Introduction

The Tax Cuts and Jobs Act of 2017[1] went into effect only two weeks ago. Many of its provisions represent significant changes to the Code, and it will take most of us several months to fully digest them,[2] to appreciate their practical consequences, and to understand how they may best be utilized for the benefit of our clients.

Among the businesses on which the Act will have a significant and immediate effect is real estate. What follows is a summary of the principal effects of the Act on a closely held real estate business and its owners.[3]

There are many facets to a closely held real estate business, including the choice of entity in which to operate the business, the acquisition and disposition of real property, the construction or other improvement of the property, the financing of the foregoing activities, the rental of the property, the management of the business, and the transfer of its ownership.

The Act touches upon each of these activities. It is the responsibility of the business’s tax advisers to analyze how the changes enacted may affect the business, and to prepare a coherent plan that addresses these changes.

Individual Income Tax Rates

The Act reduced the maximum individual income tax rate from 39.6% (applicable, in the case of married joint filers, to taxable income in excess of $470,700) to 37% (applicable, in the case of married joint filers, to taxable income in excess of $600,000).

This reduced rate will apply to an individual owner’s net rental income. It will also apply to any depreciation recapture recognized on the sale of a real property.[4]

Income Tax

The Act did not change the 20% maximum rate applicable to individuals on their net capital gains and qualified dividends, nor did it change the 25% rate applicable to unrecaptured depreciation.

The Act also left in place the 3.8% surtax on net investment income that is generally applicable to an individual’s rental income, unless the individual can establish that he is a real estate professional and that he materially participates in the rental business.

Deduction of Qualified Business Income

The Act provides that an individual who owns an equity interest in a pass-through entity (“PTE”)[5] that is engaged in a qualified trade or business (“QTB”)[6] may deduct up to 20% of the qualified business income (“QBI”) allocated to him from the PTE.

The amount of this deduction may be limited, based upon the W-2 wages paid by the QTB and by the unadjusted basis (immediately after acquisition) of depreciable tangible property used by the QTB in the production of QBI (provided its recovery period has not expired).[7]

The issue of whether an activity, especially one that involves the rental of real property, is a “trade or business” (as opposed to an “investment”) of a taxpayer is ultimately one of fact in which the scope of a taxpayer’s activities, either directly or through agents, in connection with the property, is so extensive as to rise to the stature of a trade or business.

A taxpayer’s QBI from a QTB for a taxable year means his share of the net amount of qualified items of income, gain, deduction, and loss that are taken into account in determining the taxable income of the QTB for that year.

Items of income, gain, deduction, and loss are “qualified items” only to the extent they are effectively connected with the PTE’s conduct of a QTB within the U.S. “Qualified items” do not include specified investment-related income, gain, deductions, or loss. [8]

Excess Business Losses

The Act imposes another limitation on an individual’s ability to utilize a pass-through loss against other income, whether it is realized through a sole proprietorship, S corporation or partnership; this limitation is applied after the at-risk and passive loss rules.

Specifically, the taxpayer’s excess business losses are not allowed for the taxable year. An individual’s “excess business loss” for a taxable year is the excess of:

(a) the taxpayer’s aggregate deductions attributable to his trades or businesses for the year, over

(b) the sum of:

(i) the taxpayer’s aggregate gross income or gain for the year attributable to such trades or businesses, plus

(ii) $250,000 (or $500,000 in the case of a joint return).

In the case of a partnership or S corporation, this provision is applied at the individual partner or shareholder level. Each partner’s and each S corporation shareholder’s share of the PTE’s items of income, gain, deduction, or loss is taken into account in applying the limitation for the taxable year of the partner or shareholder.

The individual’s excess business loss for a taxable year is carried forward and treated as part of the taxpayer’s net operating loss carryforward in subsequent taxable years.[9]

Technical Termination of a Partnership

Prior to the Act, a partnership was considered “technically terminated” for tax purposes if, within a 12-month period, there was a sale or exchange of 50% or more of the total interest in the partnership’s capital or income. Upon a technical termination, the partnership’s taxable year closed, partnership-level elections generally ceased to apply, and the partnership’s depreciation recovery periods for its assets started anew.

The Act repealed the technical termination rule, which makes it easier for partners to transfer their partnership interests.

Profits Interest

A partnership may issue a profits interest (a “promote”) in the partnership to a service or management partner in exchange for the performance of services. The right of the profits interest partner to receive a share of the partnership’s future profits and appreciation does not include any right to receive money or other property upon the liquidation of the partnership immediately after the issuance of the profits interest.[10]

In general, the IRS has not treated the receipt of a partnership profits interest for services as a taxable event for the partnership or the partner.

By contrast, a partnership capital interest received for services has been includable in the partner’s income if the interest was transferable or was not subject to a substantial risk of forfeiture.[11]

In order to make it more difficult for certain profits interest partners to enjoy capital gain treatment for their share of partnership income, for taxable years beginning after December 31, 2017, the Act provides for a new three-year holding period.[12]

Specifically, the partnership assets sold must have been held by the partnership for at least three years in order for a profits interest partner’s share of such gain to enjoy the lower tax rate applicable to long-term capital gains.[13]

If the assets sold had not been held by the partnership for at least three years, the entire amount of any capital gain allocated to the profits interest would be treated as short-term capital gain and would be taxed up to a maximum rate of 37% as ordinary income.

An “applicable partnership interest” is one that is transferred to a partner in connection with his performance of “substantial” services in a trade or business that consists in whole or in part of (1) raising or returning capital, and (2) investing in, or disposing of, or developing real estate held for rental or investment.

This holding-period rule should not apply to a taxpayer who only provides services to a so-called “portfolio company.”

Real Property Taxes

Under the Act, State and local taxes are generally not allowed to an individual as a deduction[14] unless they are paid or accrued in carrying on a trade or business, or an activity for the production of income. Thus, for instance, in the case of property taxes, an individual may deduct such items if these taxes were imposed on business assets, such as residential rental property.

Additional Depreciation

Prior to the Act, the Code allowed an additional first-year depreciation deduction equal to 50% of the adjusted basis of “qualified property”[15] – including certain improvements to real property – for the year it was placed in service.

The Act modified the additional first-year depreciation deduction, expanded it to include the acquisition of used property, and increased the allowance to 100% for property placed in service after September 27, 2017, and before January 1, 2023.[16]

Election to Expense

Prior to the Act, a taxpayer could elect to deduct the cost of qualifying property, rather than to recover such costs through depreciation deductions, subject to certain limitations. The maximum amount a taxpayer could expense was $500,000 of the cost of qualifying property placed in service for the taxable year. This amount was reduced by the amount by which the cost of qualifying property placed in service during the taxable year exceeded $2 million. The $500,000 and $2 million amounts were indexed for inflation for taxable years beginning after 2015.

Qualifying property was defined to include, among other things, “qualified leasehold improvement property.”

The Act increased the maximum amount a taxpayer may expense to $1 million, and increased the phase-out threshold amount to $2.5 million. Thus, the maximum amount a taxpayer may expense, for taxable years beginning after 2017, is $1 million of the cost of qualifying property placed in service for the taxable year. The $1 million amount is reduced by the amount by which the cost of qualifying property placed in service during the taxable year exceeds $2.5 million. The $1 million and $2.5 million amounts are indexed for inflation for taxable years beginning after 2018.

The Act also expanded the definition of qualifying real property to include any of the following improvements to nonresidential real property placed in service after the date such property was first placed in service: roofs; heating, ventilation, and air-conditioning property; fire protection and alarm systems; and security systems.

Interest Deduction

The Act limits the deduction that a business may claim for “business interest” paid or accrued in computing its taxable income for any taxable year. In general, the deduction is limited to 30% of the adjusted taxable income of the business for such year. The amount of any business interest not allowed as a deduction for any taxable year may be carried forward indefinitely.

“Adjusted taxable income” means the taxable income of the business computed without regard to (1) any item of income, gain, deduction, or loss which is not properly allocable to the business; (2) any business interest or business interest income; (3) the amount of any NOL deduction; (4) the 20% of QBI deduction; and (5) certain other business deductions.[17]

The limitation does not apply to a business – including a real estate business – if its average annual gross receipts for the three-taxable-year period ending with the prior taxable year does not exceed $25 million.

In addition, a real estate business may elect that any real property development, redevelopment, construction, reconstruction, acquisition, conversion, rental, operation, management, leasing, or brokerage trade or business in which it is engaged not be treated as a trade or business for purposes of the limitation, in which case the limitation would not apply to such trade or business.[18]

Like-Kind Exchange

For years, the Code has provided that no gain or loss is recognized if property held for productive use in a trade or business or for investment is exchanged for property of a “like kind” which is to be held for productive use in a trade or business or for investment.

Over the last few years, several proposals had been introduced into Congress to eliminate the favorable tax treatment for like-kind exchanges.

The Act amended the tax-deferred like-kind exchange rules such that they will apply only to real property.

Corporate Tax Changes

Real property should rarely be held in a corporation, yet the fact remains that there are many such corporations.

In the case of a C corporation, or in the case of an S corporation for which the built-in gain recognition period has not yet expired, the Act provides some relief by reducing the corporate income tax rate from a maximum rate of 35% to a flat rate of 21%.

Although this reduction is significant, it likely is not enough to cause investors to contribute their real property to a corporation, or to “check the box” to treat their partnership or single-member LLC as an association (i.e., a corporation) for tax purposes. The benefits of ownership through a partnership are too great.

Moreover, the Act also takes away a benefit from certain corporate real estate developers. Specifically, these corporations may no longer exclude from their gross income any contribution of cash or property from a governmental entity or civic group.[19]

Estate Planning

Although the Act did not repeal the federal estate tax, it greatly increased the exemption amount, from $5.6 million to $11.2 million per person for 2018. It also left intact the portability election between spouses, and the exemption amount remains subject to adjustment for inflation.[20]

Importantly, the beneficiaries of a decedent’s estate continue to enjoy a stepped-up basis in the assets that pass to them upon his death, thereby providing income tax savings to the beneficiaries in the form of reduced gain or increased depreciation.[21]

For a more detailed discussion, click here.

A foreign individual investing in U.S. real property will often do so through a foreign corporate parent and a U.S. corporate subsidiary. The stock of the foreign corporation will not subject the foreigner to U.S. estate tax upon his demise. The U.S. corporation will be subject to U.S. corporate income tax – now at a 21% federal rate (down from a maximum of 35%) – and its dividend distributions, if any, will be subject to U.S. withholding at 30% or at a lower treaty rate. The disposition of the real property will be subject to U.S. corporate tax, but the subsequent liquidation of the U.S. subsidiary will not be subject to U.S. tax.[22]

Will the reduction of the federal corporate tax rate cause more foreign corporations to invest directly in U.S. real property, or through a PTE, rather than through a U.S. subsidiary? In general, no, because such an investment may cause the foreign corporation to be treated as engaged in a U.S. trade or business[23], and may subject the foreign corporation to the branch profits tax.

How about the limitation on interest deductions? The exception for a real estate trade or business should alleviate that concern.

Will the deduction based on qualified business income cause a foreign individual to invest in U.S. real property through a PTE?[24] Probably not, because this form of ownership may cause the foreigner to be treated as engaged in a U.S. trade or business, and an interest in such a PTE should be includible in his U.S. gross estate for estate tax purposes.

Where Will This Lead?

It’s too soon to tell – the Act has only been in force for just over two weeks.

That being said, and based on the foregoing discussion, there’s a lot in the Act with which the real estate industry should be pleased.[25]

Notwithstanding that fact, there are certain questions that many taxpayers are rightfully starting to ask regarding the structure of their real estate business. To give you a sense of the environment in which we find ourselves, I have been asked:

  • Whether an S corporation should convert into a C corporation (to take advantage of the reduced corporate tax rate);
  • Whether a C corporation should elect S corporation status (to enable its individual shareholders to take advantage of the 20%-of-QBI deduction);
  • Whether a partnership/LLC should incorporate or check the box (to take advantage of the reduced corporate rate);
  • Whether a corporation should convert into a partnership or disregarded entity (to enable its individual shareholders to take advantage of the 20%-of-QBI deduction)?

In response to these questions, I ask: who or what are the business owners, what is its capital structure, does it make regular distributions to its owners, what is the appreciation inherent in its assets, does it plan to dispose of its property in the relative short-term, etc.? The point is that each taxpayer is different.

I then remind them that some of the recently-enacted provisions are scheduled to expire in the not-too-distant future; for example, the QBI-based deduction goes away after 2025.

Generally speaking, however, and subject to the unique circumstances of the business entity, its owners, and its property, a real estate business entity that is treated as a partnership for tax purposes should not change its form; an S corporation should not revoke its “S” election; a C corporation should elect “S” status (assuming it will not be subject to the excise tax on excess passive investment income), and a corporation should not convert into a partnership.


[1] Pub. L. 115-97 (the “Act”).

[2] Do you recall the history of the TRA of 1986? Committee reports beginning mid-1985, the bill introduced late 1985, the law enacted October 1986, lots of transition rules. Oh well.

[3] Some of these provisions have been discussed in earlier posts on this blog. See, for example, this post and this post.

[4] For example, personal property identified as part of a cost segregation study that benefited from accelerated depreciation.

[5] A sole proprietorship, partnership/LLC, or S corporation.

[6] A QTB includes any trade or business conducted by a PTE other than specified businesses that primarily involve the performance of services.

[7] Query how much of a benefit will be enjoyed by an established real estate business which may not have many employees, and the property of which may have been fully depreciated.

[8] Investment-type income is excluded from QBI; significantly, investment income includes capital gain from the sale or other disposition of property used in the trade or business.

[9] NOL carryovers generally are allowed for a taxable year up to the lesser of (i) the carryover amount or (ii) 80 percent of taxable income determined without regard to the deduction for NOLs. In general, carrybacks are eliminated, and carryovers to other years may be carried forward indefinitely.

This may be a significant consideration for a C corporation that elects to be an S corporation, and vice versa, in that “C-corporation-NOLs” will not expire until they are actually used.

See the discussion of the recently enacted “excess business loss” rule applicable to individuals.

[10] The right may be subject to various vesting limitations.

[11] A capital interest for this purpose is an interest that would entitle the receiving partner to a share of the proceeds if the partnership’s assets were sold at fair market value (“FMV”) immediately after the issuance of the interest and the proceeds were distributed in liquidation.

[12] This rule applies even if the partner has made a sec. 83(b) election.

[13] It is unclear whether the interest must have been held for three years by the partner.

[14] There is an exception under which a joint return may claim an itemized deduction of up to $10,000 for the aggregate of (i) State and local property taxes not paid or accrued in carrying on a trade or business, or in an activity carried on for the production of income, and (ii) State and local income taxes (or sales taxes in lieu of income taxes) paid or accrued in the taxable year.

[15] Among other things, “qualified improvement property” includes any improvement to an interior portion of a building that was nonresidential real property if such improvement was placed in service after the date such building was first placed in service.

Qualified improvement property does not include any improvement for which the expenditure is attributable to the enlargement of the building, any elevator or escalator, or the internal structural framework of the building.

The Act also provides a 15-year MACRS recovery period for qualified improvement property.

[16] The allowance is phased out through 2025.

[17] Among these deductions is depreciation. Beginning in 2022, depreciation is accounted for.

[18] An electing business will not be entitled to bonus depreciation and will have to extend, slightly, the depreciation period for its real properties.

[19] Such contributions may be made in order to induce a business to move to, and establish itself in, a particular jurisdiction, the idea being that its presence would somehow benefit the public.

[20] Unfortunately, the exemption amount returns to its pre-Act levels after 2025.

[21] In the case of a partnership interest, the partnership must have a Sec. 754 election in effect in order to enjoy this benefit.

[22] Thanks to the so-called “cleansing rule.”

[23] Or it may elect to be so treated.

[24] Other than an S corporation, of course.

[25] Our focus has been on the tax benefits bestowed upon a closely held real estate business. Of course, there are other, non-business provisions that apply to individuals that may have some impact on the real estate market and real estate businesses generally.

Obviously, I am referring to the limitations on itemized deductions for real property taxes imposed on a personal residence and residential acquisition indebtedness, both of which may adversely affect higher-income individual taxpayers.

Against these changes, one must weigh the alternative minimum tax (which often reduces the benefit of deducting property taxes anyway), and the elimination of the so-called “Pease limitation” (which reduced the benefit of itemized deductions for higher-income individual taxpayers).

When the Tax Cuts and Jobs Act[1] was introduced on November 2, 2017, perhaps the single most important issue on the minds of many closely held business owners was the future of the estate tax: was it going to be repealed as had been promised? A closely related question – and perhaps of equal significance to these owners’ tax advisers – was whether an owner’s assets would receive a so-called “stepped-up” basis in the hands of those persons to whom the assets passed upon the owner’s death?

When the smoke cleared (only seven weeks later), the estate tax remained in place, but its reach was seriously limited, at least temporarily. Moreover, the stepped-up basis rule continued to benefit the beneficiaries of a decedent’s estate.

To better understand the change wrought by the Act – and to appreciate what it left intact – we begin with an overview of the federal transfer taxes.

The Estate and Gift Tax

The Code imposes a gift tax on certain lifetime transfers, an estate tax on certain transfers at death, and a generation-skipping transfer (“GST”) tax when such transfers are made to a “skip person.”

Estate Tax

The Code imposes a tax on the transfer of the taxable estate of a decedent who is a citizen or resident of the U.S. The taxable estate is determined by deducting from the value of the decedent’s gross estate any deductions provided for in the Code. After applying tax rates to determine a tentative amount of estate tax, certain credits are subtracted to determine estate tax liability.

Estate Tax

A decedent’s gross estate includes, to the extent provided for in other sections of the Code, the date-of-death value of all of a decedent’s property, real or personal, tangible or intangible, wherever situated. In the case of a business owner, the principal asset of his gross estate may be his interest in a closely held business. In general, the value of the property for this purpose is the fair market value of the property as of the date of the decedent’s death.

A decedent’s taxable estate is determined by subtracting from the value of his gross estate any deductions provided for in the Code. Among these deductions is one for certain transfers to a surviving spouse, the effect of which is to remove the assets transferred to the surviving spouse from the decedent’s estate tax base.

After accounting for any allowable deductions, a gross amount of estate tax is computed, using a top marginal tax rate of 40%.

In order to ensure that a decedent only gets one run up through the rate brackets for all lifetime gifts and transfers at death, his taxable estate is combined with the value of the “adjusted taxable gifts” made by the decedent during his life, before applying tax rates to determine a tentative total amount of tax. The portion of the tentative tax attributable to lifetime gifts is then subtracted from the total tentative tax to determine the gross estate tax.

The estate tax liability is then determined by subtracting any allowable credits from the gross estate tax. The most significant credit allowed for estate tax purposes is the unified credit.

The unified credit is available with respect to a taxpayer’s taxable transfers by gift and at death. The credit offsets the tax up to a specified cumulative amount of lifetime and testamentary transfers (the “exemption amount”). For 2017, the inflation-indexed exemption amount was set at $5.49 million; prior to the Act, it was set to increase to $5.6 million in 2018.

Any portion of an individual taxpayer’s exemption amount that is used during his lifetime to offset taxable gifts reduces the exemption amount that remains available at his death to offset the taxable value of his estate. In other words, the unified credit available at death is reduced by the amount of unified credit used to offset gift tax incurred on gifts made during the decedent’s life.

In the case of a married decedent, an election is available under which any exemption amount that was not used by the decedent may be used by the decedent’s surviving spouse (the so-called “portability election”) during her life or at her death.

The estate tax generally is due within nine months of a decedent’s death. However, in recognition of the illiquid nature of most closely held businesses, the Code generally allows the executor of a deceased business owner’s estate to elect to pay the estate tax attributable to an interest in a closely held business in up to ten installments. An estate is eligible for payment of the estate tax in installments if the value of the decedent’s interest in a closely held business exceeds 35 percent of the decedent’s adjusted gross estate (i.e., the gross estate less certain deductions).

If the election is made, the estate may defer payment of principal and pay only interest for the first five years[2], followed by up to 10 annual installments of principal and interest. This provision effectively extends the time for paying estate tax by 14 years from the original due date of the estate tax.

Gift Tax

The Code imposes a tax for each calendar year on the transfer of property by gift during such year by any individual. The amount of taxable gifts for a calendar year is determined by subtracting from the total amount of gifts made during the year: (1) the gift tax annual exclusion; and (2) allowable deductions.

The gift tax for a taxable year is determined by: (1) computing a tentative tax on the combined amount of all taxable gifts for such year and all prior calendar years using the common gift tax and estate tax rate (up to 40 percent); (2) computing a tentative tax only on all prior-year gifts; (3) subtracting the tentative tax on prior-year gifts from the tentative tax computed for all years to arrive at the portion of the total tentative tax attributable to current-year gifts; and, finally, (4) subtracting the amount of unified credit not consumed by prior-year gifts.

The amount of a taxpayer’s taxable gifts for the year is determined by subtracting from the total amount of the taxpayer’s gifts for the year the gift tax annual exclusion amount and any available deductions.

Donors of lifetime gifts are provided an annual exclusion of $15,000 per donee in 2018 (indexed for inflation from the 1997 annual exclusion amount of $10,000) for gifts of “present interests” in property. Married couples can gift up to $30,000 per donee per year without consuming any of their unified credit.

GST Tax

The GST tax is a separate tax that can apply in addition to either the gift tax or the estate tax. The tax rate and exemption amount for GST tax purposes are set by reference to the estate tax rules. The GST tax is imposed using the highest estate tax rate (40%). Tax is imposed on cumulative generation-skipping transfers in excess of the generation-skipping transfer tax exemption amount in effect for the year of the transfer. The generation-skipping transfer tax exemption for a given year is equal to the estate tax exemption amount in effect for that year ($5.49 million in 2017).

Basis in property received at death

A bequest, or other transfer at death, of appreciated (or loss) property is not an income tax realization event for the transferor-decedent or his estate, but the Code nevertheless provides special rules for determining a recipient’s income tax basis in assets received from a decedent.

Property acquired from a decedent or his estate generally takes a stepped-up basis in the hands of the recipient. “Stepped-up basis” means that the basis of property acquired from a decedent’s estate generally is the fair market value on the date of the decedent’s death. Providing a fair market value basis eliminates the recognition of income on any appreciation in value of the property that occurred prior to the decedent’s death (by stepping-up its basis).[3]

In the case of a closely held business, depending upon the nature of the business entity (for example, a partnership or a corporation) and of its assets, the income tax savings resulting from the basis step-up may be realized as reduced gain on the sale of the decedent’s interest in the business, or as a reduced income tax liability from the operation of the business (for example, in the form of increased depreciation or amortization deductions).

The Act

To the disappointment of many, the Act did not repeal the federal estate tax.

However, the Act greatly increased the federal estate tax, gift tax, and GST tax exemption amount – for decedents dying, and for gifts made, after December 31, 2017 and before January 1, 2026 – and it preserved portability.

The “basic exemption amount” was increased from $5 million (as of 2010) to $10 million; as indicated above, this amount is indexed for inflation occurring after 2011, and was set at $5.6 million for 2018 prior to the Act.

As a result of the Act, this exemption amount was doubled to $11.2 million per person beginning in 2018 – basically, $22.4 million per married couple – and will be adjusted annually for inflation through 2025.

To put this into perspective, over 109,000 estate tax returns were filed in 2001, of which approximately 50,000 were taxable. Compare this with 2016, when approximately 11,000 returns were filed, of which approximately 5,000 were taxable. The decline appears to be due primarily to the increase in the filing threshold (based on the exemption amount) from $675,000 in 2001 to $5.45 million in 2016.[4] An increase from $5.49 million in 2017 to $11.2 million in 2018 should have a similar effect.

In addition, and notwithstanding the increased exemption amount, the Act retained the stepped-up basis rule for determining the income tax basis of assets acquired from a decedent. As a result, property acquired from a decedent’s estate generally will continue to take a stepped-up basis.

Implications

As stated immediately above, the owners of many closely held businesses will not be subject to the federal estate tax – at least not through 2025[5] – thanks to the greatly increased exemption amount and to continued portability.

Thus, a deceased owner’s taxable (not gross) estate in 2018 – even if we only account for conservative valuations of his business interests and for reasonable estate administration expenses – may be as great as $22.4 million (assuming portability) without incurring any federal estate tax.

Moreover, this amount ignores the benefits of fairly conservative gift planning including, for example, the long-term impact of regular annual exclusion gifting (and gift-splitting between spouses), the effect of transfers made for partial consideration (as in a QPRT), or for full and adequate consideration (as in zeroed-out GRATs and installment sales), as well as the benefit of properly-structured life insurance that is not includible in the decedent’s estate.

With these tools, otherwise taxable estates[6], that potentially may be much larger than the new exemption amount, may be brought within its coverage.

The increased exemption amount will also allow many owners to secure a basis step-up for their assets upon their death without incurring additional estate tax, by allowing these owners to retain assets.

Of course, some states, like New York, will continue to impose an estate tax on estates that will not be subject to the federal estate tax.[7] In those cases, the higher federal exemption amount, coupled with the absence of a New York gift tax, provides an opportunity for many taxpayers to reduce their New York taxable estate without any federal estate or gift tax consequences, other than the loss of a basis step-up. The latter may be significant enough, however, that the taxpayer may decide to bear the 16% New York estate tax on his taxable estate rather than lose the income tax savings.[8]

Planning

In light of the foregoing, taxpayers should, at the very least, review their existing estate plan and the documents that will implement it – “for man also knoweth not his time.”[9]

For example, wills or revocable trusts that provide for a mandatory credit shelter or bypass trust may have to be revised, depending upon the expected size of the estate, lest the increased exemption amount defeat one’s testamentary plan.

A more flexible instrument may be warranted – perhaps one that relies upon a disclaimer by a surviving spouse – especially given the December 31, 2025 expiration date for the increased exemption amount, and the “scheduled” reversion in 2026 to the pre-2018 exemption level (albeit adjusted for inflation).

The buy-out provisions of shareholder, partnership and operating agreements should also be reviewed in light of what may be a reduced need for liquidity following the death of an owner. For example, should such a buy-out be mandatory?[10]

Some taxpayers, with larger estates, may want to take advantage of the increased exemption amount before it expires in 2026 so as to remove assets, and the income and appreciation thereon, from their estates.[11] This applies for both estate and GST tax purposes; a trust for the benefit of skip persons may be funded now using the temporarily increased GST exemption amount.

Of course, gifting comes at a cost: the loss of stepped-up basis upon the death of the taxpayer.

Conversely, some taxpayers may want to consider bringing certain appreciated assets (for example, assets that they may have previously gifted to a family member) back into their estates in order to attain the benefit of a basis step-up.

Those taxpayers who decide to take advantage of the increased exemption amount by making lifetime gifts should consider how they may best leverage it.

Some New York taxpayers – who may otherwise have to reduce their gross estates in order to reduce their NY estate tax burden – may want to consider changing their domicile so as to avoid the New York estate tax entirely while holding on to their assets (that would be sheltered by the increased exemption amount) and thereby securing the step-up in basis upon their passing.

There may also be other planning options to consider, some of which have been considered in earlier posts to this blog. For example, ESBTs may now include nonresident aliens as potential current beneficiaries without causing the S corporation to lose its “S” election.

As always, tax savings, estate planning, and gifting strategies have to be considered in light of what the taxpayer is comfortable giving up. In the case of a closely held business owner, any loss of control may be untenable, as may the reduction of cash flow that is attributable to his ownership interest.

Moreover, there are non-tax reasons for structuring the disposition of one’s estate that may far outweigh any tax savings that may result from a different disposition. Tails, dogs, wagging – you know the idiom.


*  At least until 2026 – keep reading.  With apologies to St. Paul. 1 Corinthians, 15:55.

[1] Pub. L. 115-97 (the “Act”); signed into law on December 22, 2017.

[2] The interest rate applicable to the amount of estate tax attributable to the taxable value of the closely held business in excess of $1 million (adjusted for inflation) is equal to 45 percent of the rate applicable to underpayments of tax (i.e., 45 percent of the Federal short-term rate plus three percentage points). This interest is not deductible for estate or income tax purposes.

[3] It also eliminates the tax benefit from any unrealized loss (by stepping-down its basis to fair market value).

[4] http://www.taxpolicycenter.org/briefing-book/how-many-people-pay-estate-tax

[5] This provision expires after 2025. Assuming the provision survives beyond 2020 (the next presidential election), query whether the exemption amount will be scaled back. Has the proverbial cat been let out of the proverbial bag?

[6] Including individuals who had already exhausted their pre-2018 exemption amount.

[7] The NY estate tax exemption amount for 2018 is $5.25 million.

[8] In the case of a NYC decedent, for example, the tax savings to be considered would include the federal capital gains tax of 20%, the federal surtax on net investment income of 3.8%, the NY State income tax of 8.82%, and the NYC income tax of 3.876%. Of course, the likelihood of an asset’s being sold after death also has to be considered.

[9] Ecclesiastes, 9:12. As morbid as it may sound, planning for an elderly or ill taxpayer is different from planning for a younger or healthier individual – it is especially so now given the 2026 expiration of the increased exemption amount.

[10] Of course, there may be overriding business reasons for such a buy-out.

[11] If the exemption amount were to return to its pre-2018 levels in 2026, query how the IRS will account for any pre-2026 gifts that were covered by the increased exemption amount. The Act directs the IRS to issue regulations addressing this point.

Our last three posts focused on those provisions of the Tax Cuts and Jobs Act[1] that apply specifically to pass-through entities, including partnerships and S corporations.

The 2017 Tax Act: Other “Pass-Through” Tax Provisions – Part II

The 2017 Tax Act: Other “Pass-Through” Tax Provisions – Part I 

The New Deduction for “Qualified Business Income”: Tax Simplification Gone Awry?

Today, we turn our attention to domestic C-corporations (“C-corp”) and to some of the ways in which the taxation of their U.S.-sourced income is impacted by the Act.[2]

Why a “C” Corp?

By far, most closely held U.S. businesses are formed as pass-through entities, including sole proprietorships, partnerships, limited liability companies (“LLC”), and S corporations (“S-corp”).

C-Corporation

That being said, a number of closely held businesses are C-corps. Many of these would not qualify as S corps (for example, their capital structure may include preferred stock, or some of their shareholders may not be eligible to own stock of an S corp.). Others were formed before the advent of LLCs. Still others were formed as C-corps so as to avoid the pass-through of their taxable income to their shareholders (for example, where the owners were taxable at a higher individual income tax rate, or where the owners would be subject to self-employment tax on their share of the business income, or where the business did not plan to distribute its profits to its owners).

What is it?

A “corporation” is a business entity that is organized under a federal or state law that describes or refers to the entity as “incorporated” or as a “corporation.”

It also includes a business entity that was not formed under one of these laws but that elects to be treated as a corporation (an “association”) for tax purposes.[3]

In general, a C-corp is a corporation for which its shareholders cannot elect that it be treated as an S corporation (for example, because it is not a “small business corporation”), or have not so elected for whatever reason.

How is it Taxed?

A C-corp. is a taxable entity. It files an annual tax return on which it reports its gross income and its deductions and calculates its taxable income, on which it pays a corporate-level income tax.

When the C-corp. distributes its after-tax profits to its shareholders in the form of a dividend, the shareholders pay tax on the amount distributed to them.

Thus, the C-corp.’s taxable income is taxed twice: once to the corporation and, upon distribution, to its shareholders.

Prior to the Act, corporate taxable income was subject to tax under a graduated rate structure. The top corporate tax rate was 35% on taxable income in excess of $10 million.

As in the case of other taxpayers, certain items of revenue and certain items of expenditure are excluded in determining a C-corp.’s taxable income. Some of these items were modified by the Act.

For example:

  • the gross income of a corporation generally did not include any contribution to its capital;
  • a corporate employer generally could deduct reasonable compensation for personal services as an ordinary and necessary business expense – however, the Code limited the deductibility of compensation with respect to a “covered employee” of a publicly held corporation to no more than $1 million per year, subject to an exception for performance-based compensation (including, for example, stock options and SARs);
  • a C-corp. could reduce its dividends received from other taxable domestic corporations by 70%-to-100% of such dividends, depending upon its ownership interest in the distributing C-corp.;
  • Interest paid or accrued by a C-corp. generally was deductible in the computation of its taxable income, subject to various limitations;
    • for example, the Code limited the ability of a C-corp. to deduct its interest expense in certain situations where the corporation’s debt-to-equity ratio was “too high” and the deduction would not be “offset” by a matching inclusion in the gross income of the creditor (the “earnings stripping” rules);
  • if a C-corp. had a net operating loss (“NOL”) for a taxable year (the amount by which the C-corp.’s business deductions exceeded its gross income), the NOL could be carried back two years and carried forward 20 years to offset the C-corp.’s taxable income in such years.

In addition, a 20% alternative minimum tax (AMT) was imposed on a C-corp. if its AMT (based on its alternative minimum taxable income, which was calculated to negate the benefit of certain preferences and income deferrals that were allowed in determining its regular taxable income) exceeded its regular tax.

The Act

As a result of the Act:

  • the corporate tax rate is reduced to a flat 21%;[4]
  • the term “contribution to capital” does not include (a) any contribution in aid of construction or any other contribution as a customer or potential customer, and (b) any contribution by any governmental entity or civic group (other than a contribution made by a shareholder as such) – thus, these contributions will now be taxable;
  • the performance-based exception to the limitation on the deductibility of certain compensation paid by a publicly traded corporation is eliminated, and the limitation is extended to include certain corporations the equity of which is not publicly traded, such as large private C- or S-corps with registered debt securities;[5]
  • the 70% and 80% dividends received deductions are reduced to 50 percent and to 65%, respectively;
  • the earnings stripping rules are expanded such that the deduction for business interest for any taxable year (including on debt owed to unrelated persons) is generally limited to the sum of (a) business interest income for such year, plus (b) 30% of the corporation’s adjusted taxable income for such year;[6]
    • “adjusted taxable income” means the taxable income of the corporation computed without regard to (1) any item of income, gain, deduction, or loss which is not properly allocable to a business; (2) any business interest or business interest income; (3) the amount of any NOL deduction; and (4) certain other business deductions;
    • “business interest” means any interest paid or accrued on indebtedness properly allocable to a business (it excludes investment interest);
    • “business interest income” means the amount of interest includible in the gross income of the corporation for the taxable year which is properly allocable to a business (and not investment);
    • the amount of any business interest not allowed as a deduction for any taxable year may be carried forward indefinitely;
    • significantly for smaller businesses, the limitation does not apply to a corporation if its average annual gross receipts for the three-taxable-year period ending with the prior taxable year does not exceed $25 million;
    • significantly for real estate businesses, at the corporation’s election, any real property development, redevelopment, construction, reconstruction, acquisition, conversion, rental, operation, management, leasing, or brokerage trade or business, is not treated as a trade or business for purposes of the limitation – thus, the limitation does not apply to such an electing trade or businesses;
  • the carryover NOL deduction for a taxable year is limited to 80% of the corporation’s taxable income, the two-year carryback is repealed, and carryovers may be carried forward indefinitely;[7]
  • the corporate AMT is repealed.

These changes are effective for taxable years (and for losses arising in taxable years) beginning after December 31, 2017.[8]

Employee-Shareholders?

The Act also made certain changes that may affect the “rank-and-file” employees of a corporation to whom the corporate employer may offer shares of its stock as compensation for their services.

“Property” for Services

In general, an employee to whom shares of employer stock are issued as compensation must recognize ordinary income in the taxable year in which the employee’s right to the stock is transferable or is not subject to a substantial risk of forfeiture, whichever occurs earlier (“vesting”).

Thus, if the employee’s right to the stock is vested when the stock is transferred to the employee, the employee recognizes income in the taxable year of such transfer, in an amount equal to the fair market value (“FMV”) of the stock as of the date of transfer (less any amount paid for the stock).

If, at the time the stock is transferred to the employee, the employee’s right to the stock is unvested – for example, the employee must render a specified number of years of service in order for the stock to vest – the employee does not recognize income attributable to the stock transfer until the taxable year in which the employee’s right becomes vested. In that case, the amount includible in the employee’s income is the FMV of the stock as of the date that the employee’s right to the stock becomes vested (less any amount paid for the stock).[9]

In general, these rules do not apply to the grant of a nonqualified option on employer stock. Instead, these rules apply to the transfer of employer stock by the employee on exercise of the option; specifically, if the right to the stock is substantially vested on transfer (the time of exercise), income recognition applies for the taxable year of transfer. If the right to the stock is unvested on transfer, the timing of income inclusion is determined under the rules applicable to the transfer of unvested stock. In either case, the amount includible in income by the employee is the FMV of the stock as of the time of income inclusion, less the exercise price paid by the employee.[10]

The Act

In the case of a closely held business, the grant of stock in the employer corporation has almost always been limited to a small number of executive, or “key,” employees of the corporation.

Over the years, many such employees have, for various reasons, sought ways to further defer the recognition of compensation income attributable to unvested stock (for example, by extending the required period of service).[11]

The Act actually provides a way to achieve such additional deferral, but in a way that does not benefit a corporation’s top executives, and that is not likely to be utilized by established closely held businesses, though it may help some start-up companies.[12]

Under the Act, a qualified employee may elect to defer the inclusion in income of the FMV of qualified stock transferred to the employee by the eligible employer in connection with the exercise of a stock option or the settlement of a restricted stock unit (“RSU”):

  • the election to defer income inclusion (“inclusion deferral election”) with respect to qualified stock must be made no later than 30 days after the time the employee’s right to the stock is vested;
    • A corporation is an eligible corporation if
      • no stock of the employer corporation was readily tradable on an established securities market during any preceding calendar year, and
      • the corporation has a written plan under which, in the calendar year, not less than 80% of all employees who provide services to the corporation in the U.S. are granted options, or RSUs, with the same rights and privileges to receive qualified stock;
  • If an inclusion deferral election is made, the income must be included in the employee’s income for the taxable year that includes the earliest of:
  • the first date the qualified stock becomes transferable;
    • the date the employee first becomes an excluded employee;
      • an excluded employee with respect to a corporation is any individual (1) who owned 1% of the corporation at any time during the calendar year, or who owned at least 1% of the corporation at any time during the 10 preceding calendar years, (2) who is, or has been at any prior time, the CEO or CFO of the corporation, (3) who is a family member of such individuals, or (4) who has been one of the four highest compensated officers of the corporation for the taxable year, or for any of the 10 preceding taxable years;[13]
    • the first date on which any stock of the employer becomes readily tradable on an established securities market;
    • the date five years after the first date the employee’s right to the stock becomes substantially vested; or
    • the date on which the employee revokes the inclusion deferral election.

Having Fun Yet?

The more I read and analyze the Act, the more I realize its potential implications for closely held businesses, and the more I recognize[14] that “only time will tell,” as the saying goes.

That being said, the C-corp-related changes under the Act, discussed briefly above, raise some interesting questions, among which are the following:

  • Will the reduced rated rate induce an S-corp or its shareholders to give up its “S” election, either by revoking it, or by admitting new investors or changing its capital structure?[15]
  • Will the reduced rate cause the shareholders of a target C-corp to abandon their attempts to by-pass the C-corp, to the extent possible, in connection with the sale of its business?[16]
  • Will the limitation on the deduction of interest cause a corporation to rethink its capital structure, causing it to rely less on borrowed funds?
  • Will the elimination of the two-year NOL carryback, plus the addition of the 80%-of-taxable income cap, have an adverse effect on the recovery of a distressed corporation?[17]

The answers to these, and other, questions will best be answered by considering the unique facts and circumstances of each closely held corporate taxpayer and of its shareholders.

Taxpayers will have to review the Act’s changes with their tax advisers, consider and map out the implications thereof as to their business, and then plan accordingly.


[1] Pub. L. 115-97; the “Act.”

[2] Please note that some of the items discussed herein are not unique to C-corps, but because C-corps are liable for tax (unlike their pass-through brethren – at least in most cases), I chose to discuss these items as they apply to C-corps. By the same token, other C-corp-related changes have been covered in other posts; for example, re the application of the cash method of accounting, see The 2017 Tax Act: Other “Pass-Through” Tax Provisions – Part I 

[3] For example, a single member LLC that would otherwise be disregarded for tax purposes, but for which “the box has been checked” to treat it as an association/corporation for tax purposes.

[4] This 21% rate will also be applied to situations that determine tax liability by reference to the corporate tax rate; for example, the calculation of the built-in gains tax on S-corps.

[5] For example, a private company that does not qualify for an exemption to the securities registration requirements may have to register an offering of debt or convertible debt.

[6] This limitation rule also applies to partnerships and S corps at the entity level; special rules are provided for passing through the consequences of the rule to partners and S-corp. shareholders.

[7] See the discussion of “excess business losses” for non-corporate taxpayers at The 2017 Tax Act: Other “Pass-Through” Tax Provisions – Part I 

[8] It should be noted that existing indebtedness is not grandfathered under the new limitation for deducting interest.

[9] If the employee’s right to the stock is unvested at the time the stock is transferred to the employee, the employee may elect, within 30 days of transfer, to recognize income in the taxable year of transfer (a “section 83(b)” election). If the election is made, the amount of compensatory income is capped at the amount equal to the FMV of the stock as of the date of transfer (less any amount paid for the stock).

[10] A section 83(b) election does not apply to the grant of options by a closely held corporation. Moreover, under Sec. 409A of the Code, the exercise price of a nonqualified option cannot be less than the FMV of the underlying stock at the time the option is granted; otherwise, any spread may be includible in the employee’s income.

[11] Though doing so also defers the start of their holding period for the stock.

[12] Query whether this adds anything to the benefit provided under Sec. 83(b) for a stock in a presumably little-to-no-value start-up corporation.

[13] Except for family, basically the employees to whom such stock or options have traditionally been granted.

[14] Like the tax pun there? “Realize” and “recognize.”

[15] Perhaps – at least where the S-corp is not planning a sale of its business or is not in the habit of making regular distributions to shareholders. Before the Act, a non-materially-participating shareholder of an S-corp faced a tax of 43.4% (39.6% + 3.8%) on his pro rata share of the corporation’s income vs. a maximum C-corp tax rate of 35%; after the Act, the comparison is between 40.8% (37% + 3.8%) and 21%.

[16] For example, by arguing for the presence and sale of personal goodwill.

[17] For example, by removing its ability to receive a refund from those earlier years.

Yesterday’s post examined various changes to the taxation of S corporations, partnerships, and their owners.

Today, we will focus on a number of partnership-specific issues that were addressed by the Act.

Profits Interests2017 Tax Act

A partnership may issue a profits (or “carried”) interest in the partnership to a service or management partner in exchange for their performance of services.[1] The right of the profits interest partner to receive a share of the partnership’s future profits and appreciation does not include any right to receive money or other property upon the liquidation of the partnership immediately after the issuance of the profits interest. The right may be subject to various vesting limitations.[2]

In general, the IRS has not treated the receipt of a partnership profits interest for services as a taxable event for the partnership or the partner. However, this favorable tax treatment did not apply if: (1) the profits interest related to a substantially certain and predictable stream of income from partnership assets (i.e., one that could be readily valued); or (2) within two years of receipt, the partner disposed of the profits interest. More recent guidance clarified that this treatment would apply with respect to a substantially unvested profits interest, provided the service partner took into income his share of partnership income (i.e., the service provider is treated as the owner of the interest from the date of its grant), and the partnership did not deduct any amount of the FMV of the interest as compensation, either on grant or on vesting of the profits interest.[3]

By contrast, a partnership capital interest received for services has been includable in the partner’s income if the interest was transferable or was not subject to a substantial risk of forfeiture.[4] A capital interest for this purpose is an interest that would entitle the receiving partner to a share of the proceeds if the partnership’s assets were sold at fair market value (“FMV”) immediately after the issuance of the interest and the proceeds were distributed in liquidation.

Under general partnership tax principles, notwithstanding that a partner’s holding period for his profits interest may not exceed one year, the character of any long-term capital gain recognized by the partnership on the sale or exchange of its assets has been treated as long-term capital gain in the hands of the profits partner to whom such gain was allocated and, thus, eligible for the lower applicable tax rate.

The Act

In order to make it more difficult for some profits interest partners to enjoy capital gain treatment for their share of partnership income, for taxable years beginning after December 31, 2017, the Act provides for a new three-year holding period for certain net long-term capital gain allocated to an applicable partnership interest.

Specifically, the partnership assets sold must have been held by the partnership for at least three years[5] in order for a profits interest partner’s share of such gain to enjoy the lower tax rate applicable to long-term capital gains.

If the assets sold had not been held by the partnership for at least three years, the entire amount of any capital gain allocated to the profits interest would be treated as short-term capital gain, and would be taxed up to a maximum rate of 37% as ordinary income.[6]

An “applicable partnership interest” is any interest in a partnership that is transferred to a partner in connection with the performance of “substantial” services in any applicable trade or business.[7]

In general, an “applicable trade or business” means any activity conducted on a regular, continuous, and substantial basis that consists in whole or in part of: (1) raising or returning capital, and (2) investing in, or disposing of, or developing specified assets.

“Developing” specified assets takes place, for example, if it is represented to investors or lenders that the value, price, or yield of a portfolio business may be enhanced or increased in connection with choices or actions of a service provider or of others acting in concert with the service provider.

“Specified assets” means securities, commodities, real estate held for rental or investment, as well as other enumerated assets.

If a profits interest is not an applicable partnership interest, then its tax treatment should continue to be governed by the guidance previously issued by the IRS.[8]

Adjusting Inside Basis

In general, a partnership does not adjust the basis of partnership property following the transfer of a partnership interest unless the partnership has made an election under Code Sec. 754 to make such basis adjustments, or the partnership has a substantial built-in loss[9] immediately after the transfer.

If an election is in effect, or if the partnership has a substantial built-in loss immediately after the transfer, inside basis adjustments are made only with respect to the transferee partner. These adjustments account for the difference between the transferee partner’s proportionate share of the adjusted basis of the partnership property and the transferee’s basis in its partnership interest. The adjustments are intended to adjust the basis of partnership property to approximate the result of a direct purchase of the property by the transferee partner, and to thereby eliminate any unwarranted advantage (in the case of a downward adjustment) or disadvantage (in the case of an upward adjustment) for the transferee.

For example, without a mandatory reduction in a transferee partner’s share of a partnership’s inside basis for an asset, the transferee may be allocated a tax loss from the partnership without suffering a corresponding economic loss. Under such circumstances, if a Sec. 754 election were not in effect, it is unlikely that the partnership would make the election so as to wipe out the advantage enjoyed by the transferee partner.

The Act

In order to further reduce the potential for abuse, the Act expands the definition of a “substantial built-in loss” such that, in addition to the present-law definition, for transfers of partnership interests made after December 31, 2017, a substantial built-in loss also exists if the transferee would be allocated a loss in excess of $250,000 upon a hypothetical disposition by the partnership of all of its assets in a fully taxable transaction for cash equal to the assets’ FMV, immediately after the transfer of the partnership interest.

Limiting a Partner’s Share of Loss

A partner’s distributive share of partnership loss is allowed only to the extent of the adjusted basis (before reduction by current year’s losses) of the partner’s interest in the partnership at the end of the partnership taxable year in which the loss occurred.

Any disallowed loss is allowable as a deduction at the end of succeeding partnership taxable years, to the extent that the partner’s adjusted basis for its partnership interest at the end of any such year exceeds zero (before reduction by the loss for the year).

In general, a partner’s basis in its partnership interest is decreased (but not below zero) by distributions by the partnership and the partner’s distributive share of partnership losses and expenditures. In the case of a charitable contribution, a partner’s basis is reduced by the partner’s distributive share of the adjusted basis of the contributed property.

In computing its taxable income, no deductions for foreign taxes and charitable contributions are allowed to the partnership – instead, a partner takes into account his distributive share of the foreign taxes paid, and the charitable contributions made, by the partnership for the taxable year.

However, in applying the basis limitation on partner losses, the IRS has not taken into account the partner’s share of partnership charitable contributions and foreign taxes.

By contrast, under the S corporation basis limitation rules (see above), the shareholder’s pro rata share of charitable contributions and foreign taxes are taken into account.

The Act

In order to remedy this inconsistency in treatment between S corporations and partnerships, the Act modifies the basis limitation on partner losses to provide that the limitation takes into account a partner’s distributive share of partnership charitable contributions (to the extent of the partnership’s basis for the contributed property)[10] and foreign taxes. Thus, effective for partnership taxable years beginning after December 31, 2017, the amount of the basis limitation on partner losses is decreased to reflect these items.

What’s Next?

This marks the end of our three-post review of the more significant changes in the taxation of pass-through entities resulting from the Act.

In general, these changes appear to be favorable for the closely held business and its owners, though they do not deliver the promised-for simplification.

Indeed, the new statutory provisions raise a number of questions for which taxpayers and their advisers must await guidance from the IRS and, perhaps, from the Joint Committee (in the form of a “Blue Book”).

However, in light of the administration’s bias against the issuance of new regulations, and given its reduction of the resources available to the IRS, query when such guidance will be forthcoming, and in what form.

Until then, it will behoove practitioners to act cautiously, to keep options open, and to focus on the Act’s legislative history (including the examples contained therein) in ascertaining the intent of certain provisions and in determining an appropriate course of action for clients.

As they used to say on Hill Street Blues, “Let’s be careful out there.”

[Next week, we’ll take a look at the Act’s changes to the estate and gift tax, and how it may impact the owners of a closely held business, as well as the changes to the taxation of C corporations.]


[1]It may be issued in lieu of a management fee that would be taxed as ordinary income.

[2]See Sec. 83 of the Code.

[3]Rev. Proc. 93-27, Rev. Proc. 2001-43.

[4]In general, property is subject to a substantial risk of forfeiture if the recipient’s right to the property is conditioned on the future performance of substantial services, or if the right is subject to a condition other than the performance of services, provided that the condition relates to a purpose of the transfer and there is a substantial possibility that the property will be forfeited if the condition does not occur.

[5]Notwithstanding Code Sec. 83 or any election made by the profits interest holder under Sec. 83(b); for example, even if the interest was vested when issued, or the service provider elected under Sec. 83(b) of the Code to include the FMV of the interest in his gross income upon receipt, thus beginning a holding period for the interest.

[6]Query whether this will have any impact on profits interests that are issued in the context of a PE firm or a real estate venture, where the time frame for a sale of the underlying asset will likely exceed three years.The Act also provides a special rule for transfers by a taxpayer to related persons

[7]A partnership interest will not fail to be treated as transferred in connection with the performance of services merely because the taxpayer also made a capital contribution to the partnership. An applicable partnership interest does not include an interest in a partnership held by a corporation.

[8]Rev. Proc. 93-27, Rev. Proc. 2001-43, Prop. Reg. REG-105346-03.

[9]Prior to the Act, a “substantial built-in loss” existed only if the partnership’s adjusted basis in its property exceeded by more than $250,000 the FMV of the partnership property.

[10]The basis limitation does not apply to the excess of the contributed property’s FMV over its adjusted basis.

Our last post reviewed the “20% deduction” that may now be available to the owners of certain pass-through entities based upon their qualified business income; as we saw, there are many questions that remain unanswered.[1]

Tax Cuts and Jobs Act of 2017

Today’s post is the first of two[2] this week in which we continue our consideration of those income tax provisions of the Tax Cuts and Jobs Act of 2017[3] that most directly relate to pass-through entities – S corporations, partnerships, and sole proprietorships – and their owners.

Excess Business Losses

In determining their taxable income for a taxable year, the shareholders of an S corporation and the partners of a partnership[4] 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” 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 his interest in the pass-through entity.

If the loss is not limited by the foregoing rules, it may be applied against the shareholder’s or the partner’s other income.

The Act

The Act imposes 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.

A taxpayer’s “excess business loss” for a taxable year is the excess of:

(a) the taxpayer’s aggregate deductions attributable to his trades or businesses for the year, over

(b) the sum of:

(i) the taxpayer’s aggregate gross income or gain for the year attributable to such trades or businesses, plus

(ii) $250,000 (or $500,000 in the case of a joint return).[5]

In the case of a partnership or S corporation, this provision (as in the case of the at-risk and passive activity rules) is applied at the partner or shareholder level. Each partner’s and each S corporation shareholder’s share of the pass-through entity’s items of income, gain, deduction, or loss are taken into account in applying the limitation for the taxable year of the partner or S corporation shareholder.

The non-corporate taxpayer’s excess business loss for a taxable year is carried forward and treated as part of the taxpayer’s net operating loss (“NOL”) carryforward in subsequent taxable years.[6]

Thus, consistent with the principle underlying the new rules applicable to NOLs, the excess business loss rule seeks to limit and defer the tax benefit attributable to the “excess” loss.[7]

Accounting Methods

Taxpayers using the cash method of accounting generally recognize items of income when actually or constructively received and items of expense when paid. The cash method is administratively easy and provides the taxpayer flexibility in the timing of income recognition. It is the method used by most individual taxpayers, including sole proprietorships.

Taxpayers using an accrual method generally accrue items of income when “all the events” have occurred that fix the right to receive the income, and the amount of the income can be determined with reasonable accuracy.

Taxpayers using an accrual method of accounting generally may not deduct items of expense prior to when all events have occurred that fix the obligation to pay the liability, the amount of the liability can be determined with reasonable accuracy, and “economic performance” has occurred.

In general, a C corporation, or a partnership that has a C corporation as a partner, may not use the cash method. Prior to the Act, an exception was made to the extent the average annual gross receipts of a C corporation, or of a partnership with a C corporation partner, did not exceed $5 million for all prior years (the “gross receipts test”).

The Act

Under the Act, C corporations and partnerships with C corporation partners may use the cash method of accounting if their annual average gross receipts that do not exceed $25 million for the prior three-taxable-year period (not for all periods, as under prior law), regardless of whether the purchase, production, or sale of merchandise is an income-producing factor.[8]

The Act retains the exceptions from the required use of the accrual method for qualified personal service corporations and for taxpayers other than C corporations. Thus, S corporations, and partnerships without C corporation partners, are allowed to use the cash method without regard to whether they meet the $25 million gross receipts test, so long as the cash method clearly reflects income.

Changes in Accounting Method

Because an S corporation may be able to use the cash method of accounting while an otherwise identical C corporation may be required to use the accrual method, the voluntary or involuntary conversion of an S corporation into a C corporation may cause the corporation to switch its accounting method.[9]

In general, any resulting net adjustments that increase taxable income are generally taken into account by the corporation ratably, over a four-year period beginning with the year of the change.

The Act

Under the Act, any adjustment for an eligible terminated S corporation that is attributable to the revocation of its S corporation election – i.e., a change from the cash method to the accrual method, notwithstanding the new $25 million gross receipts test – is taken into account ratably during the six-taxable-year period beginning with the year of change.

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

Post-S-Termination Distributions

Prior to the Act, distributions of cash by a former S corporation to its shareholders during the one-year post-termination transition period (to the extent of the accumulated adjustment account, or “AAA”) were tax-free to the shareholders and reduced the adjusted basis of the stock.

The Act

Under the Act, in the case of a distribution of money by an “eligible terminated S corporation” (see above) after the post-termination transition period, the AAA will be “allocated to such distribution,” and the distribution will be “chargeable to” the corporation’s accumulated earnings and profits, in the same ratio as the amount of the AAA bears to the amount the accumulated earnings and profits.

Thus, some portion of the distribution may be treated as a taxable dividend to the shareholders.

Electing Small Business Trust (“ESBT”)

Only certain types of trusts are eligible to be shareholders of an S corporation. One such trust is the ESBT. Generally, the eligible beneficiaries of an ESBT include individuals, estates, and certain charitable organizations eligible to hold S corporation stock directly. Prior to the Act, a nonresident alien individual could not be a potential current beneficiary[10] of an ESBT.

The Act

Beginning January 1, 2018, a nonresident alien individual may be a potential current beneficiary of an ESBT.

Of course, the S corporation stock held by the ESBT may not, itself, be distributed to the nonresident alien without terminating the S corporation election, though the income therefrom may be.

ESBTs and Charitable Contributions

In addition to its non-separately computed income or loss, an S corporation reports to its shareholders their pro rata share of certain separately stated items of income, loss, deduction, and credit, including charitable contributions made by the S corporation. The treatment of such charitable contributions depends on the tax status of the shareholder.

Generally, a trust is allowed a charitable contribution deduction for amounts of gross income, without limitation, which pursuant to the terms of the governing instrument are paid for a charitable purpose. No carryover of excess contributions is allowed. An individual, by contrast, is allowed a charitable contribution deduction limited to certain percentages of adjusted gross income, generally, with a five-year carryforward of amounts in excess of this limitation.

Prior to the Act, the deduction for charitable contributions applicable to trusts – rather than the deduction applicable to individuals – applied to an ESBT.

The Act

Effective for taxable years beginning after December 31, 2017, the Act provides that the charitable contribution deduction of an ESBT is not determined by the rules generally applicable to trusts but, rather, by the rules applicable to individuals.

Thus, the percentage limitations and carryforward provisions applicable to individuals apply to charitable contributions made by the portion of an ESBT holding S corporation stock.

Technical Termination of Partnerships

Prior to the Act, a partnership was considered “technically terminated” for tax purposes if, within a 12-month period, there was a sale or exchange[11] of fifty percent or more of the total interest in the partnership’s capital or income. Upon a technical termination, the partnership’s taxable year closed, resulting in a short taxable year, partnership-level elections generally ceased to apply, and the partnership’s depreciation recovery periods for its assets started anew.[12]

In other words, a “trap for the unwary” as the saying goes.

However, a technical termination could often prove a “blessing,” as where the sale of a fifty percent interest afforded the terminating partnership an opportunity to make an irrevocable “Section 754 election, thereby generating a beneficial upward inside basis adjustment for the acquiring partner, following which the otherwise irrevocable Section 754 election (and its potential for a downward adjustment on a later transfer), as well as any other “unwanted” elections, would disappear as a result of the termination.

The Act

The Act repeals the technical termination rule, effective for partnership taxable years beginning after December 31, 2017. Thus, the partnership in which a 50% of more interest was sold would be treated as continuing, and its tax elections would remain in effect.[13]

Tomorrow’s Post

Tomorrow, we will continue our discussion regarding the treatment of pass-through entities under the Act, including the revised taxation of profits interests.


[1] For example, when is an employee’s reputation or skill the “principal asset” of a trade or business, such that the trade or business should be treated as a specified service trade or business that does not qualify for the deduction? Should we be looking to the “personal goodwill” line of cases for guidance? For example, would the absence of an employment or non-competition agreement negate the existence of a trade or business “asset?” Or should we wait for the IRS to issue guidance?
[2] The next post will appear tomorrow.
[3] Pub. L. 115-97; the “Act.”
[4] Including a limited liability company that is treated as a partnership for tax purposes.
[5] Indexed for inflation after 2018.
[6] As we will see in a later post, NOL carryovers generally are allowed for a taxable year up to the lesser of (i) the carryover amount or (ii) 80 percent of taxable income determined without regard to the deduction for NOLs. In general, carrybacks are eliminated, and carryovers to other years may be carried forward indefinitely.
[7] Query whether any excess business loss that is carried forward will be allowed in full upon the taxpayer’s disposition of the trade or business to which such loss is attributable.
[8] The $25 million amount is indexed for inflation for taxable years beginning after 2018.
[9] Congress may believe that the reduction in the C corporation tax rate to a flat 21% may cause the shareholders of some S corporations (for example, those that generate ordinary income – as opposed to capital gain – and that do not make dividend distributions) to revoke the S election.
[10] One who is entitled to, or in the discretion of the trustee may, receive a distribution from the principal or income of the trust on a current basis.
[11] A liquidation of an interest was not counted in applying the 50% test, nor was a gift or a bequest.
[12] The terminated partnership retained its EIN.
[13] Of course, if all of the partnership interests were sold to a single person, the partnership would cease to be treated as such for tax purposes under Code Sec. 708(b)(1)(A). See Rev. Rul. 99-6.

In the weeks preceding the introduction of the bill that was just enacted as the Tax Cuts and Jobs Act (the “Act”), my colleagues teased me, “Lou, what are you going to do when Congress simplifies the Code?”

“Simplify?” I responded as I reached for the Merriam-Webster’s Dictionary that I have used since 1980 – it resides next to the HP scientific calculator that I have used since 1987 – change is not always a good thing – “Congress is incapable of simplifying anything.”

Tax Cuts and Jobs Act

“The word ‘simplify’,” I continued, “is defined as follows: to make simple or simpler; to reduce to basic essentials; to diminish in scope or complexity; to make more intelligible.”

After reviewing the final version of the legislation, two thoughts came to mind: first, Congress must not have a dictionary and, second, the most influential lobbying organization in Washington must be comprised entirely of tax professionals.

In order to better appreciate – if not fully understand – the changes wrought by the Act regarding the Federal taxation of trade or business income that is recognized, “directly or indirectly,” by non-corporate taxpayers, the reader should be reminded of the existing rules, and should also be made aware of the policy underlying the changes.

Pre-2018

A business that is conducted by an individual as a sole proprietorship (whether directly or through a single-member LLC that is disregarded for tax purposes) is not treated as an entity separate from its owner. Rather, the owner is taxed directly on the income of the business.

A business that is conducted by two or more individuals as a general partnership, a state law limited partnership, or a state law limited liability company, is treated as a pass-through entity for tax purposes – a partnership. The partnership is not itself taxable on the income of the business. Rather, each partner/member is taxed on their distributive share of the partnership’s business income.

A corporation that is formed under state law to conduct a business is not itself taxable on the income of the business if it is a “small business corporation” and its shareholders elect to treat it as an S corporation. In that case, the corporation is treated as a pass-through entity for tax purposes. In general, it is not taxable on its business income; rather, its shareholders are taxed on their pro rata share of the S corporation’s business income.

In each of the foregoing situations, the business income of an individual owner of a sole proprietorship, a partnership, or an S corporation (each a “Pass-Through Entity” or “PTE”) is treated for tax purposes as though the owner had realized such income directly from the source from which it was realized by the PTE.

In determining the taxable business income generated by a PTE, the Code allows certain deductions that are “related” to the production of such income, including a deduction for the ordinary and necessary expenses that are paid or incurred by the PTE in carrying on the business.

Because business income is treated as ordinary income (as opposed to capital gain) for tax purposes, the taxable business income of the PTE is taxed to its individual owner(s) at the regular income tax rates.[1]

What’s Behind the Change?

The vast majority of closely-held businesses are organized as PTEs, and the vast majority of newly-formed closely-held businesses are organized as limited liability companies that are treated as partnerships or that are disregarded for tax purposes.[2]

In light of this reality, Congress sought to bestow some unique economic benefit or incentive upon the non-corporate owners of PTEs in the form of a new deduction, and reduced taxes.[3]

However, Congress restricted this benefit or incentive in several ways that reflect a bias in favor of businesses that invest in machinery, equipment, and other tangible assets:[4]

  • in general, it is limited to PTEs that do not involve only the performance of services;
  • it benefits only the net business income of the PTE that flows through to the taxpayer; it does not apply to any amount paid by the PTE to the taxpayer in respect of any services rendered by the taxpayer to the PTE;
  • it does not apply to the PTE’s investment income; it is limited to the PTE’s business income; and
  • the benefit is capped, based upon how much the PTE pays in wages or invests in machinery, equipment, and other tangible property.

Beginning in 2018: New Sec. 199A of the Code

For taxable years beginning after December 31, 2017 and before January 1, 2026, an individual taxpayer[5] (a “Taxpayer”) who owns an equity interest in a PTE that is engaged in a qualified trade or business may deduct up to 20% of the qualified business income allocated to him from the PTE.

Qualified Trade or Business

Taxpayer’s qualified business income (“QBI”) is determined by each qualified trade or business (“QTB”) in which Taxpayer is an owner.[6] A QTB includes any trade or business conducted by a PTE other than a specified service trade or business.[7]

A “specified service trade or business” means any trade or business involving the performance of services in the fields of health, law, accounting, consulting, financial services, brokerage services, or any trade or business where the principal asset of such trade or business is the reputation or skill of one or more of its employees, or which involves the performance of services that consist of investing and investment management, or trading or dealing in securities.[8] However, a trade or business that involves the performance of engineering or architectural services is not a “specified service.”

Qualified Business Income

Taxpayer’s QBI from a QTB for a taxable year means Taxpayer’s share of the net amount of qualified items of income, gain, deduction, and loss that are taken into account in determining the taxable income of the QTB for that year.[9]

Items of income, gain, deduction, and loss are “qualified items” only to the extent they are effectively connected with the PTE’s conduct of a QTB within the U.S.[10]

“Qualified items” do not include specified investment-related income, gain, deductions, or loss; for example, items of gain taken into account in determining net long-term capital gain, dividends, and interest income (other than that which is properly allocable to a trade or business) are not included[11]; nor are items of deduction or loss allocable to such income.

Taxpayer’s QBI also does not include any amount paid to Taxpayer by an S corporation that is treated as reasonable compensation for services rendered by Taxpayer. Similarly, Taxpayer’s QBI does not include any “guaranteed payment” made by a partnership to Taxpayer for services rendered by Taxpayer.[12]

The Deduction

In general, Taxpayer is allowed a deduction for any taxable year of an amount equal to the lesser of:

(a) Taxpayer’s “combined QBI amount” for the taxable year, or

(b) an amount equal to 20% of the excess (if any) of

(i) Taxpayer’s taxable income for the taxable year, over

(ii) any net capital gain for the taxable year.

The combined QBI amount for the taxable year is equal to the sum of the “deductible amounts” determined for each QTB “carried on” by Taxpayer through a PTE.[13]

Taxpayer’s deductible amount for each QTB is the lesser of:

(a) 20% of the Taxpayer’s share of QBI with respect to the QTB, or

(b) the greater of:

(i) 50% of the “W-2 wages” with respect to the QTB, or

(ii) the sum of:

(A) 25% of the W-2 wages with respect to the QTB, plus

(B) 2.5% of the unadjusted basis, immediately after acquisition, of all “qualified property”.[14]

In general, the W-2 wages with respect to a QTB for a taxable year are the total wages subject to wage withholding, plus any elective deferrals, plus any deferred compensation paid by the QTB with respect to the employment of its employees during the calendar year ending during the taxable year of Taxpayer.[15]

“Qualified property” means, with respect to any QTB for a taxable year, tangible property of a character subject to depreciation that is held by, and available for use in, the QTB at the close of the taxable year, which is used at any point during the taxable year in the production of QBI, and for which the depreciable period[16] has not ended before the close of the taxable year.

Example

The taxpayer is single. She is a member of an LLC (“Company”) that is treated as a partnership for tax purposes (a PTE). The company is engaged in a QTB that is not a specified service trade or business.

Taxpayer’s taxable income for 2018 is $500,000 (i.e., gross income of $520,000 less itemized deductions of $20,000), which includes a guaranteed payment from Company of $120,000, for services rendered to Company during 2018, and her allocable share of QBI from Company for 2018 of $400,000. She has no investment income for 2018.

Her allocable share of W-2 wages with respect to Company’s business for 2018 is $300,000.

During 2018, Company purchases machinery and immediately places it into service in its QTB (the machinery is “qualified property”). Taxpayer’s allocable share of the purchase price is $750,000.

The taxpayer is allowed a deduction for the taxable year of an amount equal to the lesser of:

(a) her “combined QBI amount” for the taxable year (the guaranteed payment of $120,000 is not included in QBI), or

(b) 20% of her taxable income of $500,000 for the taxable year, or $100,000.

Taxpayer’s combined QBI amount for 2018 is equal to her “deductible amount” with respect to Company. The deductible amount is the lesser of:

(a) 20% of Taxpayer’s QBI (20% of $400,000 = $80,000), or

(b) the greater of:

(i) 50% of the W-2 wages with respect to the QTB (50% of $300,000 = $150,000), or

(ii) the sum of: 25% of the W-2 wages with respect to the QTB ($75,000), plus (B) 2.5% of the unadjusted basis, immediately after acquisition, of all qualified property (2.5% of $750,000 = $18,750): $75,000 + $18,750 = $93,750.

Thus, Taxpayer’s deductible amount is $80,000. Because this amount is less than $100,000 (20% of her taxable income of $500,000 for the taxable year), Taxpayer will be allowed to deduct $80,000 in determining her taxable income for 2018.

Looking Ahead

It remains to be seen whether the “20% deduction” based upon the QBI of a PTE will be a “game changer” for the individual owners of the PTE.

After all, the deduction is subject to several limitations that may dampen its effect. For example, QBI does not include the amount paid by the PTE to Taxpayer in respect of services rendered by Taxpayer. In addition, the losses realized in one QTB may offset the income realized in another, thereby reducing the amount of the deduction. Finally, the deduction is subject to limits based upon the wages paid and the capital investments made by the QTB.

Maximizing the Deduction?

Might an S corporation shareholder or a partner in a partnership reduce the amount paid to them by the entity for their services so as to increase the amount of their QBI and, so the amount of the deduction? In the case of an S corporation, this may result in the IRS’s questioning the reasonableness (i.e., insufficiency) of the compensation paid to the shareholder-employee.[17]

Or might a PTE decide to invest in more tangible property than it otherwise would have in order to set a greater cap on the deduction?

In any case, the business must first be guided by what makes the most sense from a business perspective.

Becoming a Pass-Through?

What if a business is already organized as a C corporation? Should the QBI-based deduction tip the scales toward PTE status?

Before taking any action with respect to changing its status for tax purposes, a C corporation will have to consider much more than the effect of the deduction for PTEs.

For example, does it even qualify as a small business corporation? If not, what must it do to qualify? Must it redeem the stock owned by an ineligible shareholder, or must it recapitalize so as to eliminate the second class of stock? Either option may prove to be economically expensive for the corporation and the remaining shareholders.

If the corporation does qualify, what assurances are there that all of its shareholders will elect to treat the corporation as an S corporation? Even if the election is made, will the presence of earnings and profits from “C” taxable years implicate the “excess passive income” rules?

In any case, a C corporation that is not otherwise contemplating a change in its tax status, should probably not become an S corporation solely because of the PTE-related changes under the Act, especially if the corporation does not contemplate a sale of its business in the foreseeable future.

Wait and See?

The deduction based on the QBI of a PTE will expire at the end of 2025 unless it is extended before then. It is also possible that it may be eliminated by Congress after 2020.

An existing PTE and its owners should continue to operate in accordance with good business practice while they and their tax advisers determine the economic effect resulting from the application of the new deduction to the PTE.

They should also await the release of additional guidance from the IRS regarding “abusive” situations, tiered entities, and other items.[18]


*This post is the first of several that will be dedicated to those portions of the Tax Cuts and Jobs Act of 2017 (H.R. 1) that are most relevant to the closely-held business and it owners.

[1] The Act reduces the highest income tax rate applicable to the individual owner of a PTE to 37% (from 39.6%) for taxable years beginning after December 31, 2017 and before January 1, 2026. Note that the 3.8% surtax continues to apply to the distributive or pro rata share of an individual partnership or shareholder who does not materially participate in the trade or business conducted by the PTE.

[2] Though occasionally, the owner(s) will elect to treat the LLC as a corporation for tax purposes; for example, to reduce employment taxes.

[3] The Act includes a number of business-related benefits that are applicable to both corporate and non-corporate taxpayers. It also includes some that are unique to corporations, such as the reduction of the corporate income tax rate from a maximum of 35% to a flat 21%.

[4] As we will see in the coming weeks, that Act contains a number of such provisions.

[5] More accurately, the benefit is available to non-corporate owners; basically, individual taxpayers, though trusts and estates are also eligible for the deduction.

[6] A PTE may conduct more than one QTB – different lines of business – or Taxpayer may own equity is more than one PTE.

[7] Also excluded is the trade or business of being an employee.

[8] The exclusion from the definition of a qualified business for specified service trades or businesses is phased in for a taxpayer with taxable income in excess of a “threshold amount” of $157,500 ($315,000 in the case of a joint return). The exclusion is fully phased in for a taxpayer with taxable income at least equal to the threshold amount plus $50,000 ($100,000 in the case of a joint return).

[9] If the net amount of the QBI is a loss (negative), it is treated as a loss from a QTB in the succeeding taxable year.

[10] Generally, when a person engages in a trade or business in the U.S., all income from sources within the U.S. connected with the conduct of that trade or business is considered to be effectively connected income.

[11] Qualified items should include the gain recognized on the sale of business assets.

[12] The IRS is authorized to issue regulations that would exclude any amount paid or incurred by the partnership to Taxpayer for services provided by Taxpayer to the partnership other than in his capacity as a partner.

[13] Taxpayer does not need to be active in the business in order to qualify for the deduction.

[14] This “wage limit” is phased in for a taxpayer with taxable income in excess of the threshold amount. The limit is fully applicable for a taxpayer with taxable income equal to the threshold amount plus $50,000 ($100,000 in the case of a joint return).

[15] In the case of a partnership or S corporation, the provision applies at the partner or shareholder level. Each partner or shareholder, as the case may be, takes into account his allocable or pro rata share of each qualified item of income, gain, deduction, and loss, and is treated as having W-2 wages and unadjusted basis for the taxable year equal to his allocable or pro rata share of the W-2 wages and unadjusted basis of the partnership or S corporation, as the case may be.

[16] The “depreciable period” is the period beginning with the date the qualified property is first placed in service and ending on the later of the date that is 10 years after such date, or the last day of the last full year in the applicable recovery period for the property.

[17] State and local taxes also need to be considered; for example, NYC’s unincorporated business income tax and its general corporation tax.

[18] “What we do in haste, we regret at leisure?”

Worlds Collide?

I like to tell my partners that there are Codes (upper case “C”), and there are codes (lower case “c”). The former include the Ten Commandments, the Code of Hammurabi, the Code of Justinian, and the Internal Revenue Code. The latter include the Pirate’s Code – which, as Captain Barbossa tells us in the movie Pirates of the Caribbean, “is more what you’d call ‘guidelines’ than actual rules” – and the Bankruptcy code.[1]

Notwithstanding the great divide that normally separates these two sets of coda, the space-time continuum is sometimes warped in such a way that they overlap, as they did in a recent decision of the bankruptcy court that considered whether a debtor-corporation’s status as an “S corporation” for tax purposes should be considered “property” for the purposes of the Bankruptcy code (the “BC”).

“S” Election as “Property”?

Debtor was a privately-held company. As a result of a large settlement and the resulting adverse effects on its business, Debtor’s relationship with its secured lender became severely strained. Debtor eventually defaulted under its loan facilities. In response, the lender discontinued debtor’s borrowing ability and cut off its access to its existing accounts. With no ability to access its cash and with no alternative sources of financing immediately available, Debtor was forced to file for protection under Chapter 11 (“reorganization”) of the BC, following which the U.S. Trustee appointed a committee of unsecured creditors.

However, prior to filing its voluntary petition, and with the consent of a majority of its shareholders, Debtor revoked its election to be treated as an S corporation for tax purposes, though it continued to satisfy the criteria for such status.[2]

Pre-Petition

During the period that Debtor was classified as an S corporation, each shareholder – and not Debtor – reported, and paid tax on, his share of Debtor’s taxable income as reflected on the Sch. K-1 issued by Debtor to the shareholder.

In accordance with Debtor’s Shareholders’ Agreement, Debtor made distributions to its shareholders to reimburse them for Debtor’s pass-through tax liability. Debtor also made direct payments of tax to the IRS on behalf of its shareholders.

As a result of revoking its “S” election, Debtor became subject to corporate-level tax as a “C” corporation, and its shareholders – to whom distributions from Debtor would likely have ceased after the filing of its petition – were no longer required to report its income on their personal returns.

C vs S Corps

Under the Code, a corporation’s “default” status is as a “C corporation,” the net income of which is subject to two levels of taxation: once at the corporate level, and then to the shareholders when distributed to them as dividends.[3]

In contrast to C corporation status, S corporation status confers “pass-through taxation.” S corporations pass corporate income, gains, losses, deductions, and credits to their shareholders, who must report their respective shares of the income and losses of the S corporation on their personal income tax returns.

Sale of Assets

A couple of months following Debtor’s petition, the Court entered an order which authorized the sale of substantially all of Debtors’ operating assets to Buyer, and the sale occurred shortly thereafter. The Court then confirmed Debtor’s Plan of Liquidation, pursuant to which the Liquidating Trust was formed as the successor to Debtor and to the unsecured creditors committee.

The Liquidating Trustee filed a complaint against the IRS and Debtor’s shareholders, seeking to avoid the revocation of Debtor’s S corporation status as a fraudulent transfer of property under the BC.[4]

The U.S. filed a motion to dismiss the complaint because, it stated, “a debtor’s tax status is not ‘property’.”

Other Courts

The Court noted that only a handful of courts have considered this issue in the context of fraudulent transfers. Of these courts, only the Third Circuit concluded that S corporation status did not constitute a property right in bankruptcy; all of the others found S corporation status to be a property right in bankruptcy.

Some of the courts that found a property right defined “property” under the BC as something that a person has rights over in order to use, enjoy, and dispose of. These courts reasoned that a debtor corporation did have a property interest in its S corporation status on the date that the status was allegedly “transferred” because the Code “guarantees and protects an S corporation’s right to dispose of [the S corporation] status at will.” Until such disposition, the corporation had the “guaranteed right to use, enjoy, and dispose” of the right to revoke its S corporation status. Consequently, these courts held that the right to make or revoke S corporation status constituted “property” or “an interest of the debtor in property.”

In contrast, the Third Circuit, reviewing a post-petition revocation, concluded that S corporation status did not constitute an interest of a debtor corporation in “property” in a bankruptcy case.

Court’s Analysis

The issue before the Court was whether Debtor’s S corporation status was an interest in “property” that was subject to transfer. If it was not, then the “S” election was not subject to the fraudulent transfer provisions of the BC.

The Court explained that the issue whether S corporation status is “property” for the purposes of the BC was a question of law. The fraudulent transfer provision allows a trustee to avoid obligations voidable under state law. The fraudulent transfer provision allows a trustee to avoid certain transfers that occurred two years prior to the petition date.

The Court acknowledged that the property of the bankruptcy estate is composed of “all legal or equitable interests of the debtor in property as of the commencement of the case.” Congressional intent, it stated, indicates that “property” under the BC is a sweeping term and includes both intangible and tangible property.

Defining “Property”

However, it continued, no BC provision “answers the threshold questions of whether a debtor has an interest in a particular item of property and, if so, what the nature of that interest is.” Property interests are created and defined by state law, unless some countervailing federal interest requires a different result.

Normally, the “federal [tax] statute ‘creates no property rights but merely attaches consequences, federally defined, to rights created under state law.'” Once “‘it has been determined that state law creates sufficient interests in the [taxpayer] to satisfy the requirements of [the statute], state law is inoperative,’ and the tax consequences thenceforth are dictated by federal law.”

In this case, the Court stated, federal tax law governed any purported property right at issue. There was clearly a countervailing federal interest because S corporation status is a creature of federal tax law. State law created “sufficient interests” in the taxpaying entity by affording it the requisite corporate and shareholder attributes to qualify for S corporation status; at that point, “‘state law [became] inoperative,’ and the tax consequences [were] dictated by federal law.” Federal tax law, which was dependent on certain state law conclusions, dictated whether S corporation status was a property right for purposes of the BC.

The Court recognized that certain interests constitute “property” for federal tax purposes when they embody “essential property rights,” which include (1) the right to use; (2) the right to receive income produced by the purported property interest; (3) the right to exclude others; (4) the breadth of the control the taxpayer can exercise over the purported property; (5) whether the purported property right is valuable; and (6) whether the purported right is transferable. A reviewing court must weigh those factors, it stated, in order to determine whether the interest in S corporation status constitutes “property” for federal tax purposes.

Applying these “essential property rights” factors, the Court observed that only one of the factors leaned in favor of classifying S corporation status as property; specifically, Debtor’s ability to use the S corporation tax status to pass its tax liability through to its shareholders. However, according to the Court, the “right to use” factor was the weakest of the “essential property rights.” Without the rights of control and disposition, the right to use was “devoid of any meaningful property interest,” the Court stated. While Debtor may have had the right to use the S corporation status, it lacked the ability to control the use of its tax classification. The right to use the classification existed only until termination.

The second factor, that the tax classification was valuable, did not lean in favor of finding that S corporation status qualified as a property right. The Liquidating Trustee hoped to generate value through avoidance of the “transferred” S corporation revocation, thus retroactively reclassifying Debtor as an S corporation during that taxable year. The Liquidating Trustee believed that by doing so, Debtor’s losses would pass through to its shareholders (to the extent of their basis in Debtor stock), offsetting other income on their personal returns, and thereby generating refunds that the Liquidating Trustee intended to demand from the shareholders for the benefit of the Liquidating Trust and the creditors.[5]

In response to this “plan,” the Court pointed out that, though something may confer value to the estate, it does not necessarily create a property right in it.

Similarly, the Court continued, a corporation cannot claim a property interest to a valuable benefit that another party has the power to legally revoke at any time.

The Court explained that the “S” election removes a layer of taxation on distributed corporate earnings by permitting the corporation to pass its income through to the corporation’s shareholders. The benefit is to the shareholders — it allows them to avoid double taxation. To the extent there is value inherent in the S election, it is value Congress intended for the corporation’s shareholders and not for the corporation.

The remaining factors, the Court continued, also leaned in favor of finding that S corporation status did not constitute a property right under federal tax law. Most importantly, a corporation has very little control over its S corporation status, yet the right to exercise dominion and control over an interest is an essential characteristic defining property.

Shareholders have the overwhelming ability to control the tax status of their corporation. Election of S corporation status may be achieved by one method—unanimous shareholder consent; the corporation does not elect S corporation status. Thus, any interest in electing S corporation status belongs to the shareholders.

The Court stated that an S corporation does not have a vested interest in its tax status after the election has been made. Rather, termination of S corporation status – including by the consent of majority of shareholders – is contingent on shareholder action; the corporation has no unilateral control over the revocation of its S corporation status.

For example, the sale by a shareholder of one share of stock to a partnership would automatically terminate a corporation’s S corporation status. As the S corporation election could be terminated voluntarily by the actions of any one shareholder, it is impossible to state that a corporation has complete control over its S corporation status. Unilateral shareholder action could extinguish S corporation tax status without the corporation taking any action.

The Court observed that S corporation status is not reflected as an asset on a corporation’s balance sheet; it is not something of value that can be transferred by the corporation to an acquiring company; it does not produce income. Rather, S corporation status is a statutory privilege that qualifying shareholders can elect in order to determine how income otherwise generated is to be taxed.

The Court ended its analysis by noting that neither the BC nor the Code allow for a trustee to choose the tax status of the entity. Rather, the BC requires that a trustee furnish returns for any year where a return was not filed as required. Similarly, the Code requires that a trustee “make the return of income for such corporation in the same manner and form as corporations are required to make such returns.” In this case, Debtor was a C corporation for tax purposes. Debtor was required to file as such. The Liquidating Trustee could no use the fraudulent transfer provisions of the BC to maneuver around that requirement.

After weighing all the factors, the Court held that S corporation status was not property under the Code. Although a corporation and its shareholders could elect to use S corporation status in order to avoid double taxation, that factor alone was not enough to outweigh all the remaining characteristics essential to qualify tax status as a property right.

Accordingly, Debtor’s S corporation status could not be considered “property” for the purposes of the BC, and there was no transfer of Debtor’s interest in property that was subject to avoidance under of the BC.

Takeaway?

A financially distressed S corporation make be forced to sell properties in order to generate liquidity with which to pay creditors, or it may negotiate for the cancellation of certain indebtedness owing to such creditors.

These transactions may generate gain or income[1] that will flow through, and be taxable, to the corporation’s shareholders. Moreover, it is likely that the corporation’s creditors will not permit it to make cash distributions to its shareholders to enable them to pay the tax on the flow-through income or gain.

On the other hand, a distressed S corporation has likely generated substantial losses, having lost not only its undistributed income and its shareholders’ capital contributions, but also the funds acquired via loans from third parties and from shareholders.

Some of these losses may have been “suspended,” and remain unused by the shareholders, because the shareholders have exhausted their basis for their shares of stock and for their loans to the corporation.

The flow-through of income or gain to the shareholders would increase their debt and stock bases (in that order), thereby allowing them to utilize some, though perhaps not all, of their suspended losses. It is also possible that the income or gain will exceed the available losses, thus resulting in a net cash outlay by the shareholders for taxes owing.

Of course, if the “S” election were revoked prior to the corporation’s filing its petition, the foregoing issues may be averted, though the corporation’s creditors may object (as the Liquidating Trustee did in the decision discussed above) because any gain or income, and the related tax liability, resulting from the sale or debt cancellation would be captured at the level of the corporate debtor.

At the end of the day, it will behoove the debtor S corporation to consult its tax and bankruptcy advisers well before approaching its creditors, and to thoroughly analyze the foregoing issues and options before deciding to revoke its tax status.


[1] With apologies to the Title 11 Bar? Nah.

[2] Fewer than 100 individual shareholders, one class of stock, etc.

[3] The Tax Cuts and Jobs Act (H.R. 1), on which the House and Senate will be voting this week, would reduce the corporate income tax rate to 21%, effective January 1, 2018. If enacted, we will cover this legislation in later posts.

[4] For example, the trustee may avoid any transfer of a debtor’s interest in property: that was made within 2 years before the date of the filing of the petition if the debtor made such transfer with intent to hinder, delay, or defraud any entity to which the debtor was or became, on or after the date that such transfer was made, indebted; or for which it received less than a reasonably equivalent value in exchange for such transfer; or was insolvent on the date that such transfer was made, or became insolvent as a result of such transfer.

[5] The Trustee’s plan was a bit more convoluted than this. You can’t make this stuff up.

[6] The application of the Code’s bankruptcy and insolvency exceptions to COD income is made at the level of the S corporation.

Some shareholders are content with being wholly passive investors in a corporation. Others desire some degree of participation in the day-to-day management of the corporation’s business. Still others are willing to abstain from any involvement in the operation of the business, but insist upon having a say with respect to certain “significant” matters (so-called “sacred rights”). Then there are those who, as a result of unforeseen circumstances, are thrust into positions of authority.

Many of these taxpayers fail to appreciate that any shareholder, director, officer, or employee of a corporation who has a “duty to act” for the corporation in complying with the NY sales tax law, may be held personally liable for the sales tax collected or required to be collected by the corporation, even if the circumstances that ultimately led to the imposition of personal liability were not of the responsible person’s doing, as illustrated by a recent decision of NY’s Division of Tax Appeals.

Tale of Two Brothers

Taxpayer was an officer and shareholder of Corp, which was a subcontractor for general contractors on numerous projects in the NY metro area.

Corp was a family-owned business, and was originally owned by Taxpayer’s parents. Taxpayer, who was an attorney, joined Corp as its counsel. Over time, Taxpayer’s brother (“Brother”) became president of Corp, and Taxpayer became its CFO. In addition, the brothers eventually became shareholders, with Taxpayer owning 22% of Corp’s issued and outstanding shares, and Brother owning 28%; their parents continued to own the remaining 50%.

Corp entered into a contract with a general contractor (“GC”) to perform work on a construction project in NYC that was more than double the size of any previous project undertaken by Corp (the “Project”). Brother negotiated the contract on behalf of Corp.

Not long afterward, Brother resigned as president of Corp because he had significantly underestimated Project’s cost in making Corp’s bid, thereby causing significant financial hardship for Corp. Upon Brother’s departure, Taxpayer assumed control of Corp and, along with it, responsibility for all phases of its work on Project.

Despite the financial difficulties, Corp continued to work on Project under Taxpayer’s direction. However, according to Taxpayer, GC began to renege on payments to Corp required under the contract. Further, Taxpayer maintained that he was forced by GC to replace several of Corp’s own employees with those of an unrelated Company, on “a time and material basis.” According to Taxpayer, Company overcharged for the work it performed and abused its overtime allowance, further hampering Corp. In addition, Taxpayer claimed that GC paid Company directly from funds allocated for Corp under their contract, rather than simultaneously paying Corp. These efforts, according to Taxpayer, were made to force Corp to fail to complete Project and allow GC to collect on an insurance bond that would have provided GC with a windfall.

As a result of the difficulties arising from Project, Corp filed a voluntary petition for relief under Chapter 11 of the Bankruptcy Code. Corp continued to operate as debtor-in-possession while in bankruptcy.

Corp also brought adversary proceedings, in the course of its bankruptcy, against both GC and Company, seeking redress for fraud, breach of contract, and other similar causes of action.

The Responsible Person

In general, the sales tax is a transaction tax, with the liability for the tax arising at the time of the transaction. It is also a “consumer tax” in that the person required to collect tax – the “vendor” (Corp, in this case) – must collect it from the buyer when collecting the sales price for the transaction to which the tax applies.

The vendor collects the tax as trustee for and on account of the State, then holds it in trust for the State until the vendor remits the tax to the State.

NY imposes personal responsibility for payment of sales tax on certain owners, officers, directors, or employees (“responsible persons”) of a corporate vendor.  This means that a responsible person’s personal assets may be taken by the State to satisfy the sales tax liability of the corporation’s business.

Personal liability may attach even where the “responsible” individual’s failure to take responsibility for collecting and/or remitting the sales tax was not willful.

Corporations

Every individual who is under a duty to act for a corporation in complying with the sales tax law is a responsible person required to collect, truthfully account for, and pay over the sales tax.  Whether an individual is a responsible person is to be determined in every case on the particular facts involved. Generally, a person is under a duty to act for a corporation if he is authorized to sign a corporation’s tax returns, is responsible for maintaining the corporation’s books, or is responsible for the corporation’s management.

It is important to note that the personal liability of a responsible person (like a corporate officer) for sales taxes is separate and distinct from that of the business – it extends beyond the business.   For example, a corporate bankruptcy does not affect the officer’s liability for the tax, since the latter involves a separate claim than one that is asserted in the corporate bankruptcy proceeding.

An officer-shareholder may not be held responsible where his role was essentially that of a minority investor who was precluded from taking action with regard to the financial and management activities of the corporation.

Bankruptcy Court’s Findings

Several examiner’s reports regarding Corp were prepared pursuant to an order of the bankruptcy court. One of these reports addressed potential avoidance actions against Corp’s insiders, and reported that disbursements from Corp were made, through the date that the bankruptcy petition was filed, to or for the benefit of Taxpayer, his father, and Brother.

Additionally, the examiner reported that during the two-year period ending with Corp’s petition, Taxpayer deposited funds into Corp’s account, but also withdrew funds from Corp that he deposited into his personal account. The net effect of these withdrawals and deposits was a deposit of $1.5 million into Corp’s account, which was treated by Corp as a loan from Taxpayer.

Another of the examiner’s reports stated that after the filing of the petition, two of Corp’s stockholders received compensation from Corp, and that Corp paid rent to an entity owned by Taxpayer’s father.

Thus, notwithstanding its financial challenges, it appeared that Corp may have had funds available with which to pay the sales tax owing, but chose, instead, to pay other obligations.

The DTA’s Analysis

The State issued notices of deficiency to Taxpayer that asserted sales tax penalties against him as a responsible person of Corp for the periods beginning after Brother’s resignation, noting that each of the sales tax returns for the periods in issue were signed by Taxpayer as president of Corp.

According to NY’s sales tax law, every person required to collect the tax shall be personally liable for the tax imposed, collected or required to be collected.

The law, in turn, defines a “person required to collect” the sales tax to include, in the case of a corporate taxpayer, any officer, director or employee of the corporation (including of a dissolved corporation), who as such officer, director or employee is under a duty to act for such corporation in complying with the sales tax law.

Whether a person is a “responsible person” must be determined based upon the particular facts of each case, including whether the person was authorized to sign the corporate tax return, was responsible for managing or maintaining the corporate books, or was permitted to generally manage the corporation.

The Court explained that the question to be resolved in any particular case is whether the individual had, or could have had, sufficient authority and control over the affairs of the corporation to be considered a responsible officer or employee. The case law, it continued, identified a variety of factors as indicia of responsibility: the individual’s status as an officer, director, or shareholder; authorization to write checks on behalf of the corporation; the individual’s knowledge of and control over the financial affairs of the corporation; authorization to hire and fire employees; whether the individual signed tax returns for the corporation; the individual’s economic interest in the corporation.

Once sales tax liability has been asserted against an individual taxpayer as a “responsible person,” the taxpayer has the burden of establishing the extent of his responsibilities and authority with respect to tax law compliance.

The Court observed that Taxpayer signed all the sales tax returns as president of Corp.

The Court also noted that Taxpayer did not testify to explain why he was not a person responsible for the collection and remittance of sales tax. Instead, Taxpayer’s case rested entirely upon the financial difficulties that Corp found itself in as a result of Project.

The Court pointed out that these financial difficulties did not absolve an otherwise responsible person from liability arising from nonpayment of sales tax. Consequently, the Court affirmed the notices of deficiency and Taxpayer’s personal liability.

Decisions, Decisions

An individual shareholder has to weigh his desire to have some control over his investment in a corporation against the personal exposure for trust fund taxes (like the sales tax) that such control may bring.

In the case of a family-owned business, a family member/shareholder may find himself having to “step up to the plate” because of the family relationship.

In either case, if an individual is to be involved in the corporation’s business and in its management, he must be prepared to subordinate his own economic and personal interests in order to ensure that the corporation’s tax liabilities are satisfied.

He must also be prepared to shut down the business where it cannot satisfy its responsibility for trust fund taxes owing to the government, instead of continuing its operation and further increasing its tax liabilities, in the hope of one day “turning the corner.” After all, the government is not in the business of making loans to a failing business.

Ah, December

As we near the end of the taxable year ending December 31, 2017, the thoughts of most people turn to holidays and family gatherings, feasting and celebrations, and reflecting, perhaps, on another year gone-by.

Not so for tax professionals.

Instead of “visions of sugar plums” dancing in their heads, these poor folk dream of proposed legislation, obsess over the effective dates of regulations, struggle to close year-end transactions and to implement last-minute tax planning, and prepare for the upcoming tax filing season.

Speaking of tax filings, there is a new filing obligation that should be of interest to U.S. tax professionals who advise foreigners with U.S. investments or U.S. business interests. This filing requirement went into effect for taxable years beginning on or after January 1st of 2017; thus, the first returns to be filed under the new requirement will be due in early 2018.

Specifically, if a domestic LLC is wholly-owned by one foreign person, and it is otherwise treated as a disregarded entity for tax purposes, then the LLC must comply with certain reporting and record maintenance requirements that were previously limited to foreign-owned U.S. corporations.

Entity Classification

In general, a business entity with two or more members is treated, for tax purposes, as either a corporation or a partnership, and a business entity with a single owner is treated as either a corporation or an entity disregarded as separate from its owner (“disregarded entity”).

Certain domestic business entities, such as LLCs, are classified by default as partnerships (if they have more than one owner) or as disregarded entities (if they have only one owner), but are eligible to elect for federal tax purposes to be classified as corporations.

Some disregarded entities are not obligated to file a return or to obtain an employer identification number. According to the IRS, the absence of a return filing obligation (and the associated record maintenance requirements), made it difficult for the IRS to implement and enforce the tax laws applicable to foreigners that invest, or operate a business, in the U.S. through as disregarded entity.

Information Reporting

Under the Code, a domestic corporation that is at least 25% foreign-owned (a “reporting corporation”) is subject to specific information reporting and record maintenance requirements.

A reporting corporation is required to file an annual return on IRS Form 5472, Information Return of a 25% Foreign-Owned U.S. Corporation or a Foreign Corporation Engaged in a U.S. Trade or Business, with respect to each “related party” (including, among others, the 25%-foreign shareholder) with which the reporting corporation has had any “reportable transactions” including, for example, sales, leases, services, rentals, licenses, and loans.

The Form 5472 for a tax year must be attached to the reporting corporation’s income tax return for such year by the due date (including extensions) of the return. A separate Form 5472 must be filed for each foreign or domestic related party with which the reporting corporation had a reportable transaction during the tax year.

The reporting corporation must also keep books and records that are sufficient to establish the accuracy of the federal income tax return of the corporation, including information, documents, or records to the extent they may be relevant to determine the correct U.S. tax treatment of its transactions with related parties.

An Issue for the IRS

When a foreign-owned entity, such as an LLC, was classified as a corporation or a partnership for tax purposes, general ownership and accounting information was available to the IRS through the return filing and EIN application requirements.

Before 2017, however, when a single-member, foreign-owned, domestic LLC was treated as a disregarded entity for tax purposes, it was generally not subject to a separate income or information return filing requirement. Its owner was treated as owning directly the entity’s assets and liabilities, and the information available with respect to the disregarded entity depended on the foreign owner’s own return filings, if any were required.

Thus, if the LLC was wholly-owned by a foreign corporation, foreign partnership, or nonresident alien individual, generally no U.S. income or information return would have been required if neither the disregarded LLC nor its owner received any U.S. source income or was engaged in a U.S. trade or business.

Moreover, if the disregarded entity only received certain types of U.S. source income, such as portfolio interest or U.S. source income that was fully withheld upon at source, its foreign owner would not have had a U.S. return filing requirement.

The IRS found that even in cases when the disregarded entity had an EIN, as well as in cases when income earned through a disregarded entity had to be reported on its owner’s return (for example, income from a U.S. trade or business), it could be difficult for the IRS to associate the income with the disregarded entity based solely on the owner’s return.

The absence of specific return filing, and associated recordkeeping, requirements for foreign-owned, single-member domestic entities, and the resulting lack of ready access to information on ownership of, and transactions involving, these entities, made it difficult for the IRS to ascertain whether the entity or its owner was liable for any federal tax.

New Reporting Obligation

Thus, at the end of 2016, the IRS adopted a new regulation under which a domestic LLC, that is wholly-owned (directly, or indirectly through one or more other disregarded entities) by one foreign person, is treated as a domestic corporation (i.e., as an entity that is separate from its owner) for the limited purposes of the reporting and record maintenance requirements (including the associated procedural compliance requirements) described above. Importantly, it does not alter the framework of the existing entity classification regulations, including the treatment of certain LLCs as disregarded for income tax purposes.

By treating an affected LLC as a foreign-owned domestic corporation, the LLC becomes a “reporting corporation.” Consequently, it is required to file a Form 5472 information return with respect to any “reportable transactions” between the LLC and its foreign owner or other foreign “related parties” (transactions that would have been regarded under general U.S. tax principles if the entity had been, in fact, a corporation for U.S. tax purposes) including, for example, sales, leases, services, rentals, licenses, and loans. It is also required to maintain records sufficient to establish the accuracy of the information return and the correct U.S. tax treatment of such transactions. In addition, because the foreign-owned LLC has a filing obligation, it is required to obtain an EIN.

To ensure that a wholly-owned LLC reports all of its transactions with its foreign owner and other related parties, even if its foreign owner already has an obligation to report the income resulting from those transactions (for example, transactions resulting in income effectively connected with the conduct of a U.S. trade or business), the regulations specify, as an additional reportable category of transaction, any transaction to the extent not already covered by another reportable category. Thus, for example, contributions and distributions (both current and liquidating) are considered reportable transactions with respect to a “reporting LLC.”

Accordingly, any transaction between such an LLC and its foreign owner (or another disregarded entity of the same owner) would be considered a reportable transaction for purposes of the reporting and record maintenance requirements, even though, because the transaction involves a disregarded entity, it generally would not be considered a transaction for other tax purposes.

In order to facilitate the implementation of this reporting requirement, the reporting LLC is treated as having the same taxable year as its foreign owner, if the foreign owner has a U.S. return filing obligation. If the foreign owner has no U.S. return filing obligation, then the LLC is treated as having the calendar year as its taxable year.

Penalties

The penalty provisions associated with the failure to file the Form 5472 and the failure to maintain records will apply to reporting LLCs. For example, a penalty of $10,000 will be assessed against any reporting LLC that fails to file Form 5472 when due. The penalty also applies for a failure to maintain records as required. If the failure continues for more than 90 days after notification by the IRS, additional penalties will apply.

What Does It Mean?

Ah, the beginning of a new taxable year, and of a new era of transparency for many foreign-owned LLCs. What is one to do?

For starters, the U.S. professionals who advise these entities and their owners should alert them of the new reporting requirements, if they haven’t already done so. They should also be on the lookout for new Form 5472 instructions.

If a reporting LLC does not already have one, it must obtain an EIN as soon as possible. In connection therewith, the LLC will have to identify its “responsible party” (basically, the individual who controls the disposition of the LLC’s funds and assets), which means that the responsible party will itself have to obtain its own U.S. identification number (for example, an ITIN).

In addition, the LLC, its foreign owner, and their U.S. advisers will have to make certain that they have properly documented their 2017 reportable transactions, have maintained sufficient records to substantiate the accuracy of the information return to be filed by the LLC, and have implemented the appropriate internal procedures to ensure future compliance with the new reporting requirement.

Old Dog, New Tricks?

It’s a concern for every new investor in a closely held business: will the founding owners continue to operate the business as they always have, or will they recognize that they now have new co-owners to whom they owe a fiduciary duty, and on whom they made be dependent for funding or services, and will this recognition inform their actions with respect to the business and guide their relationship with the new investors?

Because of this concern, the new investor will insist that the owners enter into a shareholders’ or partnership agreement that includes various provisions that seek to protect the new owners’ rights, and to limit the original owners’ ability to ignore those rights and thereby compromise the economic benefits sought by the new investors.

Unfortunately, at least from the perspective of the new investor, it is not unusual for the founder, notwithstanding any shareholders’ or partnership agreement, to “forget” that he has others to whom he has to report. While such “forgetfulness” will strain the relationship among the owners of any business entity, it can be especially stress-inducing in the context of a pass-through entity like a partnership or an S corporation, the income of which is taxed to its owners without regard to any owner’s ability to influence or control the entity’s activities.

Yet Another Example

In a recent case before the Tax Court, the taxpayer tried to convince the Court that she should not be required to include her share of S corporation income in her gross income because the controlling shareholder had effectively prevented her from enjoying the beneficial ownership of her shares.

Corp was created by Founder to operate a diagnostic laboratory. Founder approached Taxpayer – who worked with Merchant Bank (“MB”) – to ask whether she would consider getting involved in Corp. Taxpayer and Founder discussed certain issues that Corp was facing, including its lack of a solid financial infrastructure.

Corp eventually entered into a consulting agreement with MB, under which MB would assist Corp with settling existing liabilities, diversifying the business, and implementing a financial infrastructure. In consideration for these services, Corp would pay MB a fixed monthly fee.

As part of this arrangement, Founder’s ownership of Corp was reduced to 50%, and members of MB or their designees (MB shareholders, including Taxpayer) acquired ownership of the other 50%.

Shareholders’ Agreement

The shareholders of Corp executed a Shareholders’ Agreement. The Agreement named various individuals, including Founder and Taxpayer, as officers of Corp. The board of directors of Corp consisted of its officers, including Taxpayer. The Shareholders’ Agreement stated that “[a]ll matters relating to the management of [Corp’s] business and operations of any kind or nature whatsoever shall be approved by a majority vote of [Corp’s] Board of Directors.” The board of directors, however, met only once after executing the Shareholders’ Agreement.

The Shareholders’ Agreement further stated:

The timing and amount of any distributions of net profits or cash flow from [Corp’s] operations or otherwise (the “Distributions”) to be made by [Corp] to the Shareholders hereunder shall be approved by the Board of Directors . . . . All Distributions shall be made by [Corp] to the Shareholders pari passu in accordance with their proportionate Share ownership hereunder.

In addition, the Agreement implemented a new payment approval procedure for Corp, stating:

The authorizing resolution to be delivered to the bank or other depository of funds of [Corp] shall provide that any officer signing singly may execute all checks or drafts of [Corp] in an amount up to $100,000.00, and two (2) persons consisting of [Founder] and one (1) member of the MB shareholders, shall be authorized as joint signatories in respect of all checks or drafts on behalf of the [Corp] in excess of $100,000.00.

Nevertheless, Corp frequently made payments in excess of $100,000 that were not authorized in conformity with the Shareholders’ Agreement.

Finally, the Agreement gave the shareholders the right to inspect and copy all books and records of Corp. At the beginning of MB’s relationship with Corp, Corp’s CFO distributed copies of monthly financial statements to representatives of the MB shareholders.

The Loan

One concern raised by Corp’s financial statements involved a loan from Founder to Corp close to the time of its organization. General ledgers made available to the MB shareholders, and reviewed as part of MB’s due diligence, showed a loan balance in excess of $7 million. Money paid by Corp on Founder’s behalf, including personal expenses, was charged against this loan, reducing the loan balance, and interest on the loan was paid to Founder monthly.

An audit of Corp’s financial statements found that payments made from Corp to Founder were recorded on the loan payable’s general ledger account, and the loan appeared as a “Note Payable” on the audited financial statements, and appeared as “Liabilities” on Corp’s Federal income tax returns. However, no “Loan from Shareholder” was reflected on the Schedules L of Corp’s Federal income tax returns on Form 1120S.

As Founder’s relationship with MB and the MB shareholders began to deteriorate, Taxpayer approached Founder concerning certain Corp expenses that Taxpayer believed were personal and unrelated to Corp’s business.

At that point, Founder no longer permitted MB and the MB shareholders to enter Corp’s premises, and he instructed Corp’s employees to stop providing financial information to them. Corp also stopped paying MB for its consulting services.

Unbeknownst to the MB shareholders, Founder also filed a complaint seeking judgment against Corp for the loans he claimed to have made to Corp over the course of many years. Founder served the complaint on the comptroller of Corp, Corp did not defend the lawsuit, and a default judgment was entered against Corp.

MB sued Founder for breach of the consulting agreement and failure to pay consulting fees. In reaction to this lawsuit, Founder filed for chapter 11 bankruptcy.

The bankruptcy court appointed a forensic accountant to investigate Corp’s business operations. The accountant’s report determined that the transfers of funds to Founder disputed by MB and the MB shareholders were recorded on the books by Corp as loan repayments. The report also described the default judgment that Founder had obtained against Corp.

As a result of the above findings, the bankruptcy court appointed a trustee as a financial overseer of Founder’s activities at Corp. The trustee was responsible for evaluating the financial status of Corp, taking financial control, and reporting his findings to the bankruptcy court. During the trustee’s time with Corp, payments of expenses or transfers of funds could not be accomplished without his approval. Additionally, the trustee provided Corp’s shareholders with monthly financial reports.

The Tax Returns

When Taxpayer filed her Forms 1040, U.S. Individual Income Tax Return, for the taxable years at issue, she attached to the return a Form 8082, Notice of Inconsistent Treatment or Administrative Adjustment Request. The Form 8082 included the following statement pertaining to Taxpayer’s ownership interest in Corp:

[Corp] has initiated litigation against the [T]axpayer retroactively contesting [T]axpayer’s ownership interest. The entity and certain shareholders have prevented [T]axpayer from exercising [her] shareholder rights including: sale of shares, voting on business matters, exercising dominion and control of the ownership interest, or enjoying any economic benefits or other ownership rights. The referenced Schedule K-1 is inconsistent with the entity’s contention that [T]axpayer is not entitled to any ownership interest. Therefore until legal ownership is resolved by the court, it was improper for the controlling shareholders to issue a Schedule K-1 to [T]axpayer, and those amounts are not reported in this return.

The issue for decision before the Tax Court was whether Taxpayer was a shareholder of Corp during the years in issue and was, therefore, liable for tax on her pro rata share of Corp’s income for the taxable years at issue.

Court’s Analysis

The Code provides that the shareholders of an S corporation are required to take into account their pro rata shares of the S corporation’s income, loss, deductions, and credits for the S corporation’s taxable year ending with or within the shareholders’ taxable year. An S corporation’s shareholders must take into account the corporation’s income regardless of whether any income is distributed to the shareholder.

The Court stated that, in determining stock ownership for Federal income tax purposes, it must look to the beneficial ownership of shares, not to mere legal title. Cases concluding that a shareholder did not have beneficial ownership, the Court continued, have considered both agreements between shareholders that effectively eliminated ownership, and provisions in the corporation’s governing articles affecting ownership rights.

Mere interference, the Court observed, with a “shareholder’s participation in the corporation as a result of a poor relationship between the shareholders * * * does not amount to a deprivation of the economic benefit of the shares.”

Taxpayer contended that while she was issued Corp shares, the removal of her power to exercise shareholder rights, as well as the actions of Founder, “removed” the beneficial ownership of her shares; therefore, Taxpayer asserted, she was not required to include in gross income her “pro rata share” of Corp’s income.

The Court noted, however, that Taxpayer identified no agreement, nor any provisions in Corp’s governing articles, removing her beneficial ownership.

Moreover, Taxpayer identified no authority supporting her position that a violation of a shareholders’ agreement could deprive shareholders of the beneficial ownership of their shares.

Further, Taxpayer cited no authority that allowed a shareholder to exclude her share of an S corporation’s income because of poor relationships with other shareholders.

In the absence of an agreement passing Taxpayer’s rights to her stock to another shareholder, a poor relationship between shareholders did not deprive Taxpayer of the economic benefit of her shares. Indeed, the Court pointed out, Taxpayer ultimately sold her shares for valuable consideration.

The Court held that because Taxpayer remained a shareholder of Corp for the taxable years at issue, she had to include in gross income her pro rata share of Corp’s income for those years.

Takeaway

The Taxpayer was hardly the first to argue that she was not liable for the tax on her share of S corporation income because she was improperly denied the beneficial ownership of shares in the corporation, notwithstanding her record ownership.

As in other cases, the Tax Court rejected Taxpayer’s position, noting that when a controlling shareholder merely interferes with another shareholder’s participation in the corporation, such interference does not amount to a deprivation of the economic benefit of the shares. Thus, the shareholder is not relieved from reporting her share of the S corporation’s income on her tax return.

A minority owner in any pass-through entity must appreciate the risk that she may be denied the opportunity to participate in the business in any meaningful way, that she may be denied any opportunity for gainful employment in the business, and that she may not receive any distributions from the entity.

The minority owner must also recognize that even when she is fortunate to be party to an agreement with the other owners that provides for mandatory tax distributions and for super-majority voting for certain decisions, such an agreement is meaningless in the face of a majority’s disregard of its terms unless the minority owner actually seeks to enforce the agreement.

In the face of a stubborn or determined founder, a minority owner must be prepared to act fairly quickly to protect herself, or “accept” the economic and tax consequences of having to report her share of the entity’s net income on her tax return. In that case, the minority owner must look to her other assets to provide the cash necessary to satisfy the resulting tax liabilities.  This can turn into an expensive proposition.