Partner or Employee?

It has long been the position of the IRS that a bona fide member of a partnership is not an employee of the partnership. Such a partner, who devotes his or her time and energies to the conduct of the trade or business of the partnership, or in providing services to the partnership, is a self-employed individual.

According to the IRS, however, it appears that some taxpayers have been misreading the so-called “entity classification” rules so as to permit the treatment of individual partners, in a partnership that owns a disregarded entity, as employees of the disregarded entity. Under this reading, some partnerships have permitted partners to participate in certain tax-favored employee benefit plans.

In order to address this issue, the IRS recently proposed regulations to clarify that such partners are subject to the same self-employment tax rules as partners in a partnership that does not own a disregarded entity. [TD 9766]

Before reviewing the proposed regulations, it may be helpful to describe the tax treatment of “partner compensation.”

Payments for Services

The rules that govern the tax treatment of transactions between partners and their partnerships are among the most complex rules in the Code. The treatment of a particular transaction will depend, in part, upon the capacity in which the partner is acting and upon the nature of the transaction.

For example, payments made by a partnership to a partner for services rendered in his or capacity as such, are considered as made to a person who is not a partner, if such payments are determined without regard to the income of the partnership. [IRC Sec. 707(c)]

However, such a “guaranteed payment” is considered as made to a non-partner only for certain enumerated purposes.

Specifically, the partner must include the amount of the payment in his or her gross income [IRC Sec. 61; https://www.law.cornell.edu/uscode/text/26/61 ], even if the partnership has a loss for the year in which the payment is made. Moreover, because the payment is made in respect of services rendered, the income is taxed as ordinary income regardless of the character of the income, if any, realized by the partnership.

Similarly, the partnership may deduct the payment [IRC Sec. 162], provided it constitutes an ordinary and necessary trade or business expense , is reasonable for the services rendered, and does not have to be capitalized under the rules relating to capital expenditures. [IRC Sec. 263]

The impact of this rule is limited to these enumerated purposes. For purposes of other provisions of the tax law, guaranteed payments are regarded as a partner’s share of the partnership’s income. Thus, as in the case of a partner’s distributive share of partnership income, the partner must include such payments in gross income for his or her taxable year within or with which ends the partnership taxable year in which the partnership deducted such payments under its method of accounting. [Reg. Sec. 1.707-1(c)]

For purposes of other provisions of the Code, guaranteed payments are regarded as a partner’s distributive share of ordinary income. Thus, a partner who receives guaranteed payments for a period during which he or she is absent from work because of personal injuries or sickness is not entitled to exclude such payments from his gross income. [IRC Sec. 105] Similarly, a partner who receives guaranteed payments is not regarded as an employee of the partnership for the purposes of income or employment tax withholding, deferred compensation plans, etc. [Reg. Sec. 1.707-1(c)] Instead, guaranteed payments received by a partner, from a partnership that is engaged in a trade or business, for services rendered to the partnership are treated as “net earnings from self-employment” and are subject to self-employment tax. [1.1402(a)-1(b)]

The Entity Classification Rules

A business entity (typically, an LLC) that has a single owner, and that is not a corporation, is disregarded as an entity separate from its owner for purposes of the income tax. The single owner is treated, for example, as owning all of the entity’s assets and as receiving all of its income.

However, such a “disregarded entity” is treated as a corporation for purposes of the employment taxes imposed under the Code. Therefore, the disregarded entity, rather than the owner, is considered to be the employer of the entity’s employees for purposes of the employment taxes.

While a disregarded entity is, thus, treated as a corporation for employment tax purposes, this rule does not apply for self-employment tax purposes. Rather, the general rule applies, and the entity will be disregarded as an entity separate from its owner for purposes of the self-employment tax.

The applicable regulation illustrates this rule in the context of a single individual owner (not a partnership) by stating that the owner of an entity that is treated in the same manner as a sole proprietorship is subject to tax on self-employment income. However, the regulation includes an example in which the disregarded entity is subject to employment tax with respect to employees of the disregarded entity, while the individual owner is subject to self-employment tax on the net earnings from self-employment resulting from the disregarded entity’s activities.

Because the regulation does not include a specific example applying the general rule in the context of a partnership, many taxpayers believed – unreasonably, you might say – that an individual partner, in a partnership that owns a disregarded entity, could be treated as an employee of the disregarded entity. Consequently, they decided to pay wages to partners through a disregarded entity, like a wholly-owned LLC, in order to qualify the partners as “employees” for purposes of certain tax-advantaged benefit plans.

The Proposed Regulation

The IRS noted that the regulation did not create a distinction between a disregarded entity owned by an individual (that is, a sole proprietorship) and a disregarded entity owned by a partnership in the application of the self-employment tax rules. Rather, the regulation applies for self-employment tax purposes for any owner of a disregarded entity without carving out an exception regarding a partnership that owns such a disregarded entity.

The regulations proposed by the IRS apply the existing general rule to illustrate that, if a partnership is the owner of a disregarded entity, the partners are subject to the same self-employment tax rules as partners in a partnership that does not own a disregarded entity. In other words, the rule that treats the entity as disregarded for self-employment tax purposes applies to partners in the same way that it applies to a sole proprietor owner. A disregarded entity that is treated as a corporation for purposes of employment taxes is not treated as a corporation for purposes of employing its individual owner, or for purposes of employing an individual that is a partner in a partnership that owns the disregarded entity.

Where Is This Leading?

In order to allow adequate time for partnerships to make necessary payroll and benefit plan adjustments, the proposed regulations, which were also issued as temporary regulations, will apply no earlier than August 1, 2016.

Between now and then, any partnership that has been treating its partners as employees of an LLC wholly-owned by the partnership will have to stop doing so.

A the same time, however, it should be noted that the IRS has indicated that it will consider whether it should allow partnerships to treat partners as employees in certain circumstances; for example, in the case of employees of a partnership who obtain a small ownership interest in the partnership as a compensatory award or incentive.

In connection therewith, the IRS will have to analyze, among other things, the impact on employee benefit plans (including, but not limited to, qualified retirement plans, health and welfare plans, and fringe benefit plans) and on employment taxes if partners were to be treated as employees in certain circumstances.

Stay tuned – the IRS may eventually change its position.

Having worked with many families in the administration of their loved ones’ estates, I can report anecdotally that over the last decade, tax-deferred retirement assets have constituted an ever-increasing share of individual wealth, even for those estates that fall below the estate tax exemption amount. Such tax-deferred assets come in many different forms; some of the more popular vehicles include the individual retirement account (IRA), the 401(k) account, and the 403(b) account.  As such assets are creatures of highly-technical tax statutes and regulations, dealing with them often requires a greater level of care and attention to detail than the “run of the mill” real estate, corporate, and partnership assets.  This reality is most often acknowledged by (and causes the most consternation to) my colleagues and me when planning for the testamentary disposition of retirement assets, such as ensuring that a trust named as beneficiary of a retirement asset satisfies the complex rules regarding continued income tax deferral. IRA

Although planning for the transfer of a decedent’s IRAs requires careful navigation around many mines, death is not the only time to be aware of the IRA rules. Indeed, many business owners have, over the years, viewed their IRAs as a ready source of funds.  In their haste to access these funds, they often discover, too late, that they have made a terrible mistake.  A recent U.S. Tax Court decision drives home the point that great care and attention is required where a business owner-IRA participant wants to use his or her IRA to fund a business.  The simple lesson to be learned is that participants are not as free to deal with their tax-deferred assets as they are with their other assets.

When reading the decision, the Taxpayers, husband and wife, both under 59 years of age, come across as sympathetic. The husband was a former 30-year employee of a grocery store chain who decided to pursue his dreams and follow his entrepreneurial spirit by investing in a metal fabrication business, a field he had long ago studied in college; the wife was an employee of the same company.  They seemingly did all the right things before taking the plunge into a new business: they consulted with an accountant, a lawyer, and an experienced business broker in order to ensure the deal was structured wisely.

The business broker advised Taxpayers that they could roll over the funds in their respective retirement accounts from the grocery store into new IRAs, cause the IRAs to acquire the initial stock of a newly-formed C corporation, and cause the C corporation to acquire the existing business. More than that, the brokerage company explained that it typically recommended to its clients acquiring companies that they borrow and issue a note to the seller as part of the consideration for the sale so that “the seller would have an interest in helping the buyer.”  In this context, that meant causing Taxpayers’ newly formed C corporation to “borrow” funds from, and issue a note to, the seller of the existing business (an installment sale).

Taxpayers then retained an accountant to advise them about the IRA funding structure. Incidentally, the accountant was referred to Taxpayers by a friend who had recently utilized the same IRA funding structure in his own business acquisition (query whether the friend’s structure was also scrutinized by the IRS).  They also retained legal counsel to establish the C corporation that acquired the target metal fabrication business.  Taxpayers were named as the sole officers and directors of the C corporation.  They then rolled over their retirement accounts at the grocery store, approximately $432,000 in the aggregate, to new, self-directed IRAs custodied at a local financial institution.  Because the IRAs were self-directed, Taxpayers retained all discretionary authority and control concerning the investment of their respective IRA’s assets.

Taxpayers directed the IRAs to purchase shares of the newly-formed C corporation, which, in turn, purchased the existing metal fabrication business. The consideration for the business consisted, in part, of a $200,000 promissory note issued by the C corporation to the seller.  The note was secured by the business’s assets and was personally guaranteed by the Taxpayers, i.e., the IRA participants.

All of the above-described transactions took place during the same tax year. On their personal income tax return filed for said tax year, Taxpayers reported the IRA rollovers, but did not disclose the guaranties of the loan or, as the Tax Court noted, “any other fact that would have put [the IRS] on notice of the nature and the amount of any deemed distribution resulting from the guaranties.”

The IRS nevertheless discovered the transaction and issued a notice of deficiency for approximately $180,000, primarily attributable to an understatement of income in the approximate amount of the IRAs that were rolled over, i.e., about $432,000 in the aggregate. At the Tax Court, the IRS argued that the IRAs ceased to be IRAs when the taxpayers guaranteed the note issued by the C corporation, which was wholly-owned by the IRAs.  The Tax Court agreed.

The Code provides that if an IRA participant engages in any “prohibited transaction” with respect to the IRA, such IRA ceases to be an IRA as of the first day of the taxable year in which such prohibited transaction took place. A “prohibited transaction” includes any “direct or indirect … lending of money or other extension of credit between a plan and a disqualified person….”  The Taxpayers fell within the meaning of “disqualified person.”

The Tax Court, citing prior case law, agreed with the IRS’s argument that the Taxpayers’ guaranties constituted indirect extensions of credit to their respective IRAs. Thus, the Taxpayers’ entire IRAs were deemed to have been distributed to them in a taxable transaction.

Again, the simple lesson is that IRA participants are not as free to deal with their tax-deferred assets as they are with their other assets. There are myriad traps for the unwary.  Red flags should certainly be raised whenever either a loan or guaranty is being made, directly or indirectly, in connection with an IRA.  Taxpayers, and their advisors, are well-advised to seek the appropriate counsel to avoid such a terrible outcome as discussed above.

The owners of a closely-held business confront several issues upon the death of any one of them:

  • How will the decedent’s shares be valued?
  • How will the decedent’s estate pay the resulting estate tax?
  • To whom will the decedent’s shares be transferred?
  • How will the acquiring party pay for such shares?

In most cases, the owners of the business will limit the universe of persons to whom the decedent’s shares can pass, for example, by entering into a shareholders’ agreement that requires the business or the surviving owners to purchase the shares from the decedent’s estate.

As to the funding for such a purchase, the owners of the business may decide to acquire life insurance upon the lives of the various shareholders, the proceeds from which would serve two purposes: to fund the purchase price for the shares, and to provide the decedent’s estate with liquidity for purposes of paying the estate tax. tornhundreddollarbill-thumb

A recent Tax Court decision considered one family’s use of split-dollar life insurance arrangements to serve these purposes.

Buy-Sell Arrangement

Decedent and her late husband started a business that eventually grew into a total of eleven companies (“Group”). All companies in the Group were brother-sister corporations with identical ownership.

Decedent established a revocable trust (“Trust”) in 1994, appointed herself as trustee, and contributed all of her stock in each company in the Group to the Trust.

Decedent then established three “dynasty” trusts in 2006: one for the benefit of each of her Sons and that Son’s family (each a “Dynasty Trust”).

Also in 2006, the Trust was amended to permit the trustee to “(i) pay premiums on life insurance policies acquired to fund the buy-sell provisions of the * * * [Group’s] business succession plan, and (ii) make loans, enter into split-dollar life insurance agreements or make other arrangements.”

Additionally, the amendment authorized the trustee of Trust to transfer each “receivable” from the split-dollar life insurance arrangement, when paid by each Dynasty Trust, back to the Dynasty Trust that owed the receivable.

In late 2006, the Dynasty Trusts, the Sons and the Trust entered into a shareholders agreement. The agreement provided that upon the death of any Son, his surviving siblings and their respective Dynasty Trusts would purchase the Group stock held by the deceased sibling.

To provide the Dynasty Trusts with the resources to purchase the Group stock held by or on behalf of a deceased Son, each Dynasty Trust purchased two life insurance policies, one on the life of each other brother.

Split-Dollar Life Insurance Arrangements

To fund the purchase of the policies, each Dynasty Trust and the Trust entered into two split-dollar life insurance arrangements in 2006, to set forth the rights of the respective parties with respect to the policies. The Trust contributed almost $10 million to each Dynasty Trust, which then used that money to pay a lump-sum premium on each policy to maintain that policy for the insured Son’s projected life expectancy.

Under the split-dollar arrangements, upon the death of the insured Son, the Trust would receive a portion of the death benefit from the policy insuring the life of the deceased Son equal to the greater of (i) the cash surrender value (“CSV”) of that policy, or (ii) the aggregate premium payments on that policy (each a “receivable”).

Each Dynasty Trust would receive the balance of the death benefit under the policy it owned on the life of the deceased Son, which would be available to fund the purchase of the stock owned by the deceased Son. If a split-dollar arrangement terminated for any reason during the lifetime of an insured Son, the Trust would have the unqualified right to receive the greater of (i) the total amount of the premiums paid or (ii) the CSV of the policy, and the Dynasty Trust would not receive anything from the policy.

Additionally, the Dynasty Trusts executed collateral assignments of the policies to the Trust to secure payment of the amounts they each owed to the Trust. Neither the Dynasty Trusts nor the Trust retained the right to borrow against a policy.

Insurance Policies

The life insurance policies acquired by the Dynasty Trusts were universal life insurance policies, a form of permanent life insurance providing the owner with flexibility in making premium payments. Under the policies, the owner could pay premiums in a lump-sum, over a limited number of years, over an extended number of years, or over the life of the insured. The owner could determine the amount of premiums at the inception of the contract, change the amount of the future premium from time to time, stop paying premiums for any other reason, and resume paying premiums at a later date if desired.

 The IRS’s Challenge

From 2006 to 2009, Decedent reported gifts to the Dynasty Trusts as determined using the so-called “economic benefit” regime. The amount of each gift reported was the cost of the current life insurance protection as determined using tables issued by the IRS.

After Decedent’s death in late 2009, her Estate retained an appraiser to value the receivables owing to the Trust and includible in Decedent’s gross estate as of the date of her death.

The IRS issued two notices of deficiency to the Estate. One sought to increase the value of the receivables payable to the Trust, as reported by the Estate. The other notice asserted that the Estate had failed to report almost $30 million of gifts in 2006 — specifically, the total amount of the policy premiums paid by Trust for the split-dollar insurance policies.

Split-Dollar Life Insurance

In general, split-dollar life insurance arrangements are governed by IRS regulations.  These regulations define a “split-dollar life insurance arrangement” as an arrangement between an owner and a non-owner of a life insurance contract in which: (i) either party to the arrangement pays all or a portion of the premiums on the life insurance contract; and (ii) the party paying for the premiums is entitled to recover all or any portion of those premiums, and such recovery is to be made from the proceeds of the life insurance contract.

The split-dollar arrangements at issue were governed by these regulations. Trust paid the premiums on the policies; it was entitled to recover, at a minimum, all of those premiums paid, and this recovery was to be made from, and was secured by, the proceeds of the policies.

The regulations provide two mutually exclusive regimes for taxing split-dollar life insurance arrangements. The determination of which regime applies to a particular arrangement depends on which party owns the life insurance policy subject to the arrangement. Generally, the person named as the owner in the insurance contract is treated as the owner.

Under this general rule, the Dynasty Trusts would be considered the owners of the policies, and the premium payments by Trust would be treated as loans to the Dynasty Trusts.

Deemed Owner

As an exception to the general rule, the regulations include a special ownership rule that provides that if the only economic benefit provided to the donee under the split-dollar arrangement is current life insurance protection, then the donor will be treated as the owner of the life insurance contract, regardless of who actually owns the policy.

On the other hand, if the donee receives any additional economic benefit, other than current life insurance protection, then the donee will be considered the owner, and the loan regime will apply.

Thus, the key question in the case – which determined which party owned, or was deemed to own, a life insurance policy – was whether the lump-sum payment of premiums made on the policies by the Trust generated any additional economic benefit, other than current life insurance protection, to the Dynasty Trusts.

If there was no additional economic benefit to the Dynasty Trusts, then the Trust would be the deemed owner of the policies, and the split-dollar life insurance arrangements would be governed by the economic benefit regime.

Economic Benefit Regime

For a split-dollar arrangement to be taxed under the economic benefit regime, the owner or deemed owner will be treated as providing an annual benefit to the non-owner in an amount equal to the value of the economic benefits provided under the arrangement, reduced by any consideration the non-owner pays for the benefits. The value of the economic benefits provided to the non-owner for a taxable year under the arrangement is equal to the sum of (i) the cost of current life insurance protection, (ii) the amount of cash value to which the non-owner has current access during the year, and (iii) any other economic benefits that are provided to the non-owner.

To determine whether any additional economic benefit was conferred by the Trust to the Dynasty Trusts, the relevant inquiry was whether the Dynasty Trusts had current access to the cash values of their respective policies under the split-dollar arrangements or whether any other economic benefit was provided.

Current Access?

The regulations provide that the non-owner has current access to any portion of the policy cash value to which the non-owner (i) has a current or future right and (ii) that currently is directly or indirectly accessible by the non-owner, inaccessible to the owner, or inaccessible to the owner’s general creditors.

For the Dynasty Trusts to have current access, they must first have had a current or future right to any portion of the policy cash value. The split-dollar arrangements, however, were structured so that upon the termination of the arrangement during the lifetime of the insured, 100% of the CSV would be paid to the Trust. Additionally, upon the death of the insured, the Dynasty Trusts would be entitled to receive only that portion of the death benefit of the policy in excess of the amount payable to the Trust.

Accordingly, the Dynasty Trusts had no current or future right to any portion of the policy cash value, and thus, no current access under the regulations.

The IRS argued that the Dynasty Trusts had a right to the cash values of the insurance policies by virtue of the terms of the 2006 amendment to the Trust. Under that amendment, the IRS argued, the Trust’s interest in the cash values of the policies would pass to the Dynasty Trusts or directly to the Sons or their heirs upon Decedent’s death.

However, because the Trust was a revocable trust with respect to Decedent, she retained an absolute right to alter the Trust throughout her lifetime. Accordingly, the Dynasty Trusts did not have a legally enforceable right to the cash values of the policies during the lifetime of the Decedent-grantor. Furthermore, the split-dollar arrangements did not require the Trust to distribute the receivables to the Dynasty Trusts. Rather, Decedent retained the right to receipt of the receivables.

The Court also noted that when the regulations state that “[t]he value of the economic benefits provided to a non-owner for a taxable year under the arrangement equals . . . [t]he amount of policy cash value to which the non-owner has current access. . .,” the regulations are referring to the split-dollar arrangement. The 2006 amendment to the Trust was not part of the split-dollar arrangements between the Trust and the Dynasty Trusts.

Under each split-dollar arrangement, the Court stated, upon the death of the insured-Son, the Trust would be entitled to receive a portion of the death benefit of the policies insuring the life of the deceased equal to the greater of (i) the CSV of the applicable policies or (ii) the aggregate premium payments made with respect to the applicable policies. The Trust obtained the receivables as a result of entering into the split-dollar arrangements. Thus, it was appropriate to execute the 2006 amendment to provide for the disposition of these assets. Importantly, the split-dollar arrangements did not address the disposition of the receivables by the Trust and did not require or permit the receivables be distributed to the Dynasty Trusts. Thus, the Dynasty Trusts did not have a right in the cash values of the policies by virtue of the 2006 amendment.

Other Economic Benefit?

The IRS argued that the circumstances of the split-dollar arrangements at issue prohibited the use of the economic benefit regime. Specifically, it compared the arrangements to certain abusive split-dollar life insurance arrangements under which one party holding a right to current life insurance protection uses inappropriately high current term insurance rates, prepayment of premiums, or other techniques to confer policy benefits other than current life insurance protection on another party. The use of such techniques by any party to understate the value of these other policy benefits distorts the income or gift tax consequences of the arrangement, the IRS claimed, and does not conform to, and is not permitted by the regulations.

The Court found that the split-dollar arrangements between the Trust and the Dynasty Trusts bore no resemblance to the transactions described by the IRS. Decedent, who was 94 at the time she set these arrangements into motion, wanted the Group to remain in her family. To that end, she caused the Trust to pay a lump-sum premium, through the Dynasty Trusts, on the life insurance policies held on the lives of her Sons, the proceeds of which would be used to purchase the stock held by each of her Sons upon his death. Unlike the abusive insurance arrangements described by the IRS, the receivables the Trust obtained in exchange for its advances provided the Trust sole access to the CSV of the policies.

Conclusion

Because the Dynasty Trusts received no additional economic benefit beyond that of current life insurance protection, the Court held that the Trust was the deemed owner of the life insurance contracts by way of the special ownership rule under the regulations. Therefore, the economic benefit regime under the regulations applied to the split-dollar arrangements.

It should be noted that the preamble to the split-dollar regulations included an example that was structured identically to the split-dollar arrangements at issue. The preamble distinguished between a donor (or the donor’s estate) who is entitled to receive an amount equal to the greater of the aggregate premiums paid by the donor or the CSV of the contract and a donor (or the donor’s estate) who is entitled to receive the lesser of those two values.

In the former situation, as in the case above, the donor makes a gift to the donee equal to the cost of the current life insurance protection provided.

Thus, the issue remaining to be resolved in this case is the value of the receivable owing to the donor’s estate, which the IRS asserted was significantly understated.

Depending upon the outcome of this valuation, estate planners may, in the appropriate situation, be able to utilize split-dollar arrangements within a family-owned business to provide funds for a buyout and for the payment of the estate tax.

Partnership Allocations

The allocation of a partnership’s items of income, gain, deduction and loss among its partners must have substantial economic effect if it is to be respected by the IRS. The determination of whether an allocation has substantial economic effect for tax purposes involves a two-part analysis: first, the allocation must have economic effect; and second, the economic effect of the allocation must be substantial.

In order for an allocation to have economic effect, it must be consistent with the underlying economic arrangement of the partners. This means that in the event there is an economic benefit or an economic burden that corresponds to the allocation, the partner to whom the allocation is made must receive such economic benefit or bear such economic burden. Stated differently, tax must follow economics. For example, if a partnership incurs debt to acquire property, and only some of its partners are ultimately responsible for the satisfaction of such debt, the depreciation deductions attributable to the acquisition indebtedness would be allocable only to those partners.

Bad Boy Guarantees

A few weeks ago, we discussed a pronouncement by the IRS regarding a partner’s guarantee of a partnership’s nonrecourse debt. The partner had provided a “bad boy guarantee,” and the ruling considered whether the guarantee would cause the debt to be treated as recourse to the partner. The outcome was important because the deductions attributable to a nonrecourse liability are generally allocated among all the partners in accordance with their interest in the partnership, while those attributable to a recourse liability are allocable only to those partners who bear the economic risk of loss for that liability.

The IRS determined that the circumstances under which the guarantee would be enforced were not “contingencies” and, so, it concluded that the guarantor-partner did bear the risk of loss, notwithstanding certain language in the partnership agreement that could have been construed as imposing an obligation on the other partners to reimburse the guarantor.

This week, the IRS released yet another memorandum regarding a partner’s guarantee of a partnership’s nonrecourse debt. As in the case of the earlier pronouncement, this memorandum addressed the treatment of a partner’s guarantee of a partnership nonrecourse liability when the guarantee was conditioned on certain “nonrecourse carve-out” events (or “bad boy guarantees”). Specifically, the IRS considered whether a partner’s guarantee of a partnership’s nonrecourse obligation, which was conditioned on the occurrence of certain “bad boy” events, would cause the obligation to fail to qualify as a nonrecourse liability of the partnership (i.e., would make it a recourse liability as to the guarantor). This time, however, the IRS reached a different conclusion.

Recourse Liabilities

In general, a partnership liability is a recourse liability to the extent that any partner bears the economic risk of loss for that liability. A partner’s share of a recourse partnership liability equals the portion of that liability, if any, for which the partner bears the economic risk of loss.

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

Upon a constructive liquidation, all of the following events are deemed to occur simultaneously:

(i) all of the partnership’s liabilities become payable in full;

(ii) with the exception of property contributed to secure a partnership liability, all of the partnership’s assets, including cash, have a value of zero;

(iii) the partnership disposes of all of its property in a fully taxable transaction for no consideration (except relief from liabilities for which the creditor’s right to repayment is limited solely to one or more assets of the partnership);

(iv) items of income, gain, loss, or deduction are allocated among the partners; and

(v) the partnership liquidates.

The determination of the extent to which a partner or related person has an obligation to make a payment is based on the facts and circumstances at the time of the determination. All statutory and contractual obligations relating to the partnership liability are taken into account for these purposes, including (i) contractual obligations outside the partnership agreement such as guarantees, indemnifications, reimbursement agreements, and other obligations running directly to creditors or other partners, or to the partnership; (ii) obligations to the partnership that are imposed by the partnership agreement, including the obligation to make a capital contribution and to restore a deficit capital account upon liquidation of the partnership, and (iii) payment obligations (whether in the form of direct remittances to another partner or a contribution to the partnership) imposed by state law.

How Likely Are the Bad Acts?

Sometimes, guarantees of partnership nonrecourse obligations are conditioned upon the occurrence of one or more of the following “nonrecourse carve-out” events:

 

  1. The borrower fails to obtain the lender’s consent before obtaining subordinate financing or transfer of the secured property;
  2. The borrower files a voluntary bankruptcy petition;
  3. Any person in control of the borrower files an involuntary bankruptcy petition against the borrower;
  4. Any person in control of the borrower solicits other creditors of the borrower to file an involuntary bankruptcy petition against the borrower;
  5. The borrower consents to or otherwise acquiesces or joins in an involuntary bankruptcy or insolvency proceeding;
  6. Any person in control of the borrower consents to the appointment of a receiver or custodian of assets; or
  7. The borrower makes an assignment for the benefit of creditors, or admits in writing, or in any legal proceeding, that it is insolvent or unable to pay its debts as they come due.

By including these provisions in a loan agreement, the lender seeks to protect itself from the risk that the borrower, or a guarantor in charge of the borrower, will undertake “bad acts” that will diminish or impair the value of the property securing the loan, that might disrupt the cash flow from the property, or that could delay, complicate or prevent the lender’s repossession of the property in the event of a default.

An important aspect of these nonrecourse carve-outs, the IRS noted, is that the bad acts that they seek to prevent are within the control of the borrower or guarantor—meaning that the borrower, or a guarantor in control of the borrower, can prevent them from occurring. Because it is in the economic self-interest of borrowers and guarantors to avoid committing those bad acts and subjecting themselves to liability, they are unlikely to voluntarily commit such acts.

Moreover, “nonrecourse carve-out” provisions are not intended to allow the lender to require an involuntary action by the borrower or guarantor, or to place borrowers or guarantors in circumstances that would require them to involuntarily commit a “bad act.” Rather, the fundamental business purpose behind such carve-outs, and the intent of the parties to such agreements, is to prevent actions by the borrower or guarantor that could make recovery on the debt, or acquisition of the security underlying the debt upon default, more difficult.

The “nonrecourse carve-out” provisions at issue, the IRS stated, should be interpreted consistently with that purpose and intent in mind. Consequently, because it is not in the economic interest of the borrower or the guarantor to commit the bad acts described in the typical “nonrecourse carve-out” provisions, it is unlikely that the contingency (the bad act) will occur and, so, the contingent payment obligation should be disregarded.

Take-Away

In sum, unless the facts and circumstances indicate otherwise, a typical “nonrecourse carve-out” provision that allows the borrower or the guarantor to avoid committing the enumerated bad act will not cause an otherwise nonrecourse liability to be treated as recourse for purposes of allocating among the partners the deductions and losses attributable to such liability, at least until such time as the contingency actually occurs.

Thus, the guarantee will not cause the obligation to fail to qualify as a nonrecourse liability of the partnership until such time as one of those events actually occurs and causes the guarantor to become personally liable for the partnership debt.

This memorandum represents a retreat from the position that the IRS staked out in its earlier pronouncement on “bad boy guarantees” and their effect on the tax treatment of partnership nonrecourse liabilities. It is also more in line with the IRS’s own regulatory rule that a payment obligation is disregarded if, taking into account all the facts and circumstances, the obligation is subject to contingencies that make it unlikely that the obligations will ever be discharged.

This result should come as a relief to “investor-partners.” Even though IRS chief counsel memoranda cannot be cited as precedent, they do give us a glimpse into the IRS’s thinking on a particular issue. Consequently, such partners should be assured, in determining the economic consequences of their investment, that their allocations of partnership deductions attributable to nonrecourse debt should, generally speaking, be respected by the IRS.

The owners of closely-held businesses are among the greatest benefactors of charitable organizations in this country. Although their contributions to charity are usually effectuated through the transfer of cash or marketable securities, it is often the case that the only asset available to satisfy an owner’s charitable inclinations is his or her interest in the closely-held business that the owner founded and/or operated.

Of course, the owner, or the owner’s estate (in the case of a testamentary transfer) will realize a tax benefit by virtue of making a charitable transfer, provided the transfer is completed in accordance with various statutory and regulatory requirements. Thus, where the interest in the closely held business is included in the owner’s gross estate, the bequest of such interest to a qualifying organization will generate a charitable contribution deduction for purposes of determining the owner’s estate tax.

Most charitable organizations, however, have no interest in owning equity in a closely-held business because it is not easily convertible into cash, at least not without some advance planning. Thus, many donors “arrange” for the purchase of such equity from the organization.

This strategy presents many challenges and risks, as illustrated in a recent decision.

Mom’s Testamentary Plan

Decedent and some family members owned DPI, a closely-held real property management corporation that managed a combination of commercial and residential rental properties.

DPI was a C corporation. Decedent owned 81%, and Son E owned 19%, of DPI’s voting shares. Decedent also owned 84% of DPI’s nonvoting shares, and her Sons  owned the remaining 16%.

Decedent and her Sons were officers and directors of DPI at the time of Decedent’s death.

During her life, Decedent had created an irrevocable life insurance trust that distributed the insurance proceeds to her children upon her death, and had established Trust and Foundation. Son E was the sole trustee of Trust and Foundation.

Decedent’s will left her entire estate to Trust. Under the terms of Trust, some cash passed to various charitable organizations. The remainder of Decedent’s estate, consisting primarily of DPI stock, was to pass to Foundation.

The Estate Tax Appraisal

The Estate obtained an appraisal to determine the date-of-death fair market value (FMV) of Decedent’s DPI shares. The appraisal explained that it would be used for estate administration purposes.

The appraisal valued the voting stock at $1,824 per share with no discount because the voting shares represented a controlling interest. It valued the nonvoting stock at $1,733 per share, which included a 5% discount to reflect the lack of voting power.

On its estate tax return, the Estate reported no estate tax liability, claiming a charitable contribution deduction for the date-of-death value of Decedent’s DPI shares.

Post-Death Events

Numerous events occurred after Decedent’s death, but before Decedent’s bequeathed property was transferred to Foundation.

S Corp. Election

Seven months after her death, DPI elected S corporation status in order to accomplish long-term corporate tax planning; specifically, the corporation’s board wanted DPI to avoid the built-in gains tax on corporate assets. The board also wanted Foundation, as an owner of shares in an S corporation, to avoid being subject to the unrelated business income tax (“UBIT”).

Redemption

In addition, DPI’s board realized that, pursuant to the Code, Foundation would be required to make annual minimum distributions of at least 5% of the value of its assets. Son E, as trustee of Foundation, was concerned that merely owning Decedent’s bequeathed DPI shares would not provide Foundation sufficient cash-flow necessary to make the requisite annual distribution.  Son E was also concerned that Foundation could be subject to excise tax on the value of any “excess business holdings” in DPI held by Foundation.

As a result, DPI agreed to redeem all of Decedent’s bequeathed voting shares, and approximately 72% of  her bequeathed nonvoting shares, from Trust in exchange for cash and promissory notes.

Son E then obtained local court approval for the redemption, to confirm that the redemption would not be a violation of the “self-dealing” rules.

At the same time as the redemption, pursuant to subscription agreements, Decedent’s Sons purchased additional shares in DPI in order to infuse the corporation with cash to assist in paying off the promissory notes DPI gave the Trust as a result of the redemption transaction.

An appraisal of Decedent’s DPI stock for purposes of the redemption and subscription agreements determined that her DPI voting shares had a FMV of $916 per share, and the nonvoting shares of $870 per share. The appraisal of the voting stock included discounts of 15% for lack of control and 35% for lack of marketability. The appraisal of the nonvoting stock included the lack of control and marketability discounts plus an additional 5% discount for the lack of voting power.

The IRS Challenge

The IRS disputed the amount of the Estate’s charitable contribution, arguing that the amount of the charitable contribution should be determined by the post-death events. The Estate argued that the charitable contribution should not be measured by the value of the property received by Foundation.

Because the IRS found that the value of Estate’s charitable contribution was lower than reported on its Estate Tax Return, the IRS also determined that additional estate tax was due. The Estate challenged the asserted deficiency in the Tax Court.

The Court considered whether the Estate was entitled to a charitable contribution deduction equal to the date-of-death FMV of DPI stock bequeathed to Foundation.

The Estate’s lawyer, who also served as DPI’s and Foundation’s lawyer, hired an appraisal firm to appraise the DPI stock. The appraisal specified that it provided a valuation of a minority interest in DPI as of the date of the redemption agreement. His understanding was that the appraisal would be used as support for the redemption. The appraisal treated DPI as a C corporation. The appraisal valued the DPI shares at $916 per voting share and at $870 per nonvoting share, reflecting discounts for lack of control and lack of marketability.

The date-of-death valuation had not included these discounts.

Foundation Tax Return

On its Form 990-PF, Foundation reported that it had received the following contributions from Trust:

  • Approximately 28% of Decedent’s nonvoting DPI shares;
  • A long-term note receivable; and
  • A short-term note receivable (the notes having been received by the Trust from DPI in the redemption transaction).

Trust Tax Return

On its Form 1041 for the taxable year of the redemption, Trust reported a capital loss for the sale of its shares of DPI voting stock, and a capital loss for the sale of its shares of DPI nonvoting stock (the redemption appraisal having been lower than the date-of-death appraisal from which the Trust’s adjusted basis for the shares was derived).

The Court’s Analysis

In general, the value of a decedent’s gross estate includes the FMV of all property that she owned, or in which she had an interest, at the time of her death. The value of stocks is the FMV per share at that time. “Fair market value” is defined as the price that a willing buyer would pay a willing seller, both persons having reasonable knowledge of all the relevant facts and neither person being under compulsion to buy or sell. The “willing buyer” and “willing seller” are hypothetical persons, rather than specific individuals or entities, and all relevant facts and elements of value as of the valuation date must be considered.

Charitable Deduction

In calculating a decedent’s taxable estate, a charitable deduction is generally allowed for bequests made to charities. The deduction from the gross estate generally is allowed for the value of property included in the decedent’s gross estate and transferred by the decedent at her death to a qualified, charitable organization. In general, the courts have held that the amount of the charitable contribution deduction is based on the amount that passes to the charity.

In the case at hand, the Estate contended that the applicable valuation date for determining the value of the charitable contribution was the date of death.

The Estate also argued that the charitable contribution deduction should not depend upon or be measured by the value received by Foundation. The Estate contended that consideration of post-death events that may alter the valuation of property would not truly reflect the FMV of Decedent’s assets. The Estate further contended that there was neither a plan of redemption nor any other precondition or contingency affecting the value of Decedent’s charitable bequest.

The IRS argued that the value of the charitable contribution should be determined by post-death events. It argued that the Sons thwarted Decedent’s intent to bequeath all of her majority interest in DPI or the equivalent value of the stock to Foundation, contending that the manner in which the two appraisals were solicited, as well as the redemption of Decedent’s controlling interest at a minority interest discount, indicated that the Sons never intended to effect Decedent’s testamentary plan.

The Valuations

The Court acknowledged that, normally, the date-of-death value determines the amount of the charitable contribution deduction, which is based on the value of property transferred to the charitable organization. There are circumstances, however, where the appropriate amount of a charitable contribution deduction does not equal the contributed property’s date-of-death value.

The Court noted that numerous events occurred after Decedent’s death, but before Decedent’s property was transferred to Foundation, that changed the nature and reduced the value of Decedent’s charitable contribution. DPI elected S corporation status. On the same date, DPI agreed to redeem all of Decedent’s voting shares and most of her nonvoting shares from the Trust, in exchange for promissory notes from DPI. Additionally, using the appraisal for the date of the redemption agreement, the Sons signed subscription agreements purchasing additional shares in DPI for $916 per voting share and $870 per nonvoting share.

The Estate contended that the foregoing subsequent events occurred for business purposes and should not affect the amount of Decedent’s charitable contribution.

The subsequent events did appear to have been done for valid business purposes. DPI elected S corporation status in order to avoid the section 1374 built-in gains tax on corporate assets. Additionally, DPI believed that the redemption would allow it to freeze the value of its shares (that would pass to Foundation) into a promissory note, which would mitigate the risk of a decline in stock value. The redemption also made Foundation a preferred creditor of DPI so that, for purposes of cash-flow, it had a priority position over DPI’s shareholders. The Sons purchased additional shares in DPI in order to infuse the corporation with cash to pay off the promissory notes that DPI gave the Trust as a result of the redemption.

The same firm that had completed the date of death appraisal was hired to perform an appraisal of Decedent’s bequeathed shares for purposes of the redemption. This appraisal included a 15% discount for lack of control and a 35% discount for lack of marketability, plus an additional 5% discount for the lack of voting power in the case of the nonvoting stock. The appraisal did not explain why these discounts were included.

Decedent’s bequeathed majority interest in DPI therefore was appraised at a significantly higher value only seven months before the redemption transactions without explanation.

Even though there were valid business reasons for the redemption and subscription transactions, the record did not support a substantial decline in DPI’s per share value. The reported decline in per share value was primarily due to the specific instruction to value Decedent’s interest as a minority interest with a significant discount.

Given that intra-family transactions in a close corporation receive a heightened level of scrutiny, Sons’ roles (especially Son E’s) needed to be examined, the Court said. Son E, as executor of the Estate and President, director, and a shareholder of DPI, instructed DPI’s attorney to inform the appraiser that Decedent’s bequeathed shares should be valued as a minority interest. He was also sole trustee of Trust and of Foundation. Decedent’s majority interest, therefore, was redeemed for a fraction of its value without any independent and outside accountability. The Sons thereby altered Decedent’s testamentary plan by reducing the value of the assets eventually transferred to Foundation without significant restraints.

Accordingly, the Tax Court held that the Estate was not entitled to the full amount of its claimed charitable contribution deduction.

Still A Good Idea

Notwithstanding the Court’s decision, the Decedent and her Sons had the right idea. The family was charitably inclined, and Foundation provided an effective vehicle through which to engage in charitable giving.

The bequest to Foundation would have enabled the Estate to escape estate tax if the Sons had not gotten greedy by “depressing” the value of the DPI shares.

The redemption would have removed the Foundation from the reach of the UBIT and some of the excise taxes (mentioned above) that apply to private foundations.

Importantly, the redemption would have removed from Foundation, and shifted to the Sons, the future appreciation in the value of decedent’s DPI shares.

Finally, if the Foundation and DPI were ever controlled by different persons in the future, the redemption would have removed the potential for shareholder disputes.

It Happens All The Time

A business owner dedicates every waking moment to the growth and well-being of the business. Invariably, the owner is motivated, in no small part, by the desire to provide for his or her family. After years of effort, and maybe some luck, the business succeeds. The owner and his or her spouse are able to accumulate wealth outside the business, or the business is sold for a significant amount.

At that point (belatedly, in my opinion), the owner and his or her spouse usually start to think about estate planning, including the reduction of estate taxes and maximizing the value of the assets that will pass to their family.

Where the estate plan is devised carefully, the owner and his or her spouse recognize that some loss of control over some of their assets may be necessary, and the plan is implemented properly and with sufficient time to “mature,” these goals may be attained. 55

Alas, too many business owners wait until it is too late to adopt and execute an effective estate plan that can also generate tax savings. This week’s post considers a recent example of one such situation.

The Limited Partnership

Decedent and her spouse owned a heating and air conditioning wholesale business and were involved in real estate development. They had accumulated substantial assets by the time the Decedent’s spouse died in 1999. His will directed that his assets be placed in three trusts. The income from two of those trusts was payable to Decedent on a regular basis, and the principal of all three could be used for her benefit. Further, at the time of her spouse’s death, Decedent had substantial assets of her own.

In 2003, Decedent moved to a nursing home, and granted her Son a power of attorney. Son attended to Decedent’s day-to-day financial needs and managed her financial assets using the power of attorney.

A few years later, Son and Decedent’s attorney devised an estate plan for some of her assets. Decedent was not involved in deciding how her assets would be held; she left this up to her Son and her attorney.

Decedent executed a certificate of limited partnership and a limited partnership agreement in November, 2006. The partnership agreement described the Partnership’s purpose in broad terms. However, one stated purpose was to provide “a means for members of the Family to acquire interests in the Partnership business and property, and to ensure that the Partnership’s business and property is continued by, and closely-held by, members of the [F]amily.” The agreement also provided that limited partners did not have the right or power to participate in the Partnership’s business, affairs, or operations.

On the same day, Decedent executed the articles of organization, and the operating agreement, of LLC, a limited liability company, with Decedent as the sole member. LLC was created for the primary purpose of being the general partner of Partnership.

In December, 2006, Partnership was funded with marketable securities transferred from Decedent’s account. A portion of this contribution was made “on behalf of” LLC. The gross value of Partnership’s assets at that time was almost $6 million. This was the only capital contribution made to Partnership. In consideration for her contribution, Decedent received a 99.9% interest as a limited partner, and LLC received a 0.1% interest as the general partner.

Subsequently, on the same day, Decedent assigned her interest in LLC to her Son in exchange for almost $6,000. The price paid by Son equaled the gross value of 0.1% of Partnership’s assets on that day, without discount. Son’s purchase of Decedent’s interest in LLC (the general partner) eliminated any formal control Decedent may have had over the assets she transferred to Partnership.

After Decedent’s transfer of her interest in LLC to Son, and still on the same day, she gave 10% of her limited partnership interest in Partnership to the Irrevocable Trust. Decedent executed this Trust on the same day that LLC and Partnership were formed. Following this transfer, Decedent held an 89.9% limited partnership interest in Partnership, which she held until her death.

At all times before Decedent’s death, Partnership’s assets consisted solely of investment assets, such as marketable securities and cash. Decedent held substantial assets that she did not transfer to Partnership.

In 2007, Partnership made a pro rata cash distribution to its partners. This was the only distribution Partnership made during Decedent’s lifetime.

When Decedent died in 2009, the fair market value of all of the assets owned by Partnership, without discount, was just over $4 million. The value of Decedent’s interest in Partnership was reported on her estate’s tax return as approximately $2.43 million as a result of discounts (over 30%) that were applied to her 89.9% limited partnership interest.

The IRS claimed that the assets of the Partnership should have been included in the Decedent’s gross estate, and issued a notice of deficiency in estate tax. Decedent’s Estate petitioned the Tax Court for relief.

 The Law

Estate tax is imposed on the transfer of a decedent’s taxable estate. The taxable estate consists of the value of the gross estate after applicable deductions.

The Code requires the inclusion in a decedent’s gross estate of certain lifetime transfers that were testamentary in nature. Accordingly, a decedent’s gross estate includes the value of all property that the decedent transferred during life, but retained the possession or enjoyment of, or the right to the income from, for the decedent’s life, provided the decedent’s transfer was not a bona fide sale for adequate and full consideration.

An interest or right is treated as having been retained or reserved if at the time of the transfer there was an understanding, express or implied, that the interest or right would later be conferred. In determining whether an implied agreement exists, the courts consider the facts and circumstances surrounding the transfer and the property’s use after the transfer. The taxpayer, of course, bears the burden of proving that an implied agreement or understanding did not exist at the time of the transfer. This burden is particularly onerous when intra-family arrangements are involved.

The Decedent’s “Retained” Interest?

The Estate denied the existence of an implied or oral agreement that allowed Decedent to retain control of the assets transferred to Partnership. The Estate asserted that after Decedent sold her interest in LLC to her Son, she did not retain possession or enjoyment of, or the right to income from, the assets that were transferred to Partnership. The Estate further contended that Decedent had no right to designate who would possess or enjoy the assets transferred to Partnership or the income from those assets.

The IRS, however, argued that Decedent did retain possession of the property transferred to Partnership and that she retained a right to income from that property. The IRS asserted that the distribution provision of the partnership agreement – which required the distribution of funds in excess of Partnership’s current operating needs – evidenced Decedent’s right to income from the assets transferred to Partnership.

The IRS also argued that there was an implied agreement that Decedent could access the income from the assets transferred to Partnership if necessary. Son’s testimony made it clear that had Decedent required a distribution, one would have been made.

On the basis of these facts and circumstances, the Court believed that there was an implied agreement that Decedent retained the right to “the possession or enjoyment of, or the right to the income from, the property” she transferred to Partnership.

 Bona Fide Sale?

If Decedent’s transfer of the assets to Partnership was a bona fide sale for adequate and full consideration, the special inclusion rule would not apply. In the context of a family limited partnership, the record must establish a legitimate and significant nontax reason for creating the partnership, and that the transferor received partnership interests proportionate to the value of the property transferred. The objective evidence must indicate that the nontax reason was a significant factor that motivated the partnership’s creation. A significant purpose must be an actual motivation, not a theoretical justification.

The Estate argued that three significant nontax business purposes prompted the creation of Partnership: first, to protect the assets from “trial attorney extortion”; second, to protect the assets from the “undue influence of caregivers”; and third, to preserve the assets for the benefit of Decedent’s heirs.

The IRS, however, asserted that the first two “purposes” were merely theoretical justifications, and not legitimate and significant nontax reasons for Partnership’s formation. The Court agreed.

The final proposed justification for the creation of Partnership was to preserve the transferred assets for the benefit of Decedent’s heirs. Though the partnership agreement explained Partnership’s purpose in extremely broad terms, it also stated that it was “formed for the purposes of providing a means for members of the [F]amily to acquire interests in the Partnership business and property, and to ensure that the Partnership’s business and property is continued by, and closely-held by, members of the [F]amily.” Son also testified that Decedent wanted to make sure that her assets were preserved for the benefit of the family.

The IRS contended that the facts surrounding the creation of Partnership showed that there was no significant nontax reason for its creation. The IRS emphasized that the transfer was not the result of arm’s-length bargaining, that Partnership held only cash and marketable securities, and that the terms of Partnership’s partnership agreement were not followed.

A Litany of Poor Planning

The Court was not convinced, on the basis of these facts and circumstances, that the formation of Partnership was for a legitimate and significant nontax reason. It found the reasons given unconvincing, particularly in the light of the fact that the assets of the Decedent’s spouse were held in trusts and there were no issues with the management of these assets. Further, Decedent was not involved in selecting the structure used to preserve her assets. Her Son testified at trial that Decedent was “fine” with whatever he and the attorney decided on.

Decedent stood on both sides of the transaction. She made the only contribution of capital to Partnership and held, directly or indirectly, a 100% interest in Partnership immediately after its formation. On the same day, Decedent assigned her interest in LLC to Son in exchange for its fair market value. There was no meaningful negotiation or bargaining associated with the formation of Partnership. In fact, the Son testified that during conversations about forming Partnership, Decedent would agree to whatever he and their attorney decided to do. This was not an arm’s-length transaction.

Partnership also failed to maintain books and records other than brokerage statements and ledgers maintained by Son. The partners did not hold formal meetings, and no minutes were kept. Despite the provisions of the partnership agreement, Partnership made only one distribution before Decedent’s death. Other portions of Partnership’s agreement that were also ignored.

Taking all of the facts and circumstances surrounding Partnership’s formation into account, the Court found that Decedent did not have a legitimate and significant nontax reason for transferring assets to Partnership. The Court also observed that Partnership held marketable securities that were not actively managed and were traded only on limited occasions. Despite the purported nontax reasons for Partnership’s formation, the Estate had failed to show that there were significant legitimate reasons.

On the basis of the foregoing, the Court held that the value of the assets Decedent transferred to Partnership should have been included in the value of Decedent’s gross estate.

Don’t Blow It At the End

Not planning properly for the transfer of one’s wealth– whether represented by a business or in the form of investments– is almost as bad as not planning at all. The tax savings are often the same: none. Witness the case above: poor planning and poor execution led to poor results.

That is why it behooves the “immortal” business owner and his or her all-too-mortal spouse to start planning early. That will require some difficult decision-making, first as to whether they should dispose of any of their assets during their lifetimes, and second, as to the disposition of their assets at their deaths. In both cases, they will have to address the questions of “to whom and how” their assets should be transferred. This is a responsibility that should not be abdicated to one’s children, as in the case above. It is a task that should be undertaken sooner rather than later.

 

The Goals

The owners of interests in closely-held businesses have long sought out ways by which they can remove the future appreciation of such interests from their gross estates for estate tax purposes, but without incurring gifts taxes and income taxes.

One popular method to achieve these goals has been the sale of the closely-held interest to a grantor trust. A grantor trust is an irrevocable trust of which the seller is treated as the owner for income tax purposes. Thus, for income tax purposes, a grantor trust is taxed as if the deemed owner owned the trust assets directly, and the deemed owner and the trust are treated as the same person. This results in transactions between the trust and the deemed owner being ignored for income tax purposes; specifically, no capital gain is recognized when an appreciated interest in a closely held business is sold by the deemed owner to the trust.

For transfer tax purposes, however, the trust and the deemed owner are treated as separate persons and, under certain circumstances, the trust is not included in the deemed owner’s gross estate for estate tax purposes at the death of the deemed owner. In this way, the post-sale appreciation has been removed from the deemed owner’s estate for estate tax purposes. The greater the post-sale appreciation, the greater the transfer tax benefit achieved.

The IRS Doesn’t Like It

Sales to grantor trusts use the disconnect between the income tax and transfer tax rules – specifically, the ability to sell a property for gift tax purposes, but to still own it for income tax purposes – in order to transfer wealth while minimizing the gift and income tax cost of such transfers. If this wasn’t bad enough for the IRS, future capital gains taxes can also be avoided by the grantor’s “repurchase,” at fair market value, of the appreciated asset from the grantor trust and the subsequent inclusion of that asset in the grantor’s gross estate at death. Under current law, the basis in that asset is then adjusted (“stepped-up”) to its fair market value at the time of the grantor’s death, often at an estate tax cost that has been significantly reduced or entirely eliminated by the grantor’s lifetime exclusion from estate tax.

Consequently, the IRS will often challenge a taxpayer’s sale to a grantor trust. The results have been mixed, depending upon how carefully the subject transaction was structured, as illustrated by one case earlier this month.

A Recent Example

The Decedent was employed by and held the majority of the voting and nonvoting shares of Company, a closely-held manufacturing business.

In 1999, the Trust was executed by Decedent and his Spouse as donors, and their two sons as trustees. The Trust purchased three life insurance policies on the joint lives of Decedent and Spouse.

The Trust and Company entered into a Split-Dollar Insurance Agreement that covered the three life insurance policies owned by the Trust. Pursuant to this agreement, Company was obligated to pay a portion of the annual premiums equal to the total premiums less the annual Value of the Economic Benefit (VEB) amounts. Decedent was required to pay the annual VEB amounts. Upon the death of the survivor of Decedent and Spouse, the Trust was required to reimburse Company for its prior premium payments.

In 2006, Decedent sold all of his nonvoting stock of Company to the Trust in exchange for a promissory note in the amount of $59 million, and bearing interest based upon the applicable federal rate. The purchase price was determined by an appraisal of the stock’s fair market value by an independent appraiser.

The sale of the nonvoting stock was made pursuant to an Installment Sale Agreement, which provided that the Decedent sold stock to the Trust worth $59 million. The agreement further provided that both the number of shares of stock sold and the purchase price of $59 million were determined one month before the sale, but that Decedent and the Trust acknowledge that the exact number of shares of stock purchased by the Trust depended on the fair market value of each share of stock. The sale agreement further provided that, based on a recent appraisal of the stock, this resulted in one million shares of stock being purchased, but that in the event that the value of a share of stock was determined to be higher or lower than that set forth in the appraisal, whether by the IRS or a court, then the purchase price would remain the same but the number of shares of stock purchased would automatically adjust so that the fair market value of the stock purchased equaled $59 million.

At the time of the 2006 stock sale, and subsequently, the Trust had significant financial capability to repay the promissory note without using the acquired nonvoting stock of Company or its proceeds.

At the time of the sale, the Trust owned three life insurance policies on Decedent’s and Spouse’s lives with an aggregate cash surrender value of over $12 million. Decedent’s estate claimed that all of this cash value could be pledged to a financial institution as collateral for a loan that could be used to make payments on the promissory note to Decedent. A portion of the cash value could also be accessed via policy loan or via the surrender of paid-up additions to the insurance policies that could be used to make payments on the note. Moreover, since Company was required to continue making payments during Decedent’s and Spouse’s lifetimes under the Split-Dollar Insurance Agreement, the amount of cash surrender value available for this purpose would continue to grow.

In addition, the beneficiaries of the Trust executed personal guarantees in the amount of ten percent of the purchase price of the stock.

Decedent passed away in 2009, and his estate tax return was filed in 2010. After examining the return, the IRS timely issued a Notice of Deficiency in 2013. Decedent’s estate filed a petition with the Tax Court .

The IRS’s Challenge

The Notice of Deficiency asserted a deficiency in gift taxes for 2006 (the year of the stock sale) in excess of $31 million. Specifically, the IRS determined that the promissory note that Decedent received in the exchange should be disregarded, and the entire fair market value of the nonvoting shares of Company stock that Decedent sold to the Trust in 2006 – which the IRS determined was over $116 million (almost double the value of the taxpayer’s appraisal) – should be treated as a taxable gift. (You should always count on the IRS to challenge the reported fair market value of a closely-held company.)

In the alternative, the IRS determined that the Decedent made a taxable gift equal to the difference between the fair market value of the Company shares sold to the Trust in 2006 and the principal of the promissory note received in exchange.

The IRS also determined that the entire value of the stock acquired by the Trust in 2006 should have been included in Decedent’s gross estate for purposes of the estate tax (again ignoring the promissory note), claiming that Decedent had retained, for his life, the possession or enjoyment of, or the right to the income from, the Company stock Decedent sold to the Trust in 2006. (By the date of Decedent’s death, the value of the stock had increased another $46 million, according to the IRS.)

Finally, the IRS asserted that the 2006 stock sale was not a bona fide sale for adequate and full consideration, and that the promissory was not the personal and enforceable obligation of Decedent.

Oh, Shucks

After being scheduled for trial, the Decedent’s estate and the IRS reached a settlement, and the Tax Court signed a stipulated decision in which both parties agreed that there were no gift tax or estate tax deficiencies.

“Why, Lou, are you disappointed?” you may ask. “Didn’t the taxpayer emerge victorious?”

True, but think about it. The Decedent’s sale to the Trust was not especially remarkable, at least on its face. The Trust was funded with sufficient assets to support the note, and the beneficiaries personally guaranteed the note. A contemporaneous value for the shares was obtained from an independent appraiser. The note bore adequate interest, at the applicable federal rate. The transaction was properly documented. Why would the IRS have challenged such a transaction?

That being said, there were some elements of the transaction, the Court’s resolution of which could have had implications for future planning. For example, the use of insurance on the life of the Decedent to support the Trust’s note. Also, did Decedent and the Trust use separate counsel? What about the beneficiaries who guaranteed the debt? Did they have independent wealth to support their guarantees?

What’s Next?

As we said last week, so much will depend upon the outcome of the November elections.  A Democratic victory could see the introduction of proposals to eliminate the disconnect between the income tax and transfer tax rules.

Under one such proposal (that has appeared in the current Administration’s budgets for several years and that would likely be reintroduced under the right circumstances), if a person who is the deemed owner of a trust under the grantor trust rule engages in a transaction with that trust that constitutes a sale or exchange that is disregarded for income tax purposes by reason of the person’s treatment as the deemed owner of the trust, then the portion of the trust attributable to the property received by the trust in that transaction (i) would be subject to estate tax as part of the gross estate of the deemed owner, (ii) would be subject to gift tax at any time during the deemed owner’s life when his or her treatment as a deemed owner of the trust is terminated, and (iii) would be treated as a gift by the deemed owner to the extent any distribution is made to another person during the life of the deemed owner.

Until then, however, taxpayers and their advisers should monitor the IRS’s efforts in the courts to restrict sales to grantor trusts, and they should be careful in how they structure such transactions.

The Greenbook

Last month, the Obama Administration released its Fiscal Year 2017 Budget, including its Revenue Proposals, known as the “Greenbook.”

“Lame duck President,” you might say, “and Republican Congress. Who cares?”

Well, as the field of candidates has narrowed, tax practitioners have started to review the remaining candidates’ positions on various tax matters. Many observers believe that the Greenbook probably gives us a glimpse of what we can expect to see in the way of tax proposals if the Democrats win in November, and as the late Sy Syms may have said, “an educated voter is our best voter.” american-flag-dollar-bill-capitol-nki

Although closely-held businesses owners will likely welcome many of the proposals put forth by the Administration, there are many others that may give them significant pause.

If Obama Had His Druthers

What follows is a brief description of some of these proposals.

Expensing for Investments Made by Small Businesses. The proposal would increase the maximum expensing limitation to $1 million and the phase-out threshold would remain at $2 million with both amounts being indexed for inflation.

Increase the Limitations for Deductible New Business Expenditures. Currently, a taxpayer is generally allowed to deduct up to $5,000 of start-up expenditures in the taxable year in which an active trade or business begins, and may deduct up to $5,000 of organizational expenditures in the taxable year in which a corporation or partnership begins business. In each case, the $5,000 amount is reduced (but not below zero), by the amount by which such expenditures exceed $50,000. The proposal would consolidate these provisions, and would allow $20,000 of combined new business expenditures to be expensed. That immediately expensed amount would be reduced by the amount by which the combined new business expenditures exceed $120,000.

Like Kind Exchanges. The proposal would limit the amount of capital gain deferred under section 1031 to $1 million (indexed for inflation) per taxpayer per taxable year.

Corporate Dividends. The proposal would amend the Code to ensure that a transfer of property by a corporation to its shareholder better reflects the corporation’s dividend-paying capacity.

It recognizes the fact that corporations have devised many ways to avoid dividend treatment under current law. For example, corporations enter into transactions (so-called “leveraged distributions”) to avoid dividend treatment upon a distribution by having a corporation with earnings and profits provide funds (for example, through a loan) to a related corporation with no or little earnings and profits, but in which the distributee shareholder has high stock basis. Under current law, these types of transactions reduce earnings and profits for the year in which a distribution is made without a commensurate reduction in a corporation’s dividend paying capacity.

Research Incentives. Current law provides a research and experimentation (R&E) credit (recently made permanent), computable using one of two allowable methods. Under the “traditional” method, the credit is 20 percent of qualified research expenses above a base amount. Under the alternative simplified research credit (ASC), the credit is 14 percent of qualified research expenses in excess of a base amount reflecting its research spending over the prior three years. The proposal would repeal the “traditional” method. In addition, the proposal would increase the rate of the ASC to 18 percent. It would also allow the credit to offset Alternative Minimum Tax liability, and repeal a special rule for pass-thru entities that limited use of the credit.

Tax Carried Interest Profits as Ordinary Income. Current law provides that an item of income or loss of partnership retains its character and flows through to the partners, regardless of whether the partners received their interests in the partnership in exchange for services. Thus, some service partners in investment partnerships are able to pay a 20 percent long-term capital gains tax rate, rather than ordinary income tax rates on income items from the partnership. The proposal would tax as ordinary income a partner’s share of income on an “investment service partnership interest” (ISPI) regardless of the character of the income at the partnership level. In addition, the partner would be required to pay self-employment taxes on such income, and the gain recognized on the sale of an ISPI that is not attributable to invested capital (including goodwill) would generally be taxed as ordinary income, not as capital gain. (Secretary Clinton has also proposed to tax carried interest as ordinary income.)

Limit Certain Tax Expenditures for the Most Affluent. This proposal would limit the tax rate at which upper-income taxpayers can use itemized deductions, and other tax preferences to reduce tax liability, to a maximum of 28 percent. This limitation would reduce the value to 28 percent of the specified exclusions and deductions that would otherwise reduce taxable income in the top three individual income tax rate brackets of 33, 35, and 39.6 percent. (This is part of Secretary Clinton’s tax plan, as well.)

“Reform” the Taxation of Capital Income. This proposal would eliminate the capital gain step-up in basis at death, but with protections for the middle class, surviving spouses, and small businesses. Among other provisions, there would be a $100,000 per-person exclusion of other gains recognized at death. The proposal would also raise the top tax rate on capital gains and qualified dividends from 20 percent to 24.2 percent, or 28 percent including the net investment income tax. (By comparison, Secretary Clinton has mentioned a new rate schedule for capital gains – with rates declining for longer holding periods – and a new holding period (2 years) for long term capital gain treatment. For example, the current 20 percent rate – 23.8 percent including the net investment income tax – would only apply to assets held at least six years.)

Net Investment Income and Self-Employment (SECA) Taxes. The proposal would close perceived “loopholes” in the SECA tax and the Net Investment Income Tax (NIIT). Under the proposal, all active business income would be subject to either the NIIT or Medicare payroll tax, so choice of business entity would not be a strategy for avoiding these taxes. The proposal would also make individual owners or professional service businesses taxed as S corporations or partnerships subject to SECA taxes in the same manner and to the same degree. Thus, for example, the fact that an S corporation shareholder or a partner did materially participate in the corporate or partnership business would not shield their share of business income from the NIIT.

Implement the Buffett Rule: A “Fair Share Tax”. This budget proposal is aimed at ensuring that high-income taxpayers cannot use deductions and preferential tax rates on capital gains and dividends to pay a lower effective rate of tax than many middle-class families. The tax is intended to ensure that very high income families pay tax equivalent to no less than 30 percent of their income, adjusted for charitable donations. (Similarly, Secretary Clinton would impose a minimum 30 percent tax on taxpayers with over $1 million of adjusted gross income.)

Eliminate Technical Partnership Terminations. If within a 12-month period, there is a sale or exchange of 50 percent or more of the total interest in a partnership’s capital and profits, the partnership is treated as having terminated for income tax purposes. Even though the business of the partnership continues in the same legal form, several consequences occur as a result of this technical termination that serve as a trap for the unwary, including, among other things, the restart of depreciation lives, the close of the partnership’s taxable year, and the loss of all partnership level elections. The proposal would repeal this rule.

Goodwill Anti-Churning Rules. The proposal would repeal the anti-churning rules applicable to the amortization of certain intangibles (such as goodwill and going concern value).

Restore the Estate, Gift, and Generation-Skipping Transfer (GST) Tax Parameters in Effect in 2009. This proposal would make permanent the estate, GST, and gift tax parameters as they applied during 2009. The top tax rate would be increased to 45 percent and the exclusion amount would be reduced to $3.5 million per person for estate and GST taxes, and to $1 million for gift taxes. (Same for Clinton.)

Modify Transfer Tax Rules for Grantor Retained Annuity Trusts and other Grantor Trusts. Donors use certain types of trusts to minimize taxes. The proposal would require that donors leave assets in grantor retained annuity trusts (GRATs) for a fairly long period of time, prohibit the grantor from engaging in a tax-free exchange of any asset held in the trust, and impose other restrictions. (Same for Clinton.)

Duration of GST Tax Exemption. The proposal would provide that, on the 90th anniversary of the creation of a trust, the GST exclusion allocated to the trust would terminate, thereby rendering no part of the trust exempt from GST tax.

Crummey Powers. The proposal would eliminate the present interest requirement for gifts that qualify for the gift tax annual exclusion. Instead, the proposal would define a new category of transfers (without regard to the existence of any withdrawal or put rights), and would impose an annual limit of $50,000 (indexed for inflation) per donor on the donor’s transfers of property within this new category that will qualify for the gift tax annual exclusion.

What’s Next?

Of course, no one knows.

The foregoing summary covered just a small portion of the 2017 Greenbook’s tax proposals (which also include, among other things, a significant number of changes to the tax treatment of U.S. multinationals).

Some of the proposals are more firmly grounded in politics than in good tax policy. Other proposals represent good policy, though I must confess that the adage of “where you stand depends upon where you sit” is especially applicable to one’s perspective on tax policy.

Regardless of where one stands or sits, it is important that we do one or the other if we hope to have any impact on where the tax laws end up and on how they will affect our economy, our businesses, and our families.

Partnership Allocations

A few weeks back we discussed the allocation of a partnership’s income and losses among its partners. Specifically, we considered the requirement that an allocation to a partner must have substantial economic effect if it is to be respected by the IRS. The determination of whether an allocation has substantial economic effect for tax purposes, we said, involves a two-part analysis: first, the allocation must have economic effect; and second, the economic effect of the allocation must be substantial.

In order for an allocation to have economic effect, it must be consistent with the underlying economic arrangement of the partners. This means that in the event there is an economic benefit or – for purposes of this week’s post – an economic burden that corresponds to the allocation, the partner to whom the allocation is made must receive such economic benefit or bear such economic burden. Stated differently, tax must follow economics.

In addition, the economic effect of the allocation must be substantial, meaning there must be a reasonable possibility that the allocation will substantially affect the dollar amounts to be received by the partners, independent of the allocation’s tax consequences.

Recourse Liabilities

A partner’s share of a loss or deduction that is attributable to a recourse partnership liability is based upon the portion of that liability, if any, for which the partner bears the economic risk of loss.

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

The determination of the extent to which a partner has an obligation to make a payment is based on the facts and circumstances at the time of the determination. All statutory and contractual obligations relating to the partnership liability are taken into account for purposes of making this determination, including:

(i) Contractual obligations outside the partnership agreement, such as guarantees, indemnifications, reimbursement agreements, etc.; and

(ii) Obligations to the partnership that are imposed by the partnership agreement, including, for example, the obligation to make a capital contribution.

A payment obligation is disregarded if, taking into account all the facts and circumstances, the obligation is subject to contingencies that make it unlikely that the obligation will ever be discharged.

A partner’s obligation to make a payment with respect to a partnership liability is reduced to the extent that the partner is entitled to reimbursement from another partner.

Issue Presented

The IRS Office of Chief Counsel recently issued an advisory that considered the application of these rules in the case of a loan to a partnership (i) under the terms of which one of the partners personally guaranteed the partnership’s obligation to satisfy the loan in the event of, among other events, the partnership admitting in writing that it was insolvent or unable to pay its debts when due, or its voluntary bankruptcy or acquiescence in an involuntary bankruptcy, and (ii) whose partnership agreement provided that, in the event that the guarantyguaranteeing partner made a payment under the guarantee, the guaranteeing partner had the right to call for the non-guaranteeing partners to make capital contributions and, if they failed to do so, to treat ratable portions of the payment as loans to those partners, to adjust their fractional interests in the partnership, or to enter into a subsequent allocation agreement under which the risk of the guarantee would be shared among the partners.

The Facts & Circumstances

Partnership (P) had three members: A, B, and C.

P’s partnership agreement (the “Agreement”) stated that no Partner was obligated to make capital contributions to P; in the event additional capital was needed for P’s business, C could elect to loan funds to P or make additional capital contributions. If C elected to do so, A and B would be given the opportunity to make similar loans or capital contributions in accordance with their respective ownership interests.

Additionally, in the event C’s contributions exceeded a certain amount, and C determined that additional capital was still needed for P’s business, A and B would have to contribute their share of the required capital to P within a specified number of days of receiving notice from C. Failing such contribution, C could elect to loan to P the amount that a defaulting partner failed to contribute, which loan would be treated as a loan to that partner. If C elected to make such a loan, the other, non-defaulting partner would be given an opportunity to make a similar loan in accordance with its respective ownership interest, or C could elect to adjust downward the ownership percentage interest of each defaulting partner.

The Agreement stated further that in the event any partner failed to contribute any cash or property when due, such partner would remain liable therefor to P, which may institute proceedings in any court of competent jurisdiction. Furthermore, in the event P’s financing or other undertakings required any partner to become personally obligated (including execution of guarantees of indebtedness, etc.), the partners would enter into a contribution agreement pursuant to which all partners agreed to allocate the risks of such personal obligations in accordance with their ownership interests in P.

The “Bad Boy” Guarantee

P borrowed funds for the purpose of acquiring and renovating real property. It executed a note (“Note”) that was secured.

C executed three personal guarantees of the Note, each subject to different terms. The first guarantee provided that C “unconditionally, absolutely and irrevocably, as a primary obligor and not merely as a surety, guarantee[d] to Lenders the punctual and complete payment of the entire amount of the [guaranteed obligations] upon demand by [the agent for the lenders].” These obligations included, among other things, the entire outstanding principal amount of the Note, together with all interest thereon and all other amounts due and payable under the Note in the event that:

(1) P failed to obtain the lender’s consent before obtaining subordinate financing or transfer of the secured property,

(2) P filed a voluntary bankruptcy petition,

(3) any person in control of P solicited other creditors to file an involuntary bankruptcy petition against P,

(4) P consented to or otherwise acquiesced in an involuntary bankruptcy or insolvency proceeding,

(5) any person in control of P consented to the appointment of a receiver or custodian of assets, or

(6) P made an assignment for the benefit of creditors, or admitted in writing or in any legal proceeding that it was insolvent or unable to pay its debts as they came due.

The IRS’s Analysis

Partner A claimed a pass-through loss for the current year as well as a pass- through net operating loss (NOL) deduction from P. A claimed that he was entitled to the NOL deduction without limitation, in part because C’s guarantee was a “contingent” liability.

The IRS explained that a partner’s share of a recourse partnership liability equals the portion of that liability, if any, for which the partner bears the economic risk of loss, and noted that a payment obligation is disregarded if, taking into account all the facts and circumstances, the obligation is subject to contingencies that make it unlikely that the obligations will ever be discharged. If a payment obligation would arise at a future time after the occurrence of an event that is not determinable with reasonable certainty, the obligation is ignored until the event occurs.

As a threshold matter, the IRS stated that a bona fide guarantee that was enforceable by the lender under local law generally would be sufficient to cause the guaranteeing partner to be treated as bearing the economic risk of loss for the guaranteed partnership liability for purposes of these rules. The IRS asserted that a third-party lender would take all permissible affirmative steps to enforce its rights under a guarantee if the primary obligor defaulted or threatened to default on its obligations.

In this case, the IRS viewed the “conditions” listed in C’s guarantee as circumstances under which the lender would enforce the guarantee to collect the entire outstanding balance on the loan, beyond an actual default by P on its obligations. It rejected the assertion that these “conditions” were properly viewed as conditions precedent that must occur before the lender was entitled to seek repayment from C under the guarantee. The failure of P to repay the loan, by itself, likely would be sufficient to trigger the guarantee, the IRS stated. In addition, the IRS believed it was reasonable to assume that one or more of these conditions, more likely than not, would be met upon a constructive liquidation of P. Accordingly, these “conditions” did not fall within the definition of “contingencies.”

For these reasons, the IRS concluded that the Note was a recourse partnership liability allocable to the guaranteeing partner (C), and not to either A or B.

The IRS next considered whether, even if the guarantee was respected as a full and bona fide guarantee that would cause C to be treated as personally liable for the guaranteed debt of P, the Agreement nevertheless operated to cause A and B to be treated as personally liable (i.e., to bear the ultimate economic risk of loss) with respect to their proportionate share of the guaranteed debt, because A and B were obligated to reimburse C in proportionate amounts for any payments that C made under the guarantees.

For purposes of determining the extent to which a partner has a payment obligation and the economic risk of loss, it is assumed that all partners who have obligations to make payments actually perform those obligations, irrespective of their actual net worth.

The IRS did not agree with A’s interpretation of the Agreement, disagreeing that it imposed a mandatory payment obligation on A and B to make additional contributions to P if C was called upon to pay on C’s personal guarantees. Rather, the IRS said, it permitted C to call for additional capital from A and B, but if A and/or B chose not to contribute additional capital, C’s remedies were limited to the remedies identified – either a loan to A and B or a reduction in their ownership interests. Moreover, the partners never entered into a separate contribution agreement with respect to the guarantee. As a result, the IRS did not believe the Agreement gave C the right to bring an action against A and B to require them to contribute additional capital to P if they choose not to. Accordingly, because neither remedy available to C required A or B to make additional contributions to P if C was called upon to pay on C’s personal guarantees, the IRS concluded that A and B did not bear the ultimate economic risk of loss for the guaranteed debt of P.

Take-Away

If a partner guarantees an obligation of the partnership and the guarantee is sufficient to cause the guaranteeing partner to bear the economic risk of loss for that obligation, the guaranteed debt is properly treated as recourse financing for purposes of applying the partnership tax allocation rules.

It is possible, for this purpose, that certain contingencies – such as the partnership’s admitting in writing that it is insolvent or unable to pay its debts when due, its voluntary bankruptcy, or its acquiescence in an involuntary bankruptcy – after taking into account all the facts and circumstances, may not be so remote a possibility (as the IRS determined above) that it is unlikely the obligation would ever be discharged.

Query, however, whether a lender would make a bona fide loan under such circumstances.

To the extent a guaranteeing partner has the right under the partnership agreement to call for the non-guaranteeing partners to make capital contributions and, if they failed to do so, to treat ratable portions of the payment as loans to those partners, or to adjust their fractional interests in the partnership, these right alone generally would not be sufficient to make the non-guaranteeing partners personally liable with respect to the guaranteed debt.

The “right” to enter into an allocation agreement, under which the guarantee would be shared among the partners, similarly would not create a recourse liability as to the non-guaranteeing partners. Of course, if the partners do enter such an agreement, then the non-guaranteeing partners will be allocated a share of the deductions and losses attributable to the recourse debt.

Again, it’s best not be surprised, ever. If recourse treatment is intended, then partners (like A, above) need plan for it and must be prepared to bear the economic consequences from which the desired tax result flows.

Be sure to start with Part I, here!

Real Estate as an Active Business

The active conduct of a trade or business does not include the holding for investment purposes of land, or other property, or the ownership and operation (including the leasing) of real property used in a trade or business, unless the owner performs significant services with respect to the operation and management of the real property.

In addition, a rental activity will not satisfy the active trade or business requirement if it is merely incidental to another business. Indeed, separations of real property, all or substantially all of which is occupied prior to the distribution by the distributing or the controlled corporation, will be carefully scrutinized with respect to this requirement.

The following illustrations are from actual IRS rulings regarding the application of the active trade or business requirement with respect to rental real estate.

 

  • A corporation did not engage in “entrepreneurial endeavors of such a nature and to such an extent as to qualitatively distinguish its operations from mere investments” where the corporation employed no individuals and virtually all of the real estate was leased to a related entity.

 

  • Corporation X owns, manages, and derives rental income from an office building and also owns vacant land. X transfers the land to new subsidiary Y and distributes the stock of Y to X’s shareholders. Y will subdivide the land, install streets and utilities, and sell the developed lots to various homebuilders. Y does not satisfy the requirements for a tax-free spin-off because no significant development activities were conducted with respect to the land during the five-year period ending on the date of the distribution.

 

  • For the past seven years, corporation X has owned an eleven-story office building, the ground floor of which X has occupied in the conduct of its business. The remaining ten floors are rented to various tenants. Throughout this seven-year period, the building has been managed and maintained by employees of the corporation. Inasmuch as the rental activities are substantial and require direction by a separate real estate department, the rental activity constitutes an active trade or business. X transfers the building to new subsidiary Y and distributes the stock of Y to X’s shareholders. Henceforth, Y will manage the building, negotiate leases, seek new tenants, and repair and maintain the building. X and Y both satisfy the requirements for a tax-free spin-off .

 

  • For the past nine years, corporation X, a bank, has owned a two-story building, the ground floor and one half of the second floor of which X has occupied in the conduct of its banking business. The other half of the second floor has been rented as storage space to a neighboring retail merchant. This rental activity was only incidental to the banking business. X transfers the building to new subsidiary Y and distributes the stock of Y to X’s shareholders. After the distribution, X leases from Y the space in the building that it formerly occupied. Under the lease, X will repair and maintain its portion of the building and pay property taxes and insurance. Y does not satisfy the requirements for a tax-free spin-off because it is not engaged in the active conduct of a trade or business immediately after the distribution.

 

  • Prior to a spin-off, a corporation was engaged in the active trade or business of renting its commercial and residential real estate to unrelated third parties even where all operational activities in connection with the rental business were performed by employees of its sister company. The corporation’s officers – who were also officers of the sister company – supervised, controlled and directed the employees of the sister company who performing the work. The corporation reimbursed its sister company for these services. Through these officers and the employees of the sister company the corporation was able to demonstrate that, among other things, it: negotiated the purchase of, and the required financing for, properties; renovated the properties; periodically refurbished the properties; endeavored to keep the properties rented; provided and paid for gas, water, electricity, sewage, and insurance for the property; paid the taxes assessed on the property; provided day-to-day maintenance and repair services; performed routine inspections of the properties; and maintained separate records and accounts to reflect the income and expenses relating to each rental property.

 

  • A corporation that owned an office building was not engaged in an active rental business where an unrelated real estate management company, acting as an independent contractor, was under contract to manage the building. The management company: supplied and supervised janitors and , maintenance personnel; arranged for all repairs to be made by independent contractors; collected rents, paid all bills, advertised for tenants; negotiated the terms of leases; and fielded and handled tenant complaints. The corporation’s activities were not different from those a prudent investor would be expected to undertake. The operational and management activity of the office building was largely performed by the management company and the independent contractors hired by the management company.

Next Steps?

What if a corporation does not currently satisfy the active trade or business requirement with respect to any of its properties?

All is not lost – the are options to consider, some of which are described below, but one has to be patient. Moreover, one must not lose sight of business exigencies or of the goal sought to be accomplished. Tax-free is nice, but probably not at the expense of a bad choice from a business perspective.

First, the corporation can change how it operates by hiring one or more employees to perform significant managerial and operational functions. This will represent a change to an active business that will have to be conducted for at least five years. Query how practical this is given the circumstances that are compelling the division of the shareholders.

Second, if the corporation plans to sell any of its non-actively-managed properties as part of a like-kind exchange, it may look for replacement properties that will require active management.

Third, the corporation can acquire new properties that will require active management. Again, the five-year period would have to pass.

Finally, the corporation may invest in one or more partnerships that are actively engaged in a rental business. Provided it acquires a not insignificant interest in the partnership(s), and holds its interest for at least five years, the corporation may satisfy the active trade or business requirement.

There are other facts and circumstances – such as a basis step-up at the death of shareholder – that may facilitate a split-off of corporate property even through what would otherwise be a taxable transaction. It may also be possible to compensate the corporation or the shareholders for the resulting tax liabilities by adjusting the exchange consideration with cash.

Of course, the best option of all would be not to acquire real property in a corporation.