A rapidly growing, closely-held business may find itself in need of additional capital.  When the owners of such a business do not have the liquidity or disposable assets from which to provide such capital, and with traditional lenders often unwilling to extend the necessary credit on acceptable terms, many close businesses have turned to private equity firms.  Such firms may be willing to make a loan to a close business that may or may not be convertible into equity, or they may purchase an equity (often preferred) interest in the business.

The Tax Court’s decision in Fish v. Comr (T.C. Memo 2013-270) involved one such scenario.  However, it also illustrated the importance of considering the potential tax consequences of such a transaction, especially where the owner of the closely-held business plans to withdraw some of the capital.

In order to fund its expansion into new markets, FishNet Consulting, Inc. (“FishNet”) agreed to issue preferred stock to Edgewater Funds (“Edgewater”) in exchange for a sum of money.  The preferred stock would represent 43% of the equity in FishNet.  Upon closing of the deal, a portion of the funds contributed by Edgewater would be distributed to Mr. Fish (the founder and sole shareholder of FishNet) in redemption of some of his shares.  In this way, Mr. Fish hoped to monetize some of his equity in the business.

In preparation for Edgewater’s investment, Mr. Fish incorporated Fish Holdings (“Holdings”) and elected to treat it as an S corporation.  He then contributed all of FishNet’s issued and outstanding shares to Holdings in exchange for Holdings common stock, and elected to treat FishNet as a Qualified Sub S Subsidiary (“Qsub”).  For income tax purposes, this election was treated as a tax-free liquidation of FishNet into Holdings, with all of the assets and liabilities of FishNet becoming the assets and liabilities of Holdings.

FishNet then amended its certificate of incorporation to create a class of preferred stock, with preferential rights to cumulative dividends.  Edgewater made a cash investment in FishNet in exchange for the issuance of shares of the preferred stock to Edgewater.  Upon issuance of the preferred shares, FishNet ceased to be a Qsub and, for income tax purposes, it was treated as a new C corporation, all of the assets and liabilities of which were deemed to have been contributed to it by Holdings in an otherwise tax-free contribution to capital in exchange for FishNet common stock.

FishNet immediately made a one-time cash distribution to Holdings, which reported the distribution as a dividend, taxable as long-term capital gain, which it allocated as flow-through income to its sole shareholder, Mr. Fish.

The IRS disagreed.  It claimed that the money distributed to Holdings constituted “boot” in the otherwise tax-free contribution of capital to FishNet.  The gain realized by Holdings in the exchange should, the IRS said, be taxed to the extent of the boot received.  Moreover, the IRS asserted, that gain should be taxed as ordinary income under Code Section 1239.  Under this provision, gain realized on the sale of property between certain “related” persons is treated as ordinary income if the property is depreciable or amortizable in the hands of the transferee.

The Tax Court agreed with the IRS that the distribution constituted taxable boot.  The Court explained that FishNet acquired an amortizable intangible from Holdings – the goodwill associated with the business – in exchange for FishNet common stock and cash.  When the cash was distributed to Holdings and gain was recognized, FishNet’s basis in the goodwill was increased and became amortizable.  (Indeed, FishNet claimed an amortization deduction following the transaction.)  Thus, if Holdings and FishNet were “related persons” under Section 1239, the gain would be taxed as ordinary income.

For purposes of Section 1239, “related persons” include a person and all entities which are “controlled entities” with respect to such person.  FishNet would be controlled by Holdings if the latter owned either more than 50% of the total voting power or of the total value of the FishNet stock.

The taxpayer argued that the shareholders’ agreement between Holdings and Edgewater included a number of restrictions on FishNet and its management.  For example, so long as Edgewater remained a shareholder, it prohibited a number of corporate actions without the prior written consent of a majority of the preferred stock.  Thus, notwithstanding Holdings’ record ownership of more than 50% of the FishNet voting stock, the taxpayer claimed that its actual voting power was less.

According to the Court, notwithstanding the various restrictions and negative covenants contained in the FishNet shareholders’ agreement (included at the behest of Edgewater), FishNet was a “controlled entity” as to Holdings.  The latter, in fact, owned more than 50% of the total combined voting power of all classes of FishNet voting stock, and more than 50% of the total value of shares of all classes of FishNet stock.  Moreover, Mr. Fish, as CEO and chairman of the FishNet board, continued to have primary control of the corporation’s business and affairs, effectively maintaining Holdings’ voting power.  The Court concluded that Mr. Fish was “essentially [FishNet], and it was his expertise and management of the company that was being purchased.”  This conclusion was supported by the fact that FishNet’s valuation was comprised almost entirely of goodwill, which was derived from Mr. Fish’s expertise, contacts and management.  The Court distinguished other cases in which restrictive covenants affected the rights of shareholders, pointing out that those cases involved large corporations, where the shareholders were “far removed from the management and operations” of the corporations.  In this case, the Court pointed out, Holdings had significant management control regardless of the negative covenants.

The Court in Fish confronted an interesting tax issue, and its analysis is instructive.  The important takeaway from its decision, however, is the Court’s emphasis on the closely-held nature of the business and the active involvement of its owner.  Fish presents only one of many scenarios in which the number of shareholders or shareholder-employees plays a significant role in determining the tax consequences of a transaction.  Other scenarios include the tax treatment of redemptions, the presence of a substantial risk of forfeiture as to compensation, and many others that are frequently encountered by closely-held businesses, where the “standard” analysis may not be appropriate. The bottom line: it behooves such a business to consider closely the tax ramifications of its capitalization, distribution, and other transactions involving its owners.