What a Mess

A “perfect storm” may be defined as a critical state of affairs arising from the convergence of a number of negative factors, often after the unexpected introduction of some catalytic event.

The situation in which we find ourselves today may be described as a perfect storm from several different perspectives.

For many years, our nation has been fracturing along various socioeconomic lines. Until fairly recently, we have been able to repair some of the cracks in our social structure, and we have prevented certain identifiable fault lines from developing into fissures of any significance.[i]

The pandemic, however, has changed the environment in which these factors interact with one another, and it has influenced – in a very negative way – how their respective proponents perceive each other.

Although various and diverse “solutions” have been suggested by some hopefully-well-intentioned folks on the national stage, these proposals share a common element: the expenditure of significant funds by the federal government.

Throw Money at the Problem(s)

In order to finance the many programs being discussed, the federal government cannot simply print or borrow more money.[ii] At some point, presumably, it has to generate tax revenues.[iii]

Do voters want to pay more taxes? Probably not, regardless of the ostensible purpose for which they will be expended. So what is a group of elected officials to do without jeopardizing their livelihoods?

Collect as much tax as possible from as small a number of voters as practicable, and especially from those whom the public has identified as having benefitted the most from “the system.”[iv]

This approach to the problem is reflected in Mr. Biden’s tax proposals: increase the individual federal tax rate on ordinary income from 37% to 39.6% (43.4% when one adds the 3.8% surtax on net investment income[v] in the case of an individual investor in a business[vi] who does not materially participate in the business); increase the rate on “qualified” dividends from 20% (23.8%) to 39.6% (43.4%); increase the rate on long-term capital gains to 39.6% (43.4%); impose the 12.4% Social Security tax[vii] on all earned income in excess of $400,000;[viii] increase the corporate income tax rate from 21% to 28%; increase the tax on GILTI from 10.5% to 21%;[ix] reduce the estate, gift, and GST tax basic exclusion amounts from $10 million to $5 million;[x] eliminate the like kind exchange for real estate[xi]; etc.[xii]

The prospect of what many see as imminent, and significant, increases in federal taxes is causing members of the “targeted” population of taxpayers, especially those who reside in states or municipalities with high overall tax burdens (like New York, New Jersey and Connecticut[xiii]), to rethink their business plans, and even their way of life.

How Will Taxpayers React?

Beginning this summer, we have heard from the founding owners of many successful, closely held businesses – hardly members of the Gates, Buffet, Bezos, Hollywood, Professional Sports, or “family money” crowd[xiv] – who are concerned about the future. A sampling of their questions: Should I try to sell my business before the year-end?[xv] Does it make sense for me to utilize my gift tax exemption in 2020? How can I give up my New York residence?[xvi]

Each of these considerations involves a tax-related goal rather than a non-tax business-driven end. That’s ass-backwards, to use the vernacular, and that’s a sign of poor tax policy.

Of course, most business owners recognize – especially based on the history of recent legislation – that no tax law is “permanent.” In the meantime, they will cut costs,[xvii] try to be more efficient, try to generate more revenue, establish a line of credit, borrow money when necessary, and otherwise figure out how to sustain and strengthen their business.

There are some bad actors out there, however, who lack patience, who are less industrious, who are unwilling to make any sacrifices, and who are ready to buy into the proverbial “quick fix” for their tax problem.

Assuming the tax proposals put forth by the Democratic Party are eventually enacted into law, we are certain to encounter more unscrupulous promoters of such tax-saving schemes, along with their more-than-willing clients.

A recent decision of the U.S. Tax Court examined one such scheme.[xviii]

Tax “Strategy”

Taxpayer was employed as an officer of Limited Partnership (“LP”), and owned limited partnership units in LP. Taxpayer was also an officer of LP’s general partner.

During the year at issue, Taxpayer met with Adviser for the purpose of formulating a tax-planning strategy to eliminate the expected tax liability on the substantial income that Taxpayer was slated to receive later that year.

The recommended tax structure involved organizing multiple new entities owned or controlled by Taxpayer, and included an S corporation, a family limited partnership (“FLP”), and a family management trust. Under the structure, Taxpayer would contribute cash and marketable securities to the S corporation in exchange for its stock; Taxpayer would use the S corporation as a vehicle for day trading. The S corporation would then transfer those same assets to the FLP in exchange for a 98% interest as a limited partner. The trust would be the general partner of the FLP, holding the remaining 2% of the partnership interests.

Under the proposed tax strategy, Taxpayer would then liquidate and dissolve the S corporation, which would distribute the 98% limited partnership interest to Taxpayer, as its shareholder. Upon the liquidation of the S corporation, Taxpayer would own the 98% interest in the limited partnership, and the partnership would own the assets that Taxpayer had initially contributed to the S corporation.

Adviser indicated that the fair market value of the distributed limited partnership interests would reflect a reduced value, for tax purposes, because of the large discounts for lack of marketability and lack of control that would be applied in determining their value.[xix] The liquidation and dissolution of the S corporation would generate a tax loss for Taxpayer to report on their individual tax return.

Taxpayer decided to implement this strategy, organizing LLC (with Taxpayer as the sole member), S Corp, FLP, and Trust (with Taxpayer as trustee and their kids as beneficiaries). Initially, Taxpayer held the 2% general partnership interest in FLP, and S Corp held a 98% limited partnership interest, but Taxpayer then transferred the general partnership interest to Trust.

Following the formation of the entities, Taxpayer transferred their units in LP to LLC. Taxpayer also transferred cash and marketable securities from personal accounts to newly opened accounts of S Corp.

Shortly afterward, S Corp transferred most of those same, newly received assets to newly opened accounts of FLP, following which S Corp was left with very few assets other than its interest in FLP.

During the period of its existence – just over one month – S Corp executed a very small number of trades in securities.

Indeed, approximately two-and-one-half weeks after the incorporation of S Corp, Taxpayer again met with Advisor to begin taking steps to dissolve S Corp and distribute its assets. Taxpayer filed the required documents with the secretary of state to terminate S Corp, effective the last day of the calendar year.[xx] Taxpayer also signed a transfer and assignment of their interest in LLC to S Corp, retroactively effective Day One (two weeks prior). That same day, and acting in his capacity as president of S Corp, Taxpayer signed another transfer and assignment, this time of S Corp’s interest in LLC to FLP, retroactively effective Day Two. S Corp then transferred its remaining cash and marketable securities FLP. One week before the year-end,  S Corp transferred its only remaining asset, the 98% limited partnership interest in FLP, in equal parts to Taxpayer and their spouse, with each receiving a 49% limited partnership interest. In addition, Taxpayer transferred a limited partnership interest in FLP to each of three trusts established for the benefit of their three sons, effective the year-end.

Tax Returns

Taxpayer timely filed their federal individual income tax return for the year at issue. On that return Taxpayer reported, among other items, approximately $700,000 of wages, and over $1 million of nonpassive partnership income,[xxi] from LP.[xxii] Taxpayer also claimed a $2 million ordinary loss deduction on Schedule E from S Corp,[xxiii] resulting in a tax liability of zero.

S Corp filed its initial and final income tax return[xxiv] for the year at issue. On its return, S Corp reported an ordinary loss[xxv] (rather than a capital loss) in excess of $2 million, which was sufficient to offset Taxpayer’s total income from LP. The corporation reported the values of the 49% limited partnership interests in FLP distributed to each of Taxpayer and their spouse as ‘gross receipts.” To calculate the values of the distributed partnership interests, the total value of the cash, securities, and units of LP that Taxpayer had transferred to FLP through S Corp, was discounted by more than 40% for lack of control, lack of marketability, and other factors. S Corp reported as “cost of goods sold” its alleged total basis in FLP.[xxvi]

FLP also filed a federal tax return,[xxvii] on which it reported no gross receipts or sales, no deductions, and no business income or loss.

Examination and Tax Court

The IRS examined Taxpayer’s return and concluded that Taxpayer was not entitled to the claimed loss deduction on the grounds that the transactions generating the reported loss lacked economic substance; that S Corp was not a trade or business and that the transaction was not entered into for profit; that Taxpayer have failed to show that they incurred a loss on the liquidation of S Corp; and that Taxpayer understated the value of the distributed assets.

Taxpayer appealed the proposed adjustment with the IRS Appeals Office, but was unsuccessful. Taxpayer then petitioned the U.S. Tax Court.

The Court acknowledged that a taxpayer is generally free to structure their business transactions as they wish, even if motivated in part by a desire to reduce taxes. That being said, the Court then added that transactions “which do not vary control or change the flow of economic benefits” are to be “dismissed from consideration.”

The economic substance doctrine, the Court explained, allows courts to enforce the legislative purpose of the Code “by preventing taxpayers from reaping tax benefits from transactions lacking economic reality.” Thus, a court may disregard a transaction for tax purposes – even one that formally complies with the Code – if the transaction has no effect other than generating an income tax loss.

Whether a transaction has economic substance, the Court continued, is a factual determination for which the taxpayer bears the burden of proof.

According to the Court, a transaction “will be respected for tax purposes only if: (1) it has economic substance compelled by business or regulatory realities; (2) it is imbued with tax-independent considerations; and (3) it is not shaped totally by tax avoidance features.”[xxviii]

In other words, the transaction must exhibit an objective economic reality, a “subjectively genuine” business purpose, and some motivation other than tax avoidance.

Taxpayer contended that they organized S Corp as a vehicle through which to engage in day trading while still working at LP. They claimed that they transferred the cash and securities to S Corp in order to finance the day trading activities and that the transfers of assets to FLP through S Corp were for asset protection purposes.

The Court rejected Taxpayer’s argument, stating that “It is clear from the record, however, that [S Corp] existed only to generate a tax loss. Despite the time, effort, and cost of establishing the company, within 17 days of organization [Taxpayer] had begun taking steps to dissolve [S Corp] . . . before any actual significant trading had occurred.” In arriving at its conclusion, the Court considered the above-referenced factors.

Economic Substance[xxix]

The first prong of the economic substance inquiry requires that the transaction have economic substance compelled by business or regulatory realities. The Court explained,

A transaction lacks economic substance if it does not “vary control or change the flow of economic benefit[s]”.  Under the objective economic inquiry, the Court examines whether the transaction affected the taxpayer’s financial position in any way, such as whether the transaction “either caused real dollars to meaningfully change hands or created a realistic possibility that they would do so.”  A circular flow of funds among related entities does not indicate a substantive economic transaction for tax purposes.

The Court found that the transactions executed by Taxpayer to generate the claimed loss deduction failed to alter Taxpayer’s economic position in any way that affected objective economic reality. The asset transfers represented a circular flow of funds among related entities used to generate an artificial tax loss to offset Taxpayer’s income for the year at issue.[xxx]

Taxpayer, the Court determined, had constant control over the assets and entities at all relevant times; neither the contribution to S Corp nor its dissolution affected Taxpayer’s position or caused “real dollars to meaningfully change hands”. The form of Taxpayer’s ownership of the assets may have changed, but the substance did not. What’s more, there was no realistic possibility that the assets would change hands at any point.

Accordingly, the Court held that the transactions lacked objective economic reality and, therefore, failed to satisfy the first prong of the economic substance doctrine.[xxxi]

Subjective Business Purpose

The Court then considered whether Taxpayer had a “subjectively genuine business” purpose or some motivation other than tax avoidance.

After noting again that taxpayers are not prohibited from “seeking tax benefits in conjunction with seeking profits for their businesses,” the Court warned against a taxpayer’s entering into a transaction only for a tax-avoidance purpose.[xxxii]

In response to Taxpayer’s claim that S Corp was formed for the purpose of day trading, the Court pointed out that Taxpayer’s actions were not consistent with a profit motive.[xxxiii]

What’s more, after organizing S Corp, Taxpayer dissolved it almost immediately. Indeed, Taxpayer began taking steps to dissolve S Corp after completing a single day trade, and the majority of the day trades that S Corp transacted were executed after the process of dissolving the corporation had begun.

Before S Corp engaged in any trading, Taxpayer caused the company to transfer nearly all of its assets to FLP, a newly formed company that never engaged in any business activity and otherwise held no assets. The transfers to FLP, the Court observed, served no business purpose and offered no potential for profit. Moreover, Taxpayer could not identify a business motive or profit potential for using S Corp as a conduit for that transfer. Nor did Taxpayer identify any business purpose in transferring the LP units to FLP through S Corp. These transfers, the Court determined, served only to increase the claimed loss when S Corp dissolved shortly thereafter.

According to the Court, Taxpayer intended from the beginning to organize and dissolve S Corp within the same year in order to generate a tax loss in an effort to reduce their income tax liability arising from Taxpayer’s services for and investment in LP. Taxpayer did not have a genuine business purpose for establishing the entities, and their actions were taken solely for tax-motivated reasons. Taxpayer knew they would be receiving substantial income from LP and sought to generate a tax loss to offset it. Adviser offered Taxpayer a prepackaged tax strategy designed to create an artificial loss through a circular flow of assets, the application of substantial discounts, and the misreporting of the resulting loss as an ordinary loss, rather than a short-term capital loss.

Thus, the Court held that the transactions at issue did not have economic substance, and that Taxpayer was not entitled to the claimed loss deduction therefrom.

Let’s Be Careful Out There[xxxiv]

Most business owners work hard, rarely taking a break from their business – it is their calling, something that they enjoy and do well. Hopefully, their investment of time, effort and money leads to a successful conclusion.[xxxv]

In my experience, most successful business owners are not averse to paying taxes. They recognize that taxes are vital to maintaining our society and culture – a “necessary evil,” if you will.

That being said, too often they are portrayed as people who pay professionals to help them abuse “the system” and thereby “avoid” paying taxes, rather than as well-informed taxpayers who are merely doing what the Code allows, and even encourages, them to do.

This feeling of being put upon may result in some business owners becoming susceptible to unscrupulous promoters of schemes to “save” taxes. That’s the time to rely upon one’s instincts – that something cannot be as good as it seems – as well as upon one’s long-time advisers, who are almost certain to recognize a modern version of the snake oil salesman.


[i] https://pubs.geoscienceworld.org/segweb/economicgeology/article-abstract/58/7/1157/17270/Fractures-joints-faults-and-fissures?redirectedFrom=PDF

[ii] Some disagree. Have you heard of Modern Monetary Theory? https://www.newyorker.com/news/news-desk/the-economist-who-believes-the-government-should-just-print-more-money Does the government spend more than it collects in taxes? No problem. Does it have to borrow more? No problem. In that case, why collect taxes at all? To control inflation, they say.

As I have said many times before, I am no economist, but WTF?!

[iii] We’re already behind the eight ball with the trillions of dollars spent on countering the effects of COVID-19 and our response thereto.

[iv] The infamous bank robber, Willie Sutton, was once asked why he robbed banks. He is reputed to have replied, “Because that’s where the money is.” Duh?

[v] IRC Sec. 1411.

[vi] Basically, a Form 1040, Schedule E filer.

[vii] 6.2% on each of the employer and the employee.

[viii] Again, you have to ask, what about those folks who fall between the current cap of $137,700 and the proposed $400,000 threshold?

[ix] I will note that no one is suggesting that the inclusion of GILTI in gross income – a product of the 2017 tax legislation – is a bad thing.

[x] Reducing the exemption from today’s $11.58 million to $5.49 million.

[xi] It’s not far-fetched to imagine that the tax-deferred contribution of property to corporations or to partnerships may be eliminated in the not-too-distant future. The same goes for the tax-free corporate reorganization provisions. Each of these plays the same role in its respective sphere as does the like kind exchange for real estate. What about the elimination of installment reporting? It was actually repealed for accrual basis taxpayers back in 1999; it was only after intensive lobbying by the real estate industry and closely held businesses that it was reinstated the following year. Query how influential these groups would be today?

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

[xiii] According to the Tax Foundation, the residents of these three States have the highest state-local tax burdens – paying somewhere between 12% and 13% of their total income to state and local taxes. https://taxfoundation.org/publications/state-local-tax-burden-rankings/

[xiv] The taxes we’re talking about are, to this “funny money” crowd, what a mosquito is to an elephant.

[xv] I might also add that, almost to a person, these folks expressed their desire to reward their key employees in the event of a sale, and to ensure continued employment for the rest of their workforce.

In fact, I can probably count on one hand the number of selling owners we have represented over the years who thought differently.

[xvi] https://www.taxlawforchb.com/2018/05/the-new-york-business-and-changing-domicile-let-it-go-let-it-go/

[xvii] That includes employees. That’s another upshot of the pandemic. Many businesses have realized they can make due with a smaller workforce.

[xviii] Daichman, v. Commissioner, T.C. Memo. 2020-126.

[xix] See, e.g., Rev. Rul. 59-60. The Court did not make any findings as to value.

[xx] In general, S corporations are required to use the calendar year for tax purposes.

[xxi] Reported to him by LP on a Schedule K-1.

[xxii] Form 1040, Schedule E, Part II.

[xxiii] Attributable to its liquidating distribution (and deemed sale per IRC Sec. 336) of the value-discounted FLP interests, and passed through to the shareholder under IRC Sec. 1366.

Query why there was no mention of the IRS’s standard position in estate/gift tax matters that interests in a partnership funded with marketable securities did not merit much in the way of valuation discounts.

Query also why there was no discussion of the Pope & Talbot decision, 162 F.3d 1236 (9th Cir. 1999), where a corporation made a non-liquidating distribution of limited partnership interests in a single partnership to its shareholders. The corporation had valued each partnership unit as a minority interest (a discounted value). The court disagreed. The units had to be valued (for purposes of IRC Sec. 311) as if sold in their entirety, as one; otherwise, the FMV of the underlying assets would not be accurately reflected.

Finally, query why no mention was made of IRC Sec. 336(d), which denies loss recognition to a liquidating corporation on certain distributions to related persons.

[xxiv] On Form 1120S, U.S. Income Tax Return for an S Corporation.

[xxv] Because it claimed to be a day-trader?

[xxvi] Taxpayer’s accountant prepared S Corp’s return with the assistance of Adviser, who directed the accountant to report the transactions as gross receipts and cost of goods sold, and who even provided the discounts and other information used to compute those amounts.

[xxvii] On Form 1065, U.S. Return of Partnership Income.

[xxviii] The Court recognized that there is “near-total overlap between the latter two factors.”

[xxix] The year at issue preceded the effective date of IRC Sec. 7701(o), which codified the doctrine.

[xxx] Just to recap: Taxpayer transferred substantial assets to S Corp, their wholly-owned corporation, which then transferred those assets to FLP. S Corp owned a 98% limited partnership interest in FLP, while Taxpayer, as trustee of the Trust, owned the remaining 2% as general partner. Within days of the transfers to FLP, S Corp dissolved, distributing its 98% interest in FLP to Taxpayer. Taxpayer claimed a loss deduction on their tax return by calculating the values of the distributed partnership interests based on substantial discounts.

[xxxi] Although failure to satisfy any one prong of the economic substance doctrine is sufficient for a finding that the transaction lacked economic substance, the Court nevertheless addressed the remaining two prongs.

[xxxii] In other words, a taxpayer who acts with mixed motives of profit and tax benefits may nonetheless satisfy the subjective test.

[xxxiii] Taxpayer had no past experience in day trading, yet conducted no prior research into the activity, did not consult any references, and did not otherwise seek advice before expending the time and resources to establish S Corp.

[xxxiv] Hill Street Blues fans will remember Sgt. Phil Esterhaus’s catch phrase.

[xxxv] Often the sale of the business.

NYC Real Estate on the Ropes

In March of this year, the Department of Homeland Security classified real estate as an “essential business.”[i] I imagine that the person in Washington who suggested that real estate be added to the list of enterprises that were deemed critical to the public’s security and well-being must have been thinking of New York City (“NYC”).

The real estate market is a major force in the life of the City, and any downturn in that industry is likely to have negative repercussions throughout NYC’s economy. This relationship has been borne out by the pandemic,[ii] which has had a significantly adverse impact upon the ownership and disposition of commercial real estate in the City, and upon the revenues of City government.[iii]

According to the Real Estate Board of New York, in the first half of 2020, total investment sales for commercial and multifamily rental properties experienced a 32 percent decline in the volume of transactions, and a 54 percent decline in total consideration, compared to the first half of 2019. The total tax revenue for the City and NY State generated from investment sales in the first half of 2020 was down 49 percent from the previous 6 months and 58 percent from the previous 12 months.[iv]

Perhaps more disconcerting, because of its potentially longer-term effects to the City’s real estate market, is the realization among many employers that their businesses may be operated remotely, without the heretofore significant cost of maintaining a physical presence in the City.[v]

At the same time, many of NYC’s more affluent denizens are preparing – some more publicly than others – to leave the City for jurisdictions with friendlier tax environments and more inviting climates.[vi]

Don’t Count NYC Out

Of course, this isn’t the first time many folks have counted the City out.

Many of us remember the extremely weak economy of the 1970s – often described as one in “freefall” – the oil embargo, the recession, and the City’s brush with bankruptcy.[vii] Over 600 hundred thousand jobs were lost – one-sixth of the City’s employment base – almost one million households were on welfare, graffiti was everywhere, arson was common, whole blocks were abandoned, crime was rampant, prostitutes crowded the streets around the then-under-construction Javits Center and, by the end of the decade, almost a million people had left the City.[viii]

The City bounced back.

More recently, many predicted that the September 11 attacks would lead to the demise of the City’s office market.

The City bounced back.

Bill de Blasio became Mayor in January of 2014.[ix] His term ends in December of 2021 – after years of watching all major crime indices increase.

The City will bounce back.

It would be wise to keep this history, and this potential, in mind as we consider the City’s future.

A recent article in Forbes, “The Case for Betting Long on New York City Real Estate,”[x] delivers a positive message both succinctly and pretty convincingly:

“The upshot is this: New York real estate has boosted the metropolitan economy for a decade with exceptional growth that can withstand even major adversity, like the current slowdown. The long-term trend is still upward.”[xi]

Be Smart – Don’t Forget Taxes[xii]

For those closely held investors who are already committed to holding NYC real properties, and for those who are thinking about making such a long-term commitment – perhaps to take advantage of the softer market – it is imperative that they understand the Federal, state and local income tax consequences arising from the acquisition, operation and disposition of their property.

It would be folly to ignore taxes – or, more appropriately, their economic impact on one’s investment – or to defer[xiii] planning for them, especially in the current environment: a softer real estate market with thinner margins, the near certainty of not insignificant income tax and other tax increases, the possible limitation on the use of the like kind exchange, and the possible elimination of the basis step-up at death.[xiv]

A recent decision by the NYC Tax Appeals Tribunal (the “Tribunal”)[xv] addressed what appear to have been the unanticipated NYC income tax consequences realized by a foreign corporation (from a state on the other side of the Hudson River[xvi]) on the indirect sale (the “Sale”) of its equity interest in a partnership that owned and operated real property in NYC.

The Joint Venture

Corp was a NY corporation that teamed up with Partner to form a joint venture (“JV”) to act as a construction contractor doing business primarily in the NY Metro area. Corp owned a 50 percent interest in JV.

At some point, JV ceased construction operations and, instead, acquired investment interests in three limited partnerships (the “LPs”) which engaged solely in the “holding, leasing, and managing” of their respective real properties located in NYC.

JV owned a limited partnership interest in each of the LPs.[xvii] None of the general partners of the LPs was related to either JV or Corp.

For all periods preceding JV’s sale of its interest in one of the limited partnerships (“LP-1”), Corp reported and paid NYC General Corporation Tax (“GCT”) on its share of the income, gain, and losses of the LPs.

Prior to the Sale, Corp “reorganized” itself as a New Jersey (“NJ”) corporation. Specifically, Taxpayer was newly incorporated under the laws of NJ in order to effectuate this reorganization; Taxpayer then elected to be treated as an S corporation for tax purposes; shortly thereafter, Corp was merged with and into Taxpayer in an “F” reorganization[xviii] – a “mere change in place of organization”[xix] – in which Taxpayer was the surviving corporation and successor to Corp.

As the successor to Corp, Taxpayer held the 50 percent ownership interest in JV.

The Sale, the Gain, the Exam

JV sold its limited partnership interest in LP-1 to an unrelated third party. It reported its gain from the Sale on its Federal,[xx] NY State, and City tax returns.

Taxpayer was allocated its 50 percent share of the gain realized on the Sale by JV (the “Capital Gain”), which it reported on its Federal corporate income tax return.[xxi] In turn, as an S corporation, Taxpayer must have issued Schedules K-1 to its shareholders, allocating the Capital Gain among them in proportion to their stock holdings.[xxii]

Taxpayer also reported the Capital Gain on its City GCT return,[xxiii] but excluded the gain from its entire net income (“ENI”) by deducting an amount equal to the Capital Gain from its Federal taxable income – the starting point for determining ENI – with a notation explaining that Taxpayer’s deduction was based upon its treatment of the gain as “Gain on the sale of partnership interest – not used in trade or business in NY.”

The NYC Department of Finance (the “Dept.”) examined Taxpayer’s GCT return for the year at issue, following which it issued a Notice of Determination[xxiv] to Taxpayer asserting a GCT deficiency for that year. The Notice explained that “Adjustment is made to include [the Capital Gain] from the sale of partnership interest” in Taxpayer’s ENI.[xxv]

Taxpayer disagreed with the Dept.’s conclusion, and filed a petition with the Tribunal to contest the asserted deficiency.

The Parties’ Positions

The issue before the Tribunal was whether, for GCT purposes, the Federal conformity provisions of the City’s Administrative Code (the “Admin. Code”) required the exclusion by a foreign taxpayer[xxvi] of the gain realized by such taxpayer from the sale of an interest in a limited partnership that did business in the City.

The parties agreed on the following basic facts:

  • During the year at issue, JV’s sole contacts with NYC were its investment interests in the LPs (including LP-1), which in turn owned interests in NYC real properties;
  • Neither JV nor Corp/Taxpayer directly or indirectly engaged in operating or managing any portion of business activities of the LPs, or engaged in a unitary business with any of the LPs;
  • JV did not independently conduct a trade or business in NYC, and had no property, payroll, or receipts in NYC; and
  • Corp/Taxpayer maintained its only office in NJ, and had no place of business in NYC.

Notwithstanding these agreed-upon facts, the Dept. argued that Taxpayer engaged in business within NYC by virtue of its ownership interest (through JV) in LP-1, which owned, leased, and managed property within NYC.[xxvii] The Dept. stated that because the GCT is imposed upon the privilege of doing business in NYC, and because Taxpayer was doing business in NYC – by virtue of (i) LP-1’s doing business in NYC, and (ii) JV’s derivatively doing business through its interest in LP-1, and (iii) Taxpayer’s interest in JV – the Capital Gain was properly included in Taxpayer’s ENI for GCT purposes.

Taxpayer argued that the proposed adjustment ran afoul of the Federal “conformity” doctrine.[xxviii] It submitted that as Federal income is the starting point for ENI,[xxix] Federal conformity required that NYC treat the Capital Gain as it would be treated under the Code; specifically, “In the case of a sale or exchange of an interest in a partnership, gain or loss shall be recognized to the transferor partner. Such gain or loss shall be considered as gain or loss from the sale or exchange of a capital asset…”[xxx]

Prior to the Tax Cuts and Jobs Act of 2017,[xxxi] Taxpayer continued, the “entity approach” to partnership taxation could apply to the disposition of a partnership interest.[xxxii] Under this approach, it noted, a partner is treated as though it owns a partnership interest, an intangible asset, as opposed to a proportionate, undivided share of the partnership’s underlying assets.[xxxiii] Taxpayer argued that the gain from the sale of the LP-1 partnership interest – an intangible not used in a trade or business – should be sourced to Taxpayer’s domicile outside NYC and, therefore, excluded from Taxpayer’s ENI.

The Dept. countered by stating that nothing in either NYC or NY State law barred the use of the “aggregate approach” toward the disposition of a partnership interest, meaning that a partner’s sale of a partnership interest could be treated as the sale by the partner of its separate, undivided interest in each asset owned by the partnership. In any case, it argued, the Federal conformity doctrine did not apply to the present case because, while the Code addresses the tax treatment of the disposition of a partnership interest, the GCT imposes a tax on the privilege of doing business in NYC.

The Tribunal’s Opinion

The Tribunal explained that the GCT is imposed on every corporation doing business, owning or leasing property, or engaging in various other activities in the City.[xxxiv] The tax, it stated, is computed as the sum of (1) the greatest amount of tax calculated under four alternative methods (including on the basis of the corporation’s ENI allocated to the City); plus (2) an amount of tax calculated on subsidiary capital.[xxxv]

The Tribunal also noted the Rules of the City provide that: “a corporation shall be deemed to be doing business in the City if it owns a limited partnership interest in a partnership that is doing business, employing capital, owning or leasing property, or maintaining an office in the City.”[xxxvi]

According to the Tribunal, interpreting “doing business” to include ownership in a limited partnership that does business in the City has been upheld by the NY courts on multiple occasions. “These decisions,” it stated, “bind this Tribunal and are determinative in this matter.”[xxxvii]

LP-1 conducted business within NYC because it leased, held, and managed real property in the City. Taxpayer, through JV, owned an interest in LP-1. Through its ownership in LP-1, Taxpayer was doing business in NYC.[xxxviii] Therefore, the Capital Gain, which flowed to Taxpayer from JV’s sale of its interest in LP-1, was properly included in Taxpayer’s ENI for the tax year at issue.

In reaching this conclusion, the Tribunal also rejected Taxpayer’s argument based upon Federal conformity. “This doctrine,” the Tribunal stated, “has its limits.” It explained that

“arguments in favor of applying the doctrine are particularly strong and persuasive where the State act and regulations were modeled upon the federal law and regulations and both statutes and regulations closely resemble each other. However, where state tax law diverges from federal law, there is no requirement that a court strain to read the federal and state provisions as identical.”

The Tribunal observed that Taxpayer did not establish any statutory authority or legislative history that would bind the City’s GCT calculations to the Federal tax treatment of the sale of a partnership interest. As a result, the differences between the two taxes “militated against the importing of federal treatment of the sale of partnership interests into the GCT’s ENI basis.”

Further, the Tribunal noted that “[T]he aggregate approach has been and continues to be applied for a variety of purposes under the GCT,” including the computation of ENI, and the character of items of income as coming from subsidiary or investment capital.[xxxix]

Therefore, Federal conformity did not require the exclusion of the Capital Gain from Taxpayer’s ENI for the tax year at issue.

Expensive Misunderstanding

The inclusion in Taxpayer’s ENI of its share of the Capital Gain subjected Taxpayer to NYC’s GCT at a rate of 8.85 percent. That’s an expensive tax, but it was one that should have been anticipated and accounted for in negotiating the terms of the sale.

Is it possible that Taxpayer’s shareholders confused the sourcing rule, applicable to nonresident individuals, which generally sources the gain from the sale of an intangible asset – for example, shares of stock of a corporation that does business in NYC – to the domicile of the nonresident? Is that why they “moved” Taxpayer (a pass-through entity) from NY to NJ?

But even that reasoning is unsatisfactory when one considers NY’s treatment of entities that own real property located in the State. For example, NY source income includes income attributable to the ownership of any interest in real property, including the gain from the sale or exchange of an interest in certain entities that own real property in NY.

Indeed, since 2009, items of gain derived from or connected with NY sources have included 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 NY, and has a fair market value that equals or exceeds 50 percent of all the assets of the entity on the date of the sale or exchange of the taxpayer’s interest in the entity.[xl] An interest in such an entity is treated as an interest in real property located in NY.

The bottom line: as we ride out what promises to be an undeniably rough time for the NYC real estate industry, it will behoove the long-term investor to familiarize themselves with, and to take advantage of, whatever tax benefits the law affords them – both during the operation and upon the disposition of their property – and to thoroughly consider, and plan for, the tax consequences of any transaction involving the property.  Of course, much may depend upon the outcome of the November elections.

The economic rewards of such “tax diligence” may be the difference between a successful and a not-so-successful investment.

—————————————————————————————

[i] https://www.wsj.com/articles/real-estate-now-an-essential-business-new-york-state-says-11585869087 . https://chicagoagentmagazine.com/2020/03/31/during-coronavirus-shutdown-real-estate-is-deemed-an-essential-business/ In the Department’s report, “residential and commercial real estate services, including settlement services” are considered essential, as are “workers responsible for the leasing of residential properties to provide individuals and families with ready access to available housing.”

[ii] Look at what has happened to all of the restaurants and retail spaces – not to mention mass transit – that serviced the City’s “business districts” when office workers started to work remotely.

[iii] For example, in 2018, real estate related taxes (real property, commercial rent, hotel occupancy, mortgage recording, and transfer taxes) accounted for 52% of all New York City taxes collected. https://www.rebny.com/content/rebny/en/research/real_estate_policy_reports/2018-Economic-Impact-of-New-York-Citys-Real-Estate-Industry.html

[iv] Citywide, investment sales transactions declined 32%, consideration declined 54% and the average price declined 32% year-over-year.

Multifamily rental, elevator transactions declined 7%, consideration declined 56% and the average price declined 53% year-over-year.

Multifamily rental, non-elevator transactions declined 32%, consideration declined 42% and the average price declined 13% year-over-year.

Office transactions declined 27%, consideration declined 47% and the average price declined 27% year-over-year.

Industrial transactions declined 37%, consideration declined 60% and the average price declined 37% year-over-year.

Hotel transactions declined 70%, consideration declined 81% and the average price declined 37% year-over-year.

Retail transactions declined 27%, consideration declined 27% and the average price remained flat year-over-year.

Commercial condo transactions declined 68%, consideration declined 98% and the average price declined 93% year-over-year.

https://rebny.com/content/dam/rebny/Documents/PDF/News/Research/NYCInvestmentSalesReport/REBNY_1H20-InvestmentSalesReport_2020_FINAL.pdf

[v] Manhattan Faces a Reckoning if Working From Home Becomes the Norm, https://www.nytimes.com/2020/05/12/nyregion/coronavirus-work-from-home.html . “[A]s the pandemic eases its grip, companies are considering not just how to safely bring back employees, but whether all of them need to come back at all. They were forced by the crisis to figure out how to function productively with workers operating from home — and realized unexpectedly that it was not all bad. If that’s the case, they are now wondering whether it’s worth continuing to spend as much money on Manhattan’s exorbitant commercial rents. They are also mindful that public health considerations might make the packed workplaces of the recent past less viable.”

[vi] The prospect of a Democrat in the White House, along with what most believe will be the attendant federal tax increases, only exacerbates the matter. https://www.taxlawforchb.com/2020/08/bidens-tax-proposals-for-capital-gain-like-kind-exchanges-basis-step-up-the-estate-tax-tough-times-ahead/ ; https://www.taxlawforchb.com/2019/07/escape-from-new-york-it-will-cost-you/

[vii] “Economic and Demographic Change,” Samuel M/ Ehrenhalt, Monthly Labor Review, February 1993. https://www.millersamuel.com/change-is-constant-100-years-of-new-york-real-estate/

[viii] https://allthatsinteresting.com/1970s-new-york-photos

[ix] The views expressed are mine alone, and should not be attributed to Farrell Fritz.

[x] By Shimon Shkury. https://www.forbes.com/sites/shimonshkury/2020/07/30/why-were-betting-long-on-nyc-real-estate/#348720dc7ecb

[xi] In case you have forgotten, Amazon spent $1.15 billion to acquire the old Lord & Taylor Building in March of this year, as closures were being announced throughout the State.

[xii] By now, you’ve probably been wondering when, if ever, taxes would make it into the discussion.

[xiii] Like the pun?

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

[xv] Mars Holdings, Inc., NYC TAT ALJ Division, TAT (H) 16-14 (GC).

[xvi] I am often tempted to say something, anything, about our western neighbor. Check out this NYU publication: “Across The River, A World Away: Why We Trash New Jersey.” https://nyulocal.com/across-the-river-a-world-away-why-we-trash-new-jersey-d10dd1aa00b?gi=74f0e8c00b5c

[xvii] LP-1’s only significant source of income was from the holding, leasing, or managing of real property consisting of rental apartments within NYC.

JV held a 25 percent limited partnership interest in LP-2, which was formed to own and operate a rental housing project in the City.

Finally, JV owned a 0.01% limited partnership interest in LP-3.

[xviii] IRC Sec. 368(a)(1)(F).

[xix] Reg. Sec. 1.368-2(m). Basically a non-event for tax purposes. See https://www.taxlawforchb.com/2015/10/sometimes-an-f-is-a-good-result/

[xx] IRS Form 1065, U.S. Return of Partnership Income.

[xxi] IRS Form 1120S, U.S. Income Tax Return for an S Corporation.

[xxii] IRC Sec. 1366.

[xxiii] Form NYC-3L, General Corporation Tax Return. https://www.taxlawforchb.com/2020/07/an-s-corporation-in-new-york-city-eschew-obfuscation-or-not/

[xxiv] The counterpart to a Federal notice of deficiency.

[xxv] Administrative Code Section 11-602(8). This is equal to total net income from all sources; it is presumably the same as the entire taxable income (i) which the taxpayer is required to report to the IRS, or (ii) which the taxpayer would have been required to report to the IRS if it had not made an S corporation election.

[xxvi] Foreign = New Jersey.

[xxvii] Similarly, see IRC Sec. 875(1), which provides that “a nonresident alien individual or foreign corporation shall be considered as being engaged in a trade or business within the United States if the partnership of which such individual or corporation is a member is so engaged.”

Mind you, I am not suggesting that NJ is not part of the U.S., nor am I intimating that the Constitution be amended to provide for the removal of a state. Secession, on the other hand? The Constitution makes no mention of it, though it does address the partition of a state and the “junction” of existing states. Article IV, Section 3, Clause 1.

Remember the Harford Convention of 1814?

California and Texas have each seen active secessionist movements in recent years. (CA, most recently, in response to the election of Mr. Trump in 2016.)

In a 1993 referendum, more than 65% of Staten Island voted to secede from NYC, but was thwarted by Albany. The borough is making noise again this year.

Canadian law provides for legal secession.

[xxviii] In brief, the incorporation of Federal tax provisions into state tax law. For a general discussion of conformity, please see https://www.taxlawforchb.com/2020/06/conformity-the-lockdown-and-new-yorks-audit-of-like-kind-exchanges/#_edn1.

[xxix] Admin. Code § 11-602.8.

[xxx] IRC Sec. 741.

[xxxi] P.L. 115-97.

[xxxii] Grecian Magnesite, 149 T.C. No. 3 (July 2017), aff’d by 926 F3d 819 (DC Cir 2019). https://www.taxlawforchb.com/2017/07/foreigners-sale-of-partnership-interest-not-taxable/

The holding was effectively overturned by IRC Sec. 864(c)(8).

[xxxiii] Under the so-called “aggregate theory,” a partner’s sale of a partnership interest would be treated as the sale by the partner of its separate, undivided interest in each asset owned by the partnership.

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

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

[xxxiv] Admin. Code Sec. 11-603.1

[xxxv] Admin. Code Sec. 11-604.1.E

[xxxvi] 19 RCNY Sec. 11-06 [a]. This provision is subject to certain limitations which were not relevant here. See 19 RCNY § 11-06 [b] with respect to an interest in a publicly traded partnership or in a “portfolio partnership.”

[xxxvii] City Charter Sec. 170 [d]. “The tribunal shall follow as precedent the prior precedential decisions of the tribunal (but not of its small claims presiding officers), the New York State Tax Appeals Tribunal or of any federal or New York state court or the U.S. Supreme Court insofar as those decisions pertain to any substantive legal issues currently before the tribunal.”

[xxxviii] 19 RCNY Sec. 11-06 [a].

[xxxix] The Tribunal remarked that the same was true under the comparable NY State Corporate Franchise Tax. Both the State and City use the aggregate approach for purposes of determining whether a corporation is doing business in the jurisdiction.

[xl] NY Tax Law 631(b)(1)(A)(1). See also TSB-M-09(5)I. The portion of the total gain allocated to NY is determined by a fraction, the numerator of which is the FMV of the entity’s NY real property, and the denominator of which is the FMV of all of the entity’s assets.

A closely held business may come to our firm for any number of reasons. The owners may be selling the business, for example, or they may be thinking about spinning off a division. In some cases, the owners are considering the admission of a new investor, or the issuance of equity to a key employee; in others, they are contemplating whether to reorganize the business structure. Succession planning or estate planning are often motivating factors for which the owners seek our assistance. Then, of course, the business may have been notified by some taxing authority that its returns have been selected for audit.

Whatever the reason, one of the first documents we review is the most-recently filed federal income return for the business, and among the items within that return for which we search, in particular, are related party transactions, including loans to the owners.

Loan to Shareholder/Partner

How often do you encounter a situation, especially with a new client, in which the tax return balance sheet of a closely held business reports a loan to a shareholder or to a partner as an asset of the business?[i] If you’re like most tax advisers, you immediately check to see whether:

  • the amount of the loan reported on the return changed during the year,[ii]
  • the business reported any interest income,[iii]
  • any distributions were made to the owners,[iv] or
  • compensation was paid to those owners who were active in the business.[v]

Occasionally, the taxpayer will choose not to report a loan to an owner on the line designated for that purpose; instead, they include it in their response to that line of the balance sheet described as “Other assets,” which serves as a catchall.[vi]

In any case, once armed with this basic information, there are some obvious questions for the owners of the business, including, for example, “What are the terms of the loan,”[vii] “Is the loan evidenced by a promissory note?” and “Do you have board minutes describing the purpose for the loan, and approving its terms?”

By now, most of us have probably grown accustomed to hiding our disappointment at the all-too-frequent responses to the first two inquiries: “There aren’t any,”[viii] and “Nope,” respectively.[ix]

Sometimes, the adviser will be pleasantly surprised to be handed a loan agreement. Upon further inquiry, however, they learn that the terms of such agreement have not been enforced, or that the interest rate has been reduced without any change in the payment terms for the loan, and without any concession (i.e., consideration) from the borrower.[x]

It is unfortunate that, in most cases, the owners of a business do not appreciate the importance of transacting with their business on terms and in a manner that resemble, as closely as is reasonably possible, their interactions with unrelated persons.[xi]

Loan to “Related Entity”

If you’ve been around closely held business entities long enough, you know that loans to shareholders or partners are not always made directly by the entity to its owners; for example, they make take the form of a loan to a “related” or “somewhat related” business entity.

“But wait,” you may say, “there is no line on the business’s tax return balance sheet for such an entry.” Not expressly,[xii] but such intercompany loans are usually found in the line for “Other assets.” This line on the return directs the taxpayer to attach a statement in which the taxpayer must, presumably, identify the asset. However, because the return instructions do not provide any guidance on this point, many taxpayers will provide the barest description of the loan; for example, “loan to affiliate” without identifying the borrower or the nature of the relationship.[xiii]

Why would a taxpayer be reluctant to provide this information?

Does It Matter?

Ostensible loans to owners in the context of any closely held business can easily affect – in fact, may be intended to affect – the economic arrangement among the owners. In doing so, however, it may generate some unintended tax consequences. For example, if a so-called “loan” is not respected as such, what was treated as a non-taxable receipt of loan proceeds by the owner-borrower – and as a nondeductible payment by the entity-lender – may, instead, be treated as a taxable dividend or compensation. In the context of an S corporation, it is possible that the loan may be treated as a second class of equity if it is determined that the arrangement was undertaken with a principal purpose of circumventing the one class of stock requirement.[xiv]

The potential for skewing the economic arrangement among the owners is even greater where the “creditor” business is owned by members of a single family. The IRS and the courts have long recognized this truth, which explains why transactions between the family and their business – as is the case for strictly intra-family transactions, generally – are subject to rigid scrutiny, and are particularly susceptible to a finding that a transfer was intended as something other than a loan.[xv]

A recent decision by the Seventh Circuit considered a history of purported loans between a family-owned holding company (“Taxpayer”), taxable as a C corporation, and a number of business entities owned by a member of the family. The issue for consideration was whether Taxpayer was entitled to bad debt deductions in respect of such loans.[xvi]

The Family Company

Taxpayer was a family-controlled company founded by Dad. Over time, it added a number of subsidiaries. Taxpayer and its subsidiaries employed Son and his siblings in various capacities. The subsidiaries operated by Son did very well. Eventually, Son became a shareholder of Taxpayer.

Son started several businesses outside of Taxpayer (the “Son-Cos”), some of which complemented Taxpayer’s business, while others competed with Taxpayer and its subsidiaries.

Notwithstanding his independent ventures, Son continued to serve as president of two of Taxpayer’s subsidiaries for a number of years. Even after he stepped down as president, his sales and customer relations role with the subsidiaries remained unchanged; in fact, Son held various licenses that were useful to the subsidiaries for obtaining certain projects.[xvii]

Need A Loan? No Credit? Bad Credit? No Problem

Over a ten-year period, including the tax years at issue, Taxpayer advanced significant sums of money to Son-Cos, including, for example, guaranties of Son-Cos’ debts, lines of credit, and payments to Son-Cos’ creditors.

Taxpayer advanced funds to Son-Cos with the goal that Son would eventually be able to manage these companies independently, and in the belief that their various projects would throw off lucrative work for Taxpayer. In other instances, Taxpayer advanced funds because it sought to preserve its own relationships with certain investors in Son-Cos.

That said, Taxpayer continued to make advances to Son-Cos even after it became apparent that the companies were financially unstable – indeed, it made loans when the companies had more debt than equity on their financial statements, when they were unable to make payments on their bank loans, and when they could not pay their bills.

What’s more, Taxpayer advanced funds even though the advances created problems for Taxpayer in obtaining surety bonds, which were integral to its own business.[xviii] In addition, Taxpayer sometimes borrowed funds to make advances to Son-Cos.

At one point, Banks, which had provided loans both to Taxpayer and Son-Cos, sought to reduce their overall exposure to Son-Cos by shifting as much of the Son-Cos debt as possible to Taxpayer. Taxpayer agreed to assume a portion of Son-Cos’ indebtedness, to guarantee the Son-Cos debt, and to subordinate to Banks any and all debts owed to it by Son-Cos.

Indeed, Taxpayer continued to advance funds even after beginning to claim bad debt deductions with respect to its earlier advances to Son-Cos.

Documentation and Collection Efforts

Taxpayer recorded its many advances to Son-Cos as notes receivable in its books and records.

According to Taxpayer’s records, it ultimately advanced over $111 million to Son-Cos,[xix] but received payments of only $28.6 million. Taxpayer also recorded that it had accrued interest income in excess of $20.8 million, but received interest payments of only $10.3 million.

At some point, Taxpayer stopped accruing interest, and paying tax on it, altogether.

Taxpayer had in its possession numerous promissory notes which purported to reflect its advances to Son-Cos. However, not all the promissory notes were signed by Son. Individuals would sometimes sign notes “imitating” Son’s signature. Some notes were signed by other individuals, and still other notes had Son’s stamped signature. Some promissory notes were unsigned.

Most of the promissory notes had fixed schedules for repayment, and renewed promissory notes were renewed without Taxpayer’s receiving payments of principal or interest. Often, promissory notes were renewed when maturity dates arose and were consolidated routinely into new, larger amounts. Taxpayer did not increase interest rates on notes that were renewed.

Although Taxpayer’s directors regularly met with Son at its offices, Taxpayer never formally requested in writing that the outstanding advances be repaid.

Taxpayer did not pursue other avenues of collection. It failed to collect through liquidating Son’s shares of Taxpayer stock, and it failed to demand repayment when Son sold one of his companies. In fact, because Taxpayer had subordinated any rights to repayments to Banks, it was unable to enforce repayment.

Deductions Claimed

For the tax years at issue, Taxpayer claimed deductions on its federal corporate income tax returns[xx] for partially worthless bad debts that it asserted were owed to it by Son-Cos. Taxpayer ultimately wrote off millions of dollars’ worth of debt.

After an audit of Taxpayer’s returns, the IRS issued a notice of deficiency to Taxpayer, rejecting almost all of these write-offs.

Taxpayer petitioned the Tax Court to review the IRS’s determination, but the Tax Court upheld the deficiency. It determined that Taxpayer could not deduct the payments to Son-Cos as “bad debts” because Son-Cos and Taxpayer lacked a bona fide debtor-creditor relationship.[xxi]

The Tax Court on Bad Debt Deductions

As a general rule, the Code allows a deduction for “any debt which becomes worthless within the taxable year.”[xxii] That being said, the Code also distinguishes business bad debts from nonbusiness bad debts.[xxiii]

Business bad debts may be deducted against ordinary income, whether wholly or partially worthless during the year (to the extent of the amount that becomes worthless).[xxiv]

A nonbusiness bad debt may be deducted, but only when it becomes completely worthless in the year for which it is claimed, and then only as a short-term capital loss.[xxv]

In the case of a guarantor, the Code limits the deduction for bad debt losses to the amounts actually paid by the guarantor.

Taxpayer contended that it was entitled to business bad debt deductions for the tax years at issue for the advances made to, or for the benefit of, Son-Cos that became partially worthless during the years at issue.

The IRS contended that Taxpayer failed to establish that the claimed advances were bona fide debt. It further contended that Taxpayer’s motivation for advancing the funds was to provide capital injections or gifts to assist in forming new companies associated with Son, to provide disguised dividends for the use of Son’s licenses, or to provide compensation for work contracts that Son-Cos sent to Taxpayer, for services Son provided to Taxpayer, or for allegedly exchanging Son’s Taxpayer voting shares into nonvoting shares.

The Tax Court explained that there is no bad debt deduction without a bona fide debt.[xxvi] The IRS’s regulations define a bona fide debt, the Tax Court continued, as one “which arises from a debtor-creditor relationship based upon a valid and enforceable obligation to pay a fixed or determinable sum of money.”

Stated differently, the parties to the transaction must have had an actual, good-faith intent to establish a debtor-creditor relationship at the time the funds were advanced. An intent to establish a debtor-creditor relationship exists if the debtor intends to repay the loan and the creditor intends to enforce repayment.[xxvii]

According to the Tax Court, whether a purported debt is “in substance and fact a debt for tax purposes” is determined from the facts and circumstances of each case, with the taxpayer bearing the burden of proof.

Among the factors ordinarily considered by the courts in determining the parties’ intent, and whether a bona fide loan occurred, are the following, no single one of which is dispositive:

(1) the name given to the certificates evidencing the indebtedness,

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

(3) the source of payments,

(4) the right to enforce repayment,

(5) participation in management as a result of the advances,

(6) the status of the advances in relation to debts owed to regular corporate creditors,

(7) thin or adequate capitalization,

(8) the risk involved in making the advances,

(9) the identity of interest between creditor and shareholder,

(10) the use to which the advances were put,

(11) the ability to obtain loans from outside lending institutions,

(12) failure to repay advances on the due date,

(13) the intent of the parties, and

(14) the payment and accrual of interest.

After considering the circumstances of Taxpayer’s advances to or for the benefit of Son-Cos, and in the light of the factors set forth above, the Tax Court concluded that the advances did not represent bona fide debt. Taxpayer did not intend to create a bona fide debtor-creditor relationship, and the economic circumstances that existed during the time Taxpayer made its advances established that it did not reasonably expect repayment. Thus, Taxpayer was not entitled to bad debt deductions for the advances it made to Son-Cos during the tax years at issue.

Taxpayer then appealed the Tax Court’s ruling.

The Court of Appeals

Specifically, Taxpayer disputed the Tax Court’s determination that its cash payments to Son-Cos did not constitute loans that were deductible as “bad debts” when they went unpaid.

After reviewing the applicable Code and regulatory provisions, the Court framed the issue by stating that Taxpayer’s ability to claim the deduction turned on whether it had a debtor-creditor relationship with Son-Cos such that Son-Cos had an enforceable obligation to pay Taxpayer a fixed sum. To determine whether such a relationship existed, the Court looked to “a number of factors” as “indications of intent,” and reminded Taxpayer that it had the burden to establish the presence of such indicators. The Court acknowledged that courts generally view intrafamily transfers with “particular skepticism.”

Still, Taxpayer argued that the Tax Court’s “reliance on indicia of a debtor-creditor relationship prevented it from seeing the forest for the trees and that the only relevant factor is the intent of the parties.”[xxviii]

Taxpayer contended that it represented to third parties that the advances to Son-Cos were debts, and it possessed signed promissory notes, both of which indicated that it believed the advances to be debt for which it expected to be repaid.

The Court observed, however, that the way Taxpayer described the advances did not match the way that Taxpayer and Son-Cos treated those payments.[xxix] For example, the Court noted that, though many of the promissory notes had fixed maturity dates, Taxpayer routinely deferred payment or renewed the notes without any receipt of payment or other consideration.

Further, the Court pointed to evidence that Taxpayer did not expect to be repaid unless various other events occurred, such as Son-Cos securing additional investments and projects. This sort of relationship, the Court remarked, is that of an investor, not of a creditor: “[T]he creditor expects repayment regardless of the debtor corporation’s success or failure, while the investor expects to make a profit … if, as he no doubt devoutly wishes, the company is successful.”

Thus, although Taxpayer may have described the payments as debt, it did not treat them as part of an ordinary debtor-creditor relationship and, therefore, did not establish that the parties intended such a relationship.

Taxpayer had the burden of demonstrating that its payments to Son-Cos were bona fide debts that arose from a debtor-creditor relationship in which it expected Son-Cos to pay Taxpayer back in full. Because Taxpayer failed to carry its burden, the Court concluded that Taxpayer’s payments to Son-Cos were not “bad debts” qualifying for the deduction.

Economic Reality

The key to determining the character of a payment between related parties as a loan or as something else ultimately turns on the economic reality of the payment.

If an outside lender would not have extended credit on the same terms and under similar circumstances as did the related entity, an inference may arise that the advance is not a bona fide loan.

On the other hand, if the transfer and surrounding circumstances give rise to a reasonable expectation, and an enforceable obligation, of repayment, then the relationship between the parties will resemble that of a creditor and debtor.

In that case, the form of the transaction should be consistent with, and support, its substance: a genuine loan transaction. Thus, there should be a written promise of repayment, a repayment schedule, interest, and security for the loan.

The factors identified by the Courts, above, provide helpful guidance for structuring and documenting a loan between related persons, including a business entity and any of its owners. If these factors are considered, the parties to the loan transaction will have objectively determinable proof of their intent, as reflected in the form and economic reality of the transaction.

Of course, the parties will also have to act consistently with what the transaction purports to be – they will have to act as any unrelated party would under the circumstances.


[i] You’ll note that Sch. L to IRS Form 1065 refers to “[l]oans to partners (or to persons related to partners)” while Sch. L to Form 1120 does not include a reference to “persons related to shareholders.” The “related persons” are described in IRC 267(b) and 707(b).

[ii] The balance sheet asks for the amounts owing at the beginning and at the end of the year. A reduction may reflect a repayment, an increase may reflect an additional loan.

If the returns provided go back far enough, we’ll know when the loan originated, how long it has been outstanding, whether there have been any payments of principal, etc.

[iii] Actually received, or imputed under IRC Sec. 7872.

[iv] It irks me (and it will certainly irk the IRS) when I see C corporations making “loans” to shareholders that are proportionate to their stock holdings, while not making any dividend distributions.

[v] Especially in the case of an S corporation. The IRS and many courts have stated very clearly that an employee-shareholder cannot avoid employment taxes by choosing the receive “distributions” in respect of their stock rather than receiving wages in exchange for their services.

[vi] Sch. L, Line 14 of Form 1120; Sch. L, Line 13 of Form 1065; Sch. L, Line 14 of Form 1120S.

How do you think an IRS auditor is going to view this? I’m reminded of those individuals who file New York State income tax returns as non-residents and who intentionally fail to answer the question on the first page of the return regarding whether they maintain living quarters in New York.

[vii] Interest rate, collateral, payment schedule, acceleration events, events of default, remedies, etc.

[viii] In this case, the debt created is presumed to be a demand loan.

[ix] The laughter from the client following the third question is a different matter.

[x] I’ve grown tired of having this discussion in this age of low rates.

[xi] I’m not just talking tax, here. The limited liability protection afforded by the corporate and limited liability company forms of business entities are premised upon their “separateness” from their owners. There are juridical persons. Once the owners start to ignore that fact, the slippery slope will eventually allow third parties to ignore the business entity, and to pursue their business-related claims against the owners directly.

[xii] Which I’ve never understood. See, for example, IRS Form 5472, Information Return of a 25% Foreign-Owned U.S. Corporation, on which 25%-foreign-owned domestic corporations disclose certain transactions with the foreign shareholder or with certain foreign related persons.

[xiii] At that point, I ask for the returns of any related entities – there should be a corresponding debt reported.

That being said, the IRS has, over the years, added schedules to the basic business tax return forms that require the identification of certain related persons.

Thus, for example, Form 1120, U.S. Corporation Income Tax Return, Sch. K, Line 4 asks whether any corporation or partnership owns directly 20 percent or more, or owns directly or indirectly (applying the constructive ownership rules of IRC Sec. 267(c)), 50 percent or more, of the total voting power of the corporation’s stock. Line 5 of Sch. K asks whether the corporation owned such interests in other entities. If either of these questions is answered in the affirmative, the taxpayer corporation must file Sch. G, Information on Certain Persons Owning the Corporation’s Voting Stock, to identify these related persons who may be in a position to influence how it transacts business. (But see also IRS Form 851, Affiliations Schedule.)

Form 1065, U.S. Return of Partnership Income, Sch. B, Lines 2 and 3 ask similar questions with respect to a partnership. If answered in the affirmative, the partnership must also file Sch. B-1, Information on Partners Owning 50% or More of the Partnership, to provide information regarding these related persons.

Form 1120S, U.S. Income Tax Return for an S Corporation, Sch. B, Line 4 asks a similar question as to corporations or partnerships in which the S corporation is an owner. (Of course, these entities are not eligible to be shareholders of an S corporation.)

[xiv] Reg. Sec. 1.1361-1(l)(2)(i). Preferred stock comes to mind – it is often difficult to distinguish this class of equity from a debt instrument. But see the safe harbor for “straight debt” under the S corporation rules.

[xv] For example, a gift or a distribution.

Of course, any “presumption” against loan treatment may be rebutted by an affirmative showing that there existed, at the time of the “loan,” a real expectation of repayment and an intent to enforce the collection of indebtedness.

However, that does not eliminate entirely the potential for a gift.

According to the IRS, transfers reached by the gift tax “are not confined to those which, being without a valuable consideration, accord with the common law concept of gifts; they also include other transfers of property in exchange for consideration to the extent that the value of the property transferred by the donor exceeds the value in money or money’s worth of the consideration given therefor” – for example, a below-market loan. IRC Sec. 7872. However, if such a transfer is made in the ordinary course of business (a transaction which is bona fide, at arm’s length, and free from any donative intent), it will be considered as made for an adequate and full consideration in money or money’s worth. Reg. Sec. 25.2512-8.

[xvi] VHC Inc. v. Commissioner, No. 18-3717 (7th Cir. Aug. 6, 2020).

[xvii] Taxpayer’s board of directors determined that Son was a “key person” and that it would be in Taxpayer’s best interest to purchase keyman life insurance on his life.

[xviii] The millions of dollars of receivables Taxpayer had on its balance sheets attributable to the advances made to Son-Cos affected its ability to obtain surety bonds, which damaged Taxpayer’s ability to bid on projects that required bonding.

[xix] Did I mention that I’m up for adoption?

[xx] On IRS Form 1120.

[xxi] The Tax Court also rejected Taxpayer’s alternative arguments, including, for example, its contention that its payments to Son-Cos were ordinary and necessary business expenses.

[xxii] IRC Sec. 166. It is important to note that the creditor must be able to establish that the debt was not worthless for the year immediately preceding the year in which the deduction is claimed (i.e., the year in which the debt became worthless).

[xxiii] IRC Sec. 166(d); Reg. Sec. 1.166-5(b).

[xxiv] Reg. Sec. 1.166-3.

[xxv] IRC Sec. 166(d).

[xxvi] Reg. Sec. 1.166-1(c).

[xxvii] Reg. Sec. 1.166-1(c). A gift or a contribution to capital is not considered to create a debt for purposes of this rule.

[xxviii] As opposed to the more objective manifestations of such intent evidenced by the enumerated factors? Odd.

[xxix] Classic form vs substance.

The Convention

The Democratic Party’s “virtual” convention last week seems to have gone pretty well. All the stars of the Party’s firmament were on hand and spoke in “virtually” one voice in their assessment of the individual who currently occupies the White House and of his performance in carrying out the duties of the nation’s chief executive.

Speaking of performance, the Party’s Nominee for the Presidency delivered a relatively well-received speech.[i] After accepting the nomination – “with great honor and humility”[ii] – Mr. Biden set the theme for his campaign against Mr. Trump as one of “light vs darkness.”[iii]

Among the plots woven into this theme, taxes figured prominently. What follows are three excerpts from Mr. Biden’s speech:

“Working families will struggle to get by, and yet, the wealthiest one percent will get tens of billions of dollars in new tax breaks.”

“And we can pay for these investments by ending loopholes and the president’s $1.3-trillion tax giveaway to the wealthiest 1 percent and the biggest, most profitable corporations, some of which pay no tax at all.”

“Because we don’t need a tax code that rewards wealth more than it rewards work. I’m not looking to punish anyone. Far from it. But it’s long past time the wealthiest people and the biggest corporations in this country paid their fair share.”

If one were to search Mr. Biden’s speech for the root words “tax” and “wealth,” one would find that they appear together every time, usually in the same sentence.

In other words, he left little doubt of his intentions.

Recap of Biden’s Tax Plan

Last week’s post explored how these soundbites may be manifested as legislation to be enacted, Mr. Biden hopes, by a Congress controlled by the Democratic Party. Many of these proposals last appeared in President Obama’s Fiscal Year 2017 Budget[iv] – when he was a “lame duck” President facing a Republican Congress.[v]

In any case, the following outlines some of the key parts of Mr. Biden’s tax plan:[vi]

  • 6% tax rate for ordinary income[vii]
  • 6% tax rate for capital gain for individual taxpayers with more than $1 million of income[viii]
  • Eliminate the qualified business income deduction[ix] for individuals making over $400,000
  • Limit itemized deductions for those in higher tax brackets (above 28 percent)[x]
  • Impose the 12.4% Social Security tax[xi] on all wages over $400,000[xii]
  • Eliminate tax deferred like kind exchanges of real property[xiii] for investors with annual income in excess of $400,000[xiv]
  • Eliminate the basis step-up[xv] for a decedent’s assets,[xvi] or tax immediately the gain inherent in a decedent’s assets as if they had been sold at their date of death
  • Reduce the basic exclusion amount for purposes of the gift, estate, and generation skipping transfer taxes (the “transfer taxes”) from $10 million to $5 million,[xvii] and
  • Increase the flat corporate income tax rate from 21 percent to 28 percent.

Last week’s post also indicated that any tax legislation coming out of a federal government managed by the Democrats is not likely to adopt Mr. Biden’s proposals verbatim. The foregoing measures are intended to win an election.[xviii]

So, in the event of a Biden victory – not a sure thing – what can we expect?

Let’s start with his running mate, Senator Harris – after all, according to the popular aphorism, the vice president is only “a heartbeat away” from the presidency.[xix]

Senator Harris and Taxes

Senator Harris dropped out of the Democratic primary contest in late 2019, before the pandemic. Before then, however, she expressed a strong desire for repealing the 2017 Tax Cuts and Jobs Act, which would include, among other things:

  • reinstating the maximum 39.6 percent rate for ordinary income received by individuals,
  • re-imposing limits on itemized deductions,[xx]
  • returning the basic exclusion amount for transfer taxes to $5 million,
  • eliminating the $10,000 limit on itemized deductions for state and local taxes,[xxi]
  • eliminating the deduction based on qualified business income, and
  • reinstating a graduated corporate tax, with a maximum rate of 35 percent.

In addition, Senator Harris supported taxing capital gains realized by individuals at the same rate at which ordinary income is taxed (39.6 percent under her plan),[xxii] as well as imposing a financial transaction tax on trades of marketable securities. She also talked about imposing an additional 4 percent income-based premium on households making more than $100,000 (to help fund Medicare).[xxiii]

Therefore, it appears that the Senator’s stance on tax policy is not incompatible with Mr. Biden’s.

In fact – if I may take some poetic license[xxiv] – based on the restoration after 2025 of many provisions that were added to the Code in 2017 by the Republican Congress,[xxv] or that were temporarily suspended, the Democratic ticket is inadvertently “aligned” with the Republicans on many tax provisions, differing only as to the timing of their implementation or reinstatement.

Unfortunately for them – and perhaps for many closely held businesses and their owners – the Democratic Party is hardly a monolithic centrist block.

The “Progressives”

Last week, Senator Sanders had the following to say on the Daily Show: “We’re going to come together to defeat Trump, and the day after Biden is elected we’re going to have a serious debate about the future of this country.”

I wondered whether the “we” to which the Senator referred was the Democrats and the Republicans, or the progressive and centrist wings of the Democratic Party.

As he did in 2016, Senator Sanders emerged as a serious contender in 2020, challenging Mr. Biden for a long stretch of the Democratic primary race.[xxvi] Then there was Senator Warren.

And Senators Sanders and Warren weren’t the only ones challenging established centrist Democrats. Witness what happened to Democratic incumbents like Rep. Engel and Rep. Clay in the primaries.

And why was Rep. Ocasio-Cortez – the unofficial spokesperson for the progressive wing – chosen to step onto the national stage to second the nomination for Mr. Sanders for purposes of the formal roll call required by the rules of the convention?

The answer is clear: because the progressive wing of the Democratic Party has emerged as a factor to be considered in any legislative agenda. Indeed, according to some, “Progressives are expected to grow their numbers in the House . . . which they hope will give them more influence. ‘If we actually get to 15 to 20, which it looks like we will, that is a potent force. I mean, that can help set the agenda for our party,’ ” said Rep. Khanna of the Congressional Progressive Caucus.[xxvii]

What does that mean for taxes?

Of course, you’ve heard about the wealth taxes proposed during the Democratic primaries. There are many more ideas being floated within the Democratic camp; for example, Rep. Ocasio-Cortez wants to increase to 70 percent the rate on those individuals making at least $10 million; she has called for taxing capital gains at the same rate as ordinary income; and she wants to tax on an annual basis the appreciation in the value of investments (i.e., a “mark to market” system), rather than wait until the investments are sold.

Still others have argued that the best way to raise extra tax dollars from the so-called wealthy is by eliminating various deductions[xxviii] and exemptions.

The “Target” Taxpayers?

Which begs the question: Who are the “wealthy”? Are they the folks who make more than $400,000 per year, and thus are marked for “special” treatment by Mr. Biden based on an Obama Administration proposal from 2012? Who are the members of the “one percent” to whom he referred in his acceptance speech? For whom do Rep. Ocasio-Cortez and her coterie reserve their ire?[xxix]

Good questions. According to a recent article in USA Today, “it takes an annual income of $538,926 to be among the top 1 percent [nationally]. Among the approximately 1.4 million taxpayers who meet this threshold, the average annual income is about $1.7 million – about 20 times the average income of $82,535 among all taxpayers.”[xxx]

In New York, the article continues, the top 1 percent earn at least $702,000, and the average income of the top 1 percent is almost $2.9 million.[xxxi]

Still, the question remains unanswered.

Please indulge me as I try to impersonate an economist. (No, I did not stay at a Holiday Inn Express last night.)

The Target “Assets”

How much of this income is attributable to what an economist might describe as human capital, which rewards individuals based on their productivity or special skills? As long as the individual can perform, they will be compensated for their services. The higher salary, the year-end bonus, the nonqualified deferred compensation plan that vests upon the completion of a specified service or the achievement of a production goal, and similar measures of compensation, all represent a return on one’s human capital. It is not an asset that may be passed down to other generations.[xxxii] The value of this compensation is taxable as ordinary income.

“Wealth” on the other hand is something else. It represents the value of one’s property and, in particular, the ability of such property to generate income without effort on one’s part. It is often acquired by investing the after-tax proceeds from the compensation received in exchange for one’s human capital. By its very nature, it may be passed from one generation to the next – it is not dependent upon the expenditure of the next generation’s human capital.

Unlike compensation, the payment of which is required as a matter of law,[xxxiii] a distribution or other form of “return” with respect to one’s investment in an asset that represents equity in a business is not, strictly speaking, legally required; rather, it depends upon the success and well-being of the asset into which the taxpayer has invested their funds, and it depends upon the needs of the asset or business.[xxxiv] Such an investment entails a long-term risk, at least in the case of a closely held business, and one’s investment in such a business, once committed, is difficult to withdraw.[xxxv]

Speaking of the closely held business, it represents the intersection of the foregoing concepts.[xxxvi] It involves the taxpayer-owner’s “expenditure” of their human capital[xxxvii] and the investment of their after-tax funds,[xxxviii] thereby putting both at risk in the hope of realizing an asset that (i) will produce income, taxable at non-preferential ordinary rates,[xxxix] without the taxpayer’s continuing involvement, or (ii) may be liquidated through the sale of the asset.

On which form of “wealth” or income are Mr. Biden and the Democrats going to focus? Are they going to say to those of productive human capital, “you make a lot of money, you should pay more taxes in order to support the government and its programs.”[xl] Or will they focus on income-producing property instead? If the latter, will they distinguish between the closely held business, on the one hand, and marketable securities on the other?[xli]

Much remains to be seen, including how influential or demanding the progressives will be. Either way, the selection is fraught with political consequences.

The Closely Held Business Needs Protection

I can accept many of the income tax and employment tax provisions in Mr. Biden’s proposal.

Like Kind Exchange

I can even get behind some limitation on the use of like kind exchanges to defer gain recognition, but not based on the taxpayer’s overall income, and certainly not at $400,000.[xlii]

President Obama’s 2017 Green Book proposal for limiting the gain deferred to a specified amount – he proposed $1 million of gain per taxpayer per year – is much more palatable; for example, in the case of a partnership with three equal partners, $3 million of gain may be deferred in total.

That being said, and for the reasons mentioned earlier, a $3 million gain in the New York metro area is very different from the same gain in almost any other part of the country. Historically, Congress has been reluctant to match tax consequences to the cost of living in the geographic area in which they are realized, yet that is the only way the above limitation will make any sense.

That said, I do not understand Mr. Biden’s thinking on capital gains, on dividends and on the basis step-up[xliii] at death.

Capital Gain

Let’s assume an individual with $X of disposable cash. This individual may invest their money in the stock of a corporation that is readily tradeable on an established market, or they may choose to invest it among several such corporations so as to diversify their risk. Although they may not be guaranteed dividend distributions (periodic or otherwise), they are free to liquidate their investment at any time.  In addition, they will never be called upon to guarantee any indebtedness or other obligations of the business, nor will they ever be asked to make to make additional capital contributions.[xliv]

What if the same individual used their $X to organize a closely held business? They may pay themselves the equivalent of a relatively small salary (at least initially) for the services they render to the business and they forego the types of benefits often provided for key employees in established companies. If they are fortunate enough to have any after-tax profits, those will more likely than not be reinvested in the business by hiring employees and making capital expenditures necessary for the business. In the vast majority of cases, the business will be organized as a pass-through entity; thus, its profits will be taxed to the individual as ordinary income whether or not the individual receives a distribution from the business. What’s more, the operation of the business will occupy this individual’s every waking hour, seven days a week. In time, after a lot of effort (human capital) and a bit of luck – 90 percent of startups fail, 75 percent of venture-backed startups fail, under 50 percent of businesses make it to their fifth year, 33 percent of startups make it to the 10-year mark, and only 40 percent of startups actually turn a profit[xlv] – the business may be doing well enough to draw the attention of a larger competitor[xlvi] or of a private equity fund.

Why would our hypothetical individual go into business, with all the risk and additional effort that it entails, only to be taxed upon the successful sale of the business at the same rate at which their salary would have been taxed had they gone to work for someone else (with the attendant employment and retirement benefits), and had invested their $X in publicly traded securities? It’s a basic principle of economics, is in not, that the greater the risk to which an investor exposes themselves, the greater the return they would require in exchange. It’s to encourage such investment, and to offer the possibility of that return, that long-term capital gains are taxed at a lower rate than ordinary income.

Qualified Dividends

Dividends are taxable at the rate applicable to long-term capital gain. Why? Because like capital gain they represent a degree a risk for which the investor has no contractual recourse against the C corporation to which the investor has contributed capital in exchange for shares of stock.[xlvii]

Broadly speaking, however, who owns the equity interests in respect of which any dividend would be payable, and whose income tax liability is the subject of this discussion?

According to an Urban-Brookings Tax Policy Center study conducted just a few years ago,[xlviii] approximately 75 percent of outstanding C corporation stock is held by non-taxable accounts; for example, qualified retirement funds;[xlix] insurance companies;[l] nonprofits;[li] foreigners; and others. The dividends paid to these holders in respect of their stock are generally not subject to federal income tax, nor is the gain they realize on the sale of such stock.

Foreign investors held approximately 25 percent of U.S. C corporation stock. The “default” federal income tax rate for dividends on such stock is set at 30 percent[lii] – well below the rate on ordinary income for U.S. individuals. Treaties, however, typically reduce this rate to 15 percent (and sometimes lower). What’s more, a foreigner’s gain from the sale of domestic stock is exempted from U.S. income tax. Thus, for purposes of the Urban-Brookings study, they were treated as non-taxable account holders.

In light of the foregoing, is it proper to tax the dividends paid to U.S. individuals at a rate of 39.6 percent? Actually, one also needs to consider the 3.8 percent surtax for net investment income.[liii] That would bring the total tax rate applicable to an individual’s dividend from a C corporation, or to their long-term capital gain from the sale of C corporation stock, to 43.4 percent.

Basis Step-up

In the alternative, let’s assume that our hypothetical business owner dies prematurely. The cause of death? Work.[liv]

The fair market value of the business is included in the decedent’s gross estate for purposes of the federal estate tax.[lv] Let’s assume that the taxable estate exceeds the decedent’s exclusion amount[lvi] – estate tax will be owing. Let’s also assume that the business will be sold.[lvii]

It is commonly understood that the basis step-up is intended to prevent the decedent’s estate from being taxed twice on the same asset: once upon the transfer of the asset at death, and again on the sale of the asset; the basis step-up addresses the gain realized on the sale.

The first factor to consider is whether there is a risk of double taxation: specifically, should there be a basis step-up where the decedent’s taxable estate is less than the decedent’s exclusion amount such that no estate tax is owing? What if the asset passes to the decedent’s spouse or to a charity, such that the marital deduction or charitable contribution deduction[lviii] applies to eliminate any estate tax exposure? When a property is gifted to a beneficiary without incurring any gift tax, the latter takes the property with the same basis it had in the hands of the individual making the gift.[lix]

The second factor is whether there is a sale of the asset, whether by the estate or by the decedent’s beneficiaries: should the basis step-up be accounted for only upon a sale of the asset, while the beneficiaries use a carryover basis for cost recovery purposes?[lx]

Does Kiss Have the Answer?

Assume Congress decides upon a scaled back basis step-up and an increased, but still preferential, capital gain tax for the disposition of a closely held business, along the lines alluded to above. What else in Mr. Biden’s tax plan may satisfy the progressive wing of his party without offending his centrist base, while perhaps even garnering some support from across the aisle?

Do you remember Gene Simmons,[lxi] the bassist for the rock group Kiss, and the co-lyricist for many of their hits?[lxii] It was reported in a March 31, 2019 article on GOBankingRates.com, that he was not planning to leave his substantial fortune to his kids. “What I wanna do,” he said, “is what every bird does in its nest – it forces the kids to go out there and figure it out for themselves. In terms of an inheritance and stuff,” he continued, “they’re gonna be taken care of, but they will never be rich off my money . . . they should be forced to get up out of bed and go to work and make their own way.”

Gene Simmons is not the only wealthy individual who plans on spending their money. Many other celebrated entertainers and business folk likewise have been quoted in the press as having announced that the vast majority of their wealth will be transferred to various charities.[lxiii] They concede that their children will be given a degree of economic security not bestowed on others, but they also add that their children will have to work if they want to make their mark or build and accumulate wealth.

If the statements attributed by the articles to these people are true, then it appears that a significant number of wealthy individuals – many of whom ceased using their human capital long ago – are not interested in leaving all, or even most, of their wealth to the next generation.

That being said, and considering Mr. Biden’s support among many members of this well-heeled group, might the least politically disruptive approach to “making the rich pay their fair share” be one that borrows liberally[lxiv] from President Obama’s 2017 Green Book?

The Green Book would have:

  • made “permanent” the estate tax, generation-skipping transfer tax, and gift tax parameters that applied during 2009
    • thus, the top tax rate would be increased from 40 percent to 45 percent, and
    • the exclusion amount would be reduced from $10 million to $3.5 million per person (rather than the $5 million under Mr. Biden’s proposal) for purposes of the estate and GST taxes, and to $1 million for gift taxes[lxv]
  • revised the rules applicable to grantor retained annuity trusts (GRATs)[lxvi]
    • require a ten-year minimum term
    • require a maximum term tied to the life expectancy of the annuitant plus ten years
    • prohibit the grantor from engaging in a “tax-free exchange” of any asset held in the trust[lxvii] by requiring that the asset received by the trust be included in the grantor’s estate
      • another proposal, but not included in the Green Book, would have eliminated “zeroed out” GRATs by requiring that the funding of the GRAT result in some taxable gift
    • provide that, on the 90th anniversary of the creation of a trust,[lxviii] the GST tax exemption amount allocated to the trust would terminate, thereby rendering the trust subject to the GST tax
      • this was aimed at so-called “dynasty” trusts, the creation of, and the distributions from which, would have escaped gift, estate and GST taxes
    • eliminate the present interest requirement for gifts to qualify for the gift tax annual exclusion, but impose an annual limit of $50,000 (indexed for inflation) per donor on the donor’s transfers of property that will qualify for the gift tax annual exclusion[lxix]
      • this would likely result in some taxable gifts in the case of life insurance trusts that hold policies with large premiums.

Why Lou, Why?

Some readers may wonder why a tax adviser to closely held businesses and their owners would espouse any of Mr. Biden’s proposals, and even suggest the adoption of some of President Obama’s 2017 Green Book proposals.

Because some of them are reasonable – they make sense;[lxx] some address what I have long believed were unintended consequences.[lxxi] I would add, as a second reason, because there are folks in Congress who want to do a lot worse; they may be well-intentioned, but their policies will ultimately hurt us. Some reasonable compromise is called for. Moreover, let’s not forget that the $10 million basic exclusion is a recent development, of a temporary nature, and not a long-recognized constitutional right.

If I could bend your ear a bit longer, it may be a good idea to cap the estate tax deduction for charitable contributions[lxxii] made to private non-operating foundations, as opposed to public charities. The removal of a significant amount of wealth, and the income therefrom, beyond the reach of the estate tax and the income tax in exchange for an annual charitable distribution based on 5 percent of the fair market value of the foundation’s assets does not seem like a good deal from the perspective of the general public.

Finally, and neither party ever makes this suggestion, Congress should increase the IRS’s enforcement budget. There are a lot of genuinely bad actors out there who are getting away with “murder.” Secretary Mnuchin reported in 2017 that for every one dollar spent on enforcement, the IRS collects four dollars.[lxxiii] That’s a great return in any circumstances.

There’s a lot more we can discuss, but I’ve already gone too long.

 



[i]
Including by some Republican pundits who “complimented” Mr. Biden; for example, Karl Rove, speaking on Fox News immediately after the convention concluded, commented that Mr. Biden’s presentation was “a very good speech,” acknowledging that Biden’s centrist position could present a challenge for Republicans. Having said that, however, he later added, “There were moments where – granted, he didn’t misstate, he didn’t lose words, the flow was pretty good – but you looked at him, and you said, ‘that’s an old guy and he’s doing his best.’”

[ii] I recognize that we are still in the introductory portion of this week’s post, but I have to digress. It irks me when candidates for election to an office – any office – state, as Mr. Biden did: “So, it is with great honor and humility that I accept this nomination . . . ”

“Humility?” This is Mr. Biden’s third attempt. It may have been his fourth if President Obama had not talked him out of running in 2016.

Politics is a dirty business – whether conducted at the national level or within the offices of a local business – and anyone who rises to, and succeeds at, its highest levels has probably compromised themselves in some morally questionable way.

By now, you’ve figured out that I enjoy quoting from certain movies to convey or stress a message. Among these is Gladiator. You may recall this exchange between Marcus Aurelius and General Maximus after the Emperor has asked Maximus to succeed him, temporarily, upon his passing:

Marcus Aurelius: Won’t you accept this great honor that I have offered you?

Maximus: With all my heart, no.

Marcus Aurelius: Maximus, that is why it must be you.

[iii] The Los Angeles Times published the full text of the speech: https://www.latimes.com/politics/story/2020-08-21/joe-biden-acceptance-speech.

[iv] The “Green Book.”

[v] I’ll endeavor to identify the similarities in the endnotes as we go along.

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

[vii] This is already scheduled to be reinstated in 2026. See the Tax Cuts and Jobs Act, P.L. 115-97; “TCJA”.

[viii] President Obama’s Green Book proposed raising the top tax rate on capital gains and qualified dividends from 20 percent to 24.2 percent. Perhaps this is where we will ultimately end up. For now, it’s the campaign season.

[ix] Already scheduled to disappear after 2025. TCJA.

[x] President Obama’s Green Book included this proposal. This limitation would reduce the value to 28 percent of the specified exclusions and deductions that would otherwise reduce taxable income in the higher income tax rate brackets.

[xi] The employer pays half of this, and collects the other half from the employee – each at 6.2 percent.

[xii] It currently stops at $137,700.

[xiii] IRC Sec. 1031.

President Obama’s last Green Book would have limited the amount of capital gain deferred under Sec. 1031 to $1 million (indexed for inflation) per taxpayer per taxable year. https://home.treasury.gov/policy-issues/tax-policy/revenue-proposals

[xiv] Anyone wondering “Why $400,000?” Why is Mr. Biden drawing the line there, and promising that folks making no more than that amount will not see an increase in taxes?

Let me take you back to 2012. (No, this doesn’t involve a crazy trip in a DeLorean.) We were approaching a “fiscal cliff;” specifically, the nation was facing over $500 billion in federal tax increases and budget cuts that were scheduled to go into effect on January 1, 2013 – the expiration of the so-called Bush tax cuts. The only way this could be avoided was if President Obama and a lame-duck Congress could reach an alternative agreement for reducing the deficit. (It’s laughable today, isn’t it?) The President’s plan at one point included higher taxes for folks making more than – you guessed it – $400,000.

In an article dated December 18, 2012, the U.S. News & World Report explained that although “$400,000 is unquestionably a high income . . . earnings are relative. A family earning $400,000 in Manhattan exists in a very different world than one earning $400,000 in” most any other part of the country. It went on to describe how the after tax cost of living in Manhattan was more than double the national average.   https://www.usnews.com/news/articles/2012/12/18/how-rich-is-400000-where-you-live-obama-willing-to-raise-taxes

By the way, $400,000 in 2012 is equal to over $451,000 today.

According to a July 29, 2020 article in Kiplinger, the cost of living in Manhattan was 145.7% above the national average. https://www.kiplinger.com/real-estate/601142/20-most-expensive-cities-in-the-us

[xv] IRC Sec. 1014.

[xvi] President Obama’s Green Book proposed the elimination of the step-up in basis at death, but with certain protections for the middle class, surviving spouses, and small businesses.

[xvii] IRC Sec. 2010, 2505 and 2631. This is already scheduled to occur after 2025. TCJA.

[xviii] Hence, Mr. Rove’s observation regarding Mr. Biden’s posture as a centrist.

[xix] Mr. Biden will turn 78 this November, after the election. Senator Harris will turn 56 years of age in October.

[xx] Also set to be reinstated in 2026. TCJA.

[xxi] Ironically, this would benefit higher income taxpayers. What’s more, this limitation is set to expire at the end of 2025. TCJA.

Other deduction limitations that will expire after 2025, and from which higher income taxpayers will benefit, are the limitation on qualified resident interest and the suspension of home equity interest.

According to the “List of Expiring Federal Tax Provisions 2016-2027” prepared by the Staff of the Joint Committee on Taxation, JCX-1-18 (Jan. 9, 2018), twenty-three provisions from the TCJA relating to individual income taxes will expire with 2025, as a result of which the amount of tax owing by most taxpayers will increase. Among these expiring provisions are the following: the reduced individual income tax rates, the increased AMT exemption and phase-out threshold, the increased standard deduction, the qualified business income deduction for pass-through business entities, and the increased estate and gift tax exemption. With the expiration of these provisions, and the restoration of others that have been suspended, the Code will look very much as it did at the end of the Obama Administration, with the exception of the reduced corporate tax rate and the taxation of overseas earnings on a current basis, which will continue (and which was long overdue).

[xxii] She did not indicate whether this increased rate would apply only to individuals with income in excess of a prescribed threshold, as Mr. Biden has. In any case, it should cover profits interests.

[xxiii] https://taxfoundation.org/kamala-harris-tax-proposals/

[xxiv] It’s my post after all.

[xxv] In accordance with the schedule set by the TCJA.

[xxvi] Query the effect of the pandemic.

[xxvii] “Biden Unites Democrats – for now,” by Jordain Carney and Mike Lillis, The Hill, August 22, 2020. According to the article, “Democrats are bracing for an all-out fight over their agenda” if Mr. Biden wins the White House in November.

[xxviii] The deduction for interest on acquisition indebtedness for a principal residence has been mentioned, as has the deduction for state and local taxes. Occasionally, there have even been whispers about the depreciation deduction in respect of real property.

[xxix] I can’t explain why, but when I think about this group I am reminded of Robespierre, the Committee of Public Safety, and The Reign of Terror. It’s a visceral reaction.

[xxx] “How much do you need to make to be in the top 1% in every state? Here’s the list,” by Samuel Stebbins and Evan Comen, USA Today, July 1, 2020. https://www.usatoday.com/story/money/2020/07/01/how-much-you-need-to-make-to-be-in-the-1-in-every-state/112002276/

[xxxi] Manhattan skews these figures.

[xxxii] This point is reinforced in the rules that govern the taxation of IRD (income in respect of a decedent), the most common example of which is compensation for services that has accrued to the service provider’s date of death but which remains unpaid. This “asset” is included in the decedent’s gross estate but it does not enjoy the benefit of a step-up in basis. Instead, the beneficiary to whom the IRD will be paid must pay tax at the ordinary income rates; however, in recognition of the fact that the value of the IRD has been included in the service provider’s gross estate, the beneficiary is allowed to deduct one-half of that portion of the estate tax paid by the estate that is attributable to the value of the IRD. IRC Sec. 691.

[xxxiii] The same holds true for interest paid to a creditor with respect to a loan. The creditor has recourse against the debtor’s property, and has a preference over the debtor to the latter’s property. That’s why compensation and interest are taxed as ordinary income. Similarly as to rent from real property, or a royalty in respect of a license. These are contractually enforceable payments.

[xxxiv] Does a real property require major capital improvements? Does a manufacturer have to purchase new equipment? Does the business need to invest in research in order to improve an existing product or process, or to develop a new one? Is the business expanding in order to take advantage of a new opportunity?

[xxxv] Certainly not without significant loss. Compare that to a marketable security, or to a publicly traded corporation that regularly offers to redeem its shares.

[xxxvi] Think of it as the overlapping parts of a Venn Diagram.

[xxxvii] Often for below market pay.

[xxxviii] We’re not just talking about equity. Remember, borrowed funds are repaid with after-tax dollars. Only the interest incurred for the use of such funds is generally deductible.

[xxxix] Think of the sole proprietorship, the partnership and the S corporation – all are pass-through entities the profits of which are taxed to their owners as ordinary income. These business entities are the vehicles of choice for the closely held business.

[xl] “From each according to his ability,” as Herr Marx wrote in his “Critique of the Gotha Program” (1875).

[xli] They should.

[xlii] Have any of these folks ever been in business?

[xliii] I am disregarding the proposal that calls for taxing the “gain” from the deemed sale of assets at death as it requires the introduction and implementation of an entirely new tax scheme – this is not the time. If we ever determine that such a system is right for us, it will take a couple years to figure it out, and it should be introduced during a relatively stable period. In any case, we cannot have both an income tax on the deemed sale of assets and an estate tax on the value of such assets.

[xliv] As an aside, they have no exposure as a “responsible person” for the sales tax and employment taxes of the business.

[xlv] https://review42.com/what-percentage-of-startups-fail/

[xlvi] A “strategic” buyer.

[xlvii] Preferred stock is the exception, in certain circumstances, but even there the holder is junior to every other creditor of the business. Compare interest, rents and royalties which are payable in exchange for the payor’s use of the payee’s property.

[xlviii] “The Dwindling Taxable Share of U.S. Corporate Stock,” Steven M. Rosenthal and Lydia S. Austin (2016).

[xlix] Defined contribution and defined benefit.

[l] Held in non-taxable segregated reserves to fund annuity contracts and whole life insurance.

[li] See IRC Sec. 512(b)(1).

[lii] IRC Sec. 871 and Sec. 881; fixed or determinable annual or periodical gains, profits, and income.

[liii] IRC Sec. 1411.

[liv] No joking here. I’m serious.

[lv] IRC Sec. 2031 and Sec. 2033.

[lvi] IRC Sec. 2010.

[lvii] All too often, owners fail to consider succession. In addition, their children often have no interest in continuing the business.

[lviii] IRC Sec. 2056 and Sec. 2055.

[lix] IRC Sec. 1015.

[lx] For example, beneficiaries who receive real property from a decedent, and continue to hold it for investment or for use in a business, may depreciate their stepped-up basis for such property.

[lxi] This Israeli-American was born Chaim Witz, changed his name to Gene Klein, became known professionally as Gene Simmons, and adopted the stage persona of “The Demon” as a member of Kiss.

[lxii] Including “Rock and Roll All Nite”.

[lxiii] It’s part of humanity’s relentless search for some form of immortality? Have you ever represented an institution that sought to change the name of a building after a subsequent donor offered a lot more money for the honor? I have.

You know what the ancient Greeks used to say about hubris, right? The gods have fixed limits on humanity; to disregard these limits, to challenge the natural order of the cosmos, to defy the gods, will elicit some form of punishment.

[lxiv] Like the pun?

[lxv] Thus limiting one’s ability to remove appreciation from one’s estate.

[lxvi] IRC Sec. 2702; Reg. Sec. 25.2702-3.

[lxvii] Under the grantor trust rules; specifically IRC Sec. 675(4). See Rev. Rul. 85-13.

[lxviii] Still very generous if you ask me.

[lxix] Thus eliminating the need for Crummey powers.

[lxx] Especially with respect to funding Social Security.

[lxxi] For example, the zeroed out GRAT.

[lxxii] IRC Sec. 2055.

[lxxiii] https://www.brookings.edu/opinions/steven-mnuchin-makes-a-welcome-case-for-boosting-irs-funding/

“The board is set. The pieces are moving. We come to it at last.”

With these words, Gandalf the White acknowledged that the decisive battle for control over Middle Earth had been joined.[i]

So it is now for the U.S. Presidential election scheduled for November 3, with both major parties having identified their respective standard-bearers and running mates.[ii]

Unfortunately, we have no Gandalf.[iii] I daresay we don’t even have a Peregrin Took.[iv]

Not Just the White House

Perhaps as important as the race for the White House is the struggle for control of the Senate, where the Republicans hold a slim majority.[v] Depending upon the outcomes of these contests,[vi] we may be looking at four years of deadlock,[vii] or we may be in store for some significant legislative changes, especially with respect to taxes.[viii]

After all, we’ve just spent trillions of dollars in response to the dire economic consequences resulting from the pandemic, we’re getting ready to spend trillions more and, depending upon which side of the aisle you sit, the pandemic may have brought into sharp focus many systemic, societal issues that call out for a solution.[ix] Someone has to bear the cost.

Because there is a possibility that the Democrats will sweep the November elections, today’s post will outline some of Mr. Biden’s tax proposals, as articulated by the then-candidate during the Democratic primaries, along with some post-primary adjustments and additions by the now-presumptive nominee. We will then consider, from a more practical perspective, his positions with respect to capital gains, like kind exchanges, basis step-up, and the estate tax.

Biden’s Tax Plan – In Brief

Of course, a nominee’s proposals are just that. Even if Mr. Biden is elected President, and even if the Senate flips, the fact remains that the more “progressive” wing of the Democratic Party is feeling its oats, which means that several of the items described below – most of which still need to be fleshed out – may eventually have to be “tweaked” before being enacted into law.[x]

For the moment, some of the key elements of Mr. Biden’s tax plan – from the perspective of the closely held business and its owners – may be summarized as follows:[xi]

Increase Personal Income Tax Rate

  • Increase the maximum federal tax rate on ordinary income from 37 percent[xii] to 39.6 percent.
    • This is the rate at which ordinary income was taxed before the Tax Cuts and Jobs Act of 2017.[xiii]
  • Ordinary income includes most income; for example, wages, commissions, business income (including one’s share of business income from a partnership or S corporation), guaranteed payments,[xiv] rent, interest, nonqualified dividends, royalties, gains from dealings in property (e.g., inventory), cancelation of indebtedness, depreciation recapture for tangible personal property and amortizable Section 197 intangibles, gain from the sale of depreciable property between certain related persons, short-term capital gain, etc.[xv]

 Increase Capital Gain Tax Rate

  • Increase the federal tax rate for long-term capital gains and for qualified dividends from 20 percent[xvi] to 39.6 percent.[xvii]
    • This increased rate would apply to the long-term capital gain of individuals with gross income for the taxable year in excess of $1 million.
      • In determining the $1 million threshold for a taxable year, the taxpayer will presumably include the capital gain for that year.
        • What about the gain arising from the sale of a business?
        • What if the purchase price is payable in installments,[xviii] or is contingent?[xix]
      • Individuals with less than $1 million of gross income for a taxable year would continue to enjoy the favorable 20 percent rate for capital gain and qualified dividends under current law.
      • Long-term capital gain is the gain from the sale, exchange or other disposition[xx] of (a)(i) a capital asset, or (ii) depreciable property used in a trade or business, or (iii) real property used in a trade or business,[xxi] and (b) held for more than one year.[xxii]
        • Thus, the capital gain from the sale of a closely held business would be taxed at the rate for ordinary income.
        • This would include a sale of shares of stock, a sale of assets – including goodwill and Sec. 1231 property, for example – and a deemed sale of assets resulting from a Sec. 338(h)(10) election.
          • This is a key item that needs to be clarified. Does Mr. Biden intend to tax the gain from the sale of assets used in a trade or business, or only the gain from the sale of investment assets?
          • It is also unclear whether Mr. Biden’s proposal will cover that portion of the gain from the disposition of real estate that is attributable to previously used depreciation allowances, which is currently taxed at 25 percent.[xxiii]
        • A “qualified dividend” is one that is paid in respect of the shares of a domestic corporation, and of certain foreign corporations, for which the owner of the shares satisfies a prescribed holding period.[xxiv]
        • What about the carried interest?[xxv] The taxation of capital gain at ordinary income rates would effectively eliminate the benefit associated with the carried interest.
          • Mr. Biden has previously stated that carried interests should be taxed as ordinary income.
        • Query whether we will see an uptick in transactions before the end of the year as taxpayers try to avoid the application of ordinary income tax rates to capital gains?
          • Of course, the sale of a business is not something to be rushed into even in the best of circumstances; nor should it be undertaken merely for tax purposes.[xxvi]

Limit QBI Deduction

  • Phase out the 20 percent qualified business income deduction for higher income taxpayers.[xxvii]
    • The deduction would be maintained for those making less than $400,000 during a taxable year.

Limit Itemized Deductions

  • Limit the benefit of itemized deductions for higher income taxpayers.[xxviii]

Increase Social Security Taxes

  • Impose social security taxes on income over $400,000.
    • Currently, employers pay a tax equal to 6.2 percent of an employee’s wages, up to $137,700, and they also withhold the same amount from the employee’s wages; a total tax of 12.4 percent of the first $137,700 of wages paid to an employee.[xxix]
  • Mr. Biden would require that the 12.4 percent Social Security tax – which is borne equally by the employer and the employee – be imposed on all wages in excess of $400,000.
    • The 2.9 percent Medicare tax (1.45 percent on each of the employer and the employee), which is imposed without regard to any cap, would continue to apply.
    • In other words, an employee’s wages would be subject to Social Security and Medicare taxes of 15.3 percent of the first $137,700, and 15.3 percent of every dollar of wages over $400,000.[xxx]

Restrict Like Kind Exchanges

  • Limit the use of like kind exchanges of real property to investors with annual incomes of not more than $400,000.
    • Beginning with exchanges completed after December 31, 2017, the TCJA limited the tax deferral benefit afforded by the Code’s like kind exchange provisions to exchanges involving real property (a) held for use in a trade or business, or (b) held for investment.[xxxi]
  • Mr. Biden’s proposal would eliminate the ability of any taxpayer with income in excess of $400,000 to use the like kind exchange provisions to defer the recognition of gain from the sale of real property used in a business or held for investment.
    • Assuming the $400,000 cap includes the gain from the sale of the real property, Mr. Biden’s proposal would basically eviscerate the Code’s like kind exchange rules.
    • Query how the cap will be applied in the case of a partnership? Presumably, it will applied at the level of each partner; thus, some partners may qualify to use the like kind exchange to defer the recognition of their pro rata share thereof, while others may not.[xxxii]

Eliminate Basis Step-Up at Death OR Make Death a Realization Event[xxxiii]

  • Eliminate the step-up in basis for assets acquired from a decedent.
    • Under current law, the basis of property in the hands of a taxpayer who acquires such property from a decedent, or to whom the property passes from the decedent, is equal to the fair market value of the property at the date of the decedent’s death.[xxxiv]
    • This taxpayer is also treated as having held the property so acquired for more than one year, thus ensuring long-term capital gain treatment for any disposition of the property occurring before the first anniversary of the decedent’s death.[xxxv]
    • The basis step-up enables the taxpayer (for example, the decedent’s estate or beneficiary) to dispose of the property acquired or passed from the decedent without recognizing any of the appreciation in such property that accrued during the decedent’s lifetime.[xxxvi]
    • If the property is depreciable, and it is placed in service by the taxpayer in a trade or business, or in an investment activity, then the taxpayer’s depreciation deductions are determined using the stepped-up basis.[xxxvii]
    • The partnership provisions of the Code allow a similar basis adjustment for a deceased partner’s share of the partnership’s basis for its assets (so-called “inside basis”). This basis adjustment benefits only the transferee who acquired the partnership interest from the decedent.[xxxviii]
  • By eliminating the step-up in basis at death, the decedent’s beneficiaries would presumably take the decedent’s properties with the same basis the properties had in the hands of the decedent.[xxxix] This acts to preserve the gain inherent in the property.
    • Thus, all unrealized appreciation on a decedent’s assets would be subject to tax on the subsequent disposition of such assets by the decedent’s estate or beneficiaries.
    • If the decedent’s assets were depreciable, the beneficiaries would not enjoy the ability to offset income by depreciating the assets, assuming they were placed in service.
    • In the case of a partner with a negative capital account balance that is attributable to partnership indebtedness (not uncommon in real estate investments), the loss of the basis step-up at death means that the recapture of debt-financed deductions or distributions will be inevitable.
  • Nota Bene. Mr. Biden has previously stated that the “built-in gain” or appreciation in a decedent’s assets would be subject to income tax upon their death.
    • The decedent’s death would be treated as a realization event for income tax purposes – income tax would be owed as if the assets had been sold for an amount equal to their fair market value at the date of death.
      • Presumably, the tax will be determined using the 39.6 percent rate described above.
    • Query how the decedent’s estate or beneficiaries are to raise the money with which to pay such income tax? After all, the assets will not yet have been sold and, in fact, may be difficult to sell.[xl]
    • The estate tax would presumably be applied to the remaining – i.e., post-income-tax – assets of the estate.
  • Ironically, by imposing an income tax at the time of the decedent’s death on the unrealized appreciation of the decedent’s property, the beneficiaries of the decedent’s estate will take the property with a basis equal to the fair market value of the property.

Reduce Gift, Estate and GST Tax Exemptions

  • Reduce the so-called “basic exclusion amount” under the federal estate and gift tax, as well as the exemption amount under the generation-skipping transfer (“GST”) tax, from $10 million to $5 million.[xli]
    • The basic exclusion amount is adjusted annually for inflation.
    • An individual taxpayer may transfer an aggregate amount of property by gift and by testamentary transfer up to the adjusted exclusion amount without incurring any gift tax or estate tax.
    • The TCJA doubled the basic exclusion amount to $10 million, but only for decedents dying, or gifts made, after December 31, 2017 and before January 1, 2026; the estate and gift tax exclusion amount for 2020, as adjusted, is equal to $11.58 million, or $23.16 million per married couple; the GST tax exemption amount for 2020 is also equal to $11.58 million.
  • Mr. Biden’s proposal accelerates the reinstatement of the pre-2018 basic exclusion amount, which as adjusted to date would be $5.49 million, or $10.58 million per married couple.[xlii]
    • The prospect of such a significant reduction in the exclusion amount will put many taxpayers into a “use it or lose it” frame of mind.[xliii]
  • To the extent a predeceasing spouse has not exhausted their gift and estate tax exclusion amount, the surviving spouse may utilize the unused amount in determining their own gift and/or estate tax liability.[xliv]
    • Mr. Biden’s proposal does not change this rule.
  • The maximum federal rate for the gift, estate and GST taxes is 40 percent.
    • Mr. Biden has not proposed increasing the tax rate.
    • I would be surprised if a Democratic Congress did not seek to increase the tax rate and further reduce the exclusion amount.

Increase Corporate Taxes

  • Increase the federal income tax rate on C corporations[xlv] from 21 percent to 28 percent.
    • The TCJA replaced the graduated rates previously applied in determining a corporation’s income tax liability with a flat rate.
    • Whereas the maximum rate under the graduated rate system was 35 percent for taxable income in excess of $10 million – generally speaking, the rate was 34 percent for taxable income between $75,000 and $10 million – the TCJA’s flat rate is equal to 21 percent.[xlvi]
  • Increase the effective rate on Global Intangible Low Tax Income (“GILTI”; basically, unrepatriated overseas income) from 10.5 percent to 21 percent.[xlvii]
  • Reinstate a form of corporate minimum tax for C corporations that have book profits of at least $100 million – the tax would be equal to 15 percent of such profits.[xlviii]
  • Eliminate the ability to carry back net operating losses (“NOLs”) generated in 2018, 2019 and 2020, and eliminate the suspension of the “80-percent-of-taxable-income” limit for utilizing NOLs in 2018 through 2020.[xlix]

Putting It All Together?

Now let’s see if we can illustrate, on a simplified basis, the application of some of these proposed changes.

Imagine, if you will, that Mr. Biden is elected President, and that the Democrats also take control of the Senate (while retaining control of the House). Assume also that they enact the proposals described above without change, effective for tax years beginning on or after January 21, 2021.[l]

Assume that Taxpayer has long been engaged in the business of acquiring, renovating and renting commercial real properties. At the end of 2020, Taxpayer owns three such properties with a total fair market value of $15 million.

During 2021, Taxpayer sells one of the real properties for $5 million in order to raise funds for the acquisition of another property in a more desirable location. Taxpayer believes this other property will generate better cash flow and more profit in the short-run, and will enjoy greater appreciation in the long-run.

Prior to 2021, Taxpayer would have used the sale proceeds, as part of a deferred like kind exchange, to acquire the desired property for $6.5 million;[li] to the extent Taxpayer would have needed additional funds to complete the acquisition (trading up in value), Taxpayer could have borrowed the shortfall of $1.5 million.

Assume Taxpayer has income of $5.5 million for the year of the sale – including the gain from the sale. Taxpayer will not be able to utilize the like kind exchange provisions to defer the tax on the sale and to apply the sale proceeds toward the acquisition of the new property. If Taxpayer’s basis in the property sold was only $1 million, Taxpayer will recognize gain of $4 million. The federal income tax on this long-term capital gain will be equal to 39.6 percent of the $4 million gain, or $1.584 million.

Taxpayer is left with approximately $3.4 million of after-tax proceeds, which is approximately $3.0 million shy of the price for the other property; in other words, Taxpayer would have to borrow twice as much as would have been required if a like kind exchange were permitted. Taxpayer is unable to borrow the extra amount, and is unwilling to admit a new investor to raise the additional capital.

As a result, Taxpayer loses the deal for the new property. Taxpayer, who is already suffering from high blood pressure, obesity, and diabetes, is very upset, which causes Taxpayer to eat. After finishing a whole pizza pie (half sausage, half mushrooms) and a half-dozen donuts, Taxpayer has a massive heart attack and dies. Taxpayer is survived by an adult daughter – the sole beneficiary of Taxpayer’s estate – and two Chihuahuas.

Taxpayer’s estate is worth $15 million. It is comprised of the remaining commercial rental properties ($10 million), a residence ($1 million), cash from the sale ($3 million after paying $400,000 for various debts and expenses) and securities ($1 million). Because of health issues, Taxpayer could never obtain life insurance.

If Taxpayer’s death is a realization event, $12 million of assets (the rental properties, the residence and the securities) are deemed to be sold. Assuming a total basis in such assets of $4 million, the gain of $8 million results in a federal income tax of $3.168 million.

The income tax reduces Taxpayer’s estate to $11.83 million. Assuming the estate tax exclusion amount is $5.6 million, and that Taxpayer has made no taxable gifts, and assuming the estate tax rate is 40 percent, Taxpayer’s estate will owe $2.49 million of federal estate tax. Of course, Taxpayer’s daughter will take the three real properties and the securities with a basis equal to their fair market value as a result of their deemed sale.

Thus, Taxpayer’s estate will have paid $5.66 million of federal income and estate tax with respect to an estate of $15 million, and Taxpayer’s daughter will take the Taxpayer’s assets with a stepped-up basis.

Prior to 2021, Taxpayer would have completed the like kind exchange by incurring $1.5 million of debt and acquitting the $6.5 million property (net value of $5 million). Instead of eating himself to death out of sadness, Taxpayer dies celebrating instead.[lii]

The estate is worth $16.6 million ($15 million of rental properties, $1 million residence, and $600,000 securities), there’s a taxable estate of $5.02 million, there is a federal estate tax of $2 million, and daughter would have taken the assets with a stepped-up basis.

Summary: Post-2020 total tax from “blown” like kind exchange, deemed sale at death, plus estate tax: $7.24 million; Pre-2021 estate tax: $2 million.[liii]

What to Do?

We’ve covered a lot of ground, but still there are many important questions that remain unanswered.

The Democratic Party’s convention will run from August 17 (today) through August 20. During that period, at least some of the open items identified above should be addressed. The election will be held 75 days later.

In between, there will be three presidential debates – September 29, October 15 and October 22[liv] – during which, one can only hope, there will be some meaningful exchange on tax policy generally, and on Mr. Biden’s proposals in particular.

Whether you are the owner of a closely held business, or an adviser to such a business and its owners, now is the time to determine how Mr. Biden’s tax plans may impact you and your business.

In order to do so effectively, you will need to remain attuned to messages coming out of Mr. Biden’s camp.

In addition, you will want to calculate the economic and tax consequences that may reasonably be expected as a result of a Biden victory and the enactment of the foregoing proposals.

As regards taxes that may be payable at the death of a business owner, how will their estate or beneficiaries satisfy (a) the income tax resulting from a deemed sale of the decedent’s assets, and (b) the estate tax liabilities arising from the reduction of the exclusion amount? Will the business have the wherewithal to redeem or liquidate interests? Will it be in a position to borrow money?[lv] Will the owner have to start thinking about acquiring life insurance to cover any gaps?

There’s a lot to think about, and there may a lot to do before the year-end.


[i] From “The Return of the King.”

[ii] The nation’s 59th quadrennial election. Think about it. The Articles of Confederation – which did not provide for a head of state – were approved by the Continental Congress in 1777, and were ratified by the States in 1781. The Articles were scrapped. The Constitution was ratified in 1788 and the first presidential election was concluded in January of 1789.

Since then, we have held elections during the Civil War, the Great Depression, and the Second World War. The election has never been delayed.

[iii] I have a T-Shirt which reads: “Keep Calm and Call Gandalf.”

It’s worth repeating: “Every nation gets the government it deserves.” – Joseph de Maistre.

[iv] Perhaps better known as “Pippin,” a Hobbit of the Shire.

[v] The Republicans hold 53 seats in the Senate, and are defending 23 of them; the Democrats hold 47 seats, and are defending 12 of them. If the Democrats win the White House, they will need to win three seats to control the Senate – the Vice President would be the tie-breaker. If the Republicans retain the presidency, the Democrats will need to win four Senate seats in order to control that chamber of Congress.

The House breaks down as follows: 232 Democrats, 198 Republicans, 4 vacancies, and one independent.

If the Republicans win the presidency and the Democrats end up with both chambers of Congress, it is extremely unlikely that the latter will win enough seats to override any presidential veto – Article One, Section 7, Clause 3 of the Constitution requires a two-thirds vote by each chamber.

[vi] On August 9, the NY Times reported that, in June and July, “Fox News was the highest-rated television channel in the prime-time hours of 8 to 11 p.m. Not just on cable. Not just among news networks. All of television. The average live Fox News viewership in those hours outstripped cable rivals like CNN, MSNBC and ESPN, as well as the broadcast networks ABC, CBS and NBC, according to Nielsen.” In fact, in terms of number of viewers, Fox equaled CNN and MSNBC combined. https://www.nytimes.com/2020/08/09/business/media/fox-news-ratings.html

If Fox viewers are more likely to support Trump over Biden, query, whom are the pollsters interviewing?

Speaking of pollsters, according to a recent Gallup poll, Congress’s approval rating has dropped to 18 percent; the president’s is at 41 percent. https://news.gallup.com/poll/316448/congress-approval-drops-trump-steady.aspx

[vii] Deadlock = (Republican President + Democrat Congress), or (Republican President + Republican Senate + Democrat House), or (Democrat President + Republican Senate + Democrat House).

[viii] A sweep by the Democrats.

[ix] I.e., more spending by those folks in the nation’s capital.

[x] That’s not to say we’re going to see a Warren- or Sanders-like wealth tax. However, there is a not insignificant number of Democrats in the House, and many vocal members of the general public, who would prefer a more punitive or “confiscatory” – euphemistically “progressive” – approach to taxing the “wealthier” members of society. (To borrow a line from Disney: “Tale as old as time.”) Concessions may have to be made.

“And again I say unto you, it is easier for a camel to go through the eye of a needle, than for a rich man to enter into the kingdom of God.” Matthew 19:24 (KJV).

[xi] In most cases, the plan is short on details; in some cases, there has been waffling. Hopefully, a more definite version will be provided as we approach Election Day.

[xii] This maximum rate applies to taxable income in excess of $510,300 in the case of a single taxpayer, and in excess of $612,350 in the case of a married couple filing jointly.

[xiii] P.L. 115-97; the “TCJA”.

[xiv] IRC Sec. 707(c).

[xv] IRC Sec. 61, 197, 1245, 1239. And don’t forget the 3.8 percent surtax on net investment income, which will continue to apply to investment income, and to a taxpayer’s share of the income of a business with respect to which the taxpayer is not a material participant. IRC Sec. 1411.

[xvi] IRC Sec. 1(h). Short-term capital gain is already taxed at the rate for ordinary income.

[xvii] Don’t forget the 3.8 percent surtax on net investment income.

Last week, Mr. Trump hinted that he may call for the reduction of the capital gain rate from 20 percent to 15 percent.

[xviii] An installment sale. IRC Sec. 453.

[xix] As in the case of an earn-out.

[xx] Including a deemed disposition; for example, a current distribution of cash by a partnership to a partner in an amount that exceeds the partner’s adjusted basis for their partnership interest. IRC Sec. 731(a) and 741.

[xxi] Property that is held primarily for sale in the ordinary course is not included.

[xxii] IRC Sec. 1221, 1222, 1231 and 1223.

[xxiii] IRC Sec. 1250; “unrecaptured Section 1250 gain”.

[xxiv] IRC Sec. 1(h)(11).

[xxv] The “promote,” as it is called in the real estate industry. IRC Sec. 1061.

[xxvi] As for the sale of marketable securities, there is nothing to prevent a taxpayer from selling now, recognizing the gain at the lower rate, then reacquiring the same class of securities in the same issuer with a cost basis.

Foreigners who are planning to emigrate to the U.S. often do this.

[xxvii] IRC Sec. 199A. This deduction was added to the Code by the TCJA as a concession to non-corporate taxpayers after the corporate tax rate was reduced from a top rate of 35 percent to a flat 21 percent. The deduction is already limited based on one’s taxable income.

[xxviii] Specifically, those in tax brackets with rates in excess of 28 percent.

[xxix] IRC Sec. 3101, Sec. 3111, and Sec. 3121. The Medicare tax of 1.45 percent is imposed on each of the employer and the employee – 2.9 percent in total – based on all wages.

[xxx] Query why there is a gap between $137,700 and $400,000 of wages?

[xxxi] No other property qualifies. Regulations were recently proposed under revised IRC Sec. 1031: https://www.taxlawforchb.com/2020/06/the-like-kind-exchange-of-real-property-according-to-the-proposed-regulations/

[xxxii] For example, LLC has two members, A and B; A has a 66.67% interest while B has a 33.33% interest. LLC sells investment real property for $1 million. Assuming neither member has any other income, A will not qualify to use Sec. 1031, but B will. Practically speaking, how will B carry out a like kind exchange?

[xxxiii] The only other instance that comes to mind in which death is a realization event for income tax purposes is upon the termination of a trust’s status as a grantor trust where the grantor had previously transferred a property to the trust in exchange for a promissory note.

[xxxiv] IRC Sec. 1014. There are exceptions; for example, items representing income in respect of a decedent (IRC Sec. 691) – such as cash basis receivables, accrued interest, unrecognized gain on installment notes – do not enjoy a basis step-up at the death of their owner. Similar rules apply with respect to partnership interests and shares of stock in an S corporation to the extent the value of these equity interests is attributable to items of income in respect of a decedent. Reg. Sec. 1.742-1; IRC Sec. 1367(b)(4).

Of course, death does not always result in a step-up. It is possible for the value of an asset to have dropped in comparison to its adjusted basis; for example, A purchases stock on the market at $50 per share; a week later, the stock tanks to $10 per share on some bad news for the issuer; A suffers a fatal stroke; his estate takes the stock with a $10 basis.

[xxxv] IRC Sec. 1223(9).

In general, property is considered to have been acquired from, or to have passed from, a decedent if: the property is acquired by bequest, devise or inheritance, or by the decedent’s estate from the decedent; the property was transferred by the decedent during their lifetime in trust, and the decedent retained certain rights with respect to the trust property such that the property is included in determining the value of the decedent’s gross estate; the property passed to the taxpayer by reason of form of ownership, or the decedent’s exercise or non-exercise of a power of appointment, if by reason thereof the property is included in determining the value of the decedent’s gross estate.

[xxxvi] The step-up is thought to have been enacted to account for the fact that the estate tax was also being imposed upon the decedent’s assets. Of course, many estates are not subject to the estate tax, yet their beneficiaries still enjoy the basis step-up for the assets they acquire from the estate or the decedent. For that reason, we cannot allow the taxability of an estate to determine whether or not there is a step-up – more affluent folks would receive the adjustment while the less affluent would end up paying income tax.

[xxxvii] IRC Sec. 162, 212, 167 and 168.

[xxxviii] IRC Sec. 754 and Sec. 743. The amount of the adjustment is treated as a separate asset that is newly placed into service.

[xxxix] So-called “carryover” basis.

[xl] Query whether estates will be allowed to pay the income tax in installments? Perhaps something akin to IRC Sec. 6166 and the estate tax attributable to a decedent’s interest in a closely held business?

[xli] IRC Sec. 2010, Sec. 2505 and Sec. 2631. The federal gift, estate and generation skipping transfer taxes may be referred to as the “transfer taxes.”

[xlii] Significantly, final regulations issued in late 2019 prevent the claw-back of the exemption amount. See T.D. 9884. https://www.taxlawforchb.com/2019/12/a-tale-of-two-estate-taxes-federal-new-york/#_ednref12

[xliii] Remember the end of 2012?

[xliv] “Portability.” This benefit is not available for a pre-deceasing spouse’s unused GST tax exemption.

[xlv] And S corporations subject to the built-in gains tax under IRC Sec. 1374.

[xlvi] IRC Sec. 11.

[xlvii] The current rate results from the interaction of IRC Sec. 951A and Sec. 250 (the latter allows a deduction for 50 percent of a corporation’s GILTI).

[xlviii] This is aimed at corporations that have no taxable income but which still report a “book profit” to their shareholders.

[xlix] NOL carrybacks were eliminated by the TCJA, but were temporarily restored by the CARES Act in response to the economic consequences of the pandemic. Likewise, the 80-percent-of-taxable-income” limit was enacted by the TCJA, but was temporarily suspended by the CARES Act.

[l] I think this is unlikely. In fact, it’s conceivable that the exclusion amount may be set even lower; say, $3.5 million, and the rate higher, at 45 percent – basically, where we were in 2009.

In addition, there are a number of other “fixes” that have long been part of the Democratic estate and gift tax agenda (or at least were part of President Obama’s Green Books); for example, the elimination of zeroed-out GRATs, the requirement of a minimum term for GRATs, the elimination of the inconsistency between the grantor trust rules and the transfer tax rules, and the limitation of valuation discounts.

I cannot see Mr. Biden’s proposals, or some version thereof, being enacted without the inclusion of one or more of the foregoing items.

[li] Reg. Sec. 1.1031(k)-1.

[lii] “I eat because I’m depressed and I’m depressed because I eat. It’s a vicious cycle.” Fat Bastard in “Austin Powers – Gold Member.”

[liii] Timing is everything? In part. The result also depends upon the fair market value and adjusted basis for the properties.

[liv] https://www.debates.org/

[lv] Think Graegin loan. https://www.taxlawforchb.com/2017/05/paying-the-estate-tax/

Today’s post briefly explores whether the term “corporate charity” is an oxymoron. It also tries to provide a framework for evaluating whether certain “charitable” activities should be undertaken by a business corporation. It is predicated, in no small part, upon the general premise that one must appeal to the corporation’s self-interest[i] in order to secure various charitable goals.[ii]

The Last Three Years

Historically, Americans have given to charitable causes like no one else. Recent experience demonstrates that they continue to respond to their charitable inclinations.

In fact, charitable giving in the U.S. during the years 2017, 2018 and 2019 achieved the three highest levels of giving ever recorded.[iii] Perhaps this should not come as a surprise when one considers the performance of various leading economic indicators during this period; during the sandwich year of 2018, for example, personal income grew 4.4 percent, gross domestic product grew 4.1 percent, and the S&P 500 grew almost 29 percent.

From 2017 through 2019, lifetime and testamentary charitable giving by individuals increased by 2.3 percent and 9.8 percent, respectively, while charitable giving by corporations increased by 9.5 percent.[iv]

Of the approximately $450 billion given to charitable organizations during 2019,[v] about 69 percent came from individuals – representing 1.9 percent of their disposable income – 10 percent came as testamentary transfers by deceased individuals, and approximately 5 percent came from corporations – representing 1 percent of corporate pre-tax profits.[vi]

Corporate Charity

Some may be inclined to throw a fit over the “discrepancy” in relative giving between individuals and corporations, both in terms of absolute numbers and as a percentage of disposable income.[vii]

Please remember that the for-profit business corporation’s reason for being is to make money for its shareholders – “persons” who are, or who are ultimately owned by, individuals. That’s why the corporation was organized, and that’s why its shareholders have dedicated their knowhow, or have contributed their capital, to the corporation – i.e., they have invested, and put at risk, their time, intellectual capital, and money[viii] – in exchange for shares of stock in the corporation. Why? For the opportunity to realize a worthwhile return on their investment.[ix]

Over time, government and society, generally, have pressured the corporation to increase its commitment to other “constituents,” especially its employees,[x] but also its customers. More recently, the corporation has been taken to task for not demonstrating a greater commitment to its “community” at large.

In general, corporations have responded by adapting old policies to these changing demands, and by adopting some new ones, with varying degrees of “success.” Some corporations have been more public and vocal than others about touting these activities and calling attention to their status as good corporate citizens.[xi] In every case, the corporation’s responses involve an expenditure of monies – in other words, there is an opportunity cost.

At the same time, the corporation’s principal profit-making purpose has not changed, notwithstanding that many would like to see the corporation transformed into an active agent of social change. The best way to reconcile these goals – and indeed the most effective way of attaining long-lasting and desirable consequences – is to demonstrate how such change will ultimately lead to greater profit, assuming that is the case.

In this way, the corporation may be enlisted as a willing partner to effectuating social change.

Without this level of self-interested involvement, the corporation will remain merely a taxpayer from which to collect revenues – be it at a flat 21 percent federal rate or pursuant to some graduated rate structure – or to encourage to make certain expenditures in exchange for tax benefits.

Corporate Giving

Let’s assume a closely held corporation with at least two shareholders; whether it is family-owned or not is not necessarily relevant. How do the corporation’s decision-makers decide upon which charitable organizations to support and from which to withhold support? What factors do they consider?

If the charity happens to be a client, or if the charity is important to the owners of a client or vendor, it may be wise for the corporation, from a business perspective, to maintain that relationship, assuming it makes economic sense, by making a contribution that is commensurate to the importance of the relationship.[xii]

Alternatively, the corporation may decide to support a charity whose mission aligns with the corporation’s products or line of business. Thus, for example, a sneaker and sportswear distributor may contribute funds to a local charity that encourages physical fitness. In this case, the corporation is promoting its business through name or brand recognition.

Expense or Contribution?

Outside of the above-described scenarios, and others similar to them, the decision becomes more difficult to justify from a business perspective when there is more than one shareholder. For instance, I was once involved with a situation in which a minority shareholder was upset that the majority shareholder had used corporate funds – without any ostensible corporate purpose or economic benefit – to support the latter’s favorite charities rather than making larger distributions.[xiii]

Either way, however, the question must be asked: Is the contribution being made in order to secure some economic benefit for the corporation?[xiv] Does the corporation expect to receive a more-than-incidental benefit in exchange for the contribution?[xv] If so, is it really a contribution, or would it be more accurately characterized as an advertising expense, for example?[xvi]

How much of an economic benefit must the corporation reasonably expect in order for the contribution to qualify as a business expense, as opposed to a charitable gift?[xvii] The answer may have tax and, therefore economic, consequences.

The Code allows a taxpayer to claim a deduction for all the ordinary and necessary expenses paid or incurred by the taxpayer in carrying out a trade or business.[xviii]

On the other hand, it has long been the case that, in order for a transfer to be treated as a gift for income tax purposes, it must be motivated by a “detached and disinterested generosity.”[xix] For example, in the case of a bargain (below market) sale of property by a taxpayer to a charity, the taxpayer must demonstrate that they intend to make a gift of the bargain element in order to claim a charitable deduction for the bargain element – the transaction cannot merely be a bad deal for the taxpayer.[xx]

Does the application of such a standard to a business corporation make any sense? As a matter of corporate law, is there a reasonable argument that such a transfer constitutes an act of “ultra vires?”

Assuming the corporation expects to receive some benefit – call it goodwill, name or brand recognition – is the benefit so “incidental,” or is the value of the benefit so difficult to determine, such that the charitable deduction should be saved?

Alternatively, what if the contribution is being made at the request or behest of a particular shareholder (as in the situation described above)? What if the shareholder sits on the charitable recipient’s board of directors? In the absence of some demonstrable business purpose, should the contribution be treated as a distribution to the shareholder – a nondeductible constructive dividend or other distribution?[xxi] Probably not, at least where there is no economic benefit to the shareholder or to some related person.[xxii]

The proper characterization of a corporate transfer to a charity will have some meaningful consequences, as discussed below.

Pre-COVID Tax Incentives

The view that corporations are business organizations operated for profit, and that eleemosynary activities, including charitable giving, are best conducted by private individuals and by not-for-profit organizations, is reflected in the tax incentives for charitable giving that are afforded to individuals versus corporations.[xxiii]

For example, for a taxable year beginning before January 1, 2026, an individual may claim an income tax deduction for a cash contribution made to a domestic public charity[xxiv] up to an amount equal to 60 percent of the individual’s contribution base;[xxv] for cash transfers made after 2025, the percentage limit becomes 50 percent.

A corporation’s total charitable contribution deduction for a taxable year, on the other hand, may not exceed 10 percent of the corporation’s taxable income for such year.[xxvi]

In addition, although the deduction for both individuals and corporations is contingent upon the recipient entity being organized in the U.S., a corporation’s contribution to a charitable trust or to a private foundation will be deductible only if it is to be used within the U.S. or any of its possessions.[xxvii] A similar gift by an individual to a trust or foundation is not limited in this way.[xxviii]

A corporation may be tempted to claim a business expense deduction for that portion of its contribution to a charity that exceeds the above-described limits. Unfortunately for the corporation, Congress foresaw this possibility; thus, the Code provides that no such deduction will be allowed for any contribution which would be allowable as a charitable deduction if not for the percentage limitations.[xxix]

In other words, the corporation must determine whether the transfer will be treated an expense or as a gift.

Pandemic and CARES Act[xxx]

The economic shutdown that followed the president’s declaration of a national emergency in March of this year resulted in a sharp decline in almost every measure of economic activity, with the exception of unemployment, which skyrocketed.[xxxi]

In response to the economic disruption caused by the pandemic, the CARES Act[xxxii] amended the income-based percentage limitations for charitable contributions, effective for taxable years ending after December 31, 2019, with the goal of maximizing the influx of immediately available funds to charitable organizations that are directly engaged in activities for the benefit of the general public.[xxxiii]

The Act suspends the TCJA’s 60 percent limitation, and in its stead provides that an individual who itemizes deductions and makes a cash payment as a charitable contribution to a public charity during the calendar year 2020, may elect to claim a deduction in respect of such contribution of an amount up to 100 percent of the taxpayer’s 2020 contribution base.

In the case of a corporation, such a cash contribution to a public charity during 2020 will be allowed as a deduction in an amount up to 25 percent of the corporation’s taxable income (rather than the otherwise applicable 10 percent).

Any amounts in excess of the taxpayer’s applicable contribution base may be carried forward by the taxpayer for up to five years.[xxxiv]

Again, it appears that Congress believes charitable giving is best handled at the individual level.

Takeaway

Corporate charitable giving as a percentage of corporate pre-tax profits fell off during and immediately after the Great Recession. The reaction to the pandemic was very different, at least initially – by all accounts, businesses were quick to react to assist charities; of course, they were responding to a genuine national emergency, rather than to a “self-inflicted” financial crisis. That being said, it is still too early to tell how charitable giving will be impacted as we continue to deal with the pandemic and its economic consequences, including the financial strains under which most businesses are now operating.

It is noteworthy that the tax environment following the Great Recession was quite different than it is today. The current flat federal corporate tax rate of 21 percent leaves a business with more options than does the prior maximum graduated rate of 35 percent,[xxxv] though even that distinction may prove to be inconsequential if profits suffer enough.

In any case, long-term tax and corporate policies toward charitable contributions should not be made in the midst of, or on the basis of data gathered during, an emergency.

That said, the factors described above should help a closely held corporation with implementing a plan for charitable gift-giving. In short, charitable contributions should be used strategically; the corporation should be able to demonstrate some economic benefit or motivation for its “gifts.”

The corporation’s financial accounts should never be used as personal check-writing accounts for the shareholders, even if the funds are being given to charity – this is just sound business practice. In this way, disputes among shareholders over the use of corporate funds can be avoided. Likewise, third parties would be harder-pressed to point to such giving as evidence of the corporation’s status as the alter ego of its shareholders.

I think that the position set forth in the federal gift tax regulations is helpful in this regard, and the guidance implicit therein should be relatively simple to implement: corporations don’t make gifts, their shareholders do.


[i] I am not trying to humanize the corporation; rather, I am merely recognizing that it represents a collection of individual decision-makers and equity owners who have come together for profit. See Reg. Sec. 301.7701-1.

Nor am I ignoring the fact that there are businesses that, under the right facts and circumstances, will act without regard to their bottom line. These folks are exceptional. By definition, there aren’t enough of them to make a societal or systemic difference.

[ii] Many charities already do this as part of their solicitation of businesses.

[iii] On June 23, 2020, Nonprofit Quarterly published the results of a study that was presented on June 18, 2020 by Dr. Patrick Rooney of the Indiana University Lilly Family School of Philanthropy at IUPUI and Laura MacDonald, the vice chair of Giving USA. I recommend this very informative and comprehensive report to anyone who works in charitable giving. https://nonprofitquarterly.org/giving-usa-2020-what-are-the-implications-for-you/?gclid=EAIaIQobChMIxsyhhaKM6wIVEQiRCh159w-KEAAYAyAAEgJxMPD_BwE

The data cited in today’s post may be found in this study. To the extent any conclusions presented herein differ from those of the study or of its authors, well, that falls on me.

[iv] Foundation grants increased by 7 percent.

[v] Of this $450 billion, 29 percent went to religious organizations, 14 percent to educational institutions, 12 percent to human services organizations, 12 percent to grant-making foundations, and 9 percent to health organizations. The balance went to a variety of charitable entities, including arts, cultural, environmental, and other organizations.

[vi] According to a study conducted a while back, small businesses donate an average of 6 percent of their profits. This may be attributable to their greater reliance upon the patronage, support and goodwill of the local community in which they operate; this, in turn, incentivizes these businesses to be visibly more supportive of local charities. https://www.businessnewsdaily.com/10470-small-business-guide-charity-donations.html

[vii] To use a corporate term, let’s call it unappropriated retained earnings. In other words, the pot from which corporate dividends would otherwise be payable to shareholders.

[viii] The opportunity costs are real.

[ix] In his 2020 annual letter to shareholders, accompanying JP Morgan’s 2019 Annual Report, Jamie Dimon told shareholders that COVID-19 was going to be a major factor in 2020’s performance. After describing the “extraordinary lengths” to which JP Morgan will go to help its customers, its employees and its communities – presented in that order – the letter then assures its shareholders that dividends will not be suspended (except in the most dire of circumstances). https://reports.jpmorganchase.com/investor-relations/2019/ar-ceo-letters.htm. (He also explained that the bank was halting buybacks of its stock.)

[x] The incentive here is obvious: align the economic interests of one’s employees with those of the business, and both should benefit.

In addition, in order to attract and retain good employees, the corporation has to offer certain basic benefits, be it competitive wages, health insurance, life insurance, 401(k) plans, year-end bonuses, flexible hours, etc.

Others support their employees’ charitable activities by taking sponsorships or by matching charitable gifts.

Some offer scholarships for the children of employees.

[xi] I am reminded of the parable of the Pharisee and the tax collector. The latter is the hero of the lesson, but let’s focus on the Pharisee. He entered the Temple, walked to the front, and prayed aloud to G-d, reminding Him (as if it were necessary), among other things, of how much of his profit he gave to the poor. Luke 18:9-14.

See also the order of the topics discussed in Mr. Dimon’s letter, above.

[xii] Why do you think so many charities seek out gala honorees on the basis of their ability or potential for raising money? Even where the honoree has no previous connection to the charity. If you’ve served on enough boards long enough, you’ve seen this many times for yourself.

[xiii] I have to say that the minority shareholder was equally upset about not having been afforded the same opportunity.

[xiv] It would behoove a corporation’s officers to review the applicable state law for any restriction on the ability of the corporation to make certain charitable contributions.

New York’s Business Corporation Law specifically provides that a corporation “shall have power in furtherance of its corporate purposes: . . . [t]o make donations, irrespective of corporate benefit, for the public welfare or for community fund, hospital, charitable, educational, scientific, civic or similar purposes, and in time of war or other national emergency in aid thereof.” BCL Sec. 202(a)(12). “In furtherance of its corporate purposes” – how direct a connection is required?

[xv] This issue has occupied charities for years in distinguishing a gift from advertising income or other unrelated business income. The array of political forces at work here have been extraordinary. In many cases, it has taken some intellectual contortionism to generate the “desired” result.

[xvi] And deductible as an ordinary and necessary expense of conducting the business. IRC Sec. 162.

[xvii] Speaking of “gifts,” it should be noted that Reg. Sec. 25.2511-1(h)(1) explains that a corporation cannot make gifts for purposes of the federal gift tax; rather, the corporate transfer is treated as a gift by its shareholders.

[xviii] IRC Sec. 162(a). It is assumed that the amount paid or incurred is reasonable in light of the consideration received in exchange – why would someone overpay?

[xix] Comm’r v. Duberstein, 363 U.S. 278 (1960).

[xx] Compare the gift tax. Reg. Sec. 25.2511-1(g)(1) states that donative intent is not an essential element in the application of the gust tax to a transfer. The tax is based on the objective facts of the transfer and the circumstances under which it is made, rather than on the subjective motives of the donor.

However, the regulation also states that the gift tax is not applicable to ordinary business transactions. Thus, Reg. Sec. 25.2512-8 provides that a transfer of property made in the ordinary course of business (bona fide, at arm’s length, free from donative intent) will be considered as made for full and adequate consideration in money or money’s worth.

[xxi] IRC Sec. 301 and Sec. 1368.

[xxii] Rev. Rul. 79-9.

Compare that to the situation of a corporation that satisfies a shareholder’s charitable pledge.

[xxiii] This refers to C-corporations. Charitable contributions by S corporations are separately stated on the Schedule K-1 issued to each shareholder because the separate treatment of such item could affect the liability for tax of that shareholder; for example, the addition of the shareholder’s distributive share of a corporate contribution may impact the shareholder’s ability to deduct currently a contribution made individually by such shareholder/. IRC Sec. 1366(a)(1)(A); the S corporation is not allowed a deduction for charitable contributions. Sec. 1363(b)(2). Similar rules apply to partnerships and their partners. IRC Sec. 702(a)(4); the partnership is not allowed a charitable deduction. IRC Sec. 703(a)(2)(C).

[xxiv] IRC Sec. 170(c) and Sec. 509(a). No income tax deduction is allowed for a transfer to a foreign charity. Interestingly, the gift tax and the estate tax generally allow deductions for transfers to foreign charities.

[xxv] IRC Sec. 170(b)(1)(G). One’s contribution base for a taxable year is means the individual’s adjusted gross income (IRC Sec. 62) for that year, but without regard to any NOL carryback to that year. IRC Sec. 170(b)(1)(H). The TCJA temporarily increased the limit from 50 percent to 60 percent. The cap reverts to 50 percent after 2025. Sec. 170(b)(1)(A).

[xxvi] IRC Sec. 170(b)(2)(A). The corporation’s taxable income is determined without regard to NOL carrybacks and other enumerated items. IRC Sec. 170(b)(2)(D).

The “excess” contribution may be carried forward to the five succeeding taxable years. IRC Sec. 170(d)(2).

[xxvii] IRC Sec. 170(c)(2).

[xxviii] That is not to say that there are no other requirements that must be satisfied before a deduction is allowed.

The use of funds contributed to a charitable corporation is not restricted in this way.

[xxix] IRC Sec. 162(b); Reg. Sec. 1.162-15.

[xxx] Here again, many businesses acted to help their communities – not all, though. Many were in survival mode.

[xxxi] Don’t talk to me about the stock market. Even the oracle at Delphi would have been hard-pressed to foresee its movements.

[xxxii] P.L. 116-136 (the “Act”).

[xxxiii] Consistent with the above-stated intent, contributions to a private foundation, to a supporting organization, or to a public charity for the establishment of a new (or for the maintenance of an existing) donor-advised fund, will not qualify for the enhanced deduction under the Act because such funds will not necessarily be immediately employed in charitable activities. For example, there are no minimum distribution requirements for a donor-advised fund; a private foundation can get away with distributing only 5 percent of the aggregate fair market value of its assets; supporting organizations may perform a number of functions on behalf of a public charity, not all of which result in immediate liquidity for use by the supported charity.

[xxxiv] https://www.taxlawforchb.com/2020/04/give-and-it-shall-be-given-unto-you-charitable-giving-after-the-cares-act/#_edn32

[xxxv] P.L. 115-97. The Tax Cuts and Jobs Act (“TCJA”) provided for a flat 21 percent federal corporate income tax rate.

Bankruptcy Resurgent?

The economic shutdown, and the ensuing recession, triggered by the COVID-19 pandemic have jeopardized the survival of many businesses and, in some cases, of entire industries.

Notwithstanding the Federal government’s efforts to mitigate the adverse consequences of this very challenging economic environment,[i] commercial bankruptcy filings under Chapter 11 of the U.S. Bankruptcy code[ii] were up 43% in June 2020 over June of last year;[iii] in May 2020, they were up 48% from last year.[iv] For the first half of 2020, total commercial Chapter 11 filings were up 26%.[v]

In reaction to these developments, and to what they may signify for the immediate future, many bankruptcy organizations[vi] have been asking Congress to consider amending those provisions of the Code that govern the taxation of cancellation of indebtedness income (“CODI”).[vii] For example, there have been requests that taxpayers be allowed to defer the recognition of such income;[viii] without such deferral, any plan of reorganization – which as a matter of course will likely include some debt cancellation – may result in a large, and immediately payable, tax bill which the debtor-business and its owners cannot satisfy. Others have suggested that the debt cancellation income be offset by reducing the taxpayer’s tax attributes.[ix]

At the moment, the Republican-controlled Senate and the Democrat-controlled House are trying to reconcile their respective versions of the next economic stimulus legislation, neither of which seems to consider the impact of CODI on a debtor-business.[x]

However, based upon the pace of bankruptcy filings described above, and assuming there will be a second wave of COVID-19 this fall[xi], along with the ensuing social-distancing-induced closures, it’s only a matter of time before Congress will have to confront – and will have to take measures to ameliorate – the impact of CODI on the tax liabilities of many debtor businesses.

Until then, the owners of a closely held business that may reasonably expect to be at risk[xii] should consult their advisers – it is never too early to start planning for the economic consequences resulting from the interplay of the tax and bankruptcy laws. It would also behoove them to understand some of the basic concepts, some of which are discussed in the decision described below.[xiii]

The Straddle Year

In October 2015, a corporate debtor (“Debtor”) filed a voluntary petition for relief under Chapter 11 of the Bankruptcy code[xiv] (the “BC”). However, prior to filing for bankruptcy, Debtor had sold substantially all of its material assets; the Bankruptcy Court (the “B-Court”) converted Debtor’s case to one under Chapter 7, and the U.S. Trustee appointed a “case” trustee (“Trustee”).[xv]

The Debtor’s tax year ended on December 31. In September 2016, Trustee filed Debtor’s federal corporate income tax return for the 2015 calendar year. Debtor’s taxable income was realized principally from its pre-petition activities.

Based on Debtor’s federal tax return for its year ending December 31, 2015,[xvi] the IRS filed an “administrative expense priority claim” in Debtor’s bankruptcy case for taxes, penalties, and interest. The events that gave rise to these asserted tax obligations occurred before the filing of Debtor’s petition in bankruptcy.

Trustee asked the B-Court to disallow the IRS’s administrative expense priority claim and to reclassify it as a general unsecured claim.

The issue before the B-Court was how to treat Debtor’s federal income tax liability for the 2015 “straddle year” – i.e., the tax year during which Debtor filed its petition for bankruptcy – for purposes of the BC’s priority rules.

The B-Court held that the straddle tax year had to be bifurcated into pre- and post-petition periods; that Debtor’s income tax obligations for its 2015 tax year had to be allocated between these two periods; and that income taxes resulting from pre-petition events during the straddle year were accorded “general unsecured [eighth priority] treatment,”[xvii] while income taxes resulting from post-petition events in that same straddle year – after the bankruptcy estate[xviii] came into existence – were granted “administrative [second] priority” treatment.

The B-Court’s determination meant that the IRS’s claim against Debtor – which was derived from pre-petition events – would be treated as a general unsecured claim; i.e., one with a relatively low probability of receiving any significant distribution from the bankruptcy estate.

The IRS Disagrees

The IRS asked the U.S. District Court (the “D-Court”) to reverse the B-Court’s conclusion that a claim for Debtor’s corporate income taxes for the straddle year was only entitled to administrative priority to the extent it was attributable to post-petition income or events.

 The IRS contended that the B-Court reached the wrong result because under applicable non-bankruptcy law – the Internal Revenue Code – a corporation’s entire annual income tax accrues on the last day of its tax year. Because a corporation has only a single tax liability for a tax year, the entire tax is “incurred by the estate” on that day. The IRS argued that the B-Court erred in its failure to consider the language of the Code in its determination of when federal income tax is incurred. The IRS asserted that both the BC and the Code distinguish income taxes, on the one hand, from transaction- or event-based taxes,[xix] on the other.

According to Trustee, the B-Court reached the correct result in holding that income tax is incurred daily, based on each day’s events and transactions, and that a single year’s tax liability must be apportioned between pre-petition and post-petition days, events, and transactions. Under this view, any portion of Debtor’s income tax traceable to events or transactions prior to the petition date, when no bankruptcy estate yet existed, was not “incurred by the estate.” Moreover, since Debtor’s tax year did not end prior to the filing of the bankruptcy petition, the tax incurred in the pre-petition portion of the straddle year was not entitled to priority status, but rather was only a general unsecured claim, notwithstanding the policy of giving preferential treatment to taxes the government has not had a reasonable time to assess or collect. According to Trustee, the distinction between income taxes and event-based taxes was irrelevant; the IRS’s claim for taxes accrued when the income was earned, at the time of the taxable event, such as the pre-petition sale of assets.

Thus, the issue before the D-Court was whether the B-Court was required to look to the underlying substantive tax law – the Code[xx] – to determine when the income tax accrued, as urged by the IRS, or whether the answer turned entirely on when individual transactions or events occurred – pre-petition vs. post-petition – as urged by Trustee’s bifurcated approach.

The District Court

The D-Court began by explaining that the BC sets out several priorities of expenses and unsecured claims against a bankruptcy estate. Second priority is accorded to certain “administrative expenses.”[xxi] To warrant administrative claim priority, the D-Court continued, the straddle year taxes must have been incurred by the estate.

Taxes “incurred by the estate” are administrative expenses, the D-Court stated, entitled to second priority. According to the D-Court, the sole issue on appeal was whether Debtor’s corporate income taxes were “incurred by the estate.”

The IRS argued that a determination of when a tax is “incurred by the estate” depends on when the estate “become[s] liable” for the tax. The IRS argued that, under the Code, a federal income tax does not become a fixed liability until the last day of the applicable tax period; the IRS asserted that this cannot occur until the last day of Debtor’s tax year.

Conversely, Trustee argued that each time a taxable event occurs during a tax year, the taxpayer “becomes liable” for any tax obligation that may arise as a result thereof, regardless of whether that the liability may be contingent, disputed, or unliquidated.[xxii]

Trustee urged that “corporate income taxes accrue – and thus are ‘incurred’ – on a daily basis as events giving rise to tax liability occur.”  According to Trustee, this construction was consistent with federal bankruptcy law “in determining when a claim arises for bankruptcy purposes.” Thus, the IRS’s claim (i.e., the right of payment of taxes on income earned pre-petition) “accrued when the income was earned.”

The D-Court noted that “The first test for administrative priority – whether a claim for taxes on income earned pre-petition in the year of bankruptcy could be considered ‘incurred by the estate’ – presents a clash between tax policy and bankruptcy policy.” Administrative priority, it stated, turns on whether and when the tax at issue was “incurred by the estate,” not whether and when the IRS’s tax claim arose. This determination, the D-Court explained, must be made based on the underlying substantive tax law.

Under substantive tax law, the D-Court continued, each type of tax is “incurred” at a different point: (1) federal income taxes are “incurred” at the end of the tax year; (2) employment taxes are incurred when wages are paid;[xxiii] and (3) excise taxes are incurred at the time of an event.

“Importing the traditional bankruptcy claims analysis,” the D-Court stated, won’t work for purposes of the priority rules because the identification of when the action which underlies a “right to payment” occurred will not necessarily comport with a determination of when the tax “accrues and becomes a fixed liability” in accordance with the relevant substantive tax law.[xxiv]

“Here,” the D-Court explained, “the Code is the substantive law creating and defining the taxes included in the IRS’s Claim.” Based on the plain language of the Code, a corporation’s federal income tax, if any, “accrues and becomes a fixed liability” on the last date of the tax year. The Code imposes a tax on “taxable income;”[xxv] taxable income, in turn, is defined as gross income, which is “all income from whatever source derived,” minus allowable deductions.[xxvi] It is only on the last day of the taxable year that all events giving rise to an income tax have occurred (both these creating income and those creating deductions).[xxvii]  A corporation’s income tax thus does not become “a fixed liability” or “inescapably imposed” until that day – December 31 for calendar year taxpayers like the Debtor.[xxviii] It is only after that moment that the corporation’s income tax liability, if any, becomes fixed and inescapably imposed.

Trustee argued that none of the foregoing compels the outcome sought by the IRS. Trustee argued that the Code does not define the terms “incurred” or “accrued” and does not address the classification or prioritization of the taxes at issue. According to Trustee, the fact that the amount of income tax due may change up until the last minute of the tax year is of no moment and does not necessarily mean that the tax is “incurred” at that point.

While the D-Court conceded that the Code does not define the terms “incurred” or “accrued,” and does not address the classification or prioritization of the taxes at issue, it rejected Trustee’s contention that the income tax at issue here was incurred prior to the end of the 2015 tax year, stating that the Code imposes a tax for an entire year, not individual events. Corporate income tax liability, the D-Court reiterated, is determined by netting all the tax year’s income with all the year’s deductible expenses, then applying the applicable tax rate. That computation is based on the sum of information at the end of the tax year.[xxix]

Applying these provisions, the D-Court concluded that Debtor’s 2015 taxable income could only be calculated at the end of its taxable year, after all income and deductions were known. Said differently, until December 31, 2015, Debtor did not have taxable income because not all possible events had occurred. While a major source of income came from sales occurring before the October 2015 petition date, it was irrelevant, the D-Court stated, “whether that income was recognized on one day during the year or on 365 separate days,” because the Code considers aggregate amounts, not individual income events or deductions, during the year. Under the substantive tax law, the Debtor’s income became taxable income only after determining all income and deductions for the taxable year, at which point the tax accrued and became a fixed liability.

Finally, Trustee asserted that applying the IRS’s interpretation would lead to an “absurd result” which would “gut the Bankruptcy Code.” According to Trustee, “if the dispositive factor in the IRS’ analysis of when a tax is ‘incurred’ turns on a[] fixed or inescapable liability, then the estate would be liable for all taxes of the [Debtor] – both pre-petition and post-petition – and elevate all of those taxes to administrative expense priority treatment.”[xxx]

Again, the D-Court disagreed, pointing out that, under this analysis, taxes for years ending on or before the petition date would not be accorded administrative expense treatment, and the attendant priority.[xxxi] What’s more, the D-Court explained, there was no support for the position that Congress intended to make straddle-year taxes entirely post-petition claims. Rather, underlying substantive tax law would determine whether and when taxes were “incurred by the estate” for purposes of the BC’s priority rules.[xxxii]

Based on the Code, federal corporate income tax liability accrues and becomes a fixed liability on the last day of the tax period – December 31, 2015 in this case.

Accordingly, the income tax at issue in the IRS’s claim was incurred by Debtor’s estate post-petition, and the tax should be entitled to priority as an administrative expense. With that, the B-Court was reversed.

Looking Ahead

It remains to be seen how the large number of bankruptcy filings already triggered by the COVID-19 economic slowdown will ultimately be resolved, and what the impact thereof will be on the timing and nature of an eventual recovery. Of course, future filings will also have to be monitored.[xxxiii]

The outcome will depend in large part upon the hopefully soon-to-be-enacted stimulus legislation, as well as upon the passage of more targeted debt-relief legislation which has probably not yet been drafted, let alone introduced.[xxxiv]

In the meantime, struggling businesses will have to do what is necessary to survive. That includes planning for a possible reorganization in bankruptcy, among the elements of which should be the preservation of tax attributes[xxxv] that may enable the business to reduce future income tax liabilities, and the reduction of CODI the tax on which would further deprive the business of needed liquidity.

Finally, the owners of a troubled business should consider their own personal exposure as “responsible persons” for the failure of the business to collect and/or remit federal and state employment taxes[xxxvi] as well as state and local sales taxes.

The best way to ensure a timely and effective response to any of these developments is for the business owners and their advisers to regularly communicate with one another.[xxxvii]


[i] For example, the Paycheck Protection Program (PPP) loans under the CARES Act. Provided certain conditions are satisfied, a PPP loan will be forgiven; the amount forgiven, however, will not have to be included by the borrower in its gross income as cancelation of indebtedness income. https://www.taxlawforchb.com/2020/04/tax-considerations-as-businesses-prepare-to-emerge-from-the-covid-19-shutdown/

Please note there were whisperings in Washington last week that an agreement between the House and Senate on the next round of stimulus legislation may allow businesses to deduct expenses that were paid with PPP loan proceeds. The following may refresh your memory: https://www.taxlawforchb.com/2020/05/ppp-loan-forgiveness-and-the-denial-of-deductions-for-covered-expenses-whats-wrong-with-the-irss-position/

[ii] A case filed under Chapter 11 of the United States Bankruptcy Code is often referred to as a “reorganization” bankruptcy.

A Chapter 11 case begins with the filing of a petition with the Bankruptcy Court. A petition may be a voluntary petition, which is filed by the debtor, or it may be an involuntary petition, which is filed by creditors that meet certain criteria.

The voluntary petition will include standard information concerning the debtor, including the location of its principal assets, the debtor’s reorganization plan, and a request for relief under the Bankruptcy Code.

Upon filing a voluntary petition for relief under Chapter 11 or, in an involuntary case, the entry of an order for relief, the debtor automatically assumes an additional identity as the “debtor in possession.” The term refers to a debtor that keeps possession and control of its assets while undergoing a reorganization under chapter 11, without the appointment of a trustee. A debtor will remain a debtor in possession until the debtor’s plan of reorganization is confirmed, the debtor’s case is dismissed or converted to Chapter 7, or a Chapter 11 trustee is appointed.

Generally, a written disclosure statement and a plan of reorganization must be filed with the court. The disclosure statement is a document that must contain information concerning the assets, liabilities, and business affairs of the debtor sufficient to enable a creditor to make an informed judgment about the debtor’s plan of reorganization. https://www.uscourts.gov/services-forms/bankruptcy/bankruptcy-basics/chapter-11-bankruptcy-basics.

The U.S. trustee is responsible for overseeing the administration of bankruptcy cases. The U.S. Trustee may also impose certain requirements on the debtor in possession concerning matters such as reporting its monthly income and operating expenses.

Creditors’ committees can play a major role in Chapter 11 cases. The committee is appointed by the U.S. trustee and ordinarily consists of unsecured creditors who hold the seven largest unsecured claims against the debtor. Among other things, the committee: consults with the debtor in possession on administration of the case; investigates the debtor’s conduct and operation of the business; and participates in formulating a plan.

[iii] https://www.globenewswire.com/news-release/2020/07/03/2057391/0/en/Chapter-11-U-S-Commercial-Bankruptcies-up-43-in-June.html

[iv] https://www.abi.org/newsroom/press-releases/may-commercial-chapter-11s-increase-48-percent-over-last-year-total-filings

[v] https://www.wsj.com/articles/chapter-11-business-bankruptcies-rose-26-in-first-half-of-2020-11593722250

[vi] See, for example, the April 23, 2020 letter from the National Bankruptcy Conference to the House and Senate “leadership.”

[vii] In particular, IRC Sec. 108.

[viii] Remember IRC Sec. 108(i)? It allowed the deferred recognition of CODI realized in 2009 and 2010 (i.e., in connection with the Great Recession).

[ix] See IRC Sec. 108(b) and Sec. 1017; for example, the adjusted basis of the taxpayer’s property and its loss carryforwards.

[x] Their hands are full at the moment. Worse yet, we’re approaching the political rutting season.

[xi] Let’s face it, this virus continues to evolve, and people are starting to behave badly after many weeks of house-quarantine. The effects of the confluence of these factors will probably come to light later this year. https://www.hopkinsmedicine.org/health/conditions-and-diseases/coronavirus/first-and-second-waves-of-coronavirus

[xii] For example, those in the real estate industry, where debt financing is a way of life. These folks have already been hit pretty hard. Social distancing and, even more so, the advent of remote working do not bode well for the future of office buildings. Amazon and its kind have been like a punch in the gut for most bricks-and-mortar retailers and their landlords. Biden wants to eliminate the like kind exchange.

[xiii] In re Affirmative Insurance Holdings Inc., No. 15-12136-CSS (D. Del. July 27, 2020).

[xiv] 11 USC Sec. 507(a).

I find myself in a quandary. There are codes and then there are Codes. I have rarely, if ever, accorded the Bankruptcy code the honor of a capital “C” – sorry, Kristina – that distinction belongs to the Internal Revenue Code, at least insofar as U.S. law is concerned.

Justinian’s Code, which formed the basis for many of Europe’s civil law jurisdictions, also merits the initial cap “C”. Query why today’s students learn nothing of the more than one thousand years of Byzantine history?

[xv] Under Chapter 7, the case trustee administers the bankruptcy case and liquidates the debtor’s assets in a manner that maximizes the return to the debtor’s unsecured creditors. (The secured creditors are already provided for.) The trustee accomplishes this by selling the debtor’s property if it is free and clear of liens or if it is worth more than any security interest or lien attached to the property. The trustee may also attempt to recover money or property from third parties (to which the debtor has made payments) under the trustee’s “avoiding powers.” https://www.taxlawforchb.com/2017/12/revoking-s-corp-status-a-fraudulent-conveyance/

The BC governs the distribution of the property of the estate (i.e., the sale proceeds). The BC prioritizes several classes of claims; each class must be paid in full before the next lower class is paid anything. The debtor is only paid if all other classes of claims have been paid in full.

For example, higher priority is accorded to “administrative expenses,” including the actual, necessary costs and expenses of preserving the estate; lower priority is accorded to unsecured claims for income taxes owing for a taxable year ending on or before the date of filing of the petition. See BC Sec. 507(a)(2), 503(b)(1)(B)(i), and 507(a)(8)(A).

[xvi] On IRS Form 1120.

[xvii] BC Sec. 507(a)(8).

[xviii] Commencement of a bankruptcy case creates an “estate.” The estate technically becomes the temporary legal owner of all the debtor’s property. It consists of all legal or equitable interests of the debtor in property as of the commencement of the case, including property owned or held by another person if the debtor has an interest in the property. BC Sec. 541.

[xix] For example, employment taxes with respect to wages paid.

[xx] You know the one I mean. Right? Don’t make me come over there.

[xxi] BC Sec. 503(b).

[xxii] Bankruptcy policies, Trustee argued, require treating the pre-petition portion of a debtor’s tax liability for the year of bankruptcy as a pre-petition claim. The BC broadly defines a “claim” to include unliquidated, contingent and unmatured obligations. While applicable non-bankruptcy law determines whether a claimant has a substantive right to payment, when a claim arises for bankruptcy purposes, Trustee argued, is a question of federal bankruptcy law.

[xxiii] IRC Sec. 3101 and 3111; Reg. Sec. 31.3101-3 and 31.3111-3. See also BC Sec. Sec. 507(a)(8)(D), which gives priority to “an employment tax on a wage, salary, or commission … earned from the debtor before the [petition date], whether or not actually paid before such date, for which a return is last due … after three years [before the petition date].”

[xxiv] That being said, the Court observed that the time of assessment or payment may not be equivalent to the time the tax is incurred for the purpose of establishing priority under the BC. Rather, the significant fact may be the date the tax accrues.

In fact, the date a federal income tax accrues and the assessment date are not the same. Assessment usually follows the filing of a tax return several months after the end of the tax year. Assessment is the determination of liability and the administrative act that allows collection when payment is not made. IRC Sec. 6201.

[xxv] IRC Sec. 11(a). “A tax is hereby imposed for each taxable year on the taxable income of every corporation.”

[xxvi] IRC Sec. 61(a) and Sec. 63(a).

[xxvii] See Reg. Sec. 1.11-1(e), providing an example of computation of liability.

[xxviii] IRC Sec. 441(b)(1). Until midnight on December 31, a corporation can still, for example, incur operating expenses or make charitable donations that will eliminate any liability that would otherwise arise from income earned during the preceding twelve months.

[xxix] IRC Sec. 441(a): “Taxable income shall be computed on the basis of the taxpayer’s taxable year.”

[xxx] Indeed, the IRS argued that Congress intended to make straddle year taxes entirely post-petition administrative claims. The BC, it stated, has always given preferential treatment to taxes the government has not had a reasonable time to assess or collect, as the taxing authority is an involuntary creditor. Because Debtor’s straddle tax year ended after the petition date, the IRS had no opportunity to collect the tax pre-petition, as any such tax by definition cannot come due until after the petition date.

[xxxi] BC Sec. 507(a)(8)(A).

[xxxii] The D-Court agreed that the distinction between income taxes, on the one hand, and other taxes which accrue upon the occurrence of certain transactions or events, on the other, is recognized in both the BC and the Code. The key is that a determination of when a specific tax accrues and becomes a fixed liability – i.e., is “incurred” for purposes of determining its priority under the BC – must be made in accordance with the substantive tax law.

[xxxiii] There is a silver lining here. These filings may present healthier businesses an opportunity to acquire assets and customers, hire key employees, eliminate competitors, establish new locations, etc.

For others, the news may not be as sanguine. The loss of a vendor or of a customer may have serious consequences for an otherwise healthy business.

The loss of a debtor may qualify a lender for a bad debt deduction. IRC Sec. 166.

[xxxiv] The fact that we find ourselves in the midst of a very abrasive and divisive election season is unfortunate to say the least.

Let’s not forget, however, that this country has come through presidential elections under much more dire circumstances. How about the election of 1864?

[xxxv] For example, net operating losses.

[xxxvi] The employee’s share thereof.

[xxxvii] To quote Austin Powers, “Okay, people, you have to tell me these things, alright? I’ve been frozen for 30 years, okay? Throw me a freakin’ bone here. I’m the boss. Need the info.” The Spy Who Shagged Me.

NYC: A “Helluva” Town, for S corps[i]

Of late, I’ve received a surprising number of inquiries regarding the taxation of S corporations doing business in New York City (“NYC”).

As many of you know, NYC does not recognize Federal or New York State (“NY”) S corporation elections; instead, NYC generally treats S corporations as if they were regular C corporations, and imposes a corporate-level income tax on S corporations[ii] with income sourced in NYC: the General Corporation Tax (“GCT”).[iii]

Moreover, if an S corporation’s shareholders reside in NYC,[iv] their NYC personal income tax is determined without any reduction for the GCT paid by the S corporation to NYC;[v] in other words, the corporation and the shareholder are taxed on the same amount of income.[vi]

Notwithstanding this state of affairs, and in spite of the restrictions under which every S corporation has to operate,[vii] the large number of closely held businesses that operate in NYC have elected to be treated as S corporations for Federal and NY tax purposes;[viii] consequently, the GCT accounts for a significant portion of NYC’s tax revenues.[ix]

Speaking of NYC’s tax revenues, the economic downturn attributable to the COVID-19 virus has taken a heavy toll on NYC’s finances. In the continued absence of fiscal support from Washington, and in recognition of the fact that so-called “progressives” seem to be on the rise at the Federal, NY and NYC levels of government, there is a greater likelihood that these taxing authorities will seek to offset this shortfall by “strengthening” and more aggressively enforcing existing taxes and, perhaps, by introducing some new taxes on more profitable businesses and their owners.

Under these circumstances, it behooves the owner of a NY S corporation that operates in NYC to understand, generally, how the GCT works.[x] With this basic information, the owner may be better equipped to confer with their advisers on tax minimization strategies.[xi]

A good place to start the business owner’s corporate tax education is the letter “C”.[xii]

Federal Tax: Corporations

A “C corporation”[xiii] is a separate taxable entity the taxable income of which is subject to Federal tax independently of its shareholders.[xiv]

The corporation’s shareholders are themselves taxed on the corporation’s net income only to the extent such income is actually or constructively[xv] distributed to them, usually in the form of a dividend.[xvi] The shareholders pay income tax[xvii] on the amount of the dividend distribution even though the corporation has already paid corporate income tax on the same amount before it was distributed.

Shareholders often seek to avoid this “double taxation” by electing to treat their corporation as an “S corporation.”[xviii]

An S corporation generally does not pay an entity-level Federal tax on its earnings.[xix] Rather, those earnings “pass-through” and are taxed directly to the shareholders of the corporation.[xx] The shareholders may then withdraw these already-taxed earnings without incurring any additional Federal income tax.[xxi]

NY Tax: C Corporations

In general, NY taxes C corporations in the same way they are taxed under the Code. In fact, a corporation’s Federal taxable income – basically, its “entire net income” under NY’s Tax Law – is the starting point for determining a C corporation’s NY income tax liability.

A corporation’s entire net income means its total net income from all sources – the same as the taxable income which the corporation is required to report to the IRS – with certain adjustments.[xxii]

This amount is then reduced by the corporation’s investment income and other “exempt income,” the difference being the corporation’s “business income.”[xxiii]

Once a corporation’s business income has been determined, the amount thereof that may be taxed by NY[xxiv] has to be determined; this is the corporation’s “business income base” – i.e., the portion of the corporation’s business income that is apportioned to the NY.[xxv]

Business income is apportioned to NY by the so-called “apportionment factor.” This is a fraction that is determined by including in the numerator and/or in the denominator only those receipts, net income, net gains, and other items prescribed by the NY Tax Law that are included in the computation of the corporation’s business income.[xxvi] Thus, the smaller the fraction – i.e., the smaller the numerator relative to the denominator – the smaller the amount of the corporation’s business income that is subject to NY tax.

NY Tax: S Corporations

Generally speaking, NY’s tax treatment of NY S corporations[xxvii] – i.e., a Federal S corporation that would otherwise be subject to corporate-level tax in NY, but for which its shareholders have filed an election to be treated as an S corporation for NY tax purposes – is the same as provided under the Code, though there are some significant differences.

For example, NY does not impose a corporate-level income tax similar to the Federal built-in gains tax;[xxviii] if such a tax is imposed upon a NY S corporation, its shareholders must, in determining their NY adjusted gross income, increase their Federal adjusted gross income[xxix] by an amount equal to their pro rata share of the Federal corporate-level tax imposed upon the corporation.[xxx]

That being said, NY does impose an annual “fixed dollar minimum” franchise tax, the amount of which depends upon the S corporation’s NY receipts for the taxable year.[xxxi]

The NY S corporation must file an annual NY tax return[xxxii] to pay the fixed dollar minimum tax, and to report, in aggregate, the NY S corporation items that those who were shareholders of the NY S corporation during any part of the year need for filing their own NY personal income tax returns.[xxxiii]

The corporation must report to each shareholder the shareholder’s pro rata share of the S corporation tax items,[xxxiv] as well as any additional information the shareholder needs for filing their personal income tax return, including the S corporation’s business apportionment factor.

A NY resident shareholder must include their pro rata share of NY S corporation income, gain, loss and deduction. However, if the corporation carries on business both in and out of NY, a nonresident shareholder will need the corporation’s business apportionment factor in order to determine their NY-sourced income.[xxxv]

S Corps in NYC

In NYC, the GCT is imposed on S corporations at a rate of 8.85%.[xxxvi] Beginning after 2014, the “business income base” is the primary tax base for corporations subject to the GCT, including S corporations, to which this rate is applied.[xxxvii]

Business income is defined as entire net income minus investment income.[xxxviii] Entire net income is generally the same as the entire taxable income which the corporation is required to report to the IRS, or which it would have been required to report if the corporation had not elected to be treated as an S corporation.[xxxix]

Entire net income does not include income and gains from subsidiary capital.[xl] According to NYC, this exclusion encompasses dividends, interest and gains from subsidiary capital, but not any other income from subsidiaries.[xli] “Subsidiary” means a corporation of which over 50% of the voting stock is owned by the taxpayer.[xlii] “Subsidiary capital” means investments in the stock of subsidiaries and any indebtedness from subsidiaries (other than accounts receivable).[xliii]

If an individual shareholder of an S corporation that is subject to tax in NYC is also a resident of NYC, they must consider how the corporation’s tax items affect their NYC personal income tax liability.

The starting point for determining a resident shareholder’s NYC income tax liability is their “city taxable income,”[xliv] which is based upon their Federal adjusted gross income – which includes their pro rata share of S corporation income[xlv] – with certain modifications.[xlvi] Among these modifications is the add-back to adjusted taxable income of any corporate-level income tax imposed by NY,[xlvii] NYC, or any other taxing jurisdiction, to the extent deductible in determining Federal adjusted gross income.[xlviii]

Consequently, the NY S corporation’s net earnings will be subject to the GCT, and these same earnings will be passed on to the corporation’s shareholders and taxed again under NYC’s personal income tax.

Thus, any GCT paid by the S corporation will be added back for purposes of determining the resident shareholder’s NYC income tax liability – the corporation’s taxable income is taxed both to the corporation and to the resident shareholder.

Does Your Head Hurt?

And you thought that Subchapter C of the Code was complicated?

The foregoing discussion highlighted just some of the differences between NY’s and NYC’s respective tax treatment of S corporations – there are many more.[xlix] Believe me when I say that both “lay people” and tax advisers are often confused by the separate application of these two sets of rules, let alone by the interplay between them.

In order to simplify matters, and to reduce the tax burden on S corporations that are doing business in NYC, as well as that of their NYC-resident shareholders, there have been many proposals over the years to conform NYC’s tax treatment of S corporations to NY’s.

To date, these proposals have been rejected, though some attempts have been made at lessening the burden on NYC-resident shareholders.

One reason for this failure is the amount of tax revenue that historically has been generated by S corporations that are subject to the GCT. In light of the dire fiscal straits in which NYC now finds itself, the possibility of its turning its back on this revenue is very remote.

In other words, any S corporation doing business in NYC will have to continue taking the GCT into account in its overall tax planning.


*A word about today’s title. One of my high school physics teachers – Mr. Gordon – had the expression “eschew obfuscation” prominently displayed at the front of his classroom. The irony was not lost on us. It continues to hound me as a tax person.

[i] “New York, New York, a helluva a town. The Bronx is up but the Battery’s down.” From Bernstein’s 1940s musical, “On the Town.”

[ii] At the rate of 8.85%.

For the same reason, a qualified subchapter S subsidiary (QSUB) of an S corporation must file a separate GCT return with NYC, provided it has sufficient nexus to NYC. Finance Memo 99-3.

[iii] NYC Adm. Code Sec. 11-602.1. After 2014, the GCT applies only to S corporations.

[iv] NYC does not impose an income tax upon nonresidents of NYC; indeed, the NYC earnings tax on nonresidents was repealed in 1999.

An individual is a resident taxpayer of NYC with respect to a taxable year if they are domiciled in NYC during that year, or if they maintained a permanent place of abode in NYC and spent more than 183 days during the taxable year in NYC. NYC Adm. Code Sec. 11-1705(b).

[v] NYC Adm. Code Sec. 11-1706(f).

[vi] It should be noted that NY does not impose a corporate-level tax on any “built-in gain” recognized by an S corporation during its five-year recognition period. See IRC Sec. 1374.

Thus, in determining their NY income tax liability, a shareholder of a NY S corporation must add back to their Federal adjusted gross income their share of any Federal built-in gains tax imposed upon the S corporation. NY Tax Law Sec. 612(b)(18).

[vii] For example, an S corporation is allowed only one class of stock outstanding, none of the shares of which may be owned by a partnership, another corporation, or a nonresident alien. See IRC Sec. 1361(b).

[viii] IRC Sec. 1361 and Sec. 1362; NY Tax Law Sec. 660.

[ix] Real property tax and personal income tax are the main sources of NYC’s tax revenue.

[x] We will assume, for our purposes, that the S corporation at issue has sufficient nexus to NYC so as to be subject to NYC income tax; thus, the corporation may be “doing business” in NYC, employing capital in NYC, owning or leasing property in NYC, or maintaining an office in NYC. NYC Adm. Code Sec. 11-603(1).

Please note that NYC does not use the “receipts” test for establishing nexus. By contrast, a corporation will have sufficient nexus with NY for a taxable year if it has receipts from NY of at least $1 million for that year. NY Tax Law Sec. 209(1)(b).

[xi] Of course, any knowledge of the tax law is valuable in and of itself. Seriously. It offers a glimpse into the infinite. . . . Don’t make that face.

[xii] No, I am not regressing to Sesame Street. See Tax Rule No. 1: Read, then keep on reading.

[xiii] A corporation the taxation of which is governed by subchapter C of the Code.

[xiv] IRC Sec. 11. As a result of the 2017 Tax Cuts and Jobs Act (“TCJA”; P.L. 115-97), corporate taxable income is subject to Federal tax at a flat rate of 21%.

[xv] Closely held corporations, and especially those that are family-owned, have to vigilant to avoid constructive dividends; for example, the corporation’s payment of a shareholder’s personal expenses, or the shareholder’s use of corporate-owned property.

[xvi] IRC Sec. 301.

[xvii] IRC Sec. 1(h). The 3.8% surtax on net investment income (which includes dividends) under IRC Sec. 1411 may also apply, depending upon the amount of the shareholder’s adjusted gross income.

[xviii] A corporation the taxation of which is governed by subchapter S of the Code. IRC Sec. 1361 and Sec. 1362. Of course, this assumes that both the corporation and the shareholder are eligible. See IRC Sec. 1361(b).

[xix] IRC Sec. 1363.

An important exception to this rule is the corporate-level built-in gains tax under IRC Sec. 1374. Generally speaking, this tax will be imposed if, within 5 years after the effective date of its S election, the corporation realizes a gain on the disposition of assets that it owned on such date. A corporate-level tax is imposed to the extent of the gain that was inherent in the asset at the time the S election became effective.

[xx] IRC Sec. 1366.

If the shareholder does not materially participate in the S corporation’s business, the shareholder’s pro rata share of this pass-through income may also be subject to the surtax on net investment income. IRC Sec. 1411(c)(2)(A). The surtax is not deductible for purposes of determining the shareholder’s individual income tax liability.

[xxi] This is accomplished by increasing a shareholder’s adjusted basis for their shares of S corporation stock by the amount of S corporation income allocated to such shareholder. IRC Sec. 1367. The corporation may then distribute to the shareholder an amount equal to the amount of this income without triggering any gain recognition; rather, the shareholder’s stock basis is reduced. IRC Sec. 1368.

[xxii] NY Tax Law Sec. 208.9.

[xxiii] NY Tax Law Sec. 208.8.

[xxiv] NY imposes a tax upon a corporation’s business income base. NY Tax Law Sec. 209.1(a).

[xxv] NY Tax Law Sec. 210.1(a). In other words, the business income is divided between NY and any other state to which the corporation has nexus such that part of its income may properly be taxed there. NY now uses a single receipts factor. NY Tax Law Sec. 210-A. See Form CT-3, Part 6.

[xxvi] NY Tax Law Sec. 210-A.

[xxvii] Please note that S corporation status for NY tax purposes is not automatic – meaning that a corporation with a Federal election in effect must still file a separate election with NY in order to be treated as a NY S corporation. The election is filed on Form CT-6, “Election by a Federal S Corporation to be Treated as a New York S Corporation.” See also TSB-M 98(4)C. If the NY election is not filed, the corporation will be treated as a C corporation for NY tax purposes.

[xxviii] IRC Sec. 1374. The NY Tax Law does not provide for such a tax.

[xxix] IRC Sec. 62. The starting point for determining their NY income tax liability. The NY taxable income of a resident individual is the same as their Federal adjusted gross income, with certain modifications. NY Tax Law Sec. 611 and Sec. 612.

[xxx] IRC Sec. 1366(f)(2); NY Tax Law Sec. 612(b)(18)(A).

[xxxi] NY Tax Law Sec. 210(1)(g). For example, a NY S corporation with NY receipts of between $5 million and $25 million will pay a State tax of $3,000.

[xxxii] On Form CT-3-S, “New York S Corporation Franchise Tax Return.”

[xxxiii] The corporation must use Form CT-34-SH for this purpose; it is attached to the Form CT-3-S.

[xxxiv] Reported on Form CT-34-SH.

[xxxv] NY Tax Law Sec. 631(a) and Sec. 632(a)(2). See Form IT-203. Only that portion of the nonresident’s pro rata share of S corporation items that are derived from or connected with NY sources are used in determining the shareholder’s NY tax liability.

[xxxvi] NYC Adm. Code Sec. 11-604. An S corporation that is subject to NYC’s GCT reports its taxable income on Form NYC 4-S, “General Corporation Tax Return.”

[xxxvii] NYC Adm. Code Sec. 11-602.7, 11-602.8, 11-603 and 11-604.

[xxxviii] NYC Adm. Code Sec. 11-602.7.

[xxxix] NYC Adm. Code Sec. 11-602.7 and 11-602.8.

[xl] NYC Adm. Code Sec. 11.602.8(a)(1).

[xli] Rule Sec. 11-27(b)(2)(i).

[xlii] NYC Adm. Code Sec. 11-602.2.

[xliii] NYC Adm. Code Sec. 11-602.3.

[xliv] NYC Adm. Code Sec. 11-1711(a).

[xlv] As reflected on their Schedule K-1.

[xlvi] NYC Adm. Code Sec. 11-1712.

[xlvii] The fixed dollar minimum tax.

[xlviii] NYC Adm. Code. 11-1712(b)(3).

For tax years beginning on or after January 1, 2014, and before July 1, 2019, a NYC resident individual whose city adjusted gross income included a pro rata share of income, loss, and deductions from a NY S corporation, and whose city taxable income was less than $100,000, may have been eligible for a nonrefundable credit on their income tax return for their pro rata share of NYC GCT paid. See Form IT-201-ATT, Line 8a and Form IT-222. See NYC Adm. Code Sec. 11-1706(f), added by Chapter 4 of the Laws of 2013 and thereafter extended in 2019. See TSB-M-16(1)I.

[xlix] Their respective treatment of GILTI comes to mind. See IRC Sec. 951A and Finance Memo 18-10 (Sept. 2, 2019).

It’s Complicated

Coming to grips with the U.S. tax treatment of the foreign-sourced income of a closely held domestic business, and of commercial transactions involving such a business and its related foreign entities, may be intimidating not only for the owners of the business, but also for their advisers.

Indeed, the Code and Regulations include a number of complex rules that are aimed at the overseas activities and investments of U.S. businesses. Many of these involve situations that Congress and the Treasury have determined may result in the improper deferral, or even the permanent avoidance, of U.S. income tax.[i]

That being said, there are many other instances in which an owner’s application of basic U.S. tax principles, identical to those that are routinely encountered in strictly domestic transactions, may prevent a U.S. business from getting into trouble with the IRS, as one taxpayer (“Taxpayer”) recently discovered.[ii]

Before considering Taxpayer’s circumstances, a very brief review of the regime that governs the taxation of the foreign income and activities of U.S. businesses may be in order.

Taxation of Overseas Activities

In general, the U.S. taxes its citizens and residents – including both natural persons and legal entities – on both their U.S. and foreign-sourced income.[iii] For example, the foreign-sourced income attributable to the foreign branch[iv] of a domestic business is subject to U.S. income tax on a current basis; the same is true for foreign-sourced income realized by a domestic or foreign partnership of which the U.S. person is a member.

This general rule is qualified, somewhat, when the foreign-sourced income is realized by a foreign corporation in which a U.S. person is a shareholder. For example, a U.S. person who is a shareholder of a foreign corporation that is engaged in the active conduct of a foreign business will not be subject to U.S. income tax with respect to their share of the corporation’s foreign-sourced income until such income is distributed as a dividend to the U.S. person.

Over the years, however, the U.S. has enacted various anti-deferral rules that require certain U.S. persons to include in their gross income their share of foreign-sourced income that is realized by a foreign corporation of which they are a shareholder.

Subpart F

The main U.S. anti-tax-deferral regime, which addresses the taxation of income earned by controlled foreign corporations (“CFC”),[v] may cause the “U.S. Shareholders” of a CFC to be taxed currently on their pro rata share of certain categories of income earned by the CFC – “Subpart F income” – regardless of whether the income has been distributed to them as a dividend.[vi]

For most U.S. Shareholders, Subpart F income generally includes “foreign base company income,”[vii] which consists of “foreign personal holding company income” (such as dividends, interest, rents, and royalties), and certain categories of income from business operations that involve transactions with “related persons,” including “foreign base company sales income” and “foreign base company services income.”[viii]

Specifically, foreign base company sales income is income derived by a CFC from a purchase or sale of personal property involving a related party in which the property is both manufactured and sold for use/consumption outside the CFC’s country of organization,[ix] and foreign base company services income is income derived by a CFC in connection with the performance of services outside the CFC’s country of organization for or on behalf of a related person.[x]

However, the pro rata amount that a U.S. shareholder of a CFC is required to report as Subpart F income of the CFC for any taxable year cannot exceed the CFC’s current earnings and profits.[xi] After all, the purpose of Subpart F is to deny deferral of U.S. taxation; it cannot require that a U.S. shareholder of a CFC be taxed on amounts in excess of the dividends they would have received if all of the CFC’s income had been distributed currently.[xii]

GILTI

In 2017, the TCJA[xiii] introduced a new class of income – global intangible low-taxed income (“GILTI”) – that must be included in the gross income of a U.S. Shareholder of a CFC, and which further eroded a U.S. person’s ability to defer the U.S. taxation of foreign-sourced business income.

This provision requires the current inclusion in income by a U.S. Shareholder of (i) their share of all of a CFC’s non-subpart F income (other than income that is effectively connected with a U.S. trade or business and income that is excluded from foreign base company income by reason of the “high-tax” exception[xiv]), (ii) less an amount equal to the U.S. Shareholder’s share of 10% of the adjusted basis of the CFC’s tangible property used in its trade or business and of a type with respect to which a depreciation deduction is generally allowable; the difference is the shareholder’s GILTI.[xv]

In the case of an individual, the maximum federal tax rate on GILTI is 37%. This is the rate that will apply, for example, to a U.S. citizen who directly owns at least 10% of the stock of a CFC.

More forgiving rules apply in the case of a U.S. Shareholder that is a C corporation. For taxable years beginning after December 31, 2017, and before January 1, 2026, a regular domestic C corporation is generally allowed a deduction of an amount equal to 50% of its GILTI; thus, the federal corporate tax rate for GILTI is actually 10.5% (the 21% flat rate multiplied by 50%).[xvi]

With the foregoing rules in mind, let’s consider Taxpayer’s situation.

South of the Border[xvii]

Taxpayer was a U.S. citizen residing in Mexico. During the years at issue,[xviii] they operated a real estate development and construction business in Mexico. They also owned 50% of Mex-Corp, a Mexican corporation, of which Taxpayer was the president. At some point, Taxpayer transferred 41% of their 50% ownership interest in Mex-Corp to an unrelated individual (“NRA”) who was a Mexican citizen, and who was never an officer or director of Mex-Corp.  Taxpayer entered into a consulting and personal services contract with Mex-Corp, and the corporation made payments to Taxpayer for their services.

In order to manage their real estate development and construction activities, Taxpayer incorporated Foreign-Corp in the Bahamas, with the corporation’s bearer shares held by Taxpayer.[xix] The following year, Taxpayer reincorporated Foreign-Corp in Belize. In the process, Taxpayer retroactively amended the corporation’s organizational documents effective as of its original incorporation; these were also amended to reflect that Taxpayer held a 27% ownership interest, and NRA held the remaining 73% ownership interest in Foreign-Corp. Taxpayer was the president and a director of Foreign-Corp.

Taxpayer opened accounts in Foreign-Corp’s name with various financial institutions, and had sole signature authority over each of these accounts.[xx] The application submitted to open one of the accounts identified Taxpayer as Foreign-Corp’s sole director, and described Foreign-Corp’s shareholders as two “bearers” holding one share each of its capital stock. The documents for another account identified Taxpayer as the beneficial owner of the account, and as the “only shareholder and owner;” it described the account’s purpose as “[w]ealth [m]anagement of retirement funds; probably [a] loan for [a] flat in Paris.”

In addition to maintaining at least one personal bank account and several personal brokerage accounts and credit cards, Taxpayer maintained several business credit cards where Foreign-Corp and Taxpayer were listed as the primary cardholders and authorized users.

Foreign-Corp did not compensate Taxpayer by check or direct deposit for the years at issue; instead, it would transfer funds from one of its accounts to Taxpayer’s personal account, or it would directly pay some of Taxpayer’s personal expenses, including personal credit card charges, travel expenses, household furnishings, tuition, gifts to relatives, and rent for an apartment; in addition, Foreign-Corp would transfer funds from its accounts to Mex-Corp “in lieu of salary” to Taxpayer.

Mex-Corp and Foreign-Corp entered into a five-year joint venture (“JV”) agreement to acquire, develop, and sell residential real property in Mexico. Taxpayer managed the JV’s affairs and funds, and served as its managing partner. Taxpayer was also given powers of attorney to act jointly and independently as the attorney-in-fact of JV. As JV’s attorney-in-fact, Taxpayer was authorized to retain any assets owned by JV and to reinvest those assets, co-own assets and commingle Taxpayer’s funds with the funds of JV, and to personally gain from any transaction completed on JV’s behalf.[xxi]

Audit and Determination

Taxpayer’s federal income tax returns for the years at issue – all predating the TCJA and the addition of the GILTI inclusion rule to Subpart F – reported adjusted gross income consisting of wages (from Mex-Corp), interest, ordinary dividends, rent, and “other income.”[xxii]

The IRS audited Taxpayer’s returns.[xxiii] Based on its examination, the IRS identified various corporate disbursements or transfers to Taxpayer or for Taxpayer’s benefit. The IRS determined that Taxpayer had additional wage income from Foreign-Corp, or in the alternative, additional dividend income. Specifically, for the years at issue, the IRS determined that Taxpayer’s additional wage income was attributable to withdrawals from various corporate financial accounts for Taxpayer’s personal use, including for the payment of their personal expenses.

The IRS also determined that Foreign-Corp was a CFC that was 100% owned by Taxpayer for the years at issue, that the investment income from Foreign-Corp’s various accounts was foreign personal holding company income (“FPHCI”) under Subpart F of the Code and, as a result, that Taxpayer was required to report their pro rata share (100%) of that FPHCI as Subpart F income, which was taxable as additional ordinary dividend income.

A notice of deficiency was sent to Taxpayer which reflected these determinations,[xxiv] and which also proposed the imposition of the 20% accuracy-related penalty. In response, Taxpayer timely filed a petition with the U.S. Tax Court.[xxv]

Additional Wage Income?

The Court began with the basics: (i) a taxpayer’s gross income includes “all income from whatever source derived,” (ii) a taxpayer is required to maintain books or records sufficient to establish the amount of his or her gross income required to be shown by such person on any return, and (iii) if the taxpayer’s books or records do not clearly reflect income, then the IRS is authorized “to reconstruct income in accordance with a method which clearly reflects the full amount of income received.”[xxvi]

During the audit, the IRS determined[xxvii] that Taxpayer had additional wage income from Foreign-Corp. Notwithstanding Taxpayer’s contention to the contrary, the Court found that Taxpayer offered no evidence to support their position aside from self-serving testimony, which the Court found was not credible. “As we have stated many times before, this Court is not bound to accept a taxpayer’s self-serving, unverified, and undocumented testimony.”  Accordingly, based upon the corporate expenditures made in satisfaction of Taxpayer’s personal expenses, the Court sustained the IRS’s determination of additional wage income for the years at issue.

Subpart F Income

Having addressed the issue of unreported wages, the Court then turned to the IRS’s assertion of Taxpayer’s unreported Subpart F income.

The Court explained that, under Subpart F, a U.S. shareholder of a CFC must generally include in their gross income for a taxable year their pro rata share of the CFC’s “Subpart F income” for such year. A U.S. shareholder with respect to any foreign corporation, the Court continued, is a U.S. person “who owns . . . , or is considered as owning by applying [certain] rules of ownership . . . 10% or more of the total combined voting power of all classes of stock entitled to vote” of the foreign corporation.  The Court stated that a CFC is “any foreign corporation if more than 50% of (1) the total combined voting power of all classes of stock of such corporation entitled to vote, or (2) the total value of the stock of such corporation, is [directly or constructively] owned . . .  by United States shareholders on any day during the taxable year of such foreign corporation.”  And finally, the Court observed that Subpart F income includes foreign base company income, which includes FPHCI, which in turn includes dividends, interest, and the excess of gains over losses from the sale or exchange of certain property.

The IRS determined that Taxpayer had reportable Subpart F income – specifically, the investment income from Foreign-Corp’s bank and investment accounts – during each of the years at issue.

CFC?

According to the Court, Taxpayer disputed whether Foreign-Corp was a CFC on any day during each of the years at issue, with the result that if Foreign-Corp was a CFC, then Taxpayer had reportable Subpart F income for those years.

It was the IRS’s position that Foreign-Corp was a CFC (and, thus, that Taxpayer had reportable Subpart F income) because Taxpayer held a 100% ownership interest in Foreign-Corp. Taxpayer, on the other hand, contended that Foreign-Corp was not a CFC (and thus they did not have any reportable Subpart F income) because Taxpayer held no more than a 27% ownership interest in Foreign-Corp during the years at issue.

Relying upon an earlier decision[xxviii] involving this very claim, the Court rejected Taxpayer’s contention that the bearer shares that gave them 100% ownership in Foreign-Corp were eliminated and that the share ownership structure changed, reducing Taxpayer’s ownership to 27% for the years in issue. To support this claim, Taxpayer provided Foreign-Corp’s backdated amended organizational documents showing that Taxpayer held a 27% interest. However, the Court stated that nothing in the record indicated an actual change in ownership aside from Taxpayer’s self-serving testimony and the backdated amended documents. What’s more, Taxpayer was the president and a director of Foreign-Corp. Thus, the Court concluded that Taxpayer held a 100% interest in Foreign-Corp, and that the corporation was a CFC for the years in issue.

Consequently, Taxpayer was required to report as gross income their pro rata share of Foreign-Corp’s Subpart F income for the years at issue. Given that Taxpayer was the 100% shareholder of Foreign-Corp for those years, Taxpayer had to report 100% of Foreign-Corp’s Subpart F income for those years.

Moreover, the Court sustained the IRS’s imposition of the 20% accuracy-related penalty on Taxpayer’s underpayment of the tax required to be shown on their tax return, finding that such underpayment was attributable to Taxpayer’s “negligence or disregard of rules or regulations” and/or a “substantial understatement of income tax,”[xxix] and Taxpayer’s failure to demonstrate that they had acted in good faith with respect to, and had shown reasonable cause for, such underpayment.[xxx]

Lesson Learned?

Taxpayer didn’t stand much of a chance. They were not adequately compensated, as such, for their services to Foreign-Corp; instead, Taxpayer’s compensation was disguised – barely – through the payment of various personal expenses.[xxxi]

Taxpayer’s attempt at avoiding the Subpart F inclusion rules, by using a mere straw man (NRA) to hold shares of Foreign-Corp stock, was equally unavailing.

Such transparent attempts at avoiding the anti-deferral rules of Subpart F of the Code are ill-advised.

However, there is another “extreme” approach that is almost as bad. I am referring to those advisers who, seemingly for their own convenience, choose to report all of a CFC’s foreign-sourced income on the U.S. Shareholder’s federal income tax return without considering the applicable rules or analyzing any opportunities for deferral.

Somewhere in between these two sets of advisers are those folks who dedicate varying degrees of attention to the application of the Subpart F rules at the federal level, but who may not be familiar with their application by state and local taxing authorities – after all, not every domestic jurisdiction has fully conformed to these federal anti-deferral rules.

In the case of New York, for example, it is important for advisers to recognize that 95% of GILTI required to be included in a corporate taxpayer’s federal gross income[xxxii] is excluded from New York State taxation as “exempt CFC income” for tax years beginning on or after January 1, 2019.[xxxiii] By contrast, similar legislation was not enacted with respect to either New York City’s general corporation tax or its business corporation tax.

There’s a lot to chew on here, but there’s no substitute for working through the details.

 


[i] Although not relevant to the discussion here, IRC Sec. 367 generally prevents the tax-free reorganization rules from allowing certain transactions to remove assets or income from the tax jurisdiction of the U.S.

[ii] Flume v. Comm’r, T.C. Memo. 2020-80.

[iii] Most U.S. tax treaties include a so-called “savings clause” that allows the U.S. to tax its residents as if the treaty were not in force. This provision is intended to prevent U.S. residents from using the treaty to reduce their U.S. income tax liability. See Article 1, Paragraph 4 of the U.S. Model Income Tax Convention.

[iv] This includes a foreign “eligible” entity owned by the U.S. business that has elected to be treated as a disregarded entity for U.S. tax purposes. Reg. Sec. 301.7701-3; IRS Form 8832, Entity Classification Election.

[v] IRC Sec. 957. A CFC is defined as any foreign corporation in which U.S. persons own (directly, indirectly, or constructively) more than 50% of the corporation’s stock (measured by vote or value), taking into account only those U.S. persons who own at least 10% of the foreign corporation’s stock (measured by vote or value; each a “United States shareholder”).

Under the CFC rules, the U.S. generally taxes the U.S. Shareholder of a CFC on their pro rata shares of the CFC’s “Subpart F income,” without regard to whether the income is distributed to the shareholder. In effect, the U.S. treats the U.S. Shareholder of a CFC as having received a current distribution of their share of the CFC’s Subpart F income.

[vi] IRC Sec. 951.

[vii] IRC Sec. 954.

[viii] One exception to the definition of Subpart F income permits continued U.S.-tax-deferral for income received by a CFC in certain transactions with a related corporation organized and operating in the same foreign country in which the CFC is organized (the “same country exception”).

Another exception is available for any item of income received by a CFC if the taxpayer establishes that the income was subject to an effective foreign income tax rate greater than 90% of the maximum U.S. corporate income tax rate (the “high-tax exception”). In theory, the 21% U.S. federal corporate income tax rate should make it easier to qualify for this exception.

[ix] IRC Sec. 954(d).

[x] IRC Sec. 954(e).

[xi] IRC Sec. 952(c)(1)(A).

[xii] A CFC’s current earnings and profits are generally determined according to rules substantially similar to those applicable to domestic corporations. IRC Sec. 964; Reg. Sec. 1.964-1.

[xiii] Tax Cuts and Jobs Act (“TCJA”). P.L. 115-97.

[xiv] IRC Sec. 954(b)(4).

[xv] IRC Sec. 951A.

[xvi] IRC Sec. 250(a)(1)(B). However, see the election under IRC Sec. 962;

[xvii] Speaking of which, have you seen the 2004 movie, “The Day After Tomorrow,” with Dennis Quaid and Jake Gyllenhaal? As a result of climate change, most of the Northern Hemisphere is cataclysmically plunged into an ice age, and the U.S. population flees south, to Mexico. When normal access points are blocked by the Mexican government, folks start wading across the Rio Grande. Interesting premise. Total non sequitur here, of course.

[xviii] Which preceded the TCJA.

[xix] The following year, it was reincorporated in Belize.

[xx] Presumably, Taxpayer filed FinCEN Form 114 (the FBAR filing).

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

[xxii] Taxpayer claimed the earned income exclusion and certain NOL carryovers.

[xxiii] During the course of the exam, Taxpayer provided some, but not all, of the records requested by the IRS. At that point, the IRS issued third-party record keeper summonses to several U.S. financial institutions, brokerage companies, and credit card companies, and as a result of those summonses received additional records pertaining to Foreign-Corp’s accounts with those institutions and companies.

[xxiv] The IRS first notified Taxpayer of the proposed changes by way of a so-called “30-day letter,” which transmitted an examination report and various worksheets detailing the calculations of the proposed deficiencies and penalties. (The examination report is commonly called a “revenue agent’s report” or “RAR”.) This consisted of a Form 4549-A, Income Tax Examination Changes, and a Form 886-A, Explanation of Items.) The 30-day letter also explained that Taxpayer could request a conference with the IRS Office of Appeals by submitting a formal protest. The letter further advised that if Taxpayer failed to reach an agreement with Appeals or if they did not respond to the letter, then a notice of deficiency would be issued to them. IRC Sec. 6212 and Sec. 6213.

[xxv] In general, the IRS’s determinations set forth in a notice of deficiency are presumed correct and the taxpayer bears the burden of proving otherwise. See Tax Court Rule 142(a). However, for this presumption to adhere in cases (such as this one) involving unreported income, the IRS must provide some reasonable foundation connecting the taxpayer with the income-producing activity. Once the IRS has done this, the burden of proof shifts to the taxpayer to prove by a preponderance of the evidence that the IRS’s determinations of unreported income are arbitrary or erroneous. On the basis of what it described as “credible evidence,” the Court here was satisfied that the IRS had proved that Foreign-Corp was a likely source of the determined unreported income for the years at issue. Thus, as to this income, the burden of proof shifted to Taxpayer to show that the IRS’s determinations in this regard were arbitrary or erroneous.

[xxvi] Reg. Sec. 1.446-1 and Reg. Sec. 1.6001-1.

[xxvii] The IRS used the specific item method to make these determinations. The specific item method is a Court-approved “method of income reconstruction that consists of evidence of specific amounts of income received by a taxpayer and not reported on the taxpayer’s return.”

[xxviii] Flume v. Comm’r, 2017-21. “Issue preclusion,” the Court explained, “applies when suits involve separate claims, but present some of the same issues, and ‘bars the relitigation of issues actually adjudicated, and essential to the judgment, in a prior litigation between the same parties.’ ” Issue preclusion focuses on whether (1) the issue in the second suit is identical in all respects with the one actually litigated, decided, and essential to the judgment in the first suit, (2) a court of competent jurisdiction rendered a final judgment in the first suit, (3) the controlling facts and applicable legal principles in the second suit have changed significantly since the judgment in the first suit, and (4) there are special circumstances, such as fairness concerns, that warrant an exception to preclusion in the second suit.

[xxix] IRC Sec. 6662.

[xxx] IRC Sec. 6664.

[xxxi] These could just as easily have been treated as constructive dividend distributions.

[xxxii] Under IRC Sec. 951A(a) (without regard to the GILTI deduction under IRC section 250).

[xxxiii] NY Tax Law Sec. 208.6-a(b); TSB-M-19(1)C.

Politics and Wealth Inequality

As we approach the presidential convention season,[i] and the election campaign that will follow, the thoughts of many business owners have turned to the federal estate tax, and for good reason.[ii]

After the Great Recession of 2007-2009,[iii] the economy enjoyed a period of sustained growth of approximately 11 years, which ended only recently thanks, in large part, to the economic shutdown. During this time, however, many economists observed a significant increase in “wealth inequality,” whether measured in terms of income or net asset value.

Perhaps more importantly, the general public became more aware of, and attuned to, the wealth gap that almost everyone recognizes is a “natural” by-product of economic activity.[iv] Indeed, it was during this period that the catchphrases “the one percent” and “the 99 percent” entered our lexicon; more recently, “the 0.10 percent” was introduced to refer to really big earners.[v]

Ironically, to many, during this same period the federal estate tax rate and the federal exemption amount have been travelling in somewhat different directions, with the rate remaining steady while the exemption amount has been increasing, especially following the doubling of the basic exemption amount beginning in 2018.[vi] (See the table below, which indicates tax year, exemption amount, and tax rate.)

2007 $2 million 45%
2008 $2 million 45%
2009 $3.5 million 45%
2010 No tax – elective
2011 $5 million 35%
2012 $5.12 million 35%
2013 $5.25 million 40%
2014 $5.34 million 40%
2015 $5.43 million 40%
2016 $5.45 million 40%
2017 $5.49 million 40%
2018 $11.18 million 40%
2019 $11.4 million 40%
2020 $11.58 million 40%

The COVID-19 Shutdown

Thus, as we started 2020, a married couple could pass along a taxable estate worth over $23 million without incurring any federal estate tax liability. If the couple’s assets included a closely held business, it is likely that its “actual” value[vii] was somewhere north of the amount shown on the federal estate tax return.[viii] If one or both members of the couple created irrevocable life insurance trusts (“ILITs”) to acquire life insurance on their lives,[ix] then a substantial sum of cash may also be passed upon the death of the insured(s) without triggering any estate tax.[x]

Enter the quarantine[xi] and economic shutdown. The federal government has already dedicated almost $6 trillion in response to the shutdown, the states have spent several billion on their own, and it is a near certainty that still more will have to be expended, both to bolster the economy and to support the millions of individuals in need of financial assistance.

Add to this dire fiscal situation the President’s “disapproval” rating, the realistic possibility that the Democrats may take the Senate while retaining control of the House,[xii] plus the strong influence of a reinvigorated Democratic left, and you have an environment in which the revival of the federal estate tax as a tool for generating meaningful revenue,[xiii] and of “redistributing wealth,” may be an attractive option both politically and economically.[xiv]

Because of these developments, many business owners are starting to believe that their ability to transfer significant amounts of wealth to their family may become severely restricted after 2020.[xv]

For these individuals, the 2020 year-end holiday gift season may start early and run through the final day of the year.[xvi]

Regardless of which gifting vehicle a business owner decides to use in shifting equity in their business[xvii] – and the future appreciation thereon – out of their estate and into the hands of their family (and perhaps future generations), the economic benefit of the transfer will depend in large part upon the valuation of the business interest.

Valuation of Transferred Business Interests

The fair market value of an interest in a closely held business is a question of fact; according to IRS regulations, it is the price at which the interest would change hands between a willing buyer and a willing seller, neither being under any compulsion to buy or sell, and both having reasonable knowledge of the relevant facts and circumstances.[xviii] These relevant facts and circumstances include whether discounts for lack of control and lack of marketability are factored into the fair market value of an interest in the closely held entity.[xix]

In resolving valuation issues, a taxpayer, the IRS and a court will usually consider the opinion of an expert. The court, for example, will weigh an expert’s opinion in light of the expert’s qualifications and credible evidence – it has relatively broad discretion to evaluate the expert’s analysis. If the court finds one expert’s opinion persuasive, it may accept that opinion in whole or in part over that of the opposing expert. Alternatively, the court may reach “an intermediate conclusion as to value” by drawing selectively from the testimony of various experts.[xx]

Although the valuation process relies upon the analysis of objective data, the conclusions drawn therefrom are inherently subjective and will necessarily depend upon the experience of the appraiser and the exercise of their professional judgement. In other words, competent appraisers may reasonably disagree and arrive at different conclusions of value.

Defined Value Clause

This uncertainty has been the reason for the volume of gift and estate tax valuation disputes brought before the U.S. Tax Court. It is also the reason many taxpayers – especially one making a gift the value of which may exceed the taxpayer’s remaining exemption amount, thereby triggering a tax liability – have sought to limit the degree of uncertainty by utilizing a so-called “defined value clause” (“DVC”) in connection with a gift of property that is difficult to value, including an equity interest in a closely-held business.

A DVC may be used where the donor seeks to keep the value of the gift at or below their remaining gift tax exemption amount. In order to accomplish this goal, the gift may be phrased in terms of “that number of units which have an aggregate dollar value on the date of transfer that is equal to my remaining federal exemption amount” – in other words, the transfer of a fixed dollar amount. In the event the IRS successfully determines that the value of the shares of stock or partnership units gifted by the taxpayer exceeds the taxpayer’s available exemption amount, the DVC provides that some of these shares or units would be “returned” to the taxpayer, as if they had never been transferred – the taxpayer transferred only an amount equal to the exemption amount.[xxi]

Although this formulation sounds relatively straightforward, the courts continue to address situations in which the IRS has thought it worthwhile to challenge the taxpayer, as was demonstrated by a recent decision of the U.S. Tax Court in which the issue presented was whether the taxpayer had transferred a fixed dollar amount of interests in a partnership or a percentage interest in such partnership.[xxii]

Percentage or Fixed Value?

Taxpayer was a partner in Partnership. Taxpayer formed Trust for the benefit of their spouse and children. Taxpayer then transferred interests in Partnership to Trust. The first transfer (in late 2008) was a gift. The memorandum of gift provided as follows:

[Taxpayer] desires to make a gift and to assign to [the Trust] her right, title, and interest in a [partnership] interest having a fair market value of [$2.096 million] as of December 31, 2008 * * *, as determined by a qualified appraiser within ninety (90) days of the effective date of this Assignment.

Taxpayer structured the second transfer (in early 2009, just a few days after the first one) as a sale.[xxiii] The memorandum of sale provided:

[Taxpayer] desires to sell and assign to [the Trust] her right, title, and interest in a [partnership interest] having a fair market value of [$20 million, as determined by a qualified appraiser within [180] days of the effective date of this Assignment.

Neither the memorandum of gift nor the memorandum of sale (collectively, the “transfer instruments”) contained clauses defining fair market value or subjecting the partnership interests to reallocation after the valuation date.

Taxpayer retained an appraiser to value Partnership in connection with the transfers. Because the transfers occurred so close together, the appraiser used the same date for valuing both transfers. On the basis of this valuation, it was determined that Taxpayer’s two transfers equated to 6.14 percent and 58.65 percent of the interests in Partnership, respectively.[xxiv]

Partnership’s agreement was amended to reflect transfers of partnership interests of 6.14 percent and 58.65 percent from Taxpayer to Trust.[xxv] Partnership reported the reductions of Taxpayer’s partnership interest and the increases of Trust’s interests on the Schedules K-1, Partner’s Share of Income, Deductions, Credits, etc., attached to Partnership’s Forms 1065, U.S. Return of Partnership Income. Partnership also made a proportional cash distribution to Trust based upon its 64.79 percent interest, which in turn was based on the appraiser’s valuation.

Tax Returns and Examination

Taxpayer filed IRS Forms 709, United States Gift (and Generation-Skipping Transfer) Tax Returns, for 2008 and 2009. On their 2008 Form 709 they reported the gift to the Trust “having a fair market value of $2,096,000 as determined by independent appraisal to be a 6.1466275% interest” in Partnership. Taxpayer did not report the 2009 transfer of the interest in Partnership on their 2009 Forms 709, consistent with its treatment as a sale.

The IRS examined Taxpayer’s gift tax returns and asserted deficiencies based on a greater value for Partnership.[xxvi] Taxpayer sought to negotiate a settlement agreement with IRS Appeals, but it was never completed. However, on the basis of these discussions with IRS Appeals regarding Partnership’s fair market value, Taxpayer amended Partnership’s agreement to record Trust’s interest in Partnership, based on a transfer of $22.096 million of value, as 38.55 percent (rather than 64.79 percent)[xxvii] and made corresponding adjustments to the partnership’s and the trust’s books. Partnership also adjusted prior distributions[xxviii] and made a subsequent proportional cash distribution to its partners to reflect the newly adjusted interests.

The IRS issued notices of deficiency in which it determined that Taxpayer had undervalued the 2008 gift. The IRS also determined that Taxpayer had undervalued the 2009 transfer, resulting in a part-sale, part-gift.

The Gift Tax

The Court began by explaining that the gift tax is imposed upon a transfer of property by gift.[xxix]

When “property is transferred for less than an adequate and full consideration,” it stated, “then the amount by which the value of the property exceeded the value of the consideration shall be deemed a gift”.[xxx] Conversely, property exchanged for “adequate and full consideration” does not constitute a gift for Federal gift tax purposes.

Furthermore, according to IRS regulations, the gift tax does not apply to “ordinary business transactions,”[xxxi] meaning “a transaction which is bona fide, at arm’s length, and free from any donative intent.”[xxxii] A transaction meeting this standard, the Court stated, “will be considered as made for an adequate and full consideration in money or money’s worth.”

It added, however, that a transaction between family members would be “subject to special scrutiny, and the presumption is that a transfer between family members is a gift.”

The Court then turned to the transfers at issue. To determine the amount of any gift tax due on all or part of these transfers, the Court noted that it had to decide the value of the interests transferred. But before doing so, it first had to decide the nature of the interests transferred.

Nature of the Interests Transferred

The parties agreed that the transfers were complete once Taxpayer executed the transfer instruments parting with dominion and control over the interests.[xxxiii] But they disagreed over whether Taxpayer transferred interests in Partnership valued at $2,096,000 and $20 million, as Taxpayer contended, or percentage interests of 6.14 percent and 58.65 percent, as the IRS contended, the values of which were subject to adjustment based upon the IRS’s revaluation of Partnership.

The Court looked to the transfer documents to decide the amount of property given away by Taxpayer in a completed gift. Taxpayer argued that the transfer instruments showed that they transferred specific dollar amounts, not fixed percentages, citing a series of cases that respected formula clauses as transferring fixed dollar amounts of ownership interests. In each of those cases, the Court respected the terms of the formula, even though the percentage amount was not known until the fair market value was subsequently determined, because the dollar amount of the transfer was known.[xxxiv]

The Court then distinguished a DVC from a “saving clause.” The latter, it stated, has been rejected by the courts because it relies on conditions subsequent to adjust the amount of the gift or transfer; thus, the size of the transfer cannot be known on the date of the transfer.

By contrast, the courts have upheld a gift of an interest in a partnership expressed as “a dollar amount of fair market value in interest,” rather than a percentage interest that was determined in agreements subsequent to the gift. The Court explained that “a gift is valued as of the date that it is complete; the flip side of that maxim is that subsequent occurrences are off limits.”

Taxpayer argued that the Court should construe the transfer clauses here as transferring dollar amounts rather than percentages. However, as part of their argument, they also cited evidence of their intent, which included their settlement discussions with IRS Appeals and the subsequent adjustments made in Trust’s percentage interest to reflect changes in valuation of Partnership, but not of the amount transferred.[xxxv]

To decide whether the transfers at issue were of fixed dollar amounts or fixed percentages, the Court started with the formula clauses themselves, rather than the parties’ subsequent actions. The Court observed that although the gift was expressed as a partnership interest having a fair market value of $2.096 million, and the sale was expressed as a partnership interest having a fair market value of $20 million, in each case the transferred interests were expressed as an interest having a fair market value of a specified amount as determined by an appraiser within a stated period after the transfer.

The Court stated that the term “fair market value” as used in the Taxpayer’s formula clause was expressly qualified by reference to the post-transfer determination of value by the appraiser – therefore, it was not fixed amount. This could not be ignored, the Court stated; Taxpayer was bound by what they wrote at the time.

The Court concluded that Taxpayer transferred 6.14 percent and 58.65 percent interests in Partnership to the Trust, and not a dollar amount that was fixed on the transfer date; the value reported was not known at the time of the transfers, but was only determined by the appraiser after the transfers. Thus, the amount of the reported gift was not accepted by the Court.

Don’t Let Your Attention Wander-y[xxxvi]

Words to live by, sort of, if one is planning to rely upon a DVC to avoid a gift tax deficiency on the transfer of an interest in a closely held business. That being said, the Court’s decision with respect to Taxpayer’s transfers seems harsh, and should serve as a warning to anyone contemplating a Wandry-like transfer using a DVC; if you’re going to make a gift of a fixed dollar amount on the transfer date, the amount should not be qualified by subsequent events.

Of course, as indicated earlier, there are many other means by which a business owner may seek to make a tax efficient gift of an interest in the business before 2021. Some owners may even decide that these other transfer vehicles will serve them well even under a reduced exemption transfer tax regime.

These folks should be reminded of the estate and gift tax proposals set out in President Obama’s 2017 Budget.[xxxvii] The Green Book called for an increase in the transfer tax rate to 45 percent, and a reduction in the exemption amount to $3.5 million for estate and GST taxes and $1 million for gift taxes, with no indexing for inflation.

Among other changes proposed were the following:

  • Require that a grantor retained annuity trust (“GRAT”) have a minimum term of ten years and a maximum term of the actuarial life expectancy of the annuitant plus ten years. The minimum term proposal would increase the risk that the grantor would not outlive the GRAT term, thereby bringing it back into their estate and losing any anticipated transfer tax benefit.
  • The proposal also included a requirement that the remainder interest have a value greater than zero at the time the interest was created – no more “zeroed out” GRATs.
  • On the 90th anniversary of a trust’s creation, the GST exemption allocated to the trust would terminate.  This would be achieved by increasing the trust’s inclusion ratio to one, thereby rendering the entire trust subject to GST tax. Farewell dynasty trust.
  • Upon the death of a grantor who sold property to a grantor trust[xxxviii] (a disregarded transfer for income tax purposes), the portion of the trust attributable to the property received in that transaction (including all of its retained income and appreciation) would be subject to estate tax as part of the grantor’s gross estate. So much for sales to so-called “IDGTs.”
  • In addition, such portion of the trust would be subject to gift tax during the grantor’s life when their treatment as the deemed owner of the trust is terminated.  Any distribution from the trust to another person would also be treated as a gift by the grantor.

Query whether any of these earlier legislative proposals will find their way into Congress after 2020. I wouldn’t be surprised – low-hanging fruit. The same may be said for the previously withdrawn proposed regulations aimed at curtailing valuation discounts for interests in closely held businesses.

It will pay to do some homework and to be prepared for whatever may come our way.

[i] The Republican Party’s convention is scheduled for August 24-27; the Democratic Party’s for August 17-20. The suspense is killing me. Not.

The following quotation is attributed to the late 18th, early 19th century French political philosopher, Joseph de Maistre: “Every nation gets the government it deserves.” If there is any truth to this statement – and I believe there is – then no matter which way you look at our circumstances, it doesn’t say very much about us. However, it also leaves open the possibility that we can do better.

[ii] No, that is not a comment on the ages of either candidate (74 and 77), or an observation on the ages of the Senate majority leader or the speaker of the House (78 and 80, respectively). I carry my AARP card proudly, sort of.

Did you know that Roman Senators held office for life? You see the difference, don’t you?

[iii] Which saw the great bank bailout, and came only a few years after the dot.com bubble burst. And don’t forget the 1989 savings and loan bailout, or the 1987 stock market crash.

[iv] Witness the “occupy” movement of 2011.

[v] According to Forbes, the U.S. added almost 700,000 millionaires from 2018 into 2019. Jack Kelly, October 22, 2019.

[vi] Tax Cuts and Jobs Act. P.L. 115-97. The basic exemption amount is scheduled to be reduced to its pre-2018 level beginning in 2026. IRC Sec. 2010.

Also in 2018, the IRS withdrew proposed regulations that would have limited, somewhat, a donor-taxpayer’s ability to discount the value of a gifted interest in a closely held business.

[vii] If its assets were sold at FMV and the net proceeds distributed to the owners.

[viii] See the discussion below regarding the valuation of interests in closely held businesses.

[ix] Perhaps a second-to-die policy, which would be more cost efficient.

[x] And let’s not forget the effect of the GST Tax exemption and the creation of so-called “dynasty trusts,” which effectively removed these assets from the transfer tax system for generations. President Obama’s last Green Book sought to reduce the impact of such trusts. https://www.taxlawforchb.com/2016/03/1833/

[xi] The flight of many of the well-to-do to far-away locations did not go unnoticed by the American public. Selfie anyone?

[xii] Assuming they take the White House, the Democrats need to pick up only three seats to win a majority. The Republicans would need to pick up 18 or 19 seats to min a majority in the House.

[xiii] During the 1970’s the top rate was between 70% and 77%, and between 5% and 8% of estates were subject to the tax. Over the last 20 years, just over 1% of the estates, on average, have been subject to the tax. Since 2010, that figure has dropped to 0.30%. https://itep.org/the-federal-estate-tax-an-important-progressive-revenue-source/

[xiv] Alternatively, the presumptive Democratic nominee, Joe Biden, has raised the possibility of imposing a tax on the unrealized appreciation of assets that pass upon the death of a taxpayer. Such a tax would effectively eliminate the basis step-up enjoyed by a decedent’s heirs under current law. What’s more, Biden has mentioned increasing the long term capital gains tax rate to the ordinary income rate in the case of wealthier taxpayers.

[xv] Indeed, many of the very wealthy seem to be concerned enough to have formed their own organizations – for example, Millionaires for Humanity – that are calling for higher taxes on the wealthy. Remember FDR and the New Deal? It’s called co-opting the left. https://www.hoover.org/research/how-fdr-saved-capitalism . Those who are ignorant of history . . .

[xvi] Anyone remember the end of 2012? It looked like the tax cuts enacted in 2001 would expire; this included the increased exemption amount. In order to take advantage of the then $5.12 million exemption amount before it disappeared, many owners gifted interests in their business to trusts for the benefit of their children.

[xvii] For example, a straight gift, a straight sale, a bargain sale, a GRAT, a sale to a grantor trust.

[xviii] Reg. Sec. 25.2512-1. The willing buyer and willing seller are purely hypothetical figures and, generally speaking, the valuation does not take into account the personal characteristics of the actual recipients of the property being valued.

[xix] See generally Rev. Rul. 59-60.

[xx] As the Tax Court stated in the case described below, for a value (or discount), it is “not necessary that the value arrived at by the trial court be a figure as to which there is specific testimony, if it is within the range of figures that may properly be deduced from the evidence.” Stated differently, the Court may channel Solomon. See the Book of Kings in the Old Testament.

[xxi] See, for example, Wandry, T.C. Memo. 2012-88. The Tax Court ruled that what the taxpayer had gifted was LLC units having a specific dollar value – the exemption amount – and not a specific number of LLC units. https://www.taxlawforchb.com/2014/02/wandrying-about-defined-value-clauses/

[xxii] Nelson v. Comm’r, T.C. Memo. 2020-81.

[xxiii] In connection with the second transfer, Trust executed a promissory note for $20 million.The note provided for interest on the unpaid principal; it was payable and compounded annually; the note was secured by the partnership interest that was sold. Good stuff.

[xxiv] Partnership was valued at approximately $34.1 million. Taxpayer’s transfers of $2.096 million + $20 million = $22.096 million, or 64.79% of Partnership.

[xxv] Effective as of the time of the transfers.

[xxvi] The IRS valued Partnership at $57.3 million.

[xxvii] $100 will get you 64.79% of a business worth $154, but only 38.55% of one that is worth $259.

[xxviii] Partnership had previously made a distribution to Trust based on its holding a 64.79% interest. Query whether Trust was required to return the excess, or whether it was treated as a loan from Partnership.

[xxix] IRC Sec. 2501.

[xxx] IRC Sec. 2512(b).

[xxxi] Reg. Sec. 25.2511-1(g)(1).

[xxxii] Reg. Sec. 25.2512-8.

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

[xxxiv] See the Wandry decision, for example.

Taxpayer transfers $1 million of equity. The FMV of the business is not known, and the percentage interest of the transferred equity valued at $1 million is not known – the value of the business will be known after the transfer, at which point the percentage interest transferred will also be known.

[xxxv] The Court stated that it would look to the terms of the transfer instruments, and not to the parties’ later actions, except to the extent that it concluded the terms were ambiguous and their actions revealed their understanding of those terms.

[xxxvi] Pretty bad, I know. For some reason, tax folks feel compelled to come up with a catchy title or caption. One day, it’ll be my turn to come up with a good one.

[xxxvii] https://www.taxlawforchb.com/2013/09/obamas-2014-budget-estate-and-gift-tax-proposals-how-might-they-impact-your-estate-plan/. https://www.taxlawforchb.com/2016/03/1833/ . You remember Mr. Obama? Mr. Biden’s boss.

[xxxviii] One that is deemed to be owned by the grantor under the grantor trust rules. IRC Sec. 671 et seq.