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Over the last few months, we’ve been working on a number of transactions that involve the division of a closely held corporation or partnership.

In each instance, the impetus for the division has been the desire of the business entity’s owners to go their separate ways so as to enable them to focus their energies on a distinct line of business without interference from the other owners, and to allow them to fully enjoy the rewards of their own efforts.

Although it is incumbent on every tax adviser to stay current on developments in the tax law, there are times when this becomes a seemingly Sisyphean task.[i] Just witness the aftermath of the 2017 tax legislation.

For that reason, it behooves the adviser, prior to embarking upon any transaction, to review the latest IRS rulings interpreting those provisions of the Code that are applicable to the transaction.

With respect to the projects described above, this legal “due diligence” included a review of IRS letter rulings under the regulatory “assets over” form of partnership division,[ii] and under the Code’s corporate reorganization provisions.[iii]

That’s when I came across the ruling – more specifically, the phrase within a sentence within the ruling – that is the subject of today’s post.

Before describing the ruling, let’s first consider the basic requirements for a “tax-free” corporate division.

Corporate Divisions

Underlying the corporate reorganization provisions of the Code is the principle that it would be inappropriate to require the recognition and taxation of any gain realized as a result of a transaction in which the participating taxpayers – the corporations and their shareholders – have not fundamentally changed the nature of their investment in, and their relationship to, the corporation’s assets or business.

One of these reorganization provisions allows a corporation to distribute to some or all of its shareholders all of the shares of stock of a subsidiary corporation on a “tax-free” basis, provided certain requirements are satisfied. The division of the “parent” or distributing corporation may be undertaken for many reasons and it may take many forms. In general, such a distribution may be pro rata among the parent corporation’s shareholders (a “spin-off”), it may be in exchange for all of the parent corporation’s stock held by certain of its shareholders (a “split-off”), or it may be in complete liquidation of the parent corporation (a “split-up”), where the stock of at least two subsidiary corporations is distributed.

The division must comply with certain statutory and non-statutory requirements in order to achieve tax-free status, including the following:

  1. The distributing parent corporation must “control” the subsidiary corporation the stock of which is distributed;
  2. The distribution must not be a “device” for distributing the earnings and profits of either corporation;
  3. Each of the corporations must, after the distribution, conduct an “active trade or business” that has been conducted by either of them for at least five years,[iv] and that has not been acquired in a taxable transaction within that time;[v]
  4. At least enough stock of the subsidiary corporation must be distributed to constitute control of such corporation;
  5. The transaction must have a corporate business purpose;[vi] and
  6. The continuity of interest requirement must be met.

From a “mechanical” perspective, a division – for example, a spin-off – may be effectuated by the parent corporation’s distributing to its shareholders the stock of an existing subsidiary,[vii] or it may be preceded by the parent’s contribution of part of its assets to a newly-formed subsidiary corporation in exchange for all of the stock thereof, which it then distributes in the spin-off.[viii]

Active Trade or Business

Of the foregoing requirements, the one that concerns us here is that of the “active trade or business.”

The Code requires that Distributing and Controlled must each be engaged in the active conduct of a trade or business immediately after the distribution. The rules for determining whether a corporation is engaged in the active conduct of a trade or business immediately after the spin-off, however, focus almost exclusively on the five-year period before the spin-off, by defining an active business as one that has been conducted throughout the five-year period ending on the date of the spin-off.[ix]

The Corporation’s Activities

A corporation will be treated as engaged in an active trade or business immediately after the distribution if “a specific group of activities are being carried on by the corporation for the purpose of earning income or profit, and the activities included in such group include every operation that forms a part of, or a step in, the process of earning income or profit. Such group of activities ordinarily must include the collection of income and the payment of expenses.”[x]

The determination whether a trade or business is actively conducted is made from all of the facts and circumstances and, generally, the corporation is required itself to perform active and substantial management and operational functions;[xi] in other words, to have an active business the corporation must perform active and substantial management and operational functions through its own employees – even though some of its activities are performed by others, including independent contractors.

Changes in the Active Trade or Business

A trade or business that is relied upon to meet the requirement for a tax-free spin-off must have been actively conducted throughout the five-year period ending on the date of the distribution.[xii]

The fact that a trade or business underwent change during the five-year period preceding the distribution – for example, by the addition of new or the dropping of old products, changes in production capacity, and the like – are disregarded, provided that the changes are not of such a character as to constitute the acquisition of a new or different business.

In particular, if a corporation, engaged in the active conduct of one trade or business during that five-year period, purchased, created, or otherwise acquired another trade or business in the same line of business, then the acquisition of that other business is ordinarily treated as an expansion of the original business, all of which is treated as having been actively conducted during that five-year period, unless that purchase, creation, or other acquisition effects a change of such a character as to constitute the acquisition of a new or different business.[xiii]

Business Interruption

In addition, the fact that there was a partial or temporary interruption, during the five-year period preceding the distribution, in a trade or business that had been actively conducted by a corporation, may not, under the right circumstances, adversely affect the conclusion that the corporation was engaged in the active conduct of a trade or business for the five-year period.

For example, the IRS has previously ruled that a proposed spin-off would satisfy the five-year active trade or business requirement where the controlled subsidiary corporation had collected income for only four of the five years preceding the distribution of its stock.[xiv]

The subsidiary had incurred expenses and engaged in substantial managerial and operational activities representative of the active conduct of a trade or business for each of the five years preceding the date of the distribution. Its failure to receive revenue during one of the five years was unforeseen, and was caused by events outside of its control; i.e., the bankruptcy of its sole customer.

The corporation took all reasonable steps to secure revenue by redesigning its limited use product and actively seeking new customers for such product; in the absence of any sales, it also shut down its plant and substantially reduced its workforce. Approximately one year later, its business began to generate revenues once again.

The IRS indicated that there may be exceptional situations where, based upon all the facts and circumstances, a group of activities will constitute an active trade or business for purposes of the spin-off rules even when “there is no concurrent receipt of income and payment of expenses.”

When these extraordinary facts were coupled with the subsidiary’s activities before the bankruptcy of its sole customer, along with its efforts to secure revenue, the IRS was able to conclude that the subsidiary was engaged in the active conduct of a trade or business for the five-year period preceding the date of the distribution of its stock by its parent corporation.

With the foregoing in mind, we can turn to the IRS’s recent ruling.

The Ruling

The ruling[xv] addressed a proposed transaction by which a corporation (“Distributing”) would transfer one segment of its business (“Business”) to its shareholders (the “Transaction”). Distributing was engaged in Business, which was comprised of Segments 1 through 4. Distributing was in the process of exiting Segment 3 while, at the same time, expanding into Segments 2 and 4.

Distributing proposed to form a new subsidiary corporation (“Controlled”) for the purpose of effecting the Transaction.

Distributing would contribute all of the assets, and related operations, associated with Segment 4 of the Business (the “Contribution”) to Controlled, solely in exchange for all of the stock of Controlled and the assumption by Controlled of all of the liabilities associated with such assets and operations.

Distributing would then distribute all of the Controlled stock, on a pro rata basis, to Distributing’s shareholders (the “Distribution”).

As part of the Transaction, and immediately following the Distribution, Controlled would issue shares of Controlled stock to one or more investors in exchange for cash, which Controlled would retain for use in its operation of Segment 4.[xvi]

Both corporations represented that they would satisfy the Code’s active trade or business requirement for a tax-free spin-off. With respect to the Business relied on by each of Distributing and Controlled to meet this requirement, Distributing represented that there had not been any substantial operational changes since the end of Distributing’s most recent taxable year, other than the termination of Segment 3.

Distributing and Controlled represented that, following the Distribution, they would continue certain inter-Segment relationships (“Continuing Relationships”), including the provision of certain services by Controlled (“Services”) – presumably part of the operation of Segment 4 – to Distributing (operating Segments 1 and 2) for a period of time.

The corporations represented that payments made in connection with all continuing transactions, if any, between Distributing and Controlled after the Distribution would be for fair market value, based on arm’s length terms, other than payments in connection with certain Continuing Relationships, which would be provided at cost.[xvii]

They also represented that no intercorporate debt would exist between Distributing and Controlled at the time of, or subsequent to, the Distribution, except for payables and receivables arising in connection with certain Continuing Relationships.[xviii]

There was no plan or intention for Distributing or Controlled to divest themselves of any of the historic business assets of Distributing before or after the Distribution, except for the termination of Segment 3 by Distributing.

However, it was also represented that once Controlled stopped providing the Services to Distributing, Controlled could cease to generate any revenue.

In that case, Controlled represented that it would “continue to seek to generate future revenue through future Events.”[xix]

The IRS ruled that the Contribution and the Distribution, together, would be treated as a “divisive D reorganization” for federal tax purposes. Consequently, neither Distributing nor Controlled would recognize gain or loss on the Contribution, no gain or loss would be recognized by Distributing on the Distribution, and no gain or loss would be recognized by (and no amount would otherwise be included in the income of) the Distributing shareholders upon their receipt of the Controlled stock in the Distribution.

A Shift in Thinking?

In order for the IRS to have ruled that the Transaction would qualify as a tax-free reorganization, it must have determined that Controlled would satisfy the active trade or business requirement after the Distribution.

In other words, the IRS must have concluded that Controlled would conduct an active trade or business that had been conducted by Distributing for at least five years prior to the Distribution – in particular, Segment 4 of Distributing’s Business, which the ruling tells us was expanding prior to the Transaction – notwithstanding Controlled’s representation that there may be periods after the Distribution, and after it stopped providing the Services to Distributing, during which Controlled would not collect any revenue.[xx]

As indicated earlier, the rules for determining whether a corporation is engaged in the active conduct of a trade or business immediately after a spin-off focus primarily on the five-year period prior to the spin-off, by defining an active business as one with a five-year history of active and substantial managerial and operational activities by the business’s employees.

According to the IRS, the activities of an active trade or business “ordinarily must include the collection of income.”[xxi] Generally, in the absence of exceptional circumstances beyond the business’s control,[xxii] the IRS historically has required a qualifying business to have collected income continuously for at least five years.

In this ruling, however, Controlled expected that there would be periods during which it would not generate any revenue; it assured the IRS that, during these times, it would look for business opportunities, presumably for the purpose of generating revenue.[xxiii]

So what gives? The situation that may be faced by Controlled will not involve unforeseen circumstances or events beyond its control. Did the IRS simply discount the possibility of Controlled’s not generating revenue and, therefore, did not consider this factor in its analysis?

Or does the ruling signify something else? We know that Distributing had begun to expand into Segment 4 of the Business prior to the Transaction; presumably, such expansion would be continued by Controlled after the Distribution.

Entrepreneurial Ventures

A couple of months ago,[xxiv] the IRS announced that it has been studying whether, and to what extent, corporations may utilize the tax-free separation rules of the Code to separate established businesses from newer “entrepreneurial ventures” that have not yet collected income, but that have engaged in substantial research and development (R&D) and other activities.

The IRS stated that it has observed a significant increase in entrepreneurial ventures that “collect little or no income during lengthy and expensive R&D phases.” However, it continued, these types of ventures often use the R&D phase to develop new products that will generate income in the future but do not collect income during that phase.

The IRS conceded that if a corporation wishes to achieve a corporate-level business purpose – i.e., a purpose that would support a tax-free corporate division – by separating one R&D segment from an established business, or from another R&D segment, the IRS’s historical application of the income collection requirement “likely would present a challenge for qualification” as a tax-free separation.

Query whether this signals the beginning of a more relaxed approach by the IRS in the application of the active trade or business requirement?

What’s Next?

Based on the foregoing, it appears that if the IRS takes a more liberal approach to the application of the active trade or business requirement of the spin-off rules, it may be limited to businesses that need longer periods of R&D to develop their products; for example, technology-driven companies.

If the above ruling does, in fact, signify this new approach, should it be limited to businesses that require long periods of R&D?

It is true that, in the case of a start-up technology business, product development may take several years. But what about the spin-off of a business that represents the expansion of a more “traditional” business, which requires the identification and acquisition of a new location, the securing of the necessary licenses, permits, or zoning, the raising of capital, the construction of improvements, and the employment and training of new personnel? All of these factors must be addressed, significant sums and efforts must be expended, and years may pass before the spun-off business will start generating any revenue, whether through the manufacture and sale of a product, the sale of a service, or otherwise. Surely, these and other preparatory activities should be accounted for in determining whether the active trade or business requirement has been satisfied.

Stay tuned.

[i] In Greek mythology, Sisyphus was the King of Corinth. Because of his trickery and hubris, Zeus consigned him to the Underworld where he was tasked with rolling a large boulder up a steep hill. Every time he neared the top of the hill, the boulder would roll back down. Thus, Sisyphus was condemned for eternity to the an impossible and never-ending task of staying current with developments in the tax law.

[ii] Reg. Sec. 1.708-1(d); relatively straightforward, and without the stringent requirements for the division of a corporation. Ah, the repeal of General Utilities.

[iii] IRC Sec. 355 and Sec. 368(a)(1)(D). More on these in just a minute.

[iv] That’s five full years; not five taxable years.

[v] Though the expansion of an existing business may be permitted.

[vi] As opposed to a shareholder purpose. In many cases, it will be difficult to distinguish between the two.

[vii] Which would be described in IRC Sec. 355 alone.

[viii] Which would be described in IRC Sec. 368(a)(1)(D) and Sec. 355; a so-called “divisive D reorganization.”

According to IRC Sec. 368(a)(1)(D), a D reorganization is:

“a transfer by a corporation of all or a part of its assets to another corporation if immediately after the transfer the transferor, or one or more of its shareholders (including persons who were shareholders immediately before the transfer), or any combination thereof, is in control of the corporation to which the assets are transferred; but only if, in pursuance of the plan, stock or securities of the corporation to which the assets are transferred are distributed in a transaction which qualifies under section 354, 355 or 356.”

[ix] Furthermore, the trade or business must not have been acquired during the five-year period ending on the date of the spin-off in a transaction in which any gain or loss was recognized, and control of a corporation conducting such trade or business must not have been acquired by Distributing or any controlled corporation directly or through one or more other corporations within the five-year period preceding the distribution in a transaction in which any gain or loss was recognized.

[x] Emph. added. Reg. Sec. 1.355-3(b)(2)(ii).

[xi] Reg. Sec. 1.355-3(b)(2)(iii).

[xii] Whether a group of activities constitutes a “trade or business” is an issue that has enjoyed a resurgence as a result of the 2017 legislation; for example, does an activity rise to the level of trade or business for purposes of the 20-percent deduction under IRC Sec. 199A’s qualified business income rules, or for purposes of the gain deferral under Sec. 1400Z-2’s qualified opportunity fund rules?

[xiii] Reg. Sec. 1.355-3(b)(3)(ii).

[xiv] Rev. Rul. 82-219.

[xv] PLR 201920008, Release Date: 5/17/2019. Just a reminder: letters rulings are not precedent-setting, but they do give us a glimpse into what the IRS’s position may be on a given issue – thus, it makes sense to pay attention to them.

[xvi] Perhaps to help fund the expansion of Segment 4, which had begun under Distributing.

[xvii] Query whether this included the Services?

[xviii] Again, query whether this included the Services?

[xix] The term “Events” was not defined in the released version of the ruling; perhaps it refers to business opportunities that may present themselves as Segment 4 grows; however, it may also refer to the acquisition of a similar business; all speculation on my part.

[xx] Though it would continue to seek to generate future revenue.

[xxi] Reg. Sec. 1.355-3(b)(2)(ii).

[xxii] The “interruption” scenario described earlier.

[xxiii] But query how was Controlled going to fund its operations during these “down times?”

[xxiv] IRS Request for Information regarding the active trade or business requirement for section 355 separations of entrepreneurial ventures, dated May 6, 2019.


Too Good . . .?

What if I told you that you could sell your property today, receive cash in an amount equal to the property’s fair market value, and defer the payment of any tax imposed upon the gain from the sale?[i]

It sounds contrived, doesn’t it? How can one have their cake and eat it too?[ii]

Interestingly, a number of folks of late have asked me about so-called “monetized installment sales,” which are a form of transaction that promises these very results.

Before describing how such sales are often “structured,” and then reviewing their intended tax consequences, it would behoove us to first review the basic rules for the taxation of an ordinary installment sale.

Straight Sales

Assume that a taxpayer sells a capital asset or Section 1231 property[iii] to a buyer in exchange for cash that is payable at closing. The buyer may have borrowed the cash for the purchase from a third party; or it may be that the buyer had enough cash of their own available to fund the purchase.

The gain realized by the seller from the conversion of the property into cash is treated as income to the seller. The “amount realized” from the sale is equal to the amount of cash received. The general method of computing the seller’s gain from the sale contemplates that, from the amount realized, there shall be withdrawn an amount equal to the seller’s adjusted basis for the property – i.e., an amount sufficient to restore to the seller their unreturned investment in the property.[iv]

The amount which remains after the adjusted basis has been restored to the seller – i.e., the excess of the amount realized over the adjusted basis – constitutes the realized gain. This gain is generally included in the selling taxpayer’s gross income for the taxable year of the sale, and is subject to federal income tax.[v]

Example A

Seller has owned and used Property in their business for several years. Property has a FMV of $100. Seller’s adjusted basis for Property is $40. In Year One, Seller sells Property to Buyer for $100 of cash which is paid at closing. Seller’s gain from the sale is $100 minus $40 = $60. Seller includes the entire $60 in their gross income for Year One.

Installment Sales

Years ago, however, Congress recognized that it may not be appropriate to tax the entire gain realized by a seller in the taxable year of the sale when the seller has not received the entire purchase price for the property sold; for example, where the seller is to receive a payment from the buyer in a taxable year subsequent to the year of the sale, whether under the terms of the purchase and sale agreement,[vi] or pursuant to a promissory note given by the buyer to the seller in full or partial payment of the purchase price.[vii]

In cases where the payment of the purchase price is thus delayed, the seller has not completed the conversion of their property to cash; rather than having the economic certainty of cash in their pocket, the seller has, instead, assumed the economic risk that the remaining balance of the sale price may not be received. It is this economic principle that underlies the installment method of reporting.[viii]

A sale of property where at least one payment is to be received after the close of the taxable year in which the sale occurs is known as an “installment sale.”[ix] For tax purposes, the gain from such a sale is reported by the seller using the installment method.[x]

Under the installment method, the amount of any payment which is treated as income to the seller for a taxable year is that portion (or fraction) of the installment payment received in that year which the gross profit realized bears to the total contract price (the “gross profit ratio”). Generally speaking, the term “gross profit” means the selling price for the property less the taxpayer’s adjusted basis for the property – basically, the gain.

Stated differently, each payment received by a seller is treated in part as a return of their adjusted basis for the property sold,[xi] and in part (the gross profit ratio) as gain from the sale of the property.

Example B

Same facts as Example A, above, except that Buyer pays Seller $20 at closing, in Year One, and gives Seller a 4-year promissory note with a face amount of $80; the note provides for equal annual principal payments of $20 in each of Years Two through Five. The note also provides for adequate interest that is payable and compounded annually.[xii] Seller’s gross profit is $100 minus $40 = $60. Seller’s contract price is $100. Thus, Seller’s gross profit ratio is $60/$100 = 60%. When Seller receives the $20 payment in Year One, Seller will include in their gross income for Year One an amount equal to 60% of the $20 payment, or $12. The same methodology will be applied over the term of the note. Thus, assuming the timely payment of $20 of principal every year, [xiii]Seller will include $12 in their income in each of Years Two through Five; a total of $60 of gain.[xiv]


The seller’s tax liability that arises from a sale that is reported under the installment method is incurred upon the seller’s receipt of payment; thus, one must be able to identify when such a payment has been received.

For purposes of the installment method, the term “payment” includes the actual or constructive receipt of money by the seller.[xv]

It also includes the seller’s receipt of a promissory note from the buyer which is payable on demand or that is readily tradable.

Receipt of an evidence of indebtedness which is secured directly or indirectly by cash or a cash equivalent[xvi] will be treated as the receipt of payment.

In each of these instances, the seller has wholly converted their interest in the property sold to cash, or they have been given the right to immediately receive cash, or they are assured of receiving cash – they are in actual or constructive receipt of the cash.[xvii]

Because there is no credit risk associated with holding the buyer’s note and awaiting the scheduled payment(s) of principal, the seller is treated, in these instances, as having received payment of the amount specified in the promissory note or other evidence of indebtedness.

However, a payment does not include the receipt of the buyer’s promissory note – an “installment obligation”[xviii] – that is payable at one[xix] or more specified times in the future, whether or not payment of such indebtedness is guaranteed by a third party, and whether or not it is secured by property other than cash or a cash equivalent.[xx]

In the case of such a note, the seller remains at economic risk until the note is satisfied. Thus, that portion of the seller’s gain that is represented by the note will generally be taxed only as principal payments are received.

The “Anti-Pledge” Rule

It goes without saying that sellers will usually welcome the deferral of gain recognition and taxation that the installment sale provides. At the same time, however, sellers have sought to find a way by which they can currently enjoy the as-yet-unpaid cash proceeds from the sale of their property without losing the tax deferral benefit.

One method that was previously utilized to accomplish this goal was for the seller to borrow money from a lender and to pledge the buyer’s installment obligation as security for the loan. In this way, the seller was able to immediately access funds in an amount equal to the proceeds from the sale of their property, while continuing to report the gain from the sale under the installment method as the buyer made payments on the installment obligation; the loan that was secured by the installment obligation would be repaid as the installment obligation itself was satisfied.

Congress eventually became aware of this monetization technique and concluded that it was not consistent with the principles underlying the installment method. In response, Congress amended the installment sale rules[xxi] to provide that if any indebtedness is secured by an installment obligation, the net proceeds of the secured indebtedness will be treated as a payment received on the installment obligation as of the later of the time the indebtedness becomes “secured indebtedness,” or the time the proceeds of such indebtedness are received by the seller.[xxii]

For purposes of this rule, an indebtedness is secured by an installment obligation to the extent that payment of principal (or interest) on such indebtedness is directly secured – under the terms of the indebtedness or any underlying arrangements – by any interest in the installment obligation. A payment owing to the lender will be treated as directly secured by an interest in the buyer’s installment obligation to the extent “an arrangement” allows the seller to satisfy all or a portion of the indebtedness with the installment obligation.[xxiii] It is significant that the Conference Committee report to the Tax Relief Extension Act of 1999 indicates that “[o]ther arrangements that have a similar effect would be treated in the same manner.”[xxiv]

Example C

Same facts as Example B, above, except that in Year Two, Seller borrows $80 from Lender, and pledges Buyer’s $80 promissory note as security for the loan. Seller is treated as having received a payment of $80 on the promissory note in Year Two, and is therefore required to report $48 of gain on its tax return for Year Two.[xxv]

Interestingly, the above anti-pledging rule was limited in its reach to obligations which arise from the installment sale of property where the sales price of the property exceeds $150,000; for purposes of applying this threshold, all sales which are part of the same transaction (or a series of related transactions) are treated as one sale.[xxvi]

Monetized Installment Sale

Following the above change in the Code, many advisers and taxpayers set out to find another way to accomplish the desired result – immediate cash and deferred tax – but without running afoul of the anti-pledging rule.

As far as I can tell, what has emerged, generally speaking, is the following four-party structure:

  • Seller wants to sell a Property to Buyer, immediately receive cash in an amount equal to Property’s fair market value, and defer the recognition of any gain realized from the sale under the installment method;
  • Seller sells Property to Intermediary[xxvii] in exchange for Intermediary’s unsecured installment obligation in an amount equal to Property’s fair market value; the loan provides for interest only over a fairly long term, followed by a balloon payment of principal, at which point the Seller’s gain from the sale would recognized;
  • Intermediary immediately sells Property to Buyer for cash;[xxviii] Intermediary does not realize any gain on this sale;[xxix]
  • Seller obtains a loan from Lender, the terms of which “match” the terms of Intermediary’s installment obligation held by Seller; Seller does not pledge Intermediary’s installment obligation as security for the loan;[xxx] escrow accounts are established to which Intermediary will make interest payments, and from which the interest owed by Seller will be automatically remitted to Lender;
  • Seller has the non-taxable loan proceeds which they may use currently; Seller will typically invest the proceeds in another business or investment, at least initially, so as to demonstrate a “business purpose” for the loan;[xxxi]
  • Seller will report gain on the sale of Property only as Intermediary makes payments to Seller under its installment obligation; in the case of a balloon payment, the gain will be reported and taxed when the obligation matures;
  • Seller will use the payment(s) to repay the loan from Lender.


To date, the IRS has not directly addressed the foregoing arrangement. That being said, there is a single Field Attorney Advice (FAA 20123401F)[xxxii] – which represents non-precedential legal advice issued to IRS personnel from the Office of Chief Counsel (“OCC”) – that considered the application of the “substance over form” and “step transaction” doctrines to a fact pattern that included some of the elements described above. It appears that many in the “monetized installment sale” community point to this FAA as support for their transaction structure.

The taxpayer in the FAA was a business entity that needed to raise a lot of cash for a bona fide business purpose.[xxxiii] In order to do so, it decided to sell a portion of its assets. The buyer gave the taxpayer installment notes that were supported by standby letters of credit (issued by Lender A) that were nonnegotiable and could only be drawn upon in the event of default. The taxpayer then borrowed money (from Lender B) in an amount less than the buyer’s installment notes, and pledged the buyer’s notes as security. This pledge would normally have triggered immediate recognition of the gain from the sale; however, the assets constituted farm assets and, so, were exempt from the anti-pledge rule.[xxxiv]

The OCC acknowledged that, in form, the transaction comprised an installment sale and a loan that monetized the installment obligation. The question presented to the OCC was whether the substance of the transaction was essentially a sale for cash because, shortly after the asset sale, the taxpayer obtained the amount of the sale price in cash, through the loan proceeds, all while deferring the recognition of gain and the payment of the resulting tax.

The OCC concluded that the asset sale was a real transaction carried out to raise cash for the taxpayer. The letter of credit provided security for the taxpayer in the event the buyer defaulted on its installment obligation. The monetization loan was negotiated with a different lender than the one what issued the letter of credit. The economic interests of the parties to both transactions changed as a result of the transactions. The transactions reflected arm’s-length, commercial terms, each transaction had independent economic significance, and the parties treated the transactions as a separate installment sale and a monetization loan. Thus, the substance over form and step transaction doctrines were inapplicable.

Monetization, Here We Come?

Call me jaded, but I wouldn’t move too quickly to engage in such a transaction.[xxxv]

The fact remains that the IRS has not spoken to the form of monetized installment sale transaction described above.

The FAA on which the “intermediaries” of such transactions rely is not precedential and addresses the case of a taxpayer that was not even subject to the anti-pledge rule. What’s more, that taxpayer was compelled by a pressing business reason to engage in the sale in the first place – it had to raise cash for purposes of its continuing business.

By contrast, the taxpayer to whom a monetization structure is typically directed is selling their entire interest in the business or property – they are cashing out, period.

In recognition of this fact, and in order to “soften” its impact, some intermediaries recommend (others “require”) that the selling taxpayer immediately invest the loan proceeds in another property or business.[xxxvi]

As for the bona fide nature of the transaction-elements that comprise the installment sale monetization structure, consider the following: the taxpayer will sell the property to the intermediary in exchange for a long-term (thirty years is often mentioned), interest-only, unsecured loan. How is this a commercially reasonable transaction?

The intermediary, in turn, will immediately resell the property acquired from the taxpayer to the buyer, usually for cash – indeed, the property is often direct-deeded from the taxpayer to the buyer, so that the intermediary never comes into title. Thus, the intermediary never really “owns” the property – they merely act as a conduit.[xxxvii]

What’s more, the intermediary’s interest payments and, ultimately, the balloon payment, match the payments owing from the seller to the lender. The accounts that are created for the purposes of receiving the intermediary’s interest payments to the taxpayer, and of then remitting the taxpayer’s interest payments to the lender, ensure that the taxpayer never has control over these funds, and afford the lender a degree of security.

Query: why didn’t the taxpayer just sell the property to the buyer for cash, and pay the intermediary a broker’s fee for putting the parties together? Why turn down an all-cash buyer and accept a long-term promissory note instead, while at the same time borrowing an equal amount from a third party?

In the meantime, the intermediary has cash available for its long-term use – i.e., until the maturity date of the intermediary’s installment obligation to the taxpayer, which happens to coincide with the maturity date of the lender’s loan to the taxpayer – in the amount of the balloon payment which it received from the buyer as payment of the sale price for the property.

Although it is not clear to me where these funds are kept, or how they are invested by the intermediary, based upon the arrangements made for the interest payments, and given what must be described as the lender’s and the intermediary’s risk aversion, it is probably safe to say that the balloon payment – which ultimately belongs to the selling taxpayer and then the lender – is itself protected.

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

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

The IRS should clarify its position accordingly.

[i] No, the recreational use of marijuana is not yet legal in New York.

[ii] Have I ever mentioned my knack for mangling idioms? I think I got this one right. That being said, I was once speaking to a group of accountants and, after belaboring a particular point, I said something like “Well, we’ve beaten this horse to death.” After a collective gasp from the audience, someone corrected me, stating that the phrase I should have used was “beating a dead horse.” Either way, it’s not a pretty visual.

[iii] and . Why make this assumption?

[iv] IRC Sec. 1001; Reg. Sec. 1.1001-1. The unreturned investment – the adjusted basis – is the taxpayer’s original cost basis for the property, plus the cost of any capital expenditures (for example, improvements to tangible property, or additional paid-in capital in the case of an equity interest in a business entity); depending on the property, this amount may be reduced by any depreciation allowed or allowable; in the case of stock in a corporation, certain distributions will reduce a shareholder’s basis; in the case of pass-through business entities, the allocation of losses to the interest holder will reduce basis. You get the picture.

[v] IRC Sec. 1 and Sec. 11. In the case of an “individual,” the gain may also be subject to the 3.8% surtax under IRC Sec. 1411.

[vi] For example, where an amount otherwise payable by the buyer is held in escrow for the survival period of the seller’s reps and warranties (to secure the buyer against the seller’s breach of such), or where there are earn-out payments to be made over a number of years (say, two or three) based on the performance of the property (almost always a business).

[vii] There are many reasons why a buyer will give a note to the seller rather than borrowing the funds from a financial institution; for one thing, the buyer may have greater leverage in structuring the terms of the note vis-à-vis the seller. In addition, the buyer will often seek to offset the note amount by losses incurred as a result of the seller’s breach of a rep or covenant.

[viii] In general, there is a direct correlation between the economic certainty of a seller’s “return on investment” on the sale of property and the timing of its taxation; where the delayed payment of the sales price creates economic risk for the seller, the taxable event will be delayed until the payment is received.

[ix] IRC Sec. 453; Reg. Sec. 15a.453-1.

[x] Installment reporting does not apply to a sale that results in a loss to the seller. The loss is reported in the year of the sale.

Nor does it apply to the sale of certain assets; for example, accounts receivable, inventory, depreciation recapture, and marketable securities. These are ordinary income items that are recognized in the ordinary course of business, or they are items that represent cash equivalents.

It should also be noted that a seller may elect out of installment reporting, and thereby choose to report its entire gain in the year of the sale. This was certainly an attractive option before 2018, where the seller may have had expiring NOLs under IRC Sec. 172.

[xi] One minus the gross profit ratio.

[xii] We assume that the interest is determined at the Applicable Federal Rate under IRC Sec. 1274. If a lesser amount of interest were payable, the IRS would effectively treat a portion of each principal payment as interest income, thereby converting what would have been capital gain into ordinary income.

[xiii] Of course, the interest paid by the buyer will also be included in the seller’s gross income.

[xiv] The same amount of gain recognized in the first Example.

[xv] Reg. Sec. 15a.453-1(b)(3).

[xvi] For example, a bank certificate of deposit or a treasury note.

[xvii] By demanding payment on the note or by selling the note or by simply waiting for the scheduled time.

[xviii] A promise to pay in the future.

[xix] A balloon at maturity.

[xx] A standby letter of credit is treated as a third party guarantee; it represents a non-negotiable, non-transferable letter of credit that is issued by a financial institution, and that may be drawn upon in case of default – it serves as a guarantee of the installment obligation. In the case of an “ordinary” letter of credit, by contrast, the seller is deemed to be in constructive receipt of the proceeds because they may draw upon the letter at any time.

[xxi] IRC Sec. 453A(d). P.L. 100-203, Revenue Act of 1987.

[xxii] If any amount is treated as received with respect to an installment obligation as a result of this anti-pledge rule, subsequent payments actually received on such obligation are not taken into account for purposes of the installment sale rules, except to the extent that the gain that would otherwise be recognized on account of such payment exceeds the gain recognized as a result of the pledge.

[xxiii] IRC Sec. 453A(d)(4).

[xxiv] P.L. 106-170; H. Rep. 106-478.

[xxv] $80 multiplied by the gross profit ratio of 60% = $48.

[xxvi] IRC Sec. 453A(b)(1) and (5). Among the installment obligations excluded from the reach of this provision are those which arise from the sale of property used or produced in the trade or business of farming.

[xxvii] A person who facilitates these transactions in exchange for a fee.

[xxviii] In fact, the Intermediary will often, if not usually, have the Property direct-deeded from Seller to Buyer.

[xxix] Do you see where this cash goes? It appears to remain with Intermediary.

[xxx] On its face, therefore, the arrangement does not trigger the anti-pledge rule under IRC Sec. 453A.

[xxxi] It appears that most intermediaries suggest that this be done, at least for an “initial period” so as to demonstrate a business purpose for the loan. The implication is that, after a period of “cleansing,” the investment may be liquidated and the funds used for any purpose at all.


[xxxiii] Which explains the “suggestion” made by many intermediaries that the loan proceeds be applied by the seller toward a business or investment purpose, at least initially.

[xxxiv] IRC Sec. 453A(b)(3).

[xxxv] Stated more colorfully, and perhaps too harshly, as Billy tells Dutch in the 1987 movie Predator, “I wouldn’t waste that on a broke-dick dog.”

[xxxvi] Query how many actually do so.

[xxxvii] This is something that the arrangement borrowed from the deferred like-kind exchange rules.

[xxxviii] P.L. 106-170; H. Rep. 106-478.

Tax Law for the Closely Held Business blog author Lou Vlahos was extensively quoted in Peter J. Reilly’s latest Forbes column. He opined on the constitutionality of a wealth tax.

Below is Lou’s commentary:

[The wealth tax] is clearly a direct tax – period – which means that it has to satisfy the apportionment requirement. Given the geographic concentration of wealth (NYC, Miami, LA, etc.), how can such a tax ever be “apportioned” among the States according to their populations, in the commonly-accepted sense of that word? Or do we need to reconsider what we mean by apportionment or the relevant population?

We will hear legal arguments from every side of the debate. Unfortunately, much of it will be a question of semantics and wordplay. Much of it will be politically-motivated, in the worst sense of that phrase.

Moreover, if any legislation were enacted, the lawyers would be the primary beneficiaries of interpreting and planning for the new rules. (Just witness what has followed the TCJA.)

I am not going to comment on the impetus for such a tax, or on the need for it, or on the wisdom of imposing it. Nor am I going to comment on providing more funds to a dysfunctional Washington via a new tax rather than through an existing tax – the consequences will be the same.

To read the full article, please click here.

Counting Days

Do you know what June 29, 2019 is? Of course you do. It’s a Saturday. It’s also the 180th day of the period that began on January 1, 2019. Need another hint?

It is the final day by which a taxpayer who was an owner in a calendar-year pass-through entity – a partnership or S corporation –may elect to defer their share of any capital gain recognized by the pass-through entity during 2018 by contributing an amount equal to the amount of such gain to a qualified opportunity fund in exchange for an equity interest in the fund.

What’s more, it is the 74th day of the period that began on April 17, 2019 – the day on which the IRS issued its eagerly-awaited second set of proposed regulations related to the qualified opportunity zone (“QOZ”) rules.

Among the issues that were addressed in this second installment of guidance under Sec. 1400Z-2 of the Code was the ability of a taxpayer who already owns real property located in a QOZ to lease such property to a related person – say, a QOZ partnership – that would then improve the property and operate a qualifying business thereon. Significantly, the proposed regulations require that the terms of the lease must reflect arms-length market practice in the locale that includes the zone.

Related Parties

Anyone with any experience in tax matters is aware that transactions between related persons are generally subject to heightened scrutiny by the taxing authorities, lest the related persons structure a transaction to gain a tax advantage, without having a bona fide business purpose. Taxpayers have to be especially careful in situations for which the Code itself prescribes specific rules for dealings between related parties.

A recent decision[i] under the like-kind exchange[ii] rules – to which the QOZ rules are now often described as an alternative investment vehicle for deferring the recognition of otherwise taxable capital gain[iii] – should remind taxpayers of how vital it is to proceed with caution when transacting business with a related person.

The Transaction

Taxpayer was a business entity that owned real properties. It received a letter of intent from an unrelated third party offering to purchase one of Taxpayer’s commercial real properties (the “Property”). Among other things, the letter reserved to Taxpayer the right to effect an exchange of the Property as a like-kind exchange, and obligated the purchaser to cooperate toward that end. Taxpayer signed the letter of intent and, thereafter, began a search for suitable replacement property.[iv]

Taxpayer engaged a qualified intermediary (“Intermediary”) through which the Property would be exchanged.[v] Taxpayer thereupon assigned its rights under the letter to Intermediary, and transferred the Property to Intermediary, which sold the Property to the unrelated buyer for approximately $4.7 million. Taxpayer’s basis in the Property was approximately $2.7 million at the time of sale; a gain of approximately $2 million.

Identification Period

In order to meet the requirements for a tax-deferred like-kind exchange, Taxpayer had to identify replacement property within 45 days after the sale of the Property. Brokers presented numerous properties owned by unrelated parties as potential replacement properties, and Taxpayer attempted to negotiate the purchase of two of these properties, but was unsuccessful.

On the 45th day, Taxpayer identified three potential replacement properties, all belonging to RP, a business entity “related” to Taxpayer.[vi]

Related Trouble

Intermediary purchased the identified real property owned by RP (“New Prop”) for approximately $5.5 million of cash, and transferred New Prop to Taxpayer as replacement property for the Property, as part of the like-kind exchange.

Taxpayer filed its income tax return[vii] in which it reported a realized gain of approximately $2 million from the sale of the Property, but deferred recognition of the gain pursuant to Section 1031 of the Code.[viii]

RP recognized over $3 million of gain from its taxable sale of New Prop, but it had sufficient net operating losses (“NOLs”) to fully offset such gain.

The IRS issued Taxpayer a notice of deficiency in which it determined that Taxpayer’s gain realized on the sale of the Property could not be deferred under Section 1031. Taxpayer filed a timely petition with the U.S. Tax Court.

Unfortunately for Taxpayer, the Tax Court agreed with the IRS.

Section 1031

The gain realized by a taxpayer from the conversion of property into cash, or from the exchange of property for other property differing materially in kind, is generally recognized by the taxpayer and included in their gross income.[ix]

In contrast, Section 1031(a) provides for the non-recognition of gain when property that is held by a taxpayer for productive use in a trade or business (or for investment) is exchanged for property of a like-kind which is likewise held by the taxpayer for productive use in a trade or business (or for investment).

The basis of the property acquired by a taxpayer in a Section 1031 exchange (the “replacement property”) is determined by reference to the basis of the property exchanged by the taxpayer (the “relinquished property”).[x] By preserving the taxpayer’s basis for the relinquished property – by making it the basis for the replacement property – the taxpayer’s gain is preserved for future recognition.[xi]

A non-simultaneous exchange, where the relinquished property is transferred before the replacement property is acquired, generally may qualify for non-recognition of gain if the taxpayer identifies the replacement property, and then receives it, within 45 days and 180 days, respectively, of the transfer of the relinquished property.[xii] A taxpayer may use a “qualified intermediary” (“QI”) to facilitate such a deferred exchange – wherein the QI acquires the relinquished property from the taxpayer, sells it, and uses the proceeds to acquire replacement property that it transfers to the taxpayer “in exchange for” the relinquished property – without the QI’s being treated as the taxpayer’s agent, or the taxpayer’s being treated as in constructive receipt of the sales proceeds from the relinquished property.[xiii]

In the case of a transfer of relinquished property involving a QI, the taxpayer’s transfer of relinquished property to a QI and subsequent receipt of like-kind replacement property from the QI is treated as an exchange with the QI.

Related Party Rules

Congress added Section 1031(f) to the Code in order to prevent certain abuses in the case of like-kind exchanges between related persons. According to the IRS, because a like-kind exchange results in the substitution of the basis of the exchanged property for the property received, related parties were engaging in like-kind exchanges of high basis property for low basis property in anticipation of the sale of the low basis property. In this way, the related parties, as a unit, could reduce or avoid the recognition of gain on the subsequent sale.

For example, Taxpayer A owns Prop X with a FMV of $100 and basis of $10; Taxpayer B is related to A; B owns Prop Y with a FMV of $100 and a basis of $80; Props X and Y are like-kind to each other; an unrelated person wants to purchase Prop X; A and B swap Props X and Y in a like-kind exchange; Taxpayer B takes Prop X (B’s replacement property) with a basis equal to B’s basis in Prop Y (B’s relinquished property), or $80; B sells Prop X to the unrelated buyer and recognizes a gain of $100 minus $80, or $20; if A had sold Prop X directly to the buyer, A would have had gain of $100 minus $10, or $90; the A-B related party group saves a lot of taxes.

In general, Section 1031(f)(1) of the Code provides that if a taxpayer and a related person exchange like-kind property and, within two years, either one of the parties to the exchange disposes of the property received in the exchange, the non-recognition provisions of Section 1031(a) will not apply, and the gain realized on the exchange must be recognized as of the date of the disposition.[xiv]

Taxpayer and RP stipulated that they were related persons for purposes of this provision.[xv]


Section 1031(f) of the Code provides an exception to the “disallowance-upon disposition” rule for related parties. Specifically, it provides that any disposition of the relinquished or replacement property within two years of the exchange is disregarded if the taxpayer establishes to the satisfaction of the IRS, with respect to the disposition, “that neither the exchange nor such disposition had as one of its principal purposes the avoidance of Federal income tax.”[xvi]

The Tax Court

The IRS did not dispute that Taxpayer’s exchange of the Property for New Prop met the requirements for a like-kind exchange. Furthermore, because Taxpayer used Intermediary to facilitate its sale of the Property and acquisition of the New Prop, the IRS did not contend that the exchange ran afoul of the specific requirements of section 1031(f). However, the IRS contended that Taxpayer’s exchange was disqualified from non-recognition treatment as a transaction structured to avoid the purposes of Section 1031(f) of the Code.

The Tax Court noted that the transaction at issue was the economic equivalent of a direct exchange of property between a taxpayer and a related person, followed by the related person’s sale of the relinquished property and their retention of the cash proceeds. In that case, the investment in the relinquished property had been cashed out, contrary to the purpose of Section 1031(f).

According to the Tax Court, the Taxpayer’s transaction was no different: The investment in the Property was cashed out with a related person’s (RP) retaining the cash proceeds. The interposition of a QI “could not obscure that result.”

Taxpayer: “No Intent to Avoid”

Taxpayer argued, however, that the exchange of the properties was not structured to avoid the purposes of Section 1031(f) because Taxpayer had no “prearranged plan” to conduct a deferred exchange with RP. Taxpayer contended that it had no prearranged plan because it first diligently sought a replacement property held by an unrelated party and only turned to New Prop when the deadline to complete a deferred exchange was imminent.

Taxpayer also emphasized that it decided to acquire the replacement property from a related person only after it had already engaged a QI (because a deferred exchange was necessary).

The Tax Court, however, found that the presence or absence of a prearranged plan to use property from a related person to complete a like-kind exchange was not dispositive of a violation of Section 1031(f).[xvii]

The Results Say It All

According to the Tax Court, the inquiry into whether a transaction has been structured to avoid the purposes of Section 1031(f) is focused on the actual tax consequences of the transaction to the taxpayer and the related party, considered in the aggregate, as compared to the hypothetical tax consequences of a direct sale of the relinquished property by the taxpayer. Those actual consequences form the basis for an inference concerning whether the transaction was structured in violation of Section 1031(f).[xviii]

The Tax Court stated that it would infer a tax-avoidance purpose where the aggregate tax liability of the taxpayer and the related person arising from their “like-kind exchange and sale transaction” is significantly less than the hypothetical tax that would have arisen from the taxpayer’s direct sale of the relinquished property.

The Tax Court determined that Taxpayer would have had to recognize a $2 million gain had Taxpayer directly sold the Property to the unrelated third party. However, because the transaction was structured as a like-kind exchange, only RP was required to recognize gain, and that gain was almost entirely offset by its NOLs. The substantial economic benefits to Taxpayer as a result of structuring the transaction as a deferred exchange were thus clear: Taxpayer was able to cash out of the investment in the Property almost tax free. The Court thus inferred that Taxpayer structured the transaction with a tax-avoidance purpose.

Taxpayer argued that the transaction nonetheless lacked a tax-avoidance purpose because it did not involve the exchange of low-basis property for high basis property.[xix]

It is true that RP recognized more gain on the disposition of New Prop than Taxpayer realized on the disposition of the Property. However, RP was able to offset the gain recognized with NOLs, resulting in net tax savings to Taxpayer and RP as an economic unit. Net tax savings achieved through use of the related party’s NOLs may demonstrate the presence of a tax-avoidance purpose notwithstanding a lack of basis shifting.

In sum, by employing a deferred Section 1031 exchange transaction to dispose of the Property, Taxpayer and RP, viewed in the aggregate, “have, in effect, ‘cashed out’ of the investment”, virtually tax free – in contrast to the substantial tax liability Taxpayer would have incurred as a result of a direct sale to the unrelated buyer. Consequently, the transaction was “structured in contravention of Congress’s desire that non-recognition treatment only apply to transactions where a taxpayer can be viewed as merely continuing his investment.”

Therefore, the Court concluded that the transaction was structured to avoid the purposes of Section 1031(f) and, consequently, Taxpayer was not entitled to defer recognition of the gain realized on the exchange of the Property under Section 1031(a)(1).

Taxpayer then appealed to the Ninth Circuit Court of Appeals.[xx]

Can You Say “Affirmed?”

The Court began its discussion by stating that, generally, “a taxpayer must pay taxes on gain realized on the sale or exchange of property. Section 1031 is an exception to this rule and is strictly construed.”

Under Section 1031(f), it continued, “a party may benefit from nonrecognition of the gain from an exchange of like-kind property with a related party . . . . However, any transaction or series of transactions structured to avoid the purposes of Section 1031(f) is ineligible for nonrecognition.”

The Court explained that the exchange at issue was structured for “tax avoidance purposes” because Taxpayer and RP “achieved far more advantageous tax consequences” by employing Intermediary to conduct the like-kind exchange than it would have had Taxpayer simply sold the Property to the third-party buyer itself. Had it done so, Taxpayer would have had to recognize approximately $2 million of gain. “Because the aggregate tax liability arising out of the exchange was significantly less than the hypothetical tax liability that would have arisen from a direct sale between the related parties, the like-kind exchange served tax avoidance purposes.”

Therefore, Taxpayer was not entitled to non-recognition of gain under Section 1031 of the Code.

Beware the Related Person

Especially when they come bearing gifts such as NOLs or high basis assets.

But seriously, a taxpayer should never be surprised when they are transacting with a related person. This warning applies most strongly to the owners of a closely held business and its affiliates, who are especially susceptible to engaging in such a transaction. They should know that the IRS will subject the transaction to close scrutiny.

The IRS will examine the transaction to ensure that it reflects a bona fide economic arrangement – in other words, that the related parties are dealing at arm’s-length with one another, and are not trying to achieve an improper tax result by manipulating the terms of the arrangement.

In other situations, such as the one described in this post, there are statutory and regulatory requirements and limitations of which the taxpayer must be aware when dealing with a related person. The disallowance or suspension of a loss, the conversion of capital gain into ordinary income, the denial of installment reporting – all these and more await the uninformed taxpayer.[xxi]

It is imperative that the taxpayer consult with their advisers prior to undertaking any transaction with any person with which or whom they have some relationship. The adviser should be able to determine whether the relationship is among those that the IRS views as worthy of closer look. The adviser should also be able to inform the taxpayer whether the relationship comes within any of the applicable anti-abuse or other special rules prescribed by the Code or the IRS.

In this way, the taxpayer can plan accordingly, and without surprises.

[i] The Malulani Group, Limited v. Comm’r, No. 16-73959 (9th Cir. 2019).

[ii] IRC Sec. 1031.

[iii] and

[iv] The search should always begin as far in advance of the sale as is reasonably possible.

[v] As part of a deferred exchange.

[vi] Many taxpayers will identify a Delaware Statutory Trust as their final choice of replacement property – in case they cannot acquire one of their “preferred” replacement properties – simply to avoid the recognition of gain from the sale of the relinquished property.

[vii] IRS Form 8824 asks whether the exchange involved a related person.

[viii] Kris: upper case “C”.

[ix] Reg. Sec. 1.1001-1.

[x] IRC Sec. 1031(d).

[xi] Taxpayer A owns Prop X with a FMV of $100 and a basis of $20 (built-in gain of $80); A exchanges Prop X for Taxpayer B’s like-kind Prop Y, which has a FMV of $100; A takes Prop Y with a basis of $20, thereby preserving the $80 of gain.

[xii] IRC Sec. 1031(a)(3).

[xiii] Reg. Sec. 1.1031(k)-1(g)(4)(i).

[xiv] Although Section 1031(f)(1) disallows non-recognition treatment only for direct exchanges between related persons, Section 1031(f)(4) provides that non-recognition treatment does not apply to any exchange which is part of a transaction or series of transactions “structured to avoid the purposes of” Section 1031(f). Therefore, Section 1031(f)(4) may disallow non-recognition treatment of a deferred exchange that only indirectly involves related persons because of the interposition of a QI.

[xv] Related persons for purposes of this anti-abuse rule are those with relationships defined in Sections 267(b) or 707(b)(1) of the Code.

[xvi] Any inquiry under IRC Sec. 1031(f)(4) as to whether a transaction is structured to avoid the purposes of section 1031(f) also takes into consideration the “non-tax-avoidance exception” in Sec. 1031(f)(2)(C).

[xvii] Because the absence of a prearranged plan was not dispositive regarding a violation of IRC Sec. 1031(f)(4), the Court did not believe it was material that Taxpayer engaged a QI before deciding to acquire New Prop from RP.

[xviii] In other words, one must compare the hypothetical tax that would have been paid if the taxpayer had sold the relinquished property directly to a third party with the actual tax paid as a result of the taxpayer’s transfer of the relinquished property to the related party in a like-kind exchange followed by the related party’s sale of the relinquished property. For this purpose, the actual tax paid comprised the tax liability of both the taxpayer and the related in the aggregate.

[xix] As in the example, above.

[xx] IRC Sec. 7482.

[xxi] For example, IRC Sections 267, 453, 707 and 1239.

Letters, acronyms, initialisms[i] – they seem to slip into every post these days.

It has always been a goal of U.S. tax policy to ensure that taxable income sourced in the U.S. does not escape the federal income tax.

In general, this income and the scenarios in which it arises are easily identifiable. However, there are occasions where the IRS, in interpreting Congressional policy, has to address a not-so-obvious gap in legislation.

Regulations recently issued in response to one of the 2017 federal tax changes[ii] to the S corporation rules provide an example of one such scenario.

“S corporations?” you say.

C Corps and Partnerships

Yes, the C corporation may have been the principal beneficiary of the Act, especially when one considers the much reduced federal rate at which its profits are taxed;[iii] and yes, partnerships offer more flexibility than any other business entity insofar as the economic arrangements among its owners are concerned.[iv]

The fact remains, however, that the earnings of a C corporation are subject to so-called “double taxation.”[v] While this may not present an issue to a business that is reinvesting its profits, rather than paying them out as dividends,[vi] it is a serious consideration for the individual business owner who plans to sell that business one day – timing is everything – and who recognizes that most buyers will prefer to acquire the assets of the business rather than its issued and outstanding shares.[vii]

The fact also remains that the individual owners of a partnership that is engaged in an active trade or business[viii] will be subject to self-employment tax on their distributive shares of the partnership’s ordinary business income.[ix]

What about the S corporation?

Don’t Forget the S Corp

In general, a “small business corporation,” the shareholders of which have made an “S” election,[x] is not itself subject to federal income tax, either on its ordinary business income or on the gain from the sale of its assets.[xi] Instead, the corporation’s profits flow through to its shareholders (whether or not distributed), who report them on their personal income tax returns, and adjust their stock basis accordingly.[xii]

Because of these stock basis adjustments, the subsequent distribution of these profits is generally not subject to tax in the hands of the shareholders.[xiii]

Thus, only one level of federal income tax is imposed on the corporation’s profits. In addition, these profits are not subject to self-employment tax in the hands of the shareholders.[xiv]

Basic Requirements

Yes, there are a number of requirements – limitations, really – that a domestic corporation must satisfy in order to qualify as a small business corporation; it cannot have: (i) more than 100 shareholders, (ii) as a shareholder a person (other than an estate and certain trusts) who is not an individual, (iii) a nonresident alien (“NRA”) as a shareholder,[xv] and (iv) more than one class of stock.[xvi]

However, in the case of most closely held businesses, these limitations have little practical effect. What’s more, in many cases, some of the obstacles they present may be addressed through the judicious use of a partnership.[xvii]

That being said, there have been legislative efforts over the years to “modernize” the rules applicable to S corporations by scaling back some of the limitations – especially where the the underlying tax policy is not sacrificed or compromised – in order to prevent them from becoming punitive with respect to the individual shareholders of an S corporation.[xviii]


One example of a measure that modernized the S corporation rules was the introduction of the electing small business trust (“ESBT”) in 1996.[xix] Prior to that legislation, only grantor trusts, voting trusts, certain testamentary trusts, and qualified subchapter S trusts could be shareholders in an S corporation.[xx]

Congress recognized that, in order to facilitate family estate and financial planning, an individual who owned shares of stock in an S corporation should be allowed to contribute their shares to a non-grantor trust that provides for the distribution of trust income to, or its accumulation for, a class of individuals; for example, a trust that authorizes the sprinkling of income among the contributing shareholder’s family members who are beneficiaries of the trust, at such times, and in such amounts, as may be determined by a trustee.[xxi]

And, so, the ESBT was born.

An ESBT is a domestic trust[xxii] that satisfies the following requirements: (i) The trust does not have as a beneficiary any person other than an individual, an estate, or certain exempt organizations; (ii) no interest in the trust was acquired by purchase;[xxiii] and (iii) the trustee has made an election with respect to the trust.[xxiv] A grantor trust may elect to be an ESBT.


An ESBT may hold S corporation stock as well as other property, and it may accumulate trust income.[xxv] A potential current beneficiary (“PCB”)[xxvi] may be one of multiple beneficiaries of an ESBT.

The term “potential current beneficiary” means, with respect to any period, any person who at any time during such period is entitled to, or at the discretion of any person may receive, a distribution from the principal or income of the trust.[xxvii] In general, a PCB is treated as a shareholder of the corporation for purposes of determining whether the corporation qualifies as an S corporation.[xxviii] No person is treated as a PCB solely because that person[xxix] holds any future interest in the trust.

If all or a portion of an ESBT is treated as owned by a person under the grantor trust rules, such owner is also treated as a PCB.[xxx]

NRAs as PCBs

Before 2018, an NRA could have been an “eligible beneficiary” of an ESBT.[xxxi] However, if the NRA ever became a PCB of the ESBT[xxxii] – and was thereby treated as a shareholder of the corporation for purposes of its qualification as an S corporation – the corporation’s “S” election would have terminated because an NRA is not an eligible shareholder.[xxxiii]

Similarly, a change in the immigration status of a PCB of an ESBT from a resident alien (a “U.S. person”) to an NRA would have terminated an ESBT election and, thus, also terminated the corporation’s “S” election.[xxxiv]

Then, in late 2017, the Act amended the Code to allow NRAs to be PCBs of ESBTs. As amended, the Code[xxxv] provides that NRA-PCBs will not be taken into account for purposes of the S corporation shareholder-eligibility requirement that otherwise prohibits NRA shareholders. As a result of that amendment, if a resident alien PCB of an ESBT becomes an NRA, the status of that PCB as an NRA will not cause the S corporation of which the ESBT is a shareholder to terminate its “S” election. What’s more, an NRA-PCB may receive a distribution of income from an ESBT without jeopardizing the corporation’s “S” election. Of course, a distribution of principal to an NRA-PCB from the ESBT – i.e., a distribution of shares of stock in an S corporation – will terminate the “S” election.[xxxvi]

While Congress expanded the scope of qualifying beneficiaries (PCBs) of ESBTs, it left unaltered the rule that an S corporation cannot have an NRA as a shareholder.

Separate Trusts

An ESBT that owns stock of an S corporation, as well as other property, is treated as two separate trusts (an S portion and a non-S portion, respectively) for purposes of the federal income tax, even though the ESBT is treated as a single trust for administrative purposes.[xxxvii]

Specifically, the S portion, which consists solely of S corporation stock, is treated as a separate trust; in general, it is taxed on its share of the S corporation’s income at the highest rate of tax imposed on individual taxpayers.[xxxviii] This income – whether or not distributed by the ESBT – is not taxed to the beneficiaries of the ESBT.[xxxix]

The non-S portion of the ESBT remains subject to the usual trust income taxation rules that govern simple and complex trusts.

In addition, the S portion or the non-S portion of the trust (or both) can be treated as owned by a grantor (the “grantor portion”) under the grantor trust rules.[xl]

Grantor Trust

Generally speaking, a grantor trust is a trust with respect to which the grantor has retained certain rights over the trust’s income or assets such that the income of the trust should be taxed to the grantor rather than to the trust which receives the income, or to the beneficiary to whom the income may be distributed. If a trust is a grantor trust, then (i) the grantor is treated as the owner of the assets, (ii) the trust is disregarded as a separate entity for federal income tax purposes, and (iii) all items of income, deduction, and credit are taxed to the grantor as the deemed owner.

Wholly or partially-owned grantor trusts can make an ESBT election, but the grantor trust taxation rules of the Code override the ESBT provisions; in other words, the income of the portion of an ESBT treated as owned by the grantor is taken into account by the deemed owner (rather than by the ESBT) in computing the deemed owner’s taxable income.[xli] Stated differently, an ESBT pays tax directly at the trust level on its S corporation income, except for the amount that is taxed to the owner of the grantor trust portion of the ESBT.

The Issue

As indicated above, the deemed owner of the grantor trust portion of an ESBT is treated as a PCB of the ESBT. What if the deemed owner is an NRA?

Under the grantor trust rules,[xlii] the income of a domestic trust is taxed to an NRA grantor if the only amounts distributable from such trust (whether income or corpus) during the lifetime of the grantor are amounts distributable to the grantor or the spouse of the grantor.

As enacted, the Act’s expansion of an ESBT’s permissible PCBs to include an NRA may have allowed S corporation income attributed to the grantor trust portion of an ESBT that is received by an NRA deemed owner of that portion, to escape federal income taxation.

For example, if an NRA grantor were a deemed owner of a domestic trust that elected to be an ESBT, and thus were to be allocated foreign source income of the S corporation, or income not effectively connected with the conduct of a U.S. trade or business, that NRA would not be required to include such S corporation items in income because the NRA would not be liable for federal income tax on such income.[xliii] In other words, the NRA deemed owner would not be subject to U.S. federal income tax on the S corporation income unless this income was U.S. source fixed or determinable income, or income effectively connected with a U.S. trade or business.

The IRS Reacts

The general rule of ESBT taxation subjects the ESBT to tax on its S corporation income at the trust level, rather than the beneficiary level. Because the ESBT must be domestic, this rule is “indifferent” to the citizenship or residence status of the ESBT’s beneficiaries.

However, the IRS realized that this general rule does not take into account the interaction between the ESBT and grantor trust tax regimes, which allows a trust to be an ESBT for S corporation qualification purposes while permitting all or a portion of the trust subject to the grantor trust rules to be taxed as a grantor trust, rather than as an ESBT. As described earlier, the taxable income of a grantor trust that elects to be an ESBT is treated as the taxable income of the deemed owner of the trust, regardless of whether the ESBT distributes the income.

According to the IRS, Congress assumed that the taxation of income at the ESBT level would protect against potential tax avoidance that might otherwise result from permitting an NRA to be a PCB of an ESBT.

However, the IRS observed that the post-Act ability of an NRA to be a PCB of an ESBT, in combination with the potential for a grantor trust portion of an ESBT to be owned by an NRA, could result in S corporation income passing without tax from the domestic ESBT to the NRA, thereby escaping federal income taxation.

 The IRS determined that, by allowing an NRA to be a PCB of an ESBT, Congress did not intend to override statutory provisions that have operated to ensure that all of S corporation income remains subject to federal income tax.

The New Regulations

In response to the risk arising from the unintended interplay of the ESBT and grantor trust rules, the IRS issued regulations that were just recently finalized.[xliv] These regulations ensure that, with respect to situations in which an NRA is a deemed owner of a grantor trust that has elected to be an ESBT, the S corporation income of the ESBT will continue to be subject to U.S. federal income tax.

Specifically, the regulations require that the S corporation income of the ESBT be included in the S portion of the ESBT if that income otherwise would be allocated to an NRA deemed owner under the grantor trust rules.

Accordingly, such income will be taxed to the domestic ESBT by providing that, if the deemed owner is an NRA, the grantor portion of the trust’s net income must be reallocated from the grantor portion of the ESBT to the S portion of the trust.

These proposed regulations are proposed to apply to all ESBTs after December 31, 2017.

What to Do?

The addition of NRAs as PCBs of an ESBT[xlv] comes at a time when many U.S. individuals are studying, living or working overseas. These individuals may already be, or may one day become, shareholders of an S corporation. Of course, many of these individuals may develop close relationships with NRAs, and eventually seek to share some of their wealth with these NRAs; for example, by making them beneficiaries of their estates, whether outright or through trusts like ESBTs.

Notwithstanding the change in the Code to permit NRA-PCBs, and speaking generally, the shareholders of an S corporation have a duty to one another to preserve their corporation’s “S” election.[xlvi]

This “obligation” is most often (if ever) memorialized in a shareholders’ agreement under which the owners of the S corporation agree not to transfer their shares to a person that is not eligible to be a shareholder of an S corporation. In many cases, the concept of a “transfer” will be interpreted broadly by the agreement to include, for example, not only the initial transfer into a trust, but also all subsequent transfers or distributions from the trust, including any that are contingent – we don’t want our NRA-PCB eventually becoming a shareholder.

In other agreements, the shareholders go so far as to require the disclosure of their estate plans to the corporation[xlvii] so as to avoid any surprises upon the passing of a shareholder. For example, if a shareholder’s only potential beneficiaries are NRAs, it would behoove the corporation and the other shareholders to be aware of that fact in advance.[xlviii] In that instance, the shareholders and the corporation will want to provide and plan for the eventual mandatory buyout of that shareholder’s interest.[xlix]

As in all things, it pays to be prepared.


[i] Yes, it is a word.

[ii] Tax Cuts and Jobs Act; P.L. 115-97. The Act.

[iii] 21-percent; IRC Sec. 11. Down from a maximum graduated rate of 35-percent.

Of course, the Act gave pass-through entities, including partnerships and S corporations, the Sec. 199A deduction as a consolation prize.

[iv] “All” that is required is that the allocation of income among the partners have substantial economic effect. IRC Sec. 704(b); otherwise, the owners are relatively free to share the economic pie as they see fit.

[v] Once at the level of the corporation, and again when distributed to its shareholders as a dividend. In the case of individual shareholders, the dividend is subject to a federal tax rate of 20-percent (assuming a “qualified” dividend) and a federal surtax of 3.8-percent (as net investment income). IRC Sec. 1(h); IRC Sec. 1411. A combined federal rate of 39.8-percent.

[vi] Subject always to the accumulated earnings tax. IRC Sec. 531.

[vii] An asset purchase is less expensive for a buyer because it enables the buyer to recover its purchase price through depreciation, amortization, and expensing of its investment. IRC Sec. 168 and 197.

[viii] As opposed to an “investment partnership” that invests for its own account.

[ix] IRC Sec. 1401 and 1402.

[x] IRC Sec. 1362.

[xi] IRC Sec. 1363. There are exceptions; for example, the built-in gains tax under IRC Sec. 1374, and the excise tax under IRC Sec. 1375.

[xii] IRC Sec. 1366 and 1367. The maximum federal income tax rate on the ordinary income of an individual shareholder is 37-percent. However, if an individual shareholder does not materially participate in the business of the S corporation, their share of its income may also be subject to the 3.8-percent federal surtax on net investment income under IRC Sec. 1411.

[xiii] IRC Sec. 1367 and 1368. We assume for our purposes that the S corporation has no E&P from C corporation tax years (whether its own or the E&P of a corporation that it acquired on a “tax-free” basis).

[xiv] Of course, any shareholder who provides services to the S corporation should be paid a reasonable salary in exchange for such services; this salary will be subject to employment tax.

[xv] An NRA is an individual who is neither a citizen nor a resident of the U.S.[xv] In general, an alien individual is treated as a resident of the U.S. with respect to any calendar year if such individual[xv] (i) is a lawful permanent resident of the U.S. at any time during such calendar year;[xv] or (ii) meets the so-called “substantial presence test.”[xv] IRC Sec. 7701(b)(1) and Sec. 7701(b)(3).

[xvi] IRC Sec. 1361(b).

[xvii] See, e.g., Reg. Sec. 1.701-2(d), Ex. 2.

[xviii] One has to recall that, before the introduction of the LLC, S corporations were the most popular “corporate” entity for small businesses. There are a lot of S corporations out there. These corporations cannot convert into LLCs without triggering tax liability for their shareholders.

[xix] IRC Sec. 1361(e). Small Business Job Protection Act of 1996; P.L. 104-188; Sec. 1302(a), effective for tax years beginning after December 31, 1996. See Reg. Sec. 1.1361-1(m).

[xx] IRC Sec. 1361(c).

[xxi] Sometimes referred to as a “pot trust.”

[xxii] IRC Sec. 7701(a)(30)(E); meaning a domestic court exercises primary supervisions over the administration of the trust, and one or more U.S. persons have the authority to control all substantial decisions of the trust.

[xxiii] I.e., with a cost basis. IRC Sec. 1012.

[xxiv] Once made, the election applies to the year for which it is made and all subsequent years.

[xxv] Compare to a QSST. IRC Sec. 1361(d).

[xxvi] Not Polychlorinated biphenyl.

[xxvii] IRC Sec. 1361(e)(2).

[xxviii] IRC Sec. 1361(c)(2)(B)(v); Reg. Sec. 1.1361-1(m)(4)(i).

[xxix] Including an NRA.

[xxx] Reg. Sec. 1.1361-1(m)(4).

[xxxi] Reg. Sec. 1.1361-1(m)(1)(ii)(D).

[xxxii] See what I mean about acronyms and initialisms?

[xxxiii] Reg. Sec. 1.1361-1(m)(5)(iii).

[xxxiv] This result would have occurred because, prior to the Act, the Code provided that each PCB of an ESBT had to be treated as a shareholder of the S corporation.

[xxxv] IRC Sec. 1361(c)(2)(B)(v).

[xxxvi] IRC Sec. 1361(b)(1)(C) and Sec. 1362(d)(2).

[xxxvii] Reg. Sec. §1.641(c)-1(a).

[xxxviii] IRC Sec. 641(c). The maximum rate is 37-percent after the Act.

[xxxix] Accordingly, there is no distribution deduction for the trust.

[xl] IRC Sec. 671 et seq.

[xli] See §1.641(c)-1(c).

[xlii] IRC Sec. 672(f)(2)(A)(ii).

[xliii] Under IRC Sec. 871(a) or (b). Likewise, if the NRA is a resident of a country with which the U.S. has an income tax treaty, U.S. source income of the S corporation also might be exempt from tax, or subject to a lower rate of tax, in the hands of that NRA.

[xliv] T.D. 9868.

[xlv] It’s anything but poetic.

[xlvi] I know, “Lou, what do you have against love?” To which I respond, “What’s love got to do, got to do with it?”

[xlvii] Usually the board of directors.

[xlviii] I hate surprises. And the process of requesting reinstatement of an S election after an “inadvertent” termination is not always as straightforward as some may believe.

[xlix] Perhaps by purchasing life insurance on that shareholder’s life.

Tax and bankruptcy: “Can two divorced men share an apartment without driving each other crazy”[i] or Two great tastes that taste great together”?[ii]

For years I have told my partners that there are two kinds of “codes”: those with an upper case “C”, like the Ten Commandments and the Internal Revenue Code, and those with a lower case “c”, like the bankruptcy code.[iii]

There are times, however, when the veil that separates the rarefied world of tax from the gritty struggles of bankruptcy practice is inexplicably pierced and the players from each sphere slip through the openings, either invited or not, to dabble in the other’s affairs.[iv]

This should not come as a surprise to anyone who has advised closely held businesses. Whether the business is just starting out, or is going through some difficult times on its way to recovery and growth, or is on its proverbial last legs, the business or its owners (if the business is a pass-through entity for tax purposes) will have developed or generated certain tax attributes, including net operating losses, the utilization of which may be instrumental either in salvaging the business or in satisfying its creditors.[v]

A recent bankruptcy court decision[vi] considered an issue at one intersection of the two bodies of law.[vii]

The Bankruptcy

Debtor, which was formed as a partnership under state law, filed a bankruptcy petition under Chapter 11.[viii] The Court confirmed the “Debtor’s Plan” which, among other things, required Debtor to provide the creditors’ committee (the “Committee”) verification that Debtor was making the payments required under the Plan. If Debtor defaulted, Debtor had thirty days to cure, failing which the Plan provided for the appointment of a Liquidating Trustee to dispose of Debtor’s assets.

Debtor informed the Committee that the revenues necessary to make the payments under the Plan were not going to materialize within the requisite period, and stated “this is the time to name a liquidating agent” under the Plan.

The Committee confirmed the notice of default, and informed Debtor of its intent to move for the appointment of a Liquidating Trustee if Debtor failed to timely cure the default. Debtor failed to cure within thirty days.

The Committee’s motion and proposed order included a provision under which not less than ten-percent of the aggregate gross proceeds from the sale of assets by the Liquidating Trustee would be allocated for payment of allowed administrative expenses and unsecured claims.

Debtor objected to the Committee’s motion for appointment of a Liquidating Trustee.

Capital Gain

Debtor argued that any sale of assets would result in a liability for capital gains taxes. It also argued that any sale was unlikely to yield proceeds in an amount sufficient to provide for the payment of such capital gains taxes (which would be payable by the Debtor’s owners) and of the Liquidating Trustee’s fees, Debtor’s attorney fees, and the Committee’s attorney fees.

In addition, although Debtor had previously conceded that it was ineligible to be a debtor under Chapter 12 of the “code” when it filed its petition, Debtor now asserted that its total debts were below the prescribed ceiling amount, making it eligible to proceed under Chapter 12.[ix] Debtor sought to convert to Chapter 12 in order to capitalize on what it referred to as the “Grassley Law” allowing it to treat certain capital gains taxes as unsecured claims. According to Debtor, without a conversion, capital gains taxes from the sale of its assets would render the estate administratively insolvent.

According to the Committee, potential capital gains taxes were a non-issue because Debtor was a partnership, and a pass-through entity, for tax purposes. The Committee pointed out that the partners, and not the partnership, would be liable for any taxes arising from the sale of Debtor’s assets.

Debtor countered that it was eligible to elect to be taxed as an “association” (i.e. as a corporation) under the IRS’s “check the box” regulations.[x] Debtor claimed that if such an election were made,[xi] the corporation’s taxes would be discharged as an unsecured claim under Chapter 12.

According to Debtor, the “best approach” would be for the Court to deny the Committee’s motion for appointment of a Liquidating Trustee, allow the conversion of the proceeding to chapter 12, and confirm a chapter 12 plan incorporating liquidation provisions.

The Court made short work of Debtor’s request that the proceeding be converted to one under chapter 12, stating that Debtor was not a “family farmer.” Its debt exceeded the statutory limit when it filed its petition. According to the Court, conversion does not change the date on which eligibility under chapter 12 is determined. Thus, “under the facts and clear language of the statute,” Debtor was not eligible to convert to chapter 12.

Debtor’s Tax Status

The Court then turned to Debtor’s request to change its tax status from a partnership to an association taxable as a corporation.

Debtor’s Tax Status

Partnerships, for purposes of taxation, are “pass-through entities,” the Court stated. A partnership files an information return,[xii] but the partnership itself is not responsible for taxable gains and losses; rather, such gains and losses pass through to the partners themselves, who report them on their own income tax returns.[xiii]

“A partnership’s bankruptcy filing,” the Court continued, “does not alter its tax status. A partnership is recognized as an entity separate from the partners in bankruptcy proceedings, but not in income taxation.”

Thus, partnership income continues to be taxed as though a bankruptcy case had not been commenced. For purposes of the federal income tax, the commencement of a bankruptcy case by either a partner or a partnership does not alter the tax status of the partnership.

In fact, except in the case of an individual bankruptcy, no separate taxable entity results from the commencement of a case “under Title 11 of the United States Code.”[xiv]

Eligibility for Election

Having established Debtor’s tax status during the bankruptcy, the Court considered its eligibility to change such status.

An “eligible entity” with at least two owners, it stated, can elect to be treated as an association for federal tax purposes. Eligible entities include unincorporated business entities, including domestic partnerships.

Absent such an election, a partnership would continue to be taxed as a partnership. Since its creation, Debtor was a partnership for tax purposes. It never made any other election as to its status. Thus, it continued to be taxed as a partnership. The bankruptcy filing did not impact Debtor’s tax status.

The Court observed that the Code, and the regulations issued thereunder, would permit Debtor to elect to be treated as a corporation for federal tax purposes. Debtor maintained that making such an election “would be beneficial.”

While noting that the election may benefit the partners of Debtor,[xv] the Court further noted that the more relevant question was “whether it benefits [Debtor], its estate and its creditors. As a result, the Court must decide whether a change in election violates the Bankruptcy Code or Plan.”[xvi]

Specifically, the Court considered whether the change in tax status caused by the election would violate the so-called “absolute priority rule.”

The absolute priority rule provides that the owners of a debtor, or those holding an interest in a debtor, will not receive or retain under the bankruptcy plan any property, because of that ownership or other interest, unless all general unsecured claims are paid in full.[xvii]

The fundamental principle underlying the rule is to ensure the plan is “fair and equitable.” The rule prohibits the bankruptcy court from approving a plan that gives the holder of a claim anything at all unless all objecting classes senior to the claimant have been paid in full.[xviii] The rule serves to address what the Court described as “the danger inherent in any reorganization plan . . . that the plan will simply turn out to be too good a deal for the debtor’s owners.”

The Court found that the proposed tax election would violate the absolute priority rule. It was not fair and equitable. By converting Debtor into a taxable[xix] entity, and terminating its pass-through status,[xx] the election would benefit Debtor’s owners to the detriment of its creditors by shifting funds from the creditors to the taxing authorities. It would dilute the class of unsecured creditors.

From the time that Debtor filed its petition, the Court explained, its partners retained the benefit of favorable tax treatment through any depreciation or other losses that flowed through Debtor as a pass-through entity.[xxi]

The partners now sought to effect a change in the tax treatment of Debtor that would have saddled Debtor with substantial capital gains and taxes from the sale of its assets. In other words, the partners would receive a tax benefit (Debtor’s losses and deductions) through favorable tax treatment, and would shift the unfavorable treatment to the detriment of Debtor’s creditors. The absolute priority rule, the Court stated, was designed to prevent such an abuse.

What’s more, the Court continued, Debtor’s disclosure statement[xxii] detailed the tax consequences of the Plan. “There is a possibility that various transfers and transactions contemplated by the Plan would result in a reduction of certain tax attributes . . . including but not limited to . . . capital gains liability”.

At the time of the Court’s confirmation of the Plan, Debtor could have discussed the treatment of capital gains taxes and the possibility of an entity classification election. The Disclosure Statement and Plan both included the Liquidation Provision. Thus, Debtor knew that upon default, a Liquidating Trustee could be appointed and assets sold. There was no unfair surprise to Debtor, but there would be unfair surprise to its creditors. Creditors acted relying on the Disclosure Statement and Plan, which did not include a discussion of a possible change in tax treatment. The Court stated that any election to be taxed as an association should have occurred pre-petition, or at least pre-confirmation.

The Court found it troubling that the Debtor sought to change its tax status to its own detriment and, thereby, to that of its creditors. In general, the Court stated, the two purposes underlying the bankruptcy code are the “debtor’s fresh start and the repayment of creditors.” Debtor’s electing to be taxed as an association, the Court stated, would accomplish neither of these goals. Rather, it would burden Debtor with potentially substantial capital gains taxes, and reduce payments to its creditors. The election would merely allow Debtor’s partners to shift unfavorable tax treatment elsewhere.

The Court determined that the proposed tax election was not in the best interests of Debtor, the estate, or its creditors. Therefore, the Court prohibited the check-the-box election.

Electing Association Status vs. Revoking an “S” Election? [xxiii]

What can we take away from the Court’s opinion? The Court claimed to have based its decision upon the absolute priority rule. At the same time, though, the Court stated that any election by Debtor to be taxed as an association should have occurred pre-petition, or at least pre-confirmation, which is more in line with the purpose of the disclosure statement. So which is it?

A couple of years back,[xxiv] we considered the case of another pass-through entity: a debtor S-corporation which, prior to filing its voluntary petition, revoked its election to be treated as an S-corporation for tax purposes.[xxv] As a result of revoking its “S” election, the debtor became subject to corporate-level tax as a C-corporation, and its shareholders – to whom distributions from the debtor would likely have ceased after the filing of its petition – were no longer required to report its income on their personal returns.[xxvi]

Following the debtor’s petition, the Court authorized the sale of substantially all of the debtor’s operating assets. The sale occurred shortly thereafter, and the Court then confirmed the debtor’s plan of liquidation, pursuant to which a liquidating trust was formed.

The liquidating trustee filed a complaint against the debtor’s shareholders, seeking to avoid the revocation of the debtor’s S-corporation status as a fraudulent transfer of the debtor’s property under the bankruptcy code.[xxvii]

The Court noted that most other courts that had considered the issue found that a debtor’s S-corporation status was a property right in bankruptcy. These courts reasoned that a debtor corporation had a property interest in its S-corporation status on the date that the status was allegedly “transferred” because the Code “guarantees and protects an S corporation’s right to dispose of [the S-corporation] status at will.” Until such disposition, the corporation had the “guaranteed right to use, enjoy, and dispose” of the right to revoke its S-corporation status. Consequently, these courts held that the right to make or revoke S-corporation status constituted “property” or “an interest of the debtor in property.”

The Court acknowledged that the property of the bankruptcy estate is composed of “all legal or equitable interests of the debtor in property as of the commencement of the case.” Congressional intent, it stated, indicated that “property” under the code[xxviii] was a sweeping term and included both intangible and tangible property.

However, it continued, no code provision “answers the threshold questions of whether a debtor has an interest in a particular item of property and, if so, what the nature of that interest is.” Property interests are created and defined by state law, unless some countervailing federal interest requires a different result.

Normally, the “[Code] creates no property rights but merely attaches consequences, federally defined, to rights created under state law.” In that case, the Court stated, federal tax law governed any purported property right at issue because S-corporation status was a creature of federal tax law. State law created “sufficient interests” in the taxpaying entity by affording it the requisite corporate and shareholder attributes to qualify for S-corporation status; at that point, it continued, federal tax law dictated whether S-corporation status was a property right for purposes of the code.

The Court recognized that certain interests constituted “property” for federal tax purposes when they embodied “essential property rights.”[xxix] A reviewing court must weigh these factors, it stated, in order to determine whether the interest in S-corporation status constituted “property” for federal tax purposes.

Applying these “essential property rights” factors, the Court observed that only one of the factors leaned in favor of classifying S-corporation status as property; specifically, the debtor’s ability to use its S-corporation tax status to pass its tax liability through to its shareholders. The liquidating trustee hoped to generate value through avoidance of the “transferred” S-corporation revocation, thus retroactively reclassifying the debtor as an S-corporation. The liquidating trustee believed that by doing so, the debtor’s losses would pass through to its shareholders, offsetting other income on their personal returns, and thereby generating refunds that the liquidating trustee intended to demand from the shareholders for the benefit of the liquidating trust and the creditors.

In response to this “plan,” the Court pointed out that, although something may confer value to the estate, it does not necessarily create a property right in it.

The Court explained that a corporation cannot claim a property interest to a benefit that another party – its shareholders – has the power to legally revoke at any time.[xxx] The “S” election, it stated, removes a layer of taxation on distributed corporate earnings by permitting the corporation to pass its income through to the corporation’s shareholders. The benefit is to the shareholders: it allows them to avoid double taxation. To the extent there is value inherent in the election, it is value that Congress intended for the corporation’s shareholders, and not for the corporation.[xxxi]

After weighing the foregoing, the Court held that S-corporation status could not be considered “property” for purposes of the code, and there was no transfer of the debtor’s interest in property on the shareholders’ revocation of such status that was subject to avoidance under the code.


Absolute priority. Disclosure. Fraudulent Conveyance. A question of timing? A question of property rights? A question of fairness?

A pre-petition election to be treated as an association, or a pre-petition revocation of a corporation’s “S” election, would address the concern over providing creditors sufficient information with which to consider a proposed plan. Their acceptance of the plan, and a court’s confirmation thereof, would seem to bar any further discussion.

However, some creditor is bound to object, probably on the grounds described above.

Regardless of how one frames the argument as a matter of “technical” bankruptcy law, from a non-technical perspective, the election or revocation, as the case may be, shifts the tax liability for the liquidation of the business away from the partners and shareholders and onto the debtor-business entity, which of course reduces the value that will be available to satisfy the claims of the creditors. On a visceral level, that doesn’t seem right, especially in the absence of a bona fide, even compelling, non-tax business reason for effectuating such a change in tax status.[xxxii]

Of course, what feels right is not always consistent with what the law allows in a given set of circumstances. When faced with the prospect of a bankruptcy proceeding, the debtor-taxpayer and its owners should consult with their bankruptcy (and tax) advisers well before making any changes to the debtor’s tax status.

[i] From the opening of The Odd Couple.

[ii] From the ad for Reese’s Peanut Butter Cup. Don’t you miss the ‘70s? Sometimes?

[iii] If you’ve watched bankruptcy folks at work, you know that their code is more like a set of guidelines than actual rules, to paraphrase Captain Barbossa from the first Pirates of the Caribbean movie.

[iv] If you have read Salman Rushdie’s Two Years Eight Months and Twenty-Eight Nights, you’ll understand the reference; if you have not read it, please do.

[v] For example, before the passage of the Tax Cuts and Jobs Act (P.L. 115-97), a troubled taxpayer was able to carry its NOLs back two years in order to generate a refund and some badly needed cash. The Act eliminated the carryback. That being said, it also eliminated the 20-year carryforward, thereby allowing NOLs to be carried forward “indefinitely” – i.e., until they are exhausted – and removing some of the sting from the ownership change rules under Section 382 of the Code, which limit the amount of NOL that may be utilized in any taxable year. At the same time, however, the Act also limited the amount of loss that may be utilized in any tax year to 80-percent of the taxpayer’s taxable income. IRC Sec. 172.

[vi] U.S. Bankruptcy Court for the Western District of Wisconsin, In re: Schroeder Brothers Farms of Camp Douglas LLP, Debtor; Case No.: 16-13719-11, May 30, 2019.

[vii] Another, more commonly encountered intersection, involves the cancellation of indebtedness of a taxpayer in bankruptcy. IRC Sec. 108(b).

[viii] It is my understanding that many debtors will seek to liquidate under Chapter 11 because it enables their management team to remain in place and to “control” the liquidation process. Of course, a filing under Chapter 11 suspends all foreclosure actions.

[ix] Chapter 12 is designed for “family farmers” or “family fishermen” with “regular annual income.” It enables financially distressed family farmers and fishermen to propose and carry out a plan to repay all or part of their debts. Under chapter 12, debtors propose a repayment plan to make installments to creditors over three to five years. Generally, the plan must provide for payments over three years unless the court approves a longer period “for cause.”

[x] Reg. Sec. 301.7701-3.

[xi] By filing IRS Form 8832.

[xii] IRS Form 1065.

[xiii] IRC Sec. 701.

[xiv] IRC Sec. 1399. Special rules for individual bankruptcy cases are provided under IRC Sec. 1398.

[xv] By preventing the pass-through to the partners of the gain from the sale of Debtor’s assets

[xvi] In deference to the Court, I left the upper case “c” intact.

[xvii] Bankruptcy code Section 1129(b).

[xviii] Unless the seniors agree to subordinate some of their claims.

[xix] I.e., tax-paying.

[xx] Under which each of Debtor’s owners paid tax on their share of Debtor’s gains.

[xxi] Provided, of course, they had sufficient basis for their partnership interest. IRC Sec. 704(d). If losses were suspended because of insufficient basis, the gains from the sale of Debtor’s assets would have restored such basis and thereby allowed such losses to be utilized by the partners.

[xxii] Which is intended to provide its creditors with “adequate information” regarding the debtor to enable its creditors to make an informed judgement about the plan proffered.

[xxiii] How about a partnership that becomes an S-corporation/association by filing IRC Form 2553, and that subsequently revokes its “S” election, thereby becoming an association taxable as a C-corporation?


[xxv] With the consent of its shareholders holding a majority of its stock. IRC Sec. 1362(d).

[xxvi] Compare this to the Debtor-partnership electing to become an association for tax purposes.

[xxvii] In general, the trustee may avoid any transfer of a debtor’s interest in property: (a) that was made within 2 years before the date of the filing of the petition if the debtor made such transfer with intent to hinder, delay, or defraud any entity to which the debtor was or became, on or after the date that such transfer was made, indebted; or (b) for which it received less than a reasonably equivalent value in exchange for such transfer; or was insolvent on the date that such transfer was made, or became insolvent as a result of such transfer.

[xxviii] Note the lower case “c”.

[xxix] Including (1) the right to use; (2) the right to receive income produced by the purported property interest; (3) the right to exclude others; (4) the breadth of the control the taxpayer can exercise over the purported property; (5) whether the purported property right is valuable; and (6) whether the purported right is transferable.

[xxx] A corporation has little control over its S-corporation status, yet the right to exercise dominion and control over an interest is an essential characteristic defining property. Shareholders have the ability to control the tax status of their corporation. Election of S-corporation status may be achieved by one method: unanimous shareholder consent – the corporation does not elect S-corporation status. Thus, the Court concluded, any interest in electing S-corporation status belongs to the shareholders.

[xxxi] S-corporation status, it stated, is a statutory privilege that qualifying shareholders can elect in order to determine how income otherwise generated is to be taxed.

[xxxii] Especially when one considers the tax “benefit” of being able to claim the losses generated by the debtor-business.

Think about what a healthy business entity wants when considering the sale of its assets: one level of tax so as to maximize the net proceeds for its owners.

If you’ve been representing closely held businesses long enough, then the “conversation transcribed” below should sound familiar to you.

I have had several versions of this exchange in the last few months.[i] The common theme? The risk that the IRS may not accept one or more steps in the transaction at their “face value,” and that it may seek to give tax effect to the larger transaction (of which these steps are a part) in accordance with what the IRS believes is its true nature.

It is a basic precept of the tax law that the substance of a transaction, rather than its form, should determine its tax consequences when the form of the transaction does not coincide with its economic reality.

This substance-over-form argument is a powerful tool in the hands of the IRS. It can also be very frustrating for a business owner who genuinely believes that they have a bona fide, non-tax reason for the transaction structure chosen.

In the Present

The sole owner of a successful business has an issue they want to discuss with their attorney.

Owner:        I have this really great employee that I want to reward. Any ideas?

Adviser:       I know you already pay a more-than-decent salary. What about a generous annual bonus?

Owner:        Already doing that.

Adviser:       Is the bonus discretionary with you, or is it somehow tied to performance and a formula?

Owner:        I decide whether it is paid and how much. I always pay it before the year-end.[ii]

Adviser:       You know, if you removed the discretionary aspect, and gave this employee something “measurable,” you may provide them with a greater incentive to work hard and to reach whatever targets you set for them. Make the obvious more tangible or certain for them: if the business does well, they will do well.

Owner:        What about giving the employee a piece of the company?

Adviser:       Hold on a minute. First, that’s not what I’m suggesting. Second, have they asked for that?

Owner:        No. Not really. But I’m sure they’d appreciate it.

Adviser:       So would I. Would they pay for the stock?

Owner:        They can’t afford to do that.

Advisor:      OK. What if you sold it to them at a discount? Would you consider accepting a promissory note from them? Give them time to pay it off? The bargain element would be taxable to them as compensation . . . [iii]

Owner:        Actually, I was thinking that I would just gift it to them. Can’t I do that? I recall you telling me that the gift tax exemption was pretty high these days.[iv]

Adviser:       This is your employee – actually, your company’s employee. We’re not talking about a family member or friend here. I wouldn’t exhaust my exemption amount on someone who may quit next year, and whom I may have to buy out.

Your relationship is strictly of a business nature, right? Under those circumstances, the IRS is likely to treat as compensation any transfer of property you make to them. [v]

That means ordinary income to them. It also triggers employment taxes. How will you and they pay those taxes?

Owner:        How will the IRS even know . . . ?[vi]

Adviser:       Please, don’t get me started. Let’s not have this discussion again.

Owner:        Can I pay them a bonus for the taxes?

Adviser:       A “gross-up?” Yes, but this is going to turn into an expensive proposition for you. That bonus would, itself, be taxable. Do I have to remind you that the employer is responsible for its share of employment taxes?

In any case, I have a more fundamental issue for you. Why would you bring in a minority shareholder, anyway? State law affords them many rights, and imposes certain fiduciary duties on you as the controlling shareholder.

Owner:        Oh, now you’re sounding like a lawyer.

Adviser:       Well, that’s probably because I am. Sometimes, you even pay me to tell you these things before you go ahead and do something you’ll regret.

Do you think your minority shareholder is going to like the idea of the business’s paying for your clubs, your vacations, the restaurants, the cars, your spouse’s pension plan – still coming in once a month, I gather? – your niece’s tuition, your father’s and your children’s no-show jobs . . . ?

Owner:        C’mon, everyone does that.

Adviser:       Remember when you entertained that unsolicited offer for the business a few years back? Hmm? You handed over all that information to the prospective buyer’s accountants – thankfully, only after I got wind of what you were doing and prepared a non-disclosure agreement – and they came back with all of the so-called “add-backs”?

Well, your key employee-minority shareholder is going to be questioning those same items, among other things, including your obsession with golf. Don’t you work anymore?  

Owner:        Well, I need to keep this employee, which means I need to keep them happy. Everyone has their price.

Adviser:       I won’t comment on your last statement.

Look, you’ve been talking about selling the business in the next few years, right?

Owner:        Sure. That’s exactly why I need to keep this employee – to get me to the finish line.

Adviser (under his breath):        And to the golf course.

Owner:        What was that?

Adviser:       Nothing, just thinking aloud – we need to chart a course.  OK. How about a change-in-control payment, one that’s based upon a percentage of the net sale proceeds?

Owner:        I can do that?

Adviser:       Sure you can. In that way, you give the employee a chance at sharing in the value of the business – at the same time you liquidate your investment – without making them an owner. Remember that discussion we had about “phantom stock”? OK. It’s something like that. You can even require that the employee remain with the business until the sale occurs in order for them to benefit from the sale. If they leave before then, for any reason, they won’t be entitled to any of the proceeds.

Owner:        I think I recall this conversation. Something about “vesting,” right? That’s harsh, though, and I don’t want them to think that I can pull the rug out from under them just before a sale.[vii]

Adviser:       I’m not suggesting that. Look, I gave you a simple illustration of the concept. You can tailor it to satisfy whatever terms you and your key employee decide upon.[viii] My point is that you can protect yourself.

Owner:        Will this payment be taxed as capital gain to the employee?

Adviser:       No, it will be taxed as ordinary compensation income, and the company should be entitled to a deduction for the payment.[ix] Think of it as a performance-based bonus – a “thank you” for getting you to your goal.

Owner:        Ordinary income? They won’t have anything left after taxes. Can I gross them up, pay them more so they end up where they would’ve been if they had capital gain?

Adviser:       Yeah, but again, this is getting expensive for you.

Owner:        This all seems so complicated . . .

Adviser:       It isn’t, really, . . .

Owner:        I’m just going to make them an owner. Keep it simple.

Adviser:       You’re a pig-headed @#^*. Why do you waste my time, and your money? Go ahead, do whatever you want. Just do me one favor.

Owner:        What is it?

Adviser:       Two favors. Now hear me out. If you follow through with this nonsense, give this uber-employee of yours non-voting stock – remember, we recapitalized the company to provide for a class of non-voting stock when we talked about making some gifts to a trust for your kids? – and have them sign a shareholders’ agreement.

Owner:        Why a shareholders’ agreement?

Adviser:       For starters, because you want to restrict their ability to sell their shares, you want to have the right to buy back their shares if they leave the business for any reason, and you want to have the right to compel them to sell their shares if you decide to sell yours.[x]

You can also reduce the amount of compensation income to the employee by incorporating certain “non-lapse restrictions” to reduce the valuation of the shares . . .[xi]

Owner:        Sounds reasonable. I’ll consider it. Say, are you free for golf next Monday?

Adviser:       I would have thought that, by now, you’d know that I don’t golf. By the way, did you know that golf courses are identified as a “sin business” under the qualified opportunity zone rules?[xii]

Fast Forward a Few of Years

The key employee (the “Employee”) is a minority shareholder in the business (the “Business”).

There is no shareholders’ agreement between the Owner and the Employee. The Owner has gifted some shares in the Business to an irrevocable grantor trust for the benefit of the Owner’s issue.[xiii]

The Owner and the Employee have had some differences of opinion over dividend policy and the direction of the Business, generally. The Owner has been reinvesting the profits in order to prepare the Business for a sale; the Employee would like to withdraw these profits to help pay for family expenses, including tuitions.

The Adviser is being treated for an ulcer, anxiety, and depression.[xiv]

The Owner – who has been semi-retired for the last few years, and whose golf game has improved substantially – has been approached by a competitor (the “Buyer”) with an offer to buy the Business; specifically, the Buyer has offered to purchase all of the issued and outstanding shares of the Business in exchange for cash at closing, and with five-percent of the sale price to be held in escrow for eighteen months.[xv]

The Buyer plans to consolidate the Business into the Buyer’s existing infrastructure.

In recognition of the Employee’s status in the Business, the Employee has been offered an employment agreement to stay on with the Buyer for a couple of years, on the theory that their assistance will be required in order to effectuate the smooth transition of the Business’s customers. The agreement may be extended at the Buyer’s option.

The Owner is eager to consummate the deal on the terms offered. The price is right and the terms are fair[xvi] – at least in the eyes of the Owner.

The Employee is less bullish about the transaction. In fact, the Employee has given some indication that they will likely refuse to sell their shares.

The Employee thinks the Business is worth more than the Buyer has offered, and they believe they deserve more than just a short-term employment agreement.

What’s more, the Employee would like to defer some of their gain by rolling over some of their equity in the Business.[xvii]

The Employee also believes that only the Owner should be liable for any losses suffered by the Buyer on a breach of any representations and warranties regarding the Business – after all, the Owner controlled the Business.[xviii]

With the Owner’s dream of a stock sale in jeopardy, the Owner approaches the Adviser.

After several attempted “I told you so’s,” – especially regarding the drag-along in the non-existent shareholders’ agreement – which the Owner has somehow parried, the Adviser suggests that the Owner approach the Buyer about employing a reverse merger to force the Employee to sell their shares.[xix]

The Adviser explains that the Buyer would create a subsidiary, which would then merge with and into the Business, with the Business as the surviving entity.[xx] As a result of the merger, the Employee would receive the cash consideration provided for by the merger agreement; because the cash for this consideration would come from the Buyer, the transaction would be treated, for tax purposes, as a purchase of the Business’s shares by the Buyer. If the Employee was dissatisfied with this consideration, they may exercise their dissenter’s or appraisal rights under state law, but they would cease to be a shareholder of the Business.

However, the Owner doesn’t want to approach the Buyer. He doesn’t want to alert the Buyer to the dissension, for fear that it may spook the Buyer and jeopardize the deal.

The Adviser suggests that the Owner may effect the same kind of squeeze-out without involving the Buyer. He explains that the Owner may form a new corporation which would be merged into the Business with the Business surviving. The Employee would either accept the consideration provided under the merger agreement, or they would exercise their appraisal rights.

Again, the Owner rejects the Adviser’s suggestion, fearing that any squeeze-out would antagonize the Employee – and unnerve the Buyer, which planned to retain the Employee’s services for a period of transition – and that any litigation brought by the Employee in exercise of their dissenter’s rights would kill any deal with the Buyer.

“What if I purchased the Employee’s shares myself?” the Owner asks the Adviser. “I’d buy them for a premium over the per share price offered by the Buyer. I’d give the Employee my own promissory note, and I would satisfy it immediately after I sold the Business to the Buyer. That way, I keep the Buyer out of the picture, and I save my deal.”

After some research, and under the facts and circumstances described, the Adviser makes the following observations and conclusions:

  • the IRS may collapse the two sale transactions – from the Employee to the Owner, and from the Owner to the Buyer – and treat them as one;
  • in that case, the IRS would consider the Owner and the Employee as each having received their pro rata share of the consideration from the Buyer;
  • any “excess” received by the Employee over their pro rata share may be considered as a payment from the Owner in a separate transaction.[xxi]
  • because of the Employee’s status in the Business as a key employee, this payment may be treated as ordinary compensation income;
  • in that case, the payment should also be deductible;
  • alternatively, the IRS may treat the “excess” payment as having been made by the Owner to secure the Employee’s agreement to sell their shares;
  • according to the IRS, this would represent ordinary income to the Employee, but a capital expenditure by the Owner.

The Owner is incredulous. “Wait,” he says, “if I purchase the Employee’s shares at a premium in order to remove the Employee as an obstacle to a sale of the Business to the Buyer, the Employee will have ordinary income? The Employee will never agree to that. How is that possible where the Employee is selling shares of stock? Can’t we just say that the Employee negotiated a better deal, or was in a better bargaining position than I was?”

Disproportionate Distributions

Historically, the IRS has viewed with skepticism the receipt by shareholders of distributions from their corporation or of payments from a third party – in each case, purportedly in the shareholders’ capacity as such – when the amount received is disproportionate to their share holdings.

Thus, when property is transferred to a corporation by two or more persons in exchange for stock, and the stock received is disproportionate to the transferor’s prior interest in the property, the transaction may be treated as if the stock had first been received in proportion and then some of such stock had been used to make gifts, to pay compensation, or to satisfy some other obligation of the transferor, depending upon the facts and circumstances.[xxii]

The same analysis may be applied to the liquidation of a corporation where the majority shareholder (“M”) accepts less than the pro rata share of the liquidating distribution to which M is entitled – but which would nevertheless generate a gain on M’s investment – in order that an unrelated minority shareholder may receive more than their pro rata share, thereby avoiding a loss on their investment.

The non pro rata liquidating distribution by the corporation to the shareholders would be treated for tax purposes as if there had been a pro rata distribution to each shareholder in full payment in exchange for each shareholder’s stock, together with a transfer by M to the minority shareholders of an amount equal to the excess of the amount received by the minority over the minority’s pro rata share of the liquidating distribution. The difference between M’s pro rata share and the amount actually received by M would be treated as having been paid over by M to the minority shareholders in a separate transaction, the tax consequences of which would depend upon the underlying nature of the payments, which in turn depends upon all of the relevant facts and circumstances, “which must be determined from all of the extrinsic and intrinsic evidence surrounding the transaction.”[xxiii]

The foregoing would seem to support a preemptive move by the majority owner of a business, one undertaken well in advance of a sale of the business – and perhaps in “collaboration” with the minority – including by way of a squeeze-out. Such a buy-out of the minority’s interest may include a purchase price adjustment in the event the business is sold within a relatively short period after the buy-out.[xxiv]

The Tax Court

The Tax Court, on the other hand, seems to have been more receptive to the taxpayer’s position. In one case,[xxv] the issue was whether a payment made by Target’s majority shareholder (“Majority”) to a minority shareholder (“Minority”) in settlement of a lawsuit for damages for failure to deliver certain property constituted capital gain or ordinary income.

Minority filed suit against Majority for damages resulting from their failure to deliver certain options to Minority. The options were the subject of an oral agreement arising out of a plan of merger for Target. Minority objected to the portion of the plan of merger which provided for the redemption of some Majority shares by the transfer to Majority of some interest in real estate. Minority contended that the real estate was worth much more than the value assigned to it for purposes of the redemption, and they demanded to share in the redemption. Minority threatened court action to block the merger unless their demands were met.

Minority contended that the options, if executed, represented consideration for their stock in Target. The IRS contended that the options were in the nature of compensation for Minority refraining from blocking the merger; it sought to tax the settlement as ordinary income because Minority agreed not to vote against the merger.[xxvi]

The Court concluded that the options were promised as additional consideration for the Target stock owned by Minority. Majority and Minority, the Court stated, were “frantically attempting to settle their differences before the shareholders meeting which was called to vote on the merger.” According to the Court, Minority demanded more from the merger, and Majority offered the options.

The Court found as a fact that the quid pro quo for the agreement to deliver the options was additional consideration for the Target stock owned by Minority. The taxability of the settlement, the Court continued, was controlled by the nature of the litigation, which was controlled by the origin and character of the claim which gave rise to the litigation. Having found that the claim arose out of the purported inadequacy of the consideration received in the merger, it followed that the settlement represented additional consideration for Minority’s disposition of its shares in Target.

What’s an Owner to Do?

If the Employee-minority shareholder had been party to a properly drafted shareholders’ agreement, the situation described above may have been avoided. Of course, if the Employee had never been made a shareholder of the Business to begin with . . . .[xxvii] Perhaps a change-in-control bonus payment would have sufficed.

In any event, advisers are often presented with facts and circumstances beyond their control. A shareholder’s dual capacity – as an employee and as an investor – may complicate the tax treatment of a non-pro rata payment, as indicated above; it may invite closer scrutiny of the arrangement by the IRS.

In light of the Tax Court’s holding and the IRS’s contrary position, and provided the payment by the majority shareholder is, in fact, being made to a minority shareholder in their capacity as an investor – rather than as a compensatory incentive – it will behoove the parties to document the arrangement as thoroughly and as contemporaneously as possible in order to substantiate their position and support capital gain treatment for the payment.

[i] I have taken poetic license here and there to pull together (even manufacture) a smorgasbord of “facts” and issues and to provide some color, in order to convey today’s message.

[ii] In other words, there is no deferral within the meaning of IRC Sec. 409A.

[iii] IRC Sec. 83.

[iv] The Federal exemption is currently set at $11.4 million per individual donor. IRC Sec. 2010.

[v] IRC Sec. 83.

[vi] The federal gift tax return, Form 709, requires that the donor describe their relationship to the donee.

If the employer-company is a pass-through entity, such as a partnership or S corporation, the employee-owner will receive a K-1 (assuming they are vested in the equity or they have made a Sec. 83(b) election).

In other words, there a many ways for the IRS to figure out what happened.

[vii] The “vesting” event is usually tied to the employee’s having served the business for a prescribed number of years, though it may also be tied to the employee’s attainment of certain performance goals. See, e.g., Reg. Sec. 1.83-3.

[viii] Subject, of course, to the principles of the constructive receipt and economic benefit doctrines, and the deferral/distribution rules under IRC Sec. 409A.

[ix] A couple of assumptions here: (1) the compensation is reasonable for the service rendered; the fact that the sale occurs may satisfy the standard; and (2) the compensation will not trigger Sec. 280G’s “golden parachute” rules; these rules do not apply to a certain small business corporations (like an S corporation), or to certain corporations that timely secure shareholder approvals to the payment arrangement.

[x] The last item is known as a “drag-along.”

[xi] Reg. Sec. 1.83-5. A bona fide arrangement will not create a second class of stock where the employer is an S corporation. Reg. Sec. 1.1361-1(l).

[xii] IRC Sec. 1400Z-2(d)(3)(A)(ii) and Sec. 144(c)(6)(B).

[xiii] The appraisal reflects valuation discounts for lack of marketability and lack of control. The gifts occur well before the offer to buy described below.

[xiv] The Adviser still associates the word “golf” with a VW hatchback.

[xv] The shareholders are thereby assured of only one level of gain recognition, all of which will be capital gain, in contrast to an asset sale, which would be taxable to the corporation and then to the shareholders, and which could generate ordinary income.

[xvi] For example, with customary representations and warranties, covenants, and indemnity provisions.

[xvii] The Owner has no interest in leaving any of his equity at risk in the Business after his departure.

[xviii] These serve several functions; for example, they help flesh out the state of the target business as of the date of the purchase and sale agreement and, if different, as of the closing date – a disclosure or due diligence function; if the seller cannot make the statements at the time of closing (as where the agreement is signed on one day and the closing occurs on a later day), the reps and warranties allow the buyer to walk away from the deal; and if the buyer suffers a loss after the closing that is attributable to a breach of these statements, the buyer may seek indemnity from the seller for such breach.

[xix] A form of squeeze-out technique.

[xx] A reverse subsidiary merger.

[xxi] See, e.g., Rev. Rul. 73-233. Y corporation wished to acquire X by statutory merger in exchange for 100 shares of stock of Y corporation. The stock of X was owned by three individuals: A owned 60 percent of the stock of X, and B and C each owned 20 percent of the stock of X. A two-thirds vote of the target corporation’s shareholders in favor of the merger was required to meet the applicable merger laws of the State in which X was incorporated. B and C refused to vote in favor of the proposed merger unless they would each receive 25% of the consideration. In consideration for B and C voting in favor of the merger, A agreed to permit B and C each to receive 25 shares of Y stock instead of the 20 shares of Y stock which they would have been entitled to receive had the distribution of the merger consideration to the X shareholders been in proportion to their stock ownership of X. In order to effectuate this agreement, A contributed one-third of his stock in X to the capital of X with the result that A’s stock interest in X was reduced to 50 percent and B’s and C’s stock interests were each increased to 25 percent. The X shareholders then voted unanimously in favor of the merger which was thereafter consummated. A, B, and C received, respectively, 50, 25 and 25 shares of Y stock in exchange for their X stock.

According to the IRS, under the circumstances described, the contribution of X stock by A to the capital of X prior to the merger will not be considered independently of the related events surrounding the contribution. The other related events to be considered are (i) the agreement of B and C with A to vote in favor of the merger if B and C would each receive five additional shares of Y stock, and (ii) the merger.

Accordingly, the overall transaction will be viewed as (1) a merger of X into Y with a distribution of 60, 20 and 20 shares of Y stock to A, B, and C, respectively, in exchange for their X stock, with no gain or loss being recognized to A, B, or C on this exchange under IRC Sec. 354, and (2) a transfer by A of five shares of Y stock to B and five shares of Y stock to C in consideration for their voting in favor of the merger.

Gain or loss will be recognized to A on his transfer of 10 shares of Y stock, five to B and five to C, to the extent of the difference between the fair market value of the stock and the adjusted basis of the stock in A’s hands at the time of the transfer.

Since the transfer by A of Y stock to B and C was in satisfaction of B and C voting for the merger which enabled A to acquire the Y stock, such transfer will be considered a capital expenditure and, therefore, not a deductible expenses to A. A will be permitted to adjust the basis of his remaining 50 shares of Y stock by increasing his basis in such stock by the fair market value of the 10 shares given up.

The fair market value of the five shares of Y stock received by B and C, respectively, from A is includible in their gross incomes.

[xxii] Reg. Sec. 1.351-1(b).

[xxiii] Rev. Rul. 79-10.

[xxiv] Like an installment sale with a fixed maturity date but a contingent purchase price. Reg. Sec. 15A.453-1(c).

[xxv] Gidwitz Family Trust v. Comm’r, 61 T.C. 664 (1974).

[xxvi] A “negative” service, like a payment for a non-compete?

[xxvii] I told you so.

It’s Not Easy

The owners of many closely held businesses recently filed federal income tax returns on which they claimed, for the first time, the deduction based on “qualified business income” under Section 199A of the Code; many others will be doing so in October of this year.[i]

Fortunately, these taxpayers and their advisers are able to rely upon the guidance published by the IRS in the form of proposed and final regulations, in August 2018 and January 2019.

The fact remains, however, that many taxpayers, as well as many tax advisers, continue to raise questions relating to the application of Section 199A. This should not surprise anyone.

The deduction is the product of one of the most convoluted provisions to have ever entered the Code. What’s more, its relatively brief lifespan (2018 through 2025), coupled with the introduction and implementation of many other equally difficult provisions,[ii] challenged the resources of both the IRS and tax advisers to produce a timely and workable set of rules by which to administer the new deduction. [iii]

One question that I have been asked more than a few times by owners of closely held businesses that operate both domestically and overseas concerns the application of Section 199A to income derived from activities outside the U.S.[iv]

At this point, a number of readers may interject that “199A does not apply to such income – the 20-percent deduction is based upon income that is effectively connected with a U.S. trade or business.”

This not unreasonable reaction underscores the need for tax advisers to continue to educate themselves and their clients as to the application of Section 199A, lest they fail to realize the full benefit of the deduction.

Sec. 199A – Qualified Business Income

In general, for taxable years beginning after December 31, 2017, and before January 1, 2026,[v] an individual taxpayer may deduct 20-percent of their qualified business income with respect to a partnership, S corporation, or sole proprietorship.[vi]

Qualified business income (“QBI”) means the net amount of “qualified items” of income, gain, deduction, and loss with respect to the qualified trade or business (“QTB”) of the taxpayer, to the extent they are included in taxable income under the QTB’s accounting method.[vii]

Effectively Connected

Items of income, gain, deduction, and loss are treated as qualified items only to the extent they are “effectively connected” with the conduct of a trade or business within the U.S.[viii]

In determining whether such items are effectively connected with a U.S. trade or business for purposes of Section 199A, taxpayers are directed to apply the rules under Section 864(c) of the Code by substituting QTB for “nonresident alien individual or a foreign corporation,” or for “a  foreign corporation,” each place it appears in Sec. 864(c).[ix]

If only the application of Section 864(c) to Section 199A were as simple as implied by the straightforward substitution of “QTB” for “foreign person” described above. In order to better understand the interplay between the two provisions, we begin with a brief review of the ECI rules as they apply to foreigners doing business in the U.S.[x] However, it is important not to lose sight of the fact that the focus of this discussion is on the U.S. taxpayer who is planning for the Section 199A deduction, and part of whose income may be generated by overseas activities.

ECI for Foreigners

A foreign person that is engaged in the conduct of a trade or business within the U.S. is subject to U.S. net-basis taxation[xi] on any income that is ‘‘effectively connected’’ with their conduct of the U.S. trade or business.[xii]

In general, the test for determining whether a foreign person is engaged in a trade or business in the U.S. is very similar to the test that is applied for purposes of determining whether a pass-through entity[xiii] is engaged in a trade or business for purposes of Section 199A – a person will be treated as engaged in a U.S. trade or business if, based on all the facts and circumstances, it may be said that they carry on substantial profit-oriented activities in the U.S. with “continuity and regularity.”

Assuming a foreign person is engaged in a U.S. trade or business, the Code provides various rules that help determine whether income is ECI with respect to such trade or business.[xiv]


In general, all income realized by a foreign person from sources within the U.S. (other than income that is FDAP) is treated as effectively connected with the foreign person’s conduct of a U.S. trade or business;[xv] stated differently, a foreign person’s U.S.-source non-FDAP income is generally treated as ECI.[xvi]

That being said, there are situations in which U.S.-source income that would otherwise be FDAP may, instead, be treated as ECI.[xvii]

Non-U.S. Source: Categories of Income

In general, no income of a foreign person from sources outside the U.S. – as distinguished from activities outside the U.S. – will be treated as effectively connected with the conduct of a U.S. trade or business by that person.[xviii]

That being said, a foreign person engaged in a U.S. trade or business may have certain categories of “foreign-derived” income that are considered ECI.[xix]

Specifically, a foreign person’s income from foreign sources may be considered ECI if the foreign person has an office or other fixed place of business (“Office”) within the U.S. to which such income is attributable, and the income falls within one of a few identified categories of foreign-source income.[xx]

Among these categories is income that is derived from the sale outside the U.S., through the foreign person’s U.S. Office,[xxi] of inventory or personal property held by the foreign person primarily for sale to customers in the ordinary course of the trade or business.[xxii]

However, this income will not be treated as ECI if the property is sold “for use, consumption, or disposition outside” the U.S., and an Office of the foreign person outside the U.S. “participated materially in such sale.”[xxiii]

Sourcing Rules for Inventory

The sourcing rules for income that is derived from the sale of inventory property are complex, to say the least, but they are essential in the application of Section 864(c) and, therefore, of Section 199A. Whether income is U.S. or foreign-source is determined under Sections 861, 862, 863, and 865 of the Code, and the regulations thereunder.

Income that is derived from the purchase of inventory[xxiv] without the U.S. and then sold within the U.S. (where title to the property passes) is treated as U.S.-source income. Similarly, income that is derived from the purchase of inventory within the U.S. and then sold without the U.S. is treated as non-U.S.-source income.[xxv]

Income from the sale of inventory produced (in whole or in part) by the taxpayer within and sold without the U.S., or produced (in whole or in part) by the taxpayer without and sold within the U.S., is to be allocated and apportioned between sources within and without the U.S. solely on the basis of the production activities with respect to the property.[xxvi]

Notwithstanding the foregoing, if a foreign person maintains an Office in the U.S., income from any sale of inventory attributable to such Office will be sourced in the U.S., unless the inventory is sold for use, disposition, or consumption outside the U.S. and an Office of the taxpayer in a foreign country materially participated in the sale.[xxvii]

It appears that this last provision – under Section 865(e)(2) of the Code – has supplanted the ECI rule under Sec. 864(c)(4)(B) of the Code, described above (relating to the sale of inventory outside the U.S. through a foreign person’s U.S. Office), by treating such income as U.S.-source; in turn, such income becomes ECI.[xxviii] Although not explicitly stated in the regulations issued under Section 199A, it would make sense to apply the ECI rules as to inventory under Section 864(c) consistently with the sourcing rule of Section 865(e).[xxix]

Attributable to U.S. Office

If income from the sale of inventory is received by a foreign person engaged in a U.S. trade or business, such income will be treated as U.S.-source under Sec. 865(e)(2), and as ECI under Sec. 864(c), if the income is “attributable” to the foreign person’s U.S. Office.

Income is attributable to a foreign person’s U.S. Office only if such Office is a “material factor” in the realization of the income,[xxx] and if the income is realized in the ordinary course of the trade or business carried on through that Office.[xxxi]

For this purpose, the activities of the Office will not be considered a material factor in the realization of the income unless they provide “a significant contribution to” the realization of the income by being “an essential economic element” in such realization.[xxxii] However, it is not necessary that the activities of the Office in the U.S. be a major (as opposed to a “material”) factor in the realization of the income.

Material Factor

A U.S. Office of a foreign person engaged in a U.S. trade or business will be considered a material factor in the realization of income from the sale of inventory if the Office actively participates in soliciting the order, negotiating the contract of sale, or performing other significant services necessary for the consummation of the sale which are not the subject of a separate agreement between the seller and the buyer.

The U.S. Office will also be considered a material factor in the realization of income from a sale made as a result of a sales order received in such Office, except where the sales order is received unsolicited and that Office is not held out to potential customers as the place to which such sales orders should be sent. The income must be realized in the ordinary course of the trade or business carried on through the U.S. Office.[xxxiii]

A foreign person’s U.S. Office will not be considered to be a material factor in the realization of income merely because of one or more of the following activities:

(a) The sale is made subject to the final approval of such Office,

(b) The property sold is held in, and distributed from, such Office,

(c) Samples of the property sold are displayed (but not otherwise promoted or sold) in such Office, or

(d) Such Office performs merely clerical functions incident to the sale.[xxxiv]

Sale for Use Outside the U.S.

Notwithstanding the foregoing, a U.S. office of a foreign person will not be considered to be a material factor in the realization of income from sales of inventory if the property is sold for use, consumption, or disposition outside the U.S. and an Office which such foreign person has outside the U.S. participates materially in the sale. This foreign Office will be considered to have participated materially in a sale made through the U.S. Office if the foreign Office actively participates in soliciting the order resulting in the sale, negotiating the contract of sale, or performing other significant services necessary for the consummation of the sale which are not the subject of a separate agreement between the seller and buyer.[xxxv]

As a general rule, inventory which is sold to an unrelated person is presumed to have been sold for use, consumption, or disposition in the country of destination of the inventory sold.[xxxvi]

Application to Section 199A

Section 199A refers taxpayers to the rules of Section 864(c) of the Code for purposes of determining whether the income of their QTB is effectively connected with the conduct of a trade or business within the U.S.

Specifically, the term “qualified items” of income, gain, deduction, and loss are those items that are effectively connected with the conduct of a trade or business within the United States (within the meaning of section 864(c), determined by substituting “trade or business (within the meaning of section 199A)” for “nonresident alien individual or a foreign corporation” or for “a foreign corporation” each place it appears).

Under Section 864(c)(4), income from sources without the U.S. is generally not treated as effectively connected with the conduct of a U.S. trade or business unless an exception under section 864(c)(4)(B) applies. Thus, a trade or business’s foreign-source income would generally not be included in QBI, unless the income meets an exception in section 864(c)(4)(B).

Where a taxpayer’s income from the sale of inventory would previously have been treated as foreign-source, yet also treated as ECI under Section 864(c),[xxxvii] the rule under Section 865(e)(2) will treat such income as U.S.-source and, consequently, as ECI if the taxpayer has a U.S. Office to which such income, gain, or loss is attributable.[xxxviii]

This income from the sale will not be treated as ECI, however, if the inventory is sold for use, consumption or disposition outside the U.S., and the taxpayer has an Office outside the U.S. that materially participated in the sale.

Parting Thoughts[xxxix]

As if the Section 199A rules weren’t difficult enough to negotiate without introducing the rules applicable to the U.S. taxation of income generated overseas.

Those U.S. taxpayers with business activities that extend beyond the borders of the U.S. already have a lot to think about as a result of the changes enacted by the Tax Cuts and Jobs Act. For example, should they form foreign corporate subsidiaries[xl] (basically, CFCs) through which to operate these activities and, thereby, to position themselves for a better result under the GILTI rules? Should they operate through foreign branches to take advantage of the foreign tax credit for foreign-source income?

To these (and other) questions, we may now add: can the U.S. taxpayer organize its operations in a way that maximizes its ECI under Section 864 – perhaps by increasing its U.S.-source income? – so as to take advantage of the Section 199A deduction?

All of these factors have to be considered in light of each taxpayer’s unique facts and circumstances in order to determine how best to structure the taxpayer’s operations from a tax perspective.

As always, however, the desired tax results should not overshadow or compromise business priorities.


[i] Pursuant to an automatic six-month filing extension; IRS Form 4868.

See, e.g., Line 9 on page 2 of IRS Form 1040.

Section 199A was enacted by the Tax Cuts and Jobs Act (P.L. 115-97). It 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 that have QBI.

[ii] The “transition tax” under IRC Sec. 965, the GILTI rules under IRC Sec. 951A, and the Qualified Opportunity Zone program under IRC 1400Z-1 and 1400Z-2 come immediately to mind; there are others.

[iii] During the lifespan of most additions or changes to the Code, one would expect Congress, the IRS, and the courts – informed through their interaction and experience with taxpayers, tax professionals and each other – to amend or interpret a provision as necessary to attain the legislative goal that motivated its enactment.

However, where a taxpayer has only a few years – eight years in the case of Section 199A – during which to plan for and benefit from a provision, the normal evolutionary track does not apply.

[iv] Generally speaking, familiarity with the U.S. taxation of foreigners and foreign-sourced income was once limited to those who advise non-U.S. taxpayers with business interests in the U.S., or to those who represent large U.S. enterprises with foreign operations. Today, however, many smaller, closely held, U.S. businesses are now doing business overseas through branches or through corporate subsidiaries, or are engaged in joint ventures, both within and without the U.S., with foreign partners.

Of course, U.S. persons are subject to U.S. income tax on their worldwide income. Any income generated during a taxable year by a foreign branch of a U.S. person is included in their gross income for such year for U.S. tax purposes. The same is true of a U.S. person’s share of income of a partnership that operates overseas. In addition, anti-deferral rules, such as the CFC and GILTI rules, cause the current inclusion in a U.S. shareholder’s gross income of their share of the foreign corporation’s income.

[v] The statutorily prescribed lifespan of Section 199A. IRC Sec. 199A(i).

[vi] IRC Sec. 199A(a). A limitation on the amount of the deduction – based on W–2 wages, or W–2 wages plus capital investment (as applicable) – is phased in above a prescribed threshold amount of taxable income. IRC Sec. 199A(b).

A disallowance of the deduction on income from “specified service trades or businesses” is also phased in above the same threshold amount of taxable income.

[vii] IRC Sec. 199A(c).

[viii] IRC Sec. 199A(c)(3)(A)(i); effectively connected income (“ECI”).

[ix] IRC Sec. 199A(c)(3)(A); Reg. Sec. 1.199A-3(b)(2)(i)(A).

For the text of IRC Sec. 864: .

[x] This post will not address the ability of nonresident aliens to claim the Section 199A deduction with respect to a U.S. trade or business in which they are engaged.

[xi] They may claim deductions for expenses paid or incurred with respect to their ECI; the resulting taxable income is taxed according to a graduated rate schedule. Compare to a foreigner’s fixed or determinable, annual or periodic income (“FDAP”), the gross amount of which is taxed, and subject to withholding, at a flat rate of 30-percent (subject to reduction by a treaty). IRC Sec. 871(a) and Sec. 881(a). In general, FDAP includes dividends, interest, rent.

[xii] IRC Sec. 871(b), 872, 882. The preamble to the proposed regulations provides that certain items of income, gain, deduction, and loss are treated as effectively connected income, but are not with respect to a U.S. trade or business (such as items attributable to the election to treat certain U.S. real property sales as effectively connected pursuant to section 871(d)), and are thus not QBI because they are not items attributable to a qualified trade or business for purposes of section 199A.

[xiii] A sole proprietorship, a partnership, or an S corporation.

[xiv] IRC Sec. 864(c)(1)(A). In the case of a foreign person not engaged in a U.S. trade or business, none of its income is treated as ECI. IRC Sec. 864(c)(1)(B).

[xv] IRC Sec. 864(c)(3).

[xvi] This is a so-called “force of attraction” concept.

[xvii] IRC Sec. 864(c)(2). Among the factors to consider in making this determination is whether the income is derived from assets used in, or held for use in, the conduct of a U.S. trade or business, and whether the activities of the U.S. trade or business were a material factor in the realization of the amount. Under these tests, “due regard” is given to whether such asset or such income was accounted for through the trade or business.

[xviii] IRC Sec. 864(c)(4)(A).

[xix] IRC Sec. 864(c)(4). Foreign-source income that is not included in one of those categories is generally exempt from U.S. tax.

[xx] IRC Sec. 864(c)(4)(B).

[xxi] Within the meaning of Reg. Sec. 1.864-7.

[xxii] IRC Sec. 864(c)(4)(B)(iii); Sec. 1221(a)(1).

[xxiii] IRC Sec. 864(c)(4)(B)(iii). Compare this to the language in IRC Sec. 865(e)(2).

[xxiv] IRC Sec. 865(i)(1), Sec. 1221(a)(1).

[xxv] IRC Sec. 861(a)(6), Sec. 862(a)(6).

[xxvi] IRC Sec. 863(b)(2), and the last sentence of Sec. 863(b), which was added by the Tax Cuts and Jobs Act (P.L. 115-97). Prior to this addition, such income was treated as partly U.S.-source and partly foreign-source on the basis of the place of sale and the place of production. Now, the income from the sale or exchange of inventory property produced partly in, and partly outside, the U.S. is allocated and apportioned on the basis of the location of production with respect to the property, and not the place of sale.

[xxvii] IRC Sec. 865(e)(2).

[xxviii] Unless the property is sold “for use, consumption, or disposition outside” the U.S., “and an office or other fixed place of business” of the foreign person outside the U.S. “participated materially in such sale.” In this regard, Sec. 864(c)(4)(B) and 865(e)(2) are “identical”: the former causes the income not to be ECI; the latter causes it to be foreign-source and, thereby, not ECI.

[xxix] Some clarification would be welcomed here. Sec. 199A requires that Sec. 864(c) be applied to determine whether income is ECI, with the following modification: in applying Sec. 864(c), references to a “foreign person” are replaced with “QTB.” That leaves the general sourcing rules in place.

Under Sec. 865(e), however, a different sourcing rule applies with respect to the sale of inventory by foreign persons (Sec. 865(e)(2)) than by U.S. persons (Sec. 865(e)(1)).

Query: for purposes of applying Sec. 864(c) to Sec. 199A, should Sec. 865(e)(2) be applied first because Sec. 864(c) applies only to foreign persons, and then Sec. 864(c) would be applied as modified for purposes of Sec. 199A?

[xxx] IRC 864(c)(5)(B).

[xxxi] Reg. Sec. 1.864-6.

[xxxii] Thus, for example, meetings in the U.S. of the board of directors of a foreign corporation do not, by themselves, constitute a material factor in the realization of income.

[xxxiii] 1.864-6(b)(2)(iii).

Thus, if a foreign person is engaged solely in a manufacturing business in the U.S., the income derived by its U.S. Office as a result of an occasional sale outside the U.S. is not attributable to the U.S. Office if the sales office of the manufacturing business is located outside the U.S. On the other hand, if a foreign person establishes a sales office in the U.S. to sell for consumption in the Western Hemisphere merchandise which the foreign person produces in Africa, the income derived by the sales office in the U.S. as a result of an occasional sale made by it in Europe shall be attributable to the U.S. sales office.

[xxxiv] Reg. Sec. 1.864-6(b)(2)(iii).

[xxxv] An office outside the U.S. shall not be considered to have participated materially in a sale merely because of one or more of the following activities: (a) The sale is made subject to the final approval of such office or other fixed place of business, (b) the inventory sold is held in, and distributed from, such office, (c) samples of the inventory sold are displayed (but not otherwise promoted or sold) in such office, (d) such office is used for purposes of having title to the inventory pass outside the U.S., or (e) such office performs merely clerical functions incident to the sale.

[xxxvi] Reg. Sec. 1.864-6(b)(3).

[xxxvii] Under Sec. 864(c)(4)(B)(iii).

[xxxviii] In accordance with Reg. Sec. 1.864-6.

[xxxix] My head hurts.

[xl] Being mindful of the repeal of Sec. 367’s exception for the incorporation of an active foreign business. Former Sec. 367(a)(3).

The Tax Law

In theory, the primary purpose of the income tax, as a body of law, is to raise from the governed the resources that the government requires in order to perform its most basic functions.[i] However, as society has evolved and its needs have changed, and as “the economy” has become more complex, the government has added to the purposes, and expanded the uses, of the income tax law.

Instead of acting only as a revenue generator, the tax law has been adapted to encourage certain behavior among the governed, or segments thereof, that the government has determined will have a beneficial effect upon society as a whole.

The most obvious manifestation of the tax law as a vehicle for behavior modification is found in the tax treatment of various business and investment-related activities. Specifically, by providing favorable tax treatment[ii] to a business and its owners “in exchange” for their making certain investments or engaging in certain activities, the government hopes to create a level of economic prosperity that will benefit not only the business, its owners and employees, but also the persons with which the business transacts, including its customers and its vendors.[iii]

Among the most recent examples of the use of the tax law as an economic incentive is the creation of qualified opportunity zones and the gain deferral and gain “forgiveness” that a taxpayer may enjoy by investing in a qualified opportunity fund.[iv]

Of course, some of these incentives, though well-intentioned, fail to deliver on their promise, in some cases because the provisions under which they are offered are too complicated, in other cases because the drafters miscalculated the causal connection between the proffered incentive and the hoped-for consequences, and in still other cases because other provisions of the tax law negated or outweighed the incentive.

Within this last class of tax incentives – that have failed to attain their potential, in no small part because of other provisions of the tax law – is the exclusion from gross income of the gain from a non-corporate taxpayer’s disposition of certain “small business stock.”[v]

Capital Gain, Section 1202, & C Corps: Parallel Histories

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

Capital Gain Rate

The net capital gain of a non-corporate taxpayer for a taxable year – i.e., their net long-term capital gain less their net short-term capital loss for the taxable year – has, for many years, been subject to a reduced federal income tax rate, as compared to the rate applicable to ordinary income.[vii]

Indeed, from 1993 into 1998, the capital gain rate was capped at 28-percent; from 1998 into 2003, it was capped at 20-percent; from 2003 through 2012, it was capped at 15-percent; and from 2013 through today, it is capped at 20-percent.[viii]

Section 1202

In 1993,[ix] Congress determined that it could encourage the flow of investment capital to new ventures and small businesses – many of which, Congress believed, had difficulty attracting equity financing – if it provided additional “relief” for non-corporate investors who risked their funds in such businesses.

Under the relief provision enacted by Congress, as Section 1202 of the Code, a non-corporate taxpayer was generally permitted to exclude 50-percent of the gain from their sale or exchange of “qualified small business stock,” subject to certain limitations. The remaining 50-percent of their gain from the sale of such stock was taxable at the applicable capital gain rate. Thus, the aggregate capital gain tax rate applicable to an individual’s sale of qualified small business stock was capped at 14-percent.[x]

However, a portion of the excluded gain was treated as a preference item for purposes of the alternative minimum tax.

In 2009, the portion of the gain excluded from gross income was increased from 50-percent to 75-percent;[xi] in other words, with the then-maximum capital gain rate of 15-percent, a taxpayer who sold qualifying stock at a gain would have been subject to a maximum effective federal rate of 3.75-percent.[xii]

In 2010, the exclusion was increased to 100-percent – which is where it remains today – and the minimum tax preference was eliminated.[xiii]

C Corporation

In order to be eligible for this benefit, the stock, and the corporation from which it was issued, had to satisfy a number of criteria – which will be described below – including the requirement that the stock must have been issued by a “qualified small business,” which was (and continues to be) defined as a C corporation.

Between a Rock and a Hard Place

The decision by a start-up business and its owners to operate through a C corporation, so as to position themselves to take advantage of the exclusion of gain from the sale of stock in a qualified small business corporation, was no small matter when the relief provision was enacted.

In 1993, when Section 1202 was enacted, the maximum federal corporate income tax rate was set at 34-percent; dividends paid to individual shareholders from a C corporation were subject to the same 39.6-percent federal income tax rate applicable to ordinary income. From 1994 through 2017, the corporate tax rate was capped at 35-percent; until 2003, dividends paid to individuals continued to be taxed at the higher rates applicable to ordinary income, though, after 2002, the federal tax rate on such dividends was reduced and tied to the federal long-term capital gain rate.

Unfortunately, beginning with 2013, the dividends paid by a C corporation to a higher-income individual shareholder became subject to the 3.8-percent surtax on net investment income, regardless of the individual’s level of participation in the corporation’s business.[xiv]

It is likely that the combination of (i) a high federal corporate tax rate, (ii) the taxation (initially at ordinary income rates) of any dividends distributed by the corporation to its shareholders – the so-called “double taxation” of C corporation profits – and (iii) the many threshold requirements that had to be satisfied (see below), conspired to prevent Section 1202 from fulfilling its mission.

Thus, the capital gain relief provision was relegated to the shadows, where it remained dormant until . . . . [xv]

Tax Cuts and Jobs Act[xvi]

Effective for taxable years of C corporations beginning after December 31, 2017, the Act reduced the federal corporate tax rate from a maximum of 35-percent to a flat 21-percent.

In addition, the Act eliminated the alternative minimum tax for C corporations.

What’s more, the Act did not change the favorable federal tax rate applicable to long-term capital gain, nor did it cease to conform the rate for dividends to the capital gain rate.

In light of the foregoing, it may be that the gain exclusion rule of Section 1202 will finally have the opportunity to play its intended role.

Although there are still many other factors that may cause the owners of a closely held business to decide against the use of a C corporation, the significant reduction in the corporate tax rate should warrant an examination of the criteria for application of Section 1202.

Qualifying Under Section 1202

This provision generally permits a non-corporate taxpayer who holds “qualified small business stock” for more than five years[xvii] to exclude the gain realized by the taxpayer from their sale or exchange of such stock (“eligible gain”).[xviii]

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

Limits on Exclusion

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

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

This limitation notwithstanding, where the provision applies, a taxpayer may exclude a significant amount of gain from their gross income. Moreover, any amount of gain in excess of the limitation would still qualify for the favorable capital gain rate, though it will be subject to the surtax.

Qualified Small Business Stock

In order for a taxpayer’s gains from the disposition of their shares in a corporation to qualify for the exclusion, the shares in the corporation had to have been acquired after December 31, 1992.[xxii]

What’s more, with limited exceptions, the shares must have been acquired directly from the corporation – an original issuance, not a cross-purchase – in exchange for money or other property (not including stock), or as compensation for services provided to the corporation.[xxiii]

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

Qualified Corporation

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

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

Active Business

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

If in connection with any future trade or business, a corporation uses assets in certain start-up activities, research and experimental activities, or in-house research activities, the corporation is treated as using such assets in the active conduct of a qualified trade or business.[xxxii]

Assets that are held to meet reasonable working capital needs[xxxiii] of the corporation, or that are held for investment and are reasonably expected to be used within two years to finance future research and experimentation, are treated as used in the active conduct of a trade or business.[xxxiv]

Qualified Trade or Business

A “qualified trade or business” is any trade or business, other than those involving the performance of services in the fields of health, law, engineering, architecture, accounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage services, or any other trade or business where the principal asset of the trade or business is the reputation or skill of one or more of its employees.[xxxv]

The term also excludes any banking, insurance, leasing, financing, investing, or similar business, any farming business, any business involving the production or extraction of products of a character for which depletion is allowable, or any business of operating a hotel, motel, restaurant or similar business.

Gross Assets

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

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


In the case of a corporation that owns at least 50-percent of the vote or value of a subsidiary, the parent corporation is deemed to own its ratable share of the subsidiary’s assets – based on the percentage of outstanding stock owned (by value) – and to be liable for its ratable share of the subsidiary’s indebtedness, for purposes of the qualified corporation, active business, and gross assets tests.[xxxix]

Pass-Through Entities as Shareholders

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

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

Sale or Exchange of Stock

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

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

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

The Future?

Assuming a non-corporate shareholder can satisfy the foregoing criteria, they will be permitted to exclude a substantial part of the gain from their sale of stock in a qualifying C corporation.

When individual entrepreneurs and investors start to understand the potential benefit of this exclusion, and as they become acclimated to the new C corporation income tax regime, with its greatly reduced tax rate and the elimination of the alternative minimum tax, they may decide that their new business venture should be formed as a C corporation, assuming it is a qualified trade or business for purposes of Section 1202.

In making this determination, however, these non-corporate taxpayers will have to consider a number of factors, among which are the following: Is the five-year minimum holding period acceptable? Will the corporation be reinvesting its profits, without regular dividend distributions?[xlii] Is it reasonable to expect that the corporation will appreciate significantly in value?

If each of these questions can be answered in the affirmative, then the taxpayer-shareholders should strongly consider whether they can structure and capitalize their business as a C corporation, and whether the corporation’s business can satisfy the requirements described above, in order that the taxpayers may take advantage of the gain exclusion rule.

[i] Stated differently, the income tax is the means by which each member of the public contributes their pre-determined share of the costs to be incurred by the government they have chosen to serve them.

[ii] I.e., a reduced tax liability.

[iii] For example, bonus depreciation under IRC Sec. 168(k).

[iv] IRC Sec. 1400Z-1 and 1400Z-2, added by P.L. 115-97 in 2017.

[v]IRC Sec. 1202.

[vi] IRC Sec. 1222.

[vii] IRC Sec. 1(h).

[viii] Beginning with 2013, a capital gain may also be subject to the 3.8-percent surtax on net investment income. IRC Sec. 1411.

[ix] P.L. 103-66; the Omnibus Budget Reconciliation Act of 1993.

[x] 50-percent of the gain taxed at 28-percent, and 50-percent taxed at 0-percent.

[xi] P.L. 111-5; the American Recovery and Reinvestment Act.

[xii] 25-percent of the gain multiplied by 15-percent.

[xiii] P.L. 111-240; the Small Business Jobs Act of 2010.

[xiv] IRC Sec. 1411.

[xv] It was rediscovered by Smeagol, who lost it to a Hobbit, who then became a star of literature and cinema.

[xvi] P.L. 115-97; the “Act.”

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

[xviii] IRC Sec. 1202(a).

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

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

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

[xxii] Seems like yesterday. In 1993, I prepared an “Alert” for Matthew Bender (the publisher) that summarized many of the changes enacted by the Omnibus Budget Reconciliation Act of 1993.

[xxiii] IRC Sec. 1202(c).

In the case of certain transfers, including, for example, a transfer by gift or at death, the transferee is treated as having acquired the stock in the same manner as the transferor, and as having held the stock during any continuous period immediately preceding the transfer during which it was held by the transferor.

Two more special rules should be noted: (i) stock acquired by the taxpayer is not treated as qualified small business stock if, at any time during the 4-year period beginning on the date 2 years before the issuance of such stock, the issuing corporation purchased any of its stock from the taxpayer or from a person “related” to the taxpayer; and (ii) stock issued by a corporation is not treated as qualified business stock if, during the 2-year period beginning on the date 1 year before the issuance of such stock, the corporation made 1 or more purchases of its stock with an aggregate value (as of the time of the respective purchases) exceeding 5-percent of the aggregate value of all of its stock as of the beginning of such 2-year period. IRC Sec. 1202(c)(3).

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

[xxv] IRC Sec. 1202(i)(1)(B). Compare this to Sec. 351 and Sec. 358, which provide that stock received in a Sec. 351 exchange has the same basis as that of the property exchanged.

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

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

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

[xxix] IRC Sec. 1202(e)(7). The ownership of, dealing in, or renting of real property is not treated as the active conduct of a qualified trade or business for purposes of this rule.

[xxx] A corporation is considered a subsidiary if the parent owns more than 50-percent of the combined voting power of all classes of stock entitled to vote, or more than 50-percent in value of all outstanding stock, of such corporation.

[xxxi] IRC Sec. 1202(e)(1).

[xxxii] IRC Sec. 1202(e)(2).

[xxxiii] IRC Sec. 1202(e)(6). Sounds familiar? See the proposed regulations for under IRC Sec. 1.1400Z-2 and the definition of a qualified opportunity zone business.

The term “working capital” has not been defined for this purpose.

[xxxiv] For periods after the corporation has been in existence for at least 2 years, no more than 50-percent of the corporation’s assets may qualify as used in the active conduct of a qualified trade or business by reason of this rule. In other words, the corporation may have to be careful about raising “too much” capital.

[xxxv] IRC Sec. 1202(e)(6). Déjà vu, for the most part? See the exclusion of a “specified service trade or business” under IRC Sec. 199A’s qualified business income deduction rule.

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

This should be compared to the general rule under IRC Sec. 351 and Sec. 362, under which the corporation takes the contributed property with the same adjusted basis that it had in the hands of the contributing shareholder.

Property created or purchased by the corporation is not subject to this rule.

Both the corporation and the contributing taxpayer will have to be very careful to determine the fair market value of any in-kind contribution of property to the corporation lest they cause the corporation to exceed the $50 million threshold, and thereby disqualify the contributing taxpayer and any future contributors from taking advantage of Sec. 1202’s gain exclusion rule.

[xxxvii] IRC Sec. 1202(d). What’s more, the gross assets of the corporation must not have exceeded $50 million at any time after the 1993 legislation and before the issuance.

[xxxviii] Query what effect this would have on raising additional capital.

[xxxix] IRC Sec. 1202(e)(5). The subsidiary stock itself is disregarded.

[xl] IRC Sec. 1202(g).

[xli] IRC Sec. 331 treats the amount received by a shareholder in a distribution in complete liquidation of the corporation as full payment in exchange for the stock.

[xlii] In other words, will the corporation’s earnings be subject to one or two levels of tax?

Don’t Take It Lightly

Regardless of who or what they are, taxpayers have to be careful of saying things like, “I guarantee it” or “it’s guaranteed.”

First of all, they’re not Joe Namath guaranteeing a Jets victory over the Colts in Super Bowl III, where the worst thing that could have happened had Broadway Joe not delivered on his promise would have been a brief delay in the AFL/AFC’s first Super Bowl title.[i] Nor are they George Zimmer guaranteeing that you’re going to look good in a Men’s Wearhouse suit, where the worst thing that could have happened was that you . . . well . . . you didn’t look too good.

The foregoing results pale in significance to the sometimes surprising tax consequences that may accompany a taxpayer’s guarantee of a business entity’s liability.

What Are They?

Before we consider some of the more common instances of guarantees and their tax effects, it would be helpful if we first defined the term “guarantee,” at least for purposes of this discussion.

Generally speaking, the object of one person’s guarantee is another person’s obligation to perform an act – usually the repayment of an amount borrowed from a lender; stated differently, a guarantor will agree to satisfy an obligor’s indebtedness to a lender in the event the obligor itself fails to do so. The lender is typically viewed as the beneficiary of the guarantee because it provides the lender with a degree of protection from the adverse consequences of the obligor’s default under the loan.

That being said, one may just as easily characterize the obligor as the beneficiary of the guarantee because the lender may not otherwise be willing to make a loan to the obligor without the presence of the guarantee, or would be willing to do so only under less favorable terms (from the perspective of the borrower).

Tax Considerations

When considering the tax consequences of a guarantee, the focus is usually on the relationship between the guarantor and the obligor (the “beneficiary” for tax purposes); more often than not, these parties are a closely held business and its owners.

For example, the owners of a business will often be asked by a lender to personally guarantee a loan or a line of credit to their business.[ii] Alternatively, one company may be asked to guarantee the loan obligations of another company;[iii] the latter may be a parent, a subsidiary, or a sister company with respect to the guarantor.

It should be obvious that the guarantor provides an immediate economic benefit to the obligor by guaranteeing the obligor’s indebtedness to the lender; by doing so, the guarantor allows its own economic strength and creditworthiness to support the obligor.

It should also be obvious that the guarantor suffers an economic detriment because by guaranteeing the obligor’s indebtedness the guarantor has agreed to assume responsibility for the indebtedness in the event the obligor is unable to satisfy the indebtedness itself.[iv]

Which brings us to the tax question: how is this economic benefit measured, was any consideration provided by the obligor in exchange for this benefit, and what tax consequences are realized by the obligor as a result of the transaction?[v]

A Guarantee Fee?

The value of the economic benefit inuring to an obligor, and the “value” of the detriment suffered by the guarantor, as a result of a guarantee are not necessarily the same as the consideration (or fee) that may have been paid by the obligor in exchange for the guarantee; by analogy, think in terms of insurance coverage and insurance premiums – one would never guarantee an indebtedness unless the obligor was reasonably capable of satisfying the indebtedness.

With that in mind, how do a closely held business and those related to it even determine what an appropriate guarantee fee is?

If the guarantor is the controlling owner of the obligor-business, should a fee be imputed between them,[vi] such that the guarantor is deemed to have received an item of taxable income, and the obligor is deemed to have received a capital contribution of the same amount?

In the absence of any consideration for the guarantee, has there been a capital contribution by the guarantor-owner to the obligor-business? Has there been a distribution of earnings from the guarantor-subsidiary business entity to the obligor-parent business entity? If there has been, then how much? The amount of the foregone fee?

Herein lies the issue, and perhaps the source of much confusion among taxpayers. This state of affairs may best be illustrated by exploring a few not uncommon scenarios.

CFCs,[vii] U.S. Properties & Guarantees

Normally, a CFC’s non-Subpart F income – and, after 2017, its non-GILTI – is not taxable to its U.S. shareholder or shareholders unless and until the income is distributed to them.[viii] In the face of this principle, taxpayers once attempted to avoid U.S. income tax by taking loans from unrelated financial institutions and having their CFCs guarantee the loans.

Guarantee as Distribution

Then Congress amended the Code to require the inclusion in the U.S. shareholder’s income of any increase in investment in U.S. properties made by a CFC it controls. Such an investment of earnings by a CFC in U.S. properties, Congress determined, was tantamount to the repatriation of such earnings. Therefore, “U.S. property” was defined as including, among other things, an obligation of a U.S. person arising from a loan by the CFC to the U.S. person.

The Code and regulations then went further by providing that a CFC would be considered as holding an obligation of a U.S. person if the CFC was a guarantor of the obligation, where the loan was made by a third party.[ix]

They also provided that the amount of the obligation treated as held by the CFC, as a result of its guarantee, was the unpaid principal amount of the obligation; in other words, the IRS treated the CFC-guarantor as if it had made the entire loan directly, thereby acquiring a U.S. property interest – i.e., as if it had made a distribution to its U.S. shareholders of an amount equal to the principal amount of the loan – though the amount included in the gross income of the CFC’s U.S. shareholder was capped at the CFC’s earnings.[x]

S Corporation Shareholder Guarantees

The foregoing demonstrates that, in the case of a CFC, the corporation’s guarantee of its U.S. shareholder’s indebtedness bestowed a significant economic benefit upon the U.S. shareholders – one that may characterized, for tax purposes, as a distribution that accelerated the recognition by the U.S. shareholder of the CFC’s previously undistributed income.

However, where the taxpayer is a shareholder of an S corporation, the issue surrounding the shareholder’s guarantee of the corporation’s indebtedness is not one of income inclusion, or the acceleration of income recognition; rather, it is usually a question of whether the shareholder should be entitled to deduct their allocable share of S corporation loss up to the amount of indebtedness guaranteed by the shareholder.

Loss Limitation Rule

The Code provides that a shareholder may deduct their share of an S corporation’s losses only to the extent that such share does not exceed the sum of “the adjusted basis of the shareholder’s stock in the S corporation,” and “the shareholder’s adjusted basis of any indebtedness of the S corporation to the shareholder.”[xi] In other words, the shareholder cannot deduct more than the sum of the following: (i) what they have contributed to the corporation as a capital contribution,[xii] (ii) their share of corporate income and gain that has not been distributed to them by the corporation, and (iii) the amount they have loaned to the corporation. [xiii]

Any disallowed deduction – i.e., the amount by which a shareholder’s share of the corporation’s losses exceeds the shareholder’s aggregate stock and debt basis – is treated as incurred by the corporation in the succeeding taxable year with respect to the shareholder whose deductions are limited. Once the shareholder increases their basis in the S corporation, any deductions previously suspended become available to the extent of the basis increase.

Economic Outlay

The Code does not provide a means by which a shareholder may acquire basis in an S corporation’s indebtedness other than by making a direct loan to the corporation. Likewise, the courts have generally required an “actual economic outlay” by the shareholder to, or on behalf of, the corporation before determining whether the shareholder has made a bona fide loan that gives rise to an actual investment in the corporation.

A taxpayer makes an economic outlay sufficient to acquire basis in an S corporation’s indebtedness when the taxpayer incurs a ‘cost’ on a loan. The taxpayer bears the burden of establishing this basis.

It does not suffice, however, for the shareholder to have made an economic outlay. The term “basis of any indebtedness of the S corporation to the shareholder” means that there must be a bona fide indebtedness of the S corporation that runs directly to the shareholder.[xiv]

Whether a corporation’s indebtedness is “bona fide indebtedness” to a shareholder is determined under general Federal tax principles and depends upon all of the facts and circumstances.


Moreover, a shareholder does not obtain basis for an indebtedness of the S corporation to a third party merely by guaranteeing such indebtedness.

According to most courts and the IRS, it is when a shareholder makes a payment on bona fide indebtedness of the S corporation, for which the shareholder has acted as guarantor, that the shareholder creates a direct indebtedness between themselves and the corporation – the shareholder-guarantor steps into the shoes of the original creditor vis-à-vis the corporation to the extent of such payment – and the shareholder acquires basis for that indebtedness to the extent of that payment.[xv]

That being said, some shareholders have argued, unsuccessfully, against the form of the loan transaction; specifically, these taxpayers have claimed that the lender was, in fact, looking to them for repayment of the loan, and not to the corporation. Under this theory, the shareholders would be treated as having received the loan, and then as having made a capital contribution to the corporation. Unfortunately for them, the courts have not accepted their theory; rather, the courts have bound them to the form of their transaction – a loan to the corporation that is guaranteed by the shareholders; the fact that the corporation, and not the shareholders, made the loan payments did not help their position.

However, the fact remains that a shareholder’s guarantee of their S corporation’s indebtedness to a third party bestows a valuable benefit upon the corporation – that enables the corporation to borrow from an unrelated lender – and exposes the shareholder to a contingent liability for which the corporation likely paid no consideration.

Yet neither the IRS nor the courts have shown any willingness to accept the argument that the value of this guarantee – whether it is the amount of the guarantor’s actual or imputed fee, the value of the benefit, or the value of the detriment, however determined – should be treated as a capital contribution by the shareholder to the corporation.

Of course, a possible corollary to this position – and perhaps the reason that the argument has not found any traction – is that income should be imputed to the shareholder in exchange for their guarantee of the corporation’s indebtedness.

A more likely reason, however, is probably the difficulty in determining the value of the benefit.[xvi]

Partner Guarantees and Partnership Recourse Debt

As in the case of a shareholder of an S corporation, a partner’s distributive share of partnership loss is allowed only to the extent of the partner’s adjusted basis in their partnership interest at the end of the partnership year in which the loss occurred.[xvii]

In contrast to a shareholder’s guarantee of an S corporation’s indebtedness, however, a partner’s guarantee of a partnership’s indebtedness may increase the partner’s adjusted basis for their partnership interest,[xviii] and thereby allow the partner to claim a greater portion of their share of partnership loss.

Specifically, any increase in a partner’s share of partnership liabilities, or any increase in a partner’s individual liabilities by reason of the partner’s assumption of partnership liabilities,[xix] is treated as a contribution of money by that partner to the partnership and increases the partner’s basis in their partnership interest.

Economic Risk of Loss

A partner’s share of a partnership’s liability depends upon whether the liability is a recourse or a nonrecourse liability.

A partnership liability is a recourse liability to the extent that any partner bears the economic risk of loss for that liability. A partner’s share of a recourse liability equals the portion of that liability for which the partner bears the economic risk of loss. In other words, each partner’s share of a recourse liability is proportionate to the partner’s economic risk of loss with respect to such liability.[xx]

A partner bears the economic risk of loss for a partnership liability to the extent that, if the partnership constructively liquidated,[xxi] the partner would be obligated to make a payment to any person, or a capital contribution to the partnership, because that liability becomes due and payable, and the partner would not be entitled to reimbursement from another partner.

Partner Guarantee

If a partner guarantees a partnership’s liability to an unrelated lender, it would appear that the partner bears the economic risk of loss with respect to that liability – the partner is obligated to pay the lender if the partnership defaults – and, consequently, should be treated as having made a capital contribution to the partnership, which would increase the basis of the partner’s partnership interest.[xxii] The fact that the partner is never actually called upon to fulfill their guarantee is irrelevant – there does not need to be an actual economic outlay[xxiii] – it suffices that they bear the economic risk of loss.

That being said, the partner’s guarantee may be disregarded if, taking into account all the facts and circumstances, the partner’s obligation under the guarantee is subject to contingencies that make it unlikely that it will ever be discharged. In that case, the guarantee would be ignored until the event occurs that triggers the payment obligation.[xxiv]

According to the IRS, a guarantee may also be disregarded where it was not required in order to induce the lender to make the loan to the partnership, or where the terms of the loan were no different than they would have been without the guarantee.[xxv]


The point of the foregoing discussion was to remind the reader of a few common business situations in which one person’s guarantee of another’s indebtedness may have significant income tax consequences; based upon the volume of litigation and regulatory activity in this area, it appears that these consequences are not yet fully appreciated by many taxpayers, who are either unaware of the issue or who try to circumvent it.[xxvi]

This post does not seek to explain or justify the different tax treatment of a guarantee in one business scenario versus another; for example, a shareholder’s guarantee of an S corporation’s indebtedness versus a partner’s guarantee of a partnership’s indebtedness.

Nevertheless, I hope that the following themes were conveyed: (i) in order for a guarantee to be respected, it must serve a bona fide economic purpose – it cannot be undertaken only to generate a beneficial tax result (for example, additional basis); otherwise, the guarantee will not be given tax effect until the occurrence of the contingency to which the guarantee is directed; and (ii) the IRS’s treatment of a guarantee will depend in no small part upon the direction of the guarantee – for example, upstream, as in the case of the CFC described above, or downstream, as in the case of partner and a partnership – and the fiscal policy sought to be enforced.

Therefore, before agreeing to guarantee the indebtedness of a related person or business entity, a taxpayer should consult their tax adviser, lest any hoped-for tax consequences turn out to be unattainable, or lest the taxpayer incur an unintended tax liability.

[i] 1969. The Jets, the Mets and the Knicks won championships. The Rangers made it to the playoffs, losing to the Bruins (my then hero, goalie Eddie Giacomin, had a great regular season).

[ii] These guarantees may be joint and several, or they may be capped at a certain amount per owner. Sometimes, a lender will require that the owners secure their guarantee (perhaps by agreeing to maintain some minimum amount on deposit at the lending institution).

[iii] There are many permutations.

[iv] A contingent liability.

[v] OK, actually three questions. Have you ever known a tax person who stops at one question?

[vi] See IRC Sec. 482. The purpose of IRC section 482 is to ensure taxpayers clearly reflect income attributable to controlled transactions and to prevent avoidance of taxes regarding such transactions. It places a controlled taxpayer on a tax parity with an uncontrolled taxpayer by determining true taxable income. Transactions between one controlled taxpayer and another will be subject to special scrutiny to ascertain whether common control is being used to reduce, avoid, or escape taxes. In determining the true taxable income of a controlled taxpayer, the IRS’s authority extends to any case in which either by inadvertence or design the taxable income of a controlled taxpayer is other than it would have been had the taxpayer been dealing at arm’s length with an uncontrolled taxpayer.

[vii] A controlled foreign corporation (“CFC”) is defined as “any foreign corporation if more than 50-percent of (1) the total combined voting power of all classes of stock of such corporation entitled to vote, or (2) the total value of the stock of such corporation is owned by U.S. shareholders on any day during the taxable year of such foreign corporation.” IRC Sec. 957.

[viii] In the Tax Cuts and Jobs Act world, this would include its “high tax” income, as well as the amount representing the “reasonable” 10-percent return on the investment in tangible personal property. IRC Sec. 954(b), Sec. 951A(b).

[ix] IRC Sec. 956(d); Reg. Sec. 1.956-2(c)(1).

[x] IRC Sec. 951, Sec. 956. For a recent decision involving this issue, see the Third Circuit’s opinion in SIH Partners: .

[xi] IRC Sec. 1366(d); Reg. Sec. 1.1366-2.

[xii] Cash and the adjusted basis (i.e., unreturned investment) in other property.

[xiii] Basically, amounts that remain subject to the risks of the business.

[xiv] For a recent decision involving this issue, see the Eleventh Circuit’s opinion in Meruelo: .

[xv] Reg. Sec. 1.1366-2(a)(2). But if a shareholder engages in genuine “back-to-back” loans – in which a lending entity loans the shareholder funds that he then loans directly to the S corporation – those loans can establish bona fide indebtedness running directly to the shareholder.

[xvi] See, e.g., PLR 9113009, which involved a parent’s guarantee of business-related loans for his children. Although the ruling concluded that the guarantee constituted the completed gift transfer of a valuable property right, it did not explain how that right was to be valued. The IRS later withdrew the ruling as it related to the guarantee. PLR 9409018.

[xvii] IRC Sec. 704(d). Any excess loss is carried forward.

[xviii] IRC Sec. 752(a).

[xix] A partnership obligation is a liability for purposes of IRC Sec. 752 only if, when, and to the extent that incurring the obligation (i) creates or increases the basis of any of the obligor’s assets (including cash); gives rise to an immediate deduction to the obligor; or gives rise to an expense that is not deductible in computing the obligor’s taxable income and is not properly chargeable to capital. Reg. Sec. 1.752-1(a)(4).

[xx] Reg. Sec. 1.752-2.

[xxi] For purposes of this hypothetical liquidation, the partnership’s assets are assumed to have no value, its liabilities are deemed to have become due and payable, and its assets are deemed to have been sold for no consideration other than relief from any liabilities that they secure. Reg. Sec. 1.752-2(b).

[xxii] Irrespective of the form of a partner’s contractual obligation, the IRS may treat a partner as bearing the economic risk of loss with respect to a partnership liability, or a portion thereof, to the extent that  the partner undertakes one or more contractual obligations so that the partnership may obtain or retain a loan; the contractual obligations of the partner significantly reduce the risk to the lender that the partnership will not satisfy its obligations under the loan, or a portion thereof; and one of the principal purposes of using the contractual obligations is to attempt to permit partners to include a portion of the loan in the basis of their partnership interests. Reg. Sec. 1.752-2T(j)(2).

[xxiii] Contrast this to the S corporation shareholder.

[xxiv] Reg. Sec. 1.752-2(b).

[xxv] Prop. Reg. Sec. 1.752-2(j).

[xxvi] Who may also be forgetful when it is convenient.