Earlier this month, the IRS proposed regulations regarding the additional first-year depreciation deduction that was added to the Code by the Tax Cuts and Jobs Act (“TCJA”).[i] The proposed rules provide guidance that should be welcomed by those taxpayers that are considering the purchase of a closely held business or, perhaps, of an interest in such a business, and that are concerned about their ability to recover their investment.

Cost Recovery

In general, a taxpayer must capitalize the cost of property acquired for use in the taxpayer’s trade or business – in other words, the cost must be added to the taxpayer’s basis for the property.[ii] The taxpayer may then recover its acquisition cost (its investment in the property) over time – by reducing its taxable income through annual deductions for depreciation or amortization, depending upon the property.[iii] The recovery period (i.e., the number of years) and the depreciation method (for example, accelerated or straight-line) are prescribed by the Code and by the IRS.

In general, the “net cost” incurred by a taxpayer in the acquisition of a business or investment property will be reduced when such cost may be recovered over a shorter, as opposed to a longer, period of time.

In recognition of this basic principle, and in order to encourage taxpayers to acquire certain types of property, Congress has, over the years, allowed taxpayers to recover their investment in such property more quickly by claiming an additional depreciation deduction for the tax year in which the acquired property is placed in service by the taxpayer.[iv]


Prior to the TCJA, the Code allowed a taxpayer to claim an additional first-year depreciation deduction equal to 50% of the taxpayer’s adjusted basis for “qualified” property.[v]

Qualified property included tangible property with a recovery period of twenty years or less, the original use of which began with the taxpayer.[vi] It did not include a so-called “section 197 intangible,” such as the goodwill of a business.


In general, for property placed in service after September 27, 2017, the TCJA increased the amount of the additional first-year depreciation deduction to 100% of the taxpayer’s adjusted basis for the qualified property.[vii]

Significantly for transactions involving the purchase and sale of a business, the TCJA also removed the requirement that the original use of the qualified property had to commence with the taxpayer.

Specifically, the additional first-year depreciation deduction became available for “used” property, provided the property was purchased in an arm’s-length transaction, it was not acquired in a nontaxable exchange (such as a corporate reorganization), and it was not acquired from certain “related” persons.

Asset Deals

It is axiomatic that the cost of acquiring a business is reduced where the purchaser can recover such cost, or investment, over a short period of time.

By eliminating the “original use” requirement, the TCJA made the additional first-year depreciation deduction available for qualifying “used” properties purchased in connection with a taxpayer’s acquisition of a business from another taxpayer.

Thus, in the acquisition of a business that is structured as a purchase of assets,[viii] where the purchaser’s basis is determined by reference to the consideration paid for such assets, a portion of the consideration that is allocated to qualifying “Class V” assets (for example, equipment and machinery) may be immediately and fully deductible by the purchaser, instead of being depreciated over each asset’s respective recovery period.

The purchaser’s ability to expense (i.e., deduct) what may be a significant portion of the consideration paid to acquire the business will make the transaction less expensive (and, perhaps, more attractive) for the purchaser by reducing its overall economic cost.

Depending on the circumstances, it may also enable the buyer to pay more for the acquisition of the business.[ix]

Beyond Asset Deals?

Although the application of the expanded first-year depreciation deduction was fairly obvious in the case of a purchase of assets in connection with the acquisition of a business, the TCJA and the related committee reports were silent as to its application in other transactional settings, including, for example, those involving the acquisition of stock that may be treated as the purchase of assets for tax purposes.

Thankfully, the proposed regulations address these situations and provide other helpful guidance as well.

Proposed Regulations

Used Property

The proposed regulations provide that the acquisition of “used”[x] property is eligible for the additional first-year depreciation deduction if the acquisition satisfies the requirements described above – it was acquired in a taxable, arm’s-length transaction – and the property was not used by the taxpayer or a predecessor at any time prior to the acquisition.

The proposed regulations provide that property is treated as used by the taxpayer or a predecessor before its acquisition of the property only if the taxpayer or the predecessor had a depreciable interest in the property at any time before the acquisition,[xi] whether or not the taxpayer or the predecessor claimed depreciation deductions for the property.[xii]

Related Persons

In determining whether a taxpayer acquired the property at issue from a related person – for example, an entity in control of, or by, the taxpayer – the proposed regulations provide that, in the case of a series of related transactions, the transfer of the property will be treated as directly transferred from the original transferor to the ultimate transferee, and the relation between the original transferor and the ultimate transferee will be tested immediately after the last transaction in the series. Thus, a sale of assets between related persons will not qualify for the additional first-year deduction.

Deemed Asset Sales by Corporations

It may be that the assets of the target corporation include assets the direct acquisition of which may be difficult to effectuate through a conventional asset deal. In that case, the buyer may have to purchase the issued and outstanding shares of the target’s stock. Without more, the buyer would only be able to recover its investment on a later sale or liquidation of the target.

In recognition of this business reality, Congress has provided special rules by which the buyer may still obtain a recoverable basis step-up for the target’s assets.

In general, provided: (i) the buyer is a corporation, (ii) the buyer acquires at least 80% of target’s stock, (iii) the target is an S-corporation, or a member of an affiliated or consolidated group of corporations, and (iv) the target’s shareholders consent (including, in the case of an S-corporation target, any non-selling shareholders), then the stock sale will be ignored, and the buyer will be treated, for tax purposes, as having acquired the target’s assets with a basis step-up equal to the amount of consideration paid by the buyer plus the amount of the target’s liabilities (a so-called “Section 338(h)(10) election”).

Where a Sec. 338(h)(10) election is not available – for example, because the buyer is not itself a corporation – the buyer may want to consider a different election (a so-called “Section 336(e) election”).

The results of a Section 336(e) election are generally the same as those of a Section 338(h)(10) election in that the target, the stock of which was acquired by the buyer, is treated as having sold its assets to the buyer, following which the target is deemed to have made a liquidating distribution to its shareholders.

This election, however, may only be made by the seller’s shareholders – it is not an election that is made jointly with the buyer (in contrast to a Section 338(h)(10) election). In the case of an S-corporation target, all of its shareholders must enter into a binding agreement to make the election, and a “Sec. 336(e) election statement” must be attached to the S-corporation’s tax return for the year of the sale.[xiii]

The proposed regulations provide that assets deemed to have been acquired as a result of either a Section 338(h)(10) election or a Section 336(e) election will be treated as having been acquired by purchase for purposes of the first-year depreciation deduction. Thus, a buyer will be able to immediately expense the entire cost of any qualifying property held by the target, while also enjoying the ability to amortize the cost of the target’s goodwill and to depreciate the cost of its non-qualifying depreciable assets.

Partnership Transactions – Cross-Purchase

In general, the purchase of an interest in a partnership has no effect on the basis of the partnership’s assets.

However, in the case of a sale or exchange of an interest in a partnership interest that has made a so-called “Section 754 election,” the electing partnership will increase the adjusted basis of partnership property by the excess of the buyer’s cost basis in the acquired partnership interest over the buyer’s share of the adjusted basis of the partnership’s property.[xiv]

This increase is an adjustment to the basis of partnership property with respect to the acquiring partner only and, therefore, is a “partner-specific” basis adjustment to partnership property.

The basis adjustment is allocated among partnership properties based upon their relative built-in gain.[xv] Where the adjustment is allocated to partnership property that is depreciable, the amount of the adjustment itself is treated as a newly purchased property that is placed in service when the purchase of the partnership interest occurs. The depreciation deductions arising from this “newly acquired” property are allocated entirely to the acquiring partner.

Unfortunately, prior to the TCJA, this basis adjustment would always fail the “original use” requirement because the partnership property to which the basis adjustment related would have been previously used by the partnership and its partners prior to the sale that gave rise to the adjustment.

However, because this basis adjustment is a partner-specific basis adjustment to partnership property, the proposed regulations under the TCJA are able to take an “aggregate view” and provide that, in determining whether a basis adjustment meets the “used property acquisition requirements” described above, each partner is treated as having owned and used the partner’s proportionate share of partnership property.

Thus, in the case of a sale of a partnership interest, the requirement that the underlying partnership property not have been used by the acquiring partner (or by a predecessor) will be satisfied if the acquiring partner has not used the portion of the partnership property to which the basis adjustment relates at any time prior to the acquisition – that is, the buyer has not used the seller’s portion of partnership property prior to the acquisition[xvi] – notwithstanding the fact that the partnership itself has previously used the property.

Similarly, for purposes of applying the requirements that the underlying partnership property not have been acquired from a related person and that the property take a cost basis, the partner acquiring a partnership interest is treated as acquiring a portion of partnership property, the partner who is transferring a partnership interest (the seller) is treated as the person from whom that portion of partnership property is acquired, and the acquiring partner’s basis in the transferred partnership interest may not be determined by reference to the transferor’s adjusted basis.

The same result will apply regardless of whether the acquiring partner is a new partner or an existing partner purchasing an additional partnership interest from another partner. Assuming that the selling partner’s specific interest in partnership property that is acquired by the acquiring partner has not previously been used by the acquiring partner or a predecessor, the corresponding basis adjustment will be eligible for the additional first-year depreciation deduction in the hands of the acquiring partner, provided all other requirements are satisfied.[xvii]

Partnership Transactions – Redemption

By contrast, a distribution of cash and/or property from a Section 754 electing partnership to a departing partner in liquidation of that partner’s interest in the partnership will be treated very differently, even where it results in an increase of the adjusted basis of partnership property.[xviii]

The amount of this increase – equal to the sum of (a) the amount of any gain recognized to the departing partner,[xix] and (b) the excess of (i) adjusted basis (in the hands of the partnership) of any property distributed to the departing partner, over (ii) the basis of the distributed property to the departing partner[xx] – is made to the basis of partnership property (i.e., non-partner-specific basis), and the partnership used the property prior to the partnership distribution giving rise to the basis adjustment.

Thus, the proposed regulations provide that these basis adjustments are not eligible for the additional first-year depreciation deduction.


The regulations are proposed to apply to qualified property placed in service by the taxpayer during or after the taxpayer’s taxable year in which the regulations are adopted as final.

However, pending the issuance of the final regulations, a taxpayer may choose to apply the proposed regulations to qualified property acquired and placed in service after September 27, 2017.

Informed by this guidance, a taxpayer that is thinking about purchasing a business may consider the economic savings – and the true cost of the acquisition – that may be realized by structuring the transaction so as to acquire a recoverable cost basis in the assets of the business, whether through depreciation/amortization and/or through an additional first-year depreciation deduction.

Similarly, a seller that recognizes the buyer’s ability to quickly recover a portion of its investment in acquiring the seller’s business may be able to share a portion of that economic benefit in the form of an increased purchase price. Whether the seller will be successful in doing so will depend upon several factors – for example, does the buyer need the seller to make a Section 338(h)(10) election – including their relative bargaining power and their relative desire to make a deal.

As for the buyout of a partner from a Section 754 electing partnership, query whether an acquiring partner’s ability to immediately expense a portion of the basis adjustment to the partnership’s underlying qualifying assets will make a cross-purchase transaction more attractive than a liquidation of the departing partner’s interest by the partnership.

In any case, the buyer and the seller will have to remain mindful of how they allocate the purchase price for the assets as issue. Let’s just say that pigs get fat and hogs get slaughtered.

[i] Public Law 115-97.

[ii] IRC Sec. 263, 1012.

[iii] IRC Sec. 167, 168, 197.

[iv] It should be noted that this so-called “bonus” depreciation is not subject to limitations based on the taxpayer’s taxable income or investment in qualifying property. Compare IRC Sec. 179.

It should also be noted that the “recapture” rules will apply to treat as ordinary income that portion of the taxpayer’s gain from the sale of the property equal to the amount of the bonus depreciation.

[v] The property had to have been placed in service before January 1, 2020. The 50% was phased down over time, beginning in 2018.

A taxpayer’s adjusted basis for a property is a measure of the taxpayer’s unrecovered investment in the property.

In general, the taxpayer’s starting basis will be equal to the amount of consideration paid by the taxpayer to acquire the property; the “cost basis.” It is “adjusted” (reduced) over time for depreciation.

[vi] Among the other properties that qualified is any improvement to an interior portion of a building that is nonresidential real property if such improvement was placed in service after the date the building was first placed in service. However, an improvement attributable to the enlargement of a building, or to the internal structural framework of the building, did not qualify.

[vii] IRC Sec. 168(k). Provided the property is placed in service before January 1, 2023. The amount of the deduction is phased down for property placed in service thereafter.

The TCJA also extended the additional first-year depreciation deduction, from 2020 through 2026.

[viii] IRC Sec. 1060.

The asset purchase may be effected in many different forms; for example, a straight sale, a merger of the target into the buyer in exchange for cash consideration, a merger of the target into a corporate or LLC subsidiary of the buyer, the sale by the target of a wholly-owned LLC that owns the business.

[ix] An important consideration for sellers.

[x] Should we say “pre-owned” but having undergone a painstaking certification process?

[xi] If a lessee has a depreciable interest in the improvements made to leased property and subsequently the lessee acquires the leased property of which the improvements are a part, the unadjusted depreciable basis of the acquired property that is eligible for the additional first-year depreciation deduction, assuming all other requirements are met, must not include the unadjusted depreciable basis attributable to the improvements.

[xii] The IRS is considering whether a safe harbor should be provided on how many taxable years a taxpayer or a predecessor should look back to determine if the taxpayer or the predecessor previously had a depreciable interest in the property.

[xiii] In a complete digression, here is another reason that a controlling shareholder will want to have a shareholders’ agreement in place that contains a drag-along and a requirement to elect as directed.

[xiv] IRC Sec. 743. Without such an election, any taxable gain resulting from an immediate sale of such property would be allocated in part to the buyer notwithstanding that the buyer had not realized an accretion in economic value.

[xv] IRC Sec. 755.

[xvi] Query how this will be determined.

[xvii] This treatment is appropriate notwithstanding the fact that the transferee partner may have an existing interest in the underlying partnership property, because the transferee’s existing interest in the underlying partnership property is distinct from the interest being transferred.

[xviii] IRC Sec. 734.

[xix] In general, because the amount of cash distributed (or deemed to have been distributed) to the departing partner exceeds the partner’s adjusted basis for its partnership interest.

[xx] An amount equal to the adjusted basis of such partner’s interest in the partnership reduced by any money distributed in the same transaction.

Transaction Costs

It is a basic principle of M&A taxation that the more a seller pays in taxes on the sale of its business, the lower will be the economic gain realized on the sale; similarly, the more slowly that a buyer recovers the costs incurred in acquiring a business, the lower will be the return on its investment.

In general, these principles are most often considered at the inception of an M&A transaction – specifically, when the decision is made to structure the deal so as to acquire a cost basis in the seller’s assets – and are manifested in the allocation of the acquisition consideration among the assets comprising the target business.

However, there is another economic element in every transaction that needs to be considered, but that is often overlooked until after the transaction has been completed and the parties are preparing the tax returns on which the tax consequences of the transaction are to be reported; specifically, the tax treatment of the various costs that are incurred by the buyer and the seller in investigating the acquisition or disposition of a business, in conducting the associated due diligence, in preparing the necessary purchase and sale agreements and related documents, and in completing the transaction.

Where these costs may be deducted, they generate an immediate tax benefit for the party that incurred them by offsetting the party’s operating income, thereby reducing the economic cost of the transaction.

Where the costs must be capitalized – i.e., added to the basis of the property being transferred or acquired, as the case may be – they may reduce the amount of capital gain realized by the seller or, in the case of the buyer, they may be recovered over the applicable recovery period.

The IRS’s Office of Chief Counsel (“CC”) recently considered the seller’s tax treatment of an investment banker’s fee.

A Successful Sale

Taxpayer engaged Investment Banker (“IB”) to explore a possible sale of Taxpayer and to identify potential buyers. The engagement letter provided that Taxpayer would pay IB a fee, determined as a percentage of the total transaction consideration, upon successful closing of the transaction (“success-based fee”).

IB’s fee was not based on an hourly rate, but was based on a number of factors, including IB’s experience. IB identified and vetted a number of potential buyers, and ultimately recommended one buyer to Taxpayer’s board of directors, which approved the buyer. IB then performed other services until the closing of the transaction. With the closing of the transaction, Taxpayer owed IB the success-based fee for its services.

The Letter

After the closing, Taxpayer requested that IB estimate the amount of time IB spent on various activities relating to the transaction. Taxpayer advised IB that the day on which Taxpayer’s board of directors approved the transaction was the “bright line date.”

In response, IB sent Taxpayer a two-page letter stating that IB did not keep time records, and that its fee was not based on an hourly rate. IB stated that it could not provide meaningful estimates based on the amount of time spent on certain aspects of the transaction because it did not keep time records. IB also stated that, after talking with members of its acquisition team, it could approximate percentages of time spent on various activities; however, IB did not identify, or provide contact information for, the individuals who were consulted.

In its letter, IB estimated that approximately: 92% of its time was dedicated to identifying a buyer; 2% to drafting a fairness opinion; 4% to reviewing drafts of the acquisition agreement; and 2% to performing services after the identified bright line date. Significantly, IB’s letter included a caveat stating that the percentages were merely estimates and should not be relied on by Taxpayer.

The Audit

On its tax return for the tax year in which the sale occurred, and based on IB’s letter, Taxpayer deducted 92% of the success-based fee; i.e., the time described in the letter as having been dedicated to pre-bright line date activities.

The IRS examined Taxpayer’s return, and requested support for the deduction claimed. In response, Taxpayer provided IB’s two-page letter.

The CC was consulted on whether Taxpayer had satisfied the documentation requirements (described below) by providing the letter from IB estimating the percentage of time spent on so-called “facilitative” and “non-facilitative” activities where the letter included the caveat that the letter should not be relied on by Taxpayer as IB did not keep time records.

The CC determined that Taxpayer could not satisfy the documentation requirements.

The Law

The Code provides that there shall be allowed as a deduction, in determining a taxpayer’s taxable income for a tax year, all the ordinary and necessary expenses paid or incurred by the taxpayer during the year in carrying on any trade or business.

However, the Code and the Regulations promulgated thereunder also provide that a taxpayer must capitalize an amount paid to facilitate an acquisition of a trade or business. An amount is paid to “facilitate” a transaction if the amount is paid in the process of investigating or otherwise pursuing the transaction. Whether an amount is paid in the process of investigating or otherwise pursuing the transaction is determined based on all of the facts and circumstances.

Facilitative Costs

The Regulations provide that – except for certain “inherently facilitative” costs – an amount paid by the taxpayer in the process of investigating or otherwise pursuing a “covered transaction” facilitates the transaction (and must be capitalized) only if the amount paid relates to activities performed on or after the earlier of:

  1. the date a letter of intent or similar communication is executed, or
  2. the date on which the material terms of the transaction are authorized or approved by the taxpayer’s board of directors (the so-called “bright line date”).

The term “covered transaction” includes, among other things, the taxable acquisition of assets that constitute a trade or business.

Amounts that are treated as inherently facilitative, regardless of when they are incurred, include, among others:

  1. Securing an appraisal, formal written evaluation, or fairness opinion related to the transaction;
  2. Structuring the transaction, including negotiating the structure of the transaction and obtaining tax advice on the structure of the transaction;
  3. Preparing and reviewing the documents that effectuate the transaction;
  4. Obtaining regulatory approval of the transaction;
  5. Obtaining shareholder approval of the transaction; or
  6. Conveying property between the parties to the transaction.

Contingent Fees

According to the Regulations, an amount paid that is contingent on the successful closing of a transaction is treated as an amount paid to facilitate the transaction – i.e., an amount that must be capitalized – except to the extent the taxpayer maintains sufficient documentation to establish that a portion of the fee is allocable to activities that do not facilitate the transaction (the “Documentation”).

The Documentation must be completed on or before the due date of the taxpayer’s timely filed original federal income tax return (including extensions) for the taxable year during which the transaction closes.

In addition, the Documentation “must consist of more than merely an allocation between activities that facilitate the transaction and activities that do not facilitate the transaction;” rather, it must consist of supporting records – for example, time records, itemized invoices, or other records – that identify:

  1. The various activities performed by the service provider;
  2. The amount of the fee (or percentage of time) that is allocable to each of the various activities performed;
  3. Where the date the activity was performed is relevant to understanding whether the activity facilitated the transaction, the amount of the fee (or percentage of time) that is allocable to the performance of that activity before and after the relevant date; and
  4. The name, business address, and business telephone number of the service provider.

Safe Harbor

Several years back, in recognition of the difficulty that many taxpayers faced in maintaining and producing the Documentation, the IRS provided a “safe harbor” election for allocating success-based fees paid in a covered transaction. In lieu of maintaining the Documentation, electing taxpayers may treat 70% of the success-based fees as an amount that does not facilitate the transaction – and that may be deducted – and the remaining 30% must be capitalized as an amount that facilitates the transaction.

This safe harbor was provided, in part, to incentivize taxpayers to make the election rather than attempt to determine the type and extent of documentation required to establish that a portion of a success-based fee is allocable to activities that do not facilitate a covered transaction.

In the present case, Taxpayer did not make the safe harbor election. Therefore, Taxpayer had to provide the Documentation, or no portion of the success-based fee would be deductible.

The CC found that IB’s two-page letter was merely an allocation between activities that facilitated and did not facilitate the transaction, which the Regulations specifically forbid. Because the letter was merely an allocation, it could not satisfy the Documentation requirements. Accordingly, Taxpayer had to capitalize 100% of the success-based fee.

Taxpayer attempted to provide time estimates from IB even though Taxpayer knew that IB did not keep time records. The Documentation requirements do not require a taxpayer’s supporting records to identify the percentage of time that is allocable to each activity, but they do require the supporting records to identify the amount of the fee that is allocable to each activity.

The estimated allocation letter from IB had no effect, and without other documentation, Taxpayer’s deduction was denied.


Interestingly, it wasn’t until after the closing that Taxpayer asked IB to provide the documentary support that may have allowed the success-based fee to escape treatment as a facilitative cost that had to be capitalized.

Taxpayers and their advisers have to be aware that the treatment of M&A transaction costs may have a significant impact upon the net economic cost or gain of a “covered transaction” like the one described in the above ruling.

They also have to know that the necessary documentation or record should be created contemporaneously, as the transaction unfolds, not after the deal.

The most puzzling aspect of the situation described in the ruling, however, is Taxpayer’s failure to make the safe harbor election to treat 70% of the success-based fee paid to IB as a non-facilitative deal cost that Taxpayer could have deducted without question. Pigs get fat, hogs get slaughtered?


Last week, we considered the proper tax treatment for a transfer of funds from a parent corporation to its foreign subsidiary. The parent had argued, unsuccessfully, that the transfer represented the payment of a deductible expense on the theory that the payment was made to enable the subsidiary to complete a project for an unrelated third party and, thereby, to avoid serious damage to the parent’s reputation as a reliable service provider.

Today, we turn to a scenario in which an individual taxpayer utilized the same argument – also unsuccessfully – to justify a deduction claimed through a wholly-owned S corporation.

The parent corporation in last week’s post had a much more colorable claim to a deduction than the taxpayer described below. Both situations, however, illustrate the significance of considering in advance the optimal tax consequences for a particular business transaction, and of planning the form and structure for the transaction in order to attain as much of the desired result as possible.

Shareholder Litigation

Taxpayer was a U.S. individual who owned a minority interest in Foreign Corp (“FC”). At some point, FC’s shareholders discovered that Bank had engaged in a fraudulent scheme involving FC stock, which ultimately devalued FC’s shares. A consortium of minority shareholders, including Taxpayer, instituted litigation overseas against FC and Bank for corporate fraud. The purpose of the litigation was the recovery of the minority shareholders’ investment in FC.

In return for a percentage of any recovery, Taxpayer agreed to finance a portion of the consortium’s legal fees and related expenses. Taxpayer also agreed to provide services to the consortium in exchange for an extra percentage of any recovery.

In response to “capital calls” made by the consortium, Taxpayer wired funds from their domestic brokerage account which satisfied 60% of their agreed-upon contribution to fund the litigation.

“S” Corp is Formed

The remaining portion of Taxpayer’s commitment was satisfied by two subsequent payments, one from their brokerage account, and the other from the corporate bank account of Taxpayer’s newly-formed and wholly-owned S corporation (“Corp”).

During the year at issue, Corp owned and managed four rental properties; it did not otherwise engage in any property management services for third parties.

Shortly after the formation of Corp, Taxpayer signed two documents, each captioned “Special Minutes of [Corp]”. One of these documents stated, in part:

A) money transfers into [Corp] from [Taxpayer] will be deemed loans to the Corporation[,] B) costs incurred by Taxpayer associated with the assignment of assets or otherwise transferred to [Corp] shall be treated as a loan to [Corp] whereas such costs shall not be in excess of such costs incurred up until the time of the transfer, C) money transfers out of [Corp] to Taxpayer will be deemed repayment of loans or in the event such loans have been repaid such money transfers out of [Corp] will be considered a [sic] income distribution or otherwise * * *.

This document stated that any loans were noninterest bearing and were for a term of the “greater of 20 years or Perpetual Term”.

The other document stated that Taxpayer assigned “their litigation rights for any investment made by [Taxpayer] to [Corp].” It also stated that “the business of [Corp] was to make investments, including the funding of litigation costs * * * [i]n exchange for * * * a[n] ownership interest in the litigation recovery, if any.” The document further stated that “this memo is to provide further clarity that [FC] litigation funding is being done through [Corp] and that [Corp] will earn a fair return on its investment for funding such litigation.” The document further stated: “Resolved, that [Corp] accepts litigation and the costs thereof in return for a reasonable assignment of shares necessary to cover the costs of litigation and provide for a reasonable recovery.”

None of the FC stock owned by Taxpayer was ever actually assigned to Corp, and Taxpayers remained the registered owners of the FC stock at all relevant times. Corp never submitted an application to intervene in the FC litigation, and none of the legal documents relating to the FC litigation referred to Corp.

Tax Returns

On its Form 1120S, U.S. Income Tax Return for an S Corporation, Corp identified its business activity as the leasing of residential property. However, Corp claimed a deduction for legal and professional fees relating to the FC litigation, and reported the ordinary business loss that resulted from such deduction.

Taxpayer claimed a loss on their Form 1040, U.S. Individual Income Tax Return, Schedule E, Supplemental Income and Loss, that included the ordinary business loss reported by Corp on the Schedule K-1 issued to Taxpayer.

The IRS disallowed most of the legal and professional fees deduction claimed by Corp.

The primary issue before the Tax Court was whether Taxpayer was entitled to a pass-through deduction for certain legal and professional fees that Corp claimed on its corporate income tax return.[i]

Taxpayer claimed that these fees were deductible as ordinary and necessary business expenses of Corp, but the IRS disagreed.

The Court

The Code allows a deduction for “all the ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business”.

According to the Court, Taxpayer did not show that either their first or second payment represented expenses “paid or incurred” by Corp so as to support a deduction. Taxpayer wired both of these payments to the consortium from their personal account, in partial satisfaction of their personal commitment to contribute toward the consortium’s FC-litigation expenses.

The Court assigned little significance to the “Special Minutes” pursuant to which Taxpayers purportedly assigned their interest in the FC-litigation and the related costs to Corp. The Court explained that transfers between a corporation and its sole shareholder are subject to heightened scrutiny, and the labels attached to such transfers mean little if not supported by other objective evidence. The record, the Court continued, contained no objective evidence to suggest that this paperwork altered in any way Taxpayer’s relationship to the consortium or their personal obligation to the consortium for the legal expenses in question. Indeed, the Court observed that all the evidence showed that the consortium continued to invoice Taxpayer, and not Corp, for payment of Taxpayer’s commitment even after the year at issue. Corp never submitted an application to intervene in the FC-litigation, and none of the legal documents relating to the FC-litigation referred to Corp.

The Court was also not impressed by Taxpayer’s assertion that their two wire payments represented “loans” to Corp pursuant to the “Special Minutes”; neither payment could be characterized as a “transfer into” Corp under the terms of the “Special Minutes”, and there was no objective evidence of a bona fide expectation of repayment. In any event, one of the payments was made nine days before Corp was even incorporated.

Corp’s Payment?

Unlike the other two payments, the third payment was in fact made by Corp. The IRS did not argue that this payment was not “paid or incurred” by Corp. However, the IRS asserted, and the Court agreed, that this payment was also not deductible because Taxpayer failed to show that it was an ordinary and necessary business expense of Corp.

The Court pointed out that the legal and professional fees at issue were the expenses of Taxpayer rather than of Corp. A taxpayer, the Court stated, generally may not deduct the payment of another person’s expense.

The Court conceded, however, that an exception to this general rule may apply if a taxpayer pays someone else’s expenses in order to protect or promote his own separate trade or business. This exception typically applies only where the taxpayer pays the obligations of another person or entity in financial difficulty, and where the obligor’s inability to meet their obligations threatens the taxpayer’s own business with direct and proximate adverse consequences.

“[T]he showing a corporation must make to deduct the expenses of its shareholder is a strong one,” the Court stated. “The test is sometimes expressed as having two prongs:” (1) the taxpayer’s primary motive for paying the expenses must be to protect or promote the taxpayer’s business, and (2) the expenditures must constitute ordinary and necessary business expenses for the furtherance or promotion of the taxpayer’s business.

The Court determined that Taxpayer did do not meet either prong of this test. As to the first prong, Taxpayer did not show that the expenses in question were incurred primarily for the benefit of Corp, and that any benefit to Taxpayer was only incidental. The benefits to Taxpayer were obvious: The costs were incurred to recover their investment in FC. Treating the payments as business deductions of Corp, rather than as miscellaneous investment expenses of Taxpayer, would have resulted in more favorable tax treatment for Taxpayer. By contrast, the business justification for Corp to pay these expenses was not at all obvious. There was no suggestion, for instance, that any payment of the expenses by Corp would have been motivated by any genuine consideration to avoid adverse business consequences that might result if Taxpayer were unable to meet their financial obligations.

As to the second prong, Taxpayer did not show that the legal expenses in question represented ordinary and necessary business expenses in the furtherance of the business of Corp. The Court explained that the proper focus of its inquiry, as applied to legal expenses, is on the origin of the subject of the litigation and not on the consequences to the taxpayer. The origin of the claim was Bank’s alleged fraudulent activity that devalued the FC shares that Taxpayer held as a minority shareholder. Taxpayer – not Corp – joined the shareholder litigation group against Bank. The litigation and Taxpayer’s obligation to fund the litigation arose before Corp was ever created.

At all relevant times, the FC shares were registered in Taxpayer’s name. As Taxpayer testified, the purpose of the litigation was to secure judgment in favor of the FC shareholders and recover their investment.

Taxpayer contended that, in the “Special Minutes,” they assigned all their FC-litigation rights to Corp, and that the prospect of a payout to Corp from the FC-litigation constituted a legitimate business activity of Corp as to which the legal expenses should be deemed an ordinary and necessary business expense.

The Court again rejected the “Special Minutes” because they were not supported by any objective evidence. In any event, Taxpayer’s argument focused improperly on the potential consequences of the FC-shareholders’ lawsuit – a potential payout in which Corp would allegedly share – rather than upon the origin and character of the underlying claim. Moreover, the absence of any reliable documentation defining the role of Corp in the litigation, or guaranteeing it a share of any future recovery, further supported the conclusion that Taxpayer engaged in the FC-litigation in their personal capacity as an investor in FC, and not on behalf of Corp.

In the light of these considerations, the Court assigned little credence to Taxpayer’s assertions that Corp engaged in “litigation funding” as a business and that Taxpayer lent money to Corp to fund the litigation. In the first instance, for an activity to constitute a trade or business, “the taxpayer must be involved in the activity with continuity and regularity and * * * the taxpayer’s primary purpose for engaging in the activity must be for income or profit.” During the year at issue, the FC-litigation was Corp’s only claimed “litigation funding” activity. The Court was not convinced that Corp was involved in any “litigation funding” activity with the continuity and regularity necessary for that activity to constitute a trade or business. Similarly, even if Taxpayer provided advisory services to the FC-litigation through Corp, as Taxpayer alleged, the record did not show that Corp provided such services with the continuity and regularity necessary for that activity to constitute a trade or business.

The Court found that Taxpayer failed to show that any of the disputed fees were paid or incurred by Corp as ordinary and necessary expenses in carrying on its trade or business. Accordingly, the Court sustained the IRS’s determination that these items were not deductible by Corp, and thereby increased Taxpayer’s income tax liability.

[Query why the IRS did not also argue – to add insult to injury – that Corp’s satisfaction of Taxpayer’s obligation should be treated as a constructive distribution by Corp that reduced Taxpayer’s basis for their Corp stock?]

Here I Go . . . Again[ii]

The scenarios in which a closely held business, its affiliates and their owners will transfers funds or other property to, or on behalf of, one another are too many to enumerate. That these transfers often occur without being properly documented – except, perhaps, with a book entry similar to “intercompany transaction” – if at all, is troublesome.

Unfortunately, the frequency of cases like the one described above indicates that too many taxpayers make such transfers without an appreciation either for their tax consequences and the attendant economic costs, or for the importance of accurately documenting the transfers.

When they do realize their error – whether before, or during, an audit – the related parties sometimes scramble to “memorialize” what they “intended,” which results in an obviously self-serving and forced “reconciliation” of what actually occurred with what was reported on a tax return.

Under these circumstances, it should not be difficult to understand a court’s reluctance to accept a taxpayer’s after-the-fact explanation for a transfer, or to underestimate the importance of treating with a related party on as close to an arm’s-length basis as possible.


[i] An “eligible small business corporation” that elects S corporation status is generally exempt from corporate income tax. Instead, the S corporation’s shareholders must report their pro rata shares of the S corporation’s items of taxable income, gain, loss, deduction, and credit. An S corporation item generally retains its character in the hands of the shareholder.

[ii] Apologies to Bob Seeger.

It is often difficult to determine the proper tax treatment for the transfer of funds among related companies, especially when they are closely held, in which case obedience to corporate formalities may be found wanting.

At times, the nature of the transfer is clear, but the “correct” value of the property or service provided in exchange for the transfer is subject to challenge by the government.

In other situations, the amount of the transfer is accepted, but the tax consequences reported by the companies as arising therefrom – i.e., the nature of the transfer – may be disputed by the IRS, depending upon the facts and circumstances, including the steps taken by the related companies to effectuate the transfer and the documentation prepared to evidence the transfer.

One U.S. District Court recently considered the tax treatment of a transfer of funds by a U.S. corporation to a second-tier foreign subsidiary corporation that was made in response to a threat by a foreign government.

Parent’s Dilemma

U.S. Parent Corp (“Parent”) engaged in business in Foreign Country (“Country”) through a subsidiary corporation (“Sub”) formed under Country’s laws. Parent held Sub through an upper-tier foreign subsidiary corporation (“UTFS”).

Sub contracted with an unrelated Joint Venture (“JV”) to provide services to JV in Country. The contract required Parent to extend a “performance guarantee:” if Sub was unable to perform all of its obligations under the contract, Parent would, upon demand by JV, be responsible to perform or to take whatever steps necessary to perform, as well as be liable for any losses, damages, or expenses caused by Sub’s failure to complete the contract.

The contract was not as profitable as Sub had forecast, and it sustained net losses. Sub informed JV that it would not renew the contract and would exit the Country market at the conclusion of the contract.

Between a Rock and . . .

Shortly after Sub’s communication to JV, the Country Ministry of Finance (“Ministry”) advised Sub that the company it was in violation of Country’s Code and, thus, in danger of forced liquidation. Specifically, Sub was informed that it was in violation of a requirement that it maintain “net assets” in an amount at least equal to its chartered capital; it was given one month to increase its net assets, failing which, Country’s tax authority had the right to liquidate Sub through judicial process.

Parent analyzed the ramifications if Sub was liquidated. It believed that if Sub was liquidated, JV would force Parent to finish the contract pursuant to the performance guarantee, and Parent would have to pay a third party to complete the work, which Parent determined would be very costly. It also worried about the potential damage to its reputation if Sub defaulted.

Sub assured the Ministry that it was taking steps to improve its financial condition. Parent decided to transfer funds to UTFS, which then signed an agreement with Parent pursuant to which funds would be transferred by Parent to Sub, “on behalf of” UTFS. It was agreed that the funds would be used by Sub to carry on its activities, and UTFS confirmed that its financial assistance was “free” and that it did not expect Sub return the funds. Parent then made a series of fund transfers to Sub.

Parent claimed a deduction on its tax return for the amount transferred to Sub, but the deduction was disallowed by the IRS.

Parent paid the resulting tax deficiency, and then sought a refund of the taxes paid, contending that the payment to Sub was deductible as a bad debt, or as an ordinary and necessary trade or business expense.

The IRS rejected the refund claim, and Parent commenced a suit in District Court.

Bad Debt?

Parent contended the payment to Sub was deductible as a bad debt. It argued that courts have defined the term “debt” broadly, and have allowed payments that were made to discharge a guarantee to be deducted as bad debt losses. Parent insisted that a payment by the taxpayer in discharge of part or all of the taxpayer’s obligation as a guarantor should be treated as a business debt that become worthless in the year in which the payment was made.

Parent argued that it made the payment to discharge its obligation to guarantee performance on Sub’s contract with JV. Specifically:

  1. Ministry was threatening to liquidate Sub because it did not have sufficient capital;
  2. Liquidation of Sub would have caused it to default on the contract with JV;
  3. That default would have made JV a judgment-creditor and Sub a judgment-debtor;
  4. Sub would have been obligated to pay JV a fixed and determinable sum of money;
  5. Parent guaranteed Sub’s performance, creating a creditor-debtor relationship between them and making Parent liable for Sub’s debts; and
  6. The payment to Sub satisfied the debt created by Parent’s performance guarantee, and Sub’s inability to repay rendered it a bad debt.

The Court Saw it Differently

According to the Court, Parent’s arguments conflated two questions:

  1. Did Parent pay a debt owed by Sub to JV because it guaranteed that obligation? or
  2. Did the transfer of money by Parent (through UTFS) to Sub create a debt owed by Sub to Parent?

The Court answered both these questions in the negative.

The Court explained that a taxpayer is entitled to take as a deduction any debt which becomes worthless in that taxable year. A contribution to capital cannot be considered a debt for purposes of this rule. The question of whether the payment from Parent to Sub was deductible in the year made “depends on whether the advances are debt (loans) or equity (contributions to capital).”

“Articulating the essential difference,” the Court continued, “between the two types of arrangement that Congress treated so differently is no easy task. Generally, shareholders place their money ‘at the risk of the business’ while lenders seek a more reliable return.” In order for an advance of funds to be considered a debt rather than equity, the courts have stressed that a reasonable expectation of repayment must exist which does not depend solely on the success of the borrower’s business.[i]

It was clear, the Court stated, that the advances to Sub were not debts, but were more in the nature of equity. There was no note evidencing a loan, no provision for or expectation of repayment of principal or interest, and no way to enforce repayment. Instead, the operative agreement stated clearly that it was “free financial aid” and would not be paid back to Parent or to UTFS.

The intent of the parties was clear: it was not a loan and did not create an indebtedness. The Court observed that, in fact, it could not be a loan because further indebtedness for Sub would not have solved the net assets and capitalization problems identified by the Ministry. Sub’s undercapitalization also supported the conclusion that this was an infusion of capital, and not a loan that created a debt.

Performance Guarantee?

Parent next argued that the payment was made pursuant to a guarantee to perform because if Sub was liquidated, Parent would be liable for the damages caused by the breach.

The Court agreed that a guaranty payment qualifies for a bad debt deduction if “[t]here was an enforceable legal duty upon the taxpayer to make the payment.” However, voluntary payments do not qualify, it stated.

It was true that Parent executed a performance obligation with JV to guarantee the work would be done. However, Sub never failed to perform its obligations, and JV never looked to Parent to satisfy any requirements under the performance guarantee. The event that triggered the payment was not a demand by JV to perform; instead it was the notice from the Ministry that Sub was undercapitalized and at risk of being liquidated. No money was paid to JV, and no guaranteed debt or obligation was discharged by the payment. Nothing in the performance guarantee legally obligated Parent to provide funds to Sub; it was only required to perform on the contract if Sub could not. After the money was transferred to Sub, both Parent and Sub had the same obligations under the performance guarantee that existed before the transfer. The payment neither extinguished, in whole or in part, Parent’s obligation to guarantee performance, nor reduced the damages it would pay in the event of a default. It also did not impact Sub’s obligations to perform; it merely reduced the risk that Sub would be unable to perform due to liquidation for violation of Country’s legal capitalization requirements. In short, this was not a payment by a taxpayer in discharge of part or all of the taxpayer’s obligation as a guarantor, because there was no discharge of any obligation.

Parent also argued that an advance of money, pursuant to a performance guarantee, that allowed the receiving company to complete a construction project, was a debt that was deductible as a business expense.

Again, the Court pointed out that there was no contractual agreement between Parent and Sub requiring such a payment to Sub or a repayment by Sub. The payment was made to avoid being called to perform on the performance guarantee between Parent and Sub.

The terms of the payments stressed that no debtor-creditor relationship was being created because it was “free financial aid.” Because this was “free financial aid,” Sub owed no such debt to Parent, and Parent had no right to expect repayment of the funds paid. When the payer had no right to be repaid, the Court explained, the transfer of funds was a capital contribution.

Thus, the advance to Sub did not create a debt, did not pay a debt, and was not a payment of a debt pursuant to a guarantee. Therefore, it was not deductible as a bad debt.

Ordinary and Necessary Expense?

Parent next argued that the payment was deductible as an “ordinary and necessary business expense” that was paid or incurred in carrying on its trade or business.

Parent contended that the financial aid was an ordinary business expense to Parent, because it fulfilled its legal obligations under the performance guarantee and avoided serious business consequences if Sub had defaulted on the JV contract. Among those consequences were Parent’s exposure to substantial financial damages, including the loss of Sub’s assets and equipment, as well as severe damage to Parent’s reputation as a reliable service provider in the global market.

The IRS contended that Parent’s contribution of free financial aid to its subsidiary was neither an “expense,” nor was it “ordinary.” The Court agreed.

As a general rule, voluntary payments by a shareholder to his corporation in order “to bolster its financial position” are not deductible as a business expense or loss.

According to the Court, “It is settled that a shareholder’s voluntary contribution to the capital of the corporation . . . is a capital investment and the shareholder is entitled to increase the basis of his shares by the amount of his basis in the property transferred to the corporation.” This rule applies not only to transfers of cash or tangible property, but also to a shareholder’s forgiveness of a debt owed to him by the corporation.

In determining whether the appropriate tax treatment of an expenditure is immediate deduction or capitalization, “a taxpayer’s realization of benefits beyond the year in which the expenditure is incurred is undeniably important.”

Moreover, to qualify for deduction, the expense involved must be ordinary and necessary for the taxpayer’s own business. As a general rule, a taxpayer may not deduct the expenses of another.

The circumstances giving rise to Parent’s “free financial aid” to Sub, the Court continued, bore none of the hallmarks of an “expense.” Parent was under no obligation to make a payment to Sub, but chose to do so to avoid potential future losses. In response to a letter from the Ministry threatening liquidation because of undercapitalization, Parent decided to transfer (through UTFS) cash to Sub. There was no obligation to return the funds, and Sub was not restricted in how it could use them. As a result, Sub recapitalized its balance sheet, reducing its liabilities and increasing its net equity, thereby eliminating the net asset problem identified by the Ministry. Sub was thereby enabled to continue operations and complete the JV contract. Under these circumstances, the transfer of funds by Parent fit squarely within the capitalization principle.

To be sure, Parent did receive other benefits as a result of the recapitalization. By helping Sub avoid liquidation and finish the JV contract, Parent assured not only that Sub’s valuable equipment and technology would be recovered, but also that Parent’s own reputation and future business operations would not be damaged. But these expected benefits were not realized solely, or even primarily, in the tax years at issue. Instead, like any normal capital expenditure, the benefits to Parent were expected to continue into the future, well beyond the year in which the payments were made.

Reputation and Goodwill

Parent argued that the future benefits to its reputation and business operations did not preclude a current expense deduction. It relied upon a line of cases holding that, when one taxpayer pays the expenses of another, the payment may be deductible if the taxpayer’s purpose is to protect or promote its own business interests such as reputation and goodwill.

The Court conceded that there is such an exception to the general rule that a taxpayer may not deduct the expenses of another, that permits a taxpayer to claim a deduction when the expenditures were made by a taxpayer to protect or promote his own business, even though the transaction giving rise to the expenditures originated with another person and would have been deductible by that person if payment had been made by them.[ii]

The Court, however, found that the exception was inapplicable because the “free financial aid” provided by Parent was not tied to any actual expense of Sub, whether deductible or not.

The Court concluded that the fund transfer from Parent to Sub was not deductible as a bad debt, nor was it deductible as an ordinary and necessary expense of the taxpayer’s business. When distinguishing capital expenditures from current expenses, it explained, the Code makes clear that “deductions are exceptions to the norm of capitalization,” and so the burden of clearly showing entitlement to the deduction is on the taxpayer. Parent did not carry that burden.

“Why Don’t They Do What They Say, Say What They Mean?”

The Fixx may have been onto something. If a business plans to engage in a transaction in order to achieve a specific purpose, its tax treatment of the transaction – how it reports it – should be consistent with its intended purpose. Of course, this presupposes that the business has, in fact, considered the tax consequences of the transaction, as any rational actor would have done in order to understand its true economic cost.

Unfortunately, quite a few business taxpayers act irrationally, forgetting the next phrase in the song, that “one thing leads to another.” It is not enough to report a transaction in a way that yields the best economic result – for example, that most reduces the cost of the transaction – and then hope it is not challenged by the government.

Rather, the optimum economic result under a set of circumstances may only be attained by a critical analysis of the transaction and its likely tax outcome. With this information, the business may then consider, if necessary, how to adjust the transaction steps, or to otherwise offset the expected cost thereof.

[i] The Courts have identified a number of factors relevant to deciding whether an advance is debt or equity:

(1) the names given to the certificates evidencing the indebtedness;

(2) the presence or absence of a fixed maturity date;

(3) the source of payments;

(4) the right to enforce payment of principal and interest;

(5) participation in management flowing as a result;

(6) the status of the contribution in relation to regular corporate creditors;

(7) the intent of the parties;

(8) ‘thin’ or adequate capitalization;

(9) identity of interest between creditor and stockholder;

(10) source of interest payments;

(11) the ability of the corporation to obtain loans from outside lending institutions;

(12) the extent to which the advance was used to acquire capital assets; and

(13) the failure of the debtor to repay on the due date or to seek a postponement.

[ii] The IRS argued that, even under this exception, the taxpayer’s expenditure must be linked to an underlying current expense of the other business; the expenditure at issue had to be earmarked to pay an obligation or extinguish a liability owed to a third party.


The Corporate “Shield”

Ask any shareholder of a closely held corporation whether they may be held liable for the tax obligations of the corporation, and they will likely respond “of course not, that’s why we established the corporation – to benefit from the limited liability protection it provides.”

Some of these shareholders will be surprised when you explain that they may be personally liable for the employment taxes and sales taxes that the corporation was required, but failed, to collect and remit to various taxing authorities – even where the “corporate veil” has not been pierced – if the shareholders were “responsible persons” or “under a duty to act” as to such taxes.

However, the scenario by which a shareholder is most likely to be taken aback is the one in which they are held liable for the corporation’s own income taxes, notwithstanding that they may not be a controlling owner, or even a responsible officer, of the corporation.

The U.S. Court of Appeals for the Ninth Circuit recently ruled on a case in which the IRS sought to collect a corporation’s (“Corp”) income tax from its former shareholders (“Taxpayers”).

Let’s Make a Deal

Corp was taxable as a C-corporation. It sold its assets to Buyer-1 for $45 million cash, which generated a Federal corporate income tax liability in excess of $15 million. At that point, Corp did not conduct any business, nor did it have any immediate plans to liquidate.

Following the asset sale by Corp, Taxpayers were approach by Investor, who claimed that they could structure a transaction that would “manage or resolve” Corp’s tax liability.

Pursuant to an agreement with Investor, and despite their suspicions regarding Investor’s plans for Corp’s taxes, Taxpayers sold all of their Corp stock to another corporation, Buyer-2, in a taxable transaction. Using borrowed funds, Buyer-2 paid Taxpayers an amount of cash representing the net value of Corp after the asset sale, plus a premium; Buyer-2 also promised to satisfy Corp’s tax liability.

Buyer-2 and Corp then merged into a new corporation, Holding, which was purportedly engaged in the business of debt collection. As a result of the merger, and by operation of law, Holding assumed the liabilities of Corp and of Buyer-2, including Corp’s income tax liability and Buyer-2’s acquisition debt.

Using the cash acquired from Corp, Holding repaid the loan that Buyer-2 had incurred to purchase Taxpayers’ stock in Corp. After satisfying this debt, however, Holding had no assets with which to pay the income taxes due from the earlier sale of Corp’s assets.

The IRS Smells a Rat

The IRS sent notices of tax liability to Taxpayers – the former shareholders of Corp – as the ultimate transferees of the proceeds of the sale of Corp’s assets. The IRS sought to establish that Taxpayers were liable for Corp’s tax liability.

The IRS argued that Taxpayers received, in substance, a liquidating distribution from Corp, and that the form of the stock sale to Buyer-2, and the subsequent merger with Holding, should be disregarded.

Taxpayers emphasized that the proceeds they received came from Buyer-2, not from Corp; therefore, there was no liquidation.

The U.S. Tax Court considered whether Taxpayers were “transferees” within the meaning of that provision of the Code which enables the IRS to collect from a transferee of assets the unpaid taxes owed by the taxpayer-transferor of such assets, if an independent basis exists under applicable State law for holding the transferee liable for the transferor’s debts.

The Tax Court looked to State’s Uniform Fraudulent Transfer Act (“UFTA”) and concluded that it could disregard the form of the stock sale to Buyer-2, and look to the entire transactional scheme, only if Taxpayers knew that the scheme was intended to avoid taxes. The Tax Court concluded that Taxpayers had no such knowledge, and ruled in their favor. The IRS appealed.

The Court of Appeals

The Ninth Circuit explained that Taxpayers would be subject to transferee liability if two conditions were satisfied: first, the relevant factors had to show that, under Federal law, the transaction with Buyer-2 lacked independent economic substance apart from tax avoidance; and second, Taxpayers had to be liable for the tax obligation under applicable State law.

Economic Purpose

After reviewing the record, the Court found there was ample evidence that Taxpayers were, at the very least, on constructive notice that the entire scheme had no purpose other than tax avoidance.

According to the Court, the purpose of Taxpayers’ transaction with Buyer-2 was tax avoidance; reasonable actors in Taxpayers’ position, it stated, would have been on notice that Buyer-2 never intended to pay Corp’s tax obligation.

It was not disputed, the Court continued, that following its asset sale to Buyer-1, Corp was not engaged in any business activities. It held only the cash proceeds of the sale, subject to the accompanying income tax liability. When Taxpayers sold their stock to Buyer-2, along with that tax liability, Taxpayers received, in substance, a liquidating distribution from Corp. There was no legitimate economic purpose for the stock sale other than to avoid paying the corporate income taxes that would normally accompany a liquidating asset sale and distribution to shareholders.

The financing transactions demonstrated that the deal was only about tax avoidance. Buyer-2 borrowed the funds to make the purchase. After the merger of Corp into Holding, the latter, had it been intended to be a legitimate business enterprise, could have repaid the loan over time and retained sufficient capital to sustain its purported debt collection enterprise and cover the tax obligation. Instead, the financing was structured so that, after the merger, Corp’s cash holdings went immediately to repay the loan Buyer-2 used to finance its purchase of the Corp stock from Taxpayers.

The Court stated that Taxpayers’ sale to Buyer-2 was a “cash-for-cash exchange” lacking independent economic substance beyond tax avoidance.

Liability under State Law

The Court then turned to whether, under State law, Taxpayers were liable to the IRS for Corp/Holding’s tax liability. According to the Court, this question had to be resolved under State’s UFTA.

The IRS argued that Taxpayers were liable under that the UFTA’s constructive fraud provisions.

The Court explained that State’s UFTA’s constructive fraud provisions protect a creditor in the event a debtor engages in a transfer of assets that leaves the debtor unable to pay its outstanding obligations to the creditor. Specifically, the UFTA provides that a transaction is constructively fraudulent as to a creditor (the IRS) if the debtor (Corp/Holding), did not receive “a reasonably equivalent value in exchange for the transfer or obligation, and the debtor either: (a) Was engaged or was about to engage in a business or a transaction for which the remaining assets of the debtor were unreasonably small in relation to the business or transaction; or (b) Intended to incur, or believed or reasonably should have believed that he would incur, debts beyond his ability to pay as they became due.”

The Court reviewed the record and found that Taxpayers’ sale of their Corp stock to Buyer-2 and Buyer-2/Holding’s assumption of Corp’s tax liability, were, in substance, a liquidating distribution to Taxpayers, which left neither Corp, Buyer-2, nor Holding able to satisfy Corp’s tax liability. Such a transfer, in which the debtor – Corp – received no reasonably equivalent value in return for its transfer to its shareholders, and was left unable to satisfy its tax obligation, fell squarely within the constructive fraud provisions of State’s UFTA.


The Tax Court, however, had decided that Taxpayers had no actual or constructive knowledge of Buyer-2’s tax avoidance scheme, and thus concluded it had to consider merely the “rigid form” of the deal. According to the Tax Court, because Taxpayers received their money from Buyer-2, and not formally from Corp, there was no transfer from the “debtor” for purposes of the UFTA.

The IRS contended that the Court should look to the substance of the transactional scheme to see that Buyer-2 was merely the entity through which Corp passed its liquidating distribution to Taxpayers.

The Court agreed with the IRS, remarking that the Tax Court had incorrectly “viewed itself bound by the form of the transactions rather than looking to their substance.”

The Court disagreed with the Tax Court’s finding that the IRS had not established the requisite knowledge on the part of the participants in the scheme to render Taxpayers accountable.

“Reasonable actors” in Taxpayers’ position, the Court stated, would have been on notice that Buyer-2 intended to avoid paying Corp’s tax obligation. After all, Investor communicated its intention to eliminate that tax obligation, and offered to pay a premium for Taxpayers’ shares; yet despite their suspicions surrounding the transaction, Taxpayers failed to press Investor or Buyer-2 for more information.

That Buyer-2 provided little information regarding how it would eliminate Corp’s tax liability, coupled with the actual structuring of the transactions, provided indications that should have been “hard to miss.” Indeed, Taxpayers’ counsel testified that when he asked for details, Buyer-2 told them “it was proprietary”; and in a lengthy memo analyzing the subject of potential transferee liability, counsel wrote that Buyer-2 would distribute almost all of Corp’s cash to repay the loan used to finance the deal, though the memo never analyzed how Buyer-2 could legally offset Corp’s taxable gain from the asset sale – it merely concluded that Taxpayers would not be liable as transferees of the proceeds of Corp’s asset sale.

The Court concluded that Taxpayers were, at the very least, on constructive notice of Buyer-2’s tax avoidance purpose. It was clear that Taxpayers’ stock sale to Buyer-2 operated, in substance, as a liquidating distribution by Corp to Taxpayers, but in a form that was designed to avoid tax liability.

Thus, the Court held that Corp’s constructive distribution to Taxpayers of the proceeds from its asset sale was a fraudulent transfer under State’s UFTA, and Taxpayers were liable to the IRS for Corp’s federal tax obligation as “transferees.”

Too Good to Be True

Indeed. How can any reasonable person argue that the shareholders of a corporation can strip the corporation of its assets through a liquidation yet avoid responsibility for the corporation’s outstanding tax liabilities? They can’t.

The fact that the liquidation is effected through a complex scheme involving several steps does not change this conclusion – it merely evidences a taxpayer’s attempt at concealing the true nature of the transaction.

Speaking of which, tax advisers are often drawn to the challenge of structuring complex transactions. Unfortunately, that is not necessarily a good thing, especially if the economic or business purpose for the transaction – the sight of which should never be lost – may become less discernable. Just as importantly, the transaction structure should not, if possible, be made so complex that it raises the proverbial red flag and the inevitable question of “what are they hiding?”

The old adage of “keeping it simple,” and the old rule of thumb, “does it pass the smell test?” still have their place in moderating what may be described as the “complex approach” to tax planning.

One of the thorniest tasks to confront a tax adviser may be having to determine whether the business or investment relationship between two taxpayers constitutes a partnership for tax purposes.

Where the persons involved have formed a limited liability company or a limited partnership under state law, they have formed a tax law partnership[i]; the fact that they did not intend to do so, or were motivated solely by the limited liability protection afforded by such a legal entity, is irrelevant.[ii]

In the absence of such a legal entity, however, the analysis can be challenging.

For example, in a typical “drop and swap,” a partnership may distribute a tenancy-in-common interest in real property to one of its members in liquidation of their partnership interest to enable such member to effect a like kind exchange with their share of the proceeds from the sale of the property, while the partnership and the remaining members dispose of their “collective” TIC interest for cash in a taxable sale. It is often difficult to conclude that the TIC ownership arrangement resulting from the distribution is distinguishable, for tax purposes, from the partnership that preceded it.[iii]

Although the TIC owner in the foregoing example sought to avoid partnership status with their former partners, it is sometimes the case that a taxpayer will try to establish partnership status for tax purposes so as to shift income – and the resulting tax liability[iv] – to another, as illustrated by the decision described below.

The Start of Something Wonderful?

Taxpayer and Friend agreed to work together in the real estate business. They did not reduce the terms of their business relationship to writing.[v]

Taxpayer withdrew cash from his retirement account, which he used to support the new business. Friend was unable to, and did not make, a similar financial contribution to the business.

Taxpayer’s personal checking account was used for the business’s banking during the first few months of operation. Friend had explained to Taxpayer that he had a history with bad checks in a prior business and could not open business bank accounts.

Bank accounts were later opened that were identified as business accounts. In one such account, the legal designation of the business was described as “corporation.” Taxpayer was the authorized signatory for the business accounts. In another, Taxpayer was listed as the sole signatory, and the business designation selected for the account was “Sole Proprietorship,” with Taxpayer identified as the sole proprietor.

The business was run very informally, though Taxpayer and Friend had different roles and responsibilities with respect to the business. As alluded to above, Taxpayer controlled the business’s funds, and used them to pay business expenses; and if Friend incurred a business-related expense, Taxpayer would reimburse him. But Taxpayer often used the business accounts to pay personal expenses, including personal expenses for Friend. Taxpayer also used his personal accounts to pay business expenses, and did not maintain books and records tracking these payments.

While Taxpayer argued that he and Friend had agreed to an equal division of profits, Taxpayer acknowledged at trial that this did not occur. The record showed irregular cash withdrawals by Taxpayer and some payments to Friend, along with commission payments and “draws” to other individuals. These cash withdrawals exceeded the documented payments made to, or on behalf of, Friend.

As the financial situation of the business deteriorated, the lines between business accounts and Taxpayer’s personal accounts became even more blurred.

The business ultimately failed. Taxpayer and Friend agreed to part ways, and Friend agreed to buy Taxpayer’s interests in the business.

Income Tax Returns

No Form 1065, U.S. Return of Partnership Income, was ever filed for the business.

Taxpayer and Friend each filed Forms 1040, U.S. Individual Income Tax Return, for the tax years at issue.

Both Taxpayer and Friend reported business income and expenses on Schedule C, Net Profit from Business, of their respective personal income tax returns for the years at issue. For example, Friend reported income for his “real estate” activities on his Schedules C, and his “Wage and Income Transcript” for these years indicated that he was issued Forms 1099-MISC, Miscellaneous Income, related to his real estate activities, though the gross receipts Friend reported on the Schedules C exceeded the total gross receipts reported to Friend on the Forms 1099-MISC. Taxpayer never explained how the payments reported to Friend were transferred to the business.

Unreported Income

In the process of examining Taxpayer’s tax returns and bank records, the IRS identified certain transfers to Taxpayer’s bank account and subsequently summoned bank records from this account.

The IRS conducted a bank deposits analysis to compute Taxpayer’s income but was unable to complete it given the incomplete bank account records received. As a result, the IRS used the specific-item method for the years at issue to reconstruct Taxpayer’s income.[vi] The IRS determined and classified deposit sources from the descriptions of deposited items on Taxpayer’s account records.

Based on its analysis, the IRS determined that Taxpayer had unreported Schedule C gross receipts for the years at issue.

Taxpayer did not argue that the gross receipts computed by the IRS were from nontaxable sources. Instead, Taxpayer asserted that the gross receipts were the revenue of a partnership and should have been split between Taxpayer and Friend as partners.

Taxpayer further argued that because the business profits should have been split, the gross receipts Taxpayer reported on his returns were overstated and should be adjusted downward to account for the amounts attributable to Friend.

Thus, the issue before the Tax Court was whether Taxpayer’s and Friend’s business relationship constituted a partnership during the tax years at issue.

Existence of Partnership?

If the business was properly classified as a partnership for tax purposes, Taxpayer would have been taxable on only his distributive share of the partnership’s income.

The Court explained that Federal tax law controls the classification of “partners” and “partnerships” for Federal tax purposes. A partnership, it stated, is an unincorporated business entity with two or more owners.[vii]

Whether taxpayers have formed a partnership – a type of “business entity” that is recognized for tax purposes – is a question of fact, and while all the circumstances are to be considered, “the hallmark of a partnership is that the participants carry on a trade, business, financial operation, or venture and divide the profits therefrom.” Thus, the “essential question” was whether Taxpayer and Friend intended to, and did in fact, join together for the conduct of such an enterprise.

In determining whether a partnership existed, the Court considered a number of factors, each of which is addressed below.[viii]

Agreement of Parties and Conduct in Executing Terms

Petitioners and Friend did not reduce the terms of their agreement to writing. A partnership agreement may be entirely oral and informal, but the parties must demonstrate that they complied with its terms.

While they may have agreed orally to an equal division of profits, Taxpayer acknowledged that this division did not occur. Taxpayer withdrew varying sums of money from the business at irregular intervals. Friend could not withdraw money directly but instead received irregular payments in amounts different from the withdrawals and payments by Taxpayer.

Taxpayer pointed out that Friend’s returns already reported his share of the business income. Taxpayer, however, never established that the Friend did not receive income from other sources.

Moreover, Taxpayer never explained how the payments reported on Friend’s Forms 1040 made their way into the business bank accounts or were accounted for otherwise.

Parties’ Contributions to Venture

Taxpayer withdrew funds from his retirement account and used them to capitalize the business, but there was no credible evidence that Friend made any capital contributions.

However, the record also suggested that Taxpayer and Friend each performed services related to the business.

Therefore, the Court weighed this factor as favorable toward finding a partnership.

Control Over Income and Right To Make Withdrawals

Taxpayer argued that Friend had equal rights to withdraw funds from the accounts, but the credible evidence before the Court indicated that Taxpayer had sole financial control. Taxpayer was the signatory on all of the business accounts throughout the business’s existence; Friend never was.

While the record showed that Taxpayer made payments to or on behalf of Friend, no evidence showed that Friend had rights to withdraw funds from the accounts aside from the fact that Taxpayer and Friend had debit cards; but the account statements did not indicate who made the withdrawals, nor did Taxpayer tie any specific expenditures to Friend.

While Friend received some payments related to the business, and Taxpayer made certain payments on behalf of Friend, this evidence was not enough for the Court to conclude that Friend had joint control over the business’s income.

Co-Owner or Non-partner Relationship

The IRS asserted that Friend had a separate business and was an independent contractor to whom Taxpayer paid commissions. Taxpayer asserted that Friend’s compensation was contingent on the proceeds from the business and there were no fixed salaries.

The record indicated that Friend played a role in the business, but the evidence was not sufficient to show that this role was as a co-owner, rather than as an independent contractor. Business owners, for example, may agree to compensate key employees with a percentage of business income, or brokers may be retained to sell property for a commission based on the net or gross sale price. Although these arrangements may result in a division of profits, neither constitutes a partnership unless the parties become co-owners.

The only evidence that Friend received payments more akin to a partner’s share than an independent contractor’s commission or draw was Taxpayer’s uncorroborated testimony, which the Court did not find credible.

Whether Business Was Conducted in Joint Names

As the business’s bank records reflected, the accounts were held in Taxpayer’s name and included the name of the business. Friend was not listed on any of the accounts. Further, Taxpayer designated the business as either a sole proprietorship or a corporation, not as a partnership.

This suggested that the parties both treated “the real estate business” as their own sole proprietorships – not as a joint enterprise – not just on their Forms 1040, but also to financial institutions (and potentially to check recipients).

Filing of Partnership Returns or Representation of Joint Venture

Taxpayer did not prepare and file a Form 1065 for the business for the taxable years at issue. Instead, Taxpayer and Friend each reported the income and expenses on their respective Schedules C.

Taxpayer asserted that the parties represented to others that they were joint venturers. The Court rejected Taxpayer’s uncorroborated testimony, stating that it could not overcome the parties’ reporting of income and expenses on their returns and the bank account records in evidence.

Maintenance of Separate Books and Accounts

Taxpayer contended that he maintained separate books and records at the entity level. However, Taxpayer failed to produce any evidence that separate books and accounts were maintained other than his uncorroborated testimony. The business bank accounts were held in Taxpayer’s name. Taxpayer also admitted that he used business accounts for personal expenses and personal accounts for business expenses.

This factor, therefore, weighed against finding that a partnership existed.

Exercise of Mutual Control and Assumption of Mutual Responsibilities

Taxpayer and Friend testified that they each assumed separate roles in the real estate activities, and the record supported a finding that they had a business relationship in which they had different roles.

But the fact that they may have performed separate functions did not convince the Court that the parties exercised the “mutual control” and shared the “mutual responsibilities” indicative of a partnership.

Court’s Decision

Considering the record as a whole, and applying the foregoing factors, the Court concluded that the business was not properly classified as a partnership between Taxpayer and Friend for tax purposes.

While the record indicated that Taxpayer and Friend had some sort of business relationship, the record did not support a conclusion that the business was a partnership.

Therefore, the Court held that Taxpayer had unreported Schedule C gross receipts.

Be Mindful

Any facts-and-circumstances-based determination can be tricky. The existence or non-existence of a partnership for tax purposes in the absence of a business entity created under state law (such as an LLC) is no exception, and an adviser must be careful of not allowing the result that they or their client desires that to influence their conclusion.

A joint venture or other contractual arrangement may create a separate entity for federal tax purposes if the participants carry on a trade, business, financial operation, or venture and divide the profits therefrom. For example, a separate entity exists for tax purposes if co-owners of an apartment building lease space and in addition provide services to the occupants either directly or through an agent.

However, a joint undertaking merely to share expenses does not create a separate entity for tax purposes. Similarly, mere co-ownership of property that is maintained, kept in repair, and rented or leased does not constitute a separate entity for federal tax purposes.

Nevertheless, if this co-ownership arrangement is placed into a multi-member LLC, for example, or if a Form 1065 is filed on its behalf, then the arrangement will be treated as a tax partnership and the owners will be hard-pressed to disregard the form they have “chosen.”

The point is that one should not find oneself in a “facts-and-circumstances” situation with the resulting uncertainty; nor should the participants in an investment activity inadvertently create a partnership with the complexity that it entails. With proper planning and documentation, the participants in a business or investment venture should know exactly how their economic relationship with one another and the business will be treated for tax purposes.

[i] The partnership will cease to be treated as such when it: has only one member (thereby becoming a sole proprietorship), has checked the box to be treated as an association taxable as a corporation, incorporates under state law, or ceases to engage in any activity and liquidates.

[ii] Many real estate investors fall into this situation, and they often regret it subsequently, when the property is to be sold and one of them wants to engage in a like kind exchange while the other wants cash.

[iii] This explains, in no small part, the presence of IRC Sec. 761 which affords certain co-owners the ability to elect out of partnership status. It is also why the IRS issued Rev. Proc. 2002-22 and its 15 factors to consider in determining whether a TIC co-ownership arrangement constitutes a partnership for purposes of the like kind exchange rules.

[iv] This shifting through the use of a partnership is frowned upon by the Code. See IRC Sec. 704(c) and 737, for example.

[v] Of course, they didn’t. Our posts abound with instances in which a well-drafted agreement would have saved everyone involved from the exorbitant costs of litigation.

[vi] The specific-item method is a method of income reconstruction that consists of evidence of specific amounts of income received by a taxpayer and not reported on the taxpayer’s return.

A taxpayer is responsible for maintaining adequate books and records sufficient to establish the amount of his income. If a taxpayer fails to maintain and produce the required books and records, the IRS may determine the taxpayer’s income by any method that clearly reflects income. The IRS’s reconstruction of income “need only be reasonable in light of all surrounding facts and circumstances.”

[vii] Reg. Sec. 1.761-1, 301.7701-1, 301.7701-2 and 301.7701-3.

[viii] The Court considered the following factors:

(1) The agreement of the parties and their conduct in executing its terms;

(2) The contributions, if any, which each party has made to the venture;

(3) The parties’ control over income and capital and the right of each to make withdrawals;

(4) Whether each party was a principal and co-proprietor, sharing a mutual proprietary interest in the net profits and having an obligation to share losses, or whether one party was the agent or employee of the other, receiving for his services contingent compensation in the form of a percentage of income;

(5) Whether business was conducted in the joint names of the parties;

(6) Whether the parties filed Federal partnership returns or otherwise represented to respondent or to persons with whom they dealt that they were joint venturers;

(7) Whether separate books of account were maintained for the venture; and

(8) Whether the parties exercised mutual control over and assumed mutual responsibilities for the enterprise.


Woe to the Oppressed Shareholder
As I write this post on Bastille Day, I am reminded how an oppressed people, realizing the injustice of their circumstances, and having reached the limits of their endurance, took the first step toward “replacing” the lords and ladies that had long lived lavishly on their labors. [1]

If only it were so straightforward for an oppressed shareholder, especially in a pass-through entity such as an S corporation. As a minority owner, they have little to no say in the management or operation of the business, or in the distribution of the profits therefrom. Oftentimes, they are denied information regarding the finances of the business, with one exception: every year they receive a Schedule K-1 that sets forth their share of the corporation’s items of income, deduction, gain, loss, and credit for the immediately preceding year.

As a matter of Federal tax law, they are required to report these K-1 items on their own income tax returns, and – regardless of whether or not they received a distribution from the corporation – they must remit to the IRS the resulting income tax liability.

As one might imagine, this may create a cash flow problem for the oppressed shareholder. They are typically denied employment in the business and, so, do not receive compensation from the corporation. Thus, in order to satisfy their tax liability attributable to the S corporation, they are often forced to withdraw cash from other sources, or to liquidate personal assets (which may generate additional taxes).

In some cases, the oppressed shareholder in an S corporation has sought to “revoke” the “S” election and, thereby, to stop the flow-through of taxable income and the resulting outflow of cash. [2]

An S corporation may lose its tax-favored status by ceasing to qualify as a “small business corporation,” which means that it admits an ineligible person as an owner, or it has more than one class of stock outstanding. The Tax Court recently considered a situation in which an oppressed shareholder sought to use the disproportionate sharing of economic benefits between the shareholders as a basis for concluding that the corporation had more than one class of stock.

So Much for Egalité et Fraternite
Taxpayer and his brother (“Bro”) incorporated Corp. During the years in issue, Taxpayer owned 49% of the shares of Corp, and Bro owned 51%. The brothers elected to treat Corp as an S corporation for Federal income tax purposes. They also agreed that distributions would be proportional to their ownership shares.

Taxpayer, Bro and Bro’s spouse (“B-Spouse”) were the directors of Corp, and each participated in its business. Bro served as Corp’s president, B-Spouse as corporate secretary, and Taxpayer as vice president. Bro directed the administrative aspects of Corp’s business, while B-Spouse was Corp’s office manager. Bro and B-Spouse were responsible for the corporation’s bookkeeping and accounting.

Taxpayer’s work for Corp primarily involved managing operations in the field. He spent most of his working hours at jobsites, not in the office. Taxpayer received compensation as an employee of Corp for the years in issue.

Prior to the years in issue, Corp filed Forms 1120S, U.S. Income Tax Return for an S Corporation, and issued Schedules K-1 to Bro and Taxpayer. These filings reflected that the shareholders received cash distributions from Corp proportional to their stock ownership.

During the years in issue, Taxpayer began to examine more closely the administration of Corp’s business.

Taxpayer noticed that certain credits cards in his name, which he maintained for business purposes, were being used without his authorization to pay personal expenses of Bro’s children. Shortly thereafter, he reviewed the corporation’s QuickBooks records and determined that numerous items, including handwritten checks drawn on its bank accounts, had not been entered into the corporation’s accounting records. He also obtained and reviewed online banking statements for the corporation’s bank accounts. Taxpayer determined that, during the years in issue, Bro and B-Spouse had been making substantial check and ATM withdrawals from Corp’s bank accounts without his knowledge. [3]

Also during this period, Corp’s business began to struggle. Taxpayer received calls from Corp’s vendors who had tried unsuccessfully to contact Bro and B-Spouse regarding payments that they were owed and wanted to know when they would be paid. Corp had trouble paying its employees, and some of its checks were returned. Taxpayer had multiple discussions with Bro and B-Spouse about Corp’s cash flow problems. They told him that they were working on getting more money into the business.

Taxpayer became frustrated with the progress of Corp’s business and with the discussions that he was having with Bro. Finally, Taxpayer sent Bro an email stating that if Bro would not help him try to remedy the business, then Taxpayer would have no choice but to resign and sell his shares to Bro for a nominal amount. Bro responded that he would accept that offer effective immediately.

With that, Taxpayer completed some tasks for ongoing projects, and then quit his work for Corp. He never received payment from Bro for his shares of Corp.

The IRS Audit
Taxpayer filed Federal income tax returns for the years in issue. He attached Schedules E to the returns for these years, on which he listed Corp as an S corporation in which he held an interest. Taxpayer did not report any items of income or loss from Corp for the years in issue – these lines were left blank.

Taxpayer also attached to these returns Forms 8082, Notice of Inconsistent Treatment, relating to his interest in Corp, on which Taxpayer notified the IRS that he had not received Schedules K-1 from Corp.

Corp did not file Forms 1120S or issue Schedules K-1 for the years in issue. The IRS examined Corp, and prepared substitute tax returns using Corp’s banking records, general ledger, available employment tax returns, and other records to determine the corporation’s income and allowable deductions. The IRS allocated Corp’s net income as ordinary income to Taxpayer and Bro according to their 49% and 51% ownership shares, respectively.

The IRS also analyzed the shareholders’ distributions for the years in issue. For one year, the IRS determined that Taxpayer received less than one-third the amount of the distributions actually or constructively received by Bro; for the other year, it found that Taxpayer received less than one-ninth the amount of the distributions received by Bro. The IRS prepared basis computation worksheets for Taxpayer’s shares of Corp, and determined that Taxpayer was not required to include the distributions that he received in gross income for the years in issue because the amounts did not exceed his adjusted stock basis.

The notice of deficiency issued to Taxpayer determined increases to his Schedule E flow-through income for the years in issue, based upon the determinations set forth in the substitute returns prepared by the IRS for Corp.

Taxpayer disagreed with the IRS’s determination, and timely petitioned the Tax Court. Taxpayer contended that the income determined for Taxpayer – i.e., 49% of Corp’s net income for each of the years in issue – should not be attributable to him. [4]

Second Class of Stock?
Generally, an S corporation – or an electing “small business corporation” – is not subject to Federal income tax; rather, it is a conduit in that its income “flows through” to its shareholders, who are required to report and pay taxes on their pro rata shares of the S corporation’s taxable income.

The Code defines a small business corporation as a domestic corporation which must satisfy a number of requirements, including the requirement that it not have “more than 1 class of stock.” [5]

Generally, a corporation will be treated as having only one class of stock “if all outstanding shares of stock of the corporation confer identical rights to distribution and liquidation proceeds.” [6]
Once an eligible corporation elects S corporation status, that election is effective for the tax year for which it is made and for all succeeding tax years until it is terminated. The Code provides that an election shall be terminated automatically whenever the corporation ceases to qualify as a small business corporation.

When Taxpayer and Bro organized Corp, they clearly intended to create one class of stock. They agreed that all distributions would be proportional to their stock ownership, and their tax filings before the years in issue reflected that their shares of stock each had equal rights to distributions. Corp elected to be treated as an S corporation. For years before the years in issue it filed Forms 1120S and issued Schedules K-1 to Taxpayer reflecting his pro rata shares of the corporation’s taxable income.

Taxpayer contended that Corp’s “S” election was terminated during the years in issue because it ceased to be a small business corporation. Specifically, he contended that Corp no longer satisfied the requirement that it have only one class of stock – Bro withdrew large sums of money from Corp’s bank accounts during the years in issue without Taxpayer’s knowledge, and the IRS’s computations showed that Bro and Taxpayer received distributions for the years in issue that were not proportional to their stock ownership. Taxpayer argued that “these substantially disproportionate distributions appear to create a preference in distributions and . . . effectively a second class of stock”. He contended that Corp should be treated as a C corporation, and that Taxpayer should be taxed only on the distributions that he received, which he contended should be treated as dividends.

The Court’s Analysis
According to the Court, in determining whether a corporation has more than one class of stock, the rights granted to shareholders in the corporation’s organizational documents and other “binding agreements” between shareholders have to be considered. The applicable IRS regulations, the Court stated, provide that “[t]he determination of whether all outstanding shares of stock confer identical rights . . . is made based on the corporate charter, articles of incorporation, bylaws, applicable state law, and binding agreements relating to distribution and liquidation proceeds (collectively, the governing provisions).”

Evidence of distributions paid to one shareholder and not to others over the course of multiple years was insufficient on its own, the Court stated, to establish that a separate class of stock was created.

The Court concluded that Taxpayer had failed to prove that a binding agreement existed that granted Bro enhanced or disproportionate “rights to distribution and liquidation proceeds.” Rather, the Court found that, at most, there had been “an informal, oral understanding among the board members/shareholders”, and there was no evidence that the directors or shareholders ever took “formal corporate action to implement that understanding.”

The original, operative agreement between Corp’s shareholders (Taxpayer and Bro) was that distribution rights for each of their shares would be identical. Taxpayer testified that he and Bro never discussed changing the agreement regarding distributions and, during the years in issue, his understanding continued to be that distributions should be proportional to stock ownership. The record reflected that the shareholders never reached, or even considered, a new binding agreement that would change their relative rights to distributions.

Taxpayer argued that Bro’s withdrawals “effectively changed . . . [the shareholders’ agreement] by majority action.” However, the Court replied, nothing in the record indicated that Bro intended to act as Corp’s majority shareholder to grant himself rights to disproportionate distributions. Taxpayer offered no evidence of any actions taken at the corporate level to redefine shareholders’ rights or to issue a new class of stock. Moreover, he did not establish that a unilateral change of the kind described (i.e., the creation of a new class of stock) would be allowable under the applicable State law.

Taxpayer contended that the Court should regard “the substance of the actions” taken by Bro as creating a second class of stock. The Court noted, however, that Taxpayer’s own tax returns for the years in issue identified Corp as an S corporation. It then explained that taxpayers are generally bound by the form of the transaction that they choose unless they can provide “strong proof” that the parties intended a different transaction in substance. There was no proof, the Court observed, that either Taxpayer or Bro intended an arrangement different from that which they agreed to and reported consistently on their tax filings.

In short, Bro’s withdrawals during the years in issue did not establish that he held a different class of stock with disproportional distribution rights. Taxpayer failed to show that there were any changes to Corp’s governing provisions. Thus, he failed to carry his burden of proving that Corp’s election to be treated as an S corporation terminated during the years in issue and, consequently, the Court sustained the IRS’s determination that Taxpayer should be allocated 49% of Corp’s net income for each of the years in issue.

C’mon . . .?
Yes, on some visceral level, the Court’s decision seems harsh. But it is important to distinguish between the administration of the Federal tax system, on the one hand, and the protection of an oppressed shareholder, on the other. The latter may suffer certain adverse tax consequences as a result of a controlling shareholder’s inappropriate behavior, but they should not expect the Federal government to right those wrongs; rather, they have recourse to the courts and the laws of the jurisdiction under which the corporation was formed, and which govern the relationships among the shareholders and with the corporation itself.

That being said, shareholders have to be aware of what the Federal tax laws provide in order that they may take the appropriate steps to protect themselves, regardless of the size of their stockholdings. These steps are typically embodied in the terms of a shareholders’ agreement. [7]

As the Court explained, a determination of whether all outstanding [8] shares of stock confer identical rights to distribution and liquidation proceeds – i.e., whether there is only one class of stock – is made based on the corporate charter, articles of incorporation, bylaws, applicable state law, and binding agreements relating to distribution and liquidation proceeds (for example, a shareholders’ agreement).

Although a corporation is not treated as having more than one class of stock so long as these governing provisions provide for identical distribution and liquidation rights, any distributions (including actual, constructive, or deemed distributions) that differ in timing or amount are to be given appropriate tax effect in accordance with the facts and circumstances.

A commercial contractual agreement, on the other hand, such as a lease, employment agreement, or loan agreement – such as may be entered between the corporation and a controlling shareholder – is not treated as a binding agreement relating to distribution and liquidation proceeds unless a principal purpose of the agreement is to circumvent the one class of stock requirement (for example, where the terms are not at arm’s-length).

Similarly, buy-sell agreements among shareholders, agreements restricting the transferability of stock, and redemption agreements are disregarded in determining whether a corporation’s outstanding shares of stock confer identical distribution and liquidation rights. Although such an agreement may be disregarded in determining whether shares of stock confer identical distribution and liquidation rights, payments pursuant to the agreement may have other tax consequences. [9]

However, if a principal purpose of the agreement is to circumvent the one class of stock requirement, and the agreement establishes a purchase price that, at the time the agreement is entered into, is significantly in excess of or below the FMV of the stock, the one-class of stock rule may be violated.

Again, it will behoove a shareholder of an S corporation to appreciate the parameters described above.


[1] Alliteration has its place.

[2] This raises the question: do the shareholders have a shareholders’ agreement and, if they do, does it restrict the transfer of shares, or require that the shareholders preserve the corporation’s tax status?

[3] Basically, constructive dividends. Less euphemistically, theft?

[4] The Court began its discussion by pointing out that, in general, the taxpayer bears the burden of proving that the IRS’s determinations set forth in the notice of deficiency are incorrect. In cases of unreported income, however, the IRS bears the initial burden of producing evidence linking the taxpayer with the receipt of funds before the general presumption of correctness attaches to a determination. Once the IRS meets this burden of production, the Court explained, the burden of persuasion remains with the taxpayer to prove that the IRS’s deficiency calculations were arbitrary or erroneous.

Corp failed to file income tax returns or to maintain adequate books and records for the years in issue. The IRS obtained banking records and conducted bank deposits analyses to determine the company’s net income. Bank deposits are prima facie evidence of income, the Court stated, and the “bank deposits method” was an acceptable method of computing unreported income.

The Court found that the IRS satisfied the burden of production with respect to the unreported income items at issue.

[5] https://www.law.cornell.edu/uscode/text/26/1361 .

[6] Reg. Sec. 1.1361-1(l). https://www.law.cornell.edu/cfr/text/26/1.1361-1.

[7] When Taxpayer and Bro were still on good terms, they should have agreed that Corp would make regular tax distributions, at least annually.

[8] The reference to “outstanding” shares is important; an S corporation’s certificate of incorporation may authorize the issuance of a preferred class of stock, but so long as such preferred class has not been issued and remains outstanding, the “S” election will remain in effect.

[9] For example, gift tax.




Tax Returns Are Like Paintings   [I]

A not insignificant portion of our tax practice involves disputes among the shareholders and partners of closely held businesses, or among the beneficiaries and fiduciaries of estates or trusts where a significant part of the assets at issue consists of interests in closely held businesses.

In addition to structuring the separation of such parties on a tax efficient basis – including the division of the business where appropriate – we will comb through the tax filings of a business to gather information that may be helpful to our client in negotiating a settlement or, if necessary, in litigating their case. For example, the return will disclose information about distributions, loans by or to owners, compensation paid to owners, rental payments, transactions with affiliated entities, etc. In other words, the return will reveal a number of ways by which value may have been withdrawn from the business.

An earlier post considered how a business owner, to whom information about the business has been denied by their fellow owner(s), may obtain such information, as well as circumstantial evidence about other goings-on in the business, by requesting copies of tax returns from the IRS.

A recent decision[ii] by a Federal District Court described one taxpayer’s efforts to obtain tax return information from the IRS related to his family’s business.

Breach of Fiduciary Duty?

Taxpayer’s grandfather founded a successful business (the “Business”) as a sole proprietorship. Upon his death, the Business passed to Taxpayer’s father, who incorporated the Business (the “Corp”). Taxpayer claimed that he became an “authorized individual” for the business after his father’s death, and he alleged that he was the beneficiary of his father’s estate. Taxpayer’s father and grandfather each created trusts (the “Trusts”) which identified Taxpayer as a beneficiary. It appears that Taxpayer was not a direct owner of the business.

Taxpayer suspected that the trustees of the Trusts had somehow breached their fiduciary duties to the beneficiaries of the Trusts.

In order to confirm his suspicions, Taxpayer submitted forms to the IRS requesting copies of several years of income tax returns for the Business and Corp, most of which the IRS provided, along with a “Business Master File Transcript-Complete,” which listed all tax returns and documents filed on behalf of Corp.[iii]

Taxpayer subsequently submitted more Privacy Act and Freedom of Information Act (“FOIA”) requests for various tax records relating to himself, his father and grandfather, the Business, Corp, his father’s estate, and the Trusts.

Although the IRS contended that it had released all responsive records to which Taxpayer was entitled, he insisted that the IRS was unlawfully withholding documents.

Taxpayer then commenced the suit before the Court, seeking relief under the Code – which mandates disclosure of tax return information to certain persons – FOIA and the Privacy Act.

The IRS moved to dismiss some of these claims, and for summary judgment as to the others.

Laying Down the Rules

The Court reviewed the applicable standards of review, as well as the allocation of the burden of proof.


It noted that, in FOIA cases, the IRS bears the burden of demonstrating the adequacy of its search and that it properly withheld any documents from the requesting party.

The Court stated that it may grant summary judgment based solely on the information provided in the IRS’s affidavits or declarations when they “describe the documents and the justifications for nondisclosure with reasonably specific detail, demonstrate that the information withheld logically falls within the claimed exemption, and are not controverted by either contrary evidence in the record or by evidence of agency bad faith.” Such affidavits or declarations are “accorded a presumption of good faith,” the Court continued, “which cannot be rebutted by ‘purely speculative claims about the existence and discoverability of other documents.’”


The Privacy Act, the Court explained, provides a cause of action against an agency that refuses to comply with an individual’s request for his records. Before bringing such a claim in court, however, a plaintiff must submit a “Privacy Act inquiry [that is] clearly marked ‘request for notification and access’ and ‘contain[s] a statement that it is being made under the provisions of’ [the statute].” Failure to do so is cause for dismissal because exhaustion of administrative remedies under the Privacy Act is a jurisdictional prerequisite for judicial review.

The Court’s Analysis

Even accepting all of Taxpayer’s allegations as true, the Court determined that he did not actually plead that he submitted requests for most of the information sought.

Rather, he cursorily alleged that he “mailed a FOIA and PA Request with supporting documents” and the IRS never responded. Such a conclusory allegation, the Court stated, was not enough to avoid dismissal. The only specific requests Taxpayer mentioned in the complaint were for Corp’s tax returns. He never alleged that he had ever submitted a request for the other documents.

The Court next turned to Taxpayer’s requests for tax information for his grandfather, father, his father’s estate, the Trusts, the Business and Corp.

The IRS contended that it had released all responsive records to which Taxpayer was entitled.

Thus, the Court had to determine whether Taxpayer was authorized to receive the other documents he had requested and, if so, whether the IRS’s search for those records was adequate.

Authorized Access

“For good reason,” the Court stated, “not just anyone can obtain the tax information of another person or corporation. Tax returns and accompanying information are ‘confidential’ and can only be disclosed to those authorized by statute and regulation. Before the Service can release an individual’s tax information, the requester must ‘establish [his] identity and right to access such records’ by “provid[ing] adequate proof of the legal relationship under which [he] assert[s] the right to access the requested records.” Until the requester does so, the IRS “is not obligated to process the request,” and if he “nonetheless files suit, [he] is said to have failed to exhaust [his] administrative remedies.” A plaintiff bears the burden of showing entitlement to records.

Taxpayer submitted copies of the death certificates of his father and grandfather, the Trust agreements, and his own social security card. The IRS did not dispute that this information was sufficient for Taxpayer to obtain the records of himself, his father, Corp, the Trusts, and his father’s estate, but it contested that the submitted documents also established that he was authorized to receive records pertaining to his grandfather, the Business, or his grandfather’s estate.

The Court agreed with the IRS.

It explained that, when seeking tax records for a deceased individual or an estate, a requester must show that he is the “administrator, executor, or trustee of [the] estate” or an “heir at law, next of kin, or beneficiary under the will, of such decedent.” None of Taxpayer’s submitted documents established such a relationship. His grandfather’s trust agreement stated that Taxpayer was entitled only to a part of the trust; because trusts and estates are different legal entities, Taxpayer’s rights under the trust did not automatically make him a beneficiary of his grandfather’s estate under his will, as required by statute.

As to the Business, Taxpayer had to show that he was: 1) “designated [for access] by resolution of its board of directors”; 2) “an officer or employee” who has been designated access by a “principal officer and attested to by the secretary or other officer”; 3) a “bona fide shareholder of record owning 1 percent or more of the outstanding stock of such corporation”; 4) for an S corporation, that he was “a shareholder during any part of the period covered by such return during which an election . . . was in effect”; or 5) for dissolved corporations, that he has been “authorized by applicable [s]tate law to act for the corporation” or found by the IRS “to have a material interest which will be affected by” the information.

Taxpayer did not allege that he submitted any of the forms of proof required by the statute. He, instead, stated that “his records” listed him as a “Member/Shareholder of the [Business].” The Court reviewed this document and was unable to locate such an indication. Even if that information did appear on the document, it would still not satisfy the requirements for disclosure because Taxpayer had to show that, as a shareholder, he owned more than 1% of the outstanding stock or that (if an S corporation) he was a shareholder during the relevant period.

Taxpayer also seemed to argue that the IRS would be able to see whether he met the above criteria for disclosure because it could look at the returns filed by the Business and determine how much of a share Taxpayer inherited through his father.

Even if that were true, the Court countered, Taxpayer – not the IRS – bore the burden of establishing access to records. Moreover, to the extent that he attempted to argue that as a shareholder of Corp he was also an owner of the Business, and thus entitled to access, Taxpayer had not established that these two entities were the same, such that being an owner of one would mean he was an owner of the other.

The Court thus agreed with the IRS that Taxpayer had only established authorization to obtain tax information for Corp, his father, his father’s estate, the Trusts, and himself.

The appropriateness of the IRS’s search – and, therefore, of its refusal to disclose records to Taxpayer – would be limited to those entities and individuals.

Adequacy of the Search

Taxpayer challenged the IRS’s search for several categories of his requested records.

The Court explained that “an agency fulfills its obligations under FOIA if it can demonstrate beyond material doubt that its search was ‘reasonably calculated to uncover all relevant documents.’” Stated differently, the issue was not whether there might exist any other documents possibly responsive to the request but, rather, whether the search for those documents was adequate.

The adequacy of an agency’s search for documents requested under FOIA “is judged by a standard of reasonableness and depends . . . upon the facts of each case.” To meet its burden, the agency may submit affidavits or declarations that explain the scope and method of its search “in reasonable detail.” The affidavits or declarations should “set forth the search terms and the type of search performed, and aver that all files likely to contain responsive materials (if such records exist) were searched.” Absent contrary evidence, such affidavits or declarations are sufficient, the Court stated, to show that an agency complied with FOIA. “If, however, the record leaves substantial doubt as to the sufficiency of the search, summary judgment for the agency is not proper.”

The IRS produced the Declaration of a Government Information Specialist in the IRS Office of Privacy, Government Liaison and Disclosure and, based upon this affidavit, contended that it had performed an adequate search and had released all responsive records.

Schedule K-1

Taxpayer requested K-1 information for himself from several of the entities, stretching back many years. According to the IRS, this information “would show up on Taxpayer’s transcripts” if it existed, but that system only retains information returns for ten years. Unfortunately for Taxpayer, the information for the latest date for which he had requested K-1 information had already been purged.

Next, the IRS manually searched Taxpayer’s transcripts for the requested years “in case he perhaps had attached his Forms K-1 to his own returns.” It then sent a request to its long-term storage facility to locate any responsive files. Personal tax returns however, are destroyed after seven years. Again, the information for the years requested had already been destroyed.

Finally, the IRS “checked to see if the [grandfather’s trust] had filed a Form 1041,” which would have had K-1 information attached – nothing. After realizing it did not search for K-1s from the father’s trust and estate, the IRS conducted a supplemental search using the same method described above and did not locate any responsive records.

Taxpayer next argued that the IRS should have been able to locate the estate tax return filed for his grandfather’s estate because such forms are retained for 75 years. The IRS asserted simply that it had “searched for the Form 706 . . . and [was] unable to locate it.”

Such a cursory explanation, the Court stated, was not a “reasonably detailed” description of the search because it did not “set forth the search terms and the type of search performed.” Although the IRS alleged that it had a copy of the Form 706, Taxpayer sought the original, which he said may have K-1 information attached. Thus, the Court was unable to grant the IRS’s summary judgment motion on this point.

Based upon the foregoing, the Court dismissed most of Taxpayer’s complaints and granted most of the IRS’s motion for summary judgement.

Forewarned is Forearmed

There are a number of ways by which a taxpayer may obtain tax return information relating to themselves or to an entity in which they have a beneficial or other interest. The discussion above identified the most important of these, including Section 6103(e) of the Code, the Freedom of Information Act[iv] (which applies to all Federal agencies, and may provide access to many kinds of IRS records), and the Privacy Act of 1974[v] (which provides access to the taxpayer’s own records).

In every case, the taxpayer has to carefully comply with the requirements of each statutory regime, including the regulations and any other rules promulgated thereunder, if they are to obtain the desired information.

The taxpayer also has to be aware of the fact that the IRS is not required to maintain tax records indefinitely. Thus, it will behoove a taxpayer who reasonably believes that there may be cause for concern over the management of a business or other entity in which they are interested, but over which they have no control and only limited access to information, to request the relevant tax return information sooner rather than later – first, from the entity, then from the IRS – and, thereby, to begin developing a record and supporting their claims.

[i] Ok, a return may not say a thousand words, and the simile may be more akin to saying that ogres are like onions or parfaits. Sorry Shrek.

[ii] U.S. District Court for the District of Columbia, WILLIAM E. POWELL v. INTERNAL REVENUE SERVICE, Civil Action No. 17-278 (JEB).

[iii] Last week’s post described a business-owner who sought copies of the tax returns of another party – a co-owner of the business – through discovery.

[iv] 5 U.S.C. 552.

[v] P.L. 93-579.

Decisions, Decisions

The reduction in the Federal income tax rate for C corporations, from a maximum of 35-percent to a flat 21-percent, along with several other changes made by the Tax Cuts and Jobs Act (the “Act”) that generally reflect a pro-C corporation bias, have caused the owners of many pass-through entities (“PTEs”) to reconsider the continuing status of such entities as S corporations, partnerships, and sole proprietorships.

Among the factors being examined by owners and their advisers are the following:

  • the PTE is not itself a taxable entity, and the maximum Federal income rate applicable to its individual owners on their pro rata share of a PTE’s ordinary operating income is 37-percent[i], as compared to the 21-percent rate for a C corporation;
  • the owners of a PTE may be able to reduce their Federal tax rate to as low as 29.6-percent if they can take advantage of the “20-percent of qualified business income deduction”;
  • a PTE’s distribution of income that has already been taxed to its owners is generally not taxable[ii], while a C corporation’s distribution of its after-tax earnings will generally be taxable to its owners at a Federal rate of 23.8%, for an effective combined corporate and shareholder rate of 39.8%;
  • the capital gain from the sale of a PTE’s assets will generally not be taxable to the PTE[iii], and will generally be subject to a Federal tax rate of 20-percent in the hands of its owners[iv], while the same transaction by a C corporation, followed by a liquidating distribution to its shareholders, will generate a combined tax rate of 39.8%.[v]

The application of these considerations to the unique facts circumstances of a particular business may cause its owners to arrive at a different conclusion than will the owners of another business that appears to be similarly situated.

Even within a single business, there may be disagreement among its owners as to which form of business organization, or which tax status, would optimize the owners’ economic benefit, depending upon their own individual tax situation and appetite.[vi]

In the past, this kind of disagreement in the context of a closely held business has often resulted in litigation of the kind that spawned the discovery issue described below. The changes made by the Act are certain to produce more than their share of similar intra-business litigation as owners disagree over the failure of their business to make or revoke certain tax elections, as well as its failure to reorganize its “corporate” structure.

A Taste of Things to Come?

Corporation was created to invest in the development, production, and sale of a product. Among its shareholders was a limited partnership (“LP”), of which Plaintiff was the majority owner.

Plaintiff asserted that Corporation’s management (“Defendants”) had breached their fiduciary duty to LP and the other shareholders. This claim was based upon the fact that Corporation was a C corporation and, as such, its dividend distributions to LP were taxable to LP’s members, based upon their respective ownership interest of LP.[vii]

Plaintiff claimed that this “double taxation” of Corporation’s earnings – once to Corporation and again upon its distribution as a dividend to its shareholders – had cost the business and its owners millions of dollars over the years, was “unnecessary,” had reduced the value of LP, and could have been avoided if Corporation had been converted into an S corporation, at which point LP would have distributed its shares of Corporation stock to its members, who were individuals.

Plaintiff stated that it had made repeated requests to Defendants to “eliminate this waste,” but to no avail.

Thus, one of the forms of relief requested by Plaintiff was “[p]ermanent injunctive relief compelling the Defendants to take all appropriate actions necessary to eliminate the taxable status of [Corporation] that results in an unnecessary level of taxation on distributions to the limited partners of [LP].”

“Prove It”

Defendants asked the Court to compel Plaintiff to produce Plaintiff’s tax returns for any tax year as to which Plaintiff claimed to have suffered damages based upon Corporation’s tax status.

Defendants asserted that, in order to measure any damages that were suffered by Plaintiff by reason of Corporation’s status, Defendants needed certain information regarding Plaintiff’s taxes, including Plaintiff’s “tax rate, deductions, credits and the like.”

Plaintiff responded that their “tax returns have no conceivable relevance to any aspect of this case.” Among other reasons, Plaintiff asserted that the action was brought derivatively on behalf of LP such that Plaintiff’s personal tax returns were not germane.

Defendants countered that, even if Plaintiff’s claims were asserted derivatively, the tax returns nevertheless were relevant since Plaintiff was a member of LP, the entity on whose behalf the claims were made.

The Court’s Decision

According to the Court, tax returns in the possession of a taxpayer are not immune from civil discovery. It noted, however, that courts generally are “reluctant to order the production of personal financial documents and have imposed a heightened standard for the discovery of tax returns.”

The Court explained that a party seeking to compel production of tax returns in civil cases must meet a two-part test; specifically, it must demonstrate that:

  • the returns are relevant to the subject matter of the action; and
  • there is a compelling need for the returns because the information contained therein is not otherwise readily obtainable.

Limited partnerships, the Court continued, “are taxed as ‘pass-through’ entities, do not pay any income tax, but instead file information returns and reports to each partner on his or her pro-rata share of all income, deductions, gains, losses, credits and other items.” The partner then reports those items on his or her individual income tax return. “The limited partnership serves as a conduit through which the income tax consequences of a project or enterprise are passed through to the individual partners.”

The Court found that Plaintiff’s tax returns were relevant to the claims asserted. The crux of Plaintiff’s argument regarding Corporation’s status, the Court stated, was that LP’s partners, including Plaintiff, were subject to “double taxation” and were thereby damaged.

The Court also found that Defendants had established a compelling need. The Court was satisfied that, in order for Defendants to ascertain whether or not Plaintiff, who owned a majority interest in LP, would have paid less tax if Corporation had been converted to an S corporation, Plaintiff had to produce their tax returns to Defendants. The tax returns would disclose, among other things, Plaintiff’s tax rate, deductions and credits that affected the tax due by Plaintiff.

Furthermore, the Court continued, Plaintiff failed to demonstrate that there were alternative sources from which to obtain the information. “While the party seeking discovery of the tax returns bears the burden of establishing relevance, the party resisting disclosure should bear the burden of establishing alternative sources for the information.”

Any concerns that existed regarding the private nature of the information contained in the tax returns could be addressed, the Court stated, by making the tax returns subject to the terms of the “stipulation and order of confidentiality” previously entered in the case.[viii]

Accordingly, the Court granted Defendants’ motion.

What’s Good for the Goose?

For years, oppressed or disgruntled shareholders and partners have often found in the tax returns of the business, of which they are owners, the clues, leads, or circumstantial evidence that help support their claims of mismanagement or worse by those in control of the business.

As a result of the Act, it is likely that some non-controlling owners will find cause for questioning or challenging the “choice of entity” decisions made on behalf of the business by its controlling owners.[ix]

In some cases, their concerns will be validated by what turn out to be true instances of oppression intended to cause economic harm and, perhaps, to force out the intended target.

In others, however, the controlling owner’s decision will have been reached only after a lot of due diligence, including financial modelling and consulting with tax advisers. In such cases, the controlling owner may want to examine the complaining party’s tax return, as in the Court’s decision described above, so as to ascertain whether the loss claimed was actually suffered.

It bears repeating, though, that even if the tax return information may be relevant to the controlling owner’s defense, there is a judicial bias against the disclosure of such information that is manifested in the application of “a heightened standard for the discovery of tax returns.” As stated earlier, the requesting party has to demonstrate that there is a “strong necessity” for the returns, and that the return information is not readily obtainable from other sources.

In the end, the best course of action for the “choice-of-entity” decision-maker, and their best defense against any claims of oppression or mismanagement, is to demonstrate that they acted reasonably and responsibly; they should thoroughly document the decision-process, and explain the basis for their decision. With that, a potential owner-claimant would be hard-pressed to second-guess them with any reasonable likelihood of success.

[i] If the PTE’s business is a passive activity with respect to the owner, the 3.8% Federal surtax on net investment income may also apply, bumping their maximum Federal tax rate up from 37% to 40.8%.

[ii] Because of the upward basis adjustment to the owner’s partnership interest or S corp. stock resulting from the inclusion of the PTE’s income or gain in the owner’s gross income.

[iii] There are exceptions; for example, the built-in gains tax for S corps. https://www.taxlawforchb.com/2013/09/s-corp-sales-built-in-gain-and-2013/ . In addition, the gain from the sale of certain assets may generate ordinary income that would be taxable to the PTE’s owners at a Federal rate of 37%; for example, depreciation recapture.

[iv] But see endnote i, supra.

[v] The operating income and capital gain of a C corporation are taxed at the same rate; there is no preferential Federal capital gain rate as in the case of individuals.

[vi] You may have heard your own clients debating the pros and cons of spinning off “divisions” so as to position themselves for maximizing the deduction based on qualified business income. All this before the issuance of any guidance by the IRS (which is expected later this month), though the Service intimated last month that taxpayers may not be pleased with its position regarding such spin-offs.

[vii] See the third bullet point, above.

[viii] Such an order may be used in cases requiring the exchange, as part of the discovery process, of what the parties to the law suit believe is confidential information.

[ix] For example, a shareholder of an S corporation that does not make distributions, who is not employed by the business, who is a passive investor in the business, and whose pro rata share of the corporation’s income is subject to federal tax at a rate of 40.8%, may wonder why the controlling shareholder does not agree to revoke the “S” election, to at least start making tax distributions.

Last week’s post may have left some readers feeling lightheaded or anxious. [1] It is highly unlikely that this week’s post will leave these individuals in a greatly altered state, though it may alleviate their condition to some extent, at least momentarily.

That is not to say that the issue at the root of today’s post is not controversial or divisive. Indeed, the Federal government continues to treat the production and sale of marijuana as an illegal activity, while the states are split in their stance on the legalization of marijuana. [2] At present, the likelihood that these parties will hash out a resolution of their differences seems remote.

A “Grass” Roots Debate
Both sides of the debate are driven, in part, by economic considerations, including the anticipated economic benefits and burdens. Among proponents of legalization, the opportunity to generate tax revenues from this growing industry – which may be used to fund social and other government-sponsored programs – presents a compelling case. Those opposed to legalization discount the projected tax revenues and point to the opportunity costs – including the attendant economic costs of treatment – that are associated with the increased use of any drug.

Even the Code itself is somewhat inconsistent in its treatment of the marijuana business, as was illustrated in a recent Tax Court decision. https://www.ustaxcourt.gov/ustcinop/OpinionViewer.aspx?ID=11681

“Let It Grow” [3]
Corp. was a corporation organized under the laws of State. Taxpayers were the sole shareholders of Corp. and also served as its officers during the years in issue. State licensed Corp. to grow and sell medical marijuana.

For the years in issue, Corp. elected to be treated as an S corporation for Federal income tax purposes.

Corp. claimed deductions from its gross income for expenses that would normally be characterized as “ordinary and necessary” business expenses, including deductions for items such as officer compensation officers, wages, repairs and maintenance, rents, taxes and licenses, interest, depreciation, advertising, employee benefit programs, and “other deductions,” which it detailed on statements attached to its tax return.

Taxpayers filed joint income tax returns for the years in issue. They received income from Corp., both as pass-through income (in their capacity as shareholders of an S corporation) and as officer compensation (in their capacity as employees of the corporation).

Taxpayers reported the pass-through income from Corp. on their Schedules E, Supplemental Income and Loss, Part II, Income or Loss from Partnerships and S Corporations, attached to their income tax returns for the years in issue.

Taxpayers reported the wages they received from Corp. for the years at issue on their jointly filed Forms 1040, U.S. Individual Income Tax Return. These wage payments, or expenses, were included as a part of Corp.’s “ordinary and necessary” business deductions.

IRS “Enforcement” of Federal Drug Laws?
The IRS examined Corp.’s tax returns for the years in issue. Following the exam, the IRS adjusted Corp’s items of deduction that flowed through to the Taxpayers, thereby increasing their pass-through taxable income for the years at issue.

Specifically, the IRS determined that Corp.’s deductions for the wages paid to Taxpayers should be disallowed as current deductions because they were paid in carrying on an illegal drug business. [4]

At the same time, the IRS allowed Corp.’s cost of goods sold (“COGS”), to the extent they were substantiated.

Taxpayers and the IRS agreed that these disallowed wage deductions could not be characterized as COGS, and that in disallowing the wage deductions, Taxpayers’ flow-through income from Corp. would increase.

They disputed whether Corp. could deduct the wages that it paid to Taxpayers. to the extent that the IRS had disallowed the deductions.

Taxpayers petitioned the U.S. Tax Court, where the issue for consideration was whether the deductions claimed by Corp. for the wages it paid to Taxpayers that were not attributable to COGS for the years in issue should be disallowed.

Getting Into the Weed(s)
The Court began by restating the ground rules: (i) the taxpayer generally bears the burden of proving that the IRS’s determinations, as set forth in the notice of deficiency, are erroneous; and (ii) the taxpayer bears the burden of proving their entitlement to a deduction and of substantiating the amount of the item underlying the claimed deduction.

Deductions, the Court continued, are a matter of legislative grace, and a taxpayer must prove their entitlement to a particular deduction.

Ordinary and Necessary Expenses
The Code allows taxpayers to deduct “ordinary and necessary expenses,” [5] including a “reasonable allowance for salaries or other compensation for personal services actually rendered.” Thus, compensation is deductible in determining the taxable income of a business only if it is (1) reasonable in amount and (2) paid or incurred for services actually rendered.

However, it is important to separate business expenses from the expenses used to figure the COGS. If a business manufactures products, or purchases them for resale, it generally must value its inventory at the beginning and end of each tax year to determine its COGS. Some of its expenses, including wages, may be included in figuring the COGS.

Under the uniform capitalization rules, a business must capitalize, and include in its COGS, the direct costs and part of the indirect costs for certain production or resale activities. [6]

The COGS is not a “deduction” within the meaning of the Code, but it is subtracted from the gross receipts of the business to determine its gross profit for the year; the costs included in COGS are recovered upon the sale of the product (as opposed to the tax year in which they were paid or incurred).

If a business includes an expense in the COGS, it cannot deduct that expense again as a business expense. [7]

“Expenditures in Connection With the Illegal Sale of Drugs”

The Code precludes taxpayers from deducting any expense related to a business that consists of trafficking in a controlled substance.

No deduction or credit shall be allowed for any amount paid or incurred during the taxable year in carrying on any trade or business if such trade or business (or the activities which comprise such trade or business) consists of trafficking in controlled substances (within the meaning of schedule I and II of the Controlled Substances Act) which is prohibited by Federal law or the law of any State in which such trade or business is conducted. [8]

The Court noted that marijuana was a controlled substance. It then stated that the dispensing of medical marijuana, while legal in State, was illegal under Federal law. Congress set this illegality under Federal law, the Court said, as one trigger to preclude a taxpayer from deducting expenses incurred in a medical marijuana dispensary business, even if the business is legal under State law. [9]

Interestingly, although the Code disallows deductions only for the expenses paid or incurred by a business in the illegal sale of drugs, it does not preclude a taxpayer from taking into account its COGS – in other words, the disallowance does not affect the COGS; if appropriate, the expense may still be included in the taxpayer’s COGS and may be subtracted in determining the taxpayer’s profits from the sale of the drug. [10]

Taxpayers’ Arguments
Taxpayers argued that the disallowance of the wages paid to them by Corp. resulted in discriminatory treatment of S corporation owners of marijuana businesses in violation of subchapter S. They argued that the IRS’s treatment of their wage income as an expense subject to disallowance caused the same income to be taxed twice, once as wages, and a second time (because of the disallowance of the deduction) as S corporation income. They contended that this resulted in the disallowed wage deductions attributable to “drug trafficking” being included in Taxpayers’ earnings, which flowed through to them without any deduction for the wages.

Taxpayers contended that this discriminatory treatment resulted from an S corporation’s being “required” to pay a reasonable wage to its officers, [11] while other entities (for example, a partnership) were not subject to this reasonable wage requirement.

The Court’s Response
The Court pointed out that Taxpayers’ argument of double taxation assumed that there was no distinction between gross income from wages, on the one hand, and pass-through income from the ownership of an S corporation, on the other. The economic considerations for these two items of income differed, according to the Court, as did their tax treatments.

S Corp. Basics
The S corporation rules were designed, the Court explained, to create a pass-through taxation system under which income was subjected to only one level of taxation: to the shareholders and not the corporation.

The Code provides that items of income, loss, deduction, and credit of an S corporation are passed through pro rata to its shareholders and reported on their individual tax returns. The character of each item of income in the hands of a shareholder is determined as if it were directly from the source from which the corporation realized it or incurred in the same manner as it was by the corporation. A shareholder’s gross income includes their pro rata share of the S corporation’s gross income.

Thus, Corp.’s income passed through to Taxpayers, and they had to report it on their individual tax returns. Separately, and in addition to Corp.’s pass-through income, Taxpayers had to report the compensation they received as officers of Corp. as a part of their gross income on their individual returns.

Accordingly, Taxpayers had to include in their gross income not only their pro rata shares of Corp.’s income, but also their wages separately received for providing services to Corp.

The Court further stated that Taxpayers’ contention that the application of deduction-disallowance rule resulted in disparate treatment was misplaced. An S corporation subject to this rule remained a flow-through entity with one tax imposed at the shareholder level, as prescribed by subchapter S.

No Dope
The Court illustrated its point with the following example: If Taxpayers had hired a third party to perform the officer duties that they performed, and they paid that third party an amount equal to that included as wages in Taxpayers’ gross income, their gross income would not include the third party’s wages from Corp.; Taxpayers would ultimately have less income, but they would not owe Federal income tax on the wages paid to the third party. However, the deduction-disallowance rule would still disallow Corp.’s wage expense deductions not attributable to COGS. Taxpayers’ flow-through income would be the same. Thus, the application of the rule to deny Corp.’s wage expense deductions was not discriminatory; it applied equally, regardless of whether Taxpayers themselves or a third party received the wages.

To the extent that Taxpayers believed they received disparate tax treatment as a result of organizing their marijuana business as an S corporation, the Court continued, they were free to operate as any form of business entity and in other trades. Taxpayers chose to operate Corp. as an S corporation in the marijuana business. They were responsible for the tax consequences of their decision.

Wait for Pot Luck?

Until the Code is amended, or until Congress decides that marijuana should not be illegal under Federal law, taxpayers who engage in the marijuana business in those States in which it is legal to do so will have to contend with increased income tax liability resulting from the deduction-disallowance rule described above.

However, because this rule does not apply to figuring the COGS, taxpayers engaged in a marijuana-related production or resale business will have to be careful about maintaining meticulous records in order to substantiate their COGS and support the gross profit reported from the sale of their products.

As in the case of other businesses that produce property for sale or that acquire property for resale, it may be possible to increase one’s COGS. Yes, this seems counterintuitive, but not where the alternative is the disallowance of a business expense deduction.

In any case, the method by which this result is achieved must be undertaken for a bona fide and substantial non-tax business reason. [12] At the same time, it must comply closely with the uniform capitalization rules so as to squeeze as much juice from them as reasonably possible.

Time will tell.


[1] Regarding the Federal tax treatment of CFCs that are owned by S corporations following the Tax Cuts and Jobs Act. https://www.taxlawforchb.com/2018/06/s-corps-cfcs-the-tax-cuts-jobs-act/

[2] Polls indicate that a majority of Americans support the legalization of marijuana. Nine States and the District of Columbia have legalized the recreational use of marijuana. Another 29 States have legalized so-called “medical marijuana.” A handful have decriminalized its use. Last week, Canada became the second nation to legalize marijuana use.

[3] With apologies to the Grateful Dead.

[4] The disallowance of Corp.’s deduction does not necessarily change the tax treatment for Taxpayers of the wages paid to them. For example, the wages were not re-characterized as distributions made to Taxpayers in respect of the shares of Corp. stock.

[5] An ordinary expense is one that is common and accepted in your trade or business. A necessary expense is one that is helpful and appropriate for your trade or business. An expense does not have to be indispensable to be considered necessary.

[6] Indirect costs include rent, interest, taxes, storage, purchasing, processing, repackaging, handling, and administrative costs.

[7] The following are types of expenses that go into figuring COGS: The cost of products or raw materials, including freight; storage; direct labor costs (including contributions to pension plans) for workers who produce the products; factory overhead.

[8] Cannabis remains illegal under federal law. Controlled Substances Act (P.L. 91-513), as amended. IRC Sec. 280E was added to the Code in 1982 by P.L. 97-248 (“TEFRA”). Query how a court would react to a taxpayer’s invoking the Fifth Amendment in response to an information document request from the IRS. Query how new IRC Sec. 199A and its “20%-of-qualified business income deduction” will be applied to a marijuana business; after all, unlike business expenses, the “deduction” is taken after adjusted gross income is determined.

[9] At some point, Congress or the Courts will have to address the conflict between those States that have legalized the marijuana business and the Code’s deduction-disallowance rule.

[10] This rule does not appear in the Code; rather, it is found in the Senate Finance Committee Report to TEFRA 1982. Thus, for example, the costs of growing marijuana or of manufacturing marijuana products may be included in COGS.

[11] For many years, the shareholders of S corporations who were employed by, and actually provided services to, their corporations, chose not to pay themselves any salary in exchange for such services. In this way, they sought to avoid the employment taxes that are required to be imposed upon salaries; the employment taxes do not apply to a shareholder’s pro rata share of S corporation income or to the distribution of such income. The IRS has successfully challenged this gambit.

[12] In a sense, the conceptual ideas for maximizing a taxpayer’s benefit under IRC Sec. 199A may be applicable here as well.