I had a call a couple of weeks ago from the owner of a business. His brother, who owned half of the business, owed some money to someone in connection with a venture that was unrelated to the business. The brother didn’t have the wherewithal to satisfy the debt and, to make matters worse, the person to whom the money was owed was a long-time customer of the business. The customer qua creditor had proposed and, under the circumstances, the brothers had agreed, that the business would satisfy the debt by significantly discounting its services to the customer over a period of time. The brothers wanted to know how they should paper this arrangement and that the resulting tax consequences would be.

We talked about bona fide loans, constructive distributions, disguised compensation, and indirect gifts. “What?” the one brother asked incredulously, “how can all that be implicated by this simple arrangement?” After I explained, he thanked me. “We’ll get back to you,” he said.

Last week, I came across this Tax Court decision.

A Bad Deal

Taxpayer and Spouse owned Corp 1, an S corporation. Taxpayer also owned Corp 2, a C corporation.

Things were going well for a while. Then Taxpayer bid and won a contract for a project overseas. Taxpayer formed LLC to engage in this project, and was its sole member. Unfortunately, the project required a bank guaranty. Taxpayer was unable to obtain such a guaranty, but he was able to obtain a line of credit, which required cash collateralization that he was only able to provide by causing each of his business entities to take out a series of small loans from other lenders.

The project did not go well, and was eventually shut down, leaving LLC with a lot of outstanding liabilities and not much money with which to pay them.

“Intercompany Transfers”

In order to avoid a default on the loans, Taxpayer tapped the assets of the other companies that he controlled. However, because Corp 1, Corp 2, and LLC were “related” to one another, he “didn’t see the merit” in creating any formal notes or other documentation when he began moving money among them.

Taxpayer caused Corp 2 to pay some of Corp 1’s and LLC’s debts. On its ledgers, Corp 2 listed these amounts as being owed to it, but on its tax returns, Corp 2 claimed them as costs of goods sold (COGS); because Corp 2 was profitable, there was enough income to make these claimed COGS valuable. That same year, Corp 2 issued Taxpayer a W-2 that was subsequently amended to reflect a much smaller amount.

In the following year, Corp 2 paid Taxpayer a large sum, which he used to pay a portion of LLC’s debts. Corp 2’s ledgers characterized these payments as “distributions”. Corp 2 also directly paid a significant portion of Corp 1’s and LLC’s expenses, which its ledger simply described as “[Affiliate] Payments.”

That same year, Corp 2 elected to be treated as an S corporation and filed its tax return accordingly, reporting substantial gross receipts and ordinary business income, which flowed through to Taxpayer. At the same time, Taxpayer and Spouse claimed a large flow-through loss from Corp 1 – a loss that was principally derived from Corp 1’s claimed deduction for “Loss on LLC Expenses Paid” and its claimed deduction for “Loss on LLC Bad Debt.” Taxpayer’s W-2 from Corp 2, however, reported a relatively small amount in wages.

The IRS Disagrees

The IRS issued notices of deficiency to: (i) Corp 2 for income taxes for the first year at issue (its last year as a C corporation), (ii) Taxpayer for income taxes for both years at issue, and (iii) Corp 2 for employment taxes for the second year at issue in respect of the amounts it “distributed” to Taxpayer and the amounts it used to pay Corp 1’s and LLC’s expenses. Taxpayer petitioned the Tax Court.

The Court considered whether:

  • Corp 2’s payment to creditors of Corp 1 and LLC were a loan between Corp 2 and those companies, or a capital contribution that was also a constructive dividend to Taxpayer;
  • Corp 1 was entitled to a bad-debt deduction for payments it made to LLC’s creditors prior to the years at issue, or for the payments Corp 2 made; and
  • Corp 2’s payments to Taxpayer and to creditors of Corp 1 and LLC should be taxed as wages to Taxpayer and, thus, also subject to employment taxes.

Loans or Constructive Dividends?

Corp 2 claimed a COGS adjustment for expenses of Corp 1 and LLC that it had paid. However, it changed its position before the Court, arguing that the payment was a loan.

The IRS countered that the payment was only “disguised” as a loan; it was not a bona fide debt. Rather, it was really a contribution of capital by Corp 2 to each of Corp 1 and LLC. According to the IRS, this made the payment a constructive dividend to Taxpayer, for which Corp 2 could not claim a deduction, thereby increasing its income.

A bona fide debt, the Court explained, “arises from a debtor-creditor relationship based upon a valid and enforceable obligation to pay a fixed or determinable sum of money.”

Whether a transfer creates a bona fide debt or, instead, makes an equity investment is a question of fact. To answer this question, the Court stated, one must ascertain whether there was “a genuine intention to create a debt, with a reasonable expectation of repayment, and did that intention comport with the economic reality of creating a debtor-creditor relationship?”

According to the Court, there are a number of factors to consider in the “debt vs equity” analysis, including the following:

  • names given to the certificates evidencing the indebtedness
  • presence or absence of a fixed maturity date
  • source of payments
  • right to enforce payments
  • participation in management as a result of the advances
  • status of the advances in relation to regular corporate creditors
  • intent of the parties
  • identity of interest between creditor and stockholder
  • “thinness” of capital structure in relation to debt
  • ability to obtain credit from outside sources
  • use to which the advances were put
  • failure of the debtor to repay
  • risk involved in making the advances.

Corp 2’s book entries showed a write-off for payments made to Corp 1 described as “Due from Related Parties” which made it seem as though Corp 2 intended the payments to be loans. But Corp 2 deducted the payments as “purchases,” thus belying the label used on its books. And when Corp 2 made the payments, it didn’t execute a note, set an interest rate, ask for security, or set a maturity date.

The lack of these basic indicia of debt and Corp 2’s inconsistent labeling weighed in favor of finding that Corp 2 intended the payments to be capital contributions, not loans.

The fact that Corp 1 and LLC were broke when Corp 2 made the payments also undermined Taxpayer’s position that the payments were loans. Taxpayer testified that LLC “had no funds” or “wasn’t capitalized,” and its only contract (for which it hadn’t been paid) had been canceled. Corp 1’s situation was similar; it had virtually no book of business, its liabilities exceeded its assets, and it was losing money.

So, Corp 2’s payments went to entities that were undercapitalized, had no earnings, and could not have obtained loans from outside lenders – all factors suggesting that the payments were capital contributions.

The Court observed that Taxpayer treated legally separate entities as one big wallet. “Taking money from one corporation and routing it to another will almost always trigger bad tax consequences unless done thoughtfully.” The Court stated that “Taxpayer did not approach LLC’s problems with any indication that he thought through these consequences or sought the advice of someone who could help him do so.”

The Court found that Corp 2’s payments were not loans to LLC and Corp 1, but were capital contributions; the entities didn’t intend to form a debtor-creditor relationship.

Constructive Dividend

The Court then considered whether Corp 2’s payments were constructive dividends to Taxpayer. A constructive dividend, the Court explained, occurs when “a corporation confers an economic benefit on a shareholder without the expectation of repayment.”

A transfer between related corporations, the Court continued, can be a constructive dividend to common shareholders even if those shareholders don’t personally receive the funds. That type of transfer is a constructive dividend if the common shareholder has direct or indirect control over the transferred property, and the transfer wasn’t made for a legitimate business purpose but, instead, primarily benefited the shareholder.

Taxpayer had complete control over the transferred funds – he was the sole shareholder of Corp 2, the sole member of LLC, and he owned 49% of Corp 1. Moreover, there was no discernible business reason for Corp 2 to make the transfers because there was no hope of repayment or contemplation of interest. The transfer was bad for Corp 2, but it was good for Taxpayer because it reduced his other entities’ liabilities.

Corp 2’s payment of LLC’s and Corp 1’s expenses, therefore, was a constructive dividend to Taxpayer.

Bad-Debt Deduction

On their tax return, Taxpayer and Spouse claimed a large flow-through loss derived from a bad-debt deduction that Corp 1 took for earlier payments it made on behalf of LLC, and a deduction that it took for “Loss on LLC Expenses Paid.” The IRS denied all of these deductions, increasing the Taxpayer’s flow-through income from Corp 1.

Before there can be a bad-debt deduction, there had to be a bona fide debt. Even when there was such a debt, the Court continued, a bad-debt deduction was available only for the year that the debt became worthless.

The Court recognized that “transactions between closely held corporations and their shareholders are often conducted in an informal manner.” However, given the significant amount of the purported debt, the Court noted that the absence of the standard indicia of debt – formal loan documentation, set maturity date, and interest payments – weighed against a finding of debt.

The only documents Taxpayer produced about the purported loans were its books.

The amount that Corp 2 paid and that Corp 1 deducted that same year as “Loss on LLC’s Expenses Paid” appeared as entries on those books. But, the Court stated, it is not enough to look at the label a corporation sticks on a transaction; one has to look for proof of its substance, which the Court found was lacking.

Based upon the “debt vs equity” factors described above, the absence of any formal signs that a debt existed, and the underlying economics of the situation, the Court found that Taxpayer was “once again just using one of his companies’ funds to pay another of the companies’ debts.” Therefore, Corp 1’s advances to LLC did not create bona fide debt for which a bad debt deduction could be claimed.

Compensation

Taxpayer argued that the payments he received from Corp 2, and that he immediately used to pay other corporate debts, was either a distribution or a loan. He also claimed that Corp 2’s payments to Corp 1’s and LLC creditors were loans.

The IRS contended that these payments were wages to Taxpayer, and argued that Corp 2 “just called them something else” to avoid employment taxes.

The Court pointed out that these payments lacked formal loan documentation, had no set interest rate or maturity date, were made to companies with no capital, and could be repaid only if the companies generated earnings. For those reasons, the payments couldn’t have been loans.

But were the payments wages, as the IRS insisted?

Wages are payments for services performed. Whether payments to an employee-shareholder are wages paid for services performed or something else – such as dividends – is a question of fact. Again, the Court emphasized that all the evidence had to be considered; one had to look to the substance of the situation, not the name the parties gave a payment.

According to the Court, a significant part of this analysis was determining what “reasonable compensation” for the employee’s services would be. Among the factors to consider in making this determination were the following:

  • employee’s qualifications
  • nature, extent and scope of the employee’s work
  • size and complexities of the business
  • comparison of salaries paid with the gross income and the net income
  • prevailing general economic conditions
  • comparison of salaries with distributions to stockholders
  • prevailing rates of compensation for comparable positions in comparable concerns
  • salary policy of the employer as to all employees
  • in the case of small corporations with a limited number of officers, the amount of compensation paid to the particular employee in previous years.

The IRS estimated the salary for the CEO of a company comparable to Corp 2, and pointed out that while Taxpayer’s W-2 fell short of this salary, the amount paid to Taxpayer came fairly close to the IRS’s estimate when combined with the contested payments. There was no reason, the Court stated, “for us to think that the IRS’s estimate was unreasonable given Taxpayer’s decades” of business experience and the fact that he singlehandedly ran three companies, one of which was very profitable.

Be Aware

The overlapping, but not necessarily identical, ownership of closely held business entities, especially those that are controlled by the members of a single family, can breed all sorts of tax issues for the entities and for their owners.

Intercompany transactions, whether in the ordinary course of business or otherwise, have to be examined to ensure that they are being undertaken for valid business reasons. That is not to say that there cannot be other motivating factors, but it is imperative that the parties treat with one another as closely as possible on an arm’s-length basis.

To paraphrase the Court, above, related companies and their owners may avoid the sometimes surprising and bad tax consequences of dealing with one another – including the IRS’s re-characterization of their transactions – if they act thoughtfully, think through the tax consequences, and seek the advice of someone who can help them.

How many times have you said to a client, “Please don’t agree to any deal terms until we’ve had a chance to discuss your goals and plans, consider your options, and analyze the consequences.”

How many times has a client presented you with a fully executed “letter of intent” – one that you’ve never seen before – that almost (but, thankfully, not quite) constitutes an agreement to buy or sell?[1]

I’m being only partially facetious. Of course the client knows their business, well, “like nobody’s business,” and it may be that the advisor cannot add much to the business deal.

Too often, however, a taxpayer decides upon a series of steps without appreciating the tax – and, therefore, the “net” economic – consequences thereof. In some cases, the taxpayer should have known better – some truths are obvious; in others, the result is not necessarily intuitive, but it could have been anticipated and planned for had the taxpayer sought the assistance of a tax adviser.

I recently encountered this scenario in two different matters, each involving the same substantive tax issues – one obvious, the other less so (at least for a “non-tax person”) – and each requiring an analysis of how the interplay of the applicable tax rules may affect the economics of the transaction.

A Tax Truth

There are certain “tax truths” that are self-evident; for example, the gain realized by a taxpayer from the conversion into cash of property used in a business (a sale), or from the exchange of such property for other property differing materially in kind, is treated as income – the taxpayer has so changed the fundamental nature of their property interest that the Code requires the taxpayer to recognize the gain realized on the disposition and to be taxed thereon.

Amount Realized

The amount realized by a taxpayer from the disposition of their business property is the sum of any money, plus the fair market value of any other property, received by the taxpayer in exchange for their property. The taxpayer’s taxable gain from the disposition is determined by reducing the amount realized by the taxpayer’s adjusted basis for the property.

Cost Basis

In general, a taxpayer’s adjusted basis for a property used in their business represents the unreturned or unrecovered portion of the taxpayer’s investment in the property. When a taxpayer purchases property, the taxpayer is said to have a “cost basis” for the property – the amount of the taxpayer’s investment is equal to the amount paid to acquire the property.

Adjusted Basis

Depending upon the nature of the property – and depending upon the incentives provided by the Code for investing in such property – the taxpayer’s cost must be capitalized[2] and may be recovered (and its basis adjusted) over time through annual deductions for depreciation or amortization[3], or the taxpayer may elect to deduct (or “expense”) the cost in the year the property is placed into service[4] rather than by depreciating the cost over time.[5] These deductions enable the taxpayer to recover at least some of their investment in the property – prior to its disposition – by offsetting the ordinary income generated by the business. Significantly, a taxpayer’s basis for shares of stock in a corporation is not recoverable in this manner.

When the taxpayer sells the property, they recover their adjusted basis for the property – i.e., the remaining balance of their unrecovered investment – before recognizing any gain.[6]

Another Tax Truth

In contrast to the sale of property, or the disposition of such property in exchange for materially different property, no gain is recognized[7] when the taxpayer exchanges property (the “relinquished property”) that has been used in their trade or business solely for property of a “like kind” (the “replacement property”) that will also be used in the trade or business. The nature of the taxpayer’s relationship to the replacement property is not materially different from their relationship to the relinquished property; thus, the “like kind exchange” is not an appropriate occasion for the recognition of gain and the imposition of tax.

Tax Deferral

That is not to say that the gain realized on the like kind exchange is wiped away. Rather, the recognition of such gain is deferred until the taxpayer disposes of the replacement property in a taxable transaction. In order to preserve the gain inherent in the property at the time of the like kind exchange, the taxpayer is required to take the replacement property with the same basis that the taxpayer had in the relinquished property.[8]

These concepts, which are so often associated with the disposition of real property, have their counterparts in the Code’s corporate tax provisions. The Code excepts from the general recognition rule certain exchanges of property and of stock that are incident to specified readjustments of a corporate structure, that are undertaken for a bona fide business purpose, and that effect only a readjustment of a continuing interest in property under a modified corporate form.

Subsidiary Liquidation

Thus, when a corporation (the “parent”) owns shares of stock representing at least 80% of the total voting power and fair market value of another corporation (the “sub”), and causes the sub to liquidate into the parent – i.e., to transfer all of its assets, subject to all of its liabilities, to the parent, in exchange for, and in cancellation of, the sub’s outstanding stock – neither the sub nor the parent is required to recognize any of the gain realized in the exchange.[9]

As in the case of the like kind exchange, the gain inherent in the sub’s assets, which are distributed to the parent in connection with the liquidation of the sub, is preserved in the hands of the parent by requiring the parent to hold those assets with the same adjusted basis that they had in the hands of the sub.[10]

The same result follows when an S corporation elects to treat a wholly-owned sub as a qualified subchapter S subsidiary (“QSUB”), or when a parent causes a sub to merge into an LLC that is wholly-owned by the parent and that is disregarded as an entity separate from the parent for tax purposes. In both cases[11], the parent is treated as acquiring the assets of the sub in a tax-deferred liquidation of the sub, and the parent takes those assets with the same adjusted basis as the sub.

Truths Collide

The two “truths” described above coexist peacefully where the parent created and funded the sub (“organically” you might say). In that case, the parent’s basis for its shares of sub stock reflect its actual investment in the sub – the amount of cash contributed by the parent or the adjusted basis (unrecovered investment) of the assets contributed by the parent – and the sub’s basis for its assets reflects the sub’s adjusted cost basis or the parent’s basis for the assets contributed.

Target Sub

But what if the parent (the “buyer”) purchased the stock of the sub (the “target”) from an unrelated third party[12] in exchange for an amount of cash equal to the fair market value of the sub? Obviously, the parent would acquire the stock with a cost basis. Without more, the sub’s basis for its assets would not be affected by the purchase of its stock.

If the parent later sold the sub stock, it would recover its stock basis before realizing any gain.

Alternatively, if the sub sold its assets, it would recognize and be taxed on the gain realized.

Suppose the parent decided, for good business reasons, to liquidate the newly-acquired sub? According to the IRS, the two transactions – i.e., the acquisition of target-sub’s stock and the subsequent liquidation of target-sub into parent-buyer – will be respected as two separate transactions, even if they were undertaken as part of a single plan.[13]

Disappearing Basis

Consequently, notwithstanding that the parent had a fair market value cost basis for its target-sub stock immediately after the acquisition of sub’s stock and before the sub’s liquidation, the parent would take the sub’s assets with the same basis that the sub had for the assets. In effect, the parent’s cost basis for the sub’s stock ceases to have any role in the tax lives of the parent and of the assets formerly held by the sub – it simply disappears.

The same result would follow if parent-buyer were an S corporation and it elected to treat its newly-acquired target-sub as a QSUB.[14]

Thus, on the parent’s subsequent sale of the sub’s assets, the parent would recognize gain of an amount determined by reference to the sub’s adjusted basis in such assets.

At first blush, this may seem like an unfair result. After all, the parent has just paid fair market value consideration for the sub stock, yet it is burdened with a tax liability without necessarily experiencing any accretion in value.

This conclusion, however, overlooks the fact that the parent was able to acquire the sub’s assets on a tax-deferred basis – i.e., without causing the sub to incur any corporate-level income tax liability – by virtue of the liquidation.

It also overlooks the fact that the parent-buyer may have been able to negotiate with the target-sub’s selling shareholders to require that the parties elect to treat the acquisition of the sub’s stock as a purchase of its assets; in that case, the parent would have acquired such assets with a cost basis following the actual or deemed liquidation of the sub.[15]

Forewarned . . .

In the end, it is important that the parent-buyer be aware of the foregoing considerations prior to negotiating its purchase of the target-sub stock, including the consideration therefor.

Assuming the parent-buyer must acquire the target-sub’s stock – because there is some business or legal imperative that prevents it from acquiring the sub’s assets – the parent-buyer should be prepared to increase its purchase price for the stock if it wants to convince the target-sub’s shareholders to treat the stock sale as a sale of target-sub’s assets for tax purposes.

If the “deemed asset sale” election is not available, then the parent-buyer should consider offering a purchase price for the sub stock that reflects its inability to recover its cost basis for the stock through depreciation or amortization, and that reflects the tax liability inherent in the sub’s assets (their “built-in gain”), regardless of any plans to liquidate the sub. By adjusting the purchase price for the increased economic cost of the stock deal, the buyer may be able to partially offset the cost of the disappearing basis.

Of course, the buyer’s goals for acquiring a target business, including the anticipated economic benefits, may outweigh these tax considerations, or the relative bargaining power of the two sides may be such that the buyer cannot obtain the economic concessions described above without risking the loss of the deal.

In any event, the buyer must be made aware of the tax consequences in order to make an educated decision.[16]


[1] What’s your favorite antacid?

[2] It becomes or is added to its basis.

[3] Over the “useful life” of the property.

[4] Subject to certain limitations.

[5] The Tax Cuts and Jobs Act extended the ability to expense the cost of certain tangible property.

[6] It is important to note that regardless of how much the property may change in value, the taxpayer’s adjusted basis continues to represent their actual, unrecovered investment in the property. It is also important to note that a taxpayer’s stock basis may only be recovered upon the sale or liquidation of the stock.

[7] Included in income.

[8] This is consistent with the taxpayer’s deemed continuing investment in the “same” property.

[9] Without this rule, the sub would recognize gain equal to the excess of the fair market value of the assets distributed in liquidation to the parent over the sub’s adjusted basis in such assets, and the parent would recognize gain equal to the excess of the net fair market value of the assets received in liquidation of its sub stock over the parent’s adjusted basis for such stock.

[10] Thus, if the parent later sells those assets, its gain will be determined by reference to the sub’s basis in the assets.

[11] Provided the sub is solvent and the parent is not “exempt” from tax.

[12] Whether by way of a straight sale or a reverse subsidiary merger. Most buyers would certainly prefer to purchase assets from the target corporation, rather than purchase stock from the target’s shareholders.

[13] This was not always the case. Before the enactment of IRC 338, the IRS collapsed the two steps to treat parent as having purchased sub’s assets, and taking a cost basis in the assets, under the so-called “Kimbell-Diamond doctrine.”

[14] As indicated earlier, if an S corporation parent makes a valid QSUB election with respect to a subsidiary, the subsidiary is deemed to have liquidated into the S corporation, and all of the assets, liabilities, and items of income, deduction, and credit of the QSUB are treated as belonging to the S corporation.

[15] Assuming they qualified to make such an election. Whether under IRC Sec. 338(h)(10) or IRC Sec, 336(e), the cooperation of the selling shareholder(s) is required for the election, and a knowledgeable seller may use this leverage to extract a higher purchase price.

[16] As Sy Syms used to say: “An educated consumer is our best customer.”

Relationships are Hard

The well-being of a closely held business is based, in no small part, upon a number of relationships, including, for example, its dealings with customers, suppliers, service providers, employees, competitors, and government (including taxing authorities). The cultivation, management, and preservation of these relationships presents the business with many challenges. However, if I had to identify the two most-difficult-to-manage of such relationships, at least based upon the adverse tax consequences that are visited upon the business and its owners as a result of such relationships, I would point to the business’s dealings with its owners and with related companies.

This should come as no surprise. When unrelated parties are transacting with one another – as the business will do with, say, a vendor – each is seeking to maximize its potential for economic gain and to minimize its exposure to economic loss. Like any system of checks and balances, there are forces at work that encourage a reasonable resolution of the transaction; the so-called “win-win” result in which neither side wins or loses every point.

Unfortunately, these “natural” forces do not apply in the case of a closely held business because its owners generally do not view the business as something separate from themselves.

In just the last two weeks, I have encountered questions regarding a sale between commonly-owned companies, a rental between related companies, the sharing of employees between a parent and a subsidiary, a disproportionate dividend distribution by a corporation to similarly-situated shareholders, and a corporation’s guarantee of a shareholder’s personal obligation. The characteristic shared by these transactions – aside from the parties’ being “related” to one another – was the absence of any meaningful negotiation between the parties.[1]

Which brings me to one of the most frequently recurring issues raised by the IRS in its examination of closely held businesses: the true nature of an investor’s transfer of funds to the business. A recent Tax Court opinion provides a good overview of the factors to which a taxpayer-investor must be attuned.

“If You’ve Got the Money, . . . ”[2]

Taxpayer decided to transfer money to his long-time friend, Partner, provided Partner gave him an “interest” in Business. Shortly after Taxpayer transferred the funds, he and Partner together incorporated Business. Taxpayer never prepared formal loan documents for the payment, but instead recorded it in his personal books and gave a copy of that record to Partner. The two of them owned the corporation as equal shareholders, with Partner overseeing the management of Business.

As Business grew and required more capital, Taxpayer provided the money. Taxpayer kept a personal record of the amounts transferred to Business, and at the end of each year he turned it over to the corporation for inclusion in the corporate records, though Taxpayer never saw those records.

This pattern continued for several years, during which Business never ran at a profit. Eventually, Taxpayer found it necessary to seek outside financing for Business. In addition, a third owner – who became a 10% shareholder through dilution of Partner’s interest – was admitted to Business to help bear the financial burden.

Taxpayer himself continued to advance funds, though, and – amid growing concern about Business’s future – he asked for and received an additional 10% share in the corporation. After revenues continued to fall short of expectations, and after having invested over $11 million over the course of 15 years, Taxpayer finally gave up.

In 2010, Taxpayer’s attorneys prepared three promissory notes from Business. Each note was dated January 1, 2010, and was signed by Partner on behalf of Business.

In November 2010, Taxpayer sold one of his promissory notes to Partner for $1. Then, in December 2010, Business retired both Partner’s and Taxpayer’s “debt”. In exchange, Taxpayer received an additional 12.5% interest in Business (bringing his total to 82.5%).

With all this “paperwork” in place, Taxpayer’s attorneys advised him that he was entitled to claim capital losses in 2010 and 2011.

The IRS audited Taxpayer’s returns for those years and asserted tax deficiencies against Taxpayer. Taxpayer petitioned the Tax Court, where the only issue was whether Taxpayer’s advances to Business were loans or capital contributions.

Debt or Equity

Taxpayer argued that his advances to Business were bona fide debts, and the IRS argued that the advances looked more like equity.

A bona fide debt, the Court began, is one that “arises from a debtor-creditor relationship based upon a valid and enforceable obligation to pay a fixed or determinable sum of money.” Whether a purported loan is a bona fide debt, it continued, is determined by the facts and circumstances of each case.

The Court identified several factors to consider in its debt-equity analysis; it cautioned that no single factor was determinative.

Names

Formal loan documentation, such as a promissory note, tends to show that an advance is a bona fide debt.

Taxpayer did not get formal loan documentation when he made each advance. Instead, his first advance got him a 50% interest in Business, and his later advances got him a 10% increase in his ownership.

Taxpayer pointed to the January 2010 promissory notes as evidence of indebtedness, but the Court found those promissory notes were of little help in determining Taxpayer’s intent when he made the advances.

The Court also stated that the “long-after-the-fact” papering was inconsistent with how Business treated unrelated lenders.

Maturity Date

“The presence of a fixed maturity date indicates a fixed obligation to repay, a characteristic of a debt obligation.”

Taxpayer’s alleged loans to Business had no fixed maturity date, and he explained that he expected to be paid only when Business was sold or became profitable.

Source of the Payments

The Court stated that if the source of repayments depended on earnings, an advance was more likely to be equity.

According to the Court, that’s exactly what happened here: Taxpayer admitted that he didn’t expect to receive payment until the business was profitable and he’d “be paid [his] share of the profits.”

Right to Enforce

An enforceable and definite obligation to repay an advance indicates the existence of a bona fide debt.

Taxpayer argued that Business had an enforceable and definite obligation to repay his advances both before and after the execution of the 2010 promissory notes. He argued that, before the notes, Business’s financial statements recorded his advances as loans, but the Court noted that Taxpayer pointed to no authority that this would give him a right to enforce their repayment.

In any case, Taxpayer failed to take customary steps to ensure repayment – he never asked for repayment. Moreover, the Court found that he never intended to enforce the notes.

Participation in Management

The Court stated that when a taxpayer receives a right to participate in management, or an increase in his ownership stake, in exchange for an advance, it suggests that the advance was an equity investment and not a bona fide debt.

Because Taxpayer’s initial transfer to Business came with a 50% share in the company, that advance indicated an equity investment. After that, however, Taxpayer’s participation in management was unclear. He testified that his only role was to lend money, but later said that he reviewed tax documents and cash flow statements. It does not, however, seem he was involved in the day-to-day operations of Business, and any involvement he did have was minimal.

Taxpayer did not receive additional stock for later contributions until after he had already advanced millions of dollars, and this was only a 10% increase in a failing company. He testified that he wanted the additional 10% so that he would have more control over Business’s direction, given its condition and the substantial funds he had already advanced; and he emphasized that he needed it if he was going to give Business any more money.

The Court observed that an increased interest or participation needed to prevent a company’s collapse did not, by itself, mean an advance was an equity investment. But Taxpayer also received an extra 12.5% interest in Business in 2010 when it retired his debt.

Status Equal or Inferior to Other Creditors

Taking a subordinate position to other creditors indicates an equity investment.

Taxpayer admitted that his purported loans were subordinate to those of Business’s secured creditors. He argued, however, that they were not subordinate to those of Business’s unsecured creditors, though the Court noted that there was nothing in the record to support this position. And Taxpayer in fact testified that his “debt” was subordinate to several other of Business’s financial arrangements.

The Parties’ Intent

“[T]he inquiry of a court in resolving the debt-equity issue is primarily directed at ascertaining the intent of the parties.” The Court treated this factor as “the place to look for contemporaneous evidence of subjective intent.”

That evidence showed that Taxpayer never received or demanded payments of either interest or principal from Business, and that he expected to be paid back only out of profits.

That evidence also showed no contemporaneous documentation from Business that stated the advances were loans, a lack which was telling because Business did borrow money from more conventional lenders, and it papered those transactions as conventional loans.

Taxpayer admitted that during the time he was making advances to Business, he did not know for sure that they were being recorded as loans in its books.

While Business’s financial statements showed that they included Taxpayer’s advances in their total debt, the Court gave this little weight because no one from Business, other than Taxpayer, testified on its behalf.

“Thin” or Adequate Capitalization

The Court stated that thin or inadequate capitalization was strong evidence of a capital contribution where: “(1) The debt to equity ratio was initially high, (2) the parties realized that it would likely go higher, and (3) substantial portions of these funds were used for the purchase of capital assets and for meeting expenses needed to commence operations.”

However, neither Taxpayer nor the IRS argued that evidence in the record directly supported or negated this factor.

Identity of Interest

Advances in proportion to the stockholder’s capital interest indicate a finding that the advance was an equity investment.

Business’s financial records indicated that its liabilities exceeded its assets. And when Business lacked money to cover its operating expenses, Taxpayer just handed over the funds. These circumstances, the Court stated, create an identity of interest between the purported creditor and the controlling shareholder.

Payment of Interest Out of “Dividend” Money

The presence of a fixed rate of interest, and the actual payment of interest, indicate a bona fide debt.

There was no evidence, aside from Taxpayer’s testimony, that his advances were supposed to accrue interest. In addition, Business never paid any interest, and Taxpayer never asked for it. “The failure to insist on interest payments indicates that the payors are not expecting substantial interest income, but are more interested in the future earnings of the corporation or the increased market value of their interest.”

The Ability to Obtain Loans From Outside Lenders

If a corporation is able to borrow funds from an outside source at the time of the advance, the transaction looks more like a bona fide debt.

The Court claimed that the IRS had mistakenly distorted this factor to say that, although Business was able to obtain financing from other lenders, those transactions were at arm’s length and Taxpayer’s were not, and so should count against him.

The Court’s Decision

Based upon the foregoing factors, the Court concluded that the absence of the normal incidents of a loan, especially a maturity date and a stated interest rate, were the most telling. Without those aspects of a loan, the Court stated, the advances looked much more like capital contributions. Moreover, the “papering” that Taxpayer’s advisers prepared in 2010 to make the advances look more like loans just made it more likely than not that, at the time of the advances, Taxpayer and Partner intended those advances to be capital contributions.

Which brings us back to where we started: unrelated parties would have behaved differently in structuring the terms of a transaction than Taxpayer and Business did with respect to the transfers made to Business. (Indeed, the unrelated party would not have continued funding Business as Taxpayer did.) The unrelated party would have “papered” the transfers as loans on a contemporaneous basis, and would have required a maturity date, scheduled interest payments, covenants regarding expenditures and dividends, periodic financial reports, etc.

Unfortunately, as stated earlier, too many owners treat their business as their alter ego. Consequently, they sometimes treat their business, or cause their business to treat them, in a way that an unrelated party wouldn’t. While this may generate some inquiries by taxing authorities, it may also strain relationships with, and even antagonize, minority owners (including disgruntled family members), which can lead to a world of hurt, both financially and emotionally.[3] Ultimately, the owner must realize that it is in their own, long-term self-interest to act at arm’s-length with their business.


(*) A tax twist on the “golden rule.” Apologies to Matthew, 7:12 (the sermon on the mount).

[2] Of course, the relationship between the parties accounted for the absence of arm’s-length dealing. This sounds like the criticism leveled by the IRS at many gift and estate tax planning transactions (including certain sales to trusts and FLP transactions, for example) – no coincidence there.

[3] Apologies to Lefty Frizzell – I prefer Willie Nelson’s rendition.

[4] There’s a reason minority owners may claim “self-dealing” by a controlling owner.

Why a Minority Owner?

I have often asked the question, “Why would someone willingly become a minority owner in a closely held business?” Similarly, I have often advised clients who control their own business not to admit a minority owner into the business.

In the face of my ill-concealed bias against one’s becoming a minority owner, or one’s admitting another as such, I recognize that there are many reasons why, and circumstances in which[1], the admission of a minority owner may be necessary, even valuable, to the business, at least initially.

The controlling owner may have to offer equity to a key or prospective employee in order to retain their services, or to a potential investor in order to acquire a badly needed infusion of capital. In each of these situations, the business owner and the employee, or investor, should first decide upon the terms of their relationship; for example, voting rights, supermajority voting requirements, responsibility for day-to-day management, vesting schedules (if any), distributions, preferred returns, put or call rights, drag-along or tag-along rights, buy-sell arrangements (on death, disability, termination of employment, etc.), transfer restrictions, access to financial information, and many other factors should be considered.[2]

The Oppression of the Minority

I have never wished ill upon a closely held business or its owners – I have seen the work ethic, the dedication, and the courage that mark the successful entrepreneur[3] – but we have all seen how business relationships can sour, how the controlling owner can make life miserable for a minority owner (and sometimes vice versa),[4] and how this state of affairs may adversely affect the business.

The controlling owner has the means – especially in the absence of a shareholders’ or partnership agreement – by which they can inflict all sorts of “hurt” on the minority owner; for example, they may:

    • exclude the minority owner from a role in the management of the business,
    • cause the business to enter into agreements that must be personally guaranteed by the owners of the business, including the minority,
    • use company assets for non-business, even personal, purposes,[5]
    • withdraw an excessive amount of compensation,
    • deny employment to the minority owner,
    • employ or otherwise benefit family members,
    • accumulate an unreasonable amount of earnings in the business, without the distribution thereof,
    • fail to make distributions for taxes,[6]
    • cause the business to pay an excessive amount of rent for the use of property owned by the controlling owner,
    • divert business opportunities to related entities in which the minority owner has no equity interest,
    • fail to make the books and records of the business available to the minority owner.

Information from the Business Entity?

A minority owner may not have actual knowledge of many of the foregoing activities, though they may suspect that something is amiss. But how would they confirm this suspicion without acquiring information regarding the business?

They can ask the controlling owner to show them the books and financial records of the business, but how forthcoming will the controlling owner be? Is the minority owner ready to bring, and bear the cost of, a law suit to enforce their rights to such access under applicable state law, or under the terms of a shareholders’ or partnership agreement? From a strategic perspective, does the minority owner even want to alert the controlling owner that they are looking for such information?

Are there other sources of information, that are “freely” given by the business, by which the minority owner may determine whether the controlling owner is, in fact, engaging in “questionable” behavior?

In the case of a minority owner in a pass-through entity, such as a partnership, limited liability company, or S corporation, the owner will receive a Sch. K-1[7] that reflects the owner’s share of the business’s items of profit or loss, plus any distributions made to the minority owner; if the business entity is a C corporation, and dividends were paid to shareholders, the minority owner will receive a Form 1099-DIV reflecting the amount distributed to the owner; if the minority owner is “employed” by the business, the amount paid to them will be shown as a guaranteed payment in the case of a Sch. K-1 issued by a partnership[8] or LLC, or on a Form W-2 in the case of a corporation.

Unfortunately, these tax reports contain information that is limited to the minority owner – they do not provide any direct information relating to the activities of the controlling shareholder.

There is Another Way . . .

The business entity’s tax return, however, contains a wealth of information regarding both the business and the controlling owner.[9] The tax return for an S corporation (and the forms, statements and schedules attached thereto), for example, will include information regarding the compensation of shareholder-officers/employees, rents paid (which the minority owner may know are paid to an entity owned by the controlling owner), the identity of any subsidiaries (and possibly information regarding loans among the related entities), loans to shareholders, loans from shareholders, and other data.

That’s all well and good, but how may a minority owner obtain a copy of the business entity’s tax return, and may the return be obtained without putting the entity and the controlling owner on notice?

IRC Sec. 6103

The Code provides that “the return of a person shall, upon written request, be open to inspection by or disclosure to, in the case of:”

  • a partnership, any person who was a member of such partnership during any part of the period covered by the return;
  • a corporation, any bona fide shareholder of record owning 1% or more of the outstanding stock of such corporation; and
  • an S corporation, any person who was a shareholder during any part of the period covered by such return during which an S election was in effect.[10]

Thus, based upon the flush language of the Code, a partner or S corporation shareholder can obtain a copy of the Form 1065 or Form 1120S filed by the partnership[11] or S corporation. Indeed, even a minority shareholder of a C corporation has the right to obtain a copy of its corporation’s Form 1120.[12]

The term “return” includes any tax or information return, any claim for refund, and any amendment or supplement thereto, including supporting schedules or attachments which are supplemental to, or part of, the return.

By contrast, “return information” may also be open to inspection by, or disclosure to, any person authorized above, provided the IRS determines that such disclosure would not seriously impair federal tax administration. The term “return information” includes, among other things, whether the return, was, is being, or will be examined, data prepared by or collected by the IRS with respect to the return or the determination of any liability, any closing agreement, and other items.

When it passed the Tax Reform Act of 1976, Congress clearly distinguished between “returns” and “return information,” allowing greater access to tax returns than to return information:

Under the Act, disclosure can be made, upon written request, to the filing taxpayer, . . . , the partners of a partnership, the shareholders of subchapter S corporations, . . . , [and] a one-percent shareholder . . . . Return information (in contrast to “returns”) may be disclosed to persons with a material interest only to the extent the IRS determines this would not adversely affect the administration of the tax laws.[13] 

Based on the foregoing, one would reasonably conclude that the Code provides a minority shareholder or partner an alternative means by which to obtain information regarding the economics of a business entity where the controlling owner may not be forthcoming in sharing it.

. . . Or is there?

Actual experience, however, undermines that conclusion.

First of all, Form 4506, Request for Copy of Tax Return, inexplicably requires that the filing partner or shareholder certify that they have the authority to execute the form “on behalf of” the partnership or corporation the return of which is being requested by such partner or shareholder. How would a minority owner, from whom information is probably being withheld by the taxpayer-business entity,[14] ever hope to secure authorization from such entity – i.e., from the controlling owner – to obtain a copy of the entity’s tax return?

Our own recent experience with the IRS (and even with the Taxpayer Advocate) has been anything but reassuring. “You will need to get the permission of the taxpayer,” we have been told. “No we don’t,” we have replied, “please take a look at Code Sec. 6103(e). . . . Sure, we’ll fax it to you.” Then, “Did you see what we sent over? OK. Why would we still need the corporation’s permission? Our client was a shareholder during the years for which we are requesting the copy, and still is. We sent you the K-1.” And, in reply, “but your client is not the taxpayer that filed the return.”

What Are We Missing?

Thinking that perhaps we had missed something, we reviewed the legislative history, part of which was recited above. That confirmed our understanding.

We turned next to the Internal Revenue Manual for some insight.[15] The relevant provision begins by stating that:

Persons described in IRC Sec. 6103(e) always have access to the appropriate return as specified in IRC Sec. 6103(e)(1) through IRC Sec. 6103(e)(10) for partnership, . . . or Subchapter S returns which are discussed in this IRM . . .

The Manual then turns to a discussion of the persons to whom returns and return information may be disclosed, and the circumstances under which the disclosures can take place, beginning with partners.

Returns and return information of a partnership may be disclosed to any person who was a member of the partnership during any part of the period covered by the return. . . . IRC Sec. 6103(e)(10) provides that information to be disclosed cannot include any supporting schedule, attachment, or list that contains third party taxpayer identifying information other than that of the individual making the request for access. A requesting partner cannot receive any Form K-1 or other attachments that include identifying information of other partners or other individuals. The partner can receive only the Form K-1 that pertains to his or her interest in the partnership. See Exhibit 11.3.2-2, which contains detailed guidance about information that can be released to partners seeking access to partnership returns, including schedules that must be restricted or sanitized prior to release . . . .

Before disclosing a partnership’s tax returns, the Manual states that the IRS must verify that the person who has asked for the information was a partner during the requested tax year.

To determine whether a requester was a member of the partnership for the year requested, verify that a schedule K-1 was filed for the requester. . . . It is up to the requester to provide sufficient identifying information for the IRS to verify that he or she is a partner . . . .

The discussion then switches to S corporations. The Manual provides that a Form 1120S may be disclosed to any person who was a shareholder during any part of the period covered by the return requested during which an S corporation election was in effect. Shareholders may receive Subchapter S returns, regardless of the percentage of shares held. However, the Manual notes that:

Not all Schedules K-1 attached to the Sub-Chapter S return (Form 1120S) can be provided in response to a written request for access. Only the Schedule K-1 for the person making the request can be released. Any other schedules or attachments containing other 3rd party information must be sanitized or withheld per IRC §6103(e)(10). See Exhibit 11.3.2-3 for more details about what can be released and what needs to be edited or sanitized prior to release.

As for regular C corporations, the Manual explains that a corporation’s tax return may be disclosed to any bona fide shareholder of record owning 1% or more of the outstanding stock of the corporation. The requester must submit documentation which reasonably demonstrates such ownership. Corporate stock certificates displaying the corporate seal, and a printout from a state regulatory body, such as the Secretary of State’s Office, detailing the total outstanding shares of stock currently in existence, may be used to verify the percentage of ownership. The Manual states that:

If any doubt exists whether the requester meets the 1% threshold, it is permissible to contact the corporation whose information is at issue to determine if they agree that the requester owns at least 1% of its outstanding stock. The requester should be advised and given an opportunity to withdraw their request if the corporation will be contacted.[16]

All facts and circumstances must be obtained and evaluated, the Manual explains, when determining if a shareholder is a bona fide owner of stock. While the Code does not define the term “bona fide,” the Manual states that a shareholder is not considered bona fide if the shares were acquired for the purpose of obtaining the right to inspect the returns of the corporation.[17]

The requirement that a shareholder be bona fide has a direct correlation to the states’ statutory requirements that a shareholder seeking to inspect the books and records of the corporation have a proper purpose to do so. Generally, the “proper purpose” requirement means the purpose for inspection must reasonably relate to the requester’s interests as a shareholder, but must not be adverse to the interests of the corporation whose information will be accessed. Proper purpose does include . . . a situation where the shareholder is a competitor seeking to take over the corporation. The fact that the shareholder is a competitor, even in a hostile takeover situation, does not defeat the shareholder’s statutory right of inspection.

If At First You Don’t Succeed, Persevere

Based on the foregoing, a minority owner of a partnership or of an S corporation, and a 1% shareholder of a C corporation, should be able to obtain from the IRS a copy of the partnership or corporate tax return, notwithstanding the controlling owner’s refusal to share such tax return or to authorize the minority owner to contact the IRS, and notwithstanding what appears to be a lack of knowledge on the part of many IRS employees.

Perhaps some majority owners, if made aware of the minority’s ability to legally obtain such information from the IRS – in spite of their efforts to deny such access – will, instead, provide the information voluntarily, perhaps in the hope of heading off, de-escalating, or resolving any dispute, and certainly in the hope of keeping the IRS out of any dispute.[18]

Alternatively, might the controlling owner act more fairly vis-à-vis the minority owner, at least insofar as their treating with the business entity is concerned, if they realize that the minority owner has it within their power to obtain copies of business tax returns from the IRS, and the terms of those transactions are reflected on such returns?[19] One can only hope.


[1] Beyond inheritance, for example. Speaking of inheritance, it probably results in the death of many a closely held business, at least where there has not been any succession planning, and where there is no well-drafted shareholders’ or partnership agreement. Mom and dad know best? Not always.

[2] Minority owners should insist upon certain safeguards, including, for example:

  • the assurance of receiving some minimum level of regular distributions from the business (at least to cover estimated or annual income taxes in the case of a pass-through entity),
  • being able to put some or all of their equity to the business (at least upon one’s demise), and
  • having a right to vote on certain major business decisions.

[3] A bit of good luck doesn’t hurt either.

[4] This is where a well-drafted shareholders’ or partnership agreement may be vital. Of course, it may also be the reason, in hindsight, that such an agreement was never entered into.

[5] Did you think that only politicians do that sort of thing?

[6] This is a commonly used tool of “oppression” in pass through entities. The minority owner will be subject to income tax, and perhaps employment taxes, whether or not the entity’s profits are distributed to the owners. By withholding distributions from them, the minority owners (especially those that are not even employed by the business) may be forced to use other assets (which they may have to liquidate) to pay their tax liabilities.

[7] To Form 1065 or Form 1120S, as the case may be.

[8] Technically speaking, a partner cannot be an employee of their partnership, though they may be rendering services comparable to one, and for which they are compensated without reference to the profits of the partnership.

[9] Assuming the return is prepared properly and accurately. That’s a whole other story.

[10] IRC Sec. 6103(e)(1)(C) and (D). The return shall also be open to inspection by or disclosure to the attorney in fact authorized in writing by any of the persons described above to inspect the return or receive the information on his behalf.

[11] Including an LLC that is treated as a partnership for tax purposes. Of course, an LLC may elect to be taxed as a corporation.

[12] It should be noted that the information disclosed or inspected must not include any schedule, attachment or list that includes the TIN of a person other than the entity making the return or the person conducting the inspection or to whom the disclosure is made. Thus, for example, a requesting partner cannot receive any Form K-1 or other attachments that include identifying information of other partners.

[13] General Explanation of the Tax Reform Act of 1976, Joint Committee on Taxation, pg. 335.

[14] Why else would one resort to filing Form 4506?

[15] IRM 11.3.2.

[16] It is difficult to reconcile this language with our recent experience with requesting copies of tax returns. The Code, Congress, and the Manual contemplate ready access.

[17] They were not acquired for a business purpose.

[18] As the rabbi’s son says in the first scene of Fiddler on the Roof: “May God bless and keep the czar — far away from us.”

[19] Of course, there is always the possibility of a fraudulent return but, in that case, the controlling owner has much more to worry about than a disgruntled minority owner.

Why Real Property?

It is not unusual for the owners of a closely held business to also own a number of real properties. For example, they may own real property that:

  • headquarters the business;
  • serves as a warehouse for the business;
  • serves as parking for a fleet of vehicles used by the business;
  • they want to keep out of the hands of a competitor;
  • is located in proximity to the business and could be used for future growth;
  • is located in a different geographic region into which the business plans to expands; or
  • serves as a solid investment for excess cash that was generated through the business.

In most cases, the business will occupy the entire property. If the owners have been well-advised, the property is housed in an LLC (not a corporation) of which they (not the business) are the members, while a different entity holds the business and uses the property pursuant to an arm’s-length lease.

Rental Real Estate = Passive Activity?

In many cases, however, the business is not the sole tenant; in some cases, the business does not use the property at all. In those situations, the owners must be alert to the application of the passive loss rules, and the consequences thereof, as illustrated by a recent decision.

Taxpayer ran an architectural business. During Tax Year, he spent 109 hours providing architectural services to Bank and about 540 hours providing similar services to Construction Co.

During Tax Year, Taxpayer owned and managed two residential rental properties: a single building containing four separate apartments, plus a single-family home. He made weekly trips to the properties to ensure that trash bins were set out for collection, cleaned if necessary, and returned to their storage locations. He also performed minor repairs at the properties, coordinated more substantial repairs with a handyman, communicated with the tenants and collected and deposited rent, maintained insurance policies, purchased materials for the properties as needed, paid bills, and kept books and records of his expenses for tax accounting purposes.

Two of the four tenants moved out during Tax Year. As a result, Taxpayer spent additional time coordinating with them as they vacated the apartments, performed extra repair and maintenance work to ready the apartments for new tenants, placed advertisements listing the apartments for rent, and worked with new tenants as they signed leases and moved into the apartments.

Taxpayer was late paying property taxes and insurance premiums on both rental properties during Tax Year. Consequently, he was obliged to spend time negotiating a property tax installment payment plan, and had to work with his mortgage lender to eliminate redundant insurance coverage on the properties.

Tax Return and IRS’s Determination

Taxpayer timely filed IRS Form 1040, U.S. Individual Income Tax Return, for Tax Year. He reported gross receipts from his architectural business as a sole proprietor – on Schedule C, Profit or Loss from Business – offset by various expenses.

He also attached Schedule E, Supplemental Income and Loss, to his tax return, reporting gross rental income from the two properties, offset by expenses that resulted in a net loss from the rental activity, which Taxpayer reported in computing his taxable income.

The IRS determined that Taxpayer’s rental loss deduction was disallowed under the passive activity loss rules,[1] and assessed a deficiency in Taxpayer’s Federal income tax for Tax Year.

Taxpayer petitioned the Tax Court. The sole issue for decision was whether the loss that Taxpayer reported on Schedule E should be disallowed under the passive activity loss limitations.

Court’s Opinion

The Court began by stating that, as a general rule, the IRS’s determination of a taxpayer’s liability in a notice of deficiency is presumed correct, and the taxpayer bears the burden of proving that the determination is incorrect.

Deductions, the Court continued, are a matter of legislative grace, and the taxpayer generally bears the burden of proving entitlement to any deduction claimed. Specifically, a taxpayer must substantiate any deductions claimed by keeping and producing adequate records that enable the IRS to determine the taxpayer’s correct tax liability.

The Court noted that Taxpayer produced an activity log listing the personal services that he performed in managing the rental properties during Tax Year and the time that he spent providing those services. The activity log indicated that he devoted 765 and 372 hours to the management of the two properties, respectively.

Taxpayer also produced records of his email exchanges with his tenants and mortgage brokers (related to his attempts at refinancing the mortgages on the properties), and numerous receipts from home improvement stores and other vendors related to the management of, and repairs undertaken at, the rental properties.

Passive Activity

In determining their taxable income, taxpayers are allowed deductions for certain business and investment expenses. However, the Code generally disallows any deduction for so-called “passive activity” losses.

A passive activity loss is defined as the excess of the aggregate losses from all passive activities for a taxable year over the aggregate income from all passive activities for that year.

A passive activity is any activity that involves the conduct of a trade or business, or an investment activity the expenses of which are deductible as incurred for the production of income, in which the taxpayer does not materially participate.

A passive activity loss may not be used to offset non-passive income (in Taxpayer’s case, the income from his architectural business).

Rental Activities

A rental activity generally is treated as a per se passive activity regardless of whether the taxpayer materially participates. The term “rental activity” generally is defined as any activity where payments are principally for the use of tangible property.

The Code provides special rules for taxpayers engaging in real property businesses. Under these rules, the rental activities of a qualifying taxpayer in a real property trade or business – i.e., a “real estate professional” – are not per se passive activities and, if the taxpayer materially participates in the rental real estate activities, these activities are treated as non-passive activities.

A taxpayer is treated as materially participating in an activity only if the taxpayer is involved in the operations of the activity on a regular, continuous, and substantial basis.[2]

A taxpayer qualifies as a real estate professional during a taxable year if:

  • more than one-half of the personal services performed in trades or businesses by the taxpayer during such taxable year are performed in real property trades or businesses in which the taxpayer materially participates; and
  • the taxpayer performs more than 750 hours of services during the taxable year in real property trades or businesses in which the taxpayer materially participates.[3]

“Personal services” means any work performed by an individual in connection with a trade or business.

In accordance with the flush language of the Code, Taxpayer elected to treat all of his interests in rental real estate as one activity for purposes of the special rule applicable to real estate professionals.

Substantiation

The extent of a taxpayer’s participation in an activity, including evidence of the number of hours that they participate in a real property trade or business, may be established by any reasonable means.

Contemporaneous daily time reports, logs, or similar documents are generally not required – though they should certainly recommended – if the extent of such participation may be established by other reasonable means. Reasonable means may include, but are not limited to, the identification of the services performed over a period of time and the approximate number of hours spent performing such services during such period, based on appointment books, calendars, or narrative summaries.

The Court pointed out that a post-event “ballpark guesstimate” will not suffice to establish the extent of one’s participation.

Although Taxpayer worked about 650 hours providing personal services as an architect during Tax Year, the record, including his activity log and other records, showed that he also spent more than 750 hours providing personal services in connection with the management of the rental properties. Taxpayer also offered credible testimony describing the time and effort that he devoted to both activities during the year. His testimony was largely corroborated with objective evidence, including a rental activity log, receipts for various rental-related expenditures, emails, and other business records.[4]

Considering all the facts and circumstances, the Court found that Taxpayer qualified as a real estate professional during Tax Year, and that his rental real estate activities were regular, continuous, and substantial within the meaning of the passive loss rules.

Thus, the Court concluded, the loss deduction claimed by Taxpayer was not disallowed as a passive loss, and could be applied against Taxpayer’s business income.

Forewarned . . . Means No Surprises

I don’t care for surprises, nor do most business owners, at least insofar as their taxes are concerned.

In order to avoid such surprises, those business owners who also own rental real property that is not related to the owner’s primary business,[5] must be familiar with the limitations imposed by the passive loss rules, and they must be prepared to maintain records of their rental-related activities on a contemporaneous basis.

Although this level of diligence may seem like a chore to the owner, it could provide a commensurate level of certainty as to the tax treatment of the activity and of any losses generated by the activity, not to mention a reduction in the professional fees to be incurred in defending the taxpayer’s return on audit.


[1] The IRS acknowledged in the notice of deficiency that Taxpayer was entitled to deduct $25,000 of the loss in accordance with the exception prescribed in IRC Sec. 469(i). Under this rule, a taxpayer who “actively” participates in rental real estate activities may deduct up to $25,000 per year for related passive activity losses.

[2] IRS Regulations identify various tests to determine whether a taxpayer satisfies the “material participation” requirement.

[3] The term “real property trade or business” means any real property development, redevelopment, construction, reconstruction, acquisition, conversion, rental, operation, management, leasing, or brokerage trade or business.  Taxpayer did not contend that his work as an architect constituted a real property trade or business.

[4] The Court observed that Taxpayer may have exaggerated the number of hours recorded in his rental real estate activity log; for example, the Court disregarded the hours that Taxpayer listed for vehicle maintenance. Nevertheless, the record as a whole showed that Taxpayer spent at least 750 hours managing the rental properties in Tax Year.

[5] In some cases, it may be possible for the business owner to “group” his primary business activity with his related rental activities, provided the two activities constitute an “appropriate economic unit” (for example, because of interdependencies between them), and the rental activity is “insubstantial” in relation to the business activity, or each owner of the business has the same proportionate interest in the rental activity. In this way, the rental activity may avoid being characterized as passive.

Corporate attorneys usually think of trusts as estate planning tools: they are the vehicles through which the owner of a business may pass along to their family a beneficial interest in the business without actually giving them direct ownership in the business. The owner will transfer an equity (often non-voting) interest in the business by either gifting or selling the interest to the trust.[1] The trustee will hold the interest and, in accordance with the terms of the trust agreement – which presumably reflect the owner-grantor’s directions or preferences – the trustee may distribute the trust’s income, and perhaps its corpus, among the beneficiaries of the trust.[2]

The Liquidating Trust

There are many non-estate-planning situations, however, in which a trust may prove to be a useful tool in the hands of a corporate attorney; for example, where it may be difficult to complete the liquidation of a corporate subsidiary into its corporate parent within the statutorily-prescribed three-year period for a tax-free liquidation – for instance, because the subsidiary owns a difficult to sell asset, or has a litigation claim that cannot be resolved within that time frame; in that case, the subsidiary’s final liquidating distribution may be made into a so-called “liquidating trust.”

Such a trust may also be utilized to facilitate the orderly disposition of a debtor-corporation’s assets and the satisfaction of its liabilities. It may also enable shareholders to accelerate a recognition event so as to capture some tax benefit.[3]

In order to qualify as a liquidating trust, the trust at issue must be organized for the primary purpose of liquidating and distributing the assets transferred to it, and its activities must be reasonably necessary to, and consistent with, the accomplishment of that purpose. A liquidating trust will be treated as a trust for tax purposes if it is formed with the objective of liquidating particular assets, and not as an organization having as its purpose the carrying on of a profit-making business which normally would be conducted through business organizations classified as corporations or partnerships.

However, if the liquidation is unreasonably prolonged, or if the liquidation purpose becomes so obscured by business activities, that the declared purpose of liquidation can be said to have been lost or abandoned, the status of the organization will no longer be that of a liquidating trust.

Assuming a liquidating trust is respected as such, it is important to next determine how and to whom the income and gains of the trust will be taxed – this is often no easy feat. A recent IRS ruling considered the tax status of one such trust that was used to facilitate the liquidation of a corporate debtor pursuant to a bankruptcy.

The Bankruptcy Plan

Debtor filed a voluntary petition for relief under Chapter 11 of the Bankruptcy Code, and submitted to the Bankruptcy Court a Plan that was confirmed by the Court.

On the Effective Date, the transactions contemplated by the Plan were consummated. Trust was formed pursuant to the Plan, and was to be governed by the Plan and the Trust Agreement.

Trust was funded with all of Debtor’s assets, other than cash to be distributed by Debtor to cover, for example, certain expenses of administration of the bankruptcy case, certain priority claims, and fees owed to certain creditors’ professionals.

Trust would not hold any operating assets of a going business, a partnership interest in a partnership that held operating assets, or 50% or more of the stock of a corporation with operating assets.

The initial term of Trust was for three years, but the Court granted a three-year extension of the term on the basis that the extension was necessary to analyze and pursue or defend various causes of action, and to investigate, prosecute and/or resolve outstanding disputed claims against Debtor.

Trust Agreement

Pursuant to the provisions of the Trust Agreement, Trust was created for the purpose of liquidating Debtor’s assets, with no objective to continue or engage in the conduct of a trade or business. The Plan provided that the beneficial interests in Trust would be distributed to certain holders of senior notes claims, subordinated notes claims, general unsecured claims, guarantees claims, and preferred equity claims. In addition, the Plan provided that, in the event such claims were fully paid, the interests in Trust would be redistributed to certain holders of other subordinated claims and, after these were paid in full, to certain holders of preferred and common equity interests.

Pursuant to the provisions of the Trust Agreement, Trust would not receive or retain cash in excess of a reasonable amount to meet claims and contingent liabilities (including disputed claims) or to maintain the value of the assets during liquidation. Cash not available for distribution, and cash pending distribution would be held in demand and time deposits, in banks, other savings institutions, or other temporary, liquid assets. Trust was required, under the terms of the Trust Agreement, to distribute to the “beneficiaries” of Trust, at least annually, its net income and all net proceeds from the sale of Trust’s assets, except that Trust could retain an amount of net proceeds or net income reasonably necessary to maintain the value of the property or to meet claims or contingent liabilities.

Continuing Status as a Trust

Trust represented that, from its establishment, it had been formed and operated consistent with the conditions published by the IRS for treatment as a liquidating trust.[4]

Trust represented that the trustee had been working in an expeditious, commercially reasonable manner to monetize the assets transferred to it, to analyze and pursue any valid causes of action, and to investigate, prosecute and/or resolve disputed claims against Debtor.

However, two principal outstanding matters were not concluded and were not expected to conclude timely. Accordingly, Trust represented that it was impossible for it to completely liquidate by its initial extension date.

Under the Trust Agreement, multiple extensions of Trust’s term could be obtained so long as Court approval was obtained prior to the expiration of each extended term, and the extension was necessary to facilitate or complete the recovery and liquidation of Trust assets.

However, if the liquidation was unreasonably prolonged or if the liquidation purpose became so obscured by business activities that the declared purpose of liquidation was lost or abandoned, the status of the organization would no longer be that of a liquidating trust.

The IRS stated that, if warranted by the facts and circumstances, and subject to the approval of the Bankruptcy Court, upon a finding that an extension is necessary to the liquidating purpose of the trust, the term of the trust may be extended for a finite term based on such particular facts and circumstances.

Grantor Trust Status

The Plan and Trust Agreement required all parties, including Debtor, Trust and Trust beneficiaries, to treat the transfer of assets from Debtor to Trust as (i) a transfer of Trust assets (subject to any obligations relating to those assets) directly to Trust beneficiaries and, to the extent Trust assets were allocable to disputed claims, to the reserve established to hold Trust assets allocable to, or retained on account of, such disputed claims, followed by (ii) the transfer by such beneficiaries to Trust of Trust assets (other than Trust assets allocable to the disputed claims) “in exchange” for Trust interests.[5]

Accordingly, the Plan and Trust Agreement provided that Trust beneficiaries would be treated for federal income tax purposes as the grantors[6] and owners of their respective share of Trust assets (other than such Trust assets that were allocable to the reserve for disputed claims), and would file returns for Trust treating it as a grantor trust.

Under the True Code[7], the income of a trust, over which the grantor has retained (or is deemed to have retained) substantial dominion or control (a “grantor trust”), is taxed to the grantor rather than to the trust which receives the income or to the beneficiary (if different from the grantor) to whom the income may be distributed.[8]

Thus, the grantor is treated as the owner of any portion of a trust in which the grantor has a reversionary interest in either the corpus or the income therefrom, if, as of the inception of that portion of the trust, the value of such interest exceeds 5% of the value of such portion. Likewise, the grantor is treated as the owner of that portion of a trust whose income, without the approval or consent of any adverse party is or, in the discretion of the grantor or a non-adverse party, or both may be distributed to the grantor.

Based on the foregoing, the IRS ruled that Trust should be classified for federal income tax purposes as a liquidating trust and, as such, Trust was also a grantor trust for federal income tax purposes, of which the Trust beneficiaries were treated as the owners.

Additionally, based on the facts and circumstances of the case and on the representations made, the IRS ruled that an extension of Trust’s term would not adversely affect the determination that Trust was a liquidating trust.

Takeaway

Although the liquidating trust is probably the form of non-estate-planning trust most often encountered by attorneys in corporate practice, it is hardly the only one.

It is not unusual, for example, for a corporation or a partnership to make a transfer of assets to a trust for a business purpose of the corporation or partnership – as where the transfer is made to secure a legal obligation of the business entity to a third party that is unrelated to the entity.[9] In that case, the corporation or partnership will be treated as the grantor of the trust, and will be taxable on the income and gain recognized by the trust.

Thus, it would behoove the corporate attorney to have at least a passing familiarity with the situations in which trusts may be utilized, and to understand the basic rules governing the income taxation of trusts, their grantors and their beneficiaries.


[1] Attorneys who advise S corporations are generally familiar with the workings of trusts as shareholders.

[2] By keeping the ownership interest out of the hands of family members, the owner-grantor may ensure continued family ownership of the business, provide a source of income for the family, and protect the trust property from the reach of the beneficiaries’ creditors and from the beneficiaries’ own spendthrift habits.

[3] For example, the recognition of a loss by some shareholders of an S corporation in the same year as their recognition of pass-through gain from the corporation’s sale of its assets.

[4] See Rev. Proc. 94-45 for the conditions set by the IRS for issuing advance rulings classifying certain trusts as liquidating trusts.

[5] More accurately, the grantors retained interests in the assets transferred to the Trust.

[6] A “grantor” includes any person that, directly or indirectly, makes a gratuitous transfer of property to a trust. A “gratuitous” transfer is any transfer other than one for fair market value.

[7] As distinguished from the earlier-mentioned bankruptcy code.

[8] IRC Sec. 671 – 679.

[9] Most corporate attorneys have probably heard of the so-called “rabbi trust” that is often used by employers to provide a mechanism by which employers may fund their obligations for deferred compensation owing to key employees. See Rev. Proc. 92-64.

Last week’s post considered the risk assumed by a taxpayer that ignores the plain meaning of a Code provision (the definition of “capital asset”) in favor of a more “rational” – favorable? – interpretation of that provision.

capital assets

This week’s post considers the “plain meaning” of the same section of the Code: the definition of the term “capital asset;” in particular, how one well-advised taxpayer was able to establish, through contemporaneously prepared documents, that they had changed the nature of their relationship to the property at issue.

Why does it Matter?

The Code provides that the gain recognized by an individual from the sale of a “capital asset” held for more than one year shall be taxed as long-term capital gain, at a maximum federal income tax rate of 20%.

It also provides that the gain from the sale of real property used by an individual taxpayer in a “trade or business,” held for more than one year, and not “held primarily for sale in the ordinary course of the taxpayer’s trade or business,” shall be treated as long-term capital gain.

Thus, if real property does not represent a capital asset in hands of an individual taxpayer, and it is held primarily for sale to customers in the ordinary course of the taxpayer’s trade or business, the gain from the sale of the property shall be taxed to the taxpayer as ordinary income, at a maximum federal rate of 37%.

Poor Timing

LLC was formed in the late 1990’s to acquire several contiguous tracts of land (the “Property”), and to develop them into residential building lots and commercial tracts.

The Property was adjacent to other properties that were being developed by other business entities, related to LLC, and LLC’s original plan was to subdivide the Property into residential units for inclusion in the related entities’ development. To that end, LLC entered into a development agreement with City, which specified the rules that would apply to the Property should it be developed.

LLC sold or otherwise disposed of some relatively small portions of the Property, retaining three main parcels for development.

Change in Plans?

As a result of the subprime mortgage crisis, however, LLC’s managers decided that LLC would not attempt to subdivide or otherwise develop the Property. They believed that LLC would be unable to develop, subdivide, and sell residential and commercial lots from the Property because of the effects of the subprime mortgage crisis on the local housing market, and the unavailability of financing for such projects in the wake of the financial crisis.

Instead, they decided that LLC would hold the Property as an investment until the market recovered enough to sell it off. These decisions were memorialized, on a contemporaneous basis, in a written “unanimous consent” that was dated and executed by the managers, as well as in a written resolution that was adopted by the members of LLC to further clarify LLC’s policy.

Thus, between 2008 and 2012, LLC did not develop the three parcels in any way, nor did it list them with any brokers, or otherwise market the parcels.

The Sale

In 2011, an unrelated developer (“Developer”) approached LLC about buying the parcels. LLC sold one of the parcels to Developer in 2011 and the other two in 2012.

One of the sale contracts called for Developer to pay a lump sum to LLC in 2012 for two of the parcels. The contract also listed certain development obligations, almost all of which fell on Developer.

LLC’s Forms 1065, U.S. Return of Partnership Income, for 2012 – and, indeed, for all years – stated that its principal business activity was “Development” and that its principal product or service was “Real Estate”. On its 2012 Form 1065, LLC reported $11 million of capital gain from its sale of one parcel and a $1.6 million capital loss from its sale of the second parcel, and this tax treatment was reflected on the Schedules K-1 issued by LLC to its individual members.

IRS Disagrees

The IRS determined that the aggregate net income from these two sale transactions should have been taxed as ordinary income.

The issue presented to the Tax Court was whether LLC’s sales of the two parcels in 2012 should have been treated as giving rise to capital gains or ordinary income.

The Court began by reviewing the Code’s definition of capital asset: “property held by the taxpayer (whether or not connected with his trade or business),” but excluding “inventory” and “property held by the taxpayer primarily for sale to customers in the ordinary course of his trade or business.”

Factors to Consider

The Court stated that the three principal questions to be considered in deciding whether the gain is capital in character are:

a. Was taxpayer engaged in a trade or business, and, if so, what business?
b. Was taxpayer holding the property primarily for sale in that business?
c. Were the sales contemplated by taxpayer “ordinary” in the course of that business?

The Court also indicated that various factors may be relevant to these inquiries, including the:

i. Frequency and substantiality of sales of property (which the Court noted was the most important factor);
ii. Taxpayer’s purpose in acquiring the property and the duration of ownership;
iii. Purpose for which the property was subsequently held;
iv. Extent of developing and improving the property to increase the sales revenue;
v. Use of a business office for the sale of property;
vi. Extent to which the taxpayer used advertising, promotion, or other activities to increase sales; and
vii. Time and effort the taxpayer habitually devoted to the sales.

Original Intent

The parties agreed that LLC was formed to engage in real estate development; specifically, to acquire the Property and develop it into residential building lots and commercial tracts; LLC’s tax returns, City’s development agreement, LLC’s formation documents, and the testimony of its managers, all showed that LLC originally intended to be in the business of selling residential and commercial lots to customers.

Change in Purpose

But the evidence also clearly showed that, in 2008, LLC ceased to hold the Property primarily for sale in that business, and began to hold it only for investment. LLC’s members decided not to develop the parcels any further, and they decided not to sell lots from those parcels. This conclusion was supported by the testimony of its managers, by their 2008 unanimous consent, and by the members’ resolution. Moreover, from 2008 on, LLC in fact did not develop or sell lots from the Property until 2012.

More particularly, when the main parcels were sold, they were not sold in the ordinary course of LLC’s business:

a. LLC did not market the parcels by advertising or other promotional activities;
b. LLC did not solicit purchasers for the parcels, nor did its managers or members devote any time or effort to selling the property;
c. Developer approached LLC; and
d. Most importantly, the sale of the parcels was essentially a bulk sale of a single, large, and contiguous tract of land to a single seller – clearly not a frequent occurrence in LLC’s ordinary business.

Court Disagrees with the IRS

Because the parcels were held for investment and were not sold as part of the ordinary course of LLC’s business, the Court rejected the IRS’s arguments and held that the net gain from the sales was capital in character.

The IRS argued that the extent of development of the parcels showed that they were held primarily for sale in the ordinary course of LLC’s business. The Court conceded that, from 1998 to sometime before 2008, LLC developed the Property to a certain extent. But it was also clear that, in 2008, LLC’s managers decided not to develop or market the Property as they ordinarily would have.

The Court stated that a taxpayer is “entitled to show that its primary purpose changed” from held-for-sale to held-for-investment. The Court concluded that LLC made such a showing. Any development activity that occurred before the marked change in purpose in 2008 (including whatever was reported on LLC’s earlier returns) was largely irrelevant.

The IRS also argued that the frequency of sales, along with the nature and extent of LLC’s business, showed that gains from the sale of the parcels should be ordinary in character. But LLC’s sales were infrequent, the Court observed, and the extent of its business was extremely limited. After 2008, LLC disposed of the entire Property in just nine sales over eight years (most of which were small sales to related entities). Moreover, the main parcels, sold in 2012, had not been developed into a subdivision when they were sold, and little or no development activity occurred on those parcels for at least three years before the sale.

In sum, after 2008, LLC sold most of its undeveloped Property in a single transaction to a single buyer, Developer, and sold the remainder to related parties.

The IRS suggested that the Court should impute to LLC the development activity which was performed by the parties related to LLC on the other property contiguous to the Property. The IRS did not provide the Court with any legal authority or evidence in support of this position. But, the Court continued, even if one assumed that LLC engaged in substantial development activity on, or in active and continuous sales from, these parcels (by imputation or otherwise), nevertheless – in the absence of a connection between those other parcels and the parcels sold in 2012 – the Court was not persuaded that the bulk sale of the parcels to Developer would have been in the ordinary course of LLC’s alleged development business, considering that all development activity had been halted on these parcels at least three years before the sales at issue and that these parcels were never developed into a subdivision by LLC.

The Court noted, “if a taxpayer who engaged in a high volume subdivision business sold one clearly segregated tract in bulk, he might well prevail in his claim to capital gain treatment on the segregated tract.” That is precisely what happened here, the Court stated; the parcels sold were clearly segregated from the other parcels and were sold in bulk to a single buyer.

Still the IRS argued that the sale generated ordinary income because: the parcels were covered by the development agreement with the City; Developer agreed to develop the parcels; and LLC was to receive certain post-sale payments from Developer whenever certain conditions were met.

The Court found that these facts were either irrelevant or were consistent with investment intent. For example, there would have been no reason for LLC to undo or modify the development agreement with City after deciding not to develop the parcels. There seemed to be little doubt that the highest and best use of the Property was for development into residential and commercial lots. Any buyer would likely have been a developer of some kind. Therefore, the Court continued, maintenance of the development agreement was consistent with both development intent and investment intent.

Next, the IRS pointed out that, on its 2012 Form 1065, LLC listed its principal business activity as “Development” and its principal product or service as “Real Estate”. (Ugh!) Although this circumstance may count against taxpayers to some limited degree, the Court believed that these statements “are by no means conclusive of the issue.” Considering the record as a whole, the Court was inclined to believe that these “stock descriptions” were inadvertently carried over from earlier returns.

Finally, the IRS asserted a schedule of LLC’s capitalized expenses showed that LLC “continued to incur development expenses up until it sold” the land to Developer. But the Court accorded these little weight because the record as a whole clearly showed that the parcels were not developed between 2008 and the sale to Developer. Also, most of the post-2008 expenditures on the schedule of capitalized expenditures were consistent with investment intent.

Therefore, the Court concluded that LLC was not engaged in a development business after 2008 and that it held the two parcels as investments in 2012. Accordingly, LLC properly characterized the gains and losses from the sales of these properties as income from capital assets.

Lessons?

There is no doubt that, as in the case of LLC, a taxpayer’s purpose in holding certain property may change over time, thus affecting the nature of the gain recognized by the taxpayer on the sale of the property.

Of course, the taxpayer has the burden of establishing their purpose for holding the property at the time of the sale. A well-advised taxpayer will seek to substantiate such purpose well before the IRS challenges the taxpayer’s treatment of the gain recognized from the sale.

Indeed, if the taxpayer has, in fact, decided to change their relationship to the property, they should document such change contemporaneously with their decision – while the facts are still fresh and the decision-makers are still alive – including the reasoning behind it, whether as a result of a change in economic conditions, a change of business, or otherwise.

Moreover, they should reflect such change in their dealings with the property and throughout their subsequently filed tax returns. Why give the taxing authorities an easy opening on the basis of which to wrest an unnecessary concession?

What Does It Mean?

The Tax Cuts and Jobs Act[1] has now been in effect for fifty days. During this relatively brief period, many tax professionals have pored over the statutory language, as well as the Joint Explanatory Statement issued by Congress, and, in the process, have found provisions that are in need of clarification. “That doesn’t make sense” or “that could not have been intended” are among the phrases that often accompany discussions of these provisions.[2]

2018 Tax Cuts and Jobs Act

These observations are usually followed by calls for legislative “technical corrections,” or for regulatory and other guidance from the IRS. It is as yet uncertain when such legislation or guidance will be forthcoming.[3]

A recent Court of Appeals decision, however, should serve as a reminder that it could be dangerous to ignore the text of a statutory provision that yields a result that one may believe was “clearly” not intended by Congress.

Termination of Contract Rights

Taxpayer purchased commercial real property (“Property”). Although Taxpayer ultimately hoped to sell Property for a profit, it hired a third party to operate Property in the meantime.

About one year later, Taxpayer reached an agreement to sell Property to another company at a significant profit. Over the next two years – during which Taxpayer continued to operate Property – the parties amended the contract several times, eventually finalizing the purchase price, and including a 25% nonrefundable Deposit that was paid immediately to Taxpayer, and that would thereafter be credited toward the purchase price at closing.[4] Unfortunately, the buyer defaulted on the agreement and forfeited the Deposit.

On its tax return for the year of the default, Taxpayer reported the Deposit as long-term capital gain. The IRS, however, determined that Taxpayer should have reported the amount of the forfeited Deposit as ordinary income.

Taxpayer petitioned the U.S. Tax Court, asserting that the Code was meant to prescribe the same tax treatment for gains related to the disposition of “trade-or-business” property regardless of whether the property was successfully sold or the sale agreement was canceled.

The IRS responded that the plain text of the governing Code provision distinguished between consummated and terminated sales of trade-or-business property, providing capital-gain treatment only for the former.

The Tax Court agreed with the IRS, holding that under the Code’s unambiguous language Taxpayer couldn’t treat the forfeited Deposit as capital gain.

Taxpayer appealed to the Eleventh Circuit.

Thus Spoke the Court[5]

Both Taxpayer and the IRS agreed that if the sale of Property had gone through as planned, the Deposit – which, under the contract, would have been applied toward the purchase price – would have been taxed at the lower capital-gains rate. The Code provides that “any recognized gain on the sale or exchange of property used in the trade or business” shall “be treated as long-term capital gain.”[6] The Code goes on to specify that, for purposes of this provision, the “term ‘property used in the trade or business’ means property used in the [taxpayer’s] trade or business, of a character which is subject to the allowance for depreciation …, held for more than 1 year, and real property used in the trade or business, held for more than 1 year …”

The parties stipulated that Property was properly classified as real property used in Taxpayer’s trade or business. Accordingly, it was undisputed that if Taxpayer had sold Property, the resulting income, including the Deposit, would have been taxed as long-term capital gain.

But the deal fell through, and Taxpayer did not sell Property. Accordingly, the tax treatment of the Deposit was governed by a different section of the Code[7] which provides, in relevant part, as follows:

Gain or loss attributable to the cancellation, lapse, expiration, or other termination of … a right or obligation … with respect to property which is (or on acquisition would be) a capital asset in the hands of the taxpayer … shall be treated as gain or loss from the sale of a capital asset.

Thus, any gain or loss that results from the termination of an agreement to buy or sell property that is properly classified as a “capital asset” will, notwithstanding the termination, be treated as a gain or loss from a consummated sale. This rule ensures capital-gain treatment of income resulting from canceled property sales by relaxing the “sale or exchange” element of the Code’s general definition of “long-term capital gain” – i.e., “gain from the sale or exchange of a capital asset held for more than 1 year ….”[8]

According to the Court, this rule applies only to property that is classified as a “capital asset.” The Court’s analysis, therefore, turned on whether Property was a capital asset in Taxpayer’s hands during the relevant tax year.

“As a matter of plain textual analysis,” the Court began, “the answer to the question whether [Property] was a ‘capital asset’ couldn’t be clearer.” The Code defines the term “capital asset” in a way that “expressly excluded” Property from status as a capital asset; specifically, the Code states that “the term ‘capital asset’ means property held by the taxpayer (whether or not connected with his trade or business), but does not include, [among other things,] real property used in his trade or business.”[9]

This definition of “capital asset, the Court noted, reflects almost precisely the definition of the term “property used in the trade or business,” examined above.[10] “There is, however, a decisive difference,” the Court continued, “which cuts to the very heart of this case: Whereas Section 1231’s definition, which applies to consummated sales of trade or business property, expressly prescribes capital-gains treatment of the resulting income, Section 1221’s definition, which applies to terminated sales of such property, expressly proscribes capital-gains treatment.”

Because Taxpayer’s sale transaction fell through, the controlling question, the Court stated, was whether Property was real property used in Taxpayer’s trade or business.

Taxpayer and the IRS stipulated that, from the date that Taxpayer acquired Property through the year at issue, Property was used by Taxpayer in a trade or business. Accordingly, Taxpayer “conceded that [Property] . . . was not a capital asset.”

“That concession,” the Court observed, “was fatal,” because it leads to the conclusion that the rule which treats the income realized on the termination of a sale contract as capital gain did not apply to the Deposit.

Taxpayer to Court: “That’s Not Fair”

In response, Taxpayer asserted that the Court’s plain-text reading of the Code impermissibly yielded a result that was “absurd.”

First, Taxpayer noted that while all “agree that, had the sale of [Property] been completed, the [Deposit] would have been … applied toward the purchase price and, thus, treated as capital gain,”[11] it made no sense that the same Deposit “must be treated as ordinary income because the parties terminated the [c]ontract rather than completing it,”[12] especially given that it was not Taxpayer’s fault that the sale did not occur.

Second, Taxpayer complained that the exclusion of trade-or-business property from capital-gain treatment on the cancellation of a contract for the sale of such property “effectively penalize[d]” taxpayers “for operating a trade or business as opposed to being a passive investor in real property,” in which case (as with a consummated transaction) any resulting income would receive capital-gain treatment.

For both reasons, Taxpayer insisted that the only rational way to read the Code was “to give the termination of a contract the same tax treatment afforded a sale or exchange of the property underlying the contract in order to eliminate differing tax treatment of economically equivalent transactions.”

The Court disagreed. The supposed anomalies that Taxpayer posited – between completed and canceled transactions, and between active managers and passive investors – may seem a little odd, the Court stated, but they did not yield such an “absurd” result that the straightforward application of the statutory text should not be respected, particularly given that, when the sale fell through, Taxpayer got to keep not only the Deposit (albeit at an ordinary-income tax rate) but also Property.

Taxpayer also insisted that a plain-text reading of the Code’s interlocking provisions actually “ignore[d] the clear purpose behind the enactment” of the provision[13] that treated the cancellation of a sale contract as the economic equivalent of a sale, which Taxpayer said “was to ensure that taxpayers receive the same tax characterization of gain or loss whether the underlying property is sold or the contract to which the property is subject is terminated.”

The problem with Taxpayer’s argument, the Court pointed out, is that the Code’s plain language forecloses it. If an asset – like Property – is “real property used in a trade or business,” then by definition it is not a “capital asset” within the meaning of the “cancellation-of-contract” provision.  The definitions of “property used the trade or business” and “capital asset” are mutually exclusive; while one provision expressly prescribes capital-gains treatment of such income, the other expressly forbids capital gains treatment of the same property.

The Court stated that in a contest between clear statutory text and evidence of sub- or extra-textual “intent,” the former must prevail. As a formal matter, it is of course only the statutory text, the Court continued, that is “law” in the constitutional sense; and as a practical matter, “conscientious adherence to the statutory text best ensures that citizens have fair notice of the rules that govern their conduct, incentivizes Congress to write clear laws, and keeps courts within their proper lane.”[14]

Accordingly, Taxpayer was not entitled to treat the Deposit as capital gain.

Harsh Result?

I don’t think so, especially given that Taxpayer got to keep the Deposit and Property. Moreover, the Court’s reading was wholly consistent with the plain language of the Code.

The lesson, of course, as we await clarification, correction, and guidance from Congress and the IRS regarding many provisions of the Tax Cuts and Jobs Act, is to proceed with caution, to avoid assumptions that are more hopeful than grounded on objective fact, to voice our opinions and concerns as tax professionals, and to keep abreast of developments in Washington.


[1] Pub. L. 115-97.

[2] See, for example, the apparent denial of a plaintiff’s deduction for legal fees incurred in pursuing a sexual harassment claim, the settlement of which includes a non-disclosure provision. “What we do in haste, . . .”

[3] The IRS announced recently that proposed regulations would be issued by the end of 2018, and final regulations by mid-2019. The Ways and Means Committee are supposedly gathering, and filtering through, the feedback given by tax professionals, but there has been no indication of when any substantive and/or technical changes will be proposed, let alone made.

[4] Under an “open transaction” theory, the recognition and treatment of such a deposit await the consummation or failure of the sale.

[5] No, I’m not getting metaphysical on you.

[6] IRC Sec. 1231.

[7] IRC Sec. 1234A.

[8] Sale of a Contract: Capital Gain or Ordinary Income?

[9] IRC Sec. 1221(a)(2).

[10] See FN 6, FN 9, and accompanying texts.

[11] Under IRC Sec. 1231. See FN 6.

[12] Under a plain-text reading of IRC Sections 1221 and 1234A.

[13] IRC Sec. 1234A.

[14] The Court observed, that even if Congress really did mean for Section 1234A to reach beyond “capital assets” as defined in Section 1221 to include Section-1231 property, “it’s not our place or prerogative to bandage the resulting wound. If Congress thinks that we’ve misapprehended its true intent – or, more accurately, that the language that it enacted in I.R.C. §§ 1221 and 1234A inaccurately reflects its true intent – then it can and should say so by amending the Code.”

Passing Through Losses

There is a problem that will sometimes plague the shareholders of an S corp that is going through challenging financial times. Whether because of a downturn in the general economy or in its industry, whether because of stiff competition or poor planning, the S corp is suffering operating losses. As if this wasn’t disturbing enough, the corporation may have borrowed funds from a bank or other lender, including its shareholders, in order to fund and continue its operations.

Because the S corp is a “pass-through entity” for tax purposes – meaning, that the S corp is not itself a taxable entity but, rather, its “tax attributes,” including its operating losses – flow through to its shareholders and may be used by them in determining their individual income tax liability.

Although this is generally the case, there are a number of limitations upon the ability of a shareholder of an S corp to utilize the corporation’s losses. Under the first of these limitations, the corporate losses which may be taken into account by a shareholder of the S corporation – i.e., his pro rata share of such losses – are limited to the sum of the shareholder’s adjusted basis in his stock plus his basis in any debt of the corporation that is owed to the shareholder.[1] Any losses in excess of this amount are suspended and are generally carried forward until such time as the shareholder has sufficient basis in his stock and/or debt to absorb such excess.[2]

Over the years, shareholders who are aware of this limitation have tried, in various ways – some more successful than others – to generate basis in an amount sufficient to allow the flow-through of a shareholder’s pro rata share of the S corp’s losses.[3]

As for those shareholders who became aware of the limitation only after the fact, well, they have often put forth some creative theories to support their entitlement to a deduction based upon their share of the S corp’s losses. Today’s blog will consider such a situation, as well as the importance – the necessity – of maintaining accurate records and of memorializing transactions.

Creative Accounting?

Taxpayer was a real estate developer who held interests in numerous S corps, partnerships, and LLCs. One of these entities was Corp-1, which had elected “S” status, and in which Taxpayer held a 49% interest.

In 2004, Corp-1 sought to purchase real property out of a third party’s bankruptcy. The court approved the sale to Corp-1, but required that Corp-1 make a significant non-refundable deposit. To raise funds for his share of the deposit, Taxpayer obtained a personal loan from Bank of approximately $5 million, which were transferred into Corp-1’s escrow account to cover half of the required deposit.

During the tax years at issue, Corp-1 had entered into hundreds of transactions with various partnerships, S corps, and LLCs in which Taxpayer held an interest (collectively, the “Affiliates”). The Affiliates regularly paid expenses (such as payroll costs) on each other’s or on Corp-1’s behalf to simplify accounting and enhance liquidity. The payor-company recorded these payments on behalf of its Affiliates as accounts receivable, and the payee-company recorded such items as accounts payable.[4]

For a given taxable year, CPA – who prepared the tax returns filed by Taxpayer, Corp-1 and the Affiliates –would net Corp-1’s accounts payable to its Affiliates, as shown on Corp-1’s books as of the preceding December 31, against Corp-1’s accounts receivable from its Affiliates. If Corp-1had net accounts payable as of that date[5], CPA reported that amount as a “shareholder loan” on Corp-1’s tax return and allocated a percentage of this supposed Corp-1 indebtedness to Taxpayer, on the basis of Taxpayer’s ownership interests in the various Affiliates that had extended credit to Corp-1.

In an effort to show indebtedness from Corp-1 to Taxpayer, CPA drafted a promissory note whereby Taxpayer made available to Corp-1 an unsecured line of credit at a fixed interest rate. According to CPA, he would make an annual charge to Corp-1’s line of credit for an amount equal to Taxpayer’s calculated share of Corp-1’s net accounts payable to its Affiliates for the preceding year.

But there was no documentary evidence that such adjustments to principal were actually made, or that Corp-1 accrued interest annually on its books with respect to this alleged indebtedness. Moreover, there was no evidence that Corp-1 made any payments of principal or interest on its line of credit to Taxpayer. And there was no evidence that Taxpayer made any payments on the loans that Corp-1’s Affiliates extended to Corp-1 when they transferred money to it or paid its expenses.

The IRS Disagrees with the Loss Claimed

In 2008, Corp-1 incurred a loss of $26.6 million when banks foreclosed on the property it had purchased in 2004. Corp-1 reported this loss on Form 1120S, U.S. Income Tax Return for an S Corporation. It allocated 49% of the loss to Taxpayer on Schedule K-1.

Taxpayer filed his federal individual income tax returns for 2005 and 2008. On his 2005 return, he reported significant taxable income and tax owing. On his 2008 return, he claimed an ordinary loss deduction of almost $11.8 million.[6] This deduction reflected a $13 million flow-through loss from Corp-1 ($26.6 million × 49%), netted against gains of $1.2 million from two other S corporations in which Taxpayer held interests.

After accounting for other income and deductions, Taxpayer reported on his 2008 return an NOL of almost $11.8 million. He claimed an NOL carryback of this amount from 2008 to 2005.[7] After application of this NOL carryback, his original tax liability for 2005 was reduced and the IRS issued Taxpayer a refund.

After examining Taxpayer’s 2005 and 2008 returns, however, the IRS determined that his basis in Corp-1 was only $5 million; i.e., the proceeds of the Bank loan that Taxpayer contributed to Corp-1. Accordingly, the IRS disallowed, for lack of a sufficient basis, $8 million of the $13 million flow-through loss from Corp-1 that Taxpayer claimed for 2008.

After disallowing part of the NOL for 2008, the IRS determined that Taxpayer’s NOL carryback to 2005 was a lesser amount, and the refund granted was thereby excessive; consequently the Taxpayer owed tax for that year. The IRS sent Taxpayer a timely notice of deficiency setting forth these adjustments, and he petitioned the Tax Court for redetermination.

The IRS agreed that Taxpayer was entitled to basis of $5 million in Corp-1, corresponding to funds that Taxpayer personally borrowed from Bank and contributed to Corp-1.

Taxpayer contended that he had substantial additional basis in Corp-1 by virtue of the inter-company transfers between Corp-1 and its Affiliates.

The Code

The Code generally provides that the shareholders of an S corp are taxed currently on its items of income, losses, deductions, and credits, regardless of actual distributions.

However, it also provides that the amount of losses and deductions taken into account by the shareholder may not exceed the sum of: (1) the adjusted basis of the shareholder’s stock in the S corp, and (2) the adjusted basis of any indebtedness of the S corp to the shareholder.

Any disallowed loss or deduction is treated as incurred by the corporation in the succeeding taxable year with respect to the shareholder whose losses and deductions are limited. Once the shareholder increases his basis in the S corp[8], any losses or deductions previously suspended become available to the extent of the basis increase.

The Code does not specify how a shareholder may acquire basis in an S corp’s indebtedness to him, though the courts have generally required an “actual economic outlay” by the shareholder before determining whether the shareholder has made a bona fide loan that gives rise to an actual investment in the corporation. A taxpayer makes an economic outlay sufficient to acquire basis in an S corporation’s indebtedness when he “incurs a ‘cost’ on a loan or is left poorer in a material sense after the transaction.” The taxpayer bears the burden of establishing this basis.

It does not suffice, however, for the shareholder to have made an economic outlay. The term “basis of any indebtedness of the S corporation to the shareholder” means that there must be a bona fide indebtedness of the S corp that runs directly to the shareholder.

Whether indebtedness is “bona fide indebtedness” to a shareholder is determined under general Federal tax principles and depends upon all of the facts and circumstances.

In short, the controlling test dictates that basis in an S corp’s debt requires proof of “bona fide indebtedness of the S corporation that runs directly to the shareholder.”

The Tax Court

Taxpayer argued that Corp-1’s Affiliates lent money to him and that he subsequently lent these funds to Corp-1.[9]

Taxpayer contended that transactions among the Corp-1 Affiliates should be recast as loans to the shareholders (including himself) from the creditor companies, followed by loans from the shareholders (including himself) to Corp-1. The IRS’s regulations, Taxpayer argued, recognize that back-to-back loans, if they represent bona fide indebtedness from the S corp to the shareholder – i.e., they run directly to the shareholder – can give rise to increased basis.

The Court responded that the corollary of this rule is that indebtedness of an S corp running “to an entity with passthrough characteristics which advanced the funds and is closely related to the taxpayer does not satisfy the statutory requirements.” “[T]ransfers between related parties are examined with special scrutiny,” the Court noted, and taxpayers “bear a heavy burden of demonstrating that the substance of the transactions differs from their form.”

For example, the Court continued, courts have rejected the taxpayer contention that loans from one controlled S corp (S1) to another controlled S corp (S2) were, in substance, a series of dividends to the shareholder from S1, followed by loans from the shareholder to S2, holding that the taxpayer may not “easily disavow the form of [his] transaction”. Similarly, courts have upheld the transactional form originally selected by the taxpayer and have given no weight to an end-of-year reclassification of inter-company loans as shareholder loans.

The Court rejected Taxpayer’s “back-to-back loan” argument. No loan transactions were contemporaneously documented. The funds paid by a Corp-1 Affiliate as common paymaster were booked as the payment of Corp-1’s wage expenses. And the other net inter-company transfers reflected hundreds of accounts payable and accounts receivable, which went up and down depending on the various entities’ cash needs.

These inter-company accounts were recharacterized as loans to shareholders only after the end of each year, when CPA prepared the tax returns and adjusted Corp-1’s book entries to match the “shareholder loans” shown on those returns. None of these transactions was contemporaneously booked as a loan from shareholders, and Taxpayer failed to carry the “heavy burden of demonstrating that the substance of the transaction[s] [differed] from their form.”

Even if the transactions were treated as loans, the Court pointed out, Corp-1’s indebtedness ran to its Affiliates, not directly to Taxpayer. The monies moved from one controlled company to another, without affecting Taxpayer’s economic position in any way. The was true for the Corp-1 wage expenses that an Affiliate, in its capacity as common paymaster, paid on Corp-1’s behalf; and the same was true for the net inter-company payments, which Corp-1 uniformly booked as accounts payable to its Affiliates. The Affiliates advanced these funds to Corp-1, not to Taxpayer; and to the extent Corp-1 repaid its Affiliates’ advances, it made the payments to its Affiliates, not to Taxpayer.

The Court determined that there was simply no evidence that Corp-1 and its Affiliates, when booking these transactions, intended to create loans to or from Taxpayer. CPA’s adjustments to a notional line of credit, uniformly made after the close of each relevant tax year, did not suffice to create indebtedness to Taxpayer where none in fact existed.

A taxpayer, the Court observed, may not “easily disavow the form of [the] transaction” he has chosen. The transactions at issue took the form of transfers among various Corp-1 Affiliates, and the Court found that Taxpayer did not carry his burden of proving that the substance of the transactions differed from their form. Unlike the $5 million that Taxpayer initially borrowed from Bank and contributed to Corp-1, he made no “actual economic outlay” toward any of the advances that Corp-1’s Affiliates extended to it.

Accordingly, the Court found that none of the inter-company transactions mentioned above gave rise to bona fide indebtedness from Corp-1 to Taxpayer.

Thus, the Court concluded that the IRS properly reduced Taxpayer’s allowable NOL carryback to 2005, and the Taxpayer had to return a portion of the refund received for that year.

Affiliates

How many of you have examined an entry on a corporate or partnership tax return, and have wondered what it could possibly be? The entry usually appears in the line for “other expenses,” “other assets,” or “other liabilities.”[10]

With luck, there is a notation beside the entry that directs the reader to “See Statement XYZ.”[11] You flip to the back of the return, to Statement XYZ, only to see that the entry is described as an amount owed to an unidentified “affiliate,” or as an amount owed by an unidentified “affiliate.”

Then there are the times when, as in the case described above, there are several identified affiliated companies, and they have a number of “amounts owed” and “amounts owing” among them, including situations in which one affiliate is both a lender and a borrower with respect to another affiliated entity.[12] As you try to make any sense of all the cash flows, you wish you had a chart.[13]

And, in fact, I have heard “advisers” explain that the entries are intentionally vague so as to be “flexible,” and to make it more difficult for an agent to discern what actually happened.

At that point, I tell the taxpayer, “Find yourself another tax return preparer.”

As we have said countless times on this blog, always assume that the taxing authorities will examine the return. Always treat with related parties as if they were unrelated parties. A transaction should have economic substance, and it should be memorialized accordingly. If the taxpayer or his adviser would rather not have the necessary documents prepared, they should probably not engage in the transaction.


[1] Assuming the shareholder has sufficient basis to utilize his full share of the corporation’s losses, his ability to deduct those losses on his income tax return may still be limited by the passive activity loss rules of IRC Sec. 469 and by the at-risk rules of IRC Sec. 465. For taxable years beginning on or after January 1, 2018 and ending on or before December 31, 2025, there is an additional limitation, on “excess business losses,” which is applied after the at-risk and passive loss rules.

[2] The losses that pass through to the shareholder reduce his stock basis and then his debt basis; thus, a subsequent distribution in respect of the stock, or a sale of the stock, will generate additional gain; similarly, the repayment of the debt would also result in gain recognition for the shareholder-lender. IRC Sec. 1368, 1001, 1271.

[3] For example, by making new capital contributions or loans, or by accelerating the recognition of income.

[4] During the years at issue, Corp-1’s Affiliates made payments in excess of $15 million to or on behalf of Corp-1. Corp-1 repaid its Affiliates less than $6 million of these advances.

[5] On December 31 of each year, Corp-1’s books and records showed substantial net accounts payable to its Affiliates.

[6] On Form 4797, Sales of Business Property. IRC Sec. 1231(a)(2): net Sec. 1231 gains are capital; net Sec. 1231 losses are ordinary.

[7] Prior to the Tax Cuts and Jobs Act of 2017, Pub. L. 115-97, a taxpayer could ordinarily carry an NOL back only to the two taxable years preceding the loss year. However, prompted by the financial crisis and at the direction of Congress, the IRS, for taxable years 2008 and 2009, allowed “eligible small businesses” to elect a carryback period of three, four, or five years. Taxpayer made this election for 2008. After the 2017 legislation, the carryback was eliminated, and an NOL may be carried forward indefinitely, though the carryover deduction for a taxable year is limited to 80% of the taxpayer’s taxable income for the year. Query the impact of the Act’s elimination of a struggling company’s ability to carry back its losses to recover tax dollars and badly needed cash.

[8] Debt basis is restored before stock basis.

[9] Taxpayer also advanced a second theory to support his claim to basis beyond the amount the IRS allowed. Under this argument (which the Court rejected), he lent money to the Corp-1 Affiliates and they used these funds to pay Corp-1’s expenses. Taxpayer referred to this as the “incorporated pocketbook” theory.

[10] Never in the line for “other income.” Hmm.

[11] Indeed, the form itself directs the taxpayer to attach a statement explaining what is meant by “other.”

[12] Polonius would have a fit.

[13] Of course, more often than not, the return does not reflect any actual or imputed interest expense or interest income.

We’ve all heard about the profits that publicly-held U.S. corporations have generated overseas, and how those profits have, until now, escaped U.S. income taxation by virtue of not having been repatriated to the U.S.

It should be noted, however, that many closely-held U.S. corporations are also actively engaged in business overseas, and they, too, have often benefited from such tax deferral.

What follows is a brief description of some of the rules governing the U.S. income taxation of the foreign business (“outbound”) activities of closely-held U.S. businesses, and the some of the important changes thereto under the Tax Cuts and Jobs Act.[1]

Taxation of Foreign Income

U.S. persons[2] are subject to tax on their worldwide income, whether derived in the U.S. or abroad.

In general, income earned directly (or that is treated as earned directly[3]) by a U.S. person from its conduct of a foreign business is subject to U.S. tax on a current basis; for example, the income generated by the U.S. person’s branch in a foreign jurisdiction.

However, income that is earned indirectly, through the operation of a foreign business by a foreign corporation (“FC”), is generally not subject to U.S. tax on a current basis; instead, the foreign business income earned by the FC generally is not subject to U.S. tax until the income is distributed as a dividend to a U.S. owner.[4]

CFC Anti-Deferral Regime

That being said, the controlled foreign corporation (“CFC”) anti-deferral regime may cause a U.S. owner of a CFC to be taxed currently in the U.S. on its pro rata shares of certain categories of income earned by the CFC (“Subpart F income”) regardless of whether the income has been distributed as a dividend to the U.S. owner.

A CFC generally is defined as any FC if U.S. persons own (directly, indirectly, or constructively) more than 50% of the corporation’s stock (measured by vote or value), taking into account only those U.S. persons that are “U.S. Shareholders” – i.e., U.S. persons who own at least 10% of the CFC’s stock (which, prior to the Act, was measured by vote only).

In effect, the U.S. Shareholders of a CFC are treated as having received a current distribution of the CFC’s Subpart F income[5], which includes foreign base company income, among other items of income.

“Foreign base company income” includes certain categories of income from business operations, including “foreign base company sales income,” and “foreign base company services income,” as well as certain passive income.

The U.S. Shareholders of a CFC also are required to include currently in income, their pro rata shares of the CFC’s untaxed earnings that are invested in certain items of U.S. property, including, for example, tangible property located in the U.S., stock of a U.S. corporation, and an obligation of a U.S. person.[6]

Several exceptions to the definition of Subpart F income, including the “same country” exception, may permit continued deferral for income from certain business transactions.[7] Another exception is available for any item of business income received by a CFC if it can be established that the income was subject to an effective foreign income tax rate greater than 90% of the maximum U.S. corporate income tax rate.[8]

A U.S. Shareholder of a CFC may also exclude from its income any actual distributions of earnings from the CFC that were previously included in the shareholder’s income.

The Act

For the most part, the Act did not change the basic principles of the CFC regime; these anti-deferral rules will continue to apply[9], subject to certain amendments.

However, the Act also introduced some significant changes to the taxation of certain U.S. persons who own shares of stock in FCs.

CFCs

The Act amended the ownership attribution rules so that certain stock of a FC owned by a foreign person may be attributed to a related U.S. person for purposes of determining whether the U.S. person is a U.S. Shareholder of the FC and, therefore, whether the FC is a CFC.[10] For example, a U.S. corporation may be attributed shares of stock owned by its foreign shareholder.

The Act also expanded the definition of U.S. Shareholder to include any U.S. person who owns 10% or more of the total value – as opposed to 10% of the vote – of all classes of stock of a FC. It also eliminated the requirement that a FC must be controlled for an uninterrupted period of 30 days before the inclusion rules apply.

Dividends Received Deduction (“DRD”)

The Act introduced some new concepts that are aimed at encouraging the repatriation of foreign earnings by U.S. taxpayers; stated differently, it removes an incentive for the overseas accumulation of such earnings.[11]

The keystone provision is the DRD, which allows an exemption from U.S. taxation for certain foreign income by means of a 100% deduction for the foreign-source portion of dividends received from specified 10%-owned FCs by regular domestic C corporations[12] that are U.S. Shareholders of those FCs.

In general, a “specified 10%-owned FC” is any FC with respect to which any domestic corporation is a U.S. Shareholder.[13]

The term “dividend received” is intended to be interpreted broadly. For example, if a domestic corporation indirectly owns stock of a FC through a partnership, and the domestic corporation would qualify for the participation DRD with respect to dividends from the FC if the domestic corporation owned such stock directly, the domestic corporation would be allowed a participation DRD with respect to its distributive share of the partnership’s dividend from the FC. In addition, any gain from the sale of CFC stock that would be treated as a dividend would also constitute a dividend received for which the DRD may be available. That being said, it appears that a deemed dividend of subpart F income from a CFC will not qualify for the DRD.

In general, the DRD is available only for the foreign-source portion of dividends received by a domestic corporation from a specified 10%-owned FC; i.e., the amount that bears the same ratio to the dividend as the undistributed foreign earnings bear to the total undistributed earnings of the FC.[14]

The DRD is not available for any dividend received by a U.S. Shareholder from a FC if the FC received a deduction or other tax benefit from taxes imposed by a foreign country. Conversely, no foreign tax credit or deduction is allowed for any taxes paid or accrued with respect to any portion of a distribution treated as a dividend that qualifies for the DRD, including any foreign taxes withheld at the source.[15]

It should be noted that a domestic C corporation is not permitted a DRD in respect of any dividend on any share of FC stock unless it satisfies a holding period requirement. Specifically, the share must have been held by the U.S. corporation for at least 366 days during the 731-day period beginning on the date that is 365 days before the date on which the share becomes ex-dividend with respect to the dividend. The holding period requirement is treated as met only if the specified 10%-owned FC is a specified 10%-owned FC at all times during the period and the taxpayer is a U.S. Shareholder with respect to such specified 10%-owned foreign corporation at all times during the period.

Transitional Inclusion Rule[16]

In order to prevent the DRD from turning into a “permanent exclusion rule” for certain U.S. corporations with FC subsidiaries, the accumulated earnings of which have not yet been subject to U.S. income tax – and probably also to generate revenue – the Act requires that any U.S. Shareholder (including, for example, a C corporation, as well as an S corporation, a partnership, and a U.S. individual) of a “specified FC” include in income its pro rata share of the post-1986 deferred foreign earnings of the FC.[17] The inclusion occurs in the last taxable year beginning before January 1, 2018.[18]

This one-time mandatory inclusion applies to all CFCs, and to almost all other FCs in which a U.S. person owns at least a 10% voting interest. However, in the case of a FC that is not a CFC, there must be at least one U.S. Shareholder that is a U.S. corporation in order for the FC to be a specified FC.

The deferred foreign earnings of such a FC are based on the greater of its aggregate post-1986 accumulated foreign earnings as of November 2, 2017[19] or December 31, 2017, not reduced by distributions during the taxable year ending with or including the measurement date.[20]

A portion of a U.S. taxpayer’s includible pro rata share of the FC’s foreign earnings is deductible by the U.S. taxpayer, thereby resulting in a reduced rate of tax with respect to the income from the required inclusion of accumulated foreign earnings. Specifically, the amount of the deduction is such as will result in a 15.5% rate of tax on the post-1986 accumulated foreign earnings that are held in the form of cash or cash equivalents, and an 8% rate of tax on those earnings held in illiquid assets. The calculation is based on the highest rate of tax applicable to U.S. corporations in the taxable year of inclusion, even if the U.S. Shareholder is an individual.[21]

Installment Payments

A U.S. Shareholder may elect to pay the net tax liability resulting from the mandatory inclusion of a FC’s post-1986 accumulated foreign earnings in eight equal installments. The net tax liability that may be paid in installments is the excess of the U.S. Shareholder’s net income tax for the taxable year in which the foreign earnings are included in income over the taxpayer’s net income tax for that year determined without regard to the inclusion.

An election to pay the tax in installments must be made by the due date for the tax return for the taxable year in which the undistributed foreign earnings are included in income. The first installment must be paid on the due date (determined without regard to extensions) for the tax return for the taxable year of the income inclusion. Succeeding installments must be paid annually no later than the due dates (without extensions) for the income tax return of each succeeding year.[22]

The Act also provides that if (1) there is a failure to pay timely any required installment, (2) there is a liquidation or sale of substantially all of the U.S. Shareholder’s assets, (3) the U.S. Shareholder ceases business, or (4) another similar circumstance arises, then the unpaid portion of all remaining installments is due on the date of such event.

S corporations

A special rule permits continued deferral of the transitional tax liability for shareholders of a U.S. Shareholder that is an S corporation. The S corporation is required to report on its income tax return the amount of accumulated foreign earnings includible in gross income by reason of the Act, as well as the amount of the allowable deduction, and it must provide a copy of such information to its shareholders. Any shareholder of the S corporation may elect to defer his portion of this tax liability until the shareholder’s taxable year in which a prescribed triggering event occurs.

This shareholder election to defer the tax is due not later than the due date for the return of the S corporation for its last taxable year that begins before January 1, 2018 (i.e., by March 15, 2018 for an S corporation with a taxable year ending December 31, 2017).

Three types of events may trigger an end to deferral of the tax liability: (i) a change in the status of the corporation as an S corporation; (ii) the liquidation, sale of substantially all corporate assets, termination of the of business, or similar event; and (iii) a transfer of shares of stock in the S corporation by the electing taxpayer, whether by sale, death or otherwise, unless the transferee of the stock agrees with the IRS to be liable for tax liability in the same manner as the transferor.[23]

If a shareholder of an S corporation has elected deferral, and a triggering event occurs, the S corporation and the electing shareholder are jointly and severally liable for any tax liability and related interest or penalties.[24]

In addition, the electing shareholder must report the amount of the deferred tax liability on each income tax return due during the period that the election is in effect.[25]

After a triggering event occurs, a shareholder may be able elect to pay the net tax liability in eight equal installments, unless the deferral-ending triggering event is a liquidation, sale of substantially all corporate assets, termination of the company or end of business, or similar event, in which case the installment payment election is not available, and the entire tax liability is due upon notice and demand.[26]

Observations

As stated earlier, many closely-held U.S. companies (“CH”) are engaged in business overseas, and many more will surely join them.

Although the Act ostensibly focused on the tax deferral enjoyed by large, publicly-traded multinationals, its provisions will also have a significant impact on CH that do business overseas.

Regardless of its form of organization, a CH has to determine fairly soon the amount of its 2017 U.S. income tax liability resulting from the inclusion in income of any post-1986 accumulated foreign earnings of any CFC of which it is a U.S. Shareholder.

Similarly, in the case of any FC of which the CH is a U.S. Shareholder, but which is not a CFC, the CH must determine whether there is a U.S. corporation (including itself) that is a U.S. Shareholder of the FC. If there is, then the CH will be subject to the mandatory inclusion rule for its share of the FC’s post-1986 accumulated foreign earnings.

The CH and its owners will then have to determine whether to pay the resulting income tax liability at once, in 2018, or in installments.

Of course, if the CH is an S corporation, each of its shareholders will have to decide whether to defer the tax liability until one of the “triggering event” described above occurs.

After the mandatory inclusion rule has been addressed, the CH may decide whether to repatriate some of the already-taxed foreign earnings.

Looking forward, if the CH is a regular C corporation, any dividends it receives from a FC of which it is a U.S. Shareholder may qualify for the DRD.

C corporation CHs that may be operating overseas through a branch or a partnership may want to consider whether incorporating the branch or partnership as a FC, and paying any resulting tax liability, may be warranted in order to take advantage of the DRD – they should at least determine the tax exposure.

Still other CHs, that may be formed as S corporations or partnerships, must continue to be mindful of the CFC anti-deferral regime.

It’s a new tax regime, and it’s time for old dogs to learn new “tricks.” Woof.


[1] Pub. L. 115-97 (the “Act”). We will not cover the “minimum tax” provided under the new “base erosion” rules applicable to certain U.S. corporations – those with more than $500 million of average annual gross receipts – that make certain payments to related parties.

[2] Including all U.S. citizens and residents, as well as U.S. partnerships, corporations, estates and certain trusts. For legal entities, the Code determines whether an entity is subject to U.S. taxation on its worldwide income on the basis of its place of organization. For purposes of the Code, a corporation or partnership is treated as domestic if it is organized under U.S. law.

[3] As in the case of a U.S. partner in a partnership that is engaged in business overseas.

[4] It should be noted that certain foreign entities are eligible to elect their classification for U.S. tax purposes under the IRS’s “check-the-box” regulations. As a result, it is possible for such a foreign entity to be treated as a corporation for foreign tax purposes, but to be treated as a flow-through, or disregarded, entity for U.S. tax purposes; the income of such a hybrid would be taxed to the U.S. owner.

[5] Prior to the Act, and subject to certain limitations, a domestic corporation that owned at least 10% of the voting stock of a FC was allowed a “deemed-paid” credit for foreign income taxes paid by the FC that the domestic corporation was deemed to have paid when the related income was distributed as a dividend, or was included in the domestic corporation’s income under the anti-deferral rules.

[6] This inclusion rule is intended to prevent taxpayers from avoiding U.S. tax on “dividends” by repatriating CFC earnings through non-dividend payments, such as loans to U.S. persons.

[7] For example, the CFC’s purchase of personal property from a related person and its sale to another person where the purchased property was produced in the same foreign country under the laws of which the CFC is organized.

[8] This rate was 35% prior to the Act; the Act reduced the rate to 21%, which should make it easier for some CFCs to satisfy this exception. In that case, the U.S. Shareholder of a CFC will not be subject to the CFC inclusion rules – in other words, it can continue to enjoy tax deferral for the foreign earnings – if the foreign corporate tax rate is at least 19%; i.e., 90% of 21%. This will benefit U.S. persons who otherwise do not qualify for the DRD, discussed below.

[9] For example, CFCs should continue to refrain from guaranteeing their U.S. parent’s indebtedness.

[10] The pro rata share of a CFC’s subpart F income that a U.S. Shareholder is required to include in gross income, however, will continue to be determined based on direct or indirect ownership of the CFC, without application of the new attribution rule.

[11] This moves the U.S. toward a “territorial” system under which the income of foreign subsidiaries is not subject to U.S. tax.

[12] The DRD is available only to regular C corporations. As in the case of dividends paid by U.S. corporations to individuals or to an S corporation, no DRD is available to such shareholders.

[13] Query whether the DRD, combined with the new 21% tax rate for C corporations will encourage U.S. corporations that have substantial foreign operations to remain or become C corporations and to operate overseas only through foreign subsidiary corporations. Unfortunately, the Act also denies non-recognition treatment for the transfer by a U.S. person of property used in the active conduct of a trade or business to a FC.

[14] “Undistributed earnings” are the amount of the earnings and profits of a specified 10%-owned FC as of the close of the taxable year of the specified 10%-owned FC in which the dividend is distributed. A distribution of previously taxed income does not constitute a dividend.

[15] In this way, the Act seeks to avoid bestowing a double benefit upon the U.S. taxpayer; however, foreign withholding tax may prove to be a costly item.

[16] See IRS Notice 2018-13 for additional guidance.

[17] Any amount included in income by a U.S. Shareholder under this rule is not included a second time when it is distributed as a dividend.

[18] Beware, calendar year taxpayers.

[19] The date the Act was introduced.

[20] The portion of post-1986 earnings and profits subject to the transition tax does not include earnings and profits that were accumulated by a FC prior to attaining its status as a specified FC.

[21] A reduced foreign tax credit is also allowed.

[22] If installment payment is elected, the net tax liability is not paid in eight equal installments; rather, the Act requires lower payments for the first five years, followed by larger payments for the next three years. The timely payment of an installment does not incur interest.

[23] Partial transfers trigger the end of deferral only with respect to the portion of tax properly allocable to the portion of stock sold.

[24] The period within which the IRS may collect such tax liability does not begin before the date of an event that triggers the end of the deferral.

[25] Failure to include that information with each income tax return will result in a penalty equal to five-percent of the amount that should have been reported.

[26] The installment election is due with the timely return for the year in which the triggering event occurs.