Some lessons need to be repeated until learned. It’s a basic rule of life. Don’t tug on Superman’s cape; don’t spit into the wind; don’t pull the mask off that old Lone Ranger; and if you are going to make a loan, give it the indicia of a loan and treat it as a loan.

The last of these lessons appears to be an especially difficult one for many owners of closely held businesses, at least based upon the steady flow of Tax Court cases in which the principal issue for decision is whether an owner’s transfer of funds to his business is a loan or a capital contribution.

The resolution of this question can have significant tax and economic consequences, as was illustrated by a recent decision.

Throwing Good after Bad

Corp had an unusual capital structure. It had about 70 common shareholders, including key employees and some of Taxpayer’s family members, but common stock formed a very small portion of its capital structure. Indeed, although Taxpayer was Corp’s driving force, he owned no common stock. Corp’s primary funding came in the form of cash advances from Taxpayer.

Over several years, Taxpayer made 39 separate cash advances to Corp totaling millions of dollars. For each advance, Corp executed a convertible promissory note, bearing market-rate interest that Corp paid when due.

Taxpayer subsequently advanced a few more millions, of which only a small portion was covered by promissory notes, Corp recorded all these advances as loans on its books, and it continued to accrue interest, though no interest was paid on any of this purported indebtedness.

After a few years, the entirety of this purported indebtedness was converted to preferred stock (the “Conversion”), representing 78% of Corp’s capital structure.

Taxpayer then made additional cash advances to Corp which were Corp’s sole source of funding during this period. Taxpayer generally made these advances monthly or semi-monthly in amounts sufficient to cover Corp’s budgeted operating expenses for the ensuing period.

Corp executed no promissory notes for these advances and furnished no collateral. As before, it recorded these advances on its books as loans and accrued interest, but it never paid interest on any of this purported indebtedness. These advances, coupled with Taxpayer’s preferred stock, constituted roughly 92% of Corp’s capital structure.

Corp incurred substantial losses during most years of its existence. This fact, coupled with Corp’s inability to attract other investors or joint venture suitors, caused Taxpayer to question the collectability of his advances. He obtained an independent evaluation of Corp’s financial condition, and was informed that Corp’s condition was precarious: Its revenue was 98% below target, and it had massive NOLs. Without Taxpayer’s continued cash infusions, he was told, the company would have to fold.

Taxpayer discussed with his accountant the possibility of claiming a bad debt loss deduction for some or all of his advances. Taxpayer took the position that all of his advances were debt and that the advances should be written off individually under a “first-in, first-out” approach.

Taxpayer’s attorney prepared a promissory note to consolidate the still-outstanding advances that Taxpayer did not plan to write off. While these documents were being prepared, Taxpayer made additional monthly advances to Corp. Taxpayer and Corp executed a debt restructuring agreement, a consolidated promissory note, and a certificate of debt forgiveness, all of which were backdated to a date after the Conversion.

Corp continued to operate with Taxpayer continuing to advance millions which, again, were not evidenced by promissory notes.

Taxpayer filed his Federal income tax return on which he reported a business bad debt loss reflecting the write-down of his advances to Corp. According to Taxpayer, this loss corresponded to advances he had made after the Conversion. Taxpayer claimed this loss as a deduction against ordinary income.

Business Bad Debt

The IRS disallowed the business bad debt deduction, and issued a notice of deficiency. Taxpayer petitioned the Tax Court.

The Code allows as an ordinary loss deduction for any “bona fide” business debt that became worthless within the taxable year. A business debt is “a debt created or acquired in connection with a trade or business of the taxpayer” or “a debt the loss from the worthlessness of which is incurred in the taxpayer’s trade or business.” To be eligible to deduct a business bad debt, an individual taxpayer must show that he was engaged in a trade or business, and that the debt was proximately related to that trade or business.

A bona fide debt is one that arises from “a debtor-creditor relationship based upon a valid and enforceable obligation to pay a fixed or determinable sum of money.” Whether a purported loan is a bona fide debt for tax purposes is determined from the facts and circumstances of each case, including the purported creditor’s reasonable expectation that the amount will be repaid.

Advances made by an investor to a closely held or controlled corporation may properly be characterized, not as a bona fide loan, but as a capital contribution. In general, advances made to an insolvent debtor are not debts for tax purposes, but are characterized as capital contributions.

The principal issue for decision was whether Taxpayer’s advances to Corp constituted debt or equity.

Bona Fide Debt

Taxpayer asserted that all of his advances to Corp constituted bona fide debt, whereas the IRS contended that Taxpayer made capital investments in his capacity as an investor. In determining whether an advance of funds constitutes bona fide debt, the Court stated, “economic reality provides the touchstone.”

The Court began by noting that, if an outside lender would not have lent funds to the corporation on the same terms as did the insider, an inference arises that the advance was a not a bona fide loan, even if “all the formal indicia of an obligation were meticulously made to appear.”

In general, the focus of the debt-vs.-equity inquiry is whether the taxpayer intended to create a debt with a reasonable expectation of repayment and, if so, whether that intent comports with creating a debtor-creditor relationship. The key to this determination is generally the taxpayer’s actual intent.

The Court identified the following nonexclusive factors to examine in determining whether an advance of funds gives rise to bona fide debt as opposed to an equity investment:

Labels on the Documents

If a corporation issues a debt instrument, such as a promissory note, that labeling supports the debt characterization.

Corp issued promissory notes for some of the cash advances Taxpayer made before the Conversion, those notes were converted to preferred stock and were not before the Court. The amount that was before the Court was advanced after the Conversion, and Corp did not issue a single promissory note to cover any of those advances. Rather, Taxpayer advanced cash on open account.

It was only in connection with the write-down that Corp issued a promissory note to Taxpayer to consolidate the portion of his advances that he chose not to write off, backdated to an earlier time. The Court found that this document was a self-serving document created in connection with Taxpayer’s year-end tax planning.

Fixed Maturity Date

A fixed maturity date is indicative of an obligation to repay, which supports characterizing an advance of funds as debt. Conversely, the absence of a fixed maturity date indicates that repayment depends on the borrower’s success, which in turn supports characterization as equity.

Because Corp issued no promissory notes for any of the advances at issue, there was of necessity no fixed maturity date.

Source of Payments

Where repayments depend on future corporate success, an equity investment may be indicated. And where prospects for repayment are questionable because of persistent corporate losses, an equity investment may be indicated.

Corp had substantial losses, its expenses vastly exceeded its revenue for all relevant years, and no payments of principal or interest had been made on Taxpayer’s still-outstanding advances. Corp was kept afloat only because Taxpayer continued to provide regular cash infusions keyed to Corp’s expected cash needs for the ensuing period. Thus, the most likely source of repayment of Taxpayer’s advances would be further cash infusions from Taxpayer himself.

Taxpayer testified that he hoped to secure ultimate repayment upon sale of Corp to a third party or a third-party investment in Corp. But this, the Court countered, is the hope entertained by the most speculative types of equity investors. Taxpayer was a “classic capital investor hoping to make a profit, not a creditor expecting to be repaid regardless of the company’s success or failure.”

Right to Enforce Payment of Principal and Interest

A definite obligation to repay, backed by the lender’s rights to enforce payment, supports a debt characterization. A lack of security for repayment may support equity characterization.

Although Taxpayer’s advances were shown as loans on Corp’s books, there was no written evidence of indebtedness fixing Corp’s obligation to repay at any particular time. None of Taxpayer’s advances was secured by any collateral. And even if Taxpayer were thought to have a “right to enforce repayment,” that right was nugatory because his continued cash infusions were the only thing keeping Corp afloat. Had he enforced repayment, he would simply have had to make a larger capital infusion the following month.

Participation in Management

Increased management rights, in the form of greater voting rights or a larger share of the company’s equity, support equity characterization.

Although Taxpayer had de facto control, he literally owned no common stock. But through his cash advances and preferred stock he held about 92% of Corp’s capital. Taxpayer contended that none of his advances gave him increased voting rights or a larger equity share. This was literally true, but it meant little because he already had complete control of the company by virtue of his status as its sole funder.

Status Relative to Regular Creditors

If Taxpayer had subordinated his right to repayment to that of other creditors, that would have supported an equity characterization.

However, Taxpayer was the only supplier of cash to Corp, which borrowed no money from banks and had no “regular creditors.” Taxpayer had, in absolute terms, none of the rights that a “regular creditor” would have; there was no promissory note, no maturity date, no collateral, no protective covenant, no personal guaranty, and no payment of interest. No “regular creditor” would have lent funds to a loss-ridden company like Corp on such terms.

Parties’ Intent

The Court examined whether Taxpayer and Corp intended the advance to be debt or equity. The aim is to determine whether the taxpayer intended to create a “definite obligation, repayable in any event.”

Taxpayer’s actions suggested that he intended the advances to be equity. He did not execute promissory notes for any of the advances at issue. He received no interest on his advances and made no effort to collect interest or enforce repayment of principal. Although Corp recorded the advances as loans and accrued interest on them, Taxpayer’s control over the company gave him ultimate discretion to decide whether and how repayment would be made. In fact, he expected to be repaid, as a venture capitalist typically expects to be repaid, upon sale of Corp to a third party or a third-party investment in Corp.

Inadequate Capitalization

A company’s capitalization is relevant to determining the level of risk associated with repayment. Advances to a business may be characterized as equity if the business is so thinly capitalized as to make repayment unlikely.

Taxpayer urged that, after the Conversion, the bulk of Corp’s capital structure consisted of preferred stock. He accordingly insisted that Corp was adequately capitalized at the time he made later advances.

The Court disagreed with Taxpayer’s assessment of the situation, observing that he made dozens of cash advances totaling many millions of dollars, and did not receive promissory notes until he decided to write off a portion of the purported debt.

Moreover, the Court continued, while Corp’s capitalization may have been adequate, that fact was not compelling. Normally, a large “equity cushion” is important to creditors because it affords them protection if the company encounters financial stress: The creditors will not be at risk unless the common and preferred shareholders are first wiped out. But because Taxpayer himself supplied almost 100% of Corp’s “equity cushion,” he would not derive much comfort from the latter prospect.

Identity of Interest between Creditor and Sole Shareholder

Taxpayer was not Corp’s sole shareholder, but he controlled the company and during the relevant period owned between most of Corp’s capital structure. There was thus a considerable identity of interest between Taxpayer in his capacities as owner and alleged lender. Under these circumstances, there was not a “disproportionate ratio between * * * [the] stockholder’s ownership percentage and the corporation’s debt to that stockholder.”

Payment of Interest

If no interest is paid, that fact supports equity characterization. Corp made no interest payments on any of the advances that Taxpayer made after the Conversion.

Ability to Obtain Loans From Outside Lending Institutions

Evidence that the business could not have obtained similar funding from outside sources supports characterization of an insider’s advances as equity. Although lenders in related-party contexts may offer more flexible terms than could be obtained from a bank, the primary inquiry is whether the terms of the purported debt were a “patent distortion of what would normally have been available” to the debtor in an arm’s-length transaction.

The evidence was clear that no third party operating at arm’s length would have lent millions to Corp without insisting (at a minimum) on promissory notes, regular interest payments, collateral to secure the advances, and a personal guaranty from Taxpayer. Especially is that so where the purported debtor was losing millions a year and could not fund its operations without Taxpayer’s monthly cash infusions.

Corp’s financial condition was extremely precarious in every year since its inception. The IRS determined that Corp had an extremely high risk of bankruptcy and that, without Taxpayer’s continued advances, it would surely have ceased operations. Under these circumstances, no third-party lender would have lent to Corp on the terms Taxpayer did.

In addition, Taxpayer continued to advance funds to Corp even after he concluded that its financial condition was dire enough to justify writing off some of his advances. An unrelated lender would not have acted in this manner.

After evaluating these factors as a whole, the Court found that Taxpayer’s advances were equity investments and not debt. Thus, it disallowed the Taxpayer’s business bad debt deduction.

Lesson

The proper characterization of a transfer of funds is more than a metaphysical exercise enjoyed by tax professionals. It has real economic consequences. In the Taxpayer’s case, it meant the loss of a deduction against ordinary income. Whether out of ignorance, laziness, or negligence, many business owners continue to act somewhat cavalierly toward the characterization and tax treatment of fund transfers to their business.

This behavior begs the question: “Why?” Why, indeed, when the owner can dictate the result by following a simple lesson: a promissory note, consistent bookkeeping, accrual and regular payment of interest at the AFR. C’mon guys.

Setting the Stage

Over the last couple of months, I’ve encountered several situations involving the liquidation of a partner’s interest in a partnership. Years before, the partnership had borrowed money from a third party lender in order to fund the acquisition of equipment or other property. During the interim period, preceding the liquidation of his interest, the departing partner had been allocated his share of deductions attributable to the debt-financed properties, which presumably reduced his ordinary income and, thus, his income tax liability.

The departing partner negotiated the purchase price for his interest based upon the liquidation value of his equity in the partnership. Imagine his surprise when he learned (i) that his taxable gain would be calculated by reference not only to the amount of cash actually distributed to him (the amount he negotiated), but would also include his “share” of the partnership’s remaining indebtedness, and (ii) that the amount of cash he would actually receive would just barely cover the resulting tax liability.

A recent decision by the Tax Court illustrated this predicament, and much more.

The End of a Partnership

Prior to Taxpayer’s admission as a partner, Partnership had entered into a lease for office space and had borrowed funds from Lender I for leasehold improvements.

Subsequently, Taxpayer joined Partnership as a general partner. Upon joining Partnership, Taxpayer did not sign a partnership agreement. At some point after Taxpayer joined the Partnership, the Partnership entered into a line of credit loan arrangement with Lender II.

Partnership dissolved in Year One. Upon Partnership’s dissolution, the Partnership began to wind up its affairs by collecting accounts receivable and settling pending lawsuits brought against the Partnership by its lenders and landlord.

In order to create a fund out of which to make partial payments to settle with the aforementioned creditors, Partnership’s former partners signed a settlement agreement pursuant to which Taxpayer agreed to pay a fixed dollar amount, constituting X% of the Partnership settlement fund. The settlement agreement included a provision entitled “Special Tax Allocation,” which provided:

In recognition of the contribution by each of the various Partners to the settlement of the Lawsuits, to each Partners’ allocation of income and loss for the year in which the [settlement] occurs shall be credited the percentage of loss created by the settlement and satisfaction of the Lawsuits equal to the pro-rata contribution by such Partner to the fund created by the terms of this Agreement. It is specifically recognized that this is a special allocation of losses made by the Partners in recognition of the contributions to the settlement of the Lawsuits and in lieu of and in substitution for the allocation of losses pursuant to the respective interests of the Partners in the [Partnership].

In Year Two, Partnership’s former partners entered into settlement agreements with each of its Lenders, pursuant to which Partnership agreed to pay a portion of the outstanding indebtedness to settle its debts, and the Lenders forgave their remaining balance.

Partnership filed Forms 1065, U.S. Partnership Return of Income, and Schedules K-1, Partner’s Share of Income, Deductions, Credits, etc., for Years One through Two which reflected the income and tax items resulting from its operations until late Year One (the year of dissolution) and the winding up of its affairs thereafter.

Taxpayer received a Schedule K-1 from Partnership for Year One, and another for Year Two, and reported his share of Partnership income and other tax items as reflected on the Schedules K-1 on his personal income tax returns.

Taxpayer’s Year Two return reported a nonpassive loss from Partnership, but it did not report any cancellation of indebtedness income from Partnership; nor did it report any capital gains.

Some Basic Partnership Tax Concepts

In general, a partner’s adjusted basis (“investment” for our purposes) in his partnership interest reflects the amount of cash contributed by the partner to, or left in the partnership by, the partner.

Income

A partner must recognize his distributive share of partnership income regardless of whether the partnership makes any distribution to the partner. The amount of income so recognized is reflected as an increase in the partner’s adjusted basis in his partnership interest.

Distributions

A partnership’s distribution of cash to a partner (representing, perhaps, already-taxed income, or capital contributions) reduces the partner’s adjusted basis in his partnership interest. If a cash distribution exceeds the partner’s adjusted basis in his interest, the excess amount is taxable to the partner. Thus, a partner may withdraw cash from a partnership without realizing any income or gain to the extent of his adjusted basis.

Losses

A partner can deduct his distributive share of partnership loss to the extent of his adjusted basis in his partnership interest at the end of the partnership’s tax year in which the loss occurred (one cannot lose more than one has “invested”); in general, his adjusted basis reflects the amount of cash contributed by the partner to, or left in the partnership by, the partner.

Borrowed Funds

When an individual borrows money, he does not realize any income; the loan proceeds do not represent an accretion in value to the individual. However, the individual may use the borrowed funds to pay expenses for which he may claim a deduction, or he may use them to acquire an asset for which he may claim depreciation deductions.

As a pass-through entity, a partnership tries to mirror these tax consequences of borrowing by its partners. Thus, when a partnership borrows money, the indebtedness is “allocated” among the partners, as though they had borrowed the funds and then contributed them to the partnership, thereby increasing each partner’s adjusted basis by his share of the partnership indebtedness. By doing so, the partners may withdraw the borrowed funds from the partnership without recognition of income (reducing their adjusted basis in the process), and may claim deductions for expenses paid with the borrowed funds, or for depreciation deductions with respect to property acquired with the borrowed funds.

Similarly, any increase in a partner’s share of partnership liabilities is treated, for tax purposes, as a contribution of money by the partner to the partnership, thereby increasing the partner’s basis in his partnership interest.

Conversely, any decrease in a partner’s share of partnership liabilities is treated as a distribution of money by the partnership to the partner. If the amount of this decrease exceeds the partner’s adjusted basis in his partnership interest, the partner will recognize gain to the extent of the excess.

IRS Audit

After examining Taxpayer’s returns, the IRS issued a notice of deficiency to Taxpayer, relating to Year Two, in which it: disallowed the Partnership loss deductions claimed; determined that Taxpayer failed to report his distributive share of Partnership’s discharge of indebtedness income; and determined that Taxpayer failed to report capital gain stemming from the deemed distribution of cash in excess of Taxpayer’s basis in his Partnership interest.

Cancellation of Debt

According to the IRS, Partnership’s settlement of its indebtedness to its Lenders, with a partial payment, resulted in cancellation of indebtedness income for the balance; it eliminated the Partnership’s outstanding liabilities.

Reduced Share of Debt

As a result of these transactions, the IRS contended that Taxpayer had to include in income his X% share of Partnership’s discharge of indebtedness income.

The IRS also argued that there had been a deemed distribution of cash to Taxpayer in an amount equal to the canceled Partnership liabilities previously allocated to Taxpayer on his Schedule K-1. According to the IRS, this deemed distribution exceeded Taxpayer’s adjusted basis in his Partnership interest and triggered a capital gain in an amount equal to the excess, which Taxpayer had to include in income.

Insufficient Basis for Deductions

Finally, the IRS contended that because Taxpayer had no remaining basis in his Partnership interest with which to absorb his distributive share of Partnership loss for Year Two, Taxpayer was not entitled to the deduction he claimed, and had to increase his income accordingly.

Tax Court’s Analysis

Taxpayer petitioned the Tax Court to review the IRS’s determinations.

COD Income

The Court explained that gross income generally includes income from the discharge of indebtedness; when realized by a partnership, such income must be recognized by its partners as ordinary income. The recognition of such income provides each partner with an increase in the adjusted basis in his partnership interest.

Under the settlement agreement, each partner, including Taxpayer, agreed that his distributive share of Partnership income and loss for Year Two would be calculated according to the percentage of funds that each had contributed towards the settlement fund. Taxpayer contributed X% of the total; thus, Partnership allocated X% of its discharge of indebtedness income to Taxpayer on his Schedule K-1.

Taxpayer made several arguments in an attempt to avoid the allocation of this income, but the Court found they had no merit, stating that the basic principle that partners must recognize as ordinary income their distributive share of partnership discharge of indebtedness income was well-established, even as to nonrecourse debts for which no partner bears any personal liability.

In sum, Taxpayer had to recognize his X% distributive share of Partnership’s discharge of indebtedness income for Year Two, thereby increasing Taxpayer’s adjusted basis in his Partnership interest to that extent.

Deemed Cash Distribution

The Court next determined that there was a deemed cash distribution to Taxpayer as a result of the elimination of Partnership’s outstanding liabilities during Year Two when it settled with its creditors, which “relieved” Taxpayer of his share of the partnership’s liabilities. Therefore, Taxpayer received a deemed distribution of cash from Partnership in an amount equal to his share of the liabilities.

Because this deemed distribution exceeded Taxpayer’s adjusted basis in his Partnership interest, Taxpayer was required to recognize capital gain in the amount of the excess.

No Basis? No Deduction

Finally, having determined that Taxpayer had no remaining basis in his Partnership interest as of the end of Year Two, the Court concluded that Taxpayer was not entitled to deduct his share of partnership losses for that year.

Lessons?

One often hears about the “phantom income” realized by a departing partner when his partnership has outstanding indebtedness, part of which was allocated to him, and is then deemed distributed to him in liquidation of his interest.

Many partners equate “phantom” with “unfair,” which is itself unfair, and inaccurate. In fact, the deemed cash distribution that is attributable to the departing partner’s share of partnership indebtedness results in gain to the partner only to the extent he previously received a “tax-free” distribution of the loan proceeds or was allocated partnership deductions or losses attributable to the partnership’s use of the borrowed funds. A more accurate description, therefore, may be that the departing partner is forced to recapture the tax benefit previously realized.

Theory and semantics aside, though, can the departing partner reduce or defer any of the adverse tax consequences described above? Maybe.

For example, a partner to whom income is allocated from the cancellation of a partnership’s indebtedness may be able to exclude the income if he – not the partnership – is insolvent at the time of the discharge.

As regards the deemed distribution of cash resulting from a former partner’s share partnership indebtedness, the distribution may be deferred so long as the partner remains a partner for tax purposes (for example, where his interest is being liquidated in installments). The amount of the deemed distribution may also be reduced if the partner receives an in-kind liquidating distribution of encumbered property, thereby resulting in a netting of the “relieved” and “assumed” liabilities, with only the net amount relieved being treated as a cash distribution.

The key, as always, is to analyze and understand the tax, and resulting economic, consequences of a liquidation well in advance of any negotiations. You cannot bargain for something of which you are unaware.

Departing Individuals

Many of you may know that an individual who changes his status from New York (“NY”) resident to nonresident is required to accrue to the period of his NY residence – i.e., include in his final NY tax return – any items of income or gain accruing prior to the change of residence status. For example, assume a NY individual sold an asset in exchange for a promissory note, and was reporting the gain realized on the sale under the installment method, recognizing such gain for tax purposes only as principal payments were made under the note. Assume further that the individual successfully abandoned his NY domicile and established a new domicile in another state before the promissory note was fully satisfied. Under NY’s Tax Law, the individual would be required to include in his final NY income tax return the amount of gain from the sale that had not yet been recognized by the time he changed his residence status.

Departing Businesses?

At this point, you may be wondering whether a similar “accelerated inclusion” rule applies with respect to a business entity that decides to cease its NY operations.

The Tax Law provides that the State may, “whenever necessary in order properly to reflect the entire net income of any [foreign corporate] taxpayer, determine the year . . . in which any item of income . . . shall be included, without regard to the method of accounting employed by the taxpayer.”

According to the regulations promulgated under this provision, however, if a foreign corporation sells its NY real estate on the installment basis (typically, in exchange for a promissory note under which principal payments – i.e., the sale price – are made over two or more tax years), and terminates its taxable status in NY in the year of the sale, the full gain on the sale must be included in the foreign corporation’s entire net income in the year of the sale, even though no portion of the sale price had yet been received by the foreign corporation. If the foreign corporation, instead, terminates its taxable status in NY in a subsequent taxable year, prior to the receipt of all of the installment payments of the sale price, the remaining gain on the sale would be included in the corporation’s entire net income in the year it terminates its taxable status in NY.

The regulation makes sense; otherwise, a foreign corporate taxpayer may, for example, sell NY real property in a taxable transaction, defer receipt of the cash sale price until after the taxpayer has withdrawn from NY, and thereby avoid tax that was properly owing to the State.

Leaving NYC?

A recent decision demonstrated that New York City follows the same approach as the State in taxing a business that ceases to operate in the City.

“Final Return”

Taxpayer was a corporation that owned and operated a Property for many years before selling it in 2009. Taxpayer filed its corporate tax return for the year of the sale, indicating that Taxpayer had ceased operations and that the return was its final return. Attached to this “final” return was a 2009 federal corporate income tax return that was also marked as “final.” On both returns, Taxpayer reported the net gain from the sale of the Property under the installment method, reporting a net gain of approximately $200,000 in 2009, out of a gross profit (total gain realized on the sale) of approximately $6.3 million.

In 2012, the City’s Dept. of Finance asserted a deficiency against Taxpayer based on the Dept.’s addition of approximately $6.1 million to Taxpayer’s 2009 NYC income; this amount represented the balance of the gain from the sale of the Property not yet reported by Taxpayer under the installment method.

According to the Dept., when a foreign corporation sells its assets on the installment basis, and then files a final tax return, it is required to report on its final return the entire gain realized on the sale.

Ongoing Business Activity?

In order to counter this argument, Taxpayer filed an amended 2009 tax return in 2013 (the year after the deficiency was asserted), which was not marked as a “final” return, and which included an amended federal return, also not marked as final. Unfortunately, Taxpayer failed to file any City corporate tax returns for any periods subsequent to the 2009 tax year.

Taxpayer also tried to demonstrate its ongoing operations in the City, submitting statements from a bank account that Taxpayer maintained at a branch in the City. Those statements showed that Taxpayer maintained a cash balance in the account during the years 2014 and 2015, and that Taxpayer made a recurring monthly deposit of approximately $54,000, representing the installment payments Taxpayer collected under its agreement to sell the Property.

On the basis of the foregoing, and the fact that Taxpayer had not been formally dissolved, Taxpayer argued that it did not cease doing business in the City and, thus, the Dept. could not disregard the installment method of reporting and tax the full amount of the gain in 2009.

The Courts: Immediate Inclusion

The Dept. argued that it properly exercised its discretionary authority, pursuant to the City’s Administrative Code, to disregard Taxpayer’s use of the installment method of accounting in order to ensure that Taxpayer’s deferred gain from the sale of the Property did not escape taxation after Taxpayer ceased to do business in the City.

The Administrative Law Judge (“ALJ”) sustained the deficiency, and the Tax Appeals Tribunal (“TAT”) affirmed the ALJ’s decision, concluding that Taxpayer had failed to establish that it was doing business in the City after 2009, and that the Dept. properly exercised its discretion under the Administrative Code to disregard the installment method of accounting for Taxpayer’s sale of the Property and include the entire gain from the sale of the Property in Taxpayer’s NYC income for 2009.

Taxpayer’s gain from the sale of the Property was properly subject to NYC corporate tax, the TAT continued. However, if Taxpayer were permitted to report the gain on the sale using the installment method for NYC tax purposes, Taxpayer would avoid paying NYC tax on the deferred gain reflected in the payments due under the installment sale of the Property after it ceased to do business in the City. With the exception of the gain reflected in the first installment payment (in 2009), the entire gain on the sale of the Property would permanently escape City tax.

The TAT noted that the Administrative Code allows the Dept. to disregard a taxpayer’s method of accounting where it results in the understatement of income subject to the corporate tax: “The [Dept.] may, whenever necessary in order properly to reflect the entire net income of any taxpayer, determine the year or period in which any item of income . . . shall be included, without regard to the method of accounting employed by the taxpayer . . .”

The TAT cited the following example interpreting the corresponding provision of the NY Tax Law: “A foreign corporation sells its [NY] real estate on an installment basis, and terminates its taxable status in [NY] in the year of the sale. The full profit on the sale must be included in entire net income in the year of the sale.”

Further, the TAT continued, “long-standing published statements of [Dept.] policy provide that the installment method of accounting should be disregarded when a corporation files a final return and ceases to do business in the City after selling its assets in an installment sale.” Unless Taxpayer can establish that it continued to do business in the City after 2009, the TAT stated, the Dept. was authorized under the Administrative Code to disregard Taxpayer’s use of the installment method and tax the entire gain from the sale of the Property in 2009.

As for Taxpayer’s argument that it remained in business by virtue of its maintenance of a bank account in the City, to which deposits from the sale of the Property were regularly made, the TAT replied that “[a] corporation will not be deemed to be doing business, employing capital, owning or leasing property in a corporate or organized capacity . . . in [the City] because of the maintenance of cash balances with banks . . . in” the City.

Thus, the maintenance of accounts at a bank branch in the City was insufficient, by itself, to establish that Taxpayer was doing business in the City after 2009. Taxpayer’s bank records provided no proof that Taxpayer was “doing business” in the City.

The only recurring item of any substance in Taxpayer’s bank records, the TAT noted, was the monthly deposit of $54,000. However, by asserting that these recurring receipts were the installment payments for the sale of the Property, Taxpayer brought itself squarely within earlier published Dept. rulings in which the taxpayer sold all of its assets under the installment method and its only activity was to collect the payments under the installment obligation. These rulings concluded that the taxpayer had ceased doing business in the City and that the Dept. properly exercised its authority to disregard the installment method and tax the entire gain in the year of the sale. The mere holding and collecting on an installment obligation received from the sale of property in the City did not constitute engaging in a trade or business in the City.

Finally, the TAT observed that Taxpayer did not file any corporate tax returns since the 2009 tax year. Thus, Taxpayer’s own actions served to confirm that it ceased doing business in the City when it sold the Property in 2009.

Please Note

It pays to know; or, rather, if you know, you may not have to pay.

The foregoing provisions of NY and City law have certainly caught a number of unsuspecting – i.e., uninformed – taxpayers by surprise, resulting in their having to satisfy state and local income tax liabilities with respect to gain for which they have not yet received payment.

With appropriate planning, one may plan for such “phantom gain” and its effects may be alleviated.

What’s more, the acceleration of gain recognition applies only to taxable gain; for example, the disposition of NY/NYC real property in exchange for like-kind property outside the State/City (as part of a Sec. 1031 transaction) should not be affected by this rule – except to the extent gain is recognized because of the receipt of “boot” – at least for the moment; several states have considered the imposition of an “exit tax” in such cases, and NY may do so in the future as the need for revenues increases.

Oops?

Are you a member of a partnership or of a limited liability company that is treated as a partnership for tax purposes (a “partnership”)? Did your partnership file its 2016 tax return late this year? How about K-1s? Were these forms issued late to its partners? Then this post may be for you.

Late last week, the IRS issued guidance providing penalty relief for certain partnerships that did not file the required tax return, on IRS Form 1065 (“U.S. Return of Partnership Income”), or issue Schedule K-1s (“Partner’s Share of Income, Deductions, Credits, etc.”) to its partners, by the new due date for taxable years beginning in 2016.

“New due date?” you say. Yep, this post is for you.

New Due Date

The Surface Transportation and Veterans Health Care Choice Improvement Act of 2015 (the “Act”), amended the Code to change the date by which a partnership must file its annual return. https://www.congress.gov/114/plaws/publ41/PLAW-114publ41.pdf; https://www.law.cornell.edu/uscode/text/26/6072

The due date for filing the annual return of a partnership – or for requesting an extension of time to file such return (using IRS Form 7004, “Application for Automatic Extension of Time To File”) – changed from the fifteenth day of the fourth month following the close of the taxable year (April 15 for calendar-year partnerships) to the fifteenth day of the third month following the close of the taxable year (March 15 for calendar-year partnerships).

A partnership must also issue a Schedule K-1 to each of its partners – reporting such partnership information as the partners may need to complete their own income tax returns, including each partner’s share of the partnership’s income and deductions – by the same due date. Partnerships that receive an extension of time to file Form 1065 receive a concurrent extension of time to furnish their partners with Schedules K-1.

The new due date applies to the returns of partnerships for taxable years beginning after December 31, 2015.

Penalty for Late Filing

It seems that you and your partnership were not alone. Many partnerships filed their 2016 returns (for their first taxable year beginning after December 31, 2015), or requests for an extension of time to file such returns, by the date previously required by the Code (April 15 in the case of a partnership with a taxable year ending December 31); in other words, they were filed late.

Partnerships that fail to timely meet their obligations to file their partnership tax returns by the specified due date (with regard to extensions), or to furnish Schedule K-1s to their partners, will be assessed a monetary penalty, unless such failure is due to reasonable cause (for example, reliance upon the advice of a tax professional whose competence the taxpayer has no reason to doubt).

The penalty is $195 for each month or part of a month (for a maximum of 12 months) the failure to file Form 1065 continues, multiplied by the total number of persons who were partners in the partnership during any part of the partnership’s tax year for which the return is due.

For each failure to furnish Schedule K-1 to a partner when due, a $260 penalty may be imposed for each Schedule K-1 for which a failure occurs.

It should be noted that where a partnership has failed to timely file its Form 1065, it is likely that it has also failed to file additional tax returns that are required to be filed by the same due date as the Form 1065, such as IRS Form 5471, “Information Return of U.S. Persons with Respect to Certain Foreign Corporations;” such additional failures may expose the partnership to the imposition of other penalties.

Relief from Penalties

If not for the Act, these returns and requests for extension of time to file would have been timely under prior law.

Because of that fact, and given the number of late filings, the IRS recently announced that it will provide penalty relief to partnerships that filed certain untimely returns, or untimely requests for extension of time to file those returns, for the first taxable year that began after December 31, 2015, by the fifteenth day of the fourth month following the close of that taxable year. https://www.irs.gov/pub/irs-drop/n-17-47.pdf

The IRS will grant relief from the late filing penalties described above for any return described above for the first taxable year of any partnership that began after December 31, 2015, if the following conditions are satisfied:

  • the partnership filed the Form 1065 or other return required to be filed with the IRS, and furnished Schedules K-1 to the partners, by the date that would have been timely under the Code before its amendment by the Act; or
  • the partnership filed a request for an extension of time to file by the date that would have been timely under the Code before amendment by the Act and files the return with the IRS, and furnishes Schedules K-1 to the partners, by the fifteenth day of the ninth month after the close of the partnership’s taxable year. This relief will be granted automatically for penalties for failure to timely file a partnership return on Form 1065, and any other returns for which the due date is tied to the due date of the Form 1065. In addition, partnerships that qualify for this relief and that have already been assessed penalties can expect to receive a letter within the next several months notifying them that the penalties have been abated.

Do the Right Thing

The Code and the Regulations issued thereunder are full of instances in which a taxpayer may be granted relief for a late filing, a late election, an inadvertently voided election, etc.

It is comforting to know that, in the “appropriate” circumstances, the IRS may provide relief to a “qualifying” taxpayer.

The granting of such relief, however, generally remains within the discretion of the IRS. Moreover, what if the taxpayer’s situation does not satisfy the threshold criteria for consideration by the IRS for relief?

A taxpayer cannot “plan” on the basis of the IRS’s generosity and understanding. Rather, a taxpayer must consult his tax advisers to ensure that he “does the right thing” from a tax perspective, whether in undertaking a business transaction, or in reporting the tax consequences of such a transaction. It is often too late to fix a problem after it has been created, and the IRS is not charged with helping taxpayers get out of problems of their own doing.

Choice of Entity

One of the first decisions – and certainly among the most important – that the owner of a new business must make is the form of legal entity through which the business will be operated. This seemingly simple choice, which is too often made without adequate reflection, can have far-reaching tax and, therefore, economic consequences for the owner.

The well-advised owner will choose a form of entity for his business only after having considered a number of tax-related factors, including the income taxation of the entity itself, the income taxation of the entity’s owners, and the imposition of other taxes that may be determined by reference to the income generated by, or withdrawn from, the entity.

In addition to taxes, the owner will have considered the rights given to her, the protections afforded her (the most important being that of limited exposure for the debts and liabilities of the entity), and the responsibilities imposed upon her, pursuant to the state laws under which a business entity may be formed.

The challenge presented for the owner and her advisers is to identify the relevant tax and non-tax factors, analyze and (to the extent possible) quantify them, weigh them against one another, and then see if the best tax and business options may be reconciled within a single form of legal or business entity.

The foregoing may be interpreted as requiring a business owner, in all instances, to select one form of business entity over another; specifically, the creation of a corporation (taxable as a “C” or as an “S” corporation) over an LLC (taxable as a partnership or as a disregarded entity) as a matter of state law. Fortunately, that is not always the case. In order to understand why this is so, a brief review of the IRS’s entity classification rules is in order.

The Classification Regulations

A business entity that is formed as a “corporation” under a state’s corporate law – for example, under New York’s business corporation law – is classified as a corporation per se for tax purposes.

In general, a business entity that is not thereby classified as a corporation – such as an LLC – can elect its classification for federal tax purposes.

An entity with at least two members can elect to be classified as either a corporation (“association” is the term used by the IRS) or a partnership, and an entity with a single owner can elect to be classified as a corporation or to be disregarded as an entity separate from its owner.

Default Classification

Unless the entity elects otherwise, a domestic entity is classified as a partnership for tax purposes if it has two or more members; or it is disregarded as an entity separate from its owner if it has a single owner. Thus, an LLC with at least two members is treated as a partnership for tax purposes, while an LLC with only one member is disregarded for tax purposes, and its sole member is treated as owning all of the LLC’s assets, liabilities, and items of income, deduction, and credit.

Election to Change Tax Status

If a business entity classified as a partnership elects to be classified as a corporation, the partnership is treated, for tax purposes, as contributing all of its assets and liabilities to the corporation in exchange for stock in the corporation, and immediately thereafter, the partnership liquidates by distributing the stock of the corporation to its partners.

If an entity that is disregarded as an entity separate from its owner elects to be classified as a corporation, the owner of the entity is treated as contributing all of the assets and liabilities of the entity to the corporation in exchange for stock of the corporation.

An election is necessary only when an entity chooses to be classified initially (upon it creation) as other than its default classification, or when an entity chooses to change its classification. An entity whose classification is determined under the default classification retains that classification until the entity makes an election to change that classification.

In order to change its classification, a business entity must file IRS Form 8832, Entity Classification Election. Thus, an entity that is formed as an LLC or as a partnership under state law may file Form 8832 to elect to be treated as a corporation for tax purposes.

Alternatively, an LLC or a partnership that timely elects to be an S corporation (by filing IRS Form 2553) is treated as having made an election to be classified as a corporation, provided that it meets all other requirements to qualify as a small business corporation as of the effective date of the election.

Electing S Corporation Status – Why?

Most tax advisers will recommend that a new business be formed as an LLC that is taxable as a pass-through entity (either a partnership or a disregarded entity). The LLC does not pay entity level tax; its net income is taxed only to its members; in general, it may distribute in-kind property to its members without triggering recognition of gain; it may pass through to its members any deductions or losses attributable to entity-level indebtedness; it can provide for many classes of equity participation; it is not limited in the types of person who may own interests in the LLC; and it provides limited liability protection for its owners.

In light of these positive traits, why would an LLC elect to be treated as an S corporation? Yes, an S corporation, like an LLC, is not subject to entity-level income tax (in most cases), but what about the restrictive criteria for qualifying as an S corporation? An S corporation is defined as a domestic corporation that does not: have more than 100 shareholders, have as a shareholder a person who is not an individual (other than an estate, or certain trusts), have a nonresident alien as a shareholder, and have more than one class of stock.

The answer lies, in no small part, in the application of the self-employment tax.

Self-Employment Tax

The Code imposes a tax on the “self-employment income” of every individual for a taxable year (self-employment tax). In general, self-employment income is defined as “the net earnings from self-employment derived by an individual.”

“Net earnings from self-employment” is defined as the gross income derived by an individual from any trade or business carried on by such individual, less allowable deductions which are attributable to such trade or business, plus his distributive share (whether or not distributed) of income or loss from any trade or business carried on by a partnership of which he is a member . . . .”

Certain items are excluded from self-employment income, including “the distributive share of any item of income . . . of a limited partner.”

That being said, any guaranteed payments made to a limited partner for services actually rendered to or on behalf of the partnership, “to the extent that those payments are established to be in the nature of remuneration for those services . . . ,” are subject to the tax.

In creating the exclusion for limited partners, Congress recognized that certain earnings were basically in the nature of a return on investment. The “limited partner exclusion” was intended to apply to those partners who “merely invest” in, rather than those who actively participate in and perform services for, a partnership in their capacity as partners.

A partnership cannot change the character of a partner’s distributive share for purposes of the self-employment tax simply by making guaranteed payments to the partner for his services. A partnership is not a corporation and the “wage” and “reasonable compensation” rules which are applicable to corporations do not apply to partnerships.

Instead, a partner who is not a “limited partner” within the meaning of the exclusion is subject to self-employment tax on his full distributive share of the partnership’s income, even in cases involving a capital-intensive business.

Thus, individual partners who are not limited partners are subject to self-employment tax on their distributive share of partnership income regardless of their participation in the partnership’s business or the capital-intensive nature of the partnership’s business.

Unfortunately, the Code does not define the term “limited partner,” though the IRS and the courts have, on occasion, interpreted the term as applied to the members of an LLC; specifically, based upon these interpretations, the level of a member’s involvement in the management and operation of the LLC will be determinative of her status as a “limited partner” and, consequently, of her liability for self-employment tax.

S Corporations

The shareholders of an S corporation, on the other hand, are not subject to employment taxes in respect of any return on their investment in the corporation – i.e., on their pro rata share of S corporation income – though they are subject to employment taxes as to any wages paid to them by the corporation.

For that reason, the IRS has sought to compel S corporations to pay their shareholder-employees a reasonable wage for services rendered to the corporation. In that way, the IRS hopes to prevent an S corporation from “converting” what is actually compensation for services into a distribution of investment income that is not subject to employment taxes.

Why Not Incorporate?

If the self-employment tax on an owner’s share of business income can be legitimately avoided by operating through an S corporation – except to the extent it is paid out as reasonable compensation for services rendered by the owner to the corporation – why wouldn’t the owner just form a corporation through which to operate the business?

The answer is rather straightforward: because tax planning, although a very important consideration, is not necessarily the determinative factor in the choice-of-entity decision.

There may be other, non-tax business reasons, including factors under state law, for establishing a business entity other than a corporation.

For example, in the absence of a shareholders’ agreement – which under the circumstances may not be attainable – shares of stock in a corporation will generally be freely transferable, as a matter of state law; on the other hand, the ability of a transferee of an ownership interest in an LLC to become a full member will generally be limited under state law – in most cases, the transferee of a membership interest in an LLC will, in the absence of a contrary provision in the LLC’s operating agreement, become a mere assignee of the economic benefits associated with the membership interest, with none of the rights attendant on full membership in the LLC.

With that in mind – along with other favorable default rules under a state’s LLC law, as opposed to its corporate law – and recognizing the limitations imposed under the Code for qualification as an S corporation, a business owner may decide to form her entity as an LLC in order to take advantage of the “benefits” provided under state law; but she will also elect to treat the LLC as an S corporation for tax purposes so as to avoid entity-level income tax and to limit her exposure to self-employment tax.

In this way, the business owner may be able to reconcile her tax and non-tax business preferences within a single legal entity. The key, of course, will be for both the owner and her tax advisers to remain vigilant in the treatment of the LLC as an S corporation. The pass-through treatment for tax purposes will be easy to remember, but other tax rules applicable to corporations (such as the treatment of in-kind distributions as sales by the corporation), and to S corporations in particular (such as the single class of stock rule), will require greater attention, lest the owner inadvertently cause a taxable event or cause the LLC to lose its “S” status.

Form v. Substance

It is a basic precept of the tax law that the substance of a transaction, rather than its form, should determine its tax consequences when the form of the transaction does not coincide with its economic reality. This substance-over-form argument is a powerful tool in the hands of a taxing authority.

According to another basic precept of the tax law, a taxpayer will generally be bound, for purposes of determining the tax consequences of a transaction, by the form of the transaction that he has used to achieve a particular business goal; the taxpayer may not freely re-characterize a transaction.

That being said, a taxpayer may assert a substance-over-form argument under certain circumstances. In those situations, however, the taxpayer faces a higher than usual burden of proof; indeed, the taxpayer must adduce “strong proof” to establish his entitlement to a position that is at variance with the form of the transaction reported on the taxpayer’s return.

The case discussed below addressed the classic tax issue of form versus substance as the Third Circuit considered a taxpayer’s attempt at re-characterizing a transaction.[1]

The Ingredients

Taxpayer, a U.S. person, was the majority shareholder of a U.S. corporation (“Target”) that owned and operated two Russian LLCs that, in turn, owned and operated most of Russia’s Pizza Huts and KFCs. Another U.S. corporation (“Minority”) held the remaining Target shares.

In order to sell the company, Taxpayer planned to buy out Minority’s Target shares, and then transfer all the Target shares – including those just purchased – to the buyer, a European corporation (“Buyer”) that owned KFCs, Pizza Huts, and other fast-food restaurants throughout Europe.

In May of the year in question, Taxpayer agreed to “purchase”, for his “own account”, Minority’s stake in Target. At closing, Minority was to transfer its Target shares to Taxpayer and then, in the following month, Taxpayer would make a “deferred” payment of the purchase price to Minority.

“You better cut the pizza in four pieces because I’m not hungry enough to eat six.” – Yogi Berra

Taxpayer also entered into a Merger Agreement with Target and Buyer. Under the terms of this Agreement: (1) Taxpayer would ensure, at the closing, that he was the “record” owner of 100% of the Target stock, “free and clear of any restrictions”; (2) Taxpayer would transfer 100% of Target’s shares to Buyer; and (3) Buyer would transfer cash and Buyer stock to Taxpayer as consideration. The transaction was intended to qualify as a partially “tax-free” reorganization within the meaning of the Code.[2] [IRC Sec. 368, 367]

The two transactions went through as planned. In June of the year in question, Minority transferred its Target stock to Taxpayer. On July 2, the Target-Buyer merger closed, and Taxpayer transferred all the Target stock to Buyer. On July 3, Buyer paid Taxpayer over $23 million in cash and transferred over $30 million worth of Buyer stock, a total of nearly $54 million for all Target’s shares. Then on July 5, Taxpayer paid Minority $14 million for its stake in Target.

In two tax filings for the year in question, Taxpayer took two different approaches to the transaction. In his original return, Taxpayer reported tax liability of almost $3.8 million, and paid that amount to the IRS. Taxpayer subsequently amended his return, reported a lower tax liability, and requested a refund.

“Finger Lickin’ Good” – Not for the Taxpayer

The IRS audited Taxpayer, found that the originally-filed return was correct, and denied Taxpayer’s request for a refund. Taxpayer then petitioned the U.S. Tax Court for a redetermination. The Tax Court held for the IRS, and Taxpayer then appealed to the Third Circuit Court of Appeals.

Taxpayer Never Owned It?

Taxpayer challenged the IRS’s determination that he had to pay tax on the $14 million that he received from Buyer and immediately remitted to Minority. The question was whether the form of the transaction made Taxpayer liable for the gain on the Target stock that had been held by Minority.

The Court began by describing the so-called “Danielson rule”:

[W]hile a taxpayer is free to organize his affairs as he chooses, . . . once having done so, he must accept the tax consequences of his choice, whether contemplated or not, and may not enjoy the benefit of some other route he might have chosen to follow but did not.

A taxpayer who falls within the scope of this rule, the Court stated, is generally stuck with the form of his business transaction, and can make an argument that substance should prevail over that form only if a limited class of exceptions applies.

Taxpayer argued that he was never the substantive owner of the Minority block of stock and, therefore, should not be taxed on the $14 million portion of Buyer’s payment that Taxpayer passed to Minority.

However, according to the Court, none of the Danielson exceptions applied – Taxpayer was not defrauded into the transaction, for example – and the contracts signed by the parties explicitly stated that Taxpayer acquired ownership of Minority’s stock: he purchase it for his “own account” prior to selling it to Buyer; and even though the shares were in his hands for only a brief period of time, he was the “record” owner, “free and clear of any restrictions.”

Thus, under Danielson, Taxpayer had to bear the tax liability for owning all the Target shares. He could have hypothetically structured the deal so that he never acquired formal ownership of Minority’s shares, but he did not, and could not benefit from an alternative route now.

“Danielson” Policy Wasn’t Implicated?

Taxpayer argued that the Danielson rule should not apply because its policies were not implicated. According to Taxpayer, the purpose of the Danielson rule was “to prevent a taxpayer from having her cake and eating it too.” Taxpayer claimed that he realized no benefit from serving as Minority’s and Buyer’s go-between.

The Court countered that Taxpayer likely did benefit: by structuring the transaction so that he purchased Minority’s stock for his own account prior to the sale to Buyer, Taxpayer made the overall transaction simpler by ensuring that Buyer would deal with only one party, which likely reduced the deal’s transaction costs and litigation risk, increased the likelihood of the deal actually closing, and perhaps caused Buyer to pay a higher price than it otherwise may have.

In any case, the Court stated, the point of a bright-line rule like Danielson’s requires that judges enforce it without wading into policy analysis, ensuring that the rule’s application will be easy and predictable.

Agency?

Taxpayer claimed that he was nothing more than Minority’s agent in selling Minority’s block of stock, and agents are not liable for the tax burden of their principals.

In responding to this claim, the Court explained that an agency relationship is created through “manifestation by the principal to the agent that the agent may act on his account” and the agent’s “consent” to the undertaking. The problem with this argument, the Court noted, is that the written agreement between Minority and Taxpayer stated in straightforward terms that Taxpayer purchased Minority’s shares for his own account; it did not mention an agency relationship, and none of the terms suggested that Taxpayer ever had an obligation to sell his newly-acquired shares to Buyer or anyone else; Taxpayer could have kept the stock for as long as he wanted, as long as he paid Minority its $14 million. That Taxpayer did encumber himself with an obligation to sell the Minority shares to Buyer arose out of the separate Merger Agreement to which Minority was not a party.

The food in Europe is pretty disappointing. I like fried chicken. But other than that Europe is great.” – Donnie Wahlberg

“Make it Great” – Not for the Taxpayer

The Court concluded that Taxpayer owned 100% of Target’s stock when he transferred Target to Buyer for a total consideration of $54 million, comprised of Buyer stock and cash, and he had to bear the tax burden for the entire payment, even the portion associated with the $14 million he remitted to Minority.

Taxpayer argued that if he must be taxed on the full $54 million from Buyer, he should be permitted to subtract from the gain on his original shares the amount that he “lost” on the sale of the Minority shares.

The Code provides that no gain or loss shall be recognized by a shareholder of a corporation if the shareholder’s stock in the corporation is exchanged, pursuant to a “plan of reorganization,” solely for stock in another corporation that is a party to the reorganization. [IRC Sec. 354]

Thus, a target corporation shareholder who receives only shares of stock in the buyer corporation in exchange for his shares of the target corporation stock, as part of a stock-for-stock merger transaction, does not recognize any of the gain or loss realized in the exchange.

This general rule has an exception for instances when a corporate reorganization involves a transfer of target stock in exchange for both stock of the acquiring corporation and other property or money (“boot”). In those transactions, gain must be recognized by the target shareholder to the extent of the boot received, but any losses realized by the target shareholder still fall within the scope of the general rule – they may not be recognized notwithstanding the receipt of boot by the target’s shareholder. [IRC Sec. 356]

Blocks of Target Stock

The Court explained that, in order to give content to the above recognition / nonrecognition rules, the IRS and the courts historically have analyzed multifaceted transactions according to their “separate units” of stock, so as to prevent a taxpayer from making an end-run around the non-recognition-of-loss rule by tucking his unit’s statutorily unrecognizable loss under the transaction’s broader recognizable gain; thus when an exchange transaction pursuant to a reorganization involves “separate units” of stock, each unit must be analyzed separately.

Taxpayer asked the Court to treat the two blocks of target stock – his block and Minority’s – as one unit, sold in one exchange. By doing so, Taxpayer hoped to subtract the loss realized on the Minority shares from the gain on his original shares (as he could have done if the transaction had not been structured as a partially tax-free reorganization). The Court rejected this request, finding that Taxpayer’s Target stock holdings were composed of two units: Taxpayer acquired one block of Target stock years before acquiring the second block, and he had a vastly different cost basis in the two blocks. Given that the blocks were separate, the Code’s reorganization provisions prohibited recognition of any loss realized by taxpayer in the Minority block.

Plop, Plop, Fizz, Fizz

Fried chicken and pizza aren’t the only things that can give a taxpayer heartburn. Unexpected tax liabilities are just as, if not more, likely to do so. Moreover, tax liabilities cannot be relieved by a simple antacid.

This part of almost every post on this blog must sound like the proverbial broken record. I apologize, but it cannot be said often enough. Before a taxpayer enters into a transaction, he has to be as certain as reasonably possible under the circumstances – risk can never be eliminated – that the transaction will accomplish the taxpayer’s desired business goal. Assuming that is the case, the taxpayer next has to analyze and quantify the tax cost associated with the transaction. This cost has to be added to the other deal costs, and weighed against the expected economic benefits. Depending upon the results of this analysis, the taxpayer may want to reconsider some of the proposed deal terms.

“Eschew obfuscation,” one of my high school physics teachers used to say. I have my own ironic saying: “avoid surprises.” Business owners should consult their tax advisers well before executing a letter of intent for a transaction – the foregoing analysis should not to be deferred until late in the game, because doing so could prove to be an expensive mistake.

_____________________________________________________________________________________________

[1] I have to confess that when I came across this decision, I had already started writing a post on why some LLCs make S-corporation elections. For those of you who know me, as soon as I saw the references to Pizza Hut and KFC, I completely forgot about the LLC.

[2] As we shall see, this reorganization treatment was at the crux of the Taxpayer’s position (see infra).

It is not uncommon for a partner to engage in a business transaction with a partnership of which he is a member. If the partner engages in a transaction with his partnership other than in his capacity as a partner, he will be treated as if he were not a member of the partnership with respect to such transaction. Examples of such transactions include loans of money by the partner to the partnership, the sale of property by the partner to the partnership, the purchase of property by the partner from the partnership, and the rendering of services by the partner to the partnership.

Although not as common, it is sometimes the case that the “partner” with whom the partnership has engaged in a transaction is not a bona fide partner for tax purposes. For example, although a person may be member of a partnership as a matter of local law, the “member” does not have an interest in the capital, profits or losses of the partnership, and has very limited, if any, management rights with respect to the business of the partnership. Indeed, the only reason the person is a member may be to secure some benefit for the partnership under local law, or to satisfy some requirement under local law (as in the case of some foreign jurisdictions that require the presence of a resident in an entity otherwise controlled by a foreign investor).

A recent decision of the Federal Claims Court managed to implicate both of these scenarios.

Bonus Compensation

Taxpayer was a U.S. citizen. She worked for US-Employer, an investment firm based in London, as a senior analyst in its New York office. Taxpayer’s role was to analyze investment opportunities for the US-Employer. She worked for US-Employer on an at-will basis, and received a base salary and a bonus. Taxpayer’s bonus compensation was determined under a formula that was tied to the performance of certain funds.

Although US-Employer’s senior managers who received formulaic bonuses were employees, the company considered those employees to be “partners” in the company, in that they participated in the profitability of the firm according to a specific formula.

However, because US-Employer was a corporation, not a partnership, the participating individuals who received formulaic bonuses, including Taxpayer, were “partners” in name only. Taxpayer’s income from US-Employer, including her bonus, was reported to the IRS on a Form W–2, reflecting her status as an employee of US-Employer.

Welcome Partner?

In January 2008, Taxpayer transferred to US-Employer’s European affiliate, UK-Co., and moved to London. Taxpayer’s job responsibilities and compensation did not change upon transferring to UK-Employer.

Taxpayer became a “member” of UK-Co. in January 2008 by signing a “joinder agreement” and making a capital contribution. By signing the agreement, Taxpayer agreed to “observe and perform the terms and conditions of the [UK-Co.] partnership agreement. The agreement identified US-Employer as the “Corporate Member” of UK-Co., listed certain individuals as members of UK-Co., and identified Taxpayer as a “Further Member.” The agreement did not provide Taxpayer with voting rights in the UK-Co. partnership.

UK-Co. was created under English law. The partnership agreement identified US-Employer and one of the listed individuals as “Designated Members” of UK-Co. and the other listed individual as a “Member.” The agreement designated 82% of the voting rights in UK-Co. to US-Employer and the remaining voting rights to the two listed individuals.

UK-Co. members, other than US-Employer, were required “to devote [their] whole time and attention to [UK-Co.]” and could not engage in other business ventures without the consent of US-Employer. With regard to the allocation of partnership profits and losses, the agreement provided that US-Employer would determine the allocation of UK-Co. profits and losses among the partners at the end of UK-Co.’s fiscal year. UK-Co. never generated its own profits, however, because it “ha[d] no funds to invest. It only ha[d] the money sent over from [US-Employer] to pay its costs and … formulaic bonuses and the staff salaries . . . [UK-Co.] ha[d] no [other] funds.”

Taxpayer did not expect to be asked to make a capital contribution or sign the joinder agreement, but she was told upon arriving in the U.K. that both were required as a condition of her employment at UK-Co. She did not see the partnership agreement before signing the joinder agreement, and she did not receive a copy of it until 2011.

During her time working at UK-Co. Taxpayer remained an at-will employee. She performed the same duties and received the same compensation as she had as an employee at US-Employer. Taxpayer understood that she had to become a member of UK-Co. so that UK-Co. could avoid certain U.K. employment tax obligations.

The Payment

On December 31, 2008, UK-Co. directed that a formula-based bonus (the “Payment”) be made to Taxpayer. US-Employer wired the necessary funds to UK-Co. for the Payment, and UK-Co. in turn directed that money to Taxpayer’s bank. Taxpayer’s bank received the payment in January 2009, and it was credited to Taxpayer’s account.

The formula used to determine the Payment was the same formula used to calculate Taxpayer’s bonus when she was still employed by US-Employer. 

Taxpayer’s 2008 and 2009 Tax Returns

Prior to preparing her 2008 U.S. tax return, Taxpayer requested a tax-reporting statement from UK-Co. for the 2008 tax year, but to no avail. Consequently, Taxpayer reported the salary she received from UK-Co. in 2008 on her original 2008 U.S. tax return, but did not report thereon the Payment that she received in January 2009.

On her 2008 U.K. tax return, Taxpayer reported as her “share of the partnership’s profit or loss” from UK-Co. an amount equal to her salary for those months. Taxpayer paid taxes to the U.K. in 2008, and reported a foreign tax credit on her original 2008 U.S. tax return.

The amount reported on Taxpayer’s 2009 U.K. tax return as her “share of the partnership’s profit or loss” from UK-Co. included the Payment she received in 2009. She had a U.K. tax liability for 2009, and reported a foreign tax credit on her 2009 U.S. tax return.

UK-Co.’s 2008 Tax Return

On its 2008 partnership tax return, UK-Co. included an “Analysis of Partners Capital Accounts” which reflected an entry for “Partner 4” that appeared to include the Payment to Taxpayer. Nonetheless, a Schedule K-1 identifying Taxpayer and setting forth the partnership distributions she received for 2008 was not filed with UK-Co.’s 2008 tax return. The only Schedule K-1 included with the return was for US-Employer.

The IRS Audit

The IRS audited both Taxpayer and UK-Co. for the 2008 tax year.

The IRS requested clarification of Taxpayer’s role at UK-Co. In response, Taxpayer explained that she joined UK-Co. as a limited partner in 2008 and that she spent all of her working time “on duties in relation to the [US-Employer’s] Europe partnership.”

In 2011, Taxpayer received for the first time a 2008 Schedule K-1 from UK-Co. This Schedule K-1 showed that Taxpayer received the Payment in 2008.

Consequently, the IRS treated the Payment as a distribution of Taxpayer’s share of UK-Co.’s profit for 2008; therefore, the IRS asserted that the Payment had to be included by the Taxpayer as ordinary income for her 2008 tax year; i.e., the year with or within which the taxable year of the partnership ended.

In 2012, the IRS issued Taxpayer a Notice of Tax Due showing tax and interest owing.

Refund Claim and Appeal

Taxpayer paid the IRS the tax and interest, but Taxpayer also filed a claim for refund with the IRS.

As her primary ground for relief, Taxpayer alleged that the Payment was made to her in a non-partner capacity, and should be taxed in the year she received it, 2009, rather than in 2008 as reflected on the late-produced Schedule K-1.

The IRS denied Taxpayer’s’ refund claim on the grounds that the Payment was made to her as a partner, rather than as a payment for services rendered by her outside her capacity as a partner.

Taxpayer filed suit in the Court of Federal Claims in 2014, alleging that she was entitled to a refund of the amount paid to the IRS to satisfy the notice of tax due, plus interest. Taxpayer asserted that the Payment was not a partnership distribution but a bonus paid to her in her capacity other than as a partner, and therefore she – as a cash-basis taxpayer – did not need to report the payment until she received it in 2009.

Court’s Analysis

The Court examined Taxpayer’s assertion that the Payment should be taxable in the 2009, when she received the payment, because it was not a partnership distribution. In support of this contention, Taxpayer argued that she was either not a bona fide partner in UK-Co. for U.S. tax purposes, or that, if she was a partner, the Payment was for services performed outside her capacity as a partner. (For purposes of its analysis, the Court assumed, but did not decide, that Taxpayer was a member in UK-Employer in order to analyze the nature of the payment.)

Non-Partner Capacity

The Code provides that, if a partner engages in a transaction with a partnership other than in his capacity as a member of such partnership, the transaction shall generally be considered as occurring between the partnership and one who is not a partner.

If a partner (i) performs services for a partnership, (ii) there is a related direct or indirect allocation and distribution to such partner, and (iii) the performance of such services and the allocation and distribution, when viewed together, are properly characterized as a transaction occurring between the partnership and a partner acting other than in his capacity as a member of the partnership, then (iv) such allocation and distribution shall be treated as a transaction between the partnership and one who is not a partner.

Where partners perform services for a partnership outside their role as a member of the partnership and receive a commensurate payment from the partnership for those services, the payment is not classifiable as a partnership distribution. The payment is, instead, treated as a payment to a non-partner in determining the partnership’s taxable income or loss and the partner’s share thereof.

Not a Partner

The Court determined that the Payment to Taxpayer was appropriately categorized as a payment for services outside her capacity as a partner, and not as a partnership distribution. The Court also noted that the services performed by Taxpayer when she worked at UK-Co. did not change when she transferred from US-Employer in New York to UK-Co. in London and became a member of UK-Co. She continued to analyze investment opportunities for the funds managed by US-Employer. None of these funds were owned by UK-Co. or based in London; rather, Taxpayer’s job duties at UK-Co. continued to center around US-Employer’s business in New York, with UK-Co. acting as a “legal … conduit” for US-Employer and its employees to do business in Europe. Taxpayer only relocated to London to have easier access to European investment opportunities for the funds, and became a “member” of UK-Co. so that UK-Co. could avoid certain U.K. tax obligations.

The fact that she became a partner primarily to obtain tax benefits for the partnership which would not have been available if she had rendered the services to the partnership in a third party capacity was relevant to determining whether the Payment was a partnership distribution.

In her work at UK-Co., Taxpayer did not perform any services on behalf of the partnership itself, but rather the partnership served as a European conduit for Taxpayer to perform the same services she performed as an employee of US-Employer.

Other Factors

Additionally, the circumstances surrounding the issuance and receipt of the Payment indicated that it was not a partnership distribution. Taxpayer’s compensation arrangement, which remained the same when she transferred from US-Employer to UK-Co. was not tied to the success of UK-Co. in any way. Rather, Taxpayer’s formulaic bonus was tied to the yearly performance of the funds that were based at US-Employer in New York; indeed, no funds of any kind were directly tied to or controlled by UK-Co. Taxpayer’s bonus was dependent on the success of the funds, but it was not linked to any profit or risk of UK-Co., which did not generate profits on its own, but rather was merely a conduit for US-Employer to pay its European expenses and personnel. In fact, at the time the Payment was issued, UK-Co. did not have any funds on hand to be subjected to the risks of the partnership. The Payment was entirely under the control, and subject to the risks, of US-Employer, and not UK-Co., thus indicating that the Payment was not a distribution of partnership profits.

The fact that the Payment was disproportionate to Taxpayer’s actual ownership share of the partnership, further supported the conclusion that it was not a partnership distribution, but rather a payment for services performed outside her capacity as a member of UK-Co.

Thus, the Court concluded, the Payment was made to Taxpayer for services performed outside her capacity as a member of the UK-Co. partnership, the payment was taxable to Taxpayer by the U.S. in the year she received it (2009), and she was entitled to a full refund of the tax paid on the Payment for the 2008.

Guidance?

In most cases, it should not be too difficult to determine the capacity in which a partner is dealing with his partnership.

In others, it will be important for the partnership and its partners to clearly establish their intentions at the outset of the transaction though, even then, the IRS will not be bound thereby.

For example, was a transfer of money to the partnership made as a loan or as a capital contribution? The absence of documentation and the presence of inconsistent reporting can only lead to trouble down the road, perhaps because the partnership is in financial straits.

As always, a partner and the partnership will be in a better position to secure the desired tax and economic consequences if (i) they discuss these consequences among themselves and their advisers before engaging in the transaction being contemplated, (ii) they document the transaction accordingly, and, (iii) if necessary, they research and compile the appropriate legal authority to support their position.

Last week, we considered the U.S. taxation of a closely held foreign corporation that owned a minority interest in a partnership that was engaged in business in the U.S. This week, we turn our sights to the U.S. taxation of a domestic corporation that owned foreign corporate subsidiaries.

Policy Underlying the CFC Rules

In general, a U.S. person must include in its gross income its directly-earned income from foreign sources; thus, if a U.S. person operates a business through a branch located overseas, the net business income attributable to that branch is included in the U.S. person’s gross income.

Absent the so-called “Subpart F rules,” the inclusion of this foreign source income may be circumvented when the U.S. person chooses to operate overseas indirectly, through a controlled foreign corporation (“CFC”), rather than through a foreign branch. In that case, the foreign subsidiary corporation is generally treated as a separate taxpayer from its U.S. owner; the foreign-source income earned by the CFC is generally not included in the U.S. owner’s gross income; and the imposition of U.S. income tax on the foreign-source income earned by the CFC is deferred until it is repatriated by the CFC to the U.S.

Anti-deferral

That a U.S. person may defer the inclusion in its gross income of the foreign-source income earned by its controlled foreign corporate subsidiaries does not, in and of itself, violate any U.S. tax policy. However, Congress and the IRS have sought to defeat the deferral benefit in situations where certain “U.S. shareholders” may direct the flow of certain types of income (“Subpart F Income”) to a low-tax jurisdiction; for example, income earned in transactions between related corporations that are located in different countries, one of which is a tax haven. In those situations, the Code and the IRS’s regulations require the current inclusion of the CFC’s un-repatriated Subpart F Income in the U.S. shareholder’s gross income.

Deemed Repatriation

Although the current inclusion of Subpart F Income is a major concern of the Subpart F rules, they also seek to prevent the tax-free repatriation of other foreign income through investments in U.S. property. In general, the foreign-source income earned by a CFC (other than Subpart F Income) is subject to U.S. tax when the income is repatriated as a dividend. If the CFC, instead, invested the foreign-source income in the U.S., by the purchase of U.S.-situs property, or by a loan to the U.S. parent corporation, the foreign income would effectively be repatriated in a manner that would escape current U.S. tax.

In order to address this situation, the Code generally provides that certain “investments” by a CFC in U.S.-situs property will be treated as the repatriation of the CFC’s foreign-source income, as a result of which, the U.S. shareholder must include in its gross income an amount calculated by reference to the amount deemed to have been repatriated by the CFC.

A recent decision by the U.S. Tax Court considered the application of this deemed repatriation rule.

Investment in U.S. Property?

Taxpayer was a domestic “C” corporation and the parent of a group of domestic and foreign subsidiary corporations. The IRS determined that the CFCs had invested substantial amounts of untaxed foreign profits in “U.S. property”. Accordingly, the IRS determined that Taxpayer was required to include in its gross income the amounts that the CFCs had invested. As a result, the IRS asserted income tax deficiencies against the Taxpayer, and the Taxpayer petitioned the Tax Court for relief.

According to the IRS, Taxpayer’s CFCs made investments in U.S. property through the following transactions: (1) they extended loans to a domestic subsidiary, in the form of intercompany cash advances; and (2) one of them guaranteed of a loan that a domestic subsidiary had obtained from Foreign Bank.

Intercompany Loans

Taxpayer was the sole shareholder of US-Sub, a domestic corporation, which in turn was the sole shareholder of four CFCs. Taxpayer and US-Sub were U.S. shareholders of these CFCs because they owned (directly or indirectly) 100% of the total combined voting power of all classes of the CFCs’ stock.

At various times, the CFCs had made loans to US-Sub. Substantial balances on these loans remained outstanding throughout the tax periods at issue.

Guaranty Transaction

US-Sub also borrowed money from Foreign Bank. As a condition of extending credit, Foreign Bank required US-Sub to secure a guaranty for the loan, preferably from a subsidiary located in the same jurisdiction as Foreign Bank. One of Taxpayer’s CFCs (“F-Sub”) supplied the requisite guaranty.

US-Sub was also required to pledge as security for the Foreign Bank loan all the stocks that US-Sub then owned or thereafter acquired, including its equity interest in the CFCs.

The outstanding balance on the Foreign Bank loan remained constant throughout the tax periods at issue, as did F-Sub’s guaranty of the loan.

IRS Audit

Neither Taxpayer nor US-Sub had previously included in income, for any year, any portion of this outstanding loan balance.

Taxpayer filed consolidated Forms 1120, U.S. Corporation Income Tax Return, for the years at issue. The IRS examined Taxpayer’s returns and determined that the CFCs had held substantial investments in U.S. property, which Taxpayer had neglected to include in gross income; specifically, the IRS contended that Taxpayer’s CFCs held two sets of investments in U.S. property that Taxpayer was required to include in gross income: (1) the outstanding loan balances owed by US-Sub to the CFCs; and (2) F-Sub’s guaranty of the Foreign Bank loan to US-Sub. As a result, the IRS issued a notice of deficiency, and Taxpayer petitioned the Tax Court.

Governing Statutory Framework

A CFC is a foreign corporation more than 50% of whose stock (in terms of voting power or value) is owned (directly or constructively) by U.S. shareholders. A U.S. shareholder is a U.S. person who owns (directly or constructively) 10% or more of the total combined voting power of the foreign corporation’s stock.

In general, a U.S. shareholder owning CFC stock on the last day of the CFC’s taxable year must include in gross income the lesser of: (1) the excess of such shareholder’s pro rata share of the amount of U.S. property held by the CFC as of the close of such taxable year, over the amount of CFC profits otherwise included in such shareholder’s gross income; or (2) such shareholder’s pro rata share of the applicable earnings of such CFC.

“U.S. property” includes (among other things) an obligation of a U.S. person, such as a bond, note, or other indebtedness. According to IRS regulations, any obligation of a U.S. person with respect to which a CFC is a pledgor or guarantor is considered U.S. property held by the CFC. A CFC will be considered a guarantor if its assets serve at any time, even though indirectly, as security for the performance of an obligation of a U.S. person.

The amount of the investment with respect to an obligation of a U.S. person is the CFC’s adjusted basis in the obligation. In the case of a pledge or guaranty, the amount includible is based on the unpaid principal amount of the obligation with respect to which the CFC is the pledgor or guarantor. The amount includible is reduced by any previously taxed profits of the CFC, and it cannot exceed the U.S. shareholder’s pro rata share of the CFC’s earnings.

The Court’s Analysis

With respect to the loans made by Taxpayer’s CFCs to US-Sub, the Court found that substantial loan balances remained outstanding during the tax periods at issue. The Taxpayer asserted that some of the loans might have been “discharged,” but was unable to provide specific facts supporting its claim.

Thus, the Court concluded that the intercompany loan balance owed by US-Sub to each CFC constituted U.S. property held by that CFC, and that the Taxpayer was required to include in gross income, subject to the net profits of the CFCs.

CFC as Guarantor and as Pledgor

The Court next turned to US-Sub’s loan from Foreign Bank. This loan had a substantial outstanding balance during the periods at issue, and F-Sub’s guarantee of the loan remained in place throughout these periods. Neither Taxpayer nor US-Sub had previously included in income, for any year, any portion of this outstanding loan balance.

The IRS contended that F-Sub, as a guarantor of the Foreign Bank loan, was considered as holding the obligation of a U.S. person. The IRS accordingly concluded that the unpaid principal balance of that loan was includible in Taxpayer’s gross income.

Although F-Sub’s status as a guarantor would have been sufficient to support inclusion in Taxpayer’s gross income, F-Sub also appeared to have been a pledgor in support of the Foreign Bank loan. A CFC will be regarded as a pledgor if its assets serve directly or indirectly as “security for the performance of an obligation” of a U.S. person.

According to IRS regulations, the pledge by a U.S. shareholder of stock of a CFC will be considered as the indirect pledge of the CFC’s assets if at least two-thirds of the total combined voting power of all classes of CFC stock is pledged, and if the pledge of stock is accompanied by one or more negative covenants or similar restrictions on the shareholder effectively limiting the corporation’s discretion with respect to the disposition of assets and the incurrence of liabilities other than in the ordinary course of business.

Because US-Sub was required to pledge to Foreign Bank its 100% stock ownership interest in the CFCs, including F-Sub, F-Sub was treated as having pledged all of the assets which it then held or thereafter acquired. To the extent that this pledge effectively limited US-Sub’s discretion with respect to the disposition of F-Sub’s assets and the incurrence of liabilities, the Foreign Bank loan contained “negative covenants or similar restrictions,” that rendered F-Sub an indirect pledgor as well as a guarantor.

Financial Condition of CFC?

Taxpayer argued that F-Sub’s guaranty had little or no value, and represented a “meaningless gesture.” According to Taxpayer, S-Sub’s guaranty furnished only a secondary form of collateral that provided no incremental security for Foreign Bank.

The Court failed to see the relevance of this argument. A CFC, it stated, is considered as holding an obligation of a U.S. person if the CFC “is a pledgor or guarantor of such obligation.” That is the end of the inquiry, the Court said; neither the Code nor the regulations issued thereunder inquire into the relative importance that the creditor attaches to the guarantee.

In any event, the Court continued, Taxpayer failed to offer any facts to support its assertion. Foreign Bank demanded a guaranty from a company with assets in Foreign Bank’s location, and F-Sub provided that guarantee. When a bank agrees to make a substantial loan only after securing a guaranty from a local company with local assets, it is logical to assume that the bank regarded that guaranty as valuable security.

Alternatively, Taxpayer asserted that F-Sub’s guaranty was worthless because other liabilities encumbering F-Sub’s assets exceeded the fair market value of those assets at the time F-Sub guaranteed the loan.

The Court, however, observed that Taxpayer did not supply any balance sheets, income statements, or other documentation concerning F-Sub’s financial position or its insolvency. Moreover, F-Sub’s guaranty remained in place continuously, and Taxpayer did not provide any documents suggesting that Foreign Bank ever questioned the value of F-Sub’s collateral or demanded additional security.

In any event, the Court stated, it was not clear that a CFC’s financial condition is even relevant in determining whether its guaranty gives rise to an investment in U.S. property. The Code provides that a CFC shall be considered as holding an obligation of a U.S. person if such CFC is a pledgor or guarantor of such obligation. The regulations provide that any obligation of a U.S. person with respect to which a CFC is a pledgor or guarantor shall be considered U.S. property held by the CFC. They make no reference to the likelihood that the CFC will be called upon, or will be able, to make good on its guarantee. According to the Court, this reflects the common sense proposition that a lender would not ask for, or be satisfied with, a guarantee from a person who lacked the financial capacity to provide the security that the lender desires.

For these reasons, the Court concluded that F-Sub’s guarantee of the Foreign Bank loan gave rise to an investment in U.S. property and, subject to F-Sub’s earnings and profits, Taxpayer was required to include in gross income for the years at issue the outstanding balance of the Foreign Bank loan.

Takeaway

Many closely held U.S. businesses have realized that there are ample opportunities for growth and profits overseas. In pursuing such opportunities, however, a U.S. taxpayer must be mindful of the complex rules that apply in determining the taxation of overseas profits – including the Subpart F rules, discussed above – and the reporting thereof.

With an understanding of these rules, and with the guidance of knowledgeable advisers, a U.S. taxpayer may be able to structure its overseas investments, and the repatriation of its overseas earnings, in a more tax efficient manner.

Where business exigencies are such that a less than ideal tax structure has to be employed, the U.S. taxpayer must at least be able to account for the additional tax cost in analyzing the economic prospects and anticipated returns of its overseas investments and operations.

Coming to America

Whether they are acquiring an interest in U.S. real property or in a U.S. operating company, foreigners seek to structure their U.S. investments in a tax-efficient manner, so as to reduce their U.S. income tax liability with respect to both the current profits generated by the investment and the gain realized on the disposition of the investment, thereby increasing the return on their investment.

A recent decision by the U.S. Tax Court may mark a significant development in the taxation of the gain realized by a foreigner on the sale of its interest in a U.S. partnership.

Investment in Partnership

Taxpayer was a privately-owned foreign corporation that owned a minority membership interest in LLC, a U.S. limited liability company that was treated as a partnership for U.S. income tax purposes. Taxpayer had no office, employees, or business operation in the U.S.

Redemption

In 2008, LLC agreed to redeem Taxpayer’s membership interest; as a matter of state law, the redemption was to be effective as of December 31, 2008. LLC made two payments to Taxpayer – the first in 2008 and the second in 2009. Taxpayer realized gain on the redemption of its interest.

Tax returns

With its 2008 Form 1065, “U.S. Return of Partnership Income,” LLC included a Schedule K-1 for Taxpayer that reported Taxpayer’s share of LLC’s income, gain, loss, and deductions for 2008. Consistent with that Schedule K-1, Taxpayer filed a Form 1120-F, “U.S. Income Tax Return of a Foreign Corporation,” for 2008, on which it reported its distributive share of LLC’s income, gain, loss, and deductions. However, LLC did not report on that 2008 return any of the gain it had realized that year on the redemption of its interest in LLC.

With its 2009 Form 1065, LLC included a Schedule K-1 for Taxpayer that – consistent with the agreement between Taxpayer and LLC that the redemption of Taxpayer’s entire membership interest was effective as of December 31, 2008 – did not allocate to Taxpayer any income, gain, loss, or deductions for 2009. As in 2008, Taxpayer took the position that the gain realized was not subject to U.S. tax; thus, Taxpayer did not file a U.S. tax return for 2009.

IRS Audit

The IRS audited Taxpayer’s 2008 and 2009 tax years, and determined that Taxpayer should have recognized U.S.-source capital gain for those years from the redemption of its interest in LLC. This determination was based upon the IRS’s conclusion that, as a result of Taxpayer’s membership interest in LLC, its capital gain was effectively connected with a U.S. trade or business (“USTB”).

Taxpayer petitioned the U.S. Tax Court, where the issue for decision was whether the gain from the redemption of Taxpayer’s interest in LLC was U.S.-source income that was effectively connected with a USTB and, therefore, subject to U.S. taxation.

U.S. Taxation of Foreigners

Before reviewing the Court’s opinion, a brief description of how the U.S. taxes foreigners may be in order.

The income of a foreign corporation may be subject to U.S. income tax if: (1) the income is received from sources within the U.S. (“U.S.-source income”), and it is one of several kinds of income enumerated by the Code (including, for example, dividends, interest, and other “fixed or determinable annual or periodic” (“FDAP”) income); or (2) the income is “effectively connected with the conduct of” a trade or business conducted by the foreign corporation within the U.S. (“effectively connected income”).

In general, the gross amount of a foreigner’s FDAP income is subject to U.S. income tax (and withholding) at a flat 30% rate; no deductions are allowed in determining the tax base to which this rate is applied.

With some exceptions, the Code does not explicitly address the taxation of the capital gain realized by a foreigner on the sale of an equity interest in a U.S. business entity; rather, it is by virtue of addressing these exceptions that the general rule – that capital gain is not subject to U.S. tax – arises. Thus, the gain realized by a foreigner from the sale of a capital asset that is sourced in the U.S. is not subject to U.S. tax unless the asset is related to the foreigner’s USTB or the asset is “an interest in U.S. real property,” the sale of which is treated as effectively connected with a USTB.

In contrast to FDAP income, the foreigner is allowed to deduct the expenses incurred in generating its effectively connected income, and that net income is taxed at graduated rates.

Whether a foreigner is engaged in a USTB depends upon the nature and extent of the foreigner’s activities within the U.S. Generally speaking, the foreigner’s U.S. business activities must be “regular, substantial and continuous” in order for the foreigner to be treated as engaged in a USTB. In determining whether a foreigner’s U.S. activities rise to the level of a trade or business, all of the facts and circumstances need to be considered, including whether the foreigner has an office or other place of business in the U.S.

However, a special rule applies in the case of a foreigner that is a partner in a partnership that is, itself, engaged in a USTB; specifically, the foreigner shall be treated as being engaged in a USTB if the partnership of which such foreigner is a member is so engaged.

In that case, provided it is effectively connected with the conduct of a USTB, the foreigner partner must include its distributive share of the partnership’s taxable income in determining its own U.S. income tax liability.

Generally speaking, all income, gain, or loss from sources within the U.S., other than FDAP income, is treated as effectively connected with the conduct of a USTB.

Points of Agreement

Taxpayer conceded that it was engaged in a USTB by virtue of its membership interest in LLC. In fact, Taxpayer reported on Form 1120-F, and paid U.S. income tax on, its distributive share of LLC’s operating income for every tax year that it was a member of LLC, including the year in which its membership interest was redeemed.

In addition, both Taxpayer and the IRS agreed that no part of the redemption payments made to Taxpayer should be treated as a distributive share of partnership income.

The IRS also agreed with the Taxpayer that the payment made by LLC in redemption of Taxpayer’s membership interest should be treated as having been made in exchange for Taxpayer’s interest in LLC’s property. As such, the Taxpayer would recognize gain as a result of the redemption only to the extent that the amount of money distributed exceeded Taxpayer’s adjusted basis for its interest in LLC immediately before the distribution. This gain would be considered as gain from the sale or exchange of the Taxpayer’s membership interest.

Major Disagreement

In general, the gain realized on the sale of a partnership interest is treated as gain from the sale or exchange of “a capital asset.” According to Taxpayer, because the gain realized on the redemption of its membership interest was equivalent to the sale of a capital asset that was not used by Taxpayer in a USTB, it could not be subject to U.S. tax.

The IRS, however, viewed the issue differently. According to the IRS, Taxpayer’s gain did not arise from the sale of a single, indivisible asset – Taxpayer’s interest in LLC – but rather from the sale of Taxpayer’s interest in the assets that made up LLC’s business, in which Taxpayer was treated as having been engaged.

Aggregate vs. Entity

The IRS argued that the Court should employ the so-called “aggregate theory,” under which a partner’s sale of a partnership interest would be treated as the sale by the partner of its separate interest in each asset owned by the partnership.

The Court, however, rejected the IRS’s argument. It noted that the Code generally applies the “entity theory” to sales and liquidating distributions of partnership interests – it treats the sale of a partnership interest as the sale of “a capital asset” – i.e., one asset (a partnership interest) – rather than as the sale of an interest in the multiple underlying assets of the partnership.

The Court then pointed out that the Code explicitly carves out certain exceptions to this general rule that, when applicable, require that one look through the partnership to the underlying assets and deem the sale of the partnership interest as the sale of separate interests in each asset owned by the partnership; for example, where the partnership holds “hot assets,” or where it holds substantial interests in U.S. real property, in which case an aggregate approach is employed in determining the tax consequences of a sale.

Accordingly, the Court determined that Taxpayer’s gain from the redemption of its membership interest was gain from the sale or exchange of an indivisible capital asset: Taxpayer’s interest in LLC.

Effectively Connected?

The Court then considered whether the gain realized on the redemption was taxable in the U.S., which depended upon whether that gain was effectively connected with the conduct of a USTB — specifically, whether that gain was effectively connected with the trade or business of LLC, which trade or business was attributed to Taxpayer by virtue of its being a member of LLC.

The IRS argued that the gain was “effectively connected,” pointing to one of its own published rulings, in which it held that the gain realized by a foreigner upon the disposition of a U.S. partnership interest should be analyzed asset by asset, and that, to the extent the assets of the partnership would give rise to effectively connected income if sold by the entity, the departing partner’s pro rata share of such gain should be treated as effectively connected income.

The Court, however, did not find the ruling persuasive, and declined to follow it. Instead, the Court undertook its own analysis of the issue.

It considered whether the gain from the sale of the membership interest was U.S.-source. Unfortunately, the Code does not specifically address the source of a foreigner’s income from the sale or liquidation of its interest in a partnership.

However, under a default rule for sourcing gain realized on the sale of personal property (such as a partnership interest), gain from the sale of personal property by a foreigner is generally sourced outside the U.S. In accordance with this rule, the gain from Taxpayer’s sale of its LLC interest would be sourced outside the U.S.

The IRS countered, however, that this gain fell under an exception to the default rule: the “U.S. office rule.” Under this exception, if a foreigner maintains a fixed place of business in the U.S., any income from the sale of personal property attributable to such “fixed place of business” is treated as U.S.-source.

Taxpayer’s gain would be taxable under this exception, the Court stated, if it was attributable to LLC’s office, which the Court assumed – solely for purposes of its analysis – would be deemed to have been Taxpayer’s U.S. office.

In order for gain from a sale to be “attributable to” a U.S. office or fixed place of business, the U.S. office must have been a “material factor in the production” of the gain, and the U.S. office must have “regularly” carried on – i.e., “in the ordinary course of business” – activities of the type from which such gain was derived.

The IRS contended: that the redemption of Taxpayer’s interest in LLC was equivalent to LLC’s selling its underlying assets and distributing to each member its pro rata share of the proceeds; that LLC’s office was material to the deemed sale of Taxpayer’s portion of LLC’s assets; and that LLC’s office was material to the increased value of LLC’s underlying assets that Taxpayer realized in the redemption.

The Court responded that the actual “sale” that occurred here was Taxpayer’s redemption of its partnership interest, not a sale of LLC’s underlying assets. In order for LLC’s U.S. office to be a “material factor,” that office must have been material to the redemption transaction and to the gain realized.

The Court noted that Taxpayer’s redemption gain was not realized from LLC’s trade or business, that is, from activities at the partnership level; rather, Taxpayer realized gain at the partner-member level from the distinct sale of its membership interest. Increasing the value of LLC’s business as a going concern, it explained, is a distinct function from being a material factor in the realization of income in a specific transaction. Moreover, the redemption of Taxpayer’s interest was a one-time, extraordinary event, and was not undertaken in the ordinary course of LLC’s business – LLC was not in the business of buying and selling membership interests.

Therefore, Taxpayer’s gain from the redemption of its interest in LLC was not realized in the ordinary course of the trade or business carried on through LLC’s U.S. office, it was not attributable to a U.S. fixed place of business and, therefore, it was not U.S.-source.

Consequently, the gain was not taxable as effectively connected income.

It Isn’t Over ‘til the Weight-Challenged Person Sings

The Tax Court’s decision represents a victory for foreigners who invest in U.S. businesses through a pass-through entity such as a partnership or limited liability company – how significant a victory remains to be seen.

First, the IRS has ninety days after the Court’s decision is entered in which to file an appeal to a U.S. Court of Appeals. Query whether that Court would be more deferential to the IRS’s published ruling, describe above.

Second – don’t laugh – Congress may act to overturn the Tax Court’s decision by legislation. “Why?” you may ask. Foreigners who rely upon the decision will not report the gain from the sale of a partnership interest. If the partnership has in effect an election under section 754 of the Code, the partnership’s basis in its assets will be increased as a result of the sale (as opposed to the liquidation/redemption) of the foreigner’s partnership interest. This will prevent that underlying gain from being taxed to any partner in the future.

Third, the decision did not address how it would apply to “hot assets” — for example, depreciation recapture. As noted above, the Code normally looks through the sale of a partnership interest to determine whether any of the underlying assets are hot assets. Where the foreign partner has enjoyed the benefit of depreciation deductions from the operation of the partnership’s USTB – thereby reducing the foreigner’s effectively connected income – shouldn’t that benefit be captured upon the later sale of the foreigner’s partnership interest?

Finally, there is a practical issue: how many foreigners will invest through a pass-through entity rather than through a U.S. corporation? Although a corporate subsidiary will be taxable, its dividend distributions to the foreign parent will be treated as FDAP and may be subject to a reduced rate of U.S. tax under a treaty. The foreigner’s gain on the liquidation of the subsidiary will not be subject to U.S. tax. Moreover, the foreigner will not have to file U.S. returns.

Stay tuned. In the meantime, if a foreigner has paid U.S. tax in connection with the redemption of a partnership interest – on the basis of the IRS ruling rejected by the Tax Court – it may be a good idea to file a protective refund claim.

Withdrawal of Proposed Regulations

Earlier this year, the President directed the Secretary of the Treasury to review all “significant tax regulations” issued on or after January 1, 2016, and to take steps to alleviate the burden of regulations that meet certain criteria.

Although not falling within the literal reach of this directive, but perhaps in keeping with its spirit, the IRS recently withdrew proposed regulations (issued in 2005) that would have required an exchange or distribution of “net value” among the parties to certain corporate reorganizations in order for the reorganizations to qualify for non-recognition (“tax-free”) treatment under the Code.

Before taxpayers breathe a sigh of relief over the withdrawal of these proposed regulations, they need to understand the IRS’s long-held position – which it sought to formalize in the proposed regulations – that a corporation has to be solvent in order for its shareholders to benefit from favorable tax treatment under the reorganization provisions of the Code.

In particular, taxpayers should note that, in announcing the withdrawal, the IRS explained that “current law” is sufficient to ensure that tax-free treatment is accorded only to those corporate reorganizations that effectuate a “readjustment” of shareholders’ continuing proprietary interests in a corporate-held business, and that it cited various authorities that generally limit reorganization treatment to solvent corporations.

The Reorganization Rules, In Brief

In general, upon a taxpayer’s exchange of property, gain must be recognized and taxed if the new property differs materially in kind from the old property, and the amount realized in the exchange exceeds the taxpayer’s adjusted basis in the property exchanged.

In the context of a corporate reorganization, there are generally two types of exchanges: (1) the exchange in which one corporation exchanges property for stock in a second corporation; and (2) the exchange in which stock in the first corporation is exchanged by its shareholders for stock in the second corporation.

The purpose of the tax-free reorganization provisions of the Code is to except these types of exchanges from the general gain recognition rule where they (i) are incident to a plan to reorganize a corporate structure in one of the particular ways specified in the Code, (ii) are undertaken for bona fide business or corporate purposes, and (iii) effect only a readjustment of the shareholders’ continuing interest in the corporation’s property under a modified corporate form.

In order to effect only a readjustment of the shareholders’ continuing interest in the corporation’s property, and to thereby secure tax-free treatment under the Code, a reorganization must satisfy a “continuity of business enterprise” requirement and a “continuity of interest” requirement.

In general, under the continuity of business enterprise test, the acquiring corporation must either continue the target corporation’s historic business or use a significant portion of the target’s historic business assets in a business.

The continuity of interest test requires that a substantial part of the value of the proprietary interests in the target corporation be preserved in the reorganization. A proprietary interest in the target corporation is preserved if it is exchanged for a proprietary interest in the acquiring corporation.

All facts and circumstances must be considered in determining whether, in substance, a proprietary interest in the target corporation is preserved. Thus, for example, a proprietary interest in the target corporation is not preserved to the extent that creditors of the target corporation that own a proprietary interest in the corporation – for example, because the target corporation’s liabilities exceed the fair market value of its assets immediately prior to the potential reorganization – receive money for their claims prior to the potential reorganization.

The policy underlying these rules is to ensure that tax-free reorganization treatment is limited to those reorganizations and exchanges that effectuate a readjustment of the shareholders’ continuing interests in property under a modified corporate form, and to prevent transactions that resemble sales from qualifying for non-recognition treatment.

The Proposed Regulations

In general, the Code provides that no gain shall be recognized if a shareholder’s stock in a target corporation is exchanged, pursuant to a plan of reorganization, “solely for stock” in the acquiring corporation. It also provides that no gain shall be recognized to the target corporation if it exchanges property, pursuant to a plan of reorganization, “solely for stock” in the acquiring corporation.

The IRS has consistently stated that the language “solely for stock” requires that there be an exchange of net value among the parties to the reorganization, meaning that both the target corporation and the acquiring corporation must be solvent.

According to the IRS, transactions that fail this requirement – that is, transfers of property that are in effect made in exchange for the assumption of liabilities or in satisfaction of liabilities, as in the case of an insolvent corporation – resemble sales and should not receive non-recognition treatment.

The proposed regulations sought to formalize this position by providing that an exchange of net value was requisite to a tax-free corporate reorganization. According to the proposed regulations, an exchange of net value requires that there be both a surrender of net value and a receipt of net value.

Whether there is a surrender of net value is determined by reference to the assets and liabilities of the target corporation. Whether there is a receipt of net value is determined by reference to the assets and liabilities of the acquiring corporation. The purpose of the “exchange of net value” requirement, the proposed regulations stated, is to prevent transactions that resemble sales (including transfers of assets in satisfaction of liabilities) from qualifying for non-recognition treatment.

Thus, in the case of an asset transfer, the fair market value of the property transferred by the target corporation to the acquiring corporation must exceed the sum of the amount of liabilities of the target corporation that are assumed by the acquiring corporation in connection with the exchange and the amount of any money and the fair market value of any other property (other than stock in the acquiring corporation) received by the target corporation in connection with the exchange. Similarly, the fair market value of the assets of the acquiring corporation must exceed the amount of its liabilities immediately after the exchange.

In the case of a stock transfer, the fair market value of the assets of the target corporation must exceed the sum of the amount of the liabilities of the target corporation immediately prior to the exchange and the amount of any money and the fair market value of any other property (other than stock of the acquiring corporation) received by the shareholders of the target corporation in connection with the exchange. The fair market value of the assets of the acquiring corporation must exceed the amount of its liabilities immediately after the exchange.

Withdrawn, But Not Useless

It is doubtful that the withdrawal of the proposed “net value” regulations signals any change in the IRS’s position. Indeed, almost all of the case law addressing the application of the continuity of interest rule to the reorganization of an insolvent corporation is consistent with the proposed regulations.

A taxpayer would be ill-advised to draw any conclusion to the contrary. After all, the IRS did not announce a change in the representations that must be made by a taxpayer in submitting a request to the IRS for a ruling with respect to a proposed reorganization. For example, a taxpayer must still represent that the fair market value of the assets of the target corporation transferred to the acquiring corporation pursuant to the plan of reorganization is at least equal to the sum of the target liabilities assumed by the acquiring corporation, plus the amount of liabilities, if any, to which the transferred assets are subject; in other words, there must be a transfer of net value.

Rather, taxpayers would be well-served to view the withdrawn proposed rules as a useful summary of the IRS’s thinking on “net value” issues, and as a guide for assessing the qualification of a proposed corporate restructuring or acquisition as a tax-free reorganization within the meaning of the Code.