It’s Not All About 2017

A casual review of the recent tax literature may leave a “lay person” with the impression that, prior to the passage of the 2017 tax legislation, tax advisers had nothing else to write about.[i] Opportunity zones, GILTI, qualified business income, etc. – the spawn of 2017 dominates the tax hit parade.[ii]

That being said, the bread and butter issues of the tax professional have not changed: the adviser continues to plan for the recognition of income and deductions, gains and losses, with the ultimate goal being to reduce (or at least defer) their clients’ tax liabilities, to preserve their assets, and to thereby afford these clients the opportunity to channel their economic resources into more productive endeavors.

One example of such an issue, which was itself the subject of fairly recent legislation, and one form of which has been on the IRS’s own version of the hit parade,[iii] is captive insurance. Before getting into the details of a recent decision of the Tax Court – which illustrates what a taxpayer should not do – a brief description of captive insurance may be in order.

Captives

Assume that Acme Co.[iv] pays commercial market insurance premiums to commercial insurers to insure against various losses. These premiums are deductible in determining Acme’s taxable income. As in the case of most insurance, the premiums are “lost” every year as the coverage expires.[v]

In order to reduce the cost of insurance, a business will sometimes “self-insure” by setting aside funds to cover its exposure to a particular loss. Self-insurance, however, is not deductible.

The Code, on the other hand, affords businesses the opportunity to establish their own “small captive” insurance company.[vi] Indeed, the Code encourages them to do so by allowing the captive to receive up to $2.2 million of annual premium payments from the insured business free of income tax. What’s more, the insured business is allowed to deduct the premiums paid to the captive, provided they are “reasonable” for the risk of loss being insured. The insured business cannot simply choose to pay, and claim a deduction for, the $2.2 million maximum amount of premium that may be excluded from the captive’s income.

From a tax perspective, the key is that the captive actually operate as an insurance company. It must insure bona fide business risks. An insured risk must not be one that is certain of occurring; there must be an element of “fortuity” in order for it to be insurable.

In order to be respected as insurance, there must be “risk-shifting” and “risk distribution.” Risk shifting is the actual transfer of the risk from the insured business to the captive insurer. Risk distribution is the exposure of the captive insurer to third-party risk (as in the case of traditional insurance).[vii]

To achieve the status of real insurance (from a tax perspective), the captive pools its premiums with other captives (not necessarily from the same type of business).[viii] These pools are managed by a captive management company for a fee. The management company will conduct annual actuarial reviews to set the premium, manage claims, take care of regulatory compliance, etc. This pool will pay on claims as they arise.

In theory, the captive arrangement should lead to a reduction of the commercial premiums being paid by the business.[ix] Unfortunately for one taxpayer, they did not get the proverbial memo that explained the foregoing.

The Captive

Corp was a family business owned by Shareholders.[x] It had a number of subsidiaries, and maintained a dozen or so policies for which it paid substantial premiums.

Shareholders explored forming a captive insurance company. They met with Manager, a company that ran a captive insurance program and provided management services for captive insurance companies. At one point, Manager informed Shareholders that a captive would not be feasible unless Corp were paying at least $600,000 of premiums annually. After Manager’s chief underwriter indicated that it had “identified” up to $800,000 of premiums, Shareholders decided to form a captive.

Captive was incorporated in Delaware, and received a certificate of authority from the Department of Insurance. Captive was initially capitalized with a $250,000 irrevocable letter of credit naming the Department as the beneficiary. Captive was owned by two LLCs, each of which was wholly-owned by a different trust; the LLCs were managed by Shareholders, who were also Captive’s only officers; thus, Captive was basically a sister company as to Corp.

Captive and Corp participated in Manager’s captive insurance program. Participants in the program consisted of companies (like Corp) that purchased captive insurance and their related captive insurance companies. In general, participants did not purchase policies directly from their captive insurance companies but from “fronting carriers” related to Manager.[xi] The policies issued by the fronting carriers, which included “deductible reimbursement” policies,[xii] had a maximum benefit of $1 million.

Premiums and Coverage

Corp paid premiums directly to the fronting carriers, but the fronting carriers ceded 100-percent of the insurance risk. The responsibility for paying a covered claim under a policy was described as a two-layered arrangement: the first $250,000 of a single loss was allocated to “Layer 1,” and any loss between $250,000 and $1 million was allocated to “Layer 2.” Manager uniformly allocated 49-percent of each captive participant’s premiums to Layer 1 and 51-percent to Layer 2, notwithstanding that an actuarial consulting firm had reported that 70-percent of the loss experience would occur in Layer 1, given the proposed limits, and 30-percent in Layer 2.[xiii]

Captive reinsured[xiv] the first $250,000 of any Corp claim.[xv] Thus, shortly after the fronting carriers received Corp’s premiums, they ceded 49-percent of the net premiums to Captive.

For Corp’s claims between $250,000 and $1 million (Layer 2 claims), Captive agreed to reinsure its “quota-share” percentage of losses.[xvi] Additionally, Captive provided Layer 2 reinsurance for policies issued to unrelated companies in the fronting carriers’ pools. After the policy periods ended, the fronting carriers ceded the remaining 51-percent of net premiums to Captive less the amount of any claims paid for Layer 2 losses.

In other words, during the years in issue, Corp paid gross premiums to the fronting carriers, and the fronting carriers ceded net premiums to Captive.

Corp purchased a number of other policies during the years in issue. For example, it purchased deductible reimbursement policies that had among the highest premiums of any Corp policy. It also purchased various excess-coverage policies, under which the insurer agreed to indemnify against a loss only if it exceeded the amount covered by another policy.

Corp’s premiums were set by a non-actuary whose underwriting report did not detail any rating model, calculations, or any other analysis describing how premiums were determined. The report provided only general information about projected losses, previous claims, and information about Corp’s other insurance. Nothing in the report suggested that comparable premium information was used to price the premiums.[xvii]

Manager’s underwriting report projected that Captive would pay annual Layer 1 claims under certain policies, and projected that Captive would have an overall
“loss and loss adjustment expense” (LLAE) ratio[xviii] of 56-percent overall and 29-percent in Layer 2 for the years in issue. However, Captive’s actual LLAE ratio was only 1.5-percent: 0-percent for Layer 1 and 3-percent for Layer 2.

Corp did not file any claims under the captive program policies during the years in issue, but did file multiple claims under its commercial insurance policies, and it also paid deductibles, though it did not keep specific records of the deductibles.

Shareholders testified that they did not file captive program claims “because of time management issues.” They acknowledged that Corp did not have a claims management system in place for its captive program, though it had “different processes” in place for its commercial policies.

Captive’s Assets

Captive met Delaware’s minimum capitalization requirements during the years in issue. Its assets were listed on financial statements for each year in issue, and consisted of the initial $250,000 letter of credit, varying amounts of cash and cash equivalents, varying amounts of unceded premiums,[xix] and two life insurance policies on the lives of Shareholders.

However, Captive did not own the life insurance policies listed on the financial statements, nor was it a beneficiary of the policies. Rather, they were owned by the trusts (which were also the beneficiaries of the policies) under the terms of split-dollar life insurance agreements that required Captive to pay the premiums for the policies. Captive’s only right under the agreements was to be repaid the greater of the premiums paid or the policy’s cash value.[xx] Captive was prohibited from accessing the cash values of the policies, borrowing against the policies, surrendering or canceling the policies, or taking any other action with the respect to the policies.[xxi]

Returns and Notices of Deficiency

Captive decided to exit Manager’s captive insurance program after Captive’s premiums dropped significantly. Shareholders explained to Manager that Captive was changing managers because, among other things, they were displeased with the decrease in premiums.[xxii]

For the years preceding its exit from the captive program, Captive filed corporate tax returns on which it made a Section 831(b)[xxiii] election, and reported no taxable income.

Corp also filed returns for those years, in which the premium payments to the fronting carriers were apportioned among Corp’s subsidiaries, and deducted accordingly.[xxiv]

The IRS examined these returns and timely issued notices of deficiency. The IRS determined that Captive did not engage in insurance transactions and was not an insurance company. It found that Captive’s Section 831(b) election was invalid, and that the premiums were taxable income to Captive, and not deductible by Corp.

Corp and Captive (the “Taxpayers”) timely filed petitions with the U.S. Tax Court.

Tax Court

The issues before the Court were: (1) whether Captive was an insurance company, (2) whether the amounts received by Captive as premiums were excluded from its gross income under Section 831(b) of the Code, and (3) whether the amounts paid by Corp as premiums for insurance were deductible as business expenses.[xxv]

The Court began its discussion by briefly explaining the taxation and deductibility of micro-captive insurance payments.

Micro-Captives

The Court explained that insurance companies are generally taxed on their income in the same manner as other corporations, but that Section 831(b) provides an alternative taxing structure for certain “small” insurance companies. During the years in issue, the Court continued, an insurance company with written premiums that did not exceed $1.2 million for the year could elect to be taxed under section 831(b).[xxvi] A qualifying insurance company that made a valid election was taxable only on its investment income – its premiums were not taxable (a “micro-captive” insurance company). [xxvii]

What’s more, the captive rules do not prohibit deductions for the insured business that pays or incurs micro-captive insurance premiums, provided they are ordinary and necessary expenses paid or incurred in connection with a trade or business.[xxviii]

Real Insurance

According to the Court, in order for a company to make a valid Section 831(b) election, “it must transact in insurance.” Likewise, the deductibility of insurance premiums depended on whether they were truly payments for insurance.

The Court noted that, in order to determine whether a transaction constitutes insurance for income tax purposes, it had to consider certain principal criteria that had been developed by the case law, including whether the insurer distributed the risk among its policy holders, and whether the arrangement was “insurance in the commonly accepted sense”.[xxix]

Risk Distribution

Taxpayers argued that Captive distributed risk by participating in the fronting carriers’ captive insurance pools and reinsuring unrelated risks. In response, the Court stated that it had to decide whether those carriers were bona fide insurance companies in the first place.

The Court identified several following factors as relevant to determining whether an entity is an insurance company, including the following:

(1) there was a circular flow of funds;

(2) the policies were arm’s-length contracts;

(3) the entity charged actuarially determined premiums; and

(4) it was adequately capitalized.[xxx]

Circular Flow of Funds

Under the arrangements with the fronting carriers, Corp paid premiums to the carriers. The fronting carriers then reinsured all of the risk, making sure that

Captive received reinsurance premiums equal to the net premiums paid by Corp, less Captive’s liability for any Layer 2 claims. For the years in issue, this resulted in Corp’s paying the fronting carriers $1.37 million of gross premiums and the fronting carriers’ ceding $1.312 million of reinsurance premiums to Captive. “While not quite a complete loop,” the Court observed, “this arrangement looks suspiciously like a circular flow of funds.”

Arm’s-Length Contracts

The Court found that Corp paid upwards of five times more for its captive program policies than for its non-captive program policies.[xxxi]

In addition, various terms in the captive program policies indicated that Corp should have paid less for the captive program policies than the non-captive policies. For example, at least half of Corp’s captive program policies were for “excess coverage,” and others contained restrictive provisions, which should have resulted in a lower cost.

According to the Court, there was nothing to justify why Corp paid higher premiums for policies with more restrictive provisions than their commercial policies. The higher average rate-on-line coupled with the policies’ restrictive provisions led the Court to conclude that the policies were not arm’s-length contracts.

In addition, the Court pointed to Shareholders’ statement to Manager that one of the reasons Corp was leaving its captive program was the decrease in premiums, which reinforced the Court’s view that the policies were not arm’s-length contracts. It is fair to assume, the Court stated, that a purchaser of insurance would want the most coverage for the lowest premiums. In an arm’s-length negotiation, an insurance purchaser would want to negotiate lower premiums instead of higher premiums.

The main advantage of paying higher premiums, the Court found, was to increase deductions for Corp and the Shareholders, while shifting income to Captive, in whose hands the premiums were thought not to be taxable. With this, the Court concluded that the contracts were not arm’s-length contracts.

Actuarially Determined Premiums

The Court stated that premiums charged by a captive were actuarially determined when the company relied on an outside consultant’s “reliable and professionally produced and competent actuarial studies” to set premiums. The Court added that it would look favorably upon an outside actuary’s determination that premiums were reasonable. Premiums are not actuarially determined, it continued, when there is no evidence to support the calculation of premiums and when the purpose of premium pricing is to fit squarely within the limits of Section 831(b).

In the instant cases, the Court there were two issues with respect to the premiums: (1) the reasonableness of captive program premiums, and (2) the 49-percent to 51-percent allocation of premiums between Layer 1 and Layer 2 claims.

There was insufficient evidence in the record relating to how the premiums were set, and it was never determined whether they were reasonable. Accordingly, the policies issued by the fronting carriers did not have actuarially determined premiums.

There were also problems with the allocation of premiums between Layer 1 and Layer 2. Manager disregarded an actuarial firm’s conclusion that the majority of the premiums should be allocated to Layer 1. Moreover, Shareholders testified that they understood the purpose of the allocation was to take advantage of a tax-related safe harbor.

Accordingly, the Court found that the allocation of premiums was not actuarially determined.

Based on the foregoing factors, the Court concluded that the fronting carriers were not bona fide insurance companies for tax purposes, which meant that they did not issue insurance policies. In turn, this meant that Captive’s reinsurance of those policies did not distribute risk; therefore, Captive could not make the micro-captive election.

“Insurance” in the Commonly Accepted Sense

Although the absence of risk distribution by itself was enough to conclude that the transactions among Captive, Corp, and the fronting carriers were not insurance transactions, the Court nevertheless looked at whether these transactions might have constituted “insurance” in the commonly accepted sense. The Court indicated that the following factors should be considered in making this determination:

(1) the company was organized, operated, and regulated as an insurance company;

(2) it was adequately capitalized;

(3) the policies were valid and binding;

(4) premiums were reasonable and the result of arm’s-length transactions; and

(5) claims were paid.

Organization, Operation, and Regulation

Captive was organized and regulated as a Delaware insurance company. The question, however, was whether Captive was operated as an insurance company. In making this determination, the Court stated that it “must look beyond the formalities and consider the realities of the purported insurance transactions”.

The Court observed that during the years in issue, Corp did not submit a single claim to a fronting carrier or to Captive. Shareholders testified that there were various claims that were eligible for coverage under the deductible reimbursement policy that were not submitted. Because this policy was one of Corp’s most expensive insurance policies, Corp’s failure to submit claims after paying deductibles indicated that the arrangement did not constitute insurance in the commonly accepted sense.

Additionally, Shareholders testified that Corp had no claims process for the captive program claims, but did have “different processes” for their other claims.

Captive’s investment choices were also troubling. The life insurance policies insuring Shareholders totaled more than 50-percent of Captive’s assets and were its largest investments. Under the terms of the split-dollar agreements, however, Captive could neither access the cash value of the policies, borrow against the policies, surrender or cancel the policies, nor unilaterally terminate the agreements.

The Court did not think that an insurance company, in the commonly accepted sense, would invest more than 50-percent of its assets in an investment that it could not access to pay claims.

Valid and Binding Policies

The Court explained that policies were valid and binding when “[e]ach insurance policy identified the insured, contained an effective period for the policy, specified what was covered by the policy, stated the premium amount, and was signed by an authorized representative of the company.”

During the years in issue, neither Captive nor the fronting carriers timely issued a policy to Corp. The policies for some years were not even issued until after the policy years ended.[xxxii] What’s more, the policies issued to Corp had ambiguities and conflicts as to which entities were insured and what the policies covered.

Arrangement Not Insurance

Although Captive was organized and regulated as an insurance company and met Delaware’s minimum capitalization requirements, these insurance-like traits did not overcome the arrangement’s other failings. Captive was not operated like an insurance company. The fronting carriers charged unreasonable premiums, and issued policies with conflicting and ambiguous terms.

The arrangement among Corp, Captive, and the fronting carriers lacked risk distribution and was not insurance in the commonly accepted sense. Thus, the arrangement was not insurance for income tax purposes.

Because the arrangement was not insurance, Captive’s Section 831(b) election was invalid, and Captive had to recognize as income the premiums it received.

What’s more, Corp could not deduct the purported premium payments because the payments were not for insurance.

“This Will Never End ‘Cause I Want More”

We began this post by taking some liberty with the refrain from the theme sing to the “Vikings” television series. We end it with the first line from that song.

As was indicated earlier, a micro-captive can play an important role in a business’s management of its insurable risks. Moreover, Congress has recognized this role, and has sought to encourage businesses to utilize micro-captives.

In contrast to this legislative intent, we have advisers and taxpayers for whom the insurance benefits offered by the micro-captive do not appear to take precedence over the income tax benefits – as in the case of the Taxpayers described above – and the estate planning opportunities that captives may present.

These folks have it all backwards. The income tax benefits are not the goal to be attained – they are the incentives that Congress provided businesses that have a bona fide non-tax reason for creating a captive. Some taxpayers become so blind to this, they forget that the arrangement must actually constitute insurance. The same is true as to estate planning benefits that many identify as a reason for using a captive; these weren’t even on the table when the micro-captive was conceived (which explains the 2015 and 2018 legislatively-imposed diversification requirements that sought to limit the use of captives for that purpose).

With that, we return to our own refrain: the principal purpose for a transaction has to be a business purpose; assuming there is a valid business purpose, one is free to structure the transaction in a tax efficient manner. Without the business purpose, you can’t have more.

* Variation on Fever Ray’s “If I Had A Heart,” the theme from the History Channel’s “Vikings.” https://www.youtube.com/watch?v=DT7jxSmbMbs

[i] Undoubtedly, you’ve heard the comments about the legislation’s being a boon for tax advisers – a full-employment act, as it were. Although I cannot deny that there is much to be admired in the legislation (and even more so in the IRS’s efforts to implement it), it is undeniable that the haste with which it was drafted and enacted resulted in the diversion – should I say “misallocation?” – of resources by both the government and taxpayers.

[ii] As they should, considering that they became effective almost immediately after enactment, and considering further that some of their benefits will expire in just a few years – the victims of budget constraints.

[iii] The so-called “transactions of interest” and the “dirty dozen” list of suspect transactions.

[iv] Anyone remember Wile E. Coyote?

[v] Hopefully unused.

[vi] The captive, which is created as a C corporation, must operate like an insurance company; for example, it will reinsure some of its risk with other insurance companies, it will set aside appropriate reserves for the risks it does not cede, and it will invest the balance of the premiums received. Any investment income and gains recognized by the captive will be taxable to the captive.

[vii] The actuarial “law of large numbers” – meaning that the premiums received by the captive are pooled with the premiums received by other insurers, and this pool of premiums is used to satisfy the losses suffered by one of their insureds. The IRS has issued several rulings over the years regarding these requirements, including some so-called “safe harbors” (see below).

[viii] This is how risk distribution is effectuated.

[ix] For example, by permitting a larger deductible thereon.

[x] Corp was an S corporation.

[xi] The Court explained that a “fronting company” issues fronting policies, which are “a risk management technique in which an insurer underwrites a policy to cover a specific risk but then cedes the risk to a reinsurer.”

[xii] To cover large deductibles payable by the insured under commercial policies.

[xiii] Manager did not change the 51-49-percent premium allocation in response to the actuarial firm’s findings. Shareholders testified that the purpose of the allocation was to take advantage of a tax-related “safe harbor”.

According to the Court, “the safe harbor is almost certainly Rev. Rul. 2002-89, 2002-2 C.B. 984.”

This ruling addressed a captive insurance arrangement between a parent corporation and its wholly-owned captive subsidiary.

In Situation 1, the premiums that the subsidiary earned from its arrangement with the parent constituted 90% of its total premiums earned during the taxable year on both a gross and a net basis. The liability coverage the subsidiary provided to the parent accounted for 90% of the total risks borne by the subsidiary. The IRS found that the arrangement lacked the requisite risk shifting and risk distribution to constitute insurance for federal income tax purposes.

In Situation 2, the premiums that the subsidiary earned from its arrangement with its parent constituted less than 50% of the total premiums it earned during the taxable year on both a gross and a net basis. The liability coverage it provided to its parent accounted for less than 50% of the total risks borne by the subsidiary. The premiums and risks of the parent were thus pooled with those of unrelated insureds. The requisite risk shifting and risk distribution required to constitute insurance for federal income tax purposes were present. The IRS found that the arrangement was insurance for tax purposes.

[xiv] Reinsurance is an agreement between an initial insurer (the ceding company) and a second insurer (the reinsurer), under which the ceding company passes to the reinsurer some or all of the risks that the ceding company assumes through the direct underwriting of insurance policies. Generally, the ceding company and the reinsurer share profits from the reinsured policies, and the reinsurer agrees to reimburse the ceding company for some of the claims that the ceding company pays on those policies. Think of it as insurance for the risks “assumed” by an insurer.

[xv] A Layer 1 claim.

[xvi] The ratio of: (1) the net premium Corp paid to that portfolio to (2) the aggregate net premiums the portfolio received for the insurance period.

[xvii] Manager conducted an actuarial feasibility study for Captive for the purpose of determining Captive’s ability to remain solvent, not to price the premiums or to determine whether they were reasonable.

[xviii] The LLAE ratio is the cost of losses and loss adjustment expenses divided by the total premiums.

[xix] Premiums for risks that were not ceded to a reinsurer.

[xx] An “equity” type split-dollar arrangement. Reg. Sec. 1.61-22.

[xxi] The split-dollar agreements could be terminated only through the mutual consent of Captive, the insured, and the trust. Within 60 days of termination, the owner had the option to obtain a release of Captive’s interest in the policy. To obtain the release, the policy owner was required to pay Captive the greater of: (1) the premiums that it paid with respect to the policy or (2) the policy’s cash value. If the policy owner did not obtain a release, ownership of the policy reverted to Captive.

[xxii] Yes, you heard right. In fact, at trial, Shareholder testified the he was disappointed in the premium decrease because there were fixed costs associated with a captive manager and it made the most sense to have as much coverage as possible with the captive manager.

[xxiii] https://www.law.cornell.edu/uscode/text/26/831

[xxiv] Because Corp was an S corporation, the deductions flowed through to the Shareholders.

[xxv] “Ordinary and necessary” under Sec. 162 of the Code.

[xxvi] The 2015 amendments to sec. 831(b) increased the premium ceiling to $2.2 million (adjusted for inflation) and added new diversification requirements that an insurance company must meet to be eligible to make a Sec. 831(b) election. The Protecting Americans from Tax Hikes Act of 2015, P.L. 114-113. The 2018 amendments clarified the diversification requirements. Consolidated Appropriations Act of 2018, P.L. 115-141.

[xxvii] Sec. 831(b)(1).

[xxviii] Reg. Sec. 1.162-1(a).

[xxix] The other criteria: was there an insurable risk, and was risk of loss shifted to the insurer?

[xxx] Other factors included: the entity was created for legitimate nontax reasons; it was subject to regulatory control and met minimum statutory requirements; it paid claims from a separately maintained account; it faced actual and insurable risk comparable coverage was more expensive or not available.

[xxxi] The captive policies had a higher “rate-on-line.” A higher rate-on-line means that insurance coverage is more expensive per dollar of coverage.

[xxxii] An insurance binder is a “written instrument, used when a policy cannot be immediately issued, to evidence that the insurance coverage attaches at a specified time and continues . . . until the policy is issued or the risk is declined and notice thereof is given.”

 

Choice of Entity

Following the enactment of the Tax Cuts and Jobs Act,[i] tax advisers were inundated with inquiries from the individual owners of closely held businesses regarding a broad spectrum of topics.[ii] Perhaps the most often repeated question concerned the form of legal entity through which such a business should be operated. Of course, the impetus for this heightened interest in the “choice of entity” for the business was the Act’s significant reduction in the federal corporate tax rate.[iii]

This question, in turn, took several forms; for example, “Should I incorporate my single member LLC as a C corporation?” and “Should we incorporate our partnership?”[iv]

In the end, the flexibility that the LLC and partnership structures afford the closely held business and its owners from a tax perspective, plus the single level of tax that is imposed on their profits,[v] will probably result in a decision by the individual owners of such entities to retain their unincorporated status, notwithstanding that the owners do not enjoy any tax deferral for these profits, and despite the fact such profits are taxable to them up to a maximum federal income tax rate of 37 percent,[vi] though this may be reduced to as low as 29.6 percent if the qualified business income deduction is fully utilized.[vii]

Which leaves us with the “runner-up” question among business owners: “Should we revoke our corporation’s ‘S’ election?”

The S Corporation

Ah, the S corporation.[viii] Not more than 100 shareholders.[ix] Not more than one class of stock outstanding. No nonresident alien shareholders.[x] No shareholder who is not an individual (other than an individual’s estate, or certain trusts[xi] created by an individual).[xii]

Yes, it is a pass-through entity and, yes, it is not itself taxable.[xiii] As in the case of a partnership, its items of income, deduction, gain, loss and credit pass through to, and are reported by, its shareholders – based on the S corporation’s method of accounting – regardless of whether or not the income is distributed by the corporation to its shareholders.[xiv] Thus, there is no way to defer the shareholders’ inclusion of the corporation’s net operating income in their own gross income, where it will be taxable as ordinary income at a maximum federal rate of 37 percent, though the shareholders may benefit from the qualified business deduction.[xv]

When that S corporation income – which has already been taxed to the shareholders – is then distributed to the shareholders, the applicable basis adjustment and distribution rules generally prevent it from being taxed a second time.[xvi] In contrast, when a C corporation distributes its after-tax income to its shareholders as a dividend, that income is taxed to the shareholders at a federal income tax rate of 20 percent;[xvii] it may also be subject to the 3.8 percent surtax on net investment income.

But the S corporation is still a corporation and, so, it cannot do certain things that a partnership can; for example, it cannot distribute appreciated property to its shareholders in respect of their shares – either as a current or as a liquidating distribution – without being treated as having sold such property for consideration equal to its fair market value.[xviii]

In light of the foregoing, one might characterize the S corporation as an entity in limbo. Although its shareholders enjoy a single level of tax – albeit at the 37 percent ordinary income tax rate applicable to individuals[xix] – the single class of stock requirement limits the corporation’s ability to vary the terms of the economic arrangement among its owners. One might also add, because of the single class of stock rule and because of the limitation on which persons can be S corporation shareholders, that an S corporation cannot attract the same range of investments and investors that a partnership and C corporation can, though this may be a less important consideration in the case of most closely held businesses.[xx]

Converting from “S” to “C”?

Under those circumstances, the shareholders of an S corporation may decide that they would be better off with a C corporation. No single class of stock requirement, and no limitation on types of shareholders. Moreover, no taxation of the corporation’s profits to its shareholders unless the corporation pays a dividend.

In other words, why be saddled with the pass-through taxation of a partnership without having the flexibility of a partnership structure?

Of course, the corporation itself is taxed at a federal rate of 21 percent. That leaves a significant portion of its after-tax profits available for the replacement of depreciable properties[xxi] and for expansion, whether by acquisition or otherwise.[xxii] This should be compared to an S corporation that will typically distribute funds to its shareholders in an amount that is at least enough for them to satisfy their individual income tax liabilities attributable to the S corporation’s income.[xxiii]

Which brings us back to the question raised above: Should the shareholders of an S corporation revoke the “S” election? In other words, should the corporation be converted to a C corporation?

In addition to the “primary” factors touched upon above – which go to the question of whether to revoke an “S” election and operate as a C corporation – the shareholders of an S corporation also have to consider a number of “secondary” factors, including those tax consequences that are an ancillary, but potentially immediate, result of the decision to revoke the “S” election. Among these are the effect of the conversion on the corporation’s method of accounting, and its impact on the tax treatment of certain post-conversion distributions.

Accounting Method

Taxpayers using the cash method generally recognize items of income when actually or constructively received, and items of expense when paid.[xxiv] Taxpayers using an accrual method generally accrue items of income when all the events have occurred that fix the right to receive the income and the amount of the income can be determined with reasonable accuracy. Taxpayers using an accrual method of accounting generally may not deduct items of expense prior to when all events have occurred that fix the obligation to pay the liability, the amount of the liability can be determined with reasonable accuracy, and economic performance has occurred.[xxv]

A C corporation generally may not use the cash method, though an exception is made for C corporations to the extent their average annual gross receipts do not exceed a prescribed threshold for all prior years (the “gross receipts test”).[xxvi] Thus, it is conceivable that an S corporation that revokes its election may be required to cease using the cash method if it fails the gross receipts test, and to adopt the accrual method. This change is often accompanied by the immediate recognition of accrued income that had been deferred under the cash method; it may also result in the immediate deduction of certain items.

The Code prescribes the rules to be followed in computing taxable income in cases where the taxable income of the taxpayer for a taxable year is computed under a different method than used in the prior year; for example, when changing from the cash method to the accrual method. In computing taxable income for the “year of change,”[xxvii] the taxpayer must take into account those adjustments which are determined to be necessary solely by reason of such change, in order to prevent items of income or expense from being duplicated or omitted.[xxviii]

Net adjustments that decrease taxable income generally are taken into account entirely in the year of change, and net adjustments that increase taxable income generally are taken into account ratably during the four-taxable-year period beginning with the year of change.[xxix]

The Act contemplated that many S corporations and their shareholders would consider such a revocation in light of the greatly reduced corporate tax rate.

In order to reduce the economic “pain” stemming from such a change, the Act amended the Code to increase the threshold for the gross receipts test from $5 million to $25 million – thereby expanding the number of taxpayers that may use the cash method of accounting, even after a change in tax status[xxx] – and it provided that any adjustment in income of an “eligible terminated S corporation”[xxxi] attributable to the revocation of its S corporation election (i.e., a change from the cash method to an accrual method) would be taken into account ratably during the six-taxable-year period[xxxii] beginning with the year of change.

Following on this relief provision, the IRS announced that even if an eligible terminated S corporation is not required to change from a cash to an accrual method of accounting, but nevertheless chooses to change to an accrual method, the corporation may take the resulting adjustments into account ratably over the six-year period beginning with the year of change.[xxxiii]

Post-termination Distributions

Prior to the Act, in the case of an S corporation that converted to a C corporation, distributions of cash by the corporation to its shareholders – to the extent of corporation’s accumulated adjustments account[xxxiv] at the time of the conversion –during the post-termination transition period (the one-year period after the S corporation election terminated[xxxv]) were tax-free to the shareholders to the extent of the adjusted basis of the stock.[xxxvi]

Under the Act, in the case of a distribution of money by an eligible terminated S corporation after the post-termination period, the corporation’s accumulated adjustments account may be allocated to the distribution (a tax-free distribution), and chargeable to its accumulated earnings and profits (a taxable distribution), in the same ratio as the amount of the accumulated adjustments account bears to the amount the accumulated earnings and profits as of the effective date of the revocation.

Mechanics of Revocation

Let’s assume that the S corporation’s board of directors has decided that it would be in the best interest of the corporation and the shareholders to revoke the corporation’s “S” election. Let’s also assume that the shareholders agree – by whatever measure may be required by the corporation’s by-laws, their shareholders’ agreement, or any other governing agreement – to the revocation.[xxxvii] Finally, let’s assume that there are no contractual restrictions imposed by third parties – for example, a bank from whom the corporation has obtained a loan – that may prevent the revocation. What’s the next step?

Statement and Timing

An “S” election is terminated if the corporation revokes the election. To revoke the election, the corporation files a statement to that effect with the IRS service center where the “S” election was filed. It must include the number of shares of stock (including non-voting stock) issued and outstanding at the time the revocation is made.

If the revocation is made during the taxable year, and before the 16th day of the third month of the taxable year, it will be effective on the first day of the taxable year; a revocation made after the 15th day of the third month of the taxable year will be effective for the following taxable year.

If a corporation specifies a date for revocation, and the date is expressed in terms of a stated day, month, and year that is on or after the date the revocation is filed, the revocation is effective on and after the date so specified.

Short Year Returns and Allocations

If the revocation of an S election is effective on a date other than the first day of a taxable year of the corporation, the corporation’s taxable year in which the revocation occurs is an “S termination year.” The portion of the S termination year ending at the close of the day prior to the termination is treated as a short taxable year for which the corporation is an S corporation (the S short year). The portion of the S termination year beginning on the day the termination is effective is treated as a short taxable year for which the corporation is a C corporation (the C short year).

The corporation may allocate income or loss for the entire year (and between the two short years) on a pro rata basis. If the corporation elects not to allocate income or loss on a pro rata basis – by closing the books with the last day of the S short year – then these items are assigned to each short taxable year on the basis of the corporation’s normal method of accounting.[xxxviii] Either way, the due date for filing both short year returns is the due date for the C short year.

Re-Electing “S” Status

In general, the shareholders of an S corporation whose election is revoked may not make a new “S” election for five taxable years.[xxxix] However, the IRS may permit a new election before the five-year period expires, provided the corporation can establish that, under the relevant facts and circumstances, the IRS should consent to a new election. The fact that more than fifty percent of the stock in the corporation is owned by persons who did not own any stock in the corporation on the effective date of the revocation tends to establish that consent should be granted.[xl]

Wish I Had a Crystal Ball

The choice of entity decision is a difficult one. In the case of an established S corporation, however, it is somewhat less difficult – the shareholders are pretty much stuck with the corporate form.[xli] That said, the decision boils down to retaining or revoking “S” status for the corporation.

Because all of the corporation’s shareholders are U.S. individuals or domestic trusts created by them,[xlii] the “permanent” reduction of the corporate tax rate has made the C corporation an attractive entity choice, especially when one considers that the Section 199A qualified business income deduction will not be available to the shareholders of an S corporation after 2025.

In the end, the decision may depend upon two factors:

  • the likelihood that the corporation will be periodically distributing its profits to its shareholders, rather than reinvesting them in the corporation’s business, and
  • the period of time within which the shareholders plan to dispose of the corporation’s business.

In the context of a closely held business, these two considerations are not necessarily independent of one another; it all depends upon where the corporation is in its life cycle.

For example, in the case of a newer business, the corporation’s profits may have to be reinvested over time so as to grow the business. During this period, only those shareholders who are employed by the corporation will be able to withdraw any value from the corporation, albeit in the form of compensation for services. Under these circumstances, it may be reasonable for an S corporation to consider revoking its election; doing so would allow it to forego making a “tax distribution” to its shareholders (whether for a 40.8 percent or 33.4 percent individual tax rate),[xliii] while causing it to pay corporate level tax at a rate of only 21 percent.

By the same token, if the corporation is already approaching the point at which its shareholders will want to liquidate their investment by selling the business, the conversion from an S corporation to a C corporation may not be a reasonable move. If the anticipated sale transaction is likely to take the form of a sale of assets, followed by the liquidation of the corporation, the revocation of the corporation’s “S” election could double the tax liability from the sale.[xliv]

The difficulty lies somewhere in between these two scenarios. Where the business has matured to the point where it can pay dividends, and where its shareholder base has expanded beyond the individuals whose “sweat equity” grew the business, it will probably make sense to retain the corporation’s “S” status, especially when one considers that such an established business will probably be a target for a purchaser in the not-too-distant future.

[i] P.L. 115-97 (the “Act”).

[ii] Let’s face it, there was, and there remains, a lot to chew on.

[iii] From a maximum graduated rate of 35 percent to a flat rate of 21 percent. In addition, the corporate alternative minimum tax was repealed.

[iv] Remember, it is not necessary, from a tax perspective, that a new corporation be organized and the LLC or partnership somehow be transferred over (though there may be non-tax reasons for pursuing such a “physical” change; should one decide to pursue that route, Rev. Rul. 84-111 is the place to start). Instead, one may “check the box” in accordance with Reg. Sec. 301.7701-3, and thereby convert an unincorporated entity (i.e., a partnership or one that is disregarded for tax purposes) into an association that is treated as a corporation for tax purposes.

[v] Not to mention the gain from the sale of their assets.

[vi] An owner with respect to whom the business is a passive activity may also be subject to the 3.8 percent federal surtax on net investment income, for an effective federal rate of 40.8 percent. IRC Sec. 1411.

[vii] IRC Sec. 199A, which was enacted in conjunction with the reduced corporate tax rate in order to “level the playing field” for pass-through entities. You will recall that certain businesses do not qualify for this deduction. In addition, there are limitations on the amount of the deduction that may be claimed based, in most cases, upon 50 percent of the W-2 wages of the business. Finally, the deduction disappears after 2025.

[viii] I picture it as a slow-moving earthbound caterpillar that looks at its C corporation and LLC brethren with envy, as though they were butterflies. (No, I do not indulge in any hallucinogenic substances.)

[ix] An almost ridiculous number when you consider the effect of the counting rule for members of a family. IRC Sec. 1361(c)(1). For example, I’ve seen at least two S corporation with well over 100 shareholders as a matter of state corporate law – for purposes of the S corporation rules, however, they each had fewer than a dozen shareholders, thanks to this counting rule.

[x] The Act allows such individuals to be potential current beneficiaries of an ESBT.

[xi] See IRC Sec. 1361(c)(2), (d), (e). Individuals have to be able to plan for the disposition of their estate. That’s why the ESBT rules were enacted, for example.

[xii] IRC Sec. 1361(b). Yes, a charity may be a shareholder – but not really; just to generate a charitable contribution deduction, after which the corporation will quickly redeem the charity’s shares because, frankly, that’s what both the charity and the corporation want. From the charity’s perspective, its share of S corporation profit is treated an unrelated business income.

[xiii] There are exceptions: the built-in gains tax under IRC Sec. 1374, LIFO recapture under IRC Sec. 1363, and the excise tax on excess net investment income under IRC Sec. 1375. These, however, are the result of vestigial C corporation attributes.

And if the S corporation is doing business in New York City, it will be subject to the City’s corporate level tax at a rate of 8.85%.

[xiv] IRC Sec. 1366. This pass-through income is not subject to self-employment tax, though the corporation is required to pay reasonable compensation to its shareholder-employees. In contrast, the employment tax generally applies to the flow-through income of a partnership.

[xv] Add another 3.8 percent for a shareholder who does not materially participate in the business. IRC Sec. 1411.

[xvi] IRC Sec. 1367 and 1368. In general, an S corporation shareholder is not subject to tax on corporate distributions unless the distributions exceed the shareholder’s basis in the stock of the corporation.

[xvii] Assuming a qualified dividend. IRC Sec. 1(h)(11).

[xviii] IRC Sec. 311(b). What’s more, depending on the type of property, the gain may be treated as ordinary income. IRC Sec. 1239.

[xix] Before considering Sec. 199A.

[xx] As a general rule, I almost always advise against the “admission” of new owners, whether these are key employees or potential investors – I’ve seen too many instances of the new owner claiming abuse or mismanagement, and then seeking redress therefor, usually by asking a court to dissolve the business. In the end, only the litigators come out ahead. Better to incentive the employee through compensation, including upon a change in control. As to the investor, it will depend upon where in its lifecycle the business finds itself, and what other sources of funding it has available.

[xxi] Vehicles, machinery, other equipment, etc.

[xxii] Product lines, geographically, etc.

[xxiii] Let’s illustrate this point:

  • an S corp. has $100 of profit
    • this is taxable to its shareholders at 37%;
    • the S corp. distributes $37 to the shareholders;
    • this distribution is not taxable to the shareholders;
    • they use this $37 to pay taxes;
    • the S corp. is left with $63;
  • a C corp. has $100 of profit
    • it pays corporate tax of $21;
    • that leaves the C corp. with $79;
    • if the C corp. paid a dividend of $16 to its shareholders – so that it is left with the same $63 left in the S corp. – they would pay tax of $3.81;
  • the C corp. and its shareholders will have paid total tax of $24.81 (20% + 3.8%), or an effective rate of 24.81% on the $100 of profit;
  • this is compared to the 37% for the S corp. and its shareholders (perhaps more if the 3.8% surtax applied to any of the shareholders);
  • both corporations have $63 remaining;
  • the shareholders of the C corp. have $12.2 remaining from the dividend;
  • the shareholders of the S corp. have no part of the $37 distribution remaining.

Query: Does the fact that the C corporation – after making the above dividend distribution – end up with the same amount of funds as the S corporation – after making its “tax distribution” to its shareholders – support an argument that the C corporation retained earnings should not be subject to the accumulated earnings tax in the above circumstances? It ends up exactly where the S corporation did, and the latter is not subject to the tax.

Query also this: Granted that an S corporation may distribute all its income to its shareholders without incurring additional tax – but would it be wise to do so in the absence of a shareholders’ agreement that required shareholders to contribute additional funds to the corporation when needed? Will the corporation’s management be willing to enforce the capital call? Will the capital, instead, be provided through loans from the shareholders?

If a C corporation were to distribute all of its after-tax profits – a questionable move where a reasonable reserve would be prudent and where it may be difficult to bring the funds back if necessary – the combined effective tax rate would be 39.8 percent.

This would leave the C corporation shareholders with $60.2, whereas the S corporation shareholders would be left with $63 following the same distribution.

[xxiv] IRC Sec. 451.

[xxv] IRC Sec. 461.

[xxvi] IRC Sec. 448.

[xxvii] The year of change is the taxable year for which the taxable income of the taxpayer is computed under a different method than for the prior year.

[xxviii] IRC Sec. 481.

[xxix] Rev. Proc. 2015-13, Section 7.

[xxx] Consistent with present law, the cash method generally may not be used by taxpayers, other than those that meet the $25 million gross receipts test, if the purchase, production, or sale of merchandise is an income-producing factor.

[xxxi] An eligible terminated S corporation is any C corporation which (1) was an S corporation the day before the enactment of the Act, (2) during the two-year period beginning on the date of such enactment revokes its S corporation election, and (3) all of the owners of which on the date the S corporation election is revoked are the same owners (and in identical proportions) as the owners on the date of such enactment.

The two-year period referenced above began on December 22, 2017.

[xxxii] Instead of the usual four years.

[xxxiii] Rev. Proc. 2018-44.

[xxxiv] IRC Sec. 1368.

[xxxv] IRC Sec. 1377.

[xxxvi] IRC Sec. 1371(f).

[xxxvii] More than one-half of the number of issued and outstanding shares of stock (including non-voting stock) of the corporation must consent to the revocation of the S election. Reg. Sec. 1.1362-2. The shareholders may agree to a greater threshold among themselves.

See Reg. Sec. 1.1362-6 for details regarding the form of the shareholder’s consent.

[xxxviii] IRC Sec. 1362(e); Reg. Sec. 1.1362-3.

[xxxix] A C corporation that is starting to think about the sale of its business (assets) may be considering an “S” election so as to avoid the double taxation problem. However, it must be mindful of the built-in gains tax and its five-year recognition period.

[xl] Reg. Sec. 1.1362-5.

[xli] Unless they are willing to incur an immediate tax liability for the corporation’s built-in gain.

[xlii] Thereby eliminating the consideration of accepting capital contributions from other investors.

[xliii] S corporations will often make distributions based on the highest rate applicable to any of its shareholders: 37 percent + 3.8 percent, or (if the full Sec. 199A deduction is available) 29.6 percent + 3.8 percent.

[xliv] For example: sale of assets by C corp. for $100; $21 of corporate tax paid; $79 liquidating distribution to shareholders (who are active in the business); tax of 23.8%, or $18; total taxes paid of $39; net proceeds to shareholders of $61.

Compare to an asset sale by an S corp. for $100: no corporate tax; distribution of $100 to shareholders; no tax on the distribution: shareholders (who are active in the business) pay tax of 20% on the gain; total taxes paid of $20; net proceeds to shareholders of $80.

“You Must Choose, But Choose Wisely.”[I]

The enactment of the Tax Cuts and Jobs Act,[ii] and its undeniable bias in favor of C corporations, has spurred the owners of many closely held businesses, along with their advisers, to reevaluate the form of business entity through which they own and operate their business, and its classification for tax purposes.[iii]

As most readers are aware, the initial choice of entity and tax classification for a business is no small matter, as it will result in certain tax and economic consequences for both the entity and its owners.

A change in a business entity’s tax classification will likewise have a significant impact upon the business, and may even generate an immediate income tax liability.[iv]

You’ve Chosen – Now How Do You Get the Money Out?

Among the several factors to be considered in determining the form and tax status for a business entity, and one that many individual owners appear not to fully appreciate,[v] is the tax treatment of an owner’s withdrawal of value from the entity.

In general, an owner of a closely held business may have several options by which they can withdraw funds from the business without necessarily removing themselves from the business, as distinguished from receiving value in exchange for the business.[vi] For example, an owner may:

  • Receive compensation for services rendered to the business (an employee-employer relationship);[vii]
  • Receive rent for allowing the business to use the owner’s property (a landlord-tenant relationship);
  • Sell property to the business (a seller-buyer relationship);[viii] and
  • “Borrow” money from the business (a debtor-creditor relationship[ix]).

In each of these situations, the owner and the business will often agree to terms that are on the “generous” end of the spectrum of what is reasonable.[x]

Finally, the owners may withdraw funds from the business by causing the business entity to make a distribution with respect to their equity interests therein (a corporation-shareholder or partnership-partner relationship).

Distributions

Generally speaking, a cash distribution from a business entity to an owner with respect to their equity interest may be effected in one of two ways: a “current” distribution of cash (which does not change the owners’ relative equity in the business); and a distribution in exchange for some of the owner’s equity in the business (a partial redemption of an owner’s shares of stock, or a partial liquidation of the owner’s partnership interest).[xi]

Current Distributions

A current distribution is the most common type of cash distribution made by a business entity. In the case of an entity with only one outstanding class of equity,[xii] each owner of the equity is generally entitled to receive the same amount of cash per unit of equity as every other owner.

The timing and amount of a current distribution may vary widely from business to business. In some cases, the manager of the business will be authorized to determine, in their discretion, if or when to make a distribution, and how much to distribute.[xiii] In other cases, the owners may have agreed that all “available cash” must be distributed at least annually.[xiv] Then there are those situations – in the case of a pass-through entity – where the only distribution required to be made for a taxable year is of an amount of cash sufficient to enable the owners to pay their income taxes attributable to their share of the entity’s profits.[xv] In each of these situations, however, every owner will generally receive a distribution based upon their relative equity in the business.

Partial Redemptions

What if only one owner, out of several, needs a cash distribution? This owner may find themselves in somewhat of a bind, especially if they cannot compel a distribution, or if the entity is unwilling to make a loan to them. What’s more, because an interest in a closely held business is, by definition, not readily marketable, this owner is unlikely to find someone outside the entity who would be willing to purchase some of their equity; in fact, it may be that the owners have agreed not to sell their equity to any outsider.[xvi]

An effective way by which some businesses have addressed this issue is by “creating” a market for the owner who requires more liquidity than may be provided by a current distribution. This “market” is accomplished by causing the entity to periodically offer to buy back a predetermined portion of its equity, usually subject to a value cap set by the entity’s managers that takes into account the reasonable needs and prospects of the business.

Alternatively – and this is the way that most closely held businesses handle the issue – the entity will not have adopted a formal buy-back program; instead, its managers, acting on an ad hoc basis, will decide, when the occasion arises, whether to buy back some of the equity proffered by an owner in need of cash.

The Good, the Bad, the Tax

A cash distribution in partial redemption or liquidation of an owner’s equity in the business provides liquidity for the owner who wants to remove value from the business, may protect the liquidity needs of the business, and may avoid the tension that otherwise could arise among the owners in the absence of a buy-back program.

However, the distribution of cash comes with a business and economic cost to the distributee-owner: their equity interest will have been reduced, they will likely be entitled to a smaller share of business profits, distributions, appreciation and sales proceeds, and they may have a smaller vote in decision-making.

Of course, there is also a tax cost to be considered, which may reduce the amount of cash available to the distributee-owner.

The income tax consequences arising from each of the foregoing cash distributions will depend upon a number of factors, including the form of business entity from which the distribution is made, and the extent to which the owner’s equity in the business is reduced.

Before the Distribution

Before considering the income tax treatment of a cash distribution from a closely held business to its owners, it would be worthwhile reviewing how the entity’s income is taxed without regard to any subsequent distribution of such income.

The taxable income of a C corporation will be subject to federal tax at the corporate level at a flat rate of 21 percent.[xvii] The after-tax income of the corporation will not be taxed to its shareholders until it is distributed to them.[xviii]

An S corporation is generally not subject to a corporate-level income tax.[xix] Rather, its taxable income flows through, and is taxed, to its shareholders[xx] at a maximum federal income tax rate of 37 percent, even though no part of such income has been distributed to the shareholders.[xxi]

In order to allow the subsequent “tax-free” distribution from the S corporation to a shareholder of an amount of cash equal to the amount of corporate income that was already included in the gross income of the shareholder, the shareholder’s adjusted basis for their S corporation shares is increased by the amount of income so included.[xxii]

As in the case of an S corporation, a partnership – including an LLC that is treated as a partnership for tax purposes – is not subject to federal income tax; its taxable income is reported by its partners on their tax returns, and they are taxed thereon without regard to whether any distribution has been made by the partnership.[xxiii]

Also as in the case of the S corporation shareholder, a partner’s adjusted basis for their partnership interest is increased by the amount of partnership income that was included in the partner’s gross income, so as to allow the distribution of such an amount of cash to the partner without triggering additional recognition of income.[xxiv]

Current Distributions

Having reviewed how the owners of a closely held business may withdraw cash from their business entity after it has been taxed to the entity, or to the owners themselves, we now turn to the income tax consequences of a current distribution to the owners.

C Corporation

A cash distribution by a C Corporation to a shareholder with respect to its stock is included in the shareholder’s gross income as a dividend to the extent the distribution is made out of the corporation’s accumulated, and current, earnings and profits.[xxv]

If the distribution satisfies the requirements for a “qualified dividend,” it will be subject to federal income tax in the hands of the shareholder at a rate of 20 percent;[xxvi] it may also be subject to the 3.8 percent federal net investment income surtax.[xxvii]

That portion of the distribution that exceeds the corporation’s earnings and profits will be applied against, and reduce, the shareholder’s adjusted basis for their stock in the corporation; basically, a tax-free return of capital.[xxviii]

To the extent the distribution exceeds the shareholder’s adjusted basis for their stock, the excess portion will be treated as gain from the sale of the stock; in other words, a deemed sale that will likely be treated as capital gain,[xxix] and taxed accordingly at a maximum federal income tax rate of 20 percent (in the case of long-term capital gain); the 3.8 percent surtax may also apply.

Assuming the corporation has only one outstanding class of stock, the declaration and payment of a dividend by the corporation’s board of directors must necessarily be made to every one of its shareholders; a shareholder cannot turn their back on the distribution and its tax consequences.

That being said, a shareholder may, if permitted by the board or by the terms of a shareholder’s agreement, choose to “leave” their share of the cash distribution in the corporation, either as an additional capital contribution or as a loan.

S Corporation

The tax consequences arising from a distribution of cash by an S corporation to its shareholders will depend, in part, upon whether the corporation has any earnings and profits from taxable years when it was a C corporation, or from a target corporation that it may have acquired in a transaction that caused it to succeed to the target’s tax attributes.[xxx] For our purposes, we will assume that the S corporation has no such earnings and profits.

In that case, a distribution of cash by an S corporation with respect to its single class of stock, which would otherwise be treated as a dividend if made by a C corporation with earnings and profits, will first be applied against the distributee-shareholder’s adjusted basis for the stock – a tax-free return of capital – and if the amount of the distribution exceeds the shareholder’s stock basis, the excess will be treated as gain from the sale of property by the shareholder.

This gain will likely be taxed as long-term capital gain,[xxxi] at a maximum federal rate of 20 percent, without regard to the composition of the underlying assets of the corporation. If the corporation’s trade or business represents a passive activity with respect to the shareholder, the 3.8 percent surtax on net investment income may also apply.

Partnership/LLC

In the case of a cash distribution[xxxii] from a partnership to a partner, gain will not be recognized by the partner except to the extent that the amount of cash distributed exceeds the partner’s adjusted basis[xxxiii] for their partnership interest immediately before the distribution.[xxxiv]

Any gain so recognized will be considered as gain from the sale of the partnership interest of the distributee partner.[xxxv] Such gain is generally treated as gain from the sale of a capital asset;[xxxvi] thus, the gain will be treated as long-term capital gain provided the partner’s holding period for their partnership interest is more than one year.[xxxvii] In that case, the maximum federal tax rate applicable to the gain will be 20 percent.

In addition, the gain may also be subject to the 3.8 percent surtax on net investment income, if the partnership’s trade or business is a passive activity with respect to the partner.[xxxviii]

However, if any of the cash deemed to have been received by the partner – in the deemed sale of their partnership interest – is attributable to any unrealized receivables[xxxix] of the partnership, or to inventory items of the partnership, then the amount of cash attributable to such assets will be treated as having been received from the sale of such assets, not from a capital asset, and will be treated as ordinary income.[xl]

Partial Redemption/Liquidation

If the current distribution described above did not occur, or if the amount thereof was insufficient for the needs of a particular owner, and assuming the business entity has agreed to redeem a portion of this owner’s equity in the business in order to get them additional cash, what are the tax consequences to the owner?

C Corporation

The tax consequences to a shareholder, some of whose shares of stock in the C corporation are acquired by the corporation from the shareholder in exchange for cash – a redemption[xli] – will depend upon the degree by which the shareholder’s ownership in the corporation is reduced relative to the ownership of the other shareholders.[xlii]

Thus, if every shareholder sold 10 percent of their shares to the issuing corporation (a pro rata redemption), none of the shareholders will have experienced a reduction in their relative ownership. In that case, and in every case in which the redemption does not result in a “meaningful” reduction[xliii] of a shareholder’s relative interest in the corporation, the cash paid by the corporation to the shareholder in exchange for some of their shares will be treated and taxed as “essentially equivalent” to a dividend, as described above, and the shareholder’s adjusted basis in the redeemed shares will be reallocated among the shareholder’s remaining shares of stock in the corporation.

However, if only one shareholder sold all but one of their shares of stock in the corporation, and such reduction was meaningful – for example, the percentage ownership represented by that one remaining share may be so small relative to the percentage of the total number of outstanding shares of the corporation that the shareholder owned before the redemption – that the redemption may be treated instead as “not essentially equivalent to a dividend;”[xliv] specifically, as a distribution in exchange for the shares redeemed by the corporation.

In that case, the shareholder will be treated as having sold the redeemed shares to the corporation and will realize gain equal to the excess of the amount paid by the corporation over the shareholder’s adjusted basis for the redeemed shares. Because the shares were likely a capital asset in the hands of the shareholder, this gain may be long-term capital gain if the shareholder’s holding period for such shares was more than one year, in which case it would taxable at a federal rate of 20 percent; the 3.8 percent federal surtax may also apply.[xlv]

The Code provides a “safe harbor” which, if satisfied, will cause the redemption of a portion of a shareholder’s shares to be treated as a sale of such shares. Specifically, immediately after the redemption, the shareholder must own less than 50 percent of the total combined voter power of the corporation’s shares. In addition, the redemption distribution must be “substantially disproportionate” with respect to the shareholder; meaning that the ratio which the voting stock of the corporation owned by the shareholder immediately after the redemption bears to all of its voting stock at that time, is less than 80 percent of the ratio which the shareholder’s voting stock before the redemption bore to all of the voting at such time. Finally, the shareholder’s ownership of all of the common stock of the corporation (voting and nonvoting) after and before the redemption, must also meet the 80percent requirement.[xlvi]

S Corporations

As in the case of a shareholder of a C corporation, the tax consequences to a shareholder, some of whose shares of stock in an S corporation are redeemed by the S corporation for cash, will depend upon the degree by which the shareholder’s ownership in the S corporation is reduced relative to the ownership of the other shareholders of the corporation.

If the reduction in the shareholder’s stock ownership is meaningful or significant enough to qualify as a sale of stock by the shareholder, then the shareholder’s gain from the redemption will be equal to the excess of the amount of cash distributed by the S corporation over the shareholder’s adjusted basis for the shares redeemed.

Provided the shareholder held the redeemed shares for more than one year, the gain will be treated as long-term capital gain, without regard to the composition of the underlying assets of the corporation, and will be taxable at a federal rate of 20 percent. If the corporation’s trade or business represents a passive activity with respect to the shareholder, then the 3.8 percent surtax may also apply to the gain.

If, instead, the redemption is treated as a current distribution, then the amount of cash distributed will be applied against the shareholder’s adjusted basis for all of their shares in the corporation, not only those shares that were redeemed. Only after the shareholder’s entire stock basis is exceeded will any remaining cash be treated as gain from the sale of a capital asset by the shareholder.

Partnership

The term “liquidation of a partner’s interest” is defined as the termination of a partner’s entire interest in a partnership by means of a distribution, or a series of distributions.[xlvii]

A distribution which is not in liquidation of a partner’s entire interest is treated as a current distribution for tax purposes. Current distributions, therefore, include distributions in partial liquidation of a partner’s interest,[xlviii] regardless of how substantial the reduction of the partner’s interest may be.[xlix]

In light of the foregoing, the same rules will apply to a partial liquidation of a partner’s equity in a partnership as apply to a current distribution. Gain will not be recognized by the partner except to the extent that the amount of cash distributed in partial liquidation of the partner’s interest – which will include the amount by which the distributee-partner’s share of partnership liabilities is reduced as a result of the reduction of the partner’s interest in partnership profit and loss[l] – exceeds the partner’s adjusted basis for their partnership interest immediately before the distribution.[li]

The gain recognized will be considered as gain from the sale of the partnership interest,[lii] and will generally be treated as gain from the sale of a capital asset,[liii] except to the extent any of the cash received by the partner is attributable to any unrealized receivables[liv] or inventory of the partnership, in which case such amount will be treated as having been received from the sale of such assets and will be treated as ordinary income.[lv]

What’s more, even if the amount of cash distributed in a partial liquidation of a partner’s interest does not exceed the distributee-partner’s adjusted basis in such interest, the partner may still be required to recognize gain from the deemed sale of certain partnership property.

Specifically, if the distributee-partner’s receipt of cash in partial liquidation of their interest results in a reduction of their share of the partnership’s unrealized receivables or inventory – as one might expect it would – the distributee-partner will be treated as having sold a portion of their interest in such receivables and inventory in exchange for a portion of the cash distribution, thereby realizing ordinary income.[lvi]

So Much for Simplicity

It is likely that a number of readers never thought that the “simple” distribution of cash by a corporation or a partnership to its owners could raise so many issues or present so many traps from a tax perspective.

The fact remains, however, that shareholders and partners are not going to turn their backs on a proffered, agreed-upon, or planned cash distribution, notwithstanding the potential tax consequences.

For that reason, it will behoove them to plan carefully for, and sufficiently in advance of, any such distributions in order that they may first identify any lurking tax issues and, having done so, to consider how to best address them.

As Fran Lebowitz once said, “A dog who thinks he is man’s best friend is a dog who obviously never met a tax lawyer.”

————————————————————————————————————————-

[i] Remember the scene with the ancient knight and the search for the Holy Grail in Indiana Jones and the Last Crusade?

[ii] P.L. 115-97. In order to level the proverbial “playing field,” the Act also added Sec. 199A to the Code, which provides a special deduction for the non-corporate owners of partnerships and for the shareholders of S corporations.

[iii] Usually an LLC taxable as a partnership, or an S corporation.

[iv] For example, the change from an association to a partnership or disregarded entity, which is generally treated as taxable liquidation of the association. See Reg. Sec. 301.7701-3(g). Another example would be the change in accounting method, from cash to accrual, that may accompany a change from S corporation to C corporation status, the resulting accelerated recognition of income, and the related tax liability.

[v] At least in my experience.

[vi] For example, following the sale of the assets of the business, or upon the sale of their equity in the business, to a third party.

[vii] “Guaranteed payments” when made by a partnership to a partner in exchange for their services or the use of their property. IRC Sec. 707(c).

[viii] Subchapter K includes “disguised sale” rules for certain cash distributions by a partnership to a partner that are related to a contribution of property by the partner to the partnership. IRC Sec. 707; Reg. Sec. 1.707-3. For purposes of our discussion, it is assumed that these rules do not apply.

[ix] This is a relationship that taxpayers often struggle to demonstrate when challenged to do so by a taxing authority. Where there is no written evidence of a loan (like a promissory note), no interest charged, no maturity date, no collateral, and no reported distributions with respect to equity, the taxing authority will likely succeed in re-characterizing the purported loan as a distribution.

[x] These are the basic withdrawal mechanisms.

They may be structured as directly as described in the text, or they may be accomplished indirectly, as where the business entity pays an owner’s personal expense or allows the owner to use business property without adequate consideration.

In these cases of constructive or imputed withdrawals of value, the taxpayer and the taxing authorities are left to determine the parties’ intentions (for example, was the payment a form of compensation or a dividend), and the tax treatment of the withdrawal, based on the facts and circumstances.

Although the converse of these situations – as where an owner receives the services of the entity, or uses or purchases its property – does not result in the withdrawal of funds from the entity, it may nevertheless enrich the owner if the terms of the arrangement are other than arm’s-length.

[xi] Of course, a business entity may also effect a complete redemption or liquidation of the owner’s entire equity, thereby removing the owner from the business. IRC Sec. 302(b)(3); IRC Sec. 736.

[xii] S corporations are allowed only one class of stock outstanding. IRC Sec. 1361(b).

[xiii] In the case of a C corporation that accumulates earnings in excess of the reasonable needs of its business, the corporation may be subject to an additional 20 percent tax. The accumulated earnings tax does not apply to S corporations and partnerships because these are flow-through entities, the income of which is taxable to their owners without regard to whether the income has been distributed to such owners.

[xiv] With the exception of reasonable reserves, why leave the money where creditors can get it? Or so the thinking goes.

[xv] This may sound straightforward, but there are many formulations. For example, should the entity use an assumed tax rate for all of its owners? Should the individual tax attributes of an owner be considered?

[xvi] This agreement may be coupled with a right of first refusal for the purpose of ensuring that the other owners, or the entity itself, will purchase the “selling” owner’s interest.

[xvii] IRC Sec. 11.

[xviii] This may be like music to the ears of a minority shareholder – a low entity-level tax, and no flow-through of income to the minority owner, with its resulting tax liability.

[xix] IRC Sec. 1363.

For our purposes, we will assume that neither the built-in gains tax, nor the tax on excess passive investment income, applies. IRC Sec. 1374 and IRC Sec. 1375.

[xx] IRC Sec. 1366.

[xxi] The surtax on net investment income may also apply to a shareholder if the shareholder does not materially participate in the business. IRC Sec. 1411.

[xxii] IRC Sec. 1367. The distribution reduces the shareholder’s adjusted basis.

[xxiii] IRC Sec. 701 and Sec. 702.

With respect to both the shareholders of an S corporation and the partners of a partnership, the IRC Sec. 199A deduction must be considered after 2017.

[xxiv] IRC Sec. 705. The distribution reduces the partner’s adjusted basis.

[xxv] IRC Sec. 301(c)(1), Sec. 316.

[xxvi] IRC Sec. 1(h)(11).

[xxvii] IRC Sec. 1411.

[xxviii] IRC Sec. 301(c)(2).

[xxix] IRC Sec. 301(c)(3).

[xxx] IRC Sec. 381; IRC Sec. 1368(c); Reg. Sec. 1.1368-1(d).

[xxxi] Assuming the holding period is satisfied.

[xxxii] Marketable securities may be treated as cash for this purpose. IRC Sec. 731(c). As mentioned elsewhere in this post, a partnership’s satisfaction of a partner’s individual liability is treated as a distribution of cash to the partner. Likewise, a reduction in a partner’s share of a partnership’s liabilities is treated as distribution of cash. IRC Sec. 752(b).

[xxxiii] The so-called “outside” basis. It should be noted that a partner’s outside basis is adjusted for the partner’s share of partnership income, deduction, etc., only on the last day of the partnership’s taxable year.

[xxxiv] IRC Sec. 731(a)(1).

If the partnership makes, or has in effect, a Sec. 754 election, the adjusted basis of the partnership assets may be increased by the amount of gain recognized by the distributee-partner. IRC Sec. 734; Reg. Sec. 1.734-1(b).

[xxxv] IRC Sec. 731(a), last sentence.

[xxxvi] IRC Sec. 741.

[xxxvii] Of course, it is possible for a partner to have a split-holding period for their partnership interest, with some of the gain being treated as short-term capital gain. Reg. Sec. 1.1223-3.

[xxxviii] IRC Sec. 1411(c)(2).

[xxxix] IRC Sec. 751(c). This includes, for example, cash basis receivables for services rendered, plus Sec. 1245 property.

[xl] IRC Sec. 751.

[xli] IRC Sec. 317.

[xlii] Attribution rules are applied for this purpose. IRC Sec. 318.

[xliii] Very much a facts and circumstances determination, depending, among other things, upon whether the stock was voting or nonvoting, and how the redemption affected the shareholder’s ability to exercise a degree of control. For example, a redemption that causes the shareholder to become a minority owner may qualify as an exchange.

[xliv] IRC Sec. 302(b)(1).

[xlv] IRC Sec. 1001; IRC Sec. 1221 and Sec. 1222.

[xlvi] IRC Sec. 302(b)(2).

[xlvii] A series of distributions may be made in one year or in more than one year, so long as they are intended to liquidate the partner’s entire interest in the partnership.

[xlviii] Reg. Sec. 1.761-1(d).

[xlix] Compare this to the case of a corporate redemption.

[l] IRC Sec. 752(b).

[li] IRC Sec. 731(a)(1).

[lii] IRC Sec. 731(a), last sentence.

[liii] IRC Sec. 741.

[liv] IRC Sec. 751(c). This includes, for example, cash basis receivables for services rendered, plus Sec. 1245 property.

[lv] IRC Sec. 751(a).

[lvi] IRC Sec. 751(b). Thankfully, this result may be avoided if the partners agree to adjust their capital accounts prior to the partially liquidating distribution; such an adjustment (and the resulting allocation) would be based upon the partners’ interests before the partial liquidation.

Once Upon A Time

I recently recalled a client that was referred to us a few years back, shortly before it was acquired by a larger company. The client was closely held by U.S. individuals and by an S corporation, and was organized as a Delaware LLC that was treated as a partnership for U.S. tax purposes.

Beginning in the early 2000’s, the LLC had formed or acquired several foreign corporate subsidiaries (the “Foreign Subs”). I remembered reviewing a few years’ worth of the LLC’s partnership tax returns (on IRS Form 1065)[i] and, based upon what I knew of the LLC’s business and that of the Foreign Subs, I did not expect to find any subpart F income on the returns – in other words, any foreign business income realized by the Foreign Subs would not have been subject to U.S. income tax in the hands of the LLC until such income was distributed as a dividend to the LLC.[ii] However, I noticed losses from foreign operations on Schedule K of the returns. When I asked about the source of the losses, I was told they were attributable to the Foreign Subs.

As I looked further into the subsidiaries, I learned that each of them was organized as a business entity with “limited liability” under the law of the jurisdiction in which it operated – meaning that no owner or member of the entity had personal liability for the entity’s obligations by reason of being a member.[iii] Thus, each Foreign Sub’s default classification for U.S. tax purposes was as an “association”; i.e., as an entity that was treated as a corporation.[iv] More relevant to the issue before me, each Foreign Sub was a “foreign eligible entity” that may have elected to change its classification for U.S. tax purposes.[v]

I asked to see the IRS Form 8832, Entity Classification Election,[vi] that I assumed must have been filed by each Foreign Sub to elect to be disregarded as an entity separate from the LLC – the so-called “check the box”.[vii] Such an election would have caused each subsidiary to be treated as a branch of the LLC, with the branch losses treated as having been realized directly by the LLC.[viii]

As it turned out, no such elections had been made. When I asked what the client intended when it acquired or organized the Foreign Subs, I was informed that they were to be treated as branches, which was consistent with the LLC’s tax returns as filed (as reflected on the Schedule K).

In order to redress the situation, we requested, and obtained, a ruling from the IRS that allowed the Foreign Subs to file late entity classification elections.

All’s well that ends well. Right?

The End of Tax Deferral

Fast forward. The LLC is no longer a client. The Tax Cuts and Jobs Act is enacted.[ix] Every U.S. person that owns a controlled foreign subsidiary that is treated as a corporation (or association) for U.S. tax purposes (a “CFC”) is scrambling to understand the new anti-deferral rules,[x] and to develop a plan for managing their impact.

In particular, tax advisers are discovering the benefits under the Act of being a direct C corporation parent of a CFC, or – in the case of an individual U.S. shareholder who owns stock of a CFC either directly, or indirectly through a partnership or an S corporation – the benefit of electing under Section 962 of the Code to be treated as a C corporation shareholder of the CFC.[xi]

GILTI

In order to limit a U.S. person’s ability to defer the U.S. taxation of a CFC’s non-subpart F, foreign-source income, the Act introduced a new class of income – “global intangible low-taxed income” (“GILTI”) – that must be included in income by a U.S. shareholder of a CFC.

This provision generally requires the current inclusion in income by a U.S. shareholder of (i) their share of a CFC’s non-subpart F income, (ii) less an amount equal to their share of 10 percent of the adjusted basis of the CFC’s tangible property used in its trade or business of a type with respect to which a depreciation deduction is generally allowable – the difference being the U.S. shareholder’s GILTI.

This income inclusion rule applies to both individual and corporate U.S. shareholders.

In the case of an individual shareholder, the maximum federal income tax rate applicable to GILTI is 37 percent. This is the rate that will apply, for example, to a U.S. individual who directly owns at least 10 percent of the stock of a CFC, or to one who indirectly owns such CFC stock through an S-corporation or partnership.

More forgiving rules apply in the case of a U.S. shareholder that is a domestic C corporation. Such a corporation is generally allowed a deduction of an amount equal to 50 percent of its GILTI (the “50-percent deduction”) for purposes of determining its taxable income;[xii] thus, the effective federal corporate tax rate for GILTI is actually 10.5 percent.[xiii]

In addition, for any amount of GILTI included in the gross income of a domestic corporation, the corporation is allowed a deemed-paid credit equal to 80 percent of the foreign taxes paid or accrued by the CFC with respect to such GILTI (the “80-percent FTC”).[xiv]

Based on the interaction of the 50-percent deduction and the 80-percent FTC, the U.S. tax rate on GILTI that is included in the income of a domestic C corporation will be zero (0) where the foreign tax rate on such income is at least 13.125 percent.[xv]

Foreign Branches

Of course, not all foreign subsidiaries of a U.S. person are treated as corporations for U.S. tax purposes. As in the case of the Foreign Subs, described above, a foreign subsidiary may be treated as a branch of its U.S. owner for tax purposes.

Because these foreign subsidiaries are not treated as corporations for U.S. tax purposes, they are not CFCs. Therefore, neither the GILTI nor the subpart F anti-deferral rules apply to them.

Rather, the income generated by a branch of a U.S. person (including income that would have been treated as GILTI in the case of a CFC) is treated as having been earned directly by the U.S. person, and is included in such U.S. person’s gross income on a current basis, without any deferral whatsoever.[xvi]

In the case of a U.S. individual owner of the branch – whether directly or through a partnership or S corporation – the foreign branch income will be subject to federal income tax at a maximum rate of 37 percent. In the case of an owner that is a C corporation, the foreign branch income will be subject to federal tax at the flat 21 percent rate applicable to corporations.

Because the branch is not a CFC for U.S. tax purposes, neither the 50-percent deduction nor the 80-percent FTC, that are available for GILTI, may be used to reduce or even eliminate the U.S. income tax on the branch income.[xvii] That being said, the U.S. owner of the branch generally may still claim a tax credit for the foreign taxes paid by the branch, thereby reducing their U.S. income tax liability attributable to the branch income.[xviii]

Incorporate the Branch?

Under these circumstances, would it make sense for the U.S. owner of the branch to incorporate the branch, and thereby convert it into a CFC, the income of which may be eligible for the reduced tax rates on GILTI described above?

Such an incorporation may be effectuated by contributing the assets comprising the branch (and subject to its liabilities) to a foreign corporation in exchange for all of its stock.

Alternatively, where the branch is held through a foreign eligible entity – a corporation, for all intents and purposes, under local law – that has elected (“checked the box”) to be treated as a disregarded entity for U.S. tax purposes (as in the case of the LLC’s Foreign Subs, described above), the U.S. owner may consider having the foreign entity elect to be treated, instead, as an association that is taxable as a corporation for U.S. tax purposes.[xix]

Either of these options may seem like a good idea – but not necessarily.

Section 367

In general, a U.S. person will not recognize gain if they transfer property to a corporation solely in exchange for stock in such corporation and, immediately after the exchange, the transferor is in control of the corporation.[xx]

However, in order to prevent a U.S. person from placing certain assets beyond the reach of the U.S. income tax by transferring them to a foreign corporation on a tax-favored basis (as described immediately above), the Code provides that if a U.S. person transfers property to a foreign corporation in exchange for stock in the foreign corporation, the transfer by the U.S. person becomes taxable.[xxi]

Prior to the Act, the Code provided an exception to this recognition rule; specifically, the transfer of property[xxii] by a U.S. person to a foreign corporation in exchange for its stock would not be treated as a taxable exchange where the property was to be used by the foreign corporation in the active conduct of a trade or business outside of the U.S.[xxiii]

The Act repealed this nonrecognition rule for exchanges after December 31, 2017. Thus, a transfer of property used in the active conduct of a trade or business outside the U.S. – a foreign branch – by a U.S. person to a foreign corporation no longer qualifies for non-recognition of gain.

Branch Losses

What’s more, the Act also added a new rule which provides that, if a U.S. corporation transfers substantially all of the assets of a foreign branch to a foreign corporation with respect to which it owns at least 10 percent of the total voting power or total value after the transfer, the U.S. corporation will include in its gross income an amount equal to the “transferred loss amount” of the branch.[xxiv]

In general, the transferred loss amount is equal to the losses incurred by the foreign branch after December 31, 2017, and before the transfer, for which a deduction was allowed to the U.S. corporation. The amount is reduced by certain taxable income earned, and gain recognized, by the foreign branch, including the amount of gain recognized by the U.S. corporation on account of the transfer of the branch assets.

What’s a Taxpayer to Do?

It appears that there aren’t many options available to a U.S. person with a foreign branch.

The U.S. person may continue to operate through the branch; it will not be subject to the GILTI rules; it will be subject to current U.S. income tax on all of its branch-derived income at its ordinary federal income tax rate; it will be entitled to a credit against its U.S. tax for any foreign income tax paid by the branch; the remittance by the branch of its earnings to the U.S. person will not be subject to U.S. tax, though the foreign jurisdiction of the branch may impose a withholding tax on such a distribution, for which a credit should be available to the U.S. person.

The U.S. person may incorporate the branch, as described above, and pay the resulting U.S. income tax liability – of course, the liability should be quantified before any change in form is effectuated; the GILTI and the CFC subpart F rules would then become applicable; with that, the recognition of a limited amount of foreign-sourced income may be deferred; in addition, the U.S. person – whether a C corporation or an individual who elects under Section 962 of the Code (including one who holds the foreign corporation stock through a partnership or an S corporation) – will be able to achieve the reduced U.S. income tax rate resulting from the application of the reduced 21 percent corporate rate, the 50-percent deduction, and the 80-percent FTC.

The U.S. taxpayer may eliminate the branch entirely – which may be impractical from a business perspective – in which case its foreign-sourced income will continue to be subject to U.S. income tax, though the taxpayer may be able to avoid paying any foreign taxes,[xxv] not to mention the U.S. reporting requirements that are attendant on the ownership and operation of a foreign business entity.

The decision will ultimately depend upon each taxpayer’s unique facts and circumstances, including the business reasons that caused the U.S. person to operate overseas to begin with.

[i] https://www.irs.gov/pub/irs-pdf/f1065.pdf

[ii] In other words, recognition of the subsidiaries’ income would have been deferred.

[iii] In general, this determination is based solely on the law pursuant to which the entity is organized. A member has personal liability, for this purpose, if the creditors of the entity may seek satisfaction of all or any portion of the debts or claims against the entity from the member as such. Reg. Sec. 301.7701-3.

[iv] I had already determined that none of the foreign subsidiaries was described in Reg. sec. 301.7701-2 as a “per se corporation.”

[v] Reg. Sec. 7701-3(a) and 301.7701-3(b)(2).

[vi] https://www.irs.gov/pub/irs-pdf/f8832.pdf

[vii] A deemed liquidation of the association. Reg. Sec. 301.7701-3(g).

[viii] A controlled foreign corporation’s losses for a taxable year do not flow through to its U.S. shareholders; rather, they reduce the CFC’s earnings and profits for the year. According to Sec. 952 of the Code, a CFC’s subpart F income for a taxable year cannot exceed its earnings and profits for that year. In addition, the amount of subpart F income included in a U.S. shareholder’s gross income for a taxable year may generally be reduced by the shareholder’s share of a deficit in the CFC’s earnings and profits from an earlier taxable year that is attributable to an active trade or business of the CFC.

[ix] December 22, 2017. P.L. 115-97; the “Act.”

[x] IRC Sec. 951A, effective for taxable years of foreign corporations beginning after December 31, 2017, and to taxable years of U.S. shareholders in which or with which such taxable years of foreign corporations end.

[xi] https://www.taxlawforchb.com/2019/03/u-s-individuals-electing-to-be-treated-as-corporations-american-werewolves/

[xii] IRC Sec. 250.

[xiii] The 21 percent flat rate multiplied by 50 percent.

[xiv] IRC Sec. 960(d). This is to be compared with the foreign tax credit available to a domestic corporation that includes subpart F income in its gross income; in that case, under IRC Sec. 960(a), the domestic corporation is deemed to have paid so much of the CFC’s foreign income taxes as are properly attributable to such subpart F income.

[xv] 13.125 percent multiplied by 80 percent equals 10.5 percent.

[xvi] Including the limited deferral that is still available under the GILTI rules.

[xvii] The Section 962 election is only available with respect to a CFC.

[xviii] The Act added a new rule that limits the ability of a U.S. taxpayer to use the “excess” foreign tax credits attributable to a branch – the amount of foreign tax paid by the branch in excess of the U.S. income tax that would otherwise be imposed on the income of the branch – to reduce the taxpayer’s U.S. income tax on its other foreign-source income.

[xix] The owner of the eligible entity would be treated as having contributed all of the assets and liabilities of the entity to the association in exchange for stock of the association. Reg. Sec. 301.7701-3(g).It should be noted that, in general, an entity that has already elected to change its tax classification cannot make a second election during the 60-month period following the effective date of the first election.

[xx] IRC Sec. 351.

[xxi] IRC Sec. 367(a). This is accomplished by providing that the foreign corporation shall not be considered a corporation for purposes of Section 351 of the Code.

[xxii] Certain assets were excluded from this rule; for example, inventory and certain intangibles.

[xxiii] The “active trade or business” exception to gain recognition under Section 367(a) of the Code. Reg. Sec. 1.367(a)-2.

[xxiv] IRC Sec. 91.

[xxv] It may not be treated as “doing business” in the foreign jurisdiction. In the case of a treaty country, the U.S. taxpayer may be treated as not having a permanent establishment in the foreign country.

Yesterday, in Part I, we reviewed the like-kind exchange rules. https://www.taxlawforchb.com/2019/04/deferring-real-property-gain-like-kind-exchange-or-opportunity-fund-part-i/

Now we turn to the new kid on the block.

Qualified Opportunity Zones

The Act added Section 1400Z-2 to the Code, which allows a taxpayer to elect to temporarily defer the recognition of gain from the disposition of property which is reinvested in a QOF.[i] This includes gain from the disposition of real property.

QOF

In general, a QOF is an investment vehicle organized as a corporation or as a partnership for the purpose of investing in qualified opportunity zone property,[ii] and that holds at least 90-percent of its assets in such property.[iii]

In contrast to the like-kind exchange rules, the property that generated the gain that a taxpayer invests in a QOF need not be like-kind to the property held by the QOF. This may afford a taxpayer the opportunity to diversify on a tax-deferred basis.

That is not to say that diversification is not possible in the context of a like-kind exchange – though such diversification must occur within the universe of real property; for example, a taxpayer may acquire property in a different geographic area, they may acquire commercial property rather than residential, and vice versa, or they may acquire multiple replacement properties for a single relinquished property – but they must acquire real property.

Eligible Gain

Only capital gain is eligible for deferral under Section 1400Z-2.[iv]

Thus, capital gain from the sale of land held by the taxpayer for investment is eligible,[v] as is gain from the sale of real property that is used in the taxpayer’s trade or business and that is held for more than one year.[vi]

In addition, the capital gain from the sale of a taxpayer’s interest in a real property partnership, or their shares of stock in a real property corporation, will be eligible for deferral.

The proposed regulations expand upon the foregoing by providing that a gain is eligible for deferral if it is treated as a capital gain for Federal income tax purposes. Eligible gains, therefore, generally include capital gain from an actual, or from a deemed, sale or exchange, or any other gain that is required to be included in a taxpayer’s computation of capital gain.[vii]

The gain to be deferred must be gain that would otherwise be recognized[viii] not later than December 31, 2026, the final date under Section 1400Z-2 for the deferral of gain through a QOF. Thus, the window for utilizing the QOF deferral rules is fairly limited.[ix]

It should be noted that, in order to be eligible for the QOF deferral, the gain must not arise from a sale of real property to, or an exchange of real property with, a person related to the taxpayer.[x]

Eligible Taxpayer

In general, any taxpayer that recognizes gain is eligible to elect deferral under the QOF rules. These taxpayers include individuals, C corporations, and certain other taxpayers.

In addition, any time a partnership would otherwise recognize gain, the partnership may elect to defer all or part of such gain to the extent that it makes an eligible investment in a QOF. To the extent that the partnership does not elect deferral, each partner may elect to do so.[xi]

Eligible Investment

The proposed regulations clarify that, to qualify under Section 1400Z-2, an investment in a QOF must be an equity interest in the QOF; this may include preferred stock in a corporation, or an interest in a partnership with special allocations.

A debt instrument issued by a QOF is not an eligible investment.

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

Time for Deferring Gain

To be able to elect to defer gain, a taxpayer must generally invest in a QOF during the 180-day period beginning on the date of the sale or exchange giving rise to the gain.

Some capital gains, however, arise as the result of Federal tax rules that treat an amount as gain from the sale or exchange of a capital asset where no so event occurred. In those cases, as a general rule, the proposed regulations provide that the first day of the 180-day rollover period is the date on which the gain would be recognized for Federal income tax purposes, without regard to the deferral available under Section 1400Z-2.

Partnerships/Partners

If the election to defer the recognition of gain is made by the partnership that sold or exchanged the property at issue, no part of the deferred gain is required to be included in the distributive shares of its partners. To the extent that the partnership does not elect to defer the capital gain, the gain is included in the distributive shares of the partners.

If all or any portion of a partner’s distributive share of the partnership’s gain satisfies all of the rules for eligibility under Section 1400Z-2 (including that the gain not arise from a sale or exchange with a person that is related either to the partnership or to the partner), then the partner may elect its own deferral with respect to the partner’s distributive share – to the extent that the partner makes an eligible investment in a QOF – without regard to what the other partners decide to do. [xiii]

In other words, some partners may decide to defer gain recognition by investing in a QOF, while others will choose to recognize their share of the gain.[xiv]

Similarly, if a partner a realizes capital gain from the sale of their interest in a partnership that owns real property,[xv] the partner may defer recognition of the gain by making an eligible investment in a QOF.

Deferral

The maximum amount of gain that may be deferred by a taxpayer is equal to the amount of cash invested in a QOF by the taxpayer during the 180-day period beginning on the date of the sale of the asset to which the deferral pertains.

Thus, if a taxpayer timely invests an amount of cash in a QOF equal to the entire gain from the sale, the gain will be deferred; the taxpayer does not need to invest the entire sale proceeds (i.e., the amount representing a return of basis[xvi]). Any capital gain that is not deferred in accordance with this rule must be recognized.

It should be noted that the cash invested by a taxpayer in a QOF does not have to be traced to the transaction that generated the capital gain that is being deferred. The amount invested by the taxpayer may come from another source; it may even be borrowed by the taxpayer.[xvii]

Recognition of Deferred Gain

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

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

Death of Electing Taxpayer

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

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

Gain Reduction

A taxpayer’s basis for an investment in a QOF immediately after its acquisition is deemed to be zero.

If the investment is held by the taxpayer for at least five years, their basis in the investment is increased by 10-percent of the deferred gain. If the investment is held by the taxpayer for at least seven years, their basis is increased by an additional 5-percent of the deferred gain.[xxii]

If the investment is held by the taxpayer until at least December 31, 2026 – the year in which the remaining 85-percent of the taxpayer’s deferred gain will be recognized – the basis in the investment will be increased by the amount of such deferred gain.

The deferred gain is recognized on the earlier of the date on which the investment in the QOF is disposed of or December 31, 2026.[xxiii]

Elimination of Gain

In the case of the sale or exchange of an investment in a QOF held for more than 10 years, at the election of the taxpayer, the basis of such investment in the hands of the taxpayer will be adjusted to the fair market value of the investment at the date of such sale or exchange.

In other words, any appreciation in the taxpayer’s investment in a QOF will be excluded from their gross income, and will escape taxation, if the taxpayer holds the investment for more than 10 years. The taxpayer’s ability to make this election is preserved until December 31, 2047.[xxiv]

This basis step-up is available only for gains realized upon investments that were made in connection with a proper deferral election under section 1400Z-2.[xxv]

Because there is no gain deferral available with respect to any sale or exchange made after December 31, 2026, there is no exclusion available for investments in QOFs made after December 31, 2026.

Are we Talking Apples and Oranges? Or McIntosh and Red Delicious?

Probably the former.[xxvi] Although both the like-kind exchange and the QOF investment allow a taxpayer to defer the recognition of capital gain from the disposition of an interest in real property, they are founded on different principles,[xxvii] seek to achieve different goals and, consequently, require the satisfaction of different criteria.

At the most basic level, the like-kind exchange will probably continue to be the option chosen by an active investor in real property – one who wants to defer their gain, wants to retain an interest in real property that they will manage, but does not want to be limited by the requirements for a QOF, including their geographic restrictions.

A taxpayer who is withdrawing from the real property business, and who otherwise may have settled upon a Delaware Statutory Trust as their replacement property in a like-kind exchange, may find an investment in a QOF attractive, especially because they are already committed to becoming a passive investor, and they will need to invest only an amount equal to their gain from the sale, thereby allowing them to keep that portion of the sale proceeds equal to their basis in the disposed-of property.

In the case of a minority investor who is withdrawing from a real property partnership or corporation, an investment in a QOF may be the only game in town, and a fairly attractive one at that. This may especially be the case for a partner in a partnership who would realize a very large gain on their withdrawal from the partnership thanks to the deemed distribution of cash under Section 752 of the Code.[xxviii]

Finally, a taxpayer engaging in a deferred like-kind exchange, where none of the identified replacement properties can be acquired, may find that the only alternative to gain recognition is an investment in a QOF. However, query whether any qualified intermediary will release the sale proceeds before the expiration of the 180-day replacement period.[xxix]

Time will tell.

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[i] Taxpayers will make deferral elections on Form 8949, which will be attached to their Federal income tax returns for the taxable year in which the gain would have been recognized if it had not been deferred.

[ii] In the case of real property, this means property located in the zone that is “substantially improved” by the QOF.

[iii] https://www.taxlawforchb.com/2019/02/a-closely-held-qualified-opportunity-fund-its-possible-but-its-not-easy/

[iv] In general, the gain may be either short-term or long-term capital gain. Other than in the case of land that is a capital asset in the hands of the taxpayer, the disposition of real property will generate capital gain only if it has been held for more than one year.

[v] IRC Sec. 1221. A capital asset.

[vi] IRC Sec. 1231. Gain from the sale of real property that represents the taxpayer’s stock-in-trade does not qualify; nor does ordinary income arising from the recapture of depreciation.

[vii] For example, a distribution of cash by a partnership to a partner, that is treated as a sale or exchange of the partner’s partnership interest, and that generates capital gain, may be eligible for deferral. IRC Sec. 731, 741.

[viii] But for the deferral permitted under Section 1400Z-2.

[ix] That being said, who knows whether a future administration will allow the like-kind exchange of real property. The Obama administration tried to eliminate Section 1031 in its entirety.

[x] Similarly, the sale of a partnership interest or of shares of stock in a corporation may not be made to a related person if the gain therefrom is to qualify. IRC Sec. 1400Z-2 incorporates the related person definition in sections 267(b) and 707(b)(1) of the Code, but substitutes “20 percent” in place of “50 percent” each place it occurs in section 267(b) or section 707(b)(1).

[xi] Similar rules apply for S corporations and their shareholders.

[xii] The proposed regulations also clarify that deemed contributions of money under section 752(a) – e.g., when a partner’s allocable share of a partnership debt is increased – do not result in the creation of an investment in a QOF.

Compare this to a post-like-kind exchange refinancing, which may be viewed as separate from the exchange (if planned properly) and, so, does not generate boot.

[xiii] The partner’s 180-day period generally begins on the last day of the partnership’s taxable year, because that is the day on which the partner would be required to recognize the gain if the gain is not deferred.

[xiv] Many taxpayers long for such flexibility in the context of a partnership in which some partners want to engage in a like-kind exchange while other partners want to monetize their partnership interest.

[xv] Notwithstanding that the partnership remains subject to the partnership tax rules under subchapter K.

[xvi] Compare this to the requirements for a like-kind exchange, where the taxpayer must acquire a property with at least the same fair market value and equity as the relinquished property if they want to defer the entire gain.

[xvii] For example, if partnership sells an asset that generates capital gain, and a partner elects to defer their share of such gain, they may have to borrow the proceeds to be invested in a QOF if the partnership does not make a distribution.

[xviii] A like-kind exchange allows an indefinite deferral of gain.

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

The gain deferred in a like-kind exchange, in contrast, may be deferred indefinitely – i.e., until the replacement property is sold.

[xx] IRC Sec. 691.

[xxi] Compare this to the gain deferred in a like-kind exchange, where a basis step-up at the death of a taxpayer may eliminate the gain.

[xxii] 15-percent, in total. Because of the December 31, 2026 “deadline” described above, a taxpayer will have to sell and reinvest their gain by December 31, 2019 in order to enjoy the full 15-percent basis adjustment (7 years). Like-kind exchanges have no such holding period requirements.

[xxiii] Only taxpayers who rollover qualifying capital gains before December 31, 2026, will be able to take advantage of the special treatment of capital gains under Section 1400Z-2.

[xxiv] That’s many years of potential appreciation.

[xxv] It is possible for a taxpayer to invest in a QOF in part with gains for which a deferral election under section 1400Z-2 is made and in part with other funds (for which no section 1400Z-2 deferral election is made or for which no such election is available). Section 1400Z-2 requires that these two types of QOF investments be treated as separate investments, which receive different treatment for Federal income tax purposes.

[xxvi] I’ll take an apple over an orange any day.

[xxvii] https://www.taxlawforchb.com/2019/02/sale-of-a-business-and-qualified-opportunity-funds-deferral-exclusion-and-risk/

[xxviii] This is basically a recapture of tax benefits – previously received by the taxpayer in the form of deductions or tax-free distributions of cash – attributable to funds borrowed by the partnership.

[xxix] See the safe harbor under Reg. Sec. 1.1031(k)-1(g)(6).

The Act

Among the business transactions on which the Tax Cuts and Jobs Act[i] has had, and will continue to have, a significant impact is the disposition of a taxpayer’s interest in real property, whether held directly or through a business entity.

That is not to say that the Act amended an existing Code[ii] provision, or added a new provision to the Code, that was specifically intended to affect the income tax consequences arising from the sale or exchange of a taxpayer’s interest in real property. It did no such thing.

However, the Act preserved the ability of a taxpayer to defer the recognition of gain from their disposition of real property (the “relinquished” property) by acquiring other real property (the “replacement” property) of like-kind to the relinquished property,[iii] while eliminating the ability of a taxpayer to engage in a like-kind exchange for the purpose of deferring the gain from their disposition of any other type of property.[iv]

At the same time, the Act provided another deferral option for the consideration of taxpayers who realize capital gain on their disposition of property – including real property; specifically, such gain may be deferred if the taxpayer invests in a new kind of investment vehicle: a qualified opportunity fund (“QOF”).[v]

With the release of proposed regulations under the QOF rules in late 2018,[vi] and with the expectation of more guidance thereunder in the near future,[vii] some taxpayers who are invested in real property are beginning to view QOFs with greater interest, including as a possible deferral alternative to a like-kind exchange.

In light of this development, it will behoove taxpayers invested in real property to familiarize themselves with the basic operation of these two deferral options: the like-kind exchange and the QOF.

We begin with the tried-and-true like-kind exchange.

Like-Kind Exchanges

An exchange of property, like a sale, generally is a taxable event. However, Section 1031 provides that no gain (or loss) will be recognized by a taxpayer if real property held[viii] by the taxpayer for productive use in a trade or business or for investment is exchanged for real property of a “like-kind” which is to be held by the taxpayer for productive use in a trade or business or for investment.

Section 1031 does not apply to any exchange of real property that represents the taxpayer’s stock in trade (i.e., inventory) or other real property held primarily for sale.[ix] It also does not apply to exchanges involving foreign real property[x] – that being said, relinquished real property in one state may be exchanged for replacement real property in another state.[xi]

The disposition of an interest in a partnership or of stock in a corporation will not qualify for tax deferral under Section 1031. However, for purposes of the like-kind exchange rules, an interest in a partnership which has in effect a valid election to be excluded from the application of the Code’s partnership tax rules,[xii] is treated as an interest in each of the partnership’s assets, which may include qualifying real property, and not as an interest in a partnership.[xiii]

Like-Kind

For purposes of Section 1031, the determination of whether the real properties exchanged are of a “like-kind” to one another relates to the nature or character of each property, and not to its grade or quality. This rule has been applied very liberally with respect to determining whether real properties are of “like-kind” to one another. For example, improved real property and unimproved real property generally are considered to be property of a “like-kind” as this distinction relates to the grade or quality of the real property.[xiv]

Investment

Generally speaking, in order for a taxpayer to defer recognition of the entire gain realized from their disposition of a relinquished real property, the taxpayer must reinvest in the replacement real property an amount at least equal to the sales price for the relinquished property. If the taxpayer invests less than this amount, it may be that they received some cash in the disposition that was not reinvested (non-like property, or “boot”).

In addition, if the relinquished property was encumbered by debt, the taxpayer must incur at least the same amount of debt in acquiring the replacement property, or they must invest additional cash in such acquisition in an amount equal to the amount of such debt.[xv] Any net reduction in such debt, in moving from the relinquished property to the replacement property, would be treated as boot.

Boot

The non-recognition of gain in a like-kind exchange applies only to the extent that like-kind property is received in the exchange. Thus, if an exchange of real property would meet the requirements of Section 1031, but for the fact that the property received by the taxpayer in the transaction consists not only of real property that would be permitted to be exchanged on a tax-deferred basis, but also other non-qualifying property or money (including “net debt-relief”), then the gain realized by the taxpayer is required to be recognized, but not in an amount exceeding the fair market value of such other property or money.[xvi]

Basis

In general, if Section 1031 applies to an exchange of real properties, the basis of the property received in the exchange is equal to the basis of the property transferred. This basis is increased to the extent of any gain recognized as a result of the receipt of other property or money in the like-kind exchange, and decreased to the extent of any money received by the taxpayer.[xvii]

The holding period of qualifying real property received includes the holding period of the qualifying real property transferred.[xviii]

In this way, the deferred gain is preserved and may be recognized by the taxpayer on a subsequent taxable disposition, which may occur many years later.[xix]

Of course, if the taxpayer is an individual who dies before the later taxable sale of the replacement property, their estate will receive a basis step-up for the property;[xx] consequently, the estate may not recognize any gain on the sale.

Deferred Exchange

A like-kind exchange does not require that the real properties be exchanged simultaneously. Indeed, most exchanges do not involve direct swaps of the relinquished and replacement real properties.

Rather, the real property to be received in the exchange must be received not more than 180 days after the date on which the taxpayer relinquishes the original real property.[xxi]

In addition, the taxpayer must identify the real property to be received within 45 days after the date on which the taxpayer transfers the real property relinquished in the exchange.[xxii]

Until the replacement real property is acquired, the taxpayer may not receive the proceeds from the sale of the relinquished property. If the taxpayer actually or constructively receives such proceeds before the taxpayer actually receives the like-kind replacement property, the transaction will constitute a sale, and not a deferred exchange, even though the taxpayer may ultimately receive like-kind replacement property.

In order to assist a taxpayer in avoiding the actual or constructive receipt of money or other property in exchange for their relinquished real property, the IRS has provided a number of “safe harbor” arrangements pursuant to which such “sale proceeds” from the relinquished property may be held by someone other than the taxpayer pending the acquisition of the replacement property.[xxiii] If the requirements for these arrangements are satisfied, the taxpayer will not be treated as having received the sale proceeds.[xxiv]

Same Taxpayer

The same taxpayer[xxv] that disposes of the relinquished property must also acquire the replacement property. Thus, if an individual, a partnership, or a corporation sells a real property that they held for investment or for use in a trade or business, then that same individual, partnership or corporation must acquire and hold the replacement property.

Stated differently, if a partnership or a corporation sells a real property, its individual partners and shareholders cannot acquire their own separate replacement properties outside the partnership or corporation.[xxvi]

Holding Period

There is no prescribed minimum holding period – either for the relinquished property or the replacement property – that must be satisfied in order for a taxpayer to establish that they “held” the real property for the requisite purpose (and not for sale).

However, based on the facts and circumstances, a short holding period may result in a taxpayer’s failing to prove that they held the property for the requisite investment or business purpose.

Related Parties

That being said, a special rule applies where the taxpayer exchanges real property with a related person.

Where a taxpayer engages in a direct swap of like-kind real properties with a related person, the taxpayer cannot use the nonrecognition provisions of Section 1031 if, within 2 years of the date of the swap, either the related person disposes of the relinquished property or the taxpayer disposes of the replacement property. The taxpayer will recognize the deferred gain in the taxable year in which the disposition occurs.[xxvii]

It should also be noted that a taxpayer engaging in a deferred exchange, who transfers relinquished real property to a qualified intermediary in exchange for replacement real property formerly owned by a related party, is generally not entitled to nonrecognition treatment under Section 1031 if, as part of the transaction, the related party receives cash or other non-like-kind property for the replacement property.[xxviii]

Tomorrow we turn to the Qualified Opportunity Fund.

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[i] P.L. 115-97; the “Act.”

[ii] In the words of The Highlander, “There can be only one”: the Internal Revenue Code. Inside joke – part of a running dispute with some acquaintances in the bankruptcy world. Their code has a lower case “c”.

[iii] IRC Sec. 1031.

[iv] Sec. 13303 of the Act. Stated differently, the Act amended the tax-deferred like-kind exchange rules such that they will apply only to dispositions of real property.

[v] IRC Sec. 1400Z-2.

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

[vii] Treasury Assistant Secretary Kautter recently announced that such regulations were just a few weeks away.

[viii] There is no prescribed holding period, either for the relinquished property or the replacement property. However, a short holding period may result in a taxpayer’s failing to prove that they held the property for the requisite purpose.

[ix] IRC Sec. 1031(a)(2). Thus, a dealer in real property may not use the like-kind exchange rules to defer the recognition of income arising from the sale of their inventory.

[x] IRC Sec. 1031(h).

[xi] Some “relinquished property states” have made noise about keeping tabs on the ultimate taxable disposition of the replacement property; for example, California.

[xii] Subchapter K of the Code. The election is made under IRC Sec. 761. See also the regulations promulgated under Sec. 761.

[xiii] IRC Sec. 1031(e); as amended by the Act.

[xiv] Reg. Sec. 1.1031(a)-1(b). A leasehold interest with a remaining term of at least 30 years is treated as real property. An interest in a Delaware Statutory Trust (basically, a grantor trust) may be treated as real property. In addition, certain intangibles may be treated as real property, including certain development rights.

[xv] Reg. Sec. 1.1031(d)-2.

[xvi] IRC Sec. 1031(b).

[xvii] IRC Sec. 1031(d).

[xviii] The non-qualifying property received is required to begin a new holding period.

[xix] Of course, the taxpayer may decide to continue to defer the gain by engaging in yet another like-kind exchange.

[xx] IRC Sec. 1014. The estate of an individual taxpayer who is a partner in a partnership may enjoy a similar step-up in its share of the underlying real property of the partnership, provided the partnership has in effect, or makes, an election under Sec. 754 of the Code.

The foregoing assumes the sale has not progressed to the point where the contract of sale represents an item of income in respect of a decedent, in which case there will be no basis step-up. IRC Sec. 691.

[xxi] But in no event later than the due date (including extensions) of the taxpayer’s income tax return for the taxable year in which the transfer of the relinquished property occurs).

[xxii] IRC Sec. 1031(a)(3); Reg. Sec. 1.1031(k)-1(a) through (o). The taxpayer may identify more than one replacement property. Regardless of the number of relinquished properties transferred by the taxpayer as part of the same deferred exchange, the maximum number of replacement properties that the taxpayer may identify is three properties without regard to the FMV of the properties, or any number of properties as long as their aggregate FMV as of the end of the identification period does not exceed 200 percent of the aggregate FMV of all the relinquished properties as of the date the relinquished properties were transferred by the taxpayer.

[xxiii] This requires that the proceeds be traced. Form matters here.

[xxiv] Reg. Sec. 1.1031(k)-1(g).

[xxv] Not necessarily the same state law entity. For example, a newly formed single member subsidiary LLC may acquire replacement property following a sale of relinquished property by its parent corporation.

[xxvi] Of course, there are situations in which one partner may want to be cashed out rather than continue in the partnership with a new property, or may want to effect a like-kind exchange while the remaining partners want to cash out their investment. Other strategies may be used in these instances; for example, a so-called “drop-and-swap,” which is not without risk.

[xxvii] IRC Sec. 1031(f). The term “related person” means any person bearing a relationship to the taxpayer described in Sections 267(b) or 707(b)(1) of the Code.

[xxviii] Rev. Rul. 2002-83.

After Me, Who Cares?

In the context of a family-owned business, managerial succession and the transfer of ownership – not necessarily the same thing – can turn into quite an adventure when they are not well-planned.

Let’s begin with the premise that the business is owned and managed by at least one parent. As is the case with most organizations, there are persons who have a vested interest in the uninterrupted and unchanged operation of the business; there are also those who desire change, sometimes for bona fide business reasons, sometimes for purely selfish ones. Also as in the case of other organizations, there is often a strong leader in the business who holds these competing interests at bay, or who knows how to balance them or play them off of one another.

When this moderating or controlling force – i.e., the parent upon whose continued goodwill all of the competing interests depend – is no longer present, well, that’s when the adventure begins, at least where the parent has failed to provide for a transition of ownership and management in a way that effectively deals with these competing forces.

Coming Out of the Woodwork

Speaking of competing interest-holders, there may be many who will become more active or vocal following the death of a parent where the latter has failed to provide an effective “Plan B” to be implemented upon[i] their demise; these include, for example, a surviving spouse, children-in-the-business, children-not-in-the-business-but-dependent-on-it, children-not-in-the-business-and-independent-of-it,[ii] key employees of the business, business partners (such as vendors or customers), charitable organizations of which the parent or the business was a benefactor, and others. Many, if not most, of these interest-holders will take a very self-centered approach toward the resolution of those ownership and management issues that were not adequately addressed by the parent.

In some cases, the parent may have inadvertently (or not) placed one or more of these interest-holders into positions from which they can exert substantial influence over the outcome. For example, a child-in-the-business may have been placed into a key executive position in the business; another child may have been nominated or appointed to serve as a fiduciary of the parent’s estate or trust, through which the parent’s business interests (or the value they represent) are to be distributed among the parent’s beneficiaries. Sometimes, the same person will end up holding every position of authority. This individual may be ideally situated to steer events as they desire; in doing so, however, they may compromise their fiduciary duties to many of their fellow competing interest-holders, while also running afoul of the Code, as was illustrated by a recent decision.

Decedent’s Plan

Decedent’s estate (“Estate”) included a closely held C corporation (“Corp”) that managed commercial and residential real properties. At the time of Decedent’s death, Son was the president of Corp, and two of his siblings were also employed in the business. Decedent’s other children were not involved in the business.

At her death, Decedent held approximately 81-percent of Corp’s voting shares and approximately 84-percent of its nonvoting shares. The remaining voting shares were held by Son; the remaining nonvoting shares were split between Son and one of his siblings-in-the-business.

Prior to Decedent’s death, Corp’s board had preliminary discussions about purchasing Decedent’s shares as part of ongoing succession planning. In fact, the board resolved that it would “periodically purchase” Decedent’s shares based on terms acceptable to all parties. However, there were no specific redemption agreements, or other shareholder or buy-sell agreements, in place when Decedent unexpectedly died shortly thereafter.

Therefore, in accordance with Decedent’s “pour-over” will,[iii] upon her death, all of the assets owned by her at that time[iv] – including her shares of Corp stock – passed to a trust (“Trust”).

Trust provided for Decedent’s children to receive her personal effects, but no other assets from her Estate. Any assets remaining in Decedent’s Estate would pass to Foundation, a grant-making charitable organization described in Section 501(c)(3) of the Code, and classified as a private foundation.[v] These residuary assets were not intended for Decedent’s family.

Estate Administration

Son was appointed the sole executor of Estate, the sole trustee of Trust, and the sole trustee of Foundation. Son also remained the president of Corp.

To determine the value of Decedent’s Corp shares for “estate administration purposes” – including the filing of an estate tax return – Son obtained an independent appraisal of Corp, which determined that Corp’s value as of Decedent’s date of death was approximately $17.8 million, and that Decedent’s shares in Corp were worth approximately $14.2 million (a market value of approximately $1,824 per voting share and of $1,733 per nonvoting share).

After Decedent’s death, Son caused Corp to convert from a C corporation to an S corporation, in order to accomplish certain “long-term tax planning goals.”[vi]

Redemption?

Corp’s board also decided, presumably at Son’s “suggestion,” that it would redeem from Trust all of Decedent’s Corp shares, which were to pass to Foundation.[vii] Among the reasons put forth by the board for the decision to redeem these shares was its concern about the tax consequences of Foundation owning shares in an S corporation – presumably, the treatment of Foundation’s pro rata share of S corporation income as unrelated business income.[viii]

[Based upon what followed, however, some may conclude that a motivating factor was to divert value from Foundation to Son; others may determine that it was to preserve value in the business, which is not necessarily the same thing.[ix]]

Initially, Corp agreed to redeem all of Decedent’s shares for approximately $6.1 million. This amount was based on a much earlier appraisal, since the date-of-death appraisal had not yet been completed. As a result, the redemption agreement provided that the stated redemption price would be “reconciled and adjusted retroactively” to reflect the fair market value of the shares as of the effective date of the redemption. Corp executed two interest-bearing promissory notes payable to Trust in exchange for its shares; each note was adjustable retroactively, depending on the new appraisal value.

At the same time, Son and his in-the-business-siblings entered into separate subscription agreements to purchase additional Corp shares, in order to provide funding for Corp to meet the required payments on the promissory notes, and to establish their own, relative shareholder interests in Corp.

Redemption Appraisal

Then, at the direction of Corp – i.e., Son – yet another appraisal of Decedent’s Corp shares was undertaken, specifically for the purpose of the redemption. This time, Son instructed the appraiser to value Decedent’s shares as if they represented a minority interest in Corp.[x] The appraisal, therefore, included a 15-percent discount for lack of control and a 35-percent discount for lack of marketability.[xi] As a result, Decedent’s Corp shares were valued much lower in the redemption appraisal than in the date-of-death appraisal: $916 per voting share and $870 per nonvoting share.[xii]

Corp then determined that it could not afford to redeem all of Decedent’s shares, even at the new redemption appraisal price. The redemption agreement was amended, and Corp agreed to redeem all of Decedent’s voting shares and most, but not all, of her nonvoting shares for a total purchase price of approximately $5.3 million.

Post-Redemption

The state probate court approved the redemption agreement and indicated that the redemption transaction and the seller-financing represented by the promissory notes would not be acts of prohibited self-dealing.[xiii]

After the redemption agreement was implemented, Corp’s share ownership was as follows: (1) Trust owned 35-percent of the nonvoting shares; (2) Son owned 69-percent of the voting shares and 48-percent of the nonvoting shares; and (3) the in-the-business-siblings owned 31-percent of the voting shares and 17-percent of the nonvoting shares.

Trust subsequently distributed the promissory notes (received from Corp in exchange for Decedent’s voting shares and most of her nonvoting shares) and Decedent’s remaining nonvoting shares to Foundation.

Tax Reporting

Foundation reported the following contributions on its annual tax return, based upon the redemption appraisal:[xiv] a noncash contribution of Corp nonvoting shares with a fair market value of $1.86 million; and notes receivable with an aggregate fair market value of $5.17 million.

The Trust reported a capital loss on its annual income tax return for the sale of Decedent’s voting shares and for the sale of most of Decedent’s nonvoting shares, based on the greater date of death appraisal.[xv]

Estate filed its Federal estate tax return,[xvi] on which it claimed a charitable contribution deduction[xvii] based on the date-of-death value of Decedent’s Corp shares, and reporting no estate tax liability.[xviii]

The IRS examined Estate’s Form 706 and issued a notice of deficiency in which it asserted an estate tax deficiency in excess of $4 million, based on a lower charitable contribution deduction – specifically, the amount actually distributed from Trust to Foundation.

Estate filed a timely petition in the Tax Court challenging the IRS’s assertion. Estate argued that it correctly used the date-of-death appraisal to determine the value of Decedent’s Corp shares for purposes of the charitable contribution deduction.

The IRS responded that post-death redemption of Decedent’s Corp shares should be considered in determining the value of the charitable contribution, because Son’s actions reduced the value of Decedent’s contribution to Foundation.

The Tax Court upheld the IRS’s reduction of Estate’s charitable contribution deduction and the resulting increase in its estate tax liability. The Tax Court found that “post-death events” – primarily Son’s decision to redeem Corp shares from Trust based upon an appraisal that applied a minority interest discount to the redemption value of such shares – reduced the value of the contribution to Foundation and, therefore, reduced the value of Estate’s charitable deduction.

Estate timely appealed the Tax Court’s decision to the Ninth Circuit.[xix]

Court of Appeals

Estate argued that the Tax Court erred by taking into account “post-death events” – that decreased the value of the property delivered to Foundation – in determining the value of the charitable deduction. Instead, Estate asserted that the charitable deduction should have been valued and determined as of Decedent’s date of death. The Court rejected Estate’s argument.

Charitable Deduction

The Court began by noting that the “estate tax is a tax on the privilege of transferring property” after one’s death. The estate tax “is on the act of the testator,” the Court explained, “not on the receipt of the property by the legatees.”

Because the estate tax is a tax on a decedent’s bequest of property, the valuation of the gross estate is typically done as of the date of death.[xx] Except in some limited circumstances, the Court added, post-death events are generally not considered in determining an estate’s gross value for purposes of the estate tax.

A related provision, the Court continued, “allows for deductions from the value of the gross estate for transfers of assets to qualified charitable entities.”[xxi] This deduction generally is allowed “for the value of property included in the decedent’s gross estate and transferred by the decedent . . . by will.”

The Court then explained that the purpose of the charitable deduction is to encourage charitable bequests, not to permit executors and beneficiaries to rewrite a will so as to achieve tax savings.

“Valuing” the Deduction

According to the Court, deductions are valued separately from the valuation of the gross estate.[xxii] Separate valuations, it noted, allow for the consideration of post-death events.

The Court then discussed the seminal case on the subject of the valuation of a charitable bequest.

The Court explained that in Ahmanson Foundation v. United States,[xxiii] the decedent’s estate plan provided for the voting shares in a corporation to be left to family members and the nonvoting shares to be left to a charitable foundation. The court there held that, when valuing the charitable deduction for the nonvoting shares, a discount should be applied to account for the fact that the shares donated to the charity had no voting power. That a discount was not applied to the value of the nonvoting shares in the gross estate did not impact the court’s holding. Significantly, the court recognized that a charitable deduction “is subject to the principle that the testator may only be allowed a deduction for estate tax purposes for what is actually received by the charity.”

In contrast, Estate argued that the charitable deduction must be valued as of the date of Decedent’s death, in keeping with the date-of-death valuation of an estate.

The Court disagreed. Valuations of the gross estate and of a charitable deduction are separate and may differ, it stated. According to the Court, while a decedent’s gross estate is fixed as of the date of their death, deductions claimed in determining the taxable estate may not be ascertainable or even accrue until the happening of events subsequent to death.[xxiv]

The Court continued, “[t]he proper administration of the charitable deduction cannot ignore such differences in the value actually received by the charity.” This rule prohibits crafting an estate plan or will, it stated, so as to game the system and guarantee a charitable deduction that is larger than the amount actually given to charity.

The decision in Ahmanson compelled the affirmation of the Tax Court’s ruling in the case considered here. Decedent structured her Estate so as not to donate her Corp shares directly to Foundation, but to Trust. She enabled Son to commit almost unchecked abuse of the Estate by nominating him to be executor of her estate, trustee of Trust, and trustee of Foundation, in addition to his roles as president, director, and majority shareholder of Corp.

According to the Court, Son improperly directed the appraiser to determine the redemption value of the Corp shares by applying a minority interest valuation, when he knew they represented a majority interest, and that Estate had claimed a charitable deduction based upon a majority interest valuation.

Through his actions, Son manipulated the charitable deduction so that Foundation only received a fraction of the charitable deduction claimed by Estate. In doing so, he enhanced the value of Corp, of which he was now the principal shareholder.

Estate attempted to evade Ahmanson by arguing that its holding was limited to situations where the testamentary plan itself diminished the value of the charitable property. The Court rejected this reading, stating that Ahmanson “was not limited to abuses in the four corners of the testamentary plan”; rather, the Court responded, it extended to situations where “the testator would be able to produce an artificially low valuation by manipulation.”[xxv]

The Court found that the Tax Court had correctly considered the difference between the deduction claimed and the value of the property actually received by the charity due to Son’s manipulation of the redemption appraisal value.

The Court also found that there was nothing in the record to suggest that the Tax Court’s findings were clearly erroneous. Instead, it found that Son, in his capacity as the executor and heir to Decedent’s shares, claimed a large charitable deduction based on the value of Estate property at the time of death, only to manipulate the property’s value for personal gain, deliver assets to Foundation worth substantially less than the amount claimed as a deduction, and received a windfall in the process.

In light of the foregoing, the Court sustained the estate tax deficiency.

Plan B

It is a foregone conclusion – the parent/owner/CEO of the family-owned business is either going to die on the job or retire from the job.

When that happens, they are going to leave their family with what is likely a very valuable, but illiquid, asset: the business. The business will likely represent the lion’s share of the parent’s gross estate. It is also possible that several members of the family earn their livelihoods in the business, while other members may depend upon it in some fashion for part of their support.

The removal of the parent may unleash many of the competing interests identified earlier, which in turn may result in these interest-holders’ losing sight of the one thing they have in common: the preservation of the business on which they all depend, of its ability to generate cash flow, and of the value it represents.

The first great challenge to this unifying principle will be the Federal and State estate taxes that are imposed upon the disposition of, and that are payable by, the parent’s estate.[xxvi]

The next challenge will be the faithful execution of the parent’s estate plan without compromising the business.

Both may be satisfactorily addressed if they are planned for while the parent is alive and well, if the competing interest-holders are brought into the discussion, if qualified advisers are consulted, and if guardrails are installed; for example, in the form of shareholders/partnership agreements, life insurance on the parent – which, in the case described above, could have been used by Corp to fund the very foreseeable buy-out of Foundation without compromising Corp’s business or forcing Son into an aggressive valuation posture – employment or incentive compensation agreements for key employees, and the appointment of fiduciaries to the parent’s estate or trust who understand the parent’s wishes and who are familiar with the various interest-holders.[xxvii]

Of course, if the parent truly does not care what happens to the business after their death – and we’ve all experienced such individuals – then the tax adviser’s job becomes one of damage control.

[i] In the minds of many parents, “in the event of.”

[ii] Yes, I’m making up words – the hyphen is a wonderful tool, similar to the compound word, which simply omits the hyphen, but can you imagine reading “childrennotinthebusiness”? You’d think I was writing in German. Donaudampfschiffahrtsgesellschaftskapitän, for example, means “Danube steamship company captain.” First French, now German. It’s all Greek to me.

[iii] In general, a will that does not provide for any disposition of a decedent’s assets beyond directing them to a trust created by the decedent during their lifetime; this trust provides for the detailed disposition of the assets poured over from by will; it also provides for the disposition of any assets that may have been transferred by the decedent to the trust during their lifetime. Of course, any assets that may have been owned by the decedent jointly with another with rights of survivorship would have passed to the surviving co-owner, beyond the reach of the will or trust. Similarly, assets for which the decedent contractually named a successor to their interests therein (e.g., a retirement plan account) may pass outside the will or trust.

[iv] Basically, her probate assets.

[v] IRC Sec. 509(a); i.e., not publicly supported.

[vi] At that point, Son owned or controlled all of Corp’s voting shares and almost all of its non-voting shares. He was probably planning for the ultimate sale of the business and looking to avoid the two levels of tax attendant on an asset sale by a C corporation, as well as the built-in gains tax applicable to former C corporations under IRC Sec. 1374.

[vii] Other reasons proffered by the board included the following: that the shares did not provide enough liquidity for Foundation to distribute 5 percent of its funds annually as required by IRC Sec. 4942; and that “freezing” the value of Foundation’s Corp shares via their sale could prevent future decline in value given the poor economic climate. These pass the smell test.

[viii] IRC Sec. 512(e). Of course, at Decedent’s death, Corp was a C corporation, so the issue of unrelated business income was not considered. Should it have been? In any case, no mention was made of the excess business holding rule under Sec. 4943, which would have been applicable either way, and under which Foundation would have five years (maybe more) to dispose of the Corp shares – a disposition that would have required the removal of value from the business, and for which no provisions were made.

[ix] I can’t entirely blame Son. He worked in the business, was its president, and had just become its controlling shareholder. He was given the task of balancing his desire to run the business as he sees fit against his duty to a new shareholder, the charity. Then he was “forced” to remove significant value from the business – no small matter – and transfer it to a charity.

[x] The appraiser testified that he would not have done so without these instructions. Query why the appraiser agreed to follow these instructions, at least with respect to the LOC discount.

[xi] Query why a LOM discount was not claimed for purposes of the Form 706. What was the appraiser thinking? That it wouldn’t make a difference because he incorrectly believed that the valuation of the shares for purposes of the gross estate would also provide the valuation for purposes of the taxable estate; i.e., for purposes of determining the amount of the charitable deduction)? Might as well get a higher stock basis?

[xii] Compared to the $1,824 per voting share and of $1,733 per nonvoting share date of death values determined.

[xiii] See the Reg. Sec. 53.4941(d)-1(b)(3) exception to indirect self-dealing.

[xiv] Form 990-PF, Return of Private Foundation.

[xv] Form 1041 Tax Return.

[xvi] On IRS Form 706, United States Estate (and Generation-Skipping Transfer) Tax Return.

[xvii] Schedule O to the Form 706.

[xviii] The combined effect of the unified credit, the charitable deduction, and any other administration expenses.

[xix] IRC Sec. 7482.

[xx] IRC Sec. 2031; Reg. Sec. 20.2031-1(b).

[xxi] IRC Sec. 2055(a); Reg. Sec. 20.2055-1(a).

[xxii] Ahmanson (see below), which stands for “the principle that the testator may only be allowed a deduction for estate tax purposes for what is actually received by the charity.” “The statute does not ordain equal valuation as between an item in the gross estate and the same item under the charitable deduction.”

[xxiii] 674 F.2d 761 (9th Cir. 1981). https://law.resource.org/pub/us/case/reporter/F2/674/674.F2d.761.79-3600.79-3568.html

[xxiv] The Court also pointed out that certain deductions not only permit consideration of post-death events, but require them. “For example, . . . I.R.C. § 2055(c) specifies that where death taxes are payable out of a charitable bequest, any charitable deduction is limited to the value remaining in the estate after such post-death tax payment. Still another provision of the tax code, I.R.C. § 2055(d), prohibits the amount of a charitable deduction from exceeding the value of transferred property included in a gross estate – but, by negative implication, permits such a deduction to be lower than the value of donated assets at the moment of death.”

[xxv] According to the Court, Decedent’s testamentary plan laid the groundwork for Son’s manipulation by concentrating power in his hands—in his roles as executor of the Estate and as trustee of the Trust and of the Foundation—even after Decedent knew of and assented to early discussions of the share redemption plan.

[xxvi] This may include, among other options, consideration of an installment arrangement under IRC Sec. 6166 or of a Graegin loan.

[xxvii] A tall order? Maybe.

The Tax Cuts and Jobs Act[i] has been called a lot of things by a lot of different people.[ii] Certain provisions of the Act, however, coupled with recently proposed regulations thereunder,[iii] may result in its being known as the legislation that caused many individuals to willingly metamorphose – at least for some tax purposes – into one of the most dispassionate of human creations: the corporation.

Shapeshifting

The Code has long provided that the term “person” includes a corporation.[iv] That a corporation is treated as a person for tax purposes should not surprise anyone who has even a passing familiarity with the tax law. Indeed, the law in general has been attributing “personal” traits to corporations for decades.[v]

That being said, there are certain instances in the area of “business morphology” in which the Code is ahead of the curve. Take shapeshifting, for example.[vi]

The “check the box” rules allow a business entity that is an “eligible entity”[vii] to change its classification for tax purposes.[viii] Thus, a single member LLC that is otherwise disregarded for tax purposes may elect to be treated as an association taxable as a corporation;[ix] a business entity that is otherwise treated as a partnership is afforded the same option; an association may elect to be treated as a disregarded entity or as a partnership,[x] depending upon how many owners it has.[xi]

What’s more, the Code does not limit its reach to the conversion from one form of business entity to another.

IRC Sec. 962[xii]

Rather, the Code goes one step further by allowing an individual, who is a “U.S. Shareholder” (“USS”)[xiii] with respect to a controlled foreign corporation (“CFC”),[xiv] to elect to treat themselves as a domestic corporation[xv] for the purpose of computing their income tax liability on their pro rata share of the CFC’s “subpart F income.” In other words, the election allows such an individual to determine the tax imposed on such income by applying the income tax rate applicable to a domestic corporation instead of the rate applicable to individuals.

The election also allows the individual USS to claim a tax credit that would otherwise be available only to a USS that is a C-corporation, for purposes of determining their U.S. income tax liability. Specifically, the electing individual is allowed a credit for their share of the CFC’s foreign income taxes attributable to the subpart F income that is included in the individual’s gross income.[xvi]

Of course, like many elections, there is a price to pay when an individual USS elects to be treated as a domestic C-corporation under Sec. 962: the earnings and profits of a CFC that are attributable to the amounts which were included in the individual’s gross income,[xvii] and with respect to which the election was made, will be included in the individual’s gross income a second time when they are actually distributed by the CFC to the individual, to the extent that the earnings and profits distributed exceed the amount of “corporate tax” paid by the individual USS on such earnings and profits; [xviii] the amount distributed is not treated as previously taxed income, which could generally be distributed by the CFC to the USS without adverse tax consequences.

This election was added to the Code over 55 years ago, at the same time that the CFC rules under subpart F were enacted. According to its legislative history, Sec. 962 was enacted to ensure that an individual’s tax burden with respect to a CFC was no greater than it would have been had the individual invested in a domestic corporation that was doing business overseas.[xix]

However, notwithstanding its long tenure, this obscure provision has played a relatively minor role in the lives of individual USS of CFCs – until now.

The “Waxing” of the Act

Prior to the Act, a domestic corporation’s income tax liability was determined based on a graduated rate, with a maximum rate of 35 percent; an individual’s income tax was also determined based on a graduated rate, with a maximum rate of 39.6 percent.

The Act replaced the graduated corporate tax rate structure with a flat rate of 21 percent – a 40 percent reduction in the maximum corporate income tax rate. The maximum individual income tax rate was reduced to 37 percent; in other words, the flat corporate rate is now more than 43 percent lower than the maximum individual rate.

The significant reduction in the corporate tax rate relative to the individual rate is likely enough of an incentive, by itself, to cause some individual USS to elect to be treated as a domestic corporation under Sec. 962.

The changes wrought by the Act, however, went farther. In order to appreciate the impact of these changes, a quick review of the pre-Act regime for the taxation of CFCs and their USS is in order.

U.S. Taxation of CFC Income

As most readers probably know, the U.S. taxes U.S. persons on all of their income, whether derived in the U.S. or abroad. Thus, all U.S. citizens and residents,[xx] as well as domestic entities,[xxi] must include their worldwide income in their gross income for purposes of determining their U.S. income tax liability.

In general, the foreign-source income earned by a U.S. person from their direct conduct of a foreign business – for example, through the operation of a branch[xxii] or of a partnership in a foreign jurisdiction – is taxed on a current basis.[xxiii]

Prior to the Act, however, most foreign-source income that was earned by a U.S. person indirectly – as a shareholder of a foreign corporation[xxiv] that operated a business overseas – was not taxed to the U.S. person on a current basis. Instead, this foreign business income generally was not subject to U.S. tax until the foreign corporation distributed the income as a dividend to the U.S. person.

That being said, pre-Act law included certain anti-deferral regimes that would cause the U.S. person to be taxed on a current basis on certain categories of income earned by a foreign corporation, regardless of whether such income had been distributed as a dividend to the U.S. owner. The main anti-deferral regime was found in the CFC rules.

In general, a CFC is defined as any foreign corporation more than 50 percent of the stock of which is owned by U.S. persons, taking into account only those U.S. persons who own at least 10 percent of such stock.

Under these rules, the U.S. generally taxed the USS of a CFC on their pro rata shares of certain income of the CFC (“subpart F income”), without regard to whether the income was distributed to the shareholders. In effect, the U.S. treated the USS of a CFC as having received a current distribution of the corporation’s subpart F income.

When such previously included income was actually distributed to an individual USS, the latter excluded the distribution from their gross income.

With exceptions, subpart F income generally included passive income and other income that was considered readily movable from one taxing jurisdiction to another. For example, it included “foreign base company income,” which consists of “foreign personal holding company income” – basically, passive income such as dividends, interest, rents, and royalties – and a number of categories of income from business operations; the latter included “foreign base company sales income,” which was derived from transactions that involved the CFC and a related person, where the CFC’s activities were conducted outside the jurisdiction in which the CFC was organized.

Any foreign-source income earned by a CFC that was not subpart F income, and that was not distributed by the CFC to a U.S. person as a dividend, was not required to be included in the gross income of any U.S. person who owned shares of stock in the CFC; in other words, the recognition of such income for purposes of the U.S. income tax continued to be deferred.

GILTI

In order to limit a U.S. person’s ability to defer the U.S. taxation of a CFC’s non-subpart F, foreign-source income, the Act introduced a new class of income – “global intangible low-taxed income” (“GILTI”) – that must be included in income by a USS of a CFC.[xxv]

This provision generally requires the current inclusion in income by a USS of (i) their share of all of a CFC’s non-subpart F income, (ii) less an amount equal to the USS’s share of 10 percent of the adjusted basis of the CFC’s tangible property used in its trade or business of a type with respect to which a depreciation deduction is generally allowable[xxvi] – the difference being the USS’s GILTI.

This income inclusion rule applies to both individual and corporate USS.

In the case of an individual USS, the maximum federal income tax rate applicable to GILTI is 37 percent.[xxvii] This is the rate that will apply, for example, to a U.S. individual who directly owns at least 10 percent of the stock of a CFC, or to one who indirectly owns such CFC stock through an S-corporation or partnership.

More forgiving rules apply in the case of a USS that is a domestic corporation. For taxable years beginning after December 31, 2017, and before January 1, 2026, a domestic corporation is generally allowed a deduction of an amount equal to 50 percent of its GILTI (the “50-percent deduction”) for purposes of determining its taxable income;[xxviii] thus, the federal corporate tax rate for GILTI is actually 10.5 percent.[xxix]

In addition, for any amount of GILTI included in the gross income of a domestic corporation, the corporation is allowed a deemed-paid credit equal to 80 percent of the foreign taxes paid or accrued by the CFC with respect to such GILTI (“80-percent FTC”).[xxx]

Based on the interaction of the “50-percent deduction” and the 80-percent FTC, the U.S. tax rate on GILTI that is included in the income of a domestic C-corporation will be zero where the foreign tax rate on such income is at least 13.125 percent.[xxxi]

Because an S corporation’s taxable income is computed in the same manner as an individual, and because an S corporation is treated as a partnership for purposes of the CFC rules, neither the “50-percent deduction” nor the 80-percent FTC apply to S corporations or their shareholders. Thus, an individual USS is treated more harshly by the GILTI inclusion rules than is a USS that is a C-corporation.

Use a C-Corporation?

So what is an individual USS to do? Whether they own stock of a CFC directly, or through an S-corporation or partnership, how should they respond to the GILTI rules’ pro-C-corporation bias?

One option is to contribute the CFC shares to a domestic C-corporation; if the CFC is held through an S-corporation, the S-corporation may itself convert into a C-corporation.[xxxii]

However, C-corporation status has its own significant issues, and should not be undertaken lightly; for example, double taxation of the corporation’s income, though this may be less of a concern where the corporation plans to reinvest its profits. That being said, the double taxation regime applicable to C-corporations may be especially burdensome on the disposition of the corporation’s business as a sale of assets.

A Branch?

Another option is for the S-corporation to effectively liquidate its CFC and operate in the foreign jurisdiction through a branch, or through an “eligible” foreign entity for which a “check-the-box election” may be made to disregard the entity for tax purposes.

This would avoid the CFC and GITLI rules entirely, and it would allow the shareholders of the S-corporation to claim a credit for foreign taxes paid by the branch.

Of course, operating through a branch would preclude what little U.S. tax deferral is still available following the enactment of the GILTI rules, and could subject the U.S. person to a branch profits tax in the foreign jurisdiction.

It should also be noted that the liquidation or reorganization of a CFC into a branch will generally be a taxable event, with the result that the accumulated foreign earnings and profits of the CFC will be included in the income of the USS as a “deemed dividend.”[xxxiii]

Elect Under Sec. 962?

Yet another option to consider is the election under Sec. 962 – yes, we have come full-circle.

As indicated earlier, this election is available to an individual who is a USS of a CFC, either directly or through an S-corporation or a partnership.[xxxiv]

The election, which is made on annual basis,[xxxv] results in the individual USS being treated as a domestic corporation (a C-corporation) for purposes of determining the income tax on their share of GILTI and subpart F income for the taxable year to which the election relates; thus, the electing individual USS’s share of such income would be taxed at the flat 21 percent corporate tax rate.

The election also causes the individual USS to be treated as a domestic corporation for purposes of claiming the 80-percent FTC attributable to this income; thus, the USS would be allowed this credit.

However, as indicated above, once the election is made, the earnings and profits of the CFC that are attributable to the amounts which were included in the income of the USS under the GILTI or CFC rules, and with respect to which a Sec. 962 election was made, will be included in the USS’s gross income when such earnings are actually distributed to the USS (reduced by the amount of “corporate” tax paid on the amounts to which such election applied).[xxxvi]

The Recently Proposed Sec. 962 Regulations

Following the reduction of the corporate tax rate and the enactment of the GILTI rules, many tax practitioners turned to the Sec. 962 election as a way to manage and reduce the tax liability of individual USS of CFCs.

In the course of familiarizing themselves with the election and its consequences, many tax practitioners wondered whether the “50-percent deduction” available to domestic corporations would also be available to an electing individual USS. After all, Sec. 962 states that the electing individual would be treated as a domestic corporation for purposes of determining the tax on their subpart F income[xxxvii] – and by extension, thanks to the Act, the tax on their GILTI[xxxviii] – and for purposes of applying the foreign tax credit rules.

Neither the Act nor its committee reports nor the first round of proposed regulations[xxxix] addressed whether the “50-percent deduction” – which is available only to domestic corporations[xl] – would be available to an individual USS who makes the Sec. 962 election.

The preamble to the Proposed Regulations, however, echoed Sec. 962’s legislative history when it explained that Sec. 962 was enacted to ensure that individuals’ tax burdens with respect to undistributed foreign earnings of their CFCs are comparable to their tax burdens if they had held their CFCs through a domestic corporation. According to the IRS, allowing the “50-percent deduction” with respect to the GILTI of an individual (including one who is a shareholder of an S-corporation or a partner in a partnership) who makes a Sec. 962 election provides comparable treatment for this income.[xli]

Thus, the IRS decided to give individual USS the “50-percent deduction” with respect to their GILTI if they made the Sec. 962 election.

The Proposed Regulations are proposed to apply to taxable years of a CFC ending on or after March 4, 2019, and with respect to a U.S. person, for the taxable year in which or with which such taxable year of the CFC ends.

The IRS went a step further by stating that taxpayers may rely on the Proposed Regulations for taxable years ending before May 4, 2019. In other words, an individual USS who elected under Sec. 962 with respect to their taxable year ending December 31, 2018[xlii] may take the “50-percent deduction” into account in determining their taxable income for that year.

Next Steps?

There are a number of individual USS who have not yet decided how they will respond to the federal income tax on GILTI. No doubt, many of these individuals have been waiting to see whether the IRS would address the application of the “50-percent deduction” in the context of a Sec. 962 election.

In light of the proposed regulations described above, and the assurance provided therein that an individual USS may rely on them for the 2018 taxable year, these patient individuals[xliii] may now file an election under Sec. 962 secure in the knowledge that their GILTI will be taxed at the 21 percent corporate tax rate, that they will be entitled to the 80-percent FTC, and that they may claim the “50-percent deduction,” in determining their taxable income.

The Sec. 962 election for the taxable year ending December 31, 2018 must be made with the individual USS’s timely filed federal income return for 2018, on Form 1040, which is due on April 15, 2019.[xliv] The election is made by filing a statement to such effect with this tax return.

But what about the individual USS who believed, not unreasonably, that the IRS was unlikely to allow them the “50-percent deduction,” and who consequently decided to contribute their CFC to a newly-formed domestic corporation?

If the domestic “blocker” corporation was formed and funded by the USS with CFC stock in 2019, it may still be possible to rescind or unwind the transaction, and restore the CFC to the individual USS, in time to make a Sec. 962 election for 2018.[xlv]

For those individual USS who formed domestic blocker corporations to hold their CFC stock during 2018, the unwinding of this structure may not be a straightforward proposition.[xlvi]

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

[i] P.L. 115-97 (the “Act”).

[ii] Where you stand depends on where you sit? “Miles Law,” for you political science folks out there.

[iii] The “Proposed Regulations.” https://www.federalregister.gov/documents/2019/03/06/2019-03848/deduction-for-foreign-derived-intangible-income-and-global-intangible-low-taxed-income

[iv] IRC Sec. 7701(a)(1).

[v] Including First Amendment rights. See the decision of the U.S. Supreme Court in Citizens United.

[vi] Stay with me. Don’t stop reading yet.

[vii] One that is not treated per se as a corporation.

[viii] Reg. Sec. 301.7701-3. The business entity would normally file Form 8832 to effect this change; however, if it elects to be treated as an S corporation by filing a Form 2553, it will also be treated as having chosen to be treated as an association for tax purposes. The consequences of its deemed association status are significant: if the entity loses its “S” status, it will not revert to partnership status, for example; rather, it will become a C corporation for tax purposes.

[ix] Each of these “conversions” would be treated as a transaction described in IRC Sec. 351.

[x] I.e., it may elect to liquidate – a taxable event. IRC Sec. 331 and 336.

[xi] N.B. There are limits on how often an entity may check the box; i.e., revoke an election, then make another one.

[xii] https://www.law.cornell.edu/uscode/text/26/962

[xiii] IRC Sec. 951. One who owns at least 10 percent of the total voting power or total value of all classes of stock of a foreign corporation.

[xiv] IRC Sec. 957.

[xv] A regular U.S. C-corporation.

[xvi] IRC Sec. 960.

[xvii] Whether as subpart F income or as GILTI – see below.

[xviii] As would be the case when a C corporation distributes its after-tax profits to its shareholders.

If the CFC was formed in a jurisdiction with which the U.S. does not have a tax treaty, this dividend will be taxed as ordinary income, taxable at a rate of 37 percent. If the CFC resides in a treaty country, the dividend will be treated as a qualified dividend, taxable at a rate of 20 percent. IRC Sec. 1(h).

[xix] S. Rept. 1881, 87th Cong., 2d Sess., 1962-2 C.B. 784, at 798.

[xx] Noncitizens who are lawfully admitted as permanent residents of the U.S. in accordance with immigration laws (often referred to as “green card holders”) are treated as residents for tax purposes. In addition, noncitizens who meet a “substantial presence” test, and are not otherwise exempt from U.S. taxation, are also taxable as U.S. residents.

[xxi] A corporation or partnership is treated as domestic if it is organized or created under the laws of the United States or of any State.

[xxii] Including an eligible entity that has elected to be treated as a disregarded entity for tax purposes. Reg. Sec. 301.7701-3.

[xxiii] Subject to certain limitations, U.S. citizens, resident individuals, and domestic corporations are allowed to claim a credit against their U.S. income tax liability for foreign income taxes they pay.

[xxiv] A separate legal entity.

[xxv] IRC Sec. 951A.

[xxvi] A deemed “reasonable return.”

[xxvii] The highest rate applicable to individuals.

[xxviii] IRC Sec. 250. IRS Form 8993, https://www.irs.gov/forms-pubs/about-form-8993

[xxix] The 21 percent flat rate multiplied by 50 percent.

[xxx] IRC Sec. 960(d). This is to be compared with the foreign tax credit available to a domestic corporation that includes subpart F income in its gross income; in that case, under IRC Sec. 960(a), the domestic corporation is deemed to have paid so much of the CFC’s foreign income taxes as are properly attributable to such subpart F income.

[xxxi] 13.125 percent multiplied by 80 percent equals 10.5 percent.

[xxxii] Beware the IRC Sec. 965 installment payment rules.

[xxxiii] That being said, the rules for determining such accumulated earnings and profits generally exclude amounts previously included in the gross income of the USS under the CFC rules. To the extent any amount is not so excluded, the S corporation shareholder of the CFC will not be able to utilize the DRD to reduce its tax liability.

[xxxiv] In order for an individual shareholder of an S corporation of a partnership to make the election, they must own at least 10 percent of the CFC stock through their holdings in the S corporation or partnership. For example, a 25 percent shareholder of an S corporation that owns 80 percent of a CFC is deemed to own 20 percent of the CFC.

[xxxv] The election is made year-by-year. Compare this to using an actual C-corporation, which is difficult to eliminate once it is in place.

[xxxvi] This is to be contrasted with the 100 percent dividends received deduction for the foreign-source portion of dividends received from a CFC by a USS that is a domestic corporation. IRC Sec. 245A.

[xxxvii] IRC Sec. 951.

[xxxviii] IRC Sec. 951A.

[xxxix] https://www.irs.gov/pub/irs-drop/reg-104390-18.pdf

[xl] IRC Sec. 250.

[xli] The preamble goes on to state that the IRS considered not allowing the “50-percent deduction” to individuals that make the election. In that case, it continued, an individual USS would have to transfer their CFC stock to a domestic corporation in order to obtain the benefit of the deduction. Such a reorganization, the preamble concluded, would be economically costly.

[xlii] The first year to which the GILTI rules apply.

[xliii] Some might say procrastinating.

[xliv] Four days shy of a full moon. An automatic 6-month extension is available if timely requested.

[xlv] See, e.g., Rev. Rul. 80-58. Of course, this assumes that there was no other bona fide business purpose for the domestic corporation.

[xlvi] The contribution to the blocker may have accelerated any installment payments under IRC Sec. 965(h).

Choice of Entity

The owners of a closely held business will confront many difficult decisions during the life of the business. Among the earliest of these decisions – and one with which the business may have to contend for many years to come[i] – is the so-called “choice of entity”: in what legal form should the business be organized, its assets held, and its activities conducted?

In the case of only one owner, the assets of the business may be held directly by the owner as a sole proprietor; or the business may be organized as single member LLC which, if disregarded for tax purposes,[ii] is treated as a sole proprietorship. Alternatively, it may be organized as a corporation under state law, which will be treated as a C corporation[iii] unless the shareholder elects to treat the corporation as an S corporation.[iv]

Where there are at least two owners, they may decide to own and operate the business as an unincorporated entity – a partnership[v] – or as a corporation.

The form of entity selected for a business may have far-reaching tax and economic consequences, both for the business and for its owners. For example, a decision to operate as a partnership will offer the owners the greatest flexibility in terms of how they share the profits of the business,[vi] but it may subject them to self-employment tax; a decision to operate as an S corporation may require the payment of reasonable compensation to those owners who work in the business,[vii] and will require that the corporation issue only one class of stock and have only individuals as shareholders,[viii] which may limit its ability to raise capital.

In both of these cases, the entity itself is generally not subject to income tax; rather, its annual profits and gains pass through, and are taxed directly, to the entity’s owners whether or not distributed to them – in other words, the owners do not enjoy any tax deferral with respect to the entity.[ix]

By contrast, the profits and gains of a C corporation are taxed to the corporation; in general, they are not taxed to the corporation’s owners until they are distributed to the owners as a dividend. At that point, the corporation’s after-tax profits will be subject to a second level of federal tax; in the case of an individual owner, the dividends will be taxed at the same 20 percent rate generally applicable to capital gains,[x] plus an additional net investment income surtax of 3.8 percent.[xi]

Enter the TCJA

If the choice of entity decision was not already daunting enough for the owners of a business in its infancy, the Tax Cuts and Jobs Act[xii] has added another layer of factors to consider, thus making the decision even more challenging.

For example, the Act reduced the corporate income tax rate by 40 percent – from a maximum graduated rate of 35 percent to a flat rate of 21 percent[xiii] – while also providing the non-corporate owners (basically, individuals) of a pass-through entity (partnerships and S corporations) with a special deduction of up to 20 percent of their share of the entity’s “qualified business income.”[xiv]

In light of this development, the owners of many partnerships, LLCs and S corporations may be considering whether to incorporate,[xv] or to revoke their “S” election,[xvi] in order to take advantage of the much lower corporate tax rate.

Such a change may be especially attractive to a business that is planning to reinvest its profits (for example, in order fund expansion plans) rather than distribute them to the owners.[xvii]

On the other hand, if the partners or S corporation shareholders are planning to sell the business in the next few years, it may not be good idea to convert into a C corporation.[xviii]

Choices, choices, choices. Right, wrong, indifferent?

Regretting the Choice

While taxpayers are free to organize their business in whatever form they choose, once having done so, they must accept the tax consequences of that choice, whether contemplated or not.[xix]

A recent decision by a federal district court considered the strained arguments advanced by one taxpayer in a futile effort to escape the tax consequences of their choice of entity.[xx]

Taxpayer operated his business as a sole proprietorship for several years before incorporating it (the “Corporation”). As the sole shareholder of the corporation, Taxpayer then elected to treat it as an S corporation for federal income tax purposes.

For the next several years, Taxpayer caused Corporation to file a Form 1120S, U.S. Income Tax Return for an S Corporation (“Form 1120S”), to report the income earned and the expenses incurred by the business.

During Tax Year, a second shareholder was admitted to Corporation. Taxpayer and the new shareholder entered into a shareholders’ agreement (the “Agreement”) pursuant to which they agreed that any income earned by Corporation prior to the admission of the second shareholder (“Pre-Existing Business”) would belong to Taxpayer and not to Corporation.[xxi]

On his individual income tax return for Tax Year, Taxpayer attached a Schedule C, Profit and Loss from Business (Sole Proprietorship), to his personal income tax return (Form 1040), on which he claimed deductions for expenses paid or incurred with respect to Pre-Existing Business. These deductions included amounts paid out of Corporation’s bank account. In addition, Taxpayer claimed a deduction for amounts that he paid, out of his personal bank account, to certain employees of Corporation for work they performed with respect to Pre-Existing Business.

After examining Taxpayer’s return for Tax Year, the IRS disallowed each of these deductions, and assessed an income tax deficiency against Taxpayer.

Taxpayer paid the tax liability and then filed a claim for refund, which the IRS denied. Taxpayer then brought a proceeding in a federal district court in which he sought relief from the IRS’s denial of his refund claim.[xxii]

The IRS moved for summary judgment.[xxiii]

“Live With It”

The Court explained that, in a refund action, the complaining taxpayer bears the burden of proving that the challenged IRS tax assessment was erroneous. Specifically, the taxpayer has the burden of proving: his right to a deduction; the amount of the deduction; and, as the nonmoving party, definite and competent evidence to survive summary judgment.

Taxpayer argued that he was entitled to the deductions claimed because the payments on the Pre-Existing Business were not related to Corporation but, instead, were from a separate business operation that he classified as a sole proprietorship. In so arguing, Taxpayer identified the steps he took to separate this Pre-Existing Business from Corporation. He stated that, although there was no formal dissolution of Corporation prior to the admission of the second shareholder, there was a withdrawal of corporate funds, an insertion of new funds, the issuance of new stock to an additional stockholder, and the appointment of an additional officer to the corporation.

The Court pointed out, however, that although Taxpayer claimed that the fees belonged to him personally, and not to Corporation, he also admitted that the funds were deposited into, and paid from, Corporation’s account. Further, Taxpayer admitted that the clients compromising the Pre-Existing Business had not formally retained him individually; rather, they had contracted with Corporation.

The Court observed that Taxpayer’s argument was essentially that he “intended” to form a new business. The Court stated that, notwithstanding Taxpayer’s intentions, a corporation exists for tax purposes if it is formed for a business purpose or if it carries on a business after incorporation. The choice of incorporating to do business, the Court continued, required the acceptance of the tax advantages and disadvantages.

Taxpayer chose to incorporate his business and elected to treat it as an “S” corporation for tax purposes. The Court explained that “S” corporations are corporations that elect to pass corporate income, losses, deductions, and credits through to their shareholders for federal tax purposes. When the shareholders of a corporation make an S election, they switch from a two-level taxation system to a flow-through taxation system under which income is subjected to only one level of taxation.

The corporation’s profits and losses pass through directly to its shareholders on a pro rata basis and are reported on the shareholders’ individual tax returns, allowing an “S” corporation and its shareholders to avoid double taxation on its corporate income.

The Court stated that, since its formation, Corporation properly filed a Form 1120S to report its income and deductions. When a new a shareholder was added during Tax Year, Corporation amended its name, but it retained its employer identification number and continued to file tax returns using that number.

Taxpayer, however, filed a Schedule C claiming deductions from the Pre-Existing Business. In doing so, he attempted to report income and deductions stemming from a business operated as a sole proprietorship. A sole proprietor, however, is someone who owns an unincorporated business by themselves.

The Court found that Taxpayer could not establish that he operated as a sole proprietor entitling him to take deductions on a Schedule C. Corporation was not dissolved; rather, it continued to operate as an S corporation. Thus, Taxpayer should not have filed Schedule C, and the IRS properly disallowed the deductions on that form.

Though Taxpayer contended, with respect to the Pre-Existing Business, that he operated a separate business apart from Corporation. Notwithstanding that he paid the fees therefor out of Corporation’s account, he argued that he, individually, paid them because the Pre-Existing Business was not associated with Corporation.[xxiv]

The Court rejected Taxpayer’s argument, stating that he failed to establish that he operated any business other than through Corporation. As such, his payments of Corporation’s expenses constituted either a loan or a capital contribution, and were deductible, if at all, not by Taxpayer, but by Corporation.

Therefore, Taxpayer was not personally entitled to take deductions.

Additionally, Taxpayer contended that he was entitled to a deduction for the amount that he paid as bonuses to certain employees of Corporation because the payment was made for work separate and apart from that of Corporation. Taxpayer asserted that he personally, not Corporation, paid these employees and filed Forms 1099 on their behalf.

However, the clients of the Pre-Existing Business had contracted with Corporation, and the payments made in respect thereof were deposited into Corporation’s account. Taxpayer subsequently paid himself from that account. According to the Court, the fact that he did so, and personally made bonus payments to the employees for work associated with the Pre-Existing Business, was immaterial. Again, Taxpayer did not operate as a sole proprietor and, therefore, could not take deductions on a Schedule C. The payments, whether properly made or not, stemmed from Corporation’s business, that never ceased to exist, and “[b ]ecause the expenditures in issue were made on behalf of [Corporation’s] business, we conclude that [Taxpayer] may not claim these expenses as business expense deductions.”

Finally, Taxpayer argued that he entered the Agreement that carved out the Pre-Existing Business from the benefit and the liability of the newly formed corporation. As such, he argued that the work for this Pre-Existing Business was conducted as a separate business from Corporation, and he conducted that business as a sole proprietor entitling him to claim those fees as deductions on a Schedule C.

However, the Court responded, “[a] shareholder cannot convert a business expense of his corporation into a business expense of his own simply by agreeing to bear such an expense.”

“Agreements entered into between individuals may not prevail as against the provisions of the revenue laws in conflict,” the Court stated. Parties are free to contract and, when they agree to a transaction, federal law then governs the tax consequences of their agreement, whether those consequences were contemplated or not.

The Court found that Taxpayer could not establish that he was entitled to the disallowed deductions on his Schedule C – there was no clear evidence that he operated a business separate from that of Corporation.

Accordingly, the Court granted the IRS’s motion for summary judgment.

What to Do?

Taxes play a significant part in a business owner’s choice of entity decision. The selection made will result in tax consequences of which a business owner should be aware before making that decision; thus, the decision should be made only after consulting with one’s tax advisers.

It is also important that the decision be made with an understanding of the economics of the business. Among the items to be considered are the following: who will invest in the business, will the business have to borrow funds, is it expected to generate losses, will it be reinvesting its profits or distributing them?

Of course, the responses to these questions may depend upon the stage in the life of the business at which they are being considered. Likewise, the owners of the business may decide to change the form of their business entity when it makes sense to do so. In other words, the choice of entity decision should not be treated as a “make-it-and-forget-it” decision; rather, it should be viewed as one that evolves over the life of the business.[xxv]

For example, a simple evolution of a business’s form of entity may go something like this: it may start out as a sole proprietorship or partnership in order to pass through losses, it may convert to a C corporation as it becomes profitable and starts to retain earnings to fund the growth of the business,[xxvi] and it may elect S corporation status when it is ready to distribute profits or when its owners begin to consider the sale of the business.[xxvii]

What’s more, the choice of one form of entity does not necessarily preclude the concurrent use of another form for a specific purpose. Thus, for example, an S corporation that operates two lines of business may form an LLC (treated as a partnership) to serve as an investment vehicle to which it and a corporate or foreign investor[xxviii] may contribute the assets of one line of business and funds, respectively.[xxix]

However, whatever the form of entity chosen, it is imperative that the business owners respect their chosen form, lest they invite an audit. For one thing, it is certain that the IRS and the courts will hold them to their form (as the Taxpayer learned in the case described above); moreover, an audit will often entail other unexpected goodies for the IRS.

That being said, in the event the chosen form generates unexpected and adverse tax consequences, the business and its owners, in consultation with their tax advisers, may be able to mitigate them, provided they act quickly.

[i] No pressure.

[ii] Its default status in the absence of an election to be treated as an association taxable as a corporation. Reg. Sec. 301.7701-3.

[iii] Reg. Sec. 301.7701-2.

[iv] IRC Sec. 1361 and 1362.

[v] Reg. Sec. 301-7701-3; IRC Sec. 761. This includes an LLC that does not elect to be treated as an association.

[vi] For example, some owners may be issued preferred interests, or they may have special allocations of income and loss.

[vii] There is no comparable tax rule for partners.

[viii] Plus their estates and certain trusts created by these shareholders. IRC Sec. 1361(c).

[ix] The maximum federal income tax rate applicable to individuals is now set at 37 percent. If the individual partner or shareholder does not materially participate in the entity’s business, the 3.8 percent surtax on net investment income will also apply.

[x] IRC Sec. 1(h).

[xi] IRC Sec. 1411. Of course, I am assuming that the shareholder’s modified adjusted gross income exceeds the threshold amount.

[xii] P.L. 115-97 (the “Act”).

[xiii] IRC Sec. 11.

[xiv] IRC Sec. 199A.

[xv] IRC Sec. 351. Beware IRC Sec. 357(c). See Rev. Rul. 84-111.

[xvi] IRC Sec. 1362. Once the S election is revoked, the shareholders may not re-elect “S” status for five years.

It should also be noted that the conversion from “S” to “C” may require that the corporation change its accounting method from cash to accrual. This change may cause the immediate recognition of significant amounts of income. Thankfully, the Act provides for a 6-year period over which this income may be recognized by the C corporation, provided certain conditions are met. IRC Sec. 481(d).

[xvii] Although it is conceivable that a corporation may consider converting into a partnership or a disregarded entity, such a conversion, however effected, will be treated as a liquidation of the corporation, which will be taxable to both the corporation and its shareholders. Reg. Sec. 301.7701-3(g).

[xviii] Of course, I am referring to the two levels of tax attendant on the sale of C corporation. In most cases, the buyer of a closely held business will choose to structure the purchase as an acquisition of assets; not only does this allow the buyer to cherry pick the target assets to be acquired and the liabilities to be assumed, it also gives the buyer a stepped-up basis in these assets which the buyer may then expense, amortize or depreciate (depending on the asset), which enables the buyer to recover its investment faster than if it had just acquired the stock of the target corporation. Unfortunately for the target shareholders, the asset sale is taxable to the corporation and, when the remaining sale proceeds are distributed to the shareholders, those proceeds are taxable to the shareholders.

[xix] https://www.taxlawforchb.com/tag/danielson-rule/ . Call it a corollary of the “Danielson rule.”

[xx] Morowitz v. United States, No 1:17-CV-00291 (D.R.I. Mar. 7, 2019).

[xxi] Interestingly, neither the IRS nor the Court raised the issue of a prohibited second class of stock. IRC Sec. 1361(b); Reg. Sec. 1.1361-1(l). If the entity had been formed as a partnership with the admission of the new owner, the Taxpayer’s initial capital account would have reflected the value operational results of the business prior to the creation of the partnership; if the entity had already been a partnership, Taxpayer’s capital account would have been similarly adjusted prior to the admission of the new partner. Reg. Sec. 1.704(b)-1(b)(2)(iv).

[xxii] IRC Sec. 7422. It is unclear why the Taxpayer chose to pay the tax and then apply for a refund, rather than file a petition with the Tax Court. The Tax Court’s jurisdiction is not dependent on the tax having been paid.

[xxiii] Summary judgment is appropriate where the pleadings, depositions, etc., show that there is no genuine issue as to any material fact and that the moving party is entitled to judgment as a matter of law. The substantive law identifies the facts that are material; only disputes over facts that might affect the outcome of the suit under the governing law will preclude the entry of summary judgment.

[xxiv] This comes under the category of “you can’t make this shit up.”

[xxv] Complete non sequitur: life insurance also falls into this category – it should be reviewed periodically.

[xxvi] The current 21 percent flat corporate rate is key.

[xxvii] Of course, a sale structured as an actual or deemed sale of assets must consider the built-in gains tax. IRC Sec. 1374.

[xxviii] Neither of which may own shares of stock in an S corporation. IRC Sec. 1361(b).

[xxix] See the partnership anti-abuse rules in Reg. Sec. 1.701-2, in which the IRS accepted an S corporation’s bona fide business use of a partnership.

Hell of a Town

Ask most New Yorkers what New York City has in abundance and you’ll get responses that are as varied as the personalities to whom the question is put. Museums, restaurants, performing arts, college students,[i] office buildings, street food, subway lines, cabs, dog walkers, rats, and politicians are sure to make the list.[ii]

Ask the same question of a tax professional, and I guarantee you that the immediate response will be “taxes” – personal income tax, property tax, sales tax, real property transfer tax, mortgage recording tax, commercial rent tax, business corporation tax, general corporation tax, and unincorporated business tax, to name a few. Throw in those New York State taxes that are the counterparts of these City taxes, plus those taxes that are unique to the State, such as the estate tax, and you have an idea of what it means to own, operate, and dispose of a business in the City.[iii]

One of the above-referenced taxes that has been a unique feature of the City’s business tax landscape, and that often surprises business owners who are new to the City’s tax jurisdiction, is the unincorporated business tax (“UBT”).[iv]

Unincorporated Business Tax

The UBT is imposed on the unincorporated business taxable income (“UBTI”) of every unincorporated business that is wholly or partly carried on within the City.

The tax is imposed at a rate of 4 percent of a taxpayer’s UBTI.[v]

Any individual or unincorporated entity that carries on or liquidates a trade, business, profession or occupation wholly or partly within the City, and has a total gross income from all business, regardless of where carried on, of more than $95,000 (prior to any deduction for cost of goods sold or services performed), must file an Unincorporated Business Tax Return with the City.[vi]

An “unincorporated business” means any trade or business conducted or engaged in by an individual (a sole proprietorship) or unincorporated entity, including a partnership.[vii] A limited liability company (“LLC”) which is wholly-owned by an individual, and which has not elected to be taxed as a corporation for federal income tax purposes,[viii] is a disregarded entity, and the business operated through it is considered a sole proprietorship for UBT purposes. Also treated as an unincorporated business is any entity classified as a partnership for federal income tax purposes regardless of whether the entity is formed as a corporation.[ix]

Each of these entities is treated as a pass-through entity for purposes of the Federal and State income taxes; they do not pay an entity-level income tax – rather, their income “passes through” to their owners, who include it in their gross income in determining their own taxable income.

Unincorporated “Trade or Business”

Where there is doubt as to the status of an activity as a trade or business, all the relevant facts and circumstances must be considered in determining whether the activity, or the transactions involved, constitute a trade or business for purposes of the UBT. Generally, the continuity, frequency and regularity of activities (as distinguished from casual or isolated transactions), and the amount of time and resources devoted to the activity or transactions are the factors which are to be taken into consideration.[x]

If an individual or an unincorporated entity carries on two or more unincorporated trades or businesses in the City, all such businesses will be treated as one unincorporated business for purposes of the UBT.[xi]

An unincorporated entity will be treated as carrying on any trade or business carried on in whole or in part in the City by any other unincorporated entity in which the first unincorporated entity owns an interest (a tiered structure); for example, where a single member LLC that is disregarded for income tax purposes owns an interest in a partnership that is engaged in a trade or business in the City.

Personal Income Tax

The UBT is an “entity-level” tax. However, because of the entity’s pass-through nature for income tax purposes, its UBTI is subject not only to the UBT but also, in the case of an individual City resident, the City’s personal income tax.[xii]

Thus, in the case of a City resident who is a sole proprietor, or a partner in a partnership, or a member of an LLC, the entity’s UBTI (or the resident’s share thereof) will also be included in the resident-owner’s personal taxable income for purposes of determining their income tax liability to the City.

Thankfully, the City allows a credit to a resident-owner or partner against their personal income tax for at least some of the UBT paid by the sole proprietorship or partnership, though the amount of the credit allowed is reduced as the resident’s taxable income increases.[xiii]

Exceptions

Right about now, some of you may be having palpitations. You may be thinking, “UBT and personal income tax, with less than a 100 percent credit? Outrageous!”

It should be noted, however, that not every unincorporated business conducted within the City is subject to the UBT.

For example, an individual or other unincorporated entity is generally not treated as engaged in an unincorporated business solely by reason of (A) the purchase, holding and sale of property[xiv] for their or its own account, (B) the acquisition, holding or disposition, other than in the ordinary course of a trade or business, of interests in unincorporated entities that are themselves acting for their own account, or (C) any combination of such activities.[xv]

In addition, an owner of real property, or a lessee of such property, will not be deemed engaged in an unincorporated business solely by reason of holding, leasing or managing real property.

Moreover, if an owner or lessee who is holding, leasing or managing real property, is also carrying on an unincorporated business in the City, whether or not such business is carried on at, or is connected with, such real property, such holding, leasing or managing of real property will generally not be treated as an unincorporated business if, and to the extent that, such real property is held, leased or managed for the purpose of producing rental income from such real property or gain upon the sale or other disposition of such real property.[xvi]

UBTI

Assuming a taxpayer is engaged in a taxable unincorporated trade or business within the City, the UBTI of such unincorporated business for a taxable year is equal to its unincorporated business gross income for such year that is allocated to the City, less its unincorporated business deductions for the year.[xvii]

In general, the term “unincorporated business gross income” is the sum of the items of income and gain of the business includible in the entity’s gross income for federal income tax purposes (with certain modifications), including income and gain from any property employed in the business, or from the sale or other disposition by an unincorporated entity of an interest in another unincorporated entity if, and to the extent, such income or gain is attributable to a trade or business carried on in the City by such other unincorporated entity.[xviii]

The unincorporated business deductions of an unincorporated business generally include the items of loss and deduction directly connected with, or incurred in the conduct of, the business, which are allowable for federal income tax purposes for the taxable year, including losses and deductions connected with any property employed in the business (with certain modifications).[xix]

Allocating Income to the City

If an unincorporated business is carried on both within and without the City – not an unusual situation – a portion of its business income must be allocated to the City; the portion so allocated is subject to the UBT, while the portion allocated outside the City escapes the UBT.

For taxable years beginning after 2017, the City completed the phase-out of the three-factor allocation formula that it employed in determining that portion of an unincorporated entity’s business income that was allocable to the City – based on gross income, payroll and property – and replaced it with a single factor based on gross income.[xx]

“Local Cross-Border Transactions”

The City’s Department of Finance recently considered a request from a non-resident individual (“Taxpayer”[xxi]) from Nassau County – though they could just as easily have been from Suffolk, Westchester, Rockland, Connecticut, or New Jersey, for example – regarding the proper method of allocating their unincorporated business income to New York City for purposes of calculating their UBT liability.[xxii]

Taxpayer had three single member limited liability companies (i.e., wholly-owned by Taxpayer)[xxiii] through which Taxpayer provided various services.

One of the LLCs provided services within the City only for its direct clients that were located in the City. The second LLC was retained by unrelated companies to provide services for their clients, some of which were located in the City. The third LLC worked for a non-New York based company.

Basics

The Department explained that where an individual or an unincorporated entity carries on two or more distinct unincorporated business, in whole or in part in the City, all such businesses are treated as one unincorporated business for purposes of the UBT.

An unincorporated business carried on both within and outside the City, the Department continued, must allocate to the City a “fair and equitable portion” of its business income.[xxiv]

In order to do that, a taxpayer must multiply its “adjusted business income” against a “business allocation percentage”[xxv] which, as alluded to above, is now equal to the quotient obtained by dividing (A) the sum of the taxpayer’s gross sales and service charges within the City, by (B) the sum of all such receipts within and without the City.

Of course, to determine the fraction of a taxpayer’s receipts from within and from outside the City, the sources for a taxpayer’s receipts need to be determined.

Generally, the UBT treats the source of receipts derived from the provision of services (as distinguished from sales of product) to be the location where the services are performed.[xxvi]

Taxpayer’s UBT

Turning to the specifics of Taxpayer’s situation, the Department began by noting that because none of the three LLCs had elected to be treated as a corporation for tax purposes, each would be treated as a disregarded entity and considered a sole proprietorship.

Moreover, because all unincorporated businesses operated by an individual in whole or in part in the City are treated as one business for purposes of the UBT, the Department stated that the LLCs would be treated as a single business conducted by Taxpayer. Therefore, only one UBT return was required to be filed by Taxpayer.

According to the Department, for purposes of allocating receipts to the City, a reasonable was required to match the receipts to the time spent in the City earning those receipts. In order to determine the amount of the receipts from services to be allocated to the City, the Department stated that Taxpayer had to determine where the work was done that generated those receipts.

If work for a particular client was split between the City and outside the City, the Department concluded that Taxpayer had to allocate the receipts for that client based on the proportion of time spent in the City.

Furthermore, if different tasks performed by the same LLC were billed at different rates, the amount to be allocated to the City could be calculated separately, based on the time spent in the City to accomplish the various tasks.

What’s The Point, Lou?

Granted, there may not – hopefully not – have been any great revelations in the foregoing discussion. Nevertheless, it will behoove business owners and their advisers to familiarize themselves with the basic concepts that underlie the operation of an unincorporated business tax similar to the City’s UBT, especially in light of the fact that so many unincorporated, closely held businesses are no longer limited to a single taxing jurisdiction but, rather, sell their products and services throughout the country.

By far, most businesses in the United States – including, of course, New York – are formed as pass-through entities, such as sole proprietorships, partnerships, LLCs and S corporations.

Under current Federal and New York State tax laws, these pass-through entities are generally not subject to an entity-level income tax.[xxvii]

However, New York City will certainly continue to impose its UBT on the taxable income of such pass-through entities,[xxviii] and will continue to surprise the unsuspecting (and ill-informed) newcomer.[xxix]

What’s more, it is possible that other state and local jurisdictions will jump on the proverbial band wagon; for example, Connecticut recently enacted an entity-level business tax on partnerships and S corporations (i.e., pass-through entities).[xxx]

Moreover, as state and local tax jurisdictions try to cope with the evisceration[xxxi] of the itemized deduction for state and local taxes – courtesy of the Tax Cuts and Jobs Act[xxxii] – some jurisdictions are looking to an unincorporated business tax as a way to possibly circumvent the $10,000 itemized deduction cap on such taxes by shifting the incidence of tax away from the individual owners of pass-through business entities and onto the entities themselves; after all, the Act did not eliminate the deduction for taxes imposed directly on the business.[xxxiii]

As this situation evolves, how will it affect “choice of entity” decisions? The Act was decidedly biased in favor of C corporations.[xxxiv] It is true that, in response to critics, Congress also added the Sec. 199A deduction[xxxv] to the Code for qualifying non-corporate owners of pass-through entities. However, will the imposition of a state or local entity-level tax on these very same pass-through entities tip the balance toward C corporations?

Or will the itemized deduction cap on state and local taxes be eliminated, thereby reducing the “need” for entity-level taxes on pass-through entities?

Or will state and local taxing jurisdictions find, as New York City seems to have found, that such taxes are intrinsically a “good” thing?[xxxvi]

Stay tuned.

[i] Many more than Boston, by the way.

[ii] Please do not read any significance into the ordering of these items.

[iii] https://www.taxlawforchb.com/2017/03/an-overview-of-the-nyc-business-tax-environment/

[iv] The State repealed its unincorporated business tax at the end of 1982. However, there has been some talk in Albany of late regarding the possible reintroduction of such a tax, though it did not make it into the 2020 Executive Budget. https://tax.ny.gov/pdf/stats/stat_pit/pit/unincorporated-business-tax-discussion-draft-summary.pdf

[v] N.Y.C. Adm. Code Sec. 11-503. https://law.justia.com/codes/new-york/2006/new-york-city-administrative-code-new/adc011-503_11-503.html

[vi] N.Y.C. Adm. Code Sections 11-514(a)(4) and 11-506(a)(1). https://law.justia.com/codes/new-york/2006/new-york-city-administrative-code-new/adc011-514_11-514.html. Form NYC-202.

[vii] https://law.justia.com/codes/new-york/2006/new-york-city-administrative-code-new/adc011-502_11-502.html

[viii] Treas. Reg. Sec. 301.7701-3.

[ix] N.Y.C. Adm. Code Sec. 502.

[x]http://library.amlegal.com/nxt/gateway.dll/New%20York/rules/therulesofthecityofnewyork?f=templates$fn=default.htm$3.0$vid=amlegal:newyork_ny

[xi] https://law.justia.com/codes/new-york/2006/new-york-city-administrative-code-new/adc011-502_11-502.html

[xii] Unlike for federal and New York State purposes, which generally do not impose an entity level tax on unincorporated business income.

[xiii] Insofar as the State income tax is concerned, UBT that was deducted in arriving at an individual’s federal adjusted gross income must be added back by individual taxpayers to determine their New York State adjusted gross income.

[xiv] The term “property” generally means real and personal property, including, for example, stocks or bonds.

[xv] N.Y.C. Adm. Code Sec. 11-502.

[xvi] N.Y.C. Adm. Code Sec. 11-502.

[xvii] N.Y.C. Adm. Code Sec. 11-505.

[xviii] https://law.justia.com/codes/new-york/2006/new-york-city-administrative-code-new/adc011-506_11-506.html

[xix] For example, guaranteed payments described in Sec. 707(c) of the Code that are made by a partnership to a partner for services or for the use of capital are not deductible for purposes of the UBT. By the way, all references to the “Code” mean the Internal Revenue Code.

[xx] https://www1.nyc.gov/assets/finance/downloads/pdf/09pdf/conformity_highlights071309.pdf

[xxi] Interestingly, Taxpayer was once a resident of the City. Having abandoned their City residence, they continued to own their former residence in the City, which they were careful “to occupy” for fewer than 184 days a year. Presumably, this means that they avoided statutory residence. Query, however, why the ruling used the words “to occupy”? Whether or not Taxpayer occupied the residence is irrelevant for purposes of the “more than 183 days” rule. All that matters, according to the City, is that the taxpayer was present in the City in excess of 183 days during the tax year, and that the taxpayer maintained a permanent place of abode in the City for substantially all of the tax year. The Court of Appeals has held that the Taxpayer must have a residential interest in the abode. See its decision in Gaied, 22 N.Y.3d 592, 594 (2014). https://www.taxlawforchb.com/2018/11/doing-business-in-new-york-domiciled-elsewhere-paranoid-over-new-york-residency-status/

[xxii] Some might say that the UBT is an indirect City income tax on nonresident commuters – whom the City is not allowed to tax directly.

[xxiii] Disregarded entities for Federal income tax purposes. Taxpayer did not elect to treat the LLCs as “associations” that are taxable as corporations.

[xxiv] https://law.justia.com/codes/new-york/2006/new-york-city-administrative-code-new/adc011-508_11-508.html

[xxv] N.Y.C. Adm. Code Sec. 11-508(c) and 11-508(i).

[xxvi] There are special rules dealing with the sourcing for specific industries and businesses.

[xxvii] But see https://www.taxlawforchb.com/2015/12/did-you-say-a-taxable-partnership/. Of course, the Code imposes a built-in gains tax on certain dispositions by S corporations, under Sec. 1374.

[xxviii] It should be noted that the City also imposes a corporate income tax on S corporations that do business in the City – the City does not recognize the “S” election, and taxes such corporations at an 8.85 percent rate.

[xxix] My recollection is that, until recently, the District of Columbia was the only other jurisdiction that imposed such a tax.

[xxx] https://www.ctcpas.org/Content/Files/Pdfs/sn2018-4.pdf

[xxxi] Certainly from the perspective of a New Yorker.

[xxxii] P.L. 115-97 (the “Act”).

[xxxiii] See Sec. 164 of the Code.

[xxxiv] For example, the 21 percent flat income tax rate (a 40% reduction in the maximum corporate rate), and the 50 percent GILTI deduction (which, when combined with the 80% foreign tax credit, may even eliminate the tax on GILTI).

[xxxv] The so-called “20 percent of qualified business income” deduction.

[xxxvi] The UBT has been in place since the 1960’s.