Education Equals Indebtedness?

We’re more than halfway through the month of August and many college students are returning to their campuses where they will resume their studies. It should be a time of great expectation for these students and for their families.[i]

Unfortunately, for all too many of these young adults, the prospect of expanding one’s mind, and of improving one’s chances for success in the “real world,”[ii] may be overshadowed by the likelihood of also increasing one’s indebtedness to the point where a preferred career path is supplanted by a better-paying (but less satisfying) job, or where one’s debt burden may foreclose other opportunities (like starting a business or purchasing a property).

According to an article in Forbes earlier this year,[iii] “There are more than 44 million borrowers who collectively owe $1.5 trillion in student loan debt in the U.S. alone. Student loan debt is now the second highest consumer debt category – behind only mortgage debt – and higher than both credit cards and auto loans.”

There is no hyperbole in stating that the issue of student debt has become one of the greatest challenges to our economy and society. As legislatures and academia argue over where to assign blame for this state of affairs, and as they debate –without progress – over possible solutions, many closely held businesses and their owners have already taken tangible steps toward alleviating the college debt burden for at least for some of their employees.

The vehicle that is often utilized for this job is the company foundation.[iv]

“Corporate Charity”

Many successful business owners attribute some part of their financial success to their community. The term “community” may have a different meaning from one business owner to another, but it usually includes the community in which the business operates and from which it draws its workforce, though it may also extend to those areas to which it sells its services or products, as well as those locales in which its vendors are located.

For some of these business owners, it is not enough to simply acknowledge a “debt” to their community; rather, they feel an obligation to share some of their financial success with the community. Some owners or businesses will make contributions to local charities,[v] schools, and hospitals. Others will provide grants to local residents who otherwise could not afford living or medical expenses. Still others will solicit the voluntary assistance of their workforce to support a local charity in a fundraising or public awareness event.

These endeavors are commendable, but they are of an ad hoc nature, which means they are also of limited duration. This is because such activities are not necessarily institutionalized and they are dependent, in no small part, upon the business owner, who is usually the catalyst for the charitable activities of the business.

Private Foundations

Recognizing these limitations, some business owners will establish a private foundation – typically, as a not-for-profit corporation (separate from the business),[vi] that may be named for the owner, the owner’s family, or the business – which they will fund with an initial contribution of cash or property, either personally or through the business. In later years, an owner may contribute additional amounts to the foundation, often culminating with a significant bequest to the foundation upon the death of the owner.[vii]

With this funding, the foundation – which consequently will not be financially dependent upon contributions from the general public (thus a “private” foundation, as distinguished from a “public” charity) – will have the wherewithal to conduct its charitable activities.

In most cases, the foundation’s activities will be limited to making grants of money to other not-for-profit organizations that are directly and actively engaged in charitable activities (i.e., not grant-making) – within and without the business’s community – and that have been recognized by the IRS as tax-exempt, publicly supported charities.[viii]

However, some company-sponsored foundations will also provide scholarships to fund the education of certain students.[ix] There is considerable flexibility in the design of such a scholarship program; for example, it may require that a student be enrolled at a particular school in order to qualify for a grant, or that they attend a school within a designated geographic area, or that they pursue a particular field of study.

In fact, the program may even be limited to students who are lineal descendants of employees of the business that organized the foundation, as was illustrated by a recent IRS private letter ruling[x] in which the IRS considered a private foundation’s request for approval of its employer-related scholarship program[xi] to fund the education of qualifying students.

Employer-Related Scholarships

Foundation’s general purpose was to make distributions for charitable and educational purposes within the meaning of Section 501(c)(3) of the Code.

However, Foundation also sought to operate an employer-related scholarship program (the “Program”), the purpose of which was to provide educational scholarships to the lineal descendants of employees of Business by selecting qualified individuals to receive grants to advance their education.

Eligible Recipients

“Lineal descendants” included, but were not limited to, children, step-children, adopted children and grandchildren of eligible employees of Business. An eligible employee was one who had completed one year of continuous full-time service with Business prior to the date the scholarship would be awarded. Eligibility was not based upon the employee’s position or title within Business, nor was it conditioned upon the employee’s continued employment with Business.

All students who had graduated from high school and planned to attend an accredited post-secondary educational institution were encouraged to apply for a scholarship. All students were considered regardless of their sex, race, age, color, national origin, religion, marital status, handicap, veteran status or parental status.

The post-secondary educational institution had to be accredited by a regional accreditation organization, or an equivalent, as determined by the Scholarship Committee.

The Committee and the Awards

The Scholarship Committee consisted of five community representatives who were separate and independent from Business.

The size of the scholarship award would be determined by the Scholarship Committee.

The number of scholarship awards would be dependent upon the number of students who were eligible or who applied for an award. In each year, the number of awards would not exceed the lesser of: (i) twenty-five percent of the number of students who were considered by the Scholarship Committee; or (ii) ten percent of the number of individuals who could be shown to be eligible for the awards. If more than one scholarship award was granted in a given year, each award would be in identical amounts.

In any year that the above percentages tests were not met, awards would not be granted, and the funds would accumulate for the following year.

Each award was granted for a one-year period, with possible renewals. Awards did not automatically renew. Students had to reapply every year. When reapplying, a student recipient in a prior year would be considered eligible even if the student’s “employee-sponsor” was no longer employed by Business.


Foundation’s Program was communicated through employees’ newsletters, mailings to employees’ homes, company bulletin boards, presentations at employees’ meetings, inserts in employees’ checks, news releases to the media, and any other reasonable form of communication.

In all communications, the scholarship was not to be portrayed as an independent incentive or recruitment device for prospective employees, or as additional employee compensation.


Selection of award recipients was based on financial need, scholarship, recommendations, test scores, class ranking, and extracurricular involvement.

The scholarship application requested the following items:

  1. A one-page essay detailing the applicant’s high school years (or if re-applying, post-secondary years) and activities, as well as plans for the future. The essay also included extra-curricular activities.
  2. Copy of the applicant’s most recent IRS Form 1040 (individual income tax return).
  3. Copy of the applicant’s college acceptance letter (graduating high school seniors).
  4. Copy of the applicant’s most recent high school or college grades, showing all years attended.
  5. Two letters of recommendation – one from a teacher and one from an individual who was not a teacher or a relative.

After the applications had been reviewed, the applicants were rated by the Scholarship Committee based on various factors, including academic performance, extracurricular and community activities, financial need, full-time status, personal interview, and an essay designed to show the applicant’s motivation, character, ability and potential.

Award recipients were required to provide the Scholarship Committee a progress report at the end of the first semester of the academic year, and at the end of the academic year. The progress report had to include a copy of the student’s transcripts for the academic year, and a letter summarizing the student’s progress and the importance of the award to the student’s academic progress.

Supporting Records

The Scholarship Committee maintained the following records for each scholarship grant awarded:

  1. Statement of the objective and non-discriminatory procedures used to select recipients;
  2. Adequate information regarding each applicant, including all information that the Scholarship Committee secured to evaluate the qualifications of the applicant;
  3. Identification of the applicant;
  4. Specification of the award amount and demonstration of the qualifying purposes for which the award was used (qualified tuition and related expenses);[xii]
  5. Verification of the appropriate publication of the scholarship award program and results; and
  6. Information which the Scholarship Committee obtained regarding follow-up investigation, including follow-up reports required from all recipients.


Scholarship funds would be disbursed to the educational institution which the award recipient was attending, rather than to the student.

The Scholarship Committee would investigate any misuse of funds and withhold further payments, to the extent possible, if the Scholarship Committee did not receive a required report, or if reports or other information indicated that grant proceeds were not being used for the purpose for which the grants were made. The Scholarship Committee would take all reasonable and necessary steps to recover grant funds, or to ensure restoration of the funds and their dedication to the purposes the grant funds were financing.

Taxable Expenditures

Sounds challenging, doesn’t it? In fact, it is. That’s because the Code makes it difficult for a private foundation to simply write a check to a private individual, as opposed to making an unrestricted grant to a recognized public charity.[xiii]

Private foundations are not dependent upon the public for financial support and, so, are not to “answerable” to the public, at least in theory. For that reason, the Code provides a number of restrictions upon the use of foundation funds.[xiv] These restrictions seek to discourage, and hopefully prevent, certain activities by a private foundation that the IRS deems to be contrary to, or inconsistent with, the charitable nature, and tax-exempt status, of the foundation.

The IRS enforces these restrictions through the imposition of special excise taxes (i.e., penalties) upon the foundation, the foundation’s managers (e.g., its board of directors), and so-called disqualified persons (i.e., persons who are considered to be “insiders” with respect to the foundation).

Among the activities that the Code seeks to discourage is a foundation’s expenditure of funds for a proscribed purpose (a “taxable expenditure”); for example, a grant to a non-charitable organization or for a non-charitable purpose. The Code imposes a twenty percent excise tax on the taxable expenditures of a private foundation.[xv]

Grants to Individuals

A taxable expenditure also occurs when a private foundation pays a grant to an individual for travel, study, or other similar purposes.

However, a grant that meets all of the following requirements is not treated as a taxable expenditure:[xvi]

  • The grant is awarded on an objective and nondiscriminatory basis.
  • The IRS approves in advance the procedure for awarding the grant.
  • The grant is a scholarship or fellowship subject to Section 117(a) of the Code.[xvii]
  • The grant is to be used for study at a qualified educational organization.


Long ago, the IRS provided guidelines[xviii] to determine whether the grants made by a private foundation under an employer-related program to employees, or children of employees, were scholarship or fellowship grants subject to the provisions of Sec. 117(a) of the Code. If the program satisfied the seven conditions set forth in these guidelines,[xix] and also met the applicable “percentage tests” described in the guidelines, the IRS would assume the grants were subject to the provisions of Sec. 117(a) and, therefore, were not taxable expenditures.

These percentage tests require that:

  • The number of grants awarded to employees’ children in any year won’t exceed 25 percent of the number of employees’ children who were eligible for grants, were applicants for grants, and were considered by the selection committee for grants, or
  • The number of grants awarded to employees’ children in any year won’t exceed 10 percent of the number of employees’ children who were eligible for grants (whether or not they submitted an application), or
  • The number of grants awarded to employees in any year won’t exceed 10 percent of the number of employees who were eligible for grants, were applicants for grants, and were considered by the selection committee for grants.

In determining how many employees’ children are eligible for a scholarship under the 10 percent test, a private foundation may include as eligible only those children who submit a written statement or who meet the foundation’s eligibility requirements.[xx] They must also satisfy certain enrollment conditions.[xxi]

The IRS’s Ruling

Foundation represented that its procedures for awarding grants under the Program satisfied the seven conditions set forth in the guidelines:

  • An independent selection committee, whose members were separate from Foundation, its creator, and the employer, would select individual grant recipients.
  • Foundation would not use grants to recruit employees, nor would it end a grant if the employee left the employer.
  • Foundation would not limit the recipient to a course of study that would particularly benefit Foundation or the employer.
  • Foundation would not award grants to its creators, officers, directors, trustees, foundation managers, or members of selection committees or their relatives.[xxii]
  • All funds distributed to individuals would be made on a charitable basis and further Foundation’s charitable purposes.
  • Foundation would not award grants for a non-charitable purpose.
  • Foundation would keep adequate records and case histories so that it could substantiate its grant distributions with the IRS if necessary.

On the basis of the foregoing, the IRS approved Foundation’s procedures for awarding employer-related scholarships to qualifying lineal descendants of Business’s employees. As a result, the expenditures to be made by Foundation under those procedures would not be subject to the excise tax.

The IRS also ruled that the awards made under those procedures were scholarship grants and, so, were not taxable as income to the recipients if used by them for qualified tuition and related expenses.

It’s Worth the Effort

A company-sponsored grant-making foundation is an effective, and tax-advantaged, tool that may be used by a closely held business to support, or engage in, charitable activities within its community.

With appropriate safeguards, like those described above, such a foundation may expand its charitable reach – and its impact on people’s lives – by also granting scholarships for education to qualifying members of its workforce and their families.

However, if a company’s foundation disregards these safeguards as too burdensome, the foundation’s grants will essentially be treated as extra pay, an employment incentive, or an employee fringe benefit, which will be taxable to the employee.[xxiii]  What’s more, a compensatory scholarship program will cause the foundation to lose its tax exempt status because it is being operated for the private benefit of the employer-company.

The main purpose for the scholarships awarded by a private foundation to a company’s employees must be to further the recipients’ education rather than to compensate company employees. The incidental goodwill and employee loyalty generated for the business should not be underestimated.

[i] I have to confess, the sight of school buses in early September still makes me anxious.

[ii] According to the World Bank, workers with more education earn higher wages than employees with no post-secondary education. Those with only a high school degree are twice as susceptible to unemployment than workers with a bachelor’s degree.


[iv] IRC Sec. 509(a).

[v] The word “charity” is interpreted very broadly under the Code.

[vi] Though a charitable trust may also be used. For example, see Article 8 of N.Y.’s EPTL. I prefer a not-for-profit corporation.

[vii] Either directly or through a split-interest trust.

[viii] IRC Sec. 501(a), Sec. 501(c)(3), and Sec. 509(a).

[ix] Several of our clients have done so.

[x] PLR 201932018 (Release Date: 8/9/2019). It should be noted that the IRS issues many such rulings, which means that many businesses are sponsoring such programs. Please also note that such rulings may not be cited as precedent, though they do give us an indication of the IRS’s position on a given issue.

[xi] Under IRC Sec. 4945(g).

[xii] See IRC Sec. 117.

[xiii] Note that more and more private foundations are restricting the purposes for which a public charity may use the foundation’s grant. A foundation will often identify the specific purpose that the grant seeks to accomplish, and it will hold the recipient public charity accountable for the use of the grant monies; for example, the foundation may require periodic progress reports from the public charity, or it may condition future grants on the charity’s “performance” under the restricted grant.

[xiv] The price for their tax-exempt status.

[xv] A tax equal to 20 percent of the amount of the expenditure, which is payable by the foundation. Other taxes may be paid by foundation managers. IRC Sec. 4945(a).

[xvi] IRC Sec. 4945(g). See also IRS Form 1023, Schedule H, Organizations Providing Scholarships, Fellowships, Educational Loans, or Other Educational Grants to Individuals and Private Foundations Requesting Advance Approval of Individual Grant Procedures.

[xvii] IRC Sec. 117(a) provides that gross income does not include any amount received as a qualified scholarship by an individual who is a candidate for a degree at an educational organization described in section 170(b)(1)(A)(ii).The term qualified scholarship means any amount received by an individual as a scholarship or fellowship grant to the extent the individual establishes that, in accordance with the conditions of the grant, such amount was used for tuition and fees required for the enrollment or attendance of a student at an educational organization described in section 170(b)(1)(A)(ii), and fees, books, supplies, and equipment required for courses of instruction at such an educational organization.

[xviii] Revenue Procedure 76-47.

[xix] See below.

[xx] Revenue Procedure 85-51.

[xxi] They are enrolled in or have completed a course of study preparing them for admission to an educational institution at the level for which the scholarships are available, have applied or intend to apply to such an institutions, and expect, if accepted, to attend such an educational institution in the immediately succeeding academic year; or they currently attend an educational institution for which the scholarships are available but are not in the final year for which an award may be made.

[xxii] Basically, insiders. Self-dealing under IRC Sec. 4941?

[xxiii] They may even be treated as a gift by the employee to the recipient.

Choice of Entity

The owners of a closely held business are generally free to select the form of business entity through which they will operate their business. In most cases, hopefully, the decision to operate as a sole proprietorship,[i] a partnership, an S corporation, or a C corporation will have been preceded by discussions between the owner(s) and their tax adviser during which they considered, among other things,[ii] protection from personal liability for the debts of the business, the economic arrangement among the owners,[iii] and the income tax and employment tax consequences of operating through one form of business entity versus another, including the withdrawal of value from the business.[iv]

Once the owners have sifted through these and other factors, and have decided upon a particular form of entity, it is imperative that they respect the entity as a separate person, and that they not treat it as an extension of themselves.[v] Only in this way can they be certain of the “limited liability” shield afforded by the entity; if they regularly disregard the entity, so may a creditor of the business.[vi]

In addition, by transacting with the entity at arm’s length – as one would do with any unrelated person – the owners may avoid certain unpleasant tax consequences, including “constructive dividends,” which are likely to become more common as a result of the 2017 tax legislation.[vii]

The Revival of Close “C’s”

Following the Act’s substantial reduction in the federal corporate income tax rate,[viii] the owners of many closely held businesses – who would otherwise have probably chosen a pass-through entity in which to “house” their business – have expressed an interest in the use of C corporations.

Some of these owners may choose to form such a corporation to begin a new business, or in connection with the incorporation of an existing sole proprietorship or partnership.

Others may decide to “check-the-box” to treat a sole proprietorship or partnership as an association taxable as a corporation.[ix]

Those owners who are shareholders of an S corporation may decide to revoke the corporation’s S election, or to cause the corporation to cease being a “small business corporation.”[x]

In any case, these owners will have to be reminded that the profits of a C corporation are subject to income tax at two levels: once when included in the income of the corporation, and again when distributed by the corporation to its shareholders.

With respect to this second level of tax, the owners of a closely held C corporation will have to be mindful of the separate legal status of the corporation, lest they transact with the corporation in such a way as to inadvertently cause a constructive distribution by the corporation that is treated as a taxable dividend to its owners.

Close Scrutiny

It is axiomatic that interactions between a closely held business – including a C corporation – and its owners will generally be subject to heightened scrutiny by the IRS, and that the labels attached to such interactions by the parties will have limited significance unless they are supported by objective evidence.

Thus, arrangements that purport to provide for the payment of compensation, rent, interest, etc., to a shareholder – and which are generally deductible by a corporation – may be examined by the IRS, and possibly re-characterized so as to comport with what would have occurred in an arm’s-length setting.

This may result in the IRS’s treating a portion of such a payment as a dividend distribution to the shareholder, and in the partial disallowance of the corporation’s deduction.

Constructive Dividends

According to the Code, a dividend is any distribution of property that a corporation makes to its shareholders out of its accumulated or current earnings and profits.[xi] “Property” includes money and other property;[xii] under some circumstances, the courts have held that it also includes the provision of services by a corporation to its shareholders.[xiii]

A “constructive” dividend typically arises where a corporation confers an economic benefit on a shareholder without the expectation of repayment, even though neither the corporation nor the shareholder intended a dividend. However, not every corporate expenditure that incidentally confers economic benefit on a shareholder is a constructive dividend.

Where a corporation constructively distributes property to a shareholder, the constructive dividend received by the shareholder is ordinarily measured by the fair market value of the benefit conferred.[xiv]

The issue addressed in a recent Tax Court decision[xv] was whether Taxpayer had received constructive dividends from Corporation.

Taxpayer’s Strategy

Taxpayer was a performer. During the years at issue, he had various engagements. Compensation for these performances was generally made by checks payable to Corporation, not to Taxpayer individually.

This arrangement was based on the concept that Taxpayer could shift their business income to a business entity (i.e., Corporation), which would then use the funds to pay Taxpayer’s personal expenses, and claim a deduction for these expenditures.

In furtherance of this “strategy,” Taxpayer organized Corporation. Taxpayer was Corporation’s sole stockholder, president, chief executive officer, chief financial officer, sole director, and treasurer.[xvi]

During the years at issue, in accordance with this plan, the fees paid for Taxpayer’s various engagements were generally made payable to an account at Bank under the Corporation’s name.[xvii] Taxpayer was the only individual with signature authority over this account. Taxpayer was also an authorized user of Corporation’s credit card account.

Also during these years, Taxpayer paid various expenses using the credit card and the funds deposited into the account at Bank. These expenses included airfare, payments to grocery stores, restaurants, and other miscellaneous expenses.[xviii]

Taxpayer filed personal income tax returns for the years at issue,[xix] on which were reported their wages from Corporation.

Corporation also filed tax returns for those years[xx], reporting gross profits, as well as expenses for wages, taxes, advertising, employee benefits, travel, and other items.

The IRS Challenge

The IRS selected Taxpayer’s and Corporation’s returns for examination. The IRS issued a notice of deficiency by which it adjusted Corporation’s taxable income by disallowing, for lack of substantiation, most of the claimed deductions and by adjusting upward its gross profits.

In a separate notice of deficiency, the IRS determined that Taxpayer had failed to report constructive dividends attributable to personal expenses that Corporation had paid on their behalf.

In fact, for all the years at issue, the IRS counted as constructive dividends those expenses that Corporation had reported, and that the IRS had disallowed, as deductions. The IRS also counted as constructive dividends the payments that Corporation had made on its credit card account.

Taxpayer petitioned the U.S. Tax Court for a redetermination of the asserted tax deficiency.

The Court’s Analysis

The Court began by noting that the IRS’s determination of constructive dividends was a determination of unreported income. It explained that the Court of Appeals for the Ninth Circuit, to which any appeal from its decision would lie,[xxi] required that the IRS establish “some evidentiary foundation” linking a taxpayer to an alleged income-producing activity. Once such a foundation has been established, the Court continued, the burden of proof would shift to the taxpayer to prove by a preponderance of the evidence that the IRS’s determinations were arbitrary or erroneous.

The Court found that the IRS had established a sufficient evidentiary foundation to satisfy any threshold burden. The evidence showed that Taxpayer owned 100-percent of Corporation and maintained authority over its checking and credit card accounts. Taxpayer was integrally linked to – apparently the only source of – the Corporation’s income-producing activity. The record showed that the IRS’s determination was based on an extensive review of both Taxpayer’s and Corporation’s activities, bank accounts, and other financial accounts. The IRS introduced evidence to show that Corporation made significant expenditures primarily for Taxpayer’s benefit.

The Court then turned to the substantive issue of whether a dividend had been paid.


In general, Sections 301 and 316 of the Code govern the characterization, for Federal income tax purposes, of corporate distributions of property to shareholders. If the distributing corporation has sufficient earnings and profits (“E&P”), the distribution is a dividend that the shareholder must include in gross income.[xxii] If the distribution exceeds the corporation’s E&P, the excess generally represents a nontaxable return of capital to the extent of the shareholder’s basis in the corporation’s stock, and any remaining amount is taxable to the shareholder as a gain from the sale or exchange of property.[xxiii]


According to the Court, it was Taxpayer’s burden to prove that Corporation lacked sufficient E&P to support dividend treatment at the shareholder level. The Court stated that, if neither party presented evidence as to the distributing corporation’s E&P, the taxpayer has not met their burden of proof. Because Taxpayer produced no evidence concerning Corporation’s E&P during the years at issue, Taxpayer failed to meet the burden of proving that there were insufficient E&P to support the IRS’s determinations of constructive dividends to Taxpayer. Therefore, the Court deemed Corporation to have had sufficient E&P in each year to support dividend treatment.


The Court then explained that characterization of a distribution as a dividend does not depend upon a formal dividend declaration.[xxiv] Dividends may be formally declared or constructive.

According to the Court, a constructive dividend is an economic benefit conferred upon a shareholder by a corporation without an expectation of repayment. Thus, if corporate funds are diverted by a controlling shareholder to personal use, they are generally characterized for tax purposes as constructive distributions to the shareholder.[xxv]

Such a diversion may occur, for example, where a controlling shareholder causes a corporation to pay the shareholder’s personal expenses; the payment results in an economic benefit to the shareholder but serves no legitimate corporate purpose.

A “distribution” does not escape taxation as a dividend simply because the shareholder did not personally receive the property. Rather, according to the Court, “it is the power to dispose of income and the exercise of that power that determines whether * * * [a dividend] has been received.” Whether corporate expenditures were disguised dividends presents a question of fact.

The Court then described the two-part test enunciated by the Ninth Circuit for determining constructive dividends: “Corporate expenditures constitute constructive dividends only if 1) the expenditures do not give rise to a deduction on behalf of the corporation, and 2) the expenditures create ‘economic gain, benefit, or income to the owner-taxpayer.’”

Taxpayer’s Situation

For all of the years at issue, the IRS determined the amount of constructive dividends on the basis of Corporation’s disallowed claimed deductions and also on the basis of additional charges made on the corporate credit card. Taxpayer claimed that many of these expenditures and charges represented legitimate business expenses of Corporation, but failed to offer into evidence any materials that were linked in any meaningful way to the IRS’s adjustments. Moreover, the Court did not find Taxpayer’s testimony credible or adequate to show that any particular item represented an ordinary and necessary business expense[xxvi] of Corporation.

In sum, Taxpayer’s documentation, in which personal living expenses were not clearly distinguished from legitimate business expenses, provided the Court with no reasonable means of estimating or determining which, if any, of the expenditures in question were incurred as ordinary and necessary business expenses of Corporation.

Because Taxpayer failed to show that the expenditures in question properly gave rise to deductions on behalf of Corporation, the remaining question was whether these expenditures created “economic gain, benefit, or income to the owner-taxpayer.”

The expenditures in question showed a pattern of payment of personal expenses. This pattern, the Court observed, was consistent with Taxpayer’s tax-avoidance strategy to have Corporation deduct Taxpayer’s personal living expenses as business expenses.

Indeed, Taxpayer did not identify any category of challenged corporate expenses that did not benefit him personally.

With that, the Court sustained the IRS’s determination that Taxpayer received and failed to report constructive dividends. Thus, Corporation’s taxable income was increased because of the disallowed deductions, and Taxpayer’s taxable income was increased by the dividend deemed to have been made.


The Court’s decision was hardly a nail-biter.[xxvii]

Notwithstanding that the outcome was a foregone conclusion, the case is instructive for both individual taxpayers[xxviii] and their advisers.

Although it illustrates but one application of the constructive dividend concept, it hints at the number of scenarios in which a careless shareholder of a closely held C corporation with E&P[xxix] may be charged with having received a taxable distribution.

It also raises some interesting questions that do not appear to have been before the Court, but of which a closely held business should be aware.

Constructive Dividend Scenarios – Third Parties

The Court’s decision found a distribution to Taxpayer though the transfers by Corporation were to someone other than Taxpayer – the transfers were made to third parties for Taxpayer’s benefit.[xxx]

Moreover, there was no expectation that Taxpayer would reimburse Corporation for its expenditures. In other words, there was no indication that the events, taken as a whole, constituted a loan from Corporation to Taxpayer.[xxxi]

Corporation could have tried to characterize most of its expenditures to or on behalf of Taxpayer as compensation paid to Taxpayer; after all, Corporation’s income was attributable entirely to Taxpayer’s performances. Provided the aggregate amount of compensation was reasonable, Corporation would have been entitled to a deduction therefor.

In fact, the IRS could have taken the same approach, though this would have supported a larger deduction for Corporation.

It should be noted that a constructive dividend could also have been found if the corporation, instead of satisfying the shareholder’s expenses or liabilities, had made a payment to or behalf of a member of the shareholder’s family. In that case, the shareholder would be treated as having made a gift to their family member following the deemed distribution.[xxxii]

Constructive Dividend Scenarios – The Shareholder

In addition to transactions between the corporation and third parties, a constructive dividend may also be found in direct dealings between the corporation and the shareholder.

For example, a purported loan by a corporation to a shareholder may be recharacterized, in whole or in part, depending upon the facts and circumstances, as a dividend distribution.[xxxiii]

Similarly, a bargain sale by a corporation to a shareholder – one in which the consideration paid by the shareholder in exchange for corporate property is less than the fair market value of the property – may be treated as a dividend to the extent of the bargain element.[xxxiv]

Indeed, any scenario in which the corporation and the shareholder are dealing with one another at other than arm’s length raises the possibility of a deemed distribution.

For example, a shareholder’s rent-free use of corporate-owned property may constitute a dividend distribution[xxxv] in an amount equal to the fair market rental rate.[xxxvi]

Conversely, a corporation’s payment of excessive rent for the use of a shareholder’s separately owned property, or excessive compensation for their services, may be treated as a dividend to the extent it exceeds a fair market rental rate or reasonable compensation.[xxxvii]

At this point, it should also be noted – despite the result reached in the Court’s decision, above – that there is no necessary correlation between a corporation’s right to a deduction for a payment and the tax treatment of the payment to a shareholder, say, as an employee. In other words, the fact that a deduction for compensation was reduced to the extent it was unreasonable, does not “entitle” a shareholder-employee to dividend treatment as to the disallowed amount.[xxxviii]

Other Potential Arguments

At some point during the discussion of the Court’s decision, above, did you wonder why the IRS seemed to have respected Corporation as a bona fide business entity? After all, it was Taxpayer’s strategy to use Corporation to receive the income that Taxpayer earned, to cause Corporation to pay Taxpayer’s personal expenses using such income, and then for Corporation to claim business deductions for such payments (as far-fetched as that seems), thereby resulting in Taxpayer’s only being taxed on the wages paid by Corporation.

In fact, according to a footnote in the Court’s opinion[xxxix], the IRS had previously asserted that Taxpayer had failed to report “certain gross receipts” as a sole proprietor, on Schedule C, Profit or Loss from Business, but dropped it as “duplicative of the constructive dividend determination.”

In order for the IRS to have raised this argument, it must have concluded that Corporation was a sham for tax purposes, that it lacked a business purpose. It’s also possible that the IRS decided, under “assignment of income” principles, that Corporation’s income should have been reallocated to Taxpayer as the “true earner” of such income.

Why, then, would the IRS have dropped this alternative argument?

The case most cited for the treatment of corporations as entities separate from their owners for tax purposes is Moline Properties.[xl] It stands for the proposition that a corporation created for a business purpose or carrying on a business activity will be respected as an entity separate from its owner for federal tax purposes. Although the Supreme Court did not indicate the degree of corporate activity that was necessary in order for the corporation to be respected, subsequent decisions have not set a very high threshold.

It is likely for this reason, plus the fact that recharacterization of the corporation’s payments as dividends, rather than as deductible expenditures, resulted in double taxation of Corporation’s profits, that the IRS decided not to pursue its alternative position.

Last Word

If the owners of a business decide to operate the business through a separate entity – whether it is a corporation or a partnership/LLC – they must treat with the entity as they would with an unrelated person. By respecting the entity’s separate existence, they may maximize the legal and economic benefits of their choice, and avoid unexpected, and costly, tax consequences.

[i] A single-member LLC; one that is disregarded for tax purposes. Reg. Sec. 301.7701-3.

[ii] For example, the pass-through of losses generated by the business, the ability to distribute to the owners the proceeds from a borrowing, the ability to raise capital, etc.

[iii] In other words, how they intend to share profits. For example, will certain owners be entitled to a preferred return on their capital?

[iv] Of course, they will have also discussed whether the taxpayer-owner(s) were even qualified to utilize a particular form. For example, the owners may not all qualify to hold shares of stock in an S corporation, or their economic arrangement may be such that it would fail the single class of stock requirement for S corporation status.

[v] Their alter ego.

[vi] “Piercing,” basically.

[vii] The Tax Cuts and Jobs Act (P.L. 115-97); the “Act.”

[viii] From a maximum graduated rate of 35-percent to a flat rate of 21-percent, effective for tax years beginning after December 31, 2017.

[ix] Reg. Sec. 301.7701-3.

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

[xi] IRC Sec. 312 and Sec. 316.

[xii] IRC Sec. 317.


[xiv] Where the fair market value cannot be reliably ascertained, or where there is evidence that fair market value is an inappropriate measurement, the constructive dividend can be measured by the cost to the corporation of the benefit conferred.

[xv] Patrick Combs v. Commissioner, T.C. Memo 2019-96.

[xvi] Taxpayer’s spouse acted as secretary.

[xvii] The opinion does not state that Taxpayer was employed by Corporation, though Corporation did pay wages. In addition, the opinion is silent as to whether clients retained Corporation, which then provided the contracted-for services through its employee, Taxpayer.

[xviii] Rental was not separately identified as an expense.

[xix] IRS Form 1040.

[xx] IRS Form 1120.

[xxi] See IRC Sec. 7482(b)(1)(A).

[xxii] IRC Secs. 301(c)(1), 316.

[xxiii] IRC Sec. 301(c)(2) and (3).

[xxiv] For example, see N.Y.’s BCL Sec. 510.

[xxv] A variation on the “substance over form” doctrine.

[xxvi] IRC Sec. 162.

[xxvii] Go figure why Taxpayer pursued it as far as they did.

[xxviii] We are not addressing situations involving shareholders that are themselves corporations; among other considerations, these may trigger application of the dividends received deduction. IRC Sec. 243.

[xxix] And in some cases, an S corporation with E&P. This would occur where the S corporation was previously a C corporation, or where the S corporation acquired a C corporation in a tax-free reorganization.

[xxx] It should be noted that the “personal” expenditures need not have been for living expenses or personal debts. For example, if the corporation had made a charitable contribution to a qualifying organization for which a shareholder claimed a deduction, the shareholder would be treated as having received a dividend distribution, the amount of which it then transferred to the charity.

[xxxi] For example, the expenditures were not recorded as loans, nor did Taxpayer give Corporation a promissory note.

[xxxii] See, for example, Reg. Sec. 1.351-1(b)(1).

[xxxiii] Likewise, the forgiveness of an actual loan may be treated as a dividend.

[xxxiv] The value of the corporation is reduced by the amount of the bargain element.

[xxxv] That being said, the incidental or insignificant use of corporate property may not justify a finding of a constructive dividend.

[xxxvi] See IRC Sec. 7872 with respect to loans by a corporation to a shareholder that bear a below-market rate of interest.

[xxxvii] However, query whether the IRS would make this argument; after all, the rate applicable to qualified dividends[xxxvii] is lower than the ordinary income rate applicable to rent. IRC Sec. 1(h)(11).

[xxxviii] The employee would still be treated as having received compensation taxable as ordinary income (a maximum federal rate of 37-percent), rather than a dividend taxable at 20-percent.

[xxxix] Footnote 3.

[xl] 63 S.Ct. 1132 (1943).

A Penny Saved?

As a novice tax adviser, you learn certain basic principles by which to live your professional life. Among these are the following: read, then keep on reading; try to always get two bites at the apple; and don’t allow yourself to be surprised. With experience, you come to understand and to appreciate these guidelines, and you learn how to implement them in your practice.

Eventually, you realize that while the first two are largely within your control, the third is more difficult to secure, in no small part thanks to your client.

I am not implying that clients do not always provide their advisers with the relevant information[i] – it is up to the adviser to pose the appropriate question that will elicit that information.

Inspector Clouseau: “Does your dog bite?”

Hotel Clerk: “No.”

Clouseau: [bending over to pet the dog] “Nice doggie.”

[Dog bites Clouseau’s hand]

Clouseau: “I thought you said your dog did not bite!”

Hotel Clerk: “That is not my dog.”[ii]

I am saying that clients can be very cost conscious[iii] – especially in the case of the closely held business – perhaps irrationally so where professional fees are concerned, such that these clients will often fail to consult their professionals until some loss has already been incurred, or until a “transaction train” has already left the proverbial station.

At that point, the adviser may find themselves playing catchup. What’s more, they are in reactive (and sometimes damage-control) mode, rather than in planning mode.


Although I understand the owner’s motivation, there comes a time when the concern over professional fees may cost the owner far, far more. In particular, I am thinking about the sale of the business, and the owner’s not infrequent failure to engage their tax adviser at the very beginning of the sale process, even before they embark on shopping the business and negotiating the terms of its sale. And this is where the surprise is sprung on the tax adviser.

Client: “Good morning, Lou.”

Adviser: “Good morning, Bob. Been a while. How’s everything?”

Client: “I have some great news to share with you.”

Adviser: “I could use some good news. What’s up?”

Client: “I’m selling my business.”

Adviser: “Ah, so you’ve finally decided to sell. Good for you, though I wonder what you’ll do with your free time – I pray you don’t turn into a golfer.

We should get together with your accountant to talk about various deal structures, and how much you would net on an after-tax basis under each. As I recall, you’re operating through an S corporation,[iv] right?

Do you have an idea of what you’re looking for, in terms of a dollar figure, in order to make this happen?”[v]

Client: “I already have a buyer.”

Adviser: “Really? Wow, OK. What kind of discussions have you had? Is there a nondisclosure in place?”

Client: “We’ve signed a letter of intent.”

Adviser: “Come again, please.”

Client: “There’s a signed LOI. I’ll send you a copy.”[vi]

Adviser: “When did this happen?”

Client: “About three days ago. The buyer is a PE firm. They’ve already acquired a couple of my competitors, and I don’t want to miss out. We’re scheduled to close in two months. [Long silence] Lou? Are you there? You OK? Hello-o! Lou?”

Adviser: “I’m still here. Two months, huh?

Are you selling your stock or is the corporation selling its assets?

“What’s the purchase price, and how is it being paid? Cash at closing, any promissory note or earnout?

Are they expecting a rollover of any equity?

Do they expect you to stay on?

What about the real property? As I recall, the property is in a separate LLC that you own with a trust for the kids, right?”

Client: “Slow down, and don’t sound so miffed.[vii]

Yes, the buyer wants me to invest 10-percent of my equity – it’ll give me a chance to participate in the growth of the business after the sale, including that of any other businesses that may be acquired. A second bite at the apple, you might say.

I’m selling assets. The buyer mentioned that it was important that they have a step-up in basis for the assets.”

Adviser: “You mean your corporation is selling its assets.

Yes, the step-up enables the buyer to recover their purchase price through amortization, depreciation, and immediate expensing, which makes the deal less expensive for them, but generally more expensive for you.

Was there any discussion of a stock sale? What about a gross-up of the purchase price to account for any ordinary income?

Was there any discussion about your rollover being on a tax-deferred basis? What does the LOI say?”

Client: “A gross-up? No. As for taxes on the rollover, no, I don’t think it’s addressed, but why would there be any? You’ll see when I send you the LOI.

“Listen, I want this deal. I’m not getting any younger. I’m still healthy. I’ve got no one to take over the business.”

Adviser: “I hear you. When can we expect to see a draft of the asset purchase agreement?”

Client: “I think they said next week.”

Taxable Rollover?

Next week arrives, as does the draft APA. Pretty standard, thankfully. Cash plus an interest-bearing term note; unfortunately, the note will trigger the interest charge for large installment obligations.[viii] Interestingly, the buyer is a C corporation, and the APA makes no mention of a rollover, notwithstanding that it is referenced in the LOI, albeit in little detail.

Adviser contacts the buyer’s counsel (“BC”) regarding the rollover.

BC: “We never represented to your client that the rollover would be tax-deferred. We did explain that we wanted a basis step-up for the assets being acquired.

We expect your client to reinvest some of the cash received for the assets.”

Adviser: “In other words, no tax deferral. Obviously, Client did not fully appreciate that when the LOI was executed.

Tell me, is there a parent or holding company that owns the acquiring corporation? If so, how is it treated for tax purposes? As a corporation or as a partnership?”

Adviser learns that there is no holding company in place, and there are no plans for establishing such a holding company for the immediate future; thus, the rollover will have to be into the same corporation that is purchasing Client’s “corporate assets.”

Client: “What do you mean there’s no way for me to have a tax-free rollover? Why would I roll over any part of my business and take back a minority interest if I couldn’t do it on a tax-free basis?”

Adviser: “Let me explain again. First of all, your S corporation is the seller here, not you. What’s more, if anyone is going to make a tax-deferred rollover here, it is the S corporation – it owns the assets being transferred, and it is receiving the consideration from the buyer. Not you.[ix]

When one or more persons transfer property to a corporation in exchange for stock in the acquiring corporation, the exchange will be treated as a taxable event for the transferors unless they are in control of the corporation immediately after the exchange, or unless the exchange qualifies as a reorganization, which yours doesn’t do.[x]

“By ‘control’ I mean the transferors, as a group, own stock that represents at least 80-percent of the total voting power of all classes of voting stock of the corporation and at least 80-percent of the total number of all other classes of stock.[xi]

“Your S corporation’s interest in the acquiring corporation won’t be anywhere near that figure after the exchange.”

Client: “You said ‘persons,’ plural. What if others joined me in contributing property?”

Adviser: “If those who currently own all of the stock of the acquiring corporation – i.e., the vehicle through which the PE firm’s investors own their equity in the corporation, plus the former owners of the target companies already acquired by the buyer – if these shareholders were to contribute their stock to a new holding corporation,[xii] in exchange for stock in the holding corporation, and if your S corporation were to contribute some of its assets (the rollover portion) to this holding corporation solely for stock, then the transferors as a group would be in control, and their respective exchanges would be accorded tax-deferred treatment.”

Client: “Can’t we ask them to do that?”

Adviser: “I already did, when I spoke to BC, but the buyer isn’t willing to accommodate your deal – they said it isn’t large enough.”

Client: “What about a gross-up? Can they pay me more cash to cover the tax on the rollover?”

Adviser: “We’ve been through this. We were fortunate that they agreed to cover the spread between capital gain and ordinary income on the depreciation recapture.[xiii] They will move only so far beyond the terms of the LOI. They also want to wrap this up because they have another, larger deal in the wings.”

Client: “So I ask you again, should I do this deal?”

Adviser: “Again? You never asked me, remember? You agreed to terms without speaking to me. Besides, that’s your call, not mine.
“From a tax perspective, you will already be reporting 90-percent of the gain, part of it on the installment basis.

“You would take the acquiring corporation’s stock with a basis equal to its fair market value, which means less gain on any subsequent disposition of that stock.[xiv]

“I will also remind you that this equity affords you that ‘second bite at the apple’ you mentioned, though as a minority shareholder who has no ability to compel or influence decisions or policy, including distributions or a sale.

“If your S corporation adopts a plan of liquidation, and completes it within a twelve-month period, the note may be distributed to you, individually, without accelerating the gain inherent in the note.[xv] In this way, you’ll receive the cash, the note and the stock, and you will have eliminated the S corporation.

“Let me end with this: if you try to back out now, you’re inviting a lawsuit. They’ll come after you for all the costs they’ve incurred.”

How Bad Is It?

Client’s S corporation, in the above dialogue, will recognize all of the gain realized on the transfer of its assets to the acquiring corporation – that includes the gain attributable to the receipt of stock in the acquiring corporation, as well as the gain attributable to the cash received at closing; the gain associated with the note will be recognized as principal payments are made on the note.[xvi]

Client will have to report on its tax return the gain arising from the S corporation’s receipt of stock in the acquiring corporation.[xvii] Client will pay the resulting tax on such gain using the net cash proceeds from the asset sale; meaning from the proceeds remaining after all transaction expenses[xviii] have been paid, and after any corporate-level taxes have been satisfied; for example, transfer taxes and sale taxes on the sale of certain assets, as well as income taxes where the corporation is subject to the built-in gain tax.[xix] The S corporation will have to distribute these proceeds to Client, whether in liquidation or otherwise.

Query how much cash will be left in the hands of Client after all is said and done? Stated differently, how secure will Client’s financial future look?[xx] This is the key to Client’s financial wellness considering their income-generating business assets will have been converted into, or exchanged for, such cash plus an installment note (a credit risk until it is satisfied) plus a minority equity interest in the acquiring corporation (the transfer of which is likely restricted, and which may appreciate in value or even become worthless).


These are not the kinds of decisions that the owner of a closely held business should be considering for the first time under the pressures and time constraints of an active transaction.

Although the actual sale may not have been foreseen – at least as to the timing and the identity of the buyer – the elements and process of the sale should not be foreign to the business owner. In fact, the owner of a mature business, in consultation with their advisers – accountant, attorney,[xxi] and financial adviser – should periodically review their situation and plan accordingly.

For example, has a particular employee become vital to the well-being of the business? Does the business need to reward or entice that employee in order to keep them, perhaps through a deferred compensation plan that is tied to a “change-in-control?” Or, has the owner embarked on a new line of business, in addition to the core business? Should it be removed and placed into a separate entity? [xxii]

That being said, it is too often the case that the owners of a closely held business are too busy managing and operating their business to spend the time necessary to educate themselves on the “do’s and don’ts” of selling a business.

That is why it is imperative that they bring their advisers into the picture well before the terms for the sale of the business are agreed upon. These advisers should be experienced with planning, memorializing, and managing such transactions. With their input, the owner – who may never have been involved in the sale of another business – will be able to level the playing field for negotiating deal terms, including the purchase price, and will avoid getting into an untenable situation from which it may be difficult (and expensive) to extricate themselves.

In other words, it will behoove the owner not to surprise their advisers.

There are definitely instances in which information is withheld, usually because the client has determined that the information is not relevant to the issue at hand.

[ii] From The Pink Panther Strikes Again, 1976.

[iii] An admirable quality. Why spend the funds of the business needlessly?

[iv] IRC Sec. 1361.

[v] While the client owns the business, the business finances their lifestyle, and perhaps that of other family members. Wages, distributions, cars, life and health insurance, clubs, charitable giving, and many other items are provided or made possible by the business. After the business is sold, the after-tax proceeds will bear the burden.

[vi] It’s amazing how often this happens. What’s more, the LOI will sometimes be so detailed that, arguably, it may itself constitute a purchase and sale agreement – a result that is only avoided by the inclusion of language that the parties intend to enter into a “final definitive agreement,” or words to that effect.

[vii] Can you really blame the adviser?

[viii] IRC Sec. 453A. There are ways to address this.

[ix] In this scenario, we are assuming that there is no so-called “personal goodwill,” and that the client is not licensing any intellectual property to the business. We already know that the client’s LLC leases real property to the business. The client may receive compensation for consulting services to be provided over some transition period. If any family members are genuinely employed by the business, they may be retained by the buyer for some period of time.

[x] IRC Sec. 351.

If the exchange – specifically, the transfer of the assets of the business to the acquiring corporation in exchange for stock plus cash – had somehow qualified for tax-deferred treatment under Sec. 351, each item of the total consideration received (the stock and the cash) would have been allocated among all of the assets transferred according to their relative fair market values; in that way, the gain or loss from the transfer of each asset would be determined separately.

Client’s transaction will not qualify as a reorganization; for one thing, there’s way too much cash, and the structure doesn’t satisfy the statutory definition of a reorganization. See IRC Sec. 368(a)(1) and Reg. Sec. 1.368-1 and 1.368-2.

[xi] IRC Sec. 368(c).

[xii] Instead of a corporation, an LLC, treated as a partnership for tax purposes, would be preferable from the perspective of a seller who was also rolling over a portion of its equity in the business; that’s because there is no “control immediately after the exchange” requirement in the case of contributions to a partnership. See IRC Sec. 721.

[xiii] IRC Sec. 1245. A sale of stock will generate capital gain.

A sale of assets will generate some ordinary income as well as capital gain.

For example, a portion of the gain from a sale of depreciable tangible personal property will be treated as ordinary income that is taxable at a maximum federal rate of 37-percent – the tax benefit from the depreciation deductions previously generated by the property is “recaptured” as ordinary income on the sale of the property.

The gain from the sale of goodwill is treated as capital gain that is taxable at a federal rate of 20-percent.

[xiv][xiv] For a discussion of gain recognition in “tax-free exchanges,” see

[xv] IRC Sec. 453(h) and 453B(h).

[xvi] IRC Sec. 453. Of course, the interest payments received will be taxed as ordinary income. The imposition of the excise tax on net investment income, under IRC Sec. 1411, will also have to be considered.

[xvii] IRC Sec. 1366.

[xviii] Including those damned professional fees.

[xix] IRC Sec. 1374. Of course, depending upon the local jurisdiction, there may be other corporate-level income taxes (NYC, for example).

[xx] See endnote iv.

[xxi] Including their estate planner.

[xxii] See IRC Sec. 355(e) and Reg. Sec. 1.355-7. See also Reg. Sec. 1.355-3 for the active trade or business requirement under IRC Sec. 355.

Several years back, a client who had just sold their business inquired about investing some of their proceeds from the sale in a “cryptocurrency mining” venture based in Upstate N.Y. I thought they had lost their mind. “A what?” I asked. The client replied that the project involved the use of many powerful computers, but was otherwise unable to describe the business, let alone explain it to me in simple-to-understand terms.[i] Still, they pressed me, “What would you do?”

I hate that question. After reminding them that I could not provide any investment advice, I suggested they do more homework, and seek out a qualified investment adviser. Finally, I answered their question, saying that I would consider a more conventional place to park my hard-earned money.

Fast forward. Not only is cryptocurrency still with us – I think “virtual currency” may be more accurate[ii] – its acceptance seems to have grown among both closely-held and public companies; in fact, Facebook announced only last month that it was launching its own form of cryptocurrency.

These developments have caused some concern at the IRS, which believes that the increasing use of virtual currencies may jeopardize tax revenues.

Before describing the IRS’s position, including its recently announced plans, with respect to cryptocurrency, it may be helpful to review – albeit in an overly simplistic and somewhat fictional[iii] way – the evolution of currency, generally.[iv] Think of what follows as the development of my understanding of the concept.

Legal Tender

Thousands of years ago, our ancestors bartered – exchanged things of value – with one another in order to acquire the goods and services they needed. One would swap, or trade, a haunch of deer in exchange for two loaves of bread. A second would clear a field in exchange for an axe. A third would chop wood in exchange for a set of new clothes. A fourth would, to the delight of many, demonstrate their ability to successfully throw a ball through a hoop once out of every 4 attempts, for twenty minutes at a time, in exchange for a lifetime’s worth of food, clothing, shelter, protection, adulation, influence, and so much more – no wait, specialization was a later development (I’m getting ahead of myself).[v]

Specialization and Barter

The growth of societies was accompanied by two developments: (1) individuals began to realize that they could not dabble successfully in all skills;[vi] rather, they began to specialize in the production of certain goods and services – things they were good at – which they would trade with “specialists” in other goods and services; and (2) some people (the “government”) offered to protect the individuals who lived within an area (the “governed”) from the marauders that roamed the countryside, to patrol the roads that allowed them to travel to other places where they could trade their goods and services with people who lived elsewhere, and to settle disputes among the governed; in exchange for these services – another barter transaction – the governed were required to pay “taxes” and “tolls” in the form of goods and services.[vii] As the roles and responsibilities of the government grew and expanded, so did the need for more taxes by which the governed periodically paid for the additional services provided to them by the government.[viii]

Eventually, both the government and the governed realized that the transfer of value in-kind was unwieldy and inefficient. After all, what would a farmer do if the only thing of value that they owned was some seed, and they wanted to trade it with the blacksmith for some nails, but the blacksmith had no need for seed?[ix] Would you have to find someone who could use the seed who also had something of value that the blacksmith may want?[x]


In response to this quandary, the government eventually came up with the idea of “currency”: something that people can exchange for goods and services – also known as a “medium of exchange” – that is issued by the government and that is accepted at its face amount within the territory controlled by the government.

Originally, currency was issued in the form of coins made out of a precious metal (like gold), so that the coin itself was inherently valuable.[xi]

Later, currency was made out of paper that, in itself, was worthless but which was easier to handle. This paper, or banknote, was, and continues to be, a bearer note – meaning that its “value” is not “payable” to a specified person, but rather to whomever holds it – that is issued only by the government’s central bank.[xii] The paper’s status as a bearer note – “cash,” in the colloquial – affords the persons who transact business using such notes a degree of anonymity.[xiii]

It used to be, however, that the paper was backed by gold – meaning that the banknote could be presented to the government’s central bank and exchanged for gold[xiv] – but that is no longer the case.

Today, as in the case of any debt issued by the U.S. government, a banknote – your ordinary dollar bill and its siblings, all of which represent “legal tender” that a vendor of property or services is legally obligated to accept in satisfaction of the debt created in connection with such sale – is backed “only” by the “full faith and credit” of the U.S.,[xv] and that seems to be enough for most of the world.

Virtual Currency – As Understood by a Layperson [xvi]

Like “real” currency,[xvii] virtual currency acts as a medium of exchange for purchasing goods and services; as such, it can circulate from person to person, much as real currency does. Also like real currency, it can exist in different units of value.[xviii]

Unlike real currency, it is not issued by a national government or its central bank; it is not legal tender that must be accepted by someone selling goods or services within a particular jurisdiction. What’s more, it does not exist in any tangible form (like paper money), but only electronically.

Its proponents claim that, because virtual currency is not controlled by a central bank, it is free from interference by any such institution. They also claim that it may be transferred between parties to a transaction[xix] without incurring the high fees often charged by traditional financial institutions. In addition, the software that is used to effectuate these transfers functions without the need for the “identifying information” of the parties, thus providing a degree of anonymity.

I can’t comment on whether these advantages do, in fact, exist.

I will observe, however, from a theoretical perspective, that both the real and virtual systems depend upon the maintenance of a data base for each user, one that records the user’s transactions in which the real or virtual currency is acquired or transferred. In the case of real currency, a central bank handles this function; in the case of virtual currency, the function is performed by many private persons through a process called “mining,” which seeks to maintain the integrity of the “system” by validating transactions between parties.[xx]

The IRS’s Position

Although the term “cryptocurrency” seems to have entered the public lexicon around 2008,[xxi] the IRS did not issue any guidance until 2014.[xxii]

At that time, the IRS limited its guidance to virtual currency that has an equivalent value in real currency, or that acts as a substitute for real currency (so-called “convertible” virtual currency).[xxiii]

According to the IRS, virtual currency is treated as “property” for federal tax purposes; consequently, general tax principles applicable to property transactions apply to transactions using virtual currency.


For example, a taxpayer who receives virtual currency as payment for goods or services must, in computing their gross income, include the fair market value of the virtual currency, measured in U.S. dollars, as of the date that the virtual currency was received. This amount also represents the initial basis of such virtual currency in the hands of the taxpayer.[xxiv]

The fair market value of virtual currency received for services performed as an independent contractor, measured in U.S. dollars as of the date of receipt, constitutes self-employment income and is subject to self-employment tax.


If the fair market value of property received in exchange for virtual currency exceeds the taxpayer’s adjusted basis of the virtual currency,[xxv] the taxpayer has taxable gain.[xxvi] This should be compared to legal tender – like the dollar – which is always worth its face value, and the basis of which is also equal to its face amount.[xxvii]

The character of the gain generally depends on whether the virtual currency is a capital asset in the hands of the taxpayer. A taxpayer generally realizes capital gain on the sale or exchange of virtual currency that is a capital asset in the hands of the taxpayer. A taxpayer generally realizes ordinary gain on the sale or exchange of virtual currency that is not a capital asset in the hands of the taxpayer.

Information Reporting

A payment made using virtual currency is subject to information reporting to the same extent as any other payment made in property. For example, a person who in the course of a trade or business makes a payment of fixed and determinable income[xxviii] using virtual currency with a value of $600 or more to a U.S. non-exempt recipient in a taxable year is required to report the payment to the IRS and to the payee.

Similarly, a person who in the course of a trade or business makes a payment in virtual currency of $600 or more in a taxable year to an independent contractor for the performance of services is required to report that payment to the IRS and to the payee on Form 1099-MISC, Miscellaneous Income.

More Recent Developments

The foregoing guidance was all well and good.

However, in 2016, the AICPA[xxix] asked that the IRS provide additional guidance on the tax treatment of cryptocurrency. It repeated the request in 2018. The IRS has thus far failed to issue more guidance.

That being said, in early 2018, the IRS reminded taxpayers that income from virtual currency transactions was reportable on their income tax returns, and that virtual currency transactions were taxable just like transactions in any other property.[xxx] Taxpayers who did not properly report the income tax consequences of virtual currency transactions, it stated, could be audited for those transactions and, when appropriate, could be liable for penalties and interest. In more extreme situations, the IRS continued, taxpayers could be subject to criminal prosecution for failing to properly report the income tax consequences of virtual currency transactions.[xxxi]

As if to impress upon the public the magnitude of the challenge, the IRS noted that, as of the date of the release of this reminder to taxpayers, there were more than 1,500 known virtual currencies.[xxxii] The IRS stated that, because transactions in virtual currencies could be difficult to trace,[xxxiii] and have “an inherently pseudo-anonymous aspect,” some taxpayers may be tempted to hide taxable income from the government.

Compliance Campaign

Then, in July of 2018, the IRS announced a Virtual Currency Compliance Campaign to address tax noncompliance related to the use of virtual currency through outreach and through examinations of taxpayers.[xxxiv]

According to the announcement, the Compliance Campaign is aimed at addressing noncompliance related to the use of virtual currency. It stated that the compliance activities will follow the general tax principles applicable to all transactions in property, as outlined in the IRS’s 2014 guidance. It also urged taxpayers with unreported virtual currency transactions to correct their returns as soon as practical.

Significantly, the IRS indicated that it was not contemplating a voluntary disclosure program specifically to address tax non-compliance involving virtual currency.[xxxv]

Evidently not pleased with the pace of the IRS’s efforts to issue additional guidance, a group of lawmakers requested, in April of 2019, that the IRS update its 2014 guidance on the taxation of cryptocurrency transactions.

July 26, 2019

Last week, however, the IRS announced that it has begun sending letters to taxpayers with virtual currency transactions that potentially failed to report income and pay the resulting tax from such transactions, or that did not report their transactions properly.[xxxvi]

By the end of August, the IRS stated, more than 10,000 taxpayers will receive these letters. It indicated that the names of these taxpayers were obtained through “various ongoing IRS compliance efforts.”[xxxvii]

The IRS further stated that it will remain actively engaged in addressing non-compliance related to virtual currency transactions through a variety of efforts, ranging from taxpayer education to audits to criminal investigations. As if to emphasize this last point, the IRS stated that virtual currency is an ongoing focus area for IRS Criminal Investigation.

The announcement ended with a statement that the IRS anticipates issuing additional legal guidance in this area “in the near future,” and with a reminder that taxpayers who do not properly report the income tax consequences of virtual currency transactions will be liable for tax, penalties and interest, and criminal prosecution when appropriate.[xxxviii]

What’s Next?

With the announcement that it is going to start auditing taxpayers with cryptocurrency assets, the IRS is ramping up its focus on cryptocurrency transactions.

As in the case of unreported foreign accounts years ago, I would expect the IRS to engage in some high profile exams and prosecutions of both larger and smaller transactions so as to demonstrate that it is serious about across-the-board compliance in this area, and to thereby discourage noncompliance.

The fact that it is not considering, as a first step, a voluntary disclosure program, of the kind once made available to holders of unreported foreign accounts, may be an indication of the IRS’s perception of the potential magnitude of the threat to tax revenues that is presented by cryptocurrency transactions.

It is also likely that these exams will generate a great deal of data from which the IRS will derive the principles for additional guidance on the tax treatment of cryptocurrency transactions. The exams may even highlight any shortcomings in the IRS’s technical capability, as well as in its legal ability, to investigate such transactions, which in turn could form the basis for legislation to remedy any such shortcomings.

In the meantime, the IRS will rely on its not insignificant administrative, interpretive and enforcement powers to monitor cryptocurrency transactions.

Of course, there are bad actors who believe their transactions cannot be traced – like those folks who still transact business only in cash, or like those who used to hide their wealth in overseas accounts that were once protected by “privacy” laws, these taxpayers believe they are somehow acting “anonymously.”

What these folks forget is that the taxpayer bears the burden of establishing their proper tax liability. The taxpayer is charged with keeping records that support the amount of income received and expenses incurred, as well as their basis for property sold or exchanged. When they are found out, well, they may find that they are up a certain creek.

Speaking of which, it’s only a matter of time before they are found out. The same technology that they believe affords them the ability to go about their business undetected will one day enable the IRS to piece together the extent of their activities.

In light of the foregoing, any closely held business that determines, for bona fide business reasons, that it has to transact, or would benefit from transacting, with vendors or customers (“peers”) using a virtual currency must not lose sight of its tax reporting, record maintenance, and payment obligations.

[i] Call it a version of the “smell test.” If you can’t understand it well enough to explain it to someone else, stay away from it.

[ii] “Crypto” has a negative connotation in my mind. It is derived from the Greek word for “secret” or “hidden.” Query whether that selection was intended to convey something nefarious.

[iii] And hopefully humorous.

[iv] Lots of disclaimers, here. I am not a professional economic historian, though I am a student of government and of the “social contract” theory from which are derived the government’s responsibilities to the governed and the responsibilities of the governed to each other.

[v] Is it a sign of a mature or successful society that entertainers – be they athletes, singers, or actors – are treated as demigods? What about former public “servants” who become wealthy writing and talking about their years “in service”? I know, it’s what “the market” values.

[vi] I couldn’t be both a farmer and a fisherman, a teacher and a carpenter.

[vii] “In-kind.”

[viii] Think of these “exchanges” as forms of credit, debt and repayment.

[ix] We’re not going to discuss commercial credit here. In fact, commercial credit did not come into its own until after the introduction of currency.

[x] Think about the deferred like kind exchange. Rarely do you see two parties swapping properties between them. Rather, the seller who is seeking to acquire replacement property has to search elsewhere for the desirable property. Thus, at least four parties are required to effect the transaction: the seller of the relinquished property, the buyer of such property, the qualified intermediary who accepts payment for the relinquished property, and the seller of the replacement property, from whom the qualified intermediary acquires such property on behalf of the original seller. Phew!

[xi] “Valuable” in that someone was willing to give up something they had in exchange for the coin.

[xii] The Federal Reserve Bank, in the U.S.

[xiii] I.e., the ability to avoid their lawful tax obligations. After all, it is relatively difficult to trace and relatively easy to hide.

[xiv] Before 1971, paper money included the following statement: “This note is legal tender for all debts, public and private, and is redeemable in lawful money at the United States Treasury or at any Federal Reserve Bank.”

“Lawful money?” Gold.

[xv] Take a look at the paper money in your pocket or wallet, assuming you still carry any. It includes the following statement: “This Note Is Legal Tender for All Debts, Public and Private.” It is no longer redeemable for money.

In 1971, President Nixon eliminated the convertibility of the dollar into gold. One of the reasons for doing so was to prevent foreign governments from exchanging the dollars held by their central banks for the U.S.’s gold reserves.

[xvi] Me.

[xvii] For example, U.S. dollars.

[xviii] As I understand, these “units” or “tokens” are created by a complex computer code.

For a good discussion of cryptocurrencies, generally, I found the one on ASIC’s website especially helpful: .

[xix] The transfer is described as being “peer to peer.”

[xx] For example, by ensuring that the same unit of currency is not used twice in short order by the same person.

I can’t speak for others, but give me a central bank over private miners any time. Again, if I can’t understand it, . . .

[xxi] Though it appeared in the “computer world” well before that.

[xxii] Notice 2014-21.

[xxiii] Bitcoin is one example of a convertible virtual currency. Bitcoin can be digitally traded between users and can be purchased for, or exchanged into, U.S. dollars, Euros, and other real or virtual currencies.

The IRS stated that no inference should be drawn with respect to virtual currencies not described in the notice.

[xxiv] Query how such fair market value is to be determined. By reference to the value of the service rendered or of the property sold?

[xxv] To-date, the IRS has not treated virtual currency in the same way as foreign currency for purposes of IRC Sec. 988, which addresses foreign currency transactions.

[xxvi] Viewed differently, has the virtual currency appreciated in value? I’ve wrapped my head around this by thinking of the virtual currency as a metal or other commodity. Supply and demand at work?

[xxvii] Though its value relative to other items may be different at different periods of time; for example, because of inflation. I remember when a regular slice of pizza was 25 cents. Today, that regular slice is $3.00.

[xxviii] For example, as rent, premiums or compensation.

[xxix] American Institute of Certified Public Accountants.

[xxx] Virtual currency, the IRS explained, is generally defined as “a digital representation of value” that functions in the same manner as a country’s traditional currency. Hmm. A glimpse of things to come?

[xxxi] IR-2018-71.

[xxxii] The figure is probably closer to 2,000 now.

[xxxiii] Presumably because of the “peer to peer” feature. Like barter?


[xxxv] Compare the IRS’s approach (the OVDP) toward undisclosed foreign bank and other financial accounts.

[xxxvi] IR-2019-132.

[xxxvii] The IRS’s own data mining.

[xxxviii] Talk about beating a dead horse.

Teach Your Children Well [I]

It may be the dream of every parent who owns a closely held business that one or more of their children will follow in their footsteps. They envision a time when a child will enter the business as an employee, learn the “ins and outs” of the business, pay their dues,[ii] move up the ranks and, one day, assume the mantle of leadership as the parent heads off to their new pastime,[iii] secure in the knowledge that they have left their child with a good business, and equally secure in the knowledge that the business they have built is in good hands. If all goes to plan, the parent will make a gift of equity in the business to the child, or they will bequeath the business to the child.[iv]

Unfortunately, things don’t always turn out as we hoped they would. Remember Don Corleone in the garden, after his youngest son, Michael, has told him that he has assumed control of the family business? “I never wanted this for you.”[v]

The Don foresaw the troubled life that Michael had chosen. Unfortunately, it seems that some parents would knowingly put their children in harm’s way – indeed, even throw them under the proverbial bus[vi] – and there are those children who learn all the wrong things from their parents. Both of these situations are found in the case described below.[vii]

Family Business

Parents had long been engaged in the staffing business[viii] (the “Business”). After Child completed college, Parents invited Child to work in the Business. They organized a new corporation (“Corp”), of which Child was named the sole director and president, positions that Child would hold for the next twelve years.[ix]

Client businesses for which Corp provided staffing would pay Corp directly for its services. The people who were staffed at the client businesses were classified as Corp’s employees, and Corp was responsible for paying their wages and for withholding taxes from those wages.

Despite being established as the sole director and president of Corp – at least on paper – Child initially worked at locations offsite from the corporate office, under the control and direction of Parents, who in fact actively managed Corp.

After an approximately five-year period of employment with Corp (the “Earlier Period”), Child continued to work primarily offsite, though they were given additional responsibilities, some of which required Child to return to the corporate office periodically to execute a number of documents (as directed by Parents), which Child would do without reviewing.[x] Occasionally, Child would also check the corporate mail and make bank deposits, though these tasks were primarily the responsibility of Parents.

Through the Earlier Period, and just beyond, Child did not exercise any hiring or firing authority over employees, though Child would occasionally make personnel recommendations to Parents. Child had access to Corp’s checking accounts, but was not responsible for them. Most checks were signed by Parents, though Parents would occasionally ask Child to sign completed employment tax returns[xi] on behalf of Corp, which Child would do without reviewing.

Trust Fund Taxes

Corp did not pay in full its federal employment taxes for certain quarters during the Earlier Period. Parents prepared a “Report of Interview with Individual Relative to Trust Fund Recovery Penalty”[xii] on which Child was identified as the person “interviewed” – Child executed the completed form at the request of Parents.

At some point, an IRS Revenue Officer appeared at Corp’s office unannounced, and explained to Child that Corp had a “tax issue” and owed taxes. After the meeting, Child contacted Parents, and was told that they and the corporation’s attorneys would handle the tax issues.

Shortly thereafter, the IRS sent a Trust Fund Recovery Penalty (“TFRP”) Letter,[xiii] and a Proposed Assessment of Trust Fund Recovery Penalty,[xiv] with respect to Corp’s unpaid employment taxes for above-referenced quarters. The certified mail was returned to the IRS, unclaimed.[xv] The IRS assessed TFRPs against Child.

Transition in Management

During the years following the Earlier Period (the “Later Period”), new bank accounts were opened for Corp, with Child having signatory authority over a business checking general fund account, and a business checking labor payroll account. In addition, a business checking “Special Trust Fund Account” was opened to help ensure that Corp paid its tax liabilities. Child was named trustee of, and had sole signatory authority over, the Trust Fund Account.

Also during the Later Period, Child began taking over the Business in preparation for Parents’ retirement. Thus, Child assumed many of Corp’s internal operations. Child had the authority to hire and fire employees, to sign leases on behalf of the corporation, and to transfer funds from Corp’s general fund to its labor payroll account. Child had a corporate credit card and used it to make purchases. However, Child also continued to sign any documents as directed by Parents, including Corp’s tax returns.[xvi]

Transition in Delinquency

During the Later Period, Corp began to underpay its tax deposits, and its employment tax returns consistently reflected balances due. At some point, Corp’s deposits were far less than the balance due, and it oftentimes owed several hundred thousand dollars of unpaid tax on each return. Corp filed its returns and paid deposits each quarter, but the large delinquencies continued to accrue.

Inexplicably, Corp’s general fund account held funds sufficient to pay the corporation’s delinquent employment taxes, yet Child instead wrote checks out of the general fund for payments to a professional sports team and a country club, as well as other personal items.

What’s more, the funds in Corp’s labor payroll account were sufficient to have fully paid the balances reflected on the employment tax returns for several of the delinquent quarters.

Over the course of the Later Period, significant amounts were withdrawn from the Trust Fund Account that were not used to pay Corp’s employment tax liabilities.

Toward the end of the Later Period, Parents pleaded guilty to tax evasion.[xvii]

By that time, Child had fully taken over management of the day-to-day operation of Corp. Shortly thereafter, Child closed the Business.

You’re On Your Own, Kid

Child was interviewed by an IRS Revenue Officer. This was followed by a letter from the IRS indicating that Child might have some responsibility regarding Corp’s unpaid employment taxes for the Later Period.

The IRS then assessed TFRPs against Child for both the Earlier and Later Periods, aggregating approximately $2.3 million.

This was followed by a Notice of Federal Tax Lien Filing for the TFRPs with respect to the Earlier Period, and by another Notice with respect to the Later Period.

Finally, the IRS issued Child a Final Notice, Notice of Intent to Levy, and Notice of Your Right to a Hearing for TFRPs for the Later Period.

Child timely filed Requests for a Collection Due Process or Equivalent Hearing (CDP hearing requests),[xviii] in response to the two NFTL filings and the levy notice. The CDP hearing requests sought relief from the liens and proposed levy and acceptance of an offer-in-compromise or an installment agreement. Child also argued they were not a responsible person and never had the actual authority or ability to pay the taxes because Corp and its taxes were controlled by Parents.

The CDP hearing requests were assigned to a Settlement Officer (“SO”), who did not consider the substantive basis for the underlying liabilities for any of the periods in issue. Instead, the SO focused on Child’s request for an offer-in-compromise or an installment agreement. When the SO proposed a payment plan, Child’s attorney informed the SO that Child intended to close the Business and would be unable to make any proposed payments.

The IRS Office of Appeals issued Child a notice of determination sustaining the NFTLs and the proposed levy.

In response to the notice of determination, Child timely petitioned the U.S. Tax Court.[xix] Among other things, Child asserted that (1) they were not a person responsible for paying over, and they did not willfully fail to pay over, Corp’s employment taxes, and (2) Parents controlled the Business and the employment taxes.


The Court explained that an employer is required to withhold or collect from an employee’s wages the employee’s share of federal taxes,[xx] and then must pay over the withheld amounts to the IRS. Such withheld amounts are known as “trust fund taxes,” because they are “held to be a special fund in trust for the United States.”[xxi]

The Code imposes the TFRP on “[a]ny person required to collect, truthfully account for, and pay over any tax . . . who willfully fails to collect such tax, or truthfully account for and pay over such tax, or willfully attempts in any manner to evade or defeat any such tax or the payment thereof.”[xxii]

The term “person” includes an officer or employee of a corporation who is under a duty to collect, account for, and pay over the tax.[xxiii] Such persons are referred to as “responsible persons.”[xxiv] The TFRP shall be paid upon notice and demand by the IRS and shall be assessed and collected in the same manner as taxes.[xxv]

Child contended that they were not liable for TFRPs because they were not a responsible person who willfully failed to pay over the withheld taxes for any of the periods in issue.

The Court’s Analysis

The Court agreed that Child’s liability for the TFRPs rested on their being a responsible person with respect to the periods in issue.

Responsibility, the Court stated, was based on an individual’s “duty and authority to withhold and pay taxes.” It “does not require actual knowledge that one has that duty and authority.”

The Court explained that, among the factors indicative of such authority were whether the individual: “(i) is an officer or member of the board of directors; (ii) owns a substantial amount of stock in the company; (iii) manages the day-to-day operations of the business; (iv) has the authority to hire or fire employees; (v) makes decisions as to the disbursements of funds and payment of creditors; and (vi) possesses the authority to sign company checks.”

During the Earlier Period, Child was unaware that Corp had failed to pay its employment taxes. Indeed, Child worked under the control and direction of their parents. Child was not involved in the day-to-day management of the company, worked primarily offsite, and signed papers when asked to do so. Child did not exercise any hiring or firing authority over employees and, instead, left personnel decisions to the Parents.

Child became aware of the corporation’s failure to pay its employment taxes in full only after being informed of such by the Revenue Officer who visited the corporation’s office. Even then, Child contacted Parents for guidance and was told that they and the corporation’s attorneys would handle any tax matters.

However, Child did take a more active role in the corporation during the Later Period. Child acted upon their authority as the president and sole director of the corporation. Child was being groomed to take over the Business, and participated more actively in the management of the corporation. Child had signatory authority over the corporation’s bank accounts; in particular, Child had sole signatory authority over Corp’s Trust Fund Account, which was opened to ensure the corporation paid its tax liabilities. Child was more involved in the day-to-day operations of the corporation during this period, wrote checks from the corporate accounts, and chose to make payments for personal expenses instead of taxes.

The Court pointed out that the stark contrast between Child’s nominal duties during the Earlier Period and Child’s role during the Later Period demonstrated that Child was not a responsible person for the Earlier Period.

The Later Period presented a different story. At this point, Child was aware of Corp’s delinquent tax liabilities, and had been interviewed by a Revenue Officer about the outstanding tax liabilities. Moreover, Child could not have reasonably expected that Parents would resolve the corporation’s tax issues because they were about to be incarcerated.

Accordingly, the Court did not sustain the IRS’s determination for the TFRPs relating to the corporation’s employment taxes owed for the Earlier Period, but it did sustain the IRS’s determination for the Later Period.

What’s The Point?

Two points, I guess.

I don’t know about you, but there appear to be a lot of trust fund matters out there. Unpaid employment taxes continue to be a substantial problem. Amounts withheld from employee wages represent almost 70-percent of all revenue collected by the IRS, yet billions of dollars of tax reported on Employer’s Quarterly Federal Tax Returns (Forms 941) remain unpaid.[xxvi] The cause, in many cases, is a failing business – the latter will often divert the tax monies collected toward the satisfaction of business expenses in the hope of turning the corner; they usually don’t. The IRS’s position is that such businesses should be allowed to fail rather than taxes go unpaid.

Which brings us to the second point. We know that, in transactions between unrelated persons, before a prospective acquirer actually purchases a business from the current owner of the business, they will do a fair amount of due diligence, and they ask the current owners to make specific representations as to the “well-being” of the business and as to its compliance with applicable laws.[xxvii]

What does the beneficiary of a gift or bequest do before accepting the transfer of an interest in a donor’s or decedent’s business?

In the vast majority of cases, nothing – except, perhaps, say “thank you.” Remember the old saying, “Don’t look a gift horse in the mouth”?[xxviii]

In any case, what parent would transfer to their child an interest in a business with a closet full of skeletons? Unwittingly, perhaps; but not knowingly, except in rare circumstances, as we saw in the discussion of the Earlier Period, above.

It is important to note that the intended beneficiary of a gratuitous transfer is not required to accept such a transfer; indeed, state property law and federal tax law both provide for the beneficiary’s disclaimer or renunciation of a gift or bequest.[xxix]

In order to decide whether to accept a gift, I say, of course the intended beneficiary should count the horse’s teeth; they should ask the owner about its history and temperament; they may even want to ask a vet to check the horse.

Have you ever encountered a gift of an interest in real property that turned out to be environmentally challenged and very expensive to remediate? How about a gift of several properties that were not only expensive to maintain but also vacant, thereby requiring the beneficiary to dip into their savings in order to keep the property?

Can you say “thanks, but no thanks?” What about “fire sale?”

Of course, the timing and circumstances of the transfer may greatly impact the beneficiary’s ability to “negotiate” their receipt of the property; for instance, we never know when Thanatos[xxx] will come for us. That being said, it’s good to plan ahead.

In the case of a gift of an equity interest in a business,[xxxi] the management of which will pass to the beneficiary, it may behoove both “parties” to the transfer to identify any issues and to plan accordingly. Perhaps the donor-parent can remedy the problem in conjunction with making the transfer, rather than leave it for their child to confront. Alternatively, the parent may transfer other assets to the beneficiary, to provide a source of funds for use in tackling the problem, or as “compensation” for the reduced value resulting from the problem. If it is determined that the problem cannot be resolved, it may be advisable for the parent to sell the business before they retire, so as to maximize the net proceeds for the beneficiary child who may then have to seek employment elsewhere.

As always, it makes sense for the parties to openly and thoughtfully discuss these matters well in advance of the transfer.

[i] Apologies to CSNY.

[ii] The idioms are flowing freely today. Reader beware.

[iii] I pray it is anything but golf.

[iv] Beware, and do not forget, the children who are not in the business.

Query what the exemption amount will be when this transfer occurs.

Query whether the ability to claim valuation discounts will have been curtailed by then.

[v] The Don continued, “…but I thought that — that when it was your time — that — that you would be the one to hold the strings. Senator – Corleone. Governor – Corleone, or something…” A politician. I’ll leave it at that.

[vi] Nothing personal – just business.

[vii] Dixon v Comm’r, T.C. Memo 2019-79.

[viii] Employee leasing.

[ix] Presumably, Parents owned all of the issued and outstanding shares of stock.

[x] Ah, the trusting child.

[xi] Forms 940, Employer’s Annual Federal Unemployment (FUTA) Tax Return, and Forms 941, Employer’s Quarterly Federal Tax Return.

[xii] Form 4180. This form is prepared in order to assist the IRS is determining whether the individual interviewed may have been responsible for the collection and remittance of employment taxes.

[xiii] Letter 1153(DO)

[xiv] Form 2751.

[xv] Child later claimed not to have received notice of the certified mailing.

[xvi] Consistency is the mark of a champion, they say.

[xvii] So much for teaching your children well.

[xviii] Form 12153.

[xix] See IRC Sec. 6330(d)(1).

[xx] These include the employee’s share of (1) Social Security tax, see secs. 3101(a), 3102(a); (2) Medicare tax, see IRC Secs. 3101(b), 3102(a); and (3) Federal income tax, see IRC Secs. 3402(a)(1), 3403.

[xxi] IRC Sec. 7501(a).

[xxii] IRC Sec. 6672(a).

[xxiii] IRC Sec. 6671(b).

[xxiv] The term may be applied broadly.

The IRS collects the trust fund liability only once. Consequently, the IRS cross-references payments against the trust fund liability of the employer and payments against the TFRPs of responsible persons.

In addition, for circumstances in which there is more than one responsible person, a taxpayer who paid the TFRP may bring a separate suit against the other responsible person(s) claiming a right of contribution. Sec. 6672(d).

[xxv] IRC Sec. 6671(a).

[xxvi] More than $59.4 billion as of June 30, 2016. Query what the unreported amount is.

[xxvii] The breach of which would entitle the buyer to be indemnified by the seller for any resulting loss.

[xxviii] I wonder if this may be the same horse as the dead horse that one should stop beating. I did warn you about the flow of idioms today.

[xxix] See, e.g., IRC Sec. 2518, and N.Y. EPTL Sec. 2-1.11. In most cases, though, the right to disclaim is utilized as a tax planning tool.

[xxx] The god of death in Greek mythology, as distinguished from Hades, the god of the underworld and of the dead.

[xxxi] Which normally would be expected to remove not only the property from the donor’s estate, but also the post-gift appreciation in the value of the property and the income generated by the property.

If I Had a Dollar . . .

How many times have you sat with a client who wants to leave N.Y. for a jurisdiction with a more pleasant “tax climate?” A place where the combined state and local personal income tax rate does not approach 12.87-percent,[i] where the sales tax is well below 8.875-percent,[ii] where the estate tax rate is nowhere near 16-percent, and where the real property taxes are not the highest in the country.[iii]

The client has already identified this sanctuary; in fact, they have purchased a beautiful oceanfront residence[iv] in this Shangri-La, one that they claim puts their N.Y. apartment to shame (though they may keep the N.Y. property as an investment or hotel substitute). What’s more, they’ve moved all of their valuables and other cherished personal belongings to this new home.

When you ask whether they have changed their “living pattern” or adapted their activities to their “tax haven,” they reply that they now spend almost eight months of the year there, have joined local clubs and cultural organizations, have taken up surf fishing, and host all major family gatherings at their new home.[v]

Active Business Involvement

Then you turn the discussion to the source of the client’s wealth and cash flow: their business, headquartered in N.Y., and held in a business entity that is treated as a pass-through for tax purposes.[vi]

The client claims they are still active in the day-to-day management of the business – the internet and video-conferencing are wonderful things, they say. They maintain an office at the place of business, and they always visit the business when they’re in N.Y. The business pays them a generous “salary,”[vii] and periodically makes distributions.

You ask whether they plan to sell the business and, if so, when? In due course, they say, though probably sooner rather than later – they have no family member or key employee who is interested and/or capable of succeeding them, and they want to maximize the net proceeds from the sale.

You explain that, notwithstanding everything they have done to establish a new home outside N.Y.,[viii] they will remain subject to N.Y.’s personal income tax at least as to the income generated from their business, including a portion of their salary.[ix] The incredulous looks on their faces tell you to continue explaining. Even if N.Y. acknowledges that they are nonresidents, you tell them – and this is not a foregone conclusion based on the above facts – they will remain subject to N.Y. income tax on their N.Y. source income, which includes their share of the S corporation’s income that is sourced in N.Y.[x]

What’s more, you tell them, the fact that they are still very active in their N.Y. business may be enough for N.Y. to establish that they remain domiciled in N.Y.[xi], especially when one factors in their continued ownership of the N.Y. residence. You remind them that, in order to establish a change in domicile, they must demonstrate that they have “abandoned” N.Y. as their home and have “landed” elsewhere. Thus, the sale of the business may be the factor on which the abandonment of their N.Y. domicile depends; unfortunately, the sale itself will be subject to tax in N.Y.

Even if the sale of the business were not a necessary element in securing nonresident status – for example, where the clients have successfully changed their status vis-à-vis the business into that of passive investors[xii] – the gain from such sale may remain subject to N.Y. income tax as NY-source income, as illustrated by a decision of the Division of Tax Appeals just a few weeks ago.[xiii]

The Stock Sale

Taxpayer was an individual nonresident of N.Y. during the years 2009, 2010 and 2011. Through July 31, 2009, Taxpayer owned 50-percent of the shares of Target, a corporation that had elected to be treated as an S corporation for Federal and N.Y. income tax purposes.[xiv]

Target’s shareholders (including Taxpayer; the “Sellers”) entered into a stock purchase agreement with Purchaser (a corporation) pursuant to which the Sellers would sell all of the issued and outstanding shares of Target stock to Purchaser. Under the terms of the agreement, the Sellers and Purchaser agreed to make an election under Section 338(h)(10) of the Code (the “Election”). Accordingly, though the transaction was structured as a sale of stock, the effect of the Election was that Target was deemed to have sold all of its assets in a taxable transaction, Purchaser was treated as having purchased the assets, so as to receive a step-up in the basis of the assets, and Target was deemed to have then liquidated.[xv]

Prior to closing on the sale of Target to Purchaser, and prior to agreeing to make the Election, Taxpayer consulted with his CPA regarding the tax consequences of the transaction, including specifically whether the Election would subject Taxpayer’s sale proceeds to N.Y. income tax. Taxpayer was advised that, at the time of the sale (i.e., in 2009), a stock sale that was treated as a deemed sale of assets pursuant to the Election did not change the nature of the transaction for N.Y. income tax purposes. Specifically, Taxpayer was advised that under a then recently-issued decision of the Tax Appeals Tribunal (Baum),[xvi] a transaction such as the proposed stock sale would be treated, for N.Y. purposes, as the sale of an intangible (i.e., a sale of stock), notwithstanding the deemed asset sale treatment for Federal tax purposes; thus, as a nonresident, Taxpayer would not be subject to N.Y. tax on the gain from such a sale.

Based upon the foregoing advice, that N.Y. tax would not be imposed on the gain from the sale transaction, Taxpayer agreed to forego continued negotiations seeking an increased purchase price (or gross-up) for any additional taxes resulting from the Election.[xvii]

As consideration for the sale transaction, Taxpayer received a cash payment plus an installment obligation. The installment obligation qualified for installment method reporting under the Code,[xviii] permitting recognition of gain only upon receipt of principal payments on the installment obligation.

The Issue is Joined

Target filed a Federal S corporation tax return,[xix] and a corresponding N.Y. tax return,[xx] for the short period spanning January 1, 2009 through July 30, 2009,[xxi] reporting a capital gain, on an installment basis, in excess of $6.0 million; on its N.Y. return for this short period, Target reported a 100-percent N.Y. business allocation percentage (“BAP”).[xxii]

N.Y. Amends the Tax Law

On August 11, 2010, the N.Y. Tax Law[xxiii] was amended to specifically provide that a non-resident S corporation shareholder must treat the sale of stock subject to an Election as the sale of assets, and must apportion the sale proceeds to N.Y. in accordance with the S corporation’s BAP, without consideration of any deemed liquidation (the “2010 Amendments”).

On August 31, 2010, the N.Y. Department of Taxation and Finance[xxiv] issued a memorandum providing public notice and guidance with respect to the 2010 Amendments.[xxv] This memorandum noted that the amendments were retroactive and, specifically, were effective for tax years beginning on or after January 1, 2007 and any other taxable year for which the period of limitations on assessment remained open.

Taxpayer Files

On October 14, 2010, Taxpayer filed his 2009 N.Y. nonresident income tax return,[xxvi] reporting thereon his share of the foregoing capital gain. By virtue of Target’s 100-percent BAP, Taxpayer reported 100-percent of his share of the gain arising from the sale as N.Y. source income. However, on the same return, Taxpayer reported a N.Y. subtraction modification removing 100-percent of the foregoing allocated capital gain resulting from the deemed asset sale of Target from his N.Y. adjusted gross income.

Installment Payments

For the years 2010 and 2011, Taxpayer received income from the installment payment obligation arising from the sale.

Taxpayer did not file an amended return for the year 2009, and did not file any N.Y. nonresident income tax return for either 2010 or 2011. As a consequence of this reporting position, Taxpayer did not pay any N.Y. personal income tax on the proceeds arising from the sale of Target to Purchaser.

The Audit

The Department examined the final S corporation return filed for Target for the short period spanning January 1, 2009 through July 30, 2009, and Taxpayer’s corresponding reporting of his share of Target’s income. The Department’s review of Taxpayer’s and Target’s returns resulted in a determination that the transaction was properly treated as a deemed asset sale under Section 338(h)(10) of the Code, with the proceeds from the transaction constituting NY-source income to the extent of Target’s BAP.

For 2009, the Department determined that Taxpayer should not have removed the capital gain from the deemed asset sale from his return. In turn, the entire gain was treated as NY-source income, allocable as based on Target’s BAP of 100-percent, and was subject to N.Y. tax.

For 2010 and 2011, the Department determined that Taxpayer was obligated to file and report the installment payments arising from the deemed asset sale as NY-source income, allocable to N.Y. based on Target’s BAP of 100-percent, and subject to N.Y. tax.

The Department issued a notice of deficiency to Taxpayer, asserting additional N.Y. personal income tax for the years 2009, 2010 and 2011.[xxvii]

Taxpayer protested the notice of deficiency.

Division of Tax Appeals

The question before the Division was whether the Department properly determined that a nonresident individual’s gain from the sale of the stock they owned in an S corporation was required to be included in that individual’s NY-source income where the parties to the transaction had elected to treat the transaction as a sale of assets under Section 338(h)(10) of the Code.

Taxpayer argued that the asserted deficiency should be canceled because the retroactive imposition of tax liability under the 2010 Amendments constituted a violation of the Due Process Clauses of the U.S. and N.Y. Constitutions.[xxviii]

Taxpayer maintained that he reasonably relied upon the Tribunal’s opinion in Baum, according to which the substance of the transaction remained a sale of stock, notwithstanding that the parties to the stock sale had made the Election; therefore, the gain from the sale was generally not NY-source income to a nonresident and was not required to be included in the N.Y. income of an S corporation, or to be passed through to its shareholders.[xxix]

The Division reviewed the aftermath of the Baum decision, specifically as it related to Taxpayer.


On July 31, 2009 (i.e., after the decision in Baum), Taxpayer sold all of his shares in Target to Purchaser. The Baum decision was issued prior to the sale of Target, and was specifically relied upon by Taxpayer for his reporting position regarding his share of the gain from the sale, as received in the year of the transaction.

At that time, the Tax Law did not specifically address how a N.Y. nonresident’s gain from the sale of stock in a N.Y. S corporation would be impacted where such sale was treated, pursuant to an Election, as a deemed sale of the assets of the S corporation to the buyer, followed by a deemed liquidation of the S corporation.

In response to the result in Baum, N.Y. amended the Tax Law, effective August 11, 2010,[xxx] so as to address the issue of nonresident shareholders’ treatment of income related to an Election. Specifically, the Tax Law was amended to provide that, if the shareholders of an S corporation made an Election, there would be included in their income, for N.Y. tax purposes, the portion of the gain from the deemed asset sale that was derived from or connected with N.Y. sources. However, when a nonresident shareholder exchanged their S corporation stock as part of the deemed liquidation that follows the deemed asset sale, any gain recognized would be treated as the disposition of an intangible asset and would not be treated as NY-sourced.

The foregoing amendments to the Tax Law were made applicable “to taxable years beginning on or after January 1, 2007.”

The Division stated that the legislative findings accompanying the adoption of these amendments explained that they were necessary to correct the Baum decision, which had “erroneously overturned” longstanding policies that nonresident S corporation shareholders who make an Election following the sale of their shares are taxed in accordance with the transaction being treated as an asset sale producing NY-source income.[xxxi]

On August 31, 2010, the Department issued a memorandum providing public notice and guidance with respect to the 2010 Amendments.[xxxii] This memorandum stated that the 2010 Amendments were effective for tax years beginning on or after January 1, 2007, and for any other taxable year for which the period of limitations on assessment remained open.

The August 11, 2010 effective date of the 2010 Amendments, and the August 31, 2010 issuance date of the Department’s memorandum, predated the October 14, 2010 filing of Taxpayer’s N.Y. tax return for 2009.

The Division’s Analysis

It was settled law, the Division stated, that the 2010 Amendments could be applied retroactively to tax years beginning on or after 2007, without violating the Due Process Clauses of the United States and New York State Constitutions. It was likewise well settled, the Division continued, that the interpretation and application of the Tax Law by Baum prior to the 2010 Amendments, as espoused by Taxpayer, was incorrect. Consequently, the manner in which Taxpayer’s 2009 tax return was filed, in October of 2010, was likewise incorrect.

Taxpayer did not contest these facts or the facial validity of the retroactivity of the 2010 Amendments. However, Taxpayer did contest the retroactive application of the 2010 Amendments to his particular circumstances, maintaining that such application resulted in an “as applied” violation of his due process rights.

Taxpayer pointed out that his transaction took place after, and in reliance on, the Tribunal’s decision in Baum. Accordingly, Taxpayer argued that the resulting “extra level of reliance” tipped the scale in his favor, and required a conclusion that the deficiency at issue represented an unconstitutional application of the 2010 Amendments.

The Division responded that acceptance of Taxpayer’s argument would have required the Division to ignore the legislative findings that the 2010 Amendments served to clarify and confirm the Department’s longstanding and correct interpretation of existing law, whereby gains from a deemed asset sale under Section 338(h)(10) of the Code were not excluded from a nonresident’s NY-source income as gains from the disposition of intangible assets, but rather are included to the extent of the S corporation’s N.Y. BAP.

At the time of enacting the 2010 Amendments, the legislature was aware of the Baum decision, and of the consequences resulting therefrom. It recognized that such amendments were necessary in order to cure the incorrect decision reached in Baum, to clarify the concept of Federal conformity, to avoid taxpayer confusion in preparing returns, to avoid complex and protracted litigation, and to prevent unwarranted refunds so as to stem the loss of revenue that would result from such incorrect decisions.

The Division explained that, by making the 2010 Amendments retroactive, the legislature “evinced both its clarifying and corrective aims.” In doing so, it drew no distinction between transactions that predated or postdated the decision in Baum, notwithstanding that some taxpayers could claim to have relied on Baum. The legislature did not limit the retroactive reach of the 2010 Amendments by any reference to the Baum decision, but rather extended retroactivity to all open years upon the foregoing clarifying and correcting justification bases. Thus, the Division concluded, the legislature’s intended sweep of retroactivity included those who could have relied on Baum.

In sum, the imposition of the tax at issue was not an unconstitutional application of the law in violation of constitutional due process standards. Accordingly, Taxpayer’s petition was denied, and the notice of deficiency sustained.


The cost of moving to Shangri La may not be insignificant, especially for an individual N.Y. resident who owns an interest in a closely held business that operates within the state, who actively participates in the management of such business, and who is dependent upon the cash flow from the business.

For one thing, the individual’s continued ownership and involvement in the business may very well tip the scales toward a finding of continued resident status.[xxxiii]

If the individual were able to change the nature of their relationship to the business from that of an owner-participant to that of a passive investor, their continued association with the N.Y. business may not be as harmful to their claim of having abandoned their N.Y. domicile. In fact, the transition of managerial duties to another person may evidence an intent to begin a new “way of life” outside the state. Of course, this requires that the owner find someone who is capable of, and interested in, assuming these duties. The owner will certainly have to compensate this person at a level commensurate with their responsibilities; at the same time, the owner will have to cease taking a salary themselves.

Even if the owner were to successfully convert their status to that of a passive investor, if the business is owned through a pass-through entity (“PTE,” such as an S corporation or a partnership/LLC), the owner will still be subject to N.Y. income tax on their pro rata share of the PTE’s NY-source income.[xxxiv] What’s more, if the individual owner were to sell the business, it is unlikely that the buyer would agree to purchase the stock (in the case of an S corporation) without requiring an Election in order to step-up the basis of the underlying assets. As in the case of the taxpayer in the decision discussed above, that could result in significant NY-source income.[xxxv]

Did someone say “C corporation?” Don’t cut your nose to spite your face. There are Federal income taxes to consider – don’t lose sight of that.

Bottom line: there’s a lot of planning that has to precede the implementation of any steps to change a business owner’s resident status vis-à-vis N.Y.


[i] N.Y.S. at 8.82%, N.Y.C. at 3.876%.

[ii] N.Y.S. at 4.0%, N.Y.C. at 4.875%.

[iii] Whether in an absolute sense or as a portion of home value, depending upon the county.

[iv] Feel free to substitute a golf course, mountainside, or anything else that tickles your fancy – this is my post.

[v] Of course, they’ve also registered to vote there, and have registered their cars there.

[vi] An S corporation (IRC Sec. 1361), or an LLC that has not checked the box to be treated as an association (Reg. Sec. 301.7701-3).

[vii] Which, for our purposes, would include a guaranteed payment in the case of a partnership. IRC Sec. 707(c).

[viii] For the purpose of avoiding N.Y. tax.

[ix] See TSB-M-06(5)I for a discussion of the “convenience of the employer” test and the determination of the ratio of N.Y. working days to total working days.

[x] Tax Law Sec. 631(a). We’re focusing on the State’s taxation of nonresidents here.

[xi] See, e.g., Matter of Herbert L. Kartiganer et al., 194 AD2d 879.

[xii] According to the N.Y.’s Nonresident Audit Guidelines, a taxpayer’s continued employment, or active participation in N.Y. sole proprietorships and partnerships, or the substantial investment in, and management of N.Y. corporations or limited liability companies, is a primary factor in determining domicile. If a taxpayer continues active involvement in N.Y. business entities, by managing a N.Y. corporation or actively participating in N.Y. partnerships or sole proprietorships, such actions must be weighed against the individual’s involvement in businesses at other locations when determining domicile. The degree of active involvement in N.Y. businesses in comparison to involvement in businesses located outside N.Y. is an essential element to be determined during the audit.

[xiii] In The Matter of the Petition of Franklin C. Lewis, DTA No. 827791 (N.Y. Div. Tax App. 6/20/19).

[xiv] Generally, an S corporation does not pay income tax at the corporate level, but passes its income and deductions through to its shareholders, who report the same on their personal tax returns.

[xv][xv] Reg. Sec. 1.338(h)(10)-1(d).

Generally speaking, such an election at the federal level may be advantageous to a purchaser due to the stepped-up basis of the assets deemed to have been purchased for future depreciation and/or amortization purposes. This reduces the cost of the acquisition for the purchaser by allowing them to more quickly recover their investment in the transaction.

At the same time, such an election may be disadvantageous to the seller, due to a possibly greater federal tax liability as the result of being taxed at a higher rate on gain from the sale of assets than would be the case on gain from the sale of stock.

Since N.Y.’s income tax is a federal “conformity based” system, such an election can carry with it N.Y. state tax implications for both residents and nonresidents.

[xvi] Matter of Baum, Tax Appeals Tribunal (the “Tribunal”), February 12, 2009.

[xvii] The selling shareholders of a target corporation should always compare the net after-tax proceeds following a sale of stock coupled with a Sec. 338(h)(10) election with the net proceeds following a stock sale without such an election. It is not at all unusual for a seller to negotiate with the buyer for an increase in the purchase price by an amount such that the seller will end up with the same net proceeds had no election been made. On the one hand, the election is made jointly by the seller and the buyer; moreover, the amount of the increase will, itself, be amortizable by the buyer. On the other hand, a gross-up may cause the deal to be too expensive for the buyer.

[xviii] IRC Sec. 453.

[xix] IRS Form 1120-S.

[xx] Form CT-3-S.

[xxi] This omitted the date of the stock sale. The target’s S corporation election would normally terminate on the date of the sale – because of the ineligible C corporation buyer – such that the target’s last day as an S corporation is the immediately preceding day. However, when an election is made under IRC Sec. 338(h)(10), the target’s S corporation election continues through the end of the sale date in order to allow the pass-through to the target’s shareholders of the gain resulting from the deemed asset sale.

[xxii] Since its incorporation in N.Y. in 2002, 100% of Target’s receipts had been apportioned to N.Y. in its franchise tax filings.

[xxiii] The “Tax Law;” Section 632(a)(2).

[xxiv] The “Department.”

[xxv] See TSB-M-10 [10] I.

[xxvi] Form IT-203.

[xxvii] Plus interest and penalties.

[xxviii] Taxpayer also argued that the gain from the sale of Target was not subject to N.Y. tax because Target’s proper N.Y. BAP should have been zero, and not 100-percent as reported by Target. In almost all cases, the contents of the return constitute an admission by the filing taxpayer. What’s more, the taxpayer will rarely be allowed to disavow their own return position.


Nonresidents are subject to N.Y. personal income tax on their N.Y. source income. NY-source income is defined as the sum of income, gain, loss, and deduction derived from or connected with N.Y. sources. For example, where a nonresident sells real property or tangible personal property located in N.Y., the gain from the sale is taxable in N.Y.

In general, under the Tax Law, income derived from intangible personal property, including gains from the disposition of such property, constitute income derived from N.Y. sources only to the extent that the property is employed in a business, trade, profession, or occupation carried on in N.Y. From 1992 until 2009, this analysis also applied to the gain from the disposition of interests in entities that owned N.Y. real property. However, in 2009, the Taw Law was amended to provide that items of gain derived from or connected with N.Y. sources included items attributable to the ownership of any interest in real property located in N.Y. For purposes of this rule, the term “real property located in” N.Y. was defined to include an interest in a partnership, LLC, S corporation, or non-publicly traded C corporation with one hundred or fewer shareholders, that owns real property located in N.Y. and has a fair market value that equals or exceeds 50% of all the assets of the entity on the date of the sale or exchange of the taxpayer’s interest in the entity.

[xxx] Section 632 (a) (2).

[xxxi] The “act is intended to clarify the concept of federal conformity in the personal income tax and is necessary to prevent confusion in the preparation of returns, unintended refunds, and protracted litigation of issues that have been properly administered up to now.”

[xxxii] TSB-M-10(10)I.

[xxxiii] Query whether they can move the business out of N.Y.? For our purposes, I am assuming that is not the case.

[xxxiv] The number of times I’ve been involved in a resident audit where the taxpayer already pays N.Y. income tax on all of their business income under these facts! Of course, the state is looking to also tax their investment income.

[xxxv] The seller may be able to negotiate a gross-up in the price to account for this tax liability.















Tax Law for the Closely Held Business blog author Lou Vlahos was extensively quoted in Peter J. Reilly’s July 8 Forbes column “Clever Techniques To Defer Capital Gains – Maybe Too Clever.”

Below is an excerpt that includes Lou’s commentary on monetized installment sales: 

Does MIS Work?

Mr. Greenwald told me that he thinks [monetized installment sales] work provided the transaction is executed as modelled in the Chief Counsel letter.  On the other hand, he has not had a client do one as his clients want to stay in real estate and therefore favour 1031.

Lou Vlahos of Farrell Fritz PC is a lot more skeptical as he explains in this piece – Monetized Installment Sales: What Are They About?

“No, this arrangement is not undertaken as a formal pledge by the seller-taxpayer of the intermediary’s installment obligation; and, no, the intermediary’s obligation to the seller is not formally ‘secured’ by cash or cash equivalents.

Nevertheless, the monetized installment sale arrangement described above is substantively the same as one or both of these gain-recognition-triggering events. As noted, above, ‘[o]ther arrangements that have a similar effect’ should be treated in the same manner.

The IRS should clarify its position accordingly.”

Mr Vlahos highlighted something from the letter which you don’t see in other discussions that allude to it as if it were authority.

“The Transaction meets the statutory and regulatory requirements of I.R.C. § 453. Because Asset meets the definition of farm property under I.R.C. § 2032A(e)(4), Taxpayer can pledge the Purchase Notes and obtain cash through a separate loan under I.R.C. § 453A(b)(3)(B) without the proceeds being treated as a payment for installment sale purposes.” (Emphasis added)

To read the full article, please click here.

Keep On Reading

Over the last few months, we’ve been working on a number of transactions that involve the division of a closely held corporation or partnership.

In each instance, the impetus for the division has been the desire of the business entity’s owners to go their separate ways so as to enable them to focus their energies on a distinct line of business without interference from the other owners, and to allow them to fully enjoy the rewards of their own efforts.

Although it is incumbent on every tax adviser to stay current on developments in the tax law, there are times when this becomes a seemingly Sisyphean task.[i] Just witness the aftermath of the 2017 tax legislation.

For that reason, it behooves the adviser, prior to embarking upon any transaction, to review the latest IRS rulings interpreting those provisions of the Code that are applicable to the transaction.

With respect to the projects described above, this legal “due diligence” included a review of IRS letter rulings under the regulatory “assets over” form of partnership division,[ii] and under the Code’s corporate reorganization provisions.[iii]

That’s when I came across the ruling – more specifically, the phrase within a sentence within the ruling – that is the subject of today’s post.

Before describing the ruling, let’s first consider the basic requirements for a “tax-free” corporate division.

Corporate Divisions

Underlying the corporate reorganization provisions of the Code is the principle that it would be inappropriate to require the recognition and taxation of any gain realized as a result of a transaction in which the participating taxpayers – the corporations and their shareholders – have not fundamentally changed the nature of their investment in, and their relationship to, the corporation’s assets or business.

One of these reorganization provisions allows a corporation to distribute to some or all of its shareholders all of the shares of stock of a subsidiary corporation on a “tax-free” basis, provided certain requirements are satisfied. The division of the “parent” or distributing corporation may be undertaken for many reasons and it may take many forms. In general, such a distribution may be pro rata among the parent corporation’s shareholders (a “spin-off”), it may be in exchange for all of the parent corporation’s stock held by certain of its shareholders (a “split-off”), or it may be in complete liquidation of the parent corporation (a “split-up”), where the stock of at least two subsidiary corporations is distributed.

The division must comply with certain statutory and non-statutory requirements in order to achieve tax-free status, including the following:

  1. The distributing parent corporation must “control” the subsidiary corporation the stock of which is distributed;
  2. The distribution must not be a “device” for distributing the earnings and profits of either corporation;
  3. Each of the corporations must, after the distribution, conduct an “active trade or business” that has been conducted by either of them for at least five years,[iv] and that has not been acquired in a taxable transaction within that time;[v]
  4. At least enough stock of the subsidiary corporation must be distributed to constitute control of such corporation;
  5. The transaction must have a corporate business purpose;[vi] and
  6. The continuity of interest requirement must be met.

From a “mechanical” perspective, a division – for example, a spin-off – may be effectuated by the parent corporation’s distributing to its shareholders the stock of an existing subsidiary,[vii] or it may be preceded by the parent’s contribution of part of its assets to a newly-formed subsidiary corporation in exchange for all of the stock thereof, which it then distributes in the spin-off.[viii]

Active Trade or Business

Of the foregoing requirements, the one that concerns us here is that of the “active trade or business.”

The Code requires that Distributing and Controlled must each be engaged in the active conduct of a trade or business immediately after the distribution. The rules for determining whether a corporation is engaged in the active conduct of a trade or business immediately after the spin-off, however, focus almost exclusively on the five-year period before the spin-off, by defining an active business as one that has been conducted throughout the five-year period ending on the date of the spin-off.[ix]

The Corporation’s Activities

A corporation will be treated as engaged in an active 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 group of activities ordinarily must include the collection of income and the payment of expenses.”[x]

The determination whether a trade or business is actively conducted is made from all of the facts and circumstances and, generally, the corporation is required itself to perform active and substantial management and operational functions;[xi] in other words, to have an active business the corporation must perform active and substantial management and operational functions through its own employees – even though some of its activities are performed by others, including independent contractors.

Changes in the Active Trade or Business

A trade or business that is relied upon to meet the requirement for a tax-free spin-off must have been actively conducted throughout the five-year period ending on the date of the distribution.[xii]

The fact that a trade or business underwent change during the five-year period preceding the distribution – for example, by the addition of new or the dropping of old products, changes in production capacity, and the like – are disregarded, provided that the changes are not of such a character as to constitute the acquisition of a new or different business.

In particular, if a corporation, engaged in the active conduct of one trade or business during that five-year period, purchased, created, or otherwise acquired another trade or business in the same line of business, then the acquisition of that other business is ordinarily treated as an expansion of the original business, all of which is treated as having been actively conducted during that five-year period, unless that purchase, creation, or other acquisition effects a change of such a character as to constitute the acquisition of a new or different business.[xiii]

Business Interruption

In addition, the fact that there was a partial or temporary interruption, during the five-year period preceding the distribution, in a trade or business that had been actively conducted by a corporation, may not, under the right circumstances, adversely affect the conclusion that the corporation was engaged in the active conduct of a trade or business for the five-year period.

For example, the IRS has previously ruled that a proposed spin-off would satisfy the five-year active trade or business requirement where the controlled subsidiary corporation had collected income for only four of the five years preceding the distribution of its stock.[xiv]

The subsidiary had incurred expenses and engaged in substantial managerial and operational activities representative of the active conduct of a trade or business for each of the five years preceding the date of the distribution. Its failure to receive revenue during one of the five years was unforeseen, and was caused by events outside of its control; i.e., the bankruptcy of its sole customer.

The corporation took all reasonable steps to secure revenue by redesigning its limited use product and actively seeking new customers for such product; in the absence of any sales, it also shut down its plant and substantially reduced its workforce. Approximately one year later, its business began to generate revenues once again.

The IRS indicated that there may be exceptional situations where, based upon all the facts and circumstances, a group of activities will constitute an active trade or business for purposes of the spin-off rules even when “there is no concurrent receipt of income and payment of expenses.”

When these extraordinary facts were coupled with the subsidiary’s activities before the bankruptcy of its sole customer, along with its efforts to secure revenue, the IRS was able to conclude that the subsidiary was engaged in the active conduct of a trade or business for the five-year period preceding the date of the distribution of its stock by its parent corporation.

With the foregoing in mind, we can turn to the IRS’s recent ruling.

The Ruling

The ruling[xv] addressed a proposed transaction by which a corporation (“Distributing”) would transfer one segment of its business (“Business”) to its shareholders (the “Transaction”). Distributing was engaged in Business, which was comprised of Segments 1 through 4. Distributing was in the process of exiting Segment 3 while, at the same time, expanding into Segments 2 and 4.

Distributing proposed to form a new subsidiary corporation (“Controlled”) for the purpose of effecting the Transaction.

Distributing would contribute all of the assets, and related operations, associated with Segment 4 of the Business (the “Contribution”) to Controlled, solely in exchange for all of the stock of Controlled and the assumption by Controlled of all of the liabilities associated with such assets and operations.

Distributing would then distribute all of the Controlled stock, on a pro rata basis, to Distributing’s shareholders (the “Distribution”).

As part of the Transaction, and immediately following the Distribution, Controlled would issue shares of Controlled stock to one or more investors in exchange for cash, which Controlled would retain for use in its operation of Segment 4.[xvi]

Both corporations represented that they would satisfy the Code’s active trade or business requirement for a tax-free spin-off. With respect to the Business relied on by each of Distributing and Controlled to meet this requirement, Distributing represented that there had not been any substantial operational changes since the end of Distributing’s most recent taxable year, other than the termination of Segment 3.

Distributing and Controlled represented that, following the Distribution, they would continue certain inter-Segment relationships (“Continuing Relationships”), including the provision of certain services by Controlled (“Services”) – presumably part of the operation of Segment 4 – to Distributing (operating Segments 1 and 2) for a period of time.

The corporations represented that payments made in connection with all continuing transactions, if any, between Distributing and Controlled after the Distribution would be for fair market value, based on arm’s length terms, other than payments in connection with certain Continuing Relationships, which would be provided at cost.[xvii]

They also represented that no intercorporate debt would exist between Distributing and Controlled at the time of, or subsequent to, the Distribution, except for payables and receivables arising in connection with certain Continuing Relationships.[xviii]

There was no plan or intention for Distributing or Controlled to divest themselves of any of the historic business assets of Distributing before or after the Distribution, except for the termination of Segment 3 by Distributing.

However, it was also represented that once Controlled stopped providing the Services to Distributing, Controlled could cease to generate any revenue.

In that case, Controlled represented that it would “continue to seek to generate future revenue through future Events.”[xix]

The IRS ruled that the Contribution and the Distribution, together, would be treated as a “divisive D reorganization” for federal tax purposes. Consequently, neither Distributing nor Controlled would recognize gain or loss on the Contribution, no gain or loss would be recognized by Distributing on the Distribution, and no gain or loss would be recognized by (and no amount would otherwise be included in the income of) the Distributing shareholders upon their receipt of the Controlled stock in the Distribution.

A Shift in Thinking?

In order for the IRS to have ruled that the Transaction would qualify as a tax-free reorganization, it must have determined that Controlled would satisfy the active trade or business requirement after the Distribution.

In other words, the IRS must have concluded that Controlled would conduct an active trade or business that had been conducted by Distributing for at least five years prior to the Distribution – in particular, Segment 4 of Distributing’s Business, which the ruling tells us was expanding prior to the Transaction – notwithstanding Controlled’s representation that there may be periods after the Distribution, and after it stopped providing the Services to Distributing, during which Controlled would not collect any revenue.[xx]

As indicated earlier, the rules for determining whether a corporation is engaged in the active conduct of a trade or business immediately after a spin-off focus primarily on the five-year period prior to the spin-off, by defining an active business as one with a five-year history of active and substantial managerial and operational activities by the business’s employees.

According to the IRS, the activities of an active trade or business “ordinarily must include the collection of income.”[xxi] Generally, in the absence of exceptional circumstances beyond the business’s control,[xxii] the IRS historically has required a qualifying business to have collected income continuously for at least five years.

In this ruling, however, Controlled expected that there would be periods during which it would not generate any revenue; it assured the IRS that, during these times, it would look for business opportunities, presumably for the purpose of generating revenue.[xxiii]

So what gives? The situation that may be faced by Controlled will not involve unforeseen circumstances or events beyond its control. Did the IRS simply discount the possibility of Controlled’s not generating revenue and, therefore, did not consider this factor in its analysis?

Or does the ruling signify something else? We know that Distributing had begun to expand into Segment 4 of the Business prior to the Transaction; presumably, such expansion would be continued by Controlled after the Distribution.

Entrepreneurial Ventures

A couple of months ago,[xxiv] the IRS announced that it has been studying whether, and to what extent, corporations may utilize the tax-free separation rules of the Code to separate established businesses from newer “entrepreneurial ventures” that have not yet collected income, but that have engaged in substantial research and development (R&D) and other activities.

The IRS stated that it has observed a significant increase in entrepreneurial ventures that “collect little or no income during lengthy and expensive R&D phases.” However, it continued, these types of ventures often use the R&D phase to develop new products that will generate income in the future but do not collect income during that phase.

The IRS conceded that if a corporation wishes to achieve a corporate-level business purpose – i.e., a purpose that would support a tax-free corporate division – by separating one R&D segment from an established business, or from another R&D segment, the IRS’s historical application of the income collection requirement “likely would present a challenge for qualification” as a tax-free separation.

Query whether this signals the beginning of a more relaxed approach by the IRS in the application of the active trade or business requirement?

What’s Next?

Based on the foregoing, it appears that if the IRS takes a more liberal approach to the application of the active trade or business requirement of the spin-off rules, it may be limited to businesses that need longer periods of R&D to develop their products; for example, technology-driven companies.

If the above ruling does, in fact, signify this new approach, should it be limited to businesses that require long periods of R&D?

It is true that, in the case of a start-up technology business, product development may take several years. But what about the spin-off of a business that represents the expansion of a more “traditional” business, which requires the identification and acquisition of a new location, the securing of the necessary licenses, permits, or zoning, the raising of capital, the construction of improvements, and the employment and training of new personnel? All of these factors must be addressed, significant sums and efforts must be expended, and years may pass before the spun-off business will start generating any revenue, whether through the manufacture and sale of a product, the sale of a service, or otherwise. Surely, these and other preparatory activities should be accounted for in determining whether the active trade or business requirement has been satisfied.

Stay tuned.

[i] In Greek mythology, Sisyphus was the King of Corinth. Because of his trickery and hubris, Zeus consigned him to the Underworld where he was tasked with rolling a large boulder up a steep hill. Every time he neared the top of the hill, the boulder would roll back down. Thus, Sisyphus was condemned for eternity to the an impossible and never-ending task of staying current with developments in the tax law.

[ii] Reg. Sec. 1.708-1(d); relatively straightforward, and without the stringent requirements for the division of a corporation. Ah, the repeal of General Utilities.

[iii] IRC Sec. 355 and Sec. 368(a)(1)(D). More on these in just a minute.

[iv] That’s five full years; not five taxable years.

[v] Though the expansion of an existing business may be permitted.

[vi] As opposed to a shareholder purpose. In many cases, it will be difficult to distinguish between the two.

[vii] Which would be described in IRC Sec. 355 alone.

[viii] Which would be described in IRC Sec. 368(a)(1)(D) and Sec. 355; a so-called “divisive D reorganization.”

According to IRC Sec. 368(a)(1)(D), a D reorganization is:

“a transfer by a corporation of all or a part of its assets to another corporation if immediately after the transfer the transferor, or one or more of its shareholders (including persons who were shareholders immediately before the transfer), or any combination thereof, is in control of the corporation to which the assets are transferred; but only if, in pursuance of the plan, stock or securities of the corporation to which the assets are transferred are distributed in a transaction which qualifies under section 354, 355 or 356.”

[ix] Furthermore, the trade or business must not have been acquired during the five-year period ending on the date of the spin-off in a transaction in which any gain or loss was recognized, and control of a corporation conducting such trade or business must not have been acquired by Distributing or any controlled corporation directly or through one or more other corporations within the five-year period preceding the distribution in a transaction in which any gain or loss was recognized.

[x] Emph. added. Reg. Sec. 1.355-3(b)(2)(ii).

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

[xii] Whether a group of activities constitutes a “trade or business” is an issue that has enjoyed a resurgence as a result of the 2017 legislation; for example, does an activity rise to the level of trade or business for purposes of the 20-percent deduction under IRC Sec. 199A’s qualified business income rules, or for purposes of the gain deferral under Sec. 1400Z-2’s qualified opportunity fund rules?

[xiii] Reg. Sec. 1.355-3(b)(3)(ii).

[xiv] Rev. Rul. 82-219.

[xv] PLR 201920008, Release Date: 5/17/2019. Just a reminder: letters rulings are not precedent-setting, but they do give us a glimpse into what the IRS’s position may be on a given issue – thus, it makes sense to pay attention to them.

[xvi] Perhaps to help fund the expansion of Segment 4, which had begun under Distributing.

[xvii] Query whether this included the Services?

[xviii] Again, query whether this included the Services?

[xix] The term “Events” was not defined in the released version of the ruling; perhaps it refers to business opportunities that may present themselves as Segment 4 grows; however, it may also refer to the acquisition of a similar business; all speculation on my part.

[xx] Though it would continue to seek to generate future revenue.

[xxi] Reg. Sec. 1.355-3(b)(2)(ii).

[xxii] The “interruption” scenario described earlier.

[xxiii] But query how was Controlled going to fund its operations during these “down times?”

[xxiv] IRS Request for Information regarding the active trade or business requirement for section 355 separations of entrepreneurial ventures, dated May 6, 2019.


Too Good . . .?

What if I told you that you could sell your property today, receive cash in an amount equal to the property’s fair market value, and defer the payment of any tax imposed upon the gain from the sale?[i]

It sounds contrived, doesn’t it? How can one have their cake and eat it too?[ii]

Interestingly, a number of folks of late have asked me about so-called “monetized installment sales,” which are a form of transaction that promises these very results.

Before describing how such sales are often “structured,” and then reviewing their intended tax consequences, it would behoove us to first review the basic rules for the taxation of an ordinary installment sale.

Straight Sales

Assume that a taxpayer sells a capital asset or Section 1231 property[iii] to a buyer in exchange for cash that is payable at closing. The buyer may have borrowed the cash for the purchase from a third party; or it may be that the buyer had enough cash of their own available to fund the purchase.

The gain realized by the seller from the conversion of the property into cash is treated as income to the seller. The “amount realized” from the sale is equal to the amount of cash received. The general method of computing the seller’s gain from the sale contemplates that, from the amount realized, there shall be withdrawn an amount equal to the seller’s adjusted basis for the property – i.e., an amount sufficient to restore to the seller their unreturned investment in the property.[iv]

The amount which remains after the adjusted basis has been restored to the seller – i.e., the excess of the amount realized over the adjusted basis – constitutes the realized gain. This gain is generally included in the selling taxpayer’s gross income for the taxable year of the sale, and is subject to federal income tax.[v]

Example A

Seller has owned and used Property in their business for several years. Property has a FMV of $100. Seller’s adjusted basis for Property is $40. In Year One, Seller sells Property to Buyer for $100 of cash which is paid at closing. Seller’s gain from the sale is $100 minus $40 = $60. Seller includes the entire $60 in their gross income for Year One.

Installment Sales

Years ago, however, Congress recognized that it may not be appropriate to tax the entire gain realized by a seller in the taxable year of the sale when the seller has not received the entire purchase price for the property sold; for example, where the seller is to receive a payment from the buyer in a taxable year subsequent to the year of the sale, whether under the terms of the purchase and sale agreement,[vi] or pursuant to a promissory note given by the buyer to the seller in full or partial payment of the purchase price.[vii]

In cases where the payment of the purchase price is thus delayed, the seller has not completed the conversion of their property to cash; rather than having the economic certainty of cash in their pocket, the seller has, instead, assumed the economic risk that the remaining balance of the sale price may not be received. It is this economic principle that underlies the installment method of reporting.[viii]

A sale of property where at least one payment is to be received after the close of the taxable year in which the sale occurs is known as an “installment sale.”[ix] For tax purposes, the gain from such a sale is reported by the seller using the installment method.[x]

Under the installment method, the amount of any payment which is treated as income to the seller for a taxable year is that portion (or fraction) of the installment payment received in that year which the gross profit realized bears to the total contract price (the “gross profit ratio”). Generally speaking, the term “gross profit” means the selling price for the property less the taxpayer’s adjusted basis for the property – basically, the gain.

Stated differently, each payment received by a seller is treated in part as a return of their adjusted basis for the property sold,[xi] and in part (the gross profit ratio) as gain from the sale of the property.

Example B

Same facts as Example A, above, except that Buyer pays Seller $20 at closing, in Year One, and gives Seller a 4-year promissory note with a face amount of $80; the note provides for equal annual principal payments of $20 in each of Years Two through Five. The note also provides for adequate interest that is payable and compounded annually.[xii] Seller’s gross profit is $100 minus $40 = $60. Seller’s contract price is $100. Thus, Seller’s gross profit ratio is $60/$100 = 60%. When Seller receives the $20 payment in Year One, Seller will include in their gross income for Year One an amount equal to 60% of the $20 payment, or $12. The same methodology will be applied over the term of the note. Thus, assuming the timely payment of $20 of principal every year, [xiii]Seller will include $12 in their income in each of Years Two through Five; a total of $60 of gain.[xiv]


The seller’s tax liability that arises from a sale that is reported under the installment method is incurred upon the seller’s receipt of payment; thus, one must be able to identify when such a payment has been received.

For purposes of the installment method, the term “payment” includes the actual or constructive receipt of money by the seller.[xv]

It also includes the seller’s receipt of a promissory note from the buyer which is payable on demand or that is readily tradable.

Receipt of an evidence of indebtedness which is secured directly or indirectly by cash or a cash equivalent[xvi] will be treated as the receipt of payment.

In each of these instances, the seller has wholly converted their interest in the property sold to cash, or they have been given the right to immediately receive cash, or they are assured of receiving cash – they are in actual or constructive receipt of the cash.[xvii]

Because there is no credit risk associated with holding the buyer’s note and awaiting the scheduled payment(s) of principal, the seller is treated, in these instances, as having received payment of the amount specified in the promissory note or other evidence of indebtedness.

However, a payment does not include the receipt of the buyer’s promissory note – an “installment obligation”[xviii] – that is payable at one[xix] or more specified times in the future, whether or not payment of such indebtedness is guaranteed by a third party, and whether or not it is secured by property other than cash or a cash equivalent.[xx]

In the case of such a note, the seller remains at economic risk until the note is satisfied. Thus, that portion of the seller’s gain that is represented by the note will generally be taxed only as principal payments are received.

The “Anti-Pledge” Rule

It goes without saying that sellers will usually welcome the deferral of gain recognition and taxation that the installment sale provides. At the same time, however, sellers have sought to find a way by which they can currently enjoy the as-yet-unpaid cash proceeds from the sale of their property without losing the tax deferral benefit.

One method that was previously utilized to accomplish this goal was for the seller to borrow money from a lender and to pledge the buyer’s installment obligation as security for the loan. In this way, the seller was able to immediately access funds in an amount equal to the proceeds from the sale of their property, while continuing to report the gain from the sale under the installment method as the buyer made payments on the installment obligation; the loan that was secured by the installment obligation would be repaid as the installment obligation itself was satisfied.

Congress eventually became aware of this monetization technique and concluded that it was not consistent with the principles underlying the installment method. In response, Congress amended the installment sale rules[xxi] to provide that if any indebtedness is secured by an installment obligation, the net proceeds of the secured indebtedness will be treated as a payment received on the installment obligation as of the later of the time the indebtedness becomes “secured indebtedness,” or the time the proceeds of such indebtedness are received by the seller.[xxii]

For purposes of this rule, an indebtedness is secured by an installment obligation to the extent that payment of principal (or interest) on such indebtedness is directly secured – under the terms of the indebtedness or any underlying arrangements – by any interest in the installment obligation. A payment owing to the lender will be treated as directly secured by an interest in the buyer’s installment obligation to the extent “an arrangement” allows the seller to satisfy all or a portion of the indebtedness with the installment obligation.[xxiii] It is significant that the Conference Committee report to the Tax Relief Extension Act of 1999 indicates that “[o]ther arrangements that have a similar effect would be treated in the same manner.”[xxiv]

Example C

Same facts as Example B, above, except that in Year Two, Seller borrows $80 from Lender, and pledges Buyer’s $80 promissory note as security for the loan. Seller is treated as having received a payment of $80 on the promissory note in Year Two, and is therefore required to report $48 of gain on its tax return for Year Two.[xxv]

Interestingly, the above anti-pledging rule was limited in its reach to obligations which arise from the installment sale of property where the sales price of the property exceeds $150,000; for purposes of applying this threshold, all sales which are part of the same transaction (or a series of related transactions) are treated as one sale.[xxvi]

Monetized Installment Sale

Following the above change in the Code, many advisers and taxpayers set out to find another way to accomplish the desired result – immediate cash and deferred tax – but without running afoul of the anti-pledging rule.

As far as I can tell, what has emerged, generally speaking, is the following four-party structure:

  • Seller wants to sell a Property to Buyer, immediately receive cash in an amount equal to Property’s fair market value, and defer the recognition of any gain realized from the sale under the installment method;
  • Seller sells Property to Intermediary[xxvii] in exchange for Intermediary’s unsecured installment obligation in an amount equal to Property’s fair market value; the loan provides for interest only over a fairly long term, followed by a balloon payment of principal, at which point the Seller’s gain from the sale would recognized;
  • Intermediary immediately sells Property to Buyer for cash;[xxviii] Intermediary does not realize any gain on this sale;[xxix]
  • Seller obtains a loan from Lender, the terms of which “match” the terms of Intermediary’s installment obligation held by Seller; Seller does not pledge Intermediary’s installment obligation as security for the loan;[xxx] escrow accounts are established to which Intermediary will make interest payments, and from which the interest owed by Seller will be automatically remitted to Lender;
  • Seller has the non-taxable loan proceeds which they may use currently; Seller will typically invest the proceeds in another business or investment, at least initially, so as to demonstrate a “business purpose” for the loan;[xxxi]
  • Seller will report gain on the sale of Property only as Intermediary makes payments to Seller under its installment obligation; in the case of a balloon payment, the gain will be reported and taxed when the obligation matures;
  • Seller will use the payment(s) to repay the loan from Lender.


To date, the IRS has not directly addressed the foregoing arrangement. That being said, there is a single Field Attorney Advice (FAA 20123401F)[xxxii] – which represents non-precedential legal advice issued to IRS personnel from the Office of Chief Counsel (“OCC”) – that considered the application of the “substance over form” and “step transaction” doctrines to a fact pattern that included some of the elements described above. It appears that many in the “monetized installment sale” community point to this FAA as support for their transaction structure.

The taxpayer in the FAA was a business entity that needed to raise a lot of cash for a bona fide business purpose.[xxxiii] In order to do so, it decided to sell a portion of its assets. The buyer gave the taxpayer installment notes that were supported by standby letters of credit (issued by Lender A) that were nonnegotiable and could only be drawn upon in the event of default. The taxpayer then borrowed money (from Lender B) in an amount less than the buyer’s installment notes, and pledged the buyer’s notes as security. This pledge would normally have triggered immediate recognition of the gain from the sale; however, the assets constituted farm assets and, so, were exempt from the anti-pledge rule.[xxxiv]

The OCC acknowledged that, in form, the transaction comprised an installment sale and a loan that monetized the installment obligation. The question presented to the OCC was whether the substance of the transaction was essentially a sale for cash because, shortly after the asset sale, the taxpayer obtained the amount of the sale price in cash, through the loan proceeds, all while deferring the recognition of gain and the payment of the resulting tax.

The OCC concluded that the asset sale was a real transaction carried out to raise cash for the taxpayer. The letter of credit provided security for the taxpayer in the event the buyer defaulted on its installment obligation. The monetization loan was negotiated with a different lender than the one what issued the letter of credit. The economic interests of the parties to both transactions changed as a result of the transactions. The transactions reflected arm’s-length, commercial terms, each transaction had independent economic significance, and the parties treated the transactions as a separate installment sale and a monetization loan. Thus, the substance over form and step transaction doctrines were inapplicable.

Monetization, Here We Come?

Call me jaded, but I wouldn’t move too quickly to engage in such a transaction.[xxxv]

The fact remains that the IRS has not spoken to the form of monetized installment sale transaction described above.

The FAA on which the “intermediaries” of such transactions rely is not precedential and addresses the case of a taxpayer that was not even subject to the anti-pledge rule. What’s more, that taxpayer was compelled by a pressing business reason to engage in the sale in the first place – it had to raise cash for purposes of its continuing business.

By contrast, the taxpayer to whom a monetization structure is typically directed is selling their entire interest in the business or property – they are cashing out, period.

In recognition of this fact, and in order to “soften” its impact, some intermediaries recommend (others “require”) that the selling taxpayer immediately invest the loan proceeds in another property or business.[xxxvi]

As for the bona fide nature of the transaction-elements that comprise the installment sale monetization structure, consider the following: the taxpayer will sell the property to the intermediary in exchange for a long-term (thirty years is often mentioned), interest-only, unsecured loan. How is this a commercially reasonable transaction?

The intermediary, in turn, will immediately resell the property acquired from the taxpayer to the buyer, usually for cash – indeed, the property is often direct-deeded from the taxpayer to the buyer, so that the intermediary never comes into title. Thus, the intermediary never really “owns” the property – they merely act as a conduit.[xxxvii]

What’s more, the intermediary’s interest payments and, ultimately, the balloon payment, match the payments owing from the seller to the lender. The accounts that are created for the purposes of receiving the intermediary’s interest payments to the taxpayer, and of then remitting the taxpayer’s interest payments to the lender, ensure that the taxpayer never has control over these funds, and afford the lender a degree of security.

Query: why didn’t the taxpayer just sell the property to the buyer for cash, and pay the intermediary a broker’s fee for putting the parties together? Why turn down an all-cash buyer and accept a long-term promissory note instead, while at the same time borrowing an equal amount from a third party?

In the meantime, the intermediary has cash available for its long-term use – i.e., until the maturity date of the intermediary’s installment obligation to the taxpayer, which happens to coincide with the maturity date of the lender’s loan to the taxpayer – in the amount of the balloon payment which it received from the buyer as payment of the sale price for the property.

Although it is not clear to me where these funds are kept, or how they are invested by the intermediary, based upon the arrangements made for the interest payments, and given what must be described as the lender’s and the intermediary’s risk aversion, it is probably safe to say that the balloon payment – which ultimately belongs to the selling taxpayer and then the lender – is itself protected.

No, this arrangement is not undertaken as a formal pledge by the seller-taxpayer of the intermediary’s installment obligation; and, no, the intermediary’s obligation to the seller is not formally “secured” by cash or cash equivalents.

Nevertheless, the monetized installment sale arrangement described above is substantively the same as one or both of these gain-recognition-triggering events. As noted, above, “[o]ther arrangements that have a similar effect” should be treated in the same manner.[xxxviii]

The IRS should clarify its position accordingly.

[i] No, the recreational use of marijuana is not yet legal in New York.

[ii] Have I ever mentioned my knack for mangling idioms? I think I got this one right. That being said, I was once speaking to a group of accountants and, after belaboring a particular point, I said something like “Well, we’ve beaten this horse to death.” After a collective gasp from the audience, someone corrected me, stating that the phrase I should have used was “beating a dead horse.” Either way, it’s not a pretty visual.

[iii] and . Why make this assumption?

[iv] IRC Sec. 1001; Reg. Sec. 1.1001-1. The unreturned investment – the adjusted basis – is the taxpayer’s original cost basis for the property, plus the cost of any capital expenditures (for example, improvements to tangible property, or additional paid-in capital in the case of an equity interest in a business entity); depending on the property, this amount may be reduced by any depreciation allowed or allowable; in the case of stock in a corporation, certain distributions will reduce a shareholder’s basis; in the case of pass-through business entities, the allocation of losses to the interest holder will reduce basis. You get the picture.

[v] IRC Sec. 1 and Sec. 11. In the case of an “individual,” the gain may also be subject to the 3.8% surtax under IRC Sec. 1411.

[vi] For example, where an amount otherwise payable by the buyer is held in escrow for the survival period of the seller’s reps and warranties (to secure the buyer against the seller’s breach of such), or where there are earn-out payments to be made over a number of years (say, two or three) based on the performance of the property (almost always a business).

[vii] There are many reasons why a buyer will give a note to the seller rather than borrowing the funds from a financial institution; for one thing, the buyer may have greater leverage in structuring the terms of the note vis-à-vis the seller. In addition, the buyer will often seek to offset the note amount by losses incurred as a result of the seller’s breach of a rep or covenant.

[viii] In general, there is a direct correlation between the economic certainty of a seller’s “return on investment” on the sale of property and the timing of its taxation; where the delayed payment of the sales price creates economic risk for the seller, the taxable event will be delayed until the payment is received.

[ix] IRC Sec. 453; Reg. Sec. 15a.453-1.

[x] Installment reporting does not apply to a sale that results in a loss to the seller. The loss is reported in the year of the sale.

Nor does it apply to the sale of certain assets; for example, accounts receivable, inventory, depreciation recapture, and marketable securities. These are ordinary income items that are recognized in the ordinary course of business, or they are items that represent cash equivalents.

It should also be noted that a seller may elect out of installment reporting, and thereby choose to report its entire gain in the year of the sale. This was certainly an attractive option before 2018, where the seller may have had expiring NOLs under IRC Sec. 172.

[xi] One minus the gross profit ratio.

[xii] We assume that the interest is determined at the Applicable Federal Rate under IRC Sec. 1274. If a lesser amount of interest were payable, the IRS would effectively treat a portion of each principal payment as interest income, thereby converting what would have been capital gain into ordinary income.

[xiii] Of course, the interest paid by the buyer will also be included in the seller’s gross income.

[xiv] The same amount of gain recognized in the first Example.

[xv] Reg. Sec. 15a.453-1(b)(3).

[xvi] For example, a bank certificate of deposit or a treasury note.

[xvii] By demanding payment on the note or by selling the note or by simply waiting for the scheduled time.

[xviii] A promise to pay in the future.

[xix] A balloon at maturity.

[xx] A standby letter of credit is treated as a third party guarantee; it represents a non-negotiable, non-transferable letter of credit that is issued by a financial institution, and that may be drawn upon in case of default – it serves as a guarantee of the installment obligation. In the case of an “ordinary” letter of credit, by contrast, the seller is deemed to be in constructive receipt of the proceeds because they may draw upon the letter at any time.

[xxi] IRC Sec. 453A(d). P.L. 100-203, Revenue Act of 1987.

[xxii] If any amount is treated as received with respect to an installment obligation as a result of this anti-pledge rule, subsequent payments actually received on such obligation are not taken into account for purposes of the installment sale rules, except to the extent that the gain that would otherwise be recognized on account of such payment exceeds the gain recognized as a result of the pledge.

[xxiii] IRC Sec. 453A(d)(4).

[xxiv] P.L. 106-170; H. Rep. 106-478.

[xxv] $80 multiplied by the gross profit ratio of 60% = $48.

[xxvi] IRC Sec. 453A(b)(1) and (5). Among the installment obligations excluded from the reach of this provision are those which arise from the sale of property used or produced in the trade or business of farming.

[xxvii] A person who facilitates these transactions in exchange for a fee.

[xxviii] In fact, the Intermediary will often, if not usually, have the Property direct-deeded from Seller to Buyer.

[xxix] Do you see where this cash goes? It appears to remain with Intermediary.

[xxx] On its face, therefore, the arrangement does not trigger the anti-pledge rule under IRC Sec. 453A.

[xxxi] It appears that most intermediaries suggest that this be done, at least for an “initial period” so as to demonstrate a business purpose for the loan. The implication is that, after a period of “cleansing,” the investment may be liquidated and the funds used for any purpose at all.


[xxxiii] Which explains the “suggestion” made by many intermediaries that the loan proceeds be applied by the seller toward a business or investment purpose, at least initially.

[xxxiv] IRC Sec. 453A(b)(3).

[xxxv] Stated more colorfully, and perhaps too harshly, as Billy tells Dutch in the 1987 movie Predator, “I wouldn’t waste that on a broke-dick dog.”

[xxxvi] Query how many actually do so.

[xxxvii] This is something that the arrangement borrowed from the deferred like-kind exchange rules.

[xxxviii] P.L. 106-170; H. Rep. 106-478.

Tax Law for the Closely Held Business blog author Lou Vlahos was extensively quoted in Peter J. Reilly’s latest Forbes column. He opined on the constitutionality of a wealth tax.

Below is Lou’s commentary:

[The wealth tax] is clearly a direct tax – period – which means that it has to satisfy the apportionment requirement. Given the geographic concentration of wealth (NYC, Miami, LA, etc.), how can such a tax ever be “apportioned” among the States according to their populations, in the commonly-accepted sense of that word? Or do we need to reconsider what we mean by apportionment or the relevant population?

We will hear legal arguments from every side of the debate. Unfortunately, much of it will be a question of semantics and wordplay. Much of it will be politically-motivated, in the worst sense of that phrase.

Moreover, if any legislation were enacted, the lawyers would be the primary beneficiaries of interpreting and planning for the new rules. (Just witness what has followed the TCJA.)

I am not going to comment on the impetus for such a tax, or on the need for it, or on the wisdom of imposing it. Nor am I going to comment on providing more funds to a dysfunctional Washington via a new tax rather than through an existing tax – the consequences will be the same.

To read the full article, please click here.