Woe to the Oppressed Shareholder
As I write this post on Bastille Day, I am reminded how an oppressed people, realizing the injustice of their circumstances, and having reached the limits of their endurance, took the first step toward “replacing” the lords and ladies that had long lived lavishly on their labors. [1]

If only it were so straightforward for an oppressed shareholder, especially in a pass-through entity such as an S corporation. As a minority owner, they have little to no say in the management or operation of the business, or in the distribution of the profits therefrom. Oftentimes, they are denied information regarding the finances of the business, with one exception: every year they receive a Schedule K-1 that sets forth their share of the corporation’s items of income, deduction, gain, loss, and credit for the immediately preceding year.

As a matter of Federal tax law, they are required to report these K-1 items on their own income tax returns, and – regardless of whether or not they received a distribution from the corporation – they must remit to the IRS the resulting income tax liability.

As one might imagine, this may create a cash flow problem for the oppressed shareholder. They are typically denied employment in the business and, so, do not receive compensation from the corporation. Thus, in order to satisfy their tax liability attributable to the S corporation, they are often forced to withdraw cash from other sources, or to liquidate personal assets (which may generate additional taxes).

In some cases, the oppressed shareholder in an S corporation has sought to “revoke” the “S” election and, thereby, to stop the flow-through of taxable income and the resulting outflow of cash. [2]

An S corporation may lose its tax-favored status by ceasing to qualify as a “small business corporation,” which means that it admits an ineligible person as an owner, or it has more than one class of stock outstanding. The Tax Court recently considered a situation in which an oppressed shareholder sought to use the disproportionate sharing of economic benefits between the shareholders as a basis for concluding that the corporation had more than one class of stock.

So Much for Egalité et Fraternite
Taxpayer and his brother (“Bro”) incorporated Corp. During the years in issue, Taxpayer owned 49% of the shares of Corp, and Bro owned 51%. The brothers elected to treat Corp as an S corporation for Federal income tax purposes. They also agreed that distributions would be proportional to their ownership shares.

Taxpayer, Bro and Bro’s spouse (“B-Spouse”) were the directors of Corp, and each participated in its business. Bro served as Corp’s president, B-Spouse as corporate secretary, and Taxpayer as vice president. Bro directed the administrative aspects of Corp’s business, while B-Spouse was Corp’s office manager. Bro and B-Spouse were responsible for the corporation’s bookkeeping and accounting.

Taxpayer’s work for Corp primarily involved managing operations in the field. He spent most of his working hours at jobsites, not in the office. Taxpayer received compensation as an employee of Corp for the years in issue.

Prior to the years in issue, Corp filed Forms 1120S, U.S. Income Tax Return for an S Corporation, and issued Schedules K-1 to Bro and Taxpayer. These filings reflected that the shareholders received cash distributions from Corp proportional to their stock ownership.

During the years in issue, Taxpayer began to examine more closely the administration of Corp’s business.

Taxpayer noticed that certain credits cards in his name, which he maintained for business purposes, were being used without his authorization to pay personal expenses of Bro’s children. Shortly thereafter, he reviewed the corporation’s QuickBooks records and determined that numerous items, including handwritten checks drawn on its bank accounts, had not been entered into the corporation’s accounting records. He also obtained and reviewed online banking statements for the corporation’s bank accounts. Taxpayer determined that, during the years in issue, Bro and B-Spouse had been making substantial check and ATM withdrawals from Corp’s bank accounts without his knowledge. [3]

Also during this period, Corp’s business began to struggle. Taxpayer received calls from Corp’s vendors who had tried unsuccessfully to contact Bro and B-Spouse regarding payments that they were owed and wanted to know when they would be paid. Corp had trouble paying its employees, and some of its checks were returned. Taxpayer had multiple discussions with Bro and B-Spouse about Corp’s cash flow problems. They told him that they were working on getting more money into the business.

Taxpayer became frustrated with the progress of Corp’s business and with the discussions that he was having with Bro. Finally, Taxpayer sent Bro an email stating that if Bro would not help him try to remedy the business, then Taxpayer would have no choice but to resign and sell his shares to Bro for a nominal amount. Bro responded that he would accept that offer effective immediately.

With that, Taxpayer completed some tasks for ongoing projects, and then quit his work for Corp. He never received payment from Bro for his shares of Corp.

The IRS Audit
Taxpayer filed Federal income tax returns for the years in issue. He attached Schedules E to the returns for these years, on which he listed Corp as an S corporation in which he held an interest. Taxpayer did not report any items of income or loss from Corp for the years in issue – these lines were left blank.

Taxpayer also attached to these returns Forms 8082, Notice of Inconsistent Treatment, relating to his interest in Corp, on which Taxpayer notified the IRS that he had not received Schedules K-1 from Corp.

Corp did not file Forms 1120S or issue Schedules K-1 for the years in issue. The IRS examined Corp, and prepared substitute tax returns using Corp’s banking records, general ledger, available employment tax returns, and other records to determine the corporation’s income and allowable deductions. The IRS allocated Corp’s net income as ordinary income to Taxpayer and Bro according to their 49% and 51% ownership shares, respectively.

The IRS also analyzed the shareholders’ distributions for the years in issue. For one year, the IRS determined that Taxpayer received less than one-third the amount of the distributions actually or constructively received by Bro; for the other year, it found that Taxpayer received less than one-ninth the amount of the distributions received by Bro. The IRS prepared basis computation worksheets for Taxpayer’s shares of Corp, and determined that Taxpayer was not required to include the distributions that he received in gross income for the years in issue because the amounts did not exceed his adjusted stock basis.

The notice of deficiency issued to Taxpayer determined increases to his Schedule E flow-through income for the years in issue, based upon the determinations set forth in the substitute returns prepared by the IRS for Corp.

Taxpayer disagreed with the IRS’s determination, and timely petitioned the Tax Court. Taxpayer contended that the income determined for Taxpayer – i.e., 49% of Corp’s net income for each of the years in issue – should not be attributable to him. [4]

Second Class of Stock?
Generally, an S corporation – or an electing “small business corporation” – is not subject to Federal income tax; rather, it is a conduit in that its income “flows through” to its shareholders, who are required to report and pay taxes on their pro rata shares of the S corporation’s taxable income.

The Code defines a small business corporation as a domestic corporation which must satisfy a number of requirements, including the requirement that it not have “more than 1 class of stock.” [5]

Generally, a corporation will be treated as having only one class of stock “if all outstanding shares of stock of the corporation confer identical rights to distribution and liquidation proceeds.” [6]
Once an eligible corporation elects S corporation status, that election is effective for the tax year for which it is made and for all succeeding tax years until it is terminated. The Code provides that an election shall be terminated automatically whenever the corporation ceases to qualify as a small business corporation.

When Taxpayer and Bro organized Corp, they clearly intended to create one class of stock. They agreed that all distributions would be proportional to their stock ownership, and their tax filings before the years in issue reflected that their shares of stock each had equal rights to distributions. Corp elected to be treated as an S corporation. For years before the years in issue it filed Forms 1120S and issued Schedules K-1 to Taxpayer reflecting his pro rata shares of the corporation’s taxable income.

Taxpayer contended that Corp’s “S” election was terminated during the years in issue because it ceased to be a small business corporation. Specifically, he contended that Corp no longer satisfied the requirement that it have only one class of stock – Bro withdrew large sums of money from Corp’s bank accounts during the years in issue without Taxpayer’s knowledge, and the IRS’s computations showed that Bro and Taxpayer received distributions for the years in issue that were not proportional to their stock ownership. Taxpayer argued that “these substantially disproportionate distributions appear to create a preference in distributions and . . . effectively a second class of stock”. He contended that Corp should be treated as a C corporation, and that Taxpayer should be taxed only on the distributions that he received, which he contended should be treated as dividends.

The Court’s Analysis
According to the Court, in determining whether a corporation has more than one class of stock, the rights granted to shareholders in the corporation’s organizational documents and other “binding agreements” between shareholders have to be considered. The applicable IRS regulations, the Court stated, provide that “[t]he determination of whether all outstanding shares of stock confer identical rights . . . is made based on the corporate charter, articles of incorporation, bylaws, applicable state law, and binding agreements relating to distribution and liquidation proceeds (collectively, the governing provisions).”

Evidence of distributions paid to one shareholder and not to others over the course of multiple years was insufficient on its own, the Court stated, to establish that a separate class of stock was created.

The Court concluded that Taxpayer had failed to prove that a binding agreement existed that granted Bro enhanced or disproportionate “rights to distribution and liquidation proceeds.” Rather, the Court found that, at most, there had been “an informal, oral understanding among the board members/shareholders”, and there was no evidence that the directors or shareholders ever took “formal corporate action to implement that understanding.”

The original, operative agreement between Corp’s shareholders (Taxpayer and Bro) was that distribution rights for each of their shares would be identical. Taxpayer testified that he and Bro never discussed changing the agreement regarding distributions and, during the years in issue, his understanding continued to be that distributions should be proportional to stock ownership. The record reflected that the shareholders never reached, or even considered, a new binding agreement that would change their relative rights to distributions.

Taxpayer argued that Bro’s withdrawals “effectively changed . . . [the shareholders’ agreement] by majority action.” However, the Court replied, nothing in the record indicated that Bro intended to act as Corp’s majority shareholder to grant himself rights to disproportionate distributions. Taxpayer offered no evidence of any actions taken at the corporate level to redefine shareholders’ rights or to issue a new class of stock. Moreover, he did not establish that a unilateral change of the kind described (i.e., the creation of a new class of stock) would be allowable under the applicable State law.

Taxpayer contended that the Court should regard “the substance of the actions” taken by Bro as creating a second class of stock. The Court noted, however, that Taxpayer’s own tax returns for the years in issue identified Corp as an S corporation. It then explained that taxpayers are generally bound by the form of the transaction that they choose unless they can provide “strong proof” that the parties intended a different transaction in substance. There was no proof, the Court observed, that either Taxpayer or Bro intended an arrangement different from that which they agreed to and reported consistently on their tax filings.

In short, Bro’s withdrawals during the years in issue did not establish that he held a different class of stock with disproportional distribution rights. Taxpayer failed to show that there were any changes to Corp’s governing provisions. Thus, he failed to carry his burden of proving that Corp’s election to be treated as an S corporation terminated during the years in issue and, consequently, the Court sustained the IRS’s determination that Taxpayer should be allocated 49% of Corp’s net income for each of the years in issue.

C’mon . . .?
Yes, on some visceral level, the Court’s decision seems harsh. But it is important to distinguish between the administration of the Federal tax system, on the one hand, and the protection of an oppressed shareholder, on the other. The latter may suffer certain adverse tax consequences as a result of a controlling shareholder’s inappropriate behavior, but they should not expect the Federal government to right those wrongs; rather, they have recourse to the courts and the laws of the jurisdiction under which the corporation was formed, and which govern the relationships among the shareholders and with the corporation itself.

That being said, shareholders have to be aware of what the Federal tax laws provide in order that they may take the appropriate steps to protect themselves, regardless of the size of their stockholdings. These steps are typically embodied in the terms of a shareholders’ agreement. [7]

As the Court explained, a determination of whether all outstanding [8] shares of stock confer identical rights to distribution and liquidation proceeds – i.e., whether there is only one class of stock – is made based on the corporate charter, articles of incorporation, bylaws, applicable state law, and binding agreements relating to distribution and liquidation proceeds (for example, a shareholders’ agreement).

Although a corporation is not treated as having more than one class of stock so long as these governing provisions provide for identical distribution and liquidation rights, any distributions (including actual, constructive, or deemed distributions) that differ in timing or amount are to be given appropriate tax effect in accordance with the facts and circumstances.

A commercial contractual agreement, on the other hand, such as a lease, employment agreement, or loan agreement – such as may be entered between the corporation and a controlling shareholder – is not treated as a binding agreement relating to distribution and liquidation proceeds unless a principal purpose of the agreement is to circumvent the one class of stock requirement (for example, where the terms are not at arm’s-length).

Similarly, buy-sell agreements among shareholders, agreements restricting the transferability of stock, and redemption agreements are disregarded in determining whether a corporation’s outstanding shares of stock confer identical distribution and liquidation rights. Although such an agreement may be disregarded in determining whether shares of stock confer identical distribution and liquidation rights, payments pursuant to the agreement may have other tax consequences. [9]

However, if a principal purpose of the agreement is to circumvent the one class of stock requirement, and the agreement establishes a purchase price that, at the time the agreement is entered into, is significantly in excess of or below the FMV of the stock, the one-class of stock rule may be violated.

Again, it will behoove a shareholder of an S corporation to appreciate the parameters described above.

——————————————————————

[1] Alliteration has its place.

[2] This raises the question: do the shareholders have a shareholders’ agreement and, if they do, does it restrict the transfer of shares, or require that the shareholders preserve the corporation’s tax status?

[3] Basically, constructive dividends. Less euphemistically, theft?

[4] The Court began its discussion by pointing out that, in general, the taxpayer bears the burden of proving that the IRS’s determinations set forth in the notice of deficiency are incorrect. In cases of unreported income, however, the IRS bears the initial burden of producing evidence linking the taxpayer with the receipt of funds before the general presumption of correctness attaches to a determination. Once the IRS meets this burden of production, the Court explained, the burden of persuasion remains with the taxpayer to prove that the IRS’s deficiency calculations were arbitrary or erroneous.

Corp failed to file income tax returns or to maintain adequate books and records for the years in issue. The IRS obtained banking records and conducted bank deposits analyses to determine the company’s net income. Bank deposits are prima facie evidence of income, the Court stated, and the “bank deposits method” was an acceptable method of computing unreported income.

The Court found that the IRS satisfied the burden of production with respect to the unreported income items at issue.

[5] https://www.law.cornell.edu/uscode/text/26/1361 .

[6] Reg. Sec. 1.1361-1(l). https://www.law.cornell.edu/cfr/text/26/1.1361-1.

[7] When Taxpayer and Bro were still on good terms, they should have agreed that Corp would make regular tax distributions, at least annually.

[8] The reference to “outstanding” shares is important; an S corporation’s certificate of incorporation may authorize the issuance of a preferred class of stock, but so long as such preferred class has not been issued and remains outstanding, the “S” election will remain in effect.

[9] For example, gift tax.

 

 

 

Tax Returns Are Like Paintings   [I]

A not insignificant portion of our tax practice involves disputes among the shareholders and partners of closely held businesses, or among the beneficiaries and fiduciaries of estates or trusts where a significant part of the assets at issue consists of interests in closely held businesses.

In addition to structuring the separation of such parties on a tax efficient basis – including the division of the business where appropriate – we will comb through the tax filings of a business to gather information that may be helpful to our client in negotiating a settlement or, if necessary, in litigating their case. For example, the return will disclose information about distributions, loans by or to owners, compensation paid to owners, rental payments, transactions with affiliated entities, etc. In other words, the return will reveal a number of ways by which value may have been withdrawn from the business.

An earlier post considered how a business owner, to whom information about the business has been denied by their fellow owner(s), may obtain such information, as well as circumstantial evidence about other goings-on in the business, by requesting copies of tax returns from the IRS.

A recent decision[ii] by a Federal District Court described one taxpayer’s efforts to obtain tax return information from the IRS related to his family’s business.

Breach of Fiduciary Duty?

Taxpayer’s grandfather founded a successful business (the “Business”) as a sole proprietorship. Upon his death, the Business passed to Taxpayer’s father, who incorporated the Business (the “Corp”). Taxpayer claimed that he became an “authorized individual” for the business after his father’s death, and he alleged that he was the beneficiary of his father’s estate. Taxpayer’s father and grandfather each created trusts (the “Trusts”) which identified Taxpayer as a beneficiary. It appears that Taxpayer was not a direct owner of the business.

Taxpayer suspected that the trustees of the Trusts had somehow breached their fiduciary duties to the beneficiaries of the Trusts.

In order to confirm his suspicions, Taxpayer submitted forms to the IRS requesting copies of several years of income tax returns for the Business and Corp, most of which the IRS provided, along with a “Business Master File Transcript-Complete,” which listed all tax returns and documents filed on behalf of Corp.[iii]

Taxpayer subsequently submitted more Privacy Act and Freedom of Information Act (“FOIA”) requests for various tax records relating to himself, his father and grandfather, the Business, Corp, his father’s estate, and the Trusts.

Although the IRS contended that it had released all responsive records to which Taxpayer was entitled, he insisted that the IRS was unlawfully withholding documents.

Taxpayer then commenced the suit before the Court, seeking relief under the Code – which mandates disclosure of tax return information to certain persons – FOIA and the Privacy Act.

The IRS moved to dismiss some of these claims, and for summary judgment as to the others.

Laying Down the Rules

The Court reviewed the applicable standards of review, as well as the allocation of the burden of proof.

FOIA

It noted that, in FOIA cases, the IRS bears the burden of demonstrating the adequacy of its search and that it properly withheld any documents from the requesting party.

The Court stated that it may grant summary judgment based solely on the information provided in the IRS’s affidavits or declarations when they “describe the documents and the justifications for nondisclosure with reasonably specific detail, demonstrate that the information withheld logically falls within the claimed exemption, and are not controverted by either contrary evidence in the record or by evidence of agency bad faith.” Such affidavits or declarations are “accorded a presumption of good faith,” the Court continued, “which cannot be rebutted by ‘purely speculative claims about the existence and discoverability of other documents.’”

PA

The Privacy Act, the Court explained, provides a cause of action against an agency that refuses to comply with an individual’s request for his records. Before bringing such a claim in court, however, a plaintiff must submit a “Privacy Act inquiry [that is] clearly marked ‘request for notification and access’ and ‘contain[s] a statement that it is being made under the provisions of’ [the statute].” Failure to do so is cause for dismissal because exhaustion of administrative remedies under the Privacy Act is a jurisdictional prerequisite for judicial review.

The Court’s Analysis

Even accepting all of Taxpayer’s allegations as true, the Court determined that he did not actually plead that he submitted requests for most of the information sought.

Rather, he cursorily alleged that he “mailed a FOIA and PA Request with supporting documents” and the IRS never responded. Such a conclusory allegation, the Court stated, was not enough to avoid dismissal. The only specific requests Taxpayer mentioned in the complaint were for Corp’s tax returns. He never alleged that he had ever submitted a request for the other documents.

The Court next turned to Taxpayer’s requests for tax information for his grandfather, father, his father’s estate, the Trusts, the Business and Corp.

The IRS contended that it had released all responsive records to which Taxpayer was entitled.

Thus, the Court had to determine whether Taxpayer was authorized to receive the other documents he had requested and, if so, whether the IRS’s search for those records was adequate.

Authorized Access

“For good reason,” the Court stated, “not just anyone can obtain the tax information of another person or corporation. Tax returns and accompanying information are ‘confidential’ and can only be disclosed to those authorized by statute and regulation. Before the Service can release an individual’s tax information, the requester must ‘establish [his] identity and right to access such records’ by “provid[ing] adequate proof of the legal relationship under which [he] assert[s] the right to access the requested records.” Until the requester does so, the IRS “is not obligated to process the request,” and if he “nonetheless files suit, [he] is said to have failed to exhaust [his] administrative remedies.” A plaintiff bears the burden of showing entitlement to records.

Taxpayer submitted copies of the death certificates of his father and grandfather, the Trust agreements, and his own social security card. The IRS did not dispute that this information was sufficient for Taxpayer to obtain the records of himself, his father, Corp, the Trusts, and his father’s estate, but it contested that the submitted documents also established that he was authorized to receive records pertaining to his grandfather, the Business, or his grandfather’s estate.

The Court agreed with the IRS.

It explained that, when seeking tax records for a deceased individual or an estate, a requester must show that he is the “administrator, executor, or trustee of [the] estate” or an “heir at law, next of kin, or beneficiary under the will, of such decedent.” None of Taxpayer’s submitted documents established such a relationship. His grandfather’s trust agreement stated that Taxpayer was entitled only to a part of the trust; because trusts and estates are different legal entities, Taxpayer’s rights under the trust did not automatically make him a beneficiary of his grandfather’s estate under his will, as required by statute.

As to the Business, Taxpayer had to show that he was: 1) “designated [for access] by resolution of its board of directors”; 2) “an officer or employee” who has been designated access by a “principal officer and attested to by the secretary or other officer”; 3) a “bona fide shareholder of record owning 1 percent or more of the outstanding stock of such corporation”; 4) for an S corporation, that he was “a shareholder during any part of the period covered by such return during which an election . . . was in effect”; or 5) for dissolved corporations, that he has been “authorized by applicable [s]tate law to act for the corporation” or found by the IRS “to have a material interest which will be affected by” the information.

Taxpayer did not allege that he submitted any of the forms of proof required by the statute. He, instead, stated that “his records” listed him as a “Member/Shareholder of the [Business].” The Court reviewed this document and was unable to locate such an indication. Even if that information did appear on the document, it would still not satisfy the requirements for disclosure because Taxpayer had to show that, as a shareholder, he owned more than 1% of the outstanding stock or that (if an S corporation) he was a shareholder during the relevant period.

Taxpayer also seemed to argue that the IRS would be able to see whether he met the above criteria for disclosure because it could look at the returns filed by the Business and determine how much of a share Taxpayer inherited through his father.

Even if that were true, the Court countered, Taxpayer – not the IRS – bore the burden of establishing access to records. Moreover, to the extent that he attempted to argue that as a shareholder of Corp he was also an owner of the Business, and thus entitled to access, Taxpayer had not established that these two entities were the same, such that being an owner of one would mean he was an owner of the other.

The Court thus agreed with the IRS that Taxpayer had only established authorization to obtain tax information for Corp, his father, his father’s estate, the Trusts, and himself.

The appropriateness of the IRS’s search – and, therefore, of its refusal to disclose records to Taxpayer – would be limited to those entities and individuals.

Adequacy of the Search

Taxpayer challenged the IRS’s search for several categories of his requested records.

The Court explained that “an agency fulfills its obligations under FOIA if it can demonstrate beyond material doubt that its search was ‘reasonably calculated to uncover all relevant documents.’” Stated differently, the issue was not whether there might exist any other documents possibly responsive to the request but, rather, whether the search for those documents was adequate.

The adequacy of an agency’s search for documents requested under FOIA “is judged by a standard of reasonableness and depends . . . upon the facts of each case.” To meet its burden, the agency may submit affidavits or declarations that explain the scope and method of its search “in reasonable detail.” The affidavits or declarations should “set forth the search terms and the type of search performed, and aver that all files likely to contain responsive materials (if such records exist) were searched.” Absent contrary evidence, such affidavits or declarations are sufficient, the Court stated, to show that an agency complied with FOIA. “If, however, the record leaves substantial doubt as to the sufficiency of the search, summary judgment for the agency is not proper.”

The IRS produced the Declaration of a Government Information Specialist in the IRS Office of Privacy, Government Liaison and Disclosure and, based upon this affidavit, contended that it had performed an adequate search and had released all responsive records.

Schedule K-1

Taxpayer requested K-1 information for himself from several of the entities, stretching back many years. According to the IRS, this information “would show up on Taxpayer’s transcripts” if it existed, but that system only retains information returns for ten years. Unfortunately for Taxpayer, the information for the latest date for which he had requested K-1 information had already been purged.

Next, the IRS manually searched Taxpayer’s transcripts for the requested years “in case he perhaps had attached his Forms K-1 to his own returns.” It then sent a request to its long-term storage facility to locate any responsive files. Personal tax returns however, are destroyed after seven years. Again, the information for the years requested had already been destroyed.

Finally, the IRS “checked to see if the [grandfather’s trust] had filed a Form 1041,” which would have had K-1 information attached – nothing. After realizing it did not search for K-1s from the father’s trust and estate, the IRS conducted a supplemental search using the same method described above and did not locate any responsive records.

Taxpayer next argued that the IRS should have been able to locate the estate tax return filed for his grandfather’s estate because such forms are retained for 75 years. The IRS asserted simply that it had “searched for the Form 706 . . . and [was] unable to locate it.”

Such a cursory explanation, the Court stated, was not a “reasonably detailed” description of the search because it did not “set forth the search terms and the type of search performed.” Although the IRS alleged that it had a copy of the Form 706, Taxpayer sought the original, which he said may have K-1 information attached. Thus, the Court was unable to grant the IRS’s summary judgment motion on this point.

Based upon the foregoing, the Court dismissed most of Taxpayer’s complaints and granted most of the IRS’s motion for summary judgement.

Forewarned is Forearmed

There are a number of ways by which a taxpayer may obtain tax return information relating to themselves or to an entity in which they have a beneficial or other interest. The discussion above identified the most important of these, including Section 6103(e) of the Code, the Freedom of Information Act[iv] (which applies to all Federal agencies, and may provide access to many kinds of IRS records), and the Privacy Act of 1974[v] (which provides access to the taxpayer’s own records).

In every case, the taxpayer has to carefully comply with the requirements of each statutory regime, including the regulations and any other rules promulgated thereunder, if they are to obtain the desired information.

The taxpayer also has to be aware of the fact that the IRS is not required to maintain tax records indefinitely. Thus, it will behoove a taxpayer who reasonably believes that there may be cause for concern over the management of a business or other entity in which they are interested, but over which they have no control and only limited access to information, to request the relevant tax return information sooner rather than later – first, from the entity, then from the IRS – and, thereby, to begin developing a record and supporting their claims.


[i] Ok, a return may not say a thousand words, and the simile may be more akin to saying that ogres are like onions or parfaits. Sorry Shrek.

[ii] U.S. District Court for the District of Columbia, WILLIAM E. POWELL v. INTERNAL REVENUE SERVICE, Civil Action No. 17-278 (JEB).

[iii] Last week’s post described a business-owner who sought copies of the tax returns of another party – a co-owner of the business – through discovery.

[iv] 5 U.S.C. 552.

[v] P.L. 93-579.

Decisions, Decisions

The reduction in the Federal income tax rate for C corporations, from a maximum of 35-percent to a flat 21-percent, along with several other changes made by the Tax Cuts and Jobs Act (the “Act”) that generally reflect a pro-C corporation bias, have caused the owners of many pass-through entities (“PTEs”) to reconsider the continuing status of such entities as S corporations, partnerships, and sole proprietorships.

Among the factors being examined by owners and their advisers are the following:

  • the PTE is not itself a taxable entity, and the maximum Federal income rate applicable to its individual owners on their pro rata share of a PTE’s ordinary operating income is 37-percent[i], as compared to the 21-percent rate for a C corporation;
  • the owners of a PTE may be able to reduce their Federal tax rate to as low as 29.6-percent if they can take advantage of the “20-percent of qualified business income deduction”;
  • a PTE’s distribution of income that has already been taxed to its owners is generally not taxable[ii], while a C corporation’s distribution of its after-tax earnings will generally be taxable to its owners at a Federal rate of 23.8%, for an effective combined corporate and shareholder rate of 39.8%;
  • the capital gain from the sale of a PTE’s assets will generally not be taxable to the PTE[iii], and will generally be subject to a Federal tax rate of 20-percent in the hands of its owners[iv], while the same transaction by a C corporation, followed by a liquidating distribution to its shareholders, will generate a combined tax rate of 39.8%.[v]

The application of these considerations to the unique facts circumstances of a particular business may cause its owners to arrive at a different conclusion than will the owners of another business that appears to be similarly situated.

Even within a single business, there may be disagreement among its owners as to which form of business organization, or which tax status, would optimize the owners’ economic benefit, depending upon their own individual tax situation and appetite.[vi]

In the past, this kind of disagreement in the context of a closely held business has often resulted in litigation of the kind that spawned the discovery issue described below. The changes made by the Act are certain to produce more than their share of similar intra-business litigation as owners disagree over the failure of their business to make or revoke certain tax elections, as well as its failure to reorganize its “corporate” structure.

A Taste of Things to Come?

Corporation was created to invest in the development, production, and sale of a product. Among its shareholders was a limited partnership (“LP”), of which Plaintiff was the majority owner.

Plaintiff asserted that Corporation’s management (“Defendants”) had breached their fiduciary duty to LP and the other shareholders. This claim was based upon the fact that Corporation was a C corporation and, as such, its dividend distributions to LP were taxable to LP’s members, based upon their respective ownership interest of LP.[vii]

Plaintiff claimed that this “double taxation” of Corporation’s earnings – once to Corporation and again upon its distribution as a dividend to its shareholders – had cost the business and its owners millions of dollars over the years, was “unnecessary,” had reduced the value of LP, and could have been avoided if Corporation had been converted into an S corporation, at which point LP would have distributed its shares of Corporation stock to its members, who were individuals.

Plaintiff stated that it had made repeated requests to Defendants to “eliminate this waste,” but to no avail.

Thus, one of the forms of relief requested by Plaintiff was “[p]ermanent injunctive relief compelling the Defendants to take all appropriate actions necessary to eliminate the taxable status of [Corporation] that results in an unnecessary level of taxation on distributions to the limited partners of [LP].”

“Prove It”

Defendants asked the Court to compel Plaintiff to produce Plaintiff’s tax returns for any tax year as to which Plaintiff claimed to have suffered damages based upon Corporation’s tax status.

Defendants asserted that, in order to measure any damages that were suffered by Plaintiff by reason of Corporation’s status, Defendants needed certain information regarding Plaintiff’s taxes, including Plaintiff’s “tax rate, deductions, credits and the like.”

Plaintiff responded that their “tax returns have no conceivable relevance to any aspect of this case.” Among other reasons, Plaintiff asserted that the action was brought derivatively on behalf of LP such that Plaintiff’s personal tax returns were not germane.

Defendants countered that, even if Plaintiff’s claims were asserted derivatively, the tax returns nevertheless were relevant since Plaintiff was a member of LP, the entity on whose behalf the claims were made.

The Court’s Decision

According to the Court, tax returns in the possession of a taxpayer are not immune from civil discovery. It noted, however, that courts generally are “reluctant to order the production of personal financial documents and have imposed a heightened standard for the discovery of tax returns.”

The Court explained that a party seeking to compel production of tax returns in civil cases must meet a two-part test; specifically, it must demonstrate that:

  • the returns are relevant to the subject matter of the action; and
  • there is a compelling need for the returns because the information contained therein is not otherwise readily obtainable.

Limited partnerships, the Court continued, “are taxed as ‘pass-through’ entities, do not pay any income tax, but instead file information returns and reports to each partner on his or her pro-rata share of all income, deductions, gains, losses, credits and other items.” The partner then reports those items on his or her individual income tax return. “The limited partnership serves as a conduit through which the income tax consequences of a project or enterprise are passed through to the individual partners.”

The Court found that Plaintiff’s tax returns were relevant to the claims asserted. The crux of Plaintiff’s argument regarding Corporation’s status, the Court stated, was that LP’s partners, including Plaintiff, were subject to “double taxation” and were thereby damaged.

The Court also found that Defendants had established a compelling need. The Court was satisfied that, in order for Defendants to ascertain whether or not Plaintiff, who owned a majority interest in LP, would have paid less tax if Corporation had been converted to an S corporation, Plaintiff had to produce their tax returns to Defendants. The tax returns would disclose, among other things, Plaintiff’s tax rate, deductions and credits that affected the tax due by Plaintiff.

Furthermore, the Court continued, Plaintiff failed to demonstrate that there were alternative sources from which to obtain the information. “While the party seeking discovery of the tax returns bears the burden of establishing relevance, the party resisting disclosure should bear the burden of establishing alternative sources for the information.”

Any concerns that existed regarding the private nature of the information contained in the tax returns could be addressed, the Court stated, by making the tax returns subject to the terms of the “stipulation and order of confidentiality” previously entered in the case.[viii]

Accordingly, the Court granted Defendants’ motion.

What’s Good for the Goose?

For years, oppressed or disgruntled shareholders and partners have often found in the tax returns of the business, of which they are owners, the clues, leads, or circumstantial evidence that help support their claims of mismanagement or worse by those in control of the business.

As a result of the Act, it is likely that some non-controlling owners will find cause for questioning or challenging the “choice of entity” decisions made on behalf of the business by its controlling owners.[ix]

In some cases, their concerns will be validated by what turn out to be true instances of oppression intended to cause economic harm and, perhaps, to force out the intended target.

In others, however, the controlling owner’s decision will have been reached only after a lot of due diligence, including financial modelling and consulting with tax advisers. In such cases, the controlling owner may want to examine the complaining party’s tax return, as in the Court’s decision described above, so as to ascertain whether the loss claimed was actually suffered.

It bears repeating, though, that even if the tax return information may be relevant to the controlling owner’s defense, there is a judicial bias against the disclosure of such information that is manifested in the application of “a heightened standard for the discovery of tax returns.” As stated earlier, the requesting party has to demonstrate that there is a “strong necessity” for the returns, and that the return information is not readily obtainable from other sources.

In the end, the best course of action for the “choice-of-entity” decision-maker, and their best defense against any claims of oppression or mismanagement, is to demonstrate that they acted reasonably and responsibly; they should thoroughly document the decision-process, and explain the basis for their decision. With that, a potential owner-claimant would be hard-pressed to second-guess them with any reasonable likelihood of success.


[i] If the PTE’s business is a passive activity with respect to the owner, the 3.8% Federal surtax on net investment income may also apply, bumping their maximum Federal tax rate up from 37% to 40.8%.

[ii] Because of the upward basis adjustment to the owner’s partnership interest or S corp. stock resulting from the inclusion of the PTE’s income or gain in the owner’s gross income.

[iii] There are exceptions; for example, the built-in gains tax for S corps. https://www.taxlawforchb.com/2013/09/s-corp-sales-built-in-gain-and-2013/ . In addition, the gain from the sale of certain assets may generate ordinary income that would be taxable to the PTE’s owners at a Federal rate of 37%; for example, depreciation recapture.

[iv] But see endnote i, supra.

[v] The operating income and capital gain of a C corporation are taxed at the same rate; there is no preferential Federal capital gain rate as in the case of individuals.

[vi] You may have heard your own clients debating the pros and cons of spinning off “divisions” so as to position themselves for maximizing the deduction based on qualified business income. All this before the issuance of any guidance by the IRS (which is expected later this month), though the Service intimated last month that taxpayers may not be pleased with its position regarding such spin-offs.

[vii] See the third bullet point, above.

[viii] Such an order may be used in cases requiring the exchange, as part of the discovery process, of what the parties to the law suit believe is confidential information.

[ix] For example, a shareholder of an S corporation that does not make distributions, who is not employed by the business, who is a passive investor in the business, and whose pro rata share of the corporation’s income is subject to federal tax at a rate of 40.8%, may wonder why the controlling shareholder does not agree to revoke the “S” election, to at least start making tax distributions.

Last week’s post may have left some readers feeling lightheaded or anxious. [1] It is highly unlikely that this week’s post will leave these individuals in a greatly altered state, though it may alleviate their condition to some extent, at least momentarily.

That is not to say that the issue at the root of today’s post is not controversial or divisive. Indeed, the Federal government continues to treat the production and sale of marijuana as an illegal activity, while the states are split in their stance on the legalization of marijuana. [2] At present, the likelihood that these parties will hash out a resolution of their differences seems remote.

A “Grass” Roots Debate
Both sides of the debate are driven, in part, by economic considerations, including the anticipated economic benefits and burdens. Among proponents of legalization, the opportunity to generate tax revenues from this growing industry – which may be used to fund social and other government-sponsored programs – presents a compelling case. Those opposed to legalization discount the projected tax revenues and point to the opportunity costs – including the attendant economic costs of treatment – that are associated with the increased use of any drug.

Even the Code itself is somewhat inconsistent in its treatment of the marijuana business, as was illustrated in a recent Tax Court decision. https://www.ustaxcourt.gov/ustcinop/OpinionViewer.aspx?ID=11681

“Let It Grow” [3]
Corp. was a corporation organized under the laws of State. Taxpayers were the sole shareholders of Corp. and also served as its officers during the years in issue. State licensed Corp. to grow and sell medical marijuana.

For the years in issue, Corp. elected to be treated as an S corporation for Federal income tax purposes.

Corp. claimed deductions from its gross income for expenses that would normally be characterized as “ordinary and necessary” business expenses, including deductions for items such as officer compensation officers, wages, repairs and maintenance, rents, taxes and licenses, interest, depreciation, advertising, employee benefit programs, and “other deductions,” which it detailed on statements attached to its tax return.

Taxpayers filed joint income tax returns for the years in issue. They received income from Corp., both as pass-through income (in their capacity as shareholders of an S corporation) and as officer compensation (in their capacity as employees of the corporation).

Taxpayers reported the pass-through income from Corp. on their Schedules E, Supplemental Income and Loss, Part II, Income or Loss from Partnerships and S Corporations, attached to their income tax returns for the years in issue.

Taxpayers reported the wages they received from Corp. for the years at issue on their jointly filed Forms 1040, U.S. Individual Income Tax Return. These wage payments, or expenses, were included as a part of Corp.’s “ordinary and necessary” business deductions.

IRS “Enforcement” of Federal Drug Laws?
The IRS examined Corp.’s tax returns for the years in issue. Following the exam, the IRS adjusted Corp’s items of deduction that flowed through to the Taxpayers, thereby increasing their pass-through taxable income for the years at issue.

Specifically, the IRS determined that Corp.’s deductions for the wages paid to Taxpayers should be disallowed as current deductions because they were paid in carrying on an illegal drug business. [4]

At the same time, the IRS allowed Corp.’s cost of goods sold (“COGS”), to the extent they were substantiated.

Taxpayers and the IRS agreed that these disallowed wage deductions could not be characterized as COGS, and that in disallowing the wage deductions, Taxpayers’ flow-through income from Corp. would increase.

They disputed whether Corp. could deduct the wages that it paid to Taxpayers. to the extent that the IRS had disallowed the deductions.

Taxpayers petitioned the U.S. Tax Court, where the issue for consideration was whether the deductions claimed by Corp. for the wages it paid to Taxpayers that were not attributable to COGS for the years in issue should be disallowed.

Getting Into the Weed(s)
The Court began by restating the ground rules: (i) the taxpayer generally bears the burden of proving that the IRS’s determinations, as set forth in the notice of deficiency, are erroneous; and (ii) the taxpayer bears the burden of proving their entitlement to a deduction and of substantiating the amount of the item underlying the claimed deduction.

Deductions, the Court continued, are a matter of legislative grace, and a taxpayer must prove their entitlement to a particular deduction.

Ordinary and Necessary Expenses
The Code allows taxpayers to deduct “ordinary and necessary expenses,” [5] including a “reasonable allowance for salaries or other compensation for personal services actually rendered.” Thus, compensation is deductible in determining the taxable income of a business only if it is (1) reasonable in amount and (2) paid or incurred for services actually rendered.

COGS
However, it is important to separate business expenses from the expenses used to figure the COGS. If a business manufactures products, or purchases them for resale, it generally must value its inventory at the beginning and end of each tax year to determine its COGS. Some of its expenses, including wages, may be included in figuring the COGS.

Under the uniform capitalization rules, a business must capitalize, and include in its COGS, the direct costs and part of the indirect costs for certain production or resale activities. [6]

The COGS is not a “deduction” within the meaning of the Code, but it is subtracted from the gross receipts of the business to determine its gross profit for the year; the costs included in COGS are recovered upon the sale of the product (as opposed to the tax year in which they were paid or incurred).

If a business includes an expense in the COGS, it cannot deduct that expense again as a business expense. [7]

“Expenditures in Connection With the Illegal Sale of Drugs”

The Code precludes taxpayers from deducting any expense related to a business that consists of trafficking in a controlled substance.

No deduction or credit shall be allowed for any amount paid or incurred during the taxable year in carrying on any trade or business if such trade or business (or the activities which comprise such trade or business) consists of trafficking in controlled substances (within the meaning of schedule I and II of the Controlled Substances Act) which is prohibited by Federal law or the law of any State in which such trade or business is conducted. [8]

The Court noted that marijuana was a controlled substance. It then stated that the dispensing of medical marijuana, while legal in State, was illegal under Federal law. Congress set this illegality under Federal law, the Court said, as one trigger to preclude a taxpayer from deducting expenses incurred in a medical marijuana dispensary business, even if the business is legal under State law. [9]

Interestingly, although the Code disallows deductions only for the expenses paid or incurred by a business in the illegal sale of drugs, it does not preclude a taxpayer from taking into account its COGS – in other words, the disallowance does not affect the COGS; if appropriate, the expense may still be included in the taxpayer’s COGS and may be subtracted in determining the taxpayer’s profits from the sale of the drug. [10]

Taxpayers’ Arguments
Taxpayers argued that the disallowance of the wages paid to them by Corp. resulted in discriminatory treatment of S corporation owners of marijuana businesses in violation of subchapter S. They argued that the IRS’s treatment of their wage income as an expense subject to disallowance caused the same income to be taxed twice, once as wages, and a second time (because of the disallowance of the deduction) as S corporation income. They contended that this resulted in the disallowed wage deductions attributable to “drug trafficking” being included in Taxpayers’ earnings, which flowed through to them without any deduction for the wages.

Taxpayers contended that this discriminatory treatment resulted from an S corporation’s being “required” to pay a reasonable wage to its officers, [11] while other entities (for example, a partnership) were not subject to this reasonable wage requirement.

The Court’s Response
The Court pointed out that Taxpayers’ argument of double taxation assumed that there was no distinction between gross income from wages, on the one hand, and pass-through income from the ownership of an S corporation, on the other. The economic considerations for these two items of income differed, according to the Court, as did their tax treatments.

S Corp. Basics
The S corporation rules were designed, the Court explained, to create a pass-through taxation system under which income was subjected to only one level of taxation: to the shareholders and not the corporation.

The Code provides that items of income, loss, deduction, and credit of an S corporation are passed through pro rata to its shareholders and reported on their individual tax returns. The character of each item of income in the hands of a shareholder is determined as if it were directly from the source from which the corporation realized it or incurred in the same manner as it was by the corporation. A shareholder’s gross income includes their pro rata share of the S corporation’s gross income.

Thus, Corp.’s income passed through to Taxpayers, and they had to report it on their individual tax returns. Separately, and in addition to Corp.’s pass-through income, Taxpayers had to report the compensation they received as officers of Corp. as a part of their gross income on their individual returns.

Accordingly, Taxpayers had to include in their gross income not only their pro rata shares of Corp.’s income, but also their wages separately received for providing services to Corp.

The Court further stated that Taxpayers’ contention that the application of deduction-disallowance rule resulted in disparate treatment was misplaced. An S corporation subject to this rule remained a flow-through entity with one tax imposed at the shareholder level, as prescribed by subchapter S.

No Dope
The Court illustrated its point with the following example: If Taxpayers had hired a third party to perform the officer duties that they performed, and they paid that third party an amount equal to that included as wages in Taxpayers’ gross income, their gross income would not include the third party’s wages from Corp.; Taxpayers would ultimately have less income, but they would not owe Federal income tax on the wages paid to the third party. However, the deduction-disallowance rule would still disallow Corp.’s wage expense deductions not attributable to COGS. Taxpayers’ flow-through income would be the same. Thus, the application of the rule to deny Corp.’s wage expense deductions was not discriminatory; it applied equally, regardless of whether Taxpayers themselves or a third party received the wages.

To the extent that Taxpayers believed they received disparate tax treatment as a result of organizing their marijuana business as an S corporation, the Court continued, they were free to operate as any form of business entity and in other trades. Taxpayers chose to operate Corp. as an S corporation in the marijuana business. They were responsible for the tax consequences of their decision.

Wait for Pot Luck?

Until the Code is amended, or until Congress decides that marijuana should not be illegal under Federal law, taxpayers who engage in the marijuana business in those States in which it is legal to do so will have to contend with increased income tax liability resulting from the deduction-disallowance rule described above.

However, because this rule does not apply to figuring the COGS, taxpayers engaged in a marijuana-related production or resale business will have to be careful about maintaining meticulous records in order to substantiate their COGS and support the gross profit reported from the sale of their products.

As in the case of other businesses that produce property for sale or that acquire property for resale, it may be possible to increase one’s COGS. Yes, this seems counterintuitive, but not where the alternative is the disallowance of a business expense deduction.

In any case, the method by which this result is achieved must be undertaken for a bona fide and substantial non-tax business reason. [12] At the same time, it must comply closely with the uniform capitalization rules so as to squeeze as much juice from them as reasonably possible.

Time will tell.

______________________________________

[1] Regarding the Federal tax treatment of CFCs that are owned by S corporations following the Tax Cuts and Jobs Act. https://www.taxlawforchb.com/2018/06/s-corps-cfcs-the-tax-cuts-jobs-act/

[2] Polls indicate that a majority of Americans support the legalization of marijuana. Nine States and the District of Columbia have legalized the recreational use of marijuana. Another 29 States have legalized so-called “medical marijuana.” A handful have decriminalized its use. Last week, Canada became the second nation to legalize marijuana use.

[3] With apologies to the Grateful Dead.

[4] The disallowance of Corp.’s deduction does not necessarily change the tax treatment for Taxpayers of the wages paid to them. For example, the wages were not re-characterized as distributions made to Taxpayers in respect of the shares of Corp. stock.

[5] An ordinary expense is one that is common and accepted in your trade or business. A necessary expense is one that is helpful and appropriate for your trade or business. An expense does not have to be indispensable to be considered necessary.

[6] Indirect costs include rent, interest, taxes, storage, purchasing, processing, repackaging, handling, and administrative costs.

[7] The following are types of expenses that go into figuring COGS: The cost of products or raw materials, including freight; storage; direct labor costs (including contributions to pension plans) for workers who produce the products; factory overhead.

[8] Cannabis remains illegal under federal law. Controlled Substances Act (P.L. 91-513), as amended. IRC Sec. 280E was added to the Code in 1982 by P.L. 97-248 (“TEFRA”). Query how a court would react to a taxpayer’s invoking the Fifth Amendment in response to an information document request from the IRS. Query how new IRC Sec. 199A and its “20%-of-qualified business income deduction” will be applied to a marijuana business; after all, unlike business expenses, the “deduction” is taken after adjusted gross income is determined.

[9] At some point, Congress or the Courts will have to address the conflict between those States that have legalized the marijuana business and the Code’s deduction-disallowance rule.

[10] This rule does not appear in the Code; rather, it is found in the Senate Finance Committee Report to TEFRA 1982. Thus, for example, the costs of growing marijuana or of manufacturing marijuana products may be included in COGS.

[11] For many years, the shareholders of S corporations who were employed by, and actually provided services to, their corporations, chose not to pay themselves any salary in exchange for such services. In this way, they sought to avoid the employment taxes that are required to be imposed upon salaries; the employment taxes do not apply to a shareholder’s pro rata share of S corporation income or to the distribution of such income. The IRS has successfully challenged this gambit.

[12] In a sense, the conceptual ideas for maximizing a taxpayer’s benefit under IRC Sec. 199A may be applicable here as well.

 

Pro “C” Corporation Bias?

Although closely-held businesses have generally welcomed the TCJA’s[i] amendments to the Code relating to the taxation of business income, many are also frustrated by the complexity of some of these changes. Among the provisions that have drawn the most criticism on this count are the changes to the taxation of business income arising from the foreign (“outbound”) activities of U.S. persons.

Because more and more closely-held U.S. businesses, including many S corporations, have been establishing operations overseas – whether through branches or corporate subsidiaries[ii] – the impact of these changes cannot be underestimated.

Moreover, their effect may be more keenly felt by closely-held U.S. businesses that are treated as pass-through entities[iii]; in other words, there appears to be a bias in the TCJA in favor of C corporations.

Overview: Deferred Recognition of Foreign Income – Pre-TCJA

In general, the U.S. has taxed U.S. persons on their worldwide income, although there has been some deferral of the taxation of the foreign-sourced income[iv] earned by the foreign corporate (“FC”) subsidiaries of U.S. businesses.[v]

The Code defines a “U.S. person” to include U.S. citizens and residents.[vi] A corporation or partnership is treated as a U.S. person if it is organized or created under the laws of the U.S. or of any State.[vii]

In general, income earned directly by a U.S. person from the conduct of a foreign business – for example, through the operation of a branch in a foreign jurisdiction – is taxed on a current basis.[viii]

Historically, however, active foreign business income earned indirectly by a U.S. person, through a FC subsidiary, generally has not been subject to U.S. tax until the income is distributed as a dividend to the U.S. person – unless an anti-deferral rule applies.

The CFC Regime

The main U.S. anti-tax-deferral regime, which addresses the taxation of income earned by controlled foreign corporations (“CFC”), may cause some U.S. persons who own shares of stock of a CFC to be taxed currently on certain categories of income earned by the CFC, regardless of whether the income has been distributed to them as a dividend.[ix]

CFC

A CFC is defined as any FC if U.S. persons own (directly, indirectly, or constructively[x]) more than 50-percent of the corporation’s stock (measured by vote or value), taking into account only those U.S. persons who own at least 10-percent of the FC’s stock (measured by vote or value; each a “United States shareholder” or “USS”).[xi]

Subpart F Income

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

In the case of most USS, subpart F income generally includes “foreign base company income,” which consists of “foreign personal holding company income” (such as dividends, interest, rents, and royalties), and certain categories of income from business operations that involve transactions with “related persons,” including “foreign base company sales income” and “foreign base company services income.”[xii]

One exception to the definition of subpart F income permits continued U.S.-tax-deferral for income received by a CFC in certain transactions with a related corporation organized and operating in the same foreign country in which the CFC is organized (the “same country exception”). Another exception is available for any item of income received by a CFC if the taxpayer establishes that the income was subject to an effective foreign income tax rate greater than 90-percent of the maximum U.S. corporate income tax rate (the “high-tax exception”).[xiii]

Actual Distributions

A USS may exclude from its income actual distributions of earnings and profits (“E&P”) from the CFC that were previously included in the USS’s income under the CFC regime.[xiv] Ordering rules provide that distributions from a CFC are treated as coming first out of E&P of the CFC that were previously taxed under the CFC regime, then out of other E&P.[xv]

Foreign Tax Credit

Subject to certain limitations, U.S. persons are allowed to claim a credit for foreign income taxes they pay. A foreign tax credit (“FTC”) generally is available to offset, in whole or in part, the U.S. income tax owed on foreign-source income included in the U.S. person’s income; this includes foreign taxes paid by an S corporation on any of its foreign income that flows through to its shareholders.

A domestic corporation is allowed a “deemed-paid” credit for foreign income taxes paid by the CFC that the domestic corporation is deemed to have paid when the related income is included in the domestic corporation’s income under the anti-deferral rules.[xvi]

Unfortunately for S corporations, they are treated as partnerships – not corporations – for purposes of the FTC and the CFC rules; thus, they cannot pass-through any such deemed-paid credit to their shareholders.

However, any tax that is withheld by the CFC with respect to a dividend distributed to an S corporation will flow through to the S corporation’s individual shareholders.

TCJA Changes

The TCJA made some significant changes to the taxation of USS that own stock in CFCs.

Transition Rule: Mandatory Inclusion

In order to provide a clean slate for the application of these new rules, the TCJA provides a special transition rule that requires all USS of a “specified foreign corporation” (“SFC”) to include in income their pro rata shares of the SFC’s “accumulated post-1986 deferred foreign income” (“post-1986-DFI”) that was not previously taxed to them.[xvii] A SFC means (1) a CFC or (2) any FC in which a domestic corporation is a USS.[xviii]

The mechanism for the mandatory inclusion of these pre-effective-date foreign earnings is the CFC regime. The TCJA provides that the subpart F income of a SFC is increased for the last taxable year of the SFC that begins before January 1, 2018.

This transition rule applies to all USS of a SFC, including individuals.

Consistent with the general operation of the CFC regime, each USS of a SFC must include in income its pro rata share of the SFC’s subpart F income attributable to the corporation’s post-1986-DFI.

Reduced Tax Rate

Fortunately, the TCJA allows a portion of that pro rata share of deferred foreign income to be deducted. The amount deductible varies, depending upon whether the deferred foreign income is held by the SFC in the form of liquid or illiquid assets. To the extent the income is not so deductible – i.e., is included in the income of the USS – the USS may claim a portion of the foreign tax credit attributable thereto.

The total deduction from the amount included under the transition rule is the amount necessary to result in a 15.5-percent tax rate on post-1986-DFI held by the SFC in the form of cash or cash equivalents,[xix] and an 8-percent tax rate on all other earnings.

The calculation of the deduction is based on the highest rate of tax applicable to domestic corporations in the taxable year of inclusion, even if the USS is an individual.

However, an individual USS – including the shareholder of an S corporation – will be taxed on the amount included in their income at the higher federal tax rate applicable to individuals.[xx]

That being said, an individual USS, including one who is a shareholder of an S corporation, generally may elect application of the corporate tax rates for the year of inclusion.[xxi]

Deferred Payment of Tax

A USS may elect to pay the net tax liability resulting from the mandatory inclusion of post-1986-DFI in eight unequal installments.[xxii] The timely payment of an installment does not incur interest.[xxiii]

The provision also includes an acceleration rule. If (1) there is a failure to pay timely any required installment, (2) there is a liquidation or sale of substantially all of the USS’s assets, (3) the USS ceases business, or (4) another similar circumstance arises, the unpaid portion of all remaining installments will become due immediately.

Special Deferral for S corporation Shareholders

A special rule permits deferral of the above transitional tax liability for shareholders of a USS that is an S corporation.

The S corporation is required to report on its income tax return the amount includible in gross income by reason of this provision, as well as the amount of deduction that would be allowable, and to provide a copy of such information to its shareholders.

Any shareholder of the S corporation may elect to defer their portion of the tax liability until the shareholder’s taxable year in which a “triggering event” occurs.[xxiv]

Three types of events may trigger an end to deferral of this tax liability. The first is a change in the status of the corporation as an S corporation. The second category includes liquidation, sale of substantially all corporate assets, termination of the company or end of business, or similar event, including reorganization in bankruptcy. The third type of triggering event is a transfer of shares of stock in the S corporation by the electing taxpayer, whether by sale, death or otherwise, unless the transferee of the stock agrees to be liable for tax liability in the same manner as the transferor.[xxv]

If a shareholder of an S corporation has elected deferral under this special rule, and a triggering event occurs, then the S corporation and the electing shareholder will be jointly and severally liable for any tax liability (and related interest or penalties).[xxvi]

After a triggering event occurs, an electing shareholder may elect to pay the tax liability in eight installments, subject to rules similar to those generally applicable absent deferral. Whether a shareholder may elect to pay in installments depends upon the type of event that triggered the end of deferral. If the triggering event is a liquidation, sale of substantially all corporate assets, termination of the company or end of business, or similar event, the installment payment election is not available. Instead, the entire tax liability is due upon notice and demand.[xxvii]

The New CFC Regime

With the mandatory “repatriation” of the post-1986-DFI of SFC, the TCJA implemented a new “participation exemption” regime for the taxation of USS of “specified 10-percent-owned FCs,”[xxviii] effective for taxable years of FCs beginning after December 31, 2017.

Dividends Received Deduction

Specifically, it allows an exemption for certain foreign income by means of a 100-percent deduction for the foreign-source portion of dividends[xxix] received from a specified-10%-owned FC by a domestic corporation that is a USS of such FC.[xxx]

The term “dividends received” is intended to be interpreted broadly; for example, if a domestic corporation indirectly owns stock of a FC through a partnership, and the domestic corporation would qualify for the DRD with respect to dividends from the FC if the domestic corporation owned such stock directly, the domestic corporation would be allowed a DRD with respect to its distributive share of the partnership’s dividend from the FC.[xxxi]

This DRD is available only to regular domestic C corporations that are USS, including those that own stock of a FC through a partnership; it is not available to C corporations that own less than 10% of the FC. The DRD is available only for the foreign-source portion of dividends received by a qualifying domestic corporation from a speficied-10-percent-owned FC.

No foreign tax credit or deduction is allowed to a USS for any foreign taxes paid or accrued by the FC (including withholding taxes) with respect to any portion of a dividend distribution that qualifies for the DRD.[xxxii]

Significantly, the DRD is not available to individuals; nor is it available to S corporations or their shareholders. Considering that an S corporation is not entitled to the deemed-paid credit for foreign income taxes paid by its foreign subsidiary, the income of the foreign subsidiary may be taxed twice: once by the foreign country and, when distributed, by the U.S.[xxxiii]

Holding Period

A domestic corporation is not permitted a DRD in respect of any dividend on any share of stock of a specified-10-percent-owned FC unless it satisfies a minimum holding period.

Specifically, the FC’s stock must have been held by the domestic corporation for at least 365 days during the 731-day period beginning on the date that is 365 days before the date on which the share becomes ex-dividend with respect to the dividend. For this purpose, the holding period requirement is treated as met only if the specified-10-percent-owned FC qualifies as such at all times during the period, and the taxpayer is a USS with respect to such FC at all times during the period.

GILTI

Having captured and taxed the post-1986-DFI of SFC (through 2017), and having introduced the DRD, the TCJA also introduced a new class of income – “global intangible low-taxed income” (“GILTI”) – that must be included in income by a USS of a CFC, and which further erodes a taxpayer’s ability to defer the U.S. taxation of foreign income.

Amount Included

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

In the case of a CFC engaged in a service business or other business with few fixed assets, the GILTI inclusion rule may result in the U.S taxation of the CFC’s non-subpart F business income without the benefit of any deferral.

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

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

C Corporations

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

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

Based on the interaction of the 50-percent deduction and the 80-percent foreign tax credit, the U.S. tax rate on GILTI that is included in the income of a regular C corporation will be zero where the foreign tax rate on such income is 13.125%.[xxxix]

S Corporations

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

What is an S Corp. to Do?

So what is an S corporation with a FC subsidiary to do when confronted with the foregoing challenges and the TCJA’s pro-C corporation bias?

C Corporation?

One option is for the S corporation to contribute its FC shares to a domestic C corporation, or the S corporation itself could convert into a C corporation (its shareholders may revoke its election, or the corporation may cease to qualify as a small business corporation by providing for a second class of stock or by admitting a non-qualifying shareholder).

However, C corporation status has its own significant issues (like double taxation), and should not be undertaken lightly, especially if the sale of the business is reasonably foreseeable.

Branch?

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

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

Of course, operating through a branch would also prevent any deferral of U.S. taxation of the foreign income, and may subject the U.S. person to a branch profits tax in the foreign jurisdiction.[xl]

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

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

Section 962 Election?

Yet another option to consider – which pre-dates the TCJA, but which seems to have been under-utilized – is a special election that is available to an individual who is a USS, either directly or through an S corporation.

This election, which is made on annual basis, results in the individual being treated as a C corporation for purposes of determining the income tax on their share of GILTI and subpart F income; thus, the electing individual shareholder would be taxed at the corporate tax rate.[xlii]

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

Of course, like most elections, this one comes at a price. The E&P of a FC that are attributable to amounts which were included in the income of a USS under the GILTI or CFC rules, and with respect to which an election was made, shall be included in gross income, when such E&P are actually distributed to the USS, to the extent that the E&P so distributed exceed the amount of tax paid on the amounts to which such election applied.[xliii]

No Easy Way Out[xliv]

We find ourselves in a new regime for the U.S. taxation of foreign income, and there is still a lot of guidance to be issued.

In the meantime, an S corporation with a foreign subsidiary would be well-served to model out the consequences of the various options described above, taking into account its unique circumstances – including the possibility of a sale – before making any changes to the structure of its foreign operations.


[i] “TCJA”. Public Law No. 115-97.

[ii] These may be wholly-owned, or they may be partially-owned; the latter often represent a joint venture with a foreign business.

[iii] The “20% of qualified business income deduction” for pass-through entities does not apply to foreign-source income.

[iv] The Code provides sourcing rules for most categories of business income. It should be noted that, in certain cases, a foreign person that is engaged in a U.S. trade or business may have limited categories of foreign-source income that are considered to be effectively connected such U.S. trade or business.

[v] Special rules apply where the foreign subsidiary engages in business transactions with its U.S. parent or with another affiliated company. A basic U.S. tax principle applicable in dividing profits from transactions between related taxpayers is that the amount of profit allocated to each related taxpayer must be measured by reference to the amount of profit that a similarly situated taxpayer would realize in similar transactions with unrelated parties. The “transfer pricing rules” of section 482 seek to ensure that taxpayers do not shift income properly attributable to the U.S. to a related foreign company through pricing that does not reflect an arm’s-length result.

[vi] Noncitizens who are lawfully admitted as permanent residents of the U.S. (“green card holders”) are treated as residents for tax purposes. In addition, noncitizens who meet a “substantial presence test” (based upon the number of days spent in the U.S.) are also, generally speaking, taxable as U.S. residents.

[vii] It should be noted that an unincorporated entity, such as a partnership or limited liability company, may elect its classification for Federal tax purposes – as a disregarded entity, a partnership or an association – under the “check-the-box” regulations. See Treas. Reg. 301.7701-3.

[viii] The same goes for income that is treated as having been earned directly, as through a partnership. IRC Sec. 702(b).

[ix] The other main anti-deferral regime covers Passive Foreign Investment Companies (“PFIC”). There is some overlap between the CFC and PFIC regimes; the former trumps the latter.

[x] The TCJA amended the applicable ownership attribution rules so that certain stock of a FC owned by a foreign person is attributed to a related U.S. person for purposes of determining whether the related U.S. person is a USS of the FC and, therefore, whether the FC is a CFC. The pro rata share of a CFC’s subpart F income that a USS is required to include in gross income, however, continues to be determined based on direct or indirect ownership of the CFC, without application of the new downward attribution rule. In making this amendment, the TCJA intended to render ineffective certain transactions that were used to as a means of avoiding the CFC regime. One such transaction involved effectuating “de-control” of a foreign subsidiary, by taking advantage of the prior attribution rule that effectively turned off the constructive stock ownership rules when to do otherwise would result in a U.S. person being treated as owning stock owned by a foreign person.

[xi] The TCJA expanded the definition of USS under subpart F to include any U.S. person who owns 10 percent or more of the total value of shares of all classes of stock of a FC. Prior law looked only to voting power. The TCJA also eliminated the requirement that a FC must be controlled for an uninterrupted period of 30 days before subpart F inclusions apply.

[xii] The 10-percent U.S. shareholders of a CFC also are required to include currently in income for U.S. tax purposes their pro rata shares of the CFC’s untaxed earnings invested in certain items of U.S. property. This U.S. property generally includes tangible property located in the U.S. stock of a U.S. corporation, an obligation of a U.S. person, and certain intangible assets, such as patents and copyrights, acquired or developed by the CFC for use in the U.S. The inclusion rule for investment of earnings in U.S. property is intended to prevent taxpayers from avoiding U.S. tax on dividend repatriations by repatriating CFC earnings through non-dividend payments, such as loans to U.S. persons.

[xiii] Before the TCJA reduced the tax rate on C corporations to a flat 21 percent, that meant more than 90 percent of 35 percent, or 31.5 percent. The reduced corporate tax rate should make it easier for a CFC to satisfy this exception; 90% of 21% is 18.9%.

[xiv] This concept, as well as the basis-adjustment concept immediately below, should be familiar to anyone dealing with partnerships and S corporations.

[xv] In order to ensure that this previously-taxed foreign income is not taxed a second time upon distribution, a USS of a CFC generally receives a basis increase with respect to its stock in the CFC equal to the amount of the CFC’s earnings that are included in the USS’s income under the CFC regime. Conversely, a 10-percent U.S. shareholder of a CFC generally reduces its basis in the CFC’s stock in an amount equal to any distributions that the 10-percent U.S. shareholder receives from the CFC that are excluded from its income as previously taxed under subpart F.

[xvi] The deemed-paid credit is limited to the amount of foreign income taxes properly attributable to the subpart F inclusion. The foreign tax credit generally is limited to a taxpayer’s U.S. tax liability on its foreign-source taxable income. This limit is intended to ensure that the credit serves its purpose of mitigating double taxation of foreign-source income without offsetting U.S. tax on U.S.-source income.

[xvii] Basically, foreign earnings that were not previously taxed, that are not effectively connected to the conduct of a U.S. trade or business, and that are not subpart F income.

[xviii] Such entities must determine their post-1986 deferred foreign income based on the greater of the aggregate

post-1986 accumulated foreign earnings and profits as of November 2, 2017 or December 31,

[xix] The cash position of an entity consists of all cash, net accounts receivables, and the fair market value of similarly liquid assets, specifically including personal property that is actively traded on an established financial market, government securities, certificates of deposit, commercial paper, and short-term obligations.

[xx] It should be noted that the increase in income that is not taxed by reason of the deduction is treated as income that is exempt from tax for purposes of determining (i.e., increasing) a shareholder’s stock basis in an S corporation, but not as income exempt from tax for purposes of determining the accumulated adjustments account (“AAA”) of an S corporation (thus increasing the risk of a dividend from an S corporation with E&P from a C corporation).

[xxi] IRC Sec. 962. However, there are other consequences that stem from such an election that must be considered,

[xxii] The net tax liability that may be paid in installments is the excess of the USS’s net income tax for the taxable year in which the pre-effective-date undistributed CFC earnings are included in income over the taxpayer’s net income tax for that year determined without regard to the inclusion. https://www.taxlawforchb.com/?s=foreign

[xxiii] If a deficiency is determined that is attributable to an understatement of the net tax liability due under this provision, the deficiency is payable with underpayment interest for the period beginning on the date on which the net tax liability would have been due, without regard to an election to pay in installments, and ending with the payment of the deficiency.

[xxiv] The election to defer the tax is due not later than the due date for the return of the S corporation for its last taxable year that begins before January 1, 2018.

[xxv] Partial transfers trigger the end of deferral only with respect to the portion of tax properly allocable to the portion of stock sold.

[xxvi] Query how the shareholders’ agreement for an S corporation should be amended to address this possibility.

[xxvii] If an election to defer payment of the tax liability is in effect for a shareholder, that shareholder must report the amount of the deferred tax liability on each income tax return due during the period that the election is in effect. Failure to include that information with each income tax return will result in a penalty equal to five-percent of the amount that should have been reported.

[xxviii] In general, a “specified 10-percent owned foreign corporation” is any FC (other than a PFIC) with respect to which any domestic corporation is a USS.

[xxix] A distribution of previously-taxed income does not constitute a dividend, even if it reduced earnings and profits.

[xxx] The “dividends received deduction” (“DRD”).

[xxxi] In the case of the sale or exchange by a domestic corporation of stock in a FC held for one year or more, any amount received by the domestic corporation which is treated as a dividend for purposes of Code section 1248, is treated as a dividend for purposes of applying the provision. Thus, the DRD will be available to such a deemed dividend. Sec. 1248 is intended to prevent the conversion of subpart F income into capital gain.

[xxxii] In addition, the DRD is not available for any dividend received from a FC if the dividend is a “hybrid dividend.” A hybrid dividend is an amount received from a FC for which a DRD would otherwise be allowed and for which the specified-10-percent-owned FC received a deduction (or other tax benefit) with respect to any income taxes imposed by any foreign country.

[xxxiii] Of course, we also have to consider any withholding tax that the foreign country may impose of the foreign corporation’s dividend distribution to its S corporation shareholder. This tax will be creditable by the shareholders of the S corporation.

[xxxiv] For purposes of the GILTI inclusion, a person is treated as a U.S. shareholder of a CFC for any taxable year only if such person “owns” stock in the corporation on the last day, in such year, on which the corporation is a CFC. A corporation is generally treated as a CFC for any taxable year if the corporation is a CFC at any time during the taxable year.

[xxxv] Thus, subpart F income, effectively connected income, and income that is subject to foreign tax at a rate greater than 18.9% is not GILTI. For example, the corporate tax rate is 19% in the U.K., 24% in Italy, 25% in Spain 25%, 18% in Luxembourg, and 25% in the Netherlands.

[xxxvi] “Qualified business asset investment (“QBAI”). The CFC’s intangible property is not included in QBAI.

The 10% represents an arbitrary rate of return on the “unreturned capital” (i.e., tangible property) of the CFC, represented by its adjusted basis, for which continued deferral is permitted. Anything in excess thereof must be included in the gross income of the USS on a current basis.

[xxxvii] The maximum individual tax rate applicable to ordinary income.

[xxxviii] For taxable years beginning after December 31, 2025, the deduction is lowered to 37.5-percent.

It should be noted that it is intended that the “50-percent of GILTI deduction” be treated as exempting the deducted income from tax. Thus, for example, the deduction for GILTI could give rise to an increase in a domestic corporate partner’s basis in a domestic partnership that holds stock in a CFC.

[xxxix] 13.125% multiplied by 80% equals 10.5 percent.

[xl] Of course, an income tax treaty between the U.S. and the foreign jurisdiction may affect this result.

[xli] The applicable regulations have yet to be amended to reflect the changes made by the TCJA.

[xlii] However, the shareholder will not be allowed the 50-percent GILTI deduction. This deduction is not part of the CFC or FTC rules.

[xliii] In other words, the regular double taxation rules for C corporations will apply; the corporation is treated as having distributed its after-tax E&P.

[xliv] Remember “Rocky IV”?

“You Mess with the Bull . . .”

An often-explored theme of this blog is the frequency with which similarly situated business taxpayers, facing the same set of economic circumstances, and presented with the same set of choices, will knowingly repeat the “mistakes” made by countless taxpayers before them.[i] They will choose a course of action that violates the spirit, if not the letter, of the tax law.

Rational behavior? Does the answer depend upon the taxpayer’s appetite for risk-taking? Being an entrepreneur necessarily involves some exposure to risk. However, there is a difference between the calculated risk that an intelligent business owner takes, on the one hand, and the risk that comes with tweaking the nose of the IRS, on the other.

“ . . . You get the Horns”

For example, many business owners (and former owners) have regretted certain choices regarding their withholding tax obligations.

Employment Taxes

In order to assist the IRS in the collection of those taxes that are imposed on an employee’s wages, employers generally must withhold from their employees’ wages the federal income, social security, and Medicare taxes owing by such employees on account of such wages. These taxes are called “trust fund” taxes because employers actually hold the employee’s money in trust until making a federal tax deposit of the amounts withheld.

Trust Fund Penalty

The amounts withheld must be paid over to the IRS (“deposited”) in accordance with the applicable deposit schedule. To encourage the prompt payment by employers of the withheld income and employment taxes, the Code provides for the so-called trust fund recovery penalty (“TFRP”) under which a person who is responsible for withholding, accounting for, or depositing or paying these taxes, and who willfully fails to do so, can be held personally liable for a penalty equal to the full amount of the unpaid trust fund tax, plus interest.

Thus, if an employer fails to collect the appropriate amount of tax (for example, as result of having misclassified employees as independent contractors) or collects the tax but fails to remit it, and the unpaid trust fund taxes cannot be immediately collected from the business, the TFRP map be applied to the responsible persons.

It should be noted that the employer’s business does not need to have ceased operating in order for the TFRP to be assessed. Indeed, it may be that, in some cases, a business has survived only because the withheld taxes have not been remitted to the IRS but have, instead, been used to pay other expenses of the business.

In many other cases, however, the imposition of the TFRP plus interest has led to the demise of the business. Although this result may seem harsh, it is probably the correct outcome from an economic perspective. A business that cannot survive on its own should not be able to divert withheld tax amounts toward its own private use.[ii]

A Recent Example

Taxpayer formed LLC with his deceased business partner, Dead Guy[iii]. Each was a fifty-percent owner of LLC, and they were the company’s only officers. LLC’s operating agreement gave them joint managerial control of the company and prohibited either one from engaging in major financial transactions without the other’s approval. Taxpayer’s title was “managing member.” He oversaw LLC’s office operations, and Dead Guy oversaw LLC’s field operations.

Both Taxpayer and Dead Guy had signing authority on LLC’s bank accounts. Taxpayer frequently signed checks, including payroll checks, during the years at issue. LLC had a stamp of Taxpayer’s signature, and Taxpayer regularly directed the employee who handled payroll to issue checks with his signature to employees and creditors. Taxpayer admitted that he decided which bills to pay if there were insufficient funds to pay them all. LLC also had an outside accountant, CPA, who prepared LLC’s corporate income and employment tax returns. Once CPA prepared the returns, he reviewed them with Taxpayer and Dead Guy before filing.

During the years at issue, LLC did not fully pay its federal payroll taxes. Taxpayer was aware that employers are required to withhold income and social security taxes from their employees’ wages. He also became aware at some point during this time period that LLC owed taxes.

Taxpayer said that he first learned that the payroll taxes were not being paid when an IRS agent came to LLC’s office. Taxpayer then tried to work with the IRS to pay the delinquent taxes. CPA corroborated that Taxpayer was kept apprised of LLC’s ongoing tax struggles.

Following an administrative investigation, the IRS determined that both Taxpayer and Dead Guy were “responsible persons” who had willfully failed to pay over the trust fund taxes. It assessed trust fund recovery penalties against both of them.

Trust fund taxes are amounts withheld for income and social security tax and remitted to the IRS.

Procedural History

During the pendency of their case before the District Court, Dead Guy, well, died, and was dismissed as a defendant.[iv] The case proceeded against Taxpayer, and the IRS sought a judgment against Taxpayer for the unpaid balance of the amounts assessed against him. The parties filed cross-motions for summary judgment on the issues of: (i) whether Taxpayer was a person responsible for paying over the trust fund portion of LLC’s payroll taxes; and (ii) whether Taxpayer willfully failed to pay over those taxes.

The Courts Speak

The District Court concluded that Taxpayer was a responsible person because he was a fifty-percent owner, one of only two officers, he had check-signing authority, and he exercised his power to pay LLC’s bills and sign paychecks. The Court further determined that Taxpayer learned during the years at issue that the taxes were not being paid, and that he received regular updates on communications with the IRS regarding the delinquencies. The Court concluded that he was willful because he paid other creditors after having actual knowledge that the payroll taxes were not being paid, and because he acted with reckless disregard for whether the taxes were being paid.

In opposition to the IRS’s motion for summary judgment, Taxpayer claimed – contrary to his deposition testimony! – that he had not been aware of the delinquencies. The District Court disregarded this declaration because “conclusory, self-serving affidavits are insufficient to withstand a motion for summary judgment.”

The District Court granted the IRS’s motion, and Taxpayer appealed the decision to the Court of Appeals for the Third Circuit.

The Code provides that any person required to pay over trust fund taxes 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” will be liable for the amount of tax evaded. The two conditions for liability are (1) that the individual must be a “responsible person,” and (2) their failure to pay the tax must be “willful.”

On appeal, Taxpayer argued that the District Court should not have granted the IRS’s motion for summary judgment because his case presented genuine disputes of material fact regarding both conditions. The Court disagreed.

Responsible Person?

First, Taxpayer contended that he was not a “responsible person” under the Code. “Responsible person,” while not appearing in the statute itself, is a term of art for the person who has the duty or power to perform or direct the collecting, accounting for, or paying over trust fund taxes. The Court pointed out that “[r]esponsibility is a matter of status, duty or authority, not knowledge.” And “[w]hile a responsible person must have significant control over the corporation’s finances,” the Court continued, “exclusive control is not necessary.” Additionally, there can be more than one responsible person for a particular employer. The Code imposes joint and several liability on each responsible person. A person who has paid the penalty may seek contribution from other liable persons.

To determine whether an individual is a responsible person, the Court stated, the following factors are typically considered:

(1) the corporate bylaws, (2) ability to sign checks on the company’s bank account, (3) signature on the employer’s federal quarterly and other tax returns, (4) payment of other creditors in lieu of the United States, (5) identity of officers, directors, and principal stockholders in the firm, (6) identity of individuals in charge of hiring and discharging employees, and (7) identity of individuals in charge of the firm’s financial affairs.

Based on the foregoing, the Court did not see any error in the District Court’s conclusion that Taxpayer was a responsible person. The undisputed evidence established that he was a fifty-percent owner of LLC and one of only two officers, his approval was required for company decisions and many significant financial transactions, he had check-signing authority, and had exercised his power to pay the company’s bills and sign paychecks.

On appeal, Taxpayer protested that he was not responsible for LLC’s payroll or tax contributions. He claimed these responsibilities were entirely Dead Guy’s. But the District Court properly determined that the division of labor between the two partners was irrelevant, because there can be more than one responsible person, and Taxpayer possessed and exercised the authority that qualified one as statutorily “responsible” to pay over taxes. Moreover, Taxpayer’s contentions that he was somehow not responsible because he managed LLC’s business while Dead Guy directly supervised employees only solidified the District Court’s conclusion. Faced with this evidence, the Court found that Taxpayer was a responsible person.

Willful Failure?

Taxpayer next argued that his failure to pay over the taxes was not willful.

According to the Court, willfulness is “a voluntary, conscious and intentional decision to prefer other creditors over the Government.” It may also be established, the Court stated, if the responsible person acts with “reckless disregard” of a known or obvious risk that withheld taxes may not be remitted to the government. “Reckless disregard includes failure to investigate or correct mismanagement after being notified that withholding taxes have not been paid.” Willfulness need not be in bad faith, nor does it require actual knowledge of the tax delinquency.

The Court concluded that Taxpayer’s behavior was willful because he permitted LLC to pay other creditors after he knew that the taxes were in arrears. The record demonstrated that he had actual knowledge the taxes were due and, despite this knowledge, LLC paid substantial sums to Taxpayer and Dead Guy throughout the delinquency.

Moreover, to the extent that Taxpayer claimed he was unaware the taxes were not being paid, the Court countered that he was in a position to know for certain that they were not. Under the circumstances, Taxpayer’s inaction amounted to a reckless disregard qualifying as willfulness.

The More Things Change . . .

Indebtedness that isn’t “real,” unreasonable compensation, constructive dividends, below-market transactions with related parties, questionable losses[v], weakly-supported valuations, misclassified service providers – these are but some of the more common instances in which taxpayers flout the tax laws and invite the imposition of penalties.

They are also among the most easily avoidable situations because they fail to comport with economic reality and, as such, are readily identifiable by both the taxpayer and the IRS. Moreover, they typically do not involve especially convoluted fact patterns or complex issues in areas of the law where the outcome may be debatable and where a taxpayer may have a reasonable basis for its position.

For these reasons, among others, a well-advised – i.e., well-informed – taxpayer should never place itself in a position where it will have to concede such an “error” in the course of an audit. Such a taxpayer loses credibility with an examiner, which may taint other, more defensible positions on its tax return. Why jeopardize oneself by repeating the mistakes for which countless decisions have upheld the imposition of penalties? Such an action does not stem from a calculated risk – it’s just reckless.


[i] No, I am not turning this into a social science paper or a discussion on rational choice theory. However, I am channeling that great Sicilian, Vizzini: “You fell victim to one of the classic blunders – the most famous of which is ‘never get involved in a land war in Asia’ – but only slightly less well-known is this: ‘Never go in against a Sicilian when death is on the line’! Ha ha ha ha ha ha ha!” From The Princess Bride.

[ii] As one IRS agent put it to me many years ago, a taxpayer should go out of business before it fails to satisfy its tax obligations.

[iii] All references to “Dead Guy” relate to the period prior to his passing. On information and belief, Dead Guy was alive when LLC was formed, and ceased to be active in LLC’s business only after his death.

[iv] A tax lien arises at the time an assessment of tax is made and continues until the tax is satisfied or becomes unenforceable by reason of lapse of time. Thus, when a trust fund penalty is assessed, a tax lien attaches to all of the responsible person’s property. The lien remains attached and is not invalidated by a transfer of the property upon the death of the responsible person.

[v] For example, where a taxpayer makes deductible cash expenditures year after year in excess of their cash revenue, thereby generating a loss – even without regard to depreciation/amortization or elections to expense certain items – yet remaining in business.

It is said that repetition is the mother of all learning. It is also said that insanity is repeating the same mistake and expecting a different result. It is my hope that the result of the former will overwhelm the source of the latter before it is too late.

However, based upon the seemingly continuous flow of decisions from the Tax Court rejecting taxpayers’ characterization of their outlays of funds as indebtedness, it may be a forlorn hope.

What follows is a summary of one especially ill-advised or misguided taxpayer.

Debts and Distributions

Taxpayer was the sole shareholder of S-Corp.[i] The corporation operated a mortgage broker business. It acted as an intermediary between borrowers and lenders; it did not hold any loans itself. https://www.ustaxcourt.gov/USTCInOP/OpinionViewer.aspx?ID=11650

Bad Debts?

In Tax Year, S-Corp. to make a series of advances to Borrower. The advances were made by checks, credit card payments, and wire transfers. Each advance was recorded on S-Corp.’s general ledger as a loan receivable from Borrower.

Borrower did not execute any notes for the advances received during Tax Year. The advances were unsecured, and neither S-Corp. nor Taxpayer made a public filing to record a debt in connection with the advances. Taxpayer did not know the business activities that Borrower conducted.

An adjusting entry in S-Corp.’s general ledger for December 31 of Tax Year reflected that Taxpayer instructed that the loan receivable for the Tax Year advances be written off.

On its return for Tax Year, S-Corp. claimed a large deduction for bad debts; the debt deduction was attributable to a write off for advances made to Borrower.

S-Corp.’s trial balance for the following tax year reflected that it made another loan to Borrower in that year. Taxpayer claimed not to know the purpose for that advance.

“Bad” Distributions?

As S-Corp.’s president and sole shareholder, Taxpayer authorized distributions to himself during the two years in issue. In Tax Year, Taxpayer received total distributions in excess of $1.6 million. In the following year, he received distributions in excess of $2 million.

For the years in issue, S-Corp. reported ordinary business losses, based in part on the bad debt deduction claimed for the advances made to Borrower. Taxpayer claimed S-Corp.’s losses on the Schedules E, Supplemental Income and Loss, Part II, Income or Loss from Partnerships and S Corporations, attached to his Forms 1040, U.S. Individual Income Tax Return. He engaged the same CPA firm to prepare S-Corp.’s returns and his individual returns for the years in issue.

For the years in issue, S-Corp. reported on its returns the distributions to Taxpayer. It issued Schedules K-1, Shareholder’s Share of Income, Deductions, etc., for Taxpayer that reflected the distributions and reported them as “[i]tems affecting shareholder basis”.

Taxpayer did not report any of the distributions that he received from S-Corp. for the years in issue on his individual returns.

The IRS Disagrees

The IRS examined Taxpayer’s income tax returns for the years in issue, and then issued a notice of deficiency in which it: (i) disallowed the full amount of S-Corp.’s claimed bad debt deduction for Tax Year – this adjustment flowed through to Taxpayer and was reflected as an increase to the income reported on his Schedule E; and (ii) determined that Taxpayer had unreported long-term capital gains for the years in issue.

Taxpayer petitioned the U.S. Tax Court.

Bad Debt Deduction

The Code allows a deduction for a taxable year for any debt that becomes wholly worthless within the taxable year. To deduct a business bad debt, the taxpayer must establish the existence of a valid debtor-creditor relationship, that the debt was created or acquired in connection with a trade or business, the amount of the debt, the worthlessness of the debt, and the year that the debt became worthless.

The IRS contended, and the Court agreed, that Taxpayer failed to establish any of these elements as they relate to the advances made by S-Corp. to Borrower during Tax Year.

A bad debt is deductible only for the year in which it becomes worthless. The Court explained that the subjective opinion of the taxpayer that the debt is uncollectible, without more, is not sufficient evidence that the debt is worthless.

The Court observed that Taxpayer failed to present any evidence that the alleged debt was objectively worthless in Tax Year. He testified only as to his subjective belief. Taxpayer did not identify any events during Tax Year which showed that the alleged debt was uncollectible. He testified that Borrower told him early in the following year that he could not repay the Tax Year advances, but he offered no reasoning as to why in that case the alleged debt should be treated as being worthless at the end of Tax Year.

Even accepting Taxpayer’s uncorroborated testimony, Borrower’s statement early in the following year was not enough to establish that the alleged debt to S-Corp. was objectively worthless at the end of Tax Year. Taxpayer did not describe any actions taken to try to collect the alleged debt, and he testified that he did not know whether Borrower was actually insolvent in the following year. Moreover, there was no reasonable explanation for advancing more funds to Borrower the next year if the prior advances were deemed totally unrecoverable.

Bona Fide Debt?

Taxpayer also failed to establish that the advances constituted a bona fide debt – “a valid and enforceable obligation to pay a fixed or determinable sum of money” – and that the parties intended to create a bona fide debtor-creditor relationship. Generally a debtor-creditor relationship exists if the debtor genuinely intends to repay the loan and the creditor genuinely intends to enforce repayment.

Factors indicative of a bona fide debt include: (1) whether the purported debt is evidenced by a note or other instrument; (2) whether any security was requested;

(3) whether interest was charged; (4) whether the parties established a fixed schedule for repayment; (5) whether there was a demand for repayment; (6) whether any repayments were actually made; and (7) whether the parties’ records and conduct reflected the transaction as a loan.

Borrower did not execute any notes, and Taxpayer did not request any collateral or other security for the advances. Taxpayer did not provide any documents reflecting the terms for the purported loan.

Apart from the way that the advances were recorded in S-Corp.’s general ledger, the parties’ conduct did not reflect that the advances were intended as a bona fide loan. S-Corp. made a series of unsecured advances to Borrower, and as the balance of the advances rapidly increased S-Corp. did not receive any offsetting payments or obtain any guaranties of repayment. Taxpayer did not claim that he and Borrower agreed to a schedule for repaying the advances or that he ever demanded repayment. Rather, he contended that he determined that the advances were uncollectible as of the end of Tax Year, only 10 days after the last advance had been made and without making any efforts to collect the amounts allegedly owed. He testified that by early the next year, he believed Borrower would not be able repay the advances, but he continued to direct S-Corp. to advance him more funds.

Taxpayer contended that he had a “good-faith expectation” that Borrower would repay him. He testified about his prior business dealings with Borrower, but the objective evidence and the preponderance of all evidence suggested that Taxpayer had no genuine intention of requiring Borrower to repay the advances. The real purpose of the advances remained unexplained.

The Court was not persuaded that a bona fide debt was created. It held that Taxpayer had failed to establish whether and when the advances became worthless or that the advances should even be considered a bona fide debt for tax purposes. Accordingly, the Court sustained the IRS’s determination to disallow the bad debt deduction in full.

Distributions from S-Corp.

The IRS contended that Taxpayer failed to report capital gains from the distributions that he received from S-Corp., during the years in issue. According to the IRS, the distributions were in excess of Taxpayer’s adjusted basis in S-Corp’s stock.

Under the Code, a shareholder of an S corporation takes into account their pro rata share of the corporation’s items of income, loss, deduction, or credit for the corporation’s taxable year ending with or in the shareholder’s taxable year. The Code also provides that a shareholder’s basis in their stock of the S corporation is increased by items of income passed through to the shareholder, and decreased by passed through items of loss and deduction. A shareholder’s stock basis is also decreased by distributions received from the S corporation that are not includible in the shareholder’s income. A distribution is not included in the gross income of a shareholder to the extent that it does not exceed the shareholder’s adjusted basis for the stock. The portion of a distribution that exceeds this adjusted basis is treated as gain from the sale or exchange of property.

Taxpayer contended that he did not take distributions in excess of basis. He claimed that he was personally liable to S-Corp. for the distributions that he received during the years in issue because he received them in violation of State law. Under State law, Taxpayer claimed, a shareholder who knowingly receives any distribution that exceeds the amount of the corporation’s retained earnings immediately prior to the distribution is liable to the corporation for the amount so received. For each of the years in issue, S-Corp.’s tax return reflected that it had negative retained earnings.

At this point, one might have expected Taxpayer to characterize the erstwhile “distributions” as loans from the corporation; after all, if his description of the result under State law was accurate, the funds had to be returned. However, Taxpayer instead contended that his liability to S-Corp. under State law “increased his debt basis in the corporation.” How this would have been relevant in determining the proper tax treatment of the distributions made to Taxpayer is anyone’s guess.

The Court stated that Taxpayer had misinterpreted the Code in arguing that his purported obligation to repay the distributions created debt basis. The Court then pointed out that even if Taxpayer established that he had basis in some bona fide indebtedness of S-Corp., it would not affect the taxability of the distributions that he received. The Court pointed out that the Code’s S-corporation-distribution provisions do not identify distributions that decrease a shareholder’s stock basis as an item to be applied to a shareholder’s debt basis after the stock basis has been reduced to zero.

The Court agreed with the IRS that the distributions had to be reported as income and treated as capital gain to the extent that they exceeded Taxpayer’s basis in S-Corp.’s stock. Taxpayer did not dispute the IRS’s calculations of his stock basis for the years in issue. Thus, the Court sustained the determination that Taxpayer had unreported capital gain for the years in issue.

Another One Bites the Dust

Taxpayer did not fare well, but he received his “just deserts.” He totally failed to establish that the advances to Borrower were real debts. The disallowance of the bad debt deduction claimed by Taxpayer resulted in an increase of his “flow-through” S corporation income and, thereby, an increase in his basis for his S-Corp. stock.

The interplay of the disallowed bad debt deduction for Tax Year, and the tax treatment of the distribution made to Taxpayer that year, affords us an opportunity to consider the order in which stock basis is increased or decreased under the Code, and the importance thereof.

The taxability of a distribution and the deductibility of a loss are both dependent on stock basis; for this reason, there is an ordering rule in computing stock basis. Under this rule – which favors tax-free distributions over currently deductible losses – stock basis is adjusted annually, as of the last day of the S corporation’s tax year, in the following order:

  1. Increased for income items;
  2. Decreased for distributions;
  3. Decreased for non-deductible, non-capital expenses; and
  4. Decreased for items of loss and deduction.

When determining the taxability of a distribution, the shareholder looks solely to their stock basis; debt basis is not considered, as Taxpayer learned.

Thus, there was a “silver lining” in the denial of Taxpayer’s loss deduction in that his stock basis was increased, thereby sheltering some of the distribution from S-Corp. – small comfort, though, because he recognized more ordinary income in exchange for less capital gain. Oh well.

 

[i] The corporation was always treated as an S corporation for tax purposes, and had no earnings and profits accumulated from the operations of any C corporation tax years.

Metamorphosis      [i]

By now, most readers have heard about the benefits and pitfalls of “checking the box” or of failing to do so. Of course, I am referring to the election afforded certain unincorporated business entities to change their status for tax purposes. Thus, for example, an LLC with one or more members – which is otherwise treated as a disregarded entity or as a partnership – may elect to be treated as an association taxable as a corporation; an association that has one member may elect to be treated as an entity that is disregarded for tax purposes, while an association with at least two members may elect to be treated as a partnership.

Each of these elections triggers certain income tax consequences of which its owners have to be aware prior to making the election; for instance, an association that elects to be treated as a disregarded entity or as a partnership is treated as having undergone a liquidation, which may be taxable to the entity and to its owner(s).

Although incorporated entities are not eligible to check the box, they may nevertheless desire to change their tax status – i.e., the legal form through which they conduct business[ii]; for example, they may, instead, want to operate as a partnership; conversely, a partnership may desire to “incorporate.” The conversion of a corporation into a partnership constitutes a taxable liquidation, while the incorporation of a partnership may generally be accomplished on a tax-deferred basis.

Stemming Abuse

But what if a business wanted to preserve its flexibility to change its tax status by switching from one form of legal entity to another, depending upon the circumstances?

The IRS foresaw that the ability to change the tax status of a business whenever it suited the owners to do so may lead to abuse. Thus, the check-the-box rules provide that an eligible entity may not elect, as a matter of right, to change its status more than once within any five-year period; similarly, a corporation that loses or revokes its “S” corporation status may not, without the permission of the IRS, elect to again be treated as an S corporation for five years.

“Swapping” Bodies[iii]

A recent Tax Court decision involved a limited liability partnership (“LLP”) that actually shifted its business (“Business”) into a professional corporation (“PC”) – it did not check the box – then, about five years later, shifted it back to LLP. In making these shifts, the owners of these business entities – who remained the same – kept both entities in existence notwithstanding the transfers of Business between them.

Interestingly, the dispute before the Court did not involve the income tax consequences arising from the “conversion” but, rather, the overpayment of employment taxes by LLP and the underpayment of such taxes by PC.

In Year One, four individuals engaged in Business through LLP. In Year Two, they operated through LLP for only two weeks, at which point they commenced operations through newly-formed PC (a C-corporation).

Although LLP ceased conducting ongoing operations, it was maintained for the purpose of collecting revenues, satisfying liabilities, and distributing profits related to LLP’s work.

PC conducted Business from that point forward through the end of Year Two. LLP paid wages to its employees for the first quarter of Year Two (“Quarter”), but the employment tax deposits it made for that period exceeded the wages paid.

The employees who were paid wages by LLP for the first two weeks of Quarter received the balance of their wages during Quarter from PC. Although PC’s general ledger recorded the employment tax deposits made, its payroll services provider that made the employment tax deposits, erroneously submitted them under LLP’s EIN.

The IRS credited LLP’s account for the employment tax deposits made by LLP; it also recorded that LLP timely filed a Form 941, Employer’s Quarterly Federal Tax Return. However, the IRS’s account for PC recorded no employment tax deposits or filings for Quarter.

The IRS’s account transcripts for LLP’s three remaining quarters for Year Two indicated that LLP had neither filed Forms 941 nor reported any employment tax liabilities for those quarters, while PC’s account transcripts for the same quarters indicated that PC had timely filed Forms 941 and made employment tax deposits for each quarter.

In Year Five, Business was again moved to LLP, while PC was kept alive in order to collect receivables, satisfy payables, and distribute profits relating to PC’s work. Hmm.

Tax Deficiency?

In Year Seven, the IRS notified PC that there was no record of PC’s having filed a Form 941 for Quarter. PC used its general ledger to prepare the Form 941, which reported the correct amount of employment tax due, and claimed a credit for employment tax deposits made, on the basis of entries in PC’s general ledger for wages paid and employment tax deposits made. The IRS assessed the employment taxes reported as due but did not credit PC with the employment tax deposits claimed.

PC thereafter sought to correct the Form 941 filed by LLP, claiming adjustments for LLP’s overpayment of employment taxes for Quarter based on the wages actually paid and the amounts actually owing thereon. PC also requested that a credit be applied to its employment tax liability for Quarter.

The IRS informed PC that a credit for LLP’s claimed overpayment could not be applied as requested because the period of limitations for claiming a refund had expired.

PC contended that the Quarter’s employment tax liability the IRS sought to collect had been previously paid by LLP, a related entity, which entitled PC to a credit, refund, setoff or equitable recoupment for the asserted liability.

PC explained that, through the error of its payroll service provider, PC’s employment tax deposits during Quarter had been remitted under the EIN of LLP, an entity through which the business had previously conducted its operations. PC further contended that PC should be credited with the Quarter’s deposits that had been erroneously submitted under LLP’s EIN through equitable recoupment.

In addition, PC tried to explain why both LLP and PC had been maintained as active entities during Year Two and thereafter, with each entity being used at various times to conduct the bulk of Business’s operations.

The IRS concluded that (i) PC had failed to sufficiently explain the continued active status of LLP, and (ii) because PC and LLP were both active entities, it would not be appropriate to allow PC to offset any of its employment tax liability with deposits LLP had made.

Equitable Recoupment

PC petitioned the Tax Court for review of the IRS’s determination. The issue for decision was whether PC was entitled to offset its unpaid employment tax liability for Quarter with the employment tax that LLP overpaid for Quarter.

“Long story short,” as they say, the Tax Court found that PC was entitled to offset the employment tax liability that the IRS sought to collect from it with the overpayment of employment tax made by LLP for the same period, the refund of which was time-barred. Without this offset, the Court stated, the IRS would have twice collected the employment taxes for Quarter arising from the payment of wages to the employees of Business: once from the deposits made under LLP’s EIN for Quarter, and a second time from the proposed levy on PC’s property.

The Court explained that the judicially-created doctrine of equitable recoupment applied to PC’s situation.[iv] In coming to that conclusion, the Court considered the documentary evidence submitted by PC regarding the organizational history of Business, including its alternating use of LLP and PC as its principal operating entity, with the other entity maintained for the purpose of collecting revenues and paying liabilities arising from past work. This alternating use, the Court observed, was substantiated with copies of each entity’s income tax returns for several years, demonstrating that the bulk of Business’s income was received through only one of the two entities in any given year.

According to the Court, when each entity’s general ledger for Quarter was compared to the IRS’s corresponding account transcripts, they conclusively established PC’s equitable recoupment claim. Specifically, the general ledgers demonstrated that PC was the source of the employment tax payments for Quarter that created LLP’s overpayment, and PC paid the wages that gave rise to the employment tax liability that was paid under LLP’s EIN.

Shape-Shifting, At Will?

The Court’s decision was all well and good for PC’s and LLP’s owners.

But what about the shifting of Business from LLP to PC, and then back to LLP? Specifically, what about the income tax consequences resulting from the “incorporation” of LLP and the “liquidation” of PC? The Court made no mention of these whatsoever, which begs several question.

Did the LLP liabilities assumed or taken subject to by PC exceed the adjusted bases of the assets “contributed” by LLP to PC? Did the fair market value of PC’s assets exceed their adjusted bases, or the owners’ adjusted bases for their shares of PC stock? The decision does not indicate whether LLP, PC, or their owners reported any gain on the transfer of “Business” between PC and LLP.

Indeed, was there any transfer of assets at all, other than a transfer of employees? Is that why the-then existing receivables and payables remained with LLP in Year Two and with PC in Year Five?

Did LLP’s/PC’s tangible personal properties remain in one entity, and were these leased or subleased to the other entity when Business was shifted to that entity? Was the real property they occupied leased or subleased between them? Was a market or below-market rate charged for the use or assignment? Or were these properties sold or exchanged for consideration?

What about projects that were ongoing at the time of the shift – how were these handled? What about the goodwill associated with Business – how was it transferred? Or did the goodwill reside with the individual owners of LLP and PC (so-called “personal goodwill”), and not with the entities?

Of course, these issues were not before the Court, but the “identity of interest” among PC, LLP, and their owners underpinned the Court’s decision. It is clear from the decision that LLP and PC operated a single Business, that their owners were identical, that the entities used the same name (but for the “PC” versus “LLP” designation), and that they employed the same individuals.[v]

What, then, was the impetus for the owners of LLP and PC to shift the operation of Business between the two entities? It wasn’t the nature of a particular project – for example, the complexity of the project, or the degree of liability exposure – after all, only one entity was active at any one time; the owners did not assign some projects to LLP and others to PC. Was there another business reason at work? Or was the shifting based upon some undisclosed tax considerations?

Whatever the reasons for LLP’s and PC’s actions, the owners of a closely held business should not think, based upon the underlying facts of the above decision, that they may freely, and without adverse tax consequences, shift the operation of a single business between two commonly-controlled entities simply by “turning off” one entity and “turning on” the other. The use of “successor” entities to a single business without a significant change in beneficial ownership of the business is an invitation to trouble with the IRS.

Indeed, even the allocation of projects among two or more commonly-controlled entities engaged in a single business may generate adverse tax results.

The owners should first consider why they would allocate projects – is it only for tax savings, or is there a bona fide business reason? For example, as mentioned above, does one entity engage in one aspect of a business, such as design, while another handles another aspect, such as construction? Or does one entity handle higher-end work, and markets or brands itself accordingly, while the other takes care of “lesser” jobs? Does one entity assume riskier projects and is insured therefor, while the other gets the plain-vanilla assignments?

Assuming there is a bona fide business reason for the allocation of work among the controlled entities, the owners will still have to consider how to allocate the resources of the business among these entities, and for what consideration; for example, if the equipment necessary for the completion of a project resides in an entity other than the one engaged in the project, how will the equipment be made available and at what price; what about employees and overhead, such as office space?

In every case, the owners of the related entities need to consider the business reason for the allocation of work to one entity as opposed to another; then they have to consider the tax consequences thereof and how to deal with them.


[i] Fear not, we’re talking tax, not Kafka.

[ii] By contrast, some entities may seek to change their legal form (for example, switching from a corporation to an LLC as a matter of state law), while maintaining their tax status. Thus, the merger a corporation into an LLC that has elected to be taxed as a corporation may qualify as an F-reorganization; the entity remains a corporation for tax purposes, but it is now governed by the state rules applicable to limited liability companies rather than those applicable to corporations.

[iii] Fear not, we’re talking tax, not “The Exorcist.”

[iv] The doctrine operates as a defense that may be asserted by a taxpayer to raise a time-barred refund claim as an offset to reduce the amount owed on the IRS’s timely claim of a deficiency, thereby preventing an inequitable windfall to the IRS. In general, a taxpayer claiming the benefit of an equitable recoupment defense must establish the following elements: (1) the overpayment for which recoupment is sought by way of offset is barred by an expired period of limitations; (2) the time-barred overpayment arose out of the same transaction, item, or taxable event as the deficiency before the Court; (3) the transaction, item, or taxable event was inconsistently subjected to two taxes; and (4) if the transaction, item, or taxable event involves two or more taxpayers, there is sufficient identity of interest between the taxpayers subject to the two taxes that the taxpayers should be treated as one.

[v] Courts may, in certain circumstances, permit a taxpayer to recoup an erroneously paid tax that the taxpayer did not pay himself. But the payor of the tax and the recipient of the recoupment must have a sufficient identity of interest such that they should be treated as a single taxpayer in equity.

Though LLP and PC were separate legal entities with distinct EINs during Quarter, each was owned by the same individuals during that period. Consequently, the burden of double taxation would be borne by the same individuals. Therefore, PC demonstrated sufficient identity of interest with LLP to allow PC to recoup the employment tax for Quarter that LLP overpaid.

 

 

“Leaving” the Business

There is a common theme that runs through the history of most closely held businesses. It begins with a motivated, diligent, and independent individual who is not afraid to take charge and to make things happen. Add a bit of luck to the mix, plus the support and guidance of family, friends and mentors, and the business may grow and thrive. The years pass and, at some point, the owner may decide that they are ready to begin the next stage of their life.

In many cases, that next stage is retirement – the owner sells their business and rides off into the sunset.

For some owners, however, the next stage looks more like a form of quasi-retirement, where they step back from the day-to-day management and operation of their business – turning this function over to a family member or a trusted employee – and become a passive investor. This “conversion” may be accompanied by a transfer of some equity in the business to the owner’s anointed successor.

Alternatively, it may mean selling all or part of the business and starting another. The new business may be a variant on the old one, though on a smaller scale; it may be something entirely new; or it may be one that does not require as much hands-on involvement.

For many business owners who reside in New York, this quasi-retirement is often coupled with a change in residence, usually to a warmer, less expensive, and less taxing environment, like Florida.

A quasi-retired business owner who decides to make such a move has to recognize that, at some point, they may be required to convince the New York State Department of Taxation and Finance that they have established Florida as their new domicile.

Domicile

Under New York’s Tax Law, an individual’s “domicile” is defined as the place the individual intends to be their permanent home. It is a subjective inquiry because it goes to one’s state of mind.

Once an individual’s New York domicile has been established, it continues until they abandon it and move to a new location with the bona fide intention of making their permanent home there.

Whether or not an individual’s domicile has been replaced by another depends on an evaluation of their circumstances.  According to the State, certain “primary” factors must be considered in determining the individual’s intent as to domicile – these factors are viewed as objective manifestations of such intent.

Each primary factor must be analyzed to determine if it points toward proving a New York or other domicile.  In conducting this analysis, an individual’s New York ties must be explored in relationship to the individual’s connection to the new domicile claimed.  Each factor is weighed separately, and then collectively.

The primary factors are as follows: (i) the individual’s use and maintenance of a New York residence, (ii) their active business involvement, (iii) where they spend time during the year, (iv) the location of items which they hold near and dear, and (v) the location of family connections.

The evidence required to support a change of domicile must be “clear and convincing.”  Thus, a taxpayer who has been historically domiciled in New York, and who is claiming to have changed their domicile, must be able to support their intention with unequivocal acts.

This is where the nature of the business owner’s continuing connection to their New York business – when weighed against their connection to any business activity in which they are already engaged in Florida, or which they decide to undertake after moving to Florida – may put them at a disadvantage in proving the abandonment of their New York home, as was demonstrated in the decision described below.

Audit of Nonresident Return

Like many others, Taxpayer immigrated to New York and established a successful business. Taxpayer started his business with a single retail location in New York. He later opened additional locations, both in New York and in Florida. Building upon the success of, and parallel to, his retail business, Taxpayer also developed extensive real estate holdings by investing in New York and Florida rental real estate.

Taxpayer and his spouse jointly filed New York State and City resident income tax returns up until the tax years under audit (the “Audit Years”). For both those years, Taxpayer filed a New York nonresident income tax return, claiming the filing status of married but filing separately, and identifying his Florida address as his home.

The Department of Taxation and Finance examined Taxpayer’s nonresident income tax returns for the Audit Years – which included a large gain from the sale of real property in Florida – and concluded that he had failed to present clear and convincing evidence that he had abandoned his New York domicile and acquired a new Florida domicile.

The Department issued a notice of deficiency assessing additional personal income taxes, as well as penalties, against Taxpayer, which he challenged. However, an Administrative Law Judge (“ALJ”) sustained the deficiency. Taxpayer appealed the ALJ’s decision to the Tax Appeals Tribunal, which affirmed the ALJ’s determination. Following this setback, Taxpayer filed a so-called “article 78 proceeding” to appeal the Tribunal’s decision.

Taxpayer’s Business Connections

The Appellate Division, Third Department (to which Tax Appeals Tribunal decisions are appealed), began by stating that, for income tax purposes, an individual is a resident of New York when that individual is domiciled in this State. A person’s domicile, the Court continued, “is the place which an individual intends to be such individual’s permanent home.” Once a domicile is established, it “continues until the individual in question moves to a new location with the bona fide intention of making such individual’s fixed and permanent home there.”

As the individual seeking to establish a change in domicile, it was Taxpayer’s burden, the Court noted, to prove his change of domicile by clear and convincing evidence.

The Court observed that Taxpayer did not contend that his domicile changed from New York to Florida as of a date certain. Rather, Taxpayer maintained that his contacts in Florida dated back over 25 years, to when he opened his first retail location in the State and purchased a condominium there. Taxpayer contended that, slowly over the course of time, his business interests grew and he began spending an increasingly significant amount of time at his Florida residence such that, by the Audit Years, he had effectively abandoned his New York domicile and established a new domicile in Florida.

The Court acknowledged that Taxpayer had submitted evidence demonstrating his significant business ties to Florida, including his ownership and operation of four retail locations and nine rental properties, and the fact that he helped manage another business located in one of his Florida buildings. Taxpayer had also submitted evidence that he had moved many personal items to his Florida residence, and that he had spent the majority of the Audit Years in Florida.

The Court pointed out, however, that there was similarly no dispute that Taxpayer also continued to maintain substantial and significant business and personal contacts in New York.

Significantly, Taxpayer continued to maintain his New York business and, in fact, was working on expanding it. He also maintained a warehouse affiliated with his New York business and another that he rented to third parties.

In addition, Taxpayer acknowledged that the administration and bookkeeping functions for all of his New York and Florida businesses were centralized and maintained in New York. All tax filings for the Florida businesses listed Taxpayer’s New York City office address, and his New York City bookkeeper processed all receipts from the Florida businesses and rental properties.

The Court observed that, over the years, Taxpayer had established a regular pattern of travel, generally consisting of his spending long weekends in Florida, during which he visited his Florida business and investment locations, while spending the rest of the week working in New York.

Moreover, Taxpayer managed and controlled all administrative, operational, and financial aspects of his New York and Florida business and real estate investment interests from his New York City office, and he continued to be the sole owner of the entities that held these interests.

The Audit Years were no exception: all administrative and financial functions for all of Taxpayer’s businesses and real estate investments continued to be handled in New York, Taxpayer spent almost half the year in New York, he derived significant income from his New York businesses and investments, and he continued to be actively engaged in the management and control thereof.

Such active business ties to New York, the Court maintained, typically indicate a failure to abandon a New York domicile.

On the record before it, including Taxpayer’s New York business and real estate investment interests, the presence of his spouse in New York, and his continued ownership and use of his long-time New York City condominium, the Court sustained the Tax Appeal Tribunal’s determination that, as of the Audit Years, Taxpayer had not shown a change in his lifestyle that would support his claimed change of domicile to Florida and the abandonment of New York as his domicile.[I]

Is It All or Nothing?

A business owner’s continued employment or active participation in their New York business, or their substantial investment and management of their New York business, after they have acquired a new residence elsewhere, will be a primary factor in determining their domicile.

If the owner continues to be actively involved in their New York business by managing or actively participating in such business without establishing comparable or greater business connections to the location they claim to be their new home, then their New York business activity will support their continued status as a New York domiciliary.

Does this mean that a business owner who has moved out-of-state cannot remain connected to their New York business if they hope to abandon New York as their domicile?

Not necessarily. It depends upon the extent and nature of the owner’s control and supervision over the New York business.

On the one hand, an owner’s active participation in the day-to-day operation or management of a New York business points to continued New York domicile, even if the business is being run from an out-of-state location.

On the other hand, an owner’s conversion of his interest in a New York business from an active to a passive investment is not supportive of continued domicile; for example, where the owner has resigned his position as an officer and employee of the business, has reduced his compensation accordingly, and has actually – not simply formalistically – turned management over to others.

The conversion of the owner’s interest to that of a “mere” investment does not require that the owner disregard the business entirely. In fact, it is reasonable to expect that the owner would take some interest in the business they have built and which now supplies a stream of income to them in retirement. This continuing interest does not compel a conclusion that the owner remains actively involved in the business.

Thus, the owner’s occasional office visit or phone call to the business should not constitute evidence of active involvement where they are limited in amount of duration.

If the owner has also undertaken other activities in their new home on which to focus their attention and efforts, the change of their relationship to the New York business is consistent with the so-called “change in lifestyle” that supports a conclusion that one domicile has been replaced with another.

Of course, it may be difficult for some owners to step away from their business and to pass control to someone else – did I mention something about an owner’s independence and determination? It’s the same issue they confront when considering gift and estate planning strategies, or in approaching succession planning. Interestingly, the proper planning for any one of these purposes will necessarily assist the owner in successfully removing themselves from New York.


[i] It should be noted that on both of Taxpayer’s nonresident income tax returns, the “No” box was checked in response to the question, “Did you or your spouse maintain living quarters in NYS [for that given year],” despite the fact that Taxpayer continued to own and maintain the condominium in New York City in which his spouse resided, and in which he stayed when he was in New York. The Court sustained the assessment of a negligence penalty against Taxpayer based on this “misrepresentation.” Despite the fact that Taxpayer claimed these misrepresentations were the product of a mistake by his accountant, the Court found no error in the Tribunal’s reliance upon these misrepresentations in upholding the negligence penalty.

I encounter the “‘No’ box” situation with too much frequency. First and foremost, a tax return must be accurate and truthful. The taxpayer is charged with reviewing the return to confirm the information contained therein – whether one owns or rents an apartment in the City is an easy one. Why give the auditor a lay-up, not to mention a bad impression?

 

“Personal liability?!” the client screams. “For sales tax? How is that possible?” The look on their face is at once incredulous and accusatory. “Didn’t you say that the LLC would protect me and my assets from the liabilities of the business so long as we respected ‘corporate’ formalities, and treated the LLC as a separate entity? I’m not even involved in its day-to-day operation and management – I’m just a ‘big-picture’ guy, a passive investor.”

The client’s confusion is understandable. Most investors do not realize that a member of an LLC may be held personally liable by N.Y. State for any sales tax required to be collected and remitted by the LLC, even when the “LLC veil” has not been pierced, and even when the member does not participate in the LLC’s business.

The rationale for this per se personal liability lies in the “trust fund” nature of the sales tax.

The Sales Tax

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

The seller collects the tax as a trustee for, and on account of, the State. The tax is imposed on the purchase of a taxable good or service, but it is collected from the buyer by the seller, and then held by the seller in trust for the State, until the seller remits the tax to the State.

Responsible Persons

The State’s Tax Law imposes personal responsibility for the collection and remittance of the sales tax on an LLC’s so-called “responsible persons,” which may include certain employees or managers, as well as the members, of the LLC.  More than one person may be treated as a responsible person.

A responsible person is jointly and severally liable for all of the sales tax owed, along with the LLC and any of the LLC’s other responsible persons.  This means that the responsible person’s personal assets could be taken by the State to satisfy the entire sales tax liability of the business. Members of an LLC can be held personally responsible even though they are otherwise protected from the business liabilities of the LLC.

Personal liability attaches whether or not the tax imposed was collected.  In other words, it is not limited to tax that has been collected but has not been remitted.  Thus, it will also apply where a business might have had a sales tax collection obligation, but was unaware of it.

Along the same lines, the personal liability applies even where the individual’s failure to take responsibility for collecting and/or remitting the sales tax was not willful.

In addition, the penalties and interest on the corporation’s unpaid sales tax pass through to the responsible person.

Administrative Relief

In general, the Tax Law provides that every member of an LLC is a “person required to collect” any sales tax for which the LLC is responsible; thus, a member is per se liable for the LLC’s unpaid sales tax, plus interest and penalties, without regard to their role or degree of involvement in the LLC’s business. 

Beginning in 2011, however, the State’s Department of Taxation and Finance provided some relief from the per se personal liability for certain LLC members.

Specifically, a qualifying member would not be personally liable for any penalties relating to the LLC’s unpaid sales taxes, and their liability for such taxes would be limited to their pro rata share thereof.

In order to qualify for this relief, a member of an LLC had to document that their ownership interest in, and distributive share of the profits and losses of, the LLC were each less than 50%. They also had to demonstrate that they were not “under a duty to act” on behalf of the LLC – for example, because of their management position – in complying with the sales tax.

In addition, the member had to agree to such terms and conditions as the State may require in exchange for such relief, including cooperation with the State by providing information regarding the identities of other potentially responsible persons—particularly those persons involved in the day-to-day affairs of the business.

It is important to note that any member of an LLC that held a 50% or more ownership interest in the LLC, or that was entitled to a distributive share of 50% or more of the profits and losses of the LLC, was not eligible for this relief.

2018-2019 Fiscal Year Budget

A variation on this administratively-provided relief was recently codified by the State as part of its 2018-2019 Fiscal Year Budget.

Under the new law, a member of an LLC continues to be treated as a “person required to collect” sales tax. Thus, membership by itself remains a sufficient reason for imposing personal liability on a member for the LLC’s unpaid sales tax.

Application for Relief

However, the new law also provides that the State may grant a member relief from such personal liability if the member applies for relief, and demonstrates that (i) their percentage ownership interest, and their percentage distributive share of profits and losses, of the LLC are each less than 50%, and (ii) they were not under a duty to act for the LLC in complying with the sales tax.

If the State approves a member’s application for relief, the member’s liability will be limited to that percentage of the LLC’s sales tax liability that reflects the member’s ownership interest or distributive share, whichever percentage is higher, plus any interest accrued thereon; the member will not be liable for any penalty owed by the LLC.

Practical Impact?

It is unlikely that more LLC members will find relief under the 2018-2019 Budget provision than under the administrative relief program it replaced.

Members with an LLC ownership interest or distributive share of at least 50% will continue to be out of luck in avoiding personal liability, notwithstanding the level of their “disengagement” from the business of the LLC – there will continue to be an effective presumption that such a member could have acted to ensure compliance with the sales tax law.

This “presumption” was illustrated in a recent ALJ decision. Taxpayer and his partner each owned 50% on an LLC. According to Taxpayer, his partner was the general manager of the business and oversaw all the daily activities of the business, including, among other things, hiring, firing and supervising employees, and purchasing supplies. Taxpayer testified that his health prevented him from being actively involved in the business.

At some point, LLC began having issues paying its bills, and its vendors began pursuing collection from LLC, Taxpayer and his partner.

The State performed a sales tax audit of LLC, which resulted in the assertion of a sales tax deficiency, which LLC agreed to satisfy pursuant to a payment plan. Unfortunately, LLC failed to make any of the scheduled payments, and the State issued a notice and demand for payment of tax due.

The auditor determined that Taxpayer was a responsible person for LLC and, consequently, the State issued a notice of determination to Taxpayer assessing the sales and use taxes due from LLC.

Taxpayer agreed that LLC owed owes sales taxes, and did not challenge the underlying audit amount. However, he asserted that he was not a responsible person during the audit periods. Taxpayer asserted that he could not take an active role in managing LLC because of his health. He further asserted that the other 50% owner was the general manager of the business and the responsible person during the audit periods.

Taxpayer might as well have been speaking to the wall.

ALJ’s Opinion

The ALJ explained that, under the Tax Law, “every person required to collect the sales tax shall be personally liable for the tax imposed, collected or required to be collected.”

The Tax Law, the ALJ continued, defines “person required to collect” sales tax to include: “any employee or manager of [an LLC] . . . who as such . . . employee or manager is under a duty to act for such . . . [LLC] . . . in complying with [the sales tax law]; and any member of a . . . limited liability company.”

The ALJ emphasized that the law “clearly states that any member of [an LLC] is a ‘person required to collect’ [the sales tax]” and, furthermore, that a member of an LLC “shall be personally liable for the [sales] tax imposed, collected or required to be collected.”

The ALJ also pointed out that the Tax Law contains no factors to qualify or limit the liability imposed upon members of an LLC. “[Taxpayer] was a member of [an LLC] and . . . , such members are subject to per se liability for the taxes due from the [LLC]. . . . Since [the Tax Law] imposes strict liability upon members of . . . [an LLC], all that is required to be shown by the [State] for liability to obtain is the person’s status as a member.”

Because Taxpayer was a 50% member of LLC during the audit periods, the ALJ concluded that he was per se personally liable for the sales taxes due; moreover, he was not eligible for the administrative relief afforded under the 2011 program described above.

“Minority” Member?

Ah, the fate of a 50% member.

But what about a “less-than-50%,” or minority, member who was unable to secure any voice in the management of the business from the other member(s) of the LLC (for example, executive employment or a position on its board)? Such a member may be able to demonstrate that they were not “under a duty to act” in connection with sales tax matters and, so, they should be able to avoid personal liability for the LLC’s unpaid sales taxes.

That may provide some comfort to a minority member, who may not be in a position to compel or influence decision-making, and thereby enjoy the economic benefits of membership, including the distribution of profits, or the sale of the business, and who, for the same reasons, was unable to extract any contractual indemnity obligation from the controlling member of the LLC.

As in so many instances involving the application of the tax laws, there seems to be a direct relationship here between the ability to control one’s investment in a business, on the one hand, and one’s exposure for the tax liability of the business, on the other. Decisions, decisions.