Uptick in Business Divorces?
I’ve read a number of articles over the last few weeks in which marriage counselors have been predicting a wave of divorce filings once the COVID-19 quarantine has been lifted.[i]
That may be – we’ll just have to wait and see.[ii] Query, however, whether “business divorces” will follow suit?
The quarantine and the resulting economic downturn have likely created, highlighted, or aggravated stress points among the owners of many businesses. Disagreements over steps already taken by the business in response to the downturn, or differing opinions on the direction in which to steer the business once it emerges from quarantine,[iii] will probably cause a number of business owners to go their separate ways.
Of course, the mechanics by which such a break-up is effectuated will depend upon a number of factors, including whether the owners are already parties to a shareholders, partnership or operating agreement that specifies the form of buyout. In the absence of such an agreement, each of the owners will seek to optimize their respective after-tax economic consequences. In turn, this will inform their decisions as to the structure of the transaction, the determination of the nature and amount of the consideration to be exchanged, and the timing of such exchange.
A recent decision of the U.S. Tax Court[iv] considered the pre-coronavirus breakup of a joint venture that resulted in litigation, but which was settled for a lump-sum payment to Taxpayer in exchange for Taxpayer’s relinquishing whatever rights it had in the joint venture. Taxpayer and the IRS disagreed as to the tax treatment of this payment.
Although the Court ultimately sided with Taxpayer, the IRS raised some interesting points – although other issues were left untouched – in the context of the cross-purchase buyout[v] of a partner, of which partners and their tax advisers should be aware.
The Joint Venture
Taxpayer was a real estate development and investment firm. It would locate desirable properties to develop, and would then partner with others who would provide the capital needed for such development.
Taxpayer connected with Partner, who was interested in financing the development of certain properties identified by Taxpayer. The parties executed a term sheet which set forth the major terms for a real estate development joint venture.
While Taxpayer and Partner were working on developing these properties – each as a separate venture – conflicts arose between them. The parties struggled to formalize the terms of their deal in a written agreement, but never succeeded in doing so.
Eventually, Partner replaced Taxpayer with another development company.
Partner then filed a complaint against Taxpayer in which Partner claimed that Taxpayer did not have any interest in Partner’s joint ventures,[vi] and Partner sought declaratory relief and damages for conversion, imposition of constructive trust, breach of contract, and breach of fiduciary duty.[vii]
Partner asserted that “[p]ending the execution and delivery of written agreements [Taxpayer and Partner] entered into an oral contract, pursuant to which [Taxpayer] rendered services to and for [Partner].”
Taxpayer filed a cross-complaint alleging that Partner had breached its fiduciary duties to Taxpayer as a joint-venturer. Taxpayer sought declaratory relief and partition of the properties. Taxpayer asserted that its joint venture with Partner was reflected “in many oral and written statements and emails.” It also alleged that the parties had operated according to the above-referenced term sheet, which the parties executed intending to finalize the terms of their joint ventures. Taxpayer claimed that because they were partners in a joint venture, Partner owed Taxpayer fiduciary duties of care and loyalty and had an obligation of good faith and fair dealing, and that repudiating the existence of the joint ventures breached those duties.
A jury was presented with Taxpayer’s claims for breach of fiduciary duty. The trial court instructed the jury that to establish its claim “[Taxpayer] must prove that [Partner was] in a joint venture with Taxpayer and that [Partner] excluded Taxpayer from a joint venture, wrongfully repudiated the existence of the joint venture and converted all of the joint venture assets to [its] own use.”
The Court explained that, under State law, the victim of “repudiation” of a partnership interest could choose among several methods of measuring damages. Taxpayer chose the “conversion measure of damages, which is the value of what was taken on the date of repudiation.”
Taxpayer’s expert determined the value of the repudiated joint venture interests by considering the future fees the joint ventures expected to receive,[viii] as well as other factors.
The jury found that Taxpayer and Partner had a joint venture, and that Partner breached its fiduciary duty to Taxpayer.
The court instructed the jury that “[i]f you find that * * * [Partner] breached [its] fiduciary duty, Taxpayer would be entitled to damages measured by the reasonable value, at the time of the breach, of Taxpayer’s interest in the joint venture(s) of which Taxpayer was deprived.” The jury awarded damages in an amount that matched the estimate provided by Taxpayer’s expert. The jury also found that Partner was liable for punitive damages.
After the judgment was entered, Partner appealed. While the appeal was pending, Taxpayer explored settling the case.
Taxpayer understood that the terms of any settlement agreement would affect the net after-tax proceeds. Taxpayer’s tax adviser, CPA, advised Taxpayer that the tax treatment of the settlement proceeds would likely depend on how the settlement agreement characterized the proceeds. CPA believed that if the settlement agreement provided for an exchange of Taxpayer’s joint venture interests for the settlement proceeds, the result would be favorable capital gain treatment for Taxpayer.[ix]
While the appeal was pending, Taxpayer and Partner reached a settlement. The settlement agreement included several relevant provisions; for example, it provided for Taxpayer’s transfer and relinquishment of the joint venture interests, and stated that each party sought legal counsel and advice regarding the agreement, including its tax consequences.
The Court described how the parties worked though several drafts before reaching a final agreement. According to the Court, their negotiations clearly demonstrated what the parties intended to achieve in the settlement agreement: Taxpayer wanted it to reflect “a transfer by [Taxpayer] of its joint venture interest in these projects with Partner, transferring them to Partner as an essential part of this transaction,” while Partner intended for agreement to cause Taxpayer to relinquish any ownership interests it had in the joint ventures.
Tax Return Challenged
The settlement agreement entitled Taxpayer to receive a payment from Partner. Taxpayer reported the payment on its tax return as long-term capital gain from the disposition of a partnership interest.[x]
The IRS challenged this tax treatment and sought to re-characterize the gain reported by Taxpayer as ordinary income. Specifically, the IRS asserted that the settlement proceeds represented lost fees,[xi] taxed as ordinary income.
The IRS argued that the valuations provided by Taxpayer’s expert in the State court proceeding showed that Taxpayer received damages for its interests in the joint ventures in the form of lost fee income.
The Court’s Opinion
The Court observed that the parties did not dispute that Taxpayer may treat amounts received in exchange for the joint venture interests as capital gains. Under the Code, it explained, the sale or exchange of a partnership interest is generally treated as the sale or exchange of a capital asset.[xii] Any amounts received as compensation for lost profits, however, must be treated as ordinary income.[xiii]
Nature of the Claim
The tax treatment of proceeds received in settlement of a claim, the Court continued, is generally guided by the nature of the claim, or the characterization of the claim for which the settlement was paid.[xiv]
The nature of the underlying claim, the Court stated, was a factual determination made by considering the settlement agreement in light of all the facts and circumstances; if the settlement agreement expressly allocated the settlement proceeds to a type of damage, the Court would generally follow that allocation if the agreement was reached by adversarial parties in arm’s-length negotiations and in good faith.
The settlement agreement between Taxpayer and Partner provided an express allocation. It provided that Taxpayer was receiving payment in exchange for its interests in the joint ventures – no portion of the payment was allocated elsewhere, and the Court saw no reason to read the agreement as other than expressly written.[xv]
Adverse and At Arm’s Length
The Court also pointed out that parties were adversarial and negotiated at arm’s length and in good faith regarding the nature of the settlement payment. It explained that drafts of the agreement showed that Taxpayer wanted the agreement to reflect both that it had joint venture interests and that it was transferring those interests. In contrast, Partner wanted language that supported its contention that Taxpayer only claimed to have interests. In the final agreement, however, Partner acknowledged that it was paying to acquire whatever interests Taxpayer had.
Moreover, Partner and Taxpayer had adverse tax interests, the Court stated, in the characterization of the payment. If Partner had made the payment to compensate Taxpayer for providing services, Taxpayer would have received ordinary income, taxable at ordinary income rates, while Partner would likely have been able to deduct a payment for services as an ordinary and necessary business expense.[xvi]
But if the payment was made in exchange for joint venture interests, Taxpayer would recognize long term capital gain, taxable at favorable capital gain rates. Partner, however, would have been required to treat any amounts paid for Taxpayer’s interests in the joint ventures as additions to its bases in the joint venture interests.[xvii]
These differing tax consequences of the payment’s characterization supported the conclusion that the parties were adverse for tax purposes.
Moreover, nothing in the facts and circumstances of the negotiation indicated that Taxpayer and Partner approached the settlement agreement other than in good faith and at arm’s length, or that the payment had a different purpose.[xviii] Indeed, the Court noted, the facts and circumstances surrounding the settlement agreement demonstrated that the payment was made in exchange for the joint venture interests.
Finally, the IRS argued that the valuation report prepared by Taxpayer’s expert valued both Taxpayer’s interests in the joint ventures and the lost fee income. Therefore, the IRS argued, the economic reality was that Partner compensated Taxpayer for the latter’s loss of future income. The Court disagreed.
The Court conceded that the expert used lost fee income as a factor in calculating the values of the joint venture interests. The Court explained, however, that it was a common and accepted method for valuing an asset to consider the future economic benefits the asset would bring to its owner.[xix]
Because the settlement agreement expressly allocated the settlement proceeds to payment for Taxpayer’s interests in the joint ventures, and because the settlement agreement, including the allocation provision, was negotiated by adversarial parties at arm’s length and in good faith, the Court concluded that Taxpayer received the settlement proceeds in exchange for its interests in the joint ventures. Thus, the sale proceeds were properly treated as gain from the sale of a capital asset.
There’s More to A Cross-Purchase
Once it was accepted that Taxpayer was a member of a joint venture with Partner, the buyout of its partnership (joint venture) interest, described above, represented a fairly straightforward affair.
Even so, there were a number of points on which the Court touched, and a few that were not discussed at all, that are worthy of further comment.
In general, the Code provides that the gain realized from the sale of a partnership interest is treated as gain from the sale of a capital asset.[xx]
However, if any of the consideration for the transferor’s interest in the partnership is attributable to the value of the partnership’s unrealized receivables[xxi] or inventory items,[xxii] then part of the gain from the sale of the interest will be considered as an amount realized from the sale or exchange of property other than a capital asset;[xxiii] in others words, ordinary income.[xxiv]
Interestingly, neither the IRS nor the Court made any mention of the application of this rule to attribute some of the consideration for Taxpayer’s interest to the properties being developed.[xxv]
It should be noted that the consideration to be paid in exchange for a transferor’s partnership interest includes not only the amount of cash and the fair market value of the property to be transferred by the purchaser to the transferor; it also includes the transferor’s share of partnership liabilities that are allocated away from the transferor as a result of the sale.[xxvi]
Moreover, such “ordinary gain” will not qualify for installment reporting; rather, the amount of such gain will be included in the transferor’s gross income for the taxable year of the sale notwithstanding that the payment of the consideration in respect thereof may be deferred to a later taxable year.[xxvii]
Similarly, the amount of the “debt relief” realized by the transferor in the taxable year of the sale will be treated as cash received in such year.
Inside Basis[xxviii] Adjustment
In general, the basis of partnership property is not adjusted as the result of a transfer of an interest in a partnership by sale or exchange unless an election under Section 754 of the Code is in effect with respect to the partnership.[xxix]
Where such an election is in effect, the partnership will increase the adjusted basis of the partnership property by an amount equal to the excess of the basis to the transferee (acquiring) partner of their interest in the partnership[xxx] over their proportionate share of the adjusted basis of the partnership property.[xxxi]
This increase will constitute an adjustment to the basis of partnership property with respect to the transferee partner only.[xxxii] Thus, for purposes of calculating income, deduction, gain, and loss, the transferee will have a special basis for those partnership properties the bases of which are adjusted.[xxxiii] In the case of partnership property that is amortizable or depreciable, the adjustment will be added to the transferee’s share of inside basis in determining their amortization or depreciation deduction and, on the sale of property, the adjustment will be subtracted from the amount of gain allocated to the transferee.[xxxiv]
The Court made no mention of Partner’s ability to recover any of the consideration paid for Taxpayer’s interest. To the extent such cost would have been added to property being developed for sale, it would be recovered at the time of sale by reducing the amount of income realized;[xxxv] if the cost was added to investment property, then Partner would have been looking at a much longer recovery period, depending upon whether the real property was nonresidential or residential rental property.[xxxvi]
A long-term capital gain is generated when there is a sale or exchange of a capital asset. A capital asset is generally defined as property held by the taxpayer, whether or not connected to their trade or business, subject to several statutory exceptions.[xxxvii] Long-term capital gain may also be generated on the sale of property used in a trade or business, of a character which is subject to depreciation, or of real property used in a trade or business.[xxxviii]
Against this background, Congress, the IRS and the Courts have, over the years, developed arguments that are intended to defeat attempts by taxpayers to “convert” ordinary income into capital gain. The hot asset rule, described above, represents one statutory attempt in support of this goal.
Another, judicially-developed, argument is embodied in the “substitute for ordinary income” doctrine. In brief, if an amount is received by a taxpayer for an interest in property, but the transaction is recast as a payment in lieu of future ordinary income payments, the amount received will also be treated as ordinary income – the taxpayer is merely converting future income into present income; they are accelerating the receipt of the income.[xxxix]
Taxpayers, on the other hand – like the Court in Taxpayer’s case discussed above – have argued that many assets, including closely held business interests, are valued on the basis of the present value of their future income stream.[xl] Thus, they assert, it is possible to take the “substitute for ordinary income” doctrine too far, and to thereby define the term “capital asset” too narrowly.
Between these two extremes, the courts have stated that they must make case-by-case judgements as to whether the conversion of income rights into a single payment reflects the sale of a capital asset that produces capital gain, or whether it produces ordinary income.[xli]
Assuming we do experience an increase in business divorces after the COVID-19 quarantine is lifted, business owners who have decided to go their separate ways will have to consider, together with their advisers, a number of transaction-related options, some of which will be more tax efficient than others.
In the case of a partnership, for example, they will have to decide whether a cross-purchase or a liquidation of the interests held by the departing partner(s) represents the best buyout structure.
They will have to consider the proper valuation method for the business and the interest to be acquired in light of the circumstances in which our economy (and probably the business) finds itself.
A related issue will be the financing for such a buyout.[xlii]
The partnership may also want to consider whether an in-kind distribution, whether in the form of a division of the partnership[xliii] or in liquidation of a partner’s interest in the distributing partnership,[xliv] may be the most cost effective and tax efficient means of separating the owners of the business. Of course, this may present its own valuation and other practical challenges. In addition, an in-kind distribution may trigger the disguised sale and mixing bowl rules, thus triggering the taxable event that the owners sought to avoid.[xlv]
Over the course of the following weeks, we will try to review many of these issues. At the end of the day, however, it will be incumbent upon the business owners, the business organization, and their advisers to sift through these factors, and others, as they decide upon the terms of the buyout.
[i] Causes? Money pressures: reduced earnings, maybe job loss? Not sharing household and family duties, including homework with the kids and taking care of the newly-acquired pet? (Whose idea was that anyway?) Close proximity to one’s elderly mother-in-law for an extended period of time. (Give me a few more weeks – I’ll get back to you on that.) Finally getting to know one another? (What ever happened to the “Newly Wed Game”? In retrospect, it appears to have been serving an important societal function.)
May we accept this as proof of the converse, that “absence makes the heart grow fonder?” Not necessarily.
[ii] In general, divorce statistics come from the States, the National Center for Health Statistics, and the Census Bureau.
[iii] For example, will they close offices, drop unprofitable lines of business, reduce the number of employees, pay down debt, establish reserves, cut “fat,” etc.?
[iv] NCA Argyle LP, v. Commissioner, T.C. Memo. 2020-56.
[v] Where the remaining partner or partners acquire the departing partner’s equity interest. This is to be contrasted with a liquidation of the departing partner’s interest, in which the partnership itself is the acquiring party.
[vi] Partner alleged that Partner and Taxpayer had negotiated potential terms for real estate development ventures but never entered any written agreement.
[vii] What do you think of “litigation speak?” Do you recall “A Fish Called Wanda?”
Wanda: Archie? Do you speak Italian?
Archie: I am Italian! Sono italiano in spirito. Ma ho sposato una donna che preferisce lavorare in giardino a fare l’amore appassionato. Uno sbaglio grande! But it’s such an ugly language. How about… Russian?
[viii] Which caught the attention of the IRS.
[ix] IRC Sec. 741, Sec. 1221, Sec. 1222, 1(h).
[x] Its interest in the joint venture with Partner.
[xi] As well as punitive damages.
[xii] IRC Sec. 741.
[xiii] Ordinary income is subject to federal income tax at a maximum rate of 37 percent. Amounts received as punitive damages are also taxable as ordinary income to the recipient.
[xiv] The “origin of the claim” doctrine.
[xv] The settlement agreement stated that it represented the entire understanding of the parties, including as to the character of the payment. The Court did not find that the parties’ agreement as to the price for the converted joint venture interests was inconsistent with the economic realities of the case; rather, the Court found that such price was within the reasonable range of value placed on the joint venture interests.
[xvi] IRC Sec. 162.
[xvii] IRC Sec. 1012.
[xviii] When an expressed settlement “is incongruous with the ‘economic realities’ of the taxpayer’s underlying claims,” the Court stated, “we need not accept it.”
[xix] Like distinguishing a share of stock from its dividend history, or a building from its rental income.
[xx] IRC Sec. 741. Of course, in order for the gain from the sale of the partnership interest to be treated as long-term capital gain, the partner must satisfy the “more than one year” holding period requirement. IRC Sec. 1222 and Sec. 1223.
[xxi] IRC Sec. 751(c).
[xxii] IRC Sec. 751(d). Inventory, together with unrealized receivables, are referred as “hot assets.”
[xxiii] IRC Sec. 751. There is no comparable rule for C corporations or S corporations. The so-called “collapsible corporation” rules (IRC Sec. 341), which bore only a passing resemblance to Sec. 751, were repealed in 2003.
[xxiv] For purposes of this rule, the term “unrealized receivables” includes, to the extent not previously includible in income under the method of accounting used by the partnership, any rights to payment for goods delivered, or to be delivered, to the extent the proceeds therefrom would be treated as amounts received from the sale or exchange of property other than a capital asset, or services rendered, or to be rendered.
It also includes several less obvious items; for example, depreciation recapture. IRC Sec. 1245. This is generally described as the amount of depreciation claimed by the taxpayer with respect to depreciable tangible personal property.
[xxv] It may be that these were not held for sale but, rather, for investment; i.e., rental.
[xxvi] IRC Sec. 752(d); Reg. Sec. 1.752-1(h). Of course, this debt may have also been added to the transferor’s basis for their partnership interest. To the extent the transferor-partner was able to claim deductions as a result of this increased basis – see IRC Sec. 704(d) – the inclusion of this debt in the amount realized serves to recapture this benefit.
[xxvii] IRC Sec. 453(b)(2) and 453(i); Mingo v. Comm’r, T.C. Memo 2013-149.
[xxviii] This refers to the partnership’s basis for its assets, whereas “outside basis” refers to a partner’s basis for their partnership interest.
[xxix] IRC Sec. 743(a). Note than such an election is not necessary in the case of a two-person partnership in which one partner purchases the interest of the other. In that case, Rev. Rul. 99-6 treats the partnership as having made a liquidating distribution of its properties and the purchasing partner as having acquired, from the departing partner, the latter’s share of the partnership’s properties.
[xxx] Basically, their cost basis for the partnership interest (IRC Sec. 1012), increased by their allocable share of partnership liabilities (IRC Sec. 752(a) and Sec. 722).
[xxxi] It’s also possible to have a negative adjustment. It’s important to note that, once made, the election is irrevocable without the consent of the IRS.
[xxxii] No adjustment is made to the common basis of partnership property.
[xxxiii] Reg. Sec. 1.743-1(j). IRC Sec. 755 and the regulations thereunder provide for the allocation of the adjustment amount among the partnership’s assets.
[xxxiv] In other words, a positive adjustment may generate increased deductions and reduced gain.
[xxxv] IRC Sec. 263A.
[xxxvi] IRC Sec. 168.
[xxxvii] IRC Sec. 1221.
[xxxviii] IRC Sec. 1231. These properties must not represent inventory or other property held primarily for sale to customers in the ordinary course.
[xxxix] Hort v. Commissioner, 313 U.S. 28 (1941).
[xl] An income approach to valuation; for example, the discounted cash flow and capitalization of cash flow methods.
[xli] Congress has addressed the issue in the case of a distribution in liquidation of a partnership interest where the amount to be distributed is determined with regard to the income of the partnership. IRC Sec. 736(a).
[xlii] And, in the case of acquisition indebtedness, the tax treatment of any related interest expense. IRC Sec. 163.
[xliii] Reg. Sec. 1.708-1(d).
[xliv] IRC Sec. 731 and Sec. 736.
[xlv] IRC Sec. 704(c)(1)(B), Sec. 707, and Sec. 737.