The IRS has determined that any person required to pay Federal gift tax or generation-skipping transfer tax or to file IRS Form 709 (United States Gift and Generation-Skipping Transfer Tax Return) on April 15, 2020, is deemed to be affected by the COVID-19 emergency and, so, should be granted an extension of time within which to file such returns and to pay the related tax.

Specifically, the due date for filing Forms 709 (United States Gift and Generation-Skipping Transfer Tax Return) and for making payments of Federal gift and generation-skipping transfer tax that would otherwise be due on April 15, 2020, is automatically postponed to July 15, 2020. See IRS Notice 2020-20.

This relief is automatic; in other words, there is no requirement to file IRS Form 8892 (Application for Automatic Extension of Time to File Form 709 and/or Payment of Gift/Generation-Skipping Transfer Tax) in order to obtain the benefit of this filing and payment postponement until July 15, 2020.

However, a taxpayer may choose to file an application for extension by July 15, 2020, in order to obtain an extension to file Form 709 by October 15, 2020. Please note, however, that any Federal gift and generation-skipping transfer tax liabilities reflected on such returns, the payment of which has been postponed by Notice 2020-20, will still be due on July 15, 2020.

As a result of the postponement of the due date for filing Forms 709 and for making Federal gift and generation-skipping transfer tax payments from April 15, 2020, to July 15, 2020, the period beginning on April 15, 2020, and ending on July 15, 2020, will be disregarded in the calculation of any interest, penalty, or addition to tax for failure to file a Form 709 or to pay Federal gift and generation-skipping transfer taxes shown on that return and postponed by the Notice.

Instead, interest, penalties, and additions to tax with respect to such postponed Forms 709 and payments will begin to accrue on July 16, 2020.

One lingering question: What about the Federal estate tax? Unfortunately, the normal filing and payment due dates continue to apply to the estate tax.

If you would like to discuss how the $2 trillion CARES Act affects you, your family or your business, please do not hesitate to contact Lou Vlahos, Tax Partner at Farrell Fritz or your Farrell Fritz Relationship Partner.

For additional resources, please visit our COVID-19 Crisis Response and Help page.

Optimal Timing?

During the last twenty years, there have been a number of times during which the owners of closely held business entities have been encouraged – “urged” might be a better word, at least in some cases – by many advisers to take advantage of what may be described as “adverse” economic circumstances to do some gift and estate planning.

A sluggish economy, one with slow or no growth, is usually the catalyst. This is invariably accompanied – or caused? – by dropping consumer confidence which, in a service-based economy such as ours, only makes matters worse. The stock market will reflect[i] this less-than-positive outlook and, as the market declines, so will the value of most people’s retirement funds. The Fed will drop rates to encourage spending by businesses and consumers in the hope of limiting and hopefully reversing the effects. Government may “start” spending more in order to spark economic activity.

Where is the silver lining in all of this? “It’s the perfect environment,” many might say to a business owner, “to do some estate tax planning.” Why is that? “Because the value of your business has likely declined.”

To these folks, I say, “Slow down, don’t move too fast.”[ii]

The Goal of E-Tax Planning

The goal of estate tax planning, of course, is to transfer from members of a family’s older generation to members of its younger generation – without incurring a gift tax liability[iii] – those assets which now have a relatively low value – whether as a result of a downturn in the business, in its industry, in the economic generally, or otherwise – but which are reasonably expected to appreciate in value over time.

In theory, that is one way in which a gift tax or estate tax plan may be implemented – it is somewhat analogous to the adage about “buying low and selling high.”[iv]

For example, Parent owns an established business that may take off in a couple of years because of anticipated regulatory changes in its industry, or Parent may have recently started a business that is developing a new technology that promises to one day change the way widgets[v] are manufactured, or Parent’s business may be confident of eventually obtaining Federal approval for a new drug it is developing. In the hope of sharing with their children some portion of the future value of this business, Parent may decide to make a gift of some equity in the business to a trust for the benefit of the children.[vi] Because the value of this equity interest is relatively low as compared to what Parent reasonably believes are its prospects, such a gift makes sense.[vii] Their transfer of an equity interest to a child will not consume a large part of Parent’s federal exemption amount. What’s more, the transfer to a child or to a trust for their benefit removes the interest from Parent’s gross estate for purposes of the Federal estate tax; it also removes the future growth in the value of the interest from their estate.

That’s the underlying theory.


It is a basic precept of estate planning that Parent should not dispose of any interest in their business that they are not comfortable giving up[viii] – whether for business or personal reasons – regardless of how much such a transfer may ultimately save in gift and estate taxes. It may not be the smartest decision from a tax planning perspective, but it is Parent’s property.

Do you recall the end of 2012? The Federal unified exemption amount, which was set at $5.12 million per person, was scheduled to revert on January 1, 2013, to its 2002 level of $1 million per person.[ix] Many business owners panicked at the thought of losing the opportunity to pass at least a portion of the value of their business to their children on a tax-sheltered basis.

What did they do in the face of this pending calamity? They made gifts before the clock struck 12:00 am on January 1, 2013. On that day, however, Congress passed the American Taxpayer Relief Act,[x] which President Obama signed into law on January 2, 2013, with retroactive effect.

On January 3, 2013, many of those business owners who had rushed to make gifts in December 2012 called their attorneys to see how they could rescind their 2012 transfers. “You’ll have to buy it back,” they were told,[xi] or “your kids will have to gift it back to you.” I can tell you, no one wanted to hear that.[xii]

In the case of those who made their gifts into a grantor trust with respect to which they retained a power of substitution,[xiii] the resulting income tax liability of such a repurchase was avoided. In those other cases . . . Oh well.

The “Recalcitrant” Parent

In some instances, Parent may be reluctant to part with any of their voting power in the business, though this may be easily addressed by providing for voting and nonvoting equity interests,[xiv] with only the latter being gifted.

In addition, a well-drafted shareholders’ or partnership/operating agreement can go a long way in securing Parent’s control over the business.

Parent’s Economics

In other instances, Parent may be loath to give up any of the economic benefits, including the right to distributions, associated with their ownership of the business.

In many cases, the “lost” cash flow may be addressed, in part, by structuring the transfer to the kids as one in which Parent retains an interest in the transferred property,[xv] or as one that is made in exchange for consideration.[xvi]

This has two beneficial consequences: the amount of the gift is reduced by the amount of the consideration to be received by Parent, and it provides Parent with a flow of funds. One potentially adverse result is that the transfer may be treated as a sale for income tax purposes which may cause Parent to have a taxable gain.


For example, Parent may contribute some of their equity in the business to an irrevocable trust,[xvii] but will retain the right to be paid an annuity (basically, a fixed amount) from the trust every year, for a specified number of years[xviii] – a grantor retained annuity trust, or GRAT.[xix] When the term of Parent’s retained annuity interest ends, the property remaining in the trust will either remain in trust for the benefit of Parent’s children, or the trust may liquidate, with the property passing to the children as the beneficiaries of the remainder interest.

The trust is typically drafted so that the annuity amount payable to Parent is based upon a percentage of the value of the property as of the day the property was transferred by Parent to the trust.[xx] Once the annuity amount has been determined, Parent may calculate the amount of the gift arising from their transfer to the trust – i.e., the present value of the remainder interest, which is determined as of the date of the transfer to the trust using an interest rate prescribed by the IRS.[xxi]

In addition, the GRAT is typically drafted so as to be treated, for purposes of the income tax, as a so-called “grantor trust” – in general, a trust with respect to which the grantor has retained an interest such that the grantor will continue to be treated as the owner of the income and assets of the trust.[xxii] Because a taxpayer cannot sell property to themselves, and because the grantor is treated as owning the trust property, any transfers of property and payments of cash between Parent and the grantor trust will be disregarded for income tax purposes.[xxiii]


Alternatively, Parent may sell some of their equity interest in the business to a grantor trust[xxiv] in exchange for a promissory note with a face amount equal to the value of such equity interest. The loan should bear interest at least equal to the applicable federal rate (“AFR”), as determined by the IRS.[xxv] This interest may be payable on a current basis,[xxvi] with a balloon payment of principal when the note matures.[xxvii] Hopefully, the equity “sold” to the trust will have appreciated enough by then so that the trust may satisfy its obligation under the note by returning some of the equity to Parent. In this way, Parent avoids making a taxable gift while also avoiding taxable gain on the sale.

If there is little gain inherent in the equity interest to be transferred, Parent may choose to sell the property outright to child or to a non-grantor trust in exchange for a note bearing interest at the AFR.[xxviii]

The Federal transfer tax gambit in the case of a GRAT is that the equity interest transferred by Parent will appreciate, or will produce income, at a rate that is greater than the AFR – i.e., the interest rate that the IRS requires to be applied in determining the value of the gift in the case of the GRAT. If such appreciation or income levels are realized, then the excess will remain in the trust at the end of the term of Parent’s retained annuity interest. Thus, in a low interest rate environment like the one in which we now find ourselves, the GRAT may prove effective in removing value from Parent’s future estate.

In the case of an installment sale, the AFR represents the minimum rate of interest that the IRS requires be charged under the notes in order to avoid an imputed gift of any foregone interest.

Does Gifting Make Sense?

However, under the economic circumstances assumed herein, including the reduced value of the business – which likely stems in no small part from a not-insignificant drop in its revenues – one may question the wisdom, let alone the need, for Parent to transfer any of their equity interest in the business to, or for the benefit of, their child for the purpose of reducing Parent’s potential estate tax exposure.

As a result of the Tax Cuts and Jobs Act,[xxix] every individual has a combined Federal gift/estate tax exemption of $11.58 million;[xxx] in the case of married persons (especially a couple that takes advantage of “portability”), the exemption is $23.16 million per couple. Thus, an individual may, by a combination of lifetime and testamentary dispositions, transfer property with an aggregate fair market value of $11.58 million without incurring Federal gift or estate taxes. Where such property consists of interests in an ongoing, closely held business for which there is no ready market, the valuation of such interests will reflect their lack of liquidity.

In light of the foregoing, many business owners may ask “why give up any interest in the business?” The owner may feel that they need complete ownership – and whatever economic benefits they can derive or extract from such ownership – until the business stabilizes and starts to recover. Until then, they may not want to risk giving up any of its value or cash flow, especially if they feel they may need to sell the business down the road in order to fund their retirement because their IRA or other retirement accounts have taken a beating.

2026 or 2021?

As if a near economic disaster isn’t enough, enter the scheduled sunset of the increased gift/estate tax exemption amount. Specifically, for gifts made and for decedents dying after 2025, the exemption amount will revert to its pre-2018 levels; basically, it will be cut in half.

“But, Lou, you realize that we’re only in 2020, right?”

There is a more imminent threat to the higher exemption amount than the 2025 sunset: the November 2020 presidential election. The Democrats already control the House of Representatives – will they retain it? They need to win only three or four seats (depending on who wins the vice presidency) to take the Senate. What if they also win the White House?

Given the tenor and clear message of the Democratic primary contests, a reduction in the gift/estate tax exemption amount and an increase in the maximum gift/estate tax rate[xxxi] should be expected in 2021 in the event the Democrats do well this November.[xxxii]

What’s more, it is no longer only a question of principle or fairness or redistribution of wealth – the government must somehow come up with a way to pay for the $2.2 trillion economic stimulus package enacted on March 27, 2020,[xxxiii] and these Federal transfer taxes are fair game. In other words, the taxpayers at whom these taxes are targeted would be fortunate if we reverted to pre-TCJA law.

Scylla and Charybdis[xxxiv]

What to do?

Dispose of as much of the business as possible while the exemption amount is still high? Utilize GRATs and sales to grantor trusts to preserve some of the cash flow from the business to the owner? Retain only enough of an interest in the business so as to enable one’s estate to qualify for installment reporting of the estate tax attributable to the business?[xxxv] Hold on to the business, and purchase additional life insurance in an irrevocable trust?

All of the above? Probably.

Unfortunately, there’s a lot to think about here, but not a lot of time to plan.

[I] And reinforce? I have always viewed the stock market as a reactive element in the chemistry of the economy. You add information to the pot, and “it” responds based on some mix of perceived short-term and long-term self-interest. I’m sure that others view it differently.

[ii] Remember “The 59th Street Bridge Song”? Have you wondered whether we should now be calling it the “Ed Koch Queensboro Bridge Song”? I don’t think S&G would approve. “Slow down, you move too fast.”

[iii] New York no longer imposes a gift tax, though it will pull back into a decedent’s taxable estate any taxable gifts made by a resident decedent during the three-year period ending with the decedent’s date of death. NY Tax Law Sec. 954(a)(3). This claw-back provision applies to decedents dying before January 1, 2026. Would anyone be surprised to see it extended? Nope.

[iv] The gift and estate taxes are sometimes referred to as “transfer taxes.”

[v] No, this is not some item from Harry Potter, like a horcrux or a golden snitch. It is much more practical than such childish imaginings. For attorneys, a widget is a smallish, fictional device that is manufactured by a hypothetical business that can’t seem to catch a break. This poor widget manufacturer is forever involved, it seems, in some form of litigation, whether based on a commercial or other tort, a breach of contract, a misplaced peppercorn, etc.

[vi] Lots of good reasons for a trust. Keeping the property out of the kids’ hands will help to keep it out of the hands of their spouses and creditors, and will make it financially more difficult for the kids to engage in harmful behavior, like gambling or substance abuse.

[vii] Especially when one considers the valuation methodology for a going concern. Add to that the fact that the gift may consist of a minority interest which is not easily transferable, and the valuation may be quite favorable from a gift tax perspective.

[viii] In the words of many planners, it should be “disposable.”

[ix] The “sunset” of EGTRRA’s estate and gift tax provisions (P.L. 107-16), as extended and modified by the 2010 Extension Act (P.L. 111-312).

In addition, portability of a predeceasing spouse’s unused exemption amount would have been eliminated, and the tax rate would have increased to 55 percent. Oy.

[x] P.L. 112-240.

[xi] After all, in order for a gift to be effective for estate and gift tax purposes, it has to be a completed transfer. Reg. Sec. 25.2511-2.

Many clients asked why they had to pay to recover the gifted property. “After all,” several of them said, “my kids have no idea I even established a trust for them.” Oy, again.

[xii] And I am certain that many engaged in “self-help” at that point.

[xiii] IRC Sec. 675(4).

[xiv] In the certificate of incorporation in the case of a corporation; in general, in the operating agreement, in the case of a partnership/LLC.

[xv] Instead of an outright gift.

[xvi] A partial gift.

[xvii] With an “understanding” trustee. It also helps if Parent has the right to remove a trustee and, within certain limits, to appoint another.

[xviii] The “term” of Parent’s retained annuity interest in the trust.

[xix] IRC Sec. 2702; Reg. Sec. 25.2702-3. The GRAT will typically rely upon receiving distributions from the property contributed to the trust in order to make the annuity payments. For this reason, where the GRAT is funded with an interest in a closely held business organized as a partnership/LLC or as an S corporation – i.e., a pass-through that is not itself taxable – more cash will be left for the trust with which to make the necessary distributions.

[xx] In the event the IRS were to ever successfully challenge the reported value for the property, the annuity amounts would likewise be adjusted, thereby reducing what otherwise would have been the increased value of the gifted remainder interest. Reg. Sec. 25.2702-3(b)(2).

[xxi] IRC Sec. 7520. Specifically, 120% of the short-term AFR under Sec. 1274.

[xxii] Under the grantor trust rules. See IRC Sec. 671 – 679. The deemed owner will continue to be taxed on the income and gains recognized by the trust. If the owner-grantor can afford bearing this income tax liability, the trust may grow without being reduced for taxes. What’s more, the grantor’s payment of the income tax is not treated as a gift by the grantor for purposes of the gift tax.

[xxiii] Rev. Rul. 85-13.

[xxiv] So as to avoid adverse income tax consequences; i.e., taxable gain from the sale.

[xxv] IRC Sec. 1274. If a lower rate were charged, the foregone interest would be treated as a taxable gift by Parent.

[xxvi] The note has to be respected as such for purposes of the gift tax. The payment of such interest is not taxable to the grantor-owner. They cannot pay interest to themselves.

[xxvii] An installment sale. On the death of Parent, the trust ceases to be treated as a grantor trust, and the sale in exchange for a note is completed for purposes of the income tax. A balloon payment is often used because if Parent dies while the note remains outstanding, their estate may be able to claim a step-up in basis for the equity interest “sold” and thereby avoid any gain recognition. Of course, the note is included in Parent’s gross estate for purposes of the estate tax.

[xxviii] If the value of the equity interest was less than Parent’s adjusted basis for the interest – i.e., a sale would result in the realization of a loss – Parent may want to reconsider selling the interest to a family member; that’s because IRC Sec. 267 disallows (suspends, really) the recognition of loss arising from a sale or exchange between certain related persons.

[xxix] P.L. 115-97 (the “TCJA”). Effective for gifts made and decedents dying after 2017.

[xxx] IRC Sec. 2010(c)(3) and (c)(4); Sec. 2505. This is in addition to the annual gift exclusion amount of $15,000. IRC Sec. 2503.

[xxxi] The current maximum rate is 40 percent.

[xxxii] In addition, one should expect a Democratic assault on the discounts commonly taken when valuing interests in a closely held business for purposes of the gift and estate taxes.

[xxxiii] The Coronavirus Aid, Relief and Economic Security Act.

[xxxiv] No, not the line from Wrapped Around My Finger by The Police. Rather, the mythical monsters that were thought to inhabit opposite sides of the Straits of Messina and who preyed on passing sailors. They figured prominently in Homer’s Odyssey. Given the severity of the choices described here, we may want to throw in a Cyclops for good measure.

[xxxv] IRC Sec. 6166.

Tax Law for the Closely Held Business blog author Lou Vlahos’ op-ed entitled “Economic Losses: Blame the Virus? Not Entirely” was published yesterday, March 26, in The Empire Report.

Below is an excerpt of the article: 

In response to this stressful – but hopefully short-lived – business environment, the Federal government has taken some extraordinary measures over the last few weeks to help American businesses, and the public generally, to cope with what is expected to be the significant economic toll attributable to the Coronavirus.

Businesses that are required to provide paid leave for employees are being granted a refundable tax credit pursuant to the recently enacted Families First Coronavirus Response Act to defray the associated cost.

And on March 25, the Republican and Democratic leadership in the Senate announced an agreement on an economic stimulus plan that provides for more than $2 trillion in spending, as well as tax breaks, to bolster American business and consumers. A well-reasoned Keynesian-inspired approach? Doubtful, because how will this infusion of cash into the economy stimulate consumer demand under the circumstances in which we find ourselves? After all, folks are either not allowed to, or are fearful of, going out to places where they may encounter groups of other people.

To read the full op-ed, please click here.

The Lockdown

We are in a Coronavirus-induced lockdown. Most places of business are either closed or are open on a very limited basis. Social distancing is the order of the day. Those who can work remotely are doing so.[i] Many don’t have that option.

Certain businesses are experiencing an uptick in revenue as a result of the lockdown.[ii] Other businesses are floundering as demand for their goods or services has plummeted.[iii]

Then there is the great majority of businesses – closely held businesses – which basically live “from paycheck to paycheck.” It is a truism that they need to collect on their receivables in order to satisfy their payables.

In bad times, they may be able to rely on a line of credit for some finite period of time (assuming the line is adequate) – the question, of course, is for how long – or they may have to dip into their reserves or even request an infusion of capital from their owners.

The Economy

Many of these businesses are struggling to stay afloat.

They are trying to generate a steady flow of work from those other businesses with which they ordinarily transact, as well as from the general public – this can be a challenge in normal times, let alone under the circumstances in which they now find themselves, where even these potential or existing “client businesses” are experiencing the same challenges.

Even when this work can be found, one has to wonder whether the client will ultimately be able to pay the usual price charged by the business, or whether they will negotiate a discounted charge from the get-go. It is not at all unusual for a business to settle for a near-to-below market rate just to keep its doors open and its workers employed – we’re talking damage control until one can round the proverbial corner.

And while it may be difficult to generate the necessary business and the resulting receivables, which hopefully will be collected sooner rather than later, many business expenses are fairly fixed – unless the business is able to negotiate concessions from its landlord, bank, vendors, etc.;[iv] for example, rent, debt service, salaries, pension, insurance, and others.[v]

Congress Acts

In response to this stressful – but hopefully short-lived – business environment, the Federal government has taken some extraordinary measures over the last couple of weeks to help American businesses, and the public generally, to cope with what is expected to be the significant economic toll attributable to the Coronavirus.

Thus, income tax return filing dues dates have been pushed back 90 days, and a similar “holiday” has been granted for income tax payments, regardless of the amount owed.[vi]

Businesses that are required to provide paid leave for employees are being granted a refundable tax credit to defray the associated cost.[vii]

The “CARES” Bill

More recently, the Republican leadership in the Senate introduced an economic stimulus plan, dubbed the Coronavirus Aid, Relief and Economic Security (“CARES”) Act,[viii] and has started discussions with the Administration and the Democratic Senate leadership[ix] regarding its terms.

Among other things, the proposed legislation provides, among other things, that a business with fewer than 500 employees may qualify for a loan of up to $10 million that would help cover payroll and rent, among other obligations. If the business retains its employees and payroll levels, the loan would be forgiven to the extent it is used to cover payroll and certain preexisting obligations.[x]

Each of these measures should alleviate some of the pain that businesses have begun to feel, and will continue to experience for some time, as a result of the Coronavirus lockdown.

Net Operating Losses

Notwithstanding this promised relief, the fact remains that many businesses will be generating losses – real and immediate and substantial economic losses.[xi] Once upon a time, not that long ago, such a business would have been able to carry its net operating losses (“NOLSs”) – generally, the amount by which its business deductions exceed its gross income[xii] – for a taxable year back to its two immediately preceding taxable years,[xiii] as a result of which the business would have been entitled to a refund of all or a portion of the Federal income taxes paid in such earlier years; in other words, it would have received, in relatively short order, funds that the business needed in order to help it recover, and it would not have had to incur debt to do so.

Under existing rules, however, these businesses will be denied the full economic benefit of such losses – at a time during which this benefit may be sorely needed. That’s because the Tax Cuts and Jobs Act (“TCJA”)[xiv] eliminated the option[xv] for most taxpayers to carry back an NOL. Indeed, most taxpayers can only carry NOLs arising from taxable years ending after December 31, 2017 to a later year.[xvi]

The TCJA did not only eliminate the carryback of a taxpayer’s NOLs, it also limited the use of such NOLs for any taxable year of the taxpayer to which they may be carried forward.

Specifically, the NOL deduction – for losses arising in taxable years beginning after December 31, 2017[xvii] – cannot exceed 80 percent of the taxpayer’s taxable income for a carryforward taxable year (determined without any NOL deduction).

The practical effect of this limitation is that a taxpayer with an NOL carryforward to a taxable year, that could otherwise have been used to offset their entire business income for such year – thereby eliminating their income tax liability for the year – has to defer part of the benefit of the NOL into a later taxable year while paying income tax in the current year.

Excess Business Loss

Prior to the TCJA, an individual taxpayer’s business losses could offset the individual’s nonbusiness income,[xviii] without limitation.

The TCJA limited the amount of losses from the trades or businesses of a noncorporate taxpayer[xix] that the taxpayer can claim each taxable year.[xx] If the noncorporate taxpayer owns an interest in a partnership or in an S corporation that is engaged in a trade or business, the taxpayer’s allocable share of the losses therefrom is also considered.[xxi]

Specifically, the taxpayer cannot deduct overall net business losses in the current taxable year. This is the amount by which the total deductions from the taxpayer’s trades or businesses are more than their total gross income or gains from such trades or businesses, plus a statutorily prescribed threshold amount.[xxii]

The amount of any excess – the excess business loss – is treated as an NOL carryover in the subsequent taxable year.[xxiii]

The practical effect of this limitation is that a taxpayer with excess business losses for a taxable year, that could otherwise have been used to offset their nonbusiness income for such year – perhaps even eliminating their tax liability for the year – have to defer the benefit of the excess loss into the next taxable year while paying an amount in income tax in the current year that they otherwise could have used in their business.

What Should Congress Do?

The next few months will be challenging for almost every business in the country. Many businesses will fail that should not have failed. Others will rack up some significant operating losses that they should not have realized. The culprit in both cases is the Coronavirus, and the closely held business will be one of the inadvertent victims of our response to this very serious public health crisis.

Many “experts” have stated that they expect the crisis will pass before the end of the 2020 calendar year, maybe even as early as late Spring. At this point, we can only hope.[xxiv] Those businesses that survive – whether because they were “lean and mean” before the crisis, had adequate reserves or other financing sources, or for some other reason, including plain luck – are likely to have realized significant losses. They are also likely to be in need of new capital.

Why limit the ability of these businesses to convert their losses as soon as possible into badly needed funds? Why defer this benefit to later years when we can reasonably expect an immediate need for capital in the short-run?

Whatever the underlying policy reasons may have been for the TCJA’s enactment of the above-described loss limitation rules – other than to offset revenue losses resulting from the reduction in the Federal corporate income tax rate – they are overshadowed by the current economic threat.

Congress should act accordingly, and it should act immediately. In fact, the CARES Act proposes to make some of the changes outlined above, as well as others.

In particular, the Act calls for the retroactive elimination of the excess business loss rules for 2018 and 2019; in addition, the rules would not apply for 2020. These rules are scheduled to expire after 2025 in any case, and their retroactive repeal would allow business owners to whom the limitation applied in 2018 or 2019 to immediately file a refund claim. Frankly, their elimination from the Code[xxv] should be accelerated.

The CARES Act also proposes changes to the TCJA’s limitations on the use of NOLs. Taxpayers with NOLs arising in 2018, 2019 and 2020 would be allowed to carry such losses back to each of the five taxable years[xxvi] immediately preceding the taxable year in which the loss was realized. Assuming these taxpayers had tax liabilities for those years, they will be entitled to a refund of what is likely a badly needed infusion of cash.

The Act would also suspend the 80-percent-of-income limitation for taxable years beginning before January 1, 2021 (basically, 2018, 2019 and 2020), thereby freeing up dollars that otherwise would have been paid to the government.

The foregoing provisions of the CARES Act would be especially helpful for those businesses that will realize substantial losses this year, of which there will probably be many.

However, one must not lose sight of the fact that these amendments to the Code have not yet been enacted – indeed, they remain subject to change as Republicans and Democrats try to reach a consensus.

Speaking of which, when last I checked,[xxvii] the Washington Post had reported that Democrats were characterizing the CARES bill as a form of “corporate welfare,” and the loan program as a “slush fund” for businesses and their owners. Insisting that the preservation of workers’ jobs and salaries be the first priority of any economic aid legislation, they have promised to offer a competing legislative proposal.[xxviii]

Stay tuned. Hopefully, we will have some resolution later this week.

[i] Some more effectively than others.

[ii] I read that the consumption of “comfort foods” is on the rise. I must be in a bad way all of the time because I frequently seek out such foods. Indeed, as I revise this post, I have before me a large cup of coffee and a plate of Oreos. It’s a small plate, really. No, they are not the over-stuffed variety. Don’t judge me. Back off.

[iii] Restaurants, hotels, theaters, fast food joints, donut shops, etc. – anyplace in which people congregate.

[iv] It takes two to tango. Yada, yada, yada.

[v] Clearly, the leaner a business was going into this situation – no unnecessary obligations (so-called “fat”), an available line of credit, adequate reserves – the greater its chances of enduring the slowdown and ultimately emerging from it.

Examples of items that may be characterized as fat include the following: above-market workforce salaries and benefits, excess labor (meaning that a function that should reasonably be performed by one person is spread out over two), unnecessary overhead expenses (like an unnecessary location), personal travel and entertainment, non-targeted charitable contributions.

[vi] See IRS Notice 2020-18.

[vii] Families First Coronavirus Response Act. P.L. 116-127.

[viii] S.3548.

[ix] Mostly the Senate because the House appears to be out of session until March 24.

[x] Moreover, these businesses would not have to include the forgiven debt as COD income under IRC Sec. 61(a)(11). FYI, prior to the TCJA, in the case of a corporate business, the forgiven debt could have been treated as a capital contribution under IRC Sec. 118. As a result of the TCJA, however, the exclusion of a capital contribution from a corporation’s gross income, under Sec. 118(a), does not apply to a contribution by a governmental entity.

[xi] As distinguished from “mere” tax losses.

[xii] IRC Sec. 172(c). With certain modifications.

[xiii] IRC Sec. 172 prior to the TCJA.

[xiv] P.L. 115-97, Sec. 13302.

[xv] Before the TCJA, the taxpayer could elect to waive the carry back of NOLs for a taxable year and, instead, carry all of such losses forward.

[xvi] Under prior law, the carryforward period was limited to twenty years. Today, an NOL may be carried forward for an indefinite period, until it is fully utilized.

[xvii] IRC Sec. 172(a)(2). See the Instructions for IRS Form 1045.

[xviii] For example, investment income such as dividends, capital gains, and interest income.

[xix] Individuals, estates, and trusts.

[xx] TCJA Sec. 11012. IRC Sec. 461(l).

[xxi] The trade or business determination is made at the entity level, but the limitation is applied at the level of the partner or shareholder, as the case may be.

[xxii] For 2019, the threshold amount is $255,000 ($510,000 for married taxpayers filing a joint return). These amounts are indexed for inflation. See IRS Form 461, Limitation on Business Losses.

[xxiii] The provision applies after the application of the passive loss rules of IRC Sec. 469. Thus, the loss must have first satisfied the basis limitation rules in the case of an interest in a partnership (IRC Sec. 704(d)) or S corporation (IRC Sec. 1366(d)), as well as the at risk rules of IRC Sec. 465.

Note that the loss limitation provision does not apply to taxable years beginning on or after January 1, 2026.

[xxiv] From Lord of the Rings, The Two Towers (my favorite of the three movies):

THEODEN: [speaking loudly, that his men may hear] They will break upon this fortress like water on rock. [they walk around the inner ramparts] Saruman’s hordes will pillage and burn.
We’ve seen it before. Crops can be resown……homes rebuilt. Within these walls……we will outlast them.
ARAGORN: [raising his voice in response to what he perceives as Theoden’s foolish plan] They do not come to destroy Rohan’s crops or villages. They come to destroy its people……down to the last child.
THEODEN: [walks back towards Aragorn, takes his arm, and in a lowered voice, through clenched teeth says] What would you have me do? Look at my men. Their courage hangs by a thread.

[xxv] I am referring to the one true Code. Title 26 of the U.S.C.

[xxvi] The previous longest carryback period was three years, though there have been longer exceptions. The regime replaced by the TCJA – two years back, twenty years forward – was enacted by the TRA of 1997, P.L. 105-34.

[xxvii] At 3:00 pm EST, March 22.

[xxviii] Senate Republicans had hoped for a vote on Monday, March 23.


Estate Planning 101

A basic precept of effective estate planning is for a member of an older generation to transfer[i] property to a family member of a younger generation – for example, stock in a closely held corporation – that is reasonably anticipated to appreciate in value over time. In this way, not only will the property be removed from the older transferor’s gross estate for purposes of the federal estate tax, but any increase in the value of the property will also be excluded.[ii]

Thus, it is not uncommon[iii] for the owner (“Owner”) of a fairly new business venture to transfer to a trust for the benefit of their children some portion of their equity interest in the business entity through which the venture is to be conducted. At the time of the transfer – ideally, as close to the inception of the business as possible – the value of the equity may be relatively low, even speculative,[iv] thereby consuming only a small portion of the investor’s gift tax exclusion amount.[v] If the business ultimately fails, Owner will have “wasted” only that portion of their exclusion amount. However, if the business turns out to be a wild success, Owner will have effectively transferred a great deal of wealth to the next generation for a relatively small investment.[vi]

Beware of Deemed Gifts

This desirable result is the product of prudent gift and estate planning – not to mention some combination of foresight, effort and luck. There may be times, however, when too much of the proverbial “good thing” turns out to be a problem.[vii] For example, in their enthusiasm for shifting the hoped-for appreciation in the value of the business to their children, or to trusts for their benefit, Owner may get carried away.

Thus, Owner may contribute funds to the business without causing the business to issue additional equity to them in exchange for such funds, in the belief that by doing so they will direct more of the appreciation to the stock held by their children. In the case of a corporation, this contribution may be treated as a gift to the beneficiaries of the trust to which Owner has previously transferred shares of stock in the corporation.[viii]


Alternatively, and with the same goal in mind – to “freeze” Owner’s value while shifting appreciation to the younger generation – Owner may decide to treat their contributions of cash to the business as loans.[ix]

These loans may be recorded as such on the books of the business,[x] as well as on the balance sheet[xi] of the tax return filed by the business. They may be memorialized in a promissory note that sets forth the terms of the loan, including a maturity date,[xii] an interest rate,[xiii] and a payment schedule. The loan may even secured by the borrowing entity’s assets. Ideally, individuals who want to support the claim that their transfer of funds was a loan, rather than a gift, should require that interest be paid at least annually;[xiv] failing that, they should ensure that interest is accrued and imputed for tax purposes.[xv]

However, if this practice is not monitored closely, the combined effect of freezing Owner’s value while increasing that of Owner’s children, may leave Owner’s estate in a difficult position. Specifically, it may result in their estate failing to qualify for a special relief provision under the Code[xvi] which allows an estate that consists largely of equity in a closely held business to satisfy its federal estate tax liability attributable to such equity over a term of up to 14 years, during the first four of which only interest on the deferred tax is payable.[xvii]

Installment Payments

In order to qualify for this relief, the fair market value of a decedent’s interest in a closely held business, which is included in their gross estate for purposes of determining the estate tax,[xviii] has to exceed 35-percent of their adjusted gross estate.[xix]

A decedent’s equity in a corporation[xx] will qualify as an “interest in a closely held business” if 20-percent or more in value of the voting stock of the corporation was included in the decedent’s gross estate,[xxi] or if the corporation had no more than 45 shareholders.[xxii]

If a decedent owned a qualifying interest in a closely held business, then the estate tax attributable to the value of such interest is eligible for installment payments.[xxiii] For purposes of determining that value, however, the value of the interest attributable to any passive assets held by the business is disregarded. Thus, the benefit of the estate tax deferral is limited to the tax attributable to assets that are used in carrying on a trade or business by the closely held business.[xxiv]

Inadvertent Disqualification?

Advisers to the owners of a closely held business – for whom the ability to pay their estate tax in installments in accordance with the above rule – will often check on the status of an owner’s qualification.[xxv] In the event they discover that the owner’s estate may not be eligible for the installment rule, it may be possible to remedy the failure; for example, by adjusting the owner’s adjusted gross estate – perhaps by structuring certain otherwise testamentary dispositions as “liabilities” – or by increasing the owner’s relative equity in the business or the value of such interest relative to the owner’s other assets.

For example, the attribution rules mentioned above may be helpful.[xxvi] The owner may also purchase equity from other shareholders, exchanging value for value, and thereby avoiding a taxable gift, but probably triggering a taxable gain for those shareholders. In the case of a trust that is treated as a grantor trust on account of the owner’s retained power of substitution,[xxvii] the owner may exchange other property for the stock held by the grantor trust, which is treated as a nonevent for purposes of the income tax.[xxviii] If practicable, the corporation may redeem some of the shares of stock held by other shareholders; if treated as an exchange for tax purposes, there may be taxable gain;[xxix] if treated as a “dividend” distribution, then the entire amount will be taxable.[xxx]

Each of these options has its own economic costs which must be weighed against the benefit to the estate and its beneficiaries of being able to pay the estate tax in installments.

What about the Loans?

This brings us back to Owner, described above, who may have been overly eager about shifting value in the business away from themselves and to their children. In furtherance of that goal, Owner chose to treat their continued capital infusions into the nascent business as loans rather than as contributions to capital in exchange for more equity in the business.

Owner’s business is not at risk of failing to meet the definition of a “closely held business” under the installment payment rule – the corporation has fewer than 46 shareholders. The issue, rather, is that the value of Owner’s interest in the corporation may not exceed 35-percent of Owner’s adjusted gross estate.

In that case, Owner’s estate will not be able to defer payment of the estate tax attributable to either the stock in the closely held corporation or to the indebtedness owed by the corporation to Owner.

How, then, can the 35-percent test be satisfied?

Conversion of Debt to Equity?

Depending upon how much of the corporation’s debt is owed to Owner, the latter may decide to transfer some or all of such debt to the corporation as a contribution to capital. This transaction may result in Owner’s estate satisfying the 35-percent test by reducing the value of the debt in Owner’s estate; however, such a transfer may also result in a gift by Owner to the other shareholders of the corporation. If Owner’s transfer of the debt is paired with the corporation’s issuance of additional stock to Owner, the chance of success is increased, and the risk of a taxable gift is reduced.

In either case, however, it is imperative that Owner, the corporation, and the other shareholders consider the income tax consequences of Owner’s transfer.

Income Tax Consequences

In general, if a shareholder gratuitously forgives the debt owed to them by their corporation, the transaction represents a contribution to the capital of the corporation to the extent of the principal amount of the debt.[xxxi]

However, the Code provides more specific rules that describe the consequences of such a transaction for both the shareholder-creditor and the corporation-debtor.

The Creditor

From the shareholder-creditor’s perspective, the contribution of the debt to the corporation without the receipt of any additional shares of stock should be treated as a nonevent for income tax purposes.[xxxii]

If the corporation issues additional shares to the shareholder-creditor, the stock-for-debt exchange will be taxable to the shareholder if the debt is not evidenced by a security.[xxxiii] The amount of gain to be recognized will be equal to the fair market value of the stock received by the creditor over the creditor’s adjusted basis for the debt exchanged.[xxxiv]

Even if the debt is evidenced by a security, the exchange will be taxable to the shareholder unless they are in control of the corporation immediately after the exchange.[xxxv]

Alternatively, the exchange may qualify as an “E” reorganization – a recapitalization.[xxxvi] In that case, the creditor’s surrender of a debt security issued by the corporation in exchange for stock issued by the corporation would qualify for tax-deferred treatment.[xxxvii]

In either case, however, shares that are attributable to any accrued but unpaid interest will be taxable to the shareholder-creditor as ordinary interest income.[xxxviii]

Unfortunately, the Code does not define the term “security.” That being said, there is some authority for the proposition that a debt obligation with a term of fewer than five years will not be treated as a security.[xxxix] In other words, generally speaking, the obligation should represent a longer-term investment in the debtor-corporation in order to qualify as a security.[xl]

The Debtor

Of course, in the context of a shareholder-creditor and corporation-debtor relationship, it is not enough to consider only the consequences to the shareholder arising from the “conversion” of the indebtedness into equity. The tax cost to the debtor-corporation also has to be determined.

Where the shareholder-creditor cancels the corporation’s debt by contributing it to the corporation without receiving any stock in exchange, the corporation is treated as having satisfied the principal amount of the debt – generally, its issue price[xli] when the debt bears adequate stated interest – with an amount of money equal to the creditor’s adjusted basis[xlii] in the debt.[xliii] Thus, if such adjusted basis is less than the debt’s adjusted issue price,[xliv] the corporation will recognize cancellation of indebtedness income.[xlv] If the creditor’s adjusted basis in the debt is at least equal to debt’s adjusted issue price, then no cancellation of indebtedness income will be recognized.

Where the corporation-debtor issues additional shares of stock to the shareholder-creditor in exchange for, and in cancellation of, the corporation’s indebtedness, the corporation is treated as having satisfied the debt for an amount of money equal to the fair market value of the stock issued.[xlvi] Thus, if the value of the stock issued is less than the adjusted issue price for the debt, the corporation will recognize cancellation of indebtedness income. This is the case even where the debt obligation is evidenced by a security and the reorganization rules apply to the debt-for-stock exchange.[xlvii]


The foregoing illustrates just one instance of the interconnectedness of the estate and income taxes in the context of a closely held business. There are many more.

The adviser to such a business has to be attuned to this fact – they should not make any recommendations with respect to one of these taxes without considering its effects on the other – it will not always be possible to unwind an exchange or transaction without adverse tax consequences of one sort or another.

Moreover, in no case should they advise a course of action without first determining its impact on the business as such, including its relationship to third parties such as lenders and other investors.


It is difficult to ignore the circumstances in which we now find ourselves. It is natural to wish that things were different. In times of stress, I often find guidance in literature. The following is from The Lord of the Rings:

“I wish it need not have happened in my time,” said Frodo.
“So do I,” said Gandalf, “and so do all who live to see such times. But that is not for them to decide. All we have to decide is what to do with the time that is given us.”

[i] Whether by a completed gift or a sale, whether outright or in trust. In the case of a trust, and depending upon the current value of the property, the expected cash flow and rate of appreciation, the transfer may take the form of a gift, a GRAT, a sale, or a sale to a grantor trust.

[ii] Assuming, of course, that the transferor has not retained an interest in the property such that, notwithstanding the transfer, they continue to enjoy the benefits of ownership themselves, or the ability to determine the enjoyment of the property by others, or they retain a reversionary interest in the property. In that case, the transferred property will be included in the transferor’s estate at its value as of their date of death. IRC Sections 2035, 2036, 2037 and 2038.

[iii] Which is to say that it is not common, though it does happen. Most owners of a closely held business are reluctant to give up any part of their equity, let alone control, until after the business has established itself – i.e., appreciated in value – and the owners have reaped the rewards of their efforts. At the point, an owner may begin to think on their eventual withdrawal, both from the business and from this world. (Of course, there are some who say, “if I die,” rather than “when.”)

[iv] As always, a well-reasoned valuation report by an experienced and well-regarded professional appraiser is necessary. The money is well spent.

[v] IRC Sec. 2010(c) and Sec. 2505. Of course, any part of the exclusion amount consumed during the life of the grantor will not be available to shield the grantor’s testamentary transfers.

[vi] Indeed, if the grantor had also allocated part of their GST exemption amount at the time they transferred the property to the trust, subsequent distributions from the trust to their grandchildren would not be subject to the GST tax. IRC Sec. 2601 and Sec. 2631. See the automatic allocation rules in IRC Sec. 2632 and the regulations thereunder.

[vii] Examples abound; for example, drugs, perhaps longevity. Mark Twain had his own exception to this rule of thumb: “Too much of anything is bad, but too much good whiskey is barely enough.”

[viii] See, e.g., Reg. Sec. 1.351-1(b), which treats the contributor as having received shares of stock, which they then transfer to the other shareholders.

In the case of a partnership, the owner’s adjusted basis for their partnership interest and their capital account will reflect the additional capital contribution. IRC Sec. 705 and Sec. 722; Reg. Sec. 1.704-1(b)(2)(iv).

But, in an arm’s length deal, who would put their capital at risk without requiring additional equity, or a preferred return on their investment, or a guaranteed payment for the use of their capital? There’s a donative transfer in there.

[ix] We assume for our purposes that the loans are respected as such.

[x] If the owner-lender prepares personal financial statements at the request of a third party, they should be careful to include the loans as such.

[xi] Schedule L of either IRS Form 1065 for a partnership or IRS Form 1120 for a corporation. “Loans from partners” or “loans from shareholders” as the case may be.

[xii] In the absence of a maturity date, the loan is deemed to be a demand loan, which may be called at any time by the lender.

In some cases, it may be necessary to determine whether the loan is a “security,” in which case the length of the term will likely be pretty important. See, e.g., IRC Sec. 354 and Sec. 368(a)(1)(E).

[xiii] Often at the applicable federal rate, or AFR, under IRC Sec. 1274.

If the debt bears interest at a rate less than the AFR (a “below market rate”), the “lender” may be treated as having made a gift of the foregone interest. IRC Sec. 7872.

[xiv] In related party settings, it is important to treat with one another as closely as possible as one would with an unrelated party.

[xv] IRC Sec. 7872.

[xvi] IRC Sec. 6166. Of course, the policy underlying this relief is based upon the concededly illiquid nature of the closely held business and the desire to avoid a forced sale of the business solely for the purpose of satisfying the deceased owner’s estate tax liability. In accordance with this policy, the tax deferral will cease, and the tax will come due immediately, upon certain sales of the decedent’s interest or upon certain withdrawals of money from the business – in other words, upon the happening of certain “acceleration” events that eliminate the estate’s liquidity problem. IRC Sec. 6166(g).

[xvii] IRC Sec. 6166(a) and (f). Beginning with the fifth year, the estate will start paying the deferred estate tax and the interest thereon.

[xviii] IRC Sec. 2031.

[xix] IRC Sec. 6166(b)(6). The adjusted gross estate is determined by subtracting from the decedent’s gross estate only the estate’s administration expenses and certain casualty losses.

[xx] We’re limiting this discussion to corporations.

[xxi] The fact that the decedent was treated, for income tax purposes, as the owner of stock held by a grantor trust through the date of their death is irrelevant for purpose of this estate tax rule if the stock is not included in the decedent’s gross estate.

[xxii] IRC Sec. 6166(b). Certain attribution rules apply for purposes of determining the “number of shareholders test, or may be elected for purposes of the “percentage of value” test. IRC Sec. 6166(b)(2) and (7), respectively. The election under Sec. 6166(b)(7) comes at a price, including the loss of the initial period of interest-only payments.

[xxiii] The liquidity for an installment payment will often come from the corporation itself, in the form of a redemption of stock. Redemptions described in Sec. 303 of the Code – which are treated as exchanges of stock (not as dividends) and may thereby take advantage of the basis step-up at death under IRC Sec. 1014 – are not treated as acceleration events. IRC Sec. 6166(g)(1)(B).

[xxiv] IRC Sec. 6166(b)(9).

[xxv] That is not to say that they know when the owner will die, but reasonable assumptions may be made to enable some helpful analysis.

[xxvi] See endnote xxii.

[xxvii] Under IRC Sec. 675(4).

[xxviii] See, e.g., Rev. Rul. 85-13.

[xxix] IRC Sec. 302(a). Beware the Sec. 318 attribution rules.

[xxx] IRC Sec. 302(d), Sec. 301. The federal income tax would be imposed at a rate of 20%, plus the 3.8% federal surtax on net investment income. IRC Sec. 1(h), Sec. 1411.

Of course, if we are dealing with an S corporation that does not have earnings and profits from C corporation tax years, a redemption treated as a dividend distribution would be described in IRC Sec. 1368, and would be treated as a return of the shareholder’s entire basis in their stock before gain would be recognized.

[xxxi] Reg. Sec. 1.61-12(a).

[xxxii] We’ve already seen how it may result in a gift to the other shareholders if they are the natural objects of the contributing shareholder’s bounty.

[xxxiii] IRC Sec. 351(d)(2). Such a debt is not treated as “property” within the meaning of IRC Sec. 351.

[xxxiv] IRC Sec. 1001.

[xxxv] IRC Sec. 351(a). “Control” is defined in IRC Sec. 368(c) as the ownership of stock possessing at least 80% of the total combined voting power of all classes of stock entitled to vote and at least 80% of the total number of shares of all other classes of stock of the corporation.

[xxxvi] IRC Sec. 368(a)(1)(E); Reg. Sec. 1.368-2(e)(1) (exchange of bonds for preferred stock).

[xxxvii] IRC Sec. 354.

[xxxviii] IRC Sec. 351(d)(3).

[xxxix] See, e.g., Rev. Rul. 2004-78.

[xl] More than five years, though the other terms of the debt have to be considered.

[xli] IRC Sec. 1273.

[xlii] In the case of the original holder of the debt – i.e., the shareholder-lender – this will be the amount of the loan when the debt bears adequate stated interest.

A special rule applies for S corporation debt under which any reduction in the basis of the debt caused by the shareholder-creditor’s distributive share of corporate losses is disregarded. IRC Sec. 108(d)(7)(C).

[xliii] IRC Sec. 108(e)(6). This provision overrides IRC Sec. 118, under which contributions to the capital of a corporation are otherwise excluded from its income.

[xliv] This is initially the issue price for the debt. IRC Sec. 1272(a)(4); Reg. Sec. 1.1275-1(b). This is the amount of the loan where the debt bears adequate stated interest.

[xlv] IRC Sec. 61(a)(11). I am assuming for our purposes that none of the exclusions to recognition of such income under IRC Sec. 108 are applicable; for example, cancellation of debt when the debtor is insolvent.

[xlvi] IRC Sec. 108(e)(8). The issuance of the stock by itself is not otherwise taxable to the corporation. IRC Sec. 1032.

It appears that the IRS respects the form of the transaction, meaning that even in the case of a corporation with a single shareholder – in which case the issuance of additional shares may be treated as a “meaningless gesture” under Sec. 351’s jurisprudence – the issuance of stock in satisfaction of the corporation’s debt will trigger application of IRC Sec. 108(e)(8), rather than Sec. 108(e)(6). See, e.g., PLR 20101608.

[xlvii] Rev. Rul. 77-437.

A Basic Principle

Do you remember the scene from “History of the World Part I” when Mel Brooks, in the role of Moses, calls out “Hear me, oh hear me! All pay heed! The Lord, the Lord Jehovah has given unto you these fifteen [he drops one of the three tablets cradled in his arms and it shatters] – oy – these ten, Ten Commandments for all to obey.”[i]

Scholars have long debated what the five lost commandments may have been. I have my own hunch, at least as to one of them: “Thou shall not acquire and hold real property in a corporation, or in any business entity that has elected to be treated as an association.”[ii]

I have deduced that this must be the case from the number of inquiries I receive on a regular basis regarding the disposition of real property owned by a closely held corporation. One cannot easily explain away this state of affairs. How else might one account for any transgression of this basic principle? The only logical conclusion, I have determined, is that the public must be unaware of this missing commandment.[iii] Makes sense, right?

Lost Benefits

After all, how would one knowingly deny oneself the ability to increase the adjusted basis[iv] for their interest in a real estate partnership by their share of the indebtedness incurred by such partnership, even when the indebtedness is nonrecourse? This principle – which no doubt would have inspired realms of commentary and annotations to the missing commandment – enables a partner in such a partnership to claim their share of depreciation deductions attributable to such indebtedness[v]; it also supports a partner’s ability to withdraw their share of any loan proceeds from the partnership without incurring any tax.[vi]

There is no comparable basis adjustment rule for the shareholder of a corporation, including a pass-through entity such as an S corporation.[vii]

Regardless of how we got here, well, here we are. “Do what you can, with what you have, where you are,” as Teddy Roosevelt said.

With TR’s guidance in mind, let’s consider a question that was put to me just a few days ago.

We Want To Split Up

Corporation’s principal asset is a mixed use[viii] apartment building. Thanks to the appreciation in its value over the years, plus the cost-recovery deductions[ix] claimed by the corporation, there is substantial gain inherent in the real property.[x] The corporation would realize this gain if the corporation were to dispose of the building in a taxable transaction.[xi]

Corporation has two individual shareholders (“S/H One” and “S/H Two”) who are not related to one another. For years, they have both been active in the management and operation of the building.

For various reasons, the two shareholders no longer get along, and would like to separate from one another. They would like to do so, however, on as tax-efficient a basis as possible – meaning, they’d like to avoid taxable gain at both the corporate and shareholder levels. Ideally, each of them would also continue to be invested in real property.

Not too much to ask for, right?[xii]

Let’s begin by assuming that S/H Two will be the departing shareholder, and that S/H One is not interested in replacing S/H Two with another shareholder. There are some options to consider.

Clearly Taxable

Of course, S/H One may purchase all of S/H Two’s shares of Corporation stock. Alternatively, Corporation may redeem all of S/H Two’s shares.[xiii] Finally, S/H One and Corporation may join in buying out S/H Two.[xiv]

In each of these cases, the consideration for the purchase of S/H Two’s shares may be some combination of cash and a promissory note. It is likely that the funding source for such cash, and the collateral for such note, will be Corporation’s equity in the real property.[xv]

At the end of the day, S/H One ends up owning 100-percent of Corporation and, indirectly, the underlying real property, while S/H Two’s interest in Corporation is terminated by way of a sale of their stock.

Unfortunately for S/H Two, the gain from such a sale will be taxable to them.[xvi]

If S/H Two was still interested in holding real property, they may use the after-tax proceeds (and perhaps some debt) to acquire other real property.

Like Kind Exchange?

S/H Two is not especially keen on recognizing gain in connection with the buyout of their shares of stock in the Corporation.

They wonder whether they could “reinvest” their equity in other real property as part of a like kind exchange.[xvii] Having heard about partnership “drop and swap” transactions from various business acquaintances, S/H Two asks whether this approach is feasible in their case.

Unfortunately for S/H Two, the proceeds from the sale of their Corporation stock may not be reinvested as part of a tax-deferred like kind exchange, notwithstanding that Corporation’s only asset was real property.

Moreover, the drop-and-swap technique is not available in the case of real property that is owned by a corporation, even if the corporation is a pass-through entity, like an S corporation. To understand why, let’s first review the like kind exchange rules.

Section 1031

An exchange of property, like a sale, generally is a taxable event, and the gain therefrom is included in the exchanging taxpayer’s gross income for purposes of determining their income tax liability.

However, no gain or loss will be recognized if real property held by a taxpayer for productive use in a trade or business or for investment is exchanged for real property of a ‘‘like kind’’ which is to be held for productive use in a trade or business or for investment.[xviii] In general, this non-recognition rule does not apply to any exchange of real property that, in the hands of the taxpayer, is held primarily for sale.[xix]

The determination of whether real property is of a ‘‘like kind’’ to other real property relates to the nature or character of the property and not its grade or quality; for example, improved real estate and unimproved real estate generally are considered to be property of a ‘‘like kind’’ as this distinction relates to the grade or quality of the real estate.[xx]

The non-recognition of gain in a like kind exchange applies only to the extent that like kind property is received in the exchange. Thus, if an exchange of real property would meet the requirements for non-recognition, but for the fact that the property received in the transaction consists not only of real property that would be permitted to be exchanged on a tax-free basis, but also of non-qualifying property[xxi] or money[xxii] (“boot”), then the recipient of such boot will be required to recognize their gain realized on the exchange; however, the amount of gain recognized may not exceed the fair market value of such boot.[xxiii]


Although a partnership is a pass-through entity – meaning that its items of income, gain, deduction and loss flow through to its partners, and are included by them, in determining their respective taxable income[xxiv] – the like kind exchange rules are applied at the level of the partnership.[xxv]

In general, a partnership[xxvi] may utilize a “drop-and-swap” in a situation where some of its partners want to dispose of the partnership’s real property as part of a like kind exchange in which the partnership would acquire other real property,[xxvii] while other partners want to cash out their investment. The drop-and-swap affords both sets of partners the opportunity to satisfy their respective goals.[xxviii]

For example, the partnership may distribute tenancy-in-common (“TIC”) interests in the real property to those of its partners who want to cash out of the partnership; these partners would sell their TIC interests to the buyer for cash; meanwhile, the partnership would exchange its TIC interest for like kind property as part of a tax-deferred exchange.

The key to this technique is the ability of a partnership to distribute property in-kind[xxix] (for example, real property) to its partners without triggering recognition of the gain inherent in such property, and without causing the partners to include the distribution in their gross income.[xxx]

Corp’s In-Kind Distribution

Is this approach available to a corporation? Not really.

If a corporation were to distribute an appreciated property, or a portion thereof (a TIC interest), to some of its shareholders in exchange for their shares in the corporation (a redemption), the corporation would be treated as having sold the distributed property for consideration equal to the fair market value of such property.[xxxi] In the case of a C corporation, or of an S corporation that was subject to the built-in gain tax,[xxxii] the distribution/deemed-sale would generate gain subject to corporate-level tax. In the case of an S corporation, all of its shareholders – including those whose shares were not redeemed – would recognize the gain from the distribution[xxxiii]; depending upon whether or not the “related party sale” rules apply, such gain may be treated as ordinary income in the hands of the shareholder.[xxxiv]

What’s more, the fair market value of the property distributed would be taxable to the recipient shareholder to the extent it exceeds the shareholder’s adjusted basis for their stock.[xxxv]

In other words, a drop-and-swap-like strategy does not work where the real property is owned by a corporation.

Get Me Out of Here

Are there other alternatives? Maybe.

If Corporation’s rental business qualifies as an “active trade or business” within the meaning of the so-called “spin-off” rules,[xxxvi] and if Corporation has at least two rental properties, it may be possible for Corporation to contribute one of the properties to a subsidiary corporation and to then distribute the stock of the subsidiary corporation to S/H Two in redemption of all of the Corporation stock owned by S/H Two. Provided certain other requirements are satisfied, the distribution may be effected on a tax-deferred basis.[xxxvii]

Second Property?

But wait, you may say, Corporation has only one property. That’s true, but what is to prevent Corporation from acquiring a second property by purchase, or by replacing its one real property with two real properties as part of a like kind exchange,[xxxviii] with both properties continuing to be used in an active rental real estate business?[xxxix]

In order for a “split-off” (basically, a separation of shareholders into different corporations) to qualify as a tax-deferred transaction, each of the distributing corporation and the distributed subsidiary corporation must be engaged in the active conduct of a trade or business immediately after the distribution. The trade or business that is relied upon to satisfy this requirement is one that has been actively conducted throughout the five-year period ending on the date of the distribution.[xl]

Significantly, according to the IRS, the fact that a trade or business underwent change during the five-year period preceding the distribution will be disregarded for purposes of the active business test, provided that the changes were not of such a character as to constitute the acquisition of a new or different business.

In particular, if a corporation that is engaged in the active conduct of one trade or business during that five-year period purchases or otherwise acquires another trade or business in the same line of business, then the acquisition of that other business will ordinarily be treated as an expansion of the original business, all of which is treated as having been actively conducted during that five-year period, unless that purchase or other acquisition effected a change of such a character as to constitute the acquisition of a new or different business.[xli]

Thus, if Corporation is able to acquire a second rental real property which is operated as actively as the existing property, Corporation should be able to satisfy the active business test.

It should follow, based on the foregoing, that a corporation which has been actively engaged in a rental real estate business should be able to exchange its existing property for one or more new real properties, as part of a tax-deferred like kind exchange, without jeopardizing its satisfaction of the active business test, at least where the replacement properties are used in the same manner as the relinquished property.

In fact, about four years ago, we submitted a ruling request to the IRS on behalf of a corporate client engaged in an active rental real estate business. Between three and four years earlier, the corporation had disposed of its principal property and acquired several replacement properties during the replacement period as part of a like kind exchange.[xlii] For bona fide business reasons,[xliii] the corporation’s shareholders subsequently sought to go their own ways by dividing the real properties between two corporations. The IRS ruled that the acquisition of the replacement properties during the five-year period preceding the distribution constituted an expansion of the corporation’s business, and did not represent the acquisition of a new or different business.[xliv]

All’s Well That Ends Well?

Ugh, another idiom,[xlv] and perhaps the wrong one at that, under the circumstances. Although it may be that Corporation and S/H Two have found a path that may lead them to the tax-deferred separation of S/H Two from Corporation and S/H One, it is still the case that both shareholders will continue to hold their respective real property in corporate form, with all the impediments that it entails.

Does that mean the shareholders should accept their lot? Nope.

Although there are many factors to consider – several of which are in a state of flux this election year, including, for instance, the future of the 21-percent corporate tax rate – the shareholders should not be dissuaded from mapping out a plan for ameliorating the consequences of corporate ownership.

For one thing, they may want to ask their tax advisors about making an election to treat their corporation as an S corporation for tax purposes.[xlvi] Although this may not represent much of a difference in overall tax liability for a corporation that regularly distributes its profits to its shareholders as a dividend, at least under current rates,[xlvii] it will position a shareholder to save significant tax dollars on a later sale of their corporation’s property.[xlviii]

They may also want to consider having the corporation contribute the real property to an LLC in exchange for a preferred interest[xlix] – so as to “freeze” the corporation’s value – while the shareholders make their own capital contribution to the LLC in exchange for the common interests, which would be entitled to the future appreciation of the property.

That, however, is a topic for another day.

If you haven’t see this movie, do yourself a favor. OK? You’ll understand why Mr. Brooks has been awarded an Oscar, a Tony, an Emmy and a Grammy. “Young Frankenstein” and “Blazing Saddles” are two of my favorites.

[ii] Of course, this should be read less as a law and more like a guiding principle to which there may be exceptions under certain facts and circumstances. For example, a foreign corporation may be the right choice of entity for a nonresident alien thinking about acquiring an interest in U.S. real property, especially given the current corporate tax rate. That being said, the November elections are just around the corner. Mr. Biden has proposed increasing the corporate rate from 21% to 28%.

[iii] In case you’re wondering, yes, most of these corporations acquired their real property before the advent of the LLC (though there are exceptions). Query, however, why these folks didn’t use a limited partnership with a corporation (perhaps an S corporation) as the general partner?

[iv] A measure of their “unrecovered investment” in the partnership. Yes, that includes the partner’s share of partnership indebtedness. See IRC Sec. 752(a), which treats any increase in a partner’s share of partnership liabilities as a contribution of money by the partner to the partnership. Same as if the individual partners had borrowed the funds themselves to acquire the property – an example of the aggregate theory of partnership taxation. See also Reg. Sec. 1.752-2 and Sec. 1.752-3.

[v] Remember, a partner’s distributive share of partnership deductions/loss is allowed only to the extent of the adjusted basis of the partner’s interest in the partnership. IRC Sec. 704(d).

See also IRC Sec. 465(b)(6), which tells us that a taxpayer may be considered at risk with respect to their share of “qualified nonrecourse financing” incurred in the activity of holding real property.

[vi] A distribution of cash by a partnership to a partner will be taxable to the partner only to the extent it exceeds the adjusted basis of the partner’s interest in the partnership immediately before the distribution. IRC Sec. 731(a)(1).

[vii] In other words, the shareholder of an S corporation does not increase the basis for their stock by their “share” of the corporation’s indebtedness.

That being said, there are some S corporation rules that have counterparts in the partnership rules; for example, a shareholder cannot claim deductions in excess of the adjusted basis for their shares, and a shareholder may – generally speaking – receive distributions from the corporation without triggering a taxable event to the extent of such adjusted basis. IRC Sec. 1366(d) and Sec. 1368.

[viii] Residential and professional/commercial.

[ix] Depreciation. IRC Sec. 167 and Sec. 168.

[x] IRC Sec. 1001. Part of this gain is attributable to the depreciation deductions claimed by the corporation. This gain is treated as so-called “unrecaptured” depreciation which, in the case of an individual taxpayer (a direct owner, or an equity owner of a partnership or S corporation) would be taxed at the rate of 25%. The gain attributable to the appreciation in value over the original cost of the property is treated as capital gain, which would be taxable at 20% in the case of an individual with a direct or indirect interest in the real property. IRC Sec. 1(h). The 3.8% surtax on net investment income may also apply if the individual did not materially participate in the business. IRC Sec. 1411.

[xi] If the corporation were a C corporation, it would be taxed on the gain at the federal rate of 21%. IRC Sec. 11. If the corporation were an S corporation that was not subject to the built-in gain tax, its shareholders would be subject to federal tax, as the result of the pass-through of such gain (IRC Sec. 1366) at the rate of 20% (assuming the surtax on net investment income did not apply).

[xii] Almost a situation of having one’s cake and eating it too. There are some odd idioms out there.

[xiii] IRC Sec. 302(b)(3).

[xiv] Part-sale and part-redemption. See Rev. Rul. 75-447.

[xv] In the case of a cross-purchase, how will Corporation get the cash into S/H One’s hands? A loan?

[xvi] If Shareholder Two also recognizes losses in the year of sale, or it they have carryover losses from earlier years, the amount of gain recognized may be reduced. If Shareholder Two chooses to invest in a qualified opportunity zone fund, their gain recognition may be deferred and even reduced if they satisfy the holding period requirements. IRC Sec. 1400Z-2.

[xvii] IRC Sec. 1031(a). After the Tax Cuts and Jobs Act, this provision is limited to exchanges of real property.

[xviii] Note that a single relinquished property may be exchanged for more than one replacement property. However, be careful of the identification rules in Reg. Sec. 1.1031(k)-1(b) thru (e).

[xix] IRC Sec. 1031(a)(2).

[xx] Reg. Sec. 1.1031(a)-1(b).

[xxi] For example, real property held for sale, or personal property.

[xxii] Which may include relief from indebtedness. Reg. Sec. 1.1031(d)-2.

[xxiii] IRC Sec. 1031(b). No losses may be recognized from a like-kind exchange.

[xxiv] IRC Sec. 701, Sec. 702.

[xxv] An example of the “entity theory” of partnership taxation.

[xxvi] Including an LLC that is treated as such for tax purposes. Reg. Sec. 301.7701-3.

[xxvii] Assume that both the relinquished and the replacement property satisfy the “held for investment” or “held for use in a trade or business” requirement.

[xxviii] N.B. The IRS has not blessed this form of transaction.

[xxix] Not cash.

[xxx] IRC Sec. 731. We assume that neither the mixing bowl rules of IRC Sec. 704(c)(1)(B) and Sec. 737, nor the disguised sale rules of IRC Sec. 707, are applicable.

[xxxi] IRC Sec. 311(b).

[xxxii] IRC Sec. 1374.

[xxxiii] IRC Sec. 1366 and Sec. 1377.

[xxxiv] IRC Sec. 1239. The maximum federal tax rate on ordinary income is 37%.

[xxxv] IRC Sec. 302(a) and Sec. 1001.

[xxxvi] IRC Sec. 355(b); Reg. Sec. 1.355-3.

[xxxvii] IRC Sec. 355. For a description of spin off transactions, generally, including the “active business” requirement, please see

[xxxviii] Reg. Sec. 1.1031(k)-1(c). Of course, there is the practical reality that it may be difficult to identify within the 45-day identification period two properties that are desirable, and to acquire such properties within the 180-day replacement period. IRC Sec. 1031(a)(3).

[xxxix] Assume for our purposes that the ownership and rental of the real property constitutes an active trade or business. Reg. Sec. 1.355-3(b)(2)(iv). For more information on this topic, please see

[xl] Reg. Sec. 1.355-3(b)(3)(i).

[xli] Reg. Sec. 1.355-3(b)(3)(ii); Reg. Sec. 1.355-3(c), Ex. 7 and Ex. 8.

[xlii] There was little-to-no rental activity between the time of sale and the acquisition of the new properties.

[xliii] Of the “fit and focus” variety.

[xliv] PLR-106708-16, May 12, 2016.

[xlv] What? Were you expecting the eponymous Shakespearean play? I’m just a tax guy who quotes lines from Mel Brooks, Monty Python, Austin Powers, and the like.

[xlvi] IRC Sec. 1362.

[xlvii] 37% for the S corporation shareholder vs just under 40% for a C corporation that makes annual distributions of its after-tax profit to its shareholders.

[xlviii] 20% for the S corporation – assuming a sale outside the 5-year built-in gain period – vs just under 40% for the C corporation. Of course, I am assuming that the likelihood of a stock sale is very remote.

[xlix] Beware the disguised sale rule: Reg. Sec. 1.707-3 and 1.707-4.

We’re well into the income tax return “preparation-n-filing” season. It’s the time of year during which many businesses and their owners recognize the importance of working with a competent tax professional, one on whom they may rely not only for their tax reporting services but, more importantly, for the practical tax guidance they provide throughout the year.

Unfortunately, many business owners tend to equate “reliance” upon a tax adviser to assist them in fulfilling their tax-related obligations[i] with “abdication” of their responsibilities with respect to many of these obligations to such an adviser. These taxpayers may be unpleasantly surprised to learn that they remain subject to various penalties notwithstanding their having worked with a tax adviser. The case described below provides an illustration of one taxpayer’s recent experience.[ii]

Taxpayer’s Tax Team

Taxpayer was an S corporation. As such, it was required to file an annual return reporting its tax items on IRS Form 1120S, and to issue Schedule K-1s to its shareholders.[iii] Taxpayer failed to timely file its returns for five consecutive taxable years, though it did issue K-1s to its shareholders, who used the information reported thereon to prepare their own returns and determine their tax liability,[iv] which they satisfied.

According to Taxpayer, throughout the relevant time period, Individual was “treated as and effectively exercised the authority and control of CEO and Chairman of the Board over all of the family of companies,” including Taxpayer. In that capacity, Individual controlled and exercised final decision-making authority over all financial and tax-related matters for Taxpayer.

CPA was hired by Taxpayer and “functioned as, possessed and exercised the responsibilities    of Chief Financial Officer” for Taxpayer and all its related companies, though CPA was never an employee, officer, or director on the books and records of Taxpayer or of any related company.

Nonetheless, it was undisputed that CPA was solely responsible for preparing and filing the federal and state income tax returns for Taxpayer, as well as preparing and issuing the Schedule K-1s to its shareholders. All IRS notices and correspondence issued to Taxpayer were given directly to CPA.

CPA reported directly to, and was supervised by, Individual.

Failure to File

At some point before the years at issue, Individual became very ill. Eventually, this illness prevented Individual from fulfilling their responsibilities to the Taxpayer.

Shortly afterward, CPA became very ill. Despite this illness, CPA continued to act as Taxpayer’s de facto CFO. Indeed, CPA did not outwardly exhibit any behavior or symptoms that would have led anyone to question their ability. Unbeknownst to Taxpayer, however, CPA failed to file the income tax returns for Taxpayer for several years, though they did in fact prepare Taxpayer’s returns, and issued the Schedule K-1s, but failed to file the Forms 1120S and other returns for the years in question.

After CPA’s death, unopened IRS notices addressed to Taxpayer were found in their desk. Taxpayer hired an outside accounting firm to review Taxpayer’s income tax filing compliance. This firm found that CPA had prepared Taxpayer’s returns but failed to file them. The outside firm filed the delinquent returns for Taxpayer, several years after their due date.

The Code provides that “if any S corporation required to file a return . . . for any taxable year fails to file such return at the time prescribed therefor . . . such S corporation shall be liable for a penalty . . . unless it is shown that such failure is due to reasonable cause.”[v]

Taxpayer paid the penalty, then filed a refund claim for the amount of the penalty. After failing to convince the IRS that its failure to file timely was due to reasonable cause, Taxpayer petitioned a Federal District Court for relief.[vi]

Reasonable Cause

The Court began by stating that a taxpayer “bears a heavy burden to prove that the failure to timely file was” due to reasonable cause. It noted that, although “reasonable cause” is not defined under the applicable provision, guidance could be found under an analogous provision[vii] which imposes a penalty for failure to file other types of returns “unless it is shown that such failure is due to reasonable cause and not due to willful neglect.”

Under that standard, the Court explained, a taxpayer demonstrates reasonable cause if it can show that it “exercised ordinary business care and prudence and was nevertheless unable to file the return within the prescribed time period.[viii]

The Court then summarized the position of the U.S. Supreme Court regarding reasonable cause in the case, like the present one, of a taxpayer who hires a tax professional to prepare and file their return. The Court explained that Congress placed the burden of prompt filing on the taxpayer, not on an agent or employee of the taxpayer. Because of this “bright line rule,” reliance could not “function as a substitute for compliance.” Thus, “[t]he failure to make a timely filing of a tax return is not excused by the taxpayer’s reliance on an agent, and such reliance is not ‘reasonable cause’ for late filing under [the Code].”

In the instant case, the government argued that Taxpayer’s failure to timely file was due solely to its reliance on its agent, CPA, who was supposed to file its returns but failed to do so. Such reliance did not constitute reasonable cause excusing a late filer from penalties.

Corporate Disability?

In response, Taxpayer tried to distinguish the question of a taxpayer’s misplaced reliance on an agent to perform a known statutory duty, from the question of the taxpayer’s “inability to perform such duty.” Specifically, Taxpayer argued that it was incapable of filing because of the incapacity of Individual and of CPA, the persons who effectively controlled Taxpayer.

The Court observed that the principle underlying the IRS regulations – that a taxpayer should not be penalized for circumstances beyond their control – might cover a filing default by a taxpayer who relied on an attorney or accountant because the taxpayer was, for some reason, incapable by objective standards of meeting the criteria of “ordinary business care and prudence.”

While the Court conceded that an individual taxpayer’s illness and health problems can constitute reasonable cause for a late filing, it also noted that whether a corporation can be incapable of timely filing based on the incapacity of a corporate officer was another matter.

Numerous cases, the Court stated, have struggled with the application of disability in the corporate context. These cases have generally involved a key financial management employee who failed to carry out the tax obligations assigned to them and then hid that fact from the corporation. Most of the courts recognized that there were “at least some instances in which the conduct of an officer might render a company disabled from timely [filing], and that such situations are quite rare.”

The Court found that Taxpayer’s case was not one of those rare situations.

Taxpayer relied on CPA; regardless of whether CPA was its agent or its employee, Taxpayer could not simply rely on CPA’s illness to demonstrate Taxpayer’s inability to file. The corporation had a president and board members independent from CPA and Individual, all of whom had a responsibility to ensure that the corporation carried out its statutory duties, including the timely filing of tax returns.

What’s more, Taxpayer failed to present any evidence of any ordinary business controls to ensure that it met its responsibility. Indeed, it admitted that it ceded all responsibility to CPA without any oversight. This did not demonstrate ordinary and prudent business practice.

Consequently, the Court upheld the government’s denial of Taxpayer’s requests that the late filing penalty be abated and the amount paid refunded.

Parting Thoughts

The Court’s decision in Taxpayer’s case was correct. Taxpayer had abdicated its responsibility to CPA. It never followed up to ensure that the assigned function had, in fact, been properly performed on a timely basis. It had no mechanisms or processes in place by which to confirm that its tax obligations were being satisfied. The worst part: these safeguards could have been implemented very easily.

Although the focus of the foregoing discussion has been on the importance of a taxpayer’s “follow-through,” the more important consideration for the closely held business remains the selection of a tax adviser and the latter’s role in protecting the taxpayer from the imposition of tax-related penalties.[ix]

In many cases, a taxpayer may be able to avoid the imposition of certain penalties if the taxpayer can demonstrate that they exercised ordinary business care and prudence in determining their tax obligations, and that they acted reasonably and in good faith.

The determination of whether a taxpayer acted with good faith must be made on a case-by-case basis, and all pertinent facts and circumstances must be considered. Among the relevant circumstances are the experience, knowledge, and education of the taxpayer, and whether the taxpayer reasonably relied on the advice of a professional tax adviser.[x] For example, a taxpayer’s inexperience in tax matters and the complexity of this area of law, in conjunction with a track record of compliance, may demonstrate that the taxpayer acted reasonably in relying upon its tax advisers.

In determining whether the taxpayer reasonably relied upon a tax adviser, one must consider whether “(1) The adviser was a competent professional who had sufficient expertise to justify reliance, (2) the taxpayer provided necessary and accurate information to the adviser, and (3) the taxpayer actually relied in good faith on the adviser’s judgment.”[xi]

All well and good, but how does a taxpayer who is in the market for a tax adviser assess a candidate’s experience, knowledge and competence?

The courts have taken a practical approach toward this issue. The Tax Court, for example, has rejected the IRS’s argument that a taxpayer cannot in good faith rely on an accountant where the taxpayer did not conduct an investigation into the accountant’s background and experience prior to retaining him. In rejecting this argument, the Tax Court has stated that: “Given what little [the taxpayer] knew about the U.S. system of taxation, we cannot imagine [the taxpayer] would have known how to conduct such an investigation, let alone what value such uninformed inquiries would have added.  [The taxpayer] acted reasonably, given its admitted inexperience.”[xii]

The Supreme Court has reflected a similar approach toward the guidance provided by an adviser to a taxpayer after they have been retained. According to the Court:[xiii]

When an accountant or attorney advises a taxpayer on a matter of tax law, such as whether a liability exists, it is reasonable for the taxpayer to rely on that advice. Most taxpayers are not competent to discern error in the substantive advice of an accountant or attorney. To require the taxpayer to challenge the attorney, to seek a “second opinion,” or to try to monitor counsel on the provisions of the Code himself would nullify the very purpose of seeking the advice of a presumed expert in the first place. […] “Ordinary business care and prudence” do not demand such actions.

That being said, the taxpayer should not ignore their “spidey sense”[xiv] – that intuitive feeling that something is risky or plainly wrong. I am not referring to the more easily applied “too good to be true” test, or the equally tried and true “smell test” – these should rarely be overridden by a “well-reasoned” legal analysis. I am talking about that degree a doubt that a reasonably intelligent business owner experiences just before they ask “Are you sure?” followed by “If you say so.” At that point, it may behoove the business owner to push their adviser to defend or clarify their analysis until the owner is comfortable.

[i] Which is generally understandable, given the complexity of the tax laws.

[ii] Hunter Maintenance & Leasing Corp., Inc., Plaintiff, v. the U.S. (D.C. N.D. Ill.), Case No. 18 C 6585 (February 25, 2020).

[iii] IRC Sec. 6037. An S corporation must file Form 1120S by the 15th day of the 3rd month after the end of its tax year. For calendar year S corporations (the majority of such corporations), the due date is March 15 of the immediately succeeding tax year. Schedule K-1 must be provided to each shareholder on or before the day on which the corporation’s Form 1120S is required to be filed.

[iv] IRC Sec. 1366.

[v] IRC Sec. 6699. The penalty is equal to $195 per shareholder for every month the return was late, not to exceed 12 months.

[vi] IRC Sec. 7422.

[vii] IRC Sec. 6651.

[viii] Reg. Sec. 301.6651-1(c)(1).

[ix] Of which there are many, including, for example, penalties for (i) the late filing of a tax return, (ii) the late payment of tax (whether or not shown on a return), (iii) underpayments attributable to a taxpayer’s negligence or disregard of the tax rules, (iv) underpayments attributable to the misstatement of the value of property, (v) the failure to disclose certain investments, certain transactions, certain tax positions (including those for which there is no substantial authority), and (vi) underpayments due to fraud. See, for example, IRC Sections, 6651, 6662 and 6663, and Reg. Sec. 1.6662-4(d).

[x] Reg. Sec. 1.6664-4.

[xi] Neonatology Assocs., P.A. v. Commissioner, 115 T.C. 43 (2000), aff’d 299 F.3d 221 (3d Cir. 2002).

[xii] Grecian Magnesite, 149 T.C. No. 3 (July 2017).

[xiii] United States v. Boyle, 469 U.S. 241 (1985).

[xiv] Admit it, you followed Spiderman as a kid, didn’t you? At least enough to get the reference, right?

Keeping It Real

Contrary to what has long been an all-too-popular belief,[i] there is a method to the Code. That is not to say that no part of it is arbitrary, or that none of its provisions are tainted by political dealings, or that it cannot be improved. After all, it is the product of human beings[ii] and, as such, it is bound to reflect our mistakes and weaknesses – many of which are part and parcel of the trial-and-error process by which our system of taxation has evolved and been developed. By the same token, it is often amended in response to, and as a counter against, various manifestations of those weaknesses.

So, what is this “method” referred to above? Setting aside the Code as a tool for generating revenue,[iii] social engineering,[iv] behavior modification,[v] etc., one of the Code’s most important functions is to ensure that the benefits it bestows, and the burdens it imposes, are realized only by those taxpayers who have an economic “entitlement” to them.

For example, in computing taxable income for a taxable year, the Code permits a taxpayer to deduct all the ordinary and necessary expenses paid or incurred during the taxable year in carrying on a trade or business.[vi] However, various rules have been developed to ensure that the tax consequences of a given transaction match the economic consequences of the transaction.[vii] Among these, for example, are the so-called “at-risk” limitations, which are designed to prevent a taxpayer from deducting losses in excess of the taxpayer’s actual economic investment in an activity.[viii]

Under the at-risk rules (“ARR”), a taxpayer’s deductible losses from an activity for a taxable year are limited to the amount the taxpayer has placed at-risk – the amount the taxpayer could actually lose – in the activity. The initial amount at-risk is generally the sum of (i) the taxpayer’s cash contributions to the activity, (ii) the adjusted basis[ix] of other property contributed to the activity, and (iii) amounts borrowed for use in the activity with respect to which the taxpayer has personal liability or has pledged as security for repayment property not used in the activity.[x] This amount is generally increased each year by the taxpayer’s share of income from the activity, and is decreased by the taxpayer’s share of losses and withdrawals from the activity.[xi]

A recent decision of the U.S. Tax Court provided a helpful illustration of how these rules are applied.[xii]

The Loan

During the years at issue, Taxpayer was in the healthcare business. As part of the business, Taxpayer owned a medical services company (“Service-Co”) which provided management services to hospitals, outpatient facilities, rehabilitation facilities, and medical clinics. Service-Co was a corporation[xiii] and Taxpayer owned all of Service-Co’s issued and outstanding shares of stock.

In addition to Service-Co, Taxpayer owned all of the membership interests of Hospital LLC, which Taxpayer formed to purchase and own a hospital (“Hospital”).[xiv] Hospital LLC was a single-member limited liability company that was treated as a disregarded entity for Federal tax purposes during the relevant years.[xv]

In July 2008, Taxpayer used Hospital LLC and Service-Co to purchase Hospital for $9.9 million. Taxpayer funded the purchase using a development loan (“Hospital Loan”) obtained from Bank.

Bank granted the Hospital Loan under a Federal program overseen by Agency that provided banks with a government guarantee on loans for certain development projects; however, as a condition for such loans, Agency required borrowers to execute personal guarantees for the full loan amount; $9.9 million in this instance.

The Hospital Loan was structured so that Hospital LLC and Service-Co were identified as the co-borrowers. Taxpayer executed a corresponding promissory note on behalf of Hospital LLC and Service-Co that reflected a payment schedule, a maturity date, and collateral consisting of Hospital facilities and equipment. Taxpayer also executed Agency’s required personal guarantee that made him directly liable to Bank for the full amount of the Hospital Loan and any amounts due for as long as the Hospital Loan was outstanding.

The guarantee created strict obligations for Taxpayer regardless of any obligations of the borrowers (Hospital LLC and Service-Co). Under the terms of the personal guarantee, Bank was not required to seek payment from any other source before demanding payment from Taxpayer. The guarantee also clearly stated that Agency was “not a co-guarantor” on the Hospital Loan and that Taxpayer had “no right of contribution” from Agency with respect to the guarantee. Furthermore, the guarantee provided that if Agency paid any amounts on the Hospital Loan to Bank, those amounts would become a debt owed by Taxpayer and subject to all remedies Agency could employ to recover the debt. There were no other guarantors to the Hospital Loan, and it remained outstanding through the years at issue.

Tax Returns and IRS Exam

For 2008, Taxpayer reported the income and expenses of Hospital LLC on a Schedule C, “Profit or Loss From Business”,[xvi] of their Form 1040 and claimed the corresponding loss deduction related to Hospital LLC.

The IRS reviewed the return, determined a deficiency, and timely[xvii] mailed Taxpayer a notice of deficiency (“NOD”). The NOD disallowed almost $1 million of Taxpayer’s claimed loss deductions related to Hospital LLC on the grounds that Taxpayer had not demonstrated that they were “at-risk” to the extent of the reported loss.[xviii]

The Taxpayer timely filed petitions with the U.S. Tax Court.[xix] The issue for decision before the Court was whether the personal guarantee that Taxpayer executed in 2008 left Taxpayer “at-risk” under Section 465 of the Code to the extent of the $1 million of loss deductions Taxpayer claimed related to Hospital LLC.[xx]

Amounts At-Risk

For individuals and certain closely held corporations engaged in carrying on a trade or business or for the production of income, Section 465 of the Code generally limits loss deductions to the amount for which the taxpayer is considered “at-risk”.[xxi] If losses are disallowed under Section 465, then the losses are suspended and carried forward to the first succeeding taxable year (subject to the same “at-risk” limitations), or to each year thereafter until the losses can be deducted.[xxii]

A taxpayer’s amount at-risk for an activity generally includes: “(A) the amount of money and the adjusted basis of other property contributed by the taxpayer to the activity, and (B) amounts borrowed with respect to such activity”.[xxiii] In general, amounts borrowed are considered to be at-risk only to the extent that the taxpayer: “(A) is personally liable for the repayment of such amounts, or (B) has pledged property, other than property used in such activity, as security for such borrowed amount (to the extent of the net fair market value of the taxpayer’s interest in such property).”[xxiv] Furthermore, “a taxpayer shall not be considered at-risk with respect to amounts protected against loss through nonrecourse financing, guarantees, stop loss agreements, or other similar arrangements.”[xxv]

With regard to the Hospital LLC deductions, the IRS contended that the personal guarantee that Taxpayer executed in 2008 did not actually put Taxpayer at-risk to the extent of the disallowed deductions. The personal guarantee would qualify under section 465(b)(1)(B), if at all, only as an “amount[] borrowed”. Thus, Taxpayer had to show: (1) that they were “personally liable” for the Hospital Loan and (2) that they was not “protected against loss.”

“Personally Liable”

The ARR do not specifically address whether a guarantor is considered “personally liable” (and, therefore, potentially “at-risk”) for amounts borrowed, but the courts have generally determined that some guarantees do result in personal liability. As a general matter, the mere execution of a guarantee is insufficient to establish personal liability for purposes of the ARR. The reason is that in the case of a typical guarantee, if the guarantor were required to pay on the underlying debt, the guarantor would generally be entitled to seek reimbursement from the primary obligor.

However, as the Court explained, “not all guarantees are created equal”; when a guarantor is directly liable on a debt and there is no primary obligor bearing recourse liability for the debt, then the guarantor would not have any meaningful right to reimbursement, and thus would be ultimately liable for the debt.

Accordingly, a guarantor’s personal liability for purposes of the ARR depends on whether or not the guarantor has the ultimate liability for the debt.

To answer that question, the Court considered the “worst-case scenario” and then identified the “obligor of last resort” based on the substance of the transaction. The Court asked: If there were no funds to repay the debt, and all of the assets of the activity or business were worthless, to whom would the creditor look for repayment?

The Court was persuaded that Taxpayer bore the “ultimate liability” with respect to the Hospital Loan. In 2008, Taxpayer obtained a $9.9 million loan through two of their wholly owned entities, Hospital LLC and Service-Co. The loan was part of Agency’s lending program that required Taxpayer to personally guarantee the full amount of the loan, and Taxpayer executed the guarantee in 2008. There were no other guarantors to the loan. The guarantee created a direct liability against Taxpayer that would have permitted Bank to pursue Taxpayer directly without any action against Hospital LLC or Service-Co if either of them defaulted on the loan.

The only other viable option for Bank to pursue in the event of Hospital LLC’s or Service-Co’s default would have been to seek loss payments from the Agency through its lending program, in which case Taxpayer would have incurred a debt obligation subject to the full recourse actions available to the Federal government for any such payments. In either case, Taxpayer would have been ultimately liable for the debt, either to Bank or to Agency.

The IRS argued that, under State law, a member of an LLC was not personally liable for the debts of the LLC. The Court rejected this, stating that Taxpayer became liable for Hospital LLC’s debt not because they were a member of the LLC but because they executed a personal guarantee for that debt.

The IRS also argued that Taxpayer was not personally liable for purposes of the ARR because State law “provides that a surety who pays the creditor is entitled to reimbursement from the principal obligor.” That is, the IRS asserted that, if Taxpayer made payments on the Hospital Loan, Taxpayer then would have a right to reimbursement from the primary obligors: Hospital LLC and Service-Co. To evaluate this argument, however, the Court invoked the principle that “for purposes of these rules, we presume the worst-case scenario – a circumstance in which the primary obligors” (Hospital LLC and Service-Co) would be worthless and thus unable to reimburse Taxpayer for any amounts paid on account of Taxpayer’s guarantee.

Moreover, the Court continued, even if it looked to Hospital LLC and Service-Co (whether or not deemed defunct or insolvent) as the obligors responsible in form for any such reimbursement, it could not ignore the fact that Taxpayer, as the sole owner of Hospital LLC and Service-Co, would still bear the economic responsibility for such reimbursement in substance. In other words, any reimbursement to which Taxpayer might theoretically be entitled would be due to him from their own 100-percent-owned entity. Taxpayer would ultimately be paying the debt, and the fact that Taxpayer might then be entitled to seek reimbursement from themselves would not render Taxpayer any less at-risk.

The IRS stressed that the Hospital Loan was substantially collateralized, that it was not likely that Taxpayer would ever be called on to make payments pursuant to their guarantee, and that Taxpayer did not in fact ever do so.

But these facts did not undermine Taxpayer’s personal liability under the ARR. The Court also observed that the IRS did not cite any authority for the relevance of these propositions.

Thus, as to the Hospital Loan, the Court found Taxpayer “personally liable” for purposes of the ARR.

Protected Against Loss?

The Court next considered whether Taxpayer was “protected against loss” for purposes of the ARR,[xxvi] noting that “a taxpayer shall not be considered at-risk with respect to amounts protected against loss through nonrecourse financing, guarantees, stop loss agreements, or other similar arrangements.” The Court stated that a guarantor who had a right to reimbursement from a primary obligor was not, as a general rule, considered to be at-risk.

The Court explained: “Since a guarantor is entitled to reimbursement from the primary obligor, it is clear that Congress did not intend that a guarantor of a loan is personally liable for repayment of the loan within the meaning of” the ARR. In other words, if a guarantor were required to pay an amount on the underlying debt beyond their initial contribution, then they would have a right to reimbursement from the principal obligors, and the guarantor’s risk would be limited.

However, the Court stated that a guarantor’s right to reimbursement would limit their risk only if the facts indicated a certainty as to the reimbursement; i.e., the right to reimbursement was meaningful. Conversely, when a guarantor’s right to reimbursement was against a primary obligor that has only limited liability, and there was no definite or fixed recourse obligation for the underlying debt, then the right to reimbursement would be less meaningful and, so, there may indeed be risk.

Accordingly, when evaluating a guarantor’s loss protections (including reimbursements from primary obligors), the Court indicated that it looks at the facts and circumstances to determine not only whether there is a right to the reimbursement, but whether the substance of the right is meaningful. In other words, one must consider the “realistic possibility” that the guarantor would ultimately be subject to “economic loss” if called upon to make payments on account of the guarantee.

The Court then applied both the “worst case scenario” and the “realistic-possibility” analyses to Taxpayer’s guarantee.

In determining whether Taxpayer was personally liable, the Court presumed that the primary obligors (Hospital LLC and Service-Co) were worthless and unable to pay the amount owed under the Hospital Loan. If that presumption were maintained as to the primary obligors, and one then turned to the question of whether there was a realistic possibility of reimbursement, it was clear that Taxpayer would not be protected against loss for purposes of the ARR because Taxpayer’s right to reimbursement would be against the worthless entities with no means to repay Taxpayer for any amounts contributed.

Taxpayer executed a personal guarantee in 2008 for Hospital Loan. Under that guarantee, Taxpayer became directly liable to Bank for the full amount of the debt if the obligors defaulted. There was no other guarantor on the debt, nor was there a definite or fixed right to any contribution from other members of Hospital LLC or from Service-Co on account of the debt. Indeed, Taxpayer was the sole owner of these entities and the only person with unlimited liability for the Hospital Loan. Even if one disregarded a worthlessness determination when considering Taxpayer’s realistic possibility of economic loss, the Court could not disregard that, in substance, Taxpayer was the only one involved with respect to the liability for the Hospital Loan, the corresponding promissory note, and the personal guarantee.

Accordingly, the court found that Taxpayer was personally liable, not protected against loss, and ultimately at-risk under the Hospital Loan during 2008 so as to be entitled to deduct the losses related to Hospital LLC that were claimed on the Taxpayer’s 2008 return.

Good to Be At-Risk (?)

Not really, not if you can avoid it, or at least contain its consequences. A calculated risk is something else – it may be the price one must pay to be in business and, hopefully, to realize a worthwhile return on one’s investment[xxvii] of capital, time and effort.

Yes, losses may be generated along the way, but at least you’ll have the comfort of knowing that you may deduct those losses for purposes of determining your taxable income. Of course, I’m being somewhat facetious.[xxviii] A loss is still a loss, though a tax deduction may remove some of the sting, and thereby encourage a taxpayer to take a chance on a new project or business.[xxix]

The ARR, however, are only one step in the gauntlet of rules that are aimed at limiting a taxpayer’s ability to use the losses from one business to offset the income from another.[xxx]

A business owner would be well-served to consult with their tax adviser if they expect their new venture will be generating losses, at least initially. A familiarity with the ARR, as well as with the Code’s other loss-limitation rules, will enable the business owner and their advisers to select[xxxi] the appropriate entity through which to operate the new business or venture, and to structure the capitalization thereof, including financing, in a way that will allow the owner to maximize the use of any losses for tax purposes and, thereby, to reduce the net economic effect of such losses.

[i] Thanks to whoever, at the moment, benefits from perpetuating it.

[ii] Not philosopher kings, though we could use a few wannabes in Washington.

[iii] Its primary function.

[iv] For example, the charitable contribution deduction [IRC Sec. 170, Sec. 2055, Sec. 2522], or the credit for low income housing [IRC Sec. 42].

[v] For example, the denial of most deductions for cannabis business [IRC Sec. 280E], or the treatment of spouses as a single economic unit for most income and transfer tax purposes [IRC Sec. 1041, Sec. 2056, Sec. 2523].

[vi] IRC Sec. 63, Sec. 162.

[vii] The IRS and the courts will gauge a tax position on the basis of its economic reality. Thus, they will often look for the independent non-tax business reason for a transaction. In the realm of partnership allocations, they will look for the substantial economic (non-tax) effect of an agreement to share profits and losses.

[viii] IRC Sec. 465.

[ix] I.e., the unreturned investment – not the appreciated fair market value; only the amount by which the taxpayer has come out of pocket.

[x] We ignore the special case of real property and qualified nonrecourse financing. Ah, real estate – an example of our weaknesses? Or an attempt to encourage certain behavior? Some combination of both.

[xi] The amount that has been taxed to the taxpayer, but which they have not withdrawn from the business, thereby leaving it “at-risk” in the business.

[xii] Bordelon v. Comm’r, T.C. Memo. 2020-26.

[xiii] It was treated as a C corporation for Federal tax purposes during 2008 and 2009 and as an S corporation beginning in 2010.

[xiv] Yes, a for profit hospital – one that operates to provide a return for its investors. Approximately 25% of the non-federal hospitals in the U.S. are for profit.

[xv] Reg. Sec. 301.7701-3.

[xvi] Because Taxpayer owned 100% of Hospital LLC, and because the latter was disregarded for tax purposes, Taxpayer was treated as owning all of LLC’s assets and liabilities, income and expenses. In other words, Taxpayer was treated as a sole proprietor with respect to Hospital LLC’s business. Accordingly, the profits and losses from this business were reported on Sch. C of Taxpayer’s Form 1040.

[xvii] See IRC Sec. 6501 – the statute of limitations for the assessment of a tax deficiency.

[xviii] Consequently, Taxpayer had the burden of showing that they were at risk for the Hospital Loan

The IRS did not determine that Hospital LLC did not actually incur the expenses underlying those losses. Rather, the only dispute was Taxpayer’s entitlement to deductions for those losses under the at-risk rules.

[xix] IRC Sec. 6213. The 90-Day Letter.

[xx] There were other issues that we are not addressing in this post.

[xxi] IRC Sec. 465(a), (c)(3)(A).

[xxii] IRC Sec. 465(a)(2).

[xxiii] IRC Sec. 465(b)(1).

[xxiv] IRC Sec. 465(b)(2).

[xxv] IRC Sec. 465(b)(4).

[xxvi] IRC Sec. 465(b)(4).

[xxvii] One’s putting at risk.

[xxviii] Compare the idea of saving taxes by making a charitable contribution of cash. Unless you really intend to benefit a charity, your only savings, generally speaking, is equal to the amount of the contribution multiplied by your effective tax rate. You’re still out the cash, though it didn’t cost you as much as it otherwise would have if the charitable contribution deduction had not been available.

[xxix] The Code’s role in encouraging certain behavior.

[xxx] In determining their taxable income for a taxable year, the shareholders of an S corporation and the partners of a partnership are allocated their share of the pass-through entity’s losses for such year. However, there are a number of rules that limit the ability of these owners to deduct these losses.

As a threshold matter, the aggregate amount of losses taken into account by a shareholder or partner for a taxable year cannot exceed, (i) in the case of an S corporation, the sum of the shareholder’s adjusted basis for his stock, plus his adjusted basis of any corporate indebtedness owed to the shareholder, and, (ii) in the case of a partnership, the adjusted basis of such partner’s interest in the partnership. Any excess for which a deduction is not allowed in a taxable year is carried forward.

Any pass-through loss that is allowed under the above “basis-limitation rule” must also be tested under the “at-risk” rules and, then, the “passive activity” loss rules before it may be utilized by a shareholder or partner in determining his taxable income. A loss that is disallowed under either of these rules is “suspended” and is carried forward indefinitely to succeeding taxable years until the taxpayer has more amounts at risk, or realizes more passive income, or disposes of their interest in the pass-through entity.

The Tax Cuts and Jobs Act imposed yet another limitation on a non-corporate taxpayer’s ability to utilize a pass-through loss against other income – whether it is realized through a sole proprietorship, S corporation or partnership – which is applied after the basis-limitation, at-risk, and passive loss rules. Specifically, for taxable years beginning after December 31, 2017 and before January 1, 2026, the excess business losses of a non-corporate taxpayer are not allowed for the taxable year.

[xxxi] All other things being equal.

When It Rains

Sometimes you go for weeks without having to consider a particular tax issue in any depth. Then, unexpectedly, that issue comes to the forefront of several projects. That was my experience this past week when it seemed as though almost every other person who came to my office had a question concerning New York transfer taxes.

No, I am not talking about New York’s estate tax.[i] Rather, I am referring to the transfer taxes that are generally imposed by N.Y. State (“NYS”) and by N.Y. City (“NYC”)[ii] upon a taxpayer’s “conveyance” or “deed”[iii] of real property located in NYS or NYC,[iv] or of certain interests in such real property including, for example, the creation of a leasehold interest in such real property.

In fact, it was the granting of a leasehold interest under varying circumstances that several of my colleagues wanted to discuss with me last week. Before delving into NYS’s and NYC’s transfer tax treatment of leases – including what may come as a surprise to some – let’s first consider the basic operation of the two transfer taxes.

The NYS Tax

In general, the NYS Real Estate Transfer Tax (“RETT”) applies to the “conveyance”[v] of real property, or of an interest in real property, when the consideration for the transfer exceeds $500.

Among other things, an interest in real property[vi] includes title in fee, a leasehold interest, and an option to purchase real property. It also includes a controlling interest in an entity that holds real property, meaning 50 percent or more of the total combined voting power of all classes of stock of a corporation or, in the case of a partnership, 50 percent or more of the capital or profits interest in the partnership.

The tax is imposed on the consideration paid, or required to be paid,[vii] for the conveyance. In the case of commercial real property,[viii] if the consideration is under $2 million, the tax is determined at a rate of 0.40 percent;[ix] if the consideration is at least $2 million, the tax is determined at a rate of a rate of 0.65 percent.[x]

In the first instance, the tax is payable by the grantor, failing which it may also be collected from the grantee – it is a joint and several liability.[xi] Payment is due fifteen days after the conveyance, at which time a joint return is also required to be filed.[xii]

Some conveyances are exempted from the tax. These include a conveyance pursuant to a devise, bequest or inheritance, as well as a conveyance to secure a debt.[xiii] Another is the “mere change” exemption, which is one of the most relevant for conveyances by closely held businesses and their owners.[xiv] Under this exemption, the tax does not apply to the extent the conveyance does not change the beneficial ownership of the property. For example, a conveyance by a partner to the partnership as a contribution of partnership assets is subject to tax only to the extent there is a change in beneficial ownership. Similarly, a conveyance to partners upon the liquidation of a partnership is subject to tax only to the extent there is a change in beneficial ownership.

The NYC Tax

The NYC Real Property Transfer Tax (“RPTT”) generally applies to the delivery of a “deed”[xv] by a grantor to a grantee when the consideration for the real property exceeds $25,000.[xvi] This includes any document whereby any real property or interest therein is created or transferred. It also includes any document by which any leasehold interest in real property is granted.

The RPTT also applies to a transaction by which any economic interest in real property is transferred[xvii] where the consideration exceeds $25,000.[xviii] This includes the transfer of a controlling interest in an entity that owns real property. In the case of a corporation, this is defined as 50 percent or more of the total combined voting power of all classes of stock of the corporation, or 50 percent or more of the total fair market value of all classes of stock of such corporation; in the case of a partnership, 50 percent or more of the capital or profits interest in such partnership.

In the case of commercial real property with a value in excess of $500,000, the RPTT is imposed at the rate of 2.625 percent of the consideration.[xix] Payment, along with a joint return,[xx] are due within thirty days after the delivery of the deed by the grantor to the grantee.[xxi] If the grantor does not pay the amount of tax due, the grantee also becomes liable for the tax.

As in the case of the RETT, there are certain transactions that are exempt from the RPTT, including one that effects a mere change of identity, or form of ownership or organization, to the extent the beneficial ownership of the real property or of the economic interest therein remains the same.[xxii]


In a situation in which both the RETT and the RPTT apply – i.e., a taxable transfer of real property, or of an interest in such property, located in NYC – the grantor will be faced with a combined RETT and RPTT rate of up to 3.275 percent in the case of commercial property. This may result in a not insignificant increase in the overall cost of a transaction and, so, has to be considered by the parties in assessing the economics of a deal.

For example, the sale of real property in NYC in exchange for consideration of $20 million generates a RETT of $130,000 (0.65 percent) and a RPTT of $525,000 (2.625 percent), for a total of $655,000 in transfer taxes that must be paid by the seller shortly after closing the sale.

When this amount is added to the income taxes that are to be incurred on the sale,[xxiii] the seller may want to consider other options for “disposing” of their property, including, for example, a lease.

Creation of a Lease and the RETT

A conveyance for purposes of the RETT includes the transfer of an interest in real property located in NYS, which may include the granting of a leasehold in such property.

There are two ways by which the creation of a lease will be subject to the RETT. The first is where:

(1) the sum of (a) the term of the lease, and (b) any options for renewal exceeds 49 years; and

(2) substantial capital improvements are, or may be made, by or for the benefit of the lessee; and

(3) the lease is for substantially all of the premises constituting the real property.

“Substantially all” means at least 90 percent of the total rentable space of the premises, exclusive of common areas. For the purpose of determining whether a lease is for substantially all of the premises constituting the real property, “premises” generally include, but are not limited to, the following:

(i) an individual building;[xxiv] or

(ii) where a lease is of vacant land only, any portion of such vacant land.[xxv]

The second way by which the creation of a lease will be subject to the RETT is where an option to purchase real property is coupled with the granting of the right to use and occupancy of the real property.

Therefore, the creation of a lease coupled with the granting of an option to purchase the real property, regardless of the term of the lease, is a conveyance subject to the transfer tax.[xxvi]

RETT: Consideration for a Lease

In general, where the creation of a lease constitutes a conveyance subject to the RETT, the consideration used to compute the tax is equal the present value of the right to receive rental payments for the term of the lease, the present value of rental payments attributable to any renewal term, plus any amount paid for an option to purchase.

A discount rate equal to 110 percent of the federal long-term rate,[xxvii] compounded semiannually, is generally used in determining the present value of such payments which constitute consideration in the case of the creation of a taxable lease. The lower the rate, the greater the present value of the rental payments, and the greater the consideration on which the RETT is imposed.

The discount rate is applied to the net rents from the property.[xxviii]Net rents” means the amount by which gross rents exceed the lessor’s operating costs.[xxix]

In the case of a lease created for a term of less than 49 years, that contains an option to purchase the real property, net rental payments for periods that occur after the option is no longer exercisable, are not included in the calculation of consideration.

RETT Lease Examples

The foregoing concepts are illustrated in the following examples.[xxx]

Example 1:

A, as lessor, creates a lease with B as lessee. The lease is for a term of 60 years and covers an entire office building owned by A. The terms of the lease allow B to make substantial capital improvements to the building. The gross rents to be received by A over the term of the lease total $5 million. Operating costs are estimated to be $2 million. Net rents total $3 million (gross rents of $5 million less operating costs of $2 million paid by A). Assume the present value of the net rents is $550,000.

Since all three of the conditions set forth above are met, the creation of the lease constitutes a conveyance subject to tax. The taxable consideration is $550,000, the present value of the net rents. The total tax due, at the rate of $2 for each $500 of consideration, is $2,200.

Example 2:

Same facts as in Example 1, except that the lease is for a term of 30 years with no option to renew included. Since the lease is for a term of less than 49 years, the creation of the lease is not a conveyance subject to the transfer tax.

Example 3:

Same facts as in Example 1, except that the lease created between A and B has a fixed term of 30 years and B is granted an option to renew the lease at the end of the fixed term for another 30 years. This would be treated as the creation of a 60-year lease and, therefore, would be a taxable conveyance. The consideration used to compute the tax includes the present value of the net rental payments to be received during the fixed term and the renewal term.

Example 4:

Corporation Z owns a ten story building. Corporation Z creates a 60-year lease with corporation Y as tenant, such lease covering five floors of the building (50 percent of the premises). Since the lease covers less than 90 percent of the rentable space of the premises, the creation of the lease is not a conveyance subject to the transfer tax.

In the case of the creation of a lease for less than 49 years, coupled with the granting of an option to purchase, the consideration for purposes of determining the RETT is (a) the present value of the net rental payments under the lease, plus (b) the consideration paid for the granting of the option to purchase. Rental payments for periods that occur after the last date that the property may be purchased, if the option is exercised, are not included in the calculation of the present value of the rental payments.[xxxi]


A, as lessor, creates a lease of a building with B as lessee. The term of the lease is 20 years. The lease contains an option to purchase the building which is exercisable through the tenth year of the lease. If the option is exercised, the lease provides that the property will be transferred to B not later than 6 months after the option is exercised. B paid $10,000 specifically for the granting of the option.

Since this is the granting of an option with use and occupancy, the transaction is subject to the transfer tax. The consideration used to compute the tax would be the present value of the net rental payments to be received from the effective date of the lease through the expiration of the first ten years and six months of the lease, which is the period during which the property may be purchased pursuant to the option, plus the $10,000 paid for the granting of the option.

It should be noted that a grantor who acquired real property by exercising an option to purchase such property will be allowed a credit against the tax due on a subsequent conveyance of the property to the extent tax was paid by the grantor on a prior creation of a leasehold of all or a portion of the same real property or on the granting of an option or contract to purchase all or a portion of the same real property, by such grantor.[xxxii]

RPTT: Creation of, and Consideration for, a Lease

The RPTT is imposed at the time of the delivery of a deed by a grantor to a grantee, which includes a writing whereby a leasehold interest is granted in real property located in NYC.

In general, the RPTT is based upon the price actually paid or required to be paid for the real property or economic interest therein; i.e., the amount paid for the leasehold interest.

However, unlike the RETT, the amount of the consideration subject to the RPTT at the grant of a leasehold interest does not include any amount that is treated as rent for purposes of the commercial rent tax.[xxxiii] Significantly, there does not appear to be a requirement that the tenant be subject to the commercial rent tax. In other words, the consideration subject to the RPTT does not include the amount paid or required to be paid by a tenant for the use or occupancy of the premises anywhere within NY;[xxxiv] rather, it seems to include only the amount paid by the tenant to obtain the lease.

The determinative issue, therefore, is whether a payment made by a grantee to a grantor in connection with the grant of a leasehold interest was rent paid to the grantor in their capacity as a landlord, or whether it was paid in consideration of something else.[xxxv]

Lease Instead of Sale?

Might the application of the RPTT to the grant of a leasehold interest – or, more specifically, the calculation of the consideration paid by the grantee for such leasehold interest – present an opportunity for the owner of NYC real property who wants to develop such property but does not want to sell the property or contribute it to a joint venture, with the attendant tax costs? Should it encourage the owner to consider a lease arrangement with the developer, perhaps in the form of a ground lease?

After all, the RPTT seems to disregard the rental payments for purposes of determining the transfer tax. While the RETT would take the rental payments into account, the NYS tax rate is relatively low, at least when compared to NYC’s rate. The lease will not constitute a sale of the real property, provided the burdens and benefits of ownership remain with the owner; thus, no taxable gain is realized. What’s more, although the owner’s contribution of the real property to a joint venture partnership may not result in the imposition of any income tax,[xxxvi] the owner will likely incur RETT and RPTT to the extent there is a reduction of their beneficial interest in the contributed property.

In light of the foregoing, and assuming the use of a lease is feasible and makes sense from a business perspective, the owner of real property located in NYC may want to consider a lease arrangement as the first step in the development of the property.

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

[ii] There are differences between them, some more significant than others. The adviser should not assume that the two sets of rules are identical.

[iii] In general, NYS refers to a conveyance while NYC refers to a deed.

[iv] Of course, both the NYS and NYC taxes may apply to the conveyance/deed of an interest in real property located in NYC. Again, I use the word “may” because a transfer that is taxable by NYS may not be taxable by NYC and vice versa.

[v] NY Tax law Sec. 1401(e). This includes the creation of a leasehold. It also includes the transfer of a controlling interest in an entity with an interest in real property.

[vi] Tax Law Sec. 1401(f).

[vii] There is no installment reporting for the transfer tax.

[viii] Commercial real property is real property that is not residential property. Residential property is any premises that is or may be used in whole or in part as a personal residence; this includes a one-, two- or three-family house, a condominium unit, and a cooperative apartment unit.

[ix] $2 for every $500 of consideration (or fractional part thereof). NY Tax Law Sec. 1402; 20 NYCRR Sec. 575.2.

[x] Effective July 1, 2019 for conveyances in cities having a population of at least one million.

[xi] NY Tax Law Sec. 1404; 20 NYCRR Sec. 575.4.

[xii] NY Tax Law Sec. 1409 and Sec. 1410.

If a conveyance is to be recorded, the return must be filed with the recording officer of the county where the conveyance is recorded. A recording officer cannot record a conveyance unless the transfer tax return has been filed and any tax due has been paid. Recording officers are authorized to collect the tax and accept returns only in those cases where an instrument effecting a conveyance of real property is presented for recording. 20 NYCRR Sec. 575.14(b).

[xiii] Sec. 1401(e). It should be noted that a tax deferred like kind exchange under IRC Sec. 1031 is not exempted, as such, from the RETT or the RPTT.

[xiv] NY Tax Law Sec. 1405(b)(6). A conveyance to effectuate a mere change of identity or form of ownership or organization where there is no change in beneficial ownership.

[xv] NYC Admin. Code Sec. 11-2101.2.

[xvi] NYC Admin. Code Sec. 11-2102(a).

[xvii] NYC Admin. Code Sec. 11-2101.7. Compare this to the definition of a “controlling interest” under the RETT. NYC Admin. Code Sec. 11-2101.8.

[xviii] NYC Admin. Code Sec. 11-2102(b). Thus, one will have paid $100 of RETT before any RPTT is owed: ($25,000/$500) x $2 = $100.

[xix] NYC Admin. Code Sec. 11-2102. Generally speaking, the RETT rate does not depend upon the kind of property being transferred.

[xx] NYC Admin. Code Sec. 11-2105.

[xxi] NYC Admin. Code Sec. 11-2104.

[xxii] NYC Admin. Code Sec. 11-2106(b)(8).

[xxiii] Which, in the case of an individual seller, would include federal capital gain tax at 20%, perhaps unrecaptured depreciation at 28%, perhaps depreciation recapture at 37%, perhaps the net investment income surtax at 3.8%, NYS income tax at 8.82%, and NYC income tax at 3.876%.

[xxiv] Except for space which constitutes an individual condominium or cooperative unit.

[xxv] 20 NYCRR Sec. 575.7(a).

[xxvi] 20 NYCRR Sec. 575.7(c).

[xxvii] Which is determined pursuant to IRC Sec. 1274(d). The federal long-term rate in effect 30 days prior to the date of transfer is used when computing this discount rate.

[xxviii] 20 NYCRR Sec. 575.7(b).

[xxix] Such operating costs include amounts paid for heat and gas, electricity, furnishings, insurance, maintenance, management and real estate taxes. Operating expenses paid directly to third parties by the lessee, for example, under a net lease, are not included in gross rents, nor are they deductible as operating costs. If the lease specifies that the lessor will pay a fixed amount of operating expenses, the lessor may deduct such amount from gross rents in computing net rents. If there is no itemization of the operating costs paid by the lessor and, according to the terms of the lease, the lessor must pay such costs, the lessor may make a reasonable estimate of such costs.

[xxx] From 20 NYCRR Sec. 575.7.

[xxxi] 20 NYCRR Sec. 575.7(c).

[xxxii] NY Tax Law Sec. 1405-A.

[xxxiii] NYC Admin. Code Sec. 11-2102(a)(10)(iii).

NYC requires most tenants to pay the CRT based on the tenant’s base rent (generally at an effective rate of 3.9%) where the annual base rent exceeds $250,000. The CRT is imposed only with respect to “taxable premises.” The term “taxable premises” generally means any premises located south of the center line of 96th Street in Manhattan that are occupied or used for the purpose of carrying on any trade, business, or other commercial activity, including any premises that is used solely for the purpose of renting the same premises in whole or in part to tenants.

The term “base rent” means the amount paid, or required to be paid, by a tenant for the use or occupancy of premises for an annual period, whether received in money or otherwise.

In none of the very few rulings issued by the NYC Department of Finance has the City indicated that this favorable treatment of rent applies only to taxpayers that are, in fact, subject to the commercial rent tax.

[xxxiv] NYC Admin. Code Sec. 11-701.6. Also not included is any payment required to be made by a tenant on behalf  of  his  or  her  landlord for real estate taxes, water rents or charges,  sewer  rents  or  any  other  expenses  (including insurance) normally  payable  by a landlord who owns the realty other than expenses for the improvement, repair or maintenance of the tenant’s premises.

[xxxv] See In The Matter Of The Petition of RHM-88, LLC TAT(H) 2001-23(RP) January 11, 2006, where the taxpayer argued, unsuccessfully, that the amounts paid were rent and, therefore, exempt from the RPTT.

[xxxvi] IRC Sec. 721.

Sale of Stock

Ask a business owner to identify the parties to an agreement for the purchase and sale of the stock of a target corporation, perhaps even their own. After giving you a quizzical look,[i] they will likely reply that, on the one hand, you have the target’s shareholders, who will be selling their shares of target stock; on the other, you have the buyer, who will be purchasing those shares of target stock from the target’s shareholders.

Ask the same question of the target’s tax advisers, and you will likely hear the following: “It depends.” Now it’s your turn to give the quizzical look, to which the adviser will respond with their own questions, among which may be the following: how many shareholders are there, how many shares do they each own, how long have they held them, and what is each shareholder’s basis for their shares; how are the shareholders treated for tax purposes – individuals, trusts, estates, corporations, partnerships; are any of them likely to resist a sale, is there a shareholders’ agreement and, if so, does it include a drag-along provision; how many buyers are there, and what is their status for tax purposes; is the buyer interested in a basis step-up for the target’s assets; what long-term debts does the corporation have; does it own any real property; is the corporation a party to any agreements with change-in-control provisions?[ii]

Your responses to these questions are certain to raise still more questions as the adviser tries to gather all of the relevant facts that are to be introduced in the opening chapter of the unfolding story that is the sale of a business.

What about the Target?

The target corporation is often viewed as a passive character in this story – the object that is being transferred from one party to the other.

Although there is an element of truth in this perception of the target, at least with respect to the actual transfer of its stock, advisers who are experienced in “stock deals” know that the target is, itself, a vital player in the transaction and, as such, will likely incur significant costs throughout the term of the transaction. For example, the well-advised target will retain the services of qualified accounting and legal professionals to assist it in responding to the buyer’s due diligence requests. The target may also become obligated to pay a bonus to certain key employees as a result of the sale of its stock.

The tax treatment of these costs will, in turn, affect the overall economic cost of the acquisition to the sellers, the buyer, and to the target itself. 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. Where the costs must be capitalized (for example, added to the basis of the acquired stock), they may reduce the amount of capital gain realized by the seller on the sale of the target,[iii] whereas, in the case of the buyer, they may be recovered on a subsequent sale or liquidation[iv] of the target.

Costs Incurred by the Target

In general, the costs incurred by the target to facilitate the sale of its stock must be capitalized by the target. An amount is paid to “facilitate” a purchase and sale transaction if it is incurred in the process of investigating or otherwise pursuing the transaction. Whether an amount is incurred “in the process of investigating or pursuing the transaction” is determined based on all of the facts and circumstances. In order to simplify the determination of whether certain “routine” costs are incurred to facilitate a transaction, the IRS’s regulations provide that employee compensation and overhead costs are treated as amounts that do not facilitate an acquisition transaction and, thus do not need to be capitalized; instead, they may be deducted against the taxpayer’s operating income in the year they are incurred.

In general, an amount incurred by the taxpayer[v] in the process of investigating or otherwise pursuing the taxable acquisition of a corporation’s stock facilitates the transaction only if the amount relates to activities performed on or after the earlier of: (i) the date on which a letter of intent (“LOI”), exclusivity agreement, or similar written communication is executed by the acquirer and the target; and (ii) the date on which the material terms of the transaction are authorized or approved by the taxpayer’s governing board or officials. This “pre- vs. post-LOI timing rule” provides a helpful bright-line approach to the treatment of many deal expenses. However, the rule does not apply in the case of amounts incurred in the process of investigating or otherwise pursuing an acquisition transaction if they are “inherently facilitative.”[vi] Such amounts must be capitalized by the taxpayer regardless of whether they are incurred for activities performed prior to, or after, the execution of an LOI.

This is all well and good for a seller and for a buyer – one increases its basis for the shares of stock it is selling, while the other increases its basis for the shares of stock it is acquiring. But how does the target corporation – the shares of which are being purchased and sold – capitalize its costs? Do its expenditures create some kind of intangible asset, the cost of which may later be recovered?

This issue was considered by the IRS in a recent technical advice memorandum.[vii]

The Stock Transaction

In Year 1, Taxpayer, which was a corporation engaged in Business, acquired the stock of Target, a manufacturer of Products, in a taxable reverse triangular merger.[viii] Taxpayer and Target stated that the merger was intended to achieve cost synergies that would generate long-term growth and increased efficiencies for both Taxpayer’s and Target’s shareholders, customers, and employees.

Fees Incurred by Target

In connection with the sale of its stock to Taxpayer, Target paid various professional fees and administrative expenses. These included payments to several law firms, investment firms, accounting firms, other professional firms, and regulatory agencies. Target determined the portion of these fees and expenses that was paid in the process of investigating or otherwise pursuing its acquisition by Taxpayer, and therefore, was required to be capitalized as costs of facilitating the acquisition of its trade or business.[ix] Target also determined the amount that represented “success-based fees”[x] and elected to allocate those success-based fees between facilitative costs, which were required to be capitalized, and non-facilitative costs, which were deducted currently as business expenses.[xi]

Capitalized by Target

Taxpayer indicated that Target capitalized the facilitative fees as an intangible asset on its tax books. Taxpayer stated that “since this asset was not acquired as part of the transaction, but rather created by the transaction, neither Taxpayer nor Target recorded an intangible asset for the facilitative fees for financial accounting purposes. What’s more, neither Taxpayer nor Target amortized these fees under any provision of the Code or regulations.

Not long after its acquisition of Target, Taxpayer decided to divest itself of its Products business.[xii] After considering several suitors, Taxpayer sold the Target stock to Buyer. Taxpayer claimed a capital loss from the sale. However, in determining Target’s separate taxable income for the year of the sale, Taxpayer claimed an ordinary loss for Target which was attributable to the above-referenced fees that had been capitalized by Target.

During a subsequent examination of Target’s federal income tax return, the IRS examiner requested technical advice[xiii] from the IRS Office of Chief Counsel (the “OCC”)[xiv] as to the following issue: Whether the professional and administrative fees paid by Target in connection with Taxpayer’s acquisition of Target’s stock created or enhanced a separate and distinct intangible asset?

OCC’s Analysis

The OCC began by noting that IRS regulations generally require taxpayers to capitalize: (i) an amount paid to another party to acquire an intangible from that party in a purchase or similar transaction, (ii) an amount paid to another party to create an intangible, (iii) an amount paid to another party to create or enhance a separate and distinct intangible asset, or (iv) an amount paid to facilitate the acquisition or creation of any of the foregoing intangibles.[xv]

A “separate and distinct intangible asset,” the OCC explained, means a property interest of “ascertainable and measurable value” in money’s worth that is subject to protection under applicable state, federal or foreign law, and the possession and control of which is intrinsically capable of being sold, transferred or pledged separate and apart from a trade or business.[xvi]

The regulations also provide that a taxpayer must capitalize an amount paid to facilitate a business acquisition or reorganization transaction, including, among other transactions, an acquisition of an ownership interest in the taxpayer (other than an acquisition by the taxpayer of an ownership interest in the taxpayer, whether by redemption or otherwise).[xvii]

Assuming a facilitative cost is capitalized, the regulations provide rules for the treatment of such costs by the acquirer and target corporations in the context of transactions that involve taxable asset acquisitions. The OCC observed, however, that the regulations expressly reserve on the treatment of a target’s facilitative costs in a taxable stock acquisition.[xviii]

Taxpayer’s Position

The OCC then considered whether certain professional and administrative fees paid by Target in connection with the taxable acquisition of its stock by Taxpayer created or enhanced a separate and distinct intangible asset. The OCC explained that Taxpayer agreed with the IRS that the professional and administrative fees incurred by Target in its acquisition by Taxpayer would not, by themselves, qualify as a separate and distinct intangible asset. Instead, Taxpayer argued that Target paid these amounts to create a separate and distinct intangible asset in the form of the “synergistic benefits” that Target expected to receive from its combination with Taxpayer.

Taxpayer contended that these benefits arose from Target’s access to Taxpayer’s markets, research, quality and innovation platforms, management approaches, and supply chain productivity tools. Under this analysis, Taxpayer argued that the administrative and professional fees paid by Target in connection with Taxpayer’s acquisition of its stock created a separate and distinct intangible asset that was properly capitalized by Target. However, this asset became useless to Target at the termination of its relationship with the Taxpayer; that is, when Taxpayer sold Target’s stock to Buyer.

Taxpayer contended that this conclusion was consistent the U.S. Supreme Court’s analysis in INDOPCO, Inc. v. Commissioner,[xix]  which reasoned that professional expenses incurred by a target corporation in the course of a friendly takeover were required to be capitalized, in part, because of the synergistic benefits expected to be generated by the combination of the target and acquirer’s businesses. Taxpayer contended that in Target’s case, these synergistic benefits comprised a separate asset that was properly recoverable at the end of the asset’s useful life, consistent with the premise of INDOPCO. Taxpayer also argued that, by not providing regulations that specifically address the treatment of a target’s capitalized facilitative costs in taxable stock acquisitions, the IRS had implicitly sanctioned alternative treatments, such as “treating such costs as creating a new asset the basis of which may or may not be amortizable.”

OCC’s Response

The OCC, however, agreed with the IRS examiner that the treatment of Target’s professional and administrative costs was addressed by the regulations. As summarized above, the regulations provide rules for determining whether a taxpayer must capitalize (i) amounts paid to acquire an intangible, (ii) amounts paid to create an intangible, or (iii) amounts paid to create or enhance a separate or distinct intangible asset.[xx]

In contrast, the OCC pointed out, the rules for determining whether a taxpayer must capitalize the amounts paid or incurred to facilitate the acquisition of a trade or business provide that a taxpayer must capitalize an amount paid to facilitate an acquisition of an ownership interest in the taxpayer.[xxi]

Both the IRS examiner and the Taxpayer agreed that Target’s professional and administrative fees were incurred by Target in the acquisition of its business by Taxpayer, and that these fees facilitated this acquisition.

Moreover, Taxpayer provided no arguments that these costs were incurred to acquire or create any of the intangible assets described in the regulations. As such, the OCC stated, the professional and administrative fees paid by Target were not amounts incurred to acquire or create a separate and distinct intangible and, so, could not capitalized as such.

Rather, under the applicable rules,[xxii] these fees were properly capitalized by Target as the costs of facilitating an acquisition of Target’s business.

While the regulations are clear that a Target must capitalize the costs of facilitating the acquisition of its trade or business, Taxpayer correctly observed that they specifically reserved, and therefore do not address, the treatment of Target’s costs capitalized in a taxable stock acquisition. Nevertheless, the absence of regulations did not imply, the OCC stated, that any particular treatment was correct. Rather, with regard to Taxpayer’s facts, the OCC believed that longstanding case law, including the Supreme Court’s analysis in INDOPCO, was determinative.

The OCC explained that, in INDOPCO, the Supreme Court addressed a situation that was similar to that of Taxpayer and Target. In that case, the Court decided that certain professional investment, banking, and legal costs incurred by a target corporation in the course of a friendly takeover were required to be treated as capital expenditures. In its analysis, the Court clarified that the creation of a separate and distinct asset may be sufficient, but was not a necessary prerequisite, for determining that a taxpayer must capitalize costs. The Court also determined that a taxpayer’s expectation of significant future benefits from a corporate acquisition or restructuring was another appropriate basis to require capitalization. The Court noted that the target expected to benefit from both the acquiring corporation’s enormous resources and from the cost savings and administrative conveniences stemming from its transformation from a freestanding corporation to a wholly-owned subsidiary. The Court stated that such expenses have long been treated as “incurred for the purpose of changing the corporate structure for the benefit of future operations.”

The Court also pointed out that courts more frequently have characterized an expenditure as capital in nature because the “purpose for which the expenditure is made has to do with the corporation’s operations and betterment, sometimes a continuing capital asset, for the duration of its existence or for the indefinite future or for a time somewhat longer than the current taxable year.” Thus, in INDOPCO, the Court addressed not only the requirement to capitalize costs that produce significant future benefits, but also the nature of professional and administrative costs incurred by a target corporation in the course of its acquisition by another corporation. In its reasoning, the Court made clear that these costs were incurred for the restructuring of the target corporation, its continuing operations and betterment, for the duration of its existence, and not for the acquisition of an intangible asset that was separate and distinct from its ongoing business. In discussing the treatment of capital expenditures, the Court explained that a capital expenditure is usually amortized or depreciated over the life of the relevant asset or, where no specific asset or useful life can be ascertained, is deducted upon dissolution of the enterprise.

The OCC concluded that Taxpayer’s facts were analogous to the facts in INDOPCO, and that the same analysis and conclusion were warranted. Thus, the professional and administrative fees paid by Target in connection with Target’s acquisition by Taxpayer did not create or enhance a separate and distinct intangible asset but were incurred to facilitate a restructuring of Target’s trade or business. Consistent with INDOPCO, these facilitative costs were characterized as the costs of acquiring significant future benefits for Target’s business and operations, and they would remain capitalized for the life of that business – generally, the duration of Target’s business enterprise.

Therefore, the professional and administrative fees paid by Target in connection with Taxpayer’s acquisition of Target did not create or enhance a separate and distinct intangible asset.

Parting Thoughts

The OCC was right in concluding that Target’s capitalized expenditures neither created, nor added to the value of, a separate and distinct intangible asset.

To the extent any economic benefit resulted from Target’s pre-acquisition outlays, it was manifested in the consideration ultimately exchanged between the Taxpayer and Target’s shareholders.

If there had been a subsequent increase in Target’s value, it would have been attributable to its post-acquisition relationship with Taxpayer, not because of any asset arising from Target’s pre-acquisition expenditures.

That being said, how should the parties to a straight stock sale[xxiii] – i.e., the selling shareholders and the buyer – account for the facilitative and other capitalized costs incurred by the target corporation in connection with the purchase and sale of the target’s stock?

It is not unusual for the buyer to insist that the sellers bear the target’s transactional expenses.[xxiv] Without such a provision, after all, the buyer will indirectly bear such costs once it acquires all of the target’s stock. Alternatively, the parties will sometimes agree to share these costs.

At the end of the day, it’s all about economics and the parties’ leverage relative to one another that will determine which of them will be bear the burden of the target’s outlay of value. Thus, it will behoove each side of the deal to be aware of these target expenditures and to account for them in determining the total consideration and the overall economic effect of the transaction on the seller or the buyer, as the case may be.

[i] Many years ago, a close client said to me, in response to what he thought was a silly question: “Duh? Lou!” Never expecting him to say such a thing, I was in tears from the laughter. We still talk about it.

[ii] There’s a lot to consider. A recalcitrant shareholder who is not interested in selling their stock may necessitate the use of a reverse merger to effectuate the stock sale and compel such shareholder to go along (subject to dissenter’s rights under state law). If an election under IRC Sec. 338(h)(10) or Sec. 336(e) is being considered – which would cause the stock sale to be treated as a sale of assets, followed by the liquidation of the target, for tax purposes – the presence of such a shareholder could be a major stumbling block. These two issues may be anticipated and addressed in a shareholders’ agreement.

[iii] IRC Sec. 1001.

[iv] Other than into an 80-percent parent corporation. IRC Sec. 332 and Sec. 337.

[v] Other than employee compensation and overhead costs.

[vi] An amount is inherently facilitative if the amount is incurred for: (i) Securing an appraisal, formal written evaluation, or fairness opinion related to the transaction; (ii) Structuring the transaction, including negotiating the structure of the transaction and obtaining tax advice on the structure of the transaction; (iii) Preparing and reviewing the documents that effectuate the transaction (for example, a purchase agreement); (iv) Obtaining regulatory approval of the transaction; (v) Obtaining shareholder approval of the transaction; or (vi) Conveying property between the parties to the transaction (for example, transfer taxes).

[vii] TAM 202004010 (Jan. 24, 2020).

[viii] In which a wholly-owned subsidiary of Taxpayer was merged with and into Target; Taxpayer exchanged shares in its subsidiary for shares of Target; the Target shareholders exchanged their Target shares for cash; Target survived as a subsidiary of Taxpayer.

[ix] Under Reg. Sec. 1.263(a)-5(a).

[x] Reg. Sec. 1.263(a)-5(f).

[xi] The IRS has provided taxpayers a simplified method for allocating between facilitative and non-facilitative activities any success-based fee paid in a “covered transaction.” Under this safe harbor for allocating a success-based fee, an electing taxpayer may treat 70-percent of the success-based fee as an amount that does not facilitate the transaction; this amount would be currently deductible by the taxpayer. The remaining portion of the fee would be capitalized as an amount that facilitates the transaction. Rev. Proc. 2011-29, 2011-18 I.R.B. 746.

[xii] WTH, right?

[xiii] A technical advice memorandum, or TAM, is guidance furnished by the Office of Chief Counsel upon the request of an IRS director or an area director, appeals, in response to technical question that develops during a proceeding. A request for a TAM generally stems from an examination of a taxpayer’s return. TAMs are issued only on closed transactions and provide the interpretation of proper application of tax laws, regulations, revenue rulings or other precedents. The advice rendered represents a final determination of the position of the IRS, but only with respect to the specific issue in the specific case in which the advice is issued.

[xiv] The chief legal advisor to the IRS on all matters pertaining to the interpretation, administration and enforcement of the Internal Revenue Laws.

[xv] Reg. Sec. 1.263(a)-4(b)(1).

[xvi] Reg. Sec. 1.263(a)-4(b)(3)(i). The determination of whether a payment creates a separate and distinct intangible asset is made based on all of the facts and circumstances existing during the taxable year in which the payment is made.

[xvii] Reg. Sec. 1.263(a)-5(a)(3).

An amount is paid to facilitate a transaction if it is paid in the process of investigating or otherwise pursuing the transaction. Whether a payment if made for this purpose is determined based on all of the facts and circumstances. The amount paid by a buyer to the target’s shareholders in exchange for their stock in a stock acquisition is not an amount paid to facilitate the acquisition of the stock. Reg. Sec. 1.263(a)-5(b)(1).

[xviii] Reg. Sec. 1.263(a)-5(g)(2)(ii)(B).

[xix] 503 U.S. 79 (1992).

[xx] Reg. Sec. 1.263(a)-4.

[xxi] Reg. Sec. 1.263(a)-5(a)(3).

[xxii] Reg. Sec. 1.263(a)-5.

[xxiii] No joint election under IRC Sec. 338(h)(10) or seller election under IRC Sec. 336(e).

[xxiv] This may be reflected, for example, in the purchase price or in the working capital adjustment.