The Business-Charity Connection

As our readers know, this blog is dedicated to addressing the tax-related business and succession planning issues that are most often encountered by the owners of a closely held business. Occasionally, however, we have crossed over into the space occupied by tax-exempt charitable organizations inasmuch as such an exempt organization (“EO”) may be the object of a business owner’s philanthropy, either during the owner’s life or at their demise.

Foundations

For example, we have considered grant-making private foundations (“PF”) that have been funded by the business owner and, thus, are not reliant upon the general public for their financial survival. In particular, we have reviewed a number of the penalty (“excise”) taxes applicable to PFs. These are rooted in the government’s tacit recognition that the activities of such a PF cannot be influenced by the withholding of public support from the foundation. Rather, the threatened imposition of these taxes is intended to encourage certain “good” behavior and to discourage certain “bad” behavior by a PF.[i]

Although PFs are important players in the charitable world, a business owner is far more likely to support charitable activities by making direct financial contributions to publicly-supported charities that operate within their community, rather than to create a PF through which to engage in such charitable giving.[ii]

Board Service

Where the business owner has a personal connection to an EO’s charitable mission, the owner may seek to become a member of the organization’s board of directors. In other cases, the EO itself may solicit the owner’s involvement, in part to help secure their financial support, not to mention the access they can provide to other potential donors from the business world.

Another reason that business owners may be attractive candidates for an EO’s board of directors is that they are experienced in . . . running a business.[iii] This skillset may be especially important in light of recent changes to the Code that reflect Congress’s heightened skepticism toward EOs, and that are aimed at limiting the amount of executive compensation payable by EOs.

Increased Public Scrutiny

Congress’s reaction to EO executive compensation is, in part, attributable to the public’s own changing perspective. As the charitably-inclined segment of the “public” has become more sophisticated, and better informed, it has demanded more accountability as to how its charitable contributions are being utilized, including what percentage of the contributions made to a charity is being used for executive compensation.[iv]

These “economic” concerns are magnified when viewed in light of the reality that the vast majority of charitable organizations are governed by self-perpetuating boards of directors,[v] which in turn hire the executive employees who operate these organizations on a day-to-day basis.

In response to these concerns, Congress has slowly been adding provisions to the Code that are intended (as in the case of the excise taxes applicable to PFs) to dissuade public charities and their boards from engaging in certain behavior.

Until the passage of the Tax Cuts and Jobs Act of 2017,[vi] the most notable of these provisions was that dealing with “excess benefit transactions.”[vii]

Blurring the Lines

As a result of these economic pressures, not to mention the attendant governmental scrutiny, most public charities have sought to fulfill their charitable missions on a more efficient basis. In other words, they have tried to become more “business-like” in performing their charitable functions. In furtherance of this goal, many EOs have tried to attract and retain the services of talented and experienced executives, while also inviting successful business owners onto their boards.

Notwithstanding these efforts, many EOs continue to be in the Congressional crosshairs. In particular, some larger EOs have been accused, in some circles, of taking advantage of their tax-preferred status to generate what critics have characterized as large profits, a not-insignificant portion of which find their way, or so these critics assert, into the hands of the organizations’ key executives in the form of generous compensation packages.

The Act represents the latest Congressional effort to rein in what its proponents perceived as abuses in the compensation of EOs’ top executives.

In order to stem these “abuses,” the Act draws liberally from the tax rules applicable to executive compensation paid or incurred by business organizations. Before delving into these provisions, it would be helpful to briefly review the “for-profit” rules from which they were derived.

For-Profit Compensation Limits

In determining its taxable income from the conduct of a trade or business, an employer may claim a deduction for reasonable compensation paid or incurred for services actually rendered to the trade or business.[viii] Whether compensation is reasonable depends upon all of the facts and circumstances. In general, compensation is reasonable if the amount thereof is equal to what would ordinarily be paid for “like services by like enterprises under like circumstances.”[ix]

However, Congress has determined – without stating that it is per se unreasonable – that compensation in excess of specified levels may not be deductible in certain situations.

Public Corporations

Prior to the Act, and in order to protect shareholders from grasping executives, a publicly-held corporation generally could not deduct more than $1 million of compensation in a taxable year for each “covered employee,”[x] unless the corporation could establish that the compensation was performance-based.[xi]

Golden Parachutes

In addition, a corporation generally cannot deduct that portion of the aggregate present value of a “parachute payment” – generally a payment of compensation that is contingent on a change in corporate ownership or control[xii] – which equals or exceeds three times the “base amount” of certain shareholders, officers and highly compensated individuals.[xiii] The nondeductible excess is an “excess parachute payment.”[xiv]

The purpose of the provision is to prevent executives of widely-held corporations from furthering their own interests, presumably at the expense of the shareholders, in the sale of the business.[xv]

Quite reasonably, certain payments are excluded from “parachute payment status” – in particular, the amount established as reasonable compensation for services to be rendered after the change in ownership or control is excluded.[xvi]

In addition, the amount treated as an excess parachute payment is reduced by the amount established as reasonable compensation for services actually rendered prior to the change in ownership or control.[xvii]

Finally, the individual who receives an excess parachute payment is subject to an excise tax of 20% of the amount of such payment.[xviii]

EO Compensation Limits

Prior to the Act, the foregoing deduction limits generally did not affect an EO.

That being said, there were other provisions in the Code that addressed the payment of unreasonable compensation by an EO to certain individuals.

Self-Dealing

PFs are prohibited from engaging in an act of “self-dealing,” which includes the payment of compensation by a PF to a disqualified person.[xix]

However, the payment of compensation to a disqualified person by a PF for the performance of personal services which are reasonable and necessary to carry out the PF’s exempt purpose will not constitute self-dealing if the compensation is not excessive.[xx]

In other words, the EO-PF may pay reasonable compensation to a disqualified person.[xxi]

Where it has paid excess compensation, the EO is expected to recover the excess from the disqualified person.[xxii]

Excess Benefit Transaction

A public charity is prohibited from engaging in an “excess benefit transaction,” meaning any transaction in which an economic benefit[xxiii] is provided by the organization to a disqualified person if the value of the economic benefit provided exceeds the value of the consideration, including the performance of services, received for providing such benefit.[xxiv]

To determine whether an excess benefit transaction has occurred, all consideration and benefits exchanged between the disqualified person and the EO, and all entities that the EO controls, are taken into account.[xxv]

In other words, the EO-public charity may pay reasonable compensation to a disqualified person without triggering the excess benefit rules.

As in the case of a PF, the public charity is expected to recover the amount of any excess payment made to the disqualified person.[xxvi]

Private Inurement

An organization is not operated exclusively for one or more exempt purposes if its net earnings inure, in whole or in part, to the benefit of private individuals.[xxvii]

Whether an impermissible benefit has been conferred on an individual is essentially a question of fact. A common factual thread running through the cases where inurement has been found is that the individual stands in a relationship with the organization which offers them the opportunity to make use of the organization’s income or assets for personal gain. This has led to the conclusion that a finding of inurement is usually limited to a transaction involving “insiders.”

Whereas the excise taxes on acts of self-dealing and on excess benefit transactions are intended to address situations that do not rise to the level at which the EO’s tax-favored status should be revoked, a finding that the organization’s net earnings have inured to the benefit of its “insiders” connotes a degree of impermissible benefit that justifies the revocation of its tax-exemption.

The Act

Congress must have believed that the foregoing limitations were not adequate to police or control the compensation practices of EOs. The committee reports to the Act, however, do not articulate the reason for the enactment of the provisions we are about to consider.

The only rationale that I can think of is that Congress was attempting to maintain some sort of “parity” between for-profits and EOs with respect to executive compensation.[xxviii]

Thus, the new provision draws heavily from the limitations applicable to business organizations, described above, and its purpose likewise may be deduced from the purposes of such limitations: to prevent certain individuals in the EO from paying themselves “excessive” salaries and other benefits, and thereby ensuring that those amounts are instead used in furtherance of the EO’s exempt purpose and for the benefit of its constituents.[xxix]

The Tax

Under the Act, effective for taxable years beginning after December 31, 2017, an employer (not the individual recipient of the payment) is liable for an excise tax equal to 21 percent[xxx] of the sum of:

(1) any “remuneration” in excess of $1 million paid to a covered employee by an EO for a taxable year, and

(2) any excess parachute payment paid by the EO to a covered employee.[xxxi]

Accordingly, the excise tax may apply as a result of an excess parachute payment, even if the covered employee’s remuneration[xxxii] does not exceed $1 million; in other words, there are two events that may trigger the imposition of the tax.

Where both provisions may apply, the remuneration that is treated as an excess parachute payment is not accounted for in determining if the $1 million limit is exceeded.

Covered Employee

For purposes of the provision, a covered employee is an employee (including any former employee) of an applicable tax-exempt organization if the employee

  • is one of the five highest compensated employees of the organization for the taxable year (the current year; there is no minimum dollar threshold for an employee to be a covered employee), or
  • was a covered employee of the organization (or of a predecessor organization) for any preceding taxable year beginning after December 31, 2016.[xxxiii] Thus, if the individual was a covered employee in a prior year (beginning with 2017), they continue to be treated as such for purposes of determining whether any payments made to them in subsequent years violate one of the two limitations described above.[xxxiv]

Related Persons

Remuneration of a covered employee also includes any remuneration paid with respect to employment of the covered employee by any person related to the EO.

A person is treated as related to an EO if the person:

(1) controls, or is controlled by, the organization,

(2) is controlled by one or more persons that control the organization,

(3) is a supported organization with respect to the organization, or

(4) is a supporting organization with respect to the organization.

Parachute Payments

Under the provision, an excess parachute payment is the amount by which any parachute payment exceeds the portion of the base amount allocated to the payment.

A parachute payment is a payment in the nature of compensation to a covered employee if:

  • the payment is contingent on the employee’s separation from employment and
  • the aggregate present value of all such payments equals or exceeds three times the base amount.[xxxv]

It should be noted that this definition differs from that applicable in the case of a business organization, where the disallowance of the employer’s deduction, and the imposition of the excise tax on the employee-recipient, are not contingent on the employee’s separation from employment.

It should also be noted that the Act did not provide an exception for a payment that represents reasonable compensation. Thus, even where the payment is reasonable in light of the services provided by the employee, and thus would not be trigger an excise tax for self-dealing or an excess benefit, the excise tax will nevertheless be applied.[xxxvi]

Liability

The employer of a covered employee – not the employee – is liable for the excise tax.

This is to be contrasted with the case of an employer that is a business organization. The employer is denied a deduction for the excess parachute payment, but an excise tax is also imposed upon the employee to whom the payment was made.

In addition, if the remuneration of a covered employee from more than one employer is taken into account in determining the excise tax, each employer is liable for the tax in an amount that bears the same ratio to the total tax as the remuneration paid by that employer bears to the remuneration paid by all employers to the covered employee.[xxxvii]

Parting Thoughts

The rules described above are complicated, and the IRS has yet to propose interpretive regulations, though it recently published interim guidance[xxxviii] to assist EOs with navigating the new rule, and on which they may rely, until regulations can be issued.

Of course, an EO will not be impacted by these provisions if it does not pay an employee enough remuneration to trigger the tax; there can be no excess remuneration if an EO (together with any related organization) pays remuneration of less than $1 million to each of its employees for a taxable year, and there can be no excess parachute payment if the EO does not have any “highly compensated” employees for the taxable year.[xxxix]

Does this mean that an EO should not pay any of its executives an amount that would trigger the imposition of the above tax? Should it walk away from candidates whom the EO can only hire by paying a larger amount? Or should it seek out the best people, pay them an amount that would trigger the tax but that the EO determines would be reasonable,[xl] and accept the resulting tax liability as a cost of doing business?[xli]

These are the kind of decisions that I have seen business owners make every day, and these are usually preceded by another set of inquiries: Will the return on our investment (in this case, in intellectual capital) justify the cost? Are we overpaying, or is the amount reasonable under the circumstances? Is there another way by which we can secure the same benefit – perhaps through a different mix of incentives, payable in varying amounts and at different times so as to skirt the literal terms of the Act, while also securing the services of a great executive?

The ability to bring this type of business analysis to an EO’s board discussion on executive compensation may be at least as valuable, in the current environment, as one’s willingness to open one’s wallet to the EO.

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[i] See Subchapter A of Chapter 42 of the Code. Examples include the excise tax on a foundation that fails to pay out annually, to qualifying charities, an amount equal to at least five percent of the fair market value of its non-charitable assets, and the excise tax on certain “insiders” (with respect to the foundation) who engage in acts of self-dealing with the foundation (e.g., excessive compensation).

[ii] There are many reasons a business owner chooses to form a foundation; ego, tax planning, continued control, and family involvement are among these. There are also many reasons not to form one; the resulting administrative burden and the cost of tax compliance should not be underestimated.

[iii] Take a look at the board of any local charity. It is likely populated, in no small part, by the owners of businesses that operate within, or employ individuals from, the locality in which the EO is headquartered or that it services.

[iv] Instead of, say, furthering the charitable mission. It should be noted that these expenditures are not necessarily mutually exclusive.

[v] That’s right. The members of these boards elect themselves and their successors. It is rare for a larger charity to have “members” in a legal, “corporate law” sense– i.e., the counterparts to shareholders in a business organization – with voting rights, including the right to elect or remove directors. Rather, these charities depend upon honest, well-intentioned individuals to ensure that their charitable mission is carried out. Many of these individuals – the directors of the organization – are drawn from the business community. Of course, the Attorney General of the State in which a charity is organized also plays an important role in ensuring that the charity and those who operate it stay the course.

[vi] P.L. 115-97 (the “Act”).

[vii] IRC Sec. 4958; P.L. 104-168; enacted in 1996, it is generally applicable to public charities. More on this rule later.

[viii] IRC Sec. 162(a)(1).

[ix] Reg. Sec. 1.162-7.

[x] Specifically, its CEO, CFO, and the three other most highly compensated officers.

[xi] IRC Sec. 162(m); enacted in 1993 as part of the Omnibus Budget Reconciliation Act, P.L. 103-66. The Act eliminated the exception for performance-based pay.

[xii] IRC Sec. 280G(b)(2) and (c).

[xiii] An individual’s base amount is the average annualized compensation includible in the individual’s gross income for the five taxable years ending before the date on which the change in ownership or control occurs. IRC Sec. 280G(b)(3).

[xiv] IRC Sec. 280G(a) and (b)(1); enacted in 1984; P.L. 98-369.

[xv] The provision does not apply to “small business corporations” or to non-traded corporations that satisfy certain shareholder approval requirements. IRC Sec. 280G(b)(5).

[xvi] IRC Sec. 280G(b)(4)(A).

[xvii] IRC Sec. 280G(b)(4)(B).

[xviii] IRC Sec. 4999. Presumably because they would have been in a position to contractually obligate the corporation to make the payment.

[xix] IRC Sec. 4941. “Disqualified person” is defined in IRC Sec. 4946. https://www.law.cornell.edu/uscode/text/26/4946.

[xx] IRC Sec. 4941(d)(2)(E).

[xxi] The key, of course, is for the board to be able to demonstrate the basis for its determination of reasonableness.

[xxii] A “correction” under IRC Sec. 4941(e). The “obligation” to recover the excess portion is implicit in the calculation of the penalty.

[xxiii] For purposes of this rule, an economic benefit provided by an EO will not be treated as consideration for the performance of services rendered to the EO unless the EO clearly indicated its intent to treat such benefit as compensation.

[xxiv] IRC Sec. 4958(c)(1)(A).

[xxv] Reg. Sec. 53.4958-4. Congress foresaw that some individuals may try to circumvent the proscription by drawing down salaries from non-exempt organizations related to the EO.

[xxvi] IRC Sec. 4958(f)(6).

[xxvii] Reg. Sec. 1.501(a)-1.

[xxviii] Query whether EOs have been enticing executives away from business organizations in droves – I don’t think so.

[xxix] Interestingly, the Act made no distinction between public charities and PFs. In contrast, the comparable limitations for business organizations do not apply to “small business corporations” or certain non-publicly traded corporations.

[xxx] I.e., the newly established flat rate for C corporations – in order to mirror the amount of tax that such a corporation would have to pay in respect of the disallowed portion of the compensation paid to the individual service provider.

[xxxi] IRC Sec. 4960. https://www.law.cornell.edu/uscode/text/26/4960.

[xxxii] Remuneration includes amounts required to be included in the employee’s gross income under IRC Sec. 457(f).

Such amounts are treated as paid (and includible in gross income) when there is no substantial risk of forfeiture of the rights to such remuneration within the meaning of section 457(f). Sec. 4960(c)(3). For this purpose, a person’s rights to compensation are subject to a substantial risk of forfeiture if the rights are conditioned on the future performance of substantial services by any individual, or upon the achievement of certain organizational goals.

Up until now, the only cap on 457(f) arrangements was that the payment be reasonable for the services actually rendered.

In determining reasonableness, one looks to the totality of the recipient’s services to the EO, not only for the year paid; in other words, the payment may be “prorated” over many years for this purpose. Accordingly, the tax imposed by this provision can apply to the value of remuneration that is vested even if it is not yet received. Indeed, the excise tax can apply to amounts that are paid currently though they were earned in earlier years.

[xxxiii] Sec. 4960(c)(2).

[xxxiv] The list of covered employees may grow to include individuals who are no longer included in the five highest paid.

[xxxv] The base amount is the average annualized compensation includible in the covered employee’s gross income for the five taxable years ending before the date of the employee’s separation from employment.

[xxxvi] That being said, the Act does exempt compensation paid to employees who are not “highly compensated” employees from the definition of parachute payment.

Significantly for EO-hospitals, compensation attributable to medical services of certain qualified medical or veterinary professionals is exempted from the definitions of remuneration and parachute payment; remuneration paid to such a professional in any other capacity is taken into account.

Unfortunately, neither the Act nor the committee reports provide any guidance regarding the allocation of a medical professional’s remuneration between their medical services and, say, their administrative functions within the EO-employer.

[xxxvii] It should be noted that the Act authorizes the IRS to issue regulations to prevent the avoidance of the excise tax through the performance of services other than as an employee.

[xxxviii] Notice 2019-09, which consists of ninety pages of Q&A.

[xxxix] Within the meaning of IRC Sec. 414(q).

[xl] It should always be reasonable under the facts and circumstances.

[xli] Assuming the amount is reasonable within the meaning of the self-dealing and excess benefit rules, will there be any argument under state law that the imposition of the tax reflects a per se breach of the board’s fiduciary duty?

If the amount is not reasonable, such that the excise taxes on self-dealing and excess benefits become payable, what is purpose of the new tax?

Rescission

As kids playing ball, we learned about the “do-over” rule, pursuant to which the player in question was allowed to try again, without penalty, whatever it was that they were doing.  As we got older and our games changed, some of us learned about “taking a mulligan,” again without penalty.[i]  It may not come as a surprise, therefore, that a variation of this principle has found its way into the tax law.  It is called the “rescission doctrine,” and although it has been recognized for many years, it has been applied only in limited circumstances.

However, as we entered the final month of 2018, I found myself facing two situations in which the application of the rescission doctrine afforded the only solution for avoiding some adverse tax consequences.

Requirements

In general, the tax law treats each taxable year of a taxpayer as a “separate unit” for tax accounting purposes, and requires that one look at a particular transaction on an “annual basis,” using the facts as they exist at the end of the taxable year; in other words, one determines the tax consequences of the transaction at the end of the taxable year in which it occurred, without regard to events in subsequent years.

It is this basic principle of the annual accounting concept that underlies the rescission doctrine, and from which is derived the requirement, set forth below, that the rescission occur before the end of the taxable year in which the transaction took place.[ii]

According to the IRS,[iii] the legal concept of “rescission” (i) refers to the canceling or voiding of a contract or transaction, that (ii) has the effect of releasing the parties from further obligations to each other, and (iii) restores them to the relative positions they would have occupied had no contract been made or transaction completed.

A rescission may be effected by mutual agreement of the parties, by one of the parties declaring a rescission of the contract without the consent of the other (if sufficient grounds exist), or by applying to the court for a decree of rescission.

It is imperative, based on the annual accounting concept, that the rescission occur before the end of the taxable year in which the transaction took place.

If these requirements are satisfied, then the rescinded transaction is ignored for tax purposes – it is treated as though it never occurred.

Thus, a sale may be disregarded for federal income tax purposes where the sale is rescinded within the same taxable year that it occurred, and the parties are placed in the same positions as they were prior to the sale.[iv]

If the foregoing requirements are not satisfied, the rescission will not be respected, the tax consequences of the original transaction will have to be reported, and the “unwinding” of the original transaction will be analyzed as a separate event that generated its own tax consequences.

Why Rescind?

Whether the IRS will accept the parties’ claimed rescission of a particular transaction will, of course, depend upon the application of the above criteria to the facts and circumstances of the particular case.

Although the IRS has stated that it is studying the issue of rescission, and it has not issued letter rulings on the subject since 2012,[v] there are a number of earlier rulings to which taxpayers may turn for guidance regarding the IRS’s views.

These rulings illustrate some of the reasons for rescinding a transaction, as well as some of the means by which the rescission may be effectuated.

For example, the IRS has accepted the rescission of a transaction where the transaction was undertaken for a bona fide business reason, but without a proper understanding of the resulting tax consequences. When the parties realized what they had done, they sought to rescind the transaction and thereby avoid the unexpected adverse tax consequences;[vi] in one ruling, the parties not only rescinded the transaction, but then “did it over” so as to achieve the desired result.[vii]

The IRS has also looked favorably on the rescission of a transaction where, due to changed circumstances, the business purpose for the transaction no longer existed.[viii]

Thus, it appears that either a legitimate tax purpose or a bona fide business purpose may be the motivating factor for a rescission.

Restoring Pre-Transaction Status

Of the foregoing requirements for a successful rescission, the most difficult to satisfy may be the restoration of the parties to their pre-transaction status. The difficulty is compounded where events have occurred during the period preceding the rescission which may prevent, or which appear inconsistent with, an unwinding of the transaction.

Closely related to this requirement is the manner in which the rescission is effectuated; i.e., the steps that are taken to return the parties to their earlier positions.[ix]

For example, in one case, a taxpayer instructed their broker to sell $100,000 worth of a publicly-traded stock, but the broker instead sold 100,000 shares of such stock. In order to reverse this event, at the taxpayer’s direction, the broker reacquired over 96,000 shares in the same corporation. The court found that there was no rescission because the broker was not the buyer of the shares that were sold originally; that buyer was not returned to their original position.[x]

Common Representations

Regardless of the reasons for the rescission, the parties must be prepared to demonstrate that the requirements set forth above have been satisfied, including the requirement that the rescission restored, in all material respects, the legal and financial arrangements among the parties that would have existed had the transaction never occurred.

The taxpayers who were parties to the rescission transactions, for which the above-referenced rulings were requested, represented to the IRS – for the purpose of supporting their claim that they had been restored to their pre-transaction status – that, among other things: (i) no party took or would take any material position inconsistent with the position that would have existed had the rescinded transaction not occurred, (ii) no activities occurred prior to the rescission, or would occur after the rescission, that were materially inconsistent with the rescission, (iii) the purpose and effect of the rescission was to restore in all material respects the legal and financial arrangements among the parties that would have existed had the transaction never occurred, (iv) the legal and financial arrangements between the parties were identical in all material respects, from the date immediately before the rescinded transaction, to such arrangements that would have existed had the transaction not occurred, (v) the parties would take all reasonable actions necessary to effectuate those purposes, (vi) the parties would mutually agree to each of the steps to implement the rescission, (vii) all material items of income, deduction, gain, and loss of each party would be reflected on their respective income tax returns as if the transaction had not occurred, (viii) during the period between the transaction and the rescission, no material changes to the legal or financial relationships between parties occurred that would not have occurred if the transaction had not occurred, and (ix) the rescission would not involve any party that was not involved in the transaction.

Our Transactions

As indicated above, I was presented with two separate transactions that had to be rescinded in December of 2018. Both had occurred several months earlier during 2018.

In one transaction, a C corporation had distributed a minority interest in a subsidiary corporation to one of its shareholders in complete redemption of the shareholder’s stock in the distributing corporation. For some inexplicable reason, both parties believed that the distribution was not a taxable event to either of them; the corporation did not consider Sec. 311(b) and the former shareholder did not consider Sec. 302(a).[xi]

The redemption distribution was rescinded by having the “former” shareholder return to the distributing corporation the stock in the subsidiary and re-issuing stock in the distributing corporation to the shareholder. Between the date of the transaction and its rescission, no dividend distributions were made by either the corporation or the subsidiary, and no other event occurred that was inconsistent with the rescission of the redemption distribution.

In the second transaction, a partnership had contributed a wholly-owned disregarded entity (an LLC) to a newly-formed, and wholly-owned, C corporation subsidiary of the partnership. The partnership erroneously believed that it could obtain loans more easily through a corporation. The LLC membership interests were returned to the partnership in rescission of the contribution. As in the first case, there were no distributions by either the corporation or the LLC, nor did any other events occur that were inconsistent with the rescission.

A Useful Tool

In general, the best way to avoid a situation that calls for the rescission of a transaction is to refrain from undertaking the transaction without first vetting it in consultation with one’s tax and corporate advisers.

That being said, there will be instances in which unforeseen post-transaction events may defeat the purpose for the transaction, or may cause the transaction to be unduly expensive from an economic perspective.

In those cases, the taxpayer should bear in mind the possibility of rescinding the transaction, and they should be aware that they have only a limited period in which to exercise the rescission option.


[i] I am not a golfer, and never will be, though I do enjoy the dinners that follow many golf outings.

[ii] The rescission allows the taxpayer to view the transaction “using the facts as they exist at the end of the taxable year” – i.e., as though the transaction never occurred.

[iii] Rev. Rul. 80-58.

[iv] Stated simply: the property is returned to the seller and the cash is returned to the buyer.

[v] Rev. Proc. 2012-3. This no-ruling policy was reaffirmed in Rev. Proc. 2019-3.

[vi] See, e.g., PLR 200309009 (rescinding a distribution of property that would have disqualified taxpayers from the low income housing credit). Moreover, it does not appear to matter whether the transaction to be rescinded was undertaken between unrelated persons or within a group of related taxpayers.

[vii] PLR 201211009 (rescinded a stock sale that did not qualify for a Sec. 338(h)(10) election; substituted a new buyer for which the election would be available).

[viii] See, e.g., PLR 200923010 (rescinding a spin-off where changes in the business environment and in management subsequent to the distribution negated the benefit of the spin-off).

[ix] For example, how might taxpayers rescind a merger? If you’re facing this issue, feel free to contact me.

[x] Hutcheson v. Commissioner, T.C. Memo 1996-127.

[xi] Under IRC Sec. 311(b), a distribution of appreciated property by a corporation to its shareholders is treated as a sale of such property by the corporation. Under IRC Sec. 302(a) and 302(b)(3), the redemption of a shareholder’s entire equity in a corporation is treated as a sale of such equity by the shareholder.

Home for the Holidays?

Our last post considered the division of a business between family members as a means of preempting the adverse consequences that will often follow disagreements within the family as to the management or direction of the business. https://www.taxlawforchb.com/2018/12/business-purpose-and-dividing-the-family-corporation-think-before-you-let-it-rip/.

This week, as family members return to work – after having come together to celebrate the holidays and renew their commitment to one another – we turn to a recent IRS ruling that considered a situation that presents the proverbial “trap for the unwary,” and that arises more often than one might think in the context of a business that is plagued by family discord. https://www.irs.gov/pub/irs-wd/201850012.pdf.

Another Family Mess

Corp was formed by Dad, who elected to treat it as an S corporation for federal tax purposes.[i] Immediately prior to the events described in the ruling, Dad owned more than 50% of Corp’s non-voting shares, but less than 50% of Corp’s voting shares. Mom and Daughter owned the balance of Corp’s issued and outstanding shares.

Following Mom’s death, Daughter – who was also the CEO of the business – received a testamentary transfer of all of Mom’s voting shares, resulting in Daughter’s owning a majority of Corp’s voting shares.

For reasons not set forth in the ruling, Daughter subsequently terminated Dad’s employment with Corp. In response, Dad filed a lawsuit against Corp and Daughter (the “Litigation”) in which he alleged shareholder oppression and breach of fiduciary duties. Dad asked the court to enter an order requiring Daughter and/or Corp to buy Dad’s shares in Corp (“Dad’s Shares”), or an order requiring Dad to purchase Daughter’s shares.[ii]

Within three months after Dad initiated the Litigation, Corp and Daughter filed a notice under the Litigation (the “Election”) for Corp to purchase Dad’s Shares (the “Proposed Transaction”). Dad filed a motion to nullify the Election.[iii] The court denied Dad’s nullification motion, and ruled that the Election was valid.

Proposed Buyout

Dad died before the Litigation could be resolved and his shares in Corp purchased. His revocable trust (the “Trust”) – which became irrevocable upon his death – provided that Dad’s Shares would pass to Foundation, a tax-exempt charitable organization that was created and funded by Mom and Dad, and that was treated as a private foundation under the Code. [iv]

Pursuant to the terms of the Trust, the trustee had the power and authority to sell any stock held by or passing to the Trust, including Dad’s Shares.[v] However, because of the Litigation, Foundation did not receive Dad’s Shares from the Trust; nor could the Trust sell Dad’s Shares to anyone other than Corp during the Litigation.[vi]

The court in the Litigation was required by state law to determine the “fair value” of Dad’s Shares as of the date the Litigation was initiated, or such other date the court deemed appropriate. The Foundation represented to the IRS that the Litigation court could determine the fair value of Dad’s Shares to be less than their fair market value after marketability and control discounts were applied.[vii]

The administration of the Trust was overseen by a probate court, not the court in which the Litigation was ongoing. The probate court had the responsibility to ensure that Foundation received the full value of Dad’s Shares, and was required to approve the valuation of Dad’s Shares and the Proposed Transaction. According to the Foundation, if the probate court approved the Proposed Transaction, the Litigation court would honor the probate court’s decision.

Self-Dealing

The foregoing may seem innocuous to most persons – just a buyout of a decedent’s shares in a corporation. Fortunately, Foundation recognized that Corp’s redemption of Dad’s Shares could be treated as an act of “self-dealing” under the Code, which could in turn result in the imposition of certain penalties (i.e., excise taxes) on the “self-dealer” and on the “foundation managers.”

The Code imposes a tax on acts of self-dealing between a “disqualified person”[viii] and a private foundation.[ix] The tax with respect to any act of self-dealing is equal to 10% of the greater of the amount of money and the fair market value of the other property given or the amount of money and the fair market value of the other property received in the transaction.[x] In general, the tax imposed is paid by any disqualified person who participated in the act of self-dealing.

The term “self-dealing” includes any direct or indirect sale or exchange of property between a private foundation and a disqualified person. For purposes of this rule, it is immaterial whether the transaction results in a benefit or a detriment to the private foundation; the act itself is prohibited.

An “indirect sale” may include the sale by a decedent’s estate (or revocable trust),[xi] to a disqualified person, of property that would otherwise have passed from the estate to the private foundation pursuant to the terms of the decedent’s will; in other words, property in which the foundation had an expectancy.

However, the term “indirect self-dealing” does not include a transaction with respect to a private foundation’s interest or expectancy in property held by a revocable trust, including a trust which became irrevocable on a grantor’s death, and regardless of when title to the property vested under local law, provided the following conditions are satisfied:

(i) The trustee of the revocable trust has the power to sell the property;

(ii) The transaction is approved by a court having jurisdiction over the trust or over the private foundation;

(iii) The transaction occurs, in the case of a revocable trust, before the trust is considered a “non-exempt charitable trust”;[xii]

(iv) The trust receives an amount which equals or exceeds the fair market value of the foundation’s interest or expectancy in the property at the time of the transaction; and

(v) The transaction results in the foundation receiving an interest or expectancy at least as liquid as the one it gave up.[xiii]

The IRS Ruling

Foundation conceded that Dad was a disqualified person (a “substantial contributor”) as to Foundation while he was alive, having funded Foundation with Mom.[xiv] Daughter was a disqualified person as to Foundation because her father (a “member of her family”) was a substantial contributor to Foundation. Corp was also a disqualified person as to Foundation because Daughter owned more than 35% of Corp’s voting shares.[xv]

Because Corp was a disqualified person as to Foundation, and because of Foundation’s expectancy interest in receiving Dad’s Shares from the Trust, the proposed sale of Dad’s Shares by the Trust to Corp pursuant to the Litigation court’s order (the Proposed Transaction) could be an act of indirect self-dealing.

Foundation requested a ruling from the IRS that Corp’s purchase (i.e., redemption) of Dad’s Shares – which were held by the Trust – would satisfy the indirect self-dealing exception, described above, and would not be treated as an act of self-dealing for which a penalty could be imposed.

The IRS reviewed each of the requirements for the application of the exception.

First, a trustee must have the power to sell the trust’s property. Pursuant to the trust agreement that created Trust, Trust’s trustee had the power to sell any Trust assets, including Dad’s Shares. Thus, the Proposed Transaction met the first requirement.

Second, a court with jurisdiction over the trust must approve the transaction. Foundation sought, and was waiting to obtain, the approval of the Proposed Transaction from the probate court that had jurisdiction over, and was overseeing administration of, the Trust. Thus, the Proposed Transaction would meet the second requirement upon the Trust’s receipt of the probate court’s approval of the proposed sale.

Third, the Proposed Transaction must occur before the Trust became a non-exempt charitable trust. Foundation represented that because of the active and on-going status of the Litigation, the Trust’s trustees were, and would continue to be, unable to complete the ordinary duties of administration necessary for the settlement of Trust prior to the date of the sale of Dad’s Shares. Thus, the Trust would not be considered a non-exempt charitable trust prior to the date of the sale of Dad’s Shares; until then, the trustee would still be performing the ordinary duties of administration necessary for the settlement of the Trust.

In addition, before the sale of Dad’s Shares, the Trust will have made those other distributions required to be made from the Trust to any beneficiary other than Foundation, which would then be the sole remaining beneficiary.

Thus, if the Trust were not considered terminated for Federal income tax purposes prior to the Proposed Transaction, the Proposed Transaction would meet the third requirement.

Fourth, the Trust must receive an amount that equals or exceeds the fair market value of the foundation’s interest or expectancy in such property at the time of the transaction. The Litigation court was tasked with valuing Dad’s Shares. Foundation would endeavor to ensure that the Litigation court ordered the sale of Dad’s Shares to Corp at a price that was not less than the fair market value at the time of the Proposed Transaction. Thus, the Proposed Transaction would meet the fourth requirement if Dad’s Shares were sold to Corp at no less than their fair market value at the time of the transaction.

Fifth, the sale of Foundation’s interest or expectancy must result in its receiving an interest as liquid as the one that was given up. Pursuant to the trust agreement, Foundation had the expectancy of receiving Dad’s Shares, which were illiquid. Upon the completion of the Proposed Transaction, Foundation would receive the money that Corp paid Trust for Dad’s Shares. Thus, the Proposed Transaction would meet the fifth requirement if Foundation received the money proceeds from the Proposed Transaction.

Based on the foregoing, the IRS ruled that Corp’s purchase of Dad’s Shares held by the Trust would satisfy the “probate exception” from indirect self-dealing provided the following contingencies occurred:

  1. The probate court approved the Proposed Transaction;
  2. The Trust did not become a non-exempt charitable trust prior to the date of the sale of Dad’s Shares by the Trust; and
  3. The Trust received from the sale of Dad’s Shares to Corp an amount of cash or its equivalent that equaled or exceeded the fair market value of Corp’s Shares at the time of the transaction.

Trap for the Unwary?

Some of you may be thinking that the issue presented in the ruling discussed above, although somewhat interesting, is unlikely to arise with any regularity and, so, does not represent much of a trap for the unwary.[xvi]

I respectfully disagree. The fact pattern of the ruling is only one of many scenarios of indirect self-dealing that are encountered by advisers whose practice includes charitable planning for the owners of a closely held business.

There are two major factors that contribute to this reality: (i) the owner’s business will likely represent the principal asset of their estate, and (ii) the owner may have established a private foundation that they plan to fund at their demise (and thereby generate an estate tax deduction), either directly or through a split-interest trust.[xvii]

It is likely that the owner’s spouse, or some of their children, or perhaps a trust for their benefit, will be receiving an interest in the family business (an illiquid asset). It is also possible that the foundation will be funded with an interest in the business.

In these circumstances, the foundation may have to divest its interest in the family business in order to avoid the imposition of another private foundation excise tax (the one on “excess business holdings”).[xviii] Because of the limited market for such an interest, the foundation (or the owner’s estate or revocable trust) will probably have to sell its interest to the business itself (a redemption, as in the ruling above) or to another owner – each of which may be a disqualified person, thereby raising the issue of self-dealing. https://www.taxlawforchb.com/2018/10/private-foundations-and-business-ownership-a-new-day/.

In other circumstances, the divergent interests of the foundation to be funded, on the one hand, and of the individual beneficiaries of the owner’s estate or trust, on the other, may require that the foundation’s interest in the business be eliminated. For example, the foundation will need liquidity in order to engage in any charitable grant-making, while the other owners may prefer that the business reinvest its profits so as to expand the business; the foundation may prefer not to receive shares of stock in an S corporation, the ownership of which would result in the imposition of unrelated business income tax;[xix] or the foundation may be managed by individuals other than those operating the business, thereby setting the stage for a shareholder dispute as in the above ruling.

Bottom line:  It behooves the owners of the closely held business to consider these issues well before they arise. In many cases, it will be difficult to avoid them entirely, but the relevant parties should plan a course of action that is to be implemented after the demise of an owner.[xx] In this way, they may be able to avoid the personal, financial, and business disputes that may otherwise arise.

———————————————————————————-

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

[ii] The ruling does not disclose the jurisdiction under the laws of which Corp was formed.

In New York, the holders of shares representing 20% or more of the votes of all outstanding shares of a corporation may present a petition of dissolution on the ground that the directors or those in control of the corporation are guilty of oppressive acts toward the complaining shareholders. In determining whether to proceed with involuntary dissolution, the court must take into account whether liquidation of the corporation is the only feasible means by which the petitioners may reasonably expect to obtain a “fair return” on their investment. BCL 1104-a. This typically involves the valuation and buyout of the petitioners’ shares. However, the other shareholder(s) or the corporation may also elect to purchase the shares owned by the petitioners at fair value. BCL 1118. “Fair value” is not necessarily the same as “fair market value.” See Friedman v. Beway Realty Corp. 87 N.Y.2d 161 (1995).

[iii] Go figure. If the goal was to be bought out, congratulations. Why fight it? Or was Dad concerned that Daughter would render Corp unable to buy him out and, so, he wanted to pursue his own remedies?

[iv] Exempt from federal income tax under Sec. 501(a) of the Code, as an organization described in Sec. 501(c)(3) of the Code (educational, religious, scientific, and charitable purposes); a “private foundation” in that it did not receive financial support from the “general public.”

[v] Although a decedent should fund their revocable trust to the fullest extent possible prior to their demise, it is often the case that they forget to transfer – or that they intentionally retain direct ownership of – an asset, which thereby becomes part of their probate estate. In that case, the decedent’s last will and testament typically provides that the probate estate shall “pour over” into the now irrevocable trust – which acts as a “will substitute” – to be disposed of in accordance with the terms of the trust.

[vi] It should be noted that, effective for tax years beginning after December 31, 1997, certain tax-exempt organizations became eligible to own shares of stock in an S corporation; however, a qualifying organization’s share of S corporation income is treated as unrelated business income. IRC Sec. 1361(c)(6) and Sec. 512(e).

[vii] In general, “fair market value” as of the date of a decedent’s death is the value at which the property included in the decedent’s gross estate must be reported on their estate tax return. Reg. Sec. 20.2031-1(b).

[viii] The term “disqualified person” means, in part, with respect to a private foundation, a person who is:

(A) a “substantial contributor” to the foundation,

(B) a “foundation manager”,

(C) an owner of more than 20% of:

(i) the total combined voting power of a corporation,

(ii) the profits interest of a partnership, or

(iii) the beneficial interest of a trust or unincorporated enterprise, which is a substantial contributor to the foundation,

(D) a “member of the family” of any individual described in subparagraph (A), (B) or (C), or

(E) a corporation of which persons described in subparagraph (A), (B), (C), or (D) own more than 35% of the total combined voting power.

The term “members of the family” with respect to any person who is a disqualified person includes the individual’s spouse, ancestors, children, grandchildren, great grandchildren, and the spouses of children, grandchildren, and great grandchildren. IRC Sec. 4946.

[ix] The Code authorizes the imposition of certain excise taxes on a private foundation, on those who are disqualified persons with respect to such foundation, and on the foundation’s managers. These taxes are intended to modify the behavior of these parties – who are not otherwise dependent upon the public for financial support – by encouraging certain activities (e.g., expenditures for charitable purposes) and discouraging others (such as self-dealing).

[x] https://www.law.cornell.edu/uscode/text/26/4941

[xi] See EN iv, above.

[xii] See IRC Sec. 4947, which treats such a trust as a private foundation that is subject to all of the private foundation requirements.

A revocable trust that becomes irrevocable upon the death of the decedent-grantor, from which the trustee is required to distribute all of the net assets in trust for or free of trust to charitable beneficiaries, is not considered a charitable trust under section 4947(a)(1) for a reasonable period of settlement after becoming irrevocable. After that period, the trust is considered a charitable trust under section 4947(a)(1). The term “reasonable period of settlement” means that period reasonably required (or if shorter, actually required) by the trustee to perform the ordinary duties of administration necessary for the settlement of the trust. These duties include, for example, the collection of assets, the payment of debts, taxes, and distributions, and the determination of the rights of the subsequent beneficiaries.

[xiii] Reg. Sec. 53.4941(d)-1(b)(3); the so-called “probate exception.” https://www.law.cornell.edu/cfr/text/26/53.4941%28d%29-1 This exception had its genesis in the IRS’s recognition that a private foundation generally needs liquidity in order to carry out its charitable grant-making mission. With the appropriate safeguards (supervision by a probate court) to ensure that the foundation receives fair market value and attains the requisite liquidity, the act of self-dealing presented by the foundation’s sale of an interest in a closely held business may be forgiven.

[xiv] Interestingly, a substantial contributor’s status as such does not terminate upon their death; thus, a member of their family also remains a disqualified person.

[xv] See EN vii.

[xvi] A group of individuals to which the reader no longer belongs.

[xvii] For example, a charitable lead trust or a charitable remainder trust. IRC Sec. 2055(e). https://www.law.cornell.edu/uscode/text/26/2055.

[xviii] IRC Sec. 4943. https://www.law.cornell.edu/uscode/text/26/4943.

[xix] Taxable at 21% – as opposed to a 1% or 2% tax on investment income under IRC Sec. 4940 – and perhaps without a distribution from the corporation with which to pay the tax.

[xx] For example, corporate-owned life insurance to fund the buyout of the foundation’s interest, or the granting of options to family members to acquire the foundation’s interest.

I am excited to announce that my June 18, 2018 blog post “S Corps, CFCs & The Tax Cuts & Jobs Act” has been published as Chapter 6 in The Tax Cuts and Jobs Act: A Guide for Practitioners e-book. The chapter discusses the Tax Cuts & Jobs Act’s changes to the taxation of business income arising from the foreign activities of U.S. persons – and what that means for the increasing number of closely-held U.S. businesses who have established operations overseas.

The e-book was produced by the National Association of Enrolled Agents (NAEA). If you are interested in purchasing a copy, please click here.

Sibling Rivalry

Many of us encounter family-owned corporations in which the founder’s children are engaged in the business to varying degrees. They may even own shares in the corporation, typically having received them as gifts from their parents.[i] These situations may develop in such a way that they present difficult succession planning considerations for the business.

It may be that two or more siblings actively participate in the business. The more capable among them may aspire to lead the corporation after their parents have retired or passed away. At some point, their competing goals, personalities, or divergent management styles may generate enough friction between the siblings, and within the corporation, so as to jeopardize the continued well-being of the business.[ii]

Alternatively, the siblings may be interested in different parts of the corporation’s business. Each sibling may be responsible for a different line of business; for example, a different product, service, or geographic region. Their differing interests may lead to disagreements as to the allocation of resources and the prioritization of goals.

The dispute between the siblings will sometimes fester – and their relationship will deteriorate – to the point where litigation, along with its attendant costs and disruption of the business, are inevitable.[iii]

Dividing the Business?

In that case, it may still be possible to de-escalate the situation, and avoid further bloodshed[iv] – not to mention expense and loss of revenue – if it can be demonstrated to the feuding siblings that the business may be divided between them on a tax-efficient (i.e., economical) basis, especially where they have already incurred significant legal costs in trying to divorce themselves from one another.

Of course, it would be preferable (and less expensive) if the siblings could separate from one another without first resorting to litigation, although it is often the case that such litigation becomes the impetus for a more constructive approach toward the settlement of the parties’ disputes.

Indeed, if the parents could reasonably foresee the risk of serious disagreement among their successors in the business, they may decide to explore with their tax and corporate advisers whether the business can be divided among the kids while the parents are still alive and before the business suffers the adverse consequences that typically accompany such infighting.[v]

There are two basic forms of corporate division by which two or more shareholders may go their separate ways. In the “split-off” form of division, the parent corporation distributes all of its shares in a subsidiary corporation[vi] to one of more of its shareholders in a complete redemption of their shares in the parent corporation, leaving the parent corporation in the hands of its remaining shareholders. In the “split-up” form of division, the parent corporation distributes all its shares in at least two subsidiary corporations to at least two different sets of shareholders in a complete liquidation of the parent corporation.

There is also a third form of division – a “spin-off” – by which a parent corporation may distribute the stock of its subsidiary corporation to at least some of its shareholders by way of a “dividend,” thereby changing the form of the relationship to that of brother-sister corporations with some degree of common ownership.[vii]

“Tax-Free” Divisions

Whatever form of division is selected, there are numerous requirements that must be satisfied in order for the division to receive favorable tax treatment. In general,

    1. the distributing parent corporation must distribute to some or all of its shareholders all of the stock of a subsidiary corporation[viii] controlled by the parent,
    2. the distributing corporation and the subsidiary corporation must each be engaged in the “active conduct of a trade or business” immediately after the distribution,[ix]
    3. neither active trade or business was acquired in a taxable transaction during the five-year period preceding the distribution,
    4. there is a real and substantial business purpose for the distribution that cannot be accomplished by another nontaxable alternative which is neither impractical, nor unduly expensive,
    5. the transaction must not be used principally as a “device” for the distribution of the earnings and profits of either the distributing corporation or the subsidiary corporation,
    6. the distributee shareholders did not acquire their shares in the distributing parent corporation by “purchase” during the five-year period ending on the date of the distribution; and
    7. the distribution is not made pursuant to a plan by which at least 50% of parent or of the former subsidiary is acquired by third parties.[x]

In general, if these requirements are satisfied, (1) the shareholders will not recognize gain or loss upon the receipt of the subsidiary stock, (2) the distributing corporation will not recognize gain or loss upon the distribution of the subsidiary stock to the shareholders, (3) the aggregate basis of the subsidiary stock received by each shareholder immediately after the distribution will equal the shareholder’s aggregate basis in the distributing corporation stock surrendered in the distribution, and (4) the holding period of the subsidiary stock received by each shareholder will include the holding period of the stock in the distributing corporation with respect to which the distribution of the subsidiary stock is made.[xi]

If these criteria are not met, then the distributing corporation will be treated as having sold the distributed property for an amount equal to the property’s fair market value, it will have to recognize the gain realized on deemed sale of the property, and it will be taxed thereon. The shareholders will be taxed on their receipt of the property distributed by the corporation, either as a dividend of an amount equal to the fair market value of such property, or as a payment of the same amount in exchange for their shares of stock in the distributing corporation.

In order to avoid the adverse tax consequences described immediately above, it is imperative that each of the requirements for a “tax-free” division of the distributing corporation be satisfied.

Business Purpose

In the context of a family-owned corporation, the requirement that the distribution be carried out for a real and substantial corporate business purpose may present a unique challenge, at least where the ostensible business purpose for the division of the corporation is to enable competing siblings – who would otherwise succeed to the ownership and management of the corporation – to go their separate ways.

Specifically, it may be difficult in that case, depending upon the facts and circumstances, to distinguish between a corporate business purpose, on the one hand, and a personal non-business purpose of the shareholders, on the other.

That being said, it should be noted that one of the most commonly relied upon corporate business purposes for the distribution of a subsidiary as part of a corporate division is that it will enhance the success of each corporation’s business by enabling a significant shareholder or shareholder group to concentrate on a particular line of business, and to thereby resolve management or other problems that arise, or are exacerbated, by the operation of different businesses within a single corporation.[xii]

However, the IRS has long recognized the potential, in the context of a family-owned corporation, for such a distribution to also facilitate the personal planning (such as estate planning or gifts) of a shareholder.

In order to better understand how to prepare for an IRS challenge on such grounds,[xiii] the parties and their advisers will need to familiarize themselves, in the first instance, with the published guidance provided by the IRS itself, including the two rulings described below.[xiv]

Scenario One

The IRS once considered the case of a corporation (“Corp”) that operated an automobile dealership.[xv] Its franchise for the sale of automobiles was in Dad’s name; the franchise could not be held by the corporation, was renewable periodically, and was not transferable by inheritance or otherwise.

Dad managed Corp and owned a majority of its stock. He was elderly, and the Corp stock constituted the bulk of his estate. The balance of Corp’s stock was held equally by Dad’s five daughters, only three of whom were active in the business.

Corp’s wholly-owned subsidiary (“Sub”) was engaged in the business of renting automobiles.

The automobile manufacturer did not permit the granting or continuing of a franchise where there were inactive shareholders in the corporation unless an active majority shareholder held the franchise. Alternatively, the manufacturer permitted the granting or continuing of a franchise where there was no majority shareholder, provided the shareholders were few in number and all were active in the business.

The IRS noted that, upon Dad’s death or retirement, the present stock ownership of Corp, with proportionate bequests or gifts to Dad’s daughters, would preclude satisfaction of the active-shareholder criteria described above for the purpose of renewing the franchise.

In order to ensure that its remaining shareholders would be able to renew the franchise upon Dad’s death or retirement under the alternate conditions of the franchise policy – without chancing a potential interruption in the continuity of, or even the loss of, the franchise which might occur if nothing was done until after Dad’s departure – Corp distributed 75% of Sub’s stock to the two inactive-daughter shareholders in exchange for all of their stock in Corp. The remaining 25% of Sub’s stock was distributed to Dad in exchange for Corp shares of equal value.

Dad intended that, upon his death, the inactive-daughter shareholders would receive their inheritance in Sub stock (and assets other than Corp stock), while the active-daughter shareholders would receive his shares of Corp stock.

The IRS determined that distribution of the Sub stock to Dad furthered the objective of enabling Corp’s active-daughter shareholders to retain the franchise by increasing their percentage of ownership in Corp, and by providing Dad with Sub stock which he could bequeath or gift to the inactive-daughter shareholders, leaving his remaining Corp stock available for transfer to the active-daughter shareholders.

The IRS also found that Dad’s age presented an immediate problem, [xvi] and that the distribution of Sub’s stock was germane to the continuation of Corp’s business in the reasonably foreseeable future. Execution of the plan, therefore, was directly related to the retention of a franchise vital to Corp’s business and would forestall an impending disruption to such business by reason of the current active family group being unable to renew the corporation’s franchise upon Dad’s death or retirement.

Scenario Two

In another ruling[xvii] the IRS considered a corporation (“Corp”) the stock of which was owned equally by Parents, Son, and Daughter. Although Parents participated in some major management decisions, most of the management, and all of the operational activities, were performed by Son and Daughter.

Son and Daughter disagreed over the future direction of Corp’s business. Son wished to expand one line of business, but Daughter was opposed because this would require substantial borrowing by Corp. Daughter preferred to sell that line of business and concentrate on Corp’s other business. Despite the disagreement, the two siblings cooperated on the operation of the business in its historical manner without disruption. Nevertheless, it prevented each sibling from developing, as he or she saw fit, the business in which he or she was most interested.

Parents remained neutral on the disagreement between their children. However, because of the disagreement, Parents preferred to bequeath separate interests in the business to their children.

To enable Son and Daughter each to devote their undivided attention, and apply a consistent business strategy, to the line of business in which he or she was most interested, and to further Parents’ estate planning goals, Corp contributed one of its lines of business to a newly-formed and wholly-owned subsidiary corporation (“Sub”), and distributed 50% of Sub’s stock to Son in exchange for all of his stock in Corp. Corp then distributed the remaining Sub stock to Parents in exchange for half of their Corp stock.

Going forward, Daughter would manage and operate Corp and have no stock interest in Sub, and Son would manage and operate Sub and have no stock interest in Corp. Parents would also amend their wills to provide that Son and Daughter would inherit stock only in Sub and Corp, respectively. After the distribution, Parents would still own 50% of the outstanding stock of Corp and of Sub, and would continue to participate in certain management decisions related to the business of each corporation.

The IRS determined that the distribution would eliminate the disagreement between Son and Daughter over the future direction of Corp’s business, and would allow each sibling to devote their undivided attention to the line of business in which they were most interested, with the expectation that each business would benefit. Therefore, although the distribution was intended, in part, to further the personal estate planning of Parents and to promote family harmony, it was motivated in substantial part by a real and substantial non-tax purpose that was germane to the business of Corp. Thus, the business purpose requirement was satisfied.

Guideposts?

It is clear that the division of a family-owned corporation may be effectuated for the purpose of resolving or eliminating management disputes among siblings. It may also be undertaken for the purpose of staving off reasonably foreseeable or imminent harm to a business that is attributable to the composition of its shareholders.

Moreover, the division may be accomplished on a tax-efficient basis, provided the criteria set forth above are satisfied, including the requirement that the distribution by the family-owned corporation of the stock in its subsidiary be motivated in whole or in substantial part by a business purpose, as distinguished from a nonbusiness purpose. Specifically, can the parties to the transaction demonstrate that there is an immediate business reason for the distribution?

In each of the two scenarios described above, there were “clear and present” reasons for the divisive distribution; the failure to act would have resulted in significant harm to the business of either or both of the corporations. The difficulties anticipated were not remote, and the resulting harm to the business was not conjectural.

However, one can imagine a situation in which the immediacy of the stated business purpose may not be obvious to an outsider, or where the severity of the consequences to be avoided is not easily determinable. In the context of a family-owned corporation, the presence of these factors – a remote risk or an ill-defined harm – may call into question whether the distribution is motivated in substantial part by a bona fide business purpose; the failure to establish such a purpose may cause the corporation’s distribution of its subsidiary to be taxable.

For that reason, if a “divisive” transaction is to withstand IRS scrutiny, the closely held corporations and the shareholders that are parties to the transaction must be prepared to substantiate the corporate business purposes which they claim motivated the transaction in whole or substantial part. They must be ready to present documentation that provides complete factual support for the stated business purpose, that describes in detail the problems associated with the current corporate structure, and that demonstrates why the distribution will lessen or eliminate those problems. As always, this body of “evidence” should be compiled contemporaneously with the events that culminate in the division of the corporation – not after the IRS has selected the parties for audit.


[i] Or as partial gifts (as in the case of a bargain sale); rarely in exchange for capital contributions, or as compensation.

[ii] Regardless of the size of the social unit, be it a family, a business, or even a nation, the results can be severe. History gives us many examples. The Old Testament alone is full of references to the consequences of sibling rivalry: Cain and Abel, Isaac and Ismael, Esau and Jacob, then down to the sons of Solomon (ironic that the kingdom of the man who rendered the Judgment of Solomon – “suggesting” that a baby be split in half in order to ascertain its true mother – should be split in two after his death).

[iii] Forget about holidays and family gatherings – Thanksgiving is never the same.

[iv] Tax lawyers enjoy the figurative use of language because we are so rarely afforded the opportunity. Our exchanges (pun intended) with others are so often limited to words such as “gain, loss, deferral, recognition . . .” and, of course, “tax.”

[v] Too often, the parents don’t want to deal with the obviously gestating issues within their family. They tell themselves that the kids will learn to work together, or they will deny the problem altogether, leaving it for the kids to resolve it after the parents are gone. We know how that usually works out. Not the sort of legacy for which most folks yearn.

[vi] The subsidiary may be formed just prior to the distribution; for example, the parent corporation may contribute one line of business to a newly-formed subsidiary as a prelude to the distribution of the stock of the subsidiary, as described above; or it may be an existing entity that is engaged in a trade or business that is related to, or completely different from, the business conducted by the distributing corporation (or by its remaining subsidiary).

[vii] This is likely the form of division that parents would undertake in preparation for transferring different parts of their business to different children.

[viii] Often referred to as the “controlled corporation.”

[ix] I.e., a “trade or business” that has been “actively conducted” throughout the 5-year period ending on the date of the distribution. This requirement has spawned some litigation between taxpayers and the IRS.

[x] Underlying the divisive reorganization provisions of the Code is the principle that it would be inappropriate to tax a transaction as a result of which the participating taxpayers – the corporations and their shareholders – have not sufficiently changed the nature of their investment in the corporation’s assets or business, provided the transaction is motivated by a substantial non-tax business purpose.

[xi] IRC Sec. 355, IRC Sec. 368(a)(1)(D).

[xii] For example, in Example (2) of Reg. Sec. 1.355-2(b)(5), Corporation X is engaged in two businesses: the manufacture and sale of furniture and the sale of jewelry. The businesses are of equal value. The outstanding stock of X is owned equally by unrelated individuals A and B. A is more interested in the furniture business, while B is more interested in the jewelry business. A and B decide to split up the businesses and go their separate ways. A and B expect that the operations of each business will be enhanced by the separation because each shareholder will be able to devote his undivided attention to the business in which he is more interested and more proficient. Accordingly, X transfers the jewelry business to new corporation Y and distributes the stock of Y to B in exchange for all of B’s stock in X. The example concludes that the distribution is carried out for a corporate business purpose, notwithstanding that it is also carried out in part for shareholder purposes.

[xiii] An exercise that should be completed before the transaction is even undertaken.

[xiv] Although the IRS’s public pronouncements are generally limited to the application of the law to a specific set of facts, they nevertheless provide a useful glimpse into the IRS’s thinking on the issues examined therein.

[xv] Rev. Rul. 75-337.

[xvi] In contrast, the IRS described a decision where the court held, under a plan to avoid any remote possibility of interference in a business by future sons-in-law, that the spin-off had no immediate business reason, involved a personal motive, and had as its primary purpose a desire to make bequests in accordance with an estate plan. The difficulties anticipated were so remote that they might never come to pass. The daughters might never marry – thus eliminating completely any cause to worry about business interference by future sons-in-law. There was, at best, “only an envisaged possibility of future debilitating nepotism,” and the effect on the business was conjectural. Rafferty v. Commissioner, 452 F.2d 767 (1st Cir. 1971).

[xvii] Rev. Rul. 2003-52.

The Joy – and Tax Benefits – of Gifting

As we enter the “season of giving” and the end of yet another year, the thoughts of many tax advisers turn to . . . tax planning.(i) In keeping with the spirit of the season, an adviser may suggest that a client with a closely held business consider making a gift of equity in the business to the owner’s family or to a trust for their benefit.(ii)

Of course, annual exclusion gifts(iii) are standard fare and, over the course of several years, may result in the transfer of a not insignificant portion of the equity in a business.

However, the adviser may also recommend that the client consider making larger gifts, thereby utilizing a portion of their “unified” gift-and-estate tax exemption amount during their lifetime. Such a gift, the adviser will explain, may remove from the owner’s gross estate not only the current value of the transferred business interests, but also the future appreciation thereon.(iv)

The client and the adviser may then discuss the “size” of the gift and the valuation of the business interests to be gifted, including the application of discounts for lack of control and lack of marketability. At this point, the adviser may have to curb the client’s enthusiasm somewhat by reminding them that the IRS is still skeptical of certain valuation discounts, and that an adjustment in the valuation of a gifted business interest may result in a gift tax liability.

The key, the adviser will continue, is to remove as much value from the reach of the estate tax as reasonably possible, and without incurring a gift tax liability – by utilizing the client’s remaining exemption amount – while also leaving a portion of such exemption amount as a “cushion” in the event the IRS successfully challenges the client’s valuation.

“Ask and Ye Shall Receive”(v)

Enter the 2017 Tax Cuts and Jobs Act (the “Act”).(vi) Call it an early present for the 2018 gifting season.

One of the key features of the Act was the doubling of the federal estate and gift tax exemption for U.S. decedents dying, and for gifts made by U.S. individuals,(vii) after December 31, 2017, and before January 1, 2026.

This was accomplished by increasing the basic exemption amount (“BEA”) from $5 million to $10 million. Because the exemption amount is indexed for inflation (beginning with 2012), this provision resulted in an exemption amount of $11.18 million for 2018, and this amount will be increased to $11.4 million in 2019.(viii)

Exemption Amount in a Unified System

You will recall that the exemption amount is available with respect to taxable transfers made by an individual taxpayer either during their life (by gift) or at their death – in other words, the gift tax and the estate tax share a common exemption amount.(x)

The gift tax is imposed upon the taxable gifts made by an individual taxpayer during the taxable year (the “current taxable year”). The gift tax for the current taxable year is determined by: (1) computing a “total tentative tax” on the combined amount of all taxable gifts made by the taxpayer for the current and all prior years using the common gift tax and estate tax rate table; (2) computing a tentative tax only on all prior-year gifts; (3) subtracting the tentative tax on prior-year gifts from the tentative tax computed for all years to arrive at the portion of the total tentative tax attributable to current-year gifts; and, finally, (4) subtracting the amount of the taxpayer’s unified credit (derived from the unused exemption amount) not consumed by prior-year gifts.

Thus, taxable gift transfers(xi) that do not exceed a taxpayer’s exemption amount are not subject to gift tax. However, any part of the taxpayer’s exemption amount that is used during their life to offset taxable gifts reduces the amount of exemption that remains available at their death to offset the value of their taxable estate.(xii)

From a mechanical perspective, this “unified” relationship between the two taxes is expressed as follows:

• the deceased taxpayer’s taxable estate is combined with the value of any taxable gifts made by the taxpayer during their life;
• the estate tax rate is then applied to determine a “tentative” estate tax;
• the portion of this tentative estate tax that is attributable to lifetime gifts made by the deceased taxpayer is then subtracted from the tentative estate tax to determine the “gross estate tax” – i.e., the amount of estate tax before considering available credits, the most important of which is the so-called “unified credit”; and
• credits are subtracted to determine the estate tax liability.

This method of computation is designed to ensure that a taxpayer only gets one run up through the rate brackets for all lifetime gifts and transfers at death.(xiii)

What Happens After 2025?(xvi)

However, given the temporary nature of the increased exemption amount provided by the Act, many advisers questioned whether the cumulative nature of the gift and estate tax computations, as described above, would result in inconsistent tax treatment, or even double taxation, of certain transfers.

To its credit,(xv) Congress foresaw some of these issues and directed the IRS to prescribe regulations regarding the computation of the estate tax that would address any differences between the exemption amounts in effect: (i) at the time of a taxpayer’s death and (ii) at the time of any gifts made by the taxpayer.

Pending the issuance of this guidance – and pending the confirmation of what many advisers believed was an expression of Congressional intent not to punish individuals who make gifts using the increased exemption amount – many taxpayers decided not to take immediate advantage of the greatly increased exemption amount, lest they suffer any of the consequences referred to above.

Proposed Regulations

In response to Congress’s directive, however, the IRS proposed regulations last week that should allay the concerns of most taxpayers,(xvi) which in turn should smooth the way to increased gifting and other transfers that involve an initial or partial gift.

In describing the proposed regulations, the IRS identified and analyzed several situations that could have created unintended problems for a taxpayer, though it concluded that the existing methodology for determining the taxpayer’s gift and estate tax liabilities provided adequate protection against such problems:

Whether a taxpayer’s post-2017 increased exemption amount would be reduced by pre-2018 gifts on which gift tax was paid. If the taxpayer makes additional gifts during the post-2017 increased exemption period, would the gift tax computation apply the increased exemption to the pre-2018 gifts, thus reducing the exemption otherwise available to shelter gifts made during the post-2017 period, effectively allocating credit to a gift on which gift tax in fact was already paid, and denying the taxpayer the full benefit of the increased exemption amount for transfers made during the increased exemption period?

Whether the increased exemption amount available during the increased exemption period would be reduced by pre-2018 gifts on which gift tax was paid. If the taxpayer died during the increased exemption period, would the estate tax computation apply the increased exemption to the pre-2018 gifts, thus reducing the exemption otherwise available against the estate tax during the increased exemption period and, in effect, allocating credit to a gift on which gift tax was paid?

Whether the gift tax on a post-2025 transfer would be inflated by the theoretical gift tax on a gift made during the increased exemption period that was sheltered from gift tax when made. Would the gift tax determination on the post-2025 gift treat the gifts made during the increased exemption period as gifts that were not sheltered from gift tax given that the post-2025 gift tax determination is based on the exemption amount then in effect, rather than on the increased exemption amount, thereby increasing the gift on the later transfer and effectively subjecting the earlier gift to tax even though it was exempt from gift tax when made?

With respect to the first two situations described above, the IRS determined that the current methodology by which a taxpayer’s gift and estate tax liabilities are determined ensures that the increased exemption will not be reduced by a prior gift on which gift tax was paid. As to the third situation, the IRS concluded that the current methodology ensures that the tax on the current gift will not be improperly inflated.

New Regulations

However, there was one situation in which the IRS concluded that the methodology for computing the estate tax would, in effect, retroactively eliminate the benefit of the increased exemption that was available for gifts made during the increased exemption period.

Specifically, the IRS considered whether, for estate tax purposes, a gift made by a taxpayer during the increased exemption period, and that was sheltered from gift tax by the increased exemption available during such period, would inflate the taxpayer’s post-2025 estate tax liability.

The IRS determined that this result would follow if the estate tax computation failed to treat such gifts as sheltered from gift tax.

Under the current methodology, the estate tax computation treats the gifts made during the increased exemption period as taxable gifts not sheltered from gift tax by the increased exemption amount, given that the post-2025 estate tax computation is based on the exemption in effect at the decedent’s death rather than the exemption in effect on the date of the gifts.

For example, if a taxpayer made a gift of $11 million in 2018, (when the BEA is $10 million; a taxable gift of $1 million), then dies in 2026 with a taxable estate of $4 million (when the BEA is $5 million), the federal estate tax would be approximately $3,600,000: 40% estate tax on $9 million – specifically, the sum of the $4 million taxable estate plus $5 million of the 2018 gift that was sheltered from gift tax by the increased exemption. This, in effect, would impose estate tax on the portion of the 2018 gift that was sheltered from gift tax by the increased exemption allowable at that time.

Alternatively, what if the taxpayer dies in 2026 with no taxable estate? The taxpayer’s estate tax would be approximately $2 million, which is equal to a 40% tax on $5 million – the amount by which, after taking into account the $1 million portion of the 2018 gift on which gift tax was paid, the 2018 gift exceeded the BEA at death. This, in effect, would impose estate tax on the portion of the 2018 gift that was sheltered from the gift tax by the excess of the 2018 exemption over the 2026 exemption.

The IRS determined that this problem arises from the interplay between the differing exemption amounts that are taken into account in the computation of the estate tax.

Specifically, after first determining the tentative tax on the sum of a decedent’s taxable estate and their adjusted taxable gifts,(xvii)

i. the decedent’s estate must then determine the credit against gift taxes for all prior taxable gifts, using the exemption amount allowable on the dates of the gifts (the credit itself is determined using date of death tax rates);
ii. the gift tax payable is then subtracted from the tentative tax, the result being the net tentative estate tax; and
iii. the estate next determines a credit based on the exemption amount as in effect on the date of the decedent’s death, which is then applied to reduce the net tentative estate tax.

If this credit (based on the exemption amount at the date of death) is less than the credit allowable for the decedent’s taxable gifts (using the date of gift exemption amount), the effect is to increase the estate tax by the difference between the two credit amounts.

In this circumstance, the statutory requirements for computing the estate tax have the effect of imposing an estate tax on gifts made during the increased exemption period that were sheltered from gift tax by the increased exemption amount in effect when the gifts were made.

In order to address this unintended result, the proposed regulations would add a special computation rule in cases where (i) the portion of the credit as of the decedent’s date of death that is based on the exemption is less than (ii) the sum of the credits attributable to the exemption allowable in computing the gift tax payable. In that case, the portion of the credit against the net tentative estate tax that is attributable to the exemption amount would be based upon the greater of those two credit amounts.

Specifically, if the total amount allowable as a credit, to the extent based solely on the BEA, in computing the gift tax payable on the decedent’s post-1976 taxable gifts, exceeds the credit amount based solely on the BEA in effect at the date of death, the credit against the net tentative estate tax would be based on the larger BEA.

For example, if a decedent made cumulative taxable gifts of $9 million, all of which were sheltered from gift tax by a BEA of $10 million applicable on the dates of the gifts,(xviii) and if the decedent died after 2025 when the BEA was $5 million, the credit to be applied in computing the estate tax would be based upon the $9 million of exemption amount that was used to compute the gift tax payable.

Time to Act?

By addressing the unintended results presented in the situation described – a gift made the decedent during the increased exemption period, followed by the death of the decedent after the end of such period – the proposed regulations ensure that the decedent’s estate will not be inappropriately taxed with respect to the gift.

With this “certainty,” an individual business owner who has been thinking about gifting a substantial interest in their business may want to accelerate their gift planning. As an additional incentive, the owner need only look at the results of the mid-term elections, which do not bode well for the future of the increased exemption amount. In other words, it may behoove the owner to treat 2020 (rather than 2025) as the final year for which the increased exemption amount will be available, and to plan accordingly. Those owners who decide to take advantage of the increased exemption amount by making gifts should consider how they may best leverage it.

And as always, tax savings, estate planning, and gifting strategies have to be considered in light of what is best for the business and what the owner is comfortable giving up.

—————————————————————
(i) What? Did you really expect something else? Tax planning is not a seasonal exercise – it is something to be considered every day, similar to many other business decisions.
(ii) Of course, the interest to be gifted should be “disposable” in that the owner can comfortably afford to give up the interest. Even if that is the case, the owner may still want to consider the retention of certain “tax-favored” economic rights with respect to the interest so as to reduce the amount of the gift for tax purposes.
(iii) Usually into an irrevocable trust, and coupled with the granting of “Crummey powers” to the beneficiaries so as to support the gift as one of a “present interest” in property. A donor’s annual exclusion amount is set at $15,000 per donee for 2018 and $15,000 for 2019.
(iv) In other words, a dollar removed today will remove that dollar plus the appreciation on that dollar; a dollar at death shields only that dollar.
The removal of this value from the reach of the estate tax has to be weighed against the loss of the stepped-up basis that the beneficiaries of the decedent’s estate would otherwise enjoy if the gifted business interest were included in the decedent’s gross estate.
(v) Matthew 7:7-8. Actually, many folks asked for the repeal of the estate tax. “You Can’t Always Get What You Want,” The Rolling Stones.
(vi) P.L. 115-97.
(vii) For purposes of the estate tax, this includes a U.S. citizen or domiciliary. The distinction between a U.S. individual and non-resident-non-citizen is significant. In the absence of any estate and gift tax treaty between the U.S and the foreign individual’s country, the foreign individual is not granted any exclusion amount for purposes of determining their U.S. gift tax liability, and only a $60,000 exclusion amount for U.S. estate tax purposes.
(viii) https://www.irs.gov/pub/irs-drop/rp-18-57.pdf
(ix) Only individual transferors are subject to the gift tax. Thus, in the case of a transfer from a business entity that is treated as a gift, one or more of the owners of the business entity will be treated as having made the gift.
(x) They also share a common tax rate table.
(xi) As distinguished, for example, from the annual exclusion gift – set at $15,000 per donee for 2018 and for 2019 – which is not treated as a taxable gift (it is not counted against the exemption amount).
(xii) An election is available under which the federal exemption amount that was not used by a decedent during their life or at their death may be used by the decedent’s surviving spouse (“portability”) during such spouse’s life or death.
(xiii) A similar approach is followed in determining the gift tax, which is imposed on an individual’s transfers by gift during each calendar year.
(xiv) As indicated above, the increased exemption amount is scheduled to sunset after 2025, at which point the lower, pre-TCJA basic exclusion amount is reinstated, as adjusted for inflation through 2025. Of course, a change in Washington after 2020 could accelerate a reduction in the exemption amount.
(xv) I bet you don’t hear that much these days.
(xvi) https://www.federalregister.gov/documents/2018/11/23/2018-25538/estate-and-gift-taxes-difference-in-the-basic-exclusion-amount; the regulations are proposed to be effective on and after the date they are published as final regulations in the Federal Register.
(xvii) Defined as all taxable gifts made after 1976 other than those included in the gross estate.
(xviii) Post-TCJA and before 2026.

If there was one part of the Tax Cuts and Jobs Act (“TCJA”) that estate planners were especially pleased to see, it was the increase in the basic exclusion amount from $5.49 million, in 2017, to $11.18 million for gifts made, and decedents dying, in 2018.[i] However, many estate planners failed to appreciate the potential impact of an income tax provision that came late to the party and that was specifically intended to benefit the individual owners of pass-through entities (“PTEs”).

A Brief History

As it made its way through Congress, the TCJA was billed[ii] as a boon for corporate taxpayers, and indeed it was. The corporate tax rate was reduced from 35% to 21%. The corporate AMT was eliminated. The system for the taxation of foreign income was changed in a way that skews in favor of C corporations.

But what about the closely held business – the sole proprietorships, the S corps, the partnerships and LLCs that are owned primarily by individual taxpayers and that often represent the most significant asset in their estates?

These businesses are usually formed as PTEs for tax purposes, meaning that the net operating income generated by these entities is generally not subjected to an entity-level tax; rather, it flows through to the individual owners, who are taxed thereon as if they had realized it directly.

With the introduction of the TCJA, the owners of many PTEs began to wonder whether they should revoke their S corporation elections, or whether they should incorporate[iii] their sole proprietorships and partnerships.

In response to the anxiety felt by individual business owners, Congress enacted a special deduction for PTEs in the form of Sec. 199A.[iv] However, shortly after its enactment on December 22, 2017, tax advisers starting peppering the IRS with questions about the application of 199A.

The IRS eventually proposed regulations in August, for which hearings were held in mid-October.[v]

In September, House Republicans introduced plans for making Sec. 199A “permanent.” Then, during the first week of November, the Republicans lost control of the House.[vi]

Notwithstanding this state of affairs, the fact remains that 199A is the law for at least two more years,[vii] and estate planners will have to deal with it; after all, the income tax consequences arising from an individual’s transfer of an interest in a PTE in furtherance of their estate plan will either enhance or reduce the overall economic benefit generated by the transfer.

In order to better appreciate the application of 199A to such “estate planning transfers,” a quick refresher may be in order.

Sec. 199A Basics

Under Sec. 199A, a non-corporate taxpayer[viii] – meaning an individual, a trust, or an estate – who owns an interest in a PTE that is engaged in a qualified trade or business (“QTB”),[ix] may claim a deduction for a taxable year equal to 20% of their qualified business income (“QBI”)[x] for the taxable year.[xi]

This general rule, however, is subject to a limitation that, if triggered, may reduce the amount of the 199A deduction that may be claimed by the non-corporate taxpayer (the “limitation”).

What triggers the limitation? The amount of the taxpayer’s taxable income from all sources[xii] – not just the taxpayer’s share of the QTB’s taxable income. Moreover, if the taxpayer files a joint return with their spouse, the spouse’s taxable income is also taken into account.

Specifically, once the taxpayer’s taxable income exceeds a specified threshold amount, the limitation becomes applicable, though not fully; rather, it is phased in. In the case of a single individual, the limitation starts to apply at taxable income of $157,500 (the so-called “threshold amount”). The limitation is fully phased in when taxable income exceeds $207,500.[xiii]

This $157,500 threshold amount also applies to non-grantor trusts and to estates.

These thresholds are applied at the level of each non-corporate owner of the business – not at the level of the entity that actually conducts the business. Thus, some owners of a QTB who have higher taxable incomes may be subject to the limitations, while others with lower taxable incomes may not.

The Limitation

As stated earlier, the Sec. 199A deduction for an individual, a trust, or an estate for a particular tax year is generally equal to the 20% of the taxpayer’s QBI for the year.

However, when the above-referenced limitation becomes fully applicable, the taxpayer’s 199A deduction for the year is equal to the lesser of:

  • 20% of their QBI from a QTB, and
  • The greater of:
      • 50% of the W-2 Wages w/r/t such QTB, or
      • 25% of the W-2 Wages w/r/t such QTB plus 2.5% of the “unadjusted basis” of the “qualified property” in such QTB.

In considering the application of this limitation, the IRS recognized that there are bona fide non-tax, legal or business reasons for holding certain properties – such as real estate – separate from the operating business, and renting it to such business. For that reason, the proposed regulations allow the owners of a QTB to consider the unadjusted basis of such rental property in determining the limitations described above – even if the rental activity itself is not a QTB – provided the same taxpayers control both the QTB and the property.[xiv]

Thus, assuming the presence of at least one QTB,[xv] much of the planning for 199A will likely involve the taxpayer’s “management” of (i) their taxable income (including their wages and their share of QBI) and, thereby, their threshold amount for a particular year, (ii) the W-2 Wages paid by the business, (iii) the unadjusted basis of the qualified property[xvi] used in the business, and (iv) the aggregation of QTBs.

Of the foregoing items, the management of the unadjusted basis of qualified property may be especially fruitful in the context of estate planning, as may the management of the threshold amount.

Unadjusted Basis

Generally speaking, the unadjusted basis of qualified property is its original basis in the hands of the QTB as of the date it was placed into service by the business.

Where the business purchased the property, its cost basis would be its unadjusted basis – without regard to any adjustments for depreciation or expensing subsequently claimed with respect to the property – and this amount would be utilized in determining the limitation on an owner’s 199A deduction.

However, where the property was contributed to a PTE in a tax-free exchange for stock or a partnership interest, the PTE’s unadjusted basis would be the adjusted basis of the property in the hands of the contributor at the time of the contribution – i.e., it will reflect any cost recovery claimed by such person.

In the case of an individual who acquires property from a decedent before placing it into service in a QTB, the stepped-up basis becomes the unadjusted basis or purposes of 199A.

However, if the qualified property is held in a partnership, no Section 754 adjustment made at the death of a partner will be taken into account in determining the unadjusted basis for the transferee of the decedent’s interest for purposes of 199A.[xvii]

Based on the foregoing, and depending upon the business,[xviii] a taxpayer who can maximize the unadjusted basis of the QTB’s qualified property will increase the likelihood of supporting a larger 199A deduction in the face of the limitation.

Toward achieving this end, there may be circumstances in which qualified property should be owned directly by the owners of the PTE (say, as tenants-in-common[xix]), rather than by the PTE itself, and then leased by the owners to the business.

For example, if a sole proprietor is thinking about incorporating a business, or converting it into a partnership by bringing in a partner, and the business has qualified property with a relatively low unadjusted basis (say, the original cost basis), the sole proprietor may want to retain ownership of the depreciable property and lease it (rather than contribute it) to the business entity, so as (i) to preserve their original unadjusted cost basis and avoid a lower unadjusted cost basis in the hands of the entity (based on the owner’s adjusted basis for the property) to which it would otherwise have been contributed, and (ii) to afford their successors in the business and to the property an opportunity to increase their unadjusted basis in the property, assuming it has appreciated – basically, real estate – after the owner’s death.

Trusts – the Threshold Amount

A non-grantor trust is generally treated as a form of pass-through entity to the extent it distributes (or is required to distribute) its DNI (“distributable net income;” basically, taxable income with certain adjustments) to its beneficiaries, for which the trust claims a corresponding distribution deduction. In that case, the income tax liability for the income that is treated as having been distributed by the trust shifts to the beneficiaries to whom the distribution was made.

To the extent the trust retains its DNI – i.e., does not make (and is not required to make) a distribution to its beneficiaries – the trust itself is subject to income tax.

In the case of a non-grantor trust, at least in the first instance, the 199A deduction is applied at the trust level. Because the trust is generally treated as an individual for purposes of the income tax, the threshold amount for purposes of triggering the application of the limitation is set at $157,500 (with a $50,000 phase-in range).

Distribution

However, if the trust has made distributions during the tax year that carry out DNI to its beneficiaries, the trust’s share of the QBI, W-2 Wages, and Unadjusted Basis of the QTB in which it owns an interest are allocated between the trust and each beneficiary-distributee.

This allocation is based on the relative proportion of the DNI of the trust that is distributed, or that is required to be distributed, to each beneficiary, or that is retained by the trust. In other words, each beneficiary’s share of the trust’s 199A-related items is determined based on the proportion of the trust’s DNI that is deemed distributed to the beneficiary.

The individual beneficiary treats these items as though they had been allocated to them directly from the PTE that is engaged in the QTB.

Following this allocation, the trust uses its own taxable income for purposes of determining its own 199A deduction, and the beneficiaries use their own taxable incomes.

Based on the foregoing, a trustee may decide to make a distribution in a particular tax year if the trust beneficiaries to whom the distribution is made are in a better position to enjoy the 199A deduction than are the trust and the other beneficiaries.[xx]

In any case, the beneficiaries to whom a distribution is not made may object to the trustee’s decision notwithstanding the tax-based rationale.

Of course, where the trustee does not consider the tax attributes of an individual beneficiary, and makes a distribution to such individual which pushes them beyond the threshold amount, or disqualifies their SSTB from a 199A deduction, the beneficiary may very well assert that the trustee did not act prudently.

Limitations Applied to Non-grantor Trusts

The 199A threshold and phase-in amounts are applied at the level of the non-grantor trust.[xxi]

Because of this, the IRS is concerned that taxpayers will try to circumvent the threshold amount by dividing assets among multiple non-grantor trusts, each with its own threshold amount.

In order to prevent this from happening, the IRS has proposed regulations that introduce certain anti-abuse rules.[xxii]

Specifically, if multiple trusts are formed with a “significant purpose” – not necessarily the primary purpose – of receiving a deduction under 199A, the proposed regulations provide that the trusts will not be “respected” for purposes of 199A.[xxiii] Unfortunately, it is not entirely clear what this means: will the trusts not qualify at all, or will they be treated as a single trust for purposes of the deduction?

In addition, two or more trusts will be aggregated by the IRS, and treated as a single trust for purposes of 199A, if:

  • The trusts have substantially the same grantor(s),
  • Substantially the same “primary” beneficiary(ies), and
  • “A” principal purpose for establishing the trusts is the avoidance of federal income tax.

For purposes of applying this rule, spouses are treated as one person. In other words, if a spouse creates one trust and the other spouse creates a second trust, the grantors will be treated as the same for purposes of the applying this anti-abuse test, even if the trusts are created and funded independently by the two spouses.[xxiv]

If the creation of multiple trusts results in a “significant income tax benefit,” a principal purpose of avoiding tax will be presumed.

This presumption may be overcome, however, if there is a significant non-tax (or “non-income tax”) purpose that could not have been achieved without the creation of separate trusts; for example, if the dispositive terms of the trusts differ from one another.

Grantor Trust

The application of 199A to a grantor trust is much simpler because the individual grantor is treated as the owner of the trust property and income, and the trust is ignored, for purposes of the income tax.[xxv] Thus, any QTB interests held by the trust are treated as owned by the grantor for purposes of applying 199A.

In other words, the rules described above with respect to any individual owner of a QTB will apply to the grantor-owner of the trust; for example, the QBI, W-2 Wages, and Unadjusted Basis of the QTB operated by the PTE in which the trust holds an interest will pass through to the grantor.

Planning?

As we know, many irrevocable trusts to which completed gifts have been made are nevertheless taxed as grantor trusts for income tax purposes. The grantor has intentionally drafted the trust so that the income tax liability attributable to the trust will be taxed to the grantor, thereby enabling the trust to grow without reduction for income taxes, while at the same time reducing the grantor’s gross estate for purposes of the estate tax.

This may prove to be an expensive proposition for some grantors, which they may remedy by renouncing the retained rights or authorizing the trustee to toggle them on or off, or by being reimbursed from the trust (which defeats the purpose of grantor trust status).

The availability of the 199A deduction may reduce the need for avoiding or turning off grantor trust status, thus preserving the transfer tax benefits described above. In particular, where the business income would otherwise be taxed at a 37% federal rate,[xxvi] the full benefit of 199A would yield a less burdensome effective federal rate of 29.6%.

In addition to more “traditional” grantor trusts – which are treated as such because the grantor has retained certain rights with respect to the property contributed to the trust – there are other trusts to which the grantor trust rules may apply and which may, thereby, lend themselves to some 199A planning.

For example, a trust that holds S corporation stock may qualify as a subchapter S trust for which the sole current beneficiary of the trust may elect under Sec. 1361(d) (a “QSST” election) to be treated as the owner of such stock under Sec. 678 of the Code.[xxvii] Or a trust with separate shares for different beneficiaries, each of which is treated as a separate trust for which a beneficiary may elect treatment as a QSST.

Another possibility may be a trust that authorizes the trustee to grant a general power of appointment to a beneficiary as to only part of the trust – for example, as to a portion of one of the PTE interests held by the trust – thereby converting that portion of the trust into a grantor trust under Sec. 678.[xxviii]

What’s Next?

It remains to be seen what the final 199A regulations will look like.[xxix] That being said, estate planners should have enough guidance, based upon what has been published thus far, to advise taxpayers on how to avoid the anti-abuse rules for non-grantor trusts, how to take advantage of the grantor trust rules, and how to maximize the unadjusted basis for qualified property.

Hopefully, the final regulations will provide examples that illustrate the foregoing. Absent such examples, advisers will have to await the development of some Sec. 199A jurisprudence. Of course, this presupposes that 199A will survive through the 117th Congress.[xxx]


[i] The exclusion amount increases to $11.4 million in 2019. It is scheduled to return to “pre-TCJA” levels after 2025. See the recently proposed regulations at REG-106706-18.

[ii] Pun intended. P.L. 115-97.

[iii] Or “check the box” under Reg. Sec. 301.7701-3.

[iv] This provision covers tax years beginning after 12/31/2017, but it expires for tax years beginning after 12/31/2025.

[v] More recently, the IRS announced its 2018-2019 priority guidance project, which indicated that it planned to finalize some of the regulations already proposed, but that more regulations would be forthcoming; it also announced that a Revenue Procedure would be issued that would address some of the computational issues presented by the provision.

[vi] Thus, we find ourselves at the end of November 2018 with a provision that expires after December 31, 2025, for which the issued guidance is still in proposed form.

[vii] Through the next presidential election.

[viii] The deduction is not determined at the level of the PTE – it is determined at the level of each individual owner of the PTE, based upon each owner’s share of qualified business income.

[ix] In general, a QTB includes any trade or business other than a specified service trade or business (“SSTB”) and the provision of services as an employee.

If an individual taxpayer does not exceed the applicable taxable income threshold (described below), their QBI from their SSTB will be included in determining their 199A deduction. If the taxpayer exceeds the applicable threshold and phase-in amounts, none of the income and deduction items from the SSTB will be included in determining their 199A deduction.

[x] Basically, the owner’s pro rata share of the QTB’s taxable income.

[xi] This deduction amount is capped at 20% of the excess of (i) the owner’s taxable income for the year over (ii) their net capital gain for the year.

[xii] Business and investment, domestic and foreign.

[xiii] In the case of a joint return between spouses, the threshold amount is $315,000, and the limitation becomes fully applicable when taxable income exceeds $415,000.

[xiv] Consistent with this line of thinking, and recognizing that it is common for taxpayers to separate into different entities, parts of a business that are commonly thought of as a single business, the IRS will also allow individual owners – not the business entities themselves – to elect to aggregate (to treat as one business) different QTBs if they satisfy certain requirements, including, for example, that the same person or group of persons control each of the QTBs to be aggregated.

It should be noted that owners in the same PTEs do not have to aggregate in the same manner. Even minority owners are allowed to aggregate. In addition, a sole proprietor may aggregate their business with their share of a QTB being conducted through a PTE.

[xv] Whether a QTB exists or not is determined at the level of the PTE. An owner’s level of involvement in the business is irrelevant in determining their ability to claim a 199A deduction. A passive investor and an active investor are both entitled to claim the deduction, provided it is otherwise available.

[xvi] Basically, depreciable tangible property that is used in the QTB for the production of QBI, and for which the “depreciation period” has not yet expired.

[xvii] The Section 754 adjustment is not treated as a new asset that is placed into service for these purposes. Compare Reg. Sec. 1.743-1(j)(4).

[xviii] For example, is it labor- or capital-intensive?

[xix] Of course, this presents its own set of issues.

[xx] Of course, this assumes that the trustee has the relevant beneficiary information on the basis of which to make this decision, which may not be feasible.

[xxi] For purposes of determining whether the trust’s taxable income exceeds these amounts, the proposed regulations provide that the trust’s taxable income is determined before taking into account any distribution deduction. Query whether this represents a form of double counting? The distributed DNI is applied in determining the trust’s threshold, and it is applied again in determining the distributee’s.

[xxii] Under both IRC Sec. 199A and Sec. 643(f).

[xxiii] Prop. Reg. Sec. 1.199A-6(d)(3).

[xxiv] Prop. Reg. Sec. 1.643(f)-1.

[xxv] IRC Sec. 671 through 679.

[xxvi] The new maximum federal rate for individuals after the TCJA.

[xxvii] See Reg. Sec. 1.1361-1(j).

[xxviii] A so-called “Mallinckrodt trust.”

[xxix] The proposed regulations also address the treatment of ESBTs under Sec. 199A. According to the proposed regulations, an ESBT is entitled to the deduction. Specifically, the “S portion” of the ESBT takes into account its share of the QBI and other items from any S corp owned by the ESBT.

The grantor trust portion of the trust, if any, passes its share to the grantor-owner.

The non-S/non-grantor trust portion of the trust takes into account the QBI, etc., of any other PTEs owned by the trust. Does that mean that the ESBT is treated as two separate trusts for purposes of the 199A rules? It is not yet clear.

[xxx] January 2021 to January 2023.

“I Didn’t See That Coming”

Over the years, I have seen many business owners blanche when they learn how much income tax they will have to pay upon the sale of their business.[i] I have heard their disappointment at realizing that they may not be retaining a greater portion of the proceeds from the sale toward which they have worked for so long.

Of course, if this information is imparted to the owner well before they have even identified a buyer for their business – as it should be[ii] – they may choose not to sell the business at all,[iii] or they may conclude that the business is not yet ready to be sold.[iv] Alternatively, and having been forewarned, the owner may negotiate for a tax-friendlier – and economically more efficient – deal structure.

Then there are those owners who sold their business for what they believed was a great price, but who never consulted with a tax adviser prior to the sale, and who only learned after their returns had been prepared[v] that they were going to owe a significant sum to the government. These are the ones for which an adviser must watch out.

You Can’t Make this Up

For example, many years ago, I was brought into a Federal income tax audit that was not going well. The examiner was properly focused on the gains and losses reported on the taxpayer’s income tax return.[vi] The taxpayer’s S corporation had sold its business for a healthy sum, but his personal return also included a large capital loss that offset part of the gain from the sale. There was no information on the return from which to determine the source of the loss. When asked, the taxpayer was unable to provide any details;[vii] rather, he directed me to the accountant. The latter hemmed and hawed, and promised to provide the necessary back-up – and all the while I tried to hold the IRS examiner at bay. Finally, the accountant confessed that there was no such loss. He explained that his office had switched accounting software while the return was being prepared,[viii] and there had been a glitch in a program that added a few zeros to the loss reported on the return. Talk about creative accounting.[ix]

Lightning Strikes Again?

I wish I could say that cases like the one described immediately above are rare, but then I came across this decision just last week.

Taxpayer owned five restaurants, each of which was held in a separate and wholly-owned S corporation. Taxpayer began selling his restaurants in Tax Year, realizing a long-term capital gain in excess of $3.5 million,[x] which he reported on his IRS Form 1040, U.S. Individual Income Tax Return, for Tax Year.

Taxpayer offset this gain with a long-term capital loss of almost $3.0 million, which he claimed was attributable to an asset that was described on his return as an “overseas investment.” Taxpayer reported that he had acquired this investment approximately six years earlier, and had disposed of it at the end of Tax Year for no consideration.[xi]

Something Stinks

The IRS examined Taxpayer’s return. Neither Taxpayer nor his accountant offered a plausible explanation as to how the loss was determined; specifically, they could not substantiate the claimed cost basis of almost $3.0 million.[xii] In addition, neither of them was able to identify the “acquisition date” for the alleged investment; in fact, the accountant stated that he had arbitrarily chosen a date so as to indicate that the loss “was long term.” The accountant also stated that he had come up with the term “overseas investment,” and had listed the year-end as the date of disposition, on the basis of a conversation with Taxpayer.

The IRS concluded that Taxpayer had not substantiated (i) that he had made an investment, (ii) what his basis in that alleged investment was, or (iii) that the investment had become worthless during Tax Year. The IRS mailed Taxpayer a notice of deficiency,[xiii] and Taxpayer timely petitioned the U.S. Tax Court.

At trial, Taxpayer explained that an acquaintance had pitched an investment concept to him. Unbelievably, Taxpayer testified that he had no idea what this investment involved, but he believed it had something to do with “low interest rates” and an “opportunity *** to basically leverage *** bank funds.”

Taxpayer submitted into evidence some promotional materials which he claimed to have reviewed before investing. Notwithstanding his decades of business experience, however, Taxpayer did not seek advice about this investment from his long-time accountant, who was also a wealth manager, or from anyone else.

Despite having little understanding of the investment, Taxpayer testified that he agreed to invest $2.5 million. He submitted into evidence a copy of a purported “Investment Agreement” according to which Taxpayer would receive a 50% membership interest in a limited liability company by investing $2.5 million, which would be deposited into the escrow account of a specified law firm.

Apart from Taxpayer’s testimony,[xiv] there was no evidence that Taxpayer ever made the $2.5 million investment. He testified that the source of funds for the investment was a loan that his restaurants secured. The restaurants did appear to have secured such a loan, and the loan proceeds were allocated among them as shown in their QuickBooks entries. But there was no evidence that the S corporations disbursed any of these funds to the law firm’s escrow account or to Taxpayer; and there was no evidence, in the form of bank statements, wire transfer cover sheets, receipts, or any other document, to show that Taxpayer transferred $2.5 million (or any other sum) to the law firm.

Taxpayer also testified that he had subsequently contributed another $500,000 to this “overseas investment.” He submitted into evidence documents showing a couple of wire transfers, a cashier’s check, and a “transaction journal,” none of which established the fact of his investment.

Taxpayer also claimed to have invested in a second, previously undisclosed, investment, although he produced no evidence to establish the fact of his ownership or the amount of his investment. Taxpayer also claimed to have purchased from others their interests in this investment during the same period that he professed the investment had become worthless. However, there was no documentary evidence to establish that any of these purchases were made.

Although Taxpayer was supposed to have received regular payouts from his investments, he testified that he had never received any kind of payment. Yet Taxpayer took no action of any kind to recover his alleged investment, and did not even investigate the possibility of doing so. Instead, as his accountant explained, Taxpayer drew an inference that the investment was not doing well from the fact that his “correspondence with [the promoter] was less regular and they weren’t as upbeat.”

The Court Smells It Too

The Court began by noting that the IRS’s determination in the notice of deficiency was presumed correct, and that Taxpayer had the burden of proving it erroneous.

The Court then observed that, on his return for Tax Year, Taxpayer reported a capital loss from the disposition of a single “overseas investment.” At trial, however, Taxpayer testified that this loss was actually attributable to investments in two separate entities. In any case, Taxpayer contended that this loss was deductible as a loss from “worthless securities.”

The Court explained that, “[i]f any security which is a capital asset becomes worthless during the taxable year, the loss resulting therefrom shall * * * be treated as a loss from the sale or exchange, on the last day of the taxable year, of a capital asset.” For purposes of this rule, the Court continued, the term “security” means “a share of stock in a corporation,” the “right to subscribe for, or to receive, a share of stock in a corporation,” or a bond or other evidence of indebtedness issued by a corporation or governmental entity.

According to the Court, in order for Taxpayer to be entitled to deduct the purported loss under this rule, he had to establish three distinct facts:

  • First, that he owned a “security,” as defined in the Code;
  • Second, his “adjusted basis” in that security; and
  • Third, that the security “bec[ame] worthless during the taxable year” for which the deduction is claimed.

“Worthlessness is a factual question,” the Court stated, “and [Taxpayer] has the burden of proof to overcome [the IRS’s] determination” that the security did not become worthless during the year in question.

The Court found that Taxpayer had substantiated none of these facts.

First, Taxpayer did not show that he owned a “security.” He did not contend that the “overseas investments” took the form of a bond or other evidence of indebtedness. And he did not establish that either investment actually existed, that either was a corporation, or that he made any investment that took the form of “share[s] of stock in a corporation.”

Second, Taxpayer did not establish his basis (if any) in the investments. There was no credible evidence, documentary or otherwise, to show that he, or his S corporations, made an initial investment of $2.5 million to acquire shares of stock in any business or investment entity. In no case did any such entity furnish Taxpayer with an acknowledgment that it had received funds from him for investment, or that his ownership interest in the entity had changed. There was simply no credible evidence that any payments were made to acquire shares of corporate stock.

Third, Taxpayer did not carry his burden of proving that his alleged investments became worthless during Tax Year. To establish worthlessness in a particular year, the Court explained, a taxpayer must generally point to a “fixed and identifiable event” that caused the security to lose all value. Such an event may include a corporate dissolution or similar occurrence that “clearly evidences destruction of both the potential and liquidating values of the stock.” To establish that he has abandoned a security, the taxpayer “must permanently surrender and relinquish all rights in the security and receive no consideration in exchange.” This determination is made on the basis of “all the facts and circumstances.”

“Assuming arguendo,” the Court stated, “that [Taxpayer] made an investment in ***, he has pointed to no identifiable event evidencing that his investment became worthless during” Tax Year. He allegedly based his inference to that effect on the pessimistic tone of his communications with the promoter. But these emails did not refer to any investment that Taxpayer may have made.

In any event, Taxpayer provided at trial no reason to believe that his alleged investment had become worthless during Tax Year rather than during one of the previous six or seven years. On the other hand, he testified that he continued to make supposed investments, allegedly to buy out the interests of other investors. “These transfers sit uncomfortably with [Taxpayer’s] assertion that he viewed his investment as worthless” during that time.

The Court remarked that, by the end of the trial, “the circumstances surrounding [Taxpayer’s] alleged ‘overseas investment’ were as mysterious as they had appeared on his tax return.” Even assuming that he had made some sort of investment, the Court determined that Taxpayer did not carry his burden of proving that he had purchased a “security,” what his basis was in that security, or that the security had become worthless during Tax Year.

Thus, the Court found that Taxpayer had claimed “a fictitious loss deduction” of almost $3.0 million for Tax Year because he wished to offset the $3.5 million gain that he was required to report upon his sale of the restaurants.

“Do’s and Don’ts”

Yes, there are rogue advisers out there, and there are rogue taxpayers – somehow, they manage to find each other. Stay clear of them.[xv]

The tax-efficient disposition of a business is a process that begins at the inception of the business. There are no shortcuts. Different strategies and structures may be economically “more appropriate” at different stages in the life of the business. Some are more flexible than others. They are all aimed at growing the business and, ultimately, at maximizing the economic return on the owner’s investment.

At times, however, the owner may be presented with a choice under circumstances that are not ideal – they don’t adhere to the “plan.” For example, an offer to purchase the business from the owner may be premature from the owner’s perspective. The owner may reject the offer and rue the decision years later. Or the owner may accept the offer and rue the decision years later. Or the owner may try to change the terms of the offer, whether through an earn-out, a rollover of some of their equity, a joint venture, or some other means by which they can participate in the continued growth of the business in a tax efficient manner.

Every situation, every business, and every owner is different. The point is to consider with one’s advisers those scenarios that are likely to arise, to understand their consequences,[xvi] and to plan for them as best as reasonably possible. Avoid surprises that may trigger irrational acts.[xvii] When surprises occur, as they often do notwithstanding one’s preparation and planning, seek out those advisers before taking any action in response.[xviii]


[i] These will include Federal, state, and sometimes city, income taxes; the taxes may be imposed at the level of both the business entity and its owners. The sale may also trigger sales tax and real estate transfer tax, depending upon the form of the transaction and the nature of the assets being sold.

[ii] It may be a worthwhile exercise for the owner to informally appraise their business every few years. You never know when “that” offer is going to come and, although most owners have a ballpark idea of what their business is worth, it helps to have a more objective perspective.

[iii] That being said, there may be exigent circumstances that compel the sale.

[iv] For example, it may be that the business still has “room to grow.”

[v] In the year following the year of the sale.

[vi] Among other items, there were questions about the adjusted basis of some of the assets.

[vii] “I didn’t really review the return,” he said. “I just signed where I was told.”

[viii] “The dog ate my homework.” I guess that doesn’t resonate much in an age when kids do their homework on a computer.

[ix] The exam ended well, under the circumstances. I spoke very frankly with the examiner and their manager, fired the accountant, and restored a measure of credibility that facilitated a settlement.

[x] Meaning that the amount received by Taxpayer in exchange for the restaurants exceeded Taxpayer’s unrecovered investment (“adjusted basis”) in the restaurants by over $3.5 million.

[xi] In other words, he wrote it off as worthless.

[xii] After all, you can’t lose more than your unrecovered investment.

[xiii] The so-called “90-day letter,” which refers to the ninety days within which the taxpayer must file a petition with the Tax Court to contest the deficiency asserted in the letter. If the taxpayer fails to respond timely, the IRS is free to assess the tax, demand payment, and then seek to collect it.

[xiv] Which the Court did not find credible.

[xv] Some telltale signs: they intentionally draft ambiguity into a document; they say things like “this return is so convoluted, the IRS will never pick up the issue,” or “we control the preparation of the return, we can do whatever we want”; they ignore the legal separation among related entities; they bury questionable items in entries like “other expenses” and actually believe that no one will look.

[xvi] Which has to include running the numbers.

[xvii] One of my physics teachers was fond of saying, “Eschew obfuscation.”

[xviii] I know, I sound like your mother.

NY’s Tax Jurisdiction

Last week we considered New York’s “statutory residence” rule pursuant to which an individual domiciled outside of New York may nevertheless be taxed by New York as to all of their income for a taxable year – including their business income – regardless of its source, by virtue of maintaining a permanent place of abode in the State for substantially all of the taxable year, and spending more than 183 days of the taxable year in New York.

Of course, New York’s taxing jurisdiction extends beyond those individuals who are domiciled or resident in New York, and covers nonresidents who have New York source income. Thus, a nonresident will be subject to New York personal income tax with respect to their income from:

  • real or tangible personal property located in the State, (including certain gains or losses from the sale or exchange of an interest in an entity that owns real property in New York State);
  • services performed in New York;
  • a business, trade, profession, or occupation carried on in New York;
  • their distributive share of New York partnership income or gain;
  • any income received related to a business, trade, profession, or occupation previously carried on in the State, including, but not limited to, covenants not to compete and termination agreements; and
  • a New York S corporation in which they are a shareholder, including, for example, any gain recognized on the deemed asset sale for federal income tax purposes where the S corporation has made an election under IRC section 338(h)(10).

Although the foregoing list encompasses a great many items of income, there are limits to the State’s reach; for example, New York income does not include a nonresident’s income:

  • from interest, dividends, or gains from the sale or exchange of intangible personal property, unless they are part of the income they received from carrying on a business, trade, profession, or occupation in New York State; and
  • as a shareholder of a corporation that is a New York C corporation.

A recent series of decisions, culminating in an opinion from the Third Department, considered one taxpayer’s futile attempt to fit within, or expand upon, these excluded items.

Income from “Intangibles”?

Spouse was a member of LLC, a company that was treated as a partnership for income tax purposes and that did business in New York. He assigned his entire 18.75% ownership interest in LLC to Taxpayer. Spouse and Taxpayer were residents of New Jersey[ii] during the periods at issue.

This assignment was challenged by other members of LLC, which resulted in litigation, and in a ruling that the assignment was valid.

Litigation and Settlement

Taxpayer then commenced an action against LLC seeking a valuation of her interest in LLC, including her share of its profits. After receiving an accounting report from a court-appointed referee, the trial court determined that Taxpayer was entitled to an award of approximately $600,000 for her ownership interest in LLC and a profit distribution of approximately $1 million, together with both pre- and post-judgment interest.

Shortly thereafter, Taxpayer settled her claim against LLC for just over $2 million, and the parties agreed that approximately $600,000 of that amount would be allocated as payment for her interest in LLC and “not as ordinary income.”  

Tax Audit and Aftermath

Taxpayer and Spouse, being New Jersey residents,[iii] reported a capital gain of almost $600,000 and “other income” in the amount of almost $1.5 million on their federal return (IRS Form 1040), but none of the settlement was allocated to New York on their nonresident return (NY Form IT-203).

An audit by New York’s Department of Taxation and Finance ensued, and a notice of deficiency was issued assessing taxes and interest based on the $1.5 million that Taxpayer had identified as “other income.” Taxpayer and Spouse challenged the notice, but it was upheld by an Administrative Law Judge who noted that the litigation commenced by Taxpayer sought, among other things, her distributive share of LLC’s profits as the assignee of Spouse’s membership interest. The ALJ’s finding was, in turn, upheld by the Tax Appeals Tribunal.

Taxpayer brought an Article 78 proceeding in the Appellate Division of the Third Department to challenge the Tribunal’s decision upholding the deficiency.[iv]

The crux of Taxpayer’s challenge was that the “other income” was not taxable to them as nonresidents because it was a “return on an intangible asset” and not a distributive share of profits from a partnership doing business in New York.

Taxpayer’s Appeal

The Court began by explaining that New York may tax a nonresident only on income that is “derived from or connected with New York sources.”[v] New York source income, the Court continued, includes a taxpayer’s “distributive share of partnership income, gain, loss and deduction.”

Further, the Court continued, “only the portion [of source income] derived from or connected with New York sources of such partner’s distributive share of items of partnership income . . . entering into [her] federal adjusted gross income”. . . is included as the source income of a partner or limited liability company member.[vi] The Court noted that this includes income “derived from or connected with . . . a business . . . carried on in this state.”[vii]

However, Taxpayer contended that the Tribunal was incorrect in upholding the assessment because she was neither a “partner” nor a member of LLC, and she did not receive a distributive share of profits from LLC. According to Taxpayer, her assignee interest did not allow her to participate in the management and affairs of LLC, or to exercise any rights or powers of a member. Thus, Taxpayer argued, she should not be subject to tax as a member of LLC.

Taxpayer also asserted that her assignee interest in LLC was an intangible asset, and that income from such an asset should not be considered New York source income.

The Court disagreed, stating that the “membership interest” assigned to Taxpayer included “the member’s right to a share of the profits and losses of the [LLC]”. As the assignee of a membership interest, Taxpayer was not automatically entitled to participate in the management or affairs of LLC, but she was entitled “to receive . . . the distributions and allocations of profits and losses to which the assignor would be entitled.”[viii] Considering these provisions, the fact that Taxpayer was not a member of LLC had no bearing on whether the profit distribution to her was taxable. Further, it was undisputed that LLC “carried on” business in New York.

Origin of the Claim?

According to the Court, to determine the taxable status of a sum reached by settlement of the litigating parties, it is generally necessary to consider “[i]n lieu of what were the damages awarded?”[ix] The record showed that the settlement payment was made in consideration of Taxpayer withdrawing the causes of action in her complaint seeking her share of LLC profits. The parties, through counsel, expressly allocated approximately $600,000 of the total settlement as payment for Taxpayer’s ownership interest in LLC and “not as ordinary income,” without further characterization.

Consistently therewith, Taxpayer and Spouse reported the balance of almost $1.5 million as “other income” on their tax returns.[x] Pointing to the award in the underlying litigation, they also claimed that a portion of the settlement was attributed to interest and, therefore, not taxable in New York.

The Court pointed out that while interest income is generally not taxable as nonresident personal income, it was Taxpayer’s burden to establish that the assessment was erroneous. However, no portion of the settlement payment was expressly attributed to interest.

The Court then observed that the litigation was resolved by settlement, not court order. Given this structure, the Court continued, the Tribunal reasonably concluded that $1.5 million of the settlement was for lost profits. As such, the Court declined to disturb the Tribunal’s finding in this regard.

Having found that the Tribunal’s determination had a rational basis and was consistent with the statutory language, and that Taxpayer’s interpretation was not the “only logical construction” of the relevant provisions,[xi] the Court decided to defer to the Tribunal’s construction, and concluded that the determination by the Department of Taxation to issue the notice of deficiency was reasonable and supported by substantial evidence.

“Other Income”


Did Taxpayer actually believe that the income at issue was not taxable to a nonresident? The settlement payment was clearly attributable to Taxpayer’s interest in LLC’s profits, which were generated by the business that LLC conducted in New York. Accordingly, the “other income” was derived from New York sources and, as such, was taxable.

Yet Taxpayer stuck by her position through the audit, through the proceeding before the ALJ, through the Tax Appeals Tribunal, and through the Appellate Division.[xii]

The fact that the income at issue was not specifically addressed in the settlement, that is was paid “in exchange for” Taxpayer’s claims for her share of LLC profits, that Taxpayer labeled it as “other income” on her tax returns, and that she treated it as ordinary income for federal purposes, sealed the matter and forced Taxpayer to defend her position with fairly desperate arguments, like the one based upon her assignee status, described above.

Now, don’t get me wrong. There are times when perseverance in the face of many challenges may be commendable. There are also times, however, when advisers have to be blunt with their clients, when they cannot continue to stoke their hopes for a miracle, when no amount of legal creativity will save the day, when they simply have to throw in the proverbial towel.[xiii]

The moment for structuring a plausible argument for not taxing the settlement proceeds began when Taxpayer filed her first cause of action; it passed when the settlement was executed. Having failed to establish a basis for exclusion of the proceeds at that time, Taxpayer should have saved herself the additional interest, penalties and legal fees; she should have known “when to walk away.”[xiv]


[i] Apologies to Kenny Rogers, The Gambler.

[ii] I am told that people who live in New Jersey or who come from New Jersey are called New Jerseyites or New Jerseyans.

[iii] You may recall that last week’s post began with a review of the Tax Foundation’s State Business Tax Climate Index. You may also recall that NY did not fare too well with respect to individual income taxes, ranking 48th in the nation. Well, here’s some consolation: New Jersey ranked 50th.

[iv] Decisions rendered by the Tribunal are final and binding on the Department of Taxation and Finance, i.e., there is no appeal to the courts. Taxpayers who are not satisfied with the decision of the Tribunal have the right to appeal the Tribunal’s decision by instituting a proceeding pursuant to Article 78 of the Civil Practice Law and Rules to the Appellate Division Third Department of the State Supreme Court.

[v] Tax Law Sec. 631. https://codes.findlaw.com/ny/tax-law/tax-sect-631.html

[vi] Tax Law Sec. 632(a). https://codes.findlaw.com/ny/tax-law/tax-sect-632.html

[vii] Tax Law § 631(b)(1)(B). https://codes.findlaw.com/ny/tax-law/tax-sect-631.html

[viii] NY Limited Liability Company Law § 603. https://codes.findlaw.com/ny/limited-liability-company-law/llc-sect-603.html

[ix] What federal tax jurisprudence refers to as “the origin of the claim.”

[x] Indeed, they reported this amount as ordinary income on their federal tax return.

[xi] The Court was being kind.

[xii] “Please sir, may I have another?”

[xiii] Remember what happened to Apollo Creed in Rocky IV when the eponymous Rocky hesitated?

[xiv] As the refrain says:

You’ve got to know when to hold ’em
Know when to fold ’em
Know when to walk away
And know when to run

 

Welcome (?) to NY

The Tax Foundation recently issued its annual State Business Tax Climate Index. The 2019 Index compares the fifty States across five major areas of taxation: corporate taxes, individual income taxes, sales taxes, unemployment insurance taxes, and property taxes; it then adds the results to generate a final, overall ranking. According to the Index, the individual income tax component accounts for approximately 30% of a State’s total score.

After finding itself in 49th place during 2016, 2017, and 2018, it appears that New York is making a move to improve its standing in the business community – the 2019 Index has New York ranked in – patience, wait for it, wait for it – 48th place with respect to individual income taxes, and 48th overall. Woo hoo! Way to go team.[i]

“You Can Never Leave” [ii]

Of course, New York’s high personal income, estate, sales and property tax rates are all too familiar to those who reside, or used to reside, in the State. However, the State’s appetite for challenging a former resident’s assertion of a change of domicile is notorious, as is its penchant for taxing certain nondomiciliaries as so-called “statutory residents.”

The anxiety that this engenders among many informed taxpayers is understandable,[iii] though it may push some to borderline paranoia – or is it? – as illustrated by a recent advisory opinion issued by the Office of Counsel for New York’s Department of Taxation and Finance.[iv]

“Where [You] Lay [Your] Head is Home?” [v]  Hopefully Not?

Taxpayer was domiciled in Washington, D.C. He was an executive with an investment management firm that maintained New York offices. Taxpayer was responsible for overseeing the firm’s daily trading activity for several funds that traded in domestic and foreign markets. He was required to work during the night and consult with the firm’s traders during overseas trading hours. Because of his work duties, the firm allowed him to stay overnight in his New York office, but only when the markets in which the firm traded were open. Otherwise, Taxpayer was required to vacate the office at the end of the work day. The firm advised him in writing of these restrictions, noting that overnight stays were limited to those nights needed for work purposes, and that the office building was neither zoned nor insured for residential use.

Taxpayer typically travelled from Washington to the firm’s New York office on Monday mornings, stayed in New York on Monday, Tuesday and Wednesday nights, and returned to Washington on Thursday evenings.[vi] He did not own or rent any abode in New York. When Taxpayer was in New York overnight, he slept on a “murphy bed” in the office. The office was approximately 330 square feet[vii] and did not include any cooking facilities, bathing facilities, or a separate bathroom within its four walls. However, Taxpayer had access to common restrooms and an on-site gymnasium with showering facilities, both of which were available to all firm employees. In addition, the firm’s space had a kitchen area; however, the kitchen was intended for use by the firm’s kitchen staff and not for employees’ personal use. When taxpayer was in New York, he ordered meals from local restaurants and did not use cooking facilities in the building.[viii] Taxpayer was not required to provide any consideration, contribution, or reimbursement to the firm for the sleeping arrangement. He was prohibited from having overnight guests. Also, Taxpayer did not receive any personal mail at the office. He did maintain a small closet of work clothes in the office, along with some toiletries, but otherwise maintained his personal effects in Washington.

The Department’s Analysis

An individual is a resident of New York for a taxable year if such individual maintains a permanent place of abode in New York for substantially all of the taxable year and spends more than 183 days of the taxable year in the State.[ix]

It is not necessary that the individual actually stayed at, or even visited, the permanent place of abode for more than 183 days during the taxable year; it is only necessary that the individual could have done so while they were spending time in New York.

Thus, an individual who is domiciled in New Jersey, who owns a small studio pied-a-terre on the Upper West Side of Manhattan that they use occasionally on a Friday or Saturday, and who commutes to work Downtown on weekdays, is a statutory resident of both New York State and New York City.[x]

The term “permanent place of abode” means a dwelling place of a permanent nature maintained by an individual, whether or not owned by such individual.[xi] In general, a construction that does not contain facilities ordinarily found in a dwelling, such as facilities for cooking, bathing etc., will not be considered a permanent place of abode for tax purposes.

In order to qualify as a permanent place of abode, “there must be some basis to conclude that a dwelling is utilized as the taxpayer’s residence.”[xii] Case law and the Department’s Income Tax Nonresident Audit Guidelines (June 2014) have identified certain factors to consider when determining whether a dwelling satisfies the requisite relationship. These factors include, but are not limited to, the physical attributes of the dwelling and the relationship of the individual to the dwelling, such as ownership, property rights, maintenance, the relationship to co-habitants, personal items, and access.

Whether or not an individual has free and continuous access to a place of abode is a primary consideration in determining whether they maintain a permanent place of abode. For example, an individual maintains a permanent place of abode when they have an unrestricted right to use a room (despite the fact that they have no legal right to the property), contribute to the household expenses, have exclusive use of the room, provide their own furnishings and personal effects, regularly use the residence for a long-standing period of time to access their full-time job, and have unlimited access to the room. However, an individual does not maintain a permanent place of abode where they have intermittent access to an apartment rented and maintained by another individual, cannot access the apartment without prior notice, do not maintain clothing, personal articles or furniture in the apartment, do not have a dedicated room to which they have free and continuous access, do not use the residence for daily attendance at their full-time job, and do not share in the expenses of maintaining the apartment.

All Clear

According to the Department, the facts and circumstances in the present case indicated that Taxpayer’s arrangement did not provide unfettered access to a dwelling. His use of the office space was restricted to work nights when overseas markets were open and Taxpayer was required by his position to consult with firm traders of those markets. Furthermore, Taxpayer was prohibited from staying at the office overnight except on those nights when specifically allowed or required.

In addition to the absence of unfettered access, the Department found that Taxpayer’s arrangement lacked other necessary characteristics to be considered a permanent place of abode; these factors included the absence of bathing or kitchen facilities in the office that are ordinarily found in a dwelling, as well as other physical attributes of an abode.

Other relevant factors included the fact that: the building was not permitted by zoning laws to be used as a residence; Taxpayer did not contribute any money or other consideration to maintain the dwelling; the personal items kept in the office generally were work clothes; Taxpayer did not use the office address on any registrations, such as a driver’s license, voter registration, car registration, etc.; and he did not receive personal mail or maintain any other personal items at his office.

Considering the foregoing factors, the Department concluded that Taxpayer’s office did not constitute a permanent place of abode; consequently, the Taxpayer’s days spent in New York would not result in his being treated as a statutory resident.

Thoughts

I questioned earlier whether the Taxpayer was crazy to have requested the foregoing ruling. I don’t think so.

Some of you may be thinking, “C’mon Lou, the guy slept in a murphy bed in his office. He had no expectation of privacy there. He couldn’t just walk around in his skivvies, and isn’t that the ultimate indication of a place of abode? Oh, and by the way, many of us keep extra clothes in the office[xiii], plus a toothbrush; some of us have a refrigerator or microwave.[xiv] Don’t some firms provide showers for their employees? How can the State ever claim that this guy maintained a permanent place of abode in New York?”

To which I respond, “Why, then, did the Department feel compelled to go through the foregoing analysis? Hmm? Why bother with the exercise of considering the absence of a bathroom or of kitchen facilities within the office itself?[xv] Or the fact that Taxpayer didn’t pay his employer for the use of his office? Seriously? And why would a resident of Washington, D.C. include his New York office address on his license or registration?”

Indeed, couldn’t the Department have simply stated – relying upon the decision of the Court of Appeals in Gaied – that Taxpayer had no “residential interest” in his office – period, case closed?

Clearly, the Department decided not to go in that direction because it believed that Taxpayer did utilize his office as a residence – there was a reason that Taxpayer felt compelled to request this ruling in the first place. Thus, the Department had to establish that this particular office, in the circumstances described above, was not a permanent place of abode.

With that, did the Department leave open the possibility that a slightly larger office (say, the size of a small studio, perhaps with its own bathroom, a murphy bed or pull-out couch – maybe even a wet bar[xvi]) may constitute a permanent place of abode? And might the occupant of such an office – who is an owner of the tenant business that occupies the space – have a “residential interest” therein, such that they may be treated as a statutory resident notwithstanding that they commute to their domicile almost every night?

I don’t like it.


[i] “Every journey begins with a single step.” Lao Tsu.

[ii] Apologies to The Eagles. Speaking of California, its 2019 Index overall ranking is 49th.

[iii] Ignorance may be bliss, but I hate surprises.

[iv] An advisory opinion is issued at the request of a taxpayer – thus my statement about paranoia, or not. The opinion is limited to its facts, and is binding on the State only with respect to the taxpayer to whom it is issued.

[v] Apologies to Metallica (“Where I Lay My Head is Home”). I often answer my office phone with “Vlahos residence,” and it’s not entirely facetious.

[vi] Thus, he was “present” in New York four days per week.

[vii] There are many studios of this size in downtown Manhattan.

[viii] My kinda guy.

[ix] N.Y. Tax Law Sec. 605(b)(1)(B). This is referred to as “statutory residence,” as distinguished from “domicile,” which involves a much more subjective determination based upon the taxpayer’s intent or the objective manifestations of such intent. Under either characterization, the taxpayer’s worldwide income would be subject to New York’s personal income tax.

[x] And is subject to State and City income taxes at 8.82% and 3.876%, respectively.

[xi] 20 NYCRR Sec. 105.20(e)(1).

[xii] Matter of Gaied v. Tax Appeals Trib., 22 N.Y.3d 592, 594 (2014). It’s unfortunate that the State pays lip service to the holding in Gaied but practically limits the application of the decision to its facts.

[xiii] In today’s “dress-down” business environment, how does one distinguish between work and non-work clothes?

[xiv] That is neither an admission nor a Christmas wish list – I’m simply giving an example.

[xv] Does the Department realize that there are still a few boarding houses in Manhattan? Yes, rooms without bathrooms, and where residents eat in a common area. Would anyone seriously claim that these are not “permanent places of abode?”

[xvi] A guy can dream, can’t he?