Happy New Year?

Ask anyone outside the United States what comes to mind when they think about an American New Year’s celebration, and the odds are pretty good they will mention the ball drop in New York City’s Times Square.

That’s all well and good, but let me ask you, does the Empire State have a New Year’s Possum Drop? How about a Buzzard Drop? Maybe a Geranium Drop? None of these, you say? Hmm.

Well, in which States are the residents fortunate enough to raise “a cup of kindness”[i] while counting down the minutes to the New Year by observing the lowering of a marsupial, a raptor, and a flower? Only in one, you say?

That’s right. Georgia alone can boast that it is home to these three unique “drop” events.[ii]

Is it any wonder, then, that the political fate of the nation, for at least the next two years,[iii] will be decided tomorrow, January 5th, by the voters of the Peach State?

Election 2021

As of New Year’s Day, the final day for early voting in the run-off races for Georgia’s two seats in the U.S. Senate, over 3 million votes had already been cast; putting that figure into perspective, over 4.8 million votes in total were cast in the Perdue-Ossoff contest in November 2020, and almost 2.9 million in the Warnock-Loeffler race.[iv]

During November and December of 2020 – a span of less than two months – approximately one-half billion dollars was poured into the campaigns of these four candidates.[v]

We all know why so much effort is being expended in the Georgia run-offs. As of today, the Republican Party hold 50 seats in the Senate, while the Democrats hold 48 seats.

If the Republicans take just one of the two seats being contested, they will control the Senate and, assuming a vote strictly along party lines – not a foregone conclusion on the Republican side, at least – they will be in a position to stymie almost any proposed tax legislation coming out of a Biden White House for at least two years.[vi]

If the Democrats take both of Georgia’s Senate seats, that chamber will be evenly split; in the event of a tied vote on a tax bill – meaning a vote along party lines – Vice President-elect Harris will be in a position to cast the deciding vote as the president of the Senate.

How Much of a Difference?

Let’s assume the Democrats take both of Georgia’s Senate seats. Let’s also assume that they do not abolish the filibuster[vii] (“reform by ruling,” better known as the “nuclear option”), which would require the consent of every Democrat in the Senate, and that they decide against reconciliation.[viii]

What will that mean insofar as estate tax planning for the owner of a closely held business is concerned over the next two years?[ix]

The first items to consider include provisions that may be described as the proverbial low-hanging fruit in that they are already scheduled to disappear from the law. Others may be attainable as part of the give-and-take (or sausage-making, if you prefer) that is the legislative process. Still others are unlikely to be broached (other than in select circles) for fear of alienating voters before the 2022 elections.

What is Likely?

It is more likely than not that the Democrats will reduce the unified federal estate/gift/GST tax exemption amount to the level at which these exemption amounts would have been set this year if the 2017 Tax Cuts and Jobs Act[x] had not doubled the basic exclusion amount for the 2018 through 2025 taxable years;[xi] in other words, we can expect an acceleration (by five years) of the existing time table under which these changes would otherwise have occurred in 2026.[xii]

It is also likely that the so-called “portability” rule, by which a deceased spouse’s unused exemption (“DSUE”) amount would carry over to their surviving spouse, will remain intact.

In addition, the reduction of the exemption amount will probably not be applied in such a way as to retroactively deny some future estate the full benefit of the higher exemption amount that may have been in effect at the time of a decedent’s taxable gifts;[xiii] for example, those made in the latter part of 2020.

The reduction of the exemption amount may be accompanied by an increase in the top tax rate for the federal estate/gift/GST tax, from 40 percent to 45 percent.

Speaking of tax rates – and although it is not part of the estate tax regime, it is closely related thereto – one may reasonably expect the Democrats to increase the highest tax rate applicable to long-term capital gains,[xiv] and to qualified dividends, from 20 percent to 24.2 percent.[xv] Assuming the Supreme Court does not strike down ACA,[xvi] the 3.8-percent surtax on net investment income[xvii] would continue to apply as under current law. Thus, the maximum capital gains and dividend tax rate, including the surtax, would rise to 28 percent.

These figures were not picked out of thin air; the 24.2 percent rate for capital gains, for example, was included in President Obama’s Fiscal Year 2017 Budget.[xviii] Indeed, much of the tax plan presented by Mr. Biden during the presidential campaign was derived from this proposed budget. It also appears that most of the individuals to be nominated or appointed by Mr. Biden to his Administration were once members of the Obama Administration. Reasonable conclusions may be drawn based upon the foregoing.

What is Unlikely?

It is unlikely, however, that the Democrats will try to eliminate the basis adjustment (usually a “step-up”) for assets acquired or passing from a decedent upon the death of the decedent,[xix] or that they will seek to treat a decedent’s death as a recognition event resulting in the imposition of an income tax on the built-in gain (i.e., the untaxed appreciation in value) of a decedent’s assets as if such assets had been sold for fair market value on the date of death.[xx]

Based upon the reduction in the number of House seats held by the Democrats (from 235 to 222)[xxi], and upon what will be, at best, an even split in the Senate, it would be delusional for the Party to believe – and misleading for it to state – that it has a mandate to eliminate the basis step-up rule, or to treat death as a recognition event for purposes of the income tax. Although some of the Party’s more “radical” thinkers – almost entirely in the House – will most likely seek these changes, they are being blamed by many Democrats for what has been described, under the circumstances, as the Party’s relatively poor performance last November.

Moreover, the political foundation and theoretical underpinnings for such significant changes have not yet been laid. Although campaign slogans, like “tax the rich” – whatever that means – may resonate with some voters, they do not provide a basis for the enactment of meaningful and effective legislation.

For example, the long-standing basis adjustment rule is premised on the rationale that a decedent’s death is the equivalent of a sale of the decedent’s assets to their beneficiaries at fair market value without income tax consequences.[xxii] It will likely take many years to convince the targeted population[xxiii] – or the legislators whom they support – of the fiscal or other need to abandon this principle, let alone to introduce the imposition of an income tax upon a decedent’s estate in the absence of an actual sale or exchange of the decedent’s assets.

In other words, don’t expect the 117th Congress – which was officially convened yesterday – to blaze any new trails.

Planning for the Future

The re-election yesterday of Ms. Pelosi as Speaker of the House probably does not bode well for Democrats in the long-run, given her ideological bent, but stranger things have happened. In other words, notwithstanding this development, the Democrats may still be in a position two years from now to enact additional changes to the federal estate and gift tax regime, including, for example, a further reduction in the exemption amount, and perhaps the elimination of certain planning techniques or vehicles.

With this possibility in mind, those taxpayers who acted before the end of 2020 to make gifts in an aggregate amount equal to or approaching their remaining unified federal estate/gift tax exemption amount may believe that they have exhausted their ability to further reduce their otherwise taxable estate.

To some extent, it will be more difficult under these circumstances to reduce one’s future estate without incurring a gift tax liability.[xxiv] However, there remain a number of tools by which one may reduce, freeze, or control the growth of, one’s estate.

Annual Gifting

The annual exclusion gift remains safely ensconced in the Code;[xxv] at $15,000, it allows a married couple to make nontaxable gifts (in cash or in kind) with a fair market value of $30,000 to each of their issue every year.

Where the gift is made in-kind, meaning in the form of minority and/or non-voting equity interests in a closely held business entity, the ability to discount the value of such interests will have the effect of leveraging the annual exclusion amount.[xxvi]

Low-Interest Loans

Assuming the continuation of the low-interest rate environment in which we now find ourselves, taxpayers may take various steps to effectively “freeze” the value of part of their estate by “converting” these assets into the principal of a below-market-interest loan, and to shift the future appreciation of these assets (or of the assets acquired with the loan proceeds) to their issue.[xxvii]

Intra-family Loan. A taxpayer with liquid assets may consider making a low-interest loan to their issue, or to business entities owned by their issue. Although interest will have to be paid (and other indicia of debt will have to be present) in order to support the loan’s treatment as such for tax purposes, the younger generation’s investment of the loan proceeds may yield a return well in excess of the low amount of interest payable.

Sale to Grantor Trust. In general, a “grantor trust” is one with respect to which the grantor has “retained” certain rights such that the grantor will continue to be treated as “owning” the trust’s property and income for tax purposes.[xxviii]

 Many of the gifts made in 2020 involved the use of grantor trusts. There were several reasons for this: (i) the grantor wanted to leverage the use of their exemption by remaining liable for the income taxes attributable to the assets gifted (see below); (ii) the grantor wanted to be able to repurchase the gifted property from the trust if future circumstances warranted such a transaction; and (iii) the grantor wanted to utilize part of their exemption amount but was unable to obtain an appraisal before the year-end – they made a gift into the trust of liquid or marketable assets with a value equal to the exemption, with the intention of exchanging these for the property that they actually intended to gift once such property has been appraised in early 2021.

These same trusts may now be used to purchase other assets from the grantor (which have the potential to appreciate) in exchange for a term note[xxix] that bears interest at the applicable federal rate,[xxx] payable and compounded annually, with a balloon payment at maturity. Because of the trust’s grantor trust status, the sale will be ignored for income tax purposes, as will the interest payments;[xxxi] for purposes of the gift tax, however, the grantor will be treated as having received adequate consideration. Moreover, the grantor will continue to be taxed on any income or gain recognized by the trust, thereby further reducing their estate, while effectively making a tax-free gift to the trust beneficiaries.

GRAT. A variant of the sale to a trust is the statutorily blessed GRAT, or “grantor retained annuity trust.” It, too, works well in a low-interest rate environment, meaning that the GRAT will be viewed as having succeeded if its assets appreciate at a rate that exceeds the discount rate applied in determining the present value of the annuity.[xxxii]

The grantor would establish and fund a trust in exchange for a “fixed” amount that would be payable to the grantor at least annually over a term of years.[xxxiii] Because the trust is typically a grantor trust, it will enjoy the same benefits described above (for example, the annuity payment will not be taxable to the grantor).

The amount of the gift made by the grantor will be equal to the fair market value of the assets transferred to the trust over the present value of the grantor’s retained annuity interest; thus, the longer the term, or the greater the annuity amount, the lesser the amount of the gift. Indeed, under present law, it may be possible to enter into a GRAT arrangement with very little gift tax exposure.[xxxiv]

As in the case of annual gifts (described above), an in-kind contribution of equity interests in a business, especially one organized as a non-taxable or pass-through entity, may be used to leverage the benefit of a sale to a grantor trust or to a GRAT.

“Corporate” Transactions

In appropriate circumstances, certain business transactions may be utilized to shift appreciating assets to a younger generation of owners. For example, where a business entity, such as a corporation, or an LLC treated as a partnership for tax purposes, is engaged in two or more lines of business, it may be possible to separate the lines of businesses on a tax-deferred basis by distributing to the younger generation the faster-growing line, which is often the one in which the younger generation is more engaged.[xxxv]

Alternatively, a parent-owner may reduce the owner’s interest in the business – for example, by a partial redemption or liquidation of their interest therein – such that the owner is no longer in a position to control such business, or to block action by other family members who are owners, thereby allowing the value of the owner’s interest to be discounted for purposes of the estate tax.[xxxvi]

Life Insurance

Of course, not every business owner will be able to take advantage of these strategies, and many will simply not want to do so.

In that case, it may behoove the owner to ensure that their estate will be in a position to take advantage of the estate tax installment payment rules under Section 6166 of the Code.[xxxvii]

Alternatively, or even in conjunction therewith, the owner – or more appropriately, an irrevocable grantor trust in which the owner has no interest – should consider obtaining life insurance on the owner’s life (or on the joint lives of the owner and their spouse, depending upon their estate plan) in order to provide a source of liquidity from which their estate tax liability may be satisfied.[xxxviii]

Regulatory End-Run?

Unfortunately for business owners, Mr. Biden is beginning to realize that he may not have the ability to pass legislation that would implement most of his tax agenda. News organizations have started reporting that the President-elect will likely be expanding his focus to include regulatory changes, the effect of which will be to increase estate and gift taxes.

In particular, one should expect the reintroduction of the 2016 proposed changes to the regulatory valuation rules applicable to transfers of interests in a closely held business, which were subsequently withdrawn by Mr. Trump. As originally drafted, these were definitely overbroad – for instance, they treated investment entities the same as operating businesses – but otherwise were properly targeted at some clearly abusive situations.[xxxix]

Query what other transfer tax-related regulation projects the Administration may have in mind for the Treasury and the IRS?

For example, will the IRS increase the number of gift tax audits?[xl] Will the income tax exam function cooperate more closely with their transfer tax brethren? In each case, they should – but will the funding for such activities be forthcoming?

Unlikely to Pass, But Worthy of Consideration?

Other notable estate tax reform possibilities, none of which are likely to be passed under the presently constituted Congress – but which probably deserve serious consideration, regardless of one’s political affiliation – include the following: (i) requiring a minimum term for a GRAT (thereby increasing the mortality risk); (ii) requiring a minimum value for the remainder interest (the gift, thereby eliminating zeroed-out GRATs) at the time property is contributed to the GRAT; (iii) eliminating (at least in part) the inconsistent treatment of transactions involving irrevocable grantor trusts for income tax vs estate/gift tax purposes (think sales to grantor trusts); and (iv) limiting the use of dynasty trusts – for example, by increasing the inclusion ratio of the trust to one after a specified number of years (thereby subjecting future trust distributions to the GST tax).

Taxpayers and their advisers should be attuned to the introduction of such proposals, which I believe is inevitable, and should time their use of the targeted planning vehicles accordingly – they won’t last forever.

[i] According to a WSJ piece, the original cup of kindness to which “Auld Lang Syne” refers is whiskey (no “e” in Scottish). https://www.wsj.com/articles/whiskey-is-the-original-cup-of-kindness-11577469857. That said, I have to agree with Tom T. Hall, that beer is No.1, but whiskey (though “rough”) shares the number 2 spot with ouzo. Wine doesn’t make the top five.

[ii] Unlike my references to Staten Island, I am being facetious here. The first great educator in my life was an elementary school social studies teacher from Waycross who somehow found her way to the Bronx. Of the Presidents who have served during my lifetime, one of the only two I admire as individuals is a Georgian, Mr. Carter.

[iii] The 2022 national elections may be pivotal as the entire House will be up again, as are 34 “Class Three” seats in the Senate (comprised of 20 Republicans and 13 Democrats, so far – one of the Georgia run-off seats will be the 34th.)

[iv] None of the candidates succeeded in winning a majority of the votes cast, as required under Georgia law in order to win an election; hence, the run-offs.

The Perdue seat is for a regular six-year term. Loeffler was appointed by Georgia’s Governor Kemp to replace Senator Johnny Isakson, whose regular term would have ended in 2022.

Under Georgia law, Loeffler was required to run in the next national election cycle following her appointment (November 2020) for the right to serve the remaining two years of Mr. Isakson’s six-year term.

[v] A lot of this money has come from outside of Georgia. Just think how much good that money could have done if it had been spent on those in need – like the folks waiting for stimulus checks – rather than on ensuring that two individuals (some affluent ones, at that) attain positions of power from which they may advance the interests of some, while condescendingly lording it over others.

We need to “reform” campaign financing.

These funds have often been accompanied by folks from outside the State who would purport to tell Georgians what’s good for them. Can you imagine some politico from New York crossing over into New Jersey to persuade that State’s voters to support the election of a particular individual that the New Yorker believes can best serve New Jersey’s interests?

First of all, each State has to trust every other State to act responsibly – by which I mean the aggregate of its residents, as opposed to the legal entity – that’s the only way this works. Second, how presumptuous is it for some actor from, say, California, to make a cameo appearance in Georgia to educate Georgians on the pluses and minuses of the candidates on whom they had already voted only two months earlier? Seriously.

[vi] As indicated earlier, one of these seats – the Warnock-Loeffler race – is a Class Three seat that will be up for re-election in November 2022.

[vii] Which requires 60 votes to end debate on a matter – including a tax matter – and put it to a vote, at which point only a majority is required for passage.

[viii] The reconciliation budget process allows a simple majority to pass certain bills.

Because spending and revenue measures are almost always considered in a single bill, reconciliation can be used only once per budget cycle. As explained by The Center on Budget Policy and Priorities:

“Under Senate interpretations of the Congressional Budget Act, the Senate can consider the three basic subjects of reconciliation — spending, revenues, and debt limit — in a single bill or multiple bills, but it can consider each of these three in only one bill per year (unless Congress passes a second budget resolution).  Consequently, in the Senate there can be a maximum of three reconciliation bills in a year, one for each of the basic subjects of reconciliation.

This rule is most significant if the first reconciliation bill that the Senate takes up affects both spending and revenues.  Even if that bill is overwhelmingly devoted to only one of those subjects, no subsequent reconciliation bill can affect either revenues or spending because the first bill already addressed them.”

https://www.cbpp.org/research/federal-budget/introduction-to-budget-reconciliation .

[ix] The mid-term elections may negate everything that follows, as may the departure, for any reason, of the 78-year old President-elect.

For a summary of Mr. Biden’s tax proposals: https://www.taxlawforchb.com/2020/08/bidens-tax-proposals-for-capital-gain-like-kind-exchanges-basis-step-up-the-estate-tax-tough-times-ahead/ ; https://www.taxlawforchb.com/2020/08/responding-to-the-democratic-partys-tax-plans/ ; https://www.taxlawforchb.com/2020/11/the-2020-elections-are-almost-over-what-now/

[x] P.L. 115-97; the “TCJA.”

[xi] IRC Sec. 2010(c)(3).

[xii] Mr. Biden has talked about restoring the 2009 exemptions of $3.5 million for the estate tax and $1.0 million for the gift tax. Although he may return to this during the Second Session of the 117th Congress, it will be easier at this point to just eliminate the TCJA’s increase of the basic exclusion amount.

[xiii] See T.D. 9884 and the regulations issued in 2019, under IRC Sec. 2010, which prevent such a “claw-back.”

[xiv] IRC Sec. 1(h). Including gain from the sale of a business; for example, that portion attributable to goodwill, generally speaking.

[xv] An increase of more than 20 percent.

[xvi] Affordable Care Act. The Court heard oral arguments in California v. Texas on November 10, 2020 (No. 19-1019). Based upon the questions posed by the Justices, many observers believe that ACA will not be struck down.

[xvii] IRC Sec. 1411.

[xviii] The Republicans controlled both Sessions of the 114th Congress.

[xix] IRC Sec. 1014.

[xx] What if a mark-to-market regime were limited to marketable securities?

New York is toying with the idea of an annual mark-to-market-based tax for its approximately 120 billionaire residents. A number of tax professionals have objected to this notion, some on constitutional grounds. See https://www.taxlawforchb.com/2020/12/new-yorks-proposed-billionaires-tax-bad-idea/ .

[xxi] There is one district in New York that has not yet been certified by Albany.

[xxii] Of course, the estate tax and GST tax may be imposed at the decedent’s death. IRC Sec. 2001 and Sec. 2601, respectively.

[xxiii] Which includes many people in Congress.

[xxiv] Which may not be a bad thing if the property that is the subject of the gift is expected to appreciate significantly. Of course, if the donor-taxpayer passes away within three years of the gift, the amount if gift tax paid will be added to the donor’s gross estate. IRC Sec. 2035.

[xxv] IRC Sec. 2503(b).

[xxvi] It cannot be overstated: the services of an experienced and qualified appraiser are absolutely necessary. No shortcuts here. https://www.taxlawforchb.com/2017/05/why-care-about-business-valuation-part-i/ .

[xxvii] As always, the transaction has to make economic sense for the grantor, and the grantor has to be comfortable with assuming the credit risk.

[xxviii] IRC Sec. 671.

[xxix] The term should not exceed the grantor’s life expectancy at the time of the transaction.

[xxx] The long-term AFR for January 2021 – a term in excess of nine years – is 1.35%.

[xxxi] Rev. Rul. 85-13.

[xxxii] Under IRC Sec. 7520; currently set at 0.60 percent.

[xxxiii] IRC Sec. 2702.

[xxxiv] A so-called “zeroed-out” GRAT.

[xxxv] See IRC Sec. 355 and Sec. 368(a)(1)(D) regarding corporate divisions; see IRC Sec. 731, 736, 704(c)(1)(B), 737, 752, and Reg. Sec. 1.708-1(d) regarding partnership divisions. https://www.taxlawforchb.com/2013/11/splitting-up-the-family-corporation/

[xxxvi] Rev. Rul. 59-60.

[xxxvii] https://www.taxlawforchb.com/2014/02/deferring-the-estate-tax-section-6166/ .

[xxxviii] See IRC Sec. 2042. The insured will have to be careful not to hold any incidents of ownership in respect of the policy.

The irrevocable life insurance trust (“ILIT”) may loan funds to the estate, or it may purchase assets from the estate, thereby providing liquidity to the estate.

[xxxix] The first of three posts: https://www.taxlawforchb.com/2016/09/the-irs-takes-the-offensive-on-valuation-discounts-part-one/ .

[xl] Historically low exam rate.

Mending Walls

“Good fences make good neighbors,” or so Robert Frost’s neighbor from “beyond the hill” says to him when “on a day” they “meet to walk the line and set the wall between” them “once again.” The neighbor repeats this proverb in response both to Frost’s question regarding the purpose of the wall – “There where it is we do not need the wall,” Frost tells us– and to his observation that “something there is that doesn’t love a wall, that wants it down.”[i]

How might New Jersey or Connecticut apply this proverb when addressing New York’s recent efforts to extend the reach of its taxing jurisdiction to nonresident employees who are telecommuting from their homes in these neighboring States?

Taxing Nonresidents

It has long been accepted that a State may tax a nonresident individual only with respect to income from sources within that State. For example, a State may tax a nonresident on their rental income from real property located in the State, or on their share of partnership income from a business operating in the State.

The same source-based limitation applies to the case of an individual who provides services within a State of which they are not a resident; specifically, the State may tax the nonresident’s compensation only to the extent such compensation is attributable to services rendered by the nonresident within the State, which is usually determined by comparing the number of days worked by the nonresident within the State with their number of days worked without the State.

In other words, those wages earned by a nonresident employee for work performed outside a State may not be taxed by that State.

New York

In the case of a nonresident employee who performs services for their employer both within and without the State, New York’s law is similar to that of other States; it provides that the nonresident’s income derived from New York sources includes that proportion of their total compensation for services rendered as an employee which the total number of working days employed within New York bears to the total number of working days employed both within and without New York.

However, any allowance claimed for days worked outside New York must be based upon “the performance of services which of necessity, as distinguished from the convenience, obligate the employee to out-of-state duties” in the service of their employer.[ii]

Under these rules, New York has been able to collect billions of dollars of income tax, annually, from several hundred thousand New Jersey and Connecticut residents who commuted to jobs in New York every day – before the pandemic, that is.

In March of this year, New York’s Governor Cuomo issued a statewide order that all non-essential workers work from home; this included many nonresidents who commuted to jobs in New York. Following this order, those nonresidents who could do so telecommuted “to” their New York jobs.

Convenience of the Employer

Then, just a few months ago, in what may be described as an aggressive extension of New York’s “convenience of the employer” rule, New York issued guidance according to which the days a nonresident telecommuted from their home outside New York during the pandemic – a “normal work day” – would be considered days worked in New York if the nonresident’s “assigned or primary office” was in New York, unless the nonresident’s New York employer specifically acted to establish a bona fide employer office at the nonresident employee’s non-New York “telecommuting location.”

In the absence of such a bona fide employer office at the employee’s telecommuting location – say, in New Jersey or Connecticut – the nonresident employee would continue to owe New York personal income tax on income earned while telecommuting from their home in one of those States.

A number of factors[iii] are considered in determining whether a nonresident’s New York employer has established a “bona fide employer office” at the employee’s telecommuting location outside New York; specifically, the State in which the employee resides. It is no easy thing to demonstrate that these factors have been satisfied.

Should the Rule Apply?

The question, of course, is whether it is appropriate for New York to apply its “convenience” rule given the circumstances under which so many nonresident employees are forced to telecommute.

In the first instance, there was nothing voluntary about their decision to work from home. They were ordered to do so by the Governor of New York. Then there is their very reasonable concern for their safety and the well-being of those close to them.

According to many jaded observers – myself included – what we are witnessing does not reflect a “logical” extension of New York’s rule but, rather, an attempt by the State to make up for lost tax revenues caused by the stay-at-home order issued in response to the pandemic and the resulting economic shutdown.

“Like a Good Neighbor”[iv]

A Connecticut resident is subject to Connecticut income tax, and a New Jersey resident is subject to New Jersey income tax, on all of their income regardless of where the income is earned or sourced. However, if the Connecticut resident or the New Jersey resident works in another State that imposes an income tax on compensation earned within that State – New York comes to mind – the individual is also subject to tax in the State in which they work.

That is not to say that a resident of, say, New Jersey with compensation income for services performed in New York will necessarily pay tax on such income to both New Jersey and New York.

The New Jersey resident will have to report this income on a New York nonresident income tax return, and it will remit to Albany the New York income tax imposed on such New York source income.

At the same time, the New Jersey resident will also have to report this compensation income on their New Jersey resident return. However, in determining their New Jersey resident tax liability on such income, the resident may be eligible for a credit for any income taxes paid to New York on the income.[v]

In other words, New Jersey will forego collecting tax from a resident taxpayer on income sourced in New York to the extent the income was taxed by New York. Thus, the credit has the effect of shifting tax revenue away from the New Jersey taxpayer’s State of residence and into the State (New York) in which the income was earned.[vi]

New Jersey’s Reaction

Within days of the issuance of New York’s above-described guidance, the New Jersey Senate responded with a bill[vii] which began as follows:

“The Legislature finds and declares that:

a. Thousands of New Jersey residents, many of whom work from home, have New York income taxes taken from their paychecks because their employers are located in the State of New York.

b. New Jersey allows those residents to claim a tax credit against their New Jersey income tax liability for the taxes they paid to New York, so that their income is not taxed again.

c. It is grossly inequitable that the State of New York receives and retains income tax revenue from New Jersey residents who may only infrequently and sporadically travel to New York to conduct business.

d. The inequity extends to New Jersey residents who may be required to pay higher New York income tax rates.

e. Current inequities have been growing over time as technology improvements have allowed New York businesses to decrease office space available to New Jersey residents working in New York and effectively use New Jersey’s infrastructure and services as support for their employees.

f. Current inequities have further been exacerbated by COVID-19, which is hastening the trend of New Jersey residents no longer truly working in New York and New York businesses downsizing New York office space available to New Jersey residents.”

The bill directs the State Treasurer to prepare and submit a report concerning New York’s taxation of the income earned by New Jersey residents, to determine how much credit New Jersey gives for taxes paid to New York, and to make recommendations for how New Jersey may resolve the “inequitable tax treatment” of New Jersey residents who commute to work for employers in New York.

The bill also requests that the State consider participating in the potential litigation between New Hampshire and Massachusetts, described below.

New Hampshire vs. Massachusetts

New York is not the only State that appears to be flexing its economic muscle in the face of its smaller, economically less robust neighbors, many residents of which commute to jobs located in the larger State. In April of this year, Massachusetts sought to explain its income tax sourcing rules applicable to those nonresident employees who began telecommuting following the Commonwealth’s emergency order requiring all nonessential businesses in Massachusetts to close their physical workplaces and facilities.

According to Massachusetts, all compensation received for services performed by a nonresident who, immediately prior to the emergency order, was an employee engaged in performing services in Massachusetts, and who began performing services from a location outside Massachusetts due to a “pandemic-related circumstance,” would continue to be treated as Massachusetts source income subject to the Commonwealth’s personal income tax.

New Hampshire reacted by filing a complaint against Massachusetts in the U.S. Supreme Court claiming, among other things, that Massachusetts was infringing upon New Hampshire’s sovereignty by seeking to impose a tax upon New Hampshire residents in respect of income they earned in New Hampshire – not in Massachusetts.[viii]

Amicus Briefs

Last week, New Jersey[ix] and Connecticut filed a “friends of the court” brief[x] in which they (i) described their own experience with New York’s efforts to tax their residents, (ii) supported New Hampshire’s request that the Supreme Court accept the action initiated by the Granite State, and (iii) urged the Court the rule in favor of New Hampshire – and, by extension, New Jersey and Connecticut – on the merits.

According to the amicus brief, New York[xi] levies taxes on nonresident employees for income they earn while working at home in their New Jersey or Connecticut residences, as the case may be. The imposition of these taxes, the brief claims, is inconsistent with the Federal Constitution because they are not fairly apportioned. According to the brief, the “central purpose” of the fair apportionment requirement is “to ensure that each State taxes only its fair share” of a tax base. A State does not tax its “fair share,” the brief asserts, when the State directly taxes the income that nonresidents generated outside the State’s borders by working from home.

In urging the Court to exercise its original jurisdiction to accept New Hampshire’s petition, the amicus brief illustrated the impact of the Massachusetts and New York tax schemes as follows: “As New Hampshire highlights, an individual who spends her day working at home in New Hampshire could be required to pay Massachusetts taxes on her entire income, even though her Home State [New Hampshire] (where she spent the entire month) levies no such tax. . . . Similar rules apply . . . to the Connecticut and New Jersey residents who work most days from their Stamford or Jersey City apartments for a company based in Manhattan.”

In addition, the taxes paid by these nonresident taxpayers to New York have an adverse effect upon New Jersey’s and Connecticut’s finances because these States – in order to mitigate the risk of double taxation on their residents who have New York source compensation income – voluntarily provide a credit to their residents for taxes these residents have paid to New York. In doing so, New Jersey and Connecticut are sacrificing billions of dollars in tax revenue, while New York enjoys a windfall.

This is particularly troubling, the brief avers, because New Jersey and Connecticut provide police, medical and other services to their residents working at home without collecting tax revenue. “Yet that is the Hobson’s Choice to which [New Jersey and Connecticut] are put: doubly tax residents’ income or suffer fiscal consequences.”

The Pandemic

To drive its point home, the amicus brief then addresses the “unprecedented growth in work from home borne of the ongoing COVID-19 pandemic,” explaining that approximately “70 percent of U.S. employees ‘always’ or ‘sometimes’ worked from their home.”

Before the emergence of COVID-19, the brief explains, “more than 400,000 residents of amici New Jersey commuted to jobs in New York City (as did up to 78,000 residents of amici Connecticut).” However,

“This interstate travel came to an abrupt halt in March 2020, when rising COVID-19 cases compelled the New York Governor to prohibit employees of non-essential businesses from reporting to the workplace. Offices and stores in New York City were permitted to reopen in June 2020, but because of the ongoing pandemic, employers are still subject to various capacity limits, employers must take measures to reduce interpersonal contact in the office, and many former commuters keep working from home.”

Notwithstanding that these individuals were compelled, in effect, to work remotely from home, the briefs continues,

“New York made clear that nonresidents who are working from home due to the COVID-19 pandemic should consider their days working from home on account of these orders as ‘days worked in [New York] unless [their] employer has established a bona fide employer office at [their] telecommuting location.’ Given the stringent test for a bona fide employer office, residents working from home in amici New Jersey or Connecticut are virtually certain to fail New York’s test and will be required to pay income taxes to New York even if they never left the borders of their Home State.”

Given the number of individual taxpayers working from home, the brief concludes, “[t]he financial impact” of New York’s tax scheme cannot be understated. The tax credits that “home” States, like New Jersey and Connecticut, grant their residents who telecommute “to New York” will cost these States billions of dollars.[xii]

What’s Next?

The competition among the States for tax dollars is certain to get worse. The continuing pandemic, what promises to be a prolonged economic downturn, and Congress’s failure to include any meaningful financial relief for the States in the stimulus legislation enacted yesterday, do not bode well for the States which provide credits to those of their residents who will be telecommuting to work for an employer in a neighboring State to which they pay income taxes in respect of their compensation.

This situation may get worse in the short run if the Democrats fail to carry Georgia’s two Senate seats, thereby leaving Mr. McConnell in a position to squelch any future proposals that would provide significant financial aid to State and local governments.

Looking further down the road, unless States like New York, New Jersey and Connecticut come to some mutually beneficial agreement regarding the taxation of nonresidents who telecommute, or unless the Supreme Court accepts New Hampshire’s case and settles the matter, or unless Congress elects to provide a nationwide rule – don’t hold your breath – employers and their nonresident employees will continue to be pieces in the games that States are being forced to play.

Of course, that assumes no change in the status quo. The telecommuting experience of many employers and employees during the pandemic, however, is certain to change the way these folks do business, and especially the location from which such business is conducted[xiii] and how it is taxed. These circumstances will raise the possibility that the States in which the telecommuting employees are domiciled may try to tax the nonresident businesses that employ them, thereby recapturing the tax revenue lost to credits. This option will certainly be attractive in the case of New Jersey. Moreover, this approach may be legally supportable under the Supreme Court’s reasoning in South Dakota v. Wayfair, and its adoption of an economic nexus standard.[xiv]

Worse still, from the perspective of these States, and perhaps more likely following the proposal of income tax increases by many of these States,[xv] these employers (and, in many cases, their employees as well) will move to a warmer, tax-friendlier jurisdiction, thereby depriving both the “work State” and the “home state” of revenues.

Walls. “‘Why do they make good neighbors?”


[i] https://www.poetryfoundation.org/poems/44266/mending-wall . Robert Frost worked a farm in New Hampshire for nine years, during which period he wrote many of his poems.

[ii] 20 NYCRR 132.18.

[iii] These factors are divided into three categories: the primary factor, secondary factors, and other factors. In order for an office to be considered a bona fide employer office, the office must meet either: (a) the primary factor, or (b)(i) at least 4 of the secondary factors and (ii) 3 of the other factors.

[iv] Some jingles just won’t go away.

[v] The credit reduces the resident’s New Jersey Income Tax liability so that they don’t pay taxes twice on the same income – once to New York as a nonresident, and once to New Jersey as a resident.

It should be noted that, in order for the New Jersey resident to enjoy a credit for taxes paid to New York, such taxes must have been paid with respect to New York source income.

What about a New Jersey domiciliary who is determined to be a New York statutory resident for a particular year? In that case, the New Jersey domiciliary would be subject to tax as a resident of both states. What if the income on which this tax is imposed is attributable to an intangible, like the gain from the sale of shares of stock?

New Jersey is unlikely to treat such gain as arising from a New York source; thus, no credit would be allowed for the New York tax paid for purposes of determining the New Jersey resident’s New Jersey income tax.

See the following example of this principle applied to a Connecticut domiciliary who was found to be a statutory resident of New York: https://www.taxlawforchb.com/2020/01/cmon-new-york-give-me-some-credit/ .

[vi] This should be compared to the situation of a New Jersey resident who works in Pennsylvania, say, in Philadelphia. Under a reciprocity agreement between the two states, the New Jersey taxpayer will pay income tax only to the jurisdiction in which they reside – New Jersey – and not in the jurisdiction where they work Pennsylvania).

[vii] S-3064. https://www.njleg.state.nj.us/2020/Bills/S3500/3064_I1.PDF. The bill is now pending in the Assembly.

[viii] The complaint in New Hampshire v. Massachusetts was filed on October 19, 2020. https://www.governor.nh.gov/sites/g/files/ehbemt336/files/documents/nh-v-ma-action.pdf.

New Hampshire does not impose an income tax.

[ix] In accordance with the directive in S-3064, above.

[x] Amicus curiae.

[xi] And Massachusetts.

[xii] In 2018, New Jersey credited more than $2 billion to resident taxpayers who worked for out-of-state employers; virtually all of this income tax credit related to work done for New York employers.

[xiii] Many business owners are wondering about certain expenses, especially exorbitant rents for the use of office space in the face of an increasing number of telecommuting employees.

[xiv] 138 S. Ct. 2080 (2018). Even without Wayfair, the physical presence of a resident-telecommuting employee performing a significant function for the out-of-state business-employer may suffice.

In fact, a fairly recent survey of state tax departments revealed that many states consider the presence of a telecommuting employee of an out-of-state business as sufficient economic nexus for purposes of taxing such business. https://pro.bloombergtax.com/reports/survey-of-state-tax-departments/?trackingcode=BTXS205632.

It should be noted, however, that some states have chosen not to treat a resident employee, who is telecommuting for an out-of-state employer because of COVID-19 restrictions, as a point of nexus on which to justify the taxation of such employer.

[xv] We’re waiting for the veto-proof New York legislature to act.

Happy Holidays? Bah Humbug!

The “holiday season” is once again upon us. A time to spend with family and friends, a time for gift-giving (and re-gifting), for songs and for story-telling, and a time for remembering those who cannot be with us, those whom we have lost,[i] and a time to help those to whom life has been less than kind.

Sounds like a Hallmark card, doesn’t it? The sentiments expressed are genuinely held, but how to manifest them as tangible acts? There’s the rub, as some fictional Dane may have said.[ii]

I, for one, have failed miserably, having put my studies, my work, and my “profession” ahead of all holiday-related activity since high school. I admit, the fault for this shortcoming is almost entirely mine. Like Scrooge, it may be said of me:

“You fear the world too much…. All your other hopes have merged into the hope of being beyond the chance of its sordid reproach. I have seen your nobler aspirations fall of one by one, until the master passion, Gain, engrosses you.”[iii]

Thankfully, but sad to say, I am hardly unique. Even as I write this, I know there are many attorneys and accountants who have been working around the clock for weeks preparing transactions that “must” close before the end of the year, or who have been implementing gift and estate plans for clients who are eager to capture – before the year-end – the benefit of what many see as the end of some very generous tax laws.[iv] (You should see their expressions after I’ve explained that they will need the approval of their PPP lender before doing anything.)[v]

The last thing most of my colleagues and I want to see is people making merry,[vi] or hearing people wishing others to be merry.[vii]

The first thought that comes to mind in reaction to such holiday cheer:

“If I could work my will, every idiot who goes about with ‘Merry Christmas’ on his lips should be boiled with his own pudding and buried with a stake of holly through his heart. He should!”

And that’s putting it mildly.

Then there are those who insist that you join them and who, after you have politely refused their less-than-sincere entreaties, leave you with “We’ll miss you, it won’t be the same.” To them, I’d like to say,

“I wish to be left alone. Since you ask me what I wish, . . . , that is my answer. I don’t make merry myself at Christmas, and I can’t afford to make idle people merry.”

The final straw is the long lines of cars slowly winding their way toward the malls during the weekend – shopping? seriously? now? – effectively turning three lanes into one passable lane, as I drive to or from the office.

Years ago, this would have elicited all manner of expletives and “colorful” gestures from me. I have since inured myself to the inconvenience and to the fact that these people were not working while I was. Forget Scrooge speaking in the first person – let’s go with the omniscient narrator, instead, to convey the feeling:

“He carried his own low temperature always about with him; he iced his office in the dog-days, and didn’t thaw it one degree at Christmas. External heat and cold had little influence on Scrooge. No warmth could warm, not wintry weather chill him. No wind that blew was bitterer than he, no falling snow was more intent upon its purpose, no pelting rain less open to entreaty. Foul weather didn’t know where to have him.”

With that catharsis by confession behind me, I can turn now to some legal advice[viii] recently issued by the Office of Chief Counsel in connection with an inadvertent gift – how appropriate – by what appears to have been a sophisticated taxpayer.

An American with a Stiftung[ix]

Taxpayer was a U.S. resident individual[x] who was a primary beneficiary of the Foundation[xi] (a “Stiftung”); for our purposes, basically, a civil law entity analogous to a trust. The objectives of the Foundation included “the defrayal of expenses for the upbringing and education, the fitting out and furtherance, the livelihood in general and the economic furtherance in the widest sense of the relatives of certain families.” Of course, the Foundation was governed under Country law.

According to its governing document (its “statutes,” or articles of organization), the Foundation Council or Board (basically, the trustees) had the authority to determine the beneficiaries, as well as the conditions for their beneficial interests.

The governing document also provided that the Foundation Council was entitled to issue by-laws (“by-statutes”) which would have the same legal effect as the Foundation’s statutes.

The Foundation Council was also authorized, at its own discretion, to supplement and amend the statutes, including the Foundation’s objects and organization.

For example, the Foundation’s statutes provided that, if the circumstances under which the Foundation was formed so changed that the Foundation’s purposes may “no longer be sensibly achieved,” the Foundation Council had the authority to wholly or partly dissolve the Foundation. Upon dissolution, the Foundation assets were to be distributed to the beneficiaries in accordance with the provisions of the statutes.

In any event, according to its statutes, the Foundation would be dissolved in Year. At that time, the Foundation assets would be distributed among the then-living beneficiaries in compliance with their beneficial interests (“benefit quotas”).

At some point, the Foundation Council amended the Foundation’s statutes to provide that Taxpayer would become the primary beneficiary of all of the assets and earnings of the Foundation, including any potential liquidation proceeds. Among the benefits payable to the Taxpayer was a specified sum of money (the “Benefit”).

The Foundation’s amended statutes also provided that, in the event of the passing of the primary beneficiary (Taxpayer), an amount equal to twice the Benefit would be payable to the secondary beneficiaries, who would be Sibling 1, Sibling 2; and Sibling 3.

In addition, the primary beneficiary’s surviving spouse (Spouse) and children would receive the Benefit, which would be funded with the earnings of the Foundation assets. In the event that the earnings were insufficient to pay the Benefit, the assets of the Foundation could be used as supplements.

The Direction

Subsequently, the Foundation Council, after acknowledging the Taxpayer as the sole first beneficiary of the Foundation, amended the statutes as follows:

“IT IS HEREBY RESOLVED to distribute the total net assets of the [F]oundation to the first beneficiary of the [F]oundation and to bring such assets in alignment in accordance with his wishes.”

In an email correspondence to the Foundation Council on the same date, the Taxpayer directed the transfer of all Foundation assets held in the Bank 1 Account (which held the primary assets of Foundation) to the Bank 2 Account.

Thereafter, the assets held in the Bank 1 Account were transferred to the Bank 2 Account, and the Foundation was then dissolved.

Taxpayer was not designated as an account owner of the Bank 2 Account. Based on an affidavit from Sibling 2 and an affidavit from Taxpayer, Taxpayer never had signature authority or control over, or access, to the funds in the Bank 2 Account from the time the assets initially were transferred to the Bank 2 Account at Taxpayer’s request.

The IRS questioned whether the Taxpayer – a U.S. resident – had made a taxable transfer that was subject to the U.S. Gift Tax.

I Have a Gift for You

The Code imposes a gift tax for each calendar year on the transfer of property by gift during the calendar year. The tax applies to all transfers by gift of property, wherever situated, by an individual who is a citizen or resident of the United States.[xii] It applies whether the gift transfer is in trust or otherwise, whether the gift is direct or indirect, and whether the property is real or personal and tangible or intangible.[xiii]

It should be noted that the gift tax is not imposed upon the receipt of the property by the donee, nor is it necessarily determined by the measure of enrichment resulting to the donee from the transfer, nor is it conditioned upon the ability to identify the donee at the time of the transfer.

On the contrary, the tax is a primary and personal liability of the donor, is an excise upon the donor’s act of making the transfer, is measured by the value of the property passing from the donor, and attaches regardless of the fact that the identity of the donee may not then be known or ascertainable.[xiv]

The donor’s gift is complete as to any property, or part thereof or interest therein, of which the donor has so parted with dominion and control as to leave in him no power to change its disposition, whether for his own benefit or the benefit of another.[xv]

But I Don’t Want It!

What if you already have your own stiftung when someone offers to give you theirs?

Should you be a gracious donee and accept it, knowing you can re-gift it to some unsuspecting, stiftung-less stiff later?

You may, but you’d be facing a potential gift tax liability if you do. (Keep reading.)

If a person makes a qualified disclaimer with respect to any interest in property, the gift tax is not applied with respect to such interest; it’s as if the interest had never been transferred to such person.[xvi]

Qualified Disclaimer

The term “qualified disclaimer” means an irrevocable and unqualified refusal by a person to accept an interest in property but only if:

(1) the refusal is in writing,

(2) the writing is received by the transferor of the interest, his legal representative, or the holder of the legal title to the property to which the interest relates not later than the date that is nine months after the later of:

(A) the date on which the transfer creating the interest in the person is made, or

(B) the day on which the person attains age 21,

(3) the person has not accepted the interest or any of its benefits, and

(4) as a result of such refusal, the interest passes without any direction on the part of the person making the disclaimer and passes either:

(A) to the spouse of the decedent, or

(B) to a person other than the person making the disclaimer.[xvii]

If a person makes a qualified disclaimer for purposes of the federal gift tax, the disclaimed interest in property is treated as if it had never been transferred to the person making the qualified disclaimer. Instead, it is considered as passing directly from the transferor of the property to the person entitled to receive the property as a result of the disclaimer.

Accordingly, a person making a qualified disclaimer is not treated as making a gift.[xviii]

Good Intentions? Not Enough

In the present case, the Foundation Council resolved “to distribute the total net assets of the [F]oundation to the first beneficiary of the [F]oundation and to bring such assets in alignment in accordance with his wishes.”

Taxpayer was identified as the “primary,” “first,” or “sole first” beneficiary. The Foundation Council acted within its authority to dissolve the Foundation and to distribute the assets of Foundation to or for the benefit of Taxpayer as the primary and sole first beneficiary.

The transfer of the Foundation’s assets held in the Bank 1 Account to the Bank 2 Account was completed at Taxpayer’s request and direction. The fact that Taxpayer had no signature authority or ownership interest in the Bank 2 Account indicated Taxpayer had released dominion and control over the Foundation’s assets held in the Bank 1 Account, and constituted a completed gift for gift tax purposes.

The transfer of the Foundation’s assets to an account in which Taxpayer had no ownership interest under applicable local law was not a qualified disclaimer under the Code because Taxpayer directed the transfer to the Bank 2 Account.

Therefore, the Foundation’s assets in the Bank 1 Account were treated as if the Foundation’s assets had been transferred to Taxpayer and then transferred by gift to the owner of the Bank 2 Account.

As a resident of the U.S. at the time of the transfer, Taxpayer was subject to gift tax on the gift transfer of the assets from the Bank 1 Account to the Bank 2 Account. Taxpayer was treated as having received the Foundation assets and thereafter as transferring such assets by gift when, upon the dissolution of Foundation, the assets were transferred at Taxpayer’s direction to an account over which Taxpayer had no ownership or control.

The dissolution of Foundation and subsequent transfer at Taxpayer’s direction of Foundation assets to an account over which Taxpayer had no ownership or control constituted a release of dominion and control over the assets, thereby resulting in a completed gift for gift tax purposes.

With that, the Office of Chief Counsel advised that the transfer of the Foundation’s assets to an account in which Taxpayer had no ownership interest under applicable local law was not a qualified disclaimer because Taxpayer directed the transfer to the account.

It’s Far from Over

I hope you’ve learned a lesson that will serve you well for many holiday seasons to come. May you use it in good health. If you accept a gift, better keep it (especially if it’s a loaded stiftung[xix]). If you don’t want it, better disclaim it in accordance with the rules described above.

If you’re like me, just tell folks you don’t want anything, that you don’t have time for such frivolity. If they really want to give you something, ask them to leave you in peace and to save you some ham.

[i] My dad passed earlier this year. We lost office colleagues and friends this year: Mike Healey and Bill Brown. It’s funny, but I still see Billy everywhere I go in the office.

[ii] No time for to read Hamlet? No problem. Try this: https://www.youtube.com/watch?v=A4elUNV65tA

[iii] Apologies, but you’re in for a number of quotations from A Christmas Carol. Trying to get into the spirits, you might say. Get it? Ha.

As for the reference to “gain,” well, that’s unique to each of us. The need to constantly prove oneself can be quite the motivator.

[iv] Damn you, Georgia. Why couldn’t you have held the run-offs before Thanksgiving? There is a chance that much of this year-end fire drill may be unnecessary. Remember 2012? Where’s Sherman now?

[v] https://www.taxlawforchb.com/2020/12/year-end-gifting-of-equity-in-a-business-with-an-outstanding-ppp-loan/ .

[vi] Probably the same folks who kept going to bars and parties when they were warned not to, or who were asked to stay home during the Thanksgiving holiday but who, instead, chose to spread this wicked virus.

[vii] Please don’t get me wrong. I am trying to be facetious. (I know, “keep your day job, Lou.”) We are grateful to have our jobs. The fact that we are this busy is amazing, considering where the economy was earlier this year. The economy has a long way to go, and there are millions of folks who are in need of assistance. This is why we have taxes. The social contract doesn’t work without them.

[viii] CCA 202045011.

[ix] It’s not what it sounds like.

[x] Reg. Sec. 25.2501-1(b).

[xi] I remember the first time I encountered such a “foundation,” which is roughly the translation of “stiftung.” Something must be wrong here, I thought; how can a Sec. 501(c)(3) organization have private beneficiaries?

[xii] Reg. Sec. 25.2501-1(a)(1).

[xiii] IRC Sec. 2511(a).

[xiv] Reg. Sec. 25.2511-2(a).

[xv] Reg. Sec. 25.2511-2(b).

[xvi] IRC Sec. 2518(a).

[xvii] IRC Sec. 2518(b).

[xviii] Reg. Sec. 25.2518-1(b).

[xix] We’ll cover your tax reporting obligations at another time.

Will They Leave?

Over the years, the Democrats in Albany have regularly made noise about increasing the rates at which New York State taxes the income of its wealthier residents.

With the election of Governor Cuomo in 2010, and with the Party’s supermajority in the State Assembly since then,[i] two of the three components necessary for securing such a tax increase were seemingly in place.[ii] Unfortunately for the Democrats, the Republican Party held a majority of the seats in the State Senate during the first eight years of Mr. Cuomo’s tenure.

That changed when the Democrats took back the State Senate following the 2018 elections.[iii] The Party’s success in New York – and in the House of Representatives – was due, in no small part, to the enactment of the Tax Cuts and Jobs Act[iv] by the Republican-controlled Congress in 2017, and its cap on itemized deductions for state and local taxes, not to mention what was perceived as its pro-big business, pro-wealthy bias.[v]

At that point, the Party seemed poised to enact the desired rate increases; after all, it held a supermajority in the Assembly, a majority in the Senate, and the Governor’s office.

However, New York Democrats encountered some unexpected opposition to such tax increases within their own Party: Governor Cuomo, himself,[vi] who stated he would veto any “tax the rich” legislation because it would drive many of the State’s wealthier residents – along with their considerable commercial activity and taxable income – out of New York.[vii]

In light of Mr. Cuomo’s stance, and probably in recognition of the fact that they lacked a supermajority in the State Senate that could override any veto,[viii] the State Legislature and the Governor danced around the issue of a tax that would target affluent New Yorkers.

A Year to Forget – or to Remember?

As we entered 2020, Democrats across the country – including, of course, the Empire State[ix] – prepared to take on Mr. Trump and the Republican Party in the November elections. What no one could have anticipated was the “assistance” they received from the coronavirus pandemic and, in particular, from what many have characterized as the Federal government’s mishandling of the crisis.

As a consequence of the severe economic disruption that followed the stay-at-home orders issued by governors and mayors across the country in an attempt to contain the spread of the COVID-19 virus, thousands of businesses had to close their doors, and millions of Americans (including approximately two million New Yorkers) suddenly became unemployed.

Under such dire economic circumstances, the public reasonably expected their state and local governments to provide them with a safety net, in the form of various programs and services. However, those same circumstances caused a significant decline in the tax revenues on which state and local governments relied for providing this safety net.

Given their revenue losses, and because of the Federal government’s continuing failure to grant them any meaningful financial assistance,[x] most states – including New York, which faces a budget deficit this fiscal year of approximately $9 billion[xi] – are now faced with some difficult decisions regarding many state-sponsored programs and state-provided services:[xii] either reduce funding for these programs and services, eliminate or scale back some of them, find other sources of revenue to support them, or try some combination of the foregoing.

Tax the Rich

In New York, at least, it didn’t take long for some to identify sources of additional revenue.

There are over 570,000 millionaire households in the State,[xiii] and approximately 120 residents who are billionaires,[xiv] on whom the Democrats have long sought to impose higher taxes, and many of whom have done remarkably well during the pandemic, in contrast to the thousands of households that are struggling to survive or that are dependent upon some form of government assistance.
For example, a State Senate bill (S.7378) introduced earlier this year proposes to increase the top marginal income tax rates as follows: 9.62% for individuals with up to $5 million of taxable income during a taxable year; 10.32% for those with taxable income of up to $10 million; and 11.85% for taxpayers with more than $100 million of taxable income.[xv]

The highest rate now in effect, at 8.82%, applies to individuals with taxable income in excess of just over $1 million. It is worth noting that this rate was enacted as a temporary, three-year, increase in response to the fiscal crisis brought on by the Great Recession over ten years ago. Before then, New York’s top rate was 6.85% for individuals with taxable income in excess of $215,400. Well, since that time, the “temporary” millionaires’ tax has been extended several times; it is now scheduled to run through 2024.

November 2020 Elections

Up until now, over the course of Governor Cuomo’s tenure, such proposals have played well for political effect, but the likelihood of their enactment has been remote because, as indicated earlier, the Governor has opposed such taxes, claiming that they would drive away many of the State’s wealthier residents; in any case, the Democrats in Albany did not have a sufficient number of votes in the State Senate to override the Governor’s veto of any such proposed legislation.

As we know, the political environment changed last month when New York Democrats won a supermajority in both chambers of the State Legislature. This development has already informed the Governor’s stance with respect to increasing taxes, or imposing new taxes, on wealthier New Yorkers.

Last month, Mr. Cuomo indicated that, in the absence of Federal fiscal assistance, the State would have to increase taxes “on the higher end.”[xvi]

Just last week, he stated that tax increases on the wealthy were likely even if Congress approved an aid package for the states, though he did not provide any specifics.[xvii]

Proposed Wealth Tax

Although the Governor may not be ready to discuss the details of the tax increases that he envisions, there are others in his Party who have something very specific in mind.[xviii]

There has been a lot of talk recently about reviving interest in a bill (S.8277-B) that was introduced in the State Senate on May 1st of this year,[xix] and that is now with that chamber’s Budget and Revenue Committee. The proposed legislation – referred to as “the billionaires’ tax” or as the “mark-to-market” tax by its supporters – would impose an entirely new kind of tax,[xx] one that is imposed annually and that is based upon the year-to-year net increase in the fair market value (the unrealized gain) of the assets of a wealthy resident.[xxi]

How Does It Work?

Under this bill, generally speaking, individual New York residents with assets having a net worth of at least $1 billion dollars on the last day of a taxable year will be required to recognize gain as if each such asset was sold for its fair market value on that date.

The net gain from these deemed sales, up to a so-called “phase-in cap” amount –equal to a quarter of  the worth of a taxpayer’s net assets in excess of one billion dollars –  would be included in a resident’s New York gross income and, thereby, be subject to the State income tax. As indicated earlier, the highest individual income tax rate in New York is currently set at 8.82% for that portion of a taxpayer’s taxable income in excess of $1 million.

This process would be repeated every year, after increasing a taxpayer’s basis for an asset by the amount of gain recognized by the taxpayer with respect to such asset in the preceding year.[xxii] If an asset were actually sold by the taxpayer, the gain arising from the sale would be determined using the same adjusted basis.

Of course, there are several elements in this proposal that need to be considered, some of which may offer planning opportunities.[xxiii]


First, who is a resident for purposes of the new tax?

Basically, anyone who is domiciled in New York, or who is a statutory resident of the State.

Both of these concepts have generated volumes of litigation. The question of domicile is inherently subjective. The requirement introduced by the Gaied decision,[xxiv] that a taxpayer have a “residential interest” in a property before it may be treated as a permanent place of abode, has added an element of subjectivity to the statutory residence (day-counting) test – it remains to be seen how the courts will interpret this requirement.

If the proposed tax is enacted, the stakes will become that much higher for an otherwise covered taxpayer who tries to change their resident status.[xxv]

Assets Covered?

Second, what assets would the resident be treated as having sold?

Basically, all of the real property, tangible personal property (for example, works of art), and intangible personal property that is owned by the taxpayer.

Intangibles include shares of stock in any corporation – whether public or private, taxable or pass-through – membership interests in any partnership or LLC, securities, other financial instruments, and “other assets.”

In other words, it appears that no class of assets would be excluded from the reach of the tax.

Where the asset is located would be irrelevant to the imposition of the tax – the asset need not be situated in New York (for example, a ski house in Colorado).

Moreover, the tax would reach assets held by the taxpayer’s spouse or minor child, or by an estate or trust of which the taxpayer is a beneficiary, thereby precluding tax avoidance by taxpayers who would try to drop below the $1 billion threshold by, for example, making gifts of property to a spouse, or by acquiring property in the name of a child or trust.

Even more surprising, assets contributed by the taxpayer to private foundation (basically, a tax-exempt, non-publicly supported charitable corporation or trust described in Section 501(c)(3) of the Internal Revenue Code)[xxvi] with respect to which the taxpayer is a “substantial contributor”[xxvii] would also be considered in determining the individual’s tax liability.

Finally, in what may be described as an extension of New York’s now-infamous three-year claw-back rule,[xxviii] any assets gifted by the taxpayer (whether to another individual, a trust, or to a charitable organization) within the past five years will be accounted for in determining the individual’s tax liability as if the individual still owned the gifted property.[xxix]


As indicated earlier, the taxpayer would be treated, every year, as having sold their assets for an amount equal to their fair market value. The bill explains how these assets are to be valued.

In determining the fair market value of an asset, the bill purports to utilize the standard of the hypothetical willing buyer and willing seller; i.e., what price would a hypothetical buyer and seller agree upon, where both have knowledge of the relevant facts, and neither is under any compulsion to sell?[xxx]

However, the bill immediately eviscerates that standard by stating that no discount will be taken into account for purposes of valuing an asset that represents a minority interest in an enterprise, or an interest that cannot be easily sold.[xxxi]


Just imagine how burdensome it would be to administer, and to comply with, this mark-to-market tax. Consider how many different types of assets a covered taxpayer probably owns. Consider how many assets such an individual must own. Consider the challenge of determining the fair market value of such a taxpayer’s real properties and of their interests in non-publicly traded businesses.

Anyone who has any experience in buying and selling closely held businesses, or in advising the owners of such businesses as to their gift and estate tax planning, knows how difficult it is to establish the fair market value of such an asset.

They are also familiar with how drawn-out and expensive the process may be for defending one’s reported value for an asset against the government’s asserted value for the asset.[xxxii]

And how will these assets and their values be reported every year? It will require an army of appraisers and accounting professionals to handle the reporting, substantiation, and other compliance requirements for the tax.[xxxiii]

Then there is the State’s enforcement of the new tax. Notwithstanding there are “only” 120 billionaires in New York, the State will likely have to dedicate considerable resources if it is to establish a system that will facilitate the collection of this never-before-tried tax.


The easiest, most practical way to avoid the proposed wealth tax will be to abandon one’s New York domicile, and to establish a new domicile elsewhere.

If the taxpayer maintains a permanent place of abode in New York, they will have to demonstrate that they were not present in New York for more than 183 days during any taxable year.

Yes, the taxpayer can remain in New York and willingly, but begrudgingly, pay the tax. Or they can engage in annual valuation contests with the Department of Taxation and Finance, but that’s not much of a plan – it’s more like torture.

Alternatively, the taxpayer can try to give away appreciating assets, perhaps by selling – rather than gifting – them to trusts of which the taxpayer is treated as the owner for tax purposes (a grantor trust), and which are held for the benefit of their adult children, in exchange for interest-bearing notes, thereby avoiding a taxable gift, the five-year claw-back rule, and a taxable sale.[xxxiv]

By shifting an asset’s potential for appreciation to the beneficiaries of the trust, while also freezing the value of the taxpayer’s own assets at the face amount of the notes, the taxpayer may be able to reduce the amount of tax owed.

At the same time, even though the beneficiaries of these trusts may, themselves, be subject to the tax, query whether it may be possible to “multiply” the benefit of the phase-in cap by spreading assets among family members or trusts, thereby reducing the overall tax imposed upon the family unit.[xxxv]

The Reality Is . . .

How will New York’s approximately 120 billionaires react to yet another tax, especially one as complex, as intrusive, and as expensive as this tax promises to be?

Yes, these individuals are billionaires, they can afford anything. By the same token, they can also choose to live anywhere. Do the bill’s sponsors really believe that these taxpayers would so readily give away their property – or, perhaps more accurately, that they would allow others to simply take it?

Or perhaps the sponsors believe these billionaires will do anything for the “privilege” of remaining in New York and, in particular, in New York City?

I wouldn’t count on it. After all, why would I want to remain in a place where I am resented for having succeeded, notwithstanding my contributions to the State in terms of the amount of income tax I pay, the amount of estate tax I will pay, the charitable contributions I make, and the dollars I spend as a consumer which keep many others gainfully employed?[xxxvi]

Where would it stop?

Which brings me to the real issue: what is to keep the State from extending the tax beyond billionaires?

This threshold for application of the proposed tax is arbitrary, and politically motivated. If the goal is to make the “rich” pay their “fair share,” why limit the target population to 120 individuals? How much of a difference would such a tax make in the grand scheme of New York’s $190 billion 2021 budget?[xxxvii]

However, there are approximately 570,000 millionaires in New York. The math is pretty straightforward – the State and, according to some, the goal of “fair” taxation would be better served by imposing the proposed tax on both billionaires and millionaires. In other words, it would be only a matter of time before the tax was extended to also cover these taxpayers.

How would these folks react? What would happen to the State’s economy if large numbers of them left for friendlier tax environments?

The top 1% of New Yorkers reported over $130 billion of income on their tax returns in 2018. They paid 47% of all income taxes in the State.[xxxviii] They were also major benefactors of the State’s many charities, hospitals and institutions of higher learning.[xxxix] How does one replace this support?

The reason these folks are in New York, and have been willing to pay a premium for being here, is because of the cultural attractions, restaurants, and other amenities it offers – or should I say offered? When will these once again become a staple of life in New York?

An estimated 420,000 New Yorkers – many of the affluent – left their New York City apartments for more suburban areas when the pandemic hit the City. As these individuals and their families have acclimated to working remotely, Mr. Cuomo has asked them nicely to return to the City or to the State, while many Democratic lawmakers have pressed him to tax them rather than coddle them.[xl] Query how many have returned? Or plan to return in the face of higher taxes and social unrest?

They Were Already Leaving

Wealthy New Yorkers have long been relocating to other states in order to escape the State’s already high income and estate taxes. For example, Carl Icahn moved to Florida last year, before COVID-19 and the current condition of the City; others have announced their intention to do so, while still others have stated they will be moving their business away from New York.[xli] How will the introduction of a wealth tax influence those who, thus far, have been on the fence about moving?

In recognition of the “out-migration” from New York to Florida that has occurred to-date, and of what is expected to be the continued flow of wealthy individuals from North to South, Goldman Sachs is said to be considering South Florida as the new home for its asset management division.[xlii]

What will the introduction of a wealth tax do?

Hello, Albany? Are you listening? Is anyone there?

[i] Indeed, New York Democrats controlled the State Assembly for many years prior to Mr. Cuomo’s election.

[ii] “Two out of three ain’t bad,” as Meat Loaf sang, but it’s not enough if you have a legislative agenda to pass.

[iii] For the first time since 2010.

[iv] P.L. 115-97.

[v] Specifically, the Act was perceived by many as benefitting primarily the wealthy and big business. Witness, for example, the doubling of the Federal unified gift and estate tax exemption amount, and the reduction of the corporate income tax rate from a top rate of 35% to a flat rate of 21%.

What’s more, its $10,000 temporary cap (through the end of 2025) on the itemized deduction of state and local taxes was especially bothersome for higher income New Yorkers, who already pay some of the highest taxes in the country.

It’s ironic, isn’t it, that the Democrats want to increase taxes on the “wealthy” in New York, while also supporting the removal of the cap on the itemized deduction of those taxes at the Federal level. Because most itemizers are relatively affluent, this change would effectively shift some of the New York tax burden borne by more affluent New Yorkers to individuals living outside the State. In other words, the Federal government would partially subsidize the increased New York tax. https://www.taxlawforchb.com/2020/11/new-yorks-post-election-tax-environment-for-business-owners/.

[vi] As I write this, it has been reported on many of the national news services that Mr. Biden is considering Mr. Cuomo for U.S. Attorney General. https://www.forbes.com/sites/tommybeer/2020/12/12/biden-reportedly-considering-gov-andrew-cuomo-for-attorney-general/ . Should Mr. Cuomo be nominated, and then approved by the Senate, New York’s Lieutenant Governor, Kathy Hochul, would step into the governor’s office. Query whether she shares Mr. Cuomo’s position with respect to taxing the rich.

[vii] In 2019, Mr. Cuomo responded to calls for additional taxes on the rich: “Tax the rich. Tax the rich. Tax the rich. We did that. God forbid the rich leave,” he said. https://buffalonews.com/news/local/serious-as-a-heart-attack-cuomo-warns-of-falling-state-revenue/article_7dcb9125-1e1c-5d36-8c7c-89b085a909bb.html .

In 2020, after the State began to feel the effects of the pandemic, a number of State and NYC lawmakers urged the Governor to support tax increases for the wealthiest New Yorkers. In response, the Governor said that he did not support the idea, claiming that the ultra-rich would just leave New York. https://gothamist.com/news/cuomo-refuses-raise-taxes-billionaires-because-theyll-just-move-next-door .

[viii] An override requires a two-thirds vote of the Assembly and a two-thirds vote of the Senate.

[ix] I’m surprised that the same folks who have defaced or called for the removal of many public monuments, or who have sought to expunge or rewrite history, have not yet demanded that the State drop its nickname, “The Empire State,” because it evokes the era of American expansionism, which they believe should be condemned, and for which the country should apologize.

[x] Yes, the McConnell-Pelosi standoff continues into its ninth month; the former will not sign off on aid to state and local governments, and the latter will not consent to protecting employers from Coronavirus-related litigation. They have irresponsibly ignored the more practical members of their respective parties.

[xi] A projected deficit of $59 billion through 2022. https://www.wsj.com/articles/new-york-faces-59-billion-revenue-shortfall-11603198313 .

[xii] Some of which, it must be said, are more important than others – at least in the eyes of some, and therein lies the issue; what is important to one group may be wasteful to another.

[xiii] Second to California in the country. https://www.kiplinger.com/slideshow/investing/t006-s001-millionaires-america-all-50-states-ranked/index.html .

[xiv] First in the country. https://www.thecity.nyc/2020/10/13/21515162/proposals-to-tax-the-rich-new-york .

As an FYI: there are 52 billionaires in Florida, and approximately 430,000 millionaire households.

[xv] https://www.nysenate.gov/legislation/bills/2019/s7378 .

[xvi] https://www.foxbusiness.com/politics/ny-cuomo-income-tax-hikes-federal-aid .

[xvii] https://www.foxbusiness.com/politics/cuomo-ny-tax-hikes-congress-aid .

[xviii] AOC ramps up her crusade on billionaires by backing tax on New York’s richest residents | Daily Mail Online.

[xix] May Day. Mere coincidence?

[xx] The first of its kind in the nation, and one that shares features with Ms. Warren’s wealth tax proposal.

For purposes of our discussion, let’s set aside the very real possibility that the proposed tax is unconstitutional.

[xxi] https://www.nysenate.gov/legislation/bills/2019/s8277 .

[xxii] Speaking of accounting for taxes already paid, the bill is silent as to its interaction with New York’s estate tax (with its top rate of 16%), which is calculated on the basis of the fair market value of a deceased taxpayer’s assets. Query whether a deceased taxpayer’s estate will be entitled to a break, for purposes of calculating the decedent’s New York estate tax, for the income taxes paid by the taxpayer during their life on the appreciation in the value of their assets. After all, the estate tax is based upon the fair market value of an asset, and the proposed income tax is based upon the annual increase in the fair market value of the asset.

[xxiii] Hope you’re sitting down.

[xxiv] Gaied vs Tax Appeals Tribunal, No. 26 (N.Y. 2014).

[xxv] If this bill ever becomes law, Carl Icahn will certainly be among the “former” New York billionaires to whom the State will seek to apply the tax by claiming that he failed to abandon his New York domicile and to establish a new domicile in Florida.

[xxvi] IRC Sec. 509(a).

[xxvii] IRC Sec. 4958 (the intermediate sanctions rules).

[xxviii] Which generally brings back into a resident decedent’s New York gross estate any property gifted by the decedent during the three-year period ending with their date of death. This rule applies through the end of 2025.

[xxix] You probably need to take a deep breath at this point, but wait – there’s more.

[xxx] The same standard applied for purposes of the Federal estate and gift tax.

[xxxi] So much for using valuation discounts to get below the $1 billion threshold.

[xxxii] The only winners would be the tax attorneys (myself included), the appraisers, and the accountants.

[xxxiii] It should be noted that the bill was intended to apply beginning in 2020. The taxpayer could elect to pay the tax for that year over a five-year period, with a high rate of nondeductible interest.

[xxxiv] Mr. Biden’s tax plans may put an end to the beneficial interplay of the grantor trust and gift/estate tax rules. Oh Georgia!

[xxxv] If this tax is ever enacted, I’m certain New York would eventually eliminate this option.

[xxxvi] One of these affluent individuals may even don a costume, as Bruce Wayne did, in order to fight crime.

[xxxvii] Signed yesterday by Gov. Cuomo. Budget and Actuals | OpenBudget.NY.Gov .

[xxxviii] https://www.thecity.nyc/2020/10/13/21515162/proposals-to-tax-the-rich-new-york .

[xxxix] Those in the top 1% of the income distribution provide about a third of all charitable dollars given in the U.S., and the wealthiest 1.4% are responsible for 86% of the charitable donations made at death. https://www.philanthropyroundtable.org/almanac/statistics/who-gives .

[xl] New York needs to raise taxes to plug $8.7billion black hole due to COVID-19, Gov. Andrew Cuomo says | Daily Mail Online . That makes perfect sense, right? “Please come back so I can tax the crap out of you.”

[xli] Paul Singer’s Elliott Management, for example. https://www.nytimes.com/2020/10/22/nyregion/paul-singer-florida.html .

California is facing a similar challenge: (1) Last week Elon Musk announced that he was changing his residency from California to Texas. (2) Similarly, Oracle announced that it was moving its headquarters from California to Texas, citing California’s high taxes, steep living costs, and the shift to remote working. (3) Earlier this month, Hewlett Packard announced it was moving its headquarters from California to Texas.

[xlii] https://dailyvoice.com/new-york/nassau/news/covid-19-goldman-sachs-eyes-move-to-florida-in-latest-business-blow-to-ny-amid-pandemic/799203/ .

It has been more than eight months since the enactment of the CARES Act,[i] yet here we are, with the end of 2020 in sight, and we are still debating whether taxpayers should be allowed to claim a deduction for business expenses that were properly paid using the proceeds of a loan under the Paycheck Protection Program.[ii] Why is that?

Two reasons: (1) The IRS; and (2) The Congress. The IRS has inexplicably ignored Congressional intent, while the Congress has irresponsibly allowed the IRS to do so.


Just over one month after the enactment of the CARES Act, the IRS issued Notice 2020-32 (the “Notice”),[iii] in which it purported to “clarify” that no deduction would be allowed to a business for its payment of an otherwise deductible expense if (i) the payment was made using the proceeds of a PPP loan,[iv] (ii) such loan was ultimately forgiven by the SBA and, (iii) in accordance with the terms of the CARES Act, the income associated with such forgiveness was excluded from the gross income of the business.[v]

According to the IRS, no deduction is allowed to a taxpayer for an otherwise deductible expense that is allocable to a class of income that is excluded from the taxpayer’s gross income or that is exempt from income taxes. In this way, the IRS explained, the Code seeks to deny the taxpayer a double tax benefit: the deduction of the payment made with the loan proceeds and the subsequent exclusion of such loan proceeds from gross income notwithstanding the forgiveness of the loan.

The Notice conceded that although the CARES Act spoke directly to the exclusion of the forgiven PPP loan from the taxpayer-borrower’s gross income, it did not specifically address whether the taxpayer-borrower would still be allowed to claim a deduction for the “eligible expenses”[vi] paid with the subsequently forgiven loan proceeds.[vii]

The IRS, however, concluded that to the extent the CARES Act operates to exclude from a taxpayer’s gross income the amount of a forgiven PPP loan, it results in a “class of exempt income;” thus, the Code disallows any otherwise allowable deduction for expenses paid by the taxpayer with the forgiven loan.

As discussed below, the agency recently reaffirmed its position.

The Congress

It did not take long for Congress to react to the Notice.

Within four days of its publication, a bipartisan group of Senators introduced “The Safeguarding Small Business Act” (S. 3596) for the sole purpose of ensuring the deductibility of any expenses paid or incurred in accordance with the PPP program.[viii]

One day later, the Democratic Chair of the House Ways and Means Committee, together with the Republican Chair of the Senate Finance Committee, wrote to Secretary Mnuchin to express their disappointment with the IRS’s position:

“[W]e are writing to express our concern with the position taken by Treasury and the IRS in Notice 2020-32, which is contrary to congressional intent. Notice 2020-32 provides that otherwise deductible business expenses are not deductible if the taxpayer is the recipient of a Paycheck Protection Program (PPP) loan that is subsequently forgiven. We believe the position taken in the Notice ignores the overarching intent of the PPP, as well as the specific intent of Congress to allow deductions in the case of PPP loan recipients. . . .

“Providing assistance to small businesses, only to disallow their business deductions as provided in Notice 2020-32, reverses the benefit that Congress specifically granted by exempting PPP loan forgiveness from income. This interpretation means that whatever income a small business is able to produce will be taxed on a gross basis to the extent of the loan forgiveness, leaving substantially less after-tax capital for the swift economic recovery we hope is on the horizon.”

The Chairs went on to explain that the exclusion of PPP loan forgiveness from income was specifically included in the CARES Act to provide a tax benefit to small businesses that received the PPP loan. “Had we intended to provide neutral tax treatment for loan forgiveness,” the chairs continued, the Act’s forgiveness provision “would not have been necessary. In that case, loan forgiveness generally would have been added to the borrower’s taxable income, and the expenses covered by the PPP loan would be deductible, reducing taxable income by an offsetting amount and resulting in no additional net income. Notice 2020-32 effectively renders” the income exclusion provision meaningless, and “is contrary to the intent of  . . . the CARES Act.”

Also within five days of the issuance of the Notice, another bipartisan-sponsored bill was introduced in the Senate – as S. 3612, the Small Business Expense Protection Act of 2020 – and in the House – as H.R. 6821 – which would have added the following language to the end of Section 1106(i) of the CARES Act (which excludes the forgiven PPP loan from gross income): “. . . no deduction shall be denied or reduced, no tax attribute shall be reduced, and no basis increase shall be denied, by reason of the exclusion from gross income.”

The HEROES Act[ix] was introduced the following week, and passed the Democratic-controlled House on May 15, by-and-large along party lines.[x] This proposed economic stimulus package included a provision which read as follows: “notwithstanding any other provision of law, any deduction and the basis of any property shall be determined without regard to whether any amount is excluded from gross income under . . . section 1106(i) of the CARES Act.”

Then came a summer of wasted opportunities and political posturing,[xi] until an updated version of the HEROES Act[xii]  was passed by the House on October 1, with the same provision described above, effective for taxable years ending after the date of enactment of the CARES Act.

The IRS Missed the Mark

The folks in Congress weren’t the only ones chastising the IRS for its “guidance” as to the non-deductibility of expenses paid with forgiven PPP loans. Indeed, most of the business and tax communities were quite vocal in their disagreement with the conclusions drawn by the Notice.

The Code, they stated, permits taxpayers to deduct any ordinary or necessary trade or business expenses, which includes PPP-eligible expenses. Nothing in the CARES Act denied the borrower-business the ability to claim a tax deduction for legitimate and eligible expenses paid with the loan proceeds, even where the loan was forgiven.

They pointed out that, if Congress meant to disallow the so-called “double benefit,” a question could be raised as to why the exclusion of the loan forgiveness from income was explicitly provided for in the CARES Act at all.

The “normal” treatment under the Code would have included the forgiven loan in income (say, $X),[xiii] while the associated business expenses paid with that loan (also $X) would have been deductible: a wash for tax purposes ($X of income offset by $X of deductions).

Under the IRS’s interpretation, if the forgiven PPP loan ($X) is not taxed, is used in its entirety to pay otherwise deductible expenses ($X), and no deductions are allowed, there is no tax on the $X of income and there is no tax benefit from the $X of otherwise deductible expenses – in other words, another wash.

By contrast, if the forgiven loan ($X) is excluded from income, as provided by the CARES Act, there is no tax thereon, but a deduction is allowed for the expenses paid with such loan ($X) – which the Act did not restrict – the taxpayer is provided with a benefit in the form of tax savings – the offset of other income, or the increase of a net operating loss to offset future income – which Congress must have intended, and which is borne out by its reaction to the Notice.

Could Congress have intended the same outcome under the CARES Act as under the normal rules described above? In other words, why would – indeed, how could – the IRS overturn the tax effect of Congress’s decision to exclude a forgiven PPP loan from a taxpayer’s gross income?

Does the IRS’s position – that no deductions be allowed for expenses paid using the proceeds from a PPP loan that is ultimately forgiven – convert that loan forgiveness into a meaningless gesture?[xiv]

Did You Say Something?

In the face of criticism from Congress, and from the business and tax communities, Secretary Mnuchin indicated that Treasury would review its position. Earlier this month, at an ABA Tax Conference, IRS officials acknowledged that the agency had come under fire for its stance on the deductibility of expenses as set forth in the Notice. They also indicated that the IRS was considering the questions raised and whether additional guidance should be issued.[xv]

Rather than reversing its position and withdrawing the Notice, as many had urged it to do – thereby providing additional liquidity, in the form of immediate tax savings, to those businesses with forgiven PPP loans[xvi] – the IRS instead disregarded the criticism leveled at the Notice, dug in its heels, and issued Rev. Rul. 2020-27 in which the agency reaffirmed its earlier stance.[xvii]

Rev. Rul. 2020-27

The IRS considered two situations in Rev. Rul. 2020-27:

  • The first, in which the taxpayer received a PPP loan; used the expenses as required under the PPP and otherwise satisfied all requirements for forgiveness; applied for such forgiveness; but, as of the end of 2020, had not yet been informed that its loan was forgive; the taxpayer had a “reasonable expectation”[xviii] of “reimbursement” of the amounts expended – the forgiveness of the covered loan was foreseeable; and
  • The second, in which the same taxpayer decided to defer its application for forgiveness until 2021; the taxpayer knew the amount of its eligible expenses that qualified for “reimbursement,” in the form of covered loan forgiveness; the taxpayer had a reasonable expectation of reimbursement – as in the first situation, the forgiveness of the covered loan was foreseeable.

The IRS began by describing Notice 2020-32, in which it clarified that no deduction is allowed for an eligible expense that is otherwise deductible if the payment of the eligible expense results in forgiveness of a covered loan.

It then launched into a legal analysis in support of its position, which purports to be rooted in basic tax/economic principles, including the “economic risk” and “tax benefits” doctrines.[xix]

The IRS concluded that a taxpayer that received a PPP loan, and that paid or incurred certain prescribed expenses – that were otherwise deductible – may not deduct those expenses in the taxable year in which the expenses were paid or incurred if, at the end of such taxable year, the taxpayer reasonably expects to receive forgiveness of the PPP loan on the basis of the expenses it paid or accrued during the covered period, even if the taxpayer has not submitted an application for forgiveness of the loan by the end of such taxable year.

Is the Ruling’s Tax Analysis Correct?

Assume a taxpayer has expenses of $Y but does not have the wherewithal to pay them; the taxpayer borrows the necessary funds of $Y from a commercial lender and is obligated to repay the loan; the expenses of $Y are paid; the taxpayer still has to satisfy the $Y loan.

The taxpayer has not been economically enriched. They borrowed $Y and have to repay $Y. The receipt of the loan does not represent income to the taxpayer because it did not result in an accretion of value to the taxpayer. It’s true that the expenses were satisfied using the loan proceeds, but the debt of $Y remains outstanding.

Recognizing that the taxpayer is at economic risk for the $Y of indebtedness, the Code permits the taxpayer to deduct the expenses paid using the borrowed $Y in determining its taxable income.

If the indebtedness is subsequently forgiven, the taxpayer experiences an accretion in value of $Y and, thus, has to include the amount of the forgiveness in its income for the year of the forgiveness (basically recapturing the earlier deduction).

What if the forgiveness of the loan is somehow excluded from the taxpayer’s gross income – say, because the forgiveness does not result in an accretion of value to the taxpayer?[xx] The Code demands a price in return for this exclusion; specifically, the taxpayer is required to reduce certain tax attributes, such as loss carryovers and the adjusted basis for property, beginning in the taxable year immediately following the year of the forgiveness.[xxi] In this manner, the taxpayer’s tax savings for the year in which the debt was forgiven are recaptured in later years.[xxii]

By contrast, assume the taxpayer receives a nontaxable “grant” (please humor me) of $Y for the purpose of paying off $Y of expenses; the taxpayer is not required to include the grant monies in income; the taxpayer uses the funds to pay off expenses of $Y.

In that case, the taxpayer has realized an increase in value of $Y: the expenses have been paid off, but there is no obligation to repay the $Y grant. Because the taxpayer is not at economic risk for the $Y – the $Y received was a grant as opposed to a loan – the Code may deny the taxpayer a deduction for the expenses paid.[xxiii]

So What’s Next?

Does it matter, when viewed out of context – meaning outside of what was intended by Congress in enacting the PPP – that the IRS’s analysis, as set forth in Notice 2020-32 and Rev. Rul. 2020-27, has some merit?

No, it does not.

For one thing, as we saw above, its analysis is not the only viable game in town. In fact the regime that governs the cancellation of indebtedness, generally, may be better suited.[xxiv]

In any case, the fact remains that the respective Chairs of the House Ways and Means and Senate Finance Committees, one a Democrat and the other a Republican, have informed the IRS that its guidance is inconsistent with what Congress intended.

It is also a fact that several bipartisan bills have been introduced in the House and in the Senate, and one very partisan bill has actually passed the House, that would overturn the IRS’s position and permit the deduction of the expenses paid with the proceeds from a forgiven PPP loan.

Unfortunately for those businesses that participated in the PPP – not to mention the millions of other taxpayers who have been waiting patiently for badly-needed healthcare and economic assistance – this proposed legislation has been held hostage, along with the House and Senate economic stimulus bills that are on the table, by certain politicians who would prefer to exercise their egos rather than get a deal done.

With that said, here we are, November 30, 2020.

Last week, lawmakers in D.C. indicated that the House and Senate Appropriations Committees had reached an agreement on a spending bill to keep the federal government open after its current funding runs out in a couple of weeks.[xxv] There was even talk that some pandemic-related measures may be included the final bill.

Query whether this lame duck Congress is capable of adding a provision – even one that has already received bipartisan support – to ensure the deductibility of expenses properly paid with the proceeds of a forgiven PPP loan?

I hope so. The businesses that participated in the PPP need at least that certainty.

[i] ‘‘Coronavirus Aid, Relief, and Economic Security Act’’ or “CARES Act.” P.L. 116-93.

[ii] The “PPP.” Sec. 1101 et seq. of P.L. 116-93.

[iii] March 27, and April 30, 2020, respectively.

[iv] The first PPP loans were made on April 3 – only one week after enactment of the Program.

The Program was part of the CARES Act, which passed the Senate on March 25, 2020, with an amendment, by a vote of 96 to 0; on March 27, 2020, the House agreed to the Senate amendment by voice vote, and the President signed the legislation that same day.

The Program offered many small businesses the cash liquidity they needed to retain much of their workforce at salaries that approached pre-shutdown levels. It also provided these businesses the wherewithal to pay their rent and utilities, as well as certain other pre-existing indebtedness. The Federal government, working through private lenders, made the funds available to an eligible business through a nonrecourse, unsecured, 100 percent government-guaranteed loan.

[v] The Notice was officially released in 2020-21 IRB 837 (May 18, 2020).

[vi] For example, the rent obligations, utility payments, and payroll costs identified in the CARES Act.

The Code generally provides a deduction for all ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business. IRC Sec. 162.

[vii] As described above, the CARES Act did not address the payment of the foregoing expenses by the business. Moreover, neither the Senate nor the House has a contemporaneous legislative history regarding the CARES Act, such as a committee report or technical explanation, which sheds light on these tax issues; although the Joint Committee on Taxation prepared a helpful summary of the legislation’s tax provisions, it did nothing more than repeat the language of the forgiveness provision.

[viii] https://www.congress.gov/bill/116th-congress/senate-bill/3596/text

[ix] Health and Economic Recovery Omnibus Emergency Solutions (“HEROES”) Act, H.R. 6800.

[x] In July, the Senate introduced the HEALS Act, which inexplicably failed to address the Notice.

[xi] Unfortunately, these proposals were held hostage to the “piecemeal” vs “all-or-nothing” stimulus package debate that stupidly consumed the leadership on both sides of the political aisle.

[xii] H.R. 925.

[xiii] Absent the application of certain exceptions under IRC Sec. 108 of the Code.

[xiv] Keep reading.

[xv] See, e.g., Bloomberg’s November 11, 2020 Daily Tax Report, “IRS Official Says Stay Tuned for Loan Forgiveness Guidance.”

[xvi] I.e., those businesses that qualified to receive the loans in the first place, that used the proceeds for the prescribed purposes, and that subsequently were able to confirm their qualified status by successfully applying for and receiving forgiveness of their loans.

[xvii] The IRS issued Rev. Proc. 2020-51, which provides a “safe harbor” allowing a taxpayer to claim a deduction in 2020 for certain otherwise deductible PPP eligible expenses if (1) the expenses are paid during the taxpayer’s 2020 taxable year, (2) the taxpayer has a PPP loan which, at the end of the taxpayer’s 2020 taxable year, the taxpayer expects to be forgiven in a later taxable year, and (3) in that later taxable year, the taxpayer’s request for forgiveness of the PPP loan is denied, or the taxpayer decides not to request forgiveness of the PPP loan.

[xviii] What does that even mean? “Reasonable expectation?” Talk about introducing a subjective standard.

[xix] See, for example, former IRC Sec. 118 and Sec. 362. The former provided for the exclusion from gross income of a governmental grant to a business for purposes of constructing certain assets, the cost of which had to be capitalized by the business, while the latter reduced the adjusted basis of the assets in the hands of the business so as to avoid a “double benefit.”

See also the deduction under IRC Sec. 165 for certain losses, provided they are not compensated for by insurance or otherwise; there is an actual economic loss.

[xx] For example, the so-called “insolvency exception” applies. IRC Sec. 108(a).

[xxi] IRC Sec. 108(b)(4)(A).

[xxii] The taxpayer does not lose their deductions claimed for expenses paid with the loan proceeds in earlier years.

[xxiii] See, for example, IRC Sec. 118 before the Tax Cuts and Jobs Act.

[xxiv] https://www.taxlawforchb.com/2020/05/ppp-loan-forgiveness-and-the-denial-of-deductions-for-covered-expenses-whats-wrong-with-the-irss-position/ See the section labeled “An Alternative.”

[xxv] You can’t make this up, right?


How Are You Doing?

How are you coping with social distancing? Are you working remotely? If so, has it been as “seamless” as you would have others believe? Have you snuck out to visit family or close friends, or have they asked you to stay away because they or a loved one suffer from a compromised immune system? Do you occasionally leave your home for some fresh air? Are Zoom meetings and virtual events – including weddings, and even funerals – satisfying your need for contact with other individuals, or have they lost their luster and grown tedious? Do you miss your favorite restaurant or bar? What have you done for entertainment? How have you escaped the monotony of our current environment?

As we enter the year-end holiday season – and perhaps a “dark winter” as many healthcare professionals have warned may be the case – the entire country is experiencing a second wave of the resurgent coronavirus, in reaction to which many jurisdictions are mandating reduced travel, the closure (once again) of nonessential businesses, the continued lockdown of many public venues, the suspension of in-school classes, and the observation of stricter mask-wearing and social distancing rules, among other measures.

What have you done thus far to cope with the isolation and the stress that may have accompanied the implementation of these measures? Do you plan to try anything different over the next few months?

Just What You Needed?

It appears that many Americans have turned to a well-known plant, the sale and use of which, in various forms, is permitted to varying degrees in most states, but which remains illegal under federal law: cannabis.[i]

Indeed, sales of marijuana and other cannabis-derived products (edibles, for example, such as gummy candies) have skyrocketed.[ii]

Several jurisdictions have even designated marijuana dispensaries among those “essential” businesses that may remain open in the face of stay-at-home or lockdown orders.[iii] In fact, it may not be too farfetched to say that the products and services provided by so-called “sin” businesses, generally, have probably contributed to the short-term mental health of many over the last nine months.[iv]

During the elections earlier this month, four more states acted to legalize the recreational use of cannabis.[v] Its sale and use is now “fully legal” in 24 states; there are 6 states in which it is fully illegal; and there are 20 in which its status is mixed, depending upon the use.[vi]

According to Governor Cuomo, New York will likely join the ranks of those states in which cannabis is fully legal during 2021: “I think this year it is ripe because the state is going to be desperate for funding, even with Biden, even with the stimulus. Even with everything else, we’re still going to need funding, and it’s also the right policy. So I think we get there this year.”[vii]

Keeping Up with Demand?

As we move into what is shaping up to be the next lockdown, it is reasonable to assume that the demand for cannabis products will continue unabated.

One has to wonder, however, whether the supply will keep up with the demand. For one thing, financing for the expansion of a cannabis-related business and for the purchase of inventory may present a challenge.

After all, banks are unwilling to do business with an industry that deals in a product which continues to be treated as a “controlled substance” and, therefore, is illegal under federal law. For the same reason, cannabis businesses were denied access to loans under the Paycheck Protection Program established by the CARES Act,[viii] and are likely to be shut out of any extension of the PPP under future economic stimulus legislation.[ix]

The House of Representatives sought to address this state of affairs by including in its proposed stimulus package, known as the HEROES Act,[x] a provision the stated purpose of which is to ensure “access to financial services to cannabis-related legitimate businesses and service providers.”

Among other things, the Act would protect from federal prosecution a bank that provides financial services to a cannabis-related business that operates in a state in which such activity is legal.[xi]

We all know how well the House and Senate negotiations are going – more than six months of on-and-off discussions have yielded nothing but a lot of name-calling and finger-pointing.[xii]

The Senate – Mr. McConnell – believes that the above-described provision is irrelevant to a stimulus package that is intended to at least neutralize, and hopefully reverse, the adverse effects that our attempts to contain the pandemic (by shutting down many businesses) have had on the economy. The House – Ms. Pelosi – disagrees.

The “Highest” Court

Against this backdrop, a petition for a writ of certiorari was filed with the U.S. Supreme Court on November 6, 2020, in which the petitioner (the “Taxpayer”) has asked the nation’s highest Court[xiii] to review the decision of the U.S. Court of Appeals for the Tenth Circuit in the case of Standing Akimbo v. United States.[xiv]

The petition indicates, and the IRS has conceded, that the Taxpayer operates a legal cannabis dispensary under Colorado law.

However, it is the IRS’s position, notwithstanding the Taxpayer’s compliance with state law, that the Taxpayer is an unlawful drug trafficker under federal law.[xv] On the basis of this conclusion, the IRS has argued, among other things, that Section 280E of the Code should be applied to deny the Taxpayer all deductions for expenses incurred by the Taxpayer in its purportedly unlawful drug trafficking business.

The IRS’s position – with which the Tenth Circuit has agreed – is that federal law supersedes or preempts state law when it comes to a state-legal cannabis business.

In its petition, the Taxpayer questions the IRS’s application of the preemption doctrine. Local criminal activity, the Taxpayer points out, has “traditionally been the responsibility of the States.” Citing the principles of federalism and the Tenth Amendment, the Taxpayer argues that a federal criminal statute cannot prohibit an expressly state-legal act unless “explicitly” directed by Congress.

The Taxpayer is also challenging the constitutionality of Section 280E of the Code under the Sixteenth Amendment to the Constitution, claiming that it results in the taxation of something other than “net income.”

Before considering the Taxpayer’s argument that Section 280E is unconstitutional, let’s review the application of that provision.

The Code

In computing their taxable income, a taxpayer is allowed to deduct their ordinary and necessary expenses paid or incurred in carrying on a trade or business subject, however, to certain stated exceptions (including Section 280E).[xvi]

What about a taxpayer engaged in an unlawful business which generates income, and with respect to which the taxpayer pays certain expenses?

Under federal law, cannabis is a “Schedule I” controlled substance; thus, the manufacture, distribution, dispensation, or possession of marijuana is unlawful as a matter of federal law.[xvii]


The following phrase is sometimes attributed to mobster Al Capone: “They can’t collect legal taxes from illegal money.”

Ha! In 1931, Capone was convicted of tax evasion, just four years after the Supreme Court’s decision in U.S. v. Sullivan that “[g]ains from illicit traffic in liquor are subject to the income tax.”[xviii]

Writing for the Court in Sullivan, Justice Holmes pointed out that the definition of “gross income,” under the tax statute then in effect, did not distinguish between a lawful and an unlawful business; rather, it sought to tax income “derived from any source whatever.”

“As the defendant’s income was taxed,” Holmes continued, he was required to file a tax return.

Similarly, the Code allows a defendant who operates an illegal business to deduct, for purposes of determining its taxable income, all of “the ordinary and necessary expenses paid or incurred during the taxable year in carrying on” such business,[xix] provided the specific activity for which the expenses were incurred is not itself illegal,[xx] and subject further to certain statutory exceptions.[xxi]

One of these exceptions resides in Section 280E of the Code, which denies a “deduction” for any amount paid or incurred during the taxable year in carrying on any trade or business that consists of trafficking in certain “controlled substances”[xxii]  which is prohibited by federal law or by the law of any state in which such trade or business is conducted.[xxiii]

Cannabis/marijuana is a Schedule I controlled substance,[xxiv] and dispensing it constitutes “trafficking” within the meaning of Section 280E.

Therefore, the Code prohibits a taxpayer that is engaged in the business of “trafficking” in cannabis from deducting their related expenses.

Cost of Goods Sold

However, the fact that a taxpayer engaged in the business of trafficking in controlled substances cannot deduct its business expenses does not mean the taxpayer owes tax on the gross receipts generated by the business.

All taxpayers – including “drug traffickers” – determine their “gross income” (from which ordinary and necessary business expenses would normally be deducted[xxv] to arrive at the taxable income from a business) by reducing their gross receipts (total sales) by their cost of goods sold (“COGS”).[xxvi] Although Section 280E of the Code prohibits deductions, it says nothing about a taxpayer’s COGS.

Deduction v. COGS?

The main difference between deductions and COGS is one of timing; specifically, when does the taxpayer who incurs the cost in question benefit from the resulting reduction in their taxable income?

In general, a taxpayer can claim a deductible expense (and thereby reduce their taxable income) for the year in which the expense was incurred. However, when accounting for COGS, the taxpayer has to capitalize the cost for the item in the year of acquisition or production of the item; then the taxpayer generally waits until the year in which the item is sold to make the corresponding adjustment (i.e., reduction) to their gross income.

Recognizing that a taxpayer may be tempted to include an otherwise non-deductible expense in their COGS, the Code provides that “Any cost which . . . could not be taken into account in computing taxable income for any taxable year shall not be treated as” an adjustment to COGS.[xxvii] In this context, “cost” means expenses that would otherwise be deductible;[xxviii] thus, the taxpayer cannot circumvent the prohibition against claiming a deduction for an expense – for example, under Section 280E of the Code – by including the expense in their COGS.

With the forgoing introduction to Section 280E, let’s return to the Taxpayer’s petition.

The Sixteenth Amendment

In its petition, the Taxpayer makes the point that the power of Congress to tax under the Sixteenth Amendment is limited to taxing “income.”[xxix]

The Sixteenth Amendment reads as follows: “Congress shall have power to lay and collect taxes on incomes, from whatever source derived, without apportionment among the several States, and without regard to any census or enumeration.”

It is the Taxpayer’s position that the reference to “income” in the Sixteenth Amendment necessarily means “taxable income,” and not gross receipts or gross income.

Thus, according to the Taxpayer, the term “income” requires, as explained above, that gross receipts from a business be reduced not only by COGS (the difference being gross income), but also by the ordinary and necessary expenses incurred by the business in generating such receipts (the difference being taxable income).[xxx]

The Taxpayer claims that, because Section 280E denies a deduction for such ordinary and necessary expenses, it creates an “income” tax on amounts in excess of “constitutional income” within the meaning of the Sixteenth Amendment.

The Taxpayer concludes, therefore, that Section 280E of the Code is unconstitutional.

Will Cert be Granted?


I’m not even sure why the Taxpayer filed a petition for cert with the Supreme Court in light of the fact that, on October 13 of this year,[xxxi] the Court denied the petition of another taxpayer that challenged the constitutionality of the federal government’s treatment of cannabis.[xxxii] Among the issues presented by that petition was whether Congress, consistent with the Due Process Clause of the Fifth Amendment, could criminalize medical cannabis without exception, even for patients who require its daily administration to live.

The Taxpayer’s petition ends by explaining that only the Court can “fix” the conflict between the laws of so many states, on the one hand, and Section 280E, on the other, by declaring that Section 280E is unconstitutional and, thus, should not be enforced.

Although the Taxpayer’s statement is correct insofar as the Court’s authority is concerned, their efforts are misplaced, which may also explain why the Court will deny cert – if the state of the law is to change, it will be up to Congress to change it.

In fact, Congress has recently tried to decriminalize and de-schedule cannabis.[xxxiii] After being introduced in the House, the bill, H.R.3884, known as the Marijuana Opportunity Reinvestment and Expungement Act of 2019 (the “MORE” Act), cleared the House Judiciary Committee by a vote of 24 to 10, including two Republicans (from California and Florida), and was sent to the full chamber for consideration on November 21, 2019. After several delays, it was announced earlier this month that a vote in the House is planned for December 2020.[xxxiv] It will pass the House.

The bill was also introduced in the Senate as S.2227,[xxxv] and was referred to the Finance Committee in July of 2019. No other action has been taken[xxxvi] and, assuming a Republican-controlled Senate with Mr. McConnell at the helm, the likelihood of a vote on the Senate floor is remote.

That being said, Sen. Romney has stated that cannabis should be removed from the list of Schedule 1 controlled substances, though he opposes its legalization for recreational use.[xxxvii]

Which brings us to Georgia, with both of its Senate seats to be decided by runoff elections to be held on January 5, 2021.[xxxviii] As the Peach State goes, so the country goes?

Meanwhile, the absence of legislative change at the federal level will allow the IRS and other federal agencies to continue their enforcement of Section 280E of the Code and of the Controlled Substances Act as they relate to cannabis and its derivatives.

[i] https://www.dw.com/en/cannabis-in-high-demand-amid-coronavirus-pandemic/a-53336180 .

[ii] Did you expect me to say something about “reaching new highs?”

For those of you who follow this blog, you know that I am not shy about sharing my opinions. In this case, I side with Saruman, the Lord of Isengard, when he says to Gandalf, “your love of the halflings’ leaf has slowed your mind,” and then again, when describing Radagast the Brown as a “foolish fellow,” he says, “It’s his excessive consumption of mushrooms! They’ve addled his brain and yellowed his teeth!”

[iii] https://www.nytimes.com/article/coronavirus-weed-marijuana.html . Yep, cannabis and groceries. https://www.newyorker.com/magazine/2020/05/11/was-quarantine-made-for-cannabis

[iv] Alcohol sales have increased by 24% during the pandemic, with bipartisan support. Folks on both sides of the political aisle need their vices. https://www.npr.org/2020/09/11/908773533/hangover-from-alcohol-boom-could-last-long-after-pandemic-ends .

Query whether a grateful public will consider the current “contributions” of sin businesses in determining whether to set a place for them at the qualified opportunity zone table once society has established its new equilibrium?

[v] New Jersey, Arizona, South Dakota, and Montana.

[vi] https://disa.com/map-of-marijuana-legality-by-state . Over 40 states allow some medical use of the plant.

[vii] https://www.wamc.org/post/gov-cuomo-wamcs-roundtable-11520 ; https://www.taxlawforchb.com/2020/11/new-yorks-post-election-tax-environment-for-business-owners/ .

[viii] Public Law 116-136.

[ix] Assuming we ever see the enactment of such legislation.

[x] Health and Economic Recovery Omnibus Emergency Solutions (“HEROES”) Act, H.R. 6800, Sec. 110606.

[xi] Last year, the House Judiciary Committee approved a bill (H.R. 3884) that would decriminalize cannabis and remove it from the list of federally controlled substances.

Another bill, passed by the House (H.R. 1595), would have provided a cannabis business with greater access to banks.

[xii] According to Jamie Dimon, U.S. lawmakers are failing the country in their inability to reach a compromise on fiscal stimulus. At a virtual NYT conference last week, he stated “We have this big debate: Is it $2.2 trillion, $1.5 trillion? You’ve got to be kidding me.” Dimon added that the lawmakers should “Just split the baby and move on. This is childish behavior on the part of our politicians.” https://www.bloomberg.com/news/articles/2020-11-18/jpmorgan-s-dimon-says-congress-is-being-childish-on-stimulus

[xiii] No, the Justices are not on drugs.

[xiv] Standing Akimbo, Ltd. Liab. Co. v. United States, 955 F.3d 1146 (10th Cir. 2020), which affirmed the District Court (2018 WL 6791104 United States District Court, D. Colorado).

https://www.supremecourt.gov/search.aspx?filename=/docket/docketfiles/html/public/20-645.html . The case was docketed on November 12, 2020. The Government’s response is due December 14, 2020.

[xv] Specifically, the Controlled Substances Act.

[xvi] IRC Sec. 161 and Sec. 162.

[xvii] See Controlled Substances Act, P.L. 91-513, Sec. 202.

[xviii] 274 U.S. 259 (1927).

[xix] For example, rent or compensation.

[xx] For example, bribery, or an illegal kickback.

In response to the defendant’s argument in Sullivan, that “if a return were made, the defendant would be entitled to deduct illegal expenses, such as bribery,” Holmes responded, “This by no means follows, but it will be time enough to consider the question when a taxpayer has the temerity to raise it.”

[xxi] IRC Sec. 161 and Sec. 162.

[xxii] Within the meaning of schedule I and II of the Controlled Substances Act.

[xxiii] Cannabis, Business Expenses, and the Code | Tax Law for the Closely Held Business (taxlawforchb.com) .

[xxiv] https://www.dea.gov/controlled-substances-act .

[xxv] IRC Sec. 63(a).

[xxvi] Reg. Sec. 1.61-3(a); Reg. Sec. 1.162-1(a). Basically, the cost of acquiring inventory, either through purchase or production.

[xxvii] IRC Sec. 263A(a)(2).

[xxviii] Reg. Sec. 1.263A-1(c)(2).

[xxix] The Sixteenth Amendment reads as follows: “Congress shall have power to lay and collect taxes on incomes, from whatever source derived, without apportionment among the several States, and without regard to any census or enumeration.”

[xxx] IRC Sec. 162 business expenses.

[xxxi] After the passing of Justice Ginsberg and before the appointment of Justice Barrett.

[xxxii] Washington v. Barr, which sought review of a decision rendered by the Courts of Appeals for the Second Circuit. https://www.marijuanamoment.net/supreme-court-declines-to-hear-marijuana-case-challenging-deas-restrictive-classification/ ; https://www.supremecourt.gov/search.aspx?filename=/docket/docketfiles/html/public/20-148.html .

[xxxiii] https://www.congress.gov/bill/116th-congress/house-bill/3884/text .

[xxxiv] https://www.cannabisdispensarymag.com/article/us-house-plans-december-vote-on-more-act/ .

[xxxv] By Sen. Kamala Harris. https://www.congress.gov/bill/116th-congress/senate-bill/2227 .

[xxxvi] Ah, the power of the majority leader.

[xxxvii] https://www.sltrib.com/news/politics/2018/09/24/romney-wilson-split-utahs/ ; https://www.isidewith.com/candidates/mitt-romney/policies/healthcare/marijuana .

[xxxviii] https://www.taxlawforchb.com/2020/11/the-2020-elections-are-almost-over-what-now/ .

Something Is Rotten

There’s a gray pall hanging over New York that has clouded the judgement of many politicians, and has left many of its residents feeling anxious and off-balance.  No, it’s not the smoke from all the newly lit joints, blunts and pipes drifting across from New Jersey, following the recent approval by that State’s voters of a proposal to legalize the recreational use of cannabis.[i] It’s something far more pernicious than that.

Last month, the Tax Foundation published its “State Business Tax Climate Index.” This Index allows taxpayers to compare their state’s tax system to those of other states. It is derived by scoring a state’s “tax climate” relative to that of other states. Among the factors considered under this methodology are a state’s individual and corporate income taxes, sales taxes, real property taxes, and unemployment insurance taxes.[ii]

According to the Index, New York was ranked 48th for the third straight year.[iii] Would it surprise you if I told you that the State was ranked 49th during the five-year period running from 2014 to 2018?

I didn’t think so.

Notwithstanding its well-deserved position in what may be described as one of the lower circles in the tax version of Dante’s Inferno,[iv] the State has hardly been repentant for its tax policies; rather, New York has continued to act poorly toward the closely held businesses and business owners that make their home within its borders,[v] seemingly confident in its ability to do so without repercussions.

The same may also be said for New York City.

But how much longer will business owners subject themselves to this treatment? At what point will the tax cost of operating in New York – and in the City, in particular – when aggregated with the non-tax business costs of what has always been a very demanding and expensive business environment,[vi] so outweigh the benefits of being located there, that owners are left with little choice but to remove themselves and their businesses from the State?

How will the pandemic and its aftermath – including the economic shutdown imposed earlier this year to prevent its spread, not to mention the one that appears to be on the horizon[vii] – figure into a business owner’s deliberations over whether to maintain, scale back, or abandon their New York presence?

How might the results of the recent federal elections influence a business owner’s thinking on this question?

In order to better appreciate how the closely held New York business may respond to the challenges arising from these developments, and why, it would behoove us to first review conditions as they were before 2020.

The NY Business Environment

Prior to the onset of the pandemic, more than 2 million closely held businesses operated in New York, comprising approximately 99% of all businesses in the State. These businesses employed almost 4 million people, or about half the State’s private sector workforce.[viii]

Let’s consider one of these closely held businesses that may have operated out of New York City and which drew its workforce from the City’s boroughs and neighboring counties.

The cost of living in the City is notorious,[ix] so a business would have to pay more to hire and retain employees. Even at the lower end of the compensation spectrum, the City requires a minimum wage of $15 an hour; beginning in 2021, Nassau, Suffolk and Westchester Counties will require the same minimum wage. Also starting in 2021, qualifying employees will be entitled to 12 weeks of paid family leave.[x]

Then there is the famously outrageous cost of leasing commercial space in the City (at least pre-COVID) and, in particular, Manhattan.

Add to that the State’s and the City’s regulatory environments, which are both complex and pervasive; in other words, the cost of compliance with their rules is not insignificant.

Finally, the pièce de résistance: taxes. New York knows how to tax like nobody’s business.[xi]


There was a time we referred to Massachusetts as “Taxachusetts.” The Bay State shed that mantle years ago, leaving “Tax York” as the reigning champion. A quick review of the major taxes imposed upon New York businesses and their owners will demonstrate why the title fits.

Beginning with the City, there is (a)(i) a business corporation tax on C corporations and (ii) a general corporation tax on S corporations, each imposed at a rate of 8.85%; (b) an unincorporated business tax that applies to sole proprietorships and partnerships/LLCs at a rate of 4%[xii]; (c) a commercial rent tax[xiii] on tenants at an effective rate of 3.9%; (d) a real property transfer tax at a maximum rate of 2.625% for nonresidential properties; (e)(i) a sales tax of 4.5%, plus (ii) the  Metropolitan Commuter Transportation District surcharge of 0.375%; and (f) a personal income tax at a top rate of 3.876%.

Turning to New York State, there is (a) a franchise tax on C corporations, generally, at a rate of 6.5%; (b) a real estate transfer tax, generally at 0.40%[xiv]; (c) a sales tax of 4%[xv]; (d) an individual income tax at a top rate of 8.82%[xvi]; and (e) an estate tax of 16%, which features the unconscionable “cliff”[xvii] and its close relative, the 3-year claw-back.[xviii]

The Feds

Of course, one cannot neglect the federal taxes to which the New York business and its owners are also subject.

At least through the end of 2020, the most relevant of these taxes are the following: (a) an income tax on C corporations at a flat rate of 21%; (b) a tax on qualified dividends of 20%; (c) a tax on long-term capital gain of 20% (25% in the case of depreciable real property, to the extent of the depreciation); (d) a 3.8% surtax on the net investment income of individuals; (e) an individual income tax of 37%; (f) a Social Security tax on self-employed individuals, including many partners, of 12.4% up to the first $137,700 of self-employment income, and a Medicare tax of 2.9% on all self-employment income; (g) a 12.4% Social Security tax and a 2.9% Medicare tax on wages paid to employees, with the tax being shared equally between the employee and the employer; and (h) an estate tax, a gift tax, and/or a generation-skipping transfer tax, as applicable, on a taxable transfer of property, at the rate of 40% to the extent the amount transferred exceeds the individual transferor’s exemption amount.

In determining their federal income tax liability, an individual business owner – whether a sole proprietor, a member of a partnership/LLC, a shareholder of an S corporation, or an employee of a corporation of which the individual is a shareholder – may claim an itemized deduction of up to only $10,000 of the New York State and City income taxes paid by them on their share of the taxable income of such business entities (though it should be noted that the IRS last week approved a “state tax cap workaround” for individual owners of partnerships and S corporations).[xix]

“Tax the Rich!”

As if the foregoing barrage of taxes was not enough, “tax the rich” became a rallying cry during the Democratic Party’s presidential primaries.[xx] Its message resonated with New York Democrats, both in Albany and in the City.

But who are these rich people?[xxi]

According to the Tax Policy Center – a nonpartisan think tank based in Washington, D.C. – about 9% of the households in the U.S. have income greater than $200,000, and they receive almost 45% of all pre-tax income; the “really rich,” however, representing the top 0.40% of households, have incomes in excess of $1 million a year and receive 13% of all pre-tax income.

At the same time, the top 20% of households, who received 54% of all income, also paid 69% of federal taxes, while the top 1%, with 6% of the income, paid 25% of all federal taxes.[xxii]

According to the Empire Center – a nonpartisan think tank based in Albany – the highest-earning 1% of New Yorkers pay more City and State income taxes than the combined lowest-earning 90%.[xxiii] In the State, they account for 40%; in the City, the 1% account for 47% of the personal income taxes paid.[xxiv]


Most objective observers would agree that the imposition of the existing federal, state and city taxes on an individual taxpayer’s business earnings and assets, when viewed in the aggregate, presents a daunting challenge for the business, its owners and the owners’ families, they are made even more so when one considers the non-tax expenses of conducting business in a place like New York or the City.

The politically-driven threat of still higher taxes certainly turned up the anxiety level for business owners (and their employees) who were already on edge.

Into this already challenging tax and economic environment came the COVID-19 virus.

On March 7, 2020, Governor Cuomo declared a state of emergency, which was followed on March 20 by a statewide order that all non-essential workers work from home.

From an economic perspective, the results were not good. The City’s real estate market, for example, took a blow.[xxv] Office buildings and the businesses depending upon them (for example, restaurants and transportation) were suddenly struggling to make ends meet.

The adverse effects upon these and so many other businesses and their employees are translated into reduced tax revenues for the State and the City, thereby placing the government in the position of having to cut back on various programs.

Perhaps more disconcerting, because of its potentially longer-term effects on the City’s economy, was the realization among many employers that their businesses may be operated remotely, without the substantial cost of maintaining a physical presence in the City. As the New York Times put it almost six months ago:[xxvi]

“[A]s the pandemic eases its grip, companies are considering not just how to safely bring back employees, but whether all of them need to come back at all. They were forced by the crisis to figure out how to function productively with workers operating from home — and realized unexpectedly that it was not all bad. If that’s the case, they are now wondering whether it’s worth continuing to spend as much money on Manhattan’s exorbitant commercial rents. They are also mindful that public health considerations might make the packed workplaces of the recent past less viable.”

Just as importantly, many employees have discovered the benefits of telecommuting and, in most cases, their employers are eager to keep them happy.

New York’s Reaction

In typical fashion, the Department of Taxation and Finance went on the attack.

The Department announced that a telecommuter who lives in New Jersey or Connecticut will still be subject to New York income tax if their assigned or primary office is in New York, and their days telecommuting during the pandemic will be considered days worked in New York, unless their New York employer has established a bona fide employer office at the nonresident’s “telecommuting location.”[xxvii]

The City’s Democratic Mayor de Blasio has been going after other telecommuters: those residents with second homes outside the City. The Mayor favors a tax on wealthy New Yorkers to help close the budget gaps resulting from the pandemic. “We do not make decisions based on the wealthy few,” Mr. de Blasio has stated, while Governor Cuomo has been portrayed as “pleading with rich city dwellers” who left the City at the height of the pandemic to come back. According to Mr. Cuomo, raising taxes would make matters worse; it “would cause the wealthy to flee New York.”[xxviii]

Not to be outdone, Democrats in Albany were openly discussing their hopes of securing a supermajority in the State Senate – they already have one in the Assembly – in order to override what they expect will be the veto by Governor Cuomo, a fellow Democrat, of any State legislation that seeks to increase taxes on New York’s “wealthy”[xxix] in order to cover the budget shortfall brought on by the pandemic.[xxx] Among the tax increases being discussed is a tax on pied-à-terres, an increased rate on millionaires, and a tax on the unrealized capital gains of billionaires.[xxxi]

They needed only two seats to secure their veto-proof majority. Unfortunately for New York’s Democrats (excluding Mr. Cuomo), it appears that they will lose, rather than gain, seats in the State Senate.[xxxii]

The National Scene

Although New York business owners may have dodged a bullet in Albany – at least for now – will they dodge a similar bullet out of Washington, D.C.? That remains to be seen.[xxxiii]

If the Democrats win both runoff races in Georgia (on January 5, 2021) for that State’s two U.S. Senate seats, they will have split that chamber evenly with the Republicans, at 50 seats apiece. In that case, Ms. Harris’s vote, as president of the Senate, would break any tie regarding tax legislation.[xxxiv]

Also to be considered is the influence that may be exercised by the Democratic Party’s progressive wing. Its agenda resonated with many voters, including its calls for taxing the rich and redistributing wealth. What’s more, now that Mr. Biden will be sitting in the White House, its members are becoming more vocal about demanding representation in his cabinet and in Congressional committee appointments.

What hangs in the balance? Major tax increases for businesses and their owners, including: (a) an increase in the C corporation tax rate to 28%; (b) an increase in the rate on GILTI to 21%; (c) an increase in the individual income tax rate to 39.6%; (d) an increase in the tax rate on capital gains and qualified dividends to 39.6% for individuals with more than $1 million of income; (e) the extension of the 12.4% Social Security tax to all self-employment income and wages in excess of $400,000; (f) the elimination of the Section 199A deduction for individuals with income in excess of $400,000; (g) the elimination of the like kind exchange for individuals with income in excess of $400,000; (h) the reduction of the federal estate/gift/GST tax basic exclusion amount to $5 million[xxxv]; and (i) the elimination of the basis step-up at death.[xxxvi]

A Glimpse into the Future?

The possibility of an increase in several federal taxes. The uncertain budget situation in Albany and New York City, and what it may mean for state and local taxes. The rise of a “progressive” political agenda at both the national and state levels, and its acceptance by large segments of the population. A tendency to demonize anyone who is perceived as being “successful,” even when they are not “rich” by any stretch. A second wave of the COVID-19 virus, and the strong prospects of a so-called “dark winter.” The likelihood of another economic shutdown, including the physical lockdown of offices and other places of business, and its impact upon businesses, their employees, as well as government. Finally, the mental fatigue caused by all of the foregoing.

Based upon my own practice – and I am certain that other tax practitioners are having the same experience – many New York business owners are very concerned about the threat of increased tax rates at the federal, state and city levels, and the impact these will have upon their future.

A not insignificant number of owners are expressing an interest not only in leaving New York – and especially the City – but in also relocating their business and, where feasible, their employees. As indicated above, these owners have realized that their business may be operated successfully without the cost of a physical footprint in an expensive jurisdiction. Moreover, they have seen that their employees can work efficiently and effectively through telecommuting, and that they are happier doing so. Although these owners may not be able to do much about avoiding federal tax changes, leaving New York for another state is an option that offers the opportunity for substantial savings. “Why pay for the cost of a New York presence?” they say, including the steep tax bill – what better way to protect the bottom line in the face of increased federal taxes?

Others have read the proverbial tea leaves[xxxvii] and don’t like what they see. These owners are considering the sale of their business – in fact, we are being pushed by some to close their deals before the end of this year out of concern over the fate of the federal tax rate on long-term capital gain[xxxviii] – as the first step toward leaving New York.[xxxix]

Then there are those who feel fortunate to have sold their business before the pandemic, but who are still waiting to be paid part of their sale price, whether as an earn-out, a release of funds from escrow, or in the form of installment payments under a note. Unfortunately for them, if a taxpayer is successful in removing themselves from New York while these amounts remain outstanding, the State will the taxpayer to accrue the unpaid amount for their final year as a New Yorker.[xl] What’s more, when these amounts are, in fact, received by the seller-owner, they will be taxed at the federal capital gain rate in effect for the year of receipt, by which time Congress may have raised it.

Finally, there are former business owners who are anxious about their ability to maintain a comfortable lifestyle, while also being able to leave something for their children or grandchildren. These folks are primarily concerned about their estates, and are worried about avoiding New York’s claw-back and cliff, failing which they will be faced with an estate tax of 16% on the value of their taxable estate.

Yes, there is a lot of uncertainty out there, but with one notable exception: regardless of what the business owner does to try to escape New York taxation, the State’s Department of Taxation and Finance is certain to examine the taxpayer-owner’s returns and to challenge, as a matter of course, their claims to have abandoned New York as their home and to have established a new home elsewhere. It is imperative, therefore, that the business owner obtain the assistance of a tax adviser who is experienced both in planning for such moves and in the taxation of closely held businesses and their owners. It is also important that the taxpayer resign themselves to the fact that the inevitable examination and subsequent administrative review will likely be a protracted process.

[i] Speaking of which, on a recent “WAMC’s Roundtable” program, Governor Cuomo stated, in response to a question regarding the New Jersey vote and the prospects of similar success in New York, “I think this year it is ripe because the state is going to be desperate for funding, even with Biden, even with the stimulus. Even with everything else, we’re still going to need funding, and it’s also the right policy. So I think we get there this year.”

https://www.wamc.org/post/gov-cuomo-wamcs-roundtable-11520 .

So, the discussion moves away from outlawing high-sugar soft drinks to legalizing pot. Finally, some clear-headed thinking. Would you pass me the magic mushrooms, please?

[ii] https://taxfoundation.org/2021-state-business-tax-climate-index/ .

[iii] At least we beat California (let them keep the Dodgers and Lakers) and New Jersey, which came in at 49th and 50th, respectively. New Jersey’s showing may explain, at least in part, why the State legalized the recreational use of cannabis.

[iv] The phrase inscribed on the gate of Hell – not to be confused with the City’s Hell Gate Bridge – “Abandon all hope, ye who enter here,” would fit just as well on any of the bridges and tunnels that connect Manhattan and Queens to the mainland, at least insofar as many closely held businesses are concerned. Canto III of the Inferno.

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

[vi] https://www.inc.com/jared-hecht/the-5-most-expensive-u-s-cities-to-start-a-business.html .

[vii] As I write this, Mr. Biden is making noise about a national shutdown in 2021 (except when he’s denying plans about a shutdown), while some governors are once again issuing targeted stay-at-home orders in response to a significant increase in the number of cases and deaths across the country.

Dr. Fauci has stated that he does not expect a national lockdown but, rather, “surgical-type local restrictions.” https://thehill.com/policy/healthcare/526036-fauci-were-not-going-to-get-a-national-lockdown?rnd=1605452617

Indeed, daily infections have surpassed 150,000, and no federal relief package is in sight. https://thehill.com/policy/finance/economy/525951-fears-of-double-dip-recession-rise-alongside-covid-19-cases .

[viii] https://www.businessnewsdaily.com/8775-doing-business-in-new-york.html .

[ix] As is the cost of living in the contiguous communities; for example, Westchester, Rockland and Nassau Counties are consistently among the top 10 counties with the highest real property taxes in the country; the others are all from New Jersey and Connecticut, except Marin County in California. https://www.cbsnews.com/news/property-tax-which-homeowners-around-the-u-s-pay-the-highest/ .

[x] Up from eight. https://www1.nyc.gov/nycbusiness/description/paid-family-leave .

[xi] I never understood this idiom, and it appears that its origin is unknown.

[xii] This is an “entity-level” tax. However, because of the entity’s pass-through nature for income tax purposes, its income is also subject to the City’s personal income tax in the case of an individual City resident. 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 income, 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 tax paid by the sole proprietorship or partnership.  https://www.taxlawforchb.com/2019/03/new-york-citys-unconscionable-unexpected-unincorporated-business-tax-a-glimpse-of-things-to-come/ .

[xiii] Only in Manhattan, generally south of 96th St.

[xiv] For consideration under $2 million; 0.65% if greater. Assuming a taxable transfer below this threshold, the total tax rate in the City is 3.025%.

[xv] For a total sales tax rate in NYC of 8.875%.

[xvi] Add the City’s rate for a total of 12.696%.

[xvii] When most people think about an estate tax exclusion, they reasonably conclude that a decedent’s asses will be subject to estate tax only to the extent they exceed the exclusion amount. Of course, such rational thinking has no place in New York. Under New York’s estate tax rules, if a decedent’s taxable estate exceeds 105% of the exclusion amount, their entire taxable estate becomes taxable in New York, not just the portion in excess of the exclusion amount. Thus, if I die with an ownership interest in my business that generates a taxable estate of 1.05 x $5.85 million (the State’s current estate tax exclusion amount), plus $1, my entire taxable estate will be subject to New York estate tax at the rate of 16%.

[xviii] New York does not impose a gift tax, but the claw-back has a somewhat similar effect. This rule applies to New York residents who die before January 1, 2026, and provides, generally, that taxable gifts made by a decedent within three years of their death will be included in their gross estate for estate tax purposes. (Gifts of real property located outside New York are not captured by this rule.)

[xix] In Notice 2020-75, released last week, the IRS approved of a method by which the individual partners and shareholders of a pass-through business entity may be allowed to claim a deduction for state and local taxes that were previously payable by these individuals on their share of the entity’s income – and, thus, subject to the $10,000 cap – but which state or local law has shifted to the business entity, which is now directly liable for the taxes.

Transparent evasion, yes, but nevertheless blessed by the IRS.

It almost doesn’t matter because Mr. Biden has called for the repeal of the $10,000 cap – ironic, yes? – and it is doubtful that any Republicans would challenge that position. (After all, the cap is otherwise set to expire after 2025.)

[xx] It is being replaced by “Embrace the base” as a progressive rallying cry on social media. https://thehill.com/homenews/administration/525941-the-memo-divided-democrats-search-for-common-ground .

[xxi] I recall having coming across an article many years ago that asked how Americans identify the “rich” among them. One response: “anyone who makes more money than me.” Funny, right? But also dangerous – what is the starting point for making that determination? Mr. Biden et al say $400,000. The arbitrariness of that decision should make everyone very nervous.

[xxii] https://www.brookings.edu/policy2020/votervital/who-are-the-rich-and-how-might-we-tax-them-more/ .

[xxiii] https://www.empirecenter.org/publications/nycs-high-income-tax-habit/

[xxiv] https://ibo.nyc.ny.us/fiscalhistory.html#taxliability ; https://www.cnbc.com/2020/09/25/taxes-are-likely-to-go-up-for-the-wealthy-in-these-nine-states-.html

[xxv] https://www.taxlawforchb.com/2020/09/nyc-real-estate-post-virus-tax-planning-can-help/#_edn16

[xxvi] https://www.nytimes.com/2020/05/12/nyregion/coronavirus-work-from-home.html

[xxvii] https://www.taxlawforchb.com/2020/10/new-york-business-nonresident-telecommuters-and-the-taxation-of-wages-earned-remotely/

[xxviii] https://www.politico.com/states/new-york/albany/story/2020/08/06/de-blasio-splits-with-cuomo-on-taxing-the-rich-and-luring-them-back-to-nyc-1305410

[xxix] https://www.gothamgazette.com/state/9856-democrats-supermajority-republicans-regain-seats-2020-battle-state-senate-elections-new-york

[xxx] https://www.democratandchronicle.com/story/news/politics/albany/2020/07/30/tax-rich-nys-top-lawmakers-say-yes-andrew-cuomo-says-no/5544324002/ ; https://wskg.org/news/as-new-york-budget-crisis-looms-democrats-seek-alternatives/ .

[xxxi] https://www.nytimes.com/2020/09/07/nyregion/wealth-tax-budget-billionaires.html

[xxxii] That’s right. The counting continues.

[xxxiii] https://www.taxlawforchb.com/2020/11/the-2020-elections-are-almost-over-what-now/

[xxxiv] It would also make Mr. Schumer the majority leader, with all the authority that entails. It may even enable the Democrats to abolish the filibuster.

[xxxv] The pre-2018 amount, though some in the Biden camp have talked about reinstating the pre-2010 estate tax exemption of $3.5 million and the $1 million gift tax exemption.

[xxxvi] https://www.taxlawforchb.com/2020/08/bidens-tax-proposals-for-capital-gain-like-kind-exchanges-basis-step-up-the-estate-tax-tough-times-ahead/ ; https://www.taxlawforchb.com/2020/10/the-election-the-democrats-tax-proposals-and-year-end-tax-planning-caught-between-scylla-and-charybdis/ ; https://www.taxlawforchb.com/2020/08/responding-to-the-democratic-partys-tax-plans/ .

[xxxvii] I believe these are legal in New York.

[xxxviii] Mr. Biden’s $1 million income threshold demonstrates either extreme ignorance of business, extreme animosity for business owners, or extreme stupidity. Not a good sign any which way.

Yes, some pundits are predicting that the Republicans will take at least one of Georgia’s Senate seats, which should alleviate concerns about tax increases. Query then why both political parties are pouring millions into these races and ramping up their public outreach?

Would you trust anything these ding-a-lings say? As I see it, they now qualify as entertainers, along with pollsters, gameshow hosts, actors, athletes, sports “analysts,” television news and reality-TV personalities, and the like.

[xxxix] https://www.taxlawforchb.com/2020/07/out-of-new-york-but-still-being-taxed-by-new-york-look-to-the-source/ ; https://www.taxlawforchb.com/2019/10/statutory-resident-selling-your-new-york-business-welcome-to-double-taxation/ ; https://www.taxlawforchb.com/2019/07/escape-from-new-york-it-will-cost-you/ .

[xl] https://www.taxlawforchb.com/2017/09/withdrawing-your-business-from-new-york-did-you-pay-the-exit-tax/ .

Wither The Senate?

I was reviewing a reorganization plan Saturday morning – coffee and chocolate chip cookies within easy reach[i] – when an email crossed my screen with the subject line that each of NBC, CNN, ABC and the Associated Press[ii] had just “called” the presidential election for Mr. Biden.[iii]

Fine, I thought to myself, but until we know about the Senate, Mr. Biden might as well have lost the election insofar as his ambitious tax agenda is concerned.[iv]

Before the 2020 election, the Republicans held a 53-to-47 majority in the Senate. On the day following the election, many self-described “pundits” informed us that, in light of Senator Collins’s re-election in Maine, the Senate would likely remain under Republican control.[v]

As of today, however, each Party has 48 seats in that chamber[vi] and, in case you haven’t heard, the Senate races[vii] in North Carolina and in Alaska have yet to be decided – they’re still counting votes,[viii] though by some accounts the Republican Party expects to win those contests. If that turns out to be the case, the Republicans will hold 50 seats in the Senate as compared to 48 seats for the Democrats. Which brings us to Georgia.[ix]

Georgia on My Mind[x]

Both of Georgia’s Senate seats were up this year – and both those seats will be decided by runoff elections to be held on January 5, 2021.[xi] In order for the Democrats to control the Senate, they will have to win both Georgia races,[xii] which will bring them even with the Republicans, at 50 seats apiece. In that case, Ms. Harris, as Vice President, would have the tiebreaking vote.[xiii]

Thus, we will not know until early next year whether Mr. Biden will have the luxury of a supportive Congress, or whether his anticipated efforts to change the Code will be stymied for at least two years by a Republican-led Senate.[xiv]

If Georgia gives the Democrats two more seats in the Senate, we should expect a number of changes to the Code, none of which bodes well for the tax burdens imposed upon the owners of a closely held business.[xv]

As if to ensure this outcome, among others, Ms. Ocasio-Cortez told the New York Times during a Saturday interview that, not only must Mr. Biden pay attention to the Party’s “progressive” wing, he must also appoint progressives to top positions in the new administration.[xvi] She added that the Democrats will lose seats in 2022 if the president fails to work with the progressive members of the Party.

Midterm – Already?

Speaking of 2022, many scholars and political analysts have observed that midterm elections “are not friendly to the president’s political party. Modern midterm elections have resulted in an average loss of 30 seats in the House of Representatives and Senate by the political party whose president occupies the White House. . . . And with few exceptions, they’re pretty ugly.”[xvii]

Before we start thinking too much about the 2022 midterm elections, however, we first have to see whether Georgia will deliver for the Democrats.[xviii] It may not – Mr. McConnell seems to believe the Republicans will take at least one of those races[xix] – in which case closely held businesses and their owners will probably not have to plan for immediate and substantial tax increases.

Politics as Usual?

That is not to say that a Republican Senate would not consider cutting a tax-related deal or two with the President[xx] and the Democrat-controlled House in exchange for a meaningful concession on some other matter – under the right circumstances, it probably would. However, the chances of the Republicans’ also agreeing that any such legislation be given retroactive effect to the beginning of 2021 are remote.

Moreover, it is doubtful that the Republicans would agree to any significant changes, and it is equally unlikely that Mr. Schumer is capable of wooing any of them into crossing the aisle to vote with the Democrats, at least with respect to major changes to the Code.

Indeed, if the Republicans retain the Senate – after gaining seats in the House, as they are projected to do – notwithstanding the record billions spent by the Democrats,[xxi] I doubt they will readily abandon their positions with respect to the corporate income tax, most business deductions,[xxii] and the estate tax, as most recently reflected in the Tax Cuts and Jobs Act.[xxiii]

“What Ifs”

What if the Republicans retain control of the Senate, albeit by the skin of their teeth?

What if, notwithstanding such control, they still agree to make a tax-related deal with the Democrats?[xxiv]

What if the Republicans – who are projected to have picked up a number of seats in the House once the remaining twenty-three vote tallies are completed[xxv] – hold out for the midterm elections, in the hope that history repeats itself and the Democrats lose still more seats in the House, perhaps even finding themselves in the minority?[xxvi]

What if the Republicans lose seats instead, including maybe their razor-thin margin in the Senate?

What is the owner of a business to do during the next fifty-two days – the tail-end of 2020 – in light of all this uncertainty?[xxvii]

“You Can Only Do So Much, but You Must Do At Least That Much”[xxviii]

By now, most business owners are familiar with Mr. Biden’s plans for amending the Code. Many of these changes are based upon his determination that any taxpayer who makes at least $400,000 in a taxable year is wealthy.[xxix]

Among the changes proposed by the Democrats during the presidential campaign were the following: an increased rate for ordinary income, the application of that same rate to capital gains for higher income taxpayers, a reduced itemized deduction for higher income taxpayers, imposition of the 12.4% social security tax on wages in excess of $400,000, elimination of the basis step-up for appreciated assets held by a decedent, and the reduction of the unified estate and gift exemption amount.[xxx]

At that time, we considered these tax proposals in a “vacuum,” in the sense that we analyzed them assuming their immediate enactment.[xxxi]

By now, we should have had greater certainty regarding the political and legislative context in which to place them. In turn, we should have been in a better position to answer questions and to assist business owners in preparing for, and responding to, the possible enactment of these proposals.

Unfortunately, the information we have today is not much better than what we had before the election, thanks primarily to the Georgia runoffs in January of 2021, which will determine whether the Democrats succeeded in winning control of both the House and Senate, thereby being in a position to dictate the legislative agenda in Congress for the next two years.

Again the question: what is the owner of a closely held business to do?

Assume the Worst

The safest course of action for business owners would be to assume that the Democrats will have control of the Senate come 2021, and to plan accordingly – provided such plans will not result in a reasonably foreseeable detriment to the business that will likely outweigh the tax benefit sought to be attained.[xxxii]

For example, a taxpayer who is under contract to sell property this year in exchange for one or more deferred payments of purchase price (for example, in the form of a note, an earn-out, or an escrow) should negotiate with the buyer some way to address the economic impact of a higher rate should one be enacted during the deferral period.[xxxiii]

Another taxpayer, who controls a C corporation with earnings and profits (or an S corporation with earnings and profits from C corporation tax years[xxxiv]), may want to consider the distribution of a qualified dividend this year, rather than at the beginning of the next.[xxxv]

Yet another would be well-advised to accelerate the sale of real property held for investment into this year, as the first leg of a deferred like kind exchange; if they fail to close the exchange in 2021, the taxpayer should still be able to elect out of installment reporting for 2020.[xxxvi]

An employer who normally pays key employees their bonuses for a year in the immediately succeeding year may want to consider paying them before the year-end.[xxxvii]

Finally, let’s not forget estate planning. If a business owner is already planning to make gifts of equity in the business to, or for the benefit of, their family members, but has not yet decided when to pull the proverbial trigger, now may be the time.

The prospect of the accelerated reduction, by at least 50%, of the Federal unified gift and estate tax basic exclusion amount, and of the generation skipping transfer tax exemption amount, should be incentive enough for the business owner, who faces a taxable estate, to act before the end of the year.[xxxviii]

Assume the Best

Alternatively, the business owner may take their chances that the Republicans will, in fact, take the Alaska and North Carolina races, as well as one or both of the January 2021 Georgia runoffs.

The Republicans will need to win at least three of these four contests to secure control of the Senate – the Democrats need two.

If the taxpayer is comfortable with what the Republican Party and the pundits are saying,[xxxix] then they can probably rest easy for two years – until the midterm elections – at which point they will have to revisit this scenario: “Do I act now, or wait for the outcome of the midterm election?”

Insofar as changes to the income tax are concerned, such a wait-and-see approach may be fine. In the event a tax increase is somehow enacted (perhaps as part of a larger deal), the business owner may have various options available to them by which they may reduce the impact upon their take-home profit.[xl]

As for their estate and gift tax planning, on the other hand? The premature loss of the increased exemption amounts[xli] will greatly impact an owner’s ability to pass assets along to their issue tax efficiently, especially if paired with renewed IRS regulatory activity which was suspended by the Trump administration.

Even then, however, some effective planning may still be implemented, especially in a low interest rate environment, for assets that are expected to appreciate; for example, zeroed out GRATs, or sales to grantor trusts in exchange for installment notes, which are largely independent of the exemption amount.

Decision Time

To quote Meat Loaf (sort of): What’s it gonna be? “Yes” or “No” to year-end planning?

If yes, I gotta know right now, before we go any further. Sure, you can sleep on it, but don’t take too long.

That said, having made a decision, the last thing I want is for you to be praying for the end of time to hurry up and arrive.

[i] What? Were you expecting a low fat yogurt and granola, drizzled with just a little bit of honey? The year-end calls for comfort food, especially this year, as if you didn’t know.

[ii] Each a purveyor of selective truths and of political correctness.

What’s more, when last I checked, the 12th Amendment to the Constitution governs the election of the president. The electors of the Electoral College will not meet in their respective states until December 14, 2020, and the electoral votes from each state are not due in the Senate until December 23, 2020.

Only thirty-three states have laws against so-called “faithless” electors.

When the Founding Fathers crafted the Constitution, they recognized that human beings are, and always will be, imperfect and gullible creatures. Thus, they constructed a number of safeguards into our framework of government, including the Electoral College.

[iii] https://thehill.com/homenews/campaign/524222-biden-defeats-trump-to-win-presidency .

[iv] https://www.taxlawforchb.com/2020/08/bidens-tax-proposals-for-capital-gain-like-kind-exchanges-basis-step-up-the-estate-tax-tough-times-ahead/ .

[v] The same ding-a-lings predicted a “blue wave.” Polling isn’t good for anybody. It fails to educate and, at worst, it misleads, perhaps leading some to direct their monetary support to the expected “winner.”

[vi] A net gain, so far, of one seat for the Democrats.

[vii] Thirty-three so-called “class two” seats were up this year.

[viii] North Carolina’s population is approximately 10.5 million, while just over 734,000 call Alaska home. (I suspect that a number of moose and/or brown bears may have either absconded with ballot boxes and/or shredded them to pieces.)

By the way, the NYC borough of Queens has a population in excess of 2.24 million; Brooklyn tips the scales at almost 2.65 million; Manhattan comes in at 1.6 million and change; the Bronx has over 1.4 million residents. (I know, I omitted Staten Island. I’m waiting for it to secede.) https://worldpopulationreview.com/states/alaska-population; https://worldpopulationreview.com/us-counties/ny/bronx-county-population .

For shits and giggles, as Austin Powers would say: each of Delaware, North Dakota, South Dakota, Vermont and Wyoming has a population of less than one million. One third of the country lives in California, Texas, Florida and New York.

[ix] The “Peach State.” Also known as the “Goober State,” goober being derived from the Bantu word for peanut.

[x] Willie Nelson’s version.

[xi] In accordance with Section 2 of the 20th Amendment to the Constitution, the rest of Congress will actually begin its work on January 3, 2021.

[xii] Query how much money is going to be poured into these two races over the next two months? The total cost of the 2020 election cycle has been estimated at approximately $11 billion. Large individual contributions represented the largest source of funding (almost 40%); 54% of the total cost was incurred by the Democrats. https://www.opensecrets.org/news/2020/10/2020-election-to-near-11-billion-in-total-spending-smashing-records/

What a waste of funds, especially considering how many folks are struggling to get by.

The following reflects disclosures of net wealth made by members of the House and Senate in 2018: https://www.opensecrets.org/personal-finances/top-net-worth .

[xiii] Article I, Section 3 of the Constitution. “The Vice President of the United States shall be president of the Senate, but shall have no vote, unless they be equally divided.”

[xiv] The Senate will have 34 seats up for election in 2022 – 21 Republicans and 13 Democrats.

[xv] https://www.taxlawforchb.com/2020/08/responding-to-the-democratic-partys-tax-plans/

Even if they control both houses of Congress, the Democrats will have to deal with the Senate’s cloture (or anti-filibuster) rule, which requires 60 votes to end debate on a matter – including a tax matter – and putting it to a vote, at which point only a majority will be required for passage. (There is no such rule in the House.) See Article I, Section 5, clause 2 of the Constitution, which authorizes each chamber of Congress “to determine the rules of its proceedings.”

That being said, query whether the Democrats will be able to invoke the 1974 Congressional Budget Act’s “reconciliation” rule to circumvent the cloture rule, limit debate, and put a tax matter to a vote requiring only a majority? https://budget.house.gov/publications/fact-sheet/budget-reconciliation-basics . The Act allows reconciliation to be used for legislation that addresses revenues and spending, as well as the federal debt limit. Some Democrats have already indicated that they intend to make use of this rule.

[xvi] https://www.nytimes.com/2020/11/07/us/politics/aoc-biden-progressives.html

[xvii] https://www.thoughtco.com/historical-midterm-election-results-4087704 . “In the 21 midterm elections held since 1934, only twice has the president’s party gained seats in both the Senate and the House.”

[xviii] Interestingly, even without a resolution as to Georgia, Mr. Biden has claimed a “mandate” from the American people. Even then, I’d be careful about claiming that “the people” have spoken.

[xix] Notwithstanding Biden’s showing in Georgia?

[xx] Biden is a 47-year, career politician and former colleague of many sitting Senators (1973-2009).

[xxi] Not to mention a blatantly one-sided and hostile press.

Don’t get me wrong. Mr. Trump was not suited for the White House. The press, however, cannot allow itself to behave as it has these last four years. Back to my quoting from movies, as is my wont. In “Meet Joe Black,” media executive William Parrish says the following:

I’d hoped to create something, something which could be held to the highest standards. And what I realized was I wanted to give the news to the world, and I wanted to give it unvarnished. The more we all know about each other, the greater the chance we will survive. . . . Now if we give [John Bontecou] license to absorb Parrish Communications, and he has his eye on a few others after us, in order to reach the world you will have to go through John Bontecou. And not only will you have to pay him to do this, far more important, you’ll have to agree with him. Reporting the news is a privilege and a responsibility, and it is not exploitable.

[xxii] For example, I don’t sense a lot of support for IRC Sec. 199A.

[xxiii] P.L. 115-97.

[xxiv] Something beyond agreeing that business expenses paid with PPP loan proceeds should be deductible for tax purposes. https://www.taxlawforchb.com/2020/10/forget-congress-the-irs-needs-to-reverse-course-on-the-deduction-of-business-expenses-paid-with-ppp-loan-proceeds/ .

[xxv] https://www.cnn.com/2020/11/06/politics/house-races-republicans-democrats-2020-election/index.html

[xxvi] Before the 2020 election, the Democrats held 232 seats to 197 for the Republicans; one seat belonged to a Libertarian, and five were vacant. As of today, with 412 of the 435 races having been called, the Democrats hold 216 seats and the Republicans 196.

[xxvii] Like so many others, I had hoped that Mr. Trump would not bring a legal challenge to the election results, but he has. What’s more, it seems that a number of Republicans are backing him. Although this development may complicate the nation’s political scene, it should not be considered in a business owner’s calculus.

[xxviii] Garrison Keillor, from Public Radio’s “A Prairie Home Companion” and “News from Lake Wobegon.”

[xxix] Funny, this is the same figure by which Mr. Obama identified the “wealthy” – in 2012. In today’s dollars, that figure is actually $453,461.

I guarantee you that $400,000 buys you a lot less, on an after-tax basis, in downstate New York than it does in most parts of the country. That’s more than just a function of cost of living. New York State imposes an income tax on individuals at a top rate of 8.82%. New York City’s top rate for individuals is 3.876%. The City’s bedroom communities of New York’s Nassau and Westchester counties have among the highest property taxes in the country.

Professionals starting out in New York – like professionals elsewhere – have spent years in college and graduate school to learn their trade, and have incurred significant costs in completing their educations. Moreover, they work an inordinate number of hours servicing clients and patients in a very competitive environment.

When Mr. Biden talks about rewarding “workers” instead of “wealth,” where does he place this human capital?

When this human capital dies or becomes disabled, it ceases to be productive, it ceases to generate income. This capital cannot be inherited like a portfolio of securities or real estate, it cannot fund a trust for generations.

[xxx] What else might we expect from Mr. Biden? A good place to look is the 2017 Green Book prepared by the Obama administration.

[xxxi] https://www.taxlawforchb.com/2020/10/the-election-the-democrats-tax-proposals-and-year-end-tax-planning-caught-between-scylla-and-charybdis/#_ednref37

[xxxii] “Hope for the best, plan for the worst.” Who said that?

[xxxiii] Consider something similar to a gross-up in a stock sale for which an election is made under IRC Sec. 338(h)(10) or Sec. 336(e). After all, the seller is doing the buyer a favor by accepting the deferred payment.

[xxxiv] IRC Sec. 1368(e)(3).

[xxxv] To take advantage of today’s presumably lower rates.

[xxxvi] IRC Sec. 453(d); Sec. 1031(a)(3).

[xxxvii] So as to avoid the additional employment taxes resulting from Mr. Biden’s proposed elimination of the wage cap for Social Security taxes.

[xxxviii] What’s more, they may be able to leverage their remaining exemption amount, while taking advantage of the current low interest rate environment, by transferring an equity interest in their business through a sale to a grantor trust, or a bargain sale to a family member. The use of a GRAT would prevent the allocation of the taxpayer’s GST tax exemption to the trust until the end of the ETIP period, at which point the exemption amount may be much lower. https://www.taxlawforchb.com/2020/03/think-before-you-gift-but-dont-take-too-long/

[xxxix] The first being a biased observer, the second a discredited one.

[xl] For example, cutting fat. If necessary, and if feasible, they may also adjust prices and other costs.

[xli] They are scheduled to sunset after 2025.

If the Democrats Win

Science has not established – at least to my knowledge – any correlation between the pre-election year-end activities of individual business owners, on the one hand, and election outcomes, on the other.[i]

If the behavior of business owners were considered an accurate indicator of election results, then one may reasonably conclude – based upon my observations – that tomorrow’s general election will give Democrats not only the Presidency, but the Senate as well, while preserving their control of the House.

But what is the behavior to which I am referring, and why does it point in the direction of a Biden victory?

Over the last few weeks, many business owners – including several who, for years, deferred any estate planning – have suddenly become interested in making substantial gifts of interests in their business to family members or to trusts for their benefit, often up to the full amount of their remaining federal exemption, before the end of the year.

Other business owners, who are already in discussions to sell all or part of their business, are eager to complete their sale before the end of the year, while some are anxiously looking to dispose of real property this year as the first step in completing  a deferred like-kind exchange of such property.

Why would business owners give up property even when their taxable estate is expected to fall below the current exemption amount, why would they choose to accelerate, rather than defer, the recognition of taxable gain from the sale of business interests, and why would others rush to start the 45-day identification period for replacement real property of like-kind to the property sold without having first investigated potential acquisition candidates?[ii]

The answer to each of these questions is pretty obvious: Mr. Biden’s tax plan; specifically, the proposed reduction of the Federal exemption amount by at least 50%, the proposed increase (almost doubling) of the income tax rate applicable to capital gain, and the proposed elimination of the like kind exchange for any taxpayer with more than $400,000 of annual income.[iii]

In order for these proposals to be enacted into law, the Democrats have to win the White House and the Senate (and hold on to the House), or they have to win the Senate while also securing a veto-proof majority in both chambers of Congress.[iv]

What Else?

The effect of a Democratic Party victory will not be limited to the anticipated legislative changes that seem to be motivating the end-of-year transactions by business owners described above. Among the other important factors to be considered in the event of such a victory will be its effect upon the Federal corporate income tax rate, and the impact thereof upon a business owner’s “choice of entity” decision.

Prior to the enactment of the Tax Cuts and Jobs Act in 2017,[v] the maximum Federal income tax rate on corporations was 35%.[vi] The TCJA eliminated the graduated rate brackets applicable to corporations, and replaced them with a flat tax rate of 21%.[vii]

At the same time, the TCJA reduced the maximum Federal income tax rate for individual taxpayers from 39.6% to 37%.[viii]

In addition, the TCJA included a new deduction, intended to provide an income tax benefit to the individual owners of businesses that are operated as tax partnerships or S corporations. This deduction is based upon 20% of an individual taxpayer’s share of a partnership’s or S corporation’s qualified business income.[ix]

Surprisingly, Mr. Biden’s tax plan does not call for a return to the pre-TCJA corporate income tax rates.[x] Rather, it proposes an increase in the rate from 21% to 28% – basically, the midway point between the previous 35% rate and the current rate.[xi]

However, Mr. Biden’s plan does provide for a return to the pre-TCJA maximum income tax for individuals of 39.6%.[xii] It also proposes an increase, from 20% to 39.6%, in the Federal tax rate applicable to the long-term capital gains[xiii] and qualified dividends realized by individual taxpayers with gross income for the taxable year in excess of $1 million.[xiv]

Finally, under Mr. Biden’s plan, the “20% of qualified business income deduction” would be phased out for higher income taxpayers, such that the deduction will be maintained only for those making less than $400,000 during a taxable year.

Next Steps?

Assume, in the immediate aftermath of a Democratic sweep, that our hypothetical taxpayer is an owner of a business entity (“Partnership”) that is treated as a partnership for tax purposes.[xv] Our taxpayer and most of their partners expect to be subject to a maximum Federal income tax rate of 39.6% on both their ordinary income, qualified dividends and long-term capital gains. It follows that they will not benefit from the 20% deduction for qualified business income.

How might our taxpayer and their partners respond to the sudden and adverse changes to the tax environment in which they do business?

Following the enactment of the TCJA and its reduction of the federal corporate income tax rate to a flat 21%, many taxpayers considered organizing new business entities as – or converting existing entities, out of which they were already operating their business, into – C corporations.

Although a 28% corporate tax rate, by itself, may not be enough to convince the individual owners of a partnership[xvi] to incorporate their business as a C corporation, the imposition of a 39.6% tax rate on any capital gain resulting from the taxable disposition of an interest in the business should cause them to consider such a conversion, especially where they may qualify to exclude from their gross income all of the gain from the sale of the corporation’s stock.

Qualified Small Business Stock

Under Section 1202 of the Code, a non-corporate taxpayer who holds “qualified small business stock” for more than five years[xvii] may be able to exclude the gain realized by the taxpayer from their sale or exchange of such stock (“eligible gain”).[xviii]

The excluded gain will not be subject to either the income tax or the surtax on net investment income; nor will the excluded gain be added back as a preference item for purposes of determining the taxpayer’s alternative minimum taxable income.[xix]

That being said, the amount of gain from the disposition of stock of a qualified corporation that is eligible for this exclusion is limited in that it cannot exceed the greater of:

    1. $10 million,[xx]reduced by the aggregate amount of eligible gain excluded from gross income by the taxpayer in prior taxable years and attributable to the disposition of stock issued by such corporation, or
    2. 10 times the aggregate adjusted bases of qualified small business stock issued by such corporation and disposed of by the taxpayer during the taxable year (with basis being determined by valuing any contributed property at fair market value at the date of contribution).[xxi]

This limitation notwithstanding, where the provision applies, a taxpayer may exclude a significant amount of gain from their gross income.[xxii]

Qualified Small Business Stock

In order for a taxpayer’s gains from the disposition of their shares in a corporation to qualify for the exclusion, the shares must have been acquired directly from the corporation – an original issuance, not a cross-purchase – in exchange for money or other property (not including stock), or as compensation for services provided to the corporation.[xxiii]

If property (other than money or stock) is transferred to a corporation in exchange for its stock,[xxiv] the basis of the stock received is treated as not less than the fair market value of the property exchanged. Thus, only gains that accrue after the transfer are eligible for the exclusion.[xxv]

Qualified Corporation

The corporation must be a qualified small business as of the date of the original issuance of the stock to the taxpayer, and during substantially all of the period that the taxpayer holds the stock.[xxvi]

A “qualified small business” is a domestic C corporation[xxvii] that satisfies an “active business” requirement,[xxviii] and that does not own: (i) real property the value of which exceeds 10% of the value of its total assets, unless the real property is used in the active conduct of a qualified trade or business,[xxix] or (ii) portfolio stock or securities the value of which exceeds 10% of its total assets in excess of liabilities.

Active Business

At least 80% (by value) of the corporation’s assets (including intangible assets) must be used by the corporation in the active conduct of one or more qualified trades or businesses.[xxx]

Gross Assets

As of the date of issuance of the taxpayer’s stock, the excess of (i) the corporation’s gross assets (i.e., the sum of the cash and the aggregate adjusted bases of other property[xxxi] held by the corporation), without subtracting the corporation’s short-term indebtedness, over (ii) the aggregate amount of indebtedness of the corporation that does not have an original maturity date of more than one year, cannot exceed $50 million.[xxxii] For this purpose, amounts received in the issuance of stock are taken into account.

If a corporation satisfies the gross assets test as of the date of issuance, but subsequently exceeds the $50 million threshold, stock that otherwise constitutes qualified small business stock would not lose that characterization solely as a result of that subsequent event, but the corporation can never again issue stock that would qualify for the exclusion.

Pass-Through Entities as Shareholders

Before considering the conversion of a partnership into a corporation, it may be helpful to review how Section 1202 is applied to the gain realized by a shareholder that is itself a pass-through entity.

Gain from the disposition of qualified small business stock by a partnership or S corporation that is taken into account by a partner or shareholder of the pass-through entity is eligible for the exclusion, provided that (i) all eligibility requirements with respect to qualified small business stock are met, (ii) the stock was held by the pass-through entity for more than five years, and (iii) the partner or shareholder held their interest in the pass-through entity on the date the entity acquired its stock, and at all times thereafter and before the disposition of the stock.[xxxiii]

In addition, a partner or shareholder of a pass-through entity cannot exclude gain received from the entity to the extent that the partner’s or shareholder’s share of the entity’s gain exceeds the partner’s or shareholder’s interest in the entity at the time the entity acquired the sock.

It should be noted that any pre-conversion appreciation in the assets of the partnership’s business will not be eligible for the gain exclusion rule; only the appreciation realized after the incorporation will qualify.[xxxiv] Likewise, the required five-year holding period will not start until the conversion date.

Based on the foregoing, a partnership should be able to contribute its business assets to a newly formed corporation in exchange for all of the corporation’s stock. If a new investor is to join the partnership in funding the corporation, the new investor may be part of the control group[xxxv] that transfers property to the corporation in exchange for the corporation’s stock.

Provided the partnership remains in existence, and provided the other requirements described above are satisfied, the gain from the partnership’s subsequent sale of the stock may be excluded from the gross oncome of the partners.[xxxvi]

But what if the partnership ceases to exist for tax purposes following its incorporation?[xxxvii] For example, a new investor – indeed, the one who may have insisted upon the incorporation of the partnership before investing in the partnership’s business – may also have insisted upon having all of the shareholders[xxxviii] residing in the same tier relative to the corporation.

Incorporation and Original Issuance

There are several ways by which a partnership may be incorporated. However, in order for the shares of stock that are acquired by the partners to constitute qualified small business stock, it is important to consider whether the method of incorporation may cause the partners to fail the “original issuance” requirement.

Check the Box

Thus, the partnership may, as an eligible business entity,[xxxix] elect to be treated as an association that is taxable as a corporation.[xl]

When such an election is made, the partnership is deemed to have contributed all of its assets and liabilities to the association in exchange for stock in the association, and immediately thereafter, the partnership liquidates by distributing the stock to its partners.[xli]

Of all the conversion options, the check-the-box election, strictly speaking, is the simplest and most straightforward.[xlii] That being said, it may be difficult to correlate the applicable state law partnership rules with the corporate tax provisions of the Code.

State Law Conversion

The partnership may also convert into a corporation under a state’s conversion statute. For example, in Delaware, a limited liability company that is treated as a partnership for tax purposes may be converted into a Delaware corporation by filing a certificate of conversion and, simultaneously therewith, a certificate of incorporation.[xliii]

According to the IRS, such a “formless” conversion under state law will be treated, for tax purposes, as though the partnership formally transferred all of its assets and liabilities to the corporation in exchange for stock, and then immediately made a liquidating distribution of the stock to its partners.[xliv]

A state law conversion is a fairly simple method by which to incorporate a partnership, provided it is available under applicable state law; for example, New York does not provide for such a conversion.

Merger into Corporation

A partnership may merge with and into a corporation in accordance with state law, with the corporation surviving. Under New York law, for example, this would require the creation of a corporation, the adoption of a plan of merger,[xlv] and the filing of a certificate of merger.[xlvi]

As in the case of a merger of corporations or a merger of partnerships, the merger of a partnership into a corporation will be treated, for tax purposes, as though the partnership formally transferred all of its assets and liabilities to the corporation in exchange for stock,[xlvii] and then immediately made a liquidating distribution of the stock to its partners.[xlviii]


A partnership may transfer its assets and liabilities to a corporation in exchange for its stock. The partnership can then make a liquidating distribution of the corporation’s stock.[xlix]


Instead of transferring its assets and liabilities to the corporation, the partnership may, instead, distribute them to its partners in liquidation of the partnership. The partners would then contribute these assets and liabilities to the corporation in exchange for its stock.[l]


The partners may contribute all of the outstanding partnership interests to the corporation.[li] All of the partnership’s assets and liabilities remain within the state law entity that was the partnership.

For tax purposes, the partners are treated as contributing their partnership interests to the corporation in exchange for the corporation’s stock.[lii] The partnership ceases to exist for tax purposes when the corporation becomes the sole owner of the partnership.[liii]

Where there many partners, relatively speaking, or if one or more minority partners are reluctant to incorporate, it should be possible to utilize a reverse subsidiary merger to compel the transfer of the partnership interests.[liv]

Original Issue

As indicated earlier, a shareholder will not be permitted to exclude the gain from the sale of their stock in a qualified small business corporation unless such stock was acquired at original issuance – meaning that the shares must have been acquired directly from the corporation.

Among the various partnership-to-corporation “conversions” described above, only two involve the direct issuance of stock by the corporation to the partners in exchange for the latter’s contribution of their partnership’s assets or partnership interests: the “assets-up” and the “interests-over” conversions.

In every other conversion scenario, the stock is either actually or constructively issued directly to the partnership – an original issuance – before being distributed, or deemed distributed, to the partners. Does that prevent the resulting corporation from being treated as a qualified small business corporation, and thereby deny its shareholders the opportunity to benefit from the gain exclusion rule under Section 1202 of the Code?

According to the Code, a partner who receives a distribution of stock from a partnership will be treated as having acquired the stock in the same manner as it was acquired by the partnership, and will be treated as having held the stock during any continuous period that it was held by the partnership, provided such stock was qualified small business stock in the hands of the partnership (determined without regard to the 5-year holding period).[lv]

Thus, the form of partnership incorporation utilized should not, by itself, disqualify the former partners, now shareholders, from potentially benefiting under Section 1202’s gain exclusion rule.

The Weight-Challenged Individual is About to Sing[lvi]

The 2020 campaign for the Presidency is almost over. Perhaps just as important – at least for us tax-types – is the battle for control of the Senate.

Hopefully, before our next post – in one week from today – we’ll know who will be sitting in the White House come January 20, 2021,[lvii] and what their chances will be of enacting any meaningful legislation before the end of 2022, at which point we may once again witness a nasty brawl for control of Congress.

[i] Of course, that is not to say that such a relationship does not exist.

[ii] Like the pun?

[iii] https://www.taxlawforchb.com/2020/08/bidens-tax-proposals-for-capital-gain-like-kind-exchanges-basis-step-up-the-estate-tax-tough-times-ahead/

[iv] A Presidential veto may be overridden by a two-thirds vote of each chamber. Article I, Section 7 of the Constitution.

In the Senate, that requires 67 votes; the Democrats currently have 47 votes in the Senate, to the Republicans’ 53; thus, they will have to win a net of 20 seats. Thirty-five Senate seats are up this year, of which 23 are held by Republicans.

In the House, 290 votes are needed to override a veto; the Democrats currently hold 232 seats, as compared to the 197 held by the Republicans; thus, they will need to win a net of 58 seats.

Neither of these outcomes is likely.

It should be noted that one seat is held by a Libertarian, and there are 5 vacancies (4 Republicans resigned and one Democrat died).

[v] “TCJA”; P.L. 115-97.

[vi] This applied to taxable income in excess of $10 million. A 34% rate applied to taxable income between $75,000 and $10 million.

[vii] Applicable to taxable years beginning after December 31, 2017.

[viii] Applicable to taxable income in excess of $612,350 in the case of a married couple filing jointly, for taxable years beginning after December 31, 2017. For the immediately preceding taxable year, the 39.6% rate applied to taxable income in excess of $470,700 in the case of a married couple filing jointly.

[ix] IRC Sec. 199A. This provision represented a concession to non-corporate taxpayers following the reduction in the corporate tax rate.

[x] Assuming a Biden presidency, what role will be played by the left wing of the Democratic party?

[xi] Interestingly, no mention has been made of replacing the flat rate, and returning to a graduated rate system based upon rate brackets.

[xii] Again, the plan is silent as to whether this top rate would be made applicable to a lower level of taxable income than under the TCJA.

[xiii] For example, the gain from the sale or exchange of shares of stock in a corporation that have been held for more than one year is treated as long-term capital gain.

[xiv] Of course, one must not forget the 3.8% Federal surtax on the net investment income of individual taxpayers. IRC Sec. 1411.

Stay tuned for the U.S. Supreme Court’s decision in California v. Texas, which is scheduled to be heard later this month. It is possible the Court will determine that the Affordable Care Act is unconstitutional, which would nullify the surtax.

[xv] IRC Sec. 761; Reg. Sec. 301.7701-3.

[xvi] An S corporation cannot qualify for the benefits of IRC Sec. 1202 by converting into a C corporation. See infra.

[xvii] This holding period begins with the day the taxpayer acquired the stock. If the taxpayer contributed property other than cash to the corporation in exchange for stock, the taxpayer’s holding period for the property is disregarded for purposes of the 5-year holding requirement.

[xviii] IRC Sec. 1202(a).

The exclusion rule of Section 1202 applies to the taxpayer’s sale or exchange of stock in a qualified small business.

Obviously, this covers a sale by the shareholders of all of the issued and outstanding shares of the corporation, subject to certain limitations.

It should also cover the liquidation of a C corporation and its stock following the sale of its assets to a third party. In that case, the double taxation that normally accompanies the sale of assets by, and liquidation of, a C corporation may be substantially reduced.

[xix] IRC Sec. 1202(a)(4).

[xx] In the case of a married individual filing a separate return, $5 million is substituted for $10 million.

[xxi] Note that the first of these limits operates on a cumulative basis, beginning with the taxpayer’s acquisition of the stock and ending with the taxable year at issue; the second operates on an annual basis, and depends upon how much stock was disposed of during the taxable year at issue.

[xxii] Moreover, any amount of gain in excess of the limitation would still qualify for the favorable capital gain rate, though it will be subject to the surtax. If Mr. Biden succeeds in taxing long-term capital gain at the rate of 39.6%, this rate will presumably apply to such excess gain.

[xxiii] IRC Sec. 1202(c).

[xxiv] It is assumed for our purposes that any in-kind contribution to a corporation in exchange for stock qualifies under IRC Sec. 351; in other words, the contributor, or the contributing “group” of which the contributor is a part, will be in control of the corporation immediately after the exchange; otherwise, the contribution itself would be a taxable event.

[xxv] IRC Sec. 1202(i)(1)(B).

[xxvi] IRC Sec. 1202(c)(2)(A).

[xxvii] Because the corporation must be a C corporation at the issuance of its stock, an S corporation issuer can never qualify for the benefits under Section 1202 by converting to a C corporation.

[xxviii] IRC Sec. 1202(e)(4).

[xxix] IRC Sec. 1202(e)(7).

[xxx] IRC Sec. 1202(e)(1). Certain trades or businesses are specifically excluded. IRC Sec. 1202(e)(3).

[xxxi] For purposes of this rule, the adjusted basis of property contributed to the corporation is determined as if the basis of the property immediately after the contribution were equal to its fair market value. IRC Sec. 1202(i).

[xxxii] IRC Sec. 1202(d). What’s more, the gross assets of the corporation must not have exceeded $50 million at any time before the issuance of its stock.

[xxxiii] IRC Sec. 1202(g).

[xxxiv] IRC Sec. 1202(i).

[xxxv] For purposes of satisfying the “control immediately after” requirement for tax-free treatment under IRC Sec. 351.

[xxxvi] Note than gain from the sale of a partnership interest does not qualify.

[xxxvii] There are various reasons why a partnership may be eliminated in connection with the incorporation.

[xxxviii] Including the former partners.

[xxxix] Within the meaning of Reg. Sec. 301.7701-3.

[xl] The election is made by filing IRS Form 8832, Entity Classification Election.

[xli] Reg. Sec. 301.7701-3(g).

[xlii] It is assumed herein that every conversion that does not require an actual transfer by individual partners or by the partnership has been approved by the partners in accordance with their partnership agreement.

[xliii] Delaware Code Title 8, Sec. 265. https://codes.findlaw.com/de/title-8-corporations/de-code-sect-8-265.html .

[xliv] Rev. Rul. 2004-59.

[xlv] The terms of the partnership agreement will have to be consulted.

Dissenters’ or appraisal rights may be triggered.

[xlvi] NY LLCL Article 10.

[xlvii] This will happen by operation of law as a result of the merger.

[xlviii] Rev. Rul. 69-6; Reg. Sec. 1.708-1(c)(3).

[xlix] Rev. Rul. 84-111, Situation 1. The transfer of all of the assets of the partnership should require a vote of the partners, whether by majority or supermajority.

[l] Rev. Rul. 84-111, Situation 2. The liquidation should require a vote of the partners. It’s important to follow the terms of the partnership agreement.

[li] Rev. Rul. 84-111, Situation 3. This may present an issue where there are many partners.

[lii] Rev. Rul. 99-6. The corporation is treated as receiving these assets and liabilities.

[liii] IRC Sec. 708(b)(1).

[liv] Though it will also trigger dissenter’s or appraisal rights by which the recalcitrant partners may force the liquidation of their interests at “fair value.”

[lv] IRC Sec. 1202(h)(2)(C).

[lvi] I’m tired of politic correctness, except where it may be used in good humor. No, not the ice cream. Do people still eat ice cream? It’s made from cow’s milk, you know. Cows? Those 4-legged, two-horned, peaceful animals that say “moo,” that sometimes end up as baseball gloves (miss the smell of a new mitt), and that are credited with destroying the earth. No, not almonds or coconuts or soy beans.

[lvii] Inauguration Day.