General Principles

Many business owners who reside in New York, and whose business is headquartered in the state, pay income taxes not only to New York, but to other jurisdictions as well.

For example, the resident owners of a business may operate through a corporation that has elected to be treated as an S corporation,[i] or through a limited liability company that is treated as a partnership for tax purposes.[ii] This pass-through entity[iii] may be doing business outside New York. Because of the entity’s pass-through nature, the owners themselves may be considered as engaging in business within those jurisdictions.[iv] Thus, the New York owners may be required to file a nonresident income tax return in such a “foreign” jurisdiction in order to report their share of the business’s income that is sourced in that jurisdiction, and to pay the resulting tax liability.[v]

Of course, each resident owner will also file a resident income tax return with New York. These returns will report the owner’s entire income, regardless of source,[vi] and will determine the New York tax thereon.[vii]

The resident return will also report the income taxes paid by the resident owner to other jurisdictions on account of the owner’s deemed “business activities” therein.[viii]

Tax Credits

These “foreign” taxes generally will be credited against the tax owing by the resident owner to New York, in order to ensure that the same items of income are not taxed twice – once by New York and once by the source jurisdiction.[ix]

Specifically, the resident owner will be allowed a credit against the tax otherwise due New York only for that portion of any personal income tax imposed by the other jurisdiction that is “applicable to the income derived from sources within such other taxing jurisdiction.”[x]

Generally speaking, the term “income derived from sources within” another state is construed so as to limit the income for which New York will allow a credit to income that is attributable to real property in the other state, or to a trade or business carried on in the other state.[xi]

Income from intangible property is not treated as “income derived from sources within” another state unless the intangible property is employed in a business carried on in that other state.[xii] Thus, gains from the disposition of intangible personal property – for example, from the sale or exchange of shares of stock – will not constitute income derived from within another state except to the extent that the property is employed in a business carried on in the other state.[xiii]

Consequently, New York’s credit for “foreign” taxes generally does not extend to investment income from intangible personal property that is taxed by other states. For all intents and purposes, such income is without a geographical situs insofar as New York is concerned.

“Dual Residence”

New York’s tax credit rules may seem “limited” in that a large category of taxable income is excluded from their purview.

It should be noted, however, that a state – including New York[xiv] – will generally not impose a tax on a nonresident’s income from intangible personal property except to the extent the property is used in a business in that state. The taxation of such income is left to the individual’s state of residence, which renders moot the question of a credit for taxes paid by that individual on such income to another state.

But what happens when an individual taxpayer is a resident of two states?

Statutory Residence

There are instances in which an individual taxpayer who is not domiciled[xv] in New York will nonetheless be treated as a resident of New York for a particular tax year. Specifically, if the individual maintained a permanent place of abode[xvi] in the state for substantially all of the taxable year[xvii] and spent more than 183 days in the state during such year, they will be taxed a New York resident.[xviii]

In that case, the taxpayer is required to file as a resident of their state of domicile and as a resident of New York.[xix] In most cases, that means they have to report all of their income, from whatever source, to both states, and they have to pay tax on the same income to both states.

Unfortunately for most taxpayers, they are not aware of their classification as a “statutory resident” of New York until they have been audited by the state’s Department of Taxation and Finance, at which point they face not only a tax deficiency,[xx] but also interest and penalties.

And if that isn’t enough of a shock, the newly anointed statutory resident also learns at that time that the credit which New York extends for taxes paid to other states, on income derived from those states, is generally not available for intangible income because that income has no identifiable situs. In other words, such income generally is not deemed to have been derived from the taxpayer’s efforts in any jurisdiction outside of New York, and it cannot be traced to any jurisdiction outside New York. Rather, it is treated as investment income which is subject to tax in New York as the taxpayer’s state of residence.

In the case of a New York statutory resident who is domiciled in another state, these tax rules may cause the individual taxpayer to actually be taxed twice – by New York and by their state of domicile – on the same income from intangible property.

Sounds outrageous, doesn’t it?

The Edelman Case

One taxpayer certainly thought it did.

“Taxpayer” was domiciled in Connecticut in the years 2010 and 2013, but also maintained a home in New York City, where they had worked for thirty years and where, in 2003, they had formed a corporation (“Corp”), with its only office in New York City.

Both before and after they sold Corp to Buyer in 2010, Taxpayer – who commuted from Connecticut – served as an executive in New York City of what prior to the sale was Corp, and thereafter was a division of Buyer. Taxpayer was physically present in New York City for more than 183 days during both 2010 and 2013.

In the transaction with Buyer in 2010, Taxpayer sold their shares of Corp’s outstanding stock, of which they owned 95-percent, generating significant capital gains. In addition, in both 2010 and 2013, Taxpayer had interest and dividend income from investments in securities, in addition to their wage income from either Corp or Buyer.

Taxpayer filed Connecticut Resident Income Tax Returns for 2010 and 2013, and paid Connecticut tax on the income reported.

In their New York income tax returns for 2010 and 2013, Taxpayer claimed to be a “nonresident” of New York, and reported a substantial part of their wage income as “New York source,” because it resulted from Taxpayer’s work in New York City.

However, Taxpayer failed to treat any of their interest, dividends or capital gain income in either year as “New York source” because, as Taxpayer alleged, “it constituted income from intangible property.”[xxi]

New York’s Position

In 2014, the Department of Taxation and Finance commenced an audit of Taxpayer’s 2010 and 2013 New York tax returns, and concluded that Taxpayer was a “statutory resident” of New York State and of New York City during those years. As such, Taxpayer became subject to New York tax on their worldwide income regardless of the source of such income. This included the gain derived from the sale of their Corp stock to Buyer in 2010.

The Department issued a Notice of Deficiency asserting additional New York State and New York City income tax due from Taxpayer in excess of $4 million, plus interest of almost $2 million. Taxpayer had paid these amounts prior to the Notice of Deficiency, under protest, in order to stop the accumulation of interest.[xxii]

The Courts

In 2016, Taxpayer commenced a declaratory judgement action in the Supreme Court of New York,[xxiii] New York County, in which they claimed that New York’s statutory residence scheme – under which taxpayers who were treated as statutory residents were denied credits for taxes actually paid to their state of domicile in respect of intangible income – violated the U.S. Constitution by discriminating against, or unduly burdening, interstate commerce.[xxiv]

Well, it didn’t go too well for Taxpayer.

The Department asked the Supreme Court to dismiss Taxpayer’s action for failure to state a cause of action. The Department contended that Taxpayer’s intangible income was being taxed solely because they were New York residents. It further claimed that Taxpayer’s status as a commuter was not at issue, only their “degree of permanence” in New York. The Department also argued that the double taxation issue had no merit because Taxpayer enjoyed the privileges of protection of two states, and were given tax credits in New York for taxes paid for income “derived from” the other states.

The Court observed that Taxpayer owned an apartment in New York City, worked in New York City, and had a presence in New York for more than 183 days. Thus, Taxpayer was being taxed as a New York statutory resident. Taxpayer described themselves as domiciled in Connecticut and paying taxes in that state, but the intangible income being taxed by New York, the Court noted, was not specifically derived from employment or business conducted outside New York. Therefore, the taxation in New York did not involve income derived from Connecticut.

Accordingly, the Court dismissed Taxpayer’s complaint.[xxv]

Undeterred, Taxpayer appealed the Supreme Court’s decision to the Appellate Division[xxvi] but, in 2018, this Court upheld the lower court’s decision in a one-page opinion.[xxvii]

Perhaps thinking that the third time would be the charm, earlier this year Taxpayer asked New York’s highest court to consider its case. The Court of Appeals, however, denied Taxpayer’s motion for leave to appeal, upon the ground that no substantial constitutional question was directly involved.[xxviii]

Finally, Taxpayer asked the U.S. Supreme Court to review the decisions of the New York courts. Last week, the Taxpayer’s petition for writ of certiorari was denied.[xxix]

So Where Are We?

The refusal by the U.S. Supreme Court (i) to review the New York Court of Appeals’ refusal (ii) to review the Appellate Division’s decision (iii) to uphold the New York Supreme Court’s decision (iv) to dismiss Taxpayer’s action for failure to state a cause of action – take a deep breath – leaves intact New York’s scheme for taxing the intangible income of statutory residents.

That means a business owner who is domiciled in another state – say, in any of the states that are contiguous to New York (Connecticut, Massachusetts, New Jersey, Pennsylvania or Vermont) – and whose business is in New York, who works in New York in excess of 183 days during a taxable year, and who has a permanent place of abode in New York, whether or not such place of abode is located anywhere near the place of business, will be subject to New York income tax with respect to all of their income as if they were a resident of New York.

If the owner disposes of their business during a period of statutory residence – a status of which the owner may not become aware until a couple of years later, and only after an audit by New York – their gain realized from the sale will be subject to New York income tax as though the owner were a New York resident. Thus, the gain would be taxed at the state level at a tax rate of 8.82-percent and, if the owner is also treated as a statutory resident of New York City, an additional tax at a rate of 3.876-percent will be imposed on such gain.

Can it get any better than this? Yep. The “pièce de résistance” is New York’s denial to the statutory resident of any credit for tax paid by the owner on this very same gain to the owner’s state of domicile.

Ah, the bliss of double taxation.

I ask you: is the New York tax on the sale of a non-domiciliary’s New York business worth the apartment in New York City, or the lodge in the Adirondacks, or the beach house in Montauk, or the cabin near the Finger Lakes?[xxx]

Before such an individual disposes of their New York business in a taxable transaction, they need to address the issue of their permanent place of abode.

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

[ii] IRC Sc. 761; Reg. Sec. 301.7701-3.

[iii] The entity’s income is generally not taxed at the entity-level but, rather, passes through to its owners who report it on their own tax returns. IRC Sec. 701, Sec. 702, Sec. 1363, Sec. 1366.

[iv] There is a comparable rule with respect to non-U.S. persons who are partners of a partnership doing business in the U.S. See IRC Sec. 875.

[v] In some cases, the entity may have to make estimated tax payments to the “foreign” jurisdiction on behalf of its nonresident partners.

[vi] I.e., from all jurisdictions.

[vii] Tax Law Sec. 612(a).

[viii] I.e., through the pass-through entities of which they are a shareholder or a member/partner.

[ix] Assuming that income is subject to tax in New York. Tax Law Sec. 620(a).

[x] 20 NYCRR Sec. 120.1(a)(2).

[xi] 20 NYCRR Sec. 120.4(d). It may also include income related to a business previously carried on in that state, including, for example, payments under a covenant not to compete.

[xii] Tax Law Sec. 631.

[xiii] A business owner’s shares of stock in the corporation through which the owner operates their business do not fall within this category.

[xiv] Tax Law Sec. 631(b)(2).

[xv] “Domicile” refers to an individual’s “permanent” home. An individual can have only one domicile. One’s domicile does not change unless one can demonstrate that they have abandoned such domicile and have established a new domicile elsewhere. NYCRR Sec. 105.20(d).

[xvi] NYCRR Sec. 105.20(a).

[xvii] Generally speaking, at least eleven months.

[xviii] Tax Law Sec. 605(b). So-called “statutory residence.” It “serves the important function of taxing those ‘who, while really and [for] all intents and purposes [are] residents of the state, have maintained a voting residence elsewhere and insist on paying taxes to us as nonresidents.’” Tamagni, 91 N.Y. 2d at 535 (quoting Bill Jacket, L.1922, ch 425).

[xix] https://www.taxlawforchb.com/2019/09/statutory-residence-in-ny-the-permanent-place-of-abode-test-is-in-need-of-repair/

[xx] For which a federal itemized deduction may not be presently available, courtesy of the Tax Cuts and Jobs Act (P.L. 115-97).

[xxi] Which is not taxable to a nonresident of New York unless the property is used by the nonresident in a New York trade or business.

[xxii] The power of compound interest.

[xxiii] The trial-level court in New York.

[xxiv] The “dormant commerce clause.”

[xxv] Edelman v. New York State Department of Taxation and Finance, 2017 WL 2537050 (N.Y.Sup.) (Trial Order), Supreme Court of New York, New York County.

[xxvi] This court hears appeals from lower courts in New York, including the Supreme Court.

[xxvii] Edelman v. New York State Department of Taxation and Finance, 162 A.D.3d 574, Supreme Court, Appellate Division, First Department, New York.

[xxviii] Edelman v. New York State Department of Taxation and Finance, 32 N.Y.3d 1216, Court of Appeals of New York.

[xxix] Edelman v. New York State Department of Taxation and Finance, 2019 WL 4921468, Supreme Court of the United States.

[xxx] What’s wrong with the Vermont side of Lake Champlain, or the Poconos, or the Berkshires, or the Connecticut shore? What’s wrong with staying in a New York City hotel? I’m just saying.

The Benefit of Knowing

Monday morning quarterbacking – the connotations are anything but positive.

Life is full of instances in which someone, in possession of all the factors that informed – or that should have informed, had they known about them – another’s earlier decision, and with full knowledge of the outcome of such decision,[i] has been critical of the decision-maker, or has proffered what their own choice would have been had they been in the decision-maker’s place.

Notwithstanding the negative reactions that such behavior may elicit, it is a fact that decisions will always be judged by reference to their results[ii] – how can they not? It’s the most obvious manifestation of a decision.

Regardless of its consequences, however, a more thoughtful observer may determine that a decision was sensible under the circumstances, where it was made after careful consideration, and on the basis of the relevant facts, both known and reasonably knowable at the time.

In many cases, it may be small comfort to the decision-maker that some folks have concluded the decision made sense. In other situations, however, the ability to demonstrate that one acted reasonably and thoughtfully may be enough to shield the decision-maker from certain “penalties.”

That being said, it is unlikely that the decision-maker will be able to convince anyone that they acted sensibly, and that the consequences of their decision should be accepted, if they were no more than a passive recipient of data; rather, they must take a proactive role in gathering information, assessing its accuracy, and deducing its implications.

Post-Date Events and Taxes

Naturally, these precepts have found their way into the tax law, where they have assumed many forms.

Penalty Abatement

For example, penalties imposed with respect to various tax-related transgressions occurring in earlier years may be abated if, years later, the taxpayer can show that they had “reasonable cause” for the action taken at the time it was taken.

Generally, the most important factor in determining whether a taxpayer acted with reasonable cause is the extent of the taxpayer’s effort to assess their proper tax liability in the earlier year. Where the taxpayer consulted a professional, all facts and circumstances must be taken into account in determining whether the taxpayer reasonably relied in good faith on the professional’s advice as to the tax treatment of the taxpayer.[iii]

Earn-Out

In the case of the sale of a closely held business, the owner of the business and the potential buyer will sometimes disagree as to the fair market value of the business because they have differing expectations[iv] for the future performance of the business, at least over the short term.

That being said, they will often agree on a “base” value – in general, the amount the buyer is willing to pay at closing – and they will then wait for the actual financial results of the business, typically over a one-to-three-year period[v] immediately following the closing, to retroactively determine the “final” sale price. In that case, the seller will treat the subsequent earn-out payment as a deferred payment of purchase price; similarly, the buyer will increase their basis for the business.[vi]

Assignment of Income

More relevant to the ruling that is the subject of today’s post, a donation of shares of stock in a closely held business to a charity will often be followed by a sale of such stock, which raises the question of whether the donating taxpayer has assigned income in these circumstances.[vii]

One relevant question is whether the prospective sale of the donated stock was a mere expectation on the date of the gift, or was it or a virtual certainty? Another relevant question is whether the charity was obligated, or could be compelled by one of the parties to the transaction, to surrender the donated shares to the acquirer?

The existence of an “understanding” among the parties, or the fact that the contribution and sale transactions occurred simultaneously, or according to prearranged steps, may be relevant in answering these questions.

For example, a court will likely find there was been an assignment of income where stock was donated after a tender offer has effectively been completed and it is unlikely that the offer would be rejected.

Charitable Contribution

Another area of the tax law in which subsequent events have played a key role in determining the tax consequences of an earlier event is the charitable contribution of property; specifically, the valuation of such property.

For example, where a donee charity sells property within three years of its receipt as a charitable contribution, the charity must report the subsequent sale on IRS Form 8282; this acts as a check on the amount claimed by the donor as a charitable deduction in respect of such property for the year in which the contribution was made.[viii]

Transfer Tax Valuation Date

Consider also the valuation of a donor’s lifetime gift of property for purposes of determining the federal gift tax liability with respect to such transfer, or the valuation of property that is included in a decedent’s gross estate for purposes of determining the decedent’s federal estate tax liability.

In each case, the value of the property is the price at which such property would change hands between a willing buyer and a willing seller, neither being under any compulsion to buy or to sell, and both having reasonable knowledge of relevant facts.[ix]

In each case, the valuation is keyed to a specified date: the date on which the gift transfer is completed or the date of death, as the case may be.[x] For example, the gift tax regulations provide that “if a gift is made in property, its value at the date of the gift shall be considered the amount of the gift.” These regulations go on to state that “[a]ll relevant facts and elements of value as of the time of the gift shall be considered.”[xi]

The foregoing references to the date of death and to the date of the gift seem to imply that events occurring after the relevant valuation date should not be considered in determining fair market value as of such date; indeed, that is the general rule.

However, the IRS has long acknowledged that “[v]aluation of securities is, in essence, a prophesy as to the future and must be based on facts available at the required date of appraisal.”[xii]

Post-Transfer Date Events

Can one reconcile the statement that post-date-of-transfer events should not be considered in determining the fair market value of property on the transfer date with the statement that the valuation process seeks to “predict” the future performance of the property?

Absolutely, if one accepts the proposition that post-transfer events should be taken into account for valuation purposes if they were reasonably foreseeable as of the valuation date.[xiii]

However, what does it mean that an event was “reasonably foreseeable?”

According to the IRS, “[a] prospective seller would inform a prospective buyer of all favorable facts in an effort to obtain the best possible price, and a prospective buyer would elicit all the negative information in order to obtain the lowest possible price. In the arm’s length negotiation between the two parties, all relevant factors available to either buyer or seller, known to both, provide a basis on which the buyer and seller make a decision to buy or sell and come to an agreement on the price.”[xiv] This would include current information concerning transactions that may occur after the valuation date.

In other words, the “reasonable knowledge of relevant facts” to which the valuation regulations refer should include those “future facts” that were knowable on the valuation date.

A recent IRS pronouncement[xv] considered whether the hypothetical willing buyer and seller of shares in a corporation[xvi] should consider a pending merger when valuing shares of the corporation’s stock for gift tax purposes.

Facts of the Ruling

Donor was a co-founder and chairman of the board of Corporation A. On Date 1, Donor transferred shares to Trust, a newly-formed grantor retained annuity trust.[xvii] Under its terms, the remainder of Trust would pass to Donor’s children upon the expiration of the annuity interest.

Later, on Date 2, Corporation A announced a merger with Corporation B. The merger was the culmination of exclusive negotiations between the two corporations occurring before the Date 1 transfer to Trust.

After the merger was announced, the value of the Corporation A stock increased substantially, though it was less than the agreed-upon merger price.[xviii]

The merger was consummated at some point after Date 1, the date of Donor’s transfer to Trust.

The IRS audited Donor’s gift tax return,[xix] and reviewed the underlying transaction documents from the year preceding the merger, including the correspondence between Corporation A and Corporation B, and the Corporation A board’s meeting minutes.

According to the IRS, the record as compiled supported the position that, as of Date 1, the hypothetical willing buyer of the shares transferred to Trust could have reasonably foreseen the merger of the two corporations and anticipated that the price of Corporation A stock would trade at a premium over what its value would otherwise have been at the valuation date.

Analysis of Valuation Rules

The IRS first reviewed the valuation rules for gift transfers (described above), including the “hypothetical willing buyer and willing seller” standard, where neither party is under any compulsion to buy or sell, and both parties have reasonable knowledge of relevant facts. The CCA stated, where it is established that the value per share of stock – as determined under the normally applicable rules[xx] – does not represent the fair market value of the stock,[xxi] some reasonable modification of the value determined on that basis, or other relevant facts and elements of value, should be considered in determining fair market value.[xxii]

“The value of property for federal transfer tax purposes,” the CCA continued, “is a factual inquiry wherein the trier of fact must weigh all relevant evidence and draw appropriate inferences to arrive at the property’s fair market value.”

The willing buyer and willing seller are hypothetical persons, the CCA stated, rather than specific individuals or entities, and their characteristics are not necessarily the same as those of the donor and the donee. What’s more, “the hypothetical willing buyer and willing seller are presumed to be dedicated to achieving the maximum economic advantage.”

According to the CCA, the principle that the hypothetical willing buyer and seller are presumed to have “reasonable knowledge of relevant facts” affecting the value of the property at issue applies even if the relevant facts at issue were unknown to the actual owner of the property.

Moreover, both parties are presumed to have made a reasonable investigation of the relevant facts. Thus, in addition to facts that are publicly available, reasonable knowledge includes those facts that a reasonable buyer or seller would uncover during the course of negotiations over the purchase price of the property. In addition, a hypothetical willing buyer is presumed to be “reasonably informed” and “prudent,” and to have asked the hypothetical willing seller for information that is not publicly available.

Reasonably Foreseeable Events

Generally, a valuation of property for federal transfer tax purposes is made as of the valuation date without regard to events happening after that date.

Subsequent events may be considered, however, if they are relevant to the question of value. Specifically, a post-valuation date event may be considered if the event was reasonably foreseeable as of the valuation date.

The CCA next reviewed a Court of Appeals decision that addressed the application of the assignment of income doctrine to a charitable contribution of stock in a corporation.[xxiii] The taxpayers owned 18 percent of Target and served as officers and directors of the corporation. Target’s board authorized an investment bank to find a purchaser for Target. Shortly thereafter, Target entered into a merger agreement with Acquirer. Target’s board unanimously approved the merger agreement, and a tender offer was started. The taxpayers then executed a donation-in-kind record with respect to their intention to donate stock to certain charities. One month later, the charities tendered their stock. A couple of days later, the final shares were tendered, and then the merger was completed. The Court concluded that the transfers to charity occurred after the shares in Target “had ripened from an interest in a viable corporation into a fixed right to receive cash” because the merger was “practically certain” to go through. In particular, the Court noted that “as of [the valuation] date, the surrounding circumstances were sufficient to indicate that the tender offer and the merger were practically certain to proceed by the time of their actual deadlines – several days in the future.” Consequently, the assignment of income doctrine applied, and the taxpayers realized gain when the shares were disposed of by the charity.

The IRS observed that the situation under consideration in the CCA shared many factual similarities with the case of donor-taxpayer, above, including a merger agreement that was “practically certain” to go through. While the Court’s opinion dealt exclusively with the assignment of income doctrine, it also relied upon the proposition that the presently-known facts and circumstances surrounding a transaction were relevant to the determination that a merger was likely to go through. The current situation, the IRS stated, presented an analogous issue; that is, whether the fair market value of the stock should take into consideration the likelihood of the merger as of the Date 1 transfer of Corporation A shares to Trust. The Court’s opinion, the CCA asserted, supported the conclusion that the value of stock in Corporation A must take into consideration the pending merger with Corporation B.

Accordingly, the value determined under the applicable regulations did not represent the fair market value of the shares transferred to Trust as of the valuation date; other relevant facts and elements of value had to be considered in determining such fair market value. Under the fair market value standard as articulated in the regulations, the hypothetical willing buyer and willing seller, as of Date 1, would be reasonably informed during the course of negotiations over the purchase and sale of the shares and would have knowledge of all relevant facts, including the pending merger. Indeed, the CCA stated, “to ignore the facts and circumstances of the pending merger would undermine the basic tenets of fair market value and yield a baseless valuation.”

Thus, the IRS concluded that, under the fair market value standard, the hypothetical willing buyer and seller would consider a pending merger of a corporation when valuing the corporation’s stock for gift tax purposes.

Use Your Crystal Ball

So, what does this mean for the owner of a closely held business who may be planning for the sale of their business, but who may also be interested in doing some estate planning?

Planning Basics

In order to maximize the effectiveness of an estate plan that involves the transfer by the owner of their interest in the business, it is important to recognize certain guiding principles: (i) the gift transfer of the interest to a family member, or to a trust for the benefit of a family member, will remove the current value of the interest from the transferor’s gross estate for purposes of the federal estate tax; (ii) the transfer will also remove the income generated by that interest from the gross estate; (iii) if a grantor trust is used as the vehicle for the gift transfer, the transferor’s future gross estate will be reduced by the amount of the tax on such income; and, perhaps most importantly, (iv) the appreciation in the value of the transferred interest will be removed from the transferor’s gross estate.[xxiv]

What Really Happens

Of course, in order to obtain these transfer tax benefits, the business owner has to be willing to give up at least some of their equity in the business sooner rather than later.

Predictably, however, most business owners are reluctant to give up any ownership until they are ready to consider a sale of the business. This is borne out by the number of times I have had owners, who have just executed a letter of intent (“LOI”) for the sale of their business, ask me about transferring some of their interest in the business to a trust for the benefit of their children.[xxv]

Therein lies the issue. Assume that, within a month of executing the LOI, the owner makes a gift of some of their equity – representing a minority interest – to a trust, and say that the sale of the business is consummated a couple of months after that, on substantially the same business terms as set forth in the LOI.

The owner obtains an appraisal report for the minority interest that claims discounts for lack of control and lack of marketability. The report does not mention the LOI or the sale. The owner then files a gift tax return reporting the transfer and the gift tax consequences thereof using the value set forth in the appraisal.

The owner, the trust and the business each file an income tax return reporting the sale of the business; the gain realized is based upon the agreed-upon purchase price.[xxvi]

How is the IRS going to approach the now-former owner’s gift tax return?[xxvii] For one thing, as in the case of the CCA described above, was the sale of the business reasonably foreseeable at the time of the gift? The IRS will consider that the LOI was already executed by the time the gift was made, and it will observe that the business was, in fact, sold shortly thereafter.

With the benefit of hindsight, the IRS can choose from two lines of attack: the reported valuation was too low – no discounts should have been claimed because the sale (and the resulting conversion of the equity interest to cash) was reasonably foreseeable at the time of the gift;[xxviii] or the reported valuation was too low for purposes of the gift tax, and the grantor should be taxed on the gain from the sale.[xxix]

Bottom line: a gifting program with respect to the equity in one’s business is not something to be initiated on the eve of a sale of the business if one hopes to minimize the gift tax impact thereof, and one must take a realistic approach to the valuation of the gifted interest, which should include a consideration of significant upcoming “corporate” events.


[i] And often without due regard to the circumstances or context within which such decision was made.

[ii] I am told that psychologists refer to this as “outcome bias.” No surprise there.

[iii] See, e.g., Reg. Sec. 1.6664-4.

[iv] Based in no small part on their differing perspectives with respect to the business.

[v] Anything longer may be more indicative of the buyer’s efforts on behalf of the business rather than of the going concern that the seller built and then sold to the buyer.

[vi] This is commonly referred to as an “earn-out” and is premised on the attainment by the business of certain agreed-upon financial targets. Installment reporting, under IRC Sec. 453, will be applied to report the gain attributable to the receipt of a post-closing earn-out payment. In addition, the imputed interest rules will apply to convert some of the “deferred” purchase price from capital gain into ordinary interest income. IRC Sec. 1274.

[vii] https://www.taxlawforchb.com/2018/10/assignment-of-income-and-charitable-contributions-of-closely-held-stock/

[viii] Donee Information Return (Sale, Exchange or Other Disposition of Donated Property).

[ix] Reg. Sec. 20.2031-1(b); Reg. Sec. 25.2512-1; Rev. Rul. 59-60, 1959-1 C.B. 237.

[x] We’ll ignore the alternate valuation date under IRC Sec. 2032.

[xi] Reg. Sec. 25.2512-1.

[xii] Rev. Rul. 59-60, Sec. 3. That’s because the date-of-death value of a property – such as an equity interest in a business – necessarily reflects the future stability of the property and its prospects for growth. A negative view of its future as of the date of transfer will result in a lower value as of that date, whereas a more positive outlook would result in a greater value.

[xiii] Furthermore, a post-valuation date event, even if unforeseeable as of the valuation date, may be probative of the earlier valuation to the extent that it is relevant to establishing the amount that a hypothetical willing buyer would have paid a hypothetical willing seller for the subject property as of the valuation date.

For example, a sale of stock between other parties shortly after the valuation date. The same concept underlies the purpose of IRS Form 8282 dealing with the subsequent sale of property contributed to a charity.

[xiv] Rev. Rul. 78-367, 1978-2 C.B. 249.

[xv] Chief Counsel Advice Memorandum (“CCA”) 201939002. CCAs are issued by the Office of Chief Counsel to assist IRS personnel in performing their functions by providing legal opinions on certain matters.

[xvi] The corporation in the CCA was publicly traded, but the concepts discussed are just as applicable to the case of a closely held corporation.

[xvii] GRAT. IRC Sec. 2702; Reg. Sec. 25.2702-3.

[xviii] The merger price reflected a premium?

[xix] IRS Form 709.

[xx] For example, based on a multiple of earnings.

[xxi] For example, where, as in this case, there was a merger in the corporation’s future.

[xxii] Reg. Sec. 25.2512-2(e).

[xxiii] Ferguson v. Commissioner, 174 F.3d 997 (9th Cir. 1999), aff’g 108 T.C. 244 (1997).

[xxiv] This strategy is most effective if the donor funds a generation-skipping trust to which they allocate their GST exemption amount. In this way, the value of the gifted interests will not be taxable to the family until they are distributed to the beneficiaries, who then make a taxable transfer thereof.

[xxv] Sadly, a not-so-distant second is the following question: “Can I change my residence to Florida and avoid paying New York tax on the gain?” Shoot me now.

[xxvi] Depending upon the form of the sale, this may include the buyer’s assumption of, or their taking subject to, certain liabilities.

[xxvii] Yes, I am assuming that the return will be examined. One should always assume that a return will be examined, and advise accordingly.

[xxviii] This would result in the owner’s exhausting more of their estate tax exemption amount than they had anticipated; it may even cause the owner to incur a gift tax liability.

[xxix] If the gift was made via a grantor trust, the owner would be taxable on the gain in any event. IRC Sec. 671.

Under One Roof

I sometimes wonder at the number of corporations that own real property.

It is often the case that the property is the corporation’s principal asset, which it leases to one or more commercial tenants, for example. That’s bad enough.[i]

There are other instances, however, in which the corporation is engaged in an active trade or business that operates out of the corporation’s real property.[ii] In most cases, the operating business occupies the entire property – there are no other tenants. What’s more, the corporation is not engaged in the kind of activity that the active management of a property typically entails; in other words, the corporation is dealing with itself for the most part.[iii]

There is a kind of simplicity in this arrangement that often appeals to the owners of a closely held business. There is no need for two business entities – one that owns the operating business and one that owns the real property – no need to file two business tax returns, no need to keep separate books and records, no need to maintain separate bank accounts, no need for a lease between the two entities, etc.

Unfortunately, this minimalist approach may turn into a serious tax problem, one that may go unrecognized until it is too late to address it in any meaningful or economical way – on the “eve” of selling the business.

Asset Sale

As we’ve discussed on many occasions, a prospective buyer of a corporate-owned business would prefer to acquire from the corporate seller only those assets that will be necessary to the buyer’s operation of the business after the deal closes. This is best accomplished by identifying and purchasing only those assets.[iv]

A not insignificant benefit of such a “direct” purchase of assets is the stepped-up cost basis[v] for these assets in the hands of the buyer, which the buyer may then be able to expense, depreciate or amortize[vi] – depending upon the asset – and, thereby, reduce the buyer’s economic cost for the transaction.

Thus, where the buyer has no need for the real property owned by the corporate-seller – for example, where the buyer is consolidating the seller’s business into one of the buyer’s existing locations – the buyer may simply choose not to purchase the property.

Stock Sale

By contrast, the purchase of the stock of the corporation from its shareholders would necessarily include the indirect acquisition of every asset owned by the corporation, including those that the buyer neither needs nor wants.

There are instances, however, in which the buyer has no choice – as a legal or as a practical matter – but to acquire the stock of the target corporation, along with everything that goes with it, including the real property. This may occur, for example, where the corporation’s business includes certain difficult-to-transfer assets,[vii] and the target corporation must be kept in existence.

In recognition of this reality, the Code permits the buyer and the selling shareholders to elect to treat the actual purchase-and-sale of the target corporation’s stock as a deemed purchase-and-sale of its assets for tax purposes – provided certain conditions are satisfied – thereby generating a basis step-up in the underlying assets for the benefit of the buyer.[viii]

Removing/Keeping the “Unwanted” Property

Query, in a situation where the purchase-and-sale transaction must be effected as a sale of stock, how the corporate target may dispose of the unwanted real property before the stock sale is completed?[ix]

Conversely, what if the shareholders of the target corporation want to keep the real property for themselves, in order to lease it to the buyer, or to another party, after the stock sale?[x] How may they remove the property in a tax-efficient manner?

The issue is easily surmounted where the corporate target is selling its assets. In that case, the buyer may simply choose not to purchase, and the target corporation may simply choose not to sell, the real property. Instead, the buyer will often agree to lease the property from the corporate-seller for an arm’s-length rate over some period of time (perhaps with extensions) beginning immediately after the closing; the delivery of an executed lease will often be identified as a condition to closing the deal.

But what if the transaction is structured as a purchase-and-sale by the shareholders of the target corporation’s stock?[xi]

Sell the Property?

One of the more obvious “solutions” is for the target corporation to sell the real property to some unrelated person before the shareholders sell the corporation’s stock to the buyer. The corporation would likely realize a gain from the sale[xii] that would be taxable to the corporation,[xiii] and for which its shareholders will likely be held responsible by the buyer even after the buyer’s acquisition of their shares in the corporation.[xiv]

If the corporation is an S corporation, the gain from the sale of the property (including its character as ordinary or capital) will pass through, and be taxed, to its shareholders.[xv]

Where the corporation is a C corporation, or an S corporation with earnings and profits from taxable years during which it was a C corporation,[xvi] and the shareholders want the net proceeds from the sale of the real property to be distributed to them,[xvii] they may want to consider structuring the purchase-and-sale of their stock to include a partial redemption of their shares by the corporation.[xviii]

Sale or Distribution to Shareholders?

Another option would be for the corporation to sell the real property to those of its shareholders who want it.

In the case of an S corporation, the gain from this sale will pass through, and be taxed, to all of the shareholders based upon their relative stock ownership. However, the gain from this sale may be treated as ordinary income, rather than capital gain, under certain related party sale rules.[xix] Although this result may not matter in the case of a C corporation[xx] (except to the extent it has capital losses, which may only offset capital gains), the effect on the shareholders of an S corporation cannot be underestimated: a federal capital gain tax rate of 20-percent versus an ordinary income tax rate of 37-percent.[xxi]

The corporation may also distribute the real property to its shareholders in respect of their shares in the corporation: as a dividend, or in a partial redemption of their stock that is part of their plan to sell their shares to the buyer. Such a distribution would likewise be treated as a sale of the property by the corporation,[xxii] with the same basic consequences as above, including treatment of the gain as ordinary income.

Although the foregoing options are certainly effective in removing the real property – unwanted by the buyer and/or wanted by the target’s shareholders – from the target corporation prior to the sale by the shareholders of the corporation’s stock, they also probably generate a not-insignificant tax cost.

What other alternatives might be considered?

Spin-off?

Some readers may ask whether a “tax-free” spin-off of the real property would be possible.[xxiii] Specifically, why couldn’t the target corporation form a new subsidiary corporation, contribute the real property to the subsidiary in exchange for all of its stock, then distribute this subsidiary stock to the target’s shareholders?

Under the facts as stated, above, where the property is basically owner-occupied, probably not. The corporation would be hard-pressed to demonstrate that its activities with respect to the real property satisfy the five year “active trade or business” requirement.[xxiv]

Even if the active trade or business test were met, the relative proximity (in terms of time) of the spin-off distribution and the sale of the corporation’s stock – for all intents and purposes, on the eve of sale[xxv] – would likely cause the distribution to be taxable.[xxvi]

Disregarded Entities

Where does that leave the buyer, not to mention the target corporation and its shareholders? In the context of a stock sale where the shareholders of the target corporation want to retain ownership of the property, will they have to remove the property by way of a taxable transaction, the price tag for which includes a hefty tax liability?

Or might it be possible to remove the property by restructuring the target corporation in advance of the transaction so as to enable it to take advantage of the rules that govern transactions between a taxpayer and an entity owned by the taxpayer and that is disregarded as separate from the taxpayer for tax purposes.[xxvii]

In general, transactions between a taxpayer and an entity that is disregarded as separate from the taxpayer for tax purposes – including a sale or exchange of property – have no tax consequences for the simple reason that a taxpayer cannot sell property to themselves. That is not to say that, as a matter of contract or of state law, the transaction did not occur – indeed, a sale has occurred and ownership of the subject property has changed; it’s just that the transaction is ignored for tax purposes.[xxviii]

For example, assume corporation “Corp” owns 100-percent of limited liability company “LLC.” LLC is treated as a “disregarded entity” for tax purposes.[xxix] If LLC sells property to Corp pursuant to a contract, in exchange for full and adequate consideration paid in cash, there has been a bona fide sale between the two business entities. If LLC distributes property to Corp in respect of its membership interest, there has, in fact, been a distribution. However, because LLC is disregarded for tax purposes, Corp is treated as owning all of LLCs assets. Thus, as a tax matter, Corp cannot acquire from LLC – whether by way of a purchase-and-sale or by way of a distribution – property that Corp is already deemed to own.

Might this basic rule provide a means by which a target corporation can divest itself of unwanted real property on a tax-efficient basis, while it remains intact as a matter of state law?

Perhaps. The question, of course, is how does a corporation create an entity that is disregarded from it for tax purposes, and to which it may transfer a property (i.e., remove the property from the corporation) without adverse tax consequences, in preparation for the sale of the corporation’s stock?

Enter the F reorganization.

F Reorganization

The Code describes several types of corporate transactions that constitute “tax-free” reorganizations. The purpose of the reorganization provisions of the Code is to except from gain recognition certain specifically described exchanges that are incident to readjustments of corporate structures made in one of the particular ways specified in the Code, and which effect only a readjustment of continuing interest in property under a modified corporate form.[xxx]

One of these transactions is described as “a mere change in identity, form, or place of organization of one corporation, however effected” – a so-called “F” reorganization.[xxxi]

Like other types of corporate reorganizations, an F reorganization generally involves, in form, two corporations, one (a “transferor corporation”) that transfers (or is deemed to transfer) assets to the other (a “resulting corporation”). However, the statute describes an F reorganization as being undertaken with respect to “one corporation.”

An F reorganization is treated for most purposes of the Code as if the resulting corporation were the same entity as the transferor corporation that was in existence before the reorganization; indeed, the resulting corporation retains the transferor’s tax attributes.

Thus, the tax treatment accorded an F reorganization is more consistent with that of a single continuing corporation; for example, the taxable year of the transferor corporation does not close, its tax return includes the operations of the resulting corporation for the post-reorganization portion of the taxable year, and the resulting corporation inherits the tax elections of the transferor corporation.

A transaction that involves an actual or deemed transfer of property by a transferor corporation to a resulting corporation may qualify as an F reorganization – as may a series of related transactions, that together result in a mere change of one corporation – if certain regulatory requirements are satisfied.[xxxii]

According to one of these regulatory requirements, the transferor corporation must completely liquidate for federal income tax purposes as part of the potential F reorganization; however, the corporation is not required to dissolve under applicable state law.

Deemed transfers also include those resulting from the application of step transaction principles. For example, step transaction principles may treat a contribution of all the stock of the transferor corporation to the resulting corporation, followed by a liquidation (or deemed liquidation) of the transferor corporation – which are formally separate steps – as a deemed transfer of the transferor corporation’s property to the resulting corporation, followed by a distribution of stock of the resulting corporation in complete liquidation of the transferor corporation.

In keeping with the basic premise that the F reorganization involves a mere change in form of a single corporation, a qualifying transaction may occur before or within other transactions that effect more than a mere change, even if the resulting corporation has only a transitory existence. Related events that precede or follow the potential F reorganization generally will not cause that potential reorganization to fail to qualify as an F reorganization. Conversely, an F reorganization will not alter the character of other transactions for federal income tax purposes.

As we will see, it is the “deemed liquidation” requirement, the application of step transaction principles, and the fact that the F reorganization may be undertaken as part of a larger transaction without affecting the tax treatment of such transaction that, brought together, may provide a target corporation the means to divest itself of an unwanted asset just prior to the sale of its stock.

Practical Example

The following is but one example of how the foregoing rules and principles may be brought together to achieve the desired result: the removal of an asset from the target corporation on a tax efficient basis and the subsequent sale of the target’s stock.[xxxiii]

Assume Taxpayer owns all of the stock of Y, an S corporation. Y owns Prop plus other assets.

In Year 1, Taxpayer forms New-Corp and contributes all of the Y stock to New-Corp in exchange for all of the New-Corp stock.

New-Corp meets the requirements for qualification as an S corporation, and timely elects to treat Y as a qualified subchapter S subsidiary (QSub), effective immediately following the transaction.

As a result of the QSub election, Y is deemed to have liquidated into New-Corp on a tax-free basis, and its separate existence is then ignored, tax purposes, though it continues to exist as a matter of state law. Because Y is not treated as a separate corporation for tax purposes (but more like a division of New-Corp), and all its assets (including Prop), liabilities, and items of income, deduction, and credit are treated as assets, liabilities, etc. of the S corporation, New-Corp.

This transaction – the transfer of the Y stock to New-Corp, coupled with the QSub election – qualifies as an F reorganization, with New-Corp being treated as the “new form” of Y. Consequently, Y’s (now New-Corp’s) original S election does not terminate, but attaches to New-Corp.

In Year 2, Y distributes Prop to New-Corp. The distribution of Prop from Y to New-Corp is disregarded for tax purposes because New-Corp is already treated as owning it.

In Year 3, New-Corp sells the stock of Y to Buyer.[xxxiv] However, because New-Corp is deemed to own all of Y’s assets (for tax purposes), the sale – a stock sale as a matter of state law – is treated as a sale of an undivided interest in Y’s assets for tax purposes. Buyer acquires these assets with a basis step-up (and the opportunity for cost recovery deductions). Buyer is then treated as having contributed the newly acquired assets to a “new Y” corporation that comes into existence after the stock sale and the termination of its QSub status.

Take-Away

The fact pattern set forth above is but one illustration of how F reorganizations and disregarded entities may be utilized by a selling corporation and its shareholders to achieve some pre-sale “corporate tailoring” – the removal of an asset from a target corporation prior to the sale of its stock – on a tax efficient basis; there are others.

The interplay of these rules, however, can be complicated, and it will be imperative that the parties’ respective tax advisers be fully engaged in the analysis. Moreover, there will be times when the seller, the buyer, and their respective owners will not be able to reconcile their various goals through such corporate tailoring, though they will often need the input of their tax advisers to come to that realization.

At that point, choices will have to be made. Much will depend, as it usually does, upon relative leverage – including the ability to extract a gross-up for the tax liability arising from such tailoring – and upon how badly the parties want to consummate the sale.

—————————————————————————————————–

[i] https://www.taxlawforchb.com/2017/10/thou-shalt-not-hold-real-property-in-a-corporation/

[ii] Every now and then, you encounter a situation where the real property owned by the corporation has no connection to the business being conducted by the corporation.

[iii] For example, it is not listing the property for rent, it is not interviewing tenants or dealing with brokers, it is not negotiating leases, it is not attending to tenant complaints, etc.

[iv] A forward merger of corporations under state law that does not qualify as a tax-deferred reorganization under IRC Sec. 368 is treated as a taxable purchase and sale of assets.

[v] IRC Sec. 1012.

[vi] IRC Sec. 168(k), Sec. 167, Sec. 197.

[vii] This would include an asset that, by its terms, is generally not transferable; for example, a contract or a license.

[viii] IRC Sec. 338(h)(10) and Sec. 336(e).

[ix] Of course, the buyer may cause the newly acquired target corporation to sell the real property post-closing.

[x] Not an uncommon situation.

[xi] Including a reverse subsidiary merger, which may be necessary when dealing with a relatively large number of shareholders, or where some minority shareholders are reluctant to go along. In those circumstances, the merger will likely trigger appraisal rights for any dissenting shareholder. That’s when folks wish they had a shareholders’ agreement that included a drag-along provision.

[xii] IRC Sec. 1001.

[xiii] This would include an S corporation that is subject to the built-in gains tax. IRC Sec. 1374.

[xiv] The allocation of economic “risk” as between the seller and the buyer (including for taxes) is a significant part of any purchase-and-sale agreement.

[xv] IRC Sec. 1366. The gain will result in an upward adjustment to the shareholders’ stock basis pursuant to IRC Sec. 1367.

[xvi] Or if it acquired the assets of a C corporation in a tax-deferred exchange (for example, under IRC Sec. 368), so that the C corporation’s earnings and profits became tax attributes of the S corporation pursuant to IRC Sec. 381.

[xvii] After all, they will likely be responsible for any liabilities arising from the sale that are arise post-closing.

[xviii] Zenz v. Quinlivan, 213 F.2d 914 (6th Cir. 1954).

[xix] IRC Sec. 1239. https://www.law.cornell.edu/uscode/text/26/1239

[xx] The ordinary income and capital gain of a C corporation are taxed at the same flat rate of 21-percent; there is no reduced rate as in the case of individuals.

[xxi] One must also consider the application of the 3.8-percent surtax on net investment income under IRC Sec. 1411.

[xxii] IRC Sec. 311(b).

[xxiii] IRC Sec. 368(a)(1)(D) and Sec. 355.

[xxiv] IRC Sec. 355(b), Sec. 368(a)(1)(D). https://www.law.cornell.edu/uscode/text/26/355; Reg. Sec. 1.355-3(b)(2). https://www.law.cornell.edu/uscode/text/26/355

[xxv] I’ve really stacked the deck here.

[xxvi] IRC Sec. 355(e). Reg. Sec. 1.355-7.

[xxvii] For example, a single member LLC that has not elected to be treated as an “association” (basically, a corporation) for tax purposes.

[xxviii] The same concept has been applied in the case of transactions between a grantor trust and the grantor. Rev. Rul. 85-13. See also Reg. Sec. 1.368-2(b)(1)(iii), Ex. 2 (Good “A” reorganization where target corp. merges pursuant to state law with and into a disregarded subsidiary entity (maybe an LLC) of the acquiring corp., and the target shareholders receive stock of the acquiring corp. – the target is treated as having merged into the acquiring corp.).

[xxix] Reg. Sec. 301.7701-3.

[xxx] IRC Sec. 368(a). There are a number of statutory and regulatory requirements, not to mention a number of administrative and judicial interpretations, of which the taxpayer contemplating a reorganization must be aware.

[xxxi] IRC Sec. 368(a)(1)(F).

[xxxii] Reg. Sec. 1.368-2(m). https://www.taxlawforchb.com/2015/10/sometimes-an-f-is-a-good-result/. Note that the continuity of interest and continuity of business enterprise requirements do not apply to an F reorganization. Reg. Sec. 1.368-1(d) and (e).

In general, other requirements include no change in ownership of the corporation, and the resulting corporation must not have had any assets or conducted any business prior to the reorganization.

[xxxiii] See, e.g., Rev. Rul. 2008-18, and PLR 201115016.

[xxxiv] The sale does not affect the F reorganization. Rev. Rul. 96-29.

Most transactions have their share of hiccups. Some cases are more serious than others.

Generally speaking, they originate with the seller. For example, due diligence turns up some disturbing information about the target company’s legal status, the target’s financials aren’t as rosy as the buyer was led to believe, the target’s owners keep trying to renegotiate the deal, or a rift develops among the target’s owners – these and other surprises are not unusual. Some result in a change in purchase price or a change in payment terms (including escrows and other holdbacks), while others just kill the deal.

Of course, there are also times when the buyer is the source of the setback or hold-up; for example, the buyer’s financing for the transaction may be in question, or the buyer is distracted by another deal.

It is rarely the case, however, that the buyer’s ownership structure, or the composition of its ownership, presents a stumbling block, especially in what appears to be the well-choreographed process of a private equity deal.

Unfortunately, no one is immune from surprises.

Acquisitions by Private Equity

For the owners of many closely held businesses, the final step of a successful career may be the sale of their business.[i] At that point, the investment into which they have dedicated so much time, effort and money is monetized, leaving them with what is hopefully a significant pool of after-tax proceeds with which to enjoy their retirement, diversify their assets, or pursue other goals.

It used to be that the prospective buyer would almost always come from within the same industry[ii] as the business being sold. It was often a competitor, or someone seeking to fill a void in their own business. In other words, the buyers were strategic – they were looking for synergistic acquisitions, ones that would enable them to grow their own business and otherwise provide long-term benefits. Occasionally, the buyer would be a company from a different industry, one that was looking to diversify or add another line of business so as to hedge against a downturn in its primary business.

However, for many years now, the private equity fund (“PEF”) has been a dominant player in the competition for the acquisition of closely held businesses. In general, PEFs are not engaged in any “conventional” business; rather, they are well-funded investment vehicles that are engaged in the acquisition of conventional businesses (or “portfolio companies”).

Almost by definition, a PEF is not necessarily looking to the acquisition as a means of developing or establishing a long-term presence in a particular industry (a “buy and hold” investment strategy). Instead, it is looking for “value”[iii] to add to its portfolio of companies, perhaps even consolidating similar companies in the process in order to grow market share and reduce overall costs. In turn, the PEF hopes to sell its “inventory” of portfolio companies to other buyers not-too-far down the road, and hopefully at a sizable gain[iv] that it may share with its investors.

The PEF is formed as a partnership, which is not a taxable entity,[v] and which also facilitates the admission of new investors.[vi] The PEF will often create a holding company (the “HC”) to which it will transfer the funds contributed to the PEF by its investors. The HC, in turn, may establish and fund its own subsidiary companies through which it will aquire target businesses.

Rollover: PEF’s Perspective

One aspect of a PEF acquisition that tends to distinguish it from a strategic buyer acquisition is the PEF’s strong preference that the owners of a target business “rollover” (or reinvest) some portion of their equity in the target business into the PEF’s “corporate structure” in exchange for an equity interest therein, usually at the level of the HC.

From the perspective of the PEF, such a rollover yields several benefits. For one thing, it aligns the former owners of the target business with the interests of the PEF – their rolled-over investment is subject to the risks of the business, as is that of the PEF’s investors. Thus, the former owners are incentivized – or so the theory goes – to remain with the business, to cooperate fully in the transition of the business and its customers, and to work toward its continued growth and success.[vii]

Rollover: Seller’s Perspective

From the perspective of the target’s owners, however, the rollover may present a troublesome issue.

In many cases, an owner will want to take all of their cash off the table. They may not want to continue risking their capital, especially where the investment is to be controlled by another.

Of course, some owners will be attracted to the potential upside that a rollover investment in a PEF-controlled business may generate. After all, the owner may have the opportunity to benefit not only from the future growth of their former business, but also that of the PEF’s other portfolio companies. In fact, a business owner will generally insist upon being given the opportunity to participate in the growth of these other companies, which is consistent with most PEF’s desire that the target owners invest at the same level of the corporate structure as the PEF itself has – i.e., the HC.

However, the target owners will also insist that their rollover be effected without any adverse tax consequences. The ability of the PEF to satisfy this prerequisite will depend, in no small part, upon the form of the acquisition of the target business.

Acquisition Mechanics

Like most other buyers, the PEF will generally prefer an acquisition of the target’s assets, in a transaction that is taxable to the target, over an acquisition of the equity interests of the target’s owners.[viii] A taxable sale of assets will provide the PEF (specifically, the subsidiary through which the HC indirectly acquires the target’s business) with a cost basis in the acquired assets that may be expensed, depreciated or amortized by the PEF.[ix] The tax deductions so generated will offset the HC’s and, through it, the PEF’s income, thereby allowing the PEF to recover some of its investment in the target’s business and reducing the overall cost of the transaction to the PEF.

The target’s owners, on the other hand, will generally not choose an asset sale because such a sale may result in both the recognition of ordinary income by the target’s owners,[x] as well as an entity-level tax,[xi] thus reducing the net economic benefit to the owners. Rather, they would prefer to sell their equity interest in the target, at least in the case of a corporate target. The gain realized on such a sale will generally be treated as long-term capital gain.[xii] However, such a sale will not generate basis in the target’s assets for the PEF.

Rollover: Mechanics

As indicated above, a PEF will often create a subsidiary – the HC – through which it will acquire a target company. Where the target’s assets are being purchased, the acquisition may be effected through an acquisition vehicle (a corporation or LLC) that will be wholly-owned by the HC.[xiii]

The form of rollover by the target’s owners will depend upon the form of the acquisition. Thus, where the HC is acquiring the equity interests of the target owners, the rollover will come directly from the former owners.[xiv] Where the HC (more likely, its subsidiary) is acquiring the target’s assets, the rollover may come from the target. However, if the PEF insists that it must come from the target’s owners, then the proceeds paid to the target will have to find their way into the hands of its owners to enable them to acquire equity in the HC.[xv]

The chosen forms of acquisition and rollover will generate very different tax results for both the PEF and the target’s owners. Thus, it is imperative that the target’s owners examine the nature of both the PEF’s acquisition vehicle and of the target (e.g., corporation or partnership/LLC), and the nature of the sale (a sale of equity interests in the target or a sale of the target’s assets). They must consider how their equity rollover can be effectuated, and whether this transfer may be done tax-efficiently.

The owners of the target business have to recognize that if the rollover cannot be accomplished on a tax-deferred basis, they may be left with less cash and less liquidity than they would have preferred.[xvi]

In order to facilitate the rollover of the target’s equity, the HC may be formed as a partnership for tax purposes.[xvii] A tax-deferred contribution of property to a partnership in exchange for a partnership interest is generally easier to accomplish than a tax-deferred contribution of property to a corporation in exchange for shares of stock in the corporation. That’s because a tax-deferred contribution to a corporation requires that the contributor be in “control” of the corporation immediately after the exchange;[xviii] there is no such requirement for a contribution to a partnership.[xix]

The partnership structure, however, may present an issue for a non-U.S. investor of the PEF.

Target Partnership
Assume for our purposes that the target to be acquired by the HC is treated as a partnership for tax purposes, and that it is engaged in a U.S. trade or business. Also assume that the HC is treated as a partnership.

All Cash Deal – Fully Taxable

The gain from a sale of assets by the target partnership to a subsidiary corporation of the HC, in exchange for cash only, will flow through the partnership, and will be taxable, to the target’s owners.[xx] The nature of the gain taxed to the owners[xxi] will depend upon the nature of the assets sold.[xxii]

Alternatively, the owners of a target partnership may sell all of their partnership interests to the HC, or to its acquisition subsidiary, for cash.[xxiii] A sale of all of the partnership interests will be treated, for tax purposes from the buyer’s perspective, as a purchase of the target’s assets,[xxiv] thus providing the HC (and, ultimately, its owners) with a recoverable cost basis in such assets.[xxv]

In either case, if the target’s owners (the partners or members) are to acquire an equity interest in the HC, they will have to do so with after-tax dollars.[xxvi]

Rollover of Some Equity

In order for the target partnership to rollover a portion of its equity into the HC on a tax-advantaged basis, the target will have to contribute some of its assets to the HC in exchange for a partnership interest in the HC. In other words, the transaction will have to be effected as a part-sale-for-cash/part-contribution-for-equity by the target.[xxvii] The HC will acquire a depreciable or amortizable basis for the assets acquired for cash,[xxviii] and a carryover basis for those received in exchanged for an interest in the HC.[xxix]

The same result may be achieved where some interests in the target partnership are contributed by its partners to the HC as capital, while the remaining interests are sold to the HC (or its subsidiary) for cash.[xxx] In that case, because the HC is treated as acquiring all of the interests in the target partnership, it will receive a depreciable or amortizable basis for the assets to the extent of the cash paid, whereas it will take the target’s basis in the assets deemed to have been contributed.[xxxi]

Hiccup: PEF with Foreign Owner?

Assume the target’s owners contribute a portion of their partnership interests to the HC (the rollover) in exchange for an interest therein. Also assume that they sell the balance of their interests to a corporate subsidiary of the HC. Finally, assume that the HC immediately drops the rolled-over target partnership interests to this subsidiary.

Does the PEF, which is itself a partnership, have an issue if one of its members is a foreign investor (“FI”)?[xxxii]

It very well may.

The HC will be the owner of a partnership interest in the target, albeit for a very short period. This will cause HC to be treated as engaging in the target partnership’s business during such period, as would PEF.[xxxiii] In turn, this will cause FI to be treated as engaging in such business.[xxxiv] As a result, FI will have U.S.-source effectively connected income to the extent of its allocable share thereof. PEF will be required to pay a withholding tax with respect to FI’s allocable share of PEF’s effectively connected income.[xxxv] As importantly, FI will be required to file a U.S. federal income tax return.[xxxvi]

Can these adverse consequences be avoided where the PEF only realizes the issue during the process of acquiring the U.S. target partnership?

Possible Solution?

One possibility is for the target’s owners to contribute to a newly-formed C corporation (“Corp”), in exchange for all of Corp’s stock, that portion of their target partnership interests that are to be rolled-over to the HC.

Corp’s shareholders would then contribute its stock to the HC in exchange for partnership interests in the HC. Corp’s stock would then be dropped down to the HC’s corporate subsidiary (that purchased the remaining target partnership interests), and liquidated,[xxxvii] causing the target to become a disregarded entity.

The insertion of Corp between the target partnership and the rollover partnership interests of target’s erstwhile owners, and subsequently between the HC and the rolled-over interests in the target, would seem to prevent the HC, PEF and the FI from being engaged in the target’s trade or business.

But what is the impact of this arrangement upon the target’s owners? Will they still obtain tax-deferred treatment for the now indirect exchange of their partnership interests for equity in the HC?

The contribution of the Corp stock to the HC will qualify for tax-deferral as a capital contribution to a partnership.[xxxviii] But what about the contribution of the rollover target partnership interests to Corp?

The contribution of property to a corporation in exchange for stock in the corporation is accorded tax-deferred treatment if the contributor is in control of the corporation immediately after the contribution.[xxxix] Under the principles of the step transaction doctrine, however, where the contributor is obligated before the exchange to dispose of their stock in such a way that they lose control of the corporation, the IRS will ignore the momentary control and treat the exchange as a taxable event to the contributor.

Some have pointed to Rev. Rul. 2003-51 and to PLR 201506008 in support of the proposition that the tax-deferred contribution of property to a corporation in exchange for its stock will not be jeopardized by the pre-ordained transfer of such stock to a partnership as part of another tax-deferred exchange. Unfortunately, this revenue ruling and the PLR are easily distinguished from the scenario described above.

The revenue ruling describes a taxpayer that contributed property to a corporation in exchange for 100-percent of its stock. The taxpayer then contributed this stock to another corporation, to which another person also contributed property, and they both received stock in such second corporation,[xl] with the taxpayer receiving only 40-percent thereof. The IRS recognized that the second contribution in the ruling would normally break control with respect to the first contribution. The IRS disregarded this consequence, however, because the contributing taxpayer could have by-passed the first contribution and gone directly to the second, with the second qualifying as tax-deferred exchange. That this alternative route was available to the contributing taxpayer was key to the IRS’s ruling – the first contribution was not necessary to effect a tax-deferred exchange.[xli] The ruling distinguished earlier IRS rulings – which on similar facts had found a taxable exchange – based on the fact that there was no such alternative exchange available to the contributor in those rulings.

The above PLR is also easily distinguished. It doesn’t even rely on or cite the revenue ruling. Three taxpayers contributed assets to a new corporation in exchange for all of its stock. The same three taxpayers then contributed their stock in the new corporation to a new partnership in exchange for all of its partnership interests. The taxpayers represented that the new corporation would remain in existence and be engaged in a trade or business – it had economic substance. Thus, the new partnership, which was wholly-owned by the three taxpayers, owned all of the new corporation, which was previously owned by the three taxpayers. In other words, the three taxpayers continued to own 100-percent of the corporation, albeit indirectly.[xlii]

Neither the revenue ruling nor the PLR bear any similarity to the issue presented by the situation described above.

What’s more, there is no bona fide, non-tax business reason for the use of Corp. It is being formed for the sole purpose of shielding the FI from tax liability and from having to file tax returns. What’s more, Corp will be liquidated by the HC’s corporate subsidiary shortly after its drop-down to such subsidiary; i.e., its existence is transitory.

In light of the foregoing, the target’s owners may realize nothing but a Pyrrhic victory – a tax-deferred contribution to a partnership (the rollover) that causes the recognition of gain for their preceding contribution to a corporation – if they follow the strategy suggested to accommodate the FIs.

What Is To Be Done?

Answer: The owners of the target partnership should ask that the PEF agree to indemnify them for the amount of the lost tax deferral benefit.

The PEF itself should take measures to ensure that it does not find itself in the same position for future acquisitions. For example, if it cannot ask the FIs to contribute their interest in PEF to a corporate blocker, perhaps it should consider providing an alternative or parallel investment vehicle through which the FIs may acquire an interest in the PEF’s portfolio companies.

What is clear, is that the burden of resolving the issue should not rest with the target company’s owners, with whom the PEF has already agreed to engage in a tax-deferred rollover of a portion of their target equity.

[i] The “end” of a business does not always take the form of a sale to a new owner; indeed, many businesses simply peter out.

[ii] Or at least one related to it.

[iii] Or the potential for value that may be realized with the proper management that the PEF’s team can provide.

[iv] Return on investment.

[v] IRC Sec. 701.

[vi] IRC Sec. 721.

[vii] The rollover also saves the PEF some money: issuing equity is less expensive than paying out funds that the PEF has to borrow, or that it already has and would prefer to use for operations or further investment.

[viii] An exception would be the acquisition of all of the membership interests of an LLC that is treated as a partnership for tax purposes. In that case, the buyer is still treated as having purchased the assets of the target LLC, and as taking a cost basis in such assets. Rev. Rul. 99-6, Situation 2.

[ix] IRC Sec. 168(k), Sec. 167, and Sec. 197.

[x] For example, in the case of a target partnership or S corporation, from the sale of assets subject to depreciation recapture under IRC Sec. 1245.

[xi] In the case of a C corporation, under IRC Sec. 11; in the case of an S corporation subject to built-in gains tax, under IRC Sec. 1374. There is no entity level tax in the case of a partnership. IRC Sec. 701.

[xii] IRC Sec. 1221. But see IRC Sec. 741 in the case of the sale of a partnership interest, and its reference to Sec. 751 (regarding “hot assets”).

Also note the application of the tax on net investment income under IRC Sec. 1411 which, in the case of a target S corporation or partnership, may apply to some of the target’s owners and not others, depending upon their level of participation in the business.

[xiii] In this way, the HC’s other subsidiaries and assets may be protected from the liabilities of the business being acquired.

[xiv] If the target is an S corporation, and the parties make an election under IRC Sec. 338(h)(10) to treat the stock sale as a sale of assets instead, the rollover will not yield any tax deferral benefit. In other words, the election is incompatible with a tax-deferred rollover.

[xv] In the case of a corporate target, this will require a distribution of assets by the corporation to its shareholders. Such a distribution would be treated as a sale of the distributed assets by the corporation. IRC Sec. 311(b) or IRC Sec. 336. The distribution may also be taxable to the shareholders. IRC Sec. 301, Sec. 302, or Sec. 331.

[xvi] That’s because they will have to use some of the cash received to satisfy the tax liability arising from the exchange for equity in the HC.

[xvii] IRC Sec. 761, Reg. Sec. 301.7701-3.

[xviii] IRC Sec. 351 and Sec. 368(c). “Control” is defined as ownership of stock possessing at least 80-percent of the total combined voting power of all classes of stock entitled to vote and at least 80-percent of the total number of shares of all other classes of stock of the corporation.

[xix] IRC Sec. 721.

[xx] IRC Sec. 702(a).

[xxi] As ordinary income or as capital gain.

[xxii] IRC Sec. 702(b).

[xxiii] IRC Sec. 741 and Sec. 751.

[xxiv] Rev. Rul. 99-6, Situation 2, explains that, from the buyer’s perspective, the target LLC will be treated as having distributed its assets to its members, from whom the buyer then acquired the assets.

[xxv] IRC Sec. 1012.

[xxvi] In other words, they will pay tax on the gain recognized from the sale, then use some of the after-tax proceeds to invest in the HC.

[xxvii] Reg. Sec. 1.707-3, and IRC Sec. 721.

Assume S transfers property X to partnership HC in exchange for an interest in the partnership. At the time of the transfer, property X has a fair market value of $4,000,000 and an adjusted tax basis of $1,200,000. Immediately after the transfer, HC transfers $3 million in cash to S. The partnership’s transfer of cash to S is treated as part of a sale of property X to the partnership. Because the amount of cash S receives does not equal the fair market value of the property, S is considered to have sold a portion of property X with a value of $3,000,000 to the partnership in exchange for the cash. Accordingly, S must recognize $2,100,000 of gain ($3 million amount realized less $900,000 adjusted tax basis ($1.2 million multiplied by $3,000,000/$4,000,000)). Assuming S receives no other transfers that are treated as consideration for the sale of the property, S is considered to have contributed to the partnership, in S’s capacity as a partner, and on a tax-deferred basis, $1 million of the fair market value of the property with an adjusted tax basis of $300,000. Reg. Sec. 1.707-3(f), Ex. 1.

[xxviii] IRC Sec. 1012.

[xxix] IRC Sec. 723.

[xxx] The HC would then drop down the contributed interest to its subsidiary, following which the subsidiary will own all of the equity in the target partnership, and the target will become a disregarded entity for tax purposes. Reg. Sec. 301.7701-3.

[xxxi] Where the rollover contribution is to the HC in exchange for equity in the HC, and the sale is to a subsidiary of the HC, an election under IRC Sec. 752 should be made on the target partnership’s final tax return to adjust the basis for the assets in the hands of the acquiring subsidiary. IRC Sec. 743; Reg. Sec. 1.743-1(g).

[xxxii] A non-U.S. person. IRC Sec. 7701(a).

[xxxiii] Reg. Sec. 1.702-1(b).

[xxxiv] IRC Sec. 875. However, query in the case of an FI from a treaty country whether the permanent establishment requirement would be satisfied.

Previously, PEF’s FI did not have this issue because PEF’s activities, and those of the HC, consisted only of trading in stocks or securities for their own account, which is not treated as a trade or business. IRC Sec. 864(b)(2)(A)(ii). The HC’s only activity consisted of holding the stock of its corporate subsidiary (a C corporation), which effectively acted as a blocker with respect to any actual trade or business activities being conducted by the portfolio companies; only when the corporation paid dividends to the HC did the foreign members have U.S. income; moreover, these dividends may have qualified for a reduced U.S. tax rate depending on the jurisdiction of the FI and whether there was a tax treaty with the U.S.; in the absence of a treaty, the dividends would be subject to 30% U.S. tax on the gross amount thereof. Finally, assuming the sale of the FI’s interest in PEF generated only capital gain, it would not be subject to U.S. income at all.

See IRC Sec. 864(c)(8) – enacted as part of the Tax Cuts and Jobs Act – with respect the taxation of the gain from the sale of an interest in a partnership engaged in a U.S. trade or business.

[xxxv] IRC 1446.

[xxxvi] Reg. Sec. 1.6012-1(b), Reg. Sec. 1.6012-2(g).

[xxxvii] Under IRC Sec. 332, on a tax-deferred basis.

[xxxviii] IRC Sec. 721.

[xxxix] IRC Sec. 351.

[xl] As the “control group.”

[xli] Query why the taxpayer acted as they did – was the first contribution made in error?

[xlii] Compare this to the target partnership’s former owners who are receiving only a small interest in the HC.

See also Reg. Sec. 1.368-1(d), which addresses the continuity of business enterprise requirement for a tax-free reorganization (not a Sec. 351 transaction) where the assets acquired by the acquiring corporation are contributed to a partnership. Although not directly on point, it conveys the IRS’s thinking in a situation that, like a Sec. 351 exchange, considers whether the transferor-taxpayer’s relationship to, or form of ownership of, the assets it has transferred has changed to a degree that warrants taxation. Each partner of the partnership is treated as owning (in accordance with their partnership interest) the partnership assets used in a business. The issuing corporation is treated as conducting the business of the partnership if the corporation owns an interest in the partnership that represents a significant interest in the partnership business, or if the corporation has active and substantial management functions as a partner with respect to the partnership business; between 20-percent and 33.3-percent of the partnership is enough if the corporation performs substantial management functions.

More than one-third suffices if the corporation has no management functions in the partnership. See examples 14 and 15 of Reg. Sec. 1.368-1(d) for illustrations of situations that involve the transfer of acquired stock to a partnership.

Moving To Florida?

A few days ago, one of the daily tax services reported that the billionaire investor and businessman, Carl Icahn, was planning to move his home from New York City to Florida, presumably for tax reasons. What’s more, the article continued, Icahn was planning to move his NYC-based business (including employees) to Florida.[i]

The article noted that, over the years, a number of prominent investors and hedge fund managers have relocated to Florida for tax reasons – it cited David Tepper, Paul Tudor Jones and Eddie Lampert as examples – explaining that Florida has no personal income tax, and a corporate tax rate of 5.5-percent, as compared to NY’s corresponding rates of 8.82-percent and 6.5-percent.[ii]

Shortly after reading this article, I came across a recent decision by NY’s Tax Appeals Tribunal regarding the tax status of another hedge fund manager: Nelson Obus (the “Taxpayer”), a co-founder, and the Chief Investment Officer, of NYC-based Wynnefield Capital; specifically, the Tribunal considered whether Taxpayer was a statutory resident of NY during the 2012 and 2013 tax years.[iii]

“It’s no wonder,” I thought to myself after reviewing the Tribunal’s opinion, “that NY is among the lowest-ranked states in terms of ‘tax climate’ – not only will we tax non-resident owners on the profits they realize from operating their business within the State, we’ll also tax them on their non-NY-source income if they decide to spend some of those profits by vacationing in the State.”[iv]

“I Love NY” – Unrequited Love?

The general fact pattern was not at all unusual and, unfortunately, the outcome was not at all unexpected – indeed, it was consistent with many other decisions under similar circumstances – which is why it is instructive for individuals who are not domiciled in NY, but who own and operate a NY-based business, and who are considering the purchase of a “second home” in the State.[v]

It was undisputed that Taxpayer was domiciled in New Jersey during the years at issue – that was his “permanent” home.

It was also undisputed that Taxpayer, who worked primarily out of his NYC office,[vi] was present in NY for over 183 days during each of the years in issue.

The question of Taxpayer’s statutory residence, therefore, turned on whether he maintained a permanent place of abode in NY.

In fact, just prior to the years at issue, Taxpayer had purchased a house in Northville, New York, which is located more than 200 miles from NYC, on a northern extension of Great Sacandaga Lake, in the Adirondack Park.[vii] The house had five bedrooms and three bathrooms, with year-round climate control.

It was undisputed that Taxpayer and his family used this house for vacation purposes[viii] only: Taxpayer enjoyed cross-country skiing in the winter months and attending the Saratoga Race Track in the summer. Taxpayer spent no more than two to three weeks at a time in Northville.

The Issue is Joined

Taxpayer filed NY State nonresident income tax returns, on Form IT-203, for each of the years at issue.[ix] In response to a question on Form IT-203, Taxpayer responded that he did not maintain any living quarters within NY State for either 2012 or 2013.[x]

After an audit conducted by the Department of Taxation, a notice of deficiency was issued to Taxpayer in 2016. The notice asserted additional NY State income tax due in excess of $525,000 (plus interest and penalty) for the two years at issue.[xi]

The additional liability was based upon the Department’s finding that, because Taxpayer maintained a permanent place of abode in the NY, and was present within the State in excess of 183 days, he was liable as a statutory resident for income tax purposes for the years 2012 and 2013.

Taxpayer protested the notice by filing a timely petition with the Division of Tax Appeals.

Unfortunately, Taxpayer didn’t stand a chance of succeeding under the current state of the law relating to NY statutory residence.

Statutory Residence

The NY Tax Law sets forth the definition of a NY State resident individual for income tax purposes. A resident individual means an individual: “(A) who is domiciled in this state, . . . or (B) who is not domiciled in this state but maintains a permanent place of abode in this state and spends in the aggregate more than one hundred eighty-three days of the taxable year in this state, . . .”[xii]

As set forth above, there are two alternative bases upon which an individual taxpayer may be subjected to tax as a resident of NY State, namely (A) the domicile basis, or (B) the statutory residence basis – i.e., the maintenance of a permanent place of abode in the NY, and physical presence in the State on more than 183 days during a given taxable year.

Because Taxpayer was domiciled in New Jersey during the audit years, the issue for the Tribunal was whether Taxpayer was liable for NY personal income tax on the basis of statutory residence. As there was no dispute that Taxpayer was physically present within NY for more than 183 days – after all, he worked in the City, where his business was located – the sole issue in the case involved whether Taxpayer maintained a permanent place of abode in NY during the years at issue.

Permanent Place of Abode

The phrase “permanent place of abode” is interpreted in the Department’s regulations as “a dwelling place of a permanent nature maintained by the taxpayer, whether or not owned by such taxpayer, . . . However, a mere camp or cottage, which is suitable and used only for vacations, is not a permanent place of abode. Furthermore, . . . any construction which does not contain facilities ordinarily found in a dwelling, such as facilities for cooking, bathing, etc., will generally not be deemed a permanent place of abode.”[xiii]

Taxpayer framed his argument as whether his limited use of the Northville house, which he claimed was otherwise rented out during the year, constituted a permanent place of abode. Taxpayer relied on the NY Court of Appeals decision in Gaied [xiv] to emphasize that, because his property was maintained for another’s use, such residence did not qualify as a permanent place of abode for him.

In Gaied, the petitioner owned a multi-family apartment building in Staten Island that contained three rental units. Two of these units were rented out and the third unit was maintained by the petitioner for use by his parents. The petitioner was domiciled in New Jersey; however, he owned an automotive service and repair business on Staten Island[xv] and commuted daily from New Jersey. The Tax Appeals Tribunal concluded that the petitioner was liable as a statutory resident based upon his presence within NYC for over 183 days and his maintenance of a permanent place of abode in Staten Island. The Tribunal based its decision on the fact that the petitioner had access to the permanent place of abode[xvi] although he maintained it for his parents. The Tribunal held that access was enough, and there was no requirement that petitioner actually reside there. The Tribunal was affirmed by the Appellate Division.[xvii]

The Court of Appeals, however, disagreed and reversed. The court held that:

“The Tax Tribunal has interpreted ‘maintains a permanent place of abode’ to mean that a taxpayer need not ‘reside’ in the dwelling, but only maintain it, to qualify as ‘statutory resident’ under Tax Law § 605 [b] [1] [B]. Our review is limited to whether that interpretation comports with the meaning and intent of the statutes involved . . . Notably, nowhere in the statute does it provide anything other than the ‘permanent place of abode’ must relate to the taxpayer. The legislative history of the statute, to prevent tax evasion by New York residents, as well as the regulations, support the view that in order for a taxpayer to have maintained a permanent place of abode in New York, that taxpayer must, himself, have a residential interest in the property.” [Emph. added]

In Taxpayer’s case, the Tribunal rejected his argument that he maintained the residence for a tenant’s use. Primarily, the tenant had their own separate living quarters and, as such, their occupancy did not affect the use of the house by Taxpayer as a vacation home. The decision in Gaied simply did not apply to the facts of this case.

Taxpayer also urged the Tribunal to find that the language in the above-quoted regulation regarding “a mere camp or cottage, which is suitable and used only for vacations,” described his Northville house. Taxpayer asserted that because his use was limited to only vacations, it could not be determined that Taxpayer, in fact, maintained the home for substantially all of the year.

The Tribunal responded by pointing out that Taxpayer was at no point prevented from using the property for substantially all of the year for both 2012 and 2013. The Northville house, it stated, could be (and was) used year-round and, as such, was considered permanent. The fact that Taxpayer chose to use the property exclusively for vacations did not transform its characterization as a permanent place of abode.[xviii]

Therefore, the Tribunal concluded that the Northville house was a permanent place of abode maintained by Taxpayer for his use. Because Taxpayer maintained a permanent place of abode in NY, and was present within the State for more than 183 days during each of the years in question, the Tribunal found that he was properly taxable as a statutory resident of NY for the years 2012 and 2013.[xix]

The fact that the house was located more than 200 miles away from where Taxpayer logged almost all of those 183-plus NY-days was of no consequence to either the Department or the Tribunal. The question, however, is whether it should it have been.

Think About It

Say I lived in Burlington, Vermont, and work in Plattsburgh, New York.[xx] I commute to work almost every day, just 32 miles each way.[xxi] Say my spouse is originally from Long Island, and her family used to spend their summers in Montauk. She misses the ocean beaches, so we purchase a year-round studio apartment in Montauk – almost 400 miles away from Burlington, but within walking distance of the Atlantic – that we use on long weekends, some holidays, and vacations.

Most of my wages are earned in NY and, thus, are subject to NY income tax; I get a credit for the tax paid to NY against the income tax I owe to Vermont as a domiciliary of that State.

Imagine my surprise when NY informs me that I am a statutory resident of the State and, therefore, owe NY tax on all of my income, which includes that part of my wages that I earned outside NY, my investment portfolio income, and my rental income from a condominium in Stowe, Vermont.[xxii]

The Department explains to me that even though I am not domiciled in NY, I am nevertheless subject to income taxation as a resident of the State because I maintain a permanent place of abode in NY – one in which I clearly have some residential interest, notwithstanding that it is almost 400 miles from my job in northern NY – and (b) spend more than 183 days in NY during the year.

Would the result have been any different if I lived in eastern Pennsylvania, worked in western NY, and had a studio apartment on the East End, over 500 miles away? Under the current interpretation of the statute, nope.

You get the picture. What’s wrong with this analysis? Does it make sense?

An Alternative?

The beginnings of an answer may be found in the dissent to the Appellate Division’s decision in Gaied, where the court held for the State. The dissent there explained that the intent of the statutory residence law, as stated in its legislative history, is to tax those individuals who, as a matter of fact, are NY residents.[xxiii]

Before Gaied, the Court in Tamagni[xxiv] considered the constitutionality of two states taxing someone as a resident. The Court there referenced the legislative history of the permanent residence test – signed into law in 1922 – stating that the test was enacted to discourage tax evasion by NY residents.

The Court explained that, at the time the statute was enacted, the Department of Taxation[xxv] noted in its memorandum in support of the legislation that, “[w]e have several cases of multimillionaires[xxvi] who actually maintain homes in New York and spend ten months of every year in those homes . . . but they . . . claim to be nonresidents.”[xxvii] According to the memorandum, the statutory residence test serves the important function of taxing those “who, while really and [for] all intents and purposes [are] residents of the state, have maintained a voting residence elsewhere and insist on paying taxes to us as nonresidents.”

Similarly, the Tax Department’s memorandum in support of the 1954 amendment to the statute, which established the “more than one hundred eighty-three days” requirement, specifically states that the amendment was necessary to deal with “many cases of avoidance and . . . evasion” of income tax by NY residents.[xxviii]

Turning again to Gaied in the Appellate Division, the dissent continued, “[a] permanent place of abode means a dwelling place of a permanent nature maintained by the taxpayer.” Using language that would later be adopted by the Court of Appeals in Gaied, and heavily emphasizing the distinction between “permanently maintaining” and “continuing living arrangements at” a particular dwelling place, the dissent asserted that the inquiry should focus on the person’s own living arrangements in the purported place of abode, and on whether the taxpayer had a personal residential interest in the place.

In reaching its decision, the Court of Appeals in Gaied concluded that there was no rational basis to interpret “maintains a permanent place of abode” to mean that a taxpayer need not “reside” in a given dwelling, but only maintain it, to qualify as a statutory resident. The Court rejected the Department’s and the Appellate Division’s analyses, and made a distinction between having a property interest, as opposed to a residential interest, in a dwelling.

The Court of Appeals explained that the legislative history supported the idea that the law was intended to prevent tax evasion by de facto NY residents. Thus, the permanent place of abode had to actually relate to the taxpayer, and the taxpayer themselves must have a residential interest (as opposed to just a property interest) in the property.

Nowhere, however, did the Court discuss any requirement that there be a nexus between the permanent place of abode in which the taxpayer has a personal residential interest and the location(s) within NY at which the taxpayer spends the requisite number of days that cause them to be treated as a resident. In fact, some courts – including the Tribunal in the Taxpayer’s case, above – have rejected such arguments based upon the Department’s interpretation of the law, which fails to require such a nexus.

For example, in Barker,[xxix] a Connecticut domiciliary who worked in Manhattan every day, as an investment manager, and who owned a vacation home in East Hampton (which they used for less than three weeks in any of the years at issue), was found to be liable for NY income tax on all of their income because they spent over 183 days in NY during the year – working in NYC – and owned a permanent place of abode in NY – approximately 110 miles away from Manhattan. The Tribunal rejected the taxpayer’s argument that the house was not suitable for use by the taxpayer’s family as a permanent home – which it characterized as “subjective” – stating that it was “well settled that a dwelling is a permanent place of abode where, as here, the residence is objectively suitable for year round living and the taxpayer maintains dominion and control over the dwelling. There is no requirement,” the Tribunal added, “that the [taxpayer] actually dwell in the abode, but simply that he maintain it.”

As we just saw, the Court of Appeals in Gaied rejected this last statement, that maintenance of a dwelling alone sufficed for purposes of the statutory residence test. Relying on the legislative history, the Court held that a taxpayer cannot have a permanent place of abode in NY unless “[he], himself, ha[s] a residential interest in the property.” The purpose of the test, the Court explained by reference to the legislative history, was to prevent avoidance by people who really live in NY but attempt to be taxed as nonresidents.

A Call to Action?

What does this mean for cases like the Taxpayer’s? Presumably, it requires that a more subjective inquiry occur before a non-NY domiciliary who spends more than 183 days a year in NY – as a result of operating a business in the State – can be taxed as a resident simply by virtue of having a dwelling somewhere in NY; what’s more, this inquiry must focus on whether the dwelling is actually “utilized as the taxpayer’s residence.”

Does this inquiry necessarily include a consideration of nexus? It should. There is a huge difference between finding a residential interest in a NY-situs property that is located near the NY place of business of someone who is not domiciled in NY,[xxx] as opposed to “looking for” such an interest in a vacation property situated in NY, but many miles from the NY place of business, such that a reasonable person would not entertain a daily commute between the two points.[xxxi]

When applying the statutory residence rule, the Department and the courts should take into account its intended purpose: to tax people who actually live in NY, and to discourage tax evasion by such individuals. The rule was not enacted to tax non-resident commuters who do not live in NY, even if they have some connection to NY real property, like a vacation home.


[i] “Carl Icahn Is Said to Be Heading to Florida for Lower Tax Rates,” Bloomberg’s Daily Tax Report, Dec. 12, 2019. Another article indicated that his employees were being offered a moving allowance to back their bags and head south with him.

Clearly, he has been advised that it will not suffice for him to move from NY while leaving his business behind – the business must come along too if he is to successfully demonstrate that he has abandoned his NY domicile and has established Florida as his new domicile. https://www.taxlawforchb.com/2019/07/escape-from-new-york-it-will-cost-you/

[ii] The article could have added that New York City imposes a personal income tax on its residents at a rate of 3.876%; it also imposes a corporate tax at the rate of 8.85%, and a tax on unincorporated businesses of 4%. https://www.taxlawforchb.com/2017/03/an-overview-of-the-nyc-business-tax-environment/

The article also could have mentioned that Florida has no estate tax, whereas NY imposes an estate tax of 16%.

[iii] Nelson Obus and Eve Coulson, DTA NO. 827736 (August 22, 2019).

[iv] Yes, some hyperbole, but I’m making a point here.

[v] The opinion’s reasoning applies equally in determining the NYC resident status of a NY State domiciliary – for example, an individual whose permanent home is in Westchester or Nassau County – who owns and operates a business in NYC, and who is considering the purchase of an apartment in the City.

[vi] This is important to note because NYC did not claim he was a resident of the City, though he worked there most of the time.

[vii] A car drive of almost 4 hours; a bus or train ride of almost 5 hours; almost 5 hours by plane and car (flying from Newark to Albany then to Saratoga Springs, then by car to Northville).

[viii] It was obvious that he hasn’t going to commute to his office in NYC from Northville.

[ix] Taxpayer’s share of the profits from his NYC-based business probably included NY-source income.

[x] This drives me crazy. Whether it is done inadvertently or intentionally, I cannot say; its effect is the same: the NY auditor is left with the impression that the taxpayer is looking to avoid having their return selected for a residency exam. Why start behind the eight ball?

[xi] This translates, roughly, into additional taxable income of approximately $6 million in each of the years at issue. This income would, for example, represent wages earned outside of NY, rental income sourced outside NY, and investment income.

[xii] Tax Law Sec. 605(b)(1)(A) and (B).

[xiii] 20 NYCRR 105.20(e)(1).

[xiv] Matter of Gaied v New York State Tax Appeals Trib., 22 NY3d 592 [2014].

[xv] AKA Richmond County, and somehow one of NYC’s five boroughs.

[xvi] It was located in the same neighborhood as his business.

[xvii] Matter of Gaied v New York State Tax Appeals Trib., 101 AD3d 1492 [3d Dept. 2012].

[xviii] The regulation at 20 NYCRR 105.20[e][1], in interpreting the phrase permanent place of abode, provides guidance concerning certain living quarters maintained by a taxpayer that are not permanent in nature, where the property is not suitable for year-round use or does not contain cooking facilities or bathing facilities.

[xix] Finally, Taxpayer argued that the imposition of a resident income tax in his circumstances was unconstitutional because it would lead to multiple taxation of his income. Specifically, Taxpayer asserted that New Jersey would not allow a credit for taxes paid to other states on income – such as investment portfolio income (which represents a significant portion of the income of most money managers) – that had no identifiable situs.

According to the Tribunal – and unfortunately for Taxpayer – the Court of Appeals had already rejected this argument. Matter of Tamagni v Tax Appeals Trib., 91 NY2d 530 [1998], cert. denied, 525 U.S. 931 (1998), wherein the statutory residence statute was upheld as constitutional.

[xx] Ah, Lake Champlain.

[xxi] About the distance from Jericho, NY (a bedroom community) to Manhattan.

[xxii] Which, ironically, I lease mostly to people from NY. Again, this is my story, so I can take as much license as I need to make a point. Besides, I am told that it’s good to dream.

[xxiii] Gaied v. New York State Tax Appeals Tribunal, 957 N.Y.S. 2d 480.

[xxiv] See EN xix.

[xxv] Then known as the Income Tax Bureau.

[xxvi] No one talks about millionaires today. Billionaires are now the fashion.

[xxvii] Bill Jacket, L. 1922, ch. 425.

[xxviii] Memorandum of Dept. of Taxation and Finance, 1954 N.Y. Legis. Ann., at 296.

[xxix] Matter of Barker, DTA No. 822324 (N.Y. Tax App. Trib. 2011).

[xxx] The classic Manhattan pied-a-terre owned by a non-NY domiciliary who works in the City.

[xxxi] The question, of course, is where does one draw the line? There are people who commute to NYC every day from the East End, or from parts of Dutchess and Orange Counties. How far away is too far for this purpose?

Still a Valid S Corporation?

Much has been written regarding the limitations of the S corporation, especially the requirement that it have only one class of stock, and the prohibition against its having nonresident aliens, partnerships, or other corporations as shareholders. The fact remains, however, that there are thousands of S corporations in existence, out of which many closely held businesses operate.

For these businesses, the satisfaction of these requirements – i.e., living within these limitations and the attendant “lost opportunities”[i] – is the cost of securing and maintaining the corporation’s status as a pass-through entity[ii] for tax purposes.

There is one point in the life of the business, however – perhaps the most inopportune time – at which a corporation’s failure to satisfy these requirements or, stated somewhat differently, its inability to demonstrate that it has satisfied them, may cost its shareholders dearly. I am referring to the sale of the business and, in particular, the sale of all of its issued and outstanding stock.

I wish I could say that it is rarely the case for an S corporation that is in the midst of negotiating the sale of its business to discover that it may have lost its “S” status by virtue of having, for example, two outstanding classes of stock, but that would be inaccurate, as illustrated by a recent IRS letter ruling.[iii]

Before delving into the ruling, it may be helpful to review the “one class of stock” requirement and the tax consequences of a sale of an S corporation’s stock.

One Class of Stock

Under the Code, a corporation that has more than one class of stock does not qualify as a “small business corporation.”[iv]

A corporation is 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.[v]

Differences in voting rights among shares of stock are disregarded in determining whether a corporation has more than one class of stock.[vi] Thus, if all outstanding shares of stock of an S corporation have identical rights to distribution and liquidation proceeds, the corporation may have voting and nonvoting stock.

In general, the determination of whether all outstanding shares of stock confer identical rights to distribution and liquidation proceeds is made based on the corporate charter, articles of incorporation, bylaws, applicable state law, and binding agreements relating to distribution and liquidation proceeds.[vii]

Pass-Through

If a corporation qualifies as a small business corporation,[viii] and if its shareholders elect to treat the corporation as an S corporation for tax purposes[ix], then the corporation’s items of income, gain, deduction, loss, or credit will flow through to its shareholders, based on their respective pro rata shares, and will be taken into account in determining each shareholder’s income tax liability.[x]

The S corporation, itself, will not be subject to federal income tax.[xi]

Thus, the gain from the sale of the assets of an S corporation – or from the deemed sale of its assets (see below) – will be included in the gross income of its shareholders for purposes of determining their individual income tax liability. What’s more, the character of any item of gain (as ordinary or capital gain) that is included in a shareholder’s pro rata is determined as if such item were realized directly from the source from which realized by the corporation, or incurred in the same manner as incurred by the corporation.[xii]

A Stock Sale . . . ?

At this point, some may be wondering why the purchaser of an S corporation’s business would be acquiring the corporation’s stock instead of its assets.[xiii]

After all, in a stock deal, the buyer necessarily acquires all of the assets of the target S corporation,[xiv] both the assets that are necessary to the operation of the business, as well as those that aren’t. The buyer also takes subject to all of the target S corporation’s liabilities, both known and unknown, absolute or contingent,[xv] whether or not related to the operation of the business, including any liability for taxes owing by the target corporation.[xvi]

The buyer of stock also loses the opportunity, generally speaking, to step-up the basis of the assets acquired from the S corporation to their fair market value – the buyer’s cost for acquiring the assets[xvii] – and to expense, depreciate or amortize such cost, as the case may be, and to thereby recover their investment (i.e., the purchase price) faster than in the case of a purchase of stock.[xviii]

That being said, there are circumstances in which either the purchaser, or the shareholders of the target S corporation, may favor a stock deal.

For example, the S corporation may hold unassignable licenses or permits, or there may be contracts or other agreements, the separate transfer of which may require consents that will be difficult or too time-consuming to obtain.[xix]

A stock deal may also be easier to effectuate where the target S corporation’s assets are so numerous or extensive that it would be difficult or costly to transfer them separately. The purchase of the target’s tock would ensure the buyer of acquiring all of the necessary business assets owned or used by the corporation.

It may be that the purchaser wants to keep the corporation intact – as a going concern – perhaps after determining that the business has few liabilities,[xx] while also recognizing that is has great potential as is; only the management of the business needs to change.

Finally, the shareholders of the target S corporation will usually prefer a stock deal because it ensures them that their gain from the sale of the stock will be treated as long term capital gain for tax purposes.[xxi] If the purchaser wants the business badly enough, they will accede to the shareholders’ request.[xxii] It comes down to a question of leverage and risk allocation.

. . . And A Basis Step-Up?

Fortunately for the buyer, its decision to acquire the stock of a target S corporation does not always mean that the buyer must forfeit the ability to depreciate or amortize the purchase price. Even in the case of a stock deal, it may still be possible for the buyer to acquire a cost basis for the target S corporation’s assets, provided the selling shareholders agree to make one of two elections, depending upon the tax status of the buyer.[xxiii]

Thus, if the buyer is a single corporation, the buyer and each shareholder of the target S corporation may jointly elect to ignore the stock sale and to treat the transaction, instead, as a sale of assets by the target S corporation to a subsidiary of the buyer corporation, followed by the liquidation of the S corporation.[xxiv]

If the buyer is not a single corporation – for example, a partnership, an individual, or more than one person – then the shareholders of the target S corporation may be able to elect (without the consent of the buyer, but certainly at its insistence) to treat the stock sale as a sale of assets, as described above.[xxv]

It is unlikely that the shareholders of the target S corporation would make either of these elections unless they were asked to do so by the buyer. In that case, it is still unlikely that the shareholders would consent to the election unless they were compensated for any additional tax (including any deficiency) imposed upon them as a result of treating the transaction as a sale of assets – which may generate some ordinary income,[xxvi] or even corporate-level gain if the sale occurs during the corporation’s “recognition period”[xxvii] – followed by a liquidation of the target corporation (which may, itself, generate additional capital gain).[xxviii]

This compensation often takes the form of a “gross-up” in the purchase price for the target S corporation’s stock, such that the shareholders’ after-tax proceeds of a stock sale for which an election is made will be equal in amount to their after-tax proceeds of a stock sale without an election.[xxix]

Significantly, neither of these elections is available where the target is a stand-alone C corporation. Thus, it is imperative that the target corporation’s “S” election be intact at the time of the stock sale.

Which brings us to the letter ruling referenced above.

A Failed “S” Election?

Corp was a C corporation. Its board of directors amended Corp’s articles of incorporation to divide its common stock into shares of class A stock and shares of class B stock. The class A shares retained voting power and the class B shares held no voting power. The class A and class B shares otherwise conferred identical rights to distribution and liquidation proceeds.

The board subsequently amended Corp’s articles for a second time, to change the liquidation rights of the corporation’s stock. After this amendment, the class A and class B shares were entitled to receive equal shares of any assets of Corp in liquidation until a specified amount had been paid to each share. Upon reaching this amount in liquidation proceeds per share, the class B shares were entitled to receive the balance of any remaining assets of the corporation.

Corp later filed an election[xxx] to be taxed as an S corporation for tax purposes. At that time, Corp had only two shareholders.

Somehow unbeknownst to Corp, the election was ineffective because Corp’s two classes of stock prevented it from qualifying as a small business corporation. Corp claimed that its tax advisors were unaware of this amendment.

In addition, according to Corp, at the time this election was filed, its board of directors was either unaware or had forgotten that the distribution and liquidation rights had been changed, and differed for class A and class B shares, as a result of the second amendment to Corp’s articles of incorporation.

Corp indicated that its legal counsel discovered the second amendment,[xxxi] which created two classes of stock, in connection with due diligence performed by counsel in connection with the proposed sale of Corp’s stock by its two shareholders (the “Transaction”).

Upon learning of this issue, Corp’s board amended Corp’s articles prior to the Transaction to reconstitute the class A and class B shares into a single class of stock, with identical rights to distribution and liquidation proceeds, in order to rectify the ineffectiveness of Corp’s S corporation election.

Corp also asked that the IRS recognize the corporation’s status as an S corporation, effective retroactively as of the date requested by its original election.

In support of its request, Corp represented that it and its shareholders filed their respective tax returns consistent with Corp being an S corporation since the time of the failed election.

On the basis of the foregoing facts, the IRS concluded that Corp’s S corporation election was ineffective when made, as a result of the second class of stock that was created by the second amendment to Corp’s articles.

However, the IRS also determined that the circumstances resulting in the ineffectiveness of Corp’s election were inadvertent,[xxxii] and were not motivated by tax avoidance or retroactive tax planning.

The IRS also found that, no later than a reasonable period of time after discovery of the circumstances resulting in the ineffective election, steps were taken so that Corp qualified as a small business corporation.

Thus, the IRS decided to respect the “S” election,[xxxiii] provided that Corp, and each person who was a shareholder of Corp at any time since the date of the election, agreed to make any adjustments to their tax returns – consistent with the treatment of Corp as an S corporation – that may be required by the IRS with respect to the period beginning with what would have been the effective date of the election, through the date of the Transaction.

What If?

Corp and its shareholders were fortunate that the failed election was discovered prior to the consummation of the Transaction. It appears that they had sufficient time before the Transaction to request relief from the IRS, as reflected in the ruling described above.[xxxiv] It also appears that they had an understanding buyer; one that was willing to wait for them to put their tax situation in order.

What if events had unfolded differently?

For one thing, the buyer could have walked away from the deal. There are always other buyers, right? Or are there?

Perhaps the purchase price offered by this buyer was the highest that Corp and its shareholders had received. Or perhaps this buyer was the only one who had agreed to pay a gross-up to Corp’s shareholders in connection with an election to treat the stock sale as a sale of assets. Moreover, this buyer may have been the only one that agreed to pay the entire purchase price at closing, in cash, whereas other suitors had included a promissory note or an earn-out, each payable over a number of years, as part of their consideration for Corp’s stock. Or maybe this buyer had agreed to keep the business at its present location, and to lease such location from the former shareholders of Corp, who happened to own the property in a separate business entity, whereas other potential buyers had planned to consolidate Corp’s business into one of their other locations.

You get the picture.

Another “What If:” The SPA

What if the Transaction had closed without either side being aware of the failed “S” election, and what if the buyer had discovered the failure on its own after the sale? Worse yet, what if the IRS had audited Corp’s returns for the periods ending on or prior to the Transaction?

In the typical stock purchase agreement, the buyer asks that the sellers and the target S corporation make certain representations as to their stock ownership and as to the business and legal condition of the corporation. As in the case of other representations, these play a due diligence function in that the seller’s willingness to make a certain representation, or to schedule an exception to the representation, will disclose facts that are important to the buyer.

The representations also afford the buyer the opportunity to walk away from a deal where the closing occurs some period after the SPA has been executed by the parties.[xxxv] The sellers will state that their representations were accurate on the execution date, and will continue to be accurate through the closing. To the extent there is a “material” change in the accuracy of a particular representation, or if the buyer discovers that a representation is incorrect, then the buyer may call off the deal.

Finally, if the buyer suffers an economic loss after the closing that is attributable to an inaccurate representation, the buyer make seek to be indemnified by the sellers on account of the breached representation. The fact that the buyer had been given the opportunity to examine the target corporation’s records and documents prior to the sale will not provide a defense for the sellers.[xxxvi]

In the case of a target S corporation, the buyer may ask for the following representations and covenants (among many others) from the corporation and its shareholders: that the target S corporation has been a validly electing S corporation at all times, and will continue as such through the closing; that the corporation is not liable for the built-in gains tax; that they will not revoke the corporation’s “S” election, or take any action, or allow any action to be taken, that would result in the termination of such election (other than the sale to the buyer); and, at buyer’s option, that they will make an election to treat the stock sale as an asset sale for tax purposes.

Fast forward. The stock sale is completed and the target corporation is now a subsidiary of the buyer. The buyer subsequently learns that the target’s “S” election was either ineffective or had been lost prior to the closing of the stock sale. The buyer realizes that its newly acquired subsidiary was, in fact, a C corporation during the period preceding its acquisition.

As a result, the new subsidiary is liable for corporate-level income taxes for tax periods ending on or before the date of its acquisition by the buyer.

What’s more, the buyer and/or sellers’ election to treat the stock sale as a sale of assets was also ineffective. Consequently, the buyer did not obtain a recoverable basis step-up for the assets of its new subsidiary.

In addition, the buyer’s gross-up payment to the former shareholders of the target corporation need not have been made.

In short, the immediate economic result to the buyer from its purchase of the target corporation’s stock is substantially different from what it had planned, bargained for, and expected.

The buyer looks to the sellers to indemnify it for these economic losses. The buyer may be able to “recover” part of this loss from any portion of the purchase price that it had withheld, whether in the form of a promissory note, an escrow arrangement, or otherwise. The buyer may also have to seek recovery directly from the sellers.

In short, the economic result for the sellers is substantially different from what they had planned, bargained for, and expected.

Ease Their Pain

If the shareholders of an S corporation were honest with themselves, this is the point at which they wish they had listened to the very simple and straightforward counsel of their tax and corporate advisers.[xxxvii]

Among the nuggets of advice most often ignored by shareholders are the following:

  • Enter into a shareholders’ agreement that includes transfer restrictions, as well as other safeguards, for preserving the corporation’s “S” status, including the buyout of shares where necessary;
  • Require shareholders to share their estate plans (on a confidential basis) with the corporation’s counsel, so as to avoid any surprise transfers of their shares at their demise (like a transfer to a nonresident alien);
  • Require shareholders to cooperate in restoring the corporation’s “S” election in the event it is inadvertently lost;
  • Do not amend any corporate organizational or governing documents, and do not enter into any commercial agreements with shareholders, without first seeking tax counsel’s advice;
  • Do not issue any convertible debt instruments without first seeking counsel’s advice;
  • Do not issue equity-based compensation without first seeking counsel’s advice;
  • Keep meticulous and contemporaneous records of any and all stock transfers;
  • Provide for a drag-along right by which a majority shareholder may compel a minority shareholder to join in the sale of the corporation’s stock; and
  • Require minority shareholders to join in making an election, at the option of the majority owner, to treat a stock sale as a sale of assets.

Granted, some of these are more easily attainable than others; for example, a minority shareholder may resist some of these suggestions.

One truth that cannot be disputed, however, is the following: a business owner should start to prepare for the sale of their business as soon as they go into business; they should act accordingly throughout the life of the business; getting the business “ready” for a sale is not something that they can adequately address just prior to the sale.


[i] For example, the infusion of equity from an investment partnership, or from an investor who wants a preferred return in exchange for their capital contribution, perhaps in the form of convertible preferred stock.

[ii] An entity that is not, itself, taxable, but the income, loss, etc., of which passes through to its owners.

[iii] PLR 201935010.

[iv] IRC Sec. 1361(b)(1)(D).

The term “S corporation” means, with respect to any taxable year, a small business corporation for which an election under Sec. 1362(a) is in effect for such year.

IRC Sec. 1361(b)(1) defines a “small business corporation” as a domestic corporation which is not an “ineligible” corporation and which does not (A) have more than 100 shareholders, (B) have as a shareholder a person (other than an estate, a trust described in Sec. 1361(c)(2), or an organization described in Sec. 1361(c)(6)) who is not an individual, (C) have a nonresident alien as a shareholder, and (D) have more than one class of stock. Sec. 1362(a)(1) provides that a small business corporation may elect to be an S corporation.

[v] Reg. Sec. 1.1361-1(l).

[vi] IRC Sec. 1361(c)(4).

[vii] Reg. Sec. 1.1361-1(l)(2). It should be noted that other arrangements may be treated as creating a second class of stock if a principal purpose thereof is to circumvent the one class of stock requirement.

[viii] IRC Sec. 1361(b).

[ix] IRC Sec. 1362.

[x] IRC Sec. 1366. These amounts will be reflected on the Schedule K-1 issued by the S corporation to each of its shareholders.

[xi] IRC Sec. 1363. There are exceptions; for example, where the built-in gain rule applies. IRC Sec. 1374.

[xii] IRC Sec. 1366(b).

[xiii] We’ll consider only a couple of the factors that favor an asset deal over a stock deal. There are others, including, for example: the target corporation’s ability to sell its assets to the buyer even in the face of opposition from some minority shareholders (though the sale may trigger dissenter’s rights); and the buyer’s ability to select which assets it wants to acquire, and which liabilities it will assume.

Speaking of recalcitrant shareholders, this is where the absence of a shareholders’ agreement with a drag-along provision may be felt keenly.

[xiv] Indirectly; in a sense, the buyer steps into the shoes of the selling shareholders.

[xv] Sellers in a stock deal are always asked to represent to the buyer that the corporation has no liabilities, obligations or commitments of any nature whatsoever, asserted or unasserted, known or unknown, absolute or contingent, accrued or unaccrued, matured or unmatured or otherwise, except (a) those which are adequately reflected or reserved against in the balance sheet [as of a specified date], and (b) those which have been incurred in the ordinary course of business consistent with past practice since the [date of the balance sheet] and which are not, individually or in the aggregate, material in amount.

[xvi] Because of this exposure, a stock deal will require more due diligence, which means the expenditure of more time and fees by both the buyer and the seller(s).

It will likely also require the buyer’s holdback or escrowing of a greater portion of the purchase price for a greater period of time.

With respect to the corporation’s tax liabilities, the parties will have to agree as to the preparation of returns, and the payment of any amounts owing, for tax periods ending on or before the closing date, or which begin before the closing and end some time after the closing date.

A related issue will be a more extensive indemnity agreement by the selling shareholders to indemnify the buyer for any losses suffered by the buyer as a result of a breach of a representation by the sellers regarding the state or condition of the target corporation and its business.

[xvii] IRC Sec. 1060 and Sec. 1012. In general, Sec. 1060 requires that the purchase price for the acquisition of the business be allocated among its assets.

[xviii] The cost of which is generally recovered only upon the subsequent sale of the stock or the liquidation of the corporation. IRC Sec. 168(k), Sec. 167, and Sec. 197. The Tax Cuts and Jobs Act (P.L. 115-97) extended the bonus depreciation deduction by allowing a buyer to expense the cost of certain “used” tangible personal assets.

[xix] Note, however, that many contracts include change-in-control provisions pursuant to which the “assignment” of the contract requires the consent of a party where the ownership of the “assigning” party (i.e., the target corporation) changes, as in the case of a stock deal. A large part of the due diligence process involves reviewing the target’s contracts and determining whether such consents are required,

[xx] Or liabilities that are manageable.

[xxi] Where there are too many shareholders with whom to negotiate, or where there are some shareholders who do not want to sell their shares, the stock deal may be structured as a reverse subsidiary merger. The result of such a merger is that the target corporation becomes a subsidiary of the acquiring corporation. For tax purposes, the transaction is treated as a purchase and sale of stock. See, e.g., Rev. Rul. 90-95.

[xxii] IRC Sec. 1221 and Sec. 1222. An individual’s gain from the sale of stock in a corporation (“S” or “C”) is taxed as capital gain; if the gain is long-term, a federal income tax rate of 20-percent will be applied; the same holds true for trusts and estates. IRC Sec. 1(h).

This should be compared to the sale of partnership interests. Although generally treated as the sale of a capital asset, the gain will be treated as ordinary income to the extent the purchase price for the interest is attributable to so-called “hot assets.” IRC Sec. 741 and Sec. 751.

If the selling shareholder did not materially participate in the business of the corporation, the federal surtax of 3.8-percent of net investment income will also apply to the gain. IRC Sec. 1411.

[xxiii] Congress recognized that there are circumstances in which the buyer has a bona fide business (non-tax) reason to acquire the stock of a target corporation. In some such cases, Congress decided it would be improper for the buyer to give up its ability to recover its purchase price for tax purposes; i.e., to have to choose between good business decision and a tax benefit. The result was the elections discussed below.

[xxiv] IRC Sec. 338(h)(10); Reg. Sec. 1.338(h)(10)-1.

[xxv] IRC Sec. 336(e); Reg. Sec. 1.336-1 through -5. It should be noted, if the buyer of the target’s stock does not want the sellers to make a Sec. 336(e) election, it should include a prohibition of such an election in the stock purchase agreement; specifically, a covenant not to make the election.

[xxvi] You’ll recall that the character of the gain – for example, ordinary income from the sale of receivables, or depreciation recapture from the sale of machinery – passes through to the target S corporation’s shareholders. The maximum federal tax rate for ordinary income included in the gross income of an individual is 37-percent.

[xxvii] IRC Sec. 1374.

[xxviii] IRC Sec. 331; Sec. 1371.

[xxix] The gross-up amount paid by the buyer will end up being allocated to the target’s goodwill and going concern value, and will be amortizable over 15 years under IRC Sec. 197.

[xxx] IRS Form 2553.

[xxxi] Presumably, counsel did not prepare or file the second amendment.

[xxxii] Within the meaning of IRC Sec. 1362(f).

[xxxiii] Assuming that Corp met all of the other requirements for status as a small business corporation.

[xxxiv] Or perhaps they asked for expedited handling.

[xxxv] As opposed to signing and closing on the same day.

[xxxvi] Query whether the sellers’ and the target’s attorneys have done their own diligence.

[xxxvii] “You can pay us now to fix the problem, and avoid bigger issues down the road,” they said, “or you can ignore us now, and pay a lot more to someone else down the road.”

The Tax Gene?

King of Swamp Castle: One day, lad, all this will be yours.

Prince Herbert: What, the curtains?

King: No, not the curtains, lad. I’m talking about all of my business and investment interests, along with the related tax reporting positions.[I]

Have you ever wondered how much our parental genes define us? What about the impact of external factors?

It is a scientific fact that an individual’s genetic make-up, as passed down to them from their parents, influences their physical characteristics, and even their behavior. Each of us, therefore, “owes” a great deal to our parents for who were are.

It has also been scientifically established that the environment in which one is raised plays a significant role in one’s development as an individual. Poverty and poor nutrition, for example, may greatly influence whether one’s genetic abilities will ever be fully realized. These factors may also be attributed to who our parents were.[ii]

Until recently, however, I never seriously considered whether a parent’s tax reporting position – of all things – may be passed on to their child in such a way that it is determinative of the child’s own tax reporting. Surprisingly, that seemed to be the argument that the IRS made in a case decided by the Tax Court last week.[iii]

Dad’s Interest Expense

Dad was a real estate entrepreneur who owned[iv] a 50-percent interest in each of several partnerships (the “Partnerships”) that owned, operated, and actively managed rental real estate. The remaining interest in each partnership was held by an unrelated person.

The Partnerships borrowed money from Bank and distributed the proceeds to Dad and his partner.[v] The terms of the loans were substantially similar. Each loan had a 5.88% interest rate, and was evidenced by a note that was secured by the partnership’s assets. Neither Dad nor his partner was personally liable on the notes.[vi]

Dad invested the funds distributed to him in money market funds and other investment assets, which he held until his death.

Of course, the Partnerships incurred interest expense on the Bank loans. Each partnership issued to Dad for each year a Schedule K-1, Partner’s Share of Income, Deductions, Credits, etc., reporting his distributive shares of its rental real estate income and of its interest expense.

On his federal income tax return for each year, Dad reported his distributive shares of the interest expense on the loans as “investment interest.”[vii]

Father to Son

A couple of years before his death, Dad transferred to Son, by gift, his ownership interests in the Partnerships.[viii] Son agreed to be bound by each Partnership’s operating agreement,[ix] but he did not become personally liable on any of the Bank loans.

However, by “gratuitously” transferring his interests in the Partnerships to Son, Dad was relieved of his shares of the partnership liabilities represented by the loans.

On his federal income tax return for the year of the gift, Dad treated the nonrecourse partnership liabilities of which he was “relieved” as amounts realized on the gift transfers of his partnership interests.[x] Accordingly, Dad reported taxable capital gains to the extent the amount realized exceeded his adjusted basis in his partnership interests.[xi]

Son’s Interest Expense

The Partnerships paid interest on these loans, and issued Schedules K-1 to Son reporting his distributive shares of the Partnerships’ rental real estate income and of the interest expense attributable to the Bank loans.

Son filed his federal income tax return on IRS Form 1040, to which he attached Schedule E, Supplemental Income and Loss.[xii] He took the position that the interest paid by the Partnerships on the Bank loans was not “investment interest,” as it had been in the hands of Dad, because Son had not received any of the loan proceeds, and had not used any partnership distributions to acquire investment assets.

Rather, Son treated the interest as having been paid on indebtedness properly allocable to the Partnerships’ real estate assets, and thus treated his distributive shares of the interest expense as fully deductible against his distributive shares of the Partnerships’ real estate income. Accordingly, on each Schedule E, Son netted against the rental income for each partnership the corresponding amount of interest expense.

The IRS Disagrees

The IRS examined Son’s tax returns and issued a timely notice of deficiency in which it asserted that Son’s distributive shares of the interest paid by the Partnerships on the Bank loans should properly have been reported on the Schedules A of his Forms 1040 as investment interest – the way Dad had reported the interest.

Investment interest, the IRS pointed out, is deductible only to the extent of a taxpayer’s “net investment income.” Because Son had insufficient investment income to utilize the interest expense allocated to Son by the Partnerships, the IRS disallowed the deductions for all of the passed-through interest attributable to the Bank loans.[xiii]

Son then timely[xiv] petitioned the U.S. Tax Court for a redetermination of the deficiencies resulting from the disallowed deduction.[xv]

Interest Deductions

The Code generally provides that “[t]here shall be allowed as a deduction all interest paid or accrued within the taxable year on indebtedness,”[xvi] but this rule is subject to a number of limitations.

For example, in the case of taxpayers other than corporations, “personal interest” is generally nondeductible.[xvii]

However, nondeductible personal interest is defined to exclude (among other things) “interest paid or incurred on indebtedness properly allocable to a trade or business,” and any interest which is taken into account in computing income or loss from a passive activity.”[xviii]

Personal interest also excludes “any investment interest.”[xix]

Investment Interest

The IRS contended that the interest paid by the Partnerships on the Bank loans, part of which was passed through to Son,[xx] constituted “investment interest.”

Investment interest is defined as interest that is “paid or accrued on indebtedness properly allocable to property held for investment.”[xxi]

The Code allows a deduction for investment interest, but subject to a limitation. Specifically, it provides that, “[i]n the case of a taxpayer other than a corporation, the amount allowed as a deduction * * * for investment interest for any taxable year shall not exceed the net investment income of the taxpayer for the taxable year.”[xxii]

The interest in question was incurred by the Partnerships. These entities owned, operated, and actively managed apartment buildings and other rental real estate. The loans on which the interest was paid were secured by those real estate assets.

The IRS did not contend, however, that the operating assets held by the Partnerships constituted “property held for investment.”

How, then, could the IRS treat Son’s share of the Partnerships’ interest expense as investment interest?

Tracing the Debt Proceeds

The Court explained that tracing rules are utilized for determining when debt is “properly allocable to property held for investment.”[xxiii]

In general, according to these rules, “[d]ebt is allocated to expenditures in accordance with the use of the debt proceeds and * * * interest expense accruing on a debt * * * is allocated to expenditures in the same manner as the debt is allocated.”[xxiv] In other words, “debt is allocated by tracing disbursements of the debt proceeds to specific expenditures.”[xxv]

For example, if a taxpayer uses debt proceeds to make a personal expenditure, the interest is treated as nondeductible personal interest. If a taxpayer uses debt proceeds in connection with a passive activity, the interest is subject to the passive loss limitations.[xxvi] And if a taxpayer uses debt proceeds to make “an investment expenditure,” the interest incurred on the debt is allocable to such investment expenditure, and the interest is treated, for purposes of the interest deduction disallowance rule, as investment interest.[xxvii]

Although the tracing rules do not specify how they are to be applied to partnerships and their partners, the IRS has provided that, if a partnership uses debt proceeds to fund a distribution to its partners – i.e., to make debt-financed distributions – each partner’s use of the proceeds determines whether the interest passed through to them constitutes investment interest.[xxviii]

Thus, if a partner uses the proceeds of a debt-financed distribution to acquire property that they hold for investment, the corresponding interest expense incurred by the partnership and passed on to the partner will be treated as investment interest.

In short, if a taxpayer uses debt proceeds to acquire an investment, the interest on that debt is investment interest regardless of whether the debt originated in a partnership.

The Issue

Reduced to its essentials, the question before the Court was whether Son – who had acquired interests in the Partnerships by gift from Dad – was required to treat the interest expense passed through to him in the same manner as Dad.

The IRS argued that Son in effect stepped into Dad’s shoes, with the supposed result that the interest, properly reported by Dad as investment interest, remained investment interest as to Son so long as the loans remained on the Partnerships’ books.

Dad received debt-financed distributions from the Partnerships. He used the proceeds of those distributions to acquire shares of money market funds and other assets that he held for investment. Consistently with the tracing rule, Dad properly treated the interest expense incurred by the Partnerships and passed through to him as investment interest.

Son, however, did not receive, directly or indirectly, any portion of the debt-financed distributions that the Partnerships made to Dad. Nor did Son use distributions from the Partnerships to make investment expenditures.

The Court determined that the facts which caused the passed-through interest to be investment interest in Dad’s hands did not apply to Son.

Acquisition Indebtedness?

The Court then explained how debt should be allocated where (as in Son’s case) no loan proceeds were disbursed to a taxpayer:

If a taxpayer incurs or assumes a debt in consideration for the sale or use of property * * * or takes property subject to a debt, and no debt proceeds are disbursed to the taxpayer, the debt is treated * * * as if the taxpayer used an amount of the debt proceeds equal to the balance of the debt outstanding at such time to make an expenditure for such property * * *.

Son acquired his ownership interests in the Partnerships by gift from Dad. He acquired those interests subject to the Bank debts that were then on the Partnerships’ books. Thus, Son was treated as using his allocable share of that debt to make an expenditure for the acquisition of his partnership interests.[xxix]

In the case of a debt-financed acquisition (as opposed to a debt-financed distribution), such as the purchase of an interest in a partnership, the Court explained that the debt proceeds and the associated interest expense should be allocated among all the assets of the partnership “using any reasonable method.”

In short, whereas Dad received a debt-financed distribution, Son was treated as having made a debt-financed acquisition of the Partnership interests he acquired from Dad. For purposes of the investment interest limitation, therefore, the debt proceeds were allocated among all of the Partnerships’ real estate assets, and the interest paid on the debt was allocated to those assets in the same way.[xxx]

Because the Partnerships’ real estate assets were actively managed operating assets, they did not constitute “property held for investment.” Therefore, the interest paid on the Bank loans was not investment interest.

The IRS’s Alternative Argument

The IRS disputed the relevance of the tracing rules, urging that Son, when acquiring the Partnership interests from Dad, did not “assume[] a debt” or “take[] property subject to a debt.” The IRS emphasized that Son had no personal liability on the Bank loans, which were nonrecourse, and that the liens held by Bank ran against the Partnerships’ real estate assets, not against Son’s partnership interests.

The Court rejected the IRS’s position. In fact, it pointed out that the IRS itself had previously reasoned that, where partnership interests are transferred, each transferring partner’s share of partnership nonrecourse liabilities would be considered as a liability to which the partnership interest was subject.

Thus, Son acquired his interests in the Partnerships subject to the Bank debts, even though Son did not personally assume those debts, which remained nonrecourse with respect to the partners individually.

In the converse situation, the Court continued, where a partner sells a partnership interest, the regulations provide that the partner’s “amount realized” includes his share of the partnership liabilities of which he is relieved, even if the liabilities are nonrecourse.[xxxi]

Thus, the fact that a partner is not personally liable for a partnership’s debt does not mean that their partnership interest is not “subject to a debt” for purposes of the partnership tax rules.

The Court’s Decision

For the foregoing reasons, the Court concluded that the interest expense passed through to Son from the Partnerships was not investment interest.

The Court noted that, even if the tracing rules were somehow inapplicable, the IRS failed to articulate any principle or rule that would affirmatively require the interest expense in question to be characterized as investment interest. According to the Court, the principle that required such interest to be characterized as investment interest in Dad’s hands clearly did not apply because Son (unlike Dad) did not receive any debt-financed distributions from the Partnerships.

The IRS’s position thus was reduced, the Court stated, to the contention that, because Son acquired the partnership interests from Dad, he stood in Dad’s shoes and had to treat the passed-through interest the same way Dad did. But, the Court continued, neither the investment interest limitation rule nor its implementing regulations include any family attribution rule or similar principle that would require this result.

Purchase and Sale

When Dad gratuitously transferred interests in the Partnerships to Son, he was required to include the partnership debt from which he was relieved[xxxii] as an “amount realized,” and he reported capital gains accordingly. To the extent Dad was relieved of the debt, liability was necessarily shifted to the other partners, including Son. Son thus took his Partnership interests “subject to the debt,” even though the liabilities were nonrecourse.

It seemed obvious, the Court explained, that Son would have no “investment interest” if he had acquired his ownership interests in the Partnerships from a third party for cash. The IRS did not explain why the result should be different because Son acquired those interests from Dad by a partial gift. The Court determined that the IRS failed to articulate a principle that would justify characterizing the interest expense passed through to Son as “properly allocable to property held for investment” by Son.

Once Investment Interest . . . ?

The IRS then urged the Court to adopt a “once investment interest, always investment interest” rule on the theory that any other approach would “place a myriad of additional administrative burdens on both taxpayers and the government.”

Again, the Court turned the IRS away, pointing out that both the tracing rules and the partnership tax rules clearly dictated different outcomes depending on whether a partner received a debt-financed distribution or made a debt-financed acquisition.

Recognition that partnership interests may change hands, the Court observed, was thus an inherent part of the regulatory structure.

In sum, the Court held that the interest expense passed through to Son from the Bank loans was not investment interest. When Son acquired the partnership interests from Dad, he was in the same position as any other person who acquired partnership interests encumbered by debt. He did not receive the proceeds of those debts, and he did not use the proceeds of those debts to acquire property that he subsequently held for investment. Thus, there was no justification for treating the interest expense passed through to him as investment interest. Rather, Son correctly reported it on Schedule E as allocable to the real estate assets held by the Partnerships.

Are There Tax Genes?

So, was the IRS crazy to argue that Dad’s tax treatment of the interest expense should have determined Son’s treatment as well?

Probably, but not entirely.[xxxiii]

When one individual transfers a partnership interest to another by gift, the recipient generally takes the interest with an adjusted basis equal to the donor’s adjusted basis in the interest.[xxxiv] In this way, the unrealized gain in the donor’s hands is preserved when the property is transferred to the recipient.

In addition, the recipient of the gifted partnership interest will take the donor’s holding period for the interest gifted, thereby preserving the long-term/short-term character of any capital gain inherent in the property.[xxxv]

The donor’s amount at risk with respect to the gifted partnership interest will be added to the recipient’s amount at risk for such interest.[xxxvi]

When a donor gifts a partnership interest in a passive activity, the adjusted basis for the interest is increased by the amount of the donor’s suspended passive losses allocable to such interest, in effect allowing the recipient to utilize such losses in determining their gain on a subsequent taxable disposition; the gift is not treated as a disposition that would allow the donor to utilize such losses.[xxxvii]

In the case of a gift of a partnership interest in which the donor has a Section 754 basis adjustment, the donor is treated as transferring, and the recipient as receiving, that portion of the basis adjustment attributable to the gifted partnership interest.[xxxviii]

Likewise, when an individual makes a gift of a partnership interest that they received in exchange for a contribution of built-in gain property[xxxix] to the partnership, the built-in gain will be allocated to the recipient as it would have been allocated to the donor.[xl]

Unfortunately for the Service, there are just as many instances in which the recipient of a gift of property does not step into the shoes of the donor. In general, these instances involve the application of rules where the relationship of the gift recipient to the property interest at issue rightly supplants that of the donor.

For example, the recipient of a gift of real property that had been used by the donor in a trade or business cannot rely upon the donor’s use for purposes of themselves engaging in a like kind exchange with such property; rather, the recipient must establish their own qualifying use of the property.[xli]

Most importantly insofar as Dad and Son are concerned, the otherwise gratuitous transfer of property that is encumbered by indebtedness – or, in the case of a partnership interest, to which debt has been allocated under the partnership tax rules[xlii] – is treated as a sale and purchase of such interest to the extent of such indebtedness.

As in the case of any sale between unrelated persons, the buyer takes a cost basis in the property acquired, and begins a new holding period for such property. The buyer determines their own at-risk-amount, and ascertains whether the property constitutes an interest in an activity in which the buyer materially participates, without regard to the seller’s history. And the buyer determines their own relationship to the property for purposes of the limitations on the deduction of interest.

So, to the question of whether a parent’s personal tax traits can be genetically passed down to their children, the answer is no.[xliii]

————————————————————————————————————-

*Of course, the reference is from the Old Testament, appearing first in Exodus, Chapter 20 (the presentation of the Ten Commandments): “For I the LORD your God am a jealous God, visiting the iniquity of the fathers upon the sons to the third and fourth generation of those that hate me, and showing mercy to thousands of those that love Me and keep My commandments.”

[i] With sincerest apologies to Monty Python. What follows is the complete dialogue from this scene in Monty Python and the Holy Grail:

King of Swamp Castle: One day, lad, all this will be yours.
Prince Herbert: What, the curtains?
King: No, not the curtains, lad.
King: I built this kingdom up from nothing. When I started, all I had was swamp! Other kings said I was daft to build a castle on a swamp, but I built it all the same, just to show ’em! It sank into the swamp, so I built a second one. That sank into the swamp. I built a third one. It burned down, fell over, and then it sank into the swamp. But the fourth one stayed up! And that’s what you’re going to get, lad–the strongest castle on these islands!
King: Listen, lad, in twenty minutes you’re going to be married to a girl whose father owns the biggest tracts of open land in Britain.
Prince Herbert: But I don’t want land.
King: Listen, Alice–
Prince Herbert: Herbert.
King: Herbert. We built this castle on a bloody swamp, we need all the land we can get!
Prince Herbert: But I don’t like her.
King: Don’t like her? What’s wrong with her?! She’s beautiful, she’s rich, she’s got huge . . . tracts of land.

[ii] Fate? Karma? The alignment of the stars and planets? Just dumb luck? According to the character in the movie, A Knight’s Tale, “from peasant to knight, one man can change his stars.”

[iii] Lipnick v. Commissioner, Docket No. 1262-18; filed August 28, 2019.

[iv] Directly and through a grantor trust. IRC Sec. 671.

[v] Dad received over $22 million. One of the most attractive characteristics of a real estate partnership is its ability to borrow against the equity in the property, to thereby increase its partners’ adjusted bases for their partnership interests, and to distribute the loan proceeds to its partners without causing an immediate taxable event. IRC Sec. 752(a), Sec. 722, and Sec. 731(a).

[vi] The debt was nonrecourse as to them; Bank could only look to the partnership properties securing the debt for satisfaction of the debt.

[vii] On Schedule A of his IRS Form 1040.

[viii] I assume that Dad filed a federal gift tax return on IRS Form 709.

[ix] At this point, presumably, Son was admitted as a partner, and ceased to be a mere transferee with only an economic interest in the Partnerships.

[x] IRC Sec. 752(d); Reg. Sec. 1.752-1(h), and Sec. 1.1001-2(a)(4)(v).

[xi] In other words, Dad’s transfer to Son was part-gift/part-sale; he was treated as having sold (and as having received consideration for) an interest with a fair market value equal to the amount of debt relieved; the equity portion of the interest constituted a gift.

[xii] Part II is used to report income/loss from partnerships, among other things.

[xiii] The disallowed amount is carried forward.

[xiv] In general, 90 days from the date of the notice of deficiency.

[xv] The parties submitted the case for decision without trial.

[xvi] IRC Sec. 163(a).

[xvii] IRC Sec. 163(h).

[xviii] IRC Sec. 163(h)(2)(A), (C).

[xix] IRC Sec. 163(h)(2)(B); IRC Sec. 163(d).

[xx] IRC Sec. 702.

[xxi] IRC Sec. 163(d)(3)(A).

[xxii] IRC Sec. 163(d)(1).

Son had little net investment income for the tax years in issue (meaning, interest, dividends, annuities, royalties, and net capital gain – see IRC 163(d)(5) and Sec. 469(e)). Accordingly, he agreed that, if the interest in question constituted “investment interest” under Sec. 163(d), it would be nondeductible. And the IRS agreed that, if the interest was not investment interest, it was properly reportable and deductible on Son’s Schedule E.

[xxiii] Sec. 163(d)(3)(A); see Sec. 1.163-8T, Temporary Income Tax Regs., 52 Fed. Reg. 24999 (July 2, 1987).

[xxiv] Sec. 1.163-8T(c)(1).

[xxv] Reg. Sec. 1.163-8T(a)(3).

[xxvi] Sec. 469; Reg. Sec. 1.163-8T(a)(4)(ii), Example (1).

[xxvii] Reg. Sec. 1.163-8T(a)(4)(i)(C).

[xxviii] Notice 89-35.

[xxix] The flip-side of the part-gift/part-sale is the part-gift/part-purchase.

[xxx] Reg. Sec. 1.163-8T(c)(1).

[xxxi] Reg. Sec. 1.752-1, 1.1001-2(a)(4)(v), stating that a taxpayer’s “amount realized” on transfer of a partnership interest includes the nonrecourse liabilities of which he is relieved, where the transferee “takes the partnership interest subject to the * * * liabilities.”

For purposes of the partnership tax rules, generally, any increase or decrease in a partner’s share of partnership liabilities is treated as a deemed contribution or distribution, regardless of whether the debt is recourse or nonrecourse. Sec. 752; Sec. 1.752-1.

[xxxii] More accurately, which was allocated away from him and to Son in accordance with the regulations under Section 752 of the Code.

[xxxiii] “There’s a big difference between mostly dead and all dead.” – Miracle Max, from The Princess Bride.

[xxxiv] IRC Sec. 1015.

[xxxv] IRC Sec. 1223.

[xxxvi] Prop. Reg. Sec. 1.465-68.

[xxxvii] IRC Sec. 469(h). That being said, an activity that may have been passive as to the donor may not be treated as passive as to the recipient.

[xxxviii] Reg. Sec. 1.743-1(f).

[xxxix] IRC Sec. 704(c).

[xl] Reg. Sec. 1.704-3(a)(7).

[xli] See, e.g., Rev. Rul. 75-292.

[xlii] IRC Sec. 752 and the regulations issued thereunder.

[xliii] As distinguished from an aversion to paying tax, which is probably a product of both nature and nurture.

A Time for Planning?

It’s late August – again. As usual, many business owners are looking forward to having all of their employees back at work and ready to make the final push for a successful year.[i] Others, nearing retirement, and who may be contemplating the arrival of another winter, are considering whether it is time for a move to a warmer climate.[ii]

It may also occur to some of these owners – especially after having vacationed with their children and grandchildren – that it was time they planned for the transfer of their business interests or investment assets. Most of them have already been making so-called “annual exclusion gifts” to various family members.[iii] They may recall their advisers having told them about the greatly increased federal estate and gift tax exemption,[iv] and they may even remember that this benefit is scheduled to expire after December 31, 2025, if it is not eliminated sooner.[v]

With these thoughts in mind, a number of these business owners will visit their advisers to discuss the available estate and gift planning options, especially with respect to equity interests[vi] in their business. The advisers will likely tell them about outright gifts and gifts in trust,[vii] about installment sales and sales to grantor trusts,[viii] about GRATs,[ix] and about the importance of having a shareholders’ agreement or a partnership/operating agreement in place prior to making such transfers.[x]

Hopefully, the business owner will also be alerted to the possibility that regulations which were proposed by the IRS in 2016 – but withdrawn in 2017 – may be reintroduced after 2020;[xi] in that case, they could present a significant impediment to the tax efficient gift or testamentary transfer of interests in a closely held business.

The business owner is also likely to hear about the importance of retaining a knowledgeable and experienced appraiser, and of having a well-reasoned appraisal report to support any transfer of their business interests, whether by gift or by sale.[xii] A recent Tax Court decision illustrated the wisdom of this advice.[xiii] In the process, it also raised an interesting valuation issue.

The Gifts

Parent owned 49-percent of the voting stock, and 96% of the non-voting stock, of an “S” corporation[xiv] (“Corp”) that operated a lumber mill. The remaining outstanding shares were owned by members of Parent’s family.

The Corporation

Under the terms of a buy-sell agreement, the shareholders could not transfer their Corp stock unless they did so in compliance with the agreement. Any sale of stock that caused Corp to cease to be an S corporation would be null and void under the agreement, unless Corp and shareholders of a majority of its outstanding shares gave their consent. If a shareholder intended to transfer their Corp stock to a person other than a family member, the shareholder had to notify Corp, which had the right of first refusal with respect to those shares. If Corp declined to purchase the shares, the other shareholders were given the option to purchase them. If Corp or the other shareholders exercised their option to purchase shares, the purchase price would be the fair market value of the shares. Fair market value, for purposes of the agreement, was to be mutually agreed upon or, if the parties could not come to an agreement, determined by an appraisal. Under agreement, the reasonably anticipated cash distributions allocable to the shares had to be considered, and discounts for lack of marketability, lack of control, and lack of voting rights had to be applied in determining the fair market value.

The Partnership

Corp was the general partner of a limited partnership (“Partnership”) that invested in, acquired, held and managed timberlands which provided Corp’s inventory. Partnership was organized for the purpose of ensuring Corp with a steady stream of timber, and sold almost all of its production to Corp.

The ownership of the two entities was almost identical. In addition, Corp’s management team (paid by Corp) managed Partnership, and Partnership paid Corp a fee for administrative services, including human resources, legal services, and accounting. The companies also lent money to each other (for which interest was charged), sending cash where it was most needed.[xv]

Beyond that, Corp used Partnership’s property to secure bank loans that were integral to Corp’s operations,[xvi] and that allowed it to maintain cash flow at times when a loan would not otherwise have been available. The companies were joint parties to these third party credit agreements, but the loans were reported on Partnership’s books because its property served as collateral.

Corp had broad powers as the general partner of Partnership, including the powers to buy, sell, exchange, and encumber partnership property. The limited partners (which included Parent and members of their family) did not participate in Partnership’s management, although they had the right to vote on the continuation of the partnership, the appointment of a successor general partner, the admission of an additional general partner, the dissolution of the partnership, and amendments to the partnership agreement. The unanimous consent of all partners was required to admit an additional general partner or to dissolve Partnership.

Under the partnership agreement, limited partners were restricted in their ability to transfer their interests in Partnership. No transfer of partnership units was valid if it would terminate the partnership for tax purposes. The consent of all partners was required for the substitution of a transferee of partnership units as a limited partner. A transferee who was not substituted as a limited partner would be merely an assignee of allocations of partnership profits and loss. Limited partners were also subject to a buy-sell agreement, which restricted transfers of their interests in Partnership. It mirrored Corp’s buy-sell agreement.

The Trusts

Parent formulated a succession plan with the goal of ensuring that the business remained operational “in perpetuity.”[xvii] As part of this plan, Parent created various trusts (including generation skipping trusts) for the benefit of their issue.[xviii] Parent gifted over 26-percent of their Corp voting shares and all of their non-voting shares to these trusts. Parent also gifted over 70-percent of their limited partnership interests in Partnership to the trusts.

The Dispute

Parent filed a federal gift tax return[xix] for the above transfers. The return included an appraisal report which valued the Corp voting and non-voting shares, as well as the Partnership limited partnership units.

The IRS examined Parent’s return and determined that the fair market values of the equity interests transferred had been understated on the return.

Parent petitioned the U.S. Tax Court.[xx]

Valuation Standard

The Court began by explaining that the fair market value of property transferred as a gift is “the price at which it would change hands between a willing buyer and a willing seller, neither under any compulsion to buy or sell and both having reasonable knowledge of the relevant facts.” The willing buyer and seller are hypothetical persons, not any specific or named person.

Closely Held Business: Relevant Factors

When determining the fair market value of unlisted stocks for which no recent sales or bids have been made, the Court explained, several factors should be considered, including: the company’s net worth, its earning power and dividend-paying capacity, its goodwill, the economic outlook in the industry, its management and its position in the industry, the degree of control of the business represented in the block of stock to be valued, and the value of stock in similar, publicly traded companies.[xxi] When determining the fair market value of an interest in a partnership, the value of the partnership’s assets may be considered, along with the same factors considered in determining the fair market value of stock.[xxii]

Income vs Asset Approach

Parent’s valuation expert (“Expert”) valued Partnership and Corp as going concerns,[xxiii] and relied on an income approach – specifically the discounted cash-flow method – and a market approach in valuing the units of Partnership and Corp that were transferred as gifts. Expert determined a value for these interests on a non-controlling, nonmarketable basis, after adjustments and discounts.

The IRS also valued Partnership as a going concern,[xxiv] but relied on an asset-based approach – specifically, the net asset value method – and a market approach in valuing one Partnership limited partnership unit. After applying adjustments and discounts, the IRS determined the value of Partnership on a non-controlling, nonmarketable basis.

The Court noted that it was not bound to follow the opinion of any expert where it was contrary to the Court’s own judgment, stating that it may adopt or reject an expert’s opinion in whole or in part. The Court emphasized that valuation is a question of fact, and the factors considered in determining value should be weighed according to the circumstances in each case.

The Court continued by describing the three generally accepted approaches that are used to value equity interests in closely held businesses: the income approach, the market approach, and the asset-based approach.

The income approach uses either the direct capitalization method[xxv] or the discounted cash-flow method[xxvi] to convert the anticipated economic benefits that the holder of the interest would stand to realize into a single present-valued amount.

The market approach values the interest by comparing it to a comparable interest that was sold at arm’s length in the same timeframe, accounting for differences between the companies by making adjustments to the sale price.

The asset-based approach values the interest by reference to the company’s assets net of its liabilities.

The Court observed that, when valuing an operating company that sells products or services to the public, the company’s income receives the most weight. When valuing a holding or investment company, which receives most of its income from holding debt, securities, or other property, the value of the company’s assets receives the most weight.

The primary dispute between the parties was whether Partnership should be valued using an income approach or an asset-based approach.[xxvii]

Operating vs Holding Company

Parent contended that Partnership was an operating company that sold a product – logs – and, therefore, should be valued as a going concern with primary consideration given to its earnings.

The IRS, on the other hand, contended that Partnership was a holding company and, therefore, the value of its underlying assets[xxviii] should be given primary consideration in the valuation.

Parent rejected the IRS’s asset-based valuation because there was no likelihood of Partnership’s selling its assets.

According to the Court, not all companies lend themselves to be characterized as simply an operating company or a holding/investment company. The Court gave the example of a company whose real property plays a significant role in its income-producing operations.

When valuing an interest in a company that has aspects of both an operating company and a holding or investment company, the Court stated that it would not “restrict [its] consideration to only one approach to valuation”.

The Court pointed out that Partnership’s timberlands were its primary asset, and they would retain and increase in value, even if Partnership was not profitable on a year-to-year basis. Therefore, it may be appropriate to consider an asset-based approach in valuing an interest in Partnership. However, the Court noted that Partnership was also an operating company that planted trees and harvested and sold the logs; it also expended significant time, effort and capital to ensure that its operations were efficient.

Thus, Partnership was different from a holding or investment company, such that an income approach may be appropriate in valuing an equity interest therein.

A Combined Approach?

The Court concluded that Partnership had aspects of both an operating company and an investment or holding company. Because Partnership did not fit neatly into either category, the Court suggested that a valuation that combined consideration of Partnership’s earnings and of its assets, and that weighted each appropriately, may be necessary.

An asset-based approach, the Court stated, necessarily assumes access to the value of Partnership’s underlying assets through a hypothetical sale. The likelihood that Partnership would sell its assets went to the relative weight to be given an asset-based approach; the less likely Partnership was to sell its assets, the less weight would be assigned to an asset-based approach.

The parties disagreed on two points that were relevant to whether Partnership would sell its assets: (1) whether Partnership could sell its assets, and (2) whether Partnership should be considered separately from Corp, or as a single business enterprise with Corp.

The IRS contended that circumstances could arise in which Partnership could and would sell its assets. Parent argued that holders of limited partnership units could not force a sale of its assets under the partnership agreement, and that Corp, which had the exclusive authority to direct Partnership to make such a sale, would never exercise that authority. The IRS argued that this position inappropriately considered specific – rather than hypothetical – buyers and sellers.

The Court disagreed with the IRS. It stated that Corp’s exclusive authority (as general partner) to exercise control over Partnership under the partnership agreement, its interest in Partnership’s continued ownership of the timberlands, and the restrictions imposed on limited partners under the partnership agreement, did not depend on how many limited partners Partnership had or who they were.[xxix] These restrictions, the Court stated, applied to the interest because of the partnership agreement and the rights held by Corp, and would have been taken into account by any hypothetical buyer and seller of a limited partner interest.

A Single Operation?

As further support for its position, Parent argued that Partnership and Corp should be treated as a single business operation even though they were separate legal entities.

The IRS countered that because Partnership and Corp were separate legal entities, the Court should treat them as such and ignore their interdependent relationship when valuing them.

The Court found that Corp’s continued operation as a lumber mill company depended on Partnership’s continued ownership of timberlands, and there was no likelihood that Corp, as Partnership’s general partner, would direct Partnership to sell its timberlands while Corp continued operations as a mill. In addition, the two entities had almost identical ownership, and they shared administrative staff.

Expert’s report was consistent with the “single business” approach in that it ignored the intercompany debt between the two entities (and the free flow of cash between them as needed), because he regarded them as interdependent parts of a single enterprise, or as “simply two pockets of the same pair of pants.”

On the basis of these facts, the Court concluded that Partnership and Corp were so closely aligned and interdependent that, in valuing Partnership, it was appropriate to take into account its relationship with Corp and vice versa. Contrary to the IRS’s objection, the Court found that this approach did not ignore the status of the two as separate legal entities,[xxx] but recognized their economic relationship and its effect on their valuations.

The Court, therefore, concluded that an income-based approach was more appropriate for Partnership than was the IRS’s net asset value method valuation.[xxxi]

Thoughts on the “Single Business”

The Court accepted Expert’s analysis on most of the issues raised by the IRS with respect to the valuation of Corp and Partnership, including as to valuation approach, tax-affecting and discounting. Expert’s report was detailed and thorough, and was supported by empirical data, whereas the IRS failed to consider several items and, therefore, was unable to mount much of a challenge.

There is one point, however, that warrants a closer look: Parent’s and Expert’s argument – with which the Court agreed – that Partnership and Corp should be treated as a single business operation for valuation purposes, including for purposes of determining whether an income-based valuation method should be applied.

It is not uncommon for what may be thought of as single trades or businesses to be operated across multiple entities for various legal and economic reasons. For example, the real estate out of which a corporate business operates may be owned by a separate LLC; a business that has branches in different states, may have organized each branch as a separate corporation; a restaurant and its related catering business, that share centralized purchasing and accounting, may be formed as separate business entities.

Moreover, the Code provides a number of opportunities for the owners of separately organized businesses to combine or aggregate the separate entities for a specific tax purpose. For example, the regulations under Sec. 199A of the Code allow individuals to aggregate two or more qualified trades or businesses and to treat them as a single business for purposes of applying the “W-2 wage” and the “UBIA of qualified property” limitations, and potentially maximizing their Sec. 199A deduction;[xxxii] and Sec. 469 allows grouping of activities into a single activity for purposes of applying the material participation test, provided the activities form an “appropriate economic unit.”[xxxiii] In each of these examples, the degree of common ownership and control is considered, as are the interdependencies of the business activities.

But for estate tax purposes?

The only “estate tax aggregation” provision that immediately comes to mind is found in Sec. 6166 of the Code. Under this section, if the value of an interest in a closely held business that is included in a decedent’s gross estate exceeds 35-percent of the adjusted gross estate, the tax attributable to such interest may be paid in installments.[xxxiv] The term “interest in a closely held business” includes an interest as a partner in a partnership, and an interest in a corporation, carrying on a trade or business if 20-percent or more of the total capital interest in such partnership, or 20-percent or more in value of the voting stock of such corporation is included in determining the decedent’s gross estate. For purposes of applying the 35-percent test, interests in two or more closely held businesses, with respect to each of which there is included in determining the value of the decedent’s gross estate 20-percent or more of the total value of each such business, shall be treated as an interest in a single closely held business.[xxxv]

The decision discussed above, however, was not concerned with the proper application of a statutory or regulatory aggregation rule, but with a valuation principle that considered the economic reality of the business relationship between two related entities in determining their respective values. At least in concept, such a valuation addresses the facts as they are on the valuation date[xxxvi] – it is not required to “correct” the results of the relationship by reallocating payments or revising terms to reflect arm’s-length dealing.[xxxvii] Thus, a hypothetical buyer or seller of either Corp or Purchaser would have recognized the benefit of Corp’s position as a general partner of Partnership, as described above.

Would the result have been the same if Corp had not been the general partner of Partnership? Under different circumstances, would the IRS be justified in arguing for a greater value where the dealings between related entities resulted in favorable, below-market terms for the entity being valued? Or would such a position only be supportable where the entity favored has the ability to veto any change in the relationship; i.e., has the ability to prevent the substitution of arm’s-length terms?

Bottom line: if the values reported on a business owner’s gift or estate tax returns are to withstand IRS scrutiny, it is incumbent upon the business owner’s advisers to learn as much as they can about the intercompany dealings among the owner’s related business entities, and it is imperative that the transferor-owner provide their advisers and their appraiser[xxxviii] with as much information as possible regarding such dealings.


[i] Some are glad to have their golf-playing partners back in the office.

[ii] I only think such thoughts on February mornings, after I’ve removed the ice from the car and shoveled the driveway. I come to my senses when I’m back at my desk.

[iii] Currently set at $15,000 per individual recipient for a gift of a “present interest” in property. IRC Sec. 2503(b).

[iv] Currently set at $11.4 million per individual donor. IRC Sec. 2010.

[v] I.e., the larger exemption amount will not be available for gift transfers and testamentary transfers made after that date. IRC Sec. 2010(c)(3)(C). Query whether it will disappear even sooner if there is a change in Administration and in the Senate after the 2020 elections.

[vi] The transferred interests may be voting or non-voting interests.

[vii] Trusts for the benefit of one’s descendants may be a good option for creditor protection, if structured properly.

[viii] The grantor-parent would continue to pay the income tax on the trust’s income. IRC Sec. 671.

[ix] Grantor retained annuity trusts. IRC Sec. 2702. A good vehicle in a low interest rate environment.

[x] Such an agreement can help ensure that the business is operated smoothly and that it (or the value it represents) remains within the family; it may include transfer restrictions, special voting requirements, buy-sell arrangements (including the purchase of life insurance), drag-along rights for the parent-donor, etc.

[xi] Again, depending upon the 2020 election results.

[xii] The selection of the transfer vehicle will depend, in part, upon the owner’s desire to continue receiving cash-flow from the transferred interest.

[xiii] Est. of Aaron U. Jones v. Comm’r, T.C. Memo 2019-101.

[xiv] IRC Sec. 1361.

[xv] A not-uncommon practice in the case of related closely held businesses.

It is not clear whether promissory notes were issued to evidence this indebtedness.

[xvi] It is unclear whether Corp paid Partnership anything for this service or accommodation.

[xvii] According to an old Yiddish proverb, “Man plans, God laughs.”

[xviii] Basically, descendants. Probably a so-called “dynasty” trust.

[xix] On IRS Form 709.

[xx] IRC Sec. 6213.

[xxi] Reg. Sec. 25.2512-2(f)(2); Rev. Rul. 59-60.

[xxii] Reg. Sec. 25.2512-3(a).

[xxiii] Meaning that each had the ability to continue operating for the foreseeable future.

[xxiv] The parties did not dispute that Partnership was a going concern. Rather, they disagreed on whether it was an operating company that sold a product or a holding company that simply held its assets as an investment for its partners.

[xxv] In brief, taking the net cash flow or net operating income for a single year, then applying a capitalization rate (derived from market data); the method assumes that both these elements remain constant in perpetuity.

Any income-based approach is all about the time value of money.

[xxvi] Basically, the present value of future cash inflows and outflows over a period of time (which are projected, and account for expected changes), then applying a discount rate.

[xxvii] The parties also had several other points of dispute, including the propriety of “tax-affecting.” https://www.taxlawforchb.com/2019/05/determining-the-value-of-an-s-corp/

The Court found that Expert more accurately took into account the tax consequences of Partnership’s flow-through status than did the IRS for purposes of estimating what a willing buyer and willing seller might conclude regarding its value. Expert’s adjustments included a reduction in the total tax burden by imputing the burden of the current tax that an owner might owe on the entity’s earnings and the benefit of a future dividend tax avoided that an owner might enjoy.

[xxviii] Its timber.

[xxix] In other words, their right to vote on the continuation of Partnership would not avail them in the face of Corp’s opposition and the requirement of a unanimous vote.

[xxx] Though, under these facts, any creditor of either entity would likely have had a good shot at reaching the assets of both entities.

[xxxi] The IRS also contended that Parent’s 35% discount for lack of marketability was excessive. The Court disagreed, pointing out that Expert’s report included a detailed appendix which explained the reasoning behind the discount for lack of marketability, including both empirical and theoretical models. Expert then discussed the effect that restrictions on transferability (like the ones in the buy-sell agreement) have on a discount, as well as the other factors considered by the courts in determining discounts. The IRS did not even consider the restrictions in the buy-sell agreement.

[xxxii] Reg. Sec. 1.199A-4.

[xxxiii] Reg. Sec. 1.469-4.

[xxxiv] Up to ten installment payments, beginning on the fifth anniversary of the original due date for payment of the tax.

[xxxv] IRC Sec. 6166(c).

[xxxvi] The date of the gift or the date of death, as the case may be.

[xxxvii] It is implied that such a situation would not arise in the case of unrelated persons, who are assumed to have acted at arm’s-length with one another.

[xxxviii] Perhaps with the latter having been retained by the adviser under a Kovel arrangement?

Education Equals Indebtedness?

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

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

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

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

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

“Corporate Charity”

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

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

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

Private Foundations

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

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

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

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

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

Employer-Related Scholarships

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

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

Eligible Recipients

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

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

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

The Committee and the Awards

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

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

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

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

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

Awareness

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

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

Application

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

The scholarship application requested the following items:

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

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

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

Supporting Records

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

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

Safeguards

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

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

Taxable Expenditures

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

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

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

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

Grants to Individuals

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

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

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

Guidelines

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

These percentage tests require that:

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

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

The IRS’s Ruling

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

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

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

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

It’s Worth the Effort

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

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

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

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


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

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

[iii] https://www.forbes.com/sites/zackfriedman/2019/02/25/student-loan-debt-statistics-2019/#1c699231133f

[iv] IRC Sec. 509(a).

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

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

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

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

[ix] Several of our clients have done so.

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

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

[xii] See IRC Sec. 117.

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

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

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

[xvi] IRC Sec. 4945(g). See also IRS Form 1023, Schedule H, Organizations Providing Scholarships, Fellowships, Educational Loans, or Other Educational Grants to Individuals and Private Foundations Requesting Advance Approval of Individual Grant Procedures. https://www.irs.gov/forms-pubs/about-form-1023

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

[xviii] Revenue Procedure 76-47.

[xix] See below.

[xx] Revenue Procedure 85-51.

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

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

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

Choice of Entity

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

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

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

The Revival of Close “C’s”

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

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

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

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

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

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

Close Scrutiny

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

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

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

Constructive Dividends

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

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

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

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

Taxpayer’s Strategy

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

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

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

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

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

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

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

The IRS Challenge

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

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

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

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

The Court’s Analysis

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

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

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

Dividends

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

E&P

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

Constructive

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

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

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

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

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

Taxpayer’s Situation

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

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

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

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

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

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

Observations

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

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

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

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

Constructive Dividend Scenarios – Third Parties

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

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

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

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

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

Constructive Dividend Scenarios – The Shareholder

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

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

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

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

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

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

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

Other Potential Arguments

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

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

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

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

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

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

Last Word

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


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

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

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

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

[v] Their alter ego.

[vi] “Piercing,” basically.

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

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

[ix] Reg. Sec. 301.7701-3.

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

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

[xii] IRC Sec. 317.

[xiii] https://www.taxlawforchb.com/2014/07/receiving-services-from-your-business/

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

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

[xvi] Taxpayer’s spouse acted as secretary.

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

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

[xix] IRS Form 1040.

[xx] IRS Form 1120.

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

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

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

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

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

[xxvi] IRC Sec. 162.

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

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

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

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

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

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

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

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

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

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

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

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

[xxxix] Footnote 3.

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