“You Must Choose, But Choose Wisely.”[I]

The enactment of the Tax Cuts and Jobs Act,[ii] and its undeniable bias in favor of C corporations, has spurred the owners of many closely held businesses, along with their advisers, to reevaluate the form of business entity through which they own and operate their business, and its classification for tax purposes.[iii]

As most readers are aware, the initial choice of entity and tax classification for a business is no small matter, as it will result in certain tax and economic consequences for both the entity and its owners.

A change in a business entity’s tax classification will likewise have a significant impact upon the business, and may even generate an immediate income tax liability.[iv]

You’ve Chosen – Now How Do You Get the Money Out?

Among the several factors to be considered in determining the form and tax status for a business entity, and one that many individual owners appear not to fully appreciate,[v] is the tax treatment of an owner’s withdrawal of value from the entity.

In general, an owner of a closely held business may have several options by which they can withdraw funds from the business without necessarily removing themselves from the business, as distinguished from receiving value in exchange for the business.[vi] For example, an owner may:

  • Receive compensation for services rendered to the business (an employee-employer relationship);[vii]
  • Receive rent for allowing the business to use the owner’s property (a landlord-tenant relationship);
  • Sell property to the business (a seller-buyer relationship);[viii] and
  • “Borrow” money from the business (a debtor-creditor relationship[ix]).

In each of these situations, the owner and the business will often agree to terms that are on the “generous” end of the spectrum of what is reasonable.[x]

Finally, the owners may withdraw funds from the business by causing the business entity to make a distribution with respect to their equity interests therein (a corporation-shareholder or partnership-partner relationship).

Distributions

Generally speaking, a cash distribution from a business entity to an owner with respect to their equity interest may be effected in one of two ways: a “current” distribution of cash (which does not change the owners’ relative equity in the business); and a distribution in exchange for some of the owner’s equity in the business (a partial redemption of an owner’s shares of stock, or a partial liquidation of the owner’s partnership interest).[xi]

Current Distributions

A current distribution is the most common type of cash distribution made by a business entity. In the case of an entity with only one outstanding class of equity,[xii] each owner of the equity is generally entitled to receive the same amount of cash per unit of equity as every other owner.

The timing and amount of a current distribution may vary widely from business to business. In some cases, the manager of the business will be authorized to determine, in their discretion, if or when to make a distribution, and how much to distribute.[xiii] In other cases, the owners may have agreed that all “available cash” must be distributed at least annually.[xiv] Then there are those situations – in the case of a pass-through entity – where the only distribution required to be made for a taxable year is of an amount of cash sufficient to enable the owners to pay their income taxes attributable to their share of the entity’s profits.[xv] In each of these situations, however, every owner will generally receive a distribution based upon their relative equity in the business.

Partial Redemptions

What if only one owner, out of several, needs a cash distribution? This owner may find themselves in somewhat of a bind, especially if they cannot compel a distribution, or if the entity is unwilling to make a loan to them. What’s more, because an interest in a closely held business is, by definition, not readily marketable, this owner is unlikely to find someone outside the entity who would be willing to purchase some of their equity; in fact, it may be that the owners have agreed not to sell their equity to any outsider.[xvi]

An effective way by which some businesses have addressed this issue is by “creating” a market for the owner who requires more liquidity than may be provided by a current distribution. This “market” is accomplished by causing the entity to periodically offer to buy back a predetermined portion of its equity, usually subject to a value cap set by the entity’s managers that takes into account the reasonable needs and prospects of the business.

Alternatively – and this is the way that most closely held businesses handle the issue – the entity will not have adopted a formal buy-back program; instead, its managers, acting on an ad hoc basis, will decide, when the occasion arises, whether to buy back some of the equity proffered by an owner in need of cash.

The Good, the Bad, the Tax

A cash distribution in partial redemption or liquidation of an owner’s equity in the business provides liquidity for the owner who wants to remove value from the business, may protect the liquidity needs of the business, and may avoid the tension that otherwise could arise among the owners in the absence of a buy-back program.

However, the distribution of cash comes with a business and economic cost to the distributee-owner: their equity interest will have been reduced, they will likely be entitled to a smaller share of business profits, distributions, appreciation and sales proceeds, and they may have a smaller vote in decision-making.

Of course, there is also a tax cost to be considered, which may reduce the amount of cash available to the distributee-owner.

The income tax consequences arising from each of the foregoing cash distributions will depend upon a number of factors, including the form of business entity from which the distribution is made, and the extent to which the owner’s equity in the business is reduced.

Before the Distribution

Before considering the income tax treatment of a cash distribution from a closely held business to its owners, it would be worthwhile reviewing how the entity’s income is taxed without regard to any subsequent distribution of such income.

The taxable income of a C corporation will be subject to federal tax at the corporate level at a flat rate of 21 percent.[xvii] The after-tax income of the corporation will not be taxed to its shareholders until it is distributed to them.[xviii]

An S corporation is generally not subject to a corporate-level income tax.[xix] Rather, its taxable income flows through, and is taxed, to its shareholders[xx] at a maximum federal income tax rate of 37 percent, even though no part of such income has been distributed to the shareholders.[xxi]

In order to allow the subsequent “tax-free” distribution from the S corporation to a shareholder of an amount of cash equal to the amount of corporate income that was already included in the gross income of the shareholder, the shareholder’s adjusted basis for their S corporation shares is increased by the amount of income so included.[xxii]

As in the case of an S corporation, a partnership – including an LLC that is treated as a partnership for tax purposes – is not subject to federal income tax; its taxable income is reported by its partners on their tax returns, and they are taxed thereon without regard to whether any distribution has been made by the partnership.[xxiii]

Also as in the case of the S corporation shareholder, a partner’s adjusted basis for their partnership interest is increased by the amount of partnership income that was included in the partner’s gross income, so as to allow the distribution of such an amount of cash to the partner without triggering additional recognition of income.[xxiv]

Current Distributions

Having reviewed how the owners of a closely held business may withdraw cash from their business entity after it has been taxed to the entity, or to the owners themselves, we now turn to the income tax consequences of a current distribution to the owners.

C Corporation

A cash distribution by a C Corporation to a shareholder with respect to its stock is included in the shareholder’s gross income as a dividend to the extent the distribution is made out of the corporation’s accumulated, and current, earnings and profits.[xxv]

If the distribution satisfies the requirements for a “qualified dividend,” it will be subject to federal income tax in the hands of the shareholder at a rate of 20 percent;[xxvi] it may also be subject to the 3.8 percent federal net investment income surtax.[xxvii]

That portion of the distribution that exceeds the corporation’s earnings and profits will be applied against, and reduce, the shareholder’s adjusted basis for their stock in the corporation; basically, a tax-free return of capital.[xxviii]

To the extent the distribution exceeds the shareholder’s adjusted basis for their stock, the excess portion will be treated as gain from the sale of the stock; in other words, a deemed sale that will likely be treated as capital gain,[xxix] and taxed accordingly at a maximum federal income tax rate of 20 percent (in the case of long-term capital gain); the 3.8 percent surtax may also apply.

Assuming the corporation has only one outstanding class of stock, the declaration and payment of a dividend by the corporation’s board of directors must necessarily be made to every one of its shareholders; a shareholder cannot turn their back on the distribution and its tax consequences.

That being said, a shareholder may, if permitted by the board or by the terms of a shareholder’s agreement, choose to “leave” their share of the cash distribution in the corporation, either as an additional capital contribution or as a loan.

S Corporation

The tax consequences arising from a distribution of cash by an S corporation to its shareholders will depend, in part, upon whether the corporation has any earnings and profits from taxable years when it was a C corporation, or from a target corporation that it may have acquired in a transaction that caused it to succeed to the target’s tax attributes.[xxx] For our purposes, we will assume that the S corporation has no such earnings and profits.

In that case, a distribution of cash by an S corporation with respect to its single class of stock, which would otherwise be treated as a dividend if made by a C corporation with earnings and profits, will first be applied against the distributee-shareholder’s adjusted basis for the stock – a tax-free return of capital – and if the amount of the distribution exceeds the shareholder’s stock basis, the excess will be treated as gain from the sale of property by the shareholder.

This gain will likely be taxed as long-term capital gain,[xxxi] at a maximum federal rate of 20 percent, without regard to the composition of the underlying assets of the corporation. If the corporation’s trade or business represents a passive activity with respect to the shareholder, the 3.8 percent surtax on net investment income may also apply.

Partnership/LLC

In the case of a cash distribution[xxxii] from a partnership to a partner, gain will not be recognized by the partner except to the extent that the amount of cash distributed exceeds the partner’s adjusted basis[xxxiii] for their partnership interest immediately before the distribution.[xxxiv]

Any gain so recognized will be considered as gain from the sale of the partnership interest of the distributee partner.[xxxv] Such gain is generally treated as gain from the sale of a capital asset;[xxxvi] thus, the gain will be treated as long-term capital gain provided the partner’s holding period for their partnership interest is more than one year.[xxxvii] In that case, the maximum federal tax rate applicable to the gain will be 20 percent.

In addition, the gain may also be subject to the 3.8 percent surtax on net investment income, if the partnership’s trade or business is a passive activity with respect to the partner.[xxxviii]

However, if any of the cash deemed to have been received by the partner – in the deemed sale of their partnership interest – is attributable to any unrealized receivables[xxxix] of the partnership, or to inventory items of the partnership, then the amount of cash attributable to such assets will be treated as having been received from the sale of such assets, not from a capital asset, and will be treated as ordinary income.[xl]

Partial Redemption/Liquidation

If the current distribution described above did not occur, or if the amount thereof was insufficient for the needs of a particular owner, and assuming the business entity has agreed to redeem a portion of this owner’s equity in the business in order to get them additional cash, what are the tax consequences to the owner?

C Corporation

The tax consequences to a shareholder, some of whose shares of stock in the C corporation are acquired by the corporation from the shareholder in exchange for cash – a redemption[xli] – will depend upon the degree by which the shareholder’s ownership in the corporation is reduced relative to the ownership of the other shareholders.[xlii]

Thus, if every shareholder sold 10 percent of their shares to the issuing corporation (a pro rata redemption), none of the shareholders will have experienced a reduction in their relative ownership. In that case, and in every case in which the redemption does not result in a “meaningful” reduction[xliii] of a shareholder’s relative interest in the corporation, the cash paid by the corporation to the shareholder in exchange for some of their shares will be treated and taxed as “essentially equivalent” to a dividend, as described above, and the shareholder’s adjusted basis in the redeemed shares will be reallocated among the shareholder’s remaining shares of stock in the corporation.

However, if only one shareholder sold all but one of their shares of stock in the corporation, and such reduction was meaningful – for example, the percentage ownership represented by that one remaining share may be so small relative to the percentage of the total number of outstanding shares of the corporation that the shareholder owned before the redemption – that the redemption may be treated instead as “not essentially equivalent to a dividend;”[xliv] specifically, as a distribution in exchange for the shares redeemed by the corporation.

In that case, the shareholder will be treated as having sold the redeemed shares to the corporation and will realize gain equal to the excess of the amount paid by the corporation over the shareholder’s adjusted basis for the redeemed shares. Because the shares were likely a capital asset in the hands of the shareholder, this gain may be long-term capital gain if the shareholder’s holding period for such shares was more than one year, in which case it would taxable at a federal rate of 20 percent; the 3.8 percent federal surtax may also apply.[xlv]

The Code provides a “safe harbor” which, if satisfied, will cause the redemption of a portion of a shareholder’s shares to be treated as a sale of such shares. Specifically, immediately after the redemption, the shareholder must own less than 50 percent of the total combined voter power of the corporation’s shares. In addition, the redemption distribution must be “substantially disproportionate” with respect to the shareholder; meaning that the ratio which the voting stock of the corporation owned by the shareholder immediately after the redemption bears to all of its voting stock at that time, is less than 80 percent of the ratio which the shareholder’s voting stock before the redemption bore to all of the voting at such time. Finally, the shareholder’s ownership of all of the common stock of the corporation (voting and nonvoting) after and before the redemption, must also meet the 80percent requirement.[xlvi]

S Corporations

As in the case of a shareholder of a C corporation, the tax consequences to a shareholder, some of whose shares of stock in an S corporation are redeemed by the S corporation for cash, will depend upon the degree by which the shareholder’s ownership in the S corporation is reduced relative to the ownership of the other shareholders of the corporation.

If the reduction in the shareholder’s stock ownership is meaningful or significant enough to qualify as a sale of stock by the shareholder, then the shareholder’s gain from the redemption will be equal to the excess of the amount of cash distributed by the S corporation over the shareholder’s adjusted basis for the shares redeemed.

Provided the shareholder held the redeemed shares for more than one year, the gain will be treated as long-term capital gain, without regard to the composition of the underlying assets of the corporation, and will be taxable at a federal rate of 20 percent. If the corporation’s trade or business represents a passive activity with respect to the shareholder, then the 3.8 percent surtax may also apply to the gain.

If, instead, the redemption is treated as a current distribution, then the amount of cash distributed will be applied against the shareholder’s adjusted basis for all of their shares in the corporation, not only those shares that were redeemed. Only after the shareholder’s entire stock basis is exceeded will any remaining cash be treated as gain from the sale of a capital asset by the shareholder.

Partnership

The term “liquidation of a partner’s interest” is defined as the termination of a partner’s entire interest in a partnership by means of a distribution, or a series of distributions.[xlvii]

A distribution which is not in liquidation of a partner’s entire interest is treated as a current distribution for tax purposes. Current distributions, therefore, include distributions in partial liquidation of a partner’s interest,[xlviii] regardless of how substantial the reduction of the partner’s interest may be.[xlix]

In light of the foregoing, the same rules will apply to a partial liquidation of a partner’s equity in a partnership as apply to a current distribution. Gain will not be recognized by the partner except to the extent that the amount of cash distributed in partial liquidation of the partner’s interest – which will include the amount by which the distributee-partner’s share of partnership liabilities is reduced as a result of the reduction of the partner’s interest in partnership profit and loss[l] – exceeds the partner’s adjusted basis for their partnership interest immediately before the distribution.[li]

The gain recognized will be considered as gain from the sale of the partnership interest,[lii] and will generally be treated as gain from the sale of a capital asset,[liii] except to the extent any of the cash received by the partner is attributable to any unrealized receivables[liv] or inventory of the partnership, in which case such amount will be treated as having been received from the sale of such assets and will be treated as ordinary income.[lv]

What’s more, even if the amount of cash distributed in a partial liquidation of a partner’s interest does not exceed the distributee-partner’s adjusted basis in such interest, the partner may still be required to recognize gain from the deemed sale of certain partnership property.

Specifically, if the distributee-partner’s receipt of cash in partial liquidation of their interest results in a reduction of their share of the partnership’s unrealized receivables or inventory – as one might expect it would – the distributee-partner will be treated as having sold a portion of their interest in such receivables and inventory in exchange for a portion of the cash distribution, thereby realizing ordinary income.[lvi]

So Much for Simplicity

It is likely that a number of readers never thought that the “simple” distribution of cash by a corporation or a partnership to its owners could raise so many issues or present so many traps from a tax perspective.

The fact remains, however, that shareholders and partners are not going to turn their backs on a proffered, agreed-upon, or planned cash distribution, notwithstanding the potential tax consequences.

For that reason, it will behoove them to plan carefully for, and sufficiently in advance of, any such distributions in order that they may first identify any lurking tax issues and, having done so, to consider how to best address them.

As Fran Lebowitz once said, “A dog who thinks he is man’s best friend is a dog who obviously never met a tax lawyer.”

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[i] Remember the scene with the ancient knight and the search for the Holy Grail in Indiana Jones and the Last Crusade?

[ii] P.L. 115-97. In order to level the proverbial “playing field,” the Act also added Sec. 199A to the Code, which provides a special deduction for the non-corporate owners of partnerships and for the shareholders of S corporations.

[iii] Usually an LLC taxable as a partnership, or an S corporation.

[iv] For example, the change from an association to a partnership or disregarded entity, which is generally treated as taxable liquidation of the association. See Reg. Sec. 301.7701-3(g). Another example would be the change in accounting method, from cash to accrual, that may accompany a change from S corporation to C corporation status, the resulting accelerated recognition of income, and the related tax liability.

[v] At least in my experience.

[vi] For example, following the sale of the assets of the business, or upon the sale of their equity in the business, to a third party.

[vii] “Guaranteed payments” when made by a partnership to a partner in exchange for their services or the use of their property. IRC Sec. 707(c).

[viii] Subchapter K includes “disguised sale” rules for certain cash distributions by a partnership to a partner that are related to a contribution of property by the partner to the partnership. IRC Sec. 707; Reg. Sec. 1.707-3. For purposes of our discussion, it is assumed that these rules do not apply.

[ix] This is a relationship that taxpayers often struggle to demonstrate when challenged to do so by a taxing authority. Where there is no written evidence of a loan (like a promissory note), no interest charged, no maturity date, no collateral, and no reported distributions with respect to equity, the taxing authority will likely succeed in re-characterizing the purported loan as a distribution.

[x] These are the basic withdrawal mechanisms.

They may be structured as directly as described in the text, or they may be accomplished indirectly, as where the business entity pays an owner’s personal expense or allows the owner to use business property without adequate consideration.

In these cases of constructive or imputed withdrawals of value, the taxpayer and the taxing authorities are left to determine the parties’ intentions (for example, was the payment a form of compensation or a dividend), and the tax treatment of the withdrawal, based on the facts and circumstances.

Although the converse of these situations – as where an owner receives the services of the entity, or uses or purchases its property – does not result in the withdrawal of funds from the entity, it may nevertheless enrich the owner if the terms of the arrangement are other than arm’s-length.

[xi] Of course, a business entity may also effect a complete redemption or liquidation of the owner’s entire equity, thereby removing the owner from the business. IRC Sec. 302(b)(3); IRC Sec. 736.

[xii] S corporations are allowed only one class of stock outstanding. IRC Sec. 1361(b).

[xiii] In the case of a C corporation that accumulates earnings in excess of the reasonable needs of its business, the corporation may be subject to an additional 20 percent tax. The accumulated earnings tax does not apply to S corporations and partnerships because these are flow-through entities, the income of which is taxable to their owners without regard to whether the income has been distributed to such owners.

[xiv] With the exception of reasonable reserves, why leave the money where creditors can get it? Or so the thinking goes.

[xv] This may sound straightforward, but there are many formulations. For example, should the entity use an assumed tax rate for all of its owners? Should the individual tax attributes of an owner be considered?

[xvi] This agreement may be coupled with a right of first refusal for the purpose of ensuring that the other owners, or the entity itself, will purchase the “selling” owner’s interest.

[xvii] IRC Sec. 11.

[xviii] This may be like music to the ears of a minority shareholder – a low entity-level tax, and no flow-through of income to the minority owner, with its resulting tax liability.

[xix] IRC Sec. 1363.

For our purposes, we will assume that neither the built-in gains tax, nor the tax on excess passive investment income, applies. IRC Sec. 1374 and IRC Sec. 1375.

[xx] IRC Sec. 1366.

[xxi] The surtax on net investment income may also apply to a shareholder if the shareholder does not materially participate in the business. IRC Sec. 1411.

[xxii] IRC Sec. 1367. The distribution reduces the shareholder’s adjusted basis.

[xxiii] IRC Sec. 701 and Sec. 702.

With respect to both the shareholders of an S corporation and the partners of a partnership, the IRC Sec. 199A deduction must be considered after 2017.

[xxiv] IRC Sec. 705. The distribution reduces the partner’s adjusted basis.

[xxv] IRC Sec. 301(c)(1), Sec. 316.

[xxvi] IRC Sec. 1(h)(11).

[xxvii] IRC Sec. 1411.

[xxviii] IRC Sec. 301(c)(2).

[xxix] IRC Sec. 301(c)(3).

[xxx] IRC Sec. 381; IRC Sec. 1368(c); Reg. Sec. 1.1368-1(d).

[xxxi] Assuming the holding period is satisfied.

[xxxii] Marketable securities may be treated as cash for this purpose. IRC Sec. 731(c). As mentioned elsewhere in this post, a partnership’s satisfaction of a partner’s individual liability is treated as a distribution of cash to the partner. Likewise, a reduction in a partner’s share of a partnership’s liabilities is treated as distribution of cash. IRC Sec. 752(b).

[xxxiii] The so-called “outside” basis. It should be noted that a partner’s outside basis is adjusted for the partner’s share of partnership income, deduction, etc., only on the last day of the partnership’s taxable year.

[xxxiv] IRC Sec. 731(a)(1).

If the partnership makes, or has in effect, a Sec. 754 election, the adjusted basis of the partnership assets may be increased by the amount of gain recognized by the distributee-partner. IRC Sec. 734; Reg. Sec. 1.734-1(b).

[xxxv] IRC Sec. 731(a), last sentence.

[xxxvi] IRC Sec. 741.

[xxxvii] Of course, it is possible for a partner to have a split-holding period for their partnership interest, with some of the gain being treated as short-term capital gain. Reg. Sec. 1.1223-3.

[xxxviii] IRC Sec. 1411(c)(2).

[xxxix] IRC Sec. 751(c). This includes, for example, cash basis receivables for services rendered, plus Sec. 1245 property.

[xl] IRC Sec. 751.

[xli] IRC Sec. 317.

[xlii] Attribution rules are applied for this purpose. IRC Sec. 318.

[xliii] Very much a facts and circumstances determination, depending, among other things, upon whether the stock was voting or nonvoting, and how the redemption affected the shareholder’s ability to exercise a degree of control. For example, a redemption that causes the shareholder to become a minority owner may qualify as an exchange.

[xliv] IRC Sec. 302(b)(1).

[xlv] IRC Sec. 1001; IRC Sec. 1221 and Sec. 1222.

[xlvi] IRC Sec. 302(b)(2).

[xlvii] A series of distributions may be made in one year or in more than one year, so long as they are intended to liquidate the partner’s entire interest in the partnership.

[xlviii] Reg. Sec. 1.761-1(d).

[xlix] Compare this to the case of a corporate redemption.

[l] IRC Sec. 752(b).

[li] IRC Sec. 731(a)(1).

[lii] IRC Sec. 731(a), last sentence.

[liii] IRC Sec. 741.

[liv] IRC Sec. 751(c). This includes, for example, cash basis receivables for services rendered, plus Sec. 1245 property.

[lv] IRC Sec. 751(a).

[lvi] IRC Sec. 751(b). Thankfully, this result may be avoided if the partners agree to adjust their capital accounts prior to the partially liquidating distribution; such an adjustment (and the resulting allocation) would be based upon the partners’ interests before the partial liquidation.

Once Upon A Time

I recently recalled a client that was referred to us a few years back, shortly before it was acquired by a larger company. The client was closely held by U.S. individuals and by an S corporation, and was organized as a Delaware LLC that was treated as a partnership for U.S. tax purposes.

Beginning in the early 2000’s, the LLC had formed or acquired several foreign corporate subsidiaries (the “Foreign Subs”). I remembered reviewing a few years’ worth of the LLC’s partnership tax returns (on IRS Form 1065)[i] and, based upon what I knew of the LLC’s business and that of the Foreign Subs, I did not expect to find any subpart F income on the returns – in other words, any foreign business income realized by the Foreign Subs would not have been subject to U.S. income tax in the hands of the LLC until such income was distributed as a dividend to the LLC.[ii] However, I noticed losses from foreign operations on Schedule K of the returns. When I asked about the source of the losses, I was told they were attributable to the Foreign Subs.

As I looked further into the subsidiaries, I learned that each of them was organized as a business entity with “limited liability” under the law of the jurisdiction in which it operated – meaning that no owner or member of the entity had personal liability for the entity’s obligations by reason of being a member.[iii] Thus, each Foreign Sub’s default classification for U.S. tax purposes was as an “association”; i.e., as an entity that was treated as a corporation.[iv] More relevant to the issue before me, each Foreign Sub was a “foreign eligible entity” that may have elected to change its classification for U.S. tax purposes.[v]

I asked to see the IRS Form 8832, Entity Classification Election,[vi] that I assumed must have been filed by each Foreign Sub to elect to be disregarded as an entity separate from the LLC – the so-called “check the box”.[vii] Such an election would have caused each subsidiary to be treated as a branch of the LLC, with the branch losses treated as having been realized directly by the LLC.[viii]

As it turned out, no such elections had been made. When I asked what the client intended when it acquired or organized the Foreign Subs, I was informed that they were to be treated as branches, which was consistent with the LLC’s tax returns as filed (as reflected on the Schedule K).

In order to redress the situation, we requested, and obtained, a ruling from the IRS that allowed the Foreign Subs to file late entity classification elections.

All’s well that ends well. Right?

The End of Tax Deferral

Fast forward. The LLC is no longer a client. The Tax Cuts and Jobs Act is enacted.[ix] Every U.S. person that owns a controlled foreign subsidiary that is treated as a corporation (or association) for U.S. tax purposes (a “CFC”) is scrambling to understand the new anti-deferral rules,[x] and to develop a plan for managing their impact.

In particular, tax advisers are discovering the benefits under the Act of being a direct C corporation parent of a CFC, or – in the case of an individual U.S. shareholder who owns stock of a CFC either directly, or indirectly through a partnership or an S corporation – the benefit of electing under Section 962 of the Code to be treated as a C corporation shareholder of the CFC.[xi]

GILTI

In order to limit a U.S. person’s ability to defer the U.S. taxation of a CFC’s non-subpart F, foreign-source income, the Act introduced a new class of income – “global intangible low-taxed income” (“GILTI”) – that must be included in income by a U.S. shareholder of a CFC.

This provision generally requires the current inclusion in income by a U.S. shareholder of (i) their share of a CFC’s non-subpart F income, (ii) less an amount equal to their share of 10 percent of the adjusted basis of the CFC’s tangible property used in its trade or business of a type with respect to which a depreciation deduction is generally allowable – the difference being the U.S. shareholder’s GILTI.

This income inclusion rule applies to both individual and corporate U.S. shareholders.

In the case of an individual shareholder, the maximum federal income tax rate applicable to GILTI is 37 percent. This is the rate that will apply, for example, to a U.S. individual who directly owns at least 10 percent of the stock of a CFC, or to one who indirectly owns such CFC stock through an S-corporation or partnership.

More forgiving rules apply in the case of a U.S. shareholder that is a domestic C corporation. Such a corporation is generally allowed a deduction of an amount equal to 50 percent of its GILTI (the “50-percent deduction”) for purposes of determining its taxable income;[xii] thus, the effective federal corporate tax rate for GILTI is actually 10.5 percent.[xiii]

In addition, for any amount of GILTI included in the gross income of a domestic corporation, the corporation is allowed a deemed-paid credit equal to 80 percent of the foreign taxes paid or accrued by the CFC with respect to such GILTI (the “80-percent FTC”).[xiv]

Based on the interaction of the 50-percent deduction and the 80-percent FTC, the U.S. tax rate on GILTI that is included in the income of a domestic C corporation will be zero (0) where the foreign tax rate on such income is at least 13.125 percent.[xv]

Foreign Branches

Of course, not all foreign subsidiaries of a U.S. person are treated as corporations for U.S. tax purposes. As in the case of the Foreign Subs, described above, a foreign subsidiary may be treated as a branch of its U.S. owner for tax purposes.

Because these foreign subsidiaries are not treated as corporations for U.S. tax purposes, they are not CFCs. Therefore, neither the GILTI nor the subpart F anti-deferral rules apply to them.

Rather, the income generated by a branch of a U.S. person (including income that would have been treated as GILTI in the case of a CFC) is treated as having been earned directly by the U.S. person, and is included in such U.S. person’s gross income on a current basis, without any deferral whatsoever.[xvi]

In the case of a U.S. individual owner of the branch – whether directly or through a partnership or S corporation – the foreign branch income will be subject to federal income tax at a maximum rate of 37 percent. In the case of an owner that is a C corporation, the foreign branch income will be subject to federal tax at the flat 21 percent rate applicable to corporations.

Because the branch is not a CFC for U.S. tax purposes, neither the 50-percent deduction nor the 80-percent FTC, that are available for GILTI, may be used to reduce or even eliminate the U.S. income tax on the branch income.[xvii] That being said, the U.S. owner of the branch generally may still claim a tax credit for the foreign taxes paid by the branch, thereby reducing their U.S. income tax liability attributable to the branch income.[xviii]

Incorporate the Branch?

Under these circumstances, would it make sense for the U.S. owner of the branch to incorporate the branch, and thereby convert it into a CFC, the income of which may be eligible for the reduced tax rates on GILTI described above?

Such an incorporation may be effectuated by contributing the assets comprising the branch (and subject to its liabilities) to a foreign corporation in exchange for all of its stock.

Alternatively, where the branch is held through a foreign eligible entity – a corporation, for all intents and purposes, under local law – that has elected (“checked the box”) to be treated as a disregarded entity for U.S. tax purposes (as in the case of the LLC’s Foreign Subs, described above), the U.S. owner may consider having the foreign entity elect to be treated, instead, as an association that is taxable as a corporation for U.S. tax purposes.[xix]

Either of these options may seem like a good idea – but not necessarily.

Section 367

In general, a U.S. person will not recognize gain if they transfer property to a corporation solely in exchange for stock in such corporation and, immediately after the exchange, the transferor is in control of the corporation.[xx]

However, in order to prevent a U.S. person from placing certain assets beyond the reach of the U.S. income tax by transferring them to a foreign corporation on a tax-favored basis (as described immediately above), the Code provides that if a U.S. person transfers property to a foreign corporation in exchange for stock in the foreign corporation, the transfer by the U.S. person becomes taxable.[xxi]

Prior to the Act, the Code provided an exception to this recognition rule; specifically, the transfer of property[xxii] by a U.S. person to a foreign corporation in exchange for its stock would not be treated as a taxable exchange where the property was to be used by the foreign corporation in the active conduct of a trade or business outside of the U.S.[xxiii]

The Act repealed this nonrecognition rule for exchanges after December 31, 2017. Thus, a transfer of property used in the active conduct of a trade or business outside the U.S. – a foreign branch – by a U.S. person to a foreign corporation no longer qualifies for non-recognition of gain.

Branch Losses

What’s more, the Act also added a new rule which provides that, if a U.S. corporation transfers substantially all of the assets of a foreign branch to a foreign corporation with respect to which it owns at least 10 percent of the total voting power or total value after the transfer, the U.S. corporation will include in its gross income an amount equal to the “transferred loss amount” of the branch.[xxiv]

In general, the transferred loss amount is equal to the losses incurred by the foreign branch after December 31, 2017, and before the transfer, for which a deduction was allowed to the U.S. corporation. The amount is reduced by certain taxable income earned, and gain recognized, by the foreign branch, including the amount of gain recognized by the U.S. corporation on account of the transfer of the branch assets.

What’s a Taxpayer to Do?

It appears that there aren’t many options available to a U.S. person with a foreign branch.

The U.S. person may continue to operate through the branch; it will not be subject to the GILTI rules; it will be subject to current U.S. income tax on all of its branch-derived income at its ordinary federal income tax rate; it will be entitled to a credit against its U.S. tax for any foreign income tax paid by the branch; the remittance by the branch of its earnings to the U.S. person will not be subject to U.S. tax, though the foreign jurisdiction of the branch may impose a withholding tax on such a distribution, for which a credit should be available to the U.S. person.

The U.S. person may incorporate the branch, as described above, and pay the resulting U.S. income tax liability – of course, the liability should be quantified before any change in form is effectuated; the GILTI and the CFC subpart F rules would then become applicable; with that, the recognition of a limited amount of foreign-sourced income may be deferred; in addition, the U.S. person – whether a C corporation or an individual who elects under Section 962 of the Code (including one who holds the foreign corporation stock through a partnership or an S corporation) – will be able to achieve the reduced U.S. income tax rate resulting from the application of the reduced 21 percent corporate rate, the 50-percent deduction, and the 80-percent FTC.

The U.S. taxpayer may eliminate the branch entirely – which may be impractical from a business perspective – in which case its foreign-sourced income will continue to be subject to U.S. income tax, though the taxpayer may be able to avoid paying any foreign taxes,[xxv] not to mention the U.S. reporting requirements that are attendant on the ownership and operation of a foreign business entity.

The decision will ultimately depend upon each taxpayer’s unique facts and circumstances, including the business reasons that caused the U.S. person to operate overseas to begin with.


[i] https://www.irs.gov/pub/irs-pdf/f1065.pdf

[ii] In other words, recognition of the subsidiaries’ income would have been deferred.

[iii] In general, this determination is based solely on the law pursuant to which the entity is organized. A member has personal liability, for this purpose, if the creditors of the entity may seek satisfaction of all or any portion of the debts or claims against the entity from the member as such. Reg. Sec. 301.7701-3.

[iv] I had already determined that none of the foreign subsidiaries was described in Reg. sec. 301.7701-2 as a “per se corporation.”

[v] Reg. Sec. 7701-3(a) and 301.7701-3(b)(2).

[vi] https://www.irs.gov/pub/irs-pdf/f8832.pdf

[vii] A deemed liquidation of the association. Reg. Sec. 301.7701-3(g).

[viii] A controlled foreign corporation’s losses for a taxable year do not flow through to its U.S. shareholders; rather, they reduce the CFC’s earnings and profits for the year. According to Sec. 952 of the Code, a CFC’s subpart F income for a taxable year cannot exceed its earnings and profits for that year. In addition, the amount of subpart F income included in a U.S. shareholder’s gross income for a taxable year may generally be reduced by the shareholder’s share of a deficit in the CFC’s earnings and profits from an earlier taxable year that is attributable to an active trade or business of the CFC.

[ix] December 22, 2017. P.L. 115-97; the “Act.”

[x] IRC Sec. 951A, effective for taxable years of foreign corporations beginning after December 31, 2017, and to taxable years of U.S. shareholders in which or with which such taxable years of foreign corporations end.

[xi] https://www.taxlawforchb.com/2019/03/u-s-individuals-electing-to-be-treated-as-corporations-american-werewolves/

[xii] IRC Sec. 250.

[xiii] The 21 percent flat rate multiplied by 50 percent.

[xiv] IRC Sec. 960(d). This is to be compared with the foreign tax credit available to a domestic corporation that includes subpart F income in its gross income; in that case, under IRC Sec. 960(a), the domestic corporation is deemed to have paid so much of the CFC’s foreign income taxes as are properly attributable to such subpart F income.

[xv] 13.125 percent multiplied by 80 percent equals 10.5 percent.

[xvi] Including the limited deferral that is still available under the GILTI rules.

[xvii] The Section 962 election is only available with respect to a CFC.

[xviii] The Act added a new rule that limits the ability of a U.S. taxpayer to use the “excess” foreign tax credits attributable to a branch – the amount of foreign tax paid by the branch in excess of the U.S. income tax that would otherwise be imposed on the income of the branch – to reduce the taxpayer’s U.S. income tax on its other foreign-source income.

[xix] The owner of the eligible entity would be treated as having contributed all of the assets and liabilities of the entity to the association in exchange for stock of the association. Reg. Sec. 301.7701-3(g).It should be noted that, in general, an entity that has already elected to change its tax classification cannot make a second election during the 60-month period following the effective date of the first election.

[xx] IRC Sec. 351.

[xxi] IRC Sec. 367(a). This is accomplished by providing that the foreign corporation shall not be considered a corporation for purposes of Section 351 of the Code.

[xxii] Certain assets were excluded from this rule; for example, inventory and certain intangibles.

[xxiii] The “active trade or business” exception to gain recognition under Section 367(a) of the Code. Reg. Sec. 1.367(a)-2.

[xxiv] IRC Sec. 91.

[xxv] It may not be treated as “doing business” in the foreign jurisdiction. In the case of a treaty country, the U.S. taxpayer may be treated as not having a permanent establishment in the foreign country.

Yesterday, in Part I, we reviewed the like-kind exchange rules. https://www.taxlawforchb.com/2019/04/deferring-real-property-gain-like-kind-exchange-or-opportunity-fund-part-i/

Now we turn to the new kid on the block.

Qualified Opportunity Zones

The Act added Section 1400Z-2 to the Code, which allows a taxpayer to elect to temporarily defer the recognition of gain from the disposition of property which is reinvested in a QOF.[i] This includes gain from the disposition of real property.

QOF

In general, a QOF is an investment vehicle organized as a corporation or as a partnership for the purpose of investing in qualified opportunity zone property,[ii] and that holds at least 90-percent of its assets in such property.[iii]

In contrast to the like-kind exchange rules, the property that generated the gain that a taxpayer invests in a QOF need not be like-kind to the property held by the QOF. This may afford a taxpayer the opportunity to diversify on a tax-deferred basis.

That is not to say that diversification is not possible in the context of a like-kind exchange – though such diversification must occur within the universe of real property; for example, a taxpayer may acquire property in a different geographic area, they may acquire commercial property rather than residential, and vice versa, or they may acquire multiple replacement properties for a single relinquished property – but they must acquire real property.

Eligible Gain

Only capital gain is eligible for deferral under Section 1400Z-2.[iv]

Thus, capital gain from the sale of land held by the taxpayer for investment is eligible,[v] as is gain from the sale of real property that is used in the taxpayer’s trade or business and that is held for more than one year.[vi]

In addition, the capital gain from the sale of a taxpayer’s interest in a real property partnership, or their shares of stock in a real property corporation, will be eligible for deferral.

The proposed regulations expand upon the foregoing by providing that a gain is eligible for deferral if it is treated as a capital gain for Federal income tax purposes. Eligible gains, therefore, generally include capital gain from an actual, or from a deemed, sale or exchange, or any other gain that is required to be included in a taxpayer’s computation of capital gain.[vii]

The gain to be deferred must be gain that would otherwise be recognized[viii] not later than December 31, 2026, the final date under Section 1400Z-2 for the deferral of gain through a QOF. Thus, the window for utilizing the QOF deferral rules is fairly limited.[ix]

It should be noted that, in order to be eligible for the QOF deferral, the gain must not arise from a sale of real property to, or an exchange of real property with, a person related to the taxpayer.[x]

Eligible Taxpayer

In general, any taxpayer that recognizes gain is eligible to elect deferral under the QOF rules. These taxpayers include individuals, C corporations, and certain other taxpayers.

In addition, any time a partnership would otherwise recognize gain, the partnership may elect to defer all or part of such gain to the extent that it makes an eligible investment in a QOF. To the extent that the partnership does not elect deferral, each partner may elect to do so.[xi]

Eligible Investment

The proposed regulations clarify that, to qualify under Section 1400Z-2, an investment in a QOF must be an equity interest in the QOF; this may include preferred stock in a corporation, or an interest in a partnership with special allocations.

A debt instrument issued by a QOF is not an eligible investment.

Provided that the eligible taxpayer is the owner of the equity interest in the QOF for Federal income tax purposes, status as an eligible interest is not impaired by the taxpayer’s use of the interest as collateral for a loan, whether a purchase-money borrowing or otherwise.[xii]

Time for Deferring Gain

To be able to elect to defer gain, a taxpayer must generally invest in a QOF during the 180-day period beginning on the date of the sale or exchange giving rise to the gain.

Some capital gains, however, arise as the result of Federal tax rules that treat an amount as gain from the sale or exchange of a capital asset where no so event occurred. In those cases, as a general rule, the proposed regulations provide that the first day of the 180-day rollover period is the date on which the gain would be recognized for Federal income tax purposes, without regard to the deferral available under Section 1400Z-2.

Partnerships/Partners

If the election to defer the recognition of gain is made by the partnership that sold or exchanged the property at issue, no part of the deferred gain is required to be included in the distributive shares of its partners. To the extent that the partnership does not elect to defer the capital gain, the gain is included in the distributive shares of the partners.

If all or any portion of a partner’s distributive share of the partnership’s gain satisfies all of the rules for eligibility under Section 1400Z-2 (including that the gain not arise from a sale or exchange with a person that is related either to the partnership or to the partner), then the partner may elect its own deferral with respect to the partner’s distributive share – to the extent that the partner makes an eligible investment in a QOF – without regard to what the other partners decide to do. [xiii]

In other words, some partners may decide to defer gain recognition by investing in a QOF, while others will choose to recognize their share of the gain.[xiv]

Similarly, if a partner a realizes capital gain from the sale of their interest in a partnership that owns real property,[xv] the partner may defer recognition of the gain by making an eligible investment in a QOF.

Deferral

The maximum amount of gain that may be deferred by a taxpayer is equal to the amount of cash invested in a QOF by the taxpayer during the 180-day period beginning on the date of the sale of the asset to which the deferral pertains.

Thus, if a taxpayer timely invests an amount of cash in a QOF equal to the entire gain from the sale, the gain will be deferred; the taxpayer does not need to invest the entire sale proceeds (i.e., the amount representing a return of basis[xvi]). Any capital gain that is not deferred in accordance with this rule must be recognized.

It should be noted that the cash invested by a taxpayer in a QOF does not have to be traced to the transaction that generated the capital gain that is being deferred. The amount invested by the taxpayer may come from another source; it may even be borrowed by the taxpayer.[xvii]

Recognition of Deferred Gain

Some or all of the gain deferred by virtue of the investment in a QOF will be recognized by the taxpayer on the earlier of: (1) the date on which the QOF investment is disposed of, or (2) December 31, 2026.[xviii]

In other words, the gain that was deferred from the original sale or exchange must be recognized by the taxpayer no later than the taxpayer’s taxable year that includes December 31, 2026, notwithstanding that the taxpayer may not yet have disposed of its equity interest in the QOF.[xix]

Death of Electing Taxpayer

If an electing individual taxpayer should pass away before the deferred gain has been recognized, then the deferred gain will be treated as income in respect of a decedent, and shall be included in income in accordance with the applicable rules.[xx]

In other words, the decedent’s estate will not enjoy a basis step-up for the deferred-gain investment in the QOF at the decedent’s death that would eliminate the deferred gain.[xxi]

Gain Reduction

A taxpayer’s basis for an investment in a QOF immediately after its acquisition is deemed to be zero.

If the investment is held by the taxpayer for at least five years, their basis in the investment is increased by 10-percent of the deferred gain. If the investment is held by the taxpayer for at least seven years, their basis is increased by an additional 5-percent of the deferred gain.[xxii]

If the investment is held by the taxpayer until at least December 31, 2026 – the year in which the remaining 85-percent of the taxpayer’s deferred gain will be recognized – the basis in the investment will be increased by the amount of such deferred gain.

The deferred gain is recognized on the earlier of the date on which the investment in the QOF is disposed of or December 31, 2026.[xxiii]

Elimination of Gain

In the case of the sale or exchange of an investment in a QOF held for more than 10 years, at the election of the taxpayer, the basis of such investment in the hands of the taxpayer will be adjusted to the fair market value of the investment at the date of such sale or exchange.

In other words, any appreciation in the taxpayer’s investment in a QOF will be excluded from their gross income, and will escape taxation, if the taxpayer holds the investment for more than 10 years. The taxpayer’s ability to make this election is preserved until December 31, 2047.[xxiv]

This basis step-up is available only for gains realized upon investments that were made in connection with a proper deferral election under section 1400Z-2.[xxv]

Because there is no gain deferral available with respect to any sale or exchange made after December 31, 2026, there is no exclusion available for investments in QOFs made after December 31, 2026.

Are we Talking Apples and Oranges? Or McIntosh and Red Delicious?

Probably the former.[xxvi] Although both the like-kind exchange and the QOF investment allow a taxpayer to defer the recognition of capital gain from the disposition of an interest in real property, they are founded on different principles,[xxvii] seek to achieve different goals and, consequently, require the satisfaction of different criteria.

At the most basic level, the like-kind exchange will probably continue to be the option chosen by an active investor in real property – one who wants to defer their gain, wants to retain an interest in real property that they will manage, but does not want to be limited by the requirements for a QOF, including their geographic restrictions.

A taxpayer who is withdrawing from the real property business, and who otherwise may have settled upon a Delaware Statutory Trust as their replacement property in a like-kind exchange, may find an investment in a QOF attractive, especially because they are already committed to becoming a passive investor, and they will need to invest only an amount equal to their gain from the sale, thereby allowing them to keep that portion of the sale proceeds equal to their basis in the disposed-of property.

In the case of a minority investor who is withdrawing from a real property partnership or corporation, an investment in a QOF may be the only game in town, and a fairly attractive one at that. This may especially be the case for a partner in a partnership who would realize a very large gain on their withdrawal from the partnership thanks to the deemed distribution of cash under Section 752 of the Code.[xxviii]

Finally, a taxpayer engaging in a deferred like-kind exchange, where none of the identified replacement properties can be acquired, may find that the only alternative to gain recognition is an investment in a QOF. However, query whether any qualified intermediary will release the sale proceeds before the expiration of the 180-day replacement period.[xxix]

Time will tell.

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[i] Taxpayers will make deferral elections on Form 8949, which will be attached to their Federal income tax returns for the taxable year in which the gain would have been recognized if it had not been deferred.

[ii] In the case of real property, this means property located in the zone that is “substantially improved” by the QOF.

[iii] https://www.taxlawforchb.com/2019/02/a-closely-held-qualified-opportunity-fund-its-possible-but-its-not-easy/

[iv] In general, the gain may be either short-term or long-term capital gain. Other than in the case of land that is a capital asset in the hands of the taxpayer, the disposition of real property will generate capital gain only if it has been held for more than one year.

[v] IRC Sec. 1221. A capital asset.

[vi] IRC Sec. 1231. Gain from the sale of real property that represents the taxpayer’s stock-in-trade does not qualify; nor does ordinary income arising from the recapture of depreciation.

[vii] For example, a distribution of cash by a partnership to a partner, that is treated as a sale or exchange of the partner’s partnership interest, and that generates capital gain, may be eligible for deferral. IRC Sec. 731, 741.

[viii] But for the deferral permitted under Section 1400Z-2.

[ix] That being said, who knows whether a future administration will allow the like-kind exchange of real property. The Obama administration tried to eliminate Section 1031 in its entirety.

[x] Similarly, the sale of a partnership interest or of shares of stock in a corporation may not be made to a related person if the gain therefrom is to qualify. IRC Sec. 1400Z-2 incorporates the related person definition in sections 267(b) and 707(b)(1) of the Code, but substitutes “20 percent” in place of “50 percent” each place it occurs in section 267(b) or section 707(b)(1).

[xi] Similar rules apply for S corporations and their shareholders.

[xii] The proposed regulations also clarify that deemed contributions of money under section 752(a) – e.g., when a partner’s allocable share of a partnership debt is increased – do not result in the creation of an investment in a QOF.

Compare this to a post-like-kind exchange refinancing, which may be viewed as separate from the exchange (if planned properly) and, so, does not generate boot.

[xiii] The partner’s 180-day period generally begins on the last day of the partnership’s taxable year, because that is the day on which the partner would be required to recognize the gain if the gain is not deferred.

[xiv] Many taxpayers long for such flexibility in the context of a partnership in which some partners want to engage in a like-kind exchange while other partners want to monetize their partnership interest.

[xv] Notwithstanding that the partnership remains subject to the partnership tax rules under subchapter K.

[xvi] Compare this to the requirements for a like-kind exchange, where the taxpayer must acquire a property with at least the same fair market value and equity as the relinquished property if they want to defer the entire gain.

[xvii] For example, if partnership sells an asset that generates capital gain, and a partner elects to defer their share of such gain, they may have to borrow the proceeds to be invested in a QOF if the partnership does not make a distribution.

[xviii] A like-kind exchange allows an indefinite deferral of gain.

[xix] As to the nature of the capital gain – i.e., long-term or short-term – the deferred gain’s tax attribute will be preserved through the deferral period, and will be taken into account when the gain is recognized. Thus, if the deferred gain was short-term capital gain, the same treatment will apply when that gain is included in the taxpayer’s gross income in 2026.

The gain deferred in a like-kind exchange, in contrast, may be deferred indefinitely – i.e., until the replacement property is sold.

[xx] IRC Sec. 691.

[xxi] Compare this to the gain deferred in a like-kind exchange, where a basis step-up at the death of a taxpayer may eliminate the gain.

[xxii] 15-percent, in total. Because of the December 31, 2026 “deadline” described above, a taxpayer will have to sell and reinvest their gain by December 31, 2019 in order to enjoy the full 15-percent basis adjustment (7 years). Like-kind exchanges have no such holding period requirements.

[xxiii] Only taxpayers who rollover qualifying capital gains before December 31, 2026, will be able to take advantage of the special treatment of capital gains under Section 1400Z-2.

[xxiv] That’s many years of potential appreciation.

[xxv] It is possible for a taxpayer to invest in a QOF in part with gains for which a deferral election under section 1400Z-2 is made and in part with other funds (for which no section 1400Z-2 deferral election is made or for which no such election is available). Section 1400Z-2 requires that these two types of QOF investments be treated as separate investments, which receive different treatment for Federal income tax purposes.

[xxvi] I’ll take an apple over an orange any day.

[xxvii] https://www.taxlawforchb.com/2019/02/sale-of-a-business-and-qualified-opportunity-funds-deferral-exclusion-and-risk/

[xxviii] This is basically a recapture of tax benefits – previously received by the taxpayer in the form of deductions or tax-free distributions of cash – attributable to funds borrowed by the partnership.

[xxix] See the safe harbor under Reg. Sec. 1.1031(k)-1(g)(6).

The Act

Among the business transactions on which the Tax Cuts and Jobs Act[i] has had, and will continue to have, a significant impact is the disposition of a taxpayer’s interest in real property, whether held directly or through a business entity.

That is not to say that the Act amended an existing Code[ii] provision, or added a new provision to the Code, that was specifically intended to affect the income tax consequences arising from the sale or exchange of a taxpayer’s interest in real property. It did no such thing.

However, the Act preserved the ability of a taxpayer to defer the recognition of gain from their disposition of real property (the “relinquished” property) by acquiring other real property (the “replacement” property) of like-kind to the relinquished property,[iii] while eliminating the ability of a taxpayer to engage in a like-kind exchange for the purpose of deferring the gain from their disposition of any other type of property.[iv]

At the same time, the Act provided another deferral option for the consideration of taxpayers who realize capital gain on their disposition of property – including real property; specifically, such gain may be deferred if the taxpayer invests in a new kind of investment vehicle: a qualified opportunity fund (“QOF”).[v]

With the release of proposed regulations under the QOF rules in late 2018,[vi] and with the expectation of more guidance thereunder in the near future,[vii] some taxpayers who are invested in real property are beginning to view QOFs with greater interest, including as a possible deferral alternative to a like-kind exchange.

In light of this development, it will behoove taxpayers invested in real property to familiarize themselves with the basic operation of these two deferral options: the like-kind exchange and the QOF.

We begin with the tried-and-true like-kind exchange.

Like-Kind Exchanges

An exchange of property, like a sale, generally is a taxable event. However, Section 1031 provides that no gain (or loss) will be recognized by a taxpayer if real property held[viii] by the taxpayer for productive use in a trade or business or for investment is exchanged for real property of a “like-kind” which is to be held by the taxpayer for productive use in a trade or business or for investment.

Section 1031 does not apply to any exchange of real property that represents the taxpayer’s stock in trade (i.e., inventory) or other real property held primarily for sale.[ix] It also does not apply to exchanges involving foreign real property[x] – that being said, relinquished real property in one state may be exchanged for replacement real property in another state.[xi]

The disposition of an interest in a partnership or of stock in a corporation will not qualify for tax deferral under Section 1031. However, for purposes of the like-kind exchange rules, an interest in a partnership which has in effect a valid election to be excluded from the application of the Code’s partnership tax rules,[xii] is treated as an interest in each of the partnership’s assets, which may include qualifying real property, and not as an interest in a partnership.[xiii]

Like-Kind

For purposes of Section 1031, the determination of whether the real properties exchanged are of a “like-kind” to one another relates to the nature or character of each property, and not to its grade or quality. This rule has been applied very liberally with respect to determining whether real properties are of “like-kind” to one another. For example, improved real property and unimproved real property generally are considered to be property of a “like-kind” as this distinction relates to the grade or quality of the real property.[xiv]

Investment

Generally speaking, in order for a taxpayer to defer recognition of the entire gain realized from their disposition of a relinquished real property, the taxpayer must reinvest in the replacement real property an amount at least equal to the sales price for the relinquished property. If the taxpayer invests less than this amount, it may be that they received some cash in the disposition that was not reinvested (non-like property, or “boot”).

In addition, if the relinquished property was encumbered by debt, the taxpayer must incur at least the same amount of debt in acquiring the replacement property, or they must invest additional cash in such acquisition in an amount equal to the amount of such debt.[xv] Any net reduction in such debt, in moving from the relinquished property to the replacement property, would be treated as boot.

Boot

The non-recognition of gain in a like-kind exchange applies only to the extent that like-kind property is received in the exchange. Thus, if an exchange of real property would meet the requirements of Section 1031, but for the fact that the property received by the taxpayer in the transaction consists not only of real property that would be permitted to be exchanged on a tax-deferred basis, but also other non-qualifying property or money (including “net debt-relief”), then the gain realized by the taxpayer is required to be recognized, but not in an amount exceeding the fair market value of such other property or money.[xvi]

Basis

In general, if Section 1031 applies to an exchange of real properties, the basis of the property received in the exchange is equal to the basis of the property transferred. This basis is increased to the extent of any gain recognized as a result of the receipt of other property or money in the like-kind exchange, and decreased to the extent of any money received by the taxpayer.[xvii]

The holding period of qualifying real property received includes the holding period of the qualifying real property transferred.[xviii]

In this way, the deferred gain is preserved and may be recognized by the taxpayer on a subsequent taxable disposition, which may occur many years later.[xix]

Of course, if the taxpayer is an individual who dies before the later taxable sale of the replacement property, their estate will receive a basis step-up for the property;[xx] consequently, the estate may not recognize any gain on the sale.

Deferred Exchange

A like-kind exchange does not require that the real properties be exchanged simultaneously. Indeed, most exchanges do not involve direct swaps of the relinquished and replacement real properties.

Rather, the real property to be received in the exchange must be received not more than 180 days after the date on which the taxpayer relinquishes the original real property.[xxi]

In addition, the taxpayer must identify the real property to be received within 45 days after the date on which the taxpayer transfers the real property relinquished in the exchange.[xxii]

Until the replacement real property is acquired, the taxpayer may not receive the proceeds from the sale of the relinquished property. If the taxpayer actually or constructively receives such proceeds before the taxpayer actually receives the like-kind replacement property, the transaction will constitute a sale, and not a deferred exchange, even though the taxpayer may ultimately receive like-kind replacement property.

In order to assist a taxpayer in avoiding the actual or constructive receipt of money or other property in exchange for their relinquished real property, the IRS has provided a number of “safe harbor” arrangements pursuant to which such “sale proceeds” from the relinquished property may be held by someone other than the taxpayer pending the acquisition of the replacement property.[xxiii] If the requirements for these arrangements are satisfied, the taxpayer will not be treated as having received the sale proceeds.[xxiv]

Same Taxpayer

The same taxpayer[xxv] that disposes of the relinquished property must also acquire the replacement property. Thus, if an individual, a partnership, or a corporation sells a real property that they held for investment or for use in a trade or business, then that same individual, partnership or corporation must acquire and hold the replacement property.

Stated differently, if a partnership or a corporation sells a real property, its individual partners and shareholders cannot acquire their own separate replacement properties outside the partnership or corporation.[xxvi]

Holding Period

There is no prescribed minimum holding period – either for the relinquished property or the replacement property – that must be satisfied in order for a taxpayer to establish that they “held” the real property for the requisite purpose (and not for sale).

However, based on the facts and circumstances, a short holding period may result in a taxpayer’s failing to prove that they held the property for the requisite investment or business purpose.

Related Parties

That being said, a special rule applies where the taxpayer exchanges real property with a related person.

Where a taxpayer engages in a direct swap of like-kind real properties with a related person, the taxpayer cannot use the nonrecognition provisions of Section 1031 if, within 2 years of the date of the swap, either the related person disposes of the relinquished property or the taxpayer disposes of the replacement property. The taxpayer will recognize the deferred gain in the taxable year in which the disposition occurs.[xxvii]

It should also be noted that a taxpayer engaging in a deferred exchange, who transfers relinquished real property to a qualified intermediary in exchange for replacement real property formerly owned by a related party, is generally not entitled to nonrecognition treatment under Section 1031 if, as part of the transaction, the related party receives cash or other non-like-kind property for the replacement property.[xxviii]

Tomorrow we turn to the Qualified Opportunity Fund.

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[i] P.L. 115-97; the “Act.”

[ii] In the words of The Highlander, “There can be only one”: the Internal Revenue Code. Inside joke – part of a running dispute with some acquaintances in the bankruptcy world. Their code has a lower case “c”.

[iii] IRC Sec. 1031.

[iv] Sec. 13303 of the Act. Stated differently, the Act amended the tax-deferred like-kind exchange rules such that they will apply only to dispositions of real property.

[v] IRC Sec. 1400Z-2.

[vi] https://www.irs.gov/pub/irs-drop/reg-115420-18.pdf

[vii] Treasury Assistant Secretary Kautter recently announced that such regulations were just a few weeks away.

[viii] There is no prescribed holding period, either for the relinquished property or the replacement property. However, a short holding period may result in a taxpayer’s failing to prove that they held the property for the requisite purpose.

[ix] IRC Sec. 1031(a)(2). Thus, a dealer in real property may not use the like-kind exchange rules to defer the recognition of income arising from the sale of their inventory.

[x] IRC Sec. 1031(h).

[xi] Some “relinquished property states” have made noise about keeping tabs on the ultimate taxable disposition of the replacement property; for example, California.

[xii] Subchapter K of the Code. The election is made under IRC Sec. 761. See also the regulations promulgated under Sec. 761.

[xiii] IRC Sec. 1031(e); as amended by the Act.

[xiv] Reg. Sec. 1.1031(a)-1(b). A leasehold interest with a remaining term of at least 30 years is treated as real property. An interest in a Delaware Statutory Trust (basically, a grantor trust) may be treated as real property. In addition, certain intangibles may be treated as real property, including certain development rights.

[xv] Reg. Sec. 1.1031(d)-2.

[xvi] IRC Sec. 1031(b).

[xvii] IRC Sec. 1031(d).

[xviii] The non-qualifying property received is required to begin a new holding period.

[xix] Of course, the taxpayer may decide to continue to defer the gain by engaging in yet another like-kind exchange.

[xx] IRC Sec. 1014. The estate of an individual taxpayer who is a partner in a partnership may enjoy a similar step-up in its share of the underlying real property of the partnership, provided the partnership has in effect, or makes, an election under Sec. 754 of the Code.

The foregoing assumes the sale has not progressed to the point where the contract of sale represents an item of income in respect of a decedent, in which case there will be no basis step-up. IRC Sec. 691.

[xxi] But in no event later than the due date (including extensions) of the taxpayer’s income tax return for the taxable year in which the transfer of the relinquished property occurs).

[xxii] IRC Sec. 1031(a)(3); Reg. Sec. 1.1031(k)-1(a) through (o). The taxpayer may identify more than one replacement property. Regardless of the number of relinquished properties transferred by the taxpayer as part of the same deferred exchange, the maximum number of replacement properties that the taxpayer may identify is three properties without regard to the FMV of the properties, or any number of properties as long as their aggregate FMV as of the end of the identification period does not exceed 200 percent of the aggregate FMV of all the relinquished properties as of the date the relinquished properties were transferred by the taxpayer.

[xxiii] This requires that the proceeds be traced. Form matters here.

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

[xxv] Not necessarily the same state law entity. For example, a newly formed single member subsidiary LLC may acquire replacement property following a sale of relinquished property by its parent corporation.

[xxvi] Of course, there are situations in which one partner may want to be cashed out rather than continue in the partnership with a new property, or may want to effect a like-kind exchange while the remaining partners want to cash out their investment. Other strategies may be used in these instances; for example, a so-called “drop-and-swap,” which is not without risk.

[xxvii] IRC Sec. 1031(f). The term “related person” means any person bearing a relationship to the taxpayer described in Sections 267(b) or 707(b)(1) of the Code.

[xxviii] Rev. Rul. 2002-83.

Lou Vlahos is a recipient of a JD Supra Readers’ Choice Award in the Tax category for the second year in a row. The Readers’ Choice Awards recognize top authors and firms who were read by C-suite executives, in-house counsel, media, and other professionals across the JD Supra platform during 2018. He is one of 10 authors chosen in his category for his visibility and thought leadership.

Last year, Lou published 53 new posts and had 48,820 views of his work on JD Supra.

His top posts on JD Supra were the following:

The Real Property Business And The Tax Cuts & Jobs Act

The Federal Estate Tax Lives On, But “Where, O death, Is Your Sting?” (*)

Trusts And The Corporate Lawyer

 

After Me, Who Cares?

In the context of a family-owned business, managerial succession and the transfer of ownership – not necessarily the same thing – can turn into quite an adventure when they are not well-planned.

Let’s begin with the premise that the business is owned and managed by at least one parent. As is the case with most organizations, there are persons who have a vested interest in the uninterrupted and unchanged operation of the business; there are also those who desire change, sometimes for bona fide business reasons, sometimes for purely selfish ones. Also as in the case of other organizations, there is often a strong leader in the business who holds these competing interests at bay, or who knows how to balance them or play them off of one another.

When this moderating or controlling force – i.e., the parent upon whose continued goodwill all of the competing interests depend – is no longer present, well, that’s when the adventure begins, at least where the parent has failed to provide for a transition of ownership and management in a way that effectively deals with these competing forces.

Coming Out of the Woodwork

Speaking of competing interest-holders, there may be many who will become more active or vocal following the death of a parent where the latter has failed to provide an effective “Plan B” to be implemented upon[i] their demise; these include, for example, a surviving spouse, children-in-the-business, children-not-in-the-business-but-dependent-on-it, children-not-in-the-business-and-independent-of-it,[ii] key employees of the business, business partners (such as vendors or customers), charitable organizations of which the parent or the business was a benefactor, and others. Many, if not most, of these interest-holders will take a very self-centered approach toward the resolution of those ownership and management issues that were not adequately addressed by the parent.

In some cases, the parent may have inadvertently (or not) placed one or more of these interest-holders into positions from which they can exert substantial influence over the outcome. For example, a child-in-the-business may have been placed into a key executive position in the business; another child may have been nominated or appointed to serve as a fiduciary of the parent’s estate or trust, through which the parent’s business interests (or the value they represent) are to be distributed among the parent’s beneficiaries. Sometimes, the same person will end up holding every position of authority. This individual may be ideally situated to steer events as they desire; in doing so, however, they may compromise their fiduciary duties to many of their fellow competing interest-holders, while also running afoul of the Code, as was illustrated by a recent decision.

Decedent’s Plan

Decedent’s estate (“Estate”) included a closely held C corporation (“Corp”) that managed commercial and residential real properties. At the time of Decedent’s death, Son was the president of Corp, and two of his siblings were also employed in the business. Decedent’s other children were not involved in the business.

At her death, Decedent held approximately 81-percent of Corp’s voting shares and approximately 84-percent of its nonvoting shares. The remaining voting shares were held by Son; the remaining nonvoting shares were split between Son and one of his siblings-in-the-business.

Prior to Decedent’s death, Corp’s board had preliminary discussions about purchasing Decedent’s shares as part of ongoing succession planning. In fact, the board resolved that it would “periodically purchase” Decedent’s shares based on terms acceptable to all parties. However, there were no specific redemption agreements, or other shareholder or buy-sell agreements, in place when Decedent unexpectedly died shortly thereafter.

Therefore, in accordance with Decedent’s “pour-over” will,[iii] upon her death, all of the assets owned by her at that time[iv] – including her shares of Corp stock – passed to a trust (“Trust”).

Trust provided for Decedent’s children to receive her personal effects, but no other assets from her Estate. Any assets remaining in Decedent’s Estate would pass to Foundation, a grant-making charitable organization described in Section 501(c)(3) of the Code, and classified as a private foundation.[v] These residuary assets were not intended for Decedent’s family.

Estate Administration

Son was appointed the sole executor of Estate, the sole trustee of Trust, and the sole trustee of Foundation. Son also remained the president of Corp.

To determine the value of Decedent’s Corp shares for “estate administration purposes” – including the filing of an estate tax return – Son obtained an independent appraisal of Corp, which determined that Corp’s value as of Decedent’s date of death was approximately $17.8 million, and that Decedent’s shares in Corp were worth approximately $14.2 million (a market value of approximately $1,824 per voting share and of $1,733 per nonvoting share).

After Decedent’s death, Son caused Corp to convert from a C corporation to an S corporation, in order to accomplish certain “long-term tax planning goals.”[vi]

Redemption?

Corp’s board also decided, presumably at Son’s “suggestion,” that it would redeem from Trust all of Decedent’s Corp shares, which were to pass to Foundation.[vii] Among the reasons put forth by the board for the decision to redeem these shares was its concern about the tax consequences of Foundation owning shares in an S corporation – presumably, the treatment of Foundation’s pro rata share of S corporation income as unrelated business income.[viii]

[Based upon what followed, however, some may conclude that a motivating factor was to divert value from Foundation to Son; others may determine that it was to preserve value in the business, which is not necessarily the same thing.[ix]]

Initially, Corp agreed to redeem all of Decedent’s shares for approximately $6.1 million. This amount was based on a much earlier appraisal, since the date-of-death appraisal had not yet been completed. As a result, the redemption agreement provided that the stated redemption price would be “reconciled and adjusted retroactively” to reflect the fair market value of the shares as of the effective date of the redemption. Corp executed two interest-bearing promissory notes payable to Trust in exchange for its shares; each note was adjustable retroactively, depending on the new appraisal value.

At the same time, Son and his in-the-business-siblings entered into separate subscription agreements to purchase additional Corp shares, in order to provide funding for Corp to meet the required payments on the promissory notes, and to establish their own, relative shareholder interests in Corp.

Redemption Appraisal

Then, at the direction of Corp – i.e., Son – yet another appraisal of Decedent’s Corp shares was undertaken, specifically for the purpose of the redemption. This time, Son instructed the appraiser to value Decedent’s shares as if they represented a minority interest in Corp.[x] The appraisal, therefore, included a 15-percent discount for lack of control and a 35-percent discount for lack of marketability.[xi] As a result, Decedent’s Corp shares were valued much lower in the redemption appraisal than in the date-of-death appraisal: $916 per voting share and $870 per nonvoting share.[xii]

Corp then determined that it could not afford to redeem all of Decedent’s shares, even at the new redemption appraisal price. The redemption agreement was amended, and Corp agreed to redeem all of Decedent’s voting shares and most, but not all, of her nonvoting shares for a total purchase price of approximately $5.3 million.

Post-Redemption

The state probate court approved the redemption agreement and indicated that the redemption transaction and the seller-financing represented by the promissory notes would not be acts of prohibited self-dealing.[xiii]

After the redemption agreement was implemented, Corp’s share ownership was as follows: (1) Trust owned 35-percent of the nonvoting shares; (2) Son owned 69-percent of the voting shares and 48-percent of the nonvoting shares; and (3) the in-the-business-siblings owned 31-percent of the voting shares and 17-percent of the nonvoting shares.

Trust subsequently distributed the promissory notes (received from Corp in exchange for Decedent’s voting shares and most of her nonvoting shares) and Decedent’s remaining nonvoting shares to Foundation.

Tax Reporting

Foundation reported the following contributions on its annual tax return, based upon the redemption appraisal:[xiv] a noncash contribution of Corp nonvoting shares with a fair market value of $1.86 million; and notes receivable with an aggregate fair market value of $5.17 million.

The Trust reported a capital loss on its annual income tax return for the sale of Decedent’s voting shares and for the sale of most of Decedent’s nonvoting shares, based on the greater date of death appraisal.[xv]

Estate filed its Federal estate tax return,[xvi] on which it claimed a charitable contribution deduction[xvii] based on the date-of-death value of Decedent’s Corp shares, and reporting no estate tax liability.[xviii]

The IRS examined Estate’s Form 706 and issued a notice of deficiency in which it asserted an estate tax deficiency in excess of $4 million, based on a lower charitable contribution deduction – specifically, the amount actually distributed from Trust to Foundation.

Estate filed a timely petition in the Tax Court challenging the IRS’s assertion. Estate argued that it correctly used the date-of-death appraisal to determine the value of Decedent’s Corp shares for purposes of the charitable contribution deduction.

The IRS responded that post-death redemption of Decedent’s Corp shares should be considered in determining the value of the charitable contribution, because Son’s actions reduced the value of Decedent’s contribution to Foundation.

The Tax Court upheld the IRS’s reduction of Estate’s charitable contribution deduction and the resulting increase in its estate tax liability. The Tax Court found that “post-death events” – primarily Son’s decision to redeem Corp shares from Trust based upon an appraisal that applied a minority interest discount to the redemption value of such shares – reduced the value of the contribution to Foundation and, therefore, reduced the value of Estate’s charitable deduction.

Estate timely appealed the Tax Court’s decision to the Ninth Circuit.[xix]

Court of Appeals

Estate argued that the Tax Court erred by taking into account “post-death events” – that decreased the value of the property delivered to Foundation – in determining the value of the charitable deduction. Instead, Estate asserted that the charitable deduction should have been valued and determined as of Decedent’s date of death. The Court rejected Estate’s argument.

Charitable Deduction

The Court began by noting that the “estate tax is a tax on the privilege of transferring property” after one’s death. The estate tax “is on the act of the testator,” the Court explained, “not on the receipt of the property by the legatees.”

Because the estate tax is a tax on a decedent’s bequest of property, the valuation of the gross estate is typically done as of the date of death.[xx] Except in some limited circumstances, the Court added, post-death events are generally not considered in determining an estate’s gross value for purposes of the estate tax.

A related provision, the Court continued, “allows for deductions from the value of the gross estate for transfers of assets to qualified charitable entities.”[xxi] This deduction generally is allowed “for the value of property included in the decedent’s gross estate and transferred by the decedent . . . by will.”

The Court then explained that the purpose of the charitable deduction is to encourage charitable bequests, not to permit executors and beneficiaries to rewrite a will so as to achieve tax savings.

“Valuing” the Deduction

According to the Court, deductions are valued separately from the valuation of the gross estate.[xxii] Separate valuations, it noted, allow for the consideration of post-death events.

The Court then discussed the seminal case on the subject of the valuation of a charitable bequest.

The Court explained that in Ahmanson Foundation v. United States,[xxiii] the decedent’s estate plan provided for the voting shares in a corporation to be left to family members and the nonvoting shares to be left to a charitable foundation. The court there held that, when valuing the charitable deduction for the nonvoting shares, a discount should be applied to account for the fact that the shares donated to the charity had no voting power. That a discount was not applied to the value of the nonvoting shares in the gross estate did not impact the court’s holding. Significantly, the court recognized that a charitable deduction “is subject to the principle that the testator may only be allowed a deduction for estate tax purposes for what is actually received by the charity.”

In contrast, Estate argued that the charitable deduction must be valued as of the date of Decedent’s death, in keeping with the date-of-death valuation of an estate.

The Court disagreed. Valuations of the gross estate and of a charitable deduction are separate and may differ, it stated. According to the Court, while a decedent’s gross estate is fixed as of the date of their death, deductions claimed in determining the taxable estate may not be ascertainable or even accrue until the happening of events subsequent to death.[xxiv]

The Court continued, “[t]he proper administration of the charitable deduction cannot ignore such differences in the value actually received by the charity.” This rule prohibits crafting an estate plan or will, it stated, so as to game the system and guarantee a charitable deduction that is larger than the amount actually given to charity.

The decision in Ahmanson compelled the affirmation of the Tax Court’s ruling in the case considered here. Decedent structured her Estate so as not to donate her Corp shares directly to Foundation, but to Trust. She enabled Son to commit almost unchecked abuse of the Estate by nominating him to be executor of her estate, trustee of Trust, and trustee of Foundation, in addition to his roles as president, director, and majority shareholder of Corp.

According to the Court, Son improperly directed the appraiser to determine the redemption value of the Corp shares by applying a minority interest valuation, when he knew they represented a majority interest, and that Estate had claimed a charitable deduction based upon a majority interest valuation.

Through his actions, Son manipulated the charitable deduction so that Foundation only received a fraction of the charitable deduction claimed by Estate. In doing so, he enhanced the value of Corp, of which he was now the principal shareholder.

Estate attempted to evade Ahmanson by arguing that its holding was limited to situations where the testamentary plan itself diminished the value of the charitable property. The Court rejected this reading, stating that Ahmanson “was not limited to abuses in the four corners of the testamentary plan”; rather, the Court responded, it extended to situations where “the testator would be able to produce an artificially low valuation by manipulation.”[xxv]

The Court found that the Tax Court had correctly considered the difference between the deduction claimed and the value of the property actually received by the charity due to Son’s manipulation of the redemption appraisal value.

The Court also found that there was nothing in the record to suggest that the Tax Court’s findings were clearly erroneous. Instead, it found that Son, in his capacity as the executor and heir to Decedent’s shares, claimed a large charitable deduction based on the value of Estate property at the time of death, only to manipulate the property’s value for personal gain, deliver assets to Foundation worth substantially less than the amount claimed as a deduction, and received a windfall in the process.

In light of the foregoing, the Court sustained the estate tax deficiency.

Plan B

It is a foregone conclusion – the parent/owner/CEO of the family-owned business is either going to die on the job or retire from the job.

When that happens, they are going to leave their family with what is likely a very valuable, but illiquid, asset: the business. The business will likely represent the lion’s share of the parent’s gross estate. It is also possible that several members of the family earn their livelihoods in the business, while other members may depend upon it in some fashion for part of their support.

The removal of the parent may unleash many of the competing interests identified earlier, which in turn may result in these interest-holders’ losing sight of the one thing they have in common: the preservation of the business on which they all depend, of its ability to generate cash flow, and of the value it represents.

The first great challenge to this unifying principle will be the Federal and State estate taxes that are imposed upon the disposition of, and that are payable by, the parent’s estate.[xxvi]

The next challenge will be the faithful execution of the parent’s estate plan without compromising the business.

Both may be satisfactorily addressed if they are planned for while the parent is alive and well, if the competing interest-holders are brought into the discussion, if qualified advisers are consulted, and if guardrails are installed; for example, in the form of shareholders/partnership agreements, life insurance on the parent – which, in the case described above, could have been used by Corp to fund the very foreseeable buy-out of Foundation without compromising Corp’s business or forcing Son into an aggressive valuation posture – employment or incentive compensation agreements for key employees, and the appointment of fiduciaries to the parent’s estate or trust who understand the parent’s wishes and who are familiar with the various interest-holders.[xxvii]

Of course, if the parent truly does not care what happens to the business after their death – and we’ve all experienced such individuals – then the tax adviser’s job becomes one of damage control.


[i] In the minds of many parents, “in the event of.”

[ii] Yes, I’m making up words – the hyphen is a wonderful tool, similar to the compound word, which simply omits the hyphen, but can you imagine reading “childrennotinthebusiness”? You’d think I was writing in German. Donaudampfschiffahrtsgesellschaftskapitän, for example, means “Danube steamship company captain.” First French, now German. It’s all Greek to me.

[iii] In general, a will that does not provide for any disposition of a decedent’s assets beyond directing them to a trust created by the decedent during their lifetime; this trust provides for the detailed disposition of the assets poured over from by will; it also provides for the disposition of any assets that may have been transferred by the decedent to the trust during their lifetime. Of course, any assets that may have been owned by the decedent jointly with another with rights of survivorship would have passed to the surviving co-owner, beyond the reach of the will or trust. Similarly, assets for which the decedent contractually named a successor to their interests therein (e.g., a retirement plan account) may pass outside the will or trust.

[iv] Basically, her probate assets.

[v] IRC Sec. 509(a); i.e., not publicly supported.

[vi] At that point, Son owned or controlled all of Corp’s voting shares and almost all of its non-voting shares. He was probably planning for the ultimate sale of the business and looking to avoid the two levels of tax attendant on an asset sale by a C corporation, as well as the built-in gains tax applicable to former C corporations under IRC Sec. 1374.

[vii] Other reasons proffered by the board included the following: that the shares did not provide enough liquidity for Foundation to distribute 5 percent of its funds annually as required by IRC Sec. 4942; and that “freezing” the value of Foundation’s Corp shares via their sale could prevent future decline in value given the poor economic climate. These pass the smell test.

[viii] IRC Sec. 512(e). Of course, at Decedent’s death, Corp was a C corporation, so the issue of unrelated business income was not considered. Should it have been? In any case, no mention was made of the excess business holding rule under Sec. 4943, which would have been applicable either way, and under which Foundation would have five years (maybe more) to dispose of the Corp shares – a disposition that would have required the removal of value from the business, and for which no provisions were made.

[ix] I can’t entirely blame Son. He worked in the business, was its president, and had just become its controlling shareholder. He was given the task of balancing his desire to run the business as he sees fit against his duty to a new shareholder, the charity. Then he was “forced” to remove significant value from the business – no small matter – and transfer it to a charity.

[x] The appraiser testified that he would not have done so without these instructions. Query why the appraiser agreed to follow these instructions, at least with respect to the LOC discount.

[xi] Query why a LOM discount was not claimed for purposes of the Form 706. What was the appraiser thinking? That it wouldn’t make a difference because he incorrectly believed that the valuation of the shares for purposes of the gross estate would also provide the valuation for purposes of the taxable estate; i.e., for purposes of determining the amount of the charitable deduction)? Might as well get a higher stock basis?

[xii] Compared to the $1,824 per voting share and of $1,733 per nonvoting share date of death values determined.

[xiii] See the Reg. Sec. 53.4941(d)-1(b)(3) exception to indirect self-dealing.

[xiv] Form 990-PF, Return of Private Foundation.

[xv] Form 1041 Tax Return.

[xvi] On IRS Form 706, United States Estate (and Generation-Skipping Transfer) Tax Return.

[xvii] Schedule O to the Form 706.

[xviii] The combined effect of the unified credit, the charitable deduction, and any other administration expenses.

[xix] IRC Sec. 7482.

[xx] IRC Sec. 2031; Reg. Sec. 20.2031-1(b).

[xxi] IRC Sec. 2055(a); Reg. Sec. 20.2055-1(a).

[xxii] Ahmanson (see below), which stands for “the principle that the testator may only be allowed a deduction for estate tax purposes for what is actually received by the charity.” “The statute does not ordain equal valuation as between an item in the gross estate and the same item under the charitable deduction.”

[xxiii] 674 F.2d 761 (9th Cir. 1981). https://law.resource.org/pub/us/case/reporter/F2/674/674.F2d.761.79-3600.79-3568.html

[xxiv] The Court also pointed out that certain deductions not only permit consideration of post-death events, but require them. “For example, . . . I.R.C. § 2055(c) specifies that where death taxes are payable out of a charitable bequest, any charitable deduction is limited to the value remaining in the estate after such post-death tax payment. Still another provision of the tax code, I.R.C. § 2055(d), prohibits the amount of a charitable deduction from exceeding the value of transferred property included in a gross estate – but, by negative implication, permits such a deduction to be lower than the value of donated assets at the moment of death.”

[xxv] According to the Court, Decedent’s testamentary plan laid the groundwork for Son’s manipulation by concentrating power in his hands—in his roles as executor of the Estate and as trustee of the Trust and of the Foundation—even after Decedent knew of and assented to early discussions of the share redemption plan.

[xxvi] This may include, among other options, consideration of an installment arrangement under IRC Sec. 6166 or of a Graegin loan.

[xxvii] A tall order? Maybe.

The Tax Cuts and Jobs Act[i] has been called a lot of things by a lot of different people.[ii] Certain provisions of the Act, however, coupled with recently proposed regulations thereunder,[iii] may result in its being known as the legislation that caused many individuals to willingly metamorphose – at least for some tax purposes – into one of the most dispassionate of human creations: the corporation.

Shapeshifting

The Code has long provided that the term “person” includes a corporation.[iv] That a corporation is treated as a person for tax purposes should not surprise anyone who has even a passing familiarity with the tax law. Indeed, the law in general has been attributing “personal” traits to corporations for decades.[v]

That being said, there are certain instances in the area of “business morphology” in which the Code is ahead of the curve. Take shapeshifting, for example.[vi]

The “check the box” rules allow a business entity that is an “eligible entity”[vii] to change its classification for tax purposes.[viii] Thus, a single member LLC that is otherwise disregarded for tax purposes may elect to be treated as an association taxable as a corporation;[ix] a business entity that is otherwise treated as a partnership is afforded the same option; an association may elect to be treated as a disregarded entity or as a partnership,[x] depending upon how many owners it has.[xi]

What’s more, the Code does not limit its reach to the conversion from one form of business entity to another.

IRC Sec. 962[xii]

Rather, the Code goes one step further by allowing an individual, who is a “U.S. Shareholder” (“USS”)[xiii] with respect to a controlled foreign corporation (“CFC”),[xiv] to elect to treat themselves as a domestic corporation[xv] for the purpose of computing their income tax liability on their pro rata share of the CFC’s “subpart F income.” In other words, the election allows such an individual to determine the tax imposed on such income by applying the income tax rate applicable to a domestic corporation instead of the rate applicable to individuals.

The election also allows the individual USS to claim a tax credit that would otherwise be available only to a USS that is a C-corporation, for purposes of determining their U.S. income tax liability. Specifically, the electing individual is allowed a credit for their share of the CFC’s foreign income taxes attributable to the subpart F income that is included in the individual’s gross income.[xvi]

Of course, like many elections, there is a price to pay when an individual USS elects to be treated as a domestic C-corporation under Sec. 962: the earnings and profits of a CFC that are attributable to the amounts which were included in the individual’s gross income,[xvii] and with respect to which the election was made, will be included in the individual’s gross income a second time when they are actually distributed by the CFC to the individual, to the extent that the earnings and profits distributed exceed the amount of “corporate tax” paid by the individual USS on such earnings and profits; [xviii] the amount distributed is not treated as previously taxed income, which could generally be distributed by the CFC to the USS without adverse tax consequences.

This election was added to the Code over 55 years ago, at the same time that the CFC rules under subpart F were enacted. According to its legislative history, Sec. 962 was enacted to ensure that an individual’s tax burden with respect to a CFC was no greater than it would have been had the individual invested in a domestic corporation that was doing business overseas.[xix]

However, notwithstanding its long tenure, this obscure provision has played a relatively minor role in the lives of individual USS of CFCs – until now.

The “Waxing” of the Act

Prior to the Act, a domestic corporation’s income tax liability was determined based on a graduated rate, with a maximum rate of 35 percent; an individual’s income tax was also determined based on a graduated rate, with a maximum rate of 39.6 percent.

The Act replaced the graduated corporate tax rate structure with a flat rate of 21 percent – a 40 percent reduction in the maximum corporate income tax rate. The maximum individual income tax rate was reduced to 37 percent; in other words, the flat corporate rate is now more than 43 percent lower than the maximum individual rate.

The significant reduction in the corporate tax rate relative to the individual rate is likely enough of an incentive, by itself, to cause some individual USS to elect to be treated as a domestic corporation under Sec. 962.

The changes wrought by the Act, however, went farther. In order to appreciate the impact of these changes, a quick review of the pre-Act regime for the taxation of CFCs and their USS is in order.

U.S. Taxation of CFC Income

As most readers probably know, the U.S. taxes U.S. persons on all of their income, whether derived in the U.S. or abroad. Thus, all U.S. citizens and residents,[xx] as well as domestic entities,[xxi] must include their worldwide income in their gross income for purposes of determining their U.S. income tax liability.

In general, the foreign-source income earned by a U.S. person from their direct conduct of a foreign business – for example, through the operation of a branch[xxii] or of a partnership in a foreign jurisdiction – is taxed on a current basis.[xxiii]

Prior to the Act, however, most foreign-source income that was earned by a U.S. person indirectly – as a shareholder of a foreign corporation[xxiv] that operated a business overseas – was not taxed to the U.S. person on a current basis. Instead, this foreign business income generally was not subject to U.S. tax until the foreign corporation distributed the income as a dividend to the U.S. person.

That being said, pre-Act law included certain anti-deferral regimes that would cause the U.S. person to be taxed on a current basis on certain categories of income earned by a foreign corporation, regardless of whether such income had been distributed as a dividend to the U.S. owner. The main anti-deferral regime was found in the CFC rules.

In general, a CFC is defined as any foreign corporation more than 50 percent of the stock of which is owned by U.S. persons, taking into account only those U.S. persons who own at least 10 percent of such stock.

Under these rules, the U.S. generally taxed the USS of a CFC on their pro rata shares of certain income of the CFC (“subpart F income”), without regard to whether the income was distributed to the shareholders. In effect, the U.S. treated the USS of a CFC as having received a current distribution of the corporation’s subpart F income.

When such previously included income was actually distributed to an individual USS, the latter excluded the distribution from their gross income.

With exceptions, subpart F income generally included passive income and other income that was considered readily movable from one taxing jurisdiction to another. For example, it included “foreign base company income,” which consists of “foreign personal holding company income” – basically, passive income such as dividends, interest, rents, and royalties – and a number of categories of income from business operations; the latter included “foreign base company sales income,” which was derived from transactions that involved the CFC and a related person, where the CFC’s activities were conducted outside the jurisdiction in which the CFC was organized.

Any foreign-source income earned by a CFC that was not subpart F income, and that was not distributed by the CFC to a U.S. person as a dividend, was not required to be included in the gross income of any U.S. person who owned shares of stock in the CFC; in other words, the recognition of such income for purposes of the U.S. income tax continued to be deferred.

GILTI

In order to limit a U.S. person’s ability to defer the U.S. taxation of a CFC’s non-subpart F, foreign-source income, the Act introduced a new class of income – “global intangible low-taxed income” (“GILTI”) – that must be included in income by a USS of a CFC.[xxv]

This provision generally requires the current inclusion in income by a USS of (i) their share of all of a CFC’s non-subpart F income, (ii) less an amount equal to the USS’s share of 10 percent of the adjusted basis of the CFC’s tangible property used in its trade or business of a type with respect to which a depreciation deduction is generally allowable[xxvi] – the difference being the USS’s GILTI.

This income inclusion rule applies to both individual and corporate USS.

In the case of an individual USS, the maximum federal income tax rate applicable to GILTI is 37 percent.[xxvii] This is the rate that will apply, for example, to a U.S. individual who directly owns at least 10 percent of the stock of a CFC, or to one who indirectly owns such CFC stock through an S-corporation or partnership.

More forgiving rules apply in the case of a USS that is a domestic corporation. For taxable years beginning after December 31, 2017, and before January 1, 2026, a domestic corporation is generally allowed a deduction of an amount equal to 50 percent of its GILTI (the “50-percent deduction”) for purposes of determining its taxable income;[xxviii] thus, the federal corporate tax rate for GILTI is actually 10.5 percent.[xxix]

In addition, for any amount of GILTI included in the gross income of a domestic corporation, the corporation is allowed a deemed-paid credit equal to 80 percent of the foreign taxes paid or accrued by the CFC with respect to such GILTI (“80-percent FTC”).[xxx]

Based on the interaction of the “50-percent deduction” and the 80-percent FTC, the U.S. tax rate on GILTI that is included in the income of a domestic C-corporation will be zero where the foreign tax rate on such income is at least 13.125 percent.[xxxi]

Because an S corporation’s taxable income is computed in the same manner as an individual, and because an S corporation is treated as a partnership for purposes of the CFC rules, neither the “50-percent deduction” nor the 80-percent FTC apply to S corporations or their shareholders. Thus, an individual USS is treated more harshly by the GILTI inclusion rules than is a USS that is a C-corporation.

Use a C-Corporation?

So what is an individual USS to do? Whether they own stock of a CFC directly, or through an S-corporation or partnership, how should they respond to the GILTI rules’ pro-C-corporation bias?

One option is to contribute the CFC shares to a domestic C-corporation; if the CFC is held through an S-corporation, the S-corporation may itself convert into a C-corporation.[xxxii]

However, C-corporation status has its own significant issues, and should not be undertaken lightly; for example, double taxation of the corporation’s income, though this may be less of a concern where the corporation plans to reinvest its profits. That being said, the double taxation regime applicable to C-corporations may be especially burdensome on the disposition of the corporation’s business as a sale of assets.

A Branch?

Another option is for the S-corporation to effectively liquidate its CFC and operate in the foreign jurisdiction through a branch, or through an “eligible” foreign entity for which a “check-the-box election” may be made to disregard the entity for tax purposes.

This would avoid the CFC and GITLI rules entirely, and it would allow the shareholders of the S-corporation to claim a credit for foreign taxes paid by the branch.

Of course, operating through a branch would preclude what little U.S. tax deferral is still available following the enactment of the GILTI rules, and could subject the U.S. person to a branch profits tax in the foreign jurisdiction.

It should also be noted that the liquidation or reorganization of a CFC into a branch will generally be a taxable event, with the result that the accumulated foreign earnings and profits of the CFC will be included in the income of the USS as a “deemed dividend.”[xxxiii]

Elect Under Sec. 962?

Yet another option to consider is the election under Sec. 962 – yes, we have come full-circle.

As indicated earlier, this election is available to an individual who is a USS of a CFC, either directly or through an S-corporation or a partnership.[xxxiv]

The election, which is made on annual basis,[xxxv] results in the individual USS being treated as a domestic corporation (a C-corporation) for purposes of determining the income tax on their share of GILTI and subpart F income for the taxable year to which the election relates; thus, the electing individual USS’s share of such income would be taxed at the flat 21 percent corporate tax rate.

The election also causes the individual USS to be treated as a domestic corporation for purposes of claiming the 80-percent FTC attributable to this income; thus, the USS would be allowed this credit.

However, as indicated above, once the election is made, the earnings and profits of the CFC that are attributable to the amounts which were included in the income of the USS under the GILTI or CFC rules, and with respect to which a Sec. 962 election was made, will be included in the USS’s gross income when such earnings are actually distributed to the USS (reduced by the amount of “corporate” tax paid on the amounts to which such election applied).[xxxvi]

The Recently Proposed Sec. 962 Regulations

Following the reduction of the corporate tax rate and the enactment of the GILTI rules, many tax practitioners turned to the Sec. 962 election as a way to manage and reduce the tax liability of individual USS of CFCs.

In the course of familiarizing themselves with the election and its consequences, many tax practitioners wondered whether the “50-percent deduction” available to domestic corporations would also be available to an electing individual USS. After all, Sec. 962 states that the electing individual would be treated as a domestic corporation for purposes of determining the tax on their subpart F income[xxxvii] – and by extension, thanks to the Act, the tax on their GILTI[xxxviii] – and for purposes of applying the foreign tax credit rules.

Neither the Act nor its committee reports nor the first round of proposed regulations[xxxix] addressed whether the “50-percent deduction” – which is available only to domestic corporations[xl] – would be available to an individual USS who makes the Sec. 962 election.

The preamble to the Proposed Regulations, however, echoed Sec. 962’s legislative history when it explained that Sec. 962 was enacted to ensure that individuals’ tax burdens with respect to undistributed foreign earnings of their CFCs are comparable to their tax burdens if they had held their CFCs through a domestic corporation. According to the IRS, allowing the “50-percent deduction” with respect to the GILTI of an individual (including one who is a shareholder of an S-corporation or a partner in a partnership) who makes a Sec. 962 election provides comparable treatment for this income.[xli]

Thus, the IRS decided to give individual USS the “50-percent deduction” with respect to their GILTI if they made the Sec. 962 election.

The Proposed Regulations are proposed to apply to taxable years of a CFC ending on or after March 4, 2019, and with respect to a U.S. person, for the taxable year in which or with which such taxable year of the CFC ends.

The IRS went a step further by stating that taxpayers may rely on the Proposed Regulations for taxable years ending before May 4, 2019. In other words, an individual USS who elected under Sec. 962 with respect to their taxable year ending December 31, 2018[xlii] may take the “50-percent deduction” into account in determining their taxable income for that year.

Next Steps?

There are a number of individual USS who have not yet decided how they will respond to the federal income tax on GILTI. No doubt, many of these individuals have been waiting to see whether the IRS would address the application of the “50-percent deduction” in the context of a Sec. 962 election.

In light of the proposed regulations described above, and the assurance provided therein that an individual USS may rely on them for the 2018 taxable year, these patient individuals[xliii] may now file an election under Sec. 962 secure in the knowledge that their GILTI will be taxed at the 21 percent corporate tax rate, that they will be entitled to the 80-percent FTC, and that they may claim the “50-percent deduction,” in determining their taxable income.

The Sec. 962 election for the taxable year ending December 31, 2018 must be made with the individual USS’s timely filed federal income return for 2018, on Form 1040, which is due on April 15, 2019.[xliv] The election is made by filing a statement to such effect with this tax return.

But what about the individual USS who believed, not unreasonably, that the IRS was unlikely to allow them the “50-percent deduction,” and who consequently decided to contribute their CFC to a newly-formed domestic corporation?

If the domestic “blocker” corporation was formed and funded by the USS with CFC stock in 2019, it may still be possible to rescind or unwind the transaction, and restore the CFC to the individual USS, in time to make a Sec. 962 election for 2018.[xlv]

For those individual USS who formed domestic blocker corporations to hold their CFC stock during 2018, the unwinding of this structure may not be a straightforward proposition.[xlvi]

———————————————————————————————————————

[i] P.L. 115-97 (the “Act”).

[ii] Where you stand depends on where you sit? “Miles Law,” for you political science folks out there.

[iii] The “Proposed Regulations.” https://www.federalregister.gov/documents/2019/03/06/2019-03848/deduction-for-foreign-derived-intangible-income-and-global-intangible-low-taxed-income

[iv] IRC Sec. 7701(a)(1).

[v] Including First Amendment rights. See the decision of the U.S. Supreme Court in Citizens United.

[vi] Stay with me. Don’t stop reading yet.

[vii] One that is not treated per se as a corporation.

[viii] Reg. Sec. 301.7701-3. The business entity would normally file Form 8832 to effect this change; however, if it elects to be treated as an S corporation by filing a Form 2553, it will also be treated as having chosen to be treated as an association for tax purposes. The consequences of its deemed association status are significant: if the entity loses its “S” status, it will not revert to partnership status, for example; rather, it will become a C corporation for tax purposes.

[ix] Each of these “conversions” would be treated as a transaction described in IRC Sec. 351.

[x] I.e., it may elect to liquidate – a taxable event. IRC Sec. 331 and 336.

[xi] N.B. There are limits on how often an entity may check the box; i.e., revoke an election, then make another one.

[xii] https://www.law.cornell.edu/uscode/text/26/962

[xiii] IRC Sec. 951. One who owns at least 10 percent of the total voting power or total value of all classes of stock of a foreign corporation.

[xiv] IRC Sec. 957.

[xv] A regular U.S. C-corporation.

[xvi] IRC Sec. 960.

[xvii] Whether as subpart F income or as GILTI – see below.

[xviii] As would be the case when a C corporation distributes its after-tax profits to its shareholders.

If the CFC was formed in a jurisdiction with which the U.S. does not have a tax treaty, this dividend will be taxed as ordinary income, taxable at a rate of 37 percent. If the CFC resides in a treaty country, the dividend will be treated as a qualified dividend, taxable at a rate of 20 percent. IRC Sec. 1(h).

[xix] S. Rept. 1881, 87th Cong., 2d Sess., 1962-2 C.B. 784, at 798.

[xx] Noncitizens who are lawfully admitted as permanent residents of the U.S. in accordance with immigration laws (often referred to as “green card holders”) are treated as residents for tax purposes. In addition, noncitizens who meet a “substantial presence” test, and are not otherwise exempt from U.S. taxation, are also taxable as U.S. residents.

[xxi] A corporation or partnership is treated as domestic if it is organized or created under the laws of the United States or of any State.

[xxii] Including an eligible entity that has elected to be treated as a disregarded entity for tax purposes. Reg. Sec. 301.7701-3.

[xxiii] Subject to certain limitations, U.S. citizens, resident individuals, and domestic corporations are allowed to claim a credit against their U.S. income tax liability for foreign income taxes they pay.

[xxiv] A separate legal entity.

[xxv] IRC Sec. 951A.

[xxvi] A deemed “reasonable return.”

[xxvii] The highest rate applicable to individuals.

[xxviii] IRC Sec. 250. IRS Form 8993, https://www.irs.gov/forms-pubs/about-form-8993

[xxix] The 21 percent flat rate multiplied by 50 percent.

[xxx] IRC Sec. 960(d). This is to be compared with the foreign tax credit available to a domestic corporation that includes subpart F income in its gross income; in that case, under IRC Sec. 960(a), the domestic corporation is deemed to have paid so much of the CFC’s foreign income taxes as are properly attributable to such subpart F income.

[xxxi] 13.125 percent multiplied by 80 percent equals 10.5 percent.

[xxxii] Beware the IRC Sec. 965 installment payment rules.

[xxxiii] That being said, the rules for determining such accumulated earnings and profits generally exclude amounts previously included in the gross income of the USS under the CFC rules. To the extent any amount is not so excluded, the S corporation shareholder of the CFC will not be able to utilize the DRD to reduce its tax liability.

[xxxiv] In order for an individual shareholder of an S corporation of a partnership to make the election, they must own at least 10 percent of the CFC stock through their holdings in the S corporation or partnership. For example, a 25 percent shareholder of an S corporation that owns 80 percent of a CFC is deemed to own 20 percent of the CFC.

[xxxv] The election is made year-by-year. Compare this to using an actual C-corporation, which is difficult to eliminate once it is in place.

[xxxvi] This is to be contrasted with the 100 percent dividends received deduction for the foreign-source portion of dividends received from a CFC by a USS that is a domestic corporation. IRC Sec. 245A.

[xxxvii] IRC Sec. 951.

[xxxviii] IRC Sec. 951A.

[xxxix] https://www.irs.gov/pub/irs-drop/reg-104390-18.pdf

[xl] IRC Sec. 250.

[xli] The preamble goes on to state that the IRS considered not allowing the “50-percent deduction” to individuals that make the election. In that case, it continued, an individual USS would have to transfer their CFC stock to a domestic corporation in order to obtain the benefit of the deduction. Such a reorganization, the preamble concluded, would be economically costly.

[xlii] The first year to which the GILTI rules apply.

[xliii] Some might say procrastinating.

[xliv] Four days shy of a full moon. An automatic 6-month extension is available if timely requested.

[xlv] See, e.g., Rev. Rul. 80-58. Of course, this assumes that there was no other bona fide business purpose for the domestic corporation.

[xlvi] The contribution to the blocker may have accelerated any installment payments under IRC Sec. 965(h).

Choice of Entity

The owners of a closely held business will confront many difficult decisions during the life of the business. Among the earliest of these decisions – and one with which the business may have to contend for many years to come[i] – is the so-called “choice of entity”: in what legal form should the business be organized, its assets held, and its activities conducted?

In the case of only one owner, the assets of the business may be held directly by the owner as a sole proprietor; or the business may be organized as single member LLC which, if disregarded for tax purposes,[ii] is treated as a sole proprietorship. Alternatively, it may be organized as a corporation under state law, which will be treated as a C corporation[iii] unless the shareholder elects to treat the corporation as an S corporation.[iv]

Where there are at least two owners, they may decide to own and operate the business as an unincorporated entity – a partnership[v] – or as a corporation.

The form of entity selected for a business may have far-reaching tax and economic consequences, both for the business and for its owners. For example, a decision to operate as a partnership will offer the owners the greatest flexibility in terms of how they share the profits of the business,[vi] but it may subject them to self-employment tax; a decision to operate as an S corporation may require the payment of reasonable compensation to those owners who work in the business,[vii] and will require that the corporation issue only one class of stock and have only individuals as shareholders,[viii] which may limit its ability to raise capital.

In both of these cases, the entity itself is generally not subject to income tax; rather, its annual profits and gains pass through, and are taxed directly, to the entity’s owners whether or not distributed to them – in other words, the owners do not enjoy any tax deferral with respect to the entity.[ix]

By contrast, the profits and gains of a C corporation are taxed to the corporation; in general, they are not taxed to the corporation’s owners until they are distributed to the owners as a dividend. At that point, the corporation’s after-tax profits will be subject to a second level of federal tax; in the case of an individual owner, the dividends will be taxed at the same 20 percent rate generally applicable to capital gains,[x] plus an additional net investment income surtax of 3.8 percent.[xi]

Enter the TCJA

If the choice of entity decision was not already daunting enough for the owners of a business in its infancy, the Tax Cuts and Jobs Act[xii] has added another layer of factors to consider, thus making the decision even more challenging.

For example, the Act reduced the corporate income tax rate by 40 percent – from a maximum graduated rate of 35 percent to a flat rate of 21 percent[xiii] – while also providing the non-corporate owners (basically, individuals) of a pass-through entity (partnerships and S corporations) with a special deduction of up to 20 percent of their share of the entity’s “qualified business income.”[xiv]

In light of this development, the owners of many partnerships, LLCs and S corporations may be considering whether to incorporate,[xv] or to revoke their “S” election,[xvi] in order to take advantage of the much lower corporate tax rate.

Such a change may be especially attractive to a business that is planning to reinvest its profits (for example, in order fund expansion plans) rather than distribute them to the owners.[xvii]

On the other hand, if the partners or S corporation shareholders are planning to sell the business in the next few years, it may not be good idea to convert into a C corporation.[xviii]

Choices, choices, choices. Right, wrong, indifferent?

Regretting the Choice

While taxpayers are free to organize their business in whatever form they choose, once having done so, they must accept the tax consequences of that choice, whether contemplated or not.[xix]

A recent decision by a federal district court considered the strained arguments advanced by one taxpayer in a futile effort to escape the tax consequences of their choice of entity.[xx]

Taxpayer operated his business as a sole proprietorship for several years before incorporating it (the “Corporation”). As the sole shareholder of the corporation, Taxpayer then elected to treat it as an S corporation for federal income tax purposes.

For the next several years, Taxpayer caused Corporation to file a Form 1120S, U.S. Income Tax Return for an S Corporation (“Form 1120S”), to report the income earned and the expenses incurred by the business.

During Tax Year, a second shareholder was admitted to Corporation. Taxpayer and the new shareholder entered into a shareholders’ agreement (the “Agreement”) pursuant to which they agreed that any income earned by Corporation prior to the admission of the second shareholder (“Pre-Existing Business”) would belong to Taxpayer and not to Corporation.[xxi]

On his individual income tax return for Tax Year, Taxpayer attached a Schedule C, Profit and Loss from Business (Sole Proprietorship), to his personal income tax return (Form 1040), on which he claimed deductions for expenses paid or incurred with respect to Pre-Existing Business. These deductions included amounts paid out of Corporation’s bank account. In addition, Taxpayer claimed a deduction for amounts that he paid, out of his personal bank account, to certain employees of Corporation for work they performed with respect to Pre-Existing Business.

After examining Taxpayer’s return for Tax Year, the IRS disallowed each of these deductions, and assessed an income tax deficiency against Taxpayer.

Taxpayer paid the tax liability and then filed a claim for refund, which the IRS denied. Taxpayer then brought a proceeding in a federal district court in which he sought relief from the IRS’s denial of his refund claim.[xxii]

The IRS moved for summary judgment.[xxiii]

“Live With It”

The Court explained that, in a refund action, the complaining taxpayer bears the burden of proving that the challenged IRS tax assessment was erroneous. Specifically, the taxpayer has the burden of proving: his right to a deduction; the amount of the deduction; and, as the nonmoving party, definite and competent evidence to survive summary judgment.

Taxpayer argued that he was entitled to the deductions claimed because the payments on the Pre-Existing Business were not related to Corporation but, instead, were from a separate business operation that he classified as a sole proprietorship. In so arguing, Taxpayer identified the steps he took to separate this Pre-Existing Business from Corporation. He stated that, although there was no formal dissolution of Corporation prior to the admission of the second shareholder, there was a withdrawal of corporate funds, an insertion of new funds, the issuance of new stock to an additional stockholder, and the appointment of an additional officer to the corporation.

The Court pointed out, however, that although Taxpayer claimed that the fees belonged to him personally, and not to Corporation, he also admitted that the funds were deposited into, and paid from, Corporation’s account. Further, Taxpayer admitted that the clients compromising the Pre-Existing Business had not formally retained him individually; rather, they had contracted with Corporation.

The Court observed that Taxpayer’s argument was essentially that he “intended” to form a new business. The Court stated that, notwithstanding Taxpayer’s intentions, a corporation exists for tax purposes if it is formed for a business purpose or if it carries on a business after incorporation. The choice of incorporating to do business, the Court continued, required the acceptance of the tax advantages and disadvantages.

Taxpayer chose to incorporate his business and elected to treat it as an “S” corporation for tax purposes. The Court explained that “S” corporations are corporations that elect to pass corporate income, losses, deductions, and credits through to their shareholders for federal tax purposes. When the shareholders of a corporation make an S election, they switch from a two-level taxation system to a flow-through taxation system under which income is subjected to only one level of taxation.

The corporation’s profits and losses pass through directly to its shareholders on a pro rata basis and are reported on the shareholders’ individual tax returns, allowing an “S” corporation and its shareholders to avoid double taxation on its corporate income.

The Court stated that, since its formation, Corporation properly filed a Form 1120S to report its income and deductions. When a new a shareholder was added during Tax Year, Corporation amended its name, but it retained its employer identification number and continued to file tax returns using that number.

Taxpayer, however, filed a Schedule C claiming deductions from the Pre-Existing Business. In doing so, he attempted to report income and deductions stemming from a business operated as a sole proprietorship. A sole proprietor, however, is someone who owns an unincorporated business by themselves.

The Court found that Taxpayer could not establish that he operated as a sole proprietor entitling him to take deductions on a Schedule C. Corporation was not dissolved; rather, it continued to operate as an S corporation. Thus, Taxpayer should not have filed Schedule C, and the IRS properly disallowed the deductions on that form.

Though Taxpayer contended, with respect to the Pre-Existing Business, that he operated a separate business apart from Corporation. Notwithstanding that he paid the fees therefor out of Corporation’s account, he argued that he, individually, paid them because the Pre-Existing Business was not associated with Corporation.[xxiv]

The Court rejected Taxpayer’s argument, stating that he failed to establish that he operated any business other than through Corporation. As such, his payments of Corporation’s expenses constituted either a loan or a capital contribution, and were deductible, if at all, not by Taxpayer, but by Corporation.

Therefore, Taxpayer was not personally entitled to take deductions.

Additionally, Taxpayer contended that he was entitled to a deduction for the amount that he paid as bonuses to certain employees of Corporation because the payment was made for work separate and apart from that of Corporation. Taxpayer asserted that he personally, not Corporation, paid these employees and filed Forms 1099 on their behalf.

However, the clients of the Pre-Existing Business had contracted with Corporation, and the payments made in respect thereof were deposited into Corporation’s account. Taxpayer subsequently paid himself from that account. According to the Court, the fact that he did so, and personally made bonus payments to the employees for work associated with the Pre-Existing Business, was immaterial. Again, Taxpayer did not operate as a sole proprietor and, therefore, could not take deductions on a Schedule C. The payments, whether properly made or not, stemmed from Corporation’s business, that never ceased to exist, and “[b ]ecause the expenditures in issue were made on behalf of [Corporation’s] business, we conclude that [Taxpayer] may not claim these expenses as business expense deductions.”

Finally, Taxpayer argued that he entered the Agreement that carved out the Pre-Existing Business from the benefit and the liability of the newly formed corporation. As such, he argued that the work for this Pre-Existing Business was conducted as a separate business from Corporation, and he conducted that business as a sole proprietor entitling him to claim those fees as deductions on a Schedule C.

However, the Court responded, “[a] shareholder cannot convert a business expense of his corporation into a business expense of his own simply by agreeing to bear such an expense.”

“Agreements entered into between individuals may not prevail as against the provisions of the revenue laws in conflict,” the Court stated. Parties are free to contract and, when they agree to a transaction, federal law then governs the tax consequences of their agreement, whether those consequences were contemplated or not.

The Court found that Taxpayer could not establish that he was entitled to the disallowed deductions on his Schedule C – there was no clear evidence that he operated a business separate from that of Corporation.

Accordingly, the Court granted the IRS’s motion for summary judgment.

What to Do?

Taxes play a significant part in a business owner’s choice of entity decision. The selection made will result in tax consequences of which a business owner should be aware before making that decision; thus, the decision should be made only after consulting with one’s tax advisers.

It is also important that the decision be made with an understanding of the economics of the business. Among the items to be considered are the following: who will invest in the business, will the business have to borrow funds, is it expected to generate losses, will it be reinvesting its profits or distributing them?

Of course, the responses to these questions may depend upon the stage in the life of the business at which they are being considered. Likewise, the owners of the business may decide to change the form of their business entity when it makes sense to do so. In other words, the choice of entity decision should not be treated as a “make-it-and-forget-it” decision; rather, it should be viewed as one that evolves over the life of the business.[xxv]

For example, a simple evolution of a business’s form of entity may go something like this: it may start out as a sole proprietorship or partnership in order to pass through losses, it may convert to a C corporation as it becomes profitable and starts to retain earnings to fund the growth of the business,[xxvi] and it may elect S corporation status when it is ready to distribute profits or when its owners begin to consider the sale of the business.[xxvii]

What’s more, the choice of one form of entity does not necessarily preclude the concurrent use of another form for a specific purpose. Thus, for example, an S corporation that operates two lines of business may form an LLC (treated as a partnership) to serve as an investment vehicle to which it and a corporate or foreign investor[xxviii] may contribute the assets of one line of business and funds, respectively.[xxix]

However, whatever the form of entity chosen, it is imperative that the business owners respect their chosen form, lest they invite an audit. For one thing, it is certain that the IRS and the courts will hold them to their form (as the Taxpayer learned in the case described above); moreover, an audit will often entail other unexpected goodies for the IRS.

That being said, in the event the chosen form generates unexpected and adverse tax consequences, the business and its owners, in consultation with their tax advisers, may be able to mitigate them, provided they act quickly.


[i] No pressure.

[ii] Its default status in the absence of an election to be treated as an association taxable as a corporation. Reg. Sec. 301.7701-3.

[iii] Reg. Sec. 301.7701-2.

[iv] IRC Sec. 1361 and 1362.

[v] Reg. Sec. 301-7701-3; IRC Sec. 761. This includes an LLC that does not elect to be treated as an association.

[vi] For example, some owners may be issued preferred interests, or they may have special allocations of income and loss.

[vii] There is no comparable tax rule for partners.

[viii] Plus their estates and certain trusts created by these shareholders. IRC Sec. 1361(c).

[ix] The maximum federal income tax rate applicable to individuals is now set at 37 percent. If the individual partner or shareholder does not materially participate in the entity’s business, the 3.8 percent surtax on net investment income will also apply.

[x] IRC Sec. 1(h).

[xi] IRC Sec. 1411. Of course, I am assuming that the shareholder’s modified adjusted gross income exceeds the threshold amount.

[xii] P.L. 115-97 (the “Act”).

[xiii] IRC Sec. 11.

[xiv] IRC Sec. 199A.

[xv] IRC Sec. 351. Beware IRC Sec. 357(c). See Rev. Rul. 84-111.

[xvi] IRC Sec. 1362. Once the S election is revoked, the shareholders may not re-elect “S” status for five years.

It should also be noted that the conversion from “S” to “C” may require that the corporation change its accounting method from cash to accrual. This change may cause the immediate recognition of significant amounts of income. Thankfully, the Act provides for a 6-year period over which this income may be recognized by the C corporation, provided certain conditions are met. IRC Sec. 481(d).

[xvii] Although it is conceivable that a corporation may consider converting into a partnership or a disregarded entity, such a conversion, however effected, will be treated as a liquidation of the corporation, which will be taxable to both the corporation and its shareholders. Reg. Sec. 301.7701-3(g).

[xviii] Of course, I am referring to the two levels of tax attendant on the sale of C corporation. In most cases, the buyer of a closely held business will choose to structure the purchase as an acquisition of assets; not only does this allow the buyer to cherry pick the target assets to be acquired and the liabilities to be assumed, it also gives the buyer a stepped-up basis in these assets which the buyer may then expense, amortize or depreciate (depending on the asset), which enables the buyer to recover its investment faster than if it had just acquired the stock of the target corporation. Unfortunately for the target shareholders, the asset sale is taxable to the corporation and, when the remaining sale proceeds are distributed to the shareholders, those proceeds are taxable to the shareholders.

[xix] https://www.taxlawforchb.com/tag/danielson-rule/ . Call it a corollary of the “Danielson rule.”

[xx] Morowitz v. United States, No 1:17-CV-00291 (D.R.I. Mar. 7, 2019).

[xxi] Interestingly, neither the IRS nor the Court raised the issue of a prohibited second class of stock. IRC Sec. 1361(b); Reg. Sec. 1.1361-1(l). If the entity had been formed as a partnership with the admission of the new owner, the Taxpayer’s initial capital account would have reflected the value operational results of the business prior to the creation of the partnership; if the entity had already been a partnership, Taxpayer’s capital account would have been similarly adjusted prior to the admission of the new partner. Reg. Sec. 1.704(b)-1(b)(2)(iv).

[xxii] IRC Sec. 7422. It is unclear why the Taxpayer chose to pay the tax and then apply for a refund, rather than file a petition with the Tax Court. The Tax Court’s jurisdiction is not dependent on the tax having been paid.

[xxiii] Summary judgment is appropriate where the pleadings, depositions, etc., show that there is no genuine issue as to any material fact and that the moving party is entitled to judgment as a matter of law. The substantive law identifies the facts that are material; only disputes over facts that might affect the outcome of the suit under the governing law will preclude the entry of summary judgment.

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

[xxv] Complete non sequitur: life insurance also falls into this category – it should be reviewed periodically.

[xxvi] The current 21 percent flat corporate rate is key.

[xxvii] Of course, a sale structured as an actual or deemed sale of assets must consider the built-in gains tax. IRC Sec. 1374.

[xxviii] Neither of which may own shares of stock in an S corporation. IRC Sec. 1361(b).

[xxix] See the partnership anti-abuse rules in Reg. Sec. 1.701-2, in which the IRS accepted an S corporation’s bona fide business use of a partnership.

Hell of a Town

Ask most New Yorkers what New York City has in abundance and you’ll get responses that are as varied as the personalities to whom the question is put. Museums, restaurants, performing arts, college students,[i] office buildings, street food, subway lines, cabs, dog walkers, rats, and politicians are sure to make the list.[ii]

Ask the same question of a tax professional, and I guarantee you that the immediate response will be “taxes” – personal income tax, property tax, sales tax, real property transfer tax, mortgage recording tax, commercial rent tax, business corporation tax, general corporation tax, and unincorporated business tax, to name a few. Throw in those New York State taxes that are the counterparts of these City taxes, plus those taxes that are unique to the State, such as the estate tax, and you have an idea of what it means to own, operate, and dispose of a business in the City.[iii]

One of the above-referenced taxes that has been a unique feature of the City’s business tax landscape, and that often surprises business owners who are new to the City’s tax jurisdiction, is the unincorporated business tax (“UBT”).[iv]

Unincorporated Business Tax

The UBT is imposed on the unincorporated business taxable income (“UBTI”) of every unincorporated business that is wholly or partly carried on within the City.

The tax is imposed at a rate of 4 percent of a taxpayer’s UBTI.[v]

Any individual or unincorporated entity that carries on or liquidates a trade, business, profession or occupation wholly or partly within the City, and has a total gross income from all business, regardless of where carried on, of more than $95,000 (prior to any deduction for cost of goods sold or services performed), must file an Unincorporated Business Tax Return with the City.[vi]

An “unincorporated business” means any trade or business conducted or engaged in by an individual (a sole proprietorship) or unincorporated entity, including a partnership.[vii] A limited liability company (“LLC”) which is wholly-owned by an individual, and which has not elected to be taxed as a corporation for federal income tax purposes,[viii] is a disregarded entity, and the business operated through it is considered a sole proprietorship for UBT purposes. Also treated as an unincorporated business is any entity classified as a partnership for federal income tax purposes regardless of whether the entity is formed as a corporation.[ix]

Each of these entities is treated as a pass-through entity for purposes of the Federal and State income taxes; they do not pay an entity-level income tax – rather, their income “passes through” to their owners, who include it in their gross income in determining their own taxable income.

Unincorporated “Trade or Business”

Where there is doubt as to the status of an activity as a trade or business, all the relevant facts and circumstances must be considered in determining whether the activity, or the transactions involved, constitute a trade or business for purposes of the UBT. Generally, the continuity, frequency and regularity of activities (as distinguished from casual or isolated transactions), and the amount of time and resources devoted to the activity or transactions are the factors which are to be taken into consideration.[x]

If an individual or an unincorporated entity carries on two or more unincorporated trades or businesses in the City, all such businesses will be treated as one unincorporated business for purposes of the UBT.[xi]

An unincorporated entity will be treated as carrying on any trade or business carried on in whole or in part in the City by any other unincorporated entity in which the first unincorporated entity owns an interest (a tiered structure); for example, where a single member LLC that is disregarded for income tax purposes owns an interest in a partnership that is engaged in a trade or business in the City.

Personal Income Tax

The UBT is an “entity-level” tax. However, because of the entity’s pass-through nature for income tax purposes, its UBTI is subject not only to the UBT but also, in the case of an individual City resident, the City’s personal income tax.[xii]

Thus, in the case of a City resident who is a sole proprietor, or a partner in a partnership, or a member of an LLC, the entity’s UBTI (or the resident’s share thereof) will also be included in the resident-owner’s personal taxable income for purposes of determining their income tax liability to the City.

Thankfully, the City allows a credit to a resident-owner or partner against their personal income tax for at least some of the UBT paid by the sole proprietorship or partnership, though the amount of the credit allowed is reduced as the resident’s taxable income increases.[xiii]

Exceptions

Right about now, some of you may be having palpitations. You may be thinking, “UBT and personal income tax, with less than a 100 percent credit? Outrageous!”

It should be noted, however, that not every unincorporated business conducted within the City is subject to the UBT.

For example, an individual or other unincorporated entity is generally not treated as engaged in an unincorporated business solely by reason of (A) the purchase, holding and sale of property[xiv] for their or its own account, (B) the acquisition, holding or disposition, other than in the ordinary course of a trade or business, of interests in unincorporated entities that are themselves acting for their own account, or (C) any combination of such activities.[xv]

In addition, an owner of real property, or a lessee of such property, will not be deemed engaged in an unincorporated business solely by reason of holding, leasing or managing real property.

Moreover, if an owner or lessee who is holding, leasing or managing real property, is also carrying on an unincorporated business in the City, whether or not such business is carried on at, or is connected with, such real property, such holding, leasing or managing of real property will generally not be treated as an unincorporated business if, and to the extent that, such real property is held, leased or managed for the purpose of producing rental income from such real property or gain upon the sale or other disposition of such real property.[xvi]

UBTI

Assuming a taxpayer is engaged in a taxable unincorporated trade or business within the City, the UBTI of such unincorporated business for a taxable year is equal to its unincorporated business gross income for such year that is allocated to the City, less its unincorporated business deductions for the year.[xvii]

In general, the term “unincorporated business gross income” is the sum of the items of income and gain of the business includible in the entity’s gross income for federal income tax purposes (with certain modifications), including income and gain from any property employed in the business, or from the sale or other disposition by an unincorporated entity of an interest in another unincorporated entity if, and to the extent, such income or gain is attributable to a trade or business carried on in the City by such other unincorporated entity.[xviii]

The unincorporated business deductions of an unincorporated business generally include the items of loss and deduction directly connected with, or incurred in the conduct of, the business, which are allowable for federal income tax purposes for the taxable year, including losses and deductions connected with any property employed in the business (with certain modifications).[xix]

Allocating Income to the City

If an unincorporated business is carried on both within and without the City – not an unusual situation – a portion of its business income must be allocated to the City; the portion so allocated is subject to the UBT, while the portion allocated outside the City escapes the UBT.

For taxable years beginning after 2017, the City completed the phase-out of the three-factor allocation formula that it employed in determining that portion of an unincorporated entity’s business income that was allocable to the City – based on gross income, payroll and property – and replaced it with a single factor based on gross income.[xx]

“Local Cross-Border Transactions”

The City’s Department of Finance recently considered a request from a non-resident individual (“Taxpayer”[xxi]) from Nassau County – though they could just as easily have been from Suffolk, Westchester, Rockland, Connecticut, or New Jersey, for example – regarding the proper method of allocating their unincorporated business income to New York City for purposes of calculating their UBT liability.[xxii]

Taxpayer had three single member limited liability companies (i.e., wholly-owned by Taxpayer)[xxiii] through which Taxpayer provided various services.

One of the LLCs provided services within the City only for its direct clients that were located in the City. The second LLC was retained by unrelated companies to provide services for their clients, some of which were located in the City. The third LLC worked for a non-New York based company.

Basics

The Department explained that where an individual or an unincorporated entity carries on two or more distinct unincorporated business, in whole or in part in the City, all such businesses are treated as one unincorporated business for purposes of the UBT.

An unincorporated business carried on both within and outside the City, the Department continued, must allocate to the City a “fair and equitable portion” of its business income.[xxiv]

In order to do that, a taxpayer must multiply its “adjusted business income” against a “business allocation percentage”[xxv] which, as alluded to above, is now equal to the quotient obtained by dividing (A) the sum of the taxpayer’s gross sales and service charges within the City, by (B) the sum of all such receipts within and without the City.

Of course, to determine the fraction of a taxpayer’s receipts from within and from outside the City, the sources for a taxpayer’s receipts need to be determined.

Generally, the UBT treats the source of receipts derived from the provision of services (as distinguished from sales of product) to be the location where the services are performed.[xxvi]

Taxpayer’s UBT

Turning to the specifics of Taxpayer’s situation, the Department began by noting that because none of the three LLCs had elected to be treated as a corporation for tax purposes, each would be treated as a disregarded entity and considered a sole proprietorship.

Moreover, because all unincorporated businesses operated by an individual in whole or in part in the City are treated as one business for purposes of the UBT, the Department stated that the LLCs would be treated as a single business conducted by Taxpayer. Therefore, only one UBT return was required to be filed by Taxpayer.

According to the Department, for purposes of allocating receipts to the City, a reasonable was required to match the receipts to the time spent in the City earning those receipts. In order to determine the amount of the receipts from services to be allocated to the City, the Department stated that Taxpayer had to determine where the work was done that generated those receipts.

If work for a particular client was split between the City and outside the City, the Department concluded that Taxpayer had to allocate the receipts for that client based on the proportion of time spent in the City.

Furthermore, if different tasks performed by the same LLC were billed at different rates, the amount to be allocated to the City could be calculated separately, based on the time spent in the City to accomplish the various tasks.

What’s The Point, Lou?

Granted, there may not – hopefully not – have been any great revelations in the foregoing discussion. Nevertheless, it will behoove business owners and their advisers to familiarize themselves with the basic concepts that underlie the operation of an unincorporated business tax similar to the City’s UBT, especially in light of the fact that so many unincorporated, closely held businesses are no longer limited to a single taxing jurisdiction but, rather, sell their products and services throughout the country.

By far, most businesses in the United States – including, of course, New York – are formed as pass-through entities, such as sole proprietorships, partnerships, LLCs and S corporations.

Under current Federal and New York State tax laws, these pass-through entities are generally not subject to an entity-level income tax.[xxvii]

However, New York City will certainly continue to impose its UBT on the taxable income of such pass-through entities,[xxviii] and will continue to surprise the unsuspecting (and ill-informed) newcomer.[xxix]

What’s more, it is possible that other state and local jurisdictions will jump on the proverbial band wagon; for example, Connecticut recently enacted an entity-level business tax on partnerships and S corporations (i.e., pass-through entities).[xxx]

Moreover, as state and local tax jurisdictions try to cope with the evisceration[xxxi] of the itemized deduction for state and local taxes – courtesy of the Tax Cuts and Jobs Act[xxxii] – some jurisdictions are looking to an unincorporated business tax as a way to possibly circumvent the $10,000 itemized deduction cap on such taxes by shifting the incidence of tax away from the individual owners of pass-through business entities and onto the entities themselves; after all, the Act did not eliminate the deduction for taxes imposed directly on the business.[xxxiii]

As this situation evolves, how will it affect “choice of entity” decisions? The Act was decidedly biased in favor of C corporations.[xxxiv] It is true that, in response to critics, Congress also added the Sec. 199A deduction[xxxv] to the Code for qualifying non-corporate owners of pass-through entities. However, will the imposition of a state or local entity-level tax on these very same pass-through entities tip the balance toward C corporations?

Or will the itemized deduction cap on state and local taxes be eliminated, thereby reducing the “need” for entity-level taxes on pass-through entities?

Or will state and local taxing jurisdictions find, as New York City seems to have found, that such taxes are intrinsically a “good” thing?[xxxvi]

Stay tuned.


[i] Many more than Boston, by the way.

[ii] Please do not read any significance into the ordering of these items.

[iii] https://www.taxlawforchb.com/2017/03/an-overview-of-the-nyc-business-tax-environment/

[iv] The State repealed its unincorporated business tax at the end of 1982. However, there has been some talk in Albany of late regarding the possible reintroduction of such a tax, though it did not make it into the 2020 Executive Budget. https://tax.ny.gov/pdf/stats/stat_pit/pit/unincorporated-business-tax-discussion-draft-summary.pdf

[v] N.Y.C. Adm. Code Sec. 11-503. https://law.justia.com/codes/new-york/2006/new-york-city-administrative-code-new/adc011-503_11-503.html

[vi] N.Y.C. Adm. Code Sections 11-514(a)(4) and 11-506(a)(1). https://law.justia.com/codes/new-york/2006/new-york-city-administrative-code-new/adc011-514_11-514.html. Form NYC-202.

[vii] https://law.justia.com/codes/new-york/2006/new-york-city-administrative-code-new/adc011-502_11-502.html

[viii] Treas. Reg. Sec. 301.7701-3.

[ix] N.Y.C. Adm. Code Sec. 502.

[x]http://library.amlegal.com/nxt/gateway.dll/New%20York/rules/therulesofthecityofnewyork?f=templates$fn=default.htm$3.0$vid=amlegal:newyork_ny

[xi] https://law.justia.com/codes/new-york/2006/new-york-city-administrative-code-new/adc011-502_11-502.html

[xii] Unlike for federal and New York State purposes, which generally do not impose an entity level tax on unincorporated business income.

[xiii] Insofar as the State income tax is concerned, UBT that was deducted in arriving at an individual’s federal adjusted gross income must be added back by individual taxpayers to determine their New York State adjusted gross income.

[xiv] The term “property” generally means real and personal property, including, for example, stocks or bonds.

[xv] N.Y.C. Adm. Code Sec. 11-502.

[xvi] N.Y.C. Adm. Code Sec. 11-502.

[xvii] N.Y.C. Adm. Code Sec. 11-505.

[xviii] https://law.justia.com/codes/new-york/2006/new-york-city-administrative-code-new/adc011-506_11-506.html

[xix] For example, guaranteed payments described in Sec. 707(c) of the Code that are made by a partnership to a partner for services or for the use of capital are not deductible for purposes of the UBT. By the way, all references to the “Code” mean the Internal Revenue Code.

[xx] https://www1.nyc.gov/assets/finance/downloads/pdf/09pdf/conformity_highlights071309.pdf

[xxi] Interestingly, Taxpayer was once a resident of the City. Having abandoned their City residence, they continued to own their former residence in the City, which they were careful “to occupy” for fewer than 184 days a year. Presumably, this means that they avoided statutory residence. Query, however, why the ruling used the words “to occupy”? Whether or not Taxpayer occupied the residence is irrelevant for purposes of the “more than 183 days” rule. All that matters, according to the City, is that the taxpayer was present in the City in excess of 183 days during the tax year, and that the taxpayer maintained a permanent place of abode in the City for substantially all of the tax year. The Court of Appeals has held that the Taxpayer must have a residential interest in the abode. See its decision in Gaied, 22 N.Y.3d 592, 594 (2014). https://www.taxlawforchb.com/2018/11/doing-business-in-new-york-domiciled-elsewhere-paranoid-over-new-york-residency-status/

[xxii] Some might say that the UBT is an indirect City income tax on nonresident commuters – whom the City is not allowed to tax directly.

[xxiii] Disregarded entities for Federal income tax purposes. Taxpayer did not elect to treat the LLCs as “associations” that are taxable as corporations.

[xxiv] https://law.justia.com/codes/new-york/2006/new-york-city-administrative-code-new/adc011-508_11-508.html

[xxv] N.Y.C. Adm. Code Sec. 11-508(c) and 11-508(i).

[xxvi] There are special rules dealing with the sourcing for specific industries and businesses.

[xxvii] But see https://www.taxlawforchb.com/2015/12/did-you-say-a-taxable-partnership/. Of course, the Code imposes a built-in gains tax on certain dispositions by S corporations, under Sec. 1374.

[xxviii] It should be noted that the City also imposes a corporate income tax on S corporations that do business in the City – the City does not recognize the “S” election, and taxes such corporations at an 8.85 percent rate.

[xxix] My recollection is that, until recently, the District of Columbia was the only other jurisdiction that imposed such a tax.

[xxx] https://www.ctcpas.org/Content/Files/Pdfs/sn2018-4.pdf

[xxxi] Certainly from the perspective of a New Yorker.

[xxxii] P.L. 115-97 (the “Act”).

[xxxiii] See Sec. 164 of the Code.

[xxxiv] For example, the 21 percent flat income tax rate (a 40% reduction in the maximum corporate rate), and the 50 percent GILTI deduction (which, when combined with the 80% foreign tax credit, may even eliminate the tax on GILTI).

[xxxv] The so-called “20 percent of qualified business income” deduction.

[xxxvi] The UBT has been in place since the 1960’s.

 

Yes, it sounds odd.

It is also seems to be at odds with this blog’s constant refrain of “Thou shalt not pursue any undertaking solely for tax purposes, but thou shalt first consider the business purpose for such undertaking and, if thou findeth such purpose worthy of attainment, then, and only then, shalt thou contemplate the tax benefit, but never shalt thou lose sight of your primary business purpose.”[i]

OK. How does that tie in to the title of this post? Well, all things being equal, the point during the tax year that a pass-through entity (“PTE”) sells its qualified business may have a significant impact upon the Sec. 199A deduction that may be claimed by the PTE’s non-corporate owners.

A quick review of some Sec. 199A basics may be helpful.[ii]

Section 199A Limitations

In general, Section 199A provides non-corporate taxpayers with a deduction for a tax year equal to 20% of their qualified business income (“QBI”) for such year.

There are, however, certain limitations that may reduce the amount of the deduction that may be claimed by a taxpayer. One of these is tied to the taxpayer’s taxable income for the year; the other – which only applies to a taxpayer with taxable income in excess of a prescribed threshold and phase-in amount – is tied to (1) the W-2 wages paid by the business to its employees during the tax year, and (2) the unadjusted basis of certain depreciable tangible property (“qualified property”) held by the business at the close of the tax year.

199A Applied at Shareholder/Partner Level

Generally speaking, for purposes of Section 199A, a non-corporate taxpayer – meaning an individual, a trust, or an estate – is treated as being engaged in any qualified trade or business carried on by a PTE of which the taxpayer is an owner.

Thus, the Section 199A rules are applied at the level of the S corporation shareholder, or at the level of the partner/member of the partnership/LLC, with each shareholder or partner taking into account their allocable share of the PTE’s QBI, as well as their share of the PTE’s W-2 wages and unadjusted basis (for purposes of applying the above-referenced limitations).[iii]

Qualified Business Income – In General

Section 199A is primarily concerned with the operating (i.e., ordinary) income that is generated by the PTE entity, and passed through to its owners, during the ordinary course of its business. Thus, investment income is excluded from an entity’s QBI; this would include any capital gain recognized by the PTE.

A PTE does not typically generate capital gain in the ordinary course of its business; rather, it generates ordinary income from the sale of products or services, or from the leasing/licensing of its property. That is not to say that it never has such gain; for example, a business that sells vacant land, that it had previously held for purposes of a possible future expansion, may recognize capital gain on such sale. This gain would not constitute an item of QBI.

Sale of Assets – In General

Of course, a PTE is most likely to recognize capital gain on the sale of all, or substantially all, of its business assets. This sale may be effected in a number of ways.

Actual Sale. The business may simply sell its assets to a buyer, or it may merge into the buyer, in exchange for cash and/or a promissory note (or other deferred payment, such as an earn-out) and/or other property.

Deemed Sale. Alternatively, in the case of an S corporation, the shareholders may sell its stock and then elect (either jointly with the buyer, or on their own) to treat the stock sale as a sale of the corporation’s assets. Similar treatment may be accorded to the partners of a partnership who sell all of their partnership interests to a buyer, though without the need for a special election.

Nature of the Gain. The nature of the gain recognized by the PTE will depend upon the character of the assets being sold; the amount of such gain will depend upon the allocation of the purchase price among the assets being sold and the entity’s adjusted basis for such assets. The character of the gain included in a shareholder’s or a partner’s allocable share of S corporation or partnership gain is determined as if it were realized directly from the source from which it was realized by the PTE.

Thus, any income realized on the sale of accounts receivable or inventory will be treated as ordinary income. The gain realized on the sale of a capital asset, on the sale of property used in the trade or business of a character that may be depreciable, or on the sale of real property used in a trade or business, will generally be treated as capital gain.

Section 199A and the Sale of a Business

As indicated above, the tax treatment of an M&A transaction, like the actual or deemed sale of assets by a business, was certainly not what Congress was focused on when Section 199A was conceived.

After all, the non-corporate owners of PTEs already enjoy a single level of tax (generally no tax at the entity-level, unlike a C corporation) and a preferential 20% tax rate for capital gains.[iv]

That being said, Section 199A will play a role in the sale of a business owned by a PTE with non-corporate owners where the transaction is treated as a sale of assets for tax purposes.

At the same time, the sale of the business, and the timing of such sale – i.e., the point in the tax year at which the sale occurs – may impact a non-corporate owner’s ability to fully enjoy the benefit of a Section 199A deduction.

Let’s review each of these points.

The Deduction

Although the Section 199A deduction is often described in shorthand as being equal to 20% of a taxpayer’s QBI, the actual formulation is much more involved.

Specifically, a non-corporate taxpayer’s Section 199A deduction for a tax year is equal to the lesser of:

(1) the taxpayer’s “qualified business income amount” for that tax year, or

(2) 20% of the excess of:

(a) the taxpayer’s taxable income, over

(b) the taxpayer’s capital gain, for the tax year.

Assume for this purpose that the taxpayer owns equity in only one PTE, and that there are no REIT dividends or PTP income. Assume also that the limitations based on W-2 wages and the “unadjusted basis” of qualified property are fully applicable because the taxpayer’s taxable income exceeds the prescribed threshold and phase-in amounts.

Qualified Business Income Amount. In that case, the taxpayer’s qualified business income amount for the tax year is equal to the lesser of:

(1) 20% of the taxpayer’s QBI, or

(2) the greater of:

(a) 50% of the W-2 wages with respect to the business, or

(b) 25% of such wages plus 2.5% of the unadjusted basis of its qualified property.

Thus, the greater the amount of W-2 wages paid by a business during the tax year, and the greater the unadjusted basis of the property held by the business at the close of its tax year, the closer to the full 20% deduction the taxpayer is likely to come.

Income from the Sale of Assets. Assume that the PTE sells its assets to an unrelated party in a fully taxable exchange for cash at closing.

As we saw above, the nature of the gain recognized by the pass-through entity on the sale of its assets – which will be passed through to its owners for tax purposes – will depend upon the nature of the asset sold.

Thus, the gain from the sale of inventory and receivables will be treated as ordinary; the gain from the sale of tangible personal property which has been depreciated is likely to be ordinary as well (so-called “depreciation recapture”).

The gain from the sale of real property that is used in the pass-through entity’s business will be treated as capital, as will the gain from the sale of the goodwill and going concern value of the business. In many cases, the single largest component of the gain resulting from the sale of a business is attributable to its goodwill.

Qualified Business Income – Sale of Assets

What does this treatment mean for purposes of Section 199A?

The Code provides that the term QBI means, for any tax year, the net amount of “qualified items” of income, gain, deduction and loss with respect to a qualified trade or business of the taxpayer.

Qualified items does not include any item of capital gain or capital loss. According to the Regulations, to the extent an item is not treated as an item of capital gain or capital loss under any provision of the Code, such item shall be taken into account as a qualified item of income, gain, deduction or loss for purposes of determining QBI.

Thus, gain generated from the sale of assets that is treated as ordinary income will be included in QBI, while gain that is treated as capital will not be; both will be included in taxable income for purposes of applying the above limitation (based on 20% of the excess of a taxpayer’s taxable income over the taxpayer’s capital gain).

W-2 Wages and Unadjusted Basis

What about the limitations based upon W-2 wages and unadjusted basis? How will these be affected by the sale of a business?

After a PTE sells its assets, it will usually cease to have a significant number of employees. For instance, if the sale was to a strategic buyer, that buyer may consolidate the PTE’s workforce with its own, or it may terminate many of the PTE’s former employees; in the case of a private equity buyer, its acquisition vehicle will typically hire the PTE’s workforce.

The Code recognized that where a qualified business was sold, the ability of the selling PTE to claim the Section 199A deduction would be impacted. Thus, the Code directed the IRS to issue regulations to address the application of the limitations in the case where the entity sold its business during the tax year.

W-2 Wages. According to the regulations issued by the IRS, when a business is sold, and the employees of the business thereby become employees of the buyer, their W-2 wages for the year of the sale must be allocated between the two employers (the seller and the buyer) based on the period during which they were employed by one and then the other.

In other words, in determining its limitation based on W-2 wages, the seller-employer can look only to the W-2 wages it paid to its employees through the date of the sale.

Unadjusted Basis. As regards the limitation that is based, in part, on the unadjusted basis of qualified property, the Code states that the property must be held by the business at the close of its tax year.

The Regulations conform to this position, having rejected a suggestion that they include a rule for determining the unadjusted basis of qualified property following the sale of a business similar to the guidance provided for purposes of calculating W-2 wages (based on the number of days the qualified property was held by the seller during the year – see above).

Thus, if a selling PTE does not hold any qualified property at the close of its taxable year, its owners cannot avail themselves of the alternative limitation based on the unadjusted basis of such property (i.e., 25% of W-2 wages, plus 2.5% of unadjusted basis).

This raises an interesting question.

S Corps & Section 338(h)(10)

When a PTE sells its assets, its tax year does not automatically close; something more is required. Specifically, the entity must liquidate, which will include the distribution to its owners of the net proceeds from the sale of the business.

But what if the PTE is an S corporation? When the shareholders of an S corporation sell their stock to a corporate buyer, and they join the buyer in electing to treat the stock sale as a sale of assets (under Section 338(h)(10) of the Code), the S corporation is treated as having sold its assets just before, and as having liquidated at, the end of the day that the sale occurred. That is the same day that the S corporation’s tax year closes.

Will the S corporation be treated as having held its assets as of the close of its tax year for purposes of applying the unadjusted basis limitation? The Regulations don’t tell us.

If so, will a PTE that actually sells its assets have to liquidate immediately afterward, on the day of the sale, so as to force the close of its tax year? That remains to be seen.

Timing of the Sale

As you may have gathered from the foregoing, the point during the year at which the PTE sells its business may impact the Section 199A deduction that may be claimed by its owners.

Let’s take the extreme: a sale on January 1 by an entity that uses the calendar year as its tax year. It has no QBI on that date except to the extent the sale generates ordinary income that is treated as QBI. If the bulk of the sale gain – and the bulk of the entity’s income for the year – is treated as capital gain, then the owners may be out of luck insofar as a Section 199A deduction is concerned.

Even the qualified business income generated in the sale may not result in a Section 199A deduction because the entity may not have paid much in the way of W-2 wages by the time of the sale. Remember: the taxpayer’s qualified business income amount for the tax year is equal to the lesser of: (i) 20% of the taxpayer’s QBI, or (ii) 50% of the W-2 wages[v] with respect to the business.[vi]

What’s more, the limitation based on 20% of the excess of (1) the taxpayer’s taxable income, over (2) the taxpayer’s capital gain, for the tax year, may be even lower than the limitation based on W-2 wages, where the taxpayer’s capital gain far exceeds their ordinary income.

On the other hand, if the sale occurs midyear, for example, the business will have generated more ordinary income from its normal operations, in addition to the gain from the sale of its assets. In other words, there will be more QBI that the owners will take into account in determining their Section 199A deduction, though there will also be more ordinary income on which they will be taxed.

At the same, the entity will have paid more W-2 wages by that time, so that the limitation is also increased.

Following this reasoning, a sale that occurs in December (again, assuming the entity uses a calendar year as its tax year) will allow the entity to generate almost a full year’s worth of QBI; it will also allow it to pay almost a full year’s worth of W-2 wages. Both these items should result in a larger Section 199A deduction for the owners of the PTE.

The one item that generally does not change during the course of the tax year, but which must be held at the end of the tax year in order to be accounted for in determining the limitation on the Section 199A deduction is the unadjusted basis for qualified property.

When this property is sold, then, by definition, the selling entity will not hold it at the end of its tax year. That being said, should it make a difference in the application of the rule where the sale of the business and the immediate liquidation of the seller (actual or deemed) occur on the same date, with the liquidation marking the end of the tax year; should the seller be treated as having held the property on such date for purposes of the rule? The IRS has not addressed this point.

In light of the foregoing, might a PTE owner that is being pressured by a buyer to sell its business early in its tax year argue for an increase in the sales price to the extent of any Section 199A tax benefit expected to be “lost?” As always, it will depend upon the taxpayer’s unique facts and circumstances, but prudence may dictate that the seller accept the deal being offered without regard to Section 199A.[vii]


[i] Yes, I saw “Spamalot” last week and I am still imitating Arthur and his knights, not to mention the taunting Frenchmen. Remember the Holy Hand Grenade? “And the Lord spake, saying, ‘First shalt thou take out the Holy Pin. Then, shalt thou count to three, no more, no less. Three shall be the number thou shalt count, and the number of the counting shall be three. Four shalt thou not count, nor either count thou two, excepting that thou then proceed to three. Five is right out! Once the number three, being the third number, be reached, then lobbest thou thy Holy Hand Grenade of Antioch towards thou foe, who being naughty in my sight, shall snuff it.'”

[ii] A reminder: the provision disappears after 2025.

[iii] Because the Section 199A limitations are applied at the level of the non-corporate shareholder or partner, without regard to the owner’s degree of involvement or participation in the conduct of the business, it is possible for owners with identical equity interests in the same pass-through entity to have very different Section 199A deductions; for example, one partner may have more taxable income than another (perhaps because they receive a so-called “guaranteed payment” for services rendered to the partnership), such that the limitations apply to the former but not to the latter.

[iv] If the non-corporate owner is a material participant in the business, they also avoid the 3.8% surtax on net investment income.

[v] Or 25% of W-2 wages plus 2.5% of the unadjusted basis of qualified property.

[vi] Query whether a change in control bonus payment made to the seller’s employees in connection with the sale would address this limitation. These must be attributable to QBI in order to be taken into account as W-2 wages. https://www.taxlawforchb.com/2017/04/beyond-purchase-price-the-tax-treatment-of-ma-deal-costs/ Of course, if the employer was not already planning for such a bonus in the first place, is the 199A juice worth the squeeze?

[vii] Bird in hand, and all that.