The Joy – and Tax Benefits – of Gifting

As we enter the “season of giving” and the end of yet another year, the thoughts of many tax advisers turn to . . . tax planning.(i) In keeping with the spirit of the season, an adviser may suggest that a client with a closely held business consider making a gift of equity in the business to the owner’s family or to a trust for their benefit.(ii)

Of course, annual exclusion gifts(iii) are standard fare and, over the course of several years, may result in the transfer of a not insignificant portion of the equity in a business.

However, the adviser may also recommend that the client consider making larger gifts, thereby utilizing a portion of their “unified” gift-and-estate tax exemption amount during their lifetime. Such a gift, the adviser will explain, may remove from the owner’s gross estate not only the current value of the transferred business interests, but also the future appreciation thereon.(iv)

The client and the adviser may then discuss the “size” of the gift and the valuation of the business interests to be gifted, including the application of discounts for lack of control and lack of marketability. At this point, the adviser may have to curb the client’s enthusiasm somewhat by reminding them that the IRS is still skeptical of certain valuation discounts, and that an adjustment in the valuation of a gifted business interest may result in a gift tax liability.

The key, the adviser will continue, is to remove as much value from the reach of the estate tax as reasonably possible, and without incurring a gift tax liability – by utilizing the client’s remaining exemption amount – while also leaving a portion of such exemption amount as a “cushion” in the event the IRS successfully challenges the client’s valuation.

“Ask and Ye Shall Receive”(v)

Enter the 2017 Tax Cuts and Jobs Act (the “Act”).(vi) Call it an early present for the 2018 gifting season.

One of the key features of the Act was the doubling of the federal estate and gift tax exemption for U.S. decedents dying, and for gifts made by U.S. individuals,(vii) after December 31, 2017, and before January 1, 2026.

This was accomplished by increasing the basic exemption amount (“BEA”) from $5 million to $10 million. Because the exemption amount is indexed for inflation (beginning with 2012), this provision resulted in an exemption amount of $11.18 million for 2018, and this amount will be increased to $11.4 million in 2019.(viii)

Exemption Amount in a Unified System

You will recall that the exemption amount is available with respect to taxable transfers made by an individual taxpayer either during their life (by gift) or at their death – in other words, the gift tax and the estate tax share a common exemption amount.(x)

The gift tax is imposed upon the taxable gifts made by an individual taxpayer during the taxable year (the “current taxable year”). The gift tax for the current taxable year is determined by: (1) computing a “total tentative tax” on the combined amount of all taxable gifts made by the taxpayer for the current and all prior years using the common gift tax and estate tax rate table; (2) computing a tentative tax only on all prior-year gifts; (3) subtracting the tentative tax on prior-year gifts from the tentative tax computed for all years to arrive at the portion of the total tentative tax attributable to current-year gifts; and, finally, (4) subtracting the amount of the taxpayer’s unified credit (derived from the unused exemption amount) not consumed by prior-year gifts.

Thus, taxable gift transfers(xi) that do not exceed a taxpayer’s exemption amount are not subject to gift tax. However, any part of the taxpayer’s exemption amount that is used during their life to offset taxable gifts reduces the amount of exemption that remains available at their death to offset the value of their taxable estate.(xii)

From a mechanical perspective, this “unified” relationship between the two taxes is expressed as follows:

• the deceased taxpayer’s taxable estate is combined with the value of any taxable gifts made by the taxpayer during their life;
• the estate tax rate is then applied to determine a “tentative” estate tax;
• the portion of this tentative estate tax that is attributable to lifetime gifts made by the deceased taxpayer is then subtracted from the tentative estate tax to determine the “gross estate tax” – i.e., the amount of estate tax before considering available credits, the most important of which is the so-called “unified credit”; and
• credits are subtracted to determine the estate tax liability.

This method of computation is designed to ensure that a taxpayer only gets one run up through the rate brackets for all lifetime gifts and transfers at death.(xiii)

What Happens After 2025?(xvi)

However, given the temporary nature of the increased exemption amount provided by the Act, many advisers questioned whether the cumulative nature of the gift and estate tax computations, as described above, would result in inconsistent tax treatment, or even double taxation, of certain transfers.

To its credit,(xv) Congress foresaw some of these issues and directed the IRS to prescribe regulations regarding the computation of the estate tax that would address any differences between the exemption amounts in effect: (i) at the time of a taxpayer’s death and (ii) at the time of any gifts made by the taxpayer.

Pending the issuance of this guidance – and pending the confirmation of what many advisers believed was an expression of Congressional intent not to punish individuals who make gifts using the increased exemption amount – many taxpayers decided not to take immediate advantage of the greatly increased exemption amount, lest they suffer any of the consequences referred to above.

Proposed Regulations

In response to Congress’s directive, however, the IRS proposed regulations last week that should allay the concerns of most taxpayers,(xvi) which in turn should smooth the way to increased gifting and other transfers that involve an initial or partial gift.

In describing the proposed regulations, the IRS identified and analyzed several situations that could have created unintended problems for a taxpayer, though it concluded that the existing methodology for determining the taxpayer’s gift and estate tax liabilities provided adequate protection against such problems:

Whether a taxpayer’s post-2017 increased exemption amount would be reduced by pre-2018 gifts on which gift tax was paid. If the taxpayer makes additional gifts during the post-2017 increased exemption period, would the gift tax computation apply the increased exemption to the pre-2018 gifts, thus reducing the exemption otherwise available to shelter gifts made during the post-2017 period, effectively allocating credit to a gift on which gift tax in fact was already paid, and denying the taxpayer the full benefit of the increased exemption amount for transfers made during the increased exemption period?

Whether the increased exemption amount available during the increased exemption period would be reduced by pre-2018 gifts on which gift tax was paid. If the taxpayer died during the increased exemption period, would the estate tax computation apply the increased exemption to the pre-2018 gifts, thus reducing the exemption otherwise available against the estate tax during the increased exemption period and, in effect, allocating credit to a gift on which gift tax was paid?

Whether the gift tax on a post-2025 transfer would be inflated by the theoretical gift tax on a gift made during the increased exemption period that was sheltered from gift tax when made. Would the gift tax determination on the post-2025 gift treat the gifts made during the increased exemption period as gifts that were not sheltered from gift tax given that the post-2025 gift tax determination is based on the exemption amount then in effect, rather than on the increased exemption amount, thereby increasing the gift on the later transfer and effectively subjecting the earlier gift to tax even though it was exempt from gift tax when made?

With respect to the first two situations described above, the IRS determined that the current methodology by which a taxpayer’s gift and estate tax liabilities are determined ensures that the increased exemption will not be reduced by a prior gift on which gift tax was paid. As to the third situation, the IRS concluded that the current methodology ensures that the tax on the current gift will not be improperly inflated.

New Regulations

However, there was one situation in which the IRS concluded that the methodology for computing the estate tax would, in effect, retroactively eliminate the benefit of the increased exemption that was available for gifts made during the increased exemption period.

Specifically, the IRS considered whether, for estate tax purposes, a gift made by a taxpayer during the increased exemption period, and that was sheltered from gift tax by the increased exemption available during such period, would inflate the taxpayer’s post-2025 estate tax liability.

The IRS determined that this result would follow if the estate tax computation failed to treat such gifts as sheltered from gift tax.

Under the current methodology, the estate tax computation treats the gifts made during the increased exemption period as taxable gifts not sheltered from gift tax by the increased exemption amount, given that the post-2025 estate tax computation is based on the exemption in effect at the decedent’s death rather than the exemption in effect on the date of the gifts.

For example, if a taxpayer made a gift of $11 million in 2018, (when the BEA is $10 million; a taxable gift of $1 million), then dies in 2026 with a taxable estate of $4 million (when the BEA is $5 million), the federal estate tax would be approximately $3,600,000: 40% estate tax on $9 million – specifically, the sum of the $4 million taxable estate plus $5 million of the 2018 gift that was sheltered from gift tax by the increased exemption. This, in effect, would impose estate tax on the portion of the 2018 gift that was sheltered from gift tax by the increased exemption allowable at that time.

Alternatively, what if the taxpayer dies in 2026 with no taxable estate? The taxpayer’s estate tax would be approximately $2 million, which is equal to a 40% tax on $5 million – the amount by which, after taking into account the $1 million portion of the 2018 gift on which gift tax was paid, the 2018 gift exceeded the BEA at death. This, in effect, would impose estate tax on the portion of the 2018 gift that was sheltered from the gift tax by the excess of the 2018 exemption over the 2026 exemption.

The IRS determined that this problem arises from the interplay between the differing exemption amounts that are taken into account in the computation of the estate tax.

Specifically, after first determining the tentative tax on the sum of a decedent’s taxable estate and their adjusted taxable gifts,(xvii)

i. the decedent’s estate must then determine the credit against gift taxes for all prior taxable gifts, using the exemption amount allowable on the dates of the gifts (the credit itself is determined using date of death tax rates);
ii. the gift tax payable is then subtracted from the tentative tax, the result being the net tentative estate tax; and
iii. the estate next determines a credit based on the exemption amount as in effect on the date of the decedent’s death, which is then applied to reduce the net tentative estate tax.

If this credit (based on the exemption amount at the date of death) is less than the credit allowable for the decedent’s taxable gifts (using the date of gift exemption amount), the effect is to increase the estate tax by the difference between the two credit amounts.

In this circumstance, the statutory requirements for computing the estate tax have the effect of imposing an estate tax on gifts made during the increased exemption period that were sheltered from gift tax by the increased exemption amount in effect when the gifts were made.

In order to address this unintended result, the proposed regulations would add a special computation rule in cases where (i) the portion of the credit as of the decedent’s date of death that is based on the exemption is less than (ii) the sum of the credits attributable to the exemption allowable in computing the gift tax payable. In that case, the portion of the credit against the net tentative estate tax that is attributable to the exemption amount would be based upon the greater of those two credit amounts.

Specifically, if the total amount allowable as a credit, to the extent based solely on the BEA, in computing the gift tax payable on the decedent’s post-1976 taxable gifts, exceeds the credit amount based solely on the BEA in effect at the date of death, the credit against the net tentative estate tax would be based on the larger BEA.

For example, if a decedent made cumulative taxable gifts of $9 million, all of which were sheltered from gift tax by a BEA of $10 million applicable on the dates of the gifts,(xviii) and if the decedent died after 2025 when the BEA was $5 million, the credit to be applied in computing the estate tax would be based upon the $9 million of exemption amount that was used to compute the gift tax payable.

Time to Act?

By addressing the unintended results presented in the situation described – a gift made the decedent during the increased exemption period, followed by the death of the decedent after the end of such period – the proposed regulations ensure that the decedent’s estate will not be inappropriately taxed with respect to the gift.

With this “certainty,” an individual business owner who has been thinking about gifting a substantial interest in their business may want to accelerate their gift planning. As an additional incentive, the owner need only look at the results of the mid-term elections, which do not bode well for the future of the increased exemption amount. In other words, it may behoove the owner to treat 2020 (rather than 2025) as the final year for which the increased exemption amount will be available, and to plan accordingly. Those owners who decide to take advantage of the increased exemption amount by making gifts should consider how they may best leverage it.

And as always, tax savings, estate planning, and gifting strategies have to be considered in light of what is best for the business and what the owner is comfortable giving up.

—————————————————————
(i) What? Did you really expect something else? Tax planning is not a seasonal exercise – it is something to be considered every day, similar to many other business decisions.
(ii) Of course, the interest to be gifted should be “disposable” in that the owner can comfortably afford to give up the interest. Even if that is the case, the owner may still want to consider the retention of certain “tax-favored” economic rights with respect to the interest so as to reduce the amount of the gift for tax purposes.
(iii) Usually into an irrevocable trust, and coupled with the granting of “Crummey powers” to the beneficiaries so as to support the gift as one of a “present interest” in property. A donor’s annual exclusion amount is set at $15,000 per donee for 2018 and $15,000 for 2019.
(iv) In other words, a dollar removed today will remove that dollar plus the appreciation on that dollar; a dollar at death shields only that dollar.
The removal of this value from the reach of the estate tax has to be weighed against the loss of the stepped-up basis that the beneficiaries of the decedent’s estate would otherwise enjoy if the gifted business interest were included in the decedent’s gross estate.
(v) Matthew 7:7-8. Actually, many folks asked for the repeal of the estate tax. “You Can’t Always Get What You Want,” The Rolling Stones.
(vi) P.L. 115-97.
(vii) For purposes of the estate tax, this includes a U.S. citizen or domiciliary. The distinction between a U.S. individual and non-resident-non-citizen is significant. In the absence of any estate and gift tax treaty between the U.S and the foreign individual’s country, the foreign individual is not granted any exclusion amount for purposes of determining their U.S. gift tax liability, and only a $60,000 exclusion amount for U.S. estate tax purposes.
(viii) https://www.irs.gov/pub/irs-drop/rp-18-57.pdf
(ix) Only individual transferors are subject to the gift tax. Thus, in the case of a transfer from a business entity that is treated as a gift, one or more of the owners of the business entity will be treated as having made the gift.
(x) They also share a common tax rate table.
(xi) As distinguished, for example, from the annual exclusion gift – set at $15,000 per donee for 2018 and for 2019 – which is not treated as a taxable gift (it is not counted against the exemption amount).
(xii) An election is available under which the federal exemption amount that was not used by a decedent during their life or at their death may be used by the decedent’s surviving spouse (“portability”) during such spouse’s life or death.
(xiii) A similar approach is followed in determining the gift tax, which is imposed on an individual’s transfers by gift during each calendar year.
(xiv) As indicated above, the increased exemption amount is scheduled to sunset after 2025, at which point the lower, pre-TCJA basic exclusion amount is reinstated, as adjusted for inflation through 2025. Of course, a change in Washington after 2020 could accelerate a reduction in the exemption amount.
(xv) I bet you don’t hear that much these days.
(xvi) https://www.federalregister.gov/documents/2018/11/23/2018-25538/estate-and-gift-taxes-difference-in-the-basic-exclusion-amount; the regulations are proposed to be effective on and after the date they are published as final regulations in the Federal Register.
(xvii) Defined as all taxable gifts made after 1976 other than those included in the gross estate.
(xviii) Post-TCJA and before 2026.

If there was one part of the Tax Cuts and Jobs Act (“TCJA”) that estate planners were especially pleased to see, it was the increase in the basic exclusion amount from $5.49 million, in 2017, to $11.18 million for gifts made, and decedents dying, in 2018.[i] However, many estate planners failed to appreciate the potential impact of an income tax provision that came late to the party and that was specifically intended to benefit the individual owners of pass-through entities (“PTEs”).

A Brief History

As it made its way through Congress, the TCJA was billed[ii] as a boon for corporate taxpayers, and indeed it was. The corporate tax rate was reduced from 35% to 21%. The corporate AMT was eliminated. The system for the taxation of foreign income was changed in a way that skews in favor of C corporations.

But what about the closely held business – the sole proprietorships, the S corps, the partnerships and LLCs that are owned primarily by individual taxpayers and that often represent the most significant asset in their estates?

These businesses are usually formed as PTEs for tax purposes, meaning that the net operating income generated by these entities is generally not subjected to an entity-level tax; rather, it flows through to the individual owners, who are taxed thereon as if they had realized it directly.

With the introduction of the TCJA, the owners of many PTEs began to wonder whether they should revoke their S corporation elections, or whether they should incorporate[iii] their sole proprietorships and partnerships.

In response to the anxiety felt by individual business owners, Congress enacted a special deduction for PTEs in the form of Sec. 199A.[iv] However, shortly after its enactment on December 22, 2017, tax advisers starting peppering the IRS with questions about the application of 199A.

The IRS eventually proposed regulations in August, for which hearings were held in mid-October.[v]

In September, House Republicans introduced plans for making Sec. 199A “permanent.” Then, during the first week of November, the Republicans lost control of the House.[vi]

Notwithstanding this state of affairs, the fact remains that 199A is the law for at least two more years,[vii] and estate planners will have to deal with it; after all, the income tax consequences arising from an individual’s transfer of an interest in a PTE in furtherance of their estate plan will either enhance or reduce the overall economic benefit generated by the transfer.

In order to better appreciate the application of 199A to such “estate planning transfers,” a quick refresher may be in order.

Sec. 199A Basics

Under Sec. 199A, a non-corporate taxpayer[viii] – meaning an individual, a trust, or an estate – who owns an interest in a PTE that is engaged in a qualified trade or business (“QTB”),[ix] may claim a deduction for a taxable year equal to 20% of their qualified business income (“QBI”)[x] for the taxable year.[xi]

This general rule, however, is subject to a limitation that, if triggered, may reduce the amount of the 199A deduction that may be claimed by the non-corporate taxpayer (the “limitation”).

What triggers the limitation? The amount of the taxpayer’s taxable income from all sources[xii] – not just the taxpayer’s share of the QTB’s taxable income. Moreover, if the taxpayer files a joint return with their spouse, the spouse’s taxable income is also taken into account.

Specifically, once the taxpayer’s taxable income exceeds a specified threshold amount, the limitation becomes applicable, though not fully; rather, it is phased in. In the case of a single individual, the limitation starts to apply at taxable income of $157,500 (the so-called “threshold amount”). The limitation is fully phased in when taxable income exceeds $207,500.[xiii]

This $157,500 threshold amount also applies to non-grantor trusts and to estates.

These thresholds are applied at the level of each non-corporate owner of the business – not at the level of the entity that actually conducts the business. Thus, some owners of a QTB who have higher taxable incomes may be subject to the limitations, while others with lower taxable incomes may not.

The Limitation

As stated earlier, the Sec. 199A deduction for an individual, a trust, or an estate for a particular tax year is generally equal to the 20% of the taxpayer’s QBI for the year.

However, when the above-referenced limitation becomes fully applicable, the taxpayer’s 199A deduction for the year is equal to the lesser of:

  • 20% of their QBI from a QTB, and
  • The greater of:
      • 50% of the W-2 Wages w/r/t such QTB, or
      • 25% of the W-2 Wages w/r/t such QTB plus 2.5% of the “unadjusted basis” of the “qualified property” in such QTB.

In considering the application of this limitation, the IRS recognized that there are bona fide non-tax, legal or business reasons for holding certain properties – such as real estate – separate from the operating business, and renting it to such business. For that reason, the proposed regulations allow the owners of a QTB to consider the unadjusted basis of such rental property in determining the limitations described above – even if the rental activity itself is not a QTB – provided the same taxpayers control both the QTB and the property.[xiv]

Thus, assuming the presence of at least one QTB,[xv] much of the planning for 199A will likely involve the taxpayer’s “management” of (i) their taxable income (including their wages and their share of QBI) and, thereby, their threshold amount for a particular year, (ii) the W-2 Wages paid by the business, (iii) the unadjusted basis of the qualified property[xvi] used in the business, and (iv) the aggregation of QTBs.

Of the foregoing items, the management of the unadjusted basis of qualified property may be especially fruitful in the context of estate planning, as may the management of the threshold amount.

Unadjusted Basis

Generally speaking, the unadjusted basis of qualified property is its original basis in the hands of the QTB as of the date it was placed into service by the business.

Where the business purchased the property, its cost basis would be its unadjusted basis – without regard to any adjustments for depreciation or expensing subsequently claimed with respect to the property – and this amount would be utilized in determining the limitation on an owner’s 199A deduction.

However, where the property was contributed to a PTE in a tax-free exchange for stock or a partnership interest, the PTE’s unadjusted basis would be the adjusted basis of the property in the hands of the contributor at the time of the contribution – i.e., it will reflect any cost recovery claimed by such person.

In the case of an individual who acquires property from a decedent before placing it into service in a QTB, the stepped-up basis becomes the unadjusted basis or purposes of 199A.

However, if the qualified property is held in a partnership, no Section 754 adjustment made at the death of a partner will be taken into account in determining the unadjusted basis for the transferee of the decedent’s interest for purposes of 199A.[xvii]

Based on the foregoing, and depending upon the business,[xviii] a taxpayer who can maximize the unadjusted basis of the QTB’s qualified property will increase the likelihood of supporting a larger 199A deduction in the face of the limitation.

Toward achieving this end, there may be circumstances in which qualified property should be owned directly by the owners of the PTE (say, as tenants-in-common[xix]), rather than by the PTE itself, and then leased by the owners to the business.

For example, if a sole proprietor is thinking about incorporating a business, or converting it into a partnership by bringing in a partner, and the business has qualified property with a relatively low unadjusted basis (say, the original cost basis), the sole proprietor may want to retain ownership of the depreciable property and lease it (rather than contribute it) to the business entity, so as (i) to preserve their original unadjusted cost basis and avoid a lower unadjusted cost basis in the hands of the entity (based on the owner’s adjusted basis for the property) to which it would otherwise have been contributed, and (ii) to afford their successors in the business and to the property an opportunity to increase their unadjusted basis in the property, assuming it has appreciated – basically, real estate – after the owner’s death.

Trusts – the Threshold Amount

A non-grantor trust is generally treated as a form of pass-through entity to the extent it distributes (or is required to distribute) its DNI (“distributable net income;” basically, taxable income with certain adjustments) to its beneficiaries, for which the trust claims a corresponding distribution deduction. In that case, the income tax liability for the income that is treated as having been distributed by the trust shifts to the beneficiaries to whom the distribution was made.

To the extent the trust retains its DNI – i.e., does not make (and is not required to make) a distribution to its beneficiaries – the trust itself is subject to income tax.

In the case of a non-grantor trust, at least in the first instance, the 199A deduction is applied at the trust level. Because the trust is generally treated as an individual for purposes of the income tax, the threshold amount for purposes of triggering the application of the limitation is set at $157,500 (with a $50,000 phase-in range).

Distribution

However, if the trust has made distributions during the tax year that carry out DNI to its beneficiaries, the trust’s share of the QBI, W-2 Wages, and Unadjusted Basis of the QTB in which it owns an interest are allocated between the trust and each beneficiary-distributee.

This allocation is based on the relative proportion of the DNI of the trust that is distributed, or that is required to be distributed, to each beneficiary, or that is retained by the trust. In other words, each beneficiary’s share of the trust’s 199A-related items is determined based on the proportion of the trust’s DNI that is deemed distributed to the beneficiary.

The individual beneficiary treats these items as though they had been allocated to them directly from the PTE that is engaged in the QTB.

Following this allocation, the trust uses its own taxable income for purposes of determining its own 199A deduction, and the beneficiaries use their own taxable incomes.

Based on the foregoing, a trustee may decide to make a distribution in a particular tax year if the trust beneficiaries to whom the distribution is made are in a better position to enjoy the 199A deduction than are the trust and the other beneficiaries.[xx]

In any case, the beneficiaries to whom a distribution is not made may object to the trustee’s decision notwithstanding the tax-based rationale.

Of course, where the trustee does not consider the tax attributes of an individual beneficiary, and makes a distribution to such individual which pushes them beyond the threshold amount, or disqualifies their SSTB from a 199A deduction, the beneficiary may very well assert that the trustee did not act prudently.

Limitations Applied to Non-grantor Trusts

The 199A threshold and phase-in amounts are applied at the level of the non-grantor trust.[xxi]

Because of this, the IRS is concerned that taxpayers will try to circumvent the threshold amount by dividing assets among multiple non-grantor trusts, each with its own threshold amount.

In order to prevent this from happening, the IRS has proposed regulations that introduce certain anti-abuse rules.[xxii]

Specifically, if multiple trusts are formed with a “significant purpose” – not necessarily the primary purpose – of receiving a deduction under 199A, the proposed regulations provide that the trusts will not be “respected” for purposes of 199A.[xxiii] Unfortunately, it is not entirely clear what this means: will the trusts not qualify at all, or will they be treated as a single trust for purposes of the deduction?

In addition, two or more trusts will be aggregated by the IRS, and treated as a single trust for purposes of 199A, if:

  • The trusts have substantially the same grantor(s),
  • Substantially the same “primary” beneficiary(ies), and
  • “A” principal purpose for establishing the trusts is the avoidance of federal income tax.

For purposes of applying this rule, spouses are treated as one person. In other words, if a spouse creates one trust and the other spouse creates a second trust, the grantors will be treated as the same for purposes of the applying this anti-abuse test, even if the trusts are created and funded independently by the two spouses.[xxiv]

If the creation of multiple trusts results in a “significant income tax benefit,” a principal purpose of avoiding tax will be presumed.

This presumption may be overcome, however, if there is a significant non-tax (or “non-income tax”) purpose that could not have been achieved without the creation of separate trusts; for example, if the dispositive terms of the trusts differ from one another.

Grantor Trust

The application of 199A to a grantor trust is much simpler because the individual grantor is treated as the owner of the trust property and income, and the trust is ignored, for purposes of the income tax.[xxv] Thus, any QTB interests held by the trust are treated as owned by the grantor for purposes of applying 199A.

In other words, the rules described above with respect to any individual owner of a QTB will apply to the grantor-owner of the trust; for example, the QBI, W-2 Wages, and Unadjusted Basis of the QTB operated by the PTE in which the trust holds an interest will pass through to the grantor.

Planning?

As we know, many irrevocable trusts to which completed gifts have been made are nevertheless taxed as grantor trusts for income tax purposes. The grantor has intentionally drafted the trust so that the income tax liability attributable to the trust will be taxed to the grantor, thereby enabling the trust to grow without reduction for income taxes, while at the same time reducing the grantor’s gross estate for purposes of the estate tax.

This may prove to be an expensive proposition for some grantors, which they may remedy by renouncing the retained rights or authorizing the trustee to toggle them on or off, or by being reimbursed from the trust (which defeats the purpose of grantor trust status).

The availability of the 199A deduction may reduce the need for avoiding or turning off grantor trust status, thus preserving the transfer tax benefits described above. In particular, where the business income would otherwise be taxed at a 37% federal rate,[xxvi] the full benefit of 199A would yield a less burdensome effective federal rate of 29.6%.

In addition to more “traditional” grantor trusts – which are treated as such because the grantor has retained certain rights with respect to the property contributed to the trust – there are other trusts to which the grantor trust rules may apply and which may, thereby, lend themselves to some 199A planning.

For example, a trust that holds S corporation stock may qualify as a subchapter S trust for which the sole current beneficiary of the trust may elect under Sec. 1361(d) (a “QSST” election) to be treated as the owner of such stock under Sec. 678 of the Code.[xxvii] Or a trust with separate shares for different beneficiaries, each of which is treated as a separate trust for which a beneficiary may elect treatment as a QSST.

Another possibility may be a trust that authorizes the trustee to grant a general power of appointment to a beneficiary as to only part of the trust – for example, as to a portion of one of the PTE interests held by the trust – thereby converting that portion of the trust into a grantor trust under Sec. 678.[xxviii]

What’s Next?

It remains to be seen what the final 199A regulations will look like.[xxix] That being said, estate planners should have enough guidance, based upon what has been published thus far, to advise taxpayers on how to avoid the anti-abuse rules for non-grantor trusts, how to take advantage of the grantor trust rules, and how to maximize the unadjusted basis for qualified property.

Hopefully, the final regulations will provide examples that illustrate the foregoing. Absent such examples, advisers will have to await the development of some Sec. 199A jurisprudence. Of course, this presupposes that 199A will survive through the 117th Congress.[xxx]


[i] The exclusion amount increases to $11.4 million in 2019. It is scheduled to return to “pre-TCJA” levels after 2025. See the recently proposed regulations at REG-106706-18.

[ii] Pun intended. P.L. 115-97.

[iii] Or “check the box” under Reg. Sec. 301.7701-3.

[iv] This provision covers tax years beginning after 12/31/2017, but it expires for tax years beginning after 12/31/2025.

[v] More recently, the IRS announced its 2018-2019 priority guidance project, which indicated that it planned to finalize some of the regulations already proposed, but that more regulations would be forthcoming; it also announced that a Revenue Procedure would be issued that would address some of the computational issues presented by the provision.

[vi] Thus, we find ourselves at the end of November 2018 with a provision that expires after December 31, 2025, for which the issued guidance is still in proposed form.

[vii] Through the next presidential election.

[viii] The deduction is not determined at the level of the PTE – it is determined at the level of each individual owner of the PTE, based upon each owner’s share of qualified business income.

[ix] In general, a QTB includes any trade or business other than a specified service trade or business (“SSTB”) and the provision of services as an employee.

If an individual taxpayer does not exceed the applicable taxable income threshold (described below), their QBI from their SSTB will be included in determining their 199A deduction. If the taxpayer exceeds the applicable threshold and phase-in amounts, none of the income and deduction items from the SSTB will be included in determining their 199A deduction.

[x] Basically, the owner’s pro rata share of the QTB’s taxable income.

[xi] This deduction amount is capped at 20% of the excess of (i) the owner’s taxable income for the year over (ii) their net capital gain for the year.

[xii] Business and investment, domestic and foreign.

[xiii] In the case of a joint return between spouses, the threshold amount is $315,000, and the limitation becomes fully applicable when taxable income exceeds $415,000.

[xiv] Consistent with this line of thinking, and recognizing that it is common for taxpayers to separate into different entities, parts of a business that are commonly thought of as a single business, the IRS will also allow individual owners – not the business entities themselves – to elect to aggregate (to treat as one business) different QTBs if they satisfy certain requirements, including, for example, that the same person or group of persons control each of the QTBs to be aggregated.

It should be noted that owners in the same PTEs do not have to aggregate in the same manner. Even minority owners are allowed to aggregate. In addition, a sole proprietor may aggregate their business with their share of a QTB being conducted through a PTE.

[xv] Whether a QTB exists or not is determined at the level of the PTE. An owner’s level of involvement in the business is irrelevant in determining their ability to claim a 199A deduction. A passive investor and an active investor are both entitled to claim the deduction, provided it is otherwise available.

[xvi] Basically, depreciable tangible property that is used in the QTB for the production of QBI, and for which the “depreciation period” has not yet expired.

[xvii] The Section 754 adjustment is not treated as a new asset that is placed into service for these purposes. Compare Reg. Sec. 1.743-1(j)(4).

[xviii] For example, is it labor- or capital-intensive?

[xix] Of course, this presents its own set of issues.

[xx] Of course, this assumes that the trustee has the relevant beneficiary information on the basis of which to make this decision, which may not be feasible.

[xxi] For purposes of determining whether the trust’s taxable income exceeds these amounts, the proposed regulations provide that the trust’s taxable income is determined before taking into account any distribution deduction. Query whether this represents a form of double counting? The distributed DNI is applied in determining the trust’s threshold, and it is applied again in determining the distributee’s.

[xxii] Under both IRC Sec. 199A and Sec. 643(f).

[xxiii] Prop. Reg. Sec. 1.199A-6(d)(3).

[xxiv] Prop. Reg. Sec. 1.643(f)-1.

[xxv] IRC Sec. 671 through 679.

[xxvi] The new maximum federal rate for individuals after the TCJA.

[xxvii] See Reg. Sec. 1.1361-1(j).

[xxviii] A so-called “Mallinckrodt trust.”

[xxix] The proposed regulations also address the treatment of ESBTs under Sec. 199A. According to the proposed regulations, an ESBT is entitled to the deduction. Specifically, the “S portion” of the ESBT takes into account its share of the QBI and other items from any S corp owned by the ESBT.

The grantor trust portion of the trust, if any, passes its share to the grantor-owner.

The non-S/non-grantor trust portion of the trust takes into account the QBI, etc., of any other PTEs owned by the trust. Does that mean that the ESBT is treated as two separate trusts for purposes of the 199A rules? It is not yet clear.

[xxx] January 2021 to January 2023.

“I Didn’t See That Coming”

Over the years, I have seen many business owners blanche when they learn how much income tax they will have to pay upon the sale of their business.[i] I have heard their disappointment at realizing that they may not be retaining a greater portion of the proceeds from the sale toward which they have worked for so long.

Of course, if this information is imparted to the owner well before they have even identified a buyer for their business – as it should be[ii] – they may choose not to sell the business at all,[iii] or they may conclude that the business is not yet ready to be sold.[iv] Alternatively, and having been forewarned, the owner may negotiate for a tax-friendlier – and economically more efficient – deal structure.

Then there are those owners who sold their business for what they believed was a great price, but who never consulted with a tax adviser prior to the sale, and who only learned after their returns had been prepared[v] that they were going to owe a significant sum to the government. These are the ones for which an adviser must watch out.

You Can’t Make this Up

For example, many years ago, I was brought into a Federal income tax audit that was not going well. The examiner was properly focused on the gains and losses reported on the taxpayer’s income tax return.[vi] The taxpayer’s S corporation had sold its business for a healthy sum, but his personal return also included a large capital loss that offset part of the gain from the sale. There was no information on the return from which to determine the source of the loss. When asked, the taxpayer was unable to provide any details;[vii] rather, he directed me to the accountant. The latter hemmed and hawed, and promised to provide the necessary back-up – and all the while I tried to hold the IRS examiner at bay. Finally, the accountant confessed that there was no such loss. He explained that his office had switched accounting software while the return was being prepared,[viii] and there had been a glitch in a program that added a few zeros to the loss reported on the return. Talk about creative accounting.[ix]

Lightning Strikes Again?

I wish I could say that cases like the one described immediately above are rare, but then I came across this decision just last week.

Taxpayer owned five restaurants, each of which was held in a separate and wholly-owned S corporation. Taxpayer began selling his restaurants in Tax Year, realizing a long-term capital gain in excess of $3.5 million,[x] which he reported on his IRS Form 1040, U.S. Individual Income Tax Return, for Tax Year.

Taxpayer offset this gain with a long-term capital loss of almost $3.0 million, which he claimed was attributable to an asset that was described on his return as an “overseas investment.” Taxpayer reported that he had acquired this investment approximately six years earlier, and had disposed of it at the end of Tax Year for no consideration.[xi]

Something Stinks

The IRS examined Taxpayer’s return. Neither Taxpayer nor his accountant offered a plausible explanation as to how the loss was determined; specifically, they could not substantiate the claimed cost basis of almost $3.0 million.[xii] In addition, neither of them was able to identify the “acquisition date” for the alleged investment; in fact, the accountant stated that he had arbitrarily chosen a date so as to indicate that the loss “was long term.” The accountant also stated that he had come up with the term “overseas investment,” and had listed the year-end as the date of disposition, on the basis of a conversation with Taxpayer.

The IRS concluded that Taxpayer had not substantiated (i) that he had made an investment, (ii) what his basis in that alleged investment was, or (iii) that the investment had become worthless during Tax Year. The IRS mailed Taxpayer a notice of deficiency,[xiii] and Taxpayer timely petitioned the U.S. Tax Court.

At trial, Taxpayer explained that an acquaintance had pitched an investment concept to him. Unbelievably, Taxpayer testified that he had no idea what this investment involved, but he believed it had something to do with “low interest rates” and an “opportunity *** to basically leverage *** bank funds.”

Taxpayer submitted into evidence some promotional materials which he claimed to have reviewed before investing. Notwithstanding his decades of business experience, however, Taxpayer did not seek advice about this investment from his long-time accountant, who was also a wealth manager, or from anyone else.

Despite having little understanding of the investment, Taxpayer testified that he agreed to invest $2.5 million. He submitted into evidence a copy of a purported “Investment Agreement” according to which Taxpayer would receive a 50% membership interest in a limited liability company by investing $2.5 million, which would be deposited into the escrow account of a specified law firm.

Apart from Taxpayer’s testimony,[xiv] there was no evidence that Taxpayer ever made the $2.5 million investment. He testified that the source of funds for the investment was a loan that his restaurants secured. The restaurants did appear to have secured such a loan, and the loan proceeds were allocated among them as shown in their QuickBooks entries. But there was no evidence that the S corporations disbursed any of these funds to the law firm’s escrow account or to Taxpayer; and there was no evidence, in the form of bank statements, wire transfer cover sheets, receipts, or any other document, to show that Taxpayer transferred $2.5 million (or any other sum) to the law firm.

Taxpayer also testified that he had subsequently contributed another $500,000 to this “overseas investment.” He submitted into evidence documents showing a couple of wire transfers, a cashier’s check, and a “transaction journal,” none of which established the fact of his investment.

Taxpayer also claimed to have invested in a second, previously undisclosed, investment, although he produced no evidence to establish the fact of his ownership or the amount of his investment. Taxpayer also claimed to have purchased from others their interests in this investment during the same period that he professed the investment had become worthless. However, there was no documentary evidence to establish that any of these purchases were made.

Although Taxpayer was supposed to have received regular payouts from his investments, he testified that he had never received any kind of payment. Yet Taxpayer took no action of any kind to recover his alleged investment, and did not even investigate the possibility of doing so. Instead, as his accountant explained, Taxpayer drew an inference that the investment was not doing well from the fact that his “correspondence with [the promoter] was less regular and they weren’t as upbeat.”

The Court Smells It Too

The Court began by noting that the IRS’s determination in the notice of deficiency was presumed correct, and that Taxpayer had the burden of proving it erroneous.

The Court then observed that, on his return for Tax Year, Taxpayer reported a capital loss from the disposition of a single “overseas investment.” At trial, however, Taxpayer testified that this loss was actually attributable to investments in two separate entities. In any case, Taxpayer contended that this loss was deductible as a loss from “worthless securities.”

The Court explained that, “[i]f any security which is a capital asset becomes worthless during the taxable year, the loss resulting therefrom shall * * * be treated as a loss from the sale or exchange, on the last day of the taxable year, of a capital asset.” For purposes of this rule, the Court continued, the term “security” means “a share of stock in a corporation,” the “right to subscribe for, or to receive, a share of stock in a corporation,” or a bond or other evidence of indebtedness issued by a corporation or governmental entity.

According to the Court, in order for Taxpayer to be entitled to deduct the purported loss under this rule, he had to establish three distinct facts:

  • First, that he owned a “security,” as defined in the Code;
  • Second, his “adjusted basis” in that security; and
  • Third, that the security “bec[ame] worthless during the taxable year” for which the deduction is claimed.

“Worthlessness is a factual question,” the Court stated, “and [Taxpayer] has the burden of proof to overcome [the IRS’s] determination” that the security did not become worthless during the year in question.

The Court found that Taxpayer had substantiated none of these facts.

First, Taxpayer did not show that he owned a “security.” He did not contend that the “overseas investments” took the form of a bond or other evidence of indebtedness. And he did not establish that either investment actually existed, that either was a corporation, or that he made any investment that took the form of “share[s] of stock in a corporation.”

Second, Taxpayer did not establish his basis (if any) in the investments. There was no credible evidence, documentary or otherwise, to show that he, or his S corporations, made an initial investment of $2.5 million to acquire shares of stock in any business or investment entity. In no case did any such entity furnish Taxpayer with an acknowledgment that it had received funds from him for investment, or that his ownership interest in the entity had changed. There was simply no credible evidence that any payments were made to acquire shares of corporate stock.

Third, Taxpayer did not carry his burden of proving that his alleged investments became worthless during Tax Year. To establish worthlessness in a particular year, the Court explained, a taxpayer must generally point to a “fixed and identifiable event” that caused the security to lose all value. Such an event may include a corporate dissolution or similar occurrence that “clearly evidences destruction of both the potential and liquidating values of the stock.” To establish that he has abandoned a security, the taxpayer “must permanently surrender and relinquish all rights in the security and receive no consideration in exchange.” This determination is made on the basis of “all the facts and circumstances.”

“Assuming arguendo,” the Court stated, “that [Taxpayer] made an investment in ***, he has pointed to no identifiable event evidencing that his investment became worthless during” Tax Year. He allegedly based his inference to that effect on the pessimistic tone of his communications with the promoter. But these emails did not refer to any investment that Taxpayer may have made.

In any event, Taxpayer provided at trial no reason to believe that his alleged investment had become worthless during Tax Year rather than during one of the previous six or seven years. On the other hand, he testified that he continued to make supposed investments, allegedly to buy out the interests of other investors. “These transfers sit uncomfortably with [Taxpayer’s] assertion that he viewed his investment as worthless” during that time.

The Court remarked that, by the end of the trial, “the circumstances surrounding [Taxpayer’s] alleged ‘overseas investment’ were as mysterious as they had appeared on his tax return.” Even assuming that he had made some sort of investment, the Court determined that Taxpayer did not carry his burden of proving that he had purchased a “security,” what his basis was in that security, or that the security had become worthless during Tax Year.

Thus, the Court found that Taxpayer had claimed “a fictitious loss deduction” of almost $3.0 million for Tax Year because he wished to offset the $3.5 million gain that he was required to report upon his sale of the restaurants.

“Do’s and Don’ts”

Yes, there are rogue advisers out there, and there are rogue taxpayers – somehow, they manage to find each other. Stay clear of them.[xv]

The tax-efficient disposition of a business is a process that begins at the inception of the business. There are no shortcuts. Different strategies and structures may be economically “more appropriate” at different stages in the life of the business. Some are more flexible than others. They are all aimed at growing the business and, ultimately, at maximizing the economic return on the owner’s investment.

At times, however, the owner may be presented with a choice under circumstances that are not ideal – they don’t adhere to the “plan.” For example, an offer to purchase the business from the owner may be premature from the owner’s perspective. The owner may reject the offer and rue the decision years later. Or the owner may accept the offer and rue the decision years later. Or the owner may try to change the terms of the offer, whether through an earn-out, a rollover of some of their equity, a joint venture, or some other means by which they can participate in the continued growth of the business in a tax efficient manner.

Every situation, every business, and every owner is different. The point is to consider with one’s advisers those scenarios that are likely to arise, to understand their consequences,[xvi] and to plan for them as best as reasonably possible. Avoid surprises that may trigger irrational acts.[xvii] When surprises occur, as they often do notwithstanding one’s preparation and planning, seek out those advisers before taking any action in response.[xviii]


[i] These will include Federal, state, and sometimes city, income taxes; the taxes may be imposed at the level of both the business entity and its owners. The sale may also trigger sales tax and real estate transfer tax, depending upon the form of the transaction and the nature of the assets being sold.

[ii] It may be a worthwhile exercise for the owner to informally appraise their business every few years. You never know when “that” offer is going to come and, although most owners have a ballpark idea of what their business is worth, it helps to have a more objective perspective.

[iii] That being said, there may be exigent circumstances that compel the sale.

[iv] For example, it may be that the business still has “room to grow.”

[v] In the year following the year of the sale.

[vi] Among other items, there were questions about the adjusted basis of some of the assets.

[vii] “I didn’t really review the return,” he said. “I just signed where I was told.”

[viii] “The dog ate my homework.” I guess that doesn’t resonate much in an age when kids do their homework on a computer.

[ix] The exam ended well, under the circumstances. I spoke very frankly with the examiner and their manager, fired the accountant, and restored a measure of credibility that facilitated a settlement.

[x] Meaning that the amount received by Taxpayer in exchange for the restaurants exceeded Taxpayer’s unrecovered investment (“adjusted basis”) in the restaurants by over $3.5 million.

[xi] In other words, he wrote it off as worthless.

[xii] After all, you can’t lose more than your unrecovered investment.

[xiii] The so-called “90-day letter,” which refers to the ninety days within which the taxpayer must file a petition with the Tax Court to contest the deficiency asserted in the letter. If the taxpayer fails to respond timely, the IRS is free to assess the tax, demand payment, and then seek to collect it.

[xiv] Which the Court did not find credible.

[xv] Some telltale signs: they intentionally draft ambiguity into a document; they say things like “this return is so convoluted, the IRS will never pick up the issue,” or “we control the preparation of the return, we can do whatever we want”; they ignore the legal separation among related entities; they bury questionable items in entries like “other expenses” and actually believe that no one will look.

[xvi] Which has to include running the numbers.

[xvii] One of my physics teachers was fond of saying, “Eschew obfuscation.”

[xviii] I know, I sound like your mother.

Dr. Wallace Wrightwood: “You’ve seen hundreds, thousands of pigeons, right?”
George Henderson: “Of course.”
Dr. Wallace Wrightwood: “Have you ever seen a baby pigeon? Well neither have I. I got a hunch they exist.”[i]

When was the last time you pored over a judge’s analysis of the bona fides of a family limited partnership (“FLP”), or pondered a court’s Solomon-like judgement regarding the fair market value of an interest in a FLP? [ii]

It used to be that such decisions were de rigeur in the world of estate and gift tax planning for family-owned business and investment entities, and planners would wait breathlessly for the outcome of the next learned opinion and the direction it would provide.

Then the federal transfer tax exemption began its seemingly inexorable climb, which spawned an interest in how to best leverage the increased exemption amount and remove still more of a family’s wealth from the transfer tax system.

Of course, there was a bump in 2016, with the issuance of proposed regulations that many believed would, if finalized, mark the end of the valuation discounts that made the use of FLPs, and the transfer of interests in family-owned businesses generally, so attractive as a gift planning tool. [iii]

The presidential election results ended the IRS’s regulatory efforts to clamp down on the abuse of FLPs, and the “temporary” mega-increase of the federal exemption, beginning with 2018, gave many taxpayers a comfortable “margin of error” for any valuation missteps. [iv]

Notwithstanding the relatively “favorable” environment for gift and estate tax planning in which we find ourselves, it will still behoove taxpayers and their advisers to remain attuned to the factors on which the IRS and the courts have historically focused in their analyses of FLPs and the transfer of interests in family-owned businesses, some of which were highlighted in a recent Tax Court decision. https://www.ustaxcourt.gov/ustcinop/OpinionViewer.aspx?ID=11800 [v]

“I’ll Take Care of Everything, Dad”

Decedent, acting through his attorney-in-fact [vi] (his daughter, “Daughter”), formed FLP as a limited partnership. The partnership agreement (the “Agreement”) stated that FLP’s purpose was to “provide a means for [D]ecedent’s family to manage and preserve family assets.” Decedent funded FLP primarily with marketable securities, municipal bonds, mutual funds, and cash. Its portfolio was managed by professional money managers. FLP never held any meetings.

F-LLC was FLP’s sole general partner (“GP”). Daughter was manager of F-LLC. The Agreement provided that the GP “shall perform or cause to be performed * * * the trade or business of the Partnership,” subject only to limitations set forth expressly in the Agreement.

Decedent and his children were FLP’s original limited partners (“LPs”) under the Agreement. The LPs, other than Decedent, received their LP interests as gifts. Decedent reported these gifts on a federal gift tax return (IRS Form 709).

Agreement
The Agreement provided that FLP would terminate in 2075, unless terminated sooner; for example, upon the removal of the GP. The LPs could remove the GP by written agreement of the LPs owning 75% or more of the partnership interests held by all LPs. If the partnership terminated by reason of the GP’s removal, then 75% of the LPs could reconstitute the partnership and elect a successor GP. LPs owning at least 75% of the ownership percentage in FLP could approve the admission of additional LPs to the partnership.

The Agreement provided that an LP could not sell or assign an interest in FLP without obtaining the written approval of the GP, which the Agreement provided would not be unreasonably withheld. Any partner who assigned their interest remained liable to the partnership for promised contributions or excessive distributions unless and until the assignee was admitted as a substituted LP. The GP could elect to treat an assignee as a substituted LP in the place of the assignor. An assignor was deemed to continue to hold the assigned interest for the purposes of any vote taken by LPs under the Agreement until the assignee was admitted as a substituted LP.

All transfers of interests in FLP were subject to limitations. Partners were allowed to make only permitted transfers of their interests. “Permitted transfers” were transfers (1) to any member of the transferor’s family, (2) to the transferor’s executor, trustee, or personal representative to whom his or her interest would pass at death or by operation of law, or (3) to any purchaser, but subject to the right of first refusal held by the certain partners.

Any partner who received an outside purchase offer for their interest was required, before accepting the offer, to provide each of the “priority family”, the partnership, and the general partner an opportunity to acquire the interest. Whether FLP exercised its right of first refusal to purchase a partner’s interest was subject to the approval of the GP and the LPs owning at least 50% of FLP’s interests held by all LPs (with the exception of the seller if they were an LP).

The Agreement referred to persons who acquired interests in FLP, but who were not admitted as substituted LPs, as “assignees”. Such “assignees” were entitled only to allocations and distributions in respect of their acquired interests. “Assignees” had no right to any information or accounting of the affairs of FLP, were not entitled to inspect its books or records, and did not have any of the rights of a partner under state law.

The Agreement provided that a transferee of an interest in FLP could become a substituted LP upon satisfying the following conditions: (1) the GP consented; (2) the transferee was a permitted transferee; and (3) the transferee became a party to the Agreement as an LP. The Agreement provided that an interest holder who was admitted to FLP as a substituted LP would be treated the same as an original LP under the terms of the Agreement.

On the same day that Decedent formed FLP, he established a revocable trust (the “Trust”), and also transferred his 88.99% LP interest in FLP to Trust. Decedent held the power during his life to amend, alter, revoke, or terminate Trust. He was its sole beneficiary, and Daughter was the trustee. Decedent was entitled to receive distributions of trust income and could receive distributions of trust principal upon his request.

Decedent, through Daughter, executed an agreement (the “Assignment”), which designated Decedent as “assignor” and the Trust as “assignee”. The Assignment provided that Decedent assigned all of his LP interests in FLP, and that the Trust, “by signing this [Assignment], hereby agrees to abide by all the terms and provisions in that certain [Agreement] of [FLP].”

Decedent’s transfer of his interest was a permitted transfer under the Agreement. Daughter signed the Assignment in her capacities as Decedent’s attorney-in-fact, as trustee of the Trust, and as managing member of F-LLC.

Estate Tax Return
Following Decedent’s death, [vii] his estate (the “Estate”) filed a federal estate tax return (IRS Form 706). The Estate reported on the estate tax return that Decedent had made revocable transfers during his lifetime. It identified on the estate tax return the transfers of Decedent’s LP interests to the Trust. [viii]

The Estate described the property transferred to the Trust as an “assignee interest” in an 88.99% LP interest. The Estate reported the value of the transferred interest on the tax return; in a supplemental statement, the Estate indicated that it claimed discounts for “lack of marketability, lack of control, and lack of liquidity.”

The IRS issued a notice of deficiency asserting an estate tax deficiency. The attached Forms 886-A set forth the IRS’s determination that the corrected value of decedent’s interest in FLP was greater than that reported by the Estate.

The Estate petitioned the Tax Court.

The Court’s Approach
The Court distinguished between the nature of the property interest transferred to the Trust (a legal issue) and the fair market value (“FMV”) of such interest (a question of fact). The parties, the Court stated, disagreed as to the type of interest that had to be valued in Decedent’s gross estate.

The Estate claimed that the Assignment created an assignee interest in Decedent’s LP interest under the Agreement. It valued Decedent’s interest in the Trust as an assignee interest.

The IRS asserted that the Assignment did not create an assignee interest held by the Trust. The IRS argued that Decedent transferred his 88.99% LP interest to the Trust and the value to be included in the gross estate should be that of an LP interest.

Thus, the Court had to determine whether the interest Decedent transferred to the Trust was an LP interest or an assignee interest.

Generally, state law determines the nature of the property interest that has been transferred for federal estate tax purposes. [x] The Court explained that, under applicable state law, a partnership interest was assignable unless the partnership agreement provided otherwise. An assignee of a partnership interest was entitled to receive allocations of income, gain, loss, deduction, credit, or similar items, and to receive distributions to which the assignor was entitled, but was not entitled “to exercise rights or powers of a partner”. The assignee may become a partner, with all rights and powers of a partner under a partnership agreement, if admitted in the manner that the agreement provided.

The Court emphasized, however, that the federal tax effect of a particular transaction was governed by the substance of the transaction rather than its form. “The doctrine that the substance of a transaction will prevail over its form,” the Court stated, “indicates a willingness to look beyond the formalities of intra-family partnership transfers to determine what, in substance, was transferred.”

With that, the Court considered both the form and the substance of Decedent’s transfer to the Trust to determine whether the property interest transferred was an assignee interest or an LP interest.

The Court’s Analysis
The Agreement allowed the transfer of LP interests, and for the admission of a transferee as a substituted LP, provided certain conditions were met. [xi]

The Estate contended that these conditions were never met with respect to the interest that Decedent transferred to the Trust and that, upon the execution of the Assignment, the Trust received only an assignee interest in Decedent’s 88.99% LP interest.

The Court observed that, although the transfer was labeled an “assignment,” the Assignment stated that the Trust was entitled to all rights associated with the ownership of Decedent’s 88.99% LP interest, not just those of an assignee. All “rights and appurtenances” belonging to Decedent’s interest, the Court continued, included the right to vote as an LP and exercise certain powers as provided in the Agreement. The Assignment also required that Decedent was bound to provide any documentation necessary “to provide * * * [the Trust] all the rights * * * [Decedent] may have had” in the LP interest.

The Assignment, the Court added, satisfied all the conditions for the transfer of Decedent’s LP interest and the admission of the Trust as a substituted LP. In order for a transferee to be admitted as a substituted LP in respect of a transferred interest in FLP, (1) the GP had to consent to the transferee’s admission, (2) the transfer had to be a permitted transfer, and (3) the transferee had to agree to be bound by the terms of the Agreement. Daughter signed the Assignment as manager of FLP’s GP and consented to its terms, which provided for the transfer of all of Decedent’s rights in his LP interest to the Trust. The transfer was a permitted transfer. Lastly, the Assignment provided that the Trust agreed to abide by all terms and provisions of the Agreement, and Daughter executed the Agreement on behalf of the Trust.

The Court concluded that the form of the Assignment established that Decedent transferred to the Trust an LP interest and not an assignee interest.

What’s the Difference Anyway?
The economic realities underlying the transfer of Decedent’s interest, the Court stated, supported the conclusion that the transferred interest should be treated as an LP interest for federal estate tax purposes; regardless of whether an assignee or an LP interest had been transferred, there would have been no substantial difference before and after the transfer to the Trust.

Pursuant to the Agreement, only the GP had the right to direct the FLP; neither LPs nor assignees had managerial rights. The Agreement provided that assignees had no rights to any information regarding FLP’s business or to inspection of its books or records.

However, according to the Court, this distinction made no difference in the present case because Daughter was both a partner who was entitled to information regarding FLP (i.e., the manager of the GP) and the trustee of the Trust.

The Agreement also provided that an “assignee” did not have the right to vote as an LP. However, this difference was not significant – whether the Trust held the voting rights associated with an LP interest was of no practical significance, the Court stated.

There were no votes by LPs following the execution of the Assignment. Additionally, during his life, Decedent held the power to revoke the transfer to the Trust. If he had revoked the transfer, he would have held all the rights of an LP in FLP, including the right to vote on partnership matters. Also, F-LLC, as the GP, could have treated the holder of an assignee interest as a substitute LP.

Therefore, under the facts and circumstances of this case, the Court determined there was no difference in substance between the transfer of an LP interest in FLP and the transfer of an assignee interest in that LP interest. Accordingly, as a matter of both form and substance, the interest to be valued for estate tax purposes was an 88.99% LP interest in FLP, rather than an assignee interest. [xii]

Takeaway
Bad facts, etc., but some may see a silver lining in the result of this case.

A taxpayer who cannot act on his own; his attorney-in-fact/Daughter creates the partnership and funds it with marketable securities and cash on his behalf; she appoints herself as the manager of the GP; she creates and funds the Trust with most of the LP interests on his behalf, and appoints herself as trustee of the Trust. Sounds perfect.

Notwithstanding the foregoing, the Court respected the partnership; [xiii] in fact, it appears that the IRS did not even challenge the partnership’s bona fides.

Query what business purpose the FLP had where it held only marketable securities and cash (all provided by Decedent), where its securities were managed by a professional money manager, and where it never held any meetings. This was just a valuation play.

Silver lining? Nope. Dodged one? Yep. A map to follow? Please don’t.
———————————————————————————–
i From “Harry and the Hendersons.” C’mon, don’t pretend you haven’t seen it.
ii Usually with a beverage for inspiration.
iii https://www.taxlawforchb.com/2016/09/the-irs-takes-the-offensive-on-valuation-discounts-part-one/ ; https://www.taxlawforchb.com/2016/09/the-irs-takes-the-offensive-on-valuation-discounts-part-two/ ; https://www.taxlawforchb.com/2016/09/the-irs-takes-the-offensive-on-valuation-discounts-part-three/ .
iv The exemption amount had been set to increase from $5.49 MM in 2017 to $5.62 MM in 2018. The Tax Cuts and Jobs Act doubled the exemption to $11.2 MM for 2018, adjusted for inflation beginning in 2019, with a return to the pre-2018 levels after 2025. P.L. 115-97.
v T.C. Memo. 2018-178.
vi Anyone remember Strangi?
vii The 706 was filed August 2012. If this filing was timely, then the DOD was in November 2011. The FLP and Trust were created in October 2008, three years earlier.
viii IRC Sec. 2038; Schedule G to the Form 706. Because the transfers were revocable by the Decedent – specifically, by his attorney-in-fact in this case – the property transferred was included in his gross estate for tax purposes.
ix You can’t make this up.
x See Commissioner v. Estate of Bosch, 387 U.S. 456 (1967).
xi See above.
xii The Court then turned to the FMV of the Trust’s interest in FLP. Based on its finding that the interest transferred was an 88.99% LP interest, the Court concluded that the interest did not lack control. Accordingly, no discount for lack of control was allowed. The Court agreed with the Estate that there should be a discount for lack of marketability. However, because the Court concluded that the interest Decedent transferred was an LP interest, not an assignee interest, it found the Estate’s discount was too generous and accepted the lower discounted applied by the IRS.
xiii Yet it did, and also allowed a lack of marketability discount in determining the FMV of the interest held by the Trust. Go figure.

How Does It Work?

Many employers struggle to hire and retain key employees. In addressing this challenge, employers will sometimes add unique benefits to the compensation package offered to such individuals. In fact, it is not unusual for the employer and the key employee to jointly structure the terms of such a benefit, often in response to a particular need of the employee.[i]

One of the more common benefits that a key employee may request to be included in such a compensation package is the provision of a “permanent” life insurance policy on the life of the employee; i.e., a policy that does not expire within a specified number of years, and which includes an investment component in addition to a death benefit.[ii] Of course, permanent insurance is more expensive than term life insurance, and may be too costly for the employee to acquire and carry alone.

Enter the split-dollar arrangement.

In general, a “split-dollar life insurance arrangement” entered into in connection with the performance of services is one between an employer (the “owner” of the policy) and a key employee (the “non-owner)”[iii] that satisfies the following criteria:

  • The employer pays the premiums on the policy, and
  • The employer is entitled to recover all, or a portion, of such premiums, and such recovery is to be made from, or is secured by, the life insurance proceeds.

The employee in this arrangement will typically designate the beneficiary of the death benefit,[iv] and may also have an interest in the cash value of the policy.

This arrangement is said to be compensatory, and certain economic benefits are treated as being provided by the employer-owner to the employee-non-owner.

Specifically, in determining gross income, the employee must take into account as compensation the value of the economic benefits provided to the employee under the arrangement.[v]

In general, the value of such benefits equals the cost of the current life insurance protection provided to the employee, plus the amount of the policy cash value to which the employee has “current access.”[vi]

But it’s Not Just for Employees

Although most split-dollar arrangements employed[vii] in the context of a business are compensatory in nature, it is possible for an arrangement to be entered into between a corporation and an individual in their capacity as a shareholder in the corporation.

In that case, the corporation would still pay all or a portion of the premiums, and the individual shareholder would designate the beneficiary of the death benefit, and may have an interest in the policy cash value.

However, the economic benefits provided by the corporation to the insured shareholder would constitute a distribution with respect to the shareholder’s stock in the corporation, which may represent a dividend to the shareholder,[viii] depending upon the corporation’s C corporation earnings and profits. In that case, the shareholder would be taxed at a much lower federal rate (23.8%), as compared to the rate applicable to compensation income (37%). If the corporation is an S corporation, it is possible that the distribution may not be taxable to the shareholder at all.[ix]

Thus, it is important, in determining the proper tax treatment of a split-dollar arrangement, that the parties thereto understand the capacity in which the benefit is being provided to the individual insured; i.e., as an employee or as a shareholder.

A recent decision by the Sixth Circuit Court of Appeals addressed this very issue.

Taxpayer as Employee or Shareholder?

Taxpayer was the sole shareholder of Corp, which was an S corporation. Taxpayer was also an employee of Corp.

Corp adopted a benefit plan in order to provide certain benefits to its employees. Pursuant to the plan, Corp provided Taxpayer a life insurance policy and paid a $100,000 annual premium in Tax Year. Because Corp was an S corporation, all of its income and deductions were “passed through” to Taxpayer for tax purposes.[x] On its Form 1120S return for Tax Year, Corp deducted the $100,000 premium as a business expense; thus, that amount of Corp’s income was not included in Taxpayer’s individual income as a pass-through item.[xi] However, Taxpayer also did not include as wages the economic benefits flowing from the life insurance policy.

The IRS challenged Taxpayer’s treatment of the split-dollar arrangement and issued a notice of deficiency, in response to which Taxpayer petitioned the Tax Court.

Tax Court

The Tax Court determined that Corp was not entitled to deduct the $100,000 premium payment.[xii] Because the $100,000 premium payment was not deductible, Corp underreported its income for that year and, due to its pass-through nature as an S corporation, the increased income was passed through to Taxpayer, who was then required to pay income tax on that amount. Taxpayer conceded that he had to report an amount equal to the premium payment as pass-through income.

The dispute before the Tax Court concerned whether Taxpayer was required to report as taxable wage income – in addition to the pass-through amount – the economic benefits flowing from the increase in the cash value of the life insurance policy caused by the payment of the premium.

The Tax Court ruled against Taxpayer, and found that he was required to account for the economic benefits in his individual income as wages:

[Corp’s] deduction, when disallowed . . . increased the S corporation’s gross income, which additional income was then passed on to [Taxpayer] as the shareholder of [Corp]. However, [Taxpayer], in addition to being a shareholder of the corporation, was also one of its employees. . . . , when the previously unreported and untaxed portion of the accumulation value of his policy was determined, the value of the $100,000 contribution by [Corp], was properly attributed to [Taxpayer] as an employee of the S corporation and a non-owner of the life insurance contract. While this result may seem aberrational in view of the pass-through treatment generally afforded to S corporations, it is a result mandated by the split-dollar life insurance regulations . . . . In instances other than those governed by the split-dollar life insurance regulations, the general rule of the non-taxability of previously taxed S corporation income is unperturbed. [Emph. added]

The Tax Court found that Taxpayer’s life insurance policy qualified as a compensatory arrangement. Moreover, the parties conceded that Taxpayer’s life insurance policy was not a shareholder arrangement.

Relying on the compensatory nature of the arrangement, the Tax Court rejected Taxpayer’s argument that the economic benefits (the “build-up” in cash value) should be treated as a shareholder distribution; instead, the Tax Court ruled that Taxpayer had to include as income the economic benefits resulting from Corp’s payment of a premium on Taxpayer’s life insurance policy.

Sixth Circuit

Taxpayer appealed the Tax Court’s decision to the Sixth Circuit, which considered the interplay of the split-dollar life insurance regulations and Subchapter S.

The Court explained that the split-dollar life insurance regulations apply “to any split-dollar life insurance arrangement,” whether the arrangement is a compensatory or a shareholder arrangement. When an arrangement is governed by the split-dollar life insurance regulations, the Court continued, the non-owner of the policy “must take into account the full value of all economic benefits” provided to them. “Depending on the relationship between the owner and the non-owner,” the Court stated, “the economic benefits may constitute a payment of compensation, a distribution in respect of stock, or a transfer having a different tax character.”

However, the Court also pointed out that another regulation (the “Regulation”) governs the tax treatment of the economic benefits flowing from a split-dollar arrangement to an individual insured who is a shareholder of the corporation paying the premiums. In particular, the Regulation states that “the provision by a corporation to its shareholder pursuant to a split-dollar life insurance arrangement . . . of economic benefits . . . is treated as a distribution of property.” The Court noted that, by its terms, the Regulation applies to both compensatory and shareholder arrangements.[xiii]

The Court then observed that the split-dollar regulations make no specific reference to S corporations. It added that there was minimal case law concerning the interplay of Subchapter S and the split-dollar regulations, and that it was not aware of any case dealing with the application of the Regulation to the economic benefits provided to shareholder-employees pursuant to a compensatory arrangement.

Taxpayer’s Position

The thrust of Taxpayer’s argument was that the economic benefits provided under the split-dollar arrangement should be treated as a distribution of property by an S corporation to its shareholder, notwithstanding that they flowed from a compensatory arrangement.[xiv]

Taxpayer relied on the statement in the Regulation that the provision of economic benefits “by a corporation to its shareholder pursuant to a split-dollar life insurance arrangement . . . is treated as a distribution of property.” Thus, Taxpayer argued, the economic benefits should be treated as a “distribution of property” from Corp to Taxpayer.[xv]

Taxpayer also relied on the statutory provisions governing the tax treatment of S corporations,[xvi] arguing that they “prevent double taxation otherwise imposed pursuant to an interpretative regulation addressing split dollar life insurance premiums that have been paid by S corporations.”

An S corporation’s income and deductions, Taxpayer asserted, are passed through to its shareholders, each shareholder is taxed on their allocable share thereof, and each shareholder’s stock basis is adjusted upward accordingly. In this case, $100,000 of Corp’s income – an amount equal to the nondeductible premium payment – was taxed to Taxpayer. How, then, Taxpayer argued, could he be taxed “again” as to the increase in the cash value of the policy attributable to premium?

IRS’s Position

The IRS argued[xvii] that the economic benefits should be treated as wage income – rather than as a shareholder distribution – because Taxpayer received the life insurance coverage as part of a compensatory split-dollar arrangement. The IRS noted that such treatment would be uncontroversial if the recipient of the economic benefits were an ordinary employee, rather than an S corporation’s shareholder-employee. The distinction between Taxpayer’s different roles – employee and shareholder – was, therefore, key to the IRS’s position.

The IRS pointed only to the distinction between compensatory and shareholder arrangements. The IRS recognized that the Regulation applies to both compensatory and shareholder arrangements but concluded that it “does not mean that in any situation where a compensatory arrangement covers a shareholder, the taxpayer’s status as a shareholder trumps his status as an employee, causing the economic benefit to be treated as a distribution to a shareholder,” because “[s]uch an interpretation of the regulation would make no sense, as it would defeat the reason for distinguishing between a compensatory arrangement and a shareholder arrangement.”

The Regulation is Dispositive

The Court rejected the IRS’s argument.

According to the Court, it was not clear that treating all economic benefits to shareholders as distributions – even to those who were also employed by the corporation –would undermine the purpose of the split-dollar regulations.

The Court noted that the Tax Court had not addressed the Regulation. However, the Court also added that if the economic benefits to Taxpayer were properly treated as a distribution of property to a shareholder – rather than as compensation to an employee – then the Tax Court had erred.

The Court decided that the Regulation was dispositive, and thereby rendered irrelevant whether Taxpayer received the economic benefits through a compensatory or shareholder split-dollar arrangement. The Regulation treats economic benefits provided to a shareholder pursuant to any split-dollar arrangement as a distribution of property with respect to the shareholder’s stock. The Court stated that the inclusion in the Regulation of all arrangements described in the split-dollar rules, which include compensatory arrangements – made clear that when a shareholder-employee receives economic benefits pursuant to a compensatory split-dollar arrangement, those benefits are treated as a distribution of property, and are thus deemed to have been paid to the shareholder in their capacity as a shareholder.

The Court stated that its interpretation was further supported by the fact that the split-dollar rules state that the tax treatment of the economic benefits depends on the “relationship between the owner and the non-owner.” The IRS argued that this language showed that the tax treatment depended on the nature of the split-dollar arrangement—compensatory or shareholder—but the Court pointed out that if this were the controlling factor, the Regulation could have said so (it does not).

Thus, the Court found that the Tax Court had erred by relying on the compensatory nature of Taxpayer’s split-dollar arrangement to conclude that the economic benefits were not distributions of property to a shareholder. Where a shareholder receives economic benefits from a split-dollar arrangement, the Regulation requires that those benefits be treated as a distribution of property to a shareholder.

The Court reversed the Tax Court’s decision with respect to the tax treatment of the economic benefits flowing to Taxpayer from Corp’s payment of the $100,000 premium on Taxpayer’s life insurance policy and held, pursuant to the Regulation, that those economic benefits had to be treated as distributions of property by Corp to its shareholder. Because Corp was an S corporation, that meant that the deemed distribution would be at least partially exempt from tax.[xviii]

Thoughts

Are you kidding? Compensation is compensation, isn’t it? It is paid for services rendered or to be rendered by the recipient to the payor. Except, at least according to the Sixth Circuit, when it is paid as part of a split-dollar life insurance arrangement to a shareholder of the payor who is also employed by the payor?

It is a basic principle of taxation that the capacity in which an owner of a business entity deals with the entity determines the appropriate tax treatment of the transaction. Salary paid by a corporation to a shareholder-employee for services actually rendered to the corporation is taxed as compensation.[xix] Where the amount paid is excessive for the services provided, the excess may be treated as a distribution to the shareholder in respect of their stock in the corporation (a dividend), the premise being that no one would pay more for the services than they were actually worth. Case closed, right?

What if the compensation paid to the shareholder-employee had been below market? Would the benefits provided under what was conceded to be a compensatory split-dollar arrangement still be treated as a distribution rather than as additional compensation?

What about the IRS’s historical concern over S corporations that pay less than reasonable compensation to their shareholder-employees in order to reduce their employment tax liability?

In holding as it did, has the Court created a second class of stock issue where none would otherwise have existed? The constructive distribution to a shareholder-employee of an S corporation sets that individual apart from other shareholders of the employer-corporation who are not employed in the business. Might it be easier to find that “a principal purpose” of the split-dollar arrangement (a “commercial contractual agreement”) is to circumvent the one class of stock requirement?[xx]

The Court should have upheld the Tax Court’s decision. It should have recognized that the literal wording of the Regulation needs to be revised to comport with the intention and language of the split-dollar rules.


[i] Actual equity, restricted equity, phantom equity, equity appreciation, change-in-control, and other equity-flavored or profits-based incentive bonus arrangements are also not uncommon.

[ii] For example, a whole life policy. A permanent policy will generally include an investment or savings component, reflected as the so-called “cash value” of the policy, against which the owner of the policy may borrow, or which may be withdrawn, during the life of the insured. Compare this to term insurance, which promises only a death benefit if the insured dies within a specified number of years.

[iii] The person named as the policy owner is generally treated as the “owner” of the policy for purposes of these rules. Thus, if the insured is named as the owner, they will be treated as the owner for purposes of these rules. However, if the only benefit accorded the insured is current life insurance protection (the death proceeds; they have no access to the cash value of the policy), then the non-owner is treated as the owner.

[iv] Often a trust for the benefit of the employee’s family.

[v] The employer will not be entitled to a deduction where it is a beneficiary of the policy.

[vi] To the extent it was not taken into account in a prior year. In general, the cash value builds up tax-free within the policy when the premium exceeds the cost of the insurance.

[vii] Yes, pun intended.

[viii] As in the case of compensatory split-dollar, the premium would not be deductible by the corporation.

[ix] Depending upon the shareholder’s stock basis and the corporation’s AAA; the deemed distribution would be treated as a return of already-taxed income or as a return of capital.

[x] IRC Sec. 1366.

[xi] The deduction claimed on the corporate return reduced, dollar-for-dollar, the amount of profit allocated to the shareholder on their Sch. K-1.

[xii] The corporation was a beneficiary of the policy (IRC Sec. 264); moreover, under Sec. 83, the employee had not included the premium in income.

[xiii] Reg. Sec. 1.301-1(q)(1)(i).

[xiv] Yep. You heard right.

[xv] Reg. Sec. 1.301-1(q)(1)(i).

[xvi] IRC Sec. 1366 (pass-through of corporate income), 1367 (upward basis adjustment for pass-through of income and downward for distribution thereof), and 1368 (treatment of S corporation distribution that would otherwise be treated as a dividend – return of already-taxed income and basis).

[xvii] And the Tax Court concluded.

[xviii] See IRC Sec. 1368.

[xix] And may be deducted to the extent it was reasonable.

[xx] Reg. Sec. 1.1361-1(l).

 

Ode to a Dividend

It sounds relatively simple:

A distribution of property made by a regular “C” corporation to an individual shareholder with respect to the corporation’s stock[i] (a) will be treated as a dividend[ii] to the extent it does not exceed the corporation’s earnings and profits; (b) any remaining portion of the distribution will be applied against, and will reduce, the shareholder’s adjusted basis for the stock, to the extent thereof – i.e., a tax-free return of the shareholder’s investment in the stock; and (c) any remaining portion of the distribution will be treated as capital gain from the sale or exchange of the stock.[iii]

Unfortunately for many taxpayers, establishing the proper tax treatment for a “dividend” distribution may be anything but simple,[iv] which may lead to adverse economic consequences. In most cases, the difficulty stems from the shareholder’s inability to establish the following elements:

  • the amount distributed by the corporation where the distribution is made in-kind rather than in cash – in other words, determining the “fair market value” of the property distributed;[v]
  • the “earnings and profits” of the corporation – basically, a running account that the corporation must maintain from its inception through the present, which indicates the net earnings of the corporation that are available for distribution to its shareholders; and
  • the shareholder’s holding period and adjusted basis for their shares of stock in the distributing corporation.[vi]

Stock Basis

The final item identified above – the shareholder’s basis for their stock – is generally not an issue for the shareholders of a closely held C corporation. In most cases, an individual made a contribution of cash to the capital of the corporation in exchange for stock in the corporation; in some cases, the individual purchased shares of stock from another shareholder. Unless the shareholder subsequently makes an additional capital contribution to the corporation (for example, pursuant to a capital call under a shareholders’ agreement),[vii] or unless the shareholder receives a distribution from the corporation that exceeds the shareholder’s share of the corporation’s earnings and profits, or unless the corporation redeems a significant portion of the shareholder’s stock (such that the shareholder experiences a substantial reduction in their equity interest relative to the other shareholders),[viii] the shareholder’s stock basis will be equal to the amount paid by them to acquire the stock, and will remain constant during the period they own the stock.[ix]

However, what if the shareholder’s capital contribution was made in-kind; for example, a contribution of real property or equipment, or of a contract or other intangible right? The amount of such contribution would be equal to the fair market value of the property; however, unless the transfer of the property was a taxable event to the contributing shareholder,[x] the shareholder’s basis for their stock in the corporation would be equal to their adjusted basis – i.e., their unrecovered investment – in the contributed property immediately before such contribution.[xi]

Alternatively, what if the shareholder made a transfer of cash to the corporation that was recorded by the corporation as a loan? What if the corporation never issued a promissory note to the shareholder or otherwise memorialized the terms of the loan (maturity, interest rate, collateral)? What if it never paid or accrued interest on the loan? Can the shareholder argue against the form of their “loan,” treating it, instead, as a capital contribution that would increase their stock basis?[xii]

The Taxpayer’s Burden

The taxpayer has the responsibility to substantiate the entries, deductions, and statements made on their tax returns. Thus, in the case of a “dividend” distribution by a closely-held corporation to an individual shareholder, the latter has the burden of proving the elements of the distribution,[xiii] described above, including that portion of the distribution that represents a nontaxable return of capital; in other words, the shareholder must be able to establish their adjusted basis for the stock on which the distribution is made.

In order to carry this burden, it is imperative that the taxpayer maintain accurate records to track the amount of their equity investment in the corporation. Where the stock was issued by the corporation in exchange for a contribution of cash, it would be very helpful to have a canceled check plus an executed capital contribution agreement, or corporate minutes accepting the contribution and authorizing the issuance of the stock. If the stock was received in exchange for an in-kind contribution of property in a non-taxable transaction, evidence of the taxpayer’s adjusted basis in the property is required; for example, the original receipt evidencing the taxpayer’s acquisition of the property, plus records of any subsequent adjustments, which may depend upon the nature of the property.[xiv] If the stock was purchased from another shareholder, the executed purchase and sale agreement, along with canceled checks or proof of satisfaction of any promissory note issued to the seller would be helpful.

Where a shareholder is unable to establish their basis for the stock – i.e., where the shareholder has failed to carry their burden of proof – the IRS will treat the shareholder as having a zero basis in such stock; consequently, the entire amount of the dividend distribution to the shareholder will be taxable,[xv] as one Taxpayer – who was already having a pretty bad day[xvi] – found to his detriment.

“Return-of-Capital” Defense

The Court of Appeals for the Ninth Circuit determined that a federal district court did not abuse its discretion in precluding Taxpayer’s “return-of-capital” defense. https://cdn.ca9.uscourts.gov/datastore/memoranda/2018/09/24/17-50091.pdf.

The Taxpayer was charged with tax evasion. As part of his defense, he tried to establish that there was no tax deficiency because the money removed from his corporation represented a return of capital, or stock basis.

The Court ruled that the district court “may preclude a defense theory where ‘the evidence, as described in the defendant’s offer of proof, is insufficient as a matter of law to support the proffered defense.’”

To establish a factual foundation for a “return-of-capital” theory, the Court stated, a taxpayer must show: “(1) a corporate distribution with respect to a corporation’s stock, (2) the absence of corporate earnings or profits, and (3) stock basis in excess of the value of the distribution.”

Taxpayer, the Court continued, failed to establish that his stock basis exceeded the value of the distributions. Taxpayer presented checks that purported to demonstrate the amount he paid to purchase the stock of Corp. He also provided a declaration stating that he transferred a deed of valuable property to Corp; despite being given the opportunity to do so, however, Taxpayer provided no evidence of the property’s value aside from his own estimate.

The government presented the declaration of a CPA involved in Corp’s bankruptcy proceedings who stated that “according to escrow documents,” the property Taxpayer transferred was assigned a value below that claimed by Taxpayer. It also presented a declaration that Taxpayer submitted in his divorce proceedings, in which Corp’s CPA stated the amount for which Corp had redeemed stock from Taxpayer, thereby reducing his basis. The government submitted the bank records for such payment.

The Court explained that Taxpayer had the burden to establish factual support for a finding that his stock basis exceeded the value of the distributions. Taxpayer’s testimony was insufficient to carry his burden. He did not provide evidentiary support for his valuation, nor evidence to rebut the documents establishing how much Corp paid Taxpayer for the redemption of stock.

Because the evidence did not establish that Taxpayer had a stock basis in Corp in excess of the value of the distributions, the Court decided that the district court did not abuse its discretion in finding that Taxpayer failed to establish a factual basis for a return-of-capital defense.

It Pays to Be Prepared[xvii]

A corporation’s distribution of a large dividend, or a shareholder’s sale of their stock for a price they “couldn’t refuse,” should represent a moment of affirmation of the shareholder’s investment or business decision-making.

Of course, the imposition of income taxes, and perhaps surtaxes, with respect to the amount received by the shareholder will tend to dampen the shareholder’s celebratory mood, but every shareholder/taxpayer expects to share some of their economic gains with the government in the form of taxes. Those who are well-advised will have accounted for this tax liability in planning for the welcomed economic event.

That being said, no taxpayer would willingly remit to the government more than what was properly owed. It is the taxpayer’s burden, however, to establish this amount by, among other things, establishing their basis in the stock that was sold or on which a corporate distribution was made.

Imagine a shareholder’s having to pay tax on dollars that actually represent a return of their capital investment – which should have been returned to them free of tax – simply because the shareholder was not prepared and unable to substantiate their basis in the stock. Talk about low-hanging fruit.

——————————————————————————————————————

[i] In others words, it is made to the individual in their capacity as a shareholder.

[ii] Taxable at a federal rate of 20%, though the 3.8% surtax on net investment income may also apply.

[iii] Taxable at a federal rate of 23.8% if long-term capital gain. See EN ii.

[iv] In the case of a closely held corporation, shareholders must also be attuned to the risk of constructive dividends distributions.

[v] This is also key for the corporation, which will be treated as having sold the property distributed if the fair market value of the property exceeds its adjusted basis in the hands of the corporation.

[vi] Which will be important if the amount of the distribution exceeds the earnings and profits and the stock’s adjusted basis; will the resulting gain be long-term or short-term capital gain?

[vii] In the case of a closely held corporation, most “capital contributions” made after the initial funding of the corporation take the form of loans from the shareholders, especially when made disproportionately among the shareholders.

[viii] An “exchange” under IRC Sec. 302.

[ix] Compare to the stock basis of a shareholder of an S corporation; their basis is adjusted every year to reflect their allocable share of the corporation’s income, gain, deduction, and loss, as well as the amount of any distribution made to them. IRC Sec. 1367.

[x] IRC Sec. 1001. In which case, they would take the stock with a cost (i.e., fair market value) basis. IRC Sec. 1012.

[xi] IRC Sec 351 and Sec. 358. In this way, the shareholder’s deferred gain is preserved.

[xii] The short answer: No; which is not to say that taxpayers have not tried that argument.

[xiii] The corporation will have to issue a Form 1099-DIV but, in the case of a close corporation, the controlling shareholder may be hard-pressed to rely upon such information return without more.

[xiv]  For example, depreciation schedules.  If the stock was inherited, the fair market of the stock on the date of the decedent’s death will be necessary. Start with a copy of the estate tax return filed by the decedent’s estate, on IRS Form 706. The appraisal obtained in connection with the estate tax return, or a copy of the shareholders’ agreement that fixed the price for the buyout of the stock upon the death of a shareholder, would be helpful.

[xv] Albeit, presumably, at the rate applicable to capital gain.

[xvi] Crime shouldn’t pay.

[xvii] No, I am not thinking about the song from the “Lion King” movie made famous by Jeremy Irons in the role of Scar. I am thinking of the Boy Scout motto. Taxpayers and their advisers would do well to adopt this motto.

But I Don’t Want to Pay Any Taxes!

I was recently speaking to an older client who told me that he was contemplating the sale of a commercial rental property that he has owned for many years. The property was not used in his business, was unencumbered and, for all intents and purposes, his adjusted basis – i.e., his unrecovered investment – for the property was zero. The client was concerned about the amount of gain he would recognize on the sale, and the resulting income tax liability.

The gain would be treated as long-term capital gain, I told him, and neither he nor the property was located in a high-tax state. That didn’t alleviate his concern.

I then suggested that he consider a like-kind exchange, but he wasn’t interested in simply deferring the gain; in any case, he didn’t want another property to manage.

I asked if there was a pressing business reason for disposing of the property. When he asked why that was relevant, I replied that he may want to hold on to the property until he died, leaving the property to the beneficiaries of his estate. The property may be valued more “aggressively” than a liquid asset, I explained, and his beneficiaries would take the property with a basis step-up. “Death solves many problems,” I told him, jokingly. That didn’t go over too well.

Finally, I recalled that the client had a somewhat charitable bent, so I mentioned that he may want to consider a contribution to a public charity or to a charitable remainder trust. That seemed to pique his interest, so I explained the basics.

Then I asked him when he planned to list the property. “I already have a buyer,” he responded. Yes, I thought to myself, death solves many problems. After composing myself, I asked “What do you mean, you have a buyer? Have you agreed to a price? Do you have a contract? Are there any contingencies? . . . ”

“Stop with all the questions” – he interrupted me – “why does any of that matter?”

“Let me tell you about the ‘assignment of income doctrine’,” I replied.

Shortly after the above discussion with the client, I came across the decision described below; I forwarded a copy to the client, his accountant, and his real estate lawyer.

Sale of a Business

Target was a closely held foreign corporation in which Taxpayer and others owned stock. Buyer (an S corp.) was Target’s principal customer. Virtually all of Buyer’s stock was owned by an employee stock ownership plan (ESOP). Taxpayer and other Target shareholders were among the beneficiaries of the ESOP. Target and Buyer were also related through common management, with a majority of each corporation’s board of directors serving as directors for both corporations.

Buyer offered to acquire all of Target’s stock for bona fide business reasons. It was proposed that the stock acquisition would proceed in two steps.

First Step

Buyer would first purchase 6,100 Target shares (87% of the outstanding shares) from Taxpayer and the other Target shareholders. The proposed purchase price was $4,500 per share. The consideration to be paid by Buyer for this tranche would consist of cash and interest-bearing promissory notes.

Second Step

The second step involved the remaining 900 shares (13%) of Target’s outstanding stock.

In connection with Buyer’s acquisition of the 6,100 Target shares, Taxpayer agreed to donate 900 Target shares to Charity, an organization that was exempt from Federal income tax under Sec. 501(c)(3) of the Code, and that was treated as a public charity under Sec. 509(a) of the Code.[i] Buyer agreed to purchase each share tendered by Charity for $4,500 in cash.

Taxpayer agreed, after donating their shares to Charity, “to use all reasonable efforts” to cause Charity to tender the 900 shares to Buyer. If Taxpayer failed to persuade Charity to do this, it was expected that Buyer would use a “squeeze-out merger, a reverse stock split or such other action that will result in [Buyer] owning 100% of * * * [Target].” If Buyer failed to secure ownership of Charity’s shares within 60 days of acquiring the 6,100 shares, the entire acquisition would be unwound, and Buyer would return the 6,100 shares to the tendering Target shareholders.

The Appraisal

Because Buyer and Target were related parties, the ESOP – a tax-exempt qualified plan – believed that it was required to secure a fairness opinion to ensure that Buyer paid no more than “adequate consideration” for the Target stock. The ESOP trustee hired Appraiser to provide a fairness opinion supported by a valuation report.

In describing the proposed transaction, Appraiser expressed its understanding that Buyer would acquire 100% of Target’s stock “in two stages.” According to Appraiser, “The first stage” involved “the acquisition of 6,100 shares, or approximately 87.1%, of [Target’s] outstanding ordinary shares,” for cash and promissory notes. “Simultaneously with [Buyer’s] acquisition of the 6,100 shares,” Appraiser stated, “certain of [Target’s] shareholders will transfer 900 shares” to Charity. “The second stage of the [transaction] involves the acquisition of the Charity shares for $4,500 per share.”

Appraiser concluded that the fair market value of Target, “valued on a going concern basis,” was between $4,214 and $4,626 per share. Appraiser submitted its findings to the ESOP trustee in an appraisal report and a fairness opinion. Given the range of value it determined for Target, Appraiser opined that the proposed transaction was fair to the beneficiaries of Buyer’s ESOP.

The Sale and the Donation

Two days after Appraiser’s fairness opinion was issued, Buyer purchased 6,100 shares of Target stock from Taxpayer and the other Target shareholders.

It was unclear when Taxpayer donated their 900 shares to Charity; Taxpayer asserted that the donation occurred almost a week before the fairness opinion, whereas the IRS contended that it occurred no earlier than the day of the fairness opinion, allegedly after Charity had unconditionally agreed to sell the 900 shares to Buyer.

Both parties agreed that Charity formally tendered its 900 shares to Buyer on the same day on which the other Target shareholders tendered their shares. And the parties also agreed that Charity received the same per-share price that the other Target shareholders received, but that Charity was paid entirely in cash.

Off to Court

Taxpayer filed Form 1040, U.S. Individual Income Tax Return, for the year of the sale, and claimed a noncash charitable contribution deduction for the stock donated to Charity.

The IRS examined Taxpayer’s return and subsequently issued a notice of deficiency to Taxpayer determining that they were liable for tax under the “anticipatory assignment of income doctrine” on their transfer of shares to Charity; in other words, Taxpayer should have reported the gain from the sale of the 900 shares to Buyer and should be treated as having contributed to Charity the cash received in exchange for such shares.

Taxpayer timely petitioned the U.S. Tax Court for redetermination, and asked for summary judgement on the IRS’s application of the assignment of income doctrine to their donation of Target stock to Charity.

Assignment of Income

A longstanding principle of tax law is that income is taxed to the person who earns it. A taxpayer who is anticipating the receipt of income “cannot avoid taxation by entering into a contractual arrangement whereby that income is diverted to some other person.”

The Court noted that it had previously considered the assignment of income doctrine as it applied to charitable contributions. In the typical scenario, the Court explained, the taxpayer donates to a public charity stock that is about to be acquired by the issuing corporation through a redemption, or by another corporation through a merger or other form of acquisition.

In doing so, the taxpayer seeks to obtain a charitable deduction in an amount equal to the fair market value of the stock contributed, while avoiding recognition of the gain, and liability for the tax, resulting from the subsequent sale of the stock. The tax-exempt charity ends up with the proceeds from the sale, undiminished by taxes.

Analysis

In determining whether the donating taxpayer has assigned income in these circumstances, one relevant question is whether the prospective sale of the donated stock is a mere expectation or a virtual certainty. “More than expectation or anticipation of income is required before the assignment of income doctrine applies,” the Court stated.

Another relevant question, the Court continued, is whether the charity is obligated, or can be compelled by one of the parties to the transaction, to surrender the donated shares to the acquirer.

Thus, the existence of an “understanding” among the parties, or the fact that the contribution and sale transactions occur simultaneously or according to prearranged steps, may be relevant in answering that question.

For example, a court will likely find there has been an assignment of income where stock was donated after a tender offer has effectively been completed and it is “most unlikely” that the offer would be rejected, or where stock is donated after the other shareholders have voted and taken steps to liquidate a corporation.

In contrast, there is probably no assignment of income where stock is transferred to a charity before the issuing corporation’s board has voted to redeem it.[ii]

No Summary Judgement

Based on the facts presented, the Court concluded that there existed genuine disputes of material fact that prevented the Court from summarily resolving the assignment of income issue.

Target and Buyer were related by common management, the interests of both companies seemed to have been aligned, and both apparently desired that the stock acquisition be completed. If so, these facts supported the conclusion that the acquisition was virtually certain to occur. In turn, this evidence would support the IRS’s contention that Charity agreed in advance to tender its shares to Buyer and that all the steps of the transaction were prearranged.

However, the parties also disputed the dates on which relevant events occurred. Taxpayer asserted that they transferred their shares to Charity one week before the sale and almost one week before the fairness opinion, and there appeared to have been documentary evidence arguably supporting that assertion. The IRS contended that Charity did not acquire ownership of its 900 shares until (at the earliest) the date of the fairness opinion, allegedly after Charity had unconditionally agreed to sell the 900 shares to Buyer. That contention derived some support from other documentary evidence, as well as from Appraiser’s description of the proposed transaction, which recited that Taxpayer would transfer 900 shares to Charity simultaneously with Buyer’s acquisition of the 6,100 shares.

There were also genuine disputes of material fact concerning the extent to which Charity, having received the 900 shares, was obligated to tender them to Buyer. Appraiser stated in its report that Taxpayer would use “all reasonable efforts to cause * * * [Charity] to agree to sell the shares to [Buyer].” The record included little evidence concerning Taxpayer’s ability to influence Charity’s actions or Charity’s negotiations with Buyer. The IRS contended that Charity had no meaningful discussions with Buyer, but was “simply informed by” Taxpayer that the 900 shares should be tendered at once. The Court pointed out that a trial would be necessary to determine whose version of the facts was correct.

One fact potentially relevant to this question, the Court noted, concerned Buyer’s fiduciary duties as a custodian of charitable assets. If Charity tendered its Target shares, it would immediately receive a significant amount of cash. If it refused to tender its shares and the entire transaction were scuttled, Charity would apparently be left holding a 13% minority interest in a closely held corporation.

In sum, viewing the facts and the inferences that might be drawn therefrom in the light most favorable to the IRS as the nonmoving party, the Court found that there existed genuine disputes of material fact that prevented summary judgement on the assignment of income issue.

Thus, the Court denied Taxpayer’s motion.

Takeaway

Insofar as charitable giving is concerned, there are generally three kinds of taxpayer-donors: (i) those who genuinely believe in the mission of a particular charity and seek to support it, (ii) those who support the charity, or charitable works generally, but who want to use their charitable gift to generate some private economic benefit,[iii] and (iii) those who are not necessarily charitably inclined but who do not want to see their wealth pass to the government.[iv]

Most donors fall into the first category. This is fortunate, in part because the tax benefit that the donation generates for the donor-taxpayer will not compensate the taxpayer for the “lost” economic value represented by the property donated – the gift is being made for the right reason.

That is not say that such donors do not engage in any tax planning with respect to their charitable giving; for example, a donor would generally be better off donating a low basis asset rather than an identical asset with a high basis.

In the case of the closely held business, the donor’s tax planning almost always implicates the assignment of income doctrine. After all, would an owner’s fellow shareholders willingly accept a charity into their fold as an owner? Would the charity accept equity in a closely held business in which it will hold a minority interest, where the interest cannot readily be sold, and which cannot compel cash distributions from the business? Each of these questions has to be answered in the negative.

It is a fact that most charities prefer donations of liquid assets. Under what circumstances, then, may a donation of an interest in a close business ever find its way into the hands of a charity?

In last week’s post[v], we saw how the “excess business holdings” and other rules operate to prevent a private foundation from holding equity in a closely held business. These rules do not apply to public charities, but that does not give such charities carte blanche, nor does it change their preference for gifts of cash or cash equivalents.

A charity will be most open to accepting a gift of an interest in a closely held business where the charity is “assured” that the interest will be redeemed by the business or sold to a third party for cash shortly thereafter.

Unfortunately for the donor-taxpayer, these are also the circumstances in which the IRS will raise the assignment of income doctrine in order to tax the donor-taxpayer on the gain recognized in the redemption or sale of the interest donated to the charity.

As illustrated by the decision discussed above, the application of the doctrine will often be a close call, especially for a business owner who is unaware of its existence.


[i] See last week’s post, for a brief discussion of the distinction between private foundations and public charities.

[ii] Toujours les “facts and circumstances.” Apologies to Napoleon and Patton.

[iii] For example, contributing property to a charitable remainder – split-interest – trust, generating an immediate tax deduction, having the trust sell the property without tax liability, then investing the entire proceeds to generate the cash flow necessary for paying out the annuity or unitrust amount.

[iv] The latter typically name a charity, any charity, as the beneficiary of last resort in the so-called “Armageddon clauses” of their wills and revocable trusts.

[v] But do you remember NYU Law School’s pasta business? Mueller’s anyone?

Many not-for-profit organizations are dependent, in no small part, upon the generosity of successful businesses and their owners. The latter are motivated by a number of factors; for some, this generosity is an expression of their gratitude to the community that enables them to thrive; for others, it is a desire to share their good fortune with those in need; a not insignificant number are driven by a desire for public recognition.[i]

Whatever the motivation of these business owners, the tax laws have long played an important role in encouraging certain types of behavior relating to the contribution of property to a charity, and in discouraging certain activities that have the potential to harm a charitable organization, or to distract the organization from its charitable mission.[ii]

These tax-related, “charitable behavior modification” rules are intended to be most keenly felt by so-called “private foundations” and by those who control them.

Historical Behavior Modification

A private foundation (“foundation”) is a kind of charitable organization that is not dependent upon the “general public” for financial support;[iii] rather, it is generally controlled by the individual who created the foundation and funds its operations.[iv]

In general, the foundation limits its charitable activities to making grants to those “public charities” selected by this founder or their family, in the amounts and at the times determined by these individuals.[v]

Thus, it may be presumed that the foundation’s behavior cannot be readily influenced by the public in most instances.[vi] It is for that reason that the Code limits the tax benefits allowable to a foundation and its supporters, and also seeks to regulate certain activities in which they may engage.

Reduced Income Tax Deduction

For example, the owner of a closely held business may donate shares of stock in the business (i.e., capital gain property) to their foundation, but the amount that they may deduct for purposes of determining their income tax liability is limited to their adjusted basis in the donated stock – not its fair market value at the time of the donation – and their deduction is capped at a lower percentage of their adjusted gross income [vii] than would a similar contribution to a public charity.[viii]

The reduced tax benefit for the donor reflects the illiquid nature of an interest in a closely held business – the foundation cannot simply sell it on a public market. The Code also seeks to prevent the donor-business owner from receiving a more favorable tax benefit without giving up de facto control over the donated business interest.

Excess Business Holdings

Similarly, a foundation is generally not permitted to hold more than twenty percent of the voting stock of a corporation,[ix] reduced by the percentage of the voting stock owned by all disqualified persons[x] with respect to the foundation.[xi] If a foundation violates this rule, it may be subject to an excise tax equal to ten percent of the fair market value of its holdings in the business in excess of the permitted amount.[xii]

This prevents a business owner from contributing stock in their corporation to a foundation, either during their life or at their death, and thereby avoiding or reducing federal estate and gift taxes while at the same time enabling their family to retain indirect control of the donated stock through the foundation.

Depending upon the size of the gift or bequest, the foundation may have between five and ten years to dispose of the stock.

Minimum Distribution

Finally, a foundation is required to distribute annually an amount equal to at least five percent of the fair market value of its assets.[xiii] This rule is aimed, in part, at preventing a business owner from contributing to a foundation, and a foundation from investing in, an interest in a close business that is illiquid and that may not produce current income. A foundation that violates this rule faces a penalty tax equal to thirty percent of the distribution shortfall.

BBA of 2018

The foregoing rules have governed the relationship between foundations and closely held businesses for almost fifty years. Then, on February 9, 2018, the Bipartisan Budget Act of 2018 (the “Act”) was signed into law, effective for taxable years beginning after December 31, 2017.[xiv]

According to the accompanying committee report,[xv] in recent years, a new type of philanthropy has combined “private sector entrepreneurship” with charitable giving; for example, through the donation of a private company’s entire after-tax profits to charity.[xvi]  The report goes on to state that it is appropriate “to encourage this form of philanthropy by eliminating certain legal impediments to its use, while also ensuring that private individuals cannot improperly benefit from charitable dollars.”

Therefore, the Act amended the Code[xvii] to permit a business owner to gift or bequeath an entire business to a foundation, provided that the after-tax profits of the business will be paid to the foundation and certain other requirements are satisfied, while also ensuring that the donor’s heirs cannot improperly benefit from the arrangement.

The new provision creates an exception to the excess business holdings rules for certain “philanthropic business holdings.” Specifically, the tax on excess business holdings will not apply with respect to the holdings of a foundation in any business enterprise that, for the taxable year, satisfies:

  • the “exclusive ownership” requirements;
  • the “all profits to charity” requirement; and
  • the “independent operation” requirements.

Exclusive Ownership

The exclusive ownership requirements are satisfied for a taxable year if:

  • all voting ownership interests[xviii] in the business enterprise[xix] are held by the foundation at all times during the taxable year; and
  • all the foundation’s ownership interests in the business enterprise were acquired by the foundation as gifts during the life of the donor, or as testamentary transfers at the donor’s demise, under the terms of the donor’s will or trust, as the case may be.[xx]

All Profits to Charity

The “all profits to charity” requirement is satisfied if the business enterprise, not later than 120 days after the close of the taxable year, distributes an amount equal to its net operating income for such taxable year to the foundation.

For this purpose, the net operating income of any business enterprise for any taxable year is an amount equal to the gross income of the business enterprise for the taxable year,[xxi] reduced by the sum of: (1) the deductions allowed for the taxable year that are directly connected with the production of the income; (2) the federal income tax imposed on the business enterprise for the taxable year;[xxii] and (3) an amount for a reasonable reserve[xxiii] for working capital and other business needs of the business enterprise.

Independent Operation

The independent operation requirements are met if, at all times during the taxable year, the following three requirements are satisfied:

  • First, no substantial contributor to the private foundation, or a family member of such a contributor, is a director, officer, trustee, manager, employee, or contractor of the business enterprise (or an individual having powers or responsibilities similar to any of the foregoing[xxiv]).
  • Second, at least a majority of the board of directors of the foundation are individuals who are not (1) directors or officers of the business enterprise, nor (2) members of the family of a substantial contributor to the foundation.
  • Third, there is no loan outstanding from the business enterprise to a substantial contributor to the foundation or a family member of such contributor.

What Does It Mean?

In light of the foregoing, a foundation may now be able to own all of the issued and outstanding stock[xxv] of a corporation that operates an active business.

The Act

Of course, in order to do so, the foundation and the business must satisfy the requirements described above, some of which need to be clarified by the government; even then, there are still many issues to consider.

Of the three requirements described, the most challenging may be the “independent operation” requirement. It is clearly aimed at ensuring that the foundation’s charitable mission is not compromised because its managers are also overseeing, and are distracted by, the operation of a business.

However, we are talking about a closely held business. How likely is it that the owner or their family will give up control of the foundation or of the business (at least while the owner is alive)? In most cases, it is likely that the owner will wait until their death, or the death of their surviving spouse, before giving up their entire ownership of the business.[xxvi]

Might an owner split up their business into separate businesses – for example, geographically or according to line of business – in anticipation of contributing one of them to a foundation? Should the government be allowed to aggregate these businesses in certain situations so as to avoid abuse of the new rule?

Other Foundation Rules

Assuming the requirements established by the Act are met, the foundation must still consider the various “behavior modification” rules.

The Act did not change the limited income tax deduction available to the business owner who contributes an interest in a closely held business to a foundation. It remains limited to the owner’s adjusted basis in the interest.

Where the business contributed is an S corporation, the corporation’s election to be treated as a small business corporation will not be affected, but the foundation will be subject to the unrelated business income tax on its allocable share (100%) of the S corporation’s taxable income.[xxvii]

If all of the interests in an LLC, treated as a partnership, are transferred to a foundation, the LLC will become a disregarded entity, and the foundation will be treated as engaging directly in the LLC’s business.[xxviii] Obviously, this will raise unrelated business income tax issues, but it may also jeopardize the foundation’s tax-exempt status if the business is substantial relative to the foundation’s charitable activities.

Speaking of taxes – parum pum – although any dividends distributed to the foundation by a wholly-owned business corporation will not be subject to income tax,[xxix] the excise tax on the foundation’s net investment income will continue to apply.[xxx]

In addition, the foundation will continue to be subject to the five-percent-minimum annual distribution requirement. Query how difficult (and expensive) it will be to determine the fair market value of the closely held business every year for this purpose.

And what if the business does not make a distribution to the foundation in a particular year; for example, where it sets aside “reasonable reserves” for a bona fide business purpose? How will the foundation generate the necessary liquidity? Will it be forced to borrow money?

If there is a prolonged period during which insufficient dividends are paid, will the foundation’s continuing ownership of the business represent a “jeopardy investment” – one that jeopardizes the carrying out of its exempt purposes – with respect to which the ten percent penalty tax should be imposed?[xxxi] Might the foundation be forced to sell the business at that point?[xxxii]

Along that same line of reasoning, what if the business requires a capital contribution? If the foundation is somehow able to make the necessary infusion of cash, will it have engaged in a non-charitable activity of a type with respect to which the twenty percent, so-called “taxable expenditure,” penalty should be imposed?[xxxiii]

That’s All Folks

Lots of questions. It’s early yet – we’ll see how it plays out. Frankly, I don’t get it.[xxxiv]


[i] By now, you are aware of one of the themes of this blog: A business should only undertake an activity because it makes business sense, not because of the tax result. The same applies to charitable giving: One should not make a charitable transfer because of an expected economic benefit, but because one believes in the charitable organization or activity.

[ii] See the General Explanation of the Tax Reform Act of 1969, prepared by the Staff of the Joint Committee on Internal Revenue Taxation, December 3, 1970 (Joint Committee Explanation), for a good review.

[iii] Compare the public charity, the revenues of which come, by and large, from the general public (as contributions or as fees for services), including other charities and government. IRC Sec. 509(a).

[iv] Whether directly or through their business.

[v] Rather than providing any charitable service, itself.

[vi] The public cannot tighten the proverbial “purse strings.”

[vii] 30% vs 20%. IRC Sec. 170(e)(1) and Sec. 170(b)(1).

[viii] Query whether an independent public charity would accept equity in a close corporation that could not be converted into cash or a cash equivalent.

Note that the Small Business Job Protection Act of 1996 amended the Code to allow charities to own shares of stock in an S corporation.

[ix] Profits interest in the case of a partnership.

[x] Among others, this includes substantial contributors to the foundation, foundation managers, family members of such individuals, and certain business entities controlled by such individuals. IRC Sec. 4946.

[xi] If the foundation and its disqualified persons together do not own more than 35% of the voting stock of an incorporated business enterprise, then the foundation may own up to 35% of the voting stock, reduced by the amount owned by its disqualified persons, provided no disqualified person has effective control of the corporation.

[xii] IRC Sec. 4943.

[xiii] Other than those assets which are used directly in carrying out the foundation’s exempt purpose. IRC Sec. 4942.

[xiv] P.L. 115-123.

[xv] S. Rept. 114-20

[xvi] Newman’s Own, anybody?

[xvii] IRC Sec. 4943(g).

[xviii] What about non-voting interests? What about the “all profits” requirement? The provision should have stated that all of the equity must be owned by the foundation.

[xix] A “business enterprise” does not include a business that is functionally related to the foundation’s exempt activities, or a trade or business at least 95% of the gross income of which is derived from “passive sources.”

Might some donors with foresight be tempted to split up their business so as to satisfy the exclusive ownership interest as to those segments of the business intended for the foundation?

[xx] It appears that the donor cannot transfer some of the equity as a lifetime gift and the balance at their death. Presumably, the business may redeem a portion of the donor’s equity from their estate (thereby providing the estate with liquidity to pay taxes or make other testamentary transfers), and passing the remaining equity to a foundation.

[xxi] Including any investment income.

[xxii] Of course, the business remains subject to federal income tax. Moreover, if the foundation were to liquidate the business, such liquidation would be a taxable event under regulations issued under IRC Sec. 337.

[xxiii] Query what constitutes a “reasonable” reserve.

[xxiv] Query whether, in the case of a N.Y. membership corporation, this would cover a member of the foundation.

[xxv] Voting and non-voting.

[xxvi] For example, the owner may establish a QTIP trust for the benefit of the spouse, with the remainder passing to the foundation at the death of the spouse.

[xxvii] IRC Sec. 512(e). The gain from the sale of the S corporation stock will also be taxable.

[xxviii] IRC Sec. 512(c).

[xxix] IRC Sec. 512(b).

[xxx] IRC Sec. 4940.

[xxxi] IRC Sec, 4944.

[xxxii] If the foundation accepts a discounted price – a “fire sale” – will the state’s attorney general be knocking on the foundation’s door shortly thereafter?

[xxxiii] IRC Sec. 4945.

[xxxiv] Well, I guess I do. The Act was intended to benefit one taxpayer: Newman’s Own. Hell of a way to legislate. Just as bad as enacting provisions that are scheduled to expire only a few years later. I’ll get off my soapbox now.

“Life” Goes On

In light of all the attention given to the reams of regulations recently proposed under the Tax Cuts and Jobs Act (“TCJA”), some people may be joking that tax advisers must have stopped counseling clients on more “mundane” business matters in order to dedicate themselves to the new rules. If these jokesters only realized how lengthy and convoluted these new rules actually are, they would quickly recognize that this was no laughing matter.

That being said, allow me to assure you that we have not suspended our efforts on behalf of our clients. Speaking for myself, I continue to see a steady flow, and a wide variety, of business-related tax issues that have no connection to the TCJA or its regulations, including a number that involve that bane of so many failing businesses: the failure to pay employment taxes – which is why the decision described below caught my attention.

“I Trusted You”

The IRS notified LLC that it had failed to pay employment taxes for the three preceding tax years. Shortly thereafter, LLC remitted payment for the unpaid taxes, along with the penalties and interest accrued thereon.

LLC then conducted an internal investigation into the matter, and found that its operations manager during the relevant time period (“Manager”) had failed to pay LLC’s taxes. Manager’s duties included ensuring that LLC filed its tax returns and paid its employment taxes. Unfortunately, Manager proved to be untrustworthy – they missed filing deadlines and did not inform LLC’s owner of the numerous IRS delinquency notices received. In addition, Manager began settlement negotiations with the IRS without LLC’s knowledge, let alone its approval.

The Refund Claim

After discovering the cause of its delinquent taxes, LLC sought a refund of the penalties and related interest it had paid.

LLC claimed that these penalties and interest should be abated because it had reasonable cause for its late payment of the taxes, citing Manager’s actions. LLC also claimed that its outside CPA had assured it that LLC had paid its taxes in a timely manner. The CPA, however, did not verify that the taxes were actually paid, but instead relied on Manager’s representations that they were paid.

The IRS denied the refund claim, and LLC subsequently filed a suit against the IRS, in Federal district court, to compel the sought-after refund. LLC argued that Manager’s “profound misconduct,” coupled with the concealment of that wrongdoing, prevented LLC from discovering the delinquency and timely fulfilling its tax obligations.[I]

The IRS filed a motion to dismiss, arguing that LLC had failed to establish the requisite reasonable cause. The IRS argued that a taxpayer’s duty to file its returns and pay its employment taxes was non-delegable and, therefore, could not be excused by an agent’s (i.e., Manager’s) misconduct.

The district court dismissed LLC’s case, and ruled in favor of the IRS. The court held that “[LLC] had an obligation to timely remit employment taxes. [LLC’s] reliance on its agents—an employee and an outside CPA—cannot constitute reasonable cause for its failure to remit those taxes.” LLC appealed to the U.S. Court of Appeals for the Eighth Circuit.

The Courts of Appeals

Once again, LLC argued that its failures to file timely tax returns and timely pay its employment taxes were excusable, relying on Manager’s malfeasance.[ii]

The Court disagreed, stating that “[t]he facts, whether considered singularly or together, do not excuse [LLC’s] tax law compliance failures” and did “not support a finding of reasonable cause.”

Reasonable Cause

The Court explained that the Code imposes penalties on those who fail to timely pay certain federal taxes, including employment taxes. An employer is required to withhold these taxes, place them into a trust fund, and report on a quarterly basis. Failure to do so subjects the taxpayer to penalties. “To escape the penalties,” the Court continued, “the taxpayer bears the heavy burden of proving both (1) that the failure did not result from willful neglect, and (2) that the failure was due to reasonable cause.”

Though the terms “willful neglect” and “reasonable cause” are not defined by the Code, an IRS regulation provides:

[i]f the taxpayer exercised ordinary business care and prudence and was nevertheless unable to file the return within the prescribed time, then the delay is due to a reasonable cause. A failure to pay will be considered to be due to reasonable cause to the extent that the taxpayer has made a satisfactory showing that he exercised ordinary business care and prudence in providing for payment of his tax liability and was nevertheless . . . unable to pay the tax . . . .

Self-Assessment and Delegation

The Court reviewed a number of decisions that recognized the importance of deadlines to the administration of the tax system, and which held that the payment of taxes was a non-delegable duty, and that an agent’s failure to act as expected did not absolve the principal of that duty.

The IRS has millions of taxpayers to monitor, the Court observed, and our system of self-assessment, in the initial calculation of a tax, “cannot work on any basis other than one of strict filing deadlines and standards.” Similarly, the prompt payment of taxes “is imperative to the government, which should not have to assume the burden of unnecessary ad hoc determinations.”

According to the Court, “Congress intended to place upon the taxpayer an obligation to ascertain the statutory filing and payment deadlines and then to meet those deadlines, except in a very narrow range of situations.”

When a taxpayer seeks the advice of a professional, the Court stated, the taxpayer may demonstrate an exercise of the “ordinary business care and prudence” prescribed by the regulations, “but that does not provide an answer to the question we face here.” To say that it was “reasonable” for the taxpayer to assume that the professional would comply with the statute may resolve the matter as between them, but not with respect to the taxpayer’s obligations under the Code. Congress has charged the taxpayer with “an unambiguous, precisely defined duty” to file a return and to pay the tax by a certain date. That a professional, as the taxpayer’s agent, was expected to attend to the matter does not relieve the principal of their duty to comply with the Code.

Technical Advice?

In so holding, the Court clearly distinguished between a taxpayer’s relying on an agent for professional legal advice and the taxpayer’s relying on an agent for non-technical, non-specialized matters:

When an accountant or attorney advises a taxpayer on a matter of tax law, such as whether a liability exists, it is reasonable for the taxpayer to rely on that advice. Most taxpayers are not competent to discern error in the substantive advice of an accountant or attorney. To require the taxpayer to challenge the attorney, to seek a “second opinion,” or to try to monitor counsel on the provisions of the Code himself would nullify the very purpose of seeking the advice of a presumed expert in the first place. “Ordinary business care and prudence” do not demand such actions.

By contrast, one does not have to be a tax expert to know that tax returns have fixed filing dates and that taxes must be paid when they are due. Reliance by a lay person on a professional “cannot function as a substitute for compliance with an unambiguous statute.” Such reliance is not “reasonable cause” for a late filing or payment, the Court stated.

“Disability”

However, the Court also recognized that a taxpayer’s “disability” could provide reasonable cause for failure to meet a tax obligation:

The administrative regulations and practices exempt late filings from the penalty when the tardiness results from postal delays, illness, and other factors largely beyond the taxpayer’s control. . . . This principle might well cover a filing default by a taxpayer who relied on an attorney or accountant because the taxpayer was, for some reason, incapable by objective standards of meeting the criteria of “ordinary business care and prudence.” In that situation, however, the disability alone could well be an acceptable excuse for a late filing.

But the present case, the Court noted, did not involve the effect of a taxpayer’s “disability”; rather, it involved the effect of a taxpayer’s reliance on an agent employed by the taxpayer.

Case Law Defines “Disability”

In contrast, and by way of illustration, the Court described a case in which a company’s failure to file its taxes was excused by the fact that its principal decision-makers with regard to financial and tax matters were embezzling from the company.

The company had challenged penalties it was assessed for non-payment of taxes as a result of embezzlement committed by its CEO and its CFO. The government attempted to hold the company responsible under a strict “vicarious liability” theory.[iii]

The court acknowledged that a taxpayer’s duty to file its taxes is non-delegable, but it held that the officers’ criminal conduct divested them of their apparent authority on tax matters, rendering a vicarious liability theory inappropriate.

Significantly, however, the Court explained that this did not end the inquiry, because “[i]f a corporation has lax internal controls or fails to secure competent external auditors to ensure the filing of timely tax returns and deposit and payment of taxes, it fails to show reasonable cause or absence of willful neglect and is itself liable for statutory penalties, notwithstanding its lack of vicarious liability for the criminal actions of its agents.”

The Court then described another case, in which a business’s office manager/controller failed to ensure that the company timely fulfilled its employment tax filing and payment obligations over a period of years. When the manager received IRS notices of late penalty fees, neither the company’s officers nor its accountants were aware of the assessments because manager intercepted and screened the mail. Additionally, manager altered check descriptions and the quarterly reports when the assessments were later paid – the alterations made it appear that the tax payments were solely for the current period. The manager also concealed the deficiencies by personally undertaking the performance of all payroll function, and telling payroll clerks not to prepare the tax deposit checks anymore.

Even though the wrongdoing was all manager’s, the court noted that manager had only limited power in conducting their duties; importantly, to issue a payroll tax check, manager either had to have it signed by the company’s president and majority shareholder, or sign it themselves with a countersignature from the company’s corporate secretary.

The company only became aware of the delinquency after manager’s sudden resignation. After paying the penalty, the company filed suit seeking a refund on the basis that its manager’s “intentional misconduct disabled it from adhering timely to its tax obligation.”

However, the court explained that a corporate agent’s failure to act as they were supposed to only excuses the corporation’s failure to pay if the company “can show that it was disabled from complying timely.” It rejected the claim that manager’s actions disabled the company. The court held that manager’s “deficient and improper conduct was not largely beyond [company’s] control” because manager was subject to the supervision of both the owners and the company’s outside accountants. The court therefore held that there was no reasonable cause for company’s delinquency.

Holding

Applying the foregoing cases to the instant facts, the Court concluded that an agent’s failure to fulfill their duty to their principal to file tax returns and make payments on behalf of the principal does not constitute reasonable cause for the principal’s failure to comply with its tax obligations, unless that failure actually rendered the principal “disabled” with regard to its tax obligations.

The Court also concluded that establishing “disability” is a high bar that is not satisfied if the delinquent[iv] agent is subject to the control of their principal, whether that principal sufficiently exercised that control or not.

Though LLC argued that Manager’s dishonesty “incapacitated” LLC and rendered it unable to file its tax returns and pay taxes due, the Court found that Manager worked within a corporate structure in which they fell under the supervision of at least one person – the company’s owner.

Therefore, LLC was not disabled, and even if it was, its disability was not brought about by circumstances beyond its control. As such, Manager’s actions did not constitute reasonable cause.

Based on its conclusion that Manager’s actions did not constitute reasonable cause for LLC’s compliance, the Court rejected LLC’s argument that the district court erred by dismissing the case.[v]

Lesson?

The foregoing discussion considered the imposition of penalties on an employer-business for its failure to remit employment taxes notwithstanding that such delinquency was attributable to a “responsible” employee’s dishonesty.

Switching gears, how does the foregoing discussion affect the analysis of a principal’s “responsible person” status under the Code? Does the Court’s holding preclude any argument that an owner of a business may avoid such status if they have delegated their authority to an officer-level employee? Or does it limit this defense to situations in which the errant employee has “disabled” the business for tax purposes?

The Code provides that any person required to collect, truthfully account for, and pay over employment tax, who willfully fails to collect such tax, or truthfully account for and pay over such tax, or willfully attempts in any manner to evade or defeat any such tax or the payment thereof, shall be liable to a penalty equal to the total amount of the tax evaded, or not collected, or not accounted for and paid over.[vi]

In general, an individual cannot escape responsible person status simply by delegating most of their authority over the taxes and finances of the business to a key employee. The result may be different, however, where the following criteria are met: the individual is the equivalent of a limited partner – with no legal authority over such matters – or has contractually released any such authority, and can establish that they have not actually exercised such authority.[vii] In other words, where they have intentionally and legally “disabled” themselves.[viii]

Of course, the facts and circumstances of each situation are relatively unique, and it will be rare to encounter a closely held business in which each of the above criteria are satisfied by every owner. Someone will be held accountable, whether they are thrown under the proverbial bus or otherwise.


[I] LLC also asserted that its reliance on an outside CPA for “tax advice” excused its late payment and filing.

[ii] LLC also claimed that it had relied on its outside CPA to confirm that all employment taxes were being paid and all returns were being filed.

[iii] This is a form of secondary liability that arises under the common law doctrine of agency and which makes the principal responsible for the acts of their agent.

[iv] Hope you’re picking up on some of the puns here.

[v] LLC’s reliance on its outside CPA’s statements was also not a basis for relief. The information sought from the outside CPA was not advice about a complicated matter that required tax expertise, but instead a factual question as to whether LLC’s taxes had been filed and paid. LLC made no allegation that the accountant provided any information to LLC other than that the ministerial act of filing and paying taxes had been accomplished.

Although advice from a tax professional can, in some circumstances, provide a basis for reasonable cause for the nonpayment of taxes, LLC could not claim reliance on expertise of that sort. LLC relied on a mere factual representation by its CPAs that could have been readily verified or disproven; LLC did not rely on expert advice.

[vi] IRC Sec 6672.

[vii] Ah yes, proving a negative.

[viii] As distinguished from having stuck their head in the sand.

I realize that the last post began with “This is the fourth and final in a series of posts reviewing the recently proposed regulations (‘PR’) under Sec. 199A of the Code” – strictly speaking, it was. Yes, I know that the title of this post begins with “The Section 199A Deduction.” Its emphasis, however, is not upon the proposed regulations, as such; rather, today’s post will consider whether the recently enacted deduction, and the regulations proposed thereunder last month, will play a role in determining a taxpayer’s net economic gain from the sale of the taxpayer’s business.

 It has often been stated in this blog that the less a seller pays in taxes as a result of selling their business – or, stated differently, the more that a seller can reduce their resulting tax liability – the greater will be the seller’s economic return on the sale.[i]

 M&A and the TCJA – In General

The Tax Cuts and Jobs Act (“TCJA”)[ii] included a number of provisions that will likely have an impact upon the purchase and sale a business. Among these are the following:

  • the reduced C corporation income tax rate,
  • the exclusion of self-created intangibles from the definition of “capital asset,”
  • the elimination of the 20-year carryforward period for NOLs,
  • the limitation on a buyer’s ability to deduct the interest on indebtedness incurred to acquire a target company, and
  • the extension of the first-year bonus depreciation deduction to “used” property.

Code Section 199A

As we have seen over the last couple of weeks, Sec. 199A generally allows a non-corporate taxpayer a deduction for a taxable year equal to 20% of the taxpayer’s qualified business income (“QBI”) with respect to a qualified trade or business (“QTB”) for such taxable year.

The QBI of a QTB means, for any taxable year, the net income with respect to such trade or business of the taxpayer for the year, provided it is effectively connected with the conduct of a trade or business in the U.S.

Investment income is not included in determining QBI. Thus, if a taxpayer’s rental activity with respect to a real property owned by the taxpayer does not rise to the level of a trade or business, the taxpayer’s rental income therefrom will be treated as investment income and will not be treated as QBI.

In addition, the trade or business of performing services as an employee is not treated as a QTB; thus, the taxpayer’s compensation in exchange for such services is not QBI.

Limitations

If an individual taxpayer-owner’s taxable income for a taxable year exceeds a threshold amount, a special limitation will apply to limit that individual’s Section 199A deduction. Assuming the limitation rule is fully applicable[iii], the amount of the Section 199A deduction may not exceed the greater of:

  • 50% of the W-2 wages with respect to the QTB that are allocable to QBI, or
  • 25% of such W-2 wages, plus 2.50% of the “unadjusted basis” (“UB”)[iv] of all depreciable tangible property held by the QTB at the close of the taxable year, which is used at any point in the year in the production of QBI, and the depreciable period for which has not ended before the close of the taxable year (“qualified property”).

In addition, the amount of a taxpayer’s Section 199A deduction for a taxable year, determined under the foregoing rules, may not exceed 20% of the excess of:

  1. the taxpayer’s taxable income for the taxable year, over
  2. the taxpayer’s net capital gain for such year.

Pass-Through Entities

If the non-corporate taxpayer carries on the QTB indirectly, through a partnership or S corporation (a pass-through entity, or “PTE”), the Section 199A rules are applied at the partner or shareholder level, with each partner or shareholder taking into account their allocable share of the PTE’s QBI, as well as their allocable share of the PTE’s W-2 wages and UB (for purposes of applying the above limitations).

Because some individual owners of a PTE may have personal taxable income at a level that triggers application of the above limitations, while others may not, it is possible for some owners of a QTB to enjoy a smaller Section 199A deduction than other owners of the same QTB, even where they have the same percentage equity interest in the QTB (or in the PTE that holds the business). Stated differently, one taxpayer may have a different after-tax outcome with respect to the QBI allocated to them than would another taxpayer to whom the same amount of QBI is allocated, notwithstanding that they may have identical tax attributes[v] and have identical levels of participation in the conduct of the QTB.

Income or Gain from the Sale of a PTE’s Business

Although the sale of a business may be effected through various means as a matter of state law[vi], there are basically two kinds of sale transactions for tax purposes:

  1. the owners’ sale of their stock or partnership interests (“equity”) in the PTE that owns the business, and
  2. the sale by such PTE of the assets it uses to conduct the business, which is typically followed by the liquidation of such entity.

The character of the gain realized on the sale – i.e., capital or ordinary – will depend, in part, upon whether the PTE is an S corporation or a partnership, and whether the sale is treated as a sale of equity or a sale of assets.

Sale of Assets

If the PTE sells its assets, or is treated as selling its assets[vii], the nature and amount of the gain realized on the sale will depend upon the kind of assets being sold and the allocation of the purchase price among those assets. After all, the character of any item of income or gain included in a partner’s or a shareholder’s allocable share of partnership or S corporation income is determined as if it were realized directly from the source from which realized by the PTE, or incurred in the same manner as incurred by the PTE.[viii]

Thus, any income realized on the sale of accounts receivable or inventory will be treated as ordinary income.

The gain realized on the sale of property used in the trade or business, of a character that may be depreciable, or on the sale of real property used in the trade or business, is generally treated as capital gain.[ix]

However, some of the gain realized on the sale of property in respect of which the seller has claimed accelerated depreciation will be “recaptured” (to the extent of such depreciation) and treated as ordinary income.[x]

Sale of Equity

If the shareholders of an S corporation sell their shares of stock in the corporation, the gain realized will be treated as gain from the sale of a capital asset.[xi]

When the partners of a partnership sell their partnership interests, the gain will generally be treated as capital gain from the sale of a capital asset, except to the extent that the purchase price for such interests is attributable to the unrealized receivables or inventory items (so-called “hot assets”) of the partnership, in which case part of the gain will be treated as ordinary.[xii]

Related Transactions

Aside from the sale of the business, the former owners of a PTE may also engage in other, closely-related, transactions with the buyer.

For example, one or more of the former owners may become employees of, or consultants to, the buyer; in that case, the consideration paid to them will be treated as compensation received in exchange for services.
One of more of the former owners may enter into non-competition agreements with the buyer; the consideration received in exchange may be characterized as compensation for “negative” services.

If one or more of the former owners continue to own the real property on which the business will be operated, they may enter into lease arrangements with the buyer that provide for the payment of rental income.

Tax Rates

If any of the gain from the sale of the PTE’s business is treated as capital gain, each individual owner will be taxed on their allocable share thereof at the federal capital gain rate of 20%.

If any of such gain is treated as ordinary income, each individual owner will be subject to federal income tax on their allocable share thereof at the ordinary income rate of 37%.

If an owner did not materially participate in the business, the 3.8% federal surtax on net investment income may also be applicable to their allocable share of the above gain and ordinary income.[xiii]

Of course, any compensation for services (or “non-services”) would be taxable as ordinary income, and would be subject to employment taxes.

Any rental income would also be subject to tax as ordinary income, and may also be subject to the 3.8% surtax.[xiv]

Based on the foregoing, one may conclude, generally, that it would be in the best interest of the PTE’s owners to minimize the amount of ordinary income, and to maximize the amount of capital gain, to be realized on the sale of the PTE’s business.[xv]

Of course, the selling PTE and its owners cannot unilaterally, or even reasonably expect to, direct this result. The buyer has its own preferences and imperatives[xvi]; moreover, one simply cannot avoid ordinary income treatment in many circumstances.

Enter Section 199A

No, not astride a horse, but on tip toes, wearing sneakers.[xvii]

The tax treatment of M&A transactions was certainly not what Congress was focused on when Section 199A was conceived. PTEs already enjoyed a significant advantage in the taxation of M&A transactions in that capital gains are taxed to the individual owners of a PTE at a very favorable federal rate of 20%.

Rather, Congress sought to provide a tax benefit to the individual owners of PTEs in response to complaints from the PTE community that the tax bill which eventually became the TCJA was heavily biased in favor of C corporations, especially with the reduction in the federal corporate income tax rate from a maximum graduated rate of 35% to a flat rate of 21%.

It order to redress the perceived unfairness, Congress gave individual business owners the Section 199A deduction as a way to reduce their tax liability with respect to the ordinary net operating income of their PTEs.

Sale of a Business

This is borne out by the exclusion from the definition of QBI of dividends and interest, and by the exclusion of capital gains[xviii], regardless of whether such gains arise from the sale of a capital asset; thus, the capital gain from the sale of a property used in the PTE’s trade or business, and of a character which is subject to the allowance for depreciation, is excluded from QBI.

Does that mean that Section 199A has no role to play in the taxation of M&A transactions? Not quite.

Simply put, a number of the business assets disposed of as part of an M&A transaction represent items of ordinary income that would have been realized by the business and its owners in the ordinary course of business had the business not been sold; the sale of these assets accelerates recognition of this ordinary income.

Ordinary Income Items

For example, the ordinary income realized on the sale, or deemed sale[xix], of accounts receivable and inventory by a PTE as part of an M&A deal should qualify as QBI, and should be taken into account in determining the Section 199A deduction for the individual owners of the PTE.

Unfortunately, neither the Code nor the proposed regulations explicitly state that this is the case, though the latter clearly provide that any ordinary income arising from the disposition of a partnership interest that is attributable to the partnership’s hot assets – i.e., inventory and unrealized receivables – will be considered attributable to the trade or business conducted by the partnership and taken into account for purposes of computing QBI.[xx]

Of course, the partnership rules[xxi] define the term “unrealized receivables” expansively, so they include other items in addition to receivables; for example, the ordinary income – i.e., depreciation recapture – realized on the sale of tangible personal property used in the business, the cost of which has been depreciated on an accelerated basis, or for which a bonus depreciation deduction or Section 179 deduction has been claimed.

In light of the foregoing, the same result should obtain where the inventories and receivables are sold as part of an actual or deemed asset sale, though the proposed regulations do not speak directly to this situation. These assets are not of a kind that appreciate in value, or that generate income, as in the case of investment property. Rather, they represent “ordinary income in-waiting” and should be treated as QBI.

Similarly in the case of tangible personal property used in a business and subject to an allowance for depreciation; taxpayers are allowed to recover the cost of acquiring such assets on an accelerated basis so as to reduce the net cost thereof, and thereby to incentivize taxpayers to make such investments.; i.e., they are allowed to reduce the ordinary income that otherwise would have been realized (and taxed) in the ordinary course of business. The “recapture” of this depreciation benefit upon the sale of such property should, likewise, be treated as QBI.

Compensation

As stated above, a taxpayer’s QBI does not include any amount of compensation paid to the individual taxpayer in their capacity as an employee. In other words, if a former owner of the PTE-operated business is employed by the new owner of the business (for example, as an officer), the compensation paid to the former owner will not be treated as QBI.

If the former owner is not employed by the new owner, but is retained to provide other services as an independent contractor, the payments made to them in exchange for such services may constitute QBI, provided the service provider is properly characterized as a non-employee and the service is not a “specified service trade or business.”[xxii] Query whether the “consulting” services often provided by a former owner to the buyer are the equivalent of providing the kind of “advice and counsel” that the proposed regulations treat as a specified service trade or business, the income from which is not QBI.

Rental

As was mentioned above, it is not unusual for the owners of a PTE to sell their operating business while retaining ownership of the real property on which the business may continue to operate – hopefully, it has been residing in an entity separate from the one holding the business. Under these circumstances, the owners may ensure themselves of a continued stream of revenue, a portion of which may be sheltered by depreciation deductions.

Whether such rental activity will rise to the level of a trade or business for purposes of Section 199A will depend upon the facts and circumstances. However, if the property is wholly-occupied by one tenant – i.e., by the business that was sold, as is often the case – it is unlikely that the rental activity will represent a QTB and, so, the net rental income will not be QBI.

Don’t Forget the Limitations

Even assuming that a goodly portion of the income arising from the sale of a QTB will be treated as QBI, the individual taxpayer must bear in mind the “W-2-based” and “taxable-income-based” limitations described above.

This Time, I Promise

Well, that’s it for Section 199A – at least until the proposed regulations are finalized.

“I’m so glad we had this time together . . .”[xxiii] I know, “Lou, keep you day job.”


[i] The flip-side may be stated as follows: the faster a buyer can recover their investment – i.e., the purchase price – for the acquisition of a business, the greater is the buyer’s return on its investment in the business. See, e.g.

[ii] P.L. 115-97.

[iii] Meaning that the taxpayer’s taxable income for the taxable year exceeds the threshold amount ($315,000 in the case of married taxpayers filed jointly) plus a phase-in range (between the threshold amount and $415,000).

[iv] The term “UB” means the initial basis of the qualified property in the hands of the individual or PTE, depending upon whether it was purchased by or contributed to the PTE.

[v] Other than taxable income.

[vi] For example, a sale of assets may be accomplished through a merger of two business entities; a stock sale may be accomplished through a reverse subsidiary merger in which the target is the surviving entity.

[vii] In the case of an S corporation, where the shareholders make an election under Sec. 336(e), or where the shareholders and the buyer make a joint election under Sec. 338(h)(10), to treat the stock sale as a sale of assets by the corporation followed by the liquidation of the corporation.

In the case of a partnership, a buyer who acquires all of the partnership interests is treated, from the buyer’s perspective, as acquiring the assets of the partnership. Rev. Rul. 99-6.

[viii] Sec. 702 and Sec. 1366.

[ix] Sec. 1231. Specifically, if the “section 1231 gains” for a taxable year exceed the “section 1231 losses” for such year, such gains and losses shall be treated as long-term capital gains or losses, as the case may be.

[x] Sec. 1245.

[xi] Sec. 1221.

[xii] Sec. 741 and Sec. 751.

[xiii] Sec. 1411. The tax is imposed on the lesser of (a) the amount of the taxpayer’ net investment income for the taxable year, or (b) the excess of (i) the taxpayer’s modified adjusted gross income, over (ii) a threshold amount ($250,000 in the case of a married taxpayer filed a joint return).

[xiv] Assuming it is a passive activity. See Reg. Sec. 1.1411-5.

[xv] In the case of a PTE that is an S corporation that is subject to the built-in gains tax, the shareholders may also be interested in allocating consideration away from those corporate assets to which the tax would apply.

[xvi] See endnote “i”, supra.

[xvii] I wish I could recall the name of the presidential scholar who coined the phrase, that I am trying to paraphrase, to describe how presidents get things done. It may have been Prof. Richard Pious of Columbia University.

[xviii] Sec. 199A(c)(3)(B); Prop. Reg. Sec. 1.199A-3(b)(2).

[xix] For example, upon the filing of a Sec. 338(h)(10) election.

[xx] Prop. Reg. Sec. 1.199A-3(b).

[xxi] Sec. 751(c).

[xxii] Prop. Reg. Sec. 1.199A-5.

[xxiii] Remember Carol Burnett’s sign-off song?