners: https://www.bloomberglaw.com/public/desktop/document/SIHPartnersLLLPExplorerParvCommissionerofInternalRevenDocketNo180?1557583279 .

[xi] IRC Sec. 1366(d); Reg. Sec. 1.1366-2.

[xii] Cash and the adjusted basis (i.e., unreturned investment) in other property.

[xiii] Basically, amounts that remain subject to the risks of the business.

[xiv] For a recent decision involving this issue, see the Eleventh Circuit’s opinion in Meruelo: https://www.bloomberglaw.com/public/desktop/document/HomeroMeruelovCommissionerofIRSDocketNo181190911thCirMay072018Cou?1557602950 .

[xv] Reg. Sec. 1.1366-2(a)(2). But if a shareholder engages in genuine “back-to-back” loans – in which a lending entity loans the shareholder funds that he then loans directly to the S corporation – those loans can establish bona fide indebtedness running directly to the shareholder.

[xvi] See, e.g., PLR 9113009, which involved a parent’s guarantee of business-related loans for his children. Although the ruling concluded that the guarantee constituted the completed gift transfer of a valuable property right, it did not explain how that right was to be valued. The IRS later withdrew the ruling as it related to the guarantee. PLR 9409018.

[xvii] IRC Sec. 704(d). Any excess loss is carried forward.

[xviii] IRC Sec. 752(a).

[xix] A partnership obligation is a liability for purposes of IRC Sec. 752 only if, when, and to the extent that incurring the obligation (i) creates or increases the basis of any of the obligor’s assets (including cash); gives rise to an immediate deduction to the obligor; or gives rise to an expense that is not deductible in computing the obligor’s taxable income and is not properly chargeable to capital. Reg. Sec. 1.752-1(a)(4).

[xx] Reg. Sec. 1.752-2.

[xxi] For purposes of this hypothetical liquidation, the partnership’s assets are assumed to have no value, its liabilities are deemed to have become due and payable, and its assets are deemed to have been sold for no consideration other than relief from any liabilities that they secure. Reg. Sec. 1.752-2(b).

[xxii] Irrespective of the form of a partner’s contractual obligation, the IRS may treat a partner as bearing the economic risk of loss with respect to a partnership liability, or a portion thereof, to the extent that  the partner undertakes one or more contractual obligations so that the partnership may obtain or retain a loan; the contractual obligations of the partner significantly reduce the risk to the lender that the partnership will not satisfy its obligations under the loan, or a portion thereof; and one of the principal purposes of using the contractual obligations is to attempt to permit partners to include a portion of the loan in the basis of their partnership interests. Reg. Sec. 1.752-2T(j)(2).

[xxiii] Contrast this to the S corporation shareholder.

[xxiv] Reg. Sec. 1.752-2(b).

[xxv] Prop. Reg. Sec. 1.752-2(j).

[xxvi] Who may also be forgetful when it is convenient.

Beyond Income Tax

Over the last several weeks, we have explored various aspects of the choice of entity dilemma that confronts the owners of many closely held businesses, and we have considered how the Tax Cuts and Jobs Act[i] may influence their decision.

In the process, you may have realized that one form of business entity, in particular, has come under greater scrutiny and reconsideration than any other as a result of the Act – the S corporation.[ii] The reason for this is fairly obvious: the reduction in the Federal income tax rate for C corporations from a maximum rate of 35-percent to a flat rate of 21-percent, in contrast to the 37-percent maximum rate applicable to the individual shareholders of an S corporation.[iii]

Although most of our attention has been focused on the direct income tax consequences of an entity’s[iv] status as an S corporation, it is important that one also be mindful of the estate and gift tax consequences of such status as manifested in the valuation of a share of stock in an S corporation.[v]

Tax Affecting

Over the years, many appraisers have sought to “tax affect” the earnings of an S corporation for the purpose of determining the value of a share of stock of the corporation. The practice of “tax-affecting” may be applied under various hypotheses, transfer scenarios, and valuation methodologies.

In brief, tax affecting seeks to account for the fact that the income and gain of an S corporation are generally not subject to Federal income tax at the level of the S corporation. It does this by reducing an S Corporation earnings stream to reflect an “imputed” (hypothetical) C corporation income tax liability.

Thus, if a gift transfer of S corporation stock were to be valued using a so-called “market” approach that relies upon comparing the S corporation’s financials to those of comparable C corporations in the same industry (“guideline” companies) that are publicly traded, and that pay a corporate-level Federal income tax, an appraiser would consider reducing (i.e., tax affecting) the S corporation’s earnings so as not to inflate the relative value of the S corporation.[vi]

A variation on this approach would account for the fact that the shareholders of an S corporation are subject to income tax with respect to the corporation’s profits on a current basis, without regard to whether such profits have been distributed by the corporation. In order to enable these shareholders to satisfy the resulting tax liability, the S corporation must make a “tax distribution” to its shareholders, thereby reducing the amount of cash available to the corporation for reinvestment in its business or distribute to its shareholders as a return on their investment. If this fact were ignored, the thinking goes, the relative value of the S corporation would be inflated, as in the case where a discounted future cash flow valuation methodology were employed.[vii]

The IRS’s Position

The question to which tax affecting is directed can be stated as follows: would a hypothetical willing buyer of shares of stock in an S corporation tax affect the earnings of the S corporation in valuing the shares being acquired?

As one might expect, the IRS has opposed tax affecting, stating that an S corporation has a zero tax rate and, thus, no further adjustments are required, least of all to account for shareholder-specific tax attributes.

What’s more, the IRS has also argued that S corporations are tax-advantaged – they generally do not pay an entity-level income tax – and, so, they should be valued using a premium that recognizes this economic benefit.[viii]

Although most courts seem to have sided with the IRS in concluding that tax affecting would not be appropriate,[ix] a recent decision by a Federal district court seems to have accepted tax affecting under the facts before it, while at the same time rejecting the IRS’s arguments for an S corporation premium.

Gift, Audit, Payment, Refund Claim

Taxpayers were shareholders in Corp, a family-owned S corporation. Approximately 90-percent of Corp’s common stock was owned by Family; the remaining 10-percent was owned by certain employees and directors of Corp who had purchased their shares.

The purchase price for shares sold by Corp to its employees and directors was equal to 120-percent of the book value of each share. No similar formula was established for shares that were transferred among members of Family.

Certain restrictions limited the ability to sell both Family shares and non-Family shares of Corp stock, including a right-of-first-refusal in the corporation’s by-laws that required a non-Family shareholder to give Corp written notice of their intent to sell their shares, and to offer to such shares to Corp before selling to others.

The Corp by-laws also required that Family only gift, bequeath, or sell their shares to other members of Family. According to Family, this restriction ensured that they retained control of Corp, minimized the risk of disruption to Corp’s affairs by a dissident shareholder, ensured confidentiality of Corp’s affairs, and ensured that all sales of Corp minority stock were to qualified subchapter S shareholders.

As part of their estate planning, Taxpayers annually gifted minority shares of Corp stock to their children, including during the years in issue. Taxpayers filed gift tax returns (on IRS Form 709) for those years to report their gifts and to identify the fair market value (“FMV”) for the gifted shares. Taxpayers paid gift taxes with respect to the gifted shares.

The IRS challenged the valuation for the shares that Taxpayers reported on their gift tax returns. After examining the returns, the IRS assessed deficiencies, finding that the FMV of the gifted shares equaled the price used for actual share transactions between Corp and its employees. The IRS issued notices of deficiency for the tax years at issue, and Taxpayers paid the asserted deficiencies.

Taxpayers subsequently filed claims for refund for the years in issue, seeking a refund for the additional taxes paid, which Taxpayers claimed had been erroneously assessed by the IRS. After six months elapsed without receiving a response from the IRS regarding Taxpayers’ claims,[x] Taxpayers initiated a lawsuit in Federal district court to recover these gift taxes. [xi] The sole issue presented in the suit was the FMV of the Corp stock gifted by Taxpayers to their children.

The District Court

The Court began by explaining that the Federal gift tax was imposed for “each calendar year on the transfer of property by gift during such calendar year by any individual resident.”[xii] The amount of the gift, it stated, is considered to be the value of the gifted property on the date it was given.[xiii]

The determination of FMV, the Court stated, was a question of fact. The trier of fact “must weigh all relevant evidence of value and draw appropriate inferences.” The FMV of stock, the Court continued, is “the price at which the property would change hands between a willing buyer and a willing seller, neither being under any compulsion to buy or to sell and both having reasonable knowledge of relevant facts.”[xiv]

Valuation Factors

When the FMV of stock cannot be determined by examining actual sales of stock within a reasonable time before or after the valuation date, as was the case here, the FMV must generally be determined by analyzing factors that a reasonable buyer and seller would normally consider, including the following:

a) the nature of the business and the history of the corporation,

b) the economic outlook in general, and the condition and outlook of the specific industry in particular,

c) the book value of the stock and the financial condition of the business,

d) the earnings capacity of the corporation,

e) the dividend-paying capacity,

f) whether the business has goodwill or other intangible value,

g) sales of the stock and the size of the block to be valued, and

h) the market price of stocks of corporations engaged in the same or similar line of business having their stocks actively traded, either on an exchange or over the counter.[xv]

Valuation Methods

According to the Court, these factors had to be considered in light of the facts of the particular case. The FMV of non-publicly traded stock, the Court stated, is generally determined by using one or a combination of the following valuation methods: the market approach, the income approach, or the asset-based approach:

  • The market approach values a company’s non-publicly traded stock by comparing it to comparable stock sold in arms’ length transactions in the same time period.
  • The income approach values a company’s non-publicly traded stock by converting anticipated economic benefits into a single amount; valuation methods may “directly capitalize earnings estimates or may forecast future benefits (earnings or cash flow) and discount those future benefits to the present.”
  • The asset-based approach values a company’s non-publicly traded stock by analyzing the company’s assets net of its liabilities.

The Experts

Taxpayers’ experts prepared reports and provided testimony regarding the valuation of a minority share of Corp stock. Their reports used different valuation methods that resulted in different proposed valuations.

Taxpayers maintained that the Court should adopt the FMV of a minority share of Corp as determined by their expert and reported on their original gift tax returns.

The IRS abandoned its initial valuation assessments and requested that the Court adopt its expert’s conclusions of FMV.[xvi]

The Court reminded the parties that it was not bound by the opinion of any expert witness and could accept or reject expert testimony, in whole or in part. The Court then examined the experts’ opinions and methodologies.

IRS’s Expert

The IRS’s expert determined the FMV of the gifted shares by using both the market approach and the income approach, and then ascribing a weight to each. After analyzing the values under the market approach[xvii] and the income approach[xviii] – for which he applied an effective tax rate to Corp, as if it were a C corporation, and then applied a premium to account for Corp’s tax advantages as an S corporation[xix] – he weighted the market approach 60-percent and the income approach 40-percent to determine the final FMV.

Once the IRS’s expert had calculated the preliminary minority share value, he then applied marketability discounts[xx] to reach his conclusions of FMV.

The Court found that the IRS’s expert’s valuation conclusions overstated the value of a minority-held share of Corp stock.

Among other things, the Court noted that the IRS’s expert applied a separate “subchapter S premium” to his valuation. Although both the Taxpayers’ expert and the IRS’s expert applied C corporation level taxes to Corp’s earnings to effectively compare Corp to comparable C corporations, the IRS’s expert then assessed a premium to account for the tax advantages associated with subchapter S status, such as the elimination of a level of taxes, and noted that Corp did not pay C corporation taxes in any of the years in issue, and did not expect to pay such taxes in the future.

Taxpayers’ Expert

Taxpayers’ expert did not consider Corp’s subchapter S status to be a benefit that added value to a minority shareholder’s stock because a minority shareholder could not change Corp’s tax status.

The Court agreed with Taxpayers’ expert, finding that Corp’s subchapter S status was a neutral factor with respect to the valuation of Corp’s stock. The Court also explained that, notwithstanding the tax advantages associated with subchapter S status, there were also notable disadvantages, including the limited ability to reinvest in the corporation and the limited access to capital markets. Therefore, it was unclear, the Court stated, if a minority shareholder enjoyed those benefits.

Taxpayers’ expert employed the market approach, although he also incorporated concepts of the income approach into his overall analysis. He testified that the market approach was the better methodology here because there were a sufficient number of comparable companies for the years in issue. Taxpayers’ expert selected comparable guideline companies to determine the base value a minority share of Corp stock might be worth if it were sold at a mature public market. Accounting for Corp’s industry, its conservative management style, its entire book value, and other considerations, he compared Corp to companies on a “holistic” basis.

After selecting the guideline companies, he derived multiples via the ratio of market value of invested capital to EBITDA, to account for Corp’s subchapter S status, as well as multiples derived from earnings, dividends, sales, assets, and book value. He also evaluated price-to-earnings, price-to-EBITDA, and price-to-sales multiples. He then compared Corp’s multiples to each guideline company’s multiples to reach a base value for the stock.

To his base values, Taxpayers’ expert applied a discount for lack of marketability to reflect the illiquidity of the minority shares of Corp stock.[xxi]

Decision

After reviewing the reports and testimony of these experts,[xxii] the Court found that the valuation methodology of the Taxpayers’ expert was the most sound, and agreed with this expert’s determination of the FMV of Corp’s common minority stock.

Take-Away?

The Court was frugal in its discussion of tax affecting; it accepted the concept, noting that it had been employed by both the IRS and Taxpayers in valuing Corp’s stock. Indeed, it was noteworthy that even the IRS’s expert used tax affecting in his valuation report; although the Court was not bound by either expert’s opinion, it accepted their use of tax affecting in arriving at FMV.

Likewise, the Court did not dedicate much time to dismissing the IRS’s argument that Corp’s FMV should have been increased to account for the tax benefits Corp enjoyed as an S corporation. The Court simply stated that S corporations also faced many disadvantages because of their tax status,[xxiii] and found that Corp’s subchapter S status was a neutral factor with respect to the valuation of Corp’s stock.

Notwithstanding the brevity of its analysis, the Court’s decision is nonetheless important for those S corporation shareholders who are planning to transfer shares as part of their estate plan. These taxpayers, and their valuation professionals, should take some comfort in the fact that the Court accepted tax affecting – though the impact of the concept should be less significant in light of the much reduced corporate income tax rate – and also rejected the IRS’s argument for an S corporation tax premium.

That being said, it is worth remembering that there is no substitute for a timely, well-reasoned, and empirically-supported appraisal by a qualified and seasoned professional. Yes, it will cost the taxpayer some money today, but it will save the taxpayer a lot more money (including taxes, interest, penalties and attorney fees) later on.


[i] P.L. 115-97; the “Act.”

[ii] See, e.g., https://www.taxlawforchb.com/2019/04/post-2017-is-it-time-to-kick-your-corporations-s/

[iii] Perhaps 40.8-percent if the shareholder does not materially participate in the business of the S corporation.

[iv] Which may include an LLC; an LLC, that is otherwise disregarded or treated as a partnership for tax purposes, may elect to be treated as an S corporation. Reg. Sec. 301.7701-3.

[v] The increased exemption amount for Federal estate and gift tax purposes may have provided a greater cushion for valuation missteps; however, it has also encouraged greater gifting, with many individual taxpayers seeking to utilize their entire exemption so as to shift as much appreciation away from their estate, and to minimize the value of their gross estate. IRC Sec. 2010.

[vi] Apples and oranges.

[vii] Basically, the present value of a projected net positive income stream.

[viii] No double taxation of its profits: once at the corporate-level and again when distributed to the shareholders. https://www.irs.gov/pub/irs-utl/S%20Corporation%20Valuation%20Job%20Aid%20for%20IRS%20Valuation%20Professionals.pdf

[ix] See, e.g., Gross v. Comm’r, T.C. Memo 1999-254, aff’d 272 F.3d 333 (6th Cir. 2001).

[x] IRC Sec. 6532 and Sec. 7422.

[xi] The Court began its discussion by explaining that, in a suit seeking a tax refund, the taxpayers generally bear the burden of proving by a preponderance of the evidence that they are entitled to a refund of tax and what amount they should recover. The Court pointed out that while the IRS’ determination of the tax owed is presumed correct, the taxpayer may overcome this presumption, and shift the burden to the IRS, by introducing “credible evidence” or “substantial evidence” establishing that the IRS’ determination was incorrect. IRC Sec. 7491(a)(1).

However, the Court also noted that the shifting of the burden was only significant in the event of an evidentiary tie.

[xii] IRC Sec. 2501(a)(1).

[xiii] IRC Sec. 2512(a).

[xiv] Reg. Sec. 20.2031-1(b); Reg. Sec. 25.2512-1.

The hypothetical willing buyer and seller are presumed to be dedicated to achieving the maximum economic advantage.

[xv] Rev. Rul. 59-60, 1959-1 C.B. 237 (1959).

[xvi] Which would still have entitled Taxpayers to a refund.

[xvii] Under the market approach, the IRS’s expert identified several companies that were in the same business as Corp. He eliminated several companies based on dissimilar characteristics. He then completed a financial ratio analysis by comparing Corp to the guideline companies, and found two comparable companies. From there, he derived a set of multiples by looking at enterprise value to EBITDA, and price to earnings, and applied the multiples to the relevant Corp financial data.

[xviii] Under the income approach, the IRS’s expert completed a capitalized cash flow analysis. He determined a normalized net sales level and deducted the cost of goods sold and administrative expenses from the normalized net sales level to determine the income from operations.

[xix] Recognizing the value of the S-corporation structure, Corp never seriously consider terminating its S-corporation election during the years in issue. In fact, Corp’s management had previously reported to its shareholders that they expected to save over $200 million in taxes by virtue of the classification as an S-corporation during the period immediately preceding the years in issue.

[xx] He determined the discount by considering restricted stock studies, the costs of going public, and the overall academic research on the topic.

[xxi] In applying the discounts, Taxpayers’ expert considered restricted stock studies, which evaluate identical stock and determine the discount for an individual buying a share that she could not sell for some period of time. He also consulted pre-IPO studies because those studies compare the price of stock that is sold in advance of an initial public offering to the price of the stock at the time of the initial public offering. In reaching these discounts, he considered the financial position of Corp, the payment of dividends, the company’s management, the possibility of any future public offering, and Corp’s status as an S-corporation but did not quantify the impact any of these factors had on his conclusions.

[xxii] In response to the IRS’ criticism that Taxpayers’ expert did not employ a separate income approach, Taxpayers retained a second expert to prepare a report regarding the valuation of the minority-share of Corp stock using a combination of the market approach and the income approach. This expert weighted the market approach 14-percent and the income approach 86-percent. As to the market approach, she searched for comparable companies and compared those companies to Corp in terms of growth, profitability, and geographic distribution. She noted a perfectly comparable company does not exist because all potentially comparable companies were larger and more geographically diverse than Corp. She selected price-to-pre-tax-income as her multiple and used pre-tax income to capture the minority interest of the stock at issue, and to reflect Corp’s subchapter S status.

Under the income approach, Taxpayers’ second expert used the capitalized economic income method and the discount dividend method. She accounted for Corp’s subchapter S status under both methods. Under the capitalized economic income method, she adjusted the discount rate in the base cost to reflect an equivalent after-corporate and after-personal tax return. Under the discount dividend method, she used a tax rate based on three- and five-year averages and on the prior year effective date.

Her market approach and income approach yielded an “as-if-freely-traded” minority equitable interest. She averaged the values she calculated under the market approach and the income method approach to obtain an aggregate, as-if-freely-traded minority common equity value. She divided this amount by the total number of outstanding Corp shares to calculate the per-share value and applied a discount for lack of marketability each year. In determining the discount for lack of marketability, she considered company and industry characteristics, including the applicable stock restrictions and Corp’s S-corporation status. She concluded neither the stock restrictions nor the S-corporation status affected the marketability discount.

[xxiii] More specifically, because of the requirements it had to satisfy in order to maintain that tax status; for example, a single class of stock.

It’s Not All About 2017

A casual review of the recent tax literature may leave a “lay person” with the impression that, prior to the passage of the 2017 tax legislation, tax advisers had nothing else to write about.[i] Opportunity zones, GILTI, qualified business income, etc. – the spawn of 2017 dominates the tax hit parade.[ii]

That being said, the bread and butter issues of the tax professional have not changed: the adviser continues to plan for the recognition of income and deductions, gains and losses, with the ultimate goal being to reduce (or at least defer) their clients’ tax liabilities, to preserve their assets, and to thereby afford these clients the opportunity to channel their economic resources into more productive endeavors.

One example of such an issue, which was itself the subject of fairly recent legislation, and one form of which has been on the IRS’s own version of the hit parade,[iii] is captive insurance. Before getting into the details of a recent decision of the Tax Court – which illustrates what a taxpayer should not do – a brief description of captive insurance may be in order.

Captives

Assume that Acme Co.[iv] pays commercial market insurance premiums to commercial insurers to insure against various losses. These premiums are deductible in determining Acme’s taxable income. As in the case of most insurance, the premiums are “lost” every year as the coverage expires.[v]

In order to reduce the cost of insurance, a business will sometimes “self-insure” by setting aside funds to cover its exposure to a particular loss. Self-insurance, however, is not deductible.

The Code, on the other hand, affords businesses the opportunity to establish their own “small captive” insurance company.[vi] Indeed, the Code encourages them to do so by allowing the captive to receive up to $2.2 million of annual premium payments from the insured business free of income tax. What’s more, the insured business is allowed to deduct the premiums paid to the captive, provided they are “reasonable” for the risk of loss being insured. The insured business cannot simply choose to pay, and claim a deduction for, the $2.2 million maximum amount of premium that may be excluded from the captive’s income.

From a tax perspective, the key is that the captive actually operate as an insurance company. It must insure bona fide business risks. An insured risk must not be one that is certain of occurring; there must be an element of “fortuity” in order for it to be insurable.

In order to be respected as insurance, there must be “risk-shifting” and “risk distribution.” Risk shifting is the actual transfer of the risk from the insured business to the captive insurer. Risk distribution is the exposure of the captive insurer to third-party risk (as in the case of traditional insurance).[vii]

To achieve the status of real insurance (from a tax perspective), the captive pools its premiums with other captives (not necessarily from the same type of business).[viii] These pools are managed by a captive management company for a fee. The management company will conduct annual actuarial reviews to set the premium, manage claims, take care of regulatory compliance, etc. This pool will pay on claims as they arise.

In theory, the captive arrangement should lead to a reduction of the commercial premiums being paid by the business.[ix] Unfortunately for one taxpayer, they did not get the proverbial memo that explained the foregoing.

The Captive

Corp was a family business owned by Shareholders.[x] It had a number of subsidiaries, and maintained a dozen or so policies for which it paid substantial premiums.

Shareholders explored forming a captive insurance company. They met with Manager, a company that ran a captive insurance program and provided management services for captive insurance companies. At one point, Manager informed Shareholders that a captive would not be feasible unless Corp were paying at least $600,000 of premiums annually. After Manager’s chief underwriter indicated that it had “identified” up to $800,000 of premiums, Shareholders decided to form a captive.

Captive was incorporated in Delaware, and received a certificate of authority from the Department of Insurance. Captive was initially capitalized with a $250,000 irrevocable letter of credit naming the Department as the beneficiary. Captive was owned by two LLCs, each of which was wholly-owned by a different trust; the LLCs were managed by Shareholders, who were also Captive’s only officers; thus, Captive was basically a sister company as to Corp.

Captive and Corp participated in Manager’s captive insurance program. Participants in the program consisted of companies (like Corp) that purchased captive insurance and their related captive insurance companies. In general, participants did not purchase policies directly from their captive insurance companies but from “fronting carriers” related to Manager.[xi] The policies issued by the fronting carriers, which included “deductible reimbursement” policies,[xii] had a maximum benefit of $1 million.

Premiums and Coverage

Corp paid premiums directly to the fronting carriers, but the fronting carriers ceded 100-percent of the insurance risk. The responsibility for paying a covered claim under a policy was described as a two-layered arrangement: the first $250,000 of a single loss was allocated to “Layer 1,” and any loss between $250,000 and $1 million was allocated to “Layer 2.” Manager uniformly allocated 49-percent of each captive participant’s premiums to Layer 1 and 51-percent to Layer 2, notwithstanding that an actuarial consulting firm had reported that 70-percent of the loss experience would occur in Layer 1, given the proposed limits, and 30-percent in Layer 2.[xiii]

Captive reinsured[xiv] the first $250,000 of any Corp claim.[xv] Thus, shortly after the fronting carriers received Corp’s premiums, they ceded 49-percent of the net premiums to Captive.

For Corp’s claims between $250,000 and $1 million (Layer 2 claims), Captive agreed to reinsure its “quota-share” percentage of losses.[xvi] Additionally, Captive provided Layer 2 reinsurance for policies issued to unrelated companies in the fronting carriers’ pools. After the policy periods ended, the fronting carriers ceded the remaining 51-percent of net premiums to Captive less the amount of any claims paid for Layer 2 losses.

In other words, during the years in issue, Corp paid gross premiums to the fronting carriers, and the fronting carriers ceded net premiums to Captive.

Corp purchased a number of other policies during the years in issue. For example, it purchased deductible reimbursement policies that had among the highest premiums of any Corp policy. It also purchased various excess-coverage policies, under which the insurer agreed to indemnify against a loss only if it exceeded the amount covered by another policy.

Corp’s premiums were set by a non-actuary whose underwriting report did not detail any rating model, calculations, or any other analysis describing how premiums were determined. The report provided only general information about projected losses, previous claims, and information about Corp’s other insurance. Nothing in the report suggested that comparable premium information was used to price the premiums.[xvii]

Manager’s underwriting report projected that Captive would pay annual Layer 1 claims under certain policies, and projected that Captive would have an overall
“loss and loss adjustment expense” (LLAE) ratio[xviii] of 56-percent overall and 29-percent in Layer 2 for the years in issue. However, Captive’s actual LLAE ratio was only 1.5-percent: 0-percent for Layer 1 and 3-percent for Layer 2.

Corp did not file any claims under the captive program policies during the years in issue, but did file multiple claims under its commercial insurance policies, and it also paid deductibles, though it did not keep specific records of the deductibles.

Shareholders testified that they did not file captive program claims “because of time management issues.” They acknowledged that Corp did not have a claims management system in place for its captive program, though it had “different processes” in place for its commercial policies.

Captive’s Assets

Captive met Delaware’s minimum capitalization requirements during the years in issue. Its assets were listed on financial statements for each year in issue, and consisted of the initial $250,000 letter of credit, varying amounts of cash and cash equivalents, varying amounts of unceded premiums,[xix] and two life insurance policies on the lives of Shareholders.

However, Captive did not own the life insurance policies listed on the financial statements, nor was it a beneficiary of the policies. Rather, they were owned by the trusts (which were also the beneficiaries of the policies) under the terms of split-dollar life insurance agreements that required Captive to pay the premiums for the policies. Captive’s only right under the agreements was to be repaid the greater of the premiums paid or the policy’s cash value.[xx] Captive was prohibited from accessing the cash values of the policies, borrowing against the policies, surrendering or canceling the policies, or taking any other action with the respect to the policies.[xxi]

Returns and Notices of Deficiency

Captive decided to exit Manager’s captive insurance program after Captive’s premiums dropped significantly. Shareholders explained to Manager that Captive was changing managers because, among other things, they were displeased with the decrease in premiums.[xxii]

For the years preceding its exit from the captive program, Captive filed corporate tax returns on which it made a Section 831(b)[xxiii] election, and reported no taxable income.

Corp also filed returns for those years, in which the premium payments to the fronting carriers were apportioned among Corp’s subsidiaries, and deducted accordingly.[xxiv]

The IRS examined these returns and timely issued notices of deficiency. The IRS determined that Captive did not engage in insurance transactions and was not an insurance company. It found that Captive’s Section 831(b) election was invalid, and that the premiums were taxable income to Captive, and not deductible by Corp.

Corp and Captive (the “Taxpayers”) timely filed petitions with the U.S. Tax Court.

Tax Court

The issues before the Court were: (1) whether Captive was an insurance company, (2) whether the amounts received by Captive as premiums were excluded from its gross income under Section 831(b) of the Code, and (3) whether the amounts paid by Corp as premiums for insurance were deductible as business expenses.[xxv]

The Court began its discussion by briefly explaining the taxation and deductibility of micro-captive insurance payments.

Micro-Captives

The Court explained that insurance companies are generally taxed on their income in the same manner as other corporations, but that Section 831(b) provides an alternative taxing structure for certain “small” insurance companies. During the years in issue, the Court continued, an insurance company with written premiums that did not exceed $1.2 million for the year could elect to be taxed under section 831(b).[xxvi] A qualifying insurance company that made a valid election was taxable only on its investment income – its premiums were not taxable (a “micro-captive” insurance company). [xxvii]

What’s more, the captive rules do not prohibit deductions for the insured business that pays or incurs micro-captive insurance premiums, provided they are ordinary and necessary expenses paid or incurred in connection with a trade or business.[xxviii]

Real Insurance

According to the Court, in order for a company to make a valid Section 831(b) election, “it must transact in insurance.” Likewise, the deductibility of insurance premiums depended on whether they were truly payments for insurance.

The Court noted that, in order to determine whether a transaction constitutes insurance for income tax purposes, it had to consider certain principal criteria that had been developed by the case law, including whether the insurer distributed the risk among its policy holders, and whether the arrangement was “insurance in the commonly accepted sense”.[xxix]

Risk Distribution

Taxpayers argued that Captive distributed risk by participating in the fronting carriers’ captive insurance pools and reinsuring unrelated risks. In response, the Court stated that it had to decide whether those carriers were bona fide insurance companies in the first place.

The Court identified several following factors as relevant to determining whether an entity is an insurance company, including the following:

(1) there was a circular flow of funds;

(2) the policies were arm’s-length contracts;

(3) the entity charged actuarially determined premiums; and

(4) it was adequately capitalized.[xxx]

Circular Flow of Funds

Under the arrangements with the fronting carriers, Corp paid premiums to the carriers. The fronting carriers then reinsured all of the risk, making sure that

Captive received reinsurance premiums equal to the net premiums paid by Corp, less Captive’s liability for any Layer 2 claims. For the years in issue, this resulted in Corp’s paying the fronting carriers $1.37 million of gross premiums and the fronting carriers’ ceding $1.312 million of reinsurance premiums to Captive. “While not quite a complete loop,” the Court observed, “this arrangement looks suspiciously like a circular flow of funds.”

Arm’s-Length Contracts

The Court found that Corp paid upwards of five times more for its captive program policies than for its non-captive program policies.[xxxi]

In addition, various terms in the captive program policies indicated that Corp should have paid less for the captive program policies than the non-captive policies. For example, at least half of Corp’s captive program policies were for “excess coverage,” and others contained restrictive provisions, which should have resulted in a lower cost.

According to the Court, there was nothing to justify why Corp paid higher premiums for policies with more restrictive provisions than their commercial policies. The higher average rate-on-line coupled with the policies’ restrictive provisions led the Court to conclude that the policies were not arm’s-length contracts.

In addition, the Court pointed to Shareholders’ statement to Manager that one of the reasons Corp was leaving its captive program was the decrease in premiums, which reinforced the Court’s view that the policies were not arm’s-length contracts. It is fair to assume, the Court stated, that a purchaser of insurance would want the most coverage for the lowest premiums. In an arm’s-length negotiation, an insurance purchaser would want to negotiate lower premiums instead of higher premiums.

The main advantage of paying higher premiums, the Court found, was to increase deductions for Corp and the Shareholders, while shifting income to Captive, in whose hands the premiums were thought not to be taxable. With this, the Court concluded that the contracts were not arm’s-length contracts.

Actuarially Determined Premiums

The Court stated that premiums charged by a captive were actuarially determined when the company relied on an outside consultant’s “reliable and professionally produced and competent actuarial studies” to set premiums. The Court added that it would look favorably upon an outside actuary’s determination that premiums were reasonable. Premiums are not actuarially determined, it continued, when there is no evidence to support the calculation of premiums and when the purpose of premium pricing is to fit squarely within the limits of Section 831(b).

In the instant cases, the Court there were two issues with respect to the premiums: (1) the reasonableness of captive program premiums, and (2) the 49-percent to 51-percent allocation of premiums between Layer 1 and Layer 2 claims.

There was insufficient evidence in the record relating to how the premiums were set, and it was never determined whether they were reasonable. Accordingly, the policies issued by the fronting carriers did not have actuarially determined premiums.

There were also problems with the allocation of premiums between Layer 1 and Layer 2. Manager disregarded an actuarial firm’s conclusion that the majority of the premiums should be allocated to Layer 1. Moreover, Shareholders testified that they understood the purpose of the allocation was to take advantage of a tax-related safe harbor.

Accordingly, the Court found that the allocation of premiums was not actuarially determined.

Based on the foregoing factors, the Court concluded that the fronting carriers were not bona fide insurance companies for tax purposes, which meant that they did not issue insurance policies. In turn, this meant that Captive’s reinsurance of those policies did not distribute risk; therefore, Captive could not make the micro-captive election.

“Insurance” in the Commonly Accepted Sense

Although the absence of risk distribution by itself was enough to conclude that the transactions among Captive, Corp, and the fronting carriers were not insurance transactions, the Court nevertheless looked at whether these transactions might have constituted “insurance” in the commonly accepted sense. The Court indicated that the following factors should be considered in making this determination:

(1) the company was organized, operated, and regulated as an insurance company;

(2) it was adequately capitalized;

(3) the policies were valid and binding;

(4) premiums were reasonable and the result of arm’s-length transactions; and

(5) claims were paid.

Organization, Operation, and Regulation

Captive was organized and regulated as a Delaware insurance company. The question, however, was whether Captive was operated as an insurance company. In making this determination, the Court stated that it “must look beyond the formalities and consider the realities of the purported insurance transactions”.

The Court observed that during the years in issue, Corp did not submit a single claim to a fronting carrier or to Captive. Shareholders testified that there were various claims that were eligible for coverage under the deductible reimbursement policy that were not submitted. Because this policy was one of Corp’s most expensive insurance policies, Corp’s failure to submit claims after paying deductibles indicated that the arrangement did not constitute insurance in the commonly accepted sense.

Additionally, Shareholders testified that Corp had no claims process for the captive program claims, but did have “different processes” for their other claims.

Captive’s investment choices were also troubling. The life insurance policies insuring Shareholders totaled more than 50-percent of Captive’s assets and were its largest investments. Under the terms of the split-dollar agreements, however, Captive could neither access the cash value of the policies, borrow against the policies, surrender or cancel the policies, nor unilaterally terminate the agreements.

The Court did not think that an insurance company, in the commonly accepted sense, would invest more than 50-percent of its assets in an investment that it could not access to pay claims.

Valid and Binding Policies

The Court explained that policies were valid and binding when “[e]ach insurance policy identified the insured, contained an effective period for the policy, specified what was covered by the policy, stated the premium amount, and was signed by an authorized representative of the company.”

During the years in issue, neither Captive nor the fronting carriers timely issued a policy to Corp. The policies for some years were not even issued until after the policy years ended.[xxxii] What’s more, the policies issued to Corp had ambiguities and conflicts as to which entities were insured and what the policies covered.

Arrangement Not Insurance

Although Captive was organized and regulated as an insurance company and met Delaware’s minimum capitalization requirements, these insurance-like traits did not overcome the arrangement’s other failings. Captive was not operated like an insurance company. The fronting carriers charged unreasonable premiums, and issued policies with conflicting and ambiguous terms.

The arrangement among Corp, Captive, and the fronting carriers lacked risk distribution and was not insurance in the commonly accepted sense. Thus, the arrangement was not insurance for income tax purposes.

Because the arrangement was not insurance, Captive’s Section 831(b) election was invalid, and Captive had to recognize as income the premiums it received.

What’s more, Corp could not deduct the purported premium payments because the payments were not for insurance.

“This Will Never End ‘Cause I Want More”

We began this post by taking some liberty with the refrain from the theme sing to the “Vikings” television series. We end it with the first line from that song.

As was indicated earlier, a micro-captive can play an important role in a business’s management of its insurable risks. Moreover, Congress has recognized this role, and has sought to encourage businesses to utilize micro-captives.

In contrast to this legislative intent, we have advisers and taxpayers for whom the insurance benefits offered by the micro-captive do not appear to take precedence over the income tax benefits – as in the case of the Taxpayers described above – and the estate planning opportunities that captives may present.

These folks have it all backwards. The income tax benefits are not the goal to be attained – they are the incentives that Congress provided businesses that have a bona fide non-tax reason for creating a captive. Some taxpayers become so blind to this, they forget that the arrangement must actually constitute insurance. The same is true as to estate planning benefits that many identify as a reason for using a captive; these weren’t even on the table when the micro-captive was conceived (which explains the 2015 and 2018 legislatively-imposed diversification requirements that sought to limit the use of captives for that purpose).

With that, we return to our own refrain: the principal purpose for a transaction has to be a business purpose; assuming there is a valid business purpose, one is free to structure the transaction in a tax efficient manner. Without the business purpose, you can’t have more.


* Variation on Fever Ray’s “If I Had A Heart,” the theme from the History Channel’s “Vikings.” https://www.youtube.com/watch?v=DT7jxSmbMbs

[i] Undoubtedly, you’ve heard the comments about the legislation’s being a boon for tax advisers – a full-employment act, as it were. Although I cannot deny that there is much to be admired in the legislation (and even more so in the IRS’s efforts to implement it), it is undeniable that the haste with which it was drafted and enacted resulted in the diversion – should I say “misallocation?” – of resources by both the government and taxpayers.

[ii] As they should, considering that they became effective almost immediately after enactment, and considering further that some of their benefits will expire in just a few years – the victims of budget constraints.

[iii] The so-called “transactions of interest” and the “dirty dozen” list of suspect transactions.

[iv] Anyone remember Wile E. Coyote?

[v] Hopefully unused.

[vi] The captive, which is created as a C corporation, must operate like an insurance company; for example, it will reinsure some of its risk with other insurance companies, it will set aside appropriate reserves for the risks it does not cede, and it will invest the balance of the premiums received. Any investment income and gains recognized by the captive will be taxable to the captive.

[vii] The actuarial “law of large numbers” – meaning that the premiums received by the captive are pooled with the premiums received by other insurers, and this pool of premiums is used to satisfy the losses suffered by one of their insureds. The IRS has issued several rulings over the years regarding these requirements, including some so-called “safe harbors” (see below).

[viii] This is how risk distribution is effectuated.

[ix] For example, by permitting a larger deductible thereon.

[x] Corp was an S corporation.

[xi] The Court explained that a “fronting company” issues fronting policies, which are “a risk management technique in which an insurer underwrites a policy to cover a specific risk but then cedes the risk to a reinsurer.”

[xii] To cover large deductibles payable by the insured under commercial policies.

[xiii] Manager did not change the 51-49-percent premium allocation in response to the actuarial firm’s findings. Shareholders testified that the purpose of the allocation was to take advantage of a tax-related “safe harbor”.

According to the Court, “the safe harbor is almost certainly Rev. Rul. 2002-89, 2002-2 C.B. 984.”

This ruling addressed a captive insurance arrangement between a parent corporation and its wholly-owned captive subsidiary.

In Situation 1, the premiums that the subsidiary earned from its arrangement with the parent constituted 90% of its total premiums earned during the taxable year on both a gross and a net basis. The liability coverage the subsidiary provided to the parent accounted for 90% of the total risks borne by the subsidiary. The IRS found that the arrangement lacked the requisite risk shifting and risk distribution to constitute insurance for federal income tax purposes.

In Situation 2, the premiums that the subsidiary earned from its arrangement with its parent constituted less than 50% of the total premiums it earned during the taxable year on both a gross and a net basis. The liability coverage it provided to its parent accounted for less than 50% of the total risks borne by the subsidiary. The premiums and risks of the parent were thus pooled with those of unrelated insureds. The requisite risk shifting and risk distribution required to constitute insurance for federal income tax purposes were present. The IRS found that the arrangement was insurance for tax purposes.

[xiv] Reinsurance is an agreement between an initial insurer (the ceding company) and a second insurer (the reinsurer), under which the ceding company passes to the reinsurer some or all of the risks that the ceding company assumes through the direct underwriting of insurance policies. Generally, the ceding company and the reinsurer share profits from the reinsured policies, and the reinsurer agrees to reimburse the ceding company for some of the claims that the ceding company pays on those policies. Think of it as insurance for the risks “assumed” by an insurer.

[xv] A Layer 1 claim.

[xvi] The ratio of: (1) the net premium Corp paid to that portfolio to (2) the aggregate net premiums the portfolio received for the insurance period.

[xvii] Manager conducted an actuarial feasibility study for Captive for the purpose of determining Captive’s ability to remain solvent, not to price the premiums or to determine whether they were reasonable.

[xviii] The LLAE ratio is the cost of losses and loss adjustment expenses divided by the total premiums.

[xix] Premiums for risks that were not ceded to a reinsurer.

[xx] An “equity” type split-dollar arrangement. Reg. Sec. 1.61-22.

[xxi] The split-dollar agreements could be terminated only through the mutual consent of Captive, the insured, and the trust. Within 60 days of termination, the owner had the option to obtain a release of Captive’s interest in the policy. To obtain the release, the policy owner was required to pay Captive the greater of: (1) the premiums that it paid with respect to the policy or (2) the policy’s cash value. If the policy owner did not obtain a release, ownership of the policy reverted to Captive.

[xxii] Yes, you heard right. In fact, at trial, Shareholder testified the he was disappointed in the premium decrease because there were fixed costs associated with a captive manager and it made the most sense to have as much coverage as possible with the captive manager.

[xxiii] https://www.law.cornell.edu/uscode/text/26/831

[xxiv] Because Corp was an S corporation, the deductions flowed through to the Shareholders.

[xxv] “Ordinary and necessary” under Sec. 162 of the Code.

[xxvi] The 2015 amendments to sec. 831(b) increased the premium ceiling to $2.2 million (adjusted for inflation) and added new diversification requirements that an insurance company must meet to be eligible to make a Sec. 831(b) election. The Protecting Americans from Tax Hikes Act of 2015, P.L. 114-113. The 2018 amendments clarified the diversification requirements. Consolidated Appropriations Act of 2018, P.L. 115-141.

[xxvii] Sec. 831(b)(1).

[xxviii] Reg. Sec. 1.162-1(a).

[xxix] The other criteria: was there an insurable risk, and was risk of loss shifted to the insurer?

[xxx] Other factors included: the entity was created for legitimate nontax reasons; it was subject to regulatory control and met minimum statutory requirements; it paid claims from a separately maintained account; it faced actual and insurable risk comparable coverage was more expensive or not available.

[xxxi] The captive policies had a higher “rate-on-line.” A higher rate-on-line means that insurance coverage is more expensive per dollar of coverage.

[xxxii] An insurance binder is a “written instrument, used when a policy cannot be immediately issued, to evidence that the insurance coverage attaches at a specified time and continues . . . until the policy is issued or the risk is declined and notice thereof is given.”

 

Choice of Entity

Following the enactment of the Tax Cuts and Jobs Act,[i] tax advisers were inundated with inquiries from the individual owners of closely held businesses regarding a broad spectrum of topics.[ii] Perhaps the most often repeated question concerned the form of legal entity through which such a business should be operated. Of course, the impetus for this heightened interest in the “choice of entity” for the business was the Act’s significant reduction in the federal corporate tax rate.[iii]

This question, in turn, took several forms; for example, “Should I incorporate my single member LLC as a C corporation?” and “Should we incorporate our partnership?”[iv]

In the end, the flexibility that the LLC and partnership structures afford the closely held business and its owners from a tax perspective, plus the single level of tax that is imposed on their profits,[v] will probably result in a decision by the individual owners of such entities to retain their unincorporated status, notwithstanding that the owners do not enjoy any tax deferral for these profits, and despite the fact such profits are taxable to them up to a maximum federal income tax rate of 37 percent,[vi] though this may be reduced to as low as 29.6 percent if the qualified business income deduction is fully utilized.[vii]

Which leaves us with the “runner-up” question among business owners: “Should we revoke our corporation’s ‘S’ election?”

The S Corporation

Ah, the S corporation.[viii] Not more than 100 shareholders.[ix] Not more than one class of stock outstanding. No nonresident alien shareholders.[x] No shareholder who is not an individual (other than an individual’s estate, or certain trusts[xi] created by an individual).[xii]

Yes, it is a pass-through entity and, yes, it is not itself taxable.[xiii] As in the case of a partnership, its items of income, deduction, gain, loss and credit pass through to, and are reported by, its shareholders – based on the S corporation’s method of accounting – regardless of whether or not the income is distributed by the corporation to its shareholders.[xiv] Thus, there is no way to defer the shareholders’ inclusion of the corporation’s net operating income in their own gross income, where it will be taxable as ordinary income at a maximum federal rate of 37 percent, though the shareholders may benefit from the qualified business deduction.[xv]

When that S corporation income – which has already been taxed to the shareholders – is then distributed to the shareholders, the applicable basis adjustment and distribution rules generally prevent it from being taxed a second time.[xvi] In contrast, when a C corporation distributes its after-tax income to its shareholders as a dividend, that income is taxed to the shareholders at a federal income tax rate of 20 percent;[xvii] it may also be subject to the 3.8 percent surtax on net investment income.

But the S corporation is still a corporation and, so, it cannot do certain things that a partnership can; for example, it cannot distribute appreciated property to its shareholders in respect of their shares – either as a current or as a liquidating distribution – without being treated as having sold such property for consideration equal to its fair market value.[xviii]

In light of the foregoing, one might characterize the S corporation as an entity in limbo. Although its shareholders enjoy a single level of tax – albeit at the 37 percent ordinary income tax rate applicable to individuals[xix] – the single class of stock requirement limits the corporation’s ability to vary the terms of the economic arrangement among its owners. One might also add, because of the single class of stock rule and because of the limitation on which persons can be S corporation shareholders, that an S corporation cannot attract the same range of investments and investors that a partnership and C corporation can, though this may be a less important consideration in the case of most closely held businesses.[xx]

Converting from “S” to “C”?

Under those circumstances, the shareholders of an S corporation may decide that they would be better off with a C corporation. No single class of stock requirement, and no limitation on types of shareholders. Moreover, no taxation of the corporation’s profits to its shareholders unless the corporation pays a dividend.

In other words, why be saddled with the pass-through taxation of a partnership without having the flexibility of a partnership structure?

Of course, the corporation itself is taxed at a federal rate of 21 percent. That leaves a significant portion of its after-tax profits available for the replacement of depreciable properties[xxi] and for expansion, whether by acquisition or otherwise.[xxii] This should be compared to an S corporation that will typically distribute funds to its shareholders in an amount that is at least enough for them to satisfy their individual income tax liabilities attributable to the S corporation’s income.[xxiii]

Which brings us back to the question raised above: Should the shareholders of an S corporation revoke the “S” election? In other words, should the corporation be converted to a C corporation?

In addition to the “primary” factors touched upon above – which go to the question of whether to revoke an “S” election and operate as a C corporation – the shareholders of an S corporation also have to consider a number of “secondary” factors, including those tax consequences that are an ancillary, but potentially immediate, result of the decision to revoke the “S” election. Among these are the effect of the conversion on the corporation’s method of accounting, and its impact on the tax treatment of certain post-conversion distributions.

Accounting Method

Taxpayers using the cash method generally recognize items of income when actually or constructively received, and items of expense when paid.[xxiv] Taxpayers using an accrual method generally accrue items of income when all the events have occurred that fix the right to receive the income and the amount of the income can be determined with reasonable accuracy. Taxpayers using an accrual method of accounting generally may not deduct items of expense prior to when all events have occurred that fix the obligation to pay the liability, the amount of the liability can be determined with reasonable accuracy, and economic performance has occurred.[xxv]

A C corporation generally may not use the cash method, though an exception is made for C corporations to the extent their average annual gross receipts do not exceed a prescribed threshold for all prior years (the “gross receipts test”).[xxvi] Thus, it is conceivable that an S corporation that revokes its election may be required to cease using the cash method if it fails the gross receipts test, and to adopt the accrual method. This change is often accompanied by the immediate recognition of accrued income that had been deferred under the cash method; it may also result in the immediate deduction of certain items.

The Code prescribes the rules to be followed in computing taxable income in cases where the taxable income of the taxpayer for a taxable year is computed under a different method than used in the prior year; for example, when changing from the cash method to the accrual method. In computing taxable income for the “year of change,”[xxvii] the taxpayer must take into account those adjustments which are determined to be necessary solely by reason of such change, in order to prevent items of income or expense from being duplicated or omitted.[xxviii]

Net adjustments that decrease taxable income generally are taken into account entirely in the year of change, and net adjustments that increase taxable income generally are taken into account ratably during the four-taxable-year period beginning with the year of change.[xxix]

The Act contemplated that many S corporations and their shareholders would consider such a revocation in light of the greatly reduced corporate tax rate.

In order to reduce the economic “pain” stemming from such a change, the Act amended the Code to increase the threshold for the gross receipts test from $5 million to $25 million – thereby expanding the number of taxpayers that may use the cash method of accounting, even after a change in tax status[xxx] – and it provided that any adjustment in income of an “eligible terminated S corporation”[xxxi] attributable to the revocation of its S corporation election (i.e., a change from the cash method to an accrual method) would be taken into account ratably during the six-taxable-year period[xxxii] beginning with the year of change.

Following on this relief provision, the IRS announced that even if an eligible terminated S corporation is not required to change from a cash to an accrual method of accounting, but nevertheless chooses to change to an accrual method, the corporation may take the resulting adjustments into account ratably over the six-year period beginning with the year of change.[xxxiii]

Post-termination Distributions

Prior to the Act, in the case of an S corporation that converted to a C corporation, distributions of cash by the corporation to its shareholders – to the extent of corporation’s accumulated adjustments account[xxxiv] at the time of the conversion –during the post-termination transition period (the one-year period after the S corporation election terminated[xxxv]) were tax-free to the shareholders to the extent of the adjusted basis of the stock.[xxxvi]

Under the Act, in the case of a distribution of money by an eligible terminated S corporation after the post-termination period, the corporation’s accumulated adjustments account may be allocated to the distribution (a tax-free distribution), and chargeable to its accumulated earnings and profits (a taxable distribution), in the same ratio as the amount of the accumulated adjustments account bears to the amount the accumulated earnings and profits as of the effective date of the revocation.

Mechanics of Revocation

Let’s assume that the S corporation’s board of directors has decided that it would be in the best interest of the corporation and the shareholders to revoke the corporation’s “S” election. Let’s also assume that the shareholders agree – by whatever measure may be required by the corporation’s by-laws, their shareholders’ agreement, or any other governing agreement – to the revocation.[xxxvii] Finally, let’s assume that there are no contractual restrictions imposed by third parties – for example, a bank from whom the corporation has obtained a loan – that may prevent the revocation. What’s the next step?

Statement and Timing

An “S” election is terminated if the corporation revokes the election. To revoke the election, the corporation files a statement to that effect with the IRS service center where the “S” election was filed. It must include the number of shares of stock (including non-voting stock) issued and outstanding at the time the revocation is made.

If the revocation is made during the taxable year, and before the 16th day of the third month of the taxable year, it will be effective on the first day of the taxable year; a revocation made after the 15th day of the third month of the taxable year will be effective for the following taxable year.

If a corporation specifies a date for revocation, and the date is expressed in terms of a stated day, month, and year that is on or after the date the revocation is filed, the revocation is effective on and after the date so specified.

Short Year Returns and Allocations

If the revocation of an S election is effective on a date other than the first day of a taxable year of the corporation, the corporation’s taxable year in which the revocation occurs is an “S termination year.” The portion of the S termination year ending at the close of the day prior to the termination is treated as a short taxable year for which the corporation is an S corporation (the S short year). The portion of the S termination year beginning on the day the termination is effective is treated as a short taxable year for which the corporation is a C corporation (the C short year).

The corporation may allocate income or loss for the entire year (and between the two short years) on a pro rata basis. If the corporation elects not to allocate income or loss on a pro rata basis – by closing the books with the last day of the S short year – then these items are assigned to each short taxable year on the basis of the corporation’s normal method of accounting.[xxxviii] Either way, the due date for filing both short year returns is the due date for the C short year.

Re-Electing “S” Status

In general, the shareholders of an S corporation whose election is revoked may not make a new “S” election for five taxable years.[xxxix] However, the IRS may permit a new election before the five-year period expires, provided the corporation can establish that, under the relevant facts and circumstances, the IRS should consent to a new election. The fact that more than fifty percent of the stock in the corporation is owned by persons who did not own any stock in the corporation on the effective date of the revocation tends to establish that consent should be granted.[xl]

Wish I Had a Crystal Ball

The choice of entity decision is a difficult one. In the case of an established S corporation, however, it is somewhat less difficult – the shareholders are pretty much stuck with the corporate form.[xli] That said, the decision boils down to retaining or revoking “S” status for the corporation.

Because all of the corporation’s shareholders are U.S. individuals or domestic trusts created by them,[xlii] the “permanent” reduction of the corporate tax rate has made the C corporation an attractive entity choice, especially when one considers that the Section 199A qualified business income deduction will not be available to the shareholders of an S corporation after 2025.

In the end, the decision may depend upon two factors:

  • the likelihood that the corporation will be periodically distributing its profits to its shareholders, rather than reinvesting them in the corporation’s business, and
  • the period of time within which the shareholders plan to dispose of the corporation’s business.

In the context of a closely held business, these two considerations are not necessarily independent of one another; it all depends upon where the corporation is in its life cycle.

For example, in the case of a newer business, the corporation’s profits may have to be reinvested over time so as to grow the business. During this period, only those shareholders who are employed by the corporation will be able to withdraw any value from the corporation, albeit in the form of compensation for services. Under these circumstances, it may be reasonable for an S corporation to consider revoking its election; doing so would allow it to forego making a “tax distribution” to its shareholders (whether for a 40.8 percent or 33.4 percent individual tax rate),[xliii] while causing it to pay corporate level tax at a rate of only 21 percent.

By the same token, if the corporation is already approaching the point at which its shareholders will want to liquidate their investment by selling the business, the conversion from an S corporation to a C corporation may not be a reasonable move. If the anticipated sale transaction is likely to take the form of a sale of assets, followed by the liquidation of the corporation, the revocation of the corporation’s “S” election could double the tax liability from the sale.[xliv]

The difficulty lies somewhere in between these two scenarios. Where the business has matured to the point where it can pay dividends, and where its shareholder base has expanded beyond the individuals whose “sweat equity” grew the business, it will probably make sense to retain the corporation’s “S” status, especially when one considers that such an established business will probably be a target for a purchaser in the not-too-distant future.


[i] P.L. 115-97 (the “Act”).

[ii] Let’s face it, there was, and there remains, a lot to chew on.

[iii] From a maximum graduated rate of 35 percent to a flat rate of 21 percent. In addition, the corporate alternative minimum tax was repealed.

[iv] Remember, it is not necessary, from a tax perspective, that a new corporation be organized and the LLC or partnership somehow be transferred over (though there may be non-tax reasons for pursuing such a “physical” change; should one decide to pursue that route, Rev. Rul. 84-111 is the place to start). Instead, one may “check the box” in accordance with Reg. Sec. 301.7701-3, and thereby convert an unincorporated entity (i.e., a partnership or one that is disregarded for tax purposes) into an association that is treated as a corporation for tax purposes.

[v] Not to mention the gain from the sale of their assets.

[vi] An owner with respect to whom the business is a passive activity may also be subject to the 3.8 percent federal surtax on net investment income, for an effective federal rate of 40.8 percent. IRC Sec. 1411.

[vii] IRC Sec. 199A, which was enacted in conjunction with the reduced corporate tax rate in order to “level the playing field” for pass-through entities. You will recall that certain businesses do not qualify for this deduction. In addition, there are limitations on the amount of the deduction that may be claimed based, in most cases, upon 50 percent of the W-2 wages of the business. Finally, the deduction disappears after 2025.

[viii] I picture it as a slow-moving earthbound caterpillar that looks at its C corporation and LLC brethren with envy, as though they were butterflies. (No, I do not indulge in any hallucinogenic substances.)

[ix] An almost ridiculous number when you consider the effect of the counting rule for members of a family. IRC Sec. 1361(c)(1). For example, I’ve seen at least two S corporation with well over 100 shareholders as a matter of state corporate law – for purposes of the S corporation rules, however, they each had fewer than a dozen shareholders, thanks to this counting rule.

[x] The Act allows such individuals to be potential current beneficiaries of an ESBT.

[xi] See IRC Sec. 1361(c)(2), (d), (e). Individuals have to be able to plan for the disposition of their estate. That’s why the ESBT rules were enacted, for example.

[xii] IRC Sec. 1361(b). Yes, a charity may be a shareholder – but not really; just to generate a charitable contribution deduction, after which the corporation will quickly redeem the charity’s shares because, frankly, that’s what both the charity and the corporation want. From the charity’s perspective, its share of S corporation profit is treated an unrelated business income.

[xiii] There are exceptions: the built-in gains tax under IRC Sec. 1374, LIFO recapture under IRC Sec. 1363, and the excise tax on excess net investment income under IRC Sec. 1375. These, however, are the result of vestigial C corporation attributes.

And if the S corporation is doing business in New York City, it will be subject to the City’s corporate level tax at a rate of 8.85%.

[xiv] IRC Sec. 1366. This pass-through income is not subject to self-employment tax, though the corporation is required to pay reasonable compensation to its shareholder-employees. In contrast, the employment tax generally applies to the flow-through income of a partnership.

[xv] Add another 3.8 percent for a shareholder who does not materially participate in the business. IRC Sec. 1411.

[xvi] IRC Sec. 1367 and 1368. In general, an S corporation shareholder is not subject to tax on corporate distributions unless the distributions exceed the shareholder’s basis in the stock of the corporation.

[xvii] Assuming a qualified dividend. IRC Sec. 1(h)(11).

[xviii] IRC Sec. 311(b). What’s more, depending on the type of property, the gain may be treated as ordinary income. IRC Sec. 1239.

[xix] Before considering Sec. 199A.

[xx] As a general rule, I almost always advise against the “admission” of new owners, whether these are key employees or potential investors – I’ve seen too many instances of the new owner claiming abuse or mismanagement, and then seeking redress therefor, usually by asking a court to dissolve the business. In the end, only the litigators come out ahead. Better to incentive the employee through compensation, including upon a change in control. As to the investor, it will depend upon where in its lifecycle the business finds itself, and what other sources of funding it has available.

[xxi] Vehicles, machinery, other equipment, etc.

[xxii] Product lines, geographically, etc.

[xxiii] Let’s illustrate this point:

  • an S corp. has $100 of profit
    • this is taxable to its shareholders at 37%;
    • the S corp. distributes $37 to the shareholders;
    • this distribution is not taxable to the shareholders;
    • they use this $37 to pay taxes;
    • the S corp. is left with $63;
  • a C corp. has $100 of profit
    • it pays corporate tax of $21;
    • that leaves the C corp. with $79;
    • if the C corp. paid a dividend of $16 to its shareholders – so that it is left with the same $63 left in the S corp. – they would pay tax of $3.81;
  • the C corp. and its shareholders will have paid total tax of $24.81 (20% + 3.8%), or an effective rate of 24.81% on the $100 of profit;
  • this is compared to the 37% for the S corp. and its shareholders (perhaps more if the 3.8% surtax applied to any of the shareholders);
  • both corporations have $63 remaining;
  • the shareholders of the C corp. have $12.2 remaining from the dividend;
  • the shareholders of the S corp. have no part of the $37 distribution remaining.

Query: Does the fact that the C corporation – after making the above dividend distribution – end up with the same amount of funds as the S corporation – after making its “tax distribution” to its shareholders – support an argument that the C corporation retained earnings should not be subject to the accumulated earnings tax in the above circumstances? It ends up exactly where the S corporation did, and the latter is not subject to the tax.

Query also this: Granted that an S corporation may distribute all its income to its shareholders without incurring additional tax – but would it be wise to do so in the absence of a shareholders’ agreement that required shareholders to contribute additional funds to the corporation when needed? Will the corporation’s management be willing to enforce the capital call? Will the capital, instead, be provided through loans from the shareholders?

If a C corporation were to distribute all of its after-tax profits – a questionable move where a reasonable reserve would be prudent and where it may be difficult to bring the funds back if necessary – the combined effective tax rate would be 39.8 percent.

This would leave the C corporation shareholders with $60.2, whereas the S corporation shareholders would be left with $63 following the same distribution.

[xxiv] IRC Sec. 451.

[xxv] IRC Sec. 461.

[xxvi] IRC Sec. 448.

[xxvii] The year of change is the taxable year for which the taxable income of the taxpayer is computed under a different method than for the prior year.

[xxviii] IRC Sec. 481.

[xxix] Rev. Proc. 2015-13, Section 7.

[xxx] Consistent with present law, the cash method generally may not be used by taxpayers, other than those that meet the $25 million gross receipts test, if the purchase, production, or sale of merchandise is an income-producing factor.

[xxxi] An eligible terminated S corporation is any C corporation which (1) was an S corporation the day before the enactment of the Act, (2) during the two-year period beginning on the date of such enactment revokes its S corporation election, and (3) all of the owners of which on the date the S corporation election is revoked are the same owners (and in identical proportions) as the owners on the date of such enactment.

The two-year period referenced above began on December 22, 2017.

[xxxii] Instead of the usual four years.

[xxxiii] Rev. Proc. 2018-44.

[xxxiv] IRC Sec. 1368.

[xxxv] IRC Sec. 1377.

[xxxvi] IRC Sec. 1371(f).

[xxxvii] More than one-half of the number of issued and outstanding shares of stock (including non-voting stock) of the corporation must consent to the revocation of the S election. Reg. Sec. 1.1362-2. The shareholders may agree to a greater threshold among themselves.

See Reg. Sec. 1.1362-6 for details regarding the form of the shareholder’s consent.

[xxxviii] IRC Sec. 1362(e); Reg. Sec. 1.1362-3.

[xxxix] A C corporation that is starting to think about the sale of its business (assets) may be considering an “S” election so as to avoid the double taxation problem. However, it must be mindful of the built-in gains tax and its five-year recognition period.

[xl] Reg. Sec. 1.1362-5.

[xli] Unless they are willing to incur an immediate tax liability for the corporation’s built-in gain.

[xlii] Thereby eliminating the consideration of accepting capital contributions from other investors.

[xliii] S corporations will often make distributions based on the highest rate applicable to any of its shareholders: 37 percent + 3.8 percent, or (if the full Sec. 199A deduction is available) 29.6 percent + 3.8 percent.

[xliv] For example: sale of assets by C corp. for $100; $21 of corporate tax paid; $79 liquidating distribution to shareholders (who are active in the business); tax of 23.8%, or $18; total taxes paid of $39; net proceeds to shareholders of $61.

Compare to an asset sale by an S corp. for $100: no corporate tax; distribution of $100 to shareholders; no tax on the distribution: shareholders (who are active in the business) pay tax of 20% on the gain; total taxes paid of $20; net proceeds to shareholders of $80.

“You Must Choose, But Choose Wisely.”[I]

The enactment of the Tax Cuts and Jobs Act,[ii] and its undeniable bias in favor of C corporations, has spurred the owners of many closely held businesses, along with their advisers, to reevaluate the form of business entity through which they own and operate their business, and its classification for tax purposes.[iii]

As most readers are aware, the initial choice of entity and tax classification for a business is no small matter, as it will result in certain tax and economic consequences for both the entity and its owners.

A change in a business entity’s tax classification will likewise have a significant impact upon the business, and may even generate an immediate income tax liability.[iv]

You’ve Chosen – Now How Do You Get the Money Out?

Among the several factors to be considered in determining the form and tax status for a business entity, and one that many individual owners appear not to fully appreciate,[v] is the tax treatment of an owner’s withdrawal of value from the entity.

In general, an owner of a closely held business may have several options by which they can withdraw funds from the business without necessarily removing themselves from the business, as distinguished from receiving value in exchange for the business.[vi] For example, an owner may:

  • Receive compensation for services rendered to the business (an employee-employer relationship);[vii]
  • Receive rent for allowing the business to use the owner’s property (a landlord-tenant relationship);
  • Sell property to the business (a seller-buyer relationship);[viii] and
  • “Borrow” money from the business (a debtor-creditor relationship[ix]).

In each of these situations, the owner and the business will often agree to terms that are on the “generous” end of the spectrum of what is reasonable.[x]

Finally, the owners may withdraw funds from the business by causing the business entity to make a distribution with respect to their equity interests therein (a corporation-shareholder or partnership-partner relationship).

Distributions

Generally speaking, a cash distribution from a business entity to an owner with respect to their equity interest may be effected in one of two ways: a “current” distribution of cash (which does not change the owners’ relative equity in the business); and a distribution in exchange for some of the owner’s equity in the business (a partial redemption of an owner’s shares of stock, or a partial liquidation of the owner’s partnership interest).[xi]

Current Distributions

A current distribution is the most common type of cash distribution made by a business entity. In the case of an entity with only one outstanding class of equity,[xii] each owner of the equity is generally entitled to receive the same amount of cash per unit of equity as every other owner.

The timing and amount of a current distribution may vary widely from business to business. In some cases, the manager of the business will be authorized to determine, in their discretion, if or when to make a distribution, and how much to distribute.[xiii] In other cases, the owners may have agreed that all “available cash” must be distributed at least annually.[xiv] Then there are those situations – in the case of a pass-through entity – where the only distribution required to be made for a taxable year is of an amount of cash sufficient to enable the owners to pay their income taxes attributable to their share of the entity’s profits.[xv] In each of these situations, however, every owner will generally receive a distribution based upon their relative equity in the business.

Partial Redemptions

What if only one owner, out of several, needs a cash distribution? This owner may find themselves in somewhat of a bind, especially if they cannot compel a distribution, or if the entity is unwilling to make a loan to them. What’s more, because an interest in a closely held business is, by definition, not readily marketable, this owner is unlikely to find someone outside the entity who would be willing to purchase some of their equity; in fact, it may be that the owners have agreed not to sell their equity to any outsider.[xvi]

An effective way by which some businesses have addressed this issue is by “creating” a market for the owner who requires more liquidity than may be provided by a current distribution. This “market” is accomplished by causing the entity to periodically offer to buy back a predetermined portion of its equity, usually subject to a value cap set by the entity’s managers that takes into account the reasonable needs and prospects of the business.

Alternatively – and this is the way that most closely held businesses handle the issue – the entity will not have adopted a formal buy-back program; instead, its managers, acting on an ad hoc basis, will decide, when the occasion arises, whether to buy back some of the equity proffered by an owner in need of cash.

The Good, the Bad, the Tax

A cash distribution in partial redemption or liquidation of an owner’s equity in the business provides liquidity for the owner who wants to remove value from the business, may protect the liquidity needs of the business, and may avoid the tension that otherwise could arise among the owners in the absence of a buy-back program.

However, the distribution of cash comes with a business and economic cost to the distributee-owner: their equity interest will have been reduced, they will likely be entitled to a smaller share of business profits, distributions, appreciation and sales proceeds, and they may have a smaller vote in decision-making.

Of course, there is also a tax cost to be considered, which may reduce the amount of cash available to the distributee-owner.

The income tax consequences arising from each of the foregoing cash distributions will depend upon a number of factors, including the form of business entity from which the distribution is made, and the extent to which the owner’s equity in the business is reduced.

Before the Distribution

Before considering the income tax treatment of a cash distribution from a closely held business to its owners, it would be worthwhile reviewing how the entity’s income is taxed without regard to any subsequent distribution of such income.

The taxable income of a C corporation will be subject to federal tax at the corporate level at a flat rate of 21 percent.[xvii] The after-tax income of the corporation will not be taxed to its shareholders until it is distributed to them.[xviii]

An S corporation is generally not subject to a corporate-level income tax.[xix] Rather, its taxable income flows through, and is taxed, to its shareholders[xx] at a maximum federal income tax rate of 37 percent, even though no part of such income has been distributed to the shareholders.[xxi]

In order to allow the subsequent “tax-free” distribution from the S corporation to a shareholder of an amount of cash equal to the amount of corporate income that was already included in the gross income of the shareholder, the shareholder’s adjusted basis for their S corporation shares is increased by the amount of income so included.[xxii]

As in the case of an S corporation, a partnership – including an LLC that is treated as a partnership for tax purposes – is not subject to federal income tax; its taxable income is reported by its partners on their tax returns, and they are taxed thereon without regard to whether any distribution has been made by the partnership.[xxiii]

Also as in the case of the S corporation shareholder, a partner’s adjusted basis for their partnership interest is increased by the amount of partnership income that was included in the partner’s gross income, so as to allow the distribution of such an amount of cash to the partner without triggering additional recognition of income.[xxiv]

Current Distributions

Having reviewed how the owners of a closely held business may withdraw cash from their business entity after it has been taxed to the entity, or to the owners themselves, we now turn to the income tax consequences of a current distribution to the owners.

C Corporation

A cash distribution by a C Corporation to a shareholder with respect to its stock is included in the shareholder’s gross income as a dividend to the extent the distribution is made out of the corporation’s accumulated, and current, earnings and profits.[xxv]

If the distribution satisfies the requirements for a “qualified dividend,” it will be subject to federal income tax in the hands of the shareholder at a rate of 20 percent;[xxvi] it may also be subject to the 3.8 percent federal net investment income surtax.[xxvii]

That portion of the distribution that exceeds the corporation’s earnings and profits will be applied against, and reduce, the shareholder’s adjusted basis for their stock in the corporation; basically, a tax-free return of capital.[xxviii]

To the extent the distribution exceeds the shareholder’s adjusted basis for their stock, the excess portion will be treated as gain from the sale of the stock; in other words, a deemed sale that will likely be treated as capital gain,[xxix] and taxed accordingly at a maximum federal income tax rate of 20 percent (in the case of long-term capital gain); the 3.8 percent surtax may also apply.

Assuming the corporation has only one outstanding class of stock, the declaration and payment of a dividend by the corporation’s board of directors must necessarily be made to every one of its shareholders; a shareholder cannot turn their back on the distribution and its tax consequences.

That being said, a shareholder may, if permitted by the board or by the terms of a shareholder’s agreement, choose to “leave” their share of the cash distribution in the corporation, either as an additional capital contribution or as a loan.

S Corporation

The tax consequences arising from a distribution of cash by an S corporation to its shareholders will depend, in part, upon whether the corporation has any earnings and profits from taxable years when it was a C corporation, or from a target corporation that it may have acquired in a transaction that caused it to succeed to the target’s tax attributes.[xxx] For our purposes, we will assume that the S corporation has no such earnings and profits.

In that case, a distribution of cash by an S corporation with respect to its single class of stock, which would otherwise be treated as a dividend if made by a C corporation with earnings and profits, will first be applied against the distributee-shareholder’s adjusted basis for the stock – a tax-free return of capital – and if the amount of the distribution exceeds the shareholder’s stock basis, the excess will be treated as gain from the sale of property by the shareholder.

This gain will likely be taxed as long-term capital gain,[xxxi] at a maximum federal rate of 20 percent, without regard to the composition of the underlying assets of the corporation. If the corporation’s trade or business represents a passive activity with respect to the shareholder, the 3.8 percent surtax on net investment income may also apply.

Partnership/LLC

In the case of a cash distribution[xxxii] from a partnership to a partner, gain will not be recognized by the partner except to the extent that the amount of cash distributed exceeds the partner’s adjusted basis[xxxiii] for their partnership interest immediately before the distribution.[xxxiv]

Any gain so recognized will be considered as gain from the sale of the partnership interest of the distributee partner.[xxxv] Such gain is generally treated as gain from the sale of a capital asset;[xxxvi] thus, the gain will be treated as long-term capital gain provided the partner’s holding period for their partnership interest is more than one year.[xxxvii] In that case, the maximum federal tax rate applicable to the gain will be 20 percent.

In addition, the gain may also be subject to the 3.8 percent surtax on net investment income, if the partnership’s trade or business is a passive activity with respect to the partner.[xxxviii]

However, if any of the cash deemed to have been received by the partner – in the deemed sale of their partnership interest – is attributable to any unrealized receivables[xxxix] of the partnership, or to inventory items of the partnership, then the amount of cash attributable to such assets will be treated as having been received from the sale of such assets, not from a capital asset, and will be treated as ordinary income.[xl]

Partial Redemption/Liquidation

If the current distribution described above did not occur, or if the amount thereof was insufficient for the needs of a particular owner, and assuming the business entity has agreed to redeem a portion of this owner’s equity in the business in order to get them additional cash, what are the tax consequences to the owner?

C Corporation

The tax consequences to a shareholder, some of whose shares of stock in the C corporation are acquired by the corporation from the shareholder in exchange for cash – a redemption[xli] – will depend upon the degree by which the shareholder’s ownership in the corporation is reduced relative to the ownership of the other shareholders.[xlii]

Thus, if every shareholder sold 10 percent of their shares to the issuing corporation (a pro rata redemption), none of the shareholders will have experienced a reduction in their relative ownership. In that case, and in every case in which the redemption does not result in a “meaningful” reduction[xliii] of a shareholder’s relative interest in the corporation, the cash paid by the corporation to the shareholder in exchange for some of their shares will be treated and taxed as “essentially equivalent” to a dividend, as described above, and the shareholder’s adjusted basis in the redeemed shares will be reallocated among the shareholder’s remaining shares of stock in the corporation.

However, if only one shareholder sold all but one of their shares of stock in the corporation, and such reduction was meaningful – for example, the percentage ownership represented by that one remaining share may be so small relative to the percentage of the total number of outstanding shares of the corporation that the shareholder owned before the redemption – that the redemption may be treated instead as “not essentially equivalent to a dividend;”[xliv] specifically, as a distribution in exchange for the shares redeemed by the corporation.

In that case, the shareholder will be treated as having sold the redeemed shares to the corporation and will realize gain equal to the excess of the amount paid by the corporation over the shareholder’s adjusted basis for the redeemed shares. Because the shares were likely a capital asset in the hands of the shareholder, this gain may be long-term capital gain if the shareholder’s holding period for such shares was more than one year, in which case it would taxable at a federal rate of 20 percent; the 3.8 percent federal surtax may also apply.[xlv]

The Code provides a “safe harbor” which, if satisfied, will cause the redemption of a portion of a shareholder’s shares to be treated as a sale of such shares. Specifically, immediately after the redemption, the shareholder must own less than 50 percent of the total combined voter power of the corporation’s shares. In addition, the redemption distribution must be “substantially disproportionate” with respect to the shareholder; meaning that the ratio which the voting stock of the corporation owned by the shareholder immediately after the redemption bears to all of its voting stock at that time, is less than 80 percent of the ratio which the shareholder’s voting stock before the redemption bore to all of the voting at such time. Finally, the shareholder’s ownership of all of the common stock of the corporation (voting and nonvoting) after and before the redemption, must also meet the 80percent requirement.[xlvi]

S Corporations

As in the case of a shareholder of a C corporation, the tax consequences to a shareholder, some of whose shares of stock in an S corporation are redeemed by the S corporation for cash, will depend upon the degree by which the shareholder’s ownership in the S corporation is reduced relative to the ownership of the other shareholders of the corporation.

If the reduction in the shareholder’s stock ownership is meaningful or significant enough to qualify as a sale of stock by the shareholder, then the shareholder’s gain from the redemption will be equal to the excess of the amount of cash distributed by the S corporation over the shareholder’s adjusted basis for the shares redeemed.

Provided the shareholder held the redeemed shares for more than one year, the gain will be treated as long-term capital gain, without regard to the composition of the underlying assets of the corporation, and will be taxable at a federal rate of 20 percent. If the corporation’s trade or business represents a passive activity with respect to the shareholder, then the 3.8 percent surtax may also apply to the gain.

If, instead, the redemption is treated as a current distribution, then the amount of cash distributed will be applied against the shareholder’s adjusted basis for all of their shares in the corporation, not only those shares that were redeemed. Only after the shareholder’s entire stock basis is exceeded will any remaining cash be treated as gain from the sale of a capital asset by the shareholder.

Partnership

The term “liquidation of a partner’s interest” is defined as the termination of a partner’s entire interest in a partnership by means of a distribution, or a series of distributions.[xlvii]

A distribution which is not in liquidation of a partner’s entire interest is treated as a current distribution for tax purposes. Current distributions, therefore, include distributions in partial liquidation of a partner’s interest,[xlviii] regardless of how substantial the reduction of the partner’s interest may be.[xlix]

In light of the foregoing, the same rules will apply to a partial liquidation of a partner’s equity in a partnership as apply to a current distribution. Gain will not be recognized by the partner except to the extent that the amount of cash distributed in partial liquidation of the partner’s interest – which will include the amount by which the distributee-partner’s share of partnership liabilities is reduced as a result of the reduction of the partner’s interest in partnership profit and loss[l] – exceeds the partner’s adjusted basis for their partnership interest immediately before the distribution.[li]

The gain recognized will be considered as gain from the sale of the partnership interest,[lii] and will generally be treated as gain from the sale of a capital asset,[liii] except to the extent any of the cash received by the partner is attributable to any unrealized receivables[liv] or inventory of the partnership, in which case such amount will be treated as having been received from the sale of such assets and will be treated as ordinary income.[lv]

What’s more, even if the amount of cash distributed in a partial liquidation of a partner’s interest does not exceed the distributee-partner’s adjusted basis in such interest, the partner may still be required to recognize gain from the deemed sale of certain partnership property.

Specifically, if the distributee-partner’s receipt of cash in partial liquidation of their interest results in a reduction of their share of the partnership’s unrealized receivables or inventory – as one might expect it would – the distributee-partner will be treated as having sold a portion of their interest in such receivables and inventory in exchange for a portion of the cash distribution, thereby realizing ordinary income.[lvi]

So Much for Simplicity

It is likely that a number of readers never thought that the “simple” distribution of cash by a corporation or a partnership to its owners could raise so many issues or present so many traps from a tax perspective.

The fact remains, however, that shareholders and partners are not going to turn their backs on a proffered, agreed-upon, or planned cash distribution, notwithstanding the potential tax consequences.

For that reason, it will behoove them to plan carefully for, and sufficiently in advance of, any such distributions in order that they may first identify any lurking tax issues and, having done so, to consider how to best address them.

As Fran Lebowitz once said, “A dog who thinks he is man’s best friend is a dog who obviously never met a tax lawyer.”

————————————————————————————————————————-

[i] Remember the scene with the ancient knight and the search for the Holy Grail in Indiana Jones and the Last Crusade?

[ii] P.L. 115-97. In order to level the proverbial “playing field,” the Act also added Sec. 199A to the Code, which provides a special deduction for the non-corporate owners of partnerships and for the shareholders of S corporations.

[iii] Usually an LLC taxable as a partnership, or an S corporation.

[iv] For example, the change from an association to a partnership or disregarded entity, which is generally treated as taxable liquidation of the association. See Reg. Sec. 301.7701-3(g). Another example would be the change in accounting method, from cash to accrual, that may accompany a change from S corporation to C corporation status, the resulting accelerated recognition of income, and the related tax liability.

[v] At least in my experience.

[vi] For example, following the sale of the assets of the business, or upon the sale of their equity in the business, to a third party.

[vii] “Guaranteed payments” when made by a partnership to a partner in exchange for their services or the use of their property. IRC Sec. 707(c).

[viii] Subchapter K includes “disguised sale” rules for certain cash distributions by a partnership to a partner that are related to a contribution of property by the partner to the partnership. IRC Sec. 707; Reg. Sec. 1.707-3. For purposes of our discussion, it is assumed that these rules do not apply.

[ix] This is a relationship that taxpayers often struggle to demonstrate when challenged to do so by a taxing authority. Where there is no written evidence of a loan (like a promissory note), no interest charged, no maturity date, no collateral, and no reported distributions with respect to equity, the taxing authority will likely succeed in re-characterizing the purported loan as a distribution.

[x] These are the basic withdrawal mechanisms.

They may be structured as directly as described in the text, or they may be accomplished indirectly, as where the business entity pays an owner’s personal expense or allows the owner to use business property without adequate consideration.

In these cases of constructive or imputed withdrawals of value, the taxpayer and the taxing authorities are left to determine the parties’ intentions (for example, was the payment a form of compensation or a dividend), and the tax treatment of the withdrawal, based on the facts and circumstances.

Although the converse of these situations – as where an owner receives the services of the entity, or uses or purchases its property – does not result in the withdrawal of funds from the entity, it may nevertheless enrich the owner if the terms of the arrangement are other than arm’s-length.

[xi] Of course, a business entity may also effect a complete redemption or liquidation of the owner’s entire equity, thereby removing the owner from the business. IRC Sec. 302(b)(3); IRC Sec. 736.

[xii] S corporations are allowed only one class of stock outstanding. IRC Sec. 1361(b).

[xiii] In the case of a C corporation that accumulates earnings in excess of the reasonable needs of its business, the corporation may be subject to an additional 20 percent tax. The accumulated earnings tax does not apply to S corporations and partnerships because these are flow-through entities, the income of which is taxable to their owners without regard to whether the income has been distributed to such owners.

[xiv] With the exception of reasonable reserves, why leave the money where creditors can get it? Or so the thinking goes.

[xv] This may sound straightforward, but there are many formulations. For example, should the entity use an assumed tax rate for all of its owners? Should the individual tax attributes of an owner be considered?

[xvi] This agreement may be coupled with a right of first refusal for the purpose of ensuring that the other owners, or the entity itself, will purchase the “selling” owner’s interest.

[xvii] IRC Sec. 11.

[xviii] This may be like music to the ears of a minority shareholder – a low entity-level tax, and no flow-through of income to the minority owner, with its resulting tax liability.

[xix] IRC Sec. 1363.

For our purposes, we will assume that neither the built-in gains tax, nor the tax on excess passive investment income, applies. IRC Sec. 1374 and IRC Sec. 1375.

[xx] IRC Sec. 1366.

[xxi] The surtax on net investment income may also apply to a shareholder if the shareholder does not materially participate in the business. IRC Sec. 1411.

[xxii] IRC Sec. 1367. The distribution reduces the shareholder’s adjusted basis.

[xxiii] IRC Sec. 701 and Sec. 702.

With respect to both the shareholders of an S corporation and the partners of a partnership, the IRC Sec. 199A deduction must be considered after 2017.

[xxiv] IRC Sec. 705. The distribution reduces the partner’s adjusted basis.

[xxv] IRC Sec. 301(c)(1), Sec. 316.

[xxvi] IRC Sec. 1(h)(11).

[xxvii] IRC Sec. 1411.

[xxviii] IRC Sec. 301(c)(2).

[xxix] IRC Sec. 301(c)(3).

[xxx] IRC Sec. 381; IRC Sec. 1368(c); Reg. Sec. 1.1368-1(d).

[xxxi] Assuming the holding period is satisfied.

[xxxii] Marketable securities may be treated as cash for this purpose. IRC Sec. 731(c). As mentioned elsewhere in this post, a partnership’s satisfaction of a partner’s individual liability is treated as a distribution of cash to the partner. Likewise, a reduction in a partner’s share of a partnership’s liabilities is treated as distribution of cash. IRC Sec. 752(b).

[xxxiii] The so-called “outside” basis. It should be noted that a partner’s outside basis is adjusted for the partner’s share of partnership income, deduction, etc., only on the last day of the partnership’s taxable year.

[xxxiv] IRC Sec. 731(a)(1).

If the partnership makes, or has in effect, a Sec. 754 election, the adjusted basis of the partnership assets may be increased by the amount of gain recognized by the distributee-partner. IRC Sec. 734; Reg. Sec. 1.734-1(b).

[xxxv] IRC Sec. 731(a), last sentence.

[xxxvi] IRC Sec. 741.

[xxxvii] Of course, it is possible for a partner to have a split-holding period for their partnership interest, with some of the gain being treated as short-term capital gain. Reg. Sec. 1.1223-3.

[xxxviii] IRC Sec. 1411(c)(2).

[xxxix] IRC Sec. 751(c). This includes, for example, cash basis receivables for services rendered, plus Sec. 1245 property.

[xl] IRC Sec. 751.

[xli] IRC Sec. 317.

[xlii] Attribution rules are applied for this purpose. IRC Sec. 318.

[xliii] Very much a facts and circumstances determination, depending, among other things, upon whether the stock was voting or nonvoting, and how the redemption affected the shareholder’s ability to exercise a degree of control. For example, a redemption that causes the shareholder to become a minority owner may qualify as an exchange.

[xliv] IRC Sec. 302(b)(1).

[xlv] IRC Sec. 1001; IRC Sec. 1221 and Sec. 1222.

[xlvi] IRC Sec. 302(b)(2).

[xlvii] A series of distributions may be made in one year or in more than one year, so long as they are intended to liquidate the partner’s entire interest in the partnership.

[xlviii] Reg. Sec. 1.761-1(d).

[xlix] Compare this to the case of a corporate redemption.

[l] IRC Sec. 752(b).

[li] IRC Sec. 731(a)(1).

[lii] IRC Sec. 731(a), last sentence.

[liii] IRC Sec. 741.

[liv] IRC Sec. 751(c). This includes, for example, cash basis receivables for services rendered, plus Sec. 1245 property.

[lv] IRC Sec. 751(a).

[lvi] IRC Sec. 751(b). Thankfully, this result may be avoided if the partners agree to adjust their capital accounts prior to the partially liquidating distribution; such an adjustment (and the resulting allocation) would be based upon the partners’ interests before the partial liquidation.

Once Upon A Time

I recently recalled a client that was referred to us a few years back, shortly before it was acquired by a larger company. The client was closely held by U.S. individuals and by an S corporation, and was organized as a Delaware LLC that was treated as a partnership for U.S. tax purposes.

Beginning in the early 2000’s, the LLC had formed or acquired several foreign corporate subsidiaries (the “Foreign Subs”). I remembered reviewing a few years’ worth of the LLC’s partnership tax returns (on IRS Form 1065)[i] and, based upon what I knew of the LLC’s business and that of the Foreign Subs, I did not expect to find any subpart F income on the returns – in other words, any foreign business income realized by the Foreign Subs would not have been subject to U.S. income tax in the hands of the LLC until such income was distributed as a dividend to the LLC.[ii] However, I noticed losses from foreign operations on Schedule K of the returns. When I asked about the source of the losses, I was told they were attributable to the Foreign Subs.

As I looked further into the subsidiaries, I learned that each of them was organized as a business entity with “limited liability” under the law of the jurisdiction in which it operated – meaning that no owner or member of the entity had personal liability for the entity’s obligations by reason of being a member.[iii] Thus, each Foreign Sub’s default classification for U.S. tax purposes was as an “association”; i.e., as an entity that was treated as a corporation.[iv] More relevant to the issue before me, each Foreign Sub was a “foreign eligible entity” that may have elected to change its classification for U.S. tax purposes.[v]

I asked to see the IRS Form 8832, Entity Classification Election,[vi] that I assumed must have been filed by each Foreign Sub to elect to be disregarded as an entity separate from the LLC – the so-called “check the box”.[vii] Such an election would have caused each subsidiary to be treated as a branch of the LLC, with the branch losses treated as having been realized directly by the LLC.[viii]

As it turned out, no such elections had been made. When I asked what the client intended when it acquired or organized the Foreign Subs, I was informed that they were to be treated as branches, which was consistent with the LLC’s tax returns as filed (as reflected on the Schedule K).

In order to redress the situation, we requested, and obtained, a ruling from the IRS that allowed the Foreign Subs to file late entity classification elections.

All’s well that ends well. Right?

The End of Tax Deferral

Fast forward. The LLC is no longer a client. The Tax Cuts and Jobs Act is enacted.[ix] Every U.S. person that owns a controlled foreign subsidiary that is treated as a corporation (or association) for U.S. tax purposes (a “CFC”) is scrambling to understand the new anti-deferral rules,[x] and to develop a plan for managing their impact.

In particular, tax advisers are discovering the benefits under the Act of being a direct C corporation parent of a CFC, or – in the case of an individual U.S. shareholder who owns stock of a CFC either directly, or indirectly through a partnership or an S corporation – the benefit of electing under Section 962 of the Code to be treated as a C corporation shareholder of the CFC.[xi]

GILTI

In order to limit a U.S. person’s ability to defer the U.S. taxation of a CFC’s non-subpart F, foreign-source income, the Act introduced a new class of income – “global intangible low-taxed income” (“GILTI”) – that must be included in income by a U.S. shareholder of a CFC.

This provision generally requires the current inclusion in income by a U.S. shareholder of (i) their share of a CFC’s non-subpart F income, (ii) less an amount equal to their share of 10 percent of the adjusted basis of the CFC’s tangible property used in its trade or business of a type with respect to which a depreciation deduction is generally allowable – the difference being the U.S. shareholder’s GILTI.

This income inclusion rule applies to both individual and corporate U.S. shareholders.

In the case of an individual shareholder, the maximum federal income tax rate applicable to GILTI is 37 percent. This is the rate that will apply, for example, to a U.S. individual 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 or partnership.

More forgiving rules apply in the case of a U.S. shareholder that is a domestic C corporation. Such a corporation is generally allowed a deduction of an amount equal to 50 percent of its GILTI (the “50-percent deduction”) for purposes of determining its taxable income;[xii] thus, the effective federal corporate tax rate for GILTI is actually 10.5 percent.[xiii]

In addition, for any amount of GILTI included in the gross income of a domestic 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 (the “80-percent FTC”).[xiv]

Based on the interaction of the 50-percent deduction and the 80-percent FTC, the U.S. tax rate on GILTI that is included in the income of a domestic C corporation will be zero (0) where the foreign tax rate on such income is at least 13.125 percent.[xv]

Foreign Branches

Of course, not all foreign subsidiaries of a U.S. person are treated as corporations for U.S. tax purposes. As in the case of the Foreign Subs, described above, a foreign subsidiary may be treated as a branch of its U.S. owner for tax purposes.

Because these foreign subsidiaries are not treated as corporations for U.S. tax purposes, they are not CFCs. Therefore, neither the GILTI nor the subpart F anti-deferral rules apply to them.

Rather, the income generated by a branch of a U.S. person (including income that would have been treated as GILTI in the case of a CFC) is treated as having been earned directly by the U.S. person, and is included in such U.S. person’s gross income on a current basis, without any deferral whatsoever.[xvi]

In the case of a U.S. individual owner of the branch – whether directly or through a partnership or S corporation – the foreign branch income will be subject to federal income tax at a maximum rate of 37 percent. In the case of an owner that is a C corporation, the foreign branch income will be subject to federal tax at the flat 21 percent rate applicable to corporations.

Because the branch is not a CFC for U.S. tax purposes, neither the 50-percent deduction nor the 80-percent FTC, that are available for GILTI, may be used to reduce or even eliminate the U.S. income tax on the branch income.[xvii] That being said, the U.S. owner of the branch generally may still claim a tax credit for the foreign taxes paid by the branch, thereby reducing their U.S. income tax liability attributable to the branch income.[xviii]

Incorporate the Branch?

Under these circumstances, would it make sense for the U.S. owner of the branch to incorporate the branch, and thereby convert it into a CFC, the income of which may be eligible for the reduced tax rates on GILTI described above?

Such an incorporation may be effectuated by contributing the assets comprising the branch (and subject to its liabilities) to a foreign corporation in exchange for all of its stock.

Alternatively, where the branch is held through a foreign eligible entity – a corporation, for all intents and purposes, under local law – that has elected (“checked the box”) to be treated as a disregarded entity for U.S. tax purposes (as in the case of the LLC’s Foreign Subs, described above), the U.S. owner may consider having the foreign entity elect to be treated, instead, as an association that is taxable as a corporation for U.S. tax purposes.[xix]

Either of these options may seem like a good idea – but not necessarily.

Section 367

In general, a U.S. person will not recognize gain if they transfer property to a corporation solely in exchange for stock in such corporation and, immediately after the exchange, the transferor is in control of the corporation.[xx]

However, in order to prevent a U.S. person from placing certain assets beyond the reach of the U.S. income tax by transferring them to a foreign corporation on a tax-favored basis (as described immediately above), the Code provides that if a U.S. person transfers property to a foreign corporation in exchange for stock in the foreign corporation, the transfer by the U.S. person becomes taxable.[xxi]

Prior to the Act, the Code provided an exception to this recognition rule; specifically, the transfer of property[xxii] by a U.S. person to a foreign corporation in exchange for its stock would not be treated as a taxable exchange where the property was to be used by the foreign corporation in the active conduct of a trade or business outside of the U.S.[xxiii]

The Act repealed this nonrecognition rule for exchanges after December 31, 2017. Thus, a transfer of property used in the active conduct of a trade or business outside the U.S. – a foreign branch – by a U.S. person to a foreign corporation no longer qualifies for non-recognition of gain.

Branch Losses

What’s more, the Act also added a new rule which provides that, if a U.S. corporation transfers substantially all of the assets of a foreign branch to a foreign corporation with respect to which it owns at least 10 percent of the total voting power or total value after the transfer, the U.S. corporation will include in its gross income an amount equal to the “transferred loss amount” of the branch.[xxiv]

In general, the transferred loss amount is equal to the losses incurred by the foreign branch after December 31, 2017, and before the transfer, for which a deduction was allowed to the U.S. corporation. The amount is reduced by certain taxable income earned, and gain recognized, by the foreign branch, including the amount of gain recognized by the U.S. corporation on account of the transfer of the branch assets.

What’s a Taxpayer to Do?

It appears that there aren’t many options available to a U.S. person with a foreign branch.

The U.S. person may continue to operate through the branch; it will not be subject to the GILTI rules; it will be subject to current U.S. income tax on all of its branch-derived income at its ordinary federal income tax rate; it will be entitled to a credit against its U.S. tax for any foreign income tax paid by the branch; the remittance by the branch of its earnings to the U.S. person will not be subject to U.S. tax, though the foreign jurisdiction of the branch may impose a withholding tax on such a distribution, for which a credit should be available to the U.S. person.

The U.S. person may incorporate the branch, as described above, and pay the resulting U.S. income tax liability – of course, the liability should be quantified before any change in form is effectuated; the GILTI and the CFC subpart F rules would then become applicable; with that, the recognition of a limited amount of foreign-sourced income may be deferred; in addition, the U.S. person – whether a C corporation or an individual who elects under Section 962 of the Code (including one who holds the foreign corporation stock through a partnership or an S corporation) – will be able to achieve the reduced U.S. income tax rate resulting from the application of the reduced 21 percent corporate rate, the 50-percent deduction, and the 80-percent FTC.

The U.S. taxpayer may eliminate the branch entirely – which may be impractical from a business perspective – in which case its foreign-sourced income will continue to be subject to U.S. income tax, though the taxpayer may be able to avoid paying any foreign taxes,[xxv] not to mention the U.S. reporting requirements that are attendant on the ownership and operation of a foreign business entity.

The decision will ultimately depend upon each taxpayer’s unique facts and circumstances, including the business reasons that caused the U.S. person to operate overseas to begin with.


[i] https://www.irs.gov/pub/irs-pdf/f1065.pdf

[ii] In other words, recognition of the subsidiaries’ income would have been deferred.

[iii] In general, this determination is based solely on the law pursuant to which the entity is organized. A member has personal liability, for this purpose, if the creditors of the entity may seek satisfaction of all or any portion of the debts or claims against the entity from the member as such. Reg. Sec. 301.7701-3.

[iv] I had already determined that none of the foreign subsidiaries was described in Reg. sec. 301.7701-2 as a “per se corporation.”

[v] Reg. Sec. 7701-3(a) and 301.7701-3(b)(2).

[vi] https://www.irs.gov/pub/irs-pdf/f8832.pdf

[vii] A deemed liquidation of the association. Reg. Sec. 301.7701-3(g).

[viii] A controlled foreign corporation’s losses for a taxable year do not flow through to its U.S. shareholders; rather, they reduce the CFC’s earnings and profits for the year. According to Sec. 952 of the Code, a CFC’s subpart F income for a taxable year cannot exceed its earnings and profits for that year. In addition, the amount of subpart F income included in a U.S. shareholder’s gross income for a taxable year may generally be reduced by the shareholder’s share of a deficit in the CFC’s earnings and profits from an earlier taxable year that is attributable to an active trade or business of the CFC.

[ix] December 22, 2017. P.L. 115-97; the “Act.”

[x] IRC Sec. 951A, effective for taxable years of foreign corporations beginning after December 31, 2017, and to taxable years of U.S. shareholders in which or with which such taxable years of foreign corporations end.

[xi] https://www.taxlawforchb.com/2019/03/u-s-individuals-electing-to-be-treated-as-corporations-american-werewolves/

[xii] IRC Sec. 250.

[xiii] The 21 percent flat rate multiplied by 50 percent.

[xiv] IRC Sec. 960(d). This is to be compared with the foreign tax credit available to a domestic corporation that includes subpart F income in its gross income; in that case, under IRC Sec. 960(a), the domestic corporation is deemed to have paid so much of the CFC’s foreign income taxes as are properly attributable to such subpart F income.

[xv] 13.125 percent multiplied by 80 percent equals 10.5 percent.

[xvi] Including the limited deferral that is still available under the GILTI rules.

[xvii] The Section 962 election is only available with respect to a CFC.

[xviii] The Act added a new rule that limits the ability of a U.S. taxpayer to use the “excess” foreign tax credits attributable to a branch – the amount of foreign tax paid by the branch in excess of the U.S. income tax that would otherwise be imposed on the income of the branch – to reduce the taxpayer’s U.S. income tax on its other foreign-source income.

[xix] The owner of the eligible entity would be treated as having contributed all of the assets and liabilities of the entity to the association in exchange for stock of the association. Reg. Sec. 301.7701-3(g).It should be noted that, in general, an entity that has already elected to change its tax classification cannot make a second election during the 60-month period following the effective date of the first election.

[xx] IRC Sec. 351.

[xxi] IRC Sec. 367(a). This is accomplished by providing that the foreign corporation shall not be considered a corporation for purposes of Section 351 of the Code.

[xxii] Certain assets were excluded from this rule; for example, inventory and certain intangibles.

[xxiii] The “active trade or business” exception to gain recognition under Section 367(a) of the Code. Reg. Sec. 1.367(a)-2.

[xxiv] IRC Sec. 91.

[xxv] It may not be treated as “doing business” in the foreign jurisdiction. In the case of a treaty country, the U.S. taxpayer may be treated as not having a permanent establishment in the foreign country.

Yesterday, in Part I, we reviewed the like-kind exchange rules. https://www.taxlawforchb.com/2019/04/deferring-real-property-gain-like-kind-exchange-or-opportunity-fund-part-i/

Now we turn to the new kid on the block.

Qualified Opportunity Zones

The Act added Section 1400Z-2 to the Code, which allows a taxpayer to elect to temporarily defer the recognition of gain from the disposition of property which is reinvested in a QOF.[i] This includes gain from the disposition of real property.

QOF

In general, a QOF is an investment vehicle organized as a corporation or as a partnership for the purpose of investing in qualified opportunity zone property,[ii] and that holds at least 90-percent of its assets in such property.[iii]

In contrast to the like-kind exchange rules, the property that generated the gain that a taxpayer invests in a QOF need not be like-kind to the property held by the QOF. This may afford a taxpayer the opportunity to diversify on a tax-deferred basis.

That is not to say that diversification is not possible in the context of a like-kind exchange – though such diversification must occur within the universe of real property; for example, a taxpayer may acquire property in a different geographic area, they may acquire commercial property rather than residential, and vice versa, or they may acquire multiple replacement properties for a single relinquished property – but they must acquire real property.

Eligible Gain

Only capital gain is eligible for deferral under Section 1400Z-2.[iv]

Thus, capital gain from the sale of land held by the taxpayer for investment is eligible,[v] as is gain from the sale of real property that is used in the taxpayer’s trade or business and that is held for more than one year.[vi]

In addition, the capital gain from the sale of a taxpayer’s interest in a real property partnership, or their shares of stock in a real property corporation, will be eligible for deferral.

The proposed regulations expand upon the foregoing by providing that a gain is eligible for deferral if it is treated as a capital gain for Federal income tax purposes. Eligible gains, therefore, generally include capital gain from an actual, or from a deemed, sale or exchange, or any other gain that is required to be included in a taxpayer’s computation of capital gain.[vii]

The gain to be deferred must be gain that would otherwise be recognized[viii] not later than December 31, 2026, the final date under Section 1400Z-2 for the deferral of gain through a QOF. Thus, the window for utilizing the QOF deferral rules is fairly limited.[ix]

It should be noted that, in order to be eligible for the QOF deferral, the gain must not arise from a sale of real property to, or an exchange of real property with, a person related to the taxpayer.[x]

Eligible Taxpayer

In general, any taxpayer that recognizes gain is eligible to elect deferral under the QOF rules. These taxpayers include individuals, C corporations, and certain other taxpayers.

In addition, any time a partnership would otherwise recognize gain, the partnership may elect to defer all or part of such gain to the extent that it makes an eligible investment in a QOF. To the extent that the partnership does not elect deferral, each partner may elect to do so.[xi]

Eligible Investment

The proposed regulations clarify that, to qualify under Section 1400Z-2, an investment in a QOF must be an equity interest in the QOF; this may include preferred stock in a corporation, or an interest in a partnership with special allocations.

A debt instrument issued by a QOF is not an eligible investment.

Provided that the eligible taxpayer is the owner of the equity interest in the QOF for Federal income tax purposes, status as an eligible interest is not impaired by the taxpayer’s use of the interest as collateral for a loan, whether a purchase-money borrowing or otherwise.[xii]

Time for Deferring Gain

To be able to elect to defer gain, a taxpayer must generally invest in a QOF during the 180-day period beginning on the date of the sale or exchange giving rise to the gain.

Some capital gains, however, arise as the result of Federal tax rules that treat an amount as gain from the sale or exchange of a capital asset where no so event occurred. In those cases, as a general rule, the proposed regulations provide that the first day of the 180-day rollover period is the date on which the gain would be recognized for Federal income tax purposes, without regard to the deferral available under Section 1400Z-2.

Partnerships/Partners

If the election to defer the recognition of gain is made by the partnership that sold or exchanged the property at issue, no part of the deferred gain is required to be included in the distributive shares of its partners. To the extent that the partnership does not elect to defer the capital gain, the gain is included in the distributive shares of the partners.

If all or any portion of a partner’s distributive share of the partnership’s gain satisfies all of the rules for eligibility under Section 1400Z-2 (including that the gain not arise from a sale or exchange with a person that is related either to the partnership or to the partner), then the partner may elect its own deferral with respect to the partner’s distributive share – to the extent that the partner makes an eligible investment in a QOF – without regard to what the other partners decide to do. [xiii]

In other words, some partners may decide to defer gain recognition by investing in a QOF, while others will choose to recognize their share of the gain.[xiv]

Similarly, if a partner a realizes capital gain from the sale of their interest in a partnership that owns real property,[xv] the partner may defer recognition of the gain by making an eligible investment in a QOF.

Deferral

The maximum amount of gain that may be deferred by a taxpayer is equal to the amount of cash invested in a QOF by the taxpayer during the 180-day period beginning on the date of the sale of the asset to which the deferral pertains.

Thus, if a taxpayer timely invests an amount of cash in a QOF equal to the entire gain from the sale, the gain will be deferred; the taxpayer does not need to invest the entire sale proceeds (i.e., the amount representing a return of basis[xvi]). Any capital gain that is not deferred in accordance with this rule must be recognized.

It should be noted that the cash invested by a taxpayer in a QOF does not have to be traced to the transaction that generated the capital gain that is being deferred. The amount invested by the taxpayer may come from another source; it may even be borrowed by the taxpayer.[xvii]

Recognition of Deferred Gain

Some or all of the gain deferred by virtue of the investment in a QOF will be recognized by the taxpayer on the earlier of: (1) the date on which the QOF investment is disposed of, or (2) December 31, 2026.[xviii]

In other words, the gain that was deferred from the original sale or exchange must be recognized by the taxpayer no later than the taxpayer’s taxable year that includes December 31, 2026, notwithstanding that the taxpayer may not yet have disposed of its equity interest in the QOF.[xix]

Death of Electing Taxpayer

If an electing individual taxpayer should pass away before the deferred gain has been recognized, then the deferred gain will be treated as income in respect of a decedent, and shall be included in income in accordance with the applicable rules.[xx]

In other words, the decedent’s estate will not enjoy a basis step-up for the deferred-gain investment in the QOF at the decedent’s death that would eliminate the deferred gain.[xxi]

Gain Reduction

A taxpayer’s basis for an investment in a QOF immediately after its acquisition is deemed to be zero.

If the investment is held by the taxpayer for at least five years, their basis in the investment is increased by 10-percent of the deferred gain. If the investment is held by the taxpayer for at least seven years, their basis is increased by an additional 5-percent of the deferred gain.[xxii]

If the investment is held by the taxpayer until at least December 31, 2026 – the year in which the remaining 85-percent of the taxpayer’s deferred gain will be recognized – the basis in the investment will be increased by the amount of such deferred gain.

The deferred gain is recognized on the earlier of the date on which the investment in the QOF is disposed of or December 31, 2026.[xxiii]

Elimination of Gain

In the case of the sale or exchange of an investment in a QOF held for more than 10 years, at the election of the taxpayer, the basis of such investment in the hands of the taxpayer will be adjusted to the fair market value of the investment at the date of such sale or exchange.

In other words, any appreciation in the taxpayer’s investment in a QOF will be excluded from their gross income, and will escape taxation, if the taxpayer holds the investment for more than 10 years. The taxpayer’s ability to make this election is preserved until December 31, 2047.[xxiv]

This basis step-up is available only for gains realized upon investments that were made in connection with a proper deferral election under section 1400Z-2.[xxv]

Because there is no gain deferral available with respect to any sale or exchange made after December 31, 2026, there is no exclusion available for investments in QOFs made after December 31, 2026.

Are we Talking Apples and Oranges? Or McIntosh and Red Delicious?

Probably the former.[xxvi] Although both the like-kind exchange and the QOF investment allow a taxpayer to defer the recognition of capital gain from the disposition of an interest in real property, they are founded on different principles,[xxvii] seek to achieve different goals and, consequently, require the satisfaction of different criteria.

At the most basic level, the like-kind exchange will probably continue to be the option chosen by an active investor in real property – one who wants to defer their gain, wants to retain an interest in real property that they will manage, but does not want to be limited by the requirements for a QOF, including their geographic restrictions.

A taxpayer who is withdrawing from the real property business, and who otherwise may have settled upon a Delaware Statutory Trust as their replacement property in a like-kind exchange, may find an investment in a QOF attractive, especially because they are already committed to becoming a passive investor, and they will need to invest only an amount equal to their gain from the sale, thereby allowing them to keep that portion of the sale proceeds equal to their basis in the disposed-of property.

In the case of a minority investor who is withdrawing from a real property partnership or corporation, an investment in a QOF may be the only game in town, and a fairly attractive one at that. This may especially be the case for a partner in a partnership who would realize a very large gain on their withdrawal from the partnership thanks to the deemed distribution of cash under Section 752 of the Code.[xxviii]

Finally, a taxpayer engaging in a deferred like-kind exchange, where none of the identified replacement properties can be acquired, may find that the only alternative to gain recognition is an investment in a QOF. However, query whether any qualified intermediary will release the sale proceeds before the expiration of the 180-day replacement period.[xxix]

Time will tell.

—————————————————————————————————–

[i] Taxpayers will make deferral elections on Form 8949, which will be attached to their Federal income tax returns for the taxable year in which the gain would have been recognized if it had not been deferred.

[ii] In the case of real property, this means property located in the zone that is “substantially improved” by the QOF.

[iii] https://www.taxlawforchb.com/2019/02/a-closely-held-qualified-opportunity-fund-its-possible-but-its-not-easy/

[iv] In general, the gain may be either short-term or long-term capital gain. Other than in the case of land that is a capital asset in the hands of the taxpayer, the disposition of real property will generate capital gain only if it has been held for more than one year.

[v] IRC Sec. 1221. A capital asset.

[vi] IRC Sec. 1231. Gain from the sale of real property that represents the taxpayer’s stock-in-trade does not qualify; nor does ordinary income arising from the recapture of depreciation.

[vii] For example, a distribution of cash by a partnership to a partner, that is treated as a sale or exchange of the partner’s partnership interest, and that generates capital gain, may be eligible for deferral. IRC Sec. 731, 741.

[viii] But for the deferral permitted under Section 1400Z-2.

[ix] That being said, who knows whether a future administration will allow the like-kind exchange of real property. The Obama administration tried to eliminate Section 1031 in its entirety.

[x] Similarly, the sale of a partnership interest or of shares of stock in a corporation may not be made to a related person if the gain therefrom is to qualify. IRC Sec. 1400Z-2 incorporates the related person definition in sections 267(b) and 707(b)(1) of the Code, but substitutes “20 percent” in place of “50 percent” each place it occurs in section 267(b) or section 707(b)(1).

[xi] Similar rules apply for S corporations and their shareholders.

[xii] The proposed regulations also clarify that deemed contributions of money under section 752(a) – e.g., when a partner’s allocable share of a partnership debt is increased – do not result in the creation of an investment in a QOF.

Compare this to a post-like-kind exchange refinancing, which may be viewed as separate from the exchange (if planned properly) and, so, does not generate boot.

[xiii] The partner’s 180-day period generally begins on the last day of the partnership’s taxable year, because that is the day on which the partner would be required to recognize the gain if the gain is not deferred.

[xiv] Many taxpayers long for such flexibility in the context of a partnership in which some partners want to engage in a like-kind exchange while other partners want to monetize their partnership interest.

[xv] Notwithstanding that the partnership remains subject to the partnership tax rules under subchapter K.

[xvi] Compare this to the requirements for a like-kind exchange, where the taxpayer must acquire a property with at least the same fair market value and equity as the relinquished property if they want to defer the entire gain.

[xvii] For example, if partnership sells an asset that generates capital gain, and a partner elects to defer their share of such gain, they may have to borrow the proceeds to be invested in a QOF if the partnership does not make a distribution.

[xviii] A like-kind exchange allows an indefinite deferral of gain.

[xix] As to the nature of the capital gain – i.e., long-term or short-term – the deferred gain’s tax attribute will be preserved through the deferral period, and will be taken into account when the gain is recognized. Thus, if the deferred gain was short-term capital gain, the same treatment will apply when that gain is included in the taxpayer’s gross income in 2026.

The gain deferred in a like-kind exchange, in contrast, may be deferred indefinitely – i.e., until the replacement property is sold.

[xx] IRC Sec. 691.

[xxi] Compare this to the gain deferred in a like-kind exchange, where a basis step-up at the death of a taxpayer may eliminate the gain.

[xxii] 15-percent, in total. Because of the December 31, 2026 “deadline” described above, a taxpayer will have to sell and reinvest their gain by December 31, 2019 in order to enjoy the full 15-percent basis adjustment (7 years). Like-kind exchanges have no such holding period requirements.

[xxiii] Only taxpayers who rollover qualifying capital gains before December 31, 2026, will be able to take advantage of the special treatment of capital gains under Section 1400Z-2.

[xxiv] That’s many years of potential appreciation.

[xxv] It is possible for a taxpayer to invest in a QOF in part with gains for which a deferral election under section 1400Z-2 is made and in part with other funds (for which no section 1400Z-2 deferral election is made or for which no such election is available). Section 1400Z-2 requires that these two types of QOF investments be treated as separate investments, which receive different treatment for Federal income tax purposes.

[xxvi] I’ll take an apple over an orange any day.

[xxvii] https://www.taxlawforchb.com/2019/02/sale-of-a-business-and-qualified-opportunity-funds-deferral-exclusion-and-risk/

[xxviii] This is basically a recapture of tax benefits – previously received by the taxpayer in the form of deductions or tax-free distributions of cash – attributable to funds borrowed by the partnership.

[xxix] See the safe harbor under Reg. Sec. 1.1031(k)-1(g)(6).

The Act

Among the business transactions on which the Tax Cuts and Jobs Act[i] has had, and will continue to have, a significant impact is the disposition of a taxpayer’s interest in real property, whether held directly or through a business entity.

That is not to say that the Act amended an existing Code[ii] provision, or added a new provision to the Code, that was specifically intended to affect the income tax consequences arising from the sale or exchange of a taxpayer’s interest in real property. It did no such thing.

However, the Act preserved the ability of a taxpayer to defer the recognition of gain from their disposition of real property (the “relinquished” property) by acquiring other real property (the “replacement” property) of like-kind to the relinquished property,[iii] while eliminating the ability of a taxpayer to engage in a like-kind exchange for the purpose of deferring the gain from their disposition of any other type of property.[iv]

At the same time, the Act provided another deferral option for the consideration of taxpayers who realize capital gain on their disposition of property – including real property; specifically, such gain may be deferred if the taxpayer invests in a new kind of investment vehicle: a qualified opportunity fund (“QOF”).[v]

With the release of proposed regulations under the QOF rules in late 2018,[vi] and with the expectation of more guidance thereunder in the near future,[vii] some taxpayers who are invested in real property are beginning to view QOFs with greater interest, including as a possible deferral alternative to a like-kind exchange.

In light of this development, it will behoove taxpayers invested in real property to familiarize themselves with the basic operation of these two deferral options: the like-kind exchange and the QOF.

We begin with the tried-and-true like-kind exchange.

Like-Kind Exchanges

An exchange of property, like a sale, generally is a taxable event. However, Section 1031 provides that no gain (or loss) will be recognized by a taxpayer if real property held[viii] by the taxpayer for productive use in a trade or business or for investment is exchanged for real property of a “like-kind” which is to be held by the taxpayer for productive use in a trade or business or for investment.

Section 1031 does not apply to any exchange of real property that represents the taxpayer’s stock in trade (i.e., inventory) or other real property held primarily for sale.[ix] It also does not apply to exchanges involving foreign real property[x] – that being said, relinquished real property in one state may be exchanged for replacement real property in another state.[xi]

The disposition of an interest in a partnership or of stock in a corporation will not qualify for tax deferral under Section 1031. However, for purposes of the like-kind exchange rules, an interest in a partnership which has in effect a valid election to be excluded from the application of the Code’s partnership tax rules,[xii] is treated as an interest in each of the partnership’s assets, which may include qualifying real property, and not as an interest in a partnership.[xiii]

Like-Kind

For purposes of Section 1031, the determination of whether the real properties exchanged are of a “like-kind” to one another relates to the nature or character of each property, and not to its grade or quality. This rule has been applied very liberally with respect to determining whether real properties are of “like-kind” to one another. For example, improved real property and unimproved real property generally are considered to be property of a “like-kind” as this distinction relates to the grade or quality of the real property.[xiv]

Investment

Generally speaking, in order for a taxpayer to defer recognition of the entire gain realized from their disposition of a relinquished real property, the taxpayer must reinvest in the replacement real property an amount at least equal to the sales price for the relinquished property. If the taxpayer invests less than this amount, it may be that they received some cash in the disposition that was not reinvested (non-like property, or “boot”).

In addition, if the relinquished property was encumbered by debt, the taxpayer must incur at least the same amount of debt in acquiring the replacement property, or they must invest additional cash in such acquisition in an amount equal to the amount of such debt.[xv] Any net reduction in such debt, in moving from the relinquished property to the replacement property, would be treated as boot.

Boot

The non-recognition of gain in a like-kind exchange applies only to the extent that like-kind property is received in the exchange. Thus, if an exchange of real property would meet the requirements of Section 1031, but for the fact that the property received by the taxpayer in the transaction consists not only of real property that would be permitted to be exchanged on a tax-deferred basis, but also other non-qualifying property or money (including “net debt-relief”), then the gain realized by the taxpayer is required to be recognized, but not in an amount exceeding the fair market value of such other property or money.[xvi]

Basis

In general, if Section 1031 applies to an exchange of real properties, the basis of the property received in the exchange is equal to the basis of the property transferred. This basis is increased to the extent of any gain recognized as a result of the receipt of other property or money in the like-kind exchange, and decreased to the extent of any money received by the taxpayer.[xvii]

The holding period of qualifying real property received includes the holding period of the qualifying real property transferred.[xviii]

In this way, the deferred gain is preserved and may be recognized by the taxpayer on a subsequent taxable disposition, which may occur many years later.[xix]

Of course, if the taxpayer is an individual who dies before the later taxable sale of the replacement property, their estate will receive a basis step-up for the property;[xx] consequently, the estate may not recognize any gain on the sale.

Deferred Exchange

A like-kind exchange does not require that the real properties be exchanged simultaneously. Indeed, most exchanges do not involve direct swaps of the relinquished and replacement real properties.

Rather, the real property to be received in the exchange must be received not more than 180 days after the date on which the taxpayer relinquishes the original real property.[xxi]

In addition, the taxpayer must identify the real property to be received within 45 days after the date on which the taxpayer transfers the real property relinquished in the exchange.[xxii]

Until the replacement real property is acquired, the taxpayer may not receive the proceeds from the sale of the relinquished property. If the taxpayer actually or constructively receives such proceeds before the taxpayer actually receives the like-kind replacement property, the transaction will constitute a sale, and not a deferred exchange, even though the taxpayer may ultimately receive like-kind replacement property.

In order to assist a taxpayer in avoiding the actual or constructive receipt of money or other property in exchange for their relinquished real property, the IRS has provided a number of “safe harbor” arrangements pursuant to which such “sale proceeds” from the relinquished property may be held by someone other than the taxpayer pending the acquisition of the replacement property.[xxiii] If the requirements for these arrangements are satisfied, the taxpayer will not be treated as having received the sale proceeds.[xxiv]

Same Taxpayer

The same taxpayer[xxv] that disposes of the relinquished property must also acquire the replacement property. Thus, if an individual, a partnership, or a corporation sells a real property that they held for investment or for use in a trade or business, then that same individual, partnership or corporation must acquire and hold the replacement property.

Stated differently, if a partnership or a corporation sells a real property, its individual partners and shareholders cannot acquire their own separate replacement properties outside the partnership or corporation.[xxvi]

Holding Period

There is no prescribed minimum holding period – either for the relinquished property or the replacement property – that must be satisfied in order for a taxpayer to establish that they “held” the real property for the requisite purpose (and not for sale).

However, based on the facts and circumstances, a short holding period may result in a taxpayer’s failing to prove that they held the property for the requisite investment or business purpose.

Related Parties

That being said, a special rule applies where the taxpayer exchanges real property with a related person.

Where a taxpayer engages in a direct swap of like-kind real properties with a related person, the taxpayer cannot use the nonrecognition provisions of Section 1031 if, within 2 years of the date of the swap, either the related person disposes of the relinquished property or the taxpayer disposes of the replacement property. The taxpayer will recognize the deferred gain in the taxable year in which the disposition occurs.[xxvii]

It should also be noted that a taxpayer engaging in a deferred exchange, who transfers relinquished real property to a qualified intermediary in exchange for replacement real property formerly owned by a related party, is generally not entitled to nonrecognition treatment under Section 1031 if, as part of the transaction, the related party receives cash or other non-like-kind property for the replacement property.[xxviii]

Tomorrow we turn to the Qualified Opportunity Fund.

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[i] P.L. 115-97; the “Act.”

[ii] In the words of The Highlander, “There can be only one”: the Internal Revenue Code. Inside joke – part of a running dispute with some acquaintances in the bankruptcy world. Their code has a lower case “c”.

[iii] IRC Sec. 1031.

[iv] Sec. 13303 of the Act. Stated differently, the Act amended the tax-deferred like-kind exchange rules such that they will apply only to dispositions of real property.

[v] IRC Sec. 1400Z-2.

[vi] https://www.irs.gov/pub/irs-drop/reg-115420-18.pdf

[vii] Treasury Assistant Secretary Kautter recently announced that such regulations were just a few weeks away.

[viii] There is no prescribed holding period, either for the relinquished property or the replacement property. However, a short holding period may result in a taxpayer’s failing to prove that they held the property for the requisite purpose.

[ix] IRC Sec. 1031(a)(2). Thus, a dealer in real property may not use the like-kind exchange rules to defer the recognition of income arising from the sale of their inventory.

[x] IRC Sec. 1031(h).

[xi] Some “relinquished property states” have made noise about keeping tabs on the ultimate taxable disposition of the replacement property; for example, California.

[xii] Subchapter K of the Code. The election is made under IRC Sec. 761. See also the regulations promulgated under Sec. 761.

[xiii] IRC Sec. 1031(e); as amended by the Act.

[xiv] Reg. Sec. 1.1031(a)-1(b). A leasehold interest with a remaining term of at least 30 years is treated as real property. An interest in a Delaware Statutory Trust (basically, a grantor trust) may be treated as real property. In addition, certain intangibles may be treated as real property, including certain development rights.

[xv] Reg. Sec. 1.1031(d)-2.

[xvi] IRC Sec. 1031(b).

[xvii] IRC Sec. 1031(d).

[xviii] The non-qualifying property received is required to begin a new holding period.

[xix] Of course, the taxpayer may decide to continue to defer the gain by engaging in yet another like-kind exchange.

[xx] IRC Sec. 1014. The estate of an individual taxpayer who is a partner in a partnership may enjoy a similar step-up in its share of the underlying real property of the partnership, provided the partnership has in effect, or makes, an election under Sec. 754 of the Code.

The foregoing assumes the sale has not progressed to the point where the contract of sale represents an item of income in respect of a decedent, in which case there will be no basis step-up. IRC Sec. 691.

[xxi] But in no event later than the due date (including extensions) of the taxpayer’s income tax return for the taxable year in which the transfer of the relinquished property occurs).

[xxii] IRC Sec. 1031(a)(3); Reg. Sec. 1.1031(k)-1(a) through (o). The taxpayer may identify more than one replacement property. Regardless of the number of relinquished properties transferred by the taxpayer as part of the same deferred exchange, the maximum number of replacement properties that the taxpayer may identify is three properties without regard to the FMV of the properties, or any number of properties as long as their aggregate FMV as of the end of the identification period does not exceed 200 percent of the aggregate FMV of all the relinquished properties as of the date the relinquished properties were transferred by the taxpayer.

[xxiii] This requires that the proceeds be traced. Form matters here.

[xxiv] Reg. Sec. 1.1031(k)-1(g).

[xxv] Not necessarily the same state law entity. For example, a newly formed single member subsidiary LLC may acquire replacement property following a sale of relinquished property by its parent corporation.

[xxvi] Of course, there are situations in which one partner may want to be cashed out rather than continue in the partnership with a new property, or may want to effect a like-kind exchange while the remaining partners want to cash out their investment. Other strategies may be used in these instances; for example, a so-called “drop-and-swap,” which is not without risk.

[xxvii] IRC Sec. 1031(f). The term “related person” means any person bearing a relationship to the taxpayer described in Sections 267(b) or 707(b)(1) of the Code.

[xxviii] Rev. Rul. 2002-83.

Lou Vlahos is a recipient of a JD Supra Readers’ Choice Award in the Tax category for the second year in a row. The Readers’ Choice Awards recognize top authors and firms who were read by C-suite executives, in-house counsel, media, and other professionals across the JD Supra platform during 2018. He is one of 10 authors chosen in his category for his visibility and thought leadership.

Last year, Lou published 53 new posts and had 48,820 views of his work on JD Supra.

His top posts on JD Supra were the following:

The Real Property Business And The Tax Cuts & Jobs Act

The Federal Estate Tax Lives On, But “Where, O death, Is Your Sting?” (*)

Trusts And The Corporate Lawyer