“It Wasn’t My Fault”

When a business is successful and there are profits to share, the owners of the business get along well enough. As revenues fall off, however, while costs often remain steady or even increase, the owners will sometimes choose to “defer” the payment of so-called “trust fund” taxes in order to satisfy business expenses instead, in the hope of keeping the business afloat until it can turn the proverbial corner.

Of course, that corner turns into a spiral, the business fails, and the IRS seeks to collect the unpaid trust fund taxes from those persons in the business who were responsible for collecting and remitting the taxes. There may be several individuals to whom the IRS will look for payment, and it is not unusual to find erstwhile partners blaming one another and pointing fingers so as to deflect responsibility onto anyone but themselves. It is amazing what some people will do to avoid responsibility for the taxes owed by their business.

The U.S. Tax Court recently considered what can only be described as an especially egregious case of finger-pointing by former partners, coupled with what can most generously be described as incompetence by the IRS, that resulted in the IRS’s exoneration of those persons who were actually responsible for the unpaid taxes, and that almost ended with the assessment of those taxes against a truly innocent party.

Let’s Go Into Business

Partner and Taxpayer’s spouse (“Spouse”) formed Corp. to purchase and operate the Business. Partner and Spouse agreed they would be equal owners of Corp. but, because Spouse worked full-time at another job and had little time to participate in the Business, Partner would be the president of Corp. and would oversee its operations – indeed, Partner was the only person listed in Corp.’s articles of incorporation as an officer and director – while Spouse would be a passive investor. For family and medical reasons, Taxpayer was unable to devote much effort to the Business.

Shortly after Partner and Spouse began engaging in preliminary business matters, Partner was unexpectedly called out of state, and most of the pre-opening responsibilities fell upon Spouse. Because of his busy schedule, Spouse asked Taxpayer to carry out some of those responsibilities.

Upon his return, Partner and Spouse conducted interviews and hired new employees. Taxpayer was not involved in the interviewing and hiring process.

Spouse, Partner, and the new employees then underwent training related to the Business. Taxpayer did not attend the training.

During this pre-opening training phase, Partner contacted Taxpayer and asked her to retain the services of a payroll company so the new employees could be paid. Taxpayer engaged the services of a payroll company (“Pay-Co”) that, in addition to preparing employee paychecks and determining payroll tax liability, would debit the Business’s bank account; directly deposit Federal payroll taxes; and electronically file Forms 941.

Partner also directed Taxpayer to open a corporate bank account on behalf of Corp. She opened an account at Bank, and was identified as someone having signatory authority on the account.

Day-to-Day Operations

After the Business opened, it was run primarily by Partner and a key employee (“Employee”). Partner carried out his role as president of the corporation, and was heavily involved in the initial hiring and structuring of the Business. Partner indicated that he “drove all aspects of building business from the ground up, . . ., hired, trained, and supervised staff . . ., while managing . . . costs.”

Partner oversaw the day-to-day operations of the Business and, when he was not physically present, was in constant contact with Employee, with whom he discussed daily business dealings. Partner also monitored the Business’s bank balances and determined when it was appropriate for the Business to borrow money.

Employee was the general manager of the Business and was responsible for carrying out the day-to-day business operations. He managed the employees, paid creditors, and oversaw purchases from vendors. He was responsible for hiring, training, and firing personnel, purchasing, inventory, sales strategies and yield management, reviewing financial statements, product mix, budgeting, forecasting revenues and expenses, and management of individual department managers/supervisors. Employee was also Pay-Co’s main contact, and maintained control over the payroll process.

Taxpayer did not have a significant role at the Business. While she was directed to establish the Business’ bank account and to contract with Pay-Co during the pre-opening phase of the business, she became decidedly less involved once the Business was operational. Taxpayer’s main responsibilities were delivering checks, relaying electronic bank account balances to Employee, and delivering the Business’s mail that was sent to her private mailbox. Taxpayer occasionally transferred funds to and from the corporate bank account at the direction of Partner or Spouse. She also issued checks at the direction of Partner or Spouse for some of the Business’s recurring monthly expenses. During the periods at issue Taxpayer signed roughly 4% of the non-payroll checks.

Taxpayer made no operational decisions. Indeed, she did not have the proper education, training, or experience to hold a management position at the Business.

Payroll

Employee maintained control over the payroll process. He was responsible for compiling the payroll information and transmitting this information directly to Pay-Co every week. Because of the quick turnaround between providing the weekly payroll information to Pay-Co and payday at the Business, it was necessary for Pay-Co to hand-deliver the payroll checks by courier.

Because the Business had no business location at the time Pay-Co was first contracted, the payroll checks were initially delivered to Spouse’s and Taxpayer’s home address. Later, once the Business formally opened, Pay-Co began delivering the payroll checks directly to the business location. However, because employees were rarely onsite to receive the payroll checks at the time of delivery, the parties reverted to having the checks delivered to Spouse’s and Taxpayer’s residence.

Upon delivery of the payroll checks, Taxpayer was directed by Partner to sign the checks and deliver them to the business premises. It was usually necessary for Taxpayer to sign the checks because Employee was usually off on payday, and there was no one else onsite available to sign the checks. Taxpayer was not responsible for and did not review statements included in the Pay-Co package. Taxpayer signed about 81% of the payroll checks.

The Business Fails

Within a year of opening, the Business was losing money.

As a result of several bounced checks, vendors began to lose faith in the Business’s ability to pay its bills, and many demanded cash on delivery or certified checks.

Employee began to pay creditors by first using cash received from daily operations. When the Business’s cash balance was exhausted, he would resort to using standard checks or certified checks. The owners limited the number of checks available to Employee at any one time, in an effort to rein in his spending.

Eventually, the account at Bank was frozen. At that point, Partner directed Taxpayer to open a new bank account, with Second Bank. Before opening the account, a bank employee instructed Taxpayer to indicate she held some form of corporate office on the commercial signature card and on a form titled “Bank Resolution by Corporation”. Taxpayer handwrote “sec” next to her signature on the signature card, and she signed the Resolution as Corp.’s secretary even though she was never actually secretary for Corp.

Shortly thereafter, Pay-Co tried to withdraw $X for taxes from the account at Second Bank. The electronic withdrawals were rejected.

Pay-Co then scaled back its services to Corp., limiting them to producing payroll checks and reference copies of Forms 941. The payroll checks continued to be debited from the Second Bank account. However, Pay-Co did not debit the payroll tax portion from the account, make payroll deposits on the Business’s behalf, or file Forms 941. Taxpayer was unaware these services had been canceled.

The IRS Comes A-Knocking

Corp. finally stopped operating the Business and, within a couple of months, the IRS visited the office of Corp.’s CPA.

CPA informed Spouse and Taxpayer that a representative of the IRS had visited his office investigating unpaid payroll taxes. This was the first time Spouse and Taxpayer had knowledge that Federal payroll deposits had not been made for various quarters and that Forms 941 remained unfiled.

The IRS originally investigated Corp., but expanded its investigation to include Partner, Employee, and Taxpayer. After conducting its investigation, the IRS recommended assessing the Trust Fund Recovery Penalty (“TFRP”) against Partner, Employee, and Taxpayer.

The IRS eventually assessed the TFRP against Taxpayer as a “responsible person.” However, both Partner and Employee somehow successfully contested the IRS’s efforts to assess the penalty against them.

Taxpayer challenged the IRS’s determination, which was sustained by an IRS Appeals officer. Taxpayer then filed a petition with the Tax Court.

Trust Fund Recovery Penalties

Employers have a duty to withhold income and employment taxes from their employees’ wages. These withheld funds are often referred to as “trust fund taxes” because the Code characterizes such withholdings as “a special fund [held] in trust for the United States.” Employees generally are allowed a credit against their tax liability for the amount of taxes withheld from their wages, regardless of whether the employer actually remits the funds to the IRS. Therefore, when net wages are paid to an employee and the employer does not pay over the withheld funds, the IRS has no recourse against the employees for their payments and may collect only from the employer.

The Code provides a collection tool allowing the IRS to impose penalties on certain persons who fail to withhold and/or pay over trust fund taxes. The penalty is equal to the total amount of the tax that was withheld but not paid over, and is imposed on any “person” required to collect, truthfully account for, or pay over any tax withheld who willfully fails to do so.

The term “person” is often taken to mean a “responsible person” and includes an officer or employee of a corporation who, as such, is under a duty to collect, account for, or pay over the withheld tax. Therefore, liability for a TFRP is imposed only on (1) a responsible person who (2) willfully fails to collect, account for, or pay over the withheld tax.

Responsible Person?

The Court addressed whether Taxpayer was a responsible person. A “responsible person,” it explained, is any person required to collect, account for, or pay over withheld taxes. Whether someone is a responsible person is a “matter of status, duty and authority, not knowledge.” Indicia of responsibility include “the holding of corporate office, control over financial affairs, the authority to disburse corporate funds, stock ownership, and the ability to hire and fire employees.”

The IRS argued that Taxpayer possessed all the recognized indicia of responsibility and was, therefore, a responsible person. The IRS further asserted that Taxpayer exercised substantial financial control over Corp., and that at all times Taxpayer was a de facto officer of the corporation because she opened two corporate bank accounts, had signatory authority on both accounts, and signed checks on behalf of the corporation.

Taxpayer argued that she lacked decision-making authority and did not exercise significant control over corporate affairs. She further asserted that despite her signatory authority, she was not a responsible person because she had a limited role in the Business’s payroll process and merely signed payroll checks for the convenience of the corporation.

Taxpayer claimed that Partner and Employee were responsible for running the corporation day-to-day, and that her duties were ministerial.

The Court’s Analysis

The Court agreed with Taxpayer and found that the preponderance of the evidence showed that her role was ministerial and that she lacked decision-making authority. Accordingly, the Court held that Taxpayer was not a responsible person.

Responsibility, the Court stated, is a matter of status, duty, and authority. “In considering the individual’s status, duty, and authority, the test is one of substance.” In other words, the focus of the inquiry does not involve a mechanical application of any particular list of factors. The inquiry must focus on actual authority to control, not on trivial duties.

The Court determined that Taxpayer lacked the authority to control the financial affairs of the Business, including the disbursement of Corp.’s funds. Notwithstanding Taxpayer’s signatory authority and her spousal relationship to one of Corp.’s owners, the substance of her position was largely ministerial and she lacked actual authority.

According to the Court, the “credible” testimony and the documentary evidence introduced at trial demonstrated that Partner and Employee exercised control over the financial affairs of Corp., and that Taxpayer served only support functions. The Court commented that the testimony of Partner and Employee regarding Taxpayer was not credible.

The Court Reprimands the IRS

Interestingly, the Court noted that it was, in fact, puzzled that Partner, the president of the corporation and a hands-on owner, and Employee, the day-to-day manager, successfully “evaded” – the Court’s word – any personal liability for TFRP.

The Court observed that the IRS went to great lengths to characterize Taxpayer as a savvy business person whose actions and prior work experience made her a de facto director and officer. On the basis of the record, the Court could not make such a finding.

It was clear, the Court stated, that Taxpayer was not an officer, director, owner, or employee of Corp. at any time. With the exception of a few weeks during the preopening phase, Taxpayer had no involvement in the day-to-day affairs of the corporation. She usually visited the corporation only once a week (on payday), for less than an hour each time. The record also showed that there were times that she did not visit the business for periods of several months.

The IRS had determined that Taxpayer was a responsible person during the pre-opening phase (1) because of her alleged status as secretary of the corporation, and (2) because she signed checks.

However, the Court determined that the IRS did not conduct a thorough investigation.

Additionally, Taxpayer had no authority to hire and fire employees of the corporation. She had no responsibility to oversee or ensure the payment of payroll taxes on its behalf. She was not its bookkeeper or accountant. She did not reconcile the bank statements.

Even though she wrote and signed roughly 4% of the non-payroll checks to pay some of the corporation’s recurring operating expenses, such as rent, she was merely doing so at the direction of others and for the convenience of the corporation.

Moreover, even though Taxpayer signed most of the payroll checks prepared by Pay-Co, the duty was ministerial and done only for the convenience of the corporation. She had no duty to, and did not, oversee the employees, collect payroll information, compile payroll information, or remit the payroll information to Pay-Co on behalf of Corp.

Accordingly, because Taxpayer did not hold corporate office, did not control financial affairs, had no ownership interest, had no authority to hire and fire employees, and otherwise had little or no decision-making power beyond some ministerial duties, the Court found that she was not a responsible person.

Beware of Fair-Weather Partners

How could the IRS have absolved Partner and Employee while continuing to pursue Taxpayer in the above case? Might securing the testimony of the absolved parties have had anything to do with the IRS’s actions? Perhaps. Might their legal representatives have been more competent than Taxpayer’s? Maybe. In any case, the Court was right to be puzzled.

How can a taxpayer in a closely held business protect himself from a similar scenario? Unfortunately, there is no completely fail-safe way to do so – a resourceful “bad guy” will likely find a way or two to circumvent, at least in part, the obstacles to his evasion scheme.

A good place to start would be at the beginning. The passive investor should educate himself – what kind of activity will expose him to liability as a responsible person. During the initial phase of a business, it would behoove the passive investor to insist that each participant’s role within the business be described and documented.

A well-drafted shareholders’ agreement and by-laws would go a long way, as would accurate and timely recorded directors’ and shareholders’ minutes.

Finally, the investor should consider memorializing any activity undertaken on behalf of the business, including its nature and extent, and who requested his participation and under what circumstances.

It is not a perfect strategy, and may be resisted by others, but that in itself should be a wake-up call.

Exchanges, In General

A taxpayer must recognize the gain realized by the taxpayer from the conversion of a property into cash, or from the exchange of the property for other property differing materially in kind.

Under an exception to this general recognition rule, gain is not required to be recognized if property that is held by the taxpayer for productive use in a trade or business, or for investment, is exchanged by the taxpayer solely for property of a like-kind to be held either for productive use in a trade or business or for investment.

However, even an otherwise qualifying like kind exchange may be adversely impacted where the parties to the transaction are “related” to one another. Such a result is most likely to occur within a group of closely held business entities, as was illustrated in a recent decision of the U.S. Tax Court.

A Related Company Exchange?

Commercial Real Estate LeaseTaxpayer was a consolidated group of corporations consisting of Parent and its wholly-owned subsidiary (“Sub”). During the years at issue, Taxpayer’s operations consisted of leasing commercial real estate throughout the country.

Parent also owned 70% of the common shares of Affiliate, another corporation that owned real estate. Each company had a separate board of directors and a different president. However, Mr. Big served as president of Parent and as CEO of Sub during all relevant years.

Parent had made substantial loans to Affiliate. Decisions concerning the loans were made by a committee of Parent’s board established for that purpose. The committee’s role was to assess Affiliate’s financial condition and to determine how much would be lent. The committee was composed of Mr. Big and two other individuals.

Sub received a letter of intent from an unrelated third party offering to purchase the Relinquished Property. The letter outlined the anticipated terms for a purchase agreement covering the Relinquished Property. It reserved to Sub the right to effect an exchange of the property under Section 1031 of the Code (a “like-kind exchange”) and obligated the third party purchaser to cooperate toward that end. Sub’s representative signed the letter of intent and, thereafter, Parent and Sub began a search for suitable replacement property with the aid of real estate brokers.

Sub engaged Qualified Intermediary (“QI”) to serve as an intermediary through which the Relinquished Property could be exchanged, and entered into an exchange agreement with QI setting forth the terms under which QI would serve as an intermediary. Sub thereupon assigned its rights under the letter of intent to QI and subsequently transferred the Relinquished Property to QI. QI sold the Relinquished Property to the third party.

In order to meet the requirements of a “tax-free” like-kind exchange, Sub had to identify replacement property within 45 days after the sale of the Relinquished Property. As of the sale date of the Relinquished Property, neither Parent nor Sub had considered acquiring a replacement property from Affiliate or any other related party. The brokers presented numerous properties owned by unrelated parties to the Parent and Sub as potential replacement properties, and Sub attempted, unsuccessfully, to negotiate the purchase of some of these properties for that purpose. However, just before the identification period expired, in an attempt to preserve the like-kind exchange, Sub identified three potential replacement properties, all belonging to Affiliate.

QI timely purchased one of these real properties owned by Affiliate (the “Replacement Property”) and transferred it to Sub as replacement property for the Relinquished Property.

Like-Kind Exchanges

Taxpayer timely filed a consolidated Form 1120, U.S. Corporation Income Tax Return, on which Taxpayer reported a realized gain from the sale of the Relinquished Property but deferred recognition of the gain pursuant to Section 1031. Taxpayer also reported an unrelated net operating loss (“NOL”).

Affiliate recognized gain on its tax return from the sale of the Replacement Property, which would have increased its regular income tax liability by a significant amount. However, Affiliate had sufficient NOLs to fully offset its regular tax liability relating to the sale.

The IRS determined that the gain realized by Taxpayer on the sale of the Relinquished Property did not qualify for Section 1031 deferred recognition.

Section 1031 of the Code allows nonrecognition of gain on the exchange of property held for productive use in a trade or business, or for investment, when the property is exchanged for property of a like-kind.

As a nonrecognition provision, Section 1031 merely defers recognition of the gain inherent in the property sold – it does not eliminate it. This deferred gain is preserved for recognition by Taxpayer upon a later taxable disposition of the like-kind property acquired. This is accomplished by requiring that the basis of the property acquired in the Section 1031 exchange (the replacement property) be the same as the basis of the property exchanged (the relinquished property).

Deferred Exchanges

In most cases, a taxpayer disposing of property will not be able to find a buyer who owns like-kind property that the buyer is willing to exchange, and that the taxpayer wants to acquire (a “simultaneous exchange”). In recognition of this reality, Congress and the IRS provided special rules for non-simultaneous exchanges. Unfortunately, because of very strict statutory requirements, these rules are often not as helpful as most taxpayers would like.

A non-simultaneous exchange, where the relinquished property is transferred before the replacement property is acquired, generally may qualify for nonrecognition of gain if the taxpayer identifies the replacement property, and then receives it, within 45 days and 180 days, respectively, of the transfer of the relinquished property. These identification and acquisition periods cannot be extended.

A taxpayer may use a qualified intermediary to facilitate such a deferred exchange – wherein the intermediary acquires the relinquished property from the taxpayer, sells it, and uses the proceeds to acquire replacement property that it transfers to the taxpayer – without the intermediary’s being treated as the taxpayer’s agent or the taxpayer’s being treated as in constructive receipt of the sales proceeds from the relinquished property.

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

The Related Party Rules

In order to prevent certain perceived abuses, Congress enacted a special rule to limit nonrecognition treatment in the case of like-kind exchanges between certain related persons. This rule generally provides that if a taxpayer and a “related person” exchange like-kind property and, within two years, either one of them disposes of the property received in the exchange (i.e., “cashes out” the investment), the nonrecognition provisions will not apply, and the gain realized must be recognized as of the date of the disposition.

The anti-abuse rule applies to direct simultaneous exchanges between related persons, and to any exchange which is part of a transaction or series of transactions “structured to avoid the purposes of” the rule. Therefore, it may disallow nonrecognition treatment of deferred exchanges that only indirectly involve related persons because of the interposition of a qualified intermediary.

However, under an exception to the disallowance-upon-disposition rule, any disposition of the relinquished or replacement property within two years of the exchange is disregarded if the taxpayer establishes to the satisfaction of the IRS “that neither the exchange nor such disposition had as one of its principal purposes the avoidance of Federal income tax.”

The Tax Court’s Analysis

The parties stipulated that Parent, Sub, and Affiliate were “related persons” within the meaning of the rule.

The IRS did not dispute that Sub’s exchange of the Relinquished Property for the Replacement Property met the requirements for a like-kind exchange. Furthermore, because Sub used QI, a qualified intermediary, to facilitate its sale of the Relinquished Property and acquisition of the Replacement Property, the IRS did not contend that the exchange ran afoul of the specific requirements for like-kind exchange treatment.

However, the IRS contended that Sub’s exchange was disqualified from nonrecognition treatment pursuant to the related party rule because QI had sold the relinquished property to Affiliate for cash as part of the exchange transaction (an “indirect” transfer between related parties).

The Court noted that, in earlier cases in which had considered taxpayers who had received replacement property from related persons in deferred exchanges involving qualified intermediaries, followed by the related persons’ sales of the relinquished property, it had concluded that the transactions were the economic equivalent of direct exchanges of property between the taxpayer and the related person, followed by the related person’s sale of the relinquished property and retention of the cash proceeds. Thus, the investment in the relinquished property had been cashed out, contrary to the purpose of the related party rule.

The transaction at issue, the Court stated, was no different: The investment in the Relinquished Property was cashed out with a related person’s (Affiliate’s) retaining the cash proceeds. The interposition of a qualified intermediary could not obscure that result.

Taxpayer, however, argued that the exchange of the Relinquished and Replacement Properties was not structured to avoid the purposes of the related person rule because Sub had no “prearranged plan” to conduct a deferred exchange with Affiliate. Taxpayer argued that, initially, Sub diligently sought a replacement property held by an unrelated party, and only turned to the Replacement Property when the deadline to complete a deferred exchange was imminent.

The Court rejected this argument, stating that the presence or absence of a prearranged plan to use property from a related person to complete a like-kind exchange was not dispositive of a violation of the rule.

Instead, the inquiry into whether a transaction had been structured to avoid the rule should focus, the Court said, on the actual tax consequences of the transaction to the taxpayer and the related party, considered in the aggregate, as compared to the hypothetical tax consequences of a direct sale of the relinquished property by the taxpayer. According to the Court, those actual consequences form the basis for an inference concerning whether a transaction was structured in violation of the rule.

The Court in compared the hypothetical tax that would have been paid if a taxpayer had sold the relinquished property directly to a third party with the actual tax paid as a result of the taxpayer’s transfer of the relinquished property to the related person in a like-kind exchange followed by the related person’s sale of the relinquished property. For this purpose the actual tax paid comprised the tax liability of both the taxpayer and the related person in the aggregate.

Where the aggregate tax liability of the taxpayer and the related person arising from their like-kind exchange and sale transaction is significantly less than the hypothetical tax that would have arisen from the taxpayer’s direct sale of the relinquished property, it may be inferred that the taxpayer structured the transaction with a tax-avoidance purpose.

The Court’s Conclusion

Taxpayer would have had to recognize a significant gain had Sub directly sold the Relinquished Property to an unrelated third party. Although Taxpayer’s NOLs would have offset a portion of this gain, it would have paid additional tax as a result of the direct sale.

However, because the transaction was structured as a like-kind exchange, only Affiliate was required to recognize gain – and that gain was almost entirely offset by its NOLs.

The substantial economic benefits to Taxpayer and Affiliate as a result of structuring the transaction as a deferred exchange were thus clear: Parent and Sub were able to cash out of the investment in the Relinquished Property almost tax-free. The Court thus inferred that Sub had structured the transaction with a tax-avoidance purpose.

Taxpayer argued that the transaction nonetheless lacked a tax-avoidance purpose because it did not involve the exchange of low-basis property for high basis property. Although it was true that Affiliate recognized more gain on the disposition of the Replacement Property than Sub realized on the disposition of the Relinquished Property, Affiliate was able to offset the gain recognized with NOLs, resulting in net tax savings to Taxpayer and Affiliate as an economic unit. The Court stated that net tax savings achieved through use of the related party’s NOLs may demonstrate the presence of a tax-avoidance purpose notwithstanding a lack of basis shifting.

In sum, by employing a deferred Section 1031 exchange transaction to dispose of the Relinquished Property, Taxpayer and Affiliate, viewed in the aggregate, effectively “cashed out” of the investment, virtually tax free – in stark contrast to the substantial tax liability Taxpayer would have incurred as a result of a direct sale.

Moreover, Taxpayer failed to demonstrate that avoidance of Federal income tax was not one of the principal purposes of Sub’s exchange with Affiliate and the disposition of the Relinquished Property.

The Court, therefore, concluded that the transaction was structured to avoid the purposes of the related person rule. The transaction was structured in contravention of Congress’s desire that nonrecognition treatment only apply to transactions “where a taxpayer can be viewed as merely continuing his investment.” Consequently, Taxpayer was not entitled to defer recognition of the gain realized on the exchange of the Relinquished Property under the like-kind exchange rules.

Keep In Mind

The foregoing illustrates only one of the pitfalls of which a seller of property must be aware when dealing with a related party buyer.  There are many others. Any sale or exchange that may involve a related party should be examined closely to account for potential tax consequences. Once the tax and the business issues have been identified, and the resulting economic consequences have been considered, the taxpayer can plan accordingly.

Business Owners & Employment Taxes

In general, self-employed individuals are subject to employment taxes on their net earnings from self-employment.

The wages paid to individuals who are non-owner-employees of a business are subject to employment taxes regardless of how the business is organized.

The shareholders of a corporation are not subject to employment taxes in respect of any return on their investment in the corporation, though they are subject to employment taxes as to any wages paid to them by the corporation.

In the case of an S corporation, the IRS has sought to compel the corporation to pay its shareholder-employees a reasonable wage for services rendered to the corporation, so as to prevent its “conversion” into a distribution of investment income that is not subject to employment taxes.

In the case of a partnership, its “limited partners” are generally not subject to employment taxes in respect of their distributive share of the partnership’s income, while the shares of its “general partners” are subject to such taxes, regardless of whether or not they receive a distribution from the partnership.

The IRS recently considered whether a portion of an individual partner’s distributive share of partnership income could properly be treated as a return on his investment in the partnership and, thus, not subject to employment taxes.

Background

Taxpayer owned several franchise restaurants and contributed them to LLC, a limited liability company treated as a partnership for tax purposes.

During the years at issue, LLC’s gross receipts and net ordinary business income were almost entirely attributable to food sales.

Taxpayer owned the majority of LLC. The remaining interests in LLC were owned by Taxpayer’s spouse and an irrevocable trust. LLC’s operating agreement provided for only one class of ownership. Neither Taxpayer’s spouse nor the trust were involved with LLC’s business operations.

Taxpayer’s franchise agreements required him to personally work full-time on, and to devote his best efforts to, the operation of the restaurants. LLC’s operating agreement provided that Taxpayer was LLC’s Operating Manager, President, and CEO, and required him to conduct its day-to-day business affairs. In particular, Taxpayer had authority to manage LLC, make all decisions, and do anything reasonably necessary in light of its business and objectives.

Taxpayer directed the operations of LLC, held regular meetings and discussions with his management team and staff, made strategic, investment management and planning decisions, and was involved in the franchisor’s regional board and in its strategic planning.

LLC employed a number of individuals, many of whom had some level of management or supervisory responsibility. Pursuant to his authority under LLC’s Operating Agreement, Taxpayer appointed an executive management team consisting of financial and operations executive employees who did not have an ownership interest in LLC, but were given the responsibility of managing certain of LLC’s day-to-day business affairs, including making certain key management decisions.

Taxpayer had ultimate responsibility for hiring, firing, and overseeing all LLC’s employees, including members of the executive management team.

During the years at issue, LLC made “guaranteed payments” to Taxpayer for his services rendered to LLC.

Taxpayer as Limited Partner?

LLC treated Taxpayer as a limited partner for purposes of the employment tax rules, and included only the guaranteed payments in Taxpayer’s net earnings from self-employment, not his full distributive share of LLC’s net income.

LLC’s position was that Taxpayer’s income from LLC should be bifurcated for employment tax purposes between his (1) income attributable to capital invested or the efforts of others, which was not subject to employment tax, and (2) compensation for services rendered to LLC, which was subject to employment tax.

LLC asserted that, as a retail operation, it required capital investment for buildings, equipment, working capital and employees. LLC noted that Taxpayer and LLC made significant capital outlays to acquire and maintain the restaurants, and argued that LLC derived its income from the preparation and sale of food products by its employees, not the personal services of Taxpayer.

LLC asserted that Taxpayer had a reasonable expectation for a return on his investment beyond his compensation from LLC. It argued that Taxpayer’s guaranteed payments represented “reasonable compensation” for his services, and that his earnings beyond his guaranteed payments were earnings which were basically of an investment nature.

Therefore, LLC concluded that Taxpayer was a limited partner for employment tax purposes with respect to his distributive share of LLC’s net income.

Self-Employment Tax – In General

The Code imposes self-employment taxes on the self-employment income of every individual. The term “self-employment income” means the net earnings from self-employment derived by an individual during any taxable year.

In general, the term “net earnings from self-employment” means the net income derived by an individual from any trade or business carried on by such individual, plus his distributive share (whether or not distributed) of net income from any trade or business carried on by a partnership of which he is a member, with certain enumerated exclusions.

Among these exclusions, the Code provides that there shall be excluded any gain from the sale or exchange of property if such property is neither (i) stock-in-trade or other property of a kind which would properly be includible in inventory, nor (ii) property held primarily for sale to customers in the ordinary course of the trade or business. Thus, the exclusion does not apply to gains from the sale of stock in trade, inventory, or property held primarily for sale to customers in the ordinary course of a trade or business.

Partnerships & Self-Employment Tax

The Code also provides another exclusion:

there shall be excluded the distributive share of any item of income . . .
of a limited partner, as such, other than guaranteed payments . . .
to that partner for services actually rendered to . . . the partnership to the extent that those payments are established to be in the nature of remuneration for those services.

Unfortunately, the Code does not define “limited partner,” and the exclusion was enacted before LLCs became widely used.

Prior to the enactment of the exclusion, the Code provided that each partner’s share of partnership income was includable in his net earnings from self-employment for tax purposes, regardless of the nature of his membership in the partnership.

In creating the exclusion for limited partners, Congress recognized that certain earnings were basically of an investment nature. However, the exclusion was not extended to guaranteed payments, such as salary, received for services actually performed by the limited partner to or for the partnership.

Thus, individual partners who are not limited partners are subject to self-employment tax on their distributive share of partnership income regardless of their participation in the partnership’s business or the capital-intensive nature of the partnership’s business.

The Once-Proposed Regulations

In 1997, the IRS issued proposed regulations defining “limited partner” for these purposes. They generally provided that an individual would be treated as a limited partner unless the individual: (1) had personal liability for the debts of or claims against the partnership by reason of being a partner; (2) had authority to contract on behalf of the partnership; or (3) participated in the partnership’s trade or business for more than 500 hours.

In response to criticism from the business community, Congress immediately imposed a temporary moratorium on finalizing the proposed regulations, which expired in 1998; however, the 1997 proposed regulations were never finalized.

Subsequently, however, some Courts had the opportunity to shed light on the issue in the context of cases in which taxpayers attempted to distinguish between a partner’s wages and his share of partnership income. The Courts explained that a limited partnership has two fundamental classes of partners, general and limited. General partners typically have management power and unlimited personal liability. Limited partners lack management powers but enjoy immunity from liability for debts of the partnership. Indeed, a limited partner could lose his limited liability protection were he to engage in the business operations of the partnership. Consequently, the interest of a limited partner in a limited partnership is akin to that of a passive investor.

According to these Courts, the intent of the “limited partner exclusion” was to ensure that individuals who merely invested in a partnership and who were not actively participating in the partnership’s business operations would not receive credits toward Social Security coverage. In addition, the Courts noted that the legislative history of the “limited partner exclusion” did not support the conclusion that Congress contemplated excluding partners who performed services for a partnership in their capacity as partners (i.e., acting in the manner of self-employed persons) from liability for self-employment taxes. In addition, the Courts stated that “members of a partnership are not employees of the partnership” for purposes of self-employment taxes. Instead, a partner who participates in the partnership business is “a self-employed individual.” Thus, such a partner should treat all of his partnership income as self-employment income, rather than characterizing some of it as wages.

The IRS’s Analysis . . .

The IRS stated that, in general, a partner must include his distributive share of partnership income in calculating his net earnings from self-employment.

While the Code excludes from self-employment tax the gain on the disposition of certain property, the exclusion does not apply to a restaurant or retail operation’s sales of food or inventory. Thus, the IRS noted, the Code contemplates that a capital-intensive business such as a retail operation with stock in trade or inventory may generate income subject to self-employment tax. Because LLC earned its income from food sales in the ordinary course of its trade or business, the exclusion in the Code does not apply to LLC’s income.

Therefore, unless Taxpayer was a limited partner, he was subject to self-employment tax on his share of LLC’s income, notwithstanding the capital investments made, the capital-intensive nature of the business, or the fact that LLC had many employees.

Surprisingly, LLC did, in fact, take the position that Taxpayer was a limited partner for purposes of the “limited partner exclusion”.

The IRS disagreed. Relying upon the legislative history of the “limited partner exclusion,” the IRS explained that it was intended to apply to those who “merely invested ” rather than those who “actively participated” and “performed services for a partnership in their capacity as partners (i.e., acting in the manner of self-employed persons).”

The IRS further explained that “the interest of a limited partner in a limited partnership is generally akin to that of a passive investor,” and stated that limited partners are those who “lack management powers but enjoy immunity from liability for debts of the partnership.”

. . . And Conclusion

Taxpayer had sole authority over LLC, and was the majority owner, with ultimate authority over every employee and each aspect of LLC’s business. Even though LLC had many employees, including several executive level employees, Taxpayer was the only partner of LLC involved with the business and was not a mere investor, but rather actively participated in the partnership’s operations and performed extensive executive and operational management services for LLC in his capacity as a partner (i.e., acting in the manner of a self-employed person). Thus, the income Taxpayer earned through LLC was not income of a mere passive investor that Congress sought to exclude from self-employment tax.

LLC conceded that “service partners in a service partnership acting in the manner of self-employed persons” were not limited partners. However, LLC argued that a different analysis should apply to partners who: (1) derived their income from the sale of products, (2) made substantial capital investments, and (3) delegated significant management responsibilities to executive-level employees. LLC asserted that in these cases the IRS should apply “substance over form” principles to exclude from self-employment tax a reasonable return on the capital invested.

LLC interpreted the legislative history to mean that the “limited partner exclusion” applied to exclude a partner’s reasonable return on his capital investment in a capital-intensive partnership, regardless of the extent of the partner’s involvement with the partnership’s business.

Essentially, LLC argued that the self-employment tax rules for capital-intensive businesses carried on by partnerships were identical to the employment tax rules for corporate shareholder-employees: only reasonable compensation should be subject to employment tax.

Under this analysis, LLC argued that (1) LLC’s guaranteed payments to Taxpayer were reasonable compensation for his services, and (2) Taxpayer’s distributive share represented a reasonable return on capital investments in LLC’s business, and, therefore, Taxpayer was not subject to self-employment tax on his distributive share.

The IRS rejected these arguments, pointing out that they “inappropriately conflate the separate statutory self-employment tax rules for partners and the statutory employment tax rules for corporate shareholder employees.” The Code, it said, provides an exclusion for limited partners, not for a reasonable return on capital, and it does not indicate that a partner’s status as a limited partner depends on the presence of a guaranteed payment or the capital-intensive nature of the partnership’s business.

Lessons?

A partnership cannot change the character of a partner’s distributive share for tax purposes simply by making guaranteed payments to the partner for his services. A partnership is not a corporation and the “wage” and “reasonable compensation” rules which are applicable to corporations do not apply to partnerships.

The “limited partner exclusion” was intended to apply to those partners who “merely invest” rather than those who actively participate in and perform services for a partnership in their capacity as partners.

Instead, a partner who is not a “limited partner” within the meaning of the exclusion is subject to self-employment tax on his full distributive share of the partnership’s income, even in cases involving a capital-intensive business.

However, it should be noted that there remain other transactions involving payments from a partnership to a partner that do not generate self-employment income, including interest on loans from the partner to the partnership, and rental payments for the partnership’s use of the partner’s property. Not only are such payments excluded from the partner’s self-employment income, they also reduce the partnership’s net operating income, the partner’s distributive share of which is subject to self-employment tax.

“For the want of a nail the shoe was lost,
For the want of a shoe the horse was lost,
For the want of a horse the rider was lost,
For the want of a rider the battle was lost,
For the want of a battle the kingdom was lost,
And all for the want of a horseshoe-nail.”

― Benjamin Franklin

What is It?

We often remind the owners of a closely held business organization to respect the organization’s separate legal existence – that they not treat it as their alter ego. We advise them that by doing so, the owners can maintain the benefits afforded the organization by the state law under which it was formed, whether as a corporation, an LLC, or a limited partnership.

Among the items included in the owners’ “legal to-do list” are the following: comply with the organization’s governing documents (for example, its by-laws or operating agreement); hold annual meetings of the organization’s board, shareholders, or members, as the case may be, and keep records of such meetings; maintain complete, accurate, and separate bank and other financial accounts for the organization – do not commingle its funds with the funds of other persons; in dealing with third parties, the organization must act in its own name – owners should identify the capacity in which they are acting on behalf of the organization (for example, as officers, managers, etc.) ; and maintain the organization’s “good standing.”

Generally speaking, an organization is in “good standing” when it has complied with the laws of the jurisdiction under which it was formed, including any requirements to file tax returns with, and to pay any taxes owing to, such jurisdiction.

As a result of being in good standing, the organization may, among other things, conduct business within that jurisdiction, and it may qualify to do business in other jurisdictions. In many cases, an organization’s good standing will enable it to maintain limited liability protection for its owners, to obtain a loan, to sell its business, or even to access the U.S. Tax Court, as one taxpayer recently discovered.

Taxpayer Gets Into Trouble

Corp. was formed under State’s corporate law in Year 1. In Year 2, State’s tax department suspended Corp.’s charter on account of Corp.’s failure to pay certain taxes. Notwithstanding the suspension of its charter, Corp. continued to operate its business.

Corp. failed to file various federal tax returns and to pay various federal taxes for Years 3 through 8. The IRS prepared substitute returns for the years at issue and assessed all of the taxes in question, plus penalties. In an effort to collect these unpaid tax liabilities, the IRS sent Corp. a “Final Notice of Intent to Levy and . . . Right to a Hearing.”

Corp. timely requested a collection due process hearing. After the hearing was held, the IRS closed the case and issued a notice of determination sustaining the proposed levy. Corp. timely petitioned the Tax Court to review the IRS’s determination.

In response to the petition, the IRS filed a motion with the Court to dismiss Corp.’s petition for lack of jurisdiction; specifically, the IRS argued that because Corp.’s State charter had been suspended, it lacked legal capacity to file a petition and prosecute the case.

Kicked Out of Tax Court

According to the Tax Court’s rules, the capacity of a corporation to engage in litigation in the Court “shall be determined by the law under which it was organized.” In the present case, the relevant law was that of State, and Corp. had the burden of proving all the facts necessary to establish jurisdiction in the Tax Court.

According to State’s law, the State tax department may suspend the “powers, rights[,] and privileges of a domestic taxpayer” if the corporation fails to pay “any tax, penalty, or interest, or any portion thereof, that is due and payable” at specified times. Once a corporation’s powers have been suspended, it “may not prosecute or defend an action.”

Corp.’s corporate powers were suspended in Year 2, and it supplied no evidence that it had since become current on its State tax obligations, and had thereby been restored to good standing. Rather, State confirmed that Corp.’s corporate powers “remain suspended.”

Thus, the Court found that Corp. lacked the capacity to litigate at the time it filed its petition, and granted the IRS’s motion to dismiss for lack of jurisdiction.

Don’t Make It More Difficult Than It Already Is

Operating a business is no simple matter – far from it. Among the many issues and responsibilities that a business organization and its owners have to confront, tax planning and compliance may be the most challenging.

The application of the tax laws and regulations to the unique facts and circumstances of a particular business organization is not always clear and can be quite daunting. Tax advisers may be consulted as part of a good faith effort to comply with the applicable rules.

A well-informed business will recognize that it has the burden of establishing the facts on which it is basing its legal position, and of proving the reasonableness of its interpretation and application of the relevant rules, and it will plan and prepare accordingly.

All of this comes to naught, however, if the business organization and its owners, for whatever reason, fail to maintain or restore the organization’s good standing under state law and, thereby, deny themselves the opportunity to present their case in the appropriate legal forum.

What Is It?

Disguised SaleAssume that X and Y agree to the following: X will transfer ownership of Prop to Y, and Y will transfer cash to X.

What just happened? No, this is not a trick question. Obviously, X has sold Prop to Y. If the amount of cash that X receives is greater than his adjusted basis in Prop, then X will realize a taxable gain.

What if X borrowed money secured by Prop just before transferring Prop to Y, with Y taking subject to the mortgage?

Again, X will be treated as having sold Prop to Y for an amount of cash equal to the amount of the indebtedness.

Now assume that Y is a partnership. X transfers ownership of Prop to Y as a capital contribution in exchange for a partnership interest in Y; Y borrows cash from an unrelated lender and “distributes” some of the cash to X “in respect of” X’s partnership interest.

Has X sold Prop to Y? Well, the contribution of property to a partnership in exchange for an equity interest therein is not treated as a taxable exchange. The distribution of cash by a partnership to a partner is taxable to the partner only if, and to the extent that, the amount distributed exceeds the partner’s adjusted basis in his partnership interest. In general, when a partnership borrows money, each of its partners includes his “share” of the indebtedness in the adjusted basis of his partnership interest. Thus, Y’s cash distribution may not be taxable to X.

The Disguised Sale Rules – In General

The Code provides special rules to prevent parties from characterizing a sale or exchange of property as a contribution to a partnership followed by a distribution from the partnership, thereby deferring or avoiding tax on the transaction. Under the so-called “disguised sale rules” (“DSR”), related transfers to and by a partnership that, when viewed together, are more properly characterized as a sale or exchange of property, will be treated as a transaction between the partnership and one who is not a partner. https://www.law.cornell.edu/uscode/text/26/707

Depending upon the size of the transferor’s partnership interest and the nature of the property transferred, the gain realized may be treated as ordinary income for tax purposes.

Generally speaking, a transfer of property by a partner to a partnership followed by a transfer of money or other consideration from the partnership to the partner will be treated as a sale of property by the partner to the partnership if, based on all the facts and circumstances, the transfer of money or other consideration would not have been made but for the transfer of property and, for non-simultaneous transfers, the subsequent transfer is not dependent on the entrepreneurial risks of the partnership.

Facts & Circumstances

The weight to be given each of the facts and circumstances will depend on the particular case. In general, the facts and circumstances existing on the date of the earliest of such transfers are the ones considered in determining whether a sale exists. Among the facts and circumstances that may tend to prove the existence of a sale are the following:

(i) the timing and amount of a subsequent transfer are determinable with reasonable certainty at the time of an earlier transfer;
(ii) the transferor has a legally enforceable right to the subsequent transfer;
(iii) the partner’s right to receive the transfer of money or other consideration is secured in any manner;
(iv) any person has made a contribution to the partnership in order to permit the partnership to make the transfer of money or other consideration;
(v) any person has loaned the partnership the money or other consideration required to enable the partnership to make the transfer;
(vi) a partnership has incurred or is obligated to incur debt to acquire the money or other consideration necessary to permit it to make the transfer;
(vii) the partnership holds money or other liquid assets, beyond the reasonable needs of the business, that are expected to be available to make the transfer;
(viii) partnership distributions, allocation or control of partnership operations is designed to effect an exchange of the burdens and benefits of ownership of property;
(ix) the transfer of money or other consideration by the partnership to the partner is disproportionately large in relationship to the partner’s general and continuing interest in partnership profits; and
(x) the partner has no obligation to return or repay the money or other consideration to the partnership.

Two-year Presumption

If within a two-year period, a partner transfers property to a partnership and the partnership transfers money or other consideration to the partner (without regard to the order of the transfers), the transfers are presumed to be a sale of the property to the partnership unless the facts and circumstances clearly establish that the transfers do not constitute a sale. Conversely, if a transfer of money or other consideration to a partner by a partnership and the transfer of property to the partnership by that partner are more than two years apart, the transfers are presumed not to be a sale of the property to the partnership unless the facts and circumstances clearly establish otherwise.

Exceptions

The existing DSR provide a number of practical exceptions that recognize the realities of partnership operations, including exceptions for a reasonable preferred return on a partner’s capital contribution, or reasonable guaranteed payments for the use of a partner’s capital; some of the other exceptions are described below.

Preformation Expenditures

Transfers of money or other consideration from a partnership to reimburse a partner for certain capital expenditures and costs incurred by the partner are not treated as part of a disguised sale of property by the partner. The exception for preformation capital expenditures generally applies only to the extent that the reimbursed capital expenditures do not exceed 20 percent of the fair market value (“FMV”) of the property transferred by the partner to the partnership, and the FMV of the transferred property does not exceed 120 percent of the partner’s adjusted basis in the property at the time of the transfer.

Debt-financed Distribution

Another exception generally provides that if a partner transfers property to a partnership, the partnership incurs a liability (i.e., borrows money), and all or a portion of the proceeds of that liability are traceable to a transfer of money or other consideration to the partner, the transfer of money or other consideration is taken into account under the DSR as part of a sale of property only to the extent that the amount of money or the FMV of other consideration exceeds the partner’s allocable share of the partnership liability incurred to fund the distribution.

Qualified Liabilities

In general, a partnership’s assumption of a liability, or a partnership’s taking property subject to a liability, in connection with a transfer of property by a partner to the partnership, is treated as a distribution of cash to the contributing partner (i.e., as part of a disguised sale of the property) to the extent the liability is allocated away from the partner under the debt allocation rules applicable to partnerships.

The DSR rules provide further that a partner’s share of a liability assumed or taken subject to by a partnership is determined by taking into account certain subsequent reductions in the transferor-partner’s share of the liability under an “anticipated reduction” rule.

However, “qualified liabilities” are generally excluded from disguised sale treatment. The regulations define several types of “qualified liability,” the “transfer” of which is not treated as a distribution of sale proceeds under the DSR unless the contributing partner also receives a cash distribution from, or “transfers” a nonqualified liability to, the partnership .

One type of qualified liability is a liability that is allocable to capital expenditures with respect to the property transferred to the partnership. Another type is one incurred in the ordinary course of the trade or business in which property transferred to the partnership was used or held, but only if all of the assets that are material to that trade or business are transferred to the partnership, and the liability encumbers the transferred property. Yet another is a liability incurred more than two years before the transfer of the property to the partnership. https://www.law.cornell.edu/cfr/text/26/1.707-5

Applying the Exceptions – Revised Rules

Over the years, the IRS and taxpayers encountered certain issues in interpreting or applying the above exceptions to the DSR. In 2014, the IRS proposed changes to those areas of the existing rules that it identified as requiring clarification or revision.

Earlier this month, final regulations were issued that generally tracked these proposed rules, with some changes. Some of these final rules are described below.

Preformation Capital Expenditures

As explained above, transfers of money or other consideration from a partnership to reimburse a partner for certain capital expenditures and costs incurred by the partner are excepted from being treated as part of a disguised sale of property.

The proposed regulations provided that the determination of whether the “20- percent limitation” and the “120-percent test” apply to reimbursements of capital expenditures is to be made, in the case of multiple property transfers, separately for each property that qualifies for the exception.

The final regulations adopt this clarification. However, in order to reduce the burden of separately accounting for each property under the property-by-property rule, the final regulations also permit a limited aggregation of property provided it is not part of a plan a principal purpose of which is to avoid the DSR.

In addition to the property-by-property rule, the proposed rules provided a rule coordinating the exception for preformation capital expenditures with the rule regarding qualified liabilities.

As stated above, a partnership’s assumption of a qualified liability, or a partnership’s taking property subject to a qualified liability, in connection with a transfer of property by a partner to the partnership is generally not treated as part of a disguised sale.

In order to coordinate the exception for preformation capital expenditures and the capital expenditure qualified liability rule, the final regulations provide that to the extent any qualified liability is used by a partner to fund capital expenditures, and economic responsibility for that borrowing shifts to another partner, the exception for preformation capital expenditures will not apply, and the “transfer” of the liability may trigger a disguised sale.

Capital expenditures will be treated as funded by the proceeds of a qualified liability to the extent the proceeds are either traceable to the capital expenditures or are actually used to fund the capital expenditures.

Debt-financed Distribution – Partner’s Share of Partnership Liabilities

In determining a partner’s share of a partnership liability for DSR purposes, the regulations formerly prescribed separate rules for a partnership’s recourse liability and a partnership’s nonrecourse liability. Under the prior rules, a transferor-partner’s guarantee of a liability permitted the allocation to that partner of 100 percent of the liability for purposes of the DSR. This allowed the partner to defer gain on the transfer of the debt-encumbered property to the partnership.

The final regulations now provide that, solely for purposes of the DSR, partners are to determine their share of any liability, whether recourse or nonrecourse, using the same percentage used to determine the partner’s share of the partnership’s excess nonrecourse liabilities under the debt allocation rules applicable to partnerships based upon the partner’s share of partnership profits. Generally, a partner’s share of excess nonrecourse liabilities is determined in accordance with the partner’s share of partnership profits, taking into account all facts and circumstances relating to the economic arrangement of the partners, and – for purposes of the DSR – without regard to any partner guarantee.

Because a partner’s share of a partnership liability for DSR purposes is based on the partner’s share of partnership profits, a partner can no longer be allocated 100 percent of any liability for purposes of the DSR. As a result, some portion of both qualified liabilities and nonqualified liabilities will shift among the partners, which can cause a portion of a qualified liability to be treated as consideration under the DSR.

To mitigate the effect of this allocation method for disguised sales, the final regulations also include a rule that does not take into account qualified liabilities as consideration in transfers of property treated as a sale when the total amount of all liabilities, other than qualified liabilities that the partnership assumes or takes subject to, is equal to the lesser of 10 percent of the total amount of all qualified liabilities the partnership assumes or takes subject to, or $1 million. This is likely to be of limited benefit to larger ventures.

Anticipated Reductions

As stated above, for purposes of the DSR, a partner’s share of a liability assumed or taken subject to by a partnership is determined by taking into account certain subsequent reductions in the partner’s share of the liability. However, the final rules clarify that a reduction will not be treated as anticipatory under the DSR if it is subject to the entrepreneurial risks of partnership operations.

Ordering Rule

The final rules provide that the treatment of a transfer should first be determined under the debt-financed distribution exception (above), and any amount not excluded from the DSR under that exception should then be tested to see if such amount would be excluded under a different exception (for example, because the transfer of money is also properly treated as a reasonable guaranteed payment). This ordering rule ensures that the application of one of the other exceptions does not minimize the application of the debt-financed distribution exception.

Preformation Capital Expenditures and Liabilities Incurred by Another Person

For purposes of applying the exception for preformation capital expenditures and determining whether a liability is a qualified liability, the final regulations clarify how the DSR apply if the transferor-partner acquired the transferred property in a nonrecognition transaction, assumed a liability in a nonrecognition transaction, or took property subject to a liability in a nonrecognition transaction, from a person who incurred the preformation capital expenditures or the liability.

Under the final rules, a partner that acquires property, assumes a liability, or takes property subject to a liability from another person in connection with certain nonrecognition transactions under the Code will succeed to the status of the other person for purposes of applying the exception for preformation capital expenditures and determining whether a liability is a qualified liability.

Qualified Liabilities

The final rules expand the scope of qualified liabilities to include a liability that was not incurred in anticipation of the transfer of the property to a partnership, but that was incurred in connection with a trade or business (rather than incurred in the ordinary course of the trade or business) in which the property transferred to the partnership was used, but only if all the assets related to that trade or business are transferred to the partnership (other than assets that are not material to a continuation of the trade or business). The liability does not have to encumber the transferred property.

Planning

The IRS is clearly focused on any transfer that may implicate the DSR. With the adoption of the clarifications described above, however, taxpayers have been provided with a set of guidelines that should enable them to navigate the rules without surprises.

That being said, a taxpayer that is planning to transfer property to a partnership of which he is already a partner, or in exchange for which he will receive a partnership interest, must consult his tax advisers to ensure that he does not run afoul of the DSR.

Failing to do so may lead to unexpectedly scary results (couldn’t help myself).

Where Did I Leave That Asset?

Tell me this hasn’t happened to you. Individuals come together to start a business. One or more of them own an asset (for example, real estate) that is to be used in the business and that they intend to transfer to a newly-formed business entity as a capital contribution, in exchange for which they will receive an equity interest in the business. However, the formal transfer of the asset is never effectuated – the asset remains titled in their individual names – but the business owners never realize it.

The business entity employs the asset in its operations. It reports the income generated from the asset. It reports depreciation deductions with respect to the asset. It pays and claims deductions for other asset-related expenses. In the case of an S corporation, or an LLC treated as a partnership for tax purposes, the Forms K-1 issued to the business owners reflect the tax items attributable to the asset. The entity holds itself out to the public – for example, customers, tenants, parties to other contracts, insurance companies, banks, etc. – as the owner of the asset.

If you mess with the bull, you are going to get the horns. Years later, perhaps when the business is being audited by the IRS, or when the business is being sold, the owners realize that the business does not “own” the asset. At that point, one or more of them may take the-then self-serving position that the business does not own the asset for tax purposes.

The U.S. Tax Court recently addressed such a situation; specifically, it considered to whom the net losses from a cattle ranching operation were attributable: to a corporation owned by the Taxpayers, or to the Taxpayers themselves.

Home on the Range

Before the years in issue, the Taxpayers’ father transferred all of the cattle from his own cattle operation to the Taxpayers for use in their commercial cattle business.

The Taxpayers formed Corp. to operate their cattle business and, for the years in issue, the cattle operation had several employees that were paid by Corp., which also filed employment tax returns with respect to these employees and issued Forms W-2 to them.

Corp. held a workers’ compensation and employer’s liability insurance policy in its name with respect to the cattle operation employees. It purchased and held farm and ranch insurance in its name. It purchased vehicles and machinery in its name.

Corp. also bought and sold cattle for the cattle operation. These sales and purchases were made at livestock auctions and other public venues, and Corp. appeared as the recorded buyer or the recorded seller.

The cattle operation leased the land on which its ranches were situated. Corp. issued Forms 1099-MISC to the land owners with respect to its lease payments.

Corp. paid expenses of the cattle operation from its own account. Sometimes, Corp. paid personal expenses of the Taxpayers, which were invoiced to them, and then booked by Corp. as a receivable from the Taxpayers. The Taxpayers paid the amounts due shown on each of these invoices, and those funds were deposited in a bank account in Corp.’s name.

Receipts for sales of cattle sold by Corp. were deposited into Corp.’s account. When these sales deposits were entered, half of the revenue was booked directly into the general ledger of each of the Taxpayers, and a payable was created on Corp.’s books. All income from the sale of cattle was split equally between the Taxpayers. If total income exceeded expenses in a month, accountants prepared: (1) vouchers showing each of the Taxpayers as a vendor, (2) invoices for the Taxpayers reflecting a credit of the excess to them, and (3) corresponding account payable invoices for Corp. The Taxpayers would then each receive a check from the Corp. account in the amount shown on these invoices. This convention of Corp.’s transmitting of its remaining income to the Taxpayers would require the latter, when necessary, to advance funds to Corp. so that it could pay subsequent expenses.

The IRS Steps In

For the years in issue, Corp. timely filed Forms 1120, U.S. Corporation Income Tax Return. The returns reported no gross receipts or sales and no (or negative) taxable income. The returns described Corp.’s business activity and service as “Management of Cattle Ranch”.

The Taxpayers filed Forms 1040, U.S. Individual Income Tax Return, for the years in issue. On Schedules C, they reported the gross receipts and expenses (other than those claimed by Corp.) from the cattle operation, and identified their principal business as “animal production”. They offset other income with the cattle operation’s net losses.

The IRS audited Taxpayers’ returns for the years in issue, and made adjustments to them, asserting that the returns inappropriately reported income and expenses that belonged to Corp.

The Taxpayers argued that they, and not Corp., owned all the cattle during the years in issue and, thus, that they properly reported the income and expenses of the cattle operation on their own returns.

The Tax Court

The Court began by noting that, absent extraordinary circumstances, a corporation’s business is not attributable to its shareholders for tax purposes. Generally, when taxpayers choose to conduct business through a corporation, they will not be permitted subsequently to deny its existence if it suits them for tax purposes.

Exceptions exist where the creation of the corporation was not followed by any business activity, the purpose of creating the corporation was not a business purpose, or the corporation was the agent of the taxpayers.

The parties agreed that Corp. had a genuine business purpose and actually carried on business activity and, therefore, was a separate taxable entity. They disagreed, however, over what that purpose was. The IRS asserted that Corp. managed the cattle operation. The Taxpayers contended that Corp. was nothing more than their “accounting agent”.

It was unclear to the Court what the Taxpayers meant when they described Corp. as an “accounting agent”; i.e., whether Corp. performed billing for the cattle operation or whether it was used simply as a strawman to provide a temporary repository for the operation’s income and expenses.

In any case, the Court stated, any accounting function would have been only one aspect of Corp.’s overall business purpose, which was to manage the cattle operation. Its tax returns for the years in issue identified its business activity as “Management of Cattle Ranch”. Corp. bought and sold cattle under its own name during the years in issue. In addition, it carried out a cattle operation business in its own name, held a bank account, purchased and held title to vehicles, leased ranch property, and held ranch and workers’ compensation and employer’s liability insurance policies. Corp. paid for the services of employees, and it handled their employment tax and income tax documents. Any control over these employees by the Taxpayers would presumably have been exercised by them not as individuals, but in their roles as officers of Corp.

“Tax Ownership”

The Court next considered the issue of to whom the income, expenses, and resulting net losses of the cattle operation were attributable.

A fundamental purpose of the Code, the Court stated, is to tax income to those who earn or otherwise create the right to receive it and enjoy the benefit of it. Income from property is usually attributed and taxed to the person who, in substance, is the owner of the property generating the income.

For tax purposes, the true owner of income-producing property is the one with beneficial ownership, rather than mere legal title. It is the ability to “command the property”, or enjoy its economic benefits, that marks a true owner, the Court stated.

“Corporate entity” cases dealing with income-producing property have attributed such property’s income and expenses to the corporation instead of its shareholders where: (1) the corporation has held some type of title to that property; or (2) the shareholders have held the corporation out to others as the owner of that property.

Corp. had command over the cattle to the degree that it was the recognized seller and purchaser of this income-producing property. It deposited all income from the cattle sales into its own account, directly paid cattle operation expenses from that account, and exercised its power of ownership over the funds by directing payment of the excess thereof to its stockholders – all recognizable economic benefits.

Moreover, the Taxpayers caused Corp. to hold itself out to the public, including the livestock auctions and brokers, buyers, sellers, and vendors, as the legal entity that owned the cattle – either by its direct purchase of the livestock or by its right to sell them. Nothing in the record indicated that the Taxpayers took any steps to make third parties aware that the cattle were not owned by the selling/buying corporation, Corp.

The Taxpayers also argued that they were “synonymous” with Corp. and that all the vendors and buyers that they did business with understood that a business transaction with Corp. was actually a transaction with the Taxpayers.

The Court, however, replied that the Taxpayers chose to do business using a separate corporate entity; they benefited from that choice (e.g., limited liability); therefore, they could not disregard the corporation whenever it was beneficial for them to do so.

In considering all the evidence, the Court was satisfied that the taxpayers sufficiently held Corp. out to others as the owner of the cattle during the years in issue and that Corp. had significant control over the cattle. Therefore, Corp. was deemed to be the owner of the cattle for tax purposes and, as a separate taxable entity, was the taxpayer to whom the net losses that stemmed from those assets for the years in issue were attributable.

Agency?

The Taxpayers alternatively argued that the cattle operation losses were nonetheless attributable to them as individuals because Corp. functioned only as their agent.

An exception to the separate taxable entity principle exists where a corporation serves as the agent of the taxpayers. Generally, if a corporation is merely the shareholders’ agent, then income or expenses generated by the corporation’s assets would be income and expenses of the shareholders as principals.

The Court acknowledged that there was such a thing as “a true corporate agent of its owner-principal” and set forth four judicially-developed indicia and two requirements of agency: (1) whether the corporation operates in the name and for the account of the principal; (2) whether the corporation binds the principal by its actions; (3) whether the corporation transmits money received to the principal; (4) whether receipt of income is attributable to the services of employees of the principal and to assets belonging to the principal; and, if the corporation is shown to be a true agent, then (5) its relations with its principal must not be dependent upon the fact that it is owned by the principal; and (6) its business purpose must be the carrying on of the normal duties of an agent.

It is uncontested, the Court stated, that the law attributes tax consequences of property held by a genuine agent to the principal. The genuineness of the agency relationship is adequately assured, it went on, and tax-avoiding manipulation is adequately avoided, when the fact that the corporation is acting as agent for its shareholders with respect to a particular asset is set forth in a written agreement at the time the asset is acquired, the corporation functions as agent, and not as principal, with respect to the asset for all purposes, and the corporation is held out as the agent, and not principal, in all dealings with third parties relating to the asset.

The Court considered whether Corp. was the agent of the Taxpayers. The latter asserted that an agency relationship existed where the principals and agent, through their course of conduct, established a usual, customary, and authorized procedure pursuant to which the agent directly received funds and then disbursed those funds to the principals through a check drawn on the agent’s operating account.

The gross receipts generated by the cattle operation, however, were not transmitted from Corp. to the Taxpayers. Receipts for sales of cattle sold by Corp. were deposited into the Corp.’s account. It then used those funds to pay monthly expenses. The Taxpayers received only the excess of receipts over expenditures, and then only because of their ownership of the corporation.

Taxpayers claimed that Corp. operated in the name and for the account of the Taxpayers. However, the record showed that Corp. acted for its own account. It incurred its own debts, entered into its own contracts with third parties for the purchase of goods and services, and bought and sold cattle in its own name – not as an agent.

The Taxpayers alleged that they were liable for the expenses of the cattle operation and that any expenses incurred by Corp. become their liability. However, they offered no proof of this allegation.

Regarding the indicium of whether receipt of income is attributable to the services of employees of the principal and to assets belonging to the principal, the Taxpayers argued that Corp.’s receipt of income was attributable to the sale of cattle owned by the Taxpayers. The Court determined that the cattle were, or were held out to be, assets of Corp.; thus, any cattle operation income that the Taxpayers eventually received was not attributable to assets that they owned as principals.

The Taxpayers next argued that Corp. functioned as an agent and not a principal with respect to the cattle because “[t]here is no evidence to the contrary.” Corp., however, performed the “nitty gritty” of the cattle operation, and it acted as the controlling entity with respect to the cattle. Moreover, “any instructions that the [Taxpayers] gave to [Corp.] regarding the cattle would most likely have been in their capacity as officers of [Corp.], and the record does not reflect otherwise.” Thus, Corp. did not serve as an agent with regard to the cattle.

Finally, the Taxpayers claimed that Corp. was not held out as the principal in dealings with third parties relating to the cattle. They asserted that the employees on the ranch viewed the Taxpayers, and not Corp., as the owners of the cattle operation, and that vendors who did business with the cattle operation knew that the Taxpayers, and not Corp., would honor any business obligation.

Again, the Court noted that it was unclear how the employees differentiated between the Taxpayers’ acting as officers of Corp. and their acting on their own as principals. Additionally, the record had several examples of how Corp. appeared to be the principal at auctions and with buyers, sellers, and vendors. Nothing reliable in the record showed that Corp. was identified to any third parties as an agent, just as nothing showed that the Taxpayers were identified as its principals.

. . . You Get The Horns

On the basis of the foregoing facts, the Court properly rejected the Taxpayers’ arguments that Corp. be disregarded, and that its operations be reported on their individual income tax returns.

If the Taxpayers wanted to position themselves to utilize losses generated by the business, they should have considered electing “S” status for their corporation, or they should have chosen to use a partnership or an LLC to begin with. For whatever reasons, however, the Taxpayers chose to run Corp., not as a flow-through entity, but as a taxable corporation.

As the Court stated – and as every taxpayer must recognize – they “cannot now escape the tax consequences of that choice.”

“We Could Have Had it All”

ABC has been looking for someone special for a long time. Suitors have come and gone. Some have been better than others. Some were non-starters. Then ABC meets a person that may be “the one.” As it turns out, that person has also been looking for someone.

After getting to know each other a bit, ABC decides that it may be time to open up to one another, with the implicit understanding, of course, that neither of them would ever hurt the other by sharing this information with anybody else.Breakup Fee

In a few months’ time, that special someone indicates that they are interested in a long-term relationship, and ABC promises that it will not entertain “overtures” from others. Then, one day, the moment ABC has been waiting for finally comes. That special someone proposes a permanent relationship with ABC. They select a date to formalize their union and announce it to the world.

ABC couldn’t be happier, or so it thinks. Then someone new appears. ABC never expected to hear from anyone like this person, didn’t think they would ever be interested, but there they are. What’s more, they are offering ABC much more than any other suitor ever did.

Too good to turn down? You bet. The existing engagement has to be called off. But there’s a price to pay. ABC’s now-former suitor spent a lot of money in getting to the point where they agreed to unite with ABC. In the process, the former suitor (who has been burned before) also determined that there was a less-than remote possibility that ABC would walk away if another, “better” suitor came along. “I would never do that to you,” ABC said, and in that spirit, agreed not to hold itself out as being “available,” and also agreed to pay a break-up fee if it ever called off the engagement.

Deal Economics

Every deal, whether from the perspective of the seller or the buyer, is about economics. Few items will impact the economics of a deal more immediately than taxes. The deal involves the receipt and transfer of value, with each party striving to maximize its economic return on the deal. The more taxes that a party to the deal pays as a result of the deal structure, the lower is the party’s economic return. The more slowly that a party recovers its investment in the deal – for example, through tax deductions, such as amortization – the more expensive the deal becomes.

But what happens if the deal does not close? The buyer may have retained accountants, attorneys, financial advisers, and appraisers to assist it in investigating the deal and in putting it together. These professionals are expensive. (Sometimes, you even have to pay them what they are worth.)

Many buyers will seek to protect themselves from a target that may suffer from the jitters, or that may get a better offer, by requiring that the target agree to pay a termination fee. The target will recognize the logic in this, at least from the buyer’s perspective, and will have to take it into account – as an additional cost that it or its new suitor will have to bear – in determining whether to walk away from the deal.

Whether the amount of this fee will fully reimburse the buyer for its expenditures will depend, in no small part, upon how it will be treated for tax purposes.

Termination Fee

The IRS’s Office of Chief Counsel recently issued an advisory opinion in which it discussed how gain or loss would be determined by a buyer corporation (“Taxpayer”) that incurred expenses investigating the acquisition of a target corporation’s stock (“Target”). Taxpayer entered into an agreement (“Contract”) with Target that was designed to lead to Taxpayer’s acquisition of Target’s stock. The Contract also provided that Taxpayer would receive a fee in the event Target terminated the Contract.

The Contract required Taxpayer and Target to pursue a plan of merger to effectuate Taxpayer’s stock acquisition through a merger of a newly-formed, wholly-owned subsidiary of Taxpayer with and into Target, with Target as the surviving entity (a “reverse subsidiary merger” – often used where Target has many shareholders, some of whom may be less than cooperative).

Regarding Target’s obligations under the Contract, the Contract required Target to recommend to its shareholders that they approve the plan of merger subject, however, to the receipt of a superior offer. The Contract provided that Target may terminate the contract upon (i) entering into another agreement based on a superior offer, (ii) a rejection of Taxpayer’s offer by Target’s shareholders, or (iii) a failure to obtain approval of Target’s shareholders by a certain date. The Contract provided that in the event the Contract was terminated due to one of the foregoing, Target would have to pay a termination fee of $X to Taxpayer.

As it turned out, Target received a superior offer from another suitor and entered into an agreement with this other corporation. Target terminated the Contract and paid Taxpayer the $X termination fee. At the time the Contract was terminated, Taxpayer had incurred $Y of costs in the process of investigating and pursuing the transaction that Taxpayer capitalized as costs of facilitating the proposed transaction.

Capitalization Rules

Before discussing the IRS’s opinion, let’s review the applicable capitalization rules.

Amounts that are paid in the process of investigating or otherwise pursuing certain acquisitive transactions – including a taxable acquisition of assets that constitute a trade or business or a taxable acquisition of an ownership interest in a business entity if, immediately after the acquisition, the acquiring taxpayer owns more than 50% of the equity of the business entity – are capitalized as costs of “facilitating” the transaction.

An amount is paid to facilitate an acquisitive transaction if the amount is paid in the process of investigating or otherwise pursuing the transaction. Whether an amount is paid in the process of investigating or pursuing the transaction is determined based on all of the facts and circumstances. In determining whether an amount is paid to facilitate a transaction, the fact that the amount would not have been paid but for the transaction is relevant, but is not determinative. An amount paid to determine the value or price of a transaction is an amount paid in the process of investigating or otherwise pursuing the transaction. Employee compensation, overhead, and other costs are treated as amounts that do not facilitate a transaction.

In general, an amount paid by a taxpayer in the process of investigating or otherwise pursuing a covered transaction facilitates the transaction only if the amount relates to activities performed on or after the earlier of –

(i) The date on which a letter of intent, exclusivity agreement, or similar written communication (other than a confidentiality agreement) is executed by the acquirer and the target; or
(ii) The date on which the material terms of the transaction (as tentatively agreed to by the acquirer and the target) are authorized or approved by the taxpayer’s board of directors, or the date on which the acquirer and the target execute a binding written contract reflecting the terms of the transaction.
Notwithstanding the general rule, an amount paid in the process of investigating or otherwise pursuing a covered transaction facilitates that transaction if the amount is “inherently facilitative”, regardless of whether the amount is paid for activities performed prior to the date determined above. An amount is inherently facilitative if the amount is paid for –
(i) Securing an appraisal or formal written evaluation;
(ii) Structuring the transaction, including obtaining tax advice on the structure;
(iii) Preparing and reviewing the documents that effectuate the transaction;
(iv) Obtaining regulatory approval;
(v) Obtaining shareholder approval; or
(vi) Conveying property between the parties.

In the case of a taxable asset or stock acquisition, an amount required to be capitalized by the acquirer is added to the basis of the acquired assets (in the case of a transaction that is treated as an acquisition of the target’s assets for federal income tax purposes) or the acquired stock (in the case of a transaction that is treated as an acquisition of the target stock for federal income tax purposes).

The IRS’s Opinion: Capital Gain or Loss?

The IRS explained that capital gain or loss is gain or loss that is realized from the sale or exchange of a capital asset.

Gain or loss, it stated, that is attributable to the cancellation, lapse, expiration or other termination of a right or obligation with respect to property which is (or on acquisition would be) a capital asset in the hands of the taxpayer is treated as gain or loss from the sale of a capital asset.

The Code allows as a deduction any uncompensated loss sustained by a taxpayer during the taxable year. The IRS noted, however, that capital losses are subject to certain limitations.

Specifically, in the case of a corporation, losses from sales or exchanges of capital assets are limited to gains from the sale or exchange of such assets. The IRS noted, however, that capital losses in excess of such gains are carried forward.

In the advisory opinion, the IRS determined that Target’s stock would have been a capital asset in Taxpayer’s hands upon acquisition. The Contract provided Taxpayer with a bundle of rights vis-a-vis Target that related to Taxpayer’s proposed acquisition of Target stock. Although the Contract was between Taxpayer and Target, rather than between Taxpayer and Target’s shareholders, a contract between the acquiring corporation and the target corporation, the IRS stated, is a customary part of the process by which the stock of a target corporation may be acquired. The Contract imposed obligations on both parties with respect to Target’s stock. The Contract also provided Taxpayer with rights with respect to Target’s stock.

The IRS determined that the termination fee payable to Taxpayer under the Contract was in the nature of liquidated damages. Thus, any gain or loss realized by Taxpayer on the termination of the Contract, which provided rights and obligations with respect to Target’s stock (a capital asset), would be capital in nature.

Based on the foregoing, the IRS concluded that Taxpayer’s amount realized from the receipt of the termination fee of $X should be reduced by Taxpayer’s capitalized facilitative costs of $Y.

Where the termination fee exceeded these costs, Taxpayer would have realized a gain. Because this gain would have been attributable to the termination of Taxpayer’s right with respect to Target’s stock, property that would have been a capital asset in Taxpayer’s hands, the gain would have been treated as a gain from the sale of a capital asset. Accordingly, Taxpayer would have realized a capital gain.

Where the termination fee was less than Taxpayer’s capitalized facilitative costs, Taxpayer would have realized a loss and, because this loss was attributable to the termination of Taxpayer’s right with respect to Target’s stock, property that would have been a capital asset in Taxpayer’s hands, the loss would be treated as a loss from the sale of a capital asset. Accordingly, Taxpayer would have a capital loss that Taxpayer may deduct, subject to certain limitations on capital losses.

Take-Away

Yes, I sound like a broken record (or CD or phone or notebook or whatever), but it bears repeating.

Every transfer of value in an acquisitive transaction will have economic and tax consequences. In order to ensure the desired economic result (after taxes), a party to the transaction has to consult its tax advisers regarding the tax consequences and the manner in which the transfer should be structured and/or characterized so as to generate the desired result. Armed with this knowledge, the party can then determine whether the appropriate amount of value is being paid or received.

Last week’s post explored the federal income tax consequences to a taxpayer who failed to timely file an election for the classification of his wholly-owned business entity.

Today’s post considers how one taxpayer sought to utilize the IRS’s business entity classification rules to reduce his estate’s exposure for NY estate tax. Individuals who are not domiciled in NY (“nonresidents”), but who operate a NY business, should familiarize themselves with NY’s response to the taxpayer’s proposed plan.

Situs of an LLC Interest
NY had previously ruled in an advisory opinion that a membership interest in a single-member LLC (“SMLLC”) that owned NY real property, and that was disregarded for federal income tax purposes, would be treated as real property – not as an intangible – for NY estate tax purposes.

The opinion also held that when a SMLLC makes an election to be treated as an association (taxable as a corporation) pursuant to the IRS’s “check-the-box” rules, the membership interest in the SMLLC would be treated as intangible property.

It concluded that the election that is in place on the date of the single member’s death is the election that will be used to determine whether the interest in the SMLLC is treated as real property or as intangible property for purposes of NY’s estate tax.

A recent NY advisory opinion addressed Taxpayer’s question whether a membership interest in a SMLLC would be treated as intangible property for NY estate tax purposes where the SMLLC initially elects to be disregarded for income tax purposes but, immediately upon the single member’s death, retroactively elects to be treated as an association taxable as a corporation.

Electing to Change Tax Status – and Situs?
Taxpayer represented that he was currently a NY resident, but that he planned to move to another state. At that time, Taxpayer would transfer his NY real property into a SMLLC, of which he would be the sole member. This SMLLC would not elect to be treated as an association for federal income tax purposes. Thus, it would be treated as a disregarded entity, and Taxpayer would continue to be treated as the owner of the real property.

Taxpayer also represented that he intended to remain the sole owner of the LLC for the remainder of his life, and to continue to have the SMLLC treated as a disregarded entity until his death. This would enable Taxpayer to claim on his personal income tax return the income and deductions associated with the real property.

Upon his death, Taxpayer’s Last Will and Testament would direct his executor to elect that the SMLLC be taxed as an association, and as an S-corporation, for income tax purposes. These elections would have retroactive effect to at least one day prior to the date of Taxpayer’s death.

Before we consider NY’s response to Taxpayer’s proposal, let’s first review the application of NY’s estate tax to nonresident decedents, as well as the IRS’s entity classification rules, the interplay of which is key to NY’s opinion.

The NY Estate Tax
NY imposes an estate tax on the transfer by the estate of a nonresident decedent of real property located in NY.

However, where the real property is held by a corporation or partnership, an interest in such entity has been held to constitute intangible property.

The NY Constitution prohibits the imposition of an estate tax on a nonresident’s intangible property, even if such property is located in NY. For example, securities and other intangible personal property within the state, that are not used in carrying on any business within the state by the owner, are considered to be located at the domicile of the owner for purposes of taxation.

NY’s tax law likewise provides that the NY taxable estate of a nonresident decedent does not include the value of any intangible personal property otherwise includible in the decedent’s gross estate.

The Entity Classification (“check-the-box”) Rules
Pursuant to the IRS’s entity classification rules, an entity that has a single owner, such as a SMLLC, is disregarded as an entity separate from its owner unless it elects to be classified as an association taxable as a corporation.

In other words, where no election is filed, the default classification of the SMLLC is that of a disregarded entity, one that is not deemed to be an entity separate from its owner. The SMLLC will retain this default classification until it makes an election to change its classification.

If the SMLLC is disregarded for tax purposes, its assets and activities are treated in the same manner as those of a sole proprietorship, branch, or division of the owner – the sole member is treated as the direct owner of the LLC’s assets, and is treated as conducting the LLC’s activities himself, for tax purposes.

A SMLLC may elect to be classified as other than its default classification by filing an entity classification election with the IRS. Specifically, a SMLLC may elect to be classified as an association, and thus treated as a corporation for tax purposes, by making such an entity classification election.

Such an election would be effective on the date specified by the entity on the election form, or on the date the form was filed if no such date is specified on the form. The effective date specified on the form cannot be more than 75 days prior to the date on which the election is filed, or more than 12 months after the date on which the election is filed.

NY’s Opinion
“A membership interest in a SMLLC owning New York real property, which is disregarded for income tax purposes, is not treated as ‘intangible property’ for purposes of New York State estate tax purposes. However, where a SMLLC makes an election to be treated as a corporation pursuant to [the ‘check-the-box’ rules], rather than being treated as a disregarded entity, such ownership interest would be considered intangible property for New York State estate tax purposes.”

The opinion noted that there is no provision in NY law applicable to the estate tax that provides for retroactively changing an entity’s classification, in this case to be treated as an association/corporation, after the death of its sole owner. Consequently, any post-mortem, retroactive classification election would be disregarded and not treated as a valid election for NY estate tax purposes.

Based on the above analysis, the advisory opinion stated that where a SMLLC is disregarded for Federal income tax purposes, the assets and activities of the SMLLC are treated as those of the deceased nonresident sole member without regard to any post-mortem election directed by his Last Will and Testament.

Therefore, under the circumstances described above, the interest in the SMLLC owned by Taxpayer would not be treated, for NY estate tax purposes, as an intangible asset. Instead, the NY real property held by the SMLLC would continue to be treated as real property held by the Taxpayer for NY estate tax purposes, even after the retroactive classification election was filed.

The Right Answer
Although an advisory opinion is limited to the facts set forth therein, and is binding on NY only with respect to the person to whom it is issued, it is pretty clear that NY’s position regarding Taxpayer’s proposed gambit stands on fairly solid ground.

The proposal described above is premised on the fact that Taxpayer has no idea of when he will die. He wants to enjoy the flexibility of operating through a SMLLC during his life and, upon his demise, take advantage of the opportunity afforded by the entity classification rules to make a retroactive change to the LLC’s tax status and, thereby, to change the situs of his membership interest in the LLC.

Although there are several statutorily-approved post-mortem planning opportunities (for example, the 6-month alternate valuation rule), the ability to elect to change the situs of a nonresident decedent’s property for NY estate tax purposes is definitely not one of them.

A nonresident business owner who operates in NY through a SMLLC certainly should not rely upon his executor’s making a post-mortem entity classification election to “remove” his tangible assets from the reach of the NY estate tax.

An S-corporation is a viable alternative, though it is more restrictive than a SMLLC, and the S-corporation election would have to be made while the owner was still alive.

Alternatively, the owner could choose to admit a second member to the LLC – perhaps an S-corporation, wholly-owned by him, that would hold a de minimis membership interest. The LLC would be treated as a partnership for tax purposes, thereby affording the owner the desired flexibility and pass-through treatment. The LLC interest would also be treated as an intangible in the hands of the nonresident owner under the NY estate tax.

Fortunately, Taxpayer sought professional guidance, as well as NY’s opinion, before implementing the proposed gambit. It’s a lesson to be remembered.

Whose Tax Liability?

In order to properly assess and collect a tax, the IRS first needs to identify the taxpayer that is responsible for reporting the income, and for collecting and remitting the tax, at issue. This is not always a simple proposition. In the case of a business entity, it may depend, in part, upon the entity’s classification for tax purposes.

Tax LiabilityFor example, a business entity that was incorporated under State law will be treated as a taxable C corporation for tax purposes. The same corporation may file an election with the IRS to be treated as a pass-through small business (“S”) corporation, and it may subsequently elect to revoke its “S” election.

In the case of every other business entity, however, the classification is more “fluid.” In order to provide certainty both to the IRS and to taxpayers, the IRS has issued entity classification regulations. These regulations provide certain “default” classifications that coincide with what most taxpayers would desire for the entity in question. Where the taxpayer wants to elect a classification other than the “preferred” default status, it must affirmatively notify the IRS of its decision.

Thus, an LLC that has only one member is ignored for income tax purposes; it is treated as partnership if it has at least two members; regardless of how many members it has, it may elect to be treated as an association that is taxable as a corporation.

The importance of properly making and filing an election so as to change the classification of a business entity for tax purposes cannot be understated.

An Illustration

Taxpayer was the sole shareholder of Corp., a “C” corporation on behalf of which he consistently filed Form 1120, U.S. Corporation Income Tax Return.

Taxpayer formed LLC at the end of Year 1 and became LLC’s sole member. Immediately after the formation of LLC, Corp. merged with and into LLC, with LLC as the surviving entity, and Corp. ceased to exist. LLC continued to own Corp.’s assets and to operate Corp’s business. Since the merger, LLC filed Forms 1120 using Corp’s employer identification number (“EIN”). However, LLC did not file IRS Form 8832, Entity Classification Election.

Taxpayer filed Forms 940 and 941 on behalf of LLC, but did not make sufficient tax deposits or pay the tax due for its employment tax liabilities for several taxable periods after the merger (but before 2009 – see later).

The IRS issued a Notice of Intent to Levy for these periods and filed a Notice of Federal Tax Lien.

Taxpayer argued that LLC, and not Taxpayer individually, was liable for the employment tax liabilities due from LLC.

The only issue for consideration by the Tax Court was whether Taxpayer, as the sole member of LLC, was personally liable for the payment of the employment tax liabilities of LLC for the taxable periods in question.

Entity Classification

The so-called “check-the-box” regulations allow an “eligible business entity” to elect its classification for federal tax purposes. An eligible business entity is one that is not treated as a corporation, per se, under the regulations.

An eligible entity with a single owner, such as the LLC and Taxpayer in the present case, may elect to be classified as an association – i.e., as a corporation – for tax purposes, or it may choose to be disregarded as an entity separate from its owner.

An eligible entity with a single owner that does not file an election is disregarded as an entity separate from its owner; its default status is that of a disregarded entity.
An election is necessary only when an eligible entity chooses to be classified initially as something other than its default classification, or when an eligible entity chooses to changes its classification.

The tax treatment of a change in the classification of an entity for federal tax purposes by election is determined under all relevant provisions of the Code and general principles of tax law, including the step transaction doctrine.

For example, if an eligible entity that is disregarded as an entity separate from its owner (the default status of a single-member LLC) elects to be classified as an association, the following is deemed to occur: the owner of the eligible entity contributes all of the assets and liabilities of the entity to the association in exchange for stock of the association.

If an eligible entity classified as an association (a business entity that elected to be treated as a corporation for tax purposes) elects to be disregarded as an entity separate from its owner, the following is deemed to occur: the association distributes all of its assets and liabilities to its owner in liquidation of the association.

Form 8832

An entity whose classification is determined under the default classification rules retains that classification until the entity makes an election to change its status by filing IRS Form 8832, Entity Classification Election.

An election will not be accepted unless all of the information required by Form 8832 and its instructions is provided. Further, to avoid penalties, an eligible entity that is required to file a federal tax or information return for the taxable year in which an election is made must attach a copy of Form 8832 to its tax or information return for that year.

Under these rules, LLC was disregarded as a separate entity from Taxpayer, its owner, because it was a single-member LLC that had never filed Form 8832.

Notwithstanding this conclusion, Taxpayer made a number of arguments as to why Form 8832 was not the only method by which an eligible entity could elect to change its classification.

The Taxpayer’s Position

First, Taxpayer argued that the merger of Corp. and LLC was a valid reorganization under Section 368(a)(1)(F) of the Code (an “F reorganization,” or “mere change” in corporate identity or form) and, as a result, LLC should be treated as a corporation for federal tax purposes.

Second, Taxpayer argued that the filing of Forms 1120 for the first year after the merger of Corp. and LLC constituted a valid election for LLC to be taxed as a corporation.

Third, Taxpayer argued that the doctrine of equitable estoppel prevented the IRS from contending that LLC was not a corporation because the IRS had “tacitly acquiesced” to the filings of Forms 1120 for the year of the merger and subsequent years.

The Tax Court’s Response

The Court responded that regardless of whether the merger of Corp. and LLC qualified as a valid F reorganization, LLC never filed Form 8832 electing its classification for federal tax purposes as an association and, thus, was not a corporation but, rather, was disregarded as an entity separate from its owner. (Incidentally, this would have caused the merger to be treated as a taxable liquidation of Corp.)

Next, the Court stated that an eligible entity could not elect its entity classification by filing any particular tax return it wished; it had to do so by filing Form 8832 and following the instructions within the regulations. Thus, LLC could not elect to be treated as an association/corporation merely by filing corporate income tax returns.

Finally, according to the Court, equitable estoppel did not bar the IRS from treating LLC as a disregarded entity. The Court noted that equitable estoppel was to be applied against the IRS with the utmost restraint. The elements of estoppel, it stated, are: “(1) * * * a false representation or wrongful misleading silence; (2) the error must be in a statement of fact and not in an opinion or a statement of law; (3) the person claiming the benefits of estoppel must be ignorant of the true facts; and (4) he must be adversely affected by the acts or statements of the person against whom an estoppel is claimed.” The IRS made no false statement to Taxpayer, and the Court did not agree that the IRS’s failure to reject LLC’s filed Forms 1120 was a wrongful misleading silence. Moreover, Taxpayer knew that LLC had never filed a Form 8832 to elect to be treated as anything other than a disregarded entity.

For the foregoing reasons, the Court rejected Taxpayer’s arguments, and found that LLC was disregarded as an entity separate from Taxpayer.

The Taxes At Issue

The Code requires employers to pay employment taxes imposed on employers and to withhold from employees’ wages certain taxes imposed on employees. Employers are required to withhold from employees’ wages the amounts of federal income tax owed by those employees. The Code also imposes a tax on every employer with respect to individuals in his employ.

For employment taxes related to wages paid before January 1, 2009, a disregarded entity’s activities were treated in the same manner as those of a sole proprietorship, branch, or division of the owner.

Accordingly, the sole member of a limited liability company and the limited liability company itself were treated as a single taxpayer who is personally liable for purposes of the employment tax reporting and wages paid before January 1, 2009. Taxpayer was, therefore, liable for LLC’s unpaid employment tax liabilities arising during the tax periods at issue since they related to wages paid before 2009.

Did the Court Get it Right?

On a strict reading of the regulations, yes, it did.

However, the Court’s decision seems harsh. Taxpayer clearly intended to treat LLC as an association taxable as a corporation for tax purposes. He caused LLC and Corp. to merge as part of a transaction that was reported as a tax-free corporate reorganization, not as a taxable liquidation. He treated LLC as the continuation of Corp. for tax purposes, causing LLC to file income tax returns as a “C” corporation, using Corp.’s EIN, after the merger.

What Taxpayer failed to do was file a Form 8832 to elect to be treated as an association.

Interestingly, an eligible entity, including a single-member LLC, that timely elects to be an S corporation, by filing IRS Form 2553, is treated as having made an election under the regulations to be classified as an association, provided that (as of the effective date of the “S” election) the entity meets all other requirements to qualify as a small business corporation. The deemed election to be classified as an association will apply as of the effective date of the S corporation election and will remain in effect until the entity makes a valid election to be classified as other than an association.

When this provision of the check-the-box regulations was adopted, the IRS explained that requiring eligible entities to file two elections in order to be classified as S corporations – Form 8832 and Form 2553 – creates a burden on those entities and on the IRS. The regulations sought to simplify these paperwork requirements by eliminating the requirement that the entity also elect to be classified as an association by filing Form 8832. Instead, an eligible entity that makes a timely and valid election to be classified as an S corporation by filing Form 2553 will be deemed to have elected to be classified as an association taxable as a corporation.

The regulation also provides that, if the eligible entity’s “S” election is not timely and valid, the default classification rules will apply to the entity unless the IRS provides late S corporation election relief or inadvertent invalid S corporation election relief.

Unless the IRS amends the regulations to expand the relief available thereunder beyond “S” elections, to cover eligible business entities in general, a taxpayer seeking a particular entity classification for tax purposes must file Form 8832. It will not be enough that the taxpayer has otherwise acted consistently with the desired status.

Proposed RegulationsLast week, we considered (i) the context in which the recently proposed regulations under Section 2704 of the Code would eventually be applied, (ii) the principles underlying Section 2704, (iii) the valuation of an interest in a closely-held business, generally, and (iv) the failed legislative efforts to address the issues covered by the proposed regulations. Today, we turn to the proposed rules themselves.

The 2016 Proposed Regulations – In General

The preamble to the proposed regulations could have been lifted verbatim from the 2010 through 2013 Green Books. Indeed, any tax adviser would be hard-pressed to say that he had no idea what was going to be included in the proposed regulations (which is why their prospective effective date is generous).

Main Themes

There are two main themes that permeate the regulations, and they reflect the legislative intent behind Section 2704.

First, if there is a lapse of any voting or liquidation right upon the transfer of an interest in a business entity, and the individual transferor who held such right immediately before the lapse holds control of the entity – with members of his family – both before and after the lapse, such lapse will be treated as a transfer by such individual by gift, or as a transfer which is includible in his gross estate, whichever is applicable.

In other words, because the lapsed right can be restored after the transfer by the transferor and his family, the lapse must have been provided only for valuation purposes, and did not have an independent, non-tax purpose, or so the theory goes.

Second, a restriction that limits the ability of a business entity to liquidate will be disregarded in valuing the transfer of an interest in the business to a member of the transferor’s family if the transferor and members of his family control the entity before the transfer, and the restriction may be removed by them after the transfer.

This echoes the first theme: a restriction that may be toggled on and off by the transferor and his family must not be meaningful, other than for valuation purposes, or so the theory goes.

The elements shared by these themes are (i) the presence of “transferor/family control” of an entity both before and after the transfer of an interest in the entity, and (ii) the ability of the transferor and his family to restore any lapsed rights and to remove any restrictions.

The 2016 Proposed Regulations – Specific Provisions

The following discussion will focus upon what I regard as the principal “entity-planning-related” changes to the current regulations.

Single-Member LLCs

The proposal would clarify that Section 2704 applies to the transfer of an interest in a single-member LLC (and not just to corporations and partnerships, as is literally stated in the statute), even if the LLC is disregarded as an entity separate from its owner for tax purposes.

In other words, an LLC’s classification for other purposes of federal tax law is irrelevant for valuation purposes. A taxpayer’s transfer of a membership interest in his wholly-owned LLC will be treated as a transfer of an interest in a business entity – the LLC – not as a transfer of an interest in its underlying assets; and, thus, the value of such an interest will be determined in accordance with the terms of the LLC’s operating agreement, state law, and – more to the point – the regulations under Section 2704.

This proposed change is aimed at the Tax Court’s decision in Pierre, where the Court determined that valuation discounts may be applied to value the transfer an interest in an LLC that was wholly-owned by the transferor and that she had funded with liquid assets.

Three-Year Rule for “Deathbed (?) Transfers”

The proposal would address so-called “deathbed transfers” (a misnomer) that result in the lapse of a liquidation right.

You will recall the provision in the current regulations under which the transfer of an interest conferring a right is not treated as a lapse of that right if the right is not reduced or eliminated, but simply transferred to another.

For example, the transfer of a minority interest by a controlling shareholder, who thereby ceases to be a controlling shareholder, is not treated as a lapse of voting or liquidation rights as to the controlling shareholder even though it results in the transferor’s loss of control.

This kind of transfer is a staple among estate planners. It enables them to divide the ownership of a business between the taxpayer and his family (e.g., his spouse) without significant economic consequences, while positioning the taxpayer’s interest to be valued as something less than a controlling interest.

The proposed regulations are aimed at exactly this situation. They do not eliminate the exception, but narrow its application to transfers occurring more than three years before the transferor’s death. Thus, if the transferor dies within three years of the transfer, a lapse of a right covered by Section 2704 will be deemed to have occurred upon his death.

For example, in what turns out to be more than three years before his death, D transfers one-half of his X Corp. stock in equal shares to his three children. Section 2704 does not apply to the loss of D’s ability to liquidate X Corp. because the voting rights with respect to the transferred shares are not restricted or eliminated by reason of the transfer, and the transfer occurs more than three years before D’s death. However, had D died within three years of the transfers, the transfers would have been treated as the lapse of D’s liquidation right, occurring at D’s death.

This results in the creation of a phantom asset in the estate on which estate tax will have to be paid. Query how a taxpayer and the executor of his estate may pay for payment of the tax.

According to the proposal, this rule will apply to lapses occurring on or after the date the rules are finalized. Thus, they may cover transfers (and lapses) that have already occurred (before the proposals are finalized) if the transferor dies after the effective date of the regulations and not more than three years after the transfer.

I think it likely that the effective date will be amended to clarify that it covers transfers occurring after the effective date. (This was the approach taken when the subjective “in contemplation of death” provisions of Section 2035 of the Code were replaced by a similar three-year rule.)

The application of this proposed rule is bound to have some unintended consequences; a relatively young, healthy transferor who is hit by the bus while crossing the street is covered as much as a bed-ridden octogenarian who is adjusting his holdings for estate tax valuation purposes. However, the proposed bright-line test is reasonable when one considers its “actuarial underpinnings” and the universe of taxpayers whose estates it is likely to cover.

State Law Restrictions

The proposed regulations would refine the definition of “applicable restriction” by eliminating the comparison to the liquidation limitations of state law.

You will recall the provision in the current regulations that limits the definition of an applicable restriction to one that is more restrictive than the default rules under state law. Under this regulatory exception, a restriction will not be disregarded for valuation purposes if it is not more restrictive than the default rule under the applicable state law.

The proposal would remove this exception. The reasoning for the removal is consistent with the purpose of Section 2704. Any restriction that is not imposed or required by federal or state law is a restriction that the transferor and his family can remove or replace with a less restrictive one. It is an applicable restriction that will be disregarded for valuation purposes.

If an applicable restriction is disregarded, the fair market value of the transferred interest is determined under generally applicable valuation principles as if the restriction did not exist (that is, as if the governing documents and the local law were silent on the question) and, thus, there is deemed to be no such restriction on liquidation of the entity.

The proposal also clarifies that an applicable restriction does not include a restriction that is imposed or required to be imposed by law. A provision of law that applies only in the absence of a contrary provision in the governing documents, or that may be superseded with regard to a particular entity (whether by the shareholders, partners, members and/or managers of the entity or otherwise), is not a restriction that is imposed or required to be imposed by law.

Although I have no argument with this position in the case of a family-owned investment company holding marketable securities (in which liquid assets to pay a withdrawing owner are available or can be readily obtained), its application to a family-owned business or real estate entity seems unreasonable. Most closely-held operating businesses, including those that are family-owned, seek to limit the withdrawal of capital from the entity for bona fide business reasons and, so, restrict the ability of an owner to liquidate his interest in the business.

Assignees

Taxpayers have attempted to avoid the application of Section 2704 through the transfer of a partnership interest to an assignee, rather than to a partner. Again, relying on the regulatory exception for restrictions that are no more restrictive than those under state law, and the fact that an assignee is allocated partnership income, gain, loss, etc., but does not have the rights or powers of a partner, taxpayers have argued that an assignee’s inability to cause the partnership to liquidate his or her partnership interest is no greater a restriction than that imposed upon assignees under state law. Thus, taxpayers have argued that the conversion to assignee status of the transferred partnership interest is not an applicable restriction.

The proposed regulations provide that a transfer that results in the restriction or elimination of any of the rights or powers associated with the transferred interest (an assignee interest) will be treated as a lapse, within the meaning of Section 2704, the value of which will be taxable.

New Disregarded Restrictions

As indicated in the Obama administration’s Green Books, and pursuant to the authority granted under Section 2704 itself, the IRS has identified a new class of restrictions that are to be disregarded for valuation purposes.

According to the proposal, where an interest in a family-controlled entity is transferred, any restriction on an owner’s right to liquidate his interest (as opposed to liquidating the entity) will be disregarded for valuation purposes if the transferor and/or his family may remove or override the restriction.

Under the proposal, a “disregarded restriction” includes one that:

  • limits the ability of the holder to liquidate the interest, or
  • limits the liquidation proceeds to an amount that is less than a “minimum value”, or
  • defers the payment of the liquidation proceeds for more than six months, or
  • permits the payment of the liquidation proceeds in any manner other than cash or “other property” (generally excluding promissory notes).

For purposes of this rule, the “minimum value” of an interest is defined as the interest’s share of the net value of the entity on the date of liquidation or redemption. It is basically a liquidation value: the interest’s share of the proceeds remaining after the deemed sale of the entity’s assets at fair market value, and the deemed satisfaction of its liabilities.

Again, if we are considering a family investment vehicle holding marketable securities, I have no issue with the proposal. Such an entity can easily generate the liquidity needed, or distribute marketable assets, to redeem or liquidate a member’s interest in a timely manner.

What about a family-owned operating business? The IRS acknowledges the “legitimacy” of such a business. For example, a provision in an agreement that permits the payment of the liquidation proceeds by way of a promissory note will not be disregarded under the proposal if the proceeds are not attributable to passive investment assets, and the note is adequately secured, provides for periodic payments, bears a market rate of interest, and has a present value equal to the minimum value.

Even so, the IRS ignores the fact that close businesses will often require a “haircut” on the redemption price for someone’s interest, in part to dissuade owners from withdrawing, whether to prevent competition or to preserve capital for the business, or for some other valid business purpose.

It should be noted that the proposed regulations include an exception to these otherwise disregarded restrictions. Unfortunately, it requires the inclusion of certain provisions in the partnership or shareholders’ agreement that are rarely found even in a business owned by unrelated persons. Specifically, the exception applies if:

  • each owner has the right to put his interest to the business in exchange for cash and/or other property at least equal to the minimum value; and
  • the full amount of such purchase price must be received within six months after the owner has given notice of his intent to exercise his put right; and
  • such “other property” does not include a note, unless the entity is engaged in an active business and the note satisfies certain requirements.

If a restriction is disregarded, the fair market value of an interest in the entity is determined assuming that the disregarded restriction did not exist. The fair market value is determined under generally accepted valuation principles, including any appropriate discounts or premiums.

Ignoring Certain Unrelated “Owners”

In determining whether the transferor and/or the transferor’s family has the ability to remove a restriction, any interest in the entity held by a person who is not a member of the transferor’s family will be disregarded under the proposal if, at the time of the transfer, the interest:

  • has been held by such person for less than three years; or
  • constitutes less than 10 percent of the equity in the entity; or
  • when combined with the interests of all other persons who are not members of the transferor’s family, constitutes less than 20 percent of the equity in the entity; or
  • any such person, as the owner of an interest, does not have an enforceable right to receive in exchange for such interest, on no more than six months’ prior notice, the “minimum value.”

If an ownership interest is disregarded, the determination of whether the family has the ability to remove the restriction will be made assuming that the remaining interests are the sole interests in the entity.

This provision is aimed at the suspect practice of trying to avoid the application of Section 2704 through the transfer of a nominal business interest to a nonfamily member, such as a charity or an employee, to “ensure” that the family alone does not have the power to remove a restriction.

In the case of a charity, it is likely that this practice has been limited to investment entities that hold marketable securities. A charity would likely not be interested in acquiring an interest in an operating business with its potential for generating unrelated business taxable income and a limited ability to monetize its ownership interests.

What’s Next?

Two bills have been introduced in the House of Representatives this month that seek to void the proposed regulations. Neither of these will get very far.

As mentioned in an earlier post, the IRS has scheduled hearings on the proposed regulations for December 1, 2016. It is expected that many comments will be submitted by the November 2 deadline and, hopefully, considered.

Ignoring the fact that the results of the Presidential and Congressional elections may render the proposed regulations moot, my hope is that the IRS will refocus the proposals so that they are limited to family-owned investment entities, and not operating businesses.

As for investment entities, the regulations should distinguish between those that hold real estate and those that hold marketable securities and cash equivalents. Only the latter are appropriate subjects for the proposed rules.

Assuming the IRS proceeds with the hearings scheduled for December 1, and assuming it accepts some of the changes being suggested by the professional community, the regulations will likely not be finalized until at least early 2017. If the IRS rejects this commentary, the regulations may become effective on December 1.

Stay tuned.