Lou Vlahos

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“You Know What I Meant”

In order to determine the income tax consequences of a given transaction, a court must sometimes ascertain the intention of the taxpayers who were parties to the transaction. In making its determination, the court will consider all of the relevant facts and circumstances, including the terms of any written agreement between the parties, the tax returns filed by the parties, the parties’ testimony and actions, and other indicia of intent.

In prior posts, we have discussed situations in which a court had to evaluate whether a transaction constituted a loan or a contribution to capital, a gift or an arm’s-length transfer, compensation or a loan, a sale or a lease, an option or a sale, etc. We have considered the capacity in which one or more parties to a transaction were acting; for example, as a shareholder or as a representative of a corporation, as an employee or as an individual, as a corporate officer or as a parent.

Depending upon the characterization of the transaction, and the identity of the parties, a taxpayer may have to recognize ordinary income or capital gain, or they may have no immediate taxable event at all.

Too often, however, and especially in the context of dealings involving a closely held business, the parties to the transaction – which may include the settlement of a dispute – will fail to set forth their agreement in sufficient detail, including its intended tax treatment.[i]

An unscrupulous party may seek to exploit any ambiguity for its own benefit by taking a position that is inconsistent with the parties’ implicit agreement or understanding, whether from a tax perspective or otherwise.

Alternatively, a taxing authority may rely upon an ambiguity to interpret an agreement and its tax consequences in a way that is inconsistent with a party’s tax return position.

Either way, at least one of the parties risks an economic loss.

A Recent Illustration

https://www.ustaxcourt.gov/ustcinop/opinionviewer.aspx?ID=11871

Employer provided business-to-business lead generation services for its clients.

Under Taxpayer’s initial employment contract, Employer paid Taxpayer both a salary and a commission. Under the terms of the contract, Taxpayer’s salary was reduced over time, the expectation being that his commissions would represent a greater portion of his pay as he settled into his position. At the same time, Taxpayer’s commission rate also decreased over time, thus creating an incentive for Taxpayer to sign new clients. Taxpayer and Employer later modified his compensation structure, forgoing any salary in favor of straight commission payments.

The IP

After being hired, Taxpayer began to design a method by which a business could allocate leads and target marketing efforts more effectively (the “IP”). Taxpayer filed a provisional patent application for the IP; after Employer waived any rights it had in the IP, Taxpayer filed a regular patent application.

Taxpayer used the IP to secure several important accounts for Employer. He was not involved in managing the accounts after he secured them.

A couple of years into their relationship, Taxpayer and Employer signed a broker agreement under which Taxpayer was no longer an employee of Employer but, instead, a broker acting on Employer’s behalf through Taxpayer’s wholly-owned S corporation (“Corp”). Under this agreement, Taxpayer continued to receive a commission from new account billings, but only for three years from the date on which Employer’s work on an account originated.

PC Wants the IP

At some point, Employer’s parent company (“PC”) began to consider a sale of Employer. In preparation for the sale of Employer, PC sought to obtain, and approached Taxpayer about acquiring, the rights to the IP.

As it turned out, Taxpayer needed cash to support another venture, so he was amenable to a transfer. He proposed two options: (1) he would license the IP to PC and receive royalties, which would increase once the patent was awarded; or (2) he would assign all rights in the IP to PC, in exchange for an extension of his commissions[ii] from certain accounts (the “Accounts”).

The Agreement

Taxpayer executed an assignment of the IP to PC. At the same time, Taxpayer and PC executed a written addendum to his commission structure (the “addendum”) that extended the period during which Taxpayer would receive commissions from the Accounts.

The addendum also provided that, in the event PC terminated its relationship with Taxpayer, PC would “pay the equivalent of one month’s commission (based on the average of the most recent 12 months of commissions) for each year of service provided.” Neither party consulted a lawyer in connection with the transfer of the IP or the addendum.

Tax Reporting

During the taxable year in issue, Taxpayer received commissions from the Accounts, and Employer issued a Form 1099-MISC, Miscellaneous Income, to Corp reporting a payment of nonemployee compensation.

One year later, PC terminated its broker relationship with Corp as it prepared to file for bankruptcy. Taxpayer filed a proof of claim in PC’s bankruptcy case for severance pay.

Taxpayer reported only $400 of long-term capital gain[iii] on his Form 1040, U.S. Individual Income Tax Return for the year in issue. Corp reported over $1.3 million of total income[iv] on its Form 1120S, U.S. Income Tax Return for an S Corporation.

Later, however, Taxpayer and Corp amended their respective returns: Taxpayer reported over $800,000 of long-term capital gains and attributed them to the transfer of the IP; Corp reduced its reported total income by the same amount, on its Form 1120S, which resulted in a loss for the tax year.

The IRS questioned whether the payments to Taxpayer, attributable to the above-referenced addendum, were made in consideration for the transfer of the IP; it asserted that the payments actually represented commissions that were taxable as ordinary income. The IRS issued a notice of deficiency, and Taxpayer petitioned the U.S. Tax Court.

Classification of Income

The question before the Court was whether any of the payments under the addendum were in exchange for Taxpayer’s assignment of the IP, or were owed to Corp under its broker agreement.

Section 1235

The Court began its analysis by reviewing Section 1235 of the Code https://www.law.cornell.edu/uscode/text/26/1235 , which provides that the “transfer * * * of property consisting of all substantial rights to a patent * * * by any holder[v] shall be considered the sale or exchange of a capital asset held for more than 1 year.”[vi] This treatment, the Court observed, applies regardless of whether payments in consideration of the transfer are payable periodically or are contingent on the productivity, use, or disposition of the property. Moreover, the patent need not be in existence at the time of transfer if the requirements of Section 1235 are otherwise met.[vii]

According to the Court, the term “all substantial rights to a patent” means “all rights * * * which are of value at the time the rights to the patent * * * are transferred.”

In determining whether all substantial rights in the IP were transferred, the Court stated that it would consider “[t]he circumstances of the whole transaction, rather than the particular terminology used in the instrument of transfer.”

The Court noted that the IRS did not dispute that the IP was transferred, or that the transfer of the IP met the requirements of Section 1235. However, the IRS disputed that the payments attributable to the addendum were made in consideration for that transfer; without that direct nexus, the payments would not be treated as long-term capital gain under Section 1235.

Contract Interpretation

Turning to the addendum, the Court stated that “[t]he cardinal rule in the interpretation of contracts is to ascertain the mutual intention of the parties.”

It then added that, under applicable State law, the Court would limit the scope of its search to the four corners of the document if its terms were “clear and unambiguous.” Where the terms of the document were unclear or ambiguous, the Court “may consider extrinsic evidence as well as the parties’ interpretation of the contract to explain or clarify the ambiguous language.” The parties’ construction of ambiguous terms in a contract, the Court added, “is entitled to great weight in determining its meaning.”

The Court found that the text of the addendum was susceptible of more than one interpretation.

The IRS’s Position

The IRS contended that the payments under the addendum were not consideration for the IP but, rather, for some other purpose, and that Taxpayer was compensated for the IP – which the IRS argued had little to no value – in some other way. First, the IRS pointed out that there was no reference in the addendum to the transfer, Taxpayer did not retain a security interest in the IP, and the addendum included several provisions that were standard in a commission agreement. Second, the IRS argued that the circumstances surrounding the addendum did not support Taxpayer’s claim; specifically, the IRS asserted that the addendum was executed before Taxpayer’s discussion with PC about transferring the IP. And third, the IRS argued that the form of the transaction did not support Taxpayer’s claim because both PC (on a Form 1099-MISC) and Taxpayer (on his tax return) initially reported the payments as nonemployee compensation to Corp, rather than as consideration for the IP; according to the IRS, Taxpayer should escape the tax consequences of his chosen form.[viii]

The Court Disagrees

The Court acknowledged that there was no explicit reference to the transfer of the IP in the addendum, and the date on the addendum seemed to support the IRS’s contention that the addendum was signed before and, therefore, was independent of the Taxpayer’s discussions about the transfer of the IP.

However, the Court believed that PC’s representative credibly testified that she approached Taxpayer about the transfer of the IP in the year immediately preceding the year in which the addendum was executed. She and Taxpayer also credibly testified that they understood the addendum to be consideration for the rights to the IP. The Court believed it was significant that the parties to the addendum conceived of it in the same way.

The Court turned next to the date the addendum was signed, commenting that it was possible that the addendum was signed in contemplation of some sort of transfer. In any event, in the context of the other evidence, in particular the credible testimony of key participants in the transaction, the Court stated that it could not decide that the date on the addendum foreclosed a conclusion that PC agreed to pay the additional amounts under the addendum in exchange for the IP.

The IRS also argued that the addendum was some kind of “makeshift noncompete agreement,” rather than consideration for the rights to the IP, and that PC compensated Taxpayer for those rights in some other way.

However, Taxpayer had no involvement with the Accounts after securing them for Employer, and the Court found no evidence that Taxpayer had the desire or the capacity to manage the Accounts himself. Furthermore, the record showed that PC assigned some value to the IP – it sought to acquire the IP from Taxpayer, not a noncompete agreement. For this reason, the Court also rejected the IRS’s theory that the IP had only nominal value to PC. The Court was also convinced that PC wanted something in return for the additional payments under the modified addendum, and the only valuable consideration remaining was the IP.

Therefore, the Court found that the addendum provided for additional payments in exchange for Taxpayer’s transfer of all his rights in the IP to PC (notwithstanding that the amount of such payments was determined by reference to a formula that had been used to calculate the Taxpayer’s commission for services rendered).

The Court also found that Taxpayer’s failure to retain a security interest was a reflection of the parties’ circumstances as they were discussing the transfer rather than evidence that the addendum constituted an ordinary commission or noncompete agreement. Both Taxpayer and PC were focused on transferring the IP as soon as possible – Taxpayer wanted cash to invest in a new venture, and PC wanted to obtain the rights before PC was sold.[ix]

Thus, the Court concluded that Taxpayer’s transfer of the IP to PC met the requirements for long-term capital gain treatment under Section 1235 of the Code. Because the payments on the Accounts attributable to the addendum were consideration for the rights to the IP, those payments were properly classified as long-term capital gains.

“That’s Not What You Said”

Taxpayer had a close call. The addendum did not refer to the transfer of the IP. It did refer to the commission payments on the Accounts, which had previously been treated as ordinary income to Taxpayer. Employer issued a 1099-MISC to Corp, reporting non-employee compensation, and Taxpayer and Corp initially filed their respective income tax returns consistently therewith. Neither party to the addendum sought an appraisal of the IP. Finally, it should be noted that, by the time of the Tax Court proceeding, the patent application had been abandoned, presumably by PC, which may have been an indication of its value.

It appears that Taxpayer’s success in the face of the foregoing rested, in large part, upon the “credible testimony” of Taxpayer and of the PC representative who negotiated the terms of the addendum. Not the ideal game plan, especially where the taxpayer bears the burden of proof; after all, memories become stale, people disappear, and relationships deteriorate.

Taxpayer would have been better served if he and PC had retained counsel to ensure that the addendum – within its four corners – accurately reflected their understanding regarding the transfer of the IP and the payments made in exchange therefor.[x]

Of course, there are situations in which the parties to an agreement “genuinely” disagree on the tax treatment of a specific payment made pursuant to its terms, usually as a result of someone’s not having focused on it. For example, the payment made by a partnership to a departing partner in liquidation of their interest where the agreement fails to properly characterize the payment for tax purposes. The partnership may seek to treat such a payment as a guaranteed payment (deductible by the partnership, and includible as ordinary income by the former partner, for tax purposes), whereas the former partner will treat it as a payment made in exchange for their interest in the partnership’s assets, including goodwill (treated as a return of capital, and then as capital gain, except to the extent of any “hot assets”).[xi]

Then there are those situations where a “not-so-good” actor will do as they please insofar as reporting the tax consequences of a transaction is concerned.[xii]

In most cases, it will behoove the conscientious taxpayer and their advisors to ensure, as best they can, that the four-corners of the agreement either express the tax treatment intended by the parties, or include such terms that inexorably manifest such intent. If a taxpayer is unable to secure the foregoing, then they should be on alert as to the intentions of the other party, and act accordingly.

———————————————————————————————–

[i] Too many times have I heard a fellow adviser say that some ambiguity on a key term of a transaction document or settlement agreement may be a good thing; yeah, if you enjoy litigation and the associated costs and anxiety.

One of my high school physics teachers had a sign above his blackboard that read, “Eschew Obfuscation.” Thank you, Mr. Gordon.

[ii] Normally treated as ordinary income by Taxpayer, and deductible by Employer under Sec. 162 as an ordinary and necessary business expense.

[iii] Seemingly unrelated to the IP.

[iv] Based on the 1099-MISC.

[v] The “holder,” for purposes of Section 1235, includes “any individual whose efforts created such property.”

[vi] And taxed as long-term capital gain.

[vii] Sec. 1.1235-2(a). https://www.law.cornell.edu/cfr/text/26/1.1235-2

[viii] The “Danielson rule.” In brief: although a taxpayer is free to organize their affairs as they choose, once having done so, they must accept the tax consequences of such choice, whether contemplated or not, and may not enjoy the benefit of some other route they might have chosen to follow but did not. A taxpayer who falls within the scope of this rule is generally stuck with the form of their business transaction, and can make an argument that substance should prevail over that form only if a limited class of exceptions applies.

[ix] Finally, the Court was not convinced that PC’s reporting of the payments indicated that the addendum did not relate to the IP. Because those payments mirrored Taxpayer’s commissions, it was reasonable for both PC and Taxpayer to continue reporting commission payments as they always had in the absence of any tax or legal advice. The Court would not bind Taxpayer to the reporting by PC in the face of other contrary evidence.

[x] Query, however, whether an appraisal of the IP would have defeated capital gain treatment for the transfer of the IP. What if its fair market value was insignificant?

What if PC or Employer had deducted the payments on their tax return(s)?

[xi] IRC Sec. 736.

[xii] Form 8082 may come in handy at that point. https://www.irs.gov/forms-pubs/about-form-8082

Committed to a Zone

Last week’s post[i] considered how the newly-enacted qualified opportunity zone (“QOZ”) rules seek to encourage investment and stimulate economic growth in certain distressed communities by providing various federal income tax benefits to taxpayers who invest in businesses that operate within these zones.[ii] After describing these tax incentives, the post cautioned taxpayers who may have already recognized capital gain,[iii] or who are planning to sell or exchange property in a transaction that will generate taxable capital gain, that the tax incentives, although attractive, may be indicative of some not insignificant economic risk that is associated with the targeted investment.[iv]

This week, we continue our discussion of the QOZ rules,[v] beginning with the premise that the taxpayer already owns a business in a QOZ,[vi] or is already committed to investing in a QOZ.[vii] In other words, the taxpayer has already considered the risks of expanding within, or of moving into, such an area, and they have decided that it makes sense to do so from a long-term economic or business perspective. As to this taxpayer, the new tax incentives coincide with their long-term investment horizon, and also offer the opportunity[viii] to increase the taxpayer’s after-tax return on their investment.[ix]

However, in order to enjoy these tax benefits, the taxpayer[x] has to invest its “eligible gains”[xi] in a “qualified opportunity fund” (“QOF”).

What’s a Fund?

The use of the word “fund” may be misleading to some, who may interpret it strictly as a vehicle by which several investors can pool their resources for purposes of acquiring interests in one or more qualifying businesses.

The regulations proposed by the IRS provide that a QOF must be an entity that is classified as a partnership or as a corporation for federal income tax purposes. The reference to a “partnership” necessarily requires that there be at least two members that are respected as separate from one another for tax purposes.[xii]

The fact that a number of asset and wealth management businesses seem to have formed QOFs, and have begun to solicit investments therein from the “general public,” has reinforced the impression that a QOF must be some kind of pooled investment vehicle.[xiii]

Although such a vehicle generally offers single investors the opportunity[xiv] to combine their money to increase their “buying power,” decrease their individual risk, attain a level of diversification, and gain other advantages, such as professional management, there is nothing in the Code or in the regulations proposed thereunder that requires a QOF to be a multi-member investment vehicle.[xv]

In other words, so long as the subject entity is formed as a partnership, it can have as few as two investor-members and may still qualify as a QOF; in the case of a corporation, it can have only as few as one shareholder. Thus, a closely held business entity may be QOF.

That being said, there are a number of other requirements that the partnership or corporation must satisfy in order to be treated as a QOF, and that may prevent a closely held business from qualifying.

Requirements for QOF Status

Corporation or Partnership. The fund must be created or organized as a partnership or as a corporation in one of the 50 States, the District of Columbia, or a U.S. possession;[xvi] it must be organized for the purpose of investing in “QOZ property,” but not in another QOF.

A corporation may be a C corporation, or its shareholders may elect to treat it as an S corporation.[xvii] Alternatively, the fund may be formed as an LLC but elect to be treated as a corporation for tax purposes.[xviii]

New or Pre-existing. Moreover, the partnership or corporation may be a pre-existing entity and still qualify as a QOF,[xix] provided that the pre-existing entity satisfies the requirements for QOF status, including the requirement that QOZ property be acquired after December 31, 2017.[xx]

90 Percent of Asset Test. In addition, the fund must hold at least 90 percent of its assets[xxi] in “QOZ property,” determined by the average of the percentage of QOZ property held in the fund as measured (A) on the last day of the first 6-month period of the taxable year of the fund,[xxii] and (B) on the last day of the taxable year of the fund.[xxiii]

QOZ Property; QOZ Business Property

The following three kinds of property are treated as QOZ property that is counted toward the 90 percent test:

  • QOZ stock,
      • which is stock in a corporation that is acquired by the fund after December 31, 2017,
      • at its original issue,[xxiv] from the corporation,
      • solely in exchange for cash,
      • as of the time the stock was issued, the corporation was a “QOZ business” (or the corporation was being organized for purposes of being such a business), and
      • during “substantially all” of the fund’s holding period for the stock, the corporation qualified as a QOZ business;
  • QOZ partnership interest,
      • which is any capital or profits interest in a partnership,
      • that is acquired by a fund after December 31, 2017,
      • from the partnership,
      • solely in exchange for cash,
      • as of the time the partnership interest was acquired, the partnership was a “QOZ business” (or the partnership was being organized for purposes of being a QOZ business), and
      • (c) during “substantially all” of the fund’s holding period for the partnership interest, the partnership qualified as a QOZ business; and
  • QOZ business property,
      • which is tangible property used in a trade or business of the fund,
      • that was purchased by the fund after December 31, 2017,
      • from an “unrelated” person,[xxv]
      • for which the fund has a cost basis,
      • (i) the “original use”[xxvi] of which within the QOZ commences with the fund, or (ii) which the fund “substantially improves;” and
      • during “substantially all of the fund’s holding period” for the tangible property, “substantially all of the use” of the tangible property was in the QOZ.[xxvii]

N.B. Consequently, if a QOF operates a trade or business directly, and does not hold any equity in a QOZ business formed as a corporation or partnership, at least 90 percent of the QOF’s assets must be QOZ business property; i.e., it must be tangible property – no more than 10 percent of its property can be intangible property, such as goodwill.[xxviii]

Substantially Improved. The definition of QOZ business property basically requires the property to be used in a QOZ, and also requires that new capital be employed in a QOZ.

Specifically, tangible property is treated as “substantially improved” by a QOF (for purposes of applying the definition of QOZ business property) only if, during any 30-month period beginning after the date of acquisition of the property, additions to the basis of the property in the hands of the QOF exceed an amount equal to the adjusted basis of the property at the beginning of the 30-month period in the hands of the QOF; in other words, the fund must at least double the adjusted basis of the property during such 30-month period. For example, if property is acquired in February of 2019, it must be substantially improved by August 2021.

Significantly, if a QOF purchases a building located on land wholly within a QOZ, a substantial improvement to the purchased tangible property is measured by the QOF’s additions to the adjusted basis of the building only; the QOF is not required to separately “substantially improve” the land upon which the building is located.[xxix]

QOZ Business

In order for a share of stock in a corporation, or for a partnership interest, to be treated as QOZ property in the hands of a fund, the issuing entity must be a QOZ business, which is any trade or business:

      • In which “substantially all” of the tangible property owned or leased by the trade or business is QOZ business property;[xxx]
      • At least 50 percent of the total gross income of which is derived from the “active conduct of business”[xxxi] in the QOZ;
      • A “substantial portion” of the business’s intangible property is used in the active conduct of business[xxxii] in the QOZ; and
      • Less than 5 percent of the average of the aggregate adjusted bases of the property of the business is attributable to “nonqualified financial property;”[xxxiii]
          • nonqualified financial property does not include “reasonable amounts” of working capital held in cash, cash equivalents, or debt instruments with a term of no more than 18 months;
          • nor does it include accounts or notes receivable acquired in the ordinary course of a trade or business for services rendered or from the sale of inventory property;
      • The trade or business is not a golf course, country club, massage parlor, hot tub or suntan facility, racetrack or other facility used for gambling, or store whose principal business is the sale of alcoholic beverages for consumption off premises.[xxxiv]

Substantially All. A corporation’s or partnership’s trade or business is treated as satisfying the “substantially all” requirement (for purposes of applying the definition of QOZ business) if at least 70 percent of the tangible property owned or leased by the trade or business is QOZ business property.[xxxv] (This is to be compared to the requirement that 90 percent of the fund’s assets must be QOZ business property where the fund directly owns only a trade or business.)

Working Capital. For purposes of applying the limit on nonqualified financial property, working capital assets will be treated as reasonable in amount if all of the following requirements are satisfied:

  • The amounts are designated in writing for the acquisition, construction, and/or substantial improvement of tangible property in a QOZ.
  • There is a written schedule consistent with the ordinary start-up of a trade or business for the expenditure of the working capital assets.
  • Under the schedule, the working capital assets must be spent within 31 months of the receipt by the business of the assets.[xxxvi]
  • The working capital assets are actually used in a manner that is “substantially consistent” with the foregoing.[xxxvii]

Similarly, a safe harbor is provided for purposes of applying the 50-percent test for gross income derived from the active conduct of business. Specifically, if any gross income is derived from property that is treated as a reasonable amount of working capital, then that gross income is counted toward satisfaction of the 50-percent test.[xxxviii]

Substantial Portion. The requirement that a “substantial portion” of the business’s “intangible property” be used in the active conduct of business will be treated as being satisfied during any period in which the business is proceeding in a manner that is substantially consistent with the use of the working capital described above.

Although these “safe harbors” are helpful, the absence of guidance on other requirements is troubling, including those related to the fund’s “active conduct of business;” for example, will rental real estate be treated as an active trade or business for this purpose?

N.B. It is noteworthy that the proposed safe harbor for working capital applies only in determining whether a partnership or corporation in which a QOF owns an interest (a lower-tier entity) qualifies as a QOZ business. It does not apply to a trade or business that is owned directly by a fund, thereby making the 90 percent test more restrictive.

The 90 Percent of Assets Test

As indicated above, a QOF must undergo semi-annual tests to determine whether its assets consist, on average, of at least 90 percent QOZ property. For purposes of these semi-annual tests, a tangible asset can be treated as QOZ business property by a find that has self-certified as a QOF (or an operating subsidiary corporation or partnership) only if it acquired the asset after 2017 by purchase.

For purposes of the calculation of the “90 percent of assets test” by the QOF, the QOF is required to use the asset values that are reported on the QOF’s applicable financial statement for the taxable year.[xxxix]

Failing the 90 Percent. In general, if a fund fails to satisfy the 90 percent test, a monthly penalty will be imposed on the fund in an amount equal to the product of:

(A) the excess of (1) the amount equal to 90 percent of the fund’s aggregate assets, over (2) the aggregate amount of QOZ property held by the fund, multiplied by (B) the underpayment rate. This penalty will not apply before the first month in which the entity qualifies as a QOF.

Working Capital Safe Harbor. Query whether cash be an appropriate QOF property for purposes of the 90 percent test if the cash is held with the intent of investing in QOZ property? Specifically, because developing a new business or the construction or rehabilitation of real estate may take longer than six months (i.e., the period between testing dates), QOFs should be given longer than six months to invest in qualifying assets.[xl]

The proposed regulations provide a working capital safe harbor for QOF investments in QOZ businesses (i.e., partnerships and corporations) that acquire, construct, or rehabilitate tangible business property, which includes both real property and other tangible property used in a business operating in an opportunity zone.

The safe harbor allows qualified opportunity zone businesses a period of up to 31 months, if there is a written plan that identifies the financial property as property held for the acquisition, construction, or substantial improvement of tangible property in the opportunity zone, there is written schedule consistent with the ordinary business operations of the business that the property will be used within 31 months, and the business substantially complies with the schedule. Taxpayers would be required to retain any written plan in their records.[xli]

If a corporation or partnership qualifies as a QOZ business, the value of the QOF’s entire interest in the entity counts toward the QOF’s satisfaction of the 90 percent test. Thus, if a QOF operates a trade or business (or multiple trades or businesses) through one or more partnerships or corporations, then the QOF can satisfy the 90 percent test if each of the entities qualifies as a QOZ business;[xlii] among other things, “substantially all” of the tangible property owned or leased by the entity must be QOZ business property.

A business will be treated as satisfying the substantially all requirement for this purpose if at least 70 percent of the tangible property owned or leased by a trade or business is QOZ business property.[xliii]

N.B. Again, it is noteworthy that the proposed 70 percent test for purposes of satisfying the substantially all requirement applies only in determining whether a partnership or corporation in which a QOF owns an interest (a lower-tier entity) qualifies as a QOZ business. It does not apply to a trade or business that is owned directly by a fund; it appears that no more than 10 percent of the assets of such a business can be cash or intangibles (like goodwill).

Certification as a QOF

In order to facilitate the investment process, and minimize the information collection burden placed on taxpayers, a corporation or partnership that is eligible to be a QOF is allowed to self-certify that it is organized as a QOF.

The self-certification must identify the first taxable year that the fund wants to be a QOF; it may also identify the first month (in that initial taxable year) in which it wants to be a QOF.[xliv]

If a taxpayer who has recognized gain invests in a fund prior to the fund’s first month as a QOF, any election to defer such gain with that investment is invalid.

Return. It is expected that a fund will use IRS Form 8996, Qualified Opportunity Fund,[xlv] both for its initial self-certification and for its annual reporting of compliance with the 90-percent test. It is also expected that the Form 8996 would be attached to the fund’s federal income tax return for the relevant tax years.[xlvi]

The proposed regulations allow a QOF both to identify the taxable year in which the entity becomes a QOF and to choose the first month in that year to be treated as a QOF. If an eligible entity fails to specify the first month it is a QOF, then the first month of its initial taxable year as a QOF is treated as the first month that the eligible entity is a QOF.[xlvii]

Thoughts?

The QOZ rules were enacted in December of 2017. Regulations were proposed in October of 2018. The IRS has indicated that a second round of proposed regulations will be released relatively soon. The period for recognizing capital gains that will be eligible for reinvesting in QOFs and enjoying the resulting tax benefits expires in 2026.[xlviii] Many questions remain unanswered.

Although a closely held business entity (a fund) that chooses to own a business directly, and to operate such a business in a QOZ, may qualify as a QOF into which its taxpayer-owner may invest their post-2017 capital gains, it appears that the IRS has placed some obstacles in its path to doing so. Whether these were intentional or not remains to be seen. In the meantime, the clock continues to run.

What is a business owner (the “Taxpayer”) to do if they are planning a liquidity event, such as a sale of the business to an unrelated person, in the near future and want to defer their gain by taking advantage of the QOZ tax benefits, but without giving up control over their investment? They can create and capitalize their own fund (within the prescribed investment period), that will try to start a QOZ business that satisfies the tests described above, including the requirement that they timely purchase QOZ business property, and such property shall represent at least 90 percent of the fund’s assets. Good luck.

Alternatively, they can create their own fund, identify one or more existing QOZ businesses (C corporations or partnerships) that are ready to expand and, over the next six months, try to negotiate a cash investment in such a business in exchange for equity therein (including a preferred interest) that also provides the Taxpayer with a significant voice in the management of the business as to major decisions (“sacred rights”), including any decisions that may affect the business’s qualification as a QOZ business or the qualification of the Taxpayer’s investment vehicle as a QOF. The QOZ business would have 31 months in which to use the Taxpayer’s infusion of working capital to acquire QOZ business property.[xlix]

Failing these options, the Taxpayer may invest timely in an “institutional” fund, but with the understanding that they will have little-to-no voice therein. It may not be ideal, but it is much easier to accomplish than the alternatives described above.[l]

[i] Any “quoted” terms that are not defined herein were either defined in last week’s post or have not yet been defined by the IRS.

[ii] The temporary deferral of inclusion in gross income of certain capital gains to the extent they are reinvested in a qualified opportunity fund (“QOF”); the partial exclusion of such capital gains from gross income to the extent they remain invested in the QOF for a certain length of time; and the permanent exclusion of post-acquisition capital gains (appreciation) from the sale or exchange of an interest in a QOF held for at least 10 years.

[iii] And whose 180-day period for reinvesting the gain(s) from such sale(s) has not yet expired. As an aside, any taxpayer planning to take advantage of the QOZ rules should start investigating reinvestment options well before their capital gain event.

[iv] For example, the investment is being made in an economically-challenged area, the deferral ends in 2026, at which point the taxpayer who invests their gain in a QOF may not have the liquidity to pay the tax; in order for a taxpayer to enjoy the full 15 percent reduction in the deferred gain, they must acquire an interest in a QOF before the end of 2019 and then hold the interest for at least seven years; and the exclusion from income of any appreciation above the deferred gain requires that the taxpayer hold their investment in the QOF for at least ten years.

[v] I.e., IRC Sec. 1400Z-1 and 1400Z-2, and the regulations proposed thereunder; the regulations generally are proposed to be effective on or after the date they are published as final in the Federal Register. However, a QOF may rely on the proposed rules with respect to taxable years that begin before the final regulations’ date of applicability, but only if the QOF applies the rules in their entirety and in a consistent manner.

[vi] A complete list of designated qualified opportunity zones is found in Notice 2018-48, 2018-28 I.R.B. 9.

[vii] Consider, for instance, the number of businesses that had already moved, or had decided to move, into Long Island City, N.Y. before the enactment of these incentives as part of the Tax Cuts and Jobs Act (P.L. 115-97).

[viii] Pun intended.

[ix] Assuming all goes well.

[x] The “taxpayer” may be an individual, a C corporation, a partnership, an S corporation, an estate, or a trust.

[xi] Capital gain, which may be realized in a number of different scenarios under a number of Code provisions. The election to defer tax on an eligible gain invested in a QOF is made on Form 8949, Sales and Other Dispositions of Capital Assets, which is attached to a taxpayer’s federal income tax return.

[xii] You can’t have a tax partnership among a grantor, a 100% grantor trust, and an LLC that is wholly-owned by the grantor and disregarded as an entity separate from the grantor.

[xiii] For example, UBS circulated an email to that effect just last week.

[xiv] There’s that word again.

[xv] https://www.irs.gov/pub/irs-drop/reg-115420-18.pdf

[xvi] In addition, if the entity is organized in a U.S. possession, but not in one of the 50 States or in the District of Columbia, then it may be a QOF only if it is organized for the purpose of investing in QOZ property that relates to a trade or business operated in the possession in which the entity is organized.

[xvii] The latter cannot have more than 100 shareholders. IRC Sec. 1361(b).

[xviii] Reg. Sec. 301.7701-3.

[xix] Or as the issuer of “QOZ stock” or of a “QOZ partnership interest.”

[xx] Which requirement, by itself, may prevent a pre-existing entity from qualifying.

[xxi] By “value;” see below.

[xxii] With respect to an entity’s first year as a QOF, if the entity chooses to become a QOF beginning with a month other than the first month of its first taxable year, the phrase “first 6-month period of the taxable year of the fund” means the first 6-month period (i) composed entirely of months which are within the taxable year and (ii) during which the entity is a QOF. For example, if a calendar-year entity that was created in February chooses April as its first month as a QOF, then the 90 percent testing dates for the QOF are the end of September and the end of December. Moreover, if the calendar-year QOF chooses a month after June as its first month as a QOF, then the only testing date for the taxable year is the last day of the QOF’s taxable year. Regardless of when an entity becomes a QOF, the last day of the taxable year is a testing date.

[xxiii] June 30 and December 31 in the case of a taxpayer with a December 31 YE.

[xxiv] Directly or through an underwriter.

[xxv] IRC Sec. 1400Z-2(d)(2)(D)(i)(I), Sec. 179(d)(2).

[xxvi] The IRS did not propose a definition of “original use” and is seeking comments on possible approaches to defining the “original use” requirement, for both real property and other tangible property. For example, what metrics would be appropriate for determining whether tangible property has “original use” in an opportunity zone? Should the use of tangible property be determined based on its physical presence within an opportunity zone, or based on some other measure? See Revenue Ruling 2018-29 regarding the acquisition of an existing building on land within a QOZ. Stay tuned.

[xxvii] Hopefully, the forthcoming second round of proposed regulations will address the meaning of “substantially all” in each of the various places where it appears. The IRS has requested comments.

[xxviii] See below.

[xxix] Although the foregoing guidance is helpful, questions remain. For example, how will a fund’s satisfaction of the “substantial improvement” test be affected if it elects to expense some of its investment under Section 179 of the Code, or if it elects bonus depreciation under Section 168?

[xxx] See the definition of QOZ business property, above. Query how the asset rules will be applied to leases.

[xxxi] Hopefully, this will be defined in the next round of guidance.

[xxxii] Stay tuned for this, too.

[xxxiii] This includes debt, stock, partnership interests, annuities, and derivative financial instruments (for example, options and futures).

[xxxiv] I guess Congress doesn’t want to encourage the presence of such vile establishments in distressed areas.

[xxxv] The value of each asset of the entity as reported on the entity’s “applicable financial statement” for the relevant reporting period is used for determining whether a trade or business of the entity satisfies this requirement. Reg. Sec. 1.475(a)-4(h). If a fund does not have an applicable financial statement, the proposed regulations provide alternative methodologies for determining compliance.

[xxxvi] 31 months?! Has the IRS ever tried to develop property in N.Y.C. or on Long Island? Delays caused by legislators and regulators are standard fare.

[xxxvii] If some financial property is treated as being a reasonable amount of working capital because of compliance with the requirements above regarding the use of working capital, and if the tangible property acquired with such working capital is expected to satisfy the requirements for QOZ business property, then that tangible property is not treated as failing to satisfy those requirements solely because the scheduled consumption of the working capital is not yet complete.

[xxxviii] The requirement that the QOZ business derive at least 50 percent of its income from the QOZ may be more difficult to satisfy.

[xxxix] See EN xxxi. If a QOF does not have an applicable financial statement, it may use the cost of its assets. The IRS has requested comments on the suitability of both of these valuation methods, and whether another method, such as tax adjusted basis, would be better.

[xl] What if a QOF sells its interest in QOZ stock or its QOZ partnership interest? It should have “a reasonable period of time” to reinvest the proceeds therefrom. For example, if the sale occurs shortly before a testing date, the QOF should have a reasonable amount of time in which to bring itself into compliance with the 90 percent test. According to the IRS, soon-to-be-released proposed regulations will provide guidance on these reinvestments by a QOF.

[xli] This expansion of the term “working capital” reflects the fact that the QOZ rules anticipate situations in which a QOF or operating subsidiary may need up to 30 months after acquiring a tangible asset in which to improve the asset substantially. The IRS has requested comments about the appropriateness of any further expansion of the “working capital” concept beyond the acquisition, construction, or rehabilitation of tangible business property to the development of business operations in the opportunity zone.

[xlii] Query whether the IRS will eventually permit some sort of aggregation for purposes of applying this rule.

[xliii] This 70 percent threshold is intended to apply only to the term “substantially all” as it is used in section 1400Z-2(d)(3)(A)(i).

[xliv] If the self-certification fails to specify the month in the initial taxable year that the eligible entity first wants to be a QOF, then the first month of the eligible entity’s initial taxable year as a QOF is the first month that the eligible entity is a QOF.

[xlv] Instructions for Form 8996 were released January 24, 2019. A corporation or partnership will use the form to certify that it is organized to invest in QOZ property; they will also file the form annually to report that they meet the investment standard (or to calculate the penalty if they fail to satisfy the standard).

[xlvi] Form 1120, 1120S or 1065.

[xlvii] A deferral election under section 1400Z-2(a) may only be made for investments in a QOF. Therefore, a proper deferral election under section 1400Z-2(a) may not be made for an otherwise qualifying investment that is made before an eligible entity is a QOF.

[xlviii] IRC Sec. 1400Z-2.

[xlix] This option appears to be more manageable.

[l] There’s that inverse relationship again.

A lot has been written about the tax benefits of investing in a Qualified Opportunity Fund. Some have suggested that the gain from the sale of a closely held business may be invested in such a fund in order to defer the recognition of this gain and to shelter some of the appreciation thereon.

In order to better understand and evaluate the potential tax benefits of such an investment, especially from the perspective a business owner who may be contemplating a sale, one must appreciate the underlying tax policy.[i]

Economic Risk

Almost every aspect of a business, from the mundane to the extraordinary, involves some allocation of economic risk. In the broadest sense, “deals” get done when the parties to a transaction agree to terms that allocate an acceptable level of risk between them.[ii]

In the case of a closely held business, the owners will face a significant amount of risk throughout the life of the business. On a visceral level, their risk may seem greatest at the inception of the venture; however, this is also the point at which the owners will have less economic capital at risk, in both an absolute and a relative sense, than perhaps at any other stage of the business.[iii]

Fast forward. Let’s assume the business has survived and has grown. The owners’ investment in the business has paid off, but only after many years of concentrating their economic risk[iv] in the business. The owners may now be ready to monetize their illiquid investment,[v] and reduce their economic risk.

Sale of the Business

They will seek out buyers.[vi] Some of these buyers will pay: (1) all cash for the business at closing; (2) mostly cash plus a promissory note; (3) mostly cash plus an earn-out;[vii] (4) a relatively small amount of cash plus a promissory note; (5) mostly cash, but will also insist that the owners roll over some of their equity in the business[viii] into the buyer; or (6) equity in the buyer and, maybe (depending upon the structure of the transaction) some cash.

Each of these purchase-and-sale transactions presents a different level of risk for the owners of the business being sold, with an all-cash deal providing the lowest degree of risk, and an all-equity deal the greatest. What’s more, the equity deal will place the owner into a non-controlling position within the buyer. Generally speaking, few owners are willing to give up control of their business (and the benefits flowing therefrom) and yet remain at significant economic risk.

Gain Recognition and Economic Risk

In general, the timing of a taxpayer’s recognition of the gain realized on their sale of a property is related to the level of economic risk borne by the taxpayer.

Specifically, in the case of an all-cash, low risk deal,[ix] all of the gain realized on the sale of the business will be recognized in the year of the sale; where part of the consideration consists of a promissory note – such that the seller bears some credit risk vis-à-vis the buyer – that portion of the gain realized on the sale that is attributed to the note will be recognized only as and when principal payments are made.

Continuing Investment and Deferral

Where the buyer issues equity in exchange for the business, the gain realized on the exchange by the seller and its owners may be deferred until such equity is sold, provided certain requirements are satisfied. If the deal is structured in a way that allows the owners to receive some cash along with the equity, then gain will be recognized to some extent.[x]

The Code generally provides for the deferral of gain recognition in recognition of the fact that the selling owners’ investment remains at risk where they exchange their business for equity in the buyer; they have not liquidated their interest in the business or exchanged it for cash; rather, they are continuing their investment, albeit in a somewhat different form.[xi]

Public Policy and Deferral

There are other situations, however, in which the above-stated theoretical underpinning for the deferral of gain is not applicable – because the owners have converted their interest in the business into cash – but for which the Code nevertheless provides that the seller’s gain does not have to be recognized in the year of the sale.

In these situations, the Code is seeking to promote another economic or societal goal that Congress has determined is worthy of its support.

Consider, for example, the deferral of gain realized on the sale of “qualified small business stock,” which seeks to encourage investment in certain types of “small” business;”[xii] another is the deferral of gain from the sale of stock to an ESOP, which seeks to encourage employee-retirement plan ownership of the employer-C corporation.[xiii]

Enter the Qualified Opportunity Zone

The latest addition to the family of provisions, that seeks to encourage certain investment behavior through the deferral of otherwise taxable gain, entered the Code as part of the Tax Cuts and Jobs Act[xiv] in late 2017; regulations were proposed thereunder in October of 2018.[xv]

New Section 1400Z-2 of the Code,[xvi] in conjunction with new section 1400Z-1,[xvii] seeks to encourage economic growth and investment in designated distressed communities (“qualified opportunity zones” or “QOZ”) by providing federal income tax benefits to taxpayers who invest in businesses located within these zones.

The Tax Benefits

Section 1400Z-2 provides three tax incentives to encourage investment in a QOZ:

  • the temporary deferral of inclusion in gross income of certain capital gains to the extent they are reinvested in a qualified opportunity fund (“QOF”);[xviii]
  • the partial exclusion of such capital gains from gross income to the extent they remain invested in the QOF for a certain length of time; and
  • the permanent exclusion of post-acquisition capital gains (appreciation) from the sale or exchange of an interest in a QOF held for at least 10 years.

In brief, a QOF is an investment entity that must be classified as a corporation or as a partnership for federal income tax purposes, that is organized for the purpose of investing in QOZ property, and that holds at least 90 percent of its assets in such property.[xix]

Eligible Gain

Gain is eligible for deferral under the QOZ rules only if it is capital gain – ordinary income does not qualify. For example, the depreciation recapture[xx] that is recognized as ordinary income on the sale of equipment would not qualify; nor would the sale of inventory or receivables; but the capital gain from the sale of real property, shares of stock, or the goodwill of a business, would qualify.[xxi]

That being said, the gain may be either short-term or long-term capital gain. Thus, the gain recognized on the sale of a capital asset will qualify whether or not it has been held for more than one year.[xxii]

The capital gain may result from the actual or deemed sale or exchange of property. Thus, the gain recognized by a shareholder, on the distribution by an S corporation to the shareholder of cash in an amount in excess of the shareholder’s adjusted basis for its stock, would qualify for deferral.[xxiii]

In addition, the gain must not arise from the sale or exchange of property with a related person.[xxiv] In other words, the gain must arise from a sale to, or an exchange with, an unrelated person.

The gain to be deferred must be gain that would be recognized (but for the elective deferral) not later than December 31, 2026.[xxv]

Eligible Taxpayer

Any taxpayer that would otherwise recognize capital gain as a result of a sale or exchange is eligible to elect deferral under the QOZ rules; this includes individuals, C corporations, partnerships, S corporations, estates and trusts.

Where a partnership would otherwise recognize capital gain, it may elect to defer its gain and, to the extent that the partnership does not elect deferral, a partner may elect to do so.[xxvi]

If the election is made to defer all or part of a partnership’s capital gain – to the extent that it makes an equity investment in a QOF – no part of the deferred gain is required to be included in the distributive shares of the partners.

To the extent that a partnership does not elect to defer capital gain, the capital gain is included in the distributive shares of the partners.

If all or any portion of a partner’s distributive share satisfies all of the rules for eligibility under the QOZ rules – including the requirement that the gain did not arise from a sale or exchange with a person that is related either to the partnership or to the partner – then the partner generally may elect its own deferral with respect to the partner’s distributive share. The partner’s deferral is potentially available to the extent that the partner makes an eligible investment in a QOF.[xxvii]

Temporary Deferral

A taxpayer may elect to temporarily defer, and perhaps even partially exclude, capital gains from their gross income to the extent that the taxpayer invests the amount of those gains in a QOF.

The maximum amount of the deferred gain is equal to the amount invested in a QOF by the taxpayer during the 180-day period[xxviii] beginning on the date of the actual sale that produced the gain to be deferred. Where the capital gain results from a deemed or constructive sale of property, as provided under the Code, the 180-day investment period begins on the date on which the gain would be recognized (without regard to the deferral).[xxix]

Capital gains in excess of the amount deferred (i.e., that are not reinvested in a QOF) must be recognized and included in gross income in accordance with the applicable tax rules.

In the case of any investment in a QOF, only a portion of which consists of the investment of gain with respect to which an election is made (the “deferred-gain investment”), such investment is treated as two separate investments, consisting of one investment that includes only amounts to which the election applies, and a separate investment consisting of other amounts.

The temporary deferral and permanent exclusion provisions of the QOZ rules do not apply to the separate investment. For example, if a taxpayer sells stock (held for investment) at a gain and invests the entire sales proceeds (capital gain and return of basis) in a QOF, an election may be made only with respect to the capital gain amount. No election may be made with respect to amounts attributable to a return of basis, and no special tax benefits apply to such amounts.

Eligible Investment

In order to qualify for gain deferral, the capital gain from the taxpayer’s sale must be invested in an equity interest in the QOF; in addition to “common” equity interests, this may include preferred stock (in the case of a corporate QOF), or a partnership interest with special allocations (in the case of a partnership QOF).

The eligible investment cannot be a debt instrument.

Provided that the taxpayer is the owner of the equity interest in the QOF for federal income tax purposes, its status as an eligible interest will not be impaired by the taxpayer’s use of the interest as collateral for a loan, whether a purchase-money borrowing or otherwise.

This is an important point because it is possible that a taxpayer’s gain from a sale or exchange of property will exceed the amount of cash received by the taxpayer in such sale or exchange. Thus, a taxpayer may have to borrow money in order to make the necessary reinvestment and thereby defer the gain.

Partial Exclusion

The taxpayer’s basis for a deferred-gain investment in a QOF immediately after its acquisition is deemed to be zero, notwithstanding that they may have invested a significant amount of cash.[xxx]

If the deferred-gain investment in the QOF is held by the taxpayer for at least five years from the date of the original investment in the QOF, the basis in the deferred-gain investment (the taxpayer’s equity interest in the QOF) is increased by 10 percent of the original deferred gain.

If the QOF investment is held by the taxpayer for at least seven years,[xxxi] the basis in the deferred gain investment is increased by an additional five percent of the original deferred gain.[xxxii]

Gain Recognition

Some or all of the gain deferred by virtue of the investment in a QOF will be recognized on the earlier of: (1) the date on which the QOF investment is disposed of, or (2) December 31, 2026.

In other words, the gain that was deferred on the original sale or exchange must be recognized no later than the taxpayer’s taxable year that includes December 31, 2026, notwithstanding that the taxpayer may not yet have disposed of its equity interest in the QOF.

This point is significant insofar as a taxpayer’s ability to utilize the basis adjustment rule is concerned. In order for the taxpayer to receive the “10 percent of gain” and the additional “5 percent of gain” basis increases, described above, the taxpayer must have held the investment in the QOF for five years and seven years, respectively.

Because the taxpayer’s deferred gain from the original sale will be recognized no later than 2026, the taxpayer will have to sell or exchange “capital gain property,” and roll over the capital gain therefrom into an equity interest in a QOF, no later than December 31, 2019 in order to take advantage of the full “15 percent of gain basis increase.”[xxxiii]

The amount of gain recognized in 2026 will be equal to (1) the lesser of the amount deferred and the current fair market value of the investment,[xxxiv] over (2) the taxpayer’s basis in their QOF investment, taking into account any increases in such basis at the end of five or seven years.

As to the nature of the capital gain – i.e., long-term or short-term – the deferred gain’s tax attribute will be preserved through the deferral period, and will be taken into account when the gain is recognized. Thus, if the deferred gain was short-term capital gain, the same treatment will apply when that gain is included in the taxpayer’s gross income in 2026.

At that time, the taxpayer’s basis in the QOF interest will be increased by the amount of gain recognized.

No election to defer gain recognition under the QOZ rules may be made after December 31, 2026.[xxxv]

Death of the Electing Taxpayer

If an electing individual taxpayer should pass away before the deferred gain has been recognized,[xxxvi] then the deferred gain shall be treated as income in respect of a decedent, and shall be included in income in accordance with the applicable rules.[xxxvii]

In other words, the beneficiaries of the decedent’s estate will not enjoy a basis step-up for the deferred-gain investment in the QOF at the decedent’s death that would eliminate the deferred gain.

Exclusion of Appreciation

The post-acquisition capital gain on a deferred-gain investment in a QOF that is held for at least 10 years will be excluded from gross income.

Specifically, in the case of the sale or exchange of equity in a QOF held for at least 10 years from the date of the original investment in the QOF, a further election is allowed by the taxpayer to modify the basis of such deferred-gain investment in the hands of the taxpayer to be the “fair market value” of the deferred-gain investment at the date of such sale or exchange.[xxxviii]

However, under Sec. 1400Z-1, the designations of all QOZ in existence will expire on December 31, 2028. The IRS acknowledges that the loss of QOZ designation raises numerous issues regarding gain deferral elections that are still in effect when the designation expires. Among these is whether, after the relevant QOZ loses its designation, investors may still make basis step-up elections under Sec. 1400Z-2 for QOF investments from 2019 and later.[xxxix]

Investor Beware[xl]

A taxpayer who invests their gains in a QOF may continue to realize and recognize losses associated with their investment in the QOF. After all, the QOF is a “business” like any other, notwithstanding its genesis in Congress.

Moreover, its purpose is to invest in certain distressed communities (QOZs); that’s why the income tax incentives are being offered – to encourage investment in businesses located within QOZs.

In the case of a fund organized as a pass-through entity, a taxpayer-investor may recognize gains and losses associated with both the deferred-gain and non-deferred gain investments in the fund, under the tax rules generally applicable to pass-through entities.

Thus, for example, an investor-partner in a fund organized as a partnership would recognize their distributive share of the fund’s income or deductions, gains or losses, and the resulting increase or decrease in their “outside basis” for their interest in the partnership.[xli]

Aside from the ordinary business risk, an investor should also be aware that if a QOF fails to satisfy the requirement that the QOF hold at least 90 percent of its assets in QOZ property, the fund will have to pay a monthly penalty;[xlii] if the fund is a partnership, the penalty will be taken into account proportionately as part of the distributive share of each partner.

Example

The following example illustrates the basic operation of the above rules.

Assume a taxpayer sells stock for a gain of $1,000 on January 1, 2019, and elects to invest $1,000 in the stock of a QOF (thereby deferring this gain). Assume also that the taxpayer holds the investment for 10 years, and then sells the investment for $1,500.

The taxpayer’s initial basis in the deferred-gain investment is deemed to be zero.

After five years, the basis is increased to $100 (i.e., 10 percent of the $1,000 of deferred gain).

After seven years, the basis is increased to $150 (i.e., $100 plus an additional 5 percent of the deferred gain).

At the end of 2026, assume that the fair market value of the deferred-gain investment is at least $1,000, and thus the taxpayer has to recognize $850 of the deferred capital gain ($1,000 less $150 of basis).

At that point, the basis in the deferred gain investment is $1,000 ($150 + $850, the latter being the amount of gain recognized in 2026).

If the taxpayer holds the deferred-gain investment for 10 years and makes the election to increase the basis, the $500 of post-acquisition capital gain on the sale after 10 years is excluded from gross income.

What Does It All Mean?

QOFs are just now being organized. The IRS’s guidance on QOFs and their tax benefits is still in proposed form. The clock on the deadline for recognizing any gain that is deferred pursuant to these rules will stop ticking at the end of 2026 – that’s when the deferred gain must be recognized; generally speaking, the shorter the deferral period, the less beneficial it is to the taxpayer. In order to enjoy the full benefit of the gain reduction provided by the 15 percent of basis adjustment rule, a taxpayer will have to generate eligible gain and invest the amount thereof in a QOF prior to December 31, 2019.[xliii] Finally, in order to exclude the post-investment appreciation in a QOF interest, a taxpayer must hold that interest for at least ten years – that’s a long time.

Let’s start with the premise that, unless a taxpayer has a good business reason for selling an investment, including, for example, their business, they should not do so just to take advantage of the QOZ rules.

Assuming the taxpayer has decided that it makes sense to sell, aside from the hoped-for tax benefits, they have to consider the “tax rule of thumb” described at the beginning of this post:[xliv] economic certainty and tax deferral share an inverse relationship – there is generally an economic risk associated with long-term deferral.

With that, it will behoove the taxpayer to consult with their accountant and financial adviser, not to mention their attorney, prior to jumping into a QOF. Although questions remain, the QOZ rules provide some attractive tax benefits. Provided the taxpayer takes a balanced approach, there may be a place for a QOF investment in their portfolio.[xlv]

————————————————————————————

[i] I am neither a proponent nor an opponent of such investments. I am not qualified, nor do I purport, to give financial advice – I leave that to the financial planners. My goal is to give you something to think about.

[ii] Think Goldilocks. “Just right.”

[iii] Compare the passive investor who is willing to fund the new venture, provided they receive a preferred return for placing their money at risk, or the lender who is willing to extend credit to the business, but only at a higher rate, and maybe with the ability to convert into equity.

[iv] Not to mention their time and labor. Opportunity costs.

[v] After all, there is no market on which they may readily “trade” their equity.

[vi] Hopefully with the assistance of professionals who know the market, who can educate them in the process, who will “run interference” for them with potential buyers, and who can crunch the numbers in a meaningful way to compare offers.

[vii] Which may require the owners’ continued involvement if they hope to attain the earn-out targets.

[viii] As in the typical private equity deal.

This may be done on a pre- or post-tax basis; in the former, the owners will contribute their equity interest or assets to the buyer in exchange for equity in the buyer – the recognition of the gain inherent in the contributed property is thereby deferred; in the latter, they will take a portion of the cash paid to them (which is taxable) and invest it in the buyer.

[ix] Of course, I am ignoring the level of risk associated with the reps, warranties, and covenants given by the owners and the target business under the purchase-and-sale agreement, the breach of which may require that the now-former owners of the business indemnify the buyer for any losses incurred attributable to such breach – basically, an adjustment of the purchase price and a re-allocation of risk.

[x] For example, a forward corporate merger will allow some cash “boot” to be paid along with stock of the acquiring corporation; gain will be recognized to the extent of the cash received. In the case of a contribution to a partnership in exchange for an interest therein plus some cash, the so-called disguised sale rules will apply to determine the tax consequences.

[xi] To paraphrase Reg. Sec. 1.1001-1(a), the gain realized from the conversion of property into cash, or from the exchange of property for other property differing materially in kind, is treated as income sustained. In the context of the corporate reorganization provisions, we refer to there being a “continuity of business enterprise” and a “continuity of interest.” IRC Sec. 368; Reg. Sec. 1.368-1(d) and (e).

This recalls the like kind exchange rules under IRC Sec. 1031, the benefits of which are now limited to exchanges of real property. See Sec. 1031, as amended by the Act. https://www.law.cornell.edu/uscode/text/26/1031.

[xii] IRC Sec. 1202. Under this provision, non-corporate taxpayers may be able to exclude all of the gain from the sale of “qualified small business stock” held for more than five years. In order to qualify as qualified small business stock, several requirements must be satisfied, including the following: C corporation, original issue, qualified trade or business, gross assets not in excess of $50 million, at least 80% of the value of the assets must be used in the active conduct of the qualified trade or business. Query whether the reduction in the corporate tax rate, to a flat 21%, will spur interest in this provision and investment in qualifying corporations and businesses.

[xiii] IRC Sec. 1042. This provision affords the individual shareholder of the employer corporation the opportunity to sell stock to the ESOP (the ESOP must own at least 30%) and to defer the recognition of the gain realized on such sale by reinvesting the proceeds therefrom (within a 15-month period that begins three months prior to the sale) in the securities of other domestic corporations. This allows the owner to take some risk off the table, and to diversify their equity by investing in publicly traded corporations. In the meanwhile, the owner may continue to operate their business.

[xiv] P.L. 115-97 (the “Act”). I know, you’re tired of seeing this cite. I’m tired of . . . citing it. It is what it is.

[xv] https://www.irs.gov/pub/irs-drop/reg-115420-18.pdf .

[xvi] IRC Sec. 1400Z-2. https://www.law.cornell.edu/uscode/text/26/1400Z-2 . “Z” is so ominous. Anyone read the novel “Z” by Vassilikos?

[xvii] Which sets forth the requirements for a Qualified Opportunity Zone. We will not be discussing these requirements in this post. https://www.law.cornell.edu/uscode/text/26/1400Z-1 . See also https://www.irs.gov/pub/irs-drop/rr-18-29.pdf

[xviii] We will not be discussing the requirements for QOF status in any detail.

[xix] QOZ property, in turn, is defined to include QOZ stock, QOZ partnership interest, and QOZ business property. Although these terms are defined is some detail by the Code, one might say that the common denominator is that there be a qualified business that is conducted primarily within the QOZ. A penalty may be imposed for failing to satisfy this requirement. See EN xxxvii and the related text.

[xx] IRC Sec. 1245.

[xxi] IRC Sec. 1221, 1231.

[xxii] IRC Sec. 1222. This “attribute” of the gain is preserved for purposes of characterizing the gain when it is finally recognized.

Section 1231 property must be held for more than one year, by definition.

[xxiii] IRC Sec. 1368. This is often the case when an S corporation liquidates (or is deemed to liquidate) after the sale (or the deemed sale, under IRC Sec. 338(h)(10)) of its assets.

[xxiv] See IRC Sec. 267(b) https://www.law.cornell.edu/uscode/text/26/267 and Sec. 707(b)(1) https://www.law.cornell.edu/uscode/text/26/707 ; substitute “20 percent” in place of “50 percent” each place it appears.

[xxv] A taxpayer with gain, the recognition of which would be deferred beyond this time under the Sec. 453 installment method, would probably not elect to defer such gain under the QOZ rules. After all, why accelerate the recognition event? However, query whether there are circumstances in which it would make sense to elect out of installment reporting so as to utilize Sec. 1400Z-2? IRC Sec. 453(d). Perhaps to take advantage of the exclusion of gain after satisfying the ten-year holding period?

[xxvi] These proposed regulations clarify the circumstances under which the partnership or the partner can elect, and also clarify when the applicable 180-day period begins.

[xxvii] The proposed regulations state that rules analogous to the rules provided for partnerships and partners apply to other pass-through entities (including S corporations, decedents’ estates, and trusts) and to their shareholders and beneficiaries.

[xxviii] This investment period should be familiar to those of you who are experienced with like kind exchanges.

[xxix] A partner’s 180-day reinvestment period generally begins on the last day of the partnership’s taxable year, because that is the day on which the partner would be required to recognize the gain if the gain is not deferred. Query, however, whether the partnership will distribute the proceeds from the sale to its partners to enable them to make the roll-over investment – individual partners may have to use other funds (or borrow) in order to achieve the desired deferral.

[xxx] That being said, if the QOF is a partnership that has borrowed funds, the investor may be allocated a portion of such indebtedness, which amount would be added to their basis for their partnership interest. See IRC Sec. 752.

[xxxi] I.e., two more years.

[xxxii] Yielding basis equal to 15 percent of the original deferred gain.

[xxxiii] 2019 plus 7 equals 2026.

[xxxiv] Ah, the risk of an investment in equity.

[xxxv] Thus, the gain from a sale in 2025 may be deferred for one year. The gain from a sale during or after 2026 is not deferred under these rules.

[xxxvi] For example, before 2026.

[xxxvii] IRC Sec. 691.

[xxxviii] Query if this is the correct formulation; for example, what if the QOF is a partnership that generates losses which flow through to its members, thereby reducing their basis – does the statute intend for the members to wipe out this basis reduction and never recapture the benefit thereof on a subsequent sale? See the Example, below.

[xxxix] The proposed regulations would permit taxpayers to make the basis step-up election after the QOZ designation expires.

[xl] See EN 1. The IRS says as much in the preamble to the proposed regulations.

[xli] See EN xxxiii and the related text.

[xlii] Unless the failure is due to reasonable cause.

[xliii] An investment by December 31, 2021 may enjoy the 10 percent basis adjustment, which follows a five-year holding period.

[xliv] I know, you can’t remember that far back. I apologize. Lots to say this week.

[xlv] The saying “meden agan” was inscribed on the temple of Apollo at Delphi. It means “nothing in excess.”

 

Shortly after Section 199A was added to the Code at the end of 2017, and again after the IRS proposed regulations under the newly-enacted provision last summer, many clients called us with the following question: “Will my rental real estate activities qualify for the 199A deduction?”

In most cases, we were able to answer confidently that the client’s activities would be treated as a qualified trade or business, and that the deduction would be available, though it could be limited by the so-called “W-2 Wages and Unadjusted Basis” limitations.

In a few others, we were able to reply just as certainly that the activities did not rise to the level of a trade or business and, so, would not qualify for the deduction.

In some cases, however, we had to delve more deeply into the client’s particular facts and circumstances before we could reach any conclusion – often with the proviso that the IRS may disagree with our assessment of the situation.

“Trade or Business”

Like many other areas of the tax law, Section 199A requires a taxpayer to make a threshold determination of whether its activities rise to the level of constituting a trade or business.[i]

In general, courts have held that in order for a taxpayer’s activity to rise to the level of constituting a trade or business, the taxpayer must satisfy two requirements: (1) regular and continuous conduct of the activity, which depends on the extent of the taxpayer’s activities;[ii] and (2) a primary purpose to earn a profit, which depends on the taxpayer’s state of mind and their having a good faith intention to make a profit from the activity.[iii]

Whether a taxpayer’s activities meet these factors depends on the facts and circumstances of each case.

In most situations, neither the taxpayer nor the IRS should find it difficult to evaluate the trade or business status of the taxpayer’s activities – the level and quality of the activity will be such that its status will be obvious.

Unfortunately, there remain a number of cases in which the various “triers of fact” – first, the taxpayer, then the IRS, and finally the courts – will have to consider to the taxpayer’s unique “facts and circumstances” in determining whether the taxpayer’s activities rise to the level of a trade or business.

Because it is fact-intensive, while also being subjective, this analytical process can be costly and time-consuming.

It can also generate seemingly inconsistent conclusions by the ultimate trier of fact, a concern that has been borne out historically in the evaluation of smaller rental real estate operations.

Section 199A

One needs to keep the forgoing in mind in order to understand the tentative reaction to the enactment of Section 199A by the owners of many smaller rental real estate operations.

Section 199A provides a deduction to a non-corporate taxpayer[iv] of up to 20 percent of the taxpayer’s qualified business income from each of the taxpayer’s “qualified trades or businesses,” including those operated through a partnership, S corporation, or sole proprietorship, effective for taxable years beginning after December 31, 2017.[v]

Although the passage of Section 199A was greeted enthusiastically by most in the business community, some business owners withheld their endorsement of the provision pending the issuance of guidance as to meaning of certain key terms in the statute.

The rental real estate sector, in particular, hoped that the term “qualified trade or business” would be defined so as to provide its members with some certainty as to the application of the Section 199A deduction to their activities.

However, the statute defined a “qualified trade or business” as any trade or business other than a specified service trade or business or a trade or business of performing services as an employee.

Moreover, the legislative history failed to provide a definition of trade or business for purposes of section 199A.

Proposed Regulations

When the IRS proposed regulations in August of 2018, it stated that Section 162(a)[vi] of the Code provides the most appropriate “definition” of a trade or business for purposes of Section 199A.[vii]

The IRS explained that its decision was based on the fact that the definition of trade or business for purposes of Section 162 is derived from a large body of existing case law and administrative guidance interpreting the meaning of “trade or business” in the context of a broad range of industries.

For this reason, the IRS concluded that the definition of a trade or business under Section 162 provides for administrable rules that are appropriate for the purpose of Section 199A, and which taxpayers have experience applying.

That being said, the proposed regulations extended the definition of trade or business for purposes of Section 199A beyond Section 162 in one circumstance.

Solely for purposes of Section 199A, the IRS proposed that the rental of real property to a related trade or business would be treated as a trade or business if the rental and the other trade or business were commonly controlled. In supporting this extension, the IRS explained that it is not uncommon, for legal or other non-tax reasons, for taxpayers to segregate a rental property from an operating business. According to the IRS, this rule would allow taxpayers to effectively aggregate their trades or business with the associated rental property.[viii]

Notwithstanding the foregoing, the IRS received comments from advisers and industry groups that the status of a rental real estate enterprise as a trade or business within the meaning of Section 199A remained a subject of uncertainty for many taxpayers.

Final Regulations[ix]

The final regulations retained the proposed regulation’s definition of trade or business; specifically, for purposes of Section 199A and the regulations thereunder, a “trade or business” continues to be defined as a trade or business under Section 162 of the Code.[x]

The IRS acknowledged comments suggesting guidance in the form of a regulatory definition, a bright-line test, or a factor-based test.[xi] The IRS rejected these, however, pointing out that whether an activity rises to the level of a Section 162 trade or business is inherently a factual question, and the factual setting of various trades or businesses varies so widely, that a single rule or list of factors would be difficult to provide in a manageable manner, and would be difficult for taxpayers to apply.[xii]

However, the IRS also recognized the difficulties that a taxpayer may have in determining whether their rental real estate activity is sufficiently regular, continuous, and considerable for the activity to constitute a Section 162 trade or business.

Proposed Safe Harbor

To help mitigate the resulting uncertainty, the IRS recently proposed – concurrently with the release of the final Section 199A regulations – the issuance of a new revenue procedure that would provide for a “safe harbor” under which a taxpayer’s “rental real estate enterprise”[xiii] will be treated as a trade or business for purposes of Section 199A.[xiv]

To qualify for treatment as a trade or business under this safe harbor, a rental real estate enterprise must satisfy the requirements of the proposed revenue procedure. If the safe harbor requirements are met, the real estate enterprise will be treated as a trade or business for purposes of applying Section 199A and its regulations.

Significantly, an S corporation or a partnership[xv] (pass-through entities; “PTE”) that is owned, directly or indirectly, by at least one individual, estate, or trust may also use this safe harbor in order to determine whether a rental real estate enterprise conducted by the PTE is a trade or business within the meaning of Section 199A.[xvi]

Rental Real Estate Enterprise

For purposes of the safe harbor, a “rental real estate enterprise” is defined as an interest in real property held for the production of rents; it may consist of an interest in one or in multiple properties.

The individual or PTE relying on the proposed revenue procedure must hold the interest directly or through an entity that is disregarded as an entity separate from its owner for tax purposes.[xvii]

A taxpayer may treat each property held for the production of rents as a separate enterprise; alternatively, a taxpayer may treat all “similar” properties held for the production of rents as a single enterprise.[xviii] The treatment of a taxpayer’s rental properties as a single enterprise or as separate enterprises may not be varied from year-to-year unless there has been a “significant”[xix] change in facts and circumstances.

Commercial and residential real estate may not be part of the same rental enterprise; in other words, a taxpayer with an interest in a commercial rental property, who also owns an interest in a residential rental, will be treated as having two rental real estate enterprises for purposes of applying the revenue procedure.

Rental as Section 199A Trade or Business

A rental real estate enterprise will be treated as a trade or business for a taxable year (solely for purposes of Section 199A) if the following requirements are satisfied during the taxable year with respect to the rental real estate enterprise:

(A) Separate books and records are maintained to reflect income and expenses for each rental real estate enterprise, as well as a separate bank account for each enterprise;[xx]

(B) For taxable years beginning:

(i) prior to January 1, 2023, 250 or more hours of “rental services”[xxi] are performed per year with respect to the rental enterprise;

(ii) after December 31, 2022, in any three of the five consecutive taxable years that end with the taxable year (or in each year for an enterprise held for less than five years), 250 or more hours of rental services are performed per year with respect to the rental real estate enterprise; and

(C) The taxpayer maintains contemporaneous records, including time reports, logs, or similar documents, regarding the following:

(i) hours of all services performed;

(ii) description of all services performed;

(iii) dates on which such services were performed; and

(iv) who performed the services.

Such records are, of course, to be made available for inspection at the request of the IRS.[xxii]

Rental Services

The rental services to be performed with respect to a rental real estate enterprise for purposes of satisfying the safe harbor include the following:

(i) advertising to rent or lease the real estate;

(ii) negotiating and executing leases;

(iii) verifying information contained in prospective tenant applications;

(iv) collection of rent and payment of expenses;

(v) daily operation, maintenance, and repair of the property;

(vi) management of the real estate;

(vii) provision of services to tenants;[xxiii]

(viii) purchase of materials; and

(ix) supervision of employees and independent contractors.[xxiv]

Rental services may be performed by the individual owners (in the case of direct ownership of the real property) or by the PTE that owns the property, or by the employees, agents, and/or independent contractors of the owners.

It is important to note that hours spent by an owner or any other person with respect to the owner’s capacity as an investor are not considered to be hours of service with respect to the enterprise. Thus, the proposed revenue procedure provides that the term “rental services” does not include the following:

(i) financial or investment management activities, such as arranging financing;

(ii) procuring property;

(iii) studying and reviewing financial statements or reports on operations;

(iv) planning, managing, or constructing long-term capital improvements; or

(v) traveling to and from the real estate.[xxv]

Real estate used by the taxpayer (including by an owner of a PTE relying on this safe harbor) as a residence for any part of the year[xxvi] is not eligible for the safe harbor.

Real estate rented under a triple net lease is also not eligible for the safe harbor – it more closely resembles an investment than a trade or business. For purposes of this rule, a “triple net lease” includes a lease agreement that requires the tenant to pay taxes, fees, and insurance, and to be responsible for maintenance activities for a property in addition to rent and utilities. This also includes a lease agreement that requires the tenant to pay a portion of the taxes, fees, and insurance, and to be responsible for maintenance activities allocable to the portion of the property rented by the tenant.

Procedural Requirements, Reliance

A taxpayer or PTE must include a statement attached to the return on which it claims the Section 199A deduction or passes through Section 199A information that the requirements in the revenue procedure have been satisfied. The statement must be signed by the taxpayer, or an authorized representative of an eligible taxpayer or PTE, which states:

Under penalties of perjury, I (we) declare that I (we) have examined the statement, and, to the best of my (our) knowledge and belief, the statement contains all the relevant facts relating to the revenue procedure, and such facts are true, correct, and complete.

The individual or individuals who execute the statement must have personal knowledge of the facts and circumstances related to the statement.

If an enterprise fails to satisfy these requirements, the rental real estate enterprise may still be treated as a trade or business for purposes of Section 199A if the enterprise otherwise meets the general definition of trade or business.[xxvii]

The proposed revenue procedure is proposed to apply generally to taxpayers with taxable years beginning after December 31, 2017; i.e., the effective date for Section 199A.

In addition, until such time that the proposed revenue procedure is published in final form, taxpayers may use the safe harbor described in the proposed revenue procedure for purposes of determining when a rental real estate enterprise may be treated as a trade or business solely for purposes of Section 199A.

What’s Next?

All in all, the final regulations and the proposed safe harbor should provide some welcomed relief and “certainty” for those individual taxpayers and PTEs that own smaller rental real estate operations;[xxviii] and they came just in time – barely – for the preparation of these taxpayers’ 2018 tax returns.

But the proof is in the pudding – or something like that – and the actual impact of the proposed safe harbor will have to await the collection and analysis of the relevant data, including the reactions of taxpayers and their advisers.

As in the case of many other taxpayer-friendly regulations or procedures,[xxix] the benefit afforded requires that the taxpayer be diligent in maintaining contemporaneous, detailed records for each rental real estate enterprise. This may be a challenge for many a would-be qualified trade or business.

Whether to treat “similar” rental properties as a single enterprise may also present some difficulties for taxpayers, at least until they figure out what it means for one property to be similar to another. Based upon the term’s placement in the proposed revenue procedure, it may be that all residential properties are similar to one another, just as all commercial properties are similar to one another. In that case, a taxpayer may be able to treat all of its residential rentals, for example, as a single enterprise, which may allow it to satisfy the “250 or more hours of rental service” requirements of the safe harbor.

Just as challenging may be a taxpayer’s distinguishing between business-related services and investment-related services.[xxx]

Regardless of how the proposed safe harbor is ultimately implemented and administered, the fact remains that the IRS has clearly considered and responded to the requests of the rental real estate industry.

The questions remain, however: Will Section 199A survive through its scheduled expiration date in 2025; and, if so, will it become a “permanent” part of the Code? Or is all this fuss just a way to drive folks like me crazy?

——————————————————————————–
[i] https://www.law.cornell.edu/uscode/text/26/199A

For example, expenses are deductible if they are incurred “in carrying on any trade or business.” IRC Sec.162.

[ii] Which may distinguish a trade or business from an “investment.”

[iii] As opposed to a “hobby.”

[iv] Individuals; also trusts and estates.

[v] Tax Cuts and Jobs Act, PL 115-97, Sec. 11011. The deduction disappears for taxable years beginning after December 31, 2025.

[vi] https://www.law.cornell.edu/uscode/text/26/162. In general, Section 162 of the Code provides that the ordinary and necessary expenditures directly connected with or pertaining to a taxpayer’s “trade or business” are deductible in determining the taxpayer’s taxable income.

[vii] https://www.irs.gov/pub/irs-drop/reg-107892-18.pdf

[viii] The final regulations clarify the rule by limiting its application to situations in which the related party tenant is an individual or an PTE (not a C corporation).

[ix] https://www.irs.gov/pub/irs-drop/td-reg-107892-18.pdf

[x] Other than the trade or business of performing services as an employee.

[xi] It also considered and rejected suggestions that it define trade or business by reference to Section 469 of the Code, explaining that the definition of trade or business for Section 469 purposes is significantly broader than the definition for purposes of Section 162 as it is intended to capture a “larger universe” of activities, including passive activities. According to the IRS, Section 469 was enacted to limit the deduction of certain passive losses and therefore, serves a very different purpose than the allowance of a deduction under section 199A. Further, Section 199A does not require that a taxpayer materially participate in a trade or business in order to qualify for the Section 199A deduction.

The IRS also declined to adopt a suggestion that all rental real estate activity be deemed to be a trade or business for purposes of Section 199A.

[xii] In determining whether a rental real estate activity is a section 162 trade or business, relevant factors might include, but are not limited to (i) the type of rented property (commercial real property versus residential property), (ii) the number of properties rented, (iii) the owner’s or the owner’s agents day-to-day involvement, (iv) the types and significance of any ancillary services provided under the lease, and (v) the terms of the lease (for example, a net lease versus a traditional lease and a short-term lease versus a long-term lease).

[xiii] Yes, another defined term.

[xiv] Notice 2019-07. https://www.irs.gov/pub/irs-drop/n-19-07.pdf

[xv] Other than a publicly traded partnership.

[xvi] You may recall that it is up to the PTE (not its owners) to determine whether it is engaged in a qualified trade or business.

[xvii] Reg. Sec. 301.7701-3; for example, a single-member LLC; so, two tiers of entities at most (one of which must be disregarded) – an S corp. that owns an interest in a 2-person partnership that owns rental real estate would not qualify.

[xviii] There is no in-between, where some similar properties are treated as one enterprise while others as separate enterprises.

[xix] As of yet undefined.

[xx] Query how this may affect a taxpayer’s decision to treat all “similar” properties held for the production of rents as a single enterprise?

[xxi] You guessed it. C’mon, it’s tax – we love defined terms within defined terms. They put Russian nesting dolls to shame.

[xxii] The contemporaneous records requirement will not apply to taxable years beginning prior to January 1, 2019.

[xxiii] Although not spelled out in the proposed revenue procedure, presumably this includes some of the following: providing and paying for gas, water, electricity, sewage, and insurance for the property; paying the taxes assessed thereon; providing insect control, janitorial service, trash collection, ground maintenance, and heating, air conditioning and plumbing maintenance.

[xxiv] This does not purport to be an all-inclusive list.

[xxv] The number of times I have seen taxpayers count such travel time in trying to establish their material participation for purposes of the passive activity rules!

[xxvi] Under section 280A of the Code. In general, a taxpayer uses a property during the taxable year as a residence if he uses such property for personal purposes for a number of days which exceeds the greater of: 14 days, or 10 percent of the number of days during such year for which such property is rented at a fair rental.

[xxvii] Under Section 162, which may be small comfort – after all, that’s why the safe harbor was proposed.

[xxviii] Not that everything was rosy. Example 1 of proposed §1.199A-1(d)(4) described a taxpayer who owns several parcels of land that the taxpayer manages and leases to airports for parking lots. The IRS shared that some taxpayers questioned whether the use of the lease of unimproved land in the example was intended to imply that the lease of unimproved land is a trade or business for purposes of section 199A. The IRS explained that the example was intended to provide a simple illustration of how the 199A calculation would work; it was not intended to imply that the lease of the land is, or is not, a trade or business for purposes of section 199A beyond the assumption in the example. In order to avoid any confusion, the final regulations removed the references to land in the example.

[xxix] For example, the material participation regulations under Reg. Sec. 1.469-5T.

[xxx] For example, attending a hearing of a local zoning board.

We Want You

One of the most challenging problems facing a business is how to attract, and then retain, qualified employees.[i] The competition among businesses can be fierce and, in order to succeed, businesses have, over the years, developed a number of compensation alternatives. Some of these have become “standard” options,[ii] thereby forcing businesses to devise more tailored arrangements for certain prospective employees. In almost all cases, however, both parties have recognized the impact of taxes – in terms of the amount of compensation and the timing of its recognition – on the net economic benefit of a particular compensation package.

Transition Loan/Compensation

In the financial services industry, it has long been the practice for a firm to loan a new key employee a significant sum of money (so-called “transition compensation”) in order to entice them to join the firm. In exchange, the employee executes a promissory note to evidence the amount they owe to the firm, along with an employment agreement pursuant to which the firm “pays” the employee a monthly amount, which is then immediately applied toward the amount owing to the firm for that month under the note. This arrangement allows the employee to receive the full amount of their transition compensation upfront, while recognizing income only as each monthly payment comes due. No moneys change hands with respect to each monthly “repayment” of the loan.

If the loan is consistently treated as such by the parties, it will likely withstand IRS scrutiny and be respected as a loan.[iii] Consequently, the monthly payments will be included in the employee’s gross income and will be deductible by the firm, provided the total compensation paid by the firm to the employee is reasonable for the services to be rendered.[iv]

Of course, circumstances may arise that cause the key employee and the firm to go their separate ways. In that case, depending upon the particular facts, the amount of the “transition compensation loan” that remains outstanding may become due immediately.[v]

The U.S. Tax Court recently considered a complicated version of this situation. https://www.ustaxcourt.gov/USTCInOP/OpinionViewer.aspx?ID=11848.

Welcome

Taxpayer was a very successful financial adviser and certified financial planner. He was employed by Firm A, where he developed a large book of business. To service those clients, he worked with a five-person team of brokers and assistants who, though they were employed by Firm A, worked exclusively for Taxpayer.

Taxpayer and his team subsequently joined Firm B. Upon his agreeing to work for Firm B, the firm lent him approximately $3.6 million. To evidence the loan, Taxpayer signed a promissory note. He also signed an employment agreement, which, among other things, provided for a “monthly transition compensation payment” in an amount equal to the amount due and payable each month by Taxpayer pursuant to the terms of the note. In order to facilitate the repayment of the loan, this amount – which was taxable to Taxpayer as compensation – was deducted from Taxpayer’s compensation from Firm B.[vi]

The employment agreement provided that Taxpayer would cease to be entitled to transition compensation upon the termination of his employment with Firm B for any reason. However, if his termination was other than for “cause,”[vii] Firm B would pay Taxpayer a lump sum equal to the remaining transition compensation payments through a specified date, less any outstanding debts Taxpayer owed Firm B. In the event Taxpayer resigned or his employment was terminated by Firm B for cause, Taxpayer would not receive these payments.

The loan became immediately repayable if Taxpayer’s employment with Firm B was terminated for any reason.

Taxpayer was offered this high level of compensation in anticipation of his clients’ moving with him and his team to Firm B. His efforts to contact his clients and persuade them to leave Firm A and join him at Firm B were governed by an protocol entered into by participating financial services firms, to which Firms A and B were parties, and which set forth the specific types of information which a financial adviser, such as Taxpayer, could take with them when they left one financial services firm to join another.

Seeking to bring his clients to Firm B, Taxpayer consulted with Firm B’s attorneys to interpret the protocol, and then relied on their interpretation of the protocol when he brought his client information with him to Firm B and used it to contact the clients, inform them of the move, and invite them to change financial services firms.[viii]

Taxpayer brought his entire team to Firm B. As part of the transition, Taxpayer also brought various spreadsheets and documents with client information used by his group at Firm A, which he had developed over his years of work. These documents and spreadsheets were treated as Taxpayer’s personal property at Firm A.

Sorry It Didn’t Work Out

Less than a year after Taxpayer joined Firm B, their relationship soured. Firm B launched an investigation with respect to how Taxpayer brought his clients from Firm A to Firm B and whether he violated the protocol and/or his employment agreement.

At that point, Taxpayer voluntarily resigned and began seeking employment at another financial services firm. He was stymied, however, because Firm B did not immediately submit the requisite form to FINRA[ix] with details regarding the termination of his employment, without which no reputable would hire him. Consequently, for a time after he left Firm B, Taxpayer could not service his clients.

In the meantime, Firm B actively solicited Taxpayer’s clients. It had Taxpayer’s former team members[x] contact each client in an attempt to persuade them to abandon Taxpayer and remain with Firm B. It also retained Taxpayer’s documents and spreadsheets, which the team members continued to use to service clients.

About a month after Taxpayer’s resignation, Firm B made the requisite filing, but under the form included an explanation that Taxpayer was permitted to resign on account of “conduct resulting in loss of management’s confidence, including conduct relating to the handling of customer information and lack of cooperation in the firm’s review of the matter.”

Firm B then brought a proceeding against Taxpayer before a FINRA panel in which it sought repayment of the outstanding balance of Taxpayer’s loan, asserting that the terms of the promissory note called for such repayment upon termination of Taxpayer’s employment.[xi]

In response, Taxpayer requested that the panel award him (i.e., forgive) the “unpaid” transition compensation (approximately $3.2 million) “loaned” to him when he joined Firm B. He also requested that Firm B release to his documents and spreadsheets.

The Panel’s Decision

Taxpayer stated that the panel should reject Firm B’s demand that he repay the outstanding balance of the upfront forgivable loan because if Firm B were allowed to collect the amount allegedly remaining due under such loan,[xii] after having induced Taxpayer to transfer his entire book of business to Firm B and then effectively forcing his resignation less than one year later, the firm would have been permitted to freeze Taxpayer out of the financial services industry, thus receiving the entire benefit of his substantial book of business, including the revenues generated from such book of business, all without having to provide any compensation to Taxpayer for that book of business.[xiii]

According to Taxpayer, these same facts supported his contention that Firm B had essentially converted his book of business and misappropriated his trade secrets (in the form of the client-documents and spreadsheets) via a plan whereby it: (1) lured Taxpayer to join the firm with a large compensation package (i.e., the amount of the monthly transition compensation and the upfront forgivable loan that was based on the value of his book of business); (2) forced his resignation just before his first year bonus was due to be paid; (3) demanded he repay the upfront forgivable loan; and (4) filed “a false and defamatory Form U5”, which “virtually assured that [Taxpayer] * * * [would] not be able to find comparable employment in the financial services industry, thereby allowing [Firm B] to continue to service [Taxpayer’s] clients almost entirely free from competition.”

Taxpayer stressed the fact that, unlike the scenario wherein a hypothetical financial planner leaves one firm to work at another with an outstanding balance remaining on a forgivable loan, when Taxpayer resigned from Firm B, he did not join a competitor. Instead, having effectively sidelined Taxpayer, Firm B was able to solicit his entire book of business free from competition, while in the several months since his resignation, Taxpayer had only managed to acquire a handful of clients.

The panel declined to order Taxpayer to pay the remaining balance of the upfront forgivable loan owing to Firm B under the promissory note, and ruled that Taxpayer was entitled to retain such balance.

The panel also ordered Firm B to deliver to Taxpayer the templates for his documents and spreadsheets, but expressly stated that the templates were to be delivered to him without any data. Upon delivery, Firm B was ordered to certify that it had removed these materials from its own computer systems. However, the order did not prevent Firm B from retaining the substantive client information.

Taxpayer’s Federal Income Tax Return

Firm B issued Taxpayer an IRS Form 1099-C, Cancellation of Debt, reporting debt cancellation income of approximately $3.2 million.[xiv]

Taxpayer timely filed his Federal income tax return, wherein he reported an overall loss and claimed a refund. He reported the 1099-C cancellation of indebtedness income as “deferred compensation.”[xv] He offset this amount with certain ordinary loss items, including a “Firm A Deferred Compensation Loss” of $2.5 million.

The IRS examined Taxpayer’s tax return and determined that the Firm A deferred compensation loss was actually a capital loss from the sale of stock, and could not be used to offset ordinary income.

Taxpayer conceded this adjustment, and then amended his income tax return to recharacterize the extinguishment of the balance of the Firm B upfront forgivable loan from ordinary income to capital gain,[xvi] and again claimed a refund.

The IRS denied the refund claim, and Taxpayer petitioned the Court.

The issue before the Tax Court involved the character of the balance of the upfront forgivable loan which was extinguished as a result of the panel’s award determination. Specifically, the Court had to determine whether that award constituted capital gain resulting from Firm B’s taking of Taxpayer’s book of business, as Taxpayer maintained, or ordinary income resulting from the cancellation of indebtedness, as asserted by the IRS. To resolve the characterization of the award, the Court focused on Taxpayer’s arguments raised before the panel.

The Tax Court

It is axiomatic that a taxpayer’s gross income includes all income realized by the taxpayer, from whatever source it is derived, unless it is specifically excluded by statute. Thus, proceeds “received” pursuant to a judgment arising from a dispute – including the amount of the reduction or cancellation of a debtor’s obligation[xvii] – constitutes taxable income unless the taxpayer can establish that the proceeds come within the scope of a statutory exclusion.

Starting from this premise, the Court recognized that “[t]he taxability of the proceeds of a lawsuit, or of a sum received in settlement thereof, depends upon the nature of the claim and the actual basis of recovery.” The nature of the litigation, the Court continued, “is determined by reference to the origin and character of the claim which gave rise to the litigation.” Thus, to the extent that amounts received for injury or damage to capital assets exceed the basis of the property, such amounts are taxable as capital gain, whereas amounts received for lost profits are taxable as ordinary income.

In deciding the character of the upfront forgivable loan that was extinguished as a result of the panel’s award, the Court asked: “In lieu of what were the damages awarded?”

The IRS argued that Taxpayer was bound by his employment agreement and promissory note. The promissory note was made as part of Taxpayer’s compensation package with Firm B (i.e., the monthly transition compensation). The note made no mention of Taxpayer’s book of business.

Moreover, Taxpayer treated the monthly transition compensation he received during his tenure at Firm B as ordinary income, which is consistent with the terms of the employment agreement and promissory note.

The IRS also pointed out that Taxpayer did not assert that the income was capital gain income until the IRS determined that his Firm A stock loss was a capital (rather than ordinary) loss.

The Court observed that the panel did not explain the basis of its award; hence, the Court was left to infer the panel’s reasoning. It explained that, in similar cases, it has looked to the claims made in the pleadings to determine the nature of the taxpayers’ claims.

Taxpayer argued that his filings with the FINRA panel made it clear that the award was to compensate him for the taking of his book of business and hence should be taxed as a capital gain.

The gravamen of Taxpayer’s claim before the panel was that he was entitled to retain the unpaid portion of the loan proceeds because they represented fair compensation for Firm B’s having taken his book of business. In fact, that was the only argument he made with respect to his claim for retention of those proceeds.

The Court disagreed.

It conceded that the filings heavily emphasized Taxpayer’s argument that Firm B lured him in order to acquire his book of business and that thereafter it set out to ruin his professional reputation so as to keep him from working at a competing financial services firm.

But this argument was not the only one Taxpayer presented to the panel. For example, Taxpayer’s filings emphasized that Firm B breached the terms of the employment contract, causing Taxpayer to suffer damages. This argument, by itself, would have relieved Taxpayer of his obligation to pay the outstanding balance of the promissory note to Firm B.

Unfortunately for Taxpayer, the record before the Court did not reveal the specific argument that the panel found most persuasive when it extinguished the balance of the upfront forgivable loan.

Taxpayer had the burden of answering the question “in lieu of what were the damages awarded?” On the basis of its examination of the record, the Court concluded that Taxpayer did not meet his burden to establish that the amount at issue was solely for the acquisition of Taxpayer’s book of business.

Consequently, the Court sustained the IRS’s determination that the extinguishment of Taxpayer’s debt to Firm B constituted cancellation of debt income, and that the amount of the extinguishment was taxable as ordinary income.

Takeaways?

It’s an old question: how to distinguish between being given the opportunity to provide services for which one receives compensation taxable as ordinary income, on the one hand, and the transfer of an asset that produces ordinary income, on the other.

The Court did not expressly address the issue, nor did it have to. There were just too many indicia of ordinary income: the industry practice of the forgivable loan as a substitute for immediately taxable compensation, the fact that Taxpayer (as the purported “seller”) rather than Firm B (as the purported buyer) gave a promissory note, Taxpayer’s reporting of the transition payments as ordinary income, Taxpayer’s having negotiated the right in his employment agreement to solicit the customers he brought to Firm B in the event he left the firm, and the fact that he first reported the forgiven loan as ordinary before amending his tax return in response to the IRS’s adjustment of the Firm A stock loss.

That being said, there were also some factors that may have supported capital gain (i.e. sale) treatment under different circumstances. For example, Firm A treated Taxpayer’s spreadsheets and other documents as his personal property, his team remained with Firm B after Taxpayer’s departure, and Taxpayer was effectively precluded from taking his clients with him when he resigned from Firm B. If Taxpayer had not been an employee of Firm A prior to moving his team and clients to Firm B, an argument might have been made that the relationship among Taxpayer, his team, and his clients was indicative of a going concern and of personal goodwill, which together represented an asset, the sale of which generated capital gain.[xviii]

Of course, if the parties had intended something other than a compensatory arrangement, they could have memorialized their agreement differently, and they could have reported their payments and receipts under this arrangement, for tax purposes, other than as they did; in other words, their chosen form would presumably have been consistent with the intended tax treatment.

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[i] Last week we considered this issue from the perspective of a tax-exempt organization, in light of the Tax Cuts and Jobs Act. https://www.taxlawforchb.com/2019/01/its-a-business-no-its-a-charity-wait-its-a-charity-that-is-treated-like-a-business/ .

[ii] At least within an industry.

[iii] I.e., a receipt of value that is nontaxable because it has to be repaid; there has been no accretion in value by the recipient.

[iv] IRC Sec. 162(a).

[v] Indeed, these upfront forgivable loan arrangements are often contingent upon the continued employment of the employee with the employer-lender.

[vi] Query why the IRS did not argue that this circular flow of funds caused the entire amount of the “loan” to be treated as compensation in the taxable year the proceeds were transferred to Taxpayer?

[vii] “Cause” was defined to include, among other things:

  1. violation of any rules or regulations of any regulatory or self-regulatory organization;
  2. violation, as reasonably determined by Firm B, of its rules, regulations, policies, practices, directions, and/or procedures; or
  3. a suspension, bar, or limitation on Taxpayer’s activities for Firm B by any regulatory or self-regulatory

organization.

[viii] Taxpayer’s relationship with his clients was important to him. He negotiated special terms in his employment agreement which allowed him to solicit his longtime clients (i.e., those clients who came with him from Firm A) if he should ever leave Firm B. Specifically, for a period of one year following the termination of Taxpayer’s employment with Firm B for any reason, he agreed not to solicit, or initiate contact or communication with, either directly or indirectly, any account, customer, client, customer lead, prospect, or referral whom Taxpayer served or whose name became known to him during his employment at Firm B. However, this restriction did not apply to clients whom Taxpayer served at his prior employer (Firm A) or who became clients of Firm B within one year after he began employment with Firm B.

[ix] Form U5. FINRA is a private corporation that acts as a self-regulatory organization. It is the successor to the NASD, and ultimately reports to the SEC.

[x] Whom Firm B had convinced to stay with the firm through various incentives.

[xi] Interestingly, none of Taxpayer’s team, including his partner and the four sales assistants who transitioned with him, seem to have faced any repercussions for the actions in which they all engaged and which allegedly constituted violations of the protocol. The rest of the team remained at Firm B servicing Taxpayer’s entire book of business. “Who’s your daddy?”

[xii] Which amount was directly tied to the amount of revenue his book of business generated the year before he joined Firm B.

[xiii] Taxpayer relied on these facts to support his claims against Firm B of unjust enrichment, fraudulent inducement, breach of contract, and breach of the implied covenant of good faith.

[xiv] The remaining balance of the upfront forgivable loan.

[xv] Ordinary income.

[xvi] So as to offset the capital loss resulting from the IRS’s adjustment.

[xvii] IRC Sec. 108, 61(a)(12).

[xviii] Much as a non-compete is an important element in ensuring the transfer of a seller’s goodwill to a buyer, so the acts allegedly taken by Firm B effectively secured for its benefit the asset represented by Taxpayer’s client base.

Tax Law for the Closely Held Business blog authors Lou Vlahos and Bernadette Kasnicki presented yesterday, January 17, on how the Tax Cuts and Jobs Act affects not-for-profit organizations. Their presentation–given at the 41st Annual New York State Society Certified Public Accountants (NYSSCPA) Not-for-Profit Conference in New York City–was summarized in article format for The Trusted Professional, the NYSSCPA’s newspaper.

Below is an excerpt from the article:

The Tax Cuts and Jobs Act has a number of provisions that both directly and indirectly affect not-for-profit organizations, but tax attorneys Bernadette Kasnicki and Louis Vlahos—speaking at the Foundation for Accounting Education’s 41st Annual Nonprofit Conference today—said that the targeted provisions seem to focus on narrowing the gap between rules that govern non-profit and for-profit organizations.

For example, Kasnicki, an associate with the firm Farrell Fritz P.C., said that the TCJA imposes a 21 percent excise tax on nonprofits that pay compensation of $1 million or more to any of their five highest-paid employees, which applies to all forms of remuneration of a covered employee. She noted that, in the for-profit world, compensation of top executives cannot be deducted beyond the point of $1 million. She said that, by subjecting nonprofits to a similar rule, the TCJA is attempting to bring exempt organizations into parity with taxable ones.

Vlahos, a partner at the same firm, said that it’s actually a little worse for nonprofits under the new rules. For-profit organizations have two carveouts for the deduction limit: one is if the pay is reasonable for services rendered previously, and the other is for parachute payments that represent payment for services going forward “because we’re not firing you but keeping you.” Not-for-profits, on the other hand, have no such carveouts.

Please click here to read the full article.

 In case you missed it, you may also be interested in reading Lou Vlahos’s latest post on the blog: It’s a Business . . . No, It’s a Charity . . . Wait – It’s a Charity That Is Treated Like a Business?

 

The Business-Charity Connection

As our readers know, this blog is dedicated to addressing the tax-related business and succession planning issues that are most often encountered by the owners of a closely held business. Occasionally, however, we have crossed over into the space occupied by tax-exempt charitable organizations inasmuch as such an exempt organization (“EO”) may be the object of a business owner’s philanthropy, either during the owner’s life or at their demise.

Foundations

For example, we have considered grant-making private foundations (“PF”) that have been funded by the business owner and, thus, are not reliant upon the general public for their financial survival. In particular, we have reviewed a number of the penalty (“excise”) taxes applicable to PFs. These are rooted in the government’s tacit recognition that the activities of such a PF cannot be influenced by the withholding of public support from the foundation. Rather, the threatened imposition of these taxes is intended to encourage certain “good” behavior and to discourage certain “bad” behavior by a PF.[i]

Although PFs are important players in the charitable world, a business owner is far more likely to support charitable activities by making direct financial contributions to publicly-supported charities that operate within their community, rather than to create a PF through which to engage in such charitable giving.[ii]

Board Service

Where the business owner has a personal connection to an EO’s charitable mission, the owner may seek to become a member of the organization’s board of directors. In other cases, the EO itself may solicit the owner’s involvement, in part to help secure their financial support, not to mention the access they can provide to other potential donors from the business world.

Another reason that business owners may be attractive candidates for an EO’s board of directors is that they are experienced in . . . running a business.[iii] This skillset may be especially important in light of recent changes to the Code that reflect Congress’s heightened skepticism toward EOs, and that are aimed at limiting the amount of executive compensation payable by EOs.

Increased Public Scrutiny

Congress’s reaction to EO executive compensation is, in part, attributable to the public’s own changing perspective. As the charitably-inclined segment of the “public” has become more sophisticated, and better informed, it has demanded more accountability as to how its charitable contributions are being utilized, including what percentage of the contributions made to a charity is being used for executive compensation.[iv]

These “economic” concerns are magnified when viewed in light of the reality that the vast majority of charitable organizations are governed by self-perpetuating boards of directors,[v] which in turn hire the executive employees who operate these organizations on a day-to-day basis.

In response to these concerns, Congress has slowly been adding provisions to the Code that are intended (as in the case of the excise taxes applicable to PFs) to dissuade public charities and their boards from engaging in certain behavior.

Until the passage of the Tax Cuts and Jobs Act of 2017,[vi] the most notable of these provisions was that dealing with “excess benefit transactions.”[vii]

Blurring the Lines

As a result of these economic pressures, not to mention the attendant governmental scrutiny, most public charities have sought to fulfill their charitable missions on a more efficient basis. In other words, they have tried to become more “business-like” in performing their charitable functions. In furtherance of this goal, many EOs have tried to attract and retain the services of talented and experienced executives, while also inviting successful business owners onto their boards.

Notwithstanding these efforts, many EOs continue to be in the Congressional crosshairs. In particular, some larger EOs have been accused, in some circles, of taking advantage of their tax-preferred status to generate what critics have characterized as large profits, a not-insignificant portion of which find their way, or so these critics assert, into the hands of the organizations’ key executives in the form of generous compensation packages.

The Act represents the latest Congressional effort to rein in what its proponents perceived as abuses in the compensation of EOs’ top executives.

In order to stem these “abuses,” the Act draws liberally from the tax rules applicable to executive compensation paid or incurred by business organizations. Before delving into these provisions, it would be helpful to briefly review the “for-profit” rules from which they were derived.

For-Profit Compensation Limits

In determining its taxable income from the conduct of a trade or business, an employer may claim a deduction for reasonable compensation paid or incurred for services actually rendered to the trade or business.[viii] Whether compensation is reasonable depends upon all of the facts and circumstances. In general, compensation is reasonable if the amount thereof is equal to what would ordinarily be paid for “like services by like enterprises under like circumstances.”[ix]

However, Congress has determined – without stating that it is per se unreasonable – that compensation in excess of specified levels may not be deductible in certain situations.

Public Corporations

Prior to the Act, and in order to protect shareholders from grasping executives, a publicly-held corporation generally could not deduct more than $1 million of compensation in a taxable year for each “covered employee,”[x] unless the corporation could establish that the compensation was performance-based.[xi]

Golden Parachutes

In addition, a corporation generally cannot deduct that portion of the aggregate present value of a “parachute payment” – generally a payment of compensation that is contingent on a change in corporate ownership or control[xii] – which equals or exceeds three times the “base amount” of certain shareholders, officers and highly compensated individuals.[xiii] The nondeductible excess is an “excess parachute payment.”[xiv]

The purpose of the provision is to prevent executives of widely-held corporations from furthering their own interests, presumably at the expense of the shareholders, in the sale of the business.[xv]

Quite reasonably, certain payments are excluded from “parachute payment status” – in particular, the amount established as reasonable compensation for services to be rendered after the change in ownership or control is excluded.[xvi]

In addition, the amount treated as an excess parachute payment is reduced by the amount established as reasonable compensation for services actually rendered prior to the change in ownership or control.[xvii]

Finally, the individual who receives an excess parachute payment is subject to an excise tax of 20% of the amount of such payment.[xviii]

EO Compensation Limits

Prior to the Act, the foregoing deduction limits generally did not affect an EO.

That being said, there were other provisions in the Code that addressed the payment of unreasonable compensation by an EO to certain individuals.

Self-Dealing

PFs are prohibited from engaging in an act of “self-dealing,” which includes the payment of compensation by a PF to a disqualified person.[xix]

However, the payment of compensation to a disqualified person by a PF for the performance of personal services which are reasonable and necessary to carry out the PF’s exempt purpose will not constitute self-dealing if the compensation is not excessive.[xx]

In other words, the EO-PF may pay reasonable compensation to a disqualified person.[xxi]

Where it has paid excess compensation, the EO is expected to recover the excess from the disqualified person.[xxii]

Excess Benefit Transaction

A public charity is prohibited from engaging in an “excess benefit transaction,” meaning any transaction in which an economic benefit[xxiii] is provided by the organization to a disqualified person if the value of the economic benefit provided exceeds the value of the consideration, including the performance of services, received for providing such benefit.[xxiv]

To determine whether an excess benefit transaction has occurred, all consideration and benefits exchanged between the disqualified person and the EO, and all entities that the EO controls, are taken into account.[xxv]

In other words, the EO-public charity may pay reasonable compensation to a disqualified person without triggering the excess benefit rules.

As in the case of a PF, the public charity is expected to recover the amount of any excess payment made to the disqualified person.[xxvi]

Private Inurement

An organization is not operated exclusively for one or more exempt purposes if its net earnings inure, in whole or in part, to the benefit of private individuals.[xxvii]

Whether an impermissible benefit has been conferred on an individual is essentially a question of fact. A common factual thread running through the cases where inurement has been found is that the individual stands in a relationship with the organization which offers them the opportunity to make use of the organization’s income or assets for personal gain. This has led to the conclusion that a finding of inurement is usually limited to a transaction involving “insiders.”

Whereas the excise taxes on acts of self-dealing and on excess benefit transactions are intended to address situations that do not rise to the level at which the EO’s tax-favored status should be revoked, a finding that the organization’s net earnings have inured to the benefit of its “insiders” connotes a degree of impermissible benefit that justifies the revocation of its tax-exemption.

The Act

Congress must have believed that the foregoing limitations were not adequate to police or control the compensation practices of EOs. The committee reports to the Act, however, do not articulate the reason for the enactment of the provisions we are about to consider.

The only rationale that I can think of is that Congress was attempting to maintain some sort of “parity” between for-profits and EOs with respect to executive compensation.[xxviii]

Thus, the new provision draws heavily from the limitations applicable to business organizations, described above, and its purpose likewise may be deduced from the purposes of such limitations: to prevent certain individuals in the EO from paying themselves “excessive” salaries and other benefits, and thereby ensuring that those amounts are instead used in furtherance of the EO’s exempt purpose and for the benefit of its constituents.[xxix]

The Tax

Under the Act, effective for taxable years beginning after December 31, 2017, an employer (not the individual recipient of the payment) is liable for an excise tax equal to 21 percent[xxx] of the sum of:

(1) any “remuneration” in excess of $1 million paid to a covered employee by an EO for a taxable year, and

(2) any excess parachute payment paid by the EO to a covered employee.[xxxi]

Accordingly, the excise tax may apply as a result of an excess parachute payment, even if the covered employee’s remuneration[xxxii] does not exceed $1 million; in other words, there are two events that may trigger the imposition of the tax.

Where both provisions may apply, the remuneration that is treated as an excess parachute payment is not accounted for in determining if the $1 million limit is exceeded.

Covered Employee

For purposes of the provision, a covered employee is an employee (including any former employee) of an applicable tax-exempt organization if the employee

  • is one of the five highest compensated employees of the organization for the taxable year (the current year; there is no minimum dollar threshold for an employee to be a covered employee), or
  • was a covered employee of the organization (or of a predecessor organization) for any preceding taxable year beginning after December 31, 2016.[xxxiii] Thus, if the individual was a covered employee in a prior year (beginning with 2017), they continue to be treated as such for purposes of determining whether any payments made to them in subsequent years violate one of the two limitations described above.[xxxiv]

Related Persons

Remuneration of a covered employee also includes any remuneration paid with respect to employment of the covered employee by any person related to the EO.

A person is treated as related to an EO if the person:

(1) controls, or is controlled by, the organization,

(2) is controlled by one or more persons that control the organization,

(3) is a supported organization with respect to the organization, or

(4) is a supporting organization with respect to the organization.

Parachute Payments

Under the provision, an excess parachute payment is the amount by which any parachute payment exceeds the portion of the base amount allocated to the payment.

A parachute payment is a payment in the nature of compensation to a covered employee if:

  • the payment is contingent on the employee’s separation from employment and
  • the aggregate present value of all such payments equals or exceeds three times the base amount.[xxxv]

It should be noted that this definition differs from that applicable in the case of a business organization, where the disallowance of the employer’s deduction, and the imposition of the excise tax on the employee-recipient, are not contingent on the employee’s separation from employment.

It should also be noted that the Act did not provide an exception for a payment that represents reasonable compensation. Thus, even where the payment is reasonable in light of the services provided by the employee, and thus would not be trigger an excise tax for self-dealing or an excess benefit, the excise tax will nevertheless be applied.[xxxvi]

Liability

The employer of a covered employee – not the employee – is liable for the excise tax.

This is to be contrasted with the case of an employer that is a business organization. The employer is denied a deduction for the excess parachute payment, but an excise tax is also imposed upon the employee to whom the payment was made.

In addition, if the remuneration of a covered employee from more than one employer is taken into account in determining the excise tax, each employer is liable for the tax in an amount that bears the same ratio to the total tax as the remuneration paid by that employer bears to the remuneration paid by all employers to the covered employee.[xxxvii]

Parting Thoughts

The rules described above are complicated, and the IRS has yet to propose interpretive regulations, though it recently published interim guidance[xxxviii] to assist EOs with navigating the new rule, and on which they may rely, until regulations can be issued.

Of course, an EO will not be impacted by these provisions if it does not pay an employee enough remuneration to trigger the tax; there can be no excess remuneration if an EO (together with any related organization) pays remuneration of less than $1 million to each of its employees for a taxable year, and there can be no excess parachute payment if the EO does not have any “highly compensated” employees for the taxable year.[xxxix]

Does this mean that an EO should not pay any of its executives an amount that would trigger the imposition of the above tax? Should it walk away from candidates whom the EO can only hire by paying a larger amount? Or should it seek out the best people, pay them an amount that would trigger the tax but that the EO determines would be reasonable,[xl] and accept the resulting tax liability as a cost of doing business?[xli]

These are the kind of decisions that I have seen business owners make every day, and these are usually preceded by another set of inquiries: Will the return on our investment (in this case, in intellectual capital) justify the cost? Are we overpaying, or is the amount reasonable under the circumstances? Is there another way by which we can secure the same benefit – perhaps through a different mix of incentives, payable in varying amounts and at different times so as to skirt the literal terms of the Act, while also securing the services of a great executive?

The ability to bring this type of business analysis to an EO’s board discussion on executive compensation may be at least as valuable, in the current environment, as one’s willingness to open one’s wallet to the EO.

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[i] See Subchapter A of Chapter 42 of the Code. Examples include the excise tax on a foundation that fails to pay out annually, to qualifying charities, an amount equal to at least five percent of the fair market value of its non-charitable assets, and the excise tax on certain “insiders” (with respect to the foundation) who engage in acts of self-dealing with the foundation (e.g., excessive compensation).

[ii] There are many reasons a business owner chooses to form a foundation; ego, tax planning, continued control, and family involvement are among these. There are also many reasons not to form one; the resulting administrative burden and the cost of tax compliance should not be underestimated.

[iii] Take a look at the board of any local charity. It is likely populated, in no small part, by the owners of businesses that operate within, or employ individuals from, the locality in which the EO is headquartered or that it services.

[iv] Instead of, say, furthering the charitable mission. It should be noted that these expenditures are not necessarily mutually exclusive.

[v] That’s right. The members of these boards elect themselves and their successors. It is rare for a larger charity to have “members” in a legal, “corporate law” sense– i.e., the counterparts to shareholders in a business organization – with voting rights, including the right to elect or remove directors. Rather, these charities depend upon honest, well-intentioned individuals to ensure that their charitable mission is carried out. Many of these individuals – the directors of the organization – are drawn from the business community. Of course, the Attorney General of the State in which a charity is organized also plays an important role in ensuring that the charity and those who operate it stay the course.

[vi] P.L. 115-97 (the “Act”).

[vii] IRC Sec. 4958; P.L. 104-168; enacted in 1996, it is generally applicable to public charities. More on this rule later.

[viii] IRC Sec. 162(a)(1).

[ix] Reg. Sec. 1.162-7.

[x] Specifically, its CEO, CFO, and the three other most highly compensated officers.

[xi] IRC Sec. 162(m); enacted in 1993 as part of the Omnibus Budget Reconciliation Act, P.L. 103-66. The Act eliminated the exception for performance-based pay.

[xii] IRC Sec. 280G(b)(2) and (c).

[xiii] An individual’s base amount is the average annualized compensation includible in the individual’s gross income for the five taxable years ending before the date on which the change in ownership or control occurs. IRC Sec. 280G(b)(3).

[xiv] IRC Sec. 280G(a) and (b)(1); enacted in 1984; P.L. 98-369.

[xv] The provision does not apply to “small business corporations” or to non-traded corporations that satisfy certain shareholder approval requirements. IRC Sec. 280G(b)(5).

[xvi] IRC Sec. 280G(b)(4)(A).

[xvii] IRC Sec. 280G(b)(4)(B).

[xviii] IRC Sec. 4999. Presumably because they would have been in a position to contractually obligate the corporation to make the payment.

[xix] IRC Sec. 4941. “Disqualified person” is defined in IRC Sec. 4946. https://www.law.cornell.edu/uscode/text/26/4946.

[xx] IRC Sec. 4941(d)(2)(E).

[xxi] The key, of course, is for the board to be able to demonstrate the basis for its determination of reasonableness.

[xxii] A “correction” under IRC Sec. 4941(e). The “obligation” to recover the excess portion is implicit in the calculation of the penalty.

[xxiii] For purposes of this rule, an economic benefit provided by an EO will not be treated as consideration for the performance of services rendered to the EO unless the EO clearly indicated its intent to treat such benefit as compensation.

[xxiv] IRC Sec. 4958(c)(1)(A).

[xxv] Reg. Sec. 53.4958-4. Congress foresaw that some individuals may try to circumvent the proscription by drawing down salaries from non-exempt organizations related to the EO.

[xxvi] IRC Sec. 4958(f)(6).

[xxvii] Reg. Sec. 1.501(a)-1.

[xxviii] Query whether EOs have been enticing executives away from business organizations in droves – I don’t think so.

[xxix] Interestingly, the Act made no distinction between public charities and PFs. In contrast, the comparable limitations for business organizations do not apply to “small business corporations” or certain non-publicly traded corporations.

[xxx] I.e., the newly established flat rate for C corporations – in order to mirror the amount of tax that such a corporation would have to pay in respect of the disallowed portion of the compensation paid to the individual service provider.

[xxxi] IRC Sec. 4960. https://www.law.cornell.edu/uscode/text/26/4960.

[xxxii] Remuneration includes amounts required to be included in the employee’s gross income under IRC Sec. 457(f).

Such amounts are treated as paid (and includible in gross income) when there is no substantial risk of forfeiture of the rights to such remuneration within the meaning of section 457(f). Sec. 4960(c)(3). For this purpose, a person’s rights to compensation are subject to a substantial risk of forfeiture if the rights are conditioned on the future performance of substantial services by any individual, or upon the achievement of certain organizational goals.

Up until now, the only cap on 457(f) arrangements was that the payment be reasonable for the services actually rendered.

In determining reasonableness, one looks to the totality of the recipient’s services to the EO, not only for the year paid; in other words, the payment may be “prorated” over many years for this purpose. Accordingly, the tax imposed by this provision can apply to the value of remuneration that is vested even if it is not yet received. Indeed, the excise tax can apply to amounts that are paid currently though they were earned in earlier years.

[xxxiii] Sec. 4960(c)(2).

[xxxiv] The list of covered employees may grow to include individuals who are no longer included in the five highest paid.

[xxxv] The base amount is the average annualized compensation includible in the covered employee’s gross income for the five taxable years ending before the date of the employee’s separation from employment.

[xxxvi] That being said, the Act does exempt compensation paid to employees who are not “highly compensated” employees from the definition of parachute payment.

Significantly for EO-hospitals, compensation attributable to medical services of certain qualified medical or veterinary professionals is exempted from the definitions of remuneration and parachute payment; remuneration paid to such a professional in any other capacity is taken into account.

Unfortunately, neither the Act nor the committee reports provide any guidance regarding the allocation of a medical professional’s remuneration between their medical services and, say, their administrative functions within the EO-employer.

[xxxvii] It should be noted that the Act authorizes the IRS to issue regulations to prevent the avoidance of the excise tax through the performance of services other than as an employee.

[xxxviii] Notice 2019-09, which consists of ninety pages of Q&A.

[xxxix] Within the meaning of IRC Sec. 414(q).

[xl] It should always be reasonable under the facts and circumstances.

[xli] Assuming the amount is reasonable within the meaning of the self-dealing and excess benefit rules, will there be any argument under state law that the imposition of the tax reflects a per se breach of the board’s fiduciary duty?

If the amount is not reasonable, such that the excise taxes on self-dealing and excess benefits become payable, what is purpose of the new tax?

Rescission

As kids playing ball, we learned about the “do-over” rule, pursuant to which the player in question was allowed to try again, without penalty, whatever it was that they were doing.  As we got older and our games changed, some of us learned about “taking a mulligan,” again without penalty.[i]  It may not come as a surprise, therefore, that a variation of this principle has found its way into the tax law.  It is called the “rescission doctrine,” and although it has been recognized for many years, it has been applied only in limited circumstances.

However, as we entered the final month of 2018, I found myself facing two situations in which the application of the rescission doctrine afforded the only solution for avoiding some adverse tax consequences.

Requirements

In general, the tax law treats each taxable year of a taxpayer as a “separate unit” for tax accounting purposes, and requires that one look at a particular transaction on an “annual basis,” using the facts as they exist at the end of the taxable year; in other words, one determines the tax consequences of the transaction at the end of the taxable year in which it occurred, without regard to events in subsequent years.

It is this basic principle of the annual accounting concept that underlies the rescission doctrine, and from which is derived the requirement, set forth below, that the rescission occur before the end of the taxable year in which the transaction took place.[ii]

According to the IRS,[iii] the legal concept of “rescission” (i) refers to the canceling or voiding of a contract or transaction, that (ii) has the effect of releasing the parties from further obligations to each other, and (iii) restores them to the relative positions they would have occupied had no contract been made or transaction completed.

A rescission may be effected by mutual agreement of the parties, by one of the parties declaring a rescission of the contract without the consent of the other (if sufficient grounds exist), or by applying to the court for a decree of rescission.

It is imperative, based on the annual accounting concept, that the rescission occur before the end of the taxable year in which the transaction took place.

If these requirements are satisfied, then the rescinded transaction is ignored for tax purposes – it is treated as though it never occurred.

Thus, a sale may be disregarded for federal income tax purposes where the sale is rescinded within the same taxable year that it occurred, and the parties are placed in the same positions as they were prior to the sale.[iv]

If the foregoing requirements are not satisfied, the rescission will not be respected, the tax consequences of the original transaction will have to be reported, and the “unwinding” of the original transaction will be analyzed as a separate event that generated its own tax consequences.

Why Rescind?

Whether the IRS will accept the parties’ claimed rescission of a particular transaction will, of course, depend upon the application of the above criteria to the facts and circumstances of the particular case.

Although the IRS has stated that it is studying the issue of rescission, and it has not issued letter rulings on the subject since 2012,[v] there are a number of earlier rulings to which taxpayers may turn for guidance regarding the IRS’s views.

These rulings illustrate some of the reasons for rescinding a transaction, as well as some of the means by which the rescission may be effectuated.

For example, the IRS has accepted the rescission of a transaction where the transaction was undertaken for a bona fide business reason, but without a proper understanding of the resulting tax consequences. When the parties realized what they had done, they sought to rescind the transaction and thereby avoid the unexpected adverse tax consequences;[vi] in one ruling, the parties not only rescinded the transaction, but then “did it over” so as to achieve the desired result.[vii]

The IRS has also looked favorably on the rescission of a transaction where, due to changed circumstances, the business purpose for the transaction no longer existed.[viii]

Thus, it appears that either a legitimate tax purpose or a bona fide business purpose may be the motivating factor for a rescission.

Restoring Pre-Transaction Status

Of the foregoing requirements for a successful rescission, the most difficult to satisfy may be the restoration of the parties to their pre-transaction status. The difficulty is compounded where events have occurred during the period preceding the rescission which may prevent, or which appear inconsistent with, an unwinding of the transaction.

Closely related to this requirement is the manner in which the rescission is effectuated; i.e., the steps that are taken to return the parties to their earlier positions.[ix]

For example, in one case, a taxpayer instructed their broker to sell $100,000 worth of a publicly-traded stock, but the broker instead sold 100,000 shares of such stock. In order to reverse this event, at the taxpayer’s direction, the broker reacquired over 96,000 shares in the same corporation. The court found that there was no rescission because the broker was not the buyer of the shares that were sold originally; that buyer was not returned to their original position.[x]

Common Representations

Regardless of the reasons for the rescission, the parties must be prepared to demonstrate that the requirements set forth above have been satisfied, including the requirement that the rescission restored, in all material respects, the legal and financial arrangements among the parties that would have existed had the transaction never occurred.

The taxpayers who were parties to the rescission transactions, for which the above-referenced rulings were requested, represented to the IRS – for the purpose of supporting their claim that they had been restored to their pre-transaction status – that, among other things: (i) no party took or would take any material position inconsistent with the position that would have existed had the rescinded transaction not occurred, (ii) no activities occurred prior to the rescission, or would occur after the rescission, that were materially inconsistent with the rescission, (iii) the purpose and effect of the rescission was to restore in all material respects the legal and financial arrangements among the parties that would have existed had the transaction never occurred, (iv) the legal and financial arrangements between the parties were identical in all material respects, from the date immediately before the rescinded transaction, to such arrangements that would have existed had the transaction not occurred, (v) the parties would take all reasonable actions necessary to effectuate those purposes, (vi) the parties would mutually agree to each of the steps to implement the rescission, (vii) all material items of income, deduction, gain, and loss of each party would be reflected on their respective income tax returns as if the transaction had not occurred, (viii) during the period between the transaction and the rescission, no material changes to the legal or financial relationships between parties occurred that would not have occurred if the transaction had not occurred, and (ix) the rescission would not involve any party that was not involved in the transaction.

Our Transactions

As indicated above, I was presented with two separate transactions that had to be rescinded in December of 2018. Both had occurred several months earlier during 2018.

In one transaction, a C corporation had distributed a minority interest in a subsidiary corporation to one of its shareholders in complete redemption of the shareholder’s stock in the distributing corporation. For some inexplicable reason, both parties believed that the distribution was not a taxable event to either of them; the corporation did not consider Sec. 311(b) and the former shareholder did not consider Sec. 302(a).[xi]

The redemption distribution was rescinded by having the “former” shareholder return to the distributing corporation the stock in the subsidiary and re-issuing stock in the distributing corporation to the shareholder. Between the date of the transaction and its rescission, no dividend distributions were made by either the corporation or the subsidiary, and no other event occurred that was inconsistent with the rescission of the redemption distribution.

In the second transaction, a partnership had contributed a wholly-owned disregarded entity (an LLC) to a newly-formed, and wholly-owned, C corporation subsidiary of the partnership. The partnership erroneously believed that it could obtain loans more easily through a corporation. The LLC membership interests were returned to the partnership in rescission of the contribution. As in the first case, there were no distributions by either the corporation or the LLC, nor did any other events occur that were inconsistent with the rescission.

A Useful Tool

In general, the best way to avoid a situation that calls for the rescission of a transaction is to refrain from undertaking the transaction without first vetting it in consultation with one’s tax and corporate advisers.

That being said, there will be instances in which unforeseen post-transaction events may defeat the purpose for the transaction, or may cause the transaction to be unduly expensive from an economic perspective.

In those cases, the taxpayer should bear in mind the possibility of rescinding the transaction, and they should be aware that they have only a limited period in which to exercise the rescission option.

[i] I am not a golfer, and never will be, though I do enjoy the dinners that follow many golf outings.

[ii] The rescission allows the taxpayer to view the transaction “using the facts as they exist at the end of the taxable year” – i.e., as though the transaction never occurred.

[iii] Rev. Rul. 80-58.

[iv] Stated simply: the property is returned to the seller and the cash is returned to the buyer.

[v] Rev. Proc. 2012-3. This no-ruling policy was reaffirmed in Rev. Proc. 2019-3.

[vi] See, e.g., PLR 200309009 (rescinding a distribution of property that would have disqualified taxpayers from the low income housing credit). Moreover, it does not appear to matter whether the transaction to be rescinded was undertaken between unrelated persons or within a group of related taxpayers.

[vii] PLR 201211009 (rescinded a stock sale that did not qualify for a Sec. 338(h)(10) election; substituted a new buyer for which the election would be available).

[viii] See, e.g., PLR 200923010 (rescinding a spin-off where changes in the business environment and in management subsequent to the distribution negated the benefit of the spin-off).

[ix] For example, how might taxpayers rescind a merger? If you’re facing this issue, feel free to contact me.

[x] Hutcheson v. Commissioner, T.C. Memo 1996-127.

[xi] Under IRC Sec. 311(b), a distribution of appreciated property by a corporation to its shareholders is treated as a sale of such property by the corporation. Under IRC Sec. 302(a) and 302(b)(3), the redemption of a shareholder’s entire equity in a corporation is treated as a sale of such equity by the shareholder.

Home for the Holidays?

Our last post considered the division of a business between family members as a means of preempting the adverse consequences that will often follow disagreements within the family as to the management or direction of the business. https://www.taxlawforchb.com/2018/12/business-purpose-and-dividing-the-family-corporation-think-before-you-let-it-rip/.

This week, as family members return to work – after having come together to celebrate the holidays and renew their commitment to one another – we turn to a recent IRS ruling that considered a situation that presents the proverbial “trap for the unwary,” and that arises more often than one might think in the context of a business that is plagued by family discord. https://www.irs.gov/pub/irs-wd/201850012.pdf.

Another Family Mess

Corp was formed by Dad, who elected to treat it as an S corporation for federal tax purposes.[i] Immediately prior to the events described in the ruling, Dad owned more than 50% of Corp’s non-voting shares, but less than 50% of Corp’s voting shares. Mom and Daughter owned the balance of Corp’s issued and outstanding shares.

Following Mom’s death, Daughter – who was also the CEO of the business – received a testamentary transfer of all of Mom’s voting shares, resulting in Daughter’s owning a majority of Corp’s voting shares.

For reasons not set forth in the ruling, Daughter subsequently terminated Dad’s employment with Corp. In response, Dad filed a lawsuit against Corp and Daughter (the “Litigation”) in which he alleged shareholder oppression and breach of fiduciary duties. Dad asked the court to enter an order requiring Daughter and/or Corp to buy Dad’s shares in Corp (“Dad’s Shares”), or an order requiring Dad to purchase Daughter’s shares.[ii]

Within three months after Dad initiated the Litigation, Corp and Daughter filed a notice under the Litigation (the “Election”) for Corp to purchase Dad’s Shares (the “Proposed Transaction”). Dad filed a motion to nullify the Election.[iii] The court denied Dad’s nullification motion, and ruled that the Election was valid.

Proposed Buyout

Dad died before the Litigation could be resolved and his shares in Corp purchased. His revocable trust (the “Trust”) – which became irrevocable upon his death – provided that Dad’s Shares would pass to Foundation, a tax-exempt charitable organization that was created and funded by Mom and Dad, and that was treated as a private foundation under the Code. [iv]

Pursuant to the terms of the Trust, the trustee had the power and authority to sell any stock held by or passing to the Trust, including Dad’s Shares.[v] However, because of the Litigation, Foundation did not receive Dad’s Shares from the Trust; nor could the Trust sell Dad’s Shares to anyone other than Corp during the Litigation.[vi]

The court in the Litigation was required by state law to determine the “fair value” of Dad’s Shares as of the date the Litigation was initiated, or such other date the court deemed appropriate. The Foundation represented to the IRS that the Litigation court could determine the fair value of Dad’s Shares to be less than their fair market value after marketability and control discounts were applied.[vii]

The administration of the Trust was overseen by a probate court, not the court in which the Litigation was ongoing. The probate court had the responsibility to ensure that Foundation received the full value of Dad’s Shares, and was required to approve the valuation of Dad’s Shares and the Proposed Transaction. According to the Foundation, if the probate court approved the Proposed Transaction, the Litigation court would honor the probate court’s decision.

Self-Dealing

The foregoing may seem innocuous to most persons – just a buyout of a decedent’s shares in a corporation. Fortunately, Foundation recognized that Corp’s redemption of Dad’s Shares could be treated as an act of “self-dealing” under the Code, which could in turn result in the imposition of certain penalties (i.e., excise taxes) on the “self-dealer” and on the “foundation managers.”

The Code imposes a tax on acts of self-dealing between a “disqualified person”[viii] and a private foundation.[ix] The tax with respect to any act of self-dealing is equal to 10% of the greater of the amount of money and the fair market value of the other property given or the amount of money and the fair market value of the other property received in the transaction.[x] In general, the tax imposed is paid by any disqualified person who participated in the act of self-dealing.

The term “self-dealing” includes any direct or indirect sale or exchange of property between a private foundation and a disqualified person. For purposes of this rule, it is immaterial whether the transaction results in a benefit or a detriment to the private foundation; the act itself is prohibited.

An “indirect sale” may include the sale by a decedent’s estate (or revocable trust),[xi] to a disqualified person, of property that would otherwise have passed from the estate to the private foundation pursuant to the terms of the decedent’s will; in other words, property in which the foundation had an expectancy.

However, the term “indirect self-dealing” does not include a transaction with respect to a private foundation’s interest or expectancy in property held by a revocable trust, including a trust which became irrevocable on a grantor’s death, and regardless of when title to the property vested under local law, provided the following conditions are satisfied:

(i) The trustee of the revocable trust has the power to sell the property;

(ii) The transaction is approved by a court having jurisdiction over the trust or over the private foundation;

(iii) The transaction occurs, in the case of a revocable trust, before the trust is considered a “non-exempt charitable trust”;[xii]

(iv) The trust receives an amount which equals or exceeds the fair market value of the foundation’s interest or expectancy in the property at the time of the transaction; and

(v) The transaction results in the foundation receiving an interest or expectancy at least as liquid as the one it gave up.[xiii]

The IRS Ruling

Foundation conceded that Dad was a disqualified person (a “substantial contributor”) as to Foundation while he was alive, having funded Foundation with Mom.[xiv] Daughter was a disqualified person as to Foundation because her father (a “member of her family”) was a substantial contributor to Foundation. Corp was also a disqualified person as to Foundation because Daughter owned more than 35% of Corp’s voting shares.[xv]

Because Corp was a disqualified person as to Foundation, and because of Foundation’s expectancy interest in receiving Dad’s Shares from the Trust, the proposed sale of Dad’s Shares by the Trust to Corp pursuant to the Litigation court’s order (the Proposed Transaction) could be an act of indirect self-dealing.

Foundation requested a ruling from the IRS that Corp’s purchase (i.e., redemption) of Dad’s Shares – which were held by the Trust – would satisfy the indirect self-dealing exception, described above, and would not be treated as an act of self-dealing for which a penalty could be imposed.

The IRS reviewed each of the requirements for the application of the exception.

First, a trustee must have the power to sell the trust’s property. Pursuant to the trust agreement that created Trust, Trust’s trustee had the power to sell any Trust assets, including Dad’s Shares. Thus, the Proposed Transaction met the first requirement.

Second, a court with jurisdiction over the trust must approve the transaction. Foundation sought, and was waiting to obtain, the approval of the Proposed Transaction from the probate court that had jurisdiction over, and was overseeing administration of, the Trust. Thus, the Proposed Transaction would meet the second requirement upon the Trust’s receipt of the probate court’s approval of the proposed sale.

Third, the Proposed Transaction must occur before the Trust became a non-exempt charitable trust. Foundation represented that because of the active and on-going status of the Litigation, the Trust’s trustees were, and would continue to be, unable to complete the ordinary duties of administration necessary for the settlement of Trust prior to the date of the sale of Dad’s Shares. Thus, the Trust would not be considered a non-exempt charitable trust prior to the date of the sale of Dad’s Shares; until then, the trustee would still be performing the ordinary duties of administration necessary for the settlement of the Trust.

In addition, before the sale of Dad’s Shares, the Trust will have made those other distributions required to be made from the Trust to any beneficiary other than Foundation, which would then be the sole remaining beneficiary.

Thus, if the Trust were not considered terminated for Federal income tax purposes prior to the Proposed Transaction, the Proposed Transaction would meet the third requirement.

Fourth, the Trust must receive an amount that equals or exceeds the fair market value of the foundation’s interest or expectancy in such property at the time of the transaction. The Litigation court was tasked with valuing Dad’s Shares. Foundation would endeavor to ensure that the Litigation court ordered the sale of Dad’s Shares to Corp at a price that was not less than the fair market value at the time of the Proposed Transaction. Thus, the Proposed Transaction would meet the fourth requirement if Dad’s Shares were sold to Corp at no less than their fair market value at the time of the transaction.

Fifth, the sale of Foundation’s interest or expectancy must result in its receiving an interest as liquid as the one that was given up. Pursuant to the trust agreement, Foundation had the expectancy of receiving Dad’s Shares, which were illiquid. Upon the completion of the Proposed Transaction, Foundation would receive the money that Corp paid Trust for Dad’s Shares. Thus, the Proposed Transaction would meet the fifth requirement if Foundation received the money proceeds from the Proposed Transaction.

Based on the foregoing, the IRS ruled that Corp’s purchase of Dad’s Shares held by the Trust would satisfy the “probate exception” from indirect self-dealing provided the following contingencies occurred:

  1. The probate court approved the Proposed Transaction;
  2. The Trust did not become a non-exempt charitable trust prior to the date of the sale of Dad’s Shares by the Trust; and
  3. The Trust received from the sale of Dad’s Shares to Corp an amount of cash or its equivalent that equaled or exceeded the fair market value of Corp’s Shares at the time of the transaction.

Trap for the Unwary?

Some of you may be thinking that the issue presented in the ruling discussed above, although somewhat interesting, is unlikely to arise with any regularity and, so, does not represent much of a trap for the unwary.[xvi]

I respectfully disagree. The fact pattern of the ruling is only one of many scenarios of indirect self-dealing that are encountered by advisers whose practice includes charitable planning for the owners of a closely held business.

There are two major factors that contribute to this reality: (i) the owner’s business will likely represent the principal asset of their estate, and (ii) the owner may have established a private foundation that they plan to fund at their demise (and thereby generate an estate tax deduction), either directly or through a split-interest trust.[xvii]

It is likely that the owner’s spouse, or some of their children, or perhaps a trust for their benefit, will be receiving an interest in the family business (an illiquid asset). It is also possible that the foundation will be funded with an interest in the business.

In these circumstances, the foundation may have to divest its interest in the family business in order to avoid the imposition of another private foundation excise tax (the one on “excess business holdings”).[xviii] Because of the limited market for such an interest, the foundation (or the owner’s estate or revocable trust) will probably have to sell its interest to the business itself (a redemption, as in the ruling above) or to another owner – each of which may be a disqualified person, thereby raising the issue of self-dealing. https://www.taxlawforchb.com/2018/10/private-foundations-and-business-ownership-a-new-day/.

In other circumstances, the divergent interests of the foundation to be funded, on the one hand, and of the individual beneficiaries of the owner’s estate or trust, on the other, may require that the foundation’s interest in the business be eliminated. For example, the foundation will need liquidity in order to engage in any charitable grant-making, while the other owners may prefer that the business reinvest its profits so as to expand the business; the foundation may prefer not to receive shares of stock in an S corporation, the ownership of which would result in the imposition of unrelated business income tax;[xix] or the foundation may be managed by individuals other than those operating the business, thereby setting the stage for a shareholder dispute as in the above ruling.

Bottom line:  It behooves the owners of the closely held business to consider these issues well before they arise. In many cases, it will be difficult to avoid them entirely, but the relevant parties should plan a course of action that is to be implemented after the demise of an owner.[xx] In this way, they may be able to avoid the personal, financial, and business disputes that may otherwise arise.

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[i] IRC Sec. 1361; IRC Sec. 1362.

[ii] The ruling does not disclose the jurisdiction under the laws of which Corp was formed.

In New York, the holders of shares representing 20% or more of the votes of all outstanding shares of a corporation may present a petition of dissolution on the ground that the directors or those in control of the corporation are guilty of oppressive acts toward the complaining shareholders. In determining whether to proceed with involuntary dissolution, the court must take into account whether liquidation of the corporation is the only feasible means by which the petitioners may reasonably expect to obtain a “fair return” on their investment. BCL 1104-a. This typically involves the valuation and buyout of the petitioners’ shares. However, the other shareholder(s) or the corporation may also elect to purchase the shares owned by the petitioners at fair value. BCL 1118. “Fair value” is not necessarily the same as “fair market value.” See Friedman v. Beway Realty Corp. 87 N.Y.2d 161 (1995).

[iii] Go figure. If the goal was to be bought out, congratulations. Why fight it? Or was Dad concerned that Daughter would render Corp unable to buy him out and, so, he wanted to pursue his own remedies?

[iv] Exempt from federal income tax under Sec. 501(a) of the Code, as an organization described in Sec. 501(c)(3) of the Code (educational, religious, scientific, and charitable purposes); a “private foundation” in that it did not receive financial support from the “general public.”

[v] Although a decedent should fund their revocable trust to the fullest extent possible prior to their demise, it is often the case that they forget to transfer – or that they intentionally retain direct ownership of – an asset, which thereby becomes part of their probate estate. In that case, the decedent’s last will and testament typically provides that the probate estate shall “pour over” into the now irrevocable trust – which acts as a “will substitute” – to be disposed of in accordance with the terms of the trust.

[vi] It should be noted that, effective for tax years beginning after December 31, 1997, certain tax-exempt organizations became eligible to own shares of stock in an S corporation; however, a qualifying organization’s share of S corporation income is treated as unrelated business income. IRC Sec. 1361(c)(6) and Sec. 512(e).

[vii] In general, “fair market value” as of the date of a decedent’s death is the value at which the property included in the decedent’s gross estate must be reported on their estate tax return. Reg. Sec. 20.2031-1(b).

[viii] The term “disqualified person” means, in part, with respect to a private foundation, a person who is:

(A) a “substantial contributor” to the foundation,

(B) a “foundation manager”,

(C) an owner of more than 20% of:

(i) the total combined voting power of a corporation,

(ii) the profits interest of a partnership, or

(iii) the beneficial interest of a trust or unincorporated enterprise, which is a substantial contributor to the foundation,

(D) a “member of the family” of any individual described in subparagraph (A), (B) or (C), or

(E) a corporation of which persons described in subparagraph (A), (B), (C), or (D) own more than 35% of the total combined voting power.

The term “members of the family” with respect to any person who is a disqualified person includes the individual’s spouse, ancestors, children, grandchildren, great grandchildren, and the spouses of children, grandchildren, and great grandchildren. IRC Sec. 4946.

[ix] The Code authorizes the imposition of certain excise taxes on a private foundation, on those who are disqualified persons with respect to such foundation, and on the foundation’s managers. These taxes are intended to modify the behavior of these parties – who are not otherwise dependent upon the public for financial support – by encouraging certain activities (e.g., expenditures for charitable purposes) and discouraging others (such as self-dealing).

[x] https://www.law.cornell.edu/uscode/text/26/4941

[xi] See EN iv, above.

[xii] See IRC Sec. 4947, which treats such a trust as a private foundation that is subject to all of the private foundation requirements.

A revocable trust that becomes irrevocable upon the death of the decedent-grantor, from which the trustee is required to distribute all of the net assets in trust for or free of trust to charitable beneficiaries, is not considered a charitable trust under section 4947(a)(1) for a reasonable period of settlement after becoming irrevocable. After that period, the trust is considered a charitable trust under section 4947(a)(1). The term “reasonable period of settlement” means that period reasonably required (or if shorter, actually required) by the trustee to perform the ordinary duties of administration necessary for the settlement of the trust. These duties include, for example, the collection of assets, the payment of debts, taxes, and distributions, and the determination of the rights of the subsequent beneficiaries.

[xiii] Reg. Sec. 53.4941(d)-1(b)(3); the so-called “probate exception.” https://www.law.cornell.edu/cfr/text/26/53.4941%28d%29-1 This exception had its genesis in the IRS’s recognition that a private foundation generally needs liquidity in order to carry out its charitable grant-making mission. With the appropriate safeguards (supervision by a probate court) to ensure that the foundation receives fair market value and attains the requisite liquidity, the act of self-dealing presented by the foundation’s sale of an interest in a closely held business may be forgiven.

[xiv] Interestingly, a substantial contributor’s status as such does not terminate upon their death; thus, a member of their family also remains a disqualified person.

[xv] See EN vii.

[xvi] A group of individuals to which the reader no longer belongs.

[xvii] For example, a charitable lead trust or a charitable remainder trust. IRC Sec. 2055(e). https://www.law.cornell.edu/uscode/text/26/2055.

[xviii] IRC Sec. 4943. https://www.law.cornell.edu/uscode/text/26/4943.

[xix] Taxable at 21% – as opposed to a 1% or 2% tax on investment income under IRC Sec. 4940 – and perhaps without a distribution from the corporation with which to pay the tax.

[xx] For example, corporate-owned life insurance to fund the buyout of the foundation’s interest, or the granting of options to family members to acquire the foundation’s interest.

I am excited to announce that my June 18, 2018 blog post “S Corps, CFCs & The Tax Cuts & Jobs Act” has been published as Chapter 6 in The Tax Cuts and Jobs Act: A Guide for Practitioners e-book. The chapter discusses the Tax Cuts & Jobs Act’s changes to the taxation of business income arising from the foreign activities of U.S. persons – and what that means for the increasing number of closely-held U.S. businesses who have established operations overseas.

The e-book was produced by the National Association of Enrolled Agents (NAEA). If you are interested in purchasing a copy, please click here.