This is a question that we encounter with some frequency in the context of family-owned corporations, and the backdrop against which the issue arises is not uncommon.

In the Beginning

The older generation may have acquired a building many years ago, either as an investment that would generate a stream of rental income from unrelated commercial and/or residential tenants, or as the site for the family’s operating business.

In some cases, the older generation acquired the property in its own name and subsequently contributed the property to a corporation; in others, a corporation was created, funded, and then used to acquire the property.

At that time– well before the introduction of LLCs– the older generation may have been advised that a corporation would afford it a measure of protection against the liabilities that may arise out of the ownership and operation of a building; that direct ownership, or through a general partnership, would expose the owners, and their other assets, to such liabilities.  Whatever the reasons may have been for using a corporation, the fact remains that the older generation and its descendants became shareholders of the corporation.

As time went on and the property appreciated (as real estate tends to do), the older generation may have purchased new properties in the same corporation (perhaps by leveraging the equity in the original property), or it may have sold the original property and, through a like-kind exchange, replaced it with several other properties as a way to diversify its holdings.

The Seeds of Discontent

As the years passed, eventually so did the older generation. Either through lifetime gifts or upon the death of its members, the older generation transferred its shares in the corporation to children, grandchildren, and trusts for their benefit.

Disagreements begin to arise among the members of the younger generation. Someone is unhappy with the way in which the properties are being managed. Someone else is disappointed that the corporation is not distributing larger or more frequent dividends. Others believe that the corporation should diversify geographically, or that its holdings should be more (or less) balanced between residential and commercial properties. Still others would like to see the corporation invest in non-real estate assets.

At some point, the friction among the shareholders may become an obstacle to the operation and management of the properties (and forget about Thanksgiving dinner).

Options for Splitting up?

Assuming the parties cannot be reconciled, there are several alternatives by which this friction may be addressed.

Buyout for Cash?

The disgruntled shareholders may be bought out, either by the corporation (through a redemption of shares) or by the other shareholders (a cross-purchase of shares). The price for these shares may have to be paid in some combination of cash and/or promissory notes. The remaining shareholders or the corporation may have to borrow the monies needed to fund the purchase.

In either case, the departing shareholders would experience a taxable event, and may owe taxes if the amount realized on the sale of their shares exceeds their adjusted basis in those shares. Perhaps worse still, in their minds, they would no longer own an interest in the family’s real properties. (To quote Gerald O’Hara, from Gone with the Wind: “Why, land is the only thing in the world worth workin’ for, worth fightin’ for, worth dyin’ for, because it’s the only thing that lasts.”)

In-Kind Distributions?

Instead of being bought out for cash, the disgruntled shareholders may insist that one or more of the corporation’s properties be distributed to them in liquidation of their interests in the corporation.

While such a distribution is certainly possible from a corporate and real estate perspective – assuming it doesn’t violate the terms of any mortgage or other agreement, and assuming the parties can actually agree on how to divide the properties among them – the distribution would be treated, for tax purposes, as though the corporation had sold the distributed properties for their fair market value. As a result, the corporation may realize a taxable gain, for which it will have to pay taxes.

The departing shareholders may also realize a taxable gain to the extent the fair market value of the property distributed exceeds their adjusted basis in the shares of the distributing corporation.

Moreover, if the corporation is an S corporation, its shareholders (both those remaining and the departing shareholders) will have to report and be taxed on that gain. Although the gain realized will usually be capital gain, it is possible that the deemed sale will generate ordinary income (for example, because of depreciation recapture or the application of a “related party sale” rule).

Is a Taxable Event Inevitable?

Even at the height of their disagreement,the family members will likely concur that the less tax paid, the better. They will thus be encouraged to hear that it may be possible for a corporation that owns real properties to contribute some of those properties to a subsidiary corporation, and to then distribute all of the shares of the subsidiary to some of its shareholders in liquidation of their interests in the parent corporation, without triggering a taxable event for either the corporation or its shareholders– provided certain requirements are satisfied.

Among these requirements, the one that is often the most difficult to satisfy in the case of a real estate business is the requirement that both the parent (distributing) corporation and the subsidiary (controlled) corporation are each engaged in the active conduct of a trade or business immediately after the distribution.

The Active Trade or Business

A corporation is treated as engaged in the active conduct of a trade or business if the assets and activities of the corporation satisfy certain requirements.

Specifically, a corporation shall be treated as engaged in a trade or business if the corporation carries on a specific group of activities for the purpose of earning income or profit, and the activities include every operation that forms a part of, or a step in, the process of earning income or profit. Such group of activities ordinarily must include the collection of income and the payment of expenses.

The determination of whether a trade or business is actively conducted will be made from all of the facts and circumstances. The corporation is required itself to perform active and substantial management and operational functions through its employees. Generally, activities performed by the corporation itself do not include activities performed by persons outside the corporation, including independent contractors. However, a corporation may satisfy the requirement through the activities that it performs itself (through its employees), even though some of its activities are performed by others (for example, skilled contractors).

A trade or business that is relied upon to meet these requirements must have been actively conducted throughout the five-year period ending on the date of the distribution.

Expansion or New Business?

The fact that a trade or business underwent change during the five-year period preceding the distribution is disregarded, provided that the changes are not of such a character as to constitute the acquisition of a new or different business. In particular, if a corporation that is engaged in the active conduct of one trade or business during that five-year period, purchased, created, or otherwise acquired another trade or business in the same line of business, then the acquisition of that other business is ordinarily treated as an expansion of the original business, all of which is treated as having been actively conducted during that five-year period.  (Query how a like kind exchange of real properties would be treated for this purpose.)

However, if that purchase, creation, or other acquisition effects a change of such a character as to constitute the acquisition of a new or different business, and that trade or business is to be relied upon to meet the above requirements, then the acquisition must not have occurred during the five-year period ending on the date of the distribution unless the new business was acquired in a transaction in which no gain or loss was recognized.

Stay tuned for Part II, tomorrow.

In today’s cautionary tale, we hear about a doctor, his self-directed simplified employee pension (“SEP”) individual retirement account (“IRA”), the investment of IRA funds in a business, and the consequences of crossing over the perilous line between “direction” and “control.”

The Facts

Dr. V., an anesthesiologist, ran a medical practice with three partners (the “Practice”). Prior to the time of this case, the Practice had adopted a self-directed SEP plan arrangement with Investment Firm, through which the Practice made deductible contributions to the Plan, and the contributions were then placed in self-directed IRAs set up for each partner through the SEP plan arrangement.  Investment Firm was the custodian of Dr. V.’s SEP-IRA. shutterstock_104120462

Historically, Dr. V. had instructed Investment Firm to invest the contents of his SEP-IRA in mutual funds and stocks. In 2011, however, upon hearing of an investment opportunity from a friend, Dr. V. decided to try a more adventurous vehicle for the contents of his SEP-IRA.

Dr. V.’s friend, Mr. C., was involved in a publicly-traded company, PubCo. PubCo was looking to raise capital in the short-term, as it expected to receive funding from a large company in the near future.  Trusting his friend’s business sense and descriptions of X’s potential, Dr. V. agreed to loan X $125,000 from his SEP-IRA, and a contract memorializing the same was prepared (the “Agreement”).

The Agreement

The Agreement, titled “Corporate Loan Agreement/Promissory Note,” was between “PubCo or Mr. C.” as the borrower, and “Dr. V., SEP-IRA” as the lender. It specified that it was for $125,000, but not how that sum would be advanced.  It did, however, provide specific details about the maturity date, interest payments, and late fees.  Significantly, as it turned out, the Agreement provided that the borrower would repay the loan to “Dr. V.” at his personal residence, and Dr. V. and Mr. C. each signed the Agreement in their respective personal capacities.  Dr. C. later testified that the Agreement was worded as such because he wanted Dr. V. to know that the funds were specifically for PubCo expenses, but that he, Mr. C., would be responsible for repayment.

Transfer of Funds

Dr. V. then signed a form titled “Retirement Distribution or Internal Transfer” requesting that Investment Firm distribute $125,000 from his SEP-IRA to his joint account with his wife at Investment Firm; wired that amount from the joint account to his personal account at Bank; and then wired the same amount from Bank to an account titled “Mr. C.” at a different bank.

Reporting the Distribution

Using the same accounting firm, M&M, that they had for over twenty years, Dr. V. and his wife (together, the “Taxpayers”) filed a joint Form 1040 for 2011. Dr. V. explained to the return preparer what had happened with the distribution from his SEP-IRA, and documentation reporting the sequence of events leading up to the loan.  On the advice of the M&M accountant, Dr. V. and his wife reported that they had received $125,000 in pensions and annuities, but characterized it as a nontaxable rollover.  They included with their return a copy of the Agreement, as well as a letter from M&M stating that the return preparer believed that the funds were directly rolled over from the SEP-IRA to either PubCo’s account or Mr. C.’s account.

Notice of Deficiency

Following examination of the return, the Commissioner issued a notice of deficiency determining a $52,682 deficiency in income tax, and determining an additional tax under section 72(t) of the Code and an accuracy-related penalty for a substantial understatement of income tax. The Taxpayers petitioned for a redetermination of the deficiency.

The Arguments

The Taxpayers argued that they did not receive a distribution from the SEP-IRA because the various transfers should be stepped together and treated as an investment by the SEP-IRA in PubCo. Alternatively, they contended that the withdrawal was a non-taxable rollover.

The Commissioner argued that the loan was a taxable distribution used to finance a loan from Dr. V. to Mr. C.

The Tax Court Weighs In

Under section 408(d)(1), any amount paid or distributed out of an IRA must be included in the gross income of the payee or distribute as provided in section 72. The Taxpayers argued that Dr. V. did not have a claim of right to the $125,000 withdrawn from the SEP-IRA because he was acting as a mere conduit in transmitting the funds to Mr. C.

Claim of Right

The Court stated that a taxpayer has a claim of right to income if the taxpayer:

  1. Receives the income;
  2. Controls the use and disposition of the income; and
  3. Asserts either a “claim or right” or entitlement to that income.

The Court found that Dr. V. met these requirements, as he had “unfettered control over the funds” at all times.

The Court rejected the Taxpayers’ reliance on two previous cases in which the Court had found taxpayers to be a “custodians” of funds coming out of their self-directed IRAs for various investments. In both of those cases, the taxpayers at issue were never the payees of the funds to be invested.  Rather, they merely assisted in having the funds transferred.  In the case at issue, the Court pointed out, at no time was the note held by Dr. V.’s IRA, and at all times it was payable to Dr. V. personally.

Rollover

Section 408(d)(3) of the Code provides an exception to the general rule that any amount paid or distributed out of an IRA must be included in gross income. It provides that the taxpayer does not have to include such an amount if the entire amount that he or she receives is paid into an IRA or other eligible retirement plan within 60 days of the distribution.

The Taxpayers argued that if the amount at issue was a distribution, it was reinvested in the SEP-IRA within the prescribed 60-day period. In this argument, the Taxpayer essentially asked the Court to disregard the various agreements executed in connection with the transaction, and to find that the distribution was made directly to Mr. C.

The Court also rejected this argument, applying a “strong proof” for the case when taxpayers attempt to disregard the form of their own transactions. The Court found that the substance of what had occurred was entirely consistent with the form.

Conclusion

Self-directed IRAs provide taxpayers with a great deal of freedom in choosing how their retirement funds are invested. Thus a taxpayer may, subject to certain limitations, direct that the IRA funds be invested in a business venture.  It is critical, however, that a taxpayer know where his or her personal involvement must cease.  As Dr. V. learned the hard way, sometimes (and, in the case of handling IRA funds, all the time), it is not enough for one’s transactions to have a permissible objective; that objective must also be reached through a permissible route, with no extra “assistance” to affect its path.

The Passive Loss Rules

In general, if a taxpayer’s aggregate losses from passive activities exceed the taxpayer’s aggregate income from passive activities for the taxable year, the excess losses may not be deducted against other income for that taxable year. Such excess losses are suspended and are carried forward, to be treated as deductions from passive activities in succeeding years, at which point they may offset passive income from such activities.

An activity is generally treated as a passive activity if it involves the conduct of a trade or business, and if the taxpayer does not materially participate in the activity. An individual taxpayer materially participates in an activity only if he or she is involved in the operations of the activity of a regular, continuous, and substantial basis. This standard applies regardless of whether the individual owns an interest in a trade or business activity directly (as a sole proprietorship), or owns an interest in an activity conducted at the entity level by a pass-through entity such as a general partnership or S corporation.

In general, a passive activity is defined to include any rental activity, whether or not the taxpayer materially participates in the activity. Thus, losses from rental activities are allowed against income from other passive activities, but not against other income.

Portfolio income, which encompasses interest, dividends, royalties and certain other items not derived in the ordinary course of a trade or business, is not treated as income from a passive activity. However, if borrowed funds are used in a passive activity, the interest expense is treated as a passive activity deduction. Consequently, in certain lending transactions, a taxpayer may have interest income that is characterized as portfolio income, and interest expense that is characterized as a passive activity deduction.

Self-Charged Interest

An issue with respect to portfolio income arises where an individual receives interest income on the debt of a pass-through entity in which the individual owns an interest. The interest may essentially be “self-charged” and, thus, lacks economic significance. For example, assume that the taxpayer charges interest on a loan to an S corporation in which the taxpayer is the sole shareholder. In form, the transaction could be viewed as giving rise to offsetting payments of interest (portfolio) income and pass-through interest (passive) expense, although in economic substance the taxpayer has paid the interest to himself.

Under these circumstances, it is not appropriate to treat the transaction as giving rise both to portfolio interest and to passive interest expense. Rather, to the extent that a taxpayer receives interest income with respect to a loan to a pass-through entity in which he or she has an ownership interest, such income should be allowed to offset the interest expense passed through to the taxpayer from the passive activity for the same taxable year.

Congress anticipated that the IRS would issue regulations to provide for the above result. It also contemplated that such regulations might also identify other situations in which such netting would be appropriate with respect to the payment to a taxpayer by an entity in which he or she has an ownership interest.

In a recent decision, the Fifth Circuit considered a taxpayer’s challenge of one such regulation.

Self-Charged Rental Rule

The dispute concerned whether the Taxpayer could characterize certain income as arising from a “passive activity” under the passive loss rules and the regulations promulgated thereunder.

In general, the Code treats earned income (such as a salary) differently from passive activity income (including many types of rental income). This distinction is important because the passive loss rules only allow a taxpayer to deduct “passive activity losses up to the amount of passive activity income”; the taxpayer may not deduct passive activity losses from earned income. Thus, to gain any benefit from passive activity losses, a taxpayer must have passive activity income. The regulation at issue, the so-called “self-rental rule,” provides as follows:

An amount of the taxpayer’s gross rental activity income for the taxable year from an item of property equal to the net rental activity income for the year from that item of property is treated as not from a passive activity if the property . . . is rented for use in a trade or business activity . . . in which the taxpayer materially participates . . . for the taxable year. Essentially, the regulation provides that when a taxpayer rents property to the taxpayer’s own business, the income is not passive activity income.

Taxpayer’s Real Estate Activity

During the relevant tax years, the Taxpayer owned 100% of two companies: Real Estate, an S corporation, and Medical, a C corporation. During that time, Taxpayer worked full time for Medical and materially participated in the trade or business activities of Medical for purposes of the passive loss rules. The Taxpayer did not materially participate in the activities of Real Estate (including the rental of commercial real estate to Medical) or otherwise engaged in a “real property trade or business.”

office-space-for-lease-signDuring the years in issue, Real Estate leased to Medical the commercial real estate that Medical used in its trade or business activities. Real Estate had net rental income during those years from the rental of commercial real estate to Medical. Taxpayer reported these amounts as passive income on Schedules E, Supplemental Income and Loss, attached to his federal income tax returns for those years. Taxpayer offset these amounts with passive losses from other S corporations, partnerships, and personally owned rental properties. The IRS reclassified Real Estate’s rental income as non-passive income pursuant to the self-rental rule, and disallowed Taxpayer’s passive losses that were claimed in excess of their adjusted passive income for the tax years in issue.

In other words, the IRS’s conclusion that Real Estate’s lease of commercial real estate to Medical fell under the self-rental rule carried the following consequences: (a) Taxpayer’s rental income was deemed non-passive; (b) the Taxpayer could not deduct from it any of his passive activity losses; and, (c) thus, he owed income tax on it. The Taxpayer challenged the deficiencies assessed by the IRS, raising two arguments. First, he argued that because the passive loss rules do not define “taxpayer” to include S corporations, the IRS lacked the authority to define “taxpayer” to include S corporations in the associated regulations. Second, he argued that the self-rental rule did not apply because the lessor, Real Estate, did not materially participate in the trade or business of the lessee, Medical.

The Tax Court rejected both of those arguments, and the Court of Appeals concluded that the Tax Court had reached the right result.

The Court Disagrees

The Court acknowledged that the passive loss rules do not refer to S corporations at all. They specifically apply to “taxpayers” who are individuals, estates, trusts, closely-held C corporations, and personal service corporations. An associated regulation defining certain passive activities, including rental activities, specifies:

This section sets forth the rules for grouping a taxpayer’s trade or business activities and rental activities for purposes of applying the passive activity loss and credit limitation rules of [the passive loss rules]. A taxpayer’s activities include those conducted through C corporations that are subject to[the passive loss rules], S corporations, and partnerships.

The Court concluded, however, that the Code did not need to specifically refer to S corporations because S corporations were merely pass-through entities, and their individual shareholders were the ultimate taxpayers.

Because S corporations do not pay taxes, there was no need for the passive loss rules to include S corporations in their list of potential “taxpayers.” Likewise, the regulations referring to a “taxpayer’s activities . . . conducted through . . . S corporations” did not conflict with the passive loss rules. Rather, they merely recognized the pass-through nature of S corporations and did not state that an S corporation was itself a taxpayer. Thus, the Court concluded that the regulation was valid. Next, the Court addressed the Taxpayer’s claim that the self-rental rule did not apply because the lessor S corporation, Real Estate, did not materially participate in the trade or business of the lessee C corporation, Medical. Again, the Court agreed with the Tax Court. The regulation classified rental income as non-passive if the property “[i]s rented for use in a trade or business activity in which the taxpayer materially participates.” As explained above, the S corporation, Real Estate, was not the taxpayer for purposes of the passive loss rules. Rather, Real Estate was only a pass-through entity; the Taxpayer was the taxpayer. It was undisputed, the Court stated, that the property leased to Medical was rented for Medical’s use in a trade or business activity, and it was likewise undisputed that Taxpayer materially participated in Medical’s business. Thus, the self-rental rule applied and operated to classify the rental income from that lease as non-passive income, as the IRS had determined.

Take-Away?

Starting with the obvious, self-charged rental may present an issue for taxpayers whose activities are subject to the passive loss rules.

Beyond that is one of several recurring themes of this blog, of which every tax adviser needs to be mindful when reviewing the tax and economic consequences, and the associated risks, of a transaction.

The policy underlying the “self-charged” rules is to discourage – or at least not reward – transactions that lack economic significance. In form, the transaction could be viewed as giving rise to offsetting payments of income and expense, but in economic substance the taxpayer has only paid himself.

There are many situations in which a taxpayer is effectively paying himself. It happens every time a taxpayer transacts business with a related party as if the latter were not related to the taxpayer; for example, by charging an arm’s-length rate for the services rendered, the property used, or the products purchased. Indeed, that is how related parties should treat with one another, and when they do so, it is almost always the case that the IRS will respect the resulting tax consequences (tax will follow economics).

That being said, there are often other policy goals at work, as in the case of the passive loss rules described above. The tax adviser’s responsibility is to be aware of these “exceptions” that, notwithstanding the parties’ having acted on an arm’s-length basis, may produce unexpected – and undesirable – tax consequences.

Don’t miss Part I, here!

“I appreciate your eagerness,” said the adviser. “You can just imagine how I feel every morning when I read through the latest tax news. It takes a Herculean effort to contain myself.”

“OMG,” he’s crazy, “what was my dad thinking when he retained this guy?!”

“I see the look in your eyes. Rest assured, your patience is about to be rewarded.

The “Independent Investor Test”

“I’m sure you are familiar with the basic economic principle that the owners of an enterprise with significant capital are entitled to a return on their investment. Thus, a corporation’s consistent payment of salaries to its shareholder-employees in amounts that leave insufficient funds available to provide an adequate return to the shareholders on their invested capital indicates that a portion of the amounts paid as salaries is actually a distribution of earnings.

“The ‘independent investor test,’ the Court noted, recognizes that shareholder-employees may be economically indifferent to whether payments they receive from their corporation are labeled as compensation or as dividends.

“From a tax standpoint, however, only compensation is deductible to the corporation; dividends are not. Therefore, the shareholder-employees and their corporations generally have a bias toward labeling payments as compensation rather than dividends, without the arm’s-length check that would be in place if nonemployees owned significant interests in the corporation.

“Thus, the courts consider whether ostensible salary payments to shareholder-employees meet the standards for deductibility by taking the perspective of a hypothetical ‘independent investor’ who is not also an employee.

“Ostensible compensation payments made to shareholder-employees by a corporation with significant capital that ‘zero out’ the corporation’s income, and leave no return on the shareholders’ investments, fail the independent investor test. An independent (non-employee) shareholder would probably not approve of a compensation arrangement pursuant to which the bulk of the corporation’s earnings are being paid out in the form of compensation, so that the corporate profits, after payment of the compensation, do not represent a reasonable return on the shareholder’s equity in the corporation.

“The record established that Taxpayer had substantial capital even without regard to any intangible assets, although Taxpayer’s expert witness admitted, at trial, that a firm’s reputation and customer list could be valuable entity-level assets.

“Invested capital of the magnitude described in the decision, the Court said, could not be disregarded in determining whether ostensible compensation paid to shareholder-employees was really a distribution of earnings. The Court did not believe that Taxpayer’s shareholder-attorneys, were they not also employees, would have forgone any return on this invested capital. Thus, Taxpayer’s practice of paying out year-end bonuses to its shareholder-attorneys that eliminated its book income failed the independent investor test.

Exemption From the Independent Investor Test?

“Taxpayer observed that its shareholder-attorneys held their stock in the corporation in connection with their employment, they acquired their stock at a price equal to its cash book value, and they had to sell their stock back to Taxpayer at a price determined under the same formula upon terminating their employment. Taxpayer suggested that, as a result of this arrangement, its shareholder-attorneys lacked the normal rights of equity owners.

“Contrary to Taxpayer’s argument, the Court noted, the use of book value as a proxy for market value for the issuance and redemption of shares in a closely-held corporation to avoid the practical difficulties of more precise valuation hardly meant that the shareholder-attorneys did not really own the corporation and were not entitled to a return on their invested capital. Any shareholders who were not also employees would generally demand such a return.

“More generally, Taxpayer’s argument that its shareholder-attorneys had no real equity interests in the corporation that would have justified a return on invested capital proved too much. If Taxpayer’s shareholder-attorneys were not its owners, who was? If the shareholder-attorneys did not bear the risk of loss from declines in the value of its assets, who did? The use of book value as a proxy for fair market value deprived the shareholder-attorneys of the right to share in unrealized appreciation upon selling their stock—although they were correspondingly not required to pay for unrealized appreciation upon buying the stock.

“But acceptance of these concessions to avoid difficult valuation issues did not compel the shareholder-attorneys to forgo, in addition, any current return on their investments based on the corporation’s profitable use of its assets in conducting its business.

“Taxpayer’s arrangement effectively provided its shareholder-attorneys with a return on their capital through amounts designated as compensation. The Court believed that, were this not the case, the shareholder-attorneys would not have been willing to forgo any return on their investment.

Court’s Conclusion

“The Court concluded that the independent investor test weighed strongly against the claimed deductions. The independent investor who had provided the capital demonstrated by the cash book value of petitioner’s shares—even leaving aside the possibility of valuable firm-owned intangible assets—would have demanded a return on that capital and would not have tolerated Taxpayer’s consistent practice of paying compensation that zeroed out its income.

“The classification of a law practice as a business in which capital is not a material income-producing factor, the Court said, did not mean that all of an attorney’s income from his or her practice was treated as earned income and that any return on invested capital was ignored.

“The Court did not doubt the critical value of the services provided by employees of a professional services firm. Indeed, the employees’ services may be far more important, as a factor of production, than the capital contributed by the firm’s owners. Recognition of these basic economic realities might justify the payment of compensation that constitutes the vast majority of the firm’s profits, after payment of other expenses—as long as the remaining net income still provides an adequate return on invested capital.

“But Taxpayer, the Court said, did not have substantial authority for the deduction of amounts paid as compensation that completely eliminated its income and left its shareholder-attorneys with no return on their invested capital.

“Because Taxpayer did not have substantial authority for its treatment of the year-end bonuses it paid during the years in issue, the disallowance of a portion of the deductions Taxpayer claimed for those payments represented a ‘substantial understatement’ for each year.”

Post Script

The tax adviser turned back from the window and looked at the client. The client’s head was resting against the back of the chair. Was that drool trickling from the side of her mouth?

He cleared his throat. Nothing. He cleared it again, this time more forcefully. Her head was now upright. He looked meaningfully into her eyes. “They were lifeless eyes,” he thought, “like a doll’s eyes.” He realized he was channeling Captain Quinn from “Jaws.”

Then she blinked, or tried to – she winced in pain, moved her hands to her face, seemed to fiddle with something, rubbed her eyes, then focused on the adviser. amazing-monkey-face

“You’ve always told me that clients, like me,” she said, base hiring decisions on the reputation of the individual lawyer rather than upon that of the firm at which the lawyer practices. If I heard you correctly just now, “ and she doubted anything she might have heard by that point, “the goodwill of a law firm may be an asset of the firm, rather than of its individual partners, is that right?”

“In the right circumstances, that’s correct. That’s one of many reasons why most firms operate as a pass-through entity, like a partnership, for tax purposes.” He went to the shelf behind his desk, and as he began to remove a volume on “choice of entity” issues, the door slammed. He turned, but the client was gone.

Who can blame her for wanting to avoid another long-winded lecture, but she should have stuck around a while longer. The message of the decision described above is not limited to the personal service business, though it is chock-full of guidance for such a business.

Taxpayers have long sought structures by which they could reduce the double tax hit that attends both the ordinary operation of a C corporation and the sale of its assets.

Many of you have come across the concept of “personal goodwill,” probably in the context of a sale by a corporation.  Some shareholders have argued that they own personal goodwill, as a business asset that is separate from the goodwill of their corporation.  They have then attempted to sell this “personal” asset to a buyer, hoping to realize capital gain in the process, and – more to the point of this post – also hoping to avoid corporate level tax on a sale of corporate goodwill.

Of course, the burden is on the taxpayer to substantiate the existence of this personal goodwill and its value, not only in the context of the sale of the corporate business, but also in the sale of his or her services to the corporate business.  The best chance of supporting its existence is in the circumstances of  a business where personal relationships are paramount, or where the shareholder has a reputation in the relevant industry or possesses a unique set of skills.

The right circumstances may support a significant compensation package for a particular shareholder-employee, either on an annual basis or in the context of an asset sale by his or her corporation.  In each case, a separate, corporate-level tax would not be imposed in respect of the portion of the payments made to the shareholder-employee.

However, before a taxpayer, hell-bent on avoiding corporate-level tax, causes his or her corporation to pay compensation in an amount that wipes out any corporate-level tax, he or she needs to be certain that the existence and value of the personal goodwill – the reasonableness of the compensation for the service rendered – can be substantiated.  The taxpayer needs to plan well in advance.

The employee-owner of a corporate business will sometimes ask his or her tax adviser, “How much can I pay myself out of my corporation?”

The astute tax adviser may respond, “First of all, you are not paying yourself. The corporation is a separate entity from you, its shareholder. That being said, the corporation can pay you as much as it can reasonably afford in light of its business needs and other relevant facts and circumstances, and subject to state corporate law requirements, depending on the nature of the payment. For example, . . .”

The client will then typically interrupt, “C’mon wise guy. You know what I mean.”

The offended tax adviser will then say, “From a tax perspective, the corporation can pay you – and deduct against its income – a reasonable amount of compensation for the personal services you have actually rendered to the corporation. Anything in excess of that amount will be treated as a dividend distribution, to the extent of the corporation’s earnings and profits. Of course, . . .”

“I know, I know,” says the client, “and a dividend is not deductible by the corporation in calculating its own taxes. Give me some credit here.”

“OK. Except in the case of a start-up, or any other situation in which the corporation cannot ‘afford’ to pay its shareholder-employees, the corporate employer will – in fact, should – pay an amount of compensation that is reasonable for the services rendered – an exchange of value-for-value, or cash for services. In the case of an S corporation –”

Another interruption.

“Does the amount depend on the nature of the business?” asks the client.

“In general, yes. In a capital-intensive business, it may be more difficult to justify a certain level of compensation than in a business that involves only personal services.

“But,” continues the adviser, let me tell you about a recent decision involving a professional corporation . . .”

And as the adviser began, the client sunk deeper into the chair, recognizing the didactic look on the adviser’s face (the one that would broach no further interruptions), wishing that she had never raised the subject, willing for her phone to ring with some emergency, to extract her from her predicament.

Oblivious to his client’s plight, the tax adviser went on, encouraged by the thought that this client really cared about what he had to share.

Once Upon A Time, . . .

“Taxpayer was a law firm organized as a corporation. During the years at issue, it employed about 150 attorneys, of whom about 65 were shareholders. It also employed a non-attorney staff of about 270. storybook

“Taxpayer’s shareholders held their shares in the corporation in connection with their employment by the corporation as attorneys. Each shareholder-attorney acquired her shares at a price equal to their book value and was required to sell her shares back to Taxpayer at a price determined under the same formula upon terminating her employment.

“Taxpayer’s shareholder attorneys were entitled to dividends as and when declared by the board. For at least 10 years before and including the years in issue, however, Taxpayer had not paid a dividend. Upon a liquidation of Taxpayer, its shareholder-attorneys would share in the proceeds.

“For the years in issue, the board met to set compensation and ownership-percentages in late November or early December of the year preceding the compensation year. Before those meetings, the board settled on a budget for the compensation year. On the basis of that budget, the board determined the amount available for all shareholder-attorney compensation for that year. With that amount in mind, it set each shareholder-attorney’s expected compensation using a number of criteria, then determined the adjustments in their ownership-percentages necessary to reflect changes in proportionate compensation. Adjustments in actual share ownership were made by share redemptions and reissuances.

“The board intended the sum of the shareholder-attorneys’ year-end bonuses to exhaust Taxpayer’s book income. Shareholder-attorneys shared in the bonus pool in proportion to their ownership-percentages. Specifically, Taxpayer calculated the year-end bonus pool to equal its book income for the year after subtracting all expenses other than the bonuses. Thus, Taxpayer’s book income was zero for each year: its income statements showed revenues exactly equal to expenses.”

The client carefully placed the second toothpick at the corner of her right eye. “Great,” she exhaled, “that should do it. Sure hope he’s near-sighted.”

At that point, the adviser glanced over at the client, who seemed to be listening intently, her eyes wide open. Pleased with himself, he continued.

Compensation, Or Something Else?

“Taxpayer treated as employee compensation the amounts it paid to its shareholder-attorneys, including the year-end bonuses.  In each of its tax returns for the years at issue, Taxpayer included the year-end bonuses it paid to its shareholder-attorneys in the amount it claimed as a deduction for officer compensation.

“Taxpayer’s returns reflected a relatively small amount of taxable income. Because Taxpayer’s book income was zero for each year, the taxable income Taxpayer reported was attributable entirely to items that were treated differently for book and tax purposes.”

The IRS Disagrees

“Now comes the good part,” said the adviser, his voice rising slightly.

The client hadn’t moved, yet her eyes were fixed on him, like some Byzantine icon.

“When the IRS examined Taxpayer’s returns, it disallowed the deductions for the year-end bonuses paid to Taxpayer’s shareholder-attorneys. After negotiations, the parties entered into a closing agreement that disallowed portions of Taxpayer’s officer compensation deductions for the years in issue, which portions it re-characterized as non-deductible dividends.”

The client bent forward slightly, then rocked back, as though nodding in agreement.

Encouraged by this sign of assent, the adviser continued.

“The sole issue remaining for the court was whether Taxpayer was liable for accuracy-related penalties on the underpayments of tax relating to its deduction of those portions of the year-end bonuses that it agreed were nondeductible dividends.

“The court began by stating the general rule that the Code allows a deduction for ordinary and necessary business expenses. However, in order for amounts paid as salary to be deductible, they must be paid for services actually rendered, and they must be reasonable. Ostensible salary payments to shareholder-employees that are actually dividends are thus nondeductible.

The Parties’ Arguments

“In support of its deduction of year-end bonuses paid to its shareholder-attorneys that eliminated its book income for the years in issue, Taxpayer cited a number of authorities that purportedly established that capital was not a material income-producing factor in a professional services business.

“The IRS claimed that amounts paid to shareholder-employees of a corporation did not qualify as deductible compensation to the extent that the payments were funded by earnings attributable to the services of non-shareholder-employees or to the use of the corporation’s intangible assets or other capital. The IRS said that amounts paid to shareholder-employees that are attributable to those sources must be nondeductible dividends.

“Taxpayer responded that any ‘profit’ made from the services of non-shareholder-attorneys could justifiably be paid to its shareholder-attorneys in consideration of their business generation and other non-billable services.”

The adviser turned toward the window. “I hope he jumps,” was the first thought that occurred to the client. No such luck – he only opened it a crack.

“It’s a bit stuffy in here,” he said, as if to himself, clearly not expecting a response.

“You have no idea,” she whispered under her breath.

“What’s that?”

“I said I have no idea where this is going.”

Stay tuned for Part II, tomorrow, to find out!

WTH?

It is not unusual to come across an IRS letter ruling that elicits the following reaction from many of its readers: “why did they expend the time and money to request this ruling?”

On the face of such a ruling, the IRS’s response may seem pretty obvious; even if the readers could not cite the specific authority to support their conclusion, their knowledge of general tax principles will generally lead them to the “right” answer. Under such circumstances, why would a taxpayer pay a significant user fee, not to mention accounting and legal fees, in preparing and submitting the ruling request? shutterstock_308642543

Whatever a taxpayer’s reasons for proceeding on this path (and there may be several valid ones), from the perspective of readers such as ourselves, it is often beneficial to see what other taxpayers are doing and to familiarize oneself with the IRS’s reasoning for its positions. After all, you never know when a similar situation may be presented to one of your clients.

It’s Just An F-Reorg

In one recent ruling, for example, the IRS considered one consequence to a corporation (“Corporation”) arising out of a so-called “F” reorganization.  An F reorganization is “a mere change in identity, form, or place of organization of one corporation, however effected.”

Like other types of corporate reorganizations, an F reorganization generally involves, in form, two corporations: one that transfers (or is deemed to transfer) assets, and another that receives such assets.

However, the Code describes an F reorganization as being undertaken with respect to “one corporation,” and an F reorganization is treated for most purposes of the Code as if the reorganized corporation were the same entity as the corporation in existence before the reorganization. Thus, the tax treatment accorded an F reorganization is more consistent with that of a single continuing corporation.

Qualified Small Business Stock

The taxpayer who requested the above ruling from the IRS was one of Corporation’s shareholders. Following its formation, Corporation issued common stock to eight stockholders, including the taxpayer (the “Initial Stockholders”). Corporation represented that it satisfied the requirements of Section 1202 of the Code. The taxpayer asked the IRS to confirm that the transactions described below would jeopardize neither the Corporation’s status as a “qualified small business” nor the status of the taxpayer’s shares as “qualified small business stock,” the gain from the sale of which could be excluded, in whole or in part, from the taxpayer’s gross income.

The Conversion Transaction

Pursuant to an agreement, Buyer purchased a portion of the Corporation stock owned by each Initial Stockholder. Also pursuant to that agreement, Corporation redeemed a portion of each Initial Stockholder’s Corporation stock (together, the “Transaction”). Thus, immediately after the Transaction, Buyer and Initial Stockholders owned all the stock of Corporation.

Immediately following the Transaction, Corporation converted into an LLC pursuant to State law. Corporation elected to continue to be taxed as a corporation for federal income tax purposes.

Now, you might ask, why would Corporation convert to an LLC as a matter of State law, yet elect to continue to be treated as a corporation for tax purposes?

Some States tax LLCs differently than they tax other business entities. For example, a State may not impose an entity-level tax on an LLC, but it may impose a franchise tax on a corporate entity. In addition, there may be non-tax legal reasons that make it advantageous to be organized as an LLC rather than as a corporation. For example, certain formalities of corporate governance may not be required under State law in the case of an LLC. The fact that an LLC may be member-managed as a matter of State law is another consideration that may persuade a corporation to convert into an LLC.

Although it may be better for a business, at least for state law purposes, to be organized as an LLC, it is unlikely that a conversion from corporate status to LLC status would be effected unless it could be accomplished on a non-taxable basis. However, the conversion of a corporation into an LLC is treated as a taxable liquidation of the corporation, at least where the LLC is treated as a partnership for tax purposes.

The IRS Rules

In the ruling, the LLC was described as being an association taxable as a corporation (not as a partnership) for income tax purposes. In other words, it had elected, under the “check the box” rules, to be treated as a corporation.  The taxpayer also represented that the conversion of Corporation into the LLC, pursuant to State law, qualified as an F reorganization; i.e., a mere change in the form of organization of one corporation, where the change in business form was effectuated with the assets remaining in corporate solution and avoiding the triggering of liquidation tax. On the basis of these representations, the IRS ruled that the transfers of the Corporation’s qualified small business stock would not be treated as a sale or exchange, and the successor “corporation” in the tax-free corporate reorganization (the LLC) would be treated as the same corporation as its predecessor (Corporation). Therefore, the IRS ruled that the status of the original issue common stock of Corporation as qualified small business corporation stock held by the Initial Stockholders was unaffected by the conversion.

Lessons?

As Hulk Hogan used to say, “take your vitamins, say your prayers, read the IRS’s letter rulings, and you will never go wrong.” (OK, I may have taken some poetic license. So what?) But seriously, what’s the point of this ruling?

“Of course,” you say, “the stock of Corporation continued to be treated as qualified small business corporation stock. The Transaction was an F reorganization, after all. The same corporate taxpayer that existed before the Transaction continued to exist after the Transaction.”

But that is the point. The Transaction was a tax-free F-reorganization because the LLC elected to be taxed as a corporation for tax purposes. That simple election enabled the Corporation to restructure itself and change its business form in a way that, presumably, was favorable and more desirable as a matter of State law, and it was able to do so without sacrificing any of its valuable tax attributes.

So, keep reading those letter rulings. You never know what may come out next.

Flexible Economic Arrangements

We represent a number of entrepreneurs. The form of business entity that they most often choose to operate is an LLC that is treated as a partnership for income tax purposes. They recognize that the LLC is not a taxable entity, that there are no limitations upon who may invest in an LLC, and that an LLC is flexible enough to accommodate many kinds of economic arrangements among the members.

However, although it is true that the tax rules applicable to LLCs are intended to permit taxpayers to conduct joint business and investment activities through a flexible economic arrangement without incurring an entity-level tax, many taxpayers do not appreciate that an LLC’s members do not have unfettered discretion in allocating the related income tax consequences. Indeed, the IRS has promulgated some very complicated rules in order to prevent taxpayers from “abusing” the LLC structure.

Thus, it is imperative that the members of an LLC, as well as their advisers, have a basic understanding of the partnership/LLC allocation rules.

There Are Limits

Implicit in these rules are the requirements that the LLC must be bona fide and that each LLC transaction must be entered into for a substantial business purpose, that the form of each such transaction must be respected under “substance over form” principles, and that the tax consequences to each member arising from the LLC’s operations – i.e., from the allocation of such member’s share of the LLC’s items of income, gain, loss, deduction, or credit – must accurately reflect the members’ economic agreement and clearly reflect their income.

Accordingly, if an LLC is formed in connection with a transaction a principal purpose of which is to substantially reduce the members’ aggregate federal tax liability in a manner that is inconsistent with the partnership/LLC tax rules, the IRS can recast the transaction for federal tax purposes, as appropriate, to achieve tax results that are consistent with such rules. For example, the IRS can determine, based on the particular facts and circumstances, that to achieve the “proper” tax results, the LLC’s items of income, gain, loss, deduction, or credit should be reallocated.

As a general rule, each member is required to take into account on the member’s tax return his or her distributive share, whether distributed or not, of each class or item of LLC income, gain, loss, deduction or credit (“tax items”).  This includes the member’s share of the LLC’s net, or “bottom line,” taxable income or loss.  The character in the hands of a member of any such item is determined as if such item were realized directly from the source from which realized by the LLC, or incurred in the same manner as incurred by the LLC.

The Operating Agreement

A member’s distributive share of any LLC tax item is determined by the operating (“partnership”) agreement, unless otherwise provided by the Code or the regulations promulgated thereunder. Thus, the terms of the agreement are very important and should be closely reviewed to ensure that they accurately reflect the understanding among the members.

If the agreement does not provide for such an allocation, then each member’s distributive share of such item shall be determined in accordance with such member’s “interest in the partnership,” taking into account all the facts and circumstances relating to the economic arrangement of the members.

If the agreement provides for an allocation, the allocation shall be respected if it has substantial economic effect, or, if taking into account all the facts and circumstances, the allocation is in accordance with the members’ interest in the partnership.

In determining a member’s interest in the LLC, the following factors are among those that will be considered:

  • the members’ relative contributions to the LLC,
  • the interests of the members in economic profits and losses (if different than that in taxable income or loss),
  • the interests of the members in cash flow and other non-liquidating distributions, and
  • the rights of the members to distributions of capital upon liquidation.

To the extent an allocation to a member under the operating agreement does not have substantial economic effect, and is not in accordance with the members’ interest in the LLC, such tax item will be reallocated in accordance with the member’s interest in the LLC.

Economic Effect

In general, the determination of whether an allocation to a member 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 members. This means that in the event there is an economic benefit or economic burden that corresponds to the allocation, the member to whom an allocation is made must receive such economic benefit or bear such economic burden. Stated differently, tax must follow economics.

For example, if an LLC agreement allocates the loss for a year to one of two members, and it also provides that liquidating distributions will be made equally to the two members, the allocation may be said not to have economic effect since it did not cause the member (to whom the loss was allocated) to suffer an economic loss.

The applicable regulations provide that an allocation will have economic effect if, throughout the full term of the LLC, the operating agreement provides:

  • for the determination and maintenance of the members’ capital accounts in accordance with the rules set forth in the Regulations;
  • upon liquidation of the LLC (or of any member’s interest in the LLC), liquidating distributions are required to be made in accordance with the positive capital account balances of the members; and
  • if such member has a deficit balance in his capital account following the liquidation of his interest, he is obligated to restore the amount of such deficit.

In general, the members’ capital accounts will be considered to be determined and maintained in accordance with the Regulations if each member’s capital account is increased by (1) the amount of money contributed by him to the LLC, (2) the fair market value of property contributed by him to the LLC (net of liabilities that the LLC is considered to assume or take subject to), and (3) allocations to him of LLC income and gain (or items thereof); and is decreased by (4) the amount of money distributed to him by the LLC, and (5) the fair market value of property distributed to him by the LLC (net of liabilities that such member is considered to assume or take subject to).

Of course, absent an outstanding balance on a promissory note contributed to the LLC by such member, or any obligation under the operating agreement or state law to make subsequent contributions to the LLC, it is rarely the case that any member will agree to restore a deficit in his capital account – no member wants to come out of pocket beyond his or her initial investment in the LLC. For this reason, the regulations provide an alternate test for economic effect; specifically, provided the capital account rules are satisfied, an allocation will be deemed to have economic effect – notwithstanding the absence of an obligation to restore a deficit capital account – if the LLC agreement contains a “qualified income offset.”

An LLC agreement has a “qualified income offset” if it provides that a member who “unexpectedly” receives a specified type of allocation (e.g., relating to depletion allowances) or distribution will be allocated items of income and gain in an amount and manner sufficient to eliminate the member’s deficit balance as quickly as possible.

Is it Substantial?

That an allocation has economic effect is not sufficient. In addition, the economic effect of the allocation must be substantial.  Specifically, there must be a reasonable possibility that the allocation will substantially affect the dollar amounts to be received by the members from the LLC, independent of the allocation’s tax consequences.

The economic effect of an allocation in an LLC’s taxable year is not substantial if the after-tax economic consequences of at least one member may be enhanced compared to such consequences if the allocation were not contained in the agreement, and there is a strong likelihood that the after-tax economic consequences of no member will be substantially diminished compared to such consequences if the allocation were not contained in the agreement – in other words, there is a disconnect between tax and economics.

Thus, if there is a strong likelihood that the net increases and decreases that will be recorded in the members’ respective capital accounts for such taxable year will not differ substantially from the net increases and decreases that would be recorded in such members’ respective capital accounts for such year if the allocations were not contained in the agreement, and the total tax liability of the members (for their respective taxable years in which the allocations will be taken into account) will be less than if the allocations were not contained in the agreement.

In determining the after-tax economic benefit or detriment to a member, tax consequences that result from the interaction of the allocation with such member’s tax attributes that are unrelated to the LLC (for example, a member’s NOLs) will be taken into account.

This general rule is aimed at preventing certain abuses of the allocation rules that generate tax savings, but have a “neutral” effect from an economic perspective (where tax does not following economics). For example, an LLC holds highly-rated bonds that produce a steady stream of income; one member of the LLC has expiring NOLs; the agreement allocates all of the LLC’s income for one year to that member; the agreement provides that the LLC’s income for later years will be allocated to the second member until he or she has been allocated the same amount of income; the allocations do not have substantial economic effect.

The Takeaway

The foregoing was a simplistic summary of the allocation rules applicable to LLCs that are treated as partnerships. Unfortunately, these rules are anything but simple; indeed, they are among the most complex ever promulgated by the IRS, and their application presents significant challenges to tax advisers, let alone to the taxpayer.

If there is one principle that the reader should retain, and that should guide him or her in reviewing the allocation provisions of any operating agreement, it is that the tax consequences must follow the economics of the arrangement. Generally, speaking, this basic rule should help to ensure that the tax consequences anticipated by the members will be respected by the IRS.

I recently encountered a situation in which a partially-liquidated corporation sought to claim a net operating loss (“NOL”) as a result of payments made by the corporation in settlement of certain claims relating to its business. The corporation had previously distributed its business assets, but had retained liquid assets in an amount that it estimated would be sufficient to defend against the claims and to satisfy any liability arising therefrom. Under these circumstances, the corporation was allowed to treat the payments as deductible business expenses that generated an NOL for the year of payment that the corporation was able to carry back two years.

Subsequently, I came across an IRS advisory in which the taxpayer did not fare as well. The IRS considered whether amounts paid by the taxpayer in settlement of a claim qualified as “ordinary and necessary” trade or business expenses that were currently deductible, or as amounts paid to “defend or perfect title” to property that had to be capitalized.

The Reorg

Corp. was engaged in business A through its subsidiary, Sub, which was also engaged in business B.

Corp. went through a series of steps as part of a somewhat convoluted reorganization in order to separate Sub’s A business from its B business, and then to merge the B business into Taxpayer.

As a result of the reorganization, business A was spun off to Corp.’s shareholders, and Corp. was left with the stock of Sub (owning business B) as its primary asset.

Corp. then merged into Taxpayer.

The Lawsuits

At the time of the merger, Corp. and Sub were defendants in numerous lawsuits arising out of business A. Taxpayer also became a defendant in a number of lawsuits alleging that, as a result of the reorganization, it was responsible for the liabilities of the corporation (Newco) to which business A had been transferred.

The basis of these suits against the Taxpayer was either that the transfer of business B was a fraudulent transfer or that the reorganization transaction resulted in successor liability for Taxpayer.

The lawsuits settled, and the settlement provided for Taxpayer (which indirectly owned business B) to transfer the sum of $X million in cash, together with Y million shares of Taxpayer’s common stock, in exchange for a release from all claims under the litigation.

These payments were made to one or more trusts. The transfers were not avoided.

The settlement did not state an allocation of the transferred amounts among the various claims in the complaint.

Taxpayer’s Request

Taxpayer sought approval of its intention to deduct, on its income tax return for the year in which the payments were made, the amounts transferred to the trusts pursuant to the settlement as an ordinary and necessary business expense – that would generate an NOL in the year of payment – and to carry back the loss to the preceding tax years.

The Code provides that there shall be allowed as a deduction all the ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business. The Code also provides that no deduction shall be allowed for any amount paid out for new buildings or for permanent improvements or betterments made to increase the value of any property or estate. Regulations promulgated under the Code provide that amounts paid to defend or perfect title to property are amounts paid to acquire or produce property and must be capitalized.

Origin of the Claim

The IRS considered the tax treatment of the fraudulent conveyance claims under the “origin of the claim” test. This test generally is applied to determine whether an amount incurred in litigation is currently deductible. Thus, the substance of the underlying claim or transaction out of which the expenditure in controversy arose governs whether the item is a deductible expense or a capital expenditure.

In applying the origin of the claim test, a taxpayer’s purpose in undertaking or defending a particular piece of litigation is not relevant. The origin of the claim test is an objective inquiry to determine the origin and character of the claim, taking into account all of the facts and circumstances. Thus, while amounts paid by a business in connection with business-related litigation generally are deductible as ordinary and necessary expenses (as described in the first paragraph of this post), amounts with their origin in a capital transaction are required to be capitalized under the origin of the claim test.

According to the IRS, litigation costs incurred to defend or perfect title to property were capital expenditures that were not deductible as ordinary and necessary business expenses. The IRS looked to the nature and objectives of the litigation as evidenced by the various counts of the complaint and other language in the complaint to determine the origin of the claims, noting that the counts included claims for fraudulent transfer. These included transfers made with the intent to hinder, delay, defraud creditors, as well as assertions that assets were unfairly or improperly transferred from the debtor, for inadequate consideration at a time when the debtor was insolvent or nearly so (or made insolvent by the asset transfers), thereby draining the pool of assets available to satisfy creditors’ claims from the debtor’s bankruptcy estate.

The IRS Ruling

The settlement agreement did not allocate the amounts amongst the various claims. The IRS determined that, to the extent that settlement amounts were attributable to the fraudulent conveyance claims, they were not deductible business expenses, based on the application of the origin of the claim analysis. Fraudulent conveyance claims have their origin, the IRS said, in a defense of title to property because they seek to restore improperly transferred property back to the bankruptcy estate for the benefit of creditors; the dispute in each claim is over ownership of, or title to, property.

The IRS stated that Taxpayer could not point to the first in the chain of events that was the reason for the reorganization and asset transfer – a liability that arose out of the operation of business A, the payment of which would have generated a business deduction. Because the settlement payment had its origin in a fraudulent conveyance claim, the essence of the action was a claim for the return of property or a payment in lieu thereof. Part of the controversy settled in the case was over a dispute regarding ownership of property. Amounts paid in settlement of such claims were capital in nature, the IRS stated. Therefore, the amounts attributable to the fraudulent conveyance claims were not deductible.

Facts & Circumstances – And Timing

What a difference they make.

Of course, if the above reorganization had not occurred, any payments made in settlement of the lawsuits would probably have been deductible since the acts that gave rise to the litigation were performed in the ordinary conduct of the taxpayer’s business. Query, however, how different the terms of the settlement may have been.

Let’s change the facts, above. What if the corporate taxpayer had completely liquidated prior to the settlement of the claims? Assume, for example, that as part of its plan of liquidation, it had transferred some of its assets to a trust to meet both known and contingent claims against the corporation arising out of business A,  recognizing that they could not be settled in the short-term.

For purposes of the income tax, it is likely that the corporation’s shareholders would be treated as having constructively received these assets in a taxable distribution (reduced by the amount of the known liabilities), and then as having directed them to the trust for their own benefit (a grantor trust).

But what if, in a subsequent year, the trust discharged a contingent liability of the corporation? In that case, the discharge would give rise to a capital loss in the year of the discharge (to offset the earlier capital gain realized by the shareholders in the liquidation), notwithstanding that the claim arose out of the operation of the corporation’s business. The origin of the claim was the liquidating distribution to the shareholders, not the business-related liability.

As a business or legal matter, there were probably several avenues that the players in the above IRS ruling could have pursued in settling the litigation. Unfortunately, it appears that Taxpayer did not properly consider the potential tax exposure, and the resulting economic cost, that were generated by its acquisition of business B, including the exposure arising out of the settlement of the ongoing litigation. If it had, query whether the terms of the acquisition would have been different so as to account for the additional economic risk and cost.

When A Business Fails

It goes without saying that no one goes into business in order to realize a loss. Unfortunately, not all businesses succeed, and many owners suffer significant losses. The challenge presented for the tax adviser to the business is how to best utilize those losses for income tax purposes and, thereby, to ease the resulting economic blow to the owners of the business.

Although the solution to this problem will necessarily depend upon the facts and circumstances of the particular business and its owners, it is probably safe to say that most taxpayers would prefer to treat the loss as an ordinary, as opposed to a capital, loss. In trying to accommodate this preference, advisers must tread carefully.

A Loss Subsidiary

Consider the case of an S corporation that owns a qualified subchapter S subsidiary (or “Qsub”) that has become worthless. The S corporation parent has several obstacles to overcome in order to pass an ordinary deduction through to its shareholders. A Qsub is a disregarded entity; that is, it is not treated as a separate corporation for federal income tax purposes, even though it remains a separate legal entity under state law. Instead, all of a Qsub’s assets, liabilities, items of income, deduction and credit are treated as items of the parent S corporation.

The shareholders of the S corporation parent primarily have three ways to recognize a loss, none of which results in an ordinary loss:

Take a worthless stock deduction on their S corporation shares, resulting in a capital loss (assuming qualification under the Code);

Revoke the “S” Election?

The IRS recently considered a somewhat aggressive approach attempted by one taxpayer to secure an ordinary loss.

Taxpayer was an S corporation that owned Subsidiary, a Qsub that operated a regulated Business. In Year 1, Subsidiary’s Business operations were depressed and, based on this downturn, Taxpayer and its shareholders sought to maximize and pass through Subsidiary’s losses in Year 1, before Agency placed Subsidiary in receivership. Specifically, Taxpayer wanted to recognize a loss realized by Subsidiary and have that loss flow through to its shareholders as an ordinary loss.

In an attempt to qualify its shareholders for ordinary loss treatment for the full amount of their investment, Taxpayer affirmatively terminated its S corporation status. As a result, Subsidiary’s Qsub status also terminated and, under IRS regulations, Subsidiary (the former Qsub) was treated as a new corporation acquiring all of its assets (and assuming all of its liabilities) from Taxpayer (its S corporation parent) in exchange for stock of the new corporation.

Thus, immediately before Taxpayer’s “S” election terminated, Subsidiary’s Qsub election terminated and it became a C corporation.

Ordinary Loss – On Subsidiary Stock?

A taxpayer may realize an ordinary loss from the worthlessness of the stock of a subsidiary corporation, notwithstanding that the stock otherwise is a capital asset, if certain “affiliation” and “gross receipts” tests are satisfied.  A corporation is treated as affiliated with a taxpayer if: (1) the taxpayer owns stock in that corporation representing at least 80% of both the total voting power and total value of the stock of such corporation; and (2) generally, more than 90 percent of the aggregate of its gross receipts for all tax years has been from sources other than passive investments (e.g., rents, dividends, interest, and gains from sales of securities).

Taxpayer argued that when it was still an S corporation, but after Subsidiary became a C corporation, Subsidiary became worthless – i.e., at the moment that Subsidiary was deemed to have acquired its assets from the Taxpayer.

Based upon this analysis, Taxpayer asserted that it was entitled to an ordinary deduction, provided that its “new” subsidiary C corporation was affiliated and worthless. Once that deduction was recognized, Taxpayer passed through the ordinary deduction to its shareholders.

The IRS Disagrees

The IRS rejected the Taxpayer’s position on several grounds.

According to the IRS, when a Qsub election terminates, the former QSub is treated as a new corporation acquiring all of its assets (and assuming all of its liabilities), immediately before the termination, from the S corporation parent in exchange for stock of the new corporation.

In such a case, the deemed creation of a new corporation may qualify as a tax-free transaction. Alternatively, the transaction may be taxable and, if any of the transferred assets has a basis in excess of its fair market value, the recognition of the loss may be deferred under the “related party” rules.

In order to qualify as a tax-free transaction, a contribution of property to a corporation must be made solely in exchange for stock of such corporation and, immediately after the exchange, the contributor must be in control of the corporation.

An Insolvent QSub

However, insolvency can destroy an otherwise tax-free contribution to a corporation in two ways. First, significantly encumbered property may not be considered “property”; thus, there can be no contribution of property. Second, the “in exchange for stock” requirement is not met when the transferor receives stock in an insolvent corporation. (A similar “net value” rule applies to corporate reorganizations).

Specifically, “property” must have value, and something of value must be exchanged between the contributing shareholder and corporation. The IRS stated that because worthless subsidiary stock does not have value, the deemed contribution transaction incorporating liabilities in excess of the value of the transferred assets were taxable, and would be deferred under the related party rules.

 Worthless Stock

A taxpayer may realize an ordinary loss from the worthlessness of the stock of a subsidiary corporation if certain “affiliation” and “gross receipts” tests are satisfied.

A corporation is treated as affiliated only if none of the stock of the corporation was acquired by the taxpayer solely for the purpose of converting a capital loss sustained by reason of the worthlessness of any such stock into an ordinary loss.

Thus, according to the IRS, Taxpayer had to explain why it “acquired” the C corporation stock for reasons other than to obtain an ordinary deduction.

In determining whether this anti-abuse rule applies, the IRS noted that Taxpayer had many options to create a deduction from Subsidiary’s alleged worthlessness. Of the options available to Taxpayer, terminating the QSub election, resulting in acquiring C corporation stock, was the only option that arguably generated an ordinary loss. This stock acquisition coupled with an immediate claim of an ordinary loss deduction was evidence, the IRS said, that the sole purpose of converting the Qsub into a C corporation was to attempt to qualify for an ordinary deduction.

Indeed, though there are a few benefits bestowed on taxpayers that terminate their QSub election, none of these benefits are relevant in the context of an S corporation running a defunct business. Some of the usual reasons a taxpayer may convert from QSub-to-C status are:

  • Federal income tax rates are sometimes lower for C corporations than individuals;
  • Employee-owners of C corporations do not have to include certain fringe benefits as income;
  • C corporations may carryback capital losses two years; and
  • C corporations have greater flexibility to choose when their fiscal year ends.

An S corporation in the process of receivership would not be engaged in tax planning about future tax brackets, shareholder-employee fringe benefits, carrying back of losses, or changing to a fiscal year. With an ordinary loss at stake, Taxpayer’s purpose was clear. This is exactly the type of acquisition of stock with the intent to convert a capital loss into an ordinary loss that the anti-abuse rule was designed to prevent.

Thus, the newly created C corporation was not treated as affiliated with Taxpayer and the ordinary deduction was disallowed.

 Sometimes, You Have to Settle

Although tax advisers like to believe that no tax challenge is too daunting, or incapable of being addressed, the truth is that, quite often, there is no entirely satisfactory solution to every tax problem.

The sooner the adviser realizes this, the better he or she will manage the client-taxpayer’s expectations, and the more likely the adviser will stay clear of aggressive or “too good to be true” fixes that, in the end, will only harm the taxpayer and the adviser’s reputation.

No, I don’t mean the yellow-brick road, or any train, or anything like that. I am referring, of course, to the Protecting Americans from Tax Hikes Act of 2015 (the “PATH” or the “Act”). The recently enacted legislation provides a number of tax benefits, a few of which will be of particular interest to the owners of certain closely-held corporations who may be considering the sale of their business. PATH-Act3

 First, Some Basics

Most business owners who operate their closely-held business through a corporation know that the deal structure by which the business is sold may have a significant impact on their tax liability and, thus, on the net economic result of the sale.

 A sale of stock will generate long-term capital gain for the selling shareholders, taxable at a federal rate of 20%, provided they have held the shares for more than 12 months. If the target corporation is a C corporation, an additional 3.8% surtax (on net investment income) may be imposed on the gain realized. If the target is an S corporation and the selling shareholder has been active in its business, this surtax may not apply.

A sale of assets may yield very different results, depending upon the composition of the corporation’s assets and the corporation’s tax status.

 A sale of assets by a C corporation will generate gain that will be subject to corporate level tax, at a maximum federal rate of 35% (regardless of the nature of the assets sold); the distribution of the remaining proceeds to the shareholders in liquidation of the corporation will generate a second level of tax – to the shareholders – at the federal long-term capital gain rate of 20% and, perhaps, the 3.8% surtax.

 A sale of assets by an S corporation is generally not taxable at the corporate level; rather, the gain realized will flow through and be taxed to the shareholders. The nature of the gain, as ordinary or capital, will depend upon the nature of the assets being sold (e.g., inventory, depreciation recapture property like equipment, real estate, goodwill, etc.); this will determine the rate of tax imposed upon the shareholders, with ordinary income items being taxed at a maximum federal rate of 39.6% and capital gain items at 20%. If the business was “passive” as to a particular shareholder, these rates would be increased to include the 3.8% surtax.

 If the S corporation was previously a C corporation, and its assets were appreciated (had built-in gain, or “BIG”) at the effective date of the “S” election, then the sale of such assets within the corporation’s “recognition period” will generate a corporate level tax liability (at the maximum corporate rate), based upon the amount of the built-in gain.

 Planning for the Sale?

Oh, to have a crystal ball.

 Business owners have many things to think about when they start, or acquire, a business, and I daresay that taxes and the ultimate disposition of that business may not be at the forefront of their concerns.

 Moreover, business realities may force certain tax “decisions” upon the owners. For example, the need for an infusion of capital from an unrelated investor group (an “angel” investor in the form of a partnership), whether as equity or convertible debt, may preclude an S corporation election for the business.

However, business owners who do not consider taxes at the inception of the business, and throughout their ownership of the business, do so at their peril.

Insofar as the PATH in concerned, business owners should familiarize themselves with the changes affecting the sale of small business stock and the recognition period for S corporations that were formerly taxable as C corporations.

 Small Business Stock Exclusion

In general, a taxpayer other than a corporation may exclude 50% of the gain from the sale of certain “small business stock.” This is stock in a domestic C corporation that was acquired at original issue from the corporation (in exchange for cash, services, or property other than stock) and held for at least five years.

The amount of gain eligible for the exclusion by an individual with respect to the stock of any corporation is the greater of (1) ten times the taxpayer’s basis in the stock or (2) $10 million (reduced by the amount of gain eligible for exclusion in prior years).

To qualify as a “small business,” when the stock is issued, the aggregate gross assets (i.e., cash plus aggregate adjusted basis of other property) held by the corporation may not exceed $50 million, and the corporation must satisfy certain active trade or business requirements. The portion of the gain that is not excluded from taxable income under this rule is taxed at a maximum rate of 28% under the regular tax (not the 20% usually applicable to capital gain); 7% of the excluded gain is an alternative minimum tax preference.

 Pre-PATH History and the PATH

Prior to the passage of the Act, for stock acquired after February 17, 2009 and before September 28, 2010, the percentage exclusion for qualified small business stock sold by an individual was increased from 50% to 75%.  For stock acquired after September 27, 2010 and before January 1, 2015, the percentage exclusion was increased to 100% and the minimum tax preference does not apply.

The Act made both the post-September 27, 2010, 100% exclusion and the exception from minimum tax preference treatment permanent effective for stock acquired after December 31, 2014.

 S Corporation Recognition Period

For taxable years beginning in 2009 and 2010, no tax was imposed on the net recognized BIG of an S corporation under section 1374 if the seventh taxable year in the corporation’s recognition period preceded such taxable year. Thus, with respect to gain that arose prior to the conversion of a C corporation to an S corporation (the “BIG”), no corporate-level tax was imposed if the seventh taxable year that the S corporation election was in effect preceded the taxable year beginning in 2009 or 2010.

 For any taxable year beginning in 2011, no tax was imposed on the net recognized BIG of an S corporation if the fifth year in the corporation’s recognition period preceded such taxable year. Thus, with respect to the BIG, no corporate tax was imposed if the fifth taxable year that the S corporation election was in effect preceded the taxable year beginning in 2011.

For taxable years beginning in 2012, 2013, and 2014, the term “recognition period” was also the five-year period beginning with the first day of the first taxable year for which the corporation was an S corporation (or beginning with the date of acquisition of assets if the rules applicable to assets acquired from a C corporation applied). If an S corporation with assets subject to the BIG tax disposed of such assets in a taxable year beginning in 2012, 2013, or 2014 and the disposition occurred more than five years after the first day of the relevant recognition period, gain or loss on the disposition was not taken into account in determining the net recognized built-in gain.

 The PATH

The Act made the rules applicable to taxable years beginning in 2012, 2013, and 2014 permanent, effective for taxable years beginning after December 31, 2014.

Thus, if the fifth year of an S corporation’s recognition period ended in 2015, the gain from an asset sale (or a deemed asset sale under IRC Sec. 338(h)(10) or Sec. 336(e)) in 2016 will not be subject to the BIG tax.

 Planning for the Sale

With apologies to The Godfather, business owners never know when a potential buyer will make an offer that cannot be refused. Nor do they know when they will find themselves in circumstances under which the sale of their business, though not ideal, will make the most economic sense.

 Preparing for the sale of the business is an ongoing process, not a matter of just a few months. For this reason, business owners should stay abreast of changes in the tax laws, such as the PATH provisions described above, and should keep their tax advisers informed of changes in the business and its ownership. This will afford business owners the opportunity to avoid costly mistakes and to tailor the structure of the business so as to reduce their tax liabilities on its disposition.