Bankruptcy Resurgent?

The economic shutdown, and the ensuing recession, triggered by the COVID-19 pandemic have jeopardized the survival of many businesses and, in some cases, of entire industries.

Notwithstanding the Federal government’s efforts to mitigate the adverse consequences of this very challenging economic environment,[i] commercial bankruptcy filings under Chapter 11 of the U.S. Bankruptcy code[ii] were up 43% in June 2020 over June of last year;[iii] in May 2020, they were up 48% from last year.[iv] For the first half of 2020, total commercial Chapter 11 filings were up 26%.[v]

In reaction to these developments, and to what they may signify for the immediate future, many bankruptcy organizations[vi] have been asking Congress to consider amending those provisions of the Code that govern the taxation of cancellation of indebtedness income (“CODI”).[vii] For example, there have been requests that taxpayers be allowed to defer the recognition of such income;[viii] without such deferral, any plan of reorganization – which as a matter of course will likely include some debt cancellation – may result in a large, and immediately payable, tax bill which the debtor-business and its owners cannot satisfy. Others have suggested that the debt cancellation income be offset by reducing the taxpayer’s tax attributes.[ix]

At the moment, the Republican-controlled Senate and the Democrat-controlled House are trying to reconcile their respective versions of the next economic stimulus legislation, neither of which seems to consider the impact of CODI on a debtor-business.[x]

However, based upon the pace of bankruptcy filings described above, and assuming there will be a second wave of COVID-19 this fall[xi], along with the ensuing social-distancing-induced closures, it’s only a matter of time before Congress will have to confront – and will have to take measures to ameliorate – the impact of CODI on the tax liabilities of many debtor businesses.

Until then, the owners of a closely held business that may reasonably expect to be at risk[xii] should consult their advisers – it is never too early to start planning for the economic consequences resulting from the interplay of the tax and bankruptcy laws. It would also behoove them to understand some of the basic concepts, some of which are discussed in the decision described below.[xiii]

The Straddle Year

In October 2015, a corporate debtor (“Debtor”) filed a voluntary petition for relief under Chapter 11 of the Bankruptcy code[xiv] (the “BC”). However, prior to filing for bankruptcy, Debtor had sold substantially all of its material assets; the Bankruptcy Court (the “B-Court”) converted Debtor’s case to one under Chapter 7, and the U.S. Trustee appointed a “case” trustee (“Trustee”).[xv]

The Debtor’s tax year ended on December 31. In September 2016, Trustee filed Debtor’s federal corporate income tax return for the 2015 calendar year. Debtor’s taxable income was realized principally from its pre-petition activities.

Based on Debtor’s federal tax return for its year ending December 31, 2015,[xvi] the IRS filed an “administrative expense priority claim” in Debtor’s bankruptcy case for taxes, penalties, and interest. The events that gave rise to these asserted tax obligations occurred before the filing of Debtor’s petition in bankruptcy.

Trustee asked the B-Court to disallow the IRS’s administrative expense priority claim and to reclassify it as a general unsecured claim.

The issue before the B-Court was how to treat Debtor’s federal income tax liability for the 2015 “straddle year” – i.e., the tax year during which Debtor filed its petition for bankruptcy – for purposes of the BC’s priority rules.

The B-Court held that the straddle tax year had to be bifurcated into pre- and post-petition periods; that Debtor’s income tax obligations for its 2015 tax year had to be allocated between these two periods; and that income taxes resulting from pre-petition events during the straddle year were accorded “general unsecured [eighth priority] treatment,”[xvii] while income taxes resulting from post-petition events in that same straddle year – after the bankruptcy estate[xviii] came into existence – were granted “administrative [second] priority” treatment.

The B-Court’s determination meant that the IRS’s claim against Debtor – which was derived from pre-petition events – would be treated as a general unsecured claim; i.e., one with a relatively low probability of receiving any significant distribution from the bankruptcy estate.

The IRS Disagrees

The IRS asked the U.S. District Court (the “D-Court”) to reverse the B-Court’s conclusion that a claim for Debtor’s corporate income taxes for the straddle year was only entitled to administrative priority to the extent it was attributable to post-petition income or events.

 The IRS contended that the B-Court reached the wrong result because under applicable non-bankruptcy law – the Internal Revenue Code – a corporation’s entire annual income tax accrues on the last day of its tax year. Because a corporation has only a single tax liability for a tax year, the entire tax is “incurred by the estate” on that day. The IRS argued that the B-Court erred in its failure to consider the language of the Code in its determination of when federal income tax is incurred. The IRS asserted that both the BC and the Code distinguish income taxes, on the one hand, from transaction- or event-based taxes,[xix] on the other.

According to Trustee, the B-Court reached the correct result in holding that income tax is incurred daily, based on each day’s events and transactions, and that a single year’s tax liability must be apportioned between pre-petition and post-petition days, events, and transactions. Under this view, any portion of Debtor’s income tax traceable to events or transactions prior to the petition date, when no bankruptcy estate yet existed, was not “incurred by the estate.” Moreover, since Debtor’s tax year did not end prior to the filing of the bankruptcy petition, the tax incurred in the pre-petition portion of the straddle year was not entitled to priority status, but rather was only a general unsecured claim, notwithstanding the policy of giving preferential treatment to taxes the government has not had a reasonable time to assess or collect. According to Trustee, the distinction between income taxes and event-based taxes was irrelevant; the IRS’s claim for taxes accrued when the income was earned, at the time of the taxable event, such as the pre-petition sale of assets.

Thus, the issue before the D-Court was whether the B-Court was required to look to the underlying substantive tax law – the Code[xx] – to determine when the income tax accrued, as urged by the IRS, or whether the answer turned entirely on when individual transactions or events occurred – pre-petition vs. post-petition – as urged by Trustee’s bifurcated approach.

The District Court

The D-Court began by explaining that the BC sets out several priorities of expenses and unsecured claims against a bankruptcy estate. Second priority is accorded to certain “administrative expenses.”[xxi] To warrant administrative claim priority, the D-Court continued, the straddle year taxes must have been incurred by the estate.

Taxes “incurred by the estate” are administrative expenses, the D-Court stated, entitled to second priority. According to the D-Court, the sole issue on appeal was whether Debtor’s corporate income taxes were “incurred by the estate.”

The IRS argued that a determination of when a tax is “incurred by the estate” depends on when the estate “become[s] liable” for the tax. The IRS argued that, under the Code, a federal income tax does not become a fixed liability until the last day of the applicable tax period; the IRS asserted that this cannot occur until the last day of Debtor’s tax year.

Conversely, Trustee argued that each time a taxable event occurs during a tax year, the taxpayer “becomes liable” for any tax obligation that may arise as a result thereof, regardless of whether that the liability may be contingent, disputed, or unliquidated.[xxii]

Trustee urged that “corporate income taxes accrue – and thus are ‘incurred’ – on a daily basis as events giving rise to tax liability occur.”  According to Trustee, this construction was consistent with federal bankruptcy law “in determining when a claim arises for bankruptcy purposes.” Thus, the IRS’s claim (i.e., the right of payment of taxes on income earned pre-petition) “accrued when the income was earned.”

The D-Court noted that “The first test for administrative priority – whether a claim for taxes on income earned pre-petition in the year of bankruptcy could be considered ‘incurred by the estate’ – presents a clash between tax policy and bankruptcy policy.” Administrative priority, it stated, turns on whether and when the tax at issue was “incurred by the estate,” not whether and when the IRS’s tax claim arose. This determination, the D-Court explained, must be made based on the underlying substantive tax law.

Under substantive tax law, the D-Court continued, each type of tax is “incurred” at a different point: (1) federal income taxes are “incurred” at the end of the tax year; (2) employment taxes are incurred when wages are paid;[xxiii] and (3) excise taxes are incurred at the time of an event.

“Importing the traditional bankruptcy claims analysis,” the D-Court stated, won’t work for purposes of the priority rules because the identification of when the action which underlies a “right to payment” occurred will not necessarily comport with a determination of when the tax “accrues and becomes a fixed liability” in accordance with the relevant substantive tax law.[xxiv]

“Here,” the D-Court explained, “the Code is the substantive law creating and defining the taxes included in the IRS’s Claim.” Based on the plain language of the Code, a corporation’s federal income tax, if any, “accrues and becomes a fixed liability” on the last date of the tax year. The Code imposes a tax on “taxable income;”[xxv] taxable income, in turn, is defined as gross income, which is “all income from whatever source derived,” minus allowable deductions.[xxvi] It is only on the last day of the taxable year that all events giving rise to an income tax have occurred (both these creating income and those creating deductions).[xxvii]  A corporation’s income tax thus does not become “a fixed liability” or “inescapably imposed” until that day – December 31 for calendar year taxpayers like the Debtor.[xxviii] It is only after that moment that the corporation’s income tax liability, if any, becomes fixed and inescapably imposed.

Trustee argued that none of the foregoing compels the outcome sought by the IRS. Trustee argued that the Code does not define the terms “incurred” or “accrued” and does not address the classification or prioritization of the taxes at issue. According to Trustee, the fact that the amount of income tax due may change up until the last minute of the tax year is of no moment and does not necessarily mean that the tax is “incurred” at that point.

While the D-Court conceded that the Code does not define the terms “incurred” or “accrued,” and does not address the classification or prioritization of the taxes at issue, it rejected Trustee’s contention that the income tax at issue here was incurred prior to the end of the 2015 tax year, stating that the Code imposes a tax for an entire year, not individual events. Corporate income tax liability, the D-Court reiterated, is determined by netting all the tax year’s income with all the year’s deductible expenses, then applying the applicable tax rate. That computation is based on the sum of information at the end of the tax year.[xxix]

Applying these provisions, the D-Court concluded that Debtor’s 2015 taxable income could only be calculated at the end of its taxable year, after all income and deductions were known. Said differently, until December 31, 2015, Debtor did not have taxable income because not all possible events had occurred. While a major source of income came from sales occurring before the October 2015 petition date, it was irrelevant, the D-Court stated, “whether that income was recognized on one day during the year or on 365 separate days,” because the Code considers aggregate amounts, not individual income events or deductions, during the year. Under the substantive tax law, the Debtor’s income became taxable income only after determining all income and deductions for the taxable year, at which point the tax accrued and became a fixed liability.

Finally, Trustee asserted that applying the IRS’s interpretation would lead to an “absurd result” which would “gut the Bankruptcy Code.” According to Trustee, “if the dispositive factor in the IRS’ analysis of when a tax is ‘incurred’ turns on a[] fixed or inescapable liability, then the estate would be liable for all taxes of the [Debtor] – both pre-petition and post-petition – and elevate all of those taxes to administrative expense priority treatment.”[xxx]

Again, the D-Court disagreed, pointing out that, under this analysis, taxes for years ending on or before the petition date would not be accorded administrative expense treatment, and the attendant priority.[xxxi] What’s more, the D-Court explained, there was no support for the position that Congress intended to make straddle-year taxes entirely post-petition claims. Rather, underlying substantive tax law would determine whether and when taxes were “incurred by the estate” for purposes of the BC’s priority rules.[xxxii]

Based on the Code, federal corporate income tax liability accrues and becomes a fixed liability on the last day of the tax period – December 31, 2015 in this case.

Accordingly, the income tax at issue in the IRS’s claim was incurred by Debtor’s estate post-petition, and the tax should be entitled to priority as an administrative expense. With that, the B-Court was reversed.

Looking Ahead

It remains to be seen how the large number of bankruptcy filings already triggered by the COVID-19 economic slowdown will ultimately be resolved, and what the impact thereof will be on the timing and nature of an eventual recovery. Of course, future filings will also have to be monitored.[xxxiii]

The outcome will depend in large part upon the hopefully soon-to-be-enacted stimulus legislation, as well as upon the passage of more targeted debt-relief legislation which has probably not yet been drafted, let alone introduced.[xxxiv]

In the meantime, struggling businesses will have to do what is necessary to survive. That includes planning for a possible reorganization in bankruptcy, among the elements of which should be the preservation of tax attributes[xxxv] that may enable the business to reduce future income tax liabilities, and the reduction of CODI the tax on which would further deprive the business of needed liquidity.

Finally, the owners of a troubled business should consider their own personal exposure as “responsible persons” for the failure of the business to collect and/or remit federal and state employment taxes[xxxvi] as well as state and local sales taxes.

The best way to ensure a timely and effective response to any of these developments is for the business owners and their advisers to regularly communicate with one another.[xxxvii]

[i] For example, the Paycheck Protection Program (PPP) loans under the CARES Act. Provided certain conditions are satisfied, a PPP loan will be forgiven; the amount forgiven, however, will not have to be included by the borrower in its gross income as cancelation of indebtedness income.

Please note there were whisperings in Washington last week that an agreement between the House and Senate on the next round of stimulus legislation may allow businesses to deduct expenses that were paid with PPP loan proceeds. The following may refresh your memory:

[ii] A case filed under Chapter 11 of the United States Bankruptcy Code is often referred to as a “reorganization” bankruptcy.

A Chapter 11 case begins with the filing of a petition with the Bankruptcy Court. A petition may be a voluntary petition, which is filed by the debtor, or it may be an involuntary petition, which is filed by creditors that meet certain criteria.

The voluntary petition will include standard information concerning the debtor, including the location of its principal assets, the debtor’s reorganization plan, and a request for relief under the Bankruptcy Code.

Upon filing a voluntary petition for relief under Chapter 11 or, in an involuntary case, the entry of an order for relief, the debtor automatically assumes an additional identity as the “debtor in possession.” The term refers to a debtor that keeps possession and control of its assets while undergoing a reorganization under chapter 11, without the appointment of a trustee. A debtor will remain a debtor in possession until the debtor’s plan of reorganization is confirmed, the debtor’s case is dismissed or converted to Chapter 7, or a Chapter 11 trustee is appointed.

Generally, a written disclosure statement and a plan of reorganization must be filed with the court. The disclosure statement is a document that must contain information concerning the assets, liabilities, and business affairs of the debtor sufficient to enable a creditor to make an informed judgment about the debtor’s plan of reorganization.

The U.S. trustee is responsible for overseeing the administration of bankruptcy cases. The U.S. Trustee may also impose certain requirements on the debtor in possession concerning matters such as reporting its monthly income and operating expenses.

Creditors’ committees can play a major role in Chapter 11 cases. The committee is appointed by the U.S. trustee and ordinarily consists of unsecured creditors who hold the seven largest unsecured claims against the debtor. Among other things, the committee: consults with the debtor in possession on administration of the case; investigates the debtor’s conduct and operation of the business; and participates in formulating a plan.




[vi] See, for example, the April 23, 2020 letter from the National Bankruptcy Conference to the House and Senate “leadership.”

[vii] In particular, IRC Sec. 108.

[viii] Remember IRC Sec. 108(i)? It allowed the deferred recognition of CODI realized in 2009 and 2010 (i.e., in connection with the Great Recession).

[ix] See IRC Sec. 108(b) and Sec. 1017; for example, the adjusted basis of the taxpayer’s property and its loss carryforwards.

[x] Their hands are full at the moment. Worse yet, we’re approaching the political rutting season.

[xi] Let’s face it, this virus continues to evolve, and people are starting to behave badly after many weeks of house-quarantine. The effects of the confluence of these factors will probably come to light later this year.

[xii] For example, those in the real estate industry, where debt financing is a way of life. These folks have already been hit pretty hard. Social distancing and, even more so, the advent of remote working do not bode well for the future of office buildings. Amazon and its kind have been like a punch in the gut for most bricks-and-mortar retailers and their landlords. Biden wants to eliminate the like kind exchange.

[xiii] In re Affirmative Insurance Holdings Inc., No. 15-12136-CSS (D. Del. July 27, 2020).

[xiv] 11 USC Sec. 507(a).

I find myself in a quandary. There are codes and then there are Codes. I have rarely, if ever, accorded the Bankruptcy code the honor of a capital “C” – sorry, Kristina – that distinction belongs to the Internal Revenue Code, at least insofar as U.S. law is concerned.

Justinian’s Code, which formed the basis for many of Europe’s civil law jurisdictions, also merits the initial cap “C”. Query why today’s students learn nothing of the more than one thousand years of Byzantine history?

[xv] Under Chapter 7, the case trustee administers the bankruptcy case and liquidates the debtor’s assets in a manner that maximizes the return to the debtor’s unsecured creditors. (The secured creditors are already provided for.) The trustee accomplishes this by selling the debtor’s property if it is free and clear of liens or if it is worth more than any security interest or lien attached to the property. The trustee may also attempt to recover money or property from third parties (to which the debtor has made payments) under the trustee’s “avoiding powers.”

The BC governs the distribution of the property of the estate (i.e., the sale proceeds). The BC prioritizes several classes of claims; each class must be paid in full before the next lower class is paid anything. The debtor is only paid if all other classes of claims have been paid in full.

For example, higher priority is accorded to “administrative expenses,” including the actual, necessary costs and expenses of preserving the estate; lower priority is accorded to unsecured claims for income taxes owing for a taxable year ending on or before the date of filing of the petition. See BC Sec. 507(a)(2), 503(b)(1)(B)(i), and 507(a)(8)(A).

[xvi] On IRS Form 1120.

[xvii] BC Sec. 507(a)(8).

[xviii] Commencement of a bankruptcy case creates an “estate.” The estate technically becomes the temporary legal owner of all the debtor’s property. It consists of all legal or equitable interests of the debtor in property as of the commencement of the case, including property owned or held by another person if the debtor has an interest in the property. BC Sec. 541.

[xix] For example, employment taxes with respect to wages paid.

[xx] You know the one I mean. Right? Don’t make me come over there.

[xxi] BC Sec. 503(b).

[xxii] Bankruptcy policies, Trustee argued, require treating the pre-petition portion of a debtor’s tax liability for the year of bankruptcy as a pre-petition claim. The BC broadly defines a “claim” to include unliquidated, contingent and unmatured obligations. While applicable non-bankruptcy law determines whether a claimant has a substantive right to payment, when a claim arises for bankruptcy purposes, Trustee argued, is a question of federal bankruptcy law.

[xxiii] IRC Sec. 3101 and 3111; Reg. Sec. 31.3101-3 and 31.3111-3. See also BC Sec. Sec. 507(a)(8)(D), which gives priority to “an employment tax on a wage, salary, or commission … earned from the debtor before the [petition date], whether or not actually paid before such date, for which a return is last due … after three years [before the petition date].”

[xxiv] That being said, the Court observed that the time of assessment or payment may not be equivalent to the time the tax is incurred for the purpose of establishing priority under the BC. Rather, the significant fact may be the date the tax accrues.

In fact, the date a federal income tax accrues and the assessment date are not the same. Assessment usually follows the filing of a tax return several months after the end of the tax year. Assessment is the determination of liability and the administrative act that allows collection when payment is not made. IRC Sec. 6201.

[xxv] IRC Sec. 11(a). “A tax is hereby imposed for each taxable year on the taxable income of every corporation.”

[xxvi] IRC Sec. 61(a) and Sec. 63(a).

[xxvii] See Reg. Sec. 1.11-1(e), providing an example of computation of liability.

[xxviii] IRC Sec. 441(b)(1). Until midnight on December 31, a corporation can still, for example, incur operating expenses or make charitable donations that will eliminate any liability that would otherwise arise from income earned during the preceding twelve months.

[xxix] IRC Sec. 441(a): “Taxable income shall be computed on the basis of the taxpayer’s taxable year.”

[xxx] Indeed, the IRS argued that Congress intended to make straddle year taxes entirely post-petition administrative claims. The BC, it stated, has always given preferential treatment to taxes the government has not had a reasonable time to assess or collect, as the taxing authority is an involuntary creditor. Because Debtor’s straddle tax year ended after the petition date, the IRS had no opportunity to collect the tax pre-petition, as any such tax by definition cannot come due until after the petition date.

[xxxi] BC Sec. 507(a)(8)(A).

[xxxii] The D-Court agreed that the distinction between income taxes, on the one hand, and other taxes which accrue upon the occurrence of certain transactions or events, on the other, is recognized in both the BC and the Code. The key is that a determination of when a specific tax accrues and becomes a fixed liability – i.e., is “incurred” for purposes of determining its priority under the BC – must be made in accordance with the substantive tax law.

[xxxiii] There is a silver lining here. These filings may present healthier businesses an opportunity to acquire assets and customers, hire key employees, eliminate competitors, establish new locations, etc.

For others, the news may not be as sanguine. The loss of a vendor or of a customer may have serious consequences for an otherwise healthy business.

The loss of a debtor may qualify a lender for a bad debt deduction. IRC Sec. 166.

[xxxiv] The fact that we find ourselves in the midst of a very abrasive and divisive election season is unfortunate to say the least.

Let’s not forget, however, that this country has come through presidential elections under much more dire circumstances. How about the election of 1864?

[xxxv] For example, net operating losses.

[xxxvi] The employee’s share thereof.

[xxxvii] To quote Austin Powers, “Okay, people, you have to tell me these things, alright? I’ve been frozen for 30 years, okay? Throw me a freakin’ bone here. I’m the boss. Need the info.” The Spy Who Shagged Me.

NYC: A “Helluva” Town, for S corps[i]

Of late, I’ve received a surprising number of inquiries regarding the taxation of S corporations doing business in New York City (“NYC”).

As many of you know, NYC does not recognize Federal or New York State (“NY”) S corporation elections; instead, NYC generally treats S corporations as if they were regular C corporations, and imposes a corporate-level income tax on S corporations[ii] with income sourced in NYC: the General Corporation Tax (“GCT”).[iii]

Moreover, if an S corporation’s shareholders reside in NYC,[iv] their NYC personal income tax is determined without any reduction for the GCT paid by the S corporation to NYC;[v] in other words, the corporation and the shareholder are taxed on the same amount of income.[vi]

Notwithstanding this state of affairs, and in spite of the restrictions under which every S corporation has to operate,[vii] the large number of closely held businesses that operate in NYC have elected to be treated as S corporations for Federal and NY tax purposes;[viii] consequently, the GCT accounts for a significant portion of NYC’s tax revenues.[ix]

Speaking of NYC’s tax revenues, the economic downturn attributable to the COVID-19 virus has taken a heavy toll on NYC’s finances. In the continued absence of fiscal support from Washington, and in recognition of the fact that so-called “progressives” seem to be on the rise at the Federal, NY and NYC levels of government, there is a greater likelihood that these taxing authorities will seek to offset this shortfall by “strengthening” and more aggressively enforcing existing taxes and, perhaps, by introducing some new taxes on more profitable businesses and their owners.

Under these circumstances, it behooves the owner of a NY S corporation that operates in NYC to understand, generally, how the GCT works.[x] With this basic information, the owner may be better equipped to confer with their advisers on tax minimization strategies.[xi]

A good place to start the business owner’s corporate tax education is the letter “C”.[xii]

Federal Tax: Corporations

A “C corporation”[xiii] is a separate taxable entity the taxable income of which is subject to Federal tax independently of its shareholders.[xiv]

The corporation’s shareholders are themselves taxed on the corporation’s net income only to the extent such income is actually or constructively[xv] distributed to them, usually in the form of a dividend.[xvi] The shareholders pay income tax[xvii] on the amount of the dividend distribution even though the corporation has already paid corporate income tax on the same amount before it was distributed.

Shareholders often seek to avoid this “double taxation” by electing to treat their corporation as an “S corporation.”[xviii]

An S corporation generally does not pay an entity-level Federal tax on its earnings.[xix] Rather, those earnings “pass-through” and are taxed directly to the shareholders of the corporation.[xx] The shareholders may then withdraw these already-taxed earnings without incurring any additional Federal income tax.[xxi]

NY Tax: C Corporations

In general, NY taxes C corporations in the same way they are taxed under the Code. In fact, a corporation’s Federal taxable income – basically, its “entire net income” under NY’s Tax Law – is the starting point for determining a C corporation’s NY income tax liability.

A corporation’s entire net income means its total net income from all sources – the same as the taxable income which the corporation is required to report to the IRS – with certain adjustments.[xxii]

This amount is then reduced by the corporation’s investment income and other “exempt income,” the difference being the corporation’s “business income.”[xxiii]

Once a corporation’s business income has been determined, the amount thereof that may be taxed by NY[xxiv] has to be determined; this is the corporation’s “business income base” – i.e., the portion of the corporation’s business income that is apportioned to the NY.[xxv]

Business income is apportioned to NY by the so-called “apportionment factor.” This is a fraction that is determined by including in the numerator and/or in the denominator only those receipts, net income, net gains, and other items prescribed by the NY Tax Law that are included in the computation of the corporation’s business income.[xxvi] Thus, the smaller the fraction – i.e., the smaller the numerator relative to the denominator – the smaller the amount of the corporation’s business income that is subject to NY tax.

NY Tax: S Corporations

Generally speaking, NY’s tax treatment of NY S corporations[xxvii] – i.e., a Federal S corporation that would otherwise be subject to corporate-level tax in NY, but for which its shareholders have filed an election to be treated as an S corporation for NY tax purposes – is the same as provided under the Code, though there are some significant differences.

For example, NY does not impose a corporate-level income tax similar to the Federal built-in gains tax;[xxviii] if such a tax is imposed upon a NY S corporation, its shareholders must, in determining their NY adjusted gross income, increase their Federal adjusted gross income[xxix] by an amount equal to their pro rata share of the Federal corporate-level tax imposed upon the corporation.[xxx]

That being said, NY does impose an annual “fixed dollar minimum” franchise tax, the amount of which depends upon the S corporation’s NY receipts for the taxable year.[xxxi]

The NY S corporation must file an annual NY tax return[xxxii] to pay the fixed dollar minimum tax, and to report, in aggregate, the NY S corporation items that those who were shareholders of the NY S corporation during any part of the year need for filing their own NY personal income tax returns.[xxxiii]

The corporation must report to each shareholder the shareholder’s pro rata share of the S corporation tax items,[xxxiv] as well as any additional information the shareholder needs for filing their personal income tax return, including the S corporation’s business apportionment factor.

A NY resident shareholder must include their pro rata share of NY S corporation income, gain, loss and deduction. However, if the corporation carries on business both in and out of NY, a nonresident shareholder will need the corporation’s business apportionment factor in order to determine their NY-sourced income.[xxxv]

S Corps in NYC

In NYC, the GCT is imposed on S corporations at a rate of 8.85%.[xxxvi] Beginning after 2014, the “business income base” is the primary tax base for corporations subject to the GCT, including S corporations, to which this rate is applied.[xxxvii]

Business income is defined as entire net income minus investment income.[xxxviii] Entire net income is generally the same as the entire taxable income which the corporation is required to report to the IRS, or which it would have been required to report if the corporation had not elected to be treated as an S corporation.[xxxix]

Entire net income does not include income and gains from subsidiary capital.[xl] According to NYC, this exclusion encompasses dividends, interest and gains from subsidiary capital, but not any other income from subsidiaries.[xli] “Subsidiary” means a corporation of which over 50% of the voting stock is owned by the taxpayer.[xlii] “Subsidiary capital” means investments in the stock of subsidiaries and any indebtedness from subsidiaries (other than accounts receivable).[xliii]

If an individual shareholder of an S corporation that is subject to tax in NYC is also a resident of NYC, they must consider how the corporation’s tax items affect their NYC personal income tax liability.

The starting point for determining a resident shareholder’s NYC income tax liability is their “city taxable income,”[xliv] which is based upon their Federal adjusted gross income – which includes their pro rata share of S corporation income[xlv] – with certain modifications.[xlvi] Among these modifications is the add-back to adjusted taxable income of any corporate-level income tax imposed by NY,[xlvii] NYC, or any other taxing jurisdiction, to the extent deductible in determining Federal adjusted gross income.[xlviii]

Consequently, the NY S corporation’s net earnings will be subject to the GCT, and these same earnings will be passed on to the corporation’s shareholders and taxed again under NYC’s personal income tax.

Thus, any GCT paid by the S corporation will be added back for purposes of determining the resident shareholder’s NYC income tax liability – the corporation’s taxable income is taxed both to the corporation and to the resident shareholder.

Does Your Head Hurt?

And you thought that Subchapter C of the Code was complicated?

The foregoing discussion highlighted just some of the differences between NY’s and NYC’s respective tax treatment of S corporations – there are many more.[xlix] Believe me when I say that both “lay people” and tax advisers are often confused by the separate application of these two sets of rules, let alone by the interplay between them.

In order to simplify matters, and to reduce the tax burden on S corporations that are doing business in NYC, as well as that of their NYC-resident shareholders, there have been many proposals over the years to conform NYC’s tax treatment of S corporations to NY’s.

To date, these proposals have been rejected, though some attempts have been made at lessening the burden on NYC-resident shareholders.

One reason for this failure is the amount of tax revenue that historically has been generated by S corporations that are subject to the GCT. In light of the dire fiscal straits in which NYC now finds itself, the possibility of its turning its back on this revenue is very remote.

In other words, any S corporation doing business in NYC will have to continue taking the GCT into account in its overall tax planning.

*A word about today’s title. One of my high school physics teachers – Mr. Gordon – had the expression “eschew obfuscation” prominently displayed at the front of his classroom. The irony was not lost on us. It continues to hound me as a tax person.

[i] “New York, New York, a helluva a town. The Bronx is up but the Battery’s down.” From Bernstein’s 1940s musical, “On the Town.”

[ii] At the rate of 8.85%.

For the same reason, a qualified subchapter S subsidiary (QSUB) of an S corporation must file a separate GCT return with NYC, provided it has sufficient nexus to NYC. Finance Memo 99-3.

[iii] NYC Adm. Code Sec. 11-602.1. After 2014, the GCT applies only to S corporations.

[iv] NYC does not impose an income tax upon nonresidents of NYC; indeed, the NYC earnings tax on nonresidents was repealed in 1999.

An individual is a resident taxpayer of NYC with respect to a taxable year if they are domiciled in NYC during that year, or if they maintained a permanent place of abode in NYC and spent more than 183 days during the taxable year in NYC. NYC Adm. Code Sec. 11-1705(b).

[v] NYC Adm. Code Sec. 11-1706(f).

[vi] It should be noted that NY does not impose a corporate-level tax on any “built-in gain” recognized by an S corporation during its five-year recognition period. See IRC Sec. 1374.

Thus, in determining their NY income tax liability, a shareholder of a NY S corporation must add back to their Federal adjusted gross income their share of any Federal built-in gains tax imposed upon the S corporation. NY Tax Law Sec. 612(b)(18).

[vii] For example, an S corporation is allowed only one class of stock outstanding, none of the shares of which may be owned by a partnership, another corporation, or a nonresident alien. See IRC Sec. 1361(b).

[viii] IRC Sec. 1361 and Sec. 1362; NY Tax Law Sec. 660.

[ix] Real property tax and personal income tax are the main sources of NYC’s tax revenue.

[x] We will assume, for our purposes, that the S corporation at issue has sufficient nexus to NYC so as to be subject to NYC income tax; thus, the corporation may be “doing business” in NYC, employing capital in NYC, owning or leasing property in NYC, or maintaining an office in NYC. NYC Adm. Code Sec. 11-603(1).

Please note that NYC does not use the “receipts” test for establishing nexus. By contrast, a corporation will have sufficient nexus with NY for a taxable year if it has receipts from NY of at least $1 million for that year. NY Tax Law Sec. 209(1)(b).

[xi] Of course, any knowledge of the tax law is valuable in and of itself. Seriously. It offers a glimpse into the infinite. . . . Don’t make that face.

[xii] No, I am not regressing to Sesame Street. See Tax Rule No. 1: Read, then keep on reading.

[xiii] A corporation the taxation of which is governed by subchapter C of the Code.

[xiv] IRC Sec. 11. As a result of the 2017 Tax Cuts and Jobs Act (“TCJA”; P.L. 115-97), corporate taxable income is subject to Federal tax at a flat rate of 21%.

[xv] Closely held corporations, and especially those that are family-owned, have to vigilant to avoid constructive dividends; for example, the corporation’s payment of a shareholder’s personal expenses, or the shareholder’s use of corporate-owned property.

[xvi] IRC Sec. 301.

[xvii] IRC Sec. 1(h). The 3.8% surtax on net investment income (which includes dividends) under IRC Sec. 1411 may also apply, depending upon the amount of the shareholder’s adjusted gross income.

[xviii] A corporation the taxation of which is governed by subchapter S of the Code. IRC Sec. 1361 and Sec. 1362. Of course, this assumes that both the corporation and the shareholder are eligible. See IRC Sec. 1361(b).

[xix] IRC Sec. 1363.

An important exception to this rule is the corporate-level built-in gains tax under IRC Sec. 1374. Generally speaking, this tax will be imposed if, within 5 years after the effective date of its S election, the corporation realizes a gain on the disposition of assets that it owned on such date. A corporate-level tax is imposed to the extent of the gain that was inherent in the asset at the time the S election became effective.

[xx] IRC Sec. 1366.

If the shareholder does not materially participate in the S corporation’s business, the shareholder’s pro rata share of this pass-through income may also be subject to the surtax on net investment income. IRC Sec. 1411(c)(2)(A). The surtax is not deductible for purposes of determining the shareholder’s individual income tax liability.

[xxi] This is accomplished by increasing a shareholder’s adjusted basis for their shares of S corporation stock by the amount of S corporation income allocated to such shareholder. IRC Sec. 1367. The corporation may then distribute to the shareholder an amount equal to the amount of this income without triggering any gain recognition; rather, the shareholder’s stock basis is reduced. IRC Sec. 1368.

[xxii] NY Tax Law Sec. 208.9.

[xxiii] NY Tax Law Sec. 208.8.

[xxiv] NY imposes a tax upon a corporation’s business income base. NY Tax Law Sec. 209.1(a).

[xxv] NY Tax Law Sec. 210.1(a). In other words, the business income is divided between NY and any other state to which the corporation has nexus such that part of its income may properly be taxed there. NY now uses a single receipts factor. NY Tax Law Sec. 210-A. See Form CT-3, Part 6.

[xxvi] NY Tax Law Sec. 210-A.

[xxvii] Please note that S corporation status for NY tax purposes is not automatic – meaning that a corporation with a Federal election in effect must still file a separate election with NY in order to be treated as a NY S corporation. The election is filed on Form CT-6, “Election by a Federal S Corporation to be Treated as a New York S Corporation.” See also TSB-M 98(4)C. If the NY election is not filed, the corporation will be treated as a C corporation for NY tax purposes.

[xxviii] IRC Sec. 1374. The NY Tax Law does not provide for such a tax.

[xxix] IRC Sec. 62. The starting point for determining their NY income tax liability. The NY taxable income of a resident individual is the same as their Federal adjusted gross income, with certain modifications. NY Tax Law Sec. 611 and Sec. 612.

[xxx] IRC Sec. 1366(f)(2); NY Tax Law Sec. 612(b)(18)(A).

[xxxi] NY Tax Law Sec. 210(1)(g). For example, a NY S corporation with NY receipts of between $5 million and $25 million will pay a State tax of $3,000.

[xxxii] On Form CT-3-S, “New York S Corporation Franchise Tax Return.”

[xxxiii] The corporation must use Form CT-34-SH for this purpose; it is attached to the Form CT-3-S.

[xxxiv] Reported on Form CT-34-SH.

[xxxv] NY Tax Law Sec. 631(a) and Sec. 632(a)(2). See Form IT-203. Only that portion of the nonresident’s pro rata share of S corporation items that are derived from or connected with NY sources are used in determining the shareholder’s NY tax liability.

[xxxvi] NYC Adm. Code Sec. 11-604. An S corporation that is subject to NYC’s GCT reports its taxable income on Form NYC 4-S, “General Corporation Tax Return.”

[xxxvii] NYC Adm. Code Sec. 11-602.7, 11-602.8, 11-603 and 11-604.

[xxxviii] NYC Adm. Code Sec. 11-602.7.

[xxxix] NYC Adm. Code Sec. 11-602.7 and 11-602.8.

[xl] NYC Adm. Code Sec. 11.602.8(a)(1).

[xli] Rule Sec. 11-27(b)(2)(i).

[xlii] NYC Adm. Code Sec. 11-602.2.

[xliii] NYC Adm. Code Sec. 11-602.3.

[xliv] NYC Adm. Code Sec. 11-1711(a).

[xlv] As reflected on their Schedule K-1.

[xlvi] NYC Adm. Code Sec. 11-1712.

[xlvii] The fixed dollar minimum tax.

[xlviii] NYC Adm. Code. 11-1712(b)(3).

For tax years beginning on or after January 1, 2014, and before July 1, 2019, a NYC resident individual whose city adjusted gross income included a pro rata share of income, loss, and deductions from a NY S corporation, and whose city taxable income was less than $100,000, may have been eligible for a nonrefundable credit on their income tax return for their pro rata share of NYC GCT paid. See Form IT-201-ATT, Line 8a and Form IT-222. See NYC Adm. Code Sec. 11-1706(f), added by Chapter 4 of the Laws of 2013 and thereafter extended in 2019. See TSB-M-16(1)I.

[xlix] Their respective treatment of GILTI comes to mind. See IRC Sec. 951A and Finance Memo 18-10 (Sept. 2, 2019).

It’s Complicated

Coming to grips with the U.S. tax treatment of the foreign-sourced income of a closely held domestic business, and of commercial transactions involving such a business and its related foreign entities, may be intimidating not only for the owners of the business, but also for their advisers.

Indeed, the Code and Regulations include a number of complex rules that are aimed at the overseas activities and investments of U.S. businesses. Many of these involve situations that Congress and the Treasury have determined may result in the improper deferral, or even the permanent avoidance, of U.S. income tax.[i]

That being said, there are many other instances in which an owner’s application of basic U.S. tax principles, identical to those that are routinely encountered in strictly domestic transactions, may prevent a U.S. business from getting into trouble with the IRS, as one taxpayer (“Taxpayer”) recently discovered.[ii]

Before considering Taxpayer’s circumstances, a very brief review of the regime that governs the taxation of the foreign income and activities of U.S. businesses may be in order.

Taxation of Overseas Activities

In general, the U.S. taxes its citizens and residents – including both natural persons and legal entities – on both their U.S. and foreign-sourced income.[iii] For example, the foreign-sourced income attributable to the foreign branch[iv] of a domestic business is subject to U.S. income tax on a current basis; the same is true for foreign-sourced income realized by a domestic or foreign partnership of which the U.S. person is a member.

This general rule is qualified, somewhat, when the foreign-sourced income is realized by a foreign corporation in which a U.S. person is a shareholder. For example, a U.S. person who is a shareholder of a foreign corporation that is engaged in the active conduct of a foreign business will not be subject to U.S. income tax with respect to their share of the corporation’s foreign-sourced income until such income is distributed as a dividend to the U.S. person.

Over the years, however, the U.S. has enacted various anti-deferral rules that require certain U.S. persons to include in their gross income their share of foreign-sourced income that is realized by a foreign corporation of which they are a shareholder.

Subpart F

The main U.S. anti-tax-deferral regime, which addresses the taxation of income earned by controlled foreign corporations (“CFC”),[v] may cause the “U.S. Shareholders” of a CFC to be taxed currently on their pro rata share of certain categories of income earned by the CFC – “Subpart F income” – regardless of whether the income has been distributed to them as a dividend.[vi]

For most U.S. Shareholders, Subpart F income generally includes “foreign base company income,”[vii] which consists of “foreign personal holding company income” (such as dividends, interest, rents, and royalties), and certain categories of income from business operations that involve transactions with “related persons,” including “foreign base company sales income” and “foreign base company services income.”[viii]

Specifically, foreign base company sales income is income derived by a CFC from a purchase or sale of personal property involving a related party in which the property is both manufactured and sold for use/consumption outside the CFC’s country of organization,[ix] and foreign base company services income is income derived by a CFC in connection with the performance of services outside the CFC’s country of organization for or on behalf of a related person.[x]

However, the pro rata amount that a U.S. shareholder of a CFC is required to report as Subpart F income of the CFC for any taxable year cannot exceed the CFC’s current earnings and profits.[xi] After all, the purpose of Subpart F is to deny deferral of U.S. taxation; it cannot require that a U.S. shareholder of a CFC be taxed on amounts in excess of the dividends they would have received if all of the CFC’s income had been distributed currently.[xii]


In 2017, the TCJA[xiii] introduced a new class of income – global intangible low-taxed income (“GILTI”) – that must be included in the gross income of a U.S. Shareholder of a CFC, and which further eroded a U.S. person’s ability to defer the U.S. taxation of foreign-sourced business income.

This provision requires the current inclusion in income by a U.S. Shareholder of (i) their share of all of a CFC’s non-subpart F income (other than income that is effectively connected with a U.S. trade or business and income that is excluded from foreign base company income by reason of the “high-tax” exception[xiv]), (ii) less an amount equal to the U.S. Shareholder’s share of 10% of the adjusted basis of the CFC’s tangible property used in its trade or business and of a type with respect to which a depreciation deduction is generally allowable; the difference is the shareholder’s GILTI.[xv]

In the case of an individual, the maximum federal tax rate on GILTI is 37%. This is the rate that will apply, for example, to a U.S. citizen who directly owns at least 10% of the stock of a CFC.

More forgiving rules apply in the case of a U.S. Shareholder that is a C corporation. For taxable years beginning after December 31, 2017, and before January 1, 2026, a regular domestic C corporation is generally allowed a deduction of an amount equal to 50% of its GILTI; thus, the federal corporate tax rate for GILTI is actually 10.5% (the 21% flat rate multiplied by 50%).[xvi]

With the foregoing rules in mind, let’s consider Taxpayer’s situation.

South of the Border[xvii]

Taxpayer was a U.S. citizen residing in Mexico. During the years at issue,[xviii] they operated a real estate development and construction business in Mexico. They also owned 50% of Mex-Corp, a Mexican corporation, of which Taxpayer was the president. At some point, Taxpayer transferred 41% of their 50% ownership interest in Mex-Corp to an unrelated individual (“NRA”) who was a Mexican citizen, and who was never an officer or director of Mex-Corp.  Taxpayer entered into a consulting and personal services contract with Mex-Corp, and the corporation made payments to Taxpayer for their services.

In order to manage their real estate development and construction activities, Taxpayer incorporated Foreign-Corp in the Bahamas, with the corporation’s bearer shares held by Taxpayer.[xix] The following year, Taxpayer reincorporated Foreign-Corp in Belize. In the process, Taxpayer retroactively amended the corporation’s organizational documents effective as of its original incorporation; these were also amended to reflect that Taxpayer held a 27% ownership interest, and NRA held the remaining 73% ownership interest in Foreign-Corp. Taxpayer was the president and a director of Foreign-Corp.

Taxpayer opened accounts in Foreign-Corp’s name with various financial institutions, and had sole signature authority over each of these accounts.[xx] The application submitted to open one of the accounts identified Taxpayer as Foreign-Corp’s sole director, and described Foreign-Corp’s shareholders as two “bearers” holding one share each of its capital stock. The documents for another account identified Taxpayer as the beneficial owner of the account, and as the “only shareholder and owner;” it described the account’s purpose as “[w]ealth [m]anagement of retirement funds; probably [a] loan for [a] flat in Paris.”

In addition to maintaining at least one personal bank account and several personal brokerage accounts and credit cards, Taxpayer maintained several business credit cards where Foreign-Corp and Taxpayer were listed as the primary cardholders and authorized users.

Foreign-Corp did not compensate Taxpayer by check or direct deposit for the years at issue; instead, it would transfer funds from one of its accounts to Taxpayer’s personal account, or it would directly pay some of Taxpayer’s personal expenses, including personal credit card charges, travel expenses, household furnishings, tuition, gifts to relatives, and rent for an apartment; in addition, Foreign-Corp would transfer funds from its accounts to Mex-Corp “in lieu of salary” to Taxpayer.

Mex-Corp and Foreign-Corp entered into a five-year joint venture (“JV”) agreement to acquire, develop, and sell residential real property in Mexico. Taxpayer managed the JV’s affairs and funds, and served as its managing partner. Taxpayer was also given powers of attorney to act jointly and independently as the attorney-in-fact of JV. As JV’s attorney-in-fact, Taxpayer was authorized to retain any assets owned by JV and to reinvest those assets, co-own assets and commingle Taxpayer’s funds with the funds of JV, and to personally gain from any transaction completed on JV’s behalf.[xxi]

Audit and Determination

Taxpayer’s federal income tax returns for the years at issue – all predating the TCJA and the addition of the GILTI inclusion rule to Subpart F – reported adjusted gross income consisting of wages (from Mex-Corp), interest, ordinary dividends, rent, and “other income.”[xxii]

The IRS audited Taxpayer’s returns.[xxiii] Based on its examination, the IRS identified various corporate disbursements or transfers to Taxpayer or for Taxpayer’s benefit. The IRS determined that Taxpayer had additional wage income from Foreign-Corp, or in the alternative, additional dividend income. Specifically, for the years at issue, the IRS determined that Taxpayer’s additional wage income was attributable to withdrawals from various corporate financial accounts for Taxpayer’s personal use, including for the payment of their personal expenses.

The IRS also determined that Foreign-Corp was a CFC that was 100% owned by Taxpayer for the years at issue, that the investment income from Foreign-Corp’s various accounts was foreign personal holding company income (“FPHCI”) under Subpart F of the Code and, as a result, that Taxpayer was required to report their pro rata share (100%) of that FPHCI as Subpart F income, which was taxable as additional ordinary dividend income.

A notice of deficiency was sent to Taxpayer which reflected these determinations,[xxiv] and which also proposed the imposition of the 20% accuracy-related penalty. In response, Taxpayer timely filed a petition with the U.S. Tax Court.[xxv]

Additional Wage Income?

The Court began with the basics: (i) a taxpayer’s gross income includes “all income from whatever source derived,” (ii) a taxpayer is required to maintain books or records sufficient to establish the amount of his or her gross income required to be shown by such person on any return, and (iii) if the taxpayer’s books or records do not clearly reflect income, then the IRS is authorized “to reconstruct income in accordance with a method which clearly reflects the full amount of income received.”[xxvi]

During the audit, the IRS determined[xxvii] that Taxpayer had additional wage income from Foreign-Corp. Notwithstanding Taxpayer’s contention to the contrary, the Court found that Taxpayer offered no evidence to support their position aside from self-serving testimony, which the Court found was not credible. “As we have stated many times before, this Court is not bound to accept a taxpayer’s self-serving, unverified, and undocumented testimony.”  Accordingly, based upon the corporate expenditures made in satisfaction of Taxpayer’s personal expenses, the Court sustained the IRS’s determination of additional wage income for the years at issue.

Subpart F Income

Having addressed the issue of unreported wages, the Court then turned to the IRS’s assertion of Taxpayer’s unreported Subpart F income.

The Court explained that, under Subpart F, a U.S. shareholder of a CFC must generally include in their gross income for a taxable year their pro rata share of the CFC’s “Subpart F income” for such year. A U.S. shareholder with respect to any foreign corporation, the Court continued, is a U.S. person “who owns . . . , or is considered as owning by applying [certain] rules of ownership . . . 10% or more of the total combined voting power of all classes of stock entitled to vote” of the foreign corporation.  The Court stated that a CFC is “any foreign corporation if more than 50% of (1) the total combined voting power of all classes of stock of such corporation entitled to vote, or (2) the total value of the stock of such corporation, is [directly or constructively] owned . . .  by United States shareholders on any day during the taxable year of such foreign corporation.”  And finally, the Court observed that Subpart F income includes foreign base company income, which includes FPHCI, which in turn includes dividends, interest, and the excess of gains over losses from the sale or exchange of certain property.

The IRS determined that Taxpayer had reportable Subpart F income – specifically, the investment income from Foreign-Corp’s bank and investment accounts – during each of the years at issue.


According to the Court, Taxpayer disputed whether Foreign-Corp was a CFC on any day during each of the years at issue, with the result that if Foreign-Corp was a CFC, then Taxpayer had reportable Subpart F income for those years.

It was the IRS’s position that Foreign-Corp was a CFC (and, thus, that Taxpayer had reportable Subpart F income) because Taxpayer held a 100% ownership interest in Foreign-Corp. Taxpayer, on the other hand, contended that Foreign-Corp was not a CFC (and thus they did not have any reportable Subpart F income) because Taxpayer held no more than a 27% ownership interest in Foreign-Corp during the years at issue.

Relying upon an earlier decision[xxviii] involving this very claim, the Court rejected Taxpayer’s contention that the bearer shares that gave them 100% ownership in Foreign-Corp were eliminated and that the share ownership structure changed, reducing Taxpayer’s ownership to 27% for the years in issue. To support this claim, Taxpayer provided Foreign-Corp’s backdated amended organizational documents showing that Taxpayer held a 27% interest. However, the Court stated that nothing in the record indicated an actual change in ownership aside from Taxpayer’s self-serving testimony and the backdated amended documents. What’s more, Taxpayer was the president and a director of Foreign-Corp. Thus, the Court concluded that Taxpayer held a 100% interest in Foreign-Corp, and that the corporation was a CFC for the years in issue.

Consequently, Taxpayer was required to report as gross income their pro rata share of Foreign-Corp’s Subpart F income for the years at issue. Given that Taxpayer was the 100% shareholder of Foreign-Corp for those years, Taxpayer had to report 100% of Foreign-Corp’s Subpart F income for those years.

Moreover, the Court sustained the IRS’s imposition of the 20% accuracy-related penalty on Taxpayer’s underpayment of the tax required to be shown on their tax return, finding that such underpayment was attributable to Taxpayer’s “negligence or disregard of rules or regulations” and/or a “substantial understatement of income tax,”[xxix] and Taxpayer’s failure to demonstrate that they had acted in good faith with respect to, and had shown reasonable cause for, such underpayment.[xxx]

Lesson Learned?

Taxpayer didn’t stand much of a chance. They were not adequately compensated, as such, for their services to Foreign-Corp; instead, Taxpayer’s compensation was disguised – barely – through the payment of various personal expenses.[xxxi]

Taxpayer’s attempt at avoiding the Subpart F inclusion rules, by using a mere straw man (NRA) to hold shares of Foreign-Corp stock, was equally unavailing.

Such transparent attempts at avoiding the anti-deferral rules of Subpart F of the Code are ill-advised.

However, there is another “extreme” approach that is almost as bad. I am referring to those advisers who, seemingly for their own convenience, choose to report all of a CFC’s foreign-sourced income on the U.S. Shareholder’s federal income tax return without considering the applicable rules or analyzing any opportunities for deferral.

Somewhere in between these two sets of advisers are those folks who dedicate varying degrees of attention to the application of the Subpart F rules at the federal level, but who may not be familiar with their application by state and local taxing authorities – after all, not every domestic jurisdiction has fully conformed to these federal anti-deferral rules.

In the case of New York, for example, it is important for advisers to recognize that 95% of GILTI required to be included in a corporate taxpayer’s federal gross income[xxxii] is excluded from New York State taxation as “exempt CFC income” for tax years beginning on or after January 1, 2019.[xxxiii] By contrast, similar legislation was not enacted with respect to either New York City’s general corporation tax or its business corporation tax.

There’s a lot to chew on here, but there’s no substitute for working through the details.


[i] Although not relevant to the discussion here, IRC Sec. 367 generally prevents the tax-free reorganization rules from allowing certain transactions to remove assets or income from the tax jurisdiction of the U.S.

[ii] Flume v. Comm’r, T.C. Memo. 2020-80.

[iii] Most U.S. tax treaties include a so-called “savings clause” that allows the U.S. to tax its residents as if the treaty were not in force. This provision is intended to prevent U.S. residents from using the treaty to reduce their U.S. income tax liability. See Article 1, Paragraph 4 of the U.S. Model Income Tax Convention.

[iv] This includes a foreign “eligible” entity owned by the U.S. business that has elected to be treated as a disregarded entity for U.S. tax purposes. Reg. Sec. 301.7701-3; IRS Form 8832, Entity Classification Election.

[v] IRC Sec. 957. A CFC is defined as any foreign corporation in which U.S. persons own (directly, indirectly, or constructively) more than 50% of the corporation’s stock (measured by vote or value), taking into account only those U.S. persons who own at least 10% of the foreign corporation’s stock (measured by vote or value; each a “United States shareholder”).

Under the CFC rules, the U.S. generally taxes the U.S. Shareholder of a CFC on their pro rata shares of the CFC’s “Subpart F income,” without regard to whether the income is distributed to the shareholder. In effect, the U.S. treats the U.S. Shareholder of a CFC as having received a current distribution of their share of the CFC’s Subpart F income.

[vi] IRC Sec. 951.

[vii] IRC Sec. 954.

[viii] One exception to the definition of Subpart F income permits continued U.S.-tax-deferral for income received by a CFC in certain transactions with a related corporation organized and operating in the same foreign country in which the CFC is organized (the “same country exception”).

Another exception is available for any item of income received by a CFC if the taxpayer establishes that the income was subject to an effective foreign income tax rate greater than 90% of the maximum U.S. corporate income tax rate (the “high-tax exception”). In theory, the 21% U.S. federal corporate income tax rate should make it easier to qualify for this exception.

[ix] IRC Sec. 954(d).

[x] IRC Sec. 954(e).

[xi] IRC Sec. 952(c)(1)(A).

[xii] A CFC’s current earnings and profits are generally determined according to rules substantially similar to those applicable to domestic corporations. IRC Sec. 964; Reg. Sec. 1.964-1.

[xiii] Tax Cuts and Jobs Act (“TCJA”). P.L. 115-97.

[xiv] IRC Sec. 954(b)(4).

[xv] IRC Sec. 951A.

[xvi] IRC Sec. 250(a)(1)(B). However, see the election under IRC Sec. 962;

[xvii] Speaking of which, have you seen the 2004 movie, “The Day After Tomorrow,” with Dennis Quaid and Jake Gyllenhaal? As a result of climate change, most of the Northern Hemisphere is cataclysmically plunged into an ice age, and the U.S. population flees south, to Mexico. When normal access points are blocked by the Mexican government, folks start wading across the Rio Grande. Interesting premise. Total non sequitur here, of course.

[xviii] Which preceded the TCJA.

[xix] The following year, it was reincorporated in Belize.

[xx] Presumably, Taxpayer filed FinCEN Form 114 (the FBAR filing).

[xxi] This falls under the category of “you can’t make this shit up.”

[xxii] Taxpayer claimed the earned income exclusion and certain NOL carryovers.

[xxiii] During the course of the exam, Taxpayer provided some, but not all, of the records requested by the IRS. At that point, the IRS issued third-party record keeper summonses to several U.S. financial institutions, brokerage companies, and credit card companies, and as a result of those summonses received additional records pertaining to Foreign-Corp’s accounts with those institutions and companies.

[xxiv] The IRS first notified Taxpayer of the proposed changes by way of a so-called “30-day letter,” which transmitted an examination report and various worksheets detailing the calculations of the proposed deficiencies and penalties. (The examination report is commonly called a “revenue agent’s report” or “RAR”.) This consisted of a Form 4549-A, Income Tax Examination Changes, and a Form 886-A, Explanation of Items.) The 30-day letter also explained that Taxpayer could request a conference with the IRS Office of Appeals by submitting a formal protest. The letter further advised that if Taxpayer failed to reach an agreement with Appeals or if they did not respond to the letter, then a notice of deficiency would be issued to them. IRC Sec. 6212 and Sec. 6213.

[xxv] In general, the IRS’s determinations set forth in a notice of deficiency are presumed correct and the taxpayer bears the burden of proving otherwise. See Tax Court Rule 142(a). However, for this presumption to adhere in cases (such as this one) involving unreported income, the IRS must provide some reasonable foundation connecting the taxpayer with the income-producing activity. Once the IRS has done this, the burden of proof shifts to the taxpayer to prove by a preponderance of the evidence that the IRS’s determinations of unreported income are arbitrary or erroneous. On the basis of what it described as “credible evidence,” the Court here was satisfied that the IRS had proved that Foreign-Corp was a likely source of the determined unreported income for the years at issue. Thus, as to this income, the burden of proof shifted to Taxpayer to show that the IRS’s determinations in this regard were arbitrary or erroneous.

[xxvi] Reg. Sec. 1.446-1 and Reg. Sec. 1.6001-1.

[xxvii] The IRS used the specific item method to make these determinations. The specific item method is a Court-approved “method of income reconstruction that consists of evidence of specific amounts of income received by a taxpayer and not reported on the taxpayer’s return.”

[xxviii] Flume v. Comm’r, 2017-21. “Issue preclusion,” the Court explained, “applies when suits involve separate claims, but present some of the same issues, and ‘bars the relitigation of issues actually adjudicated, and essential to the judgment, in a prior litigation between the same parties.’ ” Issue preclusion focuses on whether (1) the issue in the second suit is identical in all respects with the one actually litigated, decided, and essential to the judgment in the first suit, (2) a court of competent jurisdiction rendered a final judgment in the first suit, (3) the controlling facts and applicable legal principles in the second suit have changed significantly since the judgment in the first suit, and (4) there are special circumstances, such as fairness concerns, that warrant an exception to preclusion in the second suit.

[xxix] IRC Sec. 6662.

[xxx] IRC Sec. 6664.

[xxxi] These could just as easily have been treated as constructive dividend distributions.

[xxxii] Under IRC Sec. 951A(a) (without regard to the GILTI deduction under IRC section 250).

[xxxiii] NY Tax Law Sec. 208.6-a(b); TSB-M-19(1)C.

Politics and Wealth Inequality

As we approach the presidential convention season,[i] and the election campaign that will follow, the thoughts of many business owners have turned to the federal estate tax, and for good reason.[ii]

After the Great Recession of 2007-2009,[iii] the economy enjoyed a period of sustained growth of approximately 11 years, which ended only recently thanks, in large part, to the economic shutdown. During this time, however, many economists observed a significant increase in “wealth inequality,” whether measured in terms of income or net asset value.

Perhaps more importantly, the general public became more aware of, and attuned to, the wealth gap that almost everyone recognizes is a “natural” by-product of economic activity.[iv] Indeed, it was during this period that the catchphrases “the one percent” and “the 99 percent” entered our lexicon; more recently, “the 0.10 percent” was introduced to refer to really big earners.[v]

Ironically, to many, during this same period the federal estate tax rate and the federal exemption amount have been travelling in somewhat different directions, with the rate remaining steady while the exemption amount has been increasing, especially following the doubling of the basic exemption amount beginning in 2018.[vi] (See the table below, which indicates tax year, exemption amount, and tax rate.)

2007 $2 million 45%
2008 $2 million 45%
2009 $3.5 million 45%
2010 No tax – elective
2011 $5 million 35%
2012 $5.12 million 35%
2013 $5.25 million 40%
2014 $5.34 million 40%
2015 $5.43 million 40%
2016 $5.45 million 40%
2017 $5.49 million 40%
2018 $11.18 million 40%
2019 $11.4 million 40%
2020 $11.58 million 40%

The COVID-19 Shutdown

Thus, as we started 2020, a married couple could pass along a taxable estate worth over $23 million without incurring any federal estate tax liability. If the couple’s assets included a closely held business, it is likely that its “actual” value[vii] was somewhere north of the amount shown on the federal estate tax return.[viii] If one or both members of the couple created irrevocable life insurance trusts (“ILITs”) to acquire life insurance on their lives,[ix] then a substantial sum of cash may also be passed upon the death of the insured(s) without triggering any estate tax.[x]

Enter the quarantine[xi] and economic shutdown. The federal government has already dedicated almost $6 trillion in response to the shutdown, the states have spent several billion on their own, and it is a near certainty that still more will have to be expended, both to bolster the economy and to support the millions of individuals in need of financial assistance.

Add to this dire fiscal situation the President’s “disapproval” rating, the realistic possibility that the Democrats may take the Senate while retaining control of the House,[xii] plus the strong influence of a reinvigorated Democratic left, and you have an environment in which the revival of the federal estate tax as a tool for generating meaningful revenue,[xiii] and of “redistributing wealth,” may be an attractive option both politically and economically.[xiv]

Because of these developments, many business owners are starting to believe that their ability to transfer significant amounts of wealth to their family may become severely restricted after 2020.[xv]

For these individuals, the 2020 year-end holiday gift season may start early and run through the final day of the year.[xvi]

Regardless of which gifting vehicle a business owner decides to use in shifting equity in their business[xvii] – and the future appreciation thereon – out of their estate and into the hands of their family (and perhaps future generations), the economic benefit of the transfer will depend in large part upon the valuation of the business interest.

Valuation of Transferred Business Interests

The fair market value of an interest in a closely held business is a question of fact; according to IRS regulations, it is the price at which the interest would change hands between a willing buyer and a willing seller, neither being under any compulsion to buy or sell, and both having reasonable knowledge of the relevant facts and circumstances.[xviii] These relevant facts and circumstances include whether discounts for lack of control and lack of marketability are factored into the fair market value of an interest in the closely held entity.[xix]

In resolving valuation issues, a taxpayer, the IRS and a court will usually consider the opinion of an expert. The court, for example, will weigh an expert’s opinion in light of the expert’s qualifications and credible evidence – it has relatively broad discretion to evaluate the expert’s analysis. If the court finds one expert’s opinion persuasive, it may accept that opinion in whole or in part over that of the opposing expert. Alternatively, the court may reach “an intermediate conclusion as to value” by drawing selectively from the testimony of various experts.[xx]

Although the valuation process relies upon the analysis of objective data, the conclusions drawn therefrom are inherently subjective and will necessarily depend upon the experience of the appraiser and the exercise of their professional judgement. In other words, competent appraisers may reasonably disagree and arrive at different conclusions of value.

Defined Value Clause

This uncertainty has been the reason for the volume of gift and estate tax valuation disputes brought before the U.S. Tax Court. It is also the reason many taxpayers – especially one making a gift the value of which may exceed the taxpayer’s remaining exemption amount, thereby triggering a tax liability – have sought to limit the degree of uncertainty by utilizing a so-called “defined value clause” (“DVC”) in connection with a gift of property that is difficult to value, including an equity interest in a closely-held business.

A DVC may be used where the donor seeks to keep the value of the gift at or below their remaining gift tax exemption amount. In order to accomplish this goal, the gift may be phrased in terms of “that number of units which have an aggregate dollar value on the date of transfer that is equal to my remaining federal exemption amount” – in other words, the transfer of a fixed dollar amount. In the event the IRS successfully determines that the value of the shares of stock or partnership units gifted by the taxpayer exceeds the taxpayer’s available exemption amount, the DVC provides that some of these shares or units would be “returned” to the taxpayer, as if they had never been transferred – the taxpayer transferred only an amount equal to the exemption amount.[xxi]

Although this formulation sounds relatively straightforward, the courts continue to address situations in which the IRS has thought it worthwhile to challenge the taxpayer, as was demonstrated by a recent decision of the U.S. Tax Court in which the issue presented was whether the taxpayer had transferred a fixed dollar amount of interests in a partnership or a percentage interest in such partnership.[xxii]

Percentage or Fixed Value?

Taxpayer was a partner in Partnership. Taxpayer formed Trust for the benefit of their spouse and children. Taxpayer then transferred interests in Partnership to Trust. The first transfer (in late 2008) was a gift. The memorandum of gift provided as follows:

[Taxpayer] desires to make a gift and to assign to [the Trust] her right, title, and interest in a [partnership] interest having a fair market value of [$2.096 million] as of December 31, 2008 * * *, as determined by a qualified appraiser within ninety (90) days of the effective date of this Assignment.

Taxpayer structured the second transfer (in early 2009, just a few days after the first one) as a sale.[xxiii] The memorandum of sale provided:

[Taxpayer] desires to sell and assign to [the Trust] her right, title, and interest in a [partnership interest] having a fair market value of [$20 million, as determined by a qualified appraiser within [180] days of the effective date of this Assignment.

Neither the memorandum of gift nor the memorandum of sale (collectively, the “transfer instruments”) contained clauses defining fair market value or subjecting the partnership interests to reallocation after the valuation date.

Taxpayer retained an appraiser to value Partnership in connection with the transfers. Because the transfers occurred so close together, the appraiser used the same date for valuing both transfers. On the basis of this valuation, it was determined that Taxpayer’s two transfers equated to 6.14 percent and 58.65 percent of the interests in Partnership, respectively.[xxiv]

Partnership’s agreement was amended to reflect transfers of partnership interests of 6.14 percent and 58.65 percent from Taxpayer to Trust.[xxv] Partnership reported the reductions of Taxpayer’s partnership interest and the increases of Trust’s interests on the Schedules K-1, Partner’s Share of Income, Deductions, Credits, etc., attached to Partnership’s Forms 1065, U.S. Return of Partnership Income. Partnership also made a proportional cash distribution to Trust based upon its 64.79 percent interest, which in turn was based on the appraiser’s valuation.

Tax Returns and Examination

Taxpayer filed IRS Forms 709, United States Gift (and Generation-Skipping Transfer) Tax Returns, for 2008 and 2009. On their 2008 Form 709 they reported the gift to the Trust “having a fair market value of $2,096,000 as determined by independent appraisal to be a 6.1466275% interest” in Partnership. Taxpayer did not report the 2009 transfer of the interest in Partnership on their 2009 Forms 709, consistent with its treatment as a sale.

The IRS examined Taxpayer’s gift tax returns and asserted deficiencies based on a greater value for Partnership.[xxvi] Taxpayer sought to negotiate a settlement agreement with IRS Appeals, but it was never completed. However, on the basis of these discussions with IRS Appeals regarding Partnership’s fair market value, Taxpayer amended Partnership’s agreement to record Trust’s interest in Partnership, based on a transfer of $22.096 million of value, as 38.55 percent (rather than 64.79 percent)[xxvii] and made corresponding adjustments to the partnership’s and the trust’s books. Partnership also adjusted prior distributions[xxviii] and made a subsequent proportional cash distribution to its partners to reflect the newly adjusted interests.

The IRS issued notices of deficiency in which it determined that Taxpayer had undervalued the 2008 gift. The IRS also determined that Taxpayer had undervalued the 2009 transfer, resulting in a part-sale, part-gift.

The Gift Tax

The Court began by explaining that the gift tax is imposed upon a transfer of property by gift.[xxix]

When “property is transferred for less than an adequate and full consideration,” it stated, “then the amount by which the value of the property exceeded the value of the consideration shall be deemed a gift”.[xxx] Conversely, property exchanged for “adequate and full consideration” does not constitute a gift for Federal gift tax purposes.

Furthermore, according to IRS regulations, the gift tax does not apply to “ordinary business transactions,”[xxxi] meaning “a transaction which is bona fide, at arm’s length, and free from any donative intent.”[xxxii] A transaction meeting this standard, the Court stated, “will be considered as made for an adequate and full consideration in money or money’s worth.”

It added, however, that a transaction between family members would be “subject to special scrutiny, and the presumption is that a transfer between family members is a gift.”

The Court then turned to the transfers at issue. To determine the amount of any gift tax due on all or part of these transfers, the Court noted that it had to decide the value of the interests transferred. But before doing so, it first had to decide the nature of the interests transferred.

Nature of the Interests Transferred

The parties agreed that the transfers were complete once Taxpayer executed the transfer instruments parting with dominion and control over the interests.[xxxiii] But they disagreed over whether Taxpayer transferred interests in Partnership valued at $2,096,000 and $20 million, as Taxpayer contended, or percentage interests of 6.14 percent and 58.65 percent, as the IRS contended, the values of which were subject to adjustment based upon the IRS’s revaluation of Partnership.

The Court looked to the transfer documents to decide the amount of property given away by Taxpayer in a completed gift. Taxpayer argued that the transfer instruments showed that they transferred specific dollar amounts, not fixed percentages, citing a series of cases that respected formula clauses as transferring fixed dollar amounts of ownership interests. In each of those cases, the Court respected the terms of the formula, even though the percentage amount was not known until the fair market value was subsequently determined, because the dollar amount of the transfer was known.[xxxiv]

The Court then distinguished a DVC from a “saving clause.” The latter, it stated, has been rejected by the courts because it relies on conditions subsequent to adjust the amount of the gift or transfer; thus, the size of the transfer cannot be known on the date of the transfer.

By contrast, the courts have upheld a gift of an interest in a partnership expressed as “a dollar amount of fair market value in interest,” rather than a percentage interest that was determined in agreements subsequent to the gift. The Court explained that “a gift is valued as of the date that it is complete; the flip side of that maxim is that subsequent occurrences are off limits.”

Taxpayer argued that the Court should construe the transfer clauses here as transferring dollar amounts rather than percentages. However, as part of their argument, they also cited evidence of their intent, which included their settlement discussions with IRS Appeals and the subsequent adjustments made in Trust’s percentage interest to reflect changes in valuation of Partnership, but not of the amount transferred.[xxxv]

To decide whether the transfers at issue were of fixed dollar amounts or fixed percentages, the Court started with the formula clauses themselves, rather than the parties’ subsequent actions. The Court observed that although the gift was expressed as a partnership interest having a fair market value of $2.096 million, and the sale was expressed as a partnership interest having a fair market value of $20 million, in each case the transferred interests were expressed as an interest having a fair market value of a specified amount as determined by an appraiser within a stated period after the transfer.

The Court stated that the term “fair market value” as used in the Taxpayer’s formula clause was expressly qualified by reference to the post-transfer determination of value by the appraiser – therefore, it was not fixed amount. This could not be ignored, the Court stated; Taxpayer was bound by what they wrote at the time.

The Court concluded that Taxpayer transferred 6.14 percent and 58.65 percent interests in Partnership to the Trust, and not a dollar amount that was fixed on the transfer date; the value reported was not known at the time of the transfers, but was only determined by the appraiser after the transfers. Thus, the amount of the reported gift was not accepted by the Court.

Don’t Let Your Attention Wander-y[xxxvi]

Words to live by, sort of, if one is planning to rely upon a DVC to avoid a gift tax deficiency on the transfer of an interest in a closely held business. That being said, the Court’s decision with respect to Taxpayer’s transfers seems harsh, and should serve as a warning to anyone contemplating a Wandry-like transfer using a DVC; if you’re going to make a gift of a fixed dollar amount on the transfer date, the amount should not be qualified by subsequent events.

Of course, as indicated earlier, there are many other means by which a business owner may seek to make a tax efficient gift of an interest in the business before 2021. Some owners may even decide that these other transfer vehicles will serve them well even under a reduced exemption transfer tax regime.

These folks should be reminded of the estate and gift tax proposals set out in President Obama’s 2017 Budget.[xxxvii] The Green Book called for an increase in the transfer tax rate to 45 percent, and a reduction in the exemption amount to $3.5 million for estate and GST taxes and $1 million for gift taxes, with no indexing for inflation.

Among other changes proposed were the following:

  • Require that a grantor retained annuity trust (“GRAT”) have a minimum term of ten years and a maximum term of the actuarial life expectancy of the annuitant plus ten years. The minimum term proposal would increase the risk that the grantor would not outlive the GRAT term, thereby bringing it back into their estate and losing any anticipated transfer tax benefit.
  • The proposal also included a requirement that the remainder interest have a value greater than zero at the time the interest was created – no more “zeroed out” GRATs.
  • On the 90th anniversary of a trust’s creation, the GST exemption allocated to the trust would terminate.  This would be achieved by increasing the trust’s inclusion ratio to one, thereby rendering the entire trust subject to GST tax. Farewell dynasty trust.
  • Upon the death of a grantor who sold property to a grantor trust[xxxviii] (a disregarded transfer for income tax purposes), the portion of the trust attributable to the property received in that transaction (including all of its retained income and appreciation) would be subject to estate tax as part of the grantor’s gross estate. So much for sales to so-called “IDGTs.”
  • In addition, such portion of the trust would be subject to gift tax during the grantor’s life when their treatment as the deemed owner of the trust is terminated.  Any distribution from the trust to another person would also be treated as a gift by the grantor.

Query whether any of these earlier legislative proposals will find their way into Congress after 2020. I wouldn’t be surprised – low-hanging fruit. The same may be said for the previously withdrawn proposed regulations aimed at curtailing valuation discounts for interests in closely held businesses.

It will pay to do some homework and to be prepared for whatever may come our way.

[i] The Republican Party’s convention is scheduled for August 24-27; the Democratic Party’s for August 17-20. The suspense is killing me. Not.

The following quotation is attributed to the late 18th, early 19th century French political philosopher, Joseph de Maistre: “Every nation gets the government it deserves.” If there is any truth to this statement – and I believe there is – then no matter which way you look at our circumstances, it doesn’t say very much about us. However, it also leaves open the possibility that we can do better.

[ii] No, that is not a comment on the ages of either candidate (74 and 77), or an observation on the ages of the Senate majority leader or the speaker of the House (78 and 80, respectively). I carry my AARP card proudly, sort of.

Did you know that Roman Senators held office for life? You see the difference, don’t you?

[iii] Which saw the great bank bailout, and came only a few years after the bubble burst. And don’t forget the 1989 savings and loan bailout, or the 1987 stock market crash.

[iv] Witness the “occupy” movement of 2011.

[v] According to Forbes, the U.S. added almost 700,000 millionaires from 2018 into 2019. Jack Kelly, October 22, 2019.

[vi] Tax Cuts and Jobs Act. P.L. 115-97. The basic exemption amount is scheduled to be reduced to its pre-2018 level beginning in 2026. IRC Sec. 2010.

Also in 2018, the IRS withdrew proposed regulations that would have limited, somewhat, a donor-taxpayer’s ability to discount the value of a gifted interest in a closely held business.

[vii] If its assets were sold at FMV and the net proceeds distributed to the owners.

[viii] See the discussion below regarding the valuation of interests in closely held businesses.

[ix] Perhaps a second-to-die policy, which would be more cost efficient.

[x] And let’s not forget the effect of the GST Tax exemption and the creation of so-called “dynasty trusts,” which effectively removed these assets from the transfer tax system for generations. President Obama’s last Green Book sought to reduce the impact of such trusts.

[xi] The flight of many of the well-to-do to far-away locations did not go unnoticed by the American public. Selfie anyone?

[xii] Assuming they take the White House, the Democrats need to pick up only three seats to win a majority. The Republicans would need to pick up 18 or 19 seats to min a majority in the House.

[xiii] During the 1970’s the top rate was between 70% and 77%, and between 5% and 8% of estates were subject to the tax. Over the last 20 years, just over 1% of the estates, on average, have been subject to the tax. Since 2010, that figure has dropped to 0.30%.

[xiv] Alternatively, the presumptive Democratic nominee, Joe Biden, has raised the possibility of imposing a tax on the unrealized appreciation of assets that pass upon the death of a taxpayer. Such a tax would effectively eliminate the basis step-up enjoyed by a decedent’s heirs under current law. What’s more, Biden has mentioned increasing the long term capital gains tax rate to the ordinary income rate in the case of wealthier taxpayers.

[xv] Indeed, many of the very wealthy seem to be concerned enough to have formed their own organizations – for example, Millionaires for Humanity – that are calling for higher taxes on the wealthy. Remember FDR and the New Deal? It’s called co-opting the left. . Those who are ignorant of history . . .

[xvi] Anyone remember the end of 2012? It looked like the tax cuts enacted in 2001 would expire; this included the increased exemption amount. In order to take advantage of the then $5.12 million exemption amount before it disappeared, many owners gifted interests in their business to trusts for the benefit of their children.

[xvii] For example, a straight gift, a straight sale, a bargain sale, a GRAT, a sale to a grantor trust.

[xviii] Reg. Sec. 25.2512-1. The willing buyer and willing seller are purely hypothetical figures and, generally speaking, the valuation does not take into account the personal characteristics of the actual recipients of the property being valued.

[xix] See generally Rev. Rul. 59-60.

[xx] As the Tax Court stated in the case described below, for a value (or discount), it is “not necessary that the value arrived at by the trial court be a figure as to which there is specific testimony, if it is within the range of figures that may properly be deduced from the evidence.” Stated differently, the Court may channel Solomon. See the Book of Kings in the Old Testament.

[xxi] See, for example, Wandry, T.C. Memo. 2012-88. The Tax Court ruled that what the taxpayer had gifted was LLC units having a specific dollar value – the exemption amount – and not a specific number of LLC units.

[xxii] Nelson v. Comm’r, T.C. Memo. 2020-81.

[xxiii] In connection with the second transfer, Trust executed a promissory note for $20 million.The note provided for interest on the unpaid principal; it was payable and compounded annually; the note was secured by the partnership interest that was sold. Good stuff.

[xxiv] Partnership was valued at approximately $34.1 million. Taxpayer’s transfers of $2.096 million + $20 million = $22.096 million, or 64.79% of Partnership.

[xxv] Effective as of the time of the transfers.

[xxvi] The IRS valued Partnership at $57.3 million.

[xxvii] $100 will get you 64.79% of a business worth $154, but only 38.55% of one that is worth $259.

[xxviii] Partnership had previously made a distribution to Trust based on its holding a 64.79% interest. Query whether Trust was required to return the excess, or whether it was treated as a loan from Partnership.

[xxix] IRC Sec. 2501.

[xxx] IRC Sec. 2512(b).

[xxxi] Reg. Sec. 25.2511-1(g)(1).

[xxxii] Reg. Sec. 25.2512-8.

[xxxiii] Reg. Sec. 25.2511-2(b).

[xxxiv] See the Wandry decision, for example.

Taxpayer transfers $1 million of equity. The FMV of the business is not known, and the percentage interest of the transferred equity valued at $1 million is not known – the value of the business will be known after the transfer, at which point the percentage interest transferred will also be known.

[xxxv] The Court stated that it would look to the terms of the transfer instruments, and not to the parties’ later actions, except to the extent that it concluded the terms were ambiguous and their actions revealed their understanding of those terms.

[xxxvi] Pretty bad, I know. For some reason, tax folks feel compelled to come up with a catchy title or caption. One day, it’ll be my turn to come up with a good one.

[xxxvii] . You remember Mr. Obama? Mr. Biden’s boss.

[xxxviii] One that is deemed to be owned by the grantor under the grantor trust rules. IRC Sec. 671 et seq.

New York Diaspora?[i]

Like most every other state in the Union, New York has experienced its share of fiscal stress over the last few decades. The source or cause of its problems? Well, that may depend upon the respondent to whom this question is posed and, unfortunately, the side of the political aisle on which they place themselves.[ii] However, almost everyone agrees that there are many factors and forces to which the State’s long-standing economic issues may be attributed.[iii]

What’s more, there is no denying that the State’s fiscal situation has been exacerbated by the unexpected expenditures that were necessarily incurred in combating the recent coronavirus outbreak, and by the reduction in badly needed tax revenues caused by the resulting economic shutdown.

What does this state of affairs portend for New York’s taxpayers, especially those who are often described by the media as the “affluent?”[iv]

These folks already pay personal income tax to the State at a top rate of 8.82 percent; if they are residents of New York City, they pay City income tax at a rate of 3.876 percent. The State’s sales tax is 4 percent,[v] but they also have to factor in their local tax; in New York City, that means a sales tax of 4.5 percent plus a Metropolitan Commuter Transportation District surcharge of 0.375 percent, for a total sales tax of 8.875 percent; Nassau County’s sales tax is 8.63 percent and Westchester’s is 8.38 percent. These last two counties regularly take top five honors, nationally, for real property taxes. Then there is New York’s cost of living. And as a parting gift, there is New York’s 16 percent estate tax.[vi]

Well before the shutdown triggered by COVID-19, New York began taking the initiative in examining taxpayers’ personal income tax returns, including – to the extent New York’s Tax Law (the “Tax Law”) conforms to the Code – the Federal tax issues presented in those returns. The obvious goal of this increased audit activity is the collection of more New York income tax.[vii]

With the shutdown, however, the State’s economic situation has only gotten worse, and the pressure to recover lost tax dollars has only increased.[viii]

Query what impact this new fiscal reality will have upon New York’s individual residents, especially those who have always been able to move their business elsewhere but chose to remain in New York anyway, as well as those who just discovered during the recent quarantine that they can effectively manage and operate their business remotely.[ix]

Will It Matter?

Of course, most New Yorkers will stay put[x] – and all of their income will remain subject to New York income tax regardless of its source – but a not insignificant number of individual residents can be expected to emigrate from the State.[xi]

New York’s Department of Taxation and Finance (the “Department”) will audit many of these “emigres”[xii] and will determine that they are still domiciled in the State because they have failed either to abandon New York as their permanent home or to establish a new domicile elsewhere.

More disciplined or committed taxpayers – who are actually willing to do what it takes[xiii] – as well as better-organized taxpayers,[xiv] will succeed in becoming nonresidents of New York.[xv]

Among these soon-to-be former New York residents will be some who will continue to participate, to varying degrees, in a New York business, or who will have a substantial investment in a New York business.[xvi] For many of these individuals, even if they successfully defend their status as nonresidents, their New York source income will continue to represent the largest part of their gross income, and they will continue to pay substantial personal income tax to New York, albeit as a nonresident.[xvii] Pyrrhic victory?

For that reason, it will behoove former residents and their advisers to familiarize themselves with New York’s source rules; only in this way can they organize their New York business or investment, and plan for recognition events with respect to those assets, so as to reduce their New York tax burden.

New York’s Source Rules

In general, nonresidents are subject to New York personal income tax on their New York source income, which is defined as the sum of income, gain, loss, and deduction derived from or connected with New York sources.[xviii] For example, where a nonresident sells real property or tangible personal property located in NY, the gain from the sale is taxable in New York.[xix]

If a nonresident carries on a trade or business party within and partly outside New York, the nonresident must determine the items of income, gain, loss and deduction that are derived from or connected with New York sources.[xx]

However, income derived from intangible personal property, including dividends and interest, as well as the gains from the disposition of such property, constitute income derived from New York sources only to the extent that the intangible property is employed in a business carried on in New York.[xxi]

From 1992 until 2009, this analysis also applied to the gain from the disposition of interests in entities that owned New York real property. Thus, generally speaking, a nonresident who owned an interest in a close corporation, for example, that owned New York real property, could sell such interest without realizing New York source income and incurring New York income tax.

However, in 2009, the Taw Law was amended to provide that items of gain derived from or connected with New York sources included items attributable to the ownership of any interest in real property located in New York.

For purposes of this rule, the term “real property located in” New York was defined to include an interest in a partnership, LLC, S corporation, or non-publicly traded C corporation with one hundred or fewer shareholders, that owns real property located in New York and has a fair market value (“FMV”) that equals or exceeds 50 percent of all the assets of the entity on the date of the sale or exchange of the taxpayer’s interest in the entity.[xxii]

In accordance with an “anti-stuffing” rule, only those assets that the entity owned for at least two years before the date of the sale or exchange of the taxpayer’s interest in the entity are used in determining the FMV of all the assets of the entity on such date.

The gain or loss derived from New York sources from a nonresident’s sale or exchange of an interest in an entity that is subject to this rule is the total gain or loss for federal income tax purposes from that sale or exchange multiplied by a fraction, the numerator of which is the FMV of the real property located in New York on the date of the sale or exchange and the denominator of which is the FMV of all the assets of the entity on such date.

For Example

With that background, let’s turn to a recent Advisory Opinion which illustrated the consequences of failing to fully consider or appreciate the impact of the State’s sourcing rules.[xxiii]

Petitioner was a limited partnership that was formed under the laws of another state for the purpose of investing in U.S. real estate. Petitioner had a large number of limited partners, many of whom were nonresident individuals as to New York.

Petitioner invested in real estate and owned land and improvements in several states, including a New York building that it owned and actively managed for over two years.[xxiv] In connection with the ownership of the building, each of Petitioner’s limited partners was allocated a distributive share of income, gain, loss and deduction[xxv] that was reported as attributable to a business carried on by Petitioner in New York.[xxvi]

Upon the sale of the building on the Closing Date, Petitioner recognized a taxable gain and paid, on behalf of its nonresident limited partners, any required estimated taxes relating to their distributive share of its New York source income associated with the building’s sale.[xxvii] At the time of the sale, the building was the only material asset held by Petitioner, other than any undistributed cash remaining from the disposition of other land and improvements. All of the cash was held for less than two years at the time of the sale of the building through the winding up of Petitioner.

After the building was sold, Petitioner wound up its operations and liquidated. The net proceeds from the sale were transferred on Closing Date to a bank account maintained by an affiliate of Petitioner’s general partner (the “Affiliate”). Affiliate distributed the net proceeds to Petitioner’s limited partners one day after the Closing Date. According to Petitioner, the proceeds were distributed one day after the sale of the New York property because the Closing Date was a bank holiday in the jurisdiction in which its limited partners were located.

Upon Petitioner’s liquidation,[xxviii] each limited partner was expected to recognize a capital loss in an amount equal to the excess of each limited partner’s outside tax basis in Petitioner over the amount of liquidation proceeds received.[xxix]

The Opinion

Petitioner asked the Department whether the loss realized by its nonresident individual limited partners upon the liquidation of Petitioner one day after the Closing Date was derived from or connected with New York sources, such that the loss would offset at least part of the New York source gain allocated to these limited partners from the Petitioner’s sale of the building.[xxx]

Unfortunately for Petitioner’s limited partners, the Department concluded that the loss was not derived from or connected with New York sources.

The Department explained that, under the Tax Law, the New York source income of a nonresident individual includes the individual’s net amount of items of income, gain, loss and deduction entering into the individual’s Federal adjusted gross income that is derived from or connected with New York sources, including the individual’s distributive share of partnership income, gain, loss and deduction.[xxxi]

According to the Department, items of income, gain, loss and deduction derived from or connected to New York sources include items attributable to the ownership of any interest in real property located in the State.[xxxii]

The term “real property located in this state,” the Department stated, includes an interest in a partnership that owns real property that is located in New York and has a fair market value that equals or exceeds 50 percent of all the assets of the entity on the date of sale or exchange of the taxpayer’s interest in the entity. “Only those assets that the entity owned for at least two years before the date of the sale or exchange of the taxpayer’s interest in the entity are to be used in determining the fair market value of all the assets of the entity on the date of sale or exchange.”[xxxiii]

“The gain or loss derived from New York sources from the taxpayer’s sale or exchange of an interest in an entity that is subject to” these provisions, the Department continued, “is the total gain or loss for federal income tax purposes from that sale or exchange multiplied by a fraction, the numerator of which is the fair market value of the real property … located in New York on the date of the sale or exchange and the denominator of which is the fair market value of all the assets of the entity on the date of the sale or exchange.”

As stated above, Petitioner sold its New York building at a gain on the Closing Date. It then wound up its affairs, settled its accounts, and liquidated.

Petitioner asked whether each limited partner’s loss, required to be recognized for Federal tax purposes upon liquidation, would also be recognized for New York tax purposes as a loss derived from New York sources that was attributable to the ownership of an interest in real property in New York.[xxxiv]

The Tax Law[xxxv] provides that items of loss are attributable to New York sources if those items are attributable to the ownership of any interest in real property in New York. This includes, the Department stated, an interest in a partnership that owns real property that is located in New York and has a fair market value that equals or exceeds 50 percent of all the assets of the entity on the date of sale or exchange of the taxpayer’s interest in the entity.

In this case, the Department observed, Petitioner sold its interest in the New York building on the Closing Date, and transferred the net proceeds from that sale to Affiliate, not to its limited partners. Thereafter, Petitioner was liquidated, and the net proceeds were delivered to the limited partners, the day after the Closing Date.

Therefore, any loss recognized by Petitioner’s limited partners from their interests in Petitioner were not attributable to the Partnership’s ownership of real property in New York because Petitioner did not own New York real property on the date on which those partnership interests were liquidated; i.e., the day after the Closing Date.[xxxvi]


Harsh result? Seems so. One day seems to have made all the difference with respect to the source of the loss realized on the liquidation of the nonresident limited partners’ interests in the partnership. Consequently, there was a mismatching of the New York source capital gain that was allocated to these nonresident partners from the sale of the partnership’s New York real property on the Closing Date, and the non-New York source capital loss realized by these same partners on the liquidation of their partnership interests the day after the Closing Date, with the result that Petitioner’s nonresident partners owed New York income tax on the gain.

Query what Petitioner could have done differently so as to avoid this outcome? Perhaps it could have created a liquidating trust to accept the liquidation proceeds?[xxxvii] Such vehicles are often used to facilitate the time-sensitive liquidation of a corporation. In the case of the Petitioner, the limited partners would have been designated as the beneficiaries of the trust. Petitioner and the partners would have agreed to treat the limited partners as having received the liquidating distribution, followed by their having contributed the proceeds thereof to the trust for the purpose of completing the legal dissolution (as opposed to the liquidation for tax purposes) of the partnership. Because the partners would have “contributed” assets to the trust while retaining the beneficial interest in such assets, the trust would have been treated as a grantor trust for tax purposes.[xxxviii]

The bottom line here is that a closer analysis of New York’s source rules may have afforded Petitioner an opportunity to avoid the conclusion reached by the Department in its advisory opinion.

This result also highlights the importance of understanding the operation of the State’s source rules if one is seeking to change their status as a New York resident for the purpose of avoiding the reach of the New York income tax. Failing to do so may not affect one’s nonresident status, but it can make a huge difference in one’s tax bill.

[i] From the Greek, to scatter about, as in the case of seeds.

[ii] See the conservative Cato Institute’s January 2020 comparative analysis, which places the blame squarely upon what it describes as New York’s “excessive” government spending.

[iii] Justifiable or not, there is no denying that the wages, overtime, and retirement benefits paid to civil servants represent an enormous expenditure of public funds. For example, the “traditional” retirement plan for union-represented public employees is a defined benefit plan that provides life-time benefits determined under a formula based upon one’s final average salary and years of service. The cost of such a plan is borne by the employer – i.e., the taxpayer. Defined contribution plans, by contrast, are funded primarily by the employee, though many employers also contribute to such a plan.

In the private sector, defined benefit plans have been a thing of the past for several years. They are just too expensive to maintain and administer. Stated differently, they are injurious to the profits of a business and its owners. No moral statement here. Just a fact. “It’s not personal, Sony, it’s strictly business,” as Michael said.

[iv] Talk about relative. Talk about overbroad. In 2019, the national cutoff for the top 1 percent of household income (gross) was approximately $475,000. The cut-off in New York State was approximately $586,000; in NYC, approximately $2.2 million. Visit DQYDJ’s website.

Net worth is another story; it does not correlate neatly to income.

Then there’s the cost of living; for example, under almost any measure, the cost of living is lower in FL than in New York.

[v] Of course, if an affluent person and a less-than-affluent person purchase the same item for the same price from the same store, the sales tax imposed upon these retail purchases will have a disproportionately greater impact upon the less-than-affluent individual, all other things being equal.

[vi] Ready to pack the car? I just told my mother-in-law that I’m planning to move. The very picture of stoicism, she is – or was that the hint of a smile? I can’t tell. Probably just . . .

What’s more, let’s not forget the $6 trillion that the Federal government has just spent over the course of approximately only five months. Someone has to pay for that, and there really is only one viable option.


The State appears to have relaxed its “wait-and-see-what-the-IRS-finds” attitude, notwithstanding that the applicable N.Y. statute of limitations on the assessment of a deficiency in income tax owed by a taxpayer (normally three years from filing) is suspended (“tolled”) if the taxpayer fails to timely inform the State that the IRS has adjusted their Federal taxable income.

New York has displayed a similar approach with respect to the N.Y. estate tax after decoupling from the Federal estate tax exemption amount.

Can you blame New York? Not really. The IRS’s recently released annual data book (for 2019) states that, “For the past decade, the IRS has seen an increase in the number of returns filed as well as a decrease in resources available for examinations.” For example, in fiscal year “2010, the IRS received 230.4 million returns and employed 13,879 revenue agents, compared to 253.0 million returns and 8,526 revenue agents in FY 2019.”

[viii] And, thereby, avoid cuts in services.

[ix] Fortuitously for them, not for N.Y. The same can be said for many New York City residents who have decamped not only to neighboring states during the virus, but also Upstate or the East End.

[x] According to the U.S. Census Bureau, approximately 70 percent of Americans live in or close to the place where they grew up. There are probably many reasons for this, including familiarity and the presence of family.

[xi] The pace of southern- or southwestern-bound “former” New Yorkers had picked up well before the recent developments. The newspapers have been highlighting the more “significant” departures. Anecdotally, however, it appears that we can expect an additional increase.

[xii] Obviously, I use this word facetiously. I don’t believe there is anything political motivating their move.

[xiii] It is no easy thing to abandon one’s place of domicile; it requires much more than merely purchasing a condo apartment elsewhere, registering to vote in the new jurisdiction, and registering one’s car there. In some cases, it may require withdrawing one’s business from N.Y., among other things.

But see

[xiv] After all, the taxpayer has the burden of proof to establish their abandonment of N.Y. and their establishment of a new domicile elsewhere.

[xv] Readers may recall that the State employs a “five principal factors” test to determine an individual taxpayer’s domicile. The five factors it will consider and weigh as between N.Y. and the state the taxpayer claims as its new home are the following: (i) the taxpayer’s physical residences in the two jurisdictions, (ii) the time the taxpayer spends in each of the two jurisdictions, (iii) the taxpayer’s active involvement in a N.Y. business, (iv) the location of the taxpayer’s near and dear items, and (v) the location of the taxpayer’s family connections.

[xvi] Indeed, the State has long recognized that the extent of an individual’s control and supervision over a New York business can be such that their active involvement in the business continues even during times when they are not physically present in New York.

[xvii] The Form IT-203, Nonresident and Part-Year Resident Income Tax Return, includes two columns, one on which the nonresident taxpayer enters their Federal income and the other on which they enter their New York income. I can’t tell you the number of cases I have seen where the two columns are almost identical, but for some investment income, yet the State fought to establish that the taxpayer was a resident. It no longer surprises me, but I continue to be disappointed at how public resources are being utilized.

Speaking of investment income, see

[xviii] NY Tax Law Sec. 631(a) and (b).

[xix] A nonresident will be subject to N.Y. personal income tax with respect to their income from:

  • real or tangible personal property located in the State, (including certain gains or losses from the sale or exchange of an interest in an entity that owns real property in N.Y.);
  • services performed in N.Y.;
  • a business, trade, profession, or occupation carried on in N.Y.;
  • their distributive share of N.Y. partnership income or gain;
  • any income received related to a business, trade, profession, or occupation previously carried on in the State, including, but not limited to, covenants not to compete and termination agreements; and
  • a N.Y. S corporation in which they are a shareholder, including, for example, any gain recognized on the deemed asset sale for federal income tax purposes where the S corporation’s shareholders have made an election under Sec. 338(h)(10) or Sec. 336(e) of the Code.

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

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

[xx] NY Tax Law Sec. 631(c). New York provides special allocation and apportionment rules for this purpose.

[xxi] NY Tax Law Sec. 631(b)(2). I should be noted that a nonresident who buys, holds, and sells securities for their own account (not a dealer) will not, by virtue of this activity alone, be treated as engaged in a N.Y. trade or business. NY Tax Law Sec. 631(d).

[xxii] NY Tax Law Sec. 631(b)(1)A)(1).

[xxiii] TSB-A-20(3)I. An Advisory Opinion is issued by the Department’s Office of Counsel at the request of a person or entity. It is limited to the facts set forth therein and is binding on the Department only with respect to the person or entity to whom it is issued and only if the person or entity fully and accurately describes all relevant facts. An Advisory Opinion is based on the law, regulations, and Department policies in effect as of the date the Opinion is issued or for the specific time period at issue in the Opinion.

In other words, it may not be cited as precedent. Nevertheless, such opinions provide a glimpse into the Department’s thinking with respect to a particular issue.

[xxiv] Remember the anti-stuffing rule described above?

[xxv] IRC Sec. 704.

[xxvi] NY Tax Law Sec. 631 and 632.

[xxvii] NY Tax Law Sec. 658(c)(4).

[xxviii] It should be noted that the liquidation of a partnership for tax purposes is not the same as its formal dissolution under state law. See, e.g., Reg. Sec. 1.332-2(c) which recognizes that the liquidation of an entity (a corporation, in that case) may be completed before its dissolution.

[xxix] IRC Sec. 731(a)(2) provides that a partner may recognize capital loss on a cash-only distribution in liquidation of their interest in the partnership. This loss is treated as loss from the sale or exchange of the partner’s interest in the partnership, which is generally treated as loss from the sale of a capital asset. IRC Sec. 741.

[xxx] NY Tax Law Sec. 631(a)(1) and Sec. 631(b)(1).

[xxxi] NY Tax Law Sec. 631(a)(1), Sec. 632(a)(1).

[xxxii] NY Tax Law Sec. 631(b)(1)(A).

[xxxiii] NY Tax Law Sec. 631(b)(1)(A)(1).

[xxxiv] Under NY Tax Law Sec. 631(b)(1)(A).

[xxxv] NY Tax Law Sec. 631(b)(1)(A).

[xxxvi] Petitioner also argued that, upon the sale of the building, Petitioner was considered “functionally liquidated” and dissolved when it transferred its net proceeds to an account maintained by Affiliate. Therefore, Petitioner claimed it should be treated as having liquidated on the date of sale and its limited partners should be treated as having sold their partnership interests on that date. The Department, however, expressed no opinion as to whether Petitioner was considered to be functionally liquidated on that date.

[xxxvii] Reg. Sec. 301.7701-4(d); Rev. Proc. 94-45.

[xxxviii] IRC Sec. 671.

Business is back . . . Sort of

As the country begins its hoped-for recovery from the disruptive economic effects of the COVID-19 virus – or, more accurately, from the measures implemented by government to contain the spread of the virus – some closely held businesses will emerge relatively unscathed while others will not survive, and some will be on life support for some time before their fate is settled while others will remain in business, albeit on a different scale than that at which they were operating before the economic shutdown.

For many businesses in this last group, the recent downturn may have represented the proverbial “wake-up call,” having exposed weaknesses in the business, especially the lack of cash reserves or other readily accessible sources of liquidity.[i] In some cases, the owners of the business will seek to redress these problems in order to ensure the business’s continued and, perhaps, more profitable existence. In others, the owners will decide that it is time to prepare the business for sale – whether as a “marriage of survival” or as an exit strategy – to a competitor, a private equity fund, or some other buyer.[ii]

Retention of Key Employees

In several of these scenarios, the successful turnaround of the business, or the preparation of the business for sale, will depend upon the continued employment and efforts of the business’s key service providers.

What’s more, it may be equally as important to ensure that these key people remain with the business after its sale. After all, in light of the havoc wreaked by the coronavirus shutdown upon the finances of so many businesses, it may be difficult for a buyer to determine an accurate purchase price for a target business based upon a typical “multiple of EBITDA”[iii] calculation. Instead, many buyers will likely insist upon making the payment of a significant portion of the purchase price contingent upon the target’s satisfaction of certain defined financial thresholds over some period of time– an “earnout.”[iv] What better way to increase a seller’s chances of hitting these earnout targets than by ensuring that the seller’s key employees remain with the business after its sale?

In either case – be it for purposes of a turnaround or a sale – the owners of the closely held business will have to consider how to retain and reward these key employees. This may present a more difficult challenge today than before the shutdown. Specifically, many owners who have just experienced severe cash flow problems may now be less willing to part with cash, and relatively more receptive to granting equity interests in the business to their key people. By the same token, these key employees may be more insistent upon having an actual ownership stake in the business, along with a say in its operation, not to mention an opportunity to realize the appreciation in the value of their equity[v] as capital gain – rather than as ordinary income[vi] – on the disposition of the business.[vii]

Equity Compensation

Although the issuance of equity by an employer-business to some of its top employees may seem like a relatively straightforward affair, there are actually many factors to consider before agreeing to such an issuance.

For example, how should the equity be valued; can the terms of the issuance, including transfer restrictions, influence the determination of value; should the employee pay for some portion of the equity; should the employee’s ownership be contingent upon their satisfaction of certain performance criteria; should their equity have voting rights; how will the employee pay any income tax liability arising from the receipt of equity?[viii]

The answers to these questions will help to determine the income tax consequences to the employee arising from their receipt of equity in the employer. In turn, these consequences will influence the employee’s negotiating position.

Before we consider a recent decision[ix] in which the taxpayers received equity in a corporation – ostensibly in exchange for their future services to the corporation[x] –let’s first briefly explore the applicable rules that determine the tax treatment of such a stock issuance. Both the employer and the key employee should be familiar with these rules if they hope to negotiate an equity-based compensation arrangement that makes economic sense for both of them.

Section 83

In general, under Section 83 of the Code, if a service recipient transfers equity in the service recipient to a service provider as compensation in exchange for their services, the service provider must include the fair market value of such equity in their gross income unless the service provider’s rights in such equity are not transferable and are subject to substantial risk of forfeiture; i.e., “restricted stock.”[xi]

Stated differently, the fair market value of the equity will be includible in the service-provider’s gross income at the time their rights in the equity become transferable or are no longer subject to substantial risk of forfeiture (i.e., when they vest), whichever occurs first.[xii] This amount, which may be greater than the fair market of the equity at the time it was issued to the service provider, will be treated as compensation, which is taxable as ordinary income.[xiii] The service provider’s holding period for the equity will begin with the inclusion of its value in their gross income;[xiv] their basis for the equity will be equal to its fair market value.

For purposes of this rule, an employee’s rights are “subject to substantial risk of forfeiture” if they are conditioned upon the employee’s future performance of substantial services, or upon the satisfaction of a condition related to a purpose of the transfer if the possibility of forfeiture is substantial.[xv]

Alternatively, a taxpayer whose rights to the equity are subject to a substantial risk of forfeiture may elect to include in their income for the year in which they receive the equity an amount equal to its fair market value.[xvi] If an employee makes such an election, they will not be required to include the value of the equity in their income when the equity subsequently vests in the hands of the employee. In other words, the election cuts off the compensatory element associated with the equity.[xvii] What’s more, the electing employee’s holding period in the equity will begin with the year it was received; this affords the employee a greater opportunity to recognize any appreciation in the value of the equity as capital gain.

For the year in which the employee is required to include in their gross income the value of the employer stock, the employer is allowed to claim a deduction for an amount equal to the amount included in the gross income of the employee.[xviii]

In the case of an employer that is an S corporation, any stock in the corporation “that is issued in connection with the performance of services . . . and that is substantially nonvested . . . is not treated as outstanding stock of the corporation” for tax purposes.[xix] As such, profits or losses of the S corporation-employer will not flow through to an employee-holder of non-vested stock, and is not required to be included in the holder’s gross income.[xx]

Now we can see how these rules were applied by the taxpayers in the decision discussed below.

The Structure

Taxpayers owned and operated of a group of corporations and limited liability companies (the “Businesses”). They decided to consolidate these separate entities into a single holding company (“Corp”), for which they elected S corporation status.[xxi] The goals of this restructuring were as follows: (1) to allow assets to be moved more efficiently between the Businesses; (2) to reduce the number of tax and financial filings the Businesses were required to make; and (3) to achieve “substantial tax benefits.”

To effectuate the contemplated reorganization, each Taxpayer transferred the entirety of his equity in the Businesses to Corp in exchange for shares of Corp common stock.[xxii]

Simultaneously with their receipt of the Corp stock, Taxpayers executed two collateral agreements, the Restricted Stock Agreement (“RSA”) and the Employment Agreement (“EA”). Taken together, these agreements provided that either Taxpayer would forfeit at least 50 percent of the value of his Corp stock if he voluntarily terminated his employment with Corp before the fifth anniversary of the EA.[xxiii] In other words, the agreements represented a substantial risk of forfeiture.

The ownership of Corp was further divided over the next few years. An ESOP[xxiv] was organized which purchased shares of Corp common stock; Taxpayers were among the beneficiaries of the ESOP. Each Taxpayer subsequently transferred some of their restricted shares of Corp stock to irrevocable grantor trusts[xxv] established for the benefit of their families. These shares remained subject to substantial risk of forfeiture under the RSA and EA.[xxvi]

The Scheme

Taxpayers hoped to utilize the foregoing structure and agreements to defer their Federal income tax on Corp’s profits.

Relying upon the principles described above, and in combination with the fact that the ESOP was a tax-exempt entity, Taxpayers sought to avoid reporting any income from Corp on their federal tax returns during the years at issue despite the fact that Corp was profitable during that period.

In short, Taxpayers took the position that their stock (and that owned by their grantor trusts) was subject to a “substantial risk of forfeiture” and was thus “substantially unvested.” Because the shares owned by Taxpayers and the trusts were not deemed to be outstanding, Corp allocated 100 percent of its income for the years at issue (the “First Period”) to the tax-exempt ESOP. Consistently with Corp’s reporting, neither Taxpayer reported any flow-through items from Corp on his tax return during the First Period. And because the ESOP was a tax-exempt entity, it likewise reported no taxable income from Corp for the First Period. In other words, no one paid any federal income tax on Corp’s profits.

Taxpayers subsequently undertook to restructure their business operations a second time, in order to attract greater outside investment, which they felt would be difficult while the business continued to operate as an S corporation.

To effectuate this restructuring, Taxpayers formed Holdings, an LLC in which they each held a 50 percent interest. Holdings purchased all of Corp’s operating assets in exchange for an interest-bearing promissory note and the assumption of various liabilities. Though Corp realized millions of dollars of capital gain on this sale, it allocated the entirety of that gain to the tax-exempt ESOP, which, according to Taxpayers, was still the only outstanding shareholder of Corp.

The following year, the restrictions imposed by the RSA and EA on Taxpayers’ Corp stock lapsed and their shares became fully vested, as did those held by the trusts. At that point, based on the rules described above, one would have expected Taxpayers to include the fair market value of the previously restricted stock in their gross income.

Taxpayers, however, entered into identical “surrender” and “subscription” agreements with Corp (the “Surrender Transactions”), pursuant to which Taxpayers purported to (1) return the entirety of their newly vested shares to Corp, and (2) simultaneously purchase an identical number of shares from Corp in exchange for a promissory note. On their tax returns for that year, Taxpayers reported a modest (compared to the value of the formerly restricted stock) amount of compensation income equal to the difference between the fair market value of the new Corp shares and the face amount of the note given to purchase the new shares.

During that same year, Corp redeemed the Corp shares owned by the ESOP, at which point Corp became entirely owned by Taxpayers and their trusts.

The IRS and the Tax Court

The IRS examined Taxpayers’ respective income tax returns for the First Period and for the year that their shares vested.

Following its examination, the IRS issued timely notices of deficiency in which it asserted that Taxpayers’ stock in Corp was substantially vested upon its original issuance to Taxpayers, such that Taxpayers were required to report their pro rata shares of Corp’s income for each succeeding year; and (2) even if the stock did not substantially vest until the RSA restrictions lapsed, Taxpayers should have reported the fair market value of that stock as taxable income in that year, notwithstanding their purported “surrender” of the shares.

Taxpayers disputed the IRS’s findings and sought redetermination in the Tax Court.[xxvii]

The Tax Court held that Taxpayers’ Corp stock remained subject to a substantial risk of forfeiture until the RSA restrictions lapsed. Because Taxpayers’ shares were not substantially vested during the First Period, they were not required to report Corp’s income on their individual returns during that period.

But the Tax Court agreed with the IRS that the fair market value of the restricted stock should have been treated as compensation income to Taxpayers at the time the stock became substantially vested. At that point, the Tax Court stated, each Taxpayer “received taxable compensation” and could not “unring this bell by subsequent actions with respect to the stock, whether that action consisted of sale to a third party or surrender to the corporation.”

Likewise, the Tax Court concluded that both the Surrender Transactions and the promissory notes delivered to Corp as part of those Transactions were “palpably lacking in economic substance” and should be disregarded in calculating their tax liability. According to the Tax Court, the Transactions were undertaken for no purpose other than avoiding tax liability, and had no reasonable possibility of generating an economic profit.

Taxpayers appealed the Tax Court’s decision to the Federal Court of Appeals.

The Fourth Circuit

Taxpayers argued that they were not required to report as compensation income the fair market value of the formerly restricted stock that they realized when their Corp shares vested. Although Taxpayers did not seriously contest this point, they maintained that the subsequent Surrender Transactions effectively negated or reversed their receipt of this compensation, such that they were not required to include it in their gross income.

The Court explained that it is a well-settled principle of tax law that compensation is included in the taxable income of the person who earned it, notwithstanding any assignment or transfer of that compensation to a third party. Thus, the Court continued, the mere fact that Taxpayers purported to return their vested shares back to Corp had no effect on their individual tax liability.


Taxpayers also argued that the Surrender Transactions effectuated a complete rescission of their contractual agreements with Corp, and because that rescission occurred in the same year as Taxpayers’ receipt of compensation income under those agreements, that income should be disregarded for Federal income tax purposes.

Again, the Court disagreed. The Surrender Transactions, it found, did not restore Taxpayers “to the relative positions that they would have occupied had no contract been made,” which is a fundamental requirement for application of the rescission doctrine.[xxviii] “Put simply,” the Court stated, “if you can’t restore, you can’t rescind.”

The contracts at issue were for personal services performed by Taxpayers on behalf of Corp. When a personal services contract has actually been performed, the Court observed, it is essentially impossible for the individual who rendered the services to be “returned” to their position as it was before the services.[xxix] What is more, as part of the underlying contracts, Taxpayers transferred the entirety of their interests in the Businesses to Corp, but they did not receive those assets back in the Surrender Transactions. As such, the Surrender Transactions were completely unlike the prototypical instance of rescission, in which all property that changes hands is returned to its original owner.

Taxpayers asserted that compensation is not taxable to an employee if returned to the employer in the year it was received. The Court found that those precedents were inapposite; they stand only for the limited proposition, it stated, that returned compensation may not be taxable income where “the original salary agreements . . . [were] subject to modification by the taxpayers and their employers and not absolute.” There was no indication, the Court added, that Taxpayers’ compensation agreements with Corp were open-ended in the sense contemplated by those cases, and, according to the Court, Taxpayers’ belated attempt to modify those agreements via the Surrender Transactions could not affect their tax liability.

In any event, even if the Surrender Transactions could somehow be seen as rescinding Taxpayers’ employment and compensation agreements with Corp, the Court agreed with the Tax Court’s conclusion that those transactions were totally devoid of economic substance and had to be disregarded for Federal income tax purposes.[xxx]

Equity-Based Compensation

The owners of closely held businesses have long recognized the importance of aligning the interests of their key employees with their own. The message underlying this principle is simple: if the owners do well, these employees will do well. It is one thing, however, to convey this message; it is something else to assure the recipients that the promised benefit will materialize.

There are many varieties of incentive compensation arrangement that may be implemented to reward a key employee for the exceptional performance of their duties.

In some cases, for example, the owners of the business may retain discretion over the selection of the key employees to be recognized, as well as over the amount of the compensation to be paid to them. In others, the employees to be paid are predetermined, while the amount of the compensation may be discretionary with the owners. In still other cases, the amount of the reward may be fixed in advance, but will be contingent upon the employee’s (or the business’s) having attained a performance target, the satisfaction of which is determinable by the owners in their discretion.

Then there are equity-flavored alternatives in which the amount of the compensation payable to the employee will be based upon changes in the value of the employer’s stock; for example, as compared to its value on the date of issuance.[xxxi]

In most situations, historically speaking, the foregoing rewards were settled in cash.

Query whether that will continue to be the case in the post-COVID[xxxii] world as to those businesses the owners of which have decided to prepare the business for sale or who have determined to turn the business around in a major way, but who need to incentive their key people to help them reach these goals?

In these instances, it may be sensible for an employer to offer their key employees some “skin in the game,” especially given what may turn out to be a continuing cash flow problem for the short-to-mid-term future, during which any available funds may have to reinvested in the business.

What’s more, it may be sensible for the employee to request some equity in the business, considering the value of the business[xxxiii] – and thus, the resulting tax hit from the receipt of such equity as compensation – has probably been reduced on account of the shutdown; in other words, it may be an opportune time for an employee to become an owner if there is a reasonable possibility of recapturing, and then realizing, much of the value of the business.

Assuming the issuance of equity is reasonable for both the employer and the employee, the employer may be able to negotiate some “substantial risk of forfeiture” conditions as an additional means of incentivizing the employee.[xxxiv]

[i] For example, a line of credit; perhaps a mechanism for a capital call among the owners of the business. That’s why the loans under the Paycheck Protection Program were so important to so many businesses.

Other weaknesses that have come to light include too large a workforce, the failure to discharge poorly performing employees, the continual expenditure of funds without concomitant economic return, the payment of personal expenses, etc.

[ii] How many business owners – and business advisers, for that matter – do you know who would get out of Dodge if they could do so in relative comfort and security?

[iii] Earnings before interest, taxes, depreciation and amortization. This “tool” provides a way for measuring the financial health of a company.

I recently came across a reference to “EBITDAC:” earnings before interest, taxes, depreciation, amortization and coronavirus. No kidding.

[iv] An earnout will be used where the buyer and the seller are unable to agree on the fair market value of the business (the purchase price). They will settle upon an agreed lowest value, with the earnouts – assuming the agreed-upon financial targets are attained – determining the upper reaches of the purchase price. The total gain arising from the sale of the business will be contingent upon the earnout payments; as these are received, the gain therefrom will be reported under the installment method. IRC Sec. 453.

[v] Attributable in no small part to their efforts.

[vi] An employee who is rewarded with a cash bonus upon the sale of the business will be taxed thereon at ordinary income tax rates; at the Federal level, the maximum rate is 37 percent. By contrast, the Federal capital gain rate is 20 percent. IRC Sec. 1.

[vii] I typically advise against the admission of an employee as an owner, except in extraordinary circumstances; compensate them with cash, I say, but don’t let them into the tent. (I think that’s an accepted idiom, right?) Once the employee is brought into the fold, they will have a number of rights as an owner as a matter of state law. Moreover, the original owner will owe certain fiduciary duties to the employee-shareholder. Even the Code bestows certain rights upon such individuals; for example, shareholders generally have the right to request copies of their corporation’s Federal income tax return. IRC Sec. 6103(e).

Where an employee “has to be” admitted as an owner, then the execution of a shareholders’ or operating agreement, as the case may be, will be important; for example, to restrict the transferability of shares, and to provide for the buyout of the employee-owner.

[viii] From the perspective of the employee, for example: will they have to guarantee the debts of the business; will they be subject to capital calls; if the business is formed as a pass-through entity (such as a partnership or S corporation) – the income of which is taxable to its owners whether or not distributed to them – how will the employee satisfy the tax on their share of the entity’s taxable income; if the stock or the assets of the business are sold, will the employee be required to make representations as to the business, and will they be liable for any breaches thereof; if their equity is subject to estate tax, how will their heirs pay for it given the equity’s illiquid nature?

[ix] Estate of Kechijian v. Commissioner, No. 18-2277 (4th Cir. 2020).

[x] As we’ll see, the taxpayers’ arrangement was structured solely for tax avoidance purposes.

[xi] The employer does not recognize gain on the issuance of its own stock as compensation. IRC Sec. 1032.

[xii] Vesting – i.e., the lapse of the risk of forfeiture – may occur at one time (“cliff vesting”; for example, after the completion of a specified number of years of service); or it may occur gradually over a number of years (for example, 20 percent per year over five years of service).

IRC Sec. 409A does not apply to amounts that are includible in income under Sec. 83. Reg. Sec. 1.409A-1(b)(6)(i).

[xiii] The employer must not lose sight of its income tax and employment tax withholding obligations.

[xiv] IRC Sec. 83(f); Reg. Sec. 1.83-4.

[xv] IRC Sec. 83(c); Reg. Sec. 1.83-3(c). For example, 7 years of continual service, or the satisfaction of predetermined performance goals the attainment of which is not a foregone conclusion.

[xvi] This is the so-called “Section 83(b) election.” The election must be made not later than 30 days after the equity is issued. Reg. Sec. 1.83-2.

[xvii] An election would make sense where the employee was reasonably confident that the value of the equity was certain to increase before vesting, and that the equity would not be forfeited. An employee who has to forfeit their equity is not allowed a deduction in respect of the forfeiture. IRC Sec. 83(b)(1).

[xviii] IRC Sec. 83(h).

[xix] Reg. Sec. 1.1361-1(b)(3).

[xx] Under IRC Sec. 1366, every shareholder of an S corporation is required to take into account their pro rata share of the corporation’s income for a taxable year for purposes of determining their income tax liability for such year.

[xxi] IRC Sec. 1361 and Sec. 1362.

[xxii] A tax-free exchange described in IRC Sec. 351.

[xxiii] This five-year period was ostensibly designed to incentivize Taxpayers to continue working for Corp.

[xxiv] An “employee stock ownership plan,” which is exempt from income tax. IRC Sec. 4975(e)(7).

The Small Business Job Protection Act of 1996 amended IRC Sec. 1361(b) to permit certain tax-exempt organizations to hold shares of S corporation stock. IRC Sec. 1361(c)(6).

[xxv] IRC Sec. 671. Each Taxpayer continued to be treated as the owner, for income tax purposes, of the shares held by their trust.

[xxvi] Thus, Taxpayers, their trusts, and the ESOP were the shareholders of Corp.

[xxvii] Tax Ct. Nos. 8967-10; 8966-10.


[xxix] Let’s face it, how does an employee rescind the services already provided?

[xxx] The economic substance doctrine permits the IRS to “ignore for tax purposes any transaction designed to create tax benefits rather than to serve a legitimate business purpose.” A two-prong test is employed to determine if a given transaction should be disregarded pursuant to the doctrine. “To treat a transaction as a sham, the court must find that the taxpayer was motivated by no business purposes other than obtaining tax benefits in entering the transaction, and that the transaction has no economic substance because no reasonable possibility of profit exists.” The first prong of the test is subjective, and the second is objective; nevertheless, while we examine both the subjective motivations of the taxpayer and the objective reasonableness of the investment, in both instances our inquiry is directed to the same question: whether the transaction contained economic substance aside from the tax consequences.”

Application of the foregoing principles to the instant case revealed that the Surrender Transactions were nothing more than a sham to avoid tax liability and were rightly disregarded.

Even Taxpayers acknowledged that the only reason they executed the Surrender Transactions was to enable Corp to avoid withholding and remitting approximately state and federal payroll and income taxes; i.e., the avoidance of tax obligations, both those of Corp and of Taxpayers. This was enough to satisfy the first prong of the economic substance test, which “requires a showing that the only purpose for entering into the transaction was the tax consequences.”

The second prong of the economic substance test was likewise met. It was inconceivable, the Court stated, that either Taxpayer “could envision a reasonable possibility of profit by surrendering, for no consideration, stock worth” millions. According to the Court, the fact that Taxpayers each gave Corp a promissory note as part of the Surrender Transactions only bolstered this conclusion, as “no rational person” would incur millions of indebtedness “to acquire stock that he already owned free and clear.”

[xxxi] Stock appreciation rights and phantom stock plans are examples of compensation arrangements that seek to mimic stock ownership. Because these types of plans usually provide for deferred compensation, they must comply with IRC Sec. 409A and the Regulations issued thereunder.

[xxxii] I use “post” tentatively as the number of cases in California, Texas, Florida, and elsewhere continue to rise.

[xxxiii] Non-lapse restrictions may also be used to further reduce the value. Reg. Sec. 1.83-5.

[xxxiv] In that case, the employee may want to consider an 83(b) election.

Bad Times

Of course, you’ve noticed that we’re in the midst of an economic mess. The nearly complete shutdown of large segments of the U.S. economy beginning in March, in response to the COVID-19 crisis, both accelerated and greatly aggravated the recession toward which we were already heading after almost ten years of steady growth.

The sudden elimination of so much economic activity, for what has turned out to be a relatively prolonged period,[i] has left us with many struggling businesses, other businesses that will never reopen, staggering unemployment numbers, a record reduction in consumer spending, the prospect of increased taxes,[ii] a bipolar stock market, and a general sense of unease and uncertainty.[iii]

Sounds awful, right? However, these conditions have created an environment that may be ideal for attorneys who practice in the area euphemistically known as “creditors’ rights,” which encompasses matters of insolvency, bankruptcy and debt collection, among other things.

One of the tools that is often utilized by a creditors’ rights attorney to facilitate the orderly disposition of a debtor’s assets and the satisfaction of its liabilities – especially for the benefit of general, unsecured creditors – is the liquidating trust.[iv]

In order to qualify as a liquidating trust,[v] a trust must be organized for the primary purpose of liquidating and distributing the assets transferred to it, and its activities must be reasonably necessary to, and consistent with, the accomplishment of that limited purpose.[vi]

Assuming a liquidating trust is respected as such, it is important to understand how and to whom the income and gains of the trust will be taxed, as one taxpayer-debtor recently learned to their detriment when they unilaterally established a trust in order to obtain a tax benefit.[vii]

The “Not-So-Great” Recession

Just before the Great Recession,[viii] Taxpayer owned Corp, an S corporation[ix] in the business of buying land and developing it into finished lots, which it then sold in the ordinary course of its business.[x]

Corp. owned three parcels of real property: Prop A, Prop B, and Prop C (the “Properties”). It borrowed significant amounts from the Banks. These loans were secured by the Properties.

Taxpayer’s real estate business was hit hard by the Great Recession. Taxpayer took a variety of actions to stay afloat, including cutting staff and overhead, renegotiating prices with subcontractors, slowing down construction and, in some cases, contributing more of their own money back into the business.[xi]

Taxpayer also negotiated with, and sought accommodations from, their lenders. Taxpayer entered into two forbearance agreements[xii] with the Banks, and had discussions with them about Taxpayer’s attempts to keep the business afloat.

The Liquidating Trust Transactions

When the Properties became worth significantly less than the liabilities they secured, Taxpayer decided to pursue a “liquidating trust strategy” for these parcels, but without consulting the Banks.

Corp organized three “Project LLCs” – one for each Property – each of which was disregarded for Federal tax purposes, with Corp as their sole member,[xiii] and transferred each of the Properties to the corresponding Project LLC for a stated consideration of zero.

On the same day, Taxpayer established three trusts (together, the “Trusts”) – one for each newly created and funded Project LLC – with a related company as the sole trustee. Corp transferred its membership interest in each of Project LLCs to the corresponding Trust. Corp did not receive any consideration for these transfers.

The trust agreements specified that the Trusts were intended to qualify as liquidating trusts for tax purposes, identified the Banks as the beneficiaries of the Trusts – though the Banks were not parties to the trust agreements and were not yet aware of their existence[xiv] – provided that the Trusts had been established for the sole purpose of liquidating the Properties for the benefit of the Banks, and stated that the Trusts had no objective or authority to pursue any trade or business activity beyond what was necessary to accomplish that purpose.

The trust instruments further specified that, for Federal tax purposes, the parties would treat the foregoing transfers as a transfer by Corp of the Project LLC membership interests to the Banks, immediately followed by a transfer of such interests by the Banks to the Trusts in exchange for the beneficial interests in the Trusts.

The end result of these transactions was that the Properties were held by the Trusts.

Consistent with these transactions, Corp. did not retain the Properties as assets on its books. However, Corp remained liable to the Banks and reported the remaining unsatisfied loan balances as liabilities on its financial reports. What’s more, Taxpayer continued to manage and market the Properties, and when the Properties were eventually sold,[xv] the net proceeds were distributed to the Banks, which in turn credited the distributed amounts against Corp’s outstanding indebtedness.[xvi]

Tax Returns and IRS Examination

On its tax return,[xvii] Corp reported ordinary business losses, stemming from its transfers of the Properties to the Trusts, in amounts equal to the difference between Corp’s adjusted tax basis in each property and its estimate of the fair market value of such property as of the transfer date. These losses were also reported on the Schedule K-1 that Corp issued to Taxpayer, and were included by Taxpayer on their individual income tax return.[xviii]

Taxpayer claimed a non-passive loss on their tax return, part of which was attributable to Corp’s “sale” of the Properties. These losses, in turn, gave rise to a net operating loss (“NOL”), which Taxpayer carried back to prior years, as well as forward to future years.[xix] The NOLs resulted in significant refunds, which Taxpayer used to pay off debts on various loans owed by his companies.

The IRS examined the tax returns filed by Taxpayer and Corp, and determined that the losses reported by Corp (and claimed by Taxpayer as the S corporation’s shareholder) with respect to the trust transactions should be disallowed.[xx] This disallowance significantly reduced the amount of Taxpayer’s allowable NOL.

The IRS issued notices of deficiency, and Taxpayer filed a timely petition in the U.S. Tax Court seeking a redetermination of the asserted deficiencies.

Net Operating Losses

The Code[xxi] permits a deduction for “any loss sustained during the taxable year and not compensated for by insurance or otherwise.” Such a loss “must be evidenced by closed and completed transactions, fixed by identifiable events, and . . . actually sustained during the taxable year”[xxii] in which it is claimed.

In most cases, a “closed and completed transaction” will occur upon a sale or other disposition of property.[xxiii]

Where the deductions allowed to a taxpayer for a given year exceed their gross income for that year, the taxpayer has an NOL.[xxiv] For the years at issue, the Code provided an NOL deduction for a given year equal to the aggregate of a taxpayer’s NOL carryovers and their NOL carrybacks to such year.[xxv]

Taxpayer asserted that Corp was entitled to a deduction because the transfers of the Properties to the Trusts for the benefit of the Banks were bona fide dispositions of property that generated actual losses.[xxvi]

Taxpayer’s argument hinged on the nature of the relationship between Corp and the respective liquidating trust, which implicated the Code’s “grantor trust” rules.[xxvii]

Characterization of the Trusts

In general, the Code provides that, where a grantor of a trust is treated as the owner of any portion of the trust, the grantor will include the trust’s items of income, gain, deduction, loss and credit in determining the grantor’s own income tax liability.[xxviii]

The grantor of a trust is treated as the owner of that trust[xxix] if certain conditions specified in the Code are met,[xxx] regardless of the existence of a bona fide nontax reason for creating the trust.[xxxi] These “grantor trust” provisions enunciate rules to be applied where, in described circumstances, a grantor has transferred property to a trust but has not parted with complete “dominion and control” over the property or over the income which it produces.[xxxii]

In the case of a liquidating trust, the most relevant of the grantor trust rules will consider a grantor the owner of any portion of the trust “whose income without the approval or consent of any adverse party is, or, in the discretion of the grantor or a nonadverse party,[xxxiii] or both, may be” distributed to the grantor.[xxxiv] According to the applicable regulation, this generally encompasses the portion of the trust “whose income is, or . . . , may be applied in discharge of a legal obligation of the grantor.”[xxxv]

Court’s Analysis

According to the Court, because ownership under the grantor trust regime results in the attribution of income directly to the deemed owner (i.e., the grantor), “the Code, in effect, disregards the trust entity.” Consequently, if a grantor is deemed an owner, the trust “is not treated as a separate taxable entity for Federal income tax purposes to the extent of the grantor’s retained interest.” Stated differently, when the grantor trust provisions apply, they function to “look through” the trust form, and ignore the “owned” portion of the trust for tax purposes as existing separately from the grantor.

Under the specific facts of this case, the Court continued, the grantor trust rules compelled the conclusions that Corp was the owner of the Properties during the years at issue, and that the Trusts were not separate taxable entities from Corp during those years. These conclusions, the Court stated, precluded the tax treatment sought by Taxpayer as Corp’s shareholder.

Corp as Grantor

As an initial matter, the Court stated that Corp was the grantor of the Trusts by virtue of its direct gratuitous transfer of ownership of the Project LLCs (which in turn held the Properties) to the Trusts.[xxxvi] As explained above, the grantor of a trust is treated as an owner where trust income is “applied in discharge of a legal obligation of the grantor.” Income, in this regard, includes the trust corpus.[xxxvii]

As the Court observed, the parties agreed that Corp remained liable to the Banks for the loans secured by the Properties after the ownership of the Properties had passed to the Trusts. When the Properties were sold, the proceeds were distributed to the Banks, which credited the amounts against Corp’s outstanding loans secured by the Properties.

Because the corpus of each trust was used to satisfy Corp’s – i.e., the grantor’s – legal obligations, the Court concluded that Corp was the owner of the Trusts; therefore, the Trusts were not separate taxable entities as to Corp.[xxxviii]

Accordingly, the transfers from Corp to the Trusts did not accomplish bona fide dispositions of the Properties evidenced by closed and completed transactions as necessary to support the losses reported by Corp and passed on to Taxpayer.

Indeed, the transfer from Corp to the trust, of which Corp was treated as the owner under the grantor trust rules, was disregarded for income tax purposes.[xxxix]

The Banks as Grantors?

The Court rejected Taxpayer’s position that the application of the grantor trust rules in this case required that the Banks be considered the owners of the Trusts. Taxpayer argued that this result was required by the nature of a liquidating trust. Taxpayer also contended that the Banks were the owners of the Trusts by virtue of their status as trust beneficiaries.

Taxpayer argued that the Banks had no legal obligation to apply any income realized from the Properties to satisfy Corp’s debt. This point was “of no moment,” the Court replied, given that the trust corpus was, in fact, used to pay these obligations. Even assuming arguendo that the Banks had such discretion, the Court explained that the Trusts nonetheless would constitute grantor trusts because they were trusts “whose income . . . , in the discretion of . . . a nonadverse party . . . may be applied in discharge of a legal obligation of the grantor.”[xl] The trust documents required the distribution of all net trust income and all net proceeds from the sale of trust assets to the Banks. Although trust beneficiaries are ordinarily considered adverse parties, the Court added that a party “can hardly be considered adverse regarding distributions for . . . [its] benefit”.[xli]

Implied Transfers?

Taxpayer asserted that the creation of the liquidating trusts here implicitly involved two steps: (1) the transfer of property from Corp to the Banks, and (2) the transfer of property from the Banks to the Trusts, of which the Banks were the beneficiaries.

According to Taxpayer, the first step – an in-kind transfer of property by a debtor to their creditor – was tantamount to a sale and, so, Corp should be able to recognize a loss in an amount equal to the difference between Corp’s aggregate adjusted bases in the Properties and their fair market values.[xlii]

Taxpayer argued that, “[g]enerally, liquidating trusts are taxed as grantor trusts with the creditors treated as the grantors and deemed owners” under the theory that “the debtor transferred its assets to the creditors in exchange for relief from its indebtedness to them, and that the creditors then transferred those assets to the trust for purposes of liquidation.”

Indeed, although not discussed by Taxpayer or the Court, the IRS has indicated, as a condition to its issuance of an advance ruling classifying a trust as a liquidating trust, that a transfer by a debtor to the trust for the benefit of creditors must be treated for all purposes of the Code as a transfer to creditors to the extent that the creditors are beneficiaries of the trust.[xliii]

This transfer, the IRS has stated, will be treated as a deemed transfer by the debtor to the beneficiary-creditors, followed by a deemed transfer by the beneficiary-creditors (as grantors) to the trust. In addition, the trust agreement must provide that the beneficiaries of the trust will be treated as the grantors and deemed owners of the trust, and that the trustee must file returns for the trust as a grantor trust.[xliv]

The foregoing would seem to support Taxpayer’s claim in the present case.

However, the Banks were not aware of Corp’s creation of the liquidating trusts; they did not agree to relieve Corp from its indebtedness in exchange for the Properties that were transferred to the liquidating trusts; and they did not view the liquidating trust transactions as having any practical effect.

The Court explained that Taxpayer’s unilateral transactions in which they placed the Properties in the Trusts without any involvement from the beneficiary-Banks did not support the implicit two-step structure proposed by Taxpayer. Moreover, the Court found that neither the Code nor the regulations supported such an implicit two-step structure under the facts presented.[xlv]

According to the Court, the grantor trust rules dictated that Corp be treated as the owner of the Trusts. Corp’s transfers of the Properties to the Trusts, therefore, did not produce the losses claimed by Taxpayer. With that, the Court sustained the asserted deficiencies.

Know Your Trust

The liquidating trust and grantor trust rules can be difficult to navigate, even for a tax professional if they don’t delve into them regularly.

That being said, it will behoove the creditor’s rights attorney, as well as any other professional who expects to be involved in debt-collection or similar matters arising from the current economic crisis, to familiarize themselves with the basic guidance provided by the IRS regarding the structure and operation of a liquidating trust.

The most important item to remember is that, in order for a liquidating trust to be respected as a trust for purposes of the Code, it must be formed with the objective of liquidating particular assets; its activities must be reasonably necessary to, and consistent with, the accomplishment of that purpose; in general, it cannot have as its purpose the carrying on of a profit-making business[xlvi] which normally would be conducted through a business entity classified as a corporation or partnership; the liquidation of the trust should not be unreasonably prolonged; the trust should not be permitted to receive or retain cash or cash equivalents in excess of a reasonable amount to meet claims and contingent liabilities (including disputed claims); the investment powers of the trustee, other than those reasonably necessary to maintain the value of the assets and to further the liquidating purpose of the trust, should be limited to the power to invest in liquid investments; the trust must be required to distribute at least annually to the beneficiaries (the creditors) its net income plus all net proceeds from the sale of assets, except that the trust may retain an amount reasonably necessary to meet claims and contingent liabilities (including disputed claims).

Of course, creditor’s rights attorneys should always remember to call their friendly neighborhood tax-adviser.[xlvii]

[i] It doesn’t help that many parts of the country are experiencing a resurgence of COVID-19 cases just as social-distancing measures are being relaxed, and businesses are starting to re-open.

[ii] Even without the very real possibility of the Democrats taking the White House and both houses of Congress in November, we’d be looking at increased Federal taxes – how else will we be able to pay for the CARES Act, which includes the Paycheck Protection Program, and other measures implemented by the government to combat the coronavirus and the economic consequences arising from our efforts to contain it? We’re talking about almost $6 trillion of Federal spending over just a few months – spending that no one could have expected to be necessary. Then there are the States that have lost billions of dollars in tax revenues that will need to be recovered in some manner; increased rates, new taxes, and more aggressive enforcement are already on the table in many jurisdictions.

[iii] “The threat is nearly invisible in ordinary ways. It is a crisis of confidence. It is a crisis that strikes at the very heart and soul and spirit of our national will. We can see this crisis in the growing doubt about the meaning of our own lives and in the loss of a unity of purpose for our nation.” President Carter, July 1979.

[iv] Liquidating trusts are not limited to situations involving debtors. For example, they have been used where it may be difficult to complete the liquidation of a corporate subsidiary into its corporate parent within the statutorily-prescribed three-year period for a tax-free liquidation – for instance, because the subsidiary owns a difficult to sell asset, or has a litigation claim that cannot be resolved within that time frame.

[v] Reg. Sec. 301.7701-4(d). Liquidating trusts are recognized as “trusts” for Federal tax purposes.

Rev. Proc. 94-45 provides the conditions under which the IRS will consider issuing advance rulings classifying certain trusts as liquidating trusts under Reg. Sec. 301.7701- 4(d).

[vi] It cannot have as its purpose the carrying on of a profit-making business. If the liquidation is unreasonably prolonged, or if the liquidation purpose becomes so obscured by business activities, that the declared purpose of liquidation can be said to have been lost or abandoned, the status of the “entity” will no longer be that of a liquidating trust.

[vii] SAGE v. Comm’r, 154 T.C. No. 12 (June 2020).

[viii] Figure, the 2007-2009 period.

[ix] IRC Sec. 1361.

[x] IRC Sec. 1221(a)(1); Sec. 1231(b)(1)(B). Thus, any gain realized on a sale represented ordinary income.

[xi] Basically, what we are seeing many businesses do today – though PPP loans may have deferred the day of reckoning for some organizations – and what we have seen businesses do in the past during difficult times.

[xii] Basically, an agreement between a lender and a delinquent borrower by which the lender agrees not to exercise its right to foreclose and the borrower agrees to a new payment plan.

[xiii] Reg. Sec. 301.7701-3.

[xiv] Taxpayer subsequently informed the Banks that the Trusts had been established for the benefit of the Banks.

[xv] With respect to Prop C, one of the Banks eventually issued a demand letter, which led to negotiations with Taxpayer. These culminated in an agreement under which Taxpayer caused the transfer of Prop C to this Bank by deed in lieu of foreclosure in exchange for settlement of the debt.

[xvi] In other words, the transfer of the Properties to the Trusts did not satisfy Corp’s indebtedness to the Banks.

[xvii] IRS Form 1120S, U.S. Income Tax Return for an S Corporation.

[xviii] IRS Form 1040, U.S. Individual Income Tax Return, Sch. E, Part II. Pursuant to Section 1366 of the Code, Corp’s ordinary loss flowed through to Taxpayer, subject to the basis limitation rule of IRC Sec. 1366(d).

[xix] Immediately prior to the Tax Cuts and Jobs Act (P.L. 115-97), IRC Sec. 172(b)(1)(A) permitted a taxpayer to apply an NOL to other taxable years by first carrying back the NOL to the two taxable years preceding the year in which the NOL was generated and then by carrying over any unused portion of the NOL to the 20 years that follow.

In response to the events that triggered the Great Recession, for taxable years ending after December 31, 2007, and beginning before January 1, 2010, The Worker, Homeownership, and Business Assistance Act of 2009, P.L. 111-92, amended IRC Sec. 172(b)(1)(H)(i) to permit a taxpayer to elect to carry back a net operating loss for the 2009 tax year to three, four, or five years instead of the usual two years. IRC Sec. 172(b)(1)(H).

Of course, the TCJA eliminated the carryback of NOLs and allowed their “indefinite” carryforward, though limited the amount of loss that be claimed in a taxable year.

Earlier this year, the CARES Act (P.L. 116-136) responded to the current economic crisis by temporarily reinstating and expanding the NOL carryback that had been eliminated by the TCJA. Specifically, the Act allows a business that realizes an NOL during a taxable year beginning after December 31, 2017 and before January 1, 2021 to carry its NOL back to each of the five taxable years preceding the year of the loss.

[xx] The IRS originally disallowed the losses because they were “attributable solely to nonbusiness expenses” of Corp. At trial and in its briefs, however, the IRS asserted a new theory for the disallowance of Corp’s loss: namely, that the trust transactions were not “closed and completed transactions” capable of producing realizable losses for that year. Because this basis for disallowance was not raised in the notices of deficiency, and represented a “new matter,” the IRS had the burden of proof with respect to the deficiencies. Tax Court Rule 142.

[xxi][xxi] IRC Sec. 165(a).

[xxii] Reg. Sec. 1.165-1(b). “Only a bona fide loss is allowable.” In determining the deductibility of a loss, “[s]ubstance and not mere form shall govern.” These requirements call for a practical test, rather than a legal one, and turn on the particular facts of each case.

[xxiii] The year for which a taxpayer can claim a loss deduction evidenced by a closed and completed transaction is a question of fact.

[xxiv] As defined by IRC Sec. 172(c).

[xxv] IRC Sec. 172(a).

[xxvi] Reg. Sec. 1.1001-2.

[xxvii] IRC Sec. 671 through 679.

[xxviii] “. . . there shall then be included in computing [the grantor’s] . . . taxable income and credits . . . those items of income, deductions, and credits . . . of the trust which are attributable to that portion of the trust to the extent that such items would be taken into account . . . in computing taxable income or credits . . . of an individual.”

[xxix] Of its assets and income.

[xxx] IRC Sec. 673 through 679.

[xxxi] The term “grantor” includes any party that creates a trust or directly (or indirectly) makes a gratuitous transfer – that is, a transfer other than for fair market value – of property to the trust. Reg. Sec. 1.671-2(e)(1) and (2)(i). A partnership or a corporation making a gratuitous transfer to a trust for a business purpose of that partnership or corporation will also be a grantor of the trust. Reg. Sec. 1.671-2(e)(4).

[xxxii] Although several of the grantor trust rules are framed in terms of trust “income”, the regulations issued thereunder clarify that “it is ordinarily immaterial whether the income involved constitutes income or corpus for trust accounting purposes” in light of the general objectives of the grantor trust rules. Reg. Sec. 1.671-2(b).

[xxxiii] An “adverse party” is any person who has “a substantial beneficial interest in the trust which would be adversely affected by the exercise or nonexercise of the power which he possesses respecting the trust.” IRC Sec. 672(a). The term “nonadverse party” refers to any person that is not an “adverse party”. IRC Sec. 672(b). Adversity is a question of fact determined in each case by reference to the particular interest created by the trust instrument.

[xxxiv] IRC Sec. 677(a).

[xxxv] Reg. Sec. 1.677(a)-1(d).

[xxxvi] Reg. Sec. 1.671-2(e)(1).

[xxxvii] Reg. Sec. 1.671-2(b).

[xxxviii] Reg. Sec. 1.677(a)-1(d).

[xxxix] Rev. Rul. 85-13.

[xl] Reg. Sec. 1.677(a)-1(d).

[xli] Reg. Sec. 1.672(a)-1(b).

[xlii] Reg. Sec. 1.1001-2.

[xliii] Rev. Proc. 94-45, Section 3.

[xliv] Reg. Sec. 1.671-4(a).

[xlv] The Court added: “And we see nothing . . . to suggest that liquidating trusts qua liquidating trusts should be treated differently under the grantor trust rules absent the involvement of the beneficiaries.”

[xlvi] Any such activities must be reasonably necessary to, and consistent with, the liquidating purpose of the trust.

[xlvii] OK, so we’re not super heroes. We’re not even semi-heroes. We don’t wear leotards – count your blessings – or carry hammers or shields, or turn into monsters when agitated (not most of us, anyway). But “who ya gonna call” when faced with a grantor trust issue?

The Taxable Exchange

As a general rule, a taxpayer’s exchange of one property for another property is treated as a taxable event; the gain realized by the taxpayer – meaning the amount by which the fair market value of the property received by the taxpayer[i] exceeds the taxpayer’s adjusted basis (unrecovered investment) in the property they have given up – is treated as income.[ii]

For example, the gain realized by the taxpayer on the “conversion” of property into cash[iii] is included in the taxpayer’s gross income for purposes of determining their income tax liability.

Likewise, the gain realized on the taxpayer’s exchange of property for other property that differs materially in kind from the property relinquished by the taxpayer is treated as income.[iv]

The general principle reflected in the foregoing rules is that a taxpayer’s “readjustment” of what is essentially their continuing interest in a property should be excepted from the general gain recognition rule. This principle underlies many of the Code’s non-recognition provisions, including, for example, those dealing with corporate reorganizations,[v] certain contributions to business entities,[vi] certain modifications to debt instruments[vii] and, of course, like-kind exchanges.[viii]

The Like-Kind Exchange

Under Section 1031 of the Code, 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. The unrecognized gain inherent in the relinquished property is preserved in the hands of the taxpayer by requiring the taxpayer to take the replacement property with an adjusted basis equal to that of the relinquished property.[ix]

However, if a taxpayer’s exchange of property would meet the requirements of Section 1031 but for the fact that the taxpayer receives not only like-kind property that would be permitted to be exchanged on a tax-deferred basis, but also other non-qualifying property[x] or money (“boot”), then the gain realized by the taxpayer will have to be recognized and included in their gross income in an amount up to the fair market value of such boot.[xi]


With the enactment of the Tax Cuts and Jobs Act,[xii] the application of the like-kind exchange rules was limited – beginning with exchanges completed after December 31, 2017 – to the exchange of real property that is not held primarily for sale.[xiii] In other words, the TCJA removed personal property and certain intangible property from eligibility for like-kind exchange treatment.[xiv]

According to the Conference Committee Report,[xv] Congress intended that “real property” eligible for like-kind exchange treatment prior to the TCJA would continue to be eligible for like-kind exchange treatment under the TCJA. In light of the IRS and the courts historically having allowed such treatment for many kinds of real property, this statement of legislative intent boded well for taxpayers.

For example, improved real property and unimproved real property are generally considered to be property of a like-kind – the fact that the real property is improved or unimproved is not material, for that fact relates only to the grade or quality of the property and not to its kind.[xvi] Unproductive real property held by a taxpayer for future appreciation is treated as being held for investment and not primarily for sale. A taxpayer may exchange city real property for a ranch or farm, or they may exchange real property held for use in a trade or business for real property that the taxpayer will hold for investment, or vice versa.

Proposed Regulations

Seems straightforward enough, right? After all, what we commonly think of as real property is by definition easily identifiable as such; of course, I am referring to land and buildings.

However, such a simplistic approach to the identification of real property would be ill-conceived, and even unfounded. In fact, many well-established, pre-TCJA authorities have gone well beyond such a restrictive interpretation. For example, the IRS has treated a leasehold interest in a fee with 30 years or more to run as real property, stating that a taxpayer may exchange such a leasehold interest for a fee interest in real property as part of a like-kind exchange.[xvii]

Unfortunately, there is no accepted statutory or regulatory definition of real property for purposes of the like-kind exchange rules. Moreover, there are many properties, or interests in property, that may not intuitively be viewed as real property but which have, under certain circumstances, been treated as such by either the IRS or the courts.[xviii]

According to the preamble to the proposed regulations, their purpose is to give taxpayers some certainty regarding whether property is “real property” for purposes of the revised like-kind exchange rules; taxpayers, the preamble continues, need certainty regarding whether any part of the replacement property received in an exchange is non-like-kind property the receipt of which would require the recognition of gain.

Real Property

“Certainty,” it seems, comes at a price: a set of nesting doll[xix] rules, with one definition embedded within, or building upon, another.

“Distinct Asset”

The predicate definition in the series of definitions developed by the proposed regulations is the term “distinct asset.”[xx] An item cannot be an improvement to land – i.e., it cannot be an “inherently permanent structure” or a “structural component” of an inherently permanent structure – and, therefore, cannot be treated as real property, unless it is a distinct asset.[xxi]

According to the proposed regulations, a distinct asset is analyzed separately from any other assets to which the asset relates to determine if the asset is real property, whether as land, an inherently permanent structure, or a structural component of an inherently permanent structure.

Buildings and other inherently permanent structures are distinct assets. The assets and systems listed below as a structural component are also treated as distinct assets.

The determination of whether a particular separately identifiable item of property is a distinct asset is based on all the facts and circumstances, including whether: (A) the item is customarily sold or acquired as a single unit rather than as a component part of a larger asset; (B) the item can be separated from a larger asset, and if so, the cost of separating the item from the larger asset; (C) the item is commonly viewed as serving a useful function  dependent of a larger asset of which it is a part; and (D) separating the item from a larger asset of which it is a part impairs the functionality of the larger asset.

“Real Property”

The proposed regulations start out easily enough, stating that real property includes land and improvements to land, unsevered natural products of land, and water and air space superjacent to land.[xxii]

Example. Taxpayer owns a marina comprised of U-shaped boat slips and end ties. The U-shaped boat slips are spaces on the water that are surrounded by a dock on three sides. The end ties are spaces on the water at the end of a slip or on a long, straight dock. Taxpayer rents the boat slips and end ties to boat owners. The boat slips and end ties are water space superjacent to land and thus are real property.


Improvements to land, in turn, include “inherently permanent structures” and the “structural components” of inherently permanent structures.[xxiii]

“Inherently Permanent Structure”

An inherently permanent structure means any building or other structure that is a “distinct asset” that is permanently affixed to real property, and that will ordinarily remain affixed for an indefinite period of time.[xxiv]


For this purpose, the proposed regulations define a “building” as any structure or edifice enclosing a space within its walls, and usually covered by a roof, the purpose of which is, for example, to provide shelter or housing, or to provide working, office, parking, display, or sales space. Thus, “buildings” include the following distinct assets if permanently affixed: houses, apartments, hotels, motels, enclosed stadiums and arenas, enclosed shopping malls, factory and office buildings, warehouses, barns, enclosed garages, enclosed transportation stations and terminals, and stores.[xxv]

“Other Structures”

The following assets are also treated as inherently permanent structures, if permanently affixed: in-ground swimming pools; roads; bridges; tunnels; paved parking areas, parking facilities, and other pavements; special foundations; stationary wharves and docks; fences; certain inherently permanent advertising displays; inherently permanent outdoor lighting facilities; railroad tracks and signals; telephone poles; power generation and transmission facilities; permanently installed telecommunications cables; microwave transmission, cell, broadcasting, and electric transmission towers; oil and gas pipelines; offshore drilling platforms, derricks, oil and gas storage tanks; grain storage bins and silos; and enclosed transportation stations and terminals.[xxvi]

If property is not included in the list of inherently permanent structures, the proposed regulations provide that the following factors that must be used to determine whether the property is an inherently permanent structure: (1) the manner in which the distinct asset is affixed to real property; (2) whether the distinct asset is designed to be removed or to remain in place; (3) the damage that removal of the distinct asset would cause to the item itself or to the real property to which it is affixed; (4) any circumstances that suggest the expected period of affixation is not indefinite; and (5) the time and expense required to move the distinct asset.[xxvii]

Example. Taxpayer owns an office building with a sculpture in its atrium. The sculpture is very large and very heavy. The building was designed to support the sculpture, which is permanently affixed to the building by supports embedded in the building’s foundation. The sculpture was constructed within the building. Removal would be costly and time consuming and would destroy the sculpture. The sculpture is reasonably expected to remain in the building indefinitely.

A sculpture is not identified as one of the inherently permanent structures enumerated in the regulations; thus, Taxpayer must use the above factors to determine whether the sculpture is an inherently permanent structure.

The sculpture: (A) is permanently affixed to the building; (B) is not designed to be removed but, rather, is designed to remain in place indefinitely; (C) would be damaged if removed, and would damage the building to which it is affixed; and (D) is expected to remain in the building indefinitely; and (E) would require significant time and expense to move. These factors support the conclusion that the sculpture is an inherently permanent structure and, thus, real property.

Example. Taxpayer owns bus shelters, each of which consists of four posts, a roof, and panels enclosing two or three sides. Taxpayer enters into a long-term lease with a local transit authority for use of the bus shelters. Each shelter is prefabricated from steel and is bolted to the sidewalk. Disassembling and moving a bus shelter takes less than a day and does not significantly damage either the bus shelter or the real property to which it was affixed. The bus shelters are not permanently affixed enclosed transportation stations or terminals, they are not buildings, nor are they listed as inherently permanent structures. Therefore, the bus shelters must be analyzed to determine whether they are inherently permanent structures using the above factors The bus shelters: (A) are not permanently affixed to the land or an inherently permanent structure; (B) are designed to be removed and not remain in place indefinitely; (C) would not be damaged if removed and would not damage the sidewalks to which they are affixed; (D) will not remain affixed indefinitely; and (E) would not require significant time and expense to move. These factors support the conclusion that the bus shelters are not inherently permanent structures and, thus, are not real property.

“Structural Components”

The term “structural component” means any distinct asset that is a constituent part of, and integrated into, an inherently permanent structure. If interconnected assets work together to serve an inherently permanent structure (for example, systems that provide a building with electricity, heat, or water), the assets are analyzed together as one distinct asset that may be a structural component. A structural component may qualify as real property only if the taxpayer holds its interest in the structural component together with a real property interest in the space in the inherently permanent structure served by the structural component.[xxviii]

Structural components include the following items, provided the item is a constituent part of, and integrated into, an inherently permanent structure: walls; partitions; doors; wiring; plumbing systems; central air conditioning and heating systems; pipes and ducts; elevators and escalators; floors; ceilings; permanent coverings of walls, floors, and ceilings; insulation; chimneys; fire suppression systems, including sprinkler systems and fire alarms; fire escapes; security systems; humidity control systems; and other similar property.[xxix]

Example. Taxpayer owns an office building that it leases to tenants. The building includes partitions owned by Taxpayer that are used to delineate space within the building. The office building has an interior, non-load-bearing, conventional drywall partition system. The system was installed during construction of the office building. The conventional system is comprised of fully integrated gypsum board partitions, studs, joint tape, and covering joint compound. It reaches from the floor to the ceiling. In addition, the system is a distinct asset within the meaning of the regulations.

Depending on the needs of a new tenant, the conventional system may remain in place when a tenant vacates the premises. The system is integrated into the office building and is designed and constructed to remain in areas not subject to reconfiguration or expansion. The conventional system can be removed only by demolition, and, once removed, neither the system nor its components can be reused. Removal of the system causes substantial damage to the system itself, but does not cause substantial damage to the building.

The conventional partition system is comprised of walls that are integrated into an inherently permanent structure and are listed as structural components in the regulations. Thus, the conventional partition system is real property.

If a component of a building or inherently permanent structure is a distinct asset and is not listed in the proposed regulations as a structural component, the determination of whether the component is a structural component will be based on the following factors: (1) the manner, time, and expense of installing and removing the component; (2) whether the component is designed to be moved; (3) the damage that removal of the component would cause to the item itself or to the inherently permanent structure to which it is affixed; and (4) whether the component is installed during construction of the inherently permanent structure.

Intangible Assets?

Having addressed the more conventional meaning of “real property,” the proposed regulations next consider instances in which intangible property may properly be treated as real property for purposes of the like-kind exchange rules.

An intangible asset may be treated as real property, or as an interest in real property, to the extent it derives its value from real property or an interest in real property, is inseparable from that real property or interest in real property, and does not produce or contribute to the production of income other than consideration for the use or occupancy of space.

For instance, a license, permit, or other similar right that is solely for the use, enjoyment, or occupation of land or an inherently permanent structure, and that is in the nature of a leasehold or easement, generally is an interest in real property.[xxx]

Example. Taxpayer receives a special use permit from the government to place a cell tower on Federal land that abuts a Federal highway. Government regulations provide that the permit is not a lease of the land, but is a permit to use the land for a cell tower. Under the permit, the government reserves the right to cancel the permit and compensate Taxpayer if the site is needed for a higher public purpose. The permit is in the nature of a leasehold that allows Taxpayer to place a cell tower in a specific location on government land. Therefore, the permit is an interest in real property.

However, the proposed regulations also provide that a license or permit to engage in or operate a business on real property is not real property or an interest in real property if the license or permit produces or contributes to the production of income other than consideration for the use and occupancy of space.[xxxi]

Personal Property

I know, “personal property?” you say. “What about the TCJA? Aren’t like-kind exchanges now limited to real properties?” Indeed, they are.

The proposed regulations, however, take a practical approach, recognizing there are times when a taxpayer’s acquisition of replacement real property as part of a like-kind exchange may necessarily include the acquisition of some personal property.

According to the proposed regulations, if such personal property is acquired incidentally to the acquisition of replacement real property in a deferred like-kind exchange,[xxxii] its acquisition will be disregarded for purposes of determining whether the taxpayer is in constructive receipt of the funds from the sale of the relinquished property, thereby causing the entire exchange to be taxable. In the absence of such a rule, it may be possible to argue that the use of the sale proceeds to acquire non-qualifying property violates the existing regulatory safe harbors by which a taxpayer in a deferred exchange may avoid claims of constructive receipt of money for purposes of the like-kind exchange rules.[xxxiii]

Under the proposed rules, personal property will be “incidental” to real property acquired in an exchange if, in standard commercial transactions, the personal property is typically transferred together with the real property, and the aggregate fair market value of such incidental personal property does not exceed 15 percent of the aggregate fair market value of the replacement real property.

For example, this may include the acquisition of office furniture where an office building is acquired as replacement property as part of a deferred like-kind exchange.[xxxiv]

First Impressions

These proposed regulations will apply to exchanges beginning on or after the date they are published as final regulations. Pending the issuance of final regulations, a taxpayer may rely on these proposed regulations – provided they are followed “consistently and in their entirety” – for exchanges of real property beginning after December 31, 2017, and before the final regulations are published.

Taxpayers and their advisers should welcome the guidance provided by the proposed regulations, as well as the opportunity for relying upon them immediately.

Most of the material presented in the proposed regulations would not be characterized as ground-breaking; nevertheless the regulations confirm the fact-intensive nature of the analysis that has to be undertaken in determining whether a particular property constitutes real property for purposes of the like-kind exchange rules.

In furtherance of this process, the proposed rules remove the uncertainty that may have surrounded the treatment of any of the inherently permanent structures and structural components specifically identified therein; equally important, they also provide a helpful set of general principles and factors for determining the treatment of any items not so described.

Of course, the IRS has requested comments on various parts of the proposed rules. It will behoove the taxpayer to stay attuned to these as they are released, and to review the final rules for any changes.


The “amount realized” by the taxpayer.

[ii] In other words, the amount that remains after the taxpayer’s remaining investment has been returned to them constitutes the realized gain. If the amount realized by the taxpayer is insufficient to restore to the taxpayer their adjusted basis for the property, the taxpayer has sustained a loss.

[iii] What we typically refer to as a “sale.”

[iv] Treas. Reg. Sec. 1.1001-1(a).

[v] IRC Sec. 368.

[vi] IRC Sec. 351 and Sec. 721.

[vii] Reg. Sec. 1.1001-3 (the “Cottage Savings” rules).

[viii] IRC Sec. 1031.

[ix] IRC Sec. 1031(d). Of course, this presumes a value-for-value exchange.

[x] Thus, the proper treatment of such “additional” replacement property as like-kind or not can make a huge difference in the amount of gain recognized by the exchanging taxpayer.

[xi] IRC Sec. 1031(b). The taxpayer’s basis for the replacement property would be increased by the amount of gain so recognized, and reduced by the amount of money received. IRC Sec. 1031(d).

[xii] P.L. 115-97. The “TCJA.”

[xiii] However, an exception is provided for any exchange if the property disposed of by the taxpayer in the exchange was disposed of on or before December 31, 2017, or the property received by the taxpayer in the exchange was received on or before such date.

[xiv] Many other classes of property were already excluded; for example, stocks, bonds, or notes; other securities or evidences of indebtedness; interests in a partnership; certificates of trust or beneficial interests; and choses in action.

[xv] Report 115-466, Sec. 13303. The Joint Committee report doesn’t add much. JCS-1-18.

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

[xvii] Reg. Sec. 1.1031(a)-1(c).

[xviii] For example, shares in a mutual ditch, reservoir, or irrigation company (described in section 501(c)(12)(A)) if at the time of the exchange such shares have been recognized by the highest court or statute of the State in which the company is organized as constituting or representing real property or an interest in real property. The proposed regulations clarify that, with the exception of the foregoing items, local law definitions generally are not controlling in determining the meaning of the term “real property” for purposes of IRC Sec. 1031. Prop. Reg. Sec. 1.1031(a)-3(a)(1). The goal, of course, is to provide uniformity across state lines.

[xix] I prefer saying “Matryoshka” dolls, though there is nothing maternal or familial about these definitions.

[xx] Prop. Reg. Sec. 1.1031(a)-3(a)(4).

[xxi] See Prop. Reg. Sec. 1.1031(a)-3(a)(2)(ii)(A) and Sec. 1.1031(a)-3(a)(2)(iii)(A).

[xxii] Prop. Reg. Sec. 1.1031(a)-3(a)(1).

Yes, the context generally informs you of the meaning, but I looked up “superjacent” anyway. “Lying immediately above or upon something else.” Works for air rights; but water rights? Close enough, I suppose.

[xxiii] Prop. Reg. Sec. 1.1031(a)-3(a)(2)(i).

[xxiv] Prop. Reg. Sec. 1.1031(a)-3(a)(2)(ii)(A).

[xxv] Prop. Reg. Sec. 1.1031(a)-3(a)(2)(ii)(B).

[xxvi] Prop. Reg. 1.1031(a)-3(a)(2)(ii)(C).

The proposed regulations do not explain what it means for a structure to be “affixed,” but they do explain that affixation to real property may be accomplished by weight alone, meaning that something may be too heavy to move. For example, “Lou is affixed to his desk.”

This example is also helpful: Taxpayer owns a natural gas pipeline transmission system that provides a conduit to transport natural gas from unrelated third-party producers and gathering facilities to unrelated third-party distributors and end users. The pipeline transmission system is comprised of underground pipelines, isolation valves and vents, pressure control and relief valves, meters, and compressors. Each of these distinct assets was installed during construction of the pipeline transmission system and each was designed to remain permanently in place. The pipelines are permanently affixed and are listed as other inherently permanent structures in the regulations. Thus, the pipelines are real property.

[xxvii] Prop. Reg. Sec. 1.1031(a)-3(a)(2)(ii)(C).

[xxviii] Prop. Reg. Sec. 1.1031(a)-3(a)(2)(iii)(A).

[xxix] Prop. Reg. Sec. 1.1031(a)-3(a)(2)(iii)(B).

[xxx] Prop. Reg. Sec. 1.1031(a)-3(a)(5).

[xxxi] Prop. Reg. Sec. 1.1031(a)-3(a)(5)(ii).

[xxxii] IRC Sec. 1031(a)(3); Reg. Sec. 1.1031(k)-1.

[xxxiii] Prop. Reg. Sec. 1.1031(k)-1(g)(7)(iii). See Reg. Sec. 1.1031(k)-1(g)(6).

[xxxiv] We’ll assume for this purpose that the acquisition of the furniture is industry practice in this type of transaction.


About sixty years ago, New York revised its personal income tax law to achieve close conformity with the Federal system of income taxation. The stated purpose for the revision was to simplify tax return preparation, improve compliance and enforcement, and aid in the interpretation of tax law provisions.[i] In furtherance of this policy of conformity, as the Code is amended by Congress, New York automatically adopts the Federal changes.[ii]

However, New York’s Tax Law does not conform to the Code in all respects. Indeed, there are a number of instances in which New York has chosen not to conform to – where it has “decoupled” from – specific provisions or amendments of the Code.[iii]

Federal AGI

By far, the most significant example of New York’s conformity to the Code is found in the State’s computation of a New York taxpayer’s State income tax liability; this begins with the taxpayer’s Federal adjusted gross income,[iv] which is then modified by certain New York “additions” and subtractions”[v] – basically, items for which New York has decided a different tax treatment is appropriate for its own purposes.

In general, a taxpayer’s adjusted gross income is determined by reducing their gross income by certain deductions attributable to the taxpayer’s trade or business, deductions attributable to the production of rental income, and losses from the sale or exchange of certain property.[vi]

Of course, a taxpayer’s gross income includes gain realized on the sale or exchange of property,[vii] unless such gain is excluded by law.[viii]

For example, the Code provides that no gain is recognized by a taxpayer on the exchange of real property held by the taxpayer for use in a trade or business, or for investment, if such real property is exchanged solely for real property of like-kind which is to be held by the taxpayer either for productive use in a trade or business or for investment.[ix]

Because the gain realized from a like-kind exchange is excluded from the exchanging taxpayer’s Federal adjusted gross income, it is also excluded from the taxpayer’s New York adjusted gross income and, thus, is not considered in determining the taxpayer’s New York income tax liability.[x]

IRS Audit of Exchange

A corollary to the conformity principle requires that any changes to the taxpayer’s Federal income tax liability[xi] be accounted for in re-determining the taxpayer’s New York income tax liability.

For example, what happens if the IRS successfully challenges a taxpayer’s treatment of an exchange as a tax-deferred like-kind exchange?[xii] How will New York learn of the resulting increase in the taxpayer’s New York income tax liability?

According to New York’s Tax Law, if the amount of a taxpayer’s Federal taxable income is changed by the IRS, the taxpayer must report such change within ninety days after the “final determination” of such change, and must concede the accuracy of such determination.[xiii] If the taxpayer fails to comply with this reporting requirement, then the resulting New York income tax liability may be assessed at any time – the applicable statute of limitations on the assessment of a deficiency is tolled.[xiv]

Based on the foregoing, one might think that it would behoove New York to wait for the IRS to examine a taxpayer’s Federal income tax return, and then assess any resulting deficiency in New York income tax.

After all, most of the substantive tax issues presented in a New York income tax return arise under the Code – Federal tax law – as a result of New York’s application of the conformity principle, described above. In addition, the taxpayer is required to report any such deficiency to New York, failing which New York may assess the deficiency at any time the State learns of it.

Such an approach would also allow the State to allocate its limited resources to presumably more productive revenue-generating applications including, for example, the examination of uniquely New York income tax issues, such as questions of residency and the allocation of income within and without the State.

New York Audit of Exchange

Over the last few years, however, it appears that New York may have relaxed its “wait-and-see-what-the-IRS-finds” attitude. Rather than piggy-backing onto the IRS’s efforts, New York has been initiating the audit of taxpayers’ income tax returns and, in the process, has been examining the Federal tax issues presented in those returns with the goal of collecting more New York income taxes.[xv]

Indeed, this year alone I have become aware of several challenges by New York to the tax-deferred treatment of transactions which, according to the taxpayers, qualified – and were reported on both their Federal and New York income tax returns – as like-kind exchanges.[xvi]

A couple of these have included transactions with partnership overtones including, for example, so-called “drop-and-swap” transactions[xvii] which the taxpayers’ advisers assured them were routine and not likely to be challenged by the IRS.

Unfortunately for these taxpayers, it is New York that is examining their transactions, not the IRS – apparently, New York is unaware of the “routine” nature of such exchanges and, so, is putting the taxpayers through their paces.[xviii]

In any event, the taxpayers were unrealistic in believing that any exchange involving a tenancy-in-common (“TIC”) interest – whether as a relinquished property or as a replacement property – which necessarily implicates partnership-related issues, could be beyond the reach of the IRS’s interest,[xix] as a recent decision of the U.S. Tax Court made clear.[xx]

Deferred Exchange

Taxpayer sold a real property in New York City at a significant gain. In order to defer recognition of the gain realized on the sale, Taxpayer sought to structure the sale as part of a deferred like-kind exchange. Treating the property sold as the “relinquished property,” Taxpayer began a search for “replacement property” that would qualify for like-kind exchange treatment.[xxi]

Taxpayer deposited the proceeds from the sale of the relinquished property into a “qualified escrow account” with a qualified intermediary (“QI”), which acted as an escrow agent.[xxii]

TIC (?) Replacement Property

Taxpayer identified a possible replacement property (the “Property”), and then formed a limited liability company (the “LLC”), of which Taxpayer was the sole member, to acquire the Property. The LLC was treated as a disregarded entity for Federal income tax purposes; thus, Taxpayer would be treated as acquiring the replacement property.[xxiii]

Taxpayer executed a contract in which it purported to acquire a 12.5% interest in the Property. The contract listed the LLC as the purchaser. The contract described the asset acquired as an “undivided interest of 12.5% as a Tenant in Common” in the Property.

Attached as an exhibit to the purchase contract was a copy of a document captioned “Tenancy in Common Agreement.” This agreement was executed by the families that held interests in the apartment building at that time. The agreement recited the parties’ desire to form a venture to “maintain, manage and operate the Property” and to “lease the Property in its entirety to a person or entity.”

Shortly thereafter, the LLC entered into a second, substantially similar contract, with a second seller in which it purported to acquire another 12.5% interest in the Property. This contract recited that the LLC thereby acquired an “undivided 12.5% interest as a Tenant in Common.”

In accordance with the IRS’s deferred like-kind exchange regulations,[xxiv] the LLC then assigned to QI its rights under the two purchase contracts. This agreement described the asset to be acquired as a “25% tenancy-in-common interest” in the Property. Acting as escrow agent, QI completed the transaction by delivering proceeds to the sellers from Taxpayer’s “qualified escrow account.”

Tax Reporting

Taxpayer filed Form 1040, U.S. Individual Income Tax Return, to which it attached IRS Form 8824, Like-Kind Exchanges, on which Taxpayer stated they had engaged in a like-kind exchange and, among other things, described the replacement property.

However, Taxpayer’s reporting was not consistent with the reporting that the IRS received from Partnership, an “entity” that identified itself as a partnership for Federal income tax purposes.[xxv] Partnership’s returns reported that it owned the Property and that the LLC acquired a partnership interest in Partnership, as opposed to a direct ownership interest in the Property.

The Court explained how, for several years, including the one at issue, Partnership had filed returns on Form 1065, U.S. Return of Partnership Income. The returns stated that Partnership was engaged in a rental real estate business. According to the Court, it was originally formed as a family partnership and, over successive generations, interests were divided and subdivided among family members and their heirs.

Partnership’s return included an IRS Form 8825, Rental Real Estate Income and Expenses of a Partnership or an S Corporation, which identified the Property as Partnership’s sole rental property.

Partnership attached to its return a Schedule K-1 for each of the partners that owned an interest during the year at issue. These schedules showed that each of the two sellers, from whom the LLC acquired the replacement property, owned a 12.5% interest in Partnership at the beginning of that year and a 0% interest at the end. The LLC was shown as owning a 0% interest in Partnership at the beginning of the year, and a 25% interest at the end of the year. After selling the relinquished property, Taxpayer designated as the replacement property a purported 25% interest in the Property.

The Schedule K-1 that Partnership issued to the LLC reported that the LLC had contributed capital, had received distributions, and was allocated a share of Partnership’s net rental real estate income. Taxpayer acknowledged receipt of this Schedule K-1.

However, Taxpayer did not report their distributive share of Partnership income on their Form 1040, but nor did Taxpayer file with the IRS a Form 8082, Notice of Inconsistent Treatment or Administrative Adjustment Request, in order to highlight Taxpayer’s “omission” (inconsistent treatment) of Partnership’s K-1 items from Taxpayer’s return.[xxvi]

Failed 1031

The IRS examined Taxpayer’s return. By claiming like-kind exchange treatment on that return, Taxpayer treated the LLC as having acquired a direct ownership interest in the Property.

Based on the foregoing, however, the IRS determined that the replacement property acquired by the LLC – i.e., by Taxpayer – was, in fact, an interest in a partnership. Of course, like-kind exchange treatment does not apply “to any exchange of . . . interests in a partnership.”[xxvii] Thus, the IRS concluded that Taxpayer was taxable on the sale of the relinquished property, having failed to acquire qualified replacement property.

In response, Taxpayer argued there was no partnership. Taxpayer asserted that “it would have been impossible for . . . [them] to have any suspicion that certain other . . . [owners] had filed a partnership return.” This was certainly not the case. The Court observed that Taxpayer or their advisers presumably did due diligence before finalizing the decision to invest in the Property. Moreover, Partnership issued a Schedule K-1 to the LLC – with the information described above – and Taxpayer acknowledged that they received this document.

Having received a Schedule K-1 that Taxpayer evidently thought was incorrect, Taxpayer should have filed a Form 8082 with their tax return, notifying the IRS that they believed the Schedule K-1 to be erroneous and that they were adopting a position inconsistent with it. Taxpayer failed to do so. But even if they had, there seemed to have been enough facts to undermine any claim that Taxpayer did not acquire an interest in a partnership and, thus, failed to complete a like-kind exchange.

Looking Ahead[xxviii]

Inconsistent tax and information returns like those considered by the Tax Court, above, raise the proverbial red flag, and will be picked up by the IRS. So will accurate disclosures on a partnership tax return; for example, in response to the question on Line 12, Schedule B, of Form 1065: “. . . did the partnership distribute to any partner a tenancy-in-common or other undivided interest in partnership property?”

As a matter of applying the like-kind exchange rules, this information raises the question of whether the taxpayer disposed of or acquired, as the case may be, a partnership interest rather than a direct interest in real property.[xxix]

But what about New York?

Independent NY Exam

It is likely that New York has only just begun to delve into the substantive Federal income tax issues presented by its taxpayers’ returns – including the qualification of an exchange as a like-kind exchange – and that its efforts in this regard will be expanded.

A number of factors support this statement, not the least of which is the reduction in the IRS’s overall enforcement capabilities, which will reduce the number of opportunities for New York to benefit from the IRS’s examination efforts.

To this must be added the fiscal crisis in which New York finds itself following the government-ordered economic shutdown as part of the State’s efforts to contain the spread of the coronavirus. The revenue losses experienced by the State,[xxx] when coupled with the extraordinary expenses incurred in coping with the virus, have placed a premium on the generation of additional revenue.

Given these conditions, New York will seek to increase its tax collection efforts, including its audit activity of income tax returns and, in particular, the determination of whether taxpayers have correctly reported their Federal (and, thereby, their New York) adjusted gross income.

Real Property Exchanges in NY

Which brings us back to the like-kind exchange and partnerships. Is New York focusing on such transactions? Probably. Consider the number of situations in which these arise, whether you’re talking about a rental property in the Hamptons or a building in Manhattan.

One should also consider the significant amount of income tax that the State – not to mention the IRS – probably loses to such transactions. Is it any wonder that, throughout the Obama Administration, its annual budget proposals sought to eliminate the like-kind exchange, or to limit the amount of gain that may be deferred under such an exchange?[xxxi]

Although New York does not impose any special reporting requirements for like-kind exchanges, there are many other returns that may help the State to identify, and then examine, a purported like-kind exchange.

For one thing, both New York and New York City impose transfer taxes on the transfer of an interest in real property. These require the filing of returns on Form TP-584 and Form NYC-RPT.

In addition, partnerships must file Form IT-204, which asks whether the partnership (i) had an interest in New York real property during the last three years, (ii) engaged in a like-kind exchange, (iii) sold property that had a deferred gain from a previous like-kind exchange, (iv) made an in-kind distribution, and (v) was under audit by the IRS or was previously audited by the IRS.[xxxii]

Armed with the information provided by these returns, and driven by the need to raise tax revenues, we can expect that New York will become more familiar with like-kind exchanges that involve a partnership or its partners, more methodical in its examination of such transactions, and more aggressive in pursuing outstanding income tax liabilities.

[i] Thus, New York’s Tax Law provides that: “Any term used in this article shall have the same meaning as when used in a comparable context in the laws of the United States relating to Federal income taxes, unless a different meaning is clearly required but such meaning shall be subject to the exceptions or modifications prescribed in this article or by statute.” N.Y. Tax Law 607(a). Consistent with the foregoing, a taxpayer’s taxable year and accounting method for purposes of the Tax Law are the same as for Federal income tax purposes. N.Y. Tax Law Sec. 605.

[ii] So-called “rolling conformity.”

[iii] For example, New York elected not to conform to parts of the 2017 Tax Cuts and Jobs Act (P.L. 115-97; the “TCJA”), including the limitation on certain itemized deductions. By decoupling, N.Y. effectively became a “fixed date” conformity jurisdiction: it applies the Federal law as it was prior to the Federal changes.

[iv] IRC Sec. 62.

[v] Start with Tax Law Sec. 612(a), (b) and (c).

[vi] IRC Sec. 62(a). Yes, there are also a few other, very targeted items.

[vii] IRC Sec. 61; Reg. Sec. 1.61-6; IRC Sec. 1001.

[viii] It should be noted that many non-recognition rules apply automatically, provided their requirements are satisfied; in those cases, the taxpayer does not have the option of electing out of non-recognition.

For a discussion on inadvertently tax-free exchanges, see

[ix] IRC Sec. 1031. The TCJA limited the benefit of this provision to the like-kind exchange of real property. This change is generally applicable to exchanges completed after December 31, 2017.

[x] N.Y. Tax Law Sec. 612(a).

[xi] This may be attributable to the inclusion in the taxpayer’s gross income of a previously omitted item of income, or to the disallowance of a deduction previously claimed by the taxpayer.

[xii] For example, by establishing that the taxpayer did not hold the relinquished property for use in a trade or business or for investment.

[xiii] N.Y. Tax Law Sec. 659.

[xiv] N.Y. Tax Law Sec. 683(c)(1)(C). The regular three-year statute of limitations on assessment, which begins to run with the filing of the tax return, will not apply. Tax Law Sec. 683(a).

[xv] New York has displayed a similar approach with respect to the N.Y. estate tax, especially after decoupling from the Federal estate tax exemption amount.

[xvi] Please note that an exchange of N.Y. City real property that qualifies for “tax-free” treatment under the income tax will likely be subject to N.Y. real estate transfer tax (maximum rate of 0.65%) and N.Y. City real property transfer tax (maximum rate of 2.625%).


[xviii] Remember “The Hustler” episode from The Odd Couple? Oscar is playing a local pool shark, Sure-Shot Wilson, who also happens to be weight-challenged and is a chain-smoker.  For starters, Felix correctly states that “pool is the same as golf – you just put a ball in the hole.” In any case, with Oscar in danger of losing, Felix talks to Sure-Shot about his awful cough and the deadly effects of smoking four packs a day. Felix explains how his uncle, who died very young, was also a smoker. Sure-Shot becomes so distracted and concerned with his well-being that he loses the game to Oscar. When Oscar asks Felix what he said to Sure-Shot that so unnerved him, Felix replies that he told Sure-Shot about his uncle. “Your uncle?” Oscar says, not understanding the reference, to which Felix replies (and I paraphrase), “yes, my uncle [XYZ] who was killed by a bus while crossing the street.”

[xix] It’s old news now, but take a look at U.S. Return of Partnership Income, IRS Form 1065, Schedule B, Lines 11 and 12.

[xx] Gluck v. Commissioner, T.C. Memo 2020-66.

[xxi] See Reg. Sec. 1.1031(k)-1(a).

[xxii] Reg. Sec. 1.1031(k)-1(g).

[xxiii] Reg. Sec. 301.7701-3(a).

[xxiv] Reg. Sec. 1.1031(k)-1(g)(4)(v).

[xxv] IRC Sec. 761; Reg. Sec. 301.7701-3.

[xxvi] IRC Sec. 6222(c). Taxpayers are instructed to file Form 8082 if they “believe an item was not properly reported on the Schedule K-1 you received from the partnership.” Instructions for Form 8082.

[xxvii] IRC Sec. 1031(a)(2)(D).

[xxviii] I am assuming that IRC Sec. 1031 will remain in the Code. There are no assurances this will be the case. For one thing, the Obama administration’s last Green Book sought to limit the amount of capital gain deferred under IRC Sec. 1031 to $1 million (indexed for inflation) per taxpayer per taxable year. Then, in 2017, the Trump administration succeeded in limiting like-kind exchanges to real property.

Following the lost tax revenues resulting from the Covid-19 economic shutdown, and given the drain on the fisc resulting from like-kind exchanges, it should come as no surprise if Congress decides to completely eliminate IRC Sec. 1031.

Likewise, it should come as no surprise if N.Y. enacts a claw-back rule similar to California’s. If a taxpayer disposes of California real property and acquires replacement property outside California, the like-kind exchange will be respected, but the taxpayer must continue to report the deferred gain and, when the replacement property is ultimately sold, California will seek to collect its tax on such deferred gain.

[xxix] It also raises the issue of whether the taxpayer held the property for the requisite business or investment purpose prior to disposing of it, whether to a third party or as contribution to a partnership.

[xxx] For example, in terms of lost or deferred tax collections.


[xxxii] A nonresident who disposes of N.Y. real property as part of a like-kind exchange must disclose this information on Form IT-2663, Nonresident Real Property Estimated Income Tax Payment Form.

Go Figure

As of last Wednesday night, the SBA’s website reported that almost 4.5 million businesses had borrowed more than $510 billion under the Paycheck Protection Program.[i] Many businesses are wondering whether they will survive through the gradual reopening of the economy.[ii]

Earlier that same day, the U.S. surpassed 100,000 coronavirus deaths.

Last Thursday, the Labor Department reported that more than 40 million people – approximately one in every four American workers – had filed for unemployment since mid-March; one day later, the Commerce Department released data indicating that April had witnessed the largest monthly drop in consumer spending since the government began keeping such records – in case you’re wondering, consumer spending generally accounts for more than two-thirds of the economic activity in the country.

By the end of the day last Friday, the S&P had registered a more than 4 percent gain for the month of May;[iii] when added to April’s 12.7 percent gain, the stock market has done remarkably well – in fact, it has increased by 36 percent since its lows of late March.

If you’re having difficulty reconciling these facts, you’re not alone.[iv]

Then there are those for whom Covid-19, the lockdown, and the poor state of the economy have barely registered.

I was reminded of this last week when one of our attorneys asked me about the U.S. Tax Court’s 2017 Lender Management decision.[v]

“Why the interest?” I asked. Wah, wah, wah.[vi] “A family investment vehicle? Tell me some more. How large . . .” Wah, wah, wah. “What? And who will be managing this fund?” Wah, wah, wah. “Ah, they’re worried about being able to deduct their expenses.” Wah, wah, wah. “Please send me the agreement. I’ll take a look at the compensation provision.”[vii]

Why does it Matter?

The Code allows a taxpayer to claim as a deduction all of the ordinary and necessary expenses paid or incurred by the taxpayer during the taxable year in carrying on a trade or business.[viii] For example, a taxpayer may deduct “a reasonable allowance for salaries or other compensation for personal services actually rendered.”[ix] In general, such expenses are deducted in full from the taxpayer’s gross income[x] for purposes of determining their income tax liability for that year.[xi]

Prior to 2018, individuals could also claim itemized deductions for certain so-called “miscellaneous expenses,” including expenses paid or incurred by an individual during the taxable year in connection with an activity engaged in “for the production or collection of income.”[xii] Such expenses have to be “ordinary and necessary, meaning they must be reasonable in amount and must bear a reasonable and proximate relation to the production or collection of taxable income, or to the management, conservation, or maintenance of property held for the production of income.[xiii]

Thus, for example, services of investment counsel, clerical help, office rent, and similar expenses paid or incurred by a taxpayer in connection with investments held by the taxpayer are deductible only if (1) they are paid or incurred by the taxpayer for the production or collection of income or for the management, conservation, or maintenance of investments held by him for the production of income; and (2) they are ordinary and necessary under all the circumstances, having regard to the type of investment and to the relation of the taxpayer to such investment.[xiv]

However, certain limitations apply to the deduction of such non-trade-or-business, investment-related, expenses that do not apply to deductions for trade or business expenses. Specifically, these investment expenses are not deductible unless – together with other miscellaneous itemized deductions – they exceed two percent of the taxpayer’s adjusted gross income, in which case the excess is deductible as an itemized deduction.[xv]

Then, in late 2017, the TCJA suspended all miscellaneous itemized deductions that are subject to this two-percent floor, thereby denying taxpayers the ability to claim investment-related expenses as itemized deductions for taxable years beginning after December 31, 2017 and ending before January 1, 2026.[xvi]

In light of the foregoing, it would behoove the owners of an income-producing activity if their activity were treated as a trade or business for tax purposes, rather than as an investment activity engaged in for the production or collection of income.

The problem, of course, is that the Code does not define the term “trade or business,” and the courts have not always been consistent in their determinations of the trade or business status of an activity.[xvii]

With this background, we can now turn Lender Management.[xviii]

Basic Facts

Management LLC operated as a fund manager, and was treated as a partnership for Federal income tax purposes. At all relevant times, Management was owned by two members of the Family, one of whom owned a 99 percent interest and also served as its managing member (“Manager”) and CIO[xix].

Management provided direct management services to three Investment LLCs, each of which was treated as a partnership for Federal income tax purposes. Management directed the investment and management of assets held by the Investment LLCs for the benefit of their owners. The ultimate owners with respect to the Investment LLCs were members of the Family.

The Investment LLCs were created to accommodate greater diversification of the managed investments and more flexible asset allocation at the individual investor level. Each was formed for the purpose of holding investments in a different class of assets: private equities, hedge funds, and public equities; of these, private equities represented the largest investment.

Management’s operating agreement permitted it, without limitation, to engage in the business of managing the “Family Office” and to provide management services to Family members, related entities, and “third-party nonfamily members.” The operating agreements for the Investment LLCs designated Management as the sole manager for each entity. Thus, Management held the exclusive rights to direct the business and affairs of the Investment LLCs.

Management also managed downstream entities in which the Investment LLCs held a controlling interest. Investors in some of these downstream entities included persons who were not members of the Family. Management received not insignificant fees from these entities in exchange for managing them.

Family members understood that they could withdraw their investments in the Investment LLCs, subject to liquidity constraints, if they became dissatisfied with how the investments were being managed.

Management’s Activities

Management made investment decisions and executed transactions on behalf of the Investment LLCs, and viewed the members of the Investment LLCs as its clients. Its main objective was to earn the highest possible return on assets under management, and it provided individual investors in the Investment LLCs with one-on-one investment advisory and financial planning services.

Manager served as Management’s CIO. Management also employed five employees on a full-time basis during each of the tax years in issue.

As CIO, Manager retained the ultimate authority to make all investment decisions on behalf of Management and the Investment LLCs. Most of CIO’s time was dedicated to researching and pursuing new investment opportunities and monitoring and managing existing positions.

Management arranged annual business meetings, which were for all clients in the Investment LLCs. These group meetings were held so that Management could review face-to-face with all of its clients the performance of their investments at least once per year. Manager would conduct additional face-to-face meetings with clients who were more interested in the status of their financial investments at times and locations that were convenient for them.

Manager interacted directly with Management’s clients, collecting information from and working with these individuals, and developing computer models to understand their cash flow needs and their risk tolerances for investment, and engaging in asset allocation based on these and other factors. Management devised and implemented special ventures known as “eligible investment options,” which allowed clients to participate in investments more directly suited to their age and risk tolerance.

Management also had a CFO who was not related to the Family. CFO worked very closely with CIO-Manager every day, attending meetings for investments, assisting CIO in reviewing and making decisions about new investment opportunities, overseeing daily cash management, monitoring the status of current investments, communicating with individual clients and forecasting their cash needs, securing necessary capital call funds from revolving lines of credit, and providing updated financial information to creditors at least monthly.

Management also retained an unrelated organization to consult with CFO, to provide both accounting and investment advisory services to Management, to prepare annual partnership tax returns and quarterly financial reports for the Investment LLCs, and to collaborate with CIO in selecting new investments for the Investment LLCs.


Management received a profits interest in each of the Investment LLCs in exchange for the services it provided to the Investment LLCs and their members. These profits interests were designated “Class A” interests under the operating agreements for the Investment LLCs. As such, they represented an allocation of future income and appreciation.[xx]

Management received income from the Class A interests only to the extent that the Investment LLCs generated profits. This arrangement was intended to align Management’s goal of maximizing profits with that of its clients and to create an incentive for Management and its employees to perform successfully as managers of the invested portfolios.

Any payments that Management earned from its profits interests were paid separately from the payments that it otherwise received as a minority member of each of the Investment LLCs.

Management paid Manager a guaranteed payment in exchange for their services.[xxi] Manager also indirectly owned – through trusts and other LLCs – minority interests in the Investment LLCs.

Tax Returns

Management reported ordinary business losses for the tax years in issue, claiming deductions for business expenses, including salaries and wages, repairs and maintenance, rent, taxes and licenses, depreciation, retirement plans, employee benefit programs, guaranteed payments to partners, and other deductions.

The IRS disallowed the deductions that Management claimed as business expenses, but allowed them as investment-related expenses, subject to the limitations thereon. The IRS argued that Management was not engaged in carrying on a trade or business, and that its primary activity was “managing the Family fortune for members of the Family by members of the Family.”

Management petitioned the Tax Court, contending that its activities constituted the active trade or business of providing investment management and financial planning services to others.[xxii]

Court’s Opinion

According to the Court, deciding whether the activities of a taxpayer constitute a trade or business requires an examination of the facts in each case.

To be engaged in a trade or business, the Court stated, a taxpayer must be involved in the activity with continuity and regularity, and the taxpayer’s primary purpose for engaging in the activity must be for income or profit.[xxiii]

Certain activities, however, are not considered trades or businesses. For example, an investor is not, by virtue of their activities undertaken to manage and monitor their own investments, engaged in a trade or business.[xxiv] Expenses incurred by the taxpayer in performing investment-related activities for their own account generally may not be deducted as expenses incurred in carrying on a trade or business. These investment activities may produce income or profit, but such profit, the Court stated, is not evidence that the taxpayer is engaged in a trade or business. Instead, any profit so derived arises from the conduct of the trade or business venture in which the taxpayer has taken a stake (an investment), rather than from the taxpayer’s own business activities.

Compensation is Key

The Court then explained that a common factor distinguishing the conduct of a trade or business from a mere investment is the receipt by the taxpayer of compensation, other than the normal investor’s return; in other words, income received by the taxpayer directly for their services, rather than indirectly through the “corporate” enterprise. If the taxpayer receives not just a return on their own investment, but compensation attributable to the services they have provided to others, then that fact tends to show they are engaged in a trade or business.

Trade-or-business designation, the Court added, may apply even though the taxpayer invests their own funds alongside those that they manage for others, provided the facts otherwise support the conclusion that the taxpayer is actively engaged in providing services to others and is not just a passive investor.

The Court observed that an activity that would otherwise be a business does not necessarily lose that status because it includes an investment function. Work that includes the investment of others’ funds may qualify as a trade or business. Thus, “[s]elling one’s investment expertise to others is as much a business as selling one’s legal expertise or medical expertise.” Investment advisory, financial planning, and other asset management services provided to others may constitute a trade or business.

The Court then described how Management provided investment advisory and financial planning services for the Investment LLCs and their individual owners; it explained that, through their operating agreements, Management had the exclusive right – through its CIO, CFO and employees, all of whom worked full-time – to direct the business and affairs of the Investment LLCs.

These services, according to the Court, were comparable to the services that hedge fund managers provide. Management had a responsibility, the Court continued, to provide its clients with sound investments that were tailored to their financial needs. Thus, Management’s activities went far beyond those of an investor.

The Court then turned to Management’s compensation arrangement. Management was entitled to profits interests as compensation for its services to its clients to the extent that it successfully managed its clients’ investments.

Management and Manager held minority interests in the Investment LLCs. Management was also entitled to a profits interests as compensation for its services as the Investment LLCs’ manager. These profits interests were the primary incentive for Management to work to maximize the Investment LLCs’ success. Management received payment for its services only if the Investment LLCs earned net profits – it received no other fees. The absence of such other fees motivated Management to increase the net values of the Investment LLCs.

To the extent that the Investment LLCs did well, their operating agreements provided that Management could receive compensation separate from, and in addition to, the normal investor’s return that it received for its membership interests, and these profit interests provided substantial incentive to deliver high-quality management services. The contingent nature of the profits interests did not negate their being compensation for services.[xxv]

Based on the foregoing, the Court concluded that Management was in the trade or business of providing investment management services to and for the benefit of its clients. Most of the assets under management were owned by members of the Family who had no ownership interest in Management. Management managed investments, had an obligation to its clients, and tailored its investment strategy, allocated assets, and performed other related financial services specifically to meet the needs of such clients.[xxvi]

What Does It Mean?

Following the Court’s decision in Lender Management, there was a lot of discussion about how it provided a model for very affluent families to establish their own, or “captive,” management firm to oversee the investment and maintenance of their wealth.

Easier said than done, at least if the goal is to treat such an organization and its activities as a trade or business, the expenses of which may be fully deductible for tax purposes.

For one thing, the Lender family appears to be quite large, with several branches and generations; they are geographically widespread and, in many instances, are strangers to one another. In a sense, the “family” looks like a segment of that portion of the public that requires investment management services.

What if the family in issue represents only a relatively small number of individuals? For example, the founder of a successful business that has just been sold, along with their spouse and children? Would the activities of a captive investment management entity for such a small number of family members constitute an investment activity rather than a trade or business, especially where it is likely that most of the family will own an interest in the entity? Unlikely.

Might such a management entity grow into trade or business status over time – assuming the family wealth is preserved and grown – as the family matures, children get married and re-married, their children do the same, etc., and only a small portion of the family is involved in the management function? Perhaps.

Assuming the management entity otherwise qualifies as a trade or business, the Lender Management case seems to have blessed the issuance to the management entity of a profits interest in an investment partnership or limited liability company as compensation for the management services rendered to such investment entity without jeopardizing its trade or business[xxvii] status. Moreover, the issuance of such an interest is generally not taxable to the recipient.

As indicated earlier, however, if this profits interest lacks entrepreneurial risk, or if its status as an equity interest in a partnership is otherwise questionable,[xxviii] there is a possibility that the allocations and distributions to the management entity may, instead, be treated as taxable compensation. If the IRS does not respect the management entity’s activities as a trade or business, the management entity may find itself in a very difficult spot, indeed: taxable compensation and no deduction for its expenses.

Of course, there are varying degrees of difficulty, and given the economic and political directions in which we seem to be travelling, it seems to me, at least, that the same folks who may be concerned about family offices and the like, would be better served if they focused, instead, on reducing their exposure to increased estate and income taxes.

[i] Title I of the CARES Act, P.L. 116-136.

[ii] Even as many health professionals worry that we’re reopening too soon.

[iii] Notwithstanding what, at that point, had been three nights of public outrage following the events in Minnesota on Monday.

[iv] OK. One is strictly historical – it reports what has already happened. The other is forward-looking – it’s betting (that’s the operative word) on what’s going to happen in light of what has already happened; a nod to social science. That’s my simplistic and forced construction.

[v] Lender Management, LLC v. Comm’r, T.C. Memo 2017-246.

[vi] Remember the “voices” of the adults in the old Charlie Brown cartoons?

[vii] The breadth and variety of one’s client base can be in constant flux. In my case, it consists of closely held businesses and their owners. If a successful business is sold – few of them are transitioned to the founders’ children – the next generation’s investment and stewardship of the wealth will determine whether the founder’s family will live comfortably for several generations to come, or be haunted by having lost a good thing.

[viii] IRC Sec. 162.

A taxpayer’s taxable income is computed on the basis of the taxpayer’s taxable year, which is the same as their annual accounting period; this, in turn, is defined as the annual period on the basis of which the taxpayer regularly computes their income in keeping their books. IRC Sec. 441. A taxpayer’s taxable income is computed under the method of accounting on the basis of which the taxpayer regularly computes their income in keeping their books. IRC Sec. 446.

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

[x] After they have run the gamut of the basis, at-risk, passive loss, and excess business loss rules, to the extent applicable. IRC 704(d)/1366(d), Sec. 465, 469, and 461(l), respectively.

[xi] What’s more, net operating losses may carry over from the year in which they were incurred to another year only if the losses were the result of operating a trade or business within the meaning of IRC Sec. 162. See IRC Sec. 172(d). Over the years, Congress has alternately imposed and relaxed certain limits on the use of such losses. The most recent “exchange” was between the Tax Cuts and Jobs Act, P.L. 115-97, and the CARES Act, with the latter temporarily suspending the changes made by the former.

[xii] IRC Sec. 212(1). Reg. Sec. 1.212-1 refers to expenses paid or incurred for the management, conservation, or maintenance of property held for the production of income.

[xiii] Reg. Sec. 1.212-1(d).

[xiv] Reg. Sec. 1.212-1(g).

[xv] IRC Sec. 67(a).

[xvi] Anyone’s guess whether this, and so many other “temporary” provisions, will survive to their scheduled expiration dates. We’re struggling to get out of this economic downturn, and the November elections are around the corner.

[xvii] The TCJA certainly brought a new urgency to defining the term; for example, for purposes of IRC Sec. 199A.

[xviii] For those of you who aren’t familiar with the decision, “Lender” refers to the family that founded Lender’s Bagels (the “Family”). I don’t know about you, but for me, growing up as a first generation American in the Bronx, a Lender Bagel defined what a bagel was – especially toasted, with “Phili” cream cheese and orange marmalade. (Excuse me. I need a moment, please.)

[xix] Chief Investment Officer.

[xx] What happens if the profits interests are not respected as partnership interests? For example, what if there is no entrepreneurial risk associated with the related allocation? See Rev. Proc. 93-27 and Rev. Proc. 2001-43; IRC Sec. 1061, enacted by the TCJA; and the proposed regulations REG-115452-14.

[xxi] Within the meaning of IRC Sec. 707(c).

[xxii] Management also contended that Management and the Investment LLCs should be respected as separate business entities distinct from their owners and that these entities engaged with one another at arm’s length.

[xxiii] A sporadic activity or a hobby does not qualify.

[xxiv] An exception to the general rule applies when the taxpayer is also an active trader of securities.

[xxv] Manager’s position compensated him for the services that he provided to Management; it was his only full-time job and he was highly motivated to see Management receive the benefit of the Class A interests.

[xxvi] The IRS asserted that the family relationship between the Manager of Management and the owners of the Investment LLCs supported its contention that Management’s activities consisted solely of making investments on its own behalf. It contended that managing investments for oneself and for members of one’s family was not within the meaning of a trade or business. The Court accepted that, in general, transactions within a family group are subjected to heightened scrutiny. Where a payment is made in the context of a family relationship, the Court will carefully scrutinize the facts to determine whether there was a bona fide business relationship and whether the payment was not made because of the familial relationship.

The Court found that Management satisfied a review under heightened scrutiny. The end-level investors in the investment LLCs were all members of the Family. However, at all relevant times, only two members of the Family were owners of Management.

What’s more, Management’s clients did not act collectively or with a single mindset. They were geographically dispersed, many did not know each other, and some were in conflict with others. Their needs as investors did not necessarily coincide. Management did not simply make investments on behalf of the Family group. It provided investment advisory services and managed investments for each of its clients individually, regardless of the clients’ relationship to each other or to the Manager.

The profits interests were provided to Management in exchange for services and not because the Manager was part of the Family.

[xxvii] As opposed to investment activity.

[xxviii] For example, under the disguised sale rules of IRC Sec. 707 and the regulations issued thereunder.