It is said that repetition is the mother of all learning. It is also said that insanity is repeating the same mistake and expecting a different result. It is my hope that the result of the former will overwhelm the source of the latter before it is too late.

However, based upon the seemingly continuous flow of decisions from the Tax Court rejecting taxpayers’ characterization of their outlays of funds as indebtedness, it may be a forlorn hope.

What follows is a summary of one especially ill-advised or misguided taxpayer.

Debts and Distributions

Taxpayer was the sole shareholder of S-Corp.[i] The corporation operated a mortgage broker business. It acted as an intermediary between borrowers and lenders; it did not hold any loans itself. https://www.ustaxcourt.gov/USTCInOP/OpinionViewer.aspx?ID=11650

Bad Debts?

In Tax Year, S-Corp. to make a series of advances to Borrower. The advances were made by checks, credit card payments, and wire transfers. Each advance was recorded on S-Corp.’s general ledger as a loan receivable from Borrower.

Borrower did not execute any notes for the advances received during Tax Year. The advances were unsecured, and neither S-Corp. nor Taxpayer made a public filing to record a debt in connection with the advances. Taxpayer did not know the business activities that Borrower conducted.

An adjusting entry in S-Corp.’s general ledger for December 31 of Tax Year reflected that Taxpayer instructed that the loan receivable for the Tax Year advances be written off.

On its return for Tax Year, S-Corp. claimed a large deduction for bad debts; the debt deduction was attributable to a write off for advances made to Borrower.

S-Corp.’s trial balance for the following tax year reflected that it made another loan to Borrower in that year. Taxpayer claimed not to know the purpose for that advance.

“Bad” Distributions?

As S-Corp.’s president and sole shareholder, Taxpayer authorized distributions to himself during the two years in issue. In Tax Year, Taxpayer received total distributions in excess of $1.6 million. In the following year, he received distributions in excess of $2 million.

For the years in issue, S-Corp. reported ordinary business losses, based in part on the bad debt deduction claimed for the advances made to Borrower. Taxpayer claimed S-Corp.’s losses on the Schedules E, Supplemental Income and Loss, Part II, Income or Loss from Partnerships and S Corporations, attached to his Forms 1040, U.S. Individual Income Tax Return. He engaged the same CPA firm to prepare S-Corp.’s returns and his individual returns for the years in issue.

For the years in issue, S-Corp. reported on its returns the distributions to Taxpayer. It issued Schedules K-1, Shareholder’s Share of Income, Deductions, etc., for Taxpayer that reflected the distributions and reported them as “[i]tems affecting shareholder basis”.

Taxpayer did not report any of the distributions that he received from S-Corp. for the years in issue on his individual returns.

The IRS Disagrees

The IRS examined Taxpayer’s income tax returns for the years in issue, and then issued a notice of deficiency in which it: (i) disallowed the full amount of S-Corp.’s claimed bad debt deduction for Tax Year – this adjustment flowed through to Taxpayer and was reflected as an increase to the income reported on his Schedule E; and (ii) determined that Taxpayer had unreported long-term capital gains for the years in issue.

Taxpayer petitioned the U.S. Tax Court.

Bad Debt Deduction

The Code allows a deduction for a taxable year for any debt that becomes wholly worthless within the taxable year. To deduct a business bad debt, the taxpayer must establish the existence of a valid debtor-creditor relationship, that the debt was created or acquired in connection with a trade or business, the amount of the debt, the worthlessness of the debt, and the year that the debt became worthless.

The IRS contended, and the Court agreed, that Taxpayer failed to establish any of these elements as they relate to the advances made by S-Corp. to Borrower during Tax Year.

A bad debt is deductible only for the year in which it becomes worthless. The Court explained that the subjective opinion of the taxpayer that the debt is uncollectible, without more, is not sufficient evidence that the debt is worthless.

The Court observed that Taxpayer failed to present any evidence that the alleged debt was objectively worthless in Tax Year. He testified only as to his subjective belief. Taxpayer did not identify any events during Tax Year which showed that the alleged debt was uncollectible. He testified that Borrower told him early in the following year that he could not repay the Tax Year advances, but he offered no reasoning as to why in that case the alleged debt should be treated as being worthless at the end of Tax Year.

Even accepting Taxpayer’s uncorroborated testimony, Borrower’s statement early in the following year was not enough to establish that the alleged debt to S-Corp. was objectively worthless at the end of Tax Year. Taxpayer did not describe any actions taken to try to collect the alleged debt, and he testified that he did not know whether Borrower was actually insolvent in the following year. Moreover, there was no reasonable explanation for advancing more funds to Borrower the next year if the prior advances were deemed totally unrecoverable.

Bona Fide Debt?

Taxpayer also failed to establish that the advances constituted a bona fide debt – “a valid and enforceable obligation to pay a fixed or determinable sum of money” – and that the parties intended to create a bona fide debtor-creditor relationship. Generally a debtor-creditor relationship exists if the debtor genuinely intends to repay the loan and the creditor genuinely intends to enforce repayment.

Factors indicative of a bona fide debt include: (1) whether the purported debt is evidenced by a note or other instrument; (2) whether any security was requested;

(3) whether interest was charged; (4) whether the parties established a fixed schedule for repayment; (5) whether there was a demand for repayment; (6) whether any repayments were actually made; and (7) whether the parties’ records and conduct reflected the transaction as a loan.

Borrower did not execute any notes, and Taxpayer did not request any collateral or other security for the advances. Taxpayer did not provide any documents reflecting the terms for the purported loan.

Apart from the way that the advances were recorded in S-Corp.’s general ledger, the parties’ conduct did not reflect that the advances were intended as a bona fide loan. S-Corp. made a series of unsecured advances to Borrower, and as the balance of the advances rapidly increased S-Corp. did not receive any offsetting payments or obtain any guaranties of repayment. Taxpayer did not claim that he and Borrower agreed to a schedule for repaying the advances or that he ever demanded repayment. Rather, he contended that he determined that the advances were uncollectible as of the end of Tax Year, only 10 days after the last advance had been made and without making any efforts to collect the amounts allegedly owed. He testified that by early the next year, he believed Borrower would not be able repay the advances, but he continued to direct S-Corp. to advance him more funds.

Taxpayer contended that he had a “good-faith expectation” that Borrower would repay him. He testified about his prior business dealings with Borrower, but the objective evidence and the preponderance of all evidence suggested that Taxpayer had no genuine intention of requiring Borrower to repay the advances. The real purpose of the advances remained unexplained.

The Court was not persuaded that a bona fide debt was created. It held that Taxpayer had failed to establish whether and when the advances became worthless or that the advances should even be considered a bona fide debt for tax purposes. Accordingly, the Court sustained the IRS’s determination to disallow the bad debt deduction in full.

Distributions from S-Corp.

The IRS contended that Taxpayer failed to report capital gains from the distributions that he received from S-Corp., during the years in issue. According to the IRS, the distributions were in excess of Taxpayer’s adjusted basis in S-Corp’s stock.

Under the Code, a shareholder of an S corporation takes into account their pro rata share of the corporation’s items of income, loss, deduction, or credit for the corporation’s taxable year ending with or in the shareholder’s taxable year. The Code also provides that a shareholder’s basis in their stock of the S corporation is increased by items of income passed through to the shareholder, and decreased by passed through items of loss and deduction. A shareholder’s stock basis is also decreased by distributions received from the S corporation that are not includible in the shareholder’s income. A distribution is not included in the gross income of a shareholder to the extent that it does not exceed the shareholder’s adjusted basis for the stock. The portion of a distribution that exceeds this adjusted basis is treated as gain from the sale or exchange of property.

Taxpayer contended that he did not take distributions in excess of basis. He claimed that he was personally liable to S-Corp. for the distributions that he received during the years in issue because he received them in violation of State law. Under State law, Taxpayer claimed, a shareholder who knowingly receives any distribution that exceeds the amount of the corporation’s retained earnings immediately prior to the distribution is liable to the corporation for the amount so received. For each of the years in issue, S-Corp.’s tax return reflected that it had negative retained earnings.

At this point, one might have expected Taxpayer to characterize the erstwhile “distributions” as loans from the corporation; after all, if his description of the result under State law was accurate, the funds had to be returned. However, Taxpayer instead contended that his liability to S-Corp. under State law “increased his debt basis in the corporation.” How this would have been relevant in determining the proper tax treatment of the distributions made to Taxpayer is anyone’s guess.

The Court stated that Taxpayer had misinterpreted the Code in arguing that his purported obligation to repay the distributions created debt basis. The Court then pointed out that even if Taxpayer established that he had basis in some bona fide indebtedness of S-Corp., it would not affect the taxability of the distributions that he received. The Court pointed out that the Code’s S-corporation-distribution provisions do not identify distributions that decrease a shareholder’s stock basis as an item to be applied to a shareholder’s debt basis after the stock basis has been reduced to zero.

The Court agreed with the IRS that the distributions had to be reported as income and treated as capital gain to the extent that they exceeded Taxpayer’s basis in S-Corp.’s stock. Taxpayer did not dispute the IRS’s calculations of his stock basis for the years in issue. Thus, the Court sustained the determination that Taxpayer had unreported capital gain for the years in issue.

Another One Bites the Dust

Taxpayer did not fare well, but he received his “just deserts.” He totally failed to establish that the advances to Borrower were real debts. The disallowance of the bad debt deduction claimed by Taxpayer resulted in an increase of his “flow-through” S corporation income and, thereby, an increase in his basis for his S-Corp. stock.

The interplay of the disallowed bad debt deduction for Tax Year, and the tax treatment of the distribution made to Taxpayer that year, affords us an opportunity to consider the order in which stock basis is increased or decreased under the Code, and the importance thereof.

The taxability of a distribution and the deductibility of a loss are both dependent on stock basis; for this reason, there is an ordering rule in computing stock basis. Under this rule – which favors tax-free distributions over currently deductible losses – stock basis is adjusted annually, as of the last day of the S corporation’s tax year, in the following order:

  1. Increased for income items;
  2. Decreased for distributions;
  3. Decreased for non-deductible, non-capital expenses; and
  4. Decreased for items of loss and deduction.

When determining the taxability of a distribution, the shareholder looks solely to their stock basis; debt basis is not considered, as Taxpayer learned.

Thus, there was a “silver lining” in the denial of Taxpayer’s loss deduction in that his stock basis was increased, thereby sheltering some of the distribution from S-Corp. – small comfort, though, because he recognized more ordinary income in exchange for less capital gain. Oh well.

 

[i] The corporation was always treated as an S corporation for tax purposes, and had no earnings and profits accumulated from the operations of any C corporation tax years.

Metamorphosis      [i]

By now, most readers have heard about the benefits and pitfalls of “checking the box” or of failing to do so. Of course, I am referring to the election afforded certain unincorporated business entities to change their status for tax purposes. Thus, for example, an LLC with one or more members – which is otherwise treated as a disregarded entity or as a partnership – may elect to be treated as an association taxable as a corporation; an association that has one member may elect to be treated as an entity that is disregarded for tax purposes, while an association with at least two members may elect to be treated as a partnership.

Each of these elections triggers certain income tax consequences of which its owners have to be aware prior to making the election; for instance, an association that elects to be treated as a disregarded entity or as a partnership is treated as having undergone a liquidation, which may be taxable to the entity and to its owner(s).

Although incorporated entities are not eligible to check the box, they may nevertheless desire to change their tax status – i.e., the legal form through which they conduct business[ii]; for example, they may, instead, want to operate as a partnership; conversely, a partnership may desire to “incorporate.” The conversion of a corporation into a partnership constitutes a taxable liquidation, while the incorporation of a partnership may generally be accomplished on a tax-deferred basis.

Stemming Abuse

But what if a business wanted to preserve its flexibility to change its tax status by switching from one form of legal entity to another, depending upon the circumstances?

The IRS foresaw that the ability to change the tax status of a business whenever it suited the owners to do so may lead to abuse. Thus, the check-the-box rules provide that an eligible entity may not elect, as a matter of right, to change its status more than once within any five-year period; similarly, a corporation that loses or revokes its “S” corporation status may not, without the permission of the IRS, elect to again be treated as an S corporation for five years.

“Swapping” Bodies[iii]

A recent Tax Court decision involved a limited liability partnership (“LLP”) that actually shifted its business (“Business”) into a professional corporation (“PC”) – it did not check the box – then, about five years later, shifted it back to LLP. In making these shifts, the owners of these business entities – who remained the same – kept both entities in existence notwithstanding the transfers of Business between them.

Interestingly, the dispute before the Court did not involve the income tax consequences arising from the “conversion” but, rather, the overpayment of employment taxes by LLP and the underpayment of such taxes by PC.

In Year One, four individuals engaged in Business through LLP. In Year Two, they operated through LLP for only two weeks, at which point they commenced operations through newly-formed PC (a C-corporation).

Although LLP ceased conducting ongoing operations, it was maintained for the purpose of collecting revenues, satisfying liabilities, and distributing profits related to LLP’s work.

PC conducted Business from that point forward through the end of Year Two. LLP paid wages to its employees for the first quarter of Year Two (“Quarter”), but the employment tax deposits it made for that period exceeded the wages paid.

The employees who were paid wages by LLP for the first two weeks of Quarter received the balance of their wages during Quarter from PC. Although PC’s general ledger recorded the employment tax deposits made, its payroll services provider that made the employment tax deposits, erroneously submitted them under LLP’s EIN.

The IRS credited LLP’s account for the employment tax deposits made by LLP; it also recorded that LLP timely filed a Form 941, Employer’s Quarterly Federal Tax Return. However, the IRS’s account for PC recorded no employment tax deposits or filings for Quarter.

The IRS’s account transcripts for LLP’s three remaining quarters for Year Two indicated that LLP had neither filed Forms 941 nor reported any employment tax liabilities for those quarters, while PC’s account transcripts for the same quarters indicated that PC had timely filed Forms 941 and made employment tax deposits for each quarter.

In Year Five, Business was again moved to LLP, while PC was kept alive in order to collect receivables, satisfy payables, and distribute profits relating to PC’s work. Hmm.

Tax Deficiency?

In Year Seven, the IRS notified PC that there was no record of PC’s having filed a Form 941 for Quarter. PC used its general ledger to prepare the Form 941, which reported the correct amount of employment tax due, and claimed a credit for employment tax deposits made, on the basis of entries in PC’s general ledger for wages paid and employment tax deposits made. The IRS assessed the employment taxes reported as due but did not credit PC with the employment tax deposits claimed.

PC thereafter sought to correct the Form 941 filed by LLP, claiming adjustments for LLP’s overpayment of employment taxes for Quarter based on the wages actually paid and the amounts actually owing thereon. PC also requested that a credit be applied to its employment tax liability for Quarter.

The IRS informed PC that a credit for LLP’s claimed overpayment could not be applied as requested because the period of limitations for claiming a refund had expired.

PC contended that the Quarter’s employment tax liability the IRS sought to collect had been previously paid by LLP, a related entity, which entitled PC to a credit, refund, setoff or equitable recoupment for the asserted liability.

PC explained that, through the error of its payroll service provider, PC’s employment tax deposits during Quarter had been remitted under the EIN of LLP, an entity through which the business had previously conducted its operations. PC further contended that PC should be credited with the Quarter’s deposits that had been erroneously submitted under LLP’s EIN through equitable recoupment.

In addition, PC tried to explain why both LLP and PC had been maintained as active entities during Year Two and thereafter, with each entity being used at various times to conduct the bulk of Business’s operations.

The IRS concluded that (i) PC had failed to sufficiently explain the continued active status of LLP, and (ii) because PC and LLP were both active entities, it would not be appropriate to allow PC to offset any of its employment tax liability with deposits LLP had made.

Equitable Recoupment

PC petitioned the Tax Court for review of the IRS’s determination. The issue for decision was whether PC was entitled to offset its unpaid employment tax liability for Quarter with the employment tax that LLP overpaid for Quarter.

“Long story short,” as they say, the Tax Court found that PC was entitled to offset the employment tax liability that the IRS sought to collect from it with the overpayment of employment tax made by LLP for the same period, the refund of which was time-barred. Without this offset, the Court stated, the IRS would have twice collected the employment taxes for Quarter arising from the payment of wages to the employees of Business: once from the deposits made under LLP’s EIN for Quarter, and a second time from the proposed levy on PC’s property.

The Court explained that the judicially-created doctrine of equitable recoupment applied to PC’s situation.[iv] In coming to that conclusion, the Court considered the documentary evidence submitted by PC regarding the organizational history of Business, including its alternating use of LLP and PC as its principal operating entity, with the other entity maintained for the purpose of collecting revenues and paying liabilities arising from past work. This alternating use, the Court observed, was substantiated with copies of each entity’s income tax returns for several years, demonstrating that the bulk of Business’s income was received through only one of the two entities in any given year.

According to the Court, when each entity’s general ledger for Quarter was compared to the IRS’s corresponding account transcripts, they conclusively established PC’s equitable recoupment claim. Specifically, the general ledgers demonstrated that PC was the source of the employment tax payments for Quarter that created LLP’s overpayment, and PC paid the wages that gave rise to the employment tax liability that was paid under LLP’s EIN.

Shape-Shifting, At Will?

The Court’s decision was all well and good for PC’s and LLP’s owners.

But what about the shifting of Business from LLP to PC, and then back to LLP? Specifically, what about the income tax consequences resulting from the “incorporation” of LLP and the “liquidation” of PC? The Court made no mention of these whatsoever, which begs several question.

Did the LLP liabilities assumed or taken subject to by PC exceed the adjusted bases of the assets “contributed” by LLP to PC? Did the fair market value of PC’s assets exceed their adjusted bases, or the owners’ adjusted bases for their shares of PC stock? The decision does not indicate whether LLP, PC, or their owners reported any gain on the transfer of “Business” between PC and LLP.

Indeed, was there any transfer of assets at all, other than a transfer of employees? Is that why the-then existing receivables and payables remained with LLP in Year Two and with PC in Year Five?

Did LLP’s/PC’s tangible personal properties remain in one entity, and were these leased or subleased to the other entity when Business was shifted to that entity? Was the real property they occupied leased or subleased between them? Was a market or below-market rate charged for the use or assignment? Or were these properties sold or exchanged for consideration?

What about projects that were ongoing at the time of the shift – how were these handled? What about the goodwill associated with Business – how was it transferred? Or did the goodwill reside with the individual owners of LLP and PC (so-called “personal goodwill”), and not with the entities?

Of course, these issues were not before the Court, but the “identity of interest” among PC, LLP, and their owners underpinned the Court’s decision. It is clear from the decision that LLP and PC operated a single Business, that their owners were identical, that the entities used the same name (but for the “PC” versus “LLP” designation), and that they employed the same individuals.[v]

What, then, was the impetus for the owners of LLP and PC to shift the operation of Business between the two entities? It wasn’t the nature of a particular project – for example, the complexity of the project, or the degree of liability exposure – after all, only one entity was active at any one time; the owners did not assign some projects to LLP and others to PC. Was there another business reason at work? Or was the shifting based upon some undisclosed tax considerations?

Whatever the reasons for LLP’s and PC’s actions, the owners of a closely held business should not think, based upon the underlying facts of the above decision, that they may freely, and without adverse tax consequences, shift the operation of a single business between two commonly-controlled entities simply by “turning off” one entity and “turning on” the other. The use of “successor” entities to a single business without a significant change in beneficial ownership of the business is an invitation to trouble with the IRS.

Indeed, even the allocation of projects among two or more commonly-controlled entities engaged in a single business may generate adverse tax results.

The owners should first consider why they would allocate projects – is it only for tax savings, or is there a bona fide business reason? For example, as mentioned above, does one entity engage in one aspect of a business, such as design, while another handles another aspect, such as construction? Or does one entity handle higher-end work, and markets or brands itself accordingly, while the other takes care of “lesser” jobs? Does one entity assume riskier projects and is insured therefor, while the other gets the plain-vanilla assignments?

Assuming there is a bona fide business reason for the allocation of work among the controlled entities, the owners will still have to consider how to allocate the resources of the business among these entities, and for what consideration; for example, if the equipment necessary for the completion of a project resides in an entity other than the one engaged in the project, how will the equipment be made available and at what price; what about employees and overhead, such as office space?

In every case, the owners of the related entities need to consider the business reason for the allocation of work to one entity as opposed to another; then they have to consider the tax consequences thereof and how to deal with them.


[i] Fear not, we’re talking tax, not Kafka.

[ii] By contrast, some entities may seek to change their legal form (for example, switching from a corporation to an LLC as a matter of state law), while maintaining their tax status. Thus, the merger a corporation into an LLC that has elected to be taxed as a corporation may qualify as an F-reorganization; the entity remains a corporation for tax purposes, but it is now governed by the state rules applicable to limited liability companies rather than those applicable to corporations.

[iii] Fear not, we’re talking tax, not “The Exorcist.”

[iv] The doctrine operates as a defense that may be asserted by a taxpayer to raise a time-barred refund claim as an offset to reduce the amount owed on the IRS’s timely claim of a deficiency, thereby preventing an inequitable windfall to the IRS. In general, a taxpayer claiming the benefit of an equitable recoupment defense must establish the following elements: (1) the overpayment for which recoupment is sought by way of offset is barred by an expired period of limitations; (2) the time-barred overpayment arose out of the same transaction, item, or taxable event as the deficiency before the Court; (3) the transaction, item, or taxable event was inconsistently subjected to two taxes; and (4) if the transaction, item, or taxable event involves two or more taxpayers, there is sufficient identity of interest between the taxpayers subject to the two taxes that the taxpayers should be treated as one.

[v] Courts may, in certain circumstances, permit a taxpayer to recoup an erroneously paid tax that the taxpayer did not pay himself. But the payor of the tax and the recipient of the recoupment must have a sufficient identity of interest such that they should be treated as a single taxpayer in equity.

Though LLP and PC were separate legal entities with distinct EINs during Quarter, each was owned by the same individuals during that period. Consequently, the burden of double taxation would be borne by the same individuals. Therefore, PC demonstrated sufficient identity of interest with LLP to allow PC to recoup the employment tax for Quarter that LLP overpaid.

 

 

Will They Ever Learn?

The following probably sounds familiar. You’re meeting with a new client who is being audited by the IRS. The client brings you their federal and state individual income tax returns and the income tax returns for their business entity.

You look at the client’s reported wages and dividends; you look at their Sch. E for information on their S corp. or partnership income; you notice on Part I that they own the real property on which the business operates (thankfully, through a wholly-owned LLC). You check the client’s home address and the property taxes on their home(s) as shown on their Sch. A (pre-2018, of course, at least for now). You see that the question on their N.Y. State return, whether they maintain living quarters in N.Y.C., has been answered in the negative.

Then you turn to their business returns. You review the reported wages or guaranteed payments paid to the client, at the dividends or other distributions paid to the client; you check the balance sheet for loans to or from the client, and at the line for interest received or paid (which you double check with the Sch. B on the client’s individual return – nothing); you look at the statement attached to the return that purports to describe the line on the return for “other deductions” and see that it states simply “other expenses;” you look at the explanatory statements for the lines on the balance sheet for “other assets” and “other liabilities,” and see something like “transactions with affiliate;” you check the depreciation schedules and notice the Range Rover.

Then you turn to the client. You’ve already “googled” them (you hate surprises) – thankfully, nothing exciting. “Thanks for the returns, but I’d also appreciate your books and other records, so I can check them against one another.” You take a deep breath, then ask the question, the answer to which you sometimes dread: “Is there anything I should know regarding the operation of the business that may not be evident from these returns?” “What do you mean?” or “Like what?” are the usual responses.

“Like pulling teeth,” you think to yourself. “For instance,” you say, “how do you determine your salary? Are family members employed? How do you determine the rental? Tell me about these ‘affiliates’ and these transactions. Do you have written agreements and leases? What about promissory notes for the loans on this balance sheet? Do you pay the business for the use of its apartment in the City?” You’re trying to develop a picture, and you’re finding that there is some cause for concern. You didn’t put them in this position, but you resolve that, once this audit is concluded, you will try to put them on the right course going forward.

Unfortunately, there’s always someone who doesn’t appreciate what you’re trying to do for them. Or it may be that they are so set in their ways that a voluntary change in their mode of operation is remote, at best. I imagine the taxpayer in a recent case, described below, as one such person.

Bad to the Bone?

Taxpayer was the sole shareholder of Corp, a C-corporation. On its tax returns, which were signed by Taxpayer as president of Corp, the corporation reported that it had loans from shareholders on its returns for years up to and including Year One, but it did not report the existence of any loans from shareholders after Year One, and no loans from shareholders were shown on Corp’s books and records. Corp did not file any federal tax returns after Year Four, notwithstanding that it had positive earnings and profits.

Corp paid net wages to Taxpayer in years before, and in the first few months of, Year Six. Taxpayer reported wages from Corp on his tax returns through Year Five.

Corp ceased operating in Year Six. Some of the checks issued to Taxpayer from Corp bore the preprinted phrase “Payroll Check” and taxes were withheld from these, while others were not so identified and taxes were not withheld from these.

During Years Six and Seven, Taxpayer endorsed several checks payable to Corp and deposited them into his personal account.

In Year Six, Taxpayer opened a checking account at Bank in the name of Newco. Taxpayer was the only individual with signature authority over the account, and during that year Taxpayer wrote three checks payable to himself from Newco.

Also in Year Six, Taxpayer deposited checks into Newco’s account which represented payment by Corp’s customers for services rendered by Corp.

Taxpayer’s Returns

Taxpayer filed Forms 1040 for Years Six, Seven and Eight. Taxpayer did not provide the C.P.A. who prepared the Year Six return with any verification of the reported amounts of income. The C.P.A. required Taxpayer to sign a letter acknowledging that Taxpayer had provided the C.P.A. with no verification of those amounts; that Corp had gone out of business during Year Six; and that its stock had become worthless in Year Six.

On Schedule D, Capital Gains and Losses, of the Year Six Form 1040, Taxpayer reported a long-term capital loss calculated by reference to Taxpayer’s claimed loan to Corp. Taxpayer carried over the unused portion of the long-term capital loss to the Years Seven and Eight Forms 1040.

The IRS issued a notice of deficiency to Taxpayer for Years Six, Seven and Eight, and Taxpayer timely petitioned the Tax Court.

Tax Court: Loan Repayments, Salary, or Dividends?

The Court began by noting that Taxpayer did not deny that he received payments from Corp in Year Six in the amounts the IRS determined. But Taxpayer contended that these amounts were the nontaxable repayment of loans that he had made to Corp. However, the only evidence in the record of any loans to Corp was Taxpayer’s testimony.

Taxpayer testified that the “payroll checks” he received in Year Six were actually loan repayments because Corp’s supply of general checks was exhausted. The Court disagreed, pointing out that the record showed that some general checks were written after these payments were made using payroll checks.

Taxpayer contended that he made several loans to Corp. However, he claimed a long-term capital loss resulting from only one of them on his Year Six return. Corp reported outstanding “loans from shareholders” on earlier returns, but none after Year One. The Court stated that it did not understand why Taxpayer would have claimed a loss resulting from only one loan if, in fact, he had lent far more than that, or why Corp did not report such outstanding, as it had done in the past, if the loans were genuine.

The IRS interviewed Taxpayer regarding whether he had received wages that were not reported on his return. Taxpayer told the IRS that the only loans he made to Corp were made in the early 1990s. The IRS also interviewed Taxpayer’s bookkeeper and reviewed Corp’s books and records with the bookkeeper. The IRS did not find any record of loans from Taxpayer to Corp after Year One. Moreover, Taxpayer testified that it would not make sense to draft a promissory note to himself when taking money out of his account and depositing it into Corp’s account, because it would be “basically out of one pocket and putting it into another.” Based on the forgoing, the Court concluded that Corp did not have outstanding loans to Taxpayer during the years at issue and that its payments to Taxpayer were salary.

The Court next considered certain other amounts received by Taxpayer from Corp in Years Six and Seven, which the IRS characterized as dividends. Taxpayer did not dispute receiving the payments, but contended that they were loan repayments rather than constructive dividends as claimed by the IRS.

The Court explained that a dividend is “any distribution of property made by a corporation to its shareholders” from its earnings and profits. Funds distributed by a corporation over which the taxpayer/shareholder has dominion and control, the Court explained, are taxed as dividends to the recipient to the extent of the earnings and profits of the corporation. A constructive dividend arises, the Court continued, where a corporation confers an economic benefit on a shareholder without the expectation of repayment, even though neither the corporation nor the shareholder intended a “formal” dividend.

In Year Six, Taxpayer opened a bank account in the name of Newco. The account was controlled solely by Taxpayer. According to the Court, the record revealed no purpose for Newco other than to serve as a conduit to transfer money from Corp to Taxpayer.

About halfway through Year Six, Corp made its final wage payment to Taxpayer. Shortly before that, Taxpayer deposited the first in a series of checks made payable to Corp by Corp’s customers into his own bank account. A while later, Taxpayer deposited checks payable to Corp into Newco’s account. Then Taxpayer wrote checks to himself from the Newco account. The sum of these checks was characterized by the IRS as constructive dividends to Taxpayer. The checks payable to Corp that Taxpayer deposited into his own account and the checks payable to Corp that Taxpayer deposited into Newco’s account represented an economic benefit to Taxpayer, and constituted constructive dividends for Year Six, and the checks written to Corp which Taxpayer cashed or deposited into his account in Year Seven were constructive dividends to Taxpayer for Year Seven.

In determining the amount of the dividends received by Taxpayer, the Court observed that Corp had earnings and profits at the end of Year Four, the last year for which it filed an income tax return. The Court also noted that there was no evidence in the record to show any change to Corp’s earnings and profits before Year Six. Thus, the Court concluded that the distributions were fully taxable.

Finally, the Court considered the long-term capital loss that Taxpayer reported on his Year Six return. His claim for entitlement to that deduction was based on his claim that Corp owed him money.

The C.P.A. who prepared Taxpayer’s Year Six tax return was unable to verify the existence of the claimed loans and asked Taxpayer to sign a statement that the return was based entirely on amounts provided by Taxpayer and his representation of the amounts of outstanding loans.

The Court found that there was no credible evidence that Taxpayer made loans to Corp after Year One, or that there was any outstanding debt from Corp to Taxpayer in Year Six, when Taxpayer reported the loss. Therefore, the Court concluded that Taxpayer was not entitled to the loss claimed for Year Six, or to the capital loss carryforward deductions claimed for the two succeeding years.

Know Your Client

I mentioned something about “googling” the client earlier. It wasn’t a joke. What does the “public record” tell you about the client and their character? We have all encountered clients or potential clients – fortunately, relatively few – who will “shop around” for an answer until they get the right one; i.e., the most favorable, though not necessarily the correct one.

Or we have seen clients like the Taxpayer, who will put anything in writing so as to induce their tax return preparer to sign a return that presents information that cannot be verified and is probably suspect.

At times, the prospect of landing a client, or the pressure to retain one, may feel irresistible. That’s when you need to check that the antennae are functioning properly.

Consider your professional duties and obligations; in particular, given the story of the Taxpayer, the duty to exercise due diligence in preparing and filing tax returns and other documents/submissions with the IRS, and in determining the correctness of representations made to the IRS.

In general, you may rely in “good faith,” and without verification, on information furnished by your client, but you cannot ignore other information that has been furnished to you, or which is actually known by you. You must make reasonable inquiries if any information furnished to you appears to be incorrect, incomplete, or inconsistent with other facts or assumptions.

Related to the duty of due diligence is the directive that you not sign a tax return, or advise a client to take a position on a return, that you know or should know contains a position for which there is no reasonable basis, or that lacks substantial authority, or which is a willful attempt to understate tax liability, or which constitutes a reckless or intentional disregard of rules or regulations.

By following these basic rules, you protect yourself and our system of self-assessment.

Estates and Beneficiaries

I recently encountered a situation in which the so-called “basis consistency” rule was implicated. This rule requires consistency between the estate tax value of a decedent’s property – its fair market value (“FMV”) as reported on the decedent’s estate tax return – that passes to a beneficiary, and the basis claimed by a beneficiary for such property; in general, this means that the “stepped-up” basis of the property in the hands of the beneficiary can be no greater than the FMV of the property reported by the estate to the IRS. The rule is aimed at preventing the government from being whipsawed between a lower valuation of a property for purposes of determining the estate tax attributable to the property, and a higher valuation for purposes of determining the beneficiary’s basis for the property and their income tax consequences on its subsequent disposition.

Prior to the enactment of this rule in 2015, the FMV of a property at the date of the decedent’s death was deemed to be its value as appraised for estate tax purposes: the price at which the property would change hands between a willing buyer and a willing seller, neither being under any compulsion to buy or to sell and both having reasonable knowledge of relevant facts.

However, the value of the property as reported on the decedent’s estate tax return provided only a rebuttable presumption of the property’s basis in the hands of the beneficiary. Thus, unless the beneficiary was estopped by their previous actions or statements with regard to the estate tax valuation, they could rebut the use of the estate’s valuation as their basis in the property by clear and convincing evidence.

What About Corporations and Shareholders?

While considering the application of this rule, I tried to recall whether a similar consistency rule applied between a corporation and its shareholders in the context of an in-kind distribution by the corporation, whether as a current distribution (a dividend or dividend-equivalent), as part of a redemption of stock that is treated as a sale or exchange for tax purposes, or as a liquidating distribution.

In-Kind Distributions, Generally

Under the Code, if a corporation distributes property (other than its own obligation) to a shareholder in respect of their stock in the corporation, and the FMV of the property exceeds its adjusted basis in the hands of the corporation, then gain must be recognized by the corporation in an amount equal to such excess, as if the corporation had sold the property.

Repeal of “General Utilities”

Prior to the enactment of this recognition rule, a corporation was permitted to distribute appreciated property to its individual shareholders without recognizing gain, but the shareholders’ basis for the property would nevertheless be stepped up without any corporate-level tax having been paid.

In repealing this rule, Congress explained that under a double-tax system for corporations, the distributing corporation generally should be taxed on any appreciation in value of property distributed to its shareholders; for example, had the corporation sold the property and distributed the proceeds, it would have been taxed on the gain from the sale.

According to Congress, the result should not be different if the corporation distributed the property to its shareholders and the shareholders then sold it.

Amount Distributed?

At the same time, the courts have rejected the suggestion by many corporate taxpayers – in an attempt to reduce the corporate-level gain – that this corporate-gain-recognition rule requires that the FMV of the property distributed by the corporation must be the same as the FMV of the property received by the shareholders. The courts have noted that the FMV of an entire interest in a property is greater than the sum of its fractional parts (for example, the FMV of a real property distributed by a corporation vs the aggregate value of the various tenancy-in-common interests in the property received by its distributee-shareholders).

Similarly, the rules that address the tax treatment of a shareholder’s receipt of property distributed from a corporation in respect of its stock, including the rule that determines the basis of such property in the hands of the shareholder, refer to the FMV of the property received by the shareholder, not the FMV of the property distributed by the corporation.

Who Decides FMV?

Of course, this begs the question: who determines the FMV of the distributed property?

Is it the corporation? After all, the corporation has to report on its income tax return any gain recognized on the distribution. It must also report on such return the value of any property distributed. The corporation must also issue a Form 1099 to the shareholder.

In the case of an S corporation, the corporation has to determine its gain on the distribution, which it must then allocate among its shareholders; this allocation, as well as the amount distributed to each shareholder, is reflected on the Sch. K-1 issued to each shareholder.

Alternatively, should each shareholder be free to determine the FMV of the property distributed to them? For example, may (or must) a shareholder who already owns an interest in the larger asset of which the distributed property is a part (as where the shareholder and the distributing corporation were co-owners before the distribution) assign a greater value to their distribution if it causes them to become the majority owner of the asset?

Provided the corporation’s determination of FMV is reasonable, it should control; otherwise, each shareholder would be free to determine the FMV of the property received by the shareholder which may result in different values for similarly situated persons and which, in turn, may lead to abuses.

Why an In-Kind Distribution?

Now, you may be wondering, how can this scenario ever occur? Why would a corporation distribute appreciated property to its shareholders and thereby intentionally trigger corporate-level tax and gain? Even if the corporation were in liquidation mode, wouldn’t it sell its properties for cash, rather than distribute them to its shareholders?

Two possible situations come immediately to mind: in the first, the corporation has sufficient net operating loss carryovers to offset a significant part of the corporate-level gain, which allows the corporation to remove the property from corporate solution with one level of tax; in the second, the corporation was going to sell the property anyway, but its shareholders plan to share the proceeds other than in accordance with their stock ownership – by distributing the property to its shareholders, the corporation enables each shareholder to sell its share of the property for the desired consideration.

The following hypothetical illustrates some of the issues that may be encountered under the second situation.

“But I Want More”

S corporation has several shareholders. As an S corporation, it has only one class of stock issued and outstanding. Its governing provisions (including its certificate of incorporation, by-laws, shareholder agreements, and state law) do not contradict the identical rights enjoyed by each share of stock to current and liquidating distributions.

The corporation proposes to make a pro rata, in-kind distribution of non-depreciable property to its shareholders.[1] The FMV of the property, as reasonably determined by the corporation, exceeds the corporation’s adjusted basis for the property. The property constitutes a capital asset in the hands of the corporation, and the corporation has held the property for more than one year.

For tax purposes, the corporation is treated as having sold the property to its shareholders. Under the S corporation rules, the corporation’s long term capital gain from the deemed sale is allocated among, and recognized by, the shareholders in accordance with their stock ownership. The S corporation will issue a Sch. K-1 to each shareholder that reflects the amount of gain allocated to the shareholder and the FMV of the property distributed to the shareholder.[2]

Each shareholder will take the property distributed to them with a starting basis equal to the FMV of such property, and each shareholder will begin a new holding period for such property.

Shortly after receiving their in-kind distribution, the shareholders sell their respective interests in the property to an unrelated buyer. With one exception, each shareholder receives an amount equal to the FMV of their interest in the property as reported to them by the S corporation. Because this amount is also equal to their basis for their respective interests in the property, these shareholders do not realize any gain on the sale to the buyer.

However, one shareholder receives consideration in excess of the FMV of the distribution reported to the shareholder on the Sch. K-1 issued to them by the S corporation.[3]

If the story ended here, this shareholder would recognize short term capital gain (taxable at the rates applicable to ordinary income) equal to the excess of the consideration received for their interest in the property over their basis for such property.[4]

What If?

But what if this shareholder took the position that, based on the amount paid by the buyer, the FMV of the property interest distributed to them was actually greater than the distribution amount reported by the S corporation on the shareholder’s Sch. K-1?

And what if, consistent with this position, the shareholder reported a greater amount of capital gain on their tax return than the amount reported by the corporation on the shareholder’s Sch. K-1 as their share of the gain from the deemed sale of the property?

Finally, what if the shareholder claimed a basis in the distributed property equal to this greater value on which they have been taxed? In that case, the shareholder will not realize any gain on the sale of their interest in the property to the buyer.

By taking a position that differs from the S corporation’s as to the value of the property distributed, will the shareholder have succeeded in converting what would have been short term capital gain into long term capital gain?

Parting Thoughts

As I contemplated this question, I identified a number of issues, with which I will leave you:

  • Should the “extra” consideration received by the one shareholder be treated as having been paid pro rata to all the shareholders, following which they paid over the extra consideration to that shareholder in a separate transaction? If so, how should that payment be treated? Would its tax treatment depend upon the facts and circumstances? For example, should it be treated as a bonus (i.e., compensation)?
  • May the IRS treat the excess payment received by the one shareholder as an additional payment or distribution from the corporation?
  • Depending upon the facts and circumstances, including any agreement among the shareholders, might the arrangement that leads to the one shareholder’s receipt of the extra consideration be interpreted as a second class of stock that would end the corporation’s “S” status?
  • May the one shareholder avoid accuracy-related or fraud penalties by disclosing to the IRS its position as to the FMV of the property distributed? In the case of an S corporation, is the shareholder required to disclose this position as an inconsistent position?
  • What if the sale of the property by the shareholders does not occur for several years? What if the statute of limitations on assessment of any deficiency for the year of the distribution has expired? Would the common law duty of consistency require that the one shareholder be barred from claiming that their basis for the property is greater than the amount of the distribution reported by the S corporation?

In light of the forgoing issues – not to mention several others not set forth above – and in the interest of facilitating the administration and fair application of the tax law, should Congress act to prohibit the shareholders of a corporation – as in the case of the beneficiaries of a decedent’s estate – from claiming a different FMV and basis for the property distributed to them by a corporation, regardless of whether such distribution takes the form of a dividend, a redemption of stock, or a liquidation of the corporation?


[1] If the property were depreciable in the hands of the shareholders, the related party sale rules may apply to treat the gain as ordinary.

[2] Assume that the corporation determines the amount of the distribution made to a shareholder by simply applying the shareholder’s percentage ownership of the corporation to the FMV of the property as a whole – it does not discount the fractional interest received by each shareholder.

[3] Perhaps the one shareholder negotiated a better deal?

[4] Query whether the gain is capital in light of the fact that the shareholders never intended to hold the property except for a brief period prior to its sale.

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.