We’ve Been Better

On March 1, 2020, New York had its first confirmed case of the coronavirus.[i] On March 6, pursuant to the Coronavirus Preparedness and Response Supplemental Appropriations Act[ii], over $8.3 billion in emergency Federal funding was appropriated to combat the spread of the coronavirus. On March 7, Governor Cuomo declared a state of emergency in New York.[iii] On March 13, President Trump declared a national state of emergency.[iv] On March 18, the Families First Coronavirus Response Act[v] became law. On March 20, Governor Cuomo signed the “New York State on Pause” Executive Order,[vi] which resulted in the statewide closure of many so-called “non-essential” businesses, and caused other such businesses to operate “remotely.”

On March 27, the President signed the Coronavirus Aid, Relief and Economic Security (“CARES”) Act[vii] which, among other things, created the $349 billion Paycheck Protection Program (“PPP”) to assist “small businesses” with 100 percent SBA-guaranteed forgivable loans. Last week saw the enactment of yet another coronavirus relief bill, which authorized an additional $321 billion of funding for the PPP.[viii]

Although this massive infusion of cash will certainly help many closely held businesses survive through this difficult period, many others are going to fail regardless of the government’s best intentions.[ix] What’s more, it is reasonable to assume that, even among those that survive, most are not likely to fully recover for many months to come given the state of the economy. For example, as of the end of last week, the estimated number of unemployment claims filed in the U.S. was approximately 26 million; the first quarter GDP is expected to show a decline of more than 3 percent, while the second quarter is expected to register a 25 percent drop in economic growth; other economic indicators are following suit.[x]

Then there are the state and local governments that have thrown their budgets out the proverbial window. Many of these are experiencing severe economic stress as tax revenues have plummeted, in part due to the reduction in economic activity, and in part because of the deferrals granted to taxpayers for the payment of various taxes.[xi] It may not be long before these public employers start to lay off workers and to cut services.

Time to Start Looking Forward?

In light of the foregoing, it may be difficult for a business owner to start thinking about, let alone implementing, a plan for what will likely be an uncertain – perhaps even “hostile” – economic and tax environment for business once the nation re-opens.

Granted, there are many factors beyond the control of any business that may nevertheless have a significant impact upon the well-being of the business; for example, the relaxation of social distancing measures. However, there are other factors that, generally speaking, may be controlled, or at least influenced, by the owner – it is these factors to which the owner should devote their attention so as to prepare themselves and their business to withstand the difficult times ahead.

One goal on which businesses and the Federal government are both focused is the relatively immediate generation of liquidity in the private sector. The CARES Act provided a number of means by which this may be accomplished – it is up to the business and its owners to take advantage of the opportunities presented.

PPP Loan Forgiveness

It seems as though everyone and their brother[xii] has applied for a PPP loan.[xiii] A business which has received the requested loan proceeds has eight weeks from such receipt to expend the funds on permitted expenses, including “payroll costs,”[xiv] rent, utilities, and certain other items.

After the eight-week period, the business may apply to its lender for forgiveness of the loan. In order to secure this benefit, the business will have to provide documentation that demonstrates how it has spent the funds, including proof that at least 75 percent of the funds were applied toward payroll costs.

Any loan that is forgiven in accordance with the terms of the PPP will not be included in the gross income of the borrower-business as income from cancellation of indebtedness.[xv]

At the same time, nothing in the CARES Act denies the borrower-business the ability to claim a deduction for the expenses paid with the loan proceeds in determining the taxable income of the business.[xvi] Thus, the payment of the salaries, rent, etc. for which the PPP loans are intended will be deductible, thereby reducing taxable income or increasing losses.

However, the amount of the loan forgiven may be reduced – meaning that a portion of the loan will have to be repaid[xvii] – if the business has reduced by more than 25 percent the salary of any employee with an annual salary of not more than $100,000. Likewise, the loan forgiveness may be reduced if a business reduces its number of employees.

Notwithstanding that a business may have reduced salaries and/or workforce, it may still qualify for full forgiveness of the PPP loan (as well as any accrued interest) if the business restores salaries and fills “vacant” positions no later than June 30, 2020.[xviii]

It should be noted that there is nothing in the PPP that prevents a business from reducing the salaries of employees whose salaries exceed $100,000. Moreover, the legislation does not prohibit the reduction of salaries or workforce at any level after the end of the eight-week spending period. Thus, a business that survives long enough to spend the PPP loan proceeds in accordance with the statute is not required to maintain salary levels or to retain employees if the business cannot afford to do so.

Building Liquidity: Tax Refunds, Tax Reductions

The PPP will support the continued existence of some closely held businesses that do not lay off their employees and do not cut their salaries, especially those businesses that had few reserves[xix] before they were suddenly shut down. But will it help these businesses to “reboot” after the health crisis passes?

Not necessarily.

Other parts of the CARES Act, however, may assist certain businesses to obtain some badly needed cash relatively quickly, and to thereby mitigate the economic effects of the health crisis.[xx]

I am referring to the few business tax-related provisions in the legislation. Most of these are not “new” tax benefits or incentives; rather, they represent the temporary relaxation of amendments enacted as part of the Tax Cuts and Jobs Act of 2017 (the “TCJA”).[xxi]

In sum, the intended effect of the CARES Act’s tax provisions is to allow businesses that realized losses during prior years (before 2020) to convert those losses into refunds that will be payable (and usable) currently, and to permit business owners to use other losses to offset otherwise taxable income, thereby enabling those tax dollars to be applied elsewhere.

In light if these changes, businesses should review earlier year returns to see if a refund is available. If a business believes it has overpaid tax for 2019, it should file its tax return and claim a refund as soon as possible.

Delay Tax Payments

The due date for filing Federal income tax returns and, more importantly for our purposes, for making Federal income tax payments otherwise due April 15, 2020, was automatically postponed to July 15, 2020.[xxii]

Unless a business is owed a refund for 2019, it should probably take advantage of the deferral.

NOLs

Historically speaking, in the case of a business coming out of an economically challenging period, the ability to carry current losses back to profitable years often provided a ready source of liquidity by generating a refund of monies that the business could use in its operations.

The TCJA eliminated a taxpayer’s ability to carry back its NOLs. It also limited the use of loss carryovers to a taxable year to 80 percent of the taxpayer’s taxable income for such year, though it permitted NOLs to be carried forward indefinitely.[xxiii]

The CARES Act allows a taxpayer that realizes an NOL during a taxable year beginning after December 31, 2017 and before January 1, 2021 to carry such NOL back to each of the five taxable years preceding the year of the loss; for example, a loss arising in 2020 may be carried back to 2015.[xxiv]

The CARES Act also repealed the “80 percent of taxable income” limitation for NOL carryovers arising in taxable years beginning before January 1, 2021.[xxv]

Thus, a taxpayer that realized an NOL during a taxable year beginning in 2018 or in 2019 may carry those NOLs back five years, which may create an opportunity for a refund claim in 2020 with respect to an earlier year for which the taxpayer had an income tax liability.

In addition, an NOL realized in a taxable year beginning in 2018 that is carried to 2019 and 2020, and an NOL realized in a taxable year beginning in 2019 that is carried back to 2018 and forward to 2020, may be utilized without regard to the TCJA’s “80 percent limitation” – the NOLs may be used to offset all of the taxpayer’s taxable income.[xxvi]

Unfortunately for a taxpayer that suffers a loss during a taxable year that begins in 2020, the tax benefit attributable to the carryback of such loss will not be realized until the taxpayer files its return for that year, in 2021, which is still several months away. That is not to say that a refund at that time would not be welcomed – it’s just that the liquidity it may provide would likely be more helpful sooner rather than later.

That being said, the tax benefit attributable to the realization of significant losses in 2020 may be used to facilitate certain strategic transactions during 2020. For example, if a business operated through a corporation wants to dispose of an unwanted asset, the NOLs may be used to offset the gain from such disposition. The same reasoning may apply with respect to the taxable spin-off of a line of business to one or more of the corporation’s shareholders.[xxvii] Similarly, if a corporation with losses incurred during 2020 is planning the sale of its assets, it may want to complete the sale in 2020, before the reinstatement of the 80 percent limitation in 2021.

Non-Corporate Taxpayer Losses

Following the enactment of the TCJA, for taxable years beginning after December 31, 2017 and before January 1, 2026, the “excess business losses” of a taxpayer other than a corporation are not allowed for the taxable year. Instead, such losses are carried forward and treated as part of the taxpayer’s NOL carryforward in subsequent taxable years.[xxviii]

A taxpayer’s excess business loss for a taxable year – which is determined after the application of the passive loss rules – is the excess of the aggregate deductions of the taxpayer attributable to trades or businesses of the taxpayer, over the sum of aggregate gross income or gain of the taxpayer (whether or not related to a trade or business) plus a “threshold amount.”[xxix]

This provision was to be effective for taxable years beginning after December 31, 2017, but the CARES Act defers the effective date (actually, suspends it retroactively) to taxable years beginning after December 31, 2020.

Consequently, an individual taxpayer who realizes a loss from an operating business in a taxable year beginning before January 1, 2021 – whether as a sole proprietor, as a partner in a partnership, or as a shareholder in an S corporation – and who runs the gauntlet of the basis, at risk and passive loss rules,[xxx] will be allowed to apply such losses against their other income for such taxable year, including salary and investment income.

As in the case of NOLs described above, this change will afford some taxpayers an opportunity to claim a refund now with respect to their taxable years beginning in 2018 and 2019, and to use the proceeds therefrom in their business.

Business Interest Deductions

Generally speaking, interest paid or accrued by a business is deductible in the computation of taxable income, subject to a number of limitations. The TCJA further limited the deduction for business interest for a taxable year to an amount equal to 30 percent of the adjusted taxable income[xxxi] of the taxpayer for the taxable year. The amount of any business interest not allowed as a deduction for any taxable year is treated as business interest paid or accrued in the succeeding taxable year, and is carried forward indefinitely, subject to certain restrictions.[xxxii]

The limitation does not apply to taxpayers with average annual gross receipts for the three-taxable year period ending with the prior taxable year that do not exceed $25 million. In addition, at the taxpayer’s election, any real property trade or business is not treated as such for purposes of the limitation, and therefore the limitation does not apply to such a trade or business.

This rule applies to taxable years beginning after December 31, 2017. However, according to the CARES Act, in the case of any taxable year beginning in 2019 or 2020, the Act increases the “interest deduction limitation” from 30 percent to 50 percent of adjusted taxable income.[xxxiii]

In this way, a taxpayer filing their income tax return for 2019 may take advantage of the increased limitation to further reduce their income tax liability and to retain the tax savings in the business.

In addition, for a taxable year beginning in 2020, the Act permits a taxpayer to use their 2019 adjusted taxable income for purposes of determining their “interest deduction limitation” for 2020. Thus, if the taxpayer’s 2019 adjusted taxable income is greater than that for 2020 – which may very well be the case given our circumstances today – the taxpayer may claim a greater interest deduction and, thereby, further reduce their income tax liability, thereby retaining liquidity in the business.

Although the relaxation of the limitation on interest deductions[xxxiv] may entice a taxpayer to borrow funds from commercial lenders during 2020, it is important for the taxpayer to recognize that the TCJA’s 30 percent cap will be reinstated in 2021.

Real Estate

As indicated above, a taxpayer with a real property trade or business may have elected out of the application of the interest limitation rule.[xxxv] In doing so, the electing taxpayer was precluded from claiming bonus depreciation,[xxxvi] and was required to extend the depreciation period for its real properties.[xxxvii]

In recognition of the CARES Act’s increase of the interest limitation from 30 percent to 50 percent of adjusted taxable income, the IRS has issued guidance[xxxviii] that allows a qualifying taxpayer to withdraw their earlier election, and to thereby claim an increased depreciation deduction (including bonus depreciation)[xxxix] for those years to which the election would otherwise have applied.

Thus, a real estate business that reverses its election out of the interest limitation regime may thereby have another opportunity for a refund of taxes paid.

Like Kind Exchanges

Most like kind exchanges are effected as deferred exchanges, with the replacement real property being acquired sometime after the sale of the relinquished real property. Generally speaking, in order for such a transaction to qualify for tax deferral as a like kind exchange,[xl] the replacement property must be identified no later than 45 days after the date of the sale of the relinquished property (the “identification period”),[xli] and it must be acquired no later than 180 days after the date of such sale (the “exchange period).[xlii]

The above-described dates are prescribed by statute and, generally, cannot be changed by the IRS. However, because the President declared a national emergency,[xliii] the IRS was authorized to postpone the time for taxpayers to perform specified “time-sensitive actions,”[xliv] including the identification of a replacement property, and the acquisition of such replacement property, in connection with a transaction intended to qualify as a like kind exchange.

Specifically, the IRS has determined that identification and exchange period deadlines occurring between April 1 and July 15, 2020 (the “relief period”) are extended to July 15, 2020. Any such period that does not end within the relief period is not affected.

Thus, a taxpayer that began an exchange before or during the relief period may want to take advantage of the extended identification or replacement period in order to avoid a taxable event and the resulting outflow of cash to pay the tax liability.

Deferring Employment Taxes

The CARES Act allows employers to defer the deposit and payment of the employer’s share of social security taxes.[xlv]

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.

Employers who have received a PPP loan, that has not yet been forgiven, may defer deposit and payment of the employer’s share of social security tax. 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. 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.[xlvi]

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

Executive Compensation

Thus far, we have been considering how opportunities afforded by the CARES Act, including IRS actions related thereto, may assist a taxpayer in generating liquidity to replace the revenues lost as a result of the shutdown and the resulting economic downturn.

Of course, a business may also try to save money by reducing the salaries of highly compensated employees. As indicated below, this may be easier said than done; nonetheless, a business should consider all of its options, being mindful, however, of the tax and other potentially adverse consequences thereof.

For example, a reduction in salary may give an executive the right to terminate their employment “for good reason,” thereby triggering an immediate obligation for the employer to make severance payments under an employment agreement.[xlviii]

Similarly, a termination of employment, or a reduction in work hours, may trigger the payment of deferred compensation under the terms of a nonqualified deferred compensation agreement.[xlix]

A business may also consider the suspension of contributions toward an executive’s future deferred compensation benefit provided their agreement allows such a suspension or the employee agrees to it.[l]

The business may also seek to suspend or defer payments to be made to an executive pursuant to a nonqualified deferred compensation plan. However, such a deferral may violate Section 409A of the Code – thereby triggering imposition of a 20 percent excise tax on the executive – unless it can be demonstrated that the current payment would “jeopardize” the business as a going concern.[li]

If the plan allows the participating executive an election to delay a payment or to change the form of a payment, such an election may not take effect until at least 12 months after the date on which the election is made,[lii] and the payment with respect to which the election is made must be deferred for a period of at least 5 years from the date such payment would otherwise have been made.[liii]

Alternatively, a business make also seek to terminate such a plan; however, such a termination will likely violate Section 409A because it is being made in connection with the “downturn” in the health of the employer’s business.[liv] Instead, the executive and the business may negotiate a reduction in the benefits to be provided to the executive without violating Section 409A, provided they do not agree to substitute another, “replacement” benefit.[lv]

Incentive Compensation

When cash pipeline is constricted, a business may have difficulty in paying executive bonuses or raising executive salaries. In that case, in order to keep its executives incentivized, the business may want to consider some form of equity-based compensation arrangement.

Where the actual issuance of equity is not “required,”[lvi] an arrangement similar to a so-called “phantom stock” plan may be advisable. Such a plan may try to mimic the economics of actual ownership (for example, by paying compensation to an executive) when the business makes distributions to its owners, or it may simply provide for a payment upon the sale of the business, with the amount thereof being based upon a percentage of the net proceeds.

Moreover, the phantom equity plan may be structured to defer income recognition, and the resulting tax liability, until the occurrence of a liquidity event.

Renegotiating Debt

Many businesses will emerge from the shutdown still owing whatever long-term debt they had previously incurred.[lvii] Some of these same businesses may have to borrow additional sums in order to replenish inventories and supplies, to pay amounts owing to vendors, or perhaps to “disinfect” their place of business.[lviii]

The business may ask its existing lender to consider a modification of the terms of the indebtedness owed by the business so as to accommodate what is likely to be a reduced flow of revenue into the business. The existing lender will probably require some consideration for any concessions given to the business.

For example, the business may have to transfer appreciated property to the lender in satisfaction of a portion of its indebtedness. If the amount deemed satisfied by such transfer exceeds the fair market value of the property, the business will realize both gain from the deemed sale of the property, and cancellation of indebtedness (“COD”) income to the extent the debt forgiven exceeds the value of the property.[lix]

As for the modifications requested by the business, these may include a reduction in the interest rate, a forgiveness of accrued but unpaid interest, perhaps a partial forgiveness of the outstanding principal of the loan, an extension of the maturity date, a relaxation of financial covenants, or some other change in payments terms.

If principal is forgiven, the amount forgiven will be included in the gross income of the business as ordinary income.[lx]

Similarly, the combined effect of several agreed-upon changes – for example, to the interest rate, the maturity date, and the payment schedule – may rise to the level of a so-called “significant modification” of the loan.[lxi] In that case, the “old” debt will be treated as having been exchanged for the “new debt;” if the issue price of the new debt given by the business in exchange for the old debt held by the lender is less than the issue price for the old debt, then the business will realize COD income. If the business is a pass-through entity for tax purposes, such as a partnership or S corporation, the income will be included by the owners on their tax returns.[lxii]

Of course, there are certain exceptions to the recognition of COD income. For example, if the taxpayer is insolvent,[lxiii] the COD income will be excluded from the taxpayer’s gross income provided the debt cancelation does not cause the taxpayer to become solvent.[lxiv]

A business that takes advantage of one of these exceptions, will be required to reduce certain tax attributes; for example, NOLs, certain tax credits, and the adjusted basis of its property.[lxv]

Renegotiating Leases

As in the case of a debt obligation, a business is likely to enter the re-opened market with a lease obligation related to the space out of which the business operates. The rent payable by the business is likely a fixed base amount that may be periodically adjusted according to some commercial index.

In any case, if the business is expecting a reduction in revenue for the foreseeable future, it may want to ask its landlord to consider a change in the terms of its lease, especially with respect to the amount and timing of the rent payable thereunder. For example, the business may ask for a reduction in the rent payable, or it may ask that payment of the rent be deferred, for some period of time.

Unfortunately, these seemingly reasonable and straightforward requests, if accepted and implemented, may risk the application of some very complex tax avoidance rules that are directed at the timing of the landlord’s inclusion of the rental in their gross income, on the one hand, and at the timing of the tenant’s deduction of such rental, on the other.[lxvi]

Thankfully, there are various safe harbors which, if satisfied, will prevent the application of these rules and will permit the parties to report the rent in accordance with their normal method of accounting.[lxvii] Among these, for example, is a rent holiday, the duration of which is reasonable (determined by reference to commercial practice in the locality where the property is located), and which does not exceed the lesser of 24 months or 10 percent of the lease term.

Bad Debts

Although a business may be indebted to a commercial lender, it is also possible for the business to stand in the shoes of a creditor. In the event a bona fide debt owing to the business becomes worthless during a taxable year, the business is allowed a bad debt deduction in determining its income tax liability for such tax year.[lxviii] “Business bad debts” are deductible against the ordinary income of the business.

Generally, a business bad debt is a loss from the worthlessness of a debt that was either created or acquired in a trade or business of the lender, or was closely related to the lender’s trade or business when it became worthless.[lxix] A debt is closely related to the lender’s trade or business if the lender’s primary motive for making the loan was business-related.

In order to claim the deduction, the business must be able to establish that debt became worthless in the year for which the deduction is being claimed, and not in an earlier year.

Gift and Estate Planning

Another option for business owners to consider is whether it makes sense for them to, and whether they can, “rescind” gifts of business interests made in earlier periods.

It is a basic precept of estate and gift tax planning for the owner of a business to transfer interests in the business to a trust for the benefit of the owner’s family before such interests have appreciated in value. The goal of such a transfer is to use as little of one’s exemption amount as possible in order to remove the future value of the business interest from the transferor’s gross estate.

Of course, in retrospect, the business owner may regret having made such a transfer where the economy subsequently takes a turn for the worse. In that case, the owner may wish that they still had the benefit of all of the cash flow from the business, especially if their non-business assets, including retirement assets, have been adversely affected by the economic downturn.

What is the owner to do in these circumstances?

Well, if the owner had retained the right, in a non-fiduciary capacity, to reacquire the gifted property from the trust in exchange for fair market value consideration,[lxx] not only may the owner exercise such right, but they may do so without causing to trust to recognize any taxable gain.[lxxi]

The owner-transferor is thereby able to reacquire the business interest without adverse income tax consequences because the owner’s retained right causes the trust to be treated as a so-called “grantor trust” for purposes of the income tax.[lxxii] In other words, the transferor is treated for tax purposes as owning all of the assets and income of the trust; because one cannot sell property to oneself, the reacquisition of the interest is disregarded for income tax purposes.[lxxiii]

If the business owner has not yet made any gifts of interests in their business, they may want to wait at least until after the November elections.[lxxiv]

A Whole New World[lxxv]

We’re still in lockdown, and the economy is still in a downturn. When the lockdown is lifted, the economy will still be in a downturn, and will likely remain so for some not insignificant period of time – at least that is what I am assuming.

I am certain that many business owners share this assumption, which will, in turn, inform many of their decisions for several months to come.

In light of these circumstances, and all other things being equal, the goal from a tax perspective should be not only to transact business in as tax efficient a manner as possible, but also to build up as much liquidity in the business as possible. This will enable the business and its owners to ride out the downturn, and should put them in a position to expand once the economy finds its new equilibrium.

However, if the Federal government decides to increase tax rates or to eliminate various tax incentives – after all, someone has to pay for the money being distributed through the CARES Act and other programs – the arrival of this new equilibrium may be postponed.

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[i] The first death attributed to the coronavirus in N.Y. was on March 14, 2020.

[ii] P.L. 116-123.

[iii] https://www.governor.ny.gov/news/novel-coronavirus-briefing-governor-cuomo-declares-state-emergency-contain-spread-virus

[iv] https://www.whitehouse.gov/presidential-actions/proclamation-declaring-national-emergency-concerning-novel-coronavirus-disease-covid-19-outbreak/

[v] P.L. 116-127. The Act requires certain employers to provide their employees with paid sick leave or expanded family and medical leave for specified reasons related to COVID-19

[vi] https://www.governor.ny.gov/news/governor-cuomo-issues-guidance-essential-services-under-new-york-state-pause-executive-order

[vii] P.L. 116-136. The Act provided more than $2.2 trillion of Federal relief funds to counter the economic effects of the state-mandated closures and social distancing policies that were implemented to limit the spread of the virus.

[viii] Known as CARES Act 3.5. (The CARES Act being the third round of coronavirus-related Federal legislation.) The total relief package amounted to approximately $484 billion.

[ix] Call it a “natural law,” though the phrase – more accurately, its underpinnings – is out of favor in many circles.

[x] Pick your source – they’re all reporting the same thing. Durable goods orders, manufacturing, auto sales, consumer confidence – the news isn’t good. Banks are increasing their loss reserves. Other economic reports are expected this week, and the Fed is meeting in a couple of days.

“What about the stock markets?” you may ask. To which I would respond, “The equity market is not the economy.”

[xi] The next round of Federal stimulus legislation may include fiscal assistance for the states and for local jurisdictions. Thus far, Republicans and Democrats are not seeing eye-to-eye on this issue.

[xii] I think I nailed that idiom.

But seriously, I wonder how many businesses have decided against participating in the PPP. Such a business may have cash reserves and/or a line of credit sufficient to withstand a reduction in revenues. It may also be more willing to cut salaries and/or employees than to accept money from the government with strings attached.

[xiii] You may recall that the “sense of the Senate,” set forth in the Senate version of the bill that eventually became the CARES Act, indicated that the SBA “should issue guidance to lenders and agents to ensure that the processing and disbursement of covered loans prioritizes small business concerns and entities in underserved and rural markets, including veterans and members of the military community, small business concerns owned and controlled by socially and economically disadvantaged individuals . . . , women, and businesses in operation for less than 2 years.”

The CARES Act, however, seems to have ignored this. CARES 3.5 tries to redress the oversight.

[xiv] Which include wages, retirement benefits, health insurance, and certain other items paid by the business.

[xv] Section 1106(i) of the CARES Act. IRC Sec. 108.

[xvi] IRC Sec. 162. An oversight or a “gimme?” Definitely the latter.

[xvii] The CARES Act sets a 2-year term for the satisfaction of the loan; interest will be imposed at an annual rate of one percent; the business will have six months before it has to begin making payments under the loan.

[xviii] https://www.farrellfritz.com/sba-7a-loans-under-the-ppp/

[xix] See my Op Ed piece in The Empire Report: https://www.taxlawforchb.com/2020/03/lou-vlahos-op-ed-economic-losses-blame-the-virus-not-entirely-published-in-the-empire-report/

[xx] In addition to the provisions described below, the CARES Act includes the Employee Retention Tax Credit, which is designed to encourage businesses to keep employees on their payroll. The credit is available to eligible employers whose business has been adversely impacted by the coronavirus emergency. However, businesses taking advantage of the PPP are not allowed to claim the credit. The amount of the credit is equal to 50 percent of qualifying wages paid; however, such wages are capped at $10,000 in total per employee.

[xxi] P.L. 115-97. These amendments were intended to compensate for lost tax revenue attributable to the replacement of a graduated rate regime (with a maximum rate of 35 percent) with a flat corporate income tax rate of 21 percent.

[xxii] Notice 2020-18.

[xxiii] These changes were effective for NOLs arising in taxable years beginning after December 31, 2017. For example, NOLs for taxable years ending on December 31, 2018, or on December 31, 2019 (for calendar year taxpayers) could not be carried back. The same applied for any taxable year beginning on or after February 1, 2018 and ending on or after January 31, 2019 (for fiscal year taxpayers); thus, in the case of an NOL realized during the taxable year starting June 1, 2019 and ending May 31, 2020, the NOL could not be carried back to an earlier year.

It should be noted that a taxpayer may waive the carryback if they believe it will be more useful to carry the losses forward, notwithstanding the reinstatement of the 80 percent limitation after 2020. Notice 2020-24.

[xxiv] Section 2303(b) of the Act. Thus, these changes have retroactive effect.

A slightly modified version of the 80% limitation remains in effect for taxable years beginning after 2020.

[xxv] Section 2303(a) of the Act.

[xxvi] The 80 percent limitation is reinstated for taxable years beginning after December 31, 2020.

[xxvii] See IRC Sec. 311(b), Sec. 336, Sec. 355.

[xxviii] IRC Sec. 461(l). In the case of a partnership or an S corporation, the provision applies at the partner or shareholder level.

[xxix] The threshold amount for a taxable year is $250,000 per taxpayer, or $500,000 in the case of a joint return. The threshold amount is indexed for inflation.

[xxx] IRC Sec. 1366(d)/704(d), 465, and 469.

[xxxi] For purposes of this limitation, “adjusted taxable income” generally means the taxable income of the taxpayer computed without regard to any item of income, gain, deduction, or loss which is not properly allocable to a trade or business; certain other adjustments are also made.

[xxxii] IRC Sec. 163(j).

[xxxiii] Sec. 2306 of the Act.

[xxxiv] That, plus the low interest rate environment in which we find ourselves.

[xxxv] IRC Sec. 163(j)(7)(B).

[xxxvi] IRC Sec. 168(k)(2)(D).

[xxxvii] IRC Sec. 168(g)(8).

[xxxviii] Rev. Proc. 2020-22. Among other things, this guidance requires the filing of an election withdrawal statement that should be titled, “Revenue Procedure 2020-22 Section 163(j)(7) Election Withdrawal.”

[xxxix] The Act also corrected an error in the TCJA which prevented “qualified improvement property” from qualifying for bonus depreciation.

[xl] IRC Sec. 1031.

[xli] Reg. Sec. 1.1031(k)-1(c)(4) provides special rules for the identification of alternative or multiple replacement properties.

[xlii] Or, if earlier, by the tax return due date, determined with extensions, for the year of the sale. IRC Sec. 1031(a)(3).

[xliii] IRC Sec. 7508A. Rev. Proc. 2018-58.

[xliv] Notice 2020-23.

[xlv] 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.

[xlvi] https://www.farrellfritz.com/deferral-of-employment-tax-deposits-and-payments-through-december-31-2020/

[xlvii] 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.

[xlviii] A constructive termination.

[xlix] The key is the definition of “separation from service” under IRC Sec. 409A.

[l] Such a plan is unsecured, and the executive is treated as a general unsecured creditor. What if the plan requires the employer to periodically set funds aside in a rabbi trust so as to provide the employer with a source from which to satisfy its payment obligations under the deferred compensation plan?

[li] Reg. Sec. 1.409A-3(d).

[lii] Query whether this 12-month waiting period makes this option impractical from the perspective of the business?

[liii] IRC Sec. 409A(a)(4)(C).

[liv] Reg. Sec. 1.409A-3(j)(4)(ix)(C).

[lv] Reg. Sec. 1.409A-3(f).

[lvi] It’s all a matter of negotiation and leverage. However, it is often dependent upon the executive’s desire or ability to pay for equity, their aversion toward incurring an income tax liability upon the receipt of equity, and their reluctance to assume any of the responsibilities of actual ownership (for example, personally guaranteeing leases and loans).

[lvii] Hopefully, the business’s PPP loan will be forgiven.

[lviii] I’ve heard stories about how expensive a “deep” clean can be.

[lix] Reg. Sec. 1.1001-2.

[lx] IRC Sec. 108(a).

[lxi] Reg. Sec. 1.1001-3; IRC Sec. 108(e)(10). Basically, a change in yield on the debt, or a change in timing of debt payments.

It should be noted that the so-called “Cottage Savings” regulations include safe harbors for certain modifications to the terms of a debt obligation.

[lxii] IRC Sec. 702 and Sec. 1366. https://www.taxlawforchb.com/2017/12/revoking-s-corp-status-a-fraudulent-conveyance/

[lxiii] IRC Sec. 108(d)(3). The excess of its liabilities over the fair market value of its assets (including intangibles, like goodwill).

[lxiv] IRC Sec. 108(a)(1)(B) and Sec. 108(a)(3). It should be noted that the insolvency exception applies differently to C corporations, S corporations and partnerships. In the case of an S corporation, the insolvency is tested at the corporate level – if the corporation is insolvent, its shareholders will not recognize COD income. By contrast, in the case of a partnership, the exception is applied at the partner level – thus, a partner who is insolvent make benefit from the exception, while a solvent partner will have to include their share of the partnership’s COD in their gross income. IRC Sec. 108(d)(6) and (7).

[lxv] IRC Sec. 108(b), Sec. 1017.

[lxvi] IRC Sec. 467.

[lxvii] Reg. Sec. 1.467-3(c)(3).

[lxviii] IRC Sec. 166.

[lxix] Reg. Sec. 1.166-5.

[lxx] Of course, this leaves open the question of what property to transfer to the trust.

[lxxi] IRC Sec. 675(4).

[lxxii] IRC Sec. 671.

[lxxiii] Rev. Rul. 85-13.

[lxxiv] https://www.taxlawforchb.com/2020/03/think-before-you-gift-but-dont-take-too-long/

[lxxv] Don’t worry, I’m not singing the Disney song.

The Code as a Tool

The Internal Revenue Code is one of the tools employed by Congress to encourage certain behaviors that it has determined are in society’s long-term best interest and, therefore, worthy of the public’s financial support. Among the socially-desirable behaviors to which the Code is applied, perhaps the best-known is that of charitable giving by individuals and businesses to privately founded charitable organizations. The Code promotes the tax-paying public’s financial support for charitable organizations and their missions by allowing taxpayers to claim a deduction for certain charitable contributions, thereby subsidizing such contributions by reducing the taxpayers’ federal income tax liability.[i]

By its nature, the Code, like most statutes, takes a long-term view toward achieving the goals to which it has been dedicated; after all, human behavior can rarely be modified overnight. However, there are instances in which the Code may be, and has been, used to direct funds as quickly as practicable from the general public to those of its members that, as a result of some unforeseen disaster, natural or otherwise, are in greatest need.

What to Do?

While considering the recently enacted Coronavirus Aid, Relief and Economic Security (“CARES”) Act, Congress looked into its toolkit to see what means it had available for addressing the various consequences of the economic emergency arising from the government-ordered shutdown of many businesses, nonprofit organizations, and social institutions in response to the spread of COVID-19.

In the end, Congress decided to include in the CARES Act[ii] – along with other measures[iii] – a greatly enhanced charitable contribution deduction,[iv] based on the theory that those taxpayers who can afford to make such contributions either will be encouraged to do so or, if they were already predisposed, will be motivated to make gifts in larger amounts than they were otherwise planning.

Before describing those provisions of the Act that are directed at charitable giving, it would be helpful to understand, generally, how the Code promotes such giving.

The Charitable Contribution Deduction

In order to be deductible in determining a taxpayer’s federal income tax liability for a given year, the taxpayer’s transfer of property to a charitable organization (in the broadest sense) must meet several requirements: (i) the recipient must be an organization that Congress has determined is eligible to receive tax-deductible charitable contributions;[v] (ii) the transfer must be made with gratuitous intent and without the expectation of receiving a benefit of substantial economic value in return; (iii) the transfer must be complete (generally, it cannot be contingent);[vi] (iv) the transfer must be of a taxpayer-donor’s entire interest in the contributed property (generally, it cannot represent a partial interest);[vii] (v) the transfer must be made within the taxable year for which the deduction will be claimed; (vi) the transfer must be of money or property – not a contribution of services;[viii] and (vii) the transfer must be properly substantiated.[ix]

In the case of an individual, the taxpayer must be one who itemizes eligible expenditures[x] on their federal income tax return in determining their taxable income, rather than claiming the so-called “standard” deduction.[xi]

Limits – Generally

Ironically, at the same time that the Code encourages charitable giving by a taxpayer, it also imposes certain limitations upon the amount of the deduction that may be claimed by the taxpayer. Thus, the deductibility of a taxpayer’s charitable contributions in a given year is limited to a percentage of the taxpayer’s income for such year.[xii] Similarly, other special rules limit the deductible value of a contributed property.[xiii] In each case, the application of these limitations depends upon the nature of the property transferred and upon whether the recipient organization is a public charity[xiv] (one which generally receives its financial support from a broad segment of the public) or a private foundation (one which generally receives its support from a single family or business).

Percentage Limits

For example, an individual’s charitable contribution deduction for a taxable year is limited to a specified percentage of the individual’s gross income for such year (with certain adjustments; the “contribution base”). More favorable percentage limits apply to contributions of cash, than to in-kind contributions of capital gain property. One reason for this distinction is the fact a taxpayer who donates an unencumbered appreciated capital gain asset to a charity is not required to recognize the gain inherent in the property, yet may still claim a fair market value charitable deduction therefor.

More favorable limits also generally apply for contributions to public charities than for contributions to grant-making private foundations; this distinction is based, in part, upon the fact the former are “accountable” to the general public, while the latter are less so.

Specifically, the deduction for charitable contributions of cash by an individual taxpayer to a public charity may not exceed 50 percent of the taxpayer’s contribution base.[xv] (But see below regarding a temporary change by the Tax Cuts and Jobs Act.) In contrast, a cash contribution to a private foundation may be deducted up to 30 percent of the taxpayer’s contribution base.[xvi]

An individual taxpayer’s contributions of appreciated capital gain property to a public charity generally are deductible up to 30 percent of the taxpayer’s contribution base.[xvii] Contributions of such property to a private foundation are deductible up to 20 percent of the taxpayer’s contribution base.[xviii]

In the case of a corporate donor, the charitable contribution deduction is limited to 10 percent of the corporation’s taxable income for the year (with certain adjustments).[xix]

A taxpayer’s charitable contribution that exceeds the applicable percentage limit generally may be carried forward by the taxpayer for up to five years.[xx]

Property Limits

In general, charitable contributions of cash are deductible in the amount contributed, subject to the percentage limits discussed above. In addition, a taxpayer generally may deduct the full fair market value of long-term capital gain property contributed to a public charity.[xxi]

In certain cases, however, the Code limits the deductible “value” of the contribution of appreciated property to the donor’s tax basis in the property. This limitation generally applies for: (1) contributions of inventory or other ordinary income or short-term capital gain property;[xxii] (2) contributions of tangible personal property if the use of the property by the recipient charitable organization is unrelated to the organization’s tax-exempt purpose (for example, the donation of a rare violin to a hospital);[xxiii] and (3) contributions of any property to a grant-making private foundation (other than contributions of stock that is long-term capital gain property for which market quotations are readily available on an established securities market).[xxiv]

Special Inventory Rule

Although most charitable contributions of property are valued at fair market value or at the donor’s tax basis in the property, certain contributions of appreciated inventory and other property (for example, contributions of “apparently wholesome food”[xxv]) may qualify for an enhanced deduction that exceeds the donor’s tax basis in the property, but which is less than the fair market value of the property.[xxvi]

Record-Keeping

A donor who claims a deduction for a charitable contribution must maintain reliable written records regarding the contribution, regardless of the value or amount of such contribution. No charitable contribution deduction is allowed for a separate contribution of $250 or more unless the taxpayer-donor obtains a contemporaneous written acknowledgement of the contribution from the recipient charity indicating whether the charity provided any good or service (and an estimate of the value of any such good or service) to the taxpayer in consideration for the contribution.[xxvii]

If the total charitable deduction claimed for noncash property is more than $500, the taxpayer must attach a completed IRS Form 8283 (Noncash Charitable Contributions) to the taxpayer’s federal income tax return or the deduction is not allowed. If the deduction claimed is more than $5,000, the taxpayer must also obtain a qualified appraisal and attach a summary thereof to the tax return.[xxviii]

The Tax Cuts and Jobs Act (“TCJA”) of 2017

As part of the tax legislation passed in 2017,[xxix] Congress increased the income-based percentage limit for certain charitable contributions of cash by an individual taxpayer to public charities from 50 percent to 60 percent. To the extent such contributions exceed the 60 percent limit for any taxable year, the excess is carried forward and treated as a charitable contribution that is subject to the 60 percent limit in each of the five succeeding taxable years in order of time.[xxx]

This enhanced deduction provision applies to the amount of charitable contributions taken into account for taxable years beginning after December 31, 2017, and before January 1, 2026.[xxxi] The 50 percent limit is reinstated for cash contributions to public charities for taxable years beginning on or after January 1, 2026.

The CARES Act

The Act revisited the income-based percentage limitation for charitable contributions. Specifically, it amended this, as well as other related provisions – effective for taxable years ending after December 31, 2019[xxxii] – with the goal of maximizing the influx of immediately available funds to charitable organizations that are directly engaged in activities for the benefit of the general public.

Under the Act, an individual who itemizes deductions and makes a cash payment as a charitable contribution to a public charity during the calendar year 2020,[xxxiii] may elect[xxxiv] to claim a deduction in respect of such contribution of an amount up to 100 percent of the taxpayer’s 2020 contribution base;[xxxv] thus, the TCJA’s 60 percent limitation is suspended for 2020, and the taxpayer-donor may use a cash contribution to offset their entire 2020 income.

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

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

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

Looking Forward

Most of the country has been on lockdown since early-to-mid-March; in the case of New York, the lockdown is scheduled to continue at least through mid-May.

The CARES Act became law on March 27. At that time, the Congress was necessarily working with less than adequate data and making a number of semi-educated assumptions.[xlii]

A lot has happened since then. For example, we have discovered that the $349 billion that had been set aside to fund SBA-guaranteed loans to small businesses and nonprofits under the Paycheck Protection Program was woefully inadequate, having been fully expended by mid-April.[xliii] Many business groups have been clamoring for Congress to provide a massive amount of additional funding for the program, and Congress is certain to comply in fairly short order.[xliv]

We have seen the number of jobless claims exceed 22 million over just a four-week period of coronavirus-related shutdowns.

Many state and local governments are reporting that they are nearly financially broke.

Despite these developments, most states remain wary of re-opening their economies in the near-term for fear of allowing a second wave of coronavirus infections to spread.

Finally, and most relevant to this post, many nonprofit organizations[xlv] are already urging Congress to further expand the tax breaks for charitable contributions by individuals[xlvi] – in other words, to go beyond the mere one-year suspension of the income-based percentage limitation for cash gifts to public charities – only three weeks after the enactment of the CARES Act.

Where does that leave us insofar as charitable giving and nonprofits are concerned? Intuitively, it is unreasonable to expect that any tax-based incentive would cause the general public to even consider increasing their charitable giving under the circumstances in which we find ourselves; businesses are even less likely to do so.

It is unfortunate, but for the same reason that many businesses will fail, so will many nonprofits – it is likely that not all of them can be saved. At this point, only those nonprofits that are deemed “essential” should be the beneficiaries of additional governmental support. Others should adapt as best they can to their changed circumstances, both today and after the health crisis passes; in some cases, that may require a reduction in activities, or a redirection of efforts; in others, it may require some degree of collaboration with other organizations, both nonprofit and for profit.

At the same time, perhaps we should encourage nonprofits to establish reserves, or to otherwise modify their behavior or structure so as to build or develop their resilience.[xlvii] We’re in a strange new world. This may be the time to experiment with new models of behavior for nonprofits and their supporters. The Code can be a very effective tool in this process.


[i] IRC Sec. 170.

[ii] P.L. 116-136.

[iii] See, for example, https://www.taxlawforchb.com/2020/04/coronavirus-vs-the-code-today-but-what-about-tomorrow/

[iv] Section 2205 of the CARES Act.

[v][v] IRC Sec. 170(c).

[vi] Reg. Sec. 1.170A-1(e).

[vii] IRC Sec. 170(f)(3).

[viii] Reg. Sec. 1.170A-1(g).

[ix] IRC Sec. 170(f)(8); Reg. Sec. 1.170A-13, 1.170A-15, 1.170A-16 and 1.170A-17.

[x] IRC Sec. 63(d).

[xi] IRC Sec. 63(c).

[xii] IRC Sec. 170(b).

[xiii] IRC Sec. 170(e).

[xiv] IRC Sec. 509(a).

[xv] IRC Sec. 170(b)(1)(A).

[xvi] IRC Sec. 170(b)(1)(B).

[xvii] IRC Sec. 170(b)(1)(C).

[xviii] IRC Sec. 170(b)(1)(D).

[xix] IRC Sec. 170(b)(2).

[xx] IRC Sec. 170(d).

[xxi] IRC Sec. 170(e).

[xxii] IRC Sec. 170(e)(1)(A).

[xxiii] IRC Sec. 170(e)(1)(B).

[xxiv] IRC Sec. 170(e)(5).

[xxv] If you ask me, “apparently wholesome” is in the eye of the beholder. What can appear more wholesome-looking than a double quarter pounder with cheese, I ask you? Alas, Congress is presumptuous enough to define “apparently wholesome food” by reference to the Bill Emerson Good Samaritan Food Donation Act. Seriously?

[xxvi] IRC Sec. 170(e)(3)(C).

[xxvii] IRC Sec. 170(f)(8).

[xxviii] Reg. Sec. 1.170A-13, 1.170A-15, 1.170A-16 and 1.170A-17.

[xxix] P.L. 115-97.

[xxx] IRC Sec. 170(b)(1)(G).

[xxxi] IRC Sec. 170(b)(1)(G)(i).

[xxxii] Section 2205(c) of the CARES Act.

[xxxiii] Section 2205(a)(3)(A) of the CARES Act.

[xxxiv] Section 2205(a)(3)(A)(ii) of the CARES Act. The application of the relaxed income-based limitation is elective with the taxpayer. In the case of a contribution by a partnership or an S corporation, the election is made separately by each partner or shareholder. Section 2205(a)(3)(C) of the CARES Act.

[xxxv] Section 2205(a)(1) and Section 2205(a)(2)(A) of the CARES Act.

[xxxvi] Section 2205(a)(3)(B) of the CARES Act.

[xxxvii] IRC Sec. 4966.

It should be noted that a public charity which sponsors a donor-advised fund may itself be engaged in a number of direct charitable activities, contributions to which would qualify for the enhanced charitable deduction.

[xxxviii] IRC Sec. 4942.

[xxxix] Their public charity status is derived from that of the public charities which they support. IRC Sec. 509(a)(3); Reg. Sec. 1.509(a)-4.

[xl] Section 2205(a)(1) and Section 2205(a)(2)(B) of the CARES Act.

[xli] Section 2205(a)(2)(A)(ii) and Section 2205(a)(2)(B)(ii) of the CARES Act.

[xlii] One might say, with less than a full deck . . . of information.

[xliii] It was originally intended that loans would be available through the end of June.

[xliv] But only after the parties have walked around the proverbial ring a bit, holding each other up like a couple of punch-drunk boxers.

[xlv] Who may also qualify for the forgivable, unsecured loans under the Paycheck Protection Program.

[xlvi] The greatest part of charitable giving comes from individuals, not from corporations or foundations. The so-called “1 percent” account for approximately one-third of all charitable giving.

[xlvii] https://www.taxlawforchb.com/2020/03/lou-vlahos-op-ed-economic-losses-blame-the-virus-not-entirely-published-in-the-empire-report/

The Coronavirus Aid, Relief and Economic Security (“CARES”) Act became law[i] on March 27, 2020. Almost immediately, “small” businesses[ii] from every industry – including real estate – began the process of determining whether they would be eligible for the forgivable, unsecured, non-recourse loans to be made under the Paycheck Protection Program, which is viewed by most closely held businesses as the centerpiece of the legislation.[iii]

However, there are a few tax-related provisions in the legislation that may assist a qualifying business to obtain through a refund – or to retain through lower taxes – some of the liquidity needed for the operation of the business. Although most of these tax provisions represent the temporary – and in some cases retroactive – relaxation of certain amendments made by the Tax Cuts and Jobs Act of 2017,[iv] they promise to mitigate the adverse economic effects of the health crisis [v]for many businesses.

Not to be outdone by Congress,[vi] the IRS has acted quickly to implement these changes. In addition, with the President’s declaration of a national emergency, the IRS has taken steps to address some of the specific concerns of taxpayers in the real estate industry.[vii]

We begin with a brief description of certain provisions of the Act that may be of interest to real estate businesses. This is followed by a summary of actions undertaken by the IRS with respect to like kind exchange transactions that were “interrupted” by the health crisis.

NOLs

The Act temporarily reinstates and expands the NOL carryback that had been eliminated by the TCJA.[viii] Specifically, the Act allows a business that realizes a net operating loss (“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.[ix] If the business had taxable income during those earlier years, the carryback of the NOLs may create an opportunity for an immediate refund claim and more liquidity.[x]

The Act also suspended the TCJA’s “80 percent of taxable income” limitation for NOL carryovers arising in taxable years beginning before January 1, 2021.[xi] Thus, for a taxable year beginning in 2018, 2019 or 2020, an NOL carryover may be utilized to offset all of the business’s taxable income for that year; it is not limited to 80 percent thereof. As in the case of the carryback, the retroactive elimination of the “80 percent” cap may give rise to a refund claim for an eligible taxpayer.

The TCJA’s elimination of the NOL carryback, and its imposition of the 80 percent limitation on NOL carryovers, are reinstated for taxable years beginning after December 31, 2020.

The IRS

As indicated above, taxpayers whose NOLs may now be carried back to an earlier taxable year will generally be able to file amended returns to claim refunds resulting from the temporary change in the law. Unfortunately, the Act did not provide additional time for certain taxpayers to file tentative carryback adjustment applications[xii] – basically, an expedited procedure for tax refunds resulting from the carryback of the NOL.

In response, the IRS has extended the deadline[xiii] for filing an application for a tentative carryback adjustment with respect to the carryback of an NOL that arose in any taxable year that began during calendar year 2018 and that ended on or before June 30, 2019.[xiv]

For example, in the case of an NOL that arose in a taxable year ending on December 31, 2018, a taxpayer normally would have until December 31, 2019, to file an application; because of this relief, however, the taxpayer will now have until June 30, 2020, to file.

Excess Business Loss

For taxable years beginning after December 31, 2017 and before January 1, 2026, the TCJA limited the ability of a non-corporate taxpayer – basically, individuals – to offset their nonbusiness income with losses arising from their business. Instead, such losses are required to be treated as part of the taxpayer’s NOL carryforward to subsequent taxable years.[xv]

The Act retroactively defers the effective date of these “excess business loss” rules. Specifically, the rules will now apply only to taxable years beginning after December 31, 2020 and before January 1, 2026.[xvi]

Consequently, an individual taxpayer who realized, or realizes, a loss from an operating business in a taxable year beginning before January 1, 2021 – whether as a sole proprietor, as a partner in a partnership, or as a shareholder in an S corporation – and who successfully runs the gauntlet of the basis limitation, at risk and passive loss rules,[xvii] will be allowed to apply such losses against their other income for such taxable year, including salary and investment income.

This change may afford those taxpayers, to whom the excess business loss rules have already been applied, an opportunity to claim a refund with respect to their taxable years beginning in 2018 and 2019.

Business Interest Deductions

Generally speaking, interest paid or accrued by a business is deductible in the computation of taxable income, subject to a number of limitations. The TCJA added one more limitation: for taxable years beginning after December 31, 2017, a taxpayer’s deduction for business interest for a taxable year is capped at 30 percent of the taxpayer’s “adjusted taxable income” for the taxable year. Any “excess interest deduction” will be carried forward to succeeding taxable years.[xviii]

The Act reduces the impact of this rule by increasing the limitation from 30 percent to 50 percent of adjusted taxable income for any taxable year beginning in 2019 or 2020.[xix] In this way, a taxpayer filing their income tax return for 2019 may take advantage of the increased limitation to reduce their income tax liability and to retain the tax savings in the business.

In addition, for a taxable year beginning in 2020, the Act permits a taxpayer to use their 2019 adjusted taxable income for purposes of determining their “interest deduction limitation” for 2020.[xx] Thus, if the taxpayer’s 2019 adjusted taxable income is greater than that for 2020 – which may very well be the case – the taxpayer may claim a greater interest deduction and, thereby, further reduce their tax liability.

Although the relaxation of the limitation on interest deductions[xxi] may entice a taxpayer to borrow funds during 2020, it is important for the taxpayer to recognize that the TCJA’s 30 percent cap will be reinstated in 2021.

Notwithstanding the foregoing, it should be noted that the limitation does not apply to taxpayers with average annual gross receipts, for the three-taxable year period ending with the prior taxable year, that do not exceed $25 million.[xxii]

In addition, at the taxpayer’s election, any real property trade or business is not treated as such for purposes of the limitation, and therefore the limitation does not apply to such a trade or business.[xxiii] The election to be excluded from the interest limitation rule, however, comes at a price: the electing taxpayer is not allowed to claim bonus depreciation,[xxiv] and is required to extend the depreciation period for its real properties.[xxv] In addition, once made, the election is irrevocable; thus, it is binding for all succeeding years.

However, the IRS has recognized that a taxpayer who made an election in 2018 to exclude their real property business from the TCJA’s “30 percent interest limitation” rule, may have acted differently had the Act’s 50 percent limitation been in effect instead. Thus, the IRS has issued guidance[xxvi] that allows a qualifying taxpayer to withdraw the otherwise irrevocable election.

Specifically, for a 2018 or 2019 taxable year, a taxpayer must timely file an amended Federal tax return for the year in which the election was made, along with an election withdrawal statement.[xxvii] The amended return must be filed on or before October 15, 2021, but in no event later than the applicable period of limitations on assessment[xxviii] for the taxable year for which the amended return is being filed. The amended tax return must include the adjustment to taxable income for the withdrawn election and any collateral adjustments to taxable income or to tax liability. A taxpayer also must file amended returns, which include such collateral adjustments, for any affected succeeding taxable years.

An example of such a collateral adjustment – and a possible reason for withdrawing the election in the first place – is the amount of depreciation, including bonus depreciation, allowed or allowable in the applicable taxable year for the property to which the withdrawn election applies.

In other words, a taxpayer may be able to take advantage of both the temporary 50 percent limitation on interest deductions, and the ability to claim an increased depreciation deduction (including bonus depreciation) for those years to which the election would otherwise have applied. Thus, the taxpayer will have another opportunity for a refund of taxes paid.

Bonus Depreciation

The Act corrects an error in the TCJA which prevented “qualified improvement property” from qualifying for bonus depreciation.

Qualified improvement property is generally defined as any improvement to an interior of a nonresidential building that is placed in service after the building was placed in service.[xxix]

The Act retroactively amended the Code, effective for property placed in service after December 31, 2017, to treat such property as 15-year property for which bonus (100 percent) depreciation may be claimed.[xxx]

A taxpayer affected by this change may be able to amend their 2018 returns in order to take the bonus depreciation deduction and thereby generate a refund claim. The change may also allow a taxpayer to claim a larger deduction in determining their 2019 income tax liability.

Like Kind Exchange

The TCJA amended the Code so as to restrict the tax deferral benefit of the like kind exchange rules to exchanges involving only real property held for productive use in a trade or business, or for investment.[xxxi]

Most like kind exchanges with real property are effected as deferred exchanges, with the replacement property being acquired sometime after the sale of the relinquished property. Generally speaking, in order for such a transaction to qualify for tax deferral as a like kind exchange, the replacement property must be identified no later than 45 days after the date of the sale of the relinquished property (the “identification period”),[xxxii] and it must be acquired no later than 180 days after the date of such sale (or, if earlier, by the tax return due date, determined with extensions, for the year of the sale; the “exchange period”).[xxxiii]

The above-described dates are prescribed by statute and, generally, cannot be changed by the IRS; however, an exception may apply where the President has declared a national emergency.[xxxiv]

On March 13, 2020, President Trump declared a national emergency[xxxv] regarding the COVID-19 outbreak.

The IRS recently invoked its power – arising under such a federally declared emergency – to postpone the time to perform specified “time-sensitive actions” for taxpayers who are affected by the health emergency.[xxxvi]

Among these time-sensitive actions[xxxvii] are the identification of a replacement property, and the acquisition of such replacement property, in connection with a transaction intended to qualify as a like kind exchange under Section 1031 of the Code, including a “safe harbor” reverse, or “parking,” exchange.[xxxviii]

The Treasury has determined that any person performing such an act which is due to be performed on or after April 1, 2020, and before July 15, 2020, will be treated as someone “affected” by the health emergency, and the period for performing the act will be automatically extended to July 15, 2020, unless the taxpayer elects out of the extension.[xxxix]

In other words, only identification and exchange period deadlines occurring between April 1 and July 15, 2020 (the “relief period”) are extended. For example, if a taxpayer sold real property on February 29, 2020, they would normally have until April 14, 2020 to identify a replacement property. As a result of the IRS’s response to the health emergency, however, the end of the identification period is extended to July 15, 2020.[xl]

It is worth noting that the exchange period in the above example does not appear to be affected because it does not fall within the relief period – thus, it remains August 27, 2020, a mere 43 days after the close of the identification period.

Alternatively, if the taxpayer’s 180-day exchange period for acquiring the replacement property would normally end within the relief period (say, for example, on April 15, 2020), the end of the replacement period would be extended to July 15, 2020.

What’s Next?

The IRS will be implementing the foregoing measures over the coming weeks.

During that time, members of the real estate industry and their advisers will likely ask a lot of questions and to offer many suggestions; they are also likely to make a lot of requests – for clarification, and probably also for expansion of the relief already provided.

In light of the relatively brisk pace at which guidance under the Act has thus far been issued, updated, and then amended – all within the span of two weeks[xli] – and with the prospect of more legislation in the near future,[xlii] taxpayers and their advisers would be well-served to digest what has already been published, and to remain vigilant and keep informed of developments in our nation’s capital.

 

[i] P.L. 116-136 (the “Act”).

[ii] In general, a business is eligible for a loan under the PPP if it has no more than 500 employees or, if greater, the number of employees set by the SBA as the “size standard” for a particular industry. The SBA’s definition of “small business concern” also has to be considered. Section 1102(a)(2)(D) of the Act.

[iii] The liquidity to be provided under the PPP is intended to be used primarily for payroll costs, though borrowers may also apply a portion of the proceeds toward rent, utilities, and the interest on certain pre-existing indebtedness. However, in order to qualify for forgiveness of the loan, at least 75% of the proceeds have to be used to cover payroll costs. https://www.farrellfritz.com/sba-7a-loans-under-the-ppp/

[iv] P.L. 115-97 (the “TCJA”). See https://www.taxlawforchb.com/2018/01/the-real-property-business-and-the-tax-cuts-jobs-act/ for a discussion of how the TCJA affected real estate businesses.

[v] More accurately, caused by the government-ordered shutdowns employed (pun intended) to combat the spread of the coronavirus.

[vi] The power of the purse under Article I of the Constitution. Similarly, though I am loath to quote Baron Harkonnen from Frank Herbert’s Dune, “He who controls the spice controls the universe.”

[vii] Let me pause a minute, here. Following the TCJA, the IRS was presented with the challenge of issuing badly needed regulations – basically, legislating – to implement and clarify many of the very complex changes enacted by the TCJA. At the same time, the agency was told to make due with fewer resources – makes a lot of sense, right? Now, as the Service sees a light at the end of the TCJA tunnel, it is confronted with the Act. What’s more, like the rest of us, its personnel are working remotely. Oh, and yes, it is “tax return filing season.” I hope that folks in the White House and in Congress are not too forgetful.

[viii] IRC Sec. 172(b).

[ix] Sec. 2303(b) of the Act. Before the TCJA, the carryback period was two years. The five-year carryback affords taxpayers a greater chance of applying the loss to a profitable year.

The assumption, or expectation, of course, is that everything will have returned to normal before the end of 2020.

[x] IRC Sec. 6401 and Sec. 6511.

[xi] Sec. 2303(a) of the Act.

[xii] IRC Sec. 6411. See also IRS Forms 1139 (for corporations) 1045 (for other taxpayers).

[xiii] IRC Sec. 6081 authorizes the IRS to grant a reasonable extension of time to file.

The usual deadline for filing the application is on or after the date of filing for the return for the taxable year of the NOL from which the carryback results and within a period of 12 months after such taxable year.

[xiv] Notice 2020-26. The Notice also explains what a taxpayer must do to take advantage of the extension for requesting a tentative refund based on the carryback of the NOL.

[xv] IRC Sec. 461(l).

[xvi] Section 2304 of the Act. Again, the hope is that the economy will be back on its feet by the end of 2020.

[xvii] IRC Sec. 704(d)/1366(d), 465 and 469, respectively.

[xviii] IRC Sec. 163(j).

[xix] Section 2306 of the Act. Special rules apply for partnerships.

[xx] IRC Sec. 163(j)(10)(B).

[xxi] That, plus the low interest rate environment in which we find ourselves.

[xxii] IRC Sec. 163(j)(3).

[xxiii] IRC Sec. 163(j)(7)(B).

[xxiv] IRC Sec. 168(k)(2)(D).

[xxv] IRC Sec. 168(g)(8).

[xxvi] Rev. Proc. 2020-22. Among other things, this guidance requires the filing of an election withdrawal statement that should be titled, “Revenue Procedure 2020-22 Section 163(j)(7) Election Withdrawal.”

[xxvii] Special rules apply for “BBA partnerships” under Revenue Procedure 2020-23.

[xxviii] IRC Sec. 6501.

[xxix] IRC Sec. 168(e)(6). There are exceptions; for example, any improvement for which the expenditure is attributable to an elevator or escalator.

[xxx] Section 2307 of the Act. IRC Sec. 168(e)(3)(E), Sec. 168(k).

[xxxi] IRC Sec. 1031(a)(1).

[xxxii] Reg. Sec. 1.1031(k)-1(c)(4) provides special rules for the identification of alternative or multiple replacement properties.

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

[xxxiv] IRC Sec. 7508A. Rev. Proc. 2018-58.

[xxxv] Effective March 1, 2020.

[xxxvi] Notice 2020-23.

[xxxvii] See, for example, Rev. Proc. 2018-58.

According to Notice 2020-23, another “time-sensitive action” is the taxpayer’s investment in a qualified opportunity fund of an amount equal to the taxpayer’s capital gain; the investment must be made during a statutorily-prescribed 180-day period in order for the taxpayer to defer the recognition of such gain, and to take advantage of the other benefits offered under the qualified opportunity zone regime. IRC Sec. 1400Z-2(a)(1)(A).

[xxxviii] Rev. Proc. 2000-37.

[xxxix] Notice 2020-23. An election out may be appropriate if the taxpayer no longer want to complete a like kind exchange, and wants to obtain the relinquished property sale proceeds from the qualified intermediary sooner rather than after the end of the extended period. Reg. Sec. 1.1031(k)-1(g)(6).

[xl] Qualified intermediaries (“QIs”) are probably all over this change. If you are in the midst of an exchange, contact you QI immediately.

[xli] It feels much longer, doesn’t it? Working remotely has certainly contributed to our losing track of time. Thankfully, I have not yet experienced a Ground Hog Day moment.

[xlii] Perhaps by the end of April.

Public Health Disaster

Rarely has so much been expected by so many from a single legislative act.

The C.A.R.E.S. Act[i] became law on March 27, 2020, approximately two and one-half months after the country confirmed its first case of the virus. During that short period, the number of confirmed cases has increased dramatically, especially in New York.

In order to contain the spread of the virus, public gatherings were canceled. Shortly thereafter, many states[ii] and municipalities ordered the closure of most businesses within their jurisdictions. In general, individuals were directed to remain in their homes so as to avoid close contact with one another and, thereby, prevent the further transmission of the virus.

Notwithstanding these measures, and despite the efforts of healthcare workers, many of the afflicted have lost their lives and, unfortunately, many more are certain to follow. Society, broadly defined, will feel these losses on many levels.[iii]

Then there is another loss.

Economic Disaster

In response to the coronavirus and the public health strategy that governments have adopted to fight it, the stock market has gone from a record high in mid-February, to the beginnings of a bull market in mid-March.[iv] Many individuals have looked on as a significant portion of their retirement savings vanished.

With few exceptions, factories, service businesses, retailers, restaurants, hotels, not-for-profits, schools, and others have been ordered by government to close their doors in order to protect their employees and the public at large. Among those remaining open are hospitals, food markets and pharmacies.

Last week, the New York Times reported that approximately 10 million jobs disappeared over a two-week period, the Federal Reserve chairman said that he expects a contraction in Gross Domestic Product in the second quarter, and the Fed’s St. Louis district projected that the country may see a 30 percent unemployment rate.

Those who can work remotely from home are doing so but, given the interconnectedness of so many businesses (globally and domestically), the general feeling of uneasiness within the business community, the drop in economic activity, and the ensuing drop in business and consumer confidence, one has to wonder how sustainable this work-from-home approach will be.[v]

The Federal Response[vi]

This state of affairs called for an aggressive move by the Federal government, and it finally came on March 27, 2020 when the president signed the Act.[vii]

The main thrust of the legislation is to get massive amounts of money into the hands of businesses and their employees[viii] The principal vehicle by which $349 billion[ix] of these funds will be disbursed to “small businesses” – generally speaking, a business with no more than 500 employees – is the Paycheck Protection Program (the “PPP”), which will be administered by the Small Business Administration.[x] This is a forgivable loan program predicated on the requirement that any borrowing business will, during the 8-week period following the origination of its loan, expend at least 75 percent of its loan proceeds[xi] on payroll costs;[xii] the remaining 25 percent may be applied toward rent, utilities, and the interest on certain pre-existing indebtedness of the business.[xiii]

For example, if an eligible small business receives a PPP loan on April 20, 2020, it will have to expend all of the proceeds by June 15, 2020,[xiv] with at least 75% of these applied to payroll costs and the balance to rent, utilities, interest on qualified indebtedness.

The PPP will support the continued existence of some closely held businesses that do not lay off their employees and do not cut their salaries, especially those businesses that had few reserves[xv] before they were suddenly shut down. But will it help these businesses to “reboot” after the health crisis passes? It remains to be seen, but I have my doubts.

Consider the following excerpt from a report issued by the New York State Comptroller in 2019, “Small Business in New York State: An Economic Snapshot” – it speaks for itself:

While an enterprise can be classified as a small business based upon its number of employees, its annual income or both, the U.S. Small Business Administration  (SBA) and this report primarily define a small business as one with fewer than 500 employees.

Over the last five years for which data are available, employment at New York’s small businesses rose by 9.2 percent, slightly faster than the national pace. Total payroll showed strong growth, rising to $212.6 billion in New York . . .  Among the more than 465,000 businesses in New York in 2016, 99 percent were small businesses. In addition, the State was home to over 1.7 million non-employer businesses, which largely comprise self-employed individuals.

Of the small businesses with paid employees in 2016, almost two-thirds had fewer than five employees, with over 81 percent having fewer than 10 employees, as shown in Figure 2. These 374,000 microbusinesses provided over 957,000 jobs with total payroll close to $43 billion.

Altogether, small businesses accounted for just over half of all private sector jobs in New York in 2016, providing over 4.1 million jobs. In addition, these businesses provided over $212 billion in payroll, nearly 40 percent of the total private sector payroll.

. . .

Small businesses account for the vast majority of firms in every industry sector in New York. In 2016, over 95 percent of all the firms in each industry sector were small businesses. Three of the 12 industry sectors account for almost half of all small businesses in New York. As defined by the U.S. Census Bureau, payroll includes all forms of compensation paid to all employees, such as salaries, wages, commissions, bonuses, vacation allowance, and sick leave pay.

. . .

The rest is simple math.[xvi]

Tax Relief? Maybe

Other parts of the Act, however, may assist certain businesses to obtain some badly needed cash relatively quickly, and to thereby mitigate the economic effects of the health crisis; for others, the benefit may come too late.

I am referring to the few business tax-related provisions in the legislation. These are not “new” tax benefits or incentives; rather, they represent the temporary relaxation of amendments enacted as part of the Tax Cuts and Jobs Act of 2017 (the “TCJA”)[xvii] – amendments that were intended to compensate for lost tax revenue attributable to the reduction of the Federal corporate income tax rate to a flat 21 percent.[xviii]

In sum, the intended effect of the Act’s tax provisions is to allow businesses that realized losses during prior years (before 2020) to convert those losses into refunds that will be payable (and usable) currently, and to permit business owners to use other losses to offset otherwise taxable income, thereby enabling those tax dollars to be applied elsewhere.

NOLs

A taxpayer’s net operating loss (“NOL”) for a taxable year is equal to the amount by which a taxpayer’s business deductions exceed its gross income from the business for that year.[xix]

In general, prior to the TCJA, an NOL could carried back two years and carried forward 20 years to offset the taxpayer’s taxable income in such years.[xx] An NOL would offset taxable income in the order of the taxable years to which the NOL would be carried.[xxi]

In the case of a business that was coming out of a challenging period, the two-year carryback often provided a ready source of liquidity where the carryback years were profitable years for which income taxes were paid. By reducing the taxable income for those carryback years, the business could generate a refund of monies that it could then expend in its operations.

NOLs after the TCJA

The TCJA amended the Code so as to limit a taxpayer’s NOL deduction for a taxable year to 80 percent of the taxpayer’s taxable income for such year (determined without regard to the deduction).

Carryovers to other years were adjusted to take account of this limitation, and would be carried forward indefinitely.[xxii] The two-year carryback of NOLs was repealed.

These changes were effective for NOLs arising in taxable years beginning after December 31, 2017. For example, NOLs for taxable years ending on December 31, 2018, or on December 31, 2019 (for calendar year taxpayers) could not be carried back. The same applied for any taxable year beginning on or after February 1, 2018 and ending on or after January 31, 2019 (for fiscal year taxpayers); thus, in the case of an NOL realized during the taxable year starting June 1, 2019 and ending May 31, 2020, the NOL could not be carried back to an earlier year.

NOLs after the CARES Act

The Act allows a taxpayer that realizes an NOL during a taxable year beginning after December 31, 2017 and before January 1, 2021 to carry such NOL back to each of the five taxable years preceding the year of the loss.[xxiii]

Thus, a taxpayer that realized an NOL during a taxable year beginning in 2018 or in 2019 may carry those NOLs back five years, which may create an opportunity for a refund claim in 2020 with respect to an earlier year for which the taxpayer had an income tax liability.

Unfortunately for a taxpayer that suffers a loss during a taxable year that begins in 2020, the tax benefit attributable to the carryback of such loss will not be realized until the taxpayer files its return for that year, in 2021, which is still several months away. That is not to say that a refund at that time would not be welcomed – it’s just that the liquidity it may provide would likely be more helpful sooner rather than later.

The Act also repealed the “80 percent of taxable income” limitation for NOL carryovers arising in taxable years beginning before January 1, 2021.[xxiv]

Thus, an NOL realized in a taxable year beginning in 2018 that is carried to 2019 and 2020, and an NOL realized in a taxable year beginning in 2019 that is carried back to 2018 and forward to 2020, may be utilized without regard to the TCJA’s “80 percent limitation” – the NOLs may be used to offset all of the taxpayer’s taxable income.

Unfortunately for a taxpayer that suffers a NOL in a taxable year that begins in 2020, any tax benefit attributable to the carryback or carryforward of such loss will not be realized until the taxpayer files its return for that year, which is still several months away.

The 80 percent limitation is reinstated for taxable years beginning after December 31, 2020.

As indicated earlier, this change may create opportunities for refunds for those taxpayers who realized losses during the years indicated.

Non-Corporate Taxpayer Loss Limitations

The passive loss rules – which generally apply to individuals, estates and trusts – limit deductions from passive trade or business activities. A passive activity for this purpose is a trade or business activity in which the taxpayer owns an interest, but in which they do not materially participate. A taxpayer is treated as materially participating in an activity only if the taxpayer is involved in the operation of the activity on a basis that is regular, continuous, and substantial. Deductions attributable to passive activities, to the extent they exceed income from passive activities, generally may not be deducted against other income. Deductions that are suspended under these rules are carried forward and treated as deductions from passive activities in the next year. The suspended losses from a passive activity are allowed in full when a taxpayer makes a taxable disposition of their entire interest in the passive activity to an unrelated person.[xxv]

TCJA Excess Business Loss

Following the enactment of the TCJA, for taxable years beginning after December 31, 2017 and before January 1, 2026, the “excess business losses” of a taxpayer other than a corporation are not allowed for the taxable year. Instead, such losses are carried forward and treated as part of the taxpayer’s NOL carryforward in subsequent taxable years.[xxvi]

A taxpayer’s excess business loss for a taxable year – which is determined after the application of the passive loss rules – is the excess of the aggregate deductions of the taxpayer attributable to trades or businesses of the taxpayer, over the sum of aggregate gross income or gain of the taxpayer (whether or not related to a trade or business) plus a “threshold amount.” The threshold amount for a taxable year is $250,000 per taxpayer.[xxvii]

In the case of a partnership or an S corporation, the provision applies at the partner or shareholder level. Each partner’s distributive share and each S corporation shareholder’s pro rata share of items of income, gain, deduction, or loss of the partnership or S corporation are taken into account in applying the limitation under the provision for the taxable year of the partner or S corporation shareholder.

The provision was to be effective for taxable years beginning after December 31, 2017.

Excess Business Losses after the Act

The Act defers the effective date of the excess business loss rules.[xxviii] Specifically, the rules will apply only to taxable years beginning after December 31, 2020 and before January 1, 2026.

Consequently, an individual taxpayer who realizes a loss from an operating business in a taxable year beginning before January 1, 2021 – whether as a sole proprietor, as a partner in a partnership, or as a shareholder in an S corporation – and who runs the gauntlet of the basis,[xxix] at risk[xxx] and passive loss rules, will be allowed to apply such losses against their other income for such taxable year, including salary and investment income.

As in the case of NOLs described above, this change will afford some taxpayers an opportunity to claim a refund with respect to their taxable years beginning in 2018 and 2019, and to use the proceeds therefrom in their business.

Business Interest Deductions

Generally speaking, interest paid or accrued by a business is deductible in the computation of taxable income, subject to a number of limitations. In the case of a taxpayer other than a corporation, the deduction for interest on indebtedness that is allocable to property held for investment (“investment interest”) is limited to the taxpayer’s net investment income for the taxable year. Disallowed investment interest is carried forward to the next taxable year.

TCJA Interest Deduction Limitation

The TCJA limited a taxpayer’s deduction for business interest for a taxable year to an amount equal to the sum of (1) business interest income;[xxxi] and (2) 30 percent of the adjusted taxable income of the taxpayer for the taxable year. The amount of any business interest not allowed as a deduction for any taxable year is treated as business interest paid or accrued in the succeeding taxable year. Excess interest deductions are carried forward indefinitely, subject to certain restrictions.[xxxii]

For purposes of this limitation, “adjusted taxable income” generally means the taxable income of the taxpayer computed without regard to any item of income, gain, deduction, or loss which is not properly allocable to a trade or business; certain other adjustments are also made.

The limitation does not apply to taxpayers with average annual gross receipts for the three-taxable year period ending with the prior taxable year that do not exceed $25 million. In addition, at the taxpayer’s election, any real property trade or business is not treated as such for purposes of the limitation, and therefore the limitation does not apply to such a trade or business.

This rule applies to taxable years beginning after December 31, 2017.

A More Relaxed Rule

In the case of any taxable year beginning in 2019 or 2020, the Act increases the limitation from 30 percent to 50 percent of adjusted taxable income.[xxxiii]

In this way, a taxpayer filing their income tax return for 2019 may take advantage of the increased limitation to further reduce their income tax liability and to retain the tax savings in the business.

In addition, for a taxable year beginning in 2020, the Act permits a taxpayer to use their 2019 adjusted taxable income for purposes of determining their “interest deduction limitation” for 2020. Thus, if the taxpayer’s 2019 adjusted taxable income is greater than that for 2020 – which may very well be the case given our circumstances today – the taxpayer may claim a greater interest deduction and, thereby, further reduce their income tax liability.

What Else?

In addition to the foregoing “amendments” to the TCJA, the Act adds a number of other provisions that are intended to improve the cash flow of many businesses that have been impacted by our strategy for containing the coronavirus. For example, the employee retention credit for qualifying employers,[xxxiv] and the deferred remittance over a two-year period of certain payroll taxes accrued during 2020 may help a number of businesses.[xxxv] Ironically, as the restaurant industry teeters on the brink, the Act retroactively amended the Code to treat “qualified improvement property”[xxxvi] as 15-year property for which bonus depreciation may be claimed – taxpayers affected by this change should file refund claims for 2018 or 2019, as the case may be.

What’s Next?

We have to wonder how a health crisis like the present one should cause as much harm as it has, as quickly as it has. Many businesses will fail that should not have failed. As a consequence, people will lose jobs they should not have not lost. The ripple effects are obvious, and I doubt they will be short-lived.

Those closely held businesses that survive – whether because they were “lean and mean” before the coronavirus-induced economic crisis, or had adequate reserves or other financing sources, or for some other reason, including plain luck – are still likely to have realized not insignificant losses. They are also likely to be in need of new capital.

I am not an economist. I have never served in government. I’m a tax attorney.[xxxvii] I recognize that tax legislation can be a powerful tool for promoting the achievement of long-term[xxxviii] economic and other goals that our society deems worthy. One such goal should be the security of business and, thereby, of jobs.

Why not use the Code to encourage a business to establish emergency reserves for salaries and other expenses for a prescribed period of time (say, between 30 and 60 days?), that may be accessed only in the event of a “crisis” as declared by the President or, where appropriate, by the governor of a State? For example, the business would retain as reserves in a segregated account a portion of those funds that would otherwise have been distributed to owners. In exchange, the business would receive a tax credit. Or provide that a business may claim a tax deduction for the creation of a reserve based on the amounts that would otherwise have been paid as executive compensation?[xxxix] These tax benefits may be coupled with the protection of such accounts from the claims of creditors. In addition, perhaps we can “reform” the purpose for captive insurance to serve as a kind of rainy day fund for these kinds of situations, to which the insureds – a community of businesses – would make tax deductible contributions.

I am sure there are many other possibilities for using the Code in this manner.

__________________________________________________________________________________________________

[i] The Coronavirus Aid, Relief and Economic Security Act (the “Act”); H.R.748 – 116th Congress (2019-2020).

[ii] Forty-two at last count.

[iii] Perhaps even as a disruption in whatever it is that binds us to one another as humans.

Of course, I am echoing Obi-Wan Kenobi: “I felt a great disturbance in the Force. As if millions of voices cried out in terror, and were suddenly silenced. I fear something terrible has happened.” Star Wars Episode IV: A New Hope.

[iv] There were a couple of record-setting drops in between – a true crash.

[v] Like so many others, I expect that the workplace and the way we work will undergo a major transformation once we have closed this chapter in our history.

[vi] The States have taken a beating. Reserves have disappeared, and surpluses have turned into deficits. As a result of the economic downturn, tax revenues are waning. Many state and local governments are reducing their workforce. They are requesting Federal assistance.

[vii] The legislation was introduced in the Senate in Mid-March, while the House was on recess. After a couple of failed attempts by the Senate leadership to bring the bill to a vote, Nancy Pelosi threatened that the House would offer its own, very different bill. After some typical Washington wrangling, the two parties announced on March 25 that they had come to an agreement. That same day, the Senate passed the Act by a vote of 96-0. The House, though still in recess, approved the legislation by voice vote the next day.

There was one surprise, however, when Rep. Massie of Kentucky tried to force a roll-call vote. John Kerry tweeted: “Congressman Massie has tested positive for being an asshole. He must be quarantined to prevent the spread of his massive stupidity.”

[viii] Including those who have been furloughed or fired.

[ix] This is nowhere near enough.

[x] In case you haven’t gotten up to speed, the loans will be made by private banks, and will be 100% guaranteed by the SBA, will not require collateral or personal guarantees, and will be non-recourse to the owners of the borrowing business. What’s more, the loan is forgivable provided the borrower expends the proceeds during an 8-week period for certain enumerated purposes; in fact, at least 75% must be applied to payroll costs. If forgiven, the loan will not be included in the borrower’s gross income as cancellation of indebtedness income.

SBA-approved banks were supposed to start accepting loan applications under the PPP on Friday, April 3. Unfortunately, several large banks – you may recall that the U.S. taxpayer bailed them out during the Great Recession – are still sitting on the sidelines.

[xi] In general, equal to the lower of (i) 250% of its payroll costs, and (ii) $10 million.

[xii] Including employee wages, salaries, retirement benefits, paid leave, health care, and other items.

[xiii] The PPP is clearly structured to help employees weather the virus-induced storm. It provides them with the funds needed to pay for food and shelter.

But it should be noted that not every business expends over 70% of its budget on the cost of labor – some service businesses may, but not a manufacturer or other capital intensive businesses. The former generally have relatively high margins, while the latter have relatively slim ones.

What’s more, an employee may be better off if they were laid off. The PPP provides for $600 per week to an employee who has lost their job as a result of the health crisis; this is in addition to whatever State benefits they are receiving. In many cases, the total will exceed what they make while gainfully employed.

Of course, in that case, the employer-business will not qualify for a loan under the PPP. (See the required certification, above.)

[xiv] Eight weeks later.

[xv] Query how many closely held businesses maintain “rainy day” funds? It is often the case that they do not enjoy years in which they realize substantial windfalls that may be set aside. The funds are, instead, used to repay loans from third parties and from the owners themselves. Then there is the advice they receive from their attorneys not to leave “excess” funds in the business where they may be reached by its creditors or other claimants. In the case of C corporations that have accumulated earnings in excess of the “reasonable needs of the business,” the accumulated earnings tax has to be considered – perhaps we need to rethink what that means.

See my Op Ed piece in The Empire Reporthttps://www.taxlawforchb.com/2020/03/lou-vlahos-op-ed-economic-losses-blame-the-virus-not-entirely-published-in-the-empire-report/

[xvi] Especially when you consider all the taxes payable by a New York business in respect of employee salary; for example, Social Security, Medicare, Federal Unemployment, NY State Unemployment, NY Re-employment, NY Disability Benefits and, in many cases, NY Metropolitan Commuter Transportation Mobility Tax. Phew!

[xvii] P.L. 115-97.

[xviii] This replaced a graduated rate regime with a maximum rate of 35 percent.

[xix] IRC Sec. 172(c).

[xx] IRC Sec. 172(b)(1)(A) before the TCJA. Different carryback periods applied with respect to NOLs arising in different circumstances. Extended carryback periods were allowed for NOLs attributable to specified liability losses and certain casualty and disaster losses. IRC Sec. 172(b)(1)(C) and (E).

[xxi] IRC 172(b)(2) before the TCJA.

[xxii] The 20-year carryforward period was eliminated.

[xxiii] Section 2303(b) of the Act. Thus, these changes have retroactive effect.

A slightly modified version of the 80% limitation remains in effect for taxable years beginning after 2020.

[xxiv] Section 2303(a) of the Act.

[xxv] IRC Sec. 469.

[xxvi] IRC Sec. 461(l).

[xxvii] Or twice the otherwise applicable threshold amount in the case of a joint return. The threshold amount is indexed for inflation.

[xxviii] Actually, it suspends it retroactively.

[xxix] IRC Sec. 704(d), Sec. 1366(d).

[xxx] IRC Sec. 465.

[xxxi] Business interest means any interest paid or accrued on indebtedness properly allocable to a trade or business. Business interest income means the amount of interest includible in the gross income of the taxpayer for the taxable year which is properly allocable to a trade or business. Business interest does not include investment interest, and business interest income does not include investment income.

[xxxii] IRC Sec. 163(j).

[xxxiii] Sec. 2306 of the Act.

[xxxiv] Section 2301 of the Act. This amounts to a $5,000 credit per employee. Of course, a business that participates in the PPP is not entitled to the claim.

[xxxv] Section 2302(d)(3) of the Act.

[xxxvi] Section 2307 of the Act. Basically, improvements to a nonresidential building which are placed in service after the building. IRC Sec. 168(e)(3)(E).

[xxxvii] Dr. McCoy anyone? “I’m a doctor, not an engineer.” There were many variations on this line throughout the Star Trek series.

[xxxviii] This should be stressed. Tax policy has to take a long-term view in order to be effective.

[xxxix] Perhaps we can allow the business to borrow a limited amount from its account for short periods (like a bridge)?

The IRS has determined that any person required to pay Federal gift tax or generation-skipping transfer tax or to file IRS Form 709 (United States Gift and Generation-Skipping Transfer Tax Return) on April 15, 2020, is deemed to be affected by the COVID-19 emergency and, so, should be granted an extension of time within which to file such returns and to pay the related tax.

Specifically, the due date for filing Forms 709 (United States Gift and Generation-Skipping Transfer Tax Return) and for making payments of Federal gift and generation-skipping transfer tax that would otherwise be due on April 15, 2020, is automatically postponed to July 15, 2020. See IRS Notice 2020-20.

This relief is automatic; in other words, there is no requirement to file IRS Form 8892 (Application for Automatic Extension of Time to File Form 709 and/or Payment of Gift/Generation-Skipping Transfer Tax) in order to obtain the benefit of this filing and payment postponement until July 15, 2020.

However, a taxpayer may choose to file an application for extension by July 15, 2020, in order to obtain an extension to file Form 709 by October 15, 2020. Please note, however, that any Federal gift and generation-skipping transfer tax liabilities reflected on such returns, the payment of which has been postponed by Notice 2020-20, will still be due on July 15, 2020.

As a result of the postponement of the due date for filing Forms 709 and for making Federal gift and generation-skipping transfer tax payments from April 15, 2020, to July 15, 2020, the period beginning on April 15, 2020, and ending on July 15, 2020, will be disregarded in the calculation of any interest, penalty, or addition to tax for failure to file a Form 709 or to pay Federal gift and generation-skipping transfer taxes shown on that return and postponed by the Notice.

Instead, interest, penalties, and additions to tax with respect to such postponed Forms 709 and payments will begin to accrue on July 16, 2020.

One lingering question: What about the Federal estate tax? Unfortunately, the normal filing and payment due dates continue to apply to the estate tax.


If you would like to discuss how the $2 trillion CARES Act affects you, your family or your business, please do not hesitate to contact Lou Vlahos, Tax Partner at Farrell Fritz or your Farrell Fritz Relationship Partner.

For additional resources, please visit our COVID-19 Crisis Response and Help page.

Optimal Timing?

During the last twenty years, there have been a number of times during which the owners of closely held business entities have been encouraged – “urged” might be a better word, at least in some cases – by many advisers to take advantage of what may be described as “adverse” economic circumstances to do some gift and estate planning.

A sluggish economy, one with slow or no growth, is usually the catalyst. This is invariably accompanied – or caused? – by dropping consumer confidence which, in a service-based economy such as ours, only makes matters worse. The stock market will reflect[i] this less-than-positive outlook and, as the market declines, so will the value of most people’s retirement funds. The Fed will drop rates to encourage spending by businesses and consumers in the hope of limiting and hopefully reversing the effects. Government may “start” spending more in order to spark economic activity.

Where is the silver lining in all of this? “It’s the perfect environment,” many might say to a business owner, “to do some estate tax planning.” Why is that? “Because the value of your business has likely declined.”

To these folks, I say, “Slow down, don’t move too fast.”[ii]

The Goal of E-Tax Planning

The goal of estate tax planning, of course, is to transfer from members of a family’s older generation to members of its younger generation – without incurring a gift tax liability[iii] – those assets which now have a relatively low value – whether as a result of a downturn in the business, in its industry, in the economic generally, or otherwise – but which are reasonably expected to appreciate in value over time.

In theory, that is one way in which a gift tax or estate tax plan may be implemented – it is somewhat analogous to the adage about “buying low and selling high.”[iv]

For example, Parent owns an established business that may take off in a couple of years because of anticipated regulatory changes in its industry, or Parent may have recently started a business that is developing a new technology that promises to one day change the way widgets[v] are manufactured, or Parent’s business may be confident of eventually obtaining Federal approval for a new drug it is developing. In the hope of sharing with their children some portion of the future value of this business, Parent may decide to make a gift of some equity in the business to a trust for the benefit of the children.[vi] Because the value of this equity interest is relatively low as compared to what Parent reasonably believes are its prospects, such a gift makes sense.[vii] Their transfer of an equity interest to a child will not consume a large part of Parent’s federal exemption amount. What’s more, the transfer to a child or to a trust for their benefit removes the interest from Parent’s gross estate for purposes of the Federal estate tax; it also removes the future growth in the value of the interest from their estate.

That’s the underlying theory.

Flashback

It is a basic precept of estate planning that Parent should not dispose of any interest in their business that they are not comfortable giving up[viii] – whether for business or personal reasons – regardless of how much such a transfer may ultimately save in gift and estate taxes. It may not be the smartest decision from a tax planning perspective, but it is Parent’s property.

Do you recall the end of 2012? The Federal unified exemption amount, which was set at $5.12 million per person, was scheduled to revert on January 1, 2013, to its 2002 level of $1 million per person.[ix] Many business owners panicked at the thought of losing the opportunity to pass at least a portion of the value of their business to their children on a tax-sheltered basis.

What did they do in the face of this pending calamity? They made gifts before the clock struck 12:00 am on January 1, 2013. On that day, however, Congress passed the American Taxpayer Relief Act,[x] which President Obama signed into law on January 2, 2013, with retroactive effect.

On January 3, 2013, many of those business owners who had rushed to make gifts in December 2012 called their attorneys to see how they could rescind their 2012 transfers. “You’ll have to buy it back,” they were told,[xi] or “your kids will have to gift it back to you.” I can tell you, no one wanted to hear that.[xii]

In the case of those who made their gifts into a grantor trust with respect to which they retained a power of substitution,[xiii] the resulting income tax liability of such a repurchase was avoided. In those other cases . . . Oh well.

The “Recalcitrant” Parent

In some instances, Parent may be reluctant to part with any of their voting power in the business, though this may be easily addressed by providing for voting and nonvoting equity interests,[xiv] with only the latter being gifted.

In addition, a well-drafted shareholders’ or partnership/operating agreement can go a long way in securing Parent’s control over the business.

Parent’s Economics

In other instances, Parent may be loath to give up any of the economic benefits, including the right to distributions, associated with their ownership of the business.

In many cases, the “lost” cash flow may be addressed, in part, by structuring the transfer to the kids as one in which Parent retains an interest in the transferred property,[xv] or as one that is made in exchange for consideration.[xvi]

This has two beneficial consequences: the amount of the gift is reduced by the amount of the consideration to be received by Parent, and it provides Parent with a flow of funds. One potentially adverse result is that the transfer may be treated as a sale for income tax purposes which may cause Parent to have a taxable gain.

GRAT

For example, Parent may contribute some of their equity in the business to an irrevocable trust,[xvii] but will retain the right to be paid an annuity (basically, a fixed amount) from the trust every year, for a specified number of years[xviii] – a grantor retained annuity trust, or GRAT.[xix] When the term of Parent’s retained annuity interest ends, the property remaining in the trust will either remain in trust for the benefit of Parent’s children, or the trust may liquidate, with the property passing to the children as the beneficiaries of the remainder interest.

The trust is typically drafted so that the annuity amount payable to Parent is based upon a percentage of the value of the property as of the day the property was transferred by Parent to the trust.[xx] Once the annuity amount has been determined, Parent may calculate the amount of the gift arising from their transfer to the trust – i.e., the present value of the remainder interest, which is determined as of the date of the transfer to the trust using an interest rate prescribed by the IRS.[xxi]

In addition, the GRAT is typically drafted so as to be treated, for purposes of the income tax, as a so-called “grantor trust” – in general, a trust with respect to which the grantor has retained an interest such that the grantor will continue to be treated as the owner of the income and assets of the trust.[xxii] Because a taxpayer cannot sell property to themselves, and because the grantor is treated as owning the trust property, any transfers of property and payments of cash between Parent and the grantor trust will be disregarded for income tax purposes.[xxiii]

Sale

Alternatively, Parent may sell some of their equity interest in the business to a grantor trust[xxiv] in exchange for a promissory note with a face amount equal to the value of such equity interest. The loan should bear interest at least equal to the applicable federal rate (“AFR”), as determined by the IRS.[xxv] This interest may be payable on a current basis,[xxvi] with a balloon payment of principal when the note matures.[xxvii] Hopefully, the equity “sold” to the trust will have appreciated enough by then so that the trust may satisfy its obligation under the note by returning some of the equity to Parent. In this way, Parent avoids making a taxable gift while also avoiding taxable gain on the sale.

If there is little gain inherent in the equity interest to be transferred, Parent may choose to sell the property outright to child or to a non-grantor trust in exchange for a note bearing interest at the AFR.[xxviii]

The Federal transfer tax gambit in the case of a GRAT is that the equity interest transferred by Parent will appreciate, or will produce income, at a rate that is greater than the AFR – i.e., the interest rate that the IRS requires to be applied in determining the value of the gift in the case of the GRAT. If such appreciation or income levels are realized, then the excess will remain in the trust at the end of the term of Parent’s retained annuity interest. Thus, in a low interest rate environment like the one in which we now find ourselves, the GRAT may prove effective in removing value from Parent’s future estate.

In the case of an installment sale, the AFR represents the minimum rate of interest that the IRS requires be charged under the notes in order to avoid an imputed gift of any foregone interest.

Does Gifting Make Sense?

However, under the economic circumstances assumed herein, including the reduced value of the business – which likely stems in no small part from a not-insignificant drop in its revenues – one may question the wisdom, let alone the need, for Parent to transfer any of their equity interest in the business to, or for the benefit of, their child for the purpose of reducing Parent’s potential estate tax exposure.

As a result of the Tax Cuts and Jobs Act,[xxix] every individual has a combined Federal gift/estate tax exemption of $11.58 million;[xxx] in the case of married persons (especially a couple that takes advantage of “portability”), the exemption is $23.16 million per couple. Thus, an individual may, by a combination of lifetime and testamentary dispositions, transfer property with an aggregate fair market value of $11.58 million without incurring Federal gift or estate taxes. Where such property consists of interests in an ongoing, closely held business for which there is no ready market, the valuation of such interests will reflect their lack of liquidity.

In light of the foregoing, many business owners may ask “why give up any interest in the business?” The owner may feel that they need complete ownership – and whatever economic benefits they can derive or extract from such ownership – until the business stabilizes and starts to recover. Until then, they may not want to risk giving up any of its value or cash flow, especially if they feel they may need to sell the business down the road in order to fund their retirement because their IRA or other retirement accounts have taken a beating.

2026 or 2021?

As if a near economic disaster isn’t enough, enter the scheduled sunset of the increased gift/estate tax exemption amount. Specifically, for gifts made and for decedents dying after 2025, the exemption amount will revert to its pre-2018 levels; basically, it will be cut in half.

“But, Lou, you realize that we’re only in 2020, right?”

There is a more imminent threat to the higher exemption amount than the 2025 sunset: the November 2020 presidential election. The Democrats already control the House of Representatives – will they retain it? They need to win only three or four seats (depending on who wins the vice presidency) to take the Senate. What if they also win the White House?

Given the tenor and clear message of the Democratic primary contests, a reduction in the gift/estate tax exemption amount and an increase in the maximum gift/estate tax rate[xxxi] should be expected in 2021 in the event the Democrats do well this November.[xxxii]

What’s more, it is no longer only a question of principle or fairness or redistribution of wealth – the government must somehow come up with a way to pay for the $2.2 trillion economic stimulus package enacted on March 27, 2020,[xxxiii] and these Federal transfer taxes are fair game. In other words, the taxpayers at whom these taxes are targeted would be fortunate if we reverted to pre-TCJA law.

Scylla and Charybdis[xxxiv]

What to do?

Dispose of as much of the business as possible while the exemption amount is still high? Utilize GRATs and sales to grantor trusts to preserve some of the cash flow from the business to the owner? Retain only enough of an interest in the business so as to enable one’s estate to qualify for installment reporting of the estate tax attributable to the business?[xxxv] Hold on to the business, and purchase additional life insurance in an irrevocable trust?

All of the above? Probably.

Unfortunately, there’s a lot to think about here, but not a lot of time to plan.


[I] And reinforce? I have always viewed the stock market as a reactive element in the chemistry of the economy. You add information to the pot, and “it” responds based on some mix of perceived short-term and long-term self-interest. I’m sure that others view it differently.

[ii] Remember “The 59th Street Bridge Song”? Have you wondered whether we should now be calling it the “Ed Koch Queensboro Bridge Song”? I don’t think S&G would approve. “Slow down, you move too fast.”

[iii] New York no longer imposes a gift tax, though it will pull back into a decedent’s taxable estate any taxable gifts made by a resident decedent during the three-year period ending with the decedent’s date of death. NY Tax Law Sec. 954(a)(3). This claw-back provision applies to decedents dying before January 1, 2026. Would anyone be surprised to see it extended? Nope.

[iv] The gift and estate taxes are sometimes referred to as “transfer taxes.”

[v] No, this is not some item from Harry Potter, like a horcrux or a golden snitch. It is much more practical than such childish imaginings. For attorneys, a widget is a smallish, fictional device that is manufactured by a hypothetical business that can’t seem to catch a break. This poor widget manufacturer is forever involved, it seems, in some form of litigation, whether based on a commercial or other tort, a breach of contract, a misplaced peppercorn, etc.

[vi] Lots of good reasons for a trust. Keeping the property out of the kids’ hands will help to keep it out of the hands of their spouses and creditors, and will make it financially more difficult for the kids to engage in harmful behavior, like gambling or substance abuse.

[vii] Especially when one considers the valuation methodology for a going concern. Add to that the fact that the gift may consist of a minority interest which is not easily transferable, and the valuation may be quite favorable from a gift tax perspective.

[viii] In the words of many planners, it should be “disposable.”

[ix] The “sunset” of EGTRRA’s estate and gift tax provisions (P.L. 107-16), as extended and modified by the 2010 Extension Act (P.L. 111-312).

In addition, portability of a predeceasing spouse’s unused exemption amount would have been eliminated, and the tax rate would have increased to 55 percent. Oy.

[x] P.L. 112-240.

[xi] After all, in order for a gift to be effective for estate and gift tax purposes, it has to be a completed transfer. Reg. Sec. 25.2511-2.

Many clients asked why they had to pay to recover the gifted property. “After all,” several of them said, “my kids have no idea I even established a trust for them.” Oy, again.

[xii] And I am certain that many engaged in “self-help” at that point.

[xiii] IRC Sec. 675(4).

[xiv] In the certificate of incorporation in the case of a corporation; in general, in the operating agreement, in the case of a partnership/LLC.

[xv] Instead of an outright gift.

[xvi] A partial gift.

[xvii] With an “understanding” trustee. It also helps if Parent has the right to remove a trustee and, within certain limits, to appoint another.

[xviii] The “term” of Parent’s retained annuity interest in the trust.

[xix] IRC Sec. 2702; Reg. Sec. 25.2702-3. The GRAT will typically rely upon receiving distributions from the property contributed to the trust in order to make the annuity payments. For this reason, where the GRAT is funded with an interest in a closely held business organized as a partnership/LLC or as an S corporation – i.e., a pass-through that is not itself taxable – more cash will be left for the trust with which to make the necessary distributions.

[xx] In the event the IRS were to ever successfully challenge the reported value for the property, the annuity amounts would likewise be adjusted, thereby reducing what otherwise would have been the increased value of the gifted remainder interest. Reg. Sec. 25.2702-3(b)(2).

[xxi] IRC Sec. 7520. Specifically, 120% of the short-term AFR under Sec. 1274.

[xxii] Under the grantor trust rules. See IRC Sec. 671 – 679. The deemed owner will continue to be taxed on the income and gains recognized by the trust. If the owner-grantor can afford bearing this income tax liability, the trust may grow without being reduced for taxes. What’s more, the grantor’s payment of the income tax is not treated as a gift by the grantor for purposes of the gift tax.

[xxiii] Rev. Rul. 85-13.

[xxiv] So as to avoid adverse income tax consequences; i.e., taxable gain from the sale.

[xxv] IRC Sec. 1274. If a lower rate were charged, the foregone interest would be treated as a taxable gift by Parent.

[xxvi] The note has to be respected as such for purposes of the gift tax. The payment of such interest is not taxable to the grantor-owner. They cannot pay interest to themselves.

[xxvii] An installment sale. On the death of Parent, the trust ceases to be treated as a grantor trust, and the sale in exchange for a note is completed for purposes of the income tax. A balloon payment is often used because if Parent dies while the note remains outstanding, their estate may be able to claim a step-up in basis for the equity interest “sold” and thereby avoid any gain recognition. Of course, the note is included in Parent’s gross estate for purposes of the estate tax.

[xxviii] If the value of the equity interest was less than Parent’s adjusted basis for the interest – i.e., a sale would result in the realization of a loss – Parent may want to reconsider selling the interest to a family member; that’s because IRC Sec. 267 disallows (suspends, really) the recognition of loss arising from a sale or exchange between certain related persons.

[xxix] P.L. 115-97 (the “TCJA”). Effective for gifts made and decedents dying after 2017.

[xxx] IRC Sec. 2010(c)(3) and (c)(4); Sec. 2505. This is in addition to the annual gift exclusion amount of $15,000. IRC Sec. 2503.

[xxxi] The current maximum rate is 40 percent.

[xxxii] In addition, one should expect a Democratic assault on the discounts commonly taken when valuing interests in a closely held business for purposes of the gift and estate taxes.

[xxxiii] The Coronavirus Aid, Relief and Economic Security Act.

[xxxiv] No, not the line from Wrapped Around My Finger by The Police. Rather, the mythical monsters that were thought to inhabit opposite sides of the Straits of Messina and who preyed on passing sailors. They figured prominently in Homer’s Odyssey. Given the severity of the choices described here, we may want to throw in a Cyclops for good measure.

[xxxv] IRC Sec. 6166. https://www.taxlawforchb.com/2020/03/recapitalizing-debt-to-defer-payment-of-the-estate-tax-good-idea/

Tax Law for the Closely Held Business blog author Lou Vlahos’ op-ed entitled “Economic Losses: Blame the Virus? Not Entirely” was published yesterday, March 26, in The Empire Report.

Below is an excerpt of the article: 

In response to this stressful – but hopefully short-lived – business environment, the Federal government has taken some extraordinary measures over the last few weeks to help American businesses, and the public generally, to cope with what is expected to be the significant economic toll attributable to the Coronavirus.

Businesses that are required to provide paid leave for employees are being granted a refundable tax credit pursuant to the recently enacted Families First Coronavirus Response Act to defray the associated cost.

And on March 25, the Republican and Democratic leadership in the Senate announced an agreement on an economic stimulus plan that provides for more than $2 trillion in spending, as well as tax breaks, to bolster American business and consumers. A well-reasoned Keynesian-inspired approach? Doubtful, because how will this infusion of cash into the economy stimulate consumer demand under the circumstances in which we find ourselves? After all, folks are either not allowed to, or are fearful of, going out to places where they may encounter groups of other people.

To read the full op-ed, please click here.

The Lockdown

We are in a Coronavirus-induced lockdown. Most places of business are either closed or are open on a very limited basis. Social distancing is the order of the day. Those who can work remotely are doing so.[i] Many don’t have that option.

Certain businesses are experiencing an uptick in revenue as a result of the lockdown.[ii] Other businesses are floundering as demand for their goods or services has plummeted.[iii]

Then there is the great majority of businesses – closely held businesses – which basically live “from paycheck to paycheck.” It is a truism that they need to collect on their receivables in order to satisfy their payables.

In bad times, they may be able to rely on a line of credit for some finite period of time (assuming the line is adequate) – the question, of course, is for how long – or they may have to dip into their reserves or even request an infusion of capital from their owners.

The Economy

Many of these businesses are struggling to stay afloat.

They are trying to generate a steady flow of work from those other businesses with which they ordinarily transact, as well as from the general public – this can be a challenge in normal times, let alone under the circumstances in which they now find themselves, where even these potential or existing “client businesses” are experiencing the same challenges.

Even when this work can be found, one has to wonder whether the client will ultimately be able to pay the usual price charged by the business, or whether they will negotiate a discounted charge from the get-go. It is not at all unusual for a business to settle for a near-to-below market rate just to keep its doors open and its workers employed – we’re talking damage control until one can round the proverbial corner.

And while it may be difficult to generate the necessary business and the resulting receivables, which hopefully will be collected sooner rather than later, many business expenses are fairly fixed – unless the business is able to negotiate concessions from its landlord, bank, vendors, etc.;[iv] for example, rent, debt service, salaries, pension, insurance, and others.[v]

Congress Acts

In response to this stressful – but hopefully short-lived – business environment, the Federal government has taken some extraordinary measures over the last couple of weeks to help American businesses, and the public generally, to cope with what is expected to be the significant economic toll attributable to the Coronavirus.

Thus, income tax return filing dues dates have been pushed back 90 days, and a similar “holiday” has been granted for income tax payments, regardless of the amount owed.[vi]

Businesses that are required to provide paid leave for employees are being granted a refundable tax credit to defray the associated cost.[vii]

The “CARES” Bill

More recently, the Republican leadership in the Senate introduced an economic stimulus plan, dubbed the Coronavirus Aid, Relief and Economic Security (“CARES”) Act,[viii] and has started discussions with the Administration and the Democratic Senate leadership[ix] regarding its terms.

Among other things, the proposed legislation provides, among other things, that a business with fewer than 500 employees may qualify for a loan of up to $10 million that would help cover payroll and rent, among other obligations. If the business retains its employees and payroll levels, the loan would be forgiven to the extent it is used to cover payroll and certain preexisting obligations.[x]

Each of these measures should alleviate some of the pain that businesses have begun to feel, and will continue to experience for some time, as a result of the Coronavirus lockdown.

Net Operating Losses

Notwithstanding this promised relief, the fact remains that many businesses will be generating losses – real and immediate and substantial economic losses.[xi] Once upon a time, not that long ago, such a business would have been able to carry its net operating losses (“NOLSs”) – generally, the amount by which its business deductions exceed its gross income[xii] – for a taxable year back to its two immediately preceding taxable years,[xiii] as a result of which the business would have been entitled to a refund of all or a portion of the Federal income taxes paid in such earlier years; in other words, it would have received, in relatively short order, funds that the business needed in order to help it recover, and it would not have had to incur debt to do so.

Under existing rules, however, these businesses will be denied the full economic benefit of such losses – at a time during which this benefit may be sorely needed. That’s because the Tax Cuts and Jobs Act (“TCJA”)[xiv] eliminated the option[xv] for most taxpayers to carry back an NOL. Indeed, most taxpayers can only carry NOLs arising from taxable years ending after December 31, 2017 to a later year.[xvi]

The TCJA did not only eliminate the carryback of a taxpayer’s NOLs, it also limited the use of such NOLs for any taxable year of the taxpayer to which they may be carried forward.

Specifically, the NOL deduction – for losses arising in taxable years beginning after December 31, 2017[xvii] – cannot exceed 80 percent of the taxpayer’s taxable income for a carryforward taxable year (determined without any NOL deduction).

The practical effect of this limitation is that a taxpayer with an NOL carryforward to a taxable year, that could otherwise have been used to offset their entire business income for such year – thereby eliminating their income tax liability for the year – has to defer part of the benefit of the NOL into a later taxable year while paying income tax in the current year.

Excess Business Loss

Prior to the TCJA, an individual taxpayer’s business losses could offset the individual’s nonbusiness income,[xviii] without limitation.

The TCJA limited the amount of losses from the trades or businesses of a noncorporate taxpayer[xix] that the taxpayer can claim each taxable year.[xx] If the noncorporate taxpayer owns an interest in a partnership or in an S corporation that is engaged in a trade or business, the taxpayer’s allocable share of the losses therefrom is also considered.[xxi]

Specifically, the taxpayer cannot deduct overall net business losses in the current taxable year. This is the amount by which the total deductions from the taxpayer’s trades or businesses are more than their total gross income or gains from such trades or businesses, plus a statutorily prescribed threshold amount.[xxii]

The amount of any excess – the excess business loss – is treated as an NOL carryover in the subsequent taxable year.[xxiii]

The practical effect of this limitation is that a taxpayer with excess business losses for a taxable year, that could otherwise have been used to offset their nonbusiness income for such year – perhaps even eliminating their tax liability for the year – have to defer the benefit of the excess loss into the next taxable year while paying an amount in income tax in the current year that they otherwise could have used in their business.

What Should Congress Do?

The next few months will be challenging for almost every business in the country. Many businesses will fail that should not have failed. Others will rack up some significant operating losses that they should not have realized. The culprit in both cases is the Coronavirus, and the closely held business will be one of the inadvertent victims of our response to this very serious public health crisis.

Many “experts” have stated that they expect the crisis will pass before the end of the 2020 calendar year, maybe even as early as late Spring. At this point, we can only hope.[xxiv] Those businesses that survive – whether because they were “lean and mean” before the crisis, had adequate reserves or other financing sources, or for some other reason, including plain luck – are likely to have realized significant losses. They are also likely to be in need of new capital.

Why limit the ability of these businesses to convert their losses as soon as possible into badly needed funds? Why defer this benefit to later years when we can reasonably expect an immediate need for capital in the short-run?

Whatever the underlying policy reasons may have been for the TCJA’s enactment of the above-described loss limitation rules – other than to offset revenue losses resulting from the reduction in the Federal corporate income tax rate – they are overshadowed by the current economic threat.

Congress should act accordingly, and it should act immediately. In fact, the CARES Act proposes to make some of the changes outlined above, as well as others.

In particular, the Act calls for the retroactive elimination of the excess business loss rules for 2018 and 2019; in addition, the rules would not apply for 2020. These rules are scheduled to expire after 2025 in any case, and their retroactive repeal would allow business owners to whom the limitation applied in 2018 or 2019 to immediately file a refund claim. Frankly, their elimination from the Code[xxv] should be accelerated.

The CARES Act also proposes changes to the TCJA’s limitations on the use of NOLs. Taxpayers with NOLs arising in 2018, 2019 and 2020 would be allowed to carry such losses back to each of the five taxable years[xxvi] immediately preceding the taxable year in which the loss was realized. Assuming these taxpayers had tax liabilities for those years, they will be entitled to a refund of what is likely a badly needed infusion of cash.

The Act would also suspend the 80-percent-of-income limitation for taxable years beginning before January 1, 2021 (basically, 2018, 2019 and 2020), thereby freeing up dollars that otherwise would have been paid to the government.

The foregoing provisions of the CARES Act would be especially helpful for those businesses that will realize substantial losses this year, of which there will probably be many.

However, one must not lose sight of the fact that these amendments to the Code have not yet been enacted – indeed, they remain subject to change as Republicans and Democrats try to reach a consensus.

Speaking of which, when last I checked,[xxvii] the Washington Post had reported that Democrats were characterizing the CARES bill as a form of “corporate welfare,” and the loan program as a “slush fund” for businesses and their owners. Insisting that the preservation of workers’ jobs and salaries be the first priority of any economic aid legislation, they have promised to offer a competing legislative proposal.[xxviii]

Stay tuned. Hopefully, we will have some resolution later this week.


[i] Some more effectively than others.

[ii] I read that the consumption of “comfort foods” is on the rise. I must be in a bad way all of the time because I frequently seek out such foods. Indeed, as I revise this post, I have before me a large cup of coffee and a plate of Oreos. It’s a small plate, really. No, they are not the over-stuffed variety. Don’t judge me. Back off.

[iii] Restaurants, hotels, theaters, fast food joints, donut shops, etc. – anyplace in which people congregate.

[iv] It takes two to tango. Yada, yada, yada.

[v] Clearly, the leaner a business was going into this situation – no unnecessary obligations (so-called “fat”), an available line of credit, adequate reserves – the greater its chances of enduring the slowdown and ultimately emerging from it.

Examples of items that may be characterized as fat include the following: above-market workforce salaries and benefits, excess labor (meaning that a function that should reasonably be performed by one person is spread out over two), unnecessary overhead expenses (like an unnecessary location), personal travel and entertainment, non-targeted charitable contributions.

[vi] See IRS Notice 2020-18.

[vii] Families First Coronavirus Response Act. P.L. 116-127.

[viii] S.3548.

[ix] Mostly the Senate because the House appears to be out of session until March 24. https://www.congress.gov/resources/display/content/Calendars+and+Schedules

[x] Moreover, these businesses would not have to include the forgiven debt as COD income under IRC Sec. 61(a)(11). FYI, prior to the TCJA, in the case of a corporate business, the forgiven debt could have been treated as a capital contribution under IRC Sec. 118. As a result of the TCJA, however, the exclusion of a capital contribution from a corporation’s gross income, under Sec. 118(a), does not apply to a contribution by a governmental entity.

[xi] As distinguished from “mere” tax losses.

[xii] IRC Sec. 172(c). With certain modifications.

[xiii] IRC Sec. 172 prior to the TCJA.

[xiv] P.L. 115-97, Sec. 13302.

[xv] Before the TCJA, the taxpayer could elect to waive the carry back of NOLs for a taxable year and, instead, carry all of such losses forward.

[xvi] Under prior law, the carryforward period was limited to twenty years. Today, an NOL may be carried forward for an indefinite period, until it is fully utilized.

[xvii] IRC Sec. 172(a)(2). See the Instructions for IRS Form 1045.

[xviii] For example, investment income such as dividends, capital gains, and interest income.

[xix] Individuals, estates, and trusts.

[xx] TCJA Sec. 11012. IRC Sec. 461(l).

[xxi] The trade or business determination is made at the entity level, but the limitation is applied at the level of the partner or shareholder, as the case may be.

[xxii] For 2019, the threshold amount is $255,000 ($510,000 for married taxpayers filing a joint return). These amounts are indexed for inflation. See IRS Form 461, Limitation on Business Losses.

[xxiii] The provision applies after the application of the passive loss rules of IRC Sec. 469. Thus, the loss must have first satisfied the basis limitation rules in the case of an interest in a partnership (IRC Sec. 704(d)) or S corporation (IRC Sec. 1366(d)), as well as the at risk rules of IRC Sec. 465.

Note that the loss limitation provision does not apply to taxable years beginning on or after January 1, 2026.

[xxiv] From Lord of the Rings, The Two Towers (my favorite of the three movies):

THEODEN: [speaking loudly, that his men may hear] They will break upon this fortress like water on rock. [they walk around the inner ramparts] Saruman’s hordes will pillage and burn.
We’ve seen it before. Crops can be resown……homes rebuilt. Within these walls……we will outlast them.
ARAGORN: [raising his voice in response to what he perceives as Theoden’s foolish plan] They do not come to destroy Rohan’s crops or villages. They come to destroy its people……down to the last child.
THEODEN: [walks back towards Aragorn, takes his arm, and in a lowered voice, through clenched teeth says] What would you have me do? Look at my men. Their courage hangs by a thread.

[xxv] I am referring to the one true Code. Title 26 of the U.S.C.

[xxvi] The previous longest carryback period was three years, though there have been longer exceptions. The regime replaced by the TCJA – two years back, twenty years forward – was enacted by the TRA of 1997, P.L. 105-34.

[xxvii] At 3:00 pm EST, March 22.

[xxviii] Senate Republicans had hoped for a vote on Monday, March 23.

 

Estate Planning 101

A basic precept of effective estate planning is for a member of an older generation to transfer[i] property to a family member of a younger generation – for example, stock in a closely held corporation – that is reasonably anticipated to appreciate in value over time. In this way, not only will the property be removed from the older transferor’s gross estate for purposes of the federal estate tax, but any increase in the value of the property will also be excluded.[ii]

Thus, it is not uncommon[iii] for the owner (“Owner”) of a fairly new business venture to transfer to a trust for the benefit of their children some portion of their equity interest in the business entity through which the venture is to be conducted. At the time of the transfer – ideally, as close to the inception of the business as possible – the value of the equity may be relatively low, even speculative,[iv] thereby consuming only a small portion of the investor’s gift tax exclusion amount.[v] If the business ultimately fails, Owner will have “wasted” only that portion of their exclusion amount. However, if the business turns out to be a wild success, Owner will have effectively transferred a great deal of wealth to the next generation for a relatively small investment.[vi]

Beware of Deemed Gifts

This desirable result is the product of prudent gift and estate planning – not to mention some combination of foresight, effort and luck. There may be times, however, when too much of the proverbial “good thing” turns out to be a problem.[vii] For example, in their enthusiasm for shifting the hoped-for appreciation in the value of the business to their children, or to trusts for their benefit, Owner may get carried away.

Thus, Owner may contribute funds to the business without causing the business to issue additional equity to them in exchange for such funds, in the belief that by doing so they will direct more of the appreciation to the stock held by their children. In the case of a corporation, this contribution may be treated as a gift to the beneficiaries of the trust to which Owner has previously transferred shares of stock in the corporation.[viii]

“Loans”

Alternatively, and with the same goal in mind – to “freeze” Owner’s value while shifting appreciation to the younger generation – Owner may decide to treat their contributions of cash to the business as loans.[ix]

These loans may be recorded as such on the books of the business,[x] as well as on the balance sheet[xi] of the tax return filed by the business. They may be memorialized in a promissory note that sets forth the terms of the loan, including a maturity date,[xii] an interest rate,[xiii] and a payment schedule. The loan may even secured by the borrowing entity’s assets. Ideally, individuals who want to support the claim that their transfer of funds was a loan, rather than a gift, should require that interest be paid at least annually;[xiv] failing that, they should ensure that interest is accrued and imputed for tax purposes.[xv]

However, if this practice is not monitored closely, the combined effect of freezing Owner’s value while increasing that of Owner’s children, may leave Owner’s estate in a difficult position. Specifically, it may result in their estate failing to qualify for a special relief provision under the Code[xvi] which allows an estate that consists largely of equity in a closely held business to satisfy its federal estate tax liability attributable to such equity over a term of up to 14 years, during the first four of which only interest on the deferred tax is payable.[xvii]

Installment Payments

In order to qualify for this relief, the fair market value of a decedent’s interest in a closely held business, which is included in their gross estate for purposes of determining the estate tax,[xviii] has to exceed 35-percent of their adjusted gross estate.[xix]

A decedent’s equity in a corporation[xx] will qualify as an “interest in a closely held business” if 20-percent or more in value of the voting stock of the corporation was included in the decedent’s gross estate,[xxi] or if the corporation had no more than 45 shareholders.[xxii]

If a decedent owned a qualifying interest in a closely held business, then the estate tax attributable to the value of such interest is eligible for installment payments.[xxiii] For purposes of determining that value, however, the value of the interest attributable to any passive assets held by the business is disregarded. Thus, the benefit of the estate tax deferral is limited to the tax attributable to assets that are used in carrying on a trade or business by the closely held business.[xxiv]

Inadvertent Disqualification?

Advisers to the owners of a closely held business – for whom the ability to pay their estate tax in installments in accordance with the above rule – will often check on the status of an owner’s qualification.[xxv] In the event they discover that the owner’s estate may not be eligible for the installment rule, it may be possible to remedy the failure; for example, by adjusting the owner’s adjusted gross estate – perhaps by structuring certain otherwise testamentary dispositions as “liabilities” – or by increasing the owner’s relative equity in the business or the value of such interest relative to the owner’s other assets.

For example, the attribution rules mentioned above may be helpful.[xxvi] The owner may also purchase equity from other shareholders, exchanging value for value, and thereby avoiding a taxable gift, but probably triggering a taxable gain for those shareholders. In the case of a trust that is treated as a grantor trust on account of the owner’s retained power of substitution,[xxvii] the owner may exchange other property for the stock held by the grantor trust, which is treated as a nonevent for purposes of the income tax.[xxviii] If practicable, the corporation may redeem some of the shares of stock held by other shareholders; if treated as an exchange for tax purposes, there may be taxable gain;[xxix] if treated as a “dividend” distribution, then the entire amount will be taxable.[xxx]

Each of these options has its own economic costs which must be weighed against the benefit to the estate and its beneficiaries of being able to pay the estate tax in installments.

What about the Loans?

This brings us back to Owner, described above, who may have been overly eager about shifting value in the business away from themselves and to their children. In furtherance of that goal, Owner chose to treat their continued capital infusions into the nascent business as loans rather than as contributions to capital in exchange for more equity in the business.

Owner’s business is not at risk of failing to meet the definition of a “closely held business” under the installment payment rule – the corporation has fewer than 46 shareholders. The issue, rather, is that the value of Owner’s interest in the corporation may not exceed 35-percent of Owner’s adjusted gross estate.

In that case, Owner’s estate will not be able to defer payment of the estate tax attributable to either the stock in the closely held corporation or to the indebtedness owed by the corporation to Owner.

How, then, can the 35-percent test be satisfied?

Conversion of Debt to Equity?

Depending upon how much of the corporation’s debt is owed to Owner, the latter may decide to transfer some or all of such debt to the corporation as a contribution to capital. This transaction may result in Owner’s estate satisfying the 35-percent test by reducing the value of the debt in Owner’s estate; however, such a transfer may also result in a gift by Owner to the other shareholders of the corporation. If Owner’s transfer of the debt is paired with the corporation’s issuance of additional stock to Owner, the chance of success is increased, and the risk of a taxable gift is reduced.

In either case, however, it is imperative that Owner, the corporation, and the other shareholders consider the income tax consequences of Owner’s transfer.

Income Tax Consequences

In general, if a shareholder gratuitously forgives the debt owed to them by their corporation, the transaction represents a contribution to the capital of the corporation to the extent of the principal amount of the debt.[xxxi]

However, the Code provides more specific rules that describe the consequences of such a transaction for both the shareholder-creditor and the corporation-debtor.

The Creditor

From the shareholder-creditor’s perspective, the contribution of the debt to the corporation without the receipt of any additional shares of stock should be treated as a nonevent for income tax purposes.[xxxii]

If the corporation issues additional shares to the shareholder-creditor, the stock-for-debt exchange will be taxable to the shareholder if the debt is not evidenced by a security.[xxxiii] The amount of gain to be recognized will be equal to the fair market value of the stock received by the creditor over the creditor’s adjusted basis for the debt exchanged.[xxxiv]

Even if the debt is evidenced by a security, the exchange will be taxable to the shareholder unless they are in control of the corporation immediately after the exchange.[xxxv]

Alternatively, the exchange may qualify as an “E” reorganization – a recapitalization.[xxxvi] In that case, the creditor’s surrender of a debt security issued by the corporation in exchange for stock issued by the corporation would qualify for tax-deferred treatment.[xxxvii]

In either case, however, shares that are attributable to any accrued but unpaid interest will be taxable to the shareholder-creditor as ordinary interest income.[xxxviii]

Unfortunately, the Code does not define the term “security.” That being said, there is some authority for the proposition that a debt obligation with a term of fewer than five years will not be treated as a security.[xxxix] In other words, generally speaking, the obligation should represent a longer-term investment in the debtor-corporation in order to qualify as a security.[xl]

The Debtor

Of course, in the context of a shareholder-creditor and corporation-debtor relationship, it is not enough to consider only the consequences to the shareholder arising from the “conversion” of the indebtedness into equity. The tax cost to the debtor-corporation also has to be determined.

Where the shareholder-creditor cancels the corporation’s debt by contributing it to the corporation without receiving any stock in exchange, the corporation is treated as having satisfied the principal amount of the debt – generally, its issue price[xli] when the debt bears adequate stated interest – with an amount of money equal to the creditor’s adjusted basis[xlii] in the debt.[xliii] Thus, if such adjusted basis is less than the debt’s adjusted issue price,[xliv] the corporation will recognize cancellation of indebtedness income.[xlv] If the creditor’s adjusted basis in the debt is at least equal to debt’s adjusted issue price, then no cancellation of indebtedness income will be recognized.

Where the corporation-debtor issues additional shares of stock to the shareholder-creditor in exchange for, and in cancellation of, the corporation’s indebtedness, the corporation is treated as having satisfied the debt for an amount of money equal to the fair market value of the stock issued.[xlvi] Thus, if the value of the stock issued is less than the adjusted issue price for the debt, the corporation will recognize cancellation of indebtedness income. This is the case even where the debt obligation is evidenced by a security and the reorganization rules apply to the debt-for-stock exchange.[xlvii]

Lessons?

The foregoing illustrates just one instance of the interconnectedness of the estate and income taxes in the context of a closely held business. There are many more.

The adviser to such a business has to be attuned to this fact – they should not make any recommendations with respect to one of these taxes without considering its effects on the other – it will not always be possible to unwind an exchange or transaction without adverse tax consequences of one sort or another.

Moreover, in no case should they advise a course of action without first determining its impact on the business as such, including its relationship to third parties such as lenders and other investors.

*****

It is difficult to ignore the circumstances in which we now find ourselves. It is natural to wish that things were different. In times of stress, I often find guidance in literature. The following is from The Lord of the Rings:

“I wish it need not have happened in my time,” said Frodo.
“So do I,” said Gandalf, “and so do all who live to see such times. But that is not for them to decide. All we have to decide is what to do with the time that is given us.”


[i] Whether by a completed gift or a sale, whether outright or in trust. In the case of a trust, and depending upon the current value of the property, the expected cash flow and rate of appreciation, the transfer may take the form of a gift, a GRAT, a sale, or a sale to a grantor trust.

[ii] Assuming, of course, that the transferor has not retained an interest in the property such that, notwithstanding the transfer, they continue to enjoy the benefits of ownership themselves, or the ability to determine the enjoyment of the property by others, or they retain a reversionary interest in the property. In that case, the transferred property will be included in the transferor’s estate at its value as of their date of death. IRC Sections 2035, 2036, 2037 and 2038.

[iii] Which is to say that it is not common, though it does happen. Most owners of a closely held business are reluctant to give up any part of their equity, let alone control, until after the business has established itself – i.e., appreciated in value – and the owners have reaped the rewards of their efforts. At the point, an owner may begin to think on their eventual withdrawal, both from the business and from this world. (Of course, there are some who say, “if I die,” rather than “when.”)

[iv] As always, a well-reasoned valuation report by an experienced and well-regarded professional appraiser is necessary. The money is well spent.

[v] IRC Sec. 2010(c) and Sec. 2505. Of course, any part of the exclusion amount consumed during the life of the grantor will not be available to shield the grantor’s testamentary transfers.

[vi] Indeed, if the grantor had also allocated part of their GST exemption amount at the time they transferred the property to the trust, subsequent distributions from the trust to their grandchildren would not be subject to the GST tax. IRC Sec. 2601 and Sec. 2631. See the automatic allocation rules in IRC Sec. 2632 and the regulations thereunder.

[vii] Examples abound; for example, drugs, perhaps longevity. Mark Twain had his own exception to this rule of thumb: “Too much of anything is bad, but too much good whiskey is barely enough.”

[viii] See, e.g., Reg. Sec. 1.351-1(b), which treats the contributor as having received shares of stock, which they then transfer to the other shareholders.

In the case of a partnership, the owner’s adjusted basis for their partnership interest and their capital account will reflect the additional capital contribution. IRC Sec. 705 and Sec. 722; Reg. Sec. 1.704-1(b)(2)(iv).

But, in an arm’s length deal, who would put their capital at risk without requiring additional equity, or a preferred return on their investment, or a guaranteed payment for the use of their capital? There’s a donative transfer in there.

[ix] We assume for our purposes that the loans are respected as such.

[x] If the owner-lender prepares personal financial statements at the request of a third party, they should be careful to include the loans as such.

[xi] Schedule L of either IRS Form 1065 for a partnership or IRS Form 1120 for a corporation. “Loans from partners” or “loans from shareholders” as the case may be.

[xii] In the absence of a maturity date, the loan is deemed to be a demand loan, which may be called at any time by the lender.

In some cases, it may be necessary to determine whether the loan is a “security,” in which case the length of the term will likely be pretty important. See, e.g., IRC Sec. 354 and Sec. 368(a)(1)(E).

[xiii] Often at the applicable federal rate, or AFR, under IRC Sec. 1274.

If the debt bears interest at a rate less than the AFR (a “below market rate”), the “lender” may be treated as having made a gift of the foregone interest. IRC Sec. 7872.

[xiv] In related party settings, it is important to treat with one another as closely as possible as one would with an unrelated party.

[xv] IRC Sec. 7872.

[xvi] IRC Sec. 6166. Of course, the policy underlying this relief is based upon the concededly illiquid nature of the closely held business and the desire to avoid a forced sale of the business solely for the purpose of satisfying the deceased owner’s estate tax liability. In accordance with this policy, the tax deferral will cease, and the tax will come due immediately, upon certain sales of the decedent’s interest or upon certain withdrawals of money from the business – in other words, upon the happening of certain “acceleration” events that eliminate the estate’s liquidity problem. IRC Sec. 6166(g).

[xvii] IRC Sec. 6166(a) and (f). Beginning with the fifth year, the estate will start paying the deferred estate tax and the interest thereon.

[xviii] IRC Sec. 2031.

[xix] IRC Sec. 6166(b)(6). The adjusted gross estate is determined by subtracting from the decedent’s gross estate only the estate’s administration expenses and certain casualty losses.

[xx] We’re limiting this discussion to corporations.

[xxi] The fact that the decedent was treated, for income tax purposes, as the owner of stock held by a grantor trust through the date of their death is irrelevant for purpose of this estate tax rule if the stock is not included in the decedent’s gross estate.

[xxii] IRC Sec. 6166(b). Certain attribution rules apply for purposes of determining the “number of shareholders test, or may be elected for purposes of the “percentage of value” test. IRC Sec. 6166(b)(2) and (7), respectively. The election under Sec. 6166(b)(7) comes at a price, including the loss of the initial period of interest-only payments.

[xxiii] The liquidity for an installment payment will often come from the corporation itself, in the form of a redemption of stock. Redemptions described in Sec. 303 of the Code – which are treated as exchanges of stock (not as dividends) and may thereby take advantage of the basis step-up at death under IRC Sec. 1014 – are not treated as acceleration events. IRC Sec. 6166(g)(1)(B).

[xxiv] IRC Sec. 6166(b)(9).

[xxv] That is not to say that they know when the owner will die, but reasonable assumptions may be made to enable some helpful analysis.

[xxvi] See endnote xxii.

[xxvii] Under IRC Sec. 675(4).

[xxviii] See, e.g., Rev. Rul. 85-13.

[xxix] IRC Sec. 302(a). Beware the Sec. 318 attribution rules.

[xxx] IRC Sec. 302(d), Sec. 301. The federal income tax would be imposed at a rate of 20%, plus the 3.8% federal surtax on net investment income. IRC Sec. 1(h), Sec. 1411.

Of course, if we are dealing with an S corporation that does not have earnings and profits from C corporation tax years, a redemption treated as a dividend distribution would be described in IRC Sec. 1368, and would be treated as a return of the shareholder’s entire basis in their stock before gain would be recognized.

[xxxi] Reg. Sec. 1.61-12(a).

[xxxii] We’ve already seen how it may result in a gift to the other shareholders if they are the natural objects of the contributing shareholder’s bounty.

[xxxiii] IRC Sec. 351(d)(2). Such a debt is not treated as “property” within the meaning of IRC Sec. 351.

[xxxiv] IRC Sec. 1001.

[xxxv] IRC Sec. 351(a). “Control” is defined in IRC Sec. 368(c) as the ownership of stock possessing at least 80% of the total combined voting power of all classes of stock entitled to vote and at least 80% of the total number of shares of all other classes of stock of the corporation.

[xxxvi] IRC Sec. 368(a)(1)(E); Reg. Sec. 1.368-2(e)(1) (exchange of bonds for preferred stock).

[xxxvii] IRC Sec. 354.

[xxxviii] IRC Sec. 351(d)(3).

[xxxix] See, e.g., Rev. Rul. 2004-78.

[xl] More than five years, though the other terms of the debt have to be considered.

[xli] IRC Sec. 1273.

[xlii] In the case of the original holder of the debt – i.e., the shareholder-lender – this will be the amount of the loan when the debt bears adequate stated interest.

A special rule applies for S corporation debt under which any reduction in the basis of the debt caused by the shareholder-creditor’s distributive share of corporate losses is disregarded. IRC Sec. 108(d)(7)(C).

[xliii] IRC Sec. 108(e)(6). This provision overrides IRC Sec. 118, under which contributions to the capital of a corporation are otherwise excluded from its income.

[xliv] This is initially the issue price for the debt. IRC Sec. 1272(a)(4); Reg. Sec. 1.1275-1(b). This is the amount of the loan where the debt bears adequate stated interest.

[xlv] IRC Sec. 61(a)(11). I am assuming for our purposes that none of the exclusions to recognition of such income under IRC Sec. 108 are applicable; for example, cancellation of debt when the debtor is insolvent.

[xlvi] IRC Sec. 108(e)(8). The issuance of the stock by itself is not otherwise taxable to the corporation. IRC Sec. 1032.

It appears that the IRS respects the form of the transaction, meaning that even in the case of a corporation with a single shareholder – in which case the issuance of additional shares may be treated as a “meaningless gesture” under Sec. 351’s jurisprudence – the issuance of stock in satisfaction of the corporation’s debt will trigger application of IRC Sec. 108(e)(8), rather than Sec. 108(e)(6). See, e.g., PLR 20101608.

[xlvii] Rev. Rul. 77-437.

A Basic Principle

Do you remember the scene from “History of the World Part I” when Mel Brooks, in the role of Moses, calls out “Hear me, oh hear me! All pay heed! The Lord, the Lord Jehovah has given unto you these fifteen [he drops one of the three tablets cradled in his arms and it shatters] – oy – these ten, Ten Commandments for all to obey.”[i]

Scholars have long debated what the five lost commandments may have been. I have my own hunch, at least as to one of them: “Thou shall not acquire and hold real property in a corporation, or in any business entity that has elected to be treated as an association.”[ii]

I have deduced that this must be the case from the number of inquiries I receive on a regular basis regarding the disposition of real property owned by a closely held corporation. One cannot easily explain away this state of affairs. How else might one account for any transgression of this basic principle? The only logical conclusion, I have determined, is that the public must be unaware of this missing commandment.[iii] Makes sense, right?

Lost Benefits

After all, how would one knowingly deny oneself the ability to increase the adjusted basis[iv] for their interest in a real estate partnership by their share of the indebtedness incurred by such partnership, even when the indebtedness is nonrecourse? This principle – which no doubt would have inspired realms of commentary and annotations to the missing commandment – enables a partner in such a partnership to claim their share of depreciation deductions attributable to such indebtedness[v]; it also supports a partner’s ability to withdraw their share of any loan proceeds from the partnership without incurring any tax.[vi]

There is no comparable basis adjustment rule for the shareholder of a corporation, including a pass-through entity such as an S corporation.[vii]

Regardless of how we got here, well, here we are. “Do what you can, with what you have, where you are,” as Teddy Roosevelt said.

With TR’s guidance in mind, let’s consider a question that was put to me just a few days ago.

We Want To Split Up

Corporation’s principal asset is a mixed use[viii] apartment building. Thanks to the appreciation in its value over the years, plus the cost-recovery deductions[ix] claimed by the corporation, there is substantial gain inherent in the real property.[x] The corporation would realize this gain if the corporation were to dispose of the building in a taxable transaction.[xi]

Corporation has two individual shareholders (“S/H One” and “S/H Two”) who are not related to one another. For years, they have both been active in the management and operation of the building.

For various reasons, the two shareholders no longer get along, and would like to separate from one another. They would like to do so, however, on as tax-efficient a basis as possible – meaning, they’d like to avoid taxable gain at both the corporate and shareholder levels. Ideally, each of them would also continue to be invested in real property.

Not too much to ask for, right?[xii]

Let’s begin by assuming that S/H Two will be the departing shareholder, and that S/H One is not interested in replacing S/H Two with another shareholder. There are some options to consider.

Clearly Taxable

Of course, S/H One may purchase all of S/H Two’s shares of Corporation stock. Alternatively, Corporation may redeem all of S/H Two’s shares.[xiii] Finally, S/H One and Corporation may join in buying out S/H Two.[xiv]

In each of these cases, the consideration for the purchase of S/H Two’s shares may be some combination of cash and a promissory note. It is likely that the funding source for such cash, and the collateral for such note, will be Corporation’s equity in the real property.[xv]

At the end of the day, S/H One ends up owning 100-percent of Corporation and, indirectly, the underlying real property, while S/H Two’s interest in Corporation is terminated by way of a sale of their stock.

Unfortunately for S/H Two, the gain from such a sale will be taxable to them.[xvi]

If S/H Two was still interested in holding real property, they may use the after-tax proceeds (and perhaps some debt) to acquire other real property.

Like Kind Exchange?

S/H Two is not especially keen on recognizing gain in connection with the buyout of their shares of stock in the Corporation.

They wonder whether they could “reinvest” their equity in other real property as part of a like kind exchange.[xvii] Having heard about partnership “drop and swap” transactions from various business acquaintances, S/H Two asks whether this approach is feasible in their case.

Unfortunately for S/H Two, the proceeds from the sale of their Corporation stock may not be reinvested as part of a tax-deferred like kind exchange, notwithstanding that Corporation’s only asset was real property.

Moreover, the drop-and-swap technique is not available in the case of real property that is owned by a corporation, even if the corporation is a pass-through entity, like an S corporation. To understand why, let’s first review the like kind exchange rules.

Section 1031

An exchange of property, like a sale, generally is a taxable event, and the gain therefrom is included in the exchanging taxpayer’s gross income for purposes of determining their income tax liability.

However, no gain or loss will be recognized if real property held by a taxpayer for productive use in a trade or business or for investment is exchanged for real property of a ‘‘like kind’’ which is to be held for productive use in a trade or business or for investment.[xviii] In general, this non-recognition rule does not apply to any exchange of real property that, in the hands of the taxpayer, is held primarily for sale.[xix]

The determination of whether real property is of a ‘‘like kind’’ to other real property relates to the nature or character of the property and not its grade or quality; for example, improved real estate and unimproved real estate generally are considered to be property of a ‘‘like kind’’ as this distinction relates to the grade or quality of the real estate.[xx]

The non-recognition of gain in a like kind exchange applies only to the extent that like kind property is received in the exchange. Thus, if an exchange of real property would meet the requirements for non-recognition, but for the fact that the property received in the transaction consists not only of real property that would be permitted to be exchanged on a tax-free basis, but also of non-qualifying property[xxi] or money[xxii] (“boot”), then the recipient of such boot will be required to recognize their gain realized on the exchange; however, the amount of gain recognized may not exceed the fair market value of such boot.[xxiii]

Drop-And-Swap

Although a partnership is a pass-through entity – meaning that its items of income, gain, deduction and loss flow through to its partners, and are included by them, in determining their respective taxable income[xxiv] – the like kind exchange rules are applied at the level of the partnership.[xxv]

In general, a partnership[xxvi] may utilize a “drop-and-swap” in a situation where some of its partners want to dispose of the partnership’s real property as part of a like kind exchange in which the partnership would acquire other real property,[xxvii] while other partners want to cash out their investment. The drop-and-swap affords both sets of partners the opportunity to satisfy their respective goals.[xxviii]

For example, the partnership may distribute tenancy-in-common (“TIC”) interests in the real property to those of its partners who want to cash out of the partnership; these partners would sell their TIC interests to the buyer for cash; meanwhile, the partnership would exchange its TIC interest for like kind property as part of a tax-deferred exchange.

The key to this technique is the ability of a partnership to distribute property in-kind[xxix] (for example, real property) to its partners without triggering recognition of the gain inherent in such property, and without causing the partners to include the distribution in their gross income.[xxx]

Corp’s In-Kind Distribution

Is this approach available to a corporation? Not really.

If a corporation were to distribute an appreciated property, or a portion thereof (a TIC interest), to some of its shareholders in exchange for their shares in the corporation (a redemption), the corporation would be treated as having sold the distributed property for consideration equal to the fair market value of such property.[xxxi] In the case of a C corporation, or of an S corporation that was subject to the built-in gain tax,[xxxii] the distribution/deemed-sale would generate gain subject to corporate-level tax. In the case of an S corporation, all of its shareholders – including those whose shares were not redeemed – would recognize the gain from the distribution[xxxiii]; depending upon whether or not the “related party sale” rules apply, such gain may be treated as ordinary income in the hands of the shareholder.[xxxiv]

What’s more, the fair market value of the property distributed would be taxable to the recipient shareholder to the extent it exceeds the shareholder’s adjusted basis for their stock.[xxxv]

In other words, a drop-and-swap-like strategy does not work where the real property is owned by a corporation.

Get Me Out of Here

Are there other alternatives? Maybe.

If Corporation’s rental business qualifies as an “active trade or business” within the meaning of the so-called “spin-off” rules,[xxxvi] and if Corporation has at least two rental properties, it may be possible for Corporation to contribute one of the properties to a subsidiary corporation and to then distribute the stock of the subsidiary corporation to S/H Two in redemption of all of the Corporation stock owned by S/H Two. Provided certain other requirements are satisfied, the distribution may be effected on a tax-deferred basis.[xxxvii]

Second Property?

But wait, you may say, Corporation has only one property. That’s true, but what is to prevent Corporation from acquiring a second property by purchase, or by replacing its one real property with two real properties as part of a like kind exchange,[xxxviii] with both properties continuing to be used in an active rental real estate business?[xxxix]

In order for a “split-off” (basically, a separation of shareholders into different corporations) to qualify as a tax-deferred transaction, each of the distributing corporation and the distributed subsidiary corporation must be engaged in the active conduct of a trade or business immediately after the distribution. The trade or business that is relied upon to satisfy this requirement is one that has been actively conducted throughout the five-year period ending on the date of the distribution.[xl]

Significantly, according to the IRS, the fact that a trade or business underwent change during the five-year period preceding the distribution will be disregarded for purposes of the active business test, provided that the changes were not of such a character as to constitute the acquisition of a new or different business.

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

Thus, if Corporation is able to acquire a second rental real property which is operated as actively as the existing property, Corporation should be able to satisfy the active business test.

It should follow, based on the foregoing, that a corporation which has been actively engaged in a rental real estate business should be able to exchange its existing property for one or more new real properties, as part of a tax-deferred like kind exchange, without jeopardizing its satisfaction of the active business test, at least where the replacement properties are used in the same manner as the relinquished property.

In fact, about four years ago, we submitted a ruling request to the IRS on behalf of a corporate client engaged in an active rental real estate business. Between three and four years earlier, the corporation had disposed of its principal property and acquired several replacement properties during the replacement period as part of a like kind exchange.[xlii] For bona fide business reasons,[xliii] the corporation’s shareholders subsequently sought to go their own ways by dividing the real properties between two corporations. The IRS ruled that the acquisition of the replacement properties during the five-year period preceding the distribution constituted an expansion of the corporation’s business, and did not represent the acquisition of a new or different business.[xliv]

All’s Well That Ends Well?

Ugh, another idiom,[xlv] and perhaps the wrong one at that, under the circumstances. Although it may be that Corporation and S/H Two have found a path that may lead them to the tax-deferred separation of S/H Two from Corporation and S/H One, it is still the case that both shareholders will continue to hold their respective real property in corporate form, with all the impediments that it entails.

Does that mean the shareholders should accept their lot? Nope.

Although there are many factors to consider – several of which are in a state of flux this election year, including, for instance, the future of the 21-percent corporate tax rate – the shareholders should not be dissuaded from mapping out a plan for ameliorating the consequences of corporate ownership.

For one thing, they may want to ask their tax advisors about making an election to treat their corporation as an S corporation for tax purposes.[xlvi] Although this may not represent much of a difference in overall tax liability for a corporation that regularly distributes its profits to its shareholders as a dividend, at least under current rates,[xlvii] it will position a shareholder to save significant tax dollars on a later sale of their corporation’s property.[xlviii]

They may also want to consider having the corporation contribute the real property to an LLC in exchange for a preferred interest[xlix] – so as to “freeze” the corporation’s value – while the shareholders make their own capital contribution to the LLC in exchange for the common interests, which would be entitled to the future appreciation of the property.

That, however, is a topic for another day.



[i]
If you haven’t see this movie, do yourself a favor. OK? You’ll understand why Mr. Brooks has been awarded an Oscar, a Tony, an Emmy and a Grammy. “Young Frankenstein” and “Blazing Saddles” are two of my favorites.

[ii] Of course, this should be read less as a law and more like a guiding principle to which there may be exceptions under certain facts and circumstances. For example, a foreign corporation may be the right choice of entity for a nonresident alien thinking about acquiring an interest in U.S. real property, especially given the current corporate tax rate. That being said, the November elections are just around the corner. Mr. Biden has proposed increasing the corporate rate from 21% to 28%.

[iii] In case you’re wondering, yes, most of these corporations acquired their real property before the advent of the LLC (though there are exceptions). Query, however, why these folks didn’t use a limited partnership with a corporation (perhaps an S corporation) as the general partner?

[iv] A measure of their “unrecovered investment” in the partnership. Yes, that includes the partner’s share of partnership indebtedness. See IRC Sec. 752(a), which treats any increase in a partner’s share of partnership liabilities as a contribution of money by the partner to the partnership. Same as if the individual partners had borrowed the funds themselves to acquire the property – an example of the aggregate theory of partnership taxation. See also Reg. Sec. 1.752-2 and Sec. 1.752-3.

[v] Remember, a partner’s distributive share of partnership deductions/loss is allowed only to the extent of the adjusted basis of the partner’s interest in the partnership. IRC Sec. 704(d).

See also IRC Sec. 465(b)(6), which tells us that a taxpayer may be considered at risk with respect to their share of “qualified nonrecourse financing” incurred in the activity of holding real property.

[vi] A distribution of cash by a partnership to a partner will be taxable to the partner only to the extent it exceeds the adjusted basis of the partner’s interest in the partnership immediately before the distribution. IRC Sec. 731(a)(1).

[vii] In other words, the shareholder of an S corporation does not increase the basis for their stock by their “share” of the corporation’s indebtedness.

That being said, there are some S corporation rules that have counterparts in the partnership rules; for example, a shareholder cannot claim deductions in excess of the adjusted basis for their shares, and a shareholder may – generally speaking – receive distributions from the corporation without triggering a taxable event to the extent of such adjusted basis. IRC Sec. 1366(d) and Sec. 1368.

[viii] Residential and professional/commercial.

[ix] Depreciation. IRC Sec. 167 and Sec. 168.

[x] IRC Sec. 1001. Part of this gain is attributable to the depreciation deductions claimed by the corporation. This gain is treated as so-called “unrecaptured” depreciation which, in the case of an individual taxpayer (a direct owner, or an equity owner of a partnership or S corporation) would be taxed at the rate of 25%. The gain attributable to the appreciation in value over the original cost of the property is treated as capital gain, which would be taxable at 20% in the case of an individual with a direct or indirect interest in the real property. IRC Sec. 1(h). The 3.8% surtax on net investment income may also apply if the individual did not materially participate in the business. IRC Sec. 1411.

[xi] If the corporation were a C corporation, it would be taxed on the gain at the federal rate of 21%. IRC Sec. 11. If the corporation were an S corporation that was not subject to the built-in gain tax, its shareholders would be subject to federal tax, as the result of the pass-through of such gain (IRC Sec. 1366) at the rate of 20% (assuming the surtax on net investment income did not apply).

[xii] Almost a situation of having one’s cake and eating it too. There are some odd idioms out there.

[xiii] IRC Sec. 302(b)(3).

[xiv] Part-sale and part-redemption. See Rev. Rul. 75-447.

[xv] In the case of a cross-purchase, how will Corporation get the cash into S/H One’s hands? A loan?

[xvi] If Shareholder Two also recognizes losses in the year of sale, or it they have carryover losses from earlier years, the amount of gain recognized may be reduced. If Shareholder Two chooses to invest in a qualified opportunity zone fund, their gain recognition may be deferred and even reduced if they satisfy the holding period requirements. IRC Sec. 1400Z-2.

[xvii] IRC Sec. 1031(a). After the Tax Cuts and Jobs Act, this provision is limited to exchanges of real property.

[xviii] Note that a single relinquished property may be exchanged for more than one replacement property. However, be careful of the identification rules in Reg. Sec. 1.1031(k)-1(b) thru (e).

[xix] IRC Sec. 1031(a)(2).

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

[xxi] For example, real property held for sale, or personal property.

[xxii] Which may include relief from indebtedness. Reg. Sec. 1.1031(d)-2.

[xxiii] IRC Sec. 1031(b). No losses may be recognized from a like-kind exchange.

[xxiv] IRC Sec. 701, Sec. 702.

[xxv] An example of the “entity theory” of partnership taxation.

[xxvi] Including an LLC that is treated as such for tax purposes. Reg. Sec. 301.7701-3.

[xxvii] Assume that both the relinquished and the replacement property satisfy the “held for investment” or “held for use in a trade or business” requirement.

[xxviii] N.B. The IRS has not blessed this form of transaction.

[xxix] Not cash.

[xxx] IRC Sec. 731. We assume that neither the mixing bowl rules of IRC Sec. 704(c)(1)(B) and Sec. 737, nor the disguised sale rules of IRC Sec. 707, are applicable.

[xxxi] IRC Sec. 311(b).

[xxxii] IRC Sec. 1374.

[xxxiii] IRC Sec. 1366 and Sec. 1377.

[xxxiv] IRC Sec. 1239. The maximum federal tax rate on ordinary income is 37%.

[xxxv] IRC Sec. 302(a) and Sec. 1001.

[xxxvi] IRC Sec. 355(b); Reg. Sec. 1.355-3.

[xxxvii] IRC Sec. 355. For a description of spin off transactions, generally, including the “active business” requirement, please see https://www.taxlawforchb.com/2020/01/you-can-spin-it-off-or-split-it-up-but-keep-it-active/

[xxxviii] Reg. Sec. 1.1031(k)-1(c). Of course, there is the practical reality that it may be difficult to identify within the 45-day identification period two properties that are desirable, and to acquire such properties within the 180-day replacement period. IRC Sec. 1031(a)(3).

[xxxix] Assume for our purposes that the ownership and rental of the real property constitutes an active trade or business. Reg. Sec. 1.355-3(b)(2)(iv). For more information on this topic, please see https://www.taxlawforchb.com/2016/03/corporate-owned-real-estate-can-it-be-split-off-tax-free-part-ii/.

[xl] Reg. Sec. 1.355-3(b)(3)(i).

[xli] Reg. Sec. 1.355-3(b)(3)(ii); Reg. Sec. 1.355-3(c), Ex. 7 and Ex. 8.

[xlii] There was little-to-no rental activity between the time of sale and the acquisition of the new properties.

[xliii] Of the “fit and focus” variety.

[xliv] PLR-106708-16, May 12, 2016.

[xlv] What? Were you expecting the eponymous Shakespearean play? I’m just a tax guy who quotes lines from Mel Brooks, Monty Python, Austin Powers, and the like.

[xlvi] IRC Sec. 1362.

[xlvii] 37% for the S corporation shareholder vs just under 40% for a C corporation that makes annual distributions of its after-tax profit to its shareholders.

[xlviii] 20% for the S corporation – assuming a sale outside the 5-year built-in gain period – vs just under 40% for the C corporation. Of course, I am assuming that the likelihood of a stock sale is very remote.

[xlix] Beware the disguised sale rule: Reg. Sec. 1.707-3 and 1.707-4.