Welcome (?) to NY

The Tax Foundation recently issued its annual State Business Tax Climate Index. The 2019 Index compares the fifty States across five major areas of taxation: corporate taxes, individual income taxes, sales taxes, unemployment insurance taxes, and property taxes; it then adds the results to generate a final, overall ranking. According to the Index, the individual income tax component accounts for approximately 30% of a State’s total score.

After finding itself in 49th place during 2016, 2017, and 2018, it appears that New York is making a move to improve its standing in the business community – the 2019 Index has New York ranked in – patience, wait for it, wait for it – 48th place with respect to individual income taxes, and 48th overall. Woo hoo! Way to go team.[i]

“You Can Never Leave” [ii]

Of course, New York’s high personal income, estate, sales and property tax rates are all too familiar to those who reside, or used to reside, in the State. However, the State’s appetite for challenging a former resident’s assertion of a change of domicile is notorious, as is its penchant for taxing certain nondomiciliaries as so-called “statutory residents.”

The anxiety that this engenders among many informed taxpayers is understandable,[iii] though it may push some to borderline paranoia – or is it? – as illustrated by a recent advisory opinion issued by the Office of Counsel for New York’s Department of Taxation and Finance.[iv]

“Where [You] Lay [Your] Head is Home?” [v]  Hopefully Not?

Taxpayer was domiciled in Washington, D.C. He was an executive with an investment management firm that maintained New York offices. Taxpayer was responsible for overseeing the firm’s daily trading activity for several funds that traded in domestic and foreign markets. He was required to work during the night and consult with the firm’s traders during overseas trading hours. Because of his work duties, the firm allowed him to stay overnight in his New York office, but only when the markets in which the firm traded were open. Otherwise, Taxpayer was required to vacate the office at the end of the work day. The firm advised him in writing of these restrictions, noting that overnight stays were limited to those nights needed for work purposes, and that the office building was neither zoned nor insured for residential use.

Taxpayer typically travelled from Washington to the firm’s New York office on Monday mornings, stayed in New York on Monday, Tuesday and Wednesday nights, and returned to Washington on Thursday evenings.[vi] He did not own or rent any abode in New York. When Taxpayer was in New York overnight, he slept on a “murphy bed” in the office. The office was approximately 330 square feet[vii] and did not include any cooking facilities, bathing facilities, or a separate bathroom within its four walls. However, Taxpayer had access to common restrooms and an on-site gymnasium with showering facilities, both of which were available to all firm employees. In addition, the firm’s space had a kitchen area; however, the kitchen was intended for use by the firm’s kitchen staff and not for employees’ personal use. When taxpayer was in New York, he ordered meals from local restaurants and did not use cooking facilities in the building.[viii] Taxpayer was not required to provide any consideration, contribution, or reimbursement to the firm for the sleeping arrangement. He was prohibited from having overnight guests. Also, Taxpayer did not receive any personal mail at the office. He did maintain a small closet of work clothes in the office, along with some toiletries, but otherwise maintained his personal effects in Washington.

The Department’s Analysis

An individual is a resident of New York for a taxable year if such individual maintains a permanent place of abode in New York for substantially all of the taxable year and spends more than 183 days of the taxable year in the State.[ix]

It is not necessary that the individual actually stayed at, or even visited, the permanent place of abode for more than 183 days during the taxable year; it is only necessary that the individual could have done so while they were spending time in New York.

Thus, an individual who is domiciled in New Jersey, who owns a small studio pied-a-terre on the Upper West Side of Manhattan that they use occasionally on a Friday or Saturday, and who commutes to work Downtown on weekdays, is a statutory resident of both New York State and New York City.[x]

The term “permanent place of abode” means a dwelling place of a permanent nature maintained by an individual, whether or not owned by such individual.[xi] In general, a construction that does not contain facilities ordinarily found in a dwelling, such as facilities for cooking, bathing etc., will not be considered a permanent place of abode for tax purposes.

In order to qualify as a permanent place of abode, “there must be some basis to conclude that a dwelling is utilized as the taxpayer’s residence.”[xii] Case law and the Department’s Income Tax Nonresident Audit Guidelines (June 2014) have identified certain factors to consider when determining whether a dwelling satisfies the requisite relationship. These factors include, but are not limited to, the physical attributes of the dwelling and the relationship of the individual to the dwelling, such as ownership, property rights, maintenance, the relationship to co-habitants, personal items, and access.

Whether or not an individual has free and continuous access to a place of abode is a primary consideration in determining whether they maintain a permanent place of abode. For example, an individual maintains a permanent place of abode when they have an unrestricted right to use a room (despite the fact that they have no legal right to the property), contribute to the household expenses, have exclusive use of the room, provide their own furnishings and personal effects, regularly use the residence for a long-standing period of time to access their full-time job, and have unlimited access to the room. However, an individual does not maintain a permanent place of abode where they have intermittent access to an apartment rented and maintained by another individual, cannot access the apartment without prior notice, do not maintain clothing, personal articles or furniture in the apartment, do not have a dedicated room to which they have free and continuous access, do not use the residence for daily attendance at their full-time job, and do not share in the expenses of maintaining the apartment.

All Clear

According to the Department, the facts and circumstances in the present case indicated that Taxpayer’s arrangement did not provide unfettered access to a dwelling. His use of the office space was restricted to work nights when overseas markets were open and Taxpayer was required by his position to consult with firm traders of those markets. Furthermore, Taxpayer was prohibited from staying at the office overnight except on those nights when specifically allowed or required.

In addition to the absence of unfettered access, the Department found that Taxpayer’s arrangement lacked other necessary characteristics to be considered a permanent place of abode; these factors included the absence of bathing or kitchen facilities in the office that are ordinarily found in a dwelling, as well as other physical attributes of an abode.

Other relevant factors included the fact that: the building was not permitted by zoning laws to be used as a residence; Taxpayer did not contribute any money or other consideration to maintain the dwelling; the personal items kept in the office generally were work clothes; Taxpayer did not use the office address on any registrations, such as a driver’s license, voter registration, car registration, etc.; and he did not receive personal mail or maintain any other personal items at his office.

Considering the foregoing factors, the Department concluded that Taxpayer’s office did not constitute a permanent place of abode; consequently, the Taxpayer’s days spent in New York would not result in his being treated as a statutory resident.


I questioned earlier whether the Taxpayer was crazy to have requested the foregoing ruling. I don’t think so.

Some of you may be thinking, “C’mon Lou, the guy slept in a murphy bed in his office. He had no expectation of privacy there. He couldn’t just walk around in his skivvies, and isn’t that the ultimate indication of a place of abode? Oh, and by the way, many of us keep extra clothes in the office[xiii], plus a toothbrush; some of us have a refrigerator or microwave.[xiv] Don’t some firms provide showers for their employees? How can the State ever claim that this guy maintained a permanent place of abode in New York?”

To which I respond, “Why, then, did the Department feel compelled to go through the foregoing analysis? Hmm? Why bother with the exercise of considering the absence of a bathroom or of kitchen facilities within the office itself?[xv] Or the fact that Taxpayer didn’t pay his employer for the use of his office? Seriously? And why would a resident of Washington, D.C. include his New York office address on his license or registration?”

Indeed, couldn’t the Department have simply stated – relying upon the decision of the Court of Appeals in Gaied – that Taxpayer had no “residential interest” in his office – period, case closed?

Clearly, the Department decided not to go in that direction because it believed that Taxpayer did utilize his office as a residence – there was a reason that Taxpayer felt compelled to request this ruling in the first place. Thus, the Department had to establish that this particular office, in the circumstances described above, was not a permanent place of abode.

With that, did the Department leave open the possibility that a slightly larger office (say, the size of a small studio, perhaps with its own bathroom, a murphy bed or pull-out couch – maybe even a wet bar[xvi]) may constitute a permanent place of abode? And might the occupant of such an office – who is an owner of the tenant business that occupies the space – have a “residential interest” therein, such that they may be treated as a statutory resident notwithstanding that they commute to their domicile almost every night?

I don’t like it.

[i] “Every journey begins with a single step.” Lao Tsu.

[ii] Apologies to The Eagles. Speaking of California, its 2019 Index overall ranking is 49th.

[iii] Ignorance may be bliss, but I hate surprises.

[iv] An advisory opinion is issued at the request of a taxpayer – thus my statement about paranoia, or not. The opinion is limited to its facts, and is binding on the State only with respect to the taxpayer to whom it is issued.

[v] Apologies to Metallica (“Where I Lay My Head is Home”). I often answer my office phone with “Vlahos residence,” and it’s not entirely facetious.

[vi] Thus, he was “present” in New York four days per week.

[vii] There are many studios of this size in downtown Manhattan.

[viii] My kinda guy.

[ix] N.Y. Tax Law Sec. 605(b)(1)(B). This is referred to as “statutory residence,” as distinguished from “domicile,” which involves a much more subjective determination based upon the taxpayer’s intent or the objective manifestations of such intent. Under either characterization, the taxpayer’s worldwide income would be subject to New York’s personal income tax.

[x] And is subject to State and City income taxes at 8.82% and 3.876%, respectively.

[xi] 20 NYCRR Sec. 105.20(e)(1).

[xii] Matter of Gaied v. Tax Appeals Trib., 22 N.Y.3d 592, 594 (2014). It’s unfortunate that the State pays lip service to the holding in Gaied but practically limits the application of the decision to its facts.

[xiii] In today’s “dress-down” business environment, how does one distinguish between work and non-work clothes?

[xiv] That is neither an admission nor a Christmas wish list – I’m simply giving an example.

[xv] Does the Department realize that there are still a few boarding houses in Manhattan? Yes, rooms without bathrooms, and where residents eat in a common area. Would anyone seriously claim that these are not “permanent places of abode?”

[xvi] A guy can dream, can’t he?

Dr. Wallace Wrightwood: “You’ve seen hundreds, thousands of pigeons, right?”
George Henderson: “Of course.”
Dr. Wallace Wrightwood: “Have you ever seen a baby pigeon? Well neither have I. I got a hunch they exist.”[i]

When was the last time you pored over a judge’s analysis of the bona fides of a family limited partnership (“FLP”), or pondered a court’s Solomon-like judgement regarding the fair market value of an interest in a FLP? [ii]

It used to be that such decisions were de rigeur in the world of estate and gift tax planning for family-owned business and investment entities, and planners would wait breathlessly for the outcome of the next learned opinion and the direction it would provide.

Then the federal transfer tax exemption began its seemingly inexorable climb, which spawned an interest in how to best leverage the increased exemption amount and remove still more of a family’s wealth from the transfer tax system.

Of course, there was a bump in 2016, with the issuance of proposed regulations that many believed would, if finalized, mark the end of the valuation discounts that made the use of FLPs, and the transfer of interests in family-owned businesses generally, so attractive as a gift planning tool. [iii]

The presidential election results ended the IRS’s regulatory efforts to clamp down on the abuse of FLPs, and the “temporary” mega-increase of the federal exemption, beginning with 2018, gave many taxpayers a comfortable “margin of error” for any valuation missteps. [iv]

Notwithstanding the relatively “favorable” environment for gift and estate tax planning in which we find ourselves, it will still behoove taxpayers and their advisers to remain attuned to the factors on which the IRS and the courts have historically focused in their analyses of FLPs and the transfer of interests in family-owned businesses, some of which were highlighted in a recent Tax Court decision. https://www.ustaxcourt.gov/ustcinop/OpinionViewer.aspx?ID=11800 [v]

“I’ll Take Care of Everything, Dad”

Decedent, acting through his attorney-in-fact [vi] (his daughter, “Daughter”), formed FLP as a limited partnership. The partnership agreement (the “Agreement”) stated that FLP’s purpose was to “provide a means for [D]ecedent’s family to manage and preserve family assets.” Decedent funded FLP primarily with marketable securities, municipal bonds, mutual funds, and cash. Its portfolio was managed by professional money managers. FLP never held any meetings.

F-LLC was FLP’s sole general partner (“GP”). Daughter was manager of F-LLC. The Agreement provided that the GP “shall perform or cause to be performed * * * the trade or business of the Partnership,” subject only to limitations set forth expressly in the Agreement.

Decedent and his children were FLP’s original limited partners (“LPs”) under the Agreement. The LPs, other than Decedent, received their LP interests as gifts. Decedent reported these gifts on a federal gift tax return (IRS Form 709).

The Agreement provided that FLP would terminate in 2075, unless terminated sooner; for example, upon the removal of the GP. The LPs could remove the GP by written agreement of the LPs owning 75% or more of the partnership interests held by all LPs. If the partnership terminated by reason of the GP’s removal, then 75% of the LPs could reconstitute the partnership and elect a successor GP. LPs owning at least 75% of the ownership percentage in FLP could approve the admission of additional LPs to the partnership.

The Agreement provided that an LP could not sell or assign an interest in FLP without obtaining the written approval of the GP, which the Agreement provided would not be unreasonably withheld. Any partner who assigned their interest remained liable to the partnership for promised contributions or excessive distributions unless and until the assignee was admitted as a substituted LP. The GP could elect to treat an assignee as a substituted LP in the place of the assignor. An assignor was deemed to continue to hold the assigned interest for the purposes of any vote taken by LPs under the Agreement until the assignee was admitted as a substituted LP.

All transfers of interests in FLP were subject to limitations. Partners were allowed to make only permitted transfers of their interests. “Permitted transfers” were transfers (1) to any member of the transferor’s family, (2) to the transferor’s executor, trustee, or personal representative to whom his or her interest would pass at death or by operation of law, or (3) to any purchaser, but subject to the right of first refusal held by the certain partners.

Any partner who received an outside purchase offer for their interest was required, before accepting the offer, to provide each of the “priority family”, the partnership, and the general partner an opportunity to acquire the interest. Whether FLP exercised its right of first refusal to purchase a partner’s interest was subject to the approval of the GP and the LPs owning at least 50% of FLP’s interests held by all LPs (with the exception of the seller if they were an LP).

The Agreement referred to persons who acquired interests in FLP, but who were not admitted as substituted LPs, as “assignees”. Such “assignees” were entitled only to allocations and distributions in respect of their acquired interests. “Assignees” had no right to any information or accounting of the affairs of FLP, were not entitled to inspect its books or records, and did not have any of the rights of a partner under state law.

The Agreement provided that a transferee of an interest in FLP could become a substituted LP upon satisfying the following conditions: (1) the GP consented; (2) the transferee was a permitted transferee; and (3) the transferee became a party to the Agreement as an LP. The Agreement provided that an interest holder who was admitted to FLP as a substituted LP would be treated the same as an original LP under the terms of the Agreement.

On the same day that Decedent formed FLP, he established a revocable trust (the “Trust”), and also transferred his 88.99% LP interest in FLP to Trust. Decedent held the power during his life to amend, alter, revoke, or terminate Trust. He was its sole beneficiary, and Daughter was the trustee. Decedent was entitled to receive distributions of trust income and could receive distributions of trust principal upon his request.

Decedent, through Daughter, executed an agreement (the “Assignment”), which designated Decedent as “assignor” and the Trust as “assignee”. The Assignment provided that Decedent assigned all of his LP interests in FLP, and that the Trust, “by signing this [Assignment], hereby agrees to abide by all the terms and provisions in that certain [Agreement] of [FLP].”

Decedent’s transfer of his interest was a permitted transfer under the Agreement. Daughter signed the Assignment in her capacities as Decedent’s attorney-in-fact, as trustee of the Trust, and as managing member of F-LLC.

Estate Tax Return
Following Decedent’s death, [vii] his estate (the “Estate”) filed a federal estate tax return (IRS Form 706). The Estate reported on the estate tax return that Decedent had made revocable transfers during his lifetime. It identified on the estate tax return the transfers of Decedent’s LP interests to the Trust. [viii]

The Estate described the property transferred to the Trust as an “assignee interest” in an 88.99% LP interest. The Estate reported the value of the transferred interest on the tax return; in a supplemental statement, the Estate indicated that it claimed discounts for “lack of marketability, lack of control, and lack of liquidity.”

The IRS issued a notice of deficiency asserting an estate tax deficiency. The attached Forms 886-A set forth the IRS’s determination that the corrected value of decedent’s interest in FLP was greater than that reported by the Estate.

The Estate petitioned the Tax Court.

The Court’s Approach
The Court distinguished between the nature of the property interest transferred to the Trust (a legal issue) and the fair market value (“FMV”) of such interest (a question of fact). The parties, the Court stated, disagreed as to the type of interest that had to be valued in Decedent’s gross estate.

The Estate claimed that the Assignment created an assignee interest in Decedent’s LP interest under the Agreement. It valued Decedent’s interest in the Trust as an assignee interest.

The IRS asserted that the Assignment did not create an assignee interest held by the Trust. The IRS argued that Decedent transferred his 88.99% LP interest to the Trust and the value to be included in the gross estate should be that of an LP interest.

Thus, the Court had to determine whether the interest Decedent transferred to the Trust was an LP interest or an assignee interest.

Generally, state law determines the nature of the property interest that has been transferred for federal estate tax purposes. [x] The Court explained that, under applicable state law, a partnership interest was assignable unless the partnership agreement provided otherwise. An assignee of a partnership interest was entitled to receive allocations of income, gain, loss, deduction, credit, or similar items, and to receive distributions to which the assignor was entitled, but was not entitled “to exercise rights or powers of a partner”. The assignee may become a partner, with all rights and powers of a partner under a partnership agreement, if admitted in the manner that the agreement provided.

The Court emphasized, however, that the federal tax effect of a particular transaction was governed by the substance of the transaction rather than its form. “The doctrine that the substance of a transaction will prevail over its form,” the Court stated, “indicates a willingness to look beyond the formalities of intra-family partnership transfers to determine what, in substance, was transferred.”

With that, the Court considered both the form and the substance of Decedent’s transfer to the Trust to determine whether the property interest transferred was an assignee interest or an LP interest.

The Court’s Analysis
The Agreement allowed the transfer of LP interests, and for the admission of a transferee as a substituted LP, provided certain conditions were met. [xi]

The Estate contended that these conditions were never met with respect to the interest that Decedent transferred to the Trust and that, upon the execution of the Assignment, the Trust received only an assignee interest in Decedent’s 88.99% LP interest.

The Court observed that, although the transfer was labeled an “assignment,” the Assignment stated that the Trust was entitled to all rights associated with the ownership of Decedent’s 88.99% LP interest, not just those of an assignee. All “rights and appurtenances” belonging to Decedent’s interest, the Court continued, included the right to vote as an LP and exercise certain powers as provided in the Agreement. The Assignment also required that Decedent was bound to provide any documentation necessary “to provide * * * [the Trust] all the rights * * * [Decedent] may have had” in the LP interest.

The Assignment, the Court added, satisfied all the conditions for the transfer of Decedent’s LP interest and the admission of the Trust as a substituted LP. In order for a transferee to be admitted as a substituted LP in respect of a transferred interest in FLP, (1) the GP had to consent to the transferee’s admission, (2) the transfer had to be a permitted transfer, and (3) the transferee had to agree to be bound by the terms of the Agreement. Daughter signed the Assignment as manager of FLP’s GP and consented to its terms, which provided for the transfer of all of Decedent’s rights in his LP interest to the Trust. The transfer was a permitted transfer. Lastly, the Assignment provided that the Trust agreed to abide by all terms and provisions of the Agreement, and Daughter executed the Agreement on behalf of the Trust.

The Court concluded that the form of the Assignment established that Decedent transferred to the Trust an LP interest and not an assignee interest.

What’s the Difference Anyway?
The economic realities underlying the transfer of Decedent’s interest, the Court stated, supported the conclusion that the transferred interest should be treated as an LP interest for federal estate tax purposes; regardless of whether an assignee or an LP interest had been transferred, there would have been no substantial difference before and after the transfer to the Trust.

Pursuant to the Agreement, only the GP had the right to direct the FLP; neither LPs nor assignees had managerial rights. The Agreement provided that assignees had no rights to any information regarding FLP’s business or to inspection of its books or records.

However, according to the Court, this distinction made no difference in the present case because Daughter was both a partner who was entitled to information regarding FLP (i.e., the manager of the GP) and the trustee of the Trust.

The Agreement also provided that an “assignee” did not have the right to vote as an LP. However, this difference was not significant – whether the Trust held the voting rights associated with an LP interest was of no practical significance, the Court stated.

There were no votes by LPs following the execution of the Assignment. Additionally, during his life, Decedent held the power to revoke the transfer to the Trust. If he had revoked the transfer, he would have held all the rights of an LP in FLP, including the right to vote on partnership matters. Also, F-LLC, as the GP, could have treated the holder of an assignee interest as a substitute LP.

Therefore, under the facts and circumstances of this case, the Court determined there was no difference in substance between the transfer of an LP interest in FLP and the transfer of an assignee interest in that LP interest. Accordingly, as a matter of both form and substance, the interest to be valued for estate tax purposes was an 88.99% LP interest in FLP, rather than an assignee interest. [xii]

Bad facts, etc., but some may see a silver lining in the result of this case.

A taxpayer who cannot act on his own; his attorney-in-fact/Daughter creates the partnership and funds it with marketable securities and cash on his behalf; she appoints herself as the manager of the GP; she creates and funds the Trust with most of the LP interests on his behalf, and appoints herself as trustee of the Trust. Sounds perfect.

Notwithstanding the foregoing, the Court respected the partnership; [xiii] in fact, it appears that the IRS did not even challenge the partnership’s bona fides.

Query what business purpose the FLP had where it held only marketable securities and cash (all provided by Decedent), where its securities were managed by a professional money manager, and where it never held any meetings. This was just a valuation play.

Silver lining? Nope. Dodged one? Yep. A map to follow? Please don’t.
i From “Harry and the Hendersons.” C’mon, don’t pretend you haven’t seen it.
ii Usually with a beverage for inspiration.
iii https://www.taxlawforchb.com/2016/09/the-irs-takes-the-offensive-on-valuation-discounts-part-one/ ; https://www.taxlawforchb.com/2016/09/the-irs-takes-the-offensive-on-valuation-discounts-part-two/ ; https://www.taxlawforchb.com/2016/09/the-irs-takes-the-offensive-on-valuation-discounts-part-three/ .
iv The exemption amount had been set to increase from $5.49 MM in 2017 to $5.62 MM in 2018. The Tax Cuts and Jobs Act doubled the exemption to $11.2 MM for 2018, adjusted for inflation beginning in 2019, with a return to the pre-2018 levels after 2025. P.L. 115-97.
v T.C. Memo. 2018-178.
vi Anyone remember Strangi?
vii The 706 was filed August 2012. If this filing was timely, then the DOD was in November 2011. The FLP and Trust were created in October 2008, three years earlier.
viii IRC Sec. 2038; Schedule G to the Form 706. Because the transfers were revocable by the Decedent – specifically, by his attorney-in-fact in this case – the property transferred was included in his gross estate for tax purposes.
ix You can’t make this up.
x See Commissioner v. Estate of Bosch, 387 U.S. 456 (1967).
xi See above.
xii The Court then turned to the FMV of the Trust’s interest in FLP. Based on its finding that the interest transferred was an 88.99% LP interest, the Court concluded that the interest did not lack control. Accordingly, no discount for lack of control was allowed. The Court agreed with the Estate that there should be a discount for lack of marketability. However, because the Court concluded that the interest Decedent transferred was an LP interest, not an assignee interest, it found the Estate’s discount was too generous and accepted the lower discounted applied by the IRS.
xiii Yet it did, and also allowed a lack of marketability discount in determining the FMV of the interest held by the Trust. Go figure.

How Does It Work?

Many employers struggle to hire and retain key employees. In addressing this challenge, employers will sometimes add unique benefits to the compensation package offered to such individuals. In fact, it is not unusual for the employer and the key employee to jointly structure the terms of such a benefit, often in response to a particular need of the employee.[i]

One of the more common benefits that a key employee may request to be included in such a compensation package is the provision of a “permanent” life insurance policy on the life of the employee; i.e., a policy that does not expire within a specified number of years, and which includes an investment component in addition to a death benefit.[ii] Of course, permanent insurance is more expensive than term life insurance, and may be too costly for the employee to acquire and carry alone.

Enter the split-dollar arrangement.

In general, a “split-dollar life insurance arrangement” entered into in connection with the performance of services is one between an employer (the “owner” of the policy) and a key employee (the “non-owner)”[iii] that satisfies the following criteria:

  • The employer pays the premiums on the policy, and
  • The employer is entitled to recover all, or a portion, of such premiums, and such recovery is to be made from, or is secured by, the life insurance proceeds.

The employee in this arrangement will typically designate the beneficiary of the death benefit,[iv] and may also have an interest in the cash value of the policy.

This arrangement is said to be compensatory, and certain economic benefits are treated as being provided by the employer-owner to the employee-non-owner.

Specifically, in determining gross income, the employee must take into account as compensation the value of the economic benefits provided to the employee under the arrangement.[v]

In general, the value of such benefits equals the cost of the current life insurance protection provided to the employee, plus the amount of the policy cash value to which the employee has “current access.”[vi]

But it’s Not Just for Employees

Although most split-dollar arrangements employed[vii] in the context of a business are compensatory in nature, it is possible for an arrangement to be entered into between a corporation and an individual in their capacity as a shareholder in the corporation.

In that case, the corporation would still pay all or a portion of the premiums, and the individual shareholder would designate the beneficiary of the death benefit, and may have an interest in the policy cash value.

However, the economic benefits provided by the corporation to the insured shareholder would constitute a distribution with respect to the shareholder’s stock in the corporation, which may represent a dividend to the shareholder,[viii] depending upon the corporation’s C corporation earnings and profits. In that case, the shareholder would be taxed at a much lower federal rate (23.8%), as compared to the rate applicable to compensation income (37%). If the corporation is an S corporation, it is possible that the distribution may not be taxable to the shareholder at all.[ix]

Thus, it is important, in determining the proper tax treatment of a split-dollar arrangement, that the parties thereto understand the capacity in which the benefit is being provided to the individual insured; i.e., as an employee or as a shareholder.

A recent decision by the Sixth Circuit Court of Appeals addressed this very issue.

Taxpayer as Employee or Shareholder?

Taxpayer was the sole shareholder of Corp, which was an S corporation. Taxpayer was also an employee of Corp.

Corp adopted a benefit plan in order to provide certain benefits to its employees. Pursuant to the plan, Corp provided Taxpayer a life insurance policy and paid a $100,000 annual premium in Tax Year. Because Corp was an S corporation, all of its income and deductions were “passed through” to Taxpayer for tax purposes.[x] On its Form 1120S return for Tax Year, Corp deducted the $100,000 premium as a business expense; thus, that amount of Corp’s income was not included in Taxpayer’s individual income as a pass-through item.[xi] However, Taxpayer also did not include as wages the economic benefits flowing from the life insurance policy.

The IRS challenged Taxpayer’s treatment of the split-dollar arrangement and issued a notice of deficiency, in response to which Taxpayer petitioned the Tax Court.

Tax Court

The Tax Court determined that Corp was not entitled to deduct the $100,000 premium payment.[xii] Because the $100,000 premium payment was not deductible, Corp underreported its income for that year and, due to its pass-through nature as an S corporation, the increased income was passed through to Taxpayer, who was then required to pay income tax on that amount. Taxpayer conceded that he had to report an amount equal to the premium payment as pass-through income.

The dispute before the Tax Court concerned whether Taxpayer was required to report as taxable wage income – in addition to the pass-through amount – the economic benefits flowing from the increase in the cash value of the life insurance policy caused by the payment of the premium.

The Tax Court ruled against Taxpayer, and found that he was required to account for the economic benefits in his individual income as wages:

[Corp’s] deduction, when disallowed . . . increased the S corporation’s gross income, which additional income was then passed on to [Taxpayer] as the shareholder of [Corp]. However, [Taxpayer], in addition to being a shareholder of the corporation, was also one of its employees. . . . , when the previously unreported and untaxed portion of the accumulation value of his policy was determined, the value of the $100,000 contribution by [Corp], was properly attributed to [Taxpayer] as an employee of the S corporation and a non-owner of the life insurance contract. While this result may seem aberrational in view of the pass-through treatment generally afforded to S corporations, it is a result mandated by the split-dollar life insurance regulations . . . . In instances other than those governed by the split-dollar life insurance regulations, the general rule of the non-taxability of previously taxed S corporation income is unperturbed. [Emph. added]

The Tax Court found that Taxpayer’s life insurance policy qualified as a compensatory arrangement. Moreover, the parties conceded that Taxpayer’s life insurance policy was not a shareholder arrangement.

Relying on the compensatory nature of the arrangement, the Tax Court rejected Taxpayer’s argument that the economic benefits (the “build-up” in cash value) should be treated as a shareholder distribution; instead, the Tax Court ruled that Taxpayer had to include as income the economic benefits resulting from Corp’s payment of a premium on Taxpayer’s life insurance policy.

Sixth Circuit

Taxpayer appealed the Tax Court’s decision to the Sixth Circuit, which considered the interplay of the split-dollar life insurance regulations and Subchapter S.

The Court explained that the split-dollar life insurance regulations apply “to any split-dollar life insurance arrangement,” whether the arrangement is a compensatory or a shareholder arrangement. When an arrangement is governed by the split-dollar life insurance regulations, the Court continued, the non-owner of the policy “must take into account the full value of all economic benefits” provided to them. “Depending on the relationship between the owner and the non-owner,” the Court stated, “the economic benefits may constitute a payment of compensation, a distribution in respect of stock, or a transfer having a different tax character.”

However, the Court also pointed out that another regulation (the “Regulation”) governs the tax treatment of the economic benefits flowing from a split-dollar arrangement to an individual insured who is a shareholder of the corporation paying the premiums. In particular, the Regulation states that “the provision by a corporation to its shareholder pursuant to a split-dollar life insurance arrangement . . . of economic benefits . . . is treated as a distribution of property.” The Court noted that, by its terms, the Regulation applies to both compensatory and shareholder arrangements.[xiii]

The Court then observed that the split-dollar regulations make no specific reference to S corporations. It added that there was minimal case law concerning the interplay of Subchapter S and the split-dollar regulations, and that it was not aware of any case dealing with the application of the Regulation to the economic benefits provided to shareholder-employees pursuant to a compensatory arrangement.

Taxpayer’s Position

The thrust of Taxpayer’s argument was that the economic benefits provided under the split-dollar arrangement should be treated as a distribution of property by an S corporation to its shareholder, notwithstanding that they flowed from a compensatory arrangement.[xiv]

Taxpayer relied on the statement in the Regulation that the provision of economic benefits “by a corporation to its shareholder pursuant to a split-dollar life insurance arrangement . . . is treated as a distribution of property.” Thus, Taxpayer argued, the economic benefits should be treated as a “distribution of property” from Corp to Taxpayer.[xv]

Taxpayer also relied on the statutory provisions governing the tax treatment of S corporations,[xvi] arguing that they “prevent double taxation otherwise imposed pursuant to an interpretative regulation addressing split dollar life insurance premiums that have been paid by S corporations.”

An S corporation’s income and deductions, Taxpayer asserted, are passed through to its shareholders, each shareholder is taxed on their allocable share thereof, and each shareholder’s stock basis is adjusted upward accordingly. In this case, $100,000 of Corp’s income – an amount equal to the nondeductible premium payment – was taxed to Taxpayer. How, then, Taxpayer argued, could he be taxed “again” as to the increase in the cash value of the policy attributable to premium?

IRS’s Position

The IRS argued[xvii] that the economic benefits should be treated as wage income – rather than as a shareholder distribution – because Taxpayer received the life insurance coverage as part of a compensatory split-dollar arrangement. The IRS noted that such treatment would be uncontroversial if the recipient of the economic benefits were an ordinary employee, rather than an S corporation’s shareholder-employee. The distinction between Taxpayer’s different roles – employee and shareholder – was, therefore, key to the IRS’s position.

The IRS pointed only to the distinction between compensatory and shareholder arrangements. The IRS recognized that the Regulation applies to both compensatory and shareholder arrangements but concluded that it “does not mean that in any situation where a compensatory arrangement covers a shareholder, the taxpayer’s status as a shareholder trumps his status as an employee, causing the economic benefit to be treated as a distribution to a shareholder,” because “[s]uch an interpretation of the regulation would make no sense, as it would defeat the reason for distinguishing between a compensatory arrangement and a shareholder arrangement.”

The Regulation is Dispositive

The Court rejected the IRS’s argument.

According to the Court, it was not clear that treating all economic benefits to shareholders as distributions – even to those who were also employed by the corporation –would undermine the purpose of the split-dollar regulations.

The Court noted that the Tax Court had not addressed the Regulation. However, the Court also added that if the economic benefits to Taxpayer were properly treated as a distribution of property to a shareholder – rather than as compensation to an employee – then the Tax Court had erred.

The Court decided that the Regulation was dispositive, and thereby rendered irrelevant whether Taxpayer received the economic benefits through a compensatory or shareholder split-dollar arrangement. The Regulation treats economic benefits provided to a shareholder pursuant to any split-dollar arrangement as a distribution of property with respect to the shareholder’s stock. The Court stated that the inclusion in the Regulation of all arrangements described in the split-dollar rules, which include compensatory arrangements – made clear that when a shareholder-employee receives economic benefits pursuant to a compensatory split-dollar arrangement, those benefits are treated as a distribution of property, and are thus deemed to have been paid to the shareholder in their capacity as a shareholder.

The Court stated that its interpretation was further supported by the fact that the split-dollar rules state that the tax treatment of the economic benefits depends on the “relationship between the owner and the non-owner.” The IRS argued that this language showed that the tax treatment depended on the nature of the split-dollar arrangement—compensatory or shareholder—but the Court pointed out that if this were the controlling factor, the Regulation could have said so (it does not).

Thus, the Court found that the Tax Court had erred by relying on the compensatory nature of Taxpayer’s split-dollar arrangement to conclude that the economic benefits were not distributions of property to a shareholder. Where a shareholder receives economic benefits from a split-dollar arrangement, the Regulation requires that those benefits be treated as a distribution of property to a shareholder.

The Court reversed the Tax Court’s decision with respect to the tax treatment of the economic benefits flowing to Taxpayer from Corp’s payment of the $100,000 premium on Taxpayer’s life insurance policy and held, pursuant to the Regulation, that those economic benefits had to be treated as distributions of property by Corp to its shareholder. Because Corp was an S corporation, that meant that the deemed distribution would be at least partially exempt from tax.[xviii]


Are you kidding? Compensation is compensation, isn’t it? It is paid for services rendered or to be rendered by the recipient to the payor. Except, at least according to the Sixth Circuit, when it is paid as part of a split-dollar life insurance arrangement to a shareholder of the payor who is also employed by the payor?

It is a basic principle of taxation that the capacity in which an owner of a business entity deals with the entity determines the appropriate tax treatment of the transaction. Salary paid by a corporation to a shareholder-employee for services actually rendered to the corporation is taxed as compensation.[xix] Where the amount paid is excessive for the services provided, the excess may be treated as a distribution to the shareholder in respect of their stock in the corporation (a dividend), the premise being that no one would pay more for the services than they were actually worth. Case closed, right?

What if the compensation paid to the shareholder-employee had been below market? Would the benefits provided under what was conceded to be a compensatory split-dollar arrangement still be treated as a distribution rather than as additional compensation?

What about the IRS’s historical concern over S corporations that pay less than reasonable compensation to their shareholder-employees in order to reduce their employment tax liability?

In holding as it did, has the Court created a second class of stock issue where none would otherwise have existed? The constructive distribution to a shareholder-employee of an S corporation sets that individual apart from other shareholders of the employer-corporation who are not employed in the business. Might it be easier to find that “a principal purpose” of the split-dollar arrangement (a “commercial contractual agreement”) is to circumvent the one class of stock requirement?[xx]

The Court should have upheld the Tax Court’s decision. It should have recognized that the literal wording of the Regulation needs to be revised to comport with the intention and language of the split-dollar rules.

[i] Actual equity, restricted equity, phantom equity, equity appreciation, change-in-control, and other equity-flavored or profits-based incentive bonus arrangements are also not uncommon.

[ii] For example, a whole life policy. A permanent policy will generally include an investment or savings component, reflected as the so-called “cash value” of the policy, against which the owner of the policy may borrow, or which may be withdrawn, during the life of the insured. Compare this to term insurance, which promises only a death benefit if the insured dies within a specified number of years.

[iii] The person named as the policy owner is generally treated as the “owner” of the policy for purposes of these rules. Thus, if the insured is named as the owner, they will be treated as the owner for purposes of these rules. However, if the only benefit accorded the insured is current life insurance protection (the death proceeds; they have no access to the cash value of the policy), then the non-owner is treated as the owner.

[iv] Often a trust for the benefit of the employee’s family.

[v] The employer will not be entitled to a deduction where it is a beneficiary of the policy.

[vi] To the extent it was not taken into account in a prior year. In general, the cash value builds up tax-free within the policy when the premium exceeds the cost of the insurance.

[vii] Yes, pun intended.

[viii] As in the case of compensatory split-dollar, the premium would not be deductible by the corporation.

[ix] Depending upon the shareholder’s stock basis and the corporation’s AAA; the deemed distribution would be treated as a return of already-taxed income or as a return of capital.

[x] IRC Sec. 1366.

[xi] The deduction claimed on the corporate return reduced, dollar-for-dollar, the amount of profit allocated to the shareholder on their Sch. K-1.

[xii] The corporation was a beneficiary of the policy (IRC Sec. 264); moreover, under Sec. 83, the employee had not included the premium in income.

[xiii] Reg. Sec. 1.301-1(q)(1)(i).

[xiv] Yep. You heard right.

[xv] Reg. Sec. 1.301-1(q)(1)(i).

[xvi] IRC Sec. 1366 (pass-through of corporate income), 1367 (upward basis adjustment for pass-through of income and downward for distribution thereof), and 1368 (treatment of S corporation distribution that would otherwise be treated as a dividend – return of already-taxed income and basis).

[xvii] And the Tax Court concluded.

[xviii] See IRC Sec. 1368.

[xix] And may be deducted to the extent it was reasonable.

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


Ode to a Dividend

It sounds relatively simple:

A distribution of property made by a regular “C” corporation to an individual shareholder with respect to the corporation’s stock[i] (a) will be treated as a dividend[ii] to the extent it does not exceed the corporation’s earnings and profits; (b) any remaining portion of the distribution will be applied against, and will reduce, the shareholder’s adjusted basis for the stock, to the extent thereof – i.e., a tax-free return of the shareholder’s investment in the stock; and (c) any remaining portion of the distribution will be treated as capital gain from the sale or exchange of the stock.[iii]

Unfortunately for many taxpayers, establishing the proper tax treatment for a “dividend” distribution may be anything but simple,[iv] which may lead to adverse economic consequences. In most cases, the difficulty stems from the shareholder’s inability to establish the following elements:

  • the amount distributed by the corporation where the distribution is made in-kind rather than in cash – in other words, determining the “fair market value” of the property distributed;[v]
  • the “earnings and profits” of the corporation – basically, a running account that the corporation must maintain from its inception through the present, which indicates the net earnings of the corporation that are available for distribution to its shareholders; and
  • the shareholder’s holding period and adjusted basis for their shares of stock in the distributing corporation.[vi]

Stock Basis

The final item identified above – the shareholder’s basis for their stock – is generally not an issue for the shareholders of a closely held C corporation. In most cases, an individual made a contribution of cash to the capital of the corporation in exchange for stock in the corporation; in some cases, the individual purchased shares of stock from another shareholder. Unless the shareholder subsequently makes an additional capital contribution to the corporation (for example, pursuant to a capital call under a shareholders’ agreement),[vii] or unless the shareholder receives a distribution from the corporation that exceeds the shareholder’s share of the corporation’s earnings and profits, or unless the corporation redeems a significant portion of the shareholder’s stock (such that the shareholder experiences a substantial reduction in their equity interest relative to the other shareholders),[viii] the shareholder’s stock basis will be equal to the amount paid by them to acquire the stock, and will remain constant during the period they own the stock.[ix]

However, what if the shareholder’s capital contribution was made in-kind; for example, a contribution of real property or equipment, or of a contract or other intangible right? The amount of such contribution would be equal to the fair market value of the property; however, unless the transfer of the property was a taxable event to the contributing shareholder,[x] the shareholder’s basis for their stock in the corporation would be equal to their adjusted basis – i.e., their unrecovered investment – in the contributed property immediately before such contribution.[xi]

Alternatively, what if the shareholder made a transfer of cash to the corporation that was recorded by the corporation as a loan? What if the corporation never issued a promissory note to the shareholder or otherwise memorialized the terms of the loan (maturity, interest rate, collateral)? What if it never paid or accrued interest on the loan? Can the shareholder argue against the form of their “loan,” treating it, instead, as a capital contribution that would increase their stock basis?[xii]

The Taxpayer’s Burden

The taxpayer has the responsibility to substantiate the entries, deductions, and statements made on their tax returns. Thus, in the case of a “dividend” distribution by a closely-held corporation to an individual shareholder, the latter has the burden of proving the elements of the distribution,[xiii] described above, including that portion of the distribution that represents a nontaxable return of capital; in other words, the shareholder must be able to establish their adjusted basis for the stock on which the distribution is made.

In order to carry this burden, it is imperative that the taxpayer maintain accurate records to track the amount of their equity investment in the corporation. Where the stock was issued by the corporation in exchange for a contribution of cash, it would be very helpful to have a canceled check plus an executed capital contribution agreement, or corporate minutes accepting the contribution and authorizing the issuance of the stock. If the stock was received in exchange for an in-kind contribution of property in a non-taxable transaction, evidence of the taxpayer’s adjusted basis in the property is required; for example, the original receipt evidencing the taxpayer’s acquisition of the property, plus records of any subsequent adjustments, which may depend upon the nature of the property.[xiv] If the stock was purchased from another shareholder, the executed purchase and sale agreement, along with canceled checks or proof of satisfaction of any promissory note issued to the seller would be helpful.

Where a shareholder is unable to establish their basis for the stock – i.e., where the shareholder has failed to carry their burden of proof – the IRS will treat the shareholder as having a zero basis in such stock; consequently, the entire amount of the dividend distribution to the shareholder will be taxable,[xv] as one Taxpayer – who was already having a pretty bad day[xvi] – found to his detriment.

“Return-of-Capital” Defense

The Court of Appeals for the Ninth Circuit determined that a federal district court did not abuse its discretion in precluding Taxpayer’s “return-of-capital” defense. https://cdn.ca9.uscourts.gov/datastore/memoranda/2018/09/24/17-50091.pdf.

The Taxpayer was charged with tax evasion. As part of his defense, he tried to establish that there was no tax deficiency because the money removed from his corporation represented a return of capital, or stock basis.

The Court ruled that the district court “may preclude a defense theory where ‘the evidence, as described in the defendant’s offer of proof, is insufficient as a matter of law to support the proffered defense.’”

To establish a factual foundation for a “return-of-capital” theory, the Court stated, a taxpayer must show: “(1) a corporate distribution with respect to a corporation’s stock, (2) the absence of corporate earnings or profits, and (3) stock basis in excess of the value of the distribution.”

Taxpayer, the Court continued, failed to establish that his stock basis exceeded the value of the distributions. Taxpayer presented checks that purported to demonstrate the amount he paid to purchase the stock of Corp. He also provided a declaration stating that he transferred a deed of valuable property to Corp; despite being given the opportunity to do so, however, Taxpayer provided no evidence of the property’s value aside from his own estimate.

The government presented the declaration of a CPA involved in Corp’s bankruptcy proceedings who stated that “according to escrow documents,” the property Taxpayer transferred was assigned a value below that claimed by Taxpayer. It also presented a declaration that Taxpayer submitted in his divorce proceedings, in which Corp’s CPA stated the amount for which Corp had redeemed stock from Taxpayer, thereby reducing his basis. The government submitted the bank records for such payment.

The Court explained that Taxpayer had the burden to establish factual support for a finding that his stock basis exceeded the value of the distributions. Taxpayer’s testimony was insufficient to carry his burden. He did not provide evidentiary support for his valuation, nor evidence to rebut the documents establishing how much Corp paid Taxpayer for the redemption of stock.

Because the evidence did not establish that Taxpayer had a stock basis in Corp in excess of the value of the distributions, the Court decided that the district court did not abuse its discretion in finding that Taxpayer failed to establish a factual basis for a return-of-capital defense.

It Pays to Be Prepared[xvii]

A corporation’s distribution of a large dividend, or a shareholder’s sale of their stock for a price they “couldn’t refuse,” should represent a moment of affirmation of the shareholder’s investment or business decision-making.

Of course, the imposition of income taxes, and perhaps surtaxes, with respect to the amount received by the shareholder will tend to dampen the shareholder’s celebratory mood, but every shareholder/taxpayer expects to share some of their economic gains with the government in the form of taxes. Those who are well-advised will have accounted for this tax liability in planning for the welcomed economic event.

That being said, no taxpayer would willingly remit to the government more than what was properly owed. It is the taxpayer’s burden, however, to establish this amount by, among other things, establishing their basis in the stock that was sold or on which a corporate distribution was made.

Imagine a shareholder’s having to pay tax on dollars that actually represent a return of their capital investment – which should have been returned to them free of tax – simply because the shareholder was not prepared and unable to substantiate their basis in the stock. Talk about low-hanging fruit.


[i] In others words, it is made to the individual in their capacity as a shareholder.

[ii] Taxable at a federal rate of 20%, though the 3.8% surtax on net investment income may also apply.

[iii] Taxable at a federal rate of 23.8% if long-term capital gain. See EN ii.

[iv] In the case of a closely held corporation, shareholders must also be attuned to the risk of constructive dividends distributions.

[v] This is also key for the corporation, which will be treated as having sold the property distributed if the fair market value of the property exceeds its adjusted basis in the hands of the corporation.

[vi] Which will be important if the amount of the distribution exceeds the earnings and profits and the stock’s adjusted basis; will the resulting gain be long-term or short-term capital gain?

[vii] In the case of a closely held corporation, most “capital contributions” made after the initial funding of the corporation take the form of loans from the shareholders, especially when made disproportionately among the shareholders.

[viii] An “exchange” under IRC Sec. 302.

[ix] Compare to the stock basis of a shareholder of an S corporation; their basis is adjusted every year to reflect their allocable share of the corporation’s income, gain, deduction, and loss, as well as the amount of any distribution made to them. IRC Sec. 1367.

[x] IRC Sec. 1001. In which case, they would take the stock with a cost (i.e., fair market value) basis. IRC Sec. 1012.

[xi] IRC Sec 351 and Sec. 358. In this way, the shareholder’s deferred gain is preserved.

[xii] The short answer: No; which is not to say that taxpayers have not tried that argument.

[xiii] The corporation will have to issue a Form 1099-DIV but, in the case of a close corporation, the controlling shareholder may be hard-pressed to rely upon such information return without more.

[xiv]  For example, depreciation schedules.  If the stock was inherited, the fair market of the stock on the date of the decedent’s death will be necessary. Start with a copy of the estate tax return filed by the decedent’s estate, on IRS Form 706. The appraisal obtained in connection with the estate tax return, or a copy of the shareholders’ agreement that fixed the price for the buyout of the stock upon the death of a shareholder, would be helpful.

[xv] Albeit, presumably, at the rate applicable to capital gain.

[xvi] Crime shouldn’t pay.

[xvii] No, I am not thinking about the song from the “Lion King” movie made famous by Jeremy Irons in the role of Scar. I am thinking of the Boy Scout motto. Taxpayers and their advisers would do well to adopt this motto.

But I Don’t Want to Pay Any Taxes!

I was recently speaking to an older client who told me that he was contemplating the sale of a commercial rental property that he has owned for many years. The property was not used in his business, was unencumbered and, for all intents and purposes, his adjusted basis – i.e., his unrecovered investment – for the property was zero. The client was concerned about the amount of gain he would recognize on the sale, and the resulting income tax liability.

The gain would be treated as long-term capital gain, I told him, and neither he nor the property was located in a high-tax state. That didn’t alleviate his concern.

I then suggested that he consider a like-kind exchange, but he wasn’t interested in simply deferring the gain; in any case, he didn’t want another property to manage.

I asked if there was a pressing business reason for disposing of the property. When he asked why that was relevant, I replied that he may want to hold on to the property until he died, leaving the property to the beneficiaries of his estate. The property may be valued more “aggressively” than a liquid asset, I explained, and his beneficiaries would take the property with a basis step-up. “Death solves many problems,” I told him, jokingly. That didn’t go over too well.

Finally, I recalled that the client had a somewhat charitable bent, so I mentioned that he may want to consider a contribution to a public charity or to a charitable remainder trust. That seemed to pique his interest, so I explained the basics.

Then I asked him when he planned to list the property. “I already have a buyer,” he responded. Yes, I thought to myself, death solves many problems. After composing myself, I asked “What do you mean, you have a buyer? Have you agreed to a price? Do you have a contract? Are there any contingencies? . . . ”

“Stop with all the questions” – he interrupted me – “why does any of that matter?”

“Let me tell you about the ‘assignment of income doctrine’,” I replied.

Shortly after the above discussion with the client, I came across the decision described below; I forwarded a copy to the client, his accountant, and his real estate lawyer.

Sale of a Business

Target was a closely held foreign corporation in which Taxpayer and others owned stock. Buyer (an S corp.) was Target’s principal customer. Virtually all of Buyer’s stock was owned by an employee stock ownership plan (ESOP). Taxpayer and other Target shareholders were among the beneficiaries of the ESOP. Target and Buyer were also related through common management, with a majority of each corporation’s board of directors serving as directors for both corporations.

Buyer offered to acquire all of Target’s stock for bona fide business reasons. It was proposed that the stock acquisition would proceed in two steps.

First Step

Buyer would first purchase 6,100 Target shares (87% of the outstanding shares) from Taxpayer and the other Target shareholders. The proposed purchase price was $4,500 per share. The consideration to be paid by Buyer for this tranche would consist of cash and interest-bearing promissory notes.

Second Step

The second step involved the remaining 900 shares (13%) of Target’s outstanding stock.

In connection with Buyer’s acquisition of the 6,100 Target shares, Taxpayer agreed to donate 900 Target shares to Charity, an organization that was exempt from Federal income tax under Sec. 501(c)(3) of the Code, and that was treated as a public charity under Sec. 509(a) of the Code.[i] Buyer agreed to purchase each share tendered by Charity for $4,500 in cash.

Taxpayer agreed, after donating their shares to Charity, “to use all reasonable efforts” to cause Charity to tender the 900 shares to Buyer. If Taxpayer failed to persuade Charity to do this, it was expected that Buyer would use a “squeeze-out merger, a reverse stock split or such other action that will result in [Buyer] owning 100% of * * * [Target].” If Buyer failed to secure ownership of Charity’s shares within 60 days of acquiring the 6,100 shares, the entire acquisition would be unwound, and Buyer would return the 6,100 shares to the tendering Target shareholders.

The Appraisal

Because Buyer and Target were related parties, the ESOP – a tax-exempt qualified plan – believed that it was required to secure a fairness opinion to ensure that Buyer paid no more than “adequate consideration” for the Target stock. The ESOP trustee hired Appraiser to provide a fairness opinion supported by a valuation report.

In describing the proposed transaction, Appraiser expressed its understanding that Buyer would acquire 100% of Target’s stock “in two stages.” According to Appraiser, “The first stage” involved “the acquisition of 6,100 shares, or approximately 87.1%, of [Target’s] outstanding ordinary shares,” for cash and promissory notes. “Simultaneously with [Buyer’s] acquisition of the 6,100 shares,” Appraiser stated, “certain of [Target’s] shareholders will transfer 900 shares” to Charity. “The second stage of the [transaction] involves the acquisition of the Charity shares for $4,500 per share.”

Appraiser concluded that the fair market value of Target, “valued on a going concern basis,” was between $4,214 and $4,626 per share. Appraiser submitted its findings to the ESOP trustee in an appraisal report and a fairness opinion. Given the range of value it determined for Target, Appraiser opined that the proposed transaction was fair to the beneficiaries of Buyer’s ESOP.

The Sale and the Donation

Two days after Appraiser’s fairness opinion was issued, Buyer purchased 6,100 shares of Target stock from Taxpayer and the other Target shareholders.

It was unclear when Taxpayer donated their 900 shares to Charity; Taxpayer asserted that the donation occurred almost a week before the fairness opinion, whereas the IRS contended that it occurred no earlier than the day of the fairness opinion, allegedly after Charity had unconditionally agreed to sell the 900 shares to Buyer.

Both parties agreed that Charity formally tendered its 900 shares to Buyer on the same day on which the other Target shareholders tendered their shares. And the parties also agreed that Charity received the same per-share price that the other Target shareholders received, but that Charity was paid entirely in cash.

Off to Court

Taxpayer filed Form 1040, U.S. Individual Income Tax Return, for the year of the sale, and claimed a noncash charitable contribution deduction for the stock donated to Charity.

The IRS examined Taxpayer’s return and subsequently issued a notice of deficiency to Taxpayer determining that they were liable for tax under the “anticipatory assignment of income doctrine” on their transfer of shares to Charity; in other words, Taxpayer should have reported the gain from the sale of the 900 shares to Buyer and should be treated as having contributed to Charity the cash received in exchange for such shares.

Taxpayer timely petitioned the U.S. Tax Court for redetermination, and asked for summary judgement on the IRS’s application of the assignment of income doctrine to their donation of Target stock to Charity.

Assignment of Income

A longstanding principle of tax law is that income is taxed to the person who earns it. A taxpayer who is anticipating the receipt of income “cannot avoid taxation by entering into a contractual arrangement whereby that income is diverted to some other person.”

The Court noted that it had previously considered the assignment of income doctrine as it applied to charitable contributions. In the typical scenario, the Court explained, the taxpayer donates to a public charity stock that is about to be acquired by the issuing corporation through a redemption, or by another corporation through a merger or other form of acquisition.

In doing so, the taxpayer seeks to obtain a charitable deduction in an amount equal to the fair market value of the stock contributed, while avoiding recognition of the gain, and liability for the tax, resulting from the subsequent sale of the stock. The tax-exempt charity ends up with the proceeds from the sale, undiminished by taxes.


In determining whether the donating taxpayer has assigned income in these circumstances, one relevant question is whether the prospective sale of the donated stock is a mere expectation or a virtual certainty. “More than expectation or anticipation of income is required before the assignment of income doctrine applies,” the Court stated.

Another relevant question, the Court continued, is whether the charity is obligated, or can be compelled by one of the parties to the transaction, to surrender the donated shares to the acquirer.

Thus, the existence of an “understanding” among the parties, or the fact that the contribution and sale transactions occur simultaneously or according to prearranged steps, may be relevant in answering that question.

For example, a court will likely find there has been an assignment of income where stock was donated after a tender offer has effectively been completed and it is “most unlikely” that the offer would be rejected, or where stock is donated after the other shareholders have voted and taken steps to liquidate a corporation.

In contrast, there is probably no assignment of income where stock is transferred to a charity before the issuing corporation’s board has voted to redeem it.[ii]

No Summary Judgement

Based on the facts presented, the Court concluded that there existed genuine disputes of material fact that prevented the Court from summarily resolving the assignment of income issue.

Target and Buyer were related by common management, the interests of both companies seemed to have been aligned, and both apparently desired that the stock acquisition be completed. If so, these facts supported the conclusion that the acquisition was virtually certain to occur. In turn, this evidence would support the IRS’s contention that Charity agreed in advance to tender its shares to Buyer and that all the steps of the transaction were prearranged.

However, the parties also disputed the dates on which relevant events occurred. Taxpayer asserted that they transferred their shares to Charity one week before the sale and almost one week before the fairness opinion, and there appeared to have been documentary evidence arguably supporting that assertion. The IRS contended that Charity did not acquire ownership of its 900 shares until (at the earliest) the date of the fairness opinion, allegedly after Charity had unconditionally agreed to sell the 900 shares to Buyer. That contention derived some support from other documentary evidence, as well as from Appraiser’s description of the proposed transaction, which recited that Taxpayer would transfer 900 shares to Charity simultaneously with Buyer’s acquisition of the 6,100 shares.

There were also genuine disputes of material fact concerning the extent to which Charity, having received the 900 shares, was obligated to tender them to Buyer. Appraiser stated in its report that Taxpayer would use “all reasonable efforts to cause * * * [Charity] to agree to sell the shares to [Buyer].” The record included little evidence concerning Taxpayer’s ability to influence Charity’s actions or Charity’s negotiations with Buyer. The IRS contended that Charity had no meaningful discussions with Buyer, but was “simply informed by” Taxpayer that the 900 shares should be tendered at once. The Court pointed out that a trial would be necessary to determine whose version of the facts was correct.

One fact potentially relevant to this question, the Court noted, concerned Buyer’s fiduciary duties as a custodian of charitable assets. If Charity tendered its Target shares, it would immediately receive a significant amount of cash. If it refused to tender its shares and the entire transaction were scuttled, Charity would apparently be left holding a 13% minority interest in a closely held corporation.

In sum, viewing the facts and the inferences that might be drawn therefrom in the light most favorable to the IRS as the nonmoving party, the Court found that there existed genuine disputes of material fact that prevented summary judgement on the assignment of income issue.

Thus, the Court denied Taxpayer’s motion.


Insofar as charitable giving is concerned, there are generally three kinds of taxpayer-donors: (i) those who genuinely believe in the mission of a particular charity and seek to support it, (ii) those who support the charity, or charitable works generally, but who want to use their charitable gift to generate some private economic benefit,[iii] and (iii) those who are not necessarily charitably inclined but who do not want to see their wealth pass to the government.[iv]

Most donors fall into the first category. This is fortunate, in part because the tax benefit that the donation generates for the donor-taxpayer will not compensate the taxpayer for the “lost” economic value represented by the property donated – the gift is being made for the right reason.

That is not say that such donors do not engage in any tax planning with respect to their charitable giving; for example, a donor would generally be better off donating a low basis asset rather than an identical asset with a high basis.

In the case of the closely held business, the donor’s tax planning almost always implicates the assignment of income doctrine. After all, would an owner’s fellow shareholders willingly accept a charity into their fold as an owner? Would the charity accept equity in a closely held business in which it will hold a minority interest, where the interest cannot readily be sold, and which cannot compel cash distributions from the business? Each of these questions has to be answered in the negative.

It is a fact that most charities prefer donations of liquid assets. Under what circumstances, then, may a donation of an interest in a close business ever find its way into the hands of a charity?

In last week’s post[v], we saw how the “excess business holdings” and other rules operate to prevent a private foundation from holding equity in a closely held business. These rules do not apply to public charities, but that does not give such charities carte blanche, nor does it change their preference for gifts of cash or cash equivalents.

A charity will be most open to accepting a gift of an interest in a closely held business where the charity is “assured” that the interest will be redeemed by the business or sold to a third party for cash shortly thereafter.

Unfortunately for the donor-taxpayer, these are also the circumstances in which the IRS will raise the assignment of income doctrine in order to tax the donor-taxpayer on the gain recognized in the redemption or sale of the interest donated to the charity.

As illustrated by the decision discussed above, the application of the doctrine will often be a close call, especially for a business owner who is unaware of its existence.

[i] See last week’s post, for a brief discussion of the distinction between private foundations and public charities.

[ii] Toujours les “facts and circumstances.” Apologies to Napoleon and Patton.

[iii] For example, contributing property to a charitable remainder – split-interest – trust, generating an immediate tax deduction, having the trust sell the property without tax liability, then investing the entire proceeds to generate the cash flow necessary for paying out the annuity or unitrust amount.

[iv] The latter typically name a charity, any charity, as the beneficiary of last resort in the so-called “Armageddon clauses” of their wills and revocable trusts.

[v] But do you remember NYU Law School’s pasta business? Mueller’s anyone?

Many not-for-profit organizations are dependent, in no small part, upon the generosity of successful businesses and their owners. The latter are motivated by a number of factors; for some, this generosity is an expression of their gratitude to the community that enables them to thrive; for others, it is a desire to share their good fortune with those in need; a not insignificant number are driven by a desire for public recognition.[i]

Whatever the motivation of these business owners, the tax laws have long played an important role in encouraging certain types of behavior relating to the contribution of property to a charity, and in discouraging certain activities that have the potential to harm a charitable organization, or to distract the organization from its charitable mission.[ii]

These tax-related, “charitable behavior modification” rules are intended to be most keenly felt by so-called “private foundations” and by those who control them.

Historical Behavior Modification

A private foundation (“foundation”) is a kind of charitable organization that is not dependent upon the “general public” for financial support;[iii] rather, it is generally controlled by the individual who created the foundation and funds its operations.[iv]

In general, the foundation limits its charitable activities to making grants to those “public charities” selected by this founder or their family, in the amounts and at the times determined by these individuals.[v]

Thus, it may be presumed that the foundation’s behavior cannot be readily influenced by the public in most instances.[vi] It is for that reason that the Code limits the tax benefits allowable to a foundation and its supporters, and also seeks to regulate certain activities in which they may engage.

Reduced Income Tax Deduction

For example, the owner of a closely held business may donate shares of stock in the business (i.e., capital gain property) to their foundation, but the amount that they may deduct for purposes of determining their income tax liability is limited to their adjusted basis in the donated stock – not its fair market value at the time of the donation – and their deduction is capped at a lower percentage of their adjusted gross income [vii] than would a similar contribution to a public charity.[viii]

The reduced tax benefit for the donor reflects the illiquid nature of an interest in a closely held business – the foundation cannot simply sell it on a public market. The Code also seeks to prevent the donor-business owner from receiving a more favorable tax benefit without giving up de facto control over the donated business interest.

Excess Business Holdings

Similarly, a foundation is generally not permitted to hold more than twenty percent of the voting stock of a corporation,[ix] reduced by the percentage of the voting stock owned by all disqualified persons[x] with respect to the foundation.[xi] If a foundation violates this rule, it may be subject to an excise tax equal to ten percent of the fair market value of its holdings in the business in excess of the permitted amount.[xii]

This prevents a business owner from contributing stock in their corporation to a foundation, either during their life or at their death, and thereby avoiding or reducing federal estate and gift taxes while at the same time enabling their family to retain indirect control of the donated stock through the foundation.

Depending upon the size of the gift or bequest, the foundation may have between five and ten years to dispose of the stock.

Minimum Distribution

Finally, a foundation is required to distribute annually an amount equal to at least five percent of the fair market value of its assets.[xiii] This rule is aimed, in part, at preventing a business owner from contributing to a foundation, and a foundation from investing in, an interest in a close business that is illiquid and that may not produce current income. A foundation that violates this rule faces a penalty tax equal to thirty percent of the distribution shortfall.

BBA of 2018

The foregoing rules have governed the relationship between foundations and closely held businesses for almost fifty years. Then, on February 9, 2018, the Bipartisan Budget Act of 2018 (the “Act”) was signed into law, effective for taxable years beginning after December 31, 2017.[xiv]

According to the accompanying committee report,[xv] in recent years, a new type of philanthropy has combined “private sector entrepreneurship” with charitable giving; for example, through the donation of a private company’s entire after-tax profits to charity.[xvi]  The report goes on to state that it is appropriate “to encourage this form of philanthropy by eliminating certain legal impediments to its use, while also ensuring that private individuals cannot improperly benefit from charitable dollars.”

Therefore, the Act amended the Code[xvii] to permit a business owner to gift or bequeath an entire business to a foundation, provided that the after-tax profits of the business will be paid to the foundation and certain other requirements are satisfied, while also ensuring that the donor’s heirs cannot improperly benefit from the arrangement.

The new provision creates an exception to the excess business holdings rules for certain “philanthropic business holdings.” Specifically, the tax on excess business holdings will not apply with respect to the holdings of a foundation in any business enterprise that, for the taxable year, satisfies:

  • the “exclusive ownership” requirements;
  • the “all profits to charity” requirement; and
  • the “independent operation” requirements.

Exclusive Ownership

The exclusive ownership requirements are satisfied for a taxable year if:

  • all voting ownership interests[xviii] in the business enterprise[xix] are held by the foundation at all times during the taxable year; and
  • all the foundation’s ownership interests in the business enterprise were acquired by the foundation as gifts during the life of the donor, or as testamentary transfers at the donor’s demise, under the terms of the donor’s will or trust, as the case may be.[xx]

All Profits to Charity

The “all profits to charity” requirement is satisfied if the business enterprise, not later than 120 days after the close of the taxable year, distributes an amount equal to its net operating income for such taxable year to the foundation.

For this purpose, the net operating income of any business enterprise for any taxable year is an amount equal to the gross income of the business enterprise for the taxable year,[xxi] reduced by the sum of: (1) the deductions allowed for the taxable year that are directly connected with the production of the income; (2) the federal income tax imposed on the business enterprise for the taxable year;[xxii] and (3) an amount for a reasonable reserve[xxiii] for working capital and other business needs of the business enterprise.

Independent Operation

The independent operation requirements are met if, at all times during the taxable year, the following three requirements are satisfied:

  • First, no substantial contributor to the private foundation, or a family member of such a contributor, is a director, officer, trustee, manager, employee, or contractor of the business enterprise (or an individual having powers or responsibilities similar to any of the foregoing[xxiv]).
  • Second, at least a majority of the board of directors of the foundation are individuals who are not (1) directors or officers of the business enterprise, nor (2) members of the family of a substantial contributor to the foundation.
  • Third, there is no loan outstanding from the business enterprise to a substantial contributor to the foundation or a family member of such contributor.

What Does It Mean?

In light of the foregoing, a foundation may now be able to own all of the issued and outstanding stock[xxv] of a corporation that operates an active business.

The Act

Of course, in order to do so, the foundation and the business must satisfy the requirements described above, some of which need to be clarified by the government; even then, there are still many issues to consider.

Of the three requirements described, the most challenging may be the “independent operation” requirement. It is clearly aimed at ensuring that the foundation’s charitable mission is not compromised because its managers are also overseeing, and are distracted by, the operation of a business.

However, we are talking about a closely held business. How likely is it that the owner or their family will give up control of the foundation or of the business (at least while the owner is alive)? In most cases, it is likely that the owner will wait until their death, or the death of their surviving spouse, before giving up their entire ownership of the business.[xxvi]

Might an owner split up their business into separate businesses – for example, geographically or according to line of business – in anticipation of contributing one of them to a foundation? Should the government be allowed to aggregate these businesses in certain situations so as to avoid abuse of the new rule?

Other Foundation Rules

Assuming the requirements established by the Act are met, the foundation must still consider the various “behavior modification” rules.

The Act did not change the limited income tax deduction available to the business owner who contributes an interest in a closely held business to a foundation. It remains limited to the owner’s adjusted basis in the interest.

Where the business contributed is an S corporation, the corporation’s election to be treated as a small business corporation will not be affected, but the foundation will be subject to the unrelated business income tax on its allocable share (100%) of the S corporation’s taxable income.[xxvii]

If all of the interests in an LLC, treated as a partnership, are transferred to a foundation, the LLC will become a disregarded entity, and the foundation will be treated as engaging directly in the LLC’s business.[xxviii] Obviously, this will raise unrelated business income tax issues, but it may also jeopardize the foundation’s tax-exempt status if the business is substantial relative to the foundation’s charitable activities.

Speaking of taxes – parum pum – although any dividends distributed to the foundation by a wholly-owned business corporation will not be subject to income tax,[xxix] the excise tax on the foundation’s net investment income will continue to apply.[xxx]

In addition, the foundation will continue to be subject to the five-percent-minimum annual distribution requirement. Query how difficult (and expensive) it will be to determine the fair market value of the closely held business every year for this purpose.

And what if the business does not make a distribution to the foundation in a particular year; for example, where it sets aside “reasonable reserves” for a bona fide business purpose? How will the foundation generate the necessary liquidity? Will it be forced to borrow money?

If there is a prolonged period during which insufficient dividends are paid, will the foundation’s continuing ownership of the business represent a “jeopardy investment” – one that jeopardizes the carrying out of its exempt purposes – with respect to which the ten percent penalty tax should be imposed?[xxxi] Might the foundation be forced to sell the business at that point?[xxxii]

Along that same line of reasoning, what if the business requires a capital contribution? If the foundation is somehow able to make the necessary infusion of cash, will it have engaged in a non-charitable activity of a type with respect to which the twenty percent, so-called “taxable expenditure,” penalty should be imposed?[xxxiii]

That’s All Folks

Lots of questions. It’s early yet – we’ll see how it plays out. Frankly, I don’t get it.[xxxiv]

[i] By now, you are aware of one of the themes of this blog: A business should only undertake an activity because it makes business sense, not because of the tax result. The same applies to charitable giving: One should not make a charitable transfer because of an expected economic benefit, but because one believes in the charitable organization or activity.

[ii] See the General Explanation of the Tax Reform Act of 1969, prepared by the Staff of the Joint Committee on Internal Revenue Taxation, December 3, 1970 (Joint Committee Explanation), for a good review.

[iii] Compare the public charity, the revenues of which come, by and large, from the general public (as contributions or as fees for services), including other charities and government. IRC Sec. 509(a).

[iv] Whether directly or through their business.

[v] Rather than providing any charitable service, itself.

[vi] The public cannot tighten the proverbial “purse strings.”

[vii] 30% vs 20%. IRC Sec. 170(e)(1) and Sec. 170(b)(1).

[viii] Query whether an independent public charity would accept equity in a close corporation that could not be converted into cash or a cash equivalent.

Note that the Small Business Job Protection Act of 1996 amended the Code to allow charities to own shares of stock in an S corporation.

[ix] Profits interest in the case of a partnership.

[x] Among others, this includes substantial contributors to the foundation, foundation managers, family members of such individuals, and certain business entities controlled by such individuals. IRC Sec. 4946.

[xi] If the foundation and its disqualified persons together do not own more than 35% of the voting stock of an incorporated business enterprise, then the foundation may own up to 35% of the voting stock, reduced by the amount owned by its disqualified persons, provided no disqualified person has effective control of the corporation.

[xii] IRC Sec. 4943.

[xiii] Other than those assets which are used directly in carrying out the foundation’s exempt purpose. IRC Sec. 4942.

[xiv] P.L. 115-123.

[xv] S. Rept. 114-20

[xvi] Newman’s Own, anybody?

[xvii] IRC Sec. 4943(g).

[xviii] What about non-voting interests? What about the “all profits” requirement? The provision should have stated that all of the equity must be owned by the foundation.

[xix] A “business enterprise” does not include a business that is functionally related to the foundation’s exempt activities, or a trade or business at least 95% of the gross income of which is derived from “passive sources.”

Might some donors with foresight be tempted to split up their business so as to satisfy the exclusive ownership interest as to those segments of the business intended for the foundation?

[xx] It appears that the donor cannot transfer some of the equity as a lifetime gift and the balance at their death. Presumably, the business may redeem a portion of the donor’s equity from their estate (thereby providing the estate with liquidity to pay taxes or make other testamentary transfers), and passing the remaining equity to a foundation.

[xxi] Including any investment income.

[xxii] Of course, the business remains subject to federal income tax. Moreover, if the foundation were to liquidate the business, such liquidation would be a taxable event under regulations issued under IRC Sec. 337.

[xxiii] Query what constitutes a “reasonable” reserve.

[xxiv] Query whether, in the case of a N.Y. membership corporation, this would cover a member of the foundation.

[xxv] Voting and non-voting.

[xxvi] For example, the owner may establish a QTIP trust for the benefit of the spouse, with the remainder passing to the foundation at the death of the spouse.

[xxvii] IRC Sec. 512(e). The gain from the sale of the S corporation stock will also be taxable.

[xxviii] IRC Sec. 512(c).

[xxix] IRC Sec. 512(b).

[xxx] IRC Sec. 4940.

[xxxi] IRC Sec, 4944.

[xxxii] If the foundation accepts a discounted price – a “fire sale” – will the state’s attorney general be knocking on the foundation’s door shortly thereafter?

[xxxiii] IRC Sec. 4945.

[xxxiv] Well, I guess I do. The Act was intended to benefit one taxpayer: Newman’s Own. Hell of a way to legislate. Just as bad as enacting provisions that are scheduled to expire only a few years later. I’ll get off my soapbox now.

“Life” Goes On

In light of all the attention given to the reams of regulations recently proposed under the Tax Cuts and Jobs Act (“TCJA”), some people may be joking that tax advisers must have stopped counseling clients on more “mundane” business matters in order to dedicate themselves to the new rules. If these jokesters only realized how lengthy and convoluted these new rules actually are, they would quickly recognize that this was no laughing matter.

That being said, allow me to assure you that we have not suspended our efforts on behalf of our clients. Speaking for myself, I continue to see a steady flow, and a wide variety, of business-related tax issues that have no connection to the TCJA or its regulations, including a number that involve that bane of so many failing businesses: the failure to pay employment taxes – which is why the decision described below caught my attention.

“I Trusted You”

The IRS notified LLC that it had failed to pay employment taxes for the three preceding tax years. Shortly thereafter, LLC remitted payment for the unpaid taxes, along with the penalties and interest accrued thereon.

LLC then conducted an internal investigation into the matter, and found that its operations manager during the relevant time period (“Manager”) had failed to pay LLC’s taxes. Manager’s duties included ensuring that LLC filed its tax returns and paid its employment taxes. Unfortunately, Manager proved to be untrustworthy – they missed filing deadlines and did not inform LLC’s owner of the numerous IRS delinquency notices received. In addition, Manager began settlement negotiations with the IRS without LLC’s knowledge, let alone its approval.

The Refund Claim

After discovering the cause of its delinquent taxes, LLC sought a refund of the penalties and related interest it had paid.

LLC claimed that these penalties and interest should be abated because it had reasonable cause for its late payment of the taxes, citing Manager’s actions. LLC also claimed that its outside CPA had assured it that LLC had paid its taxes in a timely manner. The CPA, however, did not verify that the taxes were actually paid, but instead relied on Manager’s representations that they were paid.

The IRS denied the refund claim, and LLC subsequently filed a suit against the IRS, in Federal district court, to compel the sought-after refund. LLC argued that Manager’s “profound misconduct,” coupled with the concealment of that wrongdoing, prevented LLC from discovering the delinquency and timely fulfilling its tax obligations.[I]

The IRS filed a motion to dismiss, arguing that LLC had failed to establish the requisite reasonable cause. The IRS argued that a taxpayer’s duty to file its returns and pay its employment taxes was non-delegable and, therefore, could not be excused by an agent’s (i.e., Manager’s) misconduct.

The district court dismissed LLC’s case, and ruled in favor of the IRS. The court held that “[LLC] had an obligation to timely remit employment taxes. [LLC’s] reliance on its agents—an employee and an outside CPA—cannot constitute reasonable cause for its failure to remit those taxes.” LLC appealed to the U.S. Court of Appeals for the Eighth Circuit.

The Courts of Appeals

Once again, LLC argued that its failures to file timely tax returns and timely pay its employment taxes were excusable, relying on Manager’s malfeasance.[ii]

The Court disagreed, stating that “[t]he facts, whether considered singularly or together, do not excuse [LLC’s] tax law compliance failures” and did “not support a finding of reasonable cause.”

Reasonable Cause

The Court explained that the Code imposes penalties on those who fail to timely pay certain federal taxes, including employment taxes. An employer is required to withhold these taxes, place them into a trust fund, and report on a quarterly basis. Failure to do so subjects the taxpayer to penalties. “To escape the penalties,” the Court continued, “the taxpayer bears the heavy burden of proving both (1) that the failure did not result from willful neglect, and (2) that the failure was due to reasonable cause.”

Though the terms “willful neglect” and “reasonable cause” are not defined by the Code, an IRS regulation provides:

[i]f the taxpayer exercised ordinary business care and prudence and was nevertheless unable to file the return within the prescribed time, then the delay is due to a reasonable cause. A failure to pay will be considered to be due to reasonable cause to the extent that the taxpayer has made a satisfactory showing that he exercised ordinary business care and prudence in providing for payment of his tax liability and was nevertheless . . . unable to pay the tax . . . .

Self-Assessment and Delegation

The Court reviewed a number of decisions that recognized the importance of deadlines to the administration of the tax system, and which held that the payment of taxes was a non-delegable duty, and that an agent’s failure to act as expected did not absolve the principal of that duty.

The IRS has millions of taxpayers to monitor, the Court observed, and our system of self-assessment, in the initial calculation of a tax, “cannot work on any basis other than one of strict filing deadlines and standards.” Similarly, the prompt payment of taxes “is imperative to the government, which should not have to assume the burden of unnecessary ad hoc determinations.”

According to the Court, “Congress intended to place upon the taxpayer an obligation to ascertain the statutory filing and payment deadlines and then to meet those deadlines, except in a very narrow range of situations.”

When a taxpayer seeks the advice of a professional, the Court stated, the taxpayer may demonstrate an exercise of the “ordinary business care and prudence” prescribed by the regulations, “but that does not provide an answer to the question we face here.” To say that it was “reasonable” for the taxpayer to assume that the professional would comply with the statute may resolve the matter as between them, but not with respect to the taxpayer’s obligations under the Code. Congress has charged the taxpayer with “an unambiguous, precisely defined duty” to file a return and to pay the tax by a certain date. That a professional, as the taxpayer’s agent, was expected to attend to the matter does not relieve the principal of their duty to comply with the Code.

Technical Advice?

In so holding, the Court clearly distinguished between a taxpayer’s relying on an agent for professional legal advice and the taxpayer’s relying on an agent for non-technical, non-specialized matters:

When an accountant or attorney advises a taxpayer on a matter of tax law, such as whether a liability exists, it is reasonable for the taxpayer to rely on that advice. Most taxpayers are not competent to discern error in the substantive advice of an accountant or attorney. To require the taxpayer to challenge the attorney, to seek a “second opinion,” or to try to monitor counsel on the provisions of the Code himself would nullify the very purpose of seeking the advice of a presumed expert in the first place. “Ordinary business care and prudence” do not demand such actions.

By contrast, one does not have to be a tax expert to know that tax returns have fixed filing dates and that taxes must be paid when they are due. Reliance by a lay person on a professional “cannot function as a substitute for compliance with an unambiguous statute.” Such reliance is not “reasonable cause” for a late filing or payment, the Court stated.


However, the Court also recognized that a taxpayer’s “disability” could provide reasonable cause for failure to meet a tax obligation:

The administrative regulations and practices exempt late filings from the penalty when the tardiness results from postal delays, illness, and other factors largely beyond the taxpayer’s control. . . . This principle might well cover a filing default by a taxpayer who relied on an attorney or accountant because the taxpayer was, for some reason, incapable by objective standards of meeting the criteria of “ordinary business care and prudence.” In that situation, however, the disability alone could well be an acceptable excuse for a late filing.

But the present case, the Court noted, did not involve the effect of a taxpayer’s “disability”; rather, it involved the effect of a taxpayer’s reliance on an agent employed by the taxpayer.

Case Law Defines “Disability”

In contrast, and by way of illustration, the Court described a case in which a company’s failure to file its taxes was excused by the fact that its principal decision-makers with regard to financial and tax matters were embezzling from the company.

The company had challenged penalties it was assessed for non-payment of taxes as a result of embezzlement committed by its CEO and its CFO. The government attempted to hold the company responsible under a strict “vicarious liability” theory.[iii]

The court acknowledged that a taxpayer’s duty to file its taxes is non-delegable, but it held that the officers’ criminal conduct divested them of their apparent authority on tax matters, rendering a vicarious liability theory inappropriate.

Significantly, however, the Court explained that this did not end the inquiry, because “[i]f a corporation has lax internal controls or fails to secure competent external auditors to ensure the filing of timely tax returns and deposit and payment of taxes, it fails to show reasonable cause or absence of willful neglect and is itself liable for statutory penalties, notwithstanding its lack of vicarious liability for the criminal actions of its agents.”

The Court then described another case, in which a business’s office manager/controller failed to ensure that the company timely fulfilled its employment tax filing and payment obligations over a period of years. When the manager received IRS notices of late penalty fees, neither the company’s officers nor its accountants were aware of the assessments because manager intercepted and screened the mail. Additionally, manager altered check descriptions and the quarterly reports when the assessments were later paid – the alterations made it appear that the tax payments were solely for the current period. The manager also concealed the deficiencies by personally undertaking the performance of all payroll function, and telling payroll clerks not to prepare the tax deposit checks anymore.

Even though the wrongdoing was all manager’s, the court noted that manager had only limited power in conducting their duties; importantly, to issue a payroll tax check, manager either had to have it signed by the company’s president and majority shareholder, or sign it themselves with a countersignature from the company’s corporate secretary.

The company only became aware of the delinquency after manager’s sudden resignation. After paying the penalty, the company filed suit seeking a refund on the basis that its manager’s “intentional misconduct disabled it from adhering timely to its tax obligation.”

However, the court explained that a corporate agent’s failure to act as they were supposed to only excuses the corporation’s failure to pay if the company “can show that it was disabled from complying timely.” It rejected the claim that manager’s actions disabled the company. The court held that manager’s “deficient and improper conduct was not largely beyond [company’s] control” because manager was subject to the supervision of both the owners and the company’s outside accountants. The court therefore held that there was no reasonable cause for company’s delinquency.


Applying the foregoing cases to the instant facts, the Court concluded that an agent’s failure to fulfill their duty to their principal to file tax returns and make payments on behalf of the principal does not constitute reasonable cause for the principal’s failure to comply with its tax obligations, unless that failure actually rendered the principal “disabled” with regard to its tax obligations.

The Court also concluded that establishing “disability” is a high bar that is not satisfied if the delinquent[iv] agent is subject to the control of their principal, whether that principal sufficiently exercised that control or not.

Though LLC argued that Manager’s dishonesty “incapacitated” LLC and rendered it unable to file its tax returns and pay taxes due, the Court found that Manager worked within a corporate structure in which they fell under the supervision of at least one person – the company’s owner.

Therefore, LLC was not disabled, and even if it was, its disability was not brought about by circumstances beyond its control. As such, Manager’s actions did not constitute reasonable cause.

Based on its conclusion that Manager’s actions did not constitute reasonable cause for LLC’s compliance, the Court rejected LLC’s argument that the district court erred by dismissing the case.[v]


The foregoing discussion considered the imposition of penalties on an employer-business for its failure to remit employment taxes notwithstanding that such delinquency was attributable to a “responsible” employee’s dishonesty.

Switching gears, how does the foregoing discussion affect the analysis of a principal’s “responsible person” status under the Code? Does the Court’s holding preclude any argument that an owner of a business may avoid such status if they have delegated their authority to an officer-level employee? Or does it limit this defense to situations in which the errant employee has “disabled” the business for tax purposes?

The Code provides that any person required to collect, truthfully account for, and pay over employment tax, who willfully fails to collect such tax, or truthfully account for and pay over such tax, or willfully attempts in any manner to evade or defeat any such tax or the payment thereof, shall be liable to a penalty equal to the total amount of the tax evaded, or not collected, or not accounted for and paid over.[vi]

In general, an individual cannot escape responsible person status simply by delegating most of their authority over the taxes and finances of the business to a key employee. The result may be different, however, where the following criteria are met: the individual is the equivalent of a limited partner – with no legal authority over such matters – or has contractually released any such authority, and can establish that they have not actually exercised such authority.[vii] In other words, where they have intentionally and legally “disabled” themselves.[viii]

Of course, the facts and circumstances of each situation are relatively unique, and it will be rare to encounter a closely held business in which each of the above criteria are satisfied by every owner. Someone will be held accountable, whether they are thrown under the proverbial bus or otherwise.

[I] LLC also asserted that its reliance on an outside CPA for “tax advice” excused its late payment and filing.

[ii] LLC also claimed that it had relied on its outside CPA to confirm that all employment taxes were being paid and all returns were being filed.

[iii] This is a form of secondary liability that arises under the common law doctrine of agency and which makes the principal responsible for the acts of their agent.

[iv] Hope you’re picking up on some of the puns here.

[v] LLC’s reliance on its outside CPA’s statements was also not a basis for relief. The information sought from the outside CPA was not advice about a complicated matter that required tax expertise, but instead a factual question as to whether LLC’s taxes had been filed and paid. LLC made no allegation that the accountant provided any information to LLC other than that the ministerial act of filing and paying taxes had been accomplished.

Although advice from a tax professional can, in some circumstances, provide a basis for reasonable cause for the nonpayment of taxes, LLC could not claim reliance on expertise of that sort. LLC relied on a mere factual representation by its CPAs that could have been readily verified or disproven; LLC did not rely on expert advice.

[vi] IRC Sec 6672.

[vii] Ah yes, proving a negative.

[viii] As distinguished from having stuck their head in the sand.

I realize that the last post began with “This is the fourth and final in a series of posts reviewing the recently proposed regulations (‘PR’) under Sec. 199A of the Code” – strictly speaking, it was. Yes, I know that the title of this post begins with “The Section 199A Deduction.” Its emphasis, however, is not upon the proposed regulations, as such; rather, today’s post will consider whether the recently enacted deduction, and the regulations proposed thereunder last month, will play a role in determining a taxpayer’s net economic gain from the sale of the taxpayer’s business.

 It has often been stated in this blog that the less a seller pays in taxes as a result of selling their business – or, stated differently, the more that a seller can reduce their resulting tax liability – the greater will be the seller’s economic return on the sale.[i]

 M&A and the TCJA – In General

The Tax Cuts and Jobs Act (“TCJA”)[ii] included a number of provisions that will likely have an impact upon the purchase and sale a business. Among these are the following:

  • the reduced C corporation income tax rate,
  • the exclusion of self-created intangibles from the definition of “capital asset,”
  • the elimination of the 20-year carryforward period for NOLs,
  • the limitation on a buyer’s ability to deduct the interest on indebtedness incurred to acquire a target company, and
  • the extension of the first-year bonus depreciation deduction to “used” property.

Code Section 199A

As we have seen over the last couple of weeks, Sec. 199A generally allows a non-corporate taxpayer a deduction for a taxable year equal to 20% of the taxpayer’s qualified business income (“QBI”) with respect to a qualified trade or business (“QTB”) for such taxable year.

The QBI of a QTB means, for any taxable year, the net income with respect to such trade or business of the taxpayer for the year, provided it is effectively connected with the conduct of a trade or business in the U.S.

Investment income is not included in determining QBI. Thus, if a taxpayer’s rental activity with respect to a real property owned by the taxpayer does not rise to the level of a trade or business, the taxpayer’s rental income therefrom will be treated as investment income and will not be treated as QBI.

In addition, the trade or business of performing services as an employee is not treated as a QTB; thus, the taxpayer’s compensation in exchange for such services is not QBI.


If an individual taxpayer-owner’s taxable income for a taxable year exceeds a threshold amount, a special limitation will apply to limit that individual’s Section 199A deduction. Assuming the limitation rule is fully applicable[iii], the amount of the Section 199A deduction may not exceed the greater of:

  • 50% of the W-2 wages with respect to the QTB that are allocable to QBI, or
  • 25% of such W-2 wages, plus 2.50% of the “unadjusted basis” (“UB”)[iv] of all depreciable tangible property held by the QTB at the close of the taxable year, which is used at any point in the year in the production of QBI, and the depreciable period for which has not ended before the close of the taxable year (“qualified property”).

In addition, the amount of a taxpayer’s Section 199A deduction for a taxable year, determined under the foregoing rules, may not exceed 20% of the excess of:

  1. the taxpayer’s taxable income for the taxable year, over
  2. the taxpayer’s net capital gain for such year.

Pass-Through Entities

If the non-corporate taxpayer carries on the QTB indirectly, through a partnership or S corporation (a pass-through entity, or “PTE”), the Section 199A rules are applied at the partner or shareholder level, with each partner or shareholder taking into account their allocable share of the PTE’s QBI, as well as their allocable share of the PTE’s W-2 wages and UB (for purposes of applying the above limitations).

Because some individual owners of a PTE may have personal taxable income at a level that triggers application of the above limitations, while others may not, it is possible for some owners of a QTB to enjoy a smaller Section 199A deduction than other owners of the same QTB, even where they have the same percentage equity interest in the QTB (or in the PTE that holds the business). Stated differently, one taxpayer may have a different after-tax outcome with respect to the QBI allocated to them than would another taxpayer to whom the same amount of QBI is allocated, notwithstanding that they may have identical tax attributes[v] and have identical levels of participation in the conduct of the QTB.

Income or Gain from the Sale of a PTE’s Business

Although the sale of a business may be effected through various means as a matter of state law[vi], there are basically two kinds of sale transactions for tax purposes:

  1. the owners’ sale of their stock or partnership interests (“equity”) in the PTE that owns the business, and
  2. the sale by such PTE of the assets it uses to conduct the business, which is typically followed by the liquidation of such entity.

The character of the gain realized on the sale – i.e., capital or ordinary – will depend, in part, upon whether the PTE is an S corporation or a partnership, and whether the sale is treated as a sale of equity or a sale of assets.

Sale of Assets

If the PTE sells its assets, or is treated as selling its assets[vii], the nature and amount of the gain realized on the sale will depend upon the kind of assets being sold and the allocation of the purchase price among those assets. After all, the character of any item of income or gain included in a partner’s or a shareholder’s allocable share of partnership or S corporation income is determined as if it were realized directly from the source from which realized by the PTE, or incurred in the same manner as incurred by the PTE.[viii]

Thus, any income realized on the sale of accounts receivable or inventory will be treated as ordinary income.

The gain realized on the sale of property used in the trade or business, of a character that may be depreciable, or on the sale of real property used in the trade or business, is generally treated as capital gain.[ix]

However, some of the gain realized on the sale of property in respect of which the seller has claimed accelerated depreciation will be “recaptured” (to the extent of such depreciation) and treated as ordinary income.[x]

Sale of Equity

If the shareholders of an S corporation sell their shares of stock in the corporation, the gain realized will be treated as gain from the sale of a capital asset.[xi]

When the partners of a partnership sell their partnership interests, the gain will generally be treated as capital gain from the sale of a capital asset, except to the extent that the purchase price for such interests is attributable to the unrealized receivables or inventory items (so-called “hot assets”) of the partnership, in which case part of the gain will be treated as ordinary.[xii]

Related Transactions

Aside from the sale of the business, the former owners of a PTE may also engage in other, closely-related, transactions with the buyer.

For example, one or more of the former owners may become employees of, or consultants to, the buyer; in that case, the consideration paid to them will be treated as compensation received in exchange for services.
One of more of the former owners may enter into non-competition agreements with the buyer; the consideration received in exchange may be characterized as compensation for “negative” services.

If one or more of the former owners continue to own the real property on which the business will be operated, they may enter into lease arrangements with the buyer that provide for the payment of rental income.

Tax Rates

If any of the gain from the sale of the PTE’s business is treated as capital gain, each individual owner will be taxed on their allocable share thereof at the federal capital gain rate of 20%.

If any of such gain is treated as ordinary income, each individual owner will be subject to federal income tax on their allocable share thereof at the ordinary income rate of 37%.

If an owner did not materially participate in the business, the 3.8% federal surtax on net investment income may also be applicable to their allocable share of the above gain and ordinary income.[xiii]

Of course, any compensation for services (or “non-services”) would be taxable as ordinary income, and would be subject to employment taxes.

Any rental income would also be subject to tax as ordinary income, and may also be subject to the 3.8% surtax.[xiv]

Based on the foregoing, one may conclude, generally, that it would be in the best interest of the PTE’s owners to minimize the amount of ordinary income, and to maximize the amount of capital gain, to be realized on the sale of the PTE’s business.[xv]

Of course, the selling PTE and its owners cannot unilaterally, or even reasonably expect to, direct this result. The buyer has its own preferences and imperatives[xvi]; moreover, one simply cannot avoid ordinary income treatment in many circumstances.

Enter Section 199A

No, not astride a horse, but on tip toes, wearing sneakers.[xvii]

The tax treatment of M&A transactions was certainly not what Congress was focused on when Section 199A was conceived. PTEs already enjoyed a significant advantage in the taxation of M&A transactions in that capital gains are taxed to the individual owners of a PTE at a very favorable federal rate of 20%.

Rather, Congress sought to provide a tax benefit to the individual owners of PTEs in response to complaints from the PTE community that the tax bill which eventually became the TCJA was heavily biased in favor of C corporations, especially with the reduction in the federal corporate income tax rate from a maximum graduated rate of 35% to a flat rate of 21%.

It order to redress the perceived unfairness, Congress gave individual business owners the Section 199A deduction as a way to reduce their tax liability with respect to the ordinary net operating income of their PTEs.

Sale of a Business

This is borne out by the exclusion from the definition of QBI of dividends and interest, and by the exclusion of capital gains[xviii], regardless of whether such gains arise from the sale of a capital asset; thus, the capital gain from the sale of a property used in the PTE’s trade or business, and of a character which is subject to the allowance for depreciation, is excluded from QBI.

Does that mean that Section 199A has no role to play in the taxation of M&A transactions? Not quite.

Simply put, a number of the business assets disposed of as part of an M&A transaction represent items of ordinary income that would have been realized by the business and its owners in the ordinary course of business had the business not been sold; the sale of these assets accelerates recognition of this ordinary income.

Ordinary Income Items

For example, the ordinary income realized on the sale, or deemed sale[xix], of accounts receivable and inventory by a PTE as part of an M&A deal should qualify as QBI, and should be taken into account in determining the Section 199A deduction for the individual owners of the PTE.

Unfortunately, neither the Code nor the proposed regulations explicitly state that this is the case, though the latter clearly provide that any ordinary income arising from the disposition of a partnership interest that is attributable to the partnership’s hot assets – i.e., inventory and unrealized receivables – will be considered attributable to the trade or business conducted by the partnership and taken into account for purposes of computing QBI.[xx]

Of course, the partnership rules[xxi] define the term “unrealized receivables” expansively, so they include other items in addition to receivables; for example, the ordinary income – i.e., depreciation recapture – realized on the sale of tangible personal property used in the business, the cost of which has been depreciated on an accelerated basis, or for which a bonus depreciation deduction or Section 179 deduction has been claimed.

In light of the foregoing, the same result should obtain where the inventories and receivables are sold as part of an actual or deemed asset sale, though the proposed regulations do not speak directly to this situation. These assets are not of a kind that appreciate in value, or that generate income, as in the case of investment property. Rather, they represent “ordinary income in-waiting” and should be treated as QBI.

Similarly in the case of tangible personal property used in a business and subject to an allowance for depreciation; taxpayers are allowed to recover the cost of acquiring such assets on an accelerated basis so as to reduce the net cost thereof, and thereby to incentivize taxpayers to make such investments.; i.e., they are allowed to reduce the ordinary income that otherwise would have been realized (and taxed) in the ordinary course of business. The “recapture” of this depreciation benefit upon the sale of such property should, likewise, be treated as QBI.


As stated above, a taxpayer’s QBI does not include any amount of compensation paid to the individual taxpayer in their capacity as an employee. In other words, if a former owner of the PTE-operated business is employed by the new owner of the business (for example, as an officer), the compensation paid to the former owner will not be treated as QBI.

If the former owner is not employed by the new owner, but is retained to provide other services as an independent contractor, the payments made to them in exchange for such services may constitute QBI, provided the service provider is properly characterized as a non-employee and the service is not a “specified service trade or business.”[xxii] Query whether the “consulting” services often provided by a former owner to the buyer are the equivalent of providing the kind of “advice and counsel” that the proposed regulations treat as a specified service trade or business, the income from which is not QBI.


As was mentioned above, it is not unusual for the owners of a PTE to sell their operating business while retaining ownership of the real property on which the business may continue to operate – hopefully, it has been residing in an entity separate from the one holding the business. Under these circumstances, the owners may ensure themselves of a continued stream of revenue, a portion of which may be sheltered by depreciation deductions.

Whether such rental activity will rise to the level of a trade or business for purposes of Section 199A will depend upon the facts and circumstances. However, if the property is wholly-occupied by one tenant – i.e., by the business that was sold, as is often the case – it is unlikely that the rental activity will represent a QTB and, so, the net rental income will not be QBI.

Don’t Forget the Limitations

Even assuming that a goodly portion of the income arising from the sale of a QTB will be treated as QBI, the individual taxpayer must bear in mind the “W-2-based” and “taxable-income-based” limitations described above.

This Time, I Promise

Well, that’s it for Section 199A – at least until the proposed regulations are finalized.

“I’m so glad we had this time together . . .”[xxiii] I know, “Lou, keep you day job.”

[i] The flip-side may be stated as follows: the faster a buyer can recover their investment – i.e., the purchase price – for the acquisition of a business, the greater is the buyer’s return on its investment in the business. See, e.g.

[ii] P.L. 115-97.

[iii] Meaning that the taxpayer’s taxable income for the taxable year exceeds the threshold amount ($315,000 in the case of married taxpayers filed jointly) plus a phase-in range (between the threshold amount and $415,000).

[iv] The term “UB” means the initial basis of the qualified property in the hands of the individual or PTE, depending upon whether it was purchased by or contributed to the PTE.

[v] Other than taxable income.

[vi] For example, a sale of assets may be accomplished through a merger of two business entities; a stock sale may be accomplished through a reverse subsidiary merger in which the target is the surviving entity.

[vii] In the case of an S corporation, where the shareholders make an election under Sec. 336(e), or where the shareholders and the buyer make a joint election under Sec. 338(h)(10), to treat the stock sale as a sale of assets by the corporation followed by the liquidation of the corporation.

In the case of a partnership, a buyer who acquires all of the partnership interests is treated, from the buyer’s perspective, as acquiring the assets of the partnership. Rev. Rul. 99-6.

[viii] Sec. 702 and Sec. 1366.

[ix] Sec. 1231. Specifically, if the “section 1231 gains” for a taxable year exceed the “section 1231 losses” for such year, such gains and losses shall be treated as long-term capital gains or losses, as the case may be.

[x] Sec. 1245.

[xi] Sec. 1221.

[xii] Sec. 741 and Sec. 751.

[xiii] Sec. 1411. The tax is imposed on the lesser of (a) the amount of the taxpayer’ net investment income for the taxable year, or (b) the excess of (i) the taxpayer’s modified adjusted gross income, over (ii) a threshold amount ($250,000 in the case of a married taxpayer filed a joint return).

[xiv] Assuming it is a passive activity. See Reg. Sec. 1.1411-5.

[xv] In the case of a PTE that is an S corporation that is subject to the built-in gains tax, the shareholders may also be interested in allocating consideration away from those corporate assets to which the tax would apply.

[xvi] See endnote “i”, supra.

[xvii] I wish I could recall the name of the presidential scholar who coined the phrase, that I am trying to paraphrase, to describe how presidents get things done. It may have been Prof. Richard Pious of Columbia University.

[xviii] Sec. 199A(c)(3)(B); Prop. Reg. Sec. 1.199A-3(b)(2).

[xix] For example, upon the filing of a Sec. 338(h)(10) election.

[xx] Prop. Reg. Sec. 1.199A-3(b).

[xxi] Sec. 751(c).

[xxii] Prop. Reg. Sec. 1.199A-5.

[xxiii] Remember Carol Burnett’s sign-off song?

This is the fourth[i] and final in a series of posts reviewing the recently proposed regulations (“PR”) under Sec. 199A of the Code. https://www.federalregister.gov/documents/2018/08/16/2018-17276/qualified-business-income-deduction/

Earlier posts considered the elements of a “qualified trade or business” under Section 199A https://www.taxlawforchb.com/2018/09/the-proposed-sec-199a-regs-are-here-part-one , the related issue of what constitutes a “specified service trade or business,” the owners of which may be denied the benefit of Section 199A, https://www.taxlawforchb.com/2018/09/the-proposed-sec-199a-regs-are-here-part-two/ , and the meaning of “qualified business income.” https://www.taxlawforchb.com/2018/09/the-proposed-sec-199a-regs-are-here-part-three/. Today, we turn to the calculation of the deduction, the limitations on the amount of the deduction, and some special rules.

 Threshold and Phase-In Amounts

Let’s assume for the moment that our taxpayer (“Taxpayer”) is a married individual, files a joint return with their spouse, and owns an equity interest in a qualified trade or business (“QTB”) that is conducted through a pass-through entity (“PTE”), such as a sole proprietorship,[ii] a partnership, or an S corporation.

At this point, Taxpayer must determine their joint taxable income for the taxable year.[iii]

There are three categories of taxpayers for purposes of Section 199A – those whose joint taxable income[iv]:

  • does not exceed $315,000 (the “threshold”),
  • exceeds $315,000 but does not exceed $415,000 (the “phase-in range”),[v] and
  • exceeds $415,000.[vi]




Below the Threshold

If Taxpayer falls within the first category – joint taxable income that does not exceed $315,000 – they determine their Section 199A deduction by first calculating 20% of their QBI with respect to their QTB (Taxpayer’s “combined QBI amount”).[vii] For this first category of taxpayer, their share of income from a specified service trade or business (“SSTB”) qualifies as QBI.

Taxpayer must then compare their

  • combined QBI amount (determined above) with
  • an amount equal to 20% of the excess of:
    • their taxable income for the taxable year, over
    • their net capital gain for the year.

The lesser of these two amounts is then compared to Taxpayer’s entire taxable income for the taxable year, reduced by their net capital gain. Taxpayer’s Section 199A deduction is equal to the lesser of these two amounts.

Thus, if Taxpayer’s only source of income was their QTB, Taxpayer would be entitled to claim the full “20% of QBI” deduction, with the result that their QBI would be subject to an effective top federal income tax rate of 29.6%[viii]

Above the Threshold and Phase-In

If Taxpayer falls within the third category – joint taxable income for the taxable year in excess of $415,000 – they face several additional hurdles in determining their Section 199A deduction.[ix] It is with respect to these taxpayers that the application of the Section 199A rules becomes even more challenging, both for the taxpayers and their advisers.

To start, no SSTB in which Taxpayer has an equity interest will qualify as a QTB as to Taxpayer.

Moreover, there are other limitations, in addition to the ones described above, that must be considered in determining the amount of Taxpayer’s Section 199A deduction.


Before turning to these limitations, it is important to note the following:

  • the application of the threshold and phase-in amounts is determined at the level of the individual owner of the QTB[x], which may not be where the trade or business is operated; and
  • taxpayers with identical interests in, and identical levels of activity with respect to, the same trade or business may be treated differently if one taxpayer has more taxable income from sources outside the trade or business than does the other;
    • for example, a senior partner of a law firm, who has had years to develop an income-producing investment portfolio, vs a junior partner at the same firm, whose share of partnership income represents their only source of income.[xi]


The additional limitations referred to above are applied in determining Taxpayer’s “combined QBI amount.”

Specifically, the amount equal to 20% of Taxpayer’s QBI with respect to the QTB must be compared to the greater of:

  • 50% of the “W-2 wages” with respect to the QTB, or
  • The sum of (i) 25% of the W-2 wages plus (ii) 2.5% of the unadjusted basis (“UB”) of qualified property immediately after the acquisition of all qualified property (“a” and “b” being the “alternative limitations”).

The lesser of Taxpayer’s “20% of QBI” figure and the above “W-2 wages-based” figure may be characterized as Taxpayer’s “tentative” Section 199A deduction; it is subject to being further reduced in accordance with the following caps:

  • The Section 199A deduction cannot be greater than 20% of the excess (if any) of:
    • Taxpayer’s taxable income for the taxable year, over
    • Taxpayer’s net capital gain for the year.
  • The resulting amount – i.e., the tentative deduction reduced in accordance with “a” – is then compared to Taxpayer’s entire taxable income for the taxable year, reduced by their net capital gain.

Taxpayer’s Section 199A deduction is equal to the lesser of the two amounts described in “b”, above.

Applied to Each QTB

Under the PR, an individual taxpayer must determine the W-2 wages and the UB of qualified property attributable to each QTB contributing to the individual’s combined QBI. The W-2 wages and the UB of qualified property amounts are compared to QBI in order to determine the individual’s QBI component for each QTB.

After determining the QBI for each QTB, the individual taxpayer must compare 20% of that trade or business’s QBI to the alternative limitations for that trade or business.

If 20% of the QBI of the trade or business is greater than the relevant alternative limitation, the QBI component is limited to the amount of the alternative limitation, and the deduction is reduced.

The PR also provide that, if an individual has QBI of less than zero (a loss) from one trade or business, but has overall QBI greater than zero when all of the individual’s trades or businesses are taken together, then the individual must offset the net income in each trade or business that produced net income with the net loss from each trade or business that produced net loss before the individual applies the limitations based on W-2 wages and UB of qualified property.

The individual must apportion the net loss among the trades or businesses with positive QBI in proportion to the relative amounts of QBI in such trades or businesses. Then, for purposes of applying the limitation based on W-2 wages and UB of qualified property, the net income with respect to each trade or business (as offset by the apportioned losses) is the taxpayer’s QBI with respect to that trade or business.

The W-2 wages and UB of qualified property from the trades or businesses which produced negative QBI for the taxable year are not carried over into the subsequent year.

W-2 Wages

The PR provide that, in determining W-2 wages, the common law employer (such as a PTE) may take into account any W-2 wages paid by another person – such as a professional employer organization – and reported by such other person on Forms W-2 with the reporting person as the employer listed on the Forms W-2, provided that the W-2 wages were paid to common law employees of the common law employer for employment by the latter.[xii]

Under this rule, persons who otherwise qualify for the deduction are not limited in applying the deduction merely because they use a third party payor to pay and report wages to their employees.

The W-2 wage limitation applies separately for each trade or business. Accordingly, the PR provides that, in the case of W-2 wages that are allocable to more than one trade or business, the portion of the W-2 wages allocable to each trade or business is determined to be in the same proportion to total W-2 wages as the ordinary business deductions associated with those wages are allocated among the particular trades or businesses.

W-2 wages must be properly allocable to QBI (rather than, for example, to activity that produces investment income). W-2 wages are properly allocable to QBI if the associated wage expense is taken into account in computing QBI.

Where the QTB is conducted by a PTE, a partner’s or a shareholder’s allocable share of wages must be determined in the same manner as their share of wage expenses.

Finally, the PR provide that, in the case of an acquisition or disposition of (i) a trade or business, (ii) the major portion of a trade or business, or (iii) the major portion of a separate unit of a trade or business, that causes more than one individual or entity to be an employer of the employees of the acquired or disposed of trade or business during the calendar year, the W-2 wages of the individual or entity for the calendar year of the acquisition or disposition are allocated between each individual or entity based on the period during which the employees of the acquired or disposed of trade or business were employed by the individual or entity.

 UB of Qualified Property

The PR provides that “qualified property” means (i) tangible property of a character subject to depreciation that is held by, and available for use in, a trade or business at the close of the taxable year, (ii) which is used in the production of QBI, and (iii) for which the depreciable period has not ended before the close of the taxable year.

“Depreciable period” means the period beginning on the date the property is first placed in service by the taxpayer and ending on the later of (a) the date 10 years after that date, or (b) the last day of the last full year in the applicable recovery period that would apply to the property without regard to whether any bonus depreciation was claimed with respect to the property. Thus, it is possible for a property to be treated as qualified property even where it is no longer being depreciated for tax purposes.

The term “UB” means the initial basis of the qualified property in the hands of the individual or PTE, depending upon whether it was purchased or contributed.

UB is determined without regard to any adjustments for any portion of the basis for which the taxpayer has elected to treat as an expense (for example, under Sec. 179 of the Code). Therefore, for purchased or produced qualified property, UB generally will be its cost as of the date the property is placed in service.

For qualified property contributed to a partnership in a “tax-free” exchange for a partnership interest and immediately placed in service, UB generally will be its basis in the hands of the contributing partner, and will not be changed by subsequent “elective” basis adjustments.

For qualified property contributed to an S corporation in a “tax-free” exchange for stock and immediately placed in service, UB generally will be its basis in the hands of the contributing shareholder.[xiii]

Further, for property inherited from a decedent and immediately placed in service by the heir, the UB generally will be its fair market value at the time of the decedent’s death.

In order to prevent trades or businesses from transferring or acquiring property at the end of the year merely to manipulate the UB of qualified property attributable to the trade or business, the PR provides that property is not qualified property if the property is acquired within 60 days of the end of the taxable year and disposed of within 120 days without having been used in a trade or business for at least 45 days prior to disposition, unless the taxpayer demonstrates that the principal purpose of the acquisition and disposition was a purpose other than increasing the deduction.

For purposes of determining the depreciable period of qualified property, the PR provide that, if a PTE acquires qualified property in a non-recognition exchange, the qualified property’s “placed-in-service” date is determined as follows: (i) for the portion of the transferee-PTE’s UB of the qualified property that does not exceed the transferor’s UB of such property, the date such portion was first placed in service by the transferee-PTE is the date on which the transferor first placed the qualified property in service; (ii) for the portion of the transferee’s UB of the qualified property that exceeds the transferor’s UB of such property, if any, such portion is treated as separate qualified property that the transferee first placed in service on the date of the transfer.

Thus, qualified property acquired in these non-recognition transactions will have two separate placed in service dates under the PR: for purposes of determining the UB of the property, the relevant placed in service date will be the date the acquired property is placed in service by the transferee-PTE (for instance, the date the partnership places in service property received as a capital contribution); for purposes of determining the depreciable period of the property, the relevant placed in service date generally will be the date the transferor first placed the property in service (for instance, the date the partner placed the property in service in their sole proprietorship).

The PR also provide guidance on the treatment of subsequent improvements to qualified property.[xiv]

Finally, in the case of a trade or business conducted by a PTE, the PR provide that, in the case of qualified property held by a PTE, each partner’s or shareholder’s share of the UB of qualified property is an amount that bears the same proportion to the total UB of qualified property as the partner’s or shareholder’s share of tax depreciation bears to the entity’s total tax depreciation attributable to the property for the year.[xv]

Computational Steps for PTEs

The PR also provide additional guidance on the determination of QBI for a QTB conducted by a PTE.

A PTE conducting an SSTB may not know whether the taxable income of any of its equity owners is below the threshold amount. However, the PTE is best positioned to make the determination as to whether its trade or business is an SSTB.

Therefore, reporting rules require each PTE to determine whether it conducts an SSTB, and to disclose that information to its partners, shareholders, or owners.

In addition, notwithstanding that PTEs cannot take the Section 199A deduction at the entity level, each PTE must determine and report the information necessary for its direct and indirect individual owners to determine their own Section 199A deduction.

Thus, the PR direct PTEs to determine what amounts and information to report to their owners and the IRS, including QBI, W-2 wages, and the UB of qualified property for each trade or business directly engaged in.

The PR also require each PTE to report this information on or with the Schedules K-1 issued to the owners. PTEs must report this information regardless of whether a taxpayer is below the threshold amount.

“That’s All Folks!”[xvi]

With the series of posts ending today, we’ve covered most aspects of the new Section 199A rule, as elaborated by the PR, though the following points are also worth mentioning:

  • the Section 199A deduction has no effect on the adjusted basis of a partner’s interest in a partnership;
  • the deduction has no effect on the adjusted basis of a shareholder’s stock in an S corporation or the S corporation’s accumulated adjustments account;
  • the deduction does not reduce (i) net earnings from self-employment for purposes of the employment tax (for example, a partner’s share of a partnership’s operating income), or (ii) net investment income for purposes of the surtax on net investment income (for example, a shareholder’s share of an S corporation’s business in which the shareholder does not materially participate); and
  • for purposes of determining an individual’s alternative minimum taxable income for a taxable year, the entire deduction is allowed, without adjustment.

Stay tuned. Although taxpayers may rely upon the PR, they are not yet final. A public hearing on the PR is scheduled for October 16; the Republicans recently proposed to make the deduction “permanent” (whatever that means); midterm elections are scheduled for November 6; we have a presidential election in 2020; the deduction is scheduled to disappear after 2025. Oh, bother.


[i] Yes, I know – where has time gone? The fourth already? Seems like just yesterday, I was reading the first. Alternatively: Oh no, not another! It’s like reading . . . the Code? Where are those definitions of SSTB covered? The first or the second installment?

[ii] Including a single-member LLC that is disregarded for tax purposes.

[iii] Of course, we are only considering taxable years beginning after December 31, 2017, the effective date for Section 199A of the Code.

[iv] Regardless of the source or type of the income.

[v] See EN ix, below.

[vi] For our purposes, it is assumed that Taxpayer has no “qualified cooperative dividends,” no “qualified REIT dividends,” and no “qualified publicly traded partnership income.”

[vii] If Taxpayer has more than one QTB, this amount is determined for each such QTB, and these amounts are then added together.

[viii] I.e., 80% of the regular 37% rate.

[ix] Yes, we skipped the second category – taxpayers with taxable income in excess of the threshold amount but within the phase-in range amount.

The exclusion of QBI (for SSTBs), W-2 wages, and UB of qualified property from the computation of the Section 199A deduction is subject to a phase-in for individuals with taxable income within the phase-in range.

[x] Thus, we look at the taxable income of the individual member of the LLC or shareholder of the S corporation – not at the taxable income of the entity.

[xi] Compare to the passive activity loss rules (material participant or not?), and the net investment income surtax rules (modified adjusted gross income in excess of threshold; material participant?).

[xii] In such cases, the person paying the W-2 wages and reporting the W-2 wages on Forms W-2 is precluded from taking into account such wages for purposes of determining W-2 wages with respect to that person.

[xiii] The PR also provide special rules for determining the UB and the depreciable period for property acquired in a “tax-free” exchange.

Specifically, for purposes of determining the depreciable period, the date the exchanged basis in the replacement qualified property is first placed in service by the trade or business is the date on which the relinquished property was first placed in service by the individual or PTE, and the date the excess basis in the replacement qualified property is first placed in service by the individual or PTE is the date on which the replacement qualified property was first placed in service by the individual or PTE. As a result, the depreciable period for the exchanged basis of the replacement qualified property will end before the depreciable period for the excess basis of the replacement qualified property ends.

Thus, qualified property acquired in a like-kind exchange will have two separate placed in service dates under the PR: for purposes of determining the UBIA of the property, the relevant placed in service date will be the date the acquired property is actually placed in service; for purposes of determining the depreciable period of the property, the relevant placed in service date generally will be the date the relinquished property was first placed in service.

[xiv] Rather than treat them as a separate item of property, the PR provides that, in the case of any addition to, or improvement of, qualified property that is already placed in service by the taxpayer, such addition or improvement is treated as separate qualified property that the taxpayer first placed in service on the date such addition or improvement is placed in service by the taxpayer for purposes of determining the depreciable period of the qualified property. For example, if a taxpayer acquired and placed in service a machine on March 26, 2018, and then incurs additional capital expenditures to improve the machine in May 2020, and places such improvements in service on May 27, 2020, the taxpayer has two qualified properties: The machine acquired and placed in service on March 26, 2018, and the improvements to the machine incurred in May 2020 and placed in service on May 27, 2020.

[xv] In the case of qualified property of a partnership that does not produce tax depreciation during the year (for example, property that has been held for less than 10 years but whose recovery period has ended), each partner’s share of the UB of qualified property is based on how gain would be allocated to the partners if the qualified property were sold in a hypothetical transaction for cash equal to the fair market value of the qualified property. In the case of qualified property of an S corporation that does not produce tax depreciation during the year, each shareholder’s share of the UB of the qualified property is a share of the UB proportionate to the ratio of shares in the S corporation held by the shareholder over the total shares of the S corporation.

[xvi] And so ended every episode of Looney Tunes. Thank you Mel Blanc.

This is the third in a series of posts reviewing the recently proposed regulations (“PR”) under Sec. 199A of the Code. https://www.federalregister.gov/documents/2018/08/16/2018-17276/qualified-business-income-deduction

So far, we’ve considered the elements of a “qualified trade or business” under Section 199A https://www.taxlawforchb.com/2018/09/the-proposed-sec-199a-regs-are-here-part-one/, and the related issue of what constitutes a “specified service trade or business,” the owners of which may be denied the benefit of Section 199A. https://www.taxlawforchb.com/2018/09/the-proposed-sec-199a-regs-are-here-part-two/ Today we’ll turn to the meaning of “qualified business income.”

Qualified Business Income – In General

In general, under Section 199A of the Code, a non-corporate taxpayer is allowed a deduction (the “Section 199A deduction”) for a taxable year equal to 20% of the taxpayer’s qualified business income (“QBI”) with respect to a qualified trade or business (“QTB”) for such year.

The term “QBI” means, for any taxable year, the net amount of “qualified items of income, gain, deduction, and loss” attributable to any QTB of the taxpayer, which in turn means those items of income, gain, deduction, and loss to the extent they are (i) “effectively connected with” the conduct of a trade or business within the U.S., and (ii) included or allowed in determining taxable income for the taxable year.

QBI items must be determined for each QTB by the individual or pass-through entity (“PTE”) that directly conducts the trade or business before applying the aggregation rules. https://www.taxlawforchb.com/2018/09/the-proposed-sec-199a-regs-are-here-part-one/

Exclusion from QBI for Certain Items

The PR provide a list of items that are not taken into account as qualified items of income, gain, deduction, and loss, including capital gain or loss, dividends, interest income other than interest income properly allocable to a trade or business, and certain other items; similarly, items of deduction or loss attributable to these items of income or gain are also not taken into account in determining a taxpayer’s QBI.

Compensation for Services

In general, S corporations must pay their shareholder-employees “reasonable compensation” for services rendered before making “dividend” distributions with respect to shareholder-employees’ stock in the S corporation.

The PR provide that QBI does not include the amount of reasonable compensation paid to the shareholder-employee of an S corporation that operates a QTB for services rendered by the shareholder-employee with respect to such trade or business.

However, the S corporation’s deduction for such reasonable compensation reduces QBI if such deduction is properly allocable to the trade or business and is otherwise deductible.

Guaranteed Payments

Similarly, the PR provide that QBI does not include any guaranteed payment – one determined without regard to the income of the partnership – made by a partnership to a partner for services rendered with respect to the partnership’s trade or business.

However, the partnership’s related expense deduction for making the guaranteed payment may constitute an item of QBI. [i]

The PR clarify that QBI does not include any guaranteed payment paid to a partner for services rendered, regardless of whether the partner is an individual or a PTE. Therefore, a guaranteed payment paid by a lower-tier partnership to an upper-tier partnership retains its character as a guaranteed payment and is not included in QBI of a partner of the upper-tier partnership regardless of whether it is guaranteed to the ultimate recipient.

Other Payments to “Partners”

QBI does not include any payment to a partner, regardless of whether the partner is an individual or a PTE, for services rendered with respect to the partnership’s trade or business where the partner engages with the partnership other than in their capacity as a partner. Thus, it is treated similarly to guaranteed payments, reasonable compensation, and wages, none of which is includable in QBI.

Guaranteed Payments for the Use of Capital

Because guaranteed payments for the use of capital are determined without regard to the income of the partnership, the PR provide that such payments are not considered attributable to a trade or business, and thus do not constitute QBI.

However, the partnership’s related expense for making the guaranteed payments may constitute an item of QBI.

Interest Income

QBI does not include any interest income other than interest income that is properly allocable to a trade or business.

According to the PR, interest income received on working capital, reserves, and similar accounts is income from assets held for investment and is not properly allocable to a trade or business.

In contrast, interest income received on accounts or notes receivable for services or goods provided by the trade or business is not income from assets held for investment, but income received on assets acquired in the ordinary course of the trade or business.

QBI – Special Rules

In addition to the foregoing exclusions, the PR clarify the treatment of certain items that may be of interest to taxpayers that are disposing of their interest in a trade or business.

“Hot Asset” Gain

Under the partnership rules, the gain realized by a partner on the exchange of all or part of their interest in a partnership is treated as ordinary income to the extent it is attributable to the unrealized receivables or inventory items (“hot assets”) of the partnership. These are items that eventually would have been recognized by the partnership and allocated to the partner in the ordinary course; the exchange by the partner of their partnership interest merely accelerates this recognition and allocation.

Similarly, a distribution of property by a partnership to a partner in exchange for the partner’s interest in the “hot assets” of the partnership may be treated as sale or exchange of such hot assets between the partner and the partnership, thereby generating ordinary income.

According to the PR, any gain that is attributable to the hot assets of a partnership – thereby giving rise to ordinary income in the circumstances described above – is considered attributable to the trade or business conducted by the partnership, and therefore, may constitute QBI to the partner.

Of course, the term “unrealized receivables” is defined to include not only receivables, but other items as well; for example, depreciation recapture. This may be significant in the sale of a business by a PTE where the gain arising from the sale would otherwise be excluded from QBI.

Change in Accounting Adjustments

If a taxpayer changes their method of accounting, the Code requires that certain adjustments be made in computing the taxpayer’s taxable income in order to prevent amounts of income or deduction from being duplicated or omitted. In general, these adjustments are taken into account by the taxpayer over a three-year period.

The PR provide that when such adjustments (whether positive or negative) are attributable to a QTB, and arise in a taxable year ending after December 31, 2017, they will be treated as attributable to that trade or business. Accordingly, such adjustments may constitute QBI.

Previously Suspended Losses

Several sections of the Code provide for the disallowance of losses and deductions to a taxpayer in certain cases; for example, the “at risk” rules and the “passive activity loss” rules. Generally, the disallowed amounts are suspended and carried forward to the following year, at which point they are re-tested and may become allowable; of course, when the taxpayer disposes of their interest in the business to an unrelated party in a fully taxable transaction, the loss will cease to be suspended.

Likewise, losses may be suspended because an individual shareholder of an S corporation does not have sufficient stock or debt basis to utilize them; however, the actual or deemed sale of the assets of the S corporation’s business may generate enough gain to increase such basis and enable the shareholder to use the suspended losses.

The PR provide that, to the extent that any previously disallowed losses or deductions, attributable to a QTB, are allowed in the taxable year, they are treated as items attributable to the trade or business. Thus, losses that cease to be suspended under one of the above “disposition rules” may be treated as QBI. However, losses or deductions that were disallowed for taxable years beginning before January 1, 2018 are not taken into account for purposes of computing QBI in a later taxable year.

Net Operating Losses

Generally, items giving rise to a net operating loss (“NOL”) are allowed in computing taxable income in the year incurred. Because those items would have been taken into account in computing QBI in the year incurred, the NOL should not be treated as QBI in subsequent years.

However, to the extent the NOL is comprised of amounts attributable to a QTB that were disallowed under the new “excess business loss” rule – which are not allowed in computing taxable income for the taxable year but which are, instead, carried forward and treated as part of the taxpayer’s net operating loss carryforward in subsequent taxable years – the NOL is considered attributable to that trade or business, and may constitute QBI. https://www.taxlawforchb.com/2018/01/the-real-property-business-and-the-tax-cuts-jobs-act/

Property Used in the Trade or Business

QBI does not include any item of short-term capital gain, short-term capital loss, long-term capital gain, or long-term capital loss.

The Code provides rules under which gains and losses from the sale or exchange of certain property used in a trade or business are either treated as long-term capital gains or long-term capital losses, or are not treated as gains and losses from sales or exchanges of capital assets.[ii]

The PR clarify that QBI excludes short-term and long-term capital gains or losses, regardless of whether those items arise from the sale or exchange of a capital asset, including any item treated as one of such items taken into account in determining net long-term capital gain or net long-term capital loss.

Conversely, if the gains or losses are not treated as gains and losses from sales or exchanges of capital assets, the gains or losses may be included in QBI.

Effectively Connected With a U.S. Trade or Business

Section 199A applies to all non-corporate taxpayers, whether such taxpayers are domestic or foreign. Accordingly, Section 199A applies to both U.S. citizens and resident aliens, as well as nonresident aliens (“NRA”) that have QBI.

QBI includes items of income, gain, deduction, and loss to the extent such items are (i) included or allowed in determining the U.S. person’s or NRA’s taxable income for the taxable year, and (ii) effectively connected with the conduct of a trade or business within the U.S.

Determining Effectively Connected Income

In general, whether a QTB is engaged in a trade or business within the U.S., partially within the U.S., or solely outside the U.S., is based upon all the facts and circumstances.[iii]

If a trade or business is not engaged in a U.S. trade or business, items of income, gain, deduction, or loss from that trade or business will not be included in QBI because such items would not be effectively connected with the conduct of a U.S. trade or business.

Thus, a shareholder of an S corporation, or a U.S. partner of a partnership, that is engaged in a trade or business in both the U.S. and overseas would only take into account the items of income, deduction, gain, and loss that would be effectively connected with the business conducted by the S corporation, or partnership, in the U.S.

In determining whether income or gain from U.S. sources is effectively connected with the conduct of a trade or business within the U.S., a number of factors have to be considered, including whether the income, gain or loss is derived from assets used in or held for use in the conduct of such trade or business, or the activities of such trade or business were a material factor in the realization of the income, gain or loss.

If an NRA’s QTB is determined to be conducted in the U.S., the Code generally treats all non-investment income of the NRA from sources within the U.S. as effectively connected with the conduct of a U.S. trade or business.[iv]

Income from sources without the U.S. is generally not treated as effectively connected with the NRA’s conduct of a U.S. trade or business. Thus, a trade or business’s foreign source income, gain, or loss, (and any deductions effectively connected with such foreign source income, gain, or loss) would generally not be included in QBI.[v]

However, this rule does not mean that any item of income or deduction that is treated as effectively connected with an NRA’s conduct of a trade or business with the U.S. is necessarily QBI. Indeed, certain provisions of the Code allow items to be treated as effectively connected, even though they are not “items” with respect to a trade or business. For example, the Code allows an NRA to elect to treat income from rental real property in the U.S. that would not otherwise be treated as effectively connected with the conduct of a trade or business within the U.S. as effectively connected. However, if items are not attributable to a QTB, they do not constitute QBI.

Allocation of QBI Items

The PR provides that, if an individual or a PTE directly conducts multiple trades or businesses, and has items of QBI that are properly attributable to more than one trade or business, the taxpayer or entity must allocate those items among the several trades or businesses to which they are attributable using a reasonable method that is consistent with the purposes of Section 199A.

The chosen reasonable method for each item must be consistently applied from one taxable year to another, and must clearly reflect the income of each trade or business.

There are several different ways to allocate expenses, such as direct tracing, allocating based on gross income, or some other method, but whether these are reasonable depends on the facts and circumstances of each trade or business.

Next week, we’ll bring together the basic elements of Section 199A, which we covered in the last three posts, to see how the “20% deduction” is determined.


[i] The PR provides that QBI does not include reasonable compensation paid by an S corporation but does not extend this rule to partnerships. Because the trade or business of performing services as an employee is not a QTB, wage income received by an employee is never QBI.

The rule for reasonable compensation is merely a clarification that, even if an S corporation fails to pay a reasonable wage to its shareholder-employees, the shareholder-employees are nonetheless prevented from including an amount equal to reasonable compensation in QBI.

[ii] IRC Sec. 1231.

[iii] Because an NRA cannot be a shareholder on an S corporation, the NRA’s effectively connected income must arise from the NRA’s direct conduct of a trade or business in the U.S. (including through a disregarded entity; if the NRA is a resident of a treaty country, the NRA’s business profits will not be subject to U.S. tax unless the NRA operates the business through a permanent establishment in the U.S.); in addition, an NRA is considered engaged in a trade or business within the U.S. if the partnership of which such individual is a member is so engaged.

[iv] However, any “FDAP” income or “portfolio interest” income from sources within the U.S., and any gain or loss from the sale of capital assets, may be effectively connected only if the income meets certain requirements.

[v] There are exceptions.