After Me, Who Cares?

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

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

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

Coming Out of the Woodwork

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

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

Decedent’s Plan

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

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

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

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

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

Estate Administration

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

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

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


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

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

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

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

Redemption Appraisal

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

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


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

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

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

Tax Reporting

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

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

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

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

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

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

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

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

Court of Appeals

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

Charitable Deduction

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

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

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

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

“Valuing” the Deduction

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

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

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

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

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

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

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

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

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

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

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

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

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

Plan B

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

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

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

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

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

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

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

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

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

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

[iv] Basically, her probate assets.

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

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

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

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

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

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

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

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

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

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

[xv] Form 1041 Tax Return.

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

[xvii] Schedule O to the Form 706.

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

[xix] IRC Sec. 7482.

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

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

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

[xxiii] 674 F.2d 761 (9th Cir. 1981).

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

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

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

[xxvii] A tall order? Maybe.

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


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

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

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

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

IRC Sec. 962[xii]

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

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

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

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

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

The “Waxing” of the Act

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

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

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

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

U.S. Taxation of CFC Income

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

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

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

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

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

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

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

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

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


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

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

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

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

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

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

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

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

Use a C-Corporation?

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

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

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

A Branch?

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

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

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

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

Elect Under Sec. 962?

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

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

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

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

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

The Recently Proposed Sec. 962 Regulations

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

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

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

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

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

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

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

Next Steps?

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

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

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

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

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

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


[i] P.L. 115-97 (the “Act”).

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

[iii] The “Proposed Regulations.”

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

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

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

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

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

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

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

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


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

[xiv] IRC Sec. 957.

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

[xvi] IRC Sec. 960.

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

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

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

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

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

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

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

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

[xxiv] A separate legal entity.

[xxv] IRC Sec. 951A.

[xxvi] A deemed “reasonable return.”

[xxvii] The highest rate applicable to individuals.

[xxviii] IRC Sec. 250. IRS Form 8993,

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

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

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

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

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

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

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

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

[xxxvii] IRC Sec. 951.

[xxxviii] IRC Sec. 951A.


[xl] IRC Sec. 250.

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

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

[xliii] Some might say procrastinating.

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

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

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

Choice of Entity

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

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

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

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

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

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

Enter the TCJA

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

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

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

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

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

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

Regretting the Choice

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

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

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

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

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

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

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

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

The IRS moved for summary judgment.[xxiii]

“Live With It”

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

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

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

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

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

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

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

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

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

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

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

Therefore, Taxpayer was not personally entitled to take deductions.

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

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

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

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

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

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

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

What to Do?

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

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

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

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

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

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

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

[i] No pressure.

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

[iii] Reg. Sec. 301.7701-2.

[iv] IRC Sec. 1361 and 1362.

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

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

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

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

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

[x] IRC Sec. 1(h).

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

[xii] P.L. 115-97 (the “Act”).

[xiii] IRC Sec. 11.

[xiv] IRC Sec. 199A.

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

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

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

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

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

[xix] . Call it a corollary of the “Danielson rule.”

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

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

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

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

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

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

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

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

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

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

Hell of a Town

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

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

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

Unincorporated Business Tax

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

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

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

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

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

Unincorporated “Trade or Business”

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

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

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

Personal Income Tax

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

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

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


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

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

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

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

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


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

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

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

Allocating Income to the City

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

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

“Local Cross-Border Transactions”

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

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

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


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

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

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

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

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

Taxpayer’s UBT

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

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

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

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

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

What’s The Point, Lou?

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

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

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

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

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

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

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

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

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

Stay tuned.

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

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


[iv] The State repealed its unincorporated business tax at the end of 1982. However, there has been some talk in Albany of late regarding the possible reintroduction of such a tax, though it did not make it into the 2020 Executive Budget.

[v] N.Y.C. Adm. Code Sec. 11-503.

[vi] N.Y.C. Adm. Code Sections 11-514(a)(4) and 11-506(a)(1). Form NYC-202.


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

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



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

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

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

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

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

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


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


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

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

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


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

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

[xxvii] But see Of course, the Code imposes a built-in gains tax on certain dispositions by S corporations, under Sec. 1374.

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

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


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

[xxxii] P.L. 115-97 (the “Act”).

[xxxiii] See Sec. 164 of the Code.

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

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

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


Yes, it sounds odd.

It is also seems to be at odds with this blog’s constant refrain of “Thou shalt not pursue any undertaking solely for tax purposes, but thou shalt first consider the business purpose for such undertaking and, if thou findeth such purpose worthy of attainment, then, and only then, shalt thou contemplate the tax benefit, but never shalt thou lose sight of your primary business purpose.”[i]

OK. How does that tie in to the title of this post? Well, all things being equal, the point during the tax year that a pass-through entity (“PTE”) sells its qualified business may have a significant impact upon the Sec. 199A deduction that may be claimed by the PTE’s non-corporate owners.

A quick review of some Sec. 199A basics may be helpful.[ii]

Section 199A Limitations

In general, Section 199A provides non-corporate taxpayers with a deduction for a tax year equal to 20% of their qualified business income (“QBI”) for such year.

There are, however, certain limitations that may reduce the amount of the deduction that may be claimed by a taxpayer. One of these is tied to the taxpayer’s taxable income for the year; the other – which only applies to a taxpayer with taxable income in excess of a prescribed threshold and phase-in amount – is tied to (1) the W-2 wages paid by the business to its employees during the tax year, and (2) the unadjusted basis of certain depreciable tangible property (“qualified property”) held by the business at the close of the tax year.

199A Applied at Shareholder/Partner Level

Generally speaking, for purposes of Section 199A, a non-corporate taxpayer – meaning an individual, a trust, or an estate – is treated as being engaged in any qualified trade or business carried on by a PTE of which the taxpayer is an owner.

Thus, the Section 199A rules are applied at the level of the S corporation shareholder, or at the level of the partner/member of the partnership/LLC, with each shareholder or partner taking into account their allocable share of the PTE’s QBI, as well as their share of the PTE’s W-2 wages and unadjusted basis (for purposes of applying the above-referenced limitations).[iii]

Qualified Business Income – In General

Section 199A is primarily concerned with the operating (i.e., ordinary) income that is generated by the PTE entity, and passed through to its owners, during the ordinary course of its business. Thus, investment income is excluded from an entity’s QBI; this would include any capital gain recognized by the PTE.

A PTE does not typically generate capital gain in the ordinary course of its business; rather, it generates ordinary income from the sale of products or services, or from the leasing/licensing of its property. That is not to say that it never has such gain; for example, a business that sells vacant land, that it had previously held for purposes of a possible future expansion, may recognize capital gain on such sale. This gain would not constitute an item of QBI.

Sale of Assets – In General

Of course, a PTE is most likely to recognize capital gain on the sale of all, or substantially all, of its business assets. This sale may be effected in a number of ways.

Actual Sale. The business may simply sell its assets to a buyer, or it may merge into the buyer, in exchange for cash and/or a promissory note (or other deferred payment, such as an earn-out) and/or other property.

Deemed Sale. Alternatively, in the case of an S corporation, the shareholders may sell its stock and then elect (either jointly with the buyer, or on their own) to treat the stock sale as a sale of the corporation’s assets. Similar treatment may be accorded to the partners of a partnership who sell all of their partnership interests to a buyer, though without the need for a special election.

Nature of the Gain. The nature of the gain recognized by the PTE will depend upon the character of the assets being sold; the amount of such gain will depend upon the allocation of the purchase price among the assets being sold and the entity’s adjusted basis for such assets. The character of the gain included in a shareholder’s or a partner’s allocable share of S corporation or partnership gain is determined as if it were realized directly from the source from which it was realized by the PTE.

Thus, any income realized on the sale of accounts receivable or inventory will be treated as ordinary income. The gain realized on the sale of a capital asset, on the sale of property used in the trade or business of a character that may be depreciable, or on the sale of real property used in a trade or business, will generally be treated as capital gain.

Section 199A and the Sale of a Business

As indicated above, the tax treatment of an M&A transaction, like the actual or deemed sale of assets by a business, was certainly not what Congress was focused on when Section 199A was conceived.

After all, the non-corporate owners of PTEs already enjoy a single level of tax (generally no tax at the entity-level, unlike a C corporation) and a preferential 20% tax rate for capital gains.[iv]

That being said, Section 199A will play a role in the sale of a business owned by a PTE with non-corporate owners where the transaction is treated as a sale of assets for tax purposes.

At the same time, the sale of the business, and the timing of such sale – i.e., the point in the tax year at which the sale occurs – may impact a non-corporate owner’s ability to fully enjoy the benefit of a Section 199A deduction.

Let’s review each of these points.

The Deduction

Although the Section 199A deduction is often described in shorthand as being equal to 20% of a taxpayer’s QBI, the actual formulation is much more involved.

Specifically, a non-corporate taxpayer’s Section 199A deduction for a tax year is equal to the lesser of:

(1) the taxpayer’s “qualified business income amount” for that tax year, or

(2) 20% of the excess of:

(a) the taxpayer’s taxable income, over

(b) the taxpayer’s capital gain, for the tax year.

Assume for this purpose that the taxpayer owns equity in only one PTE, and that there are no REIT dividends or PTP income. Assume also that the limitations based on W-2 wages and the “unadjusted basis” of qualified property are fully applicable because the taxpayer’s taxable income exceeds the prescribed threshold and phase-in amounts.

Qualified Business Income Amount. In that case, the taxpayer’s qualified business income amount for the tax year is equal to the lesser of:

(1) 20% of the taxpayer’s QBI, or

(2) the greater of:

(a) 50% of the W-2 wages with respect to the business, or

(b) 25% of such wages plus 2.5% of the unadjusted basis of its qualified property.

Thus, the greater the amount of W-2 wages paid by a business during the tax year, and the greater the unadjusted basis of the property held by the business at the close of its tax year, the closer to the full 20% deduction the taxpayer is likely to come.

Income from the Sale of Assets. Assume that the PTE sells its assets to an unrelated party in a fully taxable exchange for cash at closing.

As we saw above, the nature of the gain recognized by the pass-through entity on the sale of its assets – which will be passed through to its owners for tax purposes – will depend upon the nature of the asset sold.

Thus, the gain from the sale of inventory and receivables will be treated as ordinary; the gain from the sale of tangible personal property which has been depreciated is likely to be ordinary as well (so-called “depreciation recapture”).

The gain from the sale of real property that is used in the pass-through entity’s business will be treated as capital, as will the gain from the sale of the goodwill and going concern value of the business. In many cases, the single largest component of the gain resulting from the sale of a business is attributable to its goodwill.

Qualified Business Income – Sale of Assets

What does this treatment mean for purposes of Section 199A?

The Code provides that the term QBI means, for any tax year, the net amount of “qualified items” of income, gain, deduction and loss with respect to a qualified trade or business of the taxpayer.

Qualified items does not include any item of capital gain or capital loss. According to the Regulations, to the extent an item is not treated as an item of capital gain or capital loss under any provision of the Code, such item shall be taken into account as a qualified item of income, gain, deduction or loss for purposes of determining QBI.

Thus, gain generated from the sale of assets that is treated as ordinary income will be included in QBI, while gain that is treated as capital will not be; both will be included in taxable income for purposes of applying the above limitation (based on 20% of the excess of a taxpayer’s taxable income over the taxpayer’s capital gain).

W-2 Wages and Unadjusted Basis

What about the limitations based upon W-2 wages and unadjusted basis? How will these be affected by the sale of a business?

After a PTE sells its assets, it will usually cease to have a significant number of employees. For instance, if the sale was to a strategic buyer, that buyer may consolidate the PTE’s workforce with its own, or it may terminate many of the PTE’s former employees; in the case of a private equity buyer, its acquisition vehicle will typically hire the PTE’s workforce.

The Code recognized that where a qualified business was sold, the ability of the selling PTE to claim the Section 199A deduction would be impacted. Thus, the Code directed the IRS to issue regulations to address the application of the limitations in the case where the entity sold its business during the tax year.

W-2 Wages. According to the regulations issued by the IRS, when a business is sold, and the employees of the business thereby become employees of the buyer, their W-2 wages for the year of the sale must be allocated between the two employers (the seller and the buyer) based on the period during which they were employed by one and then the other.

In other words, in determining its limitation based on W-2 wages, the seller-employer can look only to the W-2 wages it paid to its employees through the date of the sale.

Unadjusted Basis. As regards the limitation that is based, in part, on the unadjusted basis of qualified property, the Code states that the property must be held by the business at the close of its tax year.

The Regulations conform to this position, having rejected a suggestion that they include a rule for determining the unadjusted basis of qualified property following the sale of a business similar to the guidance provided for purposes of calculating W-2 wages (based on the number of days the qualified property was held by the seller during the year – see above).

Thus, if a selling PTE does not hold any qualified property at the close of its taxable year, its owners cannot avail themselves of the alternative limitation based on the unadjusted basis of such property (i.e., 25% of W-2 wages, plus 2.5% of unadjusted basis).

This raises an interesting question.

S Corps & Section 338(h)(10)

When a PTE sells its assets, its tax year does not automatically close; something more is required. Specifically, the entity must liquidate, which will include the distribution to its owners of the net proceeds from the sale of the business.

But what if the PTE is an S corporation? When the shareholders of an S corporation sell their stock to a corporate buyer, and they join the buyer in electing to treat the stock sale as a sale of assets (under Section 338(h)(10) of the Code), the S corporation is treated as having sold its assets just before, and as having liquidated at, the end of the day that the sale occurred. That is the same day that the S corporation’s tax year closes.

Will the S corporation be treated as having held its assets as of the close of its tax year for purposes of applying the unadjusted basis limitation? The Regulations don’t tell us.

If so, will a PTE that actually sells its assets have to liquidate immediately afterward, on the day of the sale, so as to force the close of its tax year? That remains to be seen.

Timing of the Sale

As you may have gathered from the foregoing, the point during the year at which the PTE sells its business may impact the Section 199A deduction that may be claimed by its owners.

Let’s take the extreme: a sale on January 1 by an entity that uses the calendar year as its tax year. It has no QBI on that date except to the extent the sale generates ordinary income that is treated as QBI. If the bulk of the sale gain – and the bulk of the entity’s income for the year – is treated as capital gain, then the owners may be out of luck insofar as a Section 199A deduction is concerned.

Even the qualified business income generated in the sale may not result in a Section 199A deduction because the entity may not have paid much in the way of W-2 wages by the time of the sale. Remember: the taxpayer’s qualified business income amount for the tax year is equal to the lesser of: (i) 20% of the taxpayer’s QBI, or (ii) 50% of the W-2 wages[v] with respect to the business.[vi]

What’s more, the limitation based on 20% of the excess of (1) the taxpayer’s taxable income, over (2) the taxpayer’s capital gain, for the tax year, may be even lower than the limitation based on W-2 wages, where the taxpayer’s capital gain far exceeds their ordinary income.

On the other hand, if the sale occurs midyear, for example, the business will have generated more ordinary income from its normal operations, in addition to the gain from the sale of its assets. In other words, there will be more QBI that the owners will take into account in determining their Section 199A deduction, though there will also be more ordinary income on which they will be taxed.

At the same, the entity will have paid more W-2 wages by that time, so that the limitation is also increased.

Following this reasoning, a sale that occurs in December (again, assuming the entity uses a calendar year as its tax year) will allow the entity to generate almost a full year’s worth of QBI; it will also allow it to pay almost a full year’s worth of W-2 wages. Both these items should result in a larger Section 199A deduction for the owners of the PTE.

The one item that generally does not change during the course of the tax year, but which must be held at the end of the tax year in order to be accounted for in determining the limitation on the Section 199A deduction is the unadjusted basis for qualified property.

When this property is sold, then, by definition, the selling entity will not hold it at the end of its tax year. That being said, should it make a difference in the application of the rule where the sale of the business and the immediate liquidation of the seller (actual or deemed) occur on the same date, with the liquidation marking the end of the tax year; should the seller be treated as having held the property on such date for purposes of the rule? The IRS has not addressed this point.

In light of the foregoing, might a PTE owner that is being pressured by a buyer to sell its business early in its tax year argue for an increase in the sales price to the extent of any Section 199A tax benefit expected to be “lost?” As always, it will depend upon the taxpayer’s unique facts and circumstances, but prudence may dictate that the seller accept the deal being offered without regard to Section 199A.[vii]

[i] Yes, I saw “Spamalot” last week and I am still imitating Arthur and his knights, not to mention the taunting Frenchmen. Remember the Holy Hand Grenade? “And the Lord spake, saying, ‘First shalt thou take out the Holy Pin. Then, shalt thou count to three, no more, no less. Three shall be the number thou shalt count, and the number of the counting shall be three. Four shalt thou not count, nor either count thou two, excepting that thou then proceed to three. Five is right out! Once the number three, being the third number, be reached, then lobbest thou thy Holy Hand Grenade of Antioch towards thou foe, who being naughty in my sight, shall snuff it.'”

[ii] A reminder: the provision disappears after 2025.

[iii] Because the Section 199A limitations are applied at the level of the non-corporate shareholder or partner, without regard to the owner’s degree of involvement or participation in the conduct of the business, it is possible for owners with identical equity interests in the same pass-through entity to have very different Section 199A deductions; for example, one partner may have more taxable income than another (perhaps because they receive a so-called “guaranteed payment” for services rendered to the partnership), such that the limitations apply to the former but not to the latter.

[iv] If the non-corporate owner is a material participant in the business, they also avoid the 3.8% surtax on net investment income.

[v] Or 25% of W-2 wages plus 2.5% of the unadjusted basis of qualified property.

[vi] Query whether a change in control bonus payment made to the seller’s employees in connection with the sale would address this limitation. These must be attributable to QBI in order to be taken into account as W-2 wages. Of course, if the employer was not already planning for such a bonus in the first place, is the 199A juice worth the squeeze?

[vii] Bird in hand, and all that.

“You Know What I Meant”

In order to determine the income tax consequences of a given transaction, a court must sometimes ascertain the intention of the taxpayers who were parties to the transaction. In making its determination, the court will consider all of the relevant facts and circumstances, including the terms of any written agreement between the parties, the tax returns filed by the parties, the parties’ testimony and actions, and other indicia of intent.

In prior posts, we have discussed situations in which a court had to evaluate whether a transaction constituted a loan or a contribution to capital, a gift or an arm’s-length transfer, compensation or a loan, a sale or a lease, an option or a sale, etc. We have considered the capacity in which one or more parties to a transaction were acting; for example, as a shareholder or as a representative of a corporation, as an employee or as an individual, as a corporate officer or as a parent.

Depending upon the characterization of the transaction, and the identity of the parties, a taxpayer may have to recognize ordinary income or capital gain, or they may have no immediate taxable event at all.

Too often, however, and especially in the context of dealings involving a closely held business, the parties to the transaction – which may include the settlement of a dispute – will fail to set forth their agreement in sufficient detail, including its intended tax treatment.[i]

An unscrupulous party may seek to exploit any ambiguity for its own benefit by taking a position that is inconsistent with the parties’ implicit agreement or understanding, whether from a tax perspective or otherwise.

Alternatively, a taxing authority may rely upon an ambiguity to interpret an agreement and its tax consequences in a way that is inconsistent with a party’s tax return position.

Either way, at least one of the parties risks an economic loss.

A Recent Illustration

Employer provided business-to-business lead generation services for its clients.

Under Taxpayer’s initial employment contract, Employer paid Taxpayer both a salary and a commission. Under the terms of the contract, Taxpayer’s salary was reduced over time, the expectation being that his commissions would represent a greater portion of his pay as he settled into his position. At the same time, Taxpayer’s commission rate also decreased over time, thus creating an incentive for Taxpayer to sign new clients. Taxpayer and Employer later modified his compensation structure, forgoing any salary in favor of straight commission payments.

The IP

After being hired, Taxpayer began to design a method by which a business could allocate leads and target marketing efforts more effectively (the “IP”). Taxpayer filed a provisional patent application for the IP; after Employer waived any rights it had in the IP, Taxpayer filed a regular patent application.

Taxpayer used the IP to secure several important accounts for Employer. He was not involved in managing the accounts after he secured them.

A couple of years into their relationship, Taxpayer and Employer signed a broker agreement under which Taxpayer was no longer an employee of Employer but, instead, a broker acting on Employer’s behalf through Taxpayer’s wholly-owned S corporation (“Corp”). Under this agreement, Taxpayer continued to receive a commission from new account billings, but only for three years from the date on which Employer’s work on an account originated.

PC Wants the IP

At some point, Employer’s parent company (“PC”) began to consider a sale of Employer. In preparation for the sale of Employer, PC sought to obtain, and approached Taxpayer about acquiring, the rights to the IP.

As it turned out, Taxpayer needed cash to support another venture, so he was amenable to a transfer. He proposed two options: (1) he would license the IP to PC and receive royalties, which would increase once the patent was awarded; or (2) he would assign all rights in the IP to PC, in exchange for an extension of his commissions[ii] from certain accounts (the “Accounts”).

The Agreement

Taxpayer executed an assignment of the IP to PC. At the same time, Taxpayer and PC executed a written addendum to his commission structure (the “addendum”) that extended the period during which Taxpayer would receive commissions from the Accounts.

The addendum also provided that, in the event PC terminated its relationship with Taxpayer, PC would “pay the equivalent of one month’s commission (based on the average of the most recent 12 months of commissions) for each year of service provided.” Neither party consulted a lawyer in connection with the transfer of the IP or the addendum.

Tax Reporting

During the taxable year in issue, Taxpayer received commissions from the Accounts, and Employer issued a Form 1099-MISC, Miscellaneous Income, to Corp reporting a payment of nonemployee compensation.

One year later, PC terminated its broker relationship with Corp as it prepared to file for bankruptcy. Taxpayer filed a proof of claim in PC’s bankruptcy case for severance pay.

Taxpayer reported only $400 of long-term capital gain[iii] on his Form 1040, U.S. Individual Income Tax Return for the year in issue. Corp reported over $1.3 million of total income[iv] on its Form 1120S, U.S. Income Tax Return for an S Corporation.

Later, however, Taxpayer and Corp amended their respective returns: Taxpayer reported over $800,000 of long-term capital gains and attributed them to the transfer of the IP; Corp reduced its reported total income by the same amount, on its Form 1120S, which resulted in a loss for the tax year.

The IRS questioned whether the payments to Taxpayer, attributable to the above-referenced addendum, were made in consideration for the transfer of the IP; it asserted that the payments actually represented commissions that were taxable as ordinary income. The IRS issued a notice of deficiency, and Taxpayer petitioned the U.S. Tax Court.

Classification of Income

The question before the Court was whether any of the payments under the addendum were in exchange for Taxpayer’s assignment of the IP, or were owed to Corp under its broker agreement.

Section 1235

The Court began its analysis by reviewing Section 1235 of the Code , which provides that the “transfer * * * of property consisting of all substantial rights to a patent * * * by any holder[v] shall be considered the sale or exchange of a capital asset held for more than 1 year.”[vi] This treatment, the Court observed, applies regardless of whether payments in consideration of the transfer are payable periodically or are contingent on the productivity, use, or disposition of the property. Moreover, the patent need not be in existence at the time of transfer if the requirements of Section 1235 are otherwise met.[vii]

According to the Court, the term “all substantial rights to a patent” means “all rights * * * which are of value at the time the rights to the patent * * * are transferred.”

In determining whether all substantial rights in the IP were transferred, the Court stated that it would consider “[t]he circumstances of the whole transaction, rather than the particular terminology used in the instrument of transfer.”

The Court noted that the IRS did not dispute that the IP was transferred, or that the transfer of the IP met the requirements of Section 1235. However, the IRS disputed that the payments attributable to the addendum were made in consideration for that transfer; without that direct nexus, the payments would not be treated as long-term capital gain under Section 1235.

Contract Interpretation

Turning to the addendum, the Court stated that “[t]he cardinal rule in the interpretation of contracts is to ascertain the mutual intention of the parties.”

It then added that, under applicable State law, the Court would limit the scope of its search to the four corners of the document if its terms were “clear and unambiguous.” Where the terms of the document were unclear or ambiguous, the Court “may consider extrinsic evidence as well as the parties’ interpretation of the contract to explain or clarify the ambiguous language.” The parties’ construction of ambiguous terms in a contract, the Court added, “is entitled to great weight in determining its meaning.”

The Court found that the text of the addendum was susceptible of more than one interpretation.

The IRS’s Position

The IRS contended that the payments under the addendum were not consideration for the IP but, rather, for some other purpose, and that Taxpayer was compensated for the IP – which the IRS argued had little to no value – in some other way. First, the IRS pointed out that there was no reference in the addendum to the transfer, Taxpayer did not retain a security interest in the IP, and the addendum included several provisions that were standard in a commission agreement. Second, the IRS argued that the circumstances surrounding the addendum did not support Taxpayer’s claim; specifically, the IRS asserted that the addendum was executed before Taxpayer’s discussion with PC about transferring the IP. And third, the IRS argued that the form of the transaction did not support Taxpayer’s claim because both PC (on a Form 1099-MISC) and Taxpayer (on his tax return) initially reported the payments as nonemployee compensation to Corp, rather than as consideration for the IP; according to the IRS, Taxpayer should escape the tax consequences of his chosen form.[viii]

The Court Disagrees

The Court acknowledged that there was no explicit reference to the transfer of the IP in the addendum, and the date on the addendum seemed to support the IRS’s contention that the addendum was signed before and, therefore, was independent of the Taxpayer’s discussions about the transfer of the IP.

However, the Court believed that PC’s representative credibly testified that she approached Taxpayer about the transfer of the IP in the year immediately preceding the year in which the addendum was executed. She and Taxpayer also credibly testified that they understood the addendum to be consideration for the rights to the IP. The Court believed it was significant that the parties to the addendum conceived of it in the same way.

The Court turned next to the date the addendum was signed, commenting that it was possible that the addendum was signed in contemplation of some sort of transfer. In any event, in the context of the other evidence, in particular the credible testimony of key participants in the transaction, the Court stated that it could not decide that the date on the addendum foreclosed a conclusion that PC agreed to pay the additional amounts under the addendum in exchange for the IP.

The IRS also argued that the addendum was some kind of “makeshift noncompete agreement,” rather than consideration for the rights to the IP, and that PC compensated Taxpayer for those rights in some other way.

However, Taxpayer had no involvement with the Accounts after securing them for Employer, and the Court found no evidence that Taxpayer had the desire or the capacity to manage the Accounts himself. Furthermore, the record showed that PC assigned some value to the IP – it sought to acquire the IP from Taxpayer, not a noncompete agreement. For this reason, the Court also rejected the IRS’s theory that the IP had only nominal value to PC. The Court was also convinced that PC wanted something in return for the additional payments under the modified addendum, and the only valuable consideration remaining was the IP.

Therefore, the Court found that the addendum provided for additional payments in exchange for Taxpayer’s transfer of all his rights in the IP to PC (notwithstanding that the amount of such payments was determined by reference to a formula that had been used to calculate the Taxpayer’s commission for services rendered).

The Court also found that Taxpayer’s failure to retain a security interest was a reflection of the parties’ circumstances as they were discussing the transfer rather than evidence that the addendum constituted an ordinary commission or noncompete agreement. Both Taxpayer and PC were focused on transferring the IP as soon as possible – Taxpayer wanted cash to invest in a new venture, and PC wanted to obtain the rights before PC was sold.[ix]

Thus, the Court concluded that Taxpayer’s transfer of the IP to PC met the requirements for long-term capital gain treatment under Section 1235 of the Code. Because the payments on the Accounts attributable to the addendum were consideration for the rights to the IP, those payments were properly classified as long-term capital gains.

“That’s Not What You Said”

Taxpayer had a close call. The addendum did not refer to the transfer of the IP. It did refer to the commission payments on the Accounts, which had previously been treated as ordinary income to Taxpayer. Employer issued a 1099-MISC to Corp, reporting non-employee compensation, and Taxpayer and Corp initially filed their respective income tax returns consistently therewith. Neither party to the addendum sought an appraisal of the IP. Finally, it should be noted that, by the time of the Tax Court proceeding, the patent application had been abandoned, presumably by PC, which may have been an indication of its value.

It appears that Taxpayer’s success in the face of the foregoing rested, in large part, upon the “credible testimony” of Taxpayer and of the PC representative who negotiated the terms of the addendum. Not the ideal game plan, especially where the taxpayer bears the burden of proof; after all, memories become stale, people disappear, and relationships deteriorate.

Taxpayer would have been better served if he and PC had retained counsel to ensure that the addendum – within its four corners – accurately reflected their understanding regarding the transfer of the IP and the payments made in exchange therefor.[x]

Of course, there are situations in which the parties to an agreement “genuinely” disagree on the tax treatment of a specific payment made pursuant to its terms, usually as a result of someone’s not having focused on it. For example, the payment made by a partnership to a departing partner in liquidation of their interest where the agreement fails to properly characterize the payment for tax purposes. The partnership may seek to treat such a payment as a guaranteed payment (deductible by the partnership, and includible as ordinary income by the former partner, for tax purposes), whereas the former partner will treat it as a payment made in exchange for their interest in the partnership’s assets, including goodwill (treated as a return of capital, and then as capital gain, except to the extent of any “hot assets”).[xi]

Then there are those situations where a “not-so-good” actor will do as they please insofar as reporting the tax consequences of a transaction is concerned.[xii]

In most cases, it will behoove the conscientious taxpayer and their advisors to ensure, as best they can, that the four-corners of the agreement either express the tax treatment intended by the parties, or include such terms that inexorably manifest such intent. If a taxpayer is unable to secure the foregoing, then they should be on alert as to the intentions of the other party, and act accordingly.


[i] Too many times have I heard a fellow adviser say that some ambiguity on a key term of a transaction document or settlement agreement may be a good thing; yeah, if you enjoy litigation and the associated costs and anxiety.

One of my high school physics teachers had a sign above his blackboard that read, “Eschew Obfuscation.” Thank you, Mr. Gordon.

[ii] Normally treated as ordinary income by Taxpayer, and deductible by Employer under Sec. 162 as an ordinary and necessary business expense.

[iii] Seemingly unrelated to the IP.

[iv] Based on the 1099-MISC.

[v] The “holder,” for purposes of Section 1235, includes “any individual whose efforts created such property.”

[vi] And taxed as long-term capital gain.

[vii] Sec. 1.1235-2(a).

[viii] The “Danielson rule.” In brief: although a taxpayer is free to organize their affairs as they choose, once having done so, they must accept the tax consequences of such choice, whether contemplated or not, and may not enjoy the benefit of some other route they might have chosen to follow but did not. A taxpayer who falls within the scope of this rule is generally stuck with the form of their business transaction, and can make an argument that substance should prevail over that form only if a limited class of exceptions applies.

[ix] Finally, the Court was not convinced that PC’s reporting of the payments indicated that the addendum did not relate to the IP. Because those payments mirrored Taxpayer’s commissions, it was reasonable for both PC and Taxpayer to continue reporting commission payments as they always had in the absence of any tax or legal advice. The Court would not bind Taxpayer to the reporting by PC in the face of other contrary evidence.

[x] Query, however, whether an appraisal of the IP would have defeated capital gain treatment for the transfer of the IP. What if its fair market value was insignificant?

What if PC or Employer had deducted the payments on their tax return(s)?

[xi] IRC Sec. 736.

[xii] Form 8082 may come in handy at that point.

Committed to a Zone

Last week’s post[i] considered how the newly-enacted qualified opportunity zone (“QOZ”) rules seek to encourage investment and stimulate economic growth in certain distressed communities by providing various federal income tax benefits to taxpayers who invest in businesses that operate within these zones.[ii] After describing these tax incentives, the post cautioned taxpayers who may have already recognized capital gain,[iii] or who are planning to sell or exchange property in a transaction that will generate taxable capital gain, that the tax incentives, although attractive, may be indicative of some not insignificant economic risk that is associated with the targeted investment.[iv]

This week, we continue our discussion of the QOZ rules,[v] beginning with the premise that the taxpayer already owns a business in a QOZ,[vi] or is already committed to investing in a QOZ.[vii] In other words, the taxpayer has already considered the risks of expanding within, or of moving into, such an area, and they have decided that it makes sense to do so from a long-term economic or business perspective. As to this taxpayer, the new tax incentives coincide with their long-term investment horizon, and also offer the opportunity[viii] to increase the taxpayer’s after-tax return on their investment.[ix]

However, in order to enjoy these tax benefits, the taxpayer[x] has to invest its “eligible gains”[xi] in a “qualified opportunity fund” (“QOF”).

What’s a Fund?

The use of the word “fund” may be misleading to some, who may interpret it strictly as a vehicle by which several investors can pool their resources for purposes of acquiring interests in one or more qualifying businesses.

The regulations proposed by the IRS provide that a QOF must be an entity that is classified as a partnership or as a corporation for federal income tax purposes. The reference to a “partnership” necessarily requires that there be at least two members that are respected as separate from one another for tax purposes.[xii]

The fact that a number of asset and wealth management businesses seem to have formed QOFs, and have begun to solicit investments therein from the “general public,” has reinforced the impression that a QOF must be some kind of pooled investment vehicle.[xiii]

Although such a vehicle generally offers single investors the opportunity[xiv] to combine their money to increase their “buying power,” decrease their individual risk, attain a level of diversification, and gain other advantages, such as professional management, there is nothing in the Code or in the regulations proposed thereunder that requires a QOF to be a multi-member investment vehicle.[xv]

In other words, so long as the subject entity is formed as a partnership, it can have as few as two investor-members and may still qualify as a QOF; in the case of a corporation, it can have only as few as one shareholder. Thus, a closely held business entity may be QOF.

That being said, there are a number of other requirements that the partnership or corporation must satisfy in order to be treated as a QOF, and that may prevent a closely held business from qualifying.

Requirements for QOF Status

Corporation or Partnership. The fund must be created or organized as a partnership or as a corporation in one of the 50 States, the District of Columbia, or a U.S. possession;[xvi] it must be organized for the purpose of investing in “QOZ property,” but not in another QOF.

A corporation may be a C corporation, or its shareholders may elect to treat it as an S corporation.[xvii] Alternatively, the fund may be formed as an LLC but elect to be treated as a corporation for tax purposes.[xviii]

New or Pre-existing. Moreover, the partnership or corporation may be a pre-existing entity and still qualify as a QOF,[xix] provided that the pre-existing entity satisfies the requirements for QOF status, including the requirement that QOZ property be acquired after December 31, 2017.[xx]

90 Percent of Asset Test. In addition, the fund must hold at least 90 percent of its assets[xxi] in “QOZ property,” determined by the average of the percentage of QOZ property held in the fund as measured (A) on the last day of the first 6-month period of the taxable year of the fund,[xxii] and (B) on the last day of the taxable year of the fund.[xxiii]

QOZ Property; QOZ Business Property

The following three kinds of property are treated as QOZ property that is counted toward the 90 percent test:

  • QOZ stock,
      • which is stock in a corporation that is acquired by the fund after December 31, 2017,
      • at its original issue,[xxiv] from the corporation,
      • solely in exchange for cash,
      • as of the time the stock was issued, the corporation was a “QOZ business” (or the corporation was being organized for purposes of being such a business), and
      • during “substantially all” of the fund’s holding period for the stock, the corporation qualified as a QOZ business;
  • QOZ partnership interest,
      • which is any capital or profits interest in a partnership,
      • that is acquired by a fund after December 31, 2017,
      • from the partnership,
      • solely in exchange for cash,
      • as of the time the partnership interest was acquired, the partnership was a “QOZ business” (or the partnership was being organized for purposes of being a QOZ business), and
      • (c) during “substantially all” of the fund’s holding period for the partnership interest, the partnership qualified as a QOZ business; and
  • QOZ business property,
      • which is tangible property used in a trade or business of the fund,
      • that was purchased by the fund after December 31, 2017,
      • from an “unrelated” person,[xxv]
      • for which the fund has a cost basis,
      • (i) the “original use”[xxvi] of which within the QOZ commences with the fund, or (ii) which the fund “substantially improves;” and
      • during “substantially all of the fund’s holding period” for the tangible property, “substantially all of the use” of the tangible property was in the QOZ.[xxvii]

N.B. Consequently, if a QOF operates a trade or business directly, and does not hold any equity in a QOZ business formed as a corporation or partnership, at least 90 percent of the QOF’s assets must be QOZ business property; i.e., it must be tangible property – no more than 10 percent of its property can be intangible property, such as goodwill.[xxviii]

Substantially Improved. The definition of QOZ business property basically requires the property to be used in a QOZ, and also requires that new capital be employed in a QOZ.

Specifically, tangible property is treated as “substantially improved” by a QOF (for purposes of applying the definition of QOZ business property) only if, during any 30-month period beginning after the date of acquisition of the property, additions to the basis of the property in the hands of the QOF exceed an amount equal to the adjusted basis of the property at the beginning of the 30-month period in the hands of the QOF; in other words, the fund must at least double the adjusted basis of the property during such 30-month period. For example, if property is acquired in February of 2019, it must be substantially improved by August 2021.

Significantly, if a QOF purchases a building located on land wholly within a QOZ, a substantial improvement to the purchased tangible property is measured by the QOF’s additions to the adjusted basis of the building only; the QOF is not required to separately “substantially improve” the land upon which the building is located.[xxix]

QOZ Business

In order for a share of stock in a corporation, or for a partnership interest, to be treated as QOZ property in the hands of a fund, the issuing entity must be a QOZ business, which is any trade or business:

      • In which “substantially all” of the tangible property owned or leased by the trade or business is QOZ business property;[xxx]
      • At least 50 percent of the total gross income of which is derived from the “active conduct of business”[xxxi] in the QOZ;
      • A “substantial portion” of the business’s intangible property is used in the active conduct of business[xxxii] in the QOZ; and
      • Less than 5 percent of the average of the aggregate adjusted bases of the property of the business is attributable to “nonqualified financial property;”[xxxiii]
          • nonqualified financial property does not include “reasonable amounts” of working capital held in cash, cash equivalents, or debt instruments with a term of no more than 18 months;
          • nor does it include accounts or notes receivable acquired in the ordinary course of a trade or business for services rendered or from the sale of inventory property;
      • The trade or business is not a golf course, country club, massage parlor, hot tub or suntan facility, racetrack or other facility used for gambling, or store whose principal business is the sale of alcoholic beverages for consumption off premises.[xxxiv]

Substantially All. A corporation’s or partnership’s trade or business is treated as satisfying the “substantially all” requirement (for purposes of applying the definition of QOZ business) if at least 70 percent of the tangible property owned or leased by the trade or business is QOZ business property.[xxxv] (This is to be compared to the requirement that 90 percent of the fund’s assets must be QOZ business property where the fund directly owns only a trade or business.)

Working Capital. For purposes of applying the limit on nonqualified financial property, working capital assets will be treated as reasonable in amount if all of the following requirements are satisfied:

  • The amounts are designated in writing for the acquisition, construction, and/or substantial improvement of tangible property in a QOZ.
  • There is a written schedule consistent with the ordinary start-up of a trade or business for the expenditure of the working capital assets.
  • Under the schedule, the working capital assets must be spent within 31 months of the receipt by the business of the assets.[xxxvi]
  • The working capital assets are actually used in a manner that is “substantially consistent” with the foregoing.[xxxvii]

Similarly, a safe harbor is provided for purposes of applying the 50-percent test for gross income derived from the active conduct of business. Specifically, if any gross income is derived from property that is treated as a reasonable amount of working capital, then that gross income is counted toward satisfaction of the 50-percent test.[xxxviii]

Substantial Portion. The requirement that a “substantial portion” of the business’s “intangible property” be used in the active conduct of business will be treated as being satisfied during any period in which the business is proceeding in a manner that is substantially consistent with the use of the working capital described above.

Although these “safe harbors” are helpful, the absence of guidance on other requirements is troubling, including those related to the fund’s “active conduct of business;” for example, will rental real estate be treated as an active trade or business for this purpose?

N.B. It is noteworthy that the proposed safe harbor for working capital applies only in determining whether a partnership or corporation in which a QOF owns an interest (a lower-tier entity) qualifies as a QOZ business. It does not apply to a trade or business that is owned directly by a fund, thereby making the 90 percent test more restrictive.

The 90 Percent of Assets Test

As indicated above, a QOF must undergo semi-annual tests to determine whether its assets consist, on average, of at least 90 percent QOZ property. For purposes of these semi-annual tests, a tangible asset can be treated as QOZ business property by a find that has self-certified as a QOF (or an operating subsidiary corporation or partnership) only if it acquired the asset after 2017 by purchase.

For purposes of the calculation of the “90 percent of assets test” by the QOF, the QOF is required to use the asset values that are reported on the QOF’s applicable financial statement for the taxable year.[xxxix]

Failing the 90 Percent. In general, if a fund fails to satisfy the 90 percent test, a monthly penalty will be imposed on the fund in an amount equal to the product of:

(A) the excess of (1) the amount equal to 90 percent of the fund’s aggregate assets, over (2) the aggregate amount of QOZ property held by the fund, multiplied by (B) the underpayment rate. This penalty will not apply before the first month in which the entity qualifies as a QOF.

Working Capital Safe Harbor. Query whether cash be an appropriate QOF property for purposes of the 90 percent test if the cash is held with the intent of investing in QOZ property? Specifically, because developing a new business or the construction or rehabilitation of real estate may take longer than six months (i.e., the period between testing dates), QOFs should be given longer than six months to invest in qualifying assets.[xl]

The proposed regulations provide a working capital safe harbor for QOF investments in QOZ businesses (i.e., partnerships and corporations) that acquire, construct, or rehabilitate tangible business property, which includes both real property and other tangible property used in a business operating in an opportunity zone.

The safe harbor allows qualified opportunity zone businesses a period of up to 31 months, if there is a written plan that identifies the financial property as property held for the acquisition, construction, or substantial improvement of tangible property in the opportunity zone, there is written schedule consistent with the ordinary business operations of the business that the property will be used within 31 months, and the business substantially complies with the schedule. Taxpayers would be required to retain any written plan in their records.[xli]

If a corporation or partnership qualifies as a QOZ business, the value of the QOF’s entire interest in the entity counts toward the QOF’s satisfaction of the 90 percent test. Thus, if a QOF operates a trade or business (or multiple trades or businesses) through one or more partnerships or corporations, then the QOF can satisfy the 90 percent test if each of the entities qualifies as a QOZ business;[xlii] among other things, “substantially all” of the tangible property owned or leased by the entity must be QOZ business property.

A business will be treated as satisfying the substantially all requirement for this purpose if at least 70 percent of the tangible property owned or leased by a trade or business is QOZ business property.[xliii]

N.B. Again, it is noteworthy that the proposed 70 percent test for purposes of satisfying the substantially all requirement applies only in determining whether a partnership or corporation in which a QOF owns an interest (a lower-tier entity) qualifies as a QOZ business. It does not apply to a trade or business that is owned directly by a fund; it appears that no more than 10 percent of the assets of such a business can be cash or intangibles (like goodwill).

Certification as a QOF

In order to facilitate the investment process, and minimize the information collection burden placed on taxpayers, a corporation or partnership that is eligible to be a QOF is allowed to self-certify that it is organized as a QOF.

The self-certification must identify the first taxable year that the fund wants to be a QOF; it may also identify the first month (in that initial taxable year) in which it wants to be a QOF.[xliv]

If a taxpayer who has recognized gain invests in a fund prior to the fund’s first month as a QOF, any election to defer such gain with that investment is invalid.

Return. It is expected that a fund will use IRS Form 8996, Qualified Opportunity Fund,[xlv] both for its initial self-certification and for its annual reporting of compliance with the 90-percent test. It is also expected that the Form 8996 would be attached to the fund’s federal income tax return for the relevant tax years.[xlvi]

The proposed regulations allow a QOF both to identify the taxable year in which the entity becomes a QOF and to choose the first month in that year to be treated as a QOF. If an eligible entity fails to specify the first month it is a QOF, then the first month of its initial taxable year as a QOF is treated as the first month that the eligible entity is a QOF.[xlvii]


The QOZ rules were enacted in December of 2017. Regulations were proposed in October of 2018. The IRS has indicated that a second round of proposed regulations will be released relatively soon. The period for recognizing capital gains that will be eligible for reinvesting in QOFs and enjoying the resulting tax benefits expires in 2026.[xlviii] Many questions remain unanswered.

Although a closely held business entity (a fund) that chooses to own a business directly, and to operate such a business in a QOZ, may qualify as a QOF into which its taxpayer-owner may invest their post-2017 capital gains, it appears that the IRS has placed some obstacles in its path to doing so. Whether these were intentional or not remains to be seen. In the meantime, the clock continues to run.

What is a business owner (the “Taxpayer”) to do if they are planning a liquidity event, such as a sale of the business to an unrelated person, in the near future and want to defer their gain by taking advantage of the QOZ tax benefits, but without giving up control over their investment? They can create and capitalize their own fund (within the prescribed investment period), that will try to start a QOZ business that satisfies the tests described above, including the requirement that they timely purchase QOZ business property, and such property shall represent at least 90 percent of the fund’s assets. Good luck.

Alternatively, they can create their own fund, identify one or more existing QOZ businesses (C corporations or partnerships) that are ready to expand and, over the next six months, try to negotiate a cash investment in such a business in exchange for equity therein (including a preferred interest) that also provides the Taxpayer with a significant voice in the management of the business as to major decisions (“sacred rights”), including any decisions that may affect the business’s qualification as a QOZ business or the qualification of the Taxpayer’s investment vehicle as a QOF. The QOZ business would have 31 months in which to use the Taxpayer’s infusion of working capital to acquire QOZ business property.[xlix]

Failing these options, the Taxpayer may invest timely in an “institutional” fund, but with the understanding that they will have little-to-no voice therein. It may not be ideal, but it is much easier to accomplish than the alternatives described above.[l]

Note: Lou Vlahos was recently quoted in a Long Island Business News article on opportunity zones. Please click here to read the article. 

[i] Any “quoted” terms that are not defined herein were either defined in last week’s post or have not yet been defined by the IRS.

[ii] The temporary deferral of inclusion in gross income of certain capital gains to the extent they are reinvested in a qualified opportunity fund (“QOF”); the partial exclusion of such capital gains from gross income to the extent they remain invested in the QOF for a certain length of time; and the permanent exclusion of post-acquisition capital gains (appreciation) from the sale or exchange of an interest in a QOF held for at least 10 years.

[iii] And whose 180-day period for reinvesting the gain(s) from such sale(s) has not yet expired. As an aside, any taxpayer planning to take advantage of the QOZ rules should start investigating reinvestment options well before their capital gain event.

[iv] For example, the investment is being made in an economically-challenged area, the deferral ends in 2026, at which point the taxpayer who invests their gain in a QOF may not have the liquidity to pay the tax; in order for a taxpayer to enjoy the full 15 percent reduction in the deferred gain, they must acquire an interest in a QOF before the end of 2019 and then hold the interest for at least seven years; and the exclusion from income of any appreciation above the deferred gain requires that the taxpayer hold their investment in the QOF for at least ten years.

[v] I.e., IRC Sec. 1400Z-1 and 1400Z-2, and the regulations proposed thereunder; the regulations generally are proposed to be effective on or after the date they are published as final in the Federal Register. However, a QOF may rely on the proposed rules with respect to taxable years that begin before the final regulations’ date of applicability, but only if the QOF applies the rules in their entirety and in a consistent manner.

[vi] A complete list of designated qualified opportunity zones is found in Notice 2018-48, 2018-28 I.R.B. 9.

[vii] Consider, for instance, the number of businesses that had already moved, or had decided to move, into Long Island City, N.Y. before the enactment of these incentives as part of the Tax Cuts and Jobs Act (P.L. 115-97).

[viii] Pun intended.

[ix] Assuming all goes well.

[x] The “taxpayer” may be an individual, a C corporation, a partnership, an S corporation, an estate, or a trust.

[xi] Capital gain, which may be realized in a number of different scenarios under a number of Code provisions. The election to defer tax on an eligible gain invested in a QOF is made on Form 8949, Sales and Other Dispositions of Capital Assets, which is attached to a taxpayer’s federal income tax return.

[xii] You can’t have a tax partnership among a grantor, a 100% grantor trust, and an LLC that is wholly-owned by the grantor and disregarded as an entity separate from the grantor.

[xiii] For example, UBS circulated an email to that effect just last week.

[xiv] There’s that word again.


[xvi] In addition, if the entity is organized in a U.S. possession, but not in one of the 50 States or in the District of Columbia, then it may be a QOF only if it is organized for the purpose of investing in QOZ property that relates to a trade or business operated in the possession in which the entity is organized.

[xvii] The latter cannot have more than 100 shareholders. IRC Sec. 1361(b).

[xviii] Reg. Sec. 301.7701-3.

[xix] Or as the issuer of “QOZ stock” or of a “QOZ partnership interest.”

[xx] Which requirement, by itself, may prevent a pre-existing entity from qualifying.

[xxi] By “value;” see below.

[xxii] With respect to an entity’s first year as a QOF, if the entity chooses to become a QOF beginning with a month other than the first month of its first taxable year, the phrase “first 6-month period of the taxable year of the fund” means the first 6-month period (i) composed entirely of months which are within the taxable year and (ii) during which the entity is a QOF. For example, if a calendar-year entity that was created in February chooses April as its first month as a QOF, then the 90 percent testing dates for the QOF are the end of September and the end of December. Moreover, if the calendar-year QOF chooses a month after June as its first month as a QOF, then the only testing date for the taxable year is the last day of the QOF’s taxable year. Regardless of when an entity becomes a QOF, the last day of the taxable year is a testing date.

[xxiii] June 30 and December 31 in the case of a taxpayer with a December 31 YE.

[xxiv] Directly or through an underwriter.

[xxv] IRC Sec. 1400Z-2(d)(2)(D)(i)(I), Sec. 179(d)(2).

[xxvi] The IRS did not propose a definition of “original use” and is seeking comments on possible approaches to defining the “original use” requirement, for both real property and other tangible property. For example, what metrics would be appropriate for determining whether tangible property has “original use” in an opportunity zone? Should the use of tangible property be determined based on its physical presence within an opportunity zone, or based on some other measure? See Revenue Ruling 2018-29 regarding the acquisition of an existing building on land within a QOZ. Stay tuned.

[xxvii] Hopefully, the forthcoming second round of proposed regulations will address the meaning of “substantially all” in each of the various places where it appears. The IRS has requested comments.

[xxviii] See below.

[xxix] Although the foregoing guidance is helpful, questions remain. For example, how will a fund’s satisfaction of the “substantial improvement” test be affected if it elects to expense some of its investment under Section 179 of the Code, or if it elects bonus depreciation under Section 168?

[xxx] See the definition of QOZ business property, above. Query how the asset rules will be applied to leases.

[xxxi] Hopefully, this will be defined in the next round of guidance.

[xxxii] Stay tuned for this, too.

[xxxiii] This includes debt, stock, partnership interests, annuities, and derivative financial instruments (for example, options and futures).

[xxxiv] I guess Congress doesn’t want to encourage the presence of such vile establishments in distressed areas.

[xxxv] The value of each asset of the entity as reported on the entity’s “applicable financial statement” for the relevant reporting period is used for determining whether a trade or business of the entity satisfies this requirement. Reg. Sec. 1.475(a)-4(h). If a fund does not have an applicable financial statement, the proposed regulations provide alternative methodologies for determining compliance.

[xxxvi] 31 months?! Has the IRS ever tried to develop property in N.Y.C. or on Long Island? Delays caused by legislators and regulators are standard fare.

[xxxvii] If some financial property is treated as being a reasonable amount of working capital because of compliance with the requirements above regarding the use of working capital, and if the tangible property acquired with such working capital is expected to satisfy the requirements for QOZ business property, then that tangible property is not treated as failing to satisfy those requirements solely because the scheduled consumption of the working capital is not yet complete.

[xxxviii] The requirement that the QOZ business derive at least 50 percent of its income from the QOZ may be more difficult to satisfy.

[xxxix] See EN xxxi. If a QOF does not have an applicable financial statement, it may use the cost of its assets. The IRS has requested comments on the suitability of both of these valuation methods, and whether another method, such as tax adjusted basis, would be better.

[xl] What if a QOF sells its interest in QOZ stock or its QOZ partnership interest? It should have “a reasonable period of time” to reinvest the proceeds therefrom. For example, if the sale occurs shortly before a testing date, the QOF should have a reasonable amount of time in which to bring itself into compliance with the 90 percent test. According to the IRS, soon-to-be-released proposed regulations will provide guidance on these reinvestments by a QOF.

[xli] This expansion of the term “working capital” reflects the fact that the QOZ rules anticipate situations in which a QOF or operating subsidiary may need up to 30 months after acquiring a tangible asset in which to improve the asset substantially. The IRS has requested comments about the appropriateness of any further expansion of the “working capital” concept beyond the acquisition, construction, or rehabilitation of tangible business property to the development of business operations in the opportunity zone.

[xlii] Query whether the IRS will eventually permit some sort of aggregation for purposes of applying this rule.

[xliii] This 70 percent threshold is intended to apply only to the term “substantially all” as it is used in section 1400Z-2(d)(3)(A)(i).

[xliv] If the self-certification fails to specify the month in the initial taxable year that the eligible entity first wants to be a QOF, then the first month of the eligible entity’s initial taxable year as a QOF is the first month that the eligible entity is a QOF.

[xlv] Instructions for Form 8996 were released January 24, 2019. A corporation or partnership will use the form to certify that it is organized to invest in QOZ property; they will also file the form annually to report that they meet the investment standard (or to calculate the penalty if they fail to satisfy the standard).

[xlvi] Form 1120, 1120S or 1065.

[xlvii] A deferral election under section 1400Z-2(a) may only be made for investments in a QOF. Therefore, a proper deferral election under section 1400Z-2(a) may not be made for an otherwise qualifying investment that is made before an eligible entity is a QOF.

[xlviii] IRC Sec. 1400Z-2.

[xlix] This option appears to be more manageable.

[l] There’s that inverse relationship again.

A lot has been written about the tax benefits of investing in a Qualified Opportunity Fund. Some have suggested that the gain from the sale of a closely held business may be invested in such a fund in order to defer the recognition of this gain and to shelter some of the appreciation thereon.

In order to better understand and evaluate the potential tax benefits of such an investment, especially from the perspective a business owner who may be contemplating a sale, one must appreciate the underlying tax policy.[i]

Economic Risk

Almost every aspect of a business, from the mundane to the extraordinary, involves some allocation of economic risk. In the broadest sense, “deals” get done when the parties to a transaction agree to terms that allocate an acceptable level of risk between them.[ii]

In the case of a closely held business, the owners will face a significant amount of risk throughout the life of the business. On a visceral level, their risk may seem greatest at the inception of the venture; however, this is also the point at which the owners will have less economic capital at risk, in both an absolute and a relative sense, than perhaps at any other stage of the business.[iii]

Fast forward. Let’s assume the business has survived and has grown. The owners’ investment in the business has paid off, but only after many years of concentrating their economic risk[iv] in the business. The owners may now be ready to monetize their illiquid investment,[v] and reduce their economic risk.

Sale of the Business

They will seek out buyers.[vi] Some of these buyers will pay: (1) all cash for the business at closing; (2) mostly cash plus a promissory note; (3) mostly cash plus an earn-out;[vii] (4) a relatively small amount of cash plus a promissory note; (5) mostly cash, but will also insist that the owners roll over some of their equity in the business[viii] into the buyer; or (6) equity in the buyer and, maybe (depending upon the structure of the transaction) some cash.

Each of these purchase-and-sale transactions presents a different level of risk for the owners of the business being sold, with an all-cash deal providing the lowest degree of risk, and an all-equity deal the greatest. What’s more, the equity deal will place the owner into a non-controlling position within the buyer. Generally speaking, few owners are willing to give up control of their business (and the benefits flowing therefrom) and yet remain at significant economic risk.

Gain Recognition and Economic Risk

In general, the timing of a taxpayer’s recognition of the gain realized on their sale of a property is related to the level of economic risk borne by the taxpayer.

Specifically, in the case of an all-cash, low risk deal,[ix] all of the gain realized on the sale of the business will be recognized in the year of the sale; where part of the consideration consists of a promissory note – such that the seller bears some credit risk vis-à-vis the buyer – that portion of the gain realized on the sale that is attributed to the note will be recognized only as and when principal payments are made.

Continuing Investment and Deferral

Where the buyer issues equity in exchange for the business, the gain realized on the exchange by the seller and its owners may be deferred until such equity is sold, provided certain requirements are satisfied. If the deal is structured in a way that allows the owners to receive some cash along with the equity, then gain will be recognized to some extent.[x]

The Code generally provides for the deferral of gain recognition in recognition of the fact that the selling owners’ investment remains at risk where they exchange their business for equity in the buyer; they have not liquidated their interest in the business or exchanged it for cash; rather, they are continuing their investment, albeit in a somewhat different form.[xi]

Public Policy and Deferral

There are other situations, however, in which the above-stated theoretical underpinning for the deferral of gain is not applicable – because the owners have converted their interest in the business into cash – but for which the Code nevertheless provides that the seller’s gain does not have to be recognized in the year of the sale.

In these situations, the Code is seeking to promote another economic or societal goal that Congress has determined is worthy of its support.

Consider, for example, the deferral of gain realized on the sale of “qualified small business stock,” which seeks to encourage investment in certain types of “small” business;”[xii] another is the deferral of gain from the sale of stock to an ESOP, which seeks to encourage employee-retirement plan ownership of the employer-C corporation.[xiii]

Enter the Qualified Opportunity Zone

The latest addition to the family of provisions, that seeks to encourage certain investment behavior through the deferral of otherwise taxable gain, entered the Code as part of the Tax Cuts and Jobs Act[xiv] in late 2017; regulations were proposed thereunder in October of 2018.[xv]

New Section 1400Z-2 of the Code,[xvi] in conjunction with new section 1400Z-1,[xvii] seeks to encourage economic growth and investment in designated distressed communities (“qualified opportunity zones” or “QOZ”) by providing federal income tax benefits to taxpayers who invest in businesses located within these zones.

The Tax Benefits

Section 1400Z-2 provides three tax incentives to encourage investment in a QOZ:

  • the temporary deferral of inclusion in gross income of certain capital gains to the extent they are reinvested in a qualified opportunity fund (“QOF”);[xviii]
  • the partial exclusion of such capital gains from gross income to the extent they remain invested in the QOF for a certain length of time; and
  • the permanent exclusion of post-acquisition capital gains (appreciation) from the sale or exchange of an interest in a QOF held for at least 10 years.

In brief, a QOF is an investment entity that must be classified as a corporation or as a partnership for federal income tax purposes, that is organized for the purpose of investing in QOZ property, and that holds at least 90 percent of its assets in such property.[xix]

Eligible Gain

Gain is eligible for deferral under the QOZ rules only if it is capital gain – ordinary income does not qualify. For example, the depreciation recapture[xx] that is recognized as ordinary income on the sale of equipment would not qualify; nor would the sale of inventory or receivables; but the capital gain from the sale of real property, shares of stock, or the goodwill of a business, would qualify.[xxi]

That being said, the gain may be either short-term or long-term capital gain. Thus, the gain recognized on the sale of a capital asset will qualify whether or not it has been held for more than one year.[xxii]

The capital gain may result from the actual or deemed sale or exchange of property. Thus, the gain recognized by a shareholder, on the distribution by an S corporation to the shareholder of cash in an amount in excess of the shareholder’s adjusted basis for its stock, would qualify for deferral.[xxiii]

In addition, the gain must not arise from the sale or exchange of property with a related person.[xxiv] In other words, the gain must arise from a sale to, or an exchange with, an unrelated person.

The gain to be deferred must be gain that would be recognized (but for the elective deferral) not later than December 31, 2026.[xxv]

Eligible Taxpayer

Any taxpayer that would otherwise recognize capital gain as a result of a sale or exchange is eligible to elect deferral under the QOZ rules; this includes individuals, C corporations, partnerships, S corporations, estates and trusts.

Where a partnership would otherwise recognize capital gain, it may elect to defer its gain and, to the extent that the partnership does not elect deferral, a partner may elect to do so.[xxvi]

If the election is made to defer all or part of a partnership’s capital gain – to the extent that it makes an equity investment in a QOF – no part of the deferred gain is required to be included in the distributive shares of the partners.

To the extent that a partnership does not elect to defer capital gain, the capital gain is included in the distributive shares of the partners.

If all or any portion of a partner’s distributive share satisfies all of the rules for eligibility under the QOZ rules – including the requirement that the gain did not arise from a sale or exchange with a person that is related either to the partnership or to the partner – then the partner generally may elect its own deferral with respect to the partner’s distributive share. The partner’s deferral is potentially available to the extent that the partner makes an eligible investment in a QOF.[xxvii]

Temporary Deferral

A taxpayer may elect to temporarily defer, and perhaps even partially exclude, capital gains from their gross income to the extent that the taxpayer invests the amount of those gains in a QOF.

The maximum amount of the deferred gain is equal to the amount invested in a QOF by the taxpayer during the 180-day period[xxviii] beginning on the date of the actual sale that produced the gain to be deferred. Where the capital gain results from a deemed or constructive sale of property, as provided under the Code, the 180-day investment period begins on the date on which the gain would be recognized (without regard to the deferral).[xxix]

Capital gains in excess of the amount deferred (i.e., that are not reinvested in a QOF) must be recognized and included in gross income in accordance with the applicable tax rules.

In the case of any investment in a QOF, only a portion of which consists of the investment of gain with respect to which an election is made (the “deferred-gain investment”), such investment is treated as two separate investments, consisting of one investment that includes only amounts to which the election applies, and a separate investment consisting of other amounts.

The temporary deferral and permanent exclusion provisions of the QOZ rules do not apply to the separate investment. For example, if a taxpayer sells stock (held for investment) at a gain and invests the entire sales proceeds (capital gain and return of basis) in a QOF, an election may be made only with respect to the capital gain amount. No election may be made with respect to amounts attributable to a return of basis, and no special tax benefits apply to such amounts.

Eligible Investment

In order to qualify for gain deferral, the capital gain from the taxpayer’s sale must be invested in an equity interest in the QOF; in addition to “common” equity interests, this may include preferred stock (in the case of a corporate QOF), or a partnership interest with special allocations (in the case of a partnership QOF).

The eligible investment cannot be a debt instrument.

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

This is an important point because it is possible that a taxpayer’s gain from a sale or exchange of property will exceed the amount of cash received by the taxpayer in such sale or exchange. Thus, a taxpayer may have to borrow money in order to make the necessary reinvestment and thereby defer the gain.

Partial Exclusion

The taxpayer’s basis for a deferred-gain investment in a QOF immediately after its acquisition is deemed to be zero, notwithstanding that they may have invested a significant amount of cash.[xxx]

If the deferred-gain investment in the QOF is held by the taxpayer for at least five years from the date of the original investment in the QOF, the basis in the deferred-gain investment (the taxpayer’s equity interest in the QOF) is increased by 10 percent of the original deferred gain.

If the QOF investment is held by the taxpayer for at least seven years,[xxxi] the basis in the deferred gain investment is increased by an additional five percent of the original deferred gain.[xxxii]

Gain Recognition

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

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

This point is significant insofar as a taxpayer’s ability to utilize the basis adjustment rule is concerned. In order for the taxpayer to receive the “10 percent of gain” and the additional “5 percent of gain” basis increases, described above, the taxpayer must have held the investment in the QOF for five years and seven years, respectively.

Because the taxpayer’s deferred gain from the original sale will be recognized no later than 2026, the taxpayer will have to sell or exchange “capital gain property,” and roll over the capital gain therefrom into an equity interest in a QOF, no later than December 31, 2019 in order to take advantage of the full “15 percent of gain basis increase.”[xxxiii]

The amount of gain recognized in 2026 will be equal to (1) the lesser of the amount deferred and the current fair market value of the investment,[xxxiv] over (2) the taxpayer’s basis in their QOF investment, taking into account any increases in such basis at the end of five or seven years.

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

At that time, the taxpayer’s basis in the QOF interest will be increased by the amount of gain recognized.

No election to defer gain recognition under the QOZ rules may be made after December 31, 2026.[xxxv]

Death of the Electing Taxpayer

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

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

Exclusion of Appreciation

The post-acquisition capital gain on a deferred-gain investment in a QOF that is held for at least 10 years will be excluded from gross income.

Specifically, in the case of the sale or exchange of equity in a QOF held for at least 10 years from the date of the original investment in the QOF, a further election is allowed by the taxpayer to modify the basis of such deferred-gain investment in the hands of the taxpayer to be the “fair market value” of the deferred-gain investment at the date of such sale or exchange.[xxxviii]

However, under Sec. 1400Z-1, the designations of all QOZ in existence will expire on December 31, 2028. The IRS acknowledges that the loss of QOZ designation raises numerous issues regarding gain deferral elections that are still in effect when the designation expires. Among these is whether, after the relevant QOZ loses its designation, investors may still make basis step-up elections under Sec. 1400Z-2 for QOF investments from 2019 and later.[xxxix]

Investor Beware[xl]

A taxpayer who invests their gains in a QOF may continue to realize and recognize losses associated with their investment in the QOF. After all, the QOF is a “business” like any other, notwithstanding its genesis in Congress.

Moreover, its purpose is to invest in certain distressed communities (QOZs); that’s why the income tax incentives are being offered – to encourage investment in businesses located within QOZs.

In the case of a fund organized as a pass-through entity, a taxpayer-investor may recognize gains and losses associated with both the deferred-gain and non-deferred gain investments in the fund, under the tax rules generally applicable to pass-through entities.

Thus, for example, an investor-partner in a fund organized as a partnership would recognize their distributive share of the fund’s income or deductions, gains or losses, and the resulting increase or decrease in their “outside basis” for their interest in the partnership.[xli]

Aside from the ordinary business risk, an investor should also be aware that if a QOF fails to satisfy the requirement that the QOF hold at least 90 percent of its assets in QOZ property, the fund will have to pay a monthly penalty;[xlii] if the fund is a partnership, the penalty will be taken into account proportionately as part of the distributive share of each partner.


The following example illustrates the basic operation of the above rules.

Assume a taxpayer sells stock for a gain of $1,000 on January 1, 2019, and elects to invest $1,000 in the stock of a QOF (thereby deferring this gain). Assume also that the taxpayer holds the investment for 10 years, and then sells the investment for $1,500.

The taxpayer’s initial basis in the deferred-gain investment is deemed to be zero.

After five years, the basis is increased to $100 (i.e., 10 percent of the $1,000 of deferred gain).

After seven years, the basis is increased to $150 (i.e., $100 plus an additional 5 percent of the deferred gain).

At the end of 2026, assume that the fair market value of the deferred-gain investment is at least $1,000, and thus the taxpayer has to recognize $850 of the deferred capital gain ($1,000 less $150 of basis).

At that point, the basis in the deferred gain investment is $1,000 ($150 + $850, the latter being the amount of gain recognized in 2026).

If the taxpayer holds the deferred-gain investment for 10 years and makes the election to increase the basis, the $500 of post-acquisition capital gain on the sale after 10 years is excluded from gross income.

What Does It All Mean?

QOFs are just now being organized. The IRS’s guidance on QOFs and their tax benefits is still in proposed form. The clock on the deadline for recognizing any gain that is deferred pursuant to these rules will stop ticking at the end of 2026 – that’s when the deferred gain must be recognized; generally speaking, the shorter the deferral period, the less beneficial it is to the taxpayer. In order to enjoy the full benefit of the gain reduction provided by the 15 percent of basis adjustment rule, a taxpayer will have to generate eligible gain and invest the amount thereof in a QOF prior to December 31, 2019.[xliii] Finally, in order to exclude the post-investment appreciation in a QOF interest, a taxpayer must hold that interest for at least ten years – that’s a long time.

Let’s start with the premise that, unless a taxpayer has a good business reason for selling an investment, including, for example, their business, they should not do so just to take advantage of the QOZ rules.

Assuming the taxpayer has decided that it makes sense to sell, aside from the hoped-for tax benefits, they have to consider the “tax rule of thumb” described at the beginning of this post:[xliv] economic certainty and tax deferral share an inverse relationship – there is generally an economic risk associated with long-term deferral.

With that, it will behoove the taxpayer to consult with their accountant and financial adviser, not to mention their attorney, prior to jumping into a QOF. Although questions remain, the QOZ rules provide some attractive tax benefits. Provided the taxpayer takes a balanced approach, there may be a place for a QOF investment in their portfolio.[xlv]

Note: Lou Vlahos was recently quoted in a Long Island Business News article on opportunity zones. Please click here to read the article. 


[i] I am neither a proponent nor an opponent of such investments. I am not qualified, nor do I purport, to give financial advice – I leave that to the financial planners. My goal is to give you something to think about.

[ii] Think Goldilocks. “Just right.”

[iii] Compare the passive investor who is willing to fund the new venture, provided they receive a preferred return for placing their money at risk, or the lender who is willing to extend credit to the business, but only at a higher rate, and maybe with the ability to convert into equity.

[iv] Not to mention their time and labor. Opportunity costs.

[v] After all, there is no market on which they may readily “trade” their equity.

[vi] Hopefully with the assistance of professionals who know the market, who can educate them in the process, who will “run interference” for them with potential buyers, and who can crunch the numbers in a meaningful way to compare offers.

[vii] Which may require the owners’ continued involvement if they hope to attain the earn-out targets.

[viii] As in the typical private equity deal.

This may be done on a pre- or post-tax basis; in the former, the owners will contribute their equity interest or assets to the buyer in exchange for equity in the buyer – the recognition of the gain inherent in the contributed property is thereby deferred; in the latter, they will take a portion of the cash paid to them (which is taxable) and invest it in the buyer.

[ix] Of course, I am ignoring the level of risk associated with the reps, warranties, and covenants given by the owners and the target business under the purchase-and-sale agreement, the breach of which may require that the now-former owners of the business indemnify the buyer for any losses incurred attributable to such breach – basically, an adjustment of the purchase price and a re-allocation of risk.

[x] For example, a forward corporate merger will allow some cash “boot” to be paid along with stock of the acquiring corporation; gain will be recognized to the extent of the cash received. In the case of a contribution to a partnership in exchange for an interest therein plus some cash, the so-called disguised sale rules will apply to determine the tax consequences.

[xi] To paraphrase Reg. Sec. 1.1001-1(a), the gain realized from the conversion of property into cash, or from the exchange of property for other property differing materially in kind, is treated as income sustained. In the context of the corporate reorganization provisions, we refer to there being a “continuity of business enterprise” and a “continuity of interest.” IRC Sec. 368; Reg. Sec. 1.368-1(d) and (e).

This recalls the like kind exchange rules under IRC Sec. 1031, the benefits of which are now limited to exchanges of real property. See Sec. 1031, as amended by the Act.

[xii] IRC Sec. 1202. Under this provision, non-corporate taxpayers may be able to exclude all of the gain from the sale of “qualified small business stock” held for more than five years. In order to qualify as qualified small business stock, several requirements must be satisfied, including the following: C corporation, original issue, qualified trade or business, gross assets not in excess of $50 million, at least 80% of the value of the assets must be used in the active conduct of the qualified trade or business. Query whether the reduction in the corporate tax rate, to a flat 21%, will spur interest in this provision and investment in qualifying corporations and businesses.

[xiii] IRC Sec. 1042. This provision affords the individual shareholder of the employer corporation the opportunity to sell stock to the ESOP (the ESOP must own at least 30%) and to defer the recognition of the gain realized on such sale by reinvesting the proceeds therefrom (within a 15-month period that begins three months prior to the sale) in the securities of other domestic corporations. This allows the owner to take some risk off the table, and to diversify their equity by investing in publicly traded corporations. In the meanwhile, the owner may continue to operate their business.

[xiv] P.L. 115-97 (the “Act”). I know, you’re tired of seeing this cite. I’m tired of . . . citing it. It is what it is.

[xv] .

[xvi] IRC Sec. 1400Z-2. . “Z” is so ominous. Anyone read the novel “Z” by Vassilikos?

[xvii] Which sets forth the requirements for a Qualified Opportunity Zone. We will not be discussing these requirements in this post. . See also

[xviii] We will not be discussing the requirements for QOF status in any detail.

[xix] QOZ property, in turn, is defined to include QOZ stock, QOZ partnership interest, and QOZ business property. Although these terms are defined is some detail by the Code, one might say that the common denominator is that there be a qualified business that is conducted primarily within the QOZ. A penalty may be imposed for failing to satisfy this requirement. See EN xxxvii and the related text.

[xx] IRC Sec. 1245.

[xxi] IRC Sec. 1221, 1231.

[xxii] IRC Sec. 1222. This “attribute” of the gain is preserved for purposes of characterizing the gain when it is finally recognized.

Section 1231 property must be held for more than one year, by definition.

[xxiii] IRC Sec. 1368. This is often the case when an S corporation liquidates (or is deemed to liquidate) after the sale (or the deemed sale, under IRC Sec. 338(h)(10)) of its assets.

[xxiv] See IRC Sec. 267(b) and Sec. 707(b)(1) ; substitute “20 percent” in place of “50 percent” each place it appears.

[xxv] A taxpayer with gain, the recognition of which would be deferred beyond this time under the Sec. 453 installment method, would probably not elect to defer such gain under the QOZ rules. After all, why accelerate the recognition event? However, query whether there are circumstances in which it would make sense to elect out of installment reporting so as to utilize Sec. 1400Z-2? IRC Sec. 453(d). Perhaps to take advantage of the exclusion of gain after satisfying the ten-year holding period?

[xxvi] These proposed regulations clarify the circumstances under which the partnership or the partner can elect, and also clarify when the applicable 180-day period begins.

[xxvii] The proposed regulations state that rules analogous to the rules provided for partnerships and partners apply to other pass-through entities (including S corporations, decedents’ estates, and trusts) and to their shareholders and beneficiaries.

[xxviii] This investment period should be familiar to those of you who are experienced with like kind exchanges.

[xxix] A partner’s 180-day reinvestment period generally begins on the last day of the partnership’s taxable year, because that is the day on which the partner would be required to recognize the gain if the gain is not deferred. Query, however, whether the partnership will distribute the proceeds from the sale to its partners to enable them to make the roll-over investment – individual partners may have to use other funds (or borrow) in order to achieve the desired deferral.

[xxx] That being said, if the QOF is a partnership that has borrowed funds, the investor may be allocated a portion of such indebtedness, which amount would be added to their basis for their partnership interest. See IRC Sec. 752.

[xxxi] I.e., two more years.

[xxxii] Yielding basis equal to 15 percent of the original deferred gain.

[xxxiii] 2019 plus 7 equals 2026.

[xxxiv] Ah, the risk of an investment in equity.

[xxxv] Thus, the gain from a sale in 2025 may be deferred for one year. The gain from a sale during or after 2026 is not deferred under these rules.

[xxxvi] For example, before 2026.

[xxxvii] IRC Sec. 691.

[xxxviii] Query if this is the correct formulation; for example, what if the QOF is a partnership that generates losses which flow through to its members, thereby reducing their basis – does the statute intend for the members to wipe out this basis reduction and never recapture the benefit thereof on a subsequent sale? See the Example, below.

[xxxix] The proposed regulations would permit taxpayers to make the basis step-up election after the QOZ designation expires.

[xl] See EN 1. The IRS says as much in the preamble to the proposed regulations.

[xli] See EN xxxiii and the related text.

[xlii] Unless the failure is due to reasonable cause.

[xliii] An investment by December 31, 2021 may enjoy the 10 percent basis adjustment, which follows a five-year holding period.

[xliv] I know, you can’t remember that far back. I apologize. Lots to say this week.

[xlv] The saying “meden agan” was inscribed on the temple of Apollo at Delphi. It means “nothing in excess.”


Shortly after Section 199A was added to the Code at the end of 2017, and again after the IRS proposed regulations under the newly-enacted provision last summer, many clients called us with the following question: “Will my rental real estate activities qualify for the 199A deduction?”

In most cases, we were able to answer confidently that the client’s activities would be treated as a qualified trade or business, and that the deduction would be available, though it could be limited by the so-called “W-2 Wages and Unadjusted Basis” limitations.

In a few others, we were able to reply just as certainly that the activities did not rise to the level of a trade or business and, so, would not qualify for the deduction.

In some cases, however, we had to delve more deeply into the client’s particular facts and circumstances before we could reach any conclusion – often with the proviso that the IRS may disagree with our assessment of the situation.

“Trade or Business”

Like many other areas of the tax law, Section 199A requires a taxpayer to make a threshold determination of whether its activities rise to the level of constituting a trade or business.[i]

In general, courts have held that in order for a taxpayer’s activity to rise to the level of constituting a trade or business, the taxpayer must satisfy two requirements: (1) regular and continuous conduct of the activity, which depends on the extent of the taxpayer’s activities;[ii] and (2) a primary purpose to earn a profit, which depends on the taxpayer’s state of mind and their having a good faith intention to make a profit from the activity.[iii]

Whether a taxpayer’s activities meet these factors depends on the facts and circumstances of each case.

In most situations, neither the taxpayer nor the IRS should find it difficult to evaluate the trade or business status of the taxpayer’s activities – the level and quality of the activity will be such that its status will be obvious.

Unfortunately, there remain a number of cases in which the various “triers of fact” – first, the taxpayer, then the IRS, and finally the courts – will have to consider to the taxpayer’s unique “facts and circumstances” in determining whether the taxpayer’s activities rise to the level of a trade or business.

Because it is fact-intensive, while also being subjective, this analytical process can be costly and time-consuming.

It can also generate seemingly inconsistent conclusions by the ultimate trier of fact, a concern that has been borne out historically in the evaluation of smaller rental real estate operations.

Section 199A

One needs to keep the forgoing in mind in order to understand the tentative reaction to the enactment of Section 199A by the owners of many smaller rental real estate operations.

Section 199A provides a deduction to a non-corporate taxpayer[iv] of up to 20 percent of the taxpayer’s qualified business income from each of the taxpayer’s “qualified trades or businesses,” including those operated through a partnership, S corporation, or sole proprietorship, effective for taxable years beginning after December 31, 2017.[v]

Although the passage of Section 199A was greeted enthusiastically by most in the business community, some business owners withheld their endorsement of the provision pending the issuance of guidance as to meaning of certain key terms in the statute.

The rental real estate sector, in particular, hoped that the term “qualified trade or business” would be defined so as to provide its members with some certainty as to the application of the Section 199A deduction to their activities.

However, the statute defined a “qualified trade or business” as any trade or business other than a specified service trade or business or a trade or business of performing services as an employee.

Moreover, the legislative history failed to provide a definition of trade or business for purposes of section 199A.

Proposed Regulations

When the IRS proposed regulations in August of 2018, it stated that Section 162(a)[vi] of the Code provides the most appropriate “definition” of a trade or business for purposes of Section 199A.[vii]

The IRS explained that its decision was based on the fact that the definition of trade or business for purposes of Section 162 is derived from a large body of existing case law and administrative guidance interpreting the meaning of “trade or business” in the context of a broad range of industries.

For this reason, the IRS concluded that the definition of a trade or business under Section 162 provides for administrable rules that are appropriate for the purpose of Section 199A, and which taxpayers have experience applying.

That being said, the proposed regulations extended the definition of trade or business for purposes of Section 199A beyond Section 162 in one circumstance.

Solely for purposes of Section 199A, the IRS proposed that the rental of real property to a related trade or business would be treated as a trade or business if the rental and the other trade or business were commonly controlled. In supporting this extension, the IRS explained that it is not uncommon, for legal or other non-tax reasons, for taxpayers to segregate a rental property from an operating business. According to the IRS, this rule would allow taxpayers to effectively aggregate their trades or business with the associated rental property.[viii]

Notwithstanding the foregoing, the IRS received comments from advisers and industry groups that the status of a rental real estate enterprise as a trade or business within the meaning of Section 199A remained a subject of uncertainty for many taxpayers.

Final Regulations[ix]

The final regulations retained the proposed regulation’s definition of trade or business; specifically, for purposes of Section 199A and the regulations thereunder, a “trade or business” continues to be defined as a trade or business under Section 162 of the Code.[x]

The IRS acknowledged comments suggesting guidance in the form of a regulatory definition, a bright-line test, or a factor-based test.[xi] The IRS rejected these, however, pointing out that whether an activity rises to the level of a Section 162 trade or business is inherently a factual question, and the factual setting of various trades or businesses varies so widely, that a single rule or list of factors would be difficult to provide in a manageable manner, and would be difficult for taxpayers to apply.[xii]

However, the IRS also recognized the difficulties that a taxpayer may have in determining whether their rental real estate activity is sufficiently regular, continuous, and considerable for the activity to constitute a Section 162 trade or business.

Proposed Safe Harbor

To help mitigate the resulting uncertainty, the IRS recently proposed – concurrently with the release of the final Section 199A regulations – the issuance of a new revenue procedure that would provide for a “safe harbor” under which a taxpayer’s “rental real estate enterprise”[xiii] will be treated as a trade or business for purposes of Section 199A.[xiv]

To qualify for treatment as a trade or business under this safe harbor, a rental real estate enterprise must satisfy the requirements of the proposed revenue procedure. If the safe harbor requirements are met, the real estate enterprise will be treated as a trade or business for purposes of applying Section 199A and its regulations.

Significantly, an S corporation or a partnership[xv] (pass-through entities; “PTE”) that is owned, directly or indirectly, by at least one individual, estate, or trust may also use this safe harbor in order to determine whether a rental real estate enterprise conducted by the PTE is a trade or business within the meaning of Section 199A.[xvi]

Rental Real Estate Enterprise

For purposes of the safe harbor, a “rental real estate enterprise” is defined as an interest in real property held for the production of rents; it may consist of an interest in one or in multiple properties.

The individual or PTE relying on the proposed revenue procedure must hold the interest directly or through an entity that is disregarded as an entity separate from its owner for tax purposes.[xvii]

A taxpayer may treat each property held for the production of rents as a separate enterprise; alternatively, a taxpayer may treat all “similar” properties held for the production of rents as a single enterprise.[xviii] The treatment of a taxpayer’s rental properties as a single enterprise or as separate enterprises may not be varied from year-to-year unless there has been a “significant”[xix] change in facts and circumstances.

Commercial and residential real estate may not be part of the same rental enterprise; in other words, a taxpayer with an interest in a commercial rental property, who also owns an interest in a residential rental, will be treated as having two rental real estate enterprises for purposes of applying the revenue procedure.

Rental as Section 199A Trade or Business

A rental real estate enterprise will be treated as a trade or business for a taxable year (solely for purposes of Section 199A) if the following requirements are satisfied during the taxable year with respect to the rental real estate enterprise:

(A) Separate books and records are maintained to reflect income and expenses for each rental real estate enterprise, as well as a separate bank account for each enterprise;[xx]

(B) For taxable years beginning:

(i) prior to January 1, 2023, 250 or more hours of “rental services”[xxi] are performed per year with respect to the rental enterprise;

(ii) after December 31, 2022, in any three of the five consecutive taxable years that end with the taxable year (or in each year for an enterprise held for less than five years), 250 or more hours of rental services are performed per year with respect to the rental real estate enterprise; and

(C) The taxpayer maintains contemporaneous records, including time reports, logs, or similar documents, regarding the following:

(i) hours of all services performed;

(ii) description of all services performed;

(iii) dates on which such services were performed; and

(iv) who performed the services.

Such records are, of course, to be made available for inspection at the request of the IRS.[xxii]

Rental Services

The rental services to be performed with respect to a rental real estate enterprise for purposes of satisfying the safe harbor include the following:

(i) advertising to rent or lease the real estate;

(ii) negotiating and executing leases;

(iii) verifying information contained in prospective tenant applications;

(iv) collection of rent and payment of expenses;

(v) daily operation, maintenance, and repair of the property;

(vi) management of the real estate;

(vii) provision of services to tenants;[xxiii]

(viii) purchase of materials; and

(ix) supervision of employees and independent contractors.[xxiv]

Rental services may be performed by the individual owners (in the case of direct ownership of the real property) or by the PTE that owns the property, or by the employees, agents, and/or independent contractors of the owners.

It is important to note that hours spent by an owner or any other person with respect to the owner’s capacity as an investor are not considered to be hours of service with respect to the enterprise. Thus, the proposed revenue procedure provides that the term “rental services” does not include the following:

(i) financial or investment management activities, such as arranging financing;

(ii) procuring property;

(iii) studying and reviewing financial statements or reports on operations;

(iv) planning, managing, or constructing long-term capital improvements; or

(v) traveling to and from the real estate.[xxv]

Real estate used by the taxpayer (including by an owner of a PTE relying on this safe harbor) as a residence for any part of the year[xxvi] is not eligible for the safe harbor.

Real estate rented under a triple net lease is also not eligible for the safe harbor – it more closely resembles an investment than a trade or business. For purposes of this rule, a “triple net lease” includes a lease agreement that requires the tenant to pay taxes, fees, and insurance, and to be responsible for maintenance activities for a property in addition to rent and utilities. This also includes a lease agreement that requires the tenant to pay a portion of the taxes, fees, and insurance, and to be responsible for maintenance activities allocable to the portion of the property rented by the tenant.

Procedural Requirements, Reliance

A taxpayer or PTE must include a statement attached to the return on which it claims the Section 199A deduction or passes through Section 199A information that the requirements in the revenue procedure have been satisfied. The statement must be signed by the taxpayer, or an authorized representative of an eligible taxpayer or PTE, which states:

Under penalties of perjury, I (we) declare that I (we) have examined the statement, and, to the best of my (our) knowledge and belief, the statement contains all the relevant facts relating to the revenue procedure, and such facts are true, correct, and complete.

The individual or individuals who execute the statement must have personal knowledge of the facts and circumstances related to the statement.

If an enterprise fails to satisfy these requirements, the rental real estate enterprise may still be treated as a trade or business for purposes of Section 199A if the enterprise otherwise meets the general definition of trade or business.[xxvii]

The proposed revenue procedure is proposed to apply generally to taxpayers with taxable years beginning after December 31, 2017; i.e., the effective date for Section 199A.

In addition, until such time that the proposed revenue procedure is published in final form, taxpayers may use the safe harbor described in the proposed revenue procedure for purposes of determining when a rental real estate enterprise may be treated as a trade or business solely for purposes of Section 199A.

What’s Next?

All in all, the final regulations and the proposed safe harbor should provide some welcomed relief and “certainty” for those individual taxpayers and PTEs that own smaller rental real estate operations;[xxviii] and they came just in time – barely – for the preparation of these taxpayers’ 2018 tax returns.

But the proof is in the pudding – or something like that – and the actual impact of the proposed safe harbor will have to await the collection and analysis of the relevant data, including the reactions of taxpayers and their advisers.

As in the case of many other taxpayer-friendly regulations or procedures,[xxix] the benefit afforded requires that the taxpayer be diligent in maintaining contemporaneous, detailed records for each rental real estate enterprise. This may be a challenge for many a would-be qualified trade or business.

Whether to treat “similar” rental properties as a single enterprise may also present some difficulties for taxpayers, at least until they figure out what it means for one property to be similar to another. Based upon the term’s placement in the proposed revenue procedure, it may be that all residential properties are similar to one another, just as all commercial properties are similar to one another. In that case, a taxpayer may be able to treat all of its residential rentals, for example, as a single enterprise, which may allow it to satisfy the “250 or more hours of rental service” requirements of the safe harbor.

Just as challenging may be a taxpayer’s distinguishing between business-related services and investment-related services.[xxx]

Regardless of how the proposed safe harbor is ultimately implemented and administered, the fact remains that the IRS has clearly considered and responded to the requests of the rental real estate industry.

The questions remain, however: Will Section 199A survive through its scheduled expiration date in 2025; and, if so, will it become a “permanent” part of the Code? Or is all this fuss just a way to drive folks like me crazy?


For example, expenses are deductible if they are incurred “in carrying on any trade or business.” IRC Sec.162.

[ii] Which may distinguish a trade or business from an “investment.”

[iii] As opposed to a “hobby.”

[iv] Individuals; also trusts and estates.

[v] Tax Cuts and Jobs Act, PL 115-97, Sec. 11011. The deduction disappears for taxable years beginning after December 31, 2025.

[vi] In general, Section 162 of the Code provides that the ordinary and necessary expenditures directly connected with or pertaining to a taxpayer’s “trade or business” are deductible in determining the taxpayer’s taxable income.


[viii] The final regulations clarify the rule by limiting its application to situations in which the related party tenant is an individual or an PTE (not a C corporation).


[x] Other than the trade or business of performing services as an employee.

[xi] It also considered and rejected suggestions that it define trade or business by reference to Section 469 of the Code, explaining that the definition of trade or business for Section 469 purposes is significantly broader than the definition for purposes of Section 162 as it is intended to capture a “larger universe” of activities, including passive activities. According to the IRS, Section 469 was enacted to limit the deduction of certain passive losses and therefore, serves a very different purpose than the allowance of a deduction under section 199A. Further, Section 199A does not require that a taxpayer materially participate in a trade or business in order to qualify for the Section 199A deduction.

The IRS also declined to adopt a suggestion that all rental real estate activity be deemed to be a trade or business for purposes of Section 199A.

[xii] In determining whether a rental real estate activity is a section 162 trade or business, relevant factors might include, but are not limited to (i) the type of rented property (commercial real property versus residential property), (ii) the number of properties rented, (iii) the owner’s or the owner’s agents day-to-day involvement, (iv) the types and significance of any ancillary services provided under the lease, and (v) the terms of the lease (for example, a net lease versus a traditional lease and a short-term lease versus a long-term lease).

[xiii] Yes, another defined term.

[xiv] Notice 2019-07.

[xv] Other than a publicly traded partnership.

[xvi] You may recall that it is up to the PTE (not its owners) to determine whether it is engaged in a qualified trade or business.

[xvii] Reg. Sec. 301.7701-3; for example, a single-member LLC; so, two tiers of entities at most (one of which must be disregarded) – an S corp. that owns an interest in a 2-person partnership that owns rental real estate would not qualify.

[xviii] There is no in-between, where some similar properties are treated as one enterprise while others as separate enterprises.

[xix] As of yet undefined.

[xx] Query how this may affect a taxpayer’s decision to treat all “similar” properties held for the production of rents as a single enterprise?

[xxi] You guessed it. C’mon, it’s tax – we love defined terms within defined terms. They put Russian nesting dolls to shame.

[xxii] The contemporaneous records requirement will not apply to taxable years beginning prior to January 1, 2019.

[xxiii] Although not spelled out in the proposed revenue procedure, presumably this includes some of the following: providing and paying for gas, water, electricity, sewage, and insurance for the property; paying the taxes assessed thereon; providing insect control, janitorial service, trash collection, ground maintenance, and heating, air conditioning and plumbing maintenance.

[xxiv] This does not purport to be an all-inclusive list.

[xxv] The number of times I have seen taxpayers count such travel time in trying to establish their material participation for purposes of the passive activity rules!

[xxvi] Under section 280A of the Code. In general, a taxpayer uses a property during the taxable year as a residence if he uses such property for personal purposes for a number of days which exceeds the greater of: 14 days, or 10 percent of the number of days during such year for which such property is rented at a fair rental.

[xxvii] Under Section 162, which may be small comfort – after all, that’s why the safe harbor was proposed.

[xxviii] Not that everything was rosy. Example 1 of proposed §1.199A-1(d)(4) described a taxpayer who owns several parcels of land that the taxpayer manages and leases to airports for parking lots. The IRS shared that some taxpayers questioned whether the use of the lease of unimproved land in the example was intended to imply that the lease of unimproved land is a trade or business for purposes of section 199A. The IRS explained that the example was intended to provide a simple illustration of how the 199A calculation would work; it was not intended to imply that the lease of the land is, or is not, a trade or business for purposes of section 199A beyond the assumption in the example. In order to avoid any confusion, the final regulations removed the references to land in the example.

[xxix] For example, the material participation regulations under Reg. Sec. 1.469-5T.

[xxx] For example, attending a hearing of a local zoning board.

We Want You

One of the most challenging problems facing a business is how to attract, and then retain, qualified employees.[i] The competition among businesses can be fierce and, in order to succeed, businesses have, over the years, developed a number of compensation alternatives. Some of these have become “standard” options,[ii] thereby forcing businesses to devise more tailored arrangements for certain prospective employees. In almost all cases, however, both parties have recognized the impact of taxes – in terms of the amount of compensation and the timing of its recognition – on the net economic benefit of a particular compensation package.

Transition Loan/Compensation

In the financial services industry, it has long been the practice for a firm to loan a new key employee a significant sum of money (so-called “transition compensation”) in order to entice them to join the firm. In exchange, the employee executes a promissory note to evidence the amount they owe to the firm, along with an employment agreement pursuant to which the firm “pays” the employee a monthly amount, which is then immediately applied toward the amount owing to the firm for that month under the note. This arrangement allows the employee to receive the full amount of their transition compensation upfront, while recognizing income only as each monthly payment comes due. No moneys change hands with respect to each monthly “repayment” of the loan.

If the loan is consistently treated as such by the parties, it will likely withstand IRS scrutiny and be respected as a loan.[iii] Consequently, the monthly payments will be included in the employee’s gross income and will be deductible by the firm, provided the total compensation paid by the firm to the employee is reasonable for the services to be rendered.[iv]

Of course, circumstances may arise that cause the key employee and the firm to go their separate ways. In that case, depending upon the particular facts, the amount of the “transition compensation loan” that remains outstanding may become due immediately.[v]

The U.S. Tax Court recently considered a complicated version of this situation.


Taxpayer was a very successful financial adviser and certified financial planner. He was employed by Firm A, where he developed a large book of business. To service those clients, he worked with a five-person team of brokers and assistants who, though they were employed by Firm A, worked exclusively for Taxpayer.

Taxpayer and his team subsequently joined Firm B. Upon his agreeing to work for Firm B, the firm lent him approximately $3.6 million. To evidence the loan, Taxpayer signed a promissory note. He also signed an employment agreement, which, among other things, provided for a “monthly transition compensation payment” in an amount equal to the amount due and payable each month by Taxpayer pursuant to the terms of the note. In order to facilitate the repayment of the loan, this amount – which was taxable to Taxpayer as compensation – was deducted from Taxpayer’s compensation from Firm B.[vi]

The employment agreement provided that Taxpayer would cease to be entitled to transition compensation upon the termination of his employment with Firm B for any reason. However, if his termination was other than for “cause,”[vii] Firm B would pay Taxpayer a lump sum equal to the remaining transition compensation payments through a specified date, less any outstanding debts Taxpayer owed Firm B. In the event Taxpayer resigned or his employment was terminated by Firm B for cause, Taxpayer would not receive these payments.

The loan became immediately repayable if Taxpayer’s employment with Firm B was terminated for any reason.

Taxpayer was offered this high level of compensation in anticipation of his clients’ moving with him and his team to Firm B. His efforts to contact his clients and persuade them to leave Firm A and join him at Firm B were governed by an protocol entered into by participating financial services firms, to which Firms A and B were parties, and which set forth the specific types of information which a financial adviser, such as Taxpayer, could take with them when they left one financial services firm to join another.

Seeking to bring his clients to Firm B, Taxpayer consulted with Firm B’s attorneys to interpret the protocol, and then relied on their interpretation of the protocol when he brought his client information with him to Firm B and used it to contact the clients, inform them of the move, and invite them to change financial services firms.[viii]

Taxpayer brought his entire team to Firm B. As part of the transition, Taxpayer also brought various spreadsheets and documents with client information used by his group at Firm A, which he had developed over his years of work. These documents and spreadsheets were treated as Taxpayer’s personal property at Firm A.

Sorry It Didn’t Work Out

Less than a year after Taxpayer joined Firm B, their relationship soured. Firm B launched an investigation with respect to how Taxpayer brought his clients from Firm A to Firm B and whether he violated the protocol and/or his employment agreement.

At that point, Taxpayer voluntarily resigned and began seeking employment at another financial services firm. He was stymied, however, because Firm B did not immediately submit the requisite form to FINRA[ix] with details regarding the termination of his employment, without which no reputable would hire him. Consequently, for a time after he left Firm B, Taxpayer could not service his clients.

In the meantime, Firm B actively solicited Taxpayer’s clients. It had Taxpayer’s former team members[x] contact each client in an attempt to persuade them to abandon Taxpayer and remain with Firm B. It also retained Taxpayer’s documents and spreadsheets, which the team members continued to use to service clients.

About a month after Taxpayer’s resignation, Firm B made the requisite filing, but under the form included an explanation that Taxpayer was permitted to resign on account of “conduct resulting in loss of management’s confidence, including conduct relating to the handling of customer information and lack of cooperation in the firm’s review of the matter.”

Firm B then brought a proceeding against Taxpayer before a FINRA panel in which it sought repayment of the outstanding balance of Taxpayer’s loan, asserting that the terms of the promissory note called for such repayment upon termination of Taxpayer’s employment.[xi]

In response, Taxpayer requested that the panel award him (i.e., forgive) the “unpaid” transition compensation (approximately $3.2 million) “loaned” to him when he joined Firm B. He also requested that Firm B release to his documents and spreadsheets.

The Panel’s Decision

Taxpayer stated that the panel should reject Firm B’s demand that he repay the outstanding balance of the upfront forgivable loan because if Firm B were allowed to collect the amount allegedly remaining due under such loan,[xii] after having induced Taxpayer to transfer his entire book of business to Firm B and then effectively forcing his resignation less than one year later, the firm would have been permitted to freeze Taxpayer out of the financial services industry, thus receiving the entire benefit of his substantial book of business, including the revenues generated from such book of business, all without having to provide any compensation to Taxpayer for that book of business.[xiii]

According to Taxpayer, these same facts supported his contention that Firm B had essentially converted his book of business and misappropriated his trade secrets (in the form of the client-documents and spreadsheets) via a plan whereby it: (1) lured Taxpayer to join the firm with a large compensation package (i.e., the amount of the monthly transition compensation and the upfront forgivable loan that was based on the value of his book of business); (2) forced his resignation just before his first year bonus was due to be paid; (3) demanded he repay the upfront forgivable loan; and (4) filed “a false and defamatory Form U5”, which “virtually assured that [Taxpayer] * * * [would] not be able to find comparable employment in the financial services industry, thereby allowing [Firm B] to continue to service [Taxpayer’s] clients almost entirely free from competition.”

Taxpayer stressed the fact that, unlike the scenario wherein a hypothetical financial planner leaves one firm to work at another with an outstanding balance remaining on a forgivable loan, when Taxpayer resigned from Firm B, he did not join a competitor. Instead, having effectively sidelined Taxpayer, Firm B was able to solicit his entire book of business free from competition, while in the several months since his resignation, Taxpayer had only managed to acquire a handful of clients.

The panel declined to order Taxpayer to pay the remaining balance of the upfront forgivable loan owing to Firm B under the promissory note, and ruled that Taxpayer was entitled to retain such balance.

The panel also ordered Firm B to deliver to Taxpayer the templates for his documents and spreadsheets, but expressly stated that the templates were to be delivered to him without any data. Upon delivery, Firm B was ordered to certify that it had removed these materials from its own computer systems. However, the order did not prevent Firm B from retaining the substantive client information.

Taxpayer’s Federal Income Tax Return

Firm B issued Taxpayer an IRS Form 1099-C, Cancellation of Debt, reporting debt cancellation income of approximately $3.2 million.[xiv]

Taxpayer timely filed his Federal income tax return, wherein he reported an overall loss and claimed a refund. He reported the 1099-C cancellation of indebtedness income as “deferred compensation.”[xv] He offset this amount with certain ordinary loss items, including a “Firm A Deferred Compensation Loss” of $2.5 million.

The IRS examined Taxpayer’s tax return and determined that the Firm A deferred compensation loss was actually a capital loss from the sale of stock, and could not be used to offset ordinary income.

Taxpayer conceded this adjustment, and then amended his income tax return to recharacterize the extinguishment of the balance of the Firm B upfront forgivable loan from ordinary income to capital gain,[xvi] and again claimed a refund.

The IRS denied the refund claim, and Taxpayer petitioned the Court.

The issue before the Tax Court involved the character of the balance of the upfront forgivable loan which was extinguished as a result of the panel’s award determination. Specifically, the Court had to determine whether that award constituted capital gain resulting from Firm B’s taking of Taxpayer’s book of business, as Taxpayer maintained, or ordinary income resulting from the cancellation of indebtedness, as asserted by the IRS. To resolve the characterization of the award, the Court focused on Taxpayer’s arguments raised before the panel.

The Tax Court

It is axiomatic that a taxpayer’s gross income includes all income realized by the taxpayer, from whatever source it is derived, unless it is specifically excluded by statute. Thus, proceeds “received” pursuant to a judgment arising from a dispute – including the amount of the reduction or cancellation of a debtor’s obligation[xvii] – constitutes taxable income unless the taxpayer can establish that the proceeds come within the scope of a statutory exclusion.

Starting from this premise, the Court recognized that “[t]he taxability of the proceeds of a lawsuit, or of a sum received in settlement thereof, depends upon the nature of the claim and the actual basis of recovery.” The nature of the litigation, the Court continued, “is determined by reference to the origin and character of the claim which gave rise to the litigation.” Thus, to the extent that amounts received for injury or damage to capital assets exceed the basis of the property, such amounts are taxable as capital gain, whereas amounts received for lost profits are taxable as ordinary income.

In deciding the character of the upfront forgivable loan that was extinguished as a result of the panel’s award, the Court asked: “In lieu of what were the damages awarded?”

The IRS argued that Taxpayer was bound by his employment agreement and promissory note. The promissory note was made as part of Taxpayer’s compensation package with Firm B (i.e., the monthly transition compensation). The note made no mention of Taxpayer’s book of business.

Moreover, Taxpayer treated the monthly transition compensation he received during his tenure at Firm B as ordinary income, which is consistent with the terms of the employment agreement and promissory note.

The IRS also pointed out that Taxpayer did not assert that the income was capital gain income until the IRS determined that his Firm A stock loss was a capital (rather than ordinary) loss.

The Court observed that the panel did not explain the basis of its award; hence, the Court was left to infer the panel’s reasoning. It explained that, in similar cases, it has looked to the claims made in the pleadings to determine the nature of the taxpayers’ claims.

Taxpayer argued that his filings with the FINRA panel made it clear that the award was to compensate him for the taking of his book of business and hence should be taxed as a capital gain.

The gravamen of Taxpayer’s claim before the panel was that he was entitled to retain the unpaid portion of the loan proceeds because they represented fair compensation for Firm B’s having taken his book of business. In fact, that was the only argument he made with respect to his claim for retention of those proceeds.

The Court disagreed.

It conceded that the filings heavily emphasized Taxpayer’s argument that Firm B lured him in order to acquire his book of business and that thereafter it set out to ruin his professional reputation so as to keep him from working at a competing financial services firm.

But this argument was not the only one Taxpayer presented to the panel. For example, Taxpayer’s filings emphasized that Firm B breached the terms of the employment contract, causing Taxpayer to suffer damages. This argument, by itself, would have relieved Taxpayer of his obligation to pay the outstanding balance of the promissory note to Firm B.

Unfortunately for Taxpayer, the record before the Court did not reveal the specific argument that the panel found most persuasive when it extinguished the balance of the upfront forgivable loan.

Taxpayer had the burden of answering the question “in lieu of what were the damages awarded?” On the basis of its examination of the record, the Court concluded that Taxpayer did not meet his burden to establish that the amount at issue was solely for the acquisition of Taxpayer’s book of business.

Consequently, the Court sustained the IRS’s determination that the extinguishment of Taxpayer’s debt to Firm B constituted cancellation of debt income, and that the amount of the extinguishment was taxable as ordinary income.


It’s an old question: how to distinguish between being given the opportunity to provide services for which one receives compensation taxable as ordinary income, on the one hand, and the transfer of an asset that produces ordinary income, on the other.

The Court did not expressly address the issue, nor did it have to. There were just too many indicia of ordinary income: the industry practice of the forgivable loan as a substitute for immediately taxable compensation, the fact that Taxpayer (as the purported “seller”) rather than Firm B (as the purported buyer) gave a promissory note, Taxpayer’s reporting of the transition payments as ordinary income, Taxpayer’s having negotiated the right in his employment agreement to solicit the customers he brought to Firm B in the event he left the firm, and the fact that he first reported the forgiven loan as ordinary before amending his tax return in response to the IRS’s adjustment of the Firm A stock loss.

That being said, there were also some factors that may have supported capital gain (i.e. sale) treatment under different circumstances. For example, Firm A treated Taxpayer’s spreadsheets and other documents as his personal property, his team remained with Firm B after Taxpayer’s departure, and Taxpayer was effectively precluded from taking his clients with him when he resigned from Firm B. If Taxpayer had not been an employee of Firm A prior to moving his team and clients to Firm B, an argument might have been made that the relationship among Taxpayer, his team, and his clients was indicative of a going concern and of personal goodwill, which together represented an asset, the sale of which generated capital gain.[xviii]

Of course, if the parties had intended something other than a compensatory arrangement, they could have memorialized their agreement differently, and they could have reported their payments and receipts under this arrangement, for tax purposes, other than as they did; in other words, their chosen form would presumably have been consistent with the intended tax treatment.


[i] Last week we considered this issue from the perspective of a tax-exempt organization, in light of the Tax Cuts and Jobs Act. .

[ii] At least within an industry.

[iii] I.e., a receipt of value that is nontaxable because it has to be repaid; there has been no accretion in value by the recipient.

[iv] IRC Sec. 162(a).

[v] Indeed, these upfront forgivable loan arrangements are often contingent upon the continued employment of the employee with the employer-lender.

[vi] Query why the IRS did not argue that this circular flow of funds caused the entire amount of the “loan” to be treated as compensation in the taxable year the proceeds were transferred to Taxpayer?

[vii] “Cause” was defined to include, among other things:

  1. violation of any rules or regulations of any regulatory or self-regulatory organization;
  2. violation, as reasonably determined by Firm B, of its rules, regulations, policies, practices, directions, and/or procedures; or
  3. a suspension, bar, or limitation on Taxpayer’s activities for Firm B by any regulatory or self-regulatory


[viii] Taxpayer’s relationship with his clients was important to him. He negotiated special terms in his employment agreement which allowed him to solicit his longtime clients (i.e., those clients who came with him from Firm A) if he should ever leave Firm B. Specifically, for a period of one year following the termination of Taxpayer’s employment with Firm B for any reason, he agreed not to solicit, or initiate contact or communication with, either directly or indirectly, any account, customer, client, customer lead, prospect, or referral whom Taxpayer served or whose name became known to him during his employment at Firm B. However, this restriction did not apply to clients whom Taxpayer served at his prior employer (Firm A) or who became clients of Firm B within one year after he began employment with Firm B.

[ix] Form U5. FINRA is a private corporation that acts as a self-regulatory organization. It is the successor to the NASD, and ultimately reports to the SEC.

[x] Whom Firm B had convinced to stay with the firm through various incentives.

[xi] Interestingly, none of Taxpayer’s team, including his partner and the four sales assistants who transitioned with him, seem to have faced any repercussions for the actions in which they all engaged and which allegedly constituted violations of the protocol. The rest of the team remained at Firm B servicing Taxpayer’s entire book of business. “Who’s your daddy?”

[xii] Which amount was directly tied to the amount of revenue his book of business generated the year before he joined Firm B.

[xiii] Taxpayer relied on these facts to support his claims against Firm B of unjust enrichment, fraudulent inducement, breach of contract, and breach of the implied covenant of good faith.

[xiv] The remaining balance of the upfront forgivable loan.

[xv] Ordinary income.

[xvi] So as to offset the capital loss resulting from the IRS’s adjustment.

[xvii] IRC Sec. 108, 61(a)(12).

[xviii] Much as a non-compete is an important element in ensuring the transfer of a seller’s goodwill to a buyer, so the acts allegedly taken by Firm B effectively secured for its benefit the asset represented by Taxpayer’s client base.