This is the third in a series of posts reviewing the recently proposed regulations (“PR”) under Sec. 199A of the Code.

So far, we’ve considered the elements of a “qualified trade or business” under Section 199A, and the related issue of what constitutes a “specified service trade or business,” the owners of which may be denied the benefit of Section 199A. Today we’ll turn to the meaning of “qualified business income.”

Qualified Business Income – In General

In general, under Section 199A of the Code, a non-corporate taxpayer is allowed a deduction (the “Section 199A deduction”) for a taxable year equal to 20% of the taxpayer’s qualified business income (“QBI”) with respect to a qualified trade or business (“QTB”) for such year.

The term “QBI” means, for any taxable year, the net amount of “qualified items of income, gain, deduction, and loss” attributable to any QTB of the taxpayer, which in turn means those items of income, gain, deduction, and loss to the extent they are (i) “effectively connected with” the conduct of a trade or business within the U.S., and (ii) included or allowed in determining taxable income for the taxable year.

QBI items must be determined for each QTB by the individual or pass-through entity (“PTE”) that directly conducts the trade or business before applying the aggregation rules.

Exclusion from QBI for Certain Items

The PR provide a list of items that are not taken into account as qualified items of income, gain, deduction, and loss, including capital gain or loss, dividends, interest income other than interest income properly allocable to a trade or business, and certain other items; similarly, items of deduction or loss attributable to these items of income or gain are also not taken into account in determining a taxpayer’s QBI.

Compensation for Services

In general, S corporations must pay their shareholder-employees “reasonable compensation” for services rendered before making “dividend” distributions with respect to shareholder-employees’ stock in the S corporation.

The PR provide that QBI does not include the amount of reasonable compensation paid to the shareholder-employee of an S corporation that operates a QTB for services rendered by the shareholder-employee with respect to such trade or business.

However, the S corporation’s deduction for such reasonable compensation reduces QBI if such deduction is properly allocable to the trade or business and is otherwise deductible.

Guaranteed Payments

Similarly, the PR provide that QBI does not include any guaranteed payment – one determined without regard to the income of the partnership – made by a partnership to a partner for services rendered with respect to the partnership’s trade or business.

However, the partnership’s related expense deduction for making the guaranteed payment may constitute an item of QBI. [i]

The PR clarify that QBI does not include any guaranteed payment paid to a partner for services rendered, regardless of whether the partner is an individual or a PTE. Therefore, a guaranteed payment paid by a lower-tier partnership to an upper-tier partnership retains its character as a guaranteed payment and is not included in QBI of a partner of the upper-tier partnership regardless of whether it is guaranteed to the ultimate recipient.

Other Payments to “Partners”

QBI does not include any payment to a partner, regardless of whether the partner is an individual or a PTE, for services rendered with respect to the partnership’s trade or business where the partner engages with the partnership other than in their capacity as a partner. Thus, it is treated similarly to guaranteed payments, reasonable compensation, and wages, none of which is includable in QBI.

Guaranteed Payments for the Use of Capital

Because guaranteed payments for the use of capital are determined without regard to the income of the partnership, the PR provide that such payments are not considered attributable to a trade or business, and thus do not constitute QBI.

However, the partnership’s related expense for making the guaranteed payments may constitute an item of QBI.

Interest Income

QBI does not include any interest income other than interest income that is properly allocable to a trade or business.

According to the PR, interest income received on working capital, reserves, and similar accounts is income from assets held for investment and is not properly allocable to a trade or business.

In contrast, interest income received on accounts or notes receivable for services or goods provided by the trade or business is not income from assets held for investment, but income received on assets acquired in the ordinary course of the trade or business.

QBI – Special Rules

In addition to the foregoing exclusions, the PR clarify the treatment of certain items that may be of interest to taxpayers that are disposing of their interest in a trade or business.

“Hot Asset” Gain

Under the partnership rules, the gain realized by a partner on the exchange of all or part of their interest in a partnership is treated as ordinary income to the extent it is attributable to the unrealized receivables or inventory items (“hot assets”) of the partnership. These are items that eventually would have been recognized by the partnership and allocated to the partner in the ordinary course; the exchange by the partner of their partnership interest merely accelerates this recognition and allocation.

Similarly, a distribution of property by a partnership to a partner in exchange for the partner’s interest in the “hot assets” of the partnership may be treated as sale or exchange of such hot assets between the partner and the partnership, thereby generating ordinary income.

According to the PR, any gain that is attributable to the hot assets of a partnership – thereby giving rise to ordinary income in the circumstances described above – is considered attributable to the trade or business conducted by the partnership, and therefore, may constitute QBI to the partner.

Of course, the term “unrealized receivables” is defined to include not only receivables, but other items as well; for example, depreciation recapture. This may be significant in the sale of a business by a PTE where the gain arising from the sale would otherwise be excluded from QBI.

Change in Accounting Adjustments

If a taxpayer changes their method of accounting, the Code requires that certain adjustments be made in computing the taxpayer’s taxable income in order to prevent amounts of income or deduction from being duplicated or omitted. In general, these adjustments are taken into account by the taxpayer over a three-year period.

The PR provide that when such adjustments (whether positive or negative) are attributable to a QTB, and arise in a taxable year ending after December 31, 2017, they will be treated as attributable to that trade or business. Accordingly, such adjustments may constitute QBI.

Previously Suspended Losses

Several sections of the Code provide for the disallowance of losses and deductions to a taxpayer in certain cases; for example, the “at risk” rules and the “passive activity loss” rules. Generally, the disallowed amounts are suspended and carried forward to the following year, at which point they are re-tested and may become allowable; of course, when the taxpayer disposes of their interest in the business to an unrelated party in a fully taxable transaction, the loss will cease to be suspended.

Likewise, losses may be suspended because an individual shareholder of an S corporation does not have sufficient stock or debt basis to utilize them; however, the actual or deemed sale of the assets of the S corporation’s business may generate enough gain to increase such basis and enable the shareholder to use the suspended losses.

The PR provide that, to the extent that any previously disallowed losses or deductions, attributable to a QTB, are allowed in the taxable year, they are treated as items attributable to the trade or business. Thus, losses that cease to be suspended under one of the above “disposition rules” may be treated as QBI. However, losses or deductions that were disallowed for taxable years beginning before January 1, 2018 are not taken into account for purposes of computing QBI in a later taxable year.

Net Operating Losses

Generally, items giving rise to a net operating loss (“NOL”) are allowed in computing taxable income in the year incurred. Because those items would have been taken into account in computing QBI in the year incurred, the NOL should not be treated as QBI in subsequent years.

However, to the extent the NOL is comprised of amounts attributable to a QTB that were disallowed under the new “excess business loss” rule – which are not allowed in computing taxable income for the taxable year but which are, instead, carried forward and treated as part of the taxpayer’s net operating loss carryforward in subsequent taxable years – the NOL is considered attributable to that trade or business, and may constitute QBI.

Property Used in the Trade or Business

QBI does not include any item of short-term capital gain, short-term capital loss, long-term capital gain, or long-term capital loss.

The Code provides rules under which gains and losses from the sale or exchange of certain property used in a trade or business are either treated as long-term capital gains or long-term capital losses, or are not treated as gains and losses from sales or exchanges of capital assets.[ii]

The PR clarify that QBI excludes short-term and long-term capital gains or losses, regardless of whether those items arise from the sale or exchange of a capital asset, including any item treated as one of such items taken into account in determining net long-term capital gain or net long-term capital loss.

Conversely, if the gains or losses are not treated as gains and losses from sales or exchanges of capital assets, the gains or losses may be included in QBI.

Effectively Connected With a U.S. Trade or Business

Section 199A applies to all non-corporate taxpayers, whether such taxpayers are domestic or foreign. Accordingly, Section 199A applies to both U.S. citizens and resident aliens, as well as nonresident aliens (“NRA”) that have QBI.

QBI includes items of income, gain, deduction, and loss to the extent such items are (i) included or allowed in determining the U.S. person’s or NRA’s taxable income for the taxable year, and (ii) effectively connected with the conduct of a trade or business within the U.S.

Determining Effectively Connected Income

In general, whether a QTB is engaged in a trade or business within the U.S., partially within the U.S., or solely outside the U.S., is based upon all the facts and circumstances.[iii]

If a trade or business is not engaged in a U.S. trade or business, items of income, gain, deduction, or loss from that trade or business will not be included in QBI because such items would not be effectively connected with the conduct of a U.S. trade or business.

Thus, a shareholder of an S corporation, or a U.S. partner of a partnership, that is engaged in a trade or business in both the U.S. and overseas would only take into account the items of income, deduction, gain, and loss that would be effectively connected with the business conducted by the S corporation, or partnership, in the U.S.

In determining whether income or gain from U.S. sources is effectively connected with the conduct of a trade or business within the U.S., a number of factors have to be considered, including whether the income, gain or loss is derived from assets used in or held for use in the conduct of such trade or business, or the activities of such trade or business were a material factor in the realization of the income, gain or loss.

If an NRA’s QTB is determined to be conducted in the U.S., the Code generally treats all non-investment income of the NRA from sources within the U.S. as effectively connected with the conduct of a U.S. trade or business.[iv]

Income from sources without the U.S. is generally not treated as effectively connected with the NRA’s conduct of a U.S. trade or business. Thus, a trade or business’s foreign source income, gain, or loss, (and any deductions effectively connected with such foreign source income, gain, or loss) would generally not be included in QBI.[v]

However, this rule does not mean that any item of income or deduction that is treated as effectively connected with an NRA’s conduct of a trade or business with the U.S. is necessarily QBI. Indeed, certain provisions of the Code allow items to be treated as effectively connected, even though they are not “items” with respect to a trade or business. For example, the Code allows an NRA to elect to treat income from rental real property in the U.S. that would not otherwise be treated as effectively connected with the conduct of a trade or business within the U.S. as effectively connected. However, if items are not attributable to a QTB, they do not constitute QBI.

Allocation of QBI Items

The PR provides that, if an individual or a PTE directly conducts multiple trades or businesses, and has items of QBI that are properly attributable to more than one trade or business, the taxpayer or entity must allocate those items among the several trades or businesses to which they are attributable using a reasonable method that is consistent with the purposes of Section 199A.

The chosen reasonable method for each item must be consistently applied from one taxable year to another, and must clearly reflect the income of each trade or business.

There are several different ways to allocate expenses, such as direct tracing, allocating based on gross income, or some other method, but whether these are reasonable depends on the facts and circumstances of each trade or business.

Next week, we’ll bring together the basic elements of Section 199A, which we covered in the last three posts, to see how the “20% deduction” is determined.


[i] The PR provides that QBI does not include reasonable compensation paid by an S corporation but does not extend this rule to partnerships. Because the trade or business of performing services as an employee is not a QTB, wage income received by an employee is never QBI.

The rule for reasonable compensation is merely a clarification that, even if an S corporation fails to pay a reasonable wage to its shareholder-employees, the shareholder-employees are nonetheless prevented from including an amount equal to reasonable compensation in QBI.

[ii] IRC Sec. 1231.

[iii] Because an NRA cannot be a shareholder on an S corporation, the NRA’s effectively connected income must arise from the NRA’s direct conduct of a trade or business in the U.S. (including through a disregarded entity; if the NRA is a resident of a treaty country, the NRA’s business profits will not be subject to U.S. tax unless the NRA operates the business through a permanent establishment in the U.S.); in addition, an NRA is considered engaged in a trade or business within the U.S. if the partnership of which such individual is a member is so engaged.

[iv] However, any “FDAP” income or “portfolio interest” income from sources within the U.S., and any gain or loss from the sale of capital assets, may be effectively connected only if the income meets certain requirements.

[v] There are exceptions.

This is the second in a series of posts reviewing the recently proposed regulations (“PR”) under Sec. 199A of the Code.

 Yesterday, we considered the elements of a “qualified” trade or business under Section 199A. Today, we’ll pick up with those trades or businesses that may be excluded from its coverage, and tomorrow we’ll turn to the meaning of qualified business income. Hold on to your seats as we continue to look at more . . . definitions.

Effect of Specified Service Trade or Business Status

A qualified trade or business (“QTB”) – the qualified business income (“QBI”) of which provides the basis for the Section 199A deduction – includes any trade or business other than a “specified service trade or business” (“SSTB”).

Thus, if a trade or business is an SSTB, no QBI, W-2 wages, or unadjusted basis (“UB”) of qualified property from the SSTB may be taken into account by an individual owner of the SSTB whose taxable income exceeds a threshold amount plus a phase-in range, even if the taxable income is derived from an activity that is not itself an SSTB.

If the trade or business conducted by a PTE is an SSTB, this limitation will apply to any direct or indirect individual owners of the business, regardless of whether the owner is passive or participated in any SSTB activity. However, the SSTB limitation will not apply to an individual with taxable income below the threshold amount.[i]

SSTB Defined

Conceptually, the definition of an SSTB emphasizes the direct provision of services by the employees or owners of a trade or business, rather than the application of capital.

Although the Code does not require a certain quantum of specified service activity is necessary to find an SSTB, the PR provide a de minimis rule under which a trade or business will not be considered an SSTB merely because it provides a small amount of services in a specified service activity.[ii]

An SSTB means any trade or business involving the performance of services in the fields of health, law, accounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage services, or any trade or business where the principal asset of such trade or business is the reputation or skill of one or more of its employees or owners, and any trade or business that involves the performance of services that consist of investing and investment management, trading, or dealing in securities, partnership interests, or commodities.

Some of these services are considered below.


The PR provide that the term “performance of services in the field of health” means the provision of medical services by physicians, pharmacists, nurses, dentists, veterinarians, physical therapists, psychologists, and other similar healthcare professionals who provide medical services directly to a patient.

The performance of services in the field of health does not include the provision of services not directly related to a medical field, even though the services may purportedly relate to the health of the service recipient.

For example, the performance of services in the field of health does not include the operation of health clubs or health spas that provide physical exercise or conditioning to their customers, payment processing, or research, testing, and manufacture and/or sales of pharmaceuticals or medical devices.


The term “performance of services in the field of law” means the provision of services by lawyers, paralegals, legal arbitrators, mediators, and similar professionals in their capacity as such.

It does not include the provision of services that do not require skills unique to the field of law; for example, the provision of services in the field of law does not include the provision of services by printers, delivery services, or stenography services.


The PR provides that the term “performance of services in the field of accounting” means the provision of services by accountants, enrolled agents, return preparers, financial auditors, and similar professionals in their capacity as such.

Provision of services in the field of accounting is not limited to services requiring state licensure as a certified public accountant (CPA). The aim of the PR is to capture the common understanding of accounting, which includes bookkeeping services.

The field of accounting does not include payment processing and billing analysis.


The term “performance of services in the field of consulting” means the provision of professional advice and counsel to clients to assist the client in achieving goals and solving problems.

Consulting includes providing advice and counsel regarding advocacy with the intention of influencing decisions made by a government or governmental agency and all attempts to influence legislators and other government officials on behalf of a client by lobbyists and other similar professionals performing services in their capacity as such.

The performance of services in the field of consulting does not include the performance of services other than advice and counsel, such as sales or economically similar services, or the provision of training or educational courses. The determination of whether a person’s services are sales or economically similar services is made based on all the facts and circumstances of that person’s business, including the manner in which the taxpayer is compensated for the services.

In recognition of the fact that, in certain kinds of sales transactions, it is common for businesses to provide consulting services in connection with the purchase of goods by customers – for example, a company that sells computers may provide customers with consulting services relating to the setup, operation, and repair of the computers – the PR provide a de minimis rule under which a trade or business is not an SSTB if less than 10% of the gross receipts (5% if the gross receipts are greater than $25 million) of the trade or business for a taxable year are attributable to the performance of services in a SSTB.

However, the IRS also recognized that this de minimis rule may not provide sufficient relief for certain trades or business that provide ancillary consulting services. Thus, the PR also provide that the field of consulting does not include the performance of consulting services that are embedded in, or ancillary to, the sale of goods or the performance of services on behalf of a trade or business that is other than an SSTB if there is no separate payment for the consulting services.

Financial Services

The PR limits the definition of financial services to services including managing wealth, advising clients with respect to finances, developing retirement plans, developing wealth transition plans, the provision of advisory and other similar services regarding valuations, mergers, acquisitions, dispositions, restructurings (including in title 11 or similar cases), and raising financial capital by underwriting, or acting as the client’s agent in the issuance of securities, and similar services.

This includes services provided by financial advisors, investment bankers, wealth planners, and retirement advisors and other similar professionals.

Brokerage Services

The PR provide that the field of brokerage services includes services in which a person arranges transactions between a buyer and a seller with respect to securities for a commission or fee. This includes services provided by stock brokers and other similar professionals, but does not include services provided by real estate agents and brokers, or insurance agents and brokers.

Principal Asset of the Business: Reputation or Skill of Employees or Owners

Thankfully, the PR rejected a broad, service-based approach to the meaning of what could have been the catch-all “reputation or skill” clause by limiting it to fact patterns in which the individual or PTE is engaged in the trade or business of: (1) Receiving income for endorsing products or services, including an individual’s distributive share of income or distributions from an PTE for which the individual provides endorsement services; (2) licensing or receiving income for the use of an individual’s image, likeness, name, signature, voice, trademark, or any other symbols associated with the individual’s identity, including an individual’s distributive share of income or distributions from an RPE to which an individual contributes the rights to use the individual’s image; or (3) receiving appearance fees or income.[iii]

Investing and Investment Management

The PR provide that any trade or business that involves the “performance of services that consist of investing and investment management” means a trade or business that earns fees for investment, asset management services, or investment management services, including providing advice with respect to buying and selling investments. The performance of services that consist of investing and investment management would include a trade or business that receives either a commission, a flat fee, or an investment management fee calculated as a percentage of assets under management.

The performance of services of investing and investment management does not include directly managing real property.


The PR provide that any trade or business involving the “performance of services that consist of trading” means a trade or business of trading in securities, commodities, or partnership interests. Whether a person is a trader is determined taking into account the relevant facts and circumstances. Factors that have been considered relevant to determining whether a person is a trader include the source and type of profit generally sought from engaging in the activity regardless of whether the activity is being provided on behalf of customers or for a taxpayer’s own account.

Dealing in Securities

The “performance of services that consist of dealing in securities” means regularly purchasing securities from and selling securities to customers in the ordinary course of a trade or business or regularly offering to enter into, assume, offset, assign, or otherwise terminate positions in securities with customers in the ordinary course of a trade or business. For purposes of the preceding sentence, a taxpayer that regularly originates loans in the ordinary course of a trade or business of making loans but engages in no more than “negligible” sales of the loans is not dealing in securities for purposes of Section 199A.

The fact that businesses are operated across entities raises the question of whether, in defining a “trade or business” for purposes of Section 199A, trades or businesses should be permitted or required to be aggregated, or disaggregated, and if so, whether such aggregation, or disaggregation, should occur at the entity level or at the individual-owner level.

Services or Property Provided to an SSTB

The IRS observed that some taxpayers have contemplated a strategy to separate out parts of what otherwise would be an integrated SSTB, such as the administrative functions, in an attempt to qualify those separated parts for the Section 199A deduction. Such a strategy, the IRS has stated, is inconsistent with the purpose of Section 199A.

Therefore, the PR provide an anti-abuse rule pursuant to which an SSTB will include any trade or business (not otherwise an SSTB) with 50% or more common ownership (direct or indirect) with an SSTB, that provides 80% or more of its property or services to the SSTB.

Additionally, if a trade or business provides less than 80% of its property or services to an SSTB, but has 50% or more common ownership with an SSTB, that portion of the trade or business of providing property or services to the SSTB will be treated as part of the SSTB (meaning the income will be treated as income from an SSTB). For example, dentist A owns a dental practice and also owns an office building. A rents half the building to the dental practice and half the building to unrelated persons. The renting of half of the building to the dental practice will be treated as an SSTB.

The PR also provide a rule that if a trade or business (that would not otherwise be treated as an SSTB) has 50% or more common ownership with an SSTB, and has shared expenses with an SSTB, including wages or overhead expenses, it is treated as incidental to the SSTB and, therefore, as part of the SSTB, if the gross receipts of the trade or business represent no more than 5% of the gross receipts of the combined business in a taxable year.

Example. A, a dermatologist, provides medical services to patients on a regular basis through LLC, a disregarded entity owned by A. In addition to providing medical services, LLC also sells skin care products to A’s patients. The same employees and office space are used for the medical services and sale of skin care products. The gross receipts with respect to the skin care product sales do not exceed 5% of the gross receipts of LLC. Accordingly, the sale of the skin care products is treated as incidental to A’s SSTB of performing services in the field of health and is treated as part of such SSTB.


[i] For purposes of this post, it is assumed that the threshold amount ($315,000 in the case of married taxpayers filing jointly) and phase-in range are exceeded. It should be noted, however, that an individual with taxable income in excess of the threshold amount but within the phase-in range will be allowed to take into account a certain “applicable percentage” of QBI, W-2 wages and QB of qualified property from an SSTB in determining their Section 199A deduction. Thus, some owners of an SSTB may qualify for the Section 199A deduction while others may not.

[ii] For more details on this de minimis rule, see the discussion below, under “consulting” services.

[iii] Oh, to be a celebrity!

What follows is the first in a series of posts that will review the long-awaited proposed regulations under Sec. 199A of the Code – the “20% deduction” – which was enacted by the Tax Cuts and Jobs Act to benefit the individual owners of pass-through business entities.

Today’s post will summarize the statutory provision, and will then consider some of the predicate definitions and special rules that are key to its application.

We will continue to explore these definitions and rules in tomorrow’s post.

Congress: “I Have Something for You”

The vast majority of our clients are closely-held businesses that are organized as pass-through entities (“PTEs”), and that are owned by individuals. These PTEs include limited liability companies that are treated as partnerships for tax purposes, as well as S corporations.

As the Tax Cuts and Jobs Act (“TCJA”)[i] moved through Congress in late 2017, it became clear that C corporations were about to realize a significant windfall.[ii] In reaction to this development, many individual clients who operate through partnerships began to wonder whether they should incorporate their business (for example, by “checking the box”[iii]); among those clients that operated their business as S corporations, many asked whether they should revoke their “S” election.

After what must have been a substantial amount of grumbling from the closely-held business community, Congress decided to add a new deduction to the TCJA – Section 199A – that was intended to benefit the individual owners of PTEs for taxable years beginning after 2017 and before 2026.[iv]

“Here It Is”

In general, under new Section 199A of the Code, a non-corporate taxpayer is allowed a deduction (the “Section 199A deduction”) for a taxable year equal to 20% of the taxpayer’s qualified business income (“QBI”) with respect to a qualified trade or business (“QTB”) for such year.

A QTB includes any trade or business other than a “specified service trade or business” (“SSTB”)[v]. It also does not include the trade or business of rendering services as an employee.

An SSTB includes, among other things, any trade or business involving the performance of services in the fields of health, law, accounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage services, or any trade or business where the principal asset of such trade or business is the reputation or skill of one or more of its employees.

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

Investment income is not included in determining QBI, nor is any reasonable compensation paid to a shareholder, nor any guaranteed payment made to a partner, for services rendered to the QTB.

If an individual taxpayer-owner’s taxable income for a taxable year exceeds a threshold amount, a special limitation will apply to limit that individual’s Section 199A deduction.

Assuming the limitation rule is fully applicable, the amount of the Section 199A deduction may not exceed the greater of:

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

If the individual taxpayer carries on more than one QTB (directly or through a PTE), the foregoing calculation is applied separately to each such QTB, and the results are then aggregated to determine the amount of the Section 199A deduction.

Thus, a loss generated in one QTB may offset the net income generated in another, thereby denying the taxpayer any Section 199A deduction.

If the taxpayer carries on the business indirectly, through a partnership or S corporation, the rule is applied at the partner or shareholder level, with each partner or shareholder taking into account their allocable share of QBI, as well as their allocable share of W-2 wages and UB (for purposes of applying the above limitation).

Because some individual owners of a PTE may have personal taxable income at a level that triggers application of the above limitation, while others may not, it is possible for some owners of a QTB to enjoy a smaller Section 199A deduction than others, even where they have the same percentage equity interest in the QTB.[vii]

Finally, the amount of a taxpayer’s Section 199A deduction for a taxable year determined under the foregoing rules may not exceed 20% of the excess of (i) the taxpayer’s taxable income for the taxable year over (ii) the taxpayer’s net capital gain for such year.

Taxpayer: “Thank You, But I Have Some Questions”

It did not take long after Section 199A was enacted as part of the TCJA, on December 22, 2017, for many tax advisers and their PTE clients to start asking questions about the meaning or application of various parts of the rule.

For example, what constitutes a “trade or business” for purposes of the rule? Would taxpayers be allowed to group together separate but related businesses for purposes of determining the Deduction? Would they be required to do so? Under what circumstances, if any, would a PTE be permitted to split off a discrete business activity or function into a different business entity? When is the reputation or skill of an employee the principal asset of a business?

Because of these and other questions, most advisers decided it would be best to wait for guidance from the IRS before advising taxpayers on how to implement and apply the new rules.[viii]

The IRS assured taxpayers that such guidance would be forthcoming in the spring of 2018; it subsequently revised its target date to July of 2018; then, on August 16, the IRS issued almost 200 pages of Proposed Regulations (“PR”).

The Proposed Regulations

The PR will apply to taxable years ending after the date they are adopted as final regulations; until then, however, taxpayers may rely on the PR.

Trade or Business – In General

The PR provide that, for purposes of Section 199A, the term “trade or business” shall mean an activity that is conducted with “continuity and regularity” and “with the primary purpose of earning income or making profit.” This is the same definition that taxpayers have applied for decades for purposes of determining whether expenses may be deducted as having been incurred in the ordinary course of a trade or business (so-called “ordinary and necessary” expenses).

However, in recognition of the fact that it is not uncommon, for legal or other bona fide non-tax reasons (for example, to limit exposure to liability), for taxpayers to segregate rental properties from operating businesses, the PR extend the definition of “trade or business” for purposes of Section 199A by including the rental or licensing of tangible or intangible property to a related trade or business – which may not otherwise satisfy the general definition of “trade or business” adopted by the PR (for example, where the entire property is rented only to the operating business) – if the “lessor/licensor trade or business” and the “lessee/licensee trade or business” are commonly controlled (generally speaking, if the same person or group of persons, directly or indirectly, owns 50% or more of each trade or business).

Trade or Business – Aggregation Rules

The above line of reasoning also informed the IRS’s thinking with respect to the “grouping” of certain trades or businesses for purposes of applying Section 199A.

Specifically, the IRS recognized that some amount of aggregation should be permitted because it is not uncommon, for what are commonly thought of as single trades or businesses, to be operated across multiple entities for various legal, economic, or other bona fide non-tax reasons.

Allowing taxpayers to aggregate trades or businesses offers taxpayers a means of combining their trades or businesses for purposes of applying the “W-2 wage” and “UB of qualified property” limitations (described above) and potentially maximizing the deduction under Section 199A. The IRS was concerned that if such aggregation were not permitted, taxpayers could be forced to incur costs to restructure solely for tax purposes. In addition, business and non-tax legal requirements may not permit many taxpayers to restructure their operations.

Therefore, the PR permits the aggregation of separate trades or businesses, provided certain requirements are satisfied; aggregation is not required.[ix]

An individual may aggregate trades or businesses only if the individual can demonstrate that certain requirements are satisfied:

  • Each “trade or business” must itself be a trade or business for purposes of Section 199A.
  • The same person, or group of persons, must directly or indirectly, own a majority interest in each of the businesses to be aggregated for the majority of the taxable year in which the items attributable to each trade or business are included in income. All of the items attributable to the trades or businesses must be reported on tax returns with the same taxable year.
    • The PR provides rules allowing for family attribution.
    • Because the proposed rules look to a group of persons, minority owners may benefit from the common ownership and are permitted to aggregate.
  • None of the aggregated trades or businesses can be an SSTB (more on this tomorrow).
  • Individuals must establish that the trades or businesses to be aggregated meet at least two of the following three factors, which demonstrate that the businesses are in fact part of a larger, integrated trade or business:
    • The businesses provide products and services that are the same (for example, a restaurant and a food truck) or they provide products and services that are customarily provided together (for example, a gas station and a car wash);
    • The businesses share facilities or share significant centralized business elements (for example, common personnel, accounting, legal, manufacturing, purchasing, human resources, or information technology resources); or
    • The businesses are operated in coordination with, or reliance on, other businesses in the aggregated group (for example, supply chain interdependencies).

Trade or Business – Aggregation by Individuals

An individual is permitted to aggregate trades or businesses that the individual operates directly and trades or businesses operated indirectly – or, more appropriately, they may aggregate the businesses they operate directly with their share of QBI, W-2 wages and UB of qualified property from trades or businesses operated through PTEs of which the individual is an owner.

Individual owners of the same PTEs are not required to aggregate in the same manner.

An individual directly engaged in a trade or business must compute QBI, W-2 wages, and UB of qualified property for each such trade or business before applying the aggregation rules.

If an individual has aggregated two or more trades or businesses, then the combined QBI, W-2 wages, and UB of qualified property for all aggregated trades or businesses is used for purposes of applying the W-2 wage and UB of qualified property limitations.

Example. Individual A wholly owns and operates a catering business and a restaurant through separate disregarded entities. The catering business and the restaurant share centralized purchasing to obtain volume discounts and a centralized accounting office that performs all of the bookkeeping, tracks and issues statements on all of the receivables, and prepares the payroll for each business. A maintains a website and print advertising materials that reference both the catering business and the restaurant. A uses the restaurant kitchen to prepare food for the catering business. The catering business employs its own staff and owns equipment and trucks that are not used or associated with the restaurant.

Because the restaurant and catering business are held in disregarded entities, A will be treated as operating each of these businesses directly. Because both businesses offer prepared food to customers, and because the two businesses share the same kitchen facilities in addition to centralized purchasing, marketing, and accounting, A may treat the catering business and the restaurant as a single trade or business for purposes of applying the limitation rules.

Example. Assume the same facts as above, but the catering and restaurant businesses are owned in separate partnerships and A, B, C, and D each own a 25% interest in the capital and profits of each of the two partnerships. A, B, C, and D are unrelated.

Because A, B, C, and D together own more than 50% of the capital and profits in each of the two partnerships, they may each treat the catering business and the restaurant as a single trade or business for purposes of applying the limitation rules.

Trade or Business – Aggregation by PTEs

PTEs must compute QBI, W-2 wages, and UB of qualified property for each trade or business. A PTE must provide its owners with information regarding QBI, W-2 wages, and UB of qualified property attributable to its trades or businesses.

The PR do not address the aggregation by a PTE in a tiered structure.

Trade or Business – Aggregation – Reporting and Consistency

The PR requires that, once multiple trades or businesses are aggregated into a single aggregated trade or business, individuals must consistently report the aggregated group in subsequent tax years.

The PR provides rules for situations in which the aggregation rules are no longer satisfied, as well as rules for when a newly-created or newly-acquired trade or business can be added to an existing aggregated group.

Finally, the PR provides reporting and disclosure requirements for individuals that choose to aggregate, including identifying information about each trade or business that constitutes a part of the aggregated trade or business. The PR allows the IRS to disaggregate trades or businesses if an individual fails to make the required disclosure.

[*] Anyone remember the following scene from “The Jerk”?

Navin: “The new phone book’s here! The new phone book’s here!”
Harry: “Well I wish I could get so excited about nothing.”
Navin: “Nothing? Are you kidding?! Page 73, Johnson, Navin, R.! I’m somebody now! Millions of people look at this book every day! This is the kind of spontaneous publicity, your name in print, that makes people. I’m in print! Things are going to start happening to me now.”

[i] Pub. L. 115-97.

[ii] See, e.g., ; ;


[iv] That’s right – the provision is scheduled to disappear in a few years. However, on July 24, the House Ways and Means Committee released “Tax Reform 2.0 Listening Session Framework” which would make the deduction permanent. These proposals will not be considered until after the Congressional elections this fall. Enough said.

[v] It should be noted that a SSTB will not be excluded from QTB status with respect to an individual taxpayer-owner of the SSTB if the taxpayer’s taxable income does not exceed certain thresholds. It is assumed herein that these thresholds, as well as the range of taxable income above such thresholds within which the benefit of Section 199A is scaled back, are exceeded for every owner of the SSTB.

[vi] In general, the unadjusted basis, immediately after acquisition, of all qualified property.

[vii] Query whether this may influence business and investment decisions.

[viii] Others, however, saw a wasting opportunity, given the scheduled elimination of the deduction after the year 2025, and may have acted hastily. Among other things, many of these advisers and taxpayers sought to bootstrap themselves into a QTB by separating its activities from a related SSTB.

[ix] The IRS is aware that many taxpayers are concerned with having multiple regimes for grouping. Accordingly, it has requested comments on the aggregation method described in the PR, including whether this would be an appropriate grouping method for purposes of the passive activity loss limitation and net investment income surtax rules, in addition to Section 199A.


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

Cost Recovery

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

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

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


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

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


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

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

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

Asset Deals

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

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

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

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

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

Beyond Asset Deals?

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

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

Proposed Regulations

Used Property

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

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

Related Persons

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

Deemed Asset Sales by Corporations

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

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

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

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

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

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

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

Partnership Transactions – Cross-Purchase

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

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

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

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

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

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

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

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

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

Partnership Transactions – Redemption

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

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

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


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

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

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

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

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

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

[i] Public Law 115-97.

[ii] IRC Sec. 263, 1012.

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

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

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

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

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

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

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

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

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

[viii] IRC Sec. 1060.

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

[ix] An important consideration for sellers.

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

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

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

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

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

[xv] IRC Sec. 755.

[xvi] Query how this will be determined.

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

[xviii] IRC Sec. 734.

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

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

Transaction Costs

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

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

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

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

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

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

A Successful Sale

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

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

The Letter

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

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

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

The Audit

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

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

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

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

The Law

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

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

Facilitative Costs

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

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

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

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

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

Contingent Fees

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

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

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

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

Safe Harbor

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

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

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

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

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

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


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

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

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

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


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

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

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

Shareholder Litigation

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

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

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

“S” Corp is Formed

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

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

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

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

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

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

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

Tax Returns

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

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

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

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

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

The Court

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

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

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

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

Corp’s Payment?

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

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

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

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

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

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

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

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

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

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

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

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

Here I Go . . . Again[ii]

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

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

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

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


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

[ii] Apologies to Bob Seeger.

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

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

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

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

Parent’s Dilemma

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

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

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

Between a Rock and . . .

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

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

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

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

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

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

Bad Debt?

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

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

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

The Court Saw it Differently

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

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

The Court answered both these questions in the negative.

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

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

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

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

Performance Guarantee?

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

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

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

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

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

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

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

Ordinary and Necessary Expense?

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

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

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

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

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

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

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

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

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

Reputation and Goodwill

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

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

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

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

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

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

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

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

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

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

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

(3) the source of payments;

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

(5) participation in management flowing as a result;

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

(7) the intent of the parties;

(8) ‘thin’ or adequate capitalization;

(9) identity of interest between creditor and stockholder;

(10) source of interest payments;

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

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

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

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


The Corporate “Shield”

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

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

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

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

Let’s Make a Deal

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

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

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

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

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

The IRS Smells a Rat

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

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

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

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

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

The Court of Appeals

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

Economic Purpose

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

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

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

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

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

Liability under State Law

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

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

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

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


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

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

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

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

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

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

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

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

Too Good to Be True

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

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

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

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

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

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

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

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

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

The Start of Something Wonderful?

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

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

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

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

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

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

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

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

Income Tax Returns

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

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

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

Unreported Income

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

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

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

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

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

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

Existence of Partnership?

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

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

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

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

Agreement of Parties and Conduct in Executing Terms

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

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

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

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

Parties’ Contributions to Venture

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

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

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

Control Over Income and Right To Make Withdrawals

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

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

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

Co-Owner or Non-partner Relationship

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

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

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

Whether Business Was Conducted in Joint Names

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

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

Filing of Partnership Returns or Representation of Joint Venture

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

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

Maintenance of Separate Books and Accounts

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

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

Exercise of Mutual Control and Assumption of Mutual Responsibilities

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

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

Court’s Decision

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

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

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

Be Mindful

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

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

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

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

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

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

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

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

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

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

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

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

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

[viii] The Court considered the following factors:

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

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

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

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

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

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

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

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


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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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


[1] Alliteration has its place.

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

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

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

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

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

[5] .

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

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

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

[9] For example, gift tax.