Counting Days

Do you know what June 29, 2019 is? Of course you do. It’s a Saturday. It’s also the 180th day of the period that began on January 1, 2019. Need another hint?

It is the final day by which a taxpayer who was an owner in a calendar-year pass-through entity – a partnership or S corporation –may elect to defer their share of any capital gain recognized by the pass-through entity during 2018 by contributing an amount equal to the amount of such gain to a qualified opportunity fund in exchange for an equity interest in the fund.

What’s more, it is the 74th day of the period that began on April 17, 2019 – the day on which the IRS issued its eagerly-awaited second set of proposed regulations related to the qualified opportunity zone (“QOZ”) rules.

Among the issues that were addressed in this second installment of guidance under Sec. 1400Z-2 of the Code was the ability of a taxpayer who already owns real property located in a QOZ to lease such property to a related person – say, a QOZ partnership – that would then improve the property and operate a qualifying business thereon. Significantly, the proposed regulations require that the terms of the lease must reflect arms-length market practice in the locale that includes the zone.

Related Parties

Anyone with any experience in tax matters is aware that transactions between related persons are generally subject to heightened scrutiny by the taxing authorities, lest the related persons structure a transaction to gain a tax advantage, without having a bona fide business purpose. Taxpayers have to be especially careful in situations for which the Code itself prescribes specific rules for dealings between related parties.

A recent decision[i] under the like-kind exchange[ii] rules – to which the QOZ rules are now often described as an alternative investment vehicle for deferring the recognition of otherwise taxable capital gain[iii] – should remind taxpayers of how vital it is to proceed with caution when transacting business with a related person.

The Transaction

Taxpayer was a business entity that owned real properties. It received a letter of intent from an unrelated third party offering to purchase one of Taxpayer’s commercial real properties (the “Property”). Among other things, the letter reserved to Taxpayer the right to effect an exchange of the Property as a like-kind exchange, and obligated the purchaser to cooperate toward that end. Taxpayer signed the letter of intent and, thereafter, began a search for suitable replacement property.[iv]

Taxpayer engaged a qualified intermediary (“Intermediary”) through which the Property would be exchanged.[v] Taxpayer thereupon assigned its rights under the letter to Intermediary, and transferred the Property to Intermediary, which sold the Property to the unrelated buyer for approximately $4.7 million. Taxpayer’s basis in the Property was approximately $2.7 million at the time of sale; a gain of approximately $2 million.

Identification Period

In order to meet the requirements for a tax-deferred like-kind exchange, Taxpayer had to identify replacement property within 45 days after the sale of the Property. Brokers presented numerous properties owned by unrelated parties as potential replacement properties, and Taxpayer attempted to negotiate the purchase of two of these properties, but was unsuccessful.

On the 45th day, Taxpayer identified three potential replacement properties, all belonging to RP, a business entity “related” to Taxpayer.[vi]

Related Trouble

Intermediary purchased the identified real property owned by RP (“New Prop”) for approximately $5.5 million of cash, and transferred New Prop to Taxpayer as replacement property for the Property, as part of the like-kind exchange.

Taxpayer filed its income tax return[vii] in which it reported a realized gain of approximately $2 million from the sale of the Property, but deferred recognition of the gain pursuant to Section 1031 of the Code.[viii]

RP recognized over $3 million of gain from its taxable sale of New Prop, but it had sufficient net operating losses (“NOLs”) to fully offset such gain.

The IRS issued Taxpayer a notice of deficiency in which it determined that Taxpayer’s gain realized on the sale of the Property could not be deferred under Section 1031. Taxpayer filed a timely petition with the U.S. Tax Court.

Unfortunately for Taxpayer, the Tax Court agreed with the IRS.

Section 1031

The gain realized by a taxpayer from the conversion of property into cash, or from the exchange of property for other property differing materially in kind, is generally recognized by the taxpayer and included in their gross income.[ix]

In contrast, Section 1031(a) provides for the non-recognition of gain when property that is held by a taxpayer for productive use in a trade or business (or for investment) is exchanged for property of a like-kind which is likewise held by the taxpayer for productive use in a trade or business (or for investment).

The basis of the property acquired by a taxpayer in a Section 1031 exchange (the “replacement property”) is determined by reference to the basis of the property exchanged by the taxpayer (the “relinquished property”).[x] By preserving the taxpayer’s basis for the relinquished property – by making it the basis for the replacement property – the taxpayer’s gain is preserved for future recognition.[xi]

A non-simultaneous exchange, where the relinquished property is transferred before the replacement property is acquired, generally may qualify for non-recognition of gain if the taxpayer identifies the replacement property, and then receives it, within 45 days and 180 days, respectively, of the transfer of the relinquished property.[xii] A taxpayer may use a “qualified intermediary” (“QI”) to facilitate such a deferred exchange – wherein the QI acquires the relinquished property from the taxpayer, sells it, and uses the proceeds to acquire replacement property that it transfers to the taxpayer “in exchange for” the relinquished property – without the QI’s being treated as the taxpayer’s agent, or the taxpayer’s being treated as in constructive receipt of the sales proceeds from the relinquished property.[xiii]

In the case of a transfer of relinquished property involving a QI, the taxpayer’s transfer of relinquished property to a QI and subsequent receipt of like-kind replacement property from the QI is treated as an exchange with the QI.

Related Party Rules

Congress added Section 1031(f) to the Code in order to prevent certain abuses in the case of like-kind exchanges between related persons. According to the IRS, because a like-kind exchange results in the substitution of the basis of the exchanged property for the property received, related parties were engaging in like-kind exchanges of high basis property for low basis property in anticipation of the sale of the low basis property. In this way, the related parties, as a unit, could reduce or avoid the recognition of gain on the subsequent sale.

For example, Taxpayer A owns Prop X with a FMV of $100 and basis of $10; Taxpayer B is related to A; B owns Prop Y with a FMV of $100 and a basis of $80; Props X and Y are like-kind to each other; an unrelated person wants to purchase Prop X; A and B swap Props X and Y in a like-kind exchange; Taxpayer B takes Prop X (B’s replacement property) with a basis equal to B’s basis in Prop Y (B’s relinquished property), or $80; B sells Prop X to the unrelated buyer and recognizes a gain of $100 minus $80, or $20; if A had sold Prop X directly to the buyer, A would have had gain of $100 minus $10, or $90; the A-B related party group saves a lot of taxes.

In general, Section 1031(f)(1) of the Code provides that if a taxpayer and a related person exchange like-kind property and, within two years, either one of the parties to the exchange disposes of the property received in the exchange, the non-recognition provisions of Section 1031(a) will not apply, and the gain realized on the exchange must be recognized as of the date of the disposition.[xiv]

Taxpayer and RP stipulated that they were related persons for purposes of this provision.[xv]

Exception

Section 1031(f) of the Code provides an exception to the “disallowance-upon disposition” rule for related parties. Specifically, it provides that any disposition of the relinquished or replacement property within two years of the exchange is disregarded if the taxpayer establishes to the satisfaction of the IRS, with respect to the disposition, “that neither the exchange nor such disposition had as one of its principal purposes the avoidance of Federal income tax.”[xvi]

The Tax Court

The IRS did not dispute that Taxpayer’s exchange of the Property for New Prop met the requirements for a like-kind exchange. Furthermore, because Taxpayer used Intermediary to facilitate its sale of the Property and acquisition of the New Prop, the IRS did not contend that the exchange ran afoul of the specific requirements of section 1031(f). However, the IRS contended that Taxpayer’s exchange was disqualified from non-recognition treatment as a transaction structured to avoid the purposes of Section 1031(f) of the Code.

The Tax Court noted that the transaction at issue was the economic equivalent of a direct exchange of property between a taxpayer and a related person, followed by the related person’s sale of the relinquished property and their retention of the cash proceeds. In that case, the investment in the relinquished property had been cashed out, contrary to the purpose of Section 1031(f).

According to the Tax Court, the Taxpayer’s transaction was no different: The investment in the Property was cashed out with a related person’s (RP) retaining the cash proceeds. The interposition of a QI “could not obscure that result.”

Taxpayer: “No Intent to Avoid”

Taxpayer argued, however, that the exchange of the properties was not structured to avoid the purposes of Section 1031(f) because Taxpayer had no “prearranged plan” to conduct a deferred exchange with RP. Taxpayer contended that it had no prearranged plan because it first diligently sought a replacement property held by an unrelated party and only turned to New Prop when the deadline to complete a deferred exchange was imminent.

Taxpayer also emphasized that it decided to acquire the replacement property from a related person only after it had already engaged a QI (because a deferred exchange was necessary).

The Tax Court, however, found that the presence or absence of a prearranged plan to use property from a related person to complete a like-kind exchange was not dispositive of a violation of Section 1031(f).[xvii]

The Results Say It All

According to the Tax Court, the inquiry into whether a transaction has been structured to avoid the purposes of Section 1031(f) is focused on the actual tax consequences of the transaction to the taxpayer and the related party, considered in the aggregate, as compared to the hypothetical tax consequences of a direct sale of the relinquished property by the taxpayer. Those actual consequences form the basis for an inference concerning whether the transaction was structured in violation of Section 1031(f).[xviii]

The Tax Court stated that it would infer a tax-avoidance purpose where the aggregate tax liability of the taxpayer and the related person arising from their “like-kind exchange and sale transaction” is significantly less than the hypothetical tax that would have arisen from the taxpayer’s direct sale of the relinquished property.

The Tax Court determined that Taxpayer would have had to recognize a $2 million gain had Taxpayer directly sold the Property to the unrelated third party. However, because the transaction was structured as a like-kind exchange, only RP was required to recognize gain, and that gain was almost entirely offset by its NOLs. The substantial economic benefits to Taxpayer as a result of structuring the transaction as a deferred exchange were thus clear: Taxpayer was able to cash out of the investment in the Property almost tax free. The Court thus inferred that Taxpayer structured the transaction with a tax-avoidance purpose.

Taxpayer argued that the transaction nonetheless lacked a tax-avoidance purpose because it did not involve the exchange of low-basis property for high basis property.[xix]

It is true that RP recognized more gain on the disposition of New Prop than Taxpayer realized on the disposition of the Property. However, RP was able to offset the gain recognized with NOLs, resulting in net tax savings to Taxpayer and RP as an economic unit. Net tax savings achieved through use of the related party’s NOLs may demonstrate the presence of a tax-avoidance purpose notwithstanding a lack of basis shifting.

In sum, by employing a deferred Section 1031 exchange transaction to dispose of the Property, Taxpayer and RP, viewed in the aggregate, “have, in effect, ‘cashed out’ of the investment”, virtually tax free – in contrast to the substantial tax liability Taxpayer would have incurred as a result of a direct sale to the unrelated buyer. Consequently, the transaction was “structured in contravention of Congress’s desire that non-recognition treatment only apply to transactions where a taxpayer can be viewed as merely continuing his investment.”

Therefore, the Court concluded that the transaction was structured to avoid the purposes of Section 1031(f) and, consequently, Taxpayer was not entitled to defer recognition of the gain realized on the exchange of the Property under Section 1031(a)(1).

Taxpayer then appealed to the Ninth Circuit Court of Appeals.[xx]

Can You Say “Affirmed?”

The Court began its discussion by stating that, generally, “a taxpayer must pay taxes on gain realized on the sale or exchange of property. Section 1031 is an exception to this rule and is strictly construed.”

Under Section 1031(f), it continued, “a party may benefit from nonrecognition of the gain from an exchange of like-kind property with a related party . . . . However, any transaction or series of transactions structured to avoid the purposes of Section 1031(f) is ineligible for nonrecognition.”

The Court explained that the exchange at issue was structured for “tax avoidance purposes” because Taxpayer and RP “achieved far more advantageous tax consequences” by employing Intermediary to conduct the like-kind exchange than it would have had Taxpayer simply sold the Property to the third-party buyer itself. Had it done so, Taxpayer would have had to recognize approximately $2 million of gain. “Because the aggregate tax liability arising out of the exchange was significantly less than the hypothetical tax liability that would have arisen from a direct sale between the related parties, the like-kind exchange served tax avoidance purposes.”

Therefore, Taxpayer was not entitled to non-recognition of gain under Section 1031 of the Code.

Beware the Related Person

Especially when they come bearing gifts such as NOLs or high basis assets.

But seriously, a taxpayer should never be surprised when they are transacting with a related person. This warning applies most strongly to the owners of a closely held business and its affiliates, who are especially susceptible to engaging in such a transaction. They should know that the IRS will subject the transaction to close scrutiny.

The IRS will examine the transaction to ensure that it reflects a bona fide economic arrangement – in other words, that the related parties are dealing at arm’s-length with one another, and are not trying to achieve an improper tax result by manipulating the terms of the arrangement.

In other situations, such as the one described in this post, there are statutory and regulatory requirements and limitations of which the taxpayer must be aware when dealing with a related person. The disallowance or suspension of a loss, the conversion of capital gain into ordinary income, the denial of installment reporting – all these and more await the uninformed taxpayer.[xxi]

It is imperative that the taxpayer consult with their advisers prior to undertaking any transaction with any person with which or whom they have some relationship. The adviser should be able to determine whether the relationship is among those that the IRS views as worthy of closer look. The adviser should also be able to inform the taxpayer whether the relationship comes within any of the applicable anti-abuse or other special rules prescribed by the Code or the IRS.

In this way, the taxpayer can plan accordingly, and without surprises.


[i] The Malulani Group, Limited v. Comm’r, No. 16-73959 (9th Cir. 2019).

[ii] IRC Sec. 1031.

[iii] https://www.taxlawforchb.com/2019/04/deferring-real-property-gain-like-kind-exchange-or-opportunity-fund-part-i/ and https://www.taxlawforchb.com/2019/04/deferring-real-property-gain-like-kind-exchange-or-opportunity-fund-part-ii/

[iv] The search should always begin as far in advance of the sale as is reasonably possible.

[v] As part of a deferred exchange.

[vi] Many taxpayers will identify a Delaware Statutory Trust as their final choice of replacement property – in case they cannot acquire one of their “preferred” replacement properties – simply to avoid the recognition of gain from the sale of the relinquished property.

[vii] IRS Form 8824 asks whether the exchange involved a related person.

[viii] Kris: upper case “C”.

[ix] Reg. Sec. 1.1001-1.

[x] IRC Sec. 1031(d).

[xi] Taxpayer A owns Prop X with a FMV of $100 and a basis of $20 (built-in gain of $80); A exchanges Prop X for Taxpayer B’s like-kind Prop Y, which has a FMV of $100; A takes Prop Y with a basis of $20, thereby preserving the $80 of gain.

[xii] IRC Sec. 1031(a)(3).

[xiii] Reg. Sec. 1.1031(k)-1(g)(4)(i).

[xiv] Although Section 1031(f)(1) disallows non-recognition treatment only for direct exchanges between related persons, Section 1031(f)(4) provides that non-recognition treatment does not apply to any exchange which is part of a transaction or series of transactions “structured to avoid the purposes of” Section 1031(f). Therefore, Section 1031(f)(4) may disallow non-recognition treatment of a deferred exchange that only indirectly involves related persons because of the interposition of a QI.

[xv] Related persons for purposes of this anti-abuse rule are those with relationships defined in Sections 267(b) or 707(b)(1) of the Code.

[xvi] Any inquiry under IRC Sec. 1031(f)(4) as to whether a transaction is structured to avoid the purposes of section 1031(f) also takes into consideration the “non-tax-avoidance exception” in Sec. 1031(f)(2)(C).

[xvii] Because the absence of a prearranged plan was not dispositive regarding a violation of IRC Sec. 1031(f)(4), the Court did not believe it was material that Taxpayer engaged a QI before deciding to acquire New Prop from RP.

[xviii] In other words, one must compare the hypothetical tax that would have been paid if the taxpayer had sold the relinquished property directly to a third party with the actual tax paid as a result of the taxpayer’s transfer of the relinquished property to the related party in a like-kind exchange followed by the related party’s sale of the relinquished property. For this purpose, the actual tax paid comprised the tax liability of both the taxpayer and the related in the aggregate.

[xix] As in the example, above.

[xx] IRC Sec. 7482.

[xxi] For example, IRC Sections 267, 453, 707 and 1239.

Letters, acronyms, initialisms[i] – they seem to slip into every post these days.

It has always been a goal of U.S. tax policy to ensure that taxable income sourced in the U.S. does not escape the federal income tax.

In general, this income and the scenarios in which it arises are easily identifiable. However, there are occasions where the IRS, in interpreting Congressional policy, has to address a not-so-obvious gap in legislation.

Regulations recently issued in response to one of the 2017 federal tax changes[ii] to the S corporation rules provide an example of one such scenario.

“S corporations?” you say.

C Corps and Partnerships

Yes, the C corporation may have been the principal beneficiary of the Act, especially when one considers the much reduced federal rate at which its profits are taxed;[iii] and yes, partnerships offer more flexibility than any other business entity insofar as the economic arrangements among its owners are concerned.[iv]

The fact remains, however, that the earnings of a C corporation are subject to so-called “double taxation.”[v] While this may not present an issue to a business that is reinvesting its profits, rather than paying them out as dividends,[vi] it is a serious consideration for the individual business owner who plans to sell that business one day – timing is everything – and who recognizes that most buyers will prefer to acquire the assets of the business rather than its issued and outstanding shares.[vii]

The fact also remains that the individual owners of a partnership that is engaged in an active trade or business[viii] will be subject to self-employment tax on their distributive shares of the partnership’s ordinary business income.[ix]

What about the S corporation?

Don’t Forget the S Corp

In general, a “small business corporation,” the shareholders of which have made an “S” election,[x] is not itself subject to federal income tax, either on its ordinary business income or on the gain from the sale of its assets.[xi] Instead, the corporation’s profits flow through to its shareholders (whether or not distributed), who report them on their personal income tax returns, and adjust their stock basis accordingly.[xii]

Because of these stock basis adjustments, the subsequent distribution of these profits is generally not subject to tax in the hands of the shareholders.[xiii]

Thus, only one level of federal income tax is imposed on the corporation’s profits. In addition, these profits are not subject to self-employment tax in the hands of the shareholders.[xiv]

Basic Requirements

Yes, there are a number of requirements – limitations, really – that a domestic corporation must satisfy in order to qualify as a small business corporation; it cannot have: (i) more than 100 shareholders, (ii) as a shareholder a person (other than an estate and certain trusts) who is not an individual, (iii) a nonresident alien (“NRA”) as a shareholder,[xv] and (iv) more than one class of stock.[xvi]

However, in the case of most closely held businesses, these limitations have little practical effect. What’s more, in many cases, some of the obstacles they present may be addressed through the judicious use of a partnership.[xvii]

That being said, there have been legislative efforts over the years to “modernize” the rules applicable to S corporations by scaling back some of the limitations – especially where the the underlying tax policy is not sacrificed or compromised – in order to prevent them from becoming punitive with respect to the individual shareholders of an S corporation.[xviii]

The ESBT

One example of a measure that modernized the S corporation rules was the introduction of the electing small business trust (“ESBT”) in 1996.[xix] Prior to that legislation, only grantor trusts, voting trusts, certain testamentary trusts, and qualified subchapter S trusts could be shareholders in an S corporation.[xx]

Congress recognized that, in order to facilitate family estate and financial planning, an individual who owned shares of stock in an S corporation should be allowed to contribute their shares to a non-grantor trust that provides for the distribution of trust income to, or its accumulation for, a class of individuals; for example, a trust that authorizes the sprinkling of income among the contributing shareholder’s family members who are beneficiaries of the trust, at such times, and in such amounts, as may be determined by a trustee.[xxi]

And, so, the ESBT was born.

An ESBT is a domestic trust[xxii] that satisfies the following requirements: (i) The trust does not have as a beneficiary any person other than an individual, an estate, or certain exempt organizations; (ii) no interest in the trust was acquired by purchase;[xxiii] and (iii) the trustee has made an election with respect to the trust.[xxiv] A grantor trust may elect to be an ESBT.

PCB

An ESBT may hold S corporation stock as well as other property, and it may accumulate trust income.[xxv] A potential current beneficiary (“PCB”)[xxvi] may be one of multiple beneficiaries of an ESBT.

The term “potential current beneficiary” means, with respect to any period, any person who at any time during such period is entitled to, or at the discretion of any person may receive, a distribution from the principal or income of the trust.[xxvii] In general, a PCB is treated as a shareholder of the corporation for purposes of determining whether the corporation qualifies as an S corporation.[xxviii] No person is treated as a PCB solely because that person[xxix] holds any future interest in the trust.

If all or a portion of an ESBT is treated as owned by a person under the grantor trust rules, such owner is also treated as a PCB.[xxx]

NRAs as PCBs

Before 2018, an NRA could have been an “eligible beneficiary” of an ESBT.[xxxi] However, if the NRA ever became a PCB of the ESBT[xxxii] – and was thereby treated as a shareholder of the corporation for purposes of its qualification as an S corporation – the corporation’s “S” election would have terminated because an NRA is not an eligible shareholder.[xxxiii]

Similarly, a change in the immigration status of a PCB of an ESBT from a resident alien (a “U.S. person”) to an NRA would have terminated an ESBT election and, thus, also terminated the corporation’s “S” election.[xxxiv]

Then, in late 2017, the Act amended the Code to allow NRAs to be PCBs of ESBTs. As amended, the Code[xxxv] provides that NRA-PCBs will not be taken into account for purposes of the S corporation shareholder-eligibility requirement that otherwise prohibits NRA shareholders. As a result of that amendment, if a resident alien PCB of an ESBT becomes an NRA, the status of that PCB as an NRA will not cause the S corporation of which the ESBT is a shareholder to terminate its “S” election. What’s more, an NRA-PCB may receive a distribution of income from an ESBT without jeopardizing the corporation’s “S” election. Of course, a distribution of principal to an NRA-PCB from the ESBT – i.e., a distribution of shares of stock in an S corporation – will terminate the “S” election.[xxxvi]

While Congress expanded the scope of qualifying beneficiaries (PCBs) of ESBTs, it left unaltered the rule that an S corporation cannot have an NRA as a shareholder.

Separate Trusts

An ESBT that owns stock of an S corporation, as well as other property, is treated as two separate trusts (an S portion and a non-S portion, respectively) for purposes of the federal income tax, even though the ESBT is treated as a single trust for administrative purposes.[xxxvii]

Specifically, the S portion, which consists solely of S corporation stock, is treated as a separate trust; in general, it is taxed on its share of the S corporation’s income at the highest rate of tax imposed on individual taxpayers.[xxxviii] This income – whether or not distributed by the ESBT – is not taxed to the beneficiaries of the ESBT.[xxxix]

The non-S portion of the ESBT remains subject to the usual trust income taxation rules that govern simple and complex trusts.

In addition, the S portion or the non-S portion of the trust (or both) can be treated as owned by a grantor (the “grantor portion”) under the grantor trust rules.[xl]

Grantor Trust

Generally speaking, a grantor trust is a trust with respect to which the grantor has retained certain rights over the trust’s income or assets such that the income of the trust should be taxed to the grantor rather than to the trust which receives the income, or to the beneficiary to whom the income may be distributed. If a trust is a grantor trust, then (i) the grantor is treated as the owner of the assets, (ii) the trust is disregarded as a separate entity for federal income tax purposes, and (iii) all items of income, deduction, and credit are taxed to the grantor as the deemed owner.

Wholly or partially-owned grantor trusts can make an ESBT election, but the grantor trust taxation rules of the Code override the ESBT provisions; in other words, the income of the portion of an ESBT treated as owned by the grantor is taken into account by the deemed owner (rather than by the ESBT) in computing the deemed owner’s taxable income.[xli] Stated differently, an ESBT pays tax directly at the trust level on its S corporation income, except for the amount that is taxed to the owner of the grantor trust portion of the ESBT.

The Issue

As indicated above, the deemed owner of the grantor trust portion of an ESBT is treated as a PCB of the ESBT. What if the deemed owner is an NRA?

Under the grantor trust rules,[xlii] the income of a domestic trust is taxed to an NRA grantor if the only amounts distributable from such trust (whether income or corpus) during the lifetime of the grantor are amounts distributable to the grantor or the spouse of the grantor.

As enacted, the Act’s expansion of an ESBT’s permissible PCBs to include an NRA may have allowed S corporation income attributed to the grantor trust portion of an ESBT that is received by an NRA deemed owner of that portion, to escape federal income taxation.

For example, if an NRA grantor were a deemed owner of a domestic trust that elected to be an ESBT, and thus were to be allocated foreign source income of the S corporation, or income not effectively connected with the conduct of a U.S. trade or business, that NRA would not be required to include such S corporation items in income because the NRA would not be liable for federal income tax on such income.[xliii] In other words, the NRA deemed owner would not be subject to U.S. federal income tax on the S corporation income unless this income was U.S. source fixed or determinable income, or income effectively connected with a U.S. trade or business.

The IRS Reacts

The general rule of ESBT taxation subjects the ESBT to tax on its S corporation income at the trust level, rather than the beneficiary level. Because the ESBT must be domestic, this rule is “indifferent” to the citizenship or residence status of the ESBT’s beneficiaries.

However, the IRS realized that this general rule does not take into account the interaction between the ESBT and grantor trust tax regimes, which allows a trust to be an ESBT for S corporation qualification purposes while permitting all or a portion of the trust subject to the grantor trust rules to be taxed as a grantor trust, rather than as an ESBT. As described earlier, the taxable income of a grantor trust that elects to be an ESBT is treated as the taxable income of the deemed owner of the trust, regardless of whether the ESBT distributes the income.

According to the IRS, Congress assumed that the taxation of income at the ESBT level would protect against potential tax avoidance that might otherwise result from permitting an NRA to be a PCB of an ESBT.

However, the IRS observed that the post-Act ability of an NRA to be a PCB of an ESBT, in combination with the potential for a grantor trust portion of an ESBT to be owned by an NRA, could result in S corporation income passing without tax from the domestic ESBT to the NRA, thereby escaping federal income taxation.

 The IRS determined that, by allowing an NRA to be a PCB of an ESBT, Congress did not intend to override statutory provisions that have operated to ensure that all of S corporation income remains subject to federal income tax.

The New Regulations

In response to the risk arising from the unintended interplay of the ESBT and grantor trust rules, the IRS issued regulations that were just recently finalized.[xliv] These regulations ensure that, with respect to situations in which an NRA is a deemed owner of a grantor trust that has elected to be an ESBT, the S corporation income of the ESBT will continue to be subject to U.S. federal income tax.

Specifically, the regulations require that the S corporation income of the ESBT be included in the S portion of the ESBT if that income otherwise would be allocated to an NRA deemed owner under the grantor trust rules.

Accordingly, such income will be taxed to the domestic ESBT by providing that, if the deemed owner is an NRA, the grantor portion of the trust’s net income must be reallocated from the grantor portion of the ESBT to the S portion of the trust.

These proposed regulations are proposed to apply to all ESBTs after December 31, 2017.

What to Do?

The addition of NRAs as PCBs of an ESBT[xlv] comes at a time when many U.S. individuals are studying, living or working overseas. These individuals may already be, or may one day become, shareholders of an S corporation. Of course, many of these individuals may develop close relationships with NRAs, and eventually seek to share some of their wealth with these NRAs; for example, by making them beneficiaries of their estates, whether outright or through trusts like ESBTs.

Notwithstanding the change in the Code to permit NRA-PCBs, and speaking generally, the shareholders of an S corporation have a duty to one another to preserve their corporation’s “S” election.[xlvi]

This “obligation” is most often (if ever) memorialized in a shareholders’ agreement under which the owners of the S corporation agree not to transfer their shares to a person that is not eligible to be a shareholder of an S corporation. In many cases, the concept of a “transfer” will be interpreted broadly by the agreement to include, for example, not only the initial transfer into a trust, but also all subsequent transfers or distributions from the trust, including any that are contingent – we don’t want our NRA-PCB eventually becoming a shareholder.

In other agreements, the shareholders go so far as to require the disclosure of their estate plans to the corporation[xlvii] so as to avoid any surprises upon the passing of a shareholder. For example, if a shareholder’s only potential beneficiaries are NRAs, it would behoove the corporation and the other shareholders to be aware of that fact in advance.[xlviii] In that instance, the shareholders and the corporation will want to provide and plan for the eventual mandatory buyout of that shareholder’s interest.[xlix]

As in all things, it pays to be prepared.

——————————————————————————————————————–

[i] Yes, it is a word.

[ii] Tax Cuts and Jobs Act; P.L. 115-97. The Act.

[iii] 21-percent; IRC Sec. 11. Down from a maximum graduated rate of 35-percent.

Of course, the Act gave pass-through entities, including partnerships and S corporations, the Sec. 199A deduction as a consolation prize.

[iv] “All” that is required is that the allocation of income among the partners have substantial economic effect. IRC Sec. 704(b); otherwise, the owners are relatively free to share the economic pie as they see fit.

[v] Once at the level of the corporation, and again when distributed to its shareholders as a dividend. In the case of individual shareholders, the dividend is subject to a federal tax rate of 20-percent (assuming a “qualified” dividend) and a federal surtax of 3.8-percent (as net investment income). IRC Sec. 1(h); IRC Sec. 1411. A combined federal rate of 39.8-percent.

[vi] Subject always to the accumulated earnings tax. IRC Sec. 531.

[vii] An asset purchase is less expensive for a buyer because it enables the buyer to recover its purchase price through depreciation, amortization, and expensing of its investment. IRC Sec. 168 and 197.

[viii] As opposed to an “investment partnership” that invests for its own account.

[ix] IRC Sec. 1401 and 1402.

[x] IRC Sec. 1362.

[xi] IRC Sec. 1363. There are exceptions; for example, the built-in gains tax under IRC Sec. 1374, and the excise tax under IRC Sec. 1375.

[xii] IRC Sec. 1366 and 1367. The maximum federal income tax rate on the ordinary income of an individual shareholder is 37-percent. However, if an individual shareholder does not materially participate in the business of the S corporation, their share of its income may also be subject to the 3.8-percent federal surtax on net investment income under IRC Sec. 1411.

[xiii] IRC Sec. 1367 and 1368. We assume for our purposes that the S corporation has no E&P from C corporation tax years (whether its own or the E&P of a corporation that it acquired on a “tax-free” basis).

[xiv] Of course, any shareholder who provides services to the S corporation should be paid a reasonable salary in exchange for such services; this salary will be subject to employment tax.

[xv] An NRA is an individual who is neither a citizen nor a resident of the U.S.[xv] In general, an alien individual is treated as a resident of the U.S. with respect to any calendar year if such individual[xv] (i) is a lawful permanent resident of the U.S. at any time during such calendar year;[xv] or (ii) meets the so-called “substantial presence test.”[xv] IRC Sec. 7701(b)(1) and Sec. 7701(b)(3).

[xvi] IRC Sec. 1361(b).

[xvii] See, e.g., Reg. Sec. 1.701-2(d), Ex. 2.

[xviii] One has to recall that, before the introduction of the LLC, S corporations were the most popular “corporate” entity for small businesses. There are a lot of S corporations out there. These corporations cannot convert into LLCs without triggering tax liability for their shareholders.

[xix] IRC Sec. 1361(e). Small Business Job Protection Act of 1996; P.L. 104-188; Sec. 1302(a), effective for tax years beginning after December 31, 1996. See Reg. Sec. 1.1361-1(m).

[xx] IRC Sec. 1361(c).

[xxi] Sometimes referred to as a “pot trust.”

[xxii] IRC Sec. 7701(a)(30)(E); meaning a domestic court exercises primary supervisions over the administration of the trust, and one or more U.S. persons have the authority to control all substantial decisions of the trust.

[xxiii] I.e., with a cost basis. IRC Sec. 1012.

[xxiv] Once made, the election applies to the year for which it is made and all subsequent years.

[xxv] Compare to a QSST. IRC Sec. 1361(d).

[xxvi] Not Polychlorinated biphenyl.

[xxvii] IRC Sec. 1361(e)(2).

[xxviii] IRC Sec. 1361(c)(2)(B)(v); Reg. Sec. 1.1361-1(m)(4)(i).

[xxix] Including an NRA.

[xxx] Reg. Sec. 1.1361-1(m)(4).

[xxxi] Reg. Sec. 1.1361-1(m)(1)(ii)(D).

[xxxii] See what I mean about acronyms and initialisms?

[xxxiii] Reg. Sec. 1.1361-1(m)(5)(iii).

[xxxiv] This result would have occurred because, prior to the Act, the Code provided that each PCB of an ESBT had to be treated as a shareholder of the S corporation.

[xxxv] IRC Sec. 1361(c)(2)(B)(v).

[xxxvi] IRC Sec. 1361(b)(1)(C) and Sec. 1362(d)(2).

[xxxvii] Reg. Sec. §1.641(c)-1(a).

[xxxviii] IRC Sec. 641(c). The maximum rate is 37-percent after the Act.

[xxxix] Accordingly, there is no distribution deduction for the trust.

[xl] IRC Sec. 671 et seq.

[xli] See §1.641(c)-1(c).

[xlii] IRC Sec. 672(f)(2)(A)(ii).

[xliii] Under IRC Sec. 871(a) or (b). Likewise, if the NRA is a resident of a country with which the U.S. has an income tax treaty, U.S. source income of the S corporation also might be exempt from tax, or subject to a lower rate of tax, in the hands of that NRA.

[xliv] T.D. 9868.

[xlv] It’s anything but poetic.

[xlvi] I know, “Lou, what do you have against love?” To which I respond, “What’s love got to do, got to do with it?”

[xlvii] Usually the board of directors.

[xlviii] I hate surprises. And the process of requesting reinstatement of an S election after an “inadvertent” termination is not always as straightforward as some may believe.

[xlix] Perhaps by purchasing life insurance on that shareholder’s life.

Tax and bankruptcy: “Can two divorced men share an apartment without driving each other crazy”[i] or Two great tastes that taste great together”?[ii]

For years I have told my partners that there are two kinds of “codes”: those with an upper case “C”, like the Ten Commandments and the Internal Revenue Code, and those with a lower case “c”, like the bankruptcy code.[iii]

There are times, however, when the veil that separates the rarefied world of tax from the gritty struggles of bankruptcy practice is inexplicably pierced and the players from each sphere slip through the openings, either invited or not, to dabble in the other’s affairs.[iv]

This should not come as a surprise to anyone who has advised closely held businesses. Whether the business is just starting out, or is going through some difficult times on its way to recovery and growth, or is on its proverbial last legs, the business or its owners (if the business is a pass-through entity for tax purposes) will have developed or generated certain tax attributes, including net operating losses, the utilization of which may be instrumental either in salvaging the business or in satisfying its creditors.[v]

A recent bankruptcy court decision[vi] considered an issue at one intersection of the two bodies of law.[vii]

The Bankruptcy

Debtor, which was formed as a partnership under state law, filed a bankruptcy petition under Chapter 11.[viii] The Court confirmed the “Debtor’s Plan” which, among other things, required Debtor to provide the creditors’ committee (the “Committee”) verification that Debtor was making the payments required under the Plan. If Debtor defaulted, Debtor had thirty days to cure, failing which the Plan provided for the appointment of a Liquidating Trustee to dispose of Debtor’s assets.

Debtor informed the Committee that the revenues necessary to make the payments under the Plan were not going to materialize within the requisite period, and stated “this is the time to name a liquidating agent” under the Plan.

The Committee confirmed the notice of default, and informed Debtor of its intent to move for the appointment of a Liquidating Trustee if Debtor failed to timely cure the default. Debtor failed to cure within thirty days.

The Committee’s motion and proposed order included a provision under which not less than ten-percent of the aggregate gross proceeds from the sale of assets by the Liquidating Trustee would be allocated for payment of allowed administrative expenses and unsecured claims.

Debtor objected to the Committee’s motion for appointment of a Liquidating Trustee.

Capital Gain

Debtor argued that any sale of assets would result in a liability for capital gains taxes. It also argued that any sale was unlikely to yield proceeds in an amount sufficient to provide for the payment of such capital gains taxes (which would be payable by the Debtor’s owners) and of the Liquidating Trustee’s fees, Debtor’s attorney fees, and the Committee’s attorney fees.

In addition, although Debtor had previously conceded that it was ineligible to be a debtor under Chapter 12 of the “code” when it filed its petition, Debtor now asserted that its total debts were below the prescribed ceiling amount, making it eligible to proceed under Chapter 12.[ix] Debtor sought to convert to Chapter 12 in order to capitalize on what it referred to as the “Grassley Law” allowing it to treat certain capital gains taxes as unsecured claims. According to Debtor, without a conversion, capital gains taxes from the sale of its assets would render the estate administratively insolvent.

According to the Committee, potential capital gains taxes were a non-issue because Debtor was a partnership, and a pass-through entity, for tax purposes. The Committee pointed out that the partners, and not the partnership, would be liable for any taxes arising from the sale of Debtor’s assets.

Debtor countered that it was eligible to elect to be taxed as an “association” (i.e. as a corporation) under the IRS’s “check the box” regulations.[x] Debtor claimed that if such an election were made,[xi] the corporation’s taxes would be discharged as an unsecured claim under Chapter 12.

According to Debtor, the “best approach” would be for the Court to deny the Committee’s motion for appointment of a Liquidating Trustee, allow the conversion of the proceeding to chapter 12, and confirm a chapter 12 plan incorporating liquidation provisions.

The Court made short work of Debtor’s request that the proceeding be converted to one under chapter 12, stating that Debtor was not a “family farmer.” Its debt exceeded the statutory limit when it filed its petition. According to the Court, conversion does not change the date on which eligibility under chapter 12 is determined. Thus, “under the facts and clear language of the statute,” Debtor was not eligible to convert to chapter 12.

Debtor’s Tax Status

The Court then turned to Debtor’s request to change its tax status from a partnership to an association taxable as a corporation.

Debtor’s Tax Status

Partnerships, for purposes of taxation, are “pass-through entities,” the Court stated. A partnership files an information return,[xii] but the partnership itself is not responsible for taxable gains and losses; rather, such gains and losses pass through to the partners themselves, who report them on their own income tax returns.[xiii]

“A partnership’s bankruptcy filing,” the Court continued, “does not alter its tax status. A partnership is recognized as an entity separate from the partners in bankruptcy proceedings, but not in income taxation.”

Thus, partnership income continues to be taxed as though a bankruptcy case had not been commenced. For purposes of the federal income tax, the commencement of a bankruptcy case by either a partner or a partnership does not alter the tax status of the partnership.

In fact, except in the case of an individual bankruptcy, no separate taxable entity results from the commencement of a case “under Title 11 of the United States Code.”[xiv]

Eligibility for Election

Having established Debtor’s tax status during the bankruptcy, the Court considered its eligibility to change such status.

An “eligible entity” with at least two owners, it stated, can elect to be treated as an association for federal tax purposes. Eligible entities include unincorporated business entities, including domestic partnerships.

Absent such an election, a partnership would continue to be taxed as a partnership. Since its creation, Debtor was a partnership for tax purposes. It never made any other election as to its status. Thus, it continued to be taxed as a partnership. The bankruptcy filing did not impact Debtor’s tax status.

The Court observed that the Code, and the regulations issued thereunder, would permit Debtor to elect to be treated as a corporation for federal tax purposes. Debtor maintained that making such an election “would be beneficial.”

While noting that the election may benefit the partners of Debtor,[xv] the Court further noted that the more relevant question was “whether it benefits [Debtor], its estate and its creditors. As a result, the Court must decide whether a change in election violates the Bankruptcy Code or Plan.”[xvi]

Specifically, the Court considered whether the change in tax status caused by the election would violate the so-called “absolute priority rule.”

The absolute priority rule provides that the owners of a debtor, or those holding an interest in a debtor, will not receive or retain under the bankruptcy plan any property, because of that ownership or other interest, unless all general unsecured claims are paid in full.[xvii]

The fundamental principle underlying the rule is to ensure the plan is “fair and equitable.” The rule prohibits the bankruptcy court from approving a plan that gives the holder of a claim anything at all unless all objecting classes senior to the claimant have been paid in full.[xviii] The rule serves to address what the Court described as “the danger inherent in any reorganization plan . . . that the plan will simply turn out to be too good a deal for the debtor’s owners.”

The Court found that the proposed tax election would violate the absolute priority rule. It was not fair and equitable. By converting Debtor into a taxable[xix] entity, and terminating its pass-through status,[xx] the election would benefit Debtor’s owners to the detriment of its creditors by shifting funds from the creditors to the taxing authorities. It would dilute the class of unsecured creditors.

From the time that Debtor filed its petition, the Court explained, its partners retained the benefit of favorable tax treatment through any depreciation or other losses that flowed through Debtor as a pass-through entity.[xxi]

The partners now sought to effect a change in the tax treatment of Debtor that would have saddled Debtor with substantial capital gains and taxes from the sale of its assets. In other words, the partners would receive a tax benefit (Debtor’s losses and deductions) through favorable tax treatment, and would shift the unfavorable treatment to the detriment of Debtor’s creditors. The absolute priority rule, the Court stated, was designed to prevent such an abuse.

What’s more, the Court continued, Debtor’s disclosure statement[xxii] detailed the tax consequences of the Plan. “There is a possibility that various transfers and transactions contemplated by the Plan would result in a reduction of certain tax attributes . . . including but not limited to . . . capital gains liability”.

At the time of the Court’s confirmation of the Plan, Debtor could have discussed the treatment of capital gains taxes and the possibility of an entity classification election. The Disclosure Statement and Plan both included the Liquidation Provision. Thus, Debtor knew that upon default, a Liquidating Trustee could be appointed and assets sold. There was no unfair surprise to Debtor, but there would be unfair surprise to its creditors. Creditors acted relying on the Disclosure Statement and Plan, which did not include a discussion of a possible change in tax treatment. The Court stated that any election to be taxed as an association should have occurred pre-petition, or at least pre-confirmation.

The Court found it troubling that the Debtor sought to change its tax status to its own detriment and, thereby, to that of its creditors. In general, the Court stated, the two purposes underlying the bankruptcy code are the “debtor’s fresh start and the repayment of creditors.” Debtor’s electing to be taxed as an association, the Court stated, would accomplish neither of these goals. Rather, it would burden Debtor with potentially substantial capital gains taxes, and reduce payments to its creditors. The election would merely allow Debtor’s partners to shift unfavorable tax treatment elsewhere.

The Court determined that the proposed tax election was not in the best interests of Debtor, the estate, or its creditors. Therefore, the Court prohibited the check-the-box election.

Electing Association Status vs. Revoking an “S” Election? [xxiii]

What can we take away from the Court’s opinion? The Court claimed to have based its decision upon the absolute priority rule. At the same time, though, the Court stated that any election by Debtor to be taxed as an association should have occurred pre-petition, or at least pre-confirmation, which is more in line with the purpose of the disclosure statement. So which is it?

A couple of years back,[xxiv] we considered the case of another pass-through entity: a debtor S-corporation which, prior to filing its voluntary petition, revoked its election to be treated as an S-corporation for tax purposes.[xxv] As a result of revoking its “S” election, the debtor became subject to corporate-level tax as a C-corporation, and its shareholders – to whom distributions from the debtor would likely have ceased after the filing of its petition – were no longer required to report its income on their personal returns.[xxvi]

Following the debtor’s petition, the Court authorized the sale of substantially all of the debtor’s operating assets. The sale occurred shortly thereafter, and the Court then confirmed the debtor’s plan of liquidation, pursuant to which a liquidating trust was formed.

The liquidating trustee filed a complaint against the debtor’s shareholders, seeking to avoid the revocation of the debtor’s S-corporation status as a fraudulent transfer of the debtor’s property under the bankruptcy code.[xxvii]

The Court noted that most other courts that had considered the issue found that a debtor’s S-corporation status was a property right in bankruptcy. These courts reasoned that a debtor corporation had a property interest in its S-corporation status on the date that the status was allegedly “transferred” because the Code “guarantees and protects an S corporation’s right to dispose of [the S-corporation] status at will.” Until such disposition, the corporation had the “guaranteed right to use, enjoy, and dispose” of the right to revoke its S-corporation status. Consequently, these courts held that the right to make or revoke S-corporation status constituted “property” or “an interest of the debtor in property.”

The Court acknowledged that the property of the bankruptcy estate is composed of “all legal or equitable interests of the debtor in property as of the commencement of the case.” Congressional intent, it stated, indicated that “property” under the code[xxviii] was a sweeping term and included both intangible and tangible property.

However, it continued, no code provision “answers the threshold questions of whether a debtor has an interest in a particular item of property and, if so, what the nature of that interest is.” Property interests are created and defined by state law, unless some countervailing federal interest requires a different result.

Normally, the “[Code] creates no property rights but merely attaches consequences, federally defined, to rights created under state law.” In that case, the Court stated, federal tax law governed any purported property right at issue because S-corporation status was a creature of federal tax law. State law created “sufficient interests” in the taxpaying entity by affording it the requisite corporate and shareholder attributes to qualify for S-corporation status; at that point, it continued, federal tax law dictated whether S-corporation status was a property right for purposes of the code.

The Court recognized that certain interests constituted “property” for federal tax purposes when they embodied “essential property rights.”[xxix] A reviewing court must weigh these factors, it stated, in order to determine whether the interest in S-corporation status constituted “property” for federal tax purposes.

Applying these “essential property rights” factors, the Court observed that only one of the factors leaned in favor of classifying S-corporation status as property; specifically, the debtor’s ability to use its S-corporation tax status to pass its tax liability through to its shareholders. The liquidating trustee hoped to generate value through avoidance of the “transferred” S-corporation revocation, thus retroactively reclassifying the debtor as an S-corporation. The liquidating trustee believed that by doing so, the debtor’s losses would pass through to its shareholders, offsetting other income on their personal returns, and thereby generating refunds that the liquidating trustee intended to demand from the shareholders for the benefit of the liquidating trust and the creditors.

In response to this “plan,” the Court pointed out that, although something may confer value to the estate, it does not necessarily create a property right in it.

The Court explained that a corporation cannot claim a property interest to a benefit that another party – its shareholders – has the power to legally revoke at any time.[xxx] The “S” election, it stated, removes a layer of taxation on distributed corporate earnings by permitting the corporation to pass its income through to the corporation’s shareholders. The benefit is to the shareholders: it allows them to avoid double taxation. To the extent there is value inherent in the election, it is value that Congress intended for the corporation’s shareholders, and not for the corporation.[xxxi]

After weighing the foregoing, the Court held that S-corporation status could not be considered “property” for purposes of the code, and there was no transfer of the debtor’s interest in property on the shareholders’ revocation of such status that was subject to avoidance under the code.

Lesson?

Absolute priority. Disclosure. Fraudulent Conveyance. A question of timing? A question of property rights? A question of fairness?

A pre-petition election to be treated as an association, or a pre-petition revocation of a corporation’s “S” election, would address the concern over providing creditors sufficient information with which to consider a proposed plan. Their acceptance of the plan, and a court’s confirmation thereof, would seem to bar any further discussion.

However, some creditor is bound to object, probably on the grounds described above.

Regardless of how one frames the argument as a matter of “technical” bankruptcy law, from a non-technical perspective, the election or revocation, as the case may be, shifts the tax liability for the liquidation of the business away from the partners and shareholders and onto the debtor-business entity, which of course reduces the value that will be available to satisfy the claims of the creditors. On a visceral level, that doesn’t seem right, especially in the absence of a bona fide, even compelling, non-tax business reason for effectuating such a change in tax status.[xxxii]

Of course, what feels right is not always consistent with what the law allows in a given set of circumstances. When faced with the prospect of a bankruptcy proceeding, the debtor-taxpayer and its owners should consult with their bankruptcy (and tax) advisers well before making any changes to the debtor’s tax status.


[i] From the opening of The Odd Couple.

[ii] From the ad for Reese’s Peanut Butter Cup. Don’t you miss the ‘70s? Sometimes?

[iii] If you’ve watched bankruptcy folks at work, you know that their code is more like a set of guidelines than actual rules, to paraphrase Captain Barbossa from the first Pirates of the Caribbean movie.

[iv] If you have read Salman Rushdie’s Two Years Eight Months and Twenty-Eight Nights, you’ll understand the reference; if you have not read it, please do.

[v] For example, before the passage of the Tax Cuts and Jobs Act (P.L. 115-97), a troubled taxpayer was able to carry its NOLs back two years in order to generate a refund and some badly needed cash. The Act eliminated the carryback. That being said, it also eliminated the 20-year carryforward, thereby allowing NOLs to be carried forward “indefinitely” – i.e., until they are exhausted – and removing some of the sting from the ownership change rules under Section 382 of the Code, which limit the amount of NOL that may be utilized in any taxable year. At the same time, however, the Act also limited the amount of loss that may be utilized in any tax year to 80-percent of the taxpayer’s taxable income. IRC Sec. 172.

[vi] U.S. Bankruptcy Court for the Western District of Wisconsin, In re: Schroeder Brothers Farms of Camp Douglas LLP, Debtor; Case No.: 16-13719-11, May 30, 2019.

[vii] Another, more commonly encountered intersection, involves the cancellation of indebtedness of a taxpayer in bankruptcy. IRC Sec. 108(b).

[viii] It is my understanding that many debtors will seek to liquidate under Chapter 11 because it enables their management team to remain in place and to “control” the liquidation process. Of course, a filing under Chapter 11 suspends all foreclosure actions.

[ix] Chapter 12 is designed for “family farmers” or “family fishermen” with “regular annual income.” It enables financially distressed family farmers and fishermen to propose and carry out a plan to repay all or part of their debts. Under chapter 12, debtors propose a repayment plan to make installments to creditors over three to five years. Generally, the plan must provide for payments over three years unless the court approves a longer period “for cause.”

[x] Reg. Sec. 301.7701-3.

[xi] By filing IRS Form 8832.

[xii] IRS Form 1065.

[xiii] IRC Sec. 701.

[xiv] IRC Sec. 1399. Special rules for individual bankruptcy cases are provided under IRC Sec. 1398.

[xv] By preventing the pass-through to the partners of the gain from the sale of Debtor’s assets

[xvi] In deference to the Court, I left the upper case “c” intact.

[xvii] Bankruptcy code Section 1129(b).

[xviii] Unless the seniors agree to subordinate some of their claims.

[xix] I.e., tax-paying.

[xx] Under which each of Debtor’s owners paid tax on their share of Debtor’s gains.

[xxi] Provided, of course, they had sufficient basis for their partnership interest. IRC Sec. 704(d). If losses were suspended because of insufficient basis, the gains from the sale of Debtor’s assets would have restored such basis and thereby allowed such losses to be utilized by the partners.

[xxii] Which is intended to provide its creditors with “adequate information” regarding the debtor to enable its creditors to make an informed judgement about the plan proffered. https://www.uscourts.gov/services-forms/bankruptcy/bankruptcy-basics/chapter-11-bankruptcy-basics

[xxiii] How about a partnership that becomes an S-corporation/association by filing IRC Form 2553, and that subsequently revokes its “S” election, thereby becoming an association taxable as a C-corporation?

[xxiv] https://www.taxlawforchb.com/2017/12/revoking-s-corp-status-a-fraudulent-conveyance/

[xxv] With the consent of its shareholders holding a majority of its stock. IRC Sec. 1362(d).

[xxvi] Compare this to the Debtor-partnership electing to become an association for tax purposes.

[xxvii] In general, the trustee may avoid any transfer of a debtor’s interest in property: (a) that was made within 2 years before the date of the filing of the petition if the debtor made such transfer with intent to hinder, delay, or defraud any entity to which the debtor was or became, on or after the date that such transfer was made, indebted; or (b) for which it received less than a reasonably equivalent value in exchange for such transfer; or was insolvent on the date that such transfer was made, or became insolvent as a result of such transfer.

[xxviii] Note the lower case “c”.

[xxix] Including (1) the right to use; (2) the right to receive income produced by the purported property interest; (3) the right to exclude others; (4) the breadth of the control the taxpayer can exercise over the purported property; (5) whether the purported property right is valuable; and (6) whether the purported right is transferable.

[xxx] A corporation has little control over its S-corporation status, yet the right to exercise dominion and control over an interest is an essential characteristic defining property. Shareholders have the ability to control the tax status of their corporation. Election of S-corporation status may be achieved by one method: unanimous shareholder consent – the corporation does not elect S-corporation status. Thus, the Court concluded, any interest in electing S-corporation status belongs to the shareholders.

[xxxi] S-corporation status, it stated, is a statutory privilege that qualifying shareholders can elect in order to determine how income otherwise generated is to be taxed.

[xxxii] Especially when one considers the tax “benefit” of being able to claim the losses generated by the debtor-business.

Think about what a healthy business entity wants when considering the sale of its assets: one level of tax so as to maximize the net proceeds for its owners.

If you’ve been representing closely held businesses long enough, then the “conversation transcribed” below should sound familiar to you.

I have had several versions of this exchange in the last few months.[i] The common theme? The risk that the IRS may not accept one or more steps in the transaction at their “face value,” and that it may seek to give tax effect to the larger transaction (of which these steps are a part) in accordance with what the IRS believes is its true nature.

It is a basic precept of the tax law that the substance of a transaction, rather than its form, should determine its tax consequences when the form of the transaction does not coincide with its economic reality.

This substance-over-form argument is a powerful tool in the hands of the IRS. It can also be very frustrating for a business owner who genuinely believes that they have a bona fide, non-tax reason for the transaction structure chosen.

In the Present

The sole owner of a successful business has an issue they want to discuss with their attorney.

Owner:        I have this really great employee that I want to reward. Any ideas?

Adviser:       I know you already pay a more-than-decent salary. What about a generous annual bonus?

Owner:        Already doing that.

Adviser:       Is the bonus discretionary with you, or is it somehow tied to performance and a formula?

Owner:        I decide whether it is paid and how much. I always pay it before the year-end.[ii]

Adviser:       You know, if you removed the discretionary aspect, and gave this employee something “measurable,” you may provide them with a greater incentive to work hard and to reach whatever targets you set for them. Make the obvious more tangible or certain for them: if the business does well, they will do well.

Owner:        What about giving the employee a piece of the company?

Adviser:       Hold on a minute. First, that’s not what I’m suggesting. Second, have they asked for that?

Owner:        No. Not really. But I’m sure they’d appreciate it.

Adviser:       So would I. Would they pay for the stock?

Owner:        They can’t afford to do that.

Advisor:      OK. What if you sold it to them at a discount? Would you consider accepting a promissory note from them? Give them time to pay it off? The bargain element would be taxable to them as compensation . . . [iii]

Owner:        Actually, I was thinking that I would just gift it to them. Can’t I do that? I recall you telling me that the gift tax exemption was pretty high these days.[iv]

Adviser:       This is your employee – actually, your company’s employee. We’re not talking about a family member or friend here. I wouldn’t exhaust my exemption amount on someone who may quit next year, and whom I may have to buy out.

Your relationship is strictly of a business nature, right? Under those circumstances, the IRS is likely to treat as compensation any transfer of property you make to them. [v]

That means ordinary income to them. It also triggers employment taxes. How will you and they pay those taxes?

Owner:        How will the IRS even know . . . ?[vi]

Adviser:       Please, don’t get me started. Let’s not have this discussion again.

Owner:        Can I pay them a bonus for the taxes?

Adviser:       A “gross-up?” Yes, but this is going to turn into an expensive proposition for you. That bonus would, itself, be taxable. Do I have to remind you that the employer is responsible for its share of employment taxes?

In any case, I have a more fundamental issue for you. Why would you bring in a minority shareholder, anyway? State law affords them many rights, and imposes certain fiduciary duties on you as the controlling shareholder.

Owner:        Oh, now you’re sounding like a lawyer.

Adviser:       Well, that’s probably because I am. Sometimes, you even pay me to tell you these things before you go ahead and do something you’ll regret.

Do you think your minority shareholder is going to like the idea of the business’s paying for your clubs, your vacations, the restaurants, the cars, your spouse’s pension plan – still coming in once a month, I gather? – your niece’s tuition, your father’s and your children’s no-show jobs . . . ?

Owner:        C’mon, everyone does that.

Adviser:       Remember when you entertained that unsolicited offer for the business a few years back? Hmm? You handed over all that information to the prospective buyer’s accountants – thankfully, only after I got wind of what you were doing and prepared a non-disclosure agreement – and they came back with all of the so-called “add-backs”?

Well, your key employee-minority shareholder is going to be questioning those same items, among other things, including your obsession with golf. Don’t you work anymore?  

Owner:        Well, I need to keep this employee, which means I need to keep them happy. Everyone has their price.

Adviser:       I won’t comment on your last statement.

Look, you’ve been talking about selling the business in the next few years, right?

Owner:        Sure. That’s exactly why I need to keep this employee – to get me to the finish line.

Adviser (under his breath):        And to the golf course.

Owner:        What was that?

Adviser:       Nothing, just thinking aloud – we need to chart a course.  OK. How about a change-in-control payment, one that’s based upon a percentage of the net sale proceeds?

Owner:        I can do that?

Adviser:       Sure you can. In that way, you give the employee a chance at sharing in the value of the business – at the same time you liquidate your investment – without making them an owner. Remember that discussion we had about “phantom stock”? OK. It’s something like that. You can even require that the employee remain with the business until the sale occurs in order for them to benefit from the sale. If they leave before then, for any reason, they won’t be entitled to any of the proceeds.

Owner:        I think I recall this conversation. Something about “vesting,” right? That’s harsh, though, and I don’t want them to think that I can pull the rug out from under them just before a sale.[vii]

Adviser:       I’m not suggesting that. Look, I gave you a simple illustration of the concept. You can tailor it to satisfy whatever terms you and your key employee decide upon.[viii] My point is that you can protect yourself.

Owner:        Will this payment be taxed as capital gain to the employee?

Adviser:       No, it will be taxed as ordinary compensation income, and the company should be entitled to a deduction for the payment.[ix] Think of it as a performance-based bonus – a “thank you” for getting you to your goal.

Owner:        Ordinary income? They won’t have anything left after taxes. Can I gross them up, pay them more so they end up where they would’ve been if they had capital gain?

Adviser:       Yeah, but again, this is getting expensive for you.

Owner:        This all seems so complicated . . .

Adviser:       It isn’t, really, . . .

Owner:        I’m just going to make them an owner. Keep it simple.

Adviser:       You’re a pig-headed @#^*. Why do you waste my time, and your money? Go ahead, do whatever you want. Just do me one favor.

Owner:        What is it?

Adviser:       Two favors. Now hear me out. If you follow through with this nonsense, give this uber-employee of yours non-voting stock – remember, we recapitalized the company to provide for a class of non-voting stock when we talked about making some gifts to a trust for your kids? – and have them sign a shareholders’ agreement.

Owner:        Why a shareholders’ agreement?

Adviser:       For starters, because you want to restrict their ability to sell their shares, you want to have the right to buy back their shares if they leave the business for any reason, and you want to have the right to compel them to sell their shares if you decide to sell yours.[x]

You can also reduce the amount of compensation income to the employee by incorporating certain “non-lapse restrictions” to reduce the valuation of the shares . . .[xi]

Owner:        Sounds reasonable. I’ll consider it. Say, are you free for golf next Monday?

Adviser:       I would have thought that, by now, you’d know that I don’t golf. By the way, did you know that golf courses are identified as a “sin business” under the qualified opportunity zone rules?[xii]

Fast Forward a Few of Years

The key employee (the “Employee”) is a minority shareholder in the business (the “Business”).

There is no shareholders’ agreement between the Owner and the Employee. The Owner has gifted some shares in the Business to an irrevocable grantor trust for the benefit of the Owner’s issue.[xiii]

The Owner and the Employee have had some differences of opinion over dividend policy and the direction of the Business, generally. The Owner has been reinvesting the profits in order to prepare the Business for a sale; the Employee would like to withdraw these profits to help pay for family expenses, including tuitions.

The Adviser is being treated for an ulcer, anxiety, and depression.[xiv]

The Owner – who has been semi-retired for the last few years, and whose golf game has improved substantially – has been approached by a competitor (the “Buyer”) with an offer to buy the Business; specifically, the Buyer has offered to purchase all of the issued and outstanding shares of the Business in exchange for cash at closing, and with five-percent of the sale price to be held in escrow for eighteen months.[xv]

The Buyer plans to consolidate the Business into the Buyer’s existing infrastructure.

In recognition of the Employee’s status in the Business, the Employee has been offered an employment agreement to stay on with the Buyer for a couple of years, on the theory that their assistance will be required in order to effectuate the smooth transition of the Business’s customers. The agreement may be extended at the Buyer’s option.

The Owner is eager to consummate the deal on the terms offered. The price is right and the terms are fair[xvi] – at least in the eyes of the Owner.

The Employee is less bullish about the transaction. In fact, the Employee has given some indication that they will likely refuse to sell their shares.

The Employee thinks the Business is worth more than the Buyer has offered, and they believe they deserve more than just a short-term employment agreement.

What’s more, the Employee would like to defer some of their gain by rolling over some of their equity in the Business.[xvii]

The Employee also believes that only the Owner should be liable for any losses suffered by the Buyer on a breach of any representations and warranties regarding the Business – after all, the Owner controlled the Business.[xviii]

With the Owner’s dream of a stock sale in jeopardy, the Owner approaches the Adviser.

After several attempted “I told you so’s,” – especially regarding the drag-along in the non-existent shareholders’ agreement – which the Owner has somehow parried, the Adviser suggests that the Owner approach the Buyer about employing a reverse merger to force the Employee to sell their shares.[xix]

The Adviser explains that the Buyer would create a subsidiary, which would then merge with and into the Business, with the Business as the surviving entity.[xx] As a result of the merger, the Employee would receive the cash consideration provided for by the merger agreement; because the cash for this consideration would come from the Buyer, the transaction would be treated, for tax purposes, as a purchase of the Business’s shares by the Buyer. If the Employee was dissatisfied with this consideration, they may exercise their dissenter’s or appraisal rights under state law, but they would cease to be a shareholder of the Business.

However, the Owner doesn’t want to approach the Buyer. He doesn’t want to alert the Buyer to the dissension, for fear that it may spook the Buyer and jeopardize the deal.

The Adviser suggests that the Owner may effect the same kind of squeeze-out without involving the Buyer. He explains that the Owner may form a new corporation which would be merged into the Business with the Business surviving. The Employee would either accept the consideration provided under the merger agreement, or they would exercise their appraisal rights.

Again, the Owner rejects the Adviser’s suggestion, fearing that any squeeze-out would antagonize the Employee – and unnerve the Buyer, which planned to retain the Employee’s services for a period of transition – and that any litigation brought by the Employee in exercise of their dissenter’s rights would kill any deal with the Buyer.

“What if I purchased the Employee’s shares myself?” the Owner asks the Adviser. “I’d buy them for a premium over the per share price offered by the Buyer. I’d give the Employee my own promissory note, and I would satisfy it immediately after I sold the Business to the Buyer. That way, I keep the Buyer out of the picture, and I save my deal.”

After some research, and under the facts and circumstances described, the Adviser makes the following observations and conclusions:

  • the IRS may collapse the two sale transactions – from the Employee to the Owner, and from the Owner to the Buyer – and treat them as one;
  • in that case, the IRS would consider the Owner and the Employee as each having received their pro rata share of the consideration from the Buyer;
  • any “excess” received by the Employee over their pro rata share may be considered as a payment from the Owner in a separate transaction.[xxi]
  • because of the Employee’s status in the Business as a key employee, this payment may be treated as ordinary compensation income;
  • in that case, the payment should also be deductible;
  • alternatively, the IRS may treat the “excess” payment as having been made by the Owner to secure the Employee’s agreement to sell their shares;
  • according to the IRS, this would represent ordinary income to the Employee, but a capital expenditure by the Owner.

The Owner is incredulous. “Wait,” he says, “if I purchase the Employee’s shares at a premium in order to remove the Employee as an obstacle to a sale of the Business to the Buyer, the Employee will have ordinary income? The Employee will never agree to that. How is that possible where the Employee is selling shares of stock? Can’t we just say that the Employee negotiated a better deal, or was in a better bargaining position than I was?”

Disproportionate Distributions

Historically, the IRS has viewed with skepticism the receipt by shareholders of distributions from their corporation or of payments from a third party – in each case, purportedly in the shareholders’ capacity as such – when the amount received is disproportionate to their share holdings.

Thus, when property is transferred to a corporation by two or more persons in exchange for stock, and the stock received is disproportionate to the transferor’s prior interest in the property, the transaction may be treated as if the stock had first been received in proportion and then some of such stock had been used to make gifts, to pay compensation, or to satisfy some other obligation of the transferor, depending upon the facts and circumstances.[xxii]

The same analysis may be applied to the liquidation of a corporation where the majority shareholder (“M”) accepts less than the pro rata share of the liquidating distribution to which M is entitled – but which would nevertheless generate a gain on M’s investment – in order that an unrelated minority shareholder may receive more than their pro rata share, thereby avoiding a loss on their investment.

The non pro rata liquidating distribution by the corporation to the shareholders would be treated for tax purposes as if there had been a pro rata distribution to each shareholder in full payment in exchange for each shareholder’s stock, together with a transfer by M to the minority shareholders of an amount equal to the excess of the amount received by the minority over the minority’s pro rata share of the liquidating distribution. The difference between M’s pro rata share and the amount actually received by M would be treated as having been paid over by M to the minority shareholders in a separate transaction, the tax consequences of which would depend upon the underlying nature of the payments, which in turn depends upon all of the relevant facts and circumstances, “which must be determined from all of the extrinsic and intrinsic evidence surrounding the transaction.”[xxiii]

The foregoing would seem to support a preemptive move by the majority owner of a business, one undertaken well in advance of a sale of the business – and perhaps in “collaboration” with the minority – including by way of a squeeze-out. Such a buy-out of the minority’s interest may include a purchase price adjustment in the event the business is sold within a relatively short period after the buy-out.[xxiv]

The Tax Court

The Tax Court, on the other hand, seems to have been more receptive to the taxpayer’s position. In one case,[xxv] the issue was whether a payment made by Target’s majority shareholder (“Majority”) to a minority shareholder (“Minority”) in settlement of a lawsuit for damages for failure to deliver certain property constituted capital gain or ordinary income.

Minority filed suit against Majority for damages resulting from their failure to deliver certain options to Minority. The options were the subject of an oral agreement arising out of a plan of merger for Target. Minority objected to the portion of the plan of merger which provided for the redemption of some Majority shares by the transfer to Majority of some interest in real estate. Minority contended that the real estate was worth much more than the value assigned to it for purposes of the redemption, and they demanded to share in the redemption. Minority threatened court action to block the merger unless their demands were met.

Minority contended that the options, if executed, represented consideration for their stock in Target. The IRS contended that the options were in the nature of compensation for Minority refraining from blocking the merger; it sought to tax the settlement as ordinary income because Minority agreed not to vote against the merger.[xxvi]

The Court concluded that the options were promised as additional consideration for the Target stock owned by Minority. Majority and Minority, the Court stated, were “frantically attempting to settle their differences before the shareholders meeting which was called to vote on the merger.” According to the Court, Minority demanded more from the merger, and Majority offered the options.

The Court found as a fact that the quid pro quo for the agreement to deliver the options was additional consideration for the Target stock owned by Minority. The taxability of the settlement, the Court continued, was controlled by the nature of the litigation, which was controlled by the origin and character of the claim which gave rise to the litigation. Having found that the claim arose out of the purported inadequacy of the consideration received in the merger, it followed that the settlement represented additional consideration for Minority’s disposition of its shares in Target.

What’s an Owner to Do?

If the Employee-minority shareholder had been party to a properly drafted shareholders’ agreement, the situation described above may have been avoided. Of course, if the Employee had never been made a shareholder of the Business to begin with . . . .[xxvii] Perhaps a change-in-control bonus payment would have sufficed.

In any event, advisers are often presented with facts and circumstances beyond their control. A shareholder’s dual capacity – as an employee and as an investor – may complicate the tax treatment of a non-pro rata payment, as indicated above; it may invite closer scrutiny of the arrangement by the IRS.

In light of the Tax Court’s holding and the IRS’s contrary position, and provided the payment by the majority shareholder is, in fact, being made to a minority shareholder in their capacity as an investor – rather than as a compensatory incentive – it will behoove the parties to document the arrangement as thoroughly and as contemporaneously as possible in order to substantiate their position and support capital gain treatment for the payment.


[i] I have taken poetic license here and there to pull together (even manufacture) a smorgasbord of “facts” and issues and to provide some color, in order to convey today’s message.

[ii] In other words, there is no deferral within the meaning of IRC Sec. 409A.

[iii] IRC Sec. 83.

[iv] The Federal exemption is currently set at $11.4 million per individual donor. IRC Sec. 2010.

[v] IRC Sec. 83.

[vi] The federal gift tax return, Form 709, requires that the donor describe their relationship to the donee.

If the employer-company is a pass-through entity, such as a partnership or S corporation, the employee-owner will receive a K-1 (assuming they are vested in the equity or they have made a Sec. 83(b) election).

In other words, there a many ways for the IRS to figure out what happened.

[vii] The “vesting” event is usually tied to the employee’s having served the business for a prescribed number of years, though it may also be tied to the employee’s attainment of certain performance goals. See, e.g., Reg. Sec. 1.83-3.

[viii] Subject, of course, to the principles of the constructive receipt and economic benefit doctrines, and the deferral/distribution rules under IRC Sec. 409A.

[ix] A couple of assumptions here: (1) the compensation is reasonable for the service rendered; the fact that the sale occurs may satisfy the standard; and (2) the compensation will not trigger Sec. 280G’s “golden parachute” rules; these rules do not apply to a certain small business corporations (like an S corporation), or to certain corporations that timely secure shareholder approvals to the payment arrangement.

[x] The last item is known as a “drag-along.”

[xi] Reg. Sec. 1.83-5. A bona fide arrangement will not create a second class of stock where the employer is an S corporation. Reg. Sec. 1.1361-1(l).

[xii] IRC Sec. 1400Z-2(d)(3)(A)(ii) and Sec. 144(c)(6)(B).

[xiii] The appraisal reflects valuation discounts for lack of marketability and lack of control. The gifts occur well before the offer to buy described below.

[xiv] The Adviser still associates the word “golf” with a VW hatchback.

[xv] The shareholders are thereby assured of only one level of gain recognition, all of which will be capital gain, in contrast to an asset sale, which would be taxable to the corporation and then to the shareholders, and which could generate ordinary income.

[xvi] For example, with customary representations and warranties, covenants, and indemnity provisions.

[xvii] The Owner has no interest in leaving any of his equity at risk in the Business after his departure.

[xviii] These serve several functions; for example, they help flesh out the state of the target business as of the date of the purchase and sale agreement and, if different, as of the closing date – a disclosure or due diligence function; if the seller cannot make the statements at the time of closing (as where the agreement is signed on one day and the closing occurs on a later day), the reps and warranties allow the buyer to walk away from the deal; and if the buyer suffers a loss after the closing that is attributable to a breach of these statements, the buyer may seek indemnity from the seller for such breach.

[xix] A form of squeeze-out technique.

[xx] A reverse subsidiary merger.

[xxi] See, e.g., Rev. Rul. 73-233. Y corporation wished to acquire X by statutory merger in exchange for 100 shares of stock of Y corporation. The stock of X was owned by three individuals: A owned 60 percent of the stock of X, and B and C each owned 20 percent of the stock of X. A two-thirds vote of the target corporation’s shareholders in favor of the merger was required to meet the applicable merger laws of the State in which X was incorporated. B and C refused to vote in favor of the proposed merger unless they would each receive 25% of the consideration. In consideration for B and C voting in favor of the merger, A agreed to permit B and C each to receive 25 shares of Y stock instead of the 20 shares of Y stock which they would have been entitled to receive had the distribution of the merger consideration to the X shareholders been in proportion to their stock ownership of X. In order to effectuate this agreement, A contributed one-third of his stock in X to the capital of X with the result that A’s stock interest in X was reduced to 50 percent and B’s and C’s stock interests were each increased to 25 percent. The X shareholders then voted unanimously in favor of the merger which was thereafter consummated. A, B, and C received, respectively, 50, 25 and 25 shares of Y stock in exchange for their X stock.

According to the IRS, under the circumstances described, the contribution of X stock by A to the capital of X prior to the merger will not be considered independently of the related events surrounding the contribution. The other related events to be considered are (i) the agreement of B and C with A to vote in favor of the merger if B and C would each receive five additional shares of Y stock, and (ii) the merger.

Accordingly, the overall transaction will be viewed as (1) a merger of X into Y with a distribution of 60, 20 and 20 shares of Y stock to A, B, and C, respectively, in exchange for their X stock, with no gain or loss being recognized to A, B, or C on this exchange under IRC Sec. 354, and (2) a transfer by A of five shares of Y stock to B and five shares of Y stock to C in consideration for their voting in favor of the merger.

Gain or loss will be recognized to A on his transfer of 10 shares of Y stock, five to B and five to C, to the extent of the difference between the fair market value of the stock and the adjusted basis of the stock in A’s hands at the time of the transfer.

Since the transfer by A of Y stock to B and C was in satisfaction of B and C voting for the merger which enabled A to acquire the Y stock, such transfer will be considered a capital expenditure and, therefore, not a deductible expenses to A. A will be permitted to adjust the basis of his remaining 50 shares of Y stock by increasing his basis in such stock by the fair market value of the 10 shares given up.

The fair market value of the five shares of Y stock received by B and C, respectively, from A is includible in their gross incomes.

[xxii] Reg. Sec. 1.351-1(b).

[xxiii] Rev. Rul. 79-10.

[xxiv] Like an installment sale with a fixed maturity date but a contingent purchase price. Reg. Sec. 15A.453-1(c).

[xxv] Gidwitz Family Trust v. Comm’r, 61 T.C. 664 (1974).

[xxvi] A “negative” service, like a payment for a non-compete?

[xxvii] I told you so.

It’s Not Easy

The owners of many closely held businesses recently filed federal income tax returns on which they claimed, for the first time, the deduction based on “qualified business income” under Section 199A of the Code; many others will be doing so in October of this year.[i]

Fortunately, these taxpayers and their advisers are able to rely upon the guidance published by the IRS in the form of proposed and final regulations, in August 2018 and January 2019.

The fact remains, however, that many taxpayers, as well as many tax advisers, continue to raise questions relating to the application of Section 199A. This should not surprise anyone.

The deduction is the product of one of the most convoluted provisions to have ever entered the Code. What’s more, its relatively brief lifespan (2018 through 2025), coupled with the introduction and implementation of many other equally difficult provisions,[ii] challenged the resources of both the IRS and tax advisers to produce a timely and workable set of rules by which to administer the new deduction. [iii]

One question that I have been asked more than a few times by owners of closely held businesses that operate both domestically and overseas concerns the application of Section 199A to income derived from activities outside the U.S.[iv]

At this point, a number of readers may interject that “199A does not apply to such income – the 20-percent deduction is based upon income that is effectively connected with a U.S. trade or business.”

This not unreasonable reaction underscores the need for tax advisers to continue to educate themselves and their clients as to the application of Section 199A, lest they fail to realize the full benefit of the deduction.

Sec. 199A – Qualified Business Income

In general, for taxable years beginning after December 31, 2017, and before January 1, 2026,[v] an individual taxpayer may deduct 20-percent of their qualified business income with respect to a partnership, S corporation, or sole proprietorship.[vi]

Qualified business income (“QBI”) means the net amount of “qualified items” of income, gain, deduction, and loss with respect to the qualified trade or business (“QTB”) of the taxpayer, to the extent they are included in taxable income under the QTB’s accounting method.[vii]

Effectively Connected

Items of income, gain, deduction, and loss are treated as qualified items only to the extent they are “effectively connected” with the conduct of a trade or business within the U.S.[viii]

In determining whether such items are effectively connected with a U.S. trade or business for purposes of Section 199A, taxpayers are directed to apply the rules under Section 864(c) of the Code by substituting QTB for “nonresident alien individual or a foreign corporation,” or for “a  foreign corporation,” each place it appears in Sec. 864(c).[ix]

If only the application of Section 864(c) to Section 199A were as simple as implied by the straightforward substitution of “QTB” for “foreign person” described above. In order to better understand the interplay between the two provisions, we begin with a brief review of the ECI rules as they apply to foreigners doing business in the U.S.[x] However, it is important not to lose sight of the fact that the focus of this discussion is on the U.S. taxpayer who is planning for the Section 199A deduction, and part of whose income may be generated by overseas activities.

ECI for Foreigners

A foreign person that is engaged in the conduct of a trade or business within the U.S. is subject to U.S. net-basis taxation[xi] on any income that is ‘‘effectively connected’’ with their conduct of the U.S. trade or business.[xii]

In general, the test for determining whether a foreign person is engaged in a trade or business in the U.S. is very similar to the test that is applied for purposes of determining whether a pass-through entity[xiii] is engaged in a trade or business for purposes of Section 199A – a person will be treated as engaged in a U.S. trade or business if, based on all the facts and circumstances, it may be said that they carry on substantial profit-oriented activities in the U.S. with “continuity and regularity.”

Assuming a foreign person is engaged in a U.S. trade or business, the Code provides various rules that help determine whether income is ECI with respect to such trade or business.[xiv]

U.S.-Source

In general, all income realized by a foreign person from sources within the U.S. (other than income that is FDAP) is treated as effectively connected with the foreign person’s conduct of a U.S. trade or business;[xv] stated differently, a foreign person’s U.S.-source non-FDAP income is generally treated as ECI.[xvi]

That being said, there are situations in which U.S.-source income that would otherwise be FDAP may, instead, be treated as ECI.[xvii]

Non-U.S. Source: Categories of Income

In general, no income of a foreign person from sources outside the U.S. – as distinguished from activities outside the U.S. – will be treated as effectively connected with the conduct of a U.S. trade or business by that person.[xviii]

That being said, a foreign person engaged in a U.S. trade or business may have certain categories of “foreign-derived” income that are considered ECI.[xix]

Specifically, a foreign person’s income from foreign sources may be considered ECI if the foreign person has an office or other fixed place of business (“Office”) within the U.S. to which such income is attributable, and the income falls within one of a few identified categories of foreign-source income.[xx]

Among these categories is income that is derived from the sale outside the U.S., through the foreign person’s U.S. Office,[xxi] of inventory or personal property held by the foreign person primarily for sale to customers in the ordinary course of the trade or business.[xxii]

However, this income will not be treated as ECI if the property is sold “for use, consumption, or disposition outside” the U.S., and an Office of the foreign person outside the U.S. “participated materially in such sale.”[xxiii]

Sourcing Rules for Inventory

The sourcing rules for income that is derived from the sale of inventory property are complex, to say the least, but they are essential in the application of Section 864(c) and, therefore, of Section 199A. Whether income is U.S. or foreign-source is determined under Sections 861, 862, 863, and 865 of the Code, and the regulations thereunder.

Income that is derived from the purchase of inventory[xxiv] without the U.S. and then sold within the U.S. (where title to the property passes) is treated as U.S.-source income. Similarly, income that is derived from the purchase of inventory within the U.S. and then sold without the U.S. is treated as non-U.S.-source income.[xxv]

Income from the sale of inventory produced (in whole or in part) by the taxpayer within and sold without the U.S., or produced (in whole or in part) by the taxpayer without and sold within the U.S., is to be allocated and apportioned between sources within and without the U.S. solely on the basis of the production activities with respect to the property.[xxvi]

Notwithstanding the foregoing, if a foreign person maintains an Office in the U.S., income from any sale of inventory attributable to such Office will be sourced in the U.S., unless the inventory is sold for use, disposition, or consumption outside the U.S. and an Office of the taxpayer in a foreign country materially participated in the sale.[xxvii]

It appears that this last provision – under Section 865(e)(2) of the Code – has supplanted the ECI rule under Sec. 864(c)(4)(B) of the Code, described above (relating to the sale of inventory outside the U.S. through a foreign person’s U.S. Office), by treating such income as U.S.-source; in turn, such income becomes ECI.[xxviii] Although not explicitly stated in the regulations issued under Section 199A, it would make sense to apply the ECI rules as to inventory under Section 864(c) consistently with the sourcing rule of Section 865(e).[xxix]

Attributable to U.S. Office

If income from the sale of inventory is received by a foreign person engaged in a U.S. trade or business, such income will be treated as U.S.-source under Sec. 865(e)(2), and as ECI under Sec. 864(c), if the income is “attributable” to the foreign person’s U.S. Office.

Income is attributable to a foreign person’s U.S. Office only if such Office is a “material factor” in the realization of the income,[xxx] and if the income is realized in the ordinary course of the trade or business carried on through that Office.[xxxi]

For this purpose, the activities of the Office will not be considered a material factor in the realization of the income unless they provide “a significant contribution to” the realization of the income by being “an essential economic element” in such realization.[xxxii] However, it is not necessary that the activities of the Office in the U.S. be a major (as opposed to a “material”) factor in the realization of the income.

Material Factor

A U.S. Office of a foreign person engaged in a U.S. trade or business will be considered a material factor in the realization of income from the sale of inventory if the Office actively participates in soliciting the order, negotiating the contract of sale, or performing other significant services necessary for the consummation of the sale which are not the subject of a separate agreement between the seller and the buyer.

The U.S. Office will also be considered a material factor in the realization of income from a sale made as a result of a sales order received in such Office, except where the sales order is received unsolicited and that Office is not held out to potential customers as the place to which such sales orders should be sent. The income must be realized in the ordinary course of the trade or business carried on through the U.S. Office.[xxxiii]

A foreign person’s U.S. Office will not be considered to be a material factor in the realization of income merely because of one or more of the following activities:

(a) The sale is made subject to the final approval of such Office,

(b) The property sold is held in, and distributed from, such Office,

(c) Samples of the property sold are displayed (but not otherwise promoted or sold) in such Office, or

(d) Such Office performs merely clerical functions incident to the sale.[xxxiv]

Sale for Use Outside the U.S.

Notwithstanding the foregoing, a U.S. office of a foreign person will not be considered to be a material factor in the realization of income from sales of inventory if the property is sold for use, consumption, or disposition outside the U.S. and an Office which such foreign person has outside the U.S. participates materially in the sale. This foreign Office will be considered to have participated materially in a sale made through the U.S. Office if the foreign Office actively participates in soliciting the order resulting in the sale, negotiating the contract of sale, or performing other significant services necessary for the consummation of the sale which are not the subject of a separate agreement between the seller and buyer.[xxxv]

As a general rule, inventory which is sold to an unrelated person is presumed to have been sold for use, consumption, or disposition in the country of destination of the inventory sold.[xxxvi]

Application to Section 199A

Section 199A refers taxpayers to the rules of Section 864(c) of the Code for purposes of determining whether the income of their QTB is effectively connected with the conduct of a trade or business within the U.S.

Specifically, the term “qualified items” of income, gain, deduction, and loss are those items that are effectively connected with the conduct of a trade or business within the United States (within the meaning of section 864(c), determined by substituting “trade or business (within the meaning of section 199A)” for “nonresident alien individual or a foreign corporation” or for “a foreign corporation” each place it appears).

Under Section 864(c)(4), income from sources without the U.S. is generally not treated as effectively connected with the conduct of a U.S. trade or business unless an exception under section 864(c)(4)(B) applies. Thus, a trade or business’s foreign-source income would generally not be included in QBI, unless the income meets an exception in section 864(c)(4)(B).

Where a taxpayer’s income from the sale of inventory would previously have been treated as foreign-source, yet also treated as ECI under Section 864(c),[xxxvii] the rule under Section 865(e)(2) will treat such income as U.S.-source and, consequently, as ECI if the taxpayer has a U.S. Office to which such income, gain, or loss is attributable.[xxxviii]

This income from the sale will not be treated as ECI, however, if the inventory is sold for use, consumption or disposition outside the U.S., and the taxpayer has an Office outside the U.S. that materially participated in the sale.

Parting Thoughts[xxxix]

As if the Section 199A rules weren’t difficult enough to negotiate without introducing the rules applicable to the U.S. taxation of income generated overseas.

Those U.S. taxpayers with business activities that extend beyond the borders of the U.S. already have a lot to think about as a result of the changes enacted by the Tax Cuts and Jobs Act. For example, should they form foreign corporate subsidiaries[xl] (basically, CFCs) through which to operate these activities and, thereby, to position themselves for a better result under the GILTI rules? Should they operate through foreign branches to take advantage of the foreign tax credit for foreign-source income?

To these (and other) questions, we may now add: can the U.S. taxpayer organize its operations in a way that maximizes its ECI under Section 864 – perhaps by increasing its U.S.-source income? – so as to take advantage of the Section 199A deduction?

All of these factors have to be considered in light of each taxpayer’s unique facts and circumstances in order to determine how best to structure the taxpayer’s operations from a tax perspective.

As always, however, the desired tax results should not overshadow or compromise business priorities.

——————————————————————————————————————————–

[i] Pursuant to an automatic six-month filing extension; IRS Form 4868.

See, e.g., Line 9 on page 2 of IRS Form 1040.

Section 199A was enacted by the Tax Cuts and Jobs Act (P.L. 115-97). It applies to all non-corporate taxpayers, whether such taxpayers are domestic or foreign. Accordingly, section 199A applies to both U.S. citizens and resident aliens as well as nonresident aliens that have QBI.

[ii] The “transition tax” under IRC Sec. 965, the GILTI rules under IRC Sec. 951A, and the Qualified Opportunity Zone program under IRC 1400Z-1 and 1400Z-2 come immediately to mind; there are others.

[iii] During the lifespan of most additions or changes to the Code, one would expect Congress, the IRS, and the courts – informed through their interaction and experience with taxpayers, tax professionals and each other – to amend or interpret a provision as necessary to attain the legislative goal that motivated its enactment.

However, where a taxpayer has only a few years – eight years in the case of Section 199A – during which to plan for and benefit from a provision, the normal evolutionary track does not apply.

[iv] Generally speaking, familiarity with the U.S. taxation of foreigners and foreign-sourced income was once limited to those who advise non-U.S. taxpayers with business interests in the U.S., or to those who represent large U.S. enterprises with foreign operations. Today, however, many smaller, closely held, U.S. businesses are now doing business overseas through branches or through corporate subsidiaries, or are engaged in joint ventures, both within and without the U.S., with foreign partners.

Of course, U.S. persons are subject to U.S. income tax on their worldwide income. Any income generated during a taxable year by a foreign branch of a U.S. person is included in their gross income for such year for U.S. tax purposes. The same is true of a U.S. person’s share of income of a partnership that operates overseas. In addition, anti-deferral rules, such as the CFC and GILTI rules, cause the current inclusion in a U.S. shareholder’s gross income of their share of the foreign corporation’s income.

[v] The statutorily prescribed lifespan of Section 199A. IRC Sec. 199A(i).

[vi] IRC Sec. 199A(a). A limitation on the amount of the deduction – based on W–2 wages, or W–2 wages plus capital investment (as applicable) – is phased in above a prescribed threshold amount of taxable income. IRC Sec. 199A(b).

A disallowance of the deduction on income from “specified service trades or businesses” is also phased in above the same threshold amount of taxable income.

[vii] IRC Sec. 199A(c).

[viii] IRC Sec. 199A(c)(3)(A)(i); effectively connected income (“ECI”).

[ix] IRC Sec. 199A(c)(3)(A); Reg. Sec. 1.199A-3(b)(2)(i)(A).

For the text of IRC Sec. 864: https://www.law.cornell.edu/uscode/text/26/864 .

[x] This post will not address the ability of nonresident aliens to claim the Section 199A deduction with respect to a U.S. trade or business in which they are engaged.

[xi] They may claim deductions for expenses paid or incurred with respect to their ECI; the resulting taxable income is taxed according to a graduated rate schedule. Compare to a foreigner’s fixed or determinable, annual or periodic income (“FDAP”), the gross amount of which is taxed, and subject to withholding, at a flat rate of 30-percent (subject to reduction by a treaty). IRC Sec. 871(a) and Sec. 881(a). In general, FDAP includes dividends, interest, rent.

[xii] IRC Sec. 871(b), 872, 882. The preamble to the proposed regulations provides that certain items of income, gain, deduction, and loss are treated as effectively connected income, but are not with respect to a U.S. trade or business (such as items attributable to the election to treat certain U.S. real property sales as effectively connected pursuant to section 871(d)), and are thus not QBI because they are not items attributable to a qualified trade or business for purposes of section 199A.

[xiii] A sole proprietorship, a partnership, or an S corporation.

[xiv] IRC Sec. 864(c)(1)(A). In the case of a foreign person not engaged in a U.S. trade or business, none of its income is treated as ECI. IRC Sec. 864(c)(1)(B).

[xv] IRC Sec. 864(c)(3).

[xvi] This is a so-called “force of attraction” concept.

[xvii] IRC Sec. 864(c)(2). Among the factors to consider in making this determination is whether the income is derived from assets used in, or held for use in, the conduct of a U.S. trade or business, and whether the activities of the U.S. trade or business were a material factor in the realization of the amount. Under these tests, “due regard” is given to whether such asset or such income was accounted for through the trade or business.

[xviii] IRC Sec. 864(c)(4)(A).

[xix] IRC Sec. 864(c)(4). Foreign-source income that is not included in one of those categories is generally exempt from U.S. tax.

[xx] IRC Sec. 864(c)(4)(B).

[xxi] Within the meaning of Reg. Sec. 1.864-7.

[xxii] IRC Sec. 864(c)(4)(B)(iii); Sec. 1221(a)(1).

[xxiii] IRC Sec. 864(c)(4)(B)(iii). Compare this to the language in IRC Sec. 865(e)(2).

[xxiv] IRC Sec. 865(i)(1), Sec. 1221(a)(1).

[xxv] IRC Sec. 861(a)(6), Sec. 862(a)(6).

[xxvi] IRC Sec. 863(b)(2), and the last sentence of Sec. 863(b), which was added by the Tax Cuts and Jobs Act (P.L. 115-97). Prior to this addition, such income was treated as partly U.S.-source and partly foreign-source on the basis of the place of sale and the place of production. Now, the income from the sale or exchange of inventory property produced partly in, and partly outside, the U.S. is allocated and apportioned on the basis of the location of production with respect to the property, and not the place of sale.

[xxvii] IRC Sec. 865(e)(2).

[xxviii] Unless the property is sold “for use, consumption, or disposition outside” the U.S., “and an office or other fixed place of business” of the foreign person outside the U.S. “participated materially in such sale.” In this regard, Sec. 864(c)(4)(B) and 865(e)(2) are “identical”: the former causes the income not to be ECI; the latter causes it to be foreign-source and, thereby, not ECI.

[xxix] Some clarification would be welcomed here. Sec. 199A requires that Sec. 864(c) be applied to determine whether income is ECI, with the following modification: in applying Sec. 864(c), references to a “foreign person” are replaced with “QTB.” That leaves the general sourcing rules in place.

Under Sec. 865(e), however, a different sourcing rule applies with respect to the sale of inventory by foreign persons (Sec. 865(e)(2)) than by U.S. persons (Sec. 865(e)(1)).

Query: for purposes of applying Sec. 864(c) to Sec. 199A, should Sec. 865(e)(2) be applied first because Sec. 864(c) applies only to foreign persons, and then Sec. 864(c) would be applied as modified for purposes of Sec. 199A?

[xxx] IRC 864(c)(5)(B).

[xxxi] Reg. Sec. 1.864-6.

[xxxii] Thus, for example, meetings in the U.S. of the board of directors of a foreign corporation do not, by themselves, constitute a material factor in the realization of income.

[xxxiii] 1.864-6(b)(2)(iii).

Thus, if a foreign person is engaged solely in a manufacturing business in the U.S., the income derived by its U.S. Office as a result of an occasional sale outside the U.S. is not attributable to the U.S. Office if the sales office of the manufacturing business is located outside the U.S. On the other hand, if a foreign person establishes a sales office in the U.S. to sell for consumption in the Western Hemisphere merchandise which the foreign person produces in Africa, the income derived by the sales office in the U.S. as a result of an occasional sale made by it in Europe shall be attributable to the U.S. sales office.

[xxxiv] Reg. Sec. 1.864-6(b)(2)(iii).

[xxxv] An office outside the U.S. shall not be considered to have participated materially in a sale merely because of one or more of the following activities: (a) The sale is made subject to the final approval of such office or other fixed place of business, (b) the inventory sold is held in, and distributed from, such office, (c) samples of the inventory sold are displayed (but not otherwise promoted or sold) in such office, (d) such office is used for purposes of having title to the inventory pass outside the U.S., or (e) such office performs merely clerical functions incident to the sale.

[xxxvi] Reg. Sec. 1.864-6(b)(3).

[xxxvii] Under Sec. 864(c)(4)(B)(iii).

[xxxviii] In accordance with Reg. Sec. 1.864-6.

[xxxix] My head hurts.

[xl] Being mindful of the repeal of Sec. 367’s exception for the incorporation of an active foreign business. Former Sec. 367(a)(3).

The Tax Law

In theory, the primary purpose of the income tax, as a body of law, is to raise from the governed the resources that the government requires in order to perform its most basic functions.[i] However, as society has evolved and its needs have changed, and as “the economy” has become more complex, the government has added to the purposes, and expanded the uses, of the income tax law.

Instead of acting only as a revenue generator, the tax law has been adapted to encourage certain behavior among the governed, or segments thereof, that the government has determined will have a beneficial effect upon society as a whole.

The most obvious manifestation of the tax law as a vehicle for behavior modification is found in the tax treatment of various business and investment-related activities. Specifically, by providing favorable tax treatment[ii] to a business and its owners “in exchange” for their making certain investments or engaging in certain activities, the government hopes to create a level of economic prosperity that will benefit not only the business, its owners and employees, but also the persons with which the business transacts, including its customers and its vendors.[iii]

Among the most recent examples of the use of the tax law as an economic incentive is the creation of qualified opportunity zones and the gain deferral and gain “forgiveness” that a taxpayer may enjoy by investing in a qualified opportunity fund.[iv]

Of course, some of these incentives, though well-intentioned, fail to deliver on their promise, in some cases because the provisions under which they are offered are too complicated, in other cases because the drafters miscalculated the causal connection between the proffered incentive and the hoped-for consequences, and in still other cases because other provisions of the tax law negated or outweighed the incentive.

Within this last class of tax incentives – that have failed to attain their potential, in no small part because of other provisions of the tax law – is the exclusion from gross income of the gain from a non-corporate taxpayer’s disposition of certain “small business stock.”[v]

Capital Gain, Section 1202, & C Corps: Parallel Histories

In general, the gain from the sale or exchange of shares of stock in a corporation that have been held for more than one year is treated as long-term capital gain.[vi]

Capital Gain Rate

The net capital gain of a non-corporate taxpayer for a taxable year – i.e., their net long-term capital gain less their net short-term capital loss for the taxable year – has, for many years, been subject to a reduced federal income tax rate, as compared to the rate applicable to ordinary income.[vii]

Indeed, from 1993 into 1998, the capital gain rate was capped at 28-percent; from 1998 into 2003, it was capped at 20-percent; from 2003 through 2012, it was capped at 15-percent; and from 2013 through today, it is capped at 20-percent.[viii]

Section 1202

In 1993,[ix] Congress determined that it could encourage the flow of investment capital to new ventures and small businesses – many of which, Congress believed, had difficulty attracting equity financing – if it provided additional “relief” for non-corporate investors who risked their funds in such businesses.

Under the relief provision enacted by Congress, as Section 1202 of the Code, a non-corporate taxpayer was generally permitted to exclude 50-percent of the gain from their sale or exchange of “qualified small business stock,” subject to certain limitations. The remaining 50-percent of their gain from the sale of such stock was taxable at the applicable capital gain rate. Thus, the aggregate capital gain tax rate applicable to an individual’s sale of qualified small business stock was capped at 14-percent.[x]

However, a portion of the excluded gain was treated as a preference item for purposes of the alternative minimum tax.

In 2009, the portion of the gain excluded from gross income was increased from 50-percent to 75-percent;[xi] in other words, with the then-maximum capital gain rate of 15-percent, a taxpayer who sold qualifying stock at a gain would have been subject to a maximum effective federal rate of 3.75-percent.[xii]

In 2010, the exclusion was increased to 100-percent – which is where it remains today – and the minimum tax preference was eliminated.[xiii]

C Corporation

In order to be eligible for this benefit, the stock, and the corporation from which it was issued, had to satisfy a number of criteria – which will be described below – including the requirement that the stock must have been issued by a “qualified small business,” which was (and continues to be) defined as a C corporation.

Between a Rock and a Hard Place

The decision by a start-up business and its owners to operate through a C corporation, so as to position themselves to take advantage of the exclusion of gain from the sale of stock in a qualified small business corporation, was no small matter when the relief provision was enacted.

In 1993, when Section 1202 was enacted, the maximum federal corporate income tax rate was set at 34-percent; dividends paid to individual shareholders from a C corporation were subject to the same 39.6-percent federal income tax rate applicable to ordinary income. From 1994 through 2017, the corporate tax rate was capped at 35-percent; until 2003, dividends paid to individuals continued to be taxed at the higher rates applicable to ordinary income, though, after 2002, the federal tax rate on such dividends was reduced and tied to the federal long-term capital gain rate.

Unfortunately, beginning with 2013, the dividends paid by a C corporation to a higher-income individual shareholder became subject to the 3.8-percent surtax on net investment income, regardless of the individual’s level of participation in the corporation’s business.[xiv]

It is likely that the combination of (i) a high federal corporate tax rate, (ii) the taxation (initially at ordinary income rates) of any dividends distributed by the corporation to its shareholders – the so-called “double taxation” of C corporation profits – and (iii) the many threshold requirements that had to be satisfied (see below), conspired to prevent Section 1202 from fulfilling its mission.

Thus, the capital gain relief provision was relegated to the shadows, where it remained dormant until . . . . [xv]

Tax Cuts and Jobs Act[xvi]

Effective for taxable years of C corporations beginning after December 31, 2017, the Act reduced the federal corporate tax rate from a maximum of 35-percent to a flat 21-percent.

In addition, the Act eliminated the alternative minimum tax for C corporations.

What’s more, the Act did not change the favorable federal tax rate applicable to long-term capital gain, nor did it cease to conform the rate for dividends to the capital gain rate.

In light of the foregoing, it may be that the gain exclusion rule of Section 1202 will finally have the opportunity to play its intended role.

Although there are still many other factors that may cause the owners of a closely held business to decide against the use of a C corporation, the significant reduction in the corporate tax rate should warrant an examination of the criteria for application of Section 1202.

Qualifying Under Section 1202

This provision generally permits a non-corporate taxpayer who holds “qualified small business stock” for more than five years[xvii] to exclude the gain realized by the taxpayer from their sale or exchange of such stock (“eligible gain”).[xviii]

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

Limits on Exclusion

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

  1. $10 million,[xx] reduced by the aggregate amount of eligible gain excluded from gross income by the taxpayer in prior taxable years and attributable to the disposition of stock issued by such corporation, or
  2. 10 times the aggregate adjusted bases of qualified small business stock issued by such corporation and disposed of by the taxpayer during the taxable year (with basis being determined by valuing any contributed property at fair market value at the date of contribution).[xxi]

This limitation notwithstanding, where the provision applies, a taxpayer may exclude a significant amount of gain from their gross income. Moreover, any amount of gain in excess of the limitation would still qualify for the favorable capital gain rate, though it will be subject to the surtax.

Qualified Small Business Stock

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

What’s more, with limited exceptions, the shares must have been acquired directly from the corporation – an original issuance, not a cross-purchase – in exchange for money or other property (not including stock), or as compensation for services provided to the corporation.[xxiii]

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

Qualified Corporation

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

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

Active Business

At least 80-percent (by value) of the corporation’s assets (including intangible assets) must be used by the corporation in the active conduct of one or more qualified trades or businesses.[xxxi]

If in connection with any future trade or business, a corporation uses assets in certain start-up activities, research and experimental activities, or in-house research activities, the corporation is treated as using such assets in the active conduct of a qualified trade or business.[xxxii]

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

Qualified Trade or Business

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

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

Gross Assets

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

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

Subsidiaries

In the case of a corporation that owns at least 50-percent of the vote or value of a subsidiary, the parent corporation is deemed to own its ratable share of the subsidiary’s assets – based on the percentage of outstanding stock owned (by value) – and to be liable for its ratable share of the subsidiary’s indebtedness, for purposes of the qualified corporation, active business, and gross assets tests.[xxxix]

Pass-Through Entities as Shareholders

Gain from the disposition of qualified small business stock by a partnership or S corporation that is taken into account by a partner or shareholder of the pass-through entity is eligible for the exclusion, provided that (i) all eligibility requirements with respect to qualified small business stock are met, (ii) the stock was held by the entity for more than five years, and (iii) the partner or shareholder held their interest in the pass-through entity on the date the entity acquired its stock and at all times thereafter and before the disposition of the stock.[xl]

In addition, a partner or shareholder of a pass-through entity cannot exclude gain received from the entity to the extent that the partner’s or shareholder’s share of the entity’s gain exceeds the partner’s or shareholder’s interest in the entity at the time the entity acquired the sock.

Sale or Exchange of Stock

The exclusion rule of Section 1202 applies to the taxpayer’s sale or exchange of stock in a qualified small business.

Obviously, this covers a sale by the shareholders of all of the issued and outstanding shares of the corporation, subject to the limitations described above.

It should also cover the liquidation of a C corporation and its stock following the sale of its assets to a third party.[xli] In that case, the double taxation that normally accompanies the sale of assets by a C corporation may be substantially reduced.

The Future?

Assuming a non-corporate shareholder can satisfy the foregoing criteria, they will be permitted to exclude a substantial part of the gain from their sale of stock in a qualifying C corporation.

When individual entrepreneurs and investors start to understand the potential benefit of this exclusion, and as they become acclimated to the new C corporation income tax regime, with its greatly reduced tax rate and the elimination of the alternative minimum tax, they may decide that their new business venture should be formed as a C corporation, assuming it is a qualified trade or business for purposes of Section 1202.

In making this determination, however, these non-corporate taxpayers will have to consider a number of factors, among which are the following: Is the five-year minimum holding period acceptable? Will the corporation be reinvesting its profits, without regular dividend distributions?[xlii] Is it reasonable to expect that the corporation will appreciate significantly in value?

If each of these questions can be answered in the affirmative, then the taxpayer-shareholders should strongly consider whether they can structure and capitalize their business as a C corporation, and whether the corporation’s business can satisfy the requirements described above, in order that the taxpayers may take advantage of the gain exclusion rule.


[i] Stated differently, the income tax is the means by which each member of the public contributes their pre-determined share of the costs to be incurred by the government they have chosen to serve them.

[ii] I.e., a reduced tax liability.

[iii] For example, bonus depreciation under IRC Sec. 168(k).

[iv] IRC Sec. 1400Z-1 and 1400Z-2, added by P.L. 115-97 in 2017.

[v]IRC Sec. 1202.

[vi] IRC Sec. 1222.

[vii] IRC Sec. 1(h).

[viii] Beginning with 2013, a capital gain may also be subject to the 3.8-percent surtax on net investment income. IRC Sec. 1411.

[ix] P.L. 103-66; the Omnibus Budget Reconciliation Act of 1993.

[x] 50-percent of the gain taxed at 28-percent, and 50-percent taxed at 0-percent.

[xi] P.L. 111-5; the American Recovery and Reinvestment Act.

[xii] 25-percent of the gain multiplied by 15-percent.

[xiii] P.L. 111-240; the Small Business Jobs Act of 2010.

[xiv] IRC Sec. 1411.

[xv] It was rediscovered by Smeagol, who lost it to a Hobbit, who then became a star of literature and cinema.

[xvi] P.L. 115-97; the “Act.”

[xvii] This holding period begins with the day the taxpayer acquired the stock. If the taxpayer contributed property other than cash to the corporation in exchange for stock, the taxpayer’s holding period for the property is disregarded for purposes of the 5-year holding requirement.

[xviii] IRC Sec. 1202(a).

[xix] IRC Sec. 1202(a)(4).

[xx] In the case of a married individual filing a separate return, $5 million is substituted for $10 million.

[xxi] Note that the first of these limits operates on a cumulative basis, beginning with the taxpayer’s acquisition of the stock and ending with the taxable year at issue; the second operates on an annual basis, and depends upon how much stock was disposed of during the taxable year at issue.

[xxii] Seems like yesterday. In 1993, I prepared an “Alert” for Matthew Bender (the publisher) that summarized many of the changes enacted by the Omnibus Budget Reconciliation Act of 1993.

[xxiii] IRC Sec. 1202(c).

In the case of certain transfers, including, for example, a transfer by gift or at death, the transferee is treated as having acquired the stock in the same manner as the transferor, and as having held the stock during any continuous period immediately preceding the transfer during which it was held by the transferor.

Two more special rules should be noted: (i) stock acquired by the taxpayer is not treated as qualified small business stock if, at any time during the 4-year period beginning on the date 2 years before the issuance of such stock, the issuing corporation purchased any of its stock from the taxpayer or from a person “related” to the taxpayer; and (ii) stock issued by a corporation is not treated as qualified business stock if, during the 2-year period beginning on the date 1 year before the issuance of such stock, the corporation made 1 or more purchases of its stock with an aggregate value (as of the time of the respective purchases) exceeding 5-percent of the aggregate value of all of its stock as of the beginning of such 2-year period. IRC Sec. 1202(c)(3).

[xxiv] It is assumed for our purposes that any in-kind contribution to a corporation in exchange for stock qualifies under IRC Sec. 351; in other words, the contributor, or the contributing “group” of which they are a part, will be in control of the corporation immediately after the exchange; otherwise, the contribution itself would be a taxable event.

[xxv] IRC Sec. 1202(i)(1)(B). Compare this to Sec. 351 and Sec. 358, which provide that stock received in a Sec. 351 exchange has the same basis as that of the property exchanged.

[xxvi] IRC Sec. 1202(c)(2)(A).

[xxvii] Because the corporation must be a C corporation at the issuance of its stock, an S corporation issuer can never qualify for the benefits under Section 1202 by converting to a C corporation.

[xxviii] IRC Sec.1202(e)(4).

[xxix] IRC Sec. 1202(e)(7). The ownership of, dealing in, or renting of real property is not treated as the active conduct of a qualified trade or business for purposes of this rule.

[xxx] A corporation is considered a subsidiary if the parent owns more than 50-percent of the combined voting power of all classes of stock entitled to vote, or more than 50-percent in value of all outstanding stock, of such corporation.

[xxxi] IRC Sec. 1202(e)(1).

[xxxii] IRC Sec. 1202(e)(2).

[xxxiii] IRC Sec. 1202(e)(6). Sounds familiar? See the proposed regulations for under IRC Sec. 1.1400Z-2 and the definition of a qualified opportunity zone business.

The term “working capital” has not been defined for this purpose.

[xxxiv] For periods after the corporation has been in existence for at least 2 years, no more than 50-percent of the corporation’s assets may qualify as used in the active conduct of a qualified trade or business by reason of this rule. In other words, the corporation may have to be careful about raising “too much” capital.

[xxxv] IRC Sec. 1202(e)(6). Déjà vu, for the most part? See the exclusion of a “specified service trade or business” under IRC Sec. 199A’s qualified business income deduction rule.

[xxxvi] For purposes of this rule, the adjusted basis of property contributed to the corporation is determined as if the basis of the property immediately after the contribution were equal to its fair market value. IRC Sec. 1202(i).

This should be compared to the general rule under IRC Sec. 351 and Sec. 362, under which the corporation takes the contributed property with the same adjusted basis that it had in the hands of the contributing shareholder.

Property created or purchased by the corporation is not subject to this rule.

Both the corporation and the contributing taxpayer will have to be very careful to determine the fair market value of any in-kind contribution of property to the corporation lest they cause the corporation to exceed the $50 million threshold, and thereby disqualify the contributing taxpayer and any future contributors from taking advantage of Sec. 1202’s gain exclusion rule.

[xxxvii] IRC Sec. 1202(d). What’s more, the gross assets of the corporation must not have exceeded $50 million at any time after the 1993 legislation and before the issuance.

[xxxviii] Query what effect this would have on raising additional capital.

[xxxix] IRC Sec. 1202(e)(5). The subsidiary stock itself is disregarded.

[xl] IRC Sec. 1202(g).

[xli] IRC Sec. 331 treats the amount received by a shareholder in a distribution in complete liquidation of the corporation as full payment in exchange for the stock.

[xlii] In other words, will the corporation’s earnings be subject to one or two levels of tax?

Don’t Take It Lightly

Regardless of who or what they are, taxpayers have to be careful of saying things like, “I guarantee it” or “it’s guaranteed.”

First of all, they’re not Joe Namath guaranteeing a Jets victory over the Colts in Super Bowl III, where the worst thing that could have happened had Broadway Joe not delivered on his promise would have been a brief delay in the AFL/AFC’s first Super Bowl title.[i] Nor are they George Zimmer guaranteeing that you’re going to look good in a Men’s Wearhouse suit, where the worst thing that could have happened was that you . . . well . . . you didn’t look too good.

The foregoing results pale in significance to the sometimes surprising tax consequences that may accompany a taxpayer’s guarantee of a business entity’s liability.

What Are They?

Before we consider some of the more common instances of guarantees and their tax effects, it would be helpful if we first defined the term “guarantee,” at least for purposes of this discussion.

Generally speaking, the object of one person’s guarantee is another person’s obligation to perform an act – usually the repayment of an amount borrowed from a lender; stated differently, a guarantor will agree to satisfy an obligor’s indebtedness to a lender in the event the obligor itself fails to do so. The lender is typically viewed as the beneficiary of the guarantee because it provides the lender with a degree of protection from the adverse consequences of the obligor’s default under the loan.

That being said, one may just as easily characterize the obligor as the beneficiary of the guarantee because the lender may not otherwise be willing to make a loan to the obligor without the presence of the guarantee, or would be willing to do so only under less favorable terms (from the perspective of the borrower).

Tax Considerations

When considering the tax consequences of a guarantee, the focus is usually on the relationship between the guarantor and the obligor (the “beneficiary” for tax purposes); more often than not, these parties are a closely held business and its owners.

For example, the owners of a business will often be asked by a lender to personally guarantee a loan or a line of credit to their business.[ii] Alternatively, one company may be asked to guarantee the loan obligations of another company;[iii] the latter may be a parent, a subsidiary, or a sister company with respect to the guarantor.

It should be obvious that the guarantor provides an immediate economic benefit to the obligor by guaranteeing the obligor’s indebtedness to the lender; by doing so, the guarantor allows its own economic strength and creditworthiness to support the obligor.

It should also be obvious that the guarantor suffers an economic detriment because by guaranteeing the obligor’s indebtedness the guarantor has agreed to assume responsibility for the indebtedness in the event the obligor is unable to satisfy the indebtedness itself.[iv]

Which brings us to the tax question: how is this economic benefit measured, was any consideration provided by the obligor in exchange for this benefit, and what tax consequences are realized by the obligor as a result of the transaction?[v]

A Guarantee Fee?

The value of the economic benefit inuring to an obligor, and the “value” of the detriment suffered by the guarantor, as a result of a guarantee are not necessarily the same as the consideration (or fee) that may have been paid by the obligor in exchange for the guarantee; by analogy, think in terms of insurance coverage and insurance premiums – one would never guarantee an indebtedness unless the obligor was reasonably capable of satisfying the indebtedness.

With that in mind, how do a closely held business and those related to it even determine what an appropriate guarantee fee is?

If the guarantor is the controlling owner of the obligor-business, should a fee be imputed between them,[vi] such that the guarantor is deemed to have received an item of taxable income, and the obligor is deemed to have received a capital contribution of the same amount?

In the absence of any consideration for the guarantee, has there been a capital contribution by the guarantor-owner to the obligor-business? Has there been a distribution of earnings from the guarantor-subsidiary business entity to the obligor-parent business entity? If there has been, then how much? The amount of the foregone fee?

Herein lies the issue, and perhaps the source of much confusion among taxpayers. This state of affairs may best be illustrated by exploring a few not uncommon scenarios.

CFCs,[vii] U.S. Properties & Guarantees

Normally, a CFC’s non-Subpart F income – and, after 2017, its non-GILTI – is not taxable to its U.S. shareholder or shareholders unless and until the income is distributed to them.[viii] In the face of this principle, taxpayers once attempted to avoid U.S. income tax by taking loans from unrelated financial institutions and having their CFCs guarantee the loans.

Guarantee as Distribution

Then Congress amended the Code to require the inclusion in the U.S. shareholder’s income of any increase in investment in U.S. properties made by a CFC it controls. Such an investment of earnings by a CFC in U.S. properties, Congress determined, was tantamount to the repatriation of such earnings. Therefore, “U.S. property” was defined as including, among other things, an obligation of a U.S. person arising from a loan by the CFC to the U.S. person.

The Code and regulations then went further by providing that a CFC would be considered as holding an obligation of a U.S. person if the CFC was a guarantor of the obligation, where the loan was made by a third party.[ix]

They also provided that the amount of the obligation treated as held by the CFC, as a result of its guarantee, was the unpaid principal amount of the obligation; in other words, the IRS treated the CFC-guarantor as if it had made the entire loan directly, thereby acquiring a U.S. property interest – i.e., as if it had made a distribution to its U.S. shareholders of an amount equal to the principal amount of the loan – though the amount included in the gross income of the CFC’s U.S. shareholder was capped at the CFC’s earnings.[x]

S Corporation Shareholder Guarantees

The foregoing demonstrates that, in the case of a CFC, the corporation’s guarantee of its U.S. shareholder’s indebtedness bestowed a significant economic benefit upon the U.S. shareholders – one that may characterized, for tax purposes, as a distribution that accelerated the recognition by the U.S. shareholder of the CFC’s previously undistributed income.

However, where the taxpayer is a shareholder of an S corporation, the issue surrounding the shareholder’s guarantee of the corporation’s indebtedness is not one of income inclusion, or the acceleration of income recognition; rather, it is usually a question of whether the shareholder should be entitled to deduct their allocable share of S corporation loss up to the amount of indebtedness guaranteed by the shareholder.

Loss Limitation Rule

The Code provides that a shareholder may deduct their share of an S corporation’s losses only to the extent that such share does not exceed the sum of “the adjusted basis of the shareholder’s stock in the S corporation,” and “the shareholder’s adjusted basis of any indebtedness of the S corporation to the shareholder.”[xi] In other words, the shareholder cannot deduct more than the sum of the following: (i) what they have contributed to the corporation as a capital contribution,[xii] (ii) their share of corporate income and gain that has not been distributed to them by the corporation, and (iii) the amount they have loaned to the corporation. [xiii]

Any disallowed deduction – i.e., the amount by which a shareholder’s share of the corporation’s losses exceeds the shareholder’s aggregate stock and debt basis – is treated as incurred by the corporation in the succeeding taxable year with respect to the shareholder whose deductions are limited. Once the shareholder increases their basis in the S corporation, any deductions previously suspended become available to the extent of the basis increase.

Economic Outlay

The Code does not provide a means by which a shareholder may acquire basis in an S corporation’s indebtedness other than by making a direct loan to the corporation. Likewise, the courts have generally required an “actual economic outlay” by the shareholder to, or on behalf of, the corporation before determining whether the shareholder has made a bona fide loan that gives rise to an actual investment in the corporation.

A taxpayer makes an economic outlay sufficient to acquire basis in an S corporation’s indebtedness when the taxpayer incurs a ‘cost’ on a loan. The taxpayer bears the burden of establishing this basis.

It does not suffice, however, for the shareholder to have made an economic outlay. The term “basis of any indebtedness of the S corporation to the shareholder” means that there must be a bona fide indebtedness of the S corporation that runs directly to the shareholder.[xiv]

Whether a corporation’s indebtedness is “bona fide indebtedness” to a shareholder is determined under general Federal tax principles and depends upon all of the facts and circumstances.

Guarantees

Moreover, a shareholder does not obtain basis for an indebtedness of the S corporation to a third party merely by guaranteeing such indebtedness.

According to most courts and the IRS, it is when a shareholder makes a payment on bona fide indebtedness of the S corporation, for which the shareholder has acted as guarantor, that the shareholder creates a direct indebtedness between themselves and the corporation – the shareholder-guarantor steps into the shoes of the original creditor vis-à-vis the corporation to the extent of such payment – and the shareholder acquires basis for that indebtedness to the extent of that payment.[xv]

That being said, some shareholders have argued, unsuccessfully, against the form of the loan transaction; specifically, these taxpayers have claimed that the lender was, in fact, looking to them for repayment of the loan, and not to the corporation. Under this theory, the shareholders would be treated as having received the loan, and then as having made a capital contribution to the corporation. Unfortunately for them, the courts have not accepted their theory; rather, the courts have bound them to the form of their transaction – a loan to the corporation that is guaranteed by the shareholders; the fact that the corporation, and not the shareholders, made the loan payments did not help their position.

However, the fact remains that a shareholder’s guarantee of their S corporation’s indebtedness to a third party bestows a valuable benefit upon the corporation – that enables the corporation to borrow from an unrelated lender – and exposes the shareholder to a contingent liability for which the corporation likely paid no consideration.

Yet neither the IRS nor the courts have shown any willingness to accept the argument that the value of this guarantee – whether it is the amount of the guarantor’s actual or imputed fee, the value of the benefit, or the value of the detriment, however determined – should be treated as a capital contribution by the shareholder to the corporation.

Of course, a possible corollary to this position – and perhaps the reason that the argument has not found any traction – is that income should be imputed to the shareholder in exchange for their guarantee of the corporation’s indebtedness.

A more likely reason, however, is probably the difficulty in determining the value of the benefit.[xvi]

Partner Guarantees and Partnership Recourse Debt

As in the case of a shareholder of an S corporation, a partner’s distributive share of partnership loss is allowed only to the extent of the partner’s adjusted basis in their partnership interest at the end of the partnership year in which the loss occurred.[xvii]

In contrast to a shareholder’s guarantee of an S corporation’s indebtedness, however, a partner’s guarantee of a partnership’s indebtedness may increase the partner’s adjusted basis for their partnership interest,[xviii] and thereby allow the partner to claim a greater portion of their share of partnership loss.

Specifically, any increase in a partner’s share of partnership liabilities, or any increase in a partner’s individual liabilities by reason of the partner’s assumption of partnership liabilities,[xix] is treated as a contribution of money by that partner to the partnership and increases the partner’s basis in their partnership interest.

Economic Risk of Loss

A partner’s share of a partnership’s liability depends upon whether the liability is a recourse or a nonrecourse liability.

A partnership liability is a recourse liability to the extent that any partner bears the economic risk of loss for that liability. A partner’s share of a recourse liability equals the portion of that liability for which the partner bears the economic risk of loss. In other words, each partner’s share of a recourse liability is proportionate to the partner’s economic risk of loss with respect to such liability.[xx]

A partner bears the economic risk of loss for a partnership liability to the extent that, if the partnership constructively liquidated,[xxi] the partner would be obligated to make a payment to any person, or a capital contribution to the partnership, because that liability becomes due and payable, and the partner would not be entitled to reimbursement from another partner.

Partner Guarantee

If a partner guarantees a partnership’s liability to an unrelated lender, it would appear that the partner bears the economic risk of loss with respect to that liability – the partner is obligated to pay the lender if the partnership defaults – and, consequently, should be treated as having made a capital contribution to the partnership, which would increase the basis of the partner’s partnership interest.[xxii] The fact that the partner is never actually called upon to fulfill their guarantee is irrelevant – there does not need to be an actual economic outlay[xxiii] – it suffices that they bear the economic risk of loss.

That being said, the partner’s guarantee may be disregarded if, taking into account all the facts and circumstances, the partner’s obligation under the guarantee is subject to contingencies that make it unlikely that it will ever be discharged. In that case, the guarantee would be ignored until the event occurs that triggers the payment obligation.[xxiv]

According to the IRS, a guarantee may also be disregarded where it was not required in order to induce the lender to make the loan to the partnership, or where the terms of the loan were no different than they would have been without the guarantee.[xxv]

Take-Away

The point of the foregoing discussion was to remind the reader of a few common business situations in which one person’s guarantee of another’s indebtedness may have significant income tax consequences; based upon the volume of litigation and regulatory activity in this area, it appears that these consequences are not yet fully appreciated by many taxpayers, who are either unaware of the issue or who try to circumvent it.[xxvi]

This post does not seek to explain or justify the different tax treatment of a guarantee in one business scenario versus another; for example, a shareholder’s guarantee of an S corporation’s indebtedness versus a partner’s guarantee of a partnership’s indebtedness.

Nevertheless, I hope that the following themes were conveyed: (i) in order for a guarantee to be respected, it must serve a bona fide economic purpose – it cannot be undertaken only to generate a beneficial tax result (for example, additional basis); otherwise, the guarantee will not be given tax effect until the occurrence of the contingency to which the guarantee is directed; and (ii) the IRS’s treatment of a guarantee will depend in no small part upon the direction of the guarantee – for example, upstream, as in the case of the CFC described above, or downstream, as in the case of partner and a partnership – and the fiscal policy sought to be enforced.

Therefore, before agreeing to guarantee the indebtedness of a related person or business entity, a taxpayer should consult their tax adviser, lest any hoped-for tax consequences turn out to be unattainable, or lest the taxpayer incur an unintended tax liability.


[i] 1969. The Jets, the Mets and the Knicks won championships. The Rangers made it to the playoffs, losing to the Bruins (my then hero, goalie Eddie Giacomin, had a great regular season).

[ii] These guarantees may be joint and several, or they may be capped at a certain amount per owner. Sometimes, a lender will require that the owners secure their guarantee (perhaps by agreeing to maintain some minimum amount on deposit at the lending institution).

[iii] There are many permutations.

[iv] A contingent liability.

[v] OK, actually three questions. Have you ever known a tax person who stops at one question?

[vi] See IRC Sec. 482. The purpose of IRC section 482 is to ensure taxpayers clearly reflect income attributable to controlled transactions and to prevent avoidance of taxes regarding such transactions. It places a controlled taxpayer on a tax parity with an uncontrolled taxpayer by determining true taxable income. Transactions between one controlled taxpayer and another will be subject to special scrutiny to ascertain whether common control is being used to reduce, avoid, or escape taxes. In determining the true taxable income of a controlled taxpayer, the IRS’s authority extends to any case in which either by inadvertence or design the taxable income of a controlled taxpayer is other than it would have been had the taxpayer been dealing at arm’s length with an uncontrolled taxpayer.

[vii] A controlled foreign corporation (“CFC”) is defined as “any foreign corporation if more than 50-percent of (1) the total combined voting power of all classes of stock of such corporation entitled to vote, or (2) the total value of the stock of such corporation is owned by U.S. shareholders on any day during the taxable year of such foreign corporation.” IRC Sec. 957.

[viii] In the Tax Cuts and Jobs Act world, this would include its “high tax” income, as well as the amount representing the “reasonable” 10-percent return on the investment in tangible personal property. IRC Sec. 954(b), Sec. 951A(b).

[ix] IRC Sec. 956(d); Reg. Sec. 1.956-2(c)(1).

[x] IRC Sec. 951, Sec. 956. For a recent decision involving this issue, see the Third Circuit’s opinion in SIH Partners: https://www.bloomberglaw.com/public/desktop/document/SIHPartnersLLLPExplorerParvCommissionerofInternalRevenDocketNo180?1557583279 .

[xi] IRC Sec. 1366(d); Reg. Sec. 1.1366-2.

[xii] Cash and the adjusted basis (i.e., unreturned investment) in other property.

[xiii] Basically, amounts that remain subject to the risks of the business.

[xiv] For a recent decision involving this issue, see the Eleventh Circuit’s opinion in Meruelo: https://www.bloomberglaw.com/public/desktop/document/HomeroMeruelovCommissionerofIRSDocketNo181190911thCirMay072018Cou?1557602950 .

[xv] Reg. Sec. 1.1366-2(a)(2). But if a shareholder engages in genuine “back-to-back” loans – in which a lending entity loans the shareholder funds that he then loans directly to the S corporation – those loans can establish bona fide indebtedness running directly to the shareholder.

[xvi] See, e.g., PLR 9113009, which involved a parent’s guarantee of business-related loans for his children. Although the ruling concluded that the guarantee constituted the completed gift transfer of a valuable property right, it did not explain how that right was to be valued. The IRS later withdrew the ruling as it related to the guarantee. PLR 9409018.

[xvii] IRC Sec. 704(d). Any excess loss is carried forward.

[xviii] IRC Sec. 752(a).

[xix] A partnership obligation is a liability for purposes of IRC Sec. 752 only if, when, and to the extent that incurring the obligation (i) creates or increases the basis of any of the obligor’s assets (including cash); gives rise to an immediate deduction to the obligor; or gives rise to an expense that is not deductible in computing the obligor’s taxable income and is not properly chargeable to capital. Reg. Sec. 1.752-1(a)(4).

[xx] Reg. Sec. 1.752-2.

[xxi] For purposes of this hypothetical liquidation, the partnership’s assets are assumed to have no value, its liabilities are deemed to have become due and payable, and its assets are deemed to have been sold for no consideration other than relief from any liabilities that they secure. Reg. Sec. 1.752-2(b).

[xxii] Irrespective of the form of a partner’s contractual obligation, the IRS may treat a partner as bearing the economic risk of loss with respect to a partnership liability, or a portion thereof, to the extent that  the partner undertakes one or more contractual obligations so that the partnership may obtain or retain a loan; the contractual obligations of the partner significantly reduce the risk to the lender that the partnership will not satisfy its obligations under the loan, or a portion thereof; and one of the principal purposes of using the contractual obligations is to attempt to permit partners to include a portion of the loan in the basis of their partnership interests. Reg. Sec. 1.752-2T(j)(2).

[xxiii] Contrast this to the S corporation shareholder.

[xxiv] Reg. Sec. 1.752-2(b).

[xxv] Prop. Reg. Sec. 1.752-2(j).

[xxvi] Who may also be forgetful when it is convenient.

Beyond Income Tax

Over the last several weeks, we have explored various aspects of the choice of entity dilemma that confronts the owners of many closely held businesses, and we have considered how the Tax Cuts and Jobs Act[i] may influence their decision.

In the process, you may have realized that one form of business entity, in particular, has come under greater scrutiny and reconsideration than any other as a result of the Act – the S corporation.[ii] The reason for this is fairly obvious: the reduction in the Federal income tax rate for C corporations from a maximum rate of 35-percent to a flat rate of 21-percent, in contrast to the 37-percent maximum rate applicable to the individual shareholders of an S corporation.[iii]

Although most of our attention has been focused on the direct income tax consequences of an entity’s[iv] status as an S corporation, it is important that one also be mindful of the estate and gift tax consequences of such status as manifested in the valuation of a share of stock in an S corporation.[v]

Tax Affecting

Over the years, many appraisers have sought to “tax affect” the earnings of an S corporation for the purpose of determining the value of a share of stock of the corporation. The practice of “tax-affecting” may be applied under various hypotheses, transfer scenarios, and valuation methodologies.

In brief, tax affecting seeks to account for the fact that the income and gain of an S corporation are generally not subject to Federal income tax at the level of the S corporation. It does this by reducing an S Corporation earnings stream to reflect an “imputed” (hypothetical) C corporation income tax liability.

Thus, if a gift transfer of S corporation stock were to be valued using a so-called “market” approach that relies upon comparing the S corporation’s financials to those of comparable C corporations in the same industry (“guideline” companies) that are publicly traded, and that pay a corporate-level Federal income tax, an appraiser would consider reducing (i.e., tax affecting) the S corporation’s earnings so as not to inflate the relative value of the S corporation.[vi]

A variation on this approach would account for the fact that the shareholders of an S corporation are subject to income tax with respect to the corporation’s profits on a current basis, without regard to whether such profits have been distributed by the corporation. In order to enable these shareholders to satisfy the resulting tax liability, the S corporation must make a “tax distribution” to its shareholders, thereby reducing the amount of cash available to the corporation for reinvestment in its business or distribute to its shareholders as a return on their investment. If this fact were ignored, the thinking goes, the relative value of the S corporation would be inflated, as in the case where a discounted future cash flow valuation methodology were employed.[vii]

The IRS’s Position

The question to which tax affecting is directed can be stated as follows: would a hypothetical willing buyer of shares of stock in an S corporation tax affect the earnings of the S corporation in valuing the shares being acquired?

As one might expect, the IRS has opposed tax affecting, stating that an S corporation has a zero tax rate and, thus, no further adjustments are required, least of all to account for shareholder-specific tax attributes.

What’s more, the IRS has also argued that S corporations are tax-advantaged – they generally do not pay an entity-level income tax – and, so, they should be valued using a premium that recognizes this economic benefit.[viii]

Although most courts seem to have sided with the IRS in concluding that tax affecting would not be appropriate,[ix] a recent decision by a Federal district court seems to have accepted tax affecting under the facts before it, while at the same time rejecting the IRS’s arguments for an S corporation premium.

Gift, Audit, Payment, Refund Claim

Taxpayers were shareholders in Corp, a family-owned S corporation. Approximately 90-percent of Corp’s common stock was owned by Family; the remaining 10-percent was owned by certain employees and directors of Corp who had purchased their shares.

The purchase price for shares sold by Corp to its employees and directors was equal to 120-percent of the book value of each share. No similar formula was established for shares that were transferred among members of Family.

Certain restrictions limited the ability to sell both Family shares and non-Family shares of Corp stock, including a right-of-first-refusal in the corporation’s by-laws that required a non-Family shareholder to give Corp written notice of their intent to sell their shares, and to offer to such shares to Corp before selling to others.

The Corp by-laws also required that Family only gift, bequeath, or sell their shares to other members of Family. According to Family, this restriction ensured that they retained control of Corp, minimized the risk of disruption to Corp’s affairs by a dissident shareholder, ensured confidentiality of Corp’s affairs, and ensured that all sales of Corp minority stock were to qualified subchapter S shareholders.

As part of their estate planning, Taxpayers annually gifted minority shares of Corp stock to their children, including during the years in issue. Taxpayers filed gift tax returns (on IRS Form 709) for those years to report their gifts and to identify the fair market value (“FMV”) for the gifted shares. Taxpayers paid gift taxes with respect to the gifted shares.

The IRS challenged the valuation for the shares that Taxpayers reported on their gift tax returns. After examining the returns, the IRS assessed deficiencies, finding that the FMV of the gifted shares equaled the price used for actual share transactions between Corp and its employees. The IRS issued notices of deficiency for the tax years at issue, and Taxpayers paid the asserted deficiencies.

Taxpayers subsequently filed claims for refund for the years in issue, seeking a refund for the additional taxes paid, which Taxpayers claimed had been erroneously assessed by the IRS. After six months elapsed without receiving a response from the IRS regarding Taxpayers’ claims,[x] Taxpayers initiated a lawsuit in Federal district court to recover these gift taxes. [xi] The sole issue presented in the suit was the FMV of the Corp stock gifted by Taxpayers to their children.

The District Court

The Court began by explaining that the Federal gift tax was imposed for “each calendar year on the transfer of property by gift during such calendar year by any individual resident.”[xii] The amount of the gift, it stated, is considered to be the value of the gifted property on the date it was given.[xiii]

The determination of FMV, the Court stated, was a question of fact. The trier of fact “must weigh all relevant evidence of value and draw appropriate inferences.” The FMV of stock, the Court continued, is “the price at which the 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.”[xiv]

Valuation Factors

When the FMV of stock cannot be determined by examining actual sales of stock within a reasonable time before or after the valuation date, as was the case here, the FMV must generally be determined by analyzing factors that a reasonable buyer and seller would normally consider, including the following:

a) the nature of the business and the history of the corporation,

b) the economic outlook in general, and the condition and outlook of the specific industry in particular,

c) the book value of the stock and the financial condition of the business,

d) the earnings capacity of the corporation,

e) the dividend-paying capacity,

f) whether the business has goodwill or other intangible value,

g) sales of the stock and the size of the block to be valued, and

h) the market price of stocks of corporations engaged in the same or similar line of business having their stocks actively traded, either on an exchange or over the counter.[xv]

Valuation Methods

According to the Court, these factors had to be considered in light of the facts of the particular case. The FMV of non-publicly traded stock, the Court stated, is generally determined by using one or a combination of the following valuation methods: the market approach, the income approach, or the asset-based approach:

  • The market approach values a company’s non-publicly traded stock by comparing it to comparable stock sold in arms’ length transactions in the same time period.
  • The income approach values a company’s non-publicly traded stock by converting anticipated economic benefits into a single amount; valuation methods may “directly capitalize earnings estimates or may forecast future benefits (earnings or cash flow) and discount those future benefits to the present.”
  • The asset-based approach values a company’s non-publicly traded stock by analyzing the company’s assets net of its liabilities.

The Experts

Taxpayers’ experts prepared reports and provided testimony regarding the valuation of a minority share of Corp stock. Their reports used different valuation methods that resulted in different proposed valuations.

Taxpayers maintained that the Court should adopt the FMV of a minority share of Corp as determined by their expert and reported on their original gift tax returns.

The IRS abandoned its initial valuation assessments and requested that the Court adopt its expert’s conclusions of FMV.[xvi]

The Court reminded the parties that it was not bound by the opinion of any expert witness and could accept or reject expert testimony, in whole or in part. The Court then examined the experts’ opinions and methodologies.

IRS’s Expert

The IRS’s expert determined the FMV of the gifted shares by using both the market approach and the income approach, and then ascribing a weight to each. After analyzing the values under the market approach[xvii] and the income approach[xviii] – for which he applied an effective tax rate to Corp, as if it were a C corporation, and then applied a premium to account for Corp’s tax advantages as an S corporation[xix] – he weighted the market approach 60-percent and the income approach 40-percent to determine the final FMV.

Once the IRS’s expert had calculated the preliminary minority share value, he then applied marketability discounts[xx] to reach his conclusions of FMV.

The Court found that the IRS’s expert’s valuation conclusions overstated the value of a minority-held share of Corp stock.

Among other things, the Court noted that the IRS’s expert applied a separate “subchapter S premium” to his valuation. Although both the Taxpayers’ expert and the IRS’s expert applied C corporation level taxes to Corp’s earnings to effectively compare Corp to comparable C corporations, the IRS’s expert then assessed a premium to account for the tax advantages associated with subchapter S status, such as the elimination of a level of taxes, and noted that Corp did not pay C corporation taxes in any of the years in issue, and did not expect to pay such taxes in the future.

Taxpayers’ Expert

Taxpayers’ expert did not consider Corp’s subchapter S status to be a benefit that added value to a minority shareholder’s stock because a minority shareholder could not change Corp’s tax status.

The Court agreed with Taxpayers’ expert, finding that Corp’s subchapter S status was a neutral factor with respect to the valuation of Corp’s stock. The Court also explained that, notwithstanding the tax advantages associated with subchapter S status, there were also notable disadvantages, including the limited ability to reinvest in the corporation and the limited access to capital markets. Therefore, it was unclear, the Court stated, if a minority shareholder enjoyed those benefits.

Taxpayers’ expert employed the market approach, although he also incorporated concepts of the income approach into his overall analysis. He testified that the market approach was the better methodology here because there were a sufficient number of comparable companies for the years in issue. Taxpayers’ expert selected comparable guideline companies to determine the base value a minority share of Corp stock might be worth if it were sold at a mature public market. Accounting for Corp’s industry, its conservative management style, its entire book value, and other considerations, he compared Corp to companies on a “holistic” basis.

After selecting the guideline companies, he derived multiples via the ratio of market value of invested capital to EBITDA, to account for Corp’s subchapter S status, as well as multiples derived from earnings, dividends, sales, assets, and book value. He also evaluated price-to-earnings, price-to-EBITDA, and price-to-sales multiples. He then compared Corp’s multiples to each guideline company’s multiples to reach a base value for the stock.

To his base values, Taxpayers’ expert applied a discount for lack of marketability to reflect the illiquidity of the minority shares of Corp stock.[xxi]

Decision

After reviewing the reports and testimony of these experts,[xxii] the Court found that the valuation methodology of the Taxpayers’ expert was the most sound, and agreed with this expert’s determination of the FMV of Corp’s common minority stock.

Take-Away?

The Court was frugal in its discussion of tax affecting; it accepted the concept, noting that it had been employed by both the IRS and Taxpayers in valuing Corp’s stock. Indeed, it was noteworthy that even the IRS’s expert used tax affecting in his valuation report; although the Court was not bound by either expert’s opinion, it accepted their use of tax affecting in arriving at FMV.

Likewise, the Court did not dedicate much time to dismissing the IRS’s argument that Corp’s FMV should have been increased to account for the tax benefits Corp enjoyed as an S corporation. The Court simply stated that S corporations also faced many disadvantages because of their tax status,[xxiii] and found that Corp’s subchapter S status was a neutral factor with respect to the valuation of Corp’s stock.

Notwithstanding the brevity of its analysis, the Court’s decision is nonetheless important for those S corporation shareholders who are planning to transfer shares as part of their estate plan. These taxpayers, and their valuation professionals, should take some comfort in the fact that the Court accepted tax affecting – though the impact of the concept should be less significant in light of the much reduced corporate income tax rate – and also rejected the IRS’s argument for an S corporation tax premium.

That being said, it is worth remembering that there is no substitute for a timely, well-reasoned, and empirically-supported appraisal by a qualified and seasoned professional. Yes, it will cost the taxpayer some money today, but it will save the taxpayer a lot more money (including taxes, interest, penalties and attorney fees) later on.


[i] P.L. 115-97; the “Act.”

[ii] See, e.g., https://www.taxlawforchb.com/2019/04/post-2017-is-it-time-to-kick-your-corporations-s/

[iii] Perhaps 40.8-percent if the shareholder does not materially participate in the business of the S corporation.

[iv] Which may include an LLC; an LLC, that is otherwise disregarded or treated as a partnership for tax purposes, may elect to be treated as an S corporation. Reg. Sec. 301.7701-3.

[v] The increased exemption amount for Federal estate and gift tax purposes may have provided a greater cushion for valuation missteps; however, it has also encouraged greater gifting, with many individual taxpayers seeking to utilize their entire exemption so as to shift as much appreciation away from their estate, and to minimize the value of their gross estate. IRC Sec. 2010.

[vi] Apples and oranges.

[vii] Basically, the present value of a projected net positive income stream.

[viii] No double taxation of its profits: once at the corporate-level and again when distributed to the shareholders. https://www.irs.gov/pub/irs-utl/S%20Corporation%20Valuation%20Job%20Aid%20for%20IRS%20Valuation%20Professionals.pdf

[ix] See, e.g., Gross v. Comm’r, T.C. Memo 1999-254, aff’d 272 F.3d 333 (6th Cir. 2001).

[x] IRC Sec. 6532 and Sec. 7422.

[xi] The Court began its discussion by explaining that, in a suit seeking a tax refund, the taxpayers generally bear the burden of proving by a preponderance of the evidence that they are entitled to a refund of tax and what amount they should recover. The Court pointed out that while the IRS’ determination of the tax owed is presumed correct, the taxpayer may overcome this presumption, and shift the burden to the IRS, by introducing “credible evidence” or “substantial evidence” establishing that the IRS’ determination was incorrect. IRC Sec. 7491(a)(1).

However, the Court also noted that the shifting of the burden was only significant in the event of an evidentiary tie.

[xii] IRC Sec. 2501(a)(1).

[xiii] IRC Sec. 2512(a).

[xiv] Reg. Sec. 20.2031-1(b); Reg. Sec. 25.2512-1.

The hypothetical willing buyer and seller are presumed to be dedicated to achieving the maximum economic advantage.

[xv] Rev. Rul. 59-60, 1959-1 C.B. 237 (1959).

[xvi] Which would still have entitled Taxpayers to a refund.

[xvii] Under the market approach, the IRS’s expert identified several companies that were in the same business as Corp. He eliminated several companies based on dissimilar characteristics. He then completed a financial ratio analysis by comparing Corp to the guideline companies, and found two comparable companies. From there, he derived a set of multiples by looking at enterprise value to EBITDA, and price to earnings, and applied the multiples to the relevant Corp financial data.

[xviii] Under the income approach, the IRS’s expert completed a capitalized cash flow analysis. He determined a normalized net sales level and deducted the cost of goods sold and administrative expenses from the normalized net sales level to determine the income from operations.

[xix] Recognizing the value of the S-corporation structure, Corp never seriously consider terminating its S-corporation election during the years in issue. In fact, Corp’s management had previously reported to its shareholders that they expected to save over $200 million in taxes by virtue of the classification as an S-corporation during the period immediately preceding the years in issue.

[xx] He determined the discount by considering restricted stock studies, the costs of going public, and the overall academic research on the topic.

[xxi] In applying the discounts, Taxpayers’ expert considered restricted stock studies, which evaluate identical stock and determine the discount for an individual buying a share that she could not sell for some period of time. He also consulted pre-IPO studies because those studies compare the price of stock that is sold in advance of an initial public offering to the price of the stock at the time of the initial public offering. In reaching these discounts, he considered the financial position of Corp, the payment of dividends, the company’s management, the possibility of any future public offering, and Corp’s status as an S-corporation but did not quantify the impact any of these factors had on his conclusions.

[xxii] In response to the IRS’ criticism that Taxpayers’ expert did not employ a separate income approach, Taxpayers retained a second expert to prepare a report regarding the valuation of the minority-share of Corp stock using a combination of the market approach and the income approach. This expert weighted the market approach 14-percent and the income approach 86-percent. As to the market approach, she searched for comparable companies and compared those companies to Corp in terms of growth, profitability, and geographic distribution. She noted a perfectly comparable company does not exist because all potentially comparable companies were larger and more geographically diverse than Corp. She selected price-to-pre-tax-income as her multiple and used pre-tax income to capture the minority interest of the stock at issue, and to reflect Corp’s subchapter S status.

Under the income approach, Taxpayers’ second expert used the capitalized economic income method and the discount dividend method. She accounted for Corp’s subchapter S status under both methods. Under the capitalized economic income method, she adjusted the discount rate in the base cost to reflect an equivalent after-corporate and after-personal tax return. Under the discount dividend method, she used a tax rate based on three- and five-year averages and on the prior year effective date.

Her market approach and income approach yielded an “as-if-freely-traded” minority equitable interest. She averaged the values she calculated under the market approach and the income method approach to obtain an aggregate, as-if-freely-traded minority common equity value. She divided this amount by the total number of outstanding Corp shares to calculate the per-share value and applied a discount for lack of marketability each year. In determining the discount for lack of marketability, she considered company and industry characteristics, including the applicable stock restrictions and Corp’s S-corporation status. She concluded neither the stock restrictions nor the S-corporation status affected the marketability discount.

[xxiii] More specifically, because of the requirements it had to satisfy in order to maintain that tax status; for example, a single class of stock.

It’s Not All About 2017

A casual review of the recent tax literature may leave a “lay person” with the impression that, prior to the passage of the 2017 tax legislation, tax advisers had nothing else to write about.[i] Opportunity zones, GILTI, qualified business income, etc. – the spawn of 2017 dominates the tax hit parade.[ii]

That being said, the bread and butter issues of the tax professional have not changed: the adviser continues to plan for the recognition of income and deductions, gains and losses, with the ultimate goal being to reduce (or at least defer) their clients’ tax liabilities, to preserve their assets, and to thereby afford these clients the opportunity to channel their economic resources into more productive endeavors.

One example of such an issue, which was itself the subject of fairly recent legislation, and one form of which has been on the IRS’s own version of the hit parade,[iii] is captive insurance. Before getting into the details of a recent decision of the Tax Court – which illustrates what a taxpayer should not do – a brief description of captive insurance may be in order.

Captives

Assume that Acme Co.[iv] pays commercial market insurance premiums to commercial insurers to insure against various losses. These premiums are deductible in determining Acme’s taxable income. As in the case of most insurance, the premiums are “lost” every year as the coverage expires.[v]

In order to reduce the cost of insurance, a business will sometimes “self-insure” by setting aside funds to cover its exposure to a particular loss. Self-insurance, however, is not deductible.

The Code, on the other hand, affords businesses the opportunity to establish their own “small captive” insurance company.[vi] Indeed, the Code encourages them to do so by allowing the captive to receive up to $2.2 million of annual premium payments from the insured business free of income tax. What’s more, the insured business is allowed to deduct the premiums paid to the captive, provided they are “reasonable” for the risk of loss being insured. The insured business cannot simply choose to pay, and claim a deduction for, the $2.2 million maximum amount of premium that may be excluded from the captive’s income.

From a tax perspective, the key is that the captive actually operate as an insurance company. It must insure bona fide business risks. An insured risk must not be one that is certain of occurring; there must be an element of “fortuity” in order for it to be insurable.

In order to be respected as insurance, there must be “risk-shifting” and “risk distribution.” Risk shifting is the actual transfer of the risk from the insured business to the captive insurer. Risk distribution is the exposure of the captive insurer to third-party risk (as in the case of traditional insurance).[vii]

To achieve the status of real insurance (from a tax perspective), the captive pools its premiums with other captives (not necessarily from the same type of business).[viii] These pools are managed by a captive management company for a fee. The management company will conduct annual actuarial reviews to set the premium, manage claims, take care of regulatory compliance, etc. This pool will pay on claims as they arise.

In theory, the captive arrangement should lead to a reduction of the commercial premiums being paid by the business.[ix] Unfortunately for one taxpayer, they did not get the proverbial memo that explained the foregoing.

The Captive

Corp was a family business owned by Shareholders.[x] It had a number of subsidiaries, and maintained a dozen or so policies for which it paid substantial premiums.

Shareholders explored forming a captive insurance company. They met with Manager, a company that ran a captive insurance program and provided management services for captive insurance companies. At one point, Manager informed Shareholders that a captive would not be feasible unless Corp were paying at least $600,000 of premiums annually. After Manager’s chief underwriter indicated that it had “identified” up to $800,000 of premiums, Shareholders decided to form a captive.

Captive was incorporated in Delaware, and received a certificate of authority from the Department of Insurance. Captive was initially capitalized with a $250,000 irrevocable letter of credit naming the Department as the beneficiary. Captive was owned by two LLCs, each of which was wholly-owned by a different trust; the LLCs were managed by Shareholders, who were also Captive’s only officers; thus, Captive was basically a sister company as to Corp.

Captive and Corp participated in Manager’s captive insurance program. Participants in the program consisted of companies (like Corp) that purchased captive insurance and their related captive insurance companies. In general, participants did not purchase policies directly from their captive insurance companies but from “fronting carriers” related to Manager.[xi] The policies issued by the fronting carriers, which included “deductible reimbursement” policies,[xii] had a maximum benefit of $1 million.

Premiums and Coverage

Corp paid premiums directly to the fronting carriers, but the fronting carriers ceded 100-percent of the insurance risk. The responsibility for paying a covered claim under a policy was described as a two-layered arrangement: the first $250,000 of a single loss was allocated to “Layer 1,” and any loss between $250,000 and $1 million was allocated to “Layer 2.” Manager uniformly allocated 49-percent of each captive participant’s premiums to Layer 1 and 51-percent to Layer 2, notwithstanding that an actuarial consulting firm had reported that 70-percent of the loss experience would occur in Layer 1, given the proposed limits, and 30-percent in Layer 2.[xiii]

Captive reinsured[xiv] the first $250,000 of any Corp claim.[xv] Thus, shortly after the fronting carriers received Corp’s premiums, they ceded 49-percent of the net premiums to Captive.

For Corp’s claims between $250,000 and $1 million (Layer 2 claims), Captive agreed to reinsure its “quota-share” percentage of losses.[xvi] Additionally, Captive provided Layer 2 reinsurance for policies issued to unrelated companies in the fronting carriers’ pools. After the policy periods ended, the fronting carriers ceded the remaining 51-percent of net premiums to Captive less the amount of any claims paid for Layer 2 losses.

In other words, during the years in issue, Corp paid gross premiums to the fronting carriers, and the fronting carriers ceded net premiums to Captive.

Corp purchased a number of other policies during the years in issue. For example, it purchased deductible reimbursement policies that had among the highest premiums of any Corp policy. It also purchased various excess-coverage policies, under which the insurer agreed to indemnify against a loss only if it exceeded the amount covered by another policy.

Corp’s premiums were set by a non-actuary whose underwriting report did not detail any rating model, calculations, or any other analysis describing how premiums were determined. The report provided only general information about projected losses, previous claims, and information about Corp’s other insurance. Nothing in the report suggested that comparable premium information was used to price the premiums.[xvii]

Manager’s underwriting report projected that Captive would pay annual Layer 1 claims under certain policies, and projected that Captive would have an overall
“loss and loss adjustment expense” (LLAE) ratio[xviii] of 56-percent overall and 29-percent in Layer 2 for the years in issue. However, Captive’s actual LLAE ratio was only 1.5-percent: 0-percent for Layer 1 and 3-percent for Layer 2.

Corp did not file any claims under the captive program policies during the years in issue, but did file multiple claims under its commercial insurance policies, and it also paid deductibles, though it did not keep specific records of the deductibles.

Shareholders testified that they did not file captive program claims “because of time management issues.” They acknowledged that Corp did not have a claims management system in place for its captive program, though it had “different processes” in place for its commercial policies.

Captive’s Assets

Captive met Delaware’s minimum capitalization requirements during the years in issue. Its assets were listed on financial statements for each year in issue, and consisted of the initial $250,000 letter of credit, varying amounts of cash and cash equivalents, varying amounts of unceded premiums,[xix] and two life insurance policies on the lives of Shareholders.

However, Captive did not own the life insurance policies listed on the financial statements, nor was it a beneficiary of the policies. Rather, they were owned by the trusts (which were also the beneficiaries of the policies) under the terms of split-dollar life insurance agreements that required Captive to pay the premiums for the policies. Captive’s only right under the agreements was to be repaid the greater of the premiums paid or the policy’s cash value.[xx] Captive was prohibited from accessing the cash values of the policies, borrowing against the policies, surrendering or canceling the policies, or taking any other action with the respect to the policies.[xxi]

Returns and Notices of Deficiency

Captive decided to exit Manager’s captive insurance program after Captive’s premiums dropped significantly. Shareholders explained to Manager that Captive was changing managers because, among other things, they were displeased with the decrease in premiums.[xxii]

For the years preceding its exit from the captive program, Captive filed corporate tax returns on which it made a Section 831(b)[xxiii] election, and reported no taxable income.

Corp also filed returns for those years, in which the premium payments to the fronting carriers were apportioned among Corp’s subsidiaries, and deducted accordingly.[xxiv]

The IRS examined these returns and timely issued notices of deficiency. The IRS determined that Captive did not engage in insurance transactions and was not an insurance company. It found that Captive’s Section 831(b) election was invalid, and that the premiums were taxable income to Captive, and not deductible by Corp.

Corp and Captive (the “Taxpayers”) timely filed petitions with the U.S. Tax Court.

Tax Court

The issues before the Court were: (1) whether Captive was an insurance company, (2) whether the amounts received by Captive as premiums were excluded from its gross income under Section 831(b) of the Code, and (3) whether the amounts paid by Corp as premiums for insurance were deductible as business expenses.[xxv]

The Court began its discussion by briefly explaining the taxation and deductibility of micro-captive insurance payments.

Micro-Captives

The Court explained that insurance companies are generally taxed on their income in the same manner as other corporations, but that Section 831(b) provides an alternative taxing structure for certain “small” insurance companies. During the years in issue, the Court continued, an insurance company with written premiums that did not exceed $1.2 million for the year could elect to be taxed under section 831(b).[xxvi] A qualifying insurance company that made a valid election was taxable only on its investment income – its premiums were not taxable (a “micro-captive” insurance company). [xxvii]

What’s more, the captive rules do not prohibit deductions for the insured business that pays or incurs micro-captive insurance premiums, provided they are ordinary and necessary expenses paid or incurred in connection with a trade or business.[xxviii]

Real Insurance

According to the Court, in order for a company to make a valid Section 831(b) election, “it must transact in insurance.” Likewise, the deductibility of insurance premiums depended on whether they were truly payments for insurance.

The Court noted that, in order to determine whether a transaction constitutes insurance for income tax purposes, it had to consider certain principal criteria that had been developed by the case law, including whether the insurer distributed the risk among its policy holders, and whether the arrangement was “insurance in the commonly accepted sense”.[xxix]

Risk Distribution

Taxpayers argued that Captive distributed risk by participating in the fronting carriers’ captive insurance pools and reinsuring unrelated risks. In response, the Court stated that it had to decide whether those carriers were bona fide insurance companies in the first place.

The Court identified several following factors as relevant to determining whether an entity is an insurance company, including the following:

(1) there was a circular flow of funds;

(2) the policies were arm’s-length contracts;

(3) the entity charged actuarially determined premiums; and

(4) it was adequately capitalized.[xxx]

Circular Flow of Funds

Under the arrangements with the fronting carriers, Corp paid premiums to the carriers. The fronting carriers then reinsured all of the risk, making sure that

Captive received reinsurance premiums equal to the net premiums paid by Corp, less Captive’s liability for any Layer 2 claims. For the years in issue, this resulted in Corp’s paying the fronting carriers $1.37 million of gross premiums and the fronting carriers’ ceding $1.312 million of reinsurance premiums to Captive. “While not quite a complete loop,” the Court observed, “this arrangement looks suspiciously like a circular flow of funds.”

Arm’s-Length Contracts

The Court found that Corp paid upwards of five times more for its captive program policies than for its non-captive program policies.[xxxi]

In addition, various terms in the captive program policies indicated that Corp should have paid less for the captive program policies than the non-captive policies. For example, at least half of Corp’s captive program policies were for “excess coverage,” and others contained restrictive provisions, which should have resulted in a lower cost.

According to the Court, there was nothing to justify why Corp paid higher premiums for policies with more restrictive provisions than their commercial policies. The higher average rate-on-line coupled with the policies’ restrictive provisions led the Court to conclude that the policies were not arm’s-length contracts.

In addition, the Court pointed to Shareholders’ statement to Manager that one of the reasons Corp was leaving its captive program was the decrease in premiums, which reinforced the Court’s view that the policies were not arm’s-length contracts. It is fair to assume, the Court stated, that a purchaser of insurance would want the most coverage for the lowest premiums. In an arm’s-length negotiation, an insurance purchaser would want to negotiate lower premiums instead of higher premiums.

The main advantage of paying higher premiums, the Court found, was to increase deductions for Corp and the Shareholders, while shifting income to Captive, in whose hands the premiums were thought not to be taxable. With this, the Court concluded that the contracts were not arm’s-length contracts.

Actuarially Determined Premiums

The Court stated that premiums charged by a captive were actuarially determined when the company relied on an outside consultant’s “reliable and professionally produced and competent actuarial studies” to set premiums. The Court added that it would look favorably upon an outside actuary’s determination that premiums were reasonable. Premiums are not actuarially determined, it continued, when there is no evidence to support the calculation of premiums and when the purpose of premium pricing is to fit squarely within the limits of Section 831(b).

In the instant cases, the Court there were two issues with respect to the premiums: (1) the reasonableness of captive program premiums, and (2) the 49-percent to 51-percent allocation of premiums between Layer 1 and Layer 2 claims.

There was insufficient evidence in the record relating to how the premiums were set, and it was never determined whether they were reasonable. Accordingly, the policies issued by the fronting carriers did not have actuarially determined premiums.

There were also problems with the allocation of premiums between Layer 1 and Layer 2. Manager disregarded an actuarial firm’s conclusion that the majority of the premiums should be allocated to Layer 1. Moreover, Shareholders testified that they understood the purpose of the allocation was to take advantage of a tax-related safe harbor.

Accordingly, the Court found that the allocation of premiums was not actuarially determined.

Based on the foregoing factors, the Court concluded that the fronting carriers were not bona fide insurance companies for tax purposes, which meant that they did not issue insurance policies. In turn, this meant that Captive’s reinsurance of those policies did not distribute risk; therefore, Captive could not make the micro-captive election.

“Insurance” in the Commonly Accepted Sense

Although the absence of risk distribution by itself was enough to conclude that the transactions among Captive, Corp, and the fronting carriers were not insurance transactions, the Court nevertheless looked at whether these transactions might have constituted “insurance” in the commonly accepted sense. The Court indicated that the following factors should be considered in making this determination:

(1) the company was organized, operated, and regulated as an insurance company;

(2) it was adequately capitalized;

(3) the policies were valid and binding;

(4) premiums were reasonable and the result of arm’s-length transactions; and

(5) claims were paid.

Organization, Operation, and Regulation

Captive was organized and regulated as a Delaware insurance company. The question, however, was whether Captive was operated as an insurance company. In making this determination, the Court stated that it “must look beyond the formalities and consider the realities of the purported insurance transactions”.

The Court observed that during the years in issue, Corp did not submit a single claim to a fronting carrier or to Captive. Shareholders testified that there were various claims that were eligible for coverage under the deductible reimbursement policy that were not submitted. Because this policy was one of Corp’s most expensive insurance policies, Corp’s failure to submit claims after paying deductibles indicated that the arrangement did not constitute insurance in the commonly accepted sense.

Additionally, Shareholders testified that Corp had no claims process for the captive program claims, but did have “different processes” for their other claims.

Captive’s investment choices were also troubling. The life insurance policies insuring Shareholders totaled more than 50-percent of Captive’s assets and were its largest investments. Under the terms of the split-dollar agreements, however, Captive could neither access the cash value of the policies, borrow against the policies, surrender or cancel the policies, nor unilaterally terminate the agreements.

The Court did not think that an insurance company, in the commonly accepted sense, would invest more than 50-percent of its assets in an investment that it could not access to pay claims.

Valid and Binding Policies

The Court explained that policies were valid and binding when “[e]ach insurance policy identified the insured, contained an effective period for the policy, specified what was covered by the policy, stated the premium amount, and was signed by an authorized representative of the company.”

During the years in issue, neither Captive nor the fronting carriers timely issued a policy to Corp. The policies for some years were not even issued until after the policy years ended.[xxxii] What’s more, the policies issued to Corp had ambiguities and conflicts as to which entities were insured and what the policies covered.

Arrangement Not Insurance

Although Captive was organized and regulated as an insurance company and met Delaware’s minimum capitalization requirements, these insurance-like traits did not overcome the arrangement’s other failings. Captive was not operated like an insurance company. The fronting carriers charged unreasonable premiums, and issued policies with conflicting and ambiguous terms.

The arrangement among Corp, Captive, and the fronting carriers lacked risk distribution and was not insurance in the commonly accepted sense. Thus, the arrangement was not insurance for income tax purposes.

Because the arrangement was not insurance, Captive’s Section 831(b) election was invalid, and Captive had to recognize as income the premiums it received.

What’s more, Corp could not deduct the purported premium payments because the payments were not for insurance.

“This Will Never End ‘Cause I Want More”

We began this post by taking some liberty with the refrain from the theme sing to the “Vikings” television series. We end it with the first line from that song.

As was indicated earlier, a micro-captive can play an important role in a business’s management of its insurable risks. Moreover, Congress has recognized this role, and has sought to encourage businesses to utilize micro-captives.

In contrast to this legislative intent, we have advisers and taxpayers for whom the insurance benefits offered by the micro-captive do not appear to take precedence over the income tax benefits – as in the case of the Taxpayers described above – and the estate planning opportunities that captives may present.

These folks have it all backwards. The income tax benefits are not the goal to be attained – they are the incentives that Congress provided businesses that have a bona fide non-tax reason for creating a captive. Some taxpayers become so blind to this, they forget that the arrangement must actually constitute insurance. The same is true as to estate planning benefits that many identify as a reason for using a captive; these weren’t even on the table when the micro-captive was conceived (which explains the 2015 and 2018 legislatively-imposed diversification requirements that sought to limit the use of captives for that purpose).

With that, we return to our own refrain: the principal purpose for a transaction has to be a business purpose; assuming there is a valid business purpose, one is free to structure the transaction in a tax efficient manner. Without the business purpose, you can’t have more.


* Variation on Fever Ray’s “If I Had A Heart,” the theme from the History Channel’s “Vikings.” https://www.youtube.com/watch?v=DT7jxSmbMbs

[i] Undoubtedly, you’ve heard the comments about the legislation’s being a boon for tax advisers – a full-employment act, as it were. Although I cannot deny that there is much to be admired in the legislation (and even more so in the IRS’s efforts to implement it), it is undeniable that the haste with which it was drafted and enacted resulted in the diversion – should I say “misallocation?” – of resources by both the government and taxpayers.

[ii] As they should, considering that they became effective almost immediately after enactment, and considering further that some of their benefits will expire in just a few years – the victims of budget constraints.

[iii] The so-called “transactions of interest” and the “dirty dozen” list of suspect transactions.

[iv] Anyone remember Wile E. Coyote?

[v] Hopefully unused.

[vi] The captive, which is created as a C corporation, must operate like an insurance company; for example, it will reinsure some of its risk with other insurance companies, it will set aside appropriate reserves for the risks it does not cede, and it will invest the balance of the premiums received. Any investment income and gains recognized by the captive will be taxable to the captive.

[vii] The actuarial “law of large numbers” – meaning that the premiums received by the captive are pooled with the premiums received by other insurers, and this pool of premiums is used to satisfy the losses suffered by one of their insureds. The IRS has issued several rulings over the years regarding these requirements, including some so-called “safe harbors” (see below).

[viii] This is how risk distribution is effectuated.

[ix] For example, by permitting a larger deductible thereon.

[x] Corp was an S corporation.

[xi] The Court explained that a “fronting company” issues fronting policies, which are “a risk management technique in which an insurer underwrites a policy to cover a specific risk but then cedes the risk to a reinsurer.”

[xii] To cover large deductibles payable by the insured under commercial policies.

[xiii] Manager did not change the 51-49-percent premium allocation in response to the actuarial firm’s findings. Shareholders testified that the purpose of the allocation was to take advantage of a tax-related “safe harbor”.

According to the Court, “the safe harbor is almost certainly Rev. Rul. 2002-89, 2002-2 C.B. 984.”

This ruling addressed a captive insurance arrangement between a parent corporation and its wholly-owned captive subsidiary.

In Situation 1, the premiums that the subsidiary earned from its arrangement with the parent constituted 90% of its total premiums earned during the taxable year on both a gross and a net basis. The liability coverage the subsidiary provided to the parent accounted for 90% of the total risks borne by the subsidiary. The IRS found that the arrangement lacked the requisite risk shifting and risk distribution to constitute insurance for federal income tax purposes.

In Situation 2, the premiums that the subsidiary earned from its arrangement with its parent constituted less than 50% of the total premiums it earned during the taxable year on both a gross and a net basis. The liability coverage it provided to its parent accounted for less than 50% of the total risks borne by the subsidiary. The premiums and risks of the parent were thus pooled with those of unrelated insureds. The requisite risk shifting and risk distribution required to constitute insurance for federal income tax purposes were present. The IRS found that the arrangement was insurance for tax purposes.

[xiv] Reinsurance is an agreement between an initial insurer (the ceding company) and a second insurer (the reinsurer), under which the ceding company passes to the reinsurer some or all of the risks that the ceding company assumes through the direct underwriting of insurance policies. Generally, the ceding company and the reinsurer share profits from the reinsured policies, and the reinsurer agrees to reimburse the ceding company for some of the claims that the ceding company pays on those policies. Think of it as insurance for the risks “assumed” by an insurer.

[xv] A Layer 1 claim.

[xvi] The ratio of: (1) the net premium Corp paid to that portfolio to (2) the aggregate net premiums the portfolio received for the insurance period.

[xvii] Manager conducted an actuarial feasibility study for Captive for the purpose of determining Captive’s ability to remain solvent, not to price the premiums or to determine whether they were reasonable.

[xviii] The LLAE ratio is the cost of losses and loss adjustment expenses divided by the total premiums.

[xix] Premiums for risks that were not ceded to a reinsurer.

[xx] An “equity” type split-dollar arrangement. Reg. Sec. 1.61-22.

[xxi] The split-dollar agreements could be terminated only through the mutual consent of Captive, the insured, and the trust. Within 60 days of termination, the owner had the option to obtain a release of Captive’s interest in the policy. To obtain the release, the policy owner was required to pay Captive the greater of: (1) the premiums that it paid with respect to the policy or (2) the policy’s cash value. If the policy owner did not obtain a release, ownership of the policy reverted to Captive.

[xxii] Yes, you heard right. In fact, at trial, Shareholder testified the he was disappointed in the premium decrease because there were fixed costs associated with a captive manager and it made the most sense to have as much coverage as possible with the captive manager.

[xxiii] https://www.law.cornell.edu/uscode/text/26/831

[xxiv] Because Corp was an S corporation, the deductions flowed through to the Shareholders.

[xxv] “Ordinary and necessary” under Sec. 162 of the Code.

[xxvi] The 2015 amendments to sec. 831(b) increased the premium ceiling to $2.2 million (adjusted for inflation) and added new diversification requirements that an insurance company must meet to be eligible to make a Sec. 831(b) election. The Protecting Americans from Tax Hikes Act of 2015, P.L. 114-113. The 2018 amendments clarified the diversification requirements. Consolidated Appropriations Act of 2018, P.L. 115-141.

[xxvii] Sec. 831(b)(1).

[xxviii] Reg. Sec. 1.162-1(a).

[xxix] The other criteria: was there an insurable risk, and was risk of loss shifted to the insurer?

[xxx] Other factors included: the entity was created for legitimate nontax reasons; it was subject to regulatory control and met minimum statutory requirements; it paid claims from a separately maintained account; it faced actual and insurable risk comparable coverage was more expensive or not available.

[xxxi] The captive policies had a higher “rate-on-line.” A higher rate-on-line means that insurance coverage is more expensive per dollar of coverage.

[xxxii] An insurance binder is a “written instrument, used when a policy cannot be immediately issued, to evidence that the insurance coverage attaches at a specified time and continues . . . until the policy is issued or the risk is declined and notice thereof is given.”

 

Choice of Entity

Following the enactment of the Tax Cuts and Jobs Act,[i] tax advisers were inundated with inquiries from the individual owners of closely held businesses regarding a broad spectrum of topics.[ii] Perhaps the most often repeated question concerned the form of legal entity through which such a business should be operated. Of course, the impetus for this heightened interest in the “choice of entity” for the business was the Act’s significant reduction in the federal corporate tax rate.[iii]

This question, in turn, took several forms; for example, “Should I incorporate my single member LLC as a C corporation?” and “Should we incorporate our partnership?”[iv]

In the end, the flexibility that the LLC and partnership structures afford the closely held business and its owners from a tax perspective, plus the single level of tax that is imposed on their profits,[v] will probably result in a decision by the individual owners of such entities to retain their unincorporated status, notwithstanding that the owners do not enjoy any tax deferral for these profits, and despite the fact such profits are taxable to them up to a maximum federal income tax rate of 37 percent,[vi] though this may be reduced to as low as 29.6 percent if the qualified business income deduction is fully utilized.[vii]

Which leaves us with the “runner-up” question among business owners: “Should we revoke our corporation’s ‘S’ election?”

The S Corporation

Ah, the S corporation.[viii] Not more than 100 shareholders.[ix] Not more than one class of stock outstanding. No nonresident alien shareholders.[x] No shareholder who is not an individual (other than an individual’s estate, or certain trusts[xi] created by an individual).[xii]

Yes, it is a pass-through entity and, yes, it is not itself taxable.[xiii] As in the case of a partnership, its items of income, deduction, gain, loss and credit pass through to, and are reported by, its shareholders – based on the S corporation’s method of accounting – regardless of whether or not the income is distributed by the corporation to its shareholders.[xiv] Thus, there is no way to defer the shareholders’ inclusion of the corporation’s net operating income in their own gross income, where it will be taxable as ordinary income at a maximum federal rate of 37 percent, though the shareholders may benefit from the qualified business deduction.[xv]

When that S corporation income – which has already been taxed to the shareholders – is then distributed to the shareholders, the applicable basis adjustment and distribution rules generally prevent it from being taxed a second time.[xvi] In contrast, when a C corporation distributes its after-tax income to its shareholders as a dividend, that income is taxed to the shareholders at a federal income tax rate of 20 percent;[xvii] it may also be subject to the 3.8 percent surtax on net investment income.

But the S corporation is still a corporation and, so, it cannot do certain things that a partnership can; for example, it cannot distribute appreciated property to its shareholders in respect of their shares – either as a current or as a liquidating distribution – without being treated as having sold such property for consideration equal to its fair market value.[xviii]

In light of the foregoing, one might characterize the S corporation as an entity in limbo. Although its shareholders enjoy a single level of tax – albeit at the 37 percent ordinary income tax rate applicable to individuals[xix] – the single class of stock requirement limits the corporation’s ability to vary the terms of the economic arrangement among its owners. One might also add, because of the single class of stock rule and because of the limitation on which persons can be S corporation shareholders, that an S corporation cannot attract the same range of investments and investors that a partnership and C corporation can, though this may be a less important consideration in the case of most closely held businesses.[xx]

Converting from “S” to “C”?

Under those circumstances, the shareholders of an S corporation may decide that they would be better off with a C corporation. No single class of stock requirement, and no limitation on types of shareholders. Moreover, no taxation of the corporation’s profits to its shareholders unless the corporation pays a dividend.

In other words, why be saddled with the pass-through taxation of a partnership without having the flexibility of a partnership structure?

Of course, the corporation itself is taxed at a federal rate of 21 percent. That leaves a significant portion of its after-tax profits available for the replacement of depreciable properties[xxi] and for expansion, whether by acquisition or otherwise.[xxii] This should be compared to an S corporation that will typically distribute funds to its shareholders in an amount that is at least enough for them to satisfy their individual income tax liabilities attributable to the S corporation’s income.[xxiii]

Which brings us back to the question raised above: Should the shareholders of an S corporation revoke the “S” election? In other words, should the corporation be converted to a C corporation?

In addition to the “primary” factors touched upon above – which go to the question of whether to revoke an “S” election and operate as a C corporation – the shareholders of an S corporation also have to consider a number of “secondary” factors, including those tax consequences that are an ancillary, but potentially immediate, result of the decision to revoke the “S” election. Among these are the effect of the conversion on the corporation’s method of accounting, and its impact on the tax treatment of certain post-conversion distributions.

Accounting Method

Taxpayers using the cash method generally recognize items of income when actually or constructively received, and items of expense when paid.[xxiv] Taxpayers using an accrual method generally accrue items of income when all the events have occurred that fix the right to receive the income and the amount of the income can be determined with reasonable accuracy. Taxpayers using an accrual method of accounting generally may not deduct items of expense prior to when all events have occurred that fix the obligation to pay the liability, the amount of the liability can be determined with reasonable accuracy, and economic performance has occurred.[xxv]

A C corporation generally may not use the cash method, though an exception is made for C corporations to the extent their average annual gross receipts do not exceed a prescribed threshold for all prior years (the “gross receipts test”).[xxvi] Thus, it is conceivable that an S corporation that revokes its election may be required to cease using the cash method if it fails the gross receipts test, and to adopt the accrual method. This change is often accompanied by the immediate recognition of accrued income that had been deferred under the cash method; it may also result in the immediate deduction of certain items.

The Code prescribes the rules to be followed in computing taxable income in cases where the taxable income of the taxpayer for a taxable year is computed under a different method than used in the prior year; for example, when changing from the cash method to the accrual method. In computing taxable income for the “year of change,”[xxvii] the taxpayer must take into account those adjustments which are determined to be necessary solely by reason of such change, in order to prevent items of income or expense from being duplicated or omitted.[xxviii]

Net adjustments that decrease taxable income generally are taken into account entirely in the year of change, and net adjustments that increase taxable income generally are taken into account ratably during the four-taxable-year period beginning with the year of change.[xxix]

The Act contemplated that many S corporations and their shareholders would consider such a revocation in light of the greatly reduced corporate tax rate.

In order to reduce the economic “pain” stemming from such a change, the Act amended the Code to increase the threshold for the gross receipts test from $5 million to $25 million – thereby expanding the number of taxpayers that may use the cash method of accounting, even after a change in tax status[xxx] – and it provided that any adjustment in income of an “eligible terminated S corporation”[xxxi] attributable to the revocation of its S corporation election (i.e., a change from the cash method to an accrual method) would be taken into account ratably during the six-taxable-year period[xxxii] beginning with the year of change.

Following on this relief provision, the IRS announced that even if an eligible terminated S corporation is not required to change from a cash to an accrual method of accounting, but nevertheless chooses to change to an accrual method, the corporation may take the resulting adjustments into account ratably over the six-year period beginning with the year of change.[xxxiii]

Post-termination Distributions

Prior to the Act, in the case of an S corporation that converted to a C corporation, distributions of cash by the corporation to its shareholders – to the extent of corporation’s accumulated adjustments account[xxxiv] at the time of the conversion –during the post-termination transition period (the one-year period after the S corporation election terminated[xxxv]) were tax-free to the shareholders to the extent of the adjusted basis of the stock.[xxxvi]

Under the Act, in the case of a distribution of money by an eligible terminated S corporation after the post-termination period, the corporation’s accumulated adjustments account may be allocated to the distribution (a tax-free distribution), and chargeable to its accumulated earnings and profits (a taxable distribution), in the same ratio as the amount of the accumulated adjustments account bears to the amount the accumulated earnings and profits as of the effective date of the revocation.

Mechanics of Revocation

Let’s assume that the S corporation’s board of directors has decided that it would be in the best interest of the corporation and the shareholders to revoke the corporation’s “S” election. Let’s also assume that the shareholders agree – by whatever measure may be required by the corporation’s by-laws, their shareholders’ agreement, or any other governing agreement – to the revocation.[xxxvii] Finally, let’s assume that there are no contractual restrictions imposed by third parties – for example, a bank from whom the corporation has obtained a loan – that may prevent the revocation. What’s the next step?

Statement and Timing

An “S” election is terminated if the corporation revokes the election. To revoke the election, the corporation files a statement to that effect with the IRS service center where the “S” election was filed. It must include the number of shares of stock (including non-voting stock) issued and outstanding at the time the revocation is made.

If the revocation is made during the taxable year, and before the 16th day of the third month of the taxable year, it will be effective on the first day of the taxable year; a revocation made after the 15th day of the third month of the taxable year will be effective for the following taxable year.

If a corporation specifies a date for revocation, and the date is expressed in terms of a stated day, month, and year that is on or after the date the revocation is filed, the revocation is effective on and after the date so specified.

Short Year Returns and Allocations

If the revocation of an S election is effective on a date other than the first day of a taxable year of the corporation, the corporation’s taxable year in which the revocation occurs is an “S termination year.” The portion of the S termination year ending at the close of the day prior to the termination is treated as a short taxable year for which the corporation is an S corporation (the S short year). The portion of the S termination year beginning on the day the termination is effective is treated as a short taxable year for which the corporation is a C corporation (the C short year).

The corporation may allocate income or loss for the entire year (and between the two short years) on a pro rata basis. If the corporation elects not to allocate income or loss on a pro rata basis – by closing the books with the last day of the S short year – then these items are assigned to each short taxable year on the basis of the corporation’s normal method of accounting.[xxxviii] Either way, the due date for filing both short year returns is the due date for the C short year.

Re-Electing “S” Status

In general, the shareholders of an S corporation whose election is revoked may not make a new “S” election for five taxable years.[xxxix] However, the IRS may permit a new election before the five-year period expires, provided the corporation can establish that, under the relevant facts and circumstances, the IRS should consent to a new election. The fact that more than fifty percent of the stock in the corporation is owned by persons who did not own any stock in the corporation on the effective date of the revocation tends to establish that consent should be granted.[xl]

Wish I Had a Crystal Ball

The choice of entity decision is a difficult one. In the case of an established S corporation, however, it is somewhat less difficult – the shareholders are pretty much stuck with the corporate form.[xli] That said, the decision boils down to retaining or revoking “S” status for the corporation.

Because all of the corporation’s shareholders are U.S. individuals or domestic trusts created by them,[xlii] the “permanent” reduction of the corporate tax rate has made the C corporation an attractive entity choice, especially when one considers that the Section 199A qualified business income deduction will not be available to the shareholders of an S corporation after 2025.

In the end, the decision may depend upon two factors:

  • the likelihood that the corporation will be periodically distributing its profits to its shareholders, rather than reinvesting them in the corporation’s business, and
  • the period of time within which the shareholders plan to dispose of the corporation’s business.

In the context of a closely held business, these two considerations are not necessarily independent of one another; it all depends upon where the corporation is in its life cycle.

For example, in the case of a newer business, the corporation’s profits may have to be reinvested over time so as to grow the business. During this period, only those shareholders who are employed by the corporation will be able to withdraw any value from the corporation, albeit in the form of compensation for services. Under these circumstances, it may be reasonable for an S corporation to consider revoking its election; doing so would allow it to forego making a “tax distribution” to its shareholders (whether for a 40.8 percent or 33.4 percent individual tax rate),[xliii] while causing it to pay corporate level tax at a rate of only 21 percent.

By the same token, if the corporation is already approaching the point at which its shareholders will want to liquidate their investment by selling the business, the conversion from an S corporation to a C corporation may not be a reasonable move. If the anticipated sale transaction is likely to take the form of a sale of assets, followed by the liquidation of the corporation, the revocation of the corporation’s “S” election could double the tax liability from the sale.[xliv]

The difficulty lies somewhere in between these two scenarios. Where the business has matured to the point where it can pay dividends, and where its shareholder base has expanded beyond the individuals whose “sweat equity” grew the business, it will probably make sense to retain the corporation’s “S” status, especially when one considers that such an established business will probably be a target for a purchaser in the not-too-distant future.


[i] P.L. 115-97 (the “Act”).

[ii] Let’s face it, there was, and there remains, a lot to chew on.

[iii] From a maximum graduated rate of 35 percent to a flat rate of 21 percent. In addition, the corporate alternative minimum tax was repealed.

[iv] Remember, it is not necessary, from a tax perspective, that a new corporation be organized and the LLC or partnership somehow be transferred over (though there may be non-tax reasons for pursuing such a “physical” change; should one decide to pursue that route, Rev. Rul. 84-111 is the place to start). Instead, one may “check the box” in accordance with Reg. Sec. 301.7701-3, and thereby convert an unincorporated entity (i.e., a partnership or one that is disregarded for tax purposes) into an association that is treated as a corporation for tax purposes.

[v] Not to mention the gain from the sale of their assets.

[vi] An owner with respect to whom the business is a passive activity may also be subject to the 3.8 percent federal surtax on net investment income, for an effective federal rate of 40.8 percent. IRC Sec. 1411.

[vii] IRC Sec. 199A, which was enacted in conjunction with the reduced corporate tax rate in order to “level the playing field” for pass-through entities. You will recall that certain businesses do not qualify for this deduction. In addition, there are limitations on the amount of the deduction that may be claimed based, in most cases, upon 50 percent of the W-2 wages of the business. Finally, the deduction disappears after 2025.

[viii] I picture it as a slow-moving earthbound caterpillar that looks at its C corporation and LLC brethren with envy, as though they were butterflies. (No, I do not indulge in any hallucinogenic substances.)

[ix] An almost ridiculous number when you consider the effect of the counting rule for members of a family. IRC Sec. 1361(c)(1). For example, I’ve seen at least two S corporation with well over 100 shareholders as a matter of state corporate law – for purposes of the S corporation rules, however, they each had fewer than a dozen shareholders, thanks to this counting rule.

[x] The Act allows such individuals to be potential current beneficiaries of an ESBT.

[xi] See IRC Sec. 1361(c)(2), (d), (e). Individuals have to be able to plan for the disposition of their estate. That’s why the ESBT rules were enacted, for example.

[xii] IRC Sec. 1361(b). Yes, a charity may be a shareholder – but not really; just to generate a charitable contribution deduction, after which the corporation will quickly redeem the charity’s shares because, frankly, that’s what both the charity and the corporation want. From the charity’s perspective, its share of S corporation profit is treated an unrelated business income.

[xiii] There are exceptions: the built-in gains tax under IRC Sec. 1374, LIFO recapture under IRC Sec. 1363, and the excise tax on excess net investment income under IRC Sec. 1375. These, however, are the result of vestigial C corporation attributes.

And if the S corporation is doing business in New York City, it will be subject to the City’s corporate level tax at a rate of 8.85%.

[xiv] IRC Sec. 1366. This pass-through income is not subject to self-employment tax, though the corporation is required to pay reasonable compensation to its shareholder-employees. In contrast, the employment tax generally applies to the flow-through income of a partnership.

[xv] Add another 3.8 percent for a shareholder who does not materially participate in the business. IRC Sec. 1411.

[xvi] IRC Sec. 1367 and 1368. In general, an S corporation shareholder is not subject to tax on corporate distributions unless the distributions exceed the shareholder’s basis in the stock of the corporation.

[xvii] Assuming a qualified dividend. IRC Sec. 1(h)(11).

[xviii] IRC Sec. 311(b). What’s more, depending on the type of property, the gain may be treated as ordinary income. IRC Sec. 1239.

[xix] Before considering Sec. 199A.

[xx] As a general rule, I almost always advise against the “admission” of new owners, whether these are key employees or potential investors – I’ve seen too many instances of the new owner claiming abuse or mismanagement, and then seeking redress therefor, usually by asking a court to dissolve the business. In the end, only the litigators come out ahead. Better to incentive the employee through compensation, including upon a change in control. As to the investor, it will depend upon where in its lifecycle the business finds itself, and what other sources of funding it has available.

[xxi] Vehicles, machinery, other equipment, etc.

[xxii] Product lines, geographically, etc.

[xxiii] Let’s illustrate this point:

  • an S corp. has $100 of profit
    • this is taxable to its shareholders at 37%;
    • the S corp. distributes $37 to the shareholders;
    • this distribution is not taxable to the shareholders;
    • they use this $37 to pay taxes;
    • the S corp. is left with $63;
  • a C corp. has $100 of profit
    • it pays corporate tax of $21;
    • that leaves the C corp. with $79;
    • if the C corp. paid a dividend of $16 to its shareholders – so that it is left with the same $63 left in the S corp. – they would pay tax of $3.81;
  • the C corp. and its shareholders will have paid total tax of $24.81 (20% + 3.8%), or an effective rate of 24.81% on the $100 of profit;
  • this is compared to the 37% for the S corp. and its shareholders (perhaps more if the 3.8% surtax applied to any of the shareholders);
  • both corporations have $63 remaining;
  • the shareholders of the C corp. have $12.2 remaining from the dividend;
  • the shareholders of the S corp. have no part of the $37 distribution remaining.

Query: Does the fact that the C corporation – after making the above dividend distribution – end up with the same amount of funds as the S corporation – after making its “tax distribution” to its shareholders – support an argument that the C corporation retained earnings should not be subject to the accumulated earnings tax in the above circumstances? It ends up exactly where the S corporation did, and the latter is not subject to the tax.

Query also this: Granted that an S corporation may distribute all its income to its shareholders without incurring additional tax – but would it be wise to do so in the absence of a shareholders’ agreement that required shareholders to contribute additional funds to the corporation when needed? Will the corporation’s management be willing to enforce the capital call? Will the capital, instead, be provided through loans from the shareholders?

If a C corporation were to distribute all of its after-tax profits – a questionable move where a reasonable reserve would be prudent and where it may be difficult to bring the funds back if necessary – the combined effective tax rate would be 39.8 percent.

This would leave the C corporation shareholders with $60.2, whereas the S corporation shareholders would be left with $63 following the same distribution.

[xxiv] IRC Sec. 451.

[xxv] IRC Sec. 461.

[xxvi] IRC Sec. 448.

[xxvii] The year of change is the taxable year for which the taxable income of the taxpayer is computed under a different method than for the prior year.

[xxviii] IRC Sec. 481.

[xxix] Rev. Proc. 2015-13, Section 7.

[xxx] Consistent with present law, the cash method generally may not be used by taxpayers, other than those that meet the $25 million gross receipts test, if the purchase, production, or sale of merchandise is an income-producing factor.

[xxxi] An eligible terminated S corporation is any C corporation which (1) was an S corporation the day before the enactment of the Act, (2) during the two-year period beginning on the date of such enactment revokes its S corporation election, and (3) all of the owners of which on the date the S corporation election is revoked are the same owners (and in identical proportions) as the owners on the date of such enactment.

The two-year period referenced above began on December 22, 2017.

[xxxii] Instead of the usual four years.

[xxxiii] Rev. Proc. 2018-44.

[xxxiv] IRC Sec. 1368.

[xxxv] IRC Sec. 1377.

[xxxvi] IRC Sec. 1371(f).

[xxxvii] More than one-half of the number of issued and outstanding shares of stock (including non-voting stock) of the corporation must consent to the revocation of the S election. Reg. Sec. 1.1362-2. The shareholders may agree to a greater threshold among themselves.

See Reg. Sec. 1.1362-6 for details regarding the form of the shareholder’s consent.

[xxxviii] IRC Sec. 1362(e); Reg. Sec. 1.1362-3.

[xxxix] A C corporation that is starting to think about the sale of its business (assets) may be considering an “S” election so as to avoid the double taxation problem. However, it must be mindful of the built-in gains tax and its five-year recognition period.

[xl] Reg. Sec. 1.1362-5.

[xli] Unless they are willing to incur an immediate tax liability for the corporation’s built-in gain.

[xlii] Thereby eliminating the consideration of accepting capital contributions from other investors.

[xliii] S corporations will often make distributions based on the highest rate applicable to any of its shareholders: 37 percent + 3.8 percent, or (if the full Sec. 199A deduction is available) 29.6 percent + 3.8 percent.

[xliv] For example: sale of assets by C corp. for $100; $21 of corporate tax paid; $79 liquidating distribution to shareholders (who are active in the business); tax of 23.8%, or $18; total taxes paid of $39; net proceeds to shareholders of $61.

Compare to an asset sale by an S corp. for $100: no corporate tax; distribution of $100 to shareholders; no tax on the distribution: shareholders (who are active in the business) pay tax of 20% on the gain; total taxes paid of $20; net proceeds to shareholders of $80.