Why Real Property?

It is not unusual for the owners of a closely held business to also own a number of real properties. For example, they may own real property that:

  • headquarters the business;
  • serves as a warehouse for the business;
  • serves as parking for a fleet of vehicles used by the business;
  • they want to keep out of the hands of a competitor;
  • is located in proximity to the business and could be used for future growth;
  • is located in a different geographic region into which the business plans to expands; or
  • serves as a solid investment for excess cash that was generated through the business.

In most cases, the business will occupy the entire property. If the owners have been well-advised, the property is housed in an LLC (not a corporation) of which they (not the business) are the members, while a different entity holds the business and uses the property pursuant to an arm’s-length lease.

Rental Real Estate = Passive Activity?

In many cases, however, the business is not the sole tenant; in some cases, the business does not use the property at all. In those situations, the owners must be alert to the application of the passive loss rules, and the consequences thereof, as illustrated by a recent decision.

Taxpayer ran an architectural business. During Tax Year, he spent 109 hours providing architectural services to Bank and about 540 hours providing similar services to Construction Co.

During Tax Year, Taxpayer owned and managed two residential rental properties: a single building containing four separate apartments, plus a single-family home. He made weekly trips to the properties to ensure that trash bins were set out for collection, cleaned if necessary, and returned to their storage locations. He also performed minor repairs at the properties, coordinated more substantial repairs with a handyman, communicated with the tenants and collected and deposited rent, maintained insurance policies, purchased materials for the properties as needed, paid bills, and kept books and records of his expenses for tax accounting purposes.

Two of the four tenants moved out during Tax Year. As a result, Taxpayer spent additional time coordinating with them as they vacated the apartments, performed extra repair and maintenance work to ready the apartments for new tenants, placed advertisements listing the apartments for rent, and worked with new tenants as they signed leases and moved into the apartments.

Taxpayer was late paying property taxes and insurance premiums on both rental properties during Tax Year. Consequently, he was obliged to spend time negotiating a property tax installment payment plan, and had to work with his mortgage lender to eliminate redundant insurance coverage on the properties.

Tax Return and IRS’s Determination

Taxpayer timely filed IRS Form 1040, U.S. Individual Income Tax Return, for Tax Year. He reported gross receipts from his architectural business as a sole proprietor – on Schedule C, Profit or Loss from Business – offset by various expenses.

He also attached Schedule E, Supplemental Income and Loss, to his tax return, reporting gross rental income from the two properties, offset by expenses that resulted in a net loss from the rental activity, which Taxpayer reported in computing his taxable income.

The IRS determined that Taxpayer’s rental loss deduction was disallowed under the passive activity loss rules,[1] and assessed a deficiency in Taxpayer’s Federal income tax for Tax Year.

Taxpayer petitioned the Tax Court. The sole issue for decision was whether the loss that Taxpayer reported on Schedule E should be disallowed under the passive activity loss limitations.

Court’s Opinion

The Court began by stating that, as a general rule, the IRS’s determination of a taxpayer’s liability in a notice of deficiency is presumed correct, and the taxpayer bears the burden of proving that the determination is incorrect.

Deductions, the Court continued, are a matter of legislative grace, and the taxpayer generally bears the burden of proving entitlement to any deduction claimed. Specifically, a taxpayer must substantiate any deductions claimed by keeping and producing adequate records that enable the IRS to determine the taxpayer’s correct tax liability.

The Court noted that Taxpayer produced an activity log listing the personal services that he performed in managing the rental properties during Tax Year and the time that he spent providing those services. The activity log indicated that he devoted 765 and 372 hours to the management of the two properties, respectively.

Taxpayer also produced records of his email exchanges with his tenants and mortgage brokers (related to his attempts at refinancing the mortgages on the properties), and numerous receipts from home improvement stores and other vendors related to the management of, and repairs undertaken at, the rental properties.

Passive Activity

In determining their taxable income, taxpayers are allowed deductions for certain business and investment expenses. However, the Code generally disallows any deduction for so-called “passive activity” losses.

A passive activity loss is defined as the excess of the aggregate losses from all passive activities for a taxable year over the aggregate income from all passive activities for that year.

A passive activity is any activity that involves the conduct of a trade or business, or an investment activity the expenses of which are deductible as incurred for the production of income, in which the taxpayer does not materially participate.

A passive activity loss may not be used to offset non-passive income (in Taxpayer’s case, the income from his architectural business).

Rental Activities

A rental activity generally is treated as a per se passive activity regardless of whether the taxpayer materially participates. The term “rental activity” generally is defined as any activity where payments are principally for the use of tangible property.

The Code provides special rules for taxpayers engaging in real property businesses. Under these rules, the rental activities of a qualifying taxpayer in a real property trade or business – i.e., a “real estate professional” – are not per se passive activities and, if the taxpayer materially participates in the rental real estate activities, these activities are treated as non-passive activities.

A taxpayer is treated as materially participating in an activity only if the taxpayer is involved in the operations of the activity on a regular, continuous, and substantial basis.[2]

A taxpayer qualifies as a real estate professional during a taxable year if:

  • more than one-half of the personal services performed in trades or businesses by the taxpayer during such taxable year are performed in real property trades or businesses in which the taxpayer materially participates; and
  • the taxpayer performs more than 750 hours of services during the taxable year in real property trades or businesses in which the taxpayer materially participates.[3]

“Personal services” means any work performed by an individual in connection with a trade or business.

In accordance with the flush language of the Code, Taxpayer elected to treat all of his interests in rental real estate as one activity for purposes of the special rule applicable to real estate professionals.


The extent of a taxpayer’s participation in an activity, including evidence of the number of hours that they participate in a real property trade or business, may be established by any reasonable means.

Contemporaneous daily time reports, logs, or similar documents are generally not required – though they should certainly recommended – if the extent of such participation may be established by other reasonable means. Reasonable means may include, but are not limited to, the identification of the services performed over a period of time and the approximate number of hours spent performing such services during such period, based on appointment books, calendars, or narrative summaries.

The Court pointed out that a post-event “ballpark guesstimate” will not suffice to establish the extent of one’s participation.

Although Taxpayer worked about 650 hours providing personal services as an architect during Tax Year, the record, including his activity log and other records, showed that he also spent more than 750 hours providing personal services in connection with the management of the rental properties. Taxpayer also offered credible testimony describing the time and effort that he devoted to both activities during the year. His testimony was largely corroborated with objective evidence, including a rental activity log, receipts for various rental-related expenditures, emails, and other business records.[4]

Considering all the facts and circumstances, the Court found that Taxpayer qualified as a real estate professional during Tax Year, and that his rental real estate activities were regular, continuous, and substantial within the meaning of the passive loss rules.

Thus, the Court concluded, the loss deduction claimed by Taxpayer was not disallowed as a passive loss, and could be applied against Taxpayer’s business income.

Forewarned . . . Means No Surprises

I don’t care for surprises, nor do most business owners, at least insofar as their taxes are concerned.

In order to avoid such surprises, those business owners who also own rental real property that is not related to the owner’s primary business,[5] must be familiar with the limitations imposed by the passive loss rules, and they must be prepared to maintain records of their rental-related activities on a contemporaneous basis.

Although this level of diligence may seem like a chore to the owner, it could provide a commensurate level of certainty as to the tax treatment of the activity and of any losses generated by the activity, not to mention a reduction in the professional fees to be incurred in defending the taxpayer’s return on audit.

[1] The IRS acknowledged in the notice of deficiency that Taxpayer was entitled to deduct $25,000 of the loss in accordance with the exception prescribed in IRC Sec. 469(i). Under this rule, a taxpayer who “actively” participates in rental real estate activities may deduct up to $25,000 per year for related passive activity losses.

[2] IRS Regulations identify various tests to determine whether a taxpayer satisfies the “material participation” requirement.

[3] The term “real property trade or business” means any real property development, redevelopment, construction, reconstruction, acquisition, conversion, rental, operation, management, leasing, or brokerage trade or business.  Taxpayer did not contend that his work as an architect constituted a real property trade or business.

[4] The Court observed that Taxpayer may have exaggerated the number of hours recorded in his rental real estate activity log; for example, the Court disregarded the hours that Taxpayer listed for vehicle maintenance. Nevertheless, the record as a whole showed that Taxpayer spent at least 750 hours managing the rental properties in Tax Year.

[5] In some cases, it may be possible for the business owner to “group” his primary business activity with his related rental activities, provided the two activities constitute an “appropriate economic unit” (for example, because of interdependencies between them), and the rental activity is “insubstantial” in relation to the business activity, or each owner of the business has the same proportionate interest in the rental activity. In this way, the rental activity may avoid being characterized as passive.

Corporate attorneys usually think of trusts as estate planning tools: they are the vehicles through which the owner of a business may pass along to their family a beneficial interest in the business without actually giving them direct ownership in the business. The owner will transfer an equity (often non-voting) interest in the business by either gifting or selling the interest to the trust.[1] The trustee will hold the interest and, in accordance with the terms of the trust agreement – which presumably reflect the owner-grantor’s directions or preferences – the trustee may distribute the trust’s income, and perhaps its corpus, among the beneficiaries of the trust.[2]

The Liquidating Trust

There are many non-estate-planning situations, however, in which a trust may prove to be a useful tool in the hands of a corporate attorney; for example, where it may be difficult to complete the liquidation of a corporate subsidiary into its corporate parent within the statutorily-prescribed three-year period for a tax-free liquidation – for instance, because the subsidiary owns a difficult to sell asset, or has a litigation claim that cannot be resolved within that time frame; in that case, the subsidiary’s final liquidating distribution may be made into a so-called “liquidating trust.”

Such a trust may also be utilized to facilitate the orderly disposition of a debtor-corporation’s assets and the satisfaction of its liabilities. It may also enable shareholders to accelerate a recognition event so as to capture some tax benefit.[3]

In order to qualify as a liquidating trust, the trust at issue must be organized for the primary purpose of liquidating and distributing the assets transferred to it, and its activities must be reasonably necessary to, and consistent with, the accomplishment of that purpose. A liquidating trust will be treated as a trust for tax purposes if it is formed with the objective of liquidating particular assets, and not as an organization having as its purpose the carrying on of a profit-making business which normally would be conducted through business organizations classified as corporations or partnerships.

However, if the liquidation is unreasonably prolonged, or if the liquidation purpose becomes so obscured by business activities, that the declared purpose of liquidation can be said to have been lost or abandoned, the status of the organization will no longer be that of a liquidating trust.

Assuming a liquidating trust is respected as such, it is important to next determine how and to whom the income and gains of the trust will be taxed – this is often no easy feat. A recent IRS ruling considered the tax status of one such trust that was used to facilitate the liquidation of a corporate debtor pursuant to a bankruptcy.

The Bankruptcy Plan

Debtor filed a voluntary petition for relief under Chapter 11 of the Bankruptcy Code, and submitted to the Bankruptcy Court a Plan that was confirmed by the Court.

On the Effective Date, the transactions contemplated by the Plan were consummated. Trust was formed pursuant to the Plan, and was to be governed by the Plan and the Trust Agreement.

Trust was funded with all of Debtor’s assets, other than cash to be distributed by Debtor to cover, for example, certain expenses of administration of the bankruptcy case, certain priority claims, and fees owed to certain creditors’ professionals.

Trust would not hold any operating assets of a going business, a partnership interest in a partnership that held operating assets, or 50% or more of the stock of a corporation with operating assets.

The initial term of Trust was for three years, but the Court granted a three-year extension of the term on the basis that the extension was necessary to analyze and pursue or defend various causes of action, and to investigate, prosecute and/or resolve outstanding disputed claims against Debtor.

Trust Agreement

Pursuant to the provisions of the Trust Agreement, Trust was created for the purpose of liquidating Debtor’s assets, with no objective to continue or engage in the conduct of a trade or business. The Plan provided that the beneficial interests in Trust would be distributed to certain holders of senior notes claims, subordinated notes claims, general unsecured claims, guarantees claims, and preferred equity claims. In addition, the Plan provided that, in the event such claims were fully paid, the interests in Trust would be redistributed to certain holders of other subordinated claims and, after these were paid in full, to certain holders of preferred and common equity interests.

Pursuant to the provisions of the Trust Agreement, Trust would not receive or retain cash in excess of a reasonable amount to meet claims and contingent liabilities (including disputed claims) or to maintain the value of the assets during liquidation. Cash not available for distribution, and cash pending distribution would be held in demand and time deposits, in banks, other savings institutions, or other temporary, liquid assets. Trust was required, under the terms of the Trust Agreement, to distribute to the “beneficiaries” of Trust, at least annually, its net income and all net proceeds from the sale of Trust’s assets, except that Trust could retain an amount of net proceeds or net income reasonably necessary to maintain the value of the property or to meet claims or contingent liabilities.

Continuing Status as a Trust

Trust represented that, from its establishment, it had been formed and operated consistent with the conditions published by the IRS for treatment as a liquidating trust.[4]

Trust represented that the trustee had been working in an expeditious, commercially reasonable manner to monetize the assets transferred to it, to analyze and pursue any valid causes of action, and to investigate, prosecute and/or resolve disputed claims against Debtor.

However, two principal outstanding matters were not concluded and were not expected to conclude timely. Accordingly, Trust represented that it was impossible for it to completely liquidate by its initial extension date.

Under the Trust Agreement, multiple extensions of Trust’s term could be obtained so long as Court approval was obtained prior to the expiration of each extended term, and the extension was necessary to facilitate or complete the recovery and liquidation of Trust assets.

However, if the liquidation was unreasonably prolonged or if the liquidation purpose became so obscured by business activities that the declared purpose of liquidation was lost or abandoned, the status of the organization would no longer be that of a liquidating trust.

The IRS stated that, if warranted by the facts and circumstances, and subject to the approval of the Bankruptcy Court, upon a finding that an extension is necessary to the liquidating purpose of the trust, the term of the trust may be extended for a finite term based on such particular facts and circumstances.

Grantor Trust Status

The Plan and Trust Agreement required all parties, including Debtor, Trust and Trust beneficiaries, to treat the transfer of assets from Debtor to Trust as (i) a transfer of Trust assets (subject to any obligations relating to those assets) directly to Trust beneficiaries and, to the extent Trust assets were allocable to disputed claims, to the reserve established to hold Trust assets allocable to, or retained on account of, such disputed claims, followed by (ii) the transfer by such beneficiaries to Trust of Trust assets (other than Trust assets allocable to the disputed claims) “in exchange” for Trust interests.[5]

Accordingly, the Plan and Trust Agreement provided that Trust beneficiaries would be treated for federal income tax purposes as the grantors[6] and owners of their respective share of Trust assets (other than such Trust assets that were allocable to the reserve for disputed claims), and would file returns for Trust treating it as a grantor trust.

Under the True Code[7], the income of a trust, over which the grantor has retained (or is deemed to have retained) substantial dominion or control (a “grantor trust”), is taxed to the grantor rather than to the trust which receives the income or to the beneficiary (if different from the grantor) to whom the income may be distributed.[8]

Thus, the grantor is treated as the owner of any portion of a trust in which the grantor has a reversionary interest in either the corpus or the income therefrom, if, as of the inception of that portion of the trust, the value of such interest exceeds 5% of the value of such portion. Likewise, the grantor is treated as the owner of that portion of a trust whose income, without the approval or consent of any adverse party is or, in the discretion of the grantor or a non-adverse party, or both may be distributed to the grantor.

Based on the foregoing, the IRS ruled that Trust should be classified for federal income tax purposes as a liquidating trust and, as such, Trust was also a grantor trust for federal income tax purposes, of which the Trust beneficiaries were treated as the owners.

Additionally, based on the facts and circumstances of the case and on the representations made, the IRS ruled that an extension of Trust’s term would not adversely affect the determination that Trust was a liquidating trust.


Although the liquidating trust is probably the form of non-estate-planning trust most often encountered by attorneys in corporate practice, it is hardly the only one.

It is not unusual, for example, for a corporation or a partnership to make a transfer of assets to a trust for a business purpose of the corporation or partnership – as where the transfer is made to secure a legal obligation of the business entity to a third party that is unrelated to the entity.[9] In that case, the corporation or partnership will be treated as the grantor of the trust, and will be taxable on the income and gain recognized by the trust.

Thus, it would behoove the corporate attorney to have at least a passing familiarity with the situations in which trusts may be utilized, and to understand the basic rules governing the income taxation of trusts, their grantors and their beneficiaries.

[1] Attorneys who advise S corporations are generally familiar with the workings of trusts as shareholders.

[2] By keeping the ownership interest out of the hands of family members, the owner-grantor may ensure continued family ownership of the business, provide a source of income for the family, and protect the trust property from the reach of the beneficiaries’ creditors and from the beneficiaries’ own spendthrift habits.

[3] For example, the recognition of a loss by some shareholders of an S corporation in the same year as their recognition of pass-through gain from the corporation’s sale of its assets.

[4] See Rev. Proc. 94-45 for the conditions set by the IRS for issuing advance rulings classifying certain trusts as liquidating trusts.

[5] More accurately, the grantors retained interests in the assets transferred to the Trust.

[6] A “grantor” includes any person that, directly or indirectly, makes a gratuitous transfer of property to a trust. A “gratuitous” transfer is any transfer other than one for fair market value.

[7] As distinguished from the earlier-mentioned bankruptcy code.

[8] IRC Sec. 671 – 679.

[9] Most corporate attorneys have probably heard of the so-called “rabbi trust” that is often used by employers to provide a mechanism by which employers may fund their obligations for deferred compensation owing to key employees. See Rev. Proc. 92-64.

Last week’s post considered the risk assumed by a taxpayer that ignores the plain meaning of a Code provision (the definition of “capital asset”) in favor of a more “rational” – favorable? – interpretation of that provision.

capital assets

This week’s post considers the “plain meaning” of the same section of the Code: the definition of the term “capital asset;” in particular, how one well-advised taxpayer was able to establish, through contemporaneously prepared documents, that they had changed the nature of their relationship to the property at issue.

Why does it Matter?

The Code provides that the gain recognized by an individual from the sale of a “capital asset” held for more than one year shall be taxed as long-term capital gain, at a maximum federal income tax rate of 20%.

It also provides that the gain from the sale of real property used by an individual taxpayer in a “trade or business,” held for more than one year, and not “held primarily for sale in the ordinary course of the taxpayer’s trade or business,” shall be treated as long-term capital gain.

Thus, if real property does not represent a capital asset in hands of an individual taxpayer, and it is held primarily for sale to customers in the ordinary course of the taxpayer’s trade or business, the gain from the sale of the property shall be taxed to the taxpayer as ordinary income, at a maximum federal rate of 37%.

Poor Timing

LLC was formed in the late 1990’s to acquire several contiguous tracts of land (the “Property”), and to develop them into residential building lots and commercial tracts.

The Property was adjacent to other properties that were being developed by other business entities, related to LLC, and LLC’s original plan was to subdivide the Property into residential units for inclusion in the related entities’ development. To that end, LLC entered into a development agreement with City, which specified the rules that would apply to the Property should it be developed.

LLC sold or otherwise disposed of some relatively small portions of the Property, retaining three main parcels for development.

Change in Plans?

As a result of the subprime mortgage crisis, however, LLC’s managers decided that LLC would not attempt to subdivide or otherwise develop the Property. They believed that LLC would be unable to develop, subdivide, and sell residential and commercial lots from the Property because of the effects of the subprime mortgage crisis on the local housing market, and the unavailability of financing for such projects in the wake of the financial crisis.

Instead, they decided that LLC would hold the Property as an investment until the market recovered enough to sell it off. These decisions were memorialized, on a contemporaneous basis, in a written “unanimous consent” that was dated and executed by the managers, as well as in a written resolution that was adopted by the members of LLC to further clarify LLC’s policy.

Thus, between 2008 and 2012, LLC did not develop the three parcels in any way, nor did it list them with any brokers, or otherwise market the parcels.

The Sale

In 2011, an unrelated developer (“Developer”) approached LLC about buying the parcels. LLC sold one of the parcels to Developer in 2011 and the other two in 2012.

One of the sale contracts called for Developer to pay a lump sum to LLC in 2012 for two of the parcels. The contract also listed certain development obligations, almost all of which fell on Developer.

LLC’s Forms 1065, U.S. Return of Partnership Income, for 2012 – and, indeed, for all years – stated that its principal business activity was “Development” and that its principal product or service was “Real Estate”. On its 2012 Form 1065, LLC reported $11 million of capital gain from its sale of one parcel and a $1.6 million capital loss from its sale of the second parcel, and this tax treatment was reflected on the Schedules K-1 issued by LLC to its individual members.

IRS Disagrees

The IRS determined that the aggregate net income from these two sale transactions should have been taxed as ordinary income.

The issue presented to the Tax Court was whether LLC’s sales of the two parcels in 2012 should have been treated as giving rise to capital gains or ordinary income.

The Court began by reviewing the Code’s definition of capital asset: “property held by the taxpayer (whether or not connected with his trade or business),” but excluding “inventory” and “property held by the taxpayer primarily for sale to customers in the ordinary course of his trade or business.”

Factors to Consider

The Court stated that the three principal questions to be considered in deciding whether the gain is capital in character are:

a. Was taxpayer engaged in a trade or business, and, if so, what business?
b. Was taxpayer holding the property primarily for sale in that business?
c. Were the sales contemplated by taxpayer “ordinary” in the course of that business?

The Court also indicated that various factors may be relevant to these inquiries, including the:

i. Frequency and substantiality of sales of property (which the Court noted was the most important factor);
ii. Taxpayer’s purpose in acquiring the property and the duration of ownership;
iii. Purpose for which the property was subsequently held;
iv. Extent of developing and improving the property to increase the sales revenue;
v. Use of a business office for the sale of property;
vi. Extent to which the taxpayer used advertising, promotion, or other activities to increase sales; and
vii. Time and effort the taxpayer habitually devoted to the sales.

Original Intent

The parties agreed that LLC was formed to engage in real estate development; specifically, to acquire the Property and develop it into residential building lots and commercial tracts; LLC’s tax returns, City’s development agreement, LLC’s formation documents, and the testimony of its managers, all showed that LLC originally intended to be in the business of selling residential and commercial lots to customers.

Change in Purpose

But the evidence also clearly showed that, in 2008, LLC ceased to hold the Property primarily for sale in that business, and began to hold it only for investment. LLC’s members decided not to develop the parcels any further, and they decided not to sell lots from those parcels. This conclusion was supported by the testimony of its managers, by their 2008 unanimous consent, and by the members’ resolution. Moreover, from 2008 on, LLC in fact did not develop or sell lots from the Property until 2012.

More particularly, when the main parcels were sold, they were not sold in the ordinary course of LLC’s business:

a. LLC did not market the parcels by advertising or other promotional activities;
b. LLC did not solicit purchasers for the parcels, nor did its managers or members devote any time or effort to selling the property;
c. Developer approached LLC; and
d. Most importantly, the sale of the parcels was essentially a bulk sale of a single, large, and contiguous tract of land to a single seller – clearly not a frequent occurrence in LLC’s ordinary business.

Court Disagrees with the IRS

Because the parcels were held for investment and were not sold as part of the ordinary course of LLC’s business, the Court rejected the IRS’s arguments and held that the net gain from the sales was capital in character.

The IRS argued that the extent of development of the parcels showed that they were held primarily for sale in the ordinary course of LLC’s business. The Court conceded that, from 1998 to sometime before 2008, LLC developed the Property to a certain extent. But it was also clear that, in 2008, LLC’s managers decided not to develop or market the Property as they ordinarily would have.

The Court stated that a taxpayer is “entitled to show that its primary purpose changed” from held-for-sale to held-for-investment. The Court concluded that LLC made such a showing. Any development activity that occurred before the marked change in purpose in 2008 (including whatever was reported on LLC’s earlier returns) was largely irrelevant.

The IRS also argued that the frequency of sales, along with the nature and extent of LLC’s business, showed that gains from the sale of the parcels should be ordinary in character. But LLC’s sales were infrequent, the Court observed, and the extent of its business was extremely limited. After 2008, LLC disposed of the entire Property in just nine sales over eight years (most of which were small sales to related entities). Moreover, the main parcels, sold in 2012, had not been developed into a subdivision when they were sold, and little or no development activity occurred on those parcels for at least three years before the sale.

In sum, after 2008, LLC sold most of its undeveloped Property in a single transaction to a single buyer, Developer, and sold the remainder to related parties.

The IRS suggested that the Court should impute to LLC the development activity which was performed by the parties related to LLC on the other property contiguous to the Property. The IRS did not provide the Court with any legal authority or evidence in support of this position. But, the Court continued, even if one assumed that LLC engaged in substantial development activity on, or in active and continuous sales from, these parcels (by imputation or otherwise), nevertheless – in the absence of a connection between those other parcels and the parcels sold in 2012 – the Court was not persuaded that the bulk sale of the parcels to Developer would have been in the ordinary course of LLC’s alleged development business, considering that all development activity had been halted on these parcels at least three years before the sales at issue and that these parcels were never developed into a subdivision by LLC.

The Court noted, “if a taxpayer who engaged in a high volume subdivision business sold one clearly segregated tract in bulk, he might well prevail in his claim to capital gain treatment on the segregated tract.” That is precisely what happened here, the Court stated; the parcels sold were clearly segregated from the other parcels and were sold in bulk to a single buyer.

Still the IRS argued that the sale generated ordinary income because: the parcels were covered by the development agreement with the City; Developer agreed to develop the parcels; and LLC was to receive certain post-sale payments from Developer whenever certain conditions were met.

The Court found that these facts were either irrelevant or were consistent with investment intent. For example, there would have been no reason for LLC to undo or modify the development agreement with City after deciding not to develop the parcels. There seemed to be little doubt that the highest and best use of the Property was for development into residential and commercial lots. Any buyer would likely have been a developer of some kind. Therefore, the Court continued, maintenance of the development agreement was consistent with both development intent and investment intent.

Next, the IRS pointed out that, on its 2012 Form 1065, LLC listed its principal business activity as “Development” and its principal product or service as “Real Estate”. (Ugh!) Although this circumstance may count against taxpayers to some limited degree, the Court believed that these statements “are by no means conclusive of the issue.” Considering the record as a whole, the Court was inclined to believe that these “stock descriptions” were inadvertently carried over from earlier returns.

Finally, the IRS asserted a schedule of LLC’s capitalized expenses showed that LLC “continued to incur development expenses up until it sold” the land to Developer. But the Court accorded these little weight because the record as a whole clearly showed that the parcels were not developed between 2008 and the sale to Developer. Also, most of the post-2008 expenditures on the schedule of capitalized expenditures were consistent with investment intent.

Therefore, the Court concluded that LLC was not engaged in a development business after 2008 and that it held the two parcels as investments in 2012. Accordingly, LLC properly characterized the gains and losses from the sales of these properties as income from capital assets.


There is no doubt that, as in the case of LLC, a taxpayer’s purpose in holding certain property may change over time, thus affecting the nature of the gain recognized by the taxpayer on the sale of the property.

Of course, the taxpayer has the burden of establishing their purpose for holding the property at the time of the sale. A well-advised taxpayer will seek to substantiate such purpose well before the IRS challenges the taxpayer’s treatment of the gain recognized from the sale.

Indeed, if the taxpayer has, in fact, decided to change their relationship to the property, they should document such change contemporaneously with their decision – while the facts are still fresh and the decision-makers are still alive – including the reasoning behind it, whether as a result of a change in economic conditions, a change of business, or otherwise.

Moreover, they should reflect such change in their dealings with the property and throughout their subsequently filed tax returns. Why give the taxing authorities an easy opening on the basis of which to wrest an unnecessary concession?

What Does It Mean?

The Tax Cuts and Jobs Act[1] has now been in effect for fifty days. During this relatively brief period, many tax professionals have pored over the statutory language, as well as the Joint Explanatory Statement issued by Congress, and, in the process, have found provisions that are in need of clarification. “That doesn’t make sense” or “that could not have been intended” are among the phrases that often accompany discussions of these provisions.[2]

2018 Tax Cuts and Jobs Act

These observations are usually followed by calls for legislative “technical corrections,” or for regulatory and other guidance from the IRS. It is as yet uncertain when such legislation or guidance will be forthcoming.[3]

A recent Court of Appeals decision, however, should serve as a reminder that it could be dangerous to ignore the text of a statutory provision that yields a result that one may believe was “clearly” not intended by Congress.

Termination of Contract Rights

Taxpayer purchased commercial real property (“Property”). Although Taxpayer ultimately hoped to sell Property for a profit, it hired a third party to operate Property in the meantime.

About one year later, Taxpayer reached an agreement to sell Property to another company at a significant profit. Over the next two years – during which Taxpayer continued to operate Property – the parties amended the contract several times, eventually finalizing the purchase price, and including a 25% nonrefundable Deposit that was paid immediately to Taxpayer, and that would thereafter be credited toward the purchase price at closing.[4] Unfortunately, the buyer defaulted on the agreement and forfeited the Deposit.

On its tax return for the year of the default, Taxpayer reported the Deposit as long-term capital gain. The IRS, however, determined that Taxpayer should have reported the amount of the forfeited Deposit as ordinary income.

Taxpayer petitioned the U.S. Tax Court, asserting that the Code was meant to prescribe the same tax treatment for gains related to the disposition of “trade-or-business” property regardless of whether the property was successfully sold or the sale agreement was canceled.

The IRS responded that the plain text of the governing Code provision distinguished between consummated and terminated sales of trade-or-business property, providing capital-gain treatment only for the former.

The Tax Court agreed with the IRS, holding that under the Code’s unambiguous language Taxpayer couldn’t treat the forfeited Deposit as capital gain.

Taxpayer appealed to the Eleventh Circuit.

Thus Spoke the Court[5]

Both Taxpayer and the IRS agreed that if the sale of Property had gone through as planned, the Deposit – which, under the contract, would have been applied toward the purchase price – would have been taxed at the lower capital-gains rate. The Code provides that “any recognized gain on the sale or exchange of property used in the trade or business” shall “be treated as long-term capital gain.”[6] The Code goes on to specify that, for purposes of this provision, the “term ‘property used in the trade or business’ means property used in the [taxpayer’s] trade or business, of a character which is subject to the allowance for depreciation …, held for more than 1 year, and real property used in the trade or business, held for more than 1 year …”

The parties stipulated that Property was properly classified as real property used in Taxpayer’s trade or business. Accordingly, it was undisputed that if Taxpayer had sold Property, the resulting income, including the Deposit, would have been taxed as long-term capital gain.

But the deal fell through, and Taxpayer did not sell Property. Accordingly, the tax treatment of the Deposit was governed by a different section of the Code[7] which provides, in relevant part, as follows:

Gain or loss attributable to the cancellation, lapse, expiration, or other termination of … a right or obligation … with respect to property which is (or on acquisition would be) a capital asset in the hands of the taxpayer … shall be treated as gain or loss from the sale of a capital asset.

Thus, any gain or loss that results from the termination of an agreement to buy or sell property that is properly classified as a “capital asset” will, notwithstanding the termination, be treated as a gain or loss from a consummated sale. This rule ensures capital-gain treatment of income resulting from canceled property sales by relaxing the “sale or exchange” element of the Code’s general definition of “long-term capital gain” – i.e., “gain from the sale or exchange of a capital asset held for more than 1 year ….”[8]

According to the Court, this rule applies only to property that is classified as a “capital asset.” The Court’s analysis, therefore, turned on whether Property was a capital asset in Taxpayer’s hands during the relevant tax year.

“As a matter of plain textual analysis,” the Court began, “the answer to the question whether [Property] was a ‘capital asset’ couldn’t be clearer.” The Code defines the term “capital asset” in a way that “expressly excluded” Property from status as a capital asset; specifically, the Code states that “the term ‘capital asset’ means property held by the taxpayer (whether or not connected with his trade or business), but does not include, [among other things,] real property used in his trade or business.”[9]

This definition of “capital asset, the Court noted, reflects almost precisely the definition of the term “property used in the trade or business,” examined above.[10] “There is, however, a decisive difference,” the Court continued, “which cuts to the very heart of this case: Whereas Section 1231’s definition, which applies to consummated sales of trade or business property, expressly prescribes capital-gains treatment of the resulting income, Section 1221’s definition, which applies to terminated sales of such property, expressly proscribes capital-gains treatment.”

Because Taxpayer’s sale transaction fell through, the controlling question, the Court stated, was whether Property was real property used in Taxpayer’s trade or business.

Taxpayer and the IRS stipulated that, from the date that Taxpayer acquired Property through the year at issue, Property was used by Taxpayer in a trade or business. Accordingly, Taxpayer “conceded that [Property] . . . was not a capital asset.”

“That concession,” the Court observed, “was fatal,” because it leads to the conclusion that the rule which treats the income realized on the termination of a sale contract as capital gain did not apply to the Deposit.

Taxpayer to Court: “That’s Not Fair”

In response, Taxpayer asserted that the Court’s plain-text reading of the Code impermissibly yielded a result that was “absurd.”

First, Taxpayer noted that while all “agree that, had the sale of [Property] been completed, the [Deposit] would have been … applied toward the purchase price and, thus, treated as capital gain,”[11] it made no sense that the same Deposit “must be treated as ordinary income because the parties terminated the [c]ontract rather than completing it,”[12] especially given that it was not Taxpayer’s fault that the sale did not occur.

Second, Taxpayer complained that the exclusion of trade-or-business property from capital-gain treatment on the cancellation of a contract for the sale of such property “effectively penalize[d]” taxpayers “for operating a trade or business as opposed to being a passive investor in real property,” in which case (as with a consummated transaction) any resulting income would receive capital-gain treatment.

For both reasons, Taxpayer insisted that the only rational way to read the Code was “to give the termination of a contract the same tax treatment afforded a sale or exchange of the property underlying the contract in order to eliminate differing tax treatment of economically equivalent transactions.”

The Court disagreed. The supposed anomalies that Taxpayer posited – between completed and canceled transactions, and between active managers and passive investors – may seem a little odd, the Court stated, but they did not yield such an “absurd” result that the straightforward application of the statutory text should not be respected, particularly given that, when the sale fell through, Taxpayer got to keep not only the Deposit (albeit at an ordinary-income tax rate) but also Property.

Taxpayer also insisted that a plain-text reading of the Code’s interlocking provisions actually “ignore[d] the clear purpose behind the enactment” of the provision[13] that treated the cancellation of a sale contract as the economic equivalent of a sale, which Taxpayer said “was to ensure that taxpayers receive the same tax characterization of gain or loss whether the underlying property is sold or the contract to which the property is subject is terminated.”

The problem with Taxpayer’s argument, the Court pointed out, is that the Code’s plain language forecloses it. If an asset – like Property – is “real property used in a trade or business,” then by definition it is not a “capital asset” within the meaning of the “cancellation-of-contract” provision.  The definitions of “property used the trade or business” and “capital asset” are mutually exclusive; while one provision expressly prescribes capital-gains treatment of such income, the other expressly forbids capital gains treatment of the same property.

The Court stated that in a contest between clear statutory text and evidence of sub- or extra-textual “intent,” the former must prevail. As a formal matter, it is of course only the statutory text, the Court continued, that is “law” in the constitutional sense; and as a practical matter, “conscientious adherence to the statutory text best ensures that citizens have fair notice of the rules that govern their conduct, incentivizes Congress to write clear laws, and keeps courts within their proper lane.”[14]

Accordingly, Taxpayer was not entitled to treat the Deposit as capital gain.

Harsh Result?

I don’t think so, especially given that Taxpayer got to keep the Deposit and Property. Moreover, the Court’s reading was wholly consistent with the plain language of the Code.

The lesson, of course, as we await clarification, correction, and guidance from Congress and the IRS regarding many provisions of the Tax Cuts and Jobs Act, is to proceed with caution, to avoid assumptions that are more hopeful than grounded on objective fact, to voice our opinions and concerns as tax professionals, and to keep abreast of developments in Washington.

[1] Pub. L. 115-97.

[2] See, for example, the apparent denial of a plaintiff’s deduction for legal fees incurred in pursuing a sexual harassment claim, the settlement of which includes a non-disclosure provision. “What we do in haste, . . .”

[3] The IRS announced recently that proposed regulations would be issued by the end of 2018, and final regulations by mid-2019. The Ways and Means Committee are supposedly gathering, and filtering through, the feedback given by tax professionals, but there has been no indication of when any substantive and/or technical changes will be proposed, let alone made.

[4] Under an “open transaction” theory, the recognition and treatment of such a deposit await the consummation or failure of the sale.

[5] No, I’m not getting metaphysical on you.

[6] IRC Sec. 1231.

[7] IRC Sec. 1234A.

[8] Sale of a Contract: Capital Gain or Ordinary Income?

[9] IRC Sec. 1221(a)(2).

[10] See FN 6, FN 9, and accompanying texts.

[11] Under IRC Sec. 1231. See FN 6.

[12] Under a plain-text reading of IRC Sections 1221 and 1234A.

[13] IRC Sec. 1234A.

[14] The Court observed, that even if Congress really did mean for Section 1234A to reach beyond “capital assets” as defined in Section 1221 to include Section-1231 property, “it’s not our place or prerogative to bandage the resulting wound. If Congress thinks that we’ve misapprehended its true intent – or, more accurately, that the language that it enacted in I.R.C. §§ 1221 and 1234A inaccurately reflects its true intent – then it can and should say so by amending the Code.”

Passing Through Losses

There is a problem that will sometimes plague the shareholders of an S corp that is going through challenging financial times. Whether because of a downturn in the general economy or in its industry, whether because of stiff competition or poor planning, the S corp is suffering operating losses. As if this wasn’t disturbing enough, the corporation may have borrowed funds from a bank or other lender, including its shareholders, in order to fund and continue its operations.

Because the S corp is a “pass-through entity” for tax purposes – meaning, that the S corp is not itself a taxable entity but, rather, its “tax attributes,” including its operating losses – flow through to its shareholders and may be used by them in determining their individual income tax liability.

Although this is generally the case, there are a number of limitations upon the ability of a shareholder of an S corp to utilize the corporation’s losses. Under the first of these limitations, the corporate losses which may be taken into account by a shareholder of the S corporation – i.e., his pro rata share of such losses – are limited to the sum of the shareholder’s adjusted basis in his stock plus his basis in any debt of the corporation that is owed to the shareholder.[1] Any losses in excess of this amount are suspended and are generally carried forward until such time as the shareholder has sufficient basis in his stock and/or debt to absorb such excess.[2]

Over the years, shareholders who are aware of this limitation have tried, in various ways – some more successful than others – to generate basis in an amount sufficient to allow the flow-through of a shareholder’s pro rata share of the S corp’s losses.[3]

As for those shareholders who became aware of the limitation only after the fact, well, they have often put forth some creative theories to support their entitlement to a deduction based upon their share of the S corp’s losses. Today’s blog will consider such a situation, as well as the importance – the necessity – of maintaining accurate records and of memorializing transactions.

Creative Accounting?

Taxpayer was a real estate developer who held interests in numerous S corps, partnerships, and LLCs. One of these entities was Corp-1, which had elected “S” status, and in which Taxpayer held a 49% interest.

In 2004, Corp-1 sought to purchase real property out of a third party’s bankruptcy. The court approved the sale to Corp-1, but required that Corp-1 make a significant non-refundable deposit. To raise funds for his share of the deposit, Taxpayer obtained a personal loan from Bank of approximately $5 million, which were transferred into Corp-1’s escrow account to cover half of the required deposit.

During the tax years at issue, Corp-1 had entered into hundreds of transactions with various partnerships, S corps, and LLCs in which Taxpayer held an interest (collectively, the “Affiliates”). The Affiliates regularly paid expenses (such as payroll costs) on each other’s or on Corp-1’s behalf to simplify accounting and enhance liquidity. The payor-company recorded these payments on behalf of its Affiliates as accounts receivable, and the payee-company recorded such items as accounts payable.[4]

For a given taxable year, CPA – who prepared the tax returns filed by Taxpayer, Corp-1 and the Affiliates –would net Corp-1’s accounts payable to its Affiliates, as shown on Corp-1’s books as of the preceding December 31, against Corp-1’s accounts receivable from its Affiliates. If Corp-1had net accounts payable as of that date[5], CPA reported that amount as a “shareholder loan” on Corp-1’s tax return and allocated a percentage of this supposed Corp-1 indebtedness to Taxpayer, on the basis of Taxpayer’s ownership interests in the various Affiliates that had extended credit to Corp-1.

In an effort to show indebtedness from Corp-1 to Taxpayer, CPA drafted a promissory note whereby Taxpayer made available to Corp-1 an unsecured line of credit at a fixed interest rate. According to CPA, he would make an annual charge to Corp-1’s line of credit for an amount equal to Taxpayer’s calculated share of Corp-1’s net accounts payable to its Affiliates for the preceding year.

But there was no documentary evidence that such adjustments to principal were actually made, or that Corp-1 accrued interest annually on its books with respect to this alleged indebtedness. Moreover, there was no evidence that Corp-1 made any payments of principal or interest on its line of credit to Taxpayer. And there was no evidence that Taxpayer made any payments on the loans that Corp-1’s Affiliates extended to Corp-1 when they transferred money to it or paid its expenses.

The IRS Disagrees with the Loss Claimed

In 2008, Corp-1 incurred a loss of $26.6 million when banks foreclosed on the property it had purchased in 2004. Corp-1 reported this loss on Form 1120S, U.S. Income Tax Return for an S Corporation. It allocated 49% of the loss to Taxpayer on Schedule K-1.

Taxpayer filed his federal individual income tax returns for 2005 and 2008. On his 2005 return, he reported significant taxable income and tax owing. On his 2008 return, he claimed an ordinary loss deduction of almost $11.8 million.[6] This deduction reflected a $13 million flow-through loss from Corp-1 ($26.6 million × 49%), netted against gains of $1.2 million from two other S corporations in which Taxpayer held interests.

After accounting for other income and deductions, Taxpayer reported on his 2008 return an NOL of almost $11.8 million. He claimed an NOL carryback of this amount from 2008 to 2005.[7] After application of this NOL carryback, his original tax liability for 2005 was reduced and the IRS issued Taxpayer a refund.

After examining Taxpayer’s 2005 and 2008 returns, however, the IRS determined that his basis in Corp-1 was only $5 million; i.e., the proceeds of the Bank loan that Taxpayer contributed to Corp-1. Accordingly, the IRS disallowed, for lack of a sufficient basis, $8 million of the $13 million flow-through loss from Corp-1 that Taxpayer claimed for 2008.

After disallowing part of the NOL for 2008, the IRS determined that Taxpayer’s NOL carryback to 2005 was a lesser amount, and the refund granted was thereby excessive; consequently the Taxpayer owed tax for that year. The IRS sent Taxpayer a timely notice of deficiency setting forth these adjustments, and he petitioned the Tax Court for redetermination.

The IRS agreed that Taxpayer was entitled to basis of $5 million in Corp-1, corresponding to funds that Taxpayer personally borrowed from Bank and contributed to Corp-1.

Taxpayer contended that he had substantial additional basis in Corp-1 by virtue of the inter-company transfers between Corp-1 and its Affiliates.

The Code

The Code generally provides that the shareholders of an S corp are taxed currently on its items of income, losses, deductions, and credits, regardless of actual distributions.

However, it also provides that the amount of losses and deductions taken into account by the shareholder may not exceed the sum of: (1) the adjusted basis of the shareholder’s stock in the S corp, and (2) the adjusted basis of any indebtedness of the S corp to the shareholder.

Any disallowed loss or deduction is treated as incurred by the corporation in the succeeding taxable year with respect to the shareholder whose losses and deductions are limited. Once the shareholder increases his basis in the S corp[8], any losses or deductions previously suspended become available to the extent of the basis increase.

The Code does not specify how a shareholder may acquire basis in an S corp’s indebtedness to him, though the courts have generally required an “actual economic outlay” by the shareholder 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 he “incurs a ‘cost’ on a loan or is left poorer in a material sense after the transaction.” 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 corp that runs directly to the shareholder.

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

In short, the controlling test dictates that basis in an S corp’s debt requires proof of “bona fide indebtedness of the S corporation that runs directly to the shareholder.”

The Tax Court

Taxpayer argued that Corp-1’s Affiliates lent money to him and that he subsequently lent these funds to Corp-1.[9]

Taxpayer contended that transactions among the Corp-1 Affiliates should be recast as loans to the shareholders (including himself) from the creditor companies, followed by loans from the shareholders (including himself) to Corp-1. The IRS’s regulations, Taxpayer argued, recognize that back-to-back loans, if they represent bona fide indebtedness from the S corp to the shareholder – i.e., they run directly to the shareholder – can give rise to increased basis.

The Court responded that the corollary of this rule is that indebtedness of an S corp running “to an entity with passthrough characteristics which advanced the funds and is closely related to the taxpayer does not satisfy the statutory requirements.” “[T]ransfers between related parties are examined with special scrutiny,” the Court noted, and taxpayers “bear a heavy burden of demonstrating that the substance of the transactions differs from their form.”

For example, the Court continued, courts have rejected the taxpayer contention that loans from one controlled S corp (S1) to another controlled S corp (S2) were, in substance, a series of dividends to the shareholder from S1, followed by loans from the shareholder to S2, holding that the taxpayer may not “easily disavow the form of [his] transaction”. Similarly, courts have upheld the transactional form originally selected by the taxpayer and have given no weight to an end-of-year reclassification of inter-company loans as shareholder loans.

The Court rejected Taxpayer’s “back-to-back loan” argument. No loan transactions were contemporaneously documented. The funds paid by a Corp-1 Affiliate as common paymaster were booked as the payment of Corp-1’s wage expenses. And the other net inter-company transfers reflected hundreds of accounts payable and accounts receivable, which went up and down depending on the various entities’ cash needs.

These inter-company accounts were recharacterized as loans to shareholders only after the end of each year, when CPA prepared the tax returns and adjusted Corp-1’s book entries to match the “shareholder loans” shown on those returns. None of these transactions was contemporaneously booked as a loan from shareholders, and Taxpayer failed to carry the “heavy burden of demonstrating that the substance of the transaction[s] [differed] from their form.”

Even if the transactions were treated as loans, the Court pointed out, Corp-1’s indebtedness ran to its Affiliates, not directly to Taxpayer. The monies moved from one controlled company to another, without affecting Taxpayer’s economic position in any way. The was true for the Corp-1 wage expenses that an Affiliate, in its capacity as common paymaster, paid on Corp-1’s behalf; and the same was true for the net inter-company payments, which Corp-1 uniformly booked as accounts payable to its Affiliates. The Affiliates advanced these funds to Corp-1, not to Taxpayer; and to the extent Corp-1 repaid its Affiliates’ advances, it made the payments to its Affiliates, not to Taxpayer.

The Court determined that there was simply no evidence that Corp-1 and its Affiliates, when booking these transactions, intended to create loans to or from Taxpayer. CPA’s adjustments to a notional line of credit, uniformly made after the close of each relevant tax year, did not suffice to create indebtedness to Taxpayer where none in fact existed.

A taxpayer, the Court observed, may not “easily disavow the form of [the] transaction” he has chosen. The transactions at issue took the form of transfers among various Corp-1 Affiliates, and the Court found that Taxpayer did not carry his burden of proving that the substance of the transactions differed from their form. Unlike the $5 million that Taxpayer initially borrowed from Bank and contributed to Corp-1, he made no “actual economic outlay” toward any of the advances that Corp-1’s Affiliates extended to it.

Accordingly, the Court found that none of the inter-company transactions mentioned above gave rise to bona fide indebtedness from Corp-1 to Taxpayer.

Thus, the Court concluded that the IRS properly reduced Taxpayer’s allowable NOL carryback to 2005, and the Taxpayer had to return a portion of the refund received for that year.


How many of you have examined an entry on a corporate or partnership tax return, and have wondered what it could possibly be? The entry usually appears in the line for “other expenses,” “other assets,” or “other liabilities.”[10]

With luck, there is a notation beside the entry that directs the reader to “See Statement XYZ.”[11] You flip to the back of the return, to Statement XYZ, only to see that the entry is described as an amount owed to an unidentified “affiliate,” or as an amount owed by an unidentified “affiliate.”

Then there are the times when, as in the case described above, there are several identified affiliated companies, and they have a number of “amounts owed” and “amounts owing” among them, including situations in which one affiliate is both a lender and a borrower with respect to another affiliated entity.[12] As you try to make any sense of all the cash flows, you wish you had a chart.[13]

And, in fact, I have heard “advisers” explain that the entries are intentionally vague so as to be “flexible,” and to make it more difficult for an agent to discern what actually happened.

At that point, I tell the taxpayer, “Find yourself another tax return preparer.”

As we have said countless times on this blog, always assume that the taxing authorities will examine the return. Always treat with related parties as if they were unrelated parties. A transaction should have economic substance, and it should be memorialized accordingly. If the taxpayer or his adviser would rather not have the necessary documents prepared, they should probably not engage in the transaction.

[1] Assuming the shareholder has sufficient basis to utilize his full share of the corporation’s losses, his ability to deduct those losses on his income tax return may still be limited by the passive activity loss rules of IRC Sec. 469 and by the at-risk rules of IRC Sec. 465. For taxable years beginning on or after January 1, 2018 and ending on or before December 31, 2025, there is an additional limitation, on “excess business losses,” which is applied after the at-risk and passive loss rules.

[2] The losses that pass through to the shareholder reduce his stock basis and then his debt basis; thus, a subsequent distribution in respect of the stock, or a sale of the stock, will generate additional gain; similarly, the repayment of the debt would also result in gain recognition for the shareholder-lender. IRC Sec. 1368, 1001, 1271.

[3] For example, by making new capital contributions or loans, or by accelerating the recognition of income.

[4] During the years at issue, Corp-1’s Affiliates made payments in excess of $15 million to or on behalf of Corp-1. Corp-1 repaid its Affiliates less than $6 million of these advances.

[5] On December 31 of each year, Corp-1’s books and records showed substantial net accounts payable to its Affiliates.

[6] On Form 4797, Sales of Business Property. IRC Sec. 1231(a)(2): net Sec. 1231 gains are capital; net Sec. 1231 losses are ordinary.

[7] Prior to the Tax Cuts and Jobs Act of 2017, Pub. L. 115-97, a taxpayer could ordinarily carry an NOL back only to the two taxable years preceding the loss year. However, prompted by the financial crisis and at the direction of Congress, the IRS, for taxable years 2008 and 2009, allowed “eligible small businesses” to elect a carryback period of three, four, or five years. Taxpayer made this election for 2008. After the 2017 legislation, the carryback was eliminated, and an NOL may be carried forward indefinitely, though the carryover deduction for a taxable year is limited to 80% of the taxpayer’s taxable income for the year. Query the impact of the Act’s elimination of a struggling company’s ability to carry back its losses to recover tax dollars and badly needed cash.

[8] Debt basis is restored before stock basis.

[9] Taxpayer also advanced a second theory to support his claim to basis beyond the amount the IRS allowed. Under this argument (which the Court rejected), he lent money to the Corp-1 Affiliates and they used these funds to pay Corp-1’s expenses. Taxpayer referred to this as the “incorporated pocketbook” theory.

[10] Never in the line for “other income.” Hmm.

[11] Indeed, the form itself directs the taxpayer to attach a statement explaining what is meant by “other.”

[12] Polonius would have a fit.

[13] Of course, more often than not, the return does not reflect any actual or imputed interest expense or interest income.

“Life” Goes On

Over the last month or so, most of the nation’s tax practitioners have been devoting an extraordinary amount of time to analyzing the recently enacted changes to the Code, to understanding the resulting consequences, and to determining how they may advise their clients.

Based upon the volume of material that these tax professionals have produced in this endeavor – myself included[1] – one might think that these folks have nothing else to do, or that the very clients that they are seeking to assist may, in fact, be suffering from neglect.

Rest assured that this is not the case. Speaking for myself, life has gone on with the usual flow of projects, including a smattering of corporate transactions and reorganizations, partnership formations and break-ups, deferred compensation and succession planning, not-for-profit compliance and UBIT, plus a healthy dose of New York residency audits.

The Residency Exams

As to the residency exams, the focus has not been on whether the clients were “domiciled” in NY during the years at issue – they clearly were not – or on whether the clients spent over 183 days in NY – they clearly did because the businesses that they owned and operated were located in NYC during those years.

Rather, the state’s emphasis has been on demonstrating that each of the clients maintained a permanent place of abode (“PPA”) in NYC, near his place of business and, consequently – according to the state – was an NY statutory resident.

Our own position has been that neither client maintained a PPA in NY because he did not have a residential interest in the property at issue. We argued that, aside from the proximity of the property to the place of business – from which the state deduced that “he must have used” the property as a residence – there was no basis to conclude that either client maintained his property as a personal dwelling. Simply stated, the property did not “relate to him” in the manner required by the NY Court of Appeals.[2]

It appears, however, that the Court’s holding is either being conveniently ignored by the Department of Taxation, or it is being interpreted in such a way as to render it meaningless.[3]

In any case, because of these circumstances, we have been following any NY decisions that address the PPA requirement for a statutory residence. One such decision is described below.[4]

Welcome to NY

Taxpayer entered into an employment contract with Corp, after which she participated in Corp’s relocation program, which provided her with several options for apartments in NYC.

In late January 2011, Taxpayer chose a fully furnished apartment with a bedroom, bathroom, living area, and kitchen. She testified that there was no lease, but that the original arrangement for the apartment was for 90 days, or approximately until the end of April 2011. The taxpayer had exclusive use of this apartment for the duration of her stay there.

In early April 2011, Taxpayer’s fiancé entered into a lease on a different NYC apartment, following which Taxpayer contacted Corp’s relocation manager to inquire whether she might be able to give the requisite 30-day notice to leave her apartment early. The relocation manager was able to extend Taxpayer’s living arrangement at the apartment until the end of May so as to accommodate her. The taxpayer then moved into her fiancé’s apartment in early June 2011.

The state audited Taxpayer’s income tax return and determined that she was liable as a statutory resident of NY and of NYC for 2011.[5] Specifically, the state found that Taxpayer maintained a PPA in NYC during 2011, and was present within NYC in excess of 183 days.

The Taxpayer did not dispute that she was within NYC in excess of 183 days during the year 2011; after all, she worked there for Corp. However, she did challenge the state’s finding that she maintained a PPA in NYC.

Statutory Residence

For purposes of NY’s and NYC’s personal income tax, a “resident individual” is defined as one:


(B) who is not domiciled in this state [city] but maintains a permanent place of abode in this state [city] and spends in the aggregate more than one hundred eighty-three days of the taxable year in this state [city], *****.

As there was no dispute that Taxpayer was physically present within the city for more than 183 days during 2011, the sole issue in the case involved whether Taxpayer maintained a PPA in NYC during 2011.

“Permanent place of abode” is defined by regulation as:

a dwelling place of a permanent nature maintained by the taxpayer, whether or not owned by such taxpayer, and will generally include a dwelling place owned or leased by such taxpayer’s spouse. However, a mere camp or cottage, which is suitable and used only for vacations, is not a permanent place of abode. Furthermore, a barracks or any construction which does not contain facilities ordinarily found in a dwelling, such as facilities for cooking, bathing, etc., will generally not be deemed a permanent place of abode.

The Court’s Analysis

According to the Court, the determination of a taxpayer’s status as a resident or nonresident for purposes of the personal income tax has long been based on the principle that the result “frequently depends on a variety of circumstances.”

Given the various meanings of the word “maintain,” the Court continued, and given “the lack of any definitional specificity on the part of the Legislature, we presume that the Legislature intended, with this principle in mind, to use the word in a practical way that did not limit its meaning to a particular usage so that the provision might apply to the ‘variety of circumstances’ inherent” to this subject matter.

“In our view,” the Court stated, “one maintains a place of abode by doing whatever is necessary to continue one’s living arrangements in a particular dwelling place.” This would include making contributions to the household, in money or otherwise.

With regard to whether a place of abode is “permanent” within the meaning of the statute, the Court did not agree with Taxpayer that the statute required that the place of abode be owned, leased, or otherwise based upon some legal right in order for it to be permanent.

Rather, the Court stated, “the permanence of a dwelling place for purposes of the personal income tax can depend on a variety of factors and cannot be limited to circumstances which establish a property right in the dwelling place.” Thus, the absence of a lease was not determinative.

The Court noted that “permanence,” in this context, “must encompass the physical aspects of the dwelling place as well as the individual’s relationship to the place.”

For example, it seemed clear to the Court that an apartment leased by one individual, and shared with other unrelated individuals, may be the permanent place of abode of those who are not named on the lease, given other appropriate facts (for example, contributing to living expenses and having unfettered access).

The Court observed that Taxpayer’s apartment was permanent in nature: the apartment contained a bedroom, bathroom, living area and kitchen; and Taxpayer had exclusive access to this apartment from January 2011 through May 2011.

Taxpayer argued that, during the period January 29 through the end of May, she stayed at the apartment for only 79 days. However, this argument did not establish that anyone else stayed at the apartment when she was out of town or that, because she did not spend every day during this time period at the apartment, her use was not exclusive.

Taxpayer also argued that her living in the apartment was temporary in nature, since the duration of the rental was for a fixed period of time. She pointed to language in the correspondence between her and Corp wherein it was stated that her living arrangement at the apartment was temporary.

The Court explained that a permanent place of abode meant a dwelling place of a permanent nature. It concluded that the apartment was permanent: it had a bedroom, bathroom, living area and kitchen. Taxpayer’s belief that her living arrangement was temporary based upon the agreement with Corp was misplaced, the Court added.

The Court clarified that a place of abode “is not deemed permanent if it is maintained only during a temporary stay for the accomplishment of a particular purpose.” The regulation’s use of the word “temporary,” it stated, did not apply to the intention of living in a certain, physical living space as temporary, but rather, a taxpayer who travels to NY for a temporary stay for the accomplishment of a particular purpose.

Clearly, Taxpayer accepted employment with Corp in NYC, and such employment did not have a certain, fixed duration. Therefore, her travel to NYC was not “temporary” within the meaning of the regulation, despite her intention to remain at the apartment for a limited time.

Taxpayer also asserted that she did not maintain the apartment. The Court replied that this argument was also without merit. Taxpayer had exclusive use of the apartment for the entire length of her stay. There was no suggestion that she was prohibited from using it at any time during her stay. Indeed, she kept her clothes and personal belongings there.

Since it was determined that Taxpayer maintained a PPA at the apartment and, subsequently, at her fiancé’s apartment, the Court next determined whether Taxpayer maintained a PPA for substantially all of 2011.

According to the applicable regulation, a resident is:

any individual . . . who maintains a permanent place of abode for substantially all of the taxable year (generally, the entire taxable year disregarding small portions of such year) in New York State and spends in the aggregate more than 183 days of the taxable year in New York State.

The Court observed that, although the statute does not “numerically” define what constitutes “substantially all” of the taxable year, the state’s Audit Guidelines indicate a length of time in excess of 11 months.

In this case, Taxpayer maintained a PPA within NYC continuously from late January through December; more than 11 months. The Court concluded that this constituted substantially all of the taxable year.

Taxpayer accepted employment for Corp in New York City; such employment was not limited in duration. Taxpayer lived at the first apartment until she found suitable living arrangements with her fiancé; then she lived in his apartment. Thus, the Court determined that Taxpayer was a statutory resident for the tax year 2011.


The Court’s conclusion was consistent with the principles underlying the statutory residence test, and Taxpayer was rightfully assessed as a statutory resident.

The test was enacted to discourage tax evasion by New York residents, and “serves the important function of taxing those who, while really and [for] all intents and purposes [are] residents of the state, have maintained voting residence elsewhere and insist on paying taxes to [NY] as nonresidents.”[6]

With respect to determining the “permanence” of a dwelling place, the Court rightly stated that it can depend on a variety of factors, and cannot be limited to circumstances that establish a property right in the dwelling place. Other courts have held that permanence in this context “must encompass the physical aspects of a dwelling place as well as the individual’s relationship to the place.[7]

That “relationship to the place” element should be key; the taxpayer himself should have a residential interest in the place in order for it to constitute his PPA. It is not enough to base a residency determination on the fact that a taxpayer had a property interest in a dwelling, nor should it suffice that the property was located relatively near to his place of business. There must be some basis to conclude that the dwelling was used as the taxpayer’s residence; the inquiry must focus on whether the dwelling is actually “utilized as the taxpayer’s residence.”[8]

Unfortunately, it appears that the state and its examiners will continue to either interpret this requirement out of the law or to distinguish Gaied. Stay tuned.

U.S. Taxation of Foreign Income After Tax Reform 
Will Tax “Reform” Affect Domestic M&A?
The Real Property Business and the Tax Cuts & Jobs Act
The Federal Estate Tax Lives On, But “Where, O death, is your sting?” (*)
Some of the TC & JA’s Corporate Tax Changes
The New Deduction for “Qualified Business Income”: Tax Simplification Gone Awry?*

[2] Gaied v. New York State Tax Appeals Tribunal, N.Y., No. 26, 2/18/14, 2014 NY Slip Op 1101, 2014 WL 590486, rev’g 101 App Div 3d 1492, 957 NYS2d 480, 2012 NY Slip Op 9108, 2012 WL 6699044 (3d Dept., 2012). The Court of Appeals considered whether a taxpayer can have a PPA in New York unless “[he], himself, ha[s] a residential interest in the property.” The Court concluded that he could not.

[3] For example, by allowing the most attenuated of connections to establish a personal residential interest.

[4] Some are more interesting than others.

[5] It was conceded that Taxpayer was not domiciled in New York for 2011.

[6] 91 N.Y.2d 530, 535 (1998), cert. denied, 525 U.S. 931 (1998).

[7] Matter of Evans v. Tax Appeals Tribunal, DTA No. 806515 (N.Y. Tax App. Trib. 1992), confirmed, 199 A.D.2d 840 (N.Y. App. Div. 3d Dept. 1993).

[8] See Gaied, FN 1, supra.

We’ve all heard about the profits that publicly-held U.S. corporations have generated overseas, and how those profits have, until now, escaped U.S. income taxation by virtue of not having been repatriated to the U.S.

It should be noted, however, that many closely-held U.S. corporations are also actively engaged in business overseas, and they, too, have often benefited from such tax deferral.

What follows is a brief description of some of the rules governing the U.S. income taxation of the foreign business (“outbound”) activities of closely-held U.S. businesses, and the some of the important changes thereto under the Tax Cuts and Jobs Act.[1]

Taxation of Foreign Income

U.S. persons[2] are subject to tax on their worldwide income, whether derived in the U.S. or abroad.

In general, income earned directly (or that is treated as earned directly[3]) by a U.S. person from its conduct of a foreign business is subject to U.S. tax on a current basis; for example, the income generated by the U.S. person’s branch in a foreign jurisdiction.

However, income that is earned indirectly, through the operation of a foreign business by a foreign corporation (“FC”), is generally not subject to U.S. tax on a current basis; instead, the foreign business income earned by the FC generally is not subject to U.S. tax until the income is distributed as a dividend to a U.S. owner.[4]

CFC Anti-Deferral Regime

That being said, the controlled foreign corporation (“CFC”) anti-deferral regime may cause a U.S. owner of a CFC to be taxed currently in the U.S. on its pro rata shares of certain categories of income earned by the CFC (“Subpart F income”) regardless of whether the income has been distributed as a dividend to the U.S. owner.

A CFC generally is defined as any FC if U.S. persons own (directly, indirectly, or constructively) more than 50% of the corporation’s stock (measured by vote or value), taking into account only those U.S. persons that are “U.S. Shareholders” – i.e., U.S. persons who own at least 10% of the CFC’s stock (which, prior to the Act, was measured by vote only).

In effect, the U.S. Shareholders of a CFC are treated as having received a current distribution of the CFC’s Subpart F income[5], which includes foreign base company income, among other items of income.

“Foreign base company income” includes certain categories of income from business operations, including “foreign base company sales income,” and “foreign base company services income,” as well as certain passive income.

The U.S. Shareholders of a CFC also are required to include currently in income, their pro rata shares of the CFC’s untaxed earnings that are invested in certain items of U.S. property, including, for example, tangible property located in the U.S., stock of a U.S. corporation, and an obligation of a U.S. person.[6]

Several exceptions to the definition of Subpart F income, including the “same country” exception, may permit continued deferral for income from certain business transactions.[7] Another exception is available for any item of business income received by a CFC if it can be established that the income was subject to an effective foreign income tax rate greater than 90% of the maximum U.S. corporate income tax rate.[8]

A U.S. Shareholder of a CFC may also exclude from its income any actual distributions of earnings from the CFC that were previously included in the shareholder’s income.

The Act

For the most part, the Act did not change the basic principles of the CFC regime; these anti-deferral rules will continue to apply[9], subject to certain amendments.

However, the Act also introduced some significant changes to the taxation of certain U.S. persons who own shares of stock in FCs.


The Act amended the ownership attribution rules so that certain stock of a FC owned by a foreign person may be attributed to a related U.S. person for purposes of determining whether the U.S. person is a U.S. Shareholder of the FC and, therefore, whether the FC is a CFC.[10] For example, a U.S. corporation may be attributed shares of stock owned by its foreign shareholder.

The Act also expanded the definition of U.S. Shareholder to include any U.S. person who owns 10% or more of the total value – as opposed to 10% of the vote – of all classes of stock of a FC. It also eliminated the requirement that a FC must be controlled for an uninterrupted period of 30 days before the inclusion rules apply.

Dividends Received Deduction (“DRD”)

The Act introduced some new concepts that are aimed at encouraging the repatriation of foreign earnings by U.S. taxpayers; stated differently, it removes an incentive for the overseas accumulation of such earnings.[11]

The keystone provision is the DRD, which allows an exemption from U.S. taxation for certain foreign income by means of a 100% deduction for the foreign-source portion of dividends received from specified 10%-owned FCs by regular domestic C corporations[12] that are U.S. Shareholders of those FCs.

In general, a “specified 10%-owned FC” is any FC with respect to which any domestic corporation is a U.S. Shareholder.[13]

The term “dividend received” is intended to be interpreted broadly. For example, if a domestic corporation indirectly owns stock of a FC through a partnership, and the domestic corporation would qualify for the participation DRD with respect to dividends from the FC if the domestic corporation owned such stock directly, the domestic corporation would be allowed a participation DRD with respect to its distributive share of the partnership’s dividend from the FC. In addition, any gain from the sale of CFC stock that would be treated as a dividend would also constitute a dividend received for which the DRD may be available. That being said, it appears that a deemed dividend of subpart F income from a CFC will not qualify for the DRD.

In general, the DRD is available only for the foreign-source portion of dividends received by a domestic corporation from a specified 10%-owned FC; i.e., the amount that bears the same ratio to the dividend as the undistributed foreign earnings bear to the total undistributed earnings of the FC.[14]

The DRD is not available for any dividend received by a U.S. Shareholder from a FC if the FC received a deduction or other tax benefit from taxes imposed by a foreign country. Conversely, no foreign tax credit or deduction is allowed for any taxes paid or accrued with respect to any portion of a distribution treated as a dividend that qualifies for the DRD, including any foreign taxes withheld at the source.[15]

It should be noted that a domestic C corporation is not permitted a DRD in respect of any dividend on any share of FC stock unless it satisfies a holding period requirement. Specifically, the share must have been held by the U.S. corporation for at least 366 days during the 731-day period beginning on the date that is 365 days before the date on which the share becomes ex-dividend with respect to the dividend. The holding period requirement is treated as met only if the specified 10%-owned FC is a specified 10%-owned FC at all times during the period and the taxpayer is a U.S. Shareholder with respect to such specified 10%-owned foreign corporation at all times during the period.

Transitional Inclusion Rule[16]

In order to prevent the DRD from turning into a “permanent exclusion rule” for certain U.S. corporations with FC subsidiaries, the accumulated earnings of which have not yet been subject to U.S. income tax – and probably also to generate revenue – the Act requires that any U.S. Shareholder (including, for example, a C corporation, as well as an S corporation, a partnership, and a U.S. individual) of a “specified FC” include in income its pro rata share of the post-1986 deferred foreign earnings of the FC.[17] The inclusion occurs in the last taxable year beginning before January 1, 2018.[18]

This one-time mandatory inclusion applies to all CFCs, and to almost all other FCs in which a U.S. person owns at least a 10% voting interest. However, in the case of a FC that is not a CFC, there must be at least one U.S. Shareholder that is a U.S. corporation in order for the FC to be a specified FC.

The deferred foreign earnings of such a FC are based on the greater of its aggregate post-1986 accumulated foreign earnings as of November 2, 2017[19] or December 31, 2017, not reduced by distributions during the taxable year ending with or including the measurement date.[20]

A portion of a U.S. taxpayer’s includible pro rata share of the FC’s foreign earnings is deductible by the U.S. taxpayer, thereby resulting in a reduced rate of tax with respect to the income from the required inclusion of accumulated foreign earnings. Specifically, the amount of the deduction is such as will result in a 15.5% rate of tax on the post-1986 accumulated foreign earnings that are held in the form of cash or cash equivalents, and an 8% rate of tax on those earnings held in illiquid assets. The calculation is based on the highest rate of tax applicable to U.S. corporations in the taxable year of inclusion, even if the U.S. Shareholder is an individual.[21]

Installment Payments

A U.S. Shareholder may elect to pay the net tax liability resulting from the mandatory inclusion of a FC’s post-1986 accumulated foreign earnings in eight equal installments. The net tax liability that may be paid in installments is the excess of the U.S. Shareholder’s net income tax for the taxable year in which the foreign earnings are included in income over the taxpayer’s net income tax for that year determined without regard to the inclusion.

An election to pay the tax in installments must be made by the due date for the tax return for the taxable year in which the undistributed foreign earnings are included in income. The first installment must be paid on the due date (determined without regard to extensions) for the tax return for the taxable year of the income inclusion. Succeeding installments must be paid annually no later than the due dates (without extensions) for the income tax return of each succeeding year.[22]

The Act also provides that if (1) there is a failure to pay timely any required installment, (2) there is a liquidation or sale of substantially all of the U.S. Shareholder’s assets, (3) the U.S. Shareholder ceases business, or (4) another similar circumstance arises, then the unpaid portion of all remaining installments is due on the date of such event.

S corporations

A special rule permits continued deferral of the transitional tax liability for shareholders of a U.S. Shareholder that is an S corporation. The S corporation is required to report on its income tax return the amount of accumulated foreign earnings includible in gross income by reason of the Act, as well as the amount of the allowable deduction, and it must provide a copy of such information to its shareholders. Any shareholder of the S corporation may elect to defer his portion of this tax liability until the shareholder’s taxable year in which a prescribed triggering event occurs.

This shareholder election to defer the tax is due not later than the due date for the return of the S corporation for its last taxable year that begins before January 1, 2018 (i.e., by March 15, 2018 for an S corporation with a taxable year ending December 31, 2017).

Three types of events may trigger an end to deferral of the tax liability: (i) a change in the status of the corporation as an S corporation; (ii) the liquidation, sale of substantially all corporate assets, termination of the of business, or similar event; and (iii) a transfer of shares of stock in the S corporation by the electing taxpayer, whether by sale, death or otherwise, unless the transferee of the stock agrees with the IRS to be liable for tax liability in the same manner as the transferor.[23]

If a shareholder of an S corporation has elected deferral, and a triggering event occurs, the S corporation and the electing shareholder are jointly and severally liable for any tax liability and related interest or penalties.[24]

In addition, the electing shareholder must report the amount of the deferred tax liability on each income tax return due during the period that the election is in effect.[25]

After a triggering event occurs, a shareholder may be able elect to pay the net tax liability in eight equal installments, unless the deferral-ending triggering event is a liquidation, sale of substantially all corporate assets, termination of the company or end of business, or similar event, in which case the installment payment election is not available, and the entire tax liability is due upon notice and demand.[26]


As stated earlier, many closely-held U.S. companies (“CH”) are engaged in business overseas, and many more will surely join them.

Although the Act ostensibly focused on the tax deferral enjoyed by large, publicly-traded multinationals, its provisions will also have a significant impact on CH that do business overseas.

Regardless of its form of organization, a CH has to determine fairly soon the amount of its 2017 U.S. income tax liability resulting from the inclusion in income of any post-1986 accumulated foreign earnings of any CFC of which it is a U.S. Shareholder.

Similarly, in the case of any FC of which the CH is a U.S. Shareholder, but which is not a CFC, the CH must determine whether there is a U.S. corporation (including itself) that is a U.S. Shareholder of the FC. If there is, then the CH will be subject to the mandatory inclusion rule for its share of the FC’s post-1986 accumulated foreign earnings.

The CH and its owners will then have to determine whether to pay the resulting income tax liability at once, in 2018, or in installments.

Of course, if the CH is an S corporation, each of its shareholders will have to decide whether to defer the tax liability until one of the “triggering event” described above occurs.

After the mandatory inclusion rule has been addressed, the CH may decide whether to repatriate some of the already-taxed foreign earnings.

Looking forward, if the CH is a regular C corporation, any dividends it receives from a FC of which it is a U.S. Shareholder may qualify for the DRD.

C corporation CHs that may be operating overseas through a branch or a partnership may want to consider whether incorporating the branch or partnership as a FC, and paying any resulting tax liability, may be warranted in order to take advantage of the DRD – they should at least determine the tax exposure.

Still other CHs, that may be formed as S corporations or partnerships, must continue to be mindful of the CFC anti-deferral regime.

It’s a new tax regime, and it’s time for old dogs to learn new “tricks.” Woof.

[1] Pub. L. 115-97 (the “Act”). We will not cover the “minimum tax” provided under the new “base erosion” rules applicable to certain U.S. corporations – those with more than $500 million of average annual gross receipts – that make certain payments to related parties.

[2] Including all U.S. citizens and residents, as well as U.S. partnerships, corporations, estates and certain trusts. For legal entities, the Code determines whether an entity is subject to U.S. taxation on its worldwide income on the basis of its place of organization. For purposes of the Code, a corporation or partnership is treated as domestic if it is organized under U.S. law.

[3] As in the case of a U.S. partner in a partnership that is engaged in business overseas.

[4] It should be noted that certain foreign entities are eligible to elect their classification for U.S. tax purposes under the IRS’s “check-the-box” regulations. As a result, it is possible for such a foreign entity to be treated as a corporation for foreign tax purposes, but to be treated as a flow-through, or disregarded, entity for U.S. tax purposes; the income of such a hybrid would be taxed to the U.S. owner.

[5] Prior to the Act, and subject to certain limitations, a domestic corporation that owned at least 10% of the voting stock of a FC was allowed a “deemed-paid” credit for foreign income taxes paid by the FC that the domestic corporation was deemed to have paid when the related income was distributed as a dividend, or was included in the domestic corporation’s income under the anti-deferral rules.

[6] This inclusion rule is intended to prevent taxpayers from avoiding U.S. tax on “dividends” by repatriating CFC earnings through non-dividend payments, such as loans to U.S. persons.

[7] For example, the CFC’s purchase of personal property from a related person and its sale to another person where the purchased property was produced in the same foreign country under the laws of which the CFC is organized.

[8] This rate was 35% prior to the Act; the Act reduced the rate to 21%, which should make it easier for some CFCs to satisfy this exception. In that case, the U.S. Shareholder of a CFC will not be subject to the CFC inclusion rules – in other words, it can continue to enjoy tax deferral for the foreign earnings – if the foreign corporate tax rate is at least 19%; i.e., 90% of 21%. This will benefit U.S. persons who otherwise do not qualify for the DRD, discussed below.

[9] For example, CFCs should continue to refrain from guaranteeing their U.S. parent’s indebtedness.

[10] The pro rata share of a CFC’s subpart F income that a U.S. Shareholder is required to include in gross income, however, will continue to be determined based on direct or indirect ownership of the CFC, without application of the new attribution rule.

[11] This moves the U.S. toward a “territorial” system under which the income of foreign subsidiaries is not subject to U.S. tax.

[12] The DRD is available only to regular C corporations. As in the case of dividends paid by U.S. corporations to individuals or to an S corporation, no DRD is available to such shareholders.

[13] Query whether the DRD, combined with the new 21% tax rate for C corporations will encourage U.S. corporations that have substantial foreign operations to remain or become C corporations and to operate overseas only through foreign subsidiary corporations. Unfortunately, the Act also denies non-recognition treatment for the transfer by a U.S. person of property used in the active conduct of a trade or business to a FC.

[14] “Undistributed earnings” are the amount of the earnings and profits of a specified 10%-owned FC as of the close of the taxable year of the specified 10%-owned FC in which the dividend is distributed. A distribution of previously taxed income does not constitute a dividend.

[15] In this way, the Act seeks to avoid bestowing a double benefit upon the U.S. taxpayer; however, foreign withholding tax may prove to be a costly item.

[16] See IRS Notice 2018-13 for additional guidance.

[17] Any amount included in income by a U.S. Shareholder under this rule is not included a second time when it is distributed as a dividend.

[18] Beware, calendar year taxpayers.

[19] The date the Act was introduced.

[20] The portion of post-1986 earnings and profits subject to the transition tax does not include earnings and profits that were accumulated by a FC prior to attaining its status as a specified FC.

[21] A reduced foreign tax credit is also allowed.

[22] If installment payment is elected, the net tax liability is not paid in eight equal installments; rather, the Act requires lower payments for the first five years, followed by larger payments for the next three years. The timely payment of an installment does not incur interest.

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

[24] The period within which the IRS may collect such tax liability does not begin before the date of an event that triggers the end of the deferral.

[25] Failure to include that information with each income tax return will result in a penalty equal to five-percent of the amount that should have been reported.

[26] The installment election is due with the timely return for the year in which the triggering event occurs.

Perhaps the single most important day in the life of any closely held business is the day on which it is sold. The occasion will often mark the culmination of years of effort on the part of its owners.

The business may have succeeded to the point that its competitors seek to acquire it in furtherance of their own expansion plans; alternatively, private equity investors may view it as a positive addition to their portfolio of growth companies.

On the flip side, the owners of the business may not have adequately planned for their own succession; consequently, they may view the business as a “wasting asset” that has to be monetized sooner rather than later.

Worse still, the business may be failing and the owners want to recover as much of their investment as possible.

In any of the foregoing scenarios, the tax consequences arising from the disposition of the business will greatly affect the net economic result for its owners.

The following outlines a number of provisions included in the recently enacted Tax Cuts and Jobs Act[1] that should be of interest to owners of a closely held business that are considering the sale of the business, as well as to the potential buyers of the business.

Corporate Tax Rate

In general, the individual owner of a C corporation, or of an S corporation that is subject to the built-in gains tax, would prefer to sell his stock to a buyer – and thereby incur only a single level of federal income tax, at the favorable 20% capital gain rate[2] – rather than cause the corporation to sell its assets.

An asset sale generally results in two levels of tax: (a) to the corporation based upon the gain recognized by the corporation on the disposition of its assets; and (b)(i) to the shareholder of a C corporation upon his receipt of the after-tax proceeds in liquidation of the corporation, or (ii) to the shareholder of an S corporation under the applicable flow-through rules.

Prior to the Act, the maximum federal corporate tax rate was set at 35%; thus, the combined effective maximum rate for the corporation and shareholder was just over 50% (assuming the sale generated only capital gain).

The Act reduced the federal corporate tax rate to a flat 21%; consequently, the combined maximum federal rate has been reduced to 39.8%.

From the tax perspective of a seller, the reduced corporate rate will make asset deals[3] less expensive. For the buyer that agrees to gross-up the seller for the additional tax arising out of an asset deal (as opposed to a stock deal), the immediate out-of-pocket cost of doing so is also reduced.

Individual Ordinary Income Rate

The Act reduced the rate at which the ordinary income recognized by an individual is taxed, from 39.6% to 37%.[4]

In the case of an S corporation shareholder, or of an individual member of an LLC taxable as a pass-through entity[5], any ordinary income generated on the sale of the corporate assets – for example, depreciation recapture[6] – will be taxed at the reduced rate.

Any interest that is paid by a buyer to a seller in respect of a deferred payment of purchase price – i.e., an installment sale – or that is imputed to the seller[7], as in the case of an earn-out, will be taxable at the reduced rate for ordinary income.

Similarly, if the seller or its owners continue to hold the real estate on which the business operates, the rental income paid by the buyer will be subject to tax at this reduced rate.

Finally, any compensation paid to the owners, either as consultants or employees, or in respect of a non-compete, will be taxable at the reduced rate.

Self-Created Intangibles

The Act amended the Code to exclude a patent, invention, model or design (whether or not patented), and a secret formula or process which is held either by the taxpayer who created the property, or a taxpayer with a substituted or transferred basis from the taxpayer who created the property (or for whom the property was created), from the definition of a “capital asset.”

Thus, gains or losses from the sale or exchange of any of the above intangibles will no longer receive capital gain treatment.


Prior to the Act, the net operating losses (“NOLs”) for a taxable year could be carried back two years and forward 20 years. The Act eliminates the carryback and allows the NOLs to be carried forward indefinitely, though it also limits the carryover deduction for a taxable year to 80% of the taxpayer’s taxable income for such year.

The Act did not change the rule that limits a target corporation’s ability to utilize its NOLs after a significant change in the ownership of its stock.[8] However, the Act’s elimination of the “NOL-20-year-carryover-limit” reduces the impact of the “change-in-ownership-loss-limitation” rule on a buyer of the target’s stock; even though the annual limitation imposed by the rule will continue to apply, the NOL will not expire unused after twenty years – rather, it will continue to be carried over until it is exhausted.

At the same time, however, the Act’s limitation of the carryover deduction for a taxable year, to 80% of the corporation’s taxable income, may impair a target’s ability to offset some of the gain recognized on the sale of its assets.

Interest Deduction Limit

The Act generally limits the deduction for business interest incurred or paid by a business for any taxable year to 30% of the business’s adjusted taxable income for such year.[9] Any interest deduction disallowed under this rule is carried forward indefinitely.

In the case of a buyer that will incur indebtedness to purchase a target company – for example, by borrowing the funds, or by issuing a promissory note as part of the consideration for the acquisition – this limitation on its ability to deduct the interest charged or imputed in respect of such indebtedness could make the acquisition more expensive from an economic perspective.[10]

Immediate Expensing

Prior to the Act, an additional first-year depreciation deduction was allowed in an amount equal to 50% of the adjusted basis of qualified property acquired and placed in service before January 1, 2020. Property qualifying for the additional first-year depreciation deduction had to meet requirements; for example, it had to be tangible personal property, certain computer software, or qualified improvement property. Moreover, the “original use” of the property had to commence with the taxpayer.

The Act, extended and modified the additional first-year depreciation deduction for qualifying property through 2026. It also increased the 50% allowance to 100% for property placed in service after September 27, 2017, and before January 1, 2023.[11]

It also removed the requirement that the original use of the qualifying property had to commence with the taxpayer. Thus, the provision applies to purchases of used as well as new items; in other words, the additional first-year depreciation deduction is now allowed for newly acquired used property.

The additional first-year depreciation deduction applies only to property that was not used by the taxpayer prior to the acquisition, and that was purchased in an arm’s-length transaction. It does not apply to property acquired in a nontaxable exchange such as a reorganization, or to property acquired from certain related persons, including a related entity (for example, from a person who controls, is controlled by, or is under common control with, the taxpayer).

Thus, a buyer will be permitted to immediately deduct the cost of acquiring “used” qualifying property[12] from a target business, thereby recovering what may be a not insignificant portion of its purchase price, and reducing the overall cost of the acquisition.


Query whether the owners of an S corporation (or of another target that is treated as a pass-through entity for tax purposes) will be allowed to claim the 20% deduction based on qualified business income in determining their tax liability from the sale of the assets of the business. Stated differently, and assuming that the owner’s income for the taxable year is derived entirely from the operation and sale of a single business, will the gain from the sale be included in determining the amount of the deduction?

It appears not. The definition of “qualified business income” excludes items of gain even where they are effectively connected with the conduct of a qualified trade or business; this would cover any capital gain arising from the sale of assets used in the trade or business. Moreover, it appears that the presence of such gain in an amount in excess of the taxable income of the business for the year of the sale (exclusive of the gain) would disallow any such deduction to the taxpayer.[13]

What Does It All Mean?

It remains to be seen whether these changes will influence the structure of M&A transactions. After all, most buyers would prefer to cherry-pick the target assets to be acquired and to assume only certain liabilities; they will consider a stock deal only if necessary. The reduction in the corporate tax rate will likely reinforce that fundamental principle, and may cause certain corporate sellers and their shareholders to be more amenable to an asset deal.

However, the pricing of an M&A transaction will likely be affected by the reduced corporate tax rate, by the limitation on a buyer’s deduction of acquisition interest, and by a buyer’s ability to immediately expense a portion of the purchase price. Each of these factors should be considered by a buyer in evaluating its acquisition of a target, the amount the buyer can offer in consideration, and its ability to finance the acquisition.

Only time and experience will tell.

As was mentioned in an earlier post, the Act was introduced on November 2, 2017, was enacted on December 22, 2017 – without the benefit of meaningful hearings and of input from tax professionals – and became effective on January 1, 2018 (just three weeks ago). The Congress is already discussing technical corrections, and the tax bar is asking for guidance from the IRS. Much remains to be discovered.

Stay tuned.

[1] Pub. L. 115-97 (the “Act”).

[2] The shareholder of a C corp, or of an S corp in which he does not materially participate, will also incur the additional 3.8% surtax on net investment income.

[3] Including sales of stock that are treated as asset sales for tax purposes under Sec. 338(h)(10) or Sec. 336(e) of the Code.

[4] The rate may be greater if the 3.8% surtax also applies to the item of income in question; for example, interest income.

[5] For example, a partnership.

[6] Sec. 1245 of the Code.

[7] Sec. 1274 of the Code.

[8] Code Sec. 382.

[9] In general, before 2022, the limitation is tied to EBITDA; thereafter, it is tied to EBIT.

[10] In general, the limitation does not apply to a corporation if its average annual gross receipts for the three-taxable-year period ending with the prior taxable year does not exceed $25 million.

[11] The allowance is thereafter reduced, and phased out, through 2026.

[12] This should cover both actual and deemed acquisitions of assets (as under a Sec. 338(h)(10) election).

[13] Although the underlying basis for the result is not discussed in the Congressional committee reports, it is likely attributable to favorable capital gain rate that applies to the individual owners of a pass-through entity.


The Tax Cuts and Jobs Act of 2017[1] went into effect only two weeks ago. Many of its provisions represent significant changes to the Code, and it will take most of us several months to fully digest them,[2] to appreciate their practical consequences, and to understand how they may best be utilized for the benefit of our clients.

Among the businesses on which the Act will have a significant and immediate effect is real estate. What follows is a summary of the principal effects of the Act on a closely held real estate business and its owners.[3]

There are many facets to a closely held real estate business, including the choice of entity in which to operate the business, the acquisition and disposition of real property, the construction or other improvement of the property, the financing of the foregoing activities, the rental of the property, the management of the business, and the transfer of its ownership.

The Act touches upon each of these activities. It is the responsibility of the business’s tax advisers to analyze how the changes enacted may affect the business, and to prepare a coherent plan that addresses these changes.

Individual Income Tax Rates

The Act reduced the maximum individual income tax rate from 39.6% (applicable, in the case of married joint filers, to taxable income in excess of $470,700) to 37% (applicable, in the case of married joint filers, to taxable income in excess of $600,000).

This reduced rate will apply to an individual owner’s net rental income. It will also apply to any depreciation recapture recognized on the sale of a real property.[4]

Income Tax

The Act did not change the 20% maximum rate applicable to individuals on their net capital gains and qualified dividends, nor did it change the 25% rate applicable to unrecaptured depreciation.

The Act also left in place the 3.8% surtax on net investment income that is generally applicable to an individual’s rental income, unless the individual can establish that he is a real estate professional and that he materially participates in the rental business.

Deduction of Qualified Business Income

The Act provides that an individual who owns an equity interest in a pass-through entity (“PTE”)[5] that is engaged in a qualified trade or business (“QTB”)[6] may deduct up to 20% of the qualified business income (“QBI”) allocated to him from the PTE.

The amount of this deduction may be limited, based upon the W-2 wages paid by the QTB and by the unadjusted basis (immediately after acquisition) of depreciable tangible property used by the QTB in the production of QBI (provided its recovery period has not expired).[7]

The issue of whether an activity, especially one that involves the rental of real property, is a “trade or business” (as opposed to an “investment”) of a taxpayer is ultimately one of fact in which the scope of a taxpayer’s activities, either directly or through agents, in connection with the property, is so extensive as to rise to the stature of a trade or business.

A taxpayer’s QBI from a QTB for a taxable year means his share of the net amount of qualified items of income, gain, deduction, and loss that are taken into account in determining the taxable income of the QTB for that year.

Items of income, gain, deduction, and loss are “qualified items” only to the extent they are effectively connected with the PTE’s conduct of a QTB within the U.S. “Qualified items” do not include specified investment-related income, gain, deductions, or loss. [8]

Excess Business Losses

The Act imposes another limitation on an individual’s ability to utilize a pass-through loss against other income, whether it is realized through a sole proprietorship, S corporation or partnership; this limitation is applied after the at-risk and passive loss rules.

Specifically, the taxpayer’s excess business losses are not allowed for the taxable year. An individual’s “excess business loss” for a taxable year is the excess of:

(a) the taxpayer’s aggregate deductions attributable to his trades or businesses for the year, over

(b) the sum of:

(i) the taxpayer’s aggregate gross income or gain for the year attributable to such trades or businesses, plus

(ii) $250,000 (or $500,000 in the case of a joint return).

In the case of a partnership or S corporation, this provision is applied at the individual partner or shareholder level. Each partner’s and each S corporation shareholder’s share of the PTE’s items of income, gain, deduction, or loss is taken into account in applying the limitation for the taxable year of the partner or shareholder.

The individual’s excess business loss for a taxable year is carried forward and treated as part of the taxpayer’s net operating loss carryforward in subsequent taxable years.[9]

Technical Termination of a Partnership

Prior to the Act, a partnership was considered “technically terminated” for tax purposes if, within a 12-month period, there was a sale or exchange of 50% or more of the total interest in the partnership’s capital or income. Upon a technical termination, the partnership’s taxable year closed, partnership-level elections generally ceased to apply, and the partnership’s depreciation recovery periods for its assets started anew.

The Act repealed the technical termination rule, which makes it easier for partners to transfer their partnership interests.

Profits Interest

A partnership may issue a profits interest (a “promote”) in the partnership to a service or management partner in exchange for the performance of services. The right of the profits interest partner to receive a share of the partnership’s future profits and appreciation does not include any right to receive money or other property upon the liquidation of the partnership immediately after the issuance of the profits interest.[10]

In general, the IRS has not treated the receipt of a partnership profits interest for services as a taxable event for the partnership or the partner.

By contrast, a partnership capital interest received for services has been includable in the partner’s income if the interest was transferable or was not subject to a substantial risk of forfeiture.[11]

In order to make it more difficult for certain profits interest partners to enjoy capital gain treatment for their share of partnership income, for taxable years beginning after December 31, 2017, the Act provides for a new three-year holding period.[12]

Specifically, the partnership assets sold must have been held by the partnership for at least three years in order for a profits interest partner’s share of such gain to enjoy the lower tax rate applicable to long-term capital gains.[13]

If the assets sold had not been held by the partnership for at least three years, the entire amount of any capital gain allocated to the profits interest would be treated as short-term capital gain and would be taxed up to a maximum rate of 37% as ordinary income.

An “applicable partnership interest” is one that is transferred to a partner in connection with his performance of “substantial” services in a trade or business that consists in whole or in part of (1) raising or returning capital, and (2) investing in, or disposing of, or developing real estate held for rental or investment.

This holding-period rule should not apply to a taxpayer who only provides services to a so-called “portfolio company.”

Real Property Taxes

Under the Act, State and local taxes are generally not allowed to an individual as a deduction[14] unless they are paid or accrued in carrying on a trade or business, or an activity for the production of income. Thus, for instance, in the case of property taxes, an individual may deduct such items if these taxes were imposed on business assets, such as residential rental property.

Additional Depreciation

Prior to the Act, the Code allowed an additional first-year depreciation deduction equal to 50% of the adjusted basis of “qualified property”[15] – including certain improvements to real property – for the year it was placed in service.

The Act modified the additional first-year depreciation deduction, expanded it to include the acquisition of used property, and increased the allowance to 100% for property placed in service after September 27, 2017, and before January 1, 2023.[16]

Election to Expense

Prior to the Act, a taxpayer could elect to deduct the cost of qualifying property, rather than to recover such costs through depreciation deductions, subject to certain limitations. The maximum amount a taxpayer could expense was $500,000 of the cost of qualifying property placed in service for the taxable year. This amount was reduced by the amount by which the cost of qualifying property placed in service during the taxable year exceeded $2 million. The $500,000 and $2 million amounts were indexed for inflation for taxable years beginning after 2015.

Qualifying property was defined to include, among other things, “qualified leasehold improvement property.”

The Act increased the maximum amount a taxpayer may expense to $1 million, and increased the phase-out threshold amount to $2.5 million. Thus, the maximum amount a taxpayer may expense, for taxable years beginning after 2017, is $1 million of the cost of qualifying property placed in service for the taxable year. The $1 million amount is reduced by the amount by which the cost of qualifying property placed in service during the taxable year exceeds $2.5 million. The $1 million and $2.5 million amounts are indexed for inflation for taxable years beginning after 2018.

The Act also expanded the definition of qualifying real property to include any of the following improvements to nonresidential real property placed in service after the date such property was first placed in service: roofs; heating, ventilation, and air-conditioning property; fire protection and alarm systems; and security systems.

Interest Deduction

The Act limits the deduction that a business may claim for “business interest” paid or accrued in computing its taxable income for any taxable year. In general, the deduction is limited to 30% of the adjusted taxable income of the business for such year. The amount of any business interest not allowed as a deduction for any taxable year may be carried forward indefinitely.

“Adjusted taxable income” means the taxable income of the business computed without regard to (1) any item of income, gain, deduction, or loss which is not properly allocable to the business; (2) any business interest or business interest income; (3) the amount of any NOL deduction; (4) the 20% of QBI deduction; and (5) certain other business deductions.[17]

The limitation does not apply to a business – including a real estate business – if its average annual gross receipts for the three-taxable-year period ending with the prior taxable year does not exceed $25 million.

In addition, a real estate business may elect that any real property development, redevelopment, construction, reconstruction, acquisition, conversion, rental, operation, management, leasing, or brokerage trade or business in which it is engaged not be treated as a trade or business for purposes of the limitation, in which case the limitation would not apply to such trade or business.[18]

Like-Kind Exchange

For years, the Code has provided that no gain or loss is recognized if property held for productive use in a trade or business or for investment is exchanged for property of a “like kind” which is to be held for productive use in a trade or business or for investment.

Over the last few years, several proposals had been introduced into Congress to eliminate the favorable tax treatment for like-kind exchanges.

The Act amended the tax-deferred like-kind exchange rules such that they will apply only to real property.

Corporate Tax Changes

Real property should rarely be held in a corporation, yet the fact remains that there are many such corporations.

In the case of a C corporation, or in the case of an S corporation for which the built-in gain recognition period has not yet expired, the Act provides some relief by reducing the corporate income tax rate from a maximum rate of 35% to a flat rate of 21%.

Although this reduction is significant, it likely is not enough to cause investors to contribute their real property to a corporation, or to “check the box” to treat their partnership or single-member LLC as an association (i.e., a corporation) for tax purposes. The benefits of ownership through a partnership are too great.

Moreover, the Act also takes away a benefit from certain corporate real estate developers. Specifically, these corporations may no longer exclude from their gross income any contribution of cash or property from a governmental entity or civic group.[19]

Estate Planning

Although the Act did not repeal the federal estate tax, it greatly increased the exemption amount, from $5.6 million to $11.2 million per person for 2018. It also left intact the portability election between spouses, and the exemption amount remains subject to adjustment for inflation.[20]

Importantly, the beneficiaries of a decedent’s estate continue to enjoy a stepped-up basis in the assets that pass to them upon his death, thereby providing income tax savings to the beneficiaries in the form of reduced gain or increased depreciation.[21]

For a more detailed discussion, click here.

A foreign individual investing in U.S. real property will often do so through a foreign corporate parent and a U.S. corporate subsidiary. The stock of the foreign corporation will not subject the foreigner to U.S. estate tax upon his demise. The U.S. corporation will be subject to U.S. corporate income tax – now at a 21% federal rate (down from a maximum of 35%) – and its dividend distributions, if any, will be subject to U.S. withholding at 30% or at a lower treaty rate. The disposition of the real property will be subject to U.S. corporate tax, but the subsequent liquidation of the U.S. subsidiary will not be subject to U.S. tax.[22]

Will the reduction of the federal corporate tax rate cause more foreign corporations to invest directly in U.S. real property, or through a PTE, rather than through a U.S. subsidiary? In general, no, because such an investment may cause the foreign corporation to be treated as engaged in a U.S. trade or business[23], and may subject the foreign corporation to the branch profits tax.

How about the limitation on interest deductions? The exception for a real estate trade or business should alleviate that concern.

Will the deduction based on qualified business income cause a foreign individual to invest in U.S. real property through a PTE?[24] Probably not, because this form of ownership may cause the foreigner to be treated as engaged in a U.S. trade or business, and an interest in such a PTE should be includible in his U.S. gross estate for estate tax purposes.

Where Will This Lead?

It’s too soon to tell – the Act has only been in force for just over two weeks.

That being said, and based on the foregoing discussion, there’s a lot in the Act with which the real estate industry should be pleased.[25]

Notwithstanding that fact, there are certain questions that many taxpayers are rightfully starting to ask regarding the structure of their real estate business. To give you a sense of the environment in which we find ourselves, I have been asked:

  • Whether an S corporation should convert into a C corporation (to take advantage of the reduced corporate tax rate);
  • Whether a C corporation should elect S corporation status (to enable its individual shareholders to take advantage of the 20%-of-QBI deduction);
  • Whether a partnership/LLC should incorporate or check the box (to take advantage of the reduced corporate rate);
  • Whether a corporation should convert into a partnership or disregarded entity (to enable its individual shareholders to take advantage of the 20%-of-QBI deduction)?

In response to these questions, I ask: who or what are the business owners, what is its capital structure, does it make regular distributions to its owners, what is the appreciation inherent in its assets, does it plan to dispose of its property in the relative short-term, etc.? The point is that each taxpayer is different.

I then remind them that some of the recently-enacted provisions are scheduled to expire in the not-too-distant future; for example, the QBI-based deduction goes away after 2025.

Generally speaking, however, and subject to the unique circumstances of the business entity, its owners, and its property, a real estate business entity that is treated as a partnership for tax purposes should not change its form; an S corporation should not revoke its “S” election; a C corporation should elect “S” status (assuming it will not be subject to the excise tax on excess passive investment income), and a corporation should not convert into a partnership.

[1] Pub. L. 115-97 (the “Act”).

[2] Do you recall the history of the TRA of 1986? Committee reports beginning mid-1985, the bill introduced late 1985, the law enacted October 1986, lots of transition rules. Oh well.

[3] Some of these provisions have been discussed in earlier posts on this blog. See, for example, this post and this post.

[4] For example, personal property identified as part of a cost segregation study that benefited from accelerated depreciation.

[5] A sole proprietorship, partnership/LLC, or S corporation.

[6] A QTB includes any trade or business conducted by a PTE other than specified businesses that primarily involve the performance of services.

[7] Query how much of a benefit will be enjoyed by an established real estate business which may not have many employees, and the property of which may have been fully depreciated.

[8] Investment-type income is excluded from QBI; significantly, investment income includes capital gain from the sale or other disposition of property used in the trade or business.

[9] NOL carryovers generally are allowed for a taxable year up to the lesser of (i) the carryover amount or (ii) 80 percent of taxable income determined without regard to the deduction for NOLs. In general, carrybacks are eliminated, and carryovers to other years may be carried forward indefinitely.

This may be a significant consideration for a C corporation that elects to be an S corporation, and vice versa, in that “C-corporation-NOLs” will not expire until they are actually used.

See the discussion of the recently enacted “excess business loss” rule applicable to individuals.

[10] The right may be subject to various vesting limitations.

[11] A capital interest for this purpose is an interest that would entitle the receiving partner to a share of the proceeds if the partnership’s assets were sold at fair market value (“FMV”) immediately after the issuance of the interest and the proceeds were distributed in liquidation.

[12] This rule applies even if the partner has made a sec. 83(b) election.

[13] It is unclear whether the interest must have been held for three years by the partner.

[14] There is an exception under which a joint return may claim an itemized deduction of up to $10,000 for the aggregate of (i) State and local property taxes not paid or accrued in carrying on a trade or business, or in an activity carried on for the production of income, and (ii) State and local income taxes (or sales taxes in lieu of income taxes) paid or accrued in the taxable year.

[15] Among other things, “qualified improvement property” includes any improvement to an interior portion of a building that was nonresidential real property if such improvement was placed in service after the date such building was first placed in service.

Qualified improvement property does not include any improvement for which the expenditure is attributable to the enlargement of the building, any elevator or escalator, or the internal structural framework of the building.

The Act also provides a 15-year MACRS recovery period for qualified improvement property.

[16] The allowance is phased out through 2025.

[17] Among these deductions is depreciation. Beginning in 2022, depreciation is accounted for.

[18] An electing business will not be entitled to bonus depreciation and will have to extend, slightly, the depreciation period for its real properties.

[19] Such contributions may be made in order to induce a business to move to, and establish itself in, a particular jurisdiction, the idea being that its presence would somehow benefit the public.

[20] Unfortunately, the exemption amount returns to its pre-Act levels after 2025.

[21] In the case of a partnership interest, the partnership must have a Sec. 754 election in effect in order to enjoy this benefit.

[22] Thanks to the so-called “cleansing rule.”

[23] Or it may elect to be so treated.

[24] Other than an S corporation, of course.

[25] Our focus has been on the tax benefits bestowed upon a closely held real estate business. Of course, there are other, non-business provisions that apply to individuals that may have some impact on the real estate market and real estate businesses generally.

Obviously, I am referring to the limitations on itemized deductions for real property taxes imposed on a personal residence and residential acquisition indebtedness, both of which may adversely affect higher-income individual taxpayers.

Against these changes, one must weigh the alternative minimum tax (which often reduces the benefit of deducting property taxes anyway), and the elimination of the so-called “Pease limitation” (which reduced the benefit of itemized deductions for higher-income individual taxpayers).

When the Tax Cuts and Jobs Act[1] was introduced on November 2, 2017, perhaps the single most important issue on the minds of many closely held business owners was the future of the estate tax: was it going to be repealed as had been promised? A closely related question – and perhaps of equal significance to these owners’ tax advisers – was whether an owner’s assets would receive a so-called “stepped-up” basis in the hands of those persons to whom the assets passed upon the owner’s death?

When the smoke cleared (only seven weeks later), the estate tax remained in place, but its reach was seriously limited, at least temporarily. Moreover, the stepped-up basis rule continued to benefit the beneficiaries of a decedent’s estate.

To better understand the change wrought by the Act – and to appreciate what it left intact – we begin with an overview of the federal transfer taxes.

The Estate and Gift Tax

The Code imposes a gift tax on certain lifetime transfers, an estate tax on certain transfers at death, and a generation-skipping transfer (“GST”) tax when such transfers are made to a “skip person.”

Estate Tax

The Code imposes a tax on the transfer of the taxable estate of a decedent who is a citizen or resident of the U.S. The taxable estate is determined by deducting from the value of the decedent’s gross estate any deductions provided for in the Code. After applying tax rates to determine a tentative amount of estate tax, certain credits are subtracted to determine estate tax liability.

Estate Tax

A decedent’s gross estate includes, to the extent provided for in other sections of the Code, the date-of-death value of all of a decedent’s property, real or personal, tangible or intangible, wherever situated. In the case of a business owner, the principal asset of his gross estate may be his interest in a closely held business. In general, the value of the property for this purpose is the fair market value of the property as of the date of the decedent’s death.

A decedent’s taxable estate is determined by subtracting from the value of his gross estate any deductions provided for in the Code. Among these deductions is one for certain transfers to a surviving spouse, the effect of which is to remove the assets transferred to the surviving spouse from the decedent’s estate tax base.

After accounting for any allowable deductions, a gross amount of estate tax is computed, using a top marginal tax rate of 40%.

In order to ensure that a decedent only gets one run up through the rate brackets for all lifetime gifts and transfers at death, his taxable estate is combined with the value of the “adjusted taxable gifts” made by the decedent during his life, before applying tax rates to determine a tentative total amount of tax. The portion of the tentative tax attributable to lifetime gifts is then subtracted from the total tentative tax to determine the gross estate tax.

The estate tax liability is then determined by subtracting any allowable credits from the gross estate tax. The most significant credit allowed for estate tax purposes is the unified credit.

The unified credit is available with respect to a taxpayer’s taxable transfers by gift and at death. The credit offsets the tax up to a specified cumulative amount of lifetime and testamentary transfers (the “exemption amount”). For 2017, the inflation-indexed exemption amount was set at $5.49 million; prior to the Act, it was set to increase to $5.6 million in 2018.

Any portion of an individual taxpayer’s exemption amount that is used during his lifetime to offset taxable gifts reduces the exemption amount that remains available at his death to offset the taxable value of his estate. In other words, the unified credit available at death is reduced by the amount of unified credit used to offset gift tax incurred on gifts made during the decedent’s life.

In the case of a married decedent, an election is available under which any exemption amount that was not used by the decedent may be used by the decedent’s surviving spouse (the so-called “portability election”) during her life or at her death.

The estate tax generally is due within nine months of a decedent’s death. However, in recognition of the illiquid nature of most closely held businesses, the Code generally allows the executor of a deceased business owner’s estate to elect to pay the estate tax attributable to an interest in a closely held business in up to ten installments. An estate is eligible for payment of the estate tax in installments if the value of the decedent’s interest in a closely held business exceeds 35 percent of the decedent’s adjusted gross estate (i.e., the gross estate less certain deductions).

If the election is made, the estate may defer payment of principal and pay only interest for the first five years[2], followed by up to 10 annual installments of principal and interest. This provision effectively extends the time for paying estate tax by 14 years from the original due date of the estate tax.

Gift Tax

The Code imposes a tax for each calendar year on the transfer of property by gift during such year by any individual. The amount of taxable gifts for a calendar year is determined by subtracting from the total amount of gifts made during the year: (1) the gift tax annual exclusion; and (2) allowable deductions.

The gift tax for a taxable year is determined by: (1) computing a tentative tax on the combined amount of all taxable gifts for such year and all prior calendar years using the common gift tax and estate tax rate (up to 40 percent); (2) computing a tentative tax only on all prior-year gifts; (3) subtracting the tentative tax on prior-year gifts from the tentative tax computed for all years to arrive at the portion of the total tentative tax attributable to current-year gifts; and, finally, (4) subtracting the amount of unified credit not consumed by prior-year gifts.

The amount of a taxpayer’s taxable gifts for the year is determined by subtracting from the total amount of the taxpayer’s gifts for the year the gift tax annual exclusion amount and any available deductions.

Donors of lifetime gifts are provided an annual exclusion of $15,000 per donee in 2018 (indexed for inflation from the 1997 annual exclusion amount of $10,000) for gifts of “present interests” in property. Married couples can gift up to $30,000 per donee per year without consuming any of their unified credit.


The GST tax is a separate tax that can apply in addition to either the gift tax or the estate tax. The tax rate and exemption amount for GST tax purposes are set by reference to the estate tax rules. The GST tax is imposed using the highest estate tax rate (40%). Tax is imposed on cumulative generation-skipping transfers in excess of the generation-skipping transfer tax exemption amount in effect for the year of the transfer. The generation-skipping transfer tax exemption for a given year is equal to the estate tax exemption amount in effect for that year ($5.49 million in 2017).

Basis in property received at death

A bequest, or other transfer at death, of appreciated (or loss) property is not an income tax realization event for the transferor-decedent or his estate, but the Code nevertheless provides special rules for determining a recipient’s income tax basis in assets received from a decedent.

Property acquired from a decedent or his estate generally takes a stepped-up basis in the hands of the recipient. “Stepped-up basis” means that the basis of property acquired from a decedent’s estate generally is the fair market value on the date of the decedent’s death. Providing a fair market value basis eliminates the recognition of income on any appreciation in value of the property that occurred prior to the decedent’s death (by stepping-up its basis).[3]

In the case of a closely held business, depending upon the nature of the business entity (for example, a partnership or a corporation) and of its assets, the income tax savings resulting from the basis step-up may be realized as reduced gain on the sale of the decedent’s interest in the business, or as a reduced income tax liability from the operation of the business (for example, in the form of increased depreciation or amortization deductions).

The Act

To the disappointment of many, the Act did not repeal the federal estate tax.

However, the Act greatly increased the federal estate tax, gift tax, and GST tax exemption amount – for decedents dying, and for gifts made, after December 31, 2017 and before January 1, 2026 – and it preserved portability.

The “basic exemption amount” was increased from $5 million (as of 2010) to $10 million; as indicated above, this amount is indexed for inflation occurring after 2011, and was set at $5.6 million for 2018 prior to the Act.

As a result of the Act, this exemption amount was doubled to $11.2 million per person beginning in 2018 – basically, $22.4 million per married couple – and will be adjusted annually for inflation through 2025.

To put this into perspective, over 109,000 estate tax returns were filed in 2001, of which approximately 50,000 were taxable. Compare this with 2016, when approximately 11,000 returns were filed, of which approximately 5,000 were taxable. The decline appears to be due primarily to the increase in the filing threshold (based on the exemption amount) from $675,000 in 2001 to $5.45 million in 2016.[4] An increase from $5.49 million in 2017 to $11.2 million in 2018 should have a similar effect.

In addition, and notwithstanding the increased exemption amount, the Act retained the stepped-up basis rule for determining the income tax basis of assets acquired from a decedent. As a result, property acquired from a decedent’s estate generally will continue to take a stepped-up basis.


As stated immediately above, the owners of many closely held businesses will not be subject to the federal estate tax – at least not through 2025[5] – thanks to the greatly increased exemption amount and to continued portability.

Thus, a deceased owner’s taxable (not gross) estate in 2018 – even if we only account for conservative valuations of his business interests and for reasonable estate administration expenses – may be as great as $22.4 million (assuming portability) without incurring any federal estate tax.

Moreover, this amount ignores the benefits of fairly conservative gift planning including, for example, the long-term impact of regular annual exclusion gifting (and gift-splitting between spouses), the effect of transfers made for partial consideration (as in a QPRT), or for full and adequate consideration (as in zeroed-out GRATs and installment sales), as well as the benefit of properly-structured life insurance that is not includible in the decedent’s estate.

With these tools, otherwise taxable estates[6], that potentially may be much larger than the new exemption amount, may be brought within its coverage.

The increased exemption amount will also allow many owners to secure a basis step-up for their assets upon their death without incurring additional estate tax, by allowing these owners to retain assets.

Of course, some states, like New York, will continue to impose an estate tax on estates that will not be subject to the federal estate tax.[7] In those cases, the higher federal exemption amount, coupled with the absence of a New York gift tax, provides an opportunity for many taxpayers to reduce their New York taxable estate without any federal estate or gift tax consequences, other than the loss of a basis step-up. The latter may be significant enough, however, that the taxpayer may decide to bear the 16% New York estate tax on his taxable estate rather than lose the income tax savings.[8]


In light of the foregoing, taxpayers should, at the very least, review their existing estate plan and the documents that will implement it – “for man also knoweth not his time.”[9]

For example, wills or revocable trusts that provide for a mandatory credit shelter or bypass trust may have to be revised, depending upon the expected size of the estate, lest the increased exemption amount defeat one’s testamentary plan.

A more flexible instrument may be warranted – perhaps one that relies upon a disclaimer by a surviving spouse – especially given the December 31, 2025 expiration date for the increased exemption amount, and the “scheduled” reversion in 2026 to the pre-2018 exemption level (albeit adjusted for inflation).

The buy-out provisions of shareholder, partnership and operating agreements should also be reviewed in light of what may be a reduced need for liquidity following the death of an owner. For example, should such a buy-out be mandatory?[10]

Some taxpayers, with larger estates, may want to take advantage of the increased exemption amount before it expires in 2026 so as to remove assets, and the income and appreciation thereon, from their estates.[11] This applies for both estate and GST tax purposes; a trust for the benefit of skip persons may be funded now using the temporarily increased GST exemption amount.

Of course, gifting comes at a cost: the loss of stepped-up basis upon the death of the taxpayer.

Conversely, some taxpayers may want to consider bringing certain appreciated assets (for example, assets that they may have previously gifted to a family member) back into their estates in order to attain the benefit of a basis step-up.

Those taxpayers who decide to take advantage of the increased exemption amount by making lifetime gifts should consider how they may best leverage it.

Some New York taxpayers – who may otherwise have to reduce their gross estates in order to reduce their NY estate tax burden – may want to consider changing their domicile so as to avoid the New York estate tax entirely while holding on to their assets (that would be sheltered by the increased exemption amount) and thereby securing the step-up in basis upon their passing.

There may also be other planning options to consider, some of which have been considered in earlier posts to this blog. For example, ESBTs may now include nonresident aliens as potential current beneficiaries without causing the S corporation to lose its “S” election.

As always, tax savings, estate planning, and gifting strategies have to be considered in light of what the taxpayer is comfortable giving up. In the case of a closely held business owner, any loss of control may be untenable, as may the reduction of cash flow that is attributable to his ownership interest.

Moreover, there are non-tax reasons for structuring the disposition of one’s estate that may far outweigh any tax savings that may result from a different disposition. Tails, dogs, wagging – you know the idiom.

*  At least until 2026 – keep reading.  With apologies to St. Paul. 1 Corinthians, 15:55.

[1] Pub. L. 115-97 (the “Act”); signed into law on December 22, 2017.

[2] The interest rate applicable to the amount of estate tax attributable to the taxable value of the closely held business in excess of $1 million (adjusted for inflation) is equal to 45 percent of the rate applicable to underpayments of tax (i.e., 45 percent of the Federal short-term rate plus three percentage points). This interest is not deductible for estate or income tax purposes.

[3] It also eliminates the tax benefit from any unrealized loss (by stepping-down its basis to fair market value).

[4] http://www.taxpolicycenter.org/briefing-book/how-many-people-pay-estate-tax

[5] This provision expires after 2025. Assuming the provision survives beyond 2020 (the next presidential election), query whether the exemption amount will be scaled back. Has the proverbial cat been let out of the proverbial bag?

[6] Including individuals who had already exhausted their pre-2018 exemption amount.

[7] The NY estate tax exemption amount for 2018 is $5.25 million.

[8] In the case of a NYC decedent, for example, the tax savings to be considered would include the federal capital gains tax of 20%, the federal surtax on net investment income of 3.8%, the NY State income tax of 8.82%, and the NYC income tax of 3.876%. Of course, the likelihood of an asset’s being sold after death also has to be considered.

[9] Ecclesiastes, 9:12. As morbid as it may sound, planning for an elderly or ill taxpayer is different from planning for a younger or healthier individual – it is especially so now given the 2026 expiration of the increased exemption amount.

[10] Of course, there may be overriding business reasons for such a buy-out.

[11] If the exemption amount were to return to its pre-2018 levels in 2026, query how the IRS will account for any pre-2026 gifts that were covered by the increased exemption amount. The Act directs the IRS to issue regulations addressing this point.