Ah, December

As we near the end of the taxable year ending December 31, 2017, the thoughts of most people turn to holidays and family gatherings, feasting and celebrations, and reflecting, perhaps, on another year gone-by.

Not so for tax professionals.

Instead of “visions of sugar plums” dancing in their heads, these poor folk dream of proposed legislation, obsess over the effective dates of regulations, struggle to close year-end transactions and to implement last-minute tax planning, and prepare for the upcoming tax filing season.

Speaking of tax filings, there is a new filing obligation that should be of interest to U.S. tax professionals who advise foreigners with U.S. investments or U.S. business interests. This filing requirement went into effect for taxable years beginning on or after January 1st of 2017; thus, the first returns to be filed under the new requirement will be due in early 2018.

Specifically, if a domestic LLC is wholly-owned by one foreign person, and it is otherwise treated as a disregarded entity for tax purposes, then the LLC must comply with certain reporting and record maintenance requirements that were previously limited to foreign-owned U.S. corporations.

Entity Classification

In general, a business entity with two or more members is treated, for tax purposes, as either a corporation or a partnership, and a business entity with a single owner is treated as either a corporation or an entity disregarded as separate from its owner (“disregarded entity”).

Certain domestic business entities, such as LLCs, are classified by default as partnerships (if they have more than one owner) or as disregarded entities (if they have only one owner), but are eligible to elect for federal tax purposes to be classified as corporations.

Some disregarded entities are not obligated to file a return or to obtain an employer identification number. According to the IRS, the absence of a return filing obligation (and the associated record maintenance requirements), made it difficult for the IRS to implement and enforce the tax laws applicable to foreigners that invest, or operate a business, in the U.S. through as disregarded entity.

Information Reporting

Under the Code, a domestic corporation that is at least 25% foreign-owned (a “reporting corporation”) is subject to specific information reporting and record maintenance requirements.

A reporting corporation is required to file an annual return on IRS Form 5472, Information Return of a 25% Foreign-Owned U.S. Corporation or a Foreign Corporation Engaged in a U.S. Trade or Business, with respect to each “related party” (including, among others, the 25%-foreign shareholder) with which the reporting corporation has had any “reportable transactions” including, for example, sales, leases, services, rentals, licenses, and loans.

The Form 5472 for a tax year must be attached to the reporting corporation’s income tax return for such year by the due date (including extensions) of the return. A separate Form 5472 must be filed for each foreign or domestic related party with which the reporting corporation had a reportable transaction during the tax year.

The reporting corporation must also keep books and records that are sufficient to establish the accuracy of the federal income tax return of the corporation, including information, documents, or records to the extent they may be relevant to determine the correct U.S. tax treatment of its transactions with related parties.

An Issue for the IRS

When a foreign-owned entity, such as an LLC, was classified as a corporation or a partnership for tax purposes, general ownership and accounting information was available to the IRS through the return filing and EIN application requirements.

Before 2017, however, when a single-member, foreign-owned, domestic LLC was treated as a disregarded entity for tax purposes, it was generally not subject to a separate income or information return filing requirement. Its owner was treated as owning directly the entity’s assets and liabilities, and the information available with respect to the disregarded entity depended on the foreign owner’s own return filings, if any were required.

Thus, if the LLC was wholly-owned by a foreign corporation, foreign partnership, or nonresident alien individual, generally no U.S. income or information return would have been required if neither the disregarded LLC nor its owner received any U.S. source income or was engaged in a U.S. trade or business.

Moreover, if the disregarded entity only received certain types of U.S. source income, such as portfolio interest or U.S. source income that was fully withheld upon at source, its foreign owner would not have had a U.S. return filing requirement.

The IRS found that even in cases when the disregarded entity had an EIN, as well as in cases when income earned through a disregarded entity had to be reported on its owner’s return (for example, income from a U.S. trade or business), it could be difficult for the IRS to associate the income with the disregarded entity based solely on the owner’s return.

The absence of specific return filing, and associated recordkeeping, requirements for foreign-owned, single-member domestic entities, and the resulting lack of ready access to information on ownership of, and transactions involving, these entities, made it difficult for the IRS to ascertain whether the entity or its owner was liable for any federal tax.

New Reporting Obligation

Thus, at the end of 2016, the IRS adopted a new regulation under which a domestic LLC, that is wholly-owned (directly, or indirectly through one or more other disregarded entities) by one foreign person, is treated as a domestic corporation (i.e., as an entity that is separate from its owner) for the limited purposes of the reporting and record maintenance requirements (including the associated procedural compliance requirements) described above. Importantly, it does not alter the framework of the existing entity classification regulations, including the treatment of certain LLCs as disregarded for income tax purposes.

By treating an affected LLC as a foreign-owned domestic corporation, the LLC becomes a “reporting corporation.” Consequently, it is required to file a Form 5472 information return with respect to any “reportable transactions” between the LLC and its foreign owner or other foreign “related parties” (transactions that would have been regarded under general U.S. tax principles if the entity had been, in fact, a corporation for U.S. tax purposes) including, for example, sales, leases, services, rentals, licenses, and loans. It is also required to maintain records sufficient to establish the accuracy of the information return and the correct U.S. tax treatment of such transactions. In addition, because the foreign-owned LLC has a filing obligation, it is required to obtain an EIN.

To ensure that a wholly-owned LLC reports all of its transactions with its foreign owner and other related parties, even if its foreign owner already has an obligation to report the income resulting from those transactions (for example, transactions resulting in income effectively connected with the conduct of a U.S. trade or business), the regulations specify, as an additional reportable category of transaction, any transaction to the extent not already covered by another reportable category. Thus, for example, contributions and distributions (both current and liquidating) are considered reportable transactions with respect to a “reporting LLC.”

Accordingly, any transaction between such an LLC and its foreign owner (or another disregarded entity of the same owner) would be considered a reportable transaction for purposes of the reporting and record maintenance requirements, even though, because the transaction involves a disregarded entity, it generally would not be considered a transaction for other tax purposes.

In order to facilitate the implementation of this reporting requirement, the reporting LLC is treated as having the same taxable year as its foreign owner, if the foreign owner has a U.S. return filing obligation. If the foreign owner has no U.S. return filing obligation, then the LLC is treated as having the calendar year as its taxable year.

Penalties

The penalty provisions associated with the failure to file the Form 5472 and the failure to maintain records will apply to reporting LLCs. For example, a penalty of $10,000 will be assessed against any reporting LLC that fails to file Form 5472 when due. The penalty also applies for a failure to maintain records as required. If the failure continues for more than 90 days after notification by the IRS, additional penalties will apply.

What Does It Mean?

Ah, the beginning of a new taxable year, and of a new era of transparency for many foreign-owned LLCs. What is one to do?

For starters, the U.S. professionals who advise these entities and their owners should alert them of the new reporting requirements, if they haven’t already done so. They should also be on the lookout for new Form 5472 instructions.

If a reporting LLC does not already have one, it must obtain an EIN as soon as possible. In connection therewith, the LLC will have to identify its “responsible party” (basically, the individual who controls the disposition of the LLC’s funds and assets), which means that the responsible party will itself have to obtain its own U.S. identification number (for example, an ITIN).

In addition, the LLC, its foreign owner, and their U.S. advisers will have to make certain that they have properly documented their 2017 reportable transactions, have maintained sufficient records to substantiate the accuracy of the information return to be filed by the LLC, and have implemented the appropriate internal procedures to ensure future compliance with the new reporting requirement.

Old Dog, New Tricks?

It’s a concern for every new investor in a closely held business: will the founding owners continue to operate the business as they always have, or will they recognize that they now have new co-owners to whom they owe a fiduciary duty, and on whom they made be dependent for funding or services, and will this recognition inform their actions with respect to the business and guide their relationship with the new investors?

Because of this concern, the new investor will insist that the owners enter into a shareholders’ or partnership agreement that includes various provisions that seek to protect the new owners’ rights, and to limit the original owners’ ability to ignore those rights and thereby compromise the economic benefits sought by the new investors.

Unfortunately, at least from the perspective of the new investor, it is not unusual for the founder, notwithstanding any shareholders’ or partnership agreement, to “forget” that he has others to whom he has to report. While such “forgetfulness” will strain the relationship among the owners of any business entity, it can be especially stress-inducing in the context of a pass-through entity like a partnership or an S corporation, the income of which is taxed to its owners without regard to any owner’s ability to influence or control the entity’s activities.

Yet Another Example

In a recent case before the Tax Court, the taxpayer tried to convince the Court that she should not be required to include her share of S corporation income in her gross income because the controlling shareholder had effectively prevented her from enjoying the beneficial ownership of her shares.

Corp was created by Founder to operate a diagnostic laboratory. Founder approached Taxpayer – who worked with Merchant Bank (“MB”) – to ask whether she would consider getting involved in Corp. Taxpayer and Founder discussed certain issues that Corp was facing, including its lack of a solid financial infrastructure.

Corp eventually entered into a consulting agreement with MB, under which MB would assist Corp with settling existing liabilities, diversifying the business, and implementing a financial infrastructure. In consideration for these services, Corp would pay MB a fixed monthly fee.

As part of this arrangement, Founder’s ownership of Corp was reduced to 50%, and members of MB or their designees (MB shareholders, including Taxpayer) acquired ownership of the other 50%.

Shareholders’ Agreement

The shareholders of Corp executed a Shareholders’ Agreement. The Agreement named various individuals, including Founder and Taxpayer, as officers of Corp. The board of directors of Corp consisted of its officers, including Taxpayer. The Shareholders’ Agreement stated that “[a]ll matters relating to the management of [Corp’s] business and operations of any kind or nature whatsoever shall be approved by a majority vote of [Corp’s] Board of Directors.” The board of directors, however, met only once after executing the Shareholders’ Agreement.

The Shareholders’ Agreement further stated:

The timing and amount of any distributions of net profits or cash flow from [Corp’s] operations or otherwise (the “Distributions”) to be made by [Corp] to the Shareholders hereunder shall be approved by the Board of Directors . . . . All Distributions shall be made by [Corp] to the Shareholders pari passu in accordance with their proportionate Share ownership hereunder.

In addition, the Agreement implemented a new payment approval procedure for Corp, stating:

The authorizing resolution to be delivered to the bank or other depository of funds of [Corp] shall provide that any officer signing singly may execute all checks or drafts of [Corp] in an amount up to $100,000.00, and two (2) persons consisting of [Founder] and one (1) member of the MB shareholders, shall be authorized as joint signatories in respect of all checks or drafts on behalf of the [Corp] in excess of $100,000.00.

Nevertheless, Corp frequently made payments in excess of $100,000 that were not authorized in conformity with the Shareholders’ Agreement.

Finally, the Agreement gave the shareholders the right to inspect and copy all books and records of Corp. At the beginning of MB’s relationship with Corp, Corp’s CFO distributed copies of monthly financial statements to representatives of the MB shareholders.

The Loan

One concern raised by Corp’s financial statements involved a loan from Founder to Corp close to the time of its organization. General ledgers made available to the MB shareholders, and reviewed as part of MB’s due diligence, showed a loan balance in excess of $7 million. Money paid by Corp on Founder’s behalf, including personal expenses, was charged against this loan, reducing the loan balance, and interest on the loan was paid to Founder monthly.

An audit of Corp’s financial statements found that payments made from Corp to Founder were recorded on the loan payable’s general ledger account, and the loan appeared as a “Note Payable” on the audited financial statements, and appeared as “Liabilities” on Corp’s Federal income tax returns. However, no “Loan from Shareholder” was reflected on the Schedules L of Corp’s Federal income tax returns on Form 1120S.

As Founder’s relationship with MB and the MB shareholders began to deteriorate, Taxpayer approached Founder concerning certain Corp expenses that Taxpayer believed were personal and unrelated to Corp’s business.

At that point, Founder no longer permitted MB and the MB shareholders to enter Corp’s premises, and he instructed Corp’s employees to stop providing financial information to them. Corp also stopped paying MB for its consulting services.

Unbeknownst to the MB shareholders, Founder also filed a complaint seeking judgment against Corp for the loans he claimed to have made to Corp over the course of many years. Founder served the complaint on the comptroller of Corp, Corp did not defend the lawsuit, and a default judgment was entered against Corp.

MB sued Founder for breach of the consulting agreement and failure to pay consulting fees. In reaction to this lawsuit, Founder filed for chapter 11 bankruptcy.

The bankruptcy court appointed a forensic accountant to investigate Corp’s business operations. The accountant’s report determined that the transfers of funds to Founder disputed by MB and the MB shareholders were recorded on the books by Corp as loan repayments. The report also described the default judgment that Founder had obtained against Corp.

As a result of the above findings, the bankruptcy court appointed a trustee as a financial overseer of Founder’s activities at Corp. The trustee was responsible for evaluating the financial status of Corp, taking financial control, and reporting his findings to the bankruptcy court. During the trustee’s time with Corp, payments of expenses or transfers of funds could not be accomplished without his approval. Additionally, the trustee provided Corp’s shareholders with monthly financial reports.

The Tax Returns

When Taxpayer filed her Forms 1040, U.S. Individual Income Tax Return, for the taxable years at issue, she attached to the return a Form 8082, Notice of Inconsistent Treatment or Administrative Adjustment Request. The Form 8082 included the following statement pertaining to Taxpayer’s ownership interest in Corp:

[Corp] has initiated litigation against the [T]axpayer retroactively contesting [T]axpayer’s ownership interest. The entity and certain shareholders have prevented [T]axpayer from exercising [her] shareholder rights including: sale of shares, voting on business matters, exercising dominion and control of the ownership interest, or enjoying any economic benefits or other ownership rights. The referenced Schedule K-1 is inconsistent with the entity’s contention that [T]axpayer is not entitled to any ownership interest. Therefore until legal ownership is resolved by the court, it was improper for the controlling shareholders to issue a Schedule K-1 to [T]axpayer, and those amounts are not reported in this return.

The issue for decision before the Tax Court was whether Taxpayer was a shareholder of Corp during the years in issue and was, therefore, liable for tax on her pro rata share of Corp’s income for the taxable years at issue.

Court’s Analysis

The Code provides that the shareholders of an S corporation are required to take into account their pro rata shares of the S corporation’s income, loss, deductions, and credits for the S corporation’s taxable year ending with or within the shareholders’ taxable year. An S corporation’s shareholders must take into account the corporation’s income regardless of whether any income is distributed to the shareholder.

The Court stated that, in determining stock ownership for Federal income tax purposes, it must look to the beneficial ownership of shares, not to mere legal title. Cases concluding that a shareholder did not have beneficial ownership, the Court continued, have considered both agreements between shareholders that effectively eliminated ownership, and provisions in the corporation’s governing articles affecting ownership rights.

Mere interference, the Court observed, with a “shareholder’s participation in the corporation as a result of a poor relationship between the shareholders * * * does not amount to a deprivation of the economic benefit of the shares.”

Taxpayer contended that while she was issued Corp shares, the removal of her power to exercise shareholder rights, as well as the actions of Founder, “removed” the beneficial ownership of her shares; therefore, Taxpayer asserted, she was not required to include in gross income her “pro rata share” of Corp’s income.

The Court noted, however, that Taxpayer identified no agreement, nor any provisions in Corp’s governing articles, removing her beneficial ownership.

Moreover, Taxpayer identified no authority supporting her position that a violation of a shareholders’ agreement could deprive shareholders of the beneficial ownership of their shares.

Further, Taxpayer cited no authority that allowed a shareholder to exclude her share of an S corporation’s income because of poor relationships with other shareholders.

In the absence of an agreement passing Taxpayer’s rights to her stock to another shareholder, a poor relationship between shareholders did not deprive Taxpayer of the economic benefit of her shares. Indeed, the Court pointed out, Taxpayer ultimately sold her shares for valuable consideration.

The Court held that because Taxpayer remained a shareholder of Corp for the taxable years at issue, she had to include in gross income her pro rata share of Corp’s income for those years.

Takeaway

The Taxpayer was hardly the first to argue that she was not liable for the tax on her share of S corporation income because she was improperly denied the beneficial ownership of shares in the corporation, notwithstanding her record ownership.

As in other cases, the Tax Court rejected Taxpayer’s position, noting that when a controlling shareholder merely interferes with another shareholder’s participation in the corporation, such interference does not amount to a deprivation of the economic benefit of the shares. Thus, the shareholder is not relieved from reporting her share of the S corporation’s income on her tax return.

A minority owner in any pass-through entity must appreciate the risk that she may be denied the opportunity to participate in the business in any meaningful way, that she may be denied any opportunity for gainful employment in the business, and that she may not receive any distributions from the entity.

The minority owner must also recognize that even when she is fortunate to be party to an agreement with the other owners that provides for mandatory tax distributions and for super-majority voting for certain decisions, such an agreement is meaningless in the face of a majority’s disregard of its terms unless the minority owner actually seeks to enforce the agreement.

In the face of a stubborn or determined founder, a minority owner must be prepared to act fairly quickly to protect herself, or “accept” the economic and tax consequences of having to report her share of the entity’s net income on her tax return. In that case, the minority owner must look to her other assets to provide the cash necessary to satisfy the resulting tax liabilities.  This can turn into an expensive proposition.

A post earlier this year considered the basis-limitation that restricts the ability of S corporation shareholders to deduct their pro rata share of the corporation’s losses. It was observed that, over the years, shareholders have employed many different approaches and arguments to increase the basis for their shares of stock or for the corporation’s indebtedness, in order to support their ability to claim their share of S corporation losses.

Many of these arguments have been made in situations in which the shareholder did not make an economic outlay, either as a capital contribution or as a loan to the S corporation.

In a recent decision, however, the Tax Court considered a shareholder who did, in fact, make a significant economic outlay, but who also utilized a form of transaction – albeit for a bona fide business purpose – that the IRS found troublesome. In defending its right to claim a loss deduction, the shareholder proffered a number of interesting arguments.

The Transaction

Taxpayer owned Parent, which was taxed as an S corporation.

Parent acquired 100% of the issued and outstanding stock of Target from Seller through a reverse triangular merger: Parent formed a new subsidiary corporation (“Merger-Sub”), which was then merged with and into Target, with Target surviving. As a result of the merger, Target became a wholly-owned subsidiary of Parent, and the Seller received cash plus a Merger-Sub promissory note; Target became the obligor on the note after the merger.

Immediately after the merger, Target made an election to be treated as a qualified subchapter S subsidiary (“QSub”).

The cash portion of the merger consideration was funded in part by a loan (the “Loan”) from Lender, which was senior to the promissory note held by Seller.

After the merger, Taxpayer decided to acquire the Loan from Lender. However, Taxpayer believed that (i) if he loaned funds directly to QSub to acquire the Loan, or (ii) if he contributed funds to Parent, intending that they be loaned to QSub to repay the Loan in full, his loan would not be senior to the QSub note held by Seller without obtaining Seller’s consent.

In order to make QSub’s repayment of the Loan to Newco senior to QSub’s repayment of the note to Seller, Taxpayer organized another S corporation, Newco, to acquire the Loan from Lender. Taxpayer transferred funds to Newco, which Newco used to purchase the Loan, following which Newco became the holder of the Loan.

Thus, the indebtedness of QSub was held, not directly by Taxpayer, but indirectly through Newco.

During the Tax Year, Parent had ordinary business losses that were passed through to Taxpayer.

The Tax Return

In preparing his return for Tax Year, Taxpayer used his adjusted basis in the Parent stock, and also claimed adjusted basis in what he believed was QSub’s indebtedness to Taxpayer, to claim deductions for the losses passed through to Taxpayer from Parent for the Tax Year.

The IRS reduced the losses Taxpayer could take into account for the Tax Year, thereby increasing Taxpayer’s taxable income by that amount. Taxpayer petitioned the Tax Court.

Taxpayer argued that Newco should be disregarded for tax purposes, and that the Loan should be deemed an indebtedness of Parent (through its disregarded QSub) to Taxpayer. This would allow Taxpayer to count Newco’s adjusted basis in the Loan in calculating the amount of Parent’s flow-through losses that he could deduct for the Tax Year.

The IRS urged the Court to respect Newco’s separate corporate existence, and not to treat the Loan as indebtedness of Parent to Taxpayer.

S Corp. Losses

The Code generally provides that an S corporation’s shareholder takes into account, for his taxable year in which the corporation’s taxable year ends, his pro rata share of the corporation’s items of income, loss, deduction, or credit.

However, the aggregate amount of losses and deductions taken into account by the shareholder is limited: It may not exceed the sum of the adjusted basis of the shareholder’s stock in the S corporation plus the shareholder’s adjusted basis of any indebtedness of the S corporation to the shareholder (the “loss-limitation rule”).

The Code does not define the term “indebtedness of the S corporation to the shareholder” as used in the loss-limitation rule.

QSub

A QSub is a domestic corporation which is wholly-owned by an S corporation, and that elects to be treated as a QSub. In general, a QSub is not treated as a separate corporation, and all of its assets, liabilities, and items of income, deduction, and credit are treated those of the S corporation. Thus, for purposes of the loss-limitation rule, a QSub’s indebtedness to its parent S corporation’s shareholder is treated as the parent’s indebtedness for purposes of determining the amount of loss that may flow through to the parent’s shareholder.

Acquisition of Basis in Indebtedness of Parent

The IRS argued that a shareholder can acquire basis in an S corporation either by contributing capital, or by directly lending funds, to the corporation. The loan must be direct, the IRS maintained; no basis is created where funds are loaned by a separate entity that is related to the shareholder.

The IRS emphasized that the Loan ran to QSub from Newco, not from Taxpayer; thus, the Loan could not be considered in computing the basis of any indebtedness of Parent to Taxpayer.

Taxpayer conceded that the courts have interpreted the loss-limitation rule generally to require that the indebtedness of an S corporation be owed directly to its shareholder. However, the Taxpayer asserted, “form is but one-half of the inquiry, and the transaction’s substance also needs to be considered.”

The IRS asserted that Taxpayer ought to be bound by the form of the transaction chosen, and should not, “in hindsight, recast the transaction as one that they might have made in order to obtain tax advantages.”

Moreover, the IRS pointed out, where the entities involved in transactions are wholly-owned by a taxpayer, the taxpayer bears “a heavy burden of demonstrating that the substance of the transactions differs from their form.”

Taxpayer posited that an intermediary, such as Newco, could be disregarded for tax purposes where it (1) acted as a taxpayer’s incorporated pocketbook, (2) was a mere conduit or agent of the taxpayer, or (3) failed to make an actual economic outlay to the loss S corporation that made the intermediary poorer in a material sense as a result of the loan.

Incorporated Pocketbook

Taxpayer urged the Court to find that Newco acted as the Taxpayer’s incorporated pocketbook in purchasing the Loan from the Lender and holding it thereafter.

Taxpayer emphasized that Newco had no business activities other than holding the Loan and acting as a conduit for payments made by QSub.

The Court observed that the term “incorporated pocketbook” refers to a taxpayer’s habitual practice of having his wholly-owned corporation pay money to third parties on his behalf.

The Court, however, stated that the “incorporated pocketbook” rationale was limited to cases where taxpayers sought to regularly direct funds from one of their entities through themselves, and then on to an S corporation. Here, the Court found, Taxpayer did not use Newco to habitually to pay QSub’s, or his own personal, expenses. “Frequent and habitual payments,” the Court stated, are “key to a finding that a corporation served as an incorporated pocketbook.” Newco did not make frequent and habitual payments on behalf of Taxpayer.

Conduit or Agent

Taxpayer also argued that Newco served as Taxpayer’s agent in purchasing the Loan from Lender and, as such, could be ignored for tax purposes.

Taxpayer pointed out that the Court had previously suggested that, in a true conduit situation, a loan running through a corporate intermediary could instead be considered to run directly from the shareholder for purposes of the loss-limitation rule.

Taxpayer emphasized that Newco had no business activity besides the Loan acquisition, and no assets besides the Loan; all the funds necessary to purchase the Loan came from Taxpayer; thus, Newco served effectively as a conduit for payments from Parent and QSub.

The IRS reminded the Court that, in other cases, it had been reluctant to apply the agency exception to the rule that indebtedness must run directly from the S corporation to its shareholder.

Moreover, the IRS argued, Parent, QSub, Newco and Taxpayer were sophisticated parties who consulted with their advisers before purchasing the Loan from Lender. They consciously chose the form of the transaction to maintain the Loan’s seniority with respect to QSub’s obligations under the notes.

The IRS also asserted that the record was devoid of any indication of an agency relationship.

The Court agreed with the IRS that Newco did not act as Taxpayer’s agent. It set forth several factors that are considered when evaluating whether a corporation is another’s agent, including:

  • whether it operates in the name, and for the account, of the principal,
  • whether its receipt of income is attributable to the services of the principal or to assets belonging to the principal,
  • whether its relations with the principal depend upon the principal’s ownership of it,
  • whether there was an agreement setting forth that the corporation was acting as agent for its shareholder with respect to a particular asset,
  • whether it functioned as agent, and not principal, with respect to the asset for all purposes, and
  • whether it was held out as agent, and not principal, in all dealings with third parties relating to the asset.

The Court reviewed each of these indicia, and concluded that no agency relationship existed between Newco and Taxpayer.

 Actual Economic Outlay

Taxpayer argued that: (i) Newco made no economic outlay to purchase the Loan, (ii) it was he who provided the funds used by Newco to purchase the Loan, (iii) he owned and controlled Newco, (iv) Newco was a shell corporation with no business or other activity besides holding the Loan, and (v) Newco’s net worth both before and after the Loan’s acquisition was the amount of Taxpayer’s capital contribution.

The IRS noted that the amounts contributed by Taxpayer to Newco were first classified by Newco’s bookkeeper as shareholder loans and then as paid-in capital, which increased Taxpayer’s basis in the Newco stock; accordingly, Taxpayer’s capital contributions to Newco, which increased his stock basis in that corporation, could not be used to increase his debt basis in Parent.

The IRS also disputed Taxpayer’s characterization of Newco as a shell corporation, arguing that Taxpayer had a significant business purpose in structuring the transaction as he did: the maintenance of the Loan’s seniority to Seller’s promissory note.

The Court agreed that Taxpayer did make actual economic outlays, and that these outlays were to Newco, a corporation with its own separate existence. It was not simply a shell corporation, but a distinct entity with at least one substantial asset, the Loan, and a significant business purpose. Taxpayer’s capital contributions, combined with Newco’s other indicia of actual corporate existence, were compelling evidence of economic outlay.

The Court also noted that taxpayers generally are bound to the form of the transaction they have chosen. Taxpayer failed to establish that he should not be held to the form of the transaction he deliberately chose. Therefore, any economic outlays by Taxpayer were fairly considered to have been made to Newco, a distinct corporate entity, which in turn made its own economic outlay.

Step Transaction Doctrine (?)

Finally, Taxpayer argued that the Court should apply the step transaction doctrine (really “substance over form”) to hold that Taxpayer, and not Newco, became the holders of the Loan after its purchase from Lender.

The IRS disputed Taxpayer’s application of the step transaction doctrine, arguing that Taxpayer intentionally chose the form of the transaction and should not be able to argue against his own form to achieve a more favorable tax result. The IRS added that because Newco was not an agent of or a mere conduit for Taxpayer, the form and the substance of the Loan acquisition were the same, and the step transaction doctrine should not apply.

Again, the Court agreed with the IRS, stating that Taxpayer’s “step transaction” argument was just another permutation of his other theories, which were also rejected by the Court.

Taxpayers, the Court continued, are bound by the form of their transaction and may not argue that the substance triggers different tax consequences. It explained that they have “the benefit of forethought and strategic planning in structuring their transactions, whereas the Government can only retrospectively enforce its revenue laws.”

Accordingly, the Court found that Taxpayer did not become the holder of the Loan after its acquisition from Lender.

Conclusion

Thus, the Court held that Taxpayer did not carried his burden of establishing that his basis in Parent’s (i.e., QSub’s) indebtedness to Taxpayer was other than as determined by the IRS.

Was it Equitable?

I suspect that some of you may believe that the Court’s reasoning was too formulaic. I disagree.

Both taxpayers and the IRS need some certainty in the application of the Code, so as to assure taxpayers of the consequences of transactions, to avoid abuses of discretion, and to facilitate administration of the tax system, among other reasons.

Of course equitable principles play an important role in the application and interpretation of the Code, but as to the Taxpayer, well, he was fully aware of the applicable loss-limitation rule, chose to secure a business advantage instead (a senior loan position) by not complying with the rule, which in turn caused him to resort to some very creative justifications for his “entitlement” to the losses claimed.

So, was the Court’s decision equitable? Yep.

Some Days Are Stones[1]

It’s not always easy to find a topic about which to write a weekly blog post. I usually look for a ruling or decision that illustrates one of the recurring themes of the tax law, and then develop a lesson or message around it. Sometimes I’ll use a project on which I’m working.

Some weeks are more fruitful than others. This week was a relatively lean one.

That being said, I did come across a recent letter ruling issued by the IRS that was short on facts and legal analysis, and the outcome of which would be obvious to most, but which I thought might serve my purpose.

The taxpayer to which the ruling was issued asked the IRS to consider whether the conversion of a State law limited liability company (“LLC”) into a State law limited partnership would cause the LLC or its members to recognize taxable income or gain.

Now, some of you may say, “big whoop.” (I did say the result was obvious.)

Nevertheless, the ruling does offer an opportunity for some fruitful discussion based upon the significance of the factual representations on which the ruling was based.

Basic Facts

LLC-1 was classified as a partnership for federal tax purposes. It had two managing members:

  • Corp-1 was a state law limited liability company that was classified as a corporation for tax purposes;
  • LLC-2 was a limited liability company that was disregarded as an entity separate from its owner for tax purposes;
    • Corp-2 was classified as a corporation for tax purposes, and was the sole member of LLC-2; thus, Corp-2 was treated as the second member of LLC-1 for tax purposes.

The other membership interests in LLC-1 were non-managing member interests owned either indirectly by Corp-2 (including through subsidiaries of LLC-2), or by other investors.

LLC-1 planned to convert to a limited partnership in accordance with State law (the “Conversion”), after which it would continue to carry on the business operations it previously conducted as a limited liability company before the Conversion.

Creation of Disregarded Entities

Before the Conversion, Corp-1, LLC-2, and one of LLC-2’s wholly-owned subsidiaries (we are not told whether this subsidiary was itself a disregarded entity – i.e., a limited liability company – or a corporation) would each form a single-member limited liability company (three in all) that would be disregarded as an entity separate from its respective owner for federal tax purposes (the “Disregarded Entities”).

In connection with the Conversion, LLC-2 and LLC-2’s subsidiary would each contribute all of its interest in LLC-1 (including its managing-member interest) to its respective Disregarded Entity. Corp-1 would contribute a portion of its interest in LLC-1 to its Disregarded Entity.

As part of the Conversion, the three Disregarded Entities would become the State law general partners of LLC-1; for tax purposes, their “regarded” owners (Corp-1, LLC-2 and LLC-2’s subsidiary) would be treated as the general partners of post-Conversion LLC-1 (as compared to the two State law managing members of pre-Conversion LLC-1).

(The ruling did not give the business reason for the Disregarded Entities. There are several possibilities, including planning for creditors upon the conversion of the managing member interests into general partner interests.)

The Representations

According to LLC-1, the limited partnership agreement that would replace its operating agreement would be substantively identical to the operating agreement; in other words, the economic arrangement among the members/partners, including the allocation of income, gain, loss, deduction, and credit among them would not be changed by virtue of the Conversion.

Consistent therewith, it was represented in the ruling that:

  • the balances in each partner’s (formerly member’s) capital account immediately after the Conversion would be the same as they were immediately before the Conversion
  • each partner’s total percentage interest in X’s profits, losses, and capital after the Conversion will be the same as that partner’s percentage interest in X’s profits, losses and capital before the Conversion, and the allocation of tax items will also remain unchanged
    • there would be no change in how they shared these tax items after the Conversion;
  • each partner’s share of liabilities of LLC-1 immediately after the Conversion would be the same as it was immediately before the Conversion
    • there would be no deemed distribution or deemed contribution of cash to any partner, or any deemed sale of partnership interests between any partners; there would be no change in any partner’s share of value, gain, or loss associated with the partnership’s unrealized receivables or inventory items in connection with the Conversion
    • thus, no partner would be treated as having exchanged an interest in so-called “hot assets” for a greater interest in other assets of the partnership, or vice versa, which could result in income or gain to such partner; and
  • LLC-1 would retain the same method of accounting and accounting period.

Interestingly, LLC-1 represented to the IRS that it had not issued any profits interest in the two years preceding the date of the Conversion. You may recall that a person’s receipt of a profits interest in a partnership will generally not be treated as a taxable event; this result will not follow, however, if the partner disposes of the profits interest within two years of receipt.

LLC-1 also represented that the “Sec. 704(b) book basis” of its property (the fair market value of the property at the time of its contribution to LLC-1, adjusted for subsequent book depreciation) that secured nonrecourse debt exceeded the amount of such debt; in other words, there was no “partnership minimum gain” – the gain that the partnership would realize if it disposed of the property for no consideration other than full satisfaction of the liability.

The IRS’s “Analysis”

According to the Code, an existing partnership is considered as continuing if it is not terminated. A partnership is considered as terminated only if: (1) no part of any business, financial operation, or venture of the partnership continues to be carried on by any of its partners in a partnership; or (2) within a 12-month period, there is a sale or exchange of 50 percent or more of the total interest in partnership capital and profits (a “technical termination”).

The IRS has, on several occasions, published rulings in which it examined the federal income tax consequences of a conversion of one form of partnership interest into another form of partnership interest in the same partnership. In general, provided each partner’s total percentage interest in the partnership’s profits, losses, and capital would remain the same after the conversion, and the partnership’s business would continue, no gain or loss would be recognized by the partners as a result of their exchanging their interests in the partnership.

Similarly, the IRS has previously ruled that the conversion of a domestic partnership into a domestic limited liability company classified as a partnership for tax purposes is treated as a partnership-to-partnership conversion that is subject to the same principles as an exchange of interests within the same partnership. It has also stated that the same holdings would apply if the conversion had been of an interest in a domestic limited liability company that is classified as a partnership for tax purposes into an interest in a domestic partnership.

IRS regulations provide that a business entity that is not classified as a corporation per se (a so-called “eligible entity”) can elect its classification for federal tax purposes. An eligible entity with at least two members can elect to be classified as either an association or a partnership, and an eligible entity with a single owner can elect to be classified as an association or to be disregarded as an entity separate from its owner. The regulations also provide that unless the entity elects otherwise, a domestic eligible entity will be treated as a partnership if it has two or more members.

Without further discussion, the IRS concluded that the Conversion would not cause a “technical termination” of LLC-1’s status as a partnership for tax purposes, and that neither LLC-1 nor its members would recognize taxable income, gain, or loss upon the Conversion.

Although not stated in the ruling, the IRS could have added that: the taxable year of the pre-Conversion limited liability company did not close as a result of the Conversion, the post-Conversion partnership would continue to use the EIN of the converted limited liability company, the tax elections made by the converted limited liability company would remain in effect as would its depreciation methods, and the members’ bases in their membership interests would carry over to their partnership interests.

So What? Is That It?

Pretty much.

The point is that there is a lot of thought and planning that goes into securing a “duh” ruling. The ruling becomes a foregone conclusion only because of the analysis, structuring and drafting that preceded it.

In the case of the ruling described herein, the failure of any of the representations set forth above may have resulted in a taxable event to one or more of the partners.

For that reason, it would behoove anyone who advises taxpayers and their business entities to become familiar with the kinds of representations that are made in connection with a “successful” ruling on a specific kind of transaction.

These representations highlight many of the issues that others have encountered in similar transactions over the years, and on which the IRS may be focusing. As such, they may provide a good starting point for an adviser’s consideration of, and planning for, his or her own client’s transaction.

 

[1] From “Some Days Are Diamonds” by Dick Feller, sung by John Denver.

Skirting Employment Tax?

The Code imposes the self-employment tax on the net earnings from self-employment derived by an individual during any taxable year.

In general, the term “net earnings from self-employment” means the net income derived by an individual from any trade or business carried on by such individual, plus his distributive share (whether or not distributed) of net income from any trade or business carried on by a partnership of which he is a member.

The shareholders of an S corporation are not subject to self-employment taxes on their distributive share of the corporation’s net income, though they and the corporation are subject to employment taxes on any wages paid to them by the corporation.

Over the years, many taxpayers have sought to reduce the exposure of their business income to employment tax.

Many taxpayers, for example, have organized their business as an S corporation, rather than as a partnership: they avoid entity-level tax; the corporation pays them a salary that is subject to employment tax but that may be considered low relative to the value of the services rendered; because the shareholders’ distributive share of S corporation income (after being reduced by their salary) is not subject to employment tax (in contrast to a partner’s share of partnership income), the shareholders are able to reduce their employment tax liability.

Of course, the IRS seeks to compel S corporations to pay their shareholder-employees a reasonable salary for services rendered to the corporation, so as to prevent the “conversion” of taxable income into investment income that is not subject to employment tax.

There are other items of income that are excluded from the reach of the employment tax, and which may be “manipulated” by some taxpayers in a manner similar to the payment of wages by some S corporations.

Among these exclusions is the rental income from real estate.

In contrast to wages, however, where the IRS’s concern is that the S corporation-employer may be paying an unreasonably low salary for the services rendered, thereby leaving the shareholder-employee with more “distributive share income” that is exempt from employment taxes, the concern as to rental payments is that a taxpayer-owner’s business may be paying an unreasonably large amount for the use of the owner’s separately-owned property, thereby reducing the taxpayer-owner’s net earnings from self-employment and the resulting employment tax.

The Tax Court recently considered a variation on the rental situation. The question presented was whether rent payments received by Taxpayer were subject to self-employment tax.

Well Life on a Farm is Kinda Laid-Back?

Taxpayer owned a farm, and performed the farm’s bookkeeping, other management services, and a portion of the physical labor.

During the years at issue, Taxpayer entered into an agreement (“Agreement’) with an unrelated party (“Chicken-Co”) pursuant to which Chicken-Co would deliver poultry to Taxpayer to be cared for in accordance with detailed instructions. Taxpayer was allowed to hire additional laborers or employees; however, Taxpayer’s discretion ended there.

Shortly thereafter, Taxpayer organized Corp as an S corporation. Using a recent appraisal which analyzed the cost of “performing” the Agreement purely as an investment (and not as an active business), Taxpayer entered into an employment agreement with Corp, and set his salary accordingly. Taxpayer agreed to provide bookkeeping services to Corp and, along with any hired laborers or employees, would provide the requisite labor and management services.

Chicken-Co approved Taxpayer’s assignment of the Agreement to Corp; nothing in the Agreement required Taxpayer to personally perform the duties required thereunder.

Taxpayer entered into a lease agreement with Corp by which Corp would rent the farm and various structures and equipment from Taxpayer. Corp agreed to pay rent to Taxpayer; Corp was required to remit each rent payment regardless of whether it had fulfilled its requirements under the Agreement or had received sufficient income. The rental amount represented fair market rent.

Corp fulfilled its duties under the lease, making all of the necessary rent payments to Taxpayer. At no point during the years in issue did Taxpayer believe that he was obligated to render farm-related services as a condition to Corp’s obligation pursuant to the lease to pay rent to Taxpayer. Corp also fulfilled its duties to Chicken-Co under the Agreement; Taxpayer was not obligated to perform farm-related services under the Agreement. Although Taxpayer participated in Corp’s activity, Corp consistently hired numerous laborers and professionals to carry out its obligations.

Trouble in the Henhouse?

Taxpayer reported: (i) rental income from Corp, which was excluded from self-employment tax; (ii) wages on which employment taxes had been paid; and (iii) a distributive share of Corp’s net income, which was not subject to self-employment tax.

The IRS determined that the “rental income” was subject to self-employment tax because, according to the IRS, it actually constituted net earnings from self-employment.

Taxpayer sought redetermination of the resulting deficiencies in the Tax Court, where the sole issue was whether the rent payments Taxpayer received were subject to self-employment tax; in other words, whether they represented something other than rental income.

Under the Code, the term “net earnings from self-employment” means the gross income derived by an individual from any trade or business carried on by such individual, less any allowable deductions. In computing such gross income and deductions, rental income from real estate is excluded.

The IRS contended that the rent payments Taxpayer received were subject to self-employment tax because, taking into account all the facts and circumstances, there existed an “arrangement” between Taxpayer and both Corp and Chicken-Co that required Taxpayer to materially participate in Corp’s farming activities under the Agreement.

Conversely, Taxpayer contended that the rent payments were not subject to self-employment tax because the rent payments were consistent with market rates, there was no nexus between the lease agreement, on the one hand, and either the Agreement or Taxpayer’s employment agreement with Corp, on the other, and neither of these agreements required Taxpayer’s material participation in Corp’s business.

“What’s It All About, Boy? Elucidate.” – Foghorn Leghorn 

The Court agreed with Taxpayer, stating that a rental agreement may stand on its own in certain circumstances, even despite the existence of a separate employment agreement requiring a taxpayer’s material services.

The fact that the rents in question, the Court stated, were consistent with market rates for farmland “very strongly” suggested that the rental arrangement stood “on its own as an independent transaction” and could not be said to be part of an “arrangement” for participation in the farming business activity. The same could be said where the rents in question were at, or below, fair market value.

The Court explained that Congress intended to apply the self-employment tax so as to provide benefits for individuals “based upon the receipt of income from labor, which old age, death, or disability would interrupt; and not upon the receipt of income from the investment of capital, which these events would presumably not affect.”

Therefore, Congress was careful, the Court continued, to exclude from self-employment income any amounts received as “rentals from real estate”; accordingly, the courts have interpreted this intent “to exclude only payments for use of space, and, by implication, such services as are required to maintain the space in condition for occupancy.”

However, when the tenant’s payment includes compensation for substantial additional services – and when the compensation for those services constitutes a material part of the payment – the “rent” consists partially of income attributable to the performance of labor not incidental to the realization of return from passive investment. In these circumstances, the Court stated, the entire payment is included in “net earnings from self-employment.”

The issue, then, becomes one of separating return of investment from compensation for services performed.

Did the Rent Stand on its Own?

Self-employment income generally is defined as “the net earnings from self-employment derived by an individual”. The Code defines “earnings from self-employment” as “the gross income derived by an individual from any trade or business carried on by such individual.”

The term “derived” necessitates a “nexus,” the Court stated, “between the income and the trade or business actually carried on by the taxpayer.” Under the “nexus” standard, according to the Court, income must arise from some income-producing activity of the taxpayer before that income is subject to self-employment tax.

The Code generally excludes rental real estate income from the computation of a taxpayer’s earnings from self-employment. This exclusion does not apply, however, if the income is derived under an “arrangement” pursuant to which the owner is required to, and actually does, materially participate in a farming activity (i.e., provide services in an active business activity) on his land.

In accordance with general tax concepts, the Court noted that the self-employment tax provisions are to be construed broadly in favor of treating income as earnings from self-employment, while the rental income exclusion is to be strictly construed.

Certain farming-related rental income is properly included in a taxpayer’s earnings from self-employment if the rental income is derived under an arrangement between the owner and tenant that specifies that the tenant will farm the rented land, and the owner will materially participate in the farming activity.

The Court interpreted the term “arrangement” broadly, finding that although the Taxpayer’s rental and employment agreements were separate, the Court would view the Taxpayers’ obligations within the overall scheme of the farming operations; the Court acknowledged that the income derived by one who owns and operates his own farm is often partially attributable to income of a rental character.

However, the Court added that, regardless of a taxpayer’s material participation – actual or required – if the rental income is shown to be less than or equal to fair market rental value, the rental income is presumed to be unrelated to any employment agreement or other business arrangement to which the taxpayer is a party; it does not “convert” included business income into excluded rental income. In that case, the rental agreement stands on its own, separate from the taxpayer’s farming/business activity.

As shown by the evidence, the rent payments Taxpayer received represented fair market rent. This, the Court found, was sufficient to establish that the lease agreement stood on its own. What’s more, Taxpayer had obtained a detailed analysis of the costs of operating the farm as an investment; in turn, Taxpayer priced Corp’s activities, including labor and management costs, to exceed the projected costs. The Court observed that these amounts were not merely remainder payments to Taxpayer after the rent checks were cashed. They were appropriate amounts for Corp to spend for the services required under the Agreement. The structuring of these expenses further illustrated the lengths to which Taxpayer went to operate Corp as a legitimate business, and not as a method to avoid self-employment tax.

Thus, the Court concluded that the rental agreement was separate and distinct from Taxpayer’s employment obligations and, therefore, the rental income was not includible in Taxpayer’s net self-employment income.

Observations

Where an agreement calls for rent payments that exceed what the market would bear, that excess may be evidence that there is an arrangement in which compensation for services is being disguised as rent, so that self-employment tax may be improperly avoided.

On the other hand, an agreement that calls for rent payments at fair market value, may be evidence that the arrangement does not involve disguised compensation for services, and may be relevant to the question of whether there is an arrangement linking rent and services.

The Court indicated that below-market rent is excluded from self-employment income because it does not “convert” taxable income into non-taxable income.

However, is it possible that a lower rent may act as an inducement for a larger payment elsewhere? Does the form of the transaction reflect its economic substance?

Regardless of the business, regardless of the circumstances, and regardless of the tax, the guidance is the same: if a taxpayer wants to avoid “tax surprises,” the taxpayer should treat with others on as close to an arm’s-length basis as possible. In most cases, this will in fact occur; where it doesn’t, the taxpayer has to understand the associated risks.

Beginning 2018, the IRS is authorized to collect from a partnership any tax deficiencies arising out of the partnership’s operations for a taxable year, even if the persons who were partners in the year to which the deficiency relates are no longer partners in the year that the deficiency is assessed.

Stated differently, the current-year partners will bear the economic burden of the tax liability even though the tax adjustments relate to a prior year in which the composition of the partnership may have been different.

How did we get to this, and what should partnerships and their partners be doing about it?

Bipartisan Budget Act of 2015

The number of partnerships and partners in the U.S. continues to increase, as do the total receipts and the value of total assets for all partnerships. LLCs classified as partnerships account for the majority of this growth. This development is a clear manifestation of the fact that the partnership represents the most flexible form of business entity.

As partnerships have grown in number, size, and complexity, the IRS has found it increasingly difficult to audit them and to collect any resulting income tax deficiencies, especially in the cases of large partnerships and tiered partnerships.

In response to these difficulties, Congress enacted the Bipartisan Budget Act of 2015 (the “BBA”), which added a number of new tax compliance provisions to the Code that become effective on January 1, 2018.

A key feature of the BBA is that it imposes liability for any audit adjustments with respect to an earlier partnership tax year on the partnership, rather than on those persons who were partners during the audited tax year.

Partnership Audits: Pre-2018

Prior to the BBA, two different regimes existed for auditing “closely-held” partnerships:

  • For partnerships with ten or fewer partners, the IRS generally applied the audit procedures for individual taxpayers, auditing the partnership and each partner separately.
  • For most large partnerships with more than ten partners, the IRS conducted a single administrative proceeding (under the so-called “TEFRA” rules, which were adopted in 1982) to resolve audit issues regarding partnership items that were more appropriately determined at the partnership level than at the  partner level.
    • Under the TEFRA rules, once the audit was completed and the resulting adjustments were determined, the IRS recalculated the tax liability of each partner in the partnership for the particular audit year.

New Default Rule: A “Taxable Partnership”

Under the BBA, the TEFRA rules are repealed, and the partnership audit rules are streamlined into a single set of rules for auditing partnerships and their partners at the partnership level.

Under  the streamlined  audit approach, the IRS  will examine the partnership’s  items of  income, gain, loss,  deduction, credit for  a particular  year of  the partnership  (the “reviewed  year”).

However, the IRS is no longer required to determine each partner’s share of the adjustments made to these partnership items, followed by a separate computational adjustment for each partner, to assess the correct tax due as a result of the partnership audit.

Instead, under the new default rules, any adjustments to these tax-related items of the partnership for the reviewed year will be taken into account by, and the tax liabilities attributable to these adjustments (including interest and penalties) – the “imputed underpayment” – will be assessed against, and collected from, the partnership.

Thus, the economic burden thereof will be borne by the persons who are partners of the partnership during the taxable year that the audit (or any administrative or judicial review thereof) is completed (the “adjustment year”) – not by those persons who were partners during the year to which the adjustments relate.

Moreover, the tax resulting from such adjustments will be computed at the highest marginal rate for individuals or corporations (as the case may be) in the reviewed year, without regard to the character of the income or gain.

Taxpayer Representative

In order to facilitate the application of the new audit regime, the BBA requires the designation by each partnership of a partnership representative (the “PR”). The PR, who does not need to be partner of the partnership, shall have the sole authority to act on behalf of the partnership in tax matters, and the partnership and all partners shall be bound by any actions taken by the PR, including in settlement of an audit.

Some Relief

The foregoing marks an important change in the audit of closely-held partnerships.

In recognition of this fact, and in order to address certain inequities that may result therefrom, the BBA provides some relief.

Where the imputed underpayment calculation exceeds the amount of tax that would have been due had the partnership and the partners reported the partnership adjustments properly, a partnership (and its partners) will have  the option of demonstrating  that the adjustment  would be  lower if  it were based  on certain  partner-level information  from the  reviewed year, and did not rely only on the partnership’s information for  such  year.

Thus, if one or more partners file amended returns for the reviewed year, such returns take into account the adjustments made by the IRS that are properly allocable to such partners, and payment of any tax due (calculated using the highest marginal rate of tax for the type of income and taxpayer) is included with the amended returns, the partnership’s imputed underpayment shall be determined without regard to the portion of the adjustments taken into account in the amended returns.

Small Partnership Election

The foregoing is not the only relief provided.

An eligible partnership is permitted to affirmatively elect out of the new audit regime, in which case the partnership and its partners will be audited under the pre-TEFRA audit procedures, under which the IRS must separately assess tax with respect to each partner under the deficiency procedures generally applicable to individual taxpayers.

In order to qualify for this “small partnership” election, the partnership must have 100 or fewer partners. A partnership satisfies this requirement when it is required to furnish 100 or fewer Schedule K-1s. For a partnership that has an “S” corporation as a partner, the number of Schedule K-1s that the S corporation is required to furnish to its shareholders is taken into account to determine the number of K-1s furnished by the partnership.

In addition, each partner of the partnership must be an individual, a “C” corporation, a foreign entity that would be treated as a “C” corporation if it were domestic, an “S” corporation, or the estate of a deceased partner. Thus, for example, another partnership, the estate of someone other than a deceased partner, and a trust cannot be partners of an electing small partnership.

It should also be noted that the election must be made on an annual basis, it must be made on a timely-filed partnership return (including extensions), and the partnership must notify the partners of the election.

Another Election Out?

A partnership that does not qualify for the small partnership election – or which does not elect to be treated as such – may still be able to elect out of the new audit regime.

It can do so by electing to have its reviewed-year partners take into account the adjustments made by the IRS, and pay any tax due as a result of those adjustments. In that case, the partnership will not be required to pay the imputed underpayment.

The electing partnership would pass the adjustments along to its reviewed-year partners by issuing adjusted Schedule K-1s to them. Those partners (and not the partnership) would then take the adjustments into account on their individual returns in the adjustment year through a simplified amended-return process.

A partnership must elect this alternative not later than 45 days after the date of the notice of a partnership adjustment (a “Sec. 6226 election”). Where the election is made, the reviewed-year partners will be subject to an increased interest charge as to any tax deficiency.

Effective Date

Because the BBA marks a significant change in the audit of partnerships, and because it applies to both existing and new partnerships, its effective date was delayed: the new rules will first become effective for returns filed for partnership tax years beginning after 2017.

In the case of a partnership with a taxable year that ends on December 31, that means the rules will become applicable on January 1, 2018 – only two months away.

The delayed effective date provided the IRS with time to prepare and issue proposed regulations to implement and interpret the statutory changes, which it did in June of this year; however, it is not clear when these will be issued in final form.

Amend Partnership Agreements

Partnerships were afforded plenty of time, between the 2015 passage of the BBA and its January 1, 2018 effective date, to consider the implications of the new audit regime.

That being said, there are still many partnerships out there that have not yet amended their partnership/operating agreements in response to these new rules. After all, the first partnership return that will be subject to the new rules, for the 2018 tax year, which will not be filed until March of 2019, and it will not be audited until a year or two later.

Nevertheless, partnerships should anticipate that they may admit new partners and lose old partners during the course of the 2018 tax year, and these persons will need to be aware of what their obligations will be insofar as 2018 tax liabilities are concerned.

Many partnerships will qualify, and will likely elect to be treated, as a small partnership.

However, many partnerships will not qualify for this election because they include “ineligible” partners, such as trusts or other partnerships.

These partnerships, or their partners, may want to consider a change in their ownership structure so as to qualify for the election; for example, by dissolving trust-partners, causing their partnership interests to be distributed to individual beneficiaries. (Of course, this first has to make sense from a business and familial perspective.)

Other partnerships will lose their qualification upon the admission of such a partner (for example, a partnership-investor). Still others will forget to make the annual election, and, so, will fall within the scope of the new rules.

Therefore, no partnership can assume that the new audit rules will not apply to it and, so, every partnership has to ensure that its partnership/operating agreement addresses the new rules.

Among the items for which the agreement should be amended are the following:

  • if the partnership believes it will qualify as a small partnership, it may require that the election be made;
  • it may also want to restrict the transfer of its partners’ partnership interests so as to ensure its continued qualification;
  • if the partnership does not qualify for, or fails to elect as, a small partnership, it may require that the Sec. 6226 election be made, under which the reviewed-year partners (including former partners) will amend their returns for such year to account for any audit adjustments and satisfy the resulting liability;
  • require reviewed-year partners (including former partners) to provide such information as may be necessary to reduce the tax liability for the reviewed year;
  • require reviewed-year partners (including former partners) to indemnify the partnership and the adjustment-year partners for any liability attributable to the reviewed year;
  • provide for the selection and removal of the PR;
  • require the PR to inform the partners of any audit, keep them abreast of the audit’s progress, including proposed adjustments;
  • limit the PR’s ability to settle an audit without the consent of the partners;
  • address reviewed year tax liabilities of the partners following the dissolution of the partnership.

Anything Else?

The foregoing considerations may be especially important to transferees of partnership interests (whether acquired by gift or purchase, as compensation, by distribution or otherwise), and to potential new investors.

Before acquiring an interest, these new or potential partners are likely to insist upon increased levels of due diligence of the partner’s tax returns and related documents. They will also insist upon protection against losses that may be incurred for prior year partnership tax liabilities.

The foregoing has assumed the existence of a partnership. What if the parties that are coming together to conduct business are not “formal” members of a partnership? Such persons must first determine whether their arrangement constitutes a partnership for tax purposes. This may not be an easy task, and there are no assurances that the IRS will agree with the parties’ conclusion.

What, then, can such persons do? Bite the bullet, concede they are partners, file partnership returns, and adopt a partnership agreement with the above-described safeguards? Or wait for the IRS to determine their status and, at that point, make a Sec. 6226 election?

These are new rules. Eventually, “final” regulations will be issued. At some point, the courts will interpret the new rules, and the IRS will apply its regulations. Their collective experience will inform taxpayer’s actions.

Until then, it’s best to approach the new rules as conservatively as possible, while at all times preserving the business arrangement among the parties, and maintaining enough flexibility to respond to future changes.

This week, we return to two recurring themes of this blog: (I) related party transactions – specifically, transactions between a taxpayer and a corporation controlled by the taxpayer; and (II) what happens when a taxpayer does not conduct the appropriate due diligence before engaging in a transaction.

Management Agreements

Taxpayers owned two operating companies (the “OCs”) that were treated as S-corporations for tax purposes. Taxpayers were the sole officers and directors of the OCs. Taxpayer One (“TP-1”) was primarily responsible for all operations of the OCs. His principal duties included: negotiating contracts, overseeing advertising purchases and content, managing the OCs’ finances, selling the products to retailers, and overseeing other employees’ work. In short, he performed all managerial tasks for the OCs.

Taxpayers’ attorney advised them that they could reduce their income tax liabilities by way of a series of transactions that included the use of a new management corporation.

TP-1 directed the attorney to implement the transactions. Accordingly, Management Corp (“MC”) was incorporated, Taxpayers were appointed as its directors, and TP-1 was designated as its president. MC then issued shares of stock to the Taxpayers, who elected that MC be taxed as an S-corporation.

The OCs entered into management agreements with MC. The agreements did not specify the particular services that MC’s employees would provide. Under these agreements, the OCs agreed to purchase management services from MC for 20% of their respective gross receipts.

This management fee was determined by TP-1, with input from his legal and tax advisers. The OCs and MC did not retain a professional consultant to assist with setting the amount of the management fee or to advise with respect to reasonable compensation.

MC then hired TP-1 to “provide management services to the client companies of * * * [MC] so as to fulfill the obligations of * * * [MC] under its various management agreements”. The contract between MC and TP-1 did not specify the particular “management services” that TP-1 was to provide. However, TP-1 provided the same services to the OCs that he had provided to them before incorporating MC.

The OCs’ functions did not change after they had hired MC, except that the employees of the OCs began providing services via MC. Employees were not aware of this change until they began receiving their salaries from MC. For all practical purposes, the work of OCs’ employees did not change when they began working for MC.

The OCs and MC subsequently amended their respective management agreements to provide that the OCs would pay MC 10% of their respective gross receipts for MC’s services because the OCs’ revenues had declined. They later amended the agreements to provide for a 3% fee. Regardless of the size of the fee, MC purportedly provided the same services to the OCs for the years at issue.

Notice of Deficiency

The IRS issued a notice of deficiency to Taxpayers in which it disallowed the deductions claimed on their respective tax returns (on IRS Form 1120S) for the management fees that the OCs reported paying to MC.

The IRS contended that Taxpayers were entitled to deduct only the portions of the management fees that were considered reasonable.

The IRS also argued that, to the extent the management fees constituted unreasonable compensation, the transaction should be re-characterized as distributions by the OCs to the Taxpayers.

As an alternative position, the IRS stated that MC should be disregarded as a sham for tax purposes because it lacked a legitimate business purpose and had no economic substance, in which case no part of the management fees would be deductible.

The Taxpayers petitioned the U.S. Tax Court.

On brief, the IRS conceded that MC was not a sham entity and should not be disregarded.

The Court’s Analysis

Because the IRS conceded that MC was not a sham entity, the Court focused on determining what constituted an arm’s-length management fee, which it noted may be higher than the salaries MC paid (i.e., there would be a profit).

The Court began by reviewing those Code provisions that were enacted to prevent tax evasion and to ensure that taxpayers clearly reflected income relating to transactions between controlled entities. The IRS, it stated, had broad authority to allocate gross income, deductions, credits, or allowances between two related corporations if the allocations were necessary either to prevent evasion of tax or to clearly reflect the income of the corporations.

To determine “true” taxable income, the Court continued, the standard to be applied in every case was that of a taxpayer dealing at arm’s-length with an uncontrolled taxpayer. The arm’s-length result of a controlled transaction must be determined under the method that, under the facts and circumstances, provides the most reliable measure of an arm’s-length result. In determining which of two or more available methods provides the most reliable measure of an arm’s-length result, the two primary factors to take into account are the degree of comparability between the controlled taxpayer and any uncontrolled comparable, and the quality of data and assumptions used in the analysis.

Arm’s-Length Fee?

The task before the Court was to determine the most reliable method for calculating an arm’s-length management fee. It began its analysis by reviewing the Taxpayers’ and the IRS’s expert reports.

The Court found that the methodology used by the Taxpayers’ expert was unreliable because the companies on which the expert relied were not comparable to the OCs.

It then turned to the IRS’s expert report.

The IRS’s expert determined that an appropriate method for calculating an arm’s-length management fee – what unrelated parties would have paid for similar services – was a markup of MC’s expenses. His method required that, after determining MC’s costs, he multiplied them by the median profit margin of a comparable group of companies for the particular year at issue.

The IRS’s expert researched companies comparable to MC in terms of revenue and services provided. He did this by first determining the operating profits earned by comparable companies as a percentage of their total costs.

Next, he determined the cost markups of these comparable companies for the years at issue. He then calculated MC’s costs by using MC’s reported expenses for the years at issue, but subtracting that portion of the expenses he considered to be unreasonable compensation to TP-1.

After allowing for a deduction of an arm’s-length management fee, the IRS’s expert calculated the OCs’ three-year average operating income margin. Because this margin was within the three-year average for the OCs’ peer group, he considered his results reasonable.

Reasonable Compensation

The Taxpayers contended that the IRS’s analysis was unreliable because it had determined that TP-1 was overcompensated.

The Court explained that a taxpayer is entitled to a deduction for compensation payments if the payments are reasonable in amount and are, in fact, paid purely for services. The question of whether amounts paid to employees represent reasonable compensation for services rendered is a question of fact that must be determined in the light of all the evidence.

Special scrutiny is given, the Court continued, in situations where a corporation is controlled by the employees to whom the compensation is paid because there is a lack of arm’s-length bargaining.

It also noted that contingent compensation agreements (like the fee paid to MC) generally invite scrutiny as a possible distribution of earnings, though the courts have upheld such agreements under appropriate circumstances. If a contingent compensation agreement generates payments greater than the amounts that would otherwise be reasonable, those payments are generally deductible only if: (1) they are paid pursuant to a free bargain between the employer and the individual; (2) the agreement is made before the services are rendered; and (3) the payments are not influenced by any consideration on the part of the employer other than that of securing the services of the individual on fair and advantageous terms.

Where there is no free bargain between the parties, the contingent compensation agreement is not dispositive as to what is deductible. Rather the Court is free to make its own determination of what is reasonable compensation.

The Court identified the following factors to determine the reasonableness of compensation, with no one factor being determinative: (1) the employee’s qualifications; (2) the nature, extent and scope of the employee’s work; (3) the size and complexities of the business; (4) a comparison of salaries paid with the gross income and net income; (5) the prevailing economic conditions; (6) a comparison of salaries with distributions to shareholders; (7) the prevailing rates of compensation for comparable positions in comparable concerns; (8) the salary policy of the taxpayer as to all employees; and (9) in the case of small corporations with a limited number of officers, the amount of compensation paid to the particular employee in previous years.

According to the Court, shareholder-executive compensation in a closely-held corporation that depletes most of a corporation’s value is generally unreasonable when the deductible salary expenses are a disguise for nondeductible profit distributions.

Taxpayers owned the OCs. In this case, the management fee depleted most, if not all, of the OCs’ profits. The management fee in turn was used primarily to pay TP-1. For example, approximately 87% of the management fee went to pay TP’s compensation in one of the years at issue.

In summary, the Court found that TP-1’s compensation was unreasonable, and that the IRS correctly adjusted his compensation before calculating an arm’s-length management fee. In calculating TP-1’s reasonable compensation, the IRS analyzed executive compensation of companies engaged in a comparable business and found that TP-1’s compensation was substantially more. Therefore, the Court found that the IRS’s conclusions regarding TP-1’s reasonable compensation were reliable.

The Court concluded that the IRS’s determination produced the most reliable measure of an arm’s-length result under the facts and circumstances. Accordingly, the Court reduced the amount that the OCs were entitled to deduct as management fees.

Lesson Learned?

You may be surprised at how frequently the IRS challenges the reasonableness, or even the nature, of the payments that are made between related taxpayers, and especially between related, closely-held businesses.

Over the years, the IRS, Congress, and the courts have developed a number of theories by which to force taxpayers to report the true income resulting from transactions with related persons, including the following: sham transaction, sham entity, substance over form, economic substance, assignment of income, “true earner,” reallocation of income, re-characterization of income, and others.

In almost every case, the best defense against an IRS challenge of the taxpayer’s treatment of a “related party transaction” is established in advance of the transaction.

The taxpayer should determine whether the transaction would be undertaken without regard to its tax consequences; whether there is an independent and bona fide business purpose for the transaction. If these inquiries cannot be answered in the affirmative, the taxpayer should avoid the transaction.

Assuming there is an independent business purpose for the related party transaction, the taxpayer may structure it in a tax-efficient manner. However, the taxpayer must also act to structure the transaction with the related party, as closely as reasonably possible, on an arm’s-length basis, and it should document its efforts and compile the data (such as comparables) and other evidence (for example, expert reports) on which it based its conclusions.

Many of our clients, most of which are closely-held U.S. businesses, are looking to expand their operations overseas. Some are venturing into foreign markets on their own, while others are joint-venturing with established foreign businesses.

In structuring a joint venture, the parties will often form a foreign business entity that affords a significant degree of limited liability protection, such as a corporation.

As a matter of U.S. Federal tax law, however, it may be advisable that the form of foreign entity not be treated as a corporation per se. Rather, the better choice may be that the foreign entity qualify as a so-called “eligible entity” under U.S. tax law – one that provides limited liability protection to its members but that may elect to be treated as a partnership.

If the foreign eligible entity is treated as a partnership for U.S. tax purposes, a share of the losses that may be generated by the entity in the early stages of its operation may flow through to the U.S. business to be used in determining its taxable income.

The IRS recently considered an interesting version of this scenario.

Joint Venture

In Year 1, US Parent corporation and Foreign Parent corporation formed JV, as a foreign limited liability company, to carry out a joint venture. As a matter of Foreign Law, JV had two equity owners: foreign corporations FC-1 and FC-2, each of which contributed funds to JV. US Parent and Foreign Parent owned the equity of FC-2; Foreign Parent was the sole owner of FC-1.

US Parent also provided funds to JV through its U.S. subsidiary, US Partner, and Foreign Parent did so directly. The amounts provided were treated as loans under Foreign Law. Thus, under Foreign Law, JV was treated as having two owners: FC-1 and FC-2.

Check the Box

US Parent elected to treat JV as a partnership for U.S. Federal tax purposes. US Parent also treated the amounts provided to JV by US Partner and Foreign Parent as equity, rather than debt. As a result, for US tax purposes, JV was treated as having four partners: FC-1, FC-2, US Partner, and Foreign Parent. Thus, the partnership allocation rules became applicable for purposes of determining US Partner’s share of JV’s tax items.

The joint venture agreement for JV did not set forth any of the “economic effect test” provisions regarding capital account maintenance, liquidation in accordance with positive capital accounts, or deficit restoration obligations; nor did it specify the allocation of JV/partnership tax items among the partners.

Additional Funding

Foreign Law required that, in order for an entity to maintain its legal status as a limited liability company, it should have net assets greater than or equal to its charter capital.

If an entity’s net assets were less than its charter capital, then the entity must either (1) decrease its charter capital, or (2) obtain additional contributions from its owners. If the entity’s owners do not take steps to improve its negative net asset position, the Foreign governmental authority may seek the liquidation of the entity. Furthermore, where an entity improves its net asset position by reducing its charter capital, in lieu of obtaining contributions from its owners, Foreign Law allows any creditor to seek the liquidation of the entity.

The JV Agreement required the owners of JV to lend additional funds pro-rata to their respective ownership interests in JV whenever JV lacked sufficient assets to meet these funding requirements.

Guaranteed Payments

According to the JV Agreement, US Partner and Foreign Parent would receive fixed payments related to their contribution amounts. The fixed payments were computed without regard to the income and cash flow of JV.

US Parent characterized these payments by JV to US Partner as guaranteed payments (for U.S. tax purposes) for the use of capital. From Year 2 to Year 5, JV deducted its payments to US Partner as guaranteed payments. JV had cumulative operating losses from Year 2 to Year 6. The guaranteed payments generated much of these losses. The loss deductions were allocated by JV solely to FC-2 and FC-1.

End of the Joint Venture

After several years of disappointing results, Foreign Parent and US Parent reached an agreement for US Parent to sell its indirect interest in JV to Foreign Parent. Because no JV loss deductions had been allocated to US Partner, US Partner’s basis in JV at the time of the sale was not insignificant and, as a result, US Parent reported a loss of on its U.S. return attributable to the sale of US Partner’s interest in JV.

The IRS’s Analysis

After examining the U.S. Parent’s tax return, the IRS field office asked the National Office to consider the proper allocation of JV’s losses. The IRS examiner believed that part of the loss allocated to FC-2 should have been allocated to US Partner, while US Parent argued that FC-2 bore the economic risk of JV’s operating losses.

Allocation Rules

Under the Code, a partner’s distributive share of income, gain, loss deduction, or credit (or item thereof) is determined in accordance with the partner’s interest in the partnership (taking into account all facts and circumstances), if:

  • the partnership agreement does not provide as to the partner’s distributive share of the partnership’s income, gain, loss, deduction, or credit (or item thereof), or
  • the allocation of such items to a partner under the agreement does not have substantial economic effect.

The IRS applies a two-part analysis for determining substantial economic effect:

  • the allocation must have economic effect; and
  • the economic effect of the allocation must be substantial.

An allocation of partnership income, gain, loss, or deduction to a partner will have economic effect if the partnership agreement provides that:

  • the partnership will maintain a capital account for each partner;
  • the partnership will liquidate according to positive capital account balances; and
  • the partners are obligated to restore any deficit balances in their capital accounts following a liquidating distribution.

If an allocation lacks substantial economic effect, the IRS requires that the item be allocated in accordance with the partners’ interest in the partnership.

“Partner’s Interest”

A partner’s “interest in the partnership” signifies the manner in which the partners have agreed to share with that partner the economic benefits or burdens corresponding to the income, gain, loss, deduction, or credit of the partnership. The determination of a partner’s interest in a partnership is made by taking into account all facts and circumstances relating to the economic arrangement of the partners.

The IRS explained that a partner receives income, not a distributive share, from a guaranteed payment for the use of capital, and the partnership receives a corresponding business deduction. The income from the guaranteed payment does not affect the recipient’s basis in its partnership interest or its capital account. The partnership’s deduction for the guaranteed payment reduces the partnership’s income (or increases the partnership’s loss) to be allocated among its partners.

Because they were determined without regard to the income of the JV-partnership, the fixed payments made by JV to US Partner and Foreign Parent from Year 2 to Year 5 were guaranteed payments for the use of capital. The guaranteed payments generated ordinary income for US Partner and Foreign Parent and deductions for JV.

During this period, JV incurred operating losses, primarily as a result of the guaranteed payment deductions. These losses were allocated entirely to FC-2 and FC-1. US Partner and Foreign Parent received no allocation of loss.

The IRS found that the allocation of JV’s operating loss did not have economic effect because JV did not maintain capital accounts, it did not provide for the liquidation of its partners’ interests in accordance with positive capital account balances, nor did it provide a deficit restoration obligation.

Thus, the IRS continued, JV’s operating loss had to be reallocated in accordance with the partners’ interests in the partnership, reflecting the manner in which the partners agreed to share the economic burden corresponding to that loss.

US Parent argued that Foreign Law effectively subjected FC-2 to a deficit restoration obligation because, if JV’s capitalization fell below a certain threshold, the equity holders of JV (FC-1 and FC-2 under Foreign Law; not US Partner and Foreign Parent) would need to contribute additional capital to JV to avoid its liquidation.

The IRS rejected this argument, finding that these additional capital contributions were not required by Foreign Law, as JV’s partners could allow JV to liquidate rather than make these additional contributions. While FC-2 and FC-1 did contribute additional amounts to JV after Year 2, these amounts were minimal compared with the substantial additional amounts contributed to JV by US Partner and Foreign Parent.

As creditors under Foreign Law, US Partner and Foreign Parent had priority over FC-2 and FC-1 if JV was liquidated. However, FC-2 and FC-1 had no obligation to restore any shortfall in payments to US Partner and Foreign Parent upon liquidation. Consequently, JV would not have the assets to repay US Partner and Foreign Parent their positive capital account balances upon liquidation, thus placing the economic burden for the operating loss allocations to FC-2 and FC-1 on US Partner and Foreign Parent. Any capital contributions by FC-2 and FC-1 would be necessary only to keep JV a going concern and avoid liquidation in the event JV became undercapitalized. Whether to keep JV a going concern would be up to US Parent and Foreign Parent, and was not mandated by Foreign Law.

Based on the foregoing, the IRS concluded that the allocation of JV’s loss to FC-2 and FC-1 should be limited to the amount of their positive capital account balances. They bore the burden of the economic loss of their capital contributions on liquidation up to this amount.

In addition, the IRS concluded that US Partner and Foreign Parent bore the economic burden of JV’s losses in excess of those positive capital accounts.

Don’t Forget

U.S. persons are subject to U.S. income tax on their worldwide income. Thus, before selecting the form of foreign entity through which to begin its foreign operations, a U.S. person should consider the options available.

The form of foreign entity ultimately chosen must be optimal from a business perspective, and it should afford the U.S. person limited liability protection.

However, as always, the tax consequences of a business structure may have a significant effect on the net economic benefit of a transaction, including the foreign operations of a U.S. business. Therefore, the U.S. person should consider how the applicable foreign law will affect the foreign entity’s tax status from a U.S. perspective.

The U.S. person should also examine how each option would be treated for U.S. tax purposes – as a corporation, partnership, or disregarded entity, and whether a check-the-box election would be advisable – and how the tax items attributable to the foreign business may impact the U.S. person’s overall tax liability.

The choice of foreign business entity should be approached with an eye toward maximizing the U.S. person’s overall foreign and U.S. tax benefits, including the use of foreign losses and foreign tax credits, and the deferral of foreign income.

The process is far from simple, but it is absolutely necessary.

Relief? Not So Fast

You may recall that the President directed the Treasury Department to identify “significant tax regulations” issued during 2016 that, among other things, add undue complexity to the tax laws. An interim report to the President in June identified the proposed rules on the valuation of family-controlled business entities as “unworkable,” and recommended that they be withdrawn.

Although many taxpayers are pleased to see the demise of the proposed valuation rules, which many had heralded as the end of valuation discounts for estate and gift tax purposes, there remain a number of traps against which taxpayers and their advisers must be vigilant – but of which many are unaware – lest they inadvertently stumble onto a taxable gift.

One such trap involves the maintenance of capital accounts where the family-controlled business entity is treated as a partnership for tax purposes.

Family Partnership

Family members often combine their “disposable” investment assets in a tax-efficient family-held investment vehicle, such as an LLC that is taxable as a partnership. By pooling their resources, they may be able to better diversify their investments and gain access to larger, more sophisticated, investments that may not have been available to any single family member.

Moreover, as younger family members mature and amass their own wealth, they may decide to participate in the family investment vehicle by making a capital contribution in exchange for a partnership interest.

Capital Account Rules

An earlier post reviewed the capital account and allocation rules applicable to partnerships; in particular, the requirement that the tax consequences to each partner arising from the partnership’s operations – specifically, from such partner’s allocable share of the partnership’s items of income, gain, loss, deduction, or credit – must accurately reflect the partners’ economic agreement.

According to these regulations, an allocation set forth in a partnership agreement shall be respected by the IRS if the allocation has substantial economic effect or, if taking into account all of the facts and circumstances, the allocation is in accordance with the partners’ interests in the partnership.

Economic Effect

In order for an allocation to have economic effect, it must be consistent with the underlying economic arrangement of the partners. This means that in the event there is an economic benefit or economic burden that corresponds to the allocation, the partner to whom an allocation is made must receive such economic benefit or bear such economic burden. Stated differently, tax must follow economics.

In general, an allocation will have economic effect if the partnership agreement provides for the determination and maintenance of the partners’ capital accounts in accordance with the rules set forth in the regulations and, upon the liquidation of the partnership (or of a partner’s interest in the partnership), liquidating distributions are made in accordance with the positive capital account balances of the partners, as determined after taking into account all capital account adjustments. In other words, a partner’s capital account will generally reflect the partner’s equity in the partnership.

Basically, the capital account rules require that a partner’s capital account be increased by (1) the amount of money contributed by him to the partnership, (2) the fair market value (“FMV”) of property contributed by him to the partnership (net of liabilities that the partnership is considered to assume or take subject to), and (3) allocations to him of partnership income and gain; and is decreased by (4) the amount of money distributed to him by the partnership, and (5) the FMV of property distributed to him by the partnership (net of liabilities that such partner is considered to assume or take subject to), and (6) allocations to him of partnership loss and deduction.

Revaluation of Property

It should be noted that the capital account rules generally do not require that the partners’ capital accounts be adjusted on an ongoing basis to reflect changes in the FMV of the partnership’s assets.

However, the rules do require that the capital accounts be adjusted to reflect a revaluation of partnership property on the partnership’s books upon the happening of certain enumerated events. In general, these adjustments are based upon the FMV of partnership property on the date of the adjustment.

These adjustments reflect the manner in which the unrealized gain inherent in such property (that has not been reflected in the capital accounts previously) would be allocated among the partners if there were a taxable disposition of such property for its FMV on the date of a “revaluation event.”

In general, a revaluation event is one that marks a change in the economic arrangement among the partners. Among these events is the contribution of money or other property (other than a de minimis amount) to the partnership by a new or existing partner as consideration for an interest in the partnership. The adjustments are made among the capital accounts of the existing partners in accordance with their existing economic agreement, just prior to the above-referenced change.

In this way, the capital accounts will reflect the amount to which each existing partner would have been entitled had the partnership been liquidated immediately prior to the admission of the new partner and the change in the partners’ economic agreement.

Grandson:      Hold it, hold it! What is this? Are you tryin’ to trick me?

   Where’s the [estate tax]? Is this a [partnership tax post?]

Grandfather:  Wait, just wait.

Grandson:     Well when does it get good?

– from “The Princess Bride” (mostly)

Book-Tax Difference

When partnership property is revalued under these rules, and the partners’ capital accounts are adjusted accordingly, the gain computed for book purposes with respect to such property will differ from the gain computed for tax purposes for such property; in other words, the book value of the property reflected in the now-adjusted capital accounts will differ from the tax basis of such property (which was not adjusted in connection with the revaluation).

Consequently, the partners’ shares of the corresponding tax items – such as the gain on the sale of the property – are not reflected by further adjustments to the capital accounts, which have already been adjusted as though a sale had occurred.

Rather, these tax items must be shared among the partners in a manner that takes account of the variations between the adjusted tax basis of the property and its book value. Otherwise, the allocation may not be respected by the IRS.

Illustration

Perhaps the best way to convey the import of the foregoing rules is with an example.

Facts

Assume dad Abe and son Ben form an equal partnership to which each contributes $10,000 cash (which is credited to their respective capital account; each has a capital account of $10,000). This $20,000 is invested in securities (the book value and the tax basis of the securities are both $20,000). Assume that the partnership breaks even on an operational basis (no profit, no loss; no change to capital accounts), and that the securities appreciate in value to $50,000.

At that point, grandson Cal joins the partnership, making a $25,000 cash contribution in exchange for a one-third interest (an amount equal to one-third of the FMV of the partnership ($75,000) immediately after his capital contribution). Assume that the cash is held in held in a bank account.

Revaluation; Account for Book-Tax Difference

Upon Cal’s admission to the partnership – a revaluation event – the capital accounts of Abe and Ben are adjusted upward (from $10,000 to $25,000, each: $50,000 FMV of securities minus book value of $20,000 = $30,000 gain, or $15,000 each) to reflect their shares of the unrealized appreciation in the securities that occurred before Cal was admitted to the partnership.

Immediately after Cal’s admission, the securities are sold for $50,000, resulting in taxable gain of $30,000 ($50,000 less tax basis of $20,000), and no book gain (because the capital accounts had already been adjusted to FMV to reflect the appreciation; $50,000 less $50,000 = zero). Because there is no gain for book purposes, the allocation of the taxable gain cannot have economic effect (tax is unable to follow book in that situation).

Unless the partnership agreement provides that the tax gain will be allocated so as to account for the variations between the adjusted tax basis of the securities and their book value – by allocating the $30,000 of tax gain to Abe and Ben ($15,000 each), to whom the economic benefit of the appreciation “accrued” prior to Cal’s admission (tax to follow economics, as reflected in the adjusted capital accounts) – the IRS may not accept the allocation.

No Revaluation, but Special Allocation

Alternatively, assume that the capital accounts of Abe and Ben are not adjusted upon Cal’s admission to reflect the $30,000 of appreciation in the partnership securities that occurred before Cal was admitted.

Rather, the partnership agreement is amended to provide that the first $30,000 of taxable gain upon the sale of the securities is allocated equally between Abe and Ben, and that all other gain (appreciation occurring after Cal’s admission) will be allocated equally among all three partners, including Cal.

These allocations of taxable gain have economic effect; tax will follow book. Moreover, the capital accounts of Abe and Ben will in effect be adjusted upon the sale (by $15,000 each, to $25,000 each) to reflect the appreciation inherent in the securities immediately prior to Cal’s admission.

No Revaluation, no Special Allocation – Gift?

If the capital accounts of Abe and Ben are not adjusted upon Cal’s admission, and the partnership agreement provides for all taxable gain (including the $30,000 attributable to the appreciation in the securities that occurred prior to Cal’s admission to the partnership) to be allocated equally among Abe, Ben and Cal ($10,000 each), the allocation will have economic effect (tax will follow book). In that case, Abe and Ben will each have a capital account of $20,000 (instead of $25,000 as above), while Cal will have a capital account of $35,000 (instead of $25,000 as above).

However, the partners will have to consider whether, and to what extent, a gift may have been made to Cal in that his capital account is allocated one-third of the appreciation ($10,000 of the $30,000) that occurred prior to his admission.

As always, query whether this same result would have followed if Cal had not been related to Abe and Ben. After all, why would someone allow value that accrued on their investment, to inure to the benefit of another?

Let’s Be Careful Out There (from “Hillstreet Blues”)

The foregoing may not be easy to digest, but anyone who purports to provide estate and gift tax advice to the members of a family-owned business or investment vehicle that is formed as a tax partnership must realize that there is nothing simple about the taxation of such an entity.

Whether we are talking about the disguised sale rules, the shifting of liabilities, hot assets, the mixing bowl rules or, as in this post, the capital account revaluation rules, there are many pitfalls. The provisions of a partnership agreement, including the revaluation rule, that are so often described as “boilerplate” are anything but, and the partnership’s advisers must be familiar with their purpose and application.

It is imperative that the partnership agreement be reviewed periodically, especially in connection with the admission or withdrawal of a partner. In this way, the tax and economic consequences of such an event may be anticipated and, if possible, any adverse results may be addressed or avoided.

“When will they ever learn?”

No, I am not channeling Seeger. I am referring to those individuals[i] who continue to acquire real property (“RP”) in, or who contribute RP to, corporations. In just the last couple of months, I have encountered taxpayers who want to remove RP from the closely held corporations in which they are shareholders. Of course, they want to do so on a “tax efficient” basis. Their reasons for removing the property are varied.

In one case, for example, the shareholders want to dispose of the business that also resides in the corporation; they want to do so by selling their shares of stock in the corporation, so as to avoid the two levels of tax that would result from a sale of the corporation’s assets; however, they also want to retain ownership of the RP.

In another, the shareholders want to withdraw some of their equity from the RP in the form of a distribution from the corporation.

In yet another, the two shareholders want to go their separate ways, each of them taking one of the RPs owned by the corporation.

There are others. In each case, the shareholders have come to realize – for the reasons set forth below – that they should not have used a corporation to hold their RP.

In the Beginning

A taxpayer who contributes RP to a corporation in exchange for shares of stock in the corporation will be taxable on the gain realized in such exchange unless the taxpayer – alone, or in conjunction with others are also contributing a not insignificant amount of money or other property to the corporation in exchange for shares – owns at least 80% of the total combined voting power of all classes of stock entitled to vote and at least 80% of the total number of other all other classes of stock of the corporation immediately after the exchange. It may not be possible for a taxpayer to attain this level of control – and the desired tax deferral –when he is seeking to become a shareholder of an established corporation.

This should be contrasted with a contribution of property to a partnership (or to an LLC that is treated as a partnership for tax purposes). In that case, the contributor is not required to attain a specific level of ownership in order to avoid gain recognition on the contribution of the RP to the partnership in exchange for a partnership interest.

However, the contributor must be attuned to the partnership “disguised sale” rules, which may treat the contributor as having sold all or some of the RP to the partnership; for example, where he mortgages the RP to withdraw equity therefrom just prior to contributing the RP (subject to the indebtedness) to the partnership.

The contributor must also be careful of “shifting” liabilities, as where he contributes mortgaged property to a partnership; if the contributor is not personally liable for the indebtedness, it will be “re-allocated” among all the partners, and he will be treated as receiving a distribution of money that may be taxable to him. .

“Day by Day” Operations

Where the RP is held in a C corporation, the corporation, of course, enjoys the benefits and burdens of ownership. If the property is leased to another, the corporation includes the rent in its gross income; it also claims the associated depreciation and other expenses in determining its taxable income. After satisfying its tax liability, the corporation may pay a dividend to its shareholders, which will be taxable to them.

If the shareholders elect to treat the corporation as an S corporation, the corporate-level tax may be avoided, the corporation’s taxable income will be passed through and taxed to its shareholders, the basis for their shares will be adjusted upward to reflect this income, and the distribution of the corporation’s net income should not generate additional tax to the shareholders.

In order to qualify as an S corporation, however, the corporation will be limited as to who may have hold its stock; for example, another corporation, a partnership, and a nonresident alien cannot own shares of stock in an S corporation.

In addition, an S corporation may have only one class of stock, meaning that each outstanding share must have the same rights to current and liquidating distributions as every other share; no preferred interests are permitted.

Thus, an S corporation is severely limited in its capitalization choices.

Finally, if an S corporation was formerly a C corporation, and has accumulated earnings and profits from its C corporation tax years, the S corporation will be subject to a 35% corporate-level excise tax on a portion of its rental income if the gross receipts from such rental activity constitute “passive investment income” and they exceed 25% of the S corporation’s total gross receipts. The corporation will even lose its “S” election if this situation continues for three consecutive tax years, in which case the corporation will generally not be eligible to re-elect “S” status for a period of five years.

In contrast, a partnership is not subject to an entity-level income tax, its profits are taxed directly to its owners and may be withdrawn by them without additional tax (to the extent the money withdrawn does exceeds a partner’s adjusted basis for his partnership interest), the partnership is not limited as to the nature or the number of its owners, and it can provide for any manner of profit allocation among its partners, including preferred and carried (“promote”) interests, provided such allocation has substantial economic effect.

Refinancing

Once a RP has reached a certain level of equity (fair market value over mortgage balance), it is not uncommon for the owner of the RP to access the increased equity – without having to sell the RP – by refinancing the existing indebtedness; the owner borrows more than the amount of the existing indebtedness, replaces that indebtedness, and withdraws the balance. Because the money that the owner has “cashed out” must eventually be repaid, the owner do not have a taxable event.

As we saw a few weeks ago, this approach to withdrawing equity from RP on a tax efficient basis works well when the property is held by a partnership. Unfortunately, the same cannot be said when a corporation owns the property.

Of course, the corporation, itself, can withdraw the increased equity from its RP through a refinancing without tax consequences. However, what happens when the corporation then distributes this cash to its shareholders? In the case of a C corporation, the amount distributed is treated as a dividend to the extent of the corporation’s current and accumulated earnings and profits; the balance is then treated as a tax-free return of capital to the extent of each shareholder’s basis for his shares of stock; any remaining portion of the distribution is taxable to the shareholders as gain from the sale of their stock.

In the case of an S corporation with no C corporation earnings and profits, the amount distributed is first applied against a shareholder’s adjusted basis for his shares, and any excess is treated as gain from the sale of such shares. Unlike the partners of a partnership, the S corporation shareholders do not receive an increased basis in their shares of corporate stock as a result of the refinancing, even if they personally guarantee the corporation’s indebtedness.

Disposition of the Property

There may come a time when the RP is sold. In the case of a C corporation, that means a corporate-level tax followed by a taxable liquidating distribution to its shareholders.

There is also a corporate-level tax where an S corporation that is subject to the built-in gain rules sells its RP within the recognition period (the 5-year period beginning with the first day of the first taxable year for which the corporation was an S corporation).

Where the S corporation was always an S corporation, and did not acquire the RP from a C corporation in a tax-free exchange, there is no corporate-level tax, and the gain from the sale is taxed to its shareholders. The subsequent distribution of the net proceeds from the sale may be taxable to a shareholder to the extent it exceeds his stock basis (as adjusted for his pro rata share of the gain from the sale of the property).

Again, in the case of a partnership, there is no entity-level tax, its partners are taxed on their pro rata share of the gain recognized on the sale (though the partner who contributed the disposed-of RP may receive a special allocation of taxable gain based upon the gain inherent in the RP at the time it was contributed to the partnership), and a partner may recognize additional taxable gain to the extent the amount of cash distributed to the partner exceeds his basis for his partnership interest (as adjusted for his pro rata share of the gain from the sale of the property).

What if the disposition is to take the form of a like kind exchange? In that case, the taxpayer that sells the “relinquished property” must also acquire the “replacement property;” thus, a corporation-seller must acquire the replacement property – there is no opportunity for a single shareholder to participate in such an exchange if most of the shareholders have no interest in doing so.

In the case a partnership, however, the partnership and one or more partners may be able to engage in a so-called “drop and swap” – by making a non-taxable in-kind distribution of a tenancy-in-common interest in the RP to one or more partners – thus enabling either the partnership or the distributee partners to participate in a like kind exchange.

Distribution of the Property

What if the RP is not to be sold? What if it is to be distributed by the entity to one or more of its owners?

In general, a corporation’s distribution of appreciated RP to its shareholders is treated as a sale of the property by the corporation, with the usual corporate tax consequences. In addition, the shareholders will be taxed upon their receipt of the property, either as a dividend or as an exchange, depending on the circumstances.

Where the corporation is an S corporation, and the RP will be depreciable in the hands of the shareholders, the gain realized on the deemed sale of the RP may be treated as ordinary income and taxed to the shareholders as such.

There is an exception where the corporation’s activity with respect to the RP rises to the level of an “active trade or business.” In that case, the actively-conducted RP business, or another active business being conducted by the corporation, may be contributed to a subsidiary corporation, the stock of which may then be distributed to one or more shareholders on a tax-deferred basis. Unfortunately, if the RP is owner-occupied, the corporation will generally not be able to establish the existence of such an active business. Moreover, the corporation will have to be engaged in a second active business.

In general, a distribution of property by a partnership to its partners will not be treated as a taxable disposition; thus, the partnership may be able to distribute a RP to a partner in liquidation of his interest, or it may split up into two or more partnerships with each taking a different property, without adverse tax consequences. There are some exceptions.

For example, if RP is distributed within seven years of its having been contributed to the partnership, its distribution to a partner other than the contributor will be treated as a taxable event as to the contributor-partner. If a contributor- partner receives a distribution of RP within seven years of his in-kind contribution of other property to the partnership, the distribution will be treated as a taxable event as to the contributor-partner.

In addition, the so-called “disguised sale” rules may cause a distribution of RP to be treated as a sale of the property; for example, where the partnership encumbers the RP with a mortgage (a “non-qualified liability”) just before distributing the RP to the partner who assumes or takes subject to the mortgage.

Even where the disguised sale rules do not apply, a distribution of RP may be treated, for tax purposes, as including a cash component where the distributee partner is “relieved” of an amount of partnership debt that is greater than the amount of debt encumbering the RP.

“Choose Wisely You Must” – Yoda

The foregoing represents a simple outline of the tax consequences that must be considered before a taxpayer decides to acquire or place RP in a corporation or in a partnership.

There may be other, non-tax, considerations that also have to be factored into the taxpayer’s thinking, and that may even outweigh the tax benefits.

All-in-all, however, a closely held partnership is a much more tax efficient vehicle than a corporation for holding, operating, and disposing of real property.

Yes, some of the tax rules applicable to partnerships are complicated, but that should not be the decisive factor. Indeed, with proper planning, these rules can negotiated without adverse effects, and may even be turned to one’s advantage.

 

 

[i] This post focuses on U.S. persons. Different considerations may apply to foreign persons. See https://www.taxlawforchb.com/?s=foreign