I realize that the last post began with “This is the fourth and final in a series of posts reviewing the recently proposed regulations (‘PR’) under Sec. 199A of the Code” – strictly speaking, it was. Yes, I know that the title of this post begins with “The Section 199A Deduction.” Its emphasis, however, is not upon the proposed regulations, as such; rather, today’s post will consider whether the recently enacted deduction, and the regulations proposed thereunder last month, will play a role in determining a taxpayer’s net economic gain from the sale of the taxpayer’s business.

 It has often been stated in this blog that the less a seller pays in taxes as a result of selling their business – or, stated differently, the more that a seller can reduce their resulting tax liability – the greater will be the seller’s economic return on the sale.[i]

 M&A and the TCJA – In General

The Tax Cuts and Jobs Act (“TCJA”)[ii] included a number of provisions that will likely have an impact upon the purchase and sale a business. Among these are the following:

  • the reduced C corporation income tax rate,
  • the exclusion of self-created intangibles from the definition of “capital asset,”
  • the elimination of the 20-year carryforward period for NOLs,
  • the limitation on a buyer’s ability to deduct the interest on indebtedness incurred to acquire a target company, and
  • the extension of the first-year bonus depreciation deduction to “used” property.

Code Section 199A

As we have seen over the last couple of weeks, Sec. 199A generally allows a non-corporate taxpayer a deduction for a taxable year equal to 20% of the taxpayer’s qualified business income (“QBI”) with respect to a qualified trade or business (“QTB”) for such taxable year.

The QBI of a QTB means, for any taxable year, the net income with respect to such trade or business of the taxpayer for the year, provided it is effectively connected with the conduct of a trade or business in the U.S.

Investment income is not included in determining QBI. Thus, if a taxpayer’s rental activity with respect to a real property owned by the taxpayer does not rise to the level of a trade or business, the taxpayer’s rental income therefrom will be treated as investment income and will not be treated as QBI.

In addition, the trade or business of performing services as an employee is not treated as a QTB; thus, the taxpayer’s compensation in exchange for such services is not QBI.

Limitations

If an individual taxpayer-owner’s taxable income for a taxable year exceeds a threshold amount, a special limitation will apply to limit that individual’s Section 199A deduction. Assuming the limitation rule is fully applicable[iii], the amount of the Section 199A deduction may not exceed the greater of:

  • 50% of the W-2 wages with respect to the QTB that are allocable to QBI, or
  • 25% of such W-2 wages, plus 2.50% of the “unadjusted basis” (“UB”)[iv] of all depreciable tangible property held by the QTB at the close of the taxable year, which is used at any point in the year in the production of QBI, and the depreciable period for which has not ended before the close of the taxable year (“qualified property”).

In addition, the amount of a taxpayer’s Section 199A deduction for a taxable year, determined under the foregoing rules, may not exceed 20% of the excess of:

  1. the taxpayer’s taxable income for the taxable year, over
  2. the taxpayer’s net capital gain for such year.

Pass-Through Entities

If the non-corporate taxpayer carries on the QTB indirectly, through a partnership or S corporation (a pass-through entity, or “PTE”), the Section 199A rules are applied at the partner or shareholder level, with each partner or shareholder taking into account their allocable share of the PTE’s QBI, as well as their allocable share of the PTE’s W-2 wages and UB (for purposes of applying the above limitations).

Because some individual owners of a PTE may have personal taxable income at a level that triggers application of the above limitations, while others may not, it is possible for some owners of a QTB to enjoy a smaller Section 199A deduction than other owners of the same QTB, even where they have the same percentage equity interest in the QTB (or in the PTE that holds the business). Stated differently, one taxpayer may have a different after-tax outcome with respect to the QBI allocated to them than would another taxpayer to whom the same amount of QBI is allocated, notwithstanding that they may have identical tax attributes[v] and have identical levels of participation in the conduct of the QTB.

Income or Gain from the Sale of a PTE’s Business

Although the sale of a business may be effected through various means as a matter of state law[vi], there are basically two kinds of sale transactions for tax purposes:

  1. the owners’ sale of their stock or partnership interests (“equity”) in the PTE that owns the business, and
  2. the sale by such PTE of the assets it uses to conduct the business, which is typically followed by the liquidation of such entity.

The character of the gain realized on the sale – i.e., capital or ordinary – will depend, in part, upon whether the PTE is an S corporation or a partnership, and whether the sale is treated as a sale of equity or a sale of assets.

Sale of Assets

If the PTE sells its assets, or is treated as selling its assets[vii], the nature and amount of the gain realized on the sale will depend upon the kind of assets being sold and the allocation of the purchase price among those assets. After all, the character of any item of income or gain included in a partner’s or a shareholder’s allocable share of partnership or S corporation income is determined as if it were realized directly from the source from which realized by the PTE, or incurred in the same manner as incurred by the PTE.[viii]

Thus, any income realized on the sale of accounts receivable or inventory will be treated as ordinary income.

The gain realized on the sale of property used in the trade or business, of a character that may be depreciable, or on the sale of real property used in the trade or business, is generally treated as capital gain.[ix]

However, some of the gain realized on the sale of property in respect of which the seller has claimed accelerated depreciation will be “recaptured” (to the extent of such depreciation) and treated as ordinary income.[x]

Sale of Equity

If the shareholders of an S corporation sell their shares of stock in the corporation, the gain realized will be treated as gain from the sale of a capital asset.[xi]

When the partners of a partnership sell their partnership interests, the gain will generally be treated as capital gain from the sale of a capital asset, except to the extent that the purchase price for such interests is attributable to the unrealized receivables or inventory items (so-called “hot assets”) of the partnership, in which case part of the gain will be treated as ordinary.[xii]

Related Transactions

Aside from the sale of the business, the former owners of a PTE may also engage in other, closely-related, transactions with the buyer.

For example, one or more of the former owners may become employees of, or consultants to, the buyer; in that case, the consideration paid to them will be treated as compensation received in exchange for services.
One of more of the former owners may enter into non-competition agreements with the buyer; the consideration received in exchange may be characterized as compensation for “negative” services.

If one or more of the former owners continue to own the real property on which the business will be operated, they may enter into lease arrangements with the buyer that provide for the payment of rental income.

Tax Rates

If any of the gain from the sale of the PTE’s business is treated as capital gain, each individual owner will be taxed on their allocable share thereof at the federal capital gain rate of 20%.

If any of such gain is treated as ordinary income, each individual owner will be subject to federal income tax on their allocable share thereof at the ordinary income rate of 37%.

If an owner did not materially participate in the business, the 3.8% federal surtax on net investment income may also be applicable to their allocable share of the above gain and ordinary income.[xiii]

Of course, any compensation for services (or “non-services”) would be taxable as ordinary income, and would be subject to employment taxes.

Any rental income would also be subject to tax as ordinary income, and may also be subject to the 3.8% surtax.[xiv]

Based on the foregoing, one may conclude, generally, that it would be in the best interest of the PTE’s owners to minimize the amount of ordinary income, and to maximize the amount of capital gain, to be realized on the sale of the PTE’s business.[xv]

Of course, the selling PTE and its owners cannot unilaterally, or even reasonably expect to, direct this result. The buyer has its own preferences and imperatives[xvi]; moreover, one simply cannot avoid ordinary income treatment in many circumstances.

Enter Section 199A

No, not astride a horse, but on tip toes, wearing sneakers.[xvii]

The tax treatment of M&A transactions was certainly not what Congress was focused on when Section 199A was conceived. PTEs already enjoyed a significant advantage in the taxation of M&A transactions in that capital gains are taxed to the individual owners of a PTE at a very favorable federal rate of 20%.

Rather, Congress sought to provide a tax benefit to the individual owners of PTEs in response to complaints from the PTE community that the tax bill which eventually became the TCJA was heavily biased in favor of C corporations, especially with the reduction in the federal corporate income tax rate from a maximum graduated rate of 35% to a flat rate of 21%.

It order to redress the perceived unfairness, Congress gave individual business owners the Section 199A deduction as a way to reduce their tax liability with respect to the ordinary net operating income of their PTEs.

Sale of a Business

This is borne out by the exclusion from the definition of QBI of dividends and interest, and by the exclusion of capital gains[xviii], regardless of whether such gains arise from the sale of a capital asset; thus, the capital gain from the sale of a property used in the PTE’s trade or business, and of a character which is subject to the allowance for depreciation, is excluded from QBI.

Does that mean that Section 199A has no role to play in the taxation of M&A transactions? Not quite.

Simply put, a number of the business assets disposed of as part of an M&A transaction represent items of ordinary income that would have been realized by the business and its owners in the ordinary course of business had the business not been sold; the sale of these assets accelerates recognition of this ordinary income.

Ordinary Income Items

For example, the ordinary income realized on the sale, or deemed sale[xix], of accounts receivable and inventory by a PTE as part of an M&A deal should qualify as QBI, and should be taken into account in determining the Section 199A deduction for the individual owners of the PTE.

Unfortunately, neither the Code nor the proposed regulations explicitly state that this is the case, though the latter clearly provide that any ordinary income arising from the disposition of a partnership interest that is attributable to the partnership’s hot assets – i.e., inventory and unrealized receivables – will be considered attributable to the trade or business conducted by the partnership and taken into account for purposes of computing QBI.[xx]

Of course, the partnership rules[xxi] define the term “unrealized receivables” expansively, so they include other items in addition to receivables; for example, the ordinary income – i.e., depreciation recapture – realized on the sale of tangible personal property used in the business, the cost of which has been depreciated on an accelerated basis, or for which a bonus depreciation deduction or Section 179 deduction has been claimed.

In light of the foregoing, the same result should obtain where the inventories and receivables are sold as part of an actual or deemed asset sale, though the proposed regulations do not speak directly to this situation. These assets are not of a kind that appreciate in value, or that generate income, as in the case of investment property. Rather, they represent “ordinary income in-waiting” and should be treated as QBI.

Similarly in the case of tangible personal property used in a business and subject to an allowance for depreciation; taxpayers are allowed to recover the cost of acquiring such assets on an accelerated basis so as to reduce the net cost thereof, and thereby to incentivize taxpayers to make such investments.; i.e., they are allowed to reduce the ordinary income that otherwise would have been realized (and taxed) in the ordinary course of business. The “recapture” of this depreciation benefit upon the sale of such property should, likewise, be treated as QBI.

Compensation

As stated above, a taxpayer’s QBI does not include any amount of compensation paid to the individual taxpayer in their capacity as an employee. In other words, if a former owner of the PTE-operated business is employed by the new owner of the business (for example, as an officer), the compensation paid to the former owner will not be treated as QBI.

If the former owner is not employed by the new owner, but is retained to provide other services as an independent contractor, the payments made to them in exchange for such services may constitute QBI, provided the service provider is properly characterized as a non-employee and the service is not a “specified service trade or business.”[xxii] Query whether the “consulting” services often provided by a former owner to the buyer are the equivalent of providing the kind of “advice and counsel” that the proposed regulations treat as a specified service trade or business, the income from which is not QBI.

Rental

As was mentioned above, it is not unusual for the owners of a PTE to sell their operating business while retaining ownership of the real property on which the business may continue to operate – hopefully, it has been residing in an entity separate from the one holding the business. Under these circumstances, the owners may ensure themselves of a continued stream of revenue, a portion of which may be sheltered by depreciation deductions.

Whether such rental activity will rise to the level of a trade or business for purposes of Section 199A will depend upon the facts and circumstances. However, if the property is wholly-occupied by one tenant – i.e., by the business that was sold, as is often the case – it is unlikely that the rental activity will represent a QTB and, so, the net rental income will not be QBI.

Don’t Forget the Limitations

Even assuming that a goodly portion of the income arising from the sale of a QTB will be treated as QBI, the individual taxpayer must bear in mind the “W-2-based” and “taxable-income-based” limitations described above.

This Time, I Promise

Well, that’s it for Section 199A – at least until the proposed regulations are finalized.

“I’m so glad we had this time together . . .”[xxiii] I know, “Lou, keep you day job.”


[i] The flip-side may be stated as follows: the faster a buyer can recover their investment – i.e., the purchase price – for the acquisition of a business, the greater is the buyer’s return on its investment in the business. See, e.g.

[ii] P.L. 115-97.

[iii] Meaning that the taxpayer’s taxable income for the taxable year exceeds the threshold amount ($315,000 in the case of married taxpayers filed jointly) plus a phase-in range (between the threshold amount and $415,000).

[iv] The term “UB” means the initial basis of the qualified property in the hands of the individual or PTE, depending upon whether it was purchased by or contributed to the PTE.

[v] Other than taxable income.

[vi] For example, a sale of assets may be accomplished through a merger of two business entities; a stock sale may be accomplished through a reverse subsidiary merger in which the target is the surviving entity.

[vii] In the case of an S corporation, where the shareholders make an election under Sec. 336(e), or where the shareholders and the buyer make a joint election under Sec. 338(h)(10), to treat the stock sale as a sale of assets by the corporation followed by the liquidation of the corporation.

In the case of a partnership, a buyer who acquires all of the partnership interests is treated, from the buyer’s perspective, as acquiring the assets of the partnership. Rev. Rul. 99-6.

[viii] Sec. 702 and Sec. 1366.

[ix] Sec. 1231. Specifically, if the “section 1231 gains” for a taxable year exceed the “section 1231 losses” for such year, such gains and losses shall be treated as long-term capital gains or losses, as the case may be.

[x] Sec. 1245.

[xi] Sec. 1221.

[xii] Sec. 741 and Sec. 751.

[xiii] Sec. 1411. The tax is imposed on the lesser of (a) the amount of the taxpayer’ net investment income for the taxable year, or (b) the excess of (i) the taxpayer’s modified adjusted gross income, over (ii) a threshold amount ($250,000 in the case of a married taxpayer filed a joint return).

[xiv] Assuming it is a passive activity. See Reg. Sec. 1.1411-5.

[xv] In the case of a PTE that is an S corporation that is subject to the built-in gains tax, the shareholders may also be interested in allocating consideration away from those corporate assets to which the tax would apply.

[xvi] See endnote “i”, supra.

[xvii] I wish I could recall the name of the presidential scholar who coined the phrase, that I am trying to paraphrase, to describe how presidents get things done. It may have been Prof. Richard Pious of Columbia University.

[xviii] Sec. 199A(c)(3)(B); Prop. Reg. Sec. 1.199A-3(b)(2).

[xix] For example, upon the filing of a Sec. 338(h)(10) election.

[xx] Prop. Reg. Sec. 1.199A-3(b).

[xxi] Sec. 751(c).

[xxii] Prop. Reg. Sec. 1.199A-5.

[xxiii] Remember Carol Burnett’s sign-off song?

This is the fourth[i] and final in a series of posts reviewing the recently proposed regulations (“PR”) under Sec. 199A of the Code. https://www.federalregister.gov/documents/2018/08/16/2018-17276/qualified-business-income-deduction/

Earlier posts considered the elements of a “qualified trade or business” under Section 199A https://www.taxlawforchb.com/2018/09/the-proposed-sec-199a-regs-are-here-part-one , the related issue of what constitutes a “specified service trade or business,” the owners of which may be denied the benefit of Section 199A, https://www.taxlawforchb.com/2018/09/the-proposed-sec-199a-regs-are-here-part-two/ , and the meaning of “qualified business income.” https://www.taxlawforchb.com/2018/09/the-proposed-sec-199a-regs-are-here-part-three/. Today, we turn to the calculation of the deduction, the limitations on the amount of the deduction, and some special rules.

 Threshold and Phase-In Amounts

Let’s assume for the moment that our taxpayer (“Taxpayer”) is a married individual, files a joint return with their spouse, and owns an equity interest in a qualified trade or business (“QTB”) that is conducted through a pass-through entity (“PTE”), such as a sole proprietorship,[ii] a partnership, or an S corporation.

At this point, Taxpayer must determine their joint taxable income for the taxable year.[iii]

There are three categories of taxpayers for purposes of Section 199A – those whose joint taxable income[iv]:

  • does not exceed $315,000 (the “threshold”),
  • exceeds $315,000 but does not exceed $415,000 (the “phase-in range”),[v] and
  • exceeds $415,000.[vi]

 

 

 

Below the Threshold

If Taxpayer falls within the first category – joint taxable income that does not exceed $315,000 – they determine their Section 199A deduction by first calculating 20% of their QBI with respect to their QTB (Taxpayer’s “combined QBI amount”).[vii] For this first category of taxpayer, their share of income from a specified service trade or business (“SSTB”) qualifies as QBI.

Taxpayer must then compare their

  • combined QBI amount (determined above) with
  • an amount equal to 20% of the excess of:
    • their taxable income for the taxable year, over
    • their net capital gain for the year.

The lesser of these two amounts is then compared to Taxpayer’s entire taxable income for the taxable year, reduced by their net capital gain. Taxpayer’s Section 199A deduction is equal to the lesser of these two amounts.

Thus, if Taxpayer’s only source of income was their QTB, Taxpayer would be entitled to claim the full “20% of QBI” deduction, with the result that their QBI would be subject to an effective top federal income tax rate of 29.6%[viii]

Above the Threshold and Phase-In

If Taxpayer falls within the third category – joint taxable income for the taxable year in excess of $415,000 – they face several additional hurdles in determining their Section 199A deduction.[ix] It is with respect to these taxpayers that the application of the Section 199A rules becomes even more challenging, both for the taxpayers and their advisers.

To start, no SSTB in which Taxpayer has an equity interest will qualify as a QTB as to Taxpayer.

Moreover, there are other limitations, in addition to the ones described above, that must be considered in determining the amount of Taxpayer’s Section 199A deduction.

N.B.

Before turning to these limitations, it is important to note the following:

  • the application of the threshold and phase-in amounts is determined at the level of the individual owner of the QTB[x], which may not be where the trade or business is operated; and
  • taxpayers with identical interests in, and identical levels of activity with respect to, the same trade or business may be treated differently if one taxpayer has more taxable income from sources outside the trade or business than does the other;
    • for example, a senior partner of a law firm, who has had years to develop an income-producing investment portfolio, vs a junior partner at the same firm, whose share of partnership income represents their only source of income.[xi]

Limitations

The additional limitations referred to above are applied in determining Taxpayer’s “combined QBI amount.”

Specifically, the amount equal to 20% of Taxpayer’s QBI with respect to the QTB must be compared to the greater of:

  • 50% of the “W-2 wages” with respect to the QTB, or
  • The sum of (i) 25% of the W-2 wages plus (ii) 2.5% of the unadjusted basis (“UB”) of qualified property immediately after the acquisition of all qualified property (“a” and “b” being the “alternative limitations”).

The lesser of Taxpayer’s “20% of QBI” figure and the above “W-2 wages-based” figure may be characterized as Taxpayer’s “tentative” Section 199A deduction; it is subject to being further reduced in accordance with the following caps:

  • The Section 199A deduction cannot be greater than 20% of the excess (if any) of:
    • Taxpayer’s taxable income for the taxable year, over
    • Taxpayer’s net capital gain for the year.
  • The resulting amount – i.e., the tentative deduction reduced in accordance with “a” – is then compared to Taxpayer’s entire taxable income for the taxable year, reduced by their net capital gain.

Taxpayer’s Section 199A deduction is equal to the lesser of the two amounts described in “b”, above.

Applied to Each QTB

Under the PR, an individual taxpayer must determine the W-2 wages and the UB of qualified property attributable to each QTB contributing to the individual’s combined QBI. The W-2 wages and the UB of qualified property amounts are compared to QBI in order to determine the individual’s QBI component for each QTB.

After determining the QBI for each QTB, the individual taxpayer must compare 20% of that trade or business’s QBI to the alternative limitations for that trade or business.

If 20% of the QBI of the trade or business is greater than the relevant alternative limitation, the QBI component is limited to the amount of the alternative limitation, and the deduction is reduced.

The PR also provide that, if an individual has QBI of less than zero (a loss) from one trade or business, but has overall QBI greater than zero when all of the individual’s trades or businesses are taken together, then the individual must offset the net income in each trade or business that produced net income with the net loss from each trade or business that produced net loss before the individual applies the limitations based on W-2 wages and UB of qualified property.

The individual must apportion the net loss among the trades or businesses with positive QBI in proportion to the relative amounts of QBI in such trades or businesses. Then, for purposes of applying the limitation based on W-2 wages and UB of qualified property, the net income with respect to each trade or business (as offset by the apportioned losses) is the taxpayer’s QBI with respect to that trade or business.

The W-2 wages and UB of qualified property from the trades or businesses which produced negative QBI for the taxable year are not carried over into the subsequent year.

W-2 Wages

The PR provide that, in determining W-2 wages, the common law employer (such as a PTE) may take into account any W-2 wages paid by another person – such as a professional employer organization – and reported by such other person on Forms W-2 with the reporting person as the employer listed on the Forms W-2, provided that the W-2 wages were paid to common law employees of the common law employer for employment by the latter.[xii]

Under this rule, persons who otherwise qualify for the deduction are not limited in applying the deduction merely because they use a third party payor to pay and report wages to their employees.

The W-2 wage limitation applies separately for each trade or business. Accordingly, the PR provides that, in the case of W-2 wages that are allocable to more than one trade or business, the portion of the W-2 wages allocable to each trade or business is determined to be in the same proportion to total W-2 wages as the ordinary business deductions associated with those wages are allocated among the particular trades or businesses.

W-2 wages must be properly allocable to QBI (rather than, for example, to activity that produces investment income). W-2 wages are properly allocable to QBI if the associated wage expense is taken into account in computing QBI.

Where the QTB is conducted by a PTE, a partner’s or a shareholder’s allocable share of wages must be determined in the same manner as their share of wage expenses.

Finally, the PR provide that, in the case of an acquisition or disposition of (i) a trade or business, (ii) the major portion of a trade or business, or (iii) the major portion of a separate unit of a trade or business, that causes more than one individual or entity to be an employer of the employees of the acquired or disposed of trade or business during the calendar year, the W-2 wages of the individual or entity for the calendar year of the acquisition or disposition are allocated between each individual or entity based on the period during which the employees of the acquired or disposed of trade or business were employed by the individual or entity.

 UB of Qualified Property

The PR provides that “qualified property” means (i) tangible property of a character subject to depreciation that is held by, and available for use in, a trade or business at the close of the taxable year, (ii) which is used in the production of QBI, and (iii) for which the depreciable period has not ended before the close of the taxable year.

“Depreciable period” means the period beginning on the date the property is first placed in service by the taxpayer and ending on the later of (a) the date 10 years after that date, or (b) the last day of the last full year in the applicable recovery period that would apply to the property without regard to whether any bonus depreciation was claimed with respect to the property. Thus, it is possible for a property to be treated as qualified property even where it is no longer being depreciated for tax purposes.

The term “UB” means the initial basis of the qualified property in the hands of the individual or PTE, depending upon whether it was purchased or contributed.

UB is determined without regard to any adjustments for any portion of the basis for which the taxpayer has elected to treat as an expense (for example, under Sec. 179 of the Code). Therefore, for purchased or produced qualified property, UB generally will be its cost as of the date the property is placed in service.

For qualified property contributed to a partnership in a “tax-free” exchange for a partnership interest and immediately placed in service, UB generally will be its basis in the hands of the contributing partner, and will not be changed by subsequent “elective” basis adjustments.

For qualified property contributed to an S corporation in a “tax-free” exchange for stock and immediately placed in service, UB generally will be its basis in the hands of the contributing shareholder.[xiii]

Further, for property inherited from a decedent and immediately placed in service by the heir, the UB generally will be its fair market value at the time of the decedent’s death.

In order to prevent trades or businesses from transferring or acquiring property at the end of the year merely to manipulate the UB of qualified property attributable to the trade or business, the PR provides that property is not qualified property if the property is acquired within 60 days of the end of the taxable year and disposed of within 120 days without having been used in a trade or business for at least 45 days prior to disposition, unless the taxpayer demonstrates that the principal purpose of the acquisition and disposition was a purpose other than increasing the deduction.

For purposes of determining the depreciable period of qualified property, the PR provide that, if a PTE acquires qualified property in a non-recognition exchange, the qualified property’s “placed-in-service” date is determined as follows: (i) for the portion of the transferee-PTE’s UB of the qualified property that does not exceed the transferor’s UB of such property, the date such portion was first placed in service by the transferee-PTE is the date on which the transferor first placed the qualified property in service; (ii) for the portion of the transferee’s UB of the qualified property that exceeds the transferor’s UB of such property, if any, such portion is treated as separate qualified property that the transferee first placed in service on the date of the transfer.

Thus, qualified property acquired in these non-recognition transactions will have two separate placed in service dates under the PR: for purposes of determining the UB of the property, the relevant placed in service date will be the date the acquired property is placed in service by the transferee-PTE (for instance, the date the partnership places in service property received as a capital contribution); for purposes of determining the depreciable period of the property, the relevant placed in service date generally will be the date the transferor first placed the property in service (for instance, the date the partner placed the property in service in their sole proprietorship).

The PR also provide guidance on the treatment of subsequent improvements to qualified property.[xiv]

Finally, in the case of a trade or business conducted by a PTE, the PR provide that, in the case of qualified property held by a PTE, each partner’s or shareholder’s share of the UB of qualified property is an amount that bears the same proportion to the total UB of qualified property as the partner’s or shareholder’s share of tax depreciation bears to the entity’s total tax depreciation attributable to the property for the year.[xv]

Computational Steps for PTEs

The PR also provide additional guidance on the determination of QBI for a QTB conducted by a PTE.

A PTE conducting an SSTB may not know whether the taxable income of any of its equity owners is below the threshold amount. However, the PTE is best positioned to make the determination as to whether its trade or business is an SSTB.

Therefore, reporting rules require each PTE to determine whether it conducts an SSTB, and to disclose that information to its partners, shareholders, or owners.

In addition, notwithstanding that PTEs cannot take the Section 199A deduction at the entity level, each PTE must determine and report the information necessary for its direct and indirect individual owners to determine their own Section 199A deduction.

Thus, the PR direct PTEs to determine what amounts and information to report to their owners and the IRS, including QBI, W-2 wages, and the UB of qualified property for each trade or business directly engaged in.

The PR also require each PTE to report this information on or with the Schedules K-1 issued to the owners. PTEs must report this information regardless of whether a taxpayer is below the threshold amount.

“That’s All Folks!”[xvi]

With the series of posts ending today, we’ve covered most aspects of the new Section 199A rule, as elaborated by the PR, though the following points are also worth mentioning:

  • the Section 199A deduction has no effect on the adjusted basis of a partner’s interest in a partnership;
  • the deduction has no effect on the adjusted basis of a shareholder’s stock in an S corporation or the S corporation’s accumulated adjustments account;
  • the deduction does not reduce (i) net earnings from self-employment for purposes of the employment tax (for example, a partner’s share of a partnership’s operating income), or (ii) net investment income for purposes of the surtax on net investment income (for example, a shareholder’s share of an S corporation’s business in which the shareholder does not materially participate); and
  • for purposes of determining an individual’s alternative minimum taxable income for a taxable year, the entire deduction is allowed, without adjustment.

Stay tuned. Although taxpayers may rely upon the PR, they are not yet final. A public hearing on the PR is scheduled for October 16; the Republicans recently proposed to make the deduction “permanent” (whatever that means); midterm elections are scheduled for November 6; we have a presidential election in 2020; the deduction is scheduled to disappear after 2025. Oh, bother.

—————————————————————————————————-

[i] Yes, I know – where has time gone? The fourth already? Seems like just yesterday, I was reading the first. Alternatively: Oh no, not another! It’s like reading . . . the Code? Where are those definitions of SSTB covered? The first or the second installment?

[ii] Including a single-member LLC that is disregarded for tax purposes.

[iii] Of course, we are only considering taxable years beginning after December 31, 2017, the effective date for Section 199A of the Code.

[iv] Regardless of the source or type of the income.

[v] See EN ix, below.

[vi] For our purposes, it is assumed that Taxpayer has no “qualified cooperative dividends,” no “qualified REIT dividends,” and no “qualified publicly traded partnership income.”

[vii] If Taxpayer has more than one QTB, this amount is determined for each such QTB, and these amounts are then added together.

[viii] I.e., 80% of the regular 37% rate.

[ix] Yes, we skipped the second category – taxpayers with taxable income in excess of the threshold amount but within the phase-in range amount.

The exclusion of QBI (for SSTBs), W-2 wages, and UB of qualified property from the computation of the Section 199A deduction is subject to a phase-in for individuals with taxable income within the phase-in range.

[x] Thus, we look at the taxable income of the individual member of the LLC or shareholder of the S corporation – not at the taxable income of the entity.

[xi] Compare to the passive activity loss rules (material participant or not?), and the net investment income surtax rules (modified adjusted gross income in excess of threshold; material participant?).

[xii] In such cases, the person paying the W-2 wages and reporting the W-2 wages on Forms W-2 is precluded from taking into account such wages for purposes of determining W-2 wages with respect to that person.

[xiii] The PR also provide special rules for determining the UB and the depreciable period for property acquired in a “tax-free” exchange.

Specifically, for purposes of determining the depreciable period, the date the exchanged basis in the replacement qualified property is first placed in service by the trade or business is the date on which the relinquished property was first placed in service by the individual or PTE, and the date the excess basis in the replacement qualified property is first placed in service by the individual or PTE is the date on which the replacement qualified property was first placed in service by the individual or PTE. As a result, the depreciable period for the exchanged basis of the replacement qualified property will end before the depreciable period for the excess basis of the replacement qualified property ends.

Thus, qualified property acquired in a like-kind exchange will have two separate placed in service dates under the PR: for purposes of determining the UBIA of the property, the relevant placed in service date will be the date the acquired property is actually placed in service; for purposes of determining the depreciable period of the property, the relevant placed in service date generally will be the date the relinquished property was first placed in service.

[xiv] Rather than treat them as a separate item of property, the PR provides that, in the case of any addition to, or improvement of, qualified property that is already placed in service by the taxpayer, such addition or improvement is treated as separate qualified property that the taxpayer first placed in service on the date such addition or improvement is placed in service by the taxpayer for purposes of determining the depreciable period of the qualified property. For example, if a taxpayer acquired and placed in service a machine on March 26, 2018, and then incurs additional capital expenditures to improve the machine in May 2020, and places such improvements in service on May 27, 2020, the taxpayer has two qualified properties: The machine acquired and placed in service on March 26, 2018, and the improvements to the machine incurred in May 2020 and placed in service on May 27, 2020.

[xv] In the case of qualified property of a partnership that does not produce tax depreciation during the year (for example, property that has been held for less than 10 years but whose recovery period has ended), each partner’s share of the UB of qualified property is based on how gain would be allocated to the partners if the qualified property were sold in a hypothetical transaction for cash equal to the fair market value of the qualified property. In the case of qualified property of an S corporation that does not produce tax depreciation during the year, each shareholder’s share of the UB of the qualified property is a share of the UB proportionate to the ratio of shares in the S corporation held by the shareholder over the total shares of the S corporation.

[xvi] And so ended every episode of Looney Tunes. Thank you Mel Blanc.

This is the third in a series of posts reviewing the recently proposed regulations (“PR”) under Sec. 199A of the Code. https://www.federalregister.gov/documents/2018/08/16/2018-17276/qualified-business-income-deduction

So far, we’ve considered the elements of a “qualified trade or business” under Section 199A https://www.taxlawforchb.com/2018/09/the-proposed-sec-199a-regs-are-here-part-one/, and the related issue of what constitutes a “specified service trade or business,” the owners of which may be denied the benefit of Section 199A. https://www.taxlawforchb.com/2018/09/the-proposed-sec-199a-regs-are-here-part-two/ Today we’ll turn to the meaning of “qualified business income.”

Qualified Business Income – In General

In general, under Section 199A of the Code, a non-corporate taxpayer is allowed a deduction (the “Section 199A deduction”) for a taxable year equal to 20% of the taxpayer’s qualified business income (“QBI”) with respect to a qualified trade or business (“QTB”) for such year.

The term “QBI” means, for any taxable year, the net amount of “qualified items of income, gain, deduction, and loss” attributable to any QTB of the taxpayer, which in turn means those items of income, gain, deduction, and loss to the extent they are (i) “effectively connected with” the conduct of a trade or business within the U.S., and (ii) included or allowed in determining taxable income for the taxable year.

QBI items must be determined for each QTB by the individual or pass-through entity (“PTE”) that directly conducts the trade or business before applying the aggregation rules. https://www.taxlawforchb.com/2018/09/the-proposed-sec-199a-regs-are-here-part-one/

Exclusion from QBI for Certain Items

The PR provide a list of items that are not taken into account as qualified items of income, gain, deduction, and loss, including capital gain or loss, dividends, interest income other than interest income properly allocable to a trade or business, and certain other items; similarly, items of deduction or loss attributable to these items of income or gain are also not taken into account in determining a taxpayer’s QBI.

Compensation for Services

In general, S corporations must pay their shareholder-employees “reasonable compensation” for services rendered before making “dividend” distributions with respect to shareholder-employees’ stock in the S corporation.

The PR provide that QBI does not include the amount of reasonable compensation paid to the shareholder-employee of an S corporation that operates a QTB for services rendered by the shareholder-employee with respect to such trade or business.

However, the S corporation’s deduction for such reasonable compensation reduces QBI if such deduction is properly allocable to the trade or business and is otherwise deductible.

Guaranteed Payments

Similarly, the PR provide that QBI does not include any guaranteed payment – one determined without regard to the income of the partnership – made by a partnership to a partner for services rendered with respect to the partnership’s trade or business.

However, the partnership’s related expense deduction for making the guaranteed payment may constitute an item of QBI. [i]

The PR clarify that QBI does not include any guaranteed payment paid to a partner for services rendered, regardless of whether the partner is an individual or a PTE. Therefore, a guaranteed payment paid by a lower-tier partnership to an upper-tier partnership retains its character as a guaranteed payment and is not included in QBI of a partner of the upper-tier partnership regardless of whether it is guaranteed to the ultimate recipient.

Other Payments to “Partners”

QBI does not include any payment to a partner, regardless of whether the partner is an individual or a PTE, for services rendered with respect to the partnership’s trade or business where the partner engages with the partnership other than in their capacity as a partner. Thus, it is treated similarly to guaranteed payments, reasonable compensation, and wages, none of which is includable in QBI.

Guaranteed Payments for the Use of Capital

Because guaranteed payments for the use of capital are determined without regard to the income of the partnership, the PR provide that such payments are not considered attributable to a trade or business, and thus do not constitute QBI.

However, the partnership’s related expense for making the guaranteed payments may constitute an item of QBI.

Interest Income

QBI does not include any interest income other than interest income that is properly allocable to a trade or business.

According to the PR, interest income received on working capital, reserves, and similar accounts is income from assets held for investment and is not properly allocable to a trade or business.

In contrast, interest income received on accounts or notes receivable for services or goods provided by the trade or business is not income from assets held for investment, but income received on assets acquired in the ordinary course of the trade or business.

QBI – Special Rules

In addition to the foregoing exclusions, the PR clarify the treatment of certain items that may be of interest to taxpayers that are disposing of their interest in a trade or business.

“Hot Asset” Gain

Under the partnership rules, the gain realized by a partner on the exchange of all or part of their interest in a partnership is treated as ordinary income to the extent it is attributable to the unrealized receivables or inventory items (“hot assets”) of the partnership. These are items that eventually would have been recognized by the partnership and allocated to the partner in the ordinary course; the exchange by the partner of their partnership interest merely accelerates this recognition and allocation.

Similarly, a distribution of property by a partnership to a partner in exchange for the partner’s interest in the “hot assets” of the partnership may be treated as sale or exchange of such hot assets between the partner and the partnership, thereby generating ordinary income.

According to the PR, any gain that is attributable to the hot assets of a partnership – thereby giving rise to ordinary income in the circumstances described above – is considered attributable to the trade or business conducted by the partnership, and therefore, may constitute QBI to the partner.

Of course, the term “unrealized receivables” is defined to include not only receivables, but other items as well; for example, depreciation recapture. This may be significant in the sale of a business by a PTE where the gain arising from the sale would otherwise be excluded from QBI.

Change in Accounting Adjustments

If a taxpayer changes their method of accounting, the Code requires that certain adjustments be made in computing the taxpayer’s taxable income in order to prevent amounts of income or deduction from being duplicated or omitted. In general, these adjustments are taken into account by the taxpayer over a three-year period.

The PR provide that when such adjustments (whether positive or negative) are attributable to a QTB, and arise in a taxable year ending after December 31, 2017, they will be treated as attributable to that trade or business. Accordingly, such adjustments may constitute QBI.

Previously Suspended Losses

Several sections of the Code provide for the disallowance of losses and deductions to a taxpayer in certain cases; for example, the “at risk” rules and the “passive activity loss” rules. Generally, the disallowed amounts are suspended and carried forward to the following year, at which point they are re-tested and may become allowable; of course, when the taxpayer disposes of their interest in the business to an unrelated party in a fully taxable transaction, the loss will cease to be suspended.

Likewise, losses may be suspended because an individual shareholder of an S corporation does not have sufficient stock or debt basis to utilize them; however, the actual or deemed sale of the assets of the S corporation’s business may generate enough gain to increase such basis and enable the shareholder to use the suspended losses.

The PR provide that, to the extent that any previously disallowed losses or deductions, attributable to a QTB, are allowed in the taxable year, they are treated as items attributable to the trade or business. Thus, losses that cease to be suspended under one of the above “disposition rules” may be treated as QBI. However, losses or deductions that were disallowed for taxable years beginning before January 1, 2018 are not taken into account for purposes of computing QBI in a later taxable year.

Net Operating Losses

Generally, items giving rise to a net operating loss (“NOL”) are allowed in computing taxable income in the year incurred. Because those items would have been taken into account in computing QBI in the year incurred, the NOL should not be treated as QBI in subsequent years.

However, to the extent the NOL is comprised of amounts attributable to a QTB that were disallowed under the new “excess business loss” rule – which are not allowed in computing taxable income for the taxable year but which are, instead, carried forward and treated as part of the taxpayer’s net operating loss carryforward in subsequent taxable years – the NOL is considered attributable to that trade or business, and may constitute QBI. https://www.taxlawforchb.com/2018/01/the-real-property-business-and-the-tax-cuts-jobs-act/

Property Used in the Trade or Business

QBI does not include any item of short-term capital gain, short-term capital loss, long-term capital gain, or long-term capital loss.

The Code provides rules under which gains and losses from the sale or exchange of certain property used in a trade or business are either treated as long-term capital gains or long-term capital losses, or are not treated as gains and losses from sales or exchanges of capital assets.[ii]

The PR clarify that QBI excludes short-term and long-term capital gains or losses, regardless of whether those items arise from the sale or exchange of a capital asset, including any item treated as one of such items taken into account in determining net long-term capital gain or net long-term capital loss.

Conversely, if the gains or losses are not treated as gains and losses from sales or exchanges of capital assets, the gains or losses may be included in QBI.

Effectively Connected With a U.S. Trade or Business

Section 199A applies to all non-corporate taxpayers, whether such taxpayers are domestic or foreign. Accordingly, Section 199A applies to both U.S. citizens and resident aliens, as well as nonresident aliens (“NRA”) that have QBI.

QBI includes items of income, gain, deduction, and loss to the extent such items are (i) included or allowed in determining the U.S. person’s or NRA’s taxable income for the taxable year, and (ii) effectively connected with the conduct of a trade or business within the U.S.

Determining Effectively Connected Income

In general, whether a QTB is engaged in a trade or business within the U.S., partially within the U.S., or solely outside the U.S., is based upon all the facts and circumstances.[iii]

If a trade or business is not engaged in a U.S. trade or business, items of income, gain, deduction, or loss from that trade or business will not be included in QBI because such items would not be effectively connected with the conduct of a U.S. trade or business.

Thus, a shareholder of an S corporation, or a U.S. partner of a partnership, that is engaged in a trade or business in both the U.S. and overseas would only take into account the items of income, deduction, gain, and loss that would be effectively connected with the business conducted by the S corporation, or partnership, in the U.S.

In determining whether income or gain from U.S. sources is effectively connected with the conduct of a trade or business within the U.S., a number of factors have to be considered, including whether the income, gain or loss is derived from assets used in or held for use in the conduct of such trade or business, or the activities of such trade or business were a material factor in the realization of the income, gain or loss.

If an NRA’s QTB is determined to be conducted in the U.S., the Code generally treats all non-investment income of the NRA from sources within the U.S. as effectively connected with the conduct of a U.S. trade or business.[iv]

Income from sources without the U.S. is generally not treated as effectively connected with the NRA’s conduct of a U.S. trade or business. Thus, a trade or business’s foreign source income, gain, or loss, (and any deductions effectively connected with such foreign source income, gain, or loss) would generally not be included in QBI.[v]

However, this rule does not mean that any item of income or deduction that is treated as effectively connected with an NRA’s conduct of a trade or business with the U.S. is necessarily QBI. Indeed, certain provisions of the Code allow items to be treated as effectively connected, even though they are not “items” with respect to a trade or business. For example, the Code allows an NRA to elect to treat income from rental real property in the U.S. that would not otherwise be treated as effectively connected with the conduct of a trade or business within the U.S. as effectively connected. However, if items are not attributable to a QTB, they do not constitute QBI.

Allocation of QBI Items

The PR provides that, if an individual or a PTE directly conducts multiple trades or businesses, and has items of QBI that are properly attributable to more than one trade or business, the taxpayer or entity must allocate those items among the several trades or businesses to which they are attributable using a reasonable method that is consistent with the purposes of Section 199A.

The chosen reasonable method for each item must be consistently applied from one taxable year to another, and must clearly reflect the income of each trade or business.

There are several different ways to allocate expenses, such as direct tracing, allocating based on gross income, or some other method, but whether these are reasonable depends on the facts and circumstances of each trade or business.

Next week, we’ll bring together the basic elements of Section 199A, which we covered in the last three posts, to see how the “20% deduction” is determined.

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[i] The PR provides that QBI does not include reasonable compensation paid by an S corporation but does not extend this rule to partnerships. Because the trade or business of performing services as an employee is not a QTB, wage income received by an employee is never QBI.

The rule for reasonable compensation is merely a clarification that, even if an S corporation fails to pay a reasonable wage to its shareholder-employees, the shareholder-employees are nonetheless prevented from including an amount equal to reasonable compensation in QBI.

[ii] IRC Sec. 1231.

[iii] Because an NRA cannot be a shareholder on an S corporation, the NRA’s effectively connected income must arise from the NRA’s direct conduct of a trade or business in the U.S. (including through a disregarded entity; if the NRA is a resident of a treaty country, the NRA’s business profits will not be subject to U.S. tax unless the NRA operates the business through a permanent establishment in the U.S.); in addition, an NRA is considered engaged in a trade or business within the U.S. if the partnership of which such individual is a member is so engaged.

[iv] However, any “FDAP” income or “portfolio interest” income from sources within the U.S., and any gain or loss from the sale of capital assets, may be effectively connected only if the income meets certain requirements.

[v] There are exceptions.

This is the second in a series of posts reviewing the recently proposed regulations (“PR”) under Sec. 199A of the Code. https://www.federalregister.gov/documents/2018/08/16/2018-17276/qualified-business-income-deduction

 Yesterday, we considered the elements of a “qualified” trade or business under Section 199A. Today, we’ll pick up with those trades or businesses that may be excluded from its coverage, and tomorrow we’ll turn to the meaning of qualified business income. https://www.taxlawforchb.com/2018/09/the-proposed-sec-199a-regs-are-here-part-one/ Hold on to your seats as we continue to look at more . . . definitions.

Effect of Specified Service Trade or Business Status

A qualified trade or business (“QTB”) – the qualified business income (“QBI”) of which provides the basis for the Section 199A deduction – includes any trade or business other than a “specified service trade or business” (“SSTB”).

Thus, if a trade or business is an SSTB, no QBI, W-2 wages, or unadjusted basis (“UB”) of qualified property from the SSTB may be taken into account by an individual owner of the SSTB whose taxable income exceeds a threshold amount plus a phase-in range, even if the taxable income is derived from an activity that is not itself an SSTB.

If the trade or business conducted by a PTE is an SSTB, this limitation will apply to any direct or indirect individual owners of the business, regardless of whether the owner is passive or participated in any SSTB activity. However, the SSTB limitation will not apply to an individual with taxable income below the threshold amount.[i]

SSTB Defined

Conceptually, the definition of an SSTB emphasizes the direct provision of services by the employees or owners of a trade or business, rather than the application of capital.

Although the Code does not require a certain quantum of specified service activity is necessary to find an SSTB, the PR provide a de minimis rule under which a trade or business will not be considered an SSTB merely because it provides a small amount of services in a specified service activity.[ii]

An SSTB means any trade or business involving the performance of services in the fields of health, law, accounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage services, or any trade or business where the principal asset of such trade or business is the reputation or skill of one or more of its employees or owners, and any trade or business that involves the performance of services that consist of investing and investment management, trading, or dealing in securities, partnership interests, or commodities.

Some of these services are considered below.

Health

The PR provide that the term “performance of services in the field of health” means the provision of medical services by physicians, pharmacists, nurses, dentists, veterinarians, physical therapists, psychologists, and other similar healthcare professionals who provide medical services directly to a patient.

The performance of services in the field of health does not include the provision of services not directly related to a medical field, even though the services may purportedly relate to the health of the service recipient.

For example, the performance of services in the field of health does not include the operation of health clubs or health spas that provide physical exercise or conditioning to their customers, payment processing, or research, testing, and manufacture and/or sales of pharmaceuticals or medical devices.

Law

The term “performance of services in the field of law” means the provision of services by lawyers, paralegals, legal arbitrators, mediators, and similar professionals in their capacity as such.

It does not include the provision of services that do not require skills unique to the field of law; for example, the provision of services in the field of law does not include the provision of services by printers, delivery services, or stenography services.

Accounting

The PR provides that the term “performance of services in the field of accounting” means the provision of services by accountants, enrolled agents, return preparers, financial auditors, and similar professionals in their capacity as such.

Provision of services in the field of accounting is not limited to services requiring state licensure as a certified public accountant (CPA). The aim of the PR is to capture the common understanding of accounting, which includes bookkeeping services.

The field of accounting does not include payment processing and billing analysis.

Consulting

The term “performance of services in the field of consulting” means the provision of professional advice and counsel to clients to assist the client in achieving goals and solving problems.

Consulting includes providing advice and counsel regarding advocacy with the intention of influencing decisions made by a government or governmental agency and all attempts to influence legislators and other government officials on behalf of a client by lobbyists and other similar professionals performing services in their capacity as such.

The performance of services in the field of consulting does not include the performance of services other than advice and counsel, such as sales or economically similar services, or the provision of training or educational courses. The determination of whether a person’s services are sales or economically similar services is made based on all the facts and circumstances of that person’s business, including the manner in which the taxpayer is compensated for the services.

In recognition of the fact that, in certain kinds of sales transactions, it is common for businesses to provide consulting services in connection with the purchase of goods by customers – for example, a company that sells computers may provide customers with consulting services relating to the setup, operation, and repair of the computers – the PR provide a de minimis rule under which a trade or business is not an SSTB if less than 10% of the gross receipts (5% if the gross receipts are greater than $25 million) of the trade or business for a taxable year are attributable to the performance of services in a SSTB.

However, the IRS also recognized that this de minimis rule may not provide sufficient relief for certain trades or business that provide ancillary consulting services. Thus, the PR also provide that the field of consulting does not include the performance of consulting services that are embedded in, or ancillary to, the sale of goods or the performance of services on behalf of a trade or business that is other than an SSTB if there is no separate payment for the consulting services.

Financial Services

The PR limits the definition of financial services to services including managing wealth, advising clients with respect to finances, developing retirement plans, developing wealth transition plans, the provision of advisory and other similar services regarding valuations, mergers, acquisitions, dispositions, restructurings (including in title 11 or similar cases), and raising financial capital by underwriting, or acting as the client’s agent in the issuance of securities, and similar services.

This includes services provided by financial advisors, investment bankers, wealth planners, and retirement advisors and other similar professionals.

Brokerage Services

The PR provide that the field of brokerage services includes services in which a person arranges transactions between a buyer and a seller with respect to securities for a commission or fee. This includes services provided by stock brokers and other similar professionals, but does not include services provided by real estate agents and brokers, or insurance agents and brokers.

Principal Asset of the Business: Reputation or Skill of Employees or Owners

Thankfully, the PR rejected a broad, service-based approach to the meaning of what could have been the catch-all “reputation or skill” clause by limiting it to fact patterns in which the individual or PTE is engaged in the trade or business of: (1) Receiving income for endorsing products or services, including an individual’s distributive share of income or distributions from an PTE for which the individual provides endorsement services; (2) licensing or receiving income for the use of an individual’s image, likeness, name, signature, voice, trademark, or any other symbols associated with the individual’s identity, including an individual’s distributive share of income or distributions from an RPE to which an individual contributes the rights to use the individual’s image; or (3) receiving appearance fees or income.[iii]

Investing and Investment Management

The PR provide that any trade or business that involves the “performance of services that consist of investing and investment management” means a trade or business that earns fees for investment, asset management services, or investment management services, including providing advice with respect to buying and selling investments. The performance of services that consist of investing and investment management would include a trade or business that receives either a commission, a flat fee, or an investment management fee calculated as a percentage of assets under management.

The performance of services of investing and investment management does not include directly managing real property.

Trading

The PR provide that any trade or business involving the “performance of services that consist of trading” means a trade or business of trading in securities, commodities, or partnership interests. Whether a person is a trader is determined taking into account the relevant facts and circumstances. Factors that have been considered relevant to determining whether a person is a trader include the source and type of profit generally sought from engaging in the activity regardless of whether the activity is being provided on behalf of customers or for a taxpayer’s own account.

Dealing in Securities

The “performance of services that consist of dealing in securities” means regularly purchasing securities from and selling securities to customers in the ordinary course of a trade or business or regularly offering to enter into, assume, offset, assign, or otherwise terminate positions in securities with customers in the ordinary course of a trade or business. For purposes of the preceding sentence, a taxpayer that regularly originates loans in the ordinary course of a trade or business of making loans but engages in no more than “negligible” sales of the loans is not dealing in securities for purposes of Section 199A.

The fact that businesses are operated across entities raises the question of whether, in defining a “trade or business” for purposes of Section 199A, trades or businesses should be permitted or required to be aggregated, or disaggregated, and if so, whether such aggregation, or disaggregation, should occur at the entity level or at the individual-owner level.

Services or Property Provided to an SSTB

The IRS observed that some taxpayers have contemplated a strategy to separate out parts of what otherwise would be an integrated SSTB, such as the administrative functions, in an attempt to qualify those separated parts for the Section 199A deduction. Such a strategy, the IRS has stated, is inconsistent with the purpose of Section 199A.

Therefore, the PR provide an anti-abuse rule pursuant to which an SSTB will include any trade or business (not otherwise an SSTB) with 50% or more common ownership (direct or indirect) with an SSTB, that provides 80% or more of its property or services to the SSTB.

Additionally, if a trade or business provides less than 80% of its property or services to an SSTB, but has 50% or more common ownership with an SSTB, that portion of the trade or business of providing property or services to the SSTB will be treated as part of the SSTB (meaning the income will be treated as income from an SSTB). For example, dentist A owns a dental practice and also owns an office building. A rents half the building to the dental practice and half the building to unrelated persons. The renting of half of the building to the dental practice will be treated as an SSTB.

The PR also provide a rule that if a trade or business (that would not otherwise be treated as an SSTB) has 50% or more common ownership with an SSTB, and has shared expenses with an SSTB, including wages or overhead expenses, it is treated as incidental to the SSTB and, therefore, as part of the SSTB, if the gross receipts of the trade or business represent no more than 5% of the gross receipts of the combined business in a taxable year.

Example. A, a dermatologist, provides medical services to patients on a regular basis through LLC, a disregarded entity owned by A. In addition to providing medical services, LLC also sells skin care products to A’s patients. The same employees and office space are used for the medical services and sale of skin care products. The gross receipts with respect to the skin care product sales do not exceed 5% of the gross receipts of LLC. Accordingly, the sale of the skin care products is treated as incidental to A’s SSTB of performing services in the field of health and is treated as part of such SSTB.

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[i] For purposes of this post, it is assumed that the threshold amount ($315,000 in the case of married taxpayers filing jointly) and phase-in range are exceeded. It should be noted, however, that an individual with taxable income in excess of the threshold amount but within the phase-in range will be allowed to take into account a certain “applicable percentage” of QBI, W-2 wages and QB of qualified property from an SSTB in determining their Section 199A deduction. Thus, some owners of an SSTB may qualify for the Section 199A deduction while others may not.

[ii] For more details on this de minimis rule, see the discussion below, under “consulting” services.

[iii] Oh, to be a celebrity!

What follows is the first in a series of posts that will review the long-awaited proposed regulations under Sec. 199A of the Code – the “20% deduction” – which was enacted by the Tax Cuts and Jobs Act to benefit the individual owners of pass-through business entities.

Today’s post will summarize the statutory provision, and will then consider some of the predicate definitions and special rules that are key to its application.

We will continue to explore these definitions and rules in tomorrow’s post.

Congress: “I Have Something for You”

The vast majority of our clients are closely-held businesses that are organized as pass-through entities (“PTEs”), and that are owned by individuals. These PTEs include limited liability companies that are treated as partnerships for tax purposes, as well as S corporations.

As the Tax Cuts and Jobs Act (“TCJA”)[i] moved through Congress in late 2017, it became clear that C corporations were about to realize a significant windfall.[ii] In reaction to this development, many individual clients who operate through partnerships began to wonder whether they should incorporate their business (for example, by “checking the box”[iii]); among those clients that operated their business as S corporations, many asked whether they should revoke their “S” election.

After what must have been a substantial amount of grumbling from the closely-held business community, Congress decided to add a new deduction to the TCJA – Section 199A – that was intended to benefit the individual owners of PTEs for taxable years beginning after 2017 and before 2026.[iv]

“Here It Is”

In general, under new Section 199A of the Code, a non-corporate taxpayer is allowed a deduction (the “Section 199A deduction”) for a taxable year equal to 20% of the taxpayer’s qualified business income (“QBI”) with respect to a qualified trade or business (“QTB”) for such year.

A QTB includes any trade or business other than a “specified service trade or business” (“SSTB”)[v]. It also does not include the trade or business of rendering services as an employee.

An SSTB includes, among other things, any trade or business involving the performance of services in the fields of health, law, accounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage services, or any trade or business where the principal asset of such trade or business is the reputation or skill of one or more of its employees.

The QBI of a QTB means, for any taxable year, the net income or loss with respect to such trade or business of the taxpayer for the year, provided it is effectively connected with the conduct of a trade or business in the U.S. (“effectively connected income,” or “ECI”).

Investment income is not included in determining QBI, nor is any reasonable compensation paid to a shareholder, nor any guaranteed payment made to a partner, for services rendered to the QTB.

If an individual taxpayer-owner’s taxable income for a taxable year exceeds a threshold amount, a special limitation will apply to limit that individual’s Section 199A deduction.

Assuming the limitation rule is fully applicable, the amount of the Section 199A deduction may not exceed the greater of:

  • 50% of the W-2 wages with respect to the QTB that are allocable to QBI, or
  • 25% of such W-2 wages, plus 2.50% of the “unadjusted basis” (“UB”)[vi] of all depreciable tangible property held by the QTB at the close of the taxable year, which is used at any point in the year in the production of QBI, and the depreciable period for which has not ended before the close of the taxable year (“qualified property”).

If the individual taxpayer carries on more than one QTB (directly or through a PTE), the foregoing calculation is applied separately to each such QTB, and the results are then aggregated to determine the amount of the Section 199A deduction.

Thus, a loss generated in one QTB may offset the net income generated in another, thereby denying the taxpayer any Section 199A deduction.

If the taxpayer carries on the business indirectly, through a partnership or S corporation, the rule is applied at the partner or shareholder level, with each partner or shareholder taking into account their allocable share of QBI, as well as their allocable share of W-2 wages and UB (for purposes of applying the above limitation).

Because some individual owners of a PTE may have personal taxable income at a level that triggers application of the above limitation, while others may not, it is possible for some owners of a QTB to enjoy a smaller Section 199A deduction than others, even where they have the same percentage equity interest in the QTB.[vii]

Finally, the amount of a taxpayer’s Section 199A deduction for a taxable year determined under the foregoing rules may not exceed 20% of the excess of (i) the taxpayer’s taxable income for the taxable year over (ii) the taxpayer’s net capital gain for such year.

Taxpayer: “Thank You, But I Have Some Questions”

It did not take long after Section 199A was enacted as part of the TCJA, on December 22, 2017, for many tax advisers and their PTE clients to start asking questions about the meaning or application of various parts of the rule.

For example, what constitutes a “trade or business” for purposes of the rule? Would taxpayers be allowed to group together separate but related businesses for purposes of determining the Deduction? Would they be required to do so? Under what circumstances, if any, would a PTE be permitted to split off a discrete business activity or function into a different business entity? When is the reputation or skill of an employee the principal asset of a business?

Because of these and other questions, most advisers decided it would be best to wait for guidance from the IRS before advising taxpayers on how to implement and apply the new rules.[viii]

The IRS assured taxpayers that such guidance would be forthcoming in the spring of 2018; it subsequently revised its target date to July of 2018; then, on August 16, the IRS issued almost 200 pages of Proposed Regulations (“PR”). https://www.federalregister.gov/documents/2018/08/16/2018-17276/qualified-business-income-deduction

The Proposed Regulations

The PR will apply to taxable years ending after the date they are adopted as final regulations; until then, however, taxpayers may rely on the PR.

Trade or Business – In General

The PR provide that, for purposes of Section 199A, the term “trade or business” shall mean an activity that is conducted with “continuity and regularity” and “with the primary purpose of earning income or making profit.” This is the same definition that taxpayers have applied for decades for purposes of determining whether expenses may be deducted as having been incurred in the ordinary course of a trade or business (so-called “ordinary and necessary” expenses).

However, in recognition of the fact that it is not uncommon, for legal or other bona fide non-tax reasons (for example, to limit exposure to liability), for taxpayers to segregate rental properties from operating businesses, the PR extend the definition of “trade or business” for purposes of Section 199A by including the rental or licensing of tangible or intangible property to a related trade or business – which may not otherwise satisfy the general definition of “trade or business” adopted by the PR (for example, where the entire property is rented only to the operating business) – if the “lessor/licensor trade or business” and the “lessee/licensee trade or business” are commonly controlled (generally speaking, if the same person or group of persons, directly or indirectly, owns 50% or more of each trade or business).

Trade or Business – Aggregation Rules

The above line of reasoning also informed the IRS’s thinking with respect to the “grouping” of certain trades or businesses for purposes of applying Section 199A.

Specifically, the IRS recognized that some amount of aggregation should be permitted because it is not uncommon, for what are commonly thought of as single trades or businesses, to be operated across multiple entities for various legal, economic, or other bona fide non-tax reasons.

Allowing taxpayers to aggregate trades or businesses offers taxpayers a means of combining their trades or businesses for purposes of applying the “W-2 wage” and “UB of qualified property” limitations (described above) and potentially maximizing the deduction under Section 199A. The IRS was concerned that if such aggregation were not permitted, taxpayers could be forced to incur costs to restructure solely for tax purposes. In addition, business and non-tax legal requirements may not permit many taxpayers to restructure their operations.

Therefore, the PR permits the aggregation of separate trades or businesses, provided certain requirements are satisfied; aggregation is not required.[ix]

An individual may aggregate trades or businesses only if the individual can demonstrate that certain requirements are satisfied:

  • Each “trade or business” must itself be a trade or business for purposes of Section 199A.
  • The same person, or group of persons, must directly or indirectly, own a majority interest in each of the businesses to be aggregated for the majority of the taxable year in which the items attributable to each trade or business are included in income. All of the items attributable to the trades or businesses must be reported on tax returns with the same taxable year.
    • The PR provides rules allowing for family attribution.
    • Because the proposed rules look to a group of persons, minority owners may benefit from the common ownership and are permitted to aggregate.
  • None of the aggregated trades or businesses can be an SSTB (more on this tomorrow).
  • Individuals must establish that the trades or businesses to be aggregated meet at least two of the following three factors, which demonstrate that the businesses are in fact part of a larger, integrated trade or business:
    • The businesses provide products and services that are the same (for example, a restaurant and a food truck) or they provide products and services that are customarily provided together (for example, a gas station and a car wash);
    • The businesses share facilities or share significant centralized business elements (for example, common personnel, accounting, legal, manufacturing, purchasing, human resources, or information technology resources); or
    • The businesses are operated in coordination with, or reliance on, other businesses in the aggregated group (for example, supply chain interdependencies).

Trade or Business – Aggregation by Individuals

An individual is permitted to aggregate trades or businesses that the individual operates directly and trades or businesses operated indirectly – or, more appropriately, they may aggregate the businesses they operate directly with their share of QBI, W-2 wages and UB of qualified property from trades or businesses operated through PTEs of which the individual is an owner.

Individual owners of the same PTEs are not required to aggregate in the same manner.

An individual directly engaged in a trade or business must compute QBI, W-2 wages, and UB of qualified property for each such trade or business before applying the aggregation rules.

If an individual has aggregated two or more trades or businesses, then the combined QBI, W-2 wages, and UB of qualified property for all aggregated trades or businesses is used for purposes of applying the W-2 wage and UB of qualified property limitations.

Example. Individual A wholly owns and operates a catering business and a restaurant through separate disregarded entities. The catering business and the restaurant share centralized purchasing to obtain volume discounts and a centralized accounting office that performs all of the bookkeeping, tracks and issues statements on all of the receivables, and prepares the payroll for each business. A maintains a website and print advertising materials that reference both the catering business and the restaurant. A uses the restaurant kitchen to prepare food for the catering business. The catering business employs its own staff and owns equipment and trucks that are not used or associated with the restaurant.

Because the restaurant and catering business are held in disregarded entities, A will be treated as operating each of these businesses directly. Because both businesses offer prepared food to customers, and because the two businesses share the same kitchen facilities in addition to centralized purchasing, marketing, and accounting, A may treat the catering business and the restaurant as a single trade or business for purposes of applying the limitation rules.

Example. Assume the same facts as above, but the catering and restaurant businesses are owned in separate partnerships and A, B, C, and D each own a 25% interest in the capital and profits of each of the two partnerships. A, B, C, and D are unrelated.

Because A, B, C, and D together own more than 50% of the capital and profits in each of the two partnerships, they may each treat the catering business and the restaurant as a single trade or business for purposes of applying the limitation rules.

Trade or Business – Aggregation by PTEs

PTEs must compute QBI, W-2 wages, and UB of qualified property for each trade or business. A PTE must provide its owners with information regarding QBI, W-2 wages, and UB of qualified property attributable to its trades or businesses.

The PR do not address the aggregation by a PTE in a tiered structure.

Trade or Business – Aggregation – Reporting and Consistency

The PR requires that, once multiple trades or businesses are aggregated into a single aggregated trade or business, individuals must consistently report the aggregated group in subsequent tax years.

The PR provides rules for situations in which the aggregation rules are no longer satisfied, as well as rules for when a newly-created or newly-acquired trade or business can be added to an existing aggregated group.

Finally, the PR provides reporting and disclosure requirements for individuals that choose to aggregate, including identifying information about each trade or business that constitutes a part of the aggregated trade or business. The PR allows the IRS to disaggregate trades or businesses if an individual fails to make the required disclosure.


[*] Anyone remember the following scene from “The Jerk”?

Navin: “The new phone book’s here! The new phone book’s here!”
Harry: “Well I wish I could get so excited about nothing.”
Navin: “Nothing? Are you kidding?! Page 73, Johnson, Navin, R.! I’m somebody now! Millions of people look at this book every day! This is the kind of spontaneous publicity, your name in print, that makes people. I’m in print! Things are going to start happening to me now.”

[i] Pub. L. 115-97.

[ii] See, e.g., https://www.taxlawforchb.com/2018/01/some-of-the-tcjas-corporate-tax-changes/ ; https://www.taxlawforchb.com/2018/01/will-tax-reform-affect-domestic-ma/ ; https://www.taxlawforchb.com/2018/06/s-corps-cfcs-the-tax-cuts-jobs-act/.

[iii] https://www.law.cornell.edu/cfr/text/26/301.7701-3

[iv] That’s right – the provision is scheduled to disappear in a few years. However, on July 24, the House Ways and Means Committee released “Tax Reform 2.0 Listening Session Framework” which would make the deduction permanent. These proposals will not be considered until after the Congressional elections this fall. Enough said. https://waysandmeansforms.house.gov/uploadedfiles/tax_reform_2.0_house_gop_listening_session_framework_.pdf

[v] It should be noted that a SSTB will not be excluded from QTB status with respect to an individual taxpayer-owner of the SSTB if the taxpayer’s taxable income does not exceed certain thresholds. It is assumed herein that these thresholds, as well as the range of taxable income above such thresholds within which the benefit of Section 199A is scaled back, are exceeded for every owner of the SSTB.

[vi] In general, the unadjusted basis, immediately after acquisition, of all qualified property.

[vii] Query whether this may influence business and investment decisions.

[viii] Others, however, saw a wasting opportunity, given the scheduled elimination of the deduction after the year 2025, and may have acted hastily. Among other things, many of these advisers and taxpayers sought to bootstrap themselves into a QTB by separating its activities from a related SSTB.

[ix] The IRS is aware that many taxpayers are concerned with having multiple regimes for grouping. Accordingly, it has requested comments on the aggregation method described in the PR, including whether this would be an appropriate grouping method for purposes of the passive activity loss limitation and net investment income surtax rules, in addition to Section 199A.

 

Earlier this month, the IRS proposed regulations regarding the additional first-year depreciation deduction that was added to the Code by the Tax Cuts and Jobs Act (“TCJA”).[i] The proposed rules provide guidance that should be welcomed by those taxpayers that are considering the purchase of a closely held business or, perhaps, of an interest in such a business, and that are concerned about their ability to recover their investment.

Cost Recovery

In general, a taxpayer must capitalize the cost of property acquired for use in the taxpayer’s trade or business – in other words, the cost must be added to the taxpayer’s basis for the property.[ii] The taxpayer may then recover its acquisition cost (its investment in the property) over time – by reducing its taxable income through annual deductions for depreciation or amortization, depending upon the property.[iii] The recovery period (i.e., the number of years) and the depreciation method (for example, accelerated or straight-line) are prescribed by the Code and by the IRS.

In general, the “net cost” incurred by a taxpayer in the acquisition of a business or investment property will be reduced when such cost may be recovered over a shorter, as opposed to a longer, period of time.

In recognition of this basic principle, and in order to encourage taxpayers to acquire certain types of property, Congress has, over the years, allowed taxpayers to recover their investment in such property more quickly by claiming an additional depreciation deduction for the tax year in which the acquired property is placed in service by the taxpayer.[iv]

Pre-TCJA

Prior to the TCJA, the Code allowed a taxpayer to claim an additional first-year depreciation deduction equal to 50% of the taxpayer’s adjusted basis for “qualified” property.[v]

Qualified property included tangible property with a recovery period of twenty years or less, the original use of which began with the taxpayer.[vi] It did not include a so-called “section 197 intangible,” such as the goodwill of a business.

TCJA

In general, for property placed in service after September 27, 2017, the TCJA increased the amount of the additional first-year depreciation deduction to 100% of the taxpayer’s adjusted basis for the qualified property.[vii]

Significantly for transactions involving the purchase and sale of a business, the TCJA also removed the requirement that the original use of the qualified property had to commence with the taxpayer.

Specifically, the additional first-year depreciation deduction became available for “used” property, provided the property was purchased in an arm’s-length transaction, it was not acquired in a nontaxable exchange (such as a corporate reorganization), and it was not acquired from certain “related” persons.

Asset Deals

It is axiomatic that the cost of acquiring a business is reduced where the purchaser can recover such cost, or investment, over a short period of time.

By eliminating the “original use” requirement, the TCJA made the additional first-year depreciation deduction available for qualifying “used” properties purchased in connection with a taxpayer’s acquisition of a business from another taxpayer.

Thus, in the acquisition of a business that is structured as a purchase of assets,[viii] where the purchaser’s basis is determined by reference to the consideration paid for such assets, a portion of the consideration that is allocated to qualifying “Class V” assets (for example, equipment and machinery) may be immediately and fully deductible by the purchaser, instead of being depreciated over each asset’s respective recovery period.

The purchaser’s ability to expense (i.e., deduct) what may be a significant portion of the consideration paid to acquire the business will make the transaction less expensive (and, perhaps, more attractive) for the purchaser by reducing its overall economic cost.

Depending on the circumstances, it may also enable the buyer to pay more for the acquisition of the business.[ix]

Beyond Asset Deals?

Although the application of the expanded first-year depreciation deduction was fairly obvious in the case of a purchase of assets in connection with the acquisition of a business, the TCJA and the related committee reports were silent as to its application in other transactional settings, including, for example, those involving the acquisition of stock that may be treated as the purchase of assets for tax purposes.

Thankfully, the proposed regulations address these situations and provide other helpful guidance as well.

Proposed Regulations

Used Property

The proposed regulations provide that the acquisition of “used”[x] property is eligible for the additional first-year depreciation deduction if the acquisition satisfies the requirements described above – it was acquired in a taxable, arm’s-length transaction – and the property was not used by the taxpayer or a predecessor at any time prior to the acquisition.

The proposed regulations provide that property is treated as used by the taxpayer or a predecessor before its acquisition of the property only if the taxpayer or the predecessor had a depreciable interest in the property at any time before the acquisition,[xi] whether or not the taxpayer or the predecessor claimed depreciation deductions for the property.[xii]

Related Persons

In determining whether a taxpayer acquired the property at issue from a related person – for example, an entity in control of, or by, the taxpayer – the proposed regulations provide that, in the case of a series of related transactions, the transfer of the property will be treated as directly transferred from the original transferor to the ultimate transferee, and the relation between the original transferor and the ultimate transferee will be tested immediately after the last transaction in the series. Thus, a sale of assets between related persons will not qualify for the additional first-year deduction.

Deemed Asset Sales by Corporations

It may be that the assets of the target corporation include assets the direct acquisition of which may be difficult to effectuate through a conventional asset deal. In that case, the buyer may have to purchase the issued and outstanding shares of the target’s stock. Without more, the buyer would only be able to recover its investment on a later sale or liquidation of the target.

In recognition of this business reality, Congress has provided special rules by which the buyer may still obtain a recoverable basis step-up for the target’s assets.

In general, provided: (i) the buyer is a corporation, (ii) the buyer acquires at least 80% of target’s stock, (iii) the target is an S-corporation, or a member of an affiliated or consolidated group of corporations, and (iv) the target’s shareholders consent (including, in the case of an S-corporation target, any non-selling shareholders), then the stock sale will be ignored, and the buyer will be treated, for tax purposes, as having acquired the target’s assets with a basis step-up equal to the amount of consideration paid by the buyer plus the amount of the target’s liabilities (a so-called “Section 338(h)(10) election”).

Where a Sec. 338(h)(10) election is not available – for example, because the buyer is not itself a corporation – the buyer may want to consider a different election (a so-called “Section 336(e) election”).

The results of a Section 336(e) election are generally the same as those of a Section 338(h)(10) election in that the target, the stock of which was acquired by the buyer, is treated as having sold its assets to the buyer, following which the target is deemed to have made a liquidating distribution to its shareholders.

This election, however, may only be made by the seller’s shareholders – it is not an election that is made jointly with the buyer (in contrast to a Section 338(h)(10) election). In the case of an S-corporation target, all of its shareholders must enter into a binding agreement to make the election, and a “Sec. 336(e) election statement” must be attached to the S-corporation’s tax return for the year of the sale.[xiii]

The proposed regulations provide that assets deemed to have been acquired as a result of either a Section 338(h)(10) election or a Section 336(e) election will be treated as having been acquired by purchase for purposes of the first-year depreciation deduction. Thus, a buyer will be able to immediately expense the entire cost of any qualifying property held by the target, while also enjoying the ability to amortize the cost of the target’s goodwill and to depreciate the cost of its non-qualifying depreciable assets.

Partnership Transactions – Cross-Purchase

In general, the purchase of an interest in a partnership has no effect on the basis of the partnership’s assets.

However, in the case of a sale or exchange of an interest in a partnership interest that has made a so-called “Section 754 election,” the electing partnership will increase the adjusted basis of partnership property by the excess of the buyer’s cost basis in the acquired partnership interest over the buyer’s share of the adjusted basis of the partnership’s property.[xiv]

This increase is an adjustment to the basis of partnership property with respect to the acquiring partner only and, therefore, is a “partner-specific” basis adjustment to partnership property.

The basis adjustment is allocated among partnership properties based upon their relative built-in gain.[xv] Where the adjustment is allocated to partnership property that is depreciable, the amount of the adjustment itself is treated as a newly purchased property that is placed in service when the purchase of the partnership interest occurs. The depreciation deductions arising from this “newly acquired” property are allocated entirely to the acquiring partner.

Unfortunately, prior to the TCJA, this basis adjustment would always fail the “original use” requirement because the partnership property to which the basis adjustment related would have been previously used by the partnership and its partners prior to the sale that gave rise to the adjustment.

However, because this basis adjustment is a partner-specific basis adjustment to partnership property, the proposed regulations under the TCJA are able to take an “aggregate view” and provide that, in determining whether a basis adjustment meets the “used property acquisition requirements” described above, each partner is treated as having owned and used the partner’s proportionate share of partnership property.

Thus, in the case of a sale of a partnership interest, the requirement that the underlying partnership property not have been used by the acquiring partner (or by a predecessor) will be satisfied if the acquiring partner has not used the portion of the partnership property to which the basis adjustment relates at any time prior to the acquisition – that is, the buyer has not used the seller’s portion of partnership property prior to the acquisition[xvi] – notwithstanding the fact that the partnership itself has previously used the property.

Similarly, for purposes of applying the requirements that the underlying partnership property not have been acquired from a related person and that the property take a cost basis, the partner acquiring a partnership interest is treated as acquiring a portion of partnership property, the partner who is transferring a partnership interest (the seller) is treated as the person from whom that portion of partnership property is acquired, and the acquiring partner’s basis in the transferred partnership interest may not be determined by reference to the transferor’s adjusted basis.

The same result will apply regardless of whether the acquiring partner is a new partner or an existing partner purchasing an additional partnership interest from another partner. Assuming that the selling partner’s specific interest in partnership property that is acquired by the acquiring partner has not previously been used by the acquiring partner or a predecessor, the corresponding basis adjustment will be eligible for the additional first-year depreciation deduction in the hands of the acquiring partner, provided all other requirements are satisfied.[xvii]

Partnership Transactions – Redemption

By contrast, a distribution of cash and/or property from a Section 754 electing partnership to a departing partner in liquidation of that partner’s interest in the partnership will be treated very differently, even where it results in an increase of the adjusted basis of partnership property.[xviii]

The amount of this increase – equal to the sum of (a) the amount of any gain recognized to the departing partner,[xix] and (b) the excess of (i) adjusted basis (in the hands of the partnership) of any property distributed to the departing partner, over (ii) the basis of the distributed property to the departing partner[xx] – is made to the basis of partnership property (i.e., non-partner-specific basis), and the partnership used the property prior to the partnership distribution giving rise to the basis adjustment.

Thus, the proposed regulations provide that these basis adjustments are not eligible for the additional first-year depreciation deduction.

Planning?

The regulations are proposed to apply to qualified property placed in service by the taxpayer during or after the taxpayer’s taxable year in which the regulations are adopted as final.

However, pending the issuance of the final regulations, a taxpayer may choose to apply the proposed regulations to qualified property acquired and placed in service after September 27, 2017.

Informed by this guidance, a taxpayer that is thinking about purchasing a business may consider the economic savings – and the true cost of the acquisition – that may be realized by structuring the transaction so as to acquire a recoverable cost basis in the assets of the business, whether through depreciation/amortization and/or through an additional first-year depreciation deduction.

Similarly, a seller that recognizes the buyer’s ability to quickly recover a portion of its investment in acquiring the seller’s business may be able to share a portion of that economic benefit in the form of an increased purchase price. Whether the seller will be successful in doing so will depend upon several factors – for example, does the buyer need the seller to make a Section 338(h)(10) election – including their relative bargaining power and their relative desire to make a deal.

As for the buyout of a partner from a Section 754 electing partnership, query whether an acquiring partner’s ability to immediately expense a portion of the basis adjustment to the partnership’s underlying qualifying assets will make a cross-purchase transaction more attractive than a liquidation of the departing partner’s interest by the partnership.

In any case, the buyer and the seller will have to remain mindful of how they allocate the purchase price for the assets as issue. Let’s just say that pigs get fat and hogs get slaughtered.


[i] Public Law 115-97.

[ii] IRC Sec. 263, 1012.

[iii] IRC Sec. 167, 168, 197.

[iv] It should be noted that this so-called “bonus” depreciation is not subject to limitations based on the taxpayer’s taxable income or investment in qualifying property. Compare IRC Sec. 179.

It should also be noted that the “recapture” rules will apply to treat as ordinary income that portion of the taxpayer’s gain from the sale of the property equal to the amount of the bonus depreciation.

[v] The property had to have been placed in service before January 1, 2020. The 50% was phased down over time, beginning in 2018.

A taxpayer’s adjusted basis for a property is a measure of the taxpayer’s unrecovered investment in the property.

In general, the taxpayer’s starting basis will be equal to the amount of consideration paid by the taxpayer to acquire the property; the “cost basis.” It is “adjusted” (reduced) over time for depreciation.

[vi] Among the other properties that qualified is any improvement to an interior portion of a building that is nonresidential real property if such improvement was placed in service after the date the building was first placed in service. However, an improvement attributable to the enlargement of a building, or to the internal structural framework of the building, did not qualify.

[vii] IRC Sec. 168(k). Provided the property is placed in service before January 1, 2023. The amount of the deduction is phased down for property placed in service thereafter.

The TCJA also extended the additional first-year depreciation deduction, from 2020 through 2026.

[viii] IRC Sec. 1060.

The asset purchase may be effected in many different forms; for example, a straight sale, a merger of the target into the buyer in exchange for cash consideration, a merger of the target into a corporate or LLC subsidiary of the buyer, the sale by the target of a wholly-owned LLC that owns the business.

[ix] An important consideration for sellers.

[x] Should we say “pre-owned” but having undergone a painstaking certification process?

[xi] If a lessee has a depreciable interest in the improvements made to leased property and subsequently the lessee acquires the leased property of which the improvements are a part, the unadjusted depreciable basis of the acquired property that is eligible for the additional first-year depreciation deduction, assuming all other requirements are met, must not include the unadjusted depreciable basis attributable to the improvements.

[xii] The IRS is considering whether a safe harbor should be provided on how many taxable years a taxpayer or a predecessor should look back to determine if the taxpayer or the predecessor previously had a depreciable interest in the property.

[xiii] In a complete digression, here is another reason that a controlling shareholder will want to have a shareholders’ agreement in place that contains a drag-along and a requirement to elect as directed.

[xiv] IRC Sec. 743. Without such an election, any taxable gain resulting from an immediate sale of such property would be allocated in part to the buyer notwithstanding that the buyer had not realized an accretion in economic value.

[xv] IRC Sec. 755.

[xvi] Query how this will be determined.

[xvii] This treatment is appropriate notwithstanding the fact that the transferee partner may have an existing interest in the underlying partnership property, because the transferee’s existing interest in the underlying partnership property is distinct from the interest being transferred.

[xviii] IRC Sec. 734.

[xix] In general, because the amount of cash distributed (or deemed to have been distributed) to the departing partner exceeds the partner’s adjusted basis for its partnership interest.

[xx] An amount equal to the adjusted basis of such partner’s interest in the partnership reduced by any money distributed in the same transaction.

Transaction Costs

It is a basic principle of M&A taxation that the more a seller pays in taxes on the sale of its business, the lower will be the economic gain realized on the sale; similarly, the more slowly that a buyer recovers the costs incurred in acquiring a business, the lower will be the return on its investment.

In general, these principles are most often considered at the inception of an M&A transaction – specifically, when the decision is made to structure the deal so as to acquire a cost basis in the seller’s assets – and are manifested in the allocation of the acquisition consideration among the assets comprising the target business.

However, there is another economic element in every transaction that needs to be considered, but that is often overlooked until after the transaction has been completed and the parties are preparing the tax returns on which the tax consequences of the transaction are to be reported; specifically, the tax treatment of the various costs that are incurred by the buyer and the seller in investigating the acquisition or disposition of a business, in conducting the associated due diligence, in preparing the necessary purchase and sale agreements and related documents, and in completing the transaction.

Where these costs may be deducted, they generate an immediate tax benefit for the party that incurred them by offsetting the party’s operating income, thereby reducing the economic cost of the transaction.

Where the costs must be capitalized – i.e., added to the basis of the property being transferred or acquired, as the case may be – they may reduce the amount of capital gain realized by the seller or, in the case of the buyer, they may be recovered over the applicable recovery period.

The IRS’s Office of Chief Counsel (“CC”) recently considered the seller’s tax treatment of an investment banker’s fee.

A Successful Sale

Taxpayer engaged Investment Banker (“IB”) to explore a possible sale of Taxpayer and to identify potential buyers. The engagement letter provided that Taxpayer would pay IB a fee, determined as a percentage of the total transaction consideration, upon successful closing of the transaction (“success-based fee”).

IB’s fee was not based on an hourly rate, but was based on a number of factors, including IB’s experience. IB identified and vetted a number of potential buyers, and ultimately recommended one buyer to Taxpayer’s board of directors, which approved the buyer. IB then performed other services until the closing of the transaction. With the closing of the transaction, Taxpayer owed IB the success-based fee for its services.

The Letter

After the closing, Taxpayer requested that IB estimate the amount of time IB spent on various activities relating to the transaction. Taxpayer advised IB that the day on which Taxpayer’s board of directors approved the transaction was the “bright line date.”

In response, IB sent Taxpayer a two-page letter stating that IB did not keep time records, and that its fee was not based on an hourly rate. IB stated that it could not provide meaningful estimates based on the amount of time spent on certain aspects of the transaction because it did not keep time records. IB also stated that, after talking with members of its acquisition team, it could approximate percentages of time spent on various activities; however, IB did not identify, or provide contact information for, the individuals who were consulted.

In its letter, IB estimated that approximately: 92% of its time was dedicated to identifying a buyer; 2% to drafting a fairness opinion; 4% to reviewing drafts of the acquisition agreement; and 2% to performing services after the identified bright line date. Significantly, IB’s letter included a caveat stating that the percentages were merely estimates and should not be relied on by Taxpayer.

The Audit

On its tax return for the tax year in which the sale occurred, and based on IB’s letter, Taxpayer deducted 92% of the success-based fee; i.e., the time described in the letter as having been dedicated to pre-bright line date activities.

The IRS examined Taxpayer’s return, and requested support for the deduction claimed. In response, Taxpayer provided IB’s two-page letter.

The CC was consulted on whether Taxpayer had satisfied the documentation requirements (described below) by providing the letter from IB estimating the percentage of time spent on so-called “facilitative” and “non-facilitative” activities where the letter included the caveat that the letter should not be relied on by Taxpayer as IB did not keep time records.

The CC determined that Taxpayer could not satisfy the documentation requirements.

The Law

The Code provides that there shall be allowed as a deduction, in determining a taxpayer’s taxable income for a tax year, all the ordinary and necessary expenses paid or incurred by the taxpayer during the year in carrying on any trade or business.

However, the Code and the Regulations promulgated thereunder also provide that a taxpayer must capitalize an amount paid to facilitate an acquisition of a trade or business. An amount is paid to “facilitate” a transaction if the amount is paid in the process of investigating or otherwise pursuing the transaction. Whether an amount is paid in the process of investigating or otherwise pursuing the transaction is determined based on all of the facts and circumstances.

Facilitative Costs

The Regulations provide that – except for certain “inherently facilitative” costs – an amount paid by the taxpayer in the process of investigating or otherwise pursuing a “covered transaction” facilitates the transaction (and must be capitalized) only if the amount paid relates to activities performed on or after the earlier of:

  1. the date a letter of intent or similar communication is executed, or
  2. the date on which the material terms of the transaction are authorized or approved by the taxpayer’s board of directors (the so-called “bright line date”).

The term “covered transaction” includes, among other things, the taxable acquisition of assets that constitute a trade or business.

Amounts that are treated as inherently facilitative, regardless of when they are incurred, include, among others:

  1. Securing an appraisal, formal written evaluation, or fairness opinion related to the transaction;
  2. Structuring the transaction, including negotiating the structure of the transaction and obtaining tax advice on the structure of the transaction;
  3. Preparing and reviewing the documents that effectuate the transaction;
  4. Obtaining regulatory approval of the transaction;
  5. Obtaining shareholder approval of the transaction; or
  6. Conveying property between the parties to the transaction.

Contingent Fees

According to the Regulations, an amount paid that is contingent on the successful closing of a transaction is treated as an amount paid to facilitate the transaction – i.e., an amount that must be capitalized – except to the extent the taxpayer maintains sufficient documentation to establish that a portion of the fee is allocable to activities that do not facilitate the transaction (the “Documentation”).

The Documentation must be completed on or before the due date of the taxpayer’s timely filed original federal income tax return (including extensions) for the taxable year during which the transaction closes.

In addition, the Documentation “must consist of more than merely an allocation between activities that facilitate the transaction and activities that do not facilitate the transaction;” rather, it must consist of supporting records – for example, time records, itemized invoices, or other records – that identify:

  1. The various activities performed by the service provider;
  2. The amount of the fee (or percentage of time) that is allocable to each of the various activities performed;
  3. Where the date the activity was performed is relevant to understanding whether the activity facilitated the transaction, the amount of the fee (or percentage of time) that is allocable to the performance of that activity before and after the relevant date; and
  4. The name, business address, and business telephone number of the service provider.

Safe Harbor

Several years back, in recognition of the difficulty that many taxpayers faced in maintaining and producing the Documentation, the IRS provided a “safe harbor” election for allocating success-based fees paid in a covered transaction. In lieu of maintaining the Documentation, electing taxpayers may treat 70% of the success-based fees as an amount that does not facilitate the transaction – and that may be deducted – and the remaining 30% must be capitalized as an amount that facilitates the transaction.

This safe harbor was provided, in part, to incentivize taxpayers to make the election rather than attempt to determine the type and extent of documentation required to establish that a portion of a success-based fee is allocable to activities that do not facilitate a covered transaction.

In the present case, Taxpayer did not make the safe harbor election. Therefore, Taxpayer had to provide the Documentation, or no portion of the success-based fee would be deductible.

The CC found that IB’s two-page letter was merely an allocation between activities that facilitated and did not facilitate the transaction, which the Regulations specifically forbid. Because the letter was merely an allocation, it could not satisfy the Documentation requirements. Accordingly, Taxpayer had to capitalize 100% of the success-based fee.

Taxpayer attempted to provide time estimates from IB even though Taxpayer knew that IB did not keep time records. The Documentation requirements do not require a taxpayer’s supporting records to identify the percentage of time that is allocable to each activity, but they do require the supporting records to identify the amount of the fee that is allocable to each activity.

The estimated allocation letter from IB had no effect, and without other documentation, Taxpayer’s deduction was denied.

Observations

Interestingly, it wasn’t until after the closing that Taxpayer asked IB to provide the documentary support that may have allowed the success-based fee to escape treatment as a facilitative cost that had to be capitalized.

Taxpayers and their advisers have to be aware that the treatment of M&A transaction costs may have a significant impact upon the net economic cost or gain of a “covered transaction” like the one described in the above ruling.

They also have to know that the necessary documentation or record should be created contemporaneously, as the transaction unfolds, not after the deal.

The most puzzling aspect of the situation described in the ruling, however, is Taxpayer’s failure to make the safe harbor election to treat 70% of the success-based fee paid to IB as a non-facilitative deal cost that Taxpayer could have deducted without question. Pigs get fat, hogs get slaughtered?

 

Last week, we considered the proper tax treatment for a transfer of funds from a parent corporation to its foreign subsidiary. The parent had argued, unsuccessfully, that the transfer represented the payment of a deductible expense on the theory that the payment was made to enable the subsidiary to complete a project for an unrelated third party and, thereby, to avoid serious damage to the parent’s reputation as a reliable service provider.

Today, we turn to a scenario in which an individual taxpayer utilized the same argument – also unsuccessfully – to justify a deduction claimed through a wholly-owned S corporation.

The parent corporation in last week’s post had a much more colorable claim to a deduction than the taxpayer described below. Both situations, however, illustrate the significance of considering in advance the optimal tax consequences for a particular business transaction, and of planning the form and structure for the transaction in order to attain as much of the desired result as possible.

Shareholder Litigation

Taxpayer was a U.S. individual who owned a minority interest in Foreign Corp (“FC”). At some point, FC’s shareholders discovered that Bank had engaged in a fraudulent scheme involving FC stock, which ultimately devalued FC’s shares. A consortium of minority shareholders, including Taxpayer, instituted litigation overseas against FC and Bank for corporate fraud. The purpose of the litigation was the recovery of the minority shareholders’ investment in FC.

In return for a percentage of any recovery, Taxpayer agreed to finance a portion of the consortium’s legal fees and related expenses. Taxpayer also agreed to provide services to the consortium in exchange for an extra percentage of any recovery.

In response to “capital calls” made by the consortium, Taxpayer wired funds from their domestic brokerage account which satisfied 60% of their agreed-upon contribution to fund the litigation.

“S” Corp is Formed

The remaining portion of Taxpayer’s commitment was satisfied by two subsequent payments, one from their brokerage account, and the other from the corporate bank account of Taxpayer’s newly-formed and wholly-owned S corporation (“Corp”).

During the year at issue, Corp owned and managed four rental properties; it did not otherwise engage in any property management services for third parties.

Shortly after the formation of Corp, Taxpayer signed two documents, each captioned “Special Minutes of [Corp]”. One of these documents stated, in part:

A) money transfers into [Corp] from [Taxpayer] will be deemed loans to the Corporation[,] B) costs incurred by Taxpayer associated with the assignment of assets or otherwise transferred to [Corp] shall be treated as a loan to [Corp] whereas such costs shall not be in excess of such costs incurred up until the time of the transfer, C) money transfers out of [Corp] to Taxpayer will be deemed repayment of loans or in the event such loans have been repaid such money transfers out of [Corp] will be considered a [sic] income distribution or otherwise * * *.

This document stated that any loans were noninterest bearing and were for a term of the “greater of 20 years or Perpetual Term”.

The other document stated that Taxpayer assigned “their litigation rights for any investment made by [Taxpayer] to [Corp].” It also stated that “the business of [Corp] was to make investments, including the funding of litigation costs * * * [i]n exchange for * * * a[n] ownership interest in the litigation recovery, if any.” The document further stated that “this memo is to provide further clarity that [FC] litigation funding is being done through [Corp] and that [Corp] will earn a fair return on its investment for funding such litigation.” The document further stated: “Resolved, that [Corp] accepts litigation and the costs thereof in return for a reasonable assignment of shares necessary to cover the costs of litigation and provide for a reasonable recovery.”

None of the FC stock owned by Taxpayer was ever actually assigned to Corp, and Taxpayers remained the registered owners of the FC stock at all relevant times. Corp never submitted an application to intervene in the FC litigation, and none of the legal documents relating to the FC litigation referred to Corp.

Tax Returns

On its Form 1120S, U.S. Income Tax Return for an S Corporation, Corp identified its business activity as the leasing of residential property. However, Corp claimed a deduction for legal and professional fees relating to the FC litigation, and reported the ordinary business loss that resulted from such deduction.

Taxpayer claimed a loss on their Form 1040, U.S. Individual Income Tax Return, Schedule E, Supplemental Income and Loss, that included the ordinary business loss reported by Corp on the Schedule K-1 issued to Taxpayer.

The IRS disallowed most of the legal and professional fees deduction claimed by Corp.

The primary issue before the Tax Court was whether Taxpayer was entitled to a pass-through deduction for certain legal and professional fees that Corp claimed on its corporate income tax return.[i]

Taxpayer claimed that these fees were deductible as ordinary and necessary business expenses of Corp, but the IRS disagreed.

The Court

The Code allows a deduction for “all the ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business”.

According to the Court, Taxpayer did not show that either their first or second payment represented expenses “paid or incurred” by Corp so as to support a deduction. Taxpayer wired both of these payments to the consortium from their personal account, in partial satisfaction of their personal commitment to contribute toward the consortium’s FC-litigation expenses.

The Court assigned little significance to the “Special Minutes” pursuant to which Taxpayers purportedly assigned their interest in the FC-litigation and the related costs to Corp. The Court explained that transfers between a corporation and its sole shareholder are subject to heightened scrutiny, and the labels attached to such transfers mean little if not supported by other objective evidence. The record, the Court continued, contained no objective evidence to suggest that this paperwork altered in any way Taxpayer’s relationship to the consortium or their personal obligation to the consortium for the legal expenses in question. Indeed, the Court observed that all the evidence showed that the consortium continued to invoice Taxpayer, and not Corp, for payment of Taxpayer’s commitment even after the year at issue. Corp never submitted an application to intervene in the FC-litigation, and none of the legal documents relating to the FC-litigation referred to Corp.

The Court was also not impressed by Taxpayer’s assertion that their two wire payments represented “loans” to Corp pursuant to the “Special Minutes”; neither payment could be characterized as a “transfer into” Corp under the terms of the “Special Minutes”, and there was no objective evidence of a bona fide expectation of repayment. In any event, one of the payments was made nine days before Corp was even incorporated.

Corp’s Payment?

Unlike the other two payments, the third payment was in fact made by Corp. The IRS did not argue that this payment was not “paid or incurred” by Corp. However, the IRS asserted, and the Court agreed, that this payment was also not deductible because Taxpayer failed to show that it was an ordinary and necessary business expense of Corp.

The Court pointed out that the legal and professional fees at issue were the expenses of Taxpayer rather than of Corp. A taxpayer, the Court stated, generally may not deduct the payment of another person’s expense.

The Court conceded, however, that an exception to this general rule may apply if a taxpayer pays someone else’s expenses in order to protect or promote his own separate trade or business. This exception typically applies only where the taxpayer pays the obligations of another person or entity in financial difficulty, and where the obligor’s inability to meet their obligations threatens the taxpayer’s own business with direct and proximate adverse consequences.

“[T]he showing a corporation must make to deduct the expenses of its shareholder is a strong one,” the Court stated. “The test is sometimes expressed as having two prongs:” (1) the taxpayer’s primary motive for paying the expenses must be to protect or promote the taxpayer’s business, and (2) the expenditures must constitute ordinary and necessary business expenses for the furtherance or promotion of the taxpayer’s business.

The Court determined that Taxpayer did do not meet either prong of this test. As to the first prong, Taxpayer did not show that the expenses in question were incurred primarily for the benefit of Corp, and that any benefit to Taxpayer was only incidental. The benefits to Taxpayer were obvious: The costs were incurred to recover their investment in FC. Treating the payments as business deductions of Corp, rather than as miscellaneous investment expenses of Taxpayer, would have resulted in more favorable tax treatment for Taxpayer. By contrast, the business justification for Corp to pay these expenses was not at all obvious. There was no suggestion, for instance, that any payment of the expenses by Corp would have been motivated by any genuine consideration to avoid adverse business consequences that might result if Taxpayer were unable to meet their financial obligations.

As to the second prong, Taxpayer did not show that the legal expenses in question represented ordinary and necessary business expenses in the furtherance of the business of Corp. The Court explained that the proper focus of its inquiry, as applied to legal expenses, is on the origin of the subject of the litigation and not on the consequences to the taxpayer. The origin of the claim was Bank’s alleged fraudulent activity that devalued the FC shares that Taxpayer held as a minority shareholder. Taxpayer – not Corp – joined the shareholder litigation group against Bank. The litigation and Taxpayer’s obligation to fund the litigation arose before Corp was ever created.

At all relevant times, the FC shares were registered in Taxpayer’s name. As Taxpayer testified, the purpose of the litigation was to secure judgment in favor of the FC shareholders and recover their investment.

Taxpayer contended that, in the “Special Minutes,” they assigned all their FC-litigation rights to Corp, and that the prospect of a payout to Corp from the FC-litigation constituted a legitimate business activity of Corp as to which the legal expenses should be deemed an ordinary and necessary business expense.

The Court again rejected the “Special Minutes” because they were not supported by any objective evidence. In any event, Taxpayer’s argument focused improperly on the potential consequences of the FC-shareholders’ lawsuit – a potential payout in which Corp would allegedly share – rather than upon the origin and character of the underlying claim. Moreover, the absence of any reliable documentation defining the role of Corp in the litigation, or guaranteeing it a share of any future recovery, further supported the conclusion that Taxpayer engaged in the FC-litigation in their personal capacity as an investor in FC, and not on behalf of Corp.

In the light of these considerations, the Court assigned little credence to Taxpayer’s assertions that Corp engaged in “litigation funding” as a business and that Taxpayer lent money to Corp to fund the litigation. In the first instance, for an activity to constitute a trade or business, “the taxpayer must be involved in the activity with continuity and regularity and * * * the taxpayer’s primary purpose for engaging in the activity must be for income or profit.” During the year at issue, the FC-litigation was Corp’s only claimed “litigation funding” activity. The Court was not convinced that Corp was involved in any “litigation funding” activity with the continuity and regularity necessary for that activity to constitute a trade or business. Similarly, even if Taxpayer provided advisory services to the FC-litigation through Corp, as Taxpayer alleged, the record did not show that Corp provided such services with the continuity and regularity necessary for that activity to constitute a trade or business.

The Court found that Taxpayer failed to show that any of the disputed fees were paid or incurred by Corp as ordinary and necessary expenses in carrying on its trade or business. Accordingly, the Court sustained the IRS’s determination that these items were not deductible by Corp, and thereby increased Taxpayer’s income tax liability.

[Query why the IRS did not also argue – to add insult to injury – that Corp’s satisfaction of Taxpayer’s obligation should be treated as a constructive distribution by Corp that reduced Taxpayer’s basis for their Corp stock?]

Here I Go . . . Again[ii]

The scenarios in which a closely held business, its affiliates and their owners will transfers funds or other property to, or on behalf of, one another are too many to enumerate. That these transfers often occur without being properly documented – except, perhaps, with a book entry similar to “intercompany transaction” – if at all, is troublesome.

Unfortunately, the frequency of cases like the one described above indicates that too many taxpayers make such transfers without an appreciation either for their tax consequences and the attendant economic costs, or for the importance of accurately documenting the transfers.

When they do realize their error – whether before, or during, an audit – the related parties sometimes scramble to “memorialize” what they “intended,” which results in an obviously self-serving and forced “reconciliation” of what actually occurred with what was reported on a tax return.

Under these circumstances, it should not be difficult to understand a court’s reluctance to accept a taxpayer’s after-the-fact explanation for a transfer, or to underestimate the importance of treating with a related party on as close to an arm’s-length basis as possible.

_________________________________________________________________________________________________________________________________________________________

[i] An “eligible small business corporation” that elects S corporation status is generally exempt from corporate income tax. Instead, the S corporation’s shareholders must report their pro rata shares of the S corporation’s items of taxable income, gain, loss, deduction, and credit. An S corporation item generally retains its character in the hands of the shareholder.

[ii] Apologies to Bob Seeger.

It is often difficult to determine the proper tax treatment for the transfer of funds among related companies, especially when they are closely held, in which case obedience to corporate formalities may be found wanting.

At times, the nature of the transfer is clear, but the “correct” value of the property or service provided in exchange for the transfer is subject to challenge by the government.

In other situations, the amount of the transfer is accepted, but the tax consequences reported by the companies as arising therefrom – i.e., the nature of the transfer – may be disputed by the IRS, depending upon the facts and circumstances, including the steps taken by the related companies to effectuate the transfer and the documentation prepared to evidence the transfer.

One U.S. District Court recently considered the tax treatment of a transfer of funds by a U.S. corporation to a second-tier foreign subsidiary corporation that was made in response to a threat by a foreign government.

Parent’s Dilemma

U.S. Parent Corp (“Parent”) engaged in business in Foreign Country (“Country”) through a subsidiary corporation (“Sub”) formed under Country’s laws. Parent held Sub through an upper-tier foreign subsidiary corporation (“UTFS”).

Sub contracted with an unrelated Joint Venture (“JV”) to provide services to JV in Country. The contract required Parent to extend a “performance guarantee:” if Sub was unable to perform all of its obligations under the contract, Parent would, upon demand by JV, be responsible to perform or to take whatever steps necessary to perform, as well as be liable for any losses, damages, or expenses caused by Sub’s failure to complete the contract.

The contract was not as profitable as Sub had forecast, and it sustained net losses. Sub informed JV that it would not renew the contract and would exit the Country market at the conclusion of the contract.

Between a Rock and . . .

Shortly after Sub’s communication to JV, the Country Ministry of Finance (“Ministry”) advised Sub that the company it was in violation of Country’s Code and, thus, in danger of forced liquidation. Specifically, Sub was informed that it was in violation of a requirement that it maintain “net assets” in an amount at least equal to its chartered capital; it was given one month to increase its net assets, failing which, Country’s tax authority had the right to liquidate Sub through judicial process.

Parent analyzed the ramifications if Sub was liquidated. It believed that if Sub was liquidated, JV would force Parent to finish the contract pursuant to the performance guarantee, and Parent would have to pay a third party to complete the work, which Parent determined would be very costly. It also worried about the potential damage to its reputation if Sub defaulted.

Sub assured the Ministry that it was taking steps to improve its financial condition. Parent decided to transfer funds to UTFS, which then signed an agreement with Parent pursuant to which funds would be transferred by Parent to Sub, “on behalf of” UTFS. It was agreed that the funds would be used by Sub to carry on its activities, and UTFS confirmed that its financial assistance was “free” and that it did not expect Sub return the funds. Parent then made a series of fund transfers to Sub.

Parent claimed a deduction on its tax return for the amount transferred to Sub, but the deduction was disallowed by the IRS.

Parent paid the resulting tax deficiency, and then sought a refund of the taxes paid, contending that the payment to Sub was deductible as a bad debt, or as an ordinary and necessary trade or business expense.

The IRS rejected the refund claim, and Parent commenced a suit in District Court.

Bad Debt?

Parent contended the payment to Sub was deductible as a bad debt. It argued that courts have defined the term “debt” broadly, and have allowed payments that were made to discharge a guarantee to be deducted as bad debt losses. Parent insisted that a payment by the taxpayer in discharge of part or all of the taxpayer’s obligation as a guarantor should be treated as a business debt that become worthless in the year in which the payment was made.

Parent argued that it made the payment to discharge its obligation to guarantee performance on Sub’s contract with JV. Specifically:

  1. Ministry was threatening to liquidate Sub because it did not have sufficient capital;
  2. Liquidation of Sub would have caused it to default on the contract with JV;
  3. That default would have made JV a judgment-creditor and Sub a judgment-debtor;
  4. Sub would have been obligated to pay JV a fixed and determinable sum of money;
  5. Parent guaranteed Sub’s performance, creating a creditor-debtor relationship between them and making Parent liable for Sub’s debts; and
  6. The payment to Sub satisfied the debt created by Parent’s performance guarantee, and Sub’s inability to repay rendered it a bad debt.

The Court Saw it Differently

According to the Court, Parent’s arguments conflated two questions:

  1. Did Parent pay a debt owed by Sub to JV because it guaranteed that obligation? or
  2. Did the transfer of money by Parent (through UTFS) to Sub create a debt owed by Sub to Parent?

The Court answered both these questions in the negative.

The Court explained that a taxpayer is entitled to take as a deduction any debt which becomes worthless in that taxable year. A contribution to capital cannot be considered a debt for purposes of this rule. The question of whether the payment from Parent to Sub was deductible in the year made “depends on whether the advances are debt (loans) or equity (contributions to capital).”

“Articulating the essential difference,” the Court continued, “between the two types of arrangement that Congress treated so differently is no easy task. Generally, shareholders place their money ‘at the risk of the business’ while lenders seek a more reliable return.” In order for an advance of funds to be considered a debt rather than equity, the courts have stressed that a reasonable expectation of repayment must exist which does not depend solely on the success of the borrower’s business.[i]

It was clear, the Court stated, that the advances to Sub were not debts, but were more in the nature of equity. There was no note evidencing a loan, no provision for or expectation of repayment of principal or interest, and no way to enforce repayment. Instead, the operative agreement stated clearly that it was “free financial aid” and would not be paid back to Parent or to UTFS.

The intent of the parties was clear: it was not a loan and did not create an indebtedness. The Court observed that, in fact, it could not be a loan because further indebtedness for Sub would not have solved the net assets and capitalization problems identified by the Ministry. Sub’s undercapitalization also supported the conclusion that this was an infusion of capital, and not a loan that created a debt.

Performance Guarantee?

Parent next argued that the payment was made pursuant to a guarantee to perform because if Sub was liquidated, Parent would be liable for the damages caused by the breach.

The Court agreed that a guaranty payment qualifies for a bad debt deduction if “[t]here was an enforceable legal duty upon the taxpayer to make the payment.” However, voluntary payments do not qualify, it stated.

It was true that Parent executed a performance obligation with JV to guarantee the work would be done. However, Sub never failed to perform its obligations, and JV never looked to Parent to satisfy any requirements under the performance guarantee. The event that triggered the payment was not a demand by JV to perform; instead it was the notice from the Ministry that Sub was undercapitalized and at risk of being liquidated. No money was paid to JV, and no guaranteed debt or obligation was discharged by the payment. Nothing in the performance guarantee legally obligated Parent to provide funds to Sub; it was only required to perform on the contract if Sub could not. After the money was transferred to Sub, both Parent and Sub had the same obligations under the performance guarantee that existed before the transfer. The payment neither extinguished, in whole or in part, Parent’s obligation to guarantee performance, nor reduced the damages it would pay in the event of a default. It also did not impact Sub’s obligations to perform; it merely reduced the risk that Sub would be unable to perform due to liquidation for violation of Country’s legal capitalization requirements. In short, this was not a payment by a taxpayer in discharge of part or all of the taxpayer’s obligation as a guarantor, because there was no discharge of any obligation.

Parent also argued that an advance of money, pursuant to a performance guarantee, that allowed the receiving company to complete a construction project, was a debt that was deductible as a business expense.

Again, the Court pointed out that there was no contractual agreement between Parent and Sub requiring such a payment to Sub or a repayment by Sub. The payment was made to avoid being called to perform on the performance guarantee between Parent and Sub.

The terms of the payments stressed that no debtor-creditor relationship was being created because it was “free financial aid.” Because this was “free financial aid,” Sub owed no such debt to Parent, and Parent had no right to expect repayment of the funds paid. When the payer had no right to be repaid, the Court explained, the transfer of funds was a capital contribution.

Thus, the advance to Sub did not create a debt, did not pay a debt, and was not a payment of a debt pursuant to a guarantee. Therefore, it was not deductible as a bad debt.

Ordinary and Necessary Expense?

Parent next argued that the payment was deductible as an “ordinary and necessary business expense” that was paid or incurred in carrying on its trade or business.

Parent contended that the financial aid was an ordinary business expense to Parent, because it fulfilled its legal obligations under the performance guarantee and avoided serious business consequences if Sub had defaulted on the JV contract. Among those consequences were Parent’s exposure to substantial financial damages, including the loss of Sub’s assets and equipment, as well as severe damage to Parent’s reputation as a reliable service provider in the global market.

The IRS contended that Parent’s contribution of free financial aid to its subsidiary was neither an “expense,” nor was it “ordinary.” The Court agreed.

As a general rule, voluntary payments by a shareholder to his corporation in order “to bolster its financial position” are not deductible as a business expense or loss.

According to the Court, “It is settled that a shareholder’s voluntary contribution to the capital of the corporation . . . is a capital investment and the shareholder is entitled to increase the basis of his shares by the amount of his basis in the property transferred to the corporation.” This rule applies not only to transfers of cash or tangible property, but also to a shareholder’s forgiveness of a debt owed to him by the corporation.

In determining whether the appropriate tax treatment of an expenditure is immediate deduction or capitalization, “a taxpayer’s realization of benefits beyond the year in which the expenditure is incurred is undeniably important.”

Moreover, to qualify for deduction, the expense involved must be ordinary and necessary for the taxpayer’s own business. As a general rule, a taxpayer may not deduct the expenses of another.

The circumstances giving rise to Parent’s “free financial aid” to Sub, the Court continued, bore none of the hallmarks of an “expense.” Parent was under no obligation to make a payment to Sub, but chose to do so to avoid potential future losses. In response to a letter from the Ministry threatening liquidation because of undercapitalization, Parent decided to transfer (through UTFS) cash to Sub. There was no obligation to return the funds, and Sub was not restricted in how it could use them. As a result, Sub recapitalized its balance sheet, reducing its liabilities and increasing its net equity, thereby eliminating the net asset problem identified by the Ministry. Sub was thereby enabled to continue operations and complete the JV contract. Under these circumstances, the transfer of funds by Parent fit squarely within the capitalization principle.

To be sure, Parent did receive other benefits as a result of the recapitalization. By helping Sub avoid liquidation and finish the JV contract, Parent assured not only that Sub’s valuable equipment and technology would be recovered, but also that Parent’s own reputation and future business operations would not be damaged. But these expected benefits were not realized solely, or even primarily, in the tax years at issue. Instead, like any normal capital expenditure, the benefits to Parent were expected to continue into the future, well beyond the year in which the payments were made.

Reputation and Goodwill

Parent argued that the future benefits to its reputation and business operations did not preclude a current expense deduction. It relied upon a line of cases holding that, when one taxpayer pays the expenses of another, the payment may be deductible if the taxpayer’s purpose is to protect or promote its own business interests such as reputation and goodwill.

The Court conceded that there is such an exception to the general rule that a taxpayer may not deduct the expenses of another, that permits a taxpayer to claim a deduction when the expenditures were made by a taxpayer to protect or promote his own business, even though the transaction giving rise to the expenditures originated with another person and would have been deductible by that person if payment had been made by them.[ii]

The Court, however, found that the exception was inapplicable because the “free financial aid” provided by Parent was not tied to any actual expense of Sub, whether deductible or not.

The Court concluded that the fund transfer from Parent to Sub was not deductible as a bad debt, nor was it deductible as an ordinary and necessary expense of the taxpayer’s business. When distinguishing capital expenditures from current expenses, it explained, the Code makes clear that “deductions are exceptions to the norm of capitalization,” and so the burden of clearly showing entitlement to the deduction is on the taxpayer. Parent did not carry that burden.

“Why Don’t They Do What They Say, Say What They Mean?”

The Fixx may have been onto something. If a business plans to engage in a transaction in order to achieve a specific purpose, its tax treatment of the transaction – how it reports it – should be consistent with its intended purpose. Of course, this presupposes that the business has, in fact, considered the tax consequences of the transaction, as any rational actor would have done in order to understand its true economic cost.

Unfortunately, quite a few business taxpayers act irrationally, forgetting the next phrase in the song, that “one thing leads to another.” It is not enough to report a transaction in a way that yields the best economic result – for example, that most reduces the cost of the transaction – and then hope it is not challenged by the government.

Rather, the optimum economic result under a set of circumstances may only be attained by a critical analysis of the transaction and its likely tax outcome. With this information, the business may then consider, if necessary, how to adjust the transaction steps, or to otherwise offset the expected cost thereof.


[i] The Courts have identified a number of factors relevant to deciding whether an advance is debt or equity:

(1) the names given to the certificates evidencing the indebtedness;

(2) the presence or absence of a fixed maturity date;

(3) the source of payments;

(4) the right to enforce payment of principal and interest;

(5) participation in management flowing as a result;

(6) the status of the contribution in relation to regular corporate creditors;

(7) the intent of the parties;

(8) ‘thin’ or adequate capitalization;

(9) identity of interest between creditor and stockholder;

(10) source of interest payments;

(11) the ability of the corporation to obtain loans from outside lending institutions;

(12) the extent to which the advance was used to acquire capital assets; and

(13) the failure of the debtor to repay on the due date or to seek a postponement.

[ii] The IRS argued that, even under this exception, the taxpayer’s expenditure must be linked to an underlying current expense of the other business; the expenditure at issue had to be earmarked to pay an obligation or extinguish a liability owed to a third party.

 

The Corporate “Shield”

Ask any shareholder of a closely held corporation whether they may be held liable for the tax obligations of the corporation, and they will likely respond “of course not, that’s why we established the corporation – to benefit from the limited liability protection it provides.”

Some of these shareholders will be surprised when you explain that they may be personally liable for the employment taxes and sales taxes that the corporation was required, but failed, to collect and remit to various taxing authorities – even where the “corporate veil” has not been pierced – if the shareholders were “responsible persons” or “under a duty to act” as to such taxes.

However, the scenario by which a shareholder is most likely to be taken aback is the one in which they are held liable for the corporation’s own income taxes, notwithstanding that they may not be a controlling owner, or even a responsible officer, of the corporation.

The U.S. Court of Appeals for the Ninth Circuit recently ruled on a case in which the IRS sought to collect a corporation’s (“Corp”) income tax from its former shareholders (“Taxpayers”).

Let’s Make a Deal

Corp was taxable as a C-corporation. It sold its assets to Buyer-1 for $45 million cash, which generated a Federal corporate income tax liability in excess of $15 million. At that point, Corp did not conduct any business, nor did it have any immediate plans to liquidate.

Following the asset sale by Corp, Taxpayers were approach by Investor, who claimed that they could structure a transaction that would “manage or resolve” Corp’s tax liability.

Pursuant to an agreement with Investor, and despite their suspicions regarding Investor’s plans for Corp’s taxes, Taxpayers sold all of their Corp stock to another corporation, Buyer-2, in a taxable transaction. Using borrowed funds, Buyer-2 paid Taxpayers an amount of cash representing the net value of Corp after the asset sale, plus a premium; Buyer-2 also promised to satisfy Corp’s tax liability.

Buyer-2 and Corp then merged into a new corporation, Holding, which was purportedly engaged in the business of debt collection. As a result of the merger, and by operation of law, Holding assumed the liabilities of Corp and of Buyer-2, including Corp’s income tax liability and Buyer-2’s acquisition debt.

Using the cash acquired from Corp, Holding repaid the loan that Buyer-2 had incurred to purchase Taxpayers’ stock in Corp. After satisfying this debt, however, Holding had no assets with which to pay the income taxes due from the earlier sale of Corp’s assets.

The IRS Smells a Rat

The IRS sent notices of tax liability to Taxpayers – the former shareholders of Corp – as the ultimate transferees of the proceeds of the sale of Corp’s assets. The IRS sought to establish that Taxpayers were liable for Corp’s tax liability.

The IRS argued that Taxpayers received, in substance, a liquidating distribution from Corp, and that the form of the stock sale to Buyer-2, and the subsequent merger with Holding, should be disregarded.

Taxpayers emphasized that the proceeds they received came from Buyer-2, not from Corp; therefore, there was no liquidation.

The U.S. Tax Court considered whether Taxpayers were “transferees” within the meaning of that provision of the Code which enables the IRS to collect from a transferee of assets the unpaid taxes owed by the taxpayer-transferor of such assets, if an independent basis exists under applicable State law for holding the transferee liable for the transferor’s debts.

The Tax Court looked to State’s Uniform Fraudulent Transfer Act (“UFTA”) and concluded that it could disregard the form of the stock sale to Buyer-2, and look to the entire transactional scheme, only if Taxpayers knew that the scheme was intended to avoid taxes. The Tax Court concluded that Taxpayers had no such knowledge, and ruled in their favor. The IRS appealed.

The Court of Appeals

The Ninth Circuit explained that Taxpayers would be subject to transferee liability if two conditions were satisfied: first, the relevant factors had to show that, under Federal law, the transaction with Buyer-2 lacked independent economic substance apart from tax avoidance; and second, Taxpayers had to be liable for the tax obligation under applicable State law.

Economic Purpose

After reviewing the record, the Court found there was ample evidence that Taxpayers were, at the very least, on constructive notice that the entire scheme had no purpose other than tax avoidance.

According to the Court, the purpose of Taxpayers’ transaction with Buyer-2 was tax avoidance; reasonable actors in Taxpayers’ position, it stated, would have been on notice that Buyer-2 never intended to pay Corp’s tax obligation.

It was not disputed, the Court continued, that following its asset sale to Buyer-1, Corp was not engaged in any business activities. It held only the cash proceeds of the sale, subject to the accompanying income tax liability. When Taxpayers sold their stock to Buyer-2, along with that tax liability, Taxpayers received, in substance, a liquidating distribution from Corp. There was no legitimate economic purpose for the stock sale other than to avoid paying the corporate income taxes that would normally accompany a liquidating asset sale and distribution to shareholders.

The financing transactions demonstrated that the deal was only about tax avoidance. Buyer-2 borrowed the funds to make the purchase. After the merger of Corp into Holding, the latter, had it been intended to be a legitimate business enterprise, could have repaid the loan over time and retained sufficient capital to sustain its purported debt collection enterprise and cover the tax obligation. Instead, the financing was structured so that, after the merger, Corp’s cash holdings went immediately to repay the loan Buyer-2 used to finance its purchase of the Corp stock from Taxpayers.

The Court stated that Taxpayers’ sale to Buyer-2 was a “cash-for-cash exchange” lacking independent economic substance beyond tax avoidance.

Liability under State Law

The Court then turned to whether, under State law, Taxpayers were liable to the IRS for Corp/Holding’s tax liability. According to the Court, this question had to be resolved under State’s UFTA.

The IRS argued that Taxpayers were liable under that the UFTA’s constructive fraud provisions.

The Court explained that State’s UFTA’s constructive fraud provisions protect a creditor in the event a debtor engages in a transfer of assets that leaves the debtor unable to pay its outstanding obligations to the creditor. Specifically, the UFTA provides that a transaction is constructively fraudulent as to a creditor (the IRS) if the debtor (Corp/Holding), did not receive “a reasonably equivalent value in exchange for the transfer or obligation, and the debtor either: (a) Was engaged or was about to engage in a business or a transaction for which the remaining assets of the debtor were unreasonably small in relation to the business or transaction; or (b) Intended to incur, or believed or reasonably should have believed that he would incur, debts beyond his ability to pay as they became due.”

The Court reviewed the record and found that Taxpayers’ sale of their Corp stock to Buyer-2 and Buyer-2/Holding’s assumption of Corp’s tax liability, were, in substance, a liquidating distribution to Taxpayers, which left neither Corp, Buyer-2, nor Holding able to satisfy Corp’s tax liability. Such a transfer, in which the debtor – Corp – received no reasonably equivalent value in return for its transfer to its shareholders, and was left unable to satisfy its tax obligation, fell squarely within the constructive fraud provisions of State’s UFTA.

Liquidation?

The Tax Court, however, had decided that Taxpayers had no actual or constructive knowledge of Buyer-2’s tax avoidance scheme, and thus concluded it had to consider merely the “rigid form” of the deal. According to the Tax Court, because Taxpayers received their money from Buyer-2, and not formally from Corp, there was no transfer from the “debtor” for purposes of the UFTA.

The IRS contended that the Court should look to the substance of the transactional scheme to see that Buyer-2 was merely the entity through which Corp passed its liquidating distribution to Taxpayers.

The Court agreed with the IRS, remarking that the Tax Court had incorrectly “viewed itself bound by the form of the transactions rather than looking to their substance.”

The Court disagreed with the Tax Court’s finding that the IRS had not established the requisite knowledge on the part of the participants in the scheme to render Taxpayers accountable.

“Reasonable actors” in Taxpayers’ position, the Court stated, would have been on notice that Buyer-2 intended to avoid paying Corp’s tax obligation. After all, Investor communicated its intention to eliminate that tax obligation, and offered to pay a premium for Taxpayers’ shares; yet despite their suspicions surrounding the transaction, Taxpayers failed to press Investor or Buyer-2 for more information.

That Buyer-2 provided little information regarding how it would eliminate Corp’s tax liability, coupled with the actual structuring of the transactions, provided indications that should have been “hard to miss.” Indeed, Taxpayers’ counsel testified that when he asked for details, Buyer-2 told them “it was proprietary”; and in a lengthy memo analyzing the subject of potential transferee liability, counsel wrote that Buyer-2 would distribute almost all of Corp’s cash to repay the loan used to finance the deal, though the memo never analyzed how Buyer-2 could legally offset Corp’s taxable gain from the asset sale – it merely concluded that Taxpayers would not be liable as transferees of the proceeds of Corp’s asset sale.

The Court concluded that Taxpayers were, at the very least, on constructive notice of Buyer-2’s tax avoidance purpose. It was clear that Taxpayers’ stock sale to Buyer-2 operated, in substance, as a liquidating distribution by Corp to Taxpayers, but in a form that was designed to avoid tax liability.

Thus, the Court held that Corp’s constructive distribution to Taxpayers of the proceeds from its asset sale was a fraudulent transfer under State’s UFTA, and Taxpayers were liable to the IRS for Corp’s federal tax obligation as “transferees.”

Too Good to Be True

Indeed. How can any reasonable person argue that the shareholders of a corporation can strip the corporation of its assets through a liquidation yet avoid responsibility for the corporation’s outstanding tax liabilities? They can’t.

The fact that the liquidation is effected through a complex scheme involving several steps does not change this conclusion – it merely evidences a taxpayer’s attempt at concealing the true nature of the transaction.

Speaking of which, tax advisers are often drawn to the challenge of structuring complex transactions. Unfortunately, that is not necessarily a good thing, especially if the economic or business purpose for the transaction – the sight of which should never be lost – may become less discernable. Just as importantly, the transaction structure should not, if possible, be made so complex that it raises the proverbial red flag and the inevitable question of “what are they hiding?”

The old adage of “keeping it simple,” and the old rule of thumb, “does it pass the smell test?” still have their place in moderating what may be described as the “complex approach” to tax planning.