Still a Valid S Corporation?

Much has been written regarding the limitations of the S corporation, especially the requirement that it have only one class of stock, and the prohibition against its having nonresident aliens, partnerships, or other corporations as shareholders. The fact remains, however, that there are thousands of S corporations in existence, out of which many closely held businesses operate.

For these businesses, the satisfaction of these requirements – i.e., living within these limitations and the attendant “lost opportunities”[i] – is the cost of securing and maintaining the corporation’s status as a pass-through entity[ii] for tax purposes.

There is one point in the life of the business, however – perhaps the most inopportune time – at which a corporation’s failure to satisfy these requirements or, stated somewhat differently, its inability to demonstrate that it has satisfied them, may cost its shareholders dearly. I am referring to the sale of the business and, in particular, the sale of all of its issued and outstanding stock.

I wish I could say that it is rarely the case for an S corporation that is in the midst of negotiating the sale of its business to discover that it may have lost its “S” status by virtue of having, for example, two outstanding classes of stock, but that would be inaccurate, as illustrated by a recent IRS letter ruling.[iii]

Before delving into the ruling, it may be helpful to review the “one class of stock” requirement and the tax consequences of a sale of an S corporation’s stock.

One Class of Stock

Under the Code, a corporation that has more than one class of stock does not qualify as a “small business corporation.”[iv]

A corporation is treated as having only one class of stock if all outstanding shares of stock of the corporation confer identical rights to distribution and liquidation proceeds.[v]

Differences in voting rights among shares of stock are disregarded in determining whether a corporation has more than one class of stock.[vi] Thus, if all outstanding shares of stock of an S corporation have identical rights to distribution and liquidation proceeds, the corporation may have voting and nonvoting stock.

In general, the determination of whether all outstanding shares of stock confer identical rights to distribution and liquidation proceeds is made based on the corporate charter, articles of incorporation, bylaws, applicable state law, and binding agreements relating to distribution and liquidation proceeds.[vii]


If a corporation qualifies as a small business corporation,[viii] and if its shareholders elect to treat the corporation as an S corporation for tax purposes[ix], then the corporation’s items of income, gain, deduction, loss, or credit will flow through to its shareholders, based on their respective pro rata shares, and will be taken into account in determining each shareholder’s income tax liability.[x]

The S corporation, itself, will not be subject to federal income tax.[xi]

Thus, the gain from the sale of the assets of an S corporation – or from the deemed sale of its assets (see below) – will be included in the gross income of its shareholders for purposes of determining their individual income tax liability. What’s more, the character of any item of gain (as ordinary or capital gain) that is included in a shareholder’s pro rata is determined as if such item were realized directly from the source from which realized by the corporation, or incurred in the same manner as incurred by the corporation.[xii]

A Stock Sale . . . ?

At this point, some may be wondering why the purchaser of an S corporation’s business would be acquiring the corporation’s stock instead of its assets.[xiii]

After all, in a stock deal, the buyer necessarily acquires all of the assets of the target S corporation,[xiv] both the assets that are necessary to the operation of the business, as well as those that aren’t. The buyer also takes subject to all of the target S corporation’s liabilities, both known and unknown, absolute or contingent,[xv] whether or not related to the operation of the business, including any liability for taxes owing by the target corporation.[xvi]

The buyer of stock also loses the opportunity, generally speaking, to step-up the basis of the assets acquired from the S corporation to their fair market value – the buyer’s cost for acquiring the assets[xvii] – and to expense, depreciate or amortize such cost, as the case may be, and to thereby recover their investment (i.e., the purchase price) faster than in the case of a purchase of stock.[xviii]

That being said, there are circumstances in which either the purchaser, or the shareholders of the target S corporation, may favor a stock deal.

For example, the S corporation may hold unassignable licenses or permits, or there may be contracts or other agreements, the separate transfer of which may require consents that will be difficult or too time-consuming to obtain.[xix]

A stock deal may also be easier to effectuate where the target S corporation’s assets are so numerous or extensive that it would be difficult or costly to transfer them separately. The purchase of the target’s tock would ensure the buyer of acquiring all of the necessary business assets owned or used by the corporation.

It may be that the purchaser wants to keep the corporation intact – as a going concern – perhaps after determining that the business has few liabilities,[xx] while also recognizing that is has great potential as is; only the management of the business needs to change.

Finally, the shareholders of the target S corporation will usually prefer a stock deal because it ensures them that their gain from the sale of the stock will be treated as long term capital gain for tax purposes.[xxi] If the purchaser wants the business badly enough, they will accede to the shareholders’ request.[xxii] It comes down to a question of leverage and risk allocation.

. . . And A Basis Step-Up?

Fortunately for the buyer, its decision to acquire the stock of a target S corporation does not always mean that the buyer must forfeit the ability to depreciate or amortize the purchase price. Even in the case of a stock deal, it may still be possible for the buyer to acquire a cost basis for the target S corporation’s assets, provided the selling shareholders agree to make one of two elections, depending upon the tax status of the buyer.[xxiii]

Thus, if the buyer is a single corporation, the buyer and each shareholder of the target S corporation may jointly elect to ignore the stock sale and to treat the transaction, instead, as a sale of assets by the target S corporation to a subsidiary of the buyer corporation, followed by the liquidation of the S corporation.[xxiv]

If the buyer is not a single corporation – for example, a partnership, an individual, or more than one person – then the shareholders of the target S corporation may be able to elect (without the consent of the buyer, but certainly at its insistence) to treat the stock sale as a sale of assets, as described above.[xxv]

It is unlikely that the shareholders of the target S corporation would make either of these elections unless they were asked to do so by the buyer. In that case, it is still unlikely that the shareholders would consent to the election unless they were compensated for any additional tax (including any deficiency) imposed upon them as a result of treating the transaction as a sale of assets – which may generate some ordinary income,[xxvi] or even corporate-level gain if the sale occurs during the corporation’s “recognition period”[xxvii] – followed by a liquidation of the target corporation (which may, itself, generate additional capital gain).[xxviii]

This compensation often takes the form of a “gross-up” in the purchase price for the target S corporation’s stock, such that the shareholders’ after-tax proceeds of a stock sale for which an election is made will be equal in amount to their after-tax proceeds of a stock sale without an election.[xxix]

Significantly, neither of these elections is available where the target is a stand-alone C corporation. Thus, it is imperative that the target corporation’s “S” election be intact at the time of the stock sale.

Which brings us to the letter ruling referenced above.

A Failed “S” Election?

Corp was a C corporation. Its board of directors amended Corp’s articles of incorporation to divide its common stock into shares of class A stock and shares of class B stock. The class A shares retained voting power and the class B shares held no voting power. The class A and class B shares otherwise conferred identical rights to distribution and liquidation proceeds.

The board subsequently amended Corp’s articles for a second time, to change the liquidation rights of the corporation’s stock. After this amendment, the class A and class B shares were entitled to receive equal shares of any assets of Corp in liquidation until a specified amount had been paid to each share. Upon reaching this amount in liquidation proceeds per share, the class B shares were entitled to receive the balance of any remaining assets of the corporation.

Corp later filed an election[xxx] to be taxed as an S corporation for tax purposes. At that time, Corp had only two shareholders.

Somehow unbeknownst to Corp, the election was ineffective because Corp’s two classes of stock prevented it from qualifying as a small business corporation. Corp claimed that its tax advisors were unaware of this amendment.

In addition, according to Corp, at the time this election was filed, its board of directors was either unaware or had forgotten that the distribution and liquidation rights had been changed, and differed for class A and class B shares, as a result of the second amendment to Corp’s articles of incorporation.

Corp indicated that its legal counsel discovered the second amendment,[xxxi] which created two classes of stock, in connection with due diligence performed by counsel in connection with the proposed sale of Corp’s stock by its two shareholders (the “Transaction”).

Upon learning of this issue, Corp’s board amended Corp’s articles prior to the Transaction to reconstitute the class A and class B shares into a single class of stock, with identical rights to distribution and liquidation proceeds, in order to rectify the ineffectiveness of Corp’s S corporation election.

Corp also asked that the IRS recognize the corporation’s status as an S corporation, effective retroactively as of the date requested by its original election.

In support of its request, Corp represented that it and its shareholders filed their respective tax returns consistent with Corp being an S corporation since the time of the failed election.

On the basis of the foregoing facts, the IRS concluded that Corp’s S corporation election was ineffective when made, as a result of the second class of stock that was created by the second amendment to Corp’s articles.

However, the IRS also determined that the circumstances resulting in the ineffectiveness of Corp’s election were inadvertent,[xxxii] and were not motivated by tax avoidance or retroactive tax planning.

The IRS also found that, no later than a reasonable period of time after discovery of the circumstances resulting in the ineffective election, steps were taken so that Corp qualified as a small business corporation.

Thus, the IRS decided to respect the “S” election,[xxxiii] provided that Corp, and each person who was a shareholder of Corp at any time since the date of the election, agreed to make any adjustments to their tax returns – consistent with the treatment of Corp as an S corporation – that may be required by the IRS with respect to the period beginning with what would have been the effective date of the election, through the date of the Transaction.

What If?

Corp and its shareholders were fortunate that the failed election was discovered prior to the consummation of the Transaction. It appears that they had sufficient time before the Transaction to request relief from the IRS, as reflected in the ruling described above.[xxxiv] It also appears that they had an understanding buyer; one that was willing to wait for them to put their tax situation in order.

What if events had unfolded differently?

For one thing, the buyer could have walked away from the deal. There are always other buyers, right? Or are there?

Perhaps the purchase price offered by this buyer was the highest that Corp and its shareholders had received. Or perhaps this buyer was the only one who had agreed to pay a gross-up to Corp’s shareholders in connection with an election to treat the stock sale as a sale of assets. Moreover, this buyer may have been the only one that agreed to pay the entire purchase price at closing, in cash, whereas other suitors had included a promissory note or an earn-out, each payable over a number of years, as part of their consideration for Corp’s stock. Or maybe this buyer had agreed to keep the business at its present location, and to lease such location from the former shareholders of Corp, who happened to own the property in a separate business entity, whereas other potential buyers had planned to consolidate Corp’s business into one of their other locations.

You get the picture.

Another “What If:” The SPA

What if the Transaction had closed without either side being aware of the failed “S” election, and what if the buyer had discovered the failure on its own after the sale? Worse yet, what if the IRS had audited Corp’s returns for the periods ending on or prior to the Transaction?

In the typical stock purchase agreement, the buyer asks that the sellers and the target S corporation make certain representations as to their stock ownership and as to the business and legal condition of the corporation. As in the case of other representations, these play a due diligence function in that the seller’s willingness to make a certain representation, or to schedule an exception to the representation, will disclose facts that are important to the buyer.

The representations also afford the buyer the opportunity to walk away from a deal where the closing occurs some period after the SPA has been executed by the parties.[xxxv] The sellers will state that their representations were accurate on the execution date, and will continue to be accurate through the closing. To the extent there is a “material” change in the accuracy of a particular representation, or if the buyer discovers that a representation is incorrect, then the buyer may call off the deal.

Finally, if the buyer suffers an economic loss after the closing that is attributable to an inaccurate representation, the buyer make seek to be indemnified by the sellers on account of the breached representation. The fact that the buyer had been given the opportunity to examine the target corporation’s records and documents prior to the sale will not provide a defense for the sellers.[xxxvi]

In the case of a target S corporation, the buyer may ask for the following representations and covenants (among many others) from the corporation and its shareholders: that the target S corporation has been a validly electing S corporation at all times, and will continue as such through the closing; that the corporation is not liable for the built-in gains tax; that they will not revoke the corporation’s “S” election, or take any action, or allow any action to be taken, that would result in the termination of such election (other than the sale to the buyer); and, at buyer’s option, that they will make an election to treat the stock sale as an asset sale for tax purposes.

Fast forward. The stock sale is completed and the target corporation is now a subsidiary of the buyer. The buyer subsequently learns that the target’s “S” election was either ineffective or had been lost prior to the closing of the stock sale. The buyer realizes that its newly acquired subsidiary was, in fact, a C corporation during the period preceding its acquisition.

As a result, the new subsidiary is liable for corporate-level income taxes for tax periods ending on or before the date of its acquisition by the buyer.

What’s more, the buyer and/or sellers’ election to treat the stock sale as a sale of assets was also ineffective. Consequently, the buyer did not obtain a recoverable basis step-up for the assets of its new subsidiary.

In addition, the buyer’s gross-up payment to the former shareholders of the target corporation need not have been made.

In short, the immediate economic result to the buyer from its purchase of the target corporation’s stock is substantially different from what it had planned, bargained for, and expected.

The buyer looks to the sellers to indemnify it for these economic losses. The buyer may be able to “recover” part of this loss from any portion of the purchase price that it had withheld, whether in the form of a promissory note, an escrow arrangement, or otherwise. The buyer may also have to seek recovery directly from the sellers.

In short, the economic result for the sellers is substantially different from what they had planned, bargained for, and expected.

Ease Their Pain

If the shareholders of an S corporation were honest with themselves, this is the point at which they wish they had listened to the very simple and straightforward counsel of their tax and corporate advisers.[xxxvii]

Among the nuggets of advice most often ignored by shareholders are the following:

  • Enter into a shareholders’ agreement that includes transfer restrictions, as well as other safeguards, for preserving the corporation’s “S” status, including the buyout of shares where necessary;
  • Require shareholders to share their estate plans (on a confidential basis) with the corporation’s counsel, so as to avoid any surprise transfers of their shares at their demise (like a transfer to a nonresident alien);
  • Require shareholders to cooperate in restoring the corporation’s “S” election in the event it is inadvertently lost;
  • Do not amend any corporate organizational or governing documents, and do not enter into any commercial agreements with shareholders, without first seeking tax counsel’s advice;
  • Do not issue any convertible debt instruments without first seeking counsel’s advice;
  • Do not issue equity-based compensation without first seeking counsel’s advice;
  • Keep meticulous and contemporaneous records of any and all stock transfers;
  • Provide for a drag-along right by which a majority shareholder may compel a minority shareholder to join in the sale of the corporation’s stock; and
  • Require minority shareholders to join in making an election, at the option of the majority owner, to treat a stock sale as a sale of assets.

Granted, some of these are more easily attainable than others; for example, a minority shareholder may resist some of these suggestions.

One truth that cannot be disputed, however, is the following: a business owner should start to prepare for the sale of their business as soon as they go into business; they should act accordingly throughout the life of the business; getting the business “ready” for a sale is not something that they can adequately address just prior to the sale.

[i] For example, the infusion of equity from an investment partnership, or from an investor who wants a preferred return in exchange for their capital contribution, perhaps in the form of convertible preferred stock.

[ii] An entity that is not, itself, taxable, but the income, loss, etc., of which passes through to its owners.

[iii] PLR 201935010.

[iv] IRC Sec. 1361(b)(1)(D).

The term “S corporation” means, with respect to any taxable year, a small business corporation for which an election under Sec. 1362(a) is in effect for such year.

IRC Sec. 1361(b)(1) defines a “small business corporation” as a domestic corporation which is not an “ineligible” corporation and which does not (A) have more than 100 shareholders, (B) have as a shareholder a person (other than an estate, a trust described in Sec. 1361(c)(2), or an organization described in Sec. 1361(c)(6)) who is not an individual, (C) have a nonresident alien as a shareholder, and (D) have more than one class of stock. Sec. 1362(a)(1) provides that a small business corporation may elect to be an S corporation.

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

[vi] IRC Sec. 1361(c)(4).

[vii] Reg. Sec. 1.1361-1(l)(2). It should be noted that other arrangements may be treated as creating a second class of stock if a principal purpose thereof is to circumvent the one class of stock requirement.

[viii] IRC Sec. 1361(b).

[ix] IRC Sec. 1362.

[x] IRC Sec. 1366. These amounts will be reflected on the Schedule K-1 issued by the S corporation to each of its shareholders.

[xi] IRC Sec. 1363. There are exceptions; for example, where the built-in gain rule applies. IRC Sec. 1374.

[xii] IRC Sec. 1366(b).

[xiii] We’ll consider only a couple of the factors that favor an asset deal over a stock deal. There are others, including, for example: the target corporation’s ability to sell its assets to the buyer even in the face of opposition from some minority shareholders (though the sale may trigger dissenter’s rights); and the buyer’s ability to select which assets it wants to acquire, and which liabilities it will assume.

Speaking of recalcitrant shareholders, this is where the absence of a shareholders’ agreement with a drag-along provision may be felt keenly.

[xiv] Indirectly; in a sense, the buyer steps into the shoes of the selling shareholders.

[xv] Sellers in a stock deal are always asked to represent to the buyer that the corporation has no liabilities, obligations or commitments of any nature whatsoever, asserted or unasserted, known or unknown, absolute or contingent, accrued or unaccrued, matured or unmatured or otherwise, except (a) those which are adequately reflected or reserved against in the balance sheet [as of a specified date], and (b) those which have been incurred in the ordinary course of business consistent with past practice since the [date of the balance sheet] and which are not, individually or in the aggregate, material in amount.

[xvi] Because of this exposure, a stock deal will require more due diligence, which means the expenditure of more time and fees by both the buyer and the seller(s).

It will likely also require the buyer’s holdback or escrowing of a greater portion of the purchase price for a greater period of time.

With respect to the corporation’s tax liabilities, the parties will have to agree as to the preparation of returns, and the payment of any amounts owing, for tax periods ending on or before the closing date, or which begin before the closing and end some time after the closing date.

A related issue will be a more extensive indemnity agreement by the selling shareholders to indemnify the buyer for any losses suffered by the buyer as a result of a breach of a representation by the sellers regarding the state or condition of the target corporation and its business.

[xvii] IRC Sec. 1060 and Sec. 1012. In general, Sec. 1060 requires that the purchase price for the acquisition of the business be allocated among its assets.

[xviii] The cost of which is generally recovered only upon the subsequent sale of the stock or the liquidation of the corporation. IRC Sec. 168(k), Sec. 167, and Sec. 197. The Tax Cuts and Jobs Act (P.L. 115-97) extended the bonus depreciation deduction by allowing a buyer to expense the cost of certain “used” tangible personal assets.

[xix] Note, however, that many contracts include change-in-control provisions pursuant to which the “assignment” of the contract requires the consent of a party where the ownership of the “assigning” party (i.e., the target corporation) changes, as in the case of a stock deal. A large part of the due diligence process involves reviewing the target’s contracts and determining whether such consents are required,

[xx] Or liabilities that are manageable.

[xxi] Where there are too many shareholders with whom to negotiate, or where there are some shareholders who do not want to sell their shares, the stock deal may be structured as a reverse subsidiary merger. The result of such a merger is that the target corporation becomes a subsidiary of the acquiring corporation. For tax purposes, the transaction is treated as a purchase and sale of stock. See, e.g., Rev. Rul. 90-95.

[xxii] IRC Sec. 1221 and Sec. 1222. An individual’s gain from the sale of stock in a corporation (“S” or “C”) is taxed as capital gain; if the gain is long-term, a federal income tax rate of 20-percent will be applied; the same holds true for trusts and estates. IRC Sec. 1(h).

This should be compared to the sale of partnership interests. Although generally treated as the sale of a capital asset, the gain will be treated as ordinary income to the extent the purchase price for the interest is attributable to so-called “hot assets.” IRC Sec. 741 and Sec. 751.

If the selling shareholder did not materially participate in the business of the corporation, the federal surtax of 3.8-percent of net investment income will also apply to the gain. IRC Sec. 1411.

[xxiii] Congress recognized that there are circumstances in which the buyer has a bona fide business (non-tax) reason to acquire the stock of a target corporation. In some such cases, Congress decided it would be improper for the buyer to give up its ability to recover its purchase price for tax purposes; i.e., to have to choose between good business decision and a tax benefit. The result was the elections discussed below.

[xxiv] IRC Sec. 338(h)(10); Reg. Sec. 1.338(h)(10)-1.

[xxv] IRC Sec. 336(e); Reg. Sec. 1.336-1 through -5. It should be noted, if the buyer of the target’s stock does not want the sellers to make a Sec. 336(e) election, it should include a prohibition of such an election in the stock purchase agreement; specifically, a covenant not to make the election.

[xxvi] You’ll recall that the character of the gain – for example, ordinary income from the sale of receivables, or depreciation recapture from the sale of machinery – passes through to the target S corporation’s shareholders. The maximum federal tax rate for ordinary income included in the gross income of an individual is 37-percent.

[xxvii] IRC Sec. 1374.

[xxviii] IRC Sec. 331; Sec. 1371.

[xxix] The gross-up amount paid by the buyer will end up being allocated to the target’s goodwill and going concern value, and will be amortizable over 15 years under IRC Sec. 197.

[xxx] IRS Form 2553.

[xxxi] Presumably, counsel did not prepare or file the second amendment.

[xxxii] Within the meaning of IRC Sec. 1362(f).

[xxxiii] Assuming that Corp met all of the other requirements for status as a small business corporation.

[xxxiv] Or perhaps they asked for expedited handling.

[xxxv] As opposed to signing and closing on the same day.

[xxxvi] Query whether the sellers’ and the target’s attorneys have done their own diligence.

[xxxvii] “You can pay us now to fix the problem, and avoid bigger issues down the road,” they said, “or you can ignore us now, and pay a lot more to someone else down the road.”

The Tax Gene?

King of Swamp Castle: One day, lad, all this will be yours.

Prince Herbert: What, the curtains?

King: No, not the curtains, lad. I’m talking about all of my business and investment interests, along with the related tax reporting positions.[I]

Have you ever wondered how much our parental genes define us? What about the impact of external factors?

It is a scientific fact that an individual’s genetic make-up, as passed down to them from their parents, influences their physical characteristics, and even their behavior. Each of us, therefore, “owes” a great deal to our parents for who were are.

It has also been scientifically established that the environment in which one is raised plays a significant role in one’s development as an individual. Poverty and poor nutrition, for example, may greatly influence whether one’s genetic abilities will ever be fully realized. These factors may also be attributed to who our parents were.[ii]

Until recently, however, I never seriously considered whether a parent’s tax reporting position – of all things – may be passed on to their child in such a way that it is determinative of the child’s own tax reporting. Surprisingly, that seemed to be the argument that the IRS made in a case decided by the Tax Court last week.[iii]

Dad’s Interest Expense

Dad was a real estate entrepreneur who owned[iv] a 50-percent interest in each of several partnerships (the “Partnerships”) that owned, operated, and actively managed rental real estate. The remaining interest in each partnership was held by an unrelated person.

The Partnerships borrowed money from Bank and distributed the proceeds to Dad and his partner.[v] The terms of the loans were substantially similar. Each loan had a 5.88% interest rate, and was evidenced by a note that was secured by the partnership’s assets. Neither Dad nor his partner was personally liable on the notes.[vi]

Dad invested the funds distributed to him in money market funds and other investment assets, which he held until his death.

Of course, the Partnerships incurred interest expense on the Bank loans. Each partnership issued to Dad for each year a Schedule K-1, Partner’s Share of Income, Deductions, Credits, etc., reporting his distributive shares of its rental real estate income and of its interest expense.

On his federal income tax return for each year, Dad reported his distributive shares of the interest expense on the loans as “investment interest.”[vii]

Father to Son

A couple of years before his death, Dad transferred to Son, by gift, his ownership interests in the Partnerships.[viii] Son agreed to be bound by each Partnership’s operating agreement,[ix] but he did not become personally liable on any of the Bank loans.

However, by “gratuitously” transferring his interests in the Partnerships to Son, Dad was relieved of his shares of the partnership liabilities represented by the loans.

On his federal income tax return for the year of the gift, Dad treated the nonrecourse partnership liabilities of which he was “relieved” as amounts realized on the gift transfers of his partnership interests.[x] Accordingly, Dad reported taxable capital gains to the extent the amount realized exceeded his adjusted basis in his partnership interests.[xi]

Son’s Interest Expense

The Partnerships paid interest on these loans, and issued Schedules K-1 to Son reporting his distributive shares of the Partnerships’ rental real estate income and of the interest expense attributable to the Bank loans.

Son filed his federal income tax return on IRS Form 1040, to which he attached Schedule E, Supplemental Income and Loss.[xii] He took the position that the interest paid by the Partnerships on the Bank loans was not “investment interest,” as it had been in the hands of Dad, because Son had not received any of the loan proceeds, and had not used any partnership distributions to acquire investment assets.

Rather, Son treated the interest as having been paid on indebtedness properly allocable to the Partnerships’ real estate assets, and thus treated his distributive shares of the interest expense as fully deductible against his distributive shares of the Partnerships’ real estate income. Accordingly, on each Schedule E, Son netted against the rental income for each partnership the corresponding amount of interest expense.

The IRS Disagrees

The IRS examined Son’s tax returns and issued a timely notice of deficiency in which it asserted that Son’s distributive shares of the interest paid by the Partnerships on the Bank loans should properly have been reported on the Schedules A of his Forms 1040 as investment interest – the way Dad had reported the interest.

Investment interest, the IRS pointed out, is deductible only to the extent of a taxpayer’s “net investment income.” Because Son had insufficient investment income to utilize the interest expense allocated to Son by the Partnerships, the IRS disallowed the deductions for all of the passed-through interest attributable to the Bank loans.[xiii]

Son then timely[xiv] petitioned the U.S. Tax Court for a redetermination of the deficiencies resulting from the disallowed deduction.[xv]

Interest Deductions

The Code generally provides that “[t]here shall be allowed as a deduction all interest paid or accrued within the taxable year on indebtedness,”[xvi] but this rule is subject to a number of limitations.

For example, in the case of taxpayers other than corporations, “personal interest” is generally nondeductible.[xvii]

However, nondeductible personal interest is defined to exclude (among other things) “interest paid or incurred on indebtedness properly allocable to a trade or business,” and any interest which is taken into account in computing income or loss from a passive activity.”[xviii]

Personal interest also excludes “any investment interest.”[xix]

Investment Interest

The IRS contended that the interest paid by the Partnerships on the Bank loans, part of which was passed through to Son,[xx] constituted “investment interest.”

Investment interest is defined as interest that is “paid or accrued on indebtedness properly allocable to property held for investment.”[xxi]

The Code allows a deduction for investment interest, but subject to a limitation. Specifically, it provides that, “[i]n the case of a taxpayer other than a corporation, the amount allowed as a deduction * * * for investment interest for any taxable year shall not exceed the net investment income of the taxpayer for the taxable year.”[xxii]

The interest in question was incurred by the Partnerships. These entities owned, operated, and actively managed apartment buildings and other rental real estate. The loans on which the interest was paid were secured by those real estate assets.

The IRS did not contend, however, that the operating assets held by the Partnerships constituted “property held for investment.”

How, then, could the IRS treat Son’s share of the Partnerships’ interest expense as investment interest?

Tracing the Debt Proceeds

The Court explained that tracing rules are utilized for determining when debt is “properly allocable to property held for investment.”[xxiii]

In general, according to these rules, “[d]ebt is allocated to expenditures in accordance with the use of the debt proceeds and * * * interest expense accruing on a debt * * * is allocated to expenditures in the same manner as the debt is allocated.”[xxiv] In other words, “debt is allocated by tracing disbursements of the debt proceeds to specific expenditures.”[xxv]

For example, if a taxpayer uses debt proceeds to make a personal expenditure, the interest is treated as nondeductible personal interest. If a taxpayer uses debt proceeds in connection with a passive activity, the interest is subject to the passive loss limitations.[xxvi] And if a taxpayer uses debt proceeds to make “an investment expenditure,” the interest incurred on the debt is allocable to such investment expenditure, and the interest is treated, for purposes of the interest deduction disallowance rule, as investment interest.[xxvii]

Although the tracing rules do not specify how they are to be applied to partnerships and their partners, the IRS has provided that, if a partnership uses debt proceeds to fund a distribution to its partners – i.e., to make debt-financed distributions – each partner’s use of the proceeds determines whether the interest passed through to them constitutes investment interest.[xxviii]

Thus, if a partner uses the proceeds of a debt-financed distribution to acquire property that they hold for investment, the corresponding interest expense incurred by the partnership and passed on to the partner will be treated as investment interest.

In short, if a taxpayer uses debt proceeds to acquire an investment, the interest on that debt is investment interest regardless of whether the debt originated in a partnership.

The Issue

Reduced to its essentials, the question before the Court was whether Son – who had acquired interests in the Partnerships by gift from Dad – was required to treat the interest expense passed through to him in the same manner as Dad.

The IRS argued that Son in effect stepped into Dad’s shoes, with the supposed result that the interest, properly reported by Dad as investment interest, remained investment interest as to Son so long as the loans remained on the Partnerships’ books.

Dad received debt-financed distributions from the Partnerships. He used the proceeds of those distributions to acquire shares of money market funds and other assets that he held for investment. Consistently with the tracing rule, Dad properly treated the interest expense incurred by the Partnerships and passed through to him as investment interest.

Son, however, did not receive, directly or indirectly, any portion of the debt-financed distributions that the Partnerships made to Dad. Nor did Son use distributions from the Partnerships to make investment expenditures.

The Court determined that the facts which caused the passed-through interest to be investment interest in Dad’s hands did not apply to Son.

Acquisition Indebtedness?

The Court then explained how debt should be allocated where (as in Son’s case) no loan proceeds were disbursed to a taxpayer:

If a taxpayer incurs or assumes a debt in consideration for the sale or use of property * * * or takes property subject to a debt, and no debt proceeds are disbursed to the taxpayer, the debt is treated * * * as if the taxpayer used an amount of the debt proceeds equal to the balance of the debt outstanding at such time to make an expenditure for such property * * *.

Son acquired his ownership interests in the Partnerships by gift from Dad. He acquired those interests subject to the Bank debts that were then on the Partnerships’ books. Thus, Son was treated as using his allocable share of that debt to make an expenditure for the acquisition of his partnership interests.[xxix]

In the case of a debt-financed acquisition (as opposed to a debt-financed distribution), such as the purchase of an interest in a partnership, the Court explained that the debt proceeds and the associated interest expense should be allocated among all the assets of the partnership “using any reasonable method.”

In short, whereas Dad received a debt-financed distribution, Son was treated as having made a debt-financed acquisition of the Partnership interests he acquired from Dad. For purposes of the investment interest limitation, therefore, the debt proceeds were allocated among all of the Partnerships’ real estate assets, and the interest paid on the debt was allocated to those assets in the same way.[xxx]

Because the Partnerships’ real estate assets were actively managed operating assets, they did not constitute “property held for investment.” Therefore, the interest paid on the Bank loans was not investment interest.

The IRS’s Alternative Argument

The IRS disputed the relevance of the tracing rules, urging that Son, when acquiring the Partnership interests from Dad, did not “assume[] a debt” or “take[] property subject to a debt.” The IRS emphasized that Son had no personal liability on the Bank loans, which were nonrecourse, and that the liens held by Bank ran against the Partnerships’ real estate assets, not against Son’s partnership interests.

The Court rejected the IRS’s position. In fact, it pointed out that the IRS itself had previously reasoned that, where partnership interests are transferred, each transferring partner’s share of partnership nonrecourse liabilities would be considered as a liability to which the partnership interest was subject.

Thus, Son acquired his interests in the Partnerships subject to the Bank debts, even though Son did not personally assume those debts, which remained nonrecourse with respect to the partners individually.

In the converse situation, the Court continued, where a partner sells a partnership interest, the regulations provide that the partner’s “amount realized” includes his share of the partnership liabilities of which he is relieved, even if the liabilities are nonrecourse.[xxxi]

Thus, the fact that a partner is not personally liable for a partnership’s debt does not mean that their partnership interest is not “subject to a debt” for purposes of the partnership tax rules.

The Court’s Decision

For the foregoing reasons, the Court concluded that the interest expense passed through to Son from the Partnerships was not investment interest.

The Court noted that, even if the tracing rules were somehow inapplicable, the IRS failed to articulate any principle or rule that would affirmatively require the interest expense in question to be characterized as investment interest. According to the Court, the principle that required such interest to be characterized as investment interest in Dad’s hands clearly did not apply because Son (unlike Dad) did not receive any debt-financed distributions from the Partnerships.

The IRS’s position thus was reduced, the Court stated, to the contention that, because Son acquired the partnership interests from Dad, he stood in Dad’s shoes and had to treat the passed-through interest the same way Dad did. But, the Court continued, neither the investment interest limitation rule nor its implementing regulations include any family attribution rule or similar principle that would require this result.

Purchase and Sale

When Dad gratuitously transferred interests in the Partnerships to Son, he was required to include the partnership debt from which he was relieved[xxxii] as an “amount realized,” and he reported capital gains accordingly. To the extent Dad was relieved of the debt, liability was necessarily shifted to the other partners, including Son. Son thus took his Partnership interests “subject to the debt,” even though the liabilities were nonrecourse.

It seemed obvious, the Court explained, that Son would have no “investment interest” if he had acquired his ownership interests in the Partnerships from a third party for cash. The IRS did not explain why the result should be different because Son acquired those interests from Dad by a partial gift. The Court determined that the IRS failed to articulate a principle that would justify characterizing the interest expense passed through to Son as “properly allocable to property held for investment” by Son.

Once Investment Interest . . . ?

The IRS then urged the Court to adopt a “once investment interest, always investment interest” rule on the theory that any other approach would “place a myriad of additional administrative burdens on both taxpayers and the government.”

Again, the Court turned the IRS away, pointing out that both the tracing rules and the partnership tax rules clearly dictated different outcomes depending on whether a partner received a debt-financed distribution or made a debt-financed acquisition.

Recognition that partnership interests may change hands, the Court observed, was thus an inherent part of the regulatory structure.

In sum, the Court held that the interest expense passed through to Son from the Bank loans was not investment interest. When Son acquired the partnership interests from Dad, he was in the same position as any other person who acquired partnership interests encumbered by debt. He did not receive the proceeds of those debts, and he did not use the proceeds of those debts to acquire property that he subsequently held for investment. Thus, there was no justification for treating the interest expense passed through to him as investment interest. Rather, Son correctly reported it on Schedule E as allocable to the real estate assets held by the Partnerships.

Are There Tax Genes?

So, was the IRS crazy to argue that Dad’s tax treatment of the interest expense should have determined Son’s treatment as well?

Probably, but not entirely.[xxxiii]

When one individual transfers a partnership interest to another by gift, the recipient generally takes the interest with an adjusted basis equal to the donor’s adjusted basis in the interest.[xxxiv] In this way, the unrealized gain in the donor’s hands is preserved when the property is transferred to the recipient.

In addition, the recipient of the gifted partnership interest will take the donor’s holding period for the interest gifted, thereby preserving the long-term/short-term character of any capital gain inherent in the property.[xxxv]

The donor’s amount at risk with respect to the gifted partnership interest will be added to the recipient’s amount at risk for such interest.[xxxvi]

When a donor gifts a partnership interest in a passive activity, the adjusted basis for the interest is increased by the amount of the donor’s suspended passive losses allocable to such interest, in effect allowing the recipient to utilize such losses in determining their gain on a subsequent taxable disposition; the gift is not treated as a disposition that would allow the donor to utilize such losses.[xxxvii]

In the case of a gift of a partnership interest in which the donor has a Section 754 basis adjustment, the donor is treated as transferring, and the recipient as receiving, that portion of the basis adjustment attributable to the gifted partnership interest.[xxxviii]

Likewise, when an individual makes a gift of a partnership interest that they received in exchange for a contribution of built-in gain property[xxxix] to the partnership, the built-in gain will be allocated to the recipient as it would have been allocated to the donor.[xl]

Unfortunately for the Service, there are just as many instances in which the recipient of a gift of property does not step into the shoes of the donor. In general, these instances involve the application of rules where the relationship of the gift recipient to the property interest at issue rightly supplants that of the donor.

For example, the recipient of a gift of real property that had been used by the donor in a trade or business cannot rely upon the donor’s use for purposes of themselves engaging in a like kind exchange with such property; rather, the recipient must establish their own qualifying use of the property.[xli]

Most importantly insofar as Dad and Son are concerned, the otherwise gratuitous transfer of property that is encumbered by indebtedness – or, in the case of a partnership interest, to which debt has been allocated under the partnership tax rules[xlii] – is treated as a sale and purchase of such interest to the extent of such indebtedness.

As in the case of any sale between unrelated persons, the buyer takes a cost basis in the property acquired, and begins a new holding period for such property. The buyer determines their own at-risk-amount, and ascertains whether the property constitutes an interest in an activity in which the buyer materially participates, without regard to the seller’s history. And the buyer determines their own relationship to the property for purposes of the limitations on the deduction of interest.

So, to the question of whether a parent’s personal tax traits can be genetically passed down to their children, the answer is no.[xliii]


*Of course, the reference is from the Old Testament, appearing first in Exodus, Chapter 20 (the presentation of the Ten Commandments): “For I the LORD your God am a jealous God, visiting the iniquity of the fathers upon the sons to the third and fourth generation of those that hate me, and showing mercy to thousands of those that love Me and keep My commandments.”

[i] With sincerest apologies to Monty Python. What follows is the complete dialogue from this scene in Monty Python and the Holy Grail:

King of Swamp Castle: One day, lad, all this will be yours.
Prince Herbert: What, the curtains?
King: No, not the curtains, lad.
King: I built this kingdom up from nothing. When I started, all I had was swamp! Other kings said I was daft to build a castle on a swamp, but I built it all the same, just to show ’em! It sank into the swamp, so I built a second one. That sank into the swamp. I built a third one. It burned down, fell over, and then it sank into the swamp. But the fourth one stayed up! And that’s what you’re going to get, lad–the strongest castle on these islands!
King: Listen, lad, in twenty minutes you’re going to be married to a girl whose father owns the biggest tracts of open land in Britain.
Prince Herbert: But I don’t want land.
King: Listen, Alice–
Prince Herbert: Herbert.
King: Herbert. We built this castle on a bloody swamp, we need all the land we can get!
Prince Herbert: But I don’t like her.
King: Don’t like her? What’s wrong with her?! She’s beautiful, she’s rich, she’s got huge . . . tracts of land.

[ii] Fate? Karma? The alignment of the stars and planets? Just dumb luck? According to the character in the movie, A Knight’s Tale, “from peasant to knight, one man can change his stars.”

[iii] Lipnick v. Commissioner, Docket No. 1262-18; filed August 28, 2019.

[iv] Directly and through a grantor trust. IRC Sec. 671.

[v] Dad received over $22 million. One of the most attractive characteristics of a real estate partnership is its ability to borrow against the equity in the property, to thereby increase its partners’ adjusted bases for their partnership interests, and to distribute the loan proceeds to its partners without causing an immediate taxable event. IRC Sec. 752(a), Sec. 722, and Sec. 731(a).

[vi] The debt was nonrecourse as to them; Bank could only look to the partnership properties securing the debt for satisfaction of the debt.

[vii] On Schedule A of his IRS Form 1040.

[viii] I assume that Dad filed a federal gift tax return on IRS Form 709.

[ix] At this point, presumably, Son was admitted as a partner, and ceased to be a mere transferee with only an economic interest in the Partnerships.

[x] IRC Sec. 752(d); Reg. Sec. 1.752-1(h), and Sec. 1.1001-2(a)(4)(v).

[xi] In other words, Dad’s transfer to Son was part-gift/part-sale; he was treated as having sold (and as having received consideration for) an interest with a fair market value equal to the amount of debt relieved; the equity portion of the interest constituted a gift.

[xii] Part II is used to report income/loss from partnerships, among other things.

[xiii] The disallowed amount is carried forward.

[xiv] In general, 90 days from the date of the notice of deficiency.

[xv] The parties submitted the case for decision without trial.

[xvi] IRC Sec. 163(a).

[xvii] IRC Sec. 163(h).

[xviii] IRC Sec. 163(h)(2)(A), (C).

[xix] IRC Sec. 163(h)(2)(B); IRC Sec. 163(d).

[xx] IRC Sec. 702.

[xxi] IRC Sec. 163(d)(3)(A).

[xxii] IRC Sec. 163(d)(1).

Son had little net investment income for the tax years in issue (meaning, interest, dividends, annuities, royalties, and net capital gain – see IRC 163(d)(5) and Sec. 469(e)). Accordingly, he agreed that, if the interest in question constituted “investment interest” under Sec. 163(d), it would be nondeductible. And the IRS agreed that, if the interest was not investment interest, it was properly reportable and deductible on Son’s Schedule E.

[xxiii] Sec. 163(d)(3)(A); see Sec. 1.163-8T, Temporary Income Tax Regs., 52 Fed. Reg. 24999 (July 2, 1987).

[xxiv] Sec. 1.163-8T(c)(1).

[xxv] Reg. Sec. 1.163-8T(a)(3).

[xxvi] Sec. 469; Reg. Sec. 1.163-8T(a)(4)(ii), Example (1).

[xxvii] Reg. Sec. 1.163-8T(a)(4)(i)(C).

[xxviii] Notice 89-35.

[xxix] The flip-side of the part-gift/part-sale is the part-gift/part-purchase.

[xxx] Reg. Sec. 1.163-8T(c)(1).

[xxxi] Reg. Sec. 1.752-1, 1.1001-2(a)(4)(v), stating that a taxpayer’s “amount realized” on transfer of a partnership interest includes the nonrecourse liabilities of which he is relieved, where the transferee “takes the partnership interest subject to the * * * liabilities.”

For purposes of the partnership tax rules, generally, any increase or decrease in a partner’s share of partnership liabilities is treated as a deemed contribution or distribution, regardless of whether the debt is recourse or nonrecourse. Sec. 752; Sec. 1.752-1.

[xxxii] More accurately, which was allocated away from him and to Son in accordance with the regulations under Section 752 of the Code.

[xxxiii] “There’s a big difference between mostly dead and all dead.” – Miracle Max, from The Princess Bride.

[xxxiv] IRC Sec. 1015.

[xxxv] IRC Sec. 1223.

[xxxvi] Prop. Reg. Sec. 1.465-68.

[xxxvii] IRC Sec. 469(h). That being said, an activity that may have been passive as to the donor may not be treated as passive as to the recipient.

[xxxviii] Reg. Sec. 1.743-1(f).

[xxxix] IRC Sec. 704(c).

[xl] Reg. Sec. 1.704-3(a)(7).

[xli] See, e.g., Rev. Rul. 75-292.

[xlii] IRC Sec. 752 and the regulations issued thereunder.

[xliii] As distinguished from an aversion to paying tax, which is probably a product of both nature and nurture.

A Time for Planning?

It’s late August – again. As usual, many business owners are looking forward to having all of their employees back at work and ready to make the final push for a successful year.[i] Others, nearing retirement, and who may be contemplating the arrival of another winter, are considering whether it is time for a move to a warmer climate.[ii]

It may also occur to some of these owners – especially after having vacationed with their children and grandchildren – that it was time they planned for the transfer of their business interests or investment assets. Most of them have already been making so-called “annual exclusion gifts” to various family members.[iii] They may recall their advisers having told them about the greatly increased federal estate and gift tax exemption,[iv] and they may even remember that this benefit is scheduled to expire after December 31, 2025, if it is not eliminated sooner.[v]

With these thoughts in mind, a number of these business owners will visit their advisers to discuss the available estate and gift planning options, especially with respect to equity interests[vi] in their business. The advisers will likely tell them about outright gifts and gifts in trust,[vii] about installment sales and sales to grantor trusts,[viii] about GRATs,[ix] and about the importance of having a shareholders’ agreement or a partnership/operating agreement in place prior to making such transfers.[x]

Hopefully, the business owner will also be alerted to the possibility that regulations which were proposed by the IRS in 2016 – but withdrawn in 2017 – may be reintroduced after 2020;[xi] in that case, they could present a significant impediment to the tax efficient gift or testamentary transfer of interests in a closely held business.

The business owner is also likely to hear about the importance of retaining a knowledgeable and experienced appraiser, and of having a well-reasoned appraisal report to support any transfer of their business interests, whether by gift or by sale.[xii] A recent Tax Court decision illustrated the wisdom of this advice.[xiii] In the process, it also raised an interesting valuation issue.

The Gifts

Parent owned 49-percent of the voting stock, and 96% of the non-voting stock, of an “S” corporation[xiv] (“Corp”) that operated a lumber mill. The remaining outstanding shares were owned by members of Parent’s family.

The Corporation

Under the terms of a buy-sell agreement, the shareholders could not transfer their Corp stock unless they did so in compliance with the agreement. Any sale of stock that caused Corp to cease to be an S corporation would be null and void under the agreement, unless Corp and shareholders of a majority of its outstanding shares gave their consent. If a shareholder intended to transfer their Corp stock to a person other than a family member, the shareholder had to notify Corp, which had the right of first refusal with respect to those shares. If Corp declined to purchase the shares, the other shareholders were given the option to purchase them. If Corp or the other shareholders exercised their option to purchase shares, the purchase price would be the fair market value of the shares. Fair market value, for purposes of the agreement, was to be mutually agreed upon or, if the parties could not come to an agreement, determined by an appraisal. Under agreement, the reasonably anticipated cash distributions allocable to the shares had to be considered, and discounts for lack of marketability, lack of control, and lack of voting rights had to be applied in determining the fair market value.

The Partnership

Corp was the general partner of a limited partnership (“Partnership”) that invested in, acquired, held and managed timberlands which provided Corp’s inventory. Partnership was organized for the purpose of ensuring Corp with a steady stream of timber, and sold almost all of its production to Corp.

The ownership of the two entities was almost identical. In addition, Corp’s management team (paid by Corp) managed Partnership, and Partnership paid Corp a fee for administrative services, including human resources, legal services, and accounting. The companies also lent money to each other (for which interest was charged), sending cash where it was most needed.[xv]

Beyond that, Corp used Partnership’s property to secure bank loans that were integral to Corp’s operations,[xvi] and that allowed it to maintain cash flow at times when a loan would not otherwise have been available. The companies were joint parties to these third party credit agreements, but the loans were reported on Partnership’s books because its property served as collateral.

Corp had broad powers as the general partner of Partnership, including the powers to buy, sell, exchange, and encumber partnership property. The limited partners (which included Parent and members of their family) did not participate in Partnership’s management, although they had the right to vote on the continuation of the partnership, the appointment of a successor general partner, the admission of an additional general partner, the dissolution of the partnership, and amendments to the partnership agreement. The unanimous consent of all partners was required to admit an additional general partner or to dissolve Partnership.

Under the partnership agreement, limited partners were restricted in their ability to transfer their interests in Partnership. No transfer of partnership units was valid if it would terminate the partnership for tax purposes. The consent of all partners was required for the substitution of a transferee of partnership units as a limited partner. A transferee who was not substituted as a limited partner would be merely an assignee of allocations of partnership profits and loss. Limited partners were also subject to a buy-sell agreement, which restricted transfers of their interests in Partnership. It mirrored Corp’s buy-sell agreement.

The Trusts

Parent formulated a succession plan with the goal of ensuring that the business remained operational “in perpetuity.”[xvii] As part of this plan, Parent created various trusts (including generation skipping trusts) for the benefit of their issue.[xviii] Parent gifted over 26-percent of their Corp voting shares and all of their non-voting shares to these trusts. Parent also gifted over 70-percent of their limited partnership interests in Partnership to the trusts.

The Dispute

Parent filed a federal gift tax return[xix] for the above transfers. The return included an appraisal report which valued the Corp voting and non-voting shares, as well as the Partnership limited partnership units.

The IRS examined Parent’s return and determined that the fair market values of the equity interests transferred had been understated on the return.

Parent petitioned the U.S. Tax Court.[xx]

Valuation Standard

The Court began by explaining that the fair market value of property transferred as a gift is “the price at which it would change hands between a willing buyer and a willing seller, neither under any compulsion to buy or sell and both having reasonable knowledge of the relevant facts.” The willing buyer and seller are hypothetical persons, not any specific or named person.

Closely Held Business: Relevant Factors

When determining the fair market value of unlisted stocks for which no recent sales or bids have been made, the Court explained, several factors should be considered, including: the company’s net worth, its earning power and dividend-paying capacity, its goodwill, the economic outlook in the industry, its management and its position in the industry, the degree of control of the business represented in the block of stock to be valued, and the value of stock in similar, publicly traded companies.[xxi] When determining the fair market value of an interest in a partnership, the value of the partnership’s assets may be considered, along with the same factors considered in determining the fair market value of stock.[xxii]

Income vs Asset Approach

Parent’s valuation expert (“Expert”) valued Partnership and Corp as going concerns,[xxiii] and relied on an income approach – specifically the discounted cash-flow method – and a market approach in valuing the units of Partnership and Corp that were transferred as gifts. Expert determined a value for these interests on a non-controlling, nonmarketable basis, after adjustments and discounts.

The IRS also valued Partnership as a going concern,[xxiv] but relied on an asset-based approach – specifically, the net asset value method – and a market approach in valuing one Partnership limited partnership unit. After applying adjustments and discounts, the IRS determined the value of Partnership on a non-controlling, nonmarketable basis.

The Court noted that it was not bound to follow the opinion of any expert where it was contrary to the Court’s own judgment, stating that it may adopt or reject an expert’s opinion in whole or in part. The Court emphasized that valuation is a question of fact, and the factors considered in determining value should be weighed according to the circumstances in each case.

The Court continued by describing the three generally accepted approaches that are used to value equity interests in closely held businesses: the income approach, the market approach, and the asset-based approach.

The income approach uses either the direct capitalization method[xxv] or the discounted cash-flow method[xxvi] to convert the anticipated economic benefits that the holder of the interest would stand to realize into a single present-valued amount.

The market approach values the interest by comparing it to a comparable interest that was sold at arm’s length in the same timeframe, accounting for differences between the companies by making adjustments to the sale price.

The asset-based approach values the interest by reference to the company’s assets net of its liabilities.

The Court observed that, when valuing an operating company that sells products or services to the public, the company’s income receives the most weight. When valuing a holding or investment company, which receives most of its income from holding debt, securities, or other property, the value of the company’s assets receives the most weight.

The primary dispute between the parties was whether Partnership should be valued using an income approach or an asset-based approach.[xxvii]

Operating vs Holding Company

Parent contended that Partnership was an operating company that sold a product – logs – and, therefore, should be valued as a going concern with primary consideration given to its earnings.

The IRS, on the other hand, contended that Partnership was a holding company and, therefore, the value of its underlying assets[xxviii] should be given primary consideration in the valuation.

Parent rejected the IRS’s asset-based valuation because there was no likelihood of Partnership’s selling its assets.

According to the Court, not all companies lend themselves to be characterized as simply an operating company or a holding/investment company. The Court gave the example of a company whose real property plays a significant role in its income-producing operations.

When valuing an interest in a company that has aspects of both an operating company and a holding or investment company, the Court stated that it would not “restrict [its] consideration to only one approach to valuation”.

The Court pointed out that Partnership’s timberlands were its primary asset, and they would retain and increase in value, even if Partnership was not profitable on a year-to-year basis. Therefore, it may be appropriate to consider an asset-based approach in valuing an interest in Partnership. However, the Court noted that Partnership was also an operating company that planted trees and harvested and sold the logs; it also expended significant time, effort and capital to ensure that its operations were efficient.

Thus, Partnership was different from a holding or investment company, such that an income approach may be appropriate in valuing an equity interest therein.

A Combined Approach?

The Court concluded that Partnership had aspects of both an operating company and an investment or holding company. Because Partnership did not fit neatly into either category, the Court suggested that a valuation that combined consideration of Partnership’s earnings and of its assets, and that weighted each appropriately, may be necessary.

An asset-based approach, the Court stated, necessarily assumes access to the value of Partnership’s underlying assets through a hypothetical sale. The likelihood that Partnership would sell its assets went to the relative weight to be given an asset-based approach; the less likely Partnership was to sell its assets, the less weight would be assigned to an asset-based approach.

The parties disagreed on two points that were relevant to whether Partnership would sell its assets: (1) whether Partnership could sell its assets, and (2) whether Partnership should be considered separately from Corp, or as a single business enterprise with Corp.

The IRS contended that circumstances could arise in which Partnership could and would sell its assets. Parent argued that holders of limited partnership units could not force a sale of its assets under the partnership agreement, and that Corp, which had the exclusive authority to direct Partnership to make such a sale, would never exercise that authority. The IRS argued that this position inappropriately considered specific – rather than hypothetical – buyers and sellers.

The Court disagreed with the IRS. It stated that Corp’s exclusive authority (as general partner) to exercise control over Partnership under the partnership agreement, its interest in Partnership’s continued ownership of the timberlands, and the restrictions imposed on limited partners under the partnership agreement, did not depend on how many limited partners Partnership had or who they were.[xxix] These restrictions, the Court stated, applied to the interest because of the partnership agreement and the rights held by Corp, and would have been taken into account by any hypothetical buyer and seller of a limited partner interest.

A Single Operation?

As further support for its position, Parent argued that Partnership and Corp should be treated as a single business operation even though they were separate legal entities.

The IRS countered that because Partnership and Corp were separate legal entities, the Court should treat them as such and ignore their interdependent relationship when valuing them.

The Court found that Corp’s continued operation as a lumber mill company depended on Partnership’s continued ownership of timberlands, and there was no likelihood that Corp, as Partnership’s general partner, would direct Partnership to sell its timberlands while Corp continued operations as a mill. In addition, the two entities had almost identical ownership, and they shared administrative staff.

Expert’s report was consistent with the “single business” approach in that it ignored the intercompany debt between the two entities (and the free flow of cash between them as needed), because he regarded them as interdependent parts of a single enterprise, or as “simply two pockets of the same pair of pants.”

On the basis of these facts, the Court concluded that Partnership and Corp were so closely aligned and interdependent that, in valuing Partnership, it was appropriate to take into account its relationship with Corp and vice versa. Contrary to the IRS’s objection, the Court found that this approach did not ignore the status of the two as separate legal entities,[xxx] but recognized their economic relationship and its effect on their valuations.

The Court, therefore, concluded that an income-based approach was more appropriate for Partnership than was the IRS’s net asset value method valuation.[xxxi]

Thoughts on the “Single Business”

The Court accepted Expert’s analysis on most of the issues raised by the IRS with respect to the valuation of Corp and Partnership, including as to valuation approach, tax-affecting and discounting. Expert’s report was detailed and thorough, and was supported by empirical data, whereas the IRS failed to consider several items and, therefore, was unable to mount much of a challenge.

There is one point, however, that warrants a closer look: Parent’s and Expert’s argument – with which the Court agreed – that Partnership and Corp should be treated as a single business operation for valuation purposes, including for purposes of determining whether an income-based valuation method should be applied.

It is not uncommon for what may be thought of as single trades or businesses to be operated across multiple entities for various legal and economic reasons. For example, the real estate out of which a corporate business operates may be owned by a separate LLC; a business that has branches in different states, may have organized each branch as a separate corporation; a restaurant and its related catering business, that share centralized purchasing and accounting, may be formed as separate business entities.

Moreover, the Code provides a number of opportunities for the owners of separately organized businesses to combine or aggregate the separate entities for a specific tax purpose. For example, the regulations under Sec. 199A of the Code allow individuals to aggregate two or more qualified trades or businesses and to treat them as a single business for purposes of applying the “W-2 wage” and the “UBIA of qualified property” limitations, and potentially maximizing their Sec. 199A deduction;[xxxii] and Sec. 469 allows grouping of activities into a single activity for purposes of applying the material participation test, provided the activities form an “appropriate economic unit.”[xxxiii] In each of these examples, the degree of common ownership and control is considered, as are the interdependencies of the business activities.

But for estate tax purposes?

The only “estate tax aggregation” provision that immediately comes to mind is found in Sec. 6166 of the Code. Under this section, if the value of an interest in a closely held business that is included in a decedent’s gross estate exceeds 35-percent of the adjusted gross estate, the tax attributable to such interest may be paid in installments.[xxxiv] The term “interest in a closely held business” includes an interest as a partner in a partnership, and an interest in a corporation, carrying on a trade or business if 20-percent or more of the total capital interest in such partnership, or 20-percent or more in value of the voting stock of such corporation is included in determining the decedent’s gross estate. For purposes of applying the 35-percent test, interests in two or more closely held businesses, with respect to each of which there is included in determining the value of the decedent’s gross estate 20-percent or more of the total value of each such business, shall be treated as an interest in a single closely held business.[xxxv]

The decision discussed above, however, was not concerned with the proper application of a statutory or regulatory aggregation rule, but with a valuation principle that considered the economic reality of the business relationship between two related entities in determining their respective values. At least in concept, such a valuation addresses the facts as they are on the valuation date[xxxvi] – it is not required to “correct” the results of the relationship by reallocating payments or revising terms to reflect arm’s-length dealing.[xxxvii] Thus, a hypothetical buyer or seller of either Corp or Purchaser would have recognized the benefit of Corp’s position as a general partner of Partnership, as described above.

Would the result have been the same if Corp had not been the general partner of Partnership? Under different circumstances, would the IRS be justified in arguing for a greater value where the dealings between related entities resulted in favorable, below-market terms for the entity being valued? Or would such a position only be supportable where the entity favored has the ability to veto any change in the relationship; i.e., has the ability to prevent the substitution of arm’s-length terms?

Bottom line: if the values reported on a business owner’s gift or estate tax returns are to withstand IRS scrutiny, it is incumbent upon the business owner’s advisers to learn as much as they can about the intercompany dealings among the owner’s related business entities, and it is imperative that the transferor-owner provide their advisers and their appraiser[xxxviii] with as much information as possible regarding such dealings.

[i] Some are glad to have their golf-playing partners back in the office.

[ii] I only think such thoughts on February mornings, after I’ve removed the ice from the car and shoveled the driveway. I come to my senses when I’m back at my desk.

[iii] Currently set at $15,000 per individual recipient for a gift of a “present interest” in property. IRC Sec. 2503(b).

[iv] Currently set at $11.4 million per individual donor. IRC Sec. 2010.

[v] I.e., the larger exemption amount will not be available for gift transfers and testamentary transfers made after that date. IRC Sec. 2010(c)(3)(C). Query whether it will disappear even sooner if there is a change in Administration and in the Senate after the 2020 elections.

[vi] The transferred interests may be voting or non-voting interests.

[vii] Trusts for the benefit of one’s descendants may be a good option for creditor protection, if structured properly.

[viii] The grantor-parent would continue to pay the income tax on the trust’s income. IRC Sec. 671.

[ix] Grantor retained annuity trusts. IRC Sec. 2702. A good vehicle in a low interest rate environment.

[x] Such an agreement can help ensure that the business is operated smoothly and that it (or the value it represents) remains within the family; it may include transfer restrictions, special voting requirements, buy-sell arrangements (including the purchase of life insurance), drag-along rights for the parent-donor, etc.

[xi] Again, depending upon the 2020 election results.

[xii] The selection of the transfer vehicle will depend, in part, upon the owner’s desire to continue receiving cash-flow from the transferred interest.

[xiii] Est. of Aaron U. Jones v. Comm’r, T.C. Memo 2019-101.

[xiv] IRC Sec. 1361.

[xv] A not-uncommon practice in the case of related closely held businesses.

It is not clear whether promissory notes were issued to evidence this indebtedness.

[xvi] It is unclear whether Corp paid Partnership anything for this service or accommodation.

[xvii] According to an old Yiddish proverb, “Man plans, God laughs.”

[xviii] Basically, descendants. Probably a so-called “dynasty” trust.

[xix] On IRS Form 709.

[xx] IRC Sec. 6213.

[xxi] Reg. Sec. 25.2512-2(f)(2); Rev. Rul. 59-60.

[xxii] Reg. Sec. 25.2512-3(a).

[xxiii] Meaning that each had the ability to continue operating for the foreseeable future.

[xxiv] The parties did not dispute that Partnership was a going concern. Rather, they disagreed on whether it was an operating company that sold a product or a holding company that simply held its assets as an investment for its partners.

[xxv] In brief, taking the net cash flow or net operating income for a single year, then applying a capitalization rate (derived from market data); the method assumes that both these elements remain constant in perpetuity.

Any income-based approach is all about the time value of money.

[xxvi] Basically, the present value of future cash inflows and outflows over a period of time (which are projected, and account for expected changes), then applying a discount rate.

[xxvii] The parties also had several other points of dispute, including the propriety of “tax-affecting.”

The Court found that Expert more accurately took into account the tax consequences of Partnership’s flow-through status than did the IRS for purposes of estimating what a willing buyer and willing seller might conclude regarding its value. Expert’s adjustments included a reduction in the total tax burden by imputing the burden of the current tax that an owner might owe on the entity’s earnings and the benefit of a future dividend tax avoided that an owner might enjoy.

[xxviii] Its timber.

[xxix] In other words, their right to vote on the continuation of Partnership would not avail them in the face of Corp’s opposition and the requirement of a unanimous vote.

[xxx] Though, under these facts, any creditor of either entity would likely have had a good shot at reaching the assets of both entities.

[xxxi] The IRS also contended that Parent’s 35% discount for lack of marketability was excessive. The Court disagreed, pointing out that Expert’s report included a detailed appendix which explained the reasoning behind the discount for lack of marketability, including both empirical and theoretical models. Expert then discussed the effect that restrictions on transferability (like the ones in the buy-sell agreement) have on a discount, as well as the other factors considered by the courts in determining discounts. The IRS did not even consider the restrictions in the buy-sell agreement.

[xxxii] Reg. Sec. 1.199A-4.

[xxxiii] Reg. Sec. 1.469-4.

[xxxiv] Up to ten installment payments, beginning on the fifth anniversary of the original due date for payment of the tax.

[xxxv] IRC Sec. 6166(c).

[xxxvi] The date of the gift or the date of death, as the case may be.

[xxxvii] It is implied that such a situation would not arise in the case of unrelated persons, who are assumed to have acted at arm’s-length with one another.

[xxxviii] Perhaps with the latter having been retained by the adviser under a Kovel arrangement?

Education Equals Indebtedness?

We’re more than halfway through the month of August and many college students are returning to their campuses where they will resume their studies. It should be a time of great expectation for these students and for their families.[i]

Unfortunately, for all too many of these young adults, the prospect of expanding one’s mind, and of improving one’s chances for success in the “real world,”[ii] may be overshadowed by the likelihood of also increasing one’s indebtedness to the point where a preferred career path is supplanted by a better-paying (but less satisfying) job, or where one’s debt burden may foreclose other opportunities (like starting a business or purchasing a property).

According to an article in Forbes earlier this year,[iii] “There are more than 44 million borrowers who collectively owe $1.5 trillion in student loan debt in the U.S. alone. Student loan debt is now the second highest consumer debt category – behind only mortgage debt – and higher than both credit cards and auto loans.”

There is no hyperbole in stating that the issue of student debt has become one of the greatest challenges to our economy and society. As legislatures and academia argue over where to assign blame for this state of affairs, and as they debate –without progress – over possible solutions, many closely held businesses and their owners have already taken tangible steps toward alleviating the college debt burden for at least for some of their employees.

The vehicle that is often utilized for this job is the company foundation.[iv]

“Corporate Charity”

Many successful business owners attribute some part of their financial success to their community. The term “community” may have a different meaning from one business owner to another, but it usually includes the community in which the business operates and from which it draws its workforce, though it may also extend to those areas to which it sells its services or products, as well as those locales in which its vendors are located.

For some of these business owners, it is not enough to simply acknowledge a “debt” to their community; rather, they feel an obligation to share some of their financial success with the community. Some owners or businesses will make contributions to local charities,[v] schools, and hospitals. Others will provide grants to local residents who otherwise could not afford living or medical expenses. Still others will solicit the voluntary assistance of their workforce to support a local charity in a fundraising or public awareness event.

These endeavors are commendable, but they are of an ad hoc nature, which means they are also of limited duration. This is because such activities are not necessarily institutionalized and they are dependent, in no small part, upon the business owner, who is usually the catalyst for the charitable activities of the business.

Private Foundations

Recognizing these limitations, some business owners will establish a private foundation – typically, as a not-for-profit corporation (separate from the business),[vi] that may be named for the owner, the owner’s family, or the business – which they will fund with an initial contribution of cash or property, either personally or through the business. In later years, an owner may contribute additional amounts to the foundation, often culminating with a significant bequest to the foundation upon the death of the owner.[vii]

With this funding, the foundation – which consequently will not be financially dependent upon contributions from the general public (thus a “private” foundation, as distinguished from a “public” charity) – will have the wherewithal to conduct its charitable activities.

In most cases, the foundation’s activities will be limited to making grants of money to other not-for-profit organizations that are directly and actively engaged in charitable activities (i.e., not grant-making) – within and without the business’s community – and that have been recognized by the IRS as tax-exempt, publicly supported charities.[viii]

However, some company-sponsored foundations will also provide scholarships to fund the education of certain students.[ix] There is considerable flexibility in the design of such a scholarship program; for example, it may require that a student be enrolled at a particular school in order to qualify for a grant, or that they attend a school within a designated geographic area, or that they pursue a particular field of study.

In fact, the program may even be limited to students who are lineal descendants of employees of the business that organized the foundation, as was illustrated by a recent IRS private letter ruling[x] in which the IRS considered a private foundation’s request for approval of its employer-related scholarship program[xi] to fund the education of qualifying students.

Employer-Related Scholarships

Foundation’s general purpose was to make distributions for charitable and educational purposes within the meaning of Section 501(c)(3) of the Code.

However, Foundation also sought to operate an employer-related scholarship program (the “Program”), the purpose of which was to provide educational scholarships to the lineal descendants of employees of Business by selecting qualified individuals to receive grants to advance their education.

Eligible Recipients

“Lineal descendants” included, but were not limited to, children, step-children, adopted children and grandchildren of eligible employees of Business. An eligible employee was one who had completed one year of continuous full-time service with Business prior to the date the scholarship would be awarded. Eligibility was not based upon the employee’s position or title within Business, nor was it conditioned upon the employee’s continued employment with Business.

All students who had graduated from high school and planned to attend an accredited post-secondary educational institution were encouraged to apply for a scholarship. All students were considered regardless of their sex, race, age, color, national origin, religion, marital status, handicap, veteran status or parental status.

The post-secondary educational institution had to be accredited by a regional accreditation organization, or an equivalent, as determined by the Scholarship Committee.

The Committee and the Awards

The Scholarship Committee consisted of five community representatives who were separate and independent from Business.

The size of the scholarship award would be determined by the Scholarship Committee.

The number of scholarship awards would be dependent upon the number of students who were eligible or who applied for an award. In each year, the number of awards would not exceed the lesser of: (i) twenty-five percent of the number of students who were considered by the Scholarship Committee; or (ii) ten percent of the number of individuals who could be shown to be eligible for the awards. If more than one scholarship award was granted in a given year, each award would be in identical amounts.

In any year that the above percentages tests were not met, awards would not be granted, and the funds would accumulate for the following year.

Each award was granted for a one-year period, with possible renewals. Awards did not automatically renew. Students had to reapply every year. When reapplying, a student recipient in a prior year would be considered eligible even if the student’s “employee-sponsor” was no longer employed by Business.


Foundation’s Program was communicated through employees’ newsletters, mailings to employees’ homes, company bulletin boards, presentations at employees’ meetings, inserts in employees’ checks, news releases to the media, and any other reasonable form of communication.

In all communications, the scholarship was not to be portrayed as an independent incentive or recruitment device for prospective employees, or as additional employee compensation.


Selection of award recipients was based on financial need, scholarship, recommendations, test scores, class ranking, and extracurricular involvement.

The scholarship application requested the following items:

  1. A one-page essay detailing the applicant’s high school years (or if re-applying, post-secondary years) and activities, as well as plans for the future. The essay also included extra-curricular activities.
  2. Copy of the applicant’s most recent IRS Form 1040 (individual income tax return).
  3. Copy of the applicant’s college acceptance letter (graduating high school seniors).
  4. Copy of the applicant’s most recent high school or college grades, showing all years attended.
  5. Two letters of recommendation – one from a teacher and one from an individual who was not a teacher or a relative.

After the applications had been reviewed, the applicants were rated by the Scholarship Committee based on various factors, including academic performance, extracurricular and community activities, financial need, full-time status, personal interview, and an essay designed to show the applicant’s motivation, character, ability and potential.

Award recipients were required to provide the Scholarship Committee a progress report at the end of the first semester of the academic year, and at the end of the academic year. The progress report had to include a copy of the student’s transcripts for the academic year, and a letter summarizing the student’s progress and the importance of the award to the student’s academic progress.

Supporting Records

The Scholarship Committee maintained the following records for each scholarship grant awarded:

  1. Statement of the objective and non-discriminatory procedures used to select recipients;
  2. Adequate information regarding each applicant, including all information that the Scholarship Committee secured to evaluate the qualifications of the applicant;
  3. Identification of the applicant;
  4. Specification of the award amount and demonstration of the qualifying purposes for which the award was used (qualified tuition and related expenses);[xii]
  5. Verification of the appropriate publication of the scholarship award program and results; and
  6. Information which the Scholarship Committee obtained regarding follow-up investigation, including follow-up reports required from all recipients.


Scholarship funds would be disbursed to the educational institution which the award recipient was attending, rather than to the student.

The Scholarship Committee would investigate any misuse of funds and withhold further payments, to the extent possible, if the Scholarship Committee did not receive a required report, or if reports or other information indicated that grant proceeds were not being used for the purpose for which the grants were made. The Scholarship Committee would take all reasonable and necessary steps to recover grant funds, or to ensure restoration of the funds and their dedication to the purposes the grant funds were financing.

Taxable Expenditures

Sounds challenging, doesn’t it? In fact, it is. That’s because the Code makes it difficult for a private foundation to simply write a check to a private individual, as opposed to making an unrestricted grant to a recognized public charity.[xiii]

Private foundations are not dependent upon the public for financial support and, so, are not to “answerable” to the public, at least in theory. For that reason, the Code provides a number of restrictions upon the use of foundation funds.[xiv] These restrictions seek to discourage, and hopefully prevent, certain activities by a private foundation that the IRS deems to be contrary to, or inconsistent with, the charitable nature, and tax-exempt status, of the foundation.

The IRS enforces these restrictions through the imposition of special excise taxes (i.e., penalties) upon the foundation, the foundation’s managers (e.g., its board of directors), and so-called disqualified persons (i.e., persons who are considered to be “insiders” with respect to the foundation).

Among the activities that the Code seeks to discourage is a foundation’s expenditure of funds for a proscribed purpose (a “taxable expenditure”); for example, a grant to a non-charitable organization or for a non-charitable purpose. The Code imposes a twenty percent excise tax on the taxable expenditures of a private foundation.[xv]

Grants to Individuals

A taxable expenditure also occurs when a private foundation pays a grant to an individual for travel, study, or other similar purposes.

However, a grant that meets all of the following requirements is not treated as a taxable expenditure:[xvi]

  • The grant is awarded on an objective and nondiscriminatory basis.
  • The IRS approves in advance the procedure for awarding the grant.
  • The grant is a scholarship or fellowship subject to Section 117(a) of the Code.[xvii]
  • The grant is to be used for study at a qualified educational organization.


Long ago, the IRS provided guidelines[xviii] to determine whether the grants made by a private foundation under an employer-related program to employees, or children of employees, were scholarship or fellowship grants subject to the provisions of Sec. 117(a) of the Code. If the program satisfied the seven conditions set forth in these guidelines,[xix] and also met the applicable “percentage tests” described in the guidelines, the IRS would assume the grants were subject to the provisions of Sec. 117(a) and, therefore, were not taxable expenditures.

These percentage tests require that:

  • The number of grants awarded to employees’ children in any year won’t exceed 25 percent of the number of employees’ children who were eligible for grants, were applicants for grants, and were considered by the selection committee for grants, or
  • The number of grants awarded to employees’ children in any year won’t exceed 10 percent of the number of employees’ children who were eligible for grants (whether or not they submitted an application), or
  • The number of grants awarded to employees in any year won’t exceed 10 percent of the number of employees who were eligible for grants, were applicants for grants, and were considered by the selection committee for grants.

In determining how many employees’ children are eligible for a scholarship under the 10 percent test, a private foundation may include as eligible only those children who submit a written statement or who meet the foundation’s eligibility requirements.[xx] They must also satisfy certain enrollment conditions.[xxi]

The IRS’s Ruling

Foundation represented that its procedures for awarding grants under the Program satisfied the seven conditions set forth in the guidelines:

  • An independent selection committee, whose members were separate from Foundation, its creator, and the employer, would select individual grant recipients.
  • Foundation would not use grants to recruit employees, nor would it end a grant if the employee left the employer.
  • Foundation would not limit the recipient to a course of study that would particularly benefit Foundation or the employer.
  • Foundation would not award grants to its creators, officers, directors, trustees, foundation managers, or members of selection committees or their relatives.[xxii]
  • All funds distributed to individuals would be made on a charitable basis and further Foundation’s charitable purposes.
  • Foundation would not award grants for a non-charitable purpose.
  • Foundation would keep adequate records and case histories so that it could substantiate its grant distributions with the IRS if necessary.

On the basis of the foregoing, the IRS approved Foundation’s procedures for awarding employer-related scholarships to qualifying lineal descendants of Business’s employees. As a result, the expenditures to be made by Foundation under those procedures would not be subject to the excise tax.

The IRS also ruled that the awards made under those procedures were scholarship grants and, so, were not taxable as income to the recipients if used by them for qualified tuition and related expenses.

It’s Worth the Effort

A company-sponsored grant-making foundation is an effective, and tax-advantaged, tool that may be used by a closely held business to support, or engage in, charitable activities within its community.

With appropriate safeguards, like those described above, such a foundation may expand its charitable reach – and its impact on people’s lives – by also granting scholarships for education to qualifying members of its workforce and their families.

However, if a company’s foundation disregards these safeguards as too burdensome, the foundation’s grants will essentially be treated as extra pay, an employment incentive, or an employee fringe benefit, which will be taxable to the employee.[xxiii]  What’s more, a compensatory scholarship program will cause the foundation to lose its tax exempt status because it is being operated for the private benefit of the employer-company.

The main purpose for the scholarships awarded by a private foundation to a company’s employees must be to further the recipients’ education rather than to compensate company employees. The incidental goodwill and employee loyalty generated for the business should not be underestimated.

[i] I have to confess, the sight of school buses in early September still makes me anxious.

[ii] According to the World Bank, workers with more education earn higher wages than employees with no post-secondary education. Those with only a high school degree are twice as susceptible to unemployment than workers with a bachelor’s degree.


[iv] IRC Sec. 509(a).

[v] The word “charity” is interpreted very broadly under the Code.

[vi] Though a charitable trust may also be used. For example, see Article 8 of N.Y.’s EPTL. I prefer a not-for-profit corporation.

[vii] Either directly or through a split-interest trust.

[viii] IRC Sec. 501(a), Sec. 501(c)(3), and Sec. 509(a).

[ix] Several of our clients have done so.

[x] PLR 201932018 (Release Date: 8/9/2019). It should be noted that the IRS issues many such rulings, which means that many businesses are sponsoring such programs. Please also note that such rulings may not be cited as precedent, though they do give us an indication of the IRS’s position on a given issue.

[xi] Under IRC Sec. 4945(g).

[xii] See IRC Sec. 117.

[xiii] Note that more and more private foundations are restricting the purposes for which a public charity may use the foundation’s grant. A foundation will often identify the specific purpose that the grant seeks to accomplish, and it will hold the recipient public charity accountable for the use of the grant monies; for example, the foundation may require periodic progress reports from the public charity, or it may condition future grants on the charity’s “performance” under the restricted grant.

[xiv] The price for their tax-exempt status.

[xv] A tax equal to 20 percent of the amount of the expenditure, which is payable by the foundation. Other taxes may be paid by foundation managers. IRC Sec. 4945(a).

[xvi] IRC Sec. 4945(g). See also IRS Form 1023, Schedule H, Organizations Providing Scholarships, Fellowships, Educational Loans, or Other Educational Grants to Individuals and Private Foundations Requesting Advance Approval of Individual Grant Procedures.

[xvii] IRC Sec. 117(a) provides that gross income does not include any amount received as a qualified scholarship by an individual who is a candidate for a degree at an educational organization described in section 170(b)(1)(A)(ii).The term qualified scholarship means any amount received by an individual as a scholarship or fellowship grant to the extent the individual establishes that, in accordance with the conditions of the grant, such amount was used for tuition and fees required for the enrollment or attendance of a student at an educational organization described in section 170(b)(1)(A)(ii), and fees, books, supplies, and equipment required for courses of instruction at such an educational organization.

[xviii] Revenue Procedure 76-47.

[xix] See below.

[xx] Revenue Procedure 85-51.

[xxi] They are enrolled in or have completed a course of study preparing them for admission to an educational institution at the level for which the scholarships are available, have applied or intend to apply to such an institutions, and expect, if accepted, to attend such an educational institution in the immediately succeeding academic year; or they currently attend an educational institution for which the scholarships are available but are not in the final year for which an award may be made.

[xxii] Basically, insiders. Self-dealing under IRC Sec. 4941?

[xxiii] They may even be treated as a gift by the employee to the recipient.

Choice of Entity

The owners of a closely held business are generally free to select the form of business entity through which they will operate their business. In most cases, hopefully, the decision to operate as a sole proprietorship,[i] a partnership, an S corporation, or a C corporation will have been preceded by discussions between the owner(s) and their tax adviser during which they considered, among other things,[ii] protection from personal liability for the debts of the business, the economic arrangement among the owners,[iii] and the income tax and employment tax consequences of operating through one form of business entity versus another, including the withdrawal of value from the business.[iv]

Once the owners have sifted through these and other factors, and have decided upon a particular form of entity, it is imperative that they respect the entity as a separate person, and that they not treat it as an extension of themselves.[v] Only in this way can they be certain of the “limited liability” shield afforded by the entity; if they regularly disregard the entity, so may a creditor of the business.[vi]

In addition, by transacting with the entity at arm’s length – as one would do with any unrelated person – the owners may avoid certain unpleasant tax consequences, including “constructive dividends,” which are likely to become more common as a result of the 2017 tax legislation.[vii]

The Revival of Close “C’s”

Following the Act’s substantial reduction in the federal corporate income tax rate,[viii] the owners of many closely held businesses – who would otherwise have probably chosen a pass-through entity in which to “house” their business – have expressed an interest in the use of C corporations.

Some of these owners may choose to form such a corporation to begin a new business, or in connection with the incorporation of an existing sole proprietorship or partnership.

Others may decide to “check-the-box” to treat a sole proprietorship or partnership as an association taxable as a corporation.[ix]

Those owners who are shareholders of an S corporation may decide to revoke the corporation’s S election, or to cause the corporation to cease being a “small business corporation.”[x]

In any case, these owners will have to be reminded that the profits of a C corporation are subject to income tax at two levels: once when included in the income of the corporation, and again when distributed by the corporation to its shareholders.

With respect to this second level of tax, the owners of a closely held C corporation will have to be mindful of the separate legal status of the corporation, lest they transact with the corporation in such a way as to inadvertently cause a constructive distribution by the corporation that is treated as a taxable dividend to its owners.

Close Scrutiny

It is axiomatic that interactions between a closely held business – including a C corporation – and its owners will generally be subject to heightened scrutiny by the IRS, and that the labels attached to such interactions by the parties will have limited significance unless they are supported by objective evidence.

Thus, arrangements that purport to provide for the payment of compensation, rent, interest, etc., to a shareholder – and which are generally deductible by a corporation – may be examined by the IRS, and possibly re-characterized so as to comport with what would have occurred in an arm’s-length setting.

This may result in the IRS’s treating a portion of such a payment as a dividend distribution to the shareholder, and in the partial disallowance of the corporation’s deduction.

Constructive Dividends

According to the Code, a dividend is any distribution of property that a corporation makes to its shareholders out of its accumulated or current earnings and profits.[xi] “Property” includes money and other property;[xii] under some circumstances, the courts have held that it also includes the provision of services by a corporation to its shareholders.[xiii]

A “constructive” dividend typically arises where a corporation confers an economic benefit on a shareholder without the expectation of repayment, even though neither the corporation nor the shareholder intended a dividend. However, not every corporate expenditure that incidentally confers economic benefit on a shareholder is a constructive dividend.

Where a corporation constructively distributes property to a shareholder, the constructive dividend received by the shareholder is ordinarily measured by the fair market value of the benefit conferred.[xiv]

The issue addressed in a recent Tax Court decision[xv] was whether Taxpayer had received constructive dividends from Corporation.

Taxpayer’s Strategy

Taxpayer was a performer. During the years at issue, he had various engagements. Compensation for these performances was generally made by checks payable to Corporation, not to Taxpayer individually.

This arrangement was based on the concept that Taxpayer could shift their business income to a business entity (i.e., Corporation), which would then use the funds to pay Taxpayer’s personal expenses, and claim a deduction for these expenditures.

In furtherance of this “strategy,” Taxpayer organized Corporation. Taxpayer was Corporation’s sole stockholder, president, chief executive officer, chief financial officer, sole director, and treasurer.[xvi]

During the years at issue, in accordance with this plan, the fees paid for Taxpayer’s various engagements were generally made payable to an account at Bank under the Corporation’s name.[xvii] Taxpayer was the only individual with signature authority over this account. Taxpayer was also an authorized user of Corporation’s credit card account.

Also during these years, Taxpayer paid various expenses using the credit card and the funds deposited into the account at Bank. These expenses included airfare, payments to grocery stores, restaurants, and other miscellaneous expenses.[xviii]

Taxpayer filed personal income tax returns for the years at issue,[xix] on which were reported their wages from Corporation.

Corporation also filed tax returns for those years[xx], reporting gross profits, as well as expenses for wages, taxes, advertising, employee benefits, travel, and other items.

The IRS Challenge

The IRS selected Taxpayer’s and Corporation’s returns for examination. The IRS issued a notice of deficiency by which it adjusted Corporation’s taxable income by disallowing, for lack of substantiation, most of the claimed deductions and by adjusting upward its gross profits.

In a separate notice of deficiency, the IRS determined that Taxpayer had failed to report constructive dividends attributable to personal expenses that Corporation had paid on their behalf.

In fact, for all the years at issue, the IRS counted as constructive dividends those expenses that Corporation had reported, and that the IRS had disallowed, as deductions. The IRS also counted as constructive dividends the payments that Corporation had made on its credit card account.

Taxpayer petitioned the U.S. Tax Court for a redetermination of the asserted tax deficiency.

The Court’s Analysis

The Court began by noting that the IRS’s determination of constructive dividends was a determination of unreported income. It explained that the Court of Appeals for the Ninth Circuit, to which any appeal from its decision would lie,[xxi] required that the IRS establish “some evidentiary foundation” linking a taxpayer to an alleged income-producing activity. Once such a foundation has been established, the Court continued, the burden of proof would shift to the taxpayer to prove by a preponderance of the evidence that the IRS’s determinations were arbitrary or erroneous.

The Court found that the IRS had established a sufficient evidentiary foundation to satisfy any threshold burden. The evidence showed that Taxpayer owned 100-percent of Corporation and maintained authority over its checking and credit card accounts. Taxpayer was integrally linked to – apparently the only source of – the Corporation’s income-producing activity. The record showed that the IRS’s determination was based on an extensive review of both Taxpayer’s and Corporation’s activities, bank accounts, and other financial accounts. The IRS introduced evidence to show that Corporation made significant expenditures primarily for Taxpayer’s benefit.

The Court then turned to the substantive issue of whether a dividend had been paid.


In general, Sections 301 and 316 of the Code govern the characterization, for Federal income tax purposes, of corporate distributions of property to shareholders. If the distributing corporation has sufficient earnings and profits (“E&P”), the distribution is a dividend that the shareholder must include in gross income.[xxii] If the distribution exceeds the corporation’s E&P, the excess generally represents a nontaxable return of capital to the extent of the shareholder’s basis in the corporation’s stock, and any remaining amount is taxable to the shareholder as a gain from the sale or exchange of property.[xxiii]


According to the Court, it was Taxpayer’s burden to prove that Corporation lacked sufficient E&P to support dividend treatment at the shareholder level. The Court stated that, if neither party presented evidence as to the distributing corporation’s E&P, the taxpayer has not met their burden of proof. Because Taxpayer produced no evidence concerning Corporation’s E&P during the years at issue, Taxpayer failed to meet the burden of proving that there were insufficient E&P to support the IRS’s determinations of constructive dividends to Taxpayer. Therefore, the Court deemed Corporation to have had sufficient E&P in each year to support dividend treatment.


The Court then explained that characterization of a distribution as a dividend does not depend upon a formal dividend declaration.[xxiv] Dividends may be formally declared or constructive.

According to the Court, a constructive dividend is an economic benefit conferred upon a shareholder by a corporation without an expectation of repayment. Thus, if corporate funds are diverted by a controlling shareholder to personal use, they are generally characterized for tax purposes as constructive distributions to the shareholder.[xxv]

Such a diversion may occur, for example, where a controlling shareholder causes a corporation to pay the shareholder’s personal expenses; the payment results in an economic benefit to the shareholder but serves no legitimate corporate purpose.

A “distribution” does not escape taxation as a dividend simply because the shareholder did not personally receive the property. Rather, according to the Court, “it is the power to dispose of income and the exercise of that power that determines whether * * * [a dividend] has been received.” Whether corporate expenditures were disguised dividends presents a question of fact.

The Court then described the two-part test enunciated by the Ninth Circuit for determining constructive dividends: “Corporate expenditures constitute constructive dividends only if 1) the expenditures do not give rise to a deduction on behalf of the corporation, and 2) the expenditures create ‘economic gain, benefit, or income to the owner-taxpayer.’”

Taxpayer’s Situation

For all of the years at issue, the IRS determined the amount of constructive dividends on the basis of Corporation’s disallowed claimed deductions and also on the basis of additional charges made on the corporate credit card. Taxpayer claimed that many of these expenditures and charges represented legitimate business expenses of Corporation, but failed to offer into evidence any materials that were linked in any meaningful way to the IRS’s adjustments. Moreover, the Court did not find Taxpayer’s testimony credible or adequate to show that any particular item represented an ordinary and necessary business expense[xxvi] of Corporation.

In sum, Taxpayer’s documentation, in which personal living expenses were not clearly distinguished from legitimate business expenses, provided the Court with no reasonable means of estimating or determining which, if any, of the expenditures in question were incurred as ordinary and necessary business expenses of Corporation.

Because Taxpayer failed to show that the expenditures in question properly gave rise to deductions on behalf of Corporation, the remaining question was whether these expenditures created “economic gain, benefit, or income to the owner-taxpayer.”

The expenditures in question showed a pattern of payment of personal expenses. This pattern, the Court observed, was consistent with Taxpayer’s tax-avoidance strategy to have Corporation deduct Taxpayer’s personal living expenses as business expenses.

Indeed, Taxpayer did not identify any category of challenged corporate expenses that did not benefit him personally.

With that, the Court sustained the IRS’s determination that Taxpayer received and failed to report constructive dividends. Thus, Corporation’s taxable income was increased because of the disallowed deductions, and Taxpayer’s taxable income was increased by the dividend deemed to have been made.


The Court’s decision was hardly a nail-biter.[xxvii]

Notwithstanding that the outcome was a foregone conclusion, the case is instructive for both individual taxpayers[xxviii] and their advisers.

Although it illustrates but one application of the constructive dividend concept, it hints at the number of scenarios in which a careless shareholder of a closely held C corporation with E&P[xxix] may be charged with having received a taxable distribution.

It also raises some interesting questions that do not appear to have been before the Court, but of which a closely held business should be aware.

Constructive Dividend Scenarios – Third Parties

The Court’s decision found a distribution to Taxpayer though the transfers by Corporation were to someone other than Taxpayer – the transfers were made to third parties for Taxpayer’s benefit.[xxx]

Moreover, there was no expectation that Taxpayer would reimburse Corporation for its expenditures. In other words, there was no indication that the events, taken as a whole, constituted a loan from Corporation to Taxpayer.[xxxi]

Corporation could have tried to characterize most of its expenditures to or on behalf of Taxpayer as compensation paid to Taxpayer; after all, Corporation’s income was attributable entirely to Taxpayer’s performances. Provided the aggregate amount of compensation was reasonable, Corporation would have been entitled to a deduction therefor.

In fact, the IRS could have taken the same approach, though this would have supported a larger deduction for Corporation.

It should be noted that a constructive dividend could also have been found if the corporation, instead of satisfying the shareholder’s expenses or liabilities, had made a payment to or behalf of a member of the shareholder’s family. In that case, the shareholder would be treated as having made a gift to their family member following the deemed distribution.[xxxii]

Constructive Dividend Scenarios – The Shareholder

In addition to transactions between the corporation and third parties, a constructive dividend may also be found in direct dealings between the corporation and the shareholder.

For example, a purported loan by a corporation to a shareholder may be recharacterized, in whole or in part, depending upon the facts and circumstances, as a dividend distribution.[xxxiii]

Similarly, a bargain sale by a corporation to a shareholder – one in which the consideration paid by the shareholder in exchange for corporate property is less than the fair market value of the property – may be treated as a dividend to the extent of the bargain element.[xxxiv]

Indeed, any scenario in which the corporation and the shareholder are dealing with one another at other than arm’s length raises the possibility of a deemed distribution.

For example, a shareholder’s rent-free use of corporate-owned property may constitute a dividend distribution[xxxv] in an amount equal to the fair market rental rate.[xxxvi]

Conversely, a corporation’s payment of excessive rent for the use of a shareholder’s separately owned property, or excessive compensation for their services, may be treated as a dividend to the extent it exceeds a fair market rental rate or reasonable compensation.[xxxvii]

At this point, it should also be noted – despite the result reached in the Court’s decision, above – that there is no necessary correlation between a corporation’s right to a deduction for a payment and the tax treatment of the payment to a shareholder, say, as an employee. In other words, the fact that a deduction for compensation was reduced to the extent it was unreasonable, does not “entitle” a shareholder-employee to dividend treatment as to the disallowed amount.[xxxviii]

Other Potential Arguments

At some point during the discussion of the Court’s decision, above, did you wonder why the IRS seemed to have respected Corporation as a bona fide business entity? After all, it was Taxpayer’s strategy to use Corporation to receive the income that Taxpayer earned, to cause Corporation to pay Taxpayer’s personal expenses using such income, and then for Corporation to claim business deductions for such payments (as far-fetched as that seems), thereby resulting in Taxpayer’s only being taxed on the wages paid by Corporation.

In fact, according to a footnote in the Court’s opinion[xxxix], the IRS had previously asserted that Taxpayer had failed to report “certain gross receipts” as a sole proprietor, on Schedule C, Profit or Loss from Business, but dropped it as “duplicative of the constructive dividend determination.”

In order for the IRS to have raised this argument, it must have concluded that Corporation was a sham for tax purposes, that it lacked a business purpose. It’s also possible that the IRS decided, under “assignment of income” principles, that Corporation’s income should have been reallocated to Taxpayer as the “true earner” of such income.

Why, then, would the IRS have dropped this alternative argument?

The case most cited for the treatment of corporations as entities separate from their owners for tax purposes is Moline Properties.[xl] It stands for the proposition that a corporation created for a business purpose or carrying on a business activity will be respected as an entity separate from its owner for federal tax purposes. Although the Supreme Court did not indicate the degree of corporate activity that was necessary in order for the corporation to be respected, subsequent decisions have not set a very high threshold.

It is likely for this reason, plus the fact that recharacterization of the corporation’s payments as dividends, rather than as deductible expenditures, resulted in double taxation of Corporation’s profits, that the IRS decided not to pursue its alternative position.

Last Word

If the owners of a business decide to operate the business through a separate entity – whether it is a corporation or a partnership/LLC – they must treat with the entity as they would with an unrelated person. By respecting the entity’s separate existence, they may maximize the legal and economic benefits of their choice, and avoid unexpected, and costly, tax consequences.

[i] A single-member LLC; one that is disregarded for tax purposes. Reg. Sec. 301.7701-3.

[ii] For example, the pass-through of losses generated by the business, the ability to distribute to the owners the proceeds from a borrowing, the ability to raise capital, etc.

[iii] In other words, how they intend to share profits. For example, will certain owners be entitled to a preferred return on their capital?

[iv] Of course, they will have also discussed whether the taxpayer-owner(s) were even qualified to utilize a particular form. For example, the owners may not all qualify to hold shares of stock in an S corporation, or their economic arrangement may be such that it would fail the single class of stock requirement for S corporation status.

[v] Their alter ego.

[vi] “Piercing,” basically.

[vii] The Tax Cuts and Jobs Act (P.L. 115-97); the “Act.”

[viii] From a maximum graduated rate of 35-percent to a flat rate of 21-percent, effective for tax years beginning after December 31, 2017.

[ix] Reg. Sec. 301.7701-3.

[x] IRC Sec. 1361 and Sec. 1362.

[xi] IRC Sec. 312 and Sec. 316.

[xii] IRC Sec. 317.


[xiv] Where the fair market value cannot be reliably ascertained, or where there is evidence that fair market value is an inappropriate measurement, the constructive dividend can be measured by the cost to the corporation of the benefit conferred.

[xv] Patrick Combs v. Commissioner, T.C. Memo 2019-96.

[xvi] Taxpayer’s spouse acted as secretary.

[xvii] The opinion does not state that Taxpayer was employed by Corporation, though Corporation did pay wages. In addition, the opinion is silent as to whether clients retained Corporation, which then provided the contracted-for services through its employee, Taxpayer.

[xviii] Rental was not separately identified as an expense.

[xix] IRS Form 1040.

[xx] IRS Form 1120.

[xxi] See IRC Sec. 7482(b)(1)(A).

[xxii] IRC Secs. 301(c)(1), 316.

[xxiii] IRC Sec. 301(c)(2) and (3).

[xxiv] For example, see N.Y.’s BCL Sec. 510.

[xxv] A variation on the “substance over form” doctrine.

[xxvi] IRC Sec. 162.

[xxvii] Go figure why Taxpayer pursued it as far as they did.

[xxviii] We are not addressing situations involving shareholders that are themselves corporations; among other considerations, these may trigger application of the dividends received deduction. IRC Sec. 243.

[xxix] And in some cases, an S corporation with E&P. This would occur where the S corporation was previously a C corporation, or where the S corporation acquired a C corporation in a tax-free reorganization.

[xxx] It should be noted that the “personal” expenditures need not have been for living expenses or personal debts. For example, if the corporation had made a charitable contribution to a qualifying organization for which a shareholder claimed a deduction, the shareholder would be treated as having received a dividend distribution, the amount of which it then transferred to the charity.

[xxxi] For example, the expenditures were not recorded as loans, nor did Taxpayer give Corporation a promissory note.

[xxxii] See, for example, Reg. Sec. 1.351-1(b)(1).

[xxxiii] Likewise, the forgiveness of an actual loan may be treated as a dividend.

[xxxiv] The value of the corporation is reduced by the amount of the bargain element.

[xxxv] That being said, the incidental or insignificant use of corporate property may not justify a finding of a constructive dividend.

[xxxvi] See IRC Sec. 7872 with respect to loans by a corporation to a shareholder that bear a below-market rate of interest.

[xxxvii] However, query whether the IRS would make this argument; after all, the rate applicable to qualified dividends[xxxvii] is lower than the ordinary income rate applicable to rent. IRC Sec. 1(h)(11).

[xxxviii] The employee would still be treated as having received compensation taxable as ordinary income (a maximum federal rate of 37-percent), rather than a dividend taxable at 20-percent.

[xxxix] Footnote 3.

[xl] 63 S.Ct. 1132 (1943).

A Penny Saved?

As a novice tax adviser, you learn certain basic principles by which to live your professional life. Among these are the following: read, then keep on reading; try to always get two bites at the apple; and don’t allow yourself to be surprised. With experience, you come to understand and to appreciate these guidelines, and you learn how to implement them in your practice.

Eventually, you realize that while the first two are largely within your control, the third is more difficult to secure, in no small part thanks to your client.

I am not implying that clients do not always provide their advisers with the relevant information[i] – it is up to the adviser to pose the appropriate question that will elicit that information.

Inspector Clouseau: “Does your dog bite?”

Hotel Clerk: “No.”

Clouseau: [bending over to pet the dog] “Nice doggie.”

[Dog bites Clouseau’s hand]

Clouseau: “I thought you said your dog did not bite!”

Hotel Clerk: “That is not my dog.”[ii]

I am saying that clients can be very cost conscious[iii] – especially in the case of the closely held business – perhaps irrationally so where professional fees are concerned, such that these clients will often fail to consult their professionals until some loss has already been incurred, or until a “transaction train” has already left the proverbial station.

At that point, the adviser may find themselves playing catchup. What’s more, they are in reactive (and sometimes damage-control) mode, rather than in planning mode.


Although I understand the owner’s motivation, there comes a time when the concern over professional fees may cost the owner far, far more. In particular, I am thinking about the sale of the business, and the owner’s not infrequent failure to engage their tax adviser at the very beginning of the sale process, even before they embark on shopping the business and negotiating the terms of its sale. And this is where the surprise is sprung on the tax adviser.

Client: “Good morning, Lou.”

Adviser: “Good morning, Bob. Been a while. How’s everything?”

Client: “I have some great news to share with you.”

Adviser: “I could use some good news. What’s up?”

Client: “I’m selling my business.”

Adviser: “Ah, so you’ve finally decided to sell. Good for you, though I wonder what you’ll do with your free time – I pray you don’t turn into a golfer.

We should get together with your accountant to talk about various deal structures, and how much you would net on an after-tax basis under each. As I recall, you’re operating through an S corporation,[iv] right?

Do you have an idea of what you’re looking for, in terms of a dollar figure, in order to make this happen?”[v]

Client: “I already have a buyer.”

Adviser: “Really? Wow, OK. What kind of discussions have you had? Is there a nondisclosure in place?”

Client: “We’ve signed a letter of intent.”

Adviser: “Come again, please.”

Client: “There’s a signed LOI. I’ll send you a copy.”[vi]

Adviser: “When did this happen?”

Client: “About three days ago. The buyer is a PE firm. They’ve already acquired a couple of my competitors, and I don’t want to miss out. We’re scheduled to close in two months. [Long silence] Lou? Are you there? You OK? Hello-o! Lou?”

Adviser: “I’m still here. Two months, huh?

Are you selling your stock or is the corporation selling its assets?

“What’s the purchase price, and how is it being paid? Cash at closing, any promissory note or earnout?

Are they expecting a rollover of any equity?

Do they expect you to stay on?

What about the real property? As I recall, the property is in a separate LLC that you own with a trust for the kids, right?”

Client: “Slow down, and don’t sound so miffed.[vii]

Yes, the buyer wants me to invest 10-percent of my equity – it’ll give me a chance to participate in the growth of the business after the sale, including that of any other businesses that may be acquired. A second bite at the apple, you might say.

I’m selling assets. The buyer mentioned that it was important that they have a step-up in basis for the assets.”

Adviser: “You mean your corporation is selling its assets.

Yes, the step-up enables the buyer to recover their purchase price through amortization, depreciation, and immediate expensing, which makes the deal less expensive for them, but generally more expensive for you.

Was there any discussion of a stock sale? What about a gross-up of the purchase price to account for any ordinary income?

Was there any discussion about your rollover being on a tax-deferred basis? What does the LOI say?”

Client: “A gross-up? No. As for taxes on the rollover, no, I don’t think it’s addressed, but why would there be any? You’ll see when I send you the LOI.

“Listen, I want this deal. I’m not getting any younger. I’m still healthy. I’ve got no one to take over the business.”

Adviser: “I hear you. When can we expect to see a draft of the asset purchase agreement?”

Client: “I think they said next week.”

Taxable Rollover?

Next week arrives, as does the draft APA. Pretty standard, thankfully. Cash plus an interest-bearing term note; unfortunately, the note will trigger the interest charge for large installment obligations.[viii] Interestingly, the buyer is a C corporation, and the APA makes no mention of a rollover, notwithstanding that it is referenced in the LOI, albeit in little detail.

Adviser contacts the buyer’s counsel (“BC”) regarding the rollover.

BC: “We never represented to your client that the rollover would be tax-deferred. We did explain that we wanted a basis step-up for the assets being acquired.

We expect your client to reinvest some of the cash received for the assets.”

Adviser: “In other words, no tax deferral. Obviously, Client did not fully appreciate that when the LOI was executed.

Tell me, is there a parent or holding company that owns the acquiring corporation? If so, how is it treated for tax purposes? As a corporation or as a partnership?”

Adviser learns that there is no holding company in place, and there are no plans for establishing such a holding company for the immediate future; thus, the rollover will have to be into the same corporation that is purchasing Client’s “corporate assets.”

Client: “What do you mean there’s no way for me to have a tax-free rollover? Why would I roll over any part of my business and take back a minority interest if I couldn’t do it on a tax-free basis?”

Adviser: “Let me explain again. First of all, your S corporation is the seller here, not you. What’s more, if anyone is going to make a tax-deferred rollover here, it is the S corporation – it owns the assets being transferred, and it is receiving the consideration from the buyer. Not you.[ix]

When one or more persons transfer property to a corporation in exchange for stock in the acquiring corporation, the exchange will be treated as a taxable event for the transferors unless they are in control of the corporation immediately after the exchange, or unless the exchange qualifies as a reorganization, which yours doesn’t do.[x]

“By ‘control’ I mean the transferors, as a group, own stock that represents at least 80-percent of the total voting power of all classes of voting stock of the corporation and at least 80-percent of the total number of all other classes of stock.[xi]

“Your S corporation’s interest in the acquiring corporation won’t be anywhere near that figure after the exchange.”

Client: “You said ‘persons,’ plural. What if others joined me in contributing property?”

Adviser: “If those who currently own all of the stock of the acquiring corporation – i.e., the vehicle through which the PE firm’s investors own their equity in the corporation, plus the former owners of the target companies already acquired by the buyer – if these shareholders were to contribute their stock to a new holding corporation,[xii] in exchange for stock in the holding corporation, and if your S corporation were to contribute some of its assets (the rollover portion) to this holding corporation solely for stock, then the transferors as a group would be in control, and their respective exchanges would be accorded tax-deferred treatment.”

Client: “Can’t we ask them to do that?”

Adviser: “I already did, when I spoke to BC, but the buyer isn’t willing to accommodate your deal – they said it isn’t large enough.”

Client: “What about a gross-up? Can they pay me more cash to cover the tax on the rollover?”

Adviser: “We’ve been through this. We were fortunate that they agreed to cover the spread between capital gain and ordinary income on the depreciation recapture.[xiii] They will move only so far beyond the terms of the LOI. They also want to wrap this up because they have another, larger deal in the wings.”

Client: “So I ask you again, should I do this deal?”

Adviser: “Again? You never asked me, remember? You agreed to terms without speaking to me. Besides, that’s your call, not mine.
“From a tax perspective, you will already be reporting 90-percent of the gain, part of it on the installment basis.

“You would take the acquiring corporation’s stock with a basis equal to its fair market value, which means less gain on any subsequent disposition of that stock.[xiv]

“I will also remind you that this equity affords you that ‘second bite at the apple’ you mentioned, though as a minority shareholder who has no ability to compel or influence decisions or policy, including distributions or a sale.

“If your S corporation adopts a plan of liquidation, and completes it within a twelve-month period, the note may be distributed to you, individually, without accelerating the gain inherent in the note.[xv] In this way, you’ll receive the cash, the note and the stock, and you will have eliminated the S corporation.

“Let me end with this: if you try to back out now, you’re inviting a lawsuit. They’ll come after you for all the costs they’ve incurred.”

How Bad Is It?

Client’s S corporation, in the above dialogue, will recognize all of the gain realized on the transfer of its assets to the acquiring corporation – that includes the gain attributable to the receipt of stock in the acquiring corporation, as well as the gain attributable to the cash received at closing; the gain associated with the note will be recognized as principal payments are made on the note.[xvi]

Client will have to report on its tax return the gain arising from the S corporation’s receipt of stock in the acquiring corporation.[xvii] Client will pay the resulting tax on such gain using the net cash proceeds from the asset sale; meaning from the proceeds remaining after all transaction expenses[xviii] have been paid, and after any corporate-level taxes have been satisfied; for example, transfer taxes and sale taxes on the sale of certain assets, as well as income taxes where the corporation is subject to the built-in gain tax.[xix] The S corporation will have to distribute these proceeds to Client, whether in liquidation or otherwise.

Query how much cash will be left in the hands of Client after all is said and done? Stated differently, how secure will Client’s financial future look?[xx] This is the key to Client’s financial wellness considering their income-generating business assets will have been converted into, or exchanged for, such cash plus an installment note (a credit risk until it is satisfied) plus a minority equity interest in the acquiring corporation (the transfer of which is likely restricted, and which may appreciate in value or even become worthless).


These are not the kinds of decisions that the owner of a closely held business should be considering for the first time under the pressures and time constraints of an active transaction.

Although the actual sale may not have been foreseen – at least as to the timing and the identity of the buyer – the elements and process of the sale should not be foreign to the business owner. In fact, the owner of a mature business, in consultation with their advisers – accountant, attorney,[xxi] and financial adviser – should periodically review their situation and plan accordingly.

For example, has a particular employee become vital to the well-being of the business? Does the business need to reward or entice that employee in order to keep them, perhaps through a deferred compensation plan that is tied to a “change-in-control?” Or, has the owner embarked on a new line of business, in addition to the core business? Should it be removed and placed into a separate entity? [xxii]

That being said, it is too often the case that the owners of a closely held business are too busy managing and operating their business to spend the time necessary to educate themselves on the “do’s and don’ts” of selling a business.

That is why it is imperative that they bring their advisers into the picture well before the terms for the sale of the business are agreed upon. These advisers should be experienced with planning, memorializing, and managing such transactions. With their input, the owner – who may never have been involved in the sale of another business – will be able to level the playing field for negotiating deal terms, including the purchase price, and will avoid getting into an untenable situation from which it may be difficult (and expensive) to extricate themselves.

In other words, it will behoove the owner not to surprise their advisers.

There are definitely instances in which information is withheld, usually because the client has determined that the information is not relevant to the issue at hand.

[ii] From The Pink Panther Strikes Again, 1976.

[iii] An admirable quality. Why spend the funds of the business needlessly?

[iv] IRC Sec. 1361.

[v] While the client owns the business, the business finances their lifestyle, and perhaps that of other family members. Wages, distributions, cars, life and health insurance, clubs, charitable giving, and many other items are provided or made possible by the business. After the business is sold, the after-tax proceeds will bear the burden.

[vi] It’s amazing how often this happens. What’s more, the LOI will sometimes be so detailed that, arguably, it may itself constitute a purchase and sale agreement – a result that is only avoided by the inclusion of language that the parties intend to enter into a “final definitive agreement,” or words to that effect.

[vii] Can you really blame the adviser?

[viii] IRC Sec. 453A. There are ways to address this.

[ix] In this scenario, we are assuming that there is no so-called “personal goodwill,” and that the client is not licensing any intellectual property to the business. We already know that the client’s LLC leases real property to the business. The client may receive compensation for consulting services to be provided over some transition period. If any family members are genuinely employed by the business, they may be retained by the buyer for some period of time.

[x] IRC Sec. 351.

If the exchange – specifically, the transfer of the assets of the business to the acquiring corporation in exchange for stock plus cash – had somehow qualified for tax-deferred treatment under Sec. 351, each item of the total consideration received (the stock and the cash) would have been allocated among all of the assets transferred according to their relative fair market values; in that way, the gain or loss from the transfer of each asset would be determined separately.

Client’s transaction will not qualify as a reorganization; for one thing, there’s way too much cash, and the structure doesn’t satisfy the statutory definition of a reorganization. See IRC Sec. 368(a)(1) and Reg. Sec. 1.368-1 and 1.368-2.

[xi] IRC Sec. 368(c).

[xii] Instead of a corporation, an LLC, treated as a partnership for tax purposes, would be preferable from the perspective of a seller who was also rolling over a portion of its equity in the business; that’s because there is no “control immediately after the exchange” requirement in the case of contributions to a partnership. See IRC Sec. 721.

[xiii] IRC Sec. 1245. A sale of stock will generate capital gain.

A sale of assets will generate some ordinary income as well as capital gain.

For example, a portion of the gain from a sale of depreciable tangible personal property will be treated as ordinary income that is taxable at a maximum federal rate of 37-percent – the tax benefit from the depreciation deductions previously generated by the property is “recaptured” as ordinary income on the sale of the property.

The gain from the sale of goodwill is treated as capital gain that is taxable at a federal rate of 20-percent.

[xiv][xiv] For a discussion of gain recognition in “tax-free exchanges,” see

[xv] IRC Sec. 453(h) and 453B(h).

[xvi] IRC Sec. 453. Of course, the interest payments received will be taxed as ordinary income. The imposition of the excise tax on net investment income, under IRC Sec. 1411, will also have to be considered.

[xvii] IRC Sec. 1366.

[xviii] Including those damned professional fees.

[xix] IRC Sec. 1374. Of course, depending upon the local jurisdiction, there may be other corporate-level income taxes (NYC, for example).

[xx] See endnote iv.

[xxi] Including their estate planner.

[xxii] See IRC Sec. 355(e) and Reg. Sec. 1.355-7. See also Reg. Sec. 1.355-3 for the active trade or business requirement under IRC Sec. 355.

Several years back, a client who had just sold their business inquired about investing some of their proceeds from the sale in a “cryptocurrency mining” venture based in Upstate N.Y. I thought they had lost their mind. “A what?” I asked. The client replied that the project involved the use of many powerful computers, but was otherwise unable to describe the business, let alone explain it to me in simple-to-understand terms.[i] Still, they pressed me, “What would you do?”

I hate that question. After reminding them that I could not provide any investment advice, I suggested they do more homework, and seek out a qualified investment adviser. Finally, I answered their question, saying that I would consider a more conventional place to park my hard-earned money.

Fast forward. Not only is cryptocurrency still with us – I think “virtual currency” may be more accurate[ii] – its acceptance seems to have grown among both closely-held and public companies; in fact, Facebook announced only last month that it was launching its own form of cryptocurrency.

These developments have caused some concern at the IRS, which believes that the increasing use of virtual currencies may jeopardize tax revenues.

Before describing the IRS’s position, including its recently announced plans, with respect to cryptocurrency, it may be helpful to review – albeit in an overly simplistic and somewhat fictional[iii] way – the evolution of currency, generally.[iv] Think of what follows as the development of my understanding of the concept.

Legal Tender

Thousands of years ago, our ancestors bartered – exchanged things of value – with one another in order to acquire the goods and services they needed. One would swap, or trade, a haunch of deer in exchange for two loaves of bread. A second would clear a field in exchange for an axe. A third would chop wood in exchange for a set of new clothes. A fourth would, to the delight of many, demonstrate their ability to successfully throw a ball through a hoop once out of every 4 attempts, for twenty minutes at a time, in exchange for a lifetime’s worth of food, clothing, shelter, protection, adulation, influence, and so much more – no wait, specialization was a later development (I’m getting ahead of myself).[v]

Specialization and Barter

The growth of societies was accompanied by two developments: (1) individuals began to realize that they could not dabble successfully in all skills;[vi] rather, they began to specialize in the production of certain goods and services – things they were good at – which they would trade with “specialists” in other goods and services; and (2) some people (the “government”) offered to protect the individuals who lived within an area (the “governed”) from the marauders that roamed the countryside, to patrol the roads that allowed them to travel to other places where they could trade their goods and services with people who lived elsewhere, and to settle disputes among the governed; in exchange for these services – another barter transaction – the governed were required to pay “taxes” and “tolls” in the form of goods and services.[vii] As the roles and responsibilities of the government grew and expanded, so did the need for more taxes by which the governed periodically paid for the additional services provided to them by the government.[viii]

Eventually, both the government and the governed realized that the transfer of value in-kind was unwieldy and inefficient. After all, what would a farmer do if the only thing of value that they owned was some seed, and they wanted to trade it with the blacksmith for some nails, but the blacksmith had no need for seed?[ix] Would you have to find someone who could use the seed who also had something of value that the blacksmith may want?[x]


In response to this quandary, the government eventually came up with the idea of “currency”: something that people can exchange for goods and services – also known as a “medium of exchange” – that is issued by the government and that is accepted at its face amount within the territory controlled by the government.

Originally, currency was issued in the form of coins made out of a precious metal (like gold), so that the coin itself was inherently valuable.[xi]

Later, currency was made out of paper that, in itself, was worthless but which was easier to handle. This paper, or banknote, was, and continues to be, a bearer note – meaning that its “value” is not “payable” to a specified person, but rather to whomever holds it – that is issued only by the government’s central bank.[xii] The paper’s status as a bearer note – “cash,” in the colloquial – affords the persons who transact business using such notes a degree of anonymity.[xiii]

It used to be, however, that the paper was backed by gold – meaning that the banknote could be presented to the government’s central bank and exchanged for gold[xiv] – but that is no longer the case.

Today, as in the case of any debt issued by the U.S. government, a banknote – your ordinary dollar bill and its siblings, all of which represent “legal tender” that a vendor of property or services is legally obligated to accept in satisfaction of the debt created in connection with such sale – is backed “only” by the “full faith and credit” of the U.S.,[xv] and that seems to be enough for most of the world.

Virtual Currency – As Understood by a Layperson [xvi]

Like “real” currency,[xvii] virtual currency acts as a medium of exchange for purchasing goods and services; as such, it can circulate from person to person, much as real currency does. Also like real currency, it can exist in different units of value.[xviii]

Unlike real currency, it is not issued by a national government or its central bank; it is not legal tender that must be accepted by someone selling goods or services within a particular jurisdiction. What’s more, it does not exist in any tangible form (like paper money), but only electronically.

Its proponents claim that, because virtual currency is not controlled by a central bank, it is free from interference by any such institution. They also claim that it may be transferred between parties to a transaction[xix] without incurring the high fees often charged by traditional financial institutions. In addition, the software that is used to effectuate these transfers functions without the need for the “identifying information” of the parties, thus providing a degree of anonymity.

I can’t comment on whether these advantages do, in fact, exist.

I will observe, however, from a theoretical perspective, that both the real and virtual systems depend upon the maintenance of a data base for each user, one that records the user’s transactions in which the real or virtual currency is acquired or transferred. In the case of real currency, a central bank handles this function; in the case of virtual currency, the function is performed by many private persons through a process called “mining,” which seeks to maintain the integrity of the “system” by validating transactions between parties.[xx]

The IRS’s Position

Although the term “cryptocurrency” seems to have entered the public lexicon around 2008,[xxi] the IRS did not issue any guidance until 2014.[xxii]

At that time, the IRS limited its guidance to virtual currency that has an equivalent value in real currency, or that acts as a substitute for real currency (so-called “convertible” virtual currency).[xxiii]

According to the IRS, virtual currency is treated as “property” for federal tax purposes; consequently, general tax principles applicable to property transactions apply to transactions using virtual currency.


For example, a taxpayer who receives virtual currency as payment for goods or services must, in computing their gross income, include the fair market value of the virtual currency, measured in U.S. dollars, as of the date that the virtual currency was received. This amount also represents the initial basis of such virtual currency in the hands of the taxpayer.[xxiv]

The fair market value of virtual currency received for services performed as an independent contractor, measured in U.S. dollars as of the date of receipt, constitutes self-employment income and is subject to self-employment tax.


If the fair market value of property received in exchange for virtual currency exceeds the taxpayer’s adjusted basis of the virtual currency,[xxv] the taxpayer has taxable gain.[xxvi] This should be compared to legal tender – like the dollar – which is always worth its face value, and the basis of which is also equal to its face amount.[xxvii]

The character of the gain generally depends on whether the virtual currency is a capital asset in the hands of the taxpayer. A taxpayer generally realizes capital gain on the sale or exchange of virtual currency that is a capital asset in the hands of the taxpayer. A taxpayer generally realizes ordinary gain on the sale or exchange of virtual currency that is not a capital asset in the hands of the taxpayer.

Information Reporting

A payment made using virtual currency is subject to information reporting to the same extent as any other payment made in property. For example, a person who in the course of a trade or business makes a payment of fixed and determinable income[xxviii] using virtual currency with a value of $600 or more to a U.S. non-exempt recipient in a taxable year is required to report the payment to the IRS and to the payee.

Similarly, a person who in the course of a trade or business makes a payment in virtual currency of $600 or more in a taxable year to an independent contractor for the performance of services is required to report that payment to the IRS and to the payee on Form 1099-MISC, Miscellaneous Income.

More Recent Developments

The foregoing guidance was all well and good.

However, in 2016, the AICPA[xxix] asked that the IRS provide additional guidance on the tax treatment of cryptocurrency. It repeated the request in 2018. The IRS has thus far failed to issue more guidance.

That being said, in early 2018, the IRS reminded taxpayers that income from virtual currency transactions was reportable on their income tax returns, and that virtual currency transactions were taxable just like transactions in any other property.[xxx] Taxpayers who did not properly report the income tax consequences of virtual currency transactions, it stated, could be audited for those transactions and, when appropriate, could be liable for penalties and interest. In more extreme situations, the IRS continued, taxpayers could be subject to criminal prosecution for failing to properly report the income tax consequences of virtual currency transactions.[xxxi]

As if to impress upon the public the magnitude of the challenge, the IRS noted that, as of the date of the release of this reminder to taxpayers, there were more than 1,500 known virtual currencies.[xxxii] The IRS stated that, because transactions in virtual currencies could be difficult to trace,[xxxiii] and have “an inherently pseudo-anonymous aspect,” some taxpayers may be tempted to hide taxable income from the government.

Compliance Campaign

Then, in July of 2018, the IRS announced a Virtual Currency Compliance Campaign to address tax noncompliance related to the use of virtual currency through outreach and through examinations of taxpayers.[xxxiv]

According to the announcement, the Compliance Campaign is aimed at addressing noncompliance related to the use of virtual currency. It stated that the compliance activities will follow the general tax principles applicable to all transactions in property, as outlined in the IRS’s 2014 guidance. It also urged taxpayers with unreported virtual currency transactions to correct their returns as soon as practical.

Significantly, the IRS indicated that it was not contemplating a voluntary disclosure program specifically to address tax non-compliance involving virtual currency.[xxxv]

Evidently not pleased with the pace of the IRS’s efforts to issue additional guidance, a group of lawmakers requested, in April of 2019, that the IRS update its 2014 guidance on the taxation of cryptocurrency transactions.

July 26, 2019

Last week, however, the IRS announced that it has begun sending letters to taxpayers with virtual currency transactions that potentially failed to report income and pay the resulting tax from such transactions, or that did not report their transactions properly.[xxxvi]

By the end of August, the IRS stated, more than 10,000 taxpayers will receive these letters. It indicated that the names of these taxpayers were obtained through “various ongoing IRS compliance efforts.”[xxxvii]

The IRS further stated that it will remain actively engaged in addressing non-compliance related to virtual currency transactions through a variety of efforts, ranging from taxpayer education to audits to criminal investigations. As if to emphasize this last point, the IRS stated that virtual currency is an ongoing focus area for IRS Criminal Investigation.

The announcement ended with a statement that the IRS anticipates issuing additional legal guidance in this area “in the near future,” and with a reminder that taxpayers who do not properly report the income tax consequences of virtual currency transactions will be liable for tax, penalties and interest, and criminal prosecution when appropriate.[xxxviii]

What’s Next?

With the announcement that it is going to start auditing taxpayers with cryptocurrency assets, the IRS is ramping up its focus on cryptocurrency transactions.

As in the case of unreported foreign accounts years ago, I would expect the IRS to engage in some high profile exams and prosecutions of both larger and smaller transactions so as to demonstrate that it is serious about across-the-board compliance in this area, and to thereby discourage noncompliance.

The fact that it is not considering, as a first step, a voluntary disclosure program, of the kind once made available to holders of unreported foreign accounts, may be an indication of the IRS’s perception of the potential magnitude of the threat to tax revenues that is presented by cryptocurrency transactions.

It is also likely that these exams will generate a great deal of data from which the IRS will derive the principles for additional guidance on the tax treatment of cryptocurrency transactions. The exams may even highlight any shortcomings in the IRS’s technical capability, as well as in its legal ability, to investigate such transactions, which in turn could form the basis for legislation to remedy any such shortcomings.

In the meantime, the IRS will rely on its not insignificant administrative, interpretive and enforcement powers to monitor cryptocurrency transactions.

Of course, there are bad actors who believe their transactions cannot be traced – like those folks who still transact business only in cash, or like those who used to hide their wealth in overseas accounts that were once protected by “privacy” laws, these taxpayers believe they are somehow acting “anonymously.”

What these folks forget is that the taxpayer bears the burden of establishing their proper tax liability. The taxpayer is charged with keeping records that support the amount of income received and expenses incurred, as well as their basis for property sold or exchanged. When they are found out, well, they may find that they are up a certain creek.

Speaking of which, it’s only a matter of time before they are found out. The same technology that they believe affords them the ability to go about their business undetected will one day enable the IRS to piece together the extent of their activities.

In light of the foregoing, any closely held business that determines, for bona fide business reasons, that it has to transact, or would benefit from transacting, with vendors or customers (“peers”) using a virtual currency must not lose sight of its tax reporting, record maintenance, and payment obligations.

[i] Call it a version of the “smell test.” If you can’t understand it well enough to explain it to someone else, stay away from it.

[ii] “Crypto” has a negative connotation in my mind. It is derived from the Greek word for “secret” or “hidden.” Query whether that selection was intended to convey something nefarious.

[iii] And hopefully humorous.

[iv] Lots of disclaimers, here. I am not a professional economic historian, though I am a student of government and of the “social contract” theory from which are derived the government’s responsibilities to the governed and the responsibilities of the governed to each other.

[v] Is it a sign of a mature or successful society that entertainers – be they athletes, singers, or actors – are treated as demigods? What about former public “servants” who become wealthy writing and talking about their years “in service”? I know, it’s what “the market” values.

[vi] I couldn’t be both a farmer and a fisherman, a teacher and a carpenter.

[vii] “In-kind.”

[viii] Think of these “exchanges” as forms of credit, debt and repayment.

[ix] We’re not going to discuss commercial credit here. In fact, commercial credit did not come into its own until after the introduction of currency.

[x] Think about the deferred like kind exchange. Rarely do you see two parties swapping properties between them. Rather, the seller who is seeking to acquire replacement property has to search elsewhere for the desirable property. Thus, at least four parties are required to effect the transaction: the seller of the relinquished property, the buyer of such property, the qualified intermediary who accepts payment for the relinquished property, and the seller of the replacement property, from whom the qualified intermediary acquires such property on behalf of the original seller. Phew!

[xi] “Valuable” in that someone was willing to give up something they had in exchange for the coin.

[xii] The Federal Reserve Bank, in the U.S.

[xiii] I.e., the ability to avoid their lawful tax obligations. After all, it is relatively difficult to trace and relatively easy to hide.

[xiv] Before 1971, paper money included the following statement: “This note is legal tender for all debts, public and private, and is redeemable in lawful money at the United States Treasury or at any Federal Reserve Bank.”

“Lawful money?” Gold.

[xv] Take a look at the paper money in your pocket or wallet, assuming you still carry any. It includes the following statement: “This Note Is Legal Tender for All Debts, Public and Private.” It is no longer redeemable for money.

In 1971, President Nixon eliminated the convertibility of the dollar into gold. One of the reasons for doing so was to prevent foreign governments from exchanging the dollars held by their central banks for the U.S.’s gold reserves.

[xvi] Me.

[xvii] For example, U.S. dollars.

[xviii] As I understand, these “units” or “tokens” are created by a complex computer code.

For a good discussion of cryptocurrencies, generally, I found the one on ASIC’s website especially helpful: .

[xix] The transfer is described as being “peer to peer.”

[xx] For example, by ensuring that the same unit of currency is not used twice in short order by the same person.

I can’t speak for others, but give me a central bank over private miners any time. Again, if I can’t understand it, . . .

[xxi] Though it appeared in the “computer world” well before that.

[xxii] Notice 2014-21.

[xxiii] Bitcoin is one example of a convertible virtual currency. Bitcoin can be digitally traded between users and can be purchased for, or exchanged into, U.S. dollars, Euros, and other real or virtual currencies.

The IRS stated that no inference should be drawn with respect to virtual currencies not described in the notice.

[xxiv] Query how such fair market value is to be determined. By reference to the value of the service rendered or of the property sold?

[xxv] To-date, the IRS has not treated virtual currency in the same way as foreign currency for purposes of IRC Sec. 988, which addresses foreign currency transactions.

[xxvi] Viewed differently, has the virtual currency appreciated in value? I’ve wrapped my head around this by thinking of the virtual currency as a metal or other commodity. Supply and demand at work?

[xxvii] Though its value relative to other items may be different at different periods of time; for example, because of inflation. I remember when a regular slice of pizza was 25 cents. Today, that regular slice is $3.00.

[xxviii] For example, as rent, premiums or compensation.

[xxix] American Institute of Certified Public Accountants.

[xxx] Virtual currency, the IRS explained, is generally defined as “a digital representation of value” that functions in the same manner as a country’s traditional currency. Hmm. A glimpse of things to come?

[xxxi] IR-2018-71.

[xxxii] The figure is probably closer to 2,000 now.

[xxxiii] Presumably because of the “peer to peer” feature. Like barter?


[xxxv] Compare the IRS’s approach (the OVDP) toward undisclosed foreign bank and other financial accounts.

[xxxvi] IR-2019-132.

[xxxvii] The IRS’s own data mining.

[xxxviii] Talk about beating a dead horse.

Teach Your Children Well [I]

It may be the dream of every parent who owns a closely held business that one or more of their children will follow in their footsteps. They envision a time when a child will enter the business as an employee, learn the “ins and outs” of the business, pay their dues,[ii] move up the ranks and, one day, assume the mantle of leadership as the parent heads off to their new pastime,[iii] secure in the knowledge that they have left their child with a good business, and equally secure in the knowledge that the business they have built is in good hands. If all goes to plan, the parent will make a gift of equity in the business to the child, or they will bequeath the business to the child.[iv]

Unfortunately, things don’t always turn out as we hoped they would. Remember Don Corleone in the garden, after his youngest son, Michael, has told him that he has assumed control of the family business? “I never wanted this for you.”[v]

The Don foresaw the troubled life that Michael had chosen. Unfortunately, it seems that some parents would knowingly put their children in harm’s way – indeed, even throw them under the proverbial bus[vi] – and there are those children who learn all the wrong things from their parents. Both of these situations are found in the case described below.[vii]

Family Business

Parents had long been engaged in the staffing business[viii] (the “Business”). After Child completed college, Parents invited Child to work in the Business. They organized a new corporation (“Corp”), of which Child was named the sole director and president, positions that Child would hold for the next twelve years.[ix]

Client businesses for which Corp provided staffing would pay Corp directly for its services. The people who were staffed at the client businesses were classified as Corp’s employees, and Corp was responsible for paying their wages and for withholding taxes from those wages.

Despite being established as the sole director and president of Corp – at least on paper – Child initially worked at locations offsite from the corporate office, under the control and direction of Parents, who in fact actively managed Corp.

After an approximately five-year period of employment with Corp (the “Earlier Period”), Child continued to work primarily offsite, though they were given additional responsibilities, some of which required Child to return to the corporate office periodically to execute a number of documents (as directed by Parents), which Child would do without reviewing.[x] Occasionally, Child would also check the corporate mail and make bank deposits, though these tasks were primarily the responsibility of Parents.

Through the Earlier Period, and just beyond, Child did not exercise any hiring or firing authority over employees, though Child would occasionally make personnel recommendations to Parents. Child had access to Corp’s checking accounts, but was not responsible for them. Most checks were signed by Parents, though Parents would occasionally ask Child to sign completed employment tax returns[xi] on behalf of Corp, which Child would do without reviewing.

Trust Fund Taxes

Corp did not pay in full its federal employment taxes for certain quarters during the Earlier Period. Parents prepared a “Report of Interview with Individual Relative to Trust Fund Recovery Penalty”[xii] on which Child was identified as the person “interviewed” – Child executed the completed form at the request of Parents.

At some point, an IRS Revenue Officer appeared at Corp’s office unannounced, and explained to Child that Corp had a “tax issue” and owed taxes. After the meeting, Child contacted Parents, and was told that they and the corporation’s attorneys would handle the tax issues.

Shortly thereafter, the IRS sent a Trust Fund Recovery Penalty (“TFRP”) Letter,[xiii] and a Proposed Assessment of Trust Fund Recovery Penalty,[xiv] with respect to Corp’s unpaid employment taxes for above-referenced quarters. The certified mail was returned to the IRS, unclaimed.[xv] The IRS assessed TFRPs against Child.

Transition in Management

During the years following the Earlier Period (the “Later Period”), new bank accounts were opened for Corp, with Child having signatory authority over a business checking general fund account, and a business checking labor payroll account. In addition, a business checking “Special Trust Fund Account” was opened to help ensure that Corp paid its tax liabilities. Child was named trustee of, and had sole signatory authority over, the Trust Fund Account.

Also during the Later Period, Child began taking over the Business in preparation for Parents’ retirement. Thus, Child assumed many of Corp’s internal operations. Child had the authority to hire and fire employees, to sign leases on behalf of the corporation, and to transfer funds from Corp’s general fund to its labor payroll account. Child had a corporate credit card and used it to make purchases. However, Child also continued to sign any documents as directed by Parents, including Corp’s tax returns.[xvi]

Transition in Delinquency

During the Later Period, Corp began to underpay its tax deposits, and its employment tax returns consistently reflected balances due. At some point, Corp’s deposits were far less than the balance due, and it oftentimes owed several hundred thousand dollars of unpaid tax on each return. Corp filed its returns and paid deposits each quarter, but the large delinquencies continued to accrue.

Inexplicably, Corp’s general fund account held funds sufficient to pay the corporation’s delinquent employment taxes, yet Child instead wrote checks out of the general fund for payments to a professional sports team and a country club, as well as other personal items.

What’s more, the funds in Corp’s labor payroll account were sufficient to have fully paid the balances reflected on the employment tax returns for several of the delinquent quarters.

Over the course of the Later Period, significant amounts were withdrawn from the Trust Fund Account that were not used to pay Corp’s employment tax liabilities.

Toward the end of the Later Period, Parents pleaded guilty to tax evasion.[xvii]

By that time, Child had fully taken over management of the day-to-day operation of Corp. Shortly thereafter, Child closed the Business.

You’re On Your Own, Kid

Child was interviewed by an IRS Revenue Officer. This was followed by a letter from the IRS indicating that Child might have some responsibility regarding Corp’s unpaid employment taxes for the Later Period.

The IRS then assessed TFRPs against Child for both the Earlier and Later Periods, aggregating approximately $2.3 million.

This was followed by a Notice of Federal Tax Lien Filing for the TFRPs with respect to the Earlier Period, and by another Notice with respect to the Later Period.

Finally, the IRS issued Child a Final Notice, Notice of Intent to Levy, and Notice of Your Right to a Hearing for TFRPs for the Later Period.

Child timely filed Requests for a Collection Due Process or Equivalent Hearing (CDP hearing requests),[xviii] in response to the two NFTL filings and the levy notice. The CDP hearing requests sought relief from the liens and proposed levy and acceptance of an offer-in-compromise or an installment agreement. Child also argued they were not a responsible person and never had the actual authority or ability to pay the taxes because Corp and its taxes were controlled by Parents.

The CDP hearing requests were assigned to a Settlement Officer (“SO”), who did not consider the substantive basis for the underlying liabilities for any of the periods in issue. Instead, the SO focused on Child’s request for an offer-in-compromise or an installment agreement. When the SO proposed a payment plan, Child’s attorney informed the SO that Child intended to close the Business and would be unable to make any proposed payments.

The IRS Office of Appeals issued Child a notice of determination sustaining the NFTLs and the proposed levy.

In response to the notice of determination, Child timely petitioned the U.S. Tax Court.[xix] Among other things, Child asserted that (1) they were not a person responsible for paying over, and they did not willfully fail to pay over, Corp’s employment taxes, and (2) Parents controlled the Business and the employment taxes.


The Court explained that an employer is required to withhold or collect from an employee’s wages the employee’s share of federal taxes,[xx] and then must pay over the withheld amounts to the IRS. Such withheld amounts are known as “trust fund taxes,” because they are “held to be a special fund in trust for the United States.”[xxi]

The Code imposes the TFRP on “[a]ny person required to collect, truthfully account for, and pay over any tax . . . who willfully fails to collect such tax, or truthfully account for and pay over such tax, or willfully attempts in any manner to evade or defeat any such tax or the payment thereof.”[xxii]

The term “person” includes an officer or employee of a corporation who is under a duty to collect, account for, and pay over the tax.[xxiii] Such persons are referred to as “responsible persons.”[xxiv] The TFRP shall be paid upon notice and demand by the IRS and shall be assessed and collected in the same manner as taxes.[xxv]

Child contended that they were not liable for TFRPs because they were not a responsible person who willfully failed to pay over the withheld taxes for any of the periods in issue.

The Court’s Analysis

The Court agreed that Child’s liability for the TFRPs rested on their being a responsible person with respect to the periods in issue.

Responsibility, the Court stated, was based on an individual’s “duty and authority to withhold and pay taxes.” It “does not require actual knowledge that one has that duty and authority.”

The Court explained that, among the factors indicative of such authority were whether the individual: “(i) is an officer or member of the board of directors; (ii) owns a substantial amount of stock in the company; (iii) manages the day-to-day operations of the business; (iv) has the authority to hire or fire employees; (v) makes decisions as to the disbursements of funds and payment of creditors; and (vi) possesses the authority to sign company checks.”

During the Earlier Period, Child was unaware that Corp had failed to pay its employment taxes. Indeed, Child worked under the control and direction of their parents. Child was not involved in the day-to-day management of the company, worked primarily offsite, and signed papers when asked to do so. Child did not exercise any hiring or firing authority over employees and, instead, left personnel decisions to the Parents.

Child became aware of the corporation’s failure to pay its employment taxes in full only after being informed of such by the Revenue Officer who visited the corporation’s office. Even then, Child contacted Parents for guidance and was told that they and the corporation’s attorneys would handle any tax matters.

However, Child did take a more active role in the corporation during the Later Period. Child acted upon their authority as the president and sole director of the corporation. Child was being groomed to take over the Business, and participated more actively in the management of the corporation. Child had signatory authority over the corporation’s bank accounts; in particular, Child had sole signatory authority over Corp’s Trust Fund Account, which was opened to ensure the corporation paid its tax liabilities. Child was more involved in the day-to-day operations of the corporation during this period, wrote checks from the corporate accounts, and chose to make payments for personal expenses instead of taxes.

The Court pointed out that the stark contrast between Child’s nominal duties during the Earlier Period and Child’s role during the Later Period demonstrated that Child was not a responsible person for the Earlier Period.

The Later Period presented a different story. At this point, Child was aware of Corp’s delinquent tax liabilities, and had been interviewed by a Revenue Officer about the outstanding tax liabilities. Moreover, Child could not have reasonably expected that Parents would resolve the corporation’s tax issues because they were about to be incarcerated.

Accordingly, the Court did not sustain the IRS’s determination for the TFRPs relating to the corporation’s employment taxes owed for the Earlier Period, but it did sustain the IRS’s determination for the Later Period.

What’s The Point?

Two points, I guess.

I don’t know about you, but there appear to be a lot of trust fund matters out there. Unpaid employment taxes continue to be a substantial problem. Amounts withheld from employee wages represent almost 70-percent of all revenue collected by the IRS, yet billions of dollars of tax reported on Employer’s Quarterly Federal Tax Returns (Forms 941) remain unpaid.[xxvi] The cause, in many cases, is a failing business – the latter will often divert the tax monies collected toward the satisfaction of business expenses in the hope of turning the corner; they usually don’t. The IRS’s position is that such businesses should be allowed to fail rather than taxes go unpaid.

Which brings us to the second point. We know that, in transactions between unrelated persons, before a prospective acquirer actually purchases a business from the current owner of the business, they will do a fair amount of due diligence, and they ask the current owners to make specific representations as to the “well-being” of the business and as to its compliance with applicable laws.[xxvii]

What does the beneficiary of a gift or bequest do before accepting the transfer of an interest in a donor’s or decedent’s business?

In the vast majority of cases, nothing – except, perhaps, say “thank you.” Remember the old saying, “Don’t look a gift horse in the mouth”?[xxviii]

In any case, what parent would transfer to their child an interest in a business with a closet full of skeletons? Unwittingly, perhaps; but not knowingly, except in rare circumstances, as we saw in the discussion of the Earlier Period, above.

It is important to note that the intended beneficiary of a gratuitous transfer is not required to accept such a transfer; indeed, state property law and federal tax law both provide for the beneficiary’s disclaimer or renunciation of a gift or bequest.[xxix]

In order to decide whether to accept a gift, I say, of course the intended beneficiary should count the horse’s teeth; they should ask the owner about its history and temperament; they may even want to ask a vet to check the horse.

Have you ever encountered a gift of an interest in real property that turned out to be environmentally challenged and very expensive to remediate? How about a gift of several properties that were not only expensive to maintain but also vacant, thereby requiring the beneficiary to dip into their savings in order to keep the property?

Can you say “thanks, but no thanks?” What about “fire sale?”

Of course, the timing and circumstances of the transfer may greatly impact the beneficiary’s ability to “negotiate” their receipt of the property; for instance, we never know when Thanatos[xxx] will come for us. That being said, it’s good to plan ahead.

In the case of a gift of an equity interest in a business,[xxxi] the management of which will pass to the beneficiary, it may behoove both “parties” to the transfer to identify any issues and to plan accordingly. Perhaps the donor-parent can remedy the problem in conjunction with making the transfer, rather than leave it for their child to confront. Alternatively, the parent may transfer other assets to the beneficiary, to provide a source of funds for use in tackling the problem, or as “compensation” for the reduced value resulting from the problem. If it is determined that the problem cannot be resolved, it may be advisable for the parent to sell the business before they retire, so as to maximize the net proceeds for the beneficiary child who may then have to seek employment elsewhere.

As always, it makes sense for the parties to openly and thoughtfully discuss these matters well in advance of the transfer.

[i] Apologies to CSNY.

[ii] The idioms are flowing freely today. Reader beware.

[iii] I pray it is anything but golf.

[iv] Beware, and do not forget, the children who are not in the business.

Query what the exemption amount will be when this transfer occurs.

Query whether the ability to claim valuation discounts will have been curtailed by then.

[v] The Don continued, “…but I thought that — that when it was your time — that — that you would be the one to hold the strings. Senator – Corleone. Governor – Corleone, or something…” A politician. I’ll leave it at that.

[vi] Nothing personal – just business.

[vii] Dixon v Comm’r, T.C. Memo 2019-79.

[viii] Employee leasing.

[ix] Presumably, Parents owned all of the issued and outstanding shares of stock.

[x] Ah, the trusting child.

[xi] Forms 940, Employer’s Annual Federal Unemployment (FUTA) Tax Return, and Forms 941, Employer’s Quarterly Federal Tax Return.

[xii] Form 4180. This form is prepared in order to assist the IRS is determining whether the individual interviewed may have been responsible for the collection and remittance of employment taxes.

[xiii] Letter 1153(DO)

[xiv] Form 2751.

[xv] Child later claimed not to have received notice of the certified mailing.

[xvi] Consistency is the mark of a champion, they say.

[xvii] So much for teaching your children well.

[xviii] Form 12153.

[xix] See IRC Sec. 6330(d)(1).

[xx] These include the employee’s share of (1) Social Security tax, see secs. 3101(a), 3102(a); (2) Medicare tax, see IRC Secs. 3101(b), 3102(a); and (3) Federal income tax, see IRC Secs. 3402(a)(1), 3403.

[xxi] IRC Sec. 7501(a).

[xxii] IRC Sec. 6672(a).

[xxiii] IRC Sec. 6671(b).

[xxiv] The term may be applied broadly.

The IRS collects the trust fund liability only once. Consequently, the IRS cross-references payments against the trust fund liability of the employer and payments against the TFRPs of responsible persons.

In addition, for circumstances in which there is more than one responsible person, a taxpayer who paid the TFRP may bring a separate suit against the other responsible person(s) claiming a right of contribution. Sec. 6672(d).

[xxv] IRC Sec. 6671(a).

[xxvi] More than $59.4 billion as of June 30, 2016. Query what the unreported amount is.

[xxvii] The breach of which would entitle the buyer to be indemnified by the seller for any resulting loss.

[xxviii] I wonder if this may be the same horse as the dead horse that one should stop beating. I did warn you about the flow of idioms today.

[xxix] See, e.g., IRC Sec. 2518, and N.Y. EPTL Sec. 2-1.11. In most cases, though, the right to disclaim is utilized as a tax planning tool.

[xxx] The god of death in Greek mythology, as distinguished from Hades, the god of the underworld and of the dead.

[xxxi] Which normally would be expected to remove not only the property from the donor’s estate, but also the post-gift appreciation in the value of the property and the income generated by the property.

If I Had a Dollar . . .

How many times have you sat with a client who wants to leave N.Y. for a jurisdiction with a more pleasant “tax climate?” A place where the combined state and local personal income tax rate does not approach 12.87-percent,[i] where the sales tax is well below 8.875-percent,[ii] where the estate tax rate is nowhere near 16-percent, and where the real property taxes are not the highest in the country.[iii]

The client has already identified this sanctuary; in fact, they have purchased a beautiful oceanfront residence[iv] in this Shangri-La, one that they claim puts their N.Y. apartment to shame (though they may keep the N.Y. property as an investment or hotel substitute). What’s more, they’ve moved all of their valuables and other cherished personal belongings to this new home.

When you ask whether they have changed their “living pattern” or adapted their activities to their “tax haven,” they reply that they now spend almost eight months of the year there, have joined local clubs and cultural organizations, have taken up surf fishing, and host all major family gatherings at their new home.[v]

Active Business Involvement

Then you turn the discussion to the source of the client’s wealth and cash flow: their business, headquartered in N.Y., and held in a business entity that is treated as a pass-through for tax purposes.[vi]

The client claims they are still active in the day-to-day management of the business – the internet and video-conferencing are wonderful things, they say. They maintain an office at the place of business, and they always visit the business when they’re in N.Y. The business pays them a generous “salary,”[vii] and periodically makes distributions.

You ask whether they plan to sell the business and, if so, when? In due course, they say, though probably sooner rather than later – they have no family member or key employee who is interested and/or capable of succeeding them, and they want to maximize the net proceeds from the sale.

You explain that, notwithstanding everything they have done to establish a new home outside N.Y.,[viii] they will remain subject to N.Y.’s personal income tax at least as to the income generated from their business, including a portion of their salary.[ix] The incredulous looks on their faces tell you to continue explaining. Even if N.Y. acknowledges that they are nonresidents, you tell them – and this is not a foregone conclusion based on the above facts – they will remain subject to N.Y. income tax on their N.Y. source income, which includes their share of the S corporation’s income that is sourced in N.Y.[x]

What’s more, you tell them, the fact that they are still very active in their N.Y. business may be enough for N.Y. to establish that they remain domiciled in N.Y.[xi], especially when one factors in their continued ownership of the N.Y. residence. You remind them that, in order to establish a change in domicile, they must demonstrate that they have “abandoned” N.Y. as their home and have “landed” elsewhere. Thus, the sale of the business may be the factor on which the abandonment of their N.Y. domicile depends; unfortunately, the sale itself will be subject to tax in N.Y.

Even if the sale of the business were not a necessary element in securing nonresident status – for example, where the clients have successfully changed their status vis-à-vis the business into that of passive investors[xii] – the gain from such sale may remain subject to N.Y. income tax as NY-source income, as illustrated by a decision of the Division of Tax Appeals just a few weeks ago.[xiii]

The Stock Sale

Taxpayer was an individual nonresident of N.Y. during the years 2009, 2010 and 2011. Through July 31, 2009, Taxpayer owned 50-percent of the shares of Target, a corporation that had elected to be treated as an S corporation for Federal and N.Y. income tax purposes.[xiv]

Target’s shareholders (including Taxpayer; the “Sellers”) entered into a stock purchase agreement with Purchaser (a corporation) pursuant to which the Sellers would sell all of the issued and outstanding shares of Target stock to Purchaser. Under the terms of the agreement, the Sellers and Purchaser agreed to make an election under Section 338(h)(10) of the Code (the “Election”). Accordingly, though the transaction was structured as a sale of stock, the effect of the Election was that Target was deemed to have sold all of its assets in a taxable transaction, Purchaser was treated as having purchased the assets, so as to receive a step-up in the basis of the assets, and Target was deemed to have then liquidated.[xv]

Prior to closing on the sale of Target to Purchaser, and prior to agreeing to make the Election, Taxpayer consulted with his CPA regarding the tax consequences of the transaction, including specifically whether the Election would subject Taxpayer’s sale proceeds to N.Y. income tax. Taxpayer was advised that, at the time of the sale (i.e., in 2009), a stock sale that was treated as a deemed sale of assets pursuant to the Election did not change the nature of the transaction for N.Y. income tax purposes. Specifically, Taxpayer was advised that under a then recently-issued decision of the Tax Appeals Tribunal (Baum),[xvi] a transaction such as the proposed stock sale would be treated, for N.Y. purposes, as the sale of an intangible (i.e., a sale of stock), notwithstanding the deemed asset sale treatment for Federal tax purposes; thus, as a nonresident, Taxpayer would not be subject to N.Y. tax on the gain from such a sale.

Based upon the foregoing advice, that N.Y. tax would not be imposed on the gain from the sale transaction, Taxpayer agreed to forego continued negotiations seeking an increased purchase price (or gross-up) for any additional taxes resulting from the Election.[xvii]

As consideration for the sale transaction, Taxpayer received a cash payment plus an installment obligation. The installment obligation qualified for installment method reporting under the Code,[xviii] permitting recognition of gain only upon receipt of principal payments on the installment obligation.

The Issue is Joined

Target filed a Federal S corporation tax return,[xix] and a corresponding N.Y. tax return,[xx] for the short period spanning January 1, 2009 through July 30, 2009,[xxi] reporting a capital gain, on an installment basis, in excess of $6.0 million; on its N.Y. return for this short period, Target reported a 100-percent N.Y. business allocation percentage (“BAP”).[xxii]

N.Y. Amends the Tax Law

On August 11, 2010, the N.Y. Tax Law[xxiii] was amended to specifically provide that a non-resident S corporation shareholder must treat the sale of stock subject to an Election as the sale of assets, and must apportion the sale proceeds to N.Y. in accordance with the S corporation’s BAP, without consideration of any deemed liquidation (the “2010 Amendments”).

On August 31, 2010, the N.Y. Department of Taxation and Finance[xxiv] issued a memorandum providing public notice and guidance with respect to the 2010 Amendments.[xxv] This memorandum noted that the amendments were retroactive and, specifically, were effective for tax years beginning on or after January 1, 2007 and any other taxable year for which the period of limitations on assessment remained open.

Taxpayer Files

On October 14, 2010, Taxpayer filed his 2009 N.Y. nonresident income tax return,[xxvi] reporting thereon his share of the foregoing capital gain. By virtue of Target’s 100-percent BAP, Taxpayer reported 100-percent of his share of the gain arising from the sale as N.Y. source income. However, on the same return, Taxpayer reported a N.Y. subtraction modification removing 100-percent of the foregoing allocated capital gain resulting from the deemed asset sale of Target from his N.Y. adjusted gross income.

Installment Payments

For the years 2010 and 2011, Taxpayer received income from the installment payment obligation arising from the sale.

Taxpayer did not file an amended return for the year 2009, and did not file any N.Y. nonresident income tax return for either 2010 or 2011. As a consequence of this reporting position, Taxpayer did not pay any N.Y. personal income tax on the proceeds arising from the sale of Target to Purchaser.

The Audit

The Department examined the final S corporation return filed for Target for the short period spanning January 1, 2009 through July 30, 2009, and Taxpayer’s corresponding reporting of his share of Target’s income. The Department’s review of Taxpayer’s and Target’s returns resulted in a determination that the transaction was properly treated as a deemed asset sale under Section 338(h)(10) of the Code, with the proceeds from the transaction constituting NY-source income to the extent of Target’s BAP.

For 2009, the Department determined that Taxpayer should not have removed the capital gain from the deemed asset sale from his return. In turn, the entire gain was treated as NY-source income, allocable as based on Target’s BAP of 100-percent, and was subject to N.Y. tax.

For 2010 and 2011, the Department determined that Taxpayer was obligated to file and report the installment payments arising from the deemed asset sale as NY-source income, allocable to N.Y. based on Target’s BAP of 100-percent, and subject to N.Y. tax.

The Department issued a notice of deficiency to Taxpayer, asserting additional N.Y. personal income tax for the years 2009, 2010 and 2011.[xxvii]

Taxpayer protested the notice of deficiency.

Division of Tax Appeals

The question before the Division was whether the Department properly determined that a nonresident individual’s gain from the sale of the stock they owned in an S corporation was required to be included in that individual’s NY-source income where the parties to the transaction had elected to treat the transaction as a sale of assets under Section 338(h)(10) of the Code.

Taxpayer argued that the asserted deficiency should be canceled because the retroactive imposition of tax liability under the 2010 Amendments constituted a violation of the Due Process Clauses of the U.S. and N.Y. Constitutions.[xxviii]

Taxpayer maintained that he reasonably relied upon the Tribunal’s opinion in Baum, according to which the substance of the transaction remained a sale of stock, notwithstanding that the parties to the stock sale had made the Election; therefore, the gain from the sale was generally not NY-source income to a nonresident and was not required to be included in the N.Y. income of an S corporation, or to be passed through to its shareholders.[xxix]

The Division reviewed the aftermath of the Baum decision, specifically as it related to Taxpayer.


On July 31, 2009 (i.e., after the decision in Baum), Taxpayer sold all of his shares in Target to Purchaser. The Baum decision was issued prior to the sale of Target, and was specifically relied upon by Taxpayer for his reporting position regarding his share of the gain from the sale, as received in the year of the transaction.

At that time, the Tax Law did not specifically address how a N.Y. nonresident’s gain from the sale of stock in a N.Y. S corporation would be impacted where such sale was treated, pursuant to an Election, as a deemed sale of the assets of the S corporation to the buyer, followed by a deemed liquidation of the S corporation.

In response to the result in Baum, N.Y. amended the Tax Law, effective August 11, 2010,[xxx] so as to address the issue of nonresident shareholders’ treatment of income related to an Election. Specifically, the Tax Law was amended to provide that, if the shareholders of an S corporation made an Election, there would be included in their income, for N.Y. tax purposes, the portion of the gain from the deemed asset sale that was derived from or connected with N.Y. sources. However, when a nonresident shareholder exchanged their S corporation stock as part of the deemed liquidation that follows the deemed asset sale, any gain recognized would be treated as the disposition of an intangible asset and would not be treated as NY-sourced.

The foregoing amendments to the Tax Law were made applicable “to taxable years beginning on or after January 1, 2007.”

The Division stated that the legislative findings accompanying the adoption of these amendments explained that they were necessary to correct the Baum decision, which had “erroneously overturned” longstanding policies that nonresident S corporation shareholders who make an Election following the sale of their shares are taxed in accordance with the transaction being treated as an asset sale producing NY-source income.[xxxi]

On August 31, 2010, the Department issued a memorandum providing public notice and guidance with respect to the 2010 Amendments.[xxxii] This memorandum stated that the 2010 Amendments were effective for tax years beginning on or after January 1, 2007, and for any other taxable year for which the period of limitations on assessment remained open.

The August 11, 2010 effective date of the 2010 Amendments, and the August 31, 2010 issuance date of the Department’s memorandum, predated the October 14, 2010 filing of Taxpayer’s N.Y. tax return for 2009.

The Division’s Analysis

It was settled law, the Division stated, that the 2010 Amendments could be applied retroactively to tax years beginning on or after 2007, without violating the Due Process Clauses of the United States and New York State Constitutions. It was likewise well settled, the Division continued, that the interpretation and application of the Tax Law by Baum prior to the 2010 Amendments, as espoused by Taxpayer, was incorrect. Consequently, the manner in which Taxpayer’s 2009 tax return was filed, in October of 2010, was likewise incorrect.

Taxpayer did not contest these facts or the facial validity of the retroactivity of the 2010 Amendments. However, Taxpayer did contest the retroactive application of the 2010 Amendments to his particular circumstances, maintaining that such application resulted in an “as applied” violation of his due process rights.

Taxpayer pointed out that his transaction took place after, and in reliance on, the Tribunal’s decision in Baum. Accordingly, Taxpayer argued that the resulting “extra level of reliance” tipped the scale in his favor, and required a conclusion that the deficiency at issue represented an unconstitutional application of the 2010 Amendments.

The Division responded that acceptance of Taxpayer’s argument would have required the Division to ignore the legislative findings that the 2010 Amendments served to clarify and confirm the Department’s longstanding and correct interpretation of existing law, whereby gains from a deemed asset sale under Section 338(h)(10) of the Code were not excluded from a nonresident’s NY-source income as gains from the disposition of intangible assets, but rather are included to the extent of the S corporation’s N.Y. BAP.

At the time of enacting the 2010 Amendments, the legislature was aware of the Baum decision, and of the consequences resulting therefrom. It recognized that such amendments were necessary in order to cure the incorrect decision reached in Baum, to clarify the concept of Federal conformity, to avoid taxpayer confusion in preparing returns, to avoid complex and protracted litigation, and to prevent unwarranted refunds so as to stem the loss of revenue that would result from such incorrect decisions.

The Division explained that, by making the 2010 Amendments retroactive, the legislature “evinced both its clarifying and corrective aims.” In doing so, it drew no distinction between transactions that predated or postdated the decision in Baum, notwithstanding that some taxpayers could claim to have relied on Baum. The legislature did not limit the retroactive reach of the 2010 Amendments by any reference to the Baum decision, but rather extended retroactivity to all open years upon the foregoing clarifying and correcting justification bases. Thus, the Division concluded, the legislature’s intended sweep of retroactivity included those who could have relied on Baum.

In sum, the imposition of the tax at issue was not an unconstitutional application of the law in violation of constitutional due process standards. Accordingly, Taxpayer’s petition was denied, and the notice of deficiency sustained.


The cost of moving to Shangri La may not be insignificant, especially for an individual N.Y. resident who owns an interest in a closely held business that operates within the state, who actively participates in the management of such business, and who is dependent upon the cash flow from the business.

For one thing, the individual’s continued ownership and involvement in the business may very well tip the scales toward a finding of continued resident status.[xxxiii]

If the individual were able to change the nature of their relationship to the business from that of an owner-participant to that of a passive investor, their continued association with the N.Y. business may not be as harmful to their claim of having abandoned their N.Y. domicile. In fact, the transition of managerial duties to another person may evidence an intent to begin a new “way of life” outside the state. Of course, this requires that the owner find someone who is capable of, and interested in, assuming these duties. The owner will certainly have to compensate this person at a level commensurate with their responsibilities; at the same time, the owner will have to cease taking a salary themselves.

Even if the owner were to successfully convert their status to that of a passive investor, if the business is owned through a pass-through entity (“PTE,” such as an S corporation or a partnership/LLC), the owner will still be subject to N.Y. income tax on their pro rata share of the PTE’s NY-source income.[xxxiv] What’s more, if the individual owner were to sell the business, it is unlikely that the buyer would agree to purchase the stock (in the case of an S corporation) without requiring an Election in order to step-up the basis of the underlying assets. As in the case of the taxpayer in the decision discussed above, that could result in significant NY-source income.[xxxv]

Did someone say “C corporation?” Don’t cut your nose to spite your face. There are Federal income taxes to consider – don’t lose sight of that.

Bottom line: there’s a lot of planning that has to precede the implementation of any steps to change a business owner’s resident status vis-à-vis N.Y.


[i] N.Y.S. at 8.82%, N.Y.C. at 3.876%.

[ii] N.Y.S. at 4.0%, N.Y.C. at 4.875%.

[iii] Whether in an absolute sense or as a portion of home value, depending upon the county.

[iv] Feel free to substitute a golf course, mountainside, or anything else that tickles your fancy – this is my post.

[v] Of course, they’ve also registered to vote there, and have registered their cars there.

[vi] An S corporation (IRC Sec. 1361), or an LLC that has not checked the box to be treated as an association (Reg. Sec. 301.7701-3).

[vii] Which, for our purposes, would include a guaranteed payment in the case of a partnership. IRC Sec. 707(c).

[viii] For the purpose of avoiding N.Y. tax.

[ix] See TSB-M-06(5)I for a discussion of the “convenience of the employer” test and the determination of the ratio of N.Y. working days to total working days.

[x] Tax Law Sec. 631(a). We’re focusing on the State’s taxation of nonresidents here.

[xi] See, e.g., Matter of Herbert L. Kartiganer et al., 194 AD2d 879.

[xii] According to the N.Y.’s Nonresident Audit Guidelines, a taxpayer’s continued employment, or active participation in N.Y. sole proprietorships and partnerships, or the substantial investment in, and management of N.Y. corporations or limited liability companies, is a primary factor in determining domicile. If a taxpayer continues active involvement in N.Y. business entities, by managing a N.Y. corporation or actively participating in N.Y. partnerships or sole proprietorships, such actions must be weighed against the individual’s involvement in businesses at other locations when determining domicile. The degree of active involvement in N.Y. businesses in comparison to involvement in businesses located outside N.Y. is an essential element to be determined during the audit.

[xiii] In The Matter of the Petition of Franklin C. Lewis, DTA No. 827791 (N.Y. Div. Tax App. 6/20/19).

[xiv] Generally, an S corporation does not pay income tax at the corporate level, but passes its income and deductions through to its shareholders, who report the same on their personal tax returns.

[xv][xv] Reg. Sec. 1.338(h)(10)-1(d).

Generally speaking, such an election at the federal level may be advantageous to a purchaser due to the stepped-up basis of the assets deemed to have been purchased for future depreciation and/or amortization purposes. This reduces the cost of the acquisition for the purchaser by allowing them to more quickly recover their investment in the transaction.

At the same time, such an election may be disadvantageous to the seller, due to a possibly greater federal tax liability as the result of being taxed at a higher rate on gain from the sale of assets than would be the case on gain from the sale of stock.

Since N.Y.’s income tax is a federal “conformity based” system, such an election can carry with it N.Y. state tax implications for both residents and nonresidents.

[xvi] Matter of Baum, Tax Appeals Tribunal (the “Tribunal”), February 12, 2009.

[xvii] The selling shareholders of a target corporation should always compare the net after-tax proceeds following a sale of stock coupled with a Sec. 338(h)(10) election with the net proceeds following a stock sale without such an election. It is not at all unusual for a seller to negotiate with the buyer for an increase in the purchase price by an amount such that the seller will end up with the same net proceeds had no election been made. On the one hand, the election is made jointly by the seller and the buyer; moreover, the amount of the increase will, itself, be amortizable by the buyer. On the other hand, a gross-up may cause the deal to be too expensive for the buyer.

[xviii] IRC Sec. 453.

[xix] IRS Form 1120-S.

[xx] Form CT-3-S.

[xxi] This omitted the date of the stock sale. The target’s S corporation election would normally terminate on the date of the sale – because of the ineligible C corporation buyer – such that the target’s last day as an S corporation is the immediately preceding day. However, when an election is made under IRC Sec. 338(h)(10), the target’s S corporation election continues through the end of the sale date in order to allow the pass-through to the target’s shareholders of the gain resulting from the deemed asset sale.

[xxii] Since its incorporation in N.Y. in 2002, 100% of Target’s receipts had been apportioned to N.Y. in its franchise tax filings.

[xxiii] The “Tax Law;” Section 632(a)(2).

[xxiv] The “Department.”

[xxv] See TSB-M-10 [10] I.

[xxvi] Form IT-203.

[xxvii] Plus interest and penalties.

[xxviii] Taxpayer also argued that the gain from the sale of Target was not subject to N.Y. tax because Target’s proper N.Y. BAP should have been zero, and not 100-percent as reported by Target. In almost all cases, the contents of the return constitute an admission by the filing taxpayer. What’s more, the taxpayer will rarely be allowed to disavow their own return position.


Nonresidents are subject to N.Y. personal income tax on their N.Y. source income. NY-source income is defined as the sum of income, gain, loss, and deduction derived from or connected with N.Y. sources. For example, where a nonresident sells real property or tangible personal property located in N.Y., the gain from the sale is taxable in N.Y.

In general, under the Tax Law, income derived from intangible personal property, including gains from the disposition of such property, constitute income derived from N.Y. sources only to the extent that the property is employed in a business, trade, profession, or occupation carried on in N.Y. From 1992 until 2009, this analysis also applied to the gain from the disposition of interests in entities that owned N.Y. real property. However, in 2009, the Taw Law was amended to provide that items of gain derived from or connected with N.Y. sources included items attributable to the ownership of any interest in real property located in N.Y. For purposes of this rule, the term “real property located in” N.Y. was defined to include an interest in a partnership, LLC, S corporation, or non-publicly traded C corporation with one hundred or fewer shareholders, that owns real property located in N.Y. and has a fair market value that equals or exceeds 50% of all the assets of the entity on the date of the sale or exchange of the taxpayer’s interest in the entity.

[xxx] Section 632 (a) (2).

[xxxi] The “act is intended to clarify the concept of federal conformity in the personal income tax and is necessary to prevent confusion in the preparation of returns, unintended refunds, and protracted litigation of issues that have been properly administered up to now.”

[xxxii] TSB-M-10(10)I.

[xxxiii] Query whether they can move the business out of N.Y.? For our purposes, I am assuming that is not the case.

[xxxiv] The number of times I’ve been involved in a resident audit where the taxpayer already pays N.Y. income tax on all of their business income under these facts! Of course, the state is looking to also tax their investment income.

[xxxv] The seller may be able to negotiate a gross-up in the price to account for this tax liability.















Tax Law for the Closely Held Business blog author Lou Vlahos was extensively quoted in Peter J. Reilly’s July 8 Forbes column “Clever Techniques To Defer Capital Gains – Maybe Too Clever.”

Below is an excerpt that includes Lou’s commentary on monetized installment sales: 

Does MIS Work?

Mr. Greenwald told me that he thinks [monetized installment sales] work provided the transaction is executed as modelled in the Chief Counsel letter.  On the other hand, he has not had a client do one as his clients want to stay in real estate and therefore favour 1031.

Lou Vlahos of Farrell Fritz PC is a lot more skeptical as he explains in this piece – Monetized Installment Sales: What Are They About?

“No, this arrangement is not undertaken as a formal pledge by the seller-taxpayer of the intermediary’s installment obligation; and, no, the intermediary’s obligation to the seller is not formally ‘secured’ by cash or cash equivalents.

Nevertheless, the monetized installment sale arrangement described above is substantively the same as one or both of these gain-recognition-triggering events. As noted, above, ‘[o]ther arrangements that have a similar effect’ should be treated in the same manner.

The IRS should clarify its position accordingly.”

Mr Vlahos highlighted something from the letter which you don’t see in other discussions that allude to it as if it were authority.

“The Transaction meets the statutory and regulatory requirements of I.R.C. § 453. Because Asset meets the definition of farm property under I.R.C. § 2032A(e)(4), Taxpayer can pledge the Purchase Notes and obtain cash through a separate loan under I.R.C. § 453A(b)(3)(B) without the proceeds being treated as a payment for installment sale purposes.” (Emphasis added)

To read the full article, please click here.