Missed Part I? Check it out here!
“Related Party” Transactions
Valuations figure prominently in determining the proper tax treatment of transactions – such as sales, loans, leases, and performance of services – between related taxpayers, including, for example, commonly-controlled business entities.
The IRS is authorized to allocate items of income or deduction, or any other items affecting taxable income, so as to ensure that the related parties properly reflect their income attributable to such transactions – in other words, that the transactions reflect an arm’s-length result.
The IRS thus requires that a taxpayer use the method that, under the facts and circumstances, provides the most reliable measure of an arm’s-length result. In determining the best method, data based on the results of transactions between unrelated parties provides the most objective basis for determining whether the results of a transaction are arm’s-length.
Where a corporation or partnership sells or leases property to one of its owners in exchange for an amount of consideration that is less than the relevant FMV, the entity may be treated as having made a distribution to the transferee. Depending upon the facts and circumstances, this constructive distribution may be taxable to the transferee.
Where the transferee has provided services to the business entity, the bargain element of the transaction may be treated as a compensation to the transferee.
Where a corporation distributes property to its shareholders, either as a dividend or as a liquidating distribution, the corporation will be treated as having sold such property. Thus, if the FMV of the property exceeds the corporation’s adjusted basis in the property, the corporation will realize a taxable gain.
Where a taxpayer contributes property to a corporation or partnership and the value of the equity issued to the taxpayer in exchange for the contribution is less than the FMV of the property contributed, the IRS may characterize the difference according to its “true” nature; for example, has the contributor made a gift to the other owners, a payment for services, or the repayment of a debt?
Capital Contributions of Property
How many of you have responded to the question on the federal partnership tax return: did the partner contribute property with a built-in gain?
How about the question on the federal S-corporation tax return: if the corporation was a C-corporation before it elected to be an S-corporation, or the corporation acquired an asset from a C-corporation in a tax-free exchange, does it have any built-in gain?
How many of you have obtained appraisals in connection with such a contribution to the partnership or in connection with an “S” election?
It is imperative that you obtain an appraisal in these situations, in order to minimize the allocation issues for the contributing partner and the exposure to corporate-level tax.
Second Class of Stock
Speaking of S-corporations, the regulations provide that buy-sell agreements among shareholders, agreements restricting the transferability of stock, and redemption agreements are disregarded in determining whether a corporation’s outstanding shares of stock confer identical distribution and liquidation rights unless (1) a principal purpose of the agreement is to circumvent the one class of stock requirement, and (2) the agreement establishes a purchase price that, at the time the agreement is entered into, is significantly in excess of or below the FMV of the stock.
Because the first requirement is subjective and, so, often presents an issue, most taxpayers choose to rely upon the second, relating to purchase price.
Agreements that provide for the purchase or redemption S-corporation of stock at book value or at a price between fair market value and book value are not considered to establish a price that is significantly in excess of or below the FMV of the stock. A good faith determination of fair market value will be respected unless it can be shown that the value was substantially in error and the determination of the value was not performed with reasonable diligence.
It should be noted that although an agreement may be disregarded in determining whether shares of stock confer identical distribution and liquidation rights, payments pursuant to the agreement may have income or transfer tax consequences.
Sale of Business
Whether the client is the sole owner of a business or one of several, it behooves the owner(s) to make sure they are getting the right price for their business.
This will be especially important where there are minority shareholders who may object to the sale negotiated by the majority owner – whether on principle, or because of the price, or because they will not be continuing in any employment or other capacity with the buyer.
Allocation of Purchase Price
There are several circumstances, attendant to the sale of a business or of an interest in a business, where the amount paid for the acquisition of the property must either be allocated among the assets purchased or attributed to the underlying assets of the business an interest in which is being acquired.
This allocation/attribution has both income and state transfer tax consequences.
Among these situations are the following:
- Purchase/sale of the assets of a business (ordinary income v. capital gain; sales tax).
- Purchase/sale of the stock of a corporation coupled with an election to treat the transaction as a sale of its underlying assets (ordinary income v. capital gain).
- Purchase/sale of an interest in a partnership that holds “hot assets” (ordinary income v. capital gain).
- Purchase/sale of stock/partnership interest in an entity that owns NY real property (NY State and NYC transfer tax).
- Election to adjust a transferee partner’s share of inside basis for a partnership asset (future depreciation/amortization/gain).
In order for a “reorganization” to qualify for tax-free treatment, it must meet certain statutory and regulatory requirements, including a requirement under proposed regulations that there be a surrender of net value (really an extension of the continuity of interest principle), determined by reference to the assets and liabilities of the target, and a receipt of net value, determined by reference to the assets and liabilities of the issuing corporation.
In other words, the FMV of the property transferred by the target must exceed the amount of the target liabilities assumed by the acquiring corporation in connection with the exchange. Similarly, the FMV of the assets of the issuing corporation must exceed the amount of its liabilities after the exchange.
No business owner wants his business to generate losses, but it happens. For some start-up businesses, the losses eventually give way to profits. In other cases, losses may be realized as a result of a downturn in the economy or the departure of a significant client.
Whatever the reason, another business or investor may see something in the struggling corporation that is worth saving or acquiring. When this person acquires stock in the corporation, or acquires the assets of the corporation in a tax-free reorganization, the target or acquiring corporation, as the case may be, could be limited in its ability to utilize the target’s NOLs.
Specifically, if there is a greater than 50% change in the beneficial ownership of the target, the target’s or acquirer’s ability to utilize the losses will be limited as follows: the amount of such losses that may be claimed by the target or acquirer in any tax year will be capped at an amount equal to the product of the FMV of the target and the long-term tax-exempt rate issued by the IRS.
Aggressive valuations can result in the imposition of significant so-called “accuracy-related penalties.”
For example, if a gift or estate tax deficiency is based upon a substantial understatement of value for a property, the IRS may impose a 20% penalty upon that portion of the deficiency that is attributable to such understatement.
There is a similar result in the case of an income tax deficiency that is based upon a substantial valuation misstatement, including an overvaluation of a property or of a property’s adjusted basis.
This penalty may also apply where the price for any property, for the use of any property, or for a service, in connection with a transaction between certain related persons is either too high or too low compared to the correct price.
Where the misstatement of value is especially egregious, the penalty may be increased to 40%.
There are many other situations in which a closely-held business, its owners, and their advisers will have to consider retaining the services of a qualified appraiser in order to give themselves a reasonable chance of defending the desired tax consequences of a transaction. After all, the IRS’s determination of a tax deficiency (whether derived from a re-valuation of property or otherwise) is presumed to be correct, and the taxpayer has the burden of proving that the IRS’s determination is invalid.
When last I checked, business appraisers – like investment bankers, business consultants, accountants, lawyers, and other service providers to the business community – do not work for free. Based upon the foregoing discussion, these other advisers may be seriously compromised in doing their jobs without the services of a reputable and qualified appraiser.
Thus, the old English maxim, “be careful not to be penny-wise and pound-foolish.”