New York Diaspora?[i]

Like most every other state in the Union, New York has experienced its share of fiscal stress over the last few decades. The source or cause of its problems? Well, that may depend upon the respondent to whom this question is posed and, unfortunately, the side of the political aisle on which they place themselves.[ii] However, almost everyone agrees that there are many factors and forces to which the State’s long-standing economic issues may be attributed.[iii]

What’s more, there is no denying that the State’s fiscal situation has been exacerbated by the unexpected expenditures that were necessarily incurred in combating the recent coronavirus outbreak, and by the reduction in badly needed tax revenues caused by the resulting economic shutdown.

What does this state of affairs portend for New York’s taxpayers, especially those who are often described by the media as the “affluent?”[iv]

These folks already pay personal income tax to the State at a top rate of 8.82 percent; if they are residents of New York City, they pay City income tax at a rate of 3.876 percent. The State’s sales tax is 4 percent,[v] but they also have to factor in their local tax; in New York City, that means a sales tax of 4.5 percent plus a Metropolitan Commuter Transportation District surcharge of 0.375 percent, for a total sales tax of 8.875 percent; Nassau County’s sales tax is 8.63 percent and Westchester’s is 8.38 percent. These last two counties regularly take top five honors, nationally, for real property taxes. Then there is New York’s cost of living. And as a parting gift, there is New York’s 16 percent estate tax.[vi]

Well before the shutdown triggered by COVID-19, New York began taking the initiative in examining taxpayers’ personal income tax returns, including – to the extent New York’s Tax Law (the “Tax Law”) conforms to the Code – the Federal tax issues presented in those returns. The obvious goal of this increased audit activity is the collection of more New York income tax.[vii]

With the shutdown, however, the State’s economic situation has only gotten worse, and the pressure to recover lost tax dollars has only increased.[viii]

Query what impact this new fiscal reality will have upon New York’s individual residents, especially those who have always been able to move their business elsewhere but chose to remain in New York anyway, as well as those who just discovered during the recent quarantine that they can effectively manage and operate their business remotely.[ix]

Will It Matter?

Of course, most New Yorkers will stay put[x] – and all of their income will remain subject to New York income tax regardless of its source – but a not insignificant number of individual residents can be expected to emigrate from the State.[xi]

New York’s Department of Taxation and Finance (the “Department”) will audit many of these “emigres”[xii] and will determine that they are still domiciled in the State because they have failed either to abandon New York as their permanent home or to establish a new domicile elsewhere.

More disciplined or committed taxpayers – who are actually willing to do what it takes[xiii] – as well as better-organized taxpayers,[xiv] will succeed in becoming nonresidents of New York.[xv]

Among these soon-to-be former New York residents will be some who will continue to participate, to varying degrees, in a New York business, or who will have a substantial investment in a New York business.[xvi] For many of these individuals, even if they successfully defend their status as nonresidents, their New York source income will continue to represent the largest part of their gross income, and they will continue to pay substantial personal income tax to New York, albeit as a nonresident.[xvii] Pyrrhic victory?

For that reason, it will behoove former residents and their advisers to familiarize themselves with New York’s source rules; only in this way can they organize their New York business or investment, and plan for recognition events with respect to those assets, so as to reduce their New York tax burden.

New York’s Source Rules

In general, nonresidents are subject to New York personal income tax on their New York source income, which is defined as the sum of income, gain, loss, and deduction derived from or connected with New York sources.[xviii] For example, where a nonresident sells real property or tangible personal property located in NY, the gain from the sale is taxable in New York.[xix]

If a nonresident carries on a trade or business party within and partly outside New York, the nonresident must determine the items of income, gain, loss and deduction that are derived from or connected with New York sources.[xx]

However, income derived from intangible personal property, including dividends and interest, as well as the gains from the disposition of such property, constitute income derived from New York sources only to the extent that the intangible property is employed in a business carried on in New York.[xxi]

From 1992 until 2009, this analysis also applied to the gain from the disposition of interests in entities that owned New York real property. Thus, generally speaking, a nonresident who owned an interest in a close corporation, for example, that owned New York real property, could sell such interest without realizing New York source income and incurring New York income tax.

However, in 2009, the Taw Law was amended to provide that items of gain derived from or connected with New York sources included items attributable to the ownership of any interest in real property located in New York.

For purposes of this rule, the term “real property located in” New York was defined to include an interest in a partnership, LLC, S corporation, or non-publicly traded C corporation with one hundred or fewer shareholders, that owns real property located in New York and has a fair market value (“FMV”) that equals or exceeds 50 percent of all the assets of the entity on the date of the sale or exchange of the taxpayer’s interest in the entity.[xxii]

In accordance with an “anti-stuffing” rule, only those assets that the entity owned for at least two years before the date of the sale or exchange of the taxpayer’s interest in the entity are used in determining the FMV of all the assets of the entity on such date.

The gain or loss derived from New York sources from a nonresident’s sale or exchange of an interest in an entity that is subject to this rule is the total gain or loss for federal income tax purposes from that sale or exchange multiplied by a fraction, the numerator of which is the FMV of the real property located in New York on the date of the sale or exchange and the denominator of which is the FMV of all the assets of the entity on such date.

For Example

With that background, let’s turn to a recent Advisory Opinion which illustrated the consequences of failing to fully consider or appreciate the impact of the State’s sourcing rules.[xxiii]

Petitioner was a limited partnership that was formed under the laws of another state for the purpose of investing in U.S. real estate. Petitioner had a large number of limited partners, many of whom were nonresident individuals as to New York.

Petitioner invested in real estate and owned land and improvements in several states, including a New York building that it owned and actively managed for over two years.[xxiv] In connection with the ownership of the building, each of Petitioner’s limited partners was allocated a distributive share of income, gain, loss and deduction[xxv] that was reported as attributable to a business carried on by Petitioner in New York.[xxvi]

Upon the sale of the building on the Closing Date, Petitioner recognized a taxable gain and paid, on behalf of its nonresident limited partners, any required estimated taxes relating to their distributive share of its New York source income associated with the building’s sale.[xxvii] At the time of the sale, the building was the only material asset held by Petitioner, other than any undistributed cash remaining from the disposition of other land and improvements. All of the cash was held for less than two years at the time of the sale of the building through the winding up of Petitioner.

After the building was sold, Petitioner wound up its operations and liquidated. The net proceeds from the sale were transferred on Closing Date to a bank account maintained by an affiliate of Petitioner’s general partner (the “Affiliate”). Affiliate distributed the net proceeds to Petitioner’s limited partners one day after the Closing Date. According to Petitioner, the proceeds were distributed one day after the sale of the New York property because the Closing Date was a bank holiday in the jurisdiction in which its limited partners were located.

Upon Petitioner’s liquidation,[xxviii] each limited partner was expected to recognize a capital loss in an amount equal to the excess of each limited partner’s outside tax basis in Petitioner over the amount of liquidation proceeds received.[xxix]

The Opinion

Petitioner asked the Department whether the loss realized by its nonresident individual limited partners upon the liquidation of Petitioner one day after the Closing Date was derived from or connected with New York sources, such that the loss would offset at least part of the New York source gain allocated to these limited partners from the Petitioner’s sale of the building.[xxx]

Unfortunately for Petitioner’s limited partners, the Department concluded that the loss was not derived from or connected with New York sources.

The Department explained that, under the Tax Law, the New York source income of a nonresident individual includes the individual’s net amount of items of income, gain, loss and deduction entering into the individual’s Federal adjusted gross income that is derived from or connected with New York sources, including the individual’s distributive share of partnership income, gain, loss and deduction.[xxxi]

According to the Department, items of income, gain, loss and deduction derived from or connected to New York sources include items attributable to the ownership of any interest in real property located in the State.[xxxii]

The term “real property located in this state,” the Department stated, includes an interest in a partnership that owns real property that is located in New York and has a fair market value that equals or exceeds 50 percent of all the assets of the entity on the date of sale or exchange of the taxpayer’s interest in the entity. “Only those assets that the entity owned for at least two years before the date of the sale or exchange of the taxpayer’s interest in the entity are to be used in determining the fair market value of all the assets of the entity on the date of sale or exchange.”[xxxiii]

“The gain or loss derived from New York sources from the taxpayer’s sale or exchange of an interest in an entity that is subject to” these provisions, the Department continued, “is the total gain or loss for federal income tax purposes from that sale or exchange multiplied by a fraction, the numerator of which is the fair market value of the real property … located in New York on the date of the sale or exchange and the denominator of which is the fair market value of all the assets of the entity on the date of the sale or exchange.”

As stated above, Petitioner sold its New York building at a gain on the Closing Date. It then wound up its affairs, settled its accounts, and liquidated.

Petitioner asked whether each limited partner’s loss, required to be recognized for Federal tax purposes upon liquidation, would also be recognized for New York tax purposes as a loss derived from New York sources that was attributable to the ownership of an interest in real property in New York.[xxxiv]

The Tax Law[xxxv] provides that items of loss are attributable to New York sources if those items are attributable to the ownership of any interest in real property in New York. This includes, the Department stated, an interest in a partnership that owns real property that is located in New York and has a fair market value that equals or exceeds 50 percent of all the assets of the entity on the date of sale or exchange of the taxpayer’s interest in the entity.

In this case, the Department observed, Petitioner sold its interest in the New York building on the Closing Date, and transferred the net proceeds from that sale to Affiliate, not to its limited partners. Thereafter, Petitioner was liquidated, and the net proceeds were delivered to the limited partners, the day after the Closing Date.

Therefore, any loss recognized by Petitioner’s limited partners from their interests in Petitioner were not attributable to the Partnership’s ownership of real property in New York because Petitioner did not own New York real property on the date on which those partnership interests were liquidated; i.e., the day after the Closing Date.[xxxvi]


Harsh result? Seems so. One day seems to have made all the difference with respect to the source of the loss realized on the liquidation of the nonresident limited partners’ interests in the partnership. Consequently, there was a mismatching of the New York source capital gain that was allocated to these nonresident partners from the sale of the partnership’s New York real property on the Closing Date, and the non-New York source capital loss realized by these same partners on the liquidation of their partnership interests the day after the Closing Date, with the result that Petitioner’s nonresident partners owed New York income tax on the gain.

Query what Petitioner could have done differently so as to avoid this outcome? Perhaps it could have created a liquidating trust to accept the liquidation proceeds?[xxxvii] Such vehicles are often used to facilitate the time-sensitive liquidation of a corporation. In the case of the Petitioner, the limited partners would have been designated as the beneficiaries of the trust. Petitioner and the partners would have agreed to treat the limited partners as having received the liquidating distribution, followed by their having contributed the proceeds thereof to the trust for the purpose of completing the legal dissolution (as opposed to the liquidation for tax purposes) of the partnership. Because the partners would have “contributed” assets to the trust while retaining the beneficial interest in such assets, the trust would have been treated as a grantor trust for tax purposes.[xxxviii]

The bottom line here is that a closer analysis of New York’s source rules may have afforded Petitioner an opportunity to avoid the conclusion reached by the Department in its advisory opinion.

This result also highlights the importance of understanding the operation of the State’s source rules if one is seeking to change their status as a New York resident for the purpose of avoiding the reach of the New York income tax. Failing to do so may not affect one’s nonresident status, but it can make a huge difference in one’s tax bill.

[i] From the Greek, to scatter about, as in the case of seeds.

[ii] See the conservative Cato Institute’s January 2020 comparative analysis, which places the blame squarely upon what it describes as New York’s “excessive” government spending.

[iii] Justifiable or not, there is no denying that the wages, overtime, and retirement benefits paid to civil servants represent an enormous expenditure of public funds. For example, the “traditional” retirement plan for union-represented public employees is a defined benefit plan that provides life-time benefits determined under a formula based upon one’s final average salary and years of service. The cost of such a plan is borne by the employer – i.e., the taxpayer. Defined contribution plans, by contrast, are funded primarily by the employee, though many employers also contribute to such a plan.

In the private sector, defined benefit plans have been a thing of the past for several years. They are just too expensive to maintain and administer. Stated differently, they are injurious to the profits of a business and its owners. No moral statement here. Just a fact. “It’s not personal, Sony, it’s strictly business,” as Michael said.

[iv] Talk about relative. Talk about overbroad. In 2019, the national cutoff for the top 1 percent of household income (gross) was approximately $475,000. The cut-off in New York State was approximately $586,000; in NYC, approximately $2.2 million. Visit DQYDJ’s website.

Net worth is another story; it does not correlate neatly to income.

Then there’s the cost of living; for example, under almost any measure, the cost of living is lower in FL than in New York.

[v] Of course, if an affluent person and a less-than-affluent person purchase the same item for the same price from the same store, the sales tax imposed upon these retail purchases will have a disproportionately greater impact upon the less-than-affluent individual, all other things being equal.

[vi] Ready to pack the car? I just told my mother-in-law that I’m planning to move. The very picture of stoicism, she is – or was that the hint of a smile? I can’t tell. Probably just . . .

What’s more, let’s not forget the $6 trillion that the Federal government has just spent over the course of approximately only five months. Someone has to pay for that, and there really is only one viable option.


The State appears to have relaxed its “wait-and-see-what-the-IRS-finds” attitude, notwithstanding that the applicable N.Y. statute of limitations on the assessment of a deficiency in income tax owed by a taxpayer (normally three years from filing) is suspended (“tolled”) if the taxpayer fails to timely inform the State that the IRS has adjusted their Federal taxable income.

New York has displayed a similar approach with respect to the N.Y. estate tax after decoupling from the Federal estate tax exemption amount.

Can you blame New York? Not really. The IRS’s recently released annual data book (for 2019) states that, “For the past decade, the IRS has seen an increase in the number of returns filed as well as a decrease in resources available for examinations.” For example, in fiscal year “2010, the IRS received 230.4 million returns and employed 13,879 revenue agents, compared to 253.0 million returns and 8,526 revenue agents in FY 2019.”

[viii] And, thereby, avoid cuts in services.

[ix] Fortuitously for them, not for N.Y. The same can be said for many New York City residents who have decamped not only to neighboring states during the virus, but also Upstate or the East End.

[x] According to the U.S. Census Bureau, approximately 70 percent of Americans live in or close to the place where they grew up. There are probably many reasons for this, including familiarity and the presence of family.

[xi] The pace of southern- or southwestern-bound “former” New Yorkers had picked up well before the recent developments. The newspapers have been highlighting the more “significant” departures. Anecdotally, however, it appears that we can expect an additional increase.

[xii] Obviously, I use this word facetiously. I don’t believe there is anything political motivating their move.

[xiii] It is no easy thing to abandon one’s place of domicile; it requires much more than merely purchasing a condo apartment elsewhere, registering to vote in the new jurisdiction, and registering one’s car there. In some cases, it may require withdrawing one’s business from N.Y., among other things.

But see

[xiv] After all, the taxpayer has the burden of proof to establish their abandonment of N.Y. and their establishment of a new domicile elsewhere.

[xv] Readers may recall that the State employs a “five principal factors” test to determine an individual taxpayer’s domicile. The five factors it will consider and weigh as between N.Y. and the state the taxpayer claims as its new home are the following: (i) the taxpayer’s physical residences in the two jurisdictions, (ii) the time the taxpayer spends in each of the two jurisdictions, (iii) the taxpayer’s active involvement in a N.Y. business, (iv) the location of the taxpayer’s near and dear items, and (v) the location of the taxpayer’s family connections.

[xvi] Indeed, the State has long recognized that the extent of an individual’s control and supervision over a New York business can be such that their active involvement in the business continues even during times when they are not physically present in New York.

[xvii] The Form IT-203, Nonresident and Part-Year Resident Income Tax Return, includes two columns, one on which the nonresident taxpayer enters their Federal income and the other on which they enter their New York income. I can’t tell you the number of cases I have seen where the two columns are almost identical, but for some investment income, yet the State fought to establish that the taxpayer was a resident. It no longer surprises me, but I continue to be disappointed at how public resources are being utilized.

Speaking of investment income, see

[xviii] NY Tax Law Sec. 631(a) and (b).

[xix] A nonresident will be subject to N.Y. personal income tax with respect to their income from:

  • real or tangible personal property located in the State, (including certain gains or losses from the sale or exchange of an interest in an entity that owns real property in N.Y.);
  • services performed in N.Y.;
  • a business, trade, profession, or occupation carried on in N.Y.;
  • their distributive share of N.Y. partnership income or gain;
  • any income received related to a business, trade, profession, or occupation previously carried on in the State, including, but not limited to, covenants not to compete and termination agreements; and
  • a N.Y. S corporation in which they are a shareholder, including, for example, any gain recognized on the deemed asset sale for federal income tax purposes where the S corporation’s shareholders have made an election under Sec. 338(h)(10) or Sec. 336(e) of the Code.

Although the foregoing list encompasses a great many items of income, there are limits to the State’s reach; for example, N.Y. income does not include a nonresident’s income:

  • from interest, dividends, or gains from the sale or exchange of intangible personal property, unless they are part of the income they received from carrying on a business, trade, profession, or occupation in N.Y.; and
  • as a shareholder of a corporation that is a N.Y. C corporation.

[xx] NY Tax Law Sec. 631(c). New York provides special allocation and apportionment rules for this purpose.

[xxi] NY Tax Law Sec. 631(b)(2). I should be noted that a nonresident who buys, holds, and sells securities for their own account (not a dealer) will not, by virtue of this activity alone, be treated as engaged in a N.Y. trade or business. NY Tax Law Sec. 631(d).

[xxii] NY Tax Law Sec. 631(b)(1)A)(1).

[xxiii] TSB-A-20(3)I. An Advisory Opinion is issued by the Department’s Office of Counsel at the request of a person or entity. It is limited to the facts set forth therein and is binding on the Department only with respect to the person or entity to whom it is issued and only if the person or entity fully and accurately describes all relevant facts. An Advisory Opinion is based on the law, regulations, and Department policies in effect as of the date the Opinion is issued or for the specific time period at issue in the Opinion.

In other words, it may not be cited as precedent. Nevertheless, such opinions provide a glimpse into the Department’s thinking with respect to a particular issue.

[xxiv] Remember the anti-stuffing rule described above?

[xxv] IRC Sec. 704.

[xxvi] NY Tax Law Sec. 631 and 632.

[xxvii] NY Tax Law Sec. 658(c)(4).

[xxviii] It should be noted that the liquidation of a partnership for tax purposes is not the same as its formal dissolution under state law. See, e.g., Reg. Sec. 1.332-2(c) which recognizes that the liquidation of an entity (a corporation, in that case) may be completed before its dissolution.

[xxix] IRC Sec. 731(a)(2) provides that a partner may recognize capital loss on a cash-only distribution in liquidation of their interest in the partnership. This loss is treated as loss from the sale or exchange of the partner’s interest in the partnership, which is generally treated as loss from the sale of a capital asset. IRC Sec. 741.

[xxx] NY Tax Law Sec. 631(a)(1) and Sec. 631(b)(1).

[xxxi] NY Tax Law Sec. 631(a)(1), Sec. 632(a)(1).

[xxxii] NY Tax Law Sec. 631(b)(1)(A).

[xxxiii] NY Tax Law Sec. 631(b)(1)(A)(1).

[xxxiv] Under NY Tax Law Sec. 631(b)(1)(A).

[xxxv] NY Tax Law Sec. 631(b)(1)(A).

[xxxvi] Petitioner also argued that, upon the sale of the building, Petitioner was considered “functionally liquidated” and dissolved when it transferred its net proceeds to an account maintained by Affiliate. Therefore, Petitioner claimed it should be treated as having liquidated on the date of sale and its limited partners should be treated as having sold their partnership interests on that date. The Department, however, expressed no opinion as to whether Petitioner was considered to be functionally liquidated on that date.

[xxxvii] Reg. Sec. 301.7701-4(d); Rev. Proc. 94-45.

[xxxviii] IRC Sec. 671.

Business is back . . . Sort of

As the country begins its hoped-for recovery from the disruptive economic effects of the COVID-19 virus – or, more accurately, from the measures implemented by government to contain the spread of the virus – some closely held businesses will emerge relatively unscathed while others will not survive, and some will be on life support for some time before their fate is settled while others will remain in business, albeit on a different scale than that at which they were operating before the economic shutdown.

For many businesses in this last group, the recent downturn may have represented the proverbial “wake-up call,” having exposed weaknesses in the business, especially the lack of cash reserves or other readily accessible sources of liquidity.[i] In some cases, the owners of the business will seek to redress these problems in order to ensure the business’s continued and, perhaps, more profitable existence. In others, the owners will decide that it is time to prepare the business for sale – whether as a “marriage of survival” or as an exit strategy – to a competitor, a private equity fund, or some other buyer.[ii]

Retention of Key Employees

In several of these scenarios, the successful turnaround of the business, or the preparation of the business for sale, will depend upon the continued employment and efforts of the business’s key service providers.

What’s more, it may be equally as important to ensure that these key people remain with the business after its sale. After all, in light of the havoc wreaked by the coronavirus shutdown upon the finances of so many businesses, it may be difficult for a buyer to determine an accurate purchase price for a target business based upon a typical “multiple of EBITDA”[iii] calculation. Instead, many buyers will likely insist upon making the payment of a significant portion of the purchase price contingent upon the target’s satisfaction of certain defined financial thresholds over some period of time– an “earnout.”[iv] What better way to increase a seller’s chances of hitting these earnout targets than by ensuring that the seller’s key employees remain with the business after its sale?

In either case – be it for purposes of a turnaround or a sale – the owners of the closely held business will have to consider how to retain and reward these key employees. This may present a more difficult challenge today than before the shutdown. Specifically, many owners who have just experienced severe cash flow problems may now be less willing to part with cash, and relatively more receptive to granting equity interests in the business to their key people. By the same token, these key employees may be more insistent upon having an actual ownership stake in the business, along with a say in its operation, not to mention an opportunity to realize the appreciation in the value of their equity[v] as capital gain – rather than as ordinary income[vi] – on the disposition of the business.[vii]

Equity Compensation

Although the issuance of equity by an employer-business to some of its top employees may seem like a relatively straightforward affair, there are actually many factors to consider before agreeing to such an issuance.

For example, how should the equity be valued; can the terms of the issuance, including transfer restrictions, influence the determination of value; should the employee pay for some portion of the equity; should the employee’s ownership be contingent upon their satisfaction of certain performance criteria; should their equity have voting rights; how will the employee pay any income tax liability arising from the receipt of equity?[viii]

The answers to these questions will help to determine the income tax consequences to the employee arising from their receipt of equity in the employer. In turn, these consequences will influence the employee’s negotiating position.

Before we consider a recent decision[ix] in which the taxpayers received equity in a corporation – ostensibly in exchange for their future services to the corporation[x] –let’s first briefly explore the applicable rules that determine the tax treatment of such a stock issuance. Both the employer and the key employee should be familiar with these rules if they hope to negotiate an equity-based compensation arrangement that makes economic sense for both of them.

Section 83

In general, under Section 83 of the Code, if a service recipient transfers equity in the service recipient to a service provider as compensation in exchange for their services, the service provider must include the fair market value of such equity in their gross income unless the service provider’s rights in such equity are not transferable and are subject to substantial risk of forfeiture; i.e., “restricted stock.”[xi]

Stated differently, the fair market value of the equity will be includible in the service-provider’s gross income at the time their rights in the equity become transferable or are no longer subject to substantial risk of forfeiture (i.e., when they vest), whichever occurs first.[xii] This amount, which may be greater than the fair market of the equity at the time it was issued to the service provider, will be treated as compensation, which is taxable as ordinary income.[xiii] The service provider’s holding period for the equity will begin with the inclusion of its value in their gross income;[xiv] their basis for the equity will be equal to its fair market value.

For purposes of this rule, an employee’s rights are “subject to substantial risk of forfeiture” if they are conditioned upon the employee’s future performance of substantial services, or upon the satisfaction of a condition related to a purpose of the transfer if the possibility of forfeiture is substantial.[xv]

Alternatively, a taxpayer whose rights to the equity are subject to a substantial risk of forfeiture may elect to include in their income for the year in which they receive the equity an amount equal to its fair market value.[xvi] If an employee makes such an election, they will not be required to include the value of the equity in their income when the equity subsequently vests in the hands of the employee. In other words, the election cuts off the compensatory element associated with the equity.[xvii] What’s more, the electing employee’s holding period in the equity will begin with the year it was received; this affords the employee a greater opportunity to recognize any appreciation in the value of the equity as capital gain.

For the year in which the employee is required to include in their gross income the value of the employer stock, the employer is allowed to claim a deduction for an amount equal to the amount included in the gross income of the employee.[xviii]

In the case of an employer that is an S corporation, any stock in the corporation “that is issued in connection with the performance of services . . . and that is substantially nonvested . . . is not treated as outstanding stock of the corporation” for tax purposes.[xix] As such, profits or losses of the S corporation-employer will not flow through to an employee-holder of non-vested stock, and is not required to be included in the holder’s gross income.[xx]

Now we can see how these rules were applied by the taxpayers in the decision discussed below.

The Structure

Taxpayers owned and operated of a group of corporations and limited liability companies (the “Businesses”). They decided to consolidate these separate entities into a single holding company (“Corp”), for which they elected S corporation status.[xxi] The goals of this restructuring were as follows: (1) to allow assets to be moved more efficiently between the Businesses; (2) to reduce the number of tax and financial filings the Businesses were required to make; and (3) to achieve “substantial tax benefits.”

To effectuate the contemplated reorganization, each Taxpayer transferred the entirety of his equity in the Businesses to Corp in exchange for shares of Corp common stock.[xxii]

Simultaneously with their receipt of the Corp stock, Taxpayers executed two collateral agreements, the Restricted Stock Agreement (“RSA”) and the Employment Agreement (“EA”). Taken together, these agreements provided that either Taxpayer would forfeit at least 50 percent of the value of his Corp stock if he voluntarily terminated his employment with Corp before the fifth anniversary of the EA.[xxiii] In other words, the agreements represented a substantial risk of forfeiture.

The ownership of Corp was further divided over the next few years. An ESOP[xxiv] was organized which purchased shares of Corp common stock; Taxpayers were among the beneficiaries of the ESOP. Each Taxpayer subsequently transferred some of their restricted shares of Corp stock to irrevocable grantor trusts[xxv] established for the benefit of their families. These shares remained subject to substantial risk of forfeiture under the RSA and EA.[xxvi]

The Scheme

Taxpayers hoped to utilize the foregoing structure and agreements to defer their Federal income tax on Corp’s profits.

Relying upon the principles described above, and in combination with the fact that the ESOP was a tax-exempt entity, Taxpayers sought to avoid reporting any income from Corp on their federal tax returns during the years at issue despite the fact that Corp was profitable during that period.

In short, Taxpayers took the position that their stock (and that owned by their grantor trusts) was subject to a “substantial risk of forfeiture” and was thus “substantially unvested.” Because the shares owned by Taxpayers and the trusts were not deemed to be outstanding, Corp allocated 100 percent of its income for the years at issue (the “First Period”) to the tax-exempt ESOP. Consistently with Corp’s reporting, neither Taxpayer reported any flow-through items from Corp on his tax return during the First Period. And because the ESOP was a tax-exempt entity, it likewise reported no taxable income from Corp for the First Period. In other words, no one paid any federal income tax on Corp’s profits.

Taxpayers subsequently undertook to restructure their business operations a second time, in order to attract greater outside investment, which they felt would be difficult while the business continued to operate as an S corporation.

To effectuate this restructuring, Taxpayers formed Holdings, an LLC in which they each held a 50 percent interest. Holdings purchased all of Corp’s operating assets in exchange for an interest-bearing promissory note and the assumption of various liabilities. Though Corp realized millions of dollars of capital gain on this sale, it allocated the entirety of that gain to the tax-exempt ESOP, which, according to Taxpayers, was still the only outstanding shareholder of Corp.

The following year, the restrictions imposed by the RSA and EA on Taxpayers’ Corp stock lapsed and their shares became fully vested, as did those held by the trusts. At that point, based on the rules described above, one would have expected Taxpayers to include the fair market value of the previously restricted stock in their gross income.

Taxpayers, however, entered into identical “surrender” and “subscription” agreements with Corp (the “Surrender Transactions”), pursuant to which Taxpayers purported to (1) return the entirety of their newly vested shares to Corp, and (2) simultaneously purchase an identical number of shares from Corp in exchange for a promissory note. On their tax returns for that year, Taxpayers reported a modest (compared to the value of the formerly restricted stock) amount of compensation income equal to the difference between the fair market value of the new Corp shares and the face amount of the note given to purchase the new shares.

During that same year, Corp redeemed the Corp shares owned by the ESOP, at which point Corp became entirely owned by Taxpayers and their trusts.

The IRS and the Tax Court

The IRS examined Taxpayers’ respective income tax returns for the First Period and for the year that their shares vested.

Following its examination, the IRS issued timely notices of deficiency in which it asserted that Taxpayers’ stock in Corp was substantially vested upon its original issuance to Taxpayers, such that Taxpayers were required to report their pro rata shares of Corp’s income for each succeeding year; and (2) even if the stock did not substantially vest until the RSA restrictions lapsed, Taxpayers should have reported the fair market value of that stock as taxable income in that year, notwithstanding their purported “surrender” of the shares.

Taxpayers disputed the IRS’s findings and sought redetermination in the Tax Court.[xxvii]

The Tax Court held that Taxpayers’ Corp stock remained subject to a substantial risk of forfeiture until the RSA restrictions lapsed. Because Taxpayers’ shares were not substantially vested during the First Period, they were not required to report Corp’s income on their individual returns during that period.

But the Tax Court agreed with the IRS that the fair market value of the restricted stock should have been treated as compensation income to Taxpayers at the time the stock became substantially vested. At that point, the Tax Court stated, each Taxpayer “received taxable compensation” and could not “unring this bell by subsequent actions with respect to the stock, whether that action consisted of sale to a third party or surrender to the corporation.”

Likewise, the Tax Court concluded that both the Surrender Transactions and the promissory notes delivered to Corp as part of those Transactions were “palpably lacking in economic substance” and should be disregarded in calculating their tax liability. According to the Tax Court, the Transactions were undertaken for no purpose other than avoiding tax liability, and had no reasonable possibility of generating an economic profit.

Taxpayers appealed the Tax Court’s decision to the Federal Court of Appeals.

The Fourth Circuit

Taxpayers argued that they were not required to report as compensation income the fair market value of the formerly restricted stock that they realized when their Corp shares vested. Although Taxpayers did not seriously contest this point, they maintained that the subsequent Surrender Transactions effectively negated or reversed their receipt of this compensation, such that they were not required to include it in their gross income.

The Court explained that it is a well-settled principle of tax law that compensation is included in the taxable income of the person who earned it, notwithstanding any assignment or transfer of that compensation to a third party. Thus, the Court continued, the mere fact that Taxpayers purported to return their vested shares back to Corp had no effect on their individual tax liability.


Taxpayers also argued that the Surrender Transactions effectuated a complete rescission of their contractual agreements with Corp, and because that rescission occurred in the same year as Taxpayers’ receipt of compensation income under those agreements, that income should be disregarded for Federal income tax purposes.

Again, the Court disagreed. The Surrender Transactions, it found, did not restore Taxpayers “to the relative positions that they would have occupied had no contract been made,” which is a fundamental requirement for application of the rescission doctrine.[xxviii] “Put simply,” the Court stated, “if you can’t restore, you can’t rescind.”

The contracts at issue were for personal services performed by Taxpayers on behalf of Corp. When a personal services contract has actually been performed, the Court observed, it is essentially impossible for the individual who rendered the services to be “returned” to their position as it was before the services.[xxix] What is more, as part of the underlying contracts, Taxpayers transferred the entirety of their interests in the Businesses to Corp, but they did not receive those assets back in the Surrender Transactions. As such, the Surrender Transactions were completely unlike the prototypical instance of rescission, in which all property that changes hands is returned to its original owner.

Taxpayers asserted that compensation is not taxable to an employee if returned to the employer in the year it was received. The Court found that those precedents were inapposite; they stand only for the limited proposition, it stated, that returned compensation may not be taxable income where “the original salary agreements . . . [were] subject to modification by the taxpayers and their employers and not absolute.” There was no indication, the Court added, that Taxpayers’ compensation agreements with Corp were open-ended in the sense contemplated by those cases, and, according to the Court, Taxpayers’ belated attempt to modify those agreements via the Surrender Transactions could not affect their tax liability.

In any event, even if the Surrender Transactions could somehow be seen as rescinding Taxpayers’ employment and compensation agreements with Corp, the Court agreed with the Tax Court’s conclusion that those transactions were totally devoid of economic substance and had to be disregarded for Federal income tax purposes.[xxx]

Equity-Based Compensation

The owners of closely held businesses have long recognized the importance of aligning the interests of their key employees with their own. The message underlying this principle is simple: if the owners do well, these employees will do well. It is one thing, however, to convey this message; it is something else to assure the recipients that the promised benefit will materialize.

There are many varieties of incentive compensation arrangement that may be implemented to reward a key employee for the exceptional performance of their duties.

In some cases, for example, the owners of the business may retain discretion over the selection of the key employees to be recognized, as well as over the amount of the compensation to be paid to them. In others, the employees to be paid are predetermined, while the amount of the compensation may be discretionary with the owners. In still other cases, the amount of the reward may be fixed in advance, but will be contingent upon the employee’s (or the business’s) having attained a performance target, the satisfaction of which is determinable by the owners in their discretion.

Then there are equity-flavored alternatives in which the amount of the compensation payable to the employee will be based upon changes in the value of the employer’s stock; for example, as compared to its value on the date of issuance.[xxxi]

In most situations, historically speaking, the foregoing rewards were settled in cash.

Query whether that will continue to be the case in the post-COVID[xxxii] world as to those businesses the owners of which have decided to prepare the business for sale or who have determined to turn the business around in a major way, but who need to incentive their key people to help them reach these goals?

In these instances, it may be sensible for an employer to offer their key employees some “skin in the game,” especially given what may turn out to be a continuing cash flow problem for the short-to-mid-term future, during which any available funds may have to reinvested in the business.

What’s more, it may be sensible for the employee to request some equity in the business, considering the value of the business[xxxiii] – and thus, the resulting tax hit from the receipt of such equity as compensation – has probably been reduced on account of the shutdown; in other words, it may be an opportune time for an employee to become an owner if there is a reasonable possibility of recapturing, and then realizing, much of the value of the business.

Assuming the issuance of equity is reasonable for both the employer and the employee, the employer may be able to negotiate some “substantial risk of forfeiture” conditions as an additional means of incentivizing the employee.[xxxiv]

[i] For example, a line of credit; perhaps a mechanism for a capital call among the owners of the business. That’s why the loans under the Paycheck Protection Program were so important to so many businesses.

Other weaknesses that have come to light include too large a workforce, the failure to discharge poorly performing employees, the continual expenditure of funds without concomitant economic return, the payment of personal expenses, etc.

[ii] How many business owners – and business advisers, for that matter – do you know who would get out of Dodge if they could do so in relative comfort and security?

[iii] Earnings before interest, taxes, depreciation and amortization. This “tool” provides a way for measuring the financial health of a company.

I recently came across a reference to “EBITDAC:” earnings before interest, taxes, depreciation, amortization and coronavirus. No kidding.

[iv] An earnout will be used where the buyer and the seller are unable to agree on the fair market value of the business (the purchase price). They will settle upon an agreed lowest value, with the earnouts – assuming the agreed-upon financial targets are attained – determining the upper reaches of the purchase price. The total gain arising from the sale of the business will be contingent upon the earnout payments; as these are received, the gain therefrom will be reported under the installment method. IRC Sec. 453.

[v] Attributable in no small part to their efforts.

[vi] An employee who is rewarded with a cash bonus upon the sale of the business will be taxed thereon at ordinary income tax rates; at the Federal level, the maximum rate is 37 percent. By contrast, the Federal capital gain rate is 20 percent. IRC Sec. 1.

[vii] I typically advise against the admission of an employee as an owner, except in extraordinary circumstances; compensate them with cash, I say, but don’t let them into the tent. (I think that’s an accepted idiom, right?) Once the employee is brought into the fold, they will have a number of rights as an owner as a matter of state law. Moreover, the original owner will owe certain fiduciary duties to the employee-shareholder. Even the Code bestows certain rights upon such individuals; for example, shareholders generally have the right to request copies of their corporation’s Federal income tax return. IRC Sec. 6103(e).

Where an employee “has to be” admitted as an owner, then the execution of a shareholders’ or operating agreement, as the case may be, will be important; for example, to restrict the transferability of shares, and to provide for the buyout of the employee-owner.

[viii] From the perspective of the employee, for example: will they have to guarantee the debts of the business; will they be subject to capital calls; if the business is formed as a pass-through entity (such as a partnership or S corporation) – the income of which is taxable to its owners whether or not distributed to them – how will the employee satisfy the tax on their share of the entity’s taxable income; if the stock or the assets of the business are sold, will the employee be required to make representations as to the business, and will they be liable for any breaches thereof; if their equity is subject to estate tax, how will their heirs pay for it given the equity’s illiquid nature?

[ix] Estate of Kechijian v. Commissioner, No. 18-2277 (4th Cir. 2020).

[x] As we’ll see, the taxpayers’ arrangement was structured solely for tax avoidance purposes.

[xi] The employer does not recognize gain on the issuance of its own stock as compensation. IRC Sec. 1032.

[xii] Vesting – i.e., the lapse of the risk of forfeiture – may occur at one time (“cliff vesting”; for example, after the completion of a specified number of years of service); or it may occur gradually over a number of years (for example, 20 percent per year over five years of service).

IRC Sec. 409A does not apply to amounts that are includible in income under Sec. 83. Reg. Sec. 1.409A-1(b)(6)(i).

[xiii] The employer must not lose sight of its income tax and employment tax withholding obligations.

[xiv] IRC Sec. 83(f); Reg. Sec. 1.83-4.

[xv] IRC Sec. 83(c); Reg. Sec. 1.83-3(c). For example, 7 years of continual service, or the satisfaction of predetermined performance goals the attainment of which is not a foregone conclusion.

[xvi] This is the so-called “Section 83(b) election.” The election must be made not later than 30 days after the equity is issued. Reg. Sec. 1.83-2.

[xvii] An election would make sense where the employee was reasonably confident that the value of the equity was certain to increase before vesting, and that the equity would not be forfeited. An employee who has to forfeit their equity is not allowed a deduction in respect of the forfeiture. IRC Sec. 83(b)(1).

[xviii] IRC Sec. 83(h).

[xix] Reg. Sec. 1.1361-1(b)(3).

[xx] Under IRC Sec. 1366, every shareholder of an S corporation is required to take into account their pro rata share of the corporation’s income for a taxable year for purposes of determining their income tax liability for such year.

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

[xxii] A tax-free exchange described in IRC Sec. 351.

[xxiii] This five-year period was ostensibly designed to incentivize Taxpayers to continue working for Corp.

[xxiv] An “employee stock ownership plan,” which is exempt from income tax. IRC Sec. 4975(e)(7).

The Small Business Job Protection Act of 1996 amended IRC Sec. 1361(b) to permit certain tax-exempt organizations to hold shares of S corporation stock. IRC Sec. 1361(c)(6).

[xxv] IRC Sec. 671. Each Taxpayer continued to be treated as the owner, for income tax purposes, of the shares held by their trust.

[xxvi] Thus, Taxpayers, their trusts, and the ESOP were the shareholders of Corp.

[xxvii] Tax Ct. Nos. 8967-10; 8966-10.


[xxix] Let’s face it, how does an employee rescind the services already provided?

[xxx] The economic substance doctrine permits the IRS to “ignore for tax purposes any transaction designed to create tax benefits rather than to serve a legitimate business purpose.” A two-prong test is employed to determine if a given transaction should be disregarded pursuant to the doctrine. “To treat a transaction as a sham, the court must find that the taxpayer was motivated by no business purposes other than obtaining tax benefits in entering the transaction, and that the transaction has no economic substance because no reasonable possibility of profit exists.” The first prong of the test is subjective, and the second is objective; nevertheless, while we examine both the subjective motivations of the taxpayer and the objective reasonableness of the investment, in both instances our inquiry is directed to the same question: whether the transaction contained economic substance aside from the tax consequences.”

Application of the foregoing principles to the instant case revealed that the Surrender Transactions were nothing more than a sham to avoid tax liability and were rightly disregarded.

Even Taxpayers acknowledged that the only reason they executed the Surrender Transactions was to enable Corp to avoid withholding and remitting approximately state and federal payroll and income taxes; i.e., the avoidance of tax obligations, both those of Corp and of Taxpayers. This was enough to satisfy the first prong of the economic substance test, which “requires a showing that the only purpose for entering into the transaction was the tax consequences.”

The second prong of the economic substance test was likewise met. It was inconceivable, the Court stated, that either Taxpayer “could envision a reasonable possibility of profit by surrendering, for no consideration, stock worth” millions. According to the Court, the fact that Taxpayers each gave Corp a promissory note as part of the Surrender Transactions only bolstered this conclusion, as “no rational person” would incur millions of indebtedness “to acquire stock that he already owned free and clear.”

[xxxi] Stock appreciation rights and phantom stock plans are examples of compensation arrangements that seek to mimic stock ownership. Because these types of plans usually provide for deferred compensation, they must comply with IRC Sec. 409A and the Regulations issued thereunder.

[xxxii] I use “post” tentatively as the number of cases in California, Texas, Florida, and elsewhere continue to rise.

[xxxiii] Non-lapse restrictions may also be used to further reduce the value. Reg. Sec. 1.83-5.

[xxxiv] In that case, the employee may want to consider an 83(b) election.

Bad Times

Of course, you’ve noticed that we’re in the midst of an economic mess. The nearly complete shutdown of large segments of the U.S. economy beginning in March, in response to the COVID-19 crisis, both accelerated and greatly aggravated the recession toward which we were already heading after almost ten years of steady growth.

The sudden elimination of so much economic activity, for what has turned out to be a relatively prolonged period,[i] has left us with many struggling businesses, other businesses that will never reopen, staggering unemployment numbers, a record reduction in consumer spending, the prospect of increased taxes,[ii] a bipolar stock market, and a general sense of unease and uncertainty.[iii]

Sounds awful, right? However, these conditions have created an environment that may be ideal for attorneys who practice in the area euphemistically known as “creditors’ rights,” which encompasses matters of insolvency, bankruptcy and debt collection, among other things.

One of the tools that is often utilized by a creditors’ rights attorney to facilitate the orderly disposition of a debtor’s assets and the satisfaction of its liabilities – especially for the benefit of general, unsecured creditors – is the liquidating trust.[iv]

In order to qualify as a liquidating trust,[v] a trust must be organized for the primary purpose of liquidating and distributing the assets transferred to it, and its activities must be reasonably necessary to, and consistent with, the accomplishment of that limited purpose.[vi]

Assuming a liquidating trust is respected as such, it is important to understand how and to whom the income and gains of the trust will be taxed, as one taxpayer-debtor recently learned to their detriment when they unilaterally established a trust in order to obtain a tax benefit.[vii]

The “Not-So-Great” Recession

Just before the Great Recession,[viii] Taxpayer owned Corp, an S corporation[ix] in the business of buying land and developing it into finished lots, which it then sold in the ordinary course of its business.[x]

Corp. owned three parcels of real property: Prop A, Prop B, and Prop C (the “Properties”). It borrowed significant amounts from the Banks. These loans were secured by the Properties.

Taxpayer’s real estate business was hit hard by the Great Recession. Taxpayer took a variety of actions to stay afloat, including cutting staff and overhead, renegotiating prices with subcontractors, slowing down construction and, in some cases, contributing more of their own money back into the business.[xi]

Taxpayer also negotiated with, and sought accommodations from, their lenders. Taxpayer entered into two forbearance agreements[xii] with the Banks, and had discussions with them about Taxpayer’s attempts to keep the business afloat.

The Liquidating Trust Transactions

When the Properties became worth significantly less than the liabilities they secured, Taxpayer decided to pursue a “liquidating trust strategy” for these parcels, but without consulting the Banks.

Corp organized three “Project LLCs” – one for each Property – each of which was disregarded for Federal tax purposes, with Corp as their sole member,[xiii] and transferred each of the Properties to the corresponding Project LLC for a stated consideration of zero.

On the same day, Taxpayer established three trusts (together, the “Trusts”) – one for each newly created and funded Project LLC – with a related company as the sole trustee. Corp transferred its membership interest in each of Project LLCs to the corresponding Trust. Corp did not receive any consideration for these transfers.

The trust agreements specified that the Trusts were intended to qualify as liquidating trusts for tax purposes, identified the Banks as the beneficiaries of the Trusts – though the Banks were not parties to the trust agreements and were not yet aware of their existence[xiv] – provided that the Trusts had been established for the sole purpose of liquidating the Properties for the benefit of the Banks, and stated that the Trusts had no objective or authority to pursue any trade or business activity beyond what was necessary to accomplish that purpose.

The trust instruments further specified that, for Federal tax purposes, the parties would treat the foregoing transfers as a transfer by Corp of the Project LLC membership interests to the Banks, immediately followed by a transfer of such interests by the Banks to the Trusts in exchange for the beneficial interests in the Trusts.

The end result of these transactions was that the Properties were held by the Trusts.

Consistent with these transactions, Corp. did not retain the Properties as assets on its books. However, Corp remained liable to the Banks and reported the remaining unsatisfied loan balances as liabilities on its financial reports. What’s more, Taxpayer continued to manage and market the Properties, and when the Properties were eventually sold,[xv] the net proceeds were distributed to the Banks, which in turn credited the distributed amounts against Corp’s outstanding indebtedness.[xvi]

Tax Returns and IRS Examination

On its tax return,[xvii] Corp reported ordinary business losses, stemming from its transfers of the Properties to the Trusts, in amounts equal to the difference between Corp’s adjusted tax basis in each property and its estimate of the fair market value of such property as of the transfer date. These losses were also reported on the Schedule K-1 that Corp issued to Taxpayer, and were included by Taxpayer on their individual income tax return.[xviii]

Taxpayer claimed a non-passive loss on their tax return, part of which was attributable to Corp’s “sale” of the Properties. These losses, in turn, gave rise to a net operating loss (“NOL”), which Taxpayer carried back to prior years, as well as forward to future years.[xix] The NOLs resulted in significant refunds, which Taxpayer used to pay off debts on various loans owed by his companies.

The IRS examined the tax returns filed by Taxpayer and Corp, and determined that the losses reported by Corp (and claimed by Taxpayer as the S corporation’s shareholder) with respect to the trust transactions should be disallowed.[xx] This disallowance significantly reduced the amount of Taxpayer’s allowable NOL.

The IRS issued notices of deficiency, and Taxpayer filed a timely petition in the U.S. Tax Court seeking a redetermination of the asserted deficiencies.

Net Operating Losses

The Code[xxi] permits a deduction for “any loss sustained during the taxable year and not compensated for by insurance or otherwise.” Such a loss “must be evidenced by closed and completed transactions, fixed by identifiable events, and . . . actually sustained during the taxable year”[xxii] in which it is claimed.

In most cases, a “closed and completed transaction” will occur upon a sale or other disposition of property.[xxiii]

Where the deductions allowed to a taxpayer for a given year exceed their gross income for that year, the taxpayer has an NOL.[xxiv] For the years at issue, the Code provided an NOL deduction for a given year equal to the aggregate of a taxpayer’s NOL carryovers and their NOL carrybacks to such year.[xxv]

Taxpayer asserted that Corp was entitled to a deduction because the transfers of the Properties to the Trusts for the benefit of the Banks were bona fide dispositions of property that generated actual losses.[xxvi]

Taxpayer’s argument hinged on the nature of the relationship between Corp and the respective liquidating trust, which implicated the Code’s “grantor trust” rules.[xxvii]

Characterization of the Trusts

In general, the Code provides that, where a grantor of a trust is treated as the owner of any portion of the trust, the grantor will include the trust’s items of income, gain, deduction, loss and credit in determining the grantor’s own income tax liability.[xxviii]

The grantor of a trust is treated as the owner of that trust[xxix] if certain conditions specified in the Code are met,[xxx] regardless of the existence of a bona fide nontax reason for creating the trust.[xxxi] These “grantor trust” provisions enunciate rules to be applied where, in described circumstances, a grantor has transferred property to a trust but has not parted with complete “dominion and control” over the property or over the income which it produces.[xxxii]

In the case of a liquidating trust, the most relevant of the grantor trust rules will consider a grantor the owner of any portion of the trust “whose income without the approval or consent of any adverse party is, or, in the discretion of the grantor or a nonadverse party,[xxxiii] or both, may be” distributed to the grantor.[xxxiv] According to the applicable regulation, this generally encompasses the portion of the trust “whose income is, or . . . , may be applied in discharge of a legal obligation of the grantor.”[xxxv]

Court’s Analysis

According to the Court, because ownership under the grantor trust regime results in the attribution of income directly to the deemed owner (i.e., the grantor), “the Code, in effect, disregards the trust entity.” Consequently, if a grantor is deemed an owner, the trust “is not treated as a separate taxable entity for Federal income tax purposes to the extent of the grantor’s retained interest.” Stated differently, when the grantor trust provisions apply, they function to “look through” the trust form, and ignore the “owned” portion of the trust for tax purposes as existing separately from the grantor.

Under the specific facts of this case, the Court continued, the grantor trust rules compelled the conclusions that Corp was the owner of the Properties during the years at issue, and that the Trusts were not separate taxable entities from Corp during those years. These conclusions, the Court stated, precluded the tax treatment sought by Taxpayer as Corp’s shareholder.

Corp as Grantor

As an initial matter, the Court stated that Corp was the grantor of the Trusts by virtue of its direct gratuitous transfer of ownership of the Project LLCs (which in turn held the Properties) to the Trusts.[xxxvi] As explained above, the grantor of a trust is treated as an owner where trust income is “applied in discharge of a legal obligation of the grantor.” Income, in this regard, includes the trust corpus.[xxxvii]

As the Court observed, the parties agreed that Corp remained liable to the Banks for the loans secured by the Properties after the ownership of the Properties had passed to the Trusts. When the Properties were sold, the proceeds were distributed to the Banks, which credited the amounts against Corp’s outstanding loans secured by the Properties.

Because the corpus of each trust was used to satisfy Corp’s – i.e., the grantor’s – legal obligations, the Court concluded that Corp was the owner of the Trusts; therefore, the Trusts were not separate taxable entities as to Corp.[xxxviii]

Accordingly, the transfers from Corp to the Trusts did not accomplish bona fide dispositions of the Properties evidenced by closed and completed transactions as necessary to support the losses reported by Corp and passed on to Taxpayer.

Indeed, the transfer from Corp to the trust, of which Corp was treated as the owner under the grantor trust rules, was disregarded for income tax purposes.[xxxix]

The Banks as Grantors?

The Court rejected Taxpayer’s position that the application of the grantor trust rules in this case required that the Banks be considered the owners of the Trusts. Taxpayer argued that this result was required by the nature of a liquidating trust. Taxpayer also contended that the Banks were the owners of the Trusts by virtue of their status as trust beneficiaries.

Taxpayer argued that the Banks had no legal obligation to apply any income realized from the Properties to satisfy Corp’s debt. This point was “of no moment,” the Court replied, given that the trust corpus was, in fact, used to pay these obligations. Even assuming arguendo that the Banks had such discretion, the Court explained that the Trusts nonetheless would constitute grantor trusts because they were trusts “whose income . . . , in the discretion of . . . a nonadverse party . . . may be applied in discharge of a legal obligation of the grantor.”[xl] The trust documents required the distribution of all net trust income and all net proceeds from the sale of trust assets to the Banks. Although trust beneficiaries are ordinarily considered adverse parties, the Court added that a party “can hardly be considered adverse regarding distributions for . . . [its] benefit”.[xli]

Implied Transfers?

Taxpayer asserted that the creation of the liquidating trusts here implicitly involved two steps: (1) the transfer of property from Corp to the Banks, and (2) the transfer of property from the Banks to the Trusts, of which the Banks were the beneficiaries.

According to Taxpayer, the first step – an in-kind transfer of property by a debtor to their creditor – was tantamount to a sale and, so, Corp should be able to recognize a loss in an amount equal to the difference between Corp’s aggregate adjusted bases in the Properties and their fair market values.[xlii]

Taxpayer argued that, “[g]enerally, liquidating trusts are taxed as grantor trusts with the creditors treated as the grantors and deemed owners” under the theory that “the debtor transferred its assets to the creditors in exchange for relief from its indebtedness to them, and that the creditors then transferred those assets to the trust for purposes of liquidation.”

Indeed, although not discussed by Taxpayer or the Court, the IRS has indicated, as a condition to its issuance of an advance ruling classifying a trust as a liquidating trust, that a transfer by a debtor to the trust for the benefit of creditors must be treated for all purposes of the Code as a transfer to creditors to the extent that the creditors are beneficiaries of the trust.[xliii]

This transfer, the IRS has stated, will be treated as a deemed transfer by the debtor to the beneficiary-creditors, followed by a deemed transfer by the beneficiary-creditors (as grantors) to the trust. In addition, the trust agreement must provide that the beneficiaries of the trust will be treated as the grantors and deemed owners of the trust, and that the trustee must file returns for the trust as a grantor trust.[xliv]

The foregoing would seem to support Taxpayer’s claim in the present case.

However, the Banks were not aware of Corp’s creation of the liquidating trusts; they did not agree to relieve Corp from its indebtedness in exchange for the Properties that were transferred to the liquidating trusts; and they did not view the liquidating trust transactions as having any practical effect.

The Court explained that Taxpayer’s unilateral transactions in which they placed the Properties in the Trusts without any involvement from the beneficiary-Banks did not support the implicit two-step structure proposed by Taxpayer. Moreover, the Court found that neither the Code nor the regulations supported such an implicit two-step structure under the facts presented.[xlv]

According to the Court, the grantor trust rules dictated that Corp be treated as the owner of the Trusts. Corp’s transfers of the Properties to the Trusts, therefore, did not produce the losses claimed by Taxpayer. With that, the Court sustained the asserted deficiencies.

Know Your Trust

The liquidating trust and grantor trust rules can be difficult to navigate, even for a tax professional if they don’t delve into them regularly.

That being said, it will behoove the creditor’s rights attorney, as well as any other professional who expects to be involved in debt-collection or similar matters arising from the current economic crisis, to familiarize themselves with the basic guidance provided by the IRS regarding the structure and operation of a liquidating trust.

The most important item to remember is that, in order for a liquidating trust to be respected as a trust for purposes of the Code, it must be formed with the objective of liquidating particular assets; its activities must be reasonably necessary to, and consistent with, the accomplishment of that purpose; in general, it cannot have as its purpose the carrying on of a profit-making business[xlvi] which normally would be conducted through a business entity classified as a corporation or partnership; the liquidation of the trust should not be unreasonably prolonged; the trust should not be permitted to receive or retain cash or cash equivalents in excess of a reasonable amount to meet claims and contingent liabilities (including disputed claims); the investment powers of the trustee, other than those reasonably necessary to maintain the value of the assets and to further the liquidating purpose of the trust, should be limited to the power to invest in liquid investments; the trust must be required to distribute at least annually to the beneficiaries (the creditors) its net income plus all net proceeds from the sale of assets, except that the trust may retain an amount reasonably necessary to meet claims and contingent liabilities (including disputed claims).

Of course, creditor’s rights attorneys should always remember to call their friendly neighborhood tax-adviser.[xlvii]

[i] It doesn’t help that many parts of the country are experiencing a resurgence of COVID-19 cases just as social-distancing measures are being relaxed, and businesses are starting to re-open.

[ii] Even without the very real possibility of the Democrats taking the White House and both houses of Congress in November, we’d be looking at increased Federal taxes – how else will we be able to pay for the CARES Act, which includes the Paycheck Protection Program, and other measures implemented by the government to combat the coronavirus and the economic consequences arising from our efforts to contain it? We’re talking about almost $6 trillion of Federal spending over just a few months – spending that no one could have expected to be necessary. Then there are the States that have lost billions of dollars in tax revenues that will need to be recovered in some manner; increased rates, new taxes, and more aggressive enforcement are already on the table in many jurisdictions.

[iii] “The threat is nearly invisible in ordinary ways. It is a crisis of confidence. It is a crisis that strikes at the very heart and soul and spirit of our national will. We can see this crisis in the growing doubt about the meaning of our own lives and in the loss of a unity of purpose for our nation.” President Carter, July 1979.

[iv] Liquidating trusts are not limited to situations involving debtors. For example, they have been used where it may be difficult to complete the liquidation of a corporate subsidiary into its corporate parent within the statutorily-prescribed three-year period for a tax-free liquidation – for instance, because the subsidiary owns a difficult to sell asset, or has a litigation claim that cannot be resolved within that time frame.

[v] Reg. Sec. 301.7701-4(d). Liquidating trusts are recognized as “trusts” for Federal tax purposes.

Rev. Proc. 94-45 provides the conditions under which the IRS will consider issuing advance rulings classifying certain trusts as liquidating trusts under Reg. Sec. 301.7701- 4(d).

[vi] It cannot have as its purpose the carrying on of a profit-making business. If the liquidation is unreasonably prolonged, or if the liquidation purpose becomes so obscured by business activities, that the declared purpose of liquidation can be said to have been lost or abandoned, the status of the “entity” will no longer be that of a liquidating trust.

[vii] SAGE v. Comm’r, 154 T.C. No. 12 (June 2020).

[viii] Figure, the 2007-2009 period.

[ix] IRC Sec. 1361.

[x] IRC Sec. 1221(a)(1); Sec. 1231(b)(1)(B). Thus, any gain realized on a sale represented ordinary income.

[xi] Basically, what we are seeing many businesses do today – though PPP loans may have deferred the day of reckoning for some organizations – and what we have seen businesses do in the past during difficult times.

[xii] Basically, an agreement between a lender and a delinquent borrower by which the lender agrees not to exercise its right to foreclose and the borrower agrees to a new payment plan.

[xiii] Reg. Sec. 301.7701-3.

[xiv] Taxpayer subsequently informed the Banks that the Trusts had been established for the benefit of the Banks.

[xv] With respect to Prop C, one of the Banks eventually issued a demand letter, which led to negotiations with Taxpayer. These culminated in an agreement under which Taxpayer caused the transfer of Prop C to this Bank by deed in lieu of foreclosure in exchange for settlement of the debt.

[xvi] In other words, the transfer of the Properties to the Trusts did not satisfy Corp’s indebtedness to the Banks.

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

[xviii] IRS Form 1040, U.S. Individual Income Tax Return, Sch. E, Part II. Pursuant to Section 1366 of the Code, Corp’s ordinary loss flowed through to Taxpayer, subject to the basis limitation rule of IRC Sec. 1366(d).

[xix] Immediately prior to the Tax Cuts and Jobs Act (P.L. 115-97), IRC Sec. 172(b)(1)(A) permitted a taxpayer to apply an NOL to other taxable years by first carrying back the NOL to the two taxable years preceding the year in which the NOL was generated and then by carrying over any unused portion of the NOL to the 20 years that follow.

In response to the events that triggered the Great Recession, for taxable years ending after December 31, 2007, and beginning before January 1, 2010, The Worker, Homeownership, and Business Assistance Act of 2009, P.L. 111-92, amended IRC Sec. 172(b)(1)(H)(i) to permit a taxpayer to elect to carry back a net operating loss for the 2009 tax year to three, four, or five years instead of the usual two years. IRC Sec. 172(b)(1)(H).

Of course, the TCJA eliminated the carryback of NOLs and allowed their “indefinite” carryforward, though limited the amount of loss that be claimed in a taxable year.

Earlier this year, the CARES Act (P.L. 116-136) responded to the current economic crisis by temporarily reinstating and expanding the NOL carryback that had been eliminated by the TCJA. Specifically, the Act allows a business that realizes an NOL during a taxable year beginning after December 31, 2017 and before January 1, 2021 to carry its NOL back to each of the five taxable years preceding the year of the loss.

[xx] The IRS originally disallowed the losses because they were “attributable solely to nonbusiness expenses” of Corp. At trial and in its briefs, however, the IRS asserted a new theory for the disallowance of Corp’s loss: namely, that the trust transactions were not “closed and completed transactions” capable of producing realizable losses for that year. Because this basis for disallowance was not raised in the notices of deficiency, and represented a “new matter,” the IRS had the burden of proof with respect to the deficiencies. Tax Court Rule 142.

[xxi][xxi] IRC Sec. 165(a).

[xxii] Reg. Sec. 1.165-1(b). “Only a bona fide loss is allowable.” In determining the deductibility of a loss, “[s]ubstance and not mere form shall govern.” These requirements call for a practical test, rather than a legal one, and turn on the particular facts of each case.

[xxiii] The year for which a taxpayer can claim a loss deduction evidenced by a closed and completed transaction is a question of fact.

[xxiv] As defined by IRC Sec. 172(c).

[xxv] IRC Sec. 172(a).

[xxvi] Reg. Sec. 1.1001-2.

[xxvii] IRC Sec. 671 through 679.

[xxviii] “. . . there shall then be included in computing [the grantor’s] . . . taxable income and credits . . . those items of income, deductions, and credits . . . of the trust which are attributable to that portion of the trust to the extent that such items would be taken into account . . . in computing taxable income or credits . . . of an individual.”

[xxix] Of its assets and income.

[xxx] IRC Sec. 673 through 679.

[xxxi] The term “grantor” includes any party that creates a trust or directly (or indirectly) makes a gratuitous transfer – that is, a transfer other than for fair market value – of property to the trust. Reg. Sec. 1.671-2(e)(1) and (2)(i). A partnership or a corporation making a gratuitous transfer to a trust for a business purpose of that partnership or corporation will also be a grantor of the trust. Reg. Sec. 1.671-2(e)(4).

[xxxii] Although several of the grantor trust rules are framed in terms of trust “income”, the regulations issued thereunder clarify that “it is ordinarily immaterial whether the income involved constitutes income or corpus for trust accounting purposes” in light of the general objectives of the grantor trust rules. Reg. Sec. 1.671-2(b).

[xxxiii] An “adverse party” is any person who has “a substantial beneficial interest in the trust which would be adversely affected by the exercise or nonexercise of the power which he possesses respecting the trust.” IRC Sec. 672(a). The term “nonadverse party” refers to any person that is not an “adverse party”. IRC Sec. 672(b). Adversity is a question of fact determined in each case by reference to the particular interest created by the trust instrument.

[xxxiv] IRC Sec. 677(a).

[xxxv] Reg. Sec. 1.677(a)-1(d).

[xxxvi] Reg. Sec. 1.671-2(e)(1).

[xxxvii] Reg. Sec. 1.671-2(b).

[xxxviii] Reg. Sec. 1.677(a)-1(d).

[xxxix] Rev. Rul. 85-13.

[xl] Reg. Sec. 1.677(a)-1(d).

[xli] Reg. Sec. 1.672(a)-1(b).

[xlii] Reg. Sec. 1.1001-2.

[xliii] Rev. Proc. 94-45, Section 3.

[xliv] Reg. Sec. 1.671-4(a).

[xlv] The Court added: “And we see nothing . . . to suggest that liquidating trusts qua liquidating trusts should be treated differently under the grantor trust rules absent the involvement of the beneficiaries.”

[xlvi] Any such activities must be reasonably necessary to, and consistent with, the liquidating purpose of the trust.

[xlvii] OK, so we’re not super heroes. We’re not even semi-heroes. We don’t wear leotards – count your blessings – or carry hammers or shields, or turn into monsters when agitated (not most of us, anyway). But “who ya gonna call” when faced with a grantor trust issue?

The Taxable Exchange

As a general rule, a taxpayer’s exchange of one property for another property is treated as a taxable event; the gain realized by the taxpayer – meaning the amount by which the fair market value of the property received by the taxpayer[i] exceeds the taxpayer’s adjusted basis (unrecovered investment) in the property they have given up – is treated as income.[ii]

For example, the gain realized by the taxpayer on the “conversion” of property into cash[iii] is included in the taxpayer’s gross income for purposes of determining their income tax liability.

Likewise, the gain realized on the taxpayer’s exchange of property for other property that differs materially in kind from the property relinquished by the taxpayer is treated as income.[iv]

The general principle reflected in the foregoing rules is that a taxpayer’s “readjustment” of what is essentially their continuing interest in a property should be excepted from the general gain recognition rule. This principle underlies many of the Code’s non-recognition provisions, including, for example, those dealing with corporate reorganizations,[v] certain contributions to business entities,[vi] certain modifications to debt instruments[vii] and, of course, like-kind exchanges.[viii]

The Like-Kind Exchange

Under Section 1031 of the Code, no gain or loss is recognized if property held for productive use in a trade or business or for investment is exchanged for property of a “like-kind” which is to be held for productive use in a trade or business or for investment. The unrecognized gain inherent in the relinquished property is preserved in the hands of the taxpayer by requiring the taxpayer to take the replacement property with an adjusted basis equal to that of the relinquished property.[ix]

However, if a taxpayer’s exchange of property would meet the requirements of Section 1031 but for the fact that the taxpayer receives not only like-kind property that would be permitted to be exchanged on a tax-deferred basis, but also other non-qualifying property[x] or money (“boot”), then the gain realized by the taxpayer will have to be recognized and included in their gross income in an amount up to the fair market value of such boot.[xi]


With the enactment of the Tax Cuts and Jobs Act,[xii] the application of the like-kind exchange rules was limited – beginning with exchanges completed after December 31, 2017 – to the exchange of real property that is not held primarily for sale.[xiii] In other words, the TCJA removed personal property and certain intangible property from eligibility for like-kind exchange treatment.[xiv]

According to the Conference Committee Report,[xv] Congress intended that “real property” eligible for like-kind exchange treatment prior to the TCJA would continue to be eligible for like-kind exchange treatment under the TCJA. In light of the IRS and the courts historically having allowed such treatment for many kinds of real property, this statement of legislative intent boded well for taxpayers.

For example, improved real property and unimproved real property are generally considered to be property of a like-kind – the fact that the real property is improved or unimproved is not material, for that fact relates only to the grade or quality of the property and not to its kind.[xvi] Unproductive real property held by a taxpayer for future appreciation is treated as being held for investment and not primarily for sale. A taxpayer may exchange city real property for a ranch or farm, or they may exchange real property held for use in a trade or business for real property that the taxpayer will hold for investment, or vice versa.

Proposed Regulations

Seems straightforward enough, right? After all, what we commonly think of as real property is by definition easily identifiable as such; of course, I am referring to land and buildings.

However, such a simplistic approach to the identification of real property would be ill-conceived, and even unfounded. In fact, many well-established, pre-TCJA authorities have gone well beyond such a restrictive interpretation. For example, the IRS has treated a leasehold interest in a fee with 30 years or more to run as real property, stating that a taxpayer may exchange such a leasehold interest for a fee interest in real property as part of a like-kind exchange.[xvii]

Unfortunately, there is no accepted statutory or regulatory definition of real property for purposes of the like-kind exchange rules. Moreover, there are many properties, or interests in property, that may not intuitively be viewed as real property but which have, under certain circumstances, been treated as such by either the IRS or the courts.[xviii]

According to the preamble to the proposed regulations, their purpose is to give taxpayers some certainty regarding whether property is “real property” for purposes of the revised like-kind exchange rules; taxpayers, the preamble continues, need certainty regarding whether any part of the replacement property received in an exchange is non-like-kind property the receipt of which would require the recognition of gain.

Real Property

“Certainty,” it seems, comes at a price: a set of nesting doll[xix] rules, with one definition embedded within, or building upon, another.

“Distinct Asset”

The predicate definition in the series of definitions developed by the proposed regulations is the term “distinct asset.”[xx] An item cannot be an improvement to land – i.e., it cannot be an “inherently permanent structure” or a “structural component” of an inherently permanent structure – and, therefore, cannot be treated as real property, unless it is a distinct asset.[xxi]

According to the proposed regulations, a distinct asset is analyzed separately from any other assets to which the asset relates to determine if the asset is real property, whether as land, an inherently permanent structure, or a structural component of an inherently permanent structure.

Buildings and other inherently permanent structures are distinct assets. The assets and systems listed below as a structural component are also treated as distinct assets.

The determination of whether a particular separately identifiable item of property is a distinct asset is based on all the facts and circumstances, including whether: (A) the item is customarily sold or acquired as a single unit rather than as a component part of a larger asset; (B) the item can be separated from a larger asset, and if so, the cost of separating the item from the larger asset; (C) the item is commonly viewed as serving a useful function  dependent of a larger asset of which it is a part; and (D) separating the item from a larger asset of which it is a part impairs the functionality of the larger asset.

“Real Property”

The proposed regulations start out easily enough, stating that real property includes land and improvements to land, unsevered natural products of land, and water and air space superjacent to land.[xxii]

Example. Taxpayer owns a marina comprised of U-shaped boat slips and end ties. The U-shaped boat slips are spaces on the water that are surrounded by a dock on three sides. The end ties are spaces on the water at the end of a slip or on a long, straight dock. Taxpayer rents the boat slips and end ties to boat owners. The boat slips and end ties are water space superjacent to land and thus are real property.


Improvements to land, in turn, include “inherently permanent structures” and the “structural components” of inherently permanent structures.[xxiii]

“Inherently Permanent Structure”

An inherently permanent structure means any building or other structure that is a “distinct asset” that is permanently affixed to real property, and that will ordinarily remain affixed for an indefinite period of time.[xxiv]


For this purpose, the proposed regulations define a “building” as any structure or edifice enclosing a space within its walls, and usually covered by a roof, the purpose of which is, for example, to provide shelter or housing, or to provide working, office, parking, display, or sales space. Thus, “buildings” include the following distinct assets if permanently affixed: houses, apartments, hotels, motels, enclosed stadiums and arenas, enclosed shopping malls, factory and office buildings, warehouses, barns, enclosed garages, enclosed transportation stations and terminals, and stores.[xxv]

“Other Structures”

The following assets are also treated as inherently permanent structures, if permanently affixed: in-ground swimming pools; roads; bridges; tunnels; paved parking areas, parking facilities, and other pavements; special foundations; stationary wharves and docks; fences; certain inherently permanent advertising displays; inherently permanent outdoor lighting facilities; railroad tracks and signals; telephone poles; power generation and transmission facilities; permanently installed telecommunications cables; microwave transmission, cell, broadcasting, and electric transmission towers; oil and gas pipelines; offshore drilling platforms, derricks, oil and gas storage tanks; grain storage bins and silos; and enclosed transportation stations and terminals.[xxvi]

If property is not included in the list of inherently permanent structures, the proposed regulations provide that the following factors that must be used to determine whether the property is an inherently permanent structure: (1) the manner in which the distinct asset is affixed to real property; (2) whether the distinct asset is designed to be removed or to remain in place; (3) the damage that removal of the distinct asset would cause to the item itself or to the real property to which it is affixed; (4) any circumstances that suggest the expected period of affixation is not indefinite; and (5) the time and expense required to move the distinct asset.[xxvii]

Example. Taxpayer owns an office building with a sculpture in its atrium. The sculpture is very large and very heavy. The building was designed to support the sculpture, which is permanently affixed to the building by supports embedded in the building’s foundation. The sculpture was constructed within the building. Removal would be costly and time consuming and would destroy the sculpture. The sculpture is reasonably expected to remain in the building indefinitely.

A sculpture is not identified as one of the inherently permanent structures enumerated in the regulations; thus, Taxpayer must use the above factors to determine whether the sculpture is an inherently permanent structure.

The sculpture: (A) is permanently affixed to the building; (B) is not designed to be removed but, rather, is designed to remain in place indefinitely; (C) would be damaged if removed, and would damage the building to which it is affixed; and (D) is expected to remain in the building indefinitely; and (E) would require significant time and expense to move. These factors support the conclusion that the sculpture is an inherently permanent structure and, thus, real property.

Example. Taxpayer owns bus shelters, each of which consists of four posts, a roof, and panels enclosing two or three sides. Taxpayer enters into a long-term lease with a local transit authority for use of the bus shelters. Each shelter is prefabricated from steel and is bolted to the sidewalk. Disassembling and moving a bus shelter takes less than a day and does not significantly damage either the bus shelter or the real property to which it was affixed. The bus shelters are not permanently affixed enclosed transportation stations or terminals, they are not buildings, nor are they listed as inherently permanent structures. Therefore, the bus shelters must be analyzed to determine whether they are inherently permanent structures using the above factors The bus shelters: (A) are not permanently affixed to the land or an inherently permanent structure; (B) are designed to be removed and not remain in place indefinitely; (C) would not be damaged if removed and would not damage the sidewalks to which they are affixed; (D) will not remain affixed indefinitely; and (E) would not require significant time and expense to move. These factors support the conclusion that the bus shelters are not inherently permanent structures and, thus, are not real property.

“Structural Components”

The term “structural component” means any distinct asset that is a constituent part of, and integrated into, an inherently permanent structure. If interconnected assets work together to serve an inherently permanent structure (for example, systems that provide a building with electricity, heat, or water), the assets are analyzed together as one distinct asset that may be a structural component. A structural component may qualify as real property only if the taxpayer holds its interest in the structural component together with a real property interest in the space in the inherently permanent structure served by the structural component.[xxviii]

Structural components include the following items, provided the item is a constituent part of, and integrated into, an inherently permanent structure: walls; partitions; doors; wiring; plumbing systems; central air conditioning and heating systems; pipes and ducts; elevators and escalators; floors; ceilings; permanent coverings of walls, floors, and ceilings; insulation; chimneys; fire suppression systems, including sprinkler systems and fire alarms; fire escapes; security systems; humidity control systems; and other similar property.[xxix]

Example. Taxpayer owns an office building that it leases to tenants. The building includes partitions owned by Taxpayer that are used to delineate space within the building. The office building has an interior, non-load-bearing, conventional drywall partition system. The system was installed during construction of the office building. The conventional system is comprised of fully integrated gypsum board partitions, studs, joint tape, and covering joint compound. It reaches from the floor to the ceiling. In addition, the system is a distinct asset within the meaning of the regulations.

Depending on the needs of a new tenant, the conventional system may remain in place when a tenant vacates the premises. The system is integrated into the office building and is designed and constructed to remain in areas not subject to reconfiguration or expansion. The conventional system can be removed only by demolition, and, once removed, neither the system nor its components can be reused. Removal of the system causes substantial damage to the system itself, but does not cause substantial damage to the building.

The conventional partition system is comprised of walls that are integrated into an inherently permanent structure and are listed as structural components in the regulations. Thus, the conventional partition system is real property.

If a component of a building or inherently permanent structure is a distinct asset and is not listed in the proposed regulations as a structural component, the determination of whether the component is a structural component will be based on the following factors: (1) the manner, time, and expense of installing and removing the component; (2) whether the component is designed to be moved; (3) the damage that removal of the component would cause to the item itself or to the inherently permanent structure to which it is affixed; and (4) whether the component is installed during construction of the inherently permanent structure.

Intangible Assets?

Having addressed the more conventional meaning of “real property,” the proposed regulations next consider instances in which intangible property may properly be treated as real property for purposes of the like-kind exchange rules.

An intangible asset may be treated as real property, or as an interest in real property, to the extent it derives its value from real property or an interest in real property, is inseparable from that real property or interest in real property, and does not produce or contribute to the production of income other than consideration for the use or occupancy of space.

For instance, a license, permit, or other similar right that is solely for the use, enjoyment, or occupation of land or an inherently permanent structure, and that is in the nature of a leasehold or easement, generally is an interest in real property.[xxx]

Example. Taxpayer receives a special use permit from the government to place a cell tower on Federal land that abuts a Federal highway. Government regulations provide that the permit is not a lease of the land, but is a permit to use the land for a cell tower. Under the permit, the government reserves the right to cancel the permit and compensate Taxpayer if the site is needed for a higher public purpose. The permit is in the nature of a leasehold that allows Taxpayer to place a cell tower in a specific location on government land. Therefore, the permit is an interest in real property.

However, the proposed regulations also provide that a license or permit to engage in or operate a business on real property is not real property or an interest in real property if the license or permit produces or contributes to the production of income other than consideration for the use and occupancy of space.[xxxi]

Personal Property

I know, “personal property?” you say. “What about the TCJA? Aren’t like-kind exchanges now limited to real properties?” Indeed, they are.

The proposed regulations, however, take a practical approach, recognizing there are times when a taxpayer’s acquisition of replacement real property as part of a like-kind exchange may necessarily include the acquisition of some personal property.

According to the proposed regulations, if such personal property is acquired incidentally to the acquisition of replacement real property in a deferred like-kind exchange,[xxxii] its acquisition will be disregarded for purposes of determining whether the taxpayer is in constructive receipt of the funds from the sale of the relinquished property, thereby causing the entire exchange to be taxable. In the absence of such a rule, it may be possible to argue that the use of the sale proceeds to acquire non-qualifying property violates the existing regulatory safe harbors by which a taxpayer in a deferred exchange may avoid claims of constructive receipt of money for purposes of the like-kind exchange rules.[xxxiii]

Under the proposed rules, personal property will be “incidental” to real property acquired in an exchange if, in standard commercial transactions, the personal property is typically transferred together with the real property, and the aggregate fair market value of such incidental personal property does not exceed 15 percent of the aggregate fair market value of the replacement real property.

For example, this may include the acquisition of office furniture where an office building is acquired as replacement property as part of a deferred like-kind exchange.[xxxiv]

First Impressions

These proposed regulations will apply to exchanges beginning on or after the date they are published as final regulations. Pending the issuance of final regulations, a taxpayer may rely on these proposed regulations – provided they are followed “consistently and in their entirety” – for exchanges of real property beginning after December 31, 2017, and before the final regulations are published.

Taxpayers and their advisers should welcome the guidance provided by the proposed regulations, as well as the opportunity for relying upon them immediately.

Most of the material presented in the proposed regulations would not be characterized as ground-breaking; nevertheless the regulations confirm the fact-intensive nature of the analysis that has to be undertaken in determining whether a particular property constitutes real property for purposes of the like-kind exchange rules.

In furtherance of this process, the proposed rules remove the uncertainty that may have surrounded the treatment of any of the inherently permanent structures and structural components specifically identified therein; equally important, they also provide a helpful set of general principles and factors for determining the treatment of any items not so described.

Of course, the IRS has requested comments on various parts of the proposed rules. It will behoove the taxpayer to stay attuned to these as they are released, and to review the final rules for any changes.


The “amount realized” by the taxpayer.

[ii] In other words, the amount that remains after the taxpayer’s remaining investment has been returned to them constitutes the realized gain. If the amount realized by the taxpayer is insufficient to restore to the taxpayer their adjusted basis for the property, the taxpayer has sustained a loss.

[iii] What we typically refer to as a “sale.”

[iv] Treas. Reg. Sec. 1.1001-1(a).

[v] IRC Sec. 368.

[vi] IRC Sec. 351 and Sec. 721.

[vii] Reg. Sec. 1.1001-3 (the “Cottage Savings” rules).

[viii] IRC Sec. 1031.

[ix] IRC Sec. 1031(d). Of course, this presumes a value-for-value exchange.

[x] Thus, the proper treatment of such “additional” replacement property as like-kind or not can make a huge difference in the amount of gain recognized by the exchanging taxpayer.

[xi] IRC Sec. 1031(b). The taxpayer’s basis for the replacement property would be increased by the amount of gain so recognized, and reduced by the amount of money received. IRC Sec. 1031(d).

[xii] P.L. 115-97. The “TCJA.”

[xiii] However, an exception is provided for any exchange if the property disposed of by the taxpayer in the exchange was disposed of on or before December 31, 2017, or the property received by the taxpayer in the exchange was received on or before such date.

[xiv] Many other classes of property were already excluded; for example, stocks, bonds, or notes; other securities or evidences of indebtedness; interests in a partnership; certificates of trust or beneficial interests; and choses in action.

[xv] Report 115-466, Sec. 13303. The Joint Committee report doesn’t add much. JCS-1-18.

[xvi] Reg. Sec. 1.1031(a)-1(b).

[xvii] Reg. Sec. 1.1031(a)-1(c).

[xviii] For example, shares in a mutual ditch, reservoir, or irrigation company (described in section 501(c)(12)(A)) if at the time of the exchange such shares have been recognized by the highest court or statute of the State in which the company is organized as constituting or representing real property or an interest in real property. The proposed regulations clarify that, with the exception of the foregoing items, local law definitions generally are not controlling in determining the meaning of the term “real property” for purposes of IRC Sec. 1031. Prop. Reg. Sec. 1.1031(a)-3(a)(1). The goal, of course, is to provide uniformity across state lines.

[xix] I prefer saying “Matryoshka” dolls, though there is nothing maternal or familial about these definitions.

[xx] Prop. Reg. Sec. 1.1031(a)-3(a)(4).

[xxi] See Prop. Reg. Sec. 1.1031(a)-3(a)(2)(ii)(A) and Sec. 1.1031(a)-3(a)(2)(iii)(A).

[xxii] Prop. Reg. Sec. 1.1031(a)-3(a)(1).

Yes, the context generally informs you of the meaning, but I looked up “superjacent” anyway. “Lying immediately above or upon something else.” Works for air rights; but water rights? Close enough, I suppose.

[xxiii] Prop. Reg. Sec. 1.1031(a)-3(a)(2)(i).

[xxiv] Prop. Reg. Sec. 1.1031(a)-3(a)(2)(ii)(A).

[xxv] Prop. Reg. Sec. 1.1031(a)-3(a)(2)(ii)(B).

[xxvi] Prop. Reg. 1.1031(a)-3(a)(2)(ii)(C).

The proposed regulations do not explain what it means for a structure to be “affixed,” but they do explain that affixation to real property may be accomplished by weight alone, meaning that something may be too heavy to move. For example, “Lou is affixed to his desk.”

This example is also helpful: Taxpayer owns a natural gas pipeline transmission system that provides a conduit to transport natural gas from unrelated third-party producers and gathering facilities to unrelated third-party distributors and end users. The pipeline transmission system is comprised of underground pipelines, isolation valves and vents, pressure control and relief valves, meters, and compressors. Each of these distinct assets was installed during construction of the pipeline transmission system and each was designed to remain permanently in place. The pipelines are permanently affixed and are listed as other inherently permanent structures in the regulations. Thus, the pipelines are real property.

[xxvii] Prop. Reg. Sec. 1.1031(a)-3(a)(2)(ii)(C).

[xxviii] Prop. Reg. Sec. 1.1031(a)-3(a)(2)(iii)(A).

[xxix] Prop. Reg. Sec. 1.1031(a)-3(a)(2)(iii)(B).

[xxx] Prop. Reg. Sec. 1.1031(a)-3(a)(5).

[xxxi] Prop. Reg. Sec. 1.1031(a)-3(a)(5)(ii).

[xxxii] IRC Sec. 1031(a)(3); Reg. Sec. 1.1031(k)-1.

[xxxiii] Prop. Reg. Sec. 1.1031(k)-1(g)(7)(iii). See Reg. Sec. 1.1031(k)-1(g)(6).

[xxxiv] We’ll assume for this purpose that the acquisition of the furniture is industry practice in this type of transaction.


About sixty years ago, New York revised its personal income tax law to achieve close conformity with the Federal system of income taxation. The stated purpose for the revision was to simplify tax return preparation, improve compliance and enforcement, and aid in the interpretation of tax law provisions.[i] In furtherance of this policy of conformity, as the Code is amended by Congress, New York automatically adopts the Federal changes.[ii]

However, New York’s Tax Law does not conform to the Code in all respects. Indeed, there are a number of instances in which New York has chosen not to conform to – where it has “decoupled” from – specific provisions or amendments of the Code.[iii]

Federal AGI

By far, the most significant example of New York’s conformity to the Code is found in the State’s computation of a New York taxpayer’s State income tax liability; this begins with the taxpayer’s Federal adjusted gross income,[iv] which is then modified by certain New York “additions” and subtractions”[v] – basically, items for which New York has decided a different tax treatment is appropriate for its own purposes.

In general, a taxpayer’s adjusted gross income is determined by reducing their gross income by certain deductions attributable to the taxpayer’s trade or business, deductions attributable to the production of rental income, and losses from the sale or exchange of certain property.[vi]

Of course, a taxpayer’s gross income includes gain realized on the sale or exchange of property,[vii] unless such gain is excluded by law.[viii]

For example, the Code provides that no gain is recognized by a taxpayer on the exchange of real property held by the taxpayer for use in a trade or business, or for investment, if such real property is exchanged solely for real property of like-kind which is to be held by the taxpayer either for productive use in a trade or business or for investment.[ix]

Because the gain realized from a like-kind exchange is excluded from the exchanging taxpayer’s Federal adjusted gross income, it is also excluded from the taxpayer’s New York adjusted gross income and, thus, is not considered in determining the taxpayer’s New York income tax liability.[x]

IRS Audit of Exchange

A corollary to the conformity principle requires that any changes to the taxpayer’s Federal income tax liability[xi] be accounted for in re-determining the taxpayer’s New York income tax liability.

For example, what happens if the IRS successfully challenges a taxpayer’s treatment of an exchange as a tax-deferred like-kind exchange?[xii] How will New York learn of the resulting increase in the taxpayer’s New York income tax liability?

According to New York’s Tax Law, if the amount of a taxpayer’s Federal taxable income is changed by the IRS, the taxpayer must report such change within ninety days after the “final determination” of such change, and must concede the accuracy of such determination.[xiii] If the taxpayer fails to comply with this reporting requirement, then the resulting New York income tax liability may be assessed at any time – the applicable statute of limitations on the assessment of a deficiency is tolled.[xiv]

Based on the foregoing, one might think that it would behoove New York to wait for the IRS to examine a taxpayer’s Federal income tax return, and then assess any resulting deficiency in New York income tax.

After all, most of the substantive tax issues presented in a New York income tax return arise under the Code – Federal tax law – as a result of New York’s application of the conformity principle, described above. In addition, the taxpayer is required to report any such deficiency to New York, failing which New York may assess the deficiency at any time the State learns of it.

Such an approach would also allow the State to allocate its limited resources to presumably more productive revenue-generating applications including, for example, the examination of uniquely New York income tax issues, such as questions of residency and the allocation of income within and without the State.

New York Audit of Exchange

Over the last few years, however, it appears that New York may have relaxed its “wait-and-see-what-the-IRS-finds” attitude. Rather than piggy-backing onto the IRS’s efforts, New York has been initiating the audit of taxpayers’ income tax returns and, in the process, has been examining the Federal tax issues presented in those returns with the goal of collecting more New York income taxes.[xv]

Indeed, this year alone I have become aware of several challenges by New York to the tax-deferred treatment of transactions which, according to the taxpayers, qualified – and were reported on both their Federal and New York income tax returns – as like-kind exchanges.[xvi]

A couple of these have included transactions with partnership overtones including, for example, so-called “drop-and-swap” transactions[xvii] which the taxpayers’ advisers assured them were routine and not likely to be challenged by the IRS.

Unfortunately for these taxpayers, it is New York that is examining their transactions, not the IRS – apparently, New York is unaware of the “routine” nature of such exchanges and, so, is putting the taxpayers through their paces.[xviii]

In any event, the taxpayers were unrealistic in believing that any exchange involving a tenancy-in-common (“TIC”) interest – whether as a relinquished property or as a replacement property – which necessarily implicates partnership-related issues, could be beyond the reach of the IRS’s interest,[xix] as a recent decision of the U.S. Tax Court made clear.[xx]

Deferred Exchange

Taxpayer sold a real property in New York City at a significant gain. In order to defer recognition of the gain realized on the sale, Taxpayer sought to structure the sale as part of a deferred like-kind exchange. Treating the property sold as the “relinquished property,” Taxpayer began a search for “replacement property” that would qualify for like-kind exchange treatment.[xxi]

Taxpayer deposited the proceeds from the sale of the relinquished property into a “qualified escrow account” with a qualified intermediary (“QI”), which acted as an escrow agent.[xxii]

TIC (?) Replacement Property

Taxpayer identified a possible replacement property (the “Property”), and then formed a limited liability company (the “LLC”), of which Taxpayer was the sole member, to acquire the Property. The LLC was treated as a disregarded entity for Federal income tax purposes; thus, Taxpayer would be treated as acquiring the replacement property.[xxiii]

Taxpayer executed a contract in which it purported to acquire a 12.5% interest in the Property. The contract listed the LLC as the purchaser. The contract described the asset acquired as an “undivided interest of 12.5% as a Tenant in Common” in the Property.

Attached as an exhibit to the purchase contract was a copy of a document captioned “Tenancy in Common Agreement.” This agreement was executed by the families that held interests in the apartment building at that time. The agreement recited the parties’ desire to form a venture to “maintain, manage and operate the Property” and to “lease the Property in its entirety to a person or entity.”

Shortly thereafter, the LLC entered into a second, substantially similar contract, with a second seller in which it purported to acquire another 12.5% interest in the Property. This contract recited that the LLC thereby acquired an “undivided 12.5% interest as a Tenant in Common.”

In accordance with the IRS’s deferred like-kind exchange regulations,[xxiv] the LLC then assigned to QI its rights under the two purchase contracts. This agreement described the asset to be acquired as a “25% tenancy-in-common interest” in the Property. Acting as escrow agent, QI completed the transaction by delivering proceeds to the sellers from Taxpayer’s “qualified escrow account.”

Tax Reporting

Taxpayer filed Form 1040, U.S. Individual Income Tax Return, to which it attached IRS Form 8824, Like-Kind Exchanges, on which Taxpayer stated they had engaged in a like-kind exchange and, among other things, described the replacement property.

However, Taxpayer’s reporting was not consistent with the reporting that the IRS received from Partnership, an “entity” that identified itself as a partnership for Federal income tax purposes.[xxv] Partnership’s returns reported that it owned the Property and that the LLC acquired a partnership interest in Partnership, as opposed to a direct ownership interest in the Property.

The Court explained how, for several years, including the one at issue, Partnership had filed returns on Form 1065, U.S. Return of Partnership Income. The returns stated that Partnership was engaged in a rental real estate business. According to the Court, it was originally formed as a family partnership and, over successive generations, interests were divided and subdivided among family members and their heirs.

Partnership’s return included an IRS Form 8825, Rental Real Estate Income and Expenses of a Partnership or an S Corporation, which identified the Property as Partnership’s sole rental property.

Partnership attached to its return a Schedule K-1 for each of the partners that owned an interest during the year at issue. These schedules showed that each of the two sellers, from whom the LLC acquired the replacement property, owned a 12.5% interest in Partnership at the beginning of that year and a 0% interest at the end. The LLC was shown as owning a 0% interest in Partnership at the beginning of the year, and a 25% interest at the end of the year. After selling the relinquished property, Taxpayer designated as the replacement property a purported 25% interest in the Property.

The Schedule K-1 that Partnership issued to the LLC reported that the LLC had contributed capital, had received distributions, and was allocated a share of Partnership’s net rental real estate income. Taxpayer acknowledged receipt of this Schedule K-1.

However, Taxpayer did not report their distributive share of Partnership income on their Form 1040, but nor did Taxpayer file with the IRS a Form 8082, Notice of Inconsistent Treatment or Administrative Adjustment Request, in order to highlight Taxpayer’s “omission” (inconsistent treatment) of Partnership’s K-1 items from Taxpayer’s return.[xxvi]

Failed 1031

The IRS examined Taxpayer’s return. By claiming like-kind exchange treatment on that return, Taxpayer treated the LLC as having acquired a direct ownership interest in the Property.

Based on the foregoing, however, the IRS determined that the replacement property acquired by the LLC – i.e., by Taxpayer – was, in fact, an interest in a partnership. Of course, like-kind exchange treatment does not apply “to any exchange of . . . interests in a partnership.”[xxvii] Thus, the IRS concluded that Taxpayer was taxable on the sale of the relinquished property, having failed to acquire qualified replacement property.

In response, Taxpayer argued there was no partnership. Taxpayer asserted that “it would have been impossible for . . . [them] to have any suspicion that certain other . . . [owners] had filed a partnership return.” This was certainly not the case. The Court observed that Taxpayer or their advisers presumably did due diligence before finalizing the decision to invest in the Property. Moreover, Partnership issued a Schedule K-1 to the LLC – with the information described above – and Taxpayer acknowledged that they received this document.

Having received a Schedule K-1 that Taxpayer evidently thought was incorrect, Taxpayer should have filed a Form 8082 with their tax return, notifying the IRS that they believed the Schedule K-1 to be erroneous and that they were adopting a position inconsistent with it. Taxpayer failed to do so. But even if they had, there seemed to have been enough facts to undermine any claim that Taxpayer did not acquire an interest in a partnership and, thus, failed to complete a like-kind exchange.

Looking Ahead[xxviii]

Inconsistent tax and information returns like those considered by the Tax Court, above, raise the proverbial red flag, and will be picked up by the IRS. So will accurate disclosures on a partnership tax return; for example, in response to the question on Line 12, Schedule B, of Form 1065: “. . . did the partnership distribute to any partner a tenancy-in-common or other undivided interest in partnership property?”

As a matter of applying the like-kind exchange rules, this information raises the question of whether the taxpayer disposed of or acquired, as the case may be, a partnership interest rather than a direct interest in real property.[xxix]

But what about New York?

Independent NY Exam

It is likely that New York has only just begun to delve into the substantive Federal income tax issues presented by its taxpayers’ returns – including the qualification of an exchange as a like-kind exchange – and that its efforts in this regard will be expanded.

A number of factors support this statement, not the least of which is the reduction in the IRS’s overall enforcement capabilities, which will reduce the number of opportunities for New York to benefit from the IRS’s examination efforts.

To this must be added the fiscal crisis in which New York finds itself following the government-ordered economic shutdown as part of the State’s efforts to contain the spread of the coronavirus. The revenue losses experienced by the State,[xxx] when coupled with the extraordinary expenses incurred in coping with the virus, have placed a premium on the generation of additional revenue.

Given these conditions, New York will seek to increase its tax collection efforts, including its audit activity of income tax returns and, in particular, the determination of whether taxpayers have correctly reported their Federal (and, thereby, their New York) adjusted gross income.

Real Property Exchanges in NY

Which brings us back to the like-kind exchange and partnerships. Is New York focusing on such transactions? Probably. Consider the number of situations in which these arise, whether you’re talking about a rental property in the Hamptons or a building in Manhattan.

One should also consider the significant amount of income tax that the State – not to mention the IRS – probably loses to such transactions. Is it any wonder that, throughout the Obama Administration, its annual budget proposals sought to eliminate the like-kind exchange, or to limit the amount of gain that may be deferred under such an exchange?[xxxi]

Although New York does not impose any special reporting requirements for like-kind exchanges, there are many other returns that may help the State to identify, and then examine, a purported like-kind exchange.

For one thing, both New York and New York City impose transfer taxes on the transfer of an interest in real property. These require the filing of returns on Form TP-584 and Form NYC-RPT.

In addition, partnerships must file Form IT-204, which asks whether the partnership (i) had an interest in New York real property during the last three years, (ii) engaged in a like-kind exchange, (iii) sold property that had a deferred gain from a previous like-kind exchange, (iv) made an in-kind distribution, and (v) was under audit by the IRS or was previously audited by the IRS.[xxxii]

Armed with the information provided by these returns, and driven by the need to raise tax revenues, we can expect that New York will become more familiar with like-kind exchanges that involve a partnership or its partners, more methodical in its examination of such transactions, and more aggressive in pursuing outstanding income tax liabilities.

[i] Thus, New York’s Tax Law provides that: “Any term used in this article shall have the same meaning as when used in a comparable context in the laws of the United States relating to Federal income taxes, unless a different meaning is clearly required but such meaning shall be subject to the exceptions or modifications prescribed in this article or by statute.” N.Y. Tax Law 607(a). Consistent with the foregoing, a taxpayer’s taxable year and accounting method for purposes of the Tax Law are the same as for Federal income tax purposes. N.Y. Tax Law Sec. 605.

[ii] So-called “rolling conformity.”

[iii] For example, New York elected not to conform to parts of the 2017 Tax Cuts and Jobs Act (P.L. 115-97; the “TCJA”), including the limitation on certain itemized deductions. By decoupling, N.Y. effectively became a “fixed date” conformity jurisdiction: it applies the Federal law as it was prior to the Federal changes.

[iv] IRC Sec. 62.

[v] Start with Tax Law Sec. 612(a), (b) and (c).

[vi] IRC Sec. 62(a). Yes, there are also a few other, very targeted items.

[vii] IRC Sec. 61; Reg. Sec. 1.61-6; IRC Sec. 1001.

[viii] It should be noted that many non-recognition rules apply automatically, provided their requirements are satisfied; in those cases, the taxpayer does not have the option of electing out of non-recognition.

For a discussion on inadvertently tax-free exchanges, see

[ix] IRC Sec. 1031. The TCJA limited the benefit of this provision to the like-kind exchange of real property. This change is generally applicable to exchanges completed after December 31, 2017.

[x] N.Y. Tax Law Sec. 612(a).

[xi] This may be attributable to the inclusion in the taxpayer’s gross income of a previously omitted item of income, or to the disallowance of a deduction previously claimed by the taxpayer.

[xii] For example, by establishing that the taxpayer did not hold the relinquished property for use in a trade or business or for investment.

[xiii] N.Y. Tax Law Sec. 659.

[xiv] N.Y. Tax Law Sec. 683(c)(1)(C). The regular three-year statute of limitations on assessment, which begins to run with the filing of the tax return, will not apply. Tax Law Sec. 683(a).

[xv] New York has displayed a similar approach with respect to the N.Y. estate tax, especially after decoupling from the Federal estate tax exemption amount.

[xvi] Please note that an exchange of N.Y. City real property that qualifies for “tax-free” treatment under the income tax will likely be subject to N.Y. real estate transfer tax (maximum rate of 0.65%) and N.Y. City real property transfer tax (maximum rate of 2.625%).


[xviii] Remember “The Hustler” episode from The Odd Couple? Oscar is playing a local pool shark, Sure-Shot Wilson, who also happens to be weight-challenged and is a chain-smoker.  For starters, Felix correctly states that “pool is the same as golf – you just put a ball in the hole.” In any case, with Oscar in danger of losing, Felix talks to Sure-Shot about his awful cough and the deadly effects of smoking four packs a day. Felix explains how his uncle, who died very young, was also a smoker. Sure-Shot becomes so distracted and concerned with his well-being that he loses the game to Oscar. When Oscar asks Felix what he said to Sure-Shot that so unnerved him, Felix replies that he told Sure-Shot about his uncle. “Your uncle?” Oscar says, not understanding the reference, to which Felix replies (and I paraphrase), “yes, my uncle [XYZ] who was killed by a bus while crossing the street.”

[xix] It’s old news now, but take a look at U.S. Return of Partnership Income, IRS Form 1065, Schedule B, Lines 11 and 12.

[xx] Gluck v. Commissioner, T.C. Memo 2020-66.

[xxi] See Reg. Sec. 1.1031(k)-1(a).

[xxii] Reg. Sec. 1.1031(k)-1(g).

[xxiii] Reg. Sec. 301.7701-3(a).

[xxiv] Reg. Sec. 1.1031(k)-1(g)(4)(v).

[xxv] IRC Sec. 761; Reg. Sec. 301.7701-3.

[xxvi] IRC Sec. 6222(c). Taxpayers are instructed to file Form 8082 if they “believe an item was not properly reported on the Schedule K-1 you received from the partnership.” Instructions for Form 8082.

[xxvii] IRC Sec. 1031(a)(2)(D).

[xxviii] I am assuming that IRC Sec. 1031 will remain in the Code. There are no assurances this will be the case. For one thing, the Obama administration’s last Green Book sought to limit the amount of capital gain deferred under IRC Sec. 1031 to $1 million (indexed for inflation) per taxpayer per taxable year. Then, in 2017, the Trump administration succeeded in limiting like-kind exchanges to real property.

Following the lost tax revenues resulting from the Covid-19 economic shutdown, and given the drain on the fisc resulting from like-kind exchanges, it should come as no surprise if Congress decides to completely eliminate IRC Sec. 1031.

Likewise, it should come as no surprise if N.Y. enacts a claw-back rule similar to California’s. If a taxpayer disposes of California real property and acquires replacement property outside California, the like-kind exchange will be respected, but the taxpayer must continue to report the deferred gain and, when the replacement property is ultimately sold, California will seek to collect its tax on such deferred gain.

[xxix] It also raises the issue of whether the taxpayer held the property for the requisite business or investment purpose prior to disposing of it, whether to a third party or as contribution to a partnership.

[xxx] For example, in terms of lost or deferred tax collections.


[xxxii] A nonresident who disposes of N.Y. real property as part of a like-kind exchange must disclose this information on Form IT-2663, Nonresident Real Property Estimated Income Tax Payment Form.

Go Figure

As of last Wednesday night, the SBA’s website reported that almost 4.5 million businesses had borrowed more than $510 billion under the Paycheck Protection Program.[i] Many businesses are wondering whether they will survive through the gradual reopening of the economy.[ii]

Earlier that same day, the U.S. surpassed 100,000 coronavirus deaths.

Last Thursday, the Labor Department reported that more than 40 million people – approximately one in every four American workers – had filed for unemployment since mid-March; one day later, the Commerce Department released data indicating that April had witnessed the largest monthly drop in consumer spending since the government began keeping such records – in case you’re wondering, consumer spending generally accounts for more than two-thirds of the economic activity in the country.

By the end of the day last Friday, the S&P had registered a more than 4 percent gain for the month of May;[iii] when added to April’s 12.7 percent gain, the stock market has done remarkably well – in fact, it has increased by 36 percent since its lows of late March.

If you’re having difficulty reconciling these facts, you’re not alone.[iv]

Then there are those for whom Covid-19, the lockdown, and the poor state of the economy have barely registered.

I was reminded of this last week when one of our attorneys asked me about the U.S. Tax Court’s 2017 Lender Management decision.[v]

“Why the interest?” I asked. Wah, wah, wah.[vi] “A family investment vehicle? Tell me some more. How large . . .” Wah, wah, wah. “What? And who will be managing this fund?” Wah, wah, wah. “Ah, they’re worried about being able to deduct their expenses.” Wah, wah, wah. “Please send me the agreement. I’ll take a look at the compensation provision.”[vii]

Why does it Matter?

The Code allows a taxpayer to claim as a deduction all of the ordinary and necessary expenses paid or incurred by the taxpayer during the taxable year in carrying on a trade or business.[viii] For example, a taxpayer may deduct “a reasonable allowance for salaries or other compensation for personal services actually rendered.”[ix] In general, such expenses are deducted in full from the taxpayer’s gross income[x] for purposes of determining their income tax liability for that year.[xi]

Prior to 2018, individuals could also claim itemized deductions for certain so-called “miscellaneous expenses,” including expenses paid or incurred by an individual during the taxable year in connection with an activity engaged in “for the production or collection of income.”[xii] Such expenses have to be “ordinary and necessary, meaning they must be reasonable in amount and must bear a reasonable and proximate relation to the production or collection of taxable income, or to the management, conservation, or maintenance of property held for the production of income.[xiii]

Thus, for example, services of investment counsel, clerical help, office rent, and similar expenses paid or incurred by a taxpayer in connection with investments held by the taxpayer are deductible only if (1) they are paid or incurred by the taxpayer for the production or collection of income or for the management, conservation, or maintenance of investments held by him for the production of income; and (2) they are ordinary and necessary under all the circumstances, having regard to the type of investment and to the relation of the taxpayer to such investment.[xiv]

However, certain limitations apply to the deduction of such non-trade-or-business, investment-related, expenses that do not apply to deductions for trade or business expenses. Specifically, these investment expenses are not deductible unless – together with other miscellaneous itemized deductions – they exceed two percent of the taxpayer’s adjusted gross income, in which case the excess is deductible as an itemized deduction.[xv]

Then, in late 2017, the TCJA suspended all miscellaneous itemized deductions that are subject to this two-percent floor, thereby denying taxpayers the ability to claim investment-related expenses as itemized deductions for taxable years beginning after December 31, 2017 and ending before January 1, 2026.[xvi]

In light of the foregoing, it would behoove the owners of an income-producing activity if their activity were treated as a trade or business for tax purposes, rather than as an investment activity engaged in for the production or collection of income.

The problem, of course, is that the Code does not define the term “trade or business,” and the courts have not always been consistent in their determinations of the trade or business status of an activity.[xvii]

With this background, we can now turn Lender Management.[xviii]

Basic Facts

Management LLC operated as a fund manager, and was treated as a partnership for Federal income tax purposes. At all relevant times, Management was owned by two members of the Family, one of whom owned a 99 percent interest and also served as its managing member (“Manager”) and CIO[xix].

Management provided direct management services to three Investment LLCs, each of which was treated as a partnership for Federal income tax purposes. Management directed the investment and management of assets held by the Investment LLCs for the benefit of their owners. The ultimate owners with respect to the Investment LLCs were members of the Family.

The Investment LLCs were created to accommodate greater diversification of the managed investments and more flexible asset allocation at the individual investor level. Each was formed for the purpose of holding investments in a different class of assets: private equities, hedge funds, and public equities; of these, private equities represented the largest investment.

Management’s operating agreement permitted it, without limitation, to engage in the business of managing the “Family Office” and to provide management services to Family members, related entities, and “third-party nonfamily members.” The operating agreements for the Investment LLCs designated Management as the sole manager for each entity. Thus, Management held the exclusive rights to direct the business and affairs of the Investment LLCs.

Management also managed downstream entities in which the Investment LLCs held a controlling interest. Investors in some of these downstream entities included persons who were not members of the Family. Management received not insignificant fees from these entities in exchange for managing them.

Family members understood that they could withdraw their investments in the Investment LLCs, subject to liquidity constraints, if they became dissatisfied with how the investments were being managed.

Management’s Activities

Management made investment decisions and executed transactions on behalf of the Investment LLCs, and viewed the members of the Investment LLCs as its clients. Its main objective was to earn the highest possible return on assets under management, and it provided individual investors in the Investment LLCs with one-on-one investment advisory and financial planning services.

Manager served as Management’s CIO. Management also employed five employees on a full-time basis during each of the tax years in issue.

As CIO, Manager retained the ultimate authority to make all investment decisions on behalf of Management and the Investment LLCs. Most of CIO’s time was dedicated to researching and pursuing new investment opportunities and monitoring and managing existing positions.

Management arranged annual business meetings, which were for all clients in the Investment LLCs. These group meetings were held so that Management could review face-to-face with all of its clients the performance of their investments at least once per year. Manager would conduct additional face-to-face meetings with clients who were more interested in the status of their financial investments at times and locations that were convenient for them.

Manager interacted directly with Management’s clients, collecting information from and working with these individuals, and developing computer models to understand their cash flow needs and their risk tolerances for investment, and engaging in asset allocation based on these and other factors. Management devised and implemented special ventures known as “eligible investment options,” which allowed clients to participate in investments more directly suited to their age and risk tolerance.

Management also had a CFO who was not related to the Family. CFO worked very closely with CIO-Manager every day, attending meetings for investments, assisting CIO in reviewing and making decisions about new investment opportunities, overseeing daily cash management, monitoring the status of current investments, communicating with individual clients and forecasting their cash needs, securing necessary capital call funds from revolving lines of credit, and providing updated financial information to creditors at least monthly.

Management also retained an unrelated organization to consult with CFO, to provide both accounting and investment advisory services to Management, to prepare annual partnership tax returns and quarterly financial reports for the Investment LLCs, and to collaborate with CIO in selecting new investments for the Investment LLCs.


Management received a profits interest in each of the Investment LLCs in exchange for the services it provided to the Investment LLCs and their members. These profits interests were designated “Class A” interests under the operating agreements for the Investment LLCs. As such, they represented an allocation of future income and appreciation.[xx]

Management received income from the Class A interests only to the extent that the Investment LLCs generated profits. This arrangement was intended to align Management’s goal of maximizing profits with that of its clients and to create an incentive for Management and its employees to perform successfully as managers of the invested portfolios.

Any payments that Management earned from its profits interests were paid separately from the payments that it otherwise received as a minority member of each of the Investment LLCs.

Management paid Manager a guaranteed payment in exchange for their services.[xxi] Manager also indirectly owned – through trusts and other LLCs – minority interests in the Investment LLCs.

Tax Returns

Management reported ordinary business losses for the tax years in issue, claiming deductions for business expenses, including salaries and wages, repairs and maintenance, rent, taxes and licenses, depreciation, retirement plans, employee benefit programs, guaranteed payments to partners, and other deductions.

The IRS disallowed the deductions that Management claimed as business expenses, but allowed them as investment-related expenses, subject to the limitations thereon. The IRS argued that Management was not engaged in carrying on a trade or business, and that its primary activity was “managing the Family fortune for members of the Family by members of the Family.”

Management petitioned the Tax Court, contending that its activities constituted the active trade or business of providing investment management and financial planning services to others.[xxii]

Court’s Opinion

According to the Court, deciding whether the activities of a taxpayer constitute a trade or business requires an examination of the facts in each case.

To be engaged in a trade or business, the Court stated, a taxpayer must be involved in the activity with continuity and regularity, and the taxpayer’s primary purpose for engaging in the activity must be for income or profit.[xxiii]

Certain activities, however, are not considered trades or businesses. For example, an investor is not, by virtue of their activities undertaken to manage and monitor their own investments, engaged in a trade or business.[xxiv] Expenses incurred by the taxpayer in performing investment-related activities for their own account generally may not be deducted as expenses incurred in carrying on a trade or business. These investment activities may produce income or profit, but such profit, the Court stated, is not evidence that the taxpayer is engaged in a trade or business. Instead, any profit so derived arises from the conduct of the trade or business venture in which the taxpayer has taken a stake (an investment), rather than from the taxpayer’s own business activities.

Compensation is Key

The Court then explained that a common factor distinguishing the conduct of a trade or business from a mere investment is the receipt by the taxpayer of compensation, other than the normal investor’s return; in other words, income received by the taxpayer directly for their services, rather than indirectly through the “corporate” enterprise. If the taxpayer receives not just a return on their own investment, but compensation attributable to the services they have provided to others, then that fact tends to show they are engaged in a trade or business.

Trade-or-business designation, the Court added, may apply even though the taxpayer invests their own funds alongside those that they manage for others, provided the facts otherwise support the conclusion that the taxpayer is actively engaged in providing services to others and is not just a passive investor.

The Court observed that an activity that would otherwise be a business does not necessarily lose that status because it includes an investment function. Work that includes the investment of others’ funds may qualify as a trade or business. Thus, “[s]elling one’s investment expertise to others is as much a business as selling one’s legal expertise or medical expertise.” Investment advisory, financial planning, and other asset management services provided to others may constitute a trade or business.

The Court then described how Management provided investment advisory and financial planning services for the Investment LLCs and their individual owners; it explained that, through their operating agreements, Management had the exclusive right – through its CIO, CFO and employees, all of whom worked full-time – to direct the business and affairs of the Investment LLCs.

These services, according to the Court, were comparable to the services that hedge fund managers provide. Management had a responsibility, the Court continued, to provide its clients with sound investments that were tailored to their financial needs. Thus, Management’s activities went far beyond those of an investor.

The Court then turned to Management’s compensation arrangement. Management was entitled to profits interests as compensation for its services to its clients to the extent that it successfully managed its clients’ investments.

Management and Manager held minority interests in the Investment LLCs. Management was also entitled to a profits interests as compensation for its services as the Investment LLCs’ manager. These profits interests were the primary incentive for Management to work to maximize the Investment LLCs’ success. Management received payment for its services only if the Investment LLCs earned net profits – it received no other fees. The absence of such other fees motivated Management to increase the net values of the Investment LLCs.

To the extent that the Investment LLCs did well, their operating agreements provided that Management could receive compensation separate from, and in addition to, the normal investor’s return that it received for its membership interests, and these profit interests provided substantial incentive to deliver high-quality management services. The contingent nature of the profits interests did not negate their being compensation for services.[xxv]

Based on the foregoing, the Court concluded that Management was in the trade or business of providing investment management services to and for the benefit of its clients. Most of the assets under management were owned by members of the Family who had no ownership interest in Management. Management managed investments, had an obligation to its clients, and tailored its investment strategy, allocated assets, and performed other related financial services specifically to meet the needs of such clients.[xxvi]

What Does It Mean?

Following the Court’s decision in Lender Management, there was a lot of discussion about how it provided a model for very affluent families to establish their own, or “captive,” management firm to oversee the investment and maintenance of their wealth.

Easier said than done, at least if the goal is to treat such an organization and its activities as a trade or business, the expenses of which may be fully deductible for tax purposes.

For one thing, the Lender family appears to be quite large, with several branches and generations; they are geographically widespread and, in many instances, are strangers to one another. In a sense, the “family” looks like a segment of that portion of the public that requires investment management services.

What if the family in issue represents only a relatively small number of individuals? For example, the founder of a successful business that has just been sold, along with their spouse and children? Would the activities of a captive investment management entity for such a small number of family members constitute an investment activity rather than a trade or business, especially where it is likely that most of the family will own an interest in the entity? Unlikely.

Might such a management entity grow into trade or business status over time – assuming the family wealth is preserved and grown – as the family matures, children get married and re-married, their children do the same, etc., and only a small portion of the family is involved in the management function? Perhaps.

Assuming the management entity otherwise qualifies as a trade or business, the Lender Management case seems to have blessed the issuance to the management entity of a profits interest in an investment partnership or limited liability company as compensation for the management services rendered to such investment entity without jeopardizing its trade or business[xxvii] status. Moreover, the issuance of such an interest is generally not taxable to the recipient.

As indicated earlier, however, if this profits interest lacks entrepreneurial risk, or if its status as an equity interest in a partnership is otherwise questionable,[xxviii] there is a possibility that the allocations and distributions to the management entity may, instead, be treated as taxable compensation. If the IRS does not respect the management entity’s activities as a trade or business, the management entity may find itself in a very difficult spot, indeed: taxable compensation and no deduction for its expenses.

Of course, there are varying degrees of difficulty, and given the economic and political directions in which we seem to be travelling, it seems to me, at least, that the same folks who may be concerned about family offices and the like, would be better served if they focused, instead, on reducing their exposure to increased estate and income taxes.

[i] Title I of the CARES Act, P.L. 116-136.

[ii] Even as many health professionals worry that we’re reopening too soon.

[iii] Notwithstanding what, at that point, had been three nights of public outrage following the events in Minnesota on Monday.

[iv] OK. One is strictly historical – it reports what has already happened. The other is forward-looking – it’s betting (that’s the operative word) on what’s going to happen in light of what has already happened; a nod to social science. That’s my simplistic and forced construction.

[v] Lender Management, LLC v. Comm’r, T.C. Memo 2017-246.

[vi] Remember the “voices” of the adults in the old Charlie Brown cartoons?

[vii] The breadth and variety of one’s client base can be in constant flux. In my case, it consists of closely held businesses and their owners. If a successful business is sold – few of them are transitioned to the founders’ children – the next generation’s investment and stewardship of the wealth will determine whether the founder’s family will live comfortably for several generations to come, or be haunted by having lost a good thing.

[viii] IRC Sec. 162.

A taxpayer’s taxable income is computed on the basis of the taxpayer’s taxable year, which is the same as their annual accounting period; this, in turn, is defined as the annual period on the basis of which the taxpayer regularly computes their income in keeping their books. IRC Sec. 441. A taxpayer’s taxable income is computed under the method of accounting on the basis of which the taxpayer regularly computes their income in keeping their books. IRC Sec. 446.

[ix] IRC Sec. 162(a)(1).

[x] After they have run the gamut of the basis, at-risk, passive loss, and excess business loss rules, to the extent applicable. IRC 704(d)/1366(d), Sec. 465, 469, and 461(l), respectively.

[xi] What’s more, net operating losses may carry over from the year in which they were incurred to another year only if the losses were the result of operating a trade or business within the meaning of IRC Sec. 162. See IRC Sec. 172(d). Over the years, Congress has alternately imposed and relaxed certain limits on the use of such losses. The most recent “exchange” was between the Tax Cuts and Jobs Act, P.L. 115-97, and the CARES Act, with the latter temporarily suspending the changes made by the former.

[xii] IRC Sec. 212(1). Reg. Sec. 1.212-1 refers to expenses paid or incurred for the management, conservation, or maintenance of property held for the production of income.

[xiii] Reg. Sec. 1.212-1(d).

[xiv] Reg. Sec. 1.212-1(g).

[xv] IRC Sec. 67(a).

[xvi] Anyone’s guess whether this, and so many other “temporary” provisions, will survive to their scheduled expiration dates. We’re struggling to get out of this economic downturn, and the November elections are around the corner.

[xvii] The TCJA certainly brought a new urgency to defining the term; for example, for purposes of IRC Sec. 199A.

[xviii] For those of you who aren’t familiar with the decision, “Lender” refers to the family that founded Lender’s Bagels (the “Family”). I don’t know about you, but for me, growing up as a first generation American in the Bronx, a Lender Bagel defined what a bagel was – especially toasted, with “Phili” cream cheese and orange marmalade. (Excuse me. I need a moment, please.)

[xix] Chief Investment Officer.

[xx] What happens if the profits interests are not respected as partnership interests? For example, what if there is no entrepreneurial risk associated with the related allocation? See Rev. Proc. 93-27 and Rev. Proc. 2001-43; IRC Sec. 1061, enacted by the TCJA; and the proposed regulations REG-115452-14.

[xxi] Within the meaning of IRC Sec. 707(c).

[xxii] Management also contended that Management and the Investment LLCs should be respected as separate business entities distinct from their owners and that these entities engaged with one another at arm’s length.

[xxiii] A sporadic activity or a hobby does not qualify.

[xxiv] An exception to the general rule applies when the taxpayer is also an active trader of securities.

[xxv] Manager’s position compensated him for the services that he provided to Management; it was his only full-time job and he was highly motivated to see Management receive the benefit of the Class A interests.

[xxvi] The IRS asserted that the family relationship between the Manager of Management and the owners of the Investment LLCs supported its contention that Management’s activities consisted solely of making investments on its own behalf. It contended that managing investments for oneself and for members of one’s family was not within the meaning of a trade or business. The Court accepted that, in general, transactions within a family group are subjected to heightened scrutiny. Where a payment is made in the context of a family relationship, the Court will carefully scrutinize the facts to determine whether there was a bona fide business relationship and whether the payment was not made because of the familial relationship.

The Court found that Management satisfied a review under heightened scrutiny. The end-level investors in the investment LLCs were all members of the Family. However, at all relevant times, only two members of the Family were owners of Management.

What’s more, Management’s clients did not act collectively or with a single mindset. They were geographically dispersed, many did not know each other, and some were in conflict with others. Their needs as investors did not necessarily coincide. Management did not simply make investments on behalf of the Family group. It provided investment advisory services and managed investments for each of its clients individually, regardless of the clients’ relationship to each other or to the Manager.

The profits interests were provided to Management in exchange for services and not because the Manager was part of the Family.

[xxvii] As opposed to investment activity.

[xxviii] For example, under the disguised sale rules of IRC Sec. 707 and the regulations issued thereunder.

Uptick in Business Divorces?

I’ve read a number of articles over the last few weeks in which marriage counselors have been predicting a wave of divorce filings once the COVID-19 quarantine has been lifted.[i]

That may be – we’ll just have to wait and see.[ii] Query, however, whether “business divorces” will follow suit?

The quarantine and the resulting economic downturn have likely created, highlighted, or aggravated stress points among the owners of many businesses. Disagreements over steps already taken by the business in response to the downturn, or differing opinions on the direction in which to steer the business once it emerges from quarantine,[iii] will probably cause a number of business owners to go their separate ways.

Of course, the mechanics by which such a break-up is effectuated will depend upon a number of factors, including whether the owners are already parties to a shareholders, partnership or operating agreement that specifies the form of buyout. In the absence of such an agreement, each of the owners will seek to optimize their respective after-tax economic consequences. In turn, this will inform their decisions as to the structure of the transaction, the determination of the nature and amount of the consideration to be exchanged, and the timing of such exchange.

A recent decision of the U.S. Tax Court[iv] considered the pre-coronavirus breakup of a joint venture that resulted in litigation, but which was settled for a lump-sum payment to Taxpayer in exchange for Taxpayer’s relinquishing whatever rights it had in the joint venture. Taxpayer and the IRS disagreed as to the tax treatment of this payment.

Although the Court ultimately sided with Taxpayer, the IRS raised some interesting points – although other issues were left untouched – in the context of the cross-purchase buyout[v] of a partner, of which partners and their tax advisers should be aware.

The Joint Venture

Taxpayer was a real estate development and investment firm. It would locate desirable properties to develop, and would then partner with others who would provide the capital needed for such development.

Taxpayer connected with Partner, who was interested in financing the development of certain properties identified by Taxpayer. The parties executed a term sheet which set forth the major terms for a real estate development joint venture.

While Taxpayer and Partner were working on developing these properties – each as a separate venture – conflicts arose between them. The parties struggled to formalize the terms of their deal in a written agreement, but never succeeded in doing so.

Eventually, Partner replaced Taxpayer with another development company.

The Litigation

Partner then filed a complaint against Taxpayer in which Partner claimed that Taxpayer did not have any interest in Partner’s joint ventures,[vi] and Partner sought declaratory relief and damages for conversion, imposition of constructive trust, breach of contract, and breach of fiduciary duty.[vii]

Partner asserted that “[p]ending the execution and delivery of written agreements [Taxpayer and Partner] entered into an oral contract, pursuant to which [Taxpayer] rendered services to and for [Partner].”

Taxpayer filed a cross-complaint alleging that Partner had breached its fiduciary duties to Taxpayer as a joint-venturer. Taxpayer sought declaratory relief and partition of the properties. Taxpayer asserted that its joint venture with Partner was reflected “in many oral and written statements and emails.” It also alleged that the parties had operated according to the above-referenced term sheet, which the parties executed intending to finalize the terms of their joint ventures. Taxpayer claimed that because they were partners in a joint venture, Partner owed Taxpayer fiduciary duties of care and loyalty and had an obligation of good faith and fair dealing, and that repudiating the existence of the joint ventures breached those duties.

A jury was presented with Taxpayer’s claims for breach of fiduciary duty. The trial court instructed the jury that to establish its claim “[Taxpayer] must prove that [Partner was] in a joint venture with Taxpayer and that [Partner] excluded Taxpayer from a joint venture, wrongfully repudiated the existence of the joint venture and converted all of the joint venture assets to [its] own use.”


The Court explained that, under State law, the victim of “repudiation” of a partnership interest could choose among several methods of measuring damages. Taxpayer chose the “conversion measure of damages, which is the value of what was taken on the date of repudiation.”

Taxpayer’s expert determined the value of the repudiated joint venture interests by considering the future fees the joint ventures expected to receive,[viii] as well as other factors.

The jury found that Taxpayer and Partner had a joint venture, and that Partner breached its fiduciary duty to Taxpayer.

The court instructed the jury that “[i]f you find that * * * [Partner] breached [its] fiduciary duty, Taxpayer would be entitled to damages measured by the reasonable value, at the time of the breach, of Taxpayer’s interest in the joint venture(s) of which Taxpayer was deprived.” The jury awarded damages in an amount that matched the estimate provided by Taxpayer’s expert. The jury also found that Partner was liable for punitive damages.

After the judgment was entered, Partner appealed. While the appeal was pending, Taxpayer explored settling the case.


Taxpayer understood that the terms of any settlement agreement would affect the net after-tax proceeds. Taxpayer’s tax adviser, CPA, advised Taxpayer that the tax treatment of the settlement proceeds would likely depend on how the settlement agreement characterized the proceeds. CPA believed that if the settlement agreement provided for an exchange of Taxpayer’s joint venture interests for the settlement proceeds, the result would be favorable capital gain treatment for Taxpayer.[ix]

While the appeal was pending, Taxpayer and Partner reached a settlement. The settlement agreement included several relevant provisions; for example, it provided for Taxpayer’s transfer and relinquishment of the joint venture interests, and stated that each party sought legal counsel and advice regarding the agreement, including its tax consequences.

The Court described how the parties worked though several drafts before reaching a final agreement. According to the Court, their negotiations clearly demonstrated what the parties intended to achieve in the settlement agreement: Taxpayer wanted it to reflect “a transfer by [Taxpayer] of its joint venture interest in these projects with Partner, transferring them to Partner as an essential part of this transaction,” while Partner intended for agreement to cause Taxpayer to relinquish any ownership interests it had in the joint ventures.

Tax Return Challenged

The settlement agreement entitled Taxpayer to receive a payment from Partner. Taxpayer reported the payment on its tax return as long-term capital gain from the disposition of a partnership interest.[x]

The IRS challenged this tax treatment and sought to re-characterize the gain reported by Taxpayer as ordinary income. Specifically, the IRS asserted that the settlement proceeds represented lost fees,[xi] taxed as ordinary income.

The IRS argued that the valuations provided by Taxpayer’s expert in the State court proceeding showed that Taxpayer received damages for its interests in the joint ventures in the form of lost fee income.

The Court’s Opinion

The Court observed that the parties did not dispute that Taxpayer may treat amounts received in exchange for the joint venture interests as capital gains. Under the Code, it explained, the sale or exchange of a partnership interest is generally treated as the sale or exchange of a capital asset.[xii] Any amounts received as compensation for lost profits, however, must be treated as ordinary income.[xiii]

Nature of the Claim

The tax treatment of proceeds received in settlement of a claim, the Court continued, is generally guided by the nature of the claim, or the characterization of the claim for which the settlement was paid.[xiv]

The nature of the underlying claim, the Court stated, was a factual determination made by considering the settlement agreement in light of all the facts and circumstances; if the settlement agreement expressly allocated the settlement proceeds to a type of damage, the Court would generally follow that allocation if the agreement was reached by adversarial parties in arm’s-length negotiations and in good faith.

Specific Allocation

The settlement agreement between Taxpayer and Partner provided an express allocation. It provided that Taxpayer was receiving payment in exchange for its interests in the joint ventures – no portion of the payment was allocated elsewhere, and the Court saw no reason to read the agreement as other than expressly written.[xv]

Adverse and At Arm’s Length

The Court also pointed out that parties were adversarial and negotiated at arm’s length and in good faith regarding the nature of the settlement payment. It explained that drafts of the agreement showed that Taxpayer wanted the agreement to reflect both that it had joint venture interests and that it was transferring those interests. In contrast, Partner wanted language that supported its contention that Taxpayer only claimed to have interests. In the final agreement, however, Partner acknowledged that it was paying to acquire whatever interests Taxpayer had.

Moreover, Partner and Taxpayer had adverse tax interests, the Court stated, in the characterization of the payment. If Partner had made the payment to compensate Taxpayer for providing services, Taxpayer would have received ordinary income, taxable at ordinary income rates, while Partner would likely have been able to deduct a payment for services as an ordinary and necessary business expense.[xvi]

But if the payment was made in exchange for joint venture interests, Taxpayer would recognize long term capital gain, taxable at favorable capital gain rates. Partner, however, would have been required to treat any amounts paid for Taxpayer’s interests in the joint ventures as additions to its bases in the joint venture interests.[xvii]

These differing tax consequences of the payment’s characterization supported the conclusion that the parties were adverse for tax purposes.

Moreover, nothing in the facts and circumstances of the negotiation indicated that Taxpayer and Partner approached the settlement agreement other than in good faith and at arm’s length, or that the payment had a different purpose.[xviii] Indeed, the Court noted, the facts and circumstances surrounding the settlement agreement demonstrated that the payment was made in exchange for the joint venture interests.

The Valuation

Finally, the IRS argued that the valuation report prepared by Taxpayer’s expert valued both Taxpayer’s interests in the joint ventures and the lost fee income. Therefore, the IRS argued, the economic reality was that Partner compensated Taxpayer for the latter’s loss of future income. The Court disagreed.

The Court conceded that the expert used lost fee income as a factor in calculating the values of the joint venture interests. The Court explained, however, that it was a common and accepted method for valuing an asset to consider the future economic benefits the asset would bring to its owner.[xix]

Because the settlement agreement expressly allocated the settlement proceeds to payment for Taxpayer’s interests in the joint ventures, and because the settlement agreement, including the allocation provision, was negotiated by adversarial parties at arm’s length and in good faith, the Court concluded that Taxpayer received the settlement proceeds in exchange for its interests in the joint ventures. Thus, the sale proceeds were properly treated as gain from the sale of a capital asset.

There’s More to A Cross-Purchase

Once it was accepted that Taxpayer was a member of a joint venture with Partner, the buyout of its partnership (joint venture) interest, described above, represented a fairly straightforward affair.

Even so, there were a number of points on which the Court touched, and a few that were not discussed at all, that are worthy of further comment.

“Hot Assets”

In general, the Code provides that the gain realized from the sale of a partnership interest is treated as gain from the sale of a capital asset.[xx]

However, if any of the consideration for the transferor’s interest in the partnership is attributable to the value of the partnership’s unrealized receivables[xxi] or inventory items,[xxii] then part of the gain from the sale of the interest will be considered as an amount realized from the sale or exchange of property other than a capital asset;[xxiii] in others words, ordinary income.[xxiv]

Interestingly, neither the IRS nor the Court made any mention of the application of this rule to attribute some of the consideration for Taxpayer’s interest to the properties being developed.[xxv]

“Debt Relief”

It should be noted that the consideration to be paid in exchange for a transferor’s partnership interest includes not only the amount of cash and the fair market value of the property to be transferred by the purchaser to the transferor; it also includes the transferor’s share of partnership liabilities that are allocated away from the transferor as a result of the sale.[xxvi]

Installment Reporting

Moreover, such “ordinary gain” will not qualify for installment reporting; rather, the amount of such gain will be included in the transferor’s gross income for the taxable year of the sale notwithstanding that the payment of the consideration in respect thereof may be deferred to a later taxable year.[xxvii]

Similarly, the amount of the “debt relief” realized by the transferor in the taxable year of the sale will be treated as cash received in such year.

Inside Basis[xxviii] Adjustment

In general, the basis of partnership property is not adjusted as the result of a transfer of an interest in a partnership by sale or exchange unless an election under Section 754 of the Code is in effect with respect to the partnership.[xxix]

Where such an election is in effect, the partnership will increase the adjusted basis of the partnership property by an amount equal to the excess of the basis to the transferee (acquiring) partner of their interest in the partnership[xxx] over their proportionate share of the adjusted basis of the partnership property.[xxxi]

This increase will constitute an adjustment to the basis of partnership property with respect to the transferee partner only.[xxxii] Thus, for purposes of calculating income, deduction, gain, and loss, the transferee will have a special basis for those partnership properties the bases of which are adjusted.[xxxiii] In the case of partnership property that is amortizable or depreciable, the adjustment will be added to the transferee’s share of inside basis in determining their amortization or depreciation deduction and, on the sale of property, the adjustment will be subtracted from the amount of gain allocated to the transferee.[xxxiv]

The Court made no mention of Partner’s ability to recover any of the consideration paid for Taxpayer’s interest. To the extent such cost would have been added to property being developed for sale, it would be recovered at the time of sale by reducing the amount of income realized;[xxxv] if the cost was added to investment property, then Partner would have been looking at a much longer recovery period, depending upon whether the real property was nonresidential or residential rental property.[xxxvi]


A long-term capital gain is generated when there is a sale or exchange of a capital asset. A capital asset is generally defined as property held by the taxpayer, whether or not connected to their trade or business, subject to several statutory exceptions.[xxxvii] Long-term capital gain may also be generated on the sale of property used in a trade or business, of a character which is subject to depreciation, or of real property used in a trade or business.[xxxviii]

Against this background, Congress, the IRS and the Courts have, over the years, developed arguments that are intended to defeat attempts by taxpayers to “convert” ordinary income into capital gain. The hot asset rule, described above, represents one statutory attempt in support of this goal.

Another, judicially-developed, argument is embodied in the “substitute for ordinary income” doctrine. In brief, if an amount is received by a taxpayer for an interest in property, but the transaction is recast as a payment in lieu of future ordinary income payments, the amount received will also be treated as ordinary income – the taxpayer is merely converting future income into present income; they are accelerating the receipt of the income.[xxxix]

Taxpayers, on the other hand – like the Court in Taxpayer’s case discussed above – have argued that many assets, including closely held business interests, are valued on the basis of the present value of their future income stream.[xl] Thus, they assert, it is possible to take the “substitute for ordinary income” doctrine too far, and to thereby define the term “capital asset” too narrowly.

Between these two extremes, the courts have stated that they must make case-by-case judgements as to whether the conversion of income rights into a single payment reflects the sale of a capital asset that produces capital gain, or whether it produces ordinary income.[xli]

What’s Next?

Assuming we do experience an increase in business divorces after the COVID-19 quarantine is lifted, business owners who have decided to go their separate ways will have to consider, together with their advisers, a number of transaction-related options, some of which will be more tax efficient than others.

In the case of a partnership, for example, they will have to decide whether a cross-purchase or a liquidation of the interests held by the departing partner(s) represents the best buyout structure.

They will have to consider the proper valuation method for the business and the interest to be acquired in light of the circumstances in which our economy (and probably the business) finds itself.

A related issue will be the financing for such a buyout.[xlii]

The partnership may also want to consider whether an in-kind distribution, whether in the form of a division of the partnership[xliii] or in liquidation of a partner’s interest in the distributing partnership,[xliv] may be the most cost effective and tax efficient means of separating the owners of the business. Of course, this may present its own valuation and other practical challenges. In addition, an in-kind distribution may trigger the disguised sale and mixing bowl rules, thus triggering the taxable event that the owners sought to avoid.[xlv]

Over the course of the following weeks, we will try to review many of these issues. At the end of the day, however, it will be incumbent upon the business owners, the business organization, and their advisers to sift through these factors, and others, as they decide upon the terms of the buyout.


[i] Causes? Money pressures: reduced earnings, maybe job loss? Not sharing household and family duties, including homework with the kids and taking care of the newly-acquired pet? (Whose idea was that anyway?) Close proximity to one’s elderly mother-in-law for an extended period of time. (Give me a few more weeks – I’ll get back to you on that.) Finally getting to know one another? (What ever happened to the “Newly Wed Game”? In retrospect, it appears to have been serving an important societal function.)

May we accept this as proof of the converse, that “absence makes the heart grow fonder?” Not necessarily.

[ii] In general, divorce statistics come from the States, the National Center for Health Statistics, and the Census Bureau.

[iii] For example, will they close offices, drop unprofitable lines of business, reduce the number of employees, pay down debt, establish reserves, cut “fat,” etc.?

[iv] NCA Argyle LP, v. Commissioner, T.C. Memo. 2020-56.

[v] Where the remaining partner or partners acquire the departing partner’s equity interest. This is to be contrasted with a liquidation of the departing partner’s interest, in which the partnership itself is the acquiring party.

[vi] Partner alleged that Partner and Taxpayer had negotiated potential terms for real estate development ventures but never entered any written agreement.

[vii] What do you think of “litigation speak?” Do you recall “A Fish Called Wanda?”

Wanda: Archie? Do you speak Italian?

Archie: I am Italian! Sono italiano in spirito. Ma ho sposato una donna che preferisce lavorare in giardino a fare l’amore appassionato. Uno sbaglio grande! But it’s such an ugly language. How about… Russian?

[viii] Which caught the attention of the IRS.

[ix] IRC Sec. 741, Sec. 1221, Sec. 1222, 1(h).

[x] Its interest in the joint venture with Partner.

[xi] As well as punitive damages.

[xii] IRC Sec. 741.

[xiii] Ordinary income is subject to federal income tax at a maximum rate of 37 percent. Amounts received as punitive damages are also taxable as ordinary income to the recipient.

[xiv] The “origin of the claim” doctrine.

[xv] The settlement agreement stated that it represented the entire understanding of the parties, including as to the character of the payment. The Court did not find that the parties’ agreement as to the price for the converted joint venture interests was inconsistent with the economic realities of the case; rather, the Court found that such price was within the reasonable range of value placed on the joint venture interests.

[xvi] IRC Sec. 162.

[xvii] IRC Sec. 1012.

[xviii] When an expressed settlement “is incongruous with the ‘economic realities’ of the taxpayer’s underlying claims,” the Court stated, “we need not accept it.”

[xix] Like distinguishing a share of stock from its dividend history, or a building from its rental income.

[xx] IRC Sec. 741. Of course, in order for the gain from the sale of the partnership interest to be treated as long-term capital gain, the partner must satisfy the “more than one year” holding period requirement. IRC Sec. 1222 and Sec. 1223.

[xxi] IRC Sec. 751(c).

[xxii] IRC Sec. 751(d). Inventory, together with unrealized receivables, are referred as “hot assets.”

[xxiii] IRC Sec. 751. There is no comparable rule for C corporations or S corporations. The so-called “collapsible corporation” rules (IRC Sec. 341), which bore only a passing resemblance to Sec. 751, were repealed in 2003.

[xxiv] For purposes of this rule, the term “unrealized receivables” includes, to the extent not previously includible in income under the method of accounting used by the partnership, any rights to payment for goods delivered, or to be delivered, to the extent the proceeds therefrom would be treated as amounts received from the sale or exchange of property other than a capital asset, or services rendered, or to be rendered.

It also includes several less obvious items; for example, depreciation recapture. IRC Sec. 1245. This is generally described as the amount of depreciation claimed by the taxpayer with respect to depreciable tangible personal property.

[xxv] It may be that these were not held for sale but, rather, for investment; i.e., rental.

[xxvi] IRC Sec. 752(d); Reg. Sec. 1.752-1(h). Of course, this debt may have also been added to the transferor’s basis for their partnership interest. To the extent the transferor-partner was able to claim deductions as a result of this increased basis – see IRC Sec. 704(d) – the inclusion of this debt in the amount realized serves to recapture this benefit.

[xxvii] IRC Sec. 453(b)(2) and 453(i); Mingo v. Comm’r, T.C. Memo 2013-149.

[xxviii] This refers to the partnership’s basis for its assets, whereas “outside basis” refers to a partner’s basis for their partnership interest.

[xxix] IRC Sec. 743(a). Note than such an election is not necessary in the case of a two-person partnership in which one partner purchases the interest of the other. In that case, Rev. Rul. 99-6 treats the partnership as having made a liquidating distribution of its properties and the purchasing partner as having acquired, from the departing partner, the latter’s share of the partnership’s properties.

[xxx] Basically, their cost basis for the partnership interest (IRC Sec. 1012), increased by their allocable share of partnership liabilities (IRC Sec. 752(a) and Sec. 722).

[xxxi] It’s also possible to have a negative adjustment. It’s important to note that, once made, the election is irrevocable without the consent of the IRS.

[xxxii] No adjustment is made to the common basis of partnership property.

[xxxiii] Reg. Sec. 1.743-1(j). IRC Sec. 755 and the regulations thereunder provide for the allocation of the adjustment amount among the partnership’s assets.

[xxxiv] In other words, a positive adjustment may generate increased deductions and reduced gain.

[xxxv] IRC Sec. 263A.

[xxxvi] IRC Sec. 168.

[xxxvii] IRC Sec. 1221.

[xxxviii] IRC Sec. 1231. These properties must not represent inventory or other property held primarily for sale to customers in the ordinary course.

[xxxix] Hort v. Commissioner, 313 U.S. 28 (1941).

[xl] An income approach to valuation; for example, the discounted cash flow and capitalization of cash flow methods.

[xli] Congress has addressed the issue in the case of a distribution in liquidation of a partnership interest where the amount to be distributed is determined with regard to the income of the partnership. IRC Sec. 736(a).

[xlii] And, in the case of acquisition indebtedness, the tax treatment of any related interest expense. IRC Sec. 163.

[xliii] Reg. Sec. 1.708-1(d).

[xliv] IRC Sec. 731 and Sec. 736.

[xlv] IRC Sec. 704(c)(1)(B), Sec. 707, and Sec. 737.

What Did You Do Last Night?

“Friday night, May 15 . . . You didn’t watch the roll call vote in the House? . . . On CSPN . . . The HEROES Act. . . . C’mon, seriously. . . . Really? . . . You had no interest whatsoever? . . . Foregone conclusion? . . . Hmm, probably, but there were a couple of surprises. . . . No, I don’t get a kick out of watching paint dry.”

The House passed the “Health and Economic Recovery Omnibus Emergency Solutions Act,” or the “HEROES Act,”[i] just before 9:30 pm yesterday, by a vote of 208 to 199,[ii] with 23 members not voting.[iii] If enacted, the HEROES Act will represent the fifth piece of major Federal legislation aimed at combatting the domestic health and economic effects of the coronavirus pandemic.[iv]

The bill will now be sent to the Senate, where the Republican majority has already stated that the measure does not stand a chance of being passed in its current form; the majority leader, Senator McConnell, described the proposed legislation[v] as a “liberal wish list,” and the White House has threatened to veto the measure if it somehow gets through the Senate with too many of its “offending” provisions intact.

Truth be told, the scope of the HEROES Act is not limited to dealing with the COVID-19 health crisis and with the economic consequences arising from the government-ordered shutdown of many businesses as part of our effort to contain the spread of the coronavirus.

Indeed, the bill modifies or expands a wide range of other programs and policies, including those regarding Medicare and Medicaid, health insurance, broadband service, immigration, student loans and financial aid, the federal workforce, prisons, veterans’ benefits, consumer protection requirements, the U.S. Postal Service, federal elections, aviation and railroad workers, and pension and retirement plans.[vi]

Glass Half Full?

That being said, the bill also provides payments and other assistance to state and local governments to help them through the financial crisis in which they find themselves as a result of the pandemic; modifies and expands the Paycheck Protection Program (“PPP”),[vii] which provides loans and grants to small businesses and nonprofit organizations;[viii] establishes a fund to award grants for employers to provide pandemic premium pay for essential workers; expands several tax credits and deductions;[ix] allow companies with forgiven PPP loans to defer their payroll tax payments; provides funding and establishes requirements for COVID-19 testing and contact tracing; requires employers to develop and implement infectious disease exposure control plans;[x] and more.

The Act would also suspend the $10,000 cap on the itemized deduction for state and local income taxes for 2020 and 2021.[xi]

In other words, there are enough items in the bill on which both Democrats and Republicans can agree, if they are ready and willing to act reasonably.

Significantly, among these items is a provision that addresses the deductibility of business expenses paid with the proceeds of a PPP loan.

Tax Deductibility of Business Expenses

Under the Code, taxpayers are allowed to deduct any ordinary or necessary trade or business expenses from their gross income.[xii] This would normally include PPP-eligible “covered” expenses like wages or other compensation, paid employee leave and fringe benefits, rent or utility payments associated with a business facility, interest on certain business debt, and state tax payments.

The CARES Act has no language referring to the deductibility of PPP expenses.

This left many tax advisers wondering what Congress intended; specifically, should a business that enjoyed the tax-free forgiveness of its PPP loan[xiii] also be allowed to claim a tax deduction for the expenses paid with the proceeds from the forgiven PPP loan?

Many were troubled by this “double benefit” from a conceptual perspective – it seemed out of balance, as indeed it is. They argued that an express legislative statement would be needed if Congress intended to allow a deduction for covered expenses incurred by a taxpayer whose loan is forgiven under the PPP.

Others pointed out that, if Congress meant to disallow the double benefit, why was the exclusion of the loan forgiveness from gross income explicitly provided in the legislation? If Congress had remained silent, they contended, the forgiveness would have generated cancellation of indebtedness income,[xiv] and the business would have claimed a deduction for the expenses paid with the loan proceeds.

On April 30, 2020, however, the IRS issued Notice 2020-32, setting forth the IRS’s position that recipients of PPP loans cannot claim a deduction for expenses funded from a PPP loan that has been forgiven.[xv] In support of its position, the IRS relied upon that provision of the CARES Act under which forgiven PPP loans are not to be included in the borrower’s gross income and, thus, are not taxable.[xvi]

As explained below, the IRS’s guidance would reduce the economic benefit of PPP loans.[xvii]

Congress Responds?[xviii]

Within one week of the issuance of Notice 2020-32, a bipartisan-sponsored bill was introduced in the Senate – S. 3612, the Small Business Expense Protection Act of 2020[xix] – which would add the following language to the end of Section 1106(i) of the CARES Act (which excludes the forgiven PPP loan from gross income): “and . . . no deduction shall be denied or reduced, no tax attribute shall be reduced, and no basis increase shall be denied, by reason of the exclusion from gross income.”

The HEROES Act, introduced on May 12, and passed by the House on Friday, May 15, includes a similar provision, which reads as follows: “notwithstanding any other provision of law, any deduction and the basis[xx] of any property shall be determined without regard to whether any amount is excluded from gross income under section 20233 of this Act or section 1106(i) of the CARES Act.”[xxi]

Although the Senate has not yet passed its version of this provision, I’d wager that the IRS has heard enough from Congress, generally, to realize that the legislature’s intent was to allow the borrower-business to claim a deduction, for purposes of determining its income tax liability, for the business expenses paid with the PPP loan proceeds, without regard to whether such loan is forgiven or not.

Hopefully, the IRS will act on this realization and immediately withdraw Notice 2020-32. There is no reason to hold the deduction hostage to Congressional negotiations on other items in the HEROES Act bill – businesses deserve at least that degree of certainty as they move into an otherwise uncertain future.[xxii]

Double Benefit =’s Reserves?

Speaking of uncertainty or, more accurately, perhaps one way for a business to prepare for its inevitable arrival, is to utilize the double benefit described above to establish a cash reserve. This, in turn, would address, at least in part, a shortcoming of many businesses, one that both accelerated their economic downturns and aggravated the adverse consequences thereof.

This opportunity afforded by the double benefit may be best conveyed with a simplistic example.

First, assume a business receives a conventional loan of $100. The borrower-business receives the proceeds tax-free; they represent a loan, after all. The business uses the $100 loan to pay certain expenses. The lender forgives the loan, and the business realizes taxable income from the discharge of indebtedness. However, because the expenses paid by the business are deductible for tax purposes, the business has no income tax liability at that point.

If the business later realizes a profit of $100 net of related expenses, it will owe income tax thereon. If the business is a C corporation, its Federal income tax liability will be $21, and it will be left with $79.

Now assume the business receives $100 of PPP loan proceeds. These are received tax-free. The business uses the $100 loan to pay certain expenses, as required under the PPP, and the SBA subsequently forgives the $100 loan. Pursuant to the CARES Act, this debt forgiveness is not treated as taxable income to the business and, under Notice 2020-32, the business is not allowed to deduct the expenses paid for purposes of determining its income tax liability. Because the business does not have any income from the discharge of indebtedness, the absence of a deduction has no impact on its tax liability, which is zero.

However, if the business subsequently earns a profit of $100 net of related expenses, it will owe income tax thereon in the absence of a deduction for its payment of the PPP-related expenses – no tax savings are realized from the payment of the PPP-covered expenses. If the business is a C corporation, its Federal income tax liability will be $21.[xxiii] It may retain the remaining $79 as a reserve, subject to establishing that the amount accumulated does not exceed the reasonable needs of the business.[xxiv]

Now assume that the expenses paid with the PPP loan are deductible by the business. In determining its taxable income for the year, the business excludes the forgiven loan from its gross income, as provided under the CARES Act. However, the business may deduct the $100 of PPP-related expenses against the subsequently earned $100 of profit; as a result, the business has no taxable income, nor does it have positive earnings and profits, for that year.[xxv] Thus, the business does not owe income tax on that $100 – a tax savings of $21 – and it may retain the entire amount as a reserve.

Get Ready

It will be a few weeks before the HEROES Act is negotiated to the point that it will pass muster in both the Senate and the House. In light of the clear Congressional intent, the IRS should not wait for a “final” legislative pronouncement regarding the deductibility of covered expenses that are paid with PPP loans before it withdraws Notice 2020-32 and acknowledges this tax benefit.

For the same reason, businesses that have received PPP loans, which they are reasonably confident will be forgiven by the SBA, should not squander the tax savings to be realized. Although many businesses will need the resulting liquidity to get back on their feet, those that can afford to do so should plan to set those funds aside as a reserve. You may recall the loan amount was determined by reference to 2.5 times the monthly “payroll costs” of the business[xxvi] – that’s not a bad place to start.

If the reserve is coupled with cutting fat and waste from a business, and with securing a line of credit, then the business will have placed itself in a much better position for the next economic downturn, whatever the reasons therefor.[xxvii]

[i] H.R. 6800.

Do you ever wonder what comes first, the statute’s full name or the acronym? CARES. HEROES. A reasonably strong argument can be made that some staff member in the Senate Finance Committee or in the House Ways and Means Committee thought of these emotionally-accented acronyms first – suspend for a moment, please, the definitional chicken and egg issue this presents – then found the words to match them in a reasonably coherent manner.

Have we seen the last of names like TEFRA, TRA, OBRA, EGTRRA, and their kind? Speaking as a traditionalist, I hope not.

[ii] One Republican, New York’s Peter King, voted for the bill, in part, because of its support for state and local governments. Mr. King will be retiring from the Congress shortly, after what will be his 14th term. 14 Democrats voted against the proposed legislation – according to the so-called “experts,” some of these were moderates who face a difficult re-election campaign in November and, so, could not support a measure that many described as “too partisan.” One is the Co-Chair of the Progressive Caucus – Ms. Jayapal thought the bill did not go far enough.

[iii] 12 Democrats and 11 Republicans. I’m not sure why these folks did not vote; given the number of Democrats who refused to follow the party-line, this had the potential to turn a vote that was already relatively close into a nail-biter.

[iv] The first four being (i) the Coronavirus Preparedness and Response Supplemental Appropriations Act, (ii) the Families First Coronavirus Response Act, (iii) the Coronavirus Aid, Relief and Economic Security Act, and (iv) the Paycheck Protection Program and Health Care Enhancement Act.

[v] Over 1,800 pages.


[vii] The Coronavirus Aid, Relief, and Economic Security Act (CARES Act; P.L. 116-136) established the PPP to provide short-term economic relief to certain “small” businesses and nonprofits. The initial authorization of $349 billion for PPP loans was exhausted by April 16, 2020. Congress authorized another $310 billion ($659 billion total) for PPP loans in the Paycheck Protection Program and Health Care Enhancement Act (P.L. 116-139).

[viii] Among other things, it would extend the forgiveness period to cover eligible costs incurred over 24 weeks (rather than the current eight weeks, during which most businesses have been, and will likely remain, closed by government order),

[ix] For example, it would retroactively expand the employee retention credit to cover 80% of as much as $15,000 in compensation per calendar quarter, limited to $45,000 for the year.

For more on the CARES Act’s tax credits, see

[x] It also provides additional direct payments of up to $1,200 per individual; expands paid sick days, family and medical leave, unemployment compensation, nutrition and food assistance programs, housing assistance, and payments to farmers; eliminates cost-sharing for COVID-19 treatments; and extends and expands the moratorium on certain evictions and foreclosures.

[xi] As enacted by the 2017 Tax Cuts and Jobs Act (“TCJA”).

Unfortunately – and ironically – the Act would restore and make permanent the “Republican Tax Act’s” (the TCJA) limit on excess loss deductions for pass-through business losses that was suspended for 2018 through 2020 by the CARES Act. In addition, it would eliminate the CARES Act’s changes to the net operating loss deduction, which allows businesses to carry back losses from 2018 through 2020 for five years; the idea here was to enable qualifying businesses to generate liquidity through tax refunds for earlier years. The TCJA had eliminated the two-year carryback provision that was in effect before 2018.

[xii] IRC Sec. 162.

[xiii] Not a foregone conclusion at the inception of the loan.

[xiv] Subject to IRC Sec. 108, and its “offsetting” reduction of tax attributes; for example, the exclusion of COD from income for an insolvent taxpayer.

[xv] Payments on PPP loans are deferred for the first six months of the loan. Before that period is over, a borrower can apply for forgiveness of the loan for eight weeks of expenses as long as the borrower: (1) maintains the same number of full-time equivalent employees during specified time periods and (2) does not decrease salaries by more than 25 percent for employees that make less than $100,000 in annualized compensation. At least 75 percent of the loan must be used for payroll costs.

Late last week, the SBA issued the Paycheck Protection Program Loan Forgiveness Application, with instructions for calculating the loan forgiveness. OMB Control Number 3245-0407.

[xvi] Section 1106(i) of the CARES Act. In general, forgiven debt (“cancellation of debt income”) is included in the gross income of the borrower and is subject to income taxation. IRC Sec. 61(a)(11).

[xvii] With this said, many businesses could still find that the economic benefits of PPP loans outweigh the potential costs.

[xviii] It ain’t over till the tax lawyers sing.


[xx] Both S. 3612 and H.R. 6800 refer to basis in case an otherwise deductible expense paid with PPP loan proceeds has to be capitalized. See, for example, IRC Sec. 263A.

[xxi]  Sec. 20235 of the Act.

[xxii] For many years now, we have been living with temporary measures. The Code is full of expiration dates. That’s no way to legislate. Business needs certainty; tax decisions should not be made primarily because a provision is expiring – they have to make sense from a business perspective. It’s bad enough that we’re in a general election year, with all the posturing which that entails.

[xxiii] IRC Sec. 11.

If the corporation wanted to eliminate its tax liability, it could make a deductible payment to its shareholders – for example, as “reasonable” compensation – but that would not reduce the aggregate tax liability of the corporation and its shareholders; rather, it would merely shift the tax burden to the shareholders. If the shareholders are individuals, the deductible payment would increase the aggregate tax liability because individuals are currently taxed at a higher maximum rate (37%) than the corporation.

[xxiv] The accumulated earnings tax under IRC Sec. 531 et seq. A corporation with no current or accumulated earnings and profits is not subject to this tax; its distribution of the accumulated funds would not be treated as a dividend for tax purposes. IRC Sec. 301, 312 and 316.

[xxv] Which “eliminates” its accumulated earnings tax problem.

[xxvi] Section 1102(a)(2)(E) of the CARES Act.


So Much Promise

I am not embarrassed to say that I was excited at the introduction of the bill that would eventually be enacted as the CARES Act.[i] In particular, I viewed the Paycheck Protection Program[ii] as a practical means of getting funds into the hands of those closely held businesses that needed them to survive the present economic downturn.[iii]

Even as the legislation evolved in Congress, over a short but stressful period, the basic features of the PPP remained the same: billions of dollars in nonrecourse, unsecured, SBA-guaranteed loans to be used by small businesses to satisfy their payroll costs, rental and utility expenses, as well as interest on certain pre-existing indebtedness; significantly, the loans would be forgiven if businesses could demonstrate that the proceeds were used for their intended purpose; and, finally, such forgiveness would not be treated as income from the discharge of indebtedness for purposes of determining taxable income.

Now Comes the Hard Part

The passage of any legislation, however, is only the first step toward accomplishing its goals. It has to be implemented, which is no easy task in the best of circumstances, let alone during the unprecedented shutdown of much of the nation’s economy, and it can be especially challenging for a measure as complex as the CARES Act.

Granted, the implementation of a law involves some degree of interpretation by the agencies charged with making it work. At times, Congress will authorize an agency to fill in the blanks, as it were.[iv] This process takes time.[v]

In the case of the PPP, however, the timeline was necessarily accelerated. The legislation was enacted on March 27 – by which time, 21 States were already in lockdown[vi] – and PPP loans became available on April 3.[vii] By April 16, the $349 billion appropriated by Congress for PPP loans was gone.[viii] The following week, Congress passed the Paycheck Protection Program and Health Care Enhancement Act,[ix] which authorized an additional $321 billion for the PPP.[x]

During a relatively short period, the SBA has issued, revised and updated its “interim final rule” a total of nine times, most recently on May 8.[xi] The SBA has also issued a number of FAQs[xii] to assist businesses with understanding the PPP; these have been updated approximately fourteen times.

“Economic Need”: What Was Intended?

Although most of these revisions and updates would not be described as “game changers” (though the clarification they have provided is certainly welcome), some of them have caused a number of business owners to second-guess their decision to apply for a loan under the PPP.

The principal reason for this change of heart? The addition of “Question & Answer 31” to the PPP’s hit parade of FAQs:

Question: Do businesses owned by large companies with adequate sources of liquidity to support the business’s ongoing operations qualify for a PPP loan?

Answer: . . . [B]orrowers must assess their economic need for a PPP loan . . . at the time of the loan application. . . . [B]orrowers should review carefully the required certification that “[c]urrent economic uncertainty makes this loan request necessary to support the ongoing operations of the Applicant.” Borrowers must make this certification in good faith, taking into account their current business activity and their ability to access other sources of liquidity sufficient to support their ongoing operations in a manner that is not significantly detrimental to the business. . .[xiii]

How does one define a “large” company? The FAQ merely states: “[I]t is unlikely that a public company with substantial market value and access to capital markets will be able to make the required certification in good faith.” No further guidance is provided.

What constitutes an “adequate source of liquidity?” Must the business make a capital call on its owners if they have the wherewithal to invest more in the business? Must it draw down on its available line of credit?[xiv] Must it exhaust its reserves? Must it reassign funds it had already designated for another business-related purpose? Query whether an approach similar to an “accumulated earnings tax” analysis should be applied; basically, has the borrower accumulated earnings beyond the reasonable needs of the business?[xv] Again, no other guidance has been provided.

This uncertainty – coupled with the risk of civil penalties, or criminal liability for “knowingly” making a false statement – has left the owners and officers of many closely held businesses on edge. They are reluctant to certify as to the “economic need” for the PPP loan – or are at least ambivalent about doing so – in the absence of more definitive rules.

Give It Back?

As if sensing this possibility – but probably not appreciating its breadth – the SBA announced a change to its interim final rule pursuant to which any borrower that applied for a PPP loan prior to April 24, 2020, that was concerned about its eligibility in light of FAQ 31, and that repaid the loan in full by May 7, 2020, would be deemed to have made the required certification in good faith.[xvi] Although this option brought peace of mind to many borrowers, the “squid pro row”[xvii] for such relief was significant: withdrawal from the PPP.

Last week, probably after having received what must have been a number of inquiries regarding the foregoing issues, the SBA issued FAQ 43,[xviii] which extended the repayment date from May 7 to May 14, 2020, thus giving businesses more time to consider their options.

In addition, and as if to dangle a carrot, the SBA issued FAQ 45[xix] to clarify that if a business repays its PPP loan by May 14, 2020, it will be treated as though it had never received a PPP loan for purposes of the Employee Retention Credit.[xx] Therefore, the business may qualify for the credit if it is otherwise an eligible employer for purposes of that benefit.[xxi]

Reduced Benefit?

For those businesses that were not concerned about their eligibility for a PPP loan, their participation in the program lost some of its luster when the IRS recently announced[xxii] that a business with such a loan will not be allowed an income tax deduction for the payment of any payroll costs, rent, and utilities – as directed by the PPP – that would otherwise be deductible by the business, if the PPP loan used to pay these expenses is forgiven, and such debt forgiveness is excluded from the gross income of the business for tax purposes.[xxiii]

These deductions, which were to be generated by using the PPP loan proceeds for their intended purpose – not to mention the resulting tax savings and liquidity – were taken for granted by most loan applicants and their advisers.

In fact, last week, members of the Senate Finance Committee and of the House Ways and Means Committee asked that the IRS reconsider its position. A couple of days later, a bipartisan group of Senators introduced a measure to clarify that the PPP does not affect the tax treatment of ordinary business expenses paid with PPP loan proceeds, with the result that such expenses would remain deductible for purposes of determining taxable income.[xxiv]

It remains to be seen whether the IRS will relent, or whether Congress will overturn the IRS’s position.

Meanwhile, the inexorable march toward May 14 continues.

Seventy-Five Percent?

While the CARES Act provides that a business will be eligible for forgiveness of its PPP loan in an amount equal to the sum of payroll costs and any payments of rent, utilities, and interest on certain indebtedness, made during the eight-week period beginning with the receipt of the loan proceeds,[xxv] the SBA determined[xxvi] that the non-payroll portion of the forgivable loan amount should be limited to 25 percent, whereas at least 75 percent of the PPP loan should be expended for payroll costs.[xxvii]

Many businesses that have already received their PPP loan proceeds have not yet spent the money, primarily because they are still shuttered by order of their state governments. The owners of these businesses don’t see how they can possibly apply the funds to pay salaries while their businesses remain closed and their employees remain at home. Their preference would be to wait until the stay-at-home orders are lifted so they can hire back the employees they have furloughed,[xxviii] and start generating revenue; if their businesses have to spend the funds on payroll now, the owners claim, they will not have the liquidity necessary to reopen and, hopefully, jumpstart their businesses later.

Meanwhile, the clock for the eight-week “covered period” during which the loan proceeds are required to be spent is ticking away.

Other businesses are wondering whether they should have waited longer before applying for a PPP loan, perhaps closer to the statutorily prescribed June 30, 2020 loan origination deadline, by which time there would be a greater chance of their being back in business and of satisfying the “75 percent payroll cost expenditure test” during the eight-week covered period.

Still others are confident that they will never satisfy this 75 percent test because their labor costs are not as significant as their rental costs or capital costs.[xxix] They nevertheless applied for the PPP loan because they needed the money to stay afloat.

Last week, in a letter dated May 5, 2020, a bipartisan group of Senators asked that the Treasury and the SBA consider increasing the threshold for non-payroll expenses from 25 percent to 50 percent. It is anyone’s guess what will happen.

How are these businesses going to fare when, after eight weeks, they apply to their lender for forgiveness of their PPP loan? Will they be saddled with indebtedness that will have to be repaid in two years, albeit at a low rate of interest?[xxx] Perhaps worse, will they be charged with not having certified in good faith as to their intended use of the loan proceeds?

Again, the May 14 “guilt-free” repayment date is approaching.

Next Steps?

The foregoing highlighted some of the thorniest issues facing many businesses that have not yet applied for a PPP loan, as well as those businesses that have already received PPP loans and which may be thinking about whether their applications for forgiveness will be well-received.

With respect to the latter, the SBA has extended the repayment date by a mere seven days.

Although the FAQs’ repayment option was drafted to address the issue of those applicants who, in retrospect,[xxxi] have determined they do not need a PPP loan, it is also available, practically speaking, to any other business that chooses to avoid an inquiry down the road – regarding its eligibility under the PPP, or regarding its certification as to the use of the loan – by repaying the loan and dropping out of the program.

In light of the questions raised by Congress over the deductibility of the payroll costs and other statutorily approved expenses paid with the loan proceeds, and over the appropriateness of applying the 75 percent threshold test to all businesses, the SBA and the Treasury should extend the repayment deadline by a meaningful period so as to allow these matters to be resolved.[xxxii]

PPP Dropout

“Baby don’t blow it, Don’t put my good advice to shame! Baby you know it, Even dear Abby’d say the same!”[xxxiii]

What is left for a business that decides to stay away from the PPP, its ever-changing rules, and its seemingly more elusive promise of loan forgiveness?

Plenty. By choosing not to take a PPP loan, a business is free, within the limits of the law, to let go of employees and to reduce the salaries of whatever employees it retains. Even as to those whom it furloughs, the business may choose to continue paying their health care premiums, as many have.

Rather than using PPP loans to make rental and interest payments for which no tax deduction may be available, the business may seek to renegotiate and or defer its obligations, the payments of which will still be deductible for tax purposes.[xxxiv]

Deferring Employment Taxes

Such a business may also qualify for certain tax benefits from which its participation in the PPP would have precluded it.

For example, the CARES Act allows employers to defer the deposit and payment of the employer’s share of social security taxes.[xxxv]

The deferral applies to deposits and payments that would otherwise be required to be made during the period beginning on March 27, 2020, and ending December 31, 2020. The deferred amounts must be deposited by the following dates (the “applicable dates”): (1) On December 31, 2021, 50 percent of the deferred amount; and (2) On December 31, 2022, the remaining amount.

A business that has received a PPP loan, that has not yet been forgiven, may defer the deposit and payment of the employer’s share of social security tax. However, once an employer receives a decision from its lender that its PPP loan is forgiven, the employer is no longer eligible to defer the deposit and payment of the employer’s share of social security tax that is due after that date.

In order to provide a timeframe within which to consider the benefit of this deferral, a PPP borrower applies to its lender for forgiveness of the loan after the eight-week covered period that began with the borrower’s receipt of the loan proceeds. The lender must issue its decision no more than sixty days after its receipt of the application.[xxxvi]

However, the amount of the deposit and payment of the employer’s share of social security tax that was already deferred through the date that the PPP loan is forgiven continues to be deferred and will be due on the applicable dates.[xxxvii]

A qualifying business may want to take advantage of and maximize this deferral opportunity and the increased liquidity that should arise from it.[xxxviii]

Employee Retention Credit[xxxix]

The CARES Act also provides businesses an Employee Retention Credit which may be claimed by eligible employers for wages paid after March 12, 2020, and before Jan. 1, 2021.[xl]

The credit is available to all businesses that have experienced an “economic hardship” due to COVID-19 – except for businesses that receive PPP loans.[xli] For purposes of this credit, a business experiencing an economic hardship includes one that has suspended its operations due to a government order related to COVID-19, or one that has experienced a “significant decline” in gross receipts.[xlii]

A business may have to fully or partially suspend its operations because a government order limits commerce, travel, or group meetings due to COVID-19 in a manner that prevents the business from operating at normal capacity.[xliii]

A significant decline in gross receipts begins in the first calendar quarter in 2020 in which a business’s gross receipts are less than fifty percent of its gross receipts for the same quarter in 2019.[xliv] The decline ends the first calendar quarter in 2020 after the quarter in which the business’s gross receipts are greater than eighty percent of its gross receipts for the same quarter in 2019. The business calculates these measures each calendar quarter.

The amount of the tax credit is fifty percent of up to $10,000 in “qualified wages” paid to an employee by an employer-business for all calendar quarters.[xlv] Thus, the employer’s maximum credit for qualified wages paid to any employee for all calendar quarters is $5,000. Qualified wages include the cost of employer-provided health care.

The wages that qualify for the credit vary based on the average number of the employer’s full-time employees in 2019. If the employer had 100 or fewer employees on average in 2019, the credit is based on the wages paid to all employees, regardless if they worked or not. If the employer had more than 100 employees on average in 2019, then the credit is allowed only for wages paid to employees for time they did not work.[xlvi] In each case, the wages that qualify for purposes of determining the credit are wages paid for a calendar quarter in which the employer experiences an economic hardship.[xlvii]

Beginning with the second calendar quarter of 2020, to claim the credit, employers should report their total qualified wages and the related health insurance costs for each quarter on their quarterly employment tax returns.[xlviii] The credit reduces, on a dollar-for-dollar basis, the employer’s share of social security taxes on the qualified amounts paid.[xlix]

The credit is refundable because if, for any calendar quarter, the amount of the credit to which the employer is entitled exceeds the employer’s share of the social security tax on all wages paid to all employees, then the excess is treated as an overpayment and is refunded to the employer.  Consistent with its treatment as an overpayment, the excess will be applied to offset any remaining tax liability on the employment tax return and the amount of any remaining excess will be reflected as an overpayment on the return.[l]

Neither the portion of the credit that reduces the employer’s applicable employment taxes, nor the refundable portion of the credit, is included in the employer’s gross income. At the same time, though, the employer’s aggregate deductions would be reduced by the amount of the credit.[li]

Latest Developments re the Credit

It should be noted that, last week, a bipartisan group of lawmakers proposed increasing the amount of the tax credit from $5,000 per employee for the remainder of the year to $12,000 per employee per quarter, thereby making the credit a more valuable and more meaningful economic incentive for employers. The bill would also remove some of the limits, based on the number of employees a business must have, in order to make it easier to qualify for the credit. Stay tuned.

In addition, until last week, the IRS had taken the position that an employer could not qualify for the credit by paying the health plan premiums for employees that have been furloughed and are not being paid a salary by the employer-business. However, in response to a letter from the chairs of the Senate Finance Committee and the House Ways and Means Committee, the Treasury revised the FAQs to change its position.[lii]

Now What?

So much to consider. So little time in which to do it.

There is no sugarcoating the circumstances in which so many businesses find themselves. The new rules that were enacted to help businesses through this period are complex, yet decisions have to be made, and sooner rather than later.

The best a closely held business can do is to review the guidance that’s out there with its advisers, consider the condition of the business, run the numbers, and make the choice with which the business and its owners are most comfortable, but remaining alert for possible changes coming out of Washington.

It isn’t ideal, but . . .

[i] The Coronavirus Aid, Relief and Economic Security Act. P.L. 116-136.

[ii] The “PPP” is found in Sections 1101 through 1107 of the CARES Act.


[iv] We (meaning tax people, at least in my world) talk about procedural vs. interpretive vs. legislative rules and regulations.

[v] For example, regulations are proposed, comments are solicited, and hearings are held before the regulations are revised (maybe) and finalized. Alternatively, regulations may initially be issued in temporary form when immediate guidance is needed. The temporary regulation is still treated as a proposed regulation and, so, follows the path outlined above before being finalized.

[vi] That number increased to 30 States by March 30, and 42 States by April 6 (three days after the PPP was launched).

[vii] Though many private lenders – including a few of the “too big to fail” variety (remember them?) – were late in participating and, when they did, several favored customers over others, notwithstanding the first-come, first-serve directive from the government. Oh well. Penalties anyone?

[viii] It should be noted that Section 1114 of the CARES Act directed the SBA to issue regulations to carry out the PPP within 15 days after the date of enactment.

[ix] “CARES Act 3.5.” P.L. 116-139.

[x] It was reported last week that over $100 billion remains available.


[xii] Frequently asked questions.

[xiii] As is often the case, a few bad actors take advantage of a situation, the government overreacts, and many of the intended beneficiaries of legislation are either frozen out, or voluntarily “remove” themselves for fear of the consequences of perhaps being found ineligible.

[xiv] Mind you, the CARES Act suspended the ordinary requirement that SBA borrowers demonstrate they are unable to obtain credit elsewhere. Section 1102(a)(2)(I) of the CARES Act.

[xv] See IRC Sec. 531 et seq. This has been my approach.

[xvi] 85 FR 23450 (April 28, 2020). The SBA, “in consultation with the Secretary [of the Treasury], determined that this safe harbor is necessary and appropriate to ensure that borrowers promptly repay PPP loan funds that the borrower obtained based on a misunderstanding or misapplication of the required certification standard.” Misunderstanding? Misapplication? How about poor drafting and fear of the consequences if one’s interpretation is rejected? The PPP application states that knowingly making a false statement is punishable by a fine and/or imprisonment; this includes the certification as to “need.”

[xvii] From Austin Powers in Goldmember. Translated, “quid pro quo.” Cut me some slack, OK. Starting my ninth week of house arrest – with my mother-in-law. (She’s OK, really.)

[xviii] May 5, 2020.

[xix] May 6, 2020.

[xx] Also passed as part of the CARES Act. Section 2301.

[xxi] More on this later.

[xxii] Notice 2020-32 (April 30, 2020).


[xxiv] S.3612.

[xxv] Congress probably thought we’d be back to “normal,” or at least approaching something like it, after eight weeks. Turns out that was wishful thinking.

[xxvi] In an early version of its interim final rule. 85 FR 20811 (April 15, 2020). It should be noted that although this version of the interim final rule was issued on April 2, 2020, and although loan applicants were told they could they rely on such rule, the rule did not become effective until April 15, 2020.

I can tell you that many active real estate businesses (and their advisers) waited for the SBA to modify this version of the interim rule by dropping its per se treatment of real estate development and rental businesses as passive and, thus, not eligible for SBA loans, including under the PPP. See 13 CFR 120.110 and described further in SBA’s Standard Operating Procedure (SOP) 50 10, Subpart B, Chapter 2. Inexplicably, that has not happened, though the industry continues to press Congress and the SBA.

[xxvii] To “effectuate the core purpose of the statute and ensure finite program resources are devoted primarily to payroll.”

[xxviii] Meanwhile, these former employees are receiving state unemployment benefits plus an additional federal benefit of $600 per week; in some cases, they are making more than if they had remained employed.

[xxix] Think of restaurants in large cities. Think of manufacturers.

[xxx] One percent. See the interim final rule. 85 FR 20811.

[xxxi] And with the fear of being lumped together with The Lakers, Ruth’s Chris, and Shake Shack.

[xxxii] After all, it is not the borrower’s fault that they may have applied for the PPP loan based on a “misunderstanding” of the rules.

[xxxiii] With apologies to Frankie Avalon who sang the song “Beauty School Dropout” in the 1978 movie Grease.


[xxxv] Section 2302 of the CARES Act. This tax is imposed on employers at a rate of 6.2 percent of each employee’s wages that do not exceed $137,700 for the 2020 calendar year.

[xxxvi] Section 1106(g) of the CARES Act.


[xxxviii] The IRS has indicated that the Form 941, Employer’s Quarterly Federal Tax Return, will be revised for the second calendar quarter of 2020 (April – June, 2020), and information will be provided to instruct employers how to reflect the deferred deposits and payments otherwise due on or after March 27, 2020 for the first quarter of 2020 (January – March 2020). In no case will employers be required to make a special election to be able to defer deposits and payments of these employment taxes.

[xxxix] The IRS has issued over 90 Frequently Asked Questions regarding this credit. There is no substitute for reviewing these, including the examples, if a business wants to take full advantage of the credit.

[xl] Section 2301 of the CARES Act. The credit is not available for wages paid after December 31, 2020.

[xli] Recall that a business which repays the PPP loan by May 14, 2020 will be treated as having never participated in the PPP for purposes of determining its eligibility for the credit.

[xlii] FAQ 2. The number of employees an employer has does not affect whether it is an eligible employer that may claim the credit. FAQ 16.

[xliii] FAQ 3.

[xliv] FAQs 4 and 39.

[xlv] FAQs 5 and 47.

[xlvi] An aggregation rule applies which treats all entities under common ownership as one employer, including for purposes of determining who is an eligible employer and for the 100 full-time employee threshold.

[xlvii] See FAQs 51 and 52.

[xlviii] Usually, IRS Form 941, Employer’s Quarterly Federal Tax Return.

[xlix] The employer can receive the benefit of the credit even before filing these returns by reducing their federal employment tax deposits by the amount of the credit. The employer will account for the reduction in deposits due to the Employee Retention Credit on the Form 941.

The IRS has posted Frequently Asked Questions about the ability of a business both to reduce deposits for the credit and to defer the deposit of all of the employer’s share of social security tax due before Jan. 1, 2021, as described earlier.

[l] The employer may request an advance payment of the credit from the IRS. This is done by submitting Form 7200, Advance Payment of Employer Credits Due to COVID-19.

[li] Section 2301(e) of the CARES Act; FAQs 85 and 86.

[lii] May 7, 2020 letter from the Treasury to the Chair of the Senate Finance Committee. See FAQ 64, especially Ex. 2.

The Program

The Paycheck Protection Program[i] has been welcomed by many as the cornerstone of the CARES Act.[ii] It was passed by Congress and signed into law by the President shortly after the government-ordered shutdown of businesses and other organizations[iii] throughout the country as part of the effort to contain the spread of the coronavirus, and in the wake of the economic downturn that followed this countermeasure.

The Program offers many small businesses[iv] – both those that are shuttered and those that remain open – the cash liquidity they need to retain much of their workforce at salaries that approach pre-shutdown levels.[v] It also provides these businesses the wherewithal to pay their rent and utilities, as well as certain other pre-existing indebtedness.

The Federal government, working through private lenders,[vi] is making the above-referenced funds[vii] available to an eligible business through a nonrecourse, unsecured, 100 percent government-guaranteed loan.

The first PPP loans were made on April 3 – only one week after enactment of the Program – and will continue to be offered, provided funds are available, until June 30, 2020.[viii]

PPP Loan Forgiveness

A key feature of the Program provides that a business will not be required to repay the principal amount of its PPP loan[ix] if the business uses the loan proceeds for certain statutorily prescribed purposes[x] – specifically, payroll costs, rent, utilities, and certain pre-existing indebtedness – over the eight-week period that begins with its receipt of the proceeds.[xi]

In order to fully enjoy this benefit, the business must be able to adequately substantiate its use of the proceeds.[xii] Moreover, the business must not have reduced its employee workforce or the total salary of any of its employees[xiii] during the eight-week period.[xiv]

These requirements – that the loan be used to retain workers and maintain payroll, to make lease and utility payments[xv] – are basically the same purposes that a business represents on its PPP loan application as its reasons for seeking the loan.[xvi]

Once the loan is forgiven, the SBA will remit to the lender (no later than 90 days after the date on which the amount of the forgiveness is determined) funds equal to the amount forgiven, plus any interest accrued thereon;[xvii] thus, the government will indemnify the lender for its “loss.”

Through this mechanism, a business that fully satisfies its obligations under the Program may effectively be treated as having received a grant of money from the government.[xviii]

Forgiveness: Tax Treatment

According to the legislation, for Federal tax purposes, the amount of any PPP loan which is forgiven, as described above, will be excluded from the gross income of the borrower-business,[xix] notwithstanding that it would otherwise have been includible as income from the discharge of indebtedness.[xx]

In terms that a child would appreciate – yes, I’m a big kid – if forgiveness of the PPP loan was the whipped cream on a sundae, the exclusion of such loan forgiveness from income was the cherry on top.[xxi]

The CARES Act is otherwise silent as to the tax treatment of the cash flows under the Program. It does not address (i) the receipt of the loan proceeds by the business, (ii) the receipt of the salary by the employees of the business, or the receipt of the rent by the business’s landlord, and (iii) the payment of the foregoing expenses by the business.

Moreover, neither the Senate nor the House has contemporaneous legislative history regarding the CARES Act, such as a committee report or technical explanation, which sheds light on these tax issues; and although the Joint Committee on Taxation has prepared a helpful summary of the legislation’s tax provisions, it does nothing more than repeat the language of the forgiveness provision.[xxii]

Borrowed Funds, Generally

If we accept the PPP loan as bona fide indebtedness – i.e., its forgiveness is not a foregone conclusion[xxiii] – then the business’s receipt of the loan proceeds should not be includible in the gross income of the business for purposes of determining its income tax liability. On these facts, as in the case of any other loan, the business has not realized an accretion in value; the loan has to be repaid.

In general, the business’s use of borrowed proceeds does not affect the tax treatment of the expenditures made by the business using such proceeds. Thus, a business that uses loan proceeds to satisfy its ordinary and necessary operating expenses, including, for example, reasonable salaries and rent, may nevertheless deduct the expenses in determining its taxable income.[xxiv] Similarly, if the borrowed sums are used to acquire depreciable property for use in the business, the business may claim depreciation deductions[xxv] in respect of such property.[xxvi] If the loan is used to acquire inventory, the amount so expended is added to cost of goods sold.[xxvii]

The flipside of this favorable tax treatment? The business may not deduct its repayment of the loan principal.[xxviii]

Much the same way that the use of borrowed funds by a business generally does not affect its tax treatment of the business expenditures made using such funds, the tax treatment of the recipient of those payments does not depend upon their origin as loan proceeds. Thus, the employee to whom salary is paid using these proceeds, or the landlord to whom rent is paid using borrowed funds, must include the amount received in its gross income for purposes of determining its tax liability.[xxix]

Application for Forgiveness

Unlike most loans, the Program allows a business to apply for forgiveness of its PPP loan. Such an application may be filed after the end of the eight-week period during which the loan proceeds are supposed to have been used for their legislatively mandated purposes, and must include documentary evidence that demonstrates the business’s use of the loan proceeds and supports its request for forgiveness of the loan.

The lender has 60 days after receipt of the borrower’s application to issue a decision thereon.[xxx] Until the PPP loan is forgiven, it remains a debt of the business.[xxxi]

Reasonable Assumption?

In light of the foregoing, and given the overall emphasis of the CARES Act’s tax provisions on assisting businesses with generating liquidity,[xxxii] – presumably for the period following the forgiveness of the PPP loan, during which businesses will likely not be operating at pre-lockdown levels – many businesses that have applied for PPP loans, and many that have already received them, and have been making payments using the proceeds from such loans, have done so under the assumption that such payments will be deductible for tax purposes.

The IRS Finally Speaks

On April 30, 2020, however, the IRS issued Notice 2020-32 (the “Notice”) – more than one month after the enactment of the Program, and almost four weeks after the submission of the first PPP loan applications.

According to the Notice, it “clarifies” that no deduction will be allowed under the Code for an expense that would otherwise be deductible by a business if the payment of the expense – i.e., the use of the loan proceeds by the business for payroll costs, rent and utilities, in accordance with the terms of the Program – results in forgiveness of a PPP loan pursuant to the CARES Act, and the income associated with such forgiveness is excluded from gross income for tax purposes.[xxxiii]

The CARES Act, the Notice states, provides that, for purposes of the Code, any amount which would otherwise be includible in the gross income of the borrower-business, by reason of the forgiveness of the PPP loan under the Program, “shall be excluded from [the] gross income” of the business. The Notice explains that this includes “any category of income that may arise from loan forgiveness under the Program, regardless of whether such income would be (1) properly characterized as income from the discharge of indebtedness under section 61(a)(11) of the Code, or (2) otherwise includible in gross income under section 61 of the Code.”

Before continuing with our summary of the Notice, query to what other category of income the IRS is referring therein that may arise from loan forgiveness? It is obvious that the relationship between the creditor and the debtor may result in the forgiveness being treated as something other than cancellation of indebtedness income; thus, for example, the forgiveness of a loan may be treated as a gift, a contribution to capital, an adjustment or credit to purchase price, compensation for services or for the use of property, or a distribution. However, with the exception of a “contribution to capital,”[xxxiv] none of these alternative treatments makes any sense in the context of a PPP loan.

The Notice concedes that the CARES Act does not address whether deductions otherwise allowable under the Code for payments of “eligible expenses” by the borrower-business will still be allowed if the PPP loan is subsequently forgiven “as a result of the payment of those expenses.”

As stated earlier, the Code generally provides for a deduction for all ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business. The rent obligations, utility payments, and payroll costs paid comprise typical trade or business expenses for which a deduction under the Code is usually appropriate.

The Notice points out, however, that no deduction is allowed to a taxpayer under the Code for any amount, otherwise allowable as a deduction, that is allocable to one or more classes of income that are wholly exempt from the income tax.[xxxv] The purpose of this rule is to prevent a double tax benefit: the deduction of the payment made with the loan proceeds and the subsequent exclusion of such loan proceeds from gross income notwithstanding the forgiveness of the loan.

This disallowance provision, the Notice explains, applies to otherwise deductible expenses incurred for the purpose of earning or otherwise producing tax-exempt income. It also applies where tax-exempt income is earmarked for a specific purpose and deductions are incurred in carrying out that purpose.[xxxvi]

The Notice explains that, to the extent the CARES Act operates to exclude from gross income the amount of a forgiven PPP loan, it results in a “class of exempt income.” Therefore, the Notice concludes, the Code disallows any otherwise allowable deduction for the amount of any payment of an eligible PPP expense to the extent of the resulting loan forgiveness because such payment is allocable to tax-exempt income. “This treatment,” the Notice observes, “prevents a double tax benefit.”

According to the Notice, this conclusion is consistent with prior guidance of the IRS which provides that, where tax-exempt income is earmarked for a specific purpose, and expenses are incurred in carrying out that purpose, the Code denies the deduction of such expenses because they are allocable to the tax-exempt income. The Notices states that the direct link between (1) the amount of tax-exempt loan forgiveness that a PPP loan recipient receives pursuant to the CARES Act, and (2) an equivalent amount of the otherwise deductible payments made by the recipient for expenses, constitutes a sufficient connection for the Code to disallow deductions for such payments under any provision of the Code, to the extent of the income excluded under the CARES Act.[xxxvii]

How “Strong” is the Notice?

The IRS’s reasoning for denying a deduction to a business that uses its PPP loan proceeds in accordance with the legislative mandate of the CARES Act to retain its employees and to maintain their salaries is somewhat misguided; it also presents a “chicken and egg” problem.

The Notice relies upon the tax treatment of costs (i) that are incurred for the generation of income that is intrinsically tax-exempt, without regard to the actions of the taxpayer, or (ii) that are paid with funds that are intrinsically tax-exempt, without regard to the actions of the taxpayer.

It then tries to equate these situations with the exclusion from gross income for any debt forgiveness that may be granted to a business which uses its PPP loan proceeds to pay the salaries of its employees (among other things); thus, on the one hand, it treats the loan as if it were not a loan but, rather, a tax-exempt grant, and on the other, it treats the forgiveness (and the attendant exclusion from income) as the tax-exempt income to be generated by the expenditure of the funds for the directed purpose.

An Alternative

Fortunately, there is a better alternative, one that is both more in line with the economic goal of the CARES Act, and more defensible from a tax perspective. This alternative is premised on respecting the PPP loan as such.

The cancellation of a taxpayer’s indebtedness is generally treated as ordinary income.[xxxviii] There are circumstances, however, in which the taxpayer is not required to recognize such income.[xxxix] For example, the Code has long provided that the income realized by a taxpayer by reason of the discharge of the taxpayer’s indebtedness will not be included in the taxpayer’s gross income if the discharge occurs in a bankruptcy proceeding[xl] or when the taxpayer is insolvent, to the extent of such insolvency.[xli] Over the years, additional non-recognition situations have been added to the Code for which Congress has determined that recognition of discharge of indebtedness income, and the resulting tax liability, would not serve society well.[xlii]

That is not to say that Congress decided to give taxpayers a free ride under the cancellation of indebtedness rules, having allowed them to spend the borrowed funds, claim deductions therefor, and still avoid the recognition of income upon the discharge of such indebtedness.

Rather, Congress has recognized that such immediate recognition would not be appropriate under the circumstances, when the debtor business was likely in need of liquidity.[xliii] However, in recognition of the accretion in value realized by the debtor, and in order to recapture the tax benefit bestowed upon the debtor by reason of the exclusion of the discharged indebtedness from the gross income of the business, Congress required the business to reduce certain tax attributes[xliv] which, over time, would otherwise have reduced the tax liability of the business. In this way, the business repays the tax benefit over time.[xlv]

Why wouldn’t this approach apply under the current circumstances? It would provide the borrower-business with badly needed liquidity for the post-PPP loan period, while also ensuring that the business, assuming it survives, does not enjoy a double tax benefit.

We are still in the early stages of the Program. The IRS should reverse the position set forth in the Notice. If it unwilling to do so, Congress has time to act before the appropriate tax returns have to be filed.

[i] The “PPP” or the “Program”. See Sections 1101-1107 of the CARES Act.

[ii] The Coronavirus Aid, Relief and Economic Security Act. Pub. L. 116-136.

[iii] Other than those deemed “essential.” The President declared a national state of emergency on March 13, 2020, and the legislation was enacted on March 27, 2020.

As I write this, some states are already taking steps to reopen their economies. I’m certain they mean well, but like Theoden when he led his people to Helm’s Deep, I fear they too are underestimating the threat facing them.

[iv] See Section 1102(a)(2)(D) of the CARES Act. The definition of “small business” has been the subject of much discussion over the last couple of weeks. If I were feeling magnanimous, I’d say that Congress was sloppy. The problem with that, though, is that Congress was pretty specific in the language chosen to describe what it meant by “small.” Because I’m not in a generous mood, I’m inclined to say that Congress got caught. That’s a subject for another day.

[v] Notwithstanding that many of these employees were in no position to work because the employer-businesses were still closed by government order. Indeed, many employees requested to be fired by their employers in order to qualify for state unemployment benefits which, when supplemented by the $600 per week stipend payable by the Federal government under the CARES Act, put them in a better position economically than if they had remained employed. Go figure. I seem to recall some Senators predicting that would happen. Again, that’s another subject for another day.

[vi] Many of whom seem to have forgotten a certain bailout not that long ago.

[vii] The CARES Act appropriated $349 billion for this purpose. On April 16, the Program announced it had run out of money. The following week, Congress passed the “Paycheck Protection Program and Health Care Enhancement Act” (“CARES Act 3.5”), which authorized an additional $321 billion for the Program.

[viii] Section 1102(a)(2) of the CARES Act.

[ix] Section 1106(b) of the CARES Act.

[x] Which were subsequently modified somewhat by the Small Business Administration and the Department of the Treasury. For example, the statute does not specify what portion of the loan proceeds must be applied toward the payment of payroll costs – the SBA, however, has indicated that at least 75 percent of the proceeds must be so used. See Q&A 2.o. in Part III of the interim final rule, Business Loan Program Temporary Changes; Paycheck Protection Program, Docket No. SBA-2020-0015, 85 Fed. Reg. 20811, 20813-20814 (April 15, 2020).

In some cases, this is simply impossible. Take for example, the case of a business, like a restaurant, that typically has relatively low payroll costs and high rent.

[xi] In the case of a loan made on June 30, for example, the eight-week period will end on August 24, 2020.

[xii] Section 1106(e) and (f) of the CARES Act.

[xiii] This applies only to an employee with an annualized salary of not more than $100,000. What’s more, such an employee’s salary may be reduced by up to 25 percent without adverse consequences to the employer. Section 1106(d)(3) of the ARES Act.

[xiv] Section 1106(d) of the CARES Act. However, the statute also affords the business the opportunity to cure these failures no later than June 30, 2020. Section 1106(d)(5).

[xv] See the definitions in Section 1106(a) of the CARES Act.

[xvi] To the extent the business fails to satisfy the above requirements, at least a portion of the loan will remain outstanding; according to the statute, the loan will bear interest at an annual rate not to exceed 4 percent, and will be payable over a term not to exceed ten years.

The SBA has set the interest rate at 1 percent and the term of the loan at 2 years; what’s more, the repayment schedule includes a six-month deferral.

[xvii] Section 1106(c)(3) of the CARES Act.

[xviii] Think of it as a quasi-“substance over form” analysis.

[xix] Section 1106(i) of the CARES Act.

[xx] IRC Sec. 61(a)(11); Reg. Sec. 1.61-12; IRC Sec. 108.

[xxi] The open question, until last week, was whether that sundae also came with sprinkles or peanuts?

What? Were you expecting a reference to celery dipped in hummus, with flax seeds drizzled over it? C’mon.

[xxii] Joint Committee on Taxation, Description of the Tax Provisions of Public Law 116-136, the Coronavirus Aid, Relief, and Economic Security (“CARES”) Act (JCX-12R-20). See page 104.

April 23, 2020.

[xxiii] In light of the uncertainty expressed by many loan recipients over how and when they are to spend the proceeds, the SBA may end up with more debtors than they bargained for.

[xxiv] IRC Sec. 162.

[xxv] Including bonus depreciation.

[xxvi] IRC Sec. 167.

[xxvii] IRC Sec. 263A.

[xxviii] As distinguished from the interest paid by the borrower to the lender in exchange for the use of the lender’s funds. The tax treatment of such interest payments may depend upon the uses to which the funds are put. IRC Sec. 163.

[xxix] IRC Sec. 61.

[xxx] In the case of a PPP loan made on June 30, the eight-week period ends on August 24; if the business applies to the lender for forgiveness on August 25, the lender has 60 days – until October 24, 2020 – to decide whether the business qualifies for forgiveness. Section 1106(g) of the CARES Act.

[xxxi] Albeit one that, by statute, is unsecured, nonrecourse, and guaranteed by the Federal government.

[xxxii] For example, the relaxation of the NOL, excess business loss, and interest deduction rules, and the delay of payment of the employer share of payroll taxes. See Section 2301 through 2308 of the CARES Act.

[xxxiii] Section 1106(i) of the CARES Act.

[xxxiv] In the sense of IRC Sec. 118. See the changes made thereto by the Tax Cuts and Jobs Act.

[xxxv] The Notice cites IRC Sec. 265(a)(1) and Reg. Sec. 1.265-1.

The term “class of exempt income” means any class of income that is either wholly excluded from gross income under the Code or wholly exempt from taxes under the provisions of any other law. Reg. Sec. 1.265-1(b)(1).

[xxxvi] In which case, the deductions are treated as allocable to the tax-exempt income.

[xxxvii] Inexplicably, the Notice finishes its discussion by stating that the deductibility of payments is also subject to disallowance where the taxpayer is reimbursed for such payments. This is a corollary to the tax benefit rule under which the gross income for a tax year includes the recovery in that year of an expense deducted in another.

Although the concepts underpinning the rule may be extended to other scenarios, the debt forgiveness in question is not one of them.

[xxxviii] IRC Sec. 61(a)(11).

[xxxix] IRC Sec. 108(a).

[xl] IRC Sec. 108(a)(1)(A).

[xli] IRC Sec. 108(a)(1)(B) and 108(a)(3).

[xlii] For example, IRC Sec. 108(a)(1)(D), which was added in 1993, in response to the housing bust of the early 1990s, when, by reason of a significant and sudden drop in the real estate market, owners found themselves with property that was underwater.

[xliii] There is an exception. Under IRC Sec. 108(e)(2), if an accrual basis taxpayer claimed a deduction for an expense that was later forgiven, the taxpayer would have to recognize the discharged liability as income.

[xliv] In an amount determined by reference to the amount of debt discharged that was excluded from income. IRC Sec. 108(b)(3).

[xlv] IRC Sec. 108(b). Among these tax attributes are NOLs, capital loss carryovers, the basis of property, and various credits.

For a somewhat analogous situation, see also IRC Sec. 118 and Sec. 362. According to Sec. 118 of the Code, prior to its amendment in 2017, gross income did not include any contribution to the capital of a corporation made by persons who are not shareholders of the corporation. This included a contribution from a governmental entity, provided the funds were used for certain capital expenditures and not for operating expenses. Assuming the funds were properly used and capitalized, the taxpayer was required to reduce their basis for the property acquired, thus ensuring the subsequent recognition of the “exempted” contribution.