“Limited Liability”

The experienced or well-informed investor recognizes that there is an element of risk in every business venture. They understand that the cash or other property they have contributed to the venture may be lost for any number of reasons – an economic downturn, a very competitive industry, the incompetence of officers, an adverse decision by a court or administrative agency, etc. Although the loss of one’s investment will likely cause some economic pain, the careful investor can take comfort in knowing that their exposure will generally be limited to the amount of their investment.[i]

Of course, there are other liabilities that may attach to an investor, in their capacity as such. For example, if the entity is a C corporation, the investor-shareholder will be liable for personal income tax on any dividend distribution actually or constructively made to the investor. In the case of an S corporation or an LLC that is treated as a partnership, the investor-shareholder/member will be liable for income tax on their share of the pass-through entity’s taxable income, whether or not distributed to them.

The foregoing liabilities and losses are not unexpected. They are recognized and accepted by investors as the kinds of risks and costs that are an inherent part of an investment in almost every closely held business. They do not represent a breach in the wall of limited liability protection that is accorded an investor in a corporation or in a limited liability company by virtue of the status of the business entity as a juridical person that is separate from its owners, with its own assets and its own liabilities.

It is this concept of legal separateness that underlies the derivative concept of limited liability, according to which an equity investor’s personal assets cannot be reached by the business entity or by the entity’s creditors simply because of the investor’s status as an owner. It is the concept of limited liability that encourages investors to acquire equity in a closely held business entity without fear of putting their other assets at risk for the liabilities of the business.[ii]


In light of the foregoing, imagine the reaction of a non-controlling shareholder of a corporation who receives a notice from the IRS asserting millions of dollars of liability against the shareholder for income taxes owing by the corporation.[iii]

That’s what happened to Taxpayers when they – as distinguished from their corporation – received a notice of deficiency[iv] from the IRS which asserted an aggregate amount of transferee liability in excess of $64 million, relating to Taxpayers’ ownership interest in Corp.

Needless to say, Taxpayers filed a petition with the U.S. Tax Court.[v]

Among the issues before the Court were: (1) whether Taxpayers were liable as “transferees” for their respective shares of the corporate income tax deficiency assessed against Corp by the IRS, and (2) whether Taxpayers’ transferee liabilities were limited to the extent Taxpayers were “good faith transferees” who provided value to Corp.

What Happened?

What preceded the above-referenced notice of transferee liability issued to Taxpayers? How did they get into this mess?

Corp was a closely held corporation that was engaged in the radio and television broadcasting business. As its business expanded, Corp brought in additional investors to help fund its expansion, including Taxpayers, who insisted they be represented on Corp’s board of directors.

Under the terms of a shareholders’ agreement to which Taxpayers were a party, Taxpayers were granted a right of redemption (a “put option”) that, upon exercise after a prescribed period, would have required Corp to redeem all of Taxpayers’ Corp shares in exchange for an amount of consideration equal to the fair market value of those shares, payable in cash and an interest-bearing note.

The shareholders’ agreement also provided a “drag-along” provision that permitted a supermajority of Corp’s shareholders to compel the remaining Corp shareholders to sell their Corp shares.

The Sale

As they approached retirement age, Corp’s majority shareholders (the “Founders”) began exploring several strategic alternatives. They consulted an adviser who presented six potential alternatives by which they could realize Corp’s value: (1) a sale of assets by Corp followed by its liquidation, (2) a sale of Corp stock, (3) a tax-free exchange/reorganization,[vi] (4) a “spin-off” of Corp’s radio assets followed by a sale of Corp’s stock,[vii] (5) redemption of Corp stock from the shareholders,[viii] and (6) a sale of Corp stock using an employee ownership plan.[ix]

After comparing a stock sale with an asset sale, Corp’s board decided to pursue a stock sale because the adviser’s analysis projected that a stock sale would produce a much greater return of net after-tax proceeds to Corp’s shareholders.[x]

Shortly thereafter, Corp entered into a brokerage agreement with Broker, who began seeking potential buyers for Corp. It wasn’t long before Corp realized that buyers in the broadcasting industry generally preferred an asset sale. While Broker was able to find potential buyers interested in Corp’s assets, Broker struggled to find a buyer interested in buying the stock of a company, like Corp, that had both television stations and radio stations.

At some point, Corp was introduced to Facilitator,[xi] a firm that facilitated stock sales of companies. Facilitator discussed the possibility of using an “intermediary” or “Midco” transaction strategy,[xii] to which Corp’s board eventually agreed.[xiii]

Facilitator organized a shell company to acquire Corp’s stock and, immediately thereafter, to sell Corp’s television assets to unrelated Buyer. Facilitator also organized a slew of other transactional entity shells that had no apparent business purpose, but which were utilized in such a way as to eliminate Corp’s tax liability for the asset sale.[xiv]

The closings of the sale of all of Corp’s stock, as well as the sale of Corp’s assets, and the subsequent mergers, transfers and liquidation among the other transactional entities, took place on the same day, over a three-hour period.

Taxpayers – who may have been compelled to sell their shares pursuant to the drag-along provision in the shareholders’ agreement – neither raised the possibility of exercising their right of redemption nor sought compensation for surrendering such right at any point before the sale of Corp’s stock.

Reporting the Sale

According to Corp’s Form 1120, U.S. Corporation Income Tax Return, for its short tax year ending with the day of the stock sale, Corp had no assets by the end of such tax year, and it had no tax liability. The return also reported that Corp had been “reorganized” out of existence through transfers involving the various transactional entities.

After examining the stock sale and the related, practically simultaneous, transactions arranged by Facilitator, the IRS issued multiple notices of deficiency relating to the sale of Corp’s assets.

Thereafter, the IRS undertook transferee examinations of eight of the largest Corp shareholders who sold their shares, including Taxpayers. The IRS sent notices of transferee liability to Taxpayers, asserting that they were liable for Corp’s unpaid deficiency for Federal income tax, penalties and interest.

The IRS’s theory of these cases was that Corp was liable for Federal income tax related to its sale of its assets, and that Corp’s shareholders, including the Founders and Taxpayers, were each liable for a portion of that unpaid corporate tax because they received transfers from Corp. To reach this outcome, the IRS sought to disregard the stock sale undertaken pursuant to the Midco transaction; instead, Corp would be treated as having sold its assets, following which it would be deemed to have made a liquidating distribution to its shareholders. Thus, Corp’s shareholders would be deemed to have received distributions from Corp rather than having received consideration in exchange for their Corp stock from an entity organized by Facilitator.

Applying a “substance over form” analysis, the Tax Court agreed with the IRS,[xv] and concluded that Corp should be deemed to have sold all its assets, incurred the inherent taxable gains, liquidated, and distributed the net proceeds from its asset sales to its shareholders which, for our purposes, included Taxpayers.

Tax Court

Having traced Taxpayers’ path to the Tax Court, we turn now to Taxpayers’ arguments that they were not liable as transferees under State law for their respective share of Corp’s income tax deficiency.

Transferee Liability

According to the Court, the Code provides that the liability, at law or in equity, of a transferee of property of a taxpayer owing Federal income tax “shall * * * be assessed, paid, and collected in the same manner and subject to the same provisions and limitations as in the case of the taxes with respect to which the liabilities were incurred.”[xvi]

The Court explained that the Code does not independently impose tax liability upon a transferee, but merely provides a procedure through which the IRS may collect unpaid tax – owed by a transferor of assets – from the transferee who received those assets. Thus an independent basis for liability must be available, and this basis is generally found under applicable State law or equity principles. [xvii]

Accordingly, the Court continued, “three requirements had to be met for the IRS to assess transferee liability against a party” under the Code:

(1) The party must be subject to liability under applicable State law,

(2) The party must be a transferee pursuant to Federal law, and

(3) The transferor must be liable for the unpaid tax.

The Court added that the IRS bears the burden of proving that a party is liable as a transferee of the transferor-taxpayer’s property,[xviii] but not of proving that the transferor-taxpayer is liable for the tax.[xix]

State Law Liability

As the transactions took place in State, the Court used State law to determine whether Taxpayers were liable, as transferees, for Corp’s unpaid tax.

According to the Court, applicable State law defined “transfer” very broadly as “every mode, direct or indirect, absolute or conditional, voluntary or involuntary, of disposing of or parting with an asset or an interest in an asset, and includes payment of money, release, lease and creation of a lien or other encumbrance.” The Court observed that, where a debtor transferred property to a transferee and thereby avoided creditor claims by depriving itself of the means by which to satisfy such claims, State law provided creditors with certain remedies against the transferee.

Under State law, the Court continued, transferee liability “looks to equitable principles like ‘substance over form.’” In the present case, the Court stated, “There is no dispute regarding our prior opinion disregarding the form of the transactions or our finding that in substance a transfer from” Corp to Corp’s shareholders had occurred.[xx]

Exchange for Value?

Having found a transfer from Corp to Taxpayers, the IRS argued that Taxpayers failed to provide reasonably equivalent value to Corp in exchange for such transfer and were, therefore, liable as transferees under State law.[xxi] Taxpayers disagreed, and argued that by surrendering their right of redemption (the put option) in exchange for the distributions, they provided reasonably equivalent value to Corp.

Under State law, a transfer made by a debtor is fraudulent as to a creditor whose claim arose before the transfer was made if the debtor made the transfer without receiving a reasonably equivalent value in exchange for the transfer, and the debtor was insolvent at that time, or the debtor became insolvent as a result of the transfer.

The Court explained that any transfer had to be viewed exclusively from the perspective of the creditor – the subjective intent of the putative transferee played no role in the application of State’s constructive fraud provisions, which focus on an objective result.

Whether reasonably equivalent value was received by the transferor was a question of fact, the Court stated, and the “test used to determine reasonably equivalent value in the context of a fraudulent conveyance requires the court to determine the value of what was transferred and to compare it to what was received.”

According to the Court, the record reflected that Taxpayers collectively received distributions in excess of $64 million from Corp’s asset sale proceeds. In exchange for this, Taxpayers claimed to have surrendered their put option along with their Corp stock. According to the express terms of Corp’s shareholders’ agreement, Taxpayers’ put option vested immediately. However, the agreement also limited Taxpayers’ ability to exercise such right. The earliest date that Taxpayers could exercise their right of redemption was approximately one year after the sale of Corp’s stock and of its assets. The Court also observed that while the record extensively documented the negotiations leading up to the sale of Corp’s assets, it was silent as to whether Taxpayers ever discussed surrendering their right of redemption at any point during that process. Furthermore, Taxpayers never discussed the specific value of their right of redemption, let alone sought a formal valuation.

The Court concluded that Taxpayers’ “incidental surrender” of their right of redemption as part of the transfer of their Corp shares constituted neither value nor reasonably equivalent value. Thus, Taxpayers’ right of redemption was worthless, and Corp (as the deemed transferor) did not receive value, reasonably equivalent or otherwise, in exchange for the proceeds from the sale of its assets.

Because there was no dispute regarding (1) Corp’s liability for the Federal income tax arising from the asset sale, (2) Corp’s insolvency after the transfer, (3) the existence of the IRS’s claim, or (4) the IRS’s creditor status at the time of the transfers in question, the Court concluded that Taxpayers were liable for such Federal income tax as Corp’s transferees under State law.

Federal Transferee Requirement

Having disposed of Taxpayers’ argument that they had exchanged value for the deemed distribution of the sale proceeds from Corp, the Court turned to the issue of Taxpayers’ “transferee” status under Federal law.

For purposes of the Code’s transferee liability rules, the Court explained that the term “transferee” includes a donee, heir, legatee, devisee, distributee, and shareholder of a dissolved corporation. The Court added that the principle of “substance over form” applies to determinations of transferee liability issues. In accordance with the substance over form analysis it applied in re-characterizing the transactions organized by Facilitator, the Court determined that Taxpayers, as distributees of Corp, were transferees for purposes of the Code’s transferee liability rules.[xxii]

And That’s The Way It Is[xxiii]

How can any reasonable person argue that the shareholders of a corporation can, in effect, strip the corporation of its assets through the equivalent of an asset sale and liquidation, yet avoid responsibility for the corporation’s outstanding tax liabilities?

The fact that the desired “tax reduction” is effectuated through a complex scheme involving multiple entities and steps that seek to dissemble the actual transactions does not change this conclusion – on the contrary, it should put the shareholders on alert that the proponent of the scheme is attempting to conceal the true nature of the transaction from the IRS.

How is it, then, that many business owners, when confronted with a large tax bill, are often willing to throw caution to the wind? In part, their predilection may be attributable to the fact that they are also risk-takers – after all, they did not grow successful businesses without taking some chances.

On the other hand, there is a difference between taking a calculated risk, on the one hand, and falling for a foolish scheme, on the other, that results in the shareholders being held personally liable for their corporation’s income tax liability.

What’s more, the consequences of not being able to distinguish one from the other may be dire – for although the corporate income tax would have been payable regardless, the IRS may now proceed to collect it from the personal assets of the transferee-shareholder.

[i] I say “generally” because it may be that an investor has agreed to guarantee a lease or an indebtedness incurred by the business entity, or has provided collateral to secure such an indebtedness. They may have agreed to a limited obligation to respond to a capital call under certain circumstances.

It may also be that the investor has managerial duties in the business, and may be held personally liable for damages attributable to their activities in that managerial capacity. For example, “responsible person” status – and the personal liability that goes with it – may attach for purposes of the entity’s employment taxes and sales taxes. https://www.taxlawforchb.com/2016/11/when-irresponsible-partners-are-responsible-persons/

If they are a compensated service provider, they will owe income and employment taxes in respect of such compensation.

[ii] Of course, if the owners of a business fail to respect to separate status of their business entity, if they treat with the entity other than at arm’s length, then the creditors of the business may, likewise, be allowed to disregard the separate legal status of the entity and to pursue the personal assets of the entity’s owners to satisfy the entity’s obligations to such creditors – “piercing the corporate veil.”

An owner may also effectively waive their limited liability protection by guaranteeing an entity’s obligations or by agreeing to make capital calls. This is rarely done “voluntarily” in the sense that the owner offers, unprompted, to drop their shield. However, when a lender or a landlord, for example, requires such a guarantee before agreeing to a line of credit or a lease, well, there may not be much choice.

[iii] Did you hear that? No? Sounded to me like a body hitting the floor.

[iv] IRC Sec. 6212. The taxpayer to whom/which the notice is addressed has 90 days within which to file a petition with the Tax Court for a redetermination of the asserted deficiency. IRC Sec. 6213.

[v] Alta V Limited Partnership, Et al. v. Comm’r, T.C. Memo. 2020-8.

[vi] IRC Sec. 368.

[vii] Note that these discussion with the adviser occurred a couple of years after the enactment of IRC Sec. 355(e). https://www.taxlawforchb.com/2019/10/tax-free-spin-off-that-may-depend-on-post-spin-off-events/

[viii] IRC Sec. 302.

[ix] IRC Sec. 1042.

[x] A single level of tax at the shareholder level, at a federal income tax rate of 20-percent.

[xi] “The Facilitator” – you can just picture Arnold as the main character, bespectacled and in a bespoke suit. Hey, if Ben Affleck can get away with portraying a math wiz who provides accounting services to disreputable businesses, why can’t Arnold play the part of a business broker or investment banker with an ax to grind – literally – who tracks down expats who never received their “sailing permits” and, so, should never have been allowed to leave their country?

[xii] A “Midco transaction” was structured to allow the parties to have it both ways: letting the seller engage in a stock sale and the buyer in an asset purchase. In such a transaction, the selling shareholders sold their stock in a corporation to an intermediary entity (or “Midco”) at a purchase price that did not discount for the built-in gain tax liability, as a stock sale to the ultimate purchaser would. The Midco then sold the corporation’s assets to the buyer, who obtained a purchase price basis in the assets. The Midco kept the difference between the asset sale price and the stock purchase price as its fee for facilitating the transaction. At the same time, the Midco might have losses or credits that would offset its tax liability on the asset sale.

[xiii] Shortly before Corp’s Midco transaction, the IRS released a Notice which described certain transactions as types of an “intermediary transactions tax shelter,” identified those transactions as “listed transactions,” and took the position that direct or indirect participants of the same or substantially similar transactions would be required to disclose their participation to the IRS. Notice. 2001-16, 2001-1 C.B. 730, clarified by Notice 2008-111, 2008-51 I.R.B. 1299.

When Corp’s board met with Facilitator regarding the possible use of a “Midco” transaction for the stock sale of Corp, the Founders were informed that there was a risk that the IRS might re-characterize the transaction as an asset sale. However, Facilitator represented that none of the similarly structured transactions it had facilitated over an 18-year period had been successfully challenged or unwound.

[xiv] As the Tax Court put it: “This manipulating of the Internal Revenue Code is a prime example of how a transaction can be structured so that its form might meet the letter of the law, but it nevertheless is being used in a manner incongruous with the intent of that law.”

[xv] Shockley v. Comm’r, T.C. Memo. 2015-113.

[xvi] See IRC Sec. 6901 and Sec. 6902.

[xvii] IRC Sec. 6901(a)(1)(A).

[xviii] Before continuing its analysis, the Court explained that the determinations of Taxpayers’ substantive liability under State law and transferee status under Federal law were separate and independent determinations. The Court stated that it would first consider whether Taxpayers were liable as transferees under State law before determining the application of the Code for the collection of such liability.

[xix] See IRC Sections 6902(a), 7454(c); Tax Court Rule 142(d).

[xx] See Shockley v. Comm’r, T.C. Memo. 2015-113.

[xxi] In other words, they did not transfer to the corporation assets with a value equal to that of the assets transferred to them by the corporation.

[xxii] IRC Sec. 6901.

[xxiii] Remember Walter Cronkite?

A couple of months back, a local business reporter asked whether I could identify one kind of corporate transaction that was occupying more of my time than any other. When I asked whether they were referring to any specific industry, form of M&A transaction,[i] or type of buyer,[ii] they replied that they were not necessarily thinking about the purchase and sale of a business – they were just curious whether I was seeing businesses engaging in one type of strategic transaction more any other.

“Business separations,” I immediately replied, “I’ve been working on a greater number of business separations, generally, and of corporate separations, in particular, than at any other time.”[iii]

After a brief description of “spin-off” transactions, and of the conditions that must be satisfied in order for such a transaction to enjoy “tax-free” treatment,[iv] the reporter wondered whether many closely held businesses find it difficult to satisfy the “active business” test.[v]

Some do encounter difficulties, I agreed, while others foresee them before embarking on the division of the corporation and plan accordingly.

That being said, there are still other owners and advisers who are unaware of the various accommodations the IRS has made over the years that facilitate the satisfaction of the active business requirement by recognizing certain business realities.

Before describing a recent IRS private letter ruling that illustrated the application of one such accommodation, let’s quickly review the operation of the Code’s spin-off rules, followed by a description of some of the ways by which the IRS has made it a bit easier to meet the ATB test.

Corporate Divisions – In Brief

Generally, if a corporation distributes property with respect to its stock to a shareholder, the Code provides that the amount of the distribution is equal to the amount of money plus the fair market value of other property received. This amount is treated as (1) the receipt by the shareholder of a dividend to the extent of the corporation’s earnings and profits, (2) the recovery of the shareholder’s basis in the stock, and/or (3) gain from the sale or exchange of property.[vi] The corporation recognizes gain to the extent the fair market value of the property distributed exceeds the corporation’s adjusted basis in the property.[vii]


However, the Code also provides that, under certain circumstances, a corporation (Distributing) may distribute stock in a corporation it “controls” (Controlled)[viii] to its shareholders without causing either Distributing or its shareholders to recognize income, gain, or loss on the distribution.[ix]

Distributions of the stock of Controlled generally take three different forms: (1) a pro rata distribution to Distributing’s shareholders of the Controlled stock (a “spin-off”), (2) a distribution of the Controlled stock in redemption of Distributing stock (a “split-off”), or (3) a liquidating distribution in which Distributing distributes the stock of more than one Controlled, either pro rata or non-pro rata among its shareholders (in either case, a “split-up”).

Non-recognition treatment applies to a distribution of Controlled that effects only a readjustment of the continuing interests of Distributing’s shareholders in the property of Distributing and Controlled. In this regard, one or more persons who, directly or indirectly, were the owners of the enterprise prior to the distribution or exchange own, in the aggregate, an amount of stock establishing a continuity of interest in each of the modified corporate forms in which the enterprise is conducted after the separation.[x]

Business Purpose

In order to secure this favorable tax treatment, the transaction must meet various requirements. For example, the transaction must be carried out for one or more corporate business purposes. A transaction is carried out for a corporate business purpose if it is motivated, in whole or substantial part, by one or more corporate business purposes.[xi]

A corporate business purpose is a real and substantial purpose that is germane to the business of Distributing or of Controlled. A shareholder purpose is not a corporate business purpose.[xii] Depending upon the facts of a particular case, however, a shareholder purpose for a transaction may be so nearly coextensive with a corporate business purpose as to preclude any distinction between them. In such a case, the transaction is carried out for one or more corporate business purposes.

The distribution that consummates the separation of the two corporations must itself be carried out for one or more corporate business purposes.[xiii]


Among the other requirements that must be satisfied in order for a distribution of Controlled to be “tax-free” to Distributing and its shareholders are two that are intended to prevent a distribution from being used inappropriately to avoid shareholder-level tax on dividend income; specifically, the transaction must not be used principally as a device for the distribution of the earnings and profits of Distributing or Controlled or both (a device),[xiv] and both Distributing and Controlled are required to be engaged, immediately after the distribution, in the “active conduct of a trade or business” (ATB).

An active business is one that has been actively conducted throughout the five-year period ending on the date of the distribution, and must not have been acquired within that period in a transaction in which gain or loss was recognized unless the acquisition constituted an expansion of the original, otherwise qualifying business.[xv]

Which brings us back to the ATB.

Conducting an Active Trade or Business

As indicated above, the distribution of Controlled qualifies for non-recognition treatment only if Distributing and Controlled are each engaged in the active conduct of a trade or business immediately after the distribution.[xvi]

The Code provides rules for determining whether a corporation is treated as engaged in the active conduct of a trade or business for purposes of this rule. Thus, a corporation is treated as engaged in the active conduct of a trade or business if it is itself engaged in the active conduct of a trade or business, or if substantially all of its assets consist of the stock of a corporation or corporations controlled by it (immediately after the distribution), each of which is engaged in the active conduct of a trade or business.[xvii]

According to IRS regulations, a corporation shall be treated as engaged in the active conduct of a trade or business immediately after the distribution if a specific group of activities are being carried on by the corporation for the purpose of earning income or profit, and the activities included in such group include every operation that forms a part of, or a step in, the process of earning income or profit. Such a group of activities ordinarily must include the collection of income and the payment of expenses.[xviii]

The determination whether a trade or business is actively conducted will be made from all of the facts and circumstances. Generally, the corporation is required itself – through its own employees – to perform active and substantial management and operational functions; the activities performed by persons outside the corporation, including independent contractors, are not counted toward the satisfaction of this test. That being said, the fact that the corporation also uses independent contractors will not prevent it from satisfying this requirement.[xix]


In 2005, the Code was amended[xx] to provide that the ATB test should be determined by reference to the relevant affiliated group of corporations. In the case of the distributing corporation, the group consists of Distributing as the common parent and all corporations affiliated with Distributing; the relevant affiliated group for the controlled corporation is determined in a similar manner, with Controlled as the common parent.[xxi]

Thus, for purposes of the ATB test, the activities performed by a corporation will include not only the activities of its employees, but also the activities performed by employees of an affiliate of the corporation.[xxii]

According to proposed regulations, the activities performed by shareholders of a closely held corporation will also be taken into account if they are performed for the corporation.[xxiii]

Revenue Rulings

Over the years, the IRS has issued a number of revenue rulings to which taxpayers may look for guidance in determining whether they may satisfy various aspects of the ATB test.

For example, the IRS found that a controlled corporation was engaged in an ATB where it had only two employees – a handyman and the sole shareholder of the distributing corporation – who performed substantial management and operational functions apart from the activities performed by the independent contractors.[xxiv]

In another ruling,[xxv] the IRS held that the controlled corporation was not engaged in an ATB where its two officers – the two shareholders of the distributing corporation – engaged in some managerial and operational activity but not enough to “qualitatively distinguish its operations from mere investments.”

Similarly, the IRS determined that a controlled corporation failed to satisfy the ATB test where the corporation had hired an unrelated management company to conduct the day-to-day operations of its business, while its own officers failed to demonstrate the performance of any substantial operational and managerial activities.[xxvi]

In a very instructive ruling,[xxvii] the IRS considered two corporations that were owned by a holding company. The first corporation had employees and was engaged in an ATB. The second corporation shared three officers with the first corporation, but had no paid employees of its own; rather, all of its operational activities were performed by the employees of the first corporation, under the control, supervision and direction of the second corporation’s officers. The first corporation paid its employees for these services and was reimbursed by the second corporation. The second corporation did not compensate its officers, but it reimbursed the first corporation for the amount of their time devoted to the management and supervision of the second corporation’s affairs.

Immediately following the holding company’s distribution of the second corporation, the latter employed, on a full time basis, most of those employees of the first corporation who had worked on its behalf prior to the distribution.

The IRS ruled that the second corporation met the ATB test notwithstanding the fact that, during the five-year period preceding distribution of its stock, it had no employees other than its officers.


The fact that a partnership engages in activities that would constitute the active conduct of a trade or business if conducted directly by a corporate partner does not necessarily mean that each partner in the partnership is considered to be engaged in the active conduct of a trade or business for purposes of the ATB test. In such a case, the determination of whether a partner is considered to be engaged in the active conduct of a trade or business must be based on the requirements of the spin-off rules, taking into account the activities of the partner (if any), the partner’s interest in the partnership, and the activities of the partnership.

A few years back, the IRS considered the case of a partnership in which all management and operational functions of an active business were performed by the partnership’s own employees. A corporation owned a 33.3% interest in the partnership, but performed no services with respect to the partnership’s business. The IRS ruled that the corporation was engaged in the active conduct of the partnership’s business for purposes of the ATB test because it owned a “significant” interest in the partnership and the partnership performed the required activities that constituted an active trade or business.[xxviii]

However, the IRS also ruled that if the corporation had instead owned a 20% interest in the partnership, it would not be engaged in the active conduct of the partnership’s business for purposes of the ATB test because the corporation neither owned a significant interest in the partnership nor performed active and substantial management functions for the partnership.[xxix]

During the same year that the above ruling was issued, the IRS proposed regulations under the spin-off rules that addressed the application of the ATB test where a distributing or controlled corporation was a member of a partnership. According to the proposed regulations, for purposes of the ATB test, a corporate partner in a partnership will be attributed the trade or business assets and activities of that partnership during the period that such partner satisfies the following requirements:

i. the corporate partner (or its affiliates) directly (or indirectly through one or more other partnerships) owns a significant interest (i.e., at least 33.3%) in the partnership; or

ii. the corporate partner (or affiliates of the partner) perform active and substantial management functions for the partnership with respect to the partnership’s trade or business assets and activities,[xxx] and the partner (or its affiliates) directly (or indirectly through one or more other partnerships) owns a meaningful interest (i.e., at least 20%) in the partnership. Whether such active and substantial management functions are performed with respect to the trade or business assets and activities of the partnership will be determined from all of the facts and circumstances.

The activities of independent contractors, and of partners that are not affiliates of the corporate partner, are not taken into account for these purposes.[xxxi]

PLR 201949012

Which brings us to the letter ruling to which I referred earlier.

Distributing Corp. was owned equally by Shareholder 1, Shareholder 2, and Shareholder 3 (the “Shareholders”). Distributing was directly engaged in Business A.

The Shareholders and Employee, as employees of Distributing, performed Services for Business A. Other Individuals, who were not employees of Distributing, performed Y Services and the majority of Z Services for Business A.

For what were represented to be valid corporate business purposes, Distributing proposed the following transaction:

  1. Distributing would form Controlled 1 and Controlled 2 Corps.
  1. Distributing would (a) contribute a portion of the assets of Business A to Controlled 1 in exchange for all of the stock of Controlled 1 and the assumption by Controlled 1 of a portion of Distributing’s liabilities (“Contribution 1”), and (b) a portion of the assets of Business A to Controlled 2 in exchange for all of the stock of Controlled 2 and the assumption by Controlled 2 of a portion of Distributing’s liabilities (“Contribution 2”).[xxxii]
  1. Distributing would distribute (a) all of the stock of Controlled 1 to Shareholder 1 in exchange for all of Shareholder 1’s stock in Distributing (“Distribution 1”), and (b) all of the stock of Controlled 2 to Shareholder 2 in exchange for all of Shareholder 2’s stock in Distributing (“Distribution 2, and together with Distribution 1, the “Distributions”) – basically, a split-up.[xxxiii]

Following the Distributions, Shareholder 3 and Employee would perform X Services for the portion of Business A remaining in Distributing; Shareholder 1 and Employee would perform X Services for the portion of Business A contributed to Controlled 1; and Shareholder 2 and Employee would perform X Services for the portion of Business A contributed to Controlled 2.

Distributing represented that, following the Distributions, Distributing, Controlled 1, and Controlled 2 each would continue, independently and with its separate employees, the active conduct of its share of all the integrated activities of the business on which it relied to meet the ATB requirement,[xxxiv] as conducted by Distributing prior to consummation of the transaction, except that Distributing, Controlled 1, and Controlled 2 would share the services of Employee. Distributing, Controlled 1, and Controlled 2 each would pay Employee directly for the value of Employee’s services.

Distributing also represented that (1) Contribution 1 and Distribution 1 would qualify as a transaction in which no gain or loss was recognized to Distributing, Controlled 1, or Distributing’s shareholders, and (2) Contribution 2 and Distribution 2 would qualify as a transaction in which no gain or loss was recognized to Distributing, Controlled 2, or Distributing’s shareholders.

Based on the foregoing facts and representations, the IRS ruled that Distributing, Controlled 1, and Controlled 2 each was engaged immediately after the Distributions in the active conduct of a trade or business within the meaning of the spin-off rules.

So What?

OK, the PLR did not involve an affiliate of either the distributing or controlled corporations. Nor did it involve a partnership in which either the distributing corporation or any of the controlled corporations was a member of a partnership.

However, it did involve the division of one corporation into three corporations, each of which, after the distribution, operated a vertical slice of the business previously operated entirely by the distributing corporation.

What’s more, each corporation had only one full-time employee – the individual who also happened to be such corporation’s sole shareholder. The three corporations shared a “second employee” – Employee – who performed services for each of them. In other words, it sounds like the Shareholders were lost without Employee, but the fact that they would have to share Employee wasn’t enough to keep the Shareholders together.[xxxv]

Nor, significantly, was it enough to prevent the IRS from accepting the premise that something less than two full-time employees would suffice for purposes of the distributing or controlled corporation’s satisfying the ATB requirement, at least under the circumstances presented.

This outcome reminded me of other rulings issued by the IRS over the years in which the proposed spin-off satisfied the ATB requirement notwithstanding that the corporations involved had few if any employees, and notwithstanding that they shared the services of a “related” party.

In one such ruling, for example,[xxxvi] Individuals A, B and C were officers and directors of Distributing. Distributing had no employees. The three individuals performed all managerial activities for Business A. Distributing utilized the employees of Partnership to perform certain operational activities for Business A. These employees performed these activities under the direction of Distributing. Distributing reimbursed Partnership for the cost of such services. Individuals A, B and C owned equally all the equity interests in Partnership.

It was represented that, following a split-off of Controlled to Individual C,[xxxvii] Distributing and Controlled each would continue the active conduct of its share of all the integrated activities of Business A conducted by Distributing prior to the split-off – indeed, Distributing and Controlled indicated that they may continue to utilize Partnership employees.[xxxviii]

In short, before a corporate client and its shareholders dismiss the possibility of a tax-free division on account of the absence of employees, it would behoove them to review IRS revenue rulings and private letter rulings similar to the ones discussed above. They may be surprised to find that the IRS has already considered their situation, or one similar to it, and has not found it wanting in terms of the ATB requirement.


[i] For example, a sale of stock or a sale of assets, and every permutation thereof.

[ii] A strategic buyer, who may, for example, be looking to enter a new geographic market or to eliminate a competitor and take its customer base, versus a private equity buyer that sees an opportunity to take a company to the next level before disposing of it in relatively short order for a profit that the buyer’s investors will find generous.

[iii] The reporter also asked to what I attributed the increased incidence of corporate separations.

There are several reasons, I explained. One major reason is the increased number of close, family-owned corporations that are being passed down by their founders to their children. These “children” don’t always see eye to eye, which often leads to serious disagreement within – and presents the potential for serious harm to – the business.

Such conflicts may be resolved through the sale of the business to a third party, or the buyout of a dissenting child. The first option is generally tax-inefficient for all the owners, while the second is tax-inefficient for the selling owner, and may be economically expensive for the buyer(s) who may have to borrow the funds necessary for the acquisition.

However, more and more owners who find themselves in these circumstances are turning to a source of information and ideas that was not available to their predecessors, which brings us to a second major reason for the increased spin-off activity among close corporations: the internet. The abundance of materials available on the internet have educated owners and advisers alike to options other than a taxable sale.

[iv] Tax-deferred, really.

[v] See below.

[vi] IRC Sec. 301. Of course, we are assuming that the distribution was not a redemption of a shareholder’s shares of stock in the corporation that qualified for exchange treatment under IRC Sec. 302.

[vii] IRC Sec. 311(b).

[viii] IRC Sec. 355(a)(1)(D). The controlled corporation may be a newly formed subsidiary to which Distributing has contributed the assets of an ATB: a “divisive D reorganization.” See IRC Sec. 368(a)(1)(D) and Sec. 355. If the controlled corporation is already in existence and has been engaged in an ATB, then Section 355 alone is invoked.

[ix] IRC Sec. 1032 accords tax-free treatment to Controlled for its issuance of stock to Distributing in exchange for money or other property.

[x] Reg. Sec. 1.355-2(c). See also Reg. Sec. 1.368-1(e). But note that the IRS has not applied to “divisive D reorganizations” the more lenient continuity of interest rules applicable to other reorganizations described in IRC Sec. 368(a).

[xi] Reg. Sec. 1.355-2(b). The principal reason for this business purpose requirement is to provide non-recognition treatment only to distributions that are incident to readjustments of corporate structures required by business exigencies and that effect only readjustments of continuing interests in property under modified corporate forms.

[xii] For example, the personal estate planning purposes of a shareholder.

[xiii] If a corporate business purpose can be achieved through a nontaxable transaction that does not involve the distribution of stock of a controlled corporation and which is neither impractical nor unduly expensive, then the separation is treated as not being carried out for that corporate business purpose.

[xiv] IRC Sec. 355(a)(1)(B). A tax-free distribution of the stock of a controlled corporation presents a potential for tax avoidance by facilitating the avoidance of the dividend provisions of the Code through the subsequent sale or exchange of stock of one corporation and the retention of the stock of another corporation. A device can include a transaction that effects a recovery of basis. Generally, the determination of whether a transaction was used principally as a device will be made from all of the facts and circumstances.

[xv] IRC Sec. 355(a)(1)(C) and Sec. 355(b); Reg. Sec. 1.355-3(b)(3)(ii).

[xvi] IRC Sec. 355(b)(1)(A).

[xvii] IRC Sec. 355(b)(1)(B).

[xviii] Reg. Sec. 1.355-3(b)(2). https://www.taxlawforchb.com/2019/07/corporate-spin-offs-the-active-trade-or-business-and-the-collection-of-income/

[xix] Reg. Sec. 1.355-3(b)(2)(iii).

[xx] Tax Increase Prevention and Reconciliation Act of 2005, P.L. 109-222.

The change was made in order to simplify spin-off planning for corporate groups that use a holding company structure. Prior to the change, such groups often had to undergo elaborate restructurings so as to place active businesses in the proper entities for purposes of the 5-year active business test.

[xxi] IRC Sec. 355(b)(3). Affiliation is determined by reference to IRC Sec. 1504(a); basically, a chain of corporations connected through stock ownership with a common parent. At least 80% of the total voting power and total value of a corporation is required.

[xxii] A member of its affiliated group.

[xxiii] Prop. Reg. Sec. 1.355-3(b)(2)(iii).

[xxiv] Rev. Rul. 73-234.

[xxv] Rev. Rul. 86-126.

[xxvi] Rev. Rul. 86-125.

[xxvii] Rev. Rul. 79-394; amplified by Rev. Rul. 80-181.

[xxviii] Rev. Rul. 2007-42.

[xxix] It is not clear whether a 20% partnership interest represents a floor above which no partner services are required in order for the partner to satisfy the ATB test.

[xxx] For example, makes decisions regarding significant business issues of the partnership and regularly participates in the overall supervision, direction, and control of the employees performing the operational functions for the partnership.

[xxxi] A corporation will not be treated as engaged in the active conduct of a trade or business unless it (or its affiliates, or a partnership from which the trade or business assets and activities are attributed) is the principal owner of the goodwill and significant assets of the trade or business for Federal income tax purposes.

[xxxii] Immediately after Contribution 1 and Contribution 2, Distributing (not including the value of the stock of Controlled 1 and Controlled 2), Controlled 1, and Controlled 2 each had a fair market value (assets less its assumed liabilities) that was equal to one-third of Distributing’s fair market value immediately prior to Contribution 1 and Contribution 2.

[xxxiii] Each of the three shareholders ended up with a wholly-owned corporation: the original distributing corporation and the two newly-formed controlled corporations.

[xxxiv] A “vertical” division. It appears that the only post-distribution connection among the corporations was Employee.

[xxxv] Query what the business purpose for the split-up was? Fit and focus seems like a possibility. Perhaps irreconcilable differences among the shareholders, with adverse effects to the business.

[xxxvi] PLR 201426007.

[xxxvii] The distribution of Controlled by Distributing to C in complete redemption of C’s shares in Distributing. The parties represented that the distribution of Controlled was being carried out for the corporate business purpose of fit and focus, in particular to resolve shareholder disputes.

[xxxviii] They indicated, alternatively that they may hire their own employees, or the officers of Distributing and Controlled (the Individuals) may directly conduct the activities.

The Stage is Set

On December 3, 2019, Taxpayer timely[i] filed a notice of appeal from a decision of the U.S. Tax Court that had been entered approximately two months earlier.[ii]

Because Taxpayer is a corporation, the Tax Court’s decision will be reviewed by the Court of Appeals for the Ninth Circuit, which is the circuit in which Taxpayer’s principal place of business is located.[iii] It is also the largest of the thirteen Courts of Appeals – thus, it is one of the most influential.[iv]

In accordance with the Code,[v] the Ninth Circuit will review de novo[vi] the legal rulings set forth in the Tax Court’s opinion.

With that, the stage is set for another episode of “Cannabis v. the Code.”

You all know our first contestant, the Commissioner of Internal Revenue, who hails from Washington, D.C.[vii]

Before introducing our second contestant – specifically, the appellant Taxpayer – let’s review the contest rules.[viii]

The Code

Under Federal law, cannabis is a “Schedule I” controlled substance; thus, the manufacture, distribution, dispensation, or possession of marijuana – even medical marijuana recommended by a physician – is prohibited as a matter of Federal law.[ix]


The Code allows a business to deduct, for purposes of determining its taxable income, all of “the ordinary and necessary expenses paid or incurred during the taxable year in carrying on” such business,[x] subject to certain exceptions.[xi]

One of these exceptions resides in Section 280E of the Code, which provides that:

No deduction or credit shall be allowed for any amount paid or incurred during the taxable year in carrying on any trade or business if such trade or business (or the activities which comprise such trade or business) consists of trafficking in controlled substances (within the meaning of schedule I and II of the Controlled Substances Act) which is prohibited by Federal law or the law of any State in which such trade or business is conducted.

Marijuana is a Schedule I controlled substance, and dispensing it is “trafficking” within the meaning of Section 280E.

Therefore, the Code prohibits a taxpayer that is engaged in the business of “trafficking” in marijuana from deducting their related expenses.

Cost of Goods Sold

However, the fact that a taxpayer engaged in the business of trafficking in controlled substances cannot deduct its business expenses does not mean the taxpayer owes tax on the gross receipts generated by the business.

All taxpayers – including “drug traffickers” – pay tax only on their gross income, which is equal to the excess of their gross receipts over their cost of goods sold (“COGS”).

But what is the distinction between a business expense deduction and an adjustment for COGS? Deductions are subtractions from gross income that taxpayers make when they calculate their taxable income.[xii] They are “statutory”; in other words:

Whether and to what extent deductions shall be allowed depends upon legislative grace; and only as there is clear provision therefor can any particular deduction be allowed.[xiii]

COGS is the costs of acquiring inventory, through either purchase or production.[xiv] All taxpayers, regardless of their business, use COGS to offset their gross receipts when they calculate gross income.

Deduction v. COGS?

The main difference between deductions and COGS is one of timing; specifically, when does the taxpayer who incurs the cost in question benefit from the resulting reduction in their taxable income?

In general, a taxpayer can claim a deductible expense (and thereby reduce their taxable income) for the year in which they incur it. However, when accounting for COGS, the taxpayer has to capitalize the cost for the item in the year of acquisition or production of the item; then the taxpayer generally waits until the year in which the item is sold to make the corresponding adjustment (i.e., reduction) to their gross income.

Recognizing that a taxpayer may be tempted to include an otherwise non-deductible expense in their COGS, the Code provides that “Any cost which [(but for the capitalization and COGS rules)] could not be taken into account in computing taxable income for any taxable year shall not be treated as” an adjustment to COGS.[xv] In this context, “cost” means expenses that would otherwise be deductible;[xvi] thus, the taxpayer cannot circumvent the prohibition against claiming a deduction for an expense – for example, under Section 280E of the Code – by including the expense in their COGS.[xvii]

The Golden State

During the years at issue, California law provided an exemption from California laws penalizing the possession and cultivation of marijuana for patients and their primary caregivers when the possession or cultivation was for the patient’s personal medical purposes and was recommended or approved by a physician.[xviii]

Also during those years, California allowed the collective or cooperative cultivation of marijuana for medicinal purposes.[xix]

These laws led to the formation of the first marijuana dispensaries – which brings us to our next contestant.

Taxpayer’s “Business”[xx]

Taxpayer hails from California, where they operate a medical marijuana dispensary out of a space that has a reception area, healing room, purchasing office, processing room, clone room, and multipurpose room.[xxi] The facility also has a large sales floor, offices, and storage areas.

In order to operate a dispensary in compliance with California law, Taxpayer was organized and run as a not-for-profit.[xxii] It also operated under a “closed-loop” system, meaning that mean that all of its marijuana had to be provided by its patients, sold exclusively to its patients, handled only by its employees, and not diverted into the illegal market.

Taxpayer sold a wide variety of products, comprised of four main groups: clones,[xxiii] marijuana flowers, marijuana-containing products, and non-marijuana-containing products.

Taxpayer bought clones from clone nurseries, cared for them while they were in its store, repackaged them, and then sold them to its patients. It stored the clones in a clone room and sold them at a counter dedicated to clone sales. Taxpayer had at least four employees who spent their time entirely in the purchase and sale of clones.[xxiv]

Taxpayer purchased all of its marijuana flowers[xxv] from its patient-growers. Some of these growers promised to sell what they cultivated back to Taxpayer, and Taxpayer gave them either seeds or clones to get started. Other growers, however, bought seeds and clones from Taxpayer.

Once a grower had cultivated, harvested, and otherwise prepared their marijuana buds, they would bring them to Taxpayer to sell. Taxpayer had a purchasing office to inspect and test the incoming marijuana. It would accept marijuana that satisfied its criteria and rejected the rest.

If Taxpayer agreed to purchase the marijuana, it would store the marijuana in a vault, and send a sample out for testing by a third-party laboratory. If all went well, the marijuana would go to a processing room where it underwent further preparation before being weighed, packaged, and labeled. Taxpayer’s staff would put it on display on the sales floor, or put it back in the vault until needed. At least three employees were dedicated to acquiring inventory, at least four devoted to managing inventory, and still others whose sole job was to process the marijuana and ready it for resale.

Taxpayer’s marijuana-containing products included edibles, beverages, extracts, concentrates, oils, etc. (purchased from other collectives), which it tested, repackaged, relabeled, and then sold to its own patients. Taxpayer estimated that about 55% to 60% of its employees’ total time was spent on buying and processing marijuana (both the buds and marijuana-containing products), and another 25% to 30% selling it.

Taxpayer also sold non-marijuana-containing products.[xxvi] Taxpayer purchased these items from outside vendors, stored them, and resold them to patients. A little less than 25% of the sales floor was used to display and sell these items, and around 5% to 10% of Taxpayer’s employees’ time was dedicated to buying and selling these entirely legal products.

In order to prevent its marijuana from leaking into the black market, no one could enter Taxpayer’s sales floor without going through a rigorous identification process that included the presentation of a photo ID and a written recommendation from a physician licensed to practice in California. A patient also had to sign a collective cultivation agreement giving other patients the right to cultivate marijuana on their behalf, and agree to abide by Taxpayer’s rules. Taxpayer also sold its marijuana at a premium above the black-market rate to discourage its patients from reselling it.

Taxpayer’s “Problem”

Taxpayer realized significant profits. Although Taxpayer was taxable as a C-corporation for federal tax purposes, as a non-profit-profit corporation it was prohibited by California law from paying dividends; rather, it was required to use any “excess revenue” for the benefit of its patients or the community.

To this end, Taxpayer provided its patients with a wide variety of services at no additional cost.[xxvii] It continually informed its patients that Taxpayer would use part of the purchase price of the marijuana to pay for patient services and community outreach; however, patients were not required to buy marijuana to use the services.

All of the services were coordinated by Taxpayer’s “holistic-services” director[xxviii] and took place on Taxpayer’s premises. Taxpayer paid the persons who provided these service, all of whom were independent contractors.

Taxpayer had other employees in support roles. The security department, for example, spent most of its time checking in both patients and vendors and then escorting vendors into the back of the building to meet with a purchasing manager. The security group spent 60% of its time checking in patients who came to buy marijuana, another 5% checking in people on site to receive a service, and the rest in assisting vendors. Taxpayer also had an administrative group, which included employees in its finance, human resources, and facilities departments, as well as its executives.

Tax Returns and Audit

As a C-corporation, Taxpayer filed annual Forms 1120, U.S. Corporation Income Tax Return. The IRS selected Taxpayer’s 2007, 2008, and 2009 income tax returns for audit. Eventually, the IRS issued notices of deficiency for Taxpayer’s 2007 through 2012 taxable years. The notices denied most of Taxpayer’s claimed business deductions and COGS.

The IRS’s primary reason for its adjustments was that “[n]o deduction or credit shall be allowed for any amount paid or incurred during the taxable year in carrying on a trade or business that consists of trafficking in controlled substances.”

Taxpayer petitioned the U.S. Tax Court for relief. As we shall see, no such relief was forthcoming, which is why Taxpayer filed the above-described notice of appeal, presumably in the hope that the Ninth Circuit will be more receptive to its arguments.

The Tax Court Provides Some Context

The Court began by explaining the applicable California law and describing its conflict with Federal law.

The CCUA, the Court explained, did not decriminalize marijuana in California. Instead, it created an affirmative defense to charges of possessing or cultivating marijuana for persons who did so for personal, physician-approved use. Primary caregivers of such persons could also raise the defense. In 2003, the Court continued, California extended the CCUA’s affirmative defense to charges of transporting marijuana for patients and primary caregivers who “associate within the State of California in order collectively or cooperatively to cultivate marijuana for medical purposes.”[xxix] The MMPA also instructed California’s attorney general to develop guidelines to “ensure the security and non-diversion of marijuana grown for medical use.” Those guidelines stated that medical-marijuana cooperatives should be formally organized, not operate for profit, maintain business licenses and permits, verify each member’s status as a patient, execute an agreement with each member regarding the use and distribution of marijuana, keep records of distribution, and neither buy marijuana from nor distribute marijuana to nonmembers.

The Tax Court then described how the conflict between Federal and California law went to the Supreme Court in 2005, when two California medical-marijuana users tried to enjoin the U.S. from enforcing the Federal marijuana law against them.[xxx] The Supreme Court upheld the Federal prohibition on marijuana sale and possession with respect to medical-marijuana users.

According to the Tax Court, Congress then further complicated the situation by enacting a series of appropriations riders[xxxi] that prevented the Department of Justice (“DOJ”) from using any funds “to prevent * * * [States that permit medical-marijuana use] from implementing their own laws that authorize the use, distribution, possession, or cultivation of medical marijuana.”[xxxii] When interpreting such a rider, the Ninth Circuit stated that DOJ prosecutions of individuals who complied with state medical-marijuana laws interfered with the implementation of such laws and were therefore impermissible.[xxxiii] Thus, even though medical marijuana is illegal under Federal law, it appears that the Federal law may not be enforced by the DOJ in those states that permit the medical use of marijuana.[xxxiv]

That being said, Congress did not limit the reach of the Code.[xxxv] Thus, Section 280E prevents any trade or business that “consists of trafficking in controlled substances” from deducting any business expenses, while Section 263A(a)(2) prevents taxpayers from capitalizing – and later recovering – costs that were otherwise nondeductible.

The Court then described its first major medical-marijuana dispensary case,[xxxvi] in which it found that the taxpayer operated two trades or businesses: one that provided caregiving services, and one that sold marijuana. After requiring the taxpayer in that case to allocate its expenses between its two businesses according to the number of its employees and the portion of its facilities devoted to each, the Court allowed the taxpayer to deduct the expenses properly allocated to its caregiving business, but not those allocated to its marijuana-sales business.

By contrast, the Court stated that in its next medical-marijuana case[xxxvii] it held that a dispensary that derived all its revenue from marijuana sales, but that also provided free activities and services to its patrons, was a single trade or business. Because that single trade or business was selling marijuana, the Court held that Section 280E precluded the deduction of any of the taxpayer’s operating expenses, but did not prevent the taxpayer from adjusting for costs of goods sold.[xxxviii]

Similarly, in a later case,[xxxix] the Court found that the taxpayer – which stipulated that it was “in the business of distributing medical marijuana” – was engaged in a single trade or business because its sale of non-marijuana items, such as books, “was an activity incident to its business of distributing medical marijuana.” Thus, Section 280E prohibited the deduction of any of its business expenses.

Taxpayer’s Deductions

Taxpayer presented a number of arguments in support of its right to claim deductions for the expenses reported on its tax returns.[xl] Two of these, in particular, presented some interesting issues.

More Than One Trade or Business?

Taxpayer argued – and the Court agreed – that even if Section 280E applied to its marijuana sales, it could still deduct its expenses for any separate, non-trafficking trades or businesses. The Court, therefore, needed to determine which, if any, of Taxpayer’s activities were separate trades or businesses.

According to the Court, an activity is a trade or business if the taxpayer does it continuously and regularly with the intent of making a profit.[xli] A single taxpayer can have more than one trade or business, or multiple activities that nevertheless are only a single trade or business. The Court noted that even the activities of separate entities can constitute of a single trade or business if they are part of a “unified business enterprise” with a single profit motive.[xlii]

Whether two activities are two trades or businesses or only one is a question of fact. The Court stated that, to answer the question, it had to consider the “degree of organizational and economic interrelationship of various undertakings, the business purpose which is (or might be) served by carrying on the various undertakings separately or together * * *, and the similarity of the various undertakings.”

Recalling one of its earlier decisions,[xliii] the Court described how that taxpayer had two distinct trades or businesses – caregiving services and medical-marijuana sales – even though its customers paid a single fee that entitled them to unlimited access to the services and a fixed amount of marijuana. The Court noted there that seven of the taxpayer’s employees distributed marijuana, eighteen employees provided caregiving services, and no employees did both – there were two distinct workforces. Moreover, dispensing marijuana occurred in only 10% of one of the taxpayer’s three facilities. Thus, the Court found the taxpayer’s primary purpose was to provide caregiving services, and that those services were both “substantially different” from and “stood on * * * [their] own, separate and apart” from dispensing marijuana.

In a later decision,[xliv] however, the Court held that a taxpayer who sold medical marijuana and provided complimentary services[xlv] had a single trade or business. That taxpayer charged only for marijuana, and set a price based on the amount of marijuana its patients bought; the cost of the other services was bundled into that price. The same employees who sold marijuana also provided the services, and the taxpayer paid no additional wages, rent, or other significant costs connected exclusively with those services. The taxpayer also had a single bookkeeper and accountant for both “lines of business.” On these facts, the Court held that the services were “incident to” the sale of marijuana, and that the two activities had a “close and inseparable organizational and economic relationship.” They were “one and the same business.”

Taxpayer’s Reasoning

Taxpayer asserted that it had several activities, each of which was a separate trade or business:

  • Sales of marijuana and products containing marijuana;
  • Sales of products with no marijuana; and
  • Therapeutic services.[xlvi]

The Court considered, and dismissed, Taxpayer’s position.

For starters, the Court stated there was no question that selling marijuana and products containing marijuana was Taxpayer’s primary purpose. Sixty percent of the individuals that Taxpayer’s security checked in to their facility were there to buy marijuana in one form or another. Marijuana and marijuana products took up around 75% of Taxpayer’s sales floor. Its employees spent 80-90% of their time purchasing, processing, and selling these products, and those sales generated almost all of Taxpayer’s revenue during each of the years at issue.

Thus, the Court concluded, Taxpayer was in the trade or business of trafficking in a controlled substance.

Taxpayer’s sale of items that didn’t contain marijuana[xlvii] generated the remaining 0.5% of its revenue. The same Taxpayer employees who bought, processed, and sold marijuana also sold these items, but selling them took up only 5-10% of their time. The non-marijuana items occupied only 25% of the sales floor where Taxpayer sold marijuana, and that sales floor was accessible only to patrons who had already presented their credentials to security – which meant that no one who couldn’t buy marijuana could buy these non-marijuana items. What’s more, the record showed no separate entity, management, books, or capital for the non-marijuana sales.

This led the Court to find that the sale of non-marijuana-containing products had a “close and inseparable organizational and economic relationship” with, and was “incident to,” Taxpayer’s primary business of selling marijuana. There was also an obvious business purpose, the Court added, for selling items that facilitated and encouraged marijuana use alongside actual marijuana. It also found that the sale of items that were about marijuana, were branded with Taxpayer’s logo, or enabled the use of marijuana was not “substantially different” from the sale of marijuana itself.

The Court turned next to Taxpayer’s argument that a portion of each marijuana sale was actually a purchase of its “free” holistic services. The Court distinguished the Taxpayer’s situation from one in which members paid a set fee for unlimited access to extensive services and also received a fixed amount of marijuana, noting that in the latter case the purchase of services was paramount. The Taxpayer’s “price” for services, in contrast, was included in the amount paid for marijuana; patrons paid according to the amount and type of marijuana they wanted and, in return, gained access to incidental services. As the Court put it, a marijuana dispensary that gives away services is still only a marijuana dispensary. The fact that Taxpayer used some of its marijuana-sales revenue to pay for those services did not change that fact. Moreover, there were business reasons, the Court continued, to offer these services alongside marijuana sales: it justified premium pricing and helped Taxpayer meet the community-benefit standards required under California law. Thus, the Court found that Taxpayer’s services were not a separate trade or business.

In sum, the Court found that Taxpayer “dedicated the lion’s share of its resources to selling marijuana and marijuana products.” Those sales accounted for almost all of its revenue; its other activities were neither economically separate nor substantially different. Therefore, the Court held that Taxpayer had a single trade or business: the sale of marijuana. Because that constituted “trafficking in a controlled substance” under federal law, Taxpayer could not deduct any of its related expenses.

Taxpayer’s COGS

Having rejected Taxpayer’s arguments in support of its right to deduct the expenses it incurred in carrying on its trade or business, the Court turned its attention to Taxpayer’s arguments regarding the computation of its COGS.

The Court explained that the Code informs taxpayers of what items to include in COGS. The issue in this case, however, was that two statutory provisions were invoked, with the IRS and Taxpayer disagreeing as to which was applicable.

One provision authorized the IRS to write regulations to govern how taxpayers account for inventories (the “inventory rules”).[xlviii] Pursuant to the regulations promulgated thereunder, “resellers” are directed to use as their COGS the price they paid for inventory plus any “transportation or other necessary charges incurred in acquiring possession of the goods.”[xlix] “Producers,” however, are directed to include in COGS both the direct and indirect costs of creating their inventory.[l]

A second provision (the “capitalization rules”) directs both producers and resellers to include indirect inventory costs in their COGS.[li]

Before delving further into the two COGS provisions, the Court explained how they affect the timing of a taxpayer’s realization of any tax benefit attributable to the expenses incurred by the taxpayer. For example, a business that may otherwise immediately deduct indirect costs would, instead, have to capitalize those costs in accordance with these provisions and then wait until it realizes the related income before adjusting for the expenses. In other words, the benefit of the deduction would be deferred.

Most businesses, the Court asserted, would prefer to have an immediate deduction rather than an increased COGS later. “But drug traffickers,” the Court continued, “have a different attitude.”

Although section 280E prevents them from deducting expenses, they are still entitled to COGS adjustments. By renaming COGS what had been deductions, Congress made it possible for traffickers to adjust for expenses that they couldn’t previously claim. They have to make those adjustments in the later year when the inventory is sold, but later is better than never.

Reflecting this point, Taxpayer argued that the IRS was denying it the ability to add its indirect expenses to its COGS under the capitalization rules.

In response, the Court explained that Taxpayer could not use these rules to capitalize indirect costs that it would not otherwise be able to deduct on a current basis. That’s because the capitalization rules expressly prohibit capitalizing expenses that would not otherwise be deductible.[lii] Drug traffickers, the Court stated, could not deduct any business expenses[liii] and, so, they could not use the capitalization rules to include indirect expenses in their COGS.

Aside from that, the Court observed, because Taxpayer was a reseller, it was still allowed to calculate its gross income by subtracting, as part of its COGS – under the inventory rules – the direct cost of its inventory (inventory price and transportation costs) from its gross receipts, whether or not such direct costs were legal.

Taxpayer, however, insisted that it was a producer of the marijuana bud that it sold and, therefore, could include in its COGS the indirect inventory costs described in the inventory rules.[liv]

The Court rejected this argument, observing that Taxpayer did not create the clones, maintain control over them, or take possession of everything produced. Rather, Taxpayer bought clones from nurseries and either sold them to growers with no strings attached or gave clones to growers expecting that they’d sell bud back to Taxpayer. Nothing prevented either type of grower from selling to another collective. Taxpayer had complete discretion over whether to purchase whatever the bud growers brought in, paid growers only if it purchased their bud, and at times rejected its growers’ bud.

In other words, Taxpayer was a reseller, not a producer; thus, it could not include its indirect costs in its COGS under the inventory rules.

Game over?

The Ninth

It remains to be seen when Taxpayer’s appeal from the Tax Court’s decision will be heard by the Ninth Circuit.[lv]

However, based upon the facts of Taxpayer’s case, and based upon some of the Ninth Circuit’s earlier decisions in this area,[lvi] query whether Taxpayer can reasonably expect a positive outcome?

Notwithstanding Taxpayer’s situation, the Tax Court’s decision does provide some useful guidance for those businesses that operate – or that are thinking about operating – in states that have legalized the medical use of marijuana.

In particular, the importance of separating the sale of marijuana and marijuana products from the sale of services and other products looms large. Perhaps these varied lines should be housed in different business entities, maintain separate books and accounts, and employ separate workforces? To the extent they “share” any service providers, the separate entities should agree upon a reasonable allocation of the costs therefor. Of course, each entity should charge separately for its own particular products and/or services – the two should not be bundled together. As far as locations are concerned, the two separate lines of business should be physically separated and easily distinguishable from each other.

With the implementation of the foregoing guidelines, it may be possible to maximize the deductions that are reasonably attributable to the non-marijuana activities.

As for the COGS, it is clear that Congress sought to limit the expenses that “drug traffickers” – resellers, such as Taxpayer – could include in their COGS to their direct expenses only, pursuant to the inventory rules, which do not distinguish between legal and illegal expenses. They are not permitted to use the capitalization rules to also add their indirect illegal expenses to COGS.

Any modification to this limitation will likely have to wait for a change in the Federal treatment of marijuana as an illegal controlled substance.

In any case, stay tuned for the sequel to Taxpayer’s drama, which will be played at the Ninth Circuit.

In general, a taxpayer seeking appellate review of a decision of the Tax Court must file a notice of appeal with the clerk of the Tax Court within 90 days after the Court’s decision is entered. IRC Sec. 7483.

See also Rule 13 of the Federal Rules of Appellate Procedure.

[ii] Patients Mutual Assistance Collective Corporation v. Comm’r, 151 T.C. No. 11 (11/29/18) (which consolidated Docket Nos. 14776-14, 30851-12, 29212-11); entered October 17, 2019.

Note that the date on which the opinion (November 2018) was issued is not the same as the date on which the Tax Court’s decision was entered (October 2019). The opinion, written by a Tax Court Judge, explains the conclusions reached after the trial. After the opinion is issued, a decision will be entered that is consistent with the Judge’s opinion. IRC Sec. 7459.

In general, where the Tax Court has ruled in favor of the IRS, the decision sets forth the amount of the resulting deficiency.

[iii] IRC Sec. 7482(b)(1)(B).

[iv] Its decisions cover approximately one-fifth of the country’s population, residing in Alaska, Arizona, California, Hawaii, Idaho, Montana, Nevada, Oregon, and Washington. (Its jurisdiction also covers certain Territories; e.g., Guam.)

At least until recently, the Ninth Circuit has been viewed as one of the most “liberal” of courts – Pres. Trump’s appointments have changed that.

[v] IRC Sec. 7482(a) provides that the U.S. Courts of Appeals have exclusive jurisdiction to review the decisions of the Tax Court, and directs that they do so in the same manner and to the same extent as decisions of the district courts in civil actions tried without a jury.

[vi] See, e.g., Scheidelman v. Comm’r, 755 F.3d 148 (2d Cir. 2014). This is a higher level of scrutiny than simply determining whether the lower court’s decision was clearly erroneous in light of the evidence.

[vii] IRC Sec. 7803.

[viii] In case you’re wondering, the recreational use of cannabis has not been legalized in the State of New York. Guess I’m still giddy over the Titans’ win against the Pats.

[ix] See Controlled Substances Act, P.L. 91-513, sec. 202.

[x] IRC Sec. 162(a).

[xi] IRC Sec. 161.

[xii] IRC Sec. 63(a).

[xiii] New Colonial Ice Co. v. Helvering, 292 U.S. 435, 440 (1934).

[xiv] Reg. Sec. 1.61-3(a), Sec. 1.162-1(a).

[xv] IRC Sec. 263A(a)(2).

[xvi] Reg. Sec. 1.263A-1(c)(2).

[xvii] See Technical and Miscellaneous Revenue Act of 1988, P.L. 100-647.

[xviii] See the California Compassionate Use Act of 1996 (“CCUA”). California was the first state to legalize the medical use of cannabis. Fast forward to 2016, California approved a ballot measure to legalize the recreational use of cannabis.

[xix] More on this below.

[xx] You’ll appreciate all of these details later.

[xxi] You’re expanding your vocabulary, aren’t you?

[xxii] In case you’re wondering, the IRS has determined that a marijuana dispensary generally cannot qualify as a tax-exempt organization under IRC Sec. 501(c)(3) because it is engaged in what federal law regards as a criminal enterprise and, thus, is not operated exclusively for charitable purposes.

Some might say it’s the worst of two worlds: a taxable not-for-profit.

[xxiii] Cuttings from a female cannabis plant that can be transplanted and used to cultivate marijuana. Yes, you heard me.

[xxiv] You’ll never think of “the clone wars” in the same way again.

[xxv] It’s not the leaves of the marijuana plant, but its flowers (or buds) that people can smoke.

I know what some of you may be thinking but, to quote Austin Powers, “That’s not my bag, baby!”

[xxvi] These included branded gear such as shirts, hats, and pins; non-branded gear such as socks and hemp bags; and a variety of other products including books, dabbing equipment, rolling papers, and lighters.

[xxvii] These services included one-on-one therapeutic sessions for hypnotherapy, acupuncture, and chiropractic consultations, as well as group sessions for yoga and tai chi. Taxpayer also offered grow classes, support groups, addiction treatment counseling, and a “sliding scale program” that gave discounts to patients with financial difficulties.

[xxviii] My firm has one of those – not.

[xxix] The Medical Marijuana Program Act (“MMPA”).

[xxx] See Gonzales v. Raich, 545 U.S. 1 (2005).

[xxxi] Basically, a provision added to a spending bill that denies funding for a specified action by an executive agency.

[xxxii] Consolidated Appropriations Act, 2019, P.L. 116-6, sec. 537; Consolidated Appropriations Act, 2018, P.L. 115-141, sec. 538; Consolidated Appropriations Act, 2017, P.L. 115-31, sec. 537; Consolidated Appropriations Act, 2016, P.L. 114-113, sec. 542; Consolidated and Further Continuing Appropriations Act, 2015, P.L. 113-235, sec. 538.

[xxxiii] United States v. McIntosh, 833 F.3d 1163 (9th Cir. 2016).

[xxxiv] This state of affairs continues today.

[xxxv] “The power to tax involves the power to destroy.” Chief Justice John Marshall, in McCulloch v. Maryland (1819).

[xxxvi] Californians Helping to Alleviate Med. Problems, Inc. v. Comm’r (CHAMP), 128 T.C. 173, 181 (2007).

[xxxvii] Olive v. Comm’r, 139 T.C. 19 (2012), aff’d, 792 F.3d 1146 (9th Cir. 2015).

[xxxviii] The years at issue predated the amendment, in 1988, of IRC Sec. 263A.

[xxxix] Canna Care, Inc. v. Comm’r, T.C. Memo 2015-206, aff’d, 694 F. App’x 570 (9th Cir. 2017).

[xl] One of these – that Taxpayer’s business did not “consist of” trafficking in a controlled substance under Section 280E – occupied an inordinate amount of the Court’s time and will not be considered here. The Court examined what it means for a business to “consist of” trafficking, and concluded that Taxpayer’s trade or business included trafficking in controlled substances, “even if that trade or business also engages in other activities.”

[xli] This is the standard definition.

[xlii] Witness the discussions of what constitutes a “trade or business” for purposes of Sec. 199A of the Code. For our purposes, think of the “crack and pack” strategies that so many endorsed before regulations were proposed to thwart the artificial division of what was, in substance, a single trade or business.

[xliii] CHAMP, supra note xxxvi.

[xliv] Olive, supra note xxxvii.

[xlv] Including movies, yoga classes, massages, personal counseling, and advice on how to best consume marijuana.

[xlvi] Taxpayer’s final argument was that its brand-development activity was a separate trade or business, insisting that it was performed with an independent profit motive. In order to support a profit motive without any revenue, Taxpayer claimed that its branding activities were part of a “unified business enterprise” with its money-making activities during the years at issue.

A separate entity purposely operating at a loss, the Court stated, was still a trade or business eligible for deductions if it and the entities related to it together formed a unified business enterprise that itself had a profit motive. In other words, the unified-business-enterprise doctrine Taxpayer relied on said that separate but related entities could share a single profit motive. Rather than show that Taxpayer’s branding was separate from its marijuana sales, the unified-business-enterprise doctrine instead suggested that it was part of a single overall trade or business.

As the Court stated, “Rather than being “substantially different” from the underlying sale of marijuana, Taxpayer’s brand development was necessarily entwined with it.” It was not a separate trade or business.

[xlvii] Such as branded clothing, hemp bags, books about marijuana, and marijuana paraphernalia such as rolling papers, pipes, and lighters.

[xlviii] IRC Sec. 471.

[xlix] Reg. Sec. 1.471-3(b).

[l] Reg. Sec. 1.471-3(c); Reg. Sec. 1.471-11. The regulations direct producers to capitalize the “cost of raw materials,” “expenditures for direct labor,” and “indirect production costs incident to and necessary for the production of the particular article, including * * * an appropriate portion of management expenses.”

[li] IRC Sec. 263A(a)(2)(B) and Sec. 263A(b); Reg. Sec. 1.263A-1(a)(3), (c)(1), (e).

[lii] IRC Sec. 263A(a), last sentence.

[liii] IRC Sec. 280E.

[liv] Recall that the inventory rules apply differently for resellers than for producers, with the latter being allowed to include both their direct and indirect costs.

It was clear that Taxpayer was a reseller of the marijuana edibles and non-marijuana-containing products it bought from third parties and sold at its facility – thus, it could not include the indirect costs thereof in its COGS.

[lv] It has been assigned Case Number 19-73078.

[lvi] See, e.g., Olive, supra note xxxvii.

“Ten, Nine, Eight . . .”

This is the final weekend of the final month of the final year of the decade. As the clock ticks away the hours, many folks are busy returning gifts, planning New Year celebrations, scheduling college bowl game parties, debating who was the best quarterback of the decade,[i] ignoring the latest political gaffes by a long list of megalomaniacs, and wondering when and where who will do what to whom and why on their favorite “reality” shows.

There are “those” folks, however, who are doing some last minute tax planning.[ii] They may be thinking about making charitable contributions or maximizing their contribution to a 401(k) plan. Some may be considering annual exclusion gifts. Others may be in the market to acquire (and place in service) a piece of equipment in order to secure a Section 179 deduction for the year.[iii] Still others may be searching through their portfolio for investment losses to realize before the year’s end so as to offset already-realized gains.[iv] And a few who are holding an investment that, in retrospect, turned out to be a bad idea may be wondering whether 2019 is the year for which they can claim a loss deduction with respect to that investment.

A recent decision of the U.S. Tax Court[v] considered whether Taxpayer[vi] was entitled to a loss deduction that it claimed with respect to a partnership interest that Taxpayer reported became worthless during 2009.[vii]

Before delving into the particulars of this case, and in order to better understand the relevance of the facts recited below, let’s review the applicable provisions of the Code and Regulations.

Section 165

The Code allows a deduction for any loss actually sustained during the tax year, provided it is not compensated for by insurance or otherwise.[viii]

To be allowable as a deduction, the loss must be evidenced by a closed and completed transaction, fixed by “identifiable events,” and actually sustained during the tax year.[ix] Thus, a mere decrease in the value of a property held by a taxpayer does not constitute a loss for which the taxpayer may claim a deduction. The loss has to be realized.

What’s more, only a bona fide loss is deductible; substance and not mere form governs in determining a deductible loss.

The amount of loss allowable as a deduction may not exceed the taxpayer’s adjusted basis for the property involved;[x] i.e., the amount of the taxpayer’s unrecovered investment.

A loss is allowed as a deduction under Section 165(a) only for the taxable year in which the loss is sustained.[xi] The most challenging aspect of establishing one’s right to the deduction may be establishing the taxable year in which the loss was sustained.

In most cases, a “closed and completed transaction” will occur upon a sale or other disposition of the property, but this requirement may also be satisfied if the property becomes worthless. Thus, “worthlessness” may be a stand-alone justification for a deduction under Section 165(a), and a taxpayer may deduct a loss from an investment in a partnership if their partnership interest becomes worthless during the tax year.[xii]

Whether a loss from the worthlessness of a partnership interest is a capital or an ordinary loss depends on whether or not the loss results from the sale or exchange of a capital asset.[xiii]

In general, where there is an actual or deemed distribution by the partnership to the taxpayer-partner, the transaction will be treated as a sale or exchange of the partnership interest, and any loss resulting from the transaction will be capital.[xiv] Such a transaction is not treated for tax purposes as involving a loss from the worthlessness of a partnership interest, regardless of the amount of the consideration actually received or deemed received in the exchange.

A loss from the worthlessness of a partnership interest will be ordinary if there is neither an actual nor a deemed distribution to the partner. In addition, the loss will be ordinary only if the transaction is not otherwise, in substance, a sale or exchange.

With these basic Section 165 principles under our collective belt, let’s turn to the decision.

Subprime Mortgage Crisis

Family was engaged in the real estate development and sales business, which it operated primarily through “LLC” which, in turn, operated through various wholly-owned, as well as multi-member, ventures.

Taxpayer was organized by Family to manage LLC, and also to provide a separate vehicle through which Family could make investments in LLC. At the time of its formation, Taxpayer was owned beneficially by the same persons that owned LLC.

Loans and Capital

At that time, LLC owed $35 million to Senior Lender.[xv] The loan documents required that LLC obtain Senior Lender’s approval before LLC made material outlays of cash.

Between 2004 and 2008, Taxpayer contributed approximately $57.6 million to LLC’s capital in exchange for a partnership interest that entitled Taxpayer to receive all distributions from LLC until Taxpayer received the amount of each capital contribution plus a specified return.

In 2005, with the success of its real estate development business, LLC refinanced its Senior Lender debt with $100 million of notes payable, plus interest. The loan documents required that LLC make scheduled principal payments throughout the term of the loan, with the remaining principal and accrued interest coming due in 2013.

Also in 2005, LLC borrowed $62.5 million of subordinate debt from Funding. The subordinate debt was secured by LLC’s assets and was subordinate to the liens created under the senior debt documents.[xvi]

LLC’s subsidiary project entities also incurred acquisition, development, and construction loans to finance their respective projects. This project debt was secured by the real property held by the particular borrowing project entity. Additionally, Taxpayer and LLC’s other members (the “Select Corporate Entities;” SCEs) jointly and severally guaranteed the project debt.

The loan documents for the project debt and the senior debt included cross-default provisions.[xvii]

The “You Know What” Hits the Fan

The subprime mortgage crisis that began in 2007 hit LLC’s business in a big way because subprime mortgages were prevalent in the housing markets in which LLC operated, and the values of homes financed with subprime mortgage debt declined in those markets at unprecedented rates. During 2008, LLC attempted to secure additional financing from various investment entities but was unsuccessful.

By the end of 2008, because the real estate market continued to decline, LLC removed new projects from the forecasts it provided to its project lenders.[xviii]

Also in 2008, LLC’s project debt lenders raised concerns regarding LLC’s subordinate debt with Funding. Cash flow projections suggested LLC would be unable to pay the subordinate debt owed to Funding. LLC negotiated with Funding concerning a discounted payoff of the subordinate debt. However, because of the senior lien on LLC’s assets, as well as other covenants in the senior debt loan documents, LLC’s ability to use its cash to pay down the subordinate debt was limited.

In addition, Family and the SCEs did not want to contribute additional cash to LLC because those funds would immediately become subject to the senior lien. Instead, LLC’s management concluded that another Family-owned entity might be able to purchase the subordinate debt at a discount. LLC’s management believed that acquisition by a related entity would reduce the risk that a third-party holder of the subordinate debt would attempt to force LLC into bankruptcy.

Ultimately, Funding agreed to a discounted purchase price of $16 million for the $62.5 million subordinate debt. To facilitate the acquisition, Family formed and capitalized “Holdings LLC.”

In October 2008, Holdings paid $16 million to acquire all of the subordinate debt. Holdings intended to collect the full $62.5 million face amount of the debt, plus interest.

LLC’s financial condition deteriorated in 2007 and 2008, and it had to record impairment charges with respect to its projects, including an impairment charge of $109.8 million under GAAP,[xix] which caused LLC’s net worth to decline substantially, which in turn caused LLC to struggle to comply with its various financial covenants under the senior debt and project debt loan documents. The existence of cross-default provisions in the senior debt and project debt loan documents exacerbated default risks for LLC and thus created a risk of bankruptcy.

Toward the end of 2008, LLC fell out of compliance with several covenants in the senior debt loan documents, including the minimum-net-worth requirement and the maximum-debt-to-equity ratio. This triggered a default, and motivated LLC to negotiate with the senior lender to waive or modify the covenants on the senior debt.

During 2008, LLC’s owners and management considered bankruptcy as a possibility given LLC’s continued financial deterioration. In addition, several project debt lenders stopped funding loans, halting construction at some projects. Finally, in late 2008, Family decided that they would not make any additional contributions to LLC given its substantial debt burden.

Debt Conversion

In December 2008, Holdings contributed the subordinate debt to LLC in exchange for a preferred equity interest in LLC. This debt-to-equity conversion allowed LLC to shed debt from its balance sheet and add net worth to its GAAP financial statements. As a result, LLC reported a net worth of approximately $34.5 million on its audited financial statements as of the end of 2008, which allowed LLC to comply with its minimum net-worth covenants.

The parties to the conversion intended that Holdings’ priority of payment on the converted equity interest vis-a-vis LLC’s preexisting members “mirror” the previous subordinate debt position – meaning that Holdings would be entitled to a return of the principal of $65 million, and a cumulative preferred return, before any other members, including Taxpayer, were entitled to distributions in liquidation or otherwise.

After the debt-to-equity conversion, and consistent with the foregoing arrangement, LLC’s operating agreement was amended to provide that all distributions would be made to Holdings until such time as it received its preferred equity interest and accrued cumulative preferred return, and that Taxpayer would not be entitled to any distributions in respect of its capital contributions until such time.

LLC’s 2008 and 2009 annual reports stated that Holdings, on account of its preferred interest, “has a liquidation preference of $65.1 million plus accrued but unpaid cumulative preference return.” At the end of 2009, LLC owed $70 million of senior debt accruing interest at 9.5% per annum, and Holdings had a preferred interest and accrued but unpaid cumulative preferred return that totaled $71.2 million.

In its report for 2008, LLC’s independent auditor reported that LLC incurred operating losses in 2008, was not in compliance with certain financial covenants related to its indebtedness, and certain of its debt matured in 2009. “These matters,” the reports concluded, “raise substantial doubt about [LLC’s] ability to continue as a going concern.” The audited financial statements were included in LLC’s annual report that was shared with its lenders.


The home building and real estate market worsened considerably in early 2009. Even after LLC’s debt-to-equity conversion, the continued decline in property values prompted lenders to issue notices of default and/or demands for loan repayment to many of LLC’s project entities and the SCEs.

LLC was unsuccessful in negotiating a “friendly foreclosure” with one project lender, who initiated foreclosure in 2009, and the proceeds from the sale of property were insufficient to pay off the debt, leaving a large deficiency. Following foreclosure, the lender pursued the SCEs, as guarantors, for the deficiency. The lender did not seek to attach or otherwise recover and sell Taxpayer’s partnership interest in LLC. After an audit and extensive negotiations, LLC agreed in early 2010 to a $2 million settlement on the deficiency in exchange for the release of the SCEs from their guaranties.

Around 2008, because of the amount and status of LLC’s project-level debt, the Senior Lender became concerned about its ability to collect on the senior debt. The Senior Lender recorded impairment charges with respect to LLC’s senior debt in 2008 and 2009 that together totaled 40-percent. In May 2009, LLC and the Senior Lender amended the terms of the senior debt, changing the maturity date, interest rates, principal payment dates, and certain covenants.

LLC’s cash flow forecasts throughout 2009 reflected its continued financial deterioration.[xx] LLC also prepared a liquidation analysis in 2009, which showed that if LLC were to liquidate completely in 2009 – as an alternative to a gradual wind-down over several years – it would have only $51.6 million to pay approximately $70 million in outstanding senior debt.

On the basis of these financial projections, LLC’s executive committee and managing board concluded that LLC could not fully repay its senior debt and project debt under the terms of their respective loan documents. Moreover, they determined that Holdings would not recover the full amount of its preferred equity interest upon liquidation,[xxi] and Taxpayer would not receive anything with respect to its interest.

LLC’s continued attempts to secure additional funding during 2009 failed. Ultimately, by the end of 2009, LLC’s owners decided to wind down the entity. On the basis of its December 2009 cash flow forecast, LLC believed it could sell all of its assets in an orderly manner by the end of 2014. LLC’s owners believed that an orderly liquidation over five years would be more beneficial to its lenders than a complete sell-off of its assets over a shorter timeframe.

On its 2009 audited consolidated statements of operations, LLC reported a net loss of $39 million for the 2009 tax year. It reported assets of $331 million, liabilities of $269 million and members’ equity of $62.8 million as of December 31, 2009.[xxii]

Taxpayer’s Income Tax Returns

Taxpayer filed Form 1065, U.S. Return of Partnership Income, for the 2009 tax year. This return reported an ordinary loss of $41.5 million, which the attached Form 4797, Sales of Business Property, explained was attributable to the worthlessness of Taxpayer’s investment in LLC.

Taxpayer issued to each of its members a Schedule K-1, Partner’s Share of Income, Deductions, Credits, etc., for the 2009 tax year, which its members reported on their 2009 income tax returns.

Although the IRS agreed that the character of the loss attributable to a “worthless” interest in LLC would be ordinary, the IRS disagreed that Taxpayer was entitled to a deduction with respect to such loss in 2009. Taxpayer petitioned the U.S. Tax Court for relief.

The Tax Court

The parties agreed that Taxpayer had an adjusted basis of almost $41.5 million in its LLC partnership interest as of the time of the claimed worthlessness in 2009. Therefore, the issue for the Court was whether Taxpayer could deduct the reported loss for 2009; specifically, whether the partnership interest became worthless in 2009.

The Court observed that whether a partnership interest is worthless was a question of fact. The statute’s “general requirement that losses be deducted in the year in which they are sustained calls for a practical, not a legal, test,” it stated.[xxiii]

The Requirements[xxiv]

To prove entitlement to a Section 165(a) loss deduction for worthless property, the Court explained, a taxpayer must demonstrate its “subjective determination of worthlessness in a given year, coupled with a showing that in such year the property in question is in fact essentially valueless.”

The requirement that an asset be “essentially” valueless, the Court continued, demonstrates “the de minimis rule that the taxpayer does not have to prove that a given asset is absolutely, positively without any value whatsoever.”

But, “while a taxpayer need not be ‘an incorrigible optimist in his determination of when property becomes worthless, a mere decline, diminution, or shrinkage in value is not sufficient to establish a loss.’”

In sum, the Court had to determine whether Taxpayer subjectively determined that its partnership interest in LLC was worthless in 2009 and whether objective factors confirmed that the interest became essentially valueless in that year.

Subjective Determination

The Court first considered whether Taxpayer had subjectively determined that its partnership interest in LLC was worthless in 2009. According to the Court, the subjective determination of a taxpayer, while not conclusive, is entitled to great weight.

The Court concluded that Taxpayer had subjectively determined that its partnership interest in LLC was worthless by the end of 2009. First, Taxpayer took the position on its tax return that the partnership interest was worthless in 2009.

Second, the owners and management of Taxpayer and LLCs testified credibly at trial that they believed Taxpayer’s interest became worthless in 2009. They based their belief, in part, on the dramatic and devastating impact of the financial crisis that began in 2007, LLC’s consistent operating losses in the years leading up to and including 2009, the subordinate position of Taxpayer’s partnership interest to Holdings, and the overwhelming debt burden of LLC and its project entities.

LLC’s owners and management took into account LLC’s deteriorating cash flow projections during 2009. Those projections showed that LLC would be unable to satisfy financial obligations owed to the Senior Lender, the subordinate lender, or the project debt lenders.

Ultimately, Family decided to wind down LLC in an orderly manner to maximize value for the creditors. These facts supported the conclusion that Taxpayer subjectively believed its partnership interest in LLC became worthless in 2009.

Objective Determination

The Court next considered whether objective indicia confirmed an absence of substantial value in LLC in 2009. It set forth the principles for determining worthlessness in the context of equity interests as follows:

The ultimate value of stock, and conversely its worthlessness, will depend not only on its current liquidating value, but also on what value it may acquire in the future through the foreseeable operations of the corporation. Both factors of value must be wiped out before we can definitely fix the loss. If the assets of the corporation exceed its liabilities, the stock has a liquidating value. If its assets are less than its liabilities but there is a reasonable hope and expectation that the assets will exceed the liabilities of the corporation in the future, its stock, while having no liquidating value, has a potential value and cannot be said to be worthless. The loss of potential value, if it exists, can be established ordinarily with satisfaction only by some “identifiable event” in the corporation’s life which puts an end to such hope and expectation.

There are, however, exceptional cases where the liabilities of a corporation are so greatly in excess of its assets and the nature of its assets and business is such that there is no reasonable hope and expectation that a continuation of the business will result in any profit to its stockholders. In such cases the stock, obviously, has no liquidating value, and since the limits of the corporation’s future are fixed, the stock, likewise, can presently be said to have no potential value. Where both these factors are established, the occurrence in a later year of an “identifiable event” in the corporation’s life, such as liquidation or receivership, will not, therefore, determine the worthlessness of the stock, for already “its value had become finally extinct.”

Thus, in determining whether Taxpayer’s partnership interest in LLC was objectively worthless, the Court considered whether, in 2009, Taxpayer’s partnership interest ceased to have liquidating value and potential future value.

Taxpayer asserted that Taxpayer’s partnership interest in LLC lacked both “liquidating value” and “potential value” by the end of 2009. Pointing to the priority of the project debt, the senior debt, and Holdings’ preferred interest, Taxpayer argued that its partnership interest was “hopelessly underwater” in 2009; all evidence indicated that it was extremely unlikely it would ever recover any value; and a set of “identifiable events” occurred in 2009 that demonstrated the worthlessness of the interest.

The IRS argued that the test for worthlessness was not satisfied, stating that the evidence showed only that LLC was “struggling financially” during 2009 and was insufficient to show worthlessness. The IRS also argued that Taxpayer had failed to show that “all possibilities of eventual profit had ‘effectively been destroyed.’”

Liquidation Value

A taxpayer claiming a worthlessness loss deduction must show that its equity interest ceased to have liquidating value during the year in issue. Generally this may be shown by an authoritative balance sheet showing liabilities in excess of assets, leaving no value for equity holders. The Court noted, however, that balance sheet insolvency at the entity level is not necessarily required when preferred equity interests are involved. A subordinate equity interest may become worthless if the company cannot satisfy a senior equity interest holder’s preferential claim in liquidation.

The Court was convinced that Taxpayer would have received nothing in liquidation of its partnership interest had LLC liquidated at the end of 2009. LLC projected that it could generate only $51.6 million were it to force a disposition of all projects by the end of 2009 and immediately pay down the project debt to the extent possible. And the evidence regarding market conditions suggested that this projection may have been optimistic. As of the end of 2009, many project entities were still years away from fully developing their projects, and the real estate market in the project markets was severely depressed as a result of the subprime mortgage crisis. Because an immediate fire sale in these conditions could have been catastrophic, LLC chose to wind down over five years.

At any rate, Taxpayer presented sufficient evidence to support the conclusion that the $51.6 million in proceeds that LLC could generate in a hypothetical 2009 liquidation would fall short of satisfying the $70 million in outstanding senior debt. The Senior Lender agreed that the senior debt would not be fully repaid if there was a 2009 liquidation. And at that time, Holdings’ preferred interest and preferred return, which also were senior to Taxpayer’s partnership interest, exceeded $71 million. Thus, the evidence showed that Taxpayer’s partnership interest in LLC was “under water” by a substantial margin in 2009, sitting behind both the senior debt and Holdings’ preferred interest.

The fact that LLC’s balance sheet for the year ending December 31, 2009, indicated that LLC was solvent did not change the Court’s conclusion that Taxpayer’s now-junior partnership interest in LLC had no value on liquidation.

LLC reported assets[xxv] in excess of its liabilities at the end of 2009. But as of the end of 2009, Holdings’ preferred interest and accrued preferred return exceeded members’ equity by nearly $8.5 million. And Holdings would have been entitled to its preferred interest and preferred return before Taxpayer received any liquidating distributions on account of its junior interest.

The Court recognized and gave effect to the junior status of Taxpayer’s interest. Because LLC’s balance sheet indicated that the value of its assets were insufficient to pay off all of LLC’s liabilities and Holdings’ preferred interest and accrued preferred return as of the end of 2009, it supported the conclusion that Taxpayer’s interest had no liquidating value.

In short, none of the IRS’s arguments could overcome the fact that Taxpayer held an interest that was junior to both a $70 million senior debt obligation and a preferred interest with an accrued preferred return that exceeded $71 million. And all of the economic data available to LLC, Taxpayer, and other financial players indicated that, under various scenarios, Taxpayer would recover nothing for its interest.

Potential Value

Having determined that Taxpayer’s partnership interest in LLC had no liquidating value by the end of 2009, the Court next considered whether LLC also lacked potential future value at that time. An equity interest has potential future value, the Court stated, when, despite the lack of liquidating value, there is still a “reasonable hope and expectation that [the interest] will become valuable at some future time.”

The hope and expectation that an equity interest may become valuable in the future can be foreclosed when certain “identifiable events” occur in a company’s life that effectively destroy the potential value. An “identifiable event” is “an incident or occurrence that points to or indicates a loss – an evidence of a loss.”

Identifiable events include, for example, bankruptcy, the cessation of business, liquidation, or the appointment of a receiver. In some instances, a taxpayer can demonstrate that its equity interest does not have potential future value, even in the absence of an identifiable event, if the company becomes hopelessly insolvent.

Taxpayer argued that its partnership interest in LLC no longer had potential future value in 2009, citing a combination of identifiable events. Taxpayer also argued that worthlessness was established because its partnership interest became “hopelessly insolvent” in 2009.

The Court agreed that that several identifiable events confirmed that Taxpayer’s partnership interest in LLC lacked any potential future value by the end of 2009.

First, the financial crisis and resulting recession beginning in 2007 and continuing in 2009 had a devastating impact on the residential housing markets in which LLC’s projects were being developed. LLC’s revenue decreased significantly from 2005 to 2009. LLC recorded impairment losses beginning in 2007, some project lenders stopped funding loans, and LLC was unsuccessful in attracting additional equity investment. These events, the Court stated, caused LLC to struggle to comply with its various financial covenants under the senior debt and project debt loan documents. Thus, the Court concluded that the severe recession caused by the subprime mortgage crisis that adversely affected the potential future value of Companies and its projects was an identifiable event.

Second, the audited financial statements depicted LLC’s dire financial condition in 2008 and 2009. The auditors doubted LLC’s ability to function as a going concern, and its audited financial statements reflected continued large operating losses. These “red flags” for management and lenders also were illustrative of how the cumulative events affecting LLC and its project entities “fixed” the loss of Taxpayer’s investment in LLC by the end of 2009.

Third, LLC’s cash flow forecasts reflected a significant decline in expected cash flow from operations and supported a conclusion that Taxpayer’s junior partnership interest had no potential future value by the end of 2009. As the real estate market deteriorated and Companies’ financial condition worsened, cash flow projections predictably became more pessimistic. The December 2009 forecast projected that LLC would not generate sufficient cash during its wind-down to make required principal payments on the senior debt in 2012 and 2013. The Court, therefore, concluded that the December 2009 cash flow forecast was another identifiable event indicating to Taxpayer that its junior partnership interest had lost any potential future value.

Fourth, the Court found that LLC’s decision in 2009 to wind down the entity over five years was an identifiable event fixing Taxpayer’s loss. Because Taxpayer and the SCEs remained guarantors of the project debt, they had an interest in maximizing asset values for the benefit of creditors. An immediate liquidation would have meant a fire sale of unfinished real estate projects in a very unfavorable market – a disaster scenario for these guarantors.

The IRS, however, also argued that LLC’s continued operations during 2009 and the wind-down period indicated that Taxpayer’s partnership interest must have had some potential future value.

Again, the Court disagreed. The continued operation of a company beyond the year of claimed worthlessness, the Court stated, did not itself prove future value in its equity interests. In cases involving continued operation of a company beyond the year of claimed worthlessness, the Court stated that its examination centers around whether the activities pursued during and after the year of claimed worthlessness were in the nature of an attempt to salvage something for creditors, or whether such activities were so related to a continuation of general operations that they manifest reasonable expectations of future value in the equity.

In this case, the Court continued, LLC’s operations during the wind-down were aimed at maximizing value for the project debt lenders and the senior lender. In sum, the end of LLC was inevitable in 2009 when its owners decided to wind down and that decision finally destroyed any expectation that Taxpayer might recover any value on account of its junior partnership interest.

Lastly, the 2009 defaults on project debt and subsequent foreclosures supported a finding of worthlessness in 2009. Indeed, the Senior Lender could have decided to declare a default on the senior debt because of cross-default provisions at that time. And as noted above, immediate payment of the senior debt would have left nothing for Taxpayer.

The Court found that these identifiable events together confirmed that the likelihood of potential future value was minimal.[xxvi]

With that, the Court concluded that Taxpayer properly reported a Section 165(a) loss for its worthless partnership interest in LLC in 2009.[xxvii]

Final Word

Apologies – I recognize that this a long post. And on the day before New Year’s Eve, whatever that may signify.

As always, the point is for the taxpayer to be attuned to the potential for a tax benefit in every business or investment situation, including one that may not be going well, as in the case described above.

Once the opportunity is identified, it is imperative that the taxpayer start to “develop their narrative” and “prepare the record” as contemporaneously[xxviii] and as completely as possible, keeping in mind not only the substantive requirements for claiming the benefit, but also the lines of attack that the IRS is likely to pursue.

[i] Aaron Rodgers.

[ii] In fact, there are some looking to close year-end transactions, of which I am especially fond. I ask you, how can one resist a “Bah Humbug” under those circumstances?

[iii] IRC Sec. 179.

[iv] IRC Sec. 1222. As always, do not dispose of an economically sound investment just to realize an ephemeral tax benefit. See also the “wash sale” rules under IRC Sec. 1091 – just in case you had that thought.

[v] MCM Investment Management, LLC v. Comm’r, T.C. Memo. 2019-158.

[vi] Which was actually an LLC, treated as a partnership for tax purposes. Reg. Sec. 301.7701-3.

[vii] Think about it. say the return for 2009 was filed on extension in late 2010. The tax Court’s decision was issued in December 2019. Query, did the taxpayer make a “deposit” (as opposed to a payment that would remove the case from the Court’s jurisdiction) to stop the accrual of deficiency interest?

[viii] IRC Sec. 165(a).

[ix] Reg. Sec. 1.165-1(b).

[x] Reg. Sec. 1.165-1(c).

[xi] Reg. Sec. 1.165-1(d).

[xii] See, e.g., Rev. Rul. 93-80.

[xiii] This may be helpful: https://www.taxlawforchb.com/2017/07/abandonment-of-a-partnership-interest-or-when-a-taxpayer-rejects-its-tax-return-position/

[xiv] IRC Sec. 731, Sec. 741, Sec. 752.

[xv] The debt was secured by LLC’ assets, including pledges of an economic interest in each of LLC’s project subsidiaries.

Unless stated otherwise, all the lenders described herein were unrelated to Family and Taxpayer.

[xvi] The subordinate debt instrument required quarterly interest payments through March 2015, and would mature in March 2035.

[xvii] Thus, a default on senior debt constituted a default on project debt, and a default of at least $10 million on project debt (either on a single loan or in the aggregate) constituted a default on senior debt.

[xviii] LLC’s project-level business plans were an important input in its cash flow forecasts. They were a required attachment to operating agreements entered into with joint venture partners and were updated regularly.

[xix] Very basically, a reduction in the goodwill of the business.

[xx] The January 2009 cash flow forecast showed that LLC could achieve an ending cash balance of almost $63.7 million if it were able to wind down all projects successfully through 2016 and pay its debt. LLC lost or terminated certain projects during the year, and the wind-down period for cash flow projections was reduced to five years.

LLC updated its cash flow forecast in December 2009. That forecast projected that LLC would have an ending cash balance of $12.3 million if it could wind down by the end of 2014 and pay off the senior debt. While LLC projected that it could achieve this positive cash balance by the end of the wind-down, it also projected that it would have a cash shortfall during the wind-down period in both 2012 and 2013.

Under the terms of the senior debt loan documents, LLC was required to make $32 million of principal payments in 2012, and approximately $30 million of principal payments in 2013, when the loan matured. But the December 2009 cash flow forecast showed that LLC would not have sufficient cash in 2012 and 2013 to make these required principal payments timely and cash shortfalls of approximately $14 million in 2012 and $7.4 million in 2013 would result.

[xxi] Holdings’ preferred equity interest and accrued cumulative preferred return would have exceeded $111 million by the end of the wind-down period in 2014.

[xxii] It reported operating revenue of $255 million for 2009, down from approximately $824 million in 2005 before the financial crisis. And according to LLC’s 2010 audited consolidated statements of operations, LLC’s operating revenue in 2010 was $162 million, or approximately 35-percent lower than in 2009.

[xxiii] Now do you see why all those facts, above, were included?

[xxiv] Interestingly, there is little discussion in the opinion regarding the possibility that LLC may have become worthless before 2009. I would have expected a more treatment of this point. After all, it is implicit in the requirement that an investment became worthless during a tax year that it had value at the beginning of such year.

[xxv] As a going concern.

[xxvi] The Court noted that the test for worthlessness is a “practical, not a legal, test”, and that taxpayers should not be held to “hard and fast technical rules” in determining the precise time in which their loss occurred. And while some identifiable event must occur in the year of the loss, which may be a single event or a series of events, the presence of identifiable events in earlier years is not “decisive upon the question of the worthlessness of stock where the evidence also establishes the existence of a potential value which may be realized on liquidation or through continuation of business.”

[xxvii] The IRS also argued that Taxpayer had not shown that its partnership interest in LLC was worthless because Taxpayer did not call an expert witness. In the IRS’s view, determining whether Taxpayer’s partnership interest had liquidating value or potential future value required expert valuation. Expert testimony can be helpful, the Court conceded, and it may be an important consideration in some cases. But the Court added that expert testimony was not necessary to show worthlessness for purposes of section 165. Moreover, the IRS did not cite any authority holding that expert valuation was required to prove worthlessness under section 165.  To the contrary, the Court stated that “the taxpayer need not be forced to hire valuation experts where, as here, his own testimony is credible and founded upon reasonable factual premises.”

[xxviii] Not on the final weekend of the final month of the final year of the decade.

Water, Water Everywhere, Nor Any Drop to Drink[i]

At the beginning of every week, after posting that week’s article, I start to think about a topic for the next post. There are times when I struggle to find something that may be appealing in and of itself, or that may, perhaps, provide a vehicle through which a broader “tax lesson” may be conveyed.

Recent IRS pronouncements are usually the best place to search. They come in many different varieties, from revenue rulings to letter rulings, from revenue procedures to notices, from proposed regulations to final regulations.[ii] Then there are decisions of the Tax Court and of the Federal Courts of Appeals. Finally, there may be proposed legislation, as well as recently enacted statutes.[iii]

The tax practitioner has to keep abreast of as many of the foregoing developments as is humanly possible. Given the sheer volume of material, one may wonder, “How can there ever be a shortage of interesting” – dare I say, fascinating – “things to write about?” You’d be surprised.[iv]

Sometimes, during a moment of inspirational lapse, Fortuna[v] will intercede and another tax professional will contact me for a proverbial “gut check” on an issue that turns out to be pretty interesting. That’s what happened at the end of last week when a friend of mine called with the following question:[vi]

Will the holder of a profits interest[vii] in a partnership that owns stock in a qualifying small business corporation be entitled to exclude their share of the gain from the partnership’s sale of such stock?

Hmm. Before considering this inquiry, let’s review the basic tax treatment for a profits interest in a partnership and for stock in a small business corporation.

The Carried Interest

A carried, or profits, interest in a partnership is issued to a service provider in respect of services rendered or to be rendered to the partnership.

In general, the profits interest entitles the holder to a share[viii] of future profits from the partnership and to a share of the appreciation in value[ix] of the partnership occurring after the issuance of the interest to the service partner. It does not provide a current right to share in the proceeds upon the liquidation of the partnership immediately after the issuance of the interest; thus, the profits interest has no liquidation value at that time.[x]

In 1993, the IRS issued guidance that it generally would not treat the receipt of a partnership profits interest for services as a taxable event either for the issuing partnership or for the recipient service partner.[xi] However, this treatment would not apply if: (1) the profits interest relates to a substantially certain and predictable stream of income from partnership assets; (2) within two years of receipt, the partner disposes of the profits interest; or (3) the profits interest is a limited partnership interest in a publicly traded partnership.

More recent guidance clarified that this treatment applies with respect to a substantially unvested profits interest,[xii] provided the service partner takes into income their distributive share of partnership income, and the partnership does not deduct any amount, either on grant or on vesting of the profits interest.[xiii]

By contrast, a partnership capital interest received for services is includable in the recipient partner’s income under generally applicable rules relating to the receipt of property for the performance of services.[xiv] A partnership capital interest for this purpose is an interest that would entitle the recipient partner to a share of the proceeds if, immediately after the issuance of the interest, the partnership’s assets were sold at fair market value and the proceeds were distributed in liquidation.[xv]

Regardless of the nature of the interest issued to the service-providing partner, the partnership is not, itself, subject to Federal income tax.[xvi] Instead, its items of income, gain, deduction or loss of the partnership retain their character and flow through to the partners, who must include such items on their tax returns (whether or not actually distributed) as if the items were realized directly by the partners.[xvii] Thus, for example, long-term capital gain realized by the partnership on a sale of property is treated as long-term capital gain in the hands of the partners.

Qualified Small Business Stock

A non-corporate taxpayer who holds “qualified small business stock” for more than five years may exclude from their gross income the gain realized by the taxpayer from their disposition of such stock (“eligible gain”).[xviii]

The excluded gain will not be subject to either the income tax or the surtax on net investment income; nor will the excluded gain be added back as a preference item for purposes of determining the taxpayer’s alternative minimum taxable income.

That being said, the amount of gain from the disposition of stock of a qualified corporation that is eligible for this exclusion cannot exceed the greater of:

  1. $10 million, reduced by the aggregate amount of eligible gain excluded from gross income by the taxpayer in prior taxable years and attributable to the disposition of stock issued by such corporation, or
  2. Ten (10) times the aggregate adjusted bases of qualified small business stock issued by such corporation and disposed of by the taxpayer during the taxable year (the “$10 million/10 times basis” limitation rule).[xix]

This limitation notwithstanding, where the provision applies, a qualifying taxpayer may exclude a significant amount of gain from their gross income.[xx]

In order for a non-corporate taxpayer’s gains from the disposition of their shares in a corporation to qualify for the exclusion, the shares in the corporation had to have been acquired after December 31, 1992.

What’s more, with limited exceptions, the shares must have been acquired directly from the corporation – an original issuance – in exchange for money or other property, or as compensation for services provided to the corporation.

If property, other than money, is transferred to a corporation in exchange for its stock, the basis of the stock received is treated as not less than the fair market value of the property exchanged.[xxi] Thus, only gains that accrue after the original issuance of the shares are eligible for the exclusion.

The issuing corporation must be a qualified small business as of the date of issuance of the stock to the taxpayer and during substantially all of the period that the taxpayer holds the stock.

In general, a “qualified small business” is a domestic C corporation that satisfies an “active business” requirement, and that does not own: (i) real property the value of which exceeds 10-percent of the value of its total assets, unless the real property is used in the active conduct of a “qualified trade or business,” or (ii) portfolio stock or securities (i.e., not from subsidiaries) the value of which exceeds 10-percent of its total assets in excess of liabilities.[xxii]

What’s more, at least 80-percent of the corporation’s assets,[xxiii] including intangible assets, must be used by the corporation in the active conduct of one or more qualified trades or businesses.[xxiv]

Assets that are held to meet reasonable working capital needs of the corporation, or that are held for investment and are reasonably expected to be used within two years to finance future research and experimentation, are treated as used in the active conduct of a trade or business.

A “qualified trade or business” is any trade or business, other than those involving the performance of services in the fields of health, law, engineering, architecture, accounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage services, or any other trade or business where the principal asset of the trade or business is the reputation or skill of one or more of its employees.[xxv]

As of the date of issuance of the taxpayer’s stock, the excess of (i) the corporation’s gross assets (i.e., the sum of the cash and the aggregate adjusted bases of other property held by the corporation), without subtracting the corporation’s short-term indebtedness, over (ii) the aggregate amount of indebtedness of the corporation that does not have an original maturity date of more than one year, cannot exceed $50 million.[xxvi]

If a corporation satisfies the gross assets test as of the date of issuance, but subsequently exceeds the $50 million threshold, stock that otherwise constitutes qualified small business stock would not lose that characterization solely as a result of that subsequent event, but the corporation can never again issue stock that would qualify for the exclusion.

Where the foregoing requirements are satisfied, the exclusion rule will apply to the non-corporate taxpayer’s disposition of stock in the qualified small business.

Obviously, this covers a sale by the shareholders of all of the issued and outstanding shares of the corporation, subject to the limitations described above. It should also cover the liquidation of a C corporation and its stock following the sale of its assets to a third party; in that case, the double taxation that normally accompanies the sale of assets by a C corporation may be substantially reduced.

Partnership as Shareholder of Qualified Small Business

A non-corporate partner’s allocable share of the gain from a partnership’s disposition of qualified small business stock is eligible for the exclusion, provided that (i) all the eligibility requirements with respect to qualified small business stock are met, (ii) the stock was held by the partnership for more than five years, and (iii) the partner held their partnership interest on the date the partnership acquired the stock from the corporation and at all times thereafter before the partnership’s disposition of the stock.[xxvii]

The amount of gain allocated to a partner – from a partnership’s disposition of stock in a qualified small business – that may be excluded from gross income may be limited by the “$10 million/10 times basis” limitation rule. Each partner applies this rule separately to their share of the partnership’s gain, using their proportionate share of the partnership’s adjusted basis for the stock disposed of.[xxviii]

In addition, a partner cannot exclude any gain allocated to them from the partnership based on their current percentage interest in the partnership to the extent the amount of such gain exceeds the amount that would have been allocated to them based on their percentage interest in the partnership at the time the partnership acquired the stock.[xxix] In other words, a partner can’t increase their share of the excludible gain after the original issuance of the stock.

Partnership Carried Interest

How, then, does the exclusion of gain from a partnership’s sale of stock in a qualified small business apply to a partner who holds a profits interest in a partnership when the partnership disposes of such stock?[xxx]

Well, it is clear that the profits interest will have to have been issued to the service partner prior to the partnership’s acquisition of stock in the corporation if any portion of the partnership’s subsequent gain from the sale of such stock is to be allocated to the profits interest holder.[xxxi]

It is also clear that the profits interest holder will have to apply the “$10 million/10 times basis” limitation rule to their allocable share of the partnership’s gain from the disposition of its shares in the qualified small business.

What is not entirely clear is how the holder’s percentage interest in the partnership’s assets or capital is determined for this purpose. After all, the holder of the profits interest participates only in the appreciation in value of the partnership – i.e., in the gain that accrues after the issuance of the profits interest; they do not begin to share in such gain until those who were “capital partners” as of the date the profits interest was issued are allocated an amount equal to the gain that was inherent in the partnership as of such date.

Does it matter, then, whether this “threshold gain” has already been allocated to the other partners by the time the stock in the qualified small business has been issued to the partnership by the corporation? It may.

Specifically, it is possible that the profits interest holder will be treated as having a capital interest percentage of zero at the time the stock is issued to the partnership if the above threshold allocation of gain has not yet been completed. Recall also that a partner cannot increase their share of the excludible gain from the sale of such stock after the original issuance of the stock. Thus, it is possible no part of the gain allocated to the interest holder will be excludible.

In contrast, if the threshold gain has already been allocated to the other partners prior to the partnership’s acquisition of the qualified small business stock, then the holder of the profits interest will be treated as having an interest in the partnership’s capital gains at that time, which may enable them to exclude from their gross income at least a portion of the gain from the sale of such stock.

Both positions have their merits, but it is not for us to decide. “Washington, are you listening?”

[i] From The Rime of the Ancient Mariner, by Samuel Taylor Coleridge.

[ii] And let’s not forget GCMs, CCAs, FSAs, etc.

[iii] Witness the amount of material provided by the Tax Cuts and Job Act (P.L. 115-97; the Act).

[iv] Or maybe it’s just me.

[v] The Roman goddess of fortune or luck.

[vi] Thanks Pat.

[vii] Also known as a carried interest or a “promote” interest. This endnote was not part of Pat’s question.

[viii] Based upon a stated percentage.

[ix] The partners will usually determine the value of the partnership as of the grant date so as to establish the base or starting point from which to measure any appreciation in value of the partnership.

[x] The partner starts off with a zero capital account, which is why the issuance of the profits interest is not treated as a taxable event to the recipient partner where the interest is vested in the partner.

In the case of an unvested interest, most tax practitioners will advise the recipient service partner of a profits interest to make an election under IRC Sec. 83(b) so as to cut off the compensatory element as of the grant date, when the interest has zero value.

In addition, and consistent with the foregoing approach, they will advise that the partnership adjust the partners’ capital accounts to ensure that no part of the partnership’s value may be distributed to the holder of the profits interest. A “reverse 704(c)” allocation.

[xi] Rev. Proc. 93-27.

[xii] Within the meaning of IRC Sec. 83.

[xiii] Rev. Proc. 2001-43.

See also the “safe harbor” under the proposed regulations under IRC Sec. 83: Prop. Reg. Sec. 1.83-3(l), which would treat the fair market value of a carried interest as being equal to its liquidation value; REG-105346-03; and Notice 2005-43.

[xiv] IRC Sec. 83.

[xv] In other words, the partner starts off with a positive capital account.

[xvi] IRC Sec. 701.

[xvii] IRC Sec. 702.

[xviii] IRC Sec. 1202. See also https://www.taxlawforchb.com/2019/05/is-timing-everything-only-time-will-tell-small-business-stock-and-the-reduced-corporate-tax-rate. (Yes, shameless self-promotion.)

[xix] IRC Sec. 1202(b).

[xx] Moreover, any amount of gain in excess of the limitation would still qualify for the favorable federal capital gain tax rate, though it will be subject to the surtax.

[xxi] IRC Sec. 1202(d)(2)(B).

[xxii] IRC Sec. 1202(c).

[xxiii] By value.

[xxiv] IRC Sec. 1202(e).

[xxv] The term also excludes any banking, insurance, leasing, financing, investing, or similar business, any farming business, any business involving the production or extraction of products of a character for which depletion is allowable, or any business of operating a hotel, motel, restaurant or similar business.

[xxvi] For this purpose, amounts received in the issuance of stock are taken into account.

In the case of a corporation that owns at least 50-percent of the vote or value of a subsidiary, the parent corporation is deemed to own its ratable share of the subsidiary’s assets and to be liable for its ratable share of the subsidiary’s indebtedness, for purposes of the qualified corporation, active business, and gross assets tests.

[xxvii] IRC Sec. 1202(g).

Gain from the partnership’s sale or exchange of qualified small business (QSB) stock that is eligible for the section 1202 exclusion is reported on Line 11 of the Sch. K-1 issued to the partners. Each partner will determine if they qualify for the exclusion. A statement should be attached to Schedule K-1 that reports (a) the name of the corporation that issued the QSB stock, (b) the partner’s share of the partnership’s adjusted basis and sales price of the QSB stock, and (c) the dates the QSB stock was bought and sold.

[xxviii] IRC Sec. 1202(g)(1)(B).

[xxix] IRC Sec. 1202(g)(3).

[xxx] This is different from the question of whether the holder of a profits interest – who did not incur a tax liability on the receipt of their interest, and who made no capital contribution to the partnership that may have found its way as a capital contribution to the corporation – should benefit from the exclusion rule of IRC Sec. 1202.

[xxxi] Because of the requirement under IRC Sec. 1202(g) that the partnership must have held stock in the qualified corporation for more than five years, plus the requirement that the partner (including the holder or a profits interest) must have held their partnership interest on the date the partnership acquired the stock from the corporation and at all times thereafter before the partnership’s disposition of the stock, there is no need to discuss the three-year holding for profits interests introduced by the Act as new IRC Sec. 1061.


A couple of years ago, this blog carried an article that briefly considered whether the gain realized by a taxpayer on the sale of a contract should be treated as ordinary income or capital gain for tax purposes.[i]

As it turned out, that piece has been one of the most popular articles that we have posted, and it has generated a number of inquiries, especially regarding the assignment of contracts that require the performance of a service by the assigning party (the “Contracts” and the “Assignor,” respectively) for the other party to the Contract.

Contract to Provide Services

It is obvious, if the Assignor does not sell the Contracts and, in accordance with their terms, continues to provide the agreed-upon services in exchange for the agreed-upon fee, that such fee will be reported on the Assignor’s tax return as ordinary income – compensation for services rendered.[ii]

It is equally clear, if the Assignor were to sell the Contracts in exchange for an amount equal to the present value of the fees payable under the Contracts, that the Assignor should treat the gain realized from the sale as ordinary income on their tax return.

In the case of such a payment – one made in lieu of future ordinary income payments – the taxpayer is merely converting future income into present income; they are accelerating the receipt of the ordinary income.[iii]

It may become more challenging to determine the nature of the gain arising from the assignment[iv] of the Contracts when the facts and circumstances of the assignment deviate from the straightforward scenario described above.

We begin our analysis by highlighting some of the factors I typically consider in determining the ordinary versus capital nature of the gain realized on the assignment of a Contract, which are derived in large part from those relied upon by the Courts.

Factors to Consider

Among the factors to consider are the following: the number of Contracts assigned, the number of service recipients to which such Contracts relate, the fraction of the Assignor’s overall business activity that the Contracts represent, the excess of the amount of consideration paid – including the assumption by the buyer-assignee of any liabilities of the Assignor beyond the performance of the services called for under the Contracts – over the present value of the compensation payable under the Contracts.[v]

The greater the magnitude of each of these factors, the greater the likelihood that at least a portion of the gain realized by the Assignor will be treated as capital gain.

In the end, it comes down to the nature of what is being transferred: (i) an opportunity to earn income by furnishing a specified service pursuant to a Contract, or (ii) part of a business or going concern that extends beyond the Contracts themselves? If the former, the resulting gain should constitute ordinary income; if the latter, at least part of the gain should be treated as capital gain.

This distinction may be supported by the facts and circumstances surrounding the transfer of the Contracts. Thus, additional support for capital gain treatment – specifically, for the transfer of a going concern or business – may be found if the consideration payable by the buyer in exchange for the Contracts is subject to adjustment downward (a claw-back) or upward (an earn-out), depending upon the revenues generated.[vi]

Similarly, a finding of capital gain would be bolstered if the assignment of the Contracts were attended by the transfer of other assets, including the Assignor’s files or other records pertaining to the service recipients or, more importantly, that portion of the Assignor’s workforce[vii] and independent contractors that services the Contracts. Given the technical nature of certain lines of business, the assignment of the Contracts to a buyer may be meaningless if it were not accompanied by the “assignment” of the skilled service-providers performing under those Contracts,[viii] along with the Assignor’s covenant not to solicit its former employees and not to compete with the buyer for the business of the service-recipient-parties under the Contracts.[ix]

The presence of some combination of the foregoing factors may indicate that the Assignor is transferring something more than the mere right to provide a service in exchange for ordinary compensation.

We will turn next to some of the relevant case law from which most of the foregoing factors have been distilled.

Before doing so, however, let’s review the underlying provisions of the Code that provide the impetus for our discussion; specifically, why does the capital gain versus ordinary income distinction matter?

Applicable Principles

A long-term capital gain is generated when there is a sale or exchange of a capital asset.[x]

A capital asset is defined as “property held by the taxpayer (whether or not connected with [their] trade or business),” subject to several statutory exceptions; for example, the taxpayer’s inventory, and real property or depreciable property used in the taxpayer’s trade or business.[xi]

As indicated above, the definition of a “capital asset” has never been read as broadly as the statutory language may seem to permit because such a reading would encompass items that Congress could not have intended to tax as capital gain, notwithstanding that they are not listed among the above-referenced exceptions to capital asset treatment; specifically, for our purposes, a service provider’s right to be paid for work to be performed in the future.

Thus, the Courts have limited the kinds of property that qualify as capital assets by explaining that not everything that can be called “property” in the ordinary sense, and that is outside the statutory exceptions to the definition of a “capital asset,” qualifies as a capital asset within the meaning of the Code,[xii] and they have developed arguments[xiii] that are intended to defeat attempts by individual taxpayers to “convert” ordinary income into capital gain; relevant to this post, the Courts have generally held that a mere right to receive ordinary income does not rise to the level of a capital asset.[xiv]

If an individual taxpayer were successful in such a conversion, income that would otherwise be subject to federal income tax at a maximum rate of 37-percent,[xv] would instead be taxed at a federal rate of 20-percent.[xvi]

In support of their position, taxpayers have argued that many capital assets are often valued on the basis of the present value of their future income stream. Thus, these taxpayers have asserted, it is possible to take the “substitute for ordinary income” doctrine too far, and to thereby define the term capital asset too narrowly.

The IRS has countered that taxpayers’ argument would result in treating as a capital asset any agreement that calls for services to be rendered in the future in exchange for a fee.

The Courts

Between these two extremes, the Courts have stated that they must make case-by-case judgements as to whether the conversion of income rights into a single payment reflects the sale of a capital asset that produces capital gain, or whether it produces ordinary income.

Unfortunately, the Courts have not always been consistent in their approach to the characterization of proceeds from the sale of contractual rights to earn income.

In one case, for example, the court found that two factors were crucial to its decision that a sale resulted in ordinary income, though it also conceded that these factors may not be dispositive in all cases: there was no underlying investment of capital by the taxpayer in exchange for the receipt of the “property right”, and the sale of the right did not reflect an accretion in value over such investment to any underlying asset held by the taxpayer.[xvii]

That being said, where the transaction at issue is the sale of a personal service contract – the sale of the right to perform personal services – the “substitute for ordinary income” rationale has been used to deny capital gain treatment for the seller, and to tax the proceeds from the sale as ordinary income. In other words, the sale of a contract to provide services to a client results in ordinary income.[xviii]

Some courts, however, have gone beyond this analysis. These courts have asked what the service rights under the contract represent. If they represent the right to earn future income in the form of commissions for services rendered, then the sum received for the transfer of rights is ordinary income.

One court stated that the holder of a right to earn income must do something to earn the income; the mere ownership of the right did not entitle the owner to income; thus, assets that represent the right to earn income should receive capital gain treatment.[xix]

Other courts look to the “components” of the contract to see if any of the rights thereunder are capital assets, as opposed to substitutes for future income.

According to these courts,[xx] the sale of all of the rights, title, obligations and benefits pertaining to a servicing contract, like the sale of any ongoing business, should be “comminuted into its fragments” and the purchase price for the contract should be allocated among the various assets sold. This allocation may, in turn, result in both ordinary income and capital gain, the latter including the seller’s relationship with its clientele; basically, the equivalent of goodwill, which is a capital asset.

However, the line between contractual rights representing capital assets and those representing the right to earn future income is far from clear, and there is the question of whether these two sets of rights are susceptible of separate valuation.

In other words, the taxpayer may be transferring several rights in one transaction, some of which may be characterized as interests in property that constitute capital assets and others which may not.

In one case,[xxi] the seller transferred its entire mortgage servicing business to the buyer. This included agreements, files, contracts, records and licenses that pertained to the business being sold. The seller also agreed not to compete with the buyer. A principal purpose for the buyer’s acquisition of the contracts and the related assets was to develop a relationship with one of the lending institutions being serviced.

The taxpayer argued that, in addition to the contracts, it had sold the going concern value associated with those contracts. The IRS argued that the only item sold was the taxpayer’s right to receive future service fees, so that the gain realized was ordinary income.

The Court recognized that some parts of the “bundle of rights” transferred were capital assets, but it also stated that it would be difficult to allocate the purchase price between the purchase of future income and the purchase of capital assets. However, because the Court was of the view that such an allocation was necessary,

In another decision,[xxii] the buyer-taxpayer became interested in acquiring from the seller the right to service certain mortgage loans. The buyer had no servicing department of its own, but it anticipated starting one by employing a large portion of the seller’s staff. The buyer examined a number of factors before agreeing to the transaction, including, for example, the number of mortgages and their probable remaining service lives. The buyer claimed that it only bought the servicing rights, and sought to amortize the purchase price (its cost) over the remaining service lives of the loans.

The IRS disagreed, asserting that not only did the buyer acquire the servicing rights for the existing mortgages, but also the seller’s rights to service future loans, its goodwill, and its value as a going concern.

The Court considered whether the seller had sold a capital asset in the nature of goodwill, or had sold the rights to future income in the form of servicing contracts. The Court noted that it is possible that the seller sold a combination of both. It discussed the Bisbee decision (see above), quoting from that part of the opinion explaining that some parts of the contractual rights transferred may be capital assets. It noted that the economic realities of the actual transaction were such that the buyer acquired, along with the rights to service existing loans, an opportunity to succeed the seller with respect to servicing future loans. This was a “preferred position,” the Court stated, and represented a business advantage. The fact that the contract made no mention of future loans, the Court continued, did not preclude a finding that part of the consideration was paid for this opportunity. In addition to acquiring the opportunity to service future loans, the buyer also acquired a closely related item: the value of the seller as a going concern. The seller’s personnel were expected, and did, continue to perform the same duties and services as they had for the seller. The fact that the sale agreement did not (and could not) state that the seller’s employees were bound over to the buyer did not detract from the probability that they would join the buyer’s operation – this too formed a part of the going-concern value that was purchased.

Where Does That Leave Us?

Somewhere along the continuum between the sale of a contract to perform services in exchange for a fee, on the one hand, and the sale of an entire business of which the contracts are but a portion of the assets acquired, on the other, lies an area in which a thorough examination of the facts and circumstances will be required in order to determine whether any part of the gain realized on the sale of such contracts may be treated as capital gain.

For example, if a taxpayer were to sell an entire division or line of business, would the contracts be lumped together with the going concern or goodwill that is associated with the assets sold, and taxed accordingly? Or would some portion of the consideration be allocated to the contracts and taxed accordingly?[xxiii]

As the sale swings the other way – toward an ever thinner slice of a business being transferred – it may be more difficult for the seller to substantiate the existence of, and to support an allocation of value to, an intangible asset the sale of which would generate capital gain. In that case, the seller may want to consider an agreement as to such an allocation with the buyer. However, the closer one gets to the “sale of a contract to perform services” side of the continuum, the less likely it is that such an agreement would be respected by the IRS.

As always, the taxpayer needs to be aware of the tax consequences of a sale prior to agreeing to the sale, and they need to know the factors that will influence the outcome of the transaction for tax purposes. Armed with this information, the economics of a transaction may be negotiated, or the deal terms may be structured, so as to minimize any adverse effects.

[i] https://www.taxlawforchb.com/2017/07/sale-of-a-contract-capital-gain-or-ordinary-income/

[ii] IRC Sec. 61(a)(1).

[iii] Hort v. Commissioner, 313 U.S. 28 (1941).

[iv] Assignment = Sale, for our purposes.

[v] A “premium,” one might say.

[vi] These mechanisms are typically used to shift economic risk to a seller in the context of a purchase and sale of a business.

[vii] Of course, one cannot “transfer” individuals, but the buyer will typically agree to offer them employment, and the Assignor will typically agree to use commercially reasonable efforts to facilitate the process.

[viii] Query the effect on the ordinary v. capital determination if the assignment agreement refers to IRS Rev. Proc. 2004-53 for the allocation of wage reporting responsibilities between the parties. This revenue procedure applies when a successor employer acquires substantially all the property (1) used in a trade or business of a predecessor employer, or (2) used in a separate unit of a trade or business of a predecessor, and, in connection with or immediately after the acquisition (but during the same calendar year), the successor employs individuals who immediately prior to the acquisition were employed in the trade or business of the predecessor.

[ix] Think along the lines of a “vertical slice” of the business.

In asset purchase transactions, such covenants are utilized to ensure that the seller will not impair the goodwill that the buyer has just purchased.

[x] IRC Sec. 1222. A capital gain may also be generated by the sale of property used in a trade or business (so-called “Section 1231 property”). Generally speaking, this includes real property used in a trade or business, as well as depreciable property used in a trade or business. IRC Sec. 1231(b).

[xi] IRC Sec. 1221.

[xii] Commissioner v. Gillette Motor Transport, Inc., 364 U.S. 130 (1960).

[xiii] For example, the “substitute for ordinary income” doctrine.

[xiv] Commissioner v. P.G. Lake, Inc., 356 U.S. 260 (1958).

[xv] IRC Sec. 1. The maximum rate was 39.6-percent prior to the Tax Cuts and Jobs Act (“TCJA”; P.L. 115-97).

[xvi] IRC Sec. 1(h). In contrast, a C corporation is taxed at a flat federal rate of 21-percent (a maximum of 35-percent prior to the TCJA) regardless of the ordinary or capital nature of the income or gain.

[xvii] U.S. v. Maginnis, 356 F.3d 1179 (9th Cir. 2004).

[xviii] IRS FAA 20131901F.

[xix] Lattera v. Commissioner, 437 F.3d 399 (3d Cir. 2006).

[xx] See, e.g., Bisbee-Baldwin Corp. v. Tomlinson, 320 F.2d 929 (5th Cir. 1963).

[xxi] Realty Loan Corp. v. Commissioner, 54 T.C. 1083 (1970); aff’d 478 F.2d 1049 (9th Cir. 1973).

[xxii] First Pennsylvania Banking and Trust Company v. Commissioner, 56 T.C. 677 (1971).

A subsequent case agreed with the legal principle described above, but disagreed with its application to the facts before it. The service-provider/taxpayer received an amount from the service recipient in cancelation of their contract. The taxpayer argued that the transfer of its contract rights to perform personal services also included an element of goodwill (a capital asset). The court disagreed for a number of reasons, including the fact that the goodwill belonged to the service recipient’s products, there was no covenant by the taxpayer not to compete, the taxpayer did not transfer any records, and the employees (most of whom joined the buyer-organization) had no employment contracts and were free to leave the taxpayer at any time. Thus, the court found that nothing in the “bundle of rights” transferred by the taxpayer qualified as a capital asset, and it concluded that the payments received were simply a substitute for the income taxpayer would have received for performing services under the contract. Flower v. Commissioner, 61 T.C. 140 (1973).

[xxiii] Perhaps as a component of the seller’s so-called “customer-based intangibles” See IRC Sec. 197(d). PLR 201249013.

Tax Law for the Closely Held Business blog author Lou Vlahos was extensively quoted in a Long Island Business News article entitled “Spin Doctors.” The article was published in the December 6-12, 2019, edition of the print publication and online.

Below is an excerpt of the article: 

A whole is often better than the sum of its parts, but some business owners choose to roll the dice with the parts.

Attorney Louis Vlahos has noted an uptick in shareholders opting, for various reasons, to spin-off part of their corporation, creating two separate companies. When a spin-off is done for a valid business reason and one or more of the parent corporation’s shareholders control the spun-off company (and certain other conditions are met) it can be a tax-free transaction.

“The spin-offs that I’m encountering are not limited to any particular industry,” said Vlahos, a partner at Uniondale-based law firm Farrell Fritz, who has a concentration in tax law. “I think the number of such transactions is attributable to the realization by closely held businesses and their advisers that a serious dispute among groups of shareholders need not end in litigation, or the sale of the business, or the buyout of one or more of the owners, each of which can be very expensive, and not only from a tax perspective. After all, buyouts usually have to be financed.”

To read the full article, please click here: Spin Doctors

I once heard it said that death keeps no calendar.[i] That may be, but it can sure unsettle a partnership’s advisers when the decedent is one of the partners and their estate chooses to use a fiscal year[ii] for its taxable year. Let’s see why.

Partnership Income

As we know, a partnership[iii] is not, itself, a taxable entity,[iv] and the partnership’s owners – i.e., the partners – are liable for income tax only in their separate capacities.

We also know that, in determining their income tax liability, each partner is required to take into account separately on their tax return their distributive share, whether or not distributed to them, of each class or item of partnership income, gain, loss, deduction or credit (“Tax Items”), including the taxable income or loss of the partnership,[v] as computed under the partnership’s method of accounting.[vi]

What’s more, the character of any partnership item included in a partner’s distributive share is determined as if the item were realized directly from the source from which it was realized by the partnership, or incurred in the same manner as incurred by the partnership.[vii]

In computing their taxable income for a taxable year, a partner must look to the taxable year of the partnership that ends within or with the taxable year of the partner.[viii]

Thus, in the case of a partnership comprised entirely of individuals – who are “required” to use the calendar year as their taxable year – the items of partnership income, gain, loss, deduction and credit for the partnership’s taxable year that ends on December 31, in the case of a partnership that uses the calendar year, will be taken into account by the partners for their taxable year ending December 31.

If that same partnership had chosen to use a fiscal year instead, one that ends before the partners’ own calendar taxable year,[ix] the Tax Items for the partnership’s taxable year would be taken into account by the partners for their first taxable year ending after such fiscal year.

For example, assume A is an individual partner in partnership P, and that P’s taxable year is the calendar year. For A’s taxable year ending December 31, 2020, A will compute their taxable income by taking into account A’s share of P’s Tax Items for P’s taxable year that ends December 31, 2020.

However, if P used a fiscal taxable year ending, say, on April 30, A would compute their taxable income for A’s taxable year ending December 31, 2020 by including P’s Tax Items for P’s taxable year that began on May 1, 2019 and ended on April 30, 2020; i.e., the taxable year of the partnership that ends within or with the taxable year of the partner. Thus, a portion of A’s distributive share of P’s taxable income that was “earned” in 2019[x] will be reported on A’s income tax return for 2020, and the tax liability therefor will not be due until April 15, 2021[xi] – the recognition of such income is deferred – although A may have to make estimated tax payments on a current basis in order to avoid any penalty attributable to the inclusion of A’s distributive share in their 2020 tax year.

A partner must also include in taxable income for a taxable year any guaranteed payments for services rendered by the partner to the partnership, or for the partnership’s use of the partner’s capital, that are deductible by the partnership under its method of accounting in the partnership taxable year ending within or with the partner’s taxable year.[xii]

Required Taxable Year

Which brings us to the taxable year of a partnership, which figures so importantly in the determination of a partner’s own tax liability.

Under the Code, (i) unless a partnership establishes, to the satisfaction of the IRS, a business purpose for a particular fiscal year desired by the partnership,[xiii] or (ii) unless the partnership elects to use a fiscal year that provides a deferral period of not more than three months,[xiv] the partnership’s taxable year has to be determined by reference to the taxable year of its partners.

Specifically, a partnership must use as its taxable year the so-called “majority interest taxable year.” In general, this is the taxable year, if any, which on the first day of the partnership’s taxable year[xv] constitutes the taxable year of one or more partners having an aggregate interest in partnership profits and capital of more than 50-percent.[xvi]

If partners owning a majority of the partnership profits and capital do not have the same taxable year, the partnership must adopt the same taxable year as all of its “principal partners.” A principal partner is a partner having an interest of 5-percent or more in partnership profits or capital.[xvii]

If the partnership has no majority interest taxable year, and no principal partners’ taxable year, its taxable year will be the one that produces the least aggregate deferral of income to the partners.[xviii]

Change in Required Taxable Year

Because the relationship of a partnership’s taxable year to the taxable years of its partners is integral to determining when the partners will have to include their distributive shares of the partnership’s Tax Items on their separate returns, a change in the partnership’s taxable year may affect the timing of a partner’s recognition of such Tax Items.

The Code does not mandate that a partnership retain its originally determined “required” taxable year. In fact, it contemplates that a partnership will have to change its taxable year upon a change of its majority interest taxable year.

Such a change, which is deemed to have been approved by the IRS,[xix] may occur as a result of the admission of a new partner, the complete or partial liquidation of a partner’s interest, or upon a transfer of interests among the existing partners. As we will see shortly, it appears that it may also occur following the death of a partner.

In the event of a change in the ownership of a partnership, as a result of which its “majority interest” taxable year also changes, the partnership will not be permitted to retain its current taxable year[xx] without obtaining the approval of the IRS.[xxi]

Moreover, in order to prevent partners from indirectly causing the required taxable year of their partnership to change, presumably for the purpose of gaining some tax advantage, the Code provides that a partner may not voluntarily change their own taxable year without securing the approval of the IRS.[xxii]

What about a change that the partner did not, could not foresee? For example, their own death.

Death of a Partner[xxiii]

A lot happens upon the death of an individual partner, including, for example, the following:

  • The partnership’s taxable year will close only as to the deceased partner, for purposes of determining the decedent’s distributive share of partnership Tax Items for the portion of the partnership taxable year ending with the date of death;[xxiv]
  • The decedent’s estate (or other successor, such as a living/revocable trust, depending upon how the deceased partner held their partnership interest; the “Estate”), will take such interest with an adjusted basis equal to the fair market value of such interest at the date of the partner’s death, increased by the Estate’s share of partnership liabilities on that date, and reduced to the extent such value is attributable to items constituting income in respect of a decedent;[xxv]
  • If the partnership has in effect, or if it timely makes, an election under Sec. 754 of the Code, the Estate will receive a special basis adjustment to its share of the partnership’s basis for its assets, derived from the Estate’s basis for its partnership interest at the date of the deceased partner’s death.[xxvi]

But what about the taxable year of the partnership? Does the partner’s death have any effect thereon?

The Estate as a Partner

A deceased partner’s Estate is a new and separate taxpayer that springs into existence, and begins its first taxable year, upon the death of the partner.[xxvii]

If the deceased partner’s successor is an irrevocable trust,[xxviii] it generally must use the calendar year as its taxable year.[xxix]

However, if the partnership interest is held by the decedent’s estate,[xxx] the estate may choose any annual accounting period as its taxable year,[xxxi] and there’s the rub.[xxxii]

What if the estate’s choice of taxable year results in a change of the partnership’s taxable year? This would be the case, for example, where the decedent had a greater than 50-percent interest in partnership profits and capital. The estate’s selection of a fiscal year would produce a new “majority interest” taxable year – a new required year.

What if the estate did not hold any interest in the partnership, and said interest was held, instead, by the decedent’s formerly revocable trust? As indicated earlier, a trust must use the calendar year as its taxable year; thus, with nothing more, the partner’s death would have no impact upon the partnership’s taxable year.

But what if the executor of the estate and the trustee of the trust elect to treat and tax the trust as though it were part of the estate for purposes of the income tax?[xxxiii] In that case, the trust would not be treated as a separate trust for the taxable years of the estate ending after the decedent’s date of death and before the “applicable date.”[xxxiv] Rather, as part of the estate, the trust would take the estate’s taxable year for its own. Consequently, the partnership in which the trust holds an interest may be subject to a change in its majority interest taxable year.

Change of Taxable Year

This situation raises an interesting issue: how will the partnership know that the Estate’s selection of a fiscal year may have resulted in a change of the partnership’s required taxable year? Why would the partners care?

There are a number of concerns.

For one thing, the change may affect the timing of when the partnership’s Tax Items are to be accounted for by the partners in determining their taxable income.

In addition, a short period return (of less than twelve months) will have to be filed, beginning with the day following the close of the old taxable year and ending with the day preceding the first day of the new taxable year.[xxxv] The partnership does not annualize its taxable income for purposes of preparing this short period return; rather, the return for the short period is made as if that period were a taxable year.[xxxvi]

A number of elections must be made on a timely filed tax return.[xxxvii] What if a partnership is unaware of the change to its required taxable year? In that case, it will likely fail to file the necessary short period return, along with any elections that must be made with such return.[xxxviii] It will also fail to have included with the return, or to have separately filed, any other forms that are due at the same time as the partnership’s tax return. This failure may very well result in the imposition of penalties.

“Not Again”

Let’s assume the partnership figures out that the fiscal tax year chosen by a deceased partner’s Estate will require a change in the partnership’s own tax year. Let’s also assume that the partnership acts accordingly.

The Estate remains a partner of the fiscal year partnership, at least for tax purposes,[xxxix] until the administration of the Estate is completed. At that point, the Estate will distribute the decedent’s partnership interest as directed by the latter’s will or trust.[xl]

Because the beneficiaries of a decedent’s Estate will almost certainly be individuals who use the calendar year as their taxable year, the partnership may experience another “new” majority interest taxable year, but will it again have to change its own required taxable year?

In general, the answer is yes. However, because the partnership was required to change to a new majority interest taxable year when the Estate selected its fiscal year, then no further change in the partnership’s taxable year will be required for either of the two years following the year of the change;[xli] meaning, if the Estate’s distribution of the partnership interests occurs beyond this “safe” period, the partnership may be required to again change its taxable year, based upon the taxable years of the beneficiaries.

Avoid Surprises

Can a partnership and its partners develop a plan, or a framework, for anticipating and dealing with the issues posed above?

Of course they can.

Well, they can at least try.

For example, the partnership agreement may require that the partners make their estate plans known to the partnership’s management team.[xlii] It may also require that all proposed transfers of a partnership interest be reported to the partnership, whether or not such transfers are “permitted transfers” under the terms of the agreement.

The partnership agreement may also require that the Estate keep the partnership’s management team informed of the Estate’s plans for selecting a taxable year. Query whether it would be appropriate to require that the partnership’s consent be obtained before such a taxable year is chosen, or that the Estate demonstrate that the proposed taxable year will not require a change of the partnership’s own taxable year?

Finally, it may behoove everyone concerned, even without regard to the issue of the taxable year, if the partnership were simply required to redeem the Estate’s interest.[xliii]

[i] Yes, I realize this is supposed to be a festive time of year. Go tell that to any transactional attorney working through Thanksgiving, Christmas and New Year’s Eve. Or to the estate planners who are formulating plans and preparing documents for those who suddenly feel vulnerable just days before the year-end (or just hours before their ski trip – we weren’t meant to go downhill like that – or their trip to Europe). Bah, Humbug, indeed.

[ii] Generally speaking, a twelve month period ending on the last day of any month, other than on December 31. IRC Sec. 441. A taxpayer’s taxable year is often referred to as their annual accounting period.

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

[iv] IRC Sec. 701.

[v] IRC Sec. 702(a). See Sch. K-1, Part III, Line 1. This is exclusive of items requiring separate computations – these are partnership items which, if separately taken into account by any partner, would result in an income tax liability for that partner different from that which would result if that partner did not take the item into account separately. Take a look at all those codes on page 2 of the K-1. Oy.

[vi] See IRC Sec. 448 for limitations on the use of the cash method of accounting, as amended by P.L. 115-97.

[vii] IRC Sec. 702(b).

[viii] IRC Sec. 706(a).

[ix] This would be the case where the partners were able to establish to the IRS that there was a valid business purpose for using a fiscal year. See below.

[x] At least for the period from May 1, 2019 through December 31, 2019.

[xi] The due date for A’s income tax return for the tax year ending December 31, 2020.

[xii] IRC Sec. 707(c); Reg. Sec. 1.706-1(a)(1). Thus, a partner may have to include in their gross income for a year the amount of a guaranteed payment that has properly been accrued by the partnership in that year but which will not be received by the partner until the next year.

[xiii] IRC Sec. 706(b)(1)(C). The deferral of income to partners does not qualify as a business purpose.

[xiv] IRC Sec. 444. Where the partnership’s “required’ taxable year ends December 31, the partnership may elect a taxable year ending September 30 to obtain a three-month deferral. This limited deferral comes at a price. Under IRC Sec. 7519, the partnership must pay the IRS an amount that approximates the amount of tax thereby deferred.

[xv] The “testing date.” IRC Sec. 706(b)(4)(A)(ii).

[xvi] IRC Sec. 706(b)(1)(B)(i) and Sec. 706(b)(4).

[xvii] IRC Sec. 706(b)(1)(B)(ii) and Sec. 706(b)(3).

[xviii] Reg. Sec. 1.706-1(b)(3).

[xix] Rev. Proc. 2006-46. See also IRS Form 1128, Application to Adopt, Change or Retain a Tax Year, Part II, Section B.

[xx] Corresponding to its previously required taxable year.

[xxi] Under IRC Sec. 442. Reg. Sec. 1.706-1(b)(9).

[xxii] Reg. Sec. 1.706-1(b)(8)(ii).

[xxiii] OK, you want something more in keeping with the spirit of the season rather than focused on the death of partner, here’s something that accomplishes both:

SCROOGE:  Who are you?

MARLEY:  In life I was your partner, Jacob Marley.

SCROOGE:  Can you . . . sit down?


SCROOGE:  Then do it.

MARLEY: You don’t believe in me.

SCROOGE:  I don’t.

MARLEY:  Why do you doubt your senses?

SCROOGE: Because . . . any little thing affects them . . .

You may be an undigested bit of beef, a blot of mustard, a crumb of

cheese, a fragment of an underdone potato. There’s more of gravy than of grave

about you, whatever you are! Humbug, I tell you! Humbug!

A Christmas Carol, Charles Dickens.

Of course, although the business continued to be operated under the name of “Scrooge & Marley,” after the latter’s death, it was, in fact, a sole proprietorship.

[xxiv] IRC Sec. 706(c)(2)(A). The partnership’s taxable year does not close as a result of the death of a partner. Reg. Sec. 1.706-1(c)(1).

[xxv] Reg. Sec. 1.742-1. See also IRC Sec. 1014, Sec. 752, Sec. 753, and Sec. 691.

[xxvi] IRC Sec. 754, Sec. 743. The adjustment only occurs with respect to the transferee partner (the Estate).

[xxvii] IRC Sec. 1(e), Sec. 641 et seq.

[xxviii] The formerly revocable or living trust that became irrevocable upon the grantor-partner’s death.

[xxix] IRC Sec. 644. There is an exception to this rule for “qualified revocable trusts” under IRC Sec. 645.

[xxx] As distinguished from the “Estate” as defined herein.

[xxxi] There is no rule comparable to IRC Sec. 644 that applies to estates. As a new taxpayer, the estate must determine when its taxable year will end. In general, the estate chooses its taxable year when it files its first income tax return (IRS Form 1041). The estate’s first taxable year may be any period of twelve months or less that ends on the last day of a month.

[xxxii] From Hamlet’s soliloquy on suicide: “To die, to sleep, to sleep perchance to dream: Ay, there’s the rub. For in the sleep of death, what dreams may come.”

[xxxiii] IRC Sec. 645. The trust must be a qualified revocable trust. Sec. 645(b)(1).

[xxxiv] IRC Sec. 645(b)(2) defines the applicable date as follows: if no estate tax return (IRS Form 706) is required to be field, it is the date which is two years after the date of death; if such a return is required to be field, it is the date which is six months after the date of the final determination of estate tax liability.

[xxxv] For example, assume a partnership’s required taxable year ends December 31. One of the partners dies on October 10, 2020. The partner’s death does not, by itself, change or close the partnership’s taxable year. The deceased partner’s estate chooses a fiscal year that ends on September 30; thus, its first tax year will run from October 11 2020 through September 30, 2021. Assume that the estate’s selection of a fiscal year causes a change in the partnership’s required majority interest taxable year from one ending December 31 to one ending on September 30. The partnership will have to file a short period return for the period beginning January 1, 2021 and ending September 30, 2021.

[xxxvi] Reg. Sec. 1.706-1(b)(8); IRC Sec. 443; Reg. Sec. 1.443-1. Basically, a closing of the books.

[xxxvii] Which may also include extensions of the time prescribed for filing.

[xxxviii] Depending upon the election, the automatic relief provision under Reg. Sec. 301.9100-2 may not be available.

[xxxix] Its status as a matter of state law may be that of a mere economic interest holder. It also may be that the Estate has only those partner-related rights that are necessary for settling the decedent’s estate or administering their property. See, e.g., NY’s LLCL, Sec. 608.

[xl] Don’t forget that the distribution may carry out the estate’s DNI. IRC Sec. 662.

[xli] IRC Sec. 706(b)(1)(4)(B).

[xlii] This is not unusual in the case of S corporations and their shareholders, where it is imperative that the corporation’s shares not be transferred to persons who are not qualified to own such shares. See IRC Sec. 1361(b), (c), (d) and (e).

[xliii] IRC Sec. 736. Fa-la-la-la-la, la-la, la, la.

As we approach the end of 2019, I am reminded that this was supposed to have been the year in which New York’s estate tax exclusion amount was to have become the same as the federal estate tax exclusion amount.[i] As things turned out, it didn’t come close, but that wasn’t Albany’s fault, not by a long shot – at least not this time. The Feds were to blame, and how could anyone reasonably have foreseen the 2017 tax legislation?

Looking back on the year, however, it is not difficult to identify a couple of New York’s uniquely home-grown contributions to its reputation as a place that many business owners would like to avoid, or from which they would like to escape.

Before we examine these local products, we should give the Feds their due.

Recent Federal Activity

As you probably recall, among the changes made by the 2017 Tax Cuts and Jobs Act,[ii] the one that immediately caught the attention of “more mature” business owners was the doubling of the federal estate and gift tax exclusion amount for decedents dying, and for gifts made,[iii] after December 31, 2017 and before January 1, 2026.[iv]

This increase was accomplished by doubling the “basic exclusion amount” from $5 million to $10 million for 2018, before taking into account the prescribed inflation adjustments;[v] once indexed for inflation, this generated an exclusion amount of $11.2 million per U.S. individual in 2018 and $11.4 million in 2019. As a result of recently announced inflation adjustments, the exclusion for 2020 will be increased to $11.58 million.[vi]

Thus, in 2020 – only a few weeks from now – a married U.S. couple that has not made any taxable gifts in prior years may pass along to the “objects of their bounty” property with a total fair market value of $23.16 million, by way of either lifetime or testamentary transfers, without incurring gift or estate tax, as the case may be.[vii]

What’s more, because a surviving U.S. spouse may utilize a predeceasing spouse’s unused federal exclusion amount to make tax-free gifts or testamentary transfers (“portability”), a married couple should be able to fully utilize their combined federal exclusion.[viii]

However, given the temporary nature of the increased exclusion amount provided by the Act – it reverts to pre-2018 levels, adjusted for inflation, for lifetime or testamentary transfers made after December 31, 2025 – many advisers questioned whether the cumulative, or unitary, nature of the gift and estate tax computations,[ix] coupled with the differences between the exclusion amounts in effect (i) at the time of a taxpayer’s death and (ii) at the time of any lifetime gifts made by the taxpayer, would result in inconsistent tax treatment of gifts made after 2017 and testamentary transfers made after 2025.[x]

Fortunately, the IRS proposed regulations to address these concerns just over one year ago[xi] and, last week, these regulations (with some modifications) were issued in final form.[xii]

With the publication of these final regulations, an individual business owner should be confident that their estate will not be inappropriately taxed by reason of their having made lifetime gifts that take advantage of the increased federal exclusion amount before its scheduled expiration date of December 31, 2025.

As an additional incentive to making such gifts, the owner need only consider the estate and wealth tax proposals being discussed by so many of the Democratic presidential hopefuls for 2020.[xiii]

But what about a business owner who is domiciled in New York?

Don’t Forget New York

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

What’s more, before the passage of the Act, New York was in the process of “catching up” to the federal estate tax exclusion amount.

Specifically, the New York estate tax exclusion amount, which was $1.0 million through March 31, 2014, was steadily increased to approximately $2.06 million for the 12-month period ending March 31, 2015, then to $3.125 million for the next 12-month period, ending March 31, 2016, and then to approximately $4.188 million for the period ending March 31, 2017; from April 1, 2017 to December 31, 2018, the New York exclusion amount was set at $5.25 million.[xiv]

As of January 1, 2019, the New York estate tax exclusion amount was poised to become the same as the basic federal exclusion amount of $5.0 million,[xv] adjusted annually for inflation.

Thus, if a New York decedent had died during the April 1, 2017-to-December 31, 2017 period, the New York exclusion amount was $5.25 million, while the federal exclusion was $5.49 million.

As a result of the Act, however, the federal exclusion amount[xvi] diverges greatly from the New York amount after 2017.  In the case of a New York decedent dying during 2018, the New York exclusion amount remained $5.25 million, but the federal amount was increased to $11.2 million.

For testamentary transfers made during 2019, the New York exclusion amount is $5.74 million per individual,[xvii] while the federal amount has been $11.4 million.

Finally, for a decedent passing during 2020, the New York exclusion amount is scheduled to be $5.85 million,[xviii] whereas the federal exclusion will be $11.58 million.

The New York Traps

Based on the foregoing, it appears that a New York business owner would be well-advised to start making gifts of their equity in the business so as to reduce their New York taxable estate.[xix]

This appears to be a conceptually sound approach. After all, there is no New York gift tax, and the increased federal exclusion amount may shelter a significant portion of such gifts from federal gift tax liability.[xx]

However, there are two factors, or traps, that conspire against the effectiveness of this strategy.

The first operates to deny more affluent New York business owners the benefit of New York’s increased exclusion amount. It does so by phasing out the exclusion amount when a decedent’s taxable estate exceeds the exclusion amount. What’s more, the phase-out occurs over a very narrow band of value, so that the benefit of the exclusion amount is eliminated entirely when the taxable estate is greater than 105-percent of the exclusion amount. At that point, the owner’s entire taxable estate becomes taxable, not just the part that exceeds the exclusion amount.[xxi]

This is what has been described as New York’s “estate tax cliff.” When the cliff applies, the decedent’s taxable estate is taxed according to New York’s graduated estate tax rates, beginning at 3.06-percent for the first $500,000, and then continuing upward, with the excess over $10.1 million being taxed at 16-percent.[xxii]

The second trap is intended to prevent a taxpayer, like the owner of a closely held business, from circumventing the New York estate tax by making gifts that reduce the taxable estate below the exclusion amount. Not only does this provision ensure the application of the New York tax to the estates of many resident decedents, it also increases the likelihood that New York’s “cliff” rule will apply to these estates, thereby generating a greater tax liability.

Summary of Recent N.Y. Estate Tax Legislation

Since the passage of the Act, New York has made it abundantly clear that it will neither match the federal estate tax exclusion amount, nor adopt the federal rule on portability between spouses.[xxiii]

However, that does not mean New York has been inactive on the estate tax front – on the contrary.[xxiv]

In April of 2019,[xxv] New York retroactively reinstated a provision[xxvi] by which a resident decedent’s New York gross estate will be increased by the amount of any taxable gift[xxvii] made by the decedent during the three-year period ending on the decedent’s date of death,[xxviii] provided the property transferred is not otherwise included in the decedent’s federal gross estate,[xxix] and provided the decedent dies before January 1, 2026.[xxx]

In other words, the requirement to add back taxable gifts has been extended to apply to estates of decedents dying on or after January 16, 2019 and before January 1, 2026.

That being said, the following gift transfers are not subject to the reinstated “claw-back” or inclusion rule:

  • Gifts made when the decedent was not a resident of New York;
  • Gifts made before April 1, 2014;
  • Gifts made between January 1, 2019 and January 15, 2019;
  • Gifts of real property or tangible personal property having an actual situs outside New York at the time the gift was made.[xxxi]

Planning Under the Mismatched Rules

As we approach the year 2020, tax advisors who represent business owners domiciled in New York should take stock of the basic federal and New York estate tax rules within which they will be operating:

  • Federal Rules
    • The combined gift and estate tax exclusion amount will be $11.58 million per individual;[xxxii]
      • This increased basic exclusion amount will remain through 2025;
    • The top federal estate (and gift) tax rate of 40-percent will apply to that portion of a taxable estate (or gift) in excess of $1.0 million;
    • A surviving spouse may utilize the unused exclusion amount of their predeceased spouse;
  • New York Rules
    • The estate tax exclusion amount will be $5.74 million per individual;
      • New York has no gift tax;
    • New York will include in the estate of a New York decedent dying before 2026 the sum of any taxable gifts made by the decedent during the three-year period ending with their date of death;
    • The benefit of the exclusion amount is completely lost for a New York taxable estate that exceeds 105-percent of the exclusion amount;
    • The top New York estate tax rate of 16-percent will apply to that portion of a taxable estate in excess of $10.1 million;
    • There is no portability of the unused exclusion amount from the estate of a deceased spouse to the surviving spouse – if a predeceasing spouse fails to utilize their entire exclusion amount, it will be lost.


In light of the fact that New York’s estate tax exclusion amount will be much lower than the federal exclusion amount, at least for the foreseeable future, a business owner who is domiciled in New York, and who is serious about reducing their total estate tax liability and maximizing the amount of wealth that will pass to their family, cannot simply plan for the federal estate tax and ignore New York.[xxxiii]

Depending upon who owns the business, both the owner and their spouse may consider making gifts, or splitting gifts,[xxxiv] of equity in the business in order to reduce both their federal and New York gross estates.

The owner may also want to consider making a gift of stock to their spouse in an amount sufficient to allow the spouse to fully utilize their New York exclusion amount.[xxxv]

Of course, the owner will have to survive for three years following a taxable gift if they hope to avoid New York’s claw-back rule and the inclusion of the gifted property in their New York estate. Because one never knows when Thanatos[xxxvi] will come for us, the owner may want to formulate and implement a gift plan sooner rather than later.

If the owner is concerned about giving away too much, this plan may include the use of SLATs[xxxvii] for the benefit of the owner’s spouse and/or children. This may assure the owner of continued access to the gifted property, “vicariously” through their spouse.[xxxviii]


In addition to outright gifts, this plan may also include transactions that are treated as sales – rather than as taxable gifts – for purposes of the gift tax. Thus, the owner’s sale of an equity interest in their business to a grantor trust[xxxix] in exchange for a promissory note may freeze the value of the property sold at the principal amount of the note, while shifting the appreciation in the property to the trust and away from the grantor-owner, which may keep the owner’s estate below the 105-percent threshold amount.

If there is any concern about a gift resulting from what may, in hindsight, turn out to be a bargain sale, a “Wandry”-like adjustment clause may be used to eliminate the risk of an inadvertent gift.[xl] A transfer to a GRAT may serve the same purpose.[xli]

Revisit Wills and Revocable/Living Trusts

Although gifts and other lifetime transfers are effective vehicles for planning for one’s estate – as well as for addressing the differences between the New York and federal estate tax rules – there are some individuals who find it extremely difficult to part with their property or to otherwise compromise their control, especially over their business.[xlii]

Those business owners, and their advisers, cannot lose sight of the fact that estate planning does not have to end with their demise. This is certainly true when planning for the use of the New York exclusion amount. For example, someone’s will may provide for the funding of a trust with an amount equal to the federal exclusion amount. Because the federal exclusion amount is so much greater than the New York exclusion, this provision may expose this individual’s estate to New York estate tax.[xliii]

It may be advisable to revise the terms of this testamentary trust so that it qualifies for the marital deduction as a QTIP trust;[xliv] in this way, a partial QTIP election may be made for the portion of the trust that exceeds the New York exclusion amount. Alternatively, perhaps the will should be drafted so as to allow the surviving spouse to timely disclaim[xlv] property that would thereby fund a testamentary trust up to the New York exclusion amount.

Escape from NY[xlvi]

In extreme cases, a New York business owner may try to abandon their New York domicile and establish a new domicile in a state that does not impose an estate tax.[xlvii]

However, changing a taxpayer’s domicile is easier said than done, especially where the New York business has not yet been sold and, more difficult still, where the owner remains active in its management.

Do Something

In light of the foregoing, it will behoove the business owner who is domiciled in New York to meet with their advisers for the purpose of considering how their estate plan – including their will and/or revocable trust, and any gift or other transfers that may become a part of such plan[xlviii] – may impact their New York estate tax situation.


[i] OK, some of you might view the year-end differently. I can’t account for your lapses, like “I thought the Knicks would be more competitive by this point in the year,” or “Only two and one-half months before pitchers and catchers.” Seriously? Then there are those of you who enjoy the excesses of holiday shopping, and who actually look forward to New Year’s Eve. And you believe that I need help? C’mon.

[ii] P.L. 115-97; the “Act”.

[iii] Don’t forget the GST tax.

[iv] IRC Sec. 2010(c)(3).

[v] Beginning with 2012.

[vi] Rev. Proc. 2019-44.

[vii] In general, if such gifts had been made, but not in excess of the individual’s exclusion amount at the time of the gifts, the individual’s ability to make additional gifts without incurring gift tax liability would be determined by subtracting from the new exclusion amount the fair market value of those earlier taxable gifts based upon the fair market value of the properties transferred at the time of such gifts. The same principle applies – taking into account lifetime gifts – in determining how much value a decedent may pass without incurring estate tax. (You die only once.)

[viii] IRC Sec. 2010(c)(2) and (4).

[ix] Taxable gift transfers that do not exceed a taxpayer’s exclusion amount are not subject to gift tax. However, any part of the taxpayer’s exclusion amount that is used during their life to offset taxable gifts reduces the exclusion amount that remains available at their death to offset the value of their taxable estate.

[x] https://www.taxlawforchb.com/2018/12/to-gift-or-not-to-gift-the-time-may-have-arrived/

[xi] https://www.federalregister.gov/documents/2018/11/23/2018-25538/estate-and-gift-taxes-difference-in-the-basic-exclusion-amount

[xii] T.D. 9884. The regulations apply to gifts made after 2017 and to decedents dying after 2025.

[xiii] Query whether the 2020 election results will accelerate the sunset of the increased exclusion amount into 2021, rather than as scheduled, in 2026?

[xiv] See TSB-M-14(6)M.

[xv] See P.L. 111-312, Sec. 302, and P.L. 112-240, Sec. 101.

[xvi] Effective for gifts and deaths after December 31, 2017.

[xvii] $11.48 million per couple, assuming both individuals utilize their respective exclusion amounts.

[xviii] $11.70 million per couple.

[xix] A gift of property removes the property, the income generated by the property, and the appreciation in the value of the property.

[xx] Especially if one considers the valuation of an equity interest that represents a minority stake in a closely held business.

[xxi] Contrary to the federal rule, which taxes only the excess.

[xxii] Only the states of Washington and Nebraska have a higher top marginal rate, while several others match New York at 16%. https://taxfoundation.org/state-estate-tax-state-inheritance-tax-2019/

[xxiii] Stated differently, although New York is not into portability, it definitely enjoys decoupling, at least when it comes to the federal rules.

[xxiv] See TSB-M-19(1)E.

[xxv] New York Fiscal Year 2020 Budget.

[xxvi] This provision was introduced in 2014, and had expired at the end of 2018. The reinstatement begins for gifts made on or after January 16, 2019.

[xxvii] Within the meaning of IRC Sec. 2503, even if “sheltered” by the federal exclusion amount.

[xxviii] This is derived from the old federal rule under which transfers made “in anticipation of death” were brought back into a decedent’s gross estate. Today, the three-year inclusion rules under IRC Sec. 2035 operate very differently.

[xxix] For example, by virtue of a retained interest in the gifted property under IRC Sec. 2036.

[xxx] Thus, New York’s three-year “claw-back” applies for the period of the increased federal basic exclusion amount.

[xxxi] Part F of Chapter 59 of the Laws of 2019; Tax Law § 954(a)(3).

[xxxii] Of course, 2020 is also a presidential election year. Much may depend upon the outcome, including the size of the federal exclusion.

[xxxiii] We are assuming, for our purposes, that the business will represent the most valuable asset of the estate, and will constitute most of the estate.

[xxxiv] IRC Sec. 2513. Splitting gifts allows one spouse to actually make the gift transfer, while charging one-half of the amount of the transfer against the consenting spouse’s exclusion amount.

[xxxv] Credit shelter planning for the predeceasing spouse is alive and well in New York.

As always, consider a shareholders’ agreement and recapitalizing into voting and nonvoting equity interests.

[xxxvi] The ancient Hellenic god of non-violent death. Best not to contemplate the other.

[xxxvii] Spousal limited (or lifetime) access trusts.

[xxxviii] Rather than through a “retained” interest that would cause the transferred property to be included in the transferor’s gross estate. Careful of reciprocal trusts.

[xxxix] https://www.taxlawforchb.com/2016/03/estate-planning-sales-to-grantor-trusts-not-dead-yet/ .

[xl] https://www.taxlawforchb.com/2014/02/wandrying-about-defined-value-clauses/ .

[xli] IRC Sec. 2702; Reg. Sec. 25.2702-3.

[xlii] Of course, there is no substitute for succession planning within the business. In any situation involving at least two owners, a buy-sell agreement should also be seriously considered.

[xliii] By funding it with an amount in excess of the New York exclusion.

[xliv] IRC Sec. 2056(b)(7).

[xlv] IRC Sec. 2518.

[xlvi] Do you remember this movie from the early ‘80s, with Kurt Russell, Adrienne Barbeau, Lee Van Cleef, and Donald Pleasance?

[xlvii] There are plenty of choices: https://taxfoundation.org/state-estate-tax-state-inheritance-tax-2019/ .

[xlviii] In other words, their plan for disposing of their assets among their family and perhaps others.

“Charitable Behavior”

Our society is fortunate that so many business owners are charitably inclined.

In many cases, their charitable activities are motivated purely by a desire to help others, whether the object of their assistance is a favorite social welfare agency, museum, school or university, religious institution, hospital, scientific research organization, or you name it.[i]

In others, this charitable bent is often accompanied by a desire for some public acknowledgement of the owner’s charitable activities, or perhaps recognition of the contributions made by their business to the communities in which it operates.[ii]

Reward the Good, Punish the “Not so Good”

As a general rule, the tax laws seek to encourage and facilitate the transfer of wealth from private persons – like a business and its owners – to charitable entities.[iii] Because the assets so transferred become dedicated to the public purposes served by these charities, the use and disposition of the assets become subject to regulation by the government. Thus, the Code includes a number of provisions that seek to encourage what is perceived to be “good” behavior, and to discourage what is perceived to be “unacceptable” behavior. The Code punishes such behavior.[iv]

Although it hardly rises to the level of what may commonly be viewed as “bad” behavior, the conduct of unrelated business[v] activities by a charity – whether directly, or indirectly through a pass-through entity like a partnership or LLC – is scrutinized by the IRS,[vi] and the profits therefrom are subject to tax in the hands of the charity at the flat 21-percent rate applicable to taxable C corporations.[vii]

Investment income fares better than unrelated business income because it represents the return on a “passive” activity. Such income – which includes, for example, dividends, interest, rent, and the gain from the sale of the property that produces such income – is generally not taxable unless the charity incurred debt in order to acquire the income-producing property, thereby diverting assets away from its charitable mission.[viii]

In the case of a private foundation, however, even investment income generated by property that was not the object of acquisition indebtedness is subject to a two-percent federal tax.[ix]

Real Property

Among the assets that are often transferred to a charity are interests in real property, including those that generate rental income.

Such property may be a good choice for a contribution to a private foundation organized by the business or by its owners. The property will likely have appreciated in value over time; at the same time, its basis will have been reduced by depreciation[x] – something that other investment assets can’t do. The result is a large built-in gain inherent in the property.[xi]

In order to avoid the recognition of this gain, and to fund the operation of the private foundation, a business or its owners may contribute the property to the foundation.[xii]

In any event, the subsequent sale of the property by the foundation – a not unlikely event because most foundations don’t want to be in the business of managing real property – would generally not be subject to income tax.[xiii]

Gift Acceptance Vehicle

In some cases, the charity will accept a contribution of a direct interest in such real property, following which the charity may drop the property into a wholly-owned LLC or corporation in order to shield its charitable assets from any liabilities that may arise with respect to the property. In others, the charity may insist that the owner first contribute the property to such an entity before the charity will accept the donation.[xiv]

More recently, charities have formed subsidiary LLCs – that are treated as disregarded entities for tax purposes[xv] – for the sole purpose of accepting a gift of real property.[xvi]

Like any other “business,”[xvii] a charity that is thinking of acquiring real property, whether by acceptance of a donation or by purchase, is also thinking about how it may shield its other assets – especially those that are directly used in its charitable mission – from any liabilities that may arise out of the charity’s ownership (however brief) of the real property.

NY and NYC Transfer Taxes

The favorable disposition toward charities that is found in the federal tax rules is often lacking under many provisions of state and local tax law for which there are no federal counterparts; in particular, I am thinking about New York State’s (“NY”) real estate transfer tax, which imposes a tax – payable by the transferor in the first instance – on certain conveyances of real property or of an interest therein.[xviii]

Any private donor of NY real property, and any charitable recipient of such property, has to be mindful of the cost of the NY real estate transfer tax that will be incurred on the charity’s subsequent sale of the property. They have to be even more careful of not incurring NYC’s real property transfer tax.[xix]

Direct Transfers by Charities

The transfer by a charity of an interest in NY real property[xx] is not identified under NY’s Tax Law as one of the transfers that is exempted from the tax; such a transfer, therefore, is subject to the NY transfer tax.[xxi]

The NYC Administrative Code,[xxii] however, provides that the sale by a charity of an interest in real property located in NYC is not subject to the RPTT.

Thus, the sale by a charity of an interest in NYC real property will be subject to NY transfer tax but will not be subject to the RPTT.

Indirect Transfers?

But what about an indirect sale of an interest in NYC real property? For example, what if the charity was a member of a partnership that owned, operated, and eventually sold NYC real property?


In general, a member of a partnership (including an LLC treated as a partnership for tax purposes) is allocated its distributive share of the partnership’s items of income, gain, deduction, loss, and credit for purposes of determining the member’s income tax liability.[xxiii]

What’s more, under general tax principles, the activities of a partnership are often considered to be the activities of the partners.[xxiv] In other words, a member of a partnership is treated as being engaged in the activities in which the partnership is engaged.

Similarly, the character of any item of partnership gain that is allocated to a member of the partnership is determined as if it were realized directly from the source from which realized by the partnership.[xxv] For example, if a partnership were to sell a real property that it had operated as a rental property, the gain from the sale would be treated as Section 1231 capital gain in the hands of its members, including a charity.[xxvi]

Such gain is generally excluded from the unrelated business income of a charity that is a member of the selling partnership.[xxvii] The fact that the property was actually sold by the partnership of which the charity was an owner does not change the nature of the gain in the hands of the charity (as to its distributive share). The charity is treated as having sold that portion of the property itself for purposes of determining the tax treatment for the charity’s share of the gain.[xxviii]

How do these concepts apply to the RPTT? Specifically, will a charity have to bear a portion of the economic cost of the RPTT imposed upon a partnership with respect to its sale of NYC real property? Or will the charity’s distributive share of the gross proceeds from the partnership’s sale of such property be exempted from the imposition of the RPTT?

According to a recent decision of the NYC Tax Appeals Tribunal (the “Tribunal”), the charity-partner will be treated the same as any other partner for these purposes.[xxix]

The Charity

Charity was formed in 1996, and in 1997 it was recognized[xxx] by the IRS as a tax-exempt organization described in Sec. 501(c)(3) of the Code, and as a grant-making private foundation.[xxxi]

According to Charity’s 2016 federal tax return,[xxxii] the Charity acquired a one-third interest in a partnership[xxxiii] (“Partnership”) from a related business corporation.[xxxiv] It appears that this interest in Partnership constituted Charity’s principal asset.

Sale and Refund Claim

In 2017, Partnership sold a real property that it owned in NYC for over $83 million.[xxxv] Partnership reported the sale on the appropriate transfer tax returns, and paid almost $2.2 million of combined NY and NYC transfer taxes, as determined on those returns.[xxxvi]

Charity filed a claim for refund with NYC in which it asserted that one-third of the RPTT paid by Partnership – corresponding to its one-third interest in Partnership – should be returned to Charity because Charity was exempted from payment of the RPTT.[xxxvii]

After the refund claim was disallowed, Charity requested a conciliation conference, but the conferee sustained the disallowance of the claim for refund. Charity then petitioned the Tribunal to contest the conferee’s decision.

The Petition

NYC moved to dismiss Charity’s petition, arguing that the petition failed to state a cause for relief because the entity which sold the real property and paid the RPTT – Partnership –was not tax-exempt and, accordingly, there was no exemption from the tax and no basis for a refund claim.

According to NYC, Charity did not pay the tax and, therefore, could not claim a refund.

In addition, NYC argued that no exemption from RPTT was available where the transfer was by an entity which was not tax-exempt, regardless of whether any of its owners were tax-exempt.

That being said, NYC conceded that no RPTT would have been due if Charity, rather than Partnership, had sold the real property.

Charity argued that the RPTT exemption for transfers by tax-exempt entities should be treated like the exemption for a “mere change in form,” and recognized to the extent that a seller was owned by a tax-exempt entity. In other words, one should look through a partnership to the beneficial owner of the property to determine the application of the exemption.

Charity also argued that the transaction could have been structured so that the exemption would apply.[xxxviii]

The Tribunal

The Tribunal began by noting that Charity did not have standing to assert a claim for refund of the tax paid by Partnership. Accordingly, as a procedural matter, Charity’s petition had to be dismissed.

Notwithstanding the foregoing conclusion, the Tribunal then turned to the substantive issue presented: the exemption claimed by Charity.

The Tribunal explained that the NYCAC imposes the RPTT on the transfer by deed of real property located within NYC.[xxxix]

The RPTT is also imposed, the Tribunal continued, on “each instrument or transaction . . . whereby any economic interest in real property is transferred . . .”[xl] The tax on transfers of an economic interest applies only where there is no transfer by deed. An “economic interest in real property” is defined as “the ownership of an interest or interests in a partnership, association or other unincorporated entity which owns real property.”[xli]

The Tribunal then stated that the taxpayer has the burden of proving entitlement to an exemption: “Exemption . . . provisions are to be construed in favor of the taxing authority, and . . . a taxpayer must prove entitlement.”

With that, the Tribunal turned to the two exemptions claimed by Charity. The first exempts charitable organizations from payment of the RPTT; the second exempts transactions to the extent that the beneficial ownership of the grantor and the grantee is the same.

According to the Tribunal, the first exemption[xlii] provides that the RPTT shall not apply to:

“[a] deed, instrument or transaction conveying or transferring real property or an economic interest therein by . . . any corporation . . . organized or operated exclusively for religious, charitable, or educational purposes, or for the prevention of cruelty to children or animals, and no part of the net earnings of which inures to the benefit of any private shareholder or individual and no substantial part of the activities of which is carrying on propaganda, or otherwise attempting to influence legislation . . .”

The parties agreed that Charity satisfied this definition, and that had Charity itself conveyed the property, the sale would have been exempt from RPTT.

Charity relied, by analogy, on the provisions of the second exemption,[xliii] which provides an exemption for a deed, instrument or transaction conveying or transferring real property or an economic interest therein that “effects a mere change of identity or form of ownership or organization to the extent the beneficial ownership of such real property or economic interest therein remains the same.”

Charity posited that the exemption for transfers by tax-exempt entities should be applied by considering the ownership of the entity selling the real property. Therefore, since Charity owned one-third of the partnership making the sale, the RPTT owing on the sale should be reduced to that extent.

The Tribunal considered Charity’s argument, and found that the exemption was “not susceptible to the interpretation urged by” Charity. It stated that, when construing a statute, courts are to discern and give effect to the legislature’s intent. Moreover, it continued, an exemption must be narrowly construed.

The Tribunal found there was nothing in the statute to suggest that the exemption applied to entities which were not themselves tax-exempt (like the Partnership), to the extent that they were owned by tax-exempt entities (like Charity).

Moreover, the mere change in form provision Charity relied upon states that it applies “to the extent the beneficial ownership” of the real property or economic interest remains the same. The Tribunal found that the exemption for tax-exempt entities does not contain language indicating that the exemption applies to the extent that a tax-exempt entity owns an interest in the seller. Instead, the exemption requires that the seller be a tax-exempt entity.

Because the Partnership was not a tax-exempt entity, the exemption from RPTT was not available.

Charity’s argument that it transferred an economic interest in Property was also rejected. The RPTT is imposed, the Tribunal stated, on a transfer of an economic interest only where the transfer is not evidenced by a deed subject to the RPTT. Because the transfer at issue was by deed, no economic interest in the Property was transferred for purposes of the RPTT.

On the basis of the foregoing, the Tribunal dismissed Charity’s petition and sustained the disallowance of the refund claim.

What’s Next?

It remains to be seen whether Charity will appeal the Tribunal’s decision. I hope it does.

Leaving that possibility aside, and accepting the Tribunal’s reasoning for the moment, are there other circumstances under which the Tribunal might reach a different decision notwithstanding that a charity is not the actual seller?

What if the will of a decedent had directed the executor of the decedent’s estate to sell certain real property and to distribute the net proceeds therefrom to a charity within, say, two years of the decedent’s date of death, failing which the property itself would be distributed to the charity?

Does the foregoing fact pattern support a conclusion that the interest in real property had, in fact, “passed” to the charity upon the decedent’s death, and that the executor of the decedent’s estate was acting merely as the charity’s agent in the sale?[xliv]

Stay tuned.

[i] We will refer to these as “charities;” basically, an organization described in IRC Sec. 501(c)(3).

[ii] Should it matter what motivates the donor if the effect or impact of their “generosity” on the charity and its mission is the same? Call it “charitable realpolitik.” It is the basis for “naming opportunities” ranging from entire buildings, to rooms within those buildings, to seats in a theatre, to bricks outside a school.

[iii] The tax laws operate to reduce the economic cost of transferring assets to a charity. That being said, the tax benefit enjoyed by a donor for a contribution to a public charity will be greater, under current rules, than for an identical contribution by the same donor to a private foundation.

[iv] It does so by imposing a tax upon the charity and, in appropriate circumstances, upon the charity’s officers and directors, as well as other “disqualified” persons. For example, see IRC Sec. 4941 (self-dealing with respect to a private foundation) and IRC Sec. 4958 (excess benefits provided by a public charity to certain “insiders”).

Also keep in mind the role of the States Attorneys General – the People’s lawyers – in the realm of charitable organizations. Because the public is the ultimate beneficiary of a charity’s activities, the charity has to realize that it is ultimately subject to the supervision of the Attorney General of the State in which it is organized or operates.

[v] Unrelated to the performance of the function or purpose that constitutes the basis for the entity’s tax exemption. IRC Sec. 513.

[vi] To ensure they remain an insubstantial part of a charity’s activities.

[vii] IRC Sec. 511 et seq.; IRC Sec. 11.

[viii] IRC Sec. 512(b) and Sec. 514.

[ix] IRC Sec. 4940. The rate may be reduced to 1% in certain circumstances.

[x] IRC Sec. 167 and Sec. 1016.

[xi] That would be realized upon its sale. IRC Sec. 1001.

[xii] Unfortunately, the charitable income tax deduction generated by an inter vivos contribution would be limited to the donor’s adjusted basis for the property. IRC Sec. 170(e). Unless the foundation was an operating foundation.

Of course, if the property had “passed” from a recently deceased taxpayer to the donor-taxpayer, the basis would have been stepped-up to fair market value. IRC Sec. 1014 and Sec. 1015.

[xiii] IRC Sec. 512(b)(5). Of course, the assignment of income doctrine has to be considered lest the whole plan be for naught. https://www.taxlawforchb.com/2018/10/assignment-of-income-and-charitable-contributions-of-closely-held-stock/

[xiv] Although a corporation may be formed under a state’s not-for-profit or non-stock corporation law – and operate as a title-holding company or as a supporting organization, for tax purposes – most LLC statutes, including NY’s, contemplate only for-profit business purposes. Of course, an LLC’s articles of organization may limit its “business” activities to those of its related charitable member.

[xv] Reg. Sec. 301.7701-3.

[xvi] See IRS Notice 2012-52.

[xvii] Let’s face it, in many endeavors, the lines between a pure business and a pure charity have blurred.

[xviii] NY Tax Law Sec. 1402.

[xix] “RPTT”.

[xx] Whether it is a direct interest, or a controlling interest in an entity that owns NY real property.

[xxi] Similarly, the sale of such real property to a charity is also subject to the tax.

[xxii] “NYCAC”.

[xxiii] IRC Sec. 702.

[xxiv] See, e.g., Rev. Rul. 98-15, IRC Sec. 512(c), Sec. 875.

[xxv] IRC Sec. 702.

[xxvi] IRC Sec. 1231. See also IRC Sec. 1221.

[xxvii] IRC Sec. 512(c) and Sec. 512(b)(5).

[xxviii] IRC Sec. 702(a)(3) and Sec. 702(b).

[xxix] In re Jacob & Anita Penzer Found., Inc., N.Y.C. Tax App. Trib. A.L.J. Div., No. TAT (H) 18-18 (RP), 7/31/19.

[xxx] IRC Sec. 508.

[xxxi] Under Sec. 509(a) of the Code.

[xxxii] IRS Form 990-PF. See Guidestar.org. It’s amazing how much information is available on a tax return.

[xxxiii] Probably one of many owned and managed by the investment firm, Ascot Properties Co. Query who the other partners were?

[xxxiv] Penco Fabrics Inc., a closely held business. The contribution was made in two parts: in September and in November of 2016. It appears that the family of the Charity’s founders controlled Penco.

[xxxv] The sale was in February of 2017. It is likely, when Penco contributed its interest in Partnership to Charity (in September and November of 2016), that Partnership and the buyer were already in discussions for the sale of the property.

Charity reported over $25 million as its share of the gain from Partnership’s sale of the property.

It is unclear if this was Partnership’s only real estate asset, or if Partnership liquidated after the transaction.

[xxxvi] For 2017, the NYS real estate transfer tax rate was 0.40%, and the NYC real property transfer tax rate was 2.625%; a total of 3.03%.

[xxxvii] NYCAC Sec. 11-2106.b(2).

[xxxviii] For example, by having Charity sell its interest in Partnership to the buyer, by having Partnership redeem Charity’s interest prior to the sale of the property, or by distributing the property to the partners as tenants-in-common and letting them sell the property.

Query how reasonable this statement was in light of the timing of the contribution of the Partnership interest to Charity and the subsequent sale by the Partnership?

Query also how much control or influence Charity would have had over the structure of the sale?

[xxxix] NYCAC Sec. 11-2102.a

[xl] NYCAC Sec. 11.2102.b.

[xli] NYCAC Sec. 11-2101.6.

[xlii] NYCAC Sec. 11-2106.b(2)

[xliii] NYCAC Sec. 11-2106.b(8).

[xliv] Matter of Petition of E/O Eugene Schwartz, 1995 WL 376858.